microsoft word 05 preface.docx preface sixteen months ago in a comment during office hours, we raised the idea for a journal at columbia law school dedicated to tax law and policy. within a few weeks, student interest grew in support of the idea and sparked active discussion. over the course of last year, the proposal that developed brought together the perspectives of the faculty, administration, library, alumni and colleagues outside of academia, and students pursuing tax as their field of focus. it is our pleasure to introduce the inaugural issue of the columbia journal of tax law, the culmination of over a year and a half’s preparation. the field of tax has the attribute of attracting a diverse collection of backgrounds and perspective among the individuals who participate in its lively debates. it is a great asset of this field, and one of our principal sources of inspiration as we crafted the vision for this journal. the readers and authors of the scholarship in our pages draw from at least three distinct groups within the field of tax. they include the policymakers in federal, state, and foreign governments, practitioners in the private sector, and professors in academia. as we join an esteemed collection of academic and practitioner journals in tax, our endeavor is to be the first that serves as the single forum for these three main constituents. it is a need in the marketplace of tax discourse that is presently unmet, and one that we hope to fulfill. to that end, we have carefully selected the scholarship for the inaugural issue to bridge across these groupings within the tax audience. professor burke’s article is heavily informed by her extensive involvement with the congressional debate on carried interest reform. professor cui has been involved with, and continues active engagement in, the academic, practitioner, and policymaking areas of the field of tax in china, and sheds light on a topic actively sought out by investors and their advisors here in the u.s. professor zelenak presents an insightful policy commentary and academic perspective on computational complexity in the tax code. as we proceed to further issues and volumes, we will continue our endeavor to integrate the rich perspectives that the three constituents of the tax audience add to the discourse. bringing this journal to fruition was an enjoyable and invigorating task. we are the first new journal to receive the approval of the faculty of columbia law school in at least ten years. it is a source of great pride for us, and a testament to the near and long-term viability of this journal’s vision. as we join columbia’s family of scholarly law journals, we are humbled by the tradition they have established. we owe a very special thanks to prof. alex raskolnikov for his help in our efforts to cultivate and launch this journal. we have enjoyed his longstanding support and guidance ranging from the most mundane to iii the crucially challenging aspects of this journal’s development. we are additionally grateful to the founding editorial board and staff for their unwavering dedication in building this journal, developing its processes, and maintaining the entrepreneurial spirit vital to an endeavor of this nature. we hope this journal provides an informative and enjoyable read. suyash g. paliwal kathryn a. kelly editor-in-chief executive editor columbia law school february 2010 microsoft word 7 jensen.docx 262 book review the timing of income recognition in tax law and the time value of money. by moshe shekel. london & �ew york: routledge-cavendish, 2009. pp. xxxv + 327. $130. reviewed by erik m. jensen* american income-tax law, it has often been said, boils down to two big questions: character and timing. do away with capital gains preferences and limitations on the utility of capital losses, and the numbingly complex internal revenue code provisions aimed at preventing manipulation of character rules could disappear. doing so might not be a good idea for other reasons—even if there were no capital gains preference, it might still be desirable to have rules disfavoring recognition of capital losses1—but one unquestionable benefit of jettisoning the whole structure would be simplification. in contrast, it’s impossible to imagine how timing issues can ever disappear from an income-tax system. obviously they should be minimized—all contentious issues should be minimized—but questions about when income should be recognized and when deductions should be permitted will be with us until the end of time.2 and here too simplification could come at a cost. the tension between the desire for technical precision in timing rules and the desire for simplification of the tax law can’t be eliminated: simpler tax laws almost inevitably mean that more abuses will be tolerated.3 sometimes trading off simplification for abuse-prevention is * david l. brennan professor of law, case western reserve university. 1. that prevents using the realization rules to cherrypick losses. if capital losses could be used to offset ordinary income without limitation, the assumption is that taxpayers would disproportionately recognize losses while holding on to appreciated assets to defer gain recognition. 2. or until the end of the income tax, whichever comes first. 3. for example, the original issue discount rules had to be enacted to ensure that what is interest economically would be treated as such for tax purposes, and to make sure that issuers and holders of obligations with oid had symmetrical treatment. see i.r.c. §§ 1271– 1275, 163(e) (2010). but the rules were simpler before enactment of these provisions. i say that simpler rules “almost inevitably” mean that more abuse will be accepted because there is something to the argument that, if statutes (and regulations) become too detailed, and if, as a result, it becomes excessively costly to try to comply with them, excessive detail can 2010] timi�g of i�come recog�itio� 263 worth it, sometimes it’s not. moshe shekel has produced a prodigious piece of work on timing, the result of a major research project. shekel is a partner in an israeli law firm that he founded and is also a lecturer at tel aviv university. few american practitioners, even in down economic times, can afford the time to write a comprehensive, comparative study, systematically pulling together the doctrine and the controversies about doctrine in three sophisticated jurisdictions—the united states, the united kingdom, and israel. (it’s hard enough for us american lawyers to get a grasp on and critique american doctrine.) but that comprehensive, comparative work is exactly what shekel has given us. this is not a treatise, if by treatise you mean a systematic exposition of the technical rules in a format that will help a young associate trying to determine what the law of israel or the u.k. is on a particular question.4 shekel will inform you of the relevant timing rules along the way in his comparative work, but producing a hornbook wasn’t his goal. this is a scholarly work about policy issues associated with timing questions—a great thing to have done, but not everyone’s cup of tea. many american tax professionals might be skeptical about the value of such a work. why should a practitioner care what shekel has to say about timing issues in taxation around the globe? in particular, why should a practitioner care about policy discussions in other jurisdictions? sure, in working on a particular transaction, she might need to know the rules in the u.k., but why should she want to go beyond that? american practitioners should care for several reasons. for one thing, the time value of money knows no national boundaries. second, american lawyers, who tend to be provincial (you know who you are), can learn a great deal from the practices of other jurisdictions. as i noted, the real value of shekel’s book isn’t in planning transactions that cross national boundaries—we are often told how that is increasingly becoming the norm5—but it nevertheless behooves the american practitioner to know as much as she can about transnational taxation. most important is that international sensibilities make it possible to improve american law. american tax lawyers are engaged in public policy creation and criticism to a greater extent than their colleagues in most other actually decrease compliance. 4. there are still some associates left, i believe. 5. this point might be overstated. despite the constant hyping of globalization, i’m regularly struck by how many american tax lawyers have practices that include very little work with transnational implications. still, understanding other countries’ tax rules clearly helps many american lawyers. 264 columbia jour�al of tax law [vol. 1:262 legal disciplines in the u.s.—the relative public-spiritedness (and maybe even heroism?6) of the american tax bar has often been noted7—and learning derived from the experience of other countries can inform policy discussions in the u.s. indeed, the united states would be crazy not to look at what other countries are doing with timing issues. very smart folks elsewhere are thinking about very difficult topics that are conceptually similar, and sometimes identical, to their american counterparts. even those who are skeptical about importing ideas from other countries to interpret legal documents like the constitution and the internal revenue code should see nothing wrong with congress’s looking at the way other countries handle specific tax issues. if congress enacts into law a principle derived from the u.k., the most americentric among us has to treat that enactment as the law. or if congress uses policy discussions from israel to inform its own understanding of issues, even if it ultimately rejects the learning from abroad, what is there to complain about? to be sure, in looking to the laws of other nations, we need to be sensitive to political differences that might make importation of certain doctrines unworkable. for example, u.k. tax law is much more formalistic than its u.s. counterpart—styles of dress similarly differ—and american lawyers brandishing their substance-over-form knowledge are inclined to look down on formalism. (how, i’ve often heard it said, can a reasonable person not give primacy to the substance of a transaction?8) but formalism, as british academic john tiley has taught us in his critical review of u.s. substance-over-form doctrine, actually has a lot to be said for it.9 and, 6. see erik m. jensen, aside, the heroic �ature of tax lawyers, 140 u. pa. l. rev. 367 (1991) (discussing john grisham, the firm), reprinted in 54 tax notes 1557 (1992). i have it on good authority, however, that the title of this piece might not have been intended to be taken literally. 7. see, e.g., robert w. gordon, the independence of lawyers, 68 b.u. l. rev. 1, 48, 58–59 (1988) (noting role of tax bar in fighting to create a clean internal revenue code); robert w. gordon, corporate law practice as a public calling, 49 md. l. rev. 258, 274 (1990) (noting that the “tax bar . . . often has pushed for reforms of the tax code against the interests of many of its corporate clients”). but see david m. schizer, enlisting the tax bar, 59 tax l. rev. 331, 369–70 (2006) (arguing that tax advisors have an incentive to do no more than the minimum to avoid penalties, and, indeed, “the tax bar is highly motivated to undermine the effectiveness of [the disclosure] effort” through, for example, interpreting “reportable transaction” hypertechnically and burying the government in paper). 8. the controlling doctrine in u.s. tax law, however, is not that substance always controls over form. it is that substance controls unless form does. see boris i. bittker & lawrence lokken, federal taxation of income, estates and gifts ¶ 4.3.3 (3d ed. 1999). 9. see john tiley, judicial anti-avoidance doctrines: the us alternatives, 1987 brit. tax rev. 180; john tiley, judicial anti-avoidance doctrines: some problem areas, 1988 brit. tax rev. 63; john tiley, judicial anti-avoidance doctrines: corporations and 2010] timi�g of i�come recog�itio� 265 even if we ultimately come out on the side of a relatively substance-driven system, we should know the benefits of a more formalistic one.10 timing issues, the subject of shekel’s book, might initially seem to have little potential for chauvinistic exhibitions, but they can creep in. although he understands quite well that financial accounting and tax accounting serve different purposes,11 one of shekel’s ultimate arguments is that tax systems should adhere, as much as possible, to generally accepted accounting principles (gaap): [a]lthough following gaap with regard to the timing recognition of income and liabilities for tax purposes may result in some untaxed economic advantages in contradiction of tax values, attempts to prevent such untaxed economic advantages by deviating from gaap and transforming “liabilities” into “income” using tax accounting (created in ad hoc rulings of the courts) might violate other tax values.12 conclusions, 1988 brit. tax rev. 108. 10. we should also understand how differences between political systems might make formalism more workable in one system than another. a parliamentary majority can act relatively quickly to change formal rules to deal with newly discovered abuses. one reason that extra-statutory, anti-abuse doctrines developed in the u.s. is that congress can be slow to react. when a new form of abusive tax behavior is discovered, judges are forced to wonder, in effect, whether congress would have blessed particular behavior that seems to comport with statutory requirements, but that gives rise to results that are too good to be true. for the last decade or so, congress had considered codifying an economic substance doctrine, to give one judicially created anti-avoidance doctrine a statutory boost, and codification finally occurred in the recent healthcare legislation. see health care and education reconciliation act of 2010, pub. l. no. 111-152, § 1409, 124 stat. 152 (replacing the former i.r.c. § 7701(o), now appearing as i.r.c. § 7701(p) (as amended in 2010), with a new provision entitled “clarification of economic substance doctrine,” generally effective for transactions entered into after the date of enactment). resistance to codification had come in part from those fearful that codification might limit the flexibility, and therefore the utility, of the doctrine. see erik m. jensen, the us legislative and regulatory approach to tax avoidance, in comparative perspectives on revenue law: essays in honour of john tiley 99, 114 (john avery jones et al. eds., 2008). as it is, congress defined “economic substance doctrine” by reference to the common law, see i.r.c. § 7701(o)(5)(a) (as amended in 2010), but “clarified” the doctrine by requiring that both a meaningful change in the taxpayer’s economic position and a substantial non-tax purpose exist for “any transaction to which the . . . doctrine is relevant.” i.r.c. § 7701(o)(1) (as amended in 2010). 11. see thor power tool co. v. comm’r, 439 u.s. 522 (1979) (describing the different purposes of financial and tax accounting in concluding that, just because a write-down in the value of inventory might be appropriate for financial accounting purposes, it is not permissible under the income-tax system until a realization event has occurred). 12. shekel at xxxiv. 266 columbia jour�al of tax law [vol. 1:262 but—here’s the chauvinism—gaap rules are not the same throughout the world. shekel has to distinguish (as must we) between usgaap and ias (international accounting standard) gaap. although the united states is fighting a rearguard action on this one—the international market will inevitably force u.s. accounting principles to follow international norms—the u.s. has been resistant. we don’t generally accept the generally acceptable, as proponents of the metric system know. you’ve waited long enough and here—finally!—are some examples of the substantive issues shekel addresses: such things as the timing of recognition of income from deposits and advances—an accrualbasis taxpayer gets something but might not be permitted to keep it—and the timing of deduction for future expenses.13 how and when should a taxpayer take into account an obligation that will be satisfied only in the future? on these timing issues, shekel focuses on what he calls the collection question and the quantification question—that is, questions of when and how much.14 assume accrual-basis taxpayer a with a calendaryear taxable year has earned income according to gaap rules on april 1, 2010, but is not actually to receive payment until april 1 of the following year—and then with no provision for interest to take account of the passage of time. a clearly has income at some point. but when and in what amount? requiring a to recognize the entire amount yet to be received on april 1, 2010, would overstate his income in real terms: the present value on april 1, 2010, of $1000 to be received in a year is less than $1000. furthermore, because the two times straddle the end of a taxable year, the tax liability on the amount earned, if it has to be reflected in taxable income, might even have to be paid before the amount is actually collected. should we instead discount the amount of income in 2010 and, if so, how— and when—do we treat the additional amount that will eventually be received? or should a not be treated as having income at all until 2011, even though that result would clearly be inconsistent with financial accounting? those are serious issues, addressed differently by different tax regimes, and with no clearly right answers. (there are, however, clearly wrong ones. for example, no one could reasonably conclude that income should be recognized only in 2011 in the amount of the present value 13. i have written on some of these issues, and shekel kindly cited my work. see, e.g., erik m. jensen, the deduction of future liabilities by accrual-basis taxpayers: premature accruals, the all events test, and economic performance, 37 u. fla. l. rev. 443 (1985); erik m. jensen, the supreme court and the timing of deductions for accrualbasis taxpayers, 22 ga. l. rev. 229 (1988). 14. shekel at 1. 2010] timi�g of i�come recog�itio� 267 discounted to 2010.) the shorter the time between the two events, the less serious the problem, of course. and if the time is sufficiently short, everyone would agree, i think, that we can safely ignore the issues altogether (except, perhaps, for the end-of-year straddling). with longer time periods involved, however, a simple answer may make things, well, simpler, but at a technical cost. similar questions arise from the payor’s standpoint in the above transaction. let’s assume payor b is an accrual-basis taxpayer, and the expense is ordinary and necessary in character. when should the deduction be taken and in what amount? for a time in the united states, it was thought that the controlling rule (a liability could be deducted when all events had occurred that fixed the obligation, and the amount could be determined with reasonable certainty) permitted an accrual-basis taxpayer to deduct the full face amount of a future obligation, regardless of when the obligation would be satisfied.15 an obligation to pay $1000 in twenty years could have generated a $1000 deduction at the time the obligation was incurred, a nonsensical result. that led professor alan gunn famously to remark that, if that in fact were the law, “well-advised accrual-method businesses should cancel their liability insurance and run down pedestrians at the rate of at least one a year.”16 run a guy down today, deduct the full amount of the tort liability that might not have to be satisfied for years, and use the tax savings to cover the liability and a lot more.17 another example reflects similar questions of when and how much: c receives an advance or deposit that, under financial accounting standards, is not required to be included in income currently because it might have to be returned. income, if it is to be recognized at all, occurs when the recipient’s right to keep the funds becomes sufficiently clear. c nevertheless has the dollars in hand and can make use of them (always subject to the risk of repayment, however). u.s. doctrine generally requires recognition of income before gaap would treat the amounts as financial income.18 that has some sense to it because of the taxpayer’s control over 15. e.g., ohio river collieries co. v. comm’r, 77 t.c. 1369 (1981) (permitting current deduction for undiscounted amount of future reclamation obligation). 16. alan gunn, matching of costs and revenues as a goal of tax accounting, 4 va. tax rev. 1, 26 (1984). 17. the now generally applicable rules require that, in addition to satisfying the allevents test, the taxpayer may take a deduction no earlier than the occurrence of “economic performance.” see i.r.c. § 461(h) (2010). those rules often defer deductions (and can never accelerate them). and economic performance for a tort liability would occur only as payments are made, thus deferring the deduction (and destroying gunn’s tongue-in-cheek business strategy). see i.r.c. § 461(h)(2)(c) (2010). 18. see auto. club of michigan v. comm’r, 353 u.s. 180 (1957); am. auto. ass’n v. 268 columbia jour�al of tax law [vol. 1:262 the funds. in that case, deferring the time of recognition would have the effect of understating the amount of income. with common fact patterns like those, a lot of dollars can be at stake. shekel concludes that none of the three countries adequately deals with the collection and quantification questions, and he presents his own theoretically sophisticated proposal, the saving of financing costs (sfc) model. i’m not going to print it here, in part because i’d have to use a formula, and greek letters make me nervous.19 nevertheless, although i’ve been told that reviews aren’t supposed to tell how a book ends,20 a brief summary of the underpinnings of the sfc model is appropriate. the sfc model seeks to measure the benefits associated with the difference between the time of “cash flows” and the time that income or expense is recognized. for example, to the extent a taxpayer is not required to recognize income on receipt of a deposit, but is required to return the deposit with adequate interest, the taxpayer has received no economic benefit from the arrangement. in contrast, if the taxpayer has use of the deposited funds and the deposit must be returned without interest, the taxpayer has received a clear economic benefit, which can be measured by looking to comparable financing mechanisms. a similar analysis would apply on the liability side: compare the time the liability is taken into account with the time it must be satisfied.21 if the taxpayer benefits from the timing gap—again the analysis would take into account interest in comparable financing transactions—that benefit should be relevant for tax purposes. i wouldn’t like having to explain all of this in a basic federal income tax class, but the model is grounded in good sense. in his analysis, shekel has striven to take into account not only technical issues, but how the result comports with other tax values like equity, neutrality, certainty, efficiency, and so on. getting one issue “right” in a way that undermines other tax values is hardly a victory. one value of the sfc model is that it would preserve gaap;22 we wouldn’t have to start from scratch in implementing the sfc model. shekel devotes substantial time to describing debates in the united states, 367 u.s. 687 (1961); schlude v. comm’r, 372 u.s. 128 (1963); see also rev. proc. 2004-34, 2004-1 c.b. 991 (permitting limited deferral for advance payments in some circumstances). but see comm’r v. indianapolis power & light co., 493 u.s. 203 (1990) (not requiring utility company to treat security deposits as income). 19. i don’t like fraternities. 20. c.f. yogi berra, the yogi book: “i really didn’t say everything i said!” 97 (workman publishing company 1998) (the comic-book reading yogi berra asking his roommate, bobby brown—later dr. bobby brown—how the medical text brown was studying came out). 21. see shekel at 196–97. 22. see id. at 196. as noted, however, gaap isn’t universally accepted. 2010] timi�g of i�come recog�itio� 269 academic and professional literature, such as the debate about the matching principle (or the lack thereof) in american tax law.23 some think the matching principle is fundamental. others think no “principle” is involved at all. i was astonished at how familiar shekel is with the american literature on timing issues, and how useful the book therefore is as a research resource. (i cannot claim the same familiarity with u.k. and israeli sources, but i have no reason to think he has not been equally punctilious in his research there.) those of us who feed on controversy, even on mundane subjects like matching, like to read about controversy. the timing of income recognition is competently written, but at times the sledding is heavy. that isn’t really a criticism. shekel deals with issues that can be made simpler, but not simple. the reader needs to concentrate. (that’s probably the case with articles elsewhere in this journal as well.) and i have to admit that i did not understand all of the nuances of shekel’s argument on first reading. that’s not a criticism either.24 i intend to refer to the book regularly, and i expect to learn something each time. shekel does provide more than i wanted to know about some accounting practices. in most respects, that’s my problem, not his. i admire those who do want to know so much. and we certainly cannot ignore accounting issues in tax law. but we do need to remember that tax law is not only about accounting, nor is it the province only of accountants. whatever the rules are, tax advisors need to act appropriately. some recent scholarship has emphasized the critical role tax lawyers should play as lawyers in curbing abusive behavior—not because anything in circular 230, which sets out the standards professionals have to meet to practice before the internal revenue service,25 or any other set of professional-responsibility rules applies, but because behaving responsibly and exercising good judgment are part of being a lawyer. professor linda beale, for example, has argued that “the basic opinion practices [of circular 230] (e.g., thorough consideration of law and facts, rejection of unrealistic assumptions) are not substantially different from that which has traditionally been considered good lawyering.”26 in particular, tanina 23. see id. at 63–65. 24. here’s a real criticism: i wish shekel, his editors, and the proofreaders had been more careful in avoiding typos and transcription errors. for example, shekel gets some names horribly wrong. michael graetz comes out as michael grates in a place or two (although it is right elsewhere in the book). professor graetz is great, of course, but he does not grate. 25. 31 c.f.r. § 10. rules governing practice before the irs effectively become rules of tax practice more generally. 26. linda m. beale, tax advice before the return: the case for raising standards and denying evidentiary privileges, 25 va. tax rev. 583, 619 (2006). 270 columbia jour�al of tax law [vol. 1:262 rostain has argued that tax lawyers who have moved to accounting firms, which are technically not permitted to practice law,27 might be less inclined to view themselves in a professionally appropriate way.28 that scares me. i’m not sure it’s true, but it’s a troublesome point. get too immersed in the details, get too hypertechnical in your reading of authority, get too focused on accounting doctrines, and you might forget the larger picture. so let’s not overdo the reliance on accounting and accountants. but that’s a highfalutin point that hardly is central to what is really a fine book, worth dipping into again and again. besides, if you buy it for professional purposes, you should get a large deduction.29 to determine when you can take the deduction, however, and for what amount, you’ll need to study the timing of income recognition first. 27. what they do, however, often looks a lot like law practice. 28. see tanina rostain, sheltering lawyers: the organized bar and the tax shelter industry, 23 yale j. on reg. 77, 120 (2006). on a related point, peter canellos has contended that, although many shelter “professionals” have been lawyers, they have not adhered to standards that guide lawyers generally: “the tax shelter professional is a different breed, by experience, temperament, reputation, and calling. . . . tax shelter practitioners tend to be specialists rather than generalists and often suffer from the specialist’s lack of judgment.” peter c. canellos, tax practitioner’s perspective on substance, form and business purpose in structuring business transactions and in tax shelters, 54 smu l. rev. 47, 56 (2001); see also schizer, supra note 7 (discussing lawyerly failings). 29. i’m assuming authority exists for currently deducting a capital expenditure. note time for the child tax credit to grow up: preserving the credit's availability and enhancing benefits for families jennifer mcgroarty  abstract the child tax credit is one of the largest subsidies in the tax code for families with children. the ctc provides a supplementary boost to families by providing cash income when they do not have income tax liability. the ctc has more recently been used as an economic recovery measure and as a work incentive. however, the credit's own structure undermines its ability to serve these purposes. the credit should be structured such that it will further the program's key purposes and remain available to more lowincome families. some beneficial structural changes include permanently setting the refundability threshold at $3,000 and insulating the credit's provisions from inflation.  j.d. 2011, columbia law school; b.a. 2006, drew university. the author would like to thank anne lieberman for her outstanding editorial assistance and the members of the columbia journal of tax law for their comments and editorial work. 302 columbia journal of tax law [vol.2:301 i. introduction ................................................................................................... 302 ii. the child tax credit ................................................................................... 305 a. structure of the ctc .......................................................................................... 305 b. history of the ctc ............................................................................................. 306 c. availability and distribution of the ctc ............................................................. 310 iii. the ctc and other tax code subsidies for families and children ................................................................................................................ 312 iv. analysis .......................................................................................................... 317 a. the roles of the ctc ...................................................................................... 317 1. the ctc as an economic recovery measure and aid to impoverished families ....................................................................... 317 2. the ctc as a work incentive ...................................................................... 319 b. the structure of the ctc undermines its purposes ............................................. 321 1. the effects of inflation ................................................................................ 321 2. consequences associated with future structural changes to the ctc ........... 323 v. conclusion ...................................................................................................... 326 i. introduction for several decades, the government has used the tax code to provide subsidies for families caring for children. the child tax credit (ctc), enacted in 1997, is among these subsidies. over time, the ctc has become one of the largest subsidies benefiting children in the tax code. one of the primary benefits of the ctc is its refundability feature, which allows low-income families without any tax liability to receive a cash refund instead of a reduction of tax liability. the ctc sets forth a minimum level of income, called the refundability threshold, which families must meet in order to receive the refund. the ctc is currently in its most expansive itineration—the credit is at its highest level and the refundability threshold is at its lowest. the refundable portion of the credit is meant to serve as a supplementary boost to income for families with children. more recently, the credit has been used as an economic recovery measure as well as aid for low-income families, easing tax burdens 2011] time for the child tax credit to grow up 303 and helping to stabilize the financial condition of low-income families. the credit also acts as a work incentive similar to the earned income tax credit. the credit’s own structure, however, undermines its ability to serve these purposes. currently, the most beneficial aspects of the credit are subject to inflation and the threat of future expiration of provisions. 1 this inflation risk interacts perniciously with the refundability threshold, making the credit increasingly incapable of fulfilling its goals as inflation rises. additionally, expiration of certain provisions would decrease the effectiveness of the credit as an economic recovery measure, an aid for impoverished families, and an additional support for children. section ii of this note discusses the structure of the ctc, including the mechanics of the refundable portion of the credit. the most beneficial aspect of the credit is its refundability feature, which provides cash to low-income families if they do not have any federal income tax liability to offset against the credit. this section also discusses the history of the ctc, including its many revisions since its original enactment in 1997, as well as the availability and distribution of the ctc. the ctc’s benefits are disproportionately distributed to families with higher incomes, in part because of the statutorily set refundability threshold. if the threshold at which families can receive refunds is too high, then many low-income families in need will not receive any benefit from the credit. one potential solution for this problem would be to permanently reduce the refundability threshold to $3,000. at this level, the credit would continue to benefit the families most in need. building on section ii’s discussion of structure, section iii considers the interaction between the ctc and other tax code provisions that benefit children, such as 1 tax relief, unemployment insurance reauthorization, and job creation act of 2010, pub. l. no. 111–312, § 103(b), 124 stat. 3296, 3299 (2010). when this act expires, the ctc will revert to an earlier structure, with a changed value and refundability threshold. 304 columbia journal of tax law [vol.2:301 the earned income tax credit and the dependent exemption. section iv then goes on to discuss the varying roles of the ctc, including its role as a work incentive and an economic recovery measure. the ctc encourages work by providing disposable income, via the refundable portion of the credit, to families once their earnings reach a certain level, while functioning as an economic recovery measure by providing cash to needy families and reducing their tax burdens. this extra cash plays an important role in stabilizing income for low-income families in times of economic hardship. section iv also discusses how the structure of the credit interferes with its ability to act as a work incentive and economic recovery measure. the provisions of the ctc are especially vulnerable to inflation and are at risk of expiring in the coming years. the value of the credit may soon be reduced by fifty percent, as the legislation that increased the level of the credit is set to expire in 2013. at times, the government has considered reforms to the credit that would fix the refundability threshold at $3,000 and eliminate indexing the refundability threshold to inflation. 2 the most recent adjustment to the credit, in the tax relief, unemployment insurance reauthorization, and job creation act of 2010 (tax relief act), does not implement any changes to the ctc’s structure — rather, it merely extends the credit’s current provisions through 2013. unfortunately, the tax relief act does not take into account the negative effects associated with a future reversion of the credit’s value and refundability threshold. this note argues that the credit should be structured such that it will further the program’s key purposes and remain available to more low-income families. otherwise, when the credit value decreases to $500, from its current $1,000 level, and the refundability threshold increases in 2013, many families will experience significant 2 dep’t of the treasury, general explanations of the administration’s fiscal year 2010 revenue proposals 4–5 (2009), available at http://www.treasury.gov/resource-center/taxpolicy/documents/grnbk09.pdf. 2011] time for the child tax credit to grow up 305 economic hardship. 3 additionally, the credit should be reconfigured to insulate its value from inflation. when the refundability threshold is indexed to inflation, families have to make more money every year simply to keep up with the increasing refundability threshold to receive the credit. a permanent elimination of indexing would allow families whose wages do not keep up with inflation to still be able to receive the credit. 4 ii. the child tax credit a. structure of the ctc the ctc provides a credit of $1,000 to taxpayers for each child under the age of seventeen for whom a deduction is allowed under § 151 of the i.r.c. 5 the $1,000 credit may be used to offset existing tax liability. families without any tax liability may still benefit from the ctc, as a portion of the credit may be, depending on the family’s income level, refundable in a cash payment. 6 a taxpayer only becomes eligible to receive the cash refund once his earnings reach the statutory threshold. the current income threshold (―refundability threshold‖) is set at $3,000. families with incomes above the refundability threshold that do not have tax liability are eligible to receive in cash a portion of the value of the ctc. this refundable portion, known as the ―additional child tax credit‖ (actc) or ―refundable ctc,‖ is determined by calculating 15% of income above the refundability threshold, up 3 families with incomes at and above $10,000 would be eligible for a credit worth $1,000, but would only receive $500. see discussion infra part iv.b.2. 4 in general, low-income workers do not receive wages that rise to match inflation. the federal minimum wage is not adjusted annually to match inflation, and at times it has gone for almost a decade without an adjustment. see jared bernstein & isaac shapiro, ctr. on budget & policy priorities, nine years of neglect: federal minimum wage remains unchanged for ninth straight year, falls to lowest level in more than half a century 1-2 (aug. 31, 2006), http://www.cbpp.org/files/8-3106mw.pdf. 5 i.r.c. § 24(a) (2010). other relevant requirements for the credit are that the child be the taxpayer’s son, daughter, stepchild, foster child, brother, sister, stepbrother, stepsister, or a descendant of any of the relations listed, that the child have lived with the taxpayer for more than half of the year, and that the child did not provide over half of his own support for the year. i.r.c. §§ 24(c)(1), 152(c) (2010). 6 i.r.c. § 24(d). 306 columbia journal of tax law [vol.2:301 to the full value of the ctc ($1000). for instance, a family with income of $4,000 could receive $150 in cash (15% of the $1000 difference between the family’s income of $4,000 and the refundability threshold of $3,000). 7 the effect of this structure is that as earnings increase, the refundable portion of the credit increases as well, with families earning $1,000 above the threshold receiving $150, while families earning $2,000 above the threshold receive $300. the ctc becomes increasingly less available for taxpayers as income rises above a certain level (commonly referred to as a ―phase-out‖). the level at which the ctc begins to phase out is currently $75,000 for single individuals or $110,000 for married individuals filing jointly. 8 for each $1,000 (or fraction thereof) of agi over $75,000 for single individuals or $110,000 for married individuals filing jointly, the credit is reduced by a total of $50, with the reduction being unaffected by the number of children in the household. 9 b. history of the ctc the child tax credit was first enacted as part of the taxpayer relief act of 1997. 10 the credit had three stated objectives: (1) to reduce the income tax burden for 7 i.r.c. § 24(d)(1)(b)(i). taxpayers may receive as a refundable credit the lesser of the amount equal to 15% above the earnings threshold, and the amount equal to the portion of the credit not used to offset tax liability. for example, a household with earnings of $4,000 may claim a refund of up to $150 (15% of $1,000, the amount of earnings over the threshold of $3,000) if it has at least one qualifying child. this family must use the 15% figure ($150) because it is lower than the portion of the credit not used to offset tax liability ($1,000). the code also provides a separate test for determining the refundable portion of the credit for families with three or more qualifying children, found in i.r.c. § 24 (d)(1)(b)(ii). under this test, a taxpayer would be allowed a credit of the excess of his social security taxes for the taxable year over the credit allowed under § 32 for the taxable year. 8 i.r.c. § 24(b). 9 i.r.c. § 24(b)(2). 10 taxpayer relief act of 1997, pub. l. no. 105-34, § 101, 111 stat. 788, 796 (1997) (codified as amended at i.r.c. § 24 (1997)). 2011] time for the child tax credit to grow up 307 families with dependent children, (2) to recognize the financial responsibilities of raising children, and (3) to promote family values. 11 the value of the original ctc was set at $500 for the year in which it was passed and at $400 for tax years beginning in 1998. 12 the original credit was refundable only for families with three or more children. families were not required to meet a refundability threshold; rather, the amount of unused credit that was available as a cash refund was determined by looking at the amount of the taxpayer’s other nonrefundable personal credits and social security taxes. 13 the taxpayer relief act of 1997 set the phase-out level at $75,000 for single individuals, $110,000 for married couples filing jointly, and $55,000 for married individuals filing separately. 14 the credit, as originally enacted, was primarily valuable for middle-class families. 15 the credit was of little to no value to low-income households because many of these families did not have any income tax liability and the credit was only refundable for families with three or more children. high-income families, on the other hand, would not qualify for the credit because their incomes exceeded the phase-out level. 11 h.r. rep. no. 105-148, at 310 (1997); joint comm. on taxation, 105th cong., general explanation of tax legislation enacted in 1997, part two: taxpayer relief act of 1997. 12 pub. l. 105-34, title i, § 101(a) (codified as amended at i.r.c. § 24(a) (1997). 13 taxpayer relief act § 101 (codified as amended at i.r.c. § 24 (1997)); staff of the joint comm. on tax’n, 105st cong., general explanation of tax legislation enacted in 1997 (joint comm. print 1997). the explanation on page eight provides the following example of how the credit operates for a taxpayer with three or more children: ―assume that in 1999, a, an unmarried individual with three qualifying children and an adjusted gross income below $75,000, incurs a regular tax liability in excess of the tentative minimum tax in the amount of $1,000. assume also that a's employee share of fica taxes is $3,000. also assume that a is not entitled to any other credits. a is allowed a $1,000 nonrefundable credit, as limited by section 26(a). a is also allowed a refundable credit of $500 by reason of section 24(d). the amount of this credit is the lesser of (1) $1,500 (the credit that would be allowed under section 24(a) without regard to the tax limitation of section 26) or (2) $500 (the excess of $1,500 (the amount of subpart a credits which would be allowed if a's $3,000 social security taxes were added to the $1,000 section 26(a) limit) over $1,000 (the subpart a credits otherwise allowed)).‖ 14 taxpayer relief act § 101, pub. l. 105-34, title i, § 101(a) (codified as amended at i.r.c. § 24 (1997)). 15 leonard e. burman & laura wheaton, who gets the child tax credit?, 109 tax notes 387, 387 (2005), available at http://www.taxpolicycenter.org/uploadedpdf/411232_child_tax_credit.pdf. 308 columbia journal of tax law [vol.2:301 in 2001, the economic growth and tax relief reconciliation act (egtrra) substantially changed the credit by increasing both the value of the credit and its availability for low-income families. 16 egtrra was set to increase the credit level from $500 to $600 for years 2001-2004 and to further increase the credit value incrementally for tax years 2005-2010, reaching a credit level of $1,000 for 2010. 17 egtrra was scheduled to sunset after 2010, at which point the credit level would revert to the 2000 level of $500. 18 egtrra also significantly altered the refundability feature of the ctc. unlike the taxpayer relief act of 1997, which made the ctc only refundable for families with three or more children, egtrra extended the possibility of a refund to all families with children and created a refundability threshold, set at $10,000 for 2001 and indexed for inflation for each subsequent year. 19 egtrra limited the refundability of the credit to 10% of earnings in excess of the refundability threshold for tax years 2001-2004 and 15% of earnings in excess of the refundability threshold for tax years beginning in 2005. 20 although egtrra did not schedule the level of the credit to increase to $1,000 until tax year 2010, the jobs and growth tax relief reconciliation act of 2003 (jgtrra) increased the level of the credit to $1,000 for tax years 2003 and 2004. 21 16 economic growth and tax relief reconciliation act of 2001, pub. l. no. 107–16, § 201, 115 stat. 38 (2001). 17 id. according to the legislation, for the following tax years the per child amount of the credit is as follows: 2001, 2002, 2003, or 2004..............................................$600 2005, 2006, 2007, or 2008.................................................700 2009....................................................................................800 2010 or thereafter............................................................1,000. id. 18 egtrra § 901. 19 egtrra § 201. 20 elaine maag & adam carasso, tax policy ctr., taxation and the family: what is the child tax credit? (2011), www.taxpolicycenter.org/briefing-book/key-elements/family/ctc.cfm (last modified feb. 4, 2011). 21 jobs growth tax relief reconciliation act of 2003, pub. l. no. 108-27, §101, 117 stat 753 (2003). 2011] time for the child tax credit to grow up 309 jgtrra only affected the level of credit and left egtrra’s refundability provisions in place. in 2004, however, the families tax relief act of 2004 (wftra) increased the limitation on the refundability of the credit to 15% for tax year 2004, while also extending the $1,000 credit level from tax year 2004 through tax year 2009. 22 table 1. the ctc as enacted under the taxpayer relief act and as amended by the wftra, jgtrra and egtrra. source: http://assets.opencrs.com/rpts/rs21860_20060406.pdf for low-income families, the most common limitation on the portion of the credit received is not the size of the credit but is instead the limit on the amount of the credit that is refundable. families that do not have incomes high enough to incur tax liability only benefit from a tax credit to the extent that such a credit is refundable as cash. as discussed above, prior to egtrra the limitation on refundability was defined according to both the number of children a taxpayer had and the taxpayer’s nonrefundable personal credits and social security taxes. while egtrra changed the structure of the refundability limitation by introducing (1) an income threshold below which families were ineligible for a cash refund and (2) a percentage limitation on the credit value available, the subsequent reforms in jgtrra only increased the value of the credit. 22 gregg a. esenwein, congressional research service, crs report for congress, the child tax credit 3 (2006), http://assets.opencrs.com/rpts/rs21860_20060406.pdf (last updated april 6, 2006). 310 columbia journal of tax law [vol.2:301 since jgtrra left the refundability feature unchanged, this increase in the size of the credit did not necessarily translate into an increase in the benefits received by many lowincome families. 23 this problem was addressed by the american recovery and reinvestment tax act of 2009 (arra), which reduced the refundability threshold for tax years 2009 and 2010 from the egtrra level, which would have been $12,550 in 2009 24 , to $3,000. 25 the purpose of reducing the threshold to $3,000 was to increase the number of taxpayers eligible for the refundable credit and to increase the portion of the credit eligible taxpayers could receive. 26 the child tax credit provisions of the arra that reduced the refundability threshold were limited to tax years 2009 and 2010. 27 this past year, however, the tax relief, unemployment insurance reauthorization, and job creation act of 2010 (tax relief act) was enacted and extended the arra’s reduced refundability threshold of $3,000 through tax year 2013. c. availability and distribution of the ctc in 2007, the ctc distributed about $45 billion to thirty-one million families. 28 however, the distribution of the credit is not uniform across all income levels. families with higher incomes often receive more benefits than low-income families. 29 23 andrew lee & robert greenstein, ctr. on budget & policy priorities, how the new tax law alters the child tax credit and how low income families are affected 1 (may 29, 2003), http://www.cbpp.org/archivesite/5-28-03tax3.pdf. 24 maag & carasso, supra note 20. 25 american recovery and reinvestment act of 2009 [hereinafter aara], pub. l. no. 111-5, § 1003, 123 stat. 115, 313. because the threshold is indexed to inflation, in the absence of arra § 1003, the threshold would have risen to $12,550 for 2009 and $12,600 for 2010. 26 arra and the additional child tax credit, i.r.s., http://www.irs.gov/newsroom/article/0,,id=205670,00.html (last visited feb. 15, 2010). 27 arra § 1003. 28 maag & carasso, supra note 24. 29 id. 2011] time for the child tax credit to grow up 311 table 2. proportion of eligible families receiving the ctc and average credit received by income quartile, 2007 the primary structural feature of the ctc responsible for the disproportionate distribution of benefits is the level of the statutorily-set refundability threshold. for families with no income tax liability, the cash refund is the primary benefit received from the ctc. if a family’s income does not meet the threshold, they are prevented from receiving any cash refund. even if they do meet the threshold, families with a small in 2007, a larger proportion of eligible families in higher income quintiles with at least one child benefited from the credit than those in the lowest income quintile. sixty percent of eligible families in the fourth income quintile benefited from the credit, while only ten percent of eligible families in the lowest quintile benefited from the credit. additionally, families in higher income quintiles received a larger average benefit from the credit. the fourth income quintile received approximately $1,500 in benefits, while the lowest quintile received approximately $200 in benefits. 312 columbia journal of tax law [vol.2:301 difference between their incomes and the refundability threshold do not receive the full value of the credit. in 2007, approximately one-third of working families received less than the full credit because they earned too little and two-fifths of working families received no credit at all because the families’ incomes were below the refundability threshold. 30 under the egtrra-set refutability threshold, families with incomes just above the income threshold received fewer benefits than those with incomes significantly over the threshold. under egtrra, the refundability threshold was set at $10,000 for 2001 and was indexed to match annual inflation. in 2005, the refundability threshold was $10,750 31 , and in that year 95% of cash refunds went to the 65% of the ctc-eligible families with incomes between $20,000 and $200,000. 32 additional empirical evidence indicates that the largest beneficiaries of the refundable portion of the ctc are families with incomes between $75,000 and $100,000. 33 while a substantial majority of the refundable portion of the ctc is distributed to higher income families, only 14% of families with incomes between $10,000 and $20,000 receive the refundable portion. 34 iii. the ctc and other tax code subsidies for families and children since 1960, there has been significant growth in many of the government’s programs, especially those focusing on children. 35 federal spending on children’s 30 see id. 31 gregg a. essenwein, congressional research service, the child tax credit, crs rep. for cong. order code rs21860, available at http://assets.opencrs.com/rpts/rs21860_20060406.pdf. 32 burman & wheaton, supra note 15, at 390. these families tax burdens were reduced by $330 to $605. 33 id. 34 id. at 390. families with incomes between $75,000 and $100,000 receive an average benefit of $605, and one-third of these families claim an average tax credit of $1,729. families with incomes between $10,000 and $20,000 receive an average benefit of $80. id. 35 rebecca l. clark et al., the urban institute, federal expenditures on children: 1960– 1997 (2001), available at http://www.urban.org/url.cfm?id=310309. in this report published by the urban 2011] time for the child tax credit to grow up 313 programs has increased from $55 billion in 1960 to $354 billion in 2007, generally mirroring the growth of the economy over time. 36 as a share of gdp, spending on children’s programs grew 39%, from 1.86% to 2.59% over the same period. 37 initially, the dependent exemption 38 was the government’s main tax mechanism for distributing money to children. 39 however, by 1997, the exemption comprised only 16% of federal support for children. 40 as a percentage of gdp, tax credits and exemptions related to children have declined from 1.28% in 1960 to 0.94% in 2007. 41 this change reflects a 27% reduction in the use of the tax code to distribute money to children. though the use of tax credits and exemptions as a share of gdp has decreased over time, they are still important vehicles by which the government distributes money for the benefit of children. today there are more than a dozen tax programs that are directed at benefitting children; these programs remain the largest category of federal spending on children, totaling $128.1 billion in 2007. 42 institute, changes in federal spending on programs for children are examined. the report defined spending on children as federal programs for children and families across eight budget categories: tax credits and exemptions (including the earned income tax credit and the dependent exemption), income security (including aid to families with dependent children), nutrition (including food stamps), health (including medicaid), education, social services, housing, and training. the report analyzed changes in spending through these programs over time. 36 adam carasso et al. the urban institute, kids share 2008: how children fare in the federal budget (2008), available at http://www.urban.org/url.cfm?id=411699. during this time, total federal spending grew from $525 billion to $2,370 billion. however, during this period, there was a sharp decline in the amount of spending on children due to a failure to keep the dependent exemption current with inflation. the decrease in value of the dependent exemption was corrected in 1984, when the exemption began to be indexed for inflation. 37 id. at 11. 38 i.r.c. § 151 (2009). for 2009, the dependent exemption was $3,650. 39 carasso et al., supra note 36, at 3. 40 clark et al., supra note 35, at 7. 41 carasso et al., supra note 36, at 15. 42 id. at 15-16. 314 columbia journal of tax law [vol.2:301 in addition to the ctc, the dependent exemption and earned income tax credit 43 are two important tax mechanisms designed to subsidize childcare. these tax provisions share both structural similarities and differences with the ctc. like the ctc, the eitc is a refundable credit; families with no tax liability are eligible to receive a portion of the credit as a cash refund. 44 the eitc’s value ranges from $457 (for no qualifying children) to $5,657 (for three or more qualifying children). 45 unlike the ctc, a taxpayer becomes eligible for the eitc refund with the first dollar of earnings; whereas, that same taxpayer is not eligible for the refundable ctc until he earns $3,000 (the current refundability threshold). 46 additionally, unlike for the ctc, the phase-out for the eitc begins at a much lower level of income. in 2010, the phase-out level for the eitc was $13,440 if the taxpayer had no qualifying children and $43,279 if the taxpayer had three or more children. 47 finally, more low-income families receive benefits from the eitc than from the ctc. 48 in 2005, about twenty-two million families, representing 75-85% of eligible tax filers, benefited from the credit. 49 43 these three tax provisions are most commonly cited when referring to child benefits distributed via the tax code. see leonard e. burman et al. tax subsidies to help low-income families pay for child care (2005), available at http://www.taxpolicycenter.org/uploadedpdf/411190_tpc_discussionpaper_23.pdf. the government also spends billions on other types of financial support for children. in 2005, the government accountability office identified sixty-nine programs administered through ten agencies that provided support for prekindergarten and child care. for more information on these programs, see letter from marnie shaul, director, education, workforce, and income security issues, government accounting office, to michael b. enzi, lamar alexander & george v. voinovich, u.s. senators (june 2, 2005), available at http://www.gao.gov/new.items/d05678r.pdf. 44 ctr. on budget & policy priorities, policy basics: the earned income tax credit 1 (dec. 4, 2009), http://www.cbpp.org/files/policybasics-eitc.pdf. 45 id. 46 elaine maag, credits and exemptions for children, 124 tax notes 1375 (2009), available at http://www.urban.org/uploadedpdf/1001331_credits_children.pdf. 47 eitc income limits,maximum credit amounts and tax law updates, i.r.s., http://www.irs.gov/individuals/article/0,,id=150513,00.html (last visited march 21, 2011). the threshold may be a different amount depending on the taxpayer’s filing status. 48 gregory acs & margery austin turner, the urban institute, making work pay enough: a decent standard of living for working families (2008), available at http://www.urban.org/uploadedpdf/411710_work_pay.pdf. the eitc is currently the tax benefit that lowincome families are most likely to receive. 49 id. in 2006, a married-parent family with two children may have received the maximum credit of $4,536. id. 2011] time for the child tax credit to grow up 315 the dependent exemption, on the other hand, is not a credit like the ctc or the eitc. rather, the dependent exemption is a deduction claimed by a taxpayer that reduces his taxable income by a fixed amount for each qualifying child. 50 unlike the ctc, where only the refundable portion of the credit is subject to an income threshold, taxpayers may not claim the exemption at all until income reaches $12,000. the structure of the exemption also includes a phase-out, which has been adjusted several times in the past few years. 51 currently, the dependent exemption begins to phase out when income reaches $150,000 for married individuals filing jointly or $100,000 for unmarried individuals. 52 table 3. value of child benefits at various income levels: single parent with two children (2009) source: elaine maag, credits and exemptions for children 53 50 elaine maag, who benefits from the dependent exemption?, 129 tax notes 1275, 1355 (2010), available at http://www.urban.org/uploadedpdf/1001478-tax-facts-dependent-exemptionmaag.pdf. the current value of the exemption is $2,000. 51 id. 52 i.r.c. § 151(d)(3) (2010). 53 maag, credits and exemptions for children, supra note 46, at 1. this figure shows that the eitc reaches its maximum value of $5,028 when a single parent’s earnings reach $12,750, and maintains 316 columbia journal of tax law [vol.2:301 the refundable portion of the ctc becomes available over the part of the income range in which the eitc reaches its maximum availability and subsequently phases out. once the eitc has phased out and is no longer available to families, the ctc will still be available because the ctc’s phase-out occurs at a much higher income level. 54 for example, as seen in table 3, a single taxpayer with two children will receive no benefit from the eitc once his income reaches $40,000, but will continue receiving the ctc. once the taxpayer’s income reaches $115,000, he can only benefit from the dependent exemption. 55 tax benefits provide money directly to children’s parents, the taxpayers, and the government has generally moved during the past several decades towards proving benefits in this way. the eitc, for example, signaled a shift away from in-kind benefits towards programs that give parents discretion on how to spend the benefits. such an approach has both benefits and costs, as the discretion that may help families meet their individual needs must be balanced against the need to ensure that the money is spent on true necessities for children. 56 in addition to changes in the structure of benefits for children, there has also been a shift in which children are the intended beneficiaries, with programs that had provided benefits to all children shifting towards focusing on providing benefits specifically to poor children. from 1960 to 2007, the portion of federal spending on poor children as a share of federal spending on all children rose from 11% to 59%. 57 the shift from broad this value until income reaches $16,420, where the credit begins to phase-out. the ctc reaches its maximum level for a family with two children when income reaches $16,333 and beings to phase-out when earnings exceed $75,000. at the same time, the benefit of the dependent exemption phases-in and increases as the taxpayer crosses the threshold into a higher bracket. 54 elaine maag, tax credits, the minimum wage, and inflation, the urban-brookings tax policy ctr. (2007), available at http://www.urban.org/publications/311401.html. 55 maag, credits and exemptions for children, supra note 46. 56 clark et al., supra note 35, at 12-13. 57 carasso et al., supra note 36, at 3. 2011] time for the child tax credit to grow up 317 based programs that benefited most families to targeted programs that benefited lowincome families took place through the use of programs, such as the ctc, in which benefits are phased out at steep rates as income increases. 58 this trend can also be seen in the rise of the eitc as the most prominent tax transfer mechanism for poor families. 59 iv. analysis the ctc was originally enacted to help families with children by reducing their tax burdens and by providing cash refunds if they insufficient tax liabilities. the ctc also serves other roles, such as that of an economic recovery measure and a work incentive. these goals, however, are undermined by the structure of the credit, which does not work to effectively achieve these purposes. specifically, the credit’s purposes are hindered by the effects of inflation on the credit’s value and by the future expiration of several structural provisions, including those increasing the credit’s value and those lowering the refundability threshold. a. the roles of the ctc 1. the ctc as an economic recovery measure and aid to impoverished families the refundablity threshold of the ctc was most recently reduced to $3,000 in the arra, as part of an economic recovery program, in order to provide greater benefits to low-income families. the increased availability of the refundable portion of the credit, due to the lower refundability threshold, provided cash to low-income families that would 58 id. 59 clark et al., supra note 35, at 9. in 1980, the eitc expenditure was approximately $3.7 billion. by 1997, the expenditure has reached $27.1 billion, surpassing the dependent exemption and becoming the largest tax program aimed at benefiting children. 318 columbia journal of tax law [vol.2:301 likely spend this additional income. 60 for tax year 2009, this change affected 15.8 million children, as they either became eligible for the cash refund or became eligible to receive a larger cash refund than they would have received under the scheduled egtrra threshold of $12,550. 61 this increased eligibility had a substantial effect on the families of these children. for a family with two children and combined annual income of $10,000, the refundable portion of the credit for 2009 was 400% higher than the refundable portion of the credit for 2008. 62 the expansion of the credit in the arra was enacted as part of an economic recovery program, but another effect of the expansion has been to help fight against the trend of rising child poverty and hardship. 63 this effect is more important than ever, as the recession has caused the unemployment rate to increase, from 5.8% in 2008 to 9.6% in 2010, and has left approximately 23% of the total population with income below the poverty level in 2009. 64 if the refundability threshold were to increase to the egtrra levels, an estimated 18 million children aged 16 and under with working parents would lose at least part of their refundable portion of the credit. additionally, 600,000 of these children would be pushed into poverty due to this change. 65 60 nat’l women’s law ctr., family tax credits in the american recovery and reinvestment act of 2009 1 (2009), available at http://www.nwlc.org/resource/family-tax-creditsamerican-recovery-and-reinvestment-act-2009-american-opportunity-tax-cre. 61 arloc sherman, ctr. on budget & policy priorities, recovery agreement temporarily expands child tax credit for large numbers of children in every state 2 (2009), http://www.cbpp.org/files/2-12-09tax.pdf. 62 family tax credits, supra note 60, at 1-2 (―parents with two children earning $10,000 a year, who are eligible for a refundable ctc of $225 for 2008 (0.15($10,000-$8,500)), would be eligible for a refundable ctc of $1,050 in 2009 and 2010 (0.15($10,000-$3,000)). (if they had only one child, they would be eligible for a maximum of $1,000.) compared with 2008, this change will make 2.9 million more children eligible for the credit and increase the credit for an additional 10 million children.‖). 63 id. 64 bureau of labor statistics, employment and earnings january 2011: household data annual averages, available at http://www.bls.gov/cps/cpsa2010.pdf 65 arloc sherman & marybeth j. mattingly, over 3 million low-income children in rural areas face cut in child tax credit if recovery act improvement expires, ctr. on budget & policy priorities (2010), available at http://www.cbpp.org/cms/index.cfm?fa=view&id=3210. 2011] time for the child tax credit to grow up 319 the refundability feature of the ctc is also important in the fight against poverty because the cash received by families helps to stabilize income. on a macroeconomic level, refundable credits have an important effect on stability, in the face of economywide economic shocks, by smoothing consumption. for low-income families, refundable credits are especially important because during times of financial hardship these families may not have easy access to credit and, without assistance, such hardships may persist over long periods of time and may even be passed on to younger generations. 66 a refundable credit may reduce the impact of tax burdens in recessionary periods as well as lessen the impact of wage reductions, job disruptions, or job turnover. 67 2. the ctc as a work incentive the eitc was enacted in 1975 and was designed to encourage taxpayers to become, and remain, employed by helping to offset the payroll taxes of low-wage taxpayers. 68 today, the eitc may have the effect of providing a supplementary boost to income by up to 40% for families with the lowest, but still positive, level of earnings. 69 empirical work has shown that the eitc has a strong positive effect on work by single 66 lily l. batchelder et al., efficiency and tax incentives: the case for refundable tax credits, 59 stan. l. rev. 23, 58 (2007). there are also a number of arguments against the use of refundable tax credits, some of which the article discusses. one concern is that the government should not be engaging in redistribution of wealth between different income groups. however, that argument is not strong enough to reject the use of refundable credits to subsidize socially beneficial behavior. another argument against the use of credits suggests that all americans should pay some taxes, as part of their duty to the country and as a way to feel invested in the country’s decision making. however, this argument fails to acknowledge that low-income families do pay taxes outside of the federal income tax, such as other federal, state and local taxes. further, over time, many of the families who receive the credit have a net positive federal income tax liability. this note is written under the assumption that wealth redistribution via the tax code in this context is desirable. 67 anne alstott, why the eitc doesn’t make work pay, 73 law & contemp. probs. 285, 308 (2010). 68 ctr. on budget & policy priorities, policy basics: the earned income tax credit 1 (dec. 4, 2009), available at http://www.cbpp.org/files/policybasics-eitc.pdf. 69 maag, tax credits, the minimum wage, and inflation, supra note 54, at 2. 320 columbia journal of tax law [vol.2:301 parents 70 and this is likely to be equally true for the ctc due to the structural similarities between the two programs. because both programs condition benefits on having earned income, they both help to incentivize employment by the taxpayers benefitting from them. if the goal of the ctc is to encourage taxpayers to work, then the credit must be structured in a way that increases the disposable income for low-income families while at the same time preserving incentives to earn more income. 71 permanently fixing the refundability threshold at a reduced level will strengthen the link between the ctc’s benefit and employment by bringing the ctc’s structure even more in line with that of the eitc. 72 a taxpayer who earns $5,000 a year will have less incentive to work more if he feels that the $12,550 threshold, the former threshold for 2009, is unattainable. however, at a lower threshold the taxpayer receives the benefit of more work sooner and is therefore more encouraged to work. many programs that incentivize low-income taxpayers to be employed present a ―catch-22‖ for families. this is because a credit’s phase-in, where benefits increase along with earnings, creates an incentive to work, while a credit’s phase-out, where benefits decrease as earnings rise above a certain level, creates disincentives to work. 73 today, seven out of ten low-income families have at least one working parent. 74 for many families additional work, either via a second worker, higher wages, or additional 70 david t. ellwood, the impact of the earned income tax credit and social policy reforms on work, marriage, and living arrangements (2000) available at http://www.northwestern.edu/ipr/jcpr/workingpapers/wpfiles/ellwood_eitc99_update.pdf. 71 acs & turner, supra note 48, at 8. 72 i.r.c. § 32 (2010). as discussed, the eitc's refundability feature is triggered with the first dollar of earnings. 73 ellwood, supra note 70. 74 shelley waters boots et al., the urban institute, family security: supporting parents’ employment and children’s development (2008) available at http://www.urban.org/uploadedpdf/411710_work_pay.pdf. 2011] time for the child tax credit to grow up 321 hours, does not result in a substantial increase in disposable income because the family becomes disqualified from several support programs as income rises. 75 many question why the ctc uses work incentive phase-ins for eligibility when low-income families are already subject to work incentives delivered via the eitc. 76 if the ctc is meant to be a child subsidy, then the threshold, by acting as a work incentive and excluding many families who are in need of the credit, contravenes its primary purpose. 77 when viewed primarily as a subsidy for children, the notion that many families who need the most help receive little or no help from the ctc is difficult to understand. 78 b. the structure of the ctc undermines its purposes 1. the effects of inflation the ctc is effective as a support measure for low-income families when the refundability threshold is low and credit value is high, but both its value and availability over time are eroded by inflation. there are two structural components of the ctc that make its provisions especially vulnerable to inflation. first, the amount of the credit remains fixed, causing the value of the credit to decline each year because of inflation. secondly, the refundability threshold is indexed to inflation, which has the effect of reducing the availability of the credit to low-income taxpayers with each passing year. if the refundability threshold is indexed to inflation, families need to earn more money each year to continue to qualify for the new, higher threshold. 79 structuring the refundability threshold this way hurts low-wage earners whose wages stagnate because 75 acs & turner, supra note 48, at 1. 76 burman & wheaton, supra note 15. 77 id. at 387; boots et al., supra note 74, at 7. 78 burman & wheaton, supra note 15. 79 see sherman, supra note 61. under egtrra, the threshold was set at $12,000. each year, the threshold would rise, or indexed, to match inflation. under this structure, due to inflation, the threshold would have risen to $12,550 for 2009 and $12,600 for 2010. 322 columbia journal of tax law [vol.2:301 they will not be able to meet the inflation indexed rising refundability threshold. in 2007, when the credit level was set at $1,000, the minimum wage remained at 1997 levels and had not been increased to match the inflation of the previous decade. 80 the first solution for these issues is to build automatic adjustments into the credit value in order for the credit to keep pace with inflation. other credits, such as the eitc, have automatic adjustments embedded in their structure. 81 however, even if the ctc had an automatic inflation adjustment built in, workers whose incomes fail to rise along with inflation would still receive a smaller refundable portion of the credit. depending on a taxpayer’s level of income, an increase or decrease in income may result in an increase or decrease in the refundable portion of the credit received by the taxpayer. if the taxpayer’s income is in the phase-in range, he receives a larger refundable portion of the credit as his income increases. if a taxpayer, on the other hand falls in the phase-out range, then a drop in his income will increase the amount of the credit received. 82 with regards to the refundability threshold, two helpful changes would be to either eliminate indexing of the threshold or to eliminate the threshold altogether. if the threshold were eliminated completely then the credit would be refundable starting with the first dollar of earned income, thus functioning in fashion similar to that of the eitc. the effect of this change would be to increase the amount of the credit that a family would qualify for, resulting in an increase equivalent to $0.77 per hour in earnings for a minimum wage worker with one child. 83 alternatively, the effect of eliminating indexing 80 see bernstein & shapiro, supra note 4. 81 the value of the eitc is indexed for inflation. i.r.c. § 32(j) (2010). 82 maag, tax credits, the minimum wage, and inflation, supra note 54, at 2-3. 83 id. these calculations use the 2006 levels for the credit and the 2006 minimum wage as a baseline. id. 2011] time for the child tax credit to grow up 323 would be to end the ―phenomenon of declining credits for workers with stagnating earnings‖ described above. 84 2. consequences associated with future structural changes to the ctc future structural changes to the ctc will hinder its ability to serve as an aid for families with children, to help those in poverty, and to function as a work incentive. when the current ctc structure expires after 2012, with the expiration of the extension promulgated in the tax relief act, the credit will return to its egtrra structure. the credit’s value will therefore fall from $1,000 to $500 and the refundability threshold will no longer be set at $3,000. there are several problematic consequences associated with this reversion in the credit’s structure, including an increase in the effective marginal tax rate (emtr) of low-income families and a decrease in the significance of the ctc as a subsidy for needy families with children. allowing this reversion would increase the emtr of low-income families who are in the phase-in range. 85 one problem with such an increase in the emtr is that it reduces the rewards associated with earning more income, because each additional dollar of earnings is taxed at a higher rate. 86 a reduction in credit value increases emtrs for families with lower incomes, hindering the use of the credit as a work incentive and resulting in an unraveling of the benefits associated with the original increase in the credit’s value from $500 to $1,000. this unraveling occurs because the incentive effects of the credit over the phase-in 84 id. at 7. 85 katherine lim & jeffrey rohaly, the impact of the presidential candidates’ tax proposals on effective marginal tax rates, the urban-brookings tax policy ctr. (2008), available at http://www.urban.org/url.cfm?id=411759. the ―effective marginal tax rate‖ (emtr) is the proportion of an additional dollar of income that is paid in federal income tax. emtrs are different from the statutory marginal tax rates due the effects of phase-in and phase-outs of available credits and deductions in the tax code. 86 id. at 4. 324 columbia journal of tax law [vol.2:301 period are curtailed if the phase-in is shorter and the maximum refundability level is reached at a low earnings level. much of the benefit associated with the increased availability of the refundable credit, via the lower refundability threshold, will be offset by a reduction in the value of the credit, from $1,000 to $500, if the current structure expires. structured with a $3,000 refundability threshold and a $500 credit value, the credit’s value will become a significant limitation on the refundable portion of the credit received by a taxpayer. the refundable portion of the credit will also become fully available at a very low earnings level. the 15% limitation on the portion of the credit that is refundable will play a smaller role in limiting the refundable portion of the credit. 87 this is because if the credit’s value is too low, then 15% of earnings over the threshold quickly outpace the value of the credit itself. for example, if the credit is limited to $500, a taxpayer receives the full value of the credit when his income reaches $6,350 and there is no room for the value of the credit to increase in tandem with earnings because the refundable portion of the credit’s value is already maxed out. a taxpayer with an income of $7,000 would be eligible for a $600 refund under the 15% limitation, but would be limited to a $500 refund because of the new, lower level of the credit. this structure is far more restrictive than the current structure of the credit. 88 87 i.r.c. § 24(d)(1)(b)(i) (2010). 88 see discussion supra part ii.a. 2011] time for the child tax credit to grow up 325 table 4. availability of the ctc, $500 credit level refundability threshold earned income credit available credit received $ 3,000 $ 4,000 $ 150 $ 150 3,000 5,000 300 300 3,000 6,000 450 450 3,000 6,350 503 500 3,000 7,000 600 500 3,000 8,000 750 500 3,000 9,000 900 500 3,000 10,000 1,050 500 additionally, a significant number of families that have been receiving the credit for a number of years will see their benefits greatly reduced. those with incomes at or above $10,000 will have received credits of $1,000 for tax years 2009 through 2012, but following expiration they would only receive $500. the reduction in the value of the refundable portion of the credit would decrease the significance of the ctc as a subsidy for needy families with children. if the stated goal of the ctc is to aid families with the many expenses related to raising a child, then a reduction in credit value would undermine the credit and hurt lowincome families. for many families childcare expenses can comprise a large portion of the family budget. in 1997, low-income families spent an average of $217 per month on child care, an expenditure equaling approximately 16% of their total income. 89 the 89 linda giannarelli & james barsimantov, the urban institute, child care expenses of america’s families 2, 7-8 (2000), available at http://www.urban.org/url.cfm?id=310028. 326 columbia journal of tax law [vol.2:301 amount of income devoted to a family’s childcare budget could affect whether a family becomes reliant upon public or other family assistance. 90 a program, such as the ctc, that is aimed at reducing poverty and providing assistance to low-income families should be judged by the adequacy of its ability to provide adults and their children a decent standard of living on par with prevailing social standards. 91 a significant change in the credit’s value may substantially affect poverty levels and deprive intended beneficiaries of necessary assistance. 92 v. conclusion the ctc is one of several government programs that deliver assistance to families via the tax code. congress originally acknowledged the special needs of families with children with the enactment of the credit and intended that the credit reduce some of the financial burdens associated with raising children. tax credits are useful tools to distribute money to low-income families to meet these expenses and combat poverty, as low-income families benefit more from a tax credit than they do from a deduction due to the value of a tax credit being independent of their tax rates. refundable credits in particular benefit these families because they provide cash to a family that does not have any tax liability, a not uncommon situation for families with especially low incomes. these provisions are particularly important given the current state of economic distress because low-income families and their children are especially vulnerable to economic instability and high unemployment. 90 id. 91 alstott, supra note 67, at 291. the eitc’s effect on poverty is often judged using such normative standards. 92 sheldon danziger & peter gottschalk, the impact of budget cuts and economic conditions on poverty, 4 j. pol’y analysis & mgmt. 587 (1985). the effect of transfer programs effecting poverty levels was evident through the late 1960s and 1970s when the increases in social security corresponded with a decrease in poverty rates among the elderly. 2011] time for the child tax credit to grow up 327 there are several improvements that could be made to the child tax credit to help it better serve its purposes. first, the consequences associated with a reversion in the credit’s structure after 2013 should be considered. when the credit’s value reverts to $500, the ctc will no longer be a meaningful subsidy for low-income families. the maximum refundable value of the credit will peak at a very low level of income and families with incomes over this amount will be limited to a very small refundable portion of the credit. families with income as low as $10,000 will see their ctc benefit reduced by 50%. the value of the credit should therefore be set at the $1,000 level and indexed to inflation so that it remains an effective subsidy for all low-income families. additionally, the refundability threshold of $3,000 should be made permanent. this would continue the extension of ctc benefits to families with incomes below $12,000 who were excluded from receiving the benefits under the threshold of previous legislation. another adjustment would be to eliminate indexing the threshold to inflation. this amendment to the structure of the credit would benefit low-income families because indexing the threshold to inflation punishes taxpayers whose earnings do not keep pace with inflation by making them less eligible with each passing year. these adjustments would allow the ctc to better provide benefits to low-income families in need of financial support, unhindered by rising inflation or the threat of future expirations of benefit provisions. lusztig3-1-3 note deducting the cost of sex reassignment surgery: how o’donnabhain v. commissioner can help us make sense of the medical expense deduction tamar e. lusztig* abstract in february 2010, the tax court held that a taxpayer’s expenses incurred for hormone therapy and sex reassignment surgery were deductible as medical expenses under § 213 because they treated the disease of gender identity disorder. the court, however, was deeply divided in its determination of whether sex reassignment surgery qualifies as nondeductible cosmetic surgery under § 213(d)(9). in 1990, congress amended § 213 to exclude cosmetic surgery from the definition of deductible medical care. since then, the tax court and the i.r.s. have rarely addressed the meaning and extent of that exclusion. the judges’ divergent opinions in o’donnabhain make it clear that a thorough examination of the statutory meaning of cosmetic surgery is timely. this note considers what should qualify as cosmetic surgery within the context of the medical expense deduction. it argues that a medical procedure that improves physical appearance should be deductible under § 213 when it is physician-prescribed treatment for a specific disease, and consistent with generally accepted medical practice. this analysis is grounded in the statutory language of § 213, and is supported by broader principles that bear on the policy debate surrounding the medical expense deduction more generally. * j.d. 2012, columbia law school. i am grateful for the many comments, criticisms, and suggestions from professor michael j. graetz. i would also like to thank the editorial board and staff members of the columbia journal of tax law. 2011] deducting the cost of sex reassignment surgery 87 i.
 introduction...................................................................................................... 88
 ii.
 the tax policy debate about the medical expense deduction .................................................................................................................................... 88
 a.
 tax expenditures ................................................................................................. 88
 b.
 defense of the medical expense deduction........................................................ 89
 c.
 criticism of the medical expense deduction ...................................................... 92
 d.
 the role of the medical expense deduction ...................................................... 93
 iii.
structure and scope of the medical expense deduction......... 95
 a.
 general statutory scheme.................................................................................... 95
 1.
 mechanics of the deduction .......................................................................... 95
 2.
 relationship to health insurance................................................................. 98
 b.
 cosmetic surgery................................................................................................. 99
 1.
 early treatment of cosmetic surgery ........................................................... 99
 2.
 enactment of § 213(d)(9) ............................................................................ 100
 iv. o’donnabhain v. commissioner .................................................................. 103
 a.
 the controversy and the internal revenue service’s position ......................... 103
 b.
 the tax court opinions .................................................................................... 105
 c.
 analysis.............................................................................................................. 108
 v.
 conclusion ........................................................................................................ 111
 88 columbia journal of tax law [vol.3:86 i. introduction the tax court recently held in o’donnabhain v. commissioner 1 that a taxpayer’s expenses incurred for hormone therapy and sex reassignment surgery (“srs”) were deductible as medical expenses under § 213 because they treated the disease of gender identity disorder (“gid”). the court, however, was deeply divided in its determination of whether srs qualifies as nondeductible cosmetic surgery under § 213(d)(9). the judges’ divergent opinions make clear that a thorough examination of the statutory meaning of cosmetic surgery is timely. medical expenses are permitted as itemized deductions to the extent that, in the aggregate, the amount of such unreimbursed expenses exceeds 7.5% of a taxpayer’s adjusted gross income (“agi”), or 10% of his agi for the purposes of the alternative minimum tax (“amt”).2 section 213(d) provides that deductible medical care includes amounts paid for the diagnosis, cure, mitigation, treatment, or prevention of disease. in 1990, congress amended § 213 to exclude cosmetic surgery from the definition of medical care.3 since then, the tax court and the i.r.s. have rarely addressed the meaning and extent of this exclusion. this note considers what qualifies as cosmetic surgery within the context of the medical expense deduction. part ii examines the role of the medical expense deduction and surveys the policy debate about the deduction. part iii considers the statutory language of § 213 as well as case law that has interpreted § 213. part iii closes by proposing a two-part test for the deductibility of medical procedures that also improve physical appearance. under this test, physician-prescribed treatment for disease that is consistent with generally accepted medical practice is not cosmetic surgery. part iv analyzes the controversy in o’donnabhain, and concludes that srs that is prescribed to treat gid is not cosmetic surgery. this interpretation of § 213 is grounded both in the statutory language and in the policy guidelines established in part ii. ii. the tax policy debate about the medical expense deduction a. tax expenditures the academic debate about the medical expense deduction has traditionally been over whether the deduction is a tax expenditure. an ideal income tax has been described as one in which all personal income is taxed uniformly and comprehensively.4 the tax expenditure concept is generally attributed to professor stanley surrey.5 in his book written with professor paul mcdaniel, surrey argued that a number of tax code provisions are departures from an ideal income tax and instead consist of special preferences for certain taxpayers or activities.6 according to surrey and mcdaniel, these 1 134 t.c. 34 (2010) , acq. 2011-47 i.r.b. 2. 2 i.r.c. §§ 213(a) (west supp. 2010), i.r.c. 56(b)(1)(b) (west supp. 2010). 3 see infra part iii.b.2. 4 see william d. andrews, personal deductions in an ideal income tax, 86 harv. l. rev. 309, 317 (1972). 5 see stanley s. surrey & paul r. mcdaniel, tax expenditures (1985). 6id. at 3 (“the tax expenditure concept posits that an income tax is composed of two distinct elements. the first element consists of structural provisions necessary to implement a normal income tax . . . . the second element consists of the special preferences found in every income tax. these provisions, often 2011] deducting the cost of sex reassignment surgery 89 “nonneutral” provisions are suspect alternatives to direct grants or other government assistance programs. 7 surrey and mcdaniel identified two major flaws of tax expenditures.8 first, tax expenditures are inequitable because they are upside-down subsidies.9 the tax code’s progressive rate structure means that tax expenditures in the form of exclusions or deductions benefit high-income taxpayers more than low-income taxpayers and provide no benefit at all to persons with no tax liability.10 tax expenditure deductions are also not progressive because they are itemized deductions and thus not available to taxpayers who take the standard deduction.11 second, tax expenditures are inefficient means of achieving their purposes because they often incentivize counterproductive distortions of taxpayer behavior.12 several government entities promulgate tax expenditure budgets, which characterize certain tax code provisions as government expenditures and estimate the lost revenue due to these provisions.13 the medical expense deduction, among other personal deductions, is included as a tax expenditure in these annual budgets.14 scholars are divided on whether the medical expense deduction is appropriately characterized as a tax expenditure. tax expenditure analysis urges that tax expenditure deductions are inefficient and inequitable. if the medical expense deduction is an expenditure, it may contravene progressivity and be a subsidy to wealthy taxpayers.15 this section will examine the long-standing debate on this issue. b. defense of the medical expense deduction defense of the medical expense deduction comes in different forms. the seminal defense is the 1972 article written by professor williams andrews.16 andrews begins his analysis with the classic haig-simons definition of income.17 henry simons described called tax incentives or tax subsidies, are departures from the normal tax structure and are designed to favor a particular industry, activity, or class of persons.”). 7 id. but cf. david a. weisbach & jacob nussim, the integration of tax and spending programs, 113 yale l.j. 955, 1026-27 (2004) (arguing that tax expenditures are legitimate and useful substitutes for direct government grants). 8 surrey & mcdaniel, supra note 5, at 79-87. 9 id. at 79-82. 10 id. see also andrews, supra note 4, at 310-11; jeffrey h. kahn, personal deductions–a tax “ideal” or just another “deal”?, 2002 l. rev. mich. st. u. det. c.l. 1, 4 (2002). 11 see surrey & mcdaniel, supra note 5, at 79-82; thomas d. griffith, theories of personal deductions in the income tax, 40 hastings l.j. 343, 352-53 (1989). but see griffith, supra at 355-60 (arguing that there are alternative ways to judge tax progressivity). 12 see surrey & mcdaniel, supra note 5, at 82-87. 13 see, e.g., staff of joint comm. on tax’n, 111th cong., estimates of federal tax expenditures for fiscal years 2009-2013 (joint comm. print 2010), available at http://www.access.gpo.gov/congress/joint/hjoint01cp111.html; office of mgmt. & budget, fiscal year 2012, analytical perspectives, budget of the united states government 239-56 (2011), available at http://www.whitehouse.gov/omb/budget/analytical_perspectives. 14 staff of j. comm. on tax’n, supra note 13, at 42; office of mgmt. & budget, supra note 13, at 243. 15 see generally kahn, supra note 10, at 3-4 (“critics of personal deductions contend that the deductions do not implement the goals and purposes of a progressive income tax system, but rather are employed as a device to subsidize taxpayers for programmatic purposes. the critics maintain that, as a result, these deductions will erode the tax base, reduce progressivity, and contravene the principles of horizontal and vertical equity.” (citations omitted)). 16 andrews, supra note 4. 17 id. at 320-25. simons viewed his definition as a refinement of robert haig’s. haig’s definition was "the money value of the net accretion to one's economic power between two points of time.” robert m. haig et al., the federal income tax 7 (robert m. haig ed., 1921) (emphasis in original). 90 columbia journal of tax law [vol.3:86 personal income as the algebraic sum of the market value of rights exercised in consumption and the accumulation of net worth.18 according to andrews, simons’ description of income is best understood not as a final definition, but rather as an attempt to delineate a universe in which to further elaborate on income.19 the most important thrust of simons’ efforts is to highlight the insufficiency of net receipts as the entire scope of personal income.20 because it is difficult to measure consumption directly, money income is commonly accepted as the starting point for the measurement of personal income, with adjustments made to properly reflect the taxpayer’s full consumption plus accumulation.21 simons indicated that if a taxpayer’s consumption includes things that the taxpayer did not pay for, the market value of that consumption should be included in the taxpayer’s income. 22 on the other hand, if the taxpayer’s consumption plus accumulation is less than his money income, he should be entitled to a deduction.23 typically, this is understood to be the business expense deduction in which the taxpayer is allowed to deduct from his income the cost of producing that income.24 however, andrews argues that there are deductible expenses that are not business related but also do not reflect the taxpayer’s consumption.25 according to andrews, medical expenses are not taxpayer consumption. 26 andrews contends that the use of consumption as a tax base is meant to measure “material well-being and taxable capacity.”27 when a taxpayer spends money on medical care because of his poor health, the expense merely returns the taxpayer to a state of wellbeing.28 by incurring the medical expense to treat himself, the taxpayer is put in the same position as someone in good health whose earnings equal his own after subtracting the cost of the medical expense.29 implicit in this analysis is the argument that, because the disease is not voluntary, the taxpayer is not consuming when he acts to treat the disease.30 another way to express this is that the taxpayer’s ability to pay should be evaluated only after his necessary expenses beyond normal living expenses have been 18 henry c. simons, personal income taxation 50 (1938). in its short form, this definition is described as consumption plus accumulation. 19 see andrews, supra note 4, at 324-25. 20 see id. 21 see id. at 327-31; william j. turnier, personal deductions and tax reform: the high road and the low road, 31 vill. l. rev. 1703, 1706-07 (1986). 22 andrews, supra note 4, at 325. 23 id. 24 see id. 25 see id. at 313-17 (maintaining that expenses deductible under the medical expense and charitable contribution deductions are not properly depicted as taxpayer consumption). 26 id. at 331-43. 27 id. at 335. 28 id. at 334-36. but see griffith, supra note 11, at 369-75 (contending that andrews fails to draw a sufficient distinction between monetary and nonmonetary well-being and questioning andrews’ normative justifications in general). 29 andrews, supra note 4, at 334-36. for example, a is ill, earns $50,000, and spends $10,000 to become healthy, whereas b earns only $40,000 but is in good health and does not have the $10,000 medical expense. but see louis kaplow, the income tax as insurance: the casualty loss and medical expense deductions and the exclusion of medical insurance premiums, 79 cal. l. rev. 1485, 1493-94 (1991) (arguing that the taxpayers are not put in the same position by § 213, because a is only compensated to the extent that his loss exceeds the nondeductible floor). 30 see mark g. kelman, personal deductions revisited: why they fit poorly in an “ideal” income tax and why they fit worse in a far from ideal world, 31 stan. l. rev. 831, 859, 863-64 (1979). 2011] deducting the cost of sex reassignment surgery 91 deducted from his net receipts.31 andrews argues that it follows that the medical expense deduction is not a tax expenditure and does not conflict with an ideal income tax.32 instead, the deduction is a refinement of the concept of income to bring it into line with normative tax principles.33 andrews’ position is that the medical expense deduction is a way to fine-tune the tax base to ensure that only income is being taxed. in this scheme, medical expenses are not consumption, and must be subtracted from net receipts before we can arrive at taxable income. but, one need not reconceptualize consumption in order to accept the medical expense deduction as being in line with tax policy. related lines of argument contend that tax policy goals allow for the deduction within an ideal income tax, but without finding this justification in the definitions of income or consumption. for example, professor jeffrey kahn argues that the medical expense deduction is not an expenditure because it furthers progressivity.34 although its precise justification is debated among scholars, progressivity enjoys majority support and is a foundational tenet of tax law.35 progressivity is defensible on equitable grounds because it provides for an equalization of sacrifice among taxpayers.36 we can define consumption in a more conventional sense– for example, as using money to obtain satisfaction37–and still follow kahn’s logic. kahn argues that progressive tax rates are meant to provide for a zero tax rate on subsistence income. 38 because the tax structure is standardized and crude, adjustments are sometimes necessary for taxpayers with subsistence expenses far beyond the norm.39 routine medical expenses are part of the ordinary living expenses covered by the standard tax brackets.40 however, progressivity requires that taxpayers with unusually large medical expenses be accommodated through the medical expense deduction.41 a taxpayer with such expenses experiences a reduction in his ability to pay.42 even if we concede that the taxpayer’s medical expenses are consumed assets, equitable principles– themselves a normal part of tax law–require that the taxpayer’s burden be mitigated by a 31 andrews, supra note 4, at 326-27. 32 see andrews, supra note 4, at 331-43. 33 see id. 34 see kahn, supra note 10, at 14 (citations omitted). 35 see id. at 16. 36 see walter j. blum & harry kalven, jr., the uneasy case for progressive taxation, 19 u. chi. l. rev. 417, 421 (1952) (suggesting that progressive tax rates balance out regressivity in other tax provisions and thus make the total burden of all taxes proportionate to taxpayer income); kahn, supra note 10, at 21-23 (proposing that progressive taxation is equitable because the value to a taxpayer of each dollar declines as the taxpayer’s income increases). see also andrews, supra note 4, at 325-27 (arguing that the purpose of the income tax is to levy taxes according to ability to pay). 37 kelman, supra note 30, at 834. see also turnier, supra note 21, at 1730 (“medical expenses reflect expenditures to finance consumption of goods and services by the taxpayer to attain a personal benefit, namely the alleviation of a disease or the repair of an injury.”). 38 kahn, supra note 10, at 27-29. 39 id. 40 id. 41 id. scholars have suggested that the medical deduction’s statutory floor is meant to ensure that only extraordinary expenses will be reimbursed. see boris i. bittker, income tax deductions, credits, and subsidies for personal expenditures, 16 j.l. & econ 193, 198 (1973) (referring to an earlier version of § 213); kahn, supra note 10, at 28. 42 see james e. jensen, medical expenditures and medical deduction plans, 60 j. pol. econ. 503, 503 (1952) (“medical expenditures reduce the ability to pay taxes, and, therefore, a medical deduction from the income tax creates a differentiation according to ability to pay.”); turnier, supra note 21, at 1730-31. see also staff of j. comm. on tax’n, 110th cong., tax expenditures for health care 24 (j. comm. print 2008), available at http://jct.gov/publications.html (citing andrews, supra note 4; turnier, supra). 92 columbia journal of tax law [vol.3:86 deduction.43 thus, according to kahn, because the deduction is recommended by principles within the tax structure, it is not an expenditure.44 these arguments are not totally disparate. although they differ in their conclusions about the meaning of income, there are significant generalities that can be drawn. specifically, defenses of the medical expense deduction rely, implicitly or explicitly, on the understanding that taxpayers with medical expenses stemming from involuntary disease that are beyond routine expenses merit a reduction in their tax burdens because of the financial hardship of the medical expenses. proponents of the deduction argue that such taxpayers experience a reduction in ability to pay.45 tax expenditure analysis criticizes tax spending for programs outside of tax law’s purview.46 however, the medical expense deduction may be a valuable method of addressing significant differences in taxpayers’ financial positions. whether or not we find the genesis of the deduction in the definition of consumption, or qualify it as an expenditure, it can still be justified by equitable principles within tax law. c. criticism of the medical expense deduction the most noteworthy condemnation of the medical expense deduction is the 1979 article written by professor mark kelman in response to professor andrews.47 kelman argues that non-income-seeking expenditures that are not consumption do not exist.48 kelman maintains that net receipts minus the cost of obtaining the receipts is “tautologically” income.49 kelman’s article was written specifically to attack andrews’ position. however, his comments can easily be extended to other defenses of the medical expense deduction. kelman advances several criticisms of andrews, the most important of which i will address here. first, kelman notes that it is not always clear that a taxpayer has purchased medical services because of a departure from a baseline state of good health.50 a taxpayer may choose to make medical purchases without being in poor health.51 second, kelman points out a problem of mixed motives–namely, that income 43 see kahn, supra note 10, at 17, 27; turnier, supra note 21, at 1706-07. the joint committee on taxation has described the purpose of the medical expense deduction as follows: “the primary rationale for allowing an itemized deduction for medical expenses is that ‘extraordinary’ medical costs–those in excess of a floor designed to exclude predictable, recurring expenses–reflect economic hardship, beyond the individual’s control, which reduces the ability to pay federal income tax.” staff of j. comm. on tax’n, 97th cong., general explanation of the revenue provisions of the tax equity and fiscal responsibility act of 1982, at 24 (j. comm. print 1982). but see laura e. cunningham, national health insurance and the medical deduction, 50 tax l. rev. 237, 250-51 (1995) (arguing that deductions actually taken under § 213 often go far beyond those expenses which can properly be deemed extraordinary). 44 see kahn, supra note 10. 45 see staff of j. comm. on tax’n, 110th cong., a reconsideration of tax expenditure analysis 52 (j. comm. print 2008) (“some tax expenditures may be designed to provide a better measure of what congress deems to be the correct measure of ‘ability to pay,’ and thereby improve horizontal equity. for example, the deduction for medical expenses in excess of 7.5 percent of adjusted gross income may reflect a determination that two taxpayers with the same gross income are not similarly situated if one has high medical expenses and the other does not.”). 46 see supra notes 6-12 and accompanying text. 47 kelman, supra note 30. 48 id. at 834. 49 id. 50 id. at 862. 51 id. see also id. at 867 (suggesting that the purchase of preventative care does not necessarily result from the taxpayer’s poor health). 2011] deducting the cost of sex reassignment surgery 93 and taste factor into many purchases of medical services.52 wealthy taxpayers are more likely to spend money in a medical setting for things that are not medically important (for example, private hospital rooms53 or more expensive doctors54). these are arguments about the voluntariness of medical expenses. 55 defenses of the medical expense deduction rely on the assumption that differences in medical spending reflect differences in need rather than choices among indulgences. 56 kelman’s criticism essentially questions whether medical expenses truly affect taxpayers’ ability to pay.57 if certain medical expenses are discretionary luxuries unrelated to disease, they do not represent a financial burden and accommodating them through the medical expense deduction is not progressive. professor louis kaplow has attacked the medical expense deduction as a misallocation of resources due to its status as a government-funded alternative to private health insurance.58 according to kaplow, this substitution discourages the purchase of private health insurance, which leads to increasing medical costs and unnecessary risktaking by taxpayers.59 however, this line of argument depends on the impropriety of the deduction rather than establishing its weakness.60 if the medical expense deduction is a tool for measuring taxpayers’ ability to pay, the deduction is not a misallocation of resources. on the contrary, denying the deduction would be a misallocation of resources because it might dissuade taxpayers from purchasing essential medical care–the opposite effect that the deduction appears designed to promote.61 d. the role of the medical expense deduction the question of whether the medical expense deduction is a tax expenditure may not be crucial to determine if it is an acceptable policy. professors david a. weisbach and joseph nussim argue that it is irrelevant whether government spending programs that 52 id. at 864-68. see also cunningham, supra note 43, at 250-51 (discussing the problem of mixed motives). 53 kelman, supra note 30, at 864, 866; see also cunningham, supra note 43, at 250; griffith, supra note 11, at 371 n.159. 54 see kelman, supra note 30, at 866. 55 see cunningham, supra note 43, at 250 (“although a utilitarian ethic supports excluding the costs of medical care from the tax base, there remains a significant problem in distinguishing ‘true’ medical expenses, which imply essential and involuntary expenses, from ‘luxury’ medical expenses, which reflect an individual's consumption choices.”). 56 see, e.g., andrews, supra note 4, at 336 (“the deduction will reflect differences in health only as they manifest themselves in financial terms by requiring substantially different levels of expenditure for medical services. in this respect the deduction treats substantial medical expenses like a loss of earnings.”). 57 see cunningham, supra note 43, at 250-51. 58 kaplow, supra note 29, at 1493-99. see also cunningham, supra note 43, at 253 (“section 213 can be viewed as a form of free government insurance, under which the government acts as a co-insurer to the extent of the tax rate times the amount of the allowable deduction.”); kelman, supra note 30, at 832-33; surrey & mcdaniel, supra note 5, at 79. cf. andrew blair-stanek, note, using insurance law and policy to interpret the tax code’s loss and medical expense provisions, 26 yale l. & pol’y rev. 309 (2007) (advocating for using traditional insurance law concepts to reinterpret the medical expense deduction). for further discussion of the relationship between the medical expense deduction and traditional health insurance see infra part iii.a.2. 59 kaplow, supra note 29, at 1493-99. see also staff of joint comm. on tax’n, supra note 42, at 23. cf. robert k. lu, note, gross negligence and the medical expense deduction, 71 s. cal. l. rev. 845 (1998) (arguing that barring the medical expense deduction in cases where the taxpayer is grossly negligent would increase social welfare). 60 see bittker, supra note 41, at 199 (responding to a similar position in james m. buchanan, the public finances 226 (3d ed., 1970)). 61 see bittker, supra note 41, at 199. 94 columbia journal of tax law [vol.3:86 are executed via the tax system comply with independent tax norms.62 instead, they contend that the decision to implement such programs through a tax expenditure or a direct grant is merely a matter of institutional design.63 the government will inevitably decide to subsidize or encourage any number of activities.64 the point of weisbach’s and nussim’s analysis is to emphasize that the real concern is whether the form of the subsidy is supportable given overall government policy and structure, not how the subsidy fits within an ideal income tax.65 in other words, weisbach and nussim embrace surrey’s assertion that tax expenditures are nothing more than direct grants disguised. 66 nonetheless, they find that providing for these direct grants through the tax system may be preferable.67 direct subsidies through the tax system may be desirable because they take advantage of the preexisting tax infrastructure for their administration and thus are arguably simpler to implement.68 the medical expense deduction is evidence of a government spending policy to mitigate the burden of larger-than-average medical expenses for taxpayers for whom the strain of such a burden relates to disease. under weisbach’s and nussim’s analysis, it is immaterial whether it is a tax expenditure.69 instead, it is important that there are advantages to spending via tax expenditure rather than direct grant.70 in particular, the tax system and evaluation of the burden of large medical expenses both require large-scale information and financial processing, reliance on levels of income, and some form of wealth redistribution.71 thus, there are significant benefits of coordination in implementing a subsidy for medical expenses through the tax 62 weisbach & nussim, supra note 7. 63 see id. at 958 (“if the underlying policy is held constant, there are no effects of putting a program into or taking a program out of the tax system even if doing so hurts or enhances traditional notions of tax policy. welfare is the same regardless of whether the program is formally part of the tax system or is located somewhere else in the government. if we mistakenly look only at the tax system instead of overall government policy, we will draw the wrong conclusions.”). 64 see id. at 964. 65 see id. at 963-64. but see j. clifton fleming, jr. & robert j. peroni, reinvigorating tax expenditure analysis and its international dimension, 27 va. tax rev. 437, 468-84 (2008) (criticizing weisbach and nussim for disregarding the issue of whether something is in fact a tax expenditure before turning to the benefit of its implementation via tax policy instead of with a direct grant). 66 weisbach & nussim, supra note 7, at 978-82. but see daniel n. shaviro, rethinking tax expenditures and fiscal language, 57 tax l. rev. 187, 207-13 (2004) (arguing that tax expenditures are not equivalent to direct spending). 67 weisbach & nussim, supra note 7, at 978-82. 68 id. but see edward d. kleinbard, the congress within the congress: how tax expenditures distort our budget and our political processes, 36 ohio n.u.l. rev. 1, 3 (2010) (“tax expenditures have grown in importance to the point where they are now the dominant instruments for implementing new discretionary spending policies. while it is certainly true that some forms of government intervention are best delivered through the tax system, it cannot be the case that neutral design principles would lead to the current situation, where we spend more than twice as much through tax expenditures as we do through oldfashioned explicit spending programs. as a result, tax expenditures are filling a role that goes well beyond just another available policy device in congress's toolkit.”). 69 see weisbach & nussim, supra note 7, at 975 (“[i]f we are going to subsidize medical expenses, whether it is desirable to do so through the tax system should not depend on whether a medical expense deduction meets the definition of income.”). but see fleming & peroni, supra note 65, at 469 (“a significant problem with [weisbach’s and nussim’s] argument is that to determine whether a particular government subsidy, such as a deduction for medical expenses, is best delivered as a direct expenditure or as a subsidy through the tax system, we need to know the tax system's content and structure so that we can evaluate the effectiveness of the tax expenditure alternative and the costs it imposes on the tax system.”). 70 weisbach & nussim, supra note 7, at 959. 71 see id. 2011] deducting the cost of sex reassignment surgery 95 system.72 the remaining issue is which medical expenses are appropriately mitigated through this subsidy. andrews acknowledges that some medical expenses will have a notable component of personal gratification.73 however, it is not possible to avoid all such borderline problems.74 an apt comparison is the often blurry line between business and personal expenses when evaluating the business expense deduction.75 just as a taxpayer makes certain medical decisions influenced by personal rather than medical factors, he may incur business expenses related to his personal values.76 for example, he may choose a more luxurious office location, or first class business travel.77 nonetheless, the element of personal gratification does not mean these are not real medical expenses.78 to this point, kelman answers that the comparison is misleading because the business expense deduction, unlike the medical expense deduction, is an integral part of the tax structure.79 however, kelman merely describes administrative issues of pinpointing exactly which medical expenses are appropriately deductible, instead of problems with the deduction in general.80 if the problem is that taxpayers make quasi-medical decisions because of personal taste, the suitable response to this problem is to refine the deduction to account as accurately as possible for only those medical problems that affect taxpayers’ ability to pay.81 the 1990 amendment of § 213 to exclude cosmetic surgery expenses was just such a refinement.82 iii. structure and scope of the medical expense deduction a. general statutory scheme 1. mechanics of the deduction section 213 provides a deduction for expenses paid for the medical care of the taxpayer, his or her spouse, and dependents if the taxpayer is not compensated for the expenses by insurance or otherwise (e.g., by a tortfeasor).83 qualified expenses may be deducted if the taxpayer elects to itemize deductions, and only to the extent that such 72 see id. 73 andrews, supra note 4, at 337. 74 id. 75 see bittker, supra note 41, at 199; griffith, supra note 11, at 371 n.159; kelman, supra note 30, at 876-79. but see joel s. newman, the medical expense deduction: a preliminary postmortem, 53 s. cal. l. rev. 787, 788-89 (1979) (arguing that the medical expense deduction is dissimilar to the business expense deduction because the medical expense deduction has no inherent limiting factors like the profit maximization factor that controls business decisions). 76 see bittker, supra note 41, at 199. 77 see id. 78 see id. 79 kelman, supra note 30, at 876. 80 see kahn, supra note 10, at 31. even kelman conceded that some deduction for medical care might be supportable. kelman, supra note 30, at 834. 81 see kahn, supra note 10, at 29-31 (suggesting that basing the deduction on a percentage of agi is because of congress’ recognition that medical expenses will have certain pleasurable attributes, particularly in the case of wealthy taxpayers). but cf. james w. colliton, the medical expense deduction, 34 wayne l. rev. 1307, 1310 (1988) (arguing that the 7.5% floor disproportionately advantages lower income taxpayers, who can exceed the floor by spending a lower amount). 82 see infra part iii.b. 83 i.r.c. § 213(a) (west supp. 2010) (“there shall be allowed as a deduction the expenses paid during the taxable year, not compensated for by insurance or otherwise, for medical care of the taxpayer, his spouse, or a dependent . . . to the extent that such expenses exceed 7.5 percent of adjusted gross income.”). 96 columbia journal of tax law [vol.3:86 expenses exceed 7.5% of the taxpayer’s agi, or 10% of his agi for the purposes of the amt.84 the deduction covers “medical care,” defined as amounts paid “for the diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of affecting any structure or function of the body.”85 medical expenses for “transportation primarily for and essential to medical care”86 and expenses for prescription drugs and insulin also qualify.87 expenses for lodging while away from home receiving medical care are eligible for the deduction if the lodging is primarily for and essential to the medical care, if the medical care is provided by a physician in a licensed hospital or medical care facility, and if the travel has no significant element of personal pleasure.88 no deduction is allowed for lodging that is lavish or extravagant and the deduction is limited to $50 “for each night for each individual.”89 section 213(d)(9) explicitly excludes cosmetic surgery from the definition of medical care. “cosmetic surgery” is “any procedure which is directed at improving the patient’s appearance and does not meaningfully promote the proper function of the body or prevent or treat illness or disease.”90 however, expenses incurred for cosmetic surgery are deductible if the “the surgery or procedure is necessary to ameliorate a deformity arising from, or directly related to, a congenital abnormality, a personal injury resulting from an accident or trauma, or disfiguring disease.”91 many expenses toe the line between deductible “medical care” and “personal, living, or family expenses” which are nondeductible under § 262, unless otherwise expressly provided.92 the regulations do not authorize deductions for expenditures that are “merely beneficial to the general health of an individual,” such as the cost of a vacation; deductions “will be confined strictly to expenses incurred primarily for the 84 id.; i.r.c. § 56(b)(1)(b) (west supp. 2010). 85 i.r.c. § 213(d)(1)(a) (2006). 86 id. § 213(d)(1)(b) (2006). see, e.g., winderman v. comm’r, 32 t.c. 1197 (1959) (allowing deduction for transportation expenses for los angeles resident to travel to new york city to see a specific doctor in whom he had confidence); rev. rul. 58-533, 1958-2 c.b. 108 (allowing deduction for cost of parents’ trip to visit institutionalized child if the child’s doctor deemed regular visits essential to the child’s therapy). if required for the patient’s travel, the transportation expenses of an accompanying nurse, family member or other attendant are also deductible. rev. rul. 58-110, 1958-1 c.b. 155 (allowing deduction for transportation expenses of an elderly patient and her required nurse to travel on physician’s recommendation). 87 i.r.c. § 213(b) (2006). a prescription drug is “a drug or biological which requires a prescription of a physician for its use by an individual.” id. § 213(d)(3). see also rev. rul. 2003-58, 2003-1 c.b. 959 (noting that § 213(b) does not apply to medical equipment, supplies, or diagnostic devices–such as crutches, bandages, or blood sugar test kits–that may be purchased without a physician’s prescription). nonprescription drugs other than insulin are nondeductible in part because “non-prescription drugs are more likely to represent expenses for ordinary consumption than ‘extraordinary’ medical costs that should be deductible.” staff of j. comm. on tax’n, supra note 43, at 25. 88 i.r.c. § 213(d)(2) (2006). 89 id. 90 id. § 213(d)(9)(b) (2006) (emphasis added). 91 id. § 213(d)(9)(a) (2006). see infra part iii.b.2 for further discussion of the exclusion of cosmetic surgery expenses. 92 see stringham v. comm’r, 12 t.c. 580, 584-85 (1949) (“the real difficulty arises in connection with determining the deductibility of expenses which, depending on the peculiar facts of each case, may be classified as either ‘medical’ or ‘personal’ in nature . . . . [w]here the expenses sought to be deducted may be either medical or personal in nature, the ultimate determination must be primarily one of fact.”). 2011] deducting the cost of sex reassignment surgery 97 prevention or alleviation of a physical or mental defect or illness.”93 in havey v. commissioner,94 the tax court rejected a deduction for a couple’s vacation expenses, even though the trips were recommended by the wife’s doctor after she suffered a coronary occlusion. the court opined that: to be deductible as a medical expense, there must be a direct or proximate relation between the expenses and the diagnosis, cure, mitigation, treatment, or prevention of disease or the expense must have been incurred for the purpose of affecting some structure or function of the body. . . . it seems clear to us that the deduction in question may be claimed only where there is a health or body condition coming within the statutory concept and where the expense was incurred primarily for the prevention or alleviation of such condition. an incidental benefit is not enough.95 thus, even if the taxpayer is ill, expenses on the boundary between medical and personal are not deductible if the medical benefit is remote or incidental.96 the tax court developed the prevailing test for deductibility in jacobs v. commissioner, holding that a taxpayer seeking a § 213 deduction must show: (1) “the present existence or imminent probability of a disease, defect or illness–mental or physical,”97 and (2) that the expenses incurred are “directly or proximately related to the diagnosis, cure, mitigation, treatment, or prevention of the disease or illness.”98 when the expenses provide both medical and personal benefits, the taxpayer must also pass a “but for” test and show 93 treas. reg. § 1.213-1(e)(1)(ii) (1979). see brown v. comm’r, 62 t.c. 551 (1974) (finding amounts paid for scientology processing and auditing and related travel expenses not deductible because the nature of the services was that of personal counseling for general well-being rather than psychotherapy). but see rev. rul. 62-210, 1962-2 c.b. 89 (allowing deduction for clarinet lessons to ameliorate child’s malocclusion). expenses incurred for exercise, such as for athletic devices, lessons, or club memberships are often denied deductibility because of this principle. see, e.g., france v. comm’r, 40 t.c.m. (cch) 508 (1980), aff’d per curiam, 690 f.2d 68 (6th cir. 1982) (disallowing expenses incurred for dancing lessons recommended by physician); altman v. comm’r, 53 t.c. 487 (1969) (holding the cost of getting to and from a golf course not deductible because the taxpayer, an emphysema sufferer, could get exercise otherwise); adler v. comm’r, 330 f.2d 91 (9th cir. 1964) (finding dancing lessons for taxpayer with varicose veins nondeductible). nonetheless, some taxpayers have been successful in deducting the costs of therapeutic swimming pools. compare cherry v. comm’r, 46 t.c.m. (cch) 1031 (1983) (allowing deduction for operating expenses of swimming pool used by taxpayer to alleviate emphysema and bronchitis) with haines v. comm’r, 71 t.c. 644 (1979) (denying deduction for the cost of a swimming pool used by taxpayer with a fractured leg requiring physical therapy because of lack of showing that the primary purpose for the pool was medically therapeutic rather than for general health and convenience). 94 12 t.c. 409 (1949). 95 id. at 412-13. 96 see, e.g., jacobs v. comm’r, 62 t.c. 813 (1974) (finding that expenses of divorce are not deductible, even though recommended by psychiatrist because of the negative repercussions of marriage on taxpayer’s mental health); rabb v. comm’r, 31 t.c.m. (cch) 476 (1972) (denying deduction for shopping trips as “milieu therapy”). 97 jacobs, 62 t.c. at 818. 98 id. see, e.g., rev. rul. 2002-19, 2002-16 i.r.b. 778 (finding that expenses paid for a weight-loss program as treatment for a specific disease, including obesity or hypertension diagnosed by a physician, are deductible if the taxpayer has been directed by a physician to lose weight as treatment, but that diet food is not deductible); rev. rul. 99-28, 1999-1 c.b. 1269 (allowing a deduction for expenses incurred to stop smoking, including smoking-cession programs and prescription drugs to alleviate the effects of nicotine withdrawal, because nicotine is addictive and smoking is detrimental to the health of the smoker). 98 columbia journal of tax law [vol.3:86 “both that the expenditures were an essential element of the treatment and that they would not have otherwise been incurred for nonmedical reasons.”99 2. relationship to health insurance section 213(d)(1)(d) provides that the term “medical care” covers “insurance . . . covering medical care.” under this provision, taxpayers may deduct premium payments for insurance that covers any items that would qualify as “medical care” within the meanings of §§ 213(d)(1)(a) and 213(d)(1)(b). insurance premiums deductible under § 213 are combined with other qualified medical costs in applying the nondeductible floor.100 the cost of employer-provided health insurance is deductible as a business expense for employers and excludable as a fringe benefit for employees.101 selfemployed taxpayers may deduct some or all of the insurance expenses incurred for the taxpayer, his spouse, and his dependents under § 162(l), to the extent that the deduction does not exceed the taxpayer’s earned income from the trade or business providing the insurance. this is allowed as a business expense deduction and corresponds to the exclusion of employer-sponsored insurance from employee gross income.102 because premiums paid by families are deductible subject to the nondeductible floor, whereas employer-provided (including self-employed) insurance is fully deductible, there are some inconsistencies in the tax treatment of health insurance between different groups of taxpayers. in many ways, § 213 acts as a government-funded alternative to private insurance.103 however, the scope of coverage under § 213 is considerably broader than that of private health insurance or traditional government-funded health insurance (e.g., medicare and medicaid).104 for example, medicare and medicaid, as well as many private insurers, deny coverage for medical services that are not medically necessary.105 conversely, § 213 does not require that treatment be medically necessary. instead, it allows a deduction for medical care that is primarily for the prevention or alleviation of a disease, even if medical insurers would not find the treatment necessary.106 the medical 99 jacobs, 62 t.c. at 819 (emphasis omitted). see, e.g., ende v. comm’r, 34 t.c.m. (cch) 1096 (1975) (denying deduction for cost of attending ballet school for child with scoliosis in the absence of evidence that the child would not have taken ballet lessons without the disorder). 100 see i.r.c. § 213(a) (west supp. 2010). 101 see id. § 106(a) (2006) (“[g]ross income of an employee does not include employer-provided coverage under an accident or health plan.”); treas. reg. § 1.106-1 (1960) (“the gross income of an employee does not include contributions which his employer makes to an accident or health plan for compensation (through insurance or otherwise) to the employee for personal injuries or sickness incurred by him, his spouse, or his dependents . . . .”). 102 to prevent the self-employed taxpayer from benefitting twice, he is denied the deduction if he or his spouse is eligible to participate in an employer-subsidized health plan. i.r.c. § 162(l)(2)(b) (west supp. 2010). 103 see supra notes 58-61 and accompanying text (discussing criticism of the medical expense deduction on this account). 104 see katherine t. pratt, inconceivable? deducting the costs of fertility treatment, 89 cornell l. rev. 1121, 1170-71 (2004). 105 see id. medical services that are not “reasonable and necessary” for the treatment or prevention of illness, 42 u.s.c. § 1395y(a)(1)(a), (b) (2000), are excluded from federal medicare. medicaid similarly limits coverage. see 42 c.f.r. § 440.230(d) (1981) (“the agency may place appropriate limits on a service based on such criteria as medical necessity.”). cf. mark a. hall & gerard f. anderson, health insurers’ assessment of medical necessity, 140 u. pa. l. rev., 1637, 1638 n.4 (1992) (explaining that the term “medically necessary” is generally used by health insurers to mean medically appropriate rather than strictly necessary, and incorporates concepts such as cost effective care and accepted medical practice). 106 see supra note 93 and accompanying text. 2011] deducting the cost of sex reassignment surgery 99 expense deduction is rather comprehensive in its embrace of most expenses that can be legitimately tied to specific health conditions, including many categories of expenses that are not covered by traditional health insurance. for example, § 213 covers expenses for transportation, as well as meals and lodging, when they are essential to the medical care. 107 taxpayers have successfully deducted the cost of playing a musical instrument,108 legal fees to commit a mentally ill person,109 and the excess cost of food taken solely to alleviate or treat illness. 110 many kinds of health-related capital expenditures are treated favorably under § 213. notably, taxpayers have successfully deducted the cost of therapeutic swimming pools111 in addition to various medicallyrequired residence alterations, including “expenses incurred by a physically handicapped individual for removing structural barriers in his or her personal residence for the purpose of accommodating his or her handicapped condition.”112 the cost of servicing such items is deductible as well.113 deductible medical care may also be provided by a non-medical professional, such as an acupuncturist,114 unlicensed chiropractor,115 or christian science practitioner.116 thus, the purview of § 213 is significantly broader than that of traditional health insurance. b. cosmetic surgery 1. early treatment of cosmetic surgery expenses incurred for cosmetic surgery that is not necessary to ameliorate a deformity arising from or directly related to a congenital abnormality, personal injury resulting from accident or trauma, or disfiguring disease are nondeductible under § 213(d). however, before § 213(d) was added in 1990, the courts and the i.r.s. had allowed deductions for cosmetic procedures, due to the statutory definition of “medical care” including procedures “for the purpose of affecting any structure or function of the body.” in mattes v. commissioner, the taxpayer was permitted to deduct the cost of a surgical hair transplant performed by a physician as a purely cosmetic remedy for the taxpayer’s baldness.117 although the court acknowledged that baldness is not a health risk,118 it reasoned that, “since the expense is for a medical surgical treatment to correct a specific physiological condition . . . it is deductible under section 213 without the 107 see supra notes 86-89 and accompanying text. 108 rev. rul. 62-210, 1962-2 c.b. 89 (allowing deduction for clarinet lessons to ameliorate a child’s malocclusion). 109 gerstacker v. comm’r, 414 f.2d 448 (6th cir. 1969) (finding legal expenses of obtaining guardianship for a mental patient unwilling to seek treatment deductible). 110 kalb v. comm’r, 37 t.c.m. (cch) 1511 (1978) (permitting deduction for the excess cost of high-protein food medically required due to abnormally low blood sugar); cohn v. comm’r, 38 t.c. 387 (1962), nonacq. 1963-2 c.b. 6 (allowing deduction for the additional cost of restaurant-prepared salt-free meals for a taxpayer with heart problems). but see becher v. comm’r, 53 t.c.m. (cch) 683 (1987) (denying deduction for the excess cost of organic food, despite taxpayer’s physician’s recommendation that taxpayer eat such food due to various chemical allergies). 111 see supra note 93. 112 s. rep. no. 99-313, at 59, reprinted in 1986-3 c.b. (vol. 3) 1, 59. 113 treas. reg. § 1.213-1(e)(1)(iii) (1979). see also rev. rul. 83-33, 1983-1 c.b. 70 (permitting deduction for the cost of maintaining a medically therapeutic swimming pool). 114 rev. rul. 72-593, 1972-2 c.b. 180. 115 rev. rul. 63-91, 1963-1 c.b. 54. 116 rev. rul. 55-261, 1955-1 c.b. 307. but see tautolo v. comm’r, 34 t.c.m. (cch) 1198 (1975) (disallowing deduction for treatment by native samoan healers because it was for general health); ring v. comm’r, 23 t.c. 950 (1955) (denying deduction for trip to a shrine). 117 mattes v. comm’r, 77 t.c. 650 (1981). 118 id. at 655. 100 columbia journal of tax law [vol.3:86 necessity of examining a taxpayer’s motive for such treatment. in such context, we need not draw the fine line between medical and personal expenses.”119 the i.r.s. similarly endorsed the deductibility of cosmetic procedures. for example, a taxpayer was allowed to deduct expenses incurred for a face-lift procedure, even though not recommended by the taxpayer’s physician.120 in its ruling, the i.r.s. commented that, “[s]ince the purpose of the taxpayer's operation was to affect a structure of the human body, its cost is an amount paid for medical care.”121 2. enactment of § 213(d)(9) in 1990, congress enacted section 11342(a) of the omnibus budget reconciliation act of 1990,122 which amended § 213 to add § 213(d)(9). the amendment denies deductions for cosmetic surgery except under certain specified conditions. the senate finance committee report123 says that: [e]xpenses paid for cosmetic surgery or other similar procedures are not deductible medical expenses, unless the surgery or procedure is necessary to ameliorate a deformity arising from, or directly related to . . . disfiguring disease. . . . thus, under the provision, procedures such as hair removal electrolysis, hair transplants, liposuction, and face lift operations generally are not deductible. in contrast, expenses for procedures that are medically necessary to promote the proper function of the body and only incidentally affect the patient’s appearance or expenses for treatment of a disfiguring condition arising from . . . disease (such as reconstructive surgery following removal of a malignancy) continue to be deductible.124 the exclusion of most cosmetic surgery procedures is an attempt by congress to separate essential medical expenses, such as those used to treat disease, from those expenses that represent elective consumption by the taxpayer in the form of medical expenses.125 because the former expenses affect a taxpayer’s ability to pay, they alone are the proper subject of the medical expense deduction.126 under § 213(d)(9), procedures that meaningfully promote the proper function of the body, or treat or prevent disease or illness, are not cosmetic surgery, and thus are still deductible, even when they improve physical appearance. 127 in al-murshidi v. 119 id. at 656. 120 rev. rul. 76-332, 1976-2 c.b. 81. 121 id. see also rev. rul. 82-111, 1982-1 c.b. 48 (finding that hair transplants and hair removal by electrolysis are medical care, but tattooing and ear piercing are not, because–as the skin is penetrated only superficially–they do not sufficiently affect a structure or function of the body). 122 pub. l. no. 101-508, 104 stat. 1388-471. 123 there was no formal report printed separately because the bill was brought to the senate floor before a report could be printed. instead, the report was printed directly in the congressional record. see 136 cong. rec. s15629 (1990). 124 136 cong. rec. s15629, s15711 (1990). 125 see newman, supra note 75, at 789-94 (describing legislative evidence that the deduction was conceived of in terms of the effect of medical expenses on the ability to pay, but arguing that the deduction lost this position over time). 126 see supra part ii.b.1. 127 see, e.g., rev. rul. 2003-57, 2003-22 i.r.b. 959 (allowing a deduction for expenses incurred for laser eye surgery to remedy myopia because the surgery “meaningfully promotes the proper function of the body”); rev. rul. 2002-19, 2002-16 i.r.b. 778 (finding that expenses paid for a weight-loss program as treatment for a specific disease, including obesity or hypertension diagnosed by a physician, are deductible if the taxpayer has been directed by a physician to lose weight as treatment). but see o’donnabhain v. 2011] deducting the cost of sex reassignment surgery 101 commissioner, the tax court allowed the taxpayer a deduction for her expenses incurred for three surgeries, including liposuction, to remove a mass of loose-hanging skin remaining after the taxpayer independently lost over 100 pounds.128 the court reasoned that: petitioner was 100 pounds overweight and suffered from morbid obesity. obesity is well recognized in the medical community as a serious disease. . . . furthermore, petitioner continued to suffer from the effects of the above-described skin mass that was a deformity. this mass was not merely unsightly, it was prone to infection and disease and interfered with the petitioner’s daily life. . . . the procedures that petitioner underwent meaningfully promoted the proper function of her body and treated her disease.129 taxpayers are also able to deduct expenses for cosmetic surgery–procedures that improve appearance, but do not meaningfully promote the proper function of the body or treat disease or illness–if those procedures are necessary to ameliorate a deformity arising from (or directly related to) a congenital abnormality, personal injury resulting from accident or trauma, or a disfiguring disease.130 for instance, the i.r.s. permits deduction for the expenses of breast reconstruction following a taxpayer’s mastectomy as treatment for breast cancer because reconstruction “ameliorates a deformity directly related to a disease.”131 however, expenses for teeth whitening are not a permitted deduction, because tooth discoloration is “not a deformity and is not caused by a disfiguring disease or treatment.”132 the meaning and extent of the statutory exclusion of cosmetic surgery have not been fully addressed since the 1990 amendment. despite a handful of tax court and i.r.s. decisions on the matter, it is not yet entirely clear when a medical procedure that improves appearance is deductible under § 213. a medical procedure that improves appearance should be excluded from the statutory definition of cosmetic surgery if it passes two hurdles. first, the procedure should be prescribed to the taxpayer by a medical professional as treatment for a specific disease or infirmity. second, a medical procedure that improves appearance should be generally accepted in the medical community as appropriate treatment for the disease for which it is prescribed. the first requirement corresponds to the maxim that deductible medical expenses are not those for the general health of the taxpayer or those with remote or incidental medical benefits, but instead are incurred for the explicit purpose of treating a concrete comm’r, 134 t.c. 34 (2010), acq., 2011-47 i.r.b. 2 (holding that breast augmentation surgery in connection with male to female srs is nondeductible because it was for the purpose of improving appearance and not to treat disease). 128 al-murshidi v. comm'r, no. 4230-008, 2001 wl 1922698 (t.c. dec. 13, 2001). 129 id. at 3. 130 see i.r.c. § 213(d)(9)(a) (2006). 131 rev. rul. 2003-57, 2003-22 i.r.b. 959. 132 id. see also i.r.s. priv. ltr. rul. 200344010 (oct. 31, 2003) (“[t]reatment j is cosmetic surgery pursuant to § 213(d)(9)(b) because it will improve taxpayer’s appearance without also meaningfully promoting the proper function of the body or preventing or treating illness or disease. however, [treatment j will improve condition d], a deformity that arose from, or is directly related to, the congenital abnormalities . . . suffered by taxpayer. thus, treatment j is [deductible].”). 102 columbia journal of tax law [vol.3:86 medical problem.133 this is the same test that is applied to all medical expenses deducted under § 213.134 the difficulty with procedures that improve appearance is that non-medical benefits from the procedures may be prevalent as well. thus, it is especially important in this area to carefully distinguish between disease-treating medical expenditures and quasi-medical expenses that do not trigger congress’s policy for mitigating the financial burden of serious health problems. examining case law on the traditional scope of the medical expense deduction sheds some light on this issue. taxpayers have long been forbidden from deducting expenses that do not appear to be legitimately medical, even when those expenses are incurred due to the urging of medical professionals. for example, taxpayers have been unsuccessful in attempts to deduct divorce expenses incurred to treat severe depression,135 shopping trips as therapy for neurosis,136 and dancing lessons to treat arthritis137–despite the fact that the aforementioned treatments were recommended by doctors for specific medical problems. the unifying reason for the denial of deductions for these expenses is that the “treatments” were not accepted in the medical community as legitimate treatments for the diseases they purported to address. medical procedures that improve appearance are likely to be subject to exactly this problem. therefore, it is appropriate to demand that medical procedures that improve appearance be generally accepted as medical treatment for the illnesses for which they are prescribed. this does not mean that there needs to be consensus in the medical community about what is an appropriate course of treatment in any given case. to the contrary, scientific and medical experts often dispute such questions. nonetheless, disagreement about suitable medical therapies can exist without this fact undermining the judgment of medical experts.138 if a treatment is recognized by a significant portion of the medical community, a court or the i.r.s. should defer to these medical experts in determining whether the treatment truly treats disease. given how broadly the medical expense deduction has been interpreted in the past,139 this can be a relatively low bar. those treatments that are endorsed by a noteworthy number of medical professionals as treatment for a specific disease may also improve appearance without a serious danger of being undertaken for their nonmedical benefits, and thus should escape being classified as cosmetic surgery under § 213(d)(9) when they are recommended by doctors. 133 see supra notes 93-96 and accompanying text. 134 see id. 135 jacobs v. comm’r, 62 t.c. 813 (1974). 136 rabb v. comm’r, 31 t.c.m. (cch) 476 (1972). 137 france v. comm’r, 40 t.c.m. (cch) 508 (1980), aff’d per curiam, 690 f.2d 68 (6th cir. 1982). 138 cf. margaret a. berger & lawrence m. solan, the uneasy relationship between science and law: an essay and introduction, 73 brook. l. rev. 847, 850-51 (2008) (“[s]cientists are not as certain as the lawyers would like them to be. although there are many scientific truths accepted in both the scientific and lay communities, much of contemporary science involves researchers hypothesizing about natural phenomena and offering tentative explanations that become the subject of further research, which results in both refinements and broad challenges. moreover, there is often legitimate disagreement among scientists about the mechanisms that cause disease.”); samuel r. gross & jennifer l. mnookin, expert information and expert evidence: a preliminary taxonomy, 34 seton hall l. rev. 141, 166-67 (2003) (“knowledgeable people may disagree on what the answer is, or whether it is known, or even whether the question is answerable. and even if there is a reasonably clear answer out there somewhere, it may be no mean feat to find it. none of us can absorb even a tiny fraction of the general knowledge that exists in our extremely complex culture. we have no choice but to rely on experts. . . .”). 139 see supra notes 107-16 and accompanying text. 2011] deducting the cost of sex reassignment surgery 103 the preceding analysis leaves open the possibility that taxpayers may be able to deduct expenses incurred to treat mental disease or illness that also happen to improve physical appearance. treatment of mental illness is eligible for § 213 deductions.140 the 1990 amendment is directed at procedures that affect a structure or function of the body, but are not excluded from the definition of cosmetic surgery under § 213(d)(9)(b) by treating a disease or illness. medical procedures that affect a structure or function of the body but do not treat disease are cosmetic surgery if they improve appearance.141 however, if a procedure that improves physical appearance also treats mental illness (a disease), it is not cosmetic surgery under § 213(d)(9)(b) and need not fulfill the requirements of § 213(d)(9)(a) in order to be deductible. before the enactment of § 213(d)(9), taxpayers had been allowed to deduct treatment for mental illness where the treatment also affected physical appearance. for example, before § 213(d)(9) was enacted, the i.r.s. approved a deduction for a physician-recommended wig for a child who had lost all of her hair as the result of disease, because the wig was thought essential for the girl’s mental health.142 section 213(d)(9) highlights a concern about medical procedures that improve appearance but are not undertaken for sufficiently medical reasons. under this scheme, the wig would be properly deductible now if it were both directed at treating the girl’s specific mental health problem and accepted as such treatment by a significant number of medical professionals.143 the wig appears to have been prescribed in order to remedy the patient’s specific mental affliction. however, the wig is cosmetic if it is not also genuine medical treatment for her disease. because it improves appearance, its deductibility should turn on whether there is general agreement by medical professionals that a wig is a fitting course of treatment for the girl’s mental health problems. if such agreement could be shown, the wig would escape classification as cosmetic under § 213(d)(9) due to its status as a treatment for disease. similarly, other procedures that treat specific mental diseases, but also improve appearance, should be deductible if there is adequate acceptance in the medical community for these treatments to be considered legitimately medical. iv. o’donnabhain v. commissioner a. the controversy and the internal revenue service’s position the taxpayer, rhiannon o’donnabhain, was born a genetic male.144 however, she145 was intensely uncomfortable in the male gender role from early childhood.146 o’donnabhain was first diagnosed with severe gender identity disorder (“gid”) as an adult, after having been married for more than twenty years and fathering three 140 see treas. reg. § 1.213-1(e)(1)(ii) (1979) (sanctioning § 213 deduction for treatment for mental defect or illness). see also starrett v. comm’r, 41 t.c. 877 (1964) (allowing taxpayer with mental illness to deduct the cost of psychoanalysis). 141 see i.r.c. § 213(d)(9)(b) (2006). 142 rev. rul. 62-189, 1962-2 c.b. 88. 143 this assumes that the wig was recommended to treat the girl’s mental health and not to ameliorate the deformity of baldness, which was the result of organic disease. if the girl’s doctor endorsed her purchase of a wig for the latter purpose, the wig would be cosmetic, but potentially deductible under § 213(d)(9)(a). 144 o’donnabhain v. comm’r, 134 t.c. 34 (2010), acq., 2011-47 i.r.b. 2. 145 o’donnabhain self-identifies as female, and will be referred to throughout with the feminine pronoun. 146 o’donnabhain, 134 t.c. at 35. 104 columbia journal of tax law [vol.3:86 children. 147 gid is a condition listed in the american psychiatric association’s diagnostic and statistical manual of mental disorders148 (“dsm iv tr”), a diagnostic tool for mental disorders. the dsm iv tr’s diagnostic criteria indicate that an individual has gid when he or she displays: (1) a repeatedly stated desire to be, or insistence that he or she is, the other sex; (2) persistent discomfort with his or her sex or sense of inappropriateness in the gender role of that sex, including a preoccupation with getting rid of primary or secondary sex characteristics; (3) the absence of a physical intersex condition; and (4) clinically significant distress or impairment in social, occupational, or other important areas of functioning resulting from the disturbance.149 gid is “severe” when the symptoms are particularly acute, or cause notable functional impairment.150 o’donnabhain’s psychotherapist recommended a course of treatment based on the harry benjamin standards of care (“benjamin standards”), published by the world professional association for transgender health, the most widespread standard of care for professionals working with people with gid.151 in accordance with the benjamin standards, the taxpayer received feminizing hormone therapy from 1997 through 2001.152 in 2000, she decided to undertake the benjamin standards’ “real life” experience, which consists of presenting as female full time.153 at this point the taxpayer legally changed her name from robert donovan to rhiannon o’donnabhain.154 when these steps failed to assuage o’donnabhain’s distress about her sex, her psychotherapist concluded that o’donnabhain satisfied the benjamin standards’ criteria for sex reassignment surgery (“srs”).155 in order to satisfy the benjamin standards, the taxpayer was examined and recommended for the surgery by a second licensed psychotherapist, and then referred to an experienced reconstructive surgeon who specialized in srs.156 this surgeon also concluded that o’donnabhain was a good candidate for srs.157 in october 2001, the taxpayer underwent srs.158 this consisted of genital reconstruction surgery, which reconfigured o’donnabhain’s male genitalia to create, in appearance and function, female genitalia. 159 the surgeon also performed breast augmentation surgery, to make her breasts (which had experienced notable development due to hormone therapy) more closely resemble female breasts.160 on her 2001 federal income tax return, o’donnabhain claimed her expenses for srs, totaling more than $20,000 and not compensated by insurance or otherwise, as a § 213 itemized deduction. these expenses included the cost of the genital and breast surgeries, post-surgical stay at the surgeon’s facility, medical equipment, travel and 147 id. at 35-36. 148 4th ed. 2000 text revision. 149 see dsm iv tr at 581. 150 see id. at 2. 151 o’donnabhain, 134 t.c. at 37-39. see also the harry benjamin international gender dysphoria association, standards of care for gender identity disorders, sixth version (2001), available at http://www.wpath.org/documents2/socv6.pdf. 152 o’donnabhain, 134 t.c. at 39. 153 id. at 39-40. 154 id. at 40. 155 id. at 40-41. 156 id. at 41. 157 id. 158 id. 159 id. 160 id. 2011] deducting the cost of sex reassignment surgery 105 lodging for pre-surgical consultation and surgery, psychotherapy, consultation costs for her second referral, and hormone therapy.161 the i.r.s. initially gave o’donnabhain a refund, but later disallowed the expenses on audit, finding that, under § 213(d)(9), the treatments were cosmetic in nature and thus nondeductible.162 the i.r.s. relied on a number of alternative justifications to support its conclusion. first, the i.r.s., while conceding that gid is a mental disorder, claimed that it is not a disease for the purposes of § 213, because it does not have an organic or physiological origin that reflects an abnormal structure or function of the body.163 second, the i.r.s. maintained that, based on the legislative history of § 213(d)(9), any medical procedure that is primarily directed towards improving appearance must be medically necessary to remain deductible under § 213.164 according to the service, the taxpayer’s expenses did not treat disease because they were not medically necessary, and because there was controversy over the efficacy of srs.165 finally, the i.r.s. claimed that o’donnabhain was misdiagnosed with gid, and therefore–even if srs could be treatment for a disease–it was not in o’donnabhain’s case.166 b. the tax court opinions the majority of the tax court allowed o’donnabhain deductions for all her expenses except for the breast augmentation surgery.167 the judges authored six different opinions. judge gale, writing for the majority, reached that decision by applying the leading test for deductibility that the court formulated in jacobs v. commissioner.168 the threshold question under the jacobs test is whether o’donnabhain suffered from “the present existence or imminent probability of a disease, defect or illness–mental or physical.”169 the i.r.s. argued that o’donnabhain was misdiagnosed with gid, and that gid is not a disease under § 213, because it does not have an organic or physiological origin that reflects an abnormal structure or function of the body.170 judge gale, relying on the expertise of o’donnabhain’s doctors, dismissed the contention that o’donnabhain was incorrectly diagnosed with gid.171 he also concluded that gid is a disease under § 213.172 although the i.r.s.’s position in this case seemed to be that § 213 encompasses only those diseases with physiological origins, the weight of authority–and the i.r.s.’s own regulation173–signaled the contrary.174 according to judge gale, mental disorders 161 id. at 41-42. 162 see cca 200603025 (jan. 20, 2006). but see i.r.s. priv. ltr. rul. 8321042 (feb. 18, 1983) (allowing a taxpayer to deduct the costs incurred in connection with his son’s srs before the passage of § 213(d)(9)). the i.r.s. recently acquiesced in the o’donnabhain decision and stated that it will no longer follow the position that it took in cca 200603025. see 2011-47 i.r.b. 2. 163 o’donnabhain, 134 t.c. at 46-47, 54. 164 see cca 200603025 (jan. 20, 2006). 165 see o’donnabhain, 134 t.c. at 53. see also cca 200603025 (jan. 20, 2006). 166 see o’donnabhain, 134 t.c. at 53. 167 id. at 76-77. 168 id. at 50 (citing jacobs v. comm’r, 62 t.c. 813, 818 (1974)). the jacobs test is discussed in more detail in supra notes 97-99 and accompanying text. 169 jacobs, 62 t.c. at 818. 170 see supra notes 163-166 and accompanying text. 171 o’donnabhain, 134 t.c. at 63-64. 172 id. at 55-63. 173 see treas. reg. § 1.213-1(e)(1)(ii) (1979) (identifying expenses incurred primarily for the prevention or alleviation of mental defects and illnesses as deductible, without specifying the need for a physiological origin). 106 columbia journal of tax law [vol.3:86 are diseases under § 213 without the requirement of a demonstrated physiological origin.175 instead, mental conditions are diseases “where there [is] evidence that mental health professionals regard[] the condition as creating a significant impairment to normal functioning and warranting treatment.”176 in particular, the majority found gid to be a disease because it is a “widely recognized and accepted diagnosis in the field of psychiatry” and “a serious, psychologically debilitating condition” that is associated with self-mutilation and suicide if left untreated.177 under the jacobs test, o’donnabhain’s expenses must have been “directly or proximately related to the diagnosis, cure, mitigation, treatment, or prevention of the disease or illness.”178 judge gale opined that the hormone therapy and genital surgery treated o’donnabhain’s gid because, despite some controversy, they are wellrecognized and accepted therapies for severe gid according to the benjamin standards and many psychiatric professionals.179 the majority also noted that srs is the only known effective treatment for severe gid, where psychotherapy alone is not effective.180 o’donnabhain also passes the jacobs but-for test181 because, even if the hormone therapy and genital surgery had some nonmedical benefit, they were an essential element of her treatment of severe gid, and would not have occurred except to alleviate her suffering from gid.182 in response to the service’s argument that, given the legislative history of § 213(d)(9), medical procedures that affect appearance must be medically necessary to be deductible, judge gale concluded that the hormone therapy and genital surgery were necessary to treat o’donnabhain’s gid. 183 nonetheless, he found that, because o’donnabhain had experienced sufficient breast growth during the hormone phase of her treatment, her breast augmentation surgery did not treat her disease and was therefore cosmetic and nondeductible.184 in a concurring opinion, judge holmes agreed with the majority’s result, but disagreed with the majority’s reasoning that srs is the proper and necessary treatment for gid.185 judge holmes, noting the medical controversy over srs, would have relied on a test that determined deductibility based on whether the treatment is therapeutic to the taxpayer, based on the taxpayer’s good-faith, subjective motivation.186 judge holmes also took issue with the majority’s determination that srs was medically necessary for o’donnabhain, opining that “‘[m]edically necessary’ is a loaded phrase. construing it 174 o’donnabhain, 134 t.c. at 56-58. but see 2011-47 i.r.b. 2 (acquiescing in the o’donnabhain decision). 175 id. 176 id. at 57. 177 id. at 61. 178 jacobs v. comm’r, 62 t.c. 813, 818 (1974). 179 o’donnabhain, 134 t.c. at 65. see also judith s. stern & claire v. merkine, brian l. v. administration for children’s services: ambivalence toward gender identity disorder as a medical condition, 30 women’s rts. l. rep. 566, 567-74 (2009) (discussing the acceptance of srs in the psychiatric community). 180 o’donnabhain, 134 t.c. at 67-68. 181 jacobs, 62 t.c. at 819. 182 o’donnabhain, 134 t.c. at 76. 183 id. at 70, 77. 184 id. at 72-73. 185 id. at 85-100 (holmes, j., concurring). 186 id. at 91. 2011] deducting the cost of sex reassignment surgery 107 puts us squarely, and unnecessarily, in the middle of a serious fight within the relevant scientific community . . . .”187 judge goeke wrote a concurring opinion in which he reasoned that o’donnabhain’s genital surgery was not cosmetic because it was not directed at improving her appearance, but rather was functional.188 however, he disagreed with the majority’s reasoning that left open the possibility of deductibility for surgeries directed solely at altering physical appearance if they alleviate mental pain.189 therefore, while he upheld the taxpayer’s deductions for expenses incurred for srs, he would have ruled that breast augmentation surgery is cosmetic as a matter of law.190 judges foley and gustafson both authored dissenting opinions. judge gustafson grounded his analysis solely on the statutory language of § 213.191 section 213(d)(1)(a) provides that medical care consists of “amounts paid for the diagnosis, cure, mitigation, treatment, or prevention of disease or for the purpose of affecting any structure or function of the body.” section 213(d)(9)(b) defines cosmetic surgery as “any procedure which is directed at improving the patient’s appearance, and does not meaningfully promote the proper function of the body or prevent or treat illness or disease.” thus, judge gustafson argued that, because of the omission of the word “mitigate” in § 213(d)(9)(b), procedures that improve appearance, but merely mitigate rather than prevent or treat illness, are not excluded from the definition of cosmetic surgery and are only deductible if they fall within the exception of § 213(d)(9)(a).192 to “treat” a disease, a procedure must “bear directly on the condition in question.”193 mitigation, on the other hand, merely makes a disease less severe, or lessens the symptoms. 194 therefore, “‘treatment’ addresses underlying causes and ‘mitigation’ lessens effects.”195 according to judge gustafson, srs mitigated o’donnabhain’s symptoms of gid, but was not a treatment because “a procedure that changes the patient’s healthy male body (in fact, that disables his healthy male body) and leaves his mind unchanged . . . has not treated his mental disease.”196 judge foley’s dissenting opinion focused on the definition of cosmetic surgery found in § 213(d)(9)(b), which provides that “‘cosmetic surgery’ means any procedure which is directed at improving the patient’s appearance and does not meaningfully promote the proper function of the body or prevent or treat illness or disease.”197 judge foley contended that the statutory definition does not exclude from cosmetic surgery any procedure that treats disease.198 instead, he argued that the test for cosmetic surgery set forth in 213(d)(9)(b) consists of two parts.199 the threshold question is whether the 187 id. at 92. see also anthony c. infanti, dissecting o’donnabhain, 126 tax notes 1403, 1404 (“the statute embodies no requirement of medical necessity, and this phrase appears only in passing in a senate committee report and not at all in the house conference report relating to the enactment of section 213(d)(9).”) (citations omitted). 188 o’donnabhain, 134 t.c. at 101 (goeke, j., concurring). 189 id. at 102. 190 id. 191 id. at 109-22 (gustafson, j., dissenting). 192 id. at 116-21. 193 id. at 116 (citations omitted). 194 id. 195 id. at 117. 196 id. at 122. 197 id. at 104-09 (foley, j., dissenting). 198 id. 199 id. 108 columbia journal of tax law [vol.3:86 procedure is directed at improving appearance.200 the second part of the test asks whether the procedure meaningfully promotes proper bodily function or prevents or treats disease.201 judge foley argued that this second part is disjunctive and indicates that a procedure that is directed at improving appearance is cosmetic surgery either if it does not meaningfully promote proper function of the body, or if it does not prevent or treat disease or illness.202 even if srs treated o’donnabhain’s disease, it did not (according to judge foley) meaningfully promote the proper function of her body, and thus is within the definition of nondeductible cosmetic surgery in § 213(d)(9)(b).203 c. analysis the statutory language of § 213(d)(9) is not nearly as murky as one would believe after reading the various tax court opinions authored in o’donnabhain. section 213(d)(9)(b) excludes from the definition of “medical care” any procedure which is directed at improving appearance, but “does not meaningfully promote the proper function of the body or prevent or treat illness or disease.” such procedures are cosmetic surgery. judge foley, ostensibly adhering to the plain language of § 213(d)(9), argued that in order for a procedure that improves appearance to avoid classification as cosmetic surgery, it must both meaningfully promote the proper function of the body, and treat or prevent disease or illness. 204 however, this interpretation itself ignores the plain language of the statute. in order for judge foley’s interpretation to be correct, the statute must read (or we must interpret it to read), “does not meaningfully promote the proper function of the body or does not prevent or treat illness or disease.” judge halpern, concurring in the result, authored an opinion that largely consisted of responses to arguments advanced by judges foley and gustafson in their dissenting opinions.205 judge halpern’s explanation of the logical fallacy of judge foley’s analysis is helpful: because the second part of the test contains two expressions separated by “or”, that part of the test contains a “disjunction”; i.e., a compound proposition that is true if one of its elements is true. importantly, however, the second part of the test contains not just a disjunction (i.e., (p or q)), but rather the negation of a disjunction (i.e., not (p or q)). judge foley errs because he assumes that the expression “not (p or q)” is [logically] equivalent to the expression “(not p) or (not q)” . . . [when, in fact, its] equivalent is of the form “(not p) and (not q)”, which, substituting the relevant words, is: “does not meaningfully promote the proper function of the body and does not prevent or treat illness or disease.”206 in other words, judge foley is mistaken in his interpretation of the meaning of § 213(d)(9), because he believes it to mean that a procedure that is directed at improving appearance is cosmetic if either it does not meaningfully promote the proper function of the body, or if it does not prevent or treat disease or illness. in fact, based on the plain language of the statute, a procedure need satisfy only one of these conditions to avoid 200 id. 201 id. 202 id. 203 id. 204 id. 205 id. at 77-85 (halpern, j., concurring). 206 id. at 83-84 (emphasis added). 2011] deducting the cost of sex reassignment surgery 109 being classified as cosmetic surgery. therefore, a procedure that meaningfully treats disease cannot be cosmetic surgery given the language of § 213(d)(9)(b). judge gustafson accepted both that o’donnabhain had gid, a serious medical condition, and that the medical community favors srs for patients with severe gid that have not responded to other therapies.207 however, he argued that § 213(d) excludes from the definition of cosmetic surgery therapies that treat disease, but not those that merely mitigate symptoms.208 according to judge gustafson, “treatment” is directed at the causes of a disease, whereas “mitigation” minimizes the effects of disease.209 in his opinion, srs mitigates the symptoms of gid, but does not treat the disease because the underlying mental disorder is not addressed by srs. 210 judge halpern responded to this point by arguing that for someone suffering from gid, the disease is the symptoms.211 this may be true. however, the response need not be limited to gid specifically. for most mental disorders (and many physical disorders), treatment is limited to managing symptoms. scientific knowledge has not progressed to the point where doctors know exactly what causes all illness, or what can be done to cure the underlying diseases.212 expenses to treat mental illness are nonetheless deductible.213 gid is a mental disorder, and is subject to similar treatment regimes. in order to allow a deduction for those expenses incurred to treat gid, a disease, we can only be as precise as current medical knowledge allows. at present, srs is the most effective known treatment for severe gid and is generally endorsed as such treatment by the medical community.214 o’donnabhain was deemed a suitable candidate for srs by three medical professionals.215 therefore, o’donnabhain’s srs was treatment for disease for the purposes for § 213. section 213(d)(9) provides that a procedure that treats disease remains deductible despite its effect on appearance because it is not included in the definition of cosmetic surgery. judge holmes’ concurring opinion reveals his lack of appreciation of this important point. judge holmes contended that the test for deductibility should be whether the treatment is therapeutic, given the taxpayer’s subjective, good-faith motivation.216 he argued this way because he saw no need to evaluate generally acceptable standards of care, and cited years of case law in which unorthodox expenses were nonetheless found deductible because they were subjectively therapeutic.217 this formulation, however, is much too broad and does not properly implement the statutory requirement. a taxpayer may subjectively believe that a treatment that improves physical appearance is therapeutic to him, and yet the statute does not allow for deduction unless the treatment promotes proper function of the body, treats a disease, or ameliorates a specific type of deformity. the enactment of § 213(d)(9) demonstrates congress’s intent to deny deductibility to appearance-improving medical procedures that are not genuine treatment for disease. in order to comply with this objective, the standard for deductibility must be more stringent than that proposed by judge holmes. specifically, 207 id. at 110 (gustafson, j., dissenting). 208 id. at 111-19. 209 id. at 116. 210 id. at 121-22. 211 id. at 79 (halpern, j., concurring). 212 see supra note 138. 213 see supra note 140. 214 see supra notes 179-80 and accompanying text. 215 see supra notes 155-57 and accompanying text. 216 o’donnabhain, 134 t.c. at 91 (holmes, j., concurring). 217 id. (citations omitted). 110 columbia journal of tax law [vol.3:86 the appearance-improving procedure must be one that is both prescribed by a medical professional and accepted as bona fide medical treatment by a sufficient number of medical experts.218 in order to delineate between properly deductible expenses and quasimedical consumption unrelated to disease, it is necessary to rely on a more rigorous standard than any treatment that is subjectively believed to be therapeutic. judge goeke neglected to consider the appropriate role of medical experts in an adequate § 213(d)(9) analysis. judge goeke’s error is the reverse of that of judge holmes in that he construed the statutory requirement too narrowly. judge goeke was concerned that the majority’s analysis would improperly allow for the deductibility of procedures that are directed at altering physical appearance, if they alleviate any mental suffering.219 to address this problem, he would have ruled that the breast augmentation was per se cosmetic and nondeductible, but the genital surgery was functional rather than cosmetic.220 however, functionality is not a concern of § 213(d)(9). o’donnabhain’s expenses did improve her appearance, whether or not they also contributed some functionality. the reason that they are deductible, under the statute, is because the procedures were doctor prescribed, medically accepted treatments for her gid. if, in order to treat her gid, o’donnabhain required breast augmentation, the statute could conceivably allow for that too. this would depend on whether there was sufficient agreement among medical experts that breast augmentation could be appropriate treatment for severe gid. in this case, the breast augmentation was not deductible because the taxpayer’s doctor had determined that she had had sufficient breast growth from hormones alone.221 thus, the breast augmentation surgery was not prescribed to o’donnabhain to treat her disease and is cosmetic surgery under § 213(d)(9)(b). moreover, judge goeke appears to have made an error made by many of the tax court judges in their evaluation of this controversy. namely, it is both unusual and inappropriate for the court to engage in its own medical analysis. the tax court judges are not experts in the medical field; they are experts in tax law. while they may interpret and apply standards for the deductibility of medical procedures, this process does not invite independent medical scrutiny. instead, the tax court must rely on the judgment of medical experts in determining whether a procedure is directed at treating a specific medical condition. if a procedure (such as o’donnabhain’s srs) is recommended by medical professionals to treat a taxpayer’s specific disease, and is generally accepted as such treatment by medical experts, it is deductible under § 213. cosmetic surgery is excluded from the statutory definition of medical care because it usually consists of entirely elective procedures unrelated to disease, and is just another form of voluntary consumption that should be funded from after-tax dollars. on the other hand, diseases are involuntary, and burdensome expenses to treat disease are medical expenses that merit a tax deduction. the language and structure of § 213(d)(9) forms a dichotomy between those expenses which create a financial burden stemming from disease and those expenses that do not. because of the suspect status of cosmetic procedures, they must correct a deformity (i.e., result from a medical abnormality or 218 see supra notes 133-38 and accompanying text. 219 o’donnabhain, 134 t.c. at 101-04 (goeke, j., concurring). judge gustafson apparently shared this concern, as evidenced by his discussion of the potential deductibility of cosmetic surgery used to treat body dysmorphic disorder, a mental condition in which the afflicted is preoccupied with a perceived physical deformity that does not exist. id. at 118 n.10 (gustafson, j., dissenting). 220 id. at 101-04 (goeke, j., concurring). 221 id. at 41. 2011] deducting the cost of sex reassignment surgery 111 disease process) in order to remain deductible. only those medical expenses that give rise to a financial burden originating in disease are the proper subject of the medical expense deduction. because gid is a disease, its treatment, as prescribed by doctors, is deductible. its status as a disease excludes appropriately-prescribed srs from the disallowance of deduction for cosmetic surgery, and from any heightened requirement of medical necessity. allowing a § 213 deduction for expenses used for srs is consistent both with the language of § 213, as well as the underlying policies that generally support § 213 deductions.222 allowing a tax deduction for srs also brings tax policy in line with health care knowledge and developments, and with developments in other areas of the law. many private employers now cover treatment for gid, including srs, in their health care plans.223 this trend is supported by the american medical association, which announced in june 2008 that it supports private and public health insurance coverage for gid treatment.224 these developments are evidence of a growing consensus in the medical community that srs is a medically legitimate treatment for disease. moreover, as the medical expense deduction is often broader in scope than health insurance coverage,225 it is natural and appropriate for tax policy to follow the judgment of health professionals. many courts have also recognized the importance of srs for individuals suffering from gid. for example, an increasing number of prisoners have been able to obtain funding for srs under the eighth amendment’s prohibition against cruel and unusual punishment, which requires that prisoners receive adequate medical care.226 the fact that numerous u.s. courts of appeal have determined that gid presents serious medical need only underscores the fact that the tax court should not second-guess medical experts in their assessment that srs is treatment for the disease of gid. courts have also found that srs cannot be denied under state medicaid plans as cosmetic surgery.227 while the tax court is not bound by these non-tax interpretations of cosmetic surgery, this line of authority shows persuasively that there is a growing consensus in the medical and legal communities that srs is a genuine medical treatment despite its effects on physical appearance. v. conclusion the medical expense deduction is important because it mitigates the burden of disease for taxpayers with a decreased ability to pay due to illness. critics maintain that the deduction is not supportable in practice, because it can allow deduction for expenses that arise from quasi-medical preferences that are unrelated to disease. the exclusion of 222 see supra part ii. 223 see susan l. megaard, scope of the medical expense deduction clarified and broadened by new tax court decision, 112 j. tax’n 353, 354 (2010) (citations omitted). 224 see id. 225 see supra notes 104-16 and accompanying text. 226 see, e.g., o’donnabhain, 134 t.c. at 62 (citing de’lonta v. angelone, 330 f.3d 630, 634 (4th cir. 2003); allard v. gomez, 9 fed. appx. 793, 794 (9th cir. 2001); cuoco v. moritsugu, 222 f.3d 99, 106 (2d cir. 2000); brown v. zavaras, 63 f.3d 967, 970 (10th cir. 1995); phillips v. mich. dept. of corr., 932 f.2d 969 (6th cir. 1991), aff’g 731 f. supp. 792 (w.d. mich. 1990); white v. farrier, 849 f.2d 322, 325-27 (8th cir. 1988); meriwether v. faulkner, 821 f.2d 408, 411-413 (7th cir. 1987)). 227 see pinneke v. preisser, 623 f.2d 546 (8th cir. 1980) (holding that srs is not cosmetic surgery such that it can be denied by state medicaid plan); j.d. v. lackner, 145 cal. rptr. 570, 572 (ct. app. 1978) (overturning decision that srs was cosmetic and thus ineligible for medicaid coverage). but see smith v. rasmussen, 249 f.3d 755, 759-61 (8th cir. 2001) (denying reimbursement for srs under state medicaid plan because of its cosmetic nature). 112 columbia journal of tax law [vol.3:86 cosmetic surgery from the definition of medical care should be seen as an effort by congress to further conform the medical expense deduction to its proper role. whether or not the medical expense deduction is a tax expenditure, its objective is appropriate government policy. because the policy itself is suitable, the deduction need not be interpreted narrowly.228 given this understanding, it follows that expenses used to treat disease recommended by the taxpayer’s doctor and consistent with generally accepted medical practice cannot be disallowed as cosmetic surgery. this conclusion is supported both by the policy justifications for the medical expense deduction as a whole, as well as the statutory language of § 213(d). gid is a well-recognized disease, and srs is regarded by many medical professionals as its most effective treatment in severe cases. because gid is a disease, expenses incurred for its treatment are exactly the sort of burdensome expenses that the medical expense deduction is meant to alleviate. thus, it follows that a tax deduction for physician-recommended srs is both appropriate and essential. 228 courts often construe deductions narrowly, referencing the familiar maxim that “an income tax deduction is a matter of legislative grace and . . . the burden of clearly showing the right to the claimed deduction is on the taxpayer.” interstate transit lines v. comm’r, 319 u.s. 590, 593 (1943). the appropriateness of such a narrow construction is not undisputed. see michael j. graetz & deborah h. schenk, federal income taxation: principles and policies 229 (6th ed. 2009) (“it is true that the taxpayer bears the burden of proving his right to a deduction, but the question should not be approached in terms of a ‘narrow’ construction or ‘legislative grace.’ the clear intent of congress to impose the tax on ‘taxable income’ requires recognition of deductions as well as gross income. when congress wants to limit deductions, it can do so explicitly.”). however, this debate is well beyond the scope of this note. the influence of historical tax law developments on anglo-american laws and politics arthur j. cockfield jonah mayles abstract this article highlights the influence of historical anglo-american tax law developments on the formation of new political institutions and laws. in critical periods of english and u.s. history, individuals rebelled against arbitrary royal taxes. in turn, they demanded new tax laws that became embedded in documents from the magna carta to the english bill of rights to the declaration of independence that promoted democratic constraints on the use of state power to assess and collect taxes. over time, the idea that individuals are entitled to equal treatment under the law, and possess inalienable human rights, emerged in part as a result of these tax law developments. the discussion in this article supports the view that pragmatic concerns over property and taxation drove important english and american political and legal reforms.  arthur cockfield is a professor with queen’s university faculty of law, canada. the writing and research for this paper took place in part during the spring 2013 semester when the author was a fulbright visiting chair in policy studies at the university of texas at austin.   jonah mayles is a tax associate lawyer with torkin manes llp in toronto. an earlier draft of this article was presented as part of a tax history panel at the annual meeting for the law and society association held in baltimore. the authors are grateful for the many helpful comments they received. they also wish to thank graeme adams, jd candidate at queen’s university faculty of law, for his helpful research assistance. 2013] the influence of historical tax developments 41 on anglo-american laws and politics i. introduction ............................................................................................. 42 ii. magna carta and the charter of liberties: the first tax laws .............................................................................................................. 43 the baronial tax uprising ........................................................................... 43 the signing of the magna carta and the charter of liberties .......................... 46 iii. seventeenth century england: the rise of tax law disputes ....................................................................................................... 49 a. king james versus john bate ....................................................................... 49 b. the case of the five knights, the petition of right and the three resolutions 50 c king charles versus john hampden: the ship-money case .......................... 53 d. cromwell versus cony the elder: the return to arbitrary taxation ............... 55 e. the glorious revolution and the english bill of rights ................................. 57 iv. tax developments in the formation of the american republic ....................................................................................................... 58 a. the stamp act as a unifying source for colonial anger ................................ 58 b. tea tax, rebellions and congressional responses ........................................ 60 c. taxation and the new republic .................................................................... 62 v. shaping anglo-american politics, laws and norms .................. 64 a. the political/legal effect ............................................................................ 64 b. shaping norms ............................................................................................ 66 vi. conclusion ................................................................................................. 68 42 columbia journal of tax law [vol.5:40 i. introduction this article shows how certain historical tax law developments shaped important anglo-american political/legal institutions. in critical periods of english and u.s. history, individuals rebelled against arbitrary royal taxes.1 in turn, they demanded new tax laws that became embedded in documents from the magna carta to the english bill of rights to the u.s. declaration of independence that promoted democratic constraints on the use of state power to assess and collect taxes. pragmatic concerns over property and taxation hence drove important english and american political and legal reforms. 2 under this article’s account, the political struggle over, and implementation of, tax laws led to political views by early english and american peoples that they, not the crown, were the true sovereigns of their destinies.3 the article is organized as follows. part ii discusses how the charter of liberties of 1100, the magna carta of 1215, and the confirmation of charters of 1297 in england provided the world’s first “good” tax laws that restricted the ability of the king to tax his subjects as he saw fit, leading to the first tax disputes and the struggle to develop appropriate due process protections. part iii reviews how dissatisfaction with arbitrary royal taxation in 17th century england culminated in the petition of right of 1628, the three resolutions of 1629, the bill of rights of 1689 and the emergence of england as a constitutional monarchy. the era also witnessed renowned tax prosecutions (in the bate, cony, five knights and hampden cases) that animated the productive bourgeoisie class against oppressive taxation measures. as a result of these disputes, this class of english 1 this article adopts a “big history” perspective by examining several discrete eras over a large time scale. for discussion of this approach, see david christian, the case for “big history”, 2 j. world hist. 223, 225 (1991) (noting that “big history” encourages a search for larger meanings in the past and discussing pitfalls and critiques of the approach). for a discussion on the potentials and limits of comparative history that compares and contrasts different eras and/or countries, see william h. sewell jr., marc bloch and the logic of comparative history, 6 hist. and theory 208, 214–18 (1967). 2 this account supports the view that important political and legal institutions were shaped to a significant extent by taxation concerns. for other views that emphasize how pragmatic concerns over taxation and debt, not theoretical philosophical concerns, shaped early american democratic institutions, see generally, noah feldman, divided by god: america’s church-state problem and what we should do about it (2005) (asserting that the doctrine of church/state separation within the u.s. constitution was mainly attributable to religious groups’, including baptists and quakers, opposition to compulsory religious taxation); calvin h. johnson, righteous anger at the wicked states: the meaning of the founders’ constitution (2005) (claiming that taxation concerns played a decisive role in shaping the u.s. constitution). prior literature has explored and emphasized the influence of protections against arbitrary royal prerogative found in early law, but has generally downplayed or ignored the role of tax laws. see, e.g., anne pallister, magna carta: the heritage of liberty (1971); frederic jesup stimson, the law of the federal and state constitutions of the united states (1908) (comparing civil and criminal protections under u.s. law with those in the magna carta); edward s. corwin, the “higher law” background of american constitutional law, 42 harv. l. rev. 149, 175–84 (1928) (emphasizing how theories concerning liberty and the king’s role influenced u.s. constitutional law). some historical accounts of tax matters focus on political developments without referencing in any detail the legal aspects of these developments. see also david f. burg, a world history of tax rebellions: an encyclopedia of tax rebels, revolts, and riots from antiquity to the present (2004) (providing a comprehensive discussion of historical tax rebellions). 3 the emphasis on how historical tax developments can shed light on modern political/legal institutions is drawn from the views of joseph schumpeter: “the fiscal history of a people is above all an essential part of its general history . . . in some historical periods the immediate formative influence of the fiscal needs and policy of the state on the development of the economy and with it on all forms of life and all aspects of culture explains practically all the major features of events . . . he who knows how to listen to its message here discerns the thunder of world history more clearly than anywhere else.” joseph a. schumpeter, the economics and sociology of capitalism 100–01 (richard swedberg ed., 1991). 2013] the influence of historical tax developments 43 on anglo-american laws and politics people became increasingly convinced that representative and fair tax laws were a necessary prerequisite to achieving a just and free society. part iv traces the role of tax laws in the american revolution and subsequent development of the republic, emphasizing colonial anger against “bad”, or unrepresentative english taxes without due process protections for tax disputes. these bad tax laws included the stamp act, the townsend revenue act, and the tea act, which led to passage of “good” tax laws, including the first congressional declaration, the declaration of independence and the constitution. part v outlines how these anglo-american tax developments, which influenced political and legal institutions, encouraged english and american peoples to adopt norms amenable to liberal political philosophical theories, including the movement toward evergreater equality and democracy. part vi summarizes and concludes. ii. magna carta and the charter of liberties: the first tax laws the roots of taxation go back to earliest recorded history, establishing the depressing truism that taxes and death are the only two certain things in life.4 taxes have always been interwoven with a nation’s fabric because a state needs revenues and resources to pursue its goals. so any rules or customs that promoted or restricted taxation have historically played an important role in defining the relationship between an individual and her larger community or country.5 as we shall see, something changed around the year 1100 when english kings began to be bound by laws that circumscribed their powers over taxation. these tax laws influenced the development of nascent governing councils and other political institutions as well as legal protections where individuals could challenge the legality of royal taxation through court hearings. the baronial tax uprising our story begins with angry barons in the 13th century in what we now call england, then ruled by cruel king john of robin hood fame. john may have been a cruel and unwise king by most historical accounts, but his kingdom was faced with numerous vexing problems.6 first, john’s brother—king richard the lionheart—had embarked on an expensive crusade to regain the holy land from the muslims. richard’s efforts had mixed results, at best.7 he was defeated twice by king saladin then kidnapped, forcing john to raise the necessary funds to pay the ransom.8 richard was a soldier, not a statesman, and the finances of his kingdom suffered for it.9 in 1199 richard died, and his brother john inherited the throne at about the age of 32, along with a financially mismanaged kingdom. 4 for discussion of the earliest western account of persian and egyptian tax rules by the ancient greek historian herodutus, see arthur j. cockfield, introduction: the last battleground of globalization, in globalization and its tax discontents 3 (arthur j. cockfield ed., 2010). 5 for a comprehensive discussion on the relationship between taxation and political institutions, see liam murphy & thomas nagel, the myth of ownership: taxes and justice 3, 11 (2002) (“[taxes] are also the most important instrument by which the political system puts into practice a conception of economic or distributive justice.”). 6 g.o. sayles, the medieval foundations of england 389–399 (1950). 7 id. at 381. 8 id. at 382. 9 id. at 381. 44 columbia journal of tax law [vol.5:40 second, there was an ongoing dispute between king john and the pope.10 with the death of the archbishop of canterbury in 1205, custom dictated that the king present the successor who would then, as a matter of formality, be confirmed by the church in canterbury.11 however, without waiting for john’s chosen appointee, john de gray, the monks elected their prior reginald to act as the archbishop to rome.12 king john eventually forced their hand and the church elected de gray as archbishop and sent him to rome for investiture.13 the papal authorities, however, had other ideas and pope innocent iii decided to put his own man, stephen langton (who would later play a prominent role in the uprising against king john), in place.14 the king’s denouncement of this decision led to his excommunication in 1209;15 the matter was ultimately settled when the king accepted langton as archbishop and agreed that england would become a vassal of the vatican.16 the cost, however, was steep: the pope was now entitled to substantial and ongoing compensation. the third and final nail in nation’s fiscal coffin was that king john himself embarked on various failed military campaigns to regain his ancestral homelands in normandy, which were taken away during his rule when norman feudal lords backed his nephew, arthur of brittany.17 the loss of normandy resulted in an estimated reduction of one-third of king john’s total income.18 at the end of john’s last campaign, the english armies were easily defeated at the battle of bouvines in what is now northern france on july 27, 1214 and john had to now prepare for a civil war back home in england.19 all of this led to a rather distressing financial situation on the home front, which john tried to address through increased taxation. in particular, john resorted to the use of feudal taxes called scutage and other levies (such as arbitrary fines) to replenish the royal treasury.20 with feudalism came a relationship between lord and vassal tied to the tenure of land. these feudal taxes could ordinarily be levied at the king’s discretion but custom dictated that extraordinary exactions required the consent of the vassal.21 traditionally, the king could expect his barons to participate and supply manpower in times of war.22 however, it was becoming more common for the barons to pay the king a fee in place of their services; this tax in place of a knight’s service was called scutage.23 mercenaries established themselves by the 12th century; kings frequently used them, rather than knights, to fight their wars. 24 consequently, during his reign and 10 id. at 394. 11 david nicholas, the evolution of the medieval world: society, government and thought in europe, 312–1500, at 230 (1992) 12 id. 13 id. 14 id. at 231. 15 sayles, supra note 6 at 394. 16 id. at 395. 17 nicholas, supra note 11, at 228, 238. 18 id. at 229. 19 j.c. holt, magna carta 188–89, 221 (2d ed. 1992). 20 j.c. holt, the making of magna carta (1965). 21 see william sharp mckechnie, magna carta: a commentary on the great charter of king john 232 (1914). 22 id. at 233–34. 23 id. 24 h.g. richardson & g.o. sayles, the governance of medieval england from the conquest to magna carta 375 (1963). 2013] the influence of historical tax developments 45 on anglo-american laws and politics particularly during his campaigns in normandy, john levied a total of eleven scutages and even deviated from the custom of levying the tax at the end of the war by using tax measures at the beginning of a war.25 it has been contended that scutage was effectively converted into a general tax.26 on may 26, 1214, john issued writs for the collection of scutage at a rate of three marks, which was higher than any rate imposed over the last half century.27 the northern barons, who would later be instrumental in forcing john to sign the magna carta, refused personal service and scutage in place of their service on the ground that they were not obligated to fight overseas.28 scutage was a driving force behind the creation of the magna carta, not only because of its amount, but also because of its frequency.29 john in effect used his feudal rights over taxation as a system of manipulation and as a means of controlling the barons.30 john would issue writs for excessive taxes and, when certain barons could not pay, john used the baronial debts to enforce political discipline.31 those out of favour with the king would frequently be called upon to repay their debts quickly or suffer additional penalties or imprisonment. 32 in 1213 while preparing for his campaign in poitou, john called on a number of debtors to provide the service of knights in lieu of payment or required the debtors to accept terms of payment.33 in addition, john instituted new measures of taxation while also exercising his customary rights. he raised the amounts of feudal incidents, extended the forest law by assessing charges on newly cultivated land, and married heiresses to persons of his choice.34 the barons were understandably distressed by these developments and began to stir up a rebellion against the king. they were supported by langton and the clergy, who had also become susceptible to john’s heavy taxation. in 1207, for instance, the clergy were forced to contribute 60,000 pounds to the crown treasury.35 although the uprising which lead to the signing of the magna carta cannot be construed as the result of a unified cause among the varied classes of english society, it is important to note that the barons, while acting in their own interests, had the support of the clergy and, at least to a certain extent, the lower classes.36 25 see holt, supra note 19 at 318–19. two of his eleven scutages were levied despite no “fullscale campaign.” id. at 319. 26 gottfried dietze, magna carta and property 22 (1965). 27 shepard ashman morgan, the history of parliamentary taxation in england 58, 60 (1911). 28 id. at 60. 29 id. at 50. 30 j.c. holt, magna carta and medieval government 134 (1985). 31 id. at 136. 32 id. at 136–37. 33 holt, supra note 19 at 193–94. 34 nicholas, supra note 11, at 229–30. 35 richardson & sayles, supra note 24, at 376. 36 the clergy, as already mentioned, were not immune from ruthless taxation, and when the barons were heavily taxed, a great deal of the hardship was placed on the commoners. there were also practical reasons why the barons wanted to support the interests of their workers. the barons were land-holders who lived off subleases to a productive class of farm workers; increased taxation on the barons meant that they would be forced to increase charges to these workers. unhappy commoners might even revolt against the members of the nobility—there were a number of peasant tax revolts throughout medieval europe—placing the lives of the barons and their families at risk. 46 columbia journal of tax law [vol.5:40 the signing of the magna carta and the charter of liberties to the barons, the situation was unsustainable and they stormed and captured london, ultimately forcing john to capitulate and sign a document entitled the magna carta (latin for "great charter") at runnymede on june 15, 1215.37 the magna carta is considered one of the first legal documents to impose clear restrictions on the king’s powers: it established the principle that no one, including the king, is above the law and is often cited as one of the first steps in a historical process that eventually led to the rule of law within modern democracies.38 in fact, the less-mentioned charter of liberties (sometimes referred to as the coronation charter39) signed by henry i in 1100 was likely the first document to bind the english royalty to tax laws.40 the document was written a mere thirty four years after the normans conquered briton and slew the last truly english king, harold, at the battle of hastings. henry, perhaps seeking to quell ongoing rebellions against the new rulers, makes it clear in the first paragraph of his charter that arbitrary taxation concerns also motivated its issuance: “and because the kingdom has been oppressed by unjust exactions, i, through fear of god and through the love that i have for you all”41 grant a number of freedoms, including the abolishment of taxes such as the seigniorage, which was roughly equivalent to a modern day sales tax. king henry, unlike king john, enthusiastically embraced the idea of cutting back his power over taxation through tax laws. this is evidenced by his grant of tax liberties to london in 1133 where he provided for sweeping exemptions from royal taxation so that london could assess and collect its own tax.42 while henry’s rule might seem like a natural place to begin a discussion of restrictions on arbitrary taxation, his charters apparently had far less precedential value, in both the common law and the collective memories of the english, than the magna carta. nevertheless, the charter of liberties has been said to have influenced the subsequent baronial tax revolt against john and inspired the principles set out within the magna carta.43 because the king was considered to be divine both the charter of liberties and the magna carta can be viewed as revolutionary documents: they were akin to putting hand-cuffs on god. the sixty-three chapters of the magna carta read very much like a tax statute, filled with qualifiers and caveats, cross-references, definitions, appeals to broad generalities and special preferences; in short the sort of writing only a tax lawyer could love. importantly, chapter 12 illustrates the restrictions placed on the king in levying certain taxes on the barons: no scutage nor aid shall be imposed on our kingdom, unless by common council [sometimes translated as “common counsel”] of our kingdom, except for ransoming our person, for making our eldest son a knight, and 37 morgan, supra note 27 at 61–62. 38 see, e.g., pallister, supra note 2; dietze, supra note 26, at 3–7. see also h. d. hazeltine, the influence of magna carta on american constitutional development, 17 colum. l. rev. 1 (1917) (discussing the influence of the magna carta on the laws of the american colonies and the subsequent u.s. constitution). 39 dietze, supra note 26, at 8. 40 charter of liberties of henry i, 1100, internet medieval source book – fordham university (feb. 1996), http://www.fordham.edu/halsall/source/hcoronation.asp. 41 id. at ch. 1. 42 henry i, king of england: grant of tax liberties to london, 1133, internet medieval source book – fordham university (oct. 1998), http://www.fordham.edu/halsall/source/1133hank1tax.asp. 43 see pallister, supra note 2, at 2. 2013] the influence of historical tax developments 47 on anglo-american laws and politics for once marrying our eldest daughter; and for these there shall not be levied more than a reasonable aid. in like manner it shall be done concerning the aids from the city of london.44 this provision and chapter 14, which sets out the process by which common council will be derived, are particularly notable because they are the only provisions within the magna carta that require agreement by the common council and thus restrict the ability of the king to do what he pleases.45 while the magna carta deals with a variety of other state issues,46 there are no additional provisions that create a council to scrutinize royal decision-making on an ongoing basis (although more general chapters 52 and 61 provided for the creation of a body with twenty-five elected barons who would ensure that the king abided by his agreement to grant the listed freedoms if disputes arose).47 this highlights the fact that concerns over arbitrary taxation were front and center in the barons’ minds. it is also important to take note of which taxes were included in the two chapters. a tallage, as opposed to an aid, means “a toll or exaction imposed on individuals who had no option of refusal.”48 tallage could be imposed on town citizens by the king at his prerogative.49 tallage was omitted from the charter, most likely because tallage had no great effect on the barons: the residents of cities were subjected directly to the tax whereas the barons predominantly resided in the countryside.50 the absence of any mention of tallage supports the commonly-held view that the charter was not a revolutionary document constructed with the purpose of furthering republican ideals of equality but rather was created to protect the barons from the king’s prerogative to collect taxes at will:51 “the ‘barons had no suspicion that they would one day be called the founders of english liberty’ and that the charter simply embodied the immediate practical interests which had driven them into rebellion.”52 there is no indication that the barons were concerned with the rights of all classes against arbitrary taxation. chapter 14, for instance, which stipulates who constitutes the common council—archbishops, bishops, abbots, earls, and greater barons—does not mention a representative of the common classes.53 soon after signing the magna carta, king john rescinded his support for the document and promptly died of dysentery.54 after john’s death, his son henry iii was crowned king of england at the age of nine in 1216.55 henry could not immediately assume power due to his age so the government was in the hands of his regent.56 the 44 magna carta, ch.12. 45 see magna carta chs. 12, 14. 46 in fact, the magna carta and the charter of liberties contain more provisions that grant rights to women, mainly prohibitions against marrying women against their will, than tax provisions. see, e.g., magna carta, ch. 8; charter of liberties ch. 3. 47 magna carta, chs. 52,61. 48 mckechnie, supra note 21, at 235. 49 id. 50 id. at 236–38. 51 see holt, supra note 19, at 267–68 52 id. at 268 (quoting charles petit-dutaillis, etude sur la vie et le regne de louis viii 57– 58 (1894). 53 magna carta, ch. 14; see also max radin, the myth of magna carta, 60 harv. l. rev. 1060, 1060 (1947) (noting that only two clauses in the magna carta discuss aspects of political liberty). 54 w. l. warren, king john 253 (3d ed. 1997). 55 id. at 254. 56 morgan, supra note 27, at 73. 48 columbia journal of tax law [vol.5:40 charter was promptly reissued with, most notably, chapters 12 and 14 omitted.57 the barons were able to assume substantially more power with a young king on the throne.58 with an end to john’s tyranny, the council did not favour restricting royal power especially in light of the fact that they were, at least indirectly, wielding the royal prerogative.59 chapter 44 of the reissued charter states scutage “shall be taken as it was wont to be taken in the time of king henry our uncle.”60 there is no mention of consent by common council and the only restriction is that scutage should not exceed the amount of 20 shillings.61 despite the exclusion of chapters 12 and 14, as we shall see, the reissued charter did not expel their principles from english thought or the common law.62 this did not prevent future rulers from levying taxes without consent. the difference would be that when the king found himself facing opposition for his tax policies, those opposing the exactions would claim legal rights under the magna carta. there is some evidence that the older version of the charter was still followed. for example, in 1222, there is record of the common council granting an “aid for the holy land” of three marks for an earl, one mark for a baron, and twelve pence for a knight.”63 in any event, similar provisions to the original magna carta were reintroduced, including provisions mandating the use of a common council in taxation matters, in the so-called confirmation of charters of 1297.64 the barons once again rose up in armed rebellion against their king, edward, due to his imposition of steep taxes on english wool as well as aids levied against the nobility.65 legal historians have carefully scrutinized the role of the magna carta in subsequent legal developments: much of the literature, however, emphasizes the document’s innovative civil and criminal procedural protections against arbitrary crown power.66 in fact, because the collection of tax often requires intrusive inquisition of a person or their property, the civil and criminal protections are very much related to the protections against arbitrary taxation. as we shall see, later english commentators emphasized the writ of habeas corpus as a protection against unlawful intrusions by tax collectors. all of this led to what may have been one of the first tax law disputes. in 1217 peter des roches, in an apparent struggle against the growing baronial influence over the crown, refused to pay an aid of two marks on the knight’s fee on the grounds that he had not consented to the levy.67 des roches paid the tax bill after the barons issued a writ imposing scutage on january 24, 1218, which was signed as being “assessed by the common council of our realm.”68 57 id. 58 id. 59 id. 60 id. at 75. 61 id. twenty shillings was the rate during the reign of king henry ii. id. 62 see holt, supra note 19, at 397–99. 63 mckechnie, supra note 21, at 233–34 (citing kate norgate, the minority of henry iii 194 (1912). 64 confirmation of the charters, 1297, internet medieval source book – fordham university (feb. 1996), http://www.fordham.edu/halsall/source/conf-charters.asp. 65 morgan, supra note 27, at 141. 66 see supra discussion in note 2. 67 holt, supra note 19, at 399. 68 morgan, supra note 27, at 76-77. 2013] the influence of historical tax developments 49 on anglo-american laws and politics peter des roches was later involved in another dispute regarding taxation without consent.69 in 1220, des roches along with the earls of chester and salisbury led a “widespread resistance” to the assessment of a tax.70 the knights of yorkshire refused to execute the writ stating that the tax had not been conceded by the magnates (i.e., powerful nobles) and the king’s faithful subjects.71 the knights argued that the magnates of the county did not know of nor were consulted on the levy, and it was therefore not a valid exaction.72 the barons repeated and furthered the same argument some thirty-five years later when henry iii demanded an aid. 73 this time the barons made direct reference to the fact that the aid was not raised in accordance to the terms of the charter.74 taxation disputes were hardly resolved with the great charter; it was merely the first step in a long, drawn-out dispute over the power of taxation. this battle would be fought between the monarchy and nobility for centuries to come. yet the magna carta and its restrictions on the king’s ability to levy exactions on the properties and persons of his realm can be portrayed as an important initial step in the long march towards the political philosophy of liberalism (see part v). one of the next major shifts would not come until the reigns of charles i and cromwell, almost four hundred years later. iii. seventeenth century england: the rise of tax law disputes once the barons got a taste of freedom, more tax trouble lay ahead, including tax uprisings in the thirteenth through sixteenth century. despite these troubles, there was very little progress in the development of tax laws until the seventeenth century, when the political climate would once again be ripe for the english aristocracy to gain more control over taxation.75 this century witnessed the birth of what is easily recognizable as modern england. again, turmoil and tax laws played a fundamental role in reshaping the relationship between the state and the individual, providing fertile ground for growing individual freedom that was extended for the first time to the non-elites of english society (although the struggle was primarily concerned with protecting the rights of a productive bourgeoisie class against the political power of the landed gentry). a. king james versus john bate soon after the seventeenth century began, england became embroiled in a contentious tax dispute involving an unhappy merchant named john bate. at the time, king james’s kingdom was running an annual deficit of roughly 150,000 pounds. 76 james decided to raise revenues by way of an additional levy on merchants, in addition to the traditional “currants.” 77 by harkening back to the magna carta, john bate, a merchant for the levant company, challenged the right of the king to levy these additional amounts.78 the barons presiding over the court of exchequer unanimously 69 holt, supra note 19, at 399. 70 id. 71 id. 72 id. 73 id. at 400. 74 id. 75 see, e.g., pallister, supra note 2, at 2–3 (noting the decline of the magna carta in importance until the early 17th century). 76 morgan, supra note 27, at 240. 77 id. at 240–41. 78 holt, supra note 19, at 14 50 columbia journal of tax law [vol.5:40 decided in favor of the king and against bate. 79 the decision became a notorious example of the king’s desire for absolute authority over the nation’s finance, leading many members of the emerging middle-class of artisans and entrepreneurs to question the absolutist rhetoric of baron clarke who wrote in his judgment that “any subjects [cannot] contend with the king in his high point of prerogative . . . as it is not a kingdom without subjects and government, so he is not a king without revenue . . . .”80 as mentioned in the previous sections, the barons were increasingly perceived as being together with the king in their complacency with respect to arbitrary taxation.81 the bate case was widely publicized among the bourgeoisie class who were increasingly resentful of unproductive land-holders, including the barons and king james. to english people of this earlier era, the bate case represented the tyrannical impulse of the english monarchy and nobility.82 the bate case would be subsequently used by king charles as a precedent to argue for his own attempts to broaden taxation, which culminated in disastrous results for the english monarchy.83 king james died in 1625 and was followed by king charles, then a young man of twenty-five. 84 like john before him, charles was obsessed with reclaiming lost territories through war and his disastrous foreign campaigns created an ever-growing need for more revenues.85 yet parliament had grown in power since the time of the common council to a body with real power to constrain the king’s revenue raising abilities. a parliamentarian could now be a member of the merchant class, who felt that taxation stifled their productive activities. much to charles’ dismay parliament refused to consent to the additional subsidies needed for his proposed campaigns.86 on june 15, 1626, charles dissolved parliament in part to put a stop to the constant attacks by the house of commons against his adviser and ally, the duke of buckingham.87 unfortunately, the dissolution of parliament only worsened charles’s fiscal problems and frustrated his ability to finance buckingham’s ongoing foreign campaigns.88 buckingham’s forays into france ended in defeat at the isle of rhe, which left charles without a victory and, more importantly, without the spoils of war which he intended to use to rectify his kingdom’s worsening financial situation.89 b. the case of the five knights, the petition of right and the three resolutions to finance additional campaigns, charles instituted what would later be called "forced loans."90 the "loans" were roughly equivalent to taxation as a subject who refused to pay was sentenced to prison without a formal hearing or due process, hence the "forced" aspect of the loan.91 since the time of the great charter, the need for consent to 79 morgan, supra note 27, at 242–44. 80 id. at 242. 81 see, e.g., id. at 242. 82 id. at 244–48. 83 see burg, supra note 2, at 195–96. 84 morgan, supra note 27, at 261. 85 id. at 264–67. 86 id., at 274–79. 87 id. at 264. 88 id. 89 see id. 90 id. at 264. 91 see d.h. pennington, europe in the seventeenth century 459–60 (denys hay ed., 2d ed. 1989). 2013] the influence of historical tax developments 51 on anglo-american laws and politics taxation, as previously discussed, was limited, if at all, to specific types of taxation; the king was hence ostensibly permitted to exact other taxes and loans without consent. nevertheless, five of the knights detained for their opposition to the loans protested their imprisonment based on their denial of due process rights set out in previous charters.92 in the case of the five knights, the courts again sided with the king, increasing public resentment among the nobility and the merchant class against the king’s absolute authority in a court of law.93 despite his failures in france and, later, spain, charles stubbornly persisted in his view that, with sufficient funding, he would eventually overcome his enemies. in 1628, charles summoned another session of parliament and called for its consent to increased levels of taxation.94 but parliament refused consent, in part over unhappiness surrounding the forced loans and the case of the five knights.95 before parliament would agree to grant charles additional revenue sources, a group within the house of commons, led by sir edward coke and sir john eliot, drew up the petition of right: [b]y which statutes before mentioned, and other the good laws and statutes of this realm, your subjects have inherited this freedom, that they should not be compelled to contribute to any tax, tallage, aid, or other like charge not set by common consent, in parliament.96 the magna carta clearly played a role in the development of this document. coke and others argued that the magna carta reflected more ancient traditions dating back to britain prior to the invasion and conquest by the norman armies in 1066.97 king charles initially refused to sign the petition of right but, desperate for more revenues, ultimately gave in and signed the document on june 7, 1628.98 it has been said that parliament’s limited ability to exert control over taxation played a decisive role in forcing charles to agree to limitations on his royal prerogative to issue forced loans.99 once the document was signed, parliament granted charles additional taxes that would raise 275,000 pounds.100 the petition of right can be seen as an important expansion of parliament’s ability to control aspects of taxation because parliamentary consent was now 92 proceedings on the habeas corpus, brought by sir thomas darnel, sir john corbet, sir walter earl, sir john heveningham and sir edmund hampden (1627), in 3 a complete collection of state trials 1–3 (t. b. howell, ed., 1816). 93 id. at 1. 94 morgan, supra note 27, at 265. 95 id. at 265–69. 96 petition of right 1628, american history: from revolution to reconstruction and beyond, http://www.let.rug.nl/usa/documents/1600-1650/petition-of-right-1628.php (last visited nov. 9, 2013). 97 see pallister, supra note 2, at 10. under this so-called cokean version of the magna carta, anglo-saxon england was essentially a more egalitarian and democratic state where the king was willing to share his powers with other nobility, including seeking their consent over taxation. the consensus view, however, among historians is that the early kings were no more democratic than their more recent counterparts. 98 pennington, supra note 91, at 456-57. 99 see j.s. roskell, perspectives in english parliamentary history, in 2 historical studies of the english parliament 296, 318–19 (e. b. fryde & edward miller eds., 1970). 100 see burg, supra note 2, at 196. 52 columbia journal of tax law [vol.5:40 required for taxes beyond "aids" and "scutages" to encompass "any tax, tallage, aid, or other like charge" (a non-exhaustive list familiar to readers of tax statutes).101 the link between due process protections against arbitrary imprisonment for failure to pay taxes and tax concerns is also evident within the petition of right: and whereas also by the statute called "the great charter of the liberties of england," it is declared and enacted, that no freeman may be taken or imprisoned or be disseized of his freehold or liberties, or his free customs, or be outlawed or exiled, or in any manner destroyed, but by the lawful judgment of his peers, or by the law of the land.102 like king john, charles was eventually undone by his unquenchable thirst for for revenue sources. despite the signing of the petition, king charles continued to issue taxes without parliamentary approval and continued to imprison those who refused to, or could not, pay. 103 when challenged, charles sometimes relied on the previouslymentioned bate case as the legal authority for these continued actions.104 in yet another effort to curtail the king’s taxation policies, in 1629 sir john eliot drafted the three resolutions.105 in stark contrast to the magna carta and the petition of right, eliot addressed his document directly to the people and not to the king himself. the second and third resolutions called on the people of england to refuse payment of the king’s latest taxes: [resolution] 2. whosoever shall counsel or advise the taking and levying of the subsidies of tonnage and poundage, not being granted by parliament, or shall be an actor or instrument therein, shall be likewise reputed an innovator in the government, and a capital enemy to the kingdom and commonwealth. [resolution] 3. if any merchant or person whatsoever shall voluntarily yield, or pay the said subsidies of tonnage and poundage, not being granted by parliament, he shall likewise be reputed a betrayer of the liberties of england, and an enemy to the same.106 eliot’s goal was to make the payment of the king’s unapproved taxes an act of treason.107 because they directly appeal to all royal subjects, the three resolutions can be seen as a much more radical and revolutionary document than its predecessors. yet the three resolutions has suffered from relative obscurity when compared to the magna carta or the petition of right. a plausible explanation for this may be found in the fact that the king had instructed his obedient speaker of the commons, sir john finch, to adjourn parliament when the three resolutions were introduced. 108 other members of the commons protested this adjournment and finch was physically held down by the protestors who shouted their approval of the resolutions, although no formal vote was 101 see morgan, supra note 27, at 269–70. 102 petition of right 1628, supra note 96. 103 morgan, supra note 27, at 272–74. 104 id. at 274. 105 id. at 277–78. resolution 1 was an anti-catholic screed against the introduction of “popery” into religious life. the three resolutions (mar. 2, 1629), in the stuart constitution 1603-1688, 71 (j. p. kenyon, ed., 2d ed. 1986). 106 the three resolutions, supra note 105. 107 morgan, supra note 27, at 277–78. 108 see morgan, supra note 27, at 276–79. 2013] the influence of historical tax developments 53 on anglo-american laws and politics apparently taken to make it an official document. 109 sir eliot was arrested and imprisoned in the tower of london where he died of illness.110 charles gave up in his attempts to sway the members of the commons and dissolved parliament, and so began his eleven year personal rule of england.111 c king charles versus john hampden: the ship-money case to forestall financial ruin, king charles implemented new tax initiatives, the most disastrous of which was the ship-money tax. the king had previously levied a tax on coastal towns to force these towns to construct ships for defense in the event of invasion and siege.112 this form of taxation, however, had never caused much trouble until charles renewed it with more vigor and ambition than ever before. on october 20, 1634, the first writ of ship-money was issued to several coastal towns, raising a little over 104,000 pounds.113 the king appointed his crony, sir john finch, as the chief treasurer and finch promptly issued a new writ on august 4, 1635 that, without precedent, extended the ship-money taxes inland.114 moreover, unlike the forced loans, the shipmoney tax was levied on all classes of society: this expanded tax, it has been noted, influenced the formation of a broad coalition of discontent stretching to every town and class as more and more english men and women were swept into the tax net.115 the extension of the exaction of ship-money to all classes also helped to make the ship-money case of john hampden into one of national interest as its outcome affected more than the nobility. hampden, a lawyer and parliamentarian, had previously been incarcerated for a year in 1628 for refusing to pay the forced loans.116 in 1637, hampden refused to pay the assessment of ship-money tax (a mere twenty shillings) levied on his lands and his dispute came before the court of the exchequer.117 the renowned and widely respected lawyer sir oliver st. john represented hampden and delivered what has been called “the finest argument that had ever been heard in westminster hall.”118 his argument was also notable as it lasted “two whole days”!119 looking back to ancient tax principles allegedly developed during the saxon times, the magna carta and the petition of right, st. john argued that the king was prohibited from subjecting individuals to arbitrary taxation: for the first, that to the altering of the property of the subject's goods, though for the defence of the realm, that a parliamentary assistance is necessary . . . my lords, the parliament, as it is best qualified and fitted to make this supply for some of each rank, and that through all the parts of the kingdom being there met, his majesty having declared the danger, they best knowing the estates of all men within the realm, are fittest, by 109 id. at 277. 110 id. at 280. 111 id. at 278–80. 112 burg, supra note 2, at 199. 113 id. at 199. 114 see morgan, supra note 27, at 282. 115 id. 116 john eric adair, a life of john hampden, the patriot 53–54 (1976). 117 morgan, supra note 27, at 287. 118 john lord campbell, the lives of the chief justices of england 453 (1849). 119 id. at 454. 54 columbia journal of tax law [vol.5:40 comparing the danger and men's estates together, to proportion the aid accordingly.120 st. john argued that, pursuant to the law, the ship-money tax and all other extraordinary levies required the consent of parliament.121 by restricting the king’s power to tax, royal subjects increasingly viewed their income and properties as their own. st. john’s argument appears to be closely-aligned with “the belief that the subject possessed property which was truly his own and could not be taken from him without his consent, [which] played a major part in shaping men’s beliefs and in determining their policies and actions.”122 in spite of st. john’s spirited defense, the court ruled seven to five in favour of the crown, agreeing that that the ship-money exaction was within the king’s discretion to protect the country in times of imminent danger.123 news of the court proceedings rapidly spread throughout the country by “means of coffee-houses, clubs, and newsletters.”124 as in the cases of bate and the five knights, the court’s judgment led to widespread resentment and disillusionment concerning king charles’s rule. 125 according to a contemporary, the court’s decision provided a shock to those who thought the rule of law circumscribed the king’s powers as the case was seen "to be a meere delusion and imposture, and doubtlesse it is but a picklock tricke, to overthrow all liberty and propriety of goods, and it is a great shame that so many judges should be abetters to such fraudulent practice contrived against the state."126 in the eyes of the english, the court system was revealed to be a mere puppet of royal prerogative that danced to an increasingly distressful tune: and all assuring themselves, that when they should be weary, or unwilling to continue the payment, they might resort to the law for relief and find it . . . and, instead of giving, were required to pay, and by a logic that left no man any thing which he might call his own . . . .127 the ship-money case, under the traditional view, was instrumental in the impending civil war, the toppling of charles, and the ascension of cromwell, in part because the case united the classes of england against arbitrary royal rule.128 while there are clearly other 120 extracts from the speech of oliver st. john in the ship-money case, in the constitutional documents of the puritain revolution 109, 113–14 (samuel rawson gardiner ed., 3d ed. 1906). 121 morgan, supra note 27, at 287–89. 122 margaret atwood judson, the crisis of the constitution: an essay in constitutional and political thought in england, 1603-1645, at 43 (1949). see also richard a. epstein, liberty versus property? cracks in the foundations of copyright law, 42 san diego l. rev. 1, 2–4 (2005) (noting that classical liberal tradition supports the view that private property is consistent with a regime of personal liberty). 123 morgan, supra note 27, at 290–91. 124 campbell, supra note 118, at 194. 125 morgan, supra note 27, at 291. 126 henry parker, the case of shipmony briefly discoursed, according to the grounds of law, policie, and conscience and most humbly presented to the censure and correction of the high court ofor parliament, nov. 3,1640, at 40 (1640). 127 edward earl of clarendon, the history of the rebellion and civil wars in england 28 (1843). 128 see burg, supra note 2, 199-200. 2013] the influence of historical tax developments 55 on anglo-american laws and politics motivating factors, including protestant-catholic religious turmoil, charles’ tax laws and public reaction to these laws were decisive factors that led to the overthrow of his rule.129 charles’ personal rule ended in 1640 when civil war erupted throughout the land, culminating in his beheading for "high treason and other crimes," the first time that an english monarch had been put on trial.130 in august 1641, members of the commons met and declared ship-money and the proceedings against hampden to be illegal: that the said charge imposed upon the subject for the providing and furnishing of ships commonly called shipmoney . . . were and are contrary to and against the laws and statutes of this realm the right of property the libertie of the subjects former resolutions in parliament and the petition of right made in the third yeare of the reign of his majestie that now is.131 this group, which came to be known as the long parliament, fomented the great rebellion that secured the paramountcy of parliament over the crown in english politics.132 the ship-money protests are considered to have served as a pivotal event in english political history133: of course, like all historical events, these protests did not occur in a vacuum but can be related to other events centuries in the making. nevertheless, the struggle surrounding the power to tax provided the necessary impetus to stir up revolution. parliament would subsequently take a more active role in governing and sharing power with monarchy. d. cromwell versus cony the elder: the return to arbitrary taxation after king charles was overthrown, cromwell assumed control over the country.134 after years of costly civil wars and rebellion, cromwell inherited a nation with a depleted treasury. initially viewed as a man of the people, cromwell appears not to have learned lessons from his predecessors concerning unwise tax policies. he turned, like the kings before him whom he had opposed, to taxation to resolve this problem. the cony tax case helped to transform cromwell from a man of the people into a despised despot like the tyrants of old. the event that led to the dispute, where cony the elder and his son george resisted what they viewed as illegal taxation, was recorded by a contemporary of cony as follows: that the said cony the elder and george cony the younger and others did on the fourth day of this instant november, 1654 affront and abuse theophilus colcoke and others, deputies for the commissioners of the customes in the execution of the trust to them committed, and particularly opposed, beat, or caused to be beaten some of the said deputies when they peaceably entered the house of the said cony, in 129 l. m. hill, county government in caroline england 1625-1640, in the origins of the english civil war 83-89 (conrad russell ed., 1973); conrad russell, parliament and the king’s finances, in the origins of the english civil war 116 (conrad russell ed., 1973). 130 c. v. wedgwood, the trial of charles i 9 (1964). 131 ship-writs, and proceedings thereupon, contrary to law, in 5 the statutes of the realm 116, 117 (eng., 1640). 132 burg, supra note 2, at 200. 133 id. at 200. 134 clarendon, supra note 127, at 794–95. 56 columbia journal of tax law [vol.5:40 which severall great quantities of silks, for which no custome was payed, were lodged.135 when cromwell summoned cony to appear before him, cony asserted, as did the three resolutions, that it was in fact treasonous to submit to cromwell’s illegal taxation: that all who submitted to them, and paid illegal taxes, were more to blame, and greater enemies to their country, than they who had imposed them; and that the tyranny of princes could never be grievous, but by the tameness and stupidity of the people.136 cromwell proved to be unsympathetic and sentenced cony the elder to prison for refusal to pay the tax.137 cony’s counsel, maynard, argued for his client’s freedom on the basis that his client had been denied due process and that the tax amounted to an illegal exaction.138 to the horror of many, cromwell incarcerated maynard in the tower of london for having the audacity to question his authority.139 this in turn led to the resignation of a presiding judge, justice rolle, at cony’s trial, belying cromwell’s earlier claims that he would support a more independent court through non-politicized appointments to the bench.140 justice rolle was a reputed independent thinker who resigned in opposition to cromwell’s continued use of arbitrary power to tax without proper approval from parliamentarians.141 the judge apparently feared that cromwell would imprison him if he ruled against the crown.142 justice rolle’s concerns were reflected by an address by a member of parliament in 1656 that spoke to the arbitrary rule of cromwell in the cony case: nor shall any man under these rigid tax masters retayne any longer a property in his estate then this our grand signeur shall please to continue him in it . . . it was then little imagin’d that the time should come, when this [cromwell,] great champion of the lawes, should stop the lawes in 135 samuel selwood, a narrative of the proceedings of the committee for preservation of the customes, in the case of mr. george cony merchant 10 (1655). 136 see clarendon, supra note 127, at 862. 137 id, 138 id. 139 id.; see also stephen f. black, coram protectore: the judges of westminster hall under the protectorate of oliver cromwell, 20 am. j. legal hist. 32, 56–57 (1976). 140 see id. at 57–58. cromwell had hoped to gain favour by fostering a more independent court, thus placing justices on the bench regardless of their political persuasions. id. at 58. cromwell must have been greatly disheartened at his lack of control over those appointed by his good graces and when the judges invoked magna carta, “cromwell told them ‘their magna farta should not control his actions; which he knew were for the safety of the commonwealth.’ he asked them, ‘who made them judges? whether they had any authority to sit there, but what he gave them? and if his authority were at an end, they knew well enough what would become of themselves; and therefore advised them to be more tender of that which could only preserve them;’ and so dismissed them with caution, ‘that they should not suffer the lawyers to prate what it would not become them to hear.” clarendon, supra note 127, at 862. the authors of this article note that, in a 19th century recording of this passage, “farta” has been excised to read magna fxxx, presumably to protect the delicate sensibilities of readers from that era, or possibly out of fear of state censorship. see id.; campbell, supra note 118, at 89. 141 black, supra note 139, at 57–58. 142 id. at 57–58. 2013] the influence of historical tax developments 57 on anglo-american laws and politics theyr due course and imprison the most eminent of the long robe for declaring the expresse letter of the lawes . . . .143 the cony case and subsequent resignation of justice rolle provided fuel for the growing royalist cause. two years later in 1658 cromwell succumbed to an infection; in 1661, his body was exhumed and he was posthumously beheaded with his severed head displayed on a pole outside westminster hall.144 before any royal restoration could take place, however, parliament wanted to ensure that its ability to control taxation was protected under the bill of rights.145 e. the glorious revolution and the english bill of rights the ongoing struggle over who should have the right to levy taxes again served to influence subsequent expansions of individual liberty. in the events leading up to the glorious revolution, a charged debate took place in 1689 within parliament concerning the need to constrain the monarch’s control over taxation: i think we ought to be cautious of the revenue, which is the life of the government, and consider the last two reigns.146 we may date our misery from our bounty here. if king charles ii had not had that bounty from you, he had never attempted what he had done.147 the members of the commons recognized that the granting or withholding of revenue powers was their primary bargaining tool with the crown.148 unhappy with the rule of king james ii, they decided to take action and ousted the king who fled to france, to be replaced by two new co-rulers, william and mary after they had agreed to accept a declaration of right drawn up by the parliamentarians.149 the new king and queen were forced to offer concessions that expanded individual rights against arbitrary taxation to an extent not seen within the western world. on december 16, 1689, the declaration of right was embodied in an act declaring the rights and liberties of the subject and settling the succession of the crown, which is now known as the bill of rights.150 for the first time, the bill of rights clearly set out the position that it was parliament and not the crown that had authority to enact a tax: “that levying money for or to the use of the crowne by pretence of prerogative without grant of parlyament for longer time or in other manner than the same is or shall be granted is illegall.”151 143 an appeale from the court to the country made by a member of parliament lawfully chosen, but secluded illegally by my l. protector 2, 5 (1656). 144 wedgwood, supra note 130, at 216. 145 charles adams, for good and evil: the impact of taxes on the course of civilization 257–58 (1999). 146 statement by sir thomas clarges in a grand committee on the king's revenue, in 9 debates of the house of commons, from the year 1667 to the year 1694, at 123 (hon. anchitell grey, esq. ed., 1763). 147 statement by sir edward seymour in a grand committee on the king's revenue, in 9 debates of the house of commons, from the year 1667 to the year 1694, 123, 125 (hon. anchitell grey, esq. ed., 1763). 148 see, e.g., 9 debates of the house of commons, supra note 146, at 123–128. 149 pennington, supra note 91, at 485–86. 150 morgan, supra note 27, at 306; bill of rights, 1688, 1 w. & m., c. 2. 151 see bill of rights, supra note 150. 58 columbia journal of tax law [vol.5:40 the new power over taxation forced parliament to develop more systematic methods of governance. unlike previous parliaments which in many ways acted as a rubber stamp for proposed revenue measures passed by royal prerogative, the new parliament became a functional and increasingly powerful institution within england. the members of the commons were closer to the lives and needs of their constituents—at least when compared to the king—which bred a far more efficient means of taxation that, in turn, brought in more and more revenues. miller suggests this enhanced efficiency and stability within tax administration led to a dramatic growth in england’s ability to wage successful wars and english dominance of world affairs throughout the next two hundred years.152 the passage of the bill of rights is sometimes portrayed as a turning point in world history. with its passage, england became a constitutional monarchy and fullfledged member of the modern world. iv. tax developments in the formation of the american republic the final step toward the formation of a constitutional democracy with more representative democratic institutions for taxation was left to the americans under their rallying cry of "no taxation without representation." the american innovation would have a profound political impact in shaping the modern world by influencing the subsequent push toward a parliamentary democracy in england and the development of other constitutional democracies. a. the stamp act as a unifying source for colonial anger the story of how the boston tea party sparked the american revolution is well known. while there is ongoing debate surrounding the role of taxes in sparking the american revolution,153 the historical record shows that taxation provided a significant motive for american anger at english rule: the riots, mobs and political debates circled mainly around taxation.154 the source of this discontent may have been attributable to taxes promoted by an earlier stamp act, and not to the later and more notorious tea tax.155 the tax disputes once again find their origin in a financially over-stretched english monarchy: by 1763, england had successfully defeated france in the french and indian war to gain dominion over most of north america.156 success had come at a steep price, and the country was left with a crippling debt. the english enacted a number of duties on certain articles such as rum and spirits, and continued to regulate trade through acts such as the navigation acts of 1760 and the sugar act of 1764.157 in 1765, the english parliament enacted the stamp act, which was the first direct tax on the american colonies.158 the act placed a tax on an array of goods including newspapers, 152 see john miller, the glorious revolution 40 (2d ed. 1997). 153 see joseph thorndike, tax history: a tax revolt or revolting taxes?, tax notes, dec. 19, 2005, at 1517. there is ongoing debate among historians surrounding whether it was unrepresentative taxation or an attempt by the british to promote a monopoly over the trade of tea that fomented the tea party. id. moreover, another view maintains that it was not an idealistic revolt against british oppressors but rather an attempt by the leaders of the revolution to gain control themselves over taxation of the colonials that led to the uprising. id. 154 see, e.g., adams, supra note 145, at 297. 155 see id. at 297. 156 burg, supra note 2, at 260. 157 id. at 73. 158 carol berkin, et al., making america: a history of the united states, volume 1: to 1877, 111 (ann west et al. eds., 6th ed. 2011). 2013] the influence of historical tax developments 59 on anglo-american laws and politics almanacs, pamphlets, legal documents, insurance policies, licenses, playing cards and dice: these products had to carry a tax stamp, and non-payment could potentially result in fines or even incarceration through judgment of an admiralty court, which sat without juries.159 colonial governments protested that the tax amounted to an illegal exaction passed without representation. patrick henry introduced "four or five" resolutions against the stamp act in the virginia house of burgesses; the resolutions were reprinted in newspapers and distributed throughout the colonies.160 the colonial governments mobilized quickly in opposition to the tax; nine of the thirteen colonies sent delegates to new york to speak at the stamp act congress, which issued a "declaration of rights and grievances."161 the stamp act played an important role in unifying the colonies against arbitrary english rule. for instance, the sons of liberty—the individuals behind the boston tea party—were formed as a result of this new tax.162 the colonists organized a series of protests against the tax. mobs appeared throughout the colonies, forcing stamp agents to resign and discouraging merchants from importing british goods.163 in 1766, benjamin franklin traveled to london to appear before parliament. his answers to parliamentary queries show the visceral opposition to the tax felt by the colonists:164 q: was it an opinion in america before 1763, that the parliament had no right to lay taxes and duties there? franklin: i never heard any objection to the right of laying duties to regulate commerce; but a right to lay internal taxes was never supposed to be in parliament, as we are not represented there. . . . . q: is there no means of obliging [the colonists] to erase those resolutions [against the stamp act]? franklin: none that i know of; they will never do it, unless compelled by force of arms. q: is there a power on earth that can force them to erase them? franklin: no power, how great soever, can force men to change their opinions.165 ironically, it would take an englishman, william pitt, the earl of chatham, former prime minister and famed orator, to offer what was arguably the most astute criticism of the 159 burg, supra note 2, at 249–50. 160 john e. findling & frank w. thackery, events that changed america in the eighteenth century 72 (1998). 161 id. at 72–73. 162 paul s. boyer et al., the enduring vision: a history of the american people 100 (8th ed. 2012). 163 id. 164 see benjamin franklin, petitions against the american stampe act, in 16 the parliamentary history of england from the earliest period to the year 1803, at 138–59 (1813). 165 id. at 142, 160. 60 columbia journal of tax law [vol.5:40 stamp act. on january 14, 1766, pitt, suffering from a cold, rose in parliament to deliver a blistering attack on unrepresentative taxation:166 it is my opinion, that this kingdom has no right to lay a tax on the colonies; at the same time i assert the authority of this kingdom over the colonies to be sovereign and supreme in every circumstance of government and legislation whatsoever; they were subjects of this kingdom, equally intitled by your laws to all the natural rights of manhood and the peculiar privileges of englishmen . . . we therefore, in this house [of commons], give and grant, what is our own; but in an american tax, what do we do? we, your majesty’s commons of great britain, give and grant to your majesty, what? our own property? no; we give and grant to your majesty, the property of your majesty’s commons in america, an absurdity in terms. this distinction between legislation and taxation, is essentially necessary to liberty . . . . . . . upon the whole, i will beg leave to tell the house what is my real opinion: it is, that the stamp act be repealed absolutely, totally, and immediately.167 as pitt’s concluding line makes perfectly clear, he views direct taxation ("internal taxes") without representation to be unacceptable but, like franklin, accepts certain taxes ("external taxes") such as import duties as they are mainly directed toward the regulation of international trade.168 in light of the opposition by the colonists as well as pitt and others, the stamp act was finally repealed in 1766.169 historians sometimes credit the stamp act protests with bringing together the colonial governments for the first time to explore their common interests; they began to think of themselves as part of a potentially greater political union, to think of themselves as "americans." 170 the cause that united these men—anger at unrepresentative taxation—provided an opportunity for these colonists to see that they were all opposed to arbitrary english rule and quite prepared to take action to stop it. b. tea tax, rebellions and congressional responses after a brief period of rectitude, the english government responded with renewed enthusiasm for taxes and import duties on a variety of goods from paper, lead and glass to 166 transcript of statement by william pitt, jan. 14, 1766, in the speech of mr. p---and several others, in a certain august assembly, on a late important debate (1766). 167 id. at 1, 9-10, 12, 13, 30, 33 (emphasis added). 168 at the time, there seemed to a general acceptance among the colonists of english "external taxes" (e.g., duties) while "internal taxes" (e.g., direct income taxes or indirect consumption taxes) were considered unacceptable. however, a number of the external taxes acted more like excise taxes placed on specified goods, and not like duties placed on general imports. from an economic perspective, the external taxes and the internal taxes were often equivalent because they would place a similar incidence of the tax burden on the same taxpayers. for these reasons, the similarities between the two types of taxation may not justify the different ways they were viewed by english and american observers at the time. as the revolution approached, the colonists began to feel that the external taxes, such as the duty placed on the import of tea, were also unacceptable. 169 dennis brindell fradin, the stamp act of 1765, 33 (deborah grahame ed., 2010). 170 see, e.g., edmund s. morgan & helen m. morgan, the stamp act crisis: prologue to revolution 4–5 (1995). 2013] the influence of historical tax developments 61 on anglo-american laws and politics paint under the townsend acts of 1767.171 the colonies answered back by organizing even more protests and by boycotting the purchase on certain english goods. 172 moreover, this legislation created three new admiralty courts to try americans who ignored the law (the existing court in halifax, nova scotia, was thought to be too far away.)173 rising anger against the taxes also led to the boston massacre, a violent confrontation in march 1770 between a mob of boston residents and english troops guarding a government building that housed customs agents. 174 again, the english accommodated the american views and rescinded all of the taxes with the exception of a tax on tea in part to emphasize and symbolize english authority over the colonies.175 parliament subsequently passed the tea act in 1773 to grant a monopoly on international trade to the east india company by exempting this company from the normal duty on tea exported from england; this would enable the company to undercut the price charged for tea by other companies.176 the parliamentarians hoped that the use of duties instead of direct taxes would appease the colonists (taxes that regulated trade were deemed acceptable by many americans at the time.)177 on december 16, 1773, samuel adams and his group of patriots, the sons of liberty, swept onto a cargo ship filled with tea belonging to the east india company, which they dumped into boston harbor, causing a loss of roughly 10,000 pounds.178 more "tea parties" followed in other coastal ports.179 angered at the colonial upstarts, the english passed legislation in 1774 to punish the colonists—named intolerable acts or coercive acts by the colonists—that sought to close ports such as the boston harbor until the tea losses were repaid, curtailed the powers of the massachusetts assembly, and required colonists to provide housing and supplies to british soldiers.180 these acts in turn led to widespread anger and discontent with british rule.181 they decided to form a congress with representatives from the different colonial governments. on october 14, 1774, the first continental congress passed a resolution called the declaration and resolves of the first continental congress, which denied the power of parliament to tax the colonies and presented the king of england with a list of grievances. notably, the first recital sets out opposition to unjust british taxes: 171 see the new york restraining act, 1775, 7 geo. 3, c. 59; the revenue act, 1767, 7 geo. 3 c. 46, §1; the comissioners of customs act, 1767, 7 geo. 3, c. 41. 172 natalie s. bober, abigail adams: witness to a revolution 36 (1995). 173 j. jackson owensby, the united states declaration of independence (revisited) 140 (2010). 174 louise minks & benton minks, revolutionary war 22-23 (john s. bowman ed., updated ed. 2003). 175 see thorndike, supra note 153, at 1518. the legislation reads, “for every pound weight avoirdupois tea, three pence.” see revenue act, supra note 171. 176 tea act, 1773, 13 geo. 3, c. 4. 177 as mentioned, there is an ongoing debate whether the boston tea party was sparked by the tea tax or the efforts to create a tea monopoly. under one view, the tax and the monopoly are closely related: to dodge the tea tax, the colonists had begun to smuggle in tea from holland, which led to reduced revenues for the east india company and the need for parliament to promote the tea monopoly to save the company from bankruptcy. see thorndike, supra note 153 (noting a combination of factors that influenced colonial anger against the english). 178 geoffrey todd, chronicles of the revolutionary war 4 (2006). 179 nancy furstinger, the boston tea party 30 (rebecca aldridge ed., 2002). 180 harry j. p. harmer, tom paine: the life of a revolutionary 20 (2006). 181 b. v. rao, world history from early times to a.d. 2000, 213 (3d rev. ed. 2012). 62 columbia journal of tax law [vol.5:40 whereas, since the close of the last war, the british parliament, claiming a power of right to bind the people of america, by statute, in all cases whatsoever, hath, in some acts, expressly imposed taxes on them, and in others, under various pretences, but in fact for the purpose of raising a revenue, hath imposed rates and duties payable in these colonies, established a board of commissioners, with unconstitutional powers, and extended the jurisdiction of courts of admiralty, not only for collecting the said duties, but for the trial of causes merely arising within the body of a county . . . .182 the declaration goes on to set out certain inalienable rights enjoyed by americans, in part by harkening back to english principles of justice and references to the magna carta and its descendants: that the inhabitants of the english colonies in north america, by the immutable laws of nature, the principles of the english constitution, and the several charters or compacts, have the following rights: . . . resolved, 4: that the foundation of english liberty, and of all free government, is a right in the people to participate in their legislative council: and as the english colonists are not represented, and from their local and other circumstances cannot be properly represented in the british parliament, they are entitled to a free and exclusive power of legislation in their several provincial legislatures, where their right of representation can alone be preserved, in all cases of taxation and internal polity, subject only to the negative of their sovereign, in such manner as has been heretofore used and accustomed.183 anger at british taxation continued until the continental congress adopted the declaration of independence on july 4, 1776, which included as one of its twenty-seven grievances against the king the imposition of “taxes on us without our consent . . . .”184 these passages are consistent with constitutional law writings that emphasize control over taxation, not theoretical concerns surrounding individual liberty, as the principal unifying force for resisting english rule.185 c. taxation and the new republic rebellions against taxation did not end with the conclusion of the revolution. although the new american government was born out of a tax revolt, it could not function without levying its own taxes. only a few years earlier not paying taxes was deemed patriotic but was now an act of treason. beginning in the summer of 1786, daniel shays, a former captain in the continental army led his followers (known as shaysites) in an attack against tax 182 declaration of rights (oct. 14, 1774), in 1 american archives: containing a documentary history of the english colonies in north america from the king’s message to parliament, of march 7, 1774 of the declaration of independence by the united states, at 910 (st. clair clarke & peter force eds., 4th ser. 1837). 183 id. at 911. 184 the declaration of independence, para. 21 (1776). 185 see discussion supra note 2. 2013] the influence of historical tax developments 63 on anglo-american laws and politics collectors and shopkeepers out of anger over burdensome taxes and debt.186 after the suppression of these actions in massachusetts, fourteen of the participants were put on trial then convicted and sentenced to death for treason (although they were later pardoned from the death sentence).187 the significance of shays's rebellion is twofold: firstly, it exemplifies how issues of taxation remained in the american consciousness despite the end of the revolution; and secondly, there is reason to believe that shays played an integral part in the formation of the constitution.188 under a more recent view, the federalists exaggerated the threat of the rebellion so as to increase national power.189 even after the constitution was ratified, in a similar series of events, in 1794 the federal government no longer trusted the pennsylvanian government to suppress the whiskey rebellions that were spreading throughout the state.190 many “inhabitants of western pennsylvania . . . derived their principal income from the manufacture and sale of whisky. . . .”191 outrage swept across the region as a levy of seven cents per gallon was issued by the u.s. government.192 of the original thirty-five insurgents who were indicted on charges of treason193 only two men, john mitchell and philip vigol, were convicted of high treason.194 both men were sentenced to death but were later pardoned by president washington.195 while opposition to british taxation may have served as a unifying force during the revolution, in constructing the articles of confederation taxation played a prominent role in dividing federalists and anti-federalists. according to one view, the most important fight in ratifying the constitution was over whether the federal government would have the power to exact taxes in time of war.196 the debate and subsequent resolution over whether the federal government or individual states would have the power to tax the citizens played a prominent role in shaping the structure of the american political system. in a correspondence with jefferson, washington wrote that he was willing to accept any tolerable compromise except for the amendment preventing direct 186 carol sue humphrey, the revolutionary era: primary documents on events from 1776 to 1800, at 119 (2003). 187 roger foster, treason trials in the united states, 46 alb. l. j. 345, 345 (1892). 188 see johnson, supra note 2, at 217–222. 189 id. at 216. 190 steven r. boyd, the whiskey rebellion: past and present perspectives 171 (1985). 191 hayes mckinney, treason under the constitution of the united states, 3 va. l. reg. new ser. 801, 810 (1918); john patrick diggins, john adams: the american presidents series, the 2nd president 1797–1801, at 84 (arthur m. schlesinger, jr., ed., 2003). 192 mckinney, supra note 191. 193 united states v. insurgents, 26 f. cas. 499 (paterson, circuit justice, c.c.d. pa. 1795) (no. 15,443). 194 of the 35 insurgents, the jury only indicted 24 of high treason. see, e.g., united states v. mitchell, 26 f. cas. 1277 (paterson, circuit justice, c.c.d. pa. 1795) (no. 15,788); united states v. vigol, 28 f. cas. 376 (paterson, circuit justice, c.c.d. pa. 1795) (no. 16,621). 195 see dwight f. henderson, treason, sedition, and fries' rebellion, 14 am. j. legal hist. 308, 308–18 (1970). in 1798, john fries led a small revolt protesting a direct tax in house (commonly referred to as the house tax) in northern pennsylvania. he threatened to harass the tax collectors and forced a u.s. marshall to give up prisoners. he was tried and convicted for treason and once again was pardoned by president adams of his death sentence. id. 196 see johnson, supra note 2, at 151. the ratification debate was not about individual rights, nor about democracy or slavery. such issues were important, but they did not bitterly divide the nationalists from the anti-federalists, nor did they affect the shape or adoption of the constitution. id. at 163, 277. as johnson argues, “[t]he constitution is first a tax document, a pro-tax document, written by nationalists to allow the federal government to tax people and things directly without going through the states.” id. at 276. 64 columbia journal of tax law [vol.5:40 taxation.197 it was imperative for the successful operations of the federal government to that it have taxation powers. without the power to tax, the articles of confederation lasted seven years. with the power to tax, the constitution has lasted over 200 years.198 the issue of taxation was a point of contention with both sides of the debate: “tax connects with . . . almost all other powers, and [tax] at least will in process of time draw all other after it.”199 the power over taxation was seen as the foundation for all other governmental powers in the new union. after virginia rejected the bill of rights, madison’s source said that the opposition was reducible “to a single point, the power of direct tax.”200 in 1789, the united states constitution came into effect giving the federal government the power to directly tax individuals. the federal government, rather than acting as an agent of the states, became the representative of the people.201 consequently, “we the people” would be the sovereign, not the states.202 this fundamental western political ideology is the result of the relationship based on taxation between the federal government and its citizens. had the states been granted the exclusive power of direct taxation, the political landscape in america would no doubt have a different history, present and future. v. shaping anglo-american politics, laws and norms the previous parts described how tax law expansions in england and the united states influenced the formation and development of certain political and legal institutions. we saw an iterative process whereby individuals in both countries rebelled against "bad" taxes (i.e., unrepresentative taxes without due process protections for tax disputes), which led to the passage of "good" tax laws that reduced arbitrary tax measures and promoted procedural protections against unfair taxation. this part outlines how these developments influenced broader social change, including the eventual acceptance of liberalism as a guiding political philosophy.203 no attempt is made to analyze the many other factors that promoted this acceptance; rather, the focus is directed at briefly underscoring the role played by historical tax developments in the anglo-american world. a. the political/legal effect as we have seen, the political struggle against "bad" tax laws shaped the development of certain political institutions.204 for instance, the magna carta of 1215 197 id. at 155 (citing letter from washington to jefferson (aug. 31, 1788), in 30 writings of george washington from the original manuscript sources 1745-1799, at 79 (john c. fitzpatrick, et al. eds., 1931-1944). 198 id. at 298. 199 brutus i (oct. 18, 1787), reprinted in 23 documentary history of the ratification of the constitution 408 (merill jensen et al., eds., 1976). 200 see johnson, supra note 2, at 173 (citing letter from madison to washington (dec. 5, 1789), in 12 the papers of james madison, congressional series (william t. hutchinson & william m. e. rachel eds., 1962-1991). 201 id. at 2, 4. 202 id. at 245–46. 203 for a discussion of the interactive relationship between law and norms, see lawrence m. friedman, the law and society movement, 38 stan. l. rev. 763, 763–80 (1986). 204 because taxation is intensely political, it continues to shape modern political institutions. see, e.g., arthur j. cockfield, nafta tax law and policy: resolving the clash between economic and sovereignty interests (2005) (relying on the views of economic historian karl polanyi to sustain a claim surrounding the need to respect national tax sovereignty). 2013] the influence of historical tax developments 65 on anglo-american laws and politics and the confirmation of charters of 1297 provided for the creation of a common council to approve certain royal tax measures—this council was likely the first "formal" proto-democratic body that exercised ongoing authority over a king’s decision-making power.205 by the 17th century, systematic government institutions—tax agents, clerks, record managers, bookkeepers, tax prosecution offices—were needed to administrate increasingly complex tax laws controlled by the british parliament. finally, the stamp act congress and the first continental congress, where representatives from the various colonial governments met to debate unfair english taxes, created legislative bodies that would be subsequently replicated in america and elsewhere. in addition to their impact on government bodies, early anglo-american tax laws played a formative role in influencing the path of law and the development of legal institutions. as mentioned, legal historians sometimes emphasize how western rule of law conceptions have been shaped by the criminal and civil procedural aspects of early law.206 an alternative view provided by this article is that criminal and civil procedure protections were historically interwoven with taxation concerns.207 concerns surrounding intrusive tax searches as well as incarceration for nonpayment of taxes without due process were certainly warranted.208 we reviewed efforts by king john to use scutage (i.e., payments in lieu of military service) to manipulate his noblemen and clergy in the 13th century. later on english kings would deploy forced loans, ship-money taxes and other means to collect revenues. in all cases, the uncooperative taxpayers could be jailed or worse without a fair hearing. similarly, american colonists could be imprisoned by foreign-controlled admiralty courts for refusal to pay taxes. an early impetus for civil and criminal procedure protections was hence the need to inhibit abusive tax collection practices by agents of the state. these legal protections in turn required institutional support—lawyers, courts, judges, a properly-trained police force and so on—to gain practical effect. 205 see, e.g., c. h. mcilwain, due process of law in magna carta, 14 colum. l. rev. 27, 40 (1914) (discussing how the magna carta was influenced by the barons’ “quasi-constitutional” complaint seeking restrictions on the king’s powers). 206 see discussion supra note 2. 207 under this view, bad tax laws can be seen as freedom-depriving but good tax laws (i.e., nonarbitrary representative taxes with due process protections for tax disputes) can be portrayed as securing and promoting individual liberty. after reviewing different tax systems in 18th century europe, asia and north america, the baron de montesquieu noted, “it is a general rule that taxes may be heavier in proportion to the liberty of the subject, and that there is a necessity for reducing them in proportion to the increase of slavery. this has always been and always will be the case. it is a rule derived from nature that never varies.” see baron de montesquieu, the spirit of laws, at bk. 8 no. 12 (j. v. prichard ed., thomas nugent trans., g. bell & sons 1914) (1748). these views reveal the complex interaction between tax laws and individual liberty: even good taxes arguably inhibit liberty by constraining an individual’s choice to pursue productive activities, yet tax laws raise revenues that, within democracies, promote liberty by expanding choices and opportunities for other individuals. see, e.g., marjorie e. kornhauser, equality, liberty, and a fair income tax, 23 fordham urb. l.j. 607, 609 (1996) (arguing “that the american sense of distributive justice and . . . taxation rests on the twin foundational principles of america—liberty and equality. these principles . . . under some definitions . . . are compatible, but most frequently they are in conflict.") but see robert nozick, anarchy, state, and utopia 169 (1974) (claiming that income taxes are “on par with forced labor” because they involve an unjust theft by the state of an individual’s property). 208 for example, the link between property, privacy, and taxation is revealed by the well-known passage by william pitt in a speech on the excise bill in the english parliament. pitt protested the use of government excise officers to enter homes to levy the tax: “[t]he poorest man may in his cottage bid defiance to the crown. it may be frail; its roof may shake; the wind may enter; the rain may enter—but the king of england cannot enter—all his forces dare not cross the threshold of the ruined tenement!” william pitt, speech on the excise bill, house of commons (mar. 1763). 66 columbia journal of tax law [vol.5:40 b. shaping norms the iterative process whereby individuals rebelled against bad taxes and demanded good tax laws also influenced the development of norms—the view that an individual’s interests in his or her property and income (indeed his or her very personhood) should not be placed at the unfettered discretion of a king. how did tax laws shape normative beliefs? early tax laws—the charter of liberties, the magna carta and the confirmation of charters in particular—showed pre-modern man that the king (at one time considered divine) could be bound to a set of human-devised rules that restricted his ability to tax their persons and properties. for the first time, wealthy noblemen saw that they could have some control over their own properties regardless of the king’s wishes. this influenced how they perceived themselves and their relationship with their ruler.209 tax laws played an influential role in shaping how certain community members—beginning with powerful barons in the 13th century, expanding to an elite english bourgeoisie in the 17th century, and ending with american white male property owners in the 18th century—situated themselves within their larger social universes. over time, these individuals came to believe they had a moral entitlement to keep the fruits of their labors. these norms were internalized and later rationalized by the political philosophy of liberalism, which in turn served to reinforce the norms and the greater desire for "good" or "just" tax laws. in other words, tax laws themselves helped shape important political philosophical ideas within the anglo-american world.210 consider the relationship between these developments and the works of john locke, one of the founders of the political philosophy of liberalism that has been so influential in the anglo-american world.211 the liberal tradition “is generally viewed as a relatively coherent set of principles centering on the defense of individual rights and liberties, the security of property, and the notion of limited government.”212 in particular, chapter 5 of locke’s second treatise on government sets out his views on the relationship between private property, representative taxation, and the state. 213 near the end of the 17th century in england, locke offered the radical suggestion that all men were born equal to the king. because all men are created equal, locke reasoned, they enjoyed certain "natural rights" endowed by god.214 in particular, because god put in 209 see, e.g., mcilwain, supra note 205 (discussing how the magna carta influenced how the barons’ viewed their relationship with the king). 210 schumpeter in particular urged the importance of studying fiscal history to illuminate present conditions: “most important of all is the insight which the events of fiscal history provide into the laws of social being and becoming and into the driving forces of the fate of nations . . . the public finances are one of the best starting points for an investigation of society, especially though not exclusively of its political life.” see schumpeter, supra note 3, at 101. 211 see, e.g., james tully, an approach to political philosophy: locke in contexts 137 (1993) (“three hundred years after its publication [locke's] two treatises [of government,that set out his views on the right to property] continues to present one of the major political philosophies of the modern world.”); richard a. epstein, taxation in a lockean world, in 4 soc. phil. and pol'y 49, 51 (1987) (“the american tradition of government has been heavily influenced by lockean social contract theory.”). 212 see kirstie m. mcclure, judging rights: lockean politics and the limits of consent 3 (1996). 213 for discussion, see arthur cockfield, income taxes and individual liberty: a lockean perspective on radical consumption tax reform, 46 s.d. l. rev. 8, 8 (2001). 214 philosophers have subsequently reconstructed locke’s and other natural rights theorists’ arguments by using secular premises such as rawls’s "behind the veil" or originalist position analysis to derive essentially the same outcome as locke: locke’s natural rights have been reconstructed as today’s human rights. for a discussion of how natural rights theories developed into contemporary human rights 2013] the influence of historical tax developments 67 on anglo-american laws and politics each person the drive toward self-preservation then god must also have given this individual the right to secure survival.215 locke maintained that “every man has property in his own person. this no body has any right to but himself. the labour of his body, and the work of his hands, we may say, are properly his.”216 to secure these natural rights to private property, individuals require a certain amount of freedom from state interference as well as the “arbitrary will” of other men.217 to locke, the preservation of property was the “great and chief end” of government.218 locke accepted property regulation and taxation but, harkening back to the magna carta, only if consent is granted by the people’s representatives.219 locke wrote that individuals have a moral duty to rebel against unjust rulers who do not respect private property rights, providing a moral foundation for the (english) glorious revolution and the subsequent american revolution through the view that violent rebellion was the only answer to unrepresentative taxation. we have seen several arguments against unjust tax laws that anticipated subsequent claims by locke and others in the liberal tradition.220 the earliest tax laws— the charter of liberties and the magna carta—placed limited constraints on royal taxation powers under the view that the king was not god-like and infallible (or at least the view that the king could be forced to provide limited political concessions to other powerful political figures). more cogently, arguments by 17th century english lawyers frequently focused on the unfairness of arbitrary taxes imposed by royal fiat. such tax measures were likened to slavery because they exposed a subject’s property or person to the whim of the king. some of these legal arguments deployed rhetoric similar to that used by locke when setting out his famed labor theory of property (e.g., notions that “every man has property in his own person”).221 while the historical record is unclear, these legal arguments surrounding taxation, which were widely-published and circulated during the era, may have influenced locke’s views. in any event, during critical eras of english and u.s. history, important legal documents such as the magna carta, the english bill of rights, and the american declaration of independence promoted democratic constraints on the use of state power to assess and collect taxes. these tax laws mediated the tension between the needs of the state—that requires revenues for various purposes—and the needs of its subjects/citizens—whose skills the state increasingly relied on for productive economic activities—and their desire for ongoing political freedoms. over time, the idea that individuals are entitled to equal treatment under the law, and possess inalienable human rights, emerged in part as a result of these tax laws. theories, see carl wellman, an approach to rights: studies in the philosophy of law and morals (1997). 215 note that locke used the term “propriety” to mean an expanded notion of property, when compared to its contemporary meaning, to include notions of liberty and the right to security of person. 216 see john locke, two treatises of government 287–88 (peter laslett ed., 1988). 217 for discussion on locke’s emphasis on providing relief from arbitrary actions of others, see albert o. hirschman, the passions and the interests: political arguments for capitalism before its triumph 53–54 (1977). 218 see locke, supra note 216, at 350–51. 219 id. at 362 220 see discussion, supra related to notes 37–63. writings about locke and other liberal theorists at times emphasize how they were influenced by earlier natural rights theorists such as grotius. see stephen buckle, natural law and the theory of property: grotius to hume 25–32 (1991). 221 see locke, supra note 216, at 285-302; see also buckle, supra note 220, at 179–83. 68 columbia journal of tax law [vol.5:40 the perhaps obvious point here is that liberalism did not spring whole cloth from the ether, but was shaped by hundreds of years of practices and beliefs; the less obvious point is that liberalism was influenced in part by centuries’ worth of tax law developments that enshrined protections against arbitrary exactions. in other words, without these developments it may have been the case that the english and americans would not have been as amenable to internalize the values of liberalism (and republicanism). vi. conclusion the stream of history flows with eddies, currents, cross-currents, rapids and riffles: it is always a dangerous exercise to isolate one influential factor without taking into account the broader context and the multitude of factors that influence the course of history. recognizing these dangers, this article has strived to place tax law developments within their broader social and political context to show how early english and american tax laws played an influential role in developing and reinforcing increasingly progressive political and legal institutions. several centuries in particular—13th and 17th century england as well as 18th century united states—are notable for the ways that tax law developments were interwoven with important legal and political developments that witnessed the long march toward modern democracies. during these centuries, we see the rise of increasingly representative governments, and an emphasis on the need for the rule of law with due process protections against arbitrary state rule. while the historical processes that influenced these developments are complex, tax laws played an important role. by securing rights against arbitrary taxation, individuals began to enjoy enhanced security and wealth, which led to even greater yearnings for freedom. under this article’s account, the political struggle against "bad" taxes (i.e., unrepresentative taxes without due process protections for tax disputes) led to the development of "good" tax laws (i.e., laws that promoted representative taxes along with procedural protections against arbitrary imprisonment for non-payment of taxes) that helped to create and shape anglo-american legal and political institutions, as well as liberal beliefs. microsoft word 04 foreword.docx foreword i would like to congratulate the editors and staff of the columbia journal of tax law on their inaugural edition. it is very exciting for me to participate in the birth of a new journal in an area of such importance to financial and economic policy. this inaugural issue makes several important contributions to tax scholarship. professor karen burke’s analysis of carried interest reform examines the technical and policy implications of one of the leading proposals to reshape subchapter k. professor lawrence zelenak’s essay thoughtfully juxtaposes the increasing complexity of the u.s. tax code with technological advances that have enhanced the computational capabilities of taxpayers. professor wei cui advances the first scholarly treatment of “establishment,” a concept in domestic chinese tax law of substantial import to the future of foreign portfolio investment in one of the world’s most important emerging markets. we are proud of the new addition to columbia law school’s family of scholarly publications. i look forward to future issues of the columbia journal of tax law and the insights it will contribute to tax law and policy. david m. schizer dean and lucy g. moses professor of law columbia law school february 2010 the intricacies of tax and globalization sagit leviner reviewing: global perspectives on income taxation law by reuven s. avi-yonah, nicola sartori, & omri marian (oxford, 2011) abstract the intricacies of tax & globalization review explores the effect of globalization on taxation. it looks into the available data (particularly from the oecd and eu) to explore global trends in taxation over the past three decades to evaluate whether and to what extent globalization leads to convergence or divergence of national tax policies, and to assess the merit of such changes.  sagit leviner is an associate professor of law at suny buffalo law school and an overseas affiliated faculty with ono academic college faculty of law in israel. the author is thankful for the insightful contribution of eric toder to this review. valuable comments on and discussions of earlier versions of this review were also offered by yariv brauner, tsilly dagan, david gliksberg, victor fleischer, diane ring, kirk stark, nancy staudt and the participants of the interdisciplinary center faculty of law international tax symposium, herzliya, israel (april 3013), the hebrew university faculty of law tax colloquium, jerusalem, israel (january 2013), the 6th annual joint conference of columbia university law school and ono academic college, kiryat ono, israel, (june 2012), and the international society for new institutional economics annual conference, usc gould school of law, los angeles, ca (june 2012). suny buffalo law student vanessa glushefski provided excellent research assistance. 208 columbia journal of tax law [vol.5:207 i. introduction .................................................................................................... 209 ii. globalization and taxation law: the emergence of a closerknit world ......................................................................................................... 211 iii. avoiding the strains of globalization – cooperation, harmonization and other tax related initiatives ................... 219 iv. trends of convergence and divergence in an interdependent world ................................................................................................................... 223 2014] the intricacies of tax and globalization 209 i. introduction “[t]he comparative study of tax law is not strictly theoretically oriented . . . rather it is a study of what may indeed become a reality in the foreseeable future . . . .”1 the field of taxation is often criticized for being technical in nature and lacking a broad contextual perspective.2 with their expansive comparative analysis, avi-yonah, sartori, and marian (hereinafter "the authors") underscore a new trend in the study and teaching of tax law by relying on and appreciating the value of local and international conditions that affect taxation.3 global perspectives on income taxation law comes at a time when increased forces of globalization have fueled a resurgence in comparative legal analysis,4 and comparative taxation law is concurrently beginning to develop into its own sub-discipline, introducing a rich literature of growing value.5 avi-yonah, sartori, and marian cautiously assert that to date, no distinct method of comparative taxation law—with its unique characteristics, processes, techniques, and approach to evaluation—has emerged.6 for this reason, the authors rely on what they 1 reuven s. avi-yonah, nicola sartori & omri marian, global perspectives on income taxation law, xviii (2011). 2 see, e.g., omri marian, the discursive failure in comparative tax law, 58 am. j. comp. l. 415 (2010); carlo garbarino, comparative taxation and legal theory: the tax design case of transplant of general anti-avoidance rules, 11 theoretical inquiries law 765 (2010) (discussing the missed promise of comparative taxation); carlo garbarino, an evolutionary and structural approach to comparative taxation: methods and agenda for research, 57 am. j. comp. l. 677 (2009) (exploring methods of comparative taxation and offering an outline of an evolutionary approach to this emerging field). 3 see, e.g., introduction, 11 theoretical inquiries law 469, 469 (2010) (according to the editors, this volume is dedicated to comparative tax scholarship and "evokes a tension inherent in the study of comparative law under conditions of globalization, between global legal convergence and [social, political, and economic] diversity."). these issues concern contextual questions such as: "can law be productively compared across cultures? can it be effectively transferred across cultures? which elements in law . . . ought to be examined by scholars interested in comparative analysis and in the assessment of global process? and what, if anything, can such comparison teach us for local purposes?" id. 4 see, e.g., dani rodrik, the globalization paradox: democracy & the future of world economy (2012); joseph e. stiglitz, making globalization work (2007); joseph e. stiglitz, globalization and egalitarian redistribution (pranab bardhan, samuel bowles & michael wallerstein eds., 2006); thomas l. friedman, the world is flat (2005); joseph e. stiglitz, globalization and its discontents (2002). 5 garbarino, comparative taxation and legal theory, supra note 2, at 766 ("[a]fter a long period of poor development, the debate among scholars of comparative tax law is now building up and a new web of communication and methods is beginning to evolve."); see also vito tanzi, taxation in an integrating world (1995); int’l monetary fund, tax law design and drafting i (victor thuronyi ed. 1996); hugh ault & brian j. arnold, comparative income taxation: a structural analysis (1997); int’l monetary fund, tax law design and drafting ii (victor thuronyi ed., 1998); victor thuronyi, comparative tax law (2003); michael a. livingston, law, culture, and anthropology: on the hopes and limits of comparative tax, 18 can. j. l. & juris. 119 (2005); garbarino, an evolutionary approach to comparative taxation: methods and agenda for research, supra note 2; gianluigi bizioli & claudio sacchetto, tax aspects of fiscal federalism – a comparative analysis (2011); tax law and development (yariv brauner & miranda stewart eds., 2013). 6 avi-yonah, sartori & marian, supra note 1, at 1 ("[l]egal corporatists have usually adopted well-defined comparative methods that are used in general comparative legal studies."). in particular, the authors suggest that given the breadth of methods available for legal comparison, there may be little actual need for a single, all-inclusive method of comparative taxation law. they explain: [o]ne of the main problems with comparative study of law is that there are probably as many approaches to it as there are comparative scholars. although over the past three decades or so, legal comparatists have fiercely debated what approaches should be deemed appropriate when conducting a comparative study of law, they have failed to produce any coherent outcome . . . we cannot possibly point to a single approach that can be regarded as superior to others. indeed, given 210 columbia journal of tax law [vol.5:207 describe as a functional, problem-solving method in their analysis.7 specifically, global perspectives on income taxation law covers those topics customarily taught in a basic u.s. income taxation law course, but through a less commonly explored comparative prism.8 the authors discuss topics that range from the concepts of taxable income and tax deductions, through the taxpaying unit, tax accounting, and the taxation of capital gains and losses, to the problem of tax avoidance, issues in business taxation, and selected topics in international tax law.9 the authors frequently consider the approach followed in the u.s. as a benchmark for analysis. for each topic, however, they also explore the tax policy alternatives implemented in other countries, including australia, canada, france, germany, japan, the netherlands, sweden, the united kingdom, italy, and israel.10 the underlying premise of the book is that tax law is best understood by exploring its variable development in the global sphere. such a broad perspective facilitates a better understanding of not only the u.s. tax system, but also the range of tax policy alternatives for meeting challenges that often have much in common across different countries and tax jurisdictions. 11 in addition, a comparative perspective is particularly useful in taxation because of the constantly changing and contingent nature of taxation law, which virtually makes it a cross-border field.12 against this backdrop, a globally centered tax analysis facilitates discussions and strategies that reach beyond that these approaches represent different ideological views, we should probably not be able to reach an agreement among ourselves as to the most promising method of comparative tax research. id. at 2–3; see also id. at xvi ("[w]hat we are . . . offering here is a general approach to comparative tax studies that goes beyond the view of comparative taxation as an autonomous field of legal studies."). 7 id. at 4 ("[t]he functional approach to comparative law has a long-established tradition and is probably the most widely adopted. comparative legal functionalism rests on the assumption that 'the legal system of every society faces essentially the same problems, and solves these problems by quite different means, though very often with similar results.'") (citing konrad zweigert & hein kotz, an introduction to comparative law 34 (1998)); see also id. at 12 ("[the book] follows, to a certain extent, a comparative law and economics perspective in a problem-solving-oriented manner."); but cf. id ("[t]his mode of explanatory analysis is primarily technical. namely, it does not seek to advance a particular normative choice."). 8 id. at 16 ("[t]he organization of the book is designed to help the tax student follow the book in parallel with the regular casebook that he or she is using. since most u.s. tax casebooks follow a basic pattern (income, deductions, the taxable unit, timing, capital gains, and so on), the book will follow the same order."). 9 id. at vii–x (table of contents). 10 but see id. at 16 ("a critical comparatist will probably be quick to note this construction and may even criticize us for trying to manipulate foreign tax systems to accommodate the 'mainstream' american discourse. point taken. we invite, by all means, critical tax comparatists to bring forward a critical analysis on the construction of comparative tax discourse around these usual focal points. this would be a much needed (and long overdue) contribution [to] the comparative tax discourse."). 11 see, e.g., geoffery hornsey, corporate taxation – a comparative study, 16 mod. l. rev. 26 (1953) (concluding from a comparative study conducted on corporate taxation in the united states, the united kingdom, and france during the 1950s that "the one striking fact which does emerge is the universality of the problems involved and the similarity of the solutions achieved."); avi-yonah, sartori & marian, supra note 1, at 22 ("[a]t least from a functional perspective, the design problems facing an income tax are, to a significant extent, identical across jurisdictions."). note, however, the risk of a sampling issue with respect to the countries selected for comparison: these countries already have much in common so they are likely to produce similar tax challenges and solutions. see also supra note 10. 12 avi-yonah, sartori & marian, supra note 1, at xvii ("[t]hese issues are of real importance, first and foremost, because one of the defining characteristics of tax laws is that they are constantly changing at an amazingly rapid pace . . . ."); see also infra notes 24–43, 72–81 and accompanying text (addressing the interdependency of taxation among nations and suggesting it is particularly exacerbated by globalization). 2014] the intricacies of tax and globalization 211 immediate domestic rules and mechanisms to allow both the expression of and reflection on underlying tax policy issues and solutions in a world that is closely interconnected and constantly evolving.13 avi-yonah, sartori, and marian’s aim is not to make the reader of global perspectives on income taxation law a foreign tax expert, but to provide readers with a wide comparative outlook on fundamental elements of income taxation law.14 while much of the legal tax education still lags behind actual tax practice due to its predominantly self-reliant approach, global perspectives on income taxation law adds indispensible value by redirecting and broadening the discussion on tax. although it is tailored to the prospective attorney first and foremost, 15 the book reaches beyond classroom borders. it is designed to be "the start, not the end" and serves "to ignite modes of thinking."16 the authors posit that the reader is free to choose how to utilize the information the book provides.17 to this end they present a manuscript that advances the comparative tax law dialogue in a meaningful yet accessible manner. ii. globalization and taxation law: the emergence of a closer-knit world global perspectives on income taxation law describes and examines tax policy arrangements across different jurisdictions, focusing on the law of income taxation, particularly personal income taxation. this comparative endeavor provides unique insight into global tax trends of the past three and a half decades, especially those trends that involve national decisions on the tax mix, including: what forms of economic income, goods, and services to tax; to what extent to tax these items; and how globalization limits and otherwise affects taxation in the twenty-first century.18 this insight is essential for evaluating globalization’s effects on taxation, taking into account 13 avi-yonah, sartori & marian, supra note 1, at xiii. jinyan li’s analysis of the gaar implementation in canada and china is a good example of how globally centered tax analysis offers a particularly useful and in-depth perspective. li notes that while the purpose of both gaars is antiavoidance, the policy underlying this legislation does not automatically translate into the chinese culture. this mismatch leads to a very different gaar implementation in the two countries. jinyan li, tax transplants and local culture: a comparative study of the chinese and canadian gaar, 11 theoretical inquiries law 655, 681 (2010). a similar argument in favor of exploring underlying tax policy decisions before transplanting them is also one of the main points made in omri marian, meaningless comparisons: corporate tax reform discourse in the united states, 32 va. tax rev. 133, 203 (2012) ("[a]s much as a comparative approach [in the corporate tax context] is desirable, it is also dangerous if ill executed. bad comparisons produce inaccurate guidance that may not bring about the desired results of tax reform."). 14 exploring key elements of income taxation law from a comparative perspective is a key goal for the authors. see, e.g., avi-yonah, sartori & marian, supra note 1, at xix ("[a]ny future lawyer should, at the minimum, understand some basic notions of foreign taxation."). 15 see, e.g., id. at xiii (addressing the issue of student readership and noting that, despite a revival of comparative tax law scholarship, no book currently exists for student consumption). 16 id. at 16. 17 id. 18 cf. neil brooks & thaddeus hwong, tax levels, structures, and reforms: convergence or persistence, 11 theoretical inquiries law 791 (2010) (exploring the effect of globalization on three components of the tax mix: (1) individual tax rates and revenue; (2) corporate tax rates and revenue; and (3) the tax base, particularly vat and its expansion); reuven s. avi-yonah, tax convergence and globalization 1 (pub. l. and legal theory working paper series, working paper no. 214, 2010) (arguing that, due to globalization, convergence can be detected in several areas of taxation, including: (1) countries' overall tax mix (defined as the composition of total tax revenue that usually includes personal and corporate income taxes, social security contributions, property taxes, excise taxes, and the like); (2) issues of corporate/shareholder tax integration; and (3) the choice between worldwide and territorial taxation). 212 columbia journal of tax law [vol.5:207 its risks and benefits, and exploring the mechanisms available to governments to manage and otherwise address these effects. tax law comparatists generally share the belief that the world has become increasingly globalized after the mid-1980s.19 as a historical process above all else, globalization has significantly, albeit sometimes subtly, affected key aspects of national performance.20 the term globalization usually refers to the increased integration and liberalization of markets around the world.21 globalization, however, encompasses a wider array of forces, including human innovation, technological progress, and the convergence of social and cultural norms.22 these forces are often understood to pull nations together, forming a close-knit world. 23 despite vast differences in national characteristics—including language, history, location, and natural resources—one implication of globalization’s increased closeness is that forces at play within any one country can easily cause a chain reaction, transcending traditional borders to shape and affect other sovereign nations.24 this cross-country dependency generates ripples of 19 see, e.g., avi-yonah, tax convergence and globalization, supra note 18, at 1 (indicating that the "period of globalization" commenced "from around 1980, [when] most countries began relaxing restrictions on capital mobility"); james r. hines, jr. & lawrence h. summers, how globalization affects tax design, 23 tax policy and the economy 123, 134 (jeffrey r. brown et al. eds., 2009) ("the incentive to reduce corporate tax rates in order to attract foreign direct investment has increased since the early 1980s, as levels of world foreign direct investment rose sharply during that time."); international monetary fund (imf) staff, globalization: a brief overview, 2 imf issues brief 1–2 (may 2008), available at http://www.imf.org/external/index.htm ("the term 'globalization' began to be used more commonly in the 1980s, reflecting technological advances that made it easier and quicker to complete international transactions – both trade and financial flows."). 20 the precise origin of globalization is debatable and generally depends on the scope and breadth of one’s conceptualization of it. some historians date globalization as far back as the third millennium b.c., while modern globalization is generally understood to have begun in the late nineteenth century. notwithstanding the exact origin of globalization, its definition and various applications continue to evolve. for instance, debates over globalization and its effect on international tax neutrality began as early as the kennedy administration and continue to this date. see, e.g., michael s. knoll, the connection between competitiveness and international taxation, 65 tax l. rev. 349, 363 (2012) (explaining that "since the kennedy administration, two neutrality principles have dominated u.s. international tax policy and the debate over what that policy should be: capital export neutrality (cen) and capital import neutrality (cin)."). see also id. at 363–69 (further discussing cen and cin). 21 imf staff, supra note 19, at 3–4 (indicating, for example, that "[a] core element of globalization is the expansion of world trade through the elimination or reduction of trade barriers"). 22 see, e.g., dani rodrik, sense and nonsense in the globalization debate, foreign pol’y, summer 1997, at 19, 27 ("as the technology for manufactured goods becomes standardized and diffused internationally, nations with different sets of values, norms, institutions, and collective preferences begin to compete head on in markets for similar goods.”); see also hines & summers, supra note 19, at 126–27 ("the world economy has grown considerably more open and integrated in every decade since the second world war . . . . while this reflects in part the growth of the world economy, it also reflects the impact of reduced transportation and communication costs, falling tariff rates, and reductions in other impediments to international business."). 23 see, e.g., imf staff, supra note 19, at 7 (using the 2007-2008 financial crisis to illustrate how close-knit the world has become as a result of globalization: "credit market strains have intensified and spread across asset classes and banks, precipitating a financial shock that many have characterized as the most serious since the 1930’s. [this episode is a reminder] that a breakdown in globalization—meaning a slowdown in the global flows of goods, services, capital, and people—can have extremely adverse consequences."); see also thomas friedman, the dell theory of conflict prevention, emerging: a reader 49 (barclay barrios. ed. 2008) (examining the impact of the "flattening" of the world due to forces of globalization and stating that "globalized trade, outsourcing, supply-chaining, and political forces have [all] changed the world permanently, for both better and worse."). 24 for a pragmatic view of the cross-border tax dependency effect of globalization, see, e.g., brian purcell, how the u.s. corporate rate could compete with ireland, int’l tax rev., dec.-jan. 2012, at 21, 2014] the intricacies of tax and globalization 213 cause and effect so powerful that taxation runs the risk—or enjoys the benefit—of being redefined on a national, as well as international, level.25 importantly, as nations become increasingly interdependent, their risk of being pressured into tax competition also intensifies. broadly stated, tax competition involves a strategic, non-cooperative interaction among nations,26 with each nation designing its tax system in response to the tax arrangements of other countries to attract and retain productive resources. 27 to be exact, competitive tax interactions are not limited to nations and generally require additional parties, particularly multinational corporations, but also other incorporated entities, households, and individuals.28 21 (arguing that the u.s. and the e.u. should stop complaining that ireland’s corporate tax rate is "unfair" and, instead, lower their own corporate rates). 25 see org. for econ. co-operation and dev. (oecd), tax policy reform and economic growth 20 at box 1.1 (2010), available at http://www.oecd.org/ctp/tax-policy/taxpolicystudyno20taxpolicyreformandeconomicgrowth.htm ("[the effects of globalization] mean that individual countries are likely to make different tax policy choices from those they would have made in the past, when there was less mobility."); see also vito tanzi, remarks at the conference organized by the school of international studies, university of trento: globalization and international harmonization of tax systems 8 (may 27, 2004), transcript available at http://www.unitn.it/files/download/9722/wptanzitanno.pdf ("what has happened during the last 20 years is that with the liberalisation of trade, and the enormous movements of capital at an incredible pace (each day the equivalent of the italian gdp [from one country to another]) . . . domestic fiscal problems start to become international problems, and this has consequences."). 26 see, e.g., tanzi, supra note 25, at 8 ("the global economy has become a sort of commons, like the oceans or the atmosphere, which a shrewd country may exploit for its own purposes. for example, by radically lowering tax rates on incomes from financial activities one can attract capital from other countries."); see also vito tanzi, taxation in an integrating world 6 (1994) ("like tectonic plates grinding against each other, the tax systems of different countries will develop arbitrage pressures created by different tax rates, by differences in the bases that are taxed, by different possibilities of avoidance and evasion, and so forth."). importantly, tax competition may also occur on a sub-national level. for an empirical analysis of this phenomenon, see, e.g., oecd, tax competition between sub-central governments (2011), available at http://www.oecd.org/ctp/federalism/48817035.pdf (finding, for example, that "tax competition is not only an issue for federal countries, but also for unitary countries where local governments often have far-reaching tax autonomy"). id. at 5; see also id. at 7–8 (introducing the concepts of "vertical and horizontal tax competition"). 27 importantly, the strategic, non-cooperative interaction entailed in tax competition presumes that any benefit for one economic actor is necessarily gained at the expense of other actors, under the framework of a zero-sum game. from the early 1980s to about the late 1990s, a key manifestation of the noncooperative tax dynamics among nations took the form of traditional tax havens, where jurisdictions offered no—or significantly reduced—tax on investments with little or no commitment to the region. more recently, tax competition often takes the form of production tax havens, which became common in countries like ireland, where a low rate (12.5%) is given to foreign corporations who move their manufacturing to that country. see reuven s. avi-yonah, globalization, tax competition, and the fiscal crisis of the welfare state, 113 harv. l. rev. 1573, 1579, 1601 (2000); rodrik, sense and nonsense in the globalization debate, supra note 22, at 23 (explaining that globalization allows corporations to "go abroad" to find the best "prices," putting nations in a competitive stance against each other for corporate investment). 28 eric toder explains: we [the united states] . . . compete with other nations . . . we compete to attract productive resources, such as high-skilled workers or investment capital. u.s. and foreign-resident corporations compete with each other in international markets, and corporations can exert some choice about where to establish and maintain residence. governments may exert competing claims against each other for tax revenues associated with economic activities that transcend national boundaries. eric toder, urban-brookings tax pol’y ctr, international competitiveness: who competes against whom for what? 5 (2012), available at https://www.law.upenn.edu/live/files/368-toderpdf. but cf. hearing on the need for comprehensive tax reform to help american companies compete in the global market and create jobs for american workers, before the h. comm. on ways and means, 112th cong. 9 2-3 (2011) (statement of jane gravelle, senior specialist in economic policy, congressional research service), 214 columbia journal of tax law [vol.5:207 one commonly invoked example of the strain that globalization places on the dynamics among nations—particularly its inducement of national and international tax competition—concerns the taxation of capital income, or the deficiency thereof.29 many consider it to be an axiom of modern globalization that it involves the relaxation of trade barriers, leading to the enhanced mobility of productive resources, especially capital.30 as capital increases its mobility relative to other economic resources, there is a natural shift in the tax base from capital to other, less agile, sources.31 for example, consumption taxes, such as the value added tax (vat) and general sale tax (gst), tend to fall on consumers who are generally less mobile than capital holders and producers.32 the latter groups possess a greater ability to respond to taxation by strategically adjusting their economic choices to minimize their tax liability.33 in recognition of this propensity, available at http://waysandmeans.house.gov/uploadedfiles/gravelle.pdf (suggesting that, despite its widespread use, the term competitiveness is ill fitted when it comes to nations: "although the term competitiveness has been invoked in the debate about u.s. policy in the global economy, it is not countries that are competitive, it is companies that are. a company generally thinks of itself as competitive if it can produce at the same cost as, or a lower cost than, other firms. but a county’s firms cannot be competitive in all areas. indeed, even if firms in a county are more productive in all other countries in every respect, a county would still tend to produce those goods in which its relative advantage is greatest and trade with other countries for the goods they do not have a relative advantage in productivity . . . . in sum, companies compete, and countries trade."). 29 in the context of capital taxation, the data suggests that the real difficulty concerns capital income taxes that are source-based (such as the corporate income tax) or that are based on corporate residence, which is more easy to shift overseas than individual residence. this is compared with capital income taxes that are residence-based at the individual taxpayers level, that do not suffer from the same movable tax bases problems. see rosanne altshuler et. al., capital income taxation and progressivity in global economy, 30 va. tax rev. 355 (2010) (making the assertion that because the u.s. taxes on capital gains and dividends do not distinguish between gains and dividends arising from assets in the u.s. and assets located elsewhere, they do not cause an outflow of capital from the us. accordingly, the author advance a proposition for reducing the (source-based) u.s. corporate tax rate and increasing the (residence-based) u.s. tax on individuals’ capital gains and dividends). 30 see, e.g., imf staff, globalization: a brief overview, supra note 19, at 4 ("global capital flows fluctuated between 2 and 6% of world gdp during the period 1980–95, but since then they have risen to 14.8% of gdp, and in 2006 they totaled $7.2 trillion, more than tripling since 1995."). 31 reuven s. avi-yonah, the oecd harmful tax competition report: a retrospective after a decade, 34 brook. j. int’l l. 783, 789–90 (2008–2009); but see oecd, supra note 25, at 20, box 1.1 (addressing the increased mobility of labor and explaining that "[i]t is generally assumed that choices related to corporate taxation are most affected by globalization because of the ease with which multinational enterprises can move the location of at least some of their activities. however, highly skilled workers are also becoming more mobile and some countries are taking this into account in designing their personal tax systems. in contrast, the taxation of lower-skilled workers and of consumption is seen as being less affected by globalization because these taxes are less mobile."). 32 the vat and gst are different names for what is essentially the same type of tax. to illustrate the relatively inelastic and regressive nature of this tax, consider the following excerpt during a u.s. congressional hearing on the value added tax, in response to a question on who bears the burden of vat: [with a consumption tax, such as the vat] [t]he burden is borne by consumption. and so, it depends on what your consumption is relative to your income. people with low incomes consume virtually all of their income. people in the middle bracket save some. that would not be taxed. people in the upper brackets save almost all of their income. . . . tax reform and consumptionbased tax systems: hearing before the h. comm. on ways and means, 112th cong. 15 (2011) (statement of mr. bruce bartlett, former domestic policy adviser to president ronald reagan, columnist, tax notes, the fiscal times, contributor to the new york times) (emphasis added), available at http://waysandmeans.house.gov/news/documentsingle.aspx?documentid=289865. see also infra note 47 and accompanying text. 33 see, e.g., brooks & hwong, supra note 18, at 793 ("[t]axes on capital income will be reduced as countries compete for corporate investments and as the increased mobility of capital makes enforcement of capital taxes difficult or impossible . . . ."). cf. hines & summers, supra note 19, at 126 (explaining that: "in 2014] the intricacies of tax and globalization 215 governments seek to stabilize revenues and limit the economic distortions stemming from tax planning by levying taxes in circumstances, and with respect to resources, that are less responsive to tax; the result has been, inter alia, a worldwide rise of the vat and gst and a corresponding aversion towards the taxation of capital, especially on the corporate end.34 furthermore, the increased mobility of productive resources intensifies the pressure on all countries to compete for these resources by lowering their tax rates and, subsequently, strategically broadening their bases.35 it is against this backdrop that tax comparatists commonly argue that globalization has resulted in an increased worldwide reliance on consumption taxes, accompanied by a corresponding "flattening" of personal income tax rates and drastic reduction in corporate income tax brackets.36 according to a 2011 oecd report on tax trends among oecd member countries: in the mid-1980s, many oecd countries had top marginal personal income tax (pit) rates in the excess of 65%. today most top rates are below, and in some cases substantially below, 50% . . . . similarly, top statutory corporate income tax rates in the 1980s were rarely less than 45%. in 2011, the oecd average rate was below 26%.37 compared with personal income taxation, corporate tax rates exhibit a particularly steep decline during the past three and a half decades. the 2010 u.s. president’s economic advisory board report on tax reform options illustrates this drop in both the u.s. corporate tax rate and the average and median corporate tax rates a globalizing world, expenditures have relatively clear geographic associations, reducing the potential for international tax avoidance and generally reducing the mobility of the tax base compared to alternatives such as personal income taxes or source-based business taxes including corporate income tax."). 34 see supra note 29 and accompanying text. see also oecd, consumption tax trends 2012: vat/gst and excise rates, trends and administration issues 11 (2012), available at http://www.oecdilibrary. org/taxation/consumption-tax-trends-2012_ctt-2012-en ("vat is the most widespread general consumption tax in the world having been implemented by over 150 countries and in 33 of the 34 oecd countries."); brooks & hwong, supra note 18, at 793 (indicating that "there will be a shift to immobile and more regressive tax bases such as consumption, payrolls, and real property"); avi-yonah, tax convergence and globalization, supra note 18, at 3–4 (exploring the implications of tax-base mobility and noting that "[t]he shift to dual income taxes and the shift in the corporate tax from production to consumption locations reflect the same concern about the vanishing [income tax] base"). 35 oecd, tax reform trends in oecd countries 3 (2011), available at http://www.oecd.org/ctp/48193734.pdf importantly, broadening the tax base is not necessarily beneficial in the competition for investments because this generally raises the effective tax rate. a lower rate broader base tax, however, may lead to a shift in reported income, which is more sensitive to the statutory tax rate than real investments. see toder, supra note 28. see also michael keen, tax competition, in new palgrave dictionary of economics (2008); michael devereux, ben lockwood, & michaela redoano, capital account liberalization and corporate tax (imf working paper no. 03/180, 2003), available at http://www.imf.org/external/index.htm (demonstrating how capital account liberalization, in particular, tends to lead to lower corporate tax rates and increases strategic interactions among countries). 36 note, however, that personal rates have been undergoing a process of "flattening" over approximately the past 20 years, while the reduction in marginal personal and corporate rates has been evident for a period of about 30 years. brooks & hwong, supra note 18, at 802–14. for an argument suggesting that over a longer-term perspective no convergence of nominal corporate tax rates can be seen, see omri marian, do tax laws truly converge? a case study of corporate tax rates in 11 industrialized countries, in the discursive failure in comparative tax law, 121, 137–43 (unpublished s.j.d. thesis presented at the university of michigan law school) (2009). 37 oecd, supra note 35, at 3. see also id. at 4, fig.1 ("the trend toward reduced [personal income] marginal tax rates started in the mid-1980s in most countries, with the u.s. reforms of 1986 being particularly influential. in the late 1970s it was not uncommon to find top marginal personal income tax rates above 70%, while these rates are now well below 50% in a majority of oecd countries."). 216 columbia journal of tax law [vol.5:207 for oecd member countries. the u.s. statutory corporate tax rate dropped from 50% in 1981 to close to 40% in 2009, while oecd member countries experienced a decrease in median and average rates from approximately 47% in 1981 to about 28% in 2009.38 likewise, according to the international monetary fund (imf) globalization, financial markets, and fiscal policy report, since the mid-1980s statutory corporate tax rates in industrial countries have declined from an average of about 45 percent in 1982 to approximately 35 percent in 2004, with a similar downward trend in effective rates.39 despite drastic reductions in corporate income tax rates, evidence for the period from 1965 to 2010 shows that, over time, total oecd corporate revenues as a percentage of total receipts not only remained stable but, in fact, slightly increased. 40 notwithstanding the significance of this finding, even though corporate tax revenues may appear robust, they could easily decline if tax competition intensifies, as globalization might entail. for example, according to jane gravelle, senior specialist in economic 38 the president’s economic advisory board report on tax reform options: simplification, compliance, and corporate taxation 68, fig. 4 (2010), available at http://www.whitehouse.gov/sites/default/files/microsites/perab_tax_reform_report.pdf (exploring the combined federal and state corporate tax rate and explaining that "as a result of these differences between the u.s. and the oecd countries, u.s. firms operating abroad report that they often face higher effective tax rates on their overseas activities than foreign competitor firms. in addition to affecting the international competitiveness of u.s. firms, the growing gap between the u.s. [statutory] corporate tax rate and the corporate tax rates of most other countries generates incentives for u.s. corporations to shift their income and operations to foreign locations with lower corporate tax rates to avoid u.s. taxes. over time as corporate tax rates have fallen around the world, these incentives have become stronger."). id. at 69; cf. id. at 65 ("the united states has the second highest statutory corporate income tax rate in the organization for economic co-operation and development (oecd) behind japan. despite the high statutory rate, the average effective tax rate paid by corporations is close to the oecd median, and the corporate tax raises relatively little revenue—the fourth lowest in the oecd as a share of gdp."). 39 imf, fiscal affairs department, globalization, financial markets, and fiscal policy, international monetary fund 6 (2007), available at http://www.imf.org/external/index.htm (indicating, however, that not all countries react to globalization in a similar manner, with some countries affected more adversely than others). for example, "the decline [in corporate tax rates] has been especially pronounced in some eu countries such as austria, denmark, finland, portugal and sweden, and also in emerging market countries in europe . . . the evidence for emerging markets in asia and latin america also suggests a recent decline in corporate tax rates." id.; avi-yonah, sartori, & marian, supra note 1, at 129–30, n.138 (citing an oecd report indicating that 17 oecd member countries experienced a decline in average statutory corporate tax rate from 50.9% in 1982 to 38.3% in 1997); id. at 138 (suggesting that evidence for all oecd member countries demonstrates a consistent drop from an average statutory corporate tax rate of 33.6% in 2000 to an average of 28.4% in 2006, and adding that similar findings are available for corporate effective marginal and effective average rates); cf. congressional budget office, corporate income tax rates: international comparisons 36, 39 (2005), available at http://cbo.gov/sites/default/files/cbofiles/ftpdocs/69xx/doc6902/11-28-corporatetax.pdf; oecd, policy brief, reforming corporate income tax, oecd observer, july 2008, at 3 fig.2, available at http://www.oecd.org/tax/taxpolicyanalysis/41069272.pdf (illustrating the decline in average effective corporate tax rates (aetr) from 1982 to 2005). avi-yonah, saratori and marian suggest that the trend of rate reduction is also evident for developing countries. avi-yonah, sartori, & marian, supra note 1, at 138–39. 40 see avi-yonah, saratori & marian, supra note 1, at 141 n.144 (citing an nber study reporting that since the 1970s, of all the g7 countries, only japan showed evidence of a substantial decline in corporate tax revenues); imf, supra note 39, at 6 ("[d]espite the reduction in statutory and effective tax rates, corporate tax revenue had held up well. indeed, industrial countries have experienced an increase in corporate tax revenue on average, both relative to gdp and to total tax revenue."). however, while the overall oecd total suggests that corporate revenues as a percentage of total receipts has slightly increased over time, this trend varies from nation to nation. see oecd, revenue statistics 2012, at 110 tbl.12 (2012), available at http://www.oecdilibrary.org/taxation/revenue-statistics-2012_rev_stats-2012-en-fr (comparing corporate taxes as a percentage of total receipts from 1965 to 2010). 2014] the intricacies of tax and globalization 217 policy of the congressional research service, any gains from cutting corporate rates "would be reduced if other countries responded to a u.s. rate cut by reducing their own taxes."41 this domino effect in tax rate cuts is a very real possibility, as "evidence suggests that the u.s. [corporate tax] rate cut in the tax reform act of 1986 might have triggered rate cuts in other countries."42 in fact, data for the u.s. depicts a drastic drop in corporate tax revenues since 1950, from approximately 26% of total tax receipts to only 8% in 2010.43 in addition, the observed upward trend in total oecd corporate tax revenues, as a percentage of total receipts, is likely to be the result of a number of factors. some of these factors may not necessarily represent a true increase in collection, but rather mask other economic developments. such are, for example, greater corporate profitability and a shift in the income tax base from personal to corporate, as taxpayers take advantage of incorporation and the associated lower tax rates.44 this, in turn, leads to a growing corporate sector that yields more taxes mainly due to its increased volume.45 worldwide corporate tax-base broadening, particularly among oecd member countries, is another potential contributor to the improved corporate revenue yield.46 41 hearing on the need for comprehensive tax reform to help american companies compete in the global market and create jobs for american workers, supra note 28, at before the h. comm. on ways and means, 112th cong. 9 (2011) (statement of jane gravelle, senior specialist in economic policy, congressional research service), available at http://waysandmeans.house.gov/uploadedfiles/gravelle.pdf; see also oecd, supra note 35, at 6 fig.6 ("the tax cuts introduced by [corporate and personal tax reforms] have not led to a fall in the overall tax burden (measured by the tax-to-gdp ratio) . . . indeed, the overall trend in tax burdens was upward until 2000" and increased again in 2006 and 2007, with another dip after the fiscal crisis due to decreased economic activity); but see avi-yonah, the oecd harmful tax competition report, supra note 31, at 790 ("while in developed countries this decline in rates was matched by a broadening of the tax base, so that no decline in revenues can be observed, in developing countries the same period witnessed a decline of corporate tax revenues by about 20% on average. this decline is particularly important in light of the larger share of tax revenues produced by the corporate tax in developing countries (an average of 17%) as opposed to developed countries (an average of 7%)."). 42 hearing on the need for comprehensive tax reform to help american companies compete in the global market and create jobs for american workers, supra note 28, at 9 (statement of jane gravelle). cf. oecd, supra note 35, at 5 (attributing the inception of the corporate income tax rate reduction trend to the uk and usa tax reforms undertaken in the mid-1980s). 43 memorandum from senator carl levin, permanent subcomm. on investigations, hearings on offshore profit shifting, submitted as evidence for the congressional hearing on sept. 20, 2012, exhibit #1b, available at http://www.levin.senate.gov/newsroom/press/release/subcommittee-hearing-to-examine-billionsof-dollars-in-us-tax-avoidance-by-multinational-corporations/?section=alltypes (follow the hyperlink to "psi charts on offshore profit shifting") (depicting a downward trend in u.s. corporate revenues from the 1950s and a plateau since the 1990s). the memorandum also indicates that as corporate revenues decreased from 1950 to 2010, payroll taxes increased from about 8% of tax revenue in 1950 to approximately 40% in 2010. id. at 4–5 (follow the hyperlink to "psi memo on offshore profit shifting and the u.s. tax code".). 44 this is true in most of the oecd where the personal rate is higher than the corporate rate, but not so much in the u.s., where the top statutory rates have differed little in the past 25 years. see, e.g., brooks & hwong, supra note 18, at 809 ("one important reason why corporate tax revenues [among oecd member countries] have increased even though rates have been reduced is that corporate tax profits as a share of gdp have increased greatly over the past twenty or so years."). 45 id. ("in many countries . . . corporate profits as a percentage of gdp had reached historically unprecedented levels just before the worldwide economic meltdown."). 46 see avi-yonah, sartori, & marian, supra note 1, at 142; brooks & hwong, supra note 18, at 804 ("[the reduction in the corporate tax rate as a result of the 1986 tax act] cut the u.s. tax rate from 46 to 34 percent. this reduced rate was more than compensated by base-broadening measures."); but see id. at 810–11 ("mooij and nicodème have recently estimated that as high as over 20 percent of annual corporate 218 columbia journal of tax law [vol.5:207 over the past few years, prominent tax scholars and analysts have more vocally endorsed the proposition that the long-run flattening of personal and corporate income tax rates, and the move away from taxation of capital and high-income taxpayers more generally to less mobile taxpayers and resources such as consumption and labor, seriously distort tax structures while rendering tax systems around the world more regressive.47 reuven avi-yonah explains: "[c]ountries that formerly relied on income tax revenues now must increase relatively regressive taxes, such as consumption and payroll taxes, which in recent years have been the fastest growing taxes in the member countries of the organization for economic co-operation and development (oecd)."48 a holistic view of global tax trends during the past thirty-five years thus suggests that, in order to meet present-day challenges, nations and their tax systems must reconsider the available revenue sources—either within or outside the tax realm—as well as the alternative of cutting back on government spending, given the risk of revenue decline.49 while either option has significant tax implications, both also concern a range tax revenue can be explained by the shift in the tax base from relatively higher-taxed personal income to lower-taxed corporate income."). 47 see, e.g., permanent subcomm. on investigations, offshore profit shifting memorandum, supra note 43 (indicating an erosion in corporate tax revenue and a parallel increase in payroll taxes from 1950 to 2010); avi-yonah, supra note 31, at 795 (concluding that if harmful tax competition is "left unchecked, the dire predictions of a twenty-first century world based on the vat, while perhaps premature, could in time still be borne out"). for a discussion of opposing claims that the move toward a greater usage of consumption and payroll taxes may not be troubling and, moreover, that it is the very reason why welfare states have been able to continue to fund their growing expenditures, see, e.g., brooks & hwong, supra note 18, at 815 (noting that one possible argument for consumption taxes is that "'a revenue shift to regressive taxes makes it politically easier to maintain a large public sector'") (quoting juno kato, regressive taxation and the welfare state (2003)). see also neil brooks, a restatement of the case for progressive income tax, in tax reform in the 21st century: a volume in memory of richard musgrave 277, 333 (john g. head & richard e. krever eds., 2009) ("[t]he fact that transfers can be relatively effective at reducing inequalities has led some commentators to suggest that progressive taxes are not needed for achieving a more equal society."); but see brooks & hwong, supra note 18, at 818 ("however, if there is a case for redistributing from the very rich, because they have no moral claims to their vast incomes or because their economic power threatens democratic values and the quality of life in a society, then transfer payments cannot, obviously, be used for this purpose."). furthermore, with respect to taxing labor, such measures may ultimately undermine the supposed economic growth rationale they are meant to encourage. see, e.g., oecd, supra note 25, at 122 ("it is also possible that labour taxes influence foreign direct investment adversely by increasing labour cost in the host country. for instance, [one scholar] found that the impact on fdi of labour taxes is generally substantially larger than that of cross-border effective corporate tax rates . . . this can hinder technology transfers and spillovers of best practices from multinationals to domestic firms . . . ."). 48 avi-yonah, supra note 27, at 1577; see also oecd, supra note 25, at 27 ("there has been a continuously growing share of social security contributions, which by 2007 accounted for 25 per cent of total revenues, apart from france, italy, the netherlands, and spain, where the share has decreased."); avi yonah, supra note 31, at 789 (addressing the regressive nature of alternative methods of raising revenue and arguing that "[j]urisdictions that had previously relied on income tax revenues must resultantly supplement their tax revenue by raising more regressive taxes," such as taxes on labor and consumption). relatively speaking, the regressive shift in revenue sources is less evident in the united states. here, the shift toward more regressive revenue sources at the federal level (e.g., the payroll tax) has been largely offset by increased progressivity of the individual income tax, especially at the bottom end where there has been a large growth in refundable credits, especially for families with children. however, putting aside the less than ideal trade-off, these trends have substantially restrained the u.s. from making its tax system more progressive in response to growing inequality of pretax incomes. see, e.g., congressional budget office (cbo), the distribution of household income and federal taxes, 2010 (december 2013), available at http://cbo.gov/sites/default/files/cbofiles/attachments/44604-averagetaxrates.pdf. 49 see, e.g., rodrik, supra note 22, at 23 (addressing the tenuous trade-off between increased globalization and government provision of a social safety net and stating that "a key component of the 2014] the intricacies of tax and globalization 219 of broader and more nuanced policy dilemmas, such as distribution, efficiency, and national and societal identity. discussing some of these dilemmas, tsilly dagan argues that with increased globalization the focal point of nations’ public policy has been profoundly altered. according to dagan: the incentive to cater to the preferences of the more attractive and mobile among the potential residents and investors pushes policy makers to curtail states’ redistribution functions. it requires them to choose between their original constituents and others — possibly more attractive ones (in terms of their own political interests as well as . . . the collective welfare pie).50 underscoring similar issues, a 2010 oecd tax policy reform and economic growth report further asserts that "policy makers will need to examine very carefully the tradeoff between . . . growth-enhancing proposals and other objectives . . . particularly equity."51 iii. avoiding the strains of globalization – cooperation, harmonization and other tax related initiatives whatever form the future nation-state takes, globalization offers nations and their tax systems both an abundance of benefits and some embedded perils.52 importantly, globalization highlights the value of imposing a measure of restraint on the competitive dynamics among nations. an imf report advises: implicit postwar social bargain in the advanced industrial countries has been the provision of social insurance and safety nets at home (unemployment compensation, severance payments, and adjustment assistance, for example) in exchange for the adoption of freer trade policies"); id. at 26 ("globalization [and the related competition it entails] increas[es] the demand for social insurance while simultaneously constraining the ability of governments to respond effectively to that demand.") (emphasis added). 50 tsilly dagan, dilemmas of tax policy in a globalized world, in tax law and development 57, 59 (yariv brauner & miranda stewart eds., 2013). see also rodrik, supra note 22, at 23 (explaining that nations are making drastic changes that significantly affect longtime social customs in order to increase their competitiveness in the global economy. such changes include, for instance, japan’s dismantling of its policy of lifetime employment and south korea’s relaxation of its firing restrictions). for a more recent example, consider michigan’s legislation seeking to limit the ability of unions to negotiate. one key justification for this legislation was that it would encourage u.s. companies to "bring jobs back to the states." see brian montopoli, right-to-work signed into law in michigan, cbs news, dec. 11, 2012, available at http://www.cbsnews.com/8301-250_162-57558532/right-to-workpoised-to-become-law-in-michigan/. 51 oecd, supra note 25, at 24; but see michael livingston, from mumbai to shanghai with a side trip to washington: china, india, and the future of progressive taxation in an asian-led world, 11 theoretical inquiries law 539, 544–45 (2010) ("even when [progressivity] is accepted as a goal of tax policy, [it] may clash with other goals such as economic efficiency, simplicity, or administrability, and competitiveness with other nations . . . beyond that, some . . . nations may simply assign a low priority to tax equity, believing that it is more important to let the 'pie get bigger for everyone.'"). 52 see, e.g., oecd, supra note 26, at 5 (discussing the issue of sub-central tax competition and outlining arguments both for and against tax competition). for a helpful discussion on the benefits of globalization, see, e.g., tanzi, supra note 25, at 6 ("globalisation obviously leads to a more efficient use of capital. in theory the capital produced . . . can be invested in those areas and countries where they yield more . . . i myself have argued repeatedly that perhaps [the capital flight from latin america] was not altogether a bad phenomenon, because . . . while they were abroad they yielded fairly high interest rates, they did not pay taxes and accumulated fortunes, which in theory, could return to latin america."); tyler cowen, creative destruction (2002) (embracing cross-cultural exchanges brought about by globalization). for the perils of globalization, see, e.g., joseph e. stiglitz, globalization and its discontents (2002) (discussing the shortcoming of global economic theory and the manner in which key institutions of globalization have failed developing countries they were meant to help). 220 columbia journal of tax law [vol.5:207 globalization can . . . create a framework for cooperation among nations on a range of non-economic issues that have cross-border implications, such as immigration, the environment, and legal issues. at the same time, the influx of foreign goods, services, and capital into a country can create incentives and demands for strengthening the education system [among other national infrastructures], as a country’s citizens recognize the competitive challenge before them.53 monitoring, defusing, and otherwise addressing tax competition would allow nations to manage the threat of a competition-driven race to the bottom among them. this race undermines their ability to tax and raise revenue, particularly from the most mobile resources and taxpayers. 54 similarly, monitoring and thoughtfully addressing the competitive cycle may also safeguard the capacity of nations to utilize their tax systems toward goals other than financing basic government goods and services, such as redistributing income and improving societal well-being.55 policies aimed at addressing international tax competition have been traditionally understood to include measures that advance cooperation, harmonization, and integration of national tax structures, policies, and administrations.56 until recently, however, such 53 imf staff, supra note 19, at 2; see also allison christians, steven dean, diane ring, & adam rosenzweig, taxation as a global socio-legal phenomenon, 14 ilsa j. int’l & comp. l. 303, 305 (2008) ("[t]he miracle [of an international tax regime] is flawed because of the failure of states to agree on an increasingly lengthy list of key areas . . . in effect, the flaw . . . is a series of unrelieved collective action problems among states, each multiplying the harm of the other . . . the need for revenue to address [growing inequality and growing social needs] and the increasing unease about the distributional effects of regulation in an economically integrated world, require that this web of collective actions be addressed and, if possible, overcome . . . further, states cannot raise revenue effectively or fairly in the modern international economic regime without interacting with other states and their citizens, as people, goods, services, and capital increasingly cross global borders."). 54 for example, the u.s. congress is concerned about the ability of multinational entities to escape paying income tax. the permanent subcommittee on investigations hearings on offshore profit shifting been examined the issue of corporate tax avoidance for the past few years, yet not much has been accomplished because of sentiments similar to those of senator coburn’s, who wondered whether "it’s too risky to tidy up the mess?" (referring to offshore profit shifting engaged in by multinational corporations). see permanent subcomm. on investigations, offshore profit shifting memorandum, supra note 43. furthermore, ceos have been circumventing the issue by arguing that there will be no issue to worry about if the u.s. merely lowers its corporate rates. see 60 minutes: the new tax havens (cbs television broadcast mar. 26, 2011), available at: http://www.cbsnews.com/video/watch/?id=7376848n (reporting recent data showing that ge paid an effective rate of 3.6% in 2009 and quoting the cisco ceo as stating that he would love to bring jobs back to the u.s., provided that the u.s. lowers its corporate tax rates). 55 this is desirable because a society in which some taxpayers, such as multinational entities and highly skilled workers, receive tax breaks simply because they are more mobile while other, less mobile taxpayers, such as lower-skilled workers and consumers, are forced to shoulder a larger share of the tax burden, is highly inequitable. in this scenario "less desirable [also read mobile] individuals may include sick, elderly, and poor individuals." dagan, supra note 50, at 65. 56 pragmatically, breaking down or otherwise defusing the competitive cycle among nations is politically challenging. consider the extremely difficult political battles for tax revenue centralization within various countries alone, let alone on a global scale. see, e.g., christina wagner faegri & carol wise, economic and fiscal policy in latin america, 46 latin am. res. rev. 240 (2011) ("the fiscal relationship between the provinces and the central government in argentina stands out as the most complex and volatile [compared to other latin american countries], and, despite several concrete attempts at centralizing tax revenue, a fiscal bargain similar to that of mexico was never reached."); kathryn james, an examination of convergence and resistance in global tax reform trends, 11 theoretical inquiries law 475, 484 (2010) (discussing state and local reactions to the vat in the u.s. and explaining that "state and local government representatives were concerned about the balance of federal taxing power and feared any intrusion into the sales tax area, which is dominated by state and local governments . . . ."). 2014] the intricacies of tax and globalization 221 measures have focused more on addressing what are known today as "tax havens" or "harmful tax practices," than on advancing broader integration or harmonization.57 in 1998, the oecd established a special task force to counter the spread of abusive tax practices and to implement a code of conduct for business taxation.58 among other actions, the task force drafted an unofficial list of 35 jurisdictions deemed "uncooperative."59 the oecd threatened to include these jurisdictions on a "black list," pledging severe sanctions if they refused to commit to several steps including a tax transparency and information exchange program. 60 as early as 2008, all but three jurisdictions complied with the oecd task force demands,61 with none remaining on the list by 2009.62 57 while not without its flaws, the oecd’s 1998 initiative played an important role in forming international tax relationships for the past decade and a half. see oecd, harmful tax competition: an emerging global issue (1998), available at http://www.oecd.org/tax/transparency/44430243.pdf; oecd, 2000 progress report: towards global tax co-operation: progress in identifying and eliminating harmful tax practices (2000), available at http://www.oecd.org/ctp/harmful/2090192.pdf; oecd, the oecd’s project on harmful tax practices: 2004 progress report (2004), available at http://www.oecd.org/ctp/harmful/30901115.pdf; oecd, the oecd’s project on harmful tax practices: 2006 update on progress in member counties (2006), available at http://www.oecd.org/ctp/harmful/37446434.pdf. 58 oecd, harmful tax competition, supra note 57, at 8 ("the report is intended to develop a better understanding of how tax havens and harmful preferential tax regimes, collectively referred to as harmful tax practices, affect the location of financial and other service activities, erode the tax bases of other countries, distort trade and investment patterns and undermine the fairness, neutrality and broad social acceptance of tax systems generally. such harmful tax competition diminishes global welfare and undermines taxpayer confidence in the integrity of tax systems . . . by discouraging the spread of tax havens and harmful preferential tax regimes and encouraging those countries which presently engage in harmful tax practices to review their existing measures, the report will serve to strengthen and to improve tax policies internationally."). 59 avi-yonah, supra note 31, at 784–85 (explaining that the list of uncooperative jurisdictions was drafted based on the 1998 oecd report on harmful tax competition as well as a second report, published in 2000, titled "improving access to bank information for tax purposes"). 60 id. at 785–87. among other relevant steps, the oecd global forum on tax information exchange was established in 2001 and in 2002 the oecd issued a model agreement on exchange of information issues. id. at 786. 61 id. 62 see list of unco-operative tax havens, oecd, http://www.oecd.org/countries/monaco/listofunco-operativetaxhavens.htm (last visited may 7, 2014) ("in a report issued in 2000, the oecd identified a number of jurisdictions as tax havens according to criteria it had established. between 2000 and april 2002, 31 jurisdictions made formal commitments to implement the oecd’s standards of transparency and exchange of information. seven jurisdictions (andorra, the principality of liechtenstein, liberia, the principality of monaco, the republic of the marshall islands, the republic of nauru and the republic of vanuatu) did not make commitments to transparency and exchange of information at that time and were identified in april 2002 by the oecd’s committee on fiscal affairs as unco-operative tax havens. all of these jurisdictions subsequently made commitments and were removed from the list of unco-operative tax havens. . . . in may 2009, the committee on fiscal affairs decided to remove all three remaining jurisdictions (andorra, the principality of liechtenstein and the principality of monaco) from the list of uncooperative tax havens in the light of their commitments to implement the oecd standards of transparency and effective exchange of information and the timetable they set for the implementation. as a result, no jurisdiction is currently listed as an unco-operative tax haven by the committee on fiscal affairs."). see also oecd, better policies for development: recommendations for policy coherence 25 (2011), available at http://www.oecd.org/pcd/48110465.pdf ("the economic crisis and recent cross-border tax evasion scandals have heightened the political drive to ensure rapid implementation of the oecd’s tax transparency and information exchange standards, through the oecdhosted global forum. . . . more than 600 agreements have been signed since april 2009 and many more are under negotiation."). http://www.oecd.org/ctp/harmful/42826270.pdf http://www.oecd.org/ctp/harmful/42826280.pdf http://www.oecd.org/ctp/harmful/42826253.pdf http://www.oecd.org/ctp/harmful/42826253.pdf 222 columbia journal of tax law [vol.5:207 the emphasis on tax havens and harmful tax practices is not self-evident and has in fact drawn harsh criticism over the years. some critics have doubted the actual success of the oecd initiative63 while others have viewed it as a smoke screen fashioned to target a politically safe problem in order to avoid more difficult conversations about fundamental tax reform.64 according to this proposition, the oecd initiative "may . . . be seen, at best, as a modest and inadequate effort to counter declining national revenues, and perhaps as an issue around which countries can choose to coalesce in order to create a basis for further cooperation on tax policy matters."65 likewise, harmonization efforts have also received their share of scrutiny. specifically, given the distinctive characteristics of nations and the importance of national sovereignty, autonomy and self-expression, the efficiency advantage of harmonization, and its merit more generally, have become widely disputed.66 vito tanzi, for example, cautions that "[we] need[] to be very careful with harmonisation, because harmonisation can take place around the most burdensome tax system of the group of countries or can take place around a tax system that is so inefficient that the inefficiencies 63 see, e.g., jason c. sharman, havens in a storm, the struggle for global tax regulation (2006) (suggesting that the reduction in the oecd black list was more attributed to the u.s. withdrawal of support in 2001 than to actual progress in international cooperation). see also david spancer & jason c. sharman, international tax cooperation, journal of international taxation 35 (2007); david spancer & jason c. sharman, international tax cooperation, journal of international taxation 27 (2008); david spancer & jason c. sharman, international tax cooperation, journal of international taxation 39 (2008) (finding that little progress has been made in reducing tax havens practices). but cf. avi-yonah, supra note 31 (concluding that the oecd efforts have been successful based on data that suggests no decline in individual or corporate tax revenues in oecd member countries over the decade proceeding the 1998 initiative while showing a decline in corporate tax revenues in non-oecd countries over the same period). 64 allison christians, taxation in the time of crisis: policy leadership from the oecd to the g20, 5 nw. j. l. & soc. pol’y 19, 28 (2010) (discussing the g20 and explaining that "[t]hese troublesome factors raise difficult questions about the g20’s focus on tax havens, especially since there is no indication offered to date that the elimination of tax havens is a top priority for developing countries. instead, the g20’s attention to global tax policy appears to be an effort to both attain a greater international acceptance of tax policy priorities articulated by the oecd and to avoid a more politically difficult conversation about the increasing incapacity of national tax systems to meet revenue demands, especially in times of economic instability."). 65 id. at 28. the oecd task force was also criticized for ignoring tax haven-like behavior in many countries, including the u.s. see, e.g., jane g. gravelle, cong. research serv., r40623, tax havens: international tax avoidance and evasion 6 (2013), available at http://www.fas.org/sgp/crs/misc/r40623.pdf (questioning the credibility and motivation behind the oecd "black list"); allison christians, sovereignty taxation and social contract, 18 minn. j. int’l l. 99, 119 (2009) ("what the oecd calls 'encouraging' and 'assisting' is interpreted by some as an unjustified use of force purely for self-interested ends."). furthermore, the political feasibility of the oecd’s ending all competitive activities is low. see discussion on globalization and tax competition in supra notes 26–28 and accompanying text as well as infra notes 86–90 and accompanying text. 66 see, e.g., richard e. baldwin & paul krugman, agglomeration, integrations, and tax harmonization, 48 eur. econ. rev. 1, 21 (2004); yariv brauner, an international tax regime in crystallization, 56 tax l. rev. 259 (2003); carl gaigne & stephane riou, globalization, asymmetric tax competition, and fiscal equalization, 9 j. pub. econ. theory 910, 920 (2007); michael j. graetz, taxing international income: inadequate principles, outdated concepts, and unsatisfactory policies, 26 brook. j. int'l l. 1357 (2001); julie roin, competition and evasion: another perspective on international tax competition, 89 geo. l.j. 543 (2001). dean, for example, questions the emphasis on tax harmonization as the solution for nations to avoid international tax conflicts by becoming more alike. see steven dean, more cooperation, less uniformity: tax deharmonization and the future of the international tax regime, 84 tul. l. rev. 125, 128–29 (2009). he subsequently makes a case for deharmonization—cooperation without uniformity—as a viable alternative. id. 2014] the intricacies of tax and globalization 223 of one country are passed on to all the other countries." 67 addressing the broader implications of harmonization, other scholars have questioned the legitimacy of the oecd to set the tone, serve as an authority, and lead worldwide initiatives "when oecd member countries represent a declining share of global gross domestic product."68 finally, although addressing tax competition has become a high priority in an increasingly globalized world, efforts by individual countries to strengthen tax administration are no less important.69 such efforts, however, remain largely unrealized, resulting in significant revenue loss. senator levin, for example, estimates that $4 million per day is lost due to u.s. corporate tax avoidance,70 while gravelle puts the figure at $10 to $60 billion per year.71 iv. trends of convergence and divergence in an interdependent world as nations draw closer—either intentionally or unintentionally—toward an allinclusive, homogenous world, globalization can be understood to lead inevitably to convergence of national identities and policies. 72 in this light, globalization is complemented by a unified approach to taxation that transcends national boundaries and jurisdictions.73 the area of corporate taxation is a good example of such convergence. 67 tanzi, supra note 25, at 10 (adding that: "therefore fiscal harmonisation has to be considered carefully."). 68 christians, supra note 64, at 33–34. 69 for an interesting discussion that considers tax administration an integral part of nations’ tax mix, see generally dean, supra note 66. see also assaf likhovski, is tax law culturally specific? lessons from the history of income tax law in mandatory palestine, 11 theoretical inquiries law 725 (2010) (exploring history preand post-enactment of britain’s model income tax ordinance in palestine after world war ii and highlighting the key role tax administrations played in that context). likhovski explains that many discretionary compromises were made in adapting the income tax, for example in the treatment of tax evasion. id. at 757. in the report for 1942-43, the commissioner noted that evasion was fairly widespread, but “having regard to the fact that income tax has been but recently introduced in palestine, it was decided, as a matter of policy, not to take any action [by imposing] . . . penalties for the making of incorrect returns and fraudulent acts.” id. 70 see 159 cong. rec. s6658 (daily ed. sept. 19, 2013) (statement of sen. levin). for an informative discussion of corporate tax avoidance estimates, see, e.g., senate floor statement on introducing the stop tax haven abuse act, sen. carl levin (sept. 19, 2013), available at http://www.levin.senate.gov/newsroom/speeches/speech/senate-floor-statement-on-introducing-the-stop-taxhaven-abuse-act. 71 gravelle, supra note 65, at 16–19 (discussing empirical literature and indicating that estimates on the revenue loss caused by corporate tax avoidance significantly vary). gravelle also includes tables showing the percentage of u.s. profits as a percentage of foreign gdp. id. at 14–15. for example, in bermuda, such profits amounted to an astounding 646% of the country’s gdp in 2008, indicating that "profits [were not derived] from economic motives related to productive inputs or markets, but rather reflect income easily transferred to low-tax jurisdictions." id. at 15. 72 see, e.g., james, supra note 56, at 475 ("notwithstanding a wide divergence in government and institutional structures, electoral systems, and social political values, there has often been a convergence of tax systems in western democracies."); oecd, supra note 35, at 3 ("[d]espite there being 34 countries in the oecd, trends in tax rates and burdens show more common themes than differences."). 73 see, e.g., reuven s. avi-yonah, international tax as international law: an analysis of the international tax regime 1 (2007) ("[a] coherent international tax regime exists, embodied in both the tax treaty network and in domestic laws, and that it forms a significant part of international law . . . the practical implication is that countries are not free to adopt any international tax rules they please, but rather operate in the context of the regime, which changes in the same way international law changes over time. thus, unilateral action is possible, but is also restricted, and countries are generally reluctant to take unilateral actions that violate the basic norms that underlie the regime."). http://www.levin.senate.gov/newsroom/speeches/speech/senate-floor-statement-on-introducing-the-stop-tax-haven-abuse-act http://www.levin.senate.gov/newsroom/speeches/speech/senate-floor-statement-on-introducing-the-stop-tax-haven-abuse-act 224 columbia journal of tax law [vol.5:207 as avi-yonah, sartori, and marian show, since the mid-1980s and well into the 2000s, most industrialized nations have been implementing very similar reforms to broaden their corporate tax bases.74 these commonly include (1) eliminating or significantly reducing investment credits; (2) replacing generous accelerated depreciations with depreciation rules that more closely reflect the life of assets; and (3) introducing limitations on interest deductions.75 a degree of convergence is not surprising in the context of income taxation because the structural considerations factored into the design and administration of income tax systems tend to be similar across jurisdictions. 76 similarities exist not because there are no differences among nations, but because globalization significantly levels the playing field.77 stated differently, given the effect of globalization across countries, convergence emerges as a natural phenomenon as cooperative strategies prove beneficial and markets open toward one another. 78 in fact, functional comparatists commonly argue that convergence is not only an easily observed phenomenon, but also a desirable practice.79 it is viewed as beneficial because "there is little sense in adopting different legal rules that are aimed at dealing with similar . . . problems and to achieve similar results."80 accordingly, the seeming heterogeneity across countries—whether in taxation or otherwise—may merely disguise innate similarities.81 importantly, despite the forces working toward convergence, an absolute convergence of tax systems driven by a dramatic "race to the bottom" of tax rates and bases remains unlikely.82 several domestic factors, such as the size of public sector debt, act as counterweights to tax competition.83 in addition, attracting economic resources requires more than offering preferential tax treatment. in a statement on international tax issues before the ways and means committee of the u.s. house of representatives, jane gravelle observed that "most [u.s.] stocks held in foreign firms are in firms in developed countries with similar tax rates to those of the u.s., not firms in low tax 74 avi-yonah, sartori, & marian, supra note 1, at 113–14, 142–43. 75 id. 76 see supra note 11, and accompanying text. 77 see, e.g., robert t. kudrle, governing economic globalization: the pioneering experience of the oecd, 46 j. world trade 695 (2012) (explaining that "[e]conomic globalization demands national policy accommodation"); cf. diane m. ring, what’s at stake in the sovereignty debate?: international tax and the nation-state, 49 va. j. int’l l. 155, 160–61 (2008) (suggesting that "a sovereign state must exhibit some de facto external independence," but that, at the same time, it is "never a truly absolute quality"). 78 see avi-yonah, supra note 18, and accompanying text. 79 avi-yonah, sartori, & marian, supra note 1, at 4–5 (discussing the functionalist approach to taxation and analyzing carlo garbarino's scholarship as a good example of a functionalist tax analysis). 80 id. 81 avi-yonah, sartori, & marian, supra note 1, at 4. the oecd’s model for international transfer pricing standards is another example of a legal standard adopted across different jurisdictions (albeit with differences in its administration), because [t]he incomplete and inconsistent application of international standards, inadequate legislation, or a lack of basic tax capacity in developing countries can mean that transfer prices used by mnes may depart from the arm’s length standard and lead to profits being shifted to low-tax jurisdictions, resulting in a lower revenue for normal rate jurisdictions, including developing countries. oecd, better policies for development, supra note 62, at 25. 82 avi-yonah, sartori, & marian, supra note 1, at 139–40 (indicating, for example, a trend of corporate rate divergence over the past decade). see also supra note 36. 83 avi-yonah, sartori, & marian, supra note 1, at 139 (citing duane swank & steven steinmo, the new political economy of taxation in advanced capitalistic democracies, 46 am. j. pol. sci. 642 (2002)). 2014] the intricacies of tax and globalization 225 countries."84 to the extent that these firms keep their investments in the developed world, such evidence counters the common assumption that tax rates are the sole or even predominant factor in determining investment decisions. rather, investments are more likely to be made based on a mix of considerations, including the availability and quality of local goods and services, which can be severely undermined by declining revenues if countries excessively indulge in preferential tax offerings.85 furthermore, notwithstanding the homogenizing influence of convergence, globalization may also lead to divergence as nations find it beneficial to draw on their individual strengths to gain competitive advantages.86 in fact, the undertone of most comparative tax analyses continues to demonstrate that "the most obvious finding is divergence" 87 and that, so far, "convergence is a relatively narrow phenomenon . . . limited to certain aspects of the tax system, primarily its corporate and international provisions."88 notably, in any jurisdiction law is but one piece of a broader cultural puzzle, which draws on unique local conditions. the assertion that structural tax problems and solutions across different jurisdictions are similar can therefore be seen as both inaccurate and misleading.89 on this view, "harmonization projects . . . that call— by definition—for the annulment of cultural identity as expressed in the unique laws of a given society . . . [may not only be rejected as undesirable but could also present] an unattainable goal, since cultural and political differences are irreconcilable."90 as kathryn james explains, taxation is "fundamentally about the rules of the game that determine, amongst other things, the level of social spending in society, the distribution of property among social groups, and the concentration of power . . . ."91 84 hearing on the need for comprehensive tax reform to help american companies compete in the global market and create jobs for american workers, supra note 28, at 6 (statement of jane gravelle) (emphasis added). 85 id. (emphasizing that "portfolio investors are concerned with the overall return (governed by overall tax rules) and not the details of a country’s foreign tax regime"); cf. avi-yonah, sartori, & marian, supra note 1, at 140 (discussing fdi in the context of mnes’ activity and citing joshua d. moore, the economic importance of tax competition for foreign direct investment: an analysis of international corporate tax harmonization proposals and lessons from winning corporate tax strategy in ireland, 20 pac. mcgeorge global bus. & dev. l.j 345, 357 (2007) ("[b]ecause mnes benefit from tax expenditures and provisions of public goods and services, they are unlikely to derive the rates to zero.")). 86 see, e.g., james, supra note 56, at 496 ("the mere fact that vat reform was so controversial in australia and canada and remains elusive in the u.s. challenges this presumption of necessary convergence."). 87 avi-yonah, supra note 18, at 1 ("if one compares any two national tax laws, the most obvious finding is divergence. tax law reflects specific national histories, cultures and interests, and not surprisingly they differ."). 88 id. at 5. in these areas, convergence may be a positive phenomenon to the extent that it reduces the scope of tax arbitrage where taxpayers manipulate the discrepancies among tax systems of different jurisdictions to minimize their tax liability. id. 89 avi-yonah, sartori, & marian, supra note 1, at 7; marian, supra note 2, at 465 ("tax law is very much about local context. it is the very essence of the political orientation of any regime in any given jurisdiction . . . [and] is used expressly to promote political agendas."). 90 avi-yonah, sartori, & marian, supra note 1, at 7 (adding that "rather, . . . comparative analysis should be aimed at understanding the cultural; social; political; and ultimately, the legal identities of 'the other.' in turn, such 'understanding' should serve us better 'when reflecting on our own legal rules and cultural identity.'"); likhovski, supra note 69, at 761 ("many participants in the debate about legal transplantation and the autonomy of the law assume that law is autonomous and independent of the society which it governs or, alternatively, that it reflects that society. but in fact law is both autonomous and related to society, depending on the specific phase in the life of the law that we are examining and the actors we are interested in."). 91 james, supra note 56, at 496. 226 columbia journal of tax law [vol.5:207 while "these issues might be universal . . . there are clear differences as well as similarities in the way in which societies respond to [them] . . . ." 92 in this light, divergence is both to be expected and valuable.93 as long as there are differences among societies, convergence will never be complete.94 in fact, forces of convergence and divergence may operate at the same time, pulling nations in opposite directions and at times—either partially or completely— negating each other. comparing the canadian general anti-avoidance rule (gaar) with its chinese counterpart, jinyan li argues, for example, that even though both gaars appear similar on paper, they diverge in several fundamental respects, including the challenges addressed, the motivations behind their enactment, and their application and effects. li adds, however, that because the canadian and chinese gaars affect their tax systems from almost opposite directions, they end up bringing the two systems closer together.95 ultimately, the existing literature suggests that the likely, particularly long-term, outcomes of globalization, even tax competition, are unclear.96 the ability of capital to move where it can be used most productively can enhance the growth and efficiency of local markets.97 additionally, while any downward or regressive pressures on the tax base and rates are expected to adversely affect public outlays, another trend is likely to work in the opposite direction, stimulating increased public spending on local infrastructures to manage the upshots of modernization and global competition.98 these 92 id. 93 avi-yonah, supra note 18, at 1–5 (discussing elements of convergence and divergence in taxation). 94 see, e.g., avi-yonah, sartori, & marian, supra note 1, at 7–9; cf. mathias reimann, the progress and failure of comparative law in the second half of the twentieth century, 50 am. j. comp. l. 671 (2002) (exploring convergence and divergence in the common and civil law). 95 li, supra note 13, at 658; james, supra note 56, at 495–96 ("[w]hile consumption tax reform in australia, canada and the united states was, and remains, highly controversial, these controversies are often the product of different configurations of key political and economic factors, which pull in competing directions towards convergence and divergence in tax reform outcomes."). james adds, more generally, that "[t]he vat-reform experience of . . . [australia, canada, and the united states] encapsulates the tension that arises from a tendency among developed tax systems to convergence against frequent and often fierce localized opposition." id. at 475; likhovski, supra note 69, at 761 (discussing the simultaneous convergence and divergence that occurred in implementing the palestinian income tax). likhovski concludes that "[u]ltimately what we are left with is a confusing picture, which is the result of opposing forces, each pulling in a different direction." id. 96 for a good explanation on why globalization and tax competition theories offer conflicting results, consider eric toder’s remarks on tax incentives and behavior: "correlation between two variables does not imply that one change causes the other and there are usually many aspects of a taxpayer’s situation that are changing at the same time, confounding attempts to identify the separate effect of the incentive being studied." responses to tax incentives in a complex and uncertain law before the senate fin. comm., 112th cong. 7 (2011) (statement of eric toder, fellow at urban-brookings tax policy ctr.). 97 see, e.g., chris edwards & daniel l. mitchell, global tax revolution: the rise of tax competition and the battle to defend it (2008); tanzi, supra note 25; cf. avi-yonah, supra note 27, at 1614 ("a fundamental assumption of the studies [suggesting that tax competition impairs the ability of nations to best service the needs of their citizens] is that governments are benevolent—that they seek to maximize the utility of their residents. however, governments may also be considered leviathans that seek to maximize their revenues in their own self-interest without regard for the good of the general citizenry. from this perspective, tax competition may be beneficial because it constrains governments’ tendency to grow."). 98 vito tanzi, globalization and the need for fiscal reform in developing countries, 26 j. pol. modeling 525 (2004); hines & summers, supra note 19, at 124 ("[t]he economic costs of raising tax revenue are particularly worrisome in an environment in which governments face significant demands on 2014] the intricacies of tax and globalization 227 include, for example, additional funding needed for tackling increasing rates of inequality99 and the rise in longevity and in the cost of public goods and services.100 furthermore, economic activity, including investments and other productive endeavors, is likely to be pursued where it is most profitable. profitability, however, relies heavily on the availability and quality of national infrastructures, such as law enforcement and the monetary system, which, in turn, depend on taxation.101 the evidence on the effect of globalization on public expenditure, however, is yet again inconclusive. 102 likewise, as global perspectives on income taxation law illustrates, while globalization may lead to at least some observed trends in taxation— including the flattening of income tax rates and the move toward the taxation of less mobile sources, and thus more regressive, tax schemes—there is clearly far more than meets the eye. here, global perspectives on income taxation law provides a valuable reference for how different countries confront challenges that are common among tax systems. keeping in mind that differences among national tax systems nonetheless exist and understanding how tax systems converge and diverge constitutes a vital first step toward crystallizing the necessary actions to better coordinate between multiple tax systems while retaining national sovereignty in tax design. over the long run, this could also lead to better evaluation of the net benefit or cost of globalization, allowing policymakers to respond effectively to the fiscal challenges that globalization presents. their resources . . . [these demands] put pressures on government to . . . respond in ways that help their populations thrive in more global competitive markets. social welfare programs have for many years served the first of these functions and education and training programs the second; all of these are expensive, so there is understandable interest in the ability of government to maintain their funding . . . ."). however, "since location choices, activity levels, and taxable incomes are sensitive to local taxes, it stands to reason that governments would feel intensifying pressure to reduce tax burdens on business activities, investors, and possibly high net worth individuals." id. 99 imf, supra note 39, at 10 (explaining that while there is evidence to suggest that increased inequality may be caused more by technological changes than globalization and the related expansion of the vat, governments are likely to be called upon to assist those who are adversely affected, and particularly to provide more income support and training for low-skilled workers who lose their jobs as the flow of trade increases); robert c. feenstra & gordon h. hanson, global production sharing and raising inequality: a survey of trade and wages, in 1 handbook of international trade 146 (e. kwan chio & james harrington eds., 2004) (reviewing evidence suggesting that globalization has contributed significantly to income inequality). 100 see, e.g., brooks & hwong, supra note 18, at 800–01 (explaining, for example, that "somewhat paradoxically, globalization itself increases the need for taxation because it increases the instability of economies and the economic insecurity of workers; this in turn should lead to an increased demand for social insurance schemes"). 101 kenneth stewart & michael webb, international competition in corporate taxation: evidence from the oecd time series, 45 economic policy 153 (2006) (discussing business activity). 102 some studies suggest, for example, that increased trade openness may stimulate higher government spending, but that increased trade openness combined with financial globalization leads to lower government spending. imf, supra note 39, at 10 (citing literature). according to the imf: while these results are not necessarily inconsistent . . . they do not provide definitive conclusions one way or the other on the implementation for spending. moreover, they are only partial in that they tend to focus on central government expenditure . . . which is a problem to the extent that globalization leads central governments to make room for new spending by offloading responsibility for some existing programs onto local government. id. at 10–11. articles tax liability for wage theft sachin s. pandya * abstract this paper shows how, under existing tax law, illegal wage underpayment by an employer (sometimes called “wage theft”) may generate employer tax liability for unreported income or disallowed business expense deductions. given that the tax authority needs information from the underpaid worker to prove such liability, the paper identifies two ways that a worker can transmit that information to a tax authority: becoming a tax informant, or bringing a qui tam action under a state false claims act. finally, the paper discusses possible influences on the decision of the unpaid worker to inform on the employer to the tax authority, and considers the conditions under which a tax authority is likely to audit an employer based on such information. in so doing, the paper identifies a new approach to combating wage theft and an undiscovered implication of basic income tax law. * associate professor of law, university of connecticut school of law. for comments on prior drafts, thanks to stephen utz, peter siegelman, richard pomp, ruth mason, diana leyden, and francine lipman. 114 columbia journal of tax law [vol.3:113 i. introduction .................................................................................................... 115 ii. tax liability ..................................................................................................... 117 a. unpaid wages as employer income .................................................................. 117 1. the value of misappropriated labor is employer income ......................... 117 2. gross income includes gains derived from illegal activity ..................... 119 3. illegality and fair market value ................................................................. 120 b. wage underpayment and business expense deductions .................................. 123 1. unpaid wages as business expense deductions ........................................ 123 2. wage payments that violate criminal provisions of minimum wage statutes are not deductible ...................................................................................... 125 c. no payroll tax or withholding liability ........................................................... 126 1. payroll taxes ............................................................................................... 126 2. income tax withholding ............................................................................. 127 iii. the methods of informing ........................................................................ 128 a. tax informant .................................................................................................... 129 b. qui tam action under state false claims act .................................................. 131 iv. the decision to inform ................................................................................ 132 a. benefits .............................................................................................................. 132 b. costs .................................................................................................................. 133 c. the undocumented worker ............................................................................... 134 d. tax informant immunity? .................................................................................. 136 e. audit selection .................................................................................................. 138 v. complement to other law enforcement approaches .............. 140 vi. conclusion ........................................................................................................ 142 appendix ..................................................................................................................... 143 2012] tax liability for wage theft 115 i. introduction employers often pay low-wage workers less than the wages that they must pay by law. this wage underpayment (sometimes called “wage theft”) is widespread. 1 it persists in low-wage sectors, despite the prospect of private civil actions under state contract law and the fair labor standards act (“flsa”), civil proceedings by the united states department of labor (“usdol”) and by state departments of labor, 2 and state prosecutions under criminal theft-of-service statutes. 3 there are many plausible explanations for why such wage theft persists. some of them include the predominance of small firms; the growth of subcontracting; employer misclassifications of employees as independent contractors to avoid liability under flsa and under other laws; and the particular prevalence and vulnerability of undocumented workers. 4 in turn, proposals to combat wage theft roughly fall into two groups. one group of proposals focuses on how existing enforcement institutions, such as usdol, can best use their limited resources to increase compliance. these include tailoring enforcement strategy to the unique structure of particular industries; encouraging employers to hire third-party private monitors of labor violations 5 ; and recruiting unions, workers’ centers, and other non-governmental organizations (ngos) to gather information and, in some cases, monitor workplaces directly. 6 a second group of proposals focuses on amending existing law to overcome standard problems with private lawsuits by the unpaid workers. one such problem is judgment-proof defendants. another is firms down the supply chain that pressure their contractors to reduce labor costs below mandated minimums but do not count as the unpaid worker’s “employer” under existing law. possible solutions include holding corporate shareholders jointly and severally liable for unpaid wages owed by the corporation, 7 as well as imposing unpaid-wages liability on any and all firms down the supply chain that buy or sell the non-complaint employer’s goods and services, regardless 1 see, e.g., annette bernhardt et al., broken laws, unprotected workers: violations of employment and labor laws in america's cities (2008). 2 see, e.g., u.s. gov’t accountability office, department of labor: wage and hour division's complaint intake and investigative processes leave low wage workers vulnerable to wage theft (2009). 3 rita j. verga, an advocate's toolkit: using criminal theft of service laws to enforce workers' right to be paid, 8 n.y. city l. rev. 283 (2005). 4 see, e.g., janice fine & jennifer gordon, strengthening labor standards enforcements through partnerships with workers’ organizations, 38 pol. & soc’y 552, 554-55 (2010); david weil, enforcing labour standards in fissured workplaces: the us experience, 22 econ. & labour rel. rev. 33, 36-43 (2011). 5 on different views of the success of this kind of approach to apparel contractors in the los angeles area by the u.s. department of the labor in the late 1990s, compare jill esbenshade, monitoring sweatshops: workers, consumers and the global apparel industry 60-118 (2004) with david weil, public enforcement/private monitoring: evaluating a new approach to regulating the minimum wage, 58 indus. & lab. rel. rev. 238 (2005). 6 fine & gordon, supra note 4, at 558-75. 7 see n.y. bus. corp. law § 630(a) (2012); mass. gen. laws ch. 156, § 35 (2011). cf. eric tucker, shareholder and director liability for unpaid workers’ wages in canada: from conditions of granting limited liability to exceptional remedy, 26 law & hist. rev. 57 (2008) (history of such laws in canada); kenneth b. davis, jr., shareholder liability for claims by employees, 1984 wis. l. rev. 741 (criticizing later-repealed wisconsin statute). 116 columbia journal of tax law [vol.3:113 of whether those other firms can be deemed to be the worker’s “employer” under the flsa or other laws. 8 this paper identifies an unexpected source of existing law for addressing employer wage underpayment: tax law. part ii argues that under existing federal and state tax law, under certain circumstances, employers may face income tax liability for wage underpayment if those employers fail to report the unpaid wages as gross income or take an unallowable business-expense deduction for those unpaid wages. the rest of the paper then discusses how such tax liability could be enforced. part iii suggests that because unpaid workers have the best evidence of wage underpayment, such tax liability cannot be effectively enforced unless those workers or their agents tell the internal revenue service (irs) or state tax authorities what they know. to do this, those workers can become tax informants. in a few states, those workers can also pursue qui tam tax fraud actions under the state's false claims act. in part iv, the paper discusses the conditions under which the unpaid worker might pursue these avenues, and in turn considers when a tax authority is likely to audit an employer based on such an informant’s information. finally, part v shows how the tax approach identified here complements other legal approaches to combating wage theft. in so doing, this paper contributes to the research literature in two ways. first, the tax and employment law literatures have rarely covered wage underpayment as a tax liability issue. 9 to date, no one has identified a basis under existing tax law for treating wage underpayment as generating employer tax liability, let alone discussed how such liability might be enforced. in doing so, this paper bridges the tax and employment law literatures by offering a new legal approach to combating wage theft. this approach is best taken not as a substitute for, but an important complement to, existing legal approaches. second, the paper advances the theoretical literature on the law enforcement uses of bounties and rewards. that literature has discussed tax informant rewards and qui tam actions 10 but has not focused on the low-wage or undocumented worker as a tax informant. 8 e.g., timothy b. glynn, taking the employer out of employment law? accountability for wage and hour violations in an age of enterprise disaggregation, 5 emp. rts. & emp. pol’y j. 201, 227-28 (2011) (proposing strict liability for wage and hour violations in the production of any goods and services that a firm buys, sells, or distributes, but “only for the portion of the violations attributable to the goods or services it purchases, sells, or distributes”); hina b. shah, broadening low-wage workers’ access to justice: guaranteeing unpaid wages in targeted industries, 28 hofstra lab. & emp. l.j. 9, 35-37, 43-44 (2010) (advocating extension of wage-guarantee provision on garment manufacturers in california labor code section 2673.1 to other low-wage sectors and with a private enforcement mechanism); brishen rogers, toward third-party liability for wage theft, 31 berkeley j. emp. & lab. l. 1, 34-60 (2010) (arguing for liability for downstream buyers of goods and services that fail to exercise due care to prevent wage and hour violations by upstream suppliers). 9 an exception is crane, who briefly considered the tax treatment of wage underpayment in a theoretical tax system with a completely closed tax base. charlotte crane, liabilities and the need to keep the income tax base closed, 25 va. tax rev. 31, 54 (2005). 10 yosef mealem et al., whistle-blowers as deterrents to tax evasion, 38 pub. fin. rev. 306 (2010); omri yadlin, the conspirator dilemma: introducing the "trojan horse" enforcement strategy, 2 rev. law & econ. 25 (2006); ben depoorter & jeff de mot, whistle blowing: an economic analysis of the false claims act, 14 sup. ct. econ. rev. 135 (2006); robert cooter & nuno garoupa, the virtuous circle of distrust: a mechanism to deter bribes and other cooperative crimes (university of california, berkeley program in law & economics, working paper series, 2000); gideon yaniv, revenge, tax informing, and the optimal bounty, 3 j. pub. econ. theory 225 (2001); marsha j. ferziger & daniel g. currell, snitching 2012] tax liability for wage theft 117 ii. tax liability this part presents a legal argument that, under existing federal and state tax law, an employer may incur income tax liability for failing to report gross income derived from not paying wages owed for services rendered, or for claiming paid or unpaid wages as deductible business expenses. this part also concludes that wage underpayment does not generate employer payroll tax liability or violations of income tax withholding requirements. a. unpaid wages as employer income an employer that practices wage underpayment faces penalties under tax law that may arise because the employer has failed to report the unpaid wages as gross income. this conclusion derives from two settled readings of § 61(a) of the internal revenue code, which defines gross income to include, unless otherwise provided, “all income from whatever source derived.” first, a taxpayer that benefits from a service has received income. second, gain derived from an activity is not excluded from gross income simply because that activity is illegal. moreover, it is also relatively settled that a taxpayer that benefits from a service has received income to the extent of the fair market value of that service, an approach that, as argued here, implies that the amount of income so received cannot be less than the amount of pay to which the worker was entitled under existing laws. the discussion that follows similarly implicates liability under state tax law. most states that tax personal or corporate income have incorporated the federal definition of gross income and, accordingly, these readings thereof, into their own tax law by adopting the federal income tax base (variously, federal gross, adjusted gross, net, or taxable income) as at least the starting point for calculating state income tax. 11 1. the value of misappropriated labor is employer income when an employer underpays wages, the employer gains an item of income. this follows in two steps. first, when an employer underpays wages, the employer gains income by paying less than the cash value of the services performed by the worker. suppose the employer promised the worker $100 in exchange for performing certain services, and that $100 is the cash value of those services. if the employer then only paid $45 upon completion of those services, then the employer has gained $55 in income. the income arrives to the employer in the form of the gain from services equal to the cash value of those services ($100), less the amount actually paid for them ($45). this amount is income even though the gain arrives in the form of services, not cash or property. section 61(a) covers income “from whatever source.” moreover, treasury regulation § 1.61-1(a) provides that “[g]ross income includes income realized in any form, whether in money, property, or services. income may be realized, therefore, in the form of services . . . as well as in cash.” 12 second, for wage underpayment to generate employer income, the employer must not recognize any employer obligation to pay the worker the wages owed but as yet unpaid. if both worker and employer agree that the employer is so obliged, then the for dollars: the economics and public policy of federal civil bounty programs, 1999 u. ill. l. rev. 1141 (1999). 11 all st. tax guide (ria) ¶ 221 (2011). 12 treas. reg. § 1.61-1(a) (1960). 118 columbia journal of tax law [vol.3:113 unpaid wages are not income, but a debt. proceeds from loans do not count as gross income under federal and state tax law, because both debtor and creditor recognize that the debtor is legally obliged to repay the amount in question, and that liability is treated as offsetting the debtor’s gain from the loan proceeds. 13 thus, unpaid wages are income to the employer if and when that employer stops recognizing those unpaid wages as a debt to be paid to the worker for services rendered. 14 accordingly, when the unpaid wages count as part of employer gross income depends on when the employer stops treating those unpaid wages as a debt. this matters if the employer stops treating the unpaid wages as a debt in a taxable year after the taxable year in which the worker renders services. to illustrate, consider by analogy an employer that attempts to pay wages to a worker and then, after a time, when those wages remain uncollected, decides to stop treating those wages as a debt. for example, in charleston & w.c. ry. co. v. burnet (1931), a steam railroad company had “carried” $441.05 in uncollected employee wages “on its books to be paid when called for, or when those entitled were located,” and the company had taken a deduction for those wages in 1921. 15 in december 1924, the company made an entry in its books “crediting 'profit and loss' with $441.05 on account of” those still unpaid wages. the court reasoned: “though the company intended paying proper claims on the fund if and when sought,” since the “effect” of this bookkeeping change made available the $441.05 “for general uses,” it became “a part of the [company's] gross revenue in 1924 as though paid in that year,” and thus “a part of the net on which the tax levied became due.” 16 although the railroad company never actually paid the $441.05 before or during 1924, that amount became part of its gross income only in 1924, because, as evinced by the bookkeeping change, only in that year did it stop treating those wages as a liability on its books (a debt). 17 to be sure, the company may have done so because it doubted that the workers 13 joseph m. dodge, exploring the income tax treatment of borrowing and liabilities, or why the accrual method should be eliminated, 26 va. tax rev. 245, 253-55 (2006); boris i. bittker & barton h. thompson jr, income from the discharge of indebtedness: the progeny of united states v. kirby lumber co., 66 cal. l. rev. 1159 (1978). 14 i.r.c. § 61(a)(12) (2006). the argument is not that employer wage underpayment generates employer “[i]ncome from discharge of indebtedness.” for that to happen, the unpaid worker (the creditor) has to have taken the additional and unlikely step of forgiving or canceling the employer's debt (the liability for the unpaid wages). even then, gain from discharge-of-indebtedness is excluded from gross income “to the extent that payment of the liability would have given rise to a deduction.” i.r.c. § 108(e)(2) (2006). wage payments are deductible as business expenses under i.r.c. § 162. see i.r.c. § 162(a)(1) (2006) (allowing as a deduction “a reasonable allowance for salaries or other compensation for personal services actually rendered”). therefore, any cancellation of an employer’s wage debt by the worker would still not result in discharge-of-indebtedness income. 15 charleston w. c. ry. co. v. burnet, 50 f.2d 342, 343 (d.c. cir. 1931). 16 id. then, as now, federal tax law defined a corporation's gross income, absent certain exceptions, to follow the definition of an individual's gross income. i.r.c. § 985(a) (1925-26). that definition included “gains, profits, and income derived from . . . the transaction of business carried on for gain or profit, or gains or profits and income derived from any source whatever.” id. § 954(a). 17 for other uncollected-wage examples, see chicago r.i. & p. ry. co. v. comm’r, 47 f.2d 990, 992 (7th cir. 1931) (commissioner properly charged to gross income company checks and vouchers for compensation for services and in payment of loss or damage claims that company charged to profit and loss if not presented for payment within two years from date issued); beacon auto stores, inc. v. comm’r, 42 b.t.a. 703, 704-05 (1940) (corporation realized income when it extinguished undrawn salary credits to shareholders by debit to their individual accounts and a corresponding credit to surplus account). uncollected-wage tax cases like charleston & w.c. ry. co. may well be far less likely today given the widespread adoption of state escheat statutes, most of which impose a one-year period before uncollected 2012] tax liability for wage theft 119 would ever collect the unpaid wages, even while still intending to pay those wages if those workers sought to collect. in contrast, in a wage theft scenario, the employer abandons any intent to pay even if the worker later seeks to collect. in either case, however, what matters is that the employer stopped treating the unpaid wages as a debt, not the precise reason why it did so. 2. gross income includes gains derived from illegal activity when an employer underpays wages, the employer gains income for tax law purposes even though such underpayment is illegal under other law. since united states v. sullivan (1927), the united states supreme court has read the federal tax code's definition of income to include gains derived from illegal activity. 18 in sullivan, the taxpayer had been convicted for failing to file a tax return as required by the revenue act of 1921. the case turned on whether the revenue act of 1921 required the taxpayer to report his income derived from selling intoxicating liquor, an activity that violated the national prohibition act. in upholding the conviction, the court emphasized that while the revenue act of 1913 had defined a taxable person’s net income to include “the transaction of any lawful business carried on for gain or profit,” the word “lawful” did not appear in the successor provision in the revenue act of 1921. 19 in later definitions of income under federal tax law, congress continued this omission. years later, in james v. united states (1961), the court confirmed that embezzled funds count as income by ruling that a union official who had embezzled from his employer union was obliged to report those illegal appropriations as gross income in the year in which they were received. the court declared: “when a taxpayer acquires earnings, lawfully or unlawfully, without the consensual recognition, express or implied, of an obligation to repay and without restriction as to their disposition,” those earnings count as gross income under i.r.c. § 61(a), even though the taxpayer may be later found not to be entitled to it. 20 in this respect, james simply confirmed that gains from illegal activity fall within the general rule that tax treatment of a gain as proceeds from a debt or as income turns on whether both sides of the transaction recognize any obligation to repay in the taxable year. in james and other embezzlement cases, the illegally obtained money or property has counted as income in the year of receipt, presumably because the embezzler intended to use the acquired money or property for personal use (the embezzlement) at the same time, or in the same year, that he acquired it. subsequent examples of illegal gross income in lower court opinions include racing tickets stolen by the employee of a betting wages are deemed abandoned to the state. see 1 david j. epstein, unclaimed property law and reporting forms § 5.21 (2012). 18 see boris i. bittker, taxing income from unlawful activities, 25 case w. res. l. rev. 130 (1974); frank m. keesling, illegal transactions and the income tax, 5 ucla l. rev. 26, 26-33 (1958). 19 united states v. sullivan, 274 u.s. 259, 263 (1927). congress had removed “lawful” from the definition of income in 1916. revenue act of 1916, pub. l. no. 271, § 2(a), 39 stat. 756, 757. henry campbell black declared it “probable” that congress had intended the word “lawful” in the revenue act of 1913 to “exclude occupations forbidden to all persons, as being immoral or contrary to public policy” out of concern that “taxing them might appear to legalize them.” henry campbell black, a treatise on the law of income taxation under federal and state laws 99 (1913). 20 james v. united states, 366 u.s. 213, 219 (1961) (warren, c.j., plurality opinion). 120 columbia journal of tax law [vol.3:113 parlor 21 and sums received for vessel repair services that were invoiced but not actually performed. 22 3. illegality and fair market value whereas the illegality of wage underpayment does not preclude counting the benefit of services received as gross income to the employer, such illegality can affect how much income an employer gains from wage underpayment, because of the “fair market value” approach to valuation of services. since the early twentieth century, federal tax law has determined the cash value of property using the concept of “fair market value,” defined for certain federal income tax purposes as “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts.” 23 the irs has often used a “fair market value” concept for determining the cash value of services without any apparent difference in meaning when applied to services instead of property. 24 for example, since at least 1938, a treasury regulation has provided that when a person pays for services rendered with property rather than cash, the resulting income to the payee is “the fair market value of the property taken in payment.” 25 the same regulation also provides: “if the services are rendered at a stipulated price, such price will be presumed to be the fair market value of the compensation received in the absence of evidence to the contrary.” 26 to illustrate this presumption, suppose a taxpayer initially agrees to provide services for $100 (the “stipulated price”) but thereafter accepts a wood table in lieu of that $100 as payment. 21 collins v. comm’r, 3 f.3d 625, 627 (2d cir. 1993). 22 mcgee v. comm’r, 519 f.2d 1121, 1123 (5th cir. 1975). 23 treas. reg. § 1.170-1(c)(1) (as amended in 1972) (charitable contribution of property); treas. reg. § 1.170a-1(c)(2) (as amended in 2008) (same); treas. reg. § 1.412(c)(2)-1 (1980) (deferred compensation plan assets); treas. reg. § 1.415(c)-1(b)(5) (2007) (contribution of property to defined contribution plan); treas. reg. § 31.3121(i)-4 (1973) (clothing provided to members of certain religious orders); see also treas. reg. §§ 1.704-4(a)(3), 1.737-1(b)(2) (1995) (similar for property distributed to partnership). a similar definition of “fair market value” of property appears in the federal estate tax, treas. reg. § 20.2031-1(b) (as amended in 1965), and the federal gift tax, treas. reg. § 25.2512-1 (1992). this definition of “fair market value” precedes its appearance in federal tax law. for early critical commentary on this definition as it appeared in other laws, see james c. bonbright, the valuation of property: a treatise on the appraisal of property for different legal purposes 59-61 (1937). on applications and extensions of this definition of “fair market value” for property valuation under federal tax law, see john a. bogdanski, federal tax valuation ¶ 2.01 (1996 & supp. 2011). 24 see, e.g., treas. reg. § 1.74-1(a)(2) (1960) (services provided as a prize); treas. reg. § 1.9521(a)(4) (as amended in 2002) (illegal payment in the form of services by or on behalf of a controlled foreign corporation to government officials); treas. reg. § 1.82-1(a)(2) (as amended in 1978) (employer moving of employee's “household goods and personal effects from the employee's old resident to his new residence using the employer's facilities”); treas. reg. § 1.170a-1(h)(1)(i)-(ii),(2)(i)(b) (as amended in 2008) (services for which taxpayer makes payment claimed as charitable contribution); treas. reg. § 1.199-3(i)(4) (2008) (allocation for domestic production gross receipts attributable to performance of embedded services); treas. reg. § 1.263(a)-4(d)(8) (2004) (services to produce or improve real property); treas. reg. § 1.276-1(f)(3) (as amended in 1969) (whether proceeds received by political candidate for services rendered are received in ordinary course of candidate's trade or business); treas. reg. § 1.1441-3(e)(1) (as amended in 2012) (“the amount of a payment made in a medium other than u.s. dollars is measured by the fair market value of the property or services provided in lieu of u.s. dollars.”). 25 treas. reg. § 1.61-2(d)(1) (as amended in 2003). 26 id. for discussion, see, for example, bogdanski, supra note 23, ¶ 3.07[4]; robert i. keller, the taxation of barter transactions, 67 minn. l. rev. 441, 456-57 (1982). 2012] tax liability for wage theft 121 under this regulation, the fair market value of that wood table, and thus the resulting income to the taxpayer, is presumptively $100. in 1957, this regulation was amended to include services as well as property. 27 today, that regulation provides that when a person pays for services with other services, the resulting income to the payee is “the fair market value of such other services.” 28 for example, if a housepainter paints a lawyer's house in exchange for the lawyer's personal legal services, the housepainter's gross income must include the “fair market value” of those legal services. 29 the “stipulated price” presumption remains: if the non-cash compensated services “are rendered at a stipulated price, such price will be presumed to be the fair market value of the compensation received in the absence of evidence to the contrary.” 30 in this and other uses of “fair market value” to determine the cash value of services, the term “fair market value” is not expressly defined. in contrast, in setting “fair market value” as the computational starting point for valuing fringe benefits, the irs has defined “fair market value” to mean what “an individual would have to pay for the particular fringe benefit in an arm's-length transaction,” without regard to “any special relationship” between employer and employee, or how the employee subjectively perceives the benefit's value, and not wholly determined by the benefit's cost to the employer. 31 this definition resembles the willing-buyer/willing-seller definition of the “fair market value” of property. both refer to a hypothetical transaction in which the buyer and seller have no prior relationship (“arm's-length transaction”). fringe benefits can be services, such as, for example, chauffeur services. 32 this too implies no sharp difference in the meaning of “fair market value” when used to determine the cash value of services rather than property. given federal tax law's widespread use of “fair market value” to value services, judges and tax officials may be inclined to use “fair market value” to calculate the cash value of an unpaid worker's services. 33 importantly, “fair market value” does not necessarily require taking the contract price as the full measure of the service's cash value, though judges could well treat it as presumptively so. in this respect, “fair market value” operates no differently, better or worse, for valuing services than for valuing property in screening out those aspects of the actual transaction that may have led to a 27 22 fed. reg. 9420 (nov. 26, 1957) (¶1(b)). the 1938 antecedent to the current treas. reg. § 1.61-2(d)(1) referred only to payment for services with “something other than money” and the “fair market value” of the “thing” taken in payment,” and presumed that, absent contrary evidence, any “stipulated price” for services rendered was the “fair value” of the compensation received. treas. reg. § 3.22(a)-3 (1938). 28 treas. reg. § 1.61-2(d)(1). 29 rev. rul. 79-24, 1979-1 c.b. 60. see also badell v. comm’r, 80 t.c.m. (cch) 422, 425 (2000) (roofing services as income). 30 treas. reg. § 1.61-2(d)(1). 31 treas. reg. § 1.61-21(b)(1)-(2) (as amended in 1992). 32 treas. reg. § 1.61-21(b)(5) (specifying how to compute fair market value of chauffeur services provided as fringe benefit). 33 see, e.g., koons v. united states, 315 f.2d 542, 545 (9th cir. 1963) (upholding irs use of “fair market value” to determine cash value of employer provision of moving company services to transport employee's household furniture); rooney v. comm’r, 88 t.c. 523, 528-29 (1987) (finding for federal income tax purposes the “fair market value” of goods and services received by accounting firm to cover unpaid bills to be the prices charged by the firm's clients to their retail customers, and citing the willing-buyer/willingseller definition of “fair market value” under federal estate tax, treas. reg. § 20.2031-1(b) (as amended in 1965)). 122 columbia journal of tax law [vol.3:113 higher or lower contract price. for example, we might suppose that the contract price for services exceeds “fair market value” where a restaurant owner's sister pressures the owner to hire his nephew as wait staff for wages higher than what that owner could have paid a stranger to do the same work. more importantly, the “fair market value” concept also requires accounting for federal and state laws that affect the contract price for labor. federal and state wage and hour statutes impose a price floor in labor markets, much as government price floors exist for certain commodities, such as cow's milk. 34 federal employment discrimination statutes prohibit wage discrimination with respect to certain worker characteristics. these laws matter, because “fair market value” seems to require imagining, as part of the hypothetical arm's-length transaction, that the hypothetical buyer and seller complete the transaction without violating the legislated price floor or wage-discrimination prohibitions. for example, a sale price below a price floor set by a minimum wage statute seems to suggest that the seller was “under [a] compulsion” to sell at that price, because the “fair market value” concept requires imagining hypothetical sellers that aim to maximize sale price 35 and that have “reasonable knowledge of the relevant facts,” here the minimum sale price set by applicable wage and hour statutes. if so, the price floor set by minimum wage law determines the minimum cash value of services generated by the “fair market value” inquiry, precisely because at the time of the actual transaction, that price floor applied generally to all buyers and sellers of those services. to illustrate, suppose again that an employer promises $100 in exchange for certain services, but pays only $45. before, we had assumed that $100 was the cash value of those services, and from there concluded that the employer had gained $55 in gross income. if, however, the applicable minimum wage statute had required the employer to pay at least $120 at that time, then no matter what the employer actually promised to pay, the employer has gained at least $75 in gross income. similarly, where the restaurant owner hires a woman as a waiter for wages lower than what that owner would have had to pay a man to do the same work, the contract price for those services falls below “fair market value,” if that concept requires us to screen out any illegal labor market disadvantage that hypothetical female sellers of labor have because they are women. thus, if the equal pay act 36 forbids paying the female waiter less than current male waiter employees to do the same work, then a contract price that falls below the male waiters' wages may fall below “fair market value,” because “fair market value” assumes, again, that sellers aim to maximize sale price and have “reasonable knowledge of the relevant facts,” here how much the male waiters receive in wages and that any contract price below that amount violates the equal pay act. this analysis is consistent with how “fair market value” is usually applied to property so as to account for statutes or regulations that restrict the use or sale of that 34 for brief discussion, see milk indus. found. v. glickman, 949 f. supp. 882, 885-88 (d.d.c. 1996). 35 for “fair market value” of property, the tax court has sometimes expressed this intuition. see dillard v. comm’r, 20 t.c.m. (cch) 137, 143 (1961) (“fair market value contemplates two parties, both driving the hardest bargain he can to obtain the best possible price for himself.”); see also jonathan t. bromwell & assoc. v. comm’r, 66 t.c.m. (cch) 799, 808 (1993) (“to determine that an arm's-length transaction took place, we must find that the buyer was motivated to secure the lowest purchase price possible and, conversely, that the seller looked to obtain the highest price.”). 36 29 u.s.c. § 206(d) (2006). 2012] tax liability for wage theft 123 property, such as zoning and environmental laws, or regulations on the sale of securities. 37 the main difference may be that, putting aside wage ceilings, accounting for restrictions on the contract price for services—usually imposed on the buyer of services (the employer)—tends to increase the price of the services provided in the hypothetical arm's-length transaction. in contrast, accounting for restrictions on the sale of property— usually imposed on the seller of property—may tend to reduce the price of the property in the hypothetical arm's-length transaction, effectively forcing one to calculate a discount for the restriction’s effect on the marketability of the property. to be sure, the irs also uses “fair market value” to value illegal goods, such as relying on the “retail street price” of illicit drugs, 38 which requires imagining the hypothetical buyer and seller violating the law by completing the transaction. the reason, however, is that although the very transaction is illegal at any price, without imagining it nonetheless, there would be no market at all from which to estimate cash value. the same reasoning would apply to using “fair market value” to determine the cash value of categorically illegal services, such as prostitution or private assassination. in contrast, price regulation of services, such as minimum wage statutes or the equal pay act, imply a legal market for those services, because no legislature regulates prices for services that it has already banned at any price. b. wage underpayment and business expense deductions the employer that practices wage underpayment may also face tax consequences for deducting unpaid wages, as well as certain kinds of wage payments, as business expenses. under § 162(a) of the code, a taxpayer may deduct “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including . . . a reasonable allowance for salaries or other compensation for personal services actually rendered.” 39 unless otherwise indicated, the timing of this deduction depends on the taxpayer's method of accounting. 40 the wage-underpaying employer faces two tax consequences with respect to how it claims business expense deductions for its wage payments. first, whereas a cashmethod employer can never deduct unpaid wages as business expenses, an accrualmethod employer may do so under certain circumstances subject to operation of the tax benefit rule. second, regardless of its accounting method, an employer cannot deduct paid wages as business expenses if such wage payments violate provisions of minimum wage statutes that impose criminal penalties. 1. unpaid wages as business expense deductions a business deduction for unpaid wages may be allowed, but this depends initially on the taxpayer’s chosen method of tax accounting. under the cash and disbursements method of accounting, wages are deductible as business expenses when paid. therefore, since unpaid wages are not “paid” compensation expenses for already rendered services, a cash method employer cannot deduct unpaid wages as business expenses. 37 see generally bogdanski, supra note 23, ¶ 6.02. 38 see, e.g., jones v. comm’r, 61 t.c.m. (cch) 1721, 1736 (1991) (“retail street value” of cocaine); caffery v. comm’r, 60 t.c.m. (cch) 807, 816 (1990) (using “market value” and “street value” interchangeably to refer to cash value of marijuana). 39 i.r.c. § 162(a)(1) (2006). 40 i.r.c. § 461(a) (2006). for examples of different timing rules for deducting compensation to another for services rendered, see i.r.c. § 83(h) (2006) and i.r.c. § 404(a)(5) (2006). 124 columbia journal of tax law [vol.3:113 for the accrual method employer, however, business expense deductions are, in theory, allowable for unpaid wages under certain circumstances. an accrual method taxpayer can usually deduct business expenses that have been “incurred . . . in the taxable year in which all the events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability.” 41 if the taxpayer's liability arises because “another person” provides services to the taxpayer, as a worker provides services to an employer, then “economic performance occurs as such person provides such services.” 42 applying this test, suppose that in taxable year1, the accrual-method employer promises to pay the worker $100, and the worker renders the services, but the employer only pays the worker $45. once all these events occur, that employer's liability to pay the worker the unpaid wages is established under state contract law. alternatively, if under the applicable minimum wage the employer must pay $120, but in fact the employer only pays $45, the employer's liability to pay the worker $75 is established under the minimum wage statute. in either case, the amount of the liability can be determined with reasonable accuracy, and economic performance has already occurred, because the worker has finished providing the promised services. two outcomes are possible. if, in our first example, that employer resolves to never pay the wages owed ($55) in that same year (year1), then that $55 cannot be an incurred compensation expense. indeed, as discussed earlier, at that point, the employer gains an item of income if the services' cash value exceeds wages actually paid. this outcome is effectively the same as for the cash-method employer: in no year can this employer legally deduct the unpaid wages as business expenses. suppose, however, that the employer claims the $100 (including the unpaid $55) as a business expense deduction in year1, but resolves not to pay the $55 in year2. if so, then the deduction for that $55 is allowable in year1, because in that year, the employer is still treating the unpaid wages as a debt to be paid. once the employer stops treating the unpaid wages as a debt (in year2), the tax benefit rule applies. that rule provides that a taxpayer that took a deduction in a prior year must include that amount as income in a later year when an event in that later year is "fundamentally inconsistent with the premise on which the deduction was initially based.” 43 accordingly, in our example, the tax benefit rule triggers in year2, because in that year, the employer decided not to treat the unpaid $55 as a debt owed to the worker. that decision is the event that is “fundamentally inconsistent” with the premise behind the deductibility of those unpaid wages in year1, that is, that the employer recognizes the $55 in unpaid wages as a debt owed to the worker. 44 however, if the employer would have 41 treas. reg. § 1.461-1(a)(2) (as amended in 1998); see i.r.c. § 461(h)(4) (2006) (“for purposes of this subsection, the all events test is met with respect to any item if all events have occurred which determine the fact of liability and the amount of such liability can be determined with reasonable accuracy.”). 42 i.r.c. § 461(h)(2)(a)(i) (2206); accord treas. reg. § 1.461-1(d)(2)(i) (as amended in 1998). 43 hillsboro nat’l bank v. comm’r, 460 u.s. 370, 383 (1983). the amount to be included as income in that later year, however, does not include the amount deducted if and “to the extent such amount did not reduce the amount of tax imposed” in the earlier year. i.r.c. § 111(a) (2006). 44 such an employer, however, cannot benefit from i.r.c. § 1341, which applies if and only if “an item was included in gross income for a prior taxable year (or years) because it appeared that the taxpayer had an unrestricted right to such item.” i.r.c. § 1341(a)(1) (2006). courts and the irs have refused to read this text to include cases in which the taxpayer obtained an item of income in a prior taxable year in a 2012] tax liability for wage theft 125 had the same tax liability regardless of whether it had deducted that $55 in year1, then the amount deducted in year1 is not treated as an item of income in year2. 2. wage payments that violate criminal provisions of minimum wage statutes are not deductible regardless of accounting method, business expense deductions for already paid wages may be disallowed if such wage payments violate the fair labor standards act or (some) state minimum wage statutes. section 162(c)(2) of the code disallows business expense deductions “for any payment . . . made, directly or indirectly, to any person, if the payment constitutes an . . . illegal payment” under any federal law or “generally enforced” state law that, in pertinent part, “subjects the payor to a criminal penalty.” 45 for example, when a corporation paid wages in violation of a wage ceiling, set by presidential executive order, that subjected to a criminal fine any person paying wages or salaries “higher than those permitted hereunder,” then wages and salaries paid in excess of that wage ceiling counted as “illegal payments” under § 162(c)(2). 46 for § 162(c)(2) to apply, however, the payment at issue must be in and of itself illegal, not just connected to or made to further illegal activity. 47 to illustrate, although some have suggested otherwise, 48 wages paid to undocumented workers are not clearly “illegal payments” under § 162(c)(2) just because federal immigration law imposes criminal penalties on employers that engage in a “pattern or practice” of violating certain statutory subsections concerning the employment of undocumented workers. 49 those subsections make it unlawful for any person to knowingly “hire, or to recruit or refer for a fee, for employment” an “unauthorized alien,” or continue to employ the alien though knowing he or she is or has become an “unauthorized alien.” 50 although wage payments are certainly connected with these activities, 51 these subsections do not clearly make the wage payments to undocumented workers illegal in and of themselves. for example, hiring an unauthorized alien under this statute occurs when the service or labor “commence[s],” because the word “hire” in the immigration statute means “the actual commencement of employment of an employee for wages or other remuneration,” 52 and the word “employment” means “any service or labor performed by an employee for an employer within the united states.” 53 thus, the wage knowingly illegal way. see kraft v. united states, 991 f.2d 292, 299 (6th cir. 1993); mckinney v. united states, 574 f2d. 1240, 1243 (5th cir. 1978); perez v. united states, 553 f. supp. 558, 561 (m.d. fla. 1982); irs chief counsel advice 200808019 (feb. 22, 2008) available at www.irs.gov/pub/irs-wd/0808019.pdf. 45 i.r.c. § 162(c)(2) (2006). 46 rev. rul. 72-236, 1972-1 c.b. 41. 47 bilzerian v. united states, 41 fed. cl. 134, 138-40 (1998); manning v. comm’r, 97 t.c.m. (cch) 1864, 1869 (2009); i.r.s. field serv. advisory 200128004, 2001 wl 789909 (july 13, 2001). 48 katherine d. black et al., is the irs the solution to illegal immigration?, 35 wm. mitchell l. rev. 309, 330 (2008). 49 8 u.s.c. § 1324a(f)(1) (2006). 50 8 u.s.c. § 1324a(a)(1)(a), (a)(2). 51 see, e.g., incalza v. fendi n. am., inc., 479 f.3d 1005, 1011 (9th cir. 2007) (concluding that placing employee on unpaid leave after discovering his status as unauthorized alien complies with 8 u.s.c. § 1324a(a)(2) by “in effect, suspend[ing]” the alien's employment status “during the period that he is neither working nor receiving pay”). 52 8 c.f.r. § 274a.1(c) (2011). see jenkins v. ins, 108 f.3d 195, 198 (9th cir. 1997) (“if santos had already begun physical labor, there can be little doubt that his employment had 'commenced' under 8 c.f.r. § 274a.1(c).”). 53 8 c.f.r. § 274a.1(h). 126 columbia journal of tax law [vol.3:113 payments to undocumented workers are not illegal in and of themselves under that immigration statute, because the unauthorized alien can “commence[]” any particular service or labor before or after the employer pays wages to him or her for that service or labor. in contrast, § 162(c)(2) does apply to wage payments made in violation of some minimum wage statutes. the fair labor standards act requires that “[e]very employer shall pay to each of his employees . . . wages” at certain specified rates. 54 it further declares it “unlawful” for any person to violate that requirement and subjects any person who “willfully violates” that requirement to criminal penalties. 55 over half the states with minimum wage statutes similarly subject employers to criminal penalties for willfully paying below their state minimum wage rates. 56 accordingly, if an employer pays a worker and, in so doing, violates these statutory provisions, then the payment in question is itself an “illegal payment” under § 162(c)(2) for which, as a result, no business expense deduction is allowed. to illustrate, suppose an employer willfully pays a worker $45 in exchange for performing certain services, but that, under the flsa, the employer is required to pay the worker at least $120 for those services. if so, the employer violates the flsa by paying the $45 to the worker, and is subject to a criminal penalty for that violation. accordingly, if the employer then takes the $45 as a business-expense deduction under code § 162(a), that deduction should be disallowed, because that $45 is, in and of itself, an “illegal payment” under § 162(c)(2). c. no payroll tax or withholding liability this section concludes that it is unlikely that a court would find tax liability for wage underpayment under federal tax law governing payroll taxes and income withholding requirements. 1. payroll taxes since their inception, federal programs for old age and disability insurance (social security), medicare, and state unemployment insurance have imposed payroll taxes on employers and employees. 57 the federal insurance contributions act (“fica”) finances social security and medicare by imposing on every individual a tax equal to a certain percentage of “the wages . . . received by him with respect to employment,” 58 as well as imposing “on every employer an excise tax, with respect to having individuals in his employ” equal to a certain percentage of “the wages . . . paid by him with respect to employment.” 59 54 29 u.s.c. § 206(a)(1) (2006). see also 29 u.s.c. § 206(a)(2)-(4) (same for certain categories of workers). 55 see 29 u.s.c. § 216(a) (2006) (imposing a maximum fine of $10,000, or imprisonment for up to six months, or both, for willfully violating 29 u.s.c. § 215); 29 u.s.c. § 215(a)(2) (2006) (declaring it unlawful to violate 29 u.s.c. § 206). 56 see, e.g., mass. gen. laws ch. 149 § 27c (2011); cal. lab. code § 1199 (2012); md. code ann., lab. & empl. § 3-508 (west 2011). see generally wage and hour laws: a state-by-state survey (gregory k. mcgillivary ed., 2004 & supp. 2010). 57 on the decision to finance these programs with payroll taxes, see mark h. leff, taxing the "forgotten man": the politics of social security finance in the new deal, 70 j. am. hist. 359 (1983). 58 i.r.c. § 3101(a)-(b) (2006). 59 i.r.c. § 3111(a)-(b) (2006). 2012] tax liability for wage theft 127 the federal unemployment tax act (“futa”), which governs unemployment insurance, contains similarly worded provisions: it imposes on employers “an excise tax, with respect to having individuals in his employ, equal to” a certain percentage “of the total wages . . . paid by him . . . with respect to employment.” 60 fica also imposes a withholding requirement on employers: employers must collect fica taxes on employee wage income “by deducting the amount of the tax from the wages as and when paid.” 61 the employer has tax liability for these required deductions, 62 as do third parties that pay wages to the employer's employees, 63 even if the employee does not collect the wages “paid by” the employer. 64 it is hard to read fica and futa to impose tax obligations on owed but unpaid wages. fica's statutory text refers to taxes on wages “received” by the employee and “paid” by the employer. futa's statutory text refers to wages “paid” by the employer. “received” and “paid” are verbs used in the past tense. unpaid wages are, by definition, wages that are not “received” and not “paid,” or at least not yet. although fica and futa cover both actual and “constructive” wage payments, “constructive” wage payments occur only when the employer credits the wages to an employee's account, or sets them apart for the employee, so that “they may be drawn upon by him at any time although not then actually reduced to possession.” 65 similarly, fica's employer withholding requirement also hinges on the employer’s duty to deduct employee fica tax from wages “as and when paid.” treasury regulations on fica are more explicit: “the employer tax attaches at the time that the wages are paid by the employer,” 66 and the “employee tax attaches at the time that the wages are received by the employee.” 67 the phrase “at the time” in these regulations implies that the fica employer and employee tax do not attach until the wages are paid and received, respectively. 2. income tax withholding federal income tax withholding requirements do not authorize tax liability for failure to withhold taxes on wages owed but unpaid. since the current tax payment act of 1943, 68 if an employer “mak[es] payment of wages,” it must “deduct and withhold upon such wages a tax” determined by the treasury secretary. 69 although the statutory phrase “upon such wages” could be read to cover both wages paid and wages owed, a treasury regulation conforms the employer’s income-tax withholding obligation to the relevant text of the fica withholding section: “the employer is required to collect the tax by deducting and withholding the amount thereof from the employee's wages as and 60 i.r.c. § 3301 (supp. iii 2009). 61 i.r.c. § 3102(a) (2006). 62 i.r.c. § 3102(b) (2006). 63 i.r.c. § 3505(a) (2006). 64 treas. reg. § 31.3102-1(d) (as amended in 2006). 65 treas. reg. § 31.3121(a)-2(b) (as amended in 2006) (fica); treas. reg. § 31.3301-4 (1960) (same for futa). 66 treas. reg. § 31.3111-3 (1960). 67 treas. reg. § 31.3101-3 (1960). 68 for historical background, see carolyn c. jones, class tax to mass tax: the role of propaganda in the expansion of the income tax during world war ii, 37 buff. l. rev. 685 (1988). 69 i.r.c. § 3402(a)(1) (2006). 128 columbia journal of tax law [vol.3:113 when paid, either actually or constructively.” 70 as with fica and futa, employers make “constructive” wage payments for income-tax withholding purposes by crediting wages “to the account of or set apart for an employee so that they may be drawn upon by him at any time although not then actually reduced to possession.” 71 the same conclusion applies to the backup-withholding requirement for nonwage payments for services, such as payments to independent contractors. under this provision, if a “reportable payment” occurs, the payor may be required to deduct and withhold thirty-one percent of that payment if the payee failed to properly furnish the payor with an accurate tax identification number and the irs informs the payor that the tax identification number is incorrect. 72 the phrase “reportable payment” includes “any payment of a kind, and to a payee, required to be shown on a return required under” code § 6041a(a), 73 which in turn applies to “any service-recipient engaged in a trade or business” for payment of remuneration “in the course of such trade or business . . . to any person for services performed by such person,” where “the aggregate of such remuneration paid to such person during such calendar year is $600 or more.” 74 this withholding requirement triggers based only on actual payments of remuneration for services rendered, not just the obligation to pay such remuneration. the $600 threshold is for “remuneration paid” to the person providing services. treasury regulations confirm this reading: for backup withholding purposes, “[a]mounts are considered paid when they are credited to the account of, or made available to, the payee. amounts are not considered paid solely because they are posted (e.g., an informational notation on the payee's passbook) if they are not actually credited to the payee's account or made available to the payee.” 75 iii. the methods of informing this part identifies two ways for the unpaid worker to help enforce employer tax liability for wage underpayment: (1) becoming a tax informant, either gratis or for a reward; and (2) pursuing a qui tam tax fraud action against the employer under the (few) state false claims acts that would permit such claims. in these ways, the unpaid worker can transmit to the tax authority the information necessary to prove tax liability for wage underpayment. such information includes not only the fact of underpayment, but also contract price, the type of services rendered, time actually worked, and other information relevant to determining the cash value of the services rendered. absent such information from the unpaid worker, tax authorities will find it difficult to enforce employer tax liability arising from wage underpayment, because standard wage-reporting does not contain such information. 76 70 treas. reg. § 31.3402(a)-1(b) (1983) (emphasis added). to be sure, employers may elect to adopt one among several methods of calculating how much tax to withhold based on the amount of wages estimated to be paid during a payroll period. i.r.c. § 3402(h) (2006). however, each of these calculation methods still depends on the initial input of the amount of wages paid by the employer. see, e.g., united states v. fior d'italia, 536 u.s. 238, 243 (2002) (upholding irs's “aggregate” method of estimating employer fica tax liability for tips as reasonable). 71 treas. reg. § 31.3402(a)-1(b) (as amended in 1983). 72 i.r.c. § 3406(a) (2006); treas. reg. § 31.3406(a)-1(a) (1995). 73 see i.r.c. §§ 3406(b)(1)(b), 3406(b)(3)(b) (2006). 74 i.r.c. § 6041a(a) (2006). 75 treas. reg. § 31.3406(a)-4(a)(1) (as amended in 2002). 76 every year, employers must file a w-2 with the social security administration for each worker. every quarter, employers must file a form 941 with the irs and report, among other things, the number of 2012] tax liability for wage theft 129 a. tax informant there are two main ways for the unpaid worker to become a tax informant. first, the unpaid worker can contact tax enforcement officials directly. for example, the irs provides that any person who wishes to report possible instances of tax fraud by another individual, and does not want a reward, can complete and file a designated “information referral” form, or write a letter. 77 second, the unpaid worker can apply for a tax informant reward. tax informant reward programs exist for federal taxes collected by the irs, the alcohol tobacco tax and trade bureau, 78 and some state tax authorities (table 1). in these programs, the reward is often some fraction of the tax recovered as a result of the information provided. to illustrate, consider the irs tax informant reward program. 79 the irs has the authority to pay sums “necessary” for “detecting underpayment of tax” or “detecting and bringing to trial and punishment persons guilty of violating the internal revenue laws or conniving at the same.” 80 the irs has discretion to pay an amount that would be “adequate compensation in the particular case, generally not to exceed fifteen percent of the amounts (other than interest) collected by reason of the information.” 81 since the reward is a percentage of amounts collected, the irs acknowledges that rewards generally cannot be paid “for several years after the information is submitted, because the underlying taxpayer’s case (including any appeals) must be resolved.” 82 employees who received wages, tips, and other compensation during that quarter; the total amount of such compensation paid; and the total amounts withheld from such compensation for fica and income tax. the social security administration and the irs work together to investigate discrepancies between an employer's form 941 and w-2 wage reports. social security administration, program operations manual system rm 02070.001 (2001), available at https://secure.ssa.gov/apps10/poms.nsf/lnx/0102070001. 77 internal revenue manual 25.2.1.3 (dec. 23, 2008), available at http://www.irs.gov/irm/part25/irm_25-002-001.html#d0e66. 78 this program's predecessor fell within the then-bureau of alcohol, tobacco, and firearms, 27 c.f.r. § 70.41 (2002), which had such authority at least since 1959, if not earlier, see discovery of liability and enforcement of title, 24 fed. reg. 8644 (oct. 24, 1959) (set forth at treas. reg. § 301.7623-1(g)). since its creation in 2003, however, no one has made use of the alcohol tobacco tax and trade bureau’s tax informant program. e-mail from thomas k. hogue, director, congressional and public affairs, alcohol tobacco tax and trade bureau, to author (april 20, 2012) (on file with author). 79 for descriptions, see michelle m. kwon, whistling dixie about the irs whistleblower program thanks to the irc confidentiality restrictions, 29 va. tax rev. 447 (2010); edward morse, whistleblowers and tax enforcement: using inside information to close the "tax gap", 24 akron tax j. 1 (2009); kneave riggall, should tax informants be paid? the law and economics of a government monopsony, 28 va. tax rev. 237 (2008); and terri gutierrez, irs informants reward program: is it fair?, 84 tax notes today 1203 (1999). 80 i.r.c. § 7623(a) (2006). federal tax officials have had this authority since act of mar. 2, 1867, ch. 169, § 7, 14 stat. 471, 473. 81treas. reg. § 301.7623-1(c) (as amended in 2012). 82 internal revenue manual 25.2.1.1(5) (dec. 23, 2008), available at http://www.irs.gov/irm/part25/irm_25-002-001.html#d0e66. 130 columbia journal of tax law [vol.3:113 table 1: selected tax informant reward programs agency tax type max % amounts collected as reward legal authority internal revenue service, u.s. treasury dept. all “generally” 15% (except interest) i.r.c. § 7623 (2006); treas. reg. § 301.7623-1 (as amended in 2012) alcohol tobacco tax & trade bureau, u.s. treasury dept. alcohol, tobacco, firearms 10% 27 c.f.r. § 70.41 (2011) california board of equalization sales, use 10% cal. rev. & tax. code § 7060(a) (2012) california franchise tax board personal income, corporation 10% cal. rev. & tax. code § 19525 (2012) oregon dept. of revenue income 10% of “net amount of” tax, penalties, interest or. rev. stat. § 314.855 (2011) florida dept. of revenue all 10% of tax, penalties, interest fla. stat. § 213.30 (2011) florida dept. of business and professional regulation, division of alcoholic beverages & tobacco cigarette 50% of fine levied and paid fla. stat. § 210.18(11) (2011) florida dept. of revenue vending machine items 10% fla. stat. § 212.0515(3)(b) (2011) kansas dept. of revenue motorvehicle fuels, special fuels 10% kan. stat. ann. § 79-3421 (2011) 2012] tax liability for wage theft 131 figure 1: irs informant program, fy1977-2010 figure 1 reports for fiscal years 1977-2010 the number of informant claims received and “allowed” by the irs pursuant to i.r.c. § 7623(a), as well as the annual aggregate tax recovery (including penalties, fines, and interest) and informant rewards paid pursuant to that provision. 83 in 2006, congress enacted a more generous informant rewards program, codified at i.r.c. § 7623(b). it entitles the informant to at least fifteen percent of any recovery if the irs brings an administrative or judicial action based on the informant's information. however, for that provision to apply, the tax, penalties, interest, additions to tax, and additional amounts in dispute must exceed $2 million. any one unpaid-worker informant is unlikely to meet this threshold. b. qui tam action under state false claims act another option, available only in a few states, is a qui tam lawsuit under a false claims act. by january 2010, congress, eighteen states, and the district of columbia had enacted false claims acts (“fcas”) with qui tam provisions that apply to more than certain types of health fraud. 84 however, congress, eleven of these states, and the district of columbia have expressly excluded claims under their fcas based on any obligation under tax law. 85 moreover, the florida legislature declared in 2002 that the state code section authorizing tax informant rewards is the “sole means” for seeking or obtaining money predicated upon another person's failure to comply with florida tax law. 86 thus, a court is not likely to read florida's fca to authorize tax fraud claims. 83 irs provided the underlying data to the author for the fiscal years through 2007. for fiscal years 2008-10, see irs, fiscal year 2010 report to the congress on the use of section 7623 at tbl. 2 (2011), available at http://www.irs.gov/pub/whistleblower/annual_report_to_congress_fy_2010.pdf. 84 john t. boese, civil false claims and qui tam actions 6-3 (2010). 85 31 u.s.c.a. § 3729(d) (west supp. 2011); cal. gov’t code § 12651(f) (west 2012); d.c. code § 2-381.02(d)(3) (2012); haw. rev. stat. § 661-21(f) (2011); mass. gen. laws ch. 12, § 5b(12) (2011); minn. stat. § 15c.03 (2011); mont. code ann. 17-8-403(4) (2011); n.c. rev. stat. § 1-607(c) (2011); n.j. stat. ann. 2a:32c-2 (2011); n.m. stat § 44-9-3(e) (2011); okla. stat. tit. 63 § 5053.1(e) (2011); tenn. code ann. 4-18-103(f) (2011); va. code ann. § 8.01-216.3(d) (2011). for policy arguments favoring qui tam tax fraud actions, see dennis j. ventry jr., whistleblowers and qui tam for tax, 61 tax law. 357 (2008). 86 act of may 1, 2002, ch. 2002-218, § 37, 2002 fla. laws 1510, 1558 (codified at fla. stat. § 213.30(3) (2011)). the provision was introduced as an amendment to florida senate bill 426. see h. amendment 042761, at 83 (filed march 14, 2002); s. 426e2, § 37, at 90-91, 2002 leg., reg. sess. (fla. 2002) (introduced march 23, 2002). almost a year earlier, a florida court had dismissed on procedural grounds a fca qui tam tax fraud suit filed against west palm beach condominium owners. see joe kollin, 132 columbia journal of tax law [vol.3:113 the remaining six states have fcas with provisions that can be read to cover tax claims, 87 but most of these impose substantial restrictions. illinois and indiana exclude claims under their fcas based on their state income tax obligations. 88 rhode island's fca excludes claims based on its personal income tax, 89 but it does not restrict claims based on its business income tax obligations. 90 new york's fca sets high defendant income and damage threshold for tax fraud claims. 91 although nevada's fca does not exclude tax obligations, nevada has no state income tax. in contrast, delaware, which taxes personal and corporate income, 92 has an fca that does not restrict tax fraud claims in any way. iv. the decision to inform even if courts and tax authorities agree that employers incur tax liability for wage underpayment as discussed above, only empirical research can show how much such liability would in fact deter employer wage underpayment or otherwise affect worker or employer behavior. to advance such research, this part, drawing on the theoretical literature on the law enforcement uses of bounties and rewards, 93 identifies major benefits and costs that might influence a worker to decide to inform the tax agency about the employer’s wage underpayment (by the methods described above), assuming that the worker will do so if and only if the expected benefits exceeds its expected costs. an alternative exposition appears in the appendix. a. benefits two important influences in favor of becoming a tax informant are the expected informant reward and any emotional satisfaction from facilitating tax recovery (e.g., revenge savored, conscience eased). as noted in table 1, most tax informant rewards are some fraction of the total tax recovery facilitated by the informant's assistance, often the tax owed plus penalties. in theory, the fact or amount of reward varies by enforcement mechanism. for simply sending a letter to the tax authority, of course, the expected money reward is zero. this implies that for those workers who actually pursue those avenues, the emotional satisfaction of facilitating recovery exceeds the expected costs of informing. moreover, in qui tam fca actions, if we treat the probability of successful recovery as the probability that the qui tam plaintiffs will successfully recover the taxes and penalties owed in a court judgment, tax officials control the size of the expected informant bounty only by their decision to take control of the fca lawsuit. for example, judge tosses suit on unpaid taxes, s. fla. sun-sentinel, april 4, 2001, at 1b; joe kollin, for-profit company rebuffed in lawsuit, s. fla. sun-sentinel, jan. 22, 2001, at 1b. 87 del. code ann. tit. 6 § 1201(a)(7) (2011); 740 ill. comp. stat. 175/3(a)(g) (2011); ind. code § 5-11-5.5-2(b)(6) (2011); nev. rev. stat. § 357.040(1)(g) (2010); n.y. state fin. law § 189(1) (mckinney 2011); r.i. gen. laws § 9-1.1-3(a)(7) (2011). 88 740 ill. comp. stat. 175/3(c) (2011); ind. code § 5-11-5.5-2(a) (2011). 89 r.i. gen. laws § 9-1.1-3(d) (2011). 90 r.i. gen. laws. §§ 41-11-11(a)(1), 41-11-2(c) (2011) (relying on federal income tax definition as computational starting point). 91 n.y. state fin. law § 189(4)(a) (2011) (defendant's net income or sales must be more than or equal to $1 million for relevant taxable year, and pleaded damages must exceed $350,000). 92 see del. code ann. tit. 30, § 1105 (2011) (federal adjusted gross income as computational starting point for “entire taxable income” of a state resident); id. § 1903 (corporation’s federal taxable income as computational starting point for state corporation income tax). 93 see, in particular, yaniv, supra note 10. 2012] tax liability for wage theft 133 under the fcas in delaware and rhode island, if the state attorney general elects to proceed with a tax fraud action brought by the qui tam relator, that relator must be awarded no less than fifteen and no more than twenty-five percent of the proceeds of that action. if the state attorney general elects not to proceed, then the qui tam relator must be awarded no less than twenty-five percent and no more than thirty percent of the proceeds of the action. 94 however, both the expected reward and any emotional satisfaction for facilitating recovery must be discounted by the probability that the tax authority will decide to audit the employer and successfully recover the taxes owed, plus penalties. this in turn consists of two separate variables: the odds of selecting the informant's employer for a tax audit, and, if audited, the odds of successfully recovering taxes owed from that employer. i discuss audit selection in part iv(e) below. b. costs there are three major kinds of costs to a worker who decides to inform the tax authorities about an employer’s wage underpayment. first, the worker incurs a cost to search for and acquire the relevant information. this cost may presumably be low, because, as discussed above, the failure of the employer to pay the worker the wages promised is itself sufficient to make a credible case of employer tax liability. second, the unpaid worker may suffer a psychic cost of informing, such as fear of reprisal, shame, or other forms of emotional discomfort. 95 search and psychic costs may vary, particularly when a labor union, law firm, or other ngo is involved. in some situations, such ngos may actively support workers to become tax informants. in other situations, an ngo may be the tax informant by aggregating unpaid workers’ information (e.g., by collecting worker affidavits) and applying to the tax authority for tax informant rewards on that basis. in either case, the unpaid worker must decide how much to cooperate with the ngo, but the ngo may reduce the worker's expected search and psychic costs by providing money, legal services, or emotional support arising from ngo esprit de corps. the third cost item is the expected loss of future wages from the employer on whom the worker informs, discounted to present value. the size of this loss depends on if and when the employer fires the worker after identifying him or her as an informant. it also depends on how long the worker expects to continue to work for that employer after deciding to become an informant. and this in turn is partially determined by how competitive the relevant labor market is. in a competitive labor market, we should expect unpaid workers to immediately seek work elsewhere. as worker mobility costs increase, or as labor market competition becomes more imperfect, we should expect the unpaid worker to work longer for the underpaying employer, despite the apparent risk of future wage underpayment. the worker may prefer to accept some risk of future wage underpayment from that employer over a spell of unemployment. here, the amount of foregone future wages should vary by how the unpaid worker proceeds, in part because that affects the odds that the employer will identify the unpaid worker as the informant. for example, in qui tam fca actions, if the unpaid worker is one of the named qui tam plaintiffs, then the employer can identify the worker 94 del. code ann. tit. 6, § 1205(a),(b) (2011); r.i. gen. laws § 9-1.1-4(d)(1),(2) (2011). 95 qui tam fca tax actions also entail court costs, litigation expenses, and attorney fees that may or may not be covered by a contingency-fee arrangement. to simplify, i have assumed that the cost of filing for tax informant status is zero. 134 columbia journal of tax law [vol.3:113 informant just by reading the complaint. for the tax informant who sends an informal letter or applies for a reward, the probability of employer identification will vary with how reliably the agency's procedures prevent disclosure of informant identity and how likely the procedure for imposing tax liability will cause disclosure of the informant's identity. 96 to be sure, if the informant's emotional satisfaction in facilitating recovery comes from the employer knowing who helped tax officials detect the employer's tax violations, then that satisfaction will be higher if employer identification of the workerinformant is highly likely or certain. thus far, we have assumed that, once identified, the worker-informant will always be fired. however, even if the employer positively identifies the workerinformant, ngo support may reduce the risk of any subsequent firing. the employer may fear ngo economic pressure in response or a ngo-financed lawsuit under, for example, state whistleblower statutes or state tort law for wrongful discharge in violation of public policy. such laws, however, vary by state and recovery under them is far from certain. 97 to be sure, given such ngo support, unpaid workers may well pursue traditional legal remedies, such as an flsa lawsuit, in any case. c. the undocumented worker we now consider the expected cost of deportation for a tax informant with undocumented immigration status. if the unpaid worker has undocumented immigration status, we should expect that worker, in deciding whether to become a tax informant, to be influenced by specific fears of deportation itself, and the costs of deportation discounted by the probability of deportation. for example, gleeson (2010) found, from interviews with forty-one workers at “mainstream restaurant establishments” in san jose, california, and houston, texas, that the thirty undocumented workers she interviewed tended not to complain about wage and hour violations or workplace safety concerns, because they feared deportation or other employer reprisals. 98 similarly, in her survey of latino migrant laborers in new orleans after hurricane katrina (n = 194), fussell (2011) found that over ninety percent were undocumented, and over forty percent reported experiencing wage nonpayment or underpayment—on average, two times during their time in new orleans. in separate focus groups with twenty-five post-katrina latino migrants conducted in december 2009, participants explained that employers did threaten to call immigration authorities if the migrants complained, and that, because of the fear of deportation, the migrants accepted losses due to wage theft rather than complain. 99 96 for the irs program, a tax informant’s identity is not to be disclosed to any “unauthorized person.” treas. reg. § 301.7623-1(e) (as amended in 2012). 97 for examples of court opinions rejecting state tort claims where the plaintiff alleged termination in retaliation for the plaintiff's reporting of employer violations of tax law, see milton v. iit research inst., 138 f.3d 519 (4th cir. 1998); and chism v. mid-south milling co., 762 s.w.2d 552 (tenn. 1988). 98 shannon gleeson, labor rights for all? the role of undocumented immigrant status for worker claims making, 35 law & soc. inquiry 561, 578, 581-86 (2010); see also leisy j. abrego, legal consciousness of undocumented latinos: fear and stigma as barriers to claims-making for firstand 1.5generation immigrants, 45 law & soc’y rev. 337, 365 (2011) (“workers in this study [based on interviews with largely undocumented salvadoran immigrants in los angeles] mentioned injuries, wage theft, and humiliation as part of their daily work environment, but, fearful of interacting with officials who may inquire about their legal status and possibly report them to [immigration and customs enforcement] agents, few reported the abuse they suffered.”). 99 elizabeth fussell, the deportation threat dynamic and victimization of latino migrants: wage theft and robbery, 52 sociological q. 593, 602-04, 607-08 (2011). 2012] tax liability for wage theft 135 moreover, it is reasonable to assume that any change in the probability of employer identification of the tax informant will lead to a change in the same direction in the probability of informant deportation, for at least two reasons. first, federal prosecutors and tax authorities lack the authority to bind federal immigration authorities to cooperation or immunity agreements for undocumented informants, absent their express written authorization from federal immigration authorities. 100 there appears to be no existing interagency agreement between federal tax and immigration agencies concerning undocumented tax informants. meanwhile, state officials have no authority to promise immunity from deportation or prosecution under federal law. this may be a serious problem if the worker's decision to inform leads to a proceeding that authorizes discovery. through discovery, an employer may come to learn of the informant's undocumented status. when undocumented workers are asked to provide testimonial evidence that pertains to immigration status, cunningham-parmeter (2008) argues that they could successfully invoke the fifth amendment privilege against self-incrimination, because of the quasi-criminal nature of removal proceedings. 101 moreover, courts can issue protective orders to preclude discovery that may reveal immigration status. 102 however, seeking such an order may confirm third party suspicion of undocumented status. to date, no study has found how often motions for such protective orders succeed or how much such orders or the fifth amendment privilege reduce the risk of immigration status disclosure. second, it is uncertain how many, if any, undocumented workers will be eligible for u-1 non-immigrant status (a u-visa) for cooperating with law enforcement investigating tax violations. u-visa eligibility requires that (1) the applicant suffered “substantial physical or mental abuse as a result of having been a victim of criminal activity” that falls within particular statutory categories; (2) the applicant has information “concerning” that criminal activity; (3) the applicant has been, is being, or is likely to be helpful to federal, state, or local law enforcement in investigating or prosecuting that criminal activity; and (4) the criminal activity in question violated the laws of the united states or occurred in the united states. 103 the statute, however, does not include tax fraud or theft-of-service among its categories of criminal activity. to be sure, it does include “perjury,” a felony that a taxpayer commits by willfully misreporting income on a return. 104 however, by regulation, a person who petitions for a u-1 visa as a “perjury” victim must show that he or she “has been directly and proximately harmed by the perpetrator” of the perjury, and that there are “reasonable grounds” to conclude that the perpetrator 100 28 c.f.r. § 0.197 (2011). for discussion, see, for example, colleen melody, trading information for safety: immigrant informants, federal law-enforcement agents, and the viability of nondeportation agreements, 83 wash. l. rev. 599 (2008). 101 keith cunningham-parmeter, fear of discovery: immigrant workers and the fifth amendment, 41 cornell int’l l. j. 27 (2008). 102 fed. r. civ. p. 26(c); rivera v. nibco, inc., 364 f.3d 1057 (9th cir. 2004). for examples of parallel authority in other courts, see tax ct. r. 103(a) (2010); del. super. ct. civ. r. 26(c) (2012); r.i. r. civ. p. 26(c) (2012). 103 8 u.s.c. § 1101(a)(15)(u)(i) (2006). 104 see i.r.c. § 7206(1) (2006); michael i. saltzman, irs practice and procedure ¶ 7a.04(1) (2009). 136 columbia journal of tax law [vol.3:113 committed the . . . perjury offense, at least in principal part, as a means: (1) to avoid or frustrate efforts to investigate, arrest, prosecute, or otherwise bring to justice the perpetrator for other criminal activity; or (2) to further the perpetrator's abuse or exploitation of or undue control over the petitioner through manipulation of the legal system. 105 to satisfy these additional requirements, a lawyer might argue that an employer committed tax perjury to help shield from official scrutiny the employer's capacity to wield the threat of deportation to exploit undocumented workers. on this reading, the threat of deportation is the requisite “manipulation of the legal system” used to further the employer's “exploitation or undue control over” the worker, and the fear of deportation is the “substantial . . . emotional abuse” suffered by the u-visa petitioner. there is, however, little publicly available information from which to reliably estimate the odds that an agency or court would agree with this reading. although a 2009 unpublished letter ruling can be read as concluding that fear of deportation cannot establish the requisite “substantial physical or mental abuse,” 106 that ruling has not been designated “for publication as precedent in future proceedings.” 107 moreover, because not even the u.s. citizenship and immigration service, which decides u-visa petitions, can currently track u-visa petitions by type of qualifying criminal activity alleged, 108 we cannot easily ascertain the outcomes of past u-visa petitions, if any, that made such an argument. of the over thirty letter rulings that the uscis's administrative appeals office issued to date since january 1, 2009 concerning the denial of a u-visa petition, none have concerned u-1 visas based on “perjury.” 109 d. tax informant immunity? we now consider a wage underpayment scenario in which the worker has also incurred tax liability of which the employer is aware, such as not reporting the wages he did receive as income. if wage underpayment occurs where the employer primarily conducts transactions in cash to avoid documentary evidence of taxable income or assets, unpaid workers may indirectly benefit insofar as such employers are less likely to report the wages they do pay, thereby making it easier for the worker not to report those wages as individual income. in this scenario, either worker or employer could decide to seek tax informant rewards by informing on the other to the tax authority. this scenario resembles models in cooter and garoupa (2000) and yadlin (2006) in which co-conspirators can defect or continue to cooperate under a regime where the defector's payoff is (1) a portion of the penalty that would be imposed on his coconspirator and (2) immunity to the extent of one’s own gain from the conspiracy. under certain assumptions, each co-conspirator faces a prisoner's dilemma such that, where the 105 8 c.f.r. § 214.14(a)(14)(ii) (2011). 106 matter of [redacted], no. eac 08 110 50406, 2009 wl 1742300 (office of admin. appeals, immigration and naturalization service mar. 5, 2009); farhang heydari, note, making strange bedfellows: enlisting the cooperation of undocumented employees in the enforcement of employer sanctions, 110 colum. l. rev. 1526, 1554-57 (2010) (relying on this ruling). 107 8 c.f.r. § 103.3(c) (2011). 108 e-mail from chris rhatigan, public affairs officer, uscis, to author (dec. 2, 2010) (on file with author). 109 search of westlaw database fim-aau [“section 101(a)(15)(u)”] on jan. 4, 2012. 2012] tax liability for wage theft 137 payoffs for defecting are high enough and each can anticipate the other's payoffs, each is less likely to commit to cooperation in the first place. 110 to illustrate, consider a one-shot prisoner's dilemma game between a worker and an employer who each face tax liability ($50 and $100, respectively) and who can each inform on the other. assume that tax liability is the same as the tax gain from cooperating and does not include penalties or interest. assume also that any informant (worker or employer) gains immunity for tax liability he would have otherwise had, as well as a reward in the amount of a portion (15%) of the other's tax liability, adjusted by the probability that the informant's information results in a successful tax recovery (75%). if both worker and employer inform, then each has an equal chance of becoming the first to inform. table 2 reports payoffs under these assumptions. table 2: one-shot worker-employer prisoner's dilemma game employer cooperates employer informs worker cooperates $50, $100 $12.50, $105.63 worker informs $61.25, $25 $30.63, $52.82 if both worker and employer cooperate, the employer gains by avoiding tax liability for wage underpayment ($100) and the worker gains by avoiding tax liability for not reporting wages received ($50). if only the worker informs, he gains $61.25: $50 from the tax immunity as well a reward of $11.25 (=.75[.15($100)]), while the employer loses the tax gain from wage underpayment, discounted by the probability of successful audit (=.75($100)). if only the employer informs, he gains $105.63: $100 from tax immunity as well as a reward of $5.63 (=.75[.15($50)]), while the worker only gets $12.50, that is, $50 as discounted by the probability of successful audit (=.75($50)). if both worker and employer inform, then we divide by half the payoffs in scenarios where the worker or the employer is the only informant ($61.25/2 and $105.63/2, respectively). under these conditions, both worker and employer will race to inform on the other. in turn, since they both will anticipate this result, both worker and employer are therefore less likely to underpay wages and fail to report paid wages as income, respectively. this result holds in part because we have assumed automatic tax immunity for informing. indeed, in calculating payoffs, the tax immunity is more valuable than the expected informant reward. to date, however, tax officials appear unlikely to make a tax immunity guarantee part of an informant reward. to the contrary, current irs policy provides that, for purposes of award computation under i.r.c. § 7623, it is a “negative” factor that the informant “actively and knowingly participates in carrying out the tax noncompliance” or “directly or indirectly profits from the noncompliance.” 111 110 see yadlin, supra note 10, at 31; cooter & garoupa, supra note 10, at 5. 111 internal revenue manual 25.2.2.9.2(11)(b) (june 18, 2010) available at http://www.irs.gov/irm/part25/irm_25-002-002.html#d0e844. 138 columbia journal of tax law [vol.3:113 moreover, tax officials may be unwilling to forgo the discretion to grant or deny immunity or offer other reasons to cooperate, such as a sentencing recommendation, especially if the informant has more tax liability than the one on whom he informs. absent an immunity guarantee, however, the unpaid worker may be less likely to decide to inform given uncertainty about how tax officials will react to the worker's own tax liability. e. audit selection this section discusses the difficulty of estimating the probability that the tax agency will select the employer to audit based on the unpaid worker's information and successfully recover the taxes owed plus penalties. we have thus far assumed that potential informants can accurately estimate this probability. 112 this probability matters, because absent a tax authority audit of the employer, the tax authority cannot prove any employer tax liability as a result of its wage underpayment and, in turn, the worker is ineligible for any tax-informant reward. an audit does not necessarily follow from a valid tax informant application. to reinforce the intuition, consider again figure 1. it shows that, over a thirty-year period, the number of informant claims rewarded by the irs has not varied to the same degree as the annual number of informant claims filed. this either implies that the fluctuations in informant claims consist primarily of annual changes in the number of meritless claims filed, or what is more likely, that the irs audit budget sets a limit on the number of meritorious claims that the agency can pursue to recovery. this section considers two possible influences on audit selection among valid informant claims: expected net recovery and politics. first, the audit selection literature assumes that audit selection is influenced in part by expected net recovery. in some models, 113 a tax authority selects taxpayers to audit to maximize net tax revenue, but, absent an audit, the tax authority does not know whether any taxpayer's actual gross income is equal to or greater than their reported gross income. under these conditions, the probability of selecting a particular taxpayer to audit is a function of the tax authority's estimate of the probability that there is income tax liability and the expected size of the net recovery from the audit (including penalties and interest, but subtracting the fixed cost of the audit). a tax informant's information amounts to evidence that the taxpayer's gross income exceeds its reported gross income, and thus an audit is more likely if that information implies net tax owed. however, net tax recovery still may not be positive, because we must now also subtract the informant's reward from any audit recovery. moreover, if the average net recovery is low for wage underpayment informant claims, the tax authority may elect to audit underpaying employers rarely. wage-underpayment informants are effectively competing with other kinds of tax informants for a share of the tax authority's audit investment portfolio, and are, on this view, less attractive then potential audits with a higher expected return on investment. to be sure, if the tax authority assumes that an employer who has underpaid the informant has more likely than not done so for all its workers, then the tax authority can estimate far higher gross tax recovery by multiplying it by the average number of workers 112 absent this assumption, we have to account for conditions under which potential informants are likely to overestimate or underestimate this probability, and thereby overor underestimate their expected informant reward. 113 see, e.g., james andreoni et al., tax compliance, 36 j. econ. literature 818, 824-34 (1998). 2012] tax liability for wage theft 139 doing the same job for that employer in the taxable year. another possibility is that, if wage underpayment occurs most often among small cash businesses, which are likely to underreport business cash income as well as evade employment tax and sales tax, 114 then audits of underpaying employers may yield a far higher rate of return if tax auditors investigate more than the employer's wage-underpayment. second, in the research literature, there is some evidence of political influences on tax audit selection in general. scholz and wood (1998) found that, for the period 1974-1992, the odds of corporate versus individual irs audits increased with greater democratic party control over congress, change in presidents, and the composition of the taxpaying district and revenue, but not changes in state-level partisanship. 115 howard (2001) found that federal district court filings against the irs were negatively correlated with a (lagged) ratio of the audits conducted during the period 1980-1988 of individuals with incomes over $70,000 with audits of individuals with annual incomes under $70,000. from this, he concluded that litigation led the irs to shift audits away from the wealthy to the less affluent. 116 other studies have found effects on irs audit behavior from the median ideology of the relevant federal court of appeals 117 and the tax district's electoral importance to the president. 118 if these findings hold with respect to tax audits of employers for wage underpayment, then it may well be that audits of underpaying employers, as identified by unpaid-worker informants, are more likely with more democratic party control over congress and for less affluent employers. it will be difficult to measure how much expected net recovery and politics, among other possible influences, actually affect audit selection based on wageunderpayment informants. tax informant claims files are likely the best data for this purpose, but confidentiality provisions typically restrict access to those files. even with access, claims files may lack sufficient documentation. in an internal audit study of a non-random “judgmental sample” of irs informant reward claim files processed in fiscal year 2005, the treasury inspector general for tax administration could not determine the justification for the percentage rewarded in thirty-two percent of the paid claims (seven out of twenty-two) and the rationale for rejection in seventy-six percent of rejected claims (fifty-two out of sixty-nine). 119 the audit was based on a convenience sample, because at the time, the irs had no nationwide informant claims database. 120 perhaps more recent informant claim files may better document the reasons for accepting or rejecting a claim if internal documentation protocols require an explicit accounting along 114 see, e.g., susan cleary morse et al., cash businesses and tax evasion, 20 stan. l. & pol’y rev. 37, 39 (2009). 115 john t. scholz & b. dan wood, controlling the irs: principals, principles, and public administration, 42 am. j. pol. sci. 141, 160 (1998). 116 robert m. howard, wealth, power, and the internal revenue service: changing irs audit policy through litigation, 82 soc. sci. q. 268, 277 (2001). 117 robert m. howard & david c. nixon, regional court influence over bureaucratic policymaking: courts, ideological preferences, and the internal revenue service, 55 pol. res. q. 907, 918 (2002). 118 marilyn young et al., the political economy of the irs, 13 econ. & pol. 201, 215 (2001). 119 inspector general for tax administration, u.s. dept. of the treas., 2006-30-092, the informants' rewards program needs more centralized management oversight 2 (2006). 120 id. at 11 n.2. 140 columbia journal of tax law [vol.3:113 the enumerated positive and negative factors that now govern award computation for informant claims filed after july 2010. 121 v. complement to other law enforcement approaches this part identifies two distinct advantages of the tax-liability approach to wage theft: (1) the tax authority’s special collection powers; and (2) the non-deductibility of tax penalties as business expenses. these advantages warrant treating the tax-liability approach as a serious complement to other law enforcement approaches to combating wage theft. first, tax authorities have a considerable advantage over the typical judgmentcreditor in collecting taxes owed. for example, if upon requisite notice a taxpayer neglects or refuses to pay taxes owed, the irs can seize and sell that taxpayer’s property or rights thereto. 122 moreover, if the taxpayer transfers its property to others to avoid collection, but still controls or benefits from that property, the irs can sue the transferee directly in federal tax court, rather than pursue more cumbersome actions under state fraudulent conveyance statutes. 123 to be sure, where the taxpayer has, at the outset, no assets to satisfy the judgment, these powers may not be useful. however, tax authorities do have an advantage over the typical judgment-creditor in combating efforts of the penalized employer to delay or defeat collection. second, the tax treatment of tax penalties is more favorable to preserving any deterrent effect of legal action, all else being equal, because tax penalties are not deductible as business expenses. internal revenue code § 162(a) currently permits business-expense deductions for damages (compensatory and punitive), attorney’s fees, and other costs that businesses pay to defend, settle, or satisfy judgments in lawsuits under various employment laws, including the flsa. 124 in this way, § 162(a) effectively provides business with a limited form of commercial liability insurance where policy limits increase with the applicable tax rate, and thus in theory dampens any deterrent effect that such lawsuits might have otherwise had on future employer behavior. in contrast, tax penalties, as well as other civil and criminal penalties paid to a government, are not deductible as business expenses. section 162(f) of the code does not allow such deductions under § 162(a) “for any fine or similar penalty paid to a government for the violation of any law.” 125 fines aside, the word “similar” has been read to limit this section to cover civil penalties imposed to enforce the law and punish 121 internal revenue manual 25.2.2.9.2(3), (10)-(11) (june 18, 2010). available at http://www.irs.gov/irm/part25/irm_25-002-002.html#d0e844. 122 i.r.c. § 6331 (2006). 123 see i.r.c. § 6901(a)(1)(a)(i) (2006) (transferee liability for income tax liability). for an overview of transferee liability provisions in the internal revenue code, see saltzman, supra note 104, ¶ 17.01. 124 see rev. rul. 69-581, 1969-2 c.b. 25 (fair labor standards act liquidated damages payments and attorney fee award); rev. rul. 69-547, 1969-2 cb 24 (back pay and counsel fees awards under national labor relations act); i.r.s. priv. ltr. rul. 77-42-028 (july 20, 1977) (payments made under consent decrees or conciliation agreements to individuals by employers who were sued or charged with violating title vii); william c. atwater & co. v. comm’r, 10 t.c. 218, 244-48 (1948) (judgment and legal costs of defending against former employee’s civil action for breach of employment contract). punitive damages may also be allowed as deductions under § 162(a). rev. rul. 80-211, 1980-2 c.b. 57, 58. 125 i.r.c. § 162(f) (2006); see also treas. reg. § 1.162–21(a) (as amended in 1975). 2012] tax liability for wage theft 141 violators thereof, as opposed to civil penalties to encourage prompt compliance (e.g., penalties for late filing) or to compensate another for expenses caused by the violation. 126 moreover, the accompanying treasury regulation to § 162(f) provides that the phrase “fine or similar penalty” includes, among other things, an amount “[p]aid as a civil penalty imposed by federal, state, or local law, including additions to tax and additional amounts and assessable penalties imposed by . . . the internal revenue code,” 127 as well as an amount “[p]aid in settlement of the taxpayer's actual or potential liability for a fine or penalty (civil or criminal).” 128 the phrase “fine or similar penalty” does not include “legal fees and related expenses paid or incurred in the defense of a prosecution or civil action arising from a violation of the law imposing the fine or civil penalty, nor court costs assessed against the taxpayer, or stenographic and printing charges.” 129 the phrase “fine or similar penalty” also does not include “[c]ompensatory damages . . . paid to a government.” 130 the latter gives rise to litigation over what portion, if any, of civil settlement payments to the government are properly characterized as a nondeductible “penalty” or as a potentially deductible “compensatory” payment. for example, according to the irs, if a defendant in a fca suit pays qui tam relator fees pursuant to a settlement of claims against it under the federal fca, this payment does not count as a “penalty” under § 162(f). rather, the relator-fees payment should be treated as an item of “compensatory damages . . . paid” to the government to compensate the government for its existing legal obligation to pay those fees to the fca relator. the offered reason is that, had the government paid the relator fees, it could have recovered those fees from the defendant under the fca provision authorizing government recovery of its incurred enforcement costs. 131 in contrast, where a taxpayer settles a claim for tax liability arising from wage underpayment, a tax informant’s reward is a percentage of tax recovery (see table 1). that tax recovery falls within the regulation that defines the phrase “fine or similar penalty” to include “additions to tax and additional amounts and assessable penalties imposed by . . . the internal revenue code.” 132 once a portion of that recovery is rewarded to the tax informant, there is arguably no basis to stop treating the amount of that reward as something other than a portion of a “penalty” under § 162(f). this part has identified two advantages of the tax-liability approach to combating wage theft: the tax authority’s special collection powers and the non-deductibility of tax penalties as business expenses. the value of these advantages, however, must be discounted by the probability that the unpaid worker becomes a tax informant; that the tax authority audits that worker’s employer on that basis; and that such audit generates enough proof to establish tax liability. for this reason, the tax-liability approach to wage theft only complements, not substitutes for, existing strategies for combating wage theft, such as private lawsuits and agency enforcement proceedings. 126 see, e.g., s. pac. transp. co. v. comm’r, 75 t.c. 497, 650-52 (1980). for the interpretative genealogy of i.r.c. § 162(f), see f. philip manns, jr., internal revenue code section 162(f): when does the payment of damages to a government punish the payor?, 13 va. tax rev. 271, 276-288 (1993). 127 treas. reg. § 1.162-21(b)(1)(ii) (as amended in 1975). 128 treas. reg. § 1.162–21(b)(1)(iii) (as amended in 1975). 129 treas. reg. § 1.162–21(b)(2) (as amended in 1975). 130 id. 131 i.r.s. chief counsel advice 2007-0015, at 5-9 (july 12, 2007) available at www.irs.gov/pub/irs-utl/am2007015.pdf. 132 treas. reg. § 1.162–21(b)(1)(ii). 142 columbia journal of tax law [vol.3:113 vi. conclusion this paper has shown how, under existing federal and state tax law, underpaying employers face tax liability for failing to report unpaid wages as income or, in some circumstances, for claiming paid or unpaid wages as deductible business expenses. the paper then discussed the conditions under which unpaid workers might decide to help tax authorities enforce such liability by becoming tax informants or pursuing a qui tam tax fraud action. finally, the paper identified two distinct advantages of pursuing tax liability as an important complement to other law enforcement approaches to wage theft. the paper is limited in several respects. for example, it does not consider how such tax liability, if recognized, might affect the practices of unions, labor departments, lawyers and others who elect to pursue legal remedies on behalf of unpaid workers under, among other laws, state contract law, the fair labor standards act, or the equal pay act. on the one hand, such tax liability may only negligibly affect case selection, given uncertainty as to whether the tax authority will select the case for audit and recovery, and given that underreporting gross income does not necessarily imply additional tax liability (and associated penalties). on the other hand, these actors may use employer fear of taxauthority audits on the basis of such tax liability to increase lawsuit settlement prices. i leave these and other implications of tax liability for wage underpayment for future research. 2012] tax liability for wage theft 143 appendix this appendix is an alternative to part iv(a)-(c)’s discussion of the major gains and costs that might influence the worker deciding whether to inform the tax agency about the employer’s wage underpayment. assume that the worker decides to inform the tax agency about the employer’s tax evasion (by the methods described in part iii) if and only if the expected gain of such reporting (eg) exceeds its cost (c). modifying yaniv (2001), i model the decision to inform: [ ( ) ] ∑( ) [ ( ) ] where is the probability that the tax agency will audit the employer and successfully recover all the taxes owed plus penalties; z is the amount of taxes and penalties owed; r is the informant's emotional satisfaction for facilitating the recovery; b is the fraction of the recovery to be rewarded to the informant; s is the informant’s cost of searching and acquiring the information; and k is the psychic cost of informing. ngo support may reduce values of k and increase values of r. for reporting to the tax authority without expectation of any reward, b = 0, which implies that for workers who pursue this avenue, . the term ∑ ( ) is the present value of expected future wages lost from the employer because of the decision to inform on that employer, where w = the wages to be received from the employer at the end of a time period t; the discount factor ( ) ⁄ , where r = a fixed discount rate; λ = the probability that the employer will fire the worker for becoming an informant; and n = the total number of time periods that worker expects to work for that employer after the worker’s decision to inform, such that n ≤ the minimum value of t for which . if the worker expects to leave the employer immediately after informing (e.g., to work elsewhere), then n = 0. as we move from a perfectly competitive to a monopsonistic labor market, n should increase. ngo support may decrease λ if, because of such support, the employer is less likely to fire the worker even after identifying that worker as an informant. the term [ ( ) ] is the expected cost of deportation for undocumented immigration status, where u = 1 if the worker has undocumented immigrant status, 0 if not; = the probability of deportation; d = the costs of deportation to the deported worker; and k * = the specific fears of deportation. microsoft word 5 bird-zolt.docx 174 dual income taxation and developing countries richard m. bird & eric m. zolt* the dual income tax combines a progressive tax on labor income and a lower flat rate tax on income from capital. denmark, finland, $orway, and sweden adopted dual income taxes to address a set of tax challenges that arose in the late 1980s and early 1990s. although developing countries face much different economic, political, and tax environments from the $ordic countries, the dual income tax may be the right solution to the different set of challenges facing many developing countries. providing separate tax rates for labor and capital income allows countries greater flexibility in addressing tax competition while retaining progressive tax rates for labor income. a dual income tax regime may also allow developing countries to rationalize the taxation of income from active business operations under the personal and corporate tax systems and the taxation of passive investment income under the personal tax system. developing countries could also use the move to a dual income tax system as an opportunity to make broader reforms in their personal, corporate, and payroll tax systems. finally, recent tax reforms in russia, ukraine, and several countries in central and eastern europe have led to flat tax regimes that generally apply a single tax rate to all types of income above some zero-bracket amount. we contend that a dual income tax may provide policymakers in developing countries with an attractive alternative that addresses tax competition concerns while maintaining a progressive tax on labor income. * professor emeritus of economics, university of toronto. michael h. schill professor of law, ucla school of law. 2010] dual i$come taxatio$ 175 i. introduction ............................................................................... 175 ii. dual income tax systems in developed countries ............ 180 a. the nordic pioneers .............................................................. 180 b. design of dual income tax systems .................................... 185 c. arbitrage opportunities ......................................................... 187 d. reforms and proposals outside the nordic countries .......... 189 iii. dual income tax in developing countries........................... 191 a. tax systems in developing countries ................................... 191 b. design choices ...................................................................... 197 1. personal income tax system. ............................................ 197 2. relationship of personal income tax rates and corporate tax rates under a dual income tax. .............. 202 3. taxation of normal and excess returns. ......................... 204 c. advantages and disadvantages of dual income tax regimes in developing countries ......................................... 206 iv. dual income tax versus flat tax regimes .......................... 210 a. recent flat tax reforms ....................................................... 211 b. choosing between a dual income tax and flat tax system ................................................................................... 213 v. conclusion .................................................................................. 216 i. introduction businesses often seek to find new applications for existing products. tnt was originally designed as a yellow dye. listerine, a popular mouthwash, was used as an antiseptic for surgery. viagra was initially designed to treat hypertension. the dual income tax, a combination of a progressive tax on labor income and a lower flat rate tax on income from capital, was adopted in the nordic countries to address a set of tax challenges that arose in the late 1980s. although developing countries face much different economic, political, and tax environments from the nordic countries, the dual income tax may be the right solution to the different set of challenges facing many developing countries. almost all income tax regimes combine a personal income tax and a corporate income tax. the personal income tax generally applies to wage income, as well as different types of income from capital such as dividends, interest, rents, royalties, and profits from sole proprietorships and partnerships. the corporate income tax generally applies to profits on entities operating in corporate form. the dual income tax seeks to tax wages and labor income attributable to sole proprietorships and partnerships at progressive tax rates and tax capital income at a flat rate 176 columbia jour$al of tax law [vol. 1:174 under either the personal or corporate tax systems. transplanting legal regimes, like using prescription drugs for purposes other than those for which they were designed, may result in undesirable and unintended consequences.1 nonetheless, dual income taxation may be an effective tool to improve income taxation in developing countries. global competition provides strong incentives for countries to reduce tax rates, especially developing countries that are more dependent on foreign capital inflows. providing separate tax rates for labor and capital income allows countries greater flexibility in addressing tax competition and greater opportunity to retain progressive tax rates for labor income. a dual income tax regime may also allow developing countries to rationalize the taxation of income from active business operations under the personal and corporate tax systems and the taxation of passive investment income under the personal tax system. developing countries could also use the move to a dual income tax system as an opportunity to make broader reforms in their personal, corporate, and payroll tax systems. the dual income tax approach rejects the long-held ideal of a progressive global personal income tax (a “comprehensive income tax”).2 to some, this may seem a step in the wrong direction. for decades, tax policy advisors in both developed and developing countries focused on a comprehensive income tax as an essential keystone to any modern tax system. although there have always been those who questioned the conventional wisdom, the comprehensive income tax was long accepted as the ideal towards which all income tax systems should strive.3 in reality, however, the personal income tax system in most developing countries (as well as most developed countries) has never been 1. legal sociologists sometimes argue that “legal transplants” are virtually impossible. pierre legrand, what “legal transplants”?, in adapting legal culture 55 (david nelken & johannes feest eds., 2001). 2. tax systems are considered global if they include income from all sources in a common tax base. tax systems are progressive if higher marginal income tax rates apply to greater amounts of taxable income. the general recommendations of tax advisors in recent decades for a “broad-based, low rate” approach to tax reform in developing countries do not represent a shift away from the comprehensive income tax approach. richard m. bird, the bblr approach to tax reform in emerging countries, in public economics: theory and policy (m. govinda rao & mihir rakshit eds., forthcoming 2010). 3. distinguished academics such as stanley surrey and richard musgrave spread the word to developing countries to help modernize and improve the design and implementation of tax systems. see, e.g., stanley s. surrey & oliver oldman, report of preliminary survey of the tax system of argentina, 16 public finance 155 (1961); richard a. musgrave & malcolm gillis, fiscal reform for colombia: final report and staff papers of the colombian commission on tax reform (1971); richard a. musgrave, fiscal reform in bolivia: final report of the bolivian mission on tax reform (1981). 2010] dual i$come taxatio$ 177 global or very progressive.4 the so-called comprehensive income tax system is often a set of incomplete and sometimes inconsistent rules applicable to different types of income. developing countries face serious challenges in improving the taxation of income, whether from labor, capital, or a combination of labor and capital.5 the result is that personal income taxes play a very limited role in developing countries.6 many developing countries subject income from capital to relatively light effective tax burdens under the personal income tax system through policy design, poor tax administration, or both. however, the way in which countries achieve this low tax burden is often so cumbersome and inefficient that countries reap both the costs of taxing capital (economic distortions, compliance, and enforcement costs) and the costs of failing to do so (inequity, as well as administrative problems from tax arbitrage). developing countries also face serious challenges in implementing corporate income tax systems. low-income developing countries are more likely than high-income developing countries or developed countries to adopt tax incentives that reduce the corporate tax base.7 tax holidays, taxfree zones, and other tax incentives erode the potential corporate income tax base and may, sometimes deliberately, create advantages for foreign over domestic firms. while all countries face difficulties in taxing the agricultural sector and small businesses, developing countries face greater challenges both because of the lack of administrative capacity to tax these sectors effectively and because the costs of taxes and other forms of government regulation may outweigh the benefits from operating in a formal economy. this encourages businesses to stay in the informal sector and discourages modernization and growth.8 one way to improve tax regimes in developing countries is to 4. in all countries, a large portion of private savings is tax-favored. low or no taxes apply to savings in owner-occupied housing, pension and other retirement savings. see, e.g., edward j. mccaffery, tax policy under a hybrid income-consumption tax, 70 tex. l. rev. 1145 (1992). weak tax administration in developing countries accentuates both the equity and efficiency problems that arise from such differential treatment. richard m. bird & eric m. zolt, tax policy in emerging countries, 26 env’t & plan c: gov’t & pol’y 73 (2008). 5. vito tanzi & howell h. zee, tax policy for emerging markets: developing countries (int’l monetary fund, working paper no. 00/35, 2000). 6. richard m. bird & eric m. zolt, redistribution via taxation: the limited role of the personal income tax in developing countries, 52 ucla l. rev. 1627 (2005). 7. michael keen & alejandro simone, tax policy in developing countries: some lessons from the 1990s, and some challenges ahead, in helping countries develop: the role of fiscal policy 302, 327–32 (sanjeev gupta, ben clements & gabriela inchauste eds., int’l monetary fund 2004). 8. friedrich schneider & dominik h. enste, shadow economies around the world: size, causes, and consequences (int’l monetary fund, working paper no. 00/26, 2000). 178 columbia jour$al of tax law [vol. 1:174 abandon taxing income from capital and move to a personal consumption tax of the types that have been proposed over the last few decades.9 we believe good reasons exist to retain both personal and corporate income taxes. although the personal income tax in most developing countries is limited in its ability to redistribute income, it can and should play an important role both in generating revenues and in helping to establish a more politically cohesive and stable state.10 despite its flaws the personal income tax is probably the only significantly progressive element found in most developing countries’ tax systems.11 in addition, the corporate income tax plays a much greater role in raising revenue in developing countries than in developed countries and, in particular, succeeds in capturing at least some location-specific rents.12 although we focus here on the dual income tax in the developing country context, we note that many of the same advantages and disadvantages of moving from a nominal comprehensive income tax to a dual income tax apply to the united states and other developed countries. the u.s. tax system, like other tax systems, already subjects income from capital to tax treatment different from the treatment of income from labor,13 including lower tax rates applicable to dividends and capital gains.14 global competition provides incentive to reform tax systems and tax competition concerns in the u.s. have prompted legislative proposals to reduce corporate income tax rates significantly below tax rates under the personal income tax system.15 the u.s. department of treasury has 9. for a useful review of such proposals that have been made in the u.s., see charles mclure & george zodrow, consumption-based direct taxes: a guided tour of the amusement park, 63 finanzarchiv: pub. fin. analysis 285 (2007). 10. carolyn webber & aaron wildavsky, a history of taxation and expenditure in the western world 526 (1986) note that the extent to which a nation’s finances rely on the taxation of income has historically been considered “a mirror of democracy” in the sense that it symbolized the commitment to social justice. more recently, the important political dimension of taxation as a means of building state capacity in developing countries has been emphasized. see generally taxation and state-building in developing countries (deborah brautigam, odd-helge fjeldstad & mick moore eds., 2008). 11. ke-young chu, hamid reza davoodi & sanjeev gupta, income distribution and tax and government social spending policies in developing countries 35 (unu/wider working papers no. 214, 2000). 12. peter birch sørensen, can capital income taxes survive? and should they?, 53 cesifo econ. stud. 172, 181 (2007). 13. see generally eric m. zolt, the uneasy case for uniform taxation, 16 va. tax rev. 39 (1996). 14. certain dividends are subject to tax as net capital gains under i.r.c. § 1(h)(11) and capital gains qualify for lower tax rates. i.r.c. § 1(h) (2010). 15. for example, senators ron wyden (d-ore) and judd gregg (r-n.h.) have proposed legislation to reduce corporate tax rates from 35% to 24%. bipartisan tax 2010] dual i$come taxatio$ 179 previously given serious consideration to forms of dual income taxation. as discussed in section ii.d, in 1992, the treasury department included as part of its report on the integration of the personal and corporate tax system a prototype called the “comprehensive business income tax” that is a form of dual income taxation.16 we believe that a move to a dual income tax regime in the united states, as for developing countries, would be an improvement over the current tax system.17 we begin in section ii with a brief review of the nordic experience with dual income tax regimes and several parallel reforms that have been proposed or implemented in other developed countries, including the united states.18 section iii then reviews the different ways in which developing countries might implement a dual income tax regime and considers briefly the possible advantages and disadvantages of the different approaches. substantial differences exist in the political, economic and tax environments both between and among developed and developing countries. these differences influence both the form and desirability of separating the taxation of labor and capital income. section iv compares the dual income tax with flat tax proposals of the type that have been adopted in several eastern european countries and the countries of the former soviet union. we argue that the dual income tax, properly conceived, can combine many of the advantages of flat tax regimes with the traditional virtues of a personal income tax system that has fairness and simplification act of 2010, s. ___, 111th cong. § 2 (2010). 16. see infra notes 70–85 and accompanying text. department of the treasury, integration of the individual and corporate tax systems—taxing business income once 106 (1992) [hereinafter united states treasury]. one of the co-authors of this article, eric zolt, while serving as deputy tax legislative counsel, office of tax policy, was one of the primary authors of the treasury report. 17. see also edward d. kleinbard, an american dual income tax: $ordic precedents, 5 nw. j. l. & soc. pol’y 41 (2010) (arguing that an implementable dual income tax would likely be superior on equity and efficiency grounds to the current tax system). 18. for reviews of dual income systems in developed countries, see sijbren cnossen, taxing capital income in the $ordic countries: a model for the european union?, in taxing capital income in the european union: issues and options for reform 180, 211 (sijbren cnossen ed., 2000); bernd genser & andreas reutter, fiscal policy in action: moving toward dual income taxation in europe, 63 finanzarchiv: pub. fin. analysis 436 (2007); kleinbard, supra note 17; peter birch sørensen, dual income taxation: why and how?, 61 finanzarchiv 559 (2005) [hereinafter sørensen (2005)]; peter birch sørensen, from the global income tax to the dual income tax: recent tax reforms in the $ordic countries, 1 int’l tax & pub. fin. 57 (1994) [hereinafter sørensen, from the global income tax]. earlier discussions of the dual income tax in developing countries may be found in robin w. boadway, income tax reform for a globalized world: the case for a dual income tax, 16 j. asian econ. 910 (2005) and alberto barreix & jerónimo roca, strengthening a fiscal pillar: the uruguayan dual income tax, 92 cepal rev. 121 (2007). 180 columbia jour$al of tax law [vol. 1:174 explicitly progressive tax rates. all major tax policy or tax administration reforms carry economic and political risks, and the risk-reward calculus will differ from country to country. nonetheless, the move to a dual income tax may facilitate a number of useful broader tax reforms in developing countries, including reducing or eliminating corporate tax incentives, rationalizing the taxation of portfolio income of domestic and foreign investors, adopting withholding regimes that may increase tax compliance and tax revenue, coordinating presumptive tax regimes for small and medium businesses with the corporate tax system, and integrating payroll or social security tax systems with the personal income tax systems. section v concludes. ii. dual income tax systems in developed countries a. the $ordic pioneers denmark, finland, norway and sweden were among the first countries to explicitly reject the comprehensive income tax model and adopt separate tax regimes for taxing income from labor and income from capital. while denmark was the first country to adopt a dual income tax, it has subsequently moved to a hybrid comprehensive income tax and a dual income tax system.19 table 1 describes the dual tax regimes in those countries as of 2008. 19. sørensen, from the global income tax, supra note 18, at 60–61. 2010] dual i$come taxatio$ 181 table 1. dual income tax regimes (2008) 20 �orway finland sweden denmark implementation of dit 1992 1993 1991 1987 personal income tax rates at implementation capital income 28 25 30 50–56 personal income 28–41.7 25–57 31–51 50–68 2008 capital income 28 28 30 59 personal income 28–40 16–52.5* 29–62 38–59 corporate tax rate at implementation 28 25 30 50 2008 28 26 26.3 25 * excludes church tax several factors contributed to the decisions to adopt dual income tax regimes in the nordic countries.21 in the 1980s, these countries were concerned that domestic investors were transferring portfolio investments (such as bank deposits, stocks, and corporate and government bonds) outside their countries. the highest marginal personal income tax rates in the mid-1980s ranged from 66% in norway to 87% in sweden.22 given the 20. the data for this table are from sørensen, from the global income tax, supra note 18, at 59, ibfd, global individual tax handbook (2008), and ibfd, global corporate tax handbook (2008). 21. steffen ganghof provides an excellent review of the political considerations in denmark, finland, norway, and sweden in reforming their tax systems to adopt dual income taxes. steffen ganghof, the politics of income taxation: a comparative analysis 77–111 (2006). 22. for example, sweden’s top marginal rate under the personal income tax system was 87% in 1979, 65% in 1990, and 51% in 1991. sven larson, the swedish tax system: significant features and lessons for policymakers, 43 tax notes int’l 395, 396 (2006). sweden was not alone in reducing tax rates. peter, buttrick, and duncan note that the gdpweighted average top statutory marginal personal income tax rate in the 108 countries for which they have data for the entire period was 62% in 1981, fell to 43% in 1991 and continued to decline to only 36% in 2005. klara sabirianova peter, steve buttrick & denvil duncan, global reform of personal income taxation, 1981–2005: evidence from 189 countries (iza discussion paper no. 42228, 2009). 182 columbia jour$al of tax law [vol. 1:174 high tax rates that individuals were facing on portfolio income in the nordic countries, strong incentives existed for domestic investors to move their investments offshore to avoid domestic taxation.23 the globalization of capital markets made it easier for individual investors to establish and maintain investment and bank accounts outside their home country.24 at the same time, relatively high inflation rates resulted in substantial effective tax rates on capital income.25 even at modest rates of inflation, subjecting nominal interest income to tax rates over 50% results in very high effective tax rates on real interest income. tax systems in most countries do not provide for adjustments for inflation.26 the combination of high tax rates, relatively effective tax administration, and no inflation adjustments made the problems more acute in the nordic countries.27 applying a low flat rate to capital income provided a rough adjustment for inflation.28 the then-existing tax regimes in the nordic countries also provided substantial tax preferences for capital investments.29 as in other countries, these preferences often took the form of current deductibility of many expenses while taxes on the income associated with the expenses were deferred. in particular, the full deductibility of interest on debt incurred to finance tax-favored assets resulted in negative effective tax rates on capital income.30 taxpayers used deductions associated with capital income to 23. sørensen, from the global income tax, supra note 18; peter birch sørensen, the $ordic dual income tax: principles, practices, and relevance for canada, 55 can. tax j. 557, 565–66 (2007) [hereinafter sørensen, the $ordic dual income tax]. 24. sørensen, from the global income tax, supra note 18; sørensen, the $ordic dual income tax, supra note 23. 25. sørensen, from the global income tax, supra note 18, at 62–64; sørensen, the $ordic dual income tax, supra note 23, at 11. 26. victor thuronyi, adjusting for inflation, in tax law design and drafting 434 (victor thuronyi ed., 1998). 27. sørensen, from the global income tax, supra note 18; sørensen, the $ordic dual income tax, supra note 23. 28. sørensen, from the global income tax, supra note 18; sørensen, the $ordic dual income tax, supra note 23. 29. sørensen, the $ordic dual income tax, supra note 23, at 10. 30. sørensen contends that before introducing dual income tax regimes, norway and sweden likely had negative tax revenue on capital income under the personal income tax system. id. similar results have been found in other developed countries. for a discussion of revenue from taxation of capital income in the united states, see roger gordon & joel slemrod, do we collect any revenue from taxing capital income?, 2 tax pol. & the econ. 89 (1988) and roger gordon, laura kalambodidis & joel slemrod, do we now collect any revenue from taxing capital income?, 88 j. pub. econ. 981 (2004); for a discussion of revenue from taxation of capital income in germany, see johannes becker & clemens fuest, does germany collect revenue from taxing capital income? (cesifo working paper no. 1489, 2003). 2010] dual i$come taxatio$ 183 reduce their tax liability on labor income.31 by establishing separate tax regimes for income from labor and capital, the nordic countries were able to stop the erosion of the tax base for labor income.32 lowering the tax rate on capital income made it possible for the nordic countries to broaden the capital income tax base.33 finally, the economies of the nordic countries faced difficult challenges during this time period. in particular, substantial concerns existed about high levels of unemployment. while nordic levels of unemployment were low by international standards, the levels of unemployment in the late 1980s and early 1990s were high by historical standards (and would continue to increase).34 these concerns helped provide political support for reducing the tax burden on income from capital as a means to increase economic activity.35 in addition to the challenges facing the nordic countries, tax reforms throughout the world in the mid-to-late 1980s had resulted in significant rate cuts for individual and corporate income taxes.36 while the nordic countries increased taxes on consumption during this period, large social programs still required substantial revenues from income taxes to fund government operations.37 essentially, these countries faced two choices in reforming their income tax systems: reduce tax rates for all 31. cnossen, supra note 18, at 191. 32. the u.s. took a different approach to protect the labor tax base in its 1986 reform by adopting loss rules that prevented taxpayers from sheltering labor income from losses associated with passive investments. i.r.c § 469 (2010). 33. sørensen, the $ordic dual income tax, supra note 23, at 10. 34. after a decade with an unemployment rate averaging only 2.5%, unemployment in norway began to rise sharply in 1989 to a peak of 6.0% in 1993, followed by gradual decline to 3.2% by the end of the 1990s. unemployment in sweden was even lower in the 1980s, but began to rise sharply in 1991, peaking at 10.0% in 1997. oecd statistics, lfs by sex and age indicators, http://stats.oecd.org/index.aspx?datasetcode=lfs_sexage_i_r (select “unemployment rate” in series; then select “all persons” in sex; then select “total” in age; then click “time & frequency” hyperlink and select 1979 to 1999; then click “view data”) (last visited may. 14, 2010). 35. for a discussion of the politics of tax reform in sweden, see sven steinmo, globalization and taxation: challenges to the swedish welfare state, 3 comp. pol. stud. 839 (2002). 36. peter, buttrick & duncan, supra note 22, at 48 (on individual income taxes) and michael devereux, ben lockwood & michela redoano, do countries compete over corporate tax rates?, 92 j. of pub. econ. 1210, 1222 (2008) (on corporate income tax rates). 37. for information on changes in reliance on consumption taxes in the nordic countries, see oecd, consumption tax trends, 2008 edition tables 3.1, 3.2, at 41–42 (2009). for an interesting detailed appraisal of the historic evolution of the nordic tax financing model, see peter lindert, growing public: social spending and economic growth since the eighteenth century 235–45, 267–95 (2003). 184 columbia jour$al of tax law [vol. 1:174 income and generate insufficient income tax revenue to support social programs, or bifurcate the tax regime and apply a lower rate to income from capital while maintaining higher progressive tax rates on labor income. the nordic countries chose the latter approach. steffen ganghof has set out a taxonomy that nicely demonstrates the competing considerations a country may face in designing an income tax system.38 ganghof begins with three domestic policy goals that governments may consider in designing an income tax regime. the first goal is tax progressivity.39 this goal addresses vertical equity concerns by requiring high-income recipients to pay a higher proportion of their income in tax.40 the second goal is comprehensiveness, which requires equal treatment of income from capital and income from labor.41 this addresses horizontal equity concerns, and along with the first goal, results in taxing individuals in accordance with “ability to pay” principles.42 the third goal is symmetry, which exists when all types of capital income are subject to the same tax regime.43 this goal addresses concerns of allocative efficiency as well as tax-induced distortions in investment and savings decisions.44 in a closed economy, a comprehensive income tax can theoretically satisfy these three objectives. at least in its ideal form, the comprehensive income tax achieves all three goals by taxing income from all sources equally, in a progressive manner according to a taxpayer’s ability to pay, so that a taxpayer faces the same tax regime for different types of capital income.45 with the competitive pressures in an open economy, however, all three goals are rarely met. when international competitiveness is added to the three domestic tax policy goals, governments may no longer be able to satisfy all goals, particularly as cross-border mobility of capital varies both between types of capital and types of countries.46 in ganghof’s terminology, governments face an income tax quadrilemma: their only choice is which goal to sacrifice: progressivity, comprehensiveness, 38. steffen ganghof, global markets, $ational tax systems, and domestic politics: rebalancing efficiency and equity in open states’ income taxation 7–14 (max planck institute discussion paper, 2001) [hereinafter ganghof (2001)]; steffen ganghof, the politics of (income) tax structure (yale conference on distributive politics, working paper, 2005). 39. ganghof (2001), supra note 38, at 8. 40. id. 41. id. at 8–9. 42. id. 43. id. at 9. 44. id. 45. id. at 9–11. 46. sørensen, supra note 12, at 181–84. 2010] dual i$come taxatio$ 185 symmetry, or competitiveness.47 depending on economic and political factors, countries face different considerations in determining which objective to sacrifice. the nordic countries sacrificed comprehensiveness by providing different treatment for capital and labor income.48 other countries have chosen at various times to sacrifice progressivity, symmetry, or competitiveness.49 because of the different tax environments facing the nordic countries and developing countries, many of the specific considerations that prompted the nordic countries to sacrifice comprehensiveness may not apply in developing countries. nonetheless, as we argue below, developing countries may be able to improve their tax system substantially by sacrificing comprehensiveness and adopting separate tax regimes for capital and labor income. b. design of dual income tax systems as table 1 shows, the dual income tax systems in finland, norway, and sweden provide for a progressive income tax rate schedule applicable to labor income and a flat tax rate on capital income.50 under this approach, an individual’s tax liability depends not only on total income, but also on the split between labor and capital income.51 the tax rate on capital income is at or near the lowest positive rate for labor income and the highest marginal tax rate on labor income is about 15–25% higher than the tax rate on capital income.52 however, as discussed below, many variant designs are also possible. for instance, in the so-called “pure” version of the dual income tax, the tax rate on capital income is aligned with the 47. see ganghof (2001), supra note 38, at 14–25. 48. id. at 19–23. 49. denmark chose to sacrifice symmetry also by imposing differential tax rates on capital income. australia also sacrificed symmetry, but in a different way, by electing to cut only the corporate income tax rate. new zealand chose instead to cut all income tax rates, thus sacrificing progressivity. ganghof (2001), supra note 38, at 14–25. see also steffen ganghof and richard eccleston, globalization and the dilemmas of income taxation in australia, 39 aust. j. pol. sci. 519, 530 (2006). in contrast, germany, until its most recent reforms, sacrificed competitiveness in order to retain the other three objectives. 50. good descriptions of the nordic dual income tax systems may be found in genser and reutter, supra note 18, and sørensen, from the global income tax, supra note 18. 51. sørensen, from the global income tax, supra note 18, at 61. 52. in the initial dual income tax reforms, only norway aligned the personal tax rate on capital income with the lowest positive tax rate on labor income. in finland, the rate on capital income was slightly higher than the lowest positive labor tax rate and in sweden the personal income tax rate on capital income was slightly lower than the lowest positive labor tax rate. denmark kept progressive taxes on both labor and capital income, with lower rates on the latter. 186 columbia jour$al of tax law [vol. 1:174 corporate tax rate.53 income from capital taxable under the dual income tax system generally includes business profits, dividends, interest, rents and some types of royalties. in principle, policymakers could also choose to expand the scope of dual income tax systems to include such items as imputed rent on owner-occupied housing and returns on pension savings (as well as other forms of current tax-favored savings) in capital income.54 the tax systems differ in how they divide income from labor and capital for purposes of determining tax liability. finland and sweden generally applied a strict schedular approach, placing labor income and capital income in separate baskets. finland and sweden adopted separate rate schedules for labor and capital income, limited the use of capital losses to offset labor income, and provided for any personal allowances to be applied only to labor income.55 in contrast, before the 2004 tax reforms, norway provided for a “general” tax base that was taxed at a single flat rate and qualified for personal allowances.56 both capital and labor incomes were included in the general tax base, but only labor income was included in the “personal” tax base.57 the personal tax base was subject to progressive tax rates, but contained a substantial zero-bracket amount that resulted in only relatively high levels of labor income being subject to the higher progressive tax rates. this version of a dual income tax is equivalent to a flat tax on all income with a surcharge on labor income above a certain threshold. 53. a truly “pure” version would provide for full integration of personal and corporate level taxes to avoid double taxation of corporate income. for example, sørensen and johnson propose combining a dual income tax with an allowance for corporate equity to eliminate double taxation. peter birch sørensen & shane matthew johnson, taxing capital income—options for reform in australia 100 (paper prepared for australia’s future tax system conference june 2009), available at http://taxreview.treasury.gov.au/content/html/conference/downloads/attachment_08_draft_p eter_birch_sorensen_paper.pdf (last visited may 14, 2010). but integration is not a necessary consequence of aligning the capital income and corporate income tax rates. norway historically provided the greatest degree of integration. until 2005, norway eliminated the double taxation of equity income by providing an imputation system for distributed dividends and allowed shareholders to increase the basis of their corporate shares by their pro-rata amount of the retained profits that was subject to corporate tax. in the norwegian tax system this was known by its norwegian acronym risk. vidar christiansen, $orwegian income tax reforms, 2 cesifo dice report, autumn 2004, at 9, 10. a similar version was proposed by the u.s. treasury department as a deemed dividend reinvestment plan (drip) system. united states treasury, supra note 16, at 106. 54. robin w. boadway, the dual income tax system—an overview, 2 cesifo dice report, autumn 2004, at 3, 7. for such a tax proposal for australia, see sørensen and johnson, supra note 53. a dual income tax could include returns on consumer durables and returns to human capital accumulation, although no proposal has yet gone that far. 55. cnossen, supra note 18, at 183–86. 56. kleinbard, supra note 17, at 54–55. 57. id. 2010] dual i$come taxatio$ 187 c. arbitrage opportunities the move from a comprehensive income tax to a dual income tax regime generally presents tax planning (or tax evasion) opportunities. lower tax rates on income from capital than on income from labor create a strong incentive to characterize income from labor as income from capital. this incentive exists in many tax systems, especially those that provide for favorable tax treatment for capital gains or subject labor income to payroll or social security taxes that substantially increase the effective marginal tax rates for labor income but leave unchanged the tax rates for income from capital.58 the major challenge in the nordic dual tax systems is to limit a taxpayer’s ability to convert labor income from self-employment (such as sole proprietorships or partnerships) or from wages of owner-employees of closely-held corporations into income from capital. the dual income tax regimes of the four countries reflect different approaches to prevent taxpayers from transforming labor income into capital income. one approach provides for an imputed return to the firm’s business assets by multiplying the value of the assets by an assumed rate of return on capital (for instance, the interest rate on government debt plus some risk premium).59 the asset base could be the firm’s gross assets, in which case the firm’s financial liabilities are not deducted from the asset base.60 alternatively, countries could determine the imputed return of the net assets and thus provide a deduction for business liabilities (as well as adjusting net profits for interest deductions).61 profits in excess of this imputed return are deemed to be returns from labor and are subject to taxation as labor income whether or not distributed to the owner.62 taxpayers may also seek to avoid higher tax rates on labor income in cases where owner-employees own a large percentage of the shares of 58. sørensen, supra note 12, at 213. 59. for example, the norwegian approach uses the interest rate on 5-year government bonds plus a risk premium of 4%. if the imputed rate of return equals the interest on business debt, it will not matter whether the calculation is based on gross assets or net assets (excluding liabilities). if the rates differ, taxpayers under a net asset regime may have incentives to adjust their borrowings to maximize the amount of income from capital. 60. sørensen, from the global income tax, supra note 18, at 73–75. 61. sørensen notes that norway adopted a version of the gross asset approach, finland and sweden adopted versions of the net asset approach, and denmark adopted a regime that allows taxpayers to choose between variations of the two approaches. sørensen (2005), supra note 18, at 573. 62. a variation of this approach uses the costs of shares as the base for computing the return to capital and then treats any excess returns as labor income. 188 columbia jour$al of tax law [vol. 1:174 closely-held corporations.63 such owner-employees will seek to minimize their wage compensation and extract returns in the form of lower taxed dividends and capital gains. to limit this tax strategy, countries could tax normal returns to capital as income from capital, and then tax excess returns to capital under the progressive tax rates applicable to labor income.64 alternatively, countries could choose to require closely-held businesses to be taxed as flow-through entities, regardless of legal form of organization.65 the rules designed to prevent re-characterization of income generated their own set of distortions. for example, the regime that determines capital income with reference to the amount of capital invested encourages taxpayers to stuff significant assets into their corporations that are related to business operations. those rules that only apply to closelyheld corporations with a percentage of active owners encourage taxpayers to add passive owners to avoid application of these rules.66 the larger the spreads between the flat tax rate applicable to capital income, the corporate tax rates, and the progressive tax rates applicable to labor income, the greater the arbitrage opportunities. while the nordic and other countries face significant challenges to prevent taxpayers from disguising labor income as capital income, as we discuss later, different considerations may apply in developing countries. 63. sørensen, from the global income tax, supra note 18, at 75–76; kleinbard, supra note 17, at 64–67. 64. in part because of the difficulties in taxing closely held businesses, norway changed its dual income tax regime to tax the normal returns to capital at a lower flat rate, but tax excess returns of closely held corporations at the higher progressive tax rates applicable to labor income. sørensen (2005), supra note 18, at 575–79; peter birch sørensen, $eutral taxation of shareholder income, 12 int’l. tax & pub. fin. 777 (2005). 65. sørensen notes that the mandatory income-splitting features of the norwegian tax system worked relatively well when applied to self-employed taxpayers, but were less effective when applied to active owners of small corporations. sørensen, supra note 12, at 214–17. these employee-shareholders could avoid the mandatory income-splitting rules by increasing the percentage of shares owned by passive investors to avoid treating part of the income they received from the corporation as income from labor. beginning in 2006, active owners of small businesses in norway were taxed at the lower capital income tax rates on the imputed normal rate of return on the value of their shareholdings, but at the higher effective tax rate applicable to labor income for amounts of realized income (dividends and capital gains) in excess of the normal rate of return. the business sector in all countries consists of very heterogeneous firms. consequently, no one right system to distinguish labor and capital income exists, even in the most technologically and administratively advanced countries. 66. sørensen, from the global income tax, supra note 18, at 75–76; kleinbard, supra note 17, at 66–67. 2010] dual i$come taxatio$ 189 d. reforms and proposals outside the $ordic countries over the years, several countries outside the nordic region have considered or adopted different types of dual income tax systems.67 even under a comprehensive income tax, tax regimes frequently establish different effective taxes on different types of income.68 important elements of dual income tax regimes already exist in many countries. for example, many countries have adopted final withholding taxes on interest and dividends at rates below the top marginal rates under the personal income tax system.69 elements of dual income tax regimes are also present in regimes that provide rate preferences or exclusions for capital gains. different tax regimes for income from capital and income from labor have been discussed extensively in many countries, including the united states. in the u.s., a version of a dual income tax was proposed by the u.s. department of treasury in 1992, the comprehensive business income tax (cbit).70 the “classical” corporate income tax system distorts choices between operating in non-corporate and corporate form, choosing between debt finance and equity finance, and retaining rather than distributing corporate profits.71 the u.s. treasury was concerned about the range of tax treatment applicable to income from entities operating in corporate form.72 in some cases, corporate income was subject to double taxation under the personal and corporate tax systems.73 in other cases, however, income attributed to corporate entities was subject to zero tax (for 67. see, e.g., oecd, oecd tax policy studies no. 13, fundamental reform of personal income tax, (2006) (providing a brief review of dual and “semi-dual” income tax systems in oecd countries); barreix and roca, supra note 18 (reviewing dual income tax systems in latin america and spain). 68. zolt, supra note 13. 69. in europe, for instance, such countries include austria, belgium, italy, portugal, the czech republic, lithuania, and poland. genser & reutter, supra note 18, at 448. 70. united states treasury, supra note 16, at 39–60. 71. investment decisions with respect to industry, asset mix, location, risk-taking, and timing may be influenced by variations in effective tax rates. inter-temporal decisions, like inter-sectoral decisions, are also affected by taxes on capital income, with the result that private savings are diminished. moreover, the complexity of corporate taxes may impose significant costs and barriers to the expansion of new and small firms, while uncertainty as to the precise tax implications of various corporate decisions may act as a general deterrent to investment. for a recent comprehensive review of the distortions arising from typical corporate income taxes see alan j. auerbach, michael p. devereux & helen simpson, taxing corporate income, paper prepared for the mirrlees report (march 2008). 72. united states treasury, supra note 16, at 3–14. 73. corporate income is taxed first when earned at the corporate level and then again upon distribution to shareholders under the personal income tax. corporate income may also be subject to double taxation when shareholders recognize capital gains attributable to previously taxed, but not distributed, corporate income. 190 columbia jour$al of tax law [vol. 1:174 example, interest income paid to tax-exempt entities or portfolio interest paid to foreign holders) or three or more layers of tax (for example, for multiple levels of corporate holdings not subject to consolidation).74 the 1992 treasury report set forth various proposals to reduce distortions and rationalize the treatment of business income.75 the policy aim was to design a tax regime that subjected business income to a single layer of tax.76 in the u.s., as well as many other countries, taxpayers can choose among different types of legal forms in which to conduct business operations.77 while there may be valid business and legal reasons to allow taxpayers to choose among different legal forms, differential tax treatment of those different legal forms is much less compelling.78 an additional objective of the cbit proposal was to design a tax regime that would be applicable to business income, without regard to the legal form chosen by an individual or groups of individuals to conduct operations.79 finally, the cbit proposal addressed the concern of differential tax treatment of debt and equity capital, both at the corporate level, where interest paid on debt was deductible and dividends paid on common shares were not deductible, and at the investor level, where tax-exempt and taxfavored investors paid little or no tax on interest and dividends received.80 holders of debt and equity have similar claims to the cash flow of the business activity, subject to different competing rights as to risk, return, duration and control.81 while good reasons may exist for treating debt and equity capital differently for economic and legal purposes, differential tax treatment is, again, much less compelling. the easiest ways to eliminate the distinction between debt and equity in the corporate tax regime are either to provide deductions for dividends paid or to disallow interest deductions. the cbit proposal eliminated the usual deduction for interest payments in order to impose tax 74. united states treasury, supra note 16, at 12. 75. id. at 15–60. 76. id. at 12–14. 77. see, e.g., ellen p. aprill & sanford holo, choice of entity: considerations and consequences, in 61 major tax planning ch. 5 (usc inst. fed. tax’n 2009). 78. william a. klein & eric m. zolt, business form, limited liability, and tax regimes: lurching toward a coherent outcome?, 66 u. colo. l. rev. 1001, 1010–17 (1995). 79. many countries treat small businesses differently for various reasons of varying persuasiveness. for a recent discussion of taxing small businesses in developing countries, see world bank group, designing a tax system for micro and small businesses: guide for practitioners (2007). 80. united states treasury, supra note 16, at 67–69. 81. g. mitu gulati, william a. klein & eric m. zolt, connected contracts, 47 ucla l. rev. 887, 941–43 (2000). 2010] dual i$come taxatio$ 191 liability on the share of business income attributable to debt capital.82 this was the most controversial aspect of the proposal partly because it resulted in clear winners and losers among corporate taxpayers and investors.83 alternatively, the cbit proposal could have included a deduction for interest at the corporate level and a tax on the investor level collected through final withholding (at the corporate tax rate).84 simply put, cbit was designed as a flat tax on business income, collected at the source (with no further taxation at the investor level).85 cbit is thus in effect a form of dual income tax that imposes a flat tax on income from businesses (regardless of form or label) while maintaining a progressive tax on labor income. iii. dual income tax in developing countries a. tax systems in developing countries the tax environment in most developing countries differs substantially from that in developed countries. taxing patterns differ. tax burdens as a percentage of gdp are roughly 18% for developing countries, about half the tax-to-gdp ratio of developed countries.86 developing countries rely relatively more on taxes on consumption rather than on income as compared to developed countries, with vats and excise taxes providing a substantial portion of tax revenues.87 whether measured as a percentage of gdp or a percentage of overall tax revenue, personal income taxes play a much smaller role in developing countries than in developed 82. the u.s. treasury department has generally required full deductibility of interest as a requirement for a foreign country’s income tax system to qualify as a tax on “net income” for tax credit purposes. see charles e. mclure, jr. & george m. zodrow, the economic case for foreign tax credits for cash flow taxes, 51 nat’l tax j. 1 (1998). 83. the move to the cbit regime from the current regime would benefit those entities that rely relatively more on equity finance and penalize those firms that rely relatively more on debt finance. 84. this approach was problematic in the united states because of the current tax regime applicable to the large holdings of tax-exempt and non-resident investors in the u.s. corporate debt markets. this would likely be of less concern in developing countries. for a discussion of cbit with final withholding on interest, see cnossen, supra note 18, at 211. 85. as we discuss briefly later, it is difficult to determine how best to treat capital gains under any income tax regime, whether in developed or developing countries. see infra notes 148–149 and accompanying text. 86. roy bahl & richard m. bird, tax policy in developing countries: looking back—and forward, 61 nat’l tax j. 279 (2008); tanzi & zee, supra note 5, at 8. 87. bird & zolt, supra note 6, at 1630; tanzi & zee, supra note 5, at 9–15. 192 columbia jour$al of tax law [vol. 1:174 countries.88 while the revenue from corporate income taxes in developing countries varies substantially by region, corporate income taxes provide a major source of revenue in many countries, and generally, the poorer the country, the greater the proportion of total income taxes from corporate taxes.89 many developing countries have a large traditional agricultural sector and a significant informal (shadow) economy, both operating largely outside the formal tax system.90 no country has managed to tax either of these sectors effectively.91 these hard-to-tax sectors constitute a much higher portion of total economic activity in developing countries than in developed countries.92 as a result, the tax base that tax authorities can potentially reach is relatively small in many developing countries. depending on the legal form of business operations, active business income could be taxed under either the personal income tax or corporate tax systems. alternatively, a country could adopt a business or an enterprise tax that applied to all forms of business—corporations, partnerships, and sole proprietorships.93 developing countries have also adopted presumptive tax regimes that seek to tax business activity by reference to factors other than income.94 88. bird & zolt, supra note 6, at 1653–60. 89. roger gordon & wei li, tax structure in developing countries: many puzzles and a possible explanation 4 (nat’l bureau of econ. research, working paper, no. 11267, 2005). 90. schneider & enste, supra note 8. 91. taxing the hard-to-tax: lessons from theory and practice (james alm, jorge martinez-vazquez & sally wallace, eds., 2004). 92. for estimates of the size of the informal sector in developing countries, see james alm, jorge martinez-vazquez, & friedrich schneider, “sizing” the problem of the hard-totax, in taxing the hard-to-tax: lessons from theory and practice 11, 24 (james alm, jorge martinez-vazquez & sally wallace eds., 2004). the size of the informal economy may itself be a function of the design and implementation of the tax system. for example, the high social insurance tax rates levied by some countries create an incentive for a large informal economy by discouraging employers from reporting the extent of employment and encouraging the under-reporting of wages. jan rutkowski, taxation of labor, in fiscal policy and economic growth: lessons for eastern europe and central asia 281 (cheryl grey, tracey lane & aristomene varoudakis eds., 2007). the resulting lower tax revenues often lead governments to raise tax rates still further, thus exacerbating incentives to evade taxes. 93. for example, bolivia adopted an enterprise tax that applied to all businesses regardless of legal form. musgrave, supra note 3, at 320. 94. several latin american countries such as mexico and colombia have imposed a presumptive tax on assets as a form of alternative minimum tax. for further discussion, see vito tanzi & efraim sadka, a tax on gross assets of enterprises as a form of presumptive taxation (imf working paper, no. 92/16, 1992). such systems are also found in some developed countries. for example, france taxes small farmers presumptively on the basis of a presumed return on land, and israel uses a similar system, in part based on presumed return on assets, more widely. victor thuronyi, presumptive taxation of the hard-to-tax, in 2010] dual i$come taxatio$ 193 the sources of revenue under the personal income tax system vary substantially among countries. while good comparative information about the revenue composition of personal income taxes in developing countries is not available, it is not uncommon for over 90% of personal income tax revenue in developing countries to come from wage withholding in the formal sector.95 it follows that personal income tax systems in developing countries raise relatively small amounts of revenue from either active business operations or from “passive” investment income such as dividends and interest. developing countries often provide for deductions and exemptions for different types of savings under the personal income tax.96 in several countries, individuals can deduct life insurance premiums and pension contributions and are not taxed on most types of interest and dividend income.97 but even when countries include different types of portfolio income in the tax base, the tax administration often lacks capacity to tax this income effectively.98 those countries that succeed in collecting tax revenue generally do so by using final withholding tax regimes, often at tax rates substantially below rates applicable to other types of income.99 both developed and developing countries face substantial challenges in taxing portfolio income that crosses national borders.100 first, consider the challenges in taxing residents on their portfolio income earned outside the country. the “international tax compromise” resulting from the league of nations model treaty generally allocates active business income to the country where it is earned (the source jurisdiction) and portfolio income to the country from which the capital is supplied (the residence taxing the hard-to-tax: lessons from theory and practice 101, 111–12. 118–19 (james alm, jorge martinez-vazquez & sally wallace eds., 2004). 95. bird & zolt, supra note 6, at 1658–59. 96. ved. p. gandhi, relevance of supply-side tax policy to developing countries: a summary, in supply-side tax policy: its relevance to developing countries 9, 24– 25 (ved p. gandhi et al. eds., 1987). 97. jitendra r. modi et al., statistical tables, in supply-side tax policy: its relevance to developing countries 337, table a10 at 366–67 (ved p. gandhi et al. eds., 1987) [hereinafter modi et al., statistical tables]. 98. for extensive discussion of the weakness of tax administration in most developing countries, see, e.g., improving tax administration in developing countries (richard m. bird & milka casanegra, eds., 1992) and arindam das-gupta & dilip mookherjee, incentives and institutional reform in tax enforcement: an analysis of developing country experience (1998). 99. tanzi & zee, supra note 5, at 18–19; modi et al., statistical tables, supra note 97, table a11, at 368. 100. michael j. graetz & itai grinberg, taxing international portfolio income, 56 tax l. rev. 537 (2003); reuven s. avi-yonah, globalization, tax competition, and the fiscal crisis of the welfare state, 113 harv. l. rev. 1573 (2000). 194 columbia jour$al of tax law [vol. 1:174 jurisdiction).101 but while countries have the right to tax their residents on their portfolio income earned outside the country, several countries choose to tax their residents only on income earned in their country.102 in the absence of effective information exchange or withholding regimes, even those countries that tax their residents on their world-wide income have limited ability to tax their residents’ foreign-source income effectively.103 the use of tax havens and bank secrecy laws make it difficult for taxing authorities to track the investments of their residents.104 developed countries such as the united states, germany, and japan face substantial challenges in taxing this foreign-source income; developing countries with less administrative capacity face even greater difficulties.105 second, consider the challenges to taxing foreign investors on their portfolio income from local investments. while many source countries impose withholding taxes on portfolio income paid by domestic persons to foreign investors, both developed and developing countries collect little revenue from portfolio investments held by non-residents.106 exceptions to withholding requirements often apply to interest income. in 1984, congress repealed the u.s. withholding tax on portfolio interest income held by non-u.s. residents.107 the failure of the u.s. to tax foreign investors on income earned on u.s. debt obligations makes it difficult for all countries to impose taxes on portfolio interest, especially developing countries. with respect to other types of portfolio income, many countries have entered into tax treaties that trade away the right to collect income on passive investments held by foreign investors, presumably hoping to attract more foreign investment.108 developing countries vary greatly in the tax wedge applicable to 101. see generally, reuven s. avi-yonah, the structure of international taxation: a proposal for simplification, 74 tex. l. rev. 1301 (1996). 102. hugh j. ault & brian j. arnold, comparative income taxation: a structural analysis 372–75 (2d. ed 2004). 103. avi-yonah, supra note 100, at 1584. 104. id. at 1576. 105. id. at 1581–86. 106. for a review of the challenges to taxing non-residents in the philippines see richard d. pomp, the experience of the philippines in taxing its $on-resident citizens, in income taxation and international personal mobility 43 (j. bhagwati & j. wilson eds., 1989). 107. deficit reduction act of 1984, pub. l. no. 98-369, §127(a) (codified as amended at i.r.c. § 871 (h) (1994)). 108. for a recent review of the effectiveness of tax incentives in attracting foreign investment, see alexander klemm, causes, benefits, and risks of business tax incentives (imf working paper, no. 09/21, 2009) and for an empirical analysis, see alexander klemm & stefan van parys, empirical evidence on the effects of tax incentives (imf working paper, no. 09/136, 2009). 2010] dual i$come taxatio$ 195 labor income. differences in relative tax rates under the personal income tax system partly explain the variations, but most of the difference is attributable to payroll or social security taxes imposed on workers and employers to fund unemployment, medical care, or pension benefits.109 these taxes on labor (and associated benefits) are especially high in many eastern and central european countries, countries of the former soviet union, and several latin american countries.110 to the extent that these payroll or social security taxes exceed the value of expected benefits, they constitute an additional tax on labor income. corporate tax systems in developing countries vary greatly in scope and design. many developing countries receive a large percentage of their corporate tax revenues from a relatively small number of taxpayers, whereas other countries have a more diversified tax base.111 countries differ both as to the level of corporate income tax rates and the relationship of the corporate rate to personal income tax rates. as table 2 indicates, while some regional convergence does exist, there is no easy explanation for either the variation in the level of tax rates or the differences between personal and corporate rates in these countries. 109. see world bank, paying taxes 2010, app. table 1.4 (2010) for the estimated size of social security and labor taxes paid by employers in most developing countries. 110. for discussion, see rutkowski, supra note 92, at 281; james alm & hugo lópezcastaño, payroll taxes in colombia, in fiscal reform in colombia 195 (richard m. bird et al. eds., 2005); john norregaard & tehmina s. kahn, tax policy: recent trends and coming challenges 12–15 (int’l monetary fund, working paper no. 07/274, 2007). 111. in many developing countries, as little as one percent of taxpayers generate over 70% of corporate tax revenues. see katherine baer, olivier p. benon & juan a. toro rivera, improving large taxpayers’ compliance: a review of country experience (imf occasional paper 215, 2002). this marked concentration of the tax base has, in many countries, led to the creation of large taxpayer units (ltus) dedicated specifically to servicing and monitoring such taxpayers. 196 columbia jour$al of tax law [vol. 1:174 table 2. relative personal and corporate income tax rates in selected developing countries 112 personal income tax (2009) corporate income tax (2009) difference senegal 50 25 25 croatia 45 20 25 chile 40 17 23 hungary 38 16 22 poland 40 19 21 china 45 25 20 slovenia 41 21 20 vietnam 40 25 15 turkey 35 20 15 uzbekistan 25 10 15 morocco 42 30 12 south africa 40 28 12 cyprus 25 15 10 georgia 25 15 10 indonesia 35 28 7 belarus 30 24 6 latvia 20 15 5 serbia 15 10 5 malaysia 28 25 3 mexico 30 28 2 hong kong 17 16.5 0.5 argentina 35 35 0 venezuela 34 34 0 guatemala 31 31 0 peru 30 30 0 tanzania 30 30 0 el salvador 25 25 0 estonia 21 21 0 egypt 20 20 0 slovak republic 19 19 0 romania 16 16 0 zambia 35 40 -5 czech republic 15 20 -5 russia 13 20 -7 jordan 25 35 -10 kazakhstan 10 20 -10 pakistan 20 35 -15 angola 15 35 -20 112. the data are from ernst & young, global executive (2009) [hereinafter ey global executive] and ernst & young, the 2009 worldwide corporate tax guide (2009) [hereinafter ey worldwide corp. tax guide]. 2010] dual i$come taxatio$ 197 spending patterns also differ. the aggregate levels of taxes and expenditures are smaller in developing countries than in developed countries.113 expenditure programs to alleviate poverty or to reduce inequality are much smaller in developing countries than programs in most developed countries.114 nonetheless, much as in the nordic countries in the 1980s, developing countries require tax revenues to support government programs and also face challenges in maintaining or increasing income tax revenues from increasing global tax competition.115 b. design choices as in the nordic cases, several design options exist for dual income taxes. the considerations in choosing tax rates and bases differ from the nordic countries and also vary substantially among developing countries. 1. personal income tax system. the first set of design options under the personal income tax system involves choices as to the level of tax rates and the relationship of tax rates for income from capital and income from labor. the options for any particular country are strongly influenced by the tax rates of the existing tax regime, as well as the tax rates of other countries in the region.116 choices as to the level of tax rates include both the positive marginal tax rates and the zero-bracket amounts (also referred to as the tax free minimum or basic allowance). marginal income tax rates under personal income tax systems have declined substantially in recent decades.117 the dispersion of rates among countries has also narrowed considerably, particularly within regions.118 as markets for both labor and 113. robin burgess & nicholas stern, taxation and development, 31 j. of econ. lit. 762, 764–75 (1993). 114. chu, davoodi & gupta, supra note 11, at 34–37. 115. avi-yonah, supra note 100, at 1640–41. see also martin ravallion, do poorer countries have less capacity for redistribution? (world bank policy research paper 5046, september 2009). ravallion estimates that guaranteeing poverty-line income ($1.25/day) to the poorest in those countries with annual consumption per capita of less than $2,000 would require marginal tax rates on the non-poor (those above the “poverty line”) of over 100% to eliminate the poverty gap, while for high-income developing countries (those with per capita consumption over $4,000), this goal could be achieved with an average rate of only 1%. id. at 20. 116. norregaard & kahn, supra note 110, at 3–6. 117. peter, buttrick & duncan, supra note 22, at 2. 118. in latin america, for example, the average tax rate on corporations fell from 41% 198 columbia jour$al of tax law [vol. 1:174 capital become more integrated, policymakers face greater constraints on their ability to set tax rates for labor and capital income.119 such constraints are clearly much greater for countries in the developing world than they are for larger, more developed countries (like united states and germany) that may to some extent be able to tax agglomeration (location) rents without unduly discouraging investment.120 the most common location rents found in developing countries are those in the natural resource sector or those related to government grants of exclusive rights to provide goods or services.121 for developing countries with relatively high top marginal rates under their personal income tax systems (35% or greater), the move to a dual income tax regime will likely mean substantial reductions in tax rates (which may allow policymakers the opportunity to expand the tax base).122 however, the amount of room for tax rate reductions depends on the distribution of taxable income and the relative amounts of tax revenue collected from taxpayers in the highest marginal tax brackets.123 even countries with moderate or comparatively low marginal tax rates will likely face pressure to reduce tax rates as part of any major tax reform. under the existing tax regimes, countries have taken different approaches to the size of the zero-bracket amount. the choice of the zerobracket amount influences the proportion of the population subject to tax liability and the level of progressivity of the personal income tax, especially for low-income individuals.124 the choice also affects the relationship in 1985 to 29% in 2003, and the top rate on personal income from 51% to 28%. eduardo lora & mauricio cárdenas, la reforma de las instituciones fiscales en américa latina 34 (inter-american dev. bank res. dept., documento de trabajo no. 559, 2006). 119. see generally richard m. bird & charles e. mclure jr., the personal income tax in an interdependent world, in the personal income tax: phoenix from the ashes? 235 (s. cnossen & r.m. bird, eds., 1990). 120. see sørensen & johnson, supra note 53, at 25. 121. anwar shah and john whalley argue persuasively that such “rents” are generally much more important in developing than developed countries. anwar shah & john whalley, tax incidence analysis of developing countries: an alternative view, 5 world bank econ. rev. 532 (1990). 122. many of the flat tax reforms discussed in the next section provided for an expansion of the tax base to help minimize revenue losses from rate reductions. see infra notes 165–67 and accompanying text. 123. in a few developing countries, such as papua new guinea, almost all personal income tax revenues were collected from expatriates who were subject to the top rate of the personal income tax rate schedule. richard m. bird, taxation in papua $ew guinea: backwards to the future?, 17 world dev. 1145, 1150–51 (1989). such countries may have little to gain by lowering this rate and much revenue to lose. 124. countries vary greatly in the proportion of individual income tax payers to total population, with low-income countries having much lower participation rates as compared to medium-income and high-income countries. modi et al., statistical tables, supra note 97, 2010] dual i$come taxatio$ 199 between the regular income tax system and presumptive tax regimes that apply to taxpayers who are either operating in the informal sector or are considered too small to be worth including in the regular tax system. many developing countries have different types of presumptive tax regimes that seek to tax micro and small businesses by reference to factors other than income, such as sales, number of employees, or size of establishment.125 the aim of such presumptive tax regimes is to reduce administrative and compliance costs and to educate and develop taxpayers to where they can enter the regular income tax system. when presumptive tax regimes are in place, introducing a dual income tax which taxes corporate (or large enterprise) profits and personal capital income (or small enterprise profits) at the same rate reduces tax differences based on size of enterprise. another partial solution would be to adopt different tax rates on active business income and passive income from capital, with the former close to the higher labor income rate and the latter closer to the lowest rate on labor income.126 policymakers also need to consider whether to adopt a zero-bracket amount for capital income under a personal income tax system. on equity grounds, providing tax relief for small investors may make sense. however, countries with final withholding regimes for different types of capital income are likely to find it administratively challenging to have a sufficiently good reporting system to provide for refunds for small investors. the major policy decision in adopting a dual income tax regime is setting the relative tax rates for capital and labor income. while the nordic countries set the rate for capital income at (or near) the lowest tax rate applicable to labor income, different considerations may apply in developing countries. in the pre-dual income tax regime of the nordic countries, many types of capital income were nominally subject to the high marginal tax rates applicable to income from labor, although these rates were applied very unevenly.127 by contrast, in developing countries where almost all tax revenue is from wage withholding in the formal sector, table a5, at 360. while in many countries the choice of the zero-bracket amount is driven largely by revenue concerns, several other important design elements may also arise. for example, raising the zero-bracket amount would relieve a substantial number of existing taxpayers from the obligation to file income tax declarations. this was an important consideration in uruguay’s move to a dual income tax. barreix & roca, supra note 18, at 131. 125. for some examples, see richard m. bird & sally wallace, is it really so hard to tax the hard-to-tax? the context and role of presumptive taxes, in taxing the hard-totax: lessons from theory and practice 121, 135–36 (james alm et al. eds., 2004). 126. this approach was adopted in uruguay. barreix & roca, supra note 18. 127. sørensen, from the global income tax, supra note 18, at 60. 200 columbia jour$al of tax law [vol. 1:174 applying (and effectively, collecting) any tax on either active business income (from businesses not in corporate form) or passive income would likely be a tax increase. for countries that apply final withholding taxes under their current personal income tax regimes on passive income such as dividends, interest, and some types of rents and royalties, the existing tax rates on this income from capital are likely substantially below the rates applicable to income from labor.128 box 1 sets forth some rate alternatives under a dual income tax for a personal income tax system. box 1. rate alternatives under dual income tax for personal income tax systems highest marginal tax rates for labor income higher than tax rate on capital income • top marginal rate for labor income substantially higher than capital tax rate (nordic model with 15-25% rate differential) • top marginal rate for labor income slightly higher than capital tax rate (perhaps differential of 10% of less) tax rate on capital income higher than lowest positive rate on labor income • tax rate on capital income set higher than top marginal rate on labor income • tax rate on capital income set at top marginal rate on labor income • tax rate on capital income set at a rate between the lowest and highest marginal tax rate on labor income consider the potential consequences from changing the relationship between tax rates for capital and labor. assuming, for purposes of this discussion, reasonable levels of tax compliance, setting the tax rate on capital at the highest rate applicable to labor income would reverse the tax incentives present in nordic countries by encouraging taxpayers to characterize capital income as labor income. however, if compliance levels were low, it is unlikely that many potential evaders would have to engage in such strategy. if they want to evade taxes, they can do so more easily by 128. several countries in latin america impose schedular taxes on some types of capital income. these schedular capital taxes generally apply different tax rates to different types of capital income. see, e.g., barreix & roca, supra note 18, at 129 (tax treatment of capital income in uruguay). 2010] dual i$come taxatio$ 201 simply under-reporting income. setting the tax rate on capital at the middle of the labor income tax range would also create some interesting incentives. taxpayers whose labor income would be taxed at the higher end of the progressive tax rate schedule may seek to characterize part of their income from labor as income from (lower-taxed) capital. on the other hand, taxpayers whose labor income would be taxed at the lower end of the progressive tax rate schedule may try to characterize part of their income from capital as income from labor, but not enough to move the labor income to a higher bracket.129 the trade-off is between achieving additional progressivity from taxing labor income and the potential distortions and arbitrage opportunities from the different tax rates applicable to income from labor and capital. while the gap in the nordic countries between the flat tax rate applicable to income from capital and the top rate under the progressive schedule for labor income was (and continues to be) substantial,130 the difference between the tax rates for capital and labor income in many developing countries would likely be much smaller, primarily because of the difficulties developing countries would face in imposing such high tax rates on labor income. the smaller the gap between capital and labor income tax rates, the less incentive taxpayers have to disguise the form of their income thereby lowering the potential revenue losses from such strategies. another design consideration is how broadly to define the capital income component of a dual income tax under a personal income tax system. some forms of capital income are simple to define in principle: interest income, dividends, royalties, and rents. in almost all countries, it should be possible to tax the first three of these items at a flat rate under a final withholding regime. the application of final withholding taxes to these payments from firms, whether to domestic or foreign recipients, would improve efficiency by increasing the symmetry of tax treatment of capital income and simplify administration. for many countries, adopting final withholding regimes would both expand the tax base and likely improve the overall progressivity of the tax system.131 assuming taxes on dividends are collected under a final 129. the existence, level, and structure of payroll taxes will also influence incentives to avoid characterization as labor income. 130. see supra notes 50–52 and accompanying text. 131. some adjustments in tax treaties would likely be required. one reason for imposing similar final withholding tax regimes on payments to foreign and domestic taxpayers is to reduce incentives for domestic taxpayers to use foreign entities to avoid withholding tax liabilities. policymakers could also extend final withholding taxes to returns from pensions. sørensen & johnson, supra note 53. however, doing so would raise the difficult question of whether such returns constitute capital income or deferred labor income. 202 columbia jour$al of tax law [vol. 1:174 withholding regime (or alternatively, dividends are excluded from income), the question of whether and how to tax capital gains on corporate shares at the individual level remains. one alternative is simply to exempt these capital gains from taxation. if the dual income tax system provided for full integration of distributed earnings and interest payments, any remaining gains on corporate shares would presumably largely reflect inflation, and exemption would be appropriate.132 a second alternative is to tax capital gains at the individual level. if such gains were taxed when realized, individual taxpayers should be allowed to adjust the cost basis of their shares to reflect any taxed, but undistributed, earnings at the corporate level. a third alternative is to tax capital gains only for shares held for less than a specific period of time, for example, one year. this approach would prevent taxpayers from engaging in schemes to avoid tax on labor income by selling their shares to reduce or evade tax liability. unfortunately none of these solutions is perfect, or simple to implement. an interesting design alternative maintains the progressive rate structure for labor income and provides for two different regimes for taxing income from capital: a relatively low flat tax rate on portfolio investment income and a higher flat tax rate on income related to active businesses. uruguay adopted a version of this dual income tax system (or perhaps more accurately, a tripartite tax system) in july 2007.133 under the uruguayan dual income tax, labor income is taxed at rates ranging from 10% to 25%.134 portfolio income is taxed at a 12% rate through a final withholding regime.135 self-employed persons can choose between being taxed under the business tax regime (at a 25% tax rate after deducting business expenses) or paying under the labor income tax regime at the 25% rate (with allowance for personal deductions and presumed expenses of 30% of receipts, an effective rate of 17.5%).136 2. relationship of personal income tax rates and corporate tax rates under a dual income tax. once the tax rates are set under the personal income tax system and 132. george r. zodrow, corporate income taxation in canada, 56 can. tax j. 392, 461 (2009). alternatively, sørensen & johnson, supra note 53, at 101, 121–26 propose a system of accrual taxation for gains in financial assets. successful implementation of such a system, however, is likely beyond the capacity of most developing and developed countries. 133. barreix & roca, supra note 18, at 122. 134. unlike the prior tax regime in uruguay, the dual income tax regime imposed taxes on professional services, interest, rent, and capital gains. a substantial zero bracket excludes 60% of the population from the tax system. id. at 131. 135. id. at 130. 136. id. 2010] dual i$come taxatio$ 203 the line is somehow drawn between capital and labor income, the next issue is the relationship of the personal income tax rate to the corporate income tax rate. as set forth in box 2, several alternatives exist. box 2. relationship of tax rate on capital under the personal tax regime and the corporate tax rate • pure nordic system: set corporate tax rate at the same level as the capital tax rate under the personal income tax (and at the lowest positive tax rate for labor income) • set corporate tax rate higher than either the personal income tax rates for income from capital or income from labor • set corporate tax rate lower than the personal income tax rates for income from capital or income from labor under the “pure” nordic dual income tax system, the corporate tax rate is set at the tax rate for capital income (and the lowest positive rate on labor income).137 the income shifting resulting from lower corporate income tax rates has, in several european countries, shown up primarily in the form of lower personal income tax revenues as more small businesses have incorporated to take advantage of the tax differential.138 for businesses in developing countries that are actually paying tax under the personal income tax system, a lower corporate tax rate would encourage businesses to incorporate. if greater use of the corporate form were to occur in developing countries, this would have the beneficial effect of increasing the size of the formal sector in those countries and expanding the potential tax base reachable with the available administrative resources. a second alternative sets the corporate tax rate higher than the personal tax rates for either income from labor or income from capital. to the extent corporate tax revenues are derived primarily from large corporations with substantial foreign ownership, the corporate income tax acts as a final withholding tax on the income derived in the country. if the corporate tax applies primarily to businesses engaged in extracting natural resources or other activities that generate location-specific excess returns, then this alternative might raise revenue without substantial economic distortions.139 however, setting the corporate tax rate higher than the 137. sørensen, supra note 12, at 212–13. 138. ruud de mooij & gaetan nicodème, how corporate tax competition reduces personal tax revenue, 6 cesifo dice report, spring 2008, at 27. 139. as keen and mansour note, however, even in the case of natural resources, 204 columbia jour$al of tax law [vol. 1:174 personal tax rate would discourage small businesses from incorporating, and depending on the corporate tax rate chosen compared to tax rates in other countries, may discourage foreign investment.140 a third alternative sets the corporate tax rate below the personal tax rates either for income from labor or income from capital. for those countries where income tax revenues are derived almost completely from wage withholding, this alternative achieves many of the same results as the nordic dual income tax systems. it provides for a lower tax rate on income in corporate form as a means of addressing tax competition concerns. low corporate taxes could encourage domestic and foreign investment, while progressive tax rates could be maintained for labor income. it would also, however, create incentives for those with substantial income from labor to incorporate to reduce tax liability. 3. taxation of normal and excess returns. economists distinguish between the normal return to capital and rents or excess returns. for debt capital, the normal rate of return is the market rate of interest on debt in the relevant risk class. for equity capital, the normal rate of return is determined by the market rate on stocks with similar risk characteristics.141 an extensive economic literature argues against imposing tax on the “normal” rate of return on capital, especially in small open economies in which both the elasticity of supply of capital and the desire to increase the capital stock are likely quite high.142 box 3 sets forth several alternative regimes for taxing entities on the returns from debt and equity investments. the first alternative is the conventional corporate income tax which allows the deduction of interest but taxes the full returns to corporate equity without distinguishing between normal and excess returns. the second alternative seeks to tax all returns at the entity level either by disallowing a deduction for interest or by imposing a final withholding tax on dividends and interest at the entity level at the same rate as the corporate tax. the cbit proposal discussed earlier is an example of this approach. the third alternative seeks to tax only excess countries may compete owing to scarcity of skills needed for resource extraction. michael keen & mario mansour, revenue mobilization in sub-saharan africa: challenges from globalization 11 (int’l monetary fund, working paper no. 09/157, 2009). 140. klemm and van parys emphasize that even if (as their study suggests) countries may sometimes succeed through fiscal incentives in attracting foreign investment, there is no persuasive evidence that the result is increased total investment and growth. klemm & van parys, supra note 108, at 21. 141. sørensen, supra note 12, at 176. 142. id. at 175; roger h. gordon, can capital income taxes survive in open economies?, 47 j. fin. 1159 (1992). 2010] dual i$come taxatio$ 205 returns. in recent years, several alternatives for excluding the normal return on capital from the tax base have been proposed under a variety of names and labels, such as cash flow taxation and allowance for corporate equity (ace).143 a dual income tax system with a relatively low but positive tax rate on capital income might be an appropriate compromise between the theoretically optimal zero tax rate on capital in a small open economy and the political economy arguments that might justify high tax rates on capital income.144 in addition, in at least some instances, countries may wish to consider imposing a separate cash-flow tax for firms that earn returns well in excess of the normal return on capital (for example, because they are able to capture location rents from access to limited natural resources).145 the fourth alternative provides entities with a deduction for an imputed rate of return on both debt and equity capital and imposes taxes at the individual level on interest, dividends, and capital gains. the final alternative taxes the normal returns to capital at a low flat rate but taxes excess returns at the same progressive marginal tax rates applicable to labor income. norway has adopted a variation of this approach with respect to income of closelyheld corporations.146 box 3. treatment of �ormal and excess returns under dual income tax systems • tax full returns of equity and allow a deduction for interest paid at entity level • tax full return of debt and equity at entity level • tax only excess returns at entity level with no tax at investor level • tax only excess return at entity level and tax normal returns at investor level • tax normal returns at low flat tax rate and tax excess returns at the same progressive tax rates applicable to labor income choosing among the alternatives requires policymakers to balance 143. for a recent review of such proposals in the context of a developed country, see sørensen & johnson, supra note 53, at 79. see also klemm, supra note 108, at 9 (considering similar arguments in a developing country context). 144. george r. zodrow, corporate income taxation in canada, 56 can. tax j. 392, 460 (2008). on the arguments for taxing capital income, see, e.g., john head & richard krever, taxing capital income, 22 austrl. tax f. 83 (2007). 145. see rose garnaut & anthony clunies-ross, taxation of mineral rents (oxford 1983) for an example of a resource tax proposal. 146. sørensen, supra note 12, at 214–17. 206 columbia jour$al of tax law [vol. 1:174 several competing objectives. reducing economic distortions will provide support (particularly in small economies) for exempting the normal returns from capital.147 however, if countries seek to raise the same amount of revenue from corporate taxes, a smaller tax base under a corporate tax regime that exempts normal returns will require higher tax rates. for example, if policymakers seek to raise $100 million in tax revenue, they could raise that amount by choosing to tax only the excess returns at the entity level (alternative 3) and have tax rates of, say, 35%, or tax full returns of debt and equity at the entity level (alternative 2) and have tax rates of 20%. finally, with the reduction of personal and corporate tax rates, the need for specific provisions to reduce the double taxation of distributed corporate income (and the double taxation associated with capital gains attributable to previously taxed corporate income) may be much reduced in developing countries. in addition, the potential double taxation also serves to reduce incentives for owner-managers of closely-held corporations to disguise labor income as capital income.148 with respect to capital gains on corporate shares, if the corporate tax rate is set equal to the capital income tax rate under the dual income tax, then not only can dividends be exempt from withholding taxes but in effect the proportion of capital gains attributable to increased corporate earnings is also taxed at the same rate.149 although it is difficult to think of an administratively feasible way to tax the component of real capital gains on shares attributable to goodwill, even this limited leveling out of the tax arbitrage playing field would be a substantial improvement in most developing countries. c. advantages and disadvantages of dual income tax regimes in developing countries moving to a dual income tax regime offers both advantages and disadvantages as compared to the current tax regimes in developing countries. as tax systems and tax environments differ greatly among countries, so do the relative advantages and disadvantages, as well as the relative costs and benefits, from undertaking major tax reforms. moreover, in some instances similar advantages could be achieved by reforms other 147. see joel slemrod, carl hansen & roger procter, the seesaw principle in international tax policy, 65 j. pub. econ. 163 (1997). 148. kleinbard, supra note 17, at 48. 149. dividend exemption is not an essential element of a dual income tax. if full dividend integration is not desired, countries could subject dividends to taxation under the personal income tax regime, or provide for partial imputation by providing credit for taxes paid at the entity level. 2010] dual i$come taxatio$ 207 than moving to a dual income tax regime. the dual income tax provides greater flexibility to developing countries that wish to reduce tax rates by allowing them to lower tax rates on capital income while maintaining (or adopting smaller reductions for) tax rates on labor income. as discussed in the next section, the ability to set separate rates for labor and capital income is also an important factor in choosing between dual income taxes and flat taxes. adopting separate tax rates for labor and capital income may have both revenue and progressivity implications. countries can respond to pressure to reduce tax rates by lowering rates on capital income while maintaining, and perhaps increasing, the current tax revenue generated from labor income. the progressivity implications of moving to a dual income tax are less clear-cut and depend greatly on the distribution of tax burdens for labor and capital income under the current tax system. in addition, a move to a dual income tax regime could help rationalize the taxation of income from capital, whether income from passive investments or active business operations. a single rate would provide more symmetric and less distorting treatment of income from passive investments. it might also allow countries to conform the relative tax treatment of passive investment income received by resident and nonresident investors. the move to a dual income tax regime could result in significant administrative gains from increased use of information reporting as well as increased use of provisional and, especially, final withholding.150 the move to a dual income tax could also help rationalize the tax treatment of income from active businesses under the personal or corporate tax regimes. adopting the same tax rate for income from active business under the personal tax system and under the corporate tax system will eliminate tax-induced distortion as to choice of business form. a dual income tax regime with relatively low tax rates on business income and relatively low corporate tax rates may represent an improvement over tax regimes that combine high tax rates on capital with special tax incentives, especially those incentives designed to attract foreign investment. whether this move to a dual income tax would lower costs of capital and increase domestic and foreign investment is a difficult empirical question and likely varies depending on country-specific factors.151 it depends partly on how successful past tax incentives have been in attracting 150. whether taxpayers’ compliance costs would also be reduced depends on the obligations imposed on taxpayers and other parties to report and withhold, and on the specific types of income included in the dual income tax regime. 151. liam p. ebrill, income taxes and investment: some empirical relationships for developing countries, in supply-side tax policy: its relevance to developing countries 115, 133–34 (ved p. gandhi et al. eds., 1987). 208 columbia jour$al of tax law [vol. 1:174 investment in developing countries. although the evidence is not entirely clear, such incentives have been more successful in increasing the inflow of foreign direct investment to middle-income countries or those with significant natural resources than to low-income countries without significant natural resources, which have made most use of these incentives.152 it is also not clear whether tax incentives generate additional new investment or new ownership of existing investments.153 although foreign capital inflows appear to respond to tax incentives, what may be changing is more the ownership of capital than the amount of real investment.154 the relative advantage of a dual income tax over current regimes that pair high tax rates with high tax incentives also depends on how successful a low flat rate tax on capital would be in increasing the level of investment as compared to an existing regime with high tax rates and generous tax incentives. while supporters of low flat tax rates claim low taxes have increased investment and increased tax revenue in several countries, it is difficult to isolate the effect of tax changes on the costs of capital from the effect of other tax and fiscal reforms.155 152. klemm & van parys, supra note 108, at 18 find (for a wider sample of developing countries) that foreign direct investment responds positively to increased tax incentives, and in particular, tax holidays. 153. the available data for developing countries do not separate foreign capital inflows into real and financial flows. it is therefore not clear whether the tax incentives generate additional new investment or new ownership of existing investments. because neither increased total real investment nor economic growth appears to be associated with the increased foreign direct investment inflows, it may be that either such financial transfers dominate or higher foreign investment inflows ‘crowd out’ domestically-financed investment. klemm & van parys, supra note 108, at 15. 154. id. at 19–20. this result is not inconsistent with the meta-study of corporate tax elasticities in developed countries as reported by ruud a. de mooij and sjef ederveen in corporate tax elasticities: a reader’s guide to empirical findings, 24 oxford rev. econ. pol’y. 680, 686 (2008). this study finds by far the highest and most significant responses of international corporate capital flows reflect profit shifting in response to changes in statutory rates, but that there is also a significant effect on real capital inflows when effective marginal tax rates on capital are lowered, as by incentives. id. at 694–95. however, as klemm & van parys, supra note 108, at 20, note that such positive effects of tax incentives on real investment (and growth) appear to be conditional on the existence of precisely those institutional and financial aspects of absorptive capacity that are generally missing in developing countries. see, for example, the extensive analysis in world bank, doing business 2010: reforming through difficult times (2009) [hereinafter world bank]. 155. compare daniel j. mitchell, eastern europe’s flat tax revolution, 37 tax notes int’l 989 (2005)(flat tax reforms have generated impressive results, including faster growth, more jobs, and increased competitiveness) with clifford g. gaddy & william g. gale, demythologizing the russian flat tax, 37 tax notes int’l 983, 988 (2005)(difficult to establish causal link between flat tax reforms and economic growth and higher tax revenue because of other concurrent factors that influence growth and tax compliance). 2010] dual i$come taxatio$ 209 removing tax preferences and exclusions and simply moving to a lower statutory rate would simplify tax regimes for both individual and corporate taxes, thus reducing both administrative and compliance costs. the latter point is particularly important because such costs appear to create a substantial fiscal barrier to the formalization of many economic enterprises in developing countries.156 the move to a dual income tax regime could also provide a platform on which to incorporate other related reforms, such as coordinating presumptive tax regimes for small businesses with the regular corporate tax regime and integrating the personal income tax system with the payroll or social security tax regimes. thus, adopting a dual income tax regime may provide the opportunity to coordinate with existing presumptive tax regimes and facilitate moving to a regular tax system.157 for countries with substantial payroll taxes, the dual income tax provides an opportunity to impose a single tax on labor income that would be both more transparent and easier to administer. for that matter, simply integrating the administration of payroll taxes with labor income taxes would substantially simplify and improve both systems in many countries.158 the move to a dual income tax also has costs and disadvantages. any major tax reform imposes substantial administrative costs on both taxpayers and tax authorities. depending on the current tax systems in developing countries, the move to a dual income tax could substantially raise the cost of debt capital, especially if countries adopt more effective final withholding regimes. differences in tax rates on labor and capital income, as well as any differences between tax rates on capital income under the personal tax system and corporate tax rates, would also present incentives for taxpayers to structure the type and form of income to reduce tax liability. however, this problem is likely of less concern in developing countries, because of the smaller difference in the effective marginal tax rates for capital income, labor income and corporate income rate than exists in developed countries.159 finally, it is important not to compare the dual income tax to some 156. world bank, supra note 154, at 9. 157. the economic and administrative importance of providing an incentive for firms to move from a presumptive to the regular income tax regime is emphasized by bird & wallace, supra note 125, at 143–44. 158. peter barrand, stanford ross & graham harrison, integrating a unified revenue administration for tax and social contribution collections: experiences of central and eastern european countries 33 (imf, working paper no. 04/237, 2004). 159. the rate differentials will likely be smaller in developing countries because it is unlikely that developing countries could successfully adopt and enforce personal income tax rates comparable to the high tax rates found in nordic countries. 210 columbia jour$al of tax law [vol. 1:174 ideal tax regime with high levels of tax compliance, but rather to the current imperfect tax regimes and compliance rates in the particular country.160 difficulties exist in estimating the amount of any revenue or progressivity gains or losses from the move to a dual income tax without examining the details of the proposed reforms and the effectiveness of the existing tax regimes. revenue gains from adopting a dual income tax would likely be greater in those countries where the prior tax treatment of income from capital was ineffective and where the change to the dual income tax might reduce the size of the informal economy by reducing tax barriers to formalization. similarly, in developing countries that have relatively ineffective taxation of capital income, a dual income tax may even produce some progressivity gains, particularly if reforms succeed in reducing taxes on income of low wage earners and increasing taxes on income of higher wage earners and capital income. iv. dual income tax versus flat tax regimes if policymakers in developing countries wish to retain an income tax, there are competing tax reform options. choices include trying to improve the comprehensive income tax model, adopting a dual income tax, or adopting a flat rate tax.161 the choice between a dual income tax and a flat tax appears relatively straightforward: the dual income tax provides for a single tax rate only on capital income whereas the flat tax applies a single rate to all types of income. the differences between dual income tax and flat tax systems, however, may be greater or less depending on several factors, such as the zero bracket amount and rate structure under the personal income tax, the tax rate differential between the personal income tax system and the corporate tax system, the integration of the personal and corporate tax systems, and the presence of payroll or social security tax on labor income. 160. for a similar conclusion with respect to adopting a dual income tax in the united states, see kleinbard, supra note 17, at 45. 161. see generally michael keen, yitae kim & ricardo varsano, the “flat tax(es)”: principles and experience, 15 int’l tax pub. fin. 712, 715 (2008). earlier flat tax experiments took place in such diverse places as hong kong, and jamaica. see richard cullen & antonietta wong, globalization and the hong kong revenue regime (paper presented at symposium in honor of alex easson queen’s university law school, february 2008); james alm et al., a program for reform, in the jamaican tax reform 153, 157–58 (roy bahl ed., 1991). 2010] dual i$come taxatio$ 211 a. recent flat tax reforms several recent tax reforms, particularly in central and eastern europe and the countries of the former soviet union, have followed a flat tax approach. table 3 provides information about tax systems in these countries both before and after flat tax reforms. table 3. flat tax regimes 162 year personal income tax rates corporate income tax rates before reform after reform 2008 before reform after reform 2009 estonia 1994 16-33 26 21 a 35 26 21 lithuania 1994 18-33 33 24 29 29 15 latvia 1997 10-25 25 20 25 25 15 russia 2001 12-30 13 35 20 35 16-20 b slovak republic 2004 10-37 19 19 25 19 19 ukraine 2004 10-40 13 30 30 25 25 georgia 2005 12-20 12 25 c 20 20 15 romania 2005 18-40 16 16 25 16 16 macedonia 2007 15-24 12 10 15 12 10 kazakhstan 2007 5-20 10 10 30 30 20 czech republic 2008 12-32 15 15 24 22 20 bulgaria 2008 10-24 10 10 10 10 10 a further rate reductions are planned: to 20 percent in 2009, 19 percent in 2010 and 18 percent in 2011. b corporate profit tax rates consist of a 2.5% rate payable to central government and rates ranging from 13.5% to 17.5% payable to regional governments. c in july of 2007, georgia merged the 12% flat income tax rate with the 20% social tax rate into a single flat 25% rate. almost all of these flat tax reforms are income tax systems that apply a single tax rate above a zero-bracket amount.163 though clumped together under the flat tax rubric, these reforms vary substantially across countries and over time. they differ in choice of the tax rate as compared to the range of tax rates before the reform, the types of income subject to 162. see keen, kim & varsano, supra note 161; ey global executive, supra note 112; ey worldwide corp. tax guide, supra note 112. 163. see brian jenn, flat taxes: past, present, and future, 43 tax notes int’l 995 (2006); pablo saavedra, flat income tax reforms, in fiscal policy and economic growth: lessons for eastern europe and central asia 253 (cheryl grey, tracey lane & aristomene varoudakis eds., 2007). 212 columbia jour$al of tax law [vol. 1:174 the single tax rate, the size of the zero-bracket amount, the treatment of interest, dividends, and capital gains, and the relationship of the personal income tax rate and corporate tax rates before and after the reform. they also differ with respect to interaction with other taxes on labor, such as social security or payroll taxes. these flat tax reforms are not the consumption-style flat taxes of the type that dominated recent tax discussion in the united states.164 these reforms retain income as the tax base, but eliminate multiple positive marginal tax rates with respect to certain types of income.165 the first wave of flat tax reforms (estonia 1994; lithuania 1994; and latvia 1995) generally provided a moderately high single tax rate as compared to the previously existing tax rates in those countries and as compared to international tax rates.166 the reforms applied only to the personal income tax systems and left the separate corporate tax regime (with often higher corporate tax rates) unchanged. in contrast, the second wave of flat tax reforms (for example, russia 2001; kazakhstan 2007; and bulgaria 2008) provided for a flat rate substantially below previous personal income tax rates and also low relative to international tax rates. as set forth in table 4, existing flat tax regimes have taken different approaches as to both the level of tax rates and the relationship of the flat tax rates under the personal tax system and the tax rates under the corporate tax system. 164. for a survey of such proposals, see mclure & zodrow, supra note 9. 165. with the exception of georgia, these reforms retain a zero-bracket amount, so they provide for some progressivity in the tax system. 166. keen, kim & varsano, supra note 161, at 715–18. 2010] dual i$come taxatio$ 213 table 4. relative personal and corporate income tax rates under flat tax regimes 167 personal tax rates higher than corporate rates corporate tax rates higher than personal tax rates personal and corporate tax rates equal or roughly aligned (within 3%) marginal tax rates over 20% (higher of personal or corporate tax rate is over 20%) bulgaria czech republic latvia lithuania ukraine estonia marginal tax rates 20% or less (lower rate of personal or corporate tax rate is 20% or less) georgia montenegro kazakhstan russia albania kyrgyzstan macedonia mongolia romania slovak republic flat tax systems also differ as to the extent to which they integrate the personal and corporate tax systems. most flat tax systems retain the double tax on distributed corporate income (often with final withholding regimes), although some exclude tax on further distributions. b. choosing between a dual income tax and flat tax system comparisons between the dual income tax and the flat tax model depend on the specific details of the proposals as well as the specific circumstances of particular countries. for dual income tax systems with a tax rate on capital income set at the lowest marginal tax rate on labor income, the dual income tax can be designed as a flat tax with a surcharge on high-income wage earners. in other words, the difference between the two approaches is essentially what is gained or lost by having a progressive rate schedule for labor income combined with a flat tax rate on capital income. flat tax and dual income tax systems share several advantages over the current tax systems in many developing countries. as discussed in the 167. the data for this table are from ey global executive, supra note 112 and ey worldwide corp. tax guide, supra note 112. 214 columbia jour$al of tax law [vol. 1:174 previous section, a single tax rate on income from passive investments under the personal income tax system will generally provide more symmetric and less distorting treatment of this type of capital income, reducing wasteful tax-induced distortions in investment and saving decisions. a single tax rate would also be a simpler and more effective way to tax capital income and would facilitate use of withholding regimes. combining either a flat tax or a dual income tax reform under the personal income tax system with an effective corporate income tax reform may result in a more rational approach for taxing active business income. where the move to either a flat tax or a dual income tax results in reforms that lower tax rates and broaden tax bases, existing capital should be used more efficiently and the flow of capital into the economy should be increased.168 both reforms may in some circumstances also expand revenues and make the tax system more progressive with less administrative strain and effort than required under a comprehensive income tax approach. this administrative advantage is not a minor consideration in developing countries in which administrative capacity is a severe constraint on tax policy.169 flat tax regimes have advantages over dual income tax regimes. for example, if a tax system really has only a single rate on all income, it would be simpler to explain, to comply, and to enforce than other systems.170 if the single rate under the personal income tax system is also aligned with the corporate rate, distortions would be reduced and the opportunity for arbitrage would be less than under a dual income tax. on the other hand, dual income tax regimes have several advantages over flat tax regimes. by decoupling the taxation of wage and capital income tax, policymakers gain an additional degree of freedom to address global tax competition concerns or domestic political concerns from various interest groups. it may also be a bit easier for policymakers to resist the endless clamor for special concessions and hence avoid complicating either component of the income tax system by various incentive provisions. perhaps the strongest argument for choosing a dual income tax over a flat tax is to maintain at least a modest degree of explicit progressivity in the tax system. market-driven developing countries generate both growth and inequality. all countries face challenges in maintaining high growth 168. studies looking at the revenue and progressivity consequences of moving to a flat tax regime emphasize the difficulty of isolating the effects of flat tax reforms from other concurrent tax and fiscal reforms. keen, kim & varsano, supra note 161, at 741. 169. richard m. bird, administrative dimensions of tax reform, 10 asia-pac. tax bull. 134 (2004). 170. keen, kim & varsano, supra note 161, at 732–36. 2010] dual i$come taxatio$ 215 rates without being derailed by political and social tensions created by growing inequality. for those who believe that an essential element in sustaining growth and political stability is to provide some check on the ability of those with great private incomes and wealth to influence political outcomes, a sustainable democratic tax system must have some explicit way of taxing the rich more than the poor.171 since personal wealth taxes seem unlikely to become any more popular anywhere than they are now, the combination of a more effective flat rate taxation of capital income, a high proportion of which accrues to the rich, and a moderately progressive tax on wage income, which has in recent years become increasingly unequal in many countries, may be an essential ingredient in any sustainable fiscal solution. this is exactly the combination provided by a dual income tax. in most developing countries sustainable growth also probably requires some expansion of the state to replace the social safety net formerly provided for much of the population by extended rural families.172 an increasingly educated population and expanded infrastructure are also needed. all this may call for larger government programs supported primarily by higher tax revenues. at least modest progressivity in the taxation of labor income may be necessary to provide adequate revenues to fund government programs that are likely to be an essential component of the growth and economic and political sustainability of most countries. the dual income tax may thus both look better and work better than the flat tax in the context of many developing countries precisely because it includes a more explicit progressive element in the form of a progressive rate structure rather than simply a zero-bracket. in the social and political context of such countries it is not enough simply to tax the not-so-poor at a higher rate than the poor; as a rule, one must also tax the rich more than the merely well-off and more than the average worker as well.173 171. different countries may of course choose very different balances of tax levels and tax progressivity: see, for instance, the two quite different approaches to this issue in lindert, supra note 37, and alberto alesina & george-marios angeletos, fairness and redistribution: u.s. versus europe (nat’l bureau of econ. research, working paper no. 9502, 2003). 172. for an historical example, see burbidge’s discussion of the development of social security in canada. john burbidge, social security in canada: an economic appraisal (1987). 173. on the importance of the role of tax systems in increasing state legitimacy and hence capacity to govern effectively, see brautigram et al. eds., supra note 10. the key role improved governance plays in increasing tax capacity is empirically demonstrated in richard m. bird, jorge martinez-vazquez & benno torgler, tax effort in developing countries and high income countries: the impact of corruption, voice and accountability, 38 econ. anal. & pol’y 55 (2008). 216 columbia jour$al of tax law [vol. 1:174 although it is difficult to estimate the revenue and progressivity effects of moving to a dual income tax or flat tax regime, the introduction of an explicit dual income tax approach may thus strengthen rather than weaken the role of the personal income tax and the overall tax system in developing countries. an additional consideration of significance in some more decentralized countries may be that adopting a dual income tax system would make it simpler for sub-national governments to piggyback on the labor portion of the tax.174 v. conclusion moving to a dual income tax system offers both advantages and disadvantages as compared to current tax regimes in developing countries. a dual income tax provides countries with greater flexibility to address tax competition while maintaining a progressive tax regime for labor income. a flat tax rate on capital may provide an opportunity both to rationalize the taxation of different types of passive income from capital and to eliminate many of the tax preferences contained in the personal and corporate tax systems. generally, the move to a dual income tax system provides a uniform lower capital tax rate which, if set at the same level as the corporate income tax, could reduce the apparently fatal attraction that draws many developing countries towards tax incentives that often erode the tax base, provide incentives for rent-seeking and corruption, and provide greater benefits to foreign, rather than, domestic investors. at the same time, retaining a progressive tax on labor income will provide some progressivity in countries where economic changes result in greater inequality. the combination of these two features provides an opportunity to improve tax policy and tax administration substantially in many developing countries. dual income tax systems have worked relatively well in the nordic countries. if developing countries seek to follow this approach, they have many options to choose from with respect to the details of a proposed dual income tax regime. the flat personal tax rate on income from capital could either follow the nordic model (set at or near the lowest positive tax rate for labor income), or fall at the middle or top of the progressive rate schedule for labor income. to improve compliance, countries could provide for final withholding for dividends and interest payments from corporations. ideally, final withholding would be expanded to cover other payors.175 174. boadway, supra note 18, at 926. 175. for an early proposal along these lines, see richard m. bird & oliver oldman, the transition to a global income tax: a comparative analysis, 31 bull. int’l fisc. doc. 2010] dual i$come taxatio$ 217 developing countries could also choose to follow the uruguayan model, and provide for a flat tax rate on passive income from capital at the lowest positive tax rate on labor income and a flat tax rate from capital from sole proprietorships and closely held corporations at the middle or highest rates.176 alternatively, developing countries could elect to adopt different tax treatment for normal and excess returns under dual income tax regimes, either exempting normal returns from tax or taxing the normal returns at a preferential low flat tax rate and taxing excess returns at the progressive marginal tax rates applicable to labor income. while the dual income tax provides for a single rate on income from capital, at least initially, the flat tax adopted in eastern european countries and the countries of the former soviet union provided for a single tax rate on income from labor.177 these regimes, however, generally do not integrate payroll taxes with the income tax. this results in considerably higher taxes on labor than on capital income. moving to an explicit dual income tax in which the labor income tax includes the payroll tax would provide an opportunity to rationalize the generally erratic distributional effects of the existing personal income tax and payroll tax on labor income. to the extent that the flat tax regimes increase the coverage of income from capital under the personal income tax and income under the corporate tax, these tax regimes also may achieve the goals of symmetry and comprehensiveness, and depending on the rate adopted, competitiveness. although it is an empirical question, it seems likely that in the context of most developing countries a dual income tax would be more progressive than a flat tax regime at comparable tax rates. developing countries face different and difficult challenges in reforming their tax system; different environments, different objectives, capacities and policy trade-offs all come into play. given these differences, no one approach can resolve the tax challenges facing developing countries. nonetheless, the dual income tax approach appears to provide an exceptionally promising basis on which to construct more rational, sustainable, productive, and perhaps even more progressive tax systems in many developing countries. 439, 442 (1977). 176. see supra notes 133–36 and accompanying text. 177. see supra notes 162–67 and accompanying text. formatted-monahan a partial defense of the irs as health care agency amy b. monahan* abstract despite the fact that the internal revenue service (“irs”) is overburdened and struggling to meet the needs of taxpayers, congress continues to add to irs responsibilities in areas that appear far removed from the agency’s core revenue raising function. the affordable care act (“aca”) is a commonly cited example of the non-revenue raising regulatory roles the irs is increasingly asked to play, to the criticism of many. after providing an historical overview of the irs’s involvement in health care regulation, the article provides a partial defense of the expanded role that the irs has been given as a result of the aca. the article concludes that much of the irs’s involvement in health care regulation appears not only defensible, but efficient. for better or for worse, there is no better system for processing payments to or from a large number of taxpayers than the federal income tax system. additionally, the use of excise taxes to shape taxpayer behavior appears to offer the best of both worlds: a powerful incentive that requires very few enforcement resources. the article concludes, however, that significant burden could be removed from the irs by modifying or removing the irs’s substantive rulemaking authority with respect to health care matters, deferring instead to other federal agencies, such as the department of health and human services, that have particular health policy expertise. * professor of law, university of minnesota law school. © 2016 monahan. this is an open-access publication distributed under the terms of the creative commons attribution license, https://creativecommons.org/licenses/by/4.0/, which permits the user to copy, distribute, and transmit the work provided that the original authors and source are credited. 124 columbia journal of tax law [vol.7:123 i. introduction .................................................................................................... 125 ii. how treasury initially got into the employee benefits business ............................................................................................................... 125 iii. the passage of erisa and the introduction of joint authority for employee benefits ................................................................................ 126 iv. pre-aca substantive health plan regulation through excise taxes ..................................................................................................................... 128 a. the irs as health plan rulemaker ................................................................... 132 b. the irs as health plan enforcer ....................................................................... 132 c. making sense of the excise tax model ............................................................ 133 1. why litigation is an insufficient compliance mechanism .......................... 133 2. the excise tax as compliance mechanism ................................................ 134 3. the excise tax in practice .......................................................................... 135 d. the pre-aca position ....................................................................................... 137 v. the aca and the future of the irs’s role ......................................... 137 a. the irs as substantive rulemaker under the aca .......................................... 137 b. the irs as aca enforcer ................................................................................. 138 c. could we lessen the irs’s aca burden? ....................................................... 141 vi. conclusion ........................................................................................................ 142 2016] a partial defense of the irs as health care agency 125 i. introduction there is no doubt that the internal revenue service (“irs”) is overburdened and stretched thin, failing to provide even basic levels of responsiveness to taxpayers.1 yet despite a low level of resources, congress continues to add to the irs’s responsibilities in areas that appear far removed from the agency’s core revenue raising mission. a prominent example of this is the deep involvement of the irs in implementing the affordable care act (“aca”). while the irs’s involvement in aca implementation and administration has drawn attention to the fact that the irs is one of the primary regulators of employerprovided health care, this involvement is nothing new. it was, after all, favorable tax treatment of employer-provided health care that led to the employer-centric system we have today. the aca, however, greatly expands the administrative burden on the irs in this realm, to the extent that professor hickman in this issue questions whether health care regulation is something in which the irs should have any role. nina olson, the national taxpayer advocate, labeled aca administration one of the “most serious problems encountered by taxpayers” in 2014.2 even the chief justice appears skeptical of the role of the irs in aca administration, stating in king v. burwell that the irs “has no expertise in crafting health insurance policy.”3 this article wades into the debate concerning the proper scope of irs administration in a time of restricted resources and deep unpopularity for the irs. the article begins in part ii with a historical overview of how the irs became a chief regulator of employer-provided benefits. part iii examines how the passage of the employee retirement income security act of 1974 (“erisa”) created a joint authority model for federal regulation of employee benefits, with the irs and the department of labor sharing jurisdiction. the development of the irs as a substantive regulator of employer-provided health plans is explored in part iv, noting the distinction between the irs as a rulemaker versus the irs as an enforcer of those substantive rules. the article concludes in part v by detailing how the aca expands the irs’s authority and administrative burden in health plan regulation, concluding that, while there are sound reasons to continue to use the tax code to achieve health policy goals, there are also steps that can be taken to reduce the associated administrative burdens. ii. how treasury initially got into the employee benefits business for as long as there has been an internal revenue code, there have been tax provisions addressing the taxation of employer-provided benefits.4 initially, however, these provisions were limited to the taxability of pension trusts, and simply provided that amounts set aside in pension, profit sharing, or stock bonus plans would not be taxed until distribution, provided such plans were for the exclusive purpose of providing benefits to plan participants, and benefits could only be distributed in accordance with the terms of 1 see national taxpayer advocate, 2014 annual report to congress vii (2014) (noting, among other things, “a devastating erosion of taxpayer service”). 2 id. at 67. 3 king v. burwell, 135 s. ct. 2480, 2489 (2015). 4 see i.r.c. of 1939 § 165 (providing tax benefits to employer-sponsored retirement plans). section 165 in the 1939 code was the predecessor to § 401(a) in the current code. 126 columbia journal of tax law [vol.7:123 the plan. there were broadly stated nondiscrimination requirements,5 but nothing like the complex mathematical requirements that apply today. in addition, the code provided that employers could deduct contributions made to such trusts.6 the code was originally silent regarding any health or welfare benefits offered by employers. as of the 1939 code, then, the employee benefits provisions could be characterized as “pure tax” provisions. the code was simply codifying deferred compensation theory in delaying taxation until payment of benefits, while maintaining the employer’s compensation deduction when retirement plan contributions were made, rather than requiring such deduction to be delayed until benefit payout. other than a slight tax incentive to offer such plans, and a generally stated requirement that the plan be nondiscriminatory, there was no significant social engineering of employee benefits through the code, and very little required in the way of tax administration.7 the 1954 code marked the first appearance of tax provisions related to employerprovided health care. sections 105 and 106 were added to the code, excluding from gross income payments from employer-provided health plans that reimbursed medical expenses, as well as employer contributions to such plans.8 these code provisions codified a world war ii era revenue ruling that amounts paid by employers for employee health insurance did not constitute income to employees,9 which was subsequently reversed in 1953.10 congress disagreed with this result, permanently adding the exclusion to the code in 1954. this first appearance of health plan-related provisions could also be characterized as “pure tax.” it simply excluded two types of economic benefit from the definition of gross income and did not otherwise impose any substantive requirements on employer plans. nor did it attempt to engage in any significant social engineering, other than an incentive for employers to offer health benefits, however structured. as with early pension provisions, these health plan provisions imposed nearly no administrative burden on the irs. iii. the passage of erisa and the introduction of joint authority for employee benefits the passage of erisa dramatically expanded the role of treasury in regulating employee benefit plans. as described at the time of passage, “[erisa] adopts the most sweeping overhaul of pension and employee benefit rules in history. these new rules, which are both tax and non-tax in scope, will affect virtually every pension or other employee benefit plan, whether existent or future.”11 rather than simply contain rules related to the taxation of retirement plans, erisa amended the code to include substantive participation, vesting, and funding requirements for retirement plans, and placed dollar 5 the nondiscrimination requirements prohibited discrimination in favor of highly-compensated employees. such provisions were not in the 1939 code as originally enacted, but were added as amendments on oct 21, 1942 by session law 56 stat 798 (77th congress, 2nd session, ch. 619). 6 i.r.c. of 1939 § 23(p) (2015). 7 the greatest administrative burden imposed by the employee benefits tax provisions would likely have been enforcing the nondiscrimination requirements. however, employers had a duty to self-report their compliance with such provisions, leaving the irs only with the discretionary task of verifying such reports. see internal revenue service, form 4848 (1973), https://www.irs.gov/pub/irs-prior/f4848--1973.pdf [https:// perma.cc/85cq-wpxx] (illustrating the minimal reporting requirements related to pension plan nondiscrimination rules). 8see i.r.c. of 1954 §§ 105, 106 (2015). 9 david a. hyman & mark hall, two cheers for employment-based health insurance, 2 yale j. health pol’y l. & ethics 23, 25 (2001). 10 id. 11 commerce clearing house, inc., pension reform act of 1974 with explanation, preface (1974). 2016] a partial defense of the irs as health care agency 127 amount limits on contributions and deductions.12 the code was also amended to include an excise tax on certain violations of fiduciary duties.13 in addition to these tax changes, erisa contained extensive reporting and disclosure requirements, fiduciary requirements, and remedial provisions that were not included in the code amendments.14 erisa was squarely aimed at pension plans and, while employer health plans were subject to erisa and had to comply with its general requirements, erisa did not in any way substantively regulate employer-provided health plans. as a result, no health plan provisions were added to the code as part of erisa’s passage. erisa did, however, put in place the current regulatory system for employee benefits, which involves joint rulemaking and enforcement authority shared by the irs and labor.15 the statutory text of erisa provided for joint administration by treasury and labor, 16 but also assigned areas of “primary” responsibility.17 in the early years of implementation, this did not go well. as president carter declared, “erisa has been a symbol of unnecessarily complex government regulation.” 18 erisa’s administrative provisions “have resulted in bureaucratic confusion and have been justifiably criticized by employers and unions alike. the biggest problem has been overlapping jurisdictional authority.”19 in reorganization plan no. 4, president carter gave treasury sole authority for enforcing minimum participation, vesting, and funding standards for retirement plans, while granting labor authority to enforce fiduciary obligations.20 treasury, however, continued to have authority to audit plans and levy tax penalties, while labor continued to have authority to bring civil suits, thereby retaining “the special expertise of each department.”21 given the difficulties that resulted from joint authority, it is interesting to review why such an unusual structure was adopted in the first place. what motivated congress to explicitly create joint authority for two agencies over the administration of a single statute? the answer, it appears, lies not in any special theory of agency administration, but rather in turf wars between congressional committees. as explained by one participant in erisa’s legislative journey, “there is almost nothing more sacred in congress than committee jurisdiction. if one committee encroaches on the jurisdiction of another, there is bound to be a great deal of pushback, sometimes very severe pushback. this is what happened in spades with erisa. much of the story of erisa's passage necessarily becomes the story of the clash between the tax and labor committees and how that was resolved.”22 joint treasury and labor authority was necessary in order to secure passage 12 see, e.g., i.r.c. §§ 401(a)(3); 404(a)(3)(a); 415(a), (b) (2015). 13 see i.r.c. §§ 4975(a), 4975(c)(1)(e) (2015). 14 see 29 u.s.c. §§ 1001 et seq. (2015). 15 erisa created the office of assistant commissioner, employee plans and exempt organizations within the internal revenue service. see commerce clearing house, inc., supra note 11, at 904. 16 employee retirement income security act of 1974, pub. l. 93-406, § 3004. 17 for example, primary administrative responsibility for participation, vesting, and funding provisions was assigned to the irs. commerce clearing house, inc., supra note 11, at 901. the irs was also granted authority to audit qualified plans. id. at 902. 18 reorganization plan no. 4 of 1978, 5 u.s.c. app. (2006). 19 id. 20 id. 21 id. 22 panel 2: making sausage – the ninety-third congress and erisa, 6 drexel l. rev. 291, 300 (2014). 128 columbia journal of tax law [vol.7:123 of erisa because neither committee nor agency was willing to give up jurisdiction over pensions. joint administration was the result of “interagency jealousy.”23 following passage of erisa, some saw joint administration as a positive, based on the belief that the department of labor should not be left to enforce erisa given its closeness with organized labor.24 in other words, there was a belief that treasury would be a more neutral enforcer than labor. however, this was considered to be a positive side effect of the joint administrative structure, not a motivation for the structure’s creation. while the reasons behind the creation of the joint administrative structure of erisa are not noble, scholars have put forth a variety of arguments concerning the benefits of this increasingly common regulatory structure. professors freeman and rossi have declared interagency coordination as “one of the central challenges of modern governance.” 25 one straightforward defense of multiple-agency jurisdiction is that complex policy problems can benefit from the “unique expertise and competencies of different agencies.”26 when we consider the irs and labor, this argument has some appeal. while labor may be well-suited to tasks that touch on the interactions between employers and employees, the irs may be better suited for highly technical tasks. another argument put forward is that shared jurisdiction acts as a check on agency behavior, by reducing the risk of a single agency being captured by regulated parties.27 iv. pre-aca substantive health plan regulation through excise taxes while erisa brought the irs firmly into the business of employee benefits, that work was almost exclusively concerned with traditional, defined-benefit pension plans. the only code provisions concerned with health plans were the uncomplicated sections 105 and 106.28 this relatively simple approach to the taxation of employer-sponsored health plans began to change in the 1980s, when substantive requirements for group health plans were first included in the code. prior to the enactment of the aca, there were three major health plan-related additions to the code that meaningfully expanded the irs’s role in health regulation.29 the first of these substantive requirements was passed as part of the consolidated omnibus 23 id. at 304. 24 panel 3: negotiating the agency peace treaty: reorganization plan no. 4, 6 drexel l. rev. 319, 324 (2014). 25 jody freeman & jim rossi, agency coordination in shared regulatory space, 125 harv. l. rev. 1131, 1134 (2012). 26 id. at 1142. 27 id. at 1142-43. 28 section 105 did become slightly more complicated when paragraph (h) was added as part of 1978 revenue act, pub. l. 95-600 § 366, which taxes discriminatory health benefits provided to highlycompensated employees. 29 i omit from this article any discussion of section 89 of the code, which was added to the code as part of the 1986 tax reform act. section 89 imposed non-discrimination requirements on employer provided health plans, similar to the requirements imposed on retirement plans, and for similar reasons. for plans that were considered discriminatory under section 89, highly-compensated employees covered by such plans had to include in gross income the amount of the discriminatory benefit. given the significant cost of the tax expenditure for employer-provided health plans, congress was attempting to ensure that the tax benefit was not concentrated among highly-compensated individuals. section 89, however, was not longlived. it was repealed in 1989 following significant backlash against its complexity and administrative impracticability. for further information on section 89’s history, see rosina b. barker, lessons from a legislative disaster, 47 tax notes 843 (1990), http://www.ipbtax.com/assets/pdf/publication_129.pdf. 2016] a partial defense of the irs as health care agency 129 budget reconciliation act of 1985 (cobra).30 cobra gave participants the right to continue their employer-provided group coverage for a limited period of time if such coverage was terminated as a result of a “qualifying event.”31 these provisions were codified in the code, erisa,32 and the public health services act (“phsa”).33 cobra, then, followed the basic structure established by erisa in that both treasury and labor remained involved in the regulation of employee benefits. the department of health & human services (“hhs”) was added to the legislative scheme in order to bring state and local government plans within cobra’s reach, as erisa does not apply to such plans. while three agencies were involved in administering virtually identical statutory provisions, cobra was silent as to how this joint administration was to operate in practice. as a result, the agencies relied on a conference committee report, which stated that rulemaking authority would be split, with labor authorized to issue regulations implementing the notice and disclosure requirements of cobra, and the irs authorized to issue regulations defining the required continuation coverage.34 hhs was not granted independent authority to interpret cobra, instead being ordered to conform its implementing regulations to those promulgated by labor and treasury.35 cobra does, however, contain separate enforcement provisions. on the tax side, the code originally denied a deduction to employers for their group health plan contributions if they failed to comply with cobra.36 shortly after passage, however, the penalty for noncompliance with cobra’s requirements was changed to an excise tax payable by the employer of $100 per day per affected individual.37 on the erisa side, labor has the ability to enforce cobra by bringing a civil suit against a non-complying employer, which may include a penalty of up to $100 per day for each affected beneficiary or participant.38 affected individuals may also bring civil suit under erisa and seek the same remedies.39 finally, individuals in state and local government plans are authorized to file civil suits for cobra noncompliance under the phsa.40 the second major addition to the code’s regulation of employer-provided health plans was the medicare as secondary payer (msp) rules.41 these rules regulate whether an employer plan or medicare pays first in the case of individuals covered by both, a rule that has significant financial consequences for both the medicare program and employer plans. the rules generally provide for the employer plan to pay first, thereby saving the medicare program money. these substantive provisions were codified in the social security act,42 while the code was amended to provide for an excise tax on non-complying employers equal to 25% of a non-complying employer’s group health plan expenses in the 30 consolidated omnibus budget reconciliation act of 1985 (cobra), pub. l. 99-272, 100 stat. 82 (1986). 31 i.r.c. § 4980b (2015). 32 cobra, pub. l. 99-272 § 10002. 33 id. § 10003. 34 h.r. conf. rep. no. 99-453, 99th cong., 1st sess., at 562-63 (1985). 35 id. at 563. 36 cobra § 10001(a). 37 i.r.c. § 4980b(b) (2015). 38 erisa § 502(a) (authorizing civil suits by participants or the department of labor) and §502(c)(1) (authorizing courts to award up to $100 per individual per day, along with other relief the court deems proper). 39 erisa § 502(a). 40 cobra § 10003 (adding § 2207 to the phsa). 41 omnibus budget reconciliation act of 1986, pub. l. 99-509 § 9319. 42 id. § 9319(a). 130 columbia journal of tax law [vol.7:123 relevant year.43 unlike cobra, which involved shared rulemaking and enforcement authority among three agencies, the msp rules followed a simpler model. because the msp rules are primarily a cost-saving device for medicare, the department of health & human services, specifically the centers for medicare & medicaid services (cms), is responsible for rulemaking and primary enforcement, with cms informing the irs when the excise tax may be due.44 this structure can be characterized as “split authority,” rather than the overlapping jurisdiction model we see in other areas of employee benefit regulation. the third and final regulation of health plans through the code came with the passage of the health insurance portability and accountability act of 1996 (“hipaa”).45 hipaa was a significant piece of legislation that regulated many aspects of health plans and health insurers. from an employer health plan perspective, the major changes made by hipaa were: (1) limiting the ability of employers to exclude pre-existing conditions from their plans, (2) prohibiting employer plans from discriminating on the basis of health status with respect to eligibility, premiums, and benefits, (3) requiring plans to cover minimum hospital stays following childbirth, and (4) requiring plans that covered mental health treatment and services to do so on parity with other medical services.46 as with cobra, hipaa was codified in three different statutes: the code, erisa, and the phsa.47 unlike cobra, however, hipaa contained an explicit statutory provision requiring the three agencies to cooperate in rulemaking and enforcement: sec. 104. assuring coordination. the secretary of the treasury, the secretary of health and human services, and the secretary of labor shall ensure, through the execution of an interagency memorandum of understanding among such secretaries, that— (1) regulations, rulings, and interpretations issued by such secretaries relating to the same matter over which two or more such secretaries have responsibility under this subtitle (and the amendments made by this subtitle and section 401) are administered so as to have the same effect at all times; and 43 id. § 9319(d)(1) (adding § 5000 to the i.r.c.). 44 as the cms enforcement manual explains: if cms central office determines that a plan has been a nonconforming [group health plan] in a particular year, it refers its determination, including the identity of the contributors that it has identified, to the irs, but only after the parties have exhausted all appeal rights with respect to the determination. section 5000 of the internal revenue code of 1986 imposes an excise tax penalty on employers and employee organizations that contribute to nonconforming ghps. they are taxed 25 percent of the employer's or employee organization's expenses incurred during the calendar year for each [group health plan] (conforming as well as nonconforming) to which they contribute. this tax penalty does not apply to federal and other governmental employers. the irs administers section 5000 of the irc, which imposes the tax on employers (other than governmental entities) or employee organizations that contribute to a nonconforming [group health plan] mentioned in § 80. centers for medicare and medicaid services, medicare secondary payer (msp) manual 36 (2014), https://www.cms.gov/regulations-and-guidance/guidance/manuals/downloads/msp105c01.pdf. 45 health insurance portability and accountability act of 1996 (hipaa), pub. l. 104-191, 110 stat. 1936 (codified as amended in scattered sections of the u.s. code). 46 id. § 101 (adding §§ 701 et seq. to erisa). 47 see generally hipaa, pub. l. 104-191 (1996). 2016] a partial defense of the irs as health care agency 131 (2) coordination of policies relating to enforcing the same requirements through such secretaries in order to have a coordinated enforcement strategy that avoids duplication of enforcement efforts and assigns priorities in enforcement.48 the relevant departments entered into the required memorandum of understanding (mou) in 1999, three years after the passage of hipaa.49 the process described in the mou is one of ongoing collaboration. each department assigns a representative to “work closely to ensure that all interpretations, regulations and enforcement strategies related to shared provisions [of hipaa] will be developed and implemented in a coordinated manner.”50 this “coordinating committee” is required to meet quarterly (or at other times as they mutually agree) to discuss pending interpretative guidance.51 the mou sets a 45day period to attempt to reach consensus, although it does not spell out what happens in the event that such consensus is not achieved.52 while there is little publicly available information regarding how the joint rulemaking structure has operated in practice, rulemaking under hipaa has historically been slow, with officials attributing delays to both the complexity of the statute as well as “the protracted nature of developing policy and rules when multiple federal agencies are involved and the complexity of the statutory provisions.”53 while both the statute and the mou require some degree of coordination with respect to enforcement, it is important to note that different enforcement tools are available to the various agencies. as with cobra, the irs’s sole enforcement tool is the imposition of an excise tax of $100 per day per affected individual during the period of noncompliance.54 affected individuals may bring civil lawsuits under erisa to enforce hipaa,55 although there is no monetary fine prescribed by the statute. the department of labor is not granted authority to commence civil action against a hipaa non-complying employer; only individuals may commence such actions.56 hhs, which has authority over health insurers and nonfederal governmental plans with respect to hipaa, may impose a civil monetary penalty on non-complying health insurers.57 hipaa specifically requires treasury, labor and hhs to coordinate enforcement activities, and the mou discussed above lays out the basic framework for such coordination in a highly generalized manner. the mou provides that the departments will coordinate, share information, and develop a “written operational agreement” that can address various enumerated enforcement topics.58 the only specific requirement in the mou with respect to enforcement is that the departments are required to notify each other in writing prior to commencing any 48 42 u.s.c.a. § 300gg-92 note (2015). 49 notice of signing of a memorandum of understanding among the department of the treasury, the department of labor, and the department of health and human services, 64 fed. reg. 70164 (dec. 15, 1999) [hereinafter “hipaa mou”]. 50 id. at 70165. 51 id. 52 id. 53 u.s. gen. accounting office, implementation of hipaa: progress slow in enforcing federal standards in nonconforming states 15-16 (2000). 54 i.r.c. § 4980d(b) (2012). 55 erisa § 502(a)(1). 56 id.; hipaa mou, supra note 49, at 70165. 57 42 u.s.c. § 300gg-22 (2012). 58 hipaa mou, supra note 49, at 70166. 132 columbia journal of tax law [vol.7:123 administrative or judicial proceeding on hipaa matters within the shared regulatory space.59 a. the irs as health plan rulemaker the three pieces of legislation described above were significant additions to the irs’s role in employer health plan regulation, involving both rulemaking tasks and enforcement tasks. with respect to rulemaking, however, congress initially appeared interested in shielding the irs from significant substantive involvement. the irs was given just a single piece of cobra rulemaking: the task of defining the required continuation coverage. while the irs cobra regulations are extensive, they do not force the irs to stray too far from typical tax administration. for example, the regulations involve topics such as how corporate transactions affect cobra rights,60 how to count employees,61 how to identify the “employer”62 and how to calculate plan costs,63 all topics that are comfortably within the expertise of the irs. yet irs responsibility for cobra did begin to push the irs into the health policy arena. for example, the irs defined in regulations the meaning of “health care” and issued regulations outlining the interaction between cobra and participant rights under the federal family and medical leave act.64 the irs was completely shielded from any responsibility for msp rulemaking (leaving them only to collect penalties for noncompliance). with hipaa, the irs was given a greatly expanded role in substantive health plan rulemaking (on paper, at least). the irs was given an equal role at the table with labor and hhs when it came to any rulemaking that involved employer-provided coverage, and jointly promulgated regulations that had a significant health policy impact.65 in this way, hipaa looks like a tipping point at which the irs really became a health policy agency. what is unclear, however, is what exactly the role of the irs was in developing these health policy regulations: which agency, if any, took the lead in formulating the regulations, what the actual administrative burden was on the irs, and what internal expertise, if any, the irs subsequently developed in the health policy arena. b. the irs as health plan enforcer the sole method for the irs to enforce the health plan provisions contained in the code is through the imposition of an excise tax. an excise tax can be imposed through one of two methods: (1) self-reporting by the tax payer, or (2) direct assessment by the irs, typically accomplished through audit or third-party reporting. the irs’s enforcement of cobra’s requirements has been historically almost non-existent.66 until 2010, employers did not even have a duty to self-report cobra violations and pay the excise tax.67 even worse, the dual enforcement structure shared between the irs and labor appears to confuse individuals about where they should go for help. a 1990 gao report found that thousands of individuals contacted the irs about 59 id. 60 treas. reg. § 54.4980b-9 (2012). 61 treas. reg. § 54.4980b-2 (2012). 62 id. 63 treas. reg. § 54.4980b-8 (2012). 64 treas. reg. § 54.4980b-10 (2012). 65 treas. reg. §§ 54.9801-1 to 54.9801-3, 54.9811-1 (2012); i.r.c. § 9812 (2012). 66 u.s. gen. accounting office, improvements needed in enforcing health insurance continuation requirements 5 (1990) (noting one completed examination of a potential cobra violation). 67 74 fed. reg. 45,994 (sept. 8, 2009). 2016] a partial defense of the irs as health care agency 133 cobra rights and violations but, because the code does not provide individuals with a right of action, such individuals were simply referred to labor. while it is unknown how many of those individuals subsequently followed up with labor, irs very rarely examined the employers of individuals who made inquiries.68 there is no publicly available data regarding how many employers have self-reported the excise tax, how many employers have been sanctioned on audit, nor how much revenue the excise tax has raised. with respect to hipaa compliance, the irs takes an explicitly passive role, relying solely on “voluntary employer compliance” and referrals from the department of labor.69 until 2010, however, there was no obligation for noncomplying employers to self-report the excise tax.70 as of 2001, treasury officials told the gao that “they did not believe the agency has assessed, nor has any employer voluntarily paid, an excise tax associated with noncompliance.”71 msp excise tax compliance appears better organized. while there is no requirement for noncomplying taxpayers to self-report the msp excise tax, cms has a robust enforcement regime in place, and it has a procedure in place for referring employers that fail to satisfy cms’s msp demands for compliance within a specific timeframe to treasury for imposition of the excise tax.72 there is no publicly available information regarding the number or such referrals, or the frequency or amount of any excise tax paid as a result. the health plan-related excise taxes, then, do not appear to place a significant administrative burden on the irs. c. making sense of the excise tax model the story thus far presents a rather nonsensical role for the irs in the substantive regulation of group health plans. the irs has been given what should be a very powerful enforcement mechanism, yet available data suggest that it is not used. while this is positive from an irs resource perspective, it raises legitimate questions regarding whether these provisions should be in the code in the first place. as this section will describe, however, the excise tax might not need to be enforced in order to achieve its goals. 1. why litigation is an insufficient compliance mechanism before the passage of the aca, each of the health plan provisions that was added to the code was also contained elsewhere in federal law and had litigation-based remedies available to harmed individuals under those provisions. why, then, might congress desire to add the additional layer of enforcement through an excise tax? the answer lies in the fact that excise taxes (at least in the health plan context) are not designed to raise revenue. 68 u.s. gen. accounting office, supra note 66, at 5. 69 u.s. gen. accounting office, private health insurance: federal role in enforcing new standards continues to evolve 11 (2001) [hereinafter “hipaa gao report”]. in practice, hhs appeared to be overburdened by its hipaa enforcement activities, and therefore struggled to effectively enforce hipaa’s requirements. labor, at least in the early years, relied largely on consumer complaints to identify noncompliance. a random sample of employer hipaa compliance by labor, conducted in 1999, revealed a 21% noncompliance rate for certain hipaa standards—although the dol characterized many of the violations as “technical” in nature. where dol discovered violations, it worked with the employer to voluntarily correct the default and had not (as of 2001) initiated any legal action to force compliance. id. at 10-11. 70 74 fed. reg. 45,994 (sept. 8, 2009). 71 hipaa gao report, supra note 69, at 11. 72see ctr. for medicare & medicaid serv., group health plan recovery, https://www.cms.gov /medicare/coordination-of-benefits-and-recovery/coordination-of-benefits-and-recovery-overview /group-health-plan-recovery/group-health-plan-recovery.html, for an overview of the cms enforcement process and referrals to treasury. 134 columbia journal of tax law [vol.7:123 they are designed to strongly encourage ex ante compliance. for the reasons explained below, litigation does not have the same compliance effect. participants who are harmed by a lack of health plan compliance may seek redress in state or federal court.73 because such lawsuits are brought under erisa, remedies would typically be limited to requiring the plan to cover the required service or otherwise comply with the legal requirements and to potentially pay the plaintiff’s attorneys’ fees, along with interest if applicable. punitive damages are not available to erisa litigants.74 it is likely that there will be relatively few participant lawsuits seeking to enforce group health plan requirements because of the limited remedies, barriers caused by a lack of knowledge of highly complex legal requirements, lack of easy access to legal services, and a disinclination to sue one’s employer. in addition to participant lawsuits, however, the department of labor has investigative authority that enables it to work with employers to voluntarily remedy any compliance defects that it discovers.75 the department of labor may also commence a civil action against a non-complying employer, although the remedies available are highly limited.76 as a result, the threat of department of labor action, either on audit or through civil lawsuits, is similarly unlikely to create a significant compliance incentive. the bottom line is that while litigation may serve an important remedial function for harmed participants, it is likely to have little ex ante compliance effect. lawsuits and department of labor action are neither frequent nor costly enough to be effective in making the cost-benefit analysis favor compliance over noncompliance.77 2. the excise tax as compliance mechanism while we normally rely on the cost-benefit analysis associated with potential litigation to create the optimal level of legal compliance, 78 erisa’s highly limited remedial provisions prevent this from occurring in the employer health plan context. excise taxes, however, have the potential to significantly change the cost-benefit analysis to one that strongly favors compliance. excise taxes occupy an unusual role in the federal tax system. they are not typically based on any theory of ideal taxation, nor do they have as their primary goal the raising of revenue. rather, they are almost always devised to discourage behavior that congress deems to be undesirable.79 excise taxes, it should be noted, provide a specific type of deterrence that is otherwise hard to achieve within the tax system. the most common method that is used in the code to discourage certain behavior is to deny a 73 erisa § 502. 74 mass. mut. life ins. v. russell, 473 u.s. 134 (1985). 75 erisa § 502. 76 id. 77 this is not to suggest that employers are relying solely on a cost-benefit analysis when deciding whether to comply with the law. many other forces are clearly at play. see, e.g., robert cooter, do good laws make good citizens? an economic analysis of internalized norms, 86 va. l. rev. 1577 (2000); cass r. sunstein, social norms and social roles, 96 colum. l. rev. 903 (1996). 78 see gary s. becker, crime and punishment: an economic approach, 76 j. pol. econ. 169 (1968); a. mitchell polinsky & steven shavell, punitive damages: an economic analysis, 111 harv. l. rev. 869, 887-96 (1998). 79 for example, the irs has explicitly stated that cobra excise tax is “designed as a deterrent against noncompliance.” internal revenue serv., audit techniques and tax law to examine cobra cases (continuation of employee health care coverage), http://www.irs.gov/businesses/smallbusinesses-&-self-employed/audit-techniques-and-tax-law-to-examine-cobra-cases-continuation-ofemployee-health-care-coverage. 2016] a partial defense of the irs as health care agency 135 deduction for an expense associated with the behavior. for example, the code denies a deduction for bribes and kickbacks paid by a business, even though they might otherwise be permitted under the general deduction for business expenses.80 in fact, when cobra was first added to the code, noncomplying businesses would lose their deduction for group health plan expenses, rather than face an excise tax. but the loss of a deduction is imperfect in its compliance effect because the value of a lost deduction can vary significantly with the employer’s effective tax rate.81 a lost deduction might be a strong deterrent for some taxpayers, yet have no effect on taxpayers who have little to no tax liability. in addition, lost deductions are not highly visible to taxpayers, because they are simply folded into the general income tax calculation. an excise tax solves both of these problems by applying uniformly across taxpayers and with high visibility. as a result, excise taxes should factor into the cost-benefit analysis of all taxpayers, thereby improving front-end compliance. excise taxes are in fact a form of “announced” penalty for certain behaviors.82 they are very similar to statutorily specified damages, but instead of being enforced through the courts, they are enforced by the irs. because excise taxes are due regardless of participant harm or participant legal action, they can be thought of as a type of precommitment device with respect to compliance.83 indeed, if the excise tax is set high enough, it should function to deter nearly all violations of a legal rule.84 its effect can be to “front-load” compliance so that further remedies are unnecessary.85 as professor bray summarizes this compliance function of high, announced penalties, “[t]he law is announcing in terrorem.”86 while there is a strong case to favor the use of high, fixed penalties in order to achieve compliance, it is not obvious that the best or only way to do so is through excise taxes. for example, cobra gives the department of labor the ability to file suit in the event of noncompliance and seek a monetary penalty of up to $100 per day. however, this provision is unlikely to have the same effect as an excise tax because it both requires litigation and it is discretionary in amount, in contrast to an excise tax. theoretically, however, congress could remedy both of these defects and give the department of labor the authority to impose a civil monetary fine equal to the excise tax through administrative procedures. interestingly, congress appears to have favored irs enforcement in this area because the irs is viewed as much more fearsome than labor, particularly given labor’s close historic ties to organized labor.87 so while other agencies could be given the ability to impose high, fixed penalties for noncompliance, the compliance effect might not be as great as the imposition of these penalties by the irs. 3. the excise tax in practice 80 i.r.c. § 162(c) (2012). 81 see john d. colombo, paying for sins of the master: an analysis of the tax effects of pension plan disqualification and a proposal for reform, 34 ariz. l. rev. 53, 84 (1992) (referring to excise taxes as the “obvious choice for a targeted deterrent sanction”). see also internal revenue service commissioner’s penalty study, report on civil tax penalties ix-16 (1989) (noting that excise taxes “generally have been effective” as deterrents). 82 see generally samuel l. bray, announcing remedies, 97 cornell l. rev. 753 (2012) (discussing the term in the context of civil remedies). 83 id. at 781. 84 id. at 784-85. 85 id. at 785. 86 id. 87 panel 3: negotiating the agency peace treaty: reorganization plan no. 4, 6 drexel l. rev. 319, 324, 335 (2014). 136 columbia journal of tax law [vol.7:123 on a theoretical level, then, there is much to support the excise tax model as a compliance mechanism. given current irs funding levels and resources, however, it is not clear that the excise tax will actually achieve its goals. if it becomes apparent to employers that the threat of excise tax enforcement is empty, it may have little effect. but this is speculation; the mere threat of outsized excise tax penalties may be enough to force compliance, even if regulated parties believe the probability of being caught is low. it seems reasonable to believe that the success of excise taxes in ensuring frontend compliance will depend both on actual enforcement and on perceptions of enforcement by regulated parties. publicly available information, however, suggests that there is very little enforcement of the excise tax provisions. until 2010, there was not even an affirmative obligation for taxpayers to self-report either the cobraor hipaa-related excise taxes, decades after the statutes became law,88 and available information suggests that the irs does little to no independent enforcement of these provisions. the good news from an irs resource perspective is that these excise taxes appear to require little to no effort with respect to enforcement (in contrast to rulemaking), but that raises the question of whether unenforced excise taxes have the compliance effect theorized above. usually, tax compliance is concerned with whether taxpayers voluntarily report their tax due accurately. compliance is different in the case of the excise taxes. the compliance we are concerned with is not what is reported on a tax return (indeed, as noted above, there were no requirements to self-report any of the health plan-related excise taxes until 2010), but rather whether the excise taxes result in employers complying with the underlying health plan regulations. nevertheless, there is likely still something to be learned from the tax compliance literature. there are two general theories regarding tax compliance: (1) taxpayers comply with tax laws because they engage in a cost-benefit analysis of compliance versus noncompliance, and find compliance to be the least costly, and (2) taxpayers comply with tax laws in order to conform to personal or social norms.89 applying these compliance theories to excise taxes, we can guess that both contribute to compliance with the substantive health plan rules. with respect to the costbenefit theory of tax compliance, a large penalty, even if rarely enforced, is likely to have the same deterrence effect as a smaller penalty more consistently enforced. and the excise taxes at issue here are large indeed. recall that most are $100 per day per participant. in general, it would be highly unlikely that noncompliance would occur for only a short period of time, as the structure of health plans does not frequently change (typically no more than once per year). an employer with 50 employees, who failed to comply with a group health plan requirement for a single year, would face a potential excise tax of $1.825 million. a large, national retailer with 125,000 employees would face a potential excise tax of $3.65 billion. even if the perceived probability of enforcement is incredibly low, it is not hard to imagine that the cost-benefit analysis for employers of all sizes favors compliance. on top of the cost-benefit analysis, it also appears to be the case that many taxpayers will comply with the law out of adherence to social norms. as a result, while we have no hard data on this issue, it appears likely that the excise tax strongly encourages front-end compliance even with very low levels of enforcement. from both an irs 88 74 fed. reg. 45994 (promulgating treas. reg. § 54.6011-2). 89 see michael doran, tax penalties and tax compliance, 46 harv. j. on legis. 111, 124-38 (2009); alex raskolnikov, revealing choices: using taxpayer choice to target tax enforcement, 109 colum. l. rev. 689, 694-710 (2009). 2016] a partial defense of the irs as health care agency 137 resources and compliance perspective, then, the excise taxes appear to be a worthwhile addition to the code. d. the pre-aca position prior to the aca’s enactment, the irs was already firmly entrenched in the business of employer health plan regulation. while the reasons behind that involvement may have been less than compelling, the use of the excise tax as a compliance mechanism appears sound. excise taxes should greatly improve front-end compliance with rules that might otherwise be too easy to ignore, and, even better given current irs resources, can achieve their goals with relatively little investment by the government. the irs’s substantive health plan rulemaking is more troubling, but closer examination reveals that such rulemaking often involves tasks comfortably within the irs’s expertise, and that shared rulemaking authority may have placed little burden on the irs if, as one would expect, agencies with greater substantive expertise took the lead in drafting such rules. v. the aca and the future of the irs’s role the aca continues the pattern of the irs’s involvement in the substantive regulation of employer-provided health plans. along with labor and hhs, the irs will be significantly involved in administering the aca’s individual mandate, employer mandate, premium tax credit, excise tax on high-cost employer plans, and substantive group health plan requirements. the role of the irs in both rulemaking and enforcement around these aca requirements is explored in more detail below. a. the irs as substantive rulemaker under the aca the scope of the aca is vast, and the corresponding rulemaking required to implement the law is similarly staggering.90 one of the best known tax provisions in the aca is the so-called individual mandate. the individual mandate imposes a financial penalty on uninsured individuals who have affordable health insurance available to them.91 because this provision is contained exclusively in the code, the irs has primary rulemaking authority. the rulemaking authority is not, however, exclusive. hhs has the authority to determine which individuals qualify for hardship exceptions to the individual mandate,92 and hhs and treasury are required to coordinate efforts to further define what “other coverage” might satisfy the individual mandate requirements.93 a similar rulemaking structure is used with respect to the employer mandate penalty, which is also contained exclusively in the code.94 while the irs has primary rulemaking authority, labor is relied on to define a “seasonal worker” for purposes of the penalty,95 and labor and irs together must define “hours of service” for purposes of determining who is a full-time employee for purposes of the penalty.96 the premium tax credit falls almost entirely within the irs’s authority, although the statute gives hhs the authority to determine which part of the premium, if any, is attributable to state-required benefits that are not permitted to be included for purposes of 90 see curtis w. copeland, cong. research serv., r41180, rulemaking requirements and authorities in the patient protection and affordable care act (ppaca) 1-2 (2011), http://perma.cc/xb5ktjjs, for an overview of the regulatory tasks involved in aca implementation. 91 i.r.c. § 5000a. 92 i.r.c. § 5000a(e)(5). 93 i.r.c. § 5000a(f)(1)(e). 94 ppaca § 1513 (adding § 4980h to the i.r.c.). 95 i.r.c. § 4980h(c)(2)(b)(ii). 96 i.r.c. § 4980h(c)(4)(b). 138 columbia journal of tax law [vol.7:123 the premium tax credit calculation.97 in addition, the statute instructs the irs and hhs to cooperate regarding necessary regulations on family size and household income for purposes of the premium tax credits.98 the excise tax on high-cost employer plans, known colloquially as the “cadillac tax,” falls entirely within the irs’s rulemaking authority.99 the most significant rulemaking burden imposed on the irs by the aca may be the oft-overlooked section 9815. section 9815 incorporates into the code all of the aca’s group health plan requirements that were added to the phsa. these include at least twenty substantive requirements,100 and were also codified in section 715 of erisa. plans that fail to comply with the group health plan requirements are subject to the $100 per participant per day excise tax in section 4980d. this tri-statute amendment scheme mirrors hipaa’s structure, and was presumably based on the same rationale. amending both the phsa and erisa is necessary to cover all group health plans, because erisa does not apply to governmental or church plans, and amending the code through the addition of an excise tax is an important tool to encourage front-end compliance. the result of codifying the requirements in three statutes is that all three agencies have a role in rulemaking. while the aca does not contain any specific requirement for coordinated rulemaking for the group health plan requirements, the mou the departments signed to coordinate hipaa rulemaking and enforcement was also intended by the departments to apply to any future federal legislation “concerning health care which result in two or more . . . departments having shared jurisdiction.”101 the three agencies have in fact been following the mou coordination provisions, effectively giving the three agencies an equal role in the regulatory process, given the requirement to reach a consensus. imposing such a rulemaking burden on the irs, however, is difficult to justify. the group health plan requirements are far removed from nearly any traditional tax issues or concerns,102 and may be well outside the competence of even those in the employee benefits division of the irs. the substantive group health plan requirements include detailed provisions regarding what treatments and services a plan must cover, how plans can impose cost-sharing for those services, and how coverage can be priced, among many others. perhaps the most well-known of these provisions is the requirement that group health plans cover preventive health services. preventive health services were defined to include contraception, which some private employers objected to on religious grounds, resulting in the hobby lobby litigation.103 the irs, as a result of the hobby lobby decision, helped draft a solution that both provided the required contraceptives to employees, but did not interfere with a closely-held private firm’s religious beliefs. it is hard to imagine a task that is further removed from the core tasks of a revenue agency. of course, the overlapping jurisdiction model makes it difficult to determine exactly what role the irs played in drafting these regulations. b. the irs as aca enforcer 97 i.r.c. § 36b(b)(3)(d)(ii). 98 i.r.c. § 36b(e)(3). 99 see generally i.r.c. § 4980i. 100 see patient protection and affordable care act, pub. l. no. 111-148, § 1001 (2010) (adding §§ 2711-2719a to the phsa). 101 hipaa mou, supra note 49, at 70164-65. 102 the one exception to this statement is the provision in section 2716 of the phsa that prohibits discrimination in favor of highly compensated employees. while not necessarily a traditional tax provision, it is a well-established concept within the employee benefits tax community. 103 burwell v. hobby lobby stores, inc., 134 s. ct. 2751 (2014). 2016] a partial defense of the irs as health care agency 139 prior to the aca, irs enforcement of group health plan regulations was accomplished through imposition of an excise tax on non-compliant plans. the aca continues to build on this model, but it also moves irs enforcement into new areas. several of the major tax provisions in the aca are non-excise taxes, including the individual mandate penalty and the employer mandate penalty. in terms of enforcement, these non-excise taxes fit relatively easily into the existing structure of our tax system. they require individual taxpayers to self-report and pay any tax due as a result of failing to purchase affordable health insurance and require large employers to self-report and pay any tax due as a result of failing to offer employees affordable health insurance coverage. while tax forms need to be modified accordingly, these taxes look and feel like many others already in our system. and in terms of how the irs ensures compliance with these provisions, the standard auditing mechanism can easily be utilized, requiring few extra resources. individual mandate enforcement does, however, play by slightly different rules. the statute specifies that the individual mandate tax shall be treated as an “assessable penalty under subchapter b of chapter 68.”104 however, the code specifies that the irs may not utilize liens or levies where there has been a failure to pay the individual mandate tax due.105 the employer mandate follows the same “assessable penalty” treatment,106 although there is no limitation of liens or levies in its provisions. the premium tax credits are not “enforced” in the way that we typically think of enforcement, and therefore do not result in typical enforcement costs. instead, it is more helpful to think of premium tax credits as requiring administration. here we see a significant burden being placed on irs resources. while the irs is no stranger to administering tax credits, the structure of the premium tax credits is highly unique because the credit is advanceable. tax credits are normally administered through the standard tax return filing process. when tax payers file their return for a given year, they will claim any applicable credits on their return and the amount of the tax they owe will be correspondingly reduced. while this works well for many types of credits, there was concern that requiring taxpayers to wait until the end of the year (when they filed their tax returns) to receive the benefit of the premium tax credit would defeat the purpose of providing the cash flow necessary to pay for health insurance for that year. those who are eligible to receive premium tax credits do not often have the ability to pay the cost of health insurance upfront and then wait a year or more for reimbursement through the tax filing process. as a result, the aca allows individuals to receive an advance of the premium tax credit, using a best estimate of eligibility.107 individuals who apply for coverage through an exchange are screened for tax credit eligibility. 108 the irs shares data with the exchanges to verify income from the most recently available year.109 the exchange then informs the irs of the estimated tax credit, and the irs pays the relevant insurance companies directly on the individual’s behalf.110 when that individual files her tax return for the year, the premium tax credit will be reconciled based on the actual amount of that 104 i.r.c. § 5000a(g) (2010). pursuant to i.r.c. § 6671 (2012), assessable penalties are “assessed and collected in the same manner as taxes.” 105 i.r.c. § 5000a(g) (2010). this provision was likely included for policy reasons. politicians may not have wanted individuals who failed to purchase health insurance to be subject to the full array of irs enforcement in the event they failed to pay the mandate penalty. 106 i.r.c. § 4980h(d)(1) (2003). 107 42 u.s.c. § 18082 (2011). 108 42 u.s.c. § 18081 (2011). 109 id. 110 42 u.s.c. §§ 18081-18082 (2011). 140 columbia journal of tax law [vol.7:123 individual’s household income, compared to the estimate on which the advanced credit was based.111 if additional credit amounts are due, those will be credited to the taxpayer and will either reduce the tax that is owed or be refunded.112 if the advanced credit was larger than the taxpayer was actually entitled to, the taxpayer may be required to repay the excess amount. 113 the administrative burden of estimating and reconciling tax credits is significant and has both confused and angered taxpayers.114 while it may make sense to administer widespread financial subsidies through the code, the complex system of advancing and reconciling tax credits imposes a serious burden on the irs, not only in terms of workload, but also with respect to the reputation of the irs.115 the cadillac tax is an excise tax, although it differs in key respects from the type of excise tax we typically see in the health plan context. first, the amount of the excise tax is calculated in a different manner than the typical $100 per day per individual. instead, the tax is equal to 40% of the cost of employer-provided health care coverage above a certain dollar threshold that can vary based on an individual’s age, type of profession, or union status.116 as a result, it is much harder to determine easily, and in advance, how much would be due. in addition, the tax is spread among all health plan providers, which may include multiple taxpayers, such as the employer, and one or more health insurers.117 perhaps the most important difference is that it is not designed to encourage compliance with substantive health plan regulations, but is instead aimed at encouraging employers to offer less generous health plans, with the intent of lowering overall health care expenditures. in this sense, the cadillac tax is similar to the other health-related excise taxes in that its ultimate goal is to change behavior, not raise revenue.118 as a result, while the cadillac tax’s provisions are quite complicated, there may not be a significant administrative cost associated with them, since the strong incentive it provides to avoid the excise tax in the first place largely negates the need for irs administration and enforcement. 111 i.r.c. § 36b(f) (2011). 112 id. 113 i.r.c. § 36b(f)(2) (2011). full repayment is required if the individual has household income equal to or greater than 400% of the federal poverty limit for the relevant year, but the code places limitations on the amount that must be repaid for individuals who earn less than 400% of the federal poverty limit. id. 114 see ted griggs, thousands in la. to repay portion of health subsidies, advocate (april 15, 2015), http://theadvocate.com/news/12097896-123/thousands-in-la-will-have [http://perma.cc/5wxpwaax]; jayne o’donnell, aca could trip up some at tax time, usa today (jan. 9, 2015), http://www .usatoday.com/story/news/nation/2015/01/08/obamacare-health-insurance-taxes-exemptions-check-box /21440171/ [http://perma.cc/3wps-dddj]; pamela yip, confusion likely for many filing taxes, dallas morning news (feb. 23, 2015), http://www.dallasnews.com/business/personal-finance/headlines/20150222health-insurance-confusion-likely-for-many-filing-taxes.ece [http://perma.cc/b6zf-8yqt]. 115 see timothy jost, implementing health reform: complicated aca tax forms could cause problems, health affairs blog (sept. 21, 2014), http://healthaffairs.org/blog/2014/09/21/implementinghealth-reform-complicated-aca-tax-forms-could-cause-problems/ [http://perma.cc/m6wc-lnh4] (stating that it is likely that taxpayers receiving premium tax credits are “likely to be confused, frustrated, even angry, and certainly bewildered, completing [the relevant tax] forms”). see also press release, senator orrin hatch, five years later: obamacare subsidies cause confusion and frustration for american taxpayers (mar. 18, 2015), http://www.hatch.senate.gov/public/index.cfm/2015/3/five-years-laterobamacare-subsidies-cause-confusion-and-frustration-for-american-taxpayers [http://perma.cc/7pxf-q5vc]. 116 i.r.c. § 4980i(b) (2011). 117 i.r.c. § 4980i(c) (2011). 118 for a detailed discussion of the behavioral goals of the cadillac tax, see amy b. monahan, why tax high-cost employer health plans?, 65 tax l. rev. 749 (2012). 2016] a partial defense of the irs as health care agency 141 finally, the irs has a potentially enormous compliance burden imposed by section 9815, which incorporates all of the aca’s substantive group health plan requirements into the code. section 9815, together with section 4980d, subjects non-complying employers to the same $100 per participant per day excise tax as that imposed for hipaa noncompliance.119 the mou signed between treasury, labor, and hhs by its terms also applies to the aca.120 all that the mou requires in terms of enforcement, however, is coordination between the departments. it does not grant a single agency primary authority, or in any way limit enforcement. what is not publicly known is how the agencies will handle enforcement in practice. recall that with hipaa, treasury does not independently enforce hipaa, relying instead on voluntary employer compliance and referrals from labor.121 if the same model is followed here, there will be little to no administrative burden placed on the irs. the risk, however, is that if employers begin to believe that noncompliance will never be punished via the excise tax, the excise tax may fail to achieve its compliance goal. however, as discussed above, the mere possibility of a very large fine, imposed by the “fearsome” irs,122 may be sufficient to achieve the desired employer behavior. c. could we lessen the irs’s aca burden? the aca significantly expands the irs’s role in health care regulation, and it is far from obvious that placing such a burden on the agency is a wise policy decision. this section will explore whether it might be possible to achieve the aca’s policy goals in an efficient manner while lessening the role the irs must play. the clearest justification for irs involvement in aca administration is based on the fact that the irs is the most obvious choice for processing payments to or from large numbers of taxpayers. starting with the aca’s payments to taxpayers, the aca’s tax credits are calculated based on income, and the irs obviously has the most readily available information on household income, along with pre-existing definitions of income that can be used for this purpose. the scale of the premium tax credits also supports that argument that the irs is better positioned than other agencies to handle administration, as many more individuals will be eligible for premium tax credits than for other pre-existing social welfare programs. the irs also has experience in making the types of calculations required for premium tax credit eligibility. while calculation and payment of premium tax credits could clearly be given to a different agency, with hhs being the most obvious choice, the irs would necessarily have to be involved in order to provide accurate income information. but adding an additional agency would not seem to offer any efficiencies (other than perhaps making budget allocations easier to come by given the politically disfavored status the irs currently enjoys). similar reasoning supports irs involvement in those areas of aca administration that require payments from taxpayers to the federal government as part of the individual and employer mandates. the amount of the individual mandate varies based on family size and income, both of which are readily available to the irs. and the employer mandate is based in part on employer size, again something the irs already tracks. in addition, the irs obviously already has a procedure in place for collecting amounts due from the same 119 i.r.c. §§ 9815, 4980d (2012). 120 hipaa mou, supra note 49, at 70164-65. 121 see notes 69-71 and accompanying text. 122 panel 3: negotiating the agency peace treaty: reorganization plan no. 4, 6 drexel l. rev. 319, 335 (2014). 142 columbia journal of tax law [vol.7:123 population, something no other federal agency can claim. and finally, it is important to note that the irs is required by constitutional limitations to be involved in the administration of the individual mandate. the constitutionality of the individual mandate was, after all, upheld as a valid exercise of congress’s taxing powers.123 but what about the excise taxes imposed by the aca? the previous parts have established that excise taxes cannot be thought of as “pure tax” provisions. they are distinct from our general income tax system and are not designed to raise revenue. they function as compliance mechanisms in the case of section 9815 and as a cost-control mechanism in the case of the cadillac tax. but these provisions are likely to accomplish their goals without any active irs enforcement, and in this sense appear to be highly efficient. the troublesome part of the excise taxes, from a tax administrative standpoint, is the rulemaking burden that comes along with the excise taxes.124 as professor hickman has documented, nearly ten percent of irs rulemaking projects between 2008 and 2012 were aca-related tasks.125 however, many of these regulations do involve tasks or topics that are squarely within irs expertise. for example, rulemaking on how employees are to be counted and how employers are to be aggregated for purposes of the employer mandate are subjects with which the irs has vast experience. similarly, rulemaking regarding the computation of individual mandate penalties, reconciliation and reporting requirements for the individual mandate are also standard irs functions. however, many other regulations appear to have no obvious relationship to either the tax system or irs expertise. irs regulations have covered such diverse topics as the requirements for group health plans to (1) cover preventive services, including religious exemptions therefrom resulting from the hobby lobby decision, (2) comply with specific procedures when processing claims, (3) cover pre-existing health conditions, (4) not include certain lifetime and annual limits on benefits, (5) cover children through age 26, and (6) not rescind coverage except in specific circumstances. it is in this health policy arena that i believe the strongest arguments can be made against irs involvement. yet, the health policy regulations just mentioned were not promulgated solely by the irs. because the group health plan requirements are codified in three statutes, they were jointly promulgated pursuant to the 1999 mou by irs, hhs, and labor. it is possible, therefore, that the irs’s actual involvement in these health policy oriented regulations was minimal, with the irs deferring to hhs’s lead—but no publicly available information confirms whether that intuition is accurate. vi. conclusion the irs is overburdened, and coming dangerously close to being unable to competently perform its core revenue-raising function. yet congress continues to add to the irs’s workload, most notably in recently years through the many tax-related provisions of the aca. while the irs has always had a role to play in regulated employer-provided benefits, the aca substantially expands that role. this raises an obvious question of whether it is wise to give the irs what appears to be a primary role in health plan regulation. 123 nat’l fed’n of indep. bus. v. sebelius, 132 s. ct. 2566, 2593-2601 (2012). 124 see generally kristin e. hickman, administering the tax system we have, 63 duke l. j. 1717 (2014). 125 id. at 1748. the percentage of aca-related rulemaking climbs to 15.8% if pages of rulemaking are counted instead of rulemaking projects. id. at 1750. 2016] a partial defense of the irs as health care agency 143 as this article has argued, however, much of the irs’s involvement appears not only defensible but efficient. for better or for worse, there is no better system for processing payments to or from a large number of taxpayers than the federal income tax system. additionally, using excise taxes to shape taxpayer behavior appears to offer the best of both worlds: a powerful incentive that requires very few enforcement resources. the only troubling aspect of the irs’s involvement in aca administration stems from the irs’s broad rulemaking authority across a number of substantive health plan provisions. why, after all, should it fall to the irs to determine how to accommodate the religious freedoms of closely held corporations as they apply to the provision of contraceptives? but we do not actually know the extent of irs involvement in these and other health plan regulations, because three agencies jointly promulgate such rules. there are, however, multiple steps we could take to ease our concerns both about the irs’s expertise in such matters and the burden it imposes on an already struggling agency. hhs, labor, and irs could renegotiate their mou to make the irs’s role explicitly more limited. or congress could potentially take rulemaking authority away from the irs, instead requiring irs to follow the regulations issued by hhs and labor. we may not like the role the irs has come to play in health plan regulation, and we may fear that it makes little sense. but the fault here lies not with any recent additions to the code, but rather america’s long-standing tradition of having employers as the primary providers of health insurance and the provision of a tax benefit associated with such coverage. because the aca was an attempt to achieve universal coverage through the existing employer-based system, the statute requires significant reliance on the tax system to achieve its goals. and upon closer examination of the specifics of the aca, there appears to be strong justification for most (but certainly not all) of its tax provisions. who should decide whether the apple is rotten? tax disclosure and corporate political agency ilan benshalom * abstract enron-type corporate financial accounting scandals in the beginning of the millennium have given rise to a renewed interest in corporate tax disclosure. anecdotal evidence suggesting a connection between corporate fraud and aggressive tax planning has motivated academics and policymakers to reconsider tax disclosure as a way to monitor corporate governance and limit tax avoidance. this article offers a different perspective on tax disclosure, tying it to the broader question of how policymakers should monitor the political impact of corporate business activities. the article claims that policymakers should view corporations’ tax planning strategies as part of a broader corporate political impact on social issues. this impact results from the genuine difficulty of bifurcating corporate business decisions from their political ones. this difficulty is a result of many judgment calls required in such decisions, which relate to individuals’ moral and political preferences. tax planning is one of these mixed business-political decisions, and the article advances the notion that policymakers should analyze tax planning not only as a law enforcement issue, but also through corporate governance lenses. to establish this inquiry, the article explains why the investor-shareholder relationship gives rise to political agency problems, which neither traditional nor critical corporate law literatures recognize. it then demonstrates how the costs associated with this type of agency relationship could be reduced via disclosure of information about the impact of corporate activities on issues of political concern. the article uses insights from financial markets theory to explain how disclosure of non-financial information would help to better align corporate actions with the political preferences of shareholders, despite shareholder rational passivity and apathy. it is then illustrated, through the apple case, how policymakers can use the theoretical conclusions reached through this analysis to formulate a real world policy proposal with respect to corporation tax planning. through its use of a wide range of interdisciplinary resources, this article aims to reformulate the multi-layered inquiry over the benefits and costs associated with corporate tax disclosure. * associate professor, hebrew university faculty of law, jerusalem, israel; fellow, taxation law and policy research institute, monash university; ll.m & jsd, yale law school; ll.m university college, london; ll.b hebrew university. i wish to thank hadas aharoni-barak, reuven avi-yonah, avihay dorfman, michal elbaz, david enoch, jesse fried, assaf hamdani, tammy harel-benshahar, alon harel, amir licht, adam hofri, piki ish-shalom, effi rottman, danya snyder, eyal zamir and members of commercial law and legal & political theory workshops at hebrew university and tel-aviv university. i also wish to thank the barak center for interdisciplinary legal research for the financial support of this project. most of all i wish to thank sharon hanes and ronit kedar for their thorough reading and enlightening comments, as well as noga blickstien and alex kaganov for their invaluable research assistance and their willingness to share their time and intellect in promoting this research project. 2014] tax disclosure and corporate political agency 87 i. introduction ...................................................................................................... 88 ii. corporate social responsibility in context ................................... 90 a. corporate social responsibility in context ......................................................... 91 b. the three undisputable cornerstones of the csr critique ................................ 92 iii. political concerns over rational apathy ....................................... 96 a. the political costs of rational ignorance ........................................................... 96 b. disclosure: a remedy? ..................................................................................... 101 c. assessment of the proposal ............................................................................... 104 iv. the case for tax disclosure ................................................................... 108 a. corporate tax planning: a clear case of political agency deficit .................. 108 b. tax disclosure: from theory to practice .......................................................... 111 c. the open debate about apple’s stateless (and tax-less) subsidiaries ........... 113 v. conclusions ...................................................................................................... 116 88 columbia journal of tax law [vol.6:86 “apple carefully manages its foreign cash holdings to support its overseas operations in the best interests of its shareholders . . . apple serves its shareholders by keeping these funds overseas” (apple’s senate submission) 1 “there’s something fundamentally wrong when the wealthiest company in america pays 12.6% in taxes, while [many small businesses]. . . pay a rate nearly three times higher. and it’s not just savvy accounting or a strategic maneuver—apple’s tax avoidance has a profoundly damaging effect on our whole country” (letter from a disgruntled shareholder) 2 i. introduction a corporation’s value to society can be judged not only by what it gives, but also by what it chooses to withhold. nowhere is this more evident than corporate tax policies. 3 this article advances this observation by focusing on the idea of greater corporate tax disclosure. it ties together two, seemingly distinct, topics that have attracted considerable academic interest in recent years: public finance interest on the impact of mandatory tax disclosure on tax evasion and avoidance activities, 4 and business-science interest on the costs and opportunities of corporate social responsibility (csr). 5 the article argues that behind the somewhat instrumentalist view of public finance lies an underlying and profound notion about the role of corporate power in society. therefore, tax policymakers should consider the potential impact and structure of a future tax disclosure regime as part of a broader goal—promoting accountable corporate conduct. the need to promote this accountability arises in business decisions, like tax planning, which reflect certain inherently moral and political preferences about what is a legitimate way to pursue profits. while the need to limit corporations’ political impact on the electoral process has attracted considerable (tax 6 and non-tax 7 ) academic attention, the actions of corporations 1 testimony of apple inc., offshore profit shifting and the u.s. tax code—part 2 (apple inc.): hearing before the permanent subcomm. on investigations of the comm. on homeland sec. and governmental affairs, 113th cong. 2 (written testimony of timothy cook, chief exec. officer, apple inc.), available at http://www.hsgac.senate.gov/download/?id=e0a00aaa-f4a1-4fa0-b5b2-563b86a7588a [hereinafter “apple’s testimony”]. 2 brian levin, op-ed, letter to apple ceo tim cook from a disgruntled shareholder, huffington post, may 21, 2013, available at http://www.huffingtonpost.com/brian-levin/letter-to-applestim-cook_b_3311215.html. 3 mihir a. desai & dhammika dharmapala, csr and taxation: the missing link, leading perspectives, winter 2006, at 4 (noting that taxes are the most visible and straightforward contribution that corporations make to non-shareholders and non-employees). 4 see discussion infra part iii.b. 5 see discussion infra part i. 6 i.r.c. § 501(c)(3) denies the tax exemption for npos; i.r.c. § 501(c)(4) denies charitable relief from contributions made to tax-exempt social welfare organizations that are allowed to lobby. see also steffen n. johnson, of politics and pulpits: a first amendment analysis of irs restrictions on the political activities of religious organizations, 42 b.c. l. rev 875, 878–80 (2001); meghan j. ryan, can the irs silence religious organizations?, 40 ind. l. rev. 73, 79–80 (2007); allan j. samansky, tax consequences when churches participate in political campaigns, 5 geo. j.l. & pub. pol’y 145, 156–59 (2007). 7 the supreme court's decision in citizens united placed the controversy over the political identity of corporations at the center of the debate about the role of corporate money in democratic elections. see 2014] tax disclosure and corporate political agency 89 inevitably have a substantial political impact on a wide range of issues, which may not be directly related to elections. there is no one “right” way for doing business, and the decision to pursue one avenue over another cannot be separated from moral, ideological, and political preferences. 8 hence, since corporations play an important role in the modern economy, the notion that they do not or should not have a political impact is utterly unrealistic. tim cook’s well-publicized senate testimony about apple’s tax planning strategies offers a good example of this difficulty. in reply to questions about parking billions of dollars in subsidiaries not subject to tax in any country, cook asserted that apple is an american company of strong values that believes that “to whom much is given much is required.” apple also claimed that its tax planning was done on behalf of its shareholders—thus failing to recognize the potential variation in its shareholders’ political views about the legitimacy of its somewhat controversial profit-maximizing strategy. this article tackles this topic head on, aiming to define what comprises corporate political agency in modern markets. it uses the example of tax disclosure to meaningfully discuss how problems associated with corporate political agency should be regulated. it explores an aggressive yet perfectly legal tax planning structure employed by apple, which allowed the company to report and retain its foreign earnings in a taxfree bermuda subsidiary. it argues that the decision of what comprises legitimate tax planning is, at the end of the day, a matter of moral and political preferences. the fact that it has financial significance should not cloud its political impact or the obligation of apple, as an agent, to adequately convey this political impact to its principals. the article’s analysis connects csr, corporate tax planning and corporate tax disclosure by engaging in an interdisciplinary inquiry that touches upon public finance and business science literatures as well as political philosophy, corporate law, and critical legal theory. the core of the argument is that recent changes in investment patterns— namely the emergence of portfolio investment patterns and the growing importance of institutional investors—have resulted in political agency problems. in conducting ordinary business activities, corporations are required to make judgment calls about issues that are inevitably political, such as what comprises legitimate tax planning. yet, because of common action problems associated with modern investment patterns, most of the political dimensions of corporate business decisions cannot adequately reflect the preferences of their principals. the article seeks to make the following contributions. first, it argues that the relevant inquiry is not whether socially responsible corporations should engage in specific tax-planning strategies. instead, the relevant question is how corporations can best fulfill their political agency when making ordinary business decisions (such as tax planning) that have political implications. in other words, responsible corporations are those that adequately reflect the political preferences of their shareholders. csr should therefore be understood as an internal standard reflective of shareholders’ aggregated citizens united v. fec, 558 u.s. 310 (2010); francis bingham, show me the money: public access and accountability after citizens united, 52 b.c. l. rev. 1027 (2011) (noting that it has been called both a broadside assault on democracy and a victory for free speech and that these extreme reactions suggest the importance of the case); richard a. epstein, citizens united v. fec: the constitutional right that big corporations should have but do not want, 34 harv. j. l. & pub. pol'y 639 (2011). 8 the definition of the term “preferences” is beyond the scope of this analysis. this article uses it broadly to include both principles and conventions. 90 columbia journal of tax law [vol.6:86 preferences rather than as an amorphous external standard of “social” conduct. second, this article argues that recent changes in investment patterns—namely the shift to non-control, intermediated, and retail-diversified portfolio investments—have resulted in political agency problems. put differently, it argues that while the change in investment patterns has many positive outcomes (namely risk diversification), it also has negative externalities on the political process. these externalities are inconsistent with some basic notions of democratic participation and decision-making. third, the article suggests that the negative externalities caused by the change in investment patterns can be corrected by disclosure. the efficient market hypothesis, which justifies financial disclosure, explains why non-financial disclosure would have a significant real world impact on corporations. with respect to financial disclosure, the efficient market hypothesis contends that policymakers should not be concerned with retail investors’ lack of financial literacy. professional investors, who analyze the disclosed information, are marginal buyers and sellers who correct for mispricing. this is also true with non-financial disclosure. while retail investors are unlikely to change their behavior with more information, sophisticated players (e.g., media organizations, competitors, and ngos) would. thus, even though the shareholders’ apathy results in problematic corporate-political accountability, the remedy should not necessarily aim to increase individual shareholders’ involvement or activism. in fact, much of the answer to what comprises legitimate corporate conduct will come as a result of the actions taken by well-informed “professional” parties. hence, just as in the case of financial disclosure, the success of a non-financial disclosure regime does not depend on whether it actually changes the behavior of individual investors, but on how it affects the overall (not necessarily investment) behavior of professional players. to the extent that corporate conduct on certain issues seems unjustified, non-financial disclosure would generate socio-political reactions, and these costs may alter the corporate cost-benefit equilibrium on this issue. the article then explains how its new formulation of csr interacts with the public finance scholarship on tax disclosure. the notion of tax planning is ideal because it reflects corporations’ obligation toward society. because tax planning is legal, traditional corporate law scholarship suggests that managers have an obligation to undertake legal (yet aggressive) tax minimization strategies to maximize shareholders’ returns. however, many corporations refrain from aggressive measures in avoiding taxes, which is antithetical to what they are “rationally” expected to do to maximize the financial return on their shareholders’ investment. the article addresses this issue by relying on the public finance literature dealing with the impact of disclosing corporate tax returns. part i provides an overview of the csr literature. part ii explains the concept of corporate political agency, the negative externalities of portfolio investments on democratic participation, and why disclosure may help solve some of these problems. it then assesses the strengths and weaknesses of using disclosure to address corporate political agency problems. part iii explains how disclosure could be implemented with respect to corporate tax planning strategies, analyzing how such a disclosure regime would help determine whether specific tax planning strategies, such as apple’s nocountry tax resident subsidiaries, are legitimate tax planning avenues. ii. corporate social responsibility in context the article argues that policymakers should view tax disclosure as a corporate 2014] tax disclosure and corporate political agency 91 governance issue that relates to the broader questions of csr, and not only as a mechanism for promoting tax compliance. this part provides a synoptic review of the relevant csr literature. part i.a gives the background of csr and the recent academic interest in it. the analysis of part i.b extracts three core truisms from the csr agenda: the notion that corporate officers should take into account the externalities of corporate activities; the notion of welfare (not wealth) maximization; and the idea that there is a change in the nature of agency costs associated with the growth of portfolio investments. 9 a. corporate social responsibility in context the traditional corporate law model views corporate managers and employees as agents invested with the fiduciary duty of maximizing the wealth of their principals (that is, their shareholders). 10 this model argues that corporations are more easily monitored when corporate managers have a single class of principals (that is, shareholders entitled to residual benefits) and a single goal (wealth maximization). 11 the resulting benefit of this simplified monitoring is a reduction in agency costs, which, in turn, increases the value of the corporate venture. 12 the csr movement objects to this traditional view, arguing that it fails to promote an optimal corporate regime. 13 theorists, such as einer elhauge and cynthia williams, stress that shareholder wealth maximization should not be the only principle that governs corporate law. instead, corporate law should allow managers to undertake activities that do not necessarily increase shareholders’ wealth, and also to be held 9 see infra notes 84–85 and accompanying text. 10 this principal-agent model, with its sole wealth maximization objective, has been the core of anglo-american corporate law for centuries and is widely supported by the majority of corporate law scholars, including frank easterbrook, richard posner, daniel fischel, henry hansmann, jonathan macey and roberta romano. see richard a. posner, economic analysis of law 453–54 (2007); daniel r. fischel, the corporate governance movement, 35 vand. l. rev. 1259 (1982); henry hansmann & reinier kraakman, the end of history for corporate law, 89 geo. l.j. 439 (2001); virginia harper ho, "enlightened shareholder value": corporate governance beyond the shareholder–stakeholder divide, 36 iowa j. corp. l. 59, 71–77 (2010); cynthia a. williams, corporate social responsibility in an era of economic globalization, 35 u.c. davis l. rev. 705, 711–18 (2002); milton friedman, the social responsibility of business is to increase its profits, n.y. times magazine, sept. 13, 1970, at 32. the notion that wealth maximization is the dominant view is undisputed, even by its critics. see margaret m. blair & lynn a. stout, specific investment and corporate law, in corporate social responsibility and corporate governance 99, 101. (2011). see also miriam a. cherry & judd f. sneirson, beyond profit: rethinking corporate social responsibility and greenwashing after the bp oil disaster, 85 tul. l. rev. 983 (2011). 11 einer elhauge, sacrificing corporate profits in the public interest, 80 n.y.u.l. rev. 733, 736 (2005) (describing this argument). for one of the most canonic expression for this “traditional” view of corporate law, see frank h. easterbrook & daniel r. fischel, the economic structure of corporate law 37–39 (1991). 12 accordingly, corporate law should require managers only to increase shareholders’ wealth. other goals, which may concern the welfare of other parties affected by corporate activity, should therefore be promoted or protected through other means. easterbrook & fischel, supra note 11; david g. yosifon, the public choice problem in corporate law: corporate social responsibility after citizens united, 89 n.c.l. rev. 1197, 1200–01 (2011); ian b. lee, efficiency and ethics in the debate about shareholder primacy, 31 del. j. corp. l. 533, 538 (2006). the core assumption is that a bigger pie could serve everybody better. for example, voluntary creditors (e.g., debtors and employees) would be compensated by higher returns on their investment. by the same token, the state would be better off if it took the position of involuntary creditors (e.g., individuals negatively affected by corporate externalities) by regulating these externalities directly or indirectly (e.g., via tort litigation). goals other than wealth maximization are best promoted through the political arena. 13 andere crane et al., introduction, in the oxford handbook of corporate social responsibility 363, 377 (andere crane et al. eds., 2008) [hereinafter oxford handbook]. 92 columbia journal of tax law [vol.6:86 publicly accountable for certain efforts (even if legal) to increase corporate profitability. 14 despite its intuitive appeal, the csr agenda raises serious problems that are difficult to reconcile. 15 the most fundamental concern is that it remains unclear how csr theory, given its public good characteristics, can have any significant effect on corporate behavior. it can be disputed whether the traditional argument against csr initiatives, which stresses that these initiatives tend to be managerial pet projects that significantly increase agency costs, is indeed correct. 16 however, it is unquestionable that csr objectives—e.g., environmental protection, education, and equality—are public goods. in a price-sensitive, competitive market, private actors generally do not supply public goods voluntarily; managers who choose to do so in place of tangible financial benefits would be driven out of the market. 17 rather, in profit-oriented product markets, financial markets, and managerial markets, decisions are made in response to competitive pressures. these pressures should render the legal articulation of managerial fiduciary duties insignificant, thereby nullifying much of the csr critique against traditional corporate law. 18 b. the three undisputable cornerstones of the csr critique i begin from a conservative, non-controversial starting point from which i will develop my arguments with respect to csr. throughout this analysis i assume that traditional corporate law theorists are correct in arguing that corporate managers should be seen only as agents of their shareholders, and not as agents of a more diversified group of stakeholders. 19 accepting this assumption is not of descriptive or normative value—it does not suggest that strong-form shareholder centrism is the established law or the desired corporate law framework. instead, this assumption is of instrumental value, showing that the article’s analysis, which leads to a very different conclusion from law and economic analysis of corporate law, can align even with this “traditional” framework of corporate law theory. it is important to stress that traditional corporate law scholars do not claim that wealth maximization is a goal in itself, but merely that it is an efficient means for promoting overall welfare. this article does not deny that wealth is often a proxy for welfare, or that there can be a socially productive division of labor—one that would encourage corporations to focus primarily on their profits and allow other objectives to be pursued elsewhere. however, based on the csr critique, this article’s analysis makes three central observations explaining why wealth maximization often falls short of 14 see generally elhauge, supra note 11, at 733 (providing a comprehensive review of the various justifications to allow corporate managers to deviate from the wealth maximization principle). 15 j. van oosterhout & p.p.m.a.r. heugens, much ado about nothing: a conceptual critique of corporate social responsibility, in oxford handbook 197, 198; evaristus oshionebo, the u.n. global compact and accountability of transnational corporations: separating myth from realities, 19 fla. j. int'l l. 1, 22–25 (2007) (noting that the global compact—the leading un document providing guidelines for mnes—is intentionally vague). 16 lee, supra note 12, at 551 (arguing that stakeholder and team-production theories do not specifically address the problem of enhanced agency costs). 17 david vogel, the market for virtue 71–72 (2005); peter utting, the struggle for corporate accountability, 39 dev. & change 959, 969 (2008) (reaching the conclusion that voluntary action is not enough). 18 d. gordon smith, the dystopian potential of corporate law, 57 emory l.j. 985, 989 (2008). 19 easterbrook & fischel, supra note 11, at 90; ian b. lee, corporate law, profit maximization, and the "responsible" shareholder, 10 stan. j.l. bus. & fin. 31, 38 (2005). 2014] tax disclosure and corporate political agency 93 providing an adequate proxy for welfare. first, to help corporations generate value, a legal regime should force corporations to internalize the various externalities associated with their operation. 20 the problem of holding private parties accountable for the externalities of their actions is not unique to corporations and decision-making by their managers. however, in the case of large corporations, the issue of externalities is more significant due to the entities’ dominant economic position and the large breadth and scale of their activities. 21 additionally, some of the mechanisms that would typically restrain parties from generating negative externalities on their surroundings do not exist in the context of multinational enterprises (or mnes). the potential separation of corporate decisionmakers from shareholders makes the corporate structure more susceptible to externalizing its costs to those who are not directly accounted for in its financial calculus. 22 for example, shareholders who would tend to feel socially restrained from imposing certain negative externalities may not feel these pressures (and actually may not be even aware of them) when the same externalities are imposed by the conduct of their corporate agents. 23 furthermore, the shareholder wealth maximization principle assumes that governments are the most efficient bodies to manage the incentives of actors whose activities impose externalities. 24 this assumption may be somewhat weakened by the complexity of the issues at stake, the relative weakness of certain governments, the information-asymmetry problems of government officials with respect to the wide range of implications that different forms of corporate conduct generate, and the time and transaction costs associated with the enactment of government regulations. 25 second, corporate managers, as shareholders’ agents, should aim to maximize their welfare 26 rather than their wealth. the wealth maximization principle wrongly assumes an artificial separation between individuals’ goals in their capacity as investors—maximizing the returns for their investments—and goals they have in other capacities. individuals have a range of preferences, including commitments to a wide range of political and ethical issues that are not self-serving; naturally, these preferences 20 benjamin j. richardson, socially responsible investment law regulating the unseen polluters 514 (2008) (arguing that the only permissible financial returns should be those achieved while accounting for public costs to the environment and social welfare); r. edward freeman et al., stakeholder theory and the basis for capitalism, in corporate social responsibility and corporate governance 52, 67 (2011); andrew johnston, facing up to social cost: the real meaning of corporate social responsibility, 20 griffith l. rev. 221, 221 (2011) (noting that csr should not include managers’ attempts to increase value for shareholders via green-marketing strategies). 21 yosifon, supra note 12, at 1204 (arguing that large corporations have an advantage in promoting their interests in the political arena). 22 kent greenfield & d. gordon smith, saving the world with corporate law, 57 emory l.j. 947, 959 (2008). 23 elhauge, supra note 11, at 756. 24 geoffrey heal, when principles pay, corporate social responsibility and the bottom line 9–10 (2008). 25 lorenzo sacconi, introduction, in corporate social responsibility and corporate governance, at xv (noting that a causian account of the csr issue is that, in the real world, both government and corporate governance suffer from transaction costs); elhauge, supra note 11, at 802. 26 the concept of welfare is amorphous and tricky. this article addresses it in a broad sense to include any type of fulfillment of society’s preferences, principles, and conceptions of not necessarily selfish ways to promote the public good. under this definition, if altruistic preferences are met, then welfare would increase even when society bears a cost. 94 columbia journal of tax law [vol.6:86 also relate to business and investment decisions. 27 the act of investment does not transform those preferences into one-dimensional decisions that are focused exclusively on wealth maximization . . 28 traditional corporate law scholars would argue that the heterogeneity of shareholder preferences requires managers to focus only on the common denominator— the interest in increasing the (risk-adjusted) return on their investments. nevertheless, even these scholars would concede that most shareholders would refrain from investing in certain highly contested issues (e.g., privately supplied military services, 29 legal prostitution, extreme pornography, etc.). 30 in these cases, it is clear that the division of labor, which assumes that allowing corporations to focus only on maximizing their profits will increase shareholders’ welfare, breaks down. even if such corporate conduct increases shareholders’ material wealth, it would undermine the non-wealth related values and preferences that many shareholders have, and may ultimately reduce their overall welfare. 31 hence, especially with respect to the extreme issues mentioned above, managers’ commitment to maximizing shareholders’ wealth can lead to a non-welfare maximizing course of action. 32 the third and most crucial point that should be extracted from the csr agenda is the changing nature of corporations due to a massive shift towards non-controlling share ownership. corporate law is concerned with enabling an institutional framework that can productively use different types of inputs from various contributors. 33 most importantly, it helps establish a reliable agency relationship that allows contributors of capital to supervise how others manage the business they own. 34 during the course of the twentieth century, corporate law regimes and capital markets evolved significantly, changing the patterns of investment. as part of these changes, there has been a decline in the volume of economic activity by family-owned corporations and a rise in mnes that rely on regulated financial markets as their primary source of capital. on the investment level, there has been an increase in the amount of non-controlled (dispersed) ownership of corporate equity and portfolio investments, in which investors are rationally passive and concerned primarily with diversification to attain (average) market returns. 35 additionally, there has been a radical increase in the amount of assets that are invested through institutional investors—namely pension funds 27 freeman et al., supra note 20, at 53–54. 28 richardson, supra note 20, at 20–27 (providing evidence of shareholders' increased interest in financially insignificant political spending of corporations). 29 peter w. singer, corporate warriors: the rise of the privatized military industry 217–22 (2003) (discussing some of the moral problems associated with the services provided by corporations, such as executive outcome to governments of various developing countries). 30 for further discussion of why individuals would care about these issues even if they do not invest or vote according to them, see infra note 73 and accompanying text. 31 lee, supra note 19, at 48 (noting that the assumption that shareholders care about the ethical implications of their investment decisions would be idealistic but not unreasonable). 32 elhauge, supra note 11, at 738–39. 33 greenfield & smith, supra note 22, at 958. 34 see supra note 19 and accompanying text. 35 see zvi bodie et al., investments 378–79, 405 (2005) (describing the rationale behind passive portfolio investment strategies, in which small investors know that it is costly and unlikely that they can achieve higher-than-market returns and instead focus on diversification and indexing the market); bernard s. black, agents watching agents: the promise of institutional investor voice, 39 ucla l. rev. 811, 813 (1992); michael j. graetz & itai grinberg, taxing international portfolio income, 56 tax l. rev. 537, 542– 46 (2003) (describing the growth in portfolio investment even in the international investment context). 2014] tax disclosure and corporate political agency 95 managing the retirement savings of individuals in the developed world. 36 like retail investors, institutional investors engage in non-control portfolio investment practices. these changes in investment patterns are all connected—they relate to the need for risk diversification and the difficulty for individual investors and investment managers in generating sufficient expertise in different economic fields. 37 the effect of these trends has been amplified by the liberalization of global markets and the risks and advantages associated with investing abroad in a growing but volatile global economy. 38 although the shift to non-control forms of investment (hereinafter referred to as “portfolio investment/ors”) allows more risk-taking, and thereby stimulates economic growth, it has also materially changed the shareholder-manager relationship. portfolio investor shareholders no longer have an effective way of actively influencing corporate behavior by voicing their concerns. they do, however, have an easy way to execute exit options. hence, the transferability of shares and the liquidity of financial markets compensate for shareholders’ lack of control and allow them to maintain low agency costs by easily shifting out of investments. 39 this state of affairs has two important implications for the analysis. first, it increases the group of equity shareholders to include almost everyone in society, because institutional (namely pension fund) investors do much of the portfolio investment on behalf of a wide range of individual investors. this growth in the class of shareholders blurs the classic distinction between shareholders and other parties associated with the corporate venture (e.g., consumers). second, even though shareholders can elect the board of directors and management team, small retail investors are voiceless and do not have the means to affect corporate conduct. 40 this absence of a voice for portfolio investors in corporate control is particularly noticeable in the context of investments mediated by institutional investors, especially insurance companies and pension funds. 41 these institutional investors are generally expected to maintain adequate levels of savings, so government regulation and market forces focus managerial incentives on maximizing profits. 42 thus, when investing through institutional investors, individual investors’ preferences on non-profit maximization issues remain unheard, even with respect to issues that they greatly care 36 richardson, supra note 20, at 45–46; donald c. langevoort, the sec, retail investors, and the institutionalization of the securities market, 95 va. l. rev. 1025, 1025–27 (2009); ho, supra note 10, at 64. see also pension markets in focus, oecd (sept. 2012), available at http://www.oecd.org/daf/financialmarketsinsuranceandpensions/privatepensions/pensionmarketsinfocus201 2.pdf (illustrating the growing role of pension investments in developed economies). 37 richard a. brealey et al., principles of corporate finance 160–70 (2006) (explaining the importance of risk diversification to increasing investors' risk-adjusted values); richardson, supra note 20, at 47, 193 (noting that the growth of institutional investment has expanded financial markets and resulted in a parallel reduction of direct family ownership). 38 richardson, supra note 20, at 49. 39 greenfield & smith, supra note 22, at 954. 40 black, supra note 35, at 820–26; richardson, supra note 20, at 265. 41 elhauge, supra note 11, at 817 (noting that individuals invested with institutional investors are likely to be even more insulated from social and moral sanctions). 42 richardson, supra note 20, at 233–34; elhauge, supra note 11, at 733 (noting that managerial incentives toward excessive generosity are constrained by various market forces that limit the ability to sacrifice profits); lee, supra note 12, at 585 (noting that the liquidity of shareholders’ rights and the market for corporate control provide shareholders with protection against agency costs associated with excessively responsible corporate policies). 96 columbia journal of tax law [vol.6:86 about. 43 the above analysis does not lead to the conclusion that investors’ muteness with respect to corporate conduct is a negative outcome. portfolio investors are not experts, and their excessive intervention in corporate affairs would perhaps have severe costs. as long as there are other market mechanisms that reduce the agency costs of monitoring managers’ conduct, this muteness is actually an advantage. nevertheless, the ubiquity of large corporations in the global economy and the vital role they play (either by action or omission) in contemporary markets merit examination of some additional aspects of this voicelessness. iii. political concerns over rational apathy having looked at the context of the recent interest in csr in part i, part ii examines the effect of corporate activity on the democratic political process. part ii.a advances this article’s main normative argument that while portfolio investment is, by and large, a positive development that enables risk diversification, it has some negative externalities on the democratic political process. these externalities are generated by the unaccountable and non-mandated political agency granted to corporate officers. as the economic power of large corporations (particularly mnes) continues to grow, this lack of political agency with respect to vital public policy issues should be understood as the core of the csr critique. part ii.c goes on to suggest that mandatory disclosure with respect to social and financial issues can legitimize corporate agency. a. the political costs of rational ignorance the analysis in this section questions the social construction of corporate agency with respect to shareholders. corporations are mainly investment vehicles, but, in the course of business, they inevitably interact with many issues that are political in nature. because corporations are primarily designed to generate profits, traditional corporate law theory focuses on corporations’ economic agency, translating it into a fiduciary obligation to maximize shareholders’ wealth. 44 considerably less attention has been given to corporations’ political agency, which, i argue, is a form of accountability that does not follow smoothly from the economic agency practice. financial markets and portfolio investment patterns allow investors to limit the cognitive resources they devote to managing their investments. 45 however, these same attributes come into conflict with the democratic notions that emphasize the role of individuals’ informed, responsible decision-making. therefore, despite—and perhaps even because of—its risk diversification benefits, portfolio investment patterns also result in negative externalities on the democratic political process. portfolio investment encourages individuals to be morally and politically indifferent to the consequences of their investment decisions. this is contrary to the ideals of a democratic regime that stresses the importance of individuals’ informed decision-making as the basis of public policy. it is true that there are different approaches to how a democratic regime should function and that these approaches vary considerably in how they regard the importance of investing resources in order to encourage a broad body of citizens to engage in active 43 elhauge, supra note 11, at 733. 44 see supra notes 10–12 and accompanying text. 45 victor j. vanberg, corporate social responsibility in the market economy: the perspective of constitutional economy, in corporate social responsibility and corporate governance 131, 143. 2014] tax disclosure and corporate political agency 97 decision-making. 46 however, at their very core, all democratic societies rely on decentralized, individual decision-making and all of them require some level of active participation. 47 in fact, one of the main functions of the state in a democratic regime is to facilitate mechanisms of deliberation that will allow informed, individual decisionmaking to be effective in shaping public policy. 48 this article does not participate in the longstanding inquiry over what is the “proper” level of active political knowledge and engagement to which a democratic state should aspire. 49 instead, it wishes to emphasize why recent changes in the world economy have amplified the concern about investors’ rational apathy. historically, democratic societies did not regulate businesses solely by law. rather, regulation involved a combination of explicit government regulation and social norms that reflected both community expectations and individual consumer choices. 50 all of these mechanisms have become less effective in the increasingly integrated global economy. 51 first, the opening of global markets introduced regulatorycompetition pressures, causing states to loosen their regulatory requirements to attract business investments. this created a global atmosphere of weakened state regulatory capacity, which has made it difficult for states to effectively regulate issues related to business conduct within their individual jurisdictions, and even more difficult to effectuate responses to a growing set of issues that currently require coordinated global action. 52 one of the best examples of this is the very well-documented dynamic of tax competition for mne foreign direct investments. 53 mnes are sophisticated taxpayers that have access to and awareness of many tax reduction opportunities that are unavailable to other taxpayers. 54 corporate income taxation (by the source jurisdiction) 46 liberal theorists tend to argue that political power in a representative democracy is no different from any other type of commodity—individuals and groups invest in society only to the extent that it promotes their interests. deliberative and republican theorists of modern democracy tend to view active political participation as an act of virtue—participation improves democratic decision-making because it gives a larger role to consideration of the common good. see generally jurgen habermas, three normative models of democracy, 1 constellations 1 (1994) (discussing three competing normative visions of democracy and emphasizing the role of deliberative discourse theory which emphasizes active citizenry involvement and communication as a middle path between the liberal and republican vision of democracy). 47 for example, no democratic state allows vote buying or proxy voting. 48 joshua cohen, deliberation and democratic legitimacy, in deliberative democracy: essays on reason and politics 72 (james bohman & william rehg eds., 1997). 49 for more on this point, see infra note 99. 50 stanley deetz, corporate governance, corporate social responsibility and communication, in the debate over corporate social responsibility 267, 267; elhauge, supra note 11, at 756–76. 51 deetz, supra note 50 at 267. 52 andreas georg scherer & guido palazzo, globalization and corporate social responsibility, in oxford handbook 414. 53 there is a significant amount of empirical and theoretical economic research that reveals and explains why mnes’ foreign investments are mobile and tax sensitive. see generally joseph e. stiglitz, making globalization work 188 (2006); kimberly a. clausing, multinational firm tax avoidance and tax policy, 62 nat'l tax j. 703, 705 (2009); harry grubert & john mutti, do taxes influence where u.s. corporations invest?, 53 nat’l tax j. 825, 825 (2000); gaëtan nicodème, on recent developments in fighting harmful tax practices, 62 nat’l tax j. 756, 756 (2009); alan j. auerbach et al., taxing corporate income 22 (nat'l bureau of econ. research, working paper no. 14494, 2008), available at http://www.nber.org/papers/w14494.pdf. 54 they achieve these tax reduction opportunities primarily, though not exclusively, by engaging in tax planning transactions structured to shelter profits in subsidiaries within the mne groups located in lowtax jurisdictions. see generally edward d. kleinbard, stateless income, 11 fla. tax rev. 699 (2011) (reviewing the different mechanisms through which mnes achieve this form of tax reduction). 98 columbia journal of tax law [vol.6:86 is the most important factor in determining mnes’ worldwide tax exposure. 55 this system creates a clear incentive for mnes to engage in investment-shifting and incomeshifting behaviors and further motivates countries to respond to this demand. 56 because the tax competition dynamics for both investments and profits operate simultaneously and in an interrelated manner, it is difficult to distinguish between them. 57 mnes therefore are thought to have considerable influence on governments’ tax policy decisions, which impact their effective and marginal tax rates. 58 second, the growing market share of corporate entities (especially mnes) in the global economy suggests that they are important contributors to the current problems, an idea supported by the widely regarded notion that mnes have a uniquely strong influence over the global economy.59 if policymakers manage to reduce some of the negative political externalities associated with investments in mnes, this could have a meaningful impact on a range of public policy issues. 60 for example, it has been argued 55 this means that shifting real investments to low-tax jurisdictions and shifting reported profits to them are both legally permissible strategies for increasing mnes’ profitability. see clausing, supra note 53, at 705. 56 these two tax competitions—for investment and for profit shifting—intersect at many points. whereas tax competition for capital investment reduces the effective marginal tax rate on new investments, tax competition for profits reduces statutory tax rates. see michael p. devereux, ben lockwood & michela redoano, do countries compete over corporate tax rates?, 92 j. pub. econ. 1210, 1212–13, 1231 (2007) (developing and testing a model for such a two-dimensional tax competition—finding that countries simultaneously compete across both margins and that the competition for lower statutory tax rates is best explained in terms of competition over mobile profits); michelle hanlon & shane heitzman, a review of tax research 38 (july 25, 2010) (unpublished manuscript), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1476561 (stating that there is significant evidence that differences in corporate tax rates affect firms’ pricing decisions). 57 clausing, supra note 53, at 717; peter r. merrill, corporate tax policy for the 21st century, 63 nat'l tax j. 623, 630–31 (2010) (suggesting that the high corporate tax rates in the united states make it difficult to attract investment and to prevent profit-shifting); michael overesch, the effects of multinationals’ profit shifting activities on real investments, 62 nat'l tax j. 5, 5 (2009); joel slemrod, location, (real) location, (tax) location: an essay on mobility’s place in optimal taxation, 63 nat'l tax j. 843, 861–62 (2010) (suggesting that models that accommodate both tax competition for investment and profit locations are the most promising for future research development); george r. zodrow, capital mobility and capital tax competition, 63 nat'l tax j. 865, 869 (2010). 58 for example, certain (mostly small) countries, typically thought of as tax havens, reduce their statutory tax rates to compete for profit shifting; i.e., to incentivize profit shifting by making it more lucrative. other countries indirectly compete for investments by allowing mnes to operate from tax havens when investing in them. by allowing mnes to shift income out of their jurisdictions, these high tax countries indirectly reduce their effective tax rates. see generally joel slemrod & john d. wilson, tax competition with parasitic tax havens, 93 j. pub. econ. 1261 (2009) (demonstrating that smaller tax countries chose to become tax havens to facilitate income-shifting and that abolishing these havens would improve global welfare). for a different view, see adam h. rosenzweig, why are there tax havens?, 52 wm. & mary l. rev. 923, 948, 951 (2010) (observing that in a world of capital disparities, smaller countries have an incentive to use their tax laws to attract economic activities by exploiting policies adopted by wealthier countries to mitigate double taxation). see also mihir a. desai, c. fritz foley & james r. hines, jr., do tax havens divert economic activity?, 90 econ. letters 219, 223 (2005); dhammika dharmapala, what problems and opportunities are created by tax havens?, 24 oxford rev. econ. pol'y 661, 662 (2008); overesch, supra note 57, at 20; benjamin alarie, price discrimination in income taxation (january 30, 2012) (unpublished manuscript), available at http://ssrn.com/abstract=1796284 (arguing that many of the complexities in tax system could partly be understood as an attempt of tax authorities to compete for mobile investments and investors). 59 cynthia a. williams, corporate social responsibility in an era of economic globalization, 35 u.c. davis l. rev. 705, 721 (2002). 60 richardson, supra note 20, at 520–22 (acknowledging that, despite his support of direct regulation, it may not be enough given the lack of direct governmental control over mnes); patricia h. 2014] tax disclosure and corporate political agency 99 that corporate tax avoidance negatively affects the legitimacy of the tax system.61 when sophisticated taxpayers such as corporations are able to use tax planning devices to reduce their effective tax rate, it generates a feeling that the tax system does not provide private individuals with a fair shake. as a result, this perception of unfairness or inequality legitimizes other avoidance (and perhaps even evasion) tax planning activities by non-corporate taxpayers. third, and perhaps most importantly, contemporary investors are exposed to an overwhelming number of ownership “relationships.” most of these are based on business ventures (a significant number are located beyond their country’s borders) about which the individual portfolio investors know little, if anything. 62 much of the effectiveness of social norm pressures, which are present in more localized, domestic economies, simply vanishes in the complex, global production chain. one would expect that this alienation of shareholders from their investments would make the enforcement of non-legalistic methods of control virtually impossible due to common-action problems and, especially, the huge costs associated with shareholder activism. corporate business strategy interacts and shapes political realities through the decisions made by corporate managers, who do so on behalf of their shareholders. however, in the context of widespread portfolio investment patterns, it is questionable whether corporate managers should be seen as legitimate political agents for their shareholders. 63 the analysis up until this point stresses that the business sphere cannot be clearly separated from the political sphere, and therefore corporate managers act also as political agents because corporations’ activities have an inherent political impact. prima facie, this would not be problematic—democracy does not require individuals to decide on all the political issues that may affect them. accordingly, while vote buying is indeed forbidden, private transactions (including agency contracts) that have a political impact should not necessarily be subjected to high levels of regulatory scrutiny or approval. however, the shareholder-manager political agency relationship in public corporations is different from other private transactions in several respects. first, the difficulties for portfolio shareholders of effectively monitoring their investments’ political impact make this political agency relationship unaccountable. second, corporations, particularly mnes, are not ordinary private actors, but ones that have an ever-growing role in the modern global economy at a time when regulators find it increasingly difficult to exercise effective governmental control over their actions. therefore, the shareholder-manager political agency relationship results in a significant democratic deficiency that has considerable implications for public policy (as well as on democratic theory). this suggests that the traditional csr inquiry is slightly misplaced. instead of considering whether the efficiency costs of allowing managers to promote non-profit werhane, corporate social responsibility/corporate moral responsibility: is there a difference and the difference it makes, in the debate over corporate social responsibility 459, 470. (steve may et al. eds., 2007). 61 ilan benshalom, sourcing the 'unsourceable': the cost sharing regulations and the sourcing of affiliated intangibles-related transactions, 26 va. tax rev. 631, 697 (2007). 62 lee, supra note 19, at 53 (asserting that corporate nature results in bounded feelings of empathy towards geographically remote victims of corporate irresponsibility). 63 ilan benshalom, the dual subsidy theory of charitable deductions, 84 ind. l. j. 1047, 1086–87 (2009) (discussing this issue in the context of corporate philanthropy). 100 columbia journal of tax law [vol.6:86 seeking goals are worth the benefits to society, 64 the inquiry should be whether managers are adequate political agents of the shareholders they represent. it is clear that managers are better placed than many other stakeholders in identifying the various costs and benefits of corporate conduct to third parties and society in general. 65 however, this placement does not provide managers with any special moral or political weight when deciding issues such as the fairness of tax avoidance schemes, labor practices or the appropriate balance of sustainable growth against short-term profits. these types of questions relate to the goals that should be pursued and not the methods by which they should be pursued. therefore, the answers to these questions should be grounded in individual shareholders’ preferences on these issues and not resolved solely (or primarily) with deference to managers’ expertise. framing csr as a problem of political agency leads to a very different conclusion from that of the mainstream csr literature. traditional literature focuses on how policymakers should obligate or incentivize managers to adopt certain desirable policies that could help solve specific problems associated with their business activities. 66 this article suggests that instead of trying to define what “good corporate citizenship” entails, policymakers should try to make corporations perform their political agency role adequately. as noted earlier, all of the issues attached to the csr debate relate to the provision of public goods 67 —how they should be provided, the desired amount, and prioritization relative to other public goods. the reason there are so many csr approaches stems from the (legitimate) differences in opinion with respect to what accounts for fair or optimal provision of public goods. neither governments nor markets can determine the “correct” answer to this question, simply because it depends on the aggregation of preferences of all members in a given society. for example, in modern democracies, majoritarian decision-making is one way to determine the public goods that should be supplied by the government. majoritarian decision-making has its advantages (namely, that it can be applied coercively to eliminate free riding), but it also has its weaknesses (namely, the difficulty of achieving a stable coalition on a great number of issues). people therefore try to promote their ideas about the necessity of public goods in other ways, such as through charitable donations, 68 volunteering, and their daily business and non-business associations and interactions. what comprises legitimate tax planning or environmentally conscious business conduct is something that can only partially be agreed upon and advanced through government regulation. apart from what is illegal, individuals have heterogeneous preferences with respect to this controversial, yet fundamental issue. correspondingly, they may have different ideas as to how their position could be advanced, and can choose 64 see generally elhauge, supra note 11, passim (convincingly arguing that, in many cases, allowing managers to engage in profit-sacrificing behavior to promote non-wealth maximization goals would not result in significant agency costs and would be efficient as a way of improving shareholders’ satisfaction by compensating for their lower financial returns). 65 johnston, supra note 20, at 234. 66 andere crane et al., introduction, in oxford handbook 3; greenfield & smith, supra note 22 (arguing that providing management with more latitude to undertake socially conscious, non-profit maximizing initiatives is desirable). 67 see supra notes 17–18 and accompanying text. 68 see generally saul levmore, taxes as ballots, 65 u. chi. l. rev. 387 (1998) (arguing that governments can use individuals' donations as a signal of their preferences). 2014] tax disclosure and corporate political agency 101 among an almost infinite number of legal and legitimate ways to promote these ideas. portfolio investment in public companies and mnes is one of many such ways. the reason it has attracted disproportionate scholarly attention relates to the growing importance of the corporate sector in the modern economy, as well as portfolio investors’ insulation and detachment from responsibility. to summarize, policymakers should refrain from adopting traditional csr objectives, which focus on how to generate better corporate conduct. instead, they should place the political agency deficit, which results from individual shareholders’ rational indifference to political aspects of corporate conduct, as the main element of concern with respect to the current wealth-maximization ideals of the corporate law model. according to this analysis, a csr agenda should anchor its efforts in the need to compensate for the negative political externalities that this shareholder indifference imposes on the democratic political process. this compensation requires taking institutional actions that would legitimize the unavoidable political agency of managers, while maintaining the benefits of the corporate structure and portfolio investment patterns. policymakers should take steps to ensure an active process of reflective equilibrium, 69 which aims to ensure that corporate actions better correspond with shareholders’ preferences. b. disclosure: a remedy? the above analysis suggests that policymakers need to take actions to conform corporate political agency to democratic perceptions of individual responsibility. this does not require any specific behavior; rather, it requires the establishment of mechanisms that align corporate governance practices with shareholders’ preferences. the challenge is not to tell corporations how to act, but to facilitate ways for shareholders to determine whether their investments match their preferences. democratic states provide tools that citizens can use to assume responsibility for their actions and participate in the democratic decision-making process. assuming responsibility over the political aspects of their portfolio investments requires, at the very least reliable and accessible information about the social and environmental impacts of corporate activity. reliable information, which is necessary for democratic deliberation on public policy, is a public good, and private parties are not likely to voluntarily invest resources to provide it. this implies that facilitating mandatory disclosure rules should be the main (or at least preliminary) goal of any government policy intended to enhance csr. the first issue that policymakers should address is the choice of topics to be covered by any mandatory, non-financial disclosure regime. in the same way that individuals are assumed to be interested (as shareholders) in generating profits, they could be assumed to be interested (as citizens) in a set of relevant political issues (which could be drawn from existing international legal documents). 70 as mentioned above, the traditional csr agenda is concerned with a broad set of issues that are all related to the question of how to best provide public goods, ranging from tax avoidance, anticorruption policies, and labor and environmental standards, to support of educational 69 reflective equilibrium refers to a process in which beliefs are matched with actions. see norman daniels, reflective equilibrium, in the stanford encyclopedia of philosophy (edward n. zalta ed., 2011), http://plato.stanford.edu/archives/spr2011/entries/reflective-equilibrium. 70 oliver f. williams, introduction, in peace through commerce responsible corporate citizenship and the ideals of the united nations global compact 1, 1–3 (oliver f. williams ed., 2008) (devoting an entire book to the u.n. global compact that deals with issues of csr); oshionebo, supra note 15, at 12–13. 102 columbia journal of tax law [vol.6:86 initiatives. 71 these goods differ from other commodities and services because the market cannot effectively supply them, since they involve considerable (negative or positive) externalities. hence, the optimal provision of these goods requires some type of governmental regulatory structure. while arriving at a full set of issues is impossible, determining a set of issues that would interest reasonable or average shareholders is a feasible task. in addition to the political issues concerning labor relations, human rights, and environmental concerns (discussed above), corporations should report their conduct with respect to other business-related political matters central to the global economy (e.g., tax compliance and relationships with foreign governments), their involvement in controversial industries (e.g., tobacco, pornography, and alcohol), and their own attempts to influence a political agenda (e.g., through campaign finance, charitable contributions, and lobbying activities). 72 this list of topics is open, and may change from one society to another. the main focus for selecting an issue is that individuals care about it as citizens—even if they do not vote in regard to it. 73 policymakers who determine what a corporation must disclose effectively act as agenda setters, and this power is thus open for abuse. this is a valid concern. however, while there may be disagreement about whether certain issues should be included, others (e.g., political contribution, tax payment, environmental, and labor policies) are relatively straightforward. moreover, the alternative of disclosing only financial information also manifests a non-neutral agenda-setting with respect to the role of corporations in society. the discussion over the impact of social disclosure is not new. 74 like other disclosure regimes, social disclosure is often hailed as praiseworthy for its light, yet effective, regulatory touch, which can be used to advance an array of objectives. 75 in supplementing direct regulatory requirements, it encourages moral behavior by relying on the market’s “taste” for morality and without hardwiring any moral principles into rigid 71 cynthia a. williams, the securities and exchange commission and corporate social transparency, 112 harv. l. rev. 1197, 1201–03, 1275–76 (1999) (arguing that social disclosure should include information about where products are produced, about corporations' environmental effects, and information about their labor practices). 72 lucian a. bebchuk & robert j. jackson jr., corporate political speech: who decides?, 124 harv. l. rev. 83, 85–96 (2010) (explaining why corporate decisions, with respect to their political speech, have special expressive significance for shareholders, because shareholders do not generally sort themselves according to political preferences). 73 the majoritarian democratic decision-making process often makes it difficult to reach stable coalitions over a wide range of issues. voters and politicians therefore often make decisions based on a limited set of issues (e.g., abortion, taxes, deficits, guns, and same-sex marriage). in a society where preferences over the desirability of public goods vary considerably, many groups would not be able to form coalitions that bring their topic of concern into the agenda. this does not suggest that the democratic, majoritarian decision-making process is undesirable, but only that in some cases it does not adequately reflect the full range of political preferences that individuals have. see benshalom, supra note 63, at 1078–79. 74 for some of the leading discussions in the legal literature concerning this issue, see douglas m. branson, progress in the art of social accounting and other arguments for disclosure on corporate social responsibility, 29 vand. l. rev. 539, 678–82 (1976); williams, supra note 71, at 1307. 75 paula j. dalley, the use and misuse of disclosure as a regulatory system, 34 fla. st. u.l. rev. 1089, 1108–13 (2007) (surveying the different regulatory functions of disclosure, including: making markets more efficient, monitoring compliance with standard laws and regulations, providing information for government, and increasing public awareness). but see steven m. davidoff & claire. a. hill, limits of disclosure, geo. l. j. (forthcoming 2013) (critically asserting that disclosure is too often a convenient path for policymakers and many others looking to take action and hold onto comforting beliefs in the face of a bad outcome). 2014] tax disclosure and corporate political agency 103 legislation. 76 this article highlights a different aspect, and argues that disclosure should not be viewed as a second-best supplement to direct regulation. instead, due to the growth in corporate activities, disclosure should become an important way of exerting broad civic influence over public policy. if policymakers require corporations to disclose their impacts on social and environmental issues, some of the negative political externalities associated with investors’ rational indifference would be corrected. 77 the following attributes of the disclosure regime suggest that having widely available information on corporations’ impacts would facilitate a shareholder-corporation political agency relationship that better accounts for shareholders’ multiple capacities and heterogeneity of preferences. first, disclosure seems to align with the notion of political agency—it does not require corporations to undertake any specific action but just to be transparent about their choices in acting. 78 the actual impact of this disclosure, the pressures it would expose corporations to, and the type of corporate responses to them are of less importance as long as its respective audience keeps the information internal. 79 second, disclosure requirements bridge the inherent information asymmetry between portfolio investors and managers, providing investors with the possibility of making informed and accountable decisions with respect to the broader social impact of their investment decisions. 80 systematic, comparable disclosure is a necessary first step in allowing shareholders to exercise a more sophisticated choice to ensure that their investments conform to their overall preferences. 81 third, mandatory disclosure accompanied by legal sanctions would significantly reduce problems of fraud and green-washing. 82 this in turn could help legitimize the political agency relationship by providing an assurance that corporations (as agents) are truthful about their social and environmental impacts. 83 76 this allows disclosure regimes to fit within the comfort level of liberal democracies and their commitment to a competitive capitalist market. larry cata backer, from moral obligation to international law: disclosure systems, markets and the regulation of multinational corporations, 39 geo. j. int'l l. 591, 597, 639 (2008). 77 elhauge, supra note 11, at 750, 758 (noting that portfolio investors, as well as consumers in general, are too insulated from corporations to either try to obtain information about them or to act on irresponsible corporate behavior upon receiving it). 78 disclosure supports the notion of a free market of ideas by meeting two requirements: the government should not tell shareholders how to conduct their (legal) affairs; but their agents (that is, corporate managers) should be required to explain and justify their conduct and its impacts. david w. case, corporate environmental reporting as informational regulation: a law and economics perspective, 76 u. colo. l. rev. 379, 432–33 (2005) (arguing that disclosure is important because it brings potentially controversial decisions into the open and triggers a process of deliberation with respect to them); dalley, supra note 75, at 1093 (noting that disclosure, as a regulatory tool, aligns well with a pro-market agenda because it allows individual choice without requiring direct, governmental interference); paul r. kleindorfer & eric w. orts, informational regulation of environmental risks, 18 risk analysis 155, 165–66 (1998); williams, supra note 71, at 1296. 79 the question of whether the goal of effectively communicating this type of information to shareholders is feasible is dealt with in the part ii.d. 80 see kleindorfer & orts, supra note 78, at 168. 81 see joshua a. newberg, corporate codes of ethics, mandatory disclosure, and the market for ethical conduct, 29 vt. l. rev. 253, 286 (2005); williams, supra note 71, at 1296. 82 branson, supra note 74, at 624–27. 83 by “legitimacy,” this article primarily means normative legitimacy, as the disclosure would align with the notion of agency and reduce political-agency costs. it may (or may not) also change the actual public attitudes with respect to financial markets, but this article does not address this empirical and somewhat 104 columbia journal of tax law [vol.6:86 in summary, to be legitimate within a democratic regime, public corporations should have a credible disclosure regime that highlights the way in which policies affecting salient political issues are formed. c. assessment of the proposal the process of compiling data on corporate social performance would be of a very large scale. mandatory disclosure requires significant resources for verifying the accuracy of information in order to reduce the risk of liability. 84 there is a market for information about the social and environmental impact of corporations, which is used by socially responsible (institutional) investors. hence, those advocating for a shift to a mandatory disclosure regime bear the burden of proving that this information market is not operating properly. 85 additionally, as mentioned, financial markets offer a liquid investment environment that is characterized by low exit costs. in such a setting, even low-stake portfolio investors can easily opt out from investing in corporations that do not satisfy their preferences. when exit is easy, there seems to be no need to regulate the shareholder voice. as socially responsible investment funds demonstrate, investors who are interested in non-financial aspects of corporate activities can channel their investments through professional fund managers who take these considerations into account. there are a number of responses to these concerns. the first is that shareholders wish to correctly price the relative value of assets in which they invest in accordance with the increase in welfare they expect to derive from those assets. in order to make these decisions, they need both financial and non-financial information. the analysis in earlier parts of this article demonstrated that the current (mostly) voluntary non-financial disclosure regime is materially deficient. 86 in other cases, such as information regarding the different tax positions of corporations, government officials operate under strict restrictions of confidentiality. 87 these types of restrictions effectively prohibit the supply of such information to investors. this point questions the assumption that the reason portfolio investors have a cheap exit cost option is to allow them to shift out of investing in corporations that do not satisfy their preferences. the low quality of socially responsible investment practices, which are a byproduct of poor corporate reporting practices, suggests that the information is not available to make a decision based on their preferences. therefore, the only option shareholders have is to shift out of portfolio investment altogether. 88 this is a very costly exit option, which individual shareholders cannot be reasonably expected to incur, and, on a broader level, it has a negative impact on the economy, since low transaction cost portfolio investment has many positive benefits. 89 instead, policymakers should seek other ways, such as mandatory social disclosure, to minimize the negative externalities of speculative issue. see kleindorfer & orts, supra note 78, at 167–68 (making the distinction between empirical and normative legitimacy); susanna kim ripken, the dangers and drawbacks of the disclosure antidote: toward a more substantive approach to securities regulation, 58 baylor l. rev. 139, 154 (2006) (noting, skeptically, that one of the goals of security regulation is to boost investors’ confidence in security markets). 84 easterbrook & fischel, supra note 11, at 276–309. 85 lee, supra note 12, at 574–75. 86 see supra part ii.c. 87 see infra note 128 and accompanying text. 88 see supra part ii.c. 89 see supra notes 35–37. 2014] tax disclosure and corporate political agency 105 rational ignorance on the political process. the second response is that corporations already maintain information about various social aspects of their activities, especially with respect to their tax compliance.90 indeed, tax authorities and other regulatory agencies in developed countries often require corporations to disclose such information to them. generating much of the relevant information should therefore not be too costly for mnes operating in developed countries. while compiling it into standardized reports would require some additional resources, it would also reduce some of the costs associated with the multiple standards applied today (by voluntary disclosure initiatives). furthermore, one could expect that a mandatory disclosure requirement would encourage the development of specialized auditing firms, which would help further reduce some of those costs through economies of scope and scale. the second line of criticism regarding mandatory disclosure of non-financial information is that it would remain wasteful and distortive even if compliance costs could be reduced to manageable levels. according to this train of thought, as long as consumers, managers, and investors are primarily price-sensitive (a point which even csr sympathizers acknowledge), 91 any resources invested in disclosure would be better spent elsewhere. it does not matter why all these individuals are price sensitive— whether it is because they fail to care about non-financial issues or because of common action problems that keep them blissfully ignorant and prevent them from effectively pursuing other preferences. either way, the point remains that the costs associated with a mandatory requirement to disclose non-financial information will not affect individuals’ consumption and investment behaviors and they therefore are unjustified. while a market operating with full information is an ideal, there is no point in trying to achieve it if people are unlikely to respond to additional information in any significant way. 92 despite its veneer of empirical correctness, this critique is probably overly deterministic and pessimistic as an empirical matter. 93 moreover, from a normative perspective, it fails to grasp the political agency argument advanced by this article. specifically, it fails to recognize that competitive, price-sensitive market pressures in corporate stock markets are only one sphere through which society interacts with corporate power. regulation, taxation, organized labor, and civic activism are other potential avenues that could influence the role corporations play in society. 94 repeat actors operating in these spheres would probably be more sophisticated and attentive to the disclosed information than the average portfolio investor. hence, there is a higher probability that they would respond to and make use of credible, easy to compare, and 90 see supra part iii. 91 richardson, supra note 20, at 2, 128 (noting that socially responsible investing has a very limited market share and that many of the funds that claim to make socially responsible investment screenings use very broad and questionable definitions); elhauge, supra note 11, at 750–52, 758–59, 805–11, 815, 818; johnston, supra note 20, at 237; lee, supra note 19, at 71. 92 dalley, supra note 75, at 1113–19; langevoort, supra note 36, at 1047–50; susanna kim ripken, the dangers and drawbacks of the disclosure antidote: toward a more substantive approach to securities regulation, 58 baylor l. rev. 139, 144–47, 156–59 (2006). 93 williams, supra note 71, at 1296 (noting that, despite its relatively small magnitude, the demand of socially responsible investment and its growth indicate shareholders’ interest in and willingness to act upon such information); ioannis ioannou & george serafeim, the consequences of mandatory corporate sustainability reporting 29 (harv. bus. school working paper, paper no. 11-100, 2012), available at http://ssrn.com/paper=1799589. 94 sarah a. soule, contention and corporate social responsibility 27 (2009). 106 columbia journal of tax law [vol.6:86 easy to access information with respect to corporate conduct on these issues. 95 this line of argument can be framed in two ways. the first relies on the efficient market analysis, which assumes that sophisticated institutional investors consume financial information disclosed by firms and correct the prices of assets in the market according to this information. this “market efficiency hypothesis” is the essence of modern finance theory. the development of portfolio investment is based on this assumption, allowing investors to be rationally ignorant when investing their capital in the financial markets. the belief that sophisticated actors are able to use the information provided by firms to price assets with reasonable accuracy allows investors to avoid expending resources trying to price those assets themselves. 96 the same argument should be made with respect to social disclosure. 97 there is a competitive market for political support of various ideas and initiatives. the success of the non-financial information market with respect to corporate conduct does not depend only on whether individual investors change their behavior according to it in a direct way. as long as there is reliable information cheaply available, sophisticated parties— e.g., ngos, news organizations, unions, political parties and business competitors— would be able to use this information and translate it into “outrage costs,” which could help trigger political and media reactions to the issue. 98 while disclosure is unlikely to impact the investment decisions of (rationally ignorant) individuals or (primarily price-sensitive) institutional investors, it would likely impact corporate behavior by imposing pressures in other spheres. interested parties would use this information to trigger consumer and political reactions to corporate conduct. chances of manipulation of the disclosed information are low as long as the information provided is reasonably accurate, reliable, and comprehensive. the dissemination of this information would result in a richer and more reflective debate on the various dimensions of what comprises legitimate business conduct. the notion that social disclosure could only be justified if it is proven that individuals actively consume it and directly act upon it is misleading. furthermore, this notion stands in deep opposition to the basic assumption that corporate law and finance scholars adopt in their analyses with respect to financial disclosure. another approach to this issue could stress how investment decisions are not fundamentally different from voting decisions. as public choice scholars have noted, the general public has minimal incentive to participate in the democratic process, and even less incentive to invest time and cognitive resources in trying to make informed decisions about questions of public policy. 99 since politicians can easily manipulate the public, the notion that providing more information would help individuals in improving their choice 95 this form does not have to be one that the average portfolio investment shareholder would be able to comprehend. 96 see brealey et al., supra note 37, at 337–39; langevoort, supra note 36, at 1052. this notion is generally accepted by the finance and corporate law literature. nevertheless, it is not free of doubts, even with respect to them. see davidoff & hill, supra note 75, at 622. 97 this article does not endorse or reject the various versions of the efficient market hypothesis. 98 see lucian bebchuk & jesse fried, pay without performance: the unfulfilled promise of executive compensation 64–70 (2004) (coining the term). 99 see generally russel hardin, street level epistemology and democratic participation in debating deliberative democracy 163 (james s. fishkin & peter laslett eds., 2003) (discussing the difficulty of encouraging individuals in a democracy to invest time and resources in learning the information necessary to make better judgments about public policy matters). 2014] tax disclosure and corporate political agency 107 of their representatives—so that those representatives would better advance their preferences—is naïve. in this state of affairs, there is a very low likelihood that individuals could change democratic decision-making; apathy is the most rational behavior. there is a startling resemblance between these public choice arguments with respect to voting and the criticism against the social disclosure regime. according to both arguments, the attempt to provide relevant information that would help individuals in making informed decisions constitutes a waste of resources. yet the public choice critique seems to offer only one (pessimistic) dimension of a much more complicated process. for example, according to public choice theory, voting is an irrational behavior because the ability of one voice to influence the result of large elections is negligible. despite this apparent irrationality, a significant number of people exercise their voting rights in national elections. in the context of disclosure, public choice would stress the uselessness of almost all disclosure mechanisms. nevertheless, basically all democratic regimes try to promote transparency of government decision-making and decision-makers. despite their skepticism about the impact of each and every disclosure initiative, every public choice theorist would most likely (everything else being equal) prefer to live in a country with more governmental transparency (e.g., finland) rather than less (e.g., russia). even though it is difficult to determine the utility of each part of the public disclosure regime, the whole may be greater than the sum of its parts. people take the importance of disclosure for granted as part of a broader commitment to a free democratic process. this is not coincidental; the core of the democratic process is premised upon individuals’ ability to use their informed judgments to monitor and take responsibility over the actions of elected representatives. just as in the case of public sector disclosure, disclosure of information concerning the non-financial social and environmental aspects of corporate activity may be justified out of a broad political commitment to transparency. policymakers should require corporations to provide information about the political impact of their business activities because transparency promotes proper use of political power. corporate managers are agents of their shareholders in a way that resembles how elected politicians are agents of voters in a representative democracy. this resemblance results from the growing importance of corporations in impacting issues of public policy in the integrated global economy. policymakers therefore have justification to impose high transparency requirements on corporate agents even if it is hard to determine the precise costs and benefits of every component of the disclosure policy. an additional point should be made with respect to the quality of the information disclosed. in financial markets, policymakers can assume that simply providing the information is sufficient because there is efficiency even if the information is understood only by a limited number of professionals. this, arguably, is not the case in the context of non-financial disclosure, where the range of sophistication of parties is much wider. to achieve disclosure that can expose the political impact of corporations to outsider scrutiny, the information should be transparent, and not just technically available. 100 it must be presented in a way that is more than just accurate—disclosure must operate under guidelines that require auditors to illustrate the saliency of the provided 100 see bebchuk & fried, supra note 98, at 11, 64–70 (2004) (making a similar argument about executive compensation). 108 columbia journal of tax law [vol.6:86 information. policymakers face a difficult dilemma of whether to settle for a relatively light touch disclosure regime, or to try a much more difficult (and costly) regime that promotes transparency. the balance between these two approaches varies from one field to another. part iii provides a single in-depth analysis of what i consider to be the most straightforward application of the analysis: corporate tax disclosure. in summary, the notion of social and environmental disclosure is an administrable policy alternative that would be effective in promoting normatively legitimate corporate agency. although far from offering any clear-cut and no-cost solution, the proposal offers a solution that conforms to notions of democratic accountability based on a process of informed decision-making and, therefore, should be considered seriously by policymakers. iv. the case for tax disclosure this part takes the previous theoretical analysis a step further by presenting the case of tax disclosure as an example of how the deficit of corporate political agency should be incrementally addressed. the ambition of this article is not to reduce corporate tax planning per se, but only to ensure that corporate tax planning strategies conform with shareholders’ (and public) conceptions of what comprises legitimate planning behavior. tax disclosure operates as the ideal case study for demonstrating how the concept of corporate political agency bears concrete results in analyzing csr issues and for explaining how disclosure can reduce the negative political externalities associated with rational ignorance. by demonstrating that social disclosure would be possible even with respect to such a technical and difficult issue, this article hopes to establish the plausibility and significance of its underlying proposal. to achieve this, the article draws some broad-brush lines between its analysis and recent literature on tax disclosure. 101 the first attribute of tax disclosure that makes it an ideal case study is its negligible marginal costs—corporations already produce and deliver the relevant information to tax authorities. the second is its political relevance as an issue of tax policy. the third, and most important, attribute is the seeming gap between shareholders’ positions on tax avoidance and the actual conduct of corporations. a. corporate tax planning: a clear case of political agency deficit although taxation, particularly corporate and international taxation, is viewed as a complex topic, it is not fundamentally different from other csr issues involving mnes’ creative compliance strategies. creative compliance with regulatory requirements is a byproduct of a number of factors, including ambiguity about legal norms, insufficient funding of state enforcement agencies, and corporate access to (typically legal) expertise specializing in reducing the regulatory burden. 102 even though it is similar to other csr issues, corporations’ tax payment strategies have attracted relatively little csr-oriented research. 103 the following analysis demonstrates why 101 see infra part iv.b. 102 ilan benshalom, the quest to tax financial income in a global economy: emerging to an allocation phase–taxing global financial institutions, 28 va. tax rev. 165, 174 (2008); doreen mcbarnet, corporate social responsibility beyond law, through law, for law: the new corporate accountability, in the new corporate accountability: corporate social responsibility and the law 9, 46–48 (doreen mcbarnet et al. eds., 2007). 103 john christensen & richard murphy, the social irresponsibility of corporate tax avoidance: taking csr to the bottom line, 47 dev. 37, 37 (2004); mihir a. desai & dhammika dharmapala, csr and 2014] tax disclosure and corporate political agency 109 mnes’ tax planning strategies highlight the problems associated with their lack of corporate political agency and explains how this could be remedied by a better flow of information. a case study of mnes’ tax avoidance strategies is interesting because managers’ ability to minimize corporate tax liabilities goes to the heart of their duty to maximize profits. traditional (wealth maximization-oriented) corporate law analysis views corporate tax payment as a transfer made by shareholders, as the residual owners, to the government. 104 hence, because tax planning is not a prohibited criminal activity, minimization of corporate tax liabilities is a permissible way to increase shareholders’ return for their investments. at least in theory, 105 it seems as though managers have an obligation to disregard their personal views about tax avoidance and minimize their corporation’s tax liabilities via any legal, albeit aggressive, planning option available. this obligation may strike some as odd, since many shareholders may not support this standard of behavior when it comes to tax planning. individuals have widely different views about tax avoidance and tax planning. while some view it as a legitimate attempt to minimize tax liabilities, others view it as a distasteful, irresponsible, and immoral practice. some scholars argue that (with very few exceptions) all tax planning initiatives are negative and wasteful. 106 other scholars view some corporate tax planning practices more favorably. 107 the existence of the large volumes of literature that consider what comprises legitimate tax avoidance demonstrates the plurality of views on this topic and the difficulty that academics, judges, and lawmakers have in agreeing on how to define it. 108 the relative neglect of corporate tax minimization strategies in csr literature is surprising because tax payment (and lack of tax payment) has unquestionable welfare consequences on other members of society. corporate tax planning has the consequence of the government being paid less money. 109 this generally has a negative impact on other members of society, requiring the state to either reduce public provisions, due to its reduced spending capacity, or to increase the tax burden on its members to taxation: the missing link, leading perspectives, winter 2006, at 4; grant a. richardson & roman lanis, corporate social responsibility and tax aggressiveness (working paper, 2011) (manuscript at 7), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1904002) (noting that csr research tends to focus on corporations’ environmental impacts); luke watson, corporate social responsibility and tax aggressiveness: an examination of unrecognized tax benefits (am. taxation. assoc. working paper, 2011), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1760073). 104 reuven s. avi-yonah, corporate social responsibility and strategic tax behavior, in tax and corporate governance 183 (wolfgang schon ed., 2008) (noting the different theories over the nature of corporations and tax aspects of the csr obligations); desai & dharmapala, supra note 103, at 5. 105 for different views, see desai & dharmapala, supra note 103, at 5; christensen & murphy, supra note 103. 106 david a. weisbach, ten truths about tax shelters, 55 tax. l. rev. 215, 222–25 (2002). 107 in particular, some scholars have noted that various corporate tax planning strategies are responses to intentional governmental attempts to attract large corporate investments via non-transparent methods of tax price discrimination. see mihir a. desai et al., do tax havens divert economic activity?, 90 econ. letters 219 (2005); benjamin alarie, price discrimination in income taxation (jan. 16, 2012) (unpublished manuscript) (available at http://ssrn.com/abstract=1986272). 108 for two recent examples of this literature, see leandra lederman, w(h)ither economic substance?, 95 iowa l. rev. 389 (2010); shannon weeks mccormack, tax shelters and statutory interpretation: a much needed purposive approach, u. ill. l. rev. 697 (2009). 109 myron s. scholes et al., taxes & business strategy (4th ed. 2008). 110 columbia journal of tax law [vol.6:86 compensate. 110 in fact, as some important public finance scholars have noted, corporate tax payments—especially income tax payments—are the most visible and straightforward contribution that corporations make to non-shareholders and non-employees. 111 however one views tax avoidance, individuals clearly have diverse preferences on the issue. this diversity has some real world consequences. individuals or companies with higher “tax morals,” or (as economists would frame it) higher subjective costs, are less likely to engage in tax planning, and are in turn exposed to higher tax rate burdens. 112 while aggressive tax planning can have significant financial and reputational costs, 113 there is little empirical indication that these costs play any role in determining share prices. 114 hence, differences in tax morals and professional ethics can help explain why corporations exhibit such great variances in their tax planning and, specifically, why allegedly rational corporate managers are willing to overpay taxes that they could avoid by investing in tax sheltering activities. all of this demonstrates that what constitutes legitimate tax planning behavior remains an open question, and one that cuts to the very essence of what comprises ethical business conduct. 115 members of society have clear and tangible incentives to “free ride” by letting others pay taxes without doing so themselves. in this context, the reasons that determining what constitutes legitimate tax planning is such a highly controversial political and ethical topic are clear. taxpayers have a right to structure their transactions in any way they choose, and it is difficult to determine if any one structure serves a reasonable objective or is primarily an attempt to free ride off of other tax-paying members of society. the fact that the question is unsettled provides the reason for mandatory disclosure, so that shareholders can make a determination according to their own political preferences. as discussed in part iii, comprehensive and readily comparable public disclosure of corporate tax payment information may trigger responses in other spheres. 116 current shareholder wealth maximization financial reporting requirements do not require specific details with respect to corporate tax planning strategies. therefore, a tax planning device used by a corporation should be reported only if it can substantially affect its income projections. in doing so, the current requirements require corporations 110 see richardson & lanis, supra note 103, at 6 (discussing the negative character of aggressive corporate tax planning). 111 desai & dharmapala, supra note 103. 112 see generally philipp doerrenberg et al., nice guys finish last: are people with higher tax morale taxed more heavily? (iza discussion paper no. 6275, 2012) (providing an economic model that illustrates this point). 113 jeffrey p. owens, good corporate governance: the tax dimension, in tax and corporate governance 9, 10 (wolfgang schon ed., 2008). 114 john gallemore et al., the reputational costs of tax avoidance (2012) (unpublished manuscript) (available at http://ssrn.com/abstract=1986226). 115 if asked, shareholders would presumably provide different answers to what is the optimal balance between the desire to increase the financial returns to their investments and the tax ethics. in the context of small, closely held businesses, where shareholders can communicate their aggressive tax preferences to managers, there should be no political agency problem on this issue. however, the same does not follow in the context of large, public corporations, especially mnes. 116 this may also include reputational costs associated with consumer pressure on corporations that are perceived as aggressive tax avoiders or political pressure on politicians to improve the tax system. see david l. lenter et al., public disclosure of corporate tax return information: accounting, economics, and legal perspectives, 56 nat'l tax j. 803, 803 (2003); joel slemrod, the economics of corporate tax selfishness, 57 nat'l tax j. 877, 886 (2004). 2014] tax disclosure and corporate political agency 111 to provide the type of information that “rational” investors and creditors interested only in increasing their wealth would demand—that is, only information that impacts a given corporation’s financial stability. 117 in fact, the information provided by public corporations’ financial statements is generally not sufficient to isolate and compare even very basic information such as annual tax liabilities and payments in a given year. 118 from a social perspective, shareholders’ general lack of knowledge and ability to comprehend the conduct of corporate agents is far from optimal. given the powerful arguments that tax planning has little, if any, positive social welfare effects on society, this seems to be a relatively straightforward case in which the rational ignorance among shareholders encourages corporate managers to engage in behaviors that have negative social welfare effects overall. the relatively smooth operation of modern self-reporting tax systems is possible because of individuals’ reluctance to maximize their financial returns by exploiting tax loopholes and evasion opportunities. 119 because sanctions alone are insufficient in deterring aggressive tax planning behavior, tax authorities also have to rely on the social norms of ethical tax compliance among sophisticated corporate actors. in this context, the detachment of shareholders from knowledge and accountability makes corporate tax compliance more difficult to achieve. put differently, current wealth maximization-oriented corporate law and financial disclosure regimes encourage corporations to turn their tax departments into “profit centers.” 120 these incentives to turn tax minimization into a business strategy may strike some as odd since large corporations, particularly mnes, are not ordinary taxpayers; rather, they are the ones responsible for most of a country’s corporate income tax revenue. 121 furthermore, mnes, as taxpayers, have a large number of tax reduction opportunities because they operate in multiple jurisdictions, employ economies of scope and scale, maintain considerable lobbying power, and have access to tax planning expertise. unsurprisingly, the result of tax planning by these large corporate taxpayers is extremely costly in terms of foregone revenue. 122 this result is neither neutral nor reasonable from a social perspective. nevertheless, it is a predictable outcome, given the rational response of managers to the incentives that current financial disclosure rules provide. b. tax disclosure: from theory to practice this subpart provides a basic summary of the literature dealing with tax disclosure, describing some of the key strengths and weaknesses of public disclosure of corporate tax information. it then turns to examine this article’s analysis about the negative political externalities of non-disclosure. the next subpart contextualizes these conclusions by explaining how tax disclosure would operate with respect to a recent, well-publicized tax minimization strategy employed by apple. tax disclosure has been employed in the united states in the past, 123 and is still 117 gary a. mcgill & edmund outslay, lost in translation: detecting tax shelter activity in financial statements, 57 nat'l tax j. 739, 743–44 (2004). 118 see lenter, supra note 116, at 822. 119 see weisbach, supra note 106, at 243–47. 120 see slemrod, supra note 116, at 885. 121 ilan benshalom, how to live with a tax code with which you disagree: doctrine, optimal tax, common sense, and the debt equity distinction 88 n.c.l. rev. 1217, 1239 (2010). 122 see christensen & murphy, supra note 103, at 39–40 (suggesting that reliance on the offshore economy has become an important component of many globalized sectors); slemrod, supra note 116, at 880. 123 see lenter, supra note 116, at 807–10 (describing the u.s. experience with tax disclosure rules). 112 columbia journal of tax law [vol.6:86 employed in various (primarily scandinavian) countries, where taxpayers are required to report their tax liabilities. 124 historically, the tax disclosure debate has revolved around a somewhat different axis than that presented in this analysis—namely, whether it can help improve tax compliance. 125 the idea was that wealthy people would be afraid to disclose the fact that they make low tax payments that do not correspond with their financial abilities and living standards. the issue re-emerged at the beginning of the millennium in the aftermath of several corporate-accounting scandals. 126 when enron collapsed, news coverage revealed that it and other fraudulent corporations reported enormous financial accounting profits to their shareholders but little taxable income to the government. hence, the renewed interest in public disclosure of tax information sprang from the notion that large corporations were engaged in too much tax sheltering, and that this was a symptom of a greater problem in the business ethics of corporate america. 127 it remains difficult to determine which taxpayers should be covered by tax disclosure requirements, and what information they should disclose. disclosing tax return information is obviously in conflict with the notion of taxpayers’ privacy protection. today, taxpayer privacy is such an important principle that the internal revenue service (irs) is restricted even from providing tax return information to other government agencies. 128 there seems to be agreement that full disclosure of corporate tax returns is undesirable. 129 first, while public corporations do not have a right to privacy in the same way in which individuals do, there is a fear that tax disclosure would force them to disclose sensitive proprietary information to their competitors. second, full disclosure would require corporations to disclose an enormous amount of information and would provide them with an incentive to dilute the quality of the tax information in a way that would obfuscate, rather than highlight, their relevant tax planning strategies. 130 on the other hand, it is clear that a tax disclosure regime that only provides crude, aggregated information—such as total tax liability and effective tax rate—is also insufficient. a tax disclosure regime that relies only on such data would reveal more information than what is currently available, but would not enable shareholders to grasp the nature of corporate tax reduction activities. furthermore, the idea that the disclosure 124 id. at 811–12. 125 on this issue, see joshua d. blank, what’s wrong with shaming corporate tax abuse, 62 tax l. rev. 539 (2009); lenter, supra note 116,, at 820; ronald a. pearlman, demystifying disclosure: first steps, 55 tax l. rev. 289 (2002); makoto hasegawa et al., the effect of public disclosure on reported taxable income: evidence from individuals and corporations in japan, (working paper, 2012), available at http://ssrn.com/abstract=1653948. 126 lenter, supra note 116, at 804–06. 127 id. at 804–06. 128 james n. benedict & leslie a. lupert, federal income tax returns—the tension between government access and confidentiality, 64 cornell l. rev. 940 (1979) (describing the 1976 act that limited non-irs government officials’ access to tax return information); lenter, supra note 116, at 811–12 (noting that tax confidentiality is very strong and backed with criminal liabilities). 129 see lenter, supra note 116; mcgill & outslay, supra note 117, at 753–54. see joshua d. blank, overcoming overdisclosure: toward tax shelter detection, 56 ucla l. rev. 1629, 1655–71 (2009) (engaging in a somewhat similar analysis and explaining why current disclosure rules with respect to listed transactions are overly inclusive). 130 see joshua d. blank, overcoming overdisclosure: toward tax shelter detection, 56 ucla l. rev. 1629, 1655–71 (2009)( (engaging in a somewhat similar analysis and explaining why current listed transaction rules are overly inclusive in a way that provides aggressive and conservative taxpayers with incentives to disclose too much information from what the irs can reasonably handle). 2014] tax disclosure and corporate political agency 113 of aggregated data is sufficient rests on the assumption that there is a clear social norm with regard to lowering one’s tax rates. however, in our political-legal culture, there is widespread ambivalence about whether paying fewer taxes is, indeed, antisocial behavior. 131 corporations that reduce their tax liabilities are often considered sophisticated, especially since governments intentionally provide many of these tax reduction opportunities. indeed, as mentioned, the problem with tax planning lies in the fact that there is not one clear and agreed upon answer as to what comprises legitimate behavior. 132 the above analysis does not deny that any tax disclosure regime that wishes to foster political agency with respect to corporate tax payment would need to include aggregated data (e.g., taxes paid at effective tax rates on domestic and foreign incomes). however, aggregated data would also need to include some information that provides a stronger signal for controversial, tax planning behavior. such controversial information should include levels of investment and engagement in tax sheltering transactions, penalties paid to the irs, the amount of money saved through authorized tax minimization strategies, and explanations for every major difference between tax and financial accounting figures. this type of information would be more intrusive and, therefore, more expensive (and politically difficult) to generate. however, it is important to recognize that the vast majority of this information already exists, and is already provided to the irs. 133 this suggests that the costs of generating the information are only those costs associated with detaching relevant information from the rest of the tax return and “translating” it into a format that is easier to read and comprehend. within the limited framework of this case study, it is impossible to review every technical aspect of such requirements. however, it is important to note that this regime could be made more effective through a set of simple procedures. these would include penalties for over or misleading disclosure, a list of safe haven elements that do not require disclosure, and a requirement to provide a written description of corporate strategies and tax planning transactions. 134 the next subpart provides a real world example that contextualizes the analysis. c. the open debate about apple’s stateless (and tax-less) subsidiaries this section will consider a tax-planning device that recently received considerable public attention: apple’s “stateless subsidiaries.” 135 for simplicity, this article focuses on the first component of this multistep transaction, 136 which allowed 131 for such an approach, see the opinion of judge hand in helvering v. gregory, 69 f.2d 809, 810 (2d cir. 1934). 132 see supra notes 102–08 and accompanying text. 133 blank, supra note 129, at 1635–42 (describing the current listed transactions, mandatory disclosure regime that requires corporations to report every time they engage in transactions that are considered “suspicious”). 134 id. at 1672–86. 135 memorandum from sen. carl levin, chairman, and sen. john mccain, ranking minority member, permanent subcomm. on investigations, to the members of the subcomm. on investigations (may 21, 2013), at 17-37 available at http://www.levin.senate.gov/download/?id=fc514a8c-5890-47c4-ba7c149e4a8474c2. 136 see edward d. kleinbard, stateless income, 11 fla. tax rev. 699, 706–13 (2011) (skillfully describing a similar transaction involving google). 114 columbia journal of tax law [vol.6:86 apple to shift its intangibles to a subsidiary incorporated in ireland. 137 with the authorization of the irs, apple initially injected equity capital into a subsidiary incorporated in ireland, which otherwise had very little activity. this capital was then used by the subsidiary to purchase a share in intangible assets, which had been developed by the u.s. parent, mostly through the human capital of its american employees. the transaction was complexly engineered to allow the income earned by the subsidiary to be shifted outside of ireland, in essence allowing the subsidiary to become stateless; i.e., for tax purposes, it was located nowhere. instead of paying the ordinary irish tax rate of 12.5%, apple “negotiated [with ireland] a special corporate tax rate [for its stateless subsidiaries] of less than 2%.” 138 despite the overall complexity, the core of the transaction was relatively simple. apple, a corporation operating mostly from cupertino, california, raised capital and invested it in innovative r&d activity. 139 in the process of doing so, it probably deducted most of its r&d and finance costs from the parent’s domestic tax liabilities. then, with a stroke of a pen, it capitalized what eventually became a stateless subsidiary with equity capital. this equity investment was used by the subsidiary to purchase ownership rights in the highly profitable, intangible assets of the u.s. parent corporation (a purchase that probably triggered some type of tax liability). almost immediately after this capital arrived in the subsidiary’s bank account, it re-crossed the atlantic to the parent’s bank account. over the years, the subsidiary made subsequent payments under the cost sharing agreement financed through its vastly accumulated (and modestly taxed) retained earnings, which, despite apple’s modest physical presence in ireland, accounted for two thirds of its profits. 140 given that apple controlled 100% of these stateless subsidiaries, all these actions amounted to no more than paper shuffling—moving money from one corporate pocket to another. even though the united states taxes mnes on foreign earnings, the accumulated earnings of apple’s stateless subsidiaries were unlikely to be taxed. following the general rule that earnings are only taxed when realized, the apple parent would only pay taxes on these earnings once they repatriated as dividends in the united states. 141 hence, absent serious earnings or liquidity shocks, apple has no incentive to repatriate those earnings, and thus subject them to a 35% corporate income tax rate in the united states. 142 apple is a unique mne. it is among the most profitable corporations in the world 137 memorandum to members of the subcomm. on investigations, supra note 135, at 25-31. see ilan benshalom, sourcing the "unsourceable": the cost sharing regulations and the sourcing of affiliatedintangible related transactions, 26 va. tax rev. 631, 651–67 (2007) (providing an overview of how mnes use cost-sharing arrangements as a license to migrate profitable, intangible assets to low-tax jurisdictions). 138 memorandum to members of the subcomm. on investigations, supra note 135, at 20–21. 139 see offshore profit shifting and the u.s. tax code – part 2 (apple inc.): hearing before the permanent subcomm. on investigations of the comm. on homeland sec. and governmental affairs, 113th cong. 35 (testimony of timothy cook, chief exec. officer, apple inc.), available at http://www.gpo.gov/fdsys/pkg/chrg-113shrg81657/pdf/chrg-113shrg81657.pdf. 140 richard harvey jr., apple hearing: observations from an expert witness, 139 tax notes 1171, 1174 (2013). 141 however, dividend payments are discretionary; the irish subsidiary is not obligated to make them, and the controlling parent company, wishing to defer or avoid the tax, is not likely to force it to do so. 142 the earnings of the subsidiary appear in apple’s financial statements and apple (probably) uses its control over them in a productive way (e.g., borrowing against them, reinvesting them in its own activities, and investing them in other enterprises). 2014] tax disclosure and corporate political agency 115 and its business relies on the production of highly profitable intangible assets. furthermore, its multinational scope allows it to undertake tax-planning opportunities unavailable to purely domestic corporations. it is, at the same time, a corporation that invests a lot in its brand name and reputation. most importantly, as a widely held public corporation, it is likely that the vast majority of american taxpayers are apple shareholders (either directly or indirectly, through pension savings accounts). apple’s actions were taken to maximize its shares’ value. 143 they were all legal and, to a certain extent, authorized by the irs. nevertheless, the public exposure of this tax reduction technique triggered a large-scale, sophisticated debate in all major news organizations about the taxation of mnes, in which a wide array of views were presented. 144 the debate revealed that there is no single agreed upon answer to whether apple’s behavior was right or wrong. 145 the answer to this question depends on many factors, including personal political preferences and the extent to which other corporations employ similar strategies. due to the ambiguity surrounding the question of whether this is a legitimate tax planning practice, a tax disclosure regime will not necessarily reduce the use of this type of planning device. instead, such a regime would require apple and other companies to disclose this strategy, as well as other tax reduction strategies, not only to the irs, but also to shareholders, which, in the case of apple, are the general public. certainly, there is only a low probability that revealing this would affect investment decisions. it would more likely trigger a better-informed debate among a broader circle of (non-tax expert) citizens in the general public. this type of debate may induce tax policymakers to reconsider the limitations that should be placed on such corporate tax reduction opportunities. the current information about public corporations does not provide shareholders with sufficient information to make judgments on these issues. instead, this information is made available primarily through sporadic news coverage and is thus generally anecdotal and in and out of the public agenda. this state of affairs is undesirable considering shareholders’ different preferences with respect to tax planning. for example, some shareholders may think corporations should pay more taxes and that apple’s actions were plainly unfair. others may think corporations like apple should be rewarded directly for creating high paying jobs in the united states and not indirectly 143 apple's testimony supra note 1, at 3 & 15. 144 see editorial, apple's taxes expose a rotten u.s. code, bloomberg, may 21, 2013, http://www.bloomberg.com/news/2013-05-21/apple-s-taxes-expose-the-rotten-u-s-code.html (noting that corporations' complicated tax maneuvers allow them to legitimately avoid taxes); editorial, no replacement for corporate taxes, n.y. times, may 31, 2013, http://www.nytimes.com/2013/05/31/opinion/noreplacement-for-corporate-taxes.html (arguing that the corporate tax should not be replaced because it is a progressive element and stating that “disclosure and exposure have a role to play in changing corporate norms . . . . . . [because for mnes like apple] their image is part of what they sell”); editorial, the apple tax diversion, wall st. j., may 21,, 2013, http://online.wsj.com/article/sb10001424127887324102604578497263976945032.html (noting that the apple case offered nothing new and that if anything it should prompt congress to enact a lower “ideally zero” corporate income tax rate to promote investment and growth); editorial, apple is shifting its tax burden, wash. post, may 22, 2013, http://articles.washingtonpost.com/2013-0521/opinions/39419357_1_tax-burden-corporate-tax-reform-u-s-tax-code (noting that apple's “stunning tax strategies” stress the price americans pay for the failure to promote tax reform). 145 see biting criticism, the economist, may 21, 2013, http://www.economist.com/blogs/schumpeter/2013/05/apples-tax-arrangements (noting that the issue is bound to continue to be relevant and controversial). 116 columbia journal of tax law [vol.6:86 through tax reduction opportunities that involve moving intangibles to stateless subsidiaries abroad. others still may think apple applied a legitimate self-help strategy that was a competitive necessity in the dynamic, globalized information technology market. 146 it is highly probable that the full spectrum of these views could be found among apple’s shareholders. however, the purely internal mechanism through which these types of decisions take place today avoids the political and moral debate altogether by relegating the essentially moral and political question of what comprises free riding in the context of tax planning to apple’s ceo, cfo, tax executives, and (to a limited extent) its board of directors. contemporary financial disclosure rules give corporate decisionmakers incentives only to increase the financial returns of their shareholders, which make their decisions to undertake tax-planning strategies easy to understand. this state of affairs is not “natural” or neutral—it is one that can and should be changed. requiring public corporations to incorporate more nuanced information about their tax minimization strategies, as outlined above, would facilitate the emergence of a more informed public debate about these issues. tax planning is but one of many issues in which disclosure can promote a more accountable corporate political agency. the low costs of producing relevant information and the salience of tax policy issues in contemporary political debates make corporate tax disclosure the easiest to implement and the most straightforward avenue to promote such accountability. all thousand-mile journeys start with a single step, and corporate tax disclosure offers the first step in this one. v. conclusions the article’s proposal aims to better reflect upon corporate tax planning behavior through the lens of political agency. increased or mandatory tax disclosure would encourage a more sincere and accountable public debate about the impact of corporations’ tax-planning activities and, more broadly, about the role of corporate power in a democracy. this article does not encourage controversial behaviors such as tax avoidance and does not offer a substitute for direct methods of tax enforcement regulation. instead, it provides the framework upon which complicated tax and non-tax political-regulatory decisions could adequately and transparently be made in recognition of an inherent corporate political agency. this article’s main argument is anchored by the notion that, in a democratic society, political decisions should be made by a well-informed and accountable body of citizens. the alienation of non-control shareholders from their investments creates political agency costs that conflict with this notion of democratic decision-making. current corporate law allows portfolio investors to distance themselves from their responsibility over the impact of their investment activities, resulting in managers using the people’s money to make political decisions that affect the people. these agency costs have been overlooked by the corporate law and public finance scholarship dealing with tax disclosure. this article refrains from offering a solution that aims to solve all of these related issues. instead, it focuses on addressing the problem of corporate political agency by advocating mandatory disclosure, taking the position that what the eye does not see, the heart does not feel. the main objective of this solution is to provide relevant and 146 especially given that other companies employed similar strategies. see supra note 136. 2014] tax disclosure and corporate political agency 117 accessible data to investors (mediated by “professional” actors) about the impact of their investments. the article’s proposal aims to better reflect upon corporate tax planning behavior rather than achieving any specific result. the solution encourages a more sincere and accountable public debate about the impact of corporate tax planning strategies. therefore, the article’s proposal should not be viewed as legitimizing tax planning or as a substitute for more direct methods of confronting abusive tax planning strategies. instead, it provides the public debate framework upon which these complicated political-tax decisions could transparently be made. microsoft word 07 cui, establishment a core concept in chinese inbound income taxation.docx 46 “establishment”: a core concept in chinese inbound income taxation wei cui* analogous with the concept of a u.s. “trade or business” in u.s. federal income tax law, the concept of “establishment” under chinese tax law determines the boundary between net-income and gross-income taxation of inbound investments. as central as the concept is, it has received surprisingly little interpretation. this article traces the cause of this underinterpretation to china’s traditional regulatory environment for foreign investment that was biased against portfolio investments and non-corporate business forms, and describes recent regulatory and commercial developments that may rekindle interest in elaborating the meaning of “establishment.” it then reviews the interpretations that have been given to the concept under existing law, as well as several areas of commercial practice where additional guidance is urgently needed. finally, the article examines what policy considerations should guide the further development of the concept. this policy analysis considers the overall tax policy stance toward foreign portfolio investment that may reasonably be attributed to china. the country’s large surpluses in current and capital accounts and currency reserves make it doubtful that a dramatically more favorable model for taxing foreign investment is appropriate in the near term. 'onetheless, because tax policy plays a subsidiary role to other regulatory policy in the treatment of foreign investments, cogent arguments can be advanced for adopting an interpretation of “establishment” that allows foreign portfolio investment already identified as beneficial for china to proceed. * associate professor, china university of political science and law, beijing. i am grateful to huang zhen, tong yingying and li kaigeng for research assistance, and to mr. jeffery kadet and professor adam chodorow for very helpful comments on earlier drafts of this paper. author email: wei.cui@aya.yale.edu. 2010] “establishme't” i' chi'ese tax 47 introduction ............................................................................................ 47 i. legal, regulatory and commercial context for the concept of “establishment” ...................................... 52 a. historical bias against unincorporated forms ................. 53 b. recent advances in partnership forms ............................. 58 c. increased foreign portfolio investment ............................. 60 ii. statutory concept of “establishment,” its evolution and importance ................................................ 63 a. statutory and quasi-statutory definitions ......................... 65 b. administrative announcements ......................................... 68 c. new uncertainties .............................................................. 72 iii. policy issues and the interpretation of “establishment” .................................................................. 76 a. general tax policy toward inbound portfolio investment .......................................................................... 76 1. assuming similar functions for tax and regulatory policies ..................................................... 77 2. assuming that tax and regulatory polices have different functions ..................................................... 80 b. interpretation of “establishment” for investment in partnerships ........................................................................ 83 1. symmetry between foreignand domesticallyinvested partnerships .................................................. 83 2. implication for partnership funds in china ................ 87 conclusion ............................................................................................... 89 introduction a basic similarity between the chinese approach to international income taxation and that of many other countries is the two-tiered system china uses to tax inbound foreign investments: some items of income earned by foreigners are taxed on a gross-income basis, primarily by way of withholding, while others are taxed on a net-income basis, through the filing of annual tax returns that account for both income and expenses. in the u.s., as a comparative example, whether an item of income is subject to one or the other mode of taxation turns upon whether the foreign recipient of income is engaged in a “trade or business” in the u.s. and whether the income is “effectively connected” with such u.s. trade or business.1 in china, a similar determination for a foreign non-individual taxpayer 1. i.r.c. §§ 871, 881, 882 (2009). 48 columbia jour'al of tax law [vol. 1:46 depends on whether the foreign entity’s income is effectively connected with an “establishment or site” (“jigouchangsuo,” or “establishment” for short) in china.2 the existence of this point of resemblance between chinese and american inbound income taxation is in itself unsurprising. there is, after all, the income tax treaty concept of “permanent establishment,” which determines whether the business profits of an enterprise are taxable on a net-income basis in the country where the income arises.3 this suggests that most countries adopt some combination of taxation on the basis of net and gross income for inbound investments. however, u.s. tax lawyers generally are careful in distinguishing between domestic and treaty law concepts. in the u.s., for example, the “u.s. trade or business”4 concept carries most of the weight in determining whether foreigners might be taxable on a net-income basis, whereas the “permanent establishment” concept performs, for the most part, a secondary function in determining how a nonresident would be taxed in the u.s.5 similarly, it is prudent to expect that the “permanent establishment” concept would not capture how other countries draw the line between netand gross-income basis taxation, and this determination for a foreign investor in china will rest on the interpretation of the domestic chinese concept of “establishment.” how china has drawn this line in the past, and how it might redraw it in the future, is the subject of this article.6 the urgent need to clarify the legal definition and application of “establishment” in china stems from three sets of recent legal, regulatory and commercial developments. the first is a liberalization of foreign investment regulations to permit more foreign business activities to be conducted in non-corporate forms, e.g., contractual joint ventures and partnerships.7 because the inflexibilities of china’s law for corporations 2. enterprise income tax law (10th nat’l people’s cong., mar. 16, 2007, effective jan. 1, 2008), arts. 3(2), 3(3), translated in worldlii (last visited feb. 14, 2010) [hereinafter eit law]. 3. see articles of the model convention with respect to taxes on income and on capital, arts. 5, 7 (org. for econ. cooperation & dev. 2005), available at http://www.oecd.org/dataoecd/50/49/35363840.pdf [hereinafter oecd model convention] (last visited feb. 14, 2010). 4. i.r.c. § 864(b) (2009). 5. see i.r.c. § 894(a) (2009). 6. whether any item of income received by a foreign entity may be taxed on a netincome basis also depends on whether the income is “effectively connected” with an “establishment.” thus, strictly speaking, having an “establishment” in china is only a necessary and not a sufficient condition for net-income basis taxation to apply. however, the examination of the law and practice of attribution of income to an “establishment” is beyond the scope of this article. 7. see infra notes 45–57 and accompanying text. 2010] “establishme't” i' chi'ese tax 49 have long constituted a burden for foreign investors, this regulatory relaxation is likely to be met with enthusiasm among investors interested in china.8 moreover, rapid developments in venture capital (vc) and private equity (pe), where the use of noncorporate forms prevails even in countries with flexible corporate laws, have also generated interest on the part of foreign investors in such forms in china.9 because in china, as elsewhere, whether a foreign person is taxed on a net-income or gross-income basis generally becomes an issue only when the person has an unincorporated business presence,10 exploration of new business forms has raised new questions about the line between these two bases of taxation. second, foreign portfolio investment (fpi) in china, as opposed to foreign direct investment (fdi), is now viewed more favorably than before, and it is starting to play a greater role in china’s capital markets.11 for active business operations in a foreign country (typically associated with fdi), net-income taxation, borne by either a subsidiary or a branch, is generally a given. it is typically passive investment activities that are sensitive to whether net-income or gross-income taxation applies. for example, under china’s new enterprise income tax law (“eit law”) and its implementing regulations, the corporate income tax rate is 25%, whereas the withholding tax rate on dividends, interest, royalties, capital gains, etc., is 10%.12 for most portfolio investors, despite the lack of deductions, investment income would be subject to a lower chinese tax rate (further reducible under income tax treaties) if it were not treated as received by a chinese establishment. as experience in the u.s. has shown,13 when fpi becomes an important part of a country’s domestic capital markets, delineating the boundary between net-income and gross-income taxation 8. nancy marsh et al., partnerships in china: the 'ew frontier, 14(4) ibfd asian pac. tax bull. 296, 296 (2008) (discussing the attraction of the partnership form as a way of circumventing the corporate form’s limitations on capital structure). 9. see, e.g., alan tsoi & pauline zhang, venture capital and private equity funds in china, 53 tax notes int’l 1211 (2009). 10. this is because business presence in the form of a corporate subsidiary is generally taxed under the regular income tax on a net-income basis. see infra section i.a.1. 11. see infra section i.b. 12. eit law, supra note 2, art. 4(1) (setting the corporate rate at 25%), art. 4(2) (setting the maximum withholding tax rate at 20%), art. 37 (providing for withholding on chinese-source income); enterprise income tax law implementation regulations (promulgated by the state council, decree no. 512, dec. 6, 2007, effective jan. 1, 2008) art. 91(1), translated in lawinfochina (last visited feb. 14, 2010) [hereinafter eit law ir] (reducing the withholding tax rate to 10%). 13. see generally stanford g. ross, united states taxation of aliens and foreign corporations: the foreign investors tax act of 1966 and related developments, 22 tax l. rev 277 (1967); david r. sicular & emma q. sobol, selected current effectively connected income issues for investment funds, 56 tax law 719 (2003). 50 columbia jour'al of tax law [vol. 1:46 also becomes crucial. third, the new eit law, effective since 2008, has dramatically limited the scope of tax holidays and concessions previously available to foreign investments.14 in the absence of these concessions and tax holidays, chinese tax planning for foreign investors will return to more traditional methods involving transaction structure, transfer pricing, and the like. these require more attention to technical applications of increasingly complex rules, in contrast to the previous singular focus of most fdi investors on obtaining tax holidays and other preferences. one of the many novel aspects of the eit law is that it has both rationalized and increased the complexity of the two-tiered structure of inbound taxation. at the center of this structure is the notion of “establishment or site.” yet, as this article explains, the notion of “establishment” has not been adequately interpreted under chinese tax law and remains poorly understood by both taxpayers and tax authorities. in light of growing taxpayer sophistication, this lack of clarity will become increasingly noticeable. this article offers the first scholarly analysis of the essential chinese tax concept of “establishment” in terms not only of its past and current interpretation but also of its likely treatment in the near future. in examining the latter, i will be particularly concerned with the design of appropriate tax rules for foreign portfolio investment. this focus reflects my belief that, more than other underlying economic causes for unincorporated business presences of foreigners, fpi in china’s capital markets will drive the development of the law relating to establishments.15 the article will be organized as follows. in section i, i describe the relatively unique legal, regulatory and commercial contexts in which “establishment” applies. these contextual configurations are important for tax practitioners and policymakers to understand because they significantly shape how tax issues arise and how the market and governmental authorities respond. in particular, i argue that the intertwining of organizational and regulatory law in china traditionally created a serious bias against unincorporated forms of foreign investment. this may be the single most important factor that explains the underdevelopment of the 14. tax holidays had been granted on the basis of the location and nature of the operation of the fies. they often covered at least firms’ initial five profitable years, and sometimes lasted even longer. see generally jinyan li, fundamental enterprise income tax reform in china: motivations and major changes, 61 bulletin for int’l taxation 519 (2007). 15. other underlying causes include natural resource explorations, short-term visits of professionals providing technological know-how, and so on. see arvid a. skaar, permanent establishment: erosion of a tax treaty principle (kluwer law and taxation 1991), at 13–17. 2010] “establishme't” i' chi'ese tax 51 concept of “establishment” (compared to the elaboration of the concept’s equivalent in other jurisdictions) in the past. in addition, significant barriers to foreign portfolio investment also limit the scope of application of “establishment.” although restrictions against unincorporated business forms and fpi have been significantly relaxed recently, the incremental fashion in which this is taking place also explains the slowness with which tax authorities have responded. section ii turns to government-issued interpretations of the scope of “establishment” under chinese statutes and regulations, as well as the areas of foreign investment in which the ambiguities associated with the concept have recently become most notable. while the government’s interpretations of “establishment” remain incomplete, important examples can be found showing at least an awareness of the special problems posed by noncorporate business forms and portfolio investments. however, this awareness has yet to develop into a sustained recognition of an important policy issue. in the meantime, striking inconsistencies exist in the implicit approach the government has taken toward the interpretation of “establishment.” in section iii, i try to advance this area of policy by examining some of the choices facing the further development of the notion of “establishment.” the first choice can be formulated as the following question: assuming that foreign portfolio investors favor the exclusion of passive investments from the definition of “establishment,” would a comprehensive interpretation of “establishment” in this manner be appropriate in the near future? because china is likely to continue to control capital accounts,16 particularly in the face of increasing evidence of inflow associated with the expectation of continued appreciation of the renminbi (the chinese currency) and global financial instability generally, the answer appears to be “no,” at least for the short term. assuming this answer to be correct, one may nonetheless raise the question: how can reasonable tax treatments be designed for forms of fpi, e.g., private equity investments, that are already identified as beneficial for china? using the currently-debated issue of the partnership-to-partner attributions of business nexus as an illustration, i argue that more specific policy considerations must be introduced to make advances in this area. such considerations include whether a tax rule is aimed at affecting a binary decision by investors of investing or not investing, instead of at a marginal decision of how much more to invest, as well as whether the rule introduces dissimilar treatment of foreign and domestic investors that could easily lead to manipulation. 16. see infra notes 171–184 and accompanying text. 52 columbia jour'al of tax law [vol. 1:46 while i believe that many of the empirical hypotheses and legal interpretations advanced in this article are novel in some respects, the arguments in section iii are explorations in uncharted waters to an even greater extent than others. especially because of different views about the nature of capital inflows and their impact on the chinese economy,17 it has become difficult in the past few years to find coherent articulations of china’s overall economic policy toward inbound portfolio investment. even rarer are discussions of what tax policies may be appropriate for the coming years. i believe this is largely attributable to the fact that economic and tax policies toward foreign investment fall within the jurisdiction of an at once insular and fragmented bureaucratic state, where there are few channels for public input and little inter-agency coordination. the bureaucrats in charge generally lack the incentives to confront larger policy issues and to process and integrate the information needed to resolve them. however, the politics of regulation-making in china is beyond the scope of this article.18 i nevertheless offer a tentative analysis of the considerations relevant to current tax policy toward inbound portfolio investment in the hope that the analysis (however inchoate) may shed light on where the government’s and taxpayers’ interests lie, so that technical discussions of treatments of particular transactions may take on a greater sense of purpose. i. legal, regulatory and commercial context for the concept of “establishment” non-tax legal and regulatory factors can sometimes shape tax law concepts in powerful ways. in china, as elsewhere, a locally formed corporation is treated as a domestic taxpayer even if owned wholly by foreign persons.19 thus, whether a foreign person is taxed on a net-income basis is an issue only when the person has an unincorporated business presence in china, and the concept of “establishment” applies only where unincorporated business operations are permitted by non-tax law. a crucial piece of background for understanding china’s inbound tax rules is therefore that the country’s fdi regulatory regime has traditionally displayed a substantial bias against unincorporated business forms.20 this section explores the manifestations and causes of this bias. it also examines a policy preference against foreign portfolio investment—another 17. see infra notes 173–179 and accompanying text. 18. see generally victor shih, factions and finance in china (cambridge univ. press 2008). 19. see eit law, supra note 2, art. 2. 20. see infra section i.a. 2010] “establishme't” i' chi'ese tax 53 factor that in the past has impeded the development of tax rules concerning “establishment.” besides providing the background to china’s inbound tax rules, the bias in the choice of form in china’s fdi regulation raises an interesting question for tax scholars. in the design of international tax policy, a fundamental question is whether tax law should give effect to the legal distinctness of corporate subsidiaries.21 in the context of such discussion, it seems useful to know whether multinational corporations (mncs), when they choose to invest in other jurisdictions, generally prefer to use corporate subsidiaries as opposed to branches. it is sometimes observed that, in fact, mncs predominantly use the subsidiary form.22 as we will see, while this observation also holds true in the context of foreign investment in china, it does not reveal anything about mnc preferences since in china, the branch form is generally not allowed.23 indeed, given the rigid capital structure requirements for the corporate form, many mncs investing in china, unless they have very substantial operations there, would likely have a preference for non-corporate forms. more generally, there may be other countries like china, where a relatively rigid statutory limitation on corporate form would have created a preference for the branch form, but the branch or other non-corporate form was not available to achieve mncs’ economic goals. this suggests that the empirical question of what mncs prefer is quite complicated, as it would need to take into account different countries’ regulatory hurdles for different business forms. a. historical bias against unincorporated forms while the limited availability of noncorporate business organizational forms in china has not gone unnoticed,24 there is no official or well-known account of why this is the case. a plausible hypothesis would explain the phenomenon as follows. the early development of the fdi regime focused on corporate forms.25 because foreign invested 21. see, e.g., reuven s. avi-yonah & kimberly a. clausing, a proposal to adopt formulary apportionment for corporate income taxation: the hamilton project (univ. of mich. pub. law, working paper no. 85, 2007) available at http://ssrn.com/abstract=995202 (last visited feb. 14, 2010). 22. see daniel shaviro, does more sophisticated mean better?, 54 tax l. rev. 353, 360 (2001). 23. see infra notes 38–39 and accompanying text. 24. see xinmiao tang, inquiry into the organizational forms available to foreign invested enterprises, international business daily (china), february 22, 2002, at 8 (in mandarin). 25. since the late 1970s, china has erected a legal framework for fdi by adopting a series of laws and regulations, among which three statutes have set force the three major 54 columbia jour'al of tax law [vol. 1:46 enterprises (fies) are heavily regulated in china, with regulatory power over them assigned to powerful government agencies early on, the corporate forms of fies became associated with vested interests of the regulatory agencies.26 these vested interests ensured that non-corporate forms were neglected in the legislative process and discriminated against in practice, since such forms would not enhance, and could even detract from, the authority of the agencies. the juncture at which corporate law and regulatory interest become intertwined can be identified more precisely. a basic distinction between corporate and non-corporate business forms in china is the emphasis on a relatively stable capital structure for the corporate form.27 following a continental european model,28 china’s corporations are subject to registered capital requirements where both increases and decreases in equity capital require cumbersome procedures purported to facilitate monitoring by creditors.29 these aspects of the corporate law, aimed at protecting creditors against shareholders, coincided with many early fdi regulatory concerns, such as that fies engaged only in business activities for which they were approved, that foreign investors actually contributed the capital and technologies that they promised, and that foreign investors permitted forms of foreign invested entities. the earliest of these statutory forms—the chinese-foreign equity joint venture—was required to be corporate in nature. although the two later forms (the chinese-foreign cooperative joint venture and the wholly-owned foreign enterprise) theoretically allowed non-corporate variations, their legislation was contemporaneous with efforts to draft the company law, and well preceded the partnership enterprise law and other business organizational law. see, inter alia, the law on chineseforeign equity joint ventures (promulgated by the standing comm. nat’l people’s cong., july 1, 1979, effective as amended mar. 15, 2001), translated in asianlii (last visited feb. 14, 2010) [hereinafter ejv law]; the law on chinese-foreign contractual joint ventures (promulgated by the nat’l people’s cong., april 13, 1988, effective as amended oct. 31, 2000), translated in asianlii (last visited feb. 14, 2010) [hereinafter cjv law]; the law on wholly foreign-owned enterprises (promulgated by the nat’l people’s cong., april 12, 1986, effective as amended oct. 31, 2000), available at http://english.mofcom.gov.cn/aarticle/lawsdata/chineselaw/200411/20041100311068.html (last visited feb. 14, 2010) (as revised oct. 31, 2000) (in translation); the company law (promulgated by the standing comm. nat’l people’s cong., dec. 29, 1993, effective as amended oct. 27, 2005), translated in asianlii (last visited feb. 14, 2010) [hereinafter company law]. 26. the most important of these agencies include the ministry of commerce and the state development and reform commission (and their predecessors), as well as the state administration of industry and commerce. daniel c.k. chow, the legal system of the people’s republic of china in a nutshell, 368–409 (2d ed. 2009). 27see generally yan liu, reflections on the registered capital system, 51.31 peking u. law rev. (zhongwai faxue) 34 (1997); xudong zhao, from reliance on capital to reliance on assets, 25.5 chinese journal of law (faxueyanjiu) 109 (2003). 28. see generally zhao, supra note 27. 29. id. 2010] “establishme't” i' chi'ese tax 55 did not financially harm chinese joint venture partners.30 therefore, fie regulations tended to accentuate these aspects of the corporate model: for example, changes in capital structure of an fie must not only be accountable to creditors, but also be approved by the government itself.31 even as the regulatory concerns gradually lost their relevance when china’s economy became more open after the 1990s, government agencies seemed reluctant to surrender control. enforcing the rigidities of corporate law allowed them to continue to wield power over fies; it is therefore not surprising that these agencies are at best ambivalent about the development of new, more flexible business forms. this explanation of the regulatory entrenchment of the corporate form is consistent with the history of the development of the few noncorporate business forms available to foreign investors, including the representative office, the corporate branch, and the cooperative joint venture. the most traditional type of unincorporated presence in china is the representative office (ro).32 initially, ros were the only footholds foreign businesses could establish in china’s closed economy.33 they were meant to serve no more than liaison functions and were subject to light regulatory requirements. in a very few sectors, ros were subsequently permitted to grow and perform more robust functions. for example, foreign law firms were explicitly authorized to provide certain legal services through ros, and that is how most foreign law firms in china operate now.34 but outside these sectors, ros are prohibited from engaging 30. see, e.g., ejv law, supra note 25, at art. 5 (venture partner must warrant quality of equipment and technology); regulations for the implementation of the law on sino-foreign equity joint ventures, art. 4 (promulgated by the state council, sept. 20, 1983, last amended july 22, 2001), available at http://www.fdi.gov.cn/pub/fdi_en/laws/generallawsandregulations/regulationsonforei gninvestment/p020060620322890786346.pdf (last visited feb. 14, 2010) (as revised july 22, 2001) (in translation) (stating that the government should review a joint venture contract to ensure that it is not “patently unfair to one party”). 31. see paul, hastings shanghai office, using a chinese entity for an all-foreign joint venture in china—does it make sense?, china law & practice, may 2005, at 28; see also generally chow, supra note 26, chapter 10. 32. see interim provisions on the administration of resident representative offices of foreign enterprises (promulgated by the state council, oct. 30, 1980), translated in asianlii (last visited feb. 14, 2010). 33. see owen d. nee, jr., business operations in the people’s republic of china, b.n.a. tax mgmt. portfolio 957-3d, a-25 to a-26 (2008). 34. in effect, therefore, law firm ros are like branches, even though they are not labeled as such. regulation on administration of representative offices of foreign law firms (promulgated by the state council, dec. 22, 2001, effective jan. 1, 2002), available at http://www.gov.cn/english/laws/2005-08/24/content_25816.htm (last visited feb. 14, 2010) (in translation). 56 columbia jour'al of tax law [vol. 1:46 in direct profit-making activities (including investing) and from performing other than ancillary functions.35 instead, profit-making activities must be pursued through the heavily regulated fie forms.36 in reality, the boundary between “support functions” and “direct” profit-making activities is vague; it is difficult for businesses to avoid and for the government to police. the ros of many foreign businesses venture into grey areas far from the strictest interpretation of the officially sanctioned business scope for ros.37 a second type of unincorporated presence is the corporate branch. although china’s company law has allowed foreign companies to establish branches since 1993, it required the state council to issue regulations for the approval of such branches.38 relevant regulations have been adopted for only a few sectors (including banking). thus, the only foreign companies that have opened branches in china fall within those few sectors.39 note that in the few sectors in which either ros are permitted to 35. a 1995 regulation stated that, for ros under its jurisdiction, none can engage in “direct” profit-making activities. instead, they may only pursue “liaison, marketing support, information gathering and technology exchanges.” in other words, an ro generally is not allowed to pursue businesses of its own; it can only provide support to the business activities of the foreign company of which the ro is legally a part. implementing rules for the examination, approval and administration of resident representative offices of foreign enterprises (promulgated by the ministry of foreign trade and econ. cooperation, feb. 13, 1995), available at http://www.pathtochina.com/chinabiz/2007/12/detailed-rules-of-theimplementation-of-the-examination-approval-and-administration-of-the-residentrepresentative-offices-of-foreign-enterprises-in-china/ (last visited feb. 14, 2010) (in translation). 36. in a recent sign of liberalization of foreign investment regulation, the state council has circulated a draft of the revised administrative measures for the registration of representative offices of foreign enterprises (on file with the author), which states that a representative office may engage in profit-making activities to the extent provided by treaties or agreements that china has entered into with other countries. 37. indirect evidence for this occurrence is a large number of circulars issued by the ministry of finance, the state administration of taxation and local tax agencies on the taxation of different types of income of ros. see e.g., cai shui [1985] 110 [interim provisions concerning imposition of consolidated industrial and commercial tax and enterprise income tax on resident representative offices of foreign enterprises] (promulgated by the ministry of finance, may 15 1985); cai shui [1985] 122 [interpretation of some policy matters regarding the interim provisions for the collection of consolidated industrial and commercial tax and enterprises income tax on resident representative offices] (promulgated by the ministry of finance, may 15 1985); cai shui wai [1985] 197 [additional regulations on the question concerning imposition of consolidated industrial and commercial tax and enterprise income tax on resident representative offices of foreign enterprises] (promulgated by the ministry of finance and state admin. of taxation, sept. 25, 1985). 38. company law, supra note 25, art. 11. 39. see state council decree [2006] 478 [regulations on the administration of foreign-invested banks] (promulgated by the state council, nov. 8, 2006) (permitting bank branches); state council decree [2001] 336 [regulation on the administration of insurance 2010] “establishme't” i' chi'ese tax 57 pursue profit-making activities directly or foreign companies are allowed to set up branches, specialized agencies—including the ministry of justice (which regulates the legal profession) and bank and insurance regulators— are involved, in addition to the agencies generally in charge of foreign direct investment. this may suggest that unincorporated business pursuits were made possible in these sectors only because other bureaucratic voices superseded the voice of the pro-corporate-form, traditional fdi regulators. yet another story illustrating the same inhospitality toward noncorporate forms relates to the history of the cooperative joint venture (cjv), one of the three traditional forms of fies.40 before the cjv form was codified in 1988,41 chinese and foreign venture partners experimented with the form and, in some cases, indicated a preference for a cjv to take the “non-legal person” format—in other words, to be merely contractual in nature and not limited in liability as a matter of organizational law.42 this preference, as well as the use of similar organizational forms in other countries, was recognized by the government when the cjv law was drafted.43 however, soon after the fie regulatory regime established its authority over the cjv form, the use of the non-legal person cjv declined, reportedly because “government authorities [would] generally no longer approve such cooperative enterprises.”44 this was so much the case that when the government revived the non-legal person cjv form for establishing domestic venture capital funds in 2003 (discussed immediately below), even the most experienced legal and tax practitioners in china confessed to unfamiliarity with it. companies with foreign investment] (promulgated by the state council, dec. 5, 2001) (permitting insurance company branches); state council decree [1993] 131 [regulation on sino-foreign cooperation in the exploitation of continental petroleum resources] (promulgated by the state council, oct. 7, 1993, as amended by state council decree 317, sept. 18, 2007) (permitting oil and gas company branches). 40. see cjv law, supra note 25. 41. the law on chinese-foreign cooperative joint ventures (promulgated by the nat’l people’s cong., apr. 13, 1988, revised oct. 31, 2000), available at http://www.hecpb.gov.cn/english/news/display.php?id=1 (last visited feb. 14, 2010) (in translation). 42. see tuobin deng, minister of foreign trade and econ. cooperation, (7th nat’l people’s cong. mar. 31, 1988) (discussing the draft of the cjv law submitted to the nat’l people’s cong.). 43. id. 44. nee, supra note 33, at a-23 to a-24. although the cjv (even in its legal person form) is widely perceived to be more flexible than the equity joint venture (ejv), the use of cjvs in general lagged behind the use of ejvs, likely due to the regulatory preference over the latter. 58 columbia jour'al of tax law [vol. 1:46 b. recent advances in partnership forms in contrast to the historical bias against unincorporated forms of foreign investment, a remarkable surge of interest in such forms has taken place in the last few years. this began with a multi-agency effort to promote venture capital investing in china in the early 2000s.45 foreign vc operators were perceived to be crucial providers of expertise in the nascent industry, and after a few years of consultation, the government understood that foreign fund sponsors would only accept non-corporate means of fund formation.46 because china’s partnership enterprise law did not permit foreign or non-individual investors at that time, the government turned to the cooperative joint venture for organizing “foreigninvested venture capital investment enterprises,” permitting the use of nonlegal person cjv for this purpose.47 more recently, in 2006, china revised its partnership enterprise law.48 the revised partnership enterprise law for the first time permits foreign investors to become partners in chinese partnerships and provides a statutory framework for limited partnerships.49 no particular government agency can be considered the backer or sponsor of the partnership enterprise law’s revision.50 instead, it was moved along by china’s legislative elite (including legal academics, but with little participation from legal service providers) generally responsible for planning the development of china’s statutory framework.51 for this reason, although foreign investment in chinese partnerships is now a statutory possibility, its actualization, like the actualization of the possibility of foreign corporate branches in china, still faces some uncertainty. in particular, according to the partnership enterprise law, foreign 45. see jeff wood & richard xu, china’s revised venture capital rules: limited partnerships with chinese characteristics?, china law & practice, mar. 2003, at 18. 46. id. 47. see provisions concerning the administration of foreign-funded venture investment enterprises (promulgated by the ministry of foreign trade and econ. cooperation, jan. 30, 2003, effective mar. 1, 2003) available at http://english.sohu.com/2004/07/04/78/article220847846.shtml (last visited feb. 14, 2010). 48. the partnership enterprise law (promulgated by the nat’l people’s cong., feb. 23, 1997, as amended aug. 27, 2006) available at http://www.buyusa.gov/asianow/partnership.doc (last visited feb. 14. 2010) [hereinafter partnership enterprise law]. 49. see marsh et al., supra note 8; peng tao, is it a good time to form a chinese partnership enterprise?, china tax intelligence, oct. 2007 at 22. 50. interview with shuguang li, professor, china university of political science and law, in beijing, china (aug. 10, 2006). professor li participated in the drafting of the partnership law. 51. id. 2010] “establishme't” i' chi'ese tax 59 invested partnerships (fips) can be established only pursuant to further regulations issued by the state council.52 in designing such regulations, which have not yet been issued, the state council faces a dilemma. on one hand, the regulation of fips needs to generally conform to regulations governing other fies: if the former is significantly more relaxed than the latter, then many foreign businesses will abandon the traditional rigid fie forms in favor of the more flexible partnership form.53 this could lead to an opening in the fie control regime with unpredictable consequences. “on the other hand, keeping fips in parity with traditional fies would largely deprive fips of the attractions of the partnership form, and essentially defeat the purpose” of enacting the legislation.54 however, in discussions preceding the adoption of the revised partnership enterprise law, it was clearly understood that the partnership form was necessary for venture capital development.55 indeed, some of the strongest interest in the newly available partnership form has come from chinese and foreign financial operators looking to establish onshore, rmbdenominated funds.56 it is possible that regulations for establishing fips will be issued specifically for the vc and pe industries, much as regulations for establishing branches of foreign corporations were issued for select financial industries.57 what is more difficult to predict is whether the recent and imminent advances in the use of non-corporate forms (nonlegal person cjvs and partnerships) in the context of investment businesses will transform the general bias against unincorporated forms of fdi. because of that bias, foreign companies (outside the few sectors where business operations through the ro and branch forms are permitted) have in the past been found to have establishments in china for tax purposes mostly in connection with the exploration and extraction of natural 52. partnership enterprise law, supra note 48, art. 108. 53. for further discussion of this dilemma and draft fip regulations circulated in 2007, see wei cui, china: will partnership law be worth it?, xxvii int’l fin. l. rev., sept. 2008, at 30–32. 54. id. 55. see ruihua sun, china’s venture capital at a turning point, 130 new econ. wkly, april 3, 2007 (in mandarin), available at http://www.daokan.com/articleshow.asp?articleid=2310&articlepage=1 (last visited feb. 14, 2010). 56. see rick carew, china cheers private-equity home teams, wall st. j., sept. 14, 2007, at c1; rick carew, chinese private-equity fund’s 'ew role, wall st. j., nov. 23, 2007, at c3; rick carew, 'ew private-equity fund targets deals in china, wall st. j., feb. 4, 2008, at c3; china onshore private equity funds (clifford chance client briefing), nov. 2007 (on file with author). 57. see rick carew, buyout firms race to build yuan funds to tap china, wall st. j., aug. 21, 2009, at c2 (reporting that draft rules governing yuan private-equity funds are in the hands of china’s cabinet). 60 columbia jour'al of tax law [vol. 1:46 resources, construction and installation projects, and other activities of a relatively temporary nature.58 the introduction of investment or operating partnerships (or partnership-like entities) would create significant new challenges for tax rules, as further discussed in sections ii.c and iii.b, infra. c. increased foreign portfolio investment besides giving impetus to the development of non-corporate business forms, foreign investments in chinese vc and pe funds also represent another trend with important implications for inbound taxation. such funds often acquire significant stakes in target companies, and, on occasion, provide active financial and management services to the portfolio companies. for this reason, whether investment by a fund should be treated as passive investment may be subject to debate. on the other hand, the investments made in these funds by limited partners are more clearly characterized as passive investments, and therefore can be regarded as part of a broader pattern of increased foreign portfolio investment (fpi) in china. traditionally, official chinese policy discounted the need for fpi. because of the high domestic savings rate and other factors, china was not thought to need financial capital per se.59 instead, the attraction of foreign investment was the introduction of technologies and know-how (and until recently, the development of china’s export economy), and this could happen only through fdi.60 thus china’s foreign investment regime has been heavily biased toward equity as opposed to debt investments.61 even for equity investments, foreigners are encouraged to invest only in certain sectors where china’s technological needs are obvious, and are restricted or prohibited from investing in disfavored sectors.62 58. for a discussion of the tax rules in this area, see joint oil and gas exploitation between foreign and chinese companies (deloitte world tax advisor), mar. 20, 2009, available at http://deloitte.12hna.com/newsletters/2009/wta/a090320_1.pdf (last visited feb. 14, 2010). 59. see eswar prasad & shang-jin wei, the chinese approach to capital inflows: patterns and possible explanations, in capital controls and capital flows in emerging economies: policies, practices and consequences 421 (sebastian edwards ed., 2007). 60. id. 61. id. at 433; see also neal stender et al., foreign currency debt and conversion controls tightened for strong rmb era, 18 china law & practice 73, 73 (july/aug. 2004) (summarizing the basic workings of cross-border borrowing by fies in china). 62. see generally prasad & wei, supra note 59, at 429; see also, generally, yasheng huang, selling china–foreign direct investment during the reform era 2010] “establishme't” i' chi'ese tax 61 this policy has had two consequences. one is that is that fpi has lagged behind fdi in china in terms of volume. according to imf data, by 2006, the stock of fpi into china was worth only a little over $200 billion, much less than the official fdi stock of $742 billion.63 in comparison, the u.s. attracted slightly more equity fpi than fdi in 2007; the volume of each exceeded $2 trillion.64 the other consequence is that while the total amount of china-bound fpi is still significant, most such investments have taken place offshore, as chinese companies listed their stock and debt securities in foreign exchanges in hong kong, the u.s., etc.65 given their offshore nature, very few of these investments contributed to the development of domestic capital markets. more recently, the chinese government has come to view fpi more favorably, precisely because of its potential benefit for china’s onshore markets.66 for example, there has been a shortage on china’s stock market of experienced institutional investors with long-term investment objectives;67 so in 2002, the domestic stock and bond markets were opened in a limited fashion to qualified foreign institutional investors (qfiis).68 in 2006 the qfii regime was further liberalized.69 similarly, in the field of pe (cambridge univ. press 2003) (arguing that the above policy was not in fact effective, that what passed as fdi was in many cases financial investment, and that this occurred because chinese domestic enterprises, faced with a dysfunctional domestic financial service sector, obtained foreign financing under the pretension of seeking technological know-how). 63. see international monetary fund, portfolio investment: coordinated portfolio investment survey, http://www.imf.org/external/np/sta/pi/cpis.htm (last visited feb. 14, 2010) [hereinafter cpis]; state admin. of foreign exchange, china’s international investment position 2007 (in mandarin), http://www.gov.cn/gzdt/200806/21/content_1023491.htm (last visited feb. 14, 2010) [hereinafter safe]. 64. see cpis, supra note 63; safe, supra note 63; elena l. nguyen, international investment position of the united states at year-end 2007, bureau of economic analysis survey of current business online, july 2008, at 9, available at http://www.bea.gov/scb/pdf/2008/07%20july/0708_iip.pdf (last visited feb. 14. 2010). 65. see international monetary fund, coordinated portfolio investment survey guide (2001), at 11-12 (imf data collection attempts to identify residence of issuer regardless of place of listing); alice de jonge, corporate governance and china’s h-share market 56 (edward elgar 2008) (“by december 2003, a total of 93 chinese companies had issued shares outside of china, raising 27.1 billion us dollars in total.” this number should also have risen substantially by 2006.). 66. see andrew mcginty & andrew godwin, the missing piece of the puzzle: 'ew qfii rules open a share market, china law and practice, dec. 2002 at 10. 67. id. 68. see id. before 2002, foreigners were allowed to trade chinese stock in the domestic exchanges only among themselves, in a separate market from where domestic investors traded. see also stephen green, china’s stockmarket 50–55 (profile books, the economist series 2003). 69. see taylor hui & vivien teu, china qfii rules revised—significant developments for foreign fund managers, china law and practice, nov. 2006 at 9. 62 columbia jour'al of tax law [vol. 1:46 and vc investing, it is thought that foreign institutions and professionals operating in such asset classes possess important expertise in evaluating and improving business performance and governance, and their participation is needed if the field is to develop quickly.70 the latest signs of this policy orientation include the ministry of commerce’s decision in march 2009 to delegate the authority to approve new foreign-invested venture capital enterprises with total capital not exceeding $100 million71 to provincial authorities, which are generally regarded as more eager to promote foreign investments then national agencies.72 not surprisingly, because china’s inbound taxation has traditionally focused on fdi (as has the rest of the regulatory system), its operation has faltered as fpi in china expands. for example, at the onset of the qfii regime, it was immediately unclear how withholding taxes would apply to income received by qfiis.73 should the tax exemption then granted for repatriation of profits on fdi apply to dividends paid on stock held by qfiis as well? should the tax on capital gain applicable to the sale of fdi investments also apply to gain on the trading of stock where no suitable withholding mechanisms have been put in place? if china were to tax qfii income, how would it administer the granting of treaty benefits? until quite recently,74 in the absence of explicit guidance, qfiis (and their customers on behalf of whom qfiis invested and traded in china) did not have to pay chinese income tax on many types of investment income without knowing whether there was any legal basis for this de facto exemption or how long it would last.75 we will see further below that other forms of fpi in china, for example, real estate investments,76 have generated their share of long-standing questions about appropriate tax treatments. while, unlike the onshore investment fund and qfii areas, there has been no significant liberalization in recent years in these other areas of fpi, if any momentum gathers for clarifying the tax treatment of 70. see, e.g., yan zhou, blackstone sets up 'ew private equity fund in pudong, china daily, aug. 18, 2009, available at http://www.chinadaily.com.cn/bizchina/200908/18/content_8581500.htm (last visited feb. 14, 2010). 71. see supra notes 45–47 and accompanying text. 72. see shang zi han [2009] 9 [notice regarding the approval of foreign-invested venture capital enterprises and venture capital management enterprises] (promulgated by the ministry of commerce, mar. 5, 2009); o’melveny & myers, china law and policy 'ewsflash: deregulation of foreign-invested rmb funds and managers of private equity, mar. 17, 2009 (on file with author). 73. see kehong wu, qfii investments in chinese stock–a feast of tax exemptions? (in mandarin), 2 int’l taxation in china (shewai shuiwu) 73, 73–76 (2008). 74. see infra notes 144–49 and accompanying text. 75. see kehong, supra note 73, at 74–75. 76. for a discussion of foreign real estate ownership, see infra notes 109-115 and accompanying text. 2010] “establishme't” i' chi'ese tax 63 onshore funds and qfiis, there may be implications for the whole range of fpi as well. ii. statutory concept of “establishment,” its evolution and importance before i examine the existing interpretations of “establishment,” an explanation is in order regarding the statutory framework within which the concept has its place. china’s enterprise income tax and the individual income tax (iit) currently fall under two separate statutory regimes, and “establishment,” a concept employed by the eit law, does not apply for iit purposes.77 in fact, not only is the concept inapplicable in connection with individual taxpayers, but the current structure of the iit also renders the distinction between netand gross-income taxation relatively unimportant for foreign individuals. under china’s individual income tax law and underlying regulations,78 individuals are effectively classified as residents and nonresidents on the basis of domicile and physical presence in china,79 with residents being subject to taxation on worldwide income.80 non-residents generally are not required to file income tax returns.81 their income from labor services performed in china, if not exempt under domestic or treaty law,82 is taxed by way of withholding, and they are taxed on other income at flat rates, also via withholding, regardless of nexus to china.83 moreover, the iit allows few deductions and credits, and 77. the concept does not appear under the individual income tax law (promulgated by the nat’l people’s cong., sept. 10, 1980, as last amended on dec. 29, 2007), translated in lawinfochina (last visited feb. 14, 2010) [hereinafter iit law] or its regulations (regulations on the implementation of individual income tax (promulgated by the state council, feb.18, 2008, effective jan. 28, 1994), translated in lawinfochina (last visited feb. 14, 2010) [hereinafter iit law ir]. 78. see iit law, supra note 77; iit law ir, supra note 77. 79. iit law, supra note 77, art. 1; iit law ir, supra note 77, arts. 2, 3 and 6. 80. iit law, supra note 77, art. 1. 81. see guo shui fa [2006] 162 [circular of the state administration of taxation concerning printing and distributing the measures for the self-declaration of individual income tax] (promulgated by the ministry of commerce for trial implementation, nov. 6, 2006) art. 4; see generally wei cui, china’s 'ew personal income tax return-filing regime, 45 tax notes int’l 977 (2007). 82. domestic law, following the treatment of dependent services in income tax treaties, exempts compensation received by any nonresident individual who (1) is present in china for less than 90 days during the year, and (2) receives payment from a foreign employer, (3) the cost of which payment is not borne by a chinese “establishment” of the employer. iit law ir, supra note 77, art. 7. actual income tax treaties usually extend the length of the period in (1) to 183 days. 83. iit law, supra note 77, art. 3; iit law ir, supra note 77, arts. 4 and 5. 64 columbia jour'al of tax law [vol. 1:46 essentially only labor service income is taxed at progressive rates.84 the only category of income received by an individual that is subject to genuine net-income taxation is self-employment income.85 however, foreign individuals are largely precluded by non-tax regulatory law from engaging in activities that would generate such income.86 this might seem to limit the significance of the “establishment” concept for chinese inbound taxation, but a fundamental feature of the eit law implies otherwise. the eit law treats all foreign entities in the same way, as though they are corporations.87 no foreign pass-through entities are recognized even though domestically, the pass-through concept applies to partnerships and certain other entities.88 thus, foreign partnerships, trusts, etc., investing in china would all be subject to the test of whether they have a chinese establishment. in addition, for regulatory reasons, outside the context of investments in real estate, foreign individuals rarely invest directly into china (whether the nature of the investment is fdi or fpi), and almost always use intermediate entities.89 as a result, despite its absence from the iit rules, the notion of “establishment” is relevant to foreign individual investors in china as well. 84. see li jinyan, china’s individual income tax: a 26-year-old infant, 43 tax notes int’l 297, 297 (2006). 85. iit law, supra note 77, art. 6. 86. see general principles of the civil law (promulgated by the 6th nat’l people’s cong., apr. 12, 1986, effective jan. 1, 1987) art. 26, translated in lawinfochina (generally, only citizens are permitted to register as “individual industrial and commercial households,” i.e., sole proprietorships); see also regulations on individual industrial and commercial households art. 2 (state council draft regulation circulated for public comment, july 2009), available at http://yijian.chinalaw.gov.cn/lismspro/law_download/fulltext/1248161068168.doc (last visited feb. 14, 2010). 87. article 1of the eit law defines enterprises subject to the enterprise income tax as all organizations receiving income. only specific types of entities formed in china (i.e., partnerships and single-individual-owner companies) are excluded from the definition. see eit law ir, supra note 12, art. 2. 88. see generally wei cui, the prospect of 'ew partnership taxation in china, 46 tax notes int’l 625 (2007) [hereinafter prospect of 'ew partnership taxation]. 89. telephone interview and written correspondence with both lawrence sussman, partner, o’melveny & myers and shaolin luo, partner, simpson thacher & bartlett, in beijing, china (nov. 23, 2009) (written correspondence on file with author). 2010] “establishme't” i' chi'ese tax 65 a. statutory and quasi-statutory definitions 90 ever since the first tax statute applicable to foreign and foreigninvested companies was enacted in 1981,91 chinese tax law has used the concept of “establishment.” under that statute—the foreign enterprise income tax law—income derived from a chinese “establishment” was taxed, after appropriate deductions, at graduated rates (with the top rate at 40%),92 whereas in the absence of an establishment, a foreign company would be taxed at a flat 20% rate on the gross amount of any dividends, interest, rent, royalties and other income from sources within china.93 neither the law nor its implementing rules contained a concept that characterized income as “effectively connected” with an “establishment.”94 therefore, at least on paper, the 1981 law is consistent with a “force of attraction” regime: as long as an “establishment” exists, all chinese-source income would be subject to net-basis taxation. it is unclear whether the law was interpreted and enforced in this way, although the answer is likely to be no.95 under the foreign invested enterprise and foreign enterprise income tax law of 1991, the consequences of having an “establishment” in china were reformulated. income effectively connected with the “establishment” would still be taxed on a net-income basis, but chinesesource income not effectively connected with an “establishment” was only 90. within the chinese legal system, material statutory terms and provisions are often left to be defined and elaborated by the state council instead of by the national legislature, and the state council is often the de facto ultimate decisionmaker in tax lawmaking. thus, the discussion here treats implementation regulations issued by the state council as quasistatutory. 91. foreign enterprise income tax law (promulgated by the standing comm. nat’l people’s cong., dec. 13, 1981, effective jan. 1, 1982), translated in asianlii (last visited feb. 14, 2010) [hereinafter 1981 feitl], replaced by income tax law on enterprises with foreign investment and foreign enterprises (promulgated by the standing comm. nat’l people’s cong., april 9, 1991, effective july 1, 1991), translated in asianlii (last visited feb. 14, 2010) [hereinafter 1991 feitl]. 92. 1981 feitl, supra note 91, arts. 1-3. 93. id. art. 11. 94. see rules for the implementation of the income tax law for foreign enterprises (promulgated by the ministry of finance, feb. 21, 1982), translated in asianlii (last visited feb. 14, 2010) [hereinafter 1982 feitl ir]. 95. foreign taxpayers still face fragmented tax administration in china: presence or activities in a particular locality could trigger tax return filing and other compliance obligations enforced by the tax authorities in that particular locality, without regard to the taxpayer’s other activities elsewhere. therefore, a local tax bureau may not regard itself as having the authority to tax a foreign company, which has an “establishment” within its jurisdiction, on other income received elsewhere. 66 columbia jour'al of tax law [vol. 1:46 subject to withholding tax on the gross amount.96 moreover, the definition of “establishment” itself was further developed. for example, according to the 1981 feitl, a “business agent” could constitute an establishment,97 but no definition was provided for the term. by contrast, the regulations implementing the 1991 feitl explicitly defined business agent, albeit narrowly focusing on trade-related agency activities.98 (as discussed below, this narrow definition of a business agent allowed for a significant 2003 ruling in favor of foreign taxpayers in the vc fund context.) similarly, the non-agency, physical presence type of “establishment” was redefined to include a larger variety of physical business presences.99 the 2007 eit law and its implementing regulations (which together constitute what i call the “new eit regime”) introduced what are perhaps the most significant changes to the definition of “establishment” to date. first, with respect to the agency type of establishment, the new law would find such an “establishment” where “a nonresident enterprise entrusts an agent to engage in production or trade, including signing contracts or storing and delivering commodities on behalf of the [principal] on a regular basis.”100 this is a broader definition of “business agents” than under previous law, most fundamentally because it is tied to the agent’s actions in production or trade (shengchan jingying), which potentially could be interpreted to cover many activities 101. in similar fashion, the new law no longer defines the physical presence type of “establishment” merely by enumerating examples. instead, it provides a catch-all category, “other 96. 1991 feitl, supra note 91, art. 19. although the statutory language states only that chinese-source income effectively connected with an “establishment” would be subject to net-income taxation, subsequent regulations defined chinese-source income as including any income, even if arising outside china, that is effectively connected with a chinese establishment. see detailed rules for the implementation of the income tax law for enterprises with foreign investment and foreign enterprises (promulgated by the state council, june 30, 1991, effective july 1, 1991) art. 6., translated in lawinfochina (last visited feb. 14, 2010) [hereinafter 1991 feitl ir]. this is based on an erroneous understanding of the function of source rules, and has been corrected by the eit law and the eit law ir. 97. 1982 feitl ir, supra note 94, art. 2(1). 98. a business agent was defined as a person “engaged in business as an agent for the principal and (1) regularly representing the principal in sourcing and purchasing, as well as in signing purchase contracts and buying goods on the principal’s behalf; (2) entering into an agency agreement or contract with the principal, regularly storing products or goods owned by the principal and delivering these products or goods to other parties on the principal’s behalf; or (3) being awarded the authority to regularly represent the principal in signing sales contracts and in accepting purchase orders.” 1991 feitl ir, supra note 96, art. 4. 99. id. art. 3. 100. eit law ir, supra note 12, art. 5. 101. see id. 2010] “establishme't” i' chi'ese tax 67 establishments engaged in production or trade.”102 the category of physical establishments is thus also open-ended, and the main criterion for determining its scope is whether there is engagement in “production or trade.”103 how, then, is the term “production or trade” to be understood? the answer is that although the term has been employed in the definition of “establishment” from the beginning,104 it has never been defined in statutes, administrative regulations, or agency rulings. the closest that the law has come to defining the term is the following. regulations under both the 1981 feitl and the 1991 feitl distinguished between two types of income: “income from production or trade” and “other income.” whereas “income from production or trade” was defined, circularly, by enumeration of various industries and trades and then a catch-all category of “other income from production or trade,”105 “other income” was defined as “dividend, interest, income from rental or transfer of property, royalties and income from transfer of patents and intellectual property rights, as well as income not derived from the carrying on of a trade.”106 it would appear logical to infer from the distinction between these two types of income that the mere holding or disposition of stock, debt, tangible property, and intellectual property, which does not generate “income from production or trade” but only “other income,” would not constitute “production or trade.” this inference will be particularly tempting for those familiar with the practice in the u.s. (and similar practices in oecd countries) of distinguishing between mere investments and the carrying on of a “trade or business.”107 however, the validity of this inference in the chinese context is doubtful, not because of any contrary interpretation of the term “production or trade” but for an opposite and striking reason: no known official pronouncement has ever relied on the distinction between “income from production or trade” and “other income.” indeed, perhaps precisely because of a perceived lack of relevance of the distinction, it has been eliminated in the new eit law and the regulations that have been issued so far. this is, of course, rather ironic, since the new eit regime has given the government greater latitude in interpreting the meaning of both the physical 102. id. 103. id. 104. 1982 feitl ir, supra note 94, art. 2. 105. id. 106. id. art. 4; 1991 feitl ir, supra note 96, art. 2. 107. see, e.g., higgins v. comm’r, 312 u.s. 212 (1941); chang hsiao liang v. comm’r, 23 t.c. 1040 (1955); see also ross, supra note 13, at 295, for a discussion of oecd practice. 68 columbia jour'al of tax law [vol. 1:46 presence and agency types of establishment,108 and the only articulated criterion for such interpretation is whether there is engagement in “production or trade.” against this background of interpretive vacuum, two administrative announcements stand out in that they have directly delineated the scope of “establishment.” i will examine these now, and consider to what extent they shed light on “production or trade.” b. administrative announcements in 1996, the state administration of taxation (sat) issued a circular regarding rental income received by foreign enterprises. 109 it states that if a foreign enterprise owns and rents out a house, building or other real property in china, but has not set up an “establishment or site” to carry out routine management of the property, it is subject to income tax on the rental income it receives on a gross income basis at the withholding tax rate.110 if the foreign enterprise entrusts an agent to manage the real property in question (and if, where a relevant income tax treaty applies, the agent is not an independent agent), then the foreign enterprise should be treated as having an “establishment” in china and subject to tax on a net income basis.111 the background of this circular is unclear, but its aim was probably to ensure some type of income tax collection on real estate rent received by foreigners, without particular emphasis on differential treatment between income derived from an “establishment” and income in the absence of an establishment. for example, in its instructions on the implementation of the circular, the beijing state tax bureau explicitly stated that, for rental income treated as effectively connected with an “establishment” under the sat circular, a deemed profit of 30% should be used in computing tax liability.112 had the 33% enterprise income tax rate been applied, the resulting 9.9% tax burden would be close to the 10% withholding tax rate on income not effectively connected with an establishment.113 tax bureaus 108. see supra notes 100–103 and accompanying text. 109. guo shui fa [1996] 212 [notice regarding taxing rental income of foreign enterprises from real property within china] (promulgated by the state admin. of taxation, nov. 20, 1996) [hereinafter guo shui fa [1996] 212]. 110. id. 111. id. 112. jing guo shui [1997] 27 [notice regarding the taxation of rental income of foreign enterprises by renting out buildings in china] (promulgated by the beijing state tax bureau, jan. 27, 1997). 113. see guo fa [2000] 37 [notice regarding reduced taxation of interest and other 2010] “establishme't” i' chi'ese tax 69 in shanghai allowed a similar approach and also provided for a deemed profit of 30%.114 this suggests that the distinction made in the sat circular was merely theoretical and did not have the intention of either encouraging foreign investment in real estate or securing greater revenue for the government.115 nonetheless, the text of the circular suggests, at least in the real estate context, the distinction between merely holding an asset and operating or using that asset.116 this resonates with a well-established body of u.s. law, going back to at least the 1940s, providing that mere real estate holding without servicing and maintaining the property does not give rise to a u.s. trade or business.117 conversely, under u.s. law, if a nonresident engages an agent to actively manage real property in the u.s., then the nonresident generally would be treated as engaging in a u.s. trade or business.118 the 1996 sat circular seems to have provided an extremely condensed version of this doctrine, and it is consistent with the earlier tax regulations characterizing rental income as other than “income from production or trade.”119 a second administrative announcement on the scope of “establishment” came in 2003120 and was associated with a well-known government effort to promote venture capital investments in china.121 at the start of 2003, several government ministries jointly issued regulations income from china derived by foreign enterprises] (promulgated by the state council, nov. 18, 2000). 114. hu shui wai [1997] 90 [notice regarding the taxation of rental income of foreign enterprises by renting out buildings in china] (promulgated by the shanghai state and local tax bureaus, july 11, 1997) [hereinafter hu shui wai [1997] 90]. 115. by contrast, in most of the early u.s. cases in which taxpayers and the government disputed whether real estate investment in the u.s. constituted a u.s. trade or business, important differences in tax liability existed (e.g., taxpayers sought to claim large deductions). see, e.g., lewenhaupt v. comm’r, 20 t.c. 151, 162 (1953), aff’d, 221 f.2d 227 (9th cir. 1955). 116. guo shui fa [1996] 212, supra note 109. 117. see, e.g., neill v. comm’r, 46 b.t.a. 197 (1942); de amodio v. comm’r, 34 t.c. 894 (1960). 118. de amodio, 34 t.c. at 904–905 (citing lewenhaupt v. comm’r, 20 t.c. 151 (1953)). 119. see hu shui wai [1997] 90, supra note 114 (shanghai tax authorities held further that “routine management” of real property involved the capacity to sign rental agreements, collect rent, to improve, repair and decorate the property, and “other substantive management activities,” but the mere hiring of persons to clean, guard, or perform daily maintenance of the property is not sufficient). 120. guo shui fa [2003] 61 [notice regarding the payment of enterprise income tax by foreign invested venture capital companies] (promulgated by the state admin. of taxation, june 4, 2003) [hereinafter guo shui fa [2003] 61]. 121. see supra section i.b. 70 columbia jour'al of tax law [vol. 1:46 on the formation of foreign-invested venture capital investment enterprises (fivcies); a few months later, the sat issued clarifications as to how such enterprises would be taxed.122 according to the sat pronouncement (the 2003 vc tax rules),123 if a fivcie takes a “legal person” form (i.e., its investors have limited liability), then it is taxed as a chinese corporation.124 if, on the other hand, it takes the “non-legal person” form (i.e., some investors bear unlimited liability), then the enterprise and its investors have a choice of computing their tax liabilities either at the enterprise or the investor level, but are not taxed at both levels.125 how, though, should the foreign investors be taxed if they determine their tax liabilities separately? should they be treated as having an “establishment” and taxed on a net-income basis, or should they be subject only to gross-income taxation? the 2003 vc tax rules provide that, generally, investors in non-legal person fivcie should be treated as having establishments within china and be taxed accordingly.126 however, if the fivcie does not have its own management office, and does not directly manage and advise its investments, but instead contracts with a separate management entity to conduct all of its daily affairs and manage its investments, then investors would not be treated as having an “establishment” in china by virtue of investing in the fivcie.127 while the circular contains no explicit argument for the conclusion, the underlying reasoning appears to be the following. as previously discussed, in general, a foreigner’s “establishment or site” in china can take the form either of a physical presence (e.g., a business office) or a business agent. under chinese commercial law, the investors in a non-legal person vc fund own the assets and rights of the business and are principals of its agents.128 therefore, any business office or agent of the fund itself would be deemed, for non-tax purposes, to be the office or agent of the fund’s investors. in the scenario described in the 2003 vc tax rules in which foreign investors are treated as not having an establishment, tax authorities 122. guo shui fa [2003] 61, supra note 120. 123. id. 124. id. 125. see also 1991 feitl ir, supra note 96, art. 7 (stating that participants in a “nonlegal person” cooperative joint venture may elect to pay eit separately, in lieu of the joint venture itself). 126. guo shui fa [2003] 61, supra note 120. 127. id. 128. implementation rules on chinese-foreign contractual joint ventures, arts. 50 and 52 (promulgated by the ministry of foreign trade and econ. coop., aug. 7, 1995, effective aug. 7, 1995), available at http://www.fdi.gov.cn/pub/fdi_en/laws/generallawsandregulations/regulationsonforei gninvestment/t20060620_51088.jsp (in translation) (last visited feb. 14, 2010). 2010] “establishme't” i' chi'ese tax 71 seem to have assumed that the fund does not have its own business office in china. (whether the office of the external manager should be attributed to the fund was not considered.)129 in addition, even if the external manager is an agent of the fund and its investors, there is no agency establishment. this is because under the tax law then in effect, only business agents engaged in the trading of goods were deemed to give rise to “establishments” for tax purposes.130 unlike the 1996 sat circular on foreign ownership of real estate, the 2003 vc tax rules had a genuinely positive effect, in that they enabled foreign investors to operate vc funds in china without the fear of being subject to net-income basis taxation.131 virtually all fivcies formed until recently (before the revised partnership enterprise law took effect) used the management company structure endorsed by the 2003 vc tax rules. however, as the foregoing analysis shows, the sat’s position is technically based not on characterizing vc investing as a type of investment activity, and thus as different from “production or trade.” instead, it is based on a narrow definition of “business agents”—a situation that the new eit regime has already changed. under that new regime, the questions can now be raised: why isn’t the external manager a business agent of the fund and its investors? if it is, why don’t the foreign investors have a business agent “establishment” through the manager? taken together, the 1996 real estate circular and the 2003 vc tax rules demonstrate that the government has yet to confront the distinct tax issues raised by the developments in business forms described in section i. these issues include basic items such as recognition of what is at stake in distinguishing net-income and gross-income taxation, as well as specialized items such as understanding the proper treatment of partnership and partnership-like forms. and most centrally, both rulings arose in the context of fpi, where a crucial issue is whether investment activities should be included in the scope of “production or trade” and therefore of “establishment.”132 the 2003 vc tax rules skirted that crucial issue, whereas the earlier ruling only apparently addressed it (without embracing its full consequences). 129. i.r.c. § 864(c)(5) (2009) (attributing the fixed place of business of a nonindependent agent to a foreign person). 130. see supra note 98. 131. guo shui fa [2003] 61, supra note 120. 132. see supra notes 105–107 and accompanying text. 72 columbia jour'al of tax law [vol. 1:46 c. 'ew uncertainties several recent developments in chinese tax administration highlight both the urgent need for the immediate clarification of the scope of “establishment” and how, in the absence of sustained policy focus on the matter, parties can take widely divergent and inconsistent approaches to taxing foreign investment.133 to begin, the 2003 vc tax rules134 appear to have been made obsolete—ironic in light of the already paltry amount of guidance available regarding fund formation.135 this is presumably due to the fact that the legal basis of those rules—the implementation regulations for the foreign invested enterprise and foreign enterprise income tax law of 1991—was replaced by the eit law on january 1, 2008.136 strictly speaking, therefore, there is no longer any valid legal guidance regarding the tax treatment of foreign invested venture capital investment enterprises.137 however, because other central government ministries have issued several circulars in favor of the operation of fivcies,138 market participants appear to assume that it is not the government’s intention to adopt radically new and unfavorable tax rules for fivcies, and new funds of this type continue to be formed.139 while the 2003 vc tax rules can no longer be shown to local tax authorities as binding on the treatment of fivcies, they are still presented as a reasonable way of taxing such entities in the absence of further guidance.140 133. i am grateful to lawrence sussman and min huang at the beijing office of o’melveny & myers for discussion of the developments reported in this section. 134. see guo shui fa [2003] 61, supra note 120. 135. there has been no formal announcement of revocation of the circular. instead, it is shown as “void in whole” on the website of the state administration of taxation. state admin. of taxation, http://202.108.90.178/guoshui/action/getarticleview1.do?id=3716&flag=1 (last visited feb. 14, 2010). 136. see 1991 feitl ir, supra note 96, art. 7 (stating that non-legal person cooperative joint ventures may be exempt from entity level taxation). there is no similar provision under the eit law or eit law implementation regulations. 137. some have gone so far as to suggest that such enterprises are no longer exempt from entity-level taxation. see kevin wang, foreign investors in rmb funds may face double taxation, 49 tax notes int’l 742, 742–43 (2008). as discussed in the ensuing text, the market has discounted the suggestion of such a radical change in policy. 138. see supra note 71 for deregulatory actions taken by the ministry of commerce; see also huizongfu [2008] 125 [replies to questions regarding the application of foreign exchange for domestic equity investments by foreign invested venture capital investment enterprises] (promulgated by the state admin. of foreign exchange, nov. 14, 2008) (facilitating foreign exchange conversion for fivcie investment activities). 139. telephone interview with lawrence sussman, managing partner, o’melveny & myers llp, in beijing, china (nov. 23, 2009). 140. id. 2010] “establishme't” i' chi'ese tax 73 needless to say, this state of affairs presents a significant legal risk to investors in fivcies, if only because there is no legal impediment to the government reversing the treatment in the 2003 vc tax rules. but just as importantly, as discussed above,141 the underlying reasoning in that regulation is in tension with the expansion of the scope of “business agent” type of “establishment” under the eit law implementation regulations. thus, even if the 2003 vc tax rules had not been made obsolete, there would have been a question of how it could be reconciled with the new eit regime. another source of concern is that foreign invested partnerships are widely regarded as a competing business form for the formation of rmb funds that will be available soon,142 whereas the 2003 vc tax rules, by their terms, do not apply to partnerships.143 the adoption of new tax rules for foreign invested partnerships could trigger new scrutiny of the rationale underlying the 2003 vc tax rules. in that scenario, taxpayers and their advisors may be called upon to freshly defend, for example, why holding an equity interest in a partnership or a partnership-like entity in china (which has assets and activities in china) should not constitute an “establishment” in china. as we will see in section iii below, such a defense involves complex policy considerations and is not easy to carry out. aggravating this legal uncertainty in the fund formation area is the manner in which chinese tax authorities have approached other related areas of foreign investment seemingly without awareness of the importance of the “establishment” concept, promulgating rules that imply contradictory positions. two regulations that have recently attracted practitioners’ attention illustrate this point. the first is a circular issued by the sat (state administration of taxation) at the beginning of 2009 that initiated the practice of withholding income tax paid to qfiis (qualified foreign institutional investors) by companies with stock or bonds listed on the chinese securities markets.144 this regulation (circular 47) brought an end to the previous status quo whereby qfiis were not subject to any withholding tax at all (even though there appeared to be no legal basis for such an exemption).145 a potential silver lining in circular 47, however, is 141. see supra notes 130–31 and accompanying text. 142. see supra notes 48–57 and accompanying text. 143. the 2003 vc tax rules apply only to entities formed under the provisions concerning the administration of foreign-funded venture investment enterprises. see guo shui fa [2003] 61, supra note 120; provisions concerning the administration of foreignfunded venture investment enterprises, supra note 47. 144. guo shui han [2009] 47 [notice regarding the withholding of enterprise income tax with respect to dividends and interest paid to qfii by chinese resident enterprises] (promulgated by the state admin. of taxation, jan. 23, 2009) [hereinafter guo shui han [2009] 47]. 145. see supra notes 73–75 and accompanying text; see also jinji wei, a view on 74 columbia jour'al of tax law [vol. 1:46 that it could be read as resolving an issue regarding “establishment” for qfiis. as discussed in section ii.a, under the eit law implementation regulations, a foreign entity may be deemed to have an “establishment” in china by operating through a business agent, even one that is independent in nature.146 under this regulatory language, the qfiis—foreign mutual funds, insurance companies, and other asset management companies—may all theoretically be deemed to have establishments in china via their onshore custodians and trading agents. although this issue may be mitigated for qfiis that are eligible for treaty benefits (as treaties generally provide that the conduct of business through independent agents does not give rise to permanent establishments),147 not all qfiis (or all customers that have accounts with qfiis) are formed in treaty jurisdictions. therefore, the question whether such foreign investors could be deemed to have “establishment” in china may remain unanswered. circular 47, by providing for the imposition of withholding tax on qfiis, could be read as conclusively addressing this issue: since all qfiis, regardless of whether they can claim the benefits of tax treaties,148 are treated as subject to the withholding tax and not net-income basis tax, it could be inferred that no qfii is deemed to have an “establishment” in china through actions by independent agents alone.149 this reading of circular 47, however, is contradicted by another regulation the sat issued during the same week. in this latter, widely discussed regulation (decree 19),150 the sat requires all nonresident enterprises that provide labor services151 in china to (1) register for tax purposes shortly after entering qualified foreign institutional investors in china, 56 tax notes int’l 275, 277 (2009). the regulation remains silent, however, on whether and how capital gain realized by qfiis is to be taxed, thus leaving a large vacuum in this area. 146. see eit law ir, supra note 12. 147. see, e.g., united nations model double taxation convention between developed and developing countries (2001) art. 14. 148. guo shui han [2009] 47, supra note 144. 149. under eit law ir, income is effectively connected with an “establishment” if the “establishment” “possesses, manages, or controls properties through which income is earned.” eit law ir, supra note 12, art. 8. since the securities owned by qfiis are held (possessed) by onshore custodians, it is unlikely that such custodians are deemed to be establishments but the interest and dividend income is not deemed to be “effectively connected.” 150. see state administration of taxation decree [2009] 19 [provisional administrative measures on the tax administration of contract projects and service provisions for nonresidents] (promulgated by the state admin. of taxation, jan. 20, 2009, effective mar. 1, 2009) [hereinafter state administration of taxation decree [2009] 19]; vivian jiang & koko tang, china issues guidance on tax treatment of 'onresidents on contract projects, 2009 worldwide tax daily, feb. 24, 2009, at 34–35. 151. all labor services are included in the scope of the regulation. see state administration of taxation decree [2009] 19, supra note 150, art. 3. the same regulation 2010] “establishme't” i' chi'ese tax 75 into contracts for the provision of such services,152 and (2) file income tax returns on both quarterly and annual bases.153 although nonresident enterprises may claim on their returns that their activities do not constitute permanent establishments under relevant treaties and therefore do not generate taxable income in china, there appears to be no exemption for the return filing requirement.154 the only circumstance under which the eit law requires nonresidents to file income tax returns in china is when such nonresidents have establishments in china.155 the implicit position of decree 19, therefore, seems to be that any provision of labor service in china— however transient and regardless of whether a fixed place of business is involved, no matter whether it is pursued through dependent or independent agents, and no matter whether it is pursued in the course of “production or trade”—would give rise to an “establishment” in china. this implicit position is contradictory to the implied position in circular 47. moreover, if it can be correctly attributed to the government, it will also amount to a fundamental and untenable expansion in the interpretation of “establishment.” this expansion is untenable because it implies that any physical presence in china in connection with service provision would constitute sufficient business nexus for a foreign entity to be taxed on a netincome basis in china (absent treaty protection). already, at least some nonresident enterprises are resisting compliance with decree 19.156 as surprising as it may seem that the sat would adopt measures that are at once careless and contradictory, it is equally surprising how few tax practitioners in china have voiced criticism of decree 19 for lacking legal authority.157 this silence makes it (painfully) obvious that the domestic law concept of “establishment” has been neglected by chinese tax administrators and tax practitioners alike, and that there is a widespread failure to recognize that the concept should have some substance of its own, independent of the treaty concept of establishment. also covered contract projects that nonresident enterprises have entered into (e.g., construction, installation, assembly, decoration and exploitation). 152. id. arts. 5–6. 153. id. arts. 12–13. 154. id. art. 13. 155. eit law, supra note 2, art. 51. 156. interview with lawrence sussman, supra note 139. 157. for existing commentary on decree 19, see jiang & tang, supra note 150, at 34; peng tao & sang kim, a brief examination of recent chinese tax rules on 'onresident enterprises, taxes, dec. 2009, at 39–52. 76 columbia jour'al of tax law [vol. 1:46 iii. policy issues and the interpretation of “establishment” a. general tax policy toward inbound portfolio investment in this section, i turn to the policy considerations that should guide chinese lawmakers and tax authorities in responding to the issues highlighted in the last section. the logic of the examination is as follows. in connection with a range of transactions either actively carried out today or anticipated for the near future, and including, among others, qfii activities on chinese securities markets,158 passive investments in domestic investment funds and in real estate, it is reasonable to assume that foreign investors would prefer not to be treated as having establishments in china.159 there is a range of tax rules that could deliver this result. viewing the question through the lens of u.s. tax law, for instance, one could suggest, for a start, a doctrine that treats largely passive investments as different in nature from business activities, or, in chinese terminology, from “production or trade.”160 but further, since the perceived benefit of inbound portfolio investment is not so much that it supplies additional capital to china, as it is that it would introduce sophisticated investors whose presence would contribute to capital market development, the performance of certain investment-related activities, such as due diligence and negotiation, trading, and exercise of investor rights, should be anticipated. such activities should not trigger adverse tax consequences. one could address the concerns that would arise here for, for example, qfiis, by excluding some types of securities trading from “production or trade,” analogous to the safe harbor for trading in stocks and securities of code section 864(b)(2)(a).161 investments in onshore funds may also benefit from such exclusion, depending on the nature of the funds’ activities. how should one evaluate proposals like this? clearly, the question is whether introducing such u.s.-style rules is consistent with china’s current policy objectives with respect to foreign investment. even some 158. see supra notes 67–69 and accompanying text. 159. this is mainly because the lower rates associated with the withholding tax (10% or less) generally more than compensate for the lack of deductions when income is taxed on a gross basis. see supra note 12 and accompanying text. 160. this could be thought of along the lines of u.s. judicial decisions that date back at least to higgins. higgins v. comm’r, 312 u.s. 212 (1941). such a doctrine would have to cope with variations in factual circumstances that could challenge one’s intuition about what is passive. the analog would be the judicial elaboration of the “considerable, continuous and regular” standard for “u.s. trade or business.” see sicular & sobol, supra note 13, at 735–43. 161. i.r.c. § 864(b)(2)(a) (2009). 2010] “establishme't” i' chi'ese tax 77 preliminary reflection is sufficient to cast doubt on any easy assumption that it must be good for china to encourage foreign investment through tax rules. instead, i will argue that the appropriate design of tax rules depends on understanding not only the wider economic context, but also the role tax policy plays relative to other regulatory policy. in particular, one should distinguish two conceptions of the role that tax policy might play. on the first conception, tax policy goals regarding foreign investment are set by general economic policy goals, and one may simply consider whether tax rules would in themselves advance such general goals. on the second conception, tax policy is a subordinate instrument to other regulatory policy, and it is only after considering the effects of other regulatory policy that one can choose objectives for tax policy. i will argue below that it is the second conception that more realistically characterizes the function of chinese tax policy toward foreign investment. interestingly, it is also on this second conception that arguments for rules favorable to foreign investors can be more cogently advanced. 1. assuming similar functions for tax and regulatory policies one potential model is to introduce u.s.-style rules to chinese inbound taxation. to consider whether this would be appropriate, it is useful briefly to recall the historical origin of some of the current u.s. rules. some fundamental components of current u.s. inbound tax system are the result of economic policy decisions that informed both tax and non-tax regulatory policies.162 the most important example of this is perhaps the foreign investors tax act (fita) of 1966.163 in the early 1960s, the u.s. faced a substantial balance-of-payment problem.164 despite a current account surplus from exports and significant current earnings on foreign investment, large outflows of u.s. investment capital were depleting the u.s. gold reserve and threatening the stability of the dollar.165 the kennedy and johnson administrations offered comprehensive tax and nontax policy responses to this situation, both by discouraging, or reducing the need for, certain types of outbound investment,166 and by encouraging investment into the u.s.167 these responses called for not only steps by the 162. see ross, supra note 13, at 288–90. 163. id. 164. id. 165. id. 166. id. with respect to outbound investments, for instance, tax policy responses included the enactment of controlled foreign corporation legislation and the interest equalization tax. 167. the imperative of improving the u.s. gold reserve was indeed so clear that even short-term deposits by foreigners in the united states, which “would not reduce the u.s. 78 columbia jour'al of tax law [vol. 1:46 treasury and congress to change tax rules, but also various actions by other government agencies as well as “the u.s. financial community” and u.s.based international corporations.168 the tax policy proposals that resulted in fita, which abolished the force-of-attraction regime and enacted the trading safe harbors of section 864(b), were accompanied by many other policy proposals aimed at inducing foreigners to purchase u.s. securities.169 suppose that we conceive the design of chinese inbound tax rules in general, and the interpretation of “establishment” in particular, as aimed at affecting foreign investments in a similar comprehensive fashion.170 in that case, one would have to note immediately that china’s current international investment position is diametrically the opposite of the u.s.’ in the early 1960s,171 and there is currently considerable official reservation about inbound investments. in the last few years, china has run a strong current account surplus and drawn large amounts of fdi, with the result that it now has accumulated the biggest foreign reserve in the world.172 in addition to trade and fdi-related inflows, very sizeable amounts of other capital inflow are also present, although it has been difficult to identify the precise magnitude.173 this additional inflow of capital is viewed by many observers to be the result of china’s fixed exchange rate policy and the expectation that renminbi will appreciate.174 although disagreement exists as to the extent to which the rapid capital inflows comprise “hot money”— in no small measure because there is disagreement about what is “hot money”175—the economic consequences of the inflow are evident: china’s payments deficit as customarily defined,” were to be encouraged, as they would “reduce the volume of liquid dollar assets that foreign central banks might use to buy gold.” report to the president of the united states from the task force on promoting increased foreign investment in united states corporate securities and increased foreign financing for united states corporations operating abroad, 13 (1964) available at http://www.sechistorical.org/collection/papers/1960/1964_0427_taskforceforeign.pdf (last visited feb. 14, 2010). 168. see generally id. other government agencies involved included the securities and exchange commission, the federal reserve, and the department of state. 169. id. at 13. 170. this would not be completely appropriate. see infra notes 191–94 and accompanying text. 171. see supra notes 184–89 and accompanying text. 172. andrew batson, china's reserves expand, wall st. j., jan. 16, 2010, at a-10. 173. see prasad & wei, supra note 59, at 8–12; calla wiemer, the currency: a tisket, a tasket, a band 'ot a basket, 9.2 china economic quarterly, at 42–46 (2005). the difficulty with identifying other inflows has to do with the uncertain amount of reserve increases attributable to appreciation in official asset holdings. 174. see prasad & wei, supra note 59, at 10, 12. 175. the term “hot money” typically refers to speculative flows of capital—particularly flows into countries with weak financial markets and institutions—that could potentially switch directions within a short time. see prasad & wei, supra note 59, at 10. 2010] “establishme't” i' chi'ese tax 79 foreign reserve is more and more likely to exceed the amount of optimal reserves, and the indirect addition to the domestic monetary base may contribute to inflationary pressure.176 moreover, it has been suggested that absent a currency revaluation, and as long as the domestic savings rate continues to exceed the rate of investment, the accumulation of reserves will continue.177 an analogy has indeed been drawn between this situation and a particular era in u.s. economic history: not the 1960s with large capital outflow and balance of payment problem under the bretton woods system, but the gilded age of the 1920s.178 economists disagree as to whether china should try to change this state of affairs by revaluing the renminbi.179 in any case, the chinese government has taken a series of ad hoc measures to mitigate the risk of high domestic liquidity and the non-optimality of high reserves. for example, it has loosened capital controls for outbound investments by chinese individuals180 and encouraged chinese state-owned enterprises to invest abroad.181 it has also relaxed requirements for repatriation of profits of foreign operations.182 with respect to inbound investments, foreign exchange control has been tightened,183 and a cautious approach has been 176. see michael pettis & logan wright, hot money poses risks to china’s stability, financial times, july 13, 2008, at 9. 177. see generally calla wiemer, don’t bet on the yuan, far eastern economic review, september 2008, at 23 [hereinafter don’t bet on the yuan]. 178. michael pettis, money matters: it’s the banking system, 'ot external debt, that’s scary, south china morning post, july 26, 2008, at 12. 179. china has already allowed the renminbi to float with respect to the dollar within a certain expanded range, but some argue that this is insufficient to deter speculative inflow. see andrew peaple, china fights speculative hordes, wall st. j. online, jan. 12, 2010, available at http://online.wsj.com/article/sb10001424052748704586504574653890470562198.html (last visited feb. 14, 2010). for a contrary view, see generally don’t bet on the yuan, supra note 177. 180. for a helpful overview of china’s foreign currency regime and the capital control measures to sustain a fixed exchange rate and large foreign reserves, see thomas hall, controlling for risk: an analysis of china’s system of foreign exchange and exchange rate management, 17 colum. j. asian l. 433, 464 (2004). 181. for a review of recent policies encouraging outbound investment, see daniel h. rosen & thilo hanemann, china’s changing outbound foreign direct investment profile: drivers and policy implications, peterson inst. for int’l econ. (june 2009), available at http://www.petersoninstitute.org/publications/interstitial.cfm?researchid=1245 (last visited feb. 14, 2010). 182. hui fa [2009] 30 [state administration of foreign exchange, regulations on foreign exchange administration of the overseas direct investment of domestic institutions] (promulgated by the state admin. of foreign exchange, sept. 13, 2009) art.4 (stating that foreign exchange earned can be kept overseas). 183. see hui zong fa [2008] 142 [notice regarding operational issues in enhancing the management of payment settlement in foreign exchange by foreign invested enterprises] 80 columbia jour'al of tax law [vol. 1:46 taken particularly with respect to real estate investments.184 these developments are best viewed as instinctive reactions by the relevant agencies and not as carefully considered new policies. nonetheless, they represent the complete opposite of u.s. policy toward cross border investments in the 1960s, and, as long as the government continues to resist appreciation of the renminbi or other fundamental economic undertakings, they are likely to persist. in light of this background, it would appear that any change in the tax system providing new inducements to foreign investment in china is unlikely because it would not fit the current, broader official attitude toward foreign investment. in particular, following the american model in delineating the boundary between net-income and gross-income taxation would seem to produce inconsistencies between tax policy and other policies. this could be said with respect both to the measure of excluding activities of trading securities from net-income taxation in the style of code section 864(b)(2), and the higgins-style, more conservative and more longstanding measure of excluding passive investment holding from netincome taxation under case law.185 instead, it seems more consistent for china to maintain the status quo, even if that means keeping the interpretation of “establishment” in its muddled state. however, the foregoing reasoning is based on a conception of tax policy as designed to target inbound investment in general, pari passu with non-tax regulatory policy. in reality, regulatory policy toward foreign investment has traditionally been dominant in china, whereas tax policy occupied a secondary role. put differently, the range of transactions that tax rules are allowed to affect is antecedently shaped by regulatory policy. and insofar as tax policy and regulatory policy play different roles, they may also take on different characters. 2. assuming that tax and regulatory polices have different functions the most important feature of chinese economic policy toward foreign investment is, of course, capital control.186 the country’s capital (promulgated by the state admin. of foreign exchange, aug. 29, 2008). 184. jian zhu fang [2006] 171 [opinions on regulation of approval and administration of foreign investment in the real estate market] (promulgated by the ministry of commerce, aug. 14, 2006). 185. while excluding trading activities from net-income taxation is not a prevalent international practice, excluding passive income is common at least among oecd countries. see ross, supra note 13, at 332. 186. see generally prasad & wei, supra note 59. 2010] “establishme't” i' chi'ese tax 81 account is only partially open, and only a selected group of foreign investments are allowed into china.187 as mentioned earlier, fpi (both the debt and equity varieties) and foreign loans into china have been and still are relatively restricted, with fdi tending to dominate capital inflows.188 even fdi is restricted to limited sectors.189 moreover, once inside china, financing options for fdi projects are relatively limited, again partially as a result of the policy of capital control and the foreign exchange regulations that implement it.190 in striking contrast with this picture of severe restrictions, traditional tax policy toward fdi—which, starting in 2008, is being gradually phased out by the new eit regime—had been extremely favorable.191 approved fdi projects received generous tax incentives and tax holidays,192 resulting in much lighter tax burdens than those borne by domestically-owned enterprises.193 but it would be a mistake to think that these inducements constituted the tax policy embodiment of a general favorable economic policy toward foreign investment, forgetting the careful selection that foreign investments have to go through. the tax incentives and holidays were available only to fdi of particular types,194 and should be thought of as a targeted subsidy, extended to projects that are preselected by non-tax agencies. put differently, instead of controlling the nature and form of foreign investment, tax policy tried to (positively) affect the quantity of such investments. to answer these questions, some further methodological issues must be clarified. first, if favorable tax rules were to provide an incentive for increased foreign investment, it must be the case that foreign investors are in a position to respond to this incentive. for example, a key aspect in the current regulation of foreign investment in chinese securities markets (i.e., the qfii regime) is a quota on the overall volume of such investments.195 if the demand for chinese securities on the part of foreign 187. id. 188. id. 189. id. 190. in addition to the economic policy of capital control, regulatory barriers such as lengthy approval processes also raise the cost of foreign investment, leading commentators to conclude that “in terms of the overall legal regime, it is not obvious that china makes for a particularly attractive fdi destination.” see prasad & wei, supra note 59, at 18-20. 191. see jinyan li, the rise and fall of chinese tax incentives and implications for international tax debates, 8 fla. tax rev. 669, 671–74 (2007). 192. see id. at 678–79. 193. see id. at 677, 690–91. 194. see supra notes 186–90 and accompanying text. 195. in december, 2007, the overall quota for initial qfii investment was raised from $10 billion to $30 billion. see, inter alia, hou lei, china to expand qfii quota, china daily, available at http://www.chinadaily.com.cn/china/2008-03/07/content_6518464.htm 82 columbia jour'al of tax law [vol. 1:46 investors is higher than this quota, the quota sets an effective ceiling on the volume of investment; more favorable tax treatments would not induce a larger volume, and would instead simply offer existing investors a windfall. this would not be effective tax policy. in contrast, if a favorable tax treatment is targeted as a threshold issue—foreign investors would invest only if a certain treatment is available and would not invest otherwise— then the justification for the treatment is stronger. to put it another way, it must be specified at what point on the demand curve are tax rules intended to affect investor behavior. second, it is important to specify what it means to treat foreign investments favorably. for example, under china’s prior fdi tax regime, favorable treatment of fdi meant more than that the effective corporate tax rate was lower than in many other countries.196 instead, resident enterprises are divided into two groups: those that had significant foreign-ownership (fies, with 25% or more foreign-ownership), and those that had greater than 75% domestic ownership.197 fies enjoyed better tax treatment from lower tax rates, greater use of deductions, and other measures.198 this discriminatory treatment—“supra-national” treatment for foreign investment199—led to serious distortions, including, most importantly, efforts by domestic capital to disguise itself as foreign capital investing in china.200 any proposal for new favorable treatments of foreign investments that creates significant risks of this type of distortion, it seems, should be avoided. these considerations suggest that any novel tax treatment of foreign investment needs to be of a type that is neutral between domestic (last visited feb. 14, 2010); jiang yuxia, china triples qfii quota ahead of key meetings with u.s. officials, china view, dec. 10, 2007, available at http://news.xinhuanet.com/english/2007-12/10/content_7226220.htm (last visited feb. 14, 2010). 196. li, supra note 191, at 696. 197. see 1991 feitl, supra note 91, art.2 (defining fies as including equity joint ventures, cooperative joint ventures, and wholly foreign owned enterprises). 198. li, supra note 191, at 690–91. 199. for a brief discussion on the international investment law concept of national treatment in china, see jian zhou, 'ational treatment in foreign investment law: a comparative study from a chinese perspective, 10 touro int’l l. rev. 39, 47–48 (2000). 200. see renqing jin, minister of finance, the necessity and juncture of release of the legislation of enterprise income taxation, address to the national people’s congress before the deliberation of the adoption of the eit law, (mar. 8, 2007), available at http://news.xinhuanet.com/video/2007-03/08/content_5816843.htm (last visited feb. 14, 2010). the privileged treatment of fdi contributed to the phenomenon of “roundtripping”: domestic capital being moved offshore and reinvested into china. see also qinghua xu & a.w. granwell, round-tripping: the chinese approach to business restructuring, 15 tax mgmt. transfer pricing report no. 8, 320, 320–25 (2006). 2010] “establishme't” i' chi'ese tax 83 and foreign investors.201 it should also focus on threshold issues facing foreign investors—removing obstacles that would otherwise prevent foreign investment—instead of offering windfalls. interestingly, these simple guidelines are in fact quite useful in resolving some vexing issues confronting chinese tax authorities and taxpayers today, for example, how to interpret “establishment” in the context of investments in chinese partnerships and partnership-like entities. i now turn to that question as an illustration of how the principle of equal treatment of foreignand domestically-owned investments must be applied in actual rule design. b. interpretation of “establishment” for investment in partnerships 1. symmetry between foreignand domestically-invested partnerships many countries and subnational jurisdictions have had to consider the following question: does holding a general or limited partnership interest in a partnership conducting business in jurisdiction x cause a foreign partner to have a business nexus to x, such that the foreign partner is subject to net-income taxation of by x on the partner’s share of income derived from the activities of the partnership in x? generally, being a foreign shareholder of a corporation formed in x does not create a business nexus with x for the shareholder; nor would being a creditor of the corporation, unless perhaps the credit were extended to a borrower in the business of lending.202 more modern limited partnership laws provide that limited partners have little or no control over the conduct of a partnership’s business, such that limited partners have no more control than shareholders have over corporations they own, or creditors have over their debtors.203 it is typical, for instance, that management of the partnership is wholly delegated to one or more general partners.204 it seems logical, then, that a limited partner interest should no 201. it may be worth noting that the recommendation of neutrality here is made in order to prevent manipulation, and not on the basis of a general attempt to equalize the tax competitiveness of foreign and domestic investors. the competitive advantage foreign investors enjoy relative to domestic investors depends on not only source country but also resident country taxation. see generally michael knoll, taxation and the competitiveness of sovereign wealth funds: do taxes encourage sovereign wealth funds to invest in the united states?, 82 s. cal. l. rev. 703 (2009). 202. see oecd model convention, supra note 3, art. 5(7). 203. alan r. bromberg & larry e. ribstein, bromberg and ribstein on partnership §§ 12–18, 32 (aspen publishers 27th ed. 2009). 204. id. 84 columbia jour'al of tax law [vol. 1:46 more result in a business nexus than a shareholder’s or creditor’s interest.205 many jurisdictions, however, have disregarded this logic about limited partners. for instance, section 875 of the u.s. tax code provides that “a nonresident alien individual or foreign corporation shall be considered as being engaged in a trade or business within the united states if the partnership of which such individual or corporation is a member is so engaged.”206 this rule is understood to apply to both general and limited partners.207 when the predecessor of section 875 was enacted in 1936,208 the use of limited partnerships (particularly by foreigners) was not as prevalent as it would become subsequently, and case law from which the section was extracted largely concerned general partnerships.209 in the context of general partnerships, the attribution of partnership activities to its partners followed from the view of the partnership as a mere aggregate of its partners and not a separate entity.210 however, under limited partnership statutes of the various u.s. states, attributing assets and activities of a partnership to the partners would be incorrect for non-tax purposes.211 from this perspective, the application of section 875 to limited partnerships seems inappropriate.212 one suggestion for a defense of section 875 may be that the 205. some u.s. states take this view and exempt limited partners of partnerships operating in the states from return-filing obligations. see, e.g., tenn. code ann. §§ 67-4806(a), 67-4-903(a); see also tenn. dep’t of rev. ltr. rul. 97-49 (dec. 2, 1997), available at http://www.tn.gov/revenue/rulings/fae/97-49fe.pdf (last visited feb. 14, 2010). 206. i.r.c. § 875 (2009). 207. see, e.g., vitale v. comm’r, 72 t.c. 386 (1979) (holding that a nonresident alien individual who is a limited partner in a u.s. partnership engaged in trade or business is deemed to engage in a u.s. trade or business). by contrast, the presence of limited partners demanded significant adjustment of u.s. domestic partnership tax rules, e.g., on rules that determine whether allocations of losses or liabilities to a limited partner have “substantial economic effect”. see also the “alternate test for economic effect” in treas. reg. § 1.7041(b)(2)(ii)(d) (as amended in 2008). 208. the 1936 provision addressed only non-resident alien individuals and not foreign corporations. 209. see, e.g., cantrell & cochrane, ltd., 19 b.t.a. 16, 22–25 (1930) (holding that where an irish corporation and a u.s. corporation formed a joint venture manufacturing beverages in the u.s., the irish corporation was engaged in u.s. trade or business because the joint venture was so engaged); see also w.c. johnston v. comm’r, 24 t.c. 920 (1955). 210. w.c. johnston, 24 t.c. at 922–23. 211. see wroblewski v. brucher, 550 f.supp. 742 (w.d. okla. 1982); evans v. galardi, 546 p.2d 313 (cal. 1976); bromberg & ribstein, supra note 203, at §§1.03, 11.03 and 14.02. 212. the issue of whether a limited partnership interest creates a business nexus has been contested in another area of u.s. inbound taxation: the determination of whether such an interest constitutes a permanent “establishment” under income tax treaties. see donroy, ltd. v. united states, 301 f.2d 200 (9th cir. 1962); robert unger, t.c. memo 1990-15, aff’d, unger v. comm’r, 936 f.2d 1316 (d.c. cir. 1991). 2010] “establishme't” i' chi'ese tax 85 structure of tax rules should not be made to depend on the vagaries of partnership law over time and across jurisdictions: what a limited partner does and is entitled to do could vary greatly under different partnership laws and specific partnership agreements. but a stronger defense is in fact available. the justification for the broad partnership-to-partner attribution rule of section 875 probably does not lie in any particular interpretation of partnership law. instead, it could be seen as necessary to maintain one set of partnership rules for both foreign-invested and domestically-owned partnerships, and, by the same token, equal treatment of domestic and foreign partners. this may be illustrated by reference to u.s. tax law, but the basic point is generally applicable. suppose, for instance, that a u.s. partnership is engaged in a trade or business, but that foreign limited partners in the partnership are, contrary to section 875, not deemed to be so engaged. assuming that the foreign partners do not otherwise engage in a u.s. trade or business, none of their income derived from the partnership would then be treatable as effectively connected with a u.s. trade or business. this would make it very difficult to implement the flow-through approach that generally characterizes federal income taxation of partnerships and partners. first and foremost, there would be no basis for allocating expenses to the foreign partners, since they would be taxed only on a gross-income basis. second, it would no longer make sense to allow the character of many types of income (e.g., operating income, section 1231 gain) to pass through to the partners. however, if the character of any item of income received by a foreign partner were indeterminate, its source and applicable tax rate would also become indeterminate. in other words, treating income of a partnership as received in the course of a trade or business, while treating the same income, when allocated or distributed to foreign partners, as not received in the course of a trade or business, would render flow-through taxation of partnerships incoherent.213 it is conceivable, of course, to tax foreign partners on partnership income other than on a flow-through basis. foreign partners could be subject to tax only on net income derived from a partnership, and a single tax rate could be applied to such income depending on whether the foreign partner is an individual or a corporation. this would be similar to how u.s. partnerships now compute section 1446 withholding on effectively connected income allocated or distributed to foreign partners.214 213. for an overview of the flow-through approach to partnership taxation adopted by u.s. federal income tax law, see laura e. cunningham & noel b. cunningham, the logic of subchapter k: a conceptual guide to the taxation of partnerships (west 3d ed. 2006). 214. i.r.c. § 1446 (2009). 86 columbia jour'al of tax law [vol. 1:46 simplifying even further, a single tax rate may be applied to any net income allocated or distributed to foreign partners, regardless of whether they are individuals or corporations. this would basically implement a business profits tax for foreign partners, its chief difference from a corporate income tax being that investors are not taxed on distributions from the business’s after-tax profits. these ways of taxing foreign partners are not only theoretically possible, but are in fact practiced in some jurisdictions (including some u.s. states).215 the crucial point is that they diverge from the flow-through (or aggregate) approach to partnership taxation that the federal income tax generally follows. if these non-flow-through approaches are followed, partners’ individual tax profiles will no longer determine the ultimate tax liability on income derived from a partnership. this could be unfavorable to foreign partners in some circumstances and would likely trigger a charge that the rule violated the non-discrimination article found in most income tax treaties.216 in other circumstances, computing tax on income derived from a partnership on a self-standing basis could be favorable to foreign partners, but this means that the foreign limited partners could receive better treatment than domestic limited partners who are still subject to flowthrough taxation. in summary, abandoning the partnership-to-partner attribution rule of section 875 for foreign limited partners would be inconsistent with flowthrough taxation of foreign partners, and if flow-through taxation continued to be practiced at all, there would be a discrepancy in the treatment of foreign and domestic partners.217 therefore, in any jurisdiction in which a 215. see supra note 205 and accompanying text. 216. see oecd model convention, supra note 3, art. 24(3) (“the taxation on a permanent ‘establishment’ which an enterprise of a contracting state has in the other contracting state shall not be less favorably levied in that other state than the taxation levied on enterprises of that other state carrying on the same activities.”). 217. i am not aware of such a defense of i.r.c. § 875 having been offered elsewhere, although in one important case, the u.s. tax court made an argument that could be interpreted along these lines. in unger, supra note 212, the tax court defended the donroy doctrine of attributing the permanent “establishment” of a partnership to a foreign limited partner, even while acknowledging that such an attribution would not be justifiable on the basis of partnership law alone. in particular, the court stated: [t]he tax on a partnership’s income and gains is applied at the individual partner level through the use of the aggregate theory . . . [the] characterization of a partnership as being merely an association of individuals, for purposes of determining the actual tax to be imposed on a partnership’s . . . profits, is perhaps the most important characteristic of a partnership for federal income tax purposes . . . because the actual taxation of a partnership is achieved through the aggregate theory of partnership, we hold the aggregate theory of partnership to also be applicable when determining whether a partner has a “permanent establishment” in the united states . . . regardless of whether the partner is a limited or general partner. 2010] “establishme't” i' chi'ese tax 87 flow-through, aggregate approach to partnership taxation is taken, if inbound transactions are also taxed in such a way that business nexus, however labeled, leads to net-income basis taxation, then partnership-topartner attribution of business activities of the kind code section 875 exemplifies should also be observed. 2. implication for partnership funds in china china’s previous partnership tax rules cannot easily be categorized as taking the flow-through approach.218 nonetheless, tax rules that would apply to partnerships formed under the newly revised partnership enterprise law are still being designed, and there is very strong interest on the part of both domestic and foreign investors in seeing that flow-through taxation is adopted so that the character of investment income received by a partnership is preserved when distributed to partners.219 however, if foreign investors are granted flow-through taxation, they would, by the logic of the preceding discussion, have to confront the partnership-topartner attribution of establishments (or permanent establishments, if a treaty is applicable). as we have seen in section ii.b, the issue of attribution of an “establishment” from an investment fund to the fund’s investors also arises in connection with a partnership-like form, the nonlegal person cjv. a recap of the policy considerations in this section shows clearly the predicament facing foreign investors in chinese funds. such investors will be found to have an “establishment” in china if they engage in “production or trade” through a fixed place of business or through agents. chinese tax law has not excluded acts of purchasing, holding and selling securities and other assets from the definition of “production or trade,” let alone acts of trading securities and managing underlying companies. and it is unlikely that such a narrowing of the definitions of “production or trade” would be offered in the near future as a general inducement for the inflow of foreign investments. insofar as the activities of an investment partnership might constitute “production or trade,” such a characterization would also likely be applied to its general and limited partners, resulting in robert unger, t.c. memo 1990-15, at 90-58. 218. for example, expenses and losses are not allocated to partners but, rather, offset partnership income directly and, if unused, are carried forward; similarly, the character of partnership income does not generally flow through to partners. see prospect of 'ew partnership taxation, supra note 88, at 627–29, 630. 219. id. for domestic individual partners, investment income such as dividends, interest and capital gain is taxed at a lower rate than other types of income from partnerships. domestic corporate partners may also benefit from flow-through treatment because of the inter-corporate dividend exemption, and for other reasons as well. 88 columbia jour'al of tax law [vol. 1:46 net-income basis taxation of income derived from the partnership— generally an unacceptable consequence for foreign passive investors.220 this analysis also makes clear what a concession to foreign investors in onshore partnership funds might be. what is at stake is a threshold issue: if an interest in a chinese fund is considered an “establishment” that would subject the owner to net taxation in china, most foreign investors would not acquire such interests. if the government wants to encourage foreign acquisition of partnership interests in chinese funds, the interpretation of “establishment” will have to be selectively relaxed. one approach is to designate some fund activities (e.g., performing due diligence on, negotiating for the purchase of, purchasing, holding and selling securities) as falling outside the scope of “production or trade.” in addition, for other activities (e.g., providing consulting and other services to portfolio companies) that could not be easily excluded from the scope of “production or trade,” if such activities are performed by other parties (e.g., a separate investment manager) neither at the direction of nor for the benefit of the partnership, then the government could also agree that they do not lead foreign partners in a fund to have establishments in china. this would be a continuation of the approach taken in the 2003 vc tax rules, as discussed in section ii.b above.221 such targeted relaxations would be more easy to adopt than a more liberal general interpretation of “establishment.” finally, to the extent that similar rules are adopted for domestic investors in the funds as well (e.g., flow-through taxation, certain income treated as passive investment income and not active operating income), they would also not lead to any meaningful discrepancy between the treatment of resident and non-resident investors. while this approach appears both practical and justifiable on a number of policy grounds, the analysis it is based on is only preliminary and can no doubt be further refined. what is important to note, however, is that unless a new discourse emerges in china among taxpayers, tax practitioners and administrators as well as policymakers concerning tax policy toward inbound investment and basic legal concepts such as establishment, there can be no expectation that the government will tackle 220. for a foreign corporate investor (which generally is the relevant case in the chinese context; see supra notes 88–89 and accompanying text), the effect of taxation on a net basis instead of a gross basis is roughly as follows: (1) the applicable tax rate would be 25% instead of 10%, with this rate difference being offset to some extent by the deductibility of certain expenses; and (2) where a treaty applies, a gain on sale that might otherwise have been exempted under the capital gain article in the treaty will become a normal taxable item under the business profits article. 221. it would also be similar to the practice of bifurcating the general partner and investment manager entities in u.s. fund practice. see andrew w. needham & anita beth adams, private equity funds, b.n.a. tax mgmt. portfolio 735 at a-18 (2005). 2010] “establishme't” i' chi'ese tax 89 the issues we have discussed in any fashion like what we have done here. generally, this is because tax authorities are guided chiefly by the goal of revenue preservation, and taxpayers by the goal of minimizing tax, and these conflicting goals cannot be resolved without policy and legal norms that show what is reasonable. more specifically, the determination that some activities might constitute production or trade while others do not is exactly something that the government has largely avoided doing so far in the evolution of the concept of establishment, as shown in our previous discussion.222 taxpayers’ acquiescence in this practice has arguably resulted in a general view that there are no norms in this area.223 but clearly, it cannot be the case such determination is required only in the investment fund area and not in others. conclusion this article has aimed to identify and analyze some of the basic concepts, principles, and policy considerations that underlie and unify a number of seemingly disparate and very practical issues in chinese taxation today, such as the tax treatment of onshore investment funds, foreign investment in real estate, and qfiis. it does so first by highlighting some fundamental trends that are likely to lead to paradigmatic changes in chinese inbound taxation. these trends include a gradual but definite shift to a more balanced mix of inbound direct and portfolio investment, as well as a breach in the traditional bias against the deployment of noncorporate business forms. in addition to identifying the directions in which chinese inbound taxation is likely to evolve, we have approached the legal issues involved by taking seriously the chinese tax law concept of establishment. this has meant two things. one is to examine systematically the concept’s use under existing law. the other is to evaluate this use, and its possible augmentation, not primarily in light of “international norms” or concepts playing similar roles in other countries’ tax systems, but in the first place in light of the tax and regulatory policies china may adopt in its own unique circumstances. we have largely stayed away from the treaty concept of permanent establishment, or that concept’s interpretation by chinese authorities. although a comparison between the domestic law and the treaty concept is no doubt useful, it is important to recognize, as a fundamental matter, that the domestic law concept may well follow its own logic. it is not 222. the main exception to this is guo shui fa [1996] 212 and related local government circulars. see supra notes 109–19 and accompanying text. 223. see supra notes 155–56 and accompanying text. 90 columbia jour'al of tax law [vol. 1:46 uncommon for practitioners of international taxation to speak, particularly in connection with jurisdictions not their own, of “permanent establishment” even when they are discussing whether, under the domestic tax law of a host country, particular items of income may be subject to net basis taxation, and even when it cannot be assumed that a treaty is applicable. the risk of being subject to net-income taxation and return filing obligations is sometimes referred to as “pe risk.” while this blurring of domestic law concepts with the treaty concept may often serve as convenient shorthand, it may also imply an assumption that there is one international norm for designing two-tiered tax systems for inbound investment and that countries merely differ in the details in implementing this norm. we have not made that assumption here, and our findings have shown that dispensing with such an assumption facilitates the comprehension and analysis of the issues domestic taxing authorities face. articles income tax treaty policy in the 21st century: residence vs. source bret wells* cym h. lowell** abstract the united states has repeatedly attempted to stop tax base erosion for almost the entire post-world war i era, and yet the same problems exist today. the need for fundamental tax reform is front-page material in the major newspapers with the us transfer pricing rules and us multinationals portrayed as public enemy #1. the oecd this month issued a report entitled “addressing base erosion and profit shifting,” and in a competing fashion several important developing countries have initiated their own pact to develop cooperative strategies on these issues outside of the framework of the oecd and un. the attached manuscript studies the historical record and sets forth a competing model for dealing with these matters which pre-dated the existing model treaties and transfer pricing paradigm. this earlier paradigm was offered by the international chamber of commerce’s but was prematurely abandoned by the league of nations in favor of the existing paradigm. in light of the fact that the existing paradigm has failed so miserably, the earlier proposal should be re-considered. in the inevitable re-examination process, there will be a fascinating range of political, economic, and business issues to be addressed. tax administrations will need to ascertain how their resources could be redeployed to foster economic growth. mnes will need to assess the impact of new treaty concepts on their global effective tax rate planning models. the critical question is who will initiate the evolution to come. all countries are anxious to protect their respective tax bases. at the present time, it appears that the brics and source countries have planted their stake in the sand, rejecting the existing order and declaring an intention to update the rules that apply to their own tax base defense. the oecd appears to be principally driven by the need to defend its member country tax bases, hoping, no doubt, that brics and source countries will ultimately follow its lead. whichever organization emerges as the new-found thought leader on these questions, it is now time to give the original international chamber of commerce recommendation a fair consideration on its merits (which, interestingly, addresses the current concerns of brics and source countries). * bret wells, b.b.a. southwestern university 1987, j.d. university of texas 1989, is assistant professor of law at the university of houston law center. **cym h. lowell, b.s. indiana university 1969, j.d. duke university school of law 1972, is a partner in mcdermott will & emery and vice chair of the taxation commission of the international chamber of commerce. the authors wish to thank professor douglas schmalbeck of the duke university law school faculty for a fascinating dialogue concerning an initial draft of this article. his thoughtful comments and observations were instrumental in finalizing our thoughts. 2 columbia journal of tax law [vol.5:1 introduction ........................................................................................................................................ 3 i. emergence of global tension concerning international taxation ........................................................................................................................................... 5 a. foundational premise of our treaty networks ............................................................................... 6 b. homeless income ............................................................................................................................. 7 ii. mercantilist paradigm in the post-world war i period ...................................... 10 a. application of foundational premise ............................................................................................ 11 iii. birth of twentieth century model tax treaty policy........................................ 13 a. application of icc approach to the mercantilist paradigm ......................................................... 17 b. continuation of the icc work ....................................................................................................... 18 iv. entry of the league of nations ........................................................................................ 18 v. coordination of the league and the icc positions ................................................ 23 vi. league of nations evolution ............................................................................................. 25 vii.the hungary problem ............................................................................................................. 27 viii.homeless income: the nagging reality check ......................................................... 30 ix. compounding the mistake of homeless income ........................................................ 32 x. policy evolution in the 1951 – 2012 period ..................................................................... 32 xi. foundational premise under original icc approach ............................................ 33 xii.policy evolution in the future ......................................................................................... 33 a purpose of the foundational premise ............................................................................................ 34 b. source country emergence to residence country ........................................................................ 34 c. territorial taxation: a confusing race to the bottom ................................................................. 35 d. secret world provides guidance for the way forward? ............................................................... 35 e. perceptions of homeless income ................................................................................................... 36 1. resident country perspective ................................................................................................. 36 2. source country perspective .................................................................................................... 37 3. mne perspective ..................................................................................................................... 38 4. oecd/un perspective ............................................................................................................ 38 conclusion ........................................................................................................................................... 38 2013] income tax treaty policy in the 21st century: 3 residence vs. source introduction it is rare that the global effective tax rate strategies of multinational corporations (“mnes”) become priority topics for financial center newspapers and magazines. it is even rarer that such matters become features in the popular press; yet this has become commonplace in recent years. for example, a recent story declared that a prominent mne’s 3.2 percent effective tax rate has put it “at the forefront of mounting political anger about multinationals that shift profits to low tax jurisdictions.”1 not surprisingly, the tax authorities of the world, including the predominant inter-governmental or country groups, namely the organization for economic cooperation and development (“oecd”) and the united nations (“un”), have announced their intention to address these issues. for example, the european commission has unveiled plans to “crack down on tax havens and aggressive tax planning by companies” as one means of helping eu states recover from their economic downturns. 2 similarly, the g-8 and g-20 groups have asked the oecd to review applicable rules to reduce the ability of mnes to shift profits (i.e., base erosion).3 the oecd has responded by releasing a report that attempts to address the problems of base erosion and profit shifting but does so without fundamentally re-examining the existing tax treaty paradigm.4 in the united states, treasury officials make similar declarations, advising that any broad tax reform must be focused on the base erosion fight.5 there is 1 see vanessa houlder, google moves $9.8bn revenues to bermuda, fin. times, dec. 12, 2012, at 18 (“google earns ‘substantially all’ its foreign income in ireland, according to its annual report, but holds its non-u.s. intellectual property in bermuda”), available at http://www.ft.com/intl/cms/s/0/87c1f98a-4455-11e 2-932a-00144feabdc0.html?siteedition=intl#axzz2hxqliuxb. see also wake up and smell the coffee, economist, dec. 15, 2012, at 66; szu ping chan, facebook funneled nearly half a billion into the cayman islands last year, the daily telegraph (dec. 23, 2012), available at http://www.businessinsider.com/facebo ok-funneled-nearly-half-a-billion-pounds-in-the-cayman-islands-last-year-2012-12; rupert neate, facebook paid £2.9m tax on £840m profits made outside us, figures show, guardian (dec. 23, 2012), available at http://www.guardian.co.uk/technology/2012/dec/23/facebook-tax-profits-outside-us; charles duhigg, inquiry into tech giants’ tax stategies nears end, n.y. times (jan. 3, 2013) (reporting that congressional investigators are wrapping up an inquiry into the accounting practices of apple and other technology companies that allocate revenue and intellectual property offshore to lower their us taxes), available at http://www.nytimes.com/2013/01/04/business/an-inquiry-into-tech-giants-tax-strategies-nears-an-end.html ?_r=2&. 2 see joe kirwin, european commission to crack down on tax havens, corporate loopholes, daily tax rep., dec. 6, 2012, at i-2, available at bloomberg bna no. 234. in the case of starbucks, it was so concerned about adverse publicity in the u.k. that it announced an intention to voluntarily not take deductions for royalties and other payments streams as a means of commencing a “process of enhancing trust with customers . . . .” see an open letter from kris engskov, managing director of starbucks coffee company uk, starbucks.com (dec. 6, 2012), http://www.starbucks.com/blog/an-open-letter-from-kris-engs kov/1249. the making of such “voluntary adjustments” can create a wide-range of problems for all parties, including respective tax authorities. see cym h. lowell, peter l. briger & mark r. martin, u.s. international transfer pricing ¶ 4.02[3] (2012). 3 see kevin a. bell, g-20 asks oecd to review rules with goal of curbing profit shifting, daily tax rep., dec. 11, 2012, at i-1, available at bloomberg bna no.237. 4 see addressing base erosion and profit shifting, organization for economic co-operation and development (2013), http://dx.doi.org/10.1787/9789264192744-en. this initial statement was followed in july 2013 with an oecd “action plan” for addressing the so-called homeless income or base erosion/profit shifting problem over an approximate two-year period. see action plan on base erosion and profit shifting, organization for economic co-operation and development (2013), http://www.keepee k.com/digital-asset-management/oecd/taxation/action-plan-on-base-erosion-and-profit-shifting_978926420 2719-en. 5 see u.s. reform efforts must be informed by international base erosion fight, daily tax rep., dec. 11, 2012, at g-3, available at bloomberg bna no. 237 4 columbia journal of tax law [vol.5:1 nothing new about such declarations, which have occurred repeatedly over the past fifty years.6 these comments largely relate to the concerns of the thirty-four oecd member countries. non-governmental organizations and other interest groups working on behalf of emerging or developing nations are also concerned about this issue, fearing that global tax planning strips income from such countries. at the same time, there has been controversy between non-oecd member countries concerning the defense of their own tax bases. this has occurred in the form of domestic tax policies of the so-called brics countries (brazil, russia, india, china, and south africa, as well as other “source” countries). these countries have also objected with increasingly strident voices to the negative impact of the oecd/un model income tax treaties on the economic health of their countries.7 these many voices chant a similar refrain of lament attributing economic malaise at the doorstep of mnes. a reasonable observer, not sophisticated in global taxation matters, listening to this chorus would likely ask a series of questions seeking to get her bearings for a discussion of the issues. the first would be whether the press declarations are accurate as a matter of fact. the answer would likely be in the affirmative, in the sense that mnes seek to move income from places where it could be deemed to have been earned, to a place where it would be taxed at a lower rate. it would likely be explained that tax is an expense like any other and business organizations must minimize their costs to remain competitive. this answer would lead to the second question: are such mne global tax strategies unlawful? the response would likely be that such policies are consistent with the international tax agreements throughout the twentieth century. indeed, all countries have active tax enforcement mechanisms which routinely examine the affairs of even small and medium-size mnes.8 our thoughtful observer would then be confused, asking: “hold on, i must be missing something. how can it be that these companies are so publicly criticized if they follow the law and are held to account in the very countries voicing the criticisms?” the respondent would likely answer with a shrug of shoulders and blank expression, ultimately advising “that is a good question.” indeed, the “what’s missing” element of the current debate is a fundamental matter that seems to be entirely lost in what is becoming a public crescendo of criticism pillorying mnes and their tax planning arrangements as the bad guys in times of economic malaise. it is a drama that seems to grow in volume and intensity. the purpose of this article is to provide explanation for the “what’s missing” question. as will be set out in detail below, the tension reflected in the current public dialogue is ultimately attributable to outdated treaty policy. our model income tax treaties (both oecd and un) were designed to minimize income that would be allocated 6 see richard m. hammer, cym h. lowell, marc m. levey, international transfer pricing: oecd guidelines at ¶ 2.06[2] (2012) (describing the oecd so-called “harmful tax competition” project) [hereinafter oecd transfer pricing]. 7 see oecd transfer pricing, supra note 6, at ¶ 12.01[5][a]. 8 local tax authority enforcement is facilitated by cross-border income allocation documentation requirements in at least seventy countries. see oecd transfer pricing, supra note 6, at ¶ 10.05 and ch. 14 (discussing the requirements in each country). 2013] income tax treaty policy in the 21st century: 5 residence vs. source to source countries, with the residue allocated to residence countries. this process occurred in the 1920s, immediately following world war i. needless to say, the world has changed in the interim, in politics, business practices, and in every other imaginable manner. the actual terms used to describe the respective countries in the debates of the 1920s are emblematic of the distance between then and now. the dialectic was framed in terms of the allocation of income (tax jurisdiction) between imperial and colony countries (meaning, respectively, england and india at the time). to a large extent, there has even been a reversal of roles in the intervening period of almost one hundred years. the imperial countries (residence countries in treaty terms) have become colonies (source countries in the same terms). treaty policies intended to allocate income to the framers of the treaties actually now allocate income to other countries. in other words, “what’s missing” is that: (i) no country seems to like the treaty rules which guide the allocation of income between countries; (ii) there is no movement to update those rules to reflect the economy of the twenty-first century as opposed to that of the early twentieth century; and (iii) mnes have become the villains for these failures. accordingly, it is time to update the underlying treaty policy in a manner that will be accepted by all parties singing the current song of lament. at the end of the day, mnes will abide by the rules that are established. in all likelihood, the principal request of mnes would be for any evolution of such income allocation rules to be undertaken in a neutral manner so that all competitors are treated consistently. this work cannot be limited to a few decision-makers, as was the case in the 1920s when the current rules were developed. that group was composed of the victors of world war i who were also capital exporting countries, a small fraternity. in this article, we begin by restating the foundational premise of our existing treaty and transfer pricing policies (part i). we then examine the economic context of the immediate post-world war i world of the 1920s which spawned the policy premise (part ii), followed by evolution of the framework to address the needs of the policy-makers of that era (parts iii through vii). as the policy implementation occurred, it soon became apparent that there was a serious problem in the foundational premise (parts ix and x). the flaw could have been addressed by an even earlier proposal, which continues to be a live international tax policy issue today. finally, we suggest how the flawed foundational premise could be addressed to meet the needs of both countries and mnes today (part xii). i. emergence of global tension concerning international taxation the creation of global tax treaties was a critical international taxation evolution in the twentieth century. it will almost certainly be a center stage issue in the economic world of the twenty-first century. for the reasons noted above, the current model treaties of the oecd and the un are based on the concept that residual income9 for global income tax purposes should be allocated to the country of residence (“residence country”) of a mne, and not to the country of the source of the underlying economic activity (“source country”). the allocation of income between residence and source countries is 9 for the purposes of this article, the term “residual income” refers to the portion of income earned by all parties to cross-border transactions (“combined income”) that remains after a routine return has been allocated to each of the related parties for the functions and risks that it performs (“residual income”). this is a concept that is rarely defined beyond certain tp contexts. 6 columbia journal of tax law [vol.5:1 accomplished via the associated enterprise and related articles of the model treaties, commonly referred to as transfer pricing (“tp”), which principles have evolved over many years within this conceptual framework. the origins of our existing treaty models are commonly traced to the work of the league of nations (the “league of nations”), which commenced in 1923, shortly following the cessation of hostilities in world war i. 10 an earlier model had been developed by the international chamber of commerce (the “icc”) beginning in 1920. the icc model reflected a different approach, which would have utilized a profit-split methodology for such allocation. in what now can be called a colossal mistake,11 the icc model was, beginning in 1923, rejected by the league of nations in favor of the residence concept that became the base for the extant oecd and un model treaties. the allocation of taxation rights to residual income12 has become a compelling treaty policy issue in the twenty-first century as tax base competition has arisen between: (i) source and residence countries; and (ii) tax authorities in every country and mnes, as noted above. in addition, developing and emerging countries are in need of both tax revenue for economic growth, and defense of their own tax bases. international finance and non-governmental organizations have their own interests in facilitating growth in these countries. finally, mnes are the stakeholders in this process, often pilloried for their effective tax rate policies. the resulting tension surrounding the source country vs. residence country issue is ripe for global resolution. as this process evolves, the icc model may provide an interesting frame of comparative reference for the existing treaty models. interestingly, the pre-league of nations history has not been widely studied by scholars. a. foundational premise of our treaty networks the primacy of residence in treaty policy has persisted through the global economic evolution of the post-world war ii and cold war eras. the consequence of this has been that residual income has typically been allocated to residence countries, while source countries have been left to collect withholding taxes on certain categories of income and assess net basis taxation only when an mne’s activities created a permanent establishment in that country. as the economies of the brics and other source countries matured in the late twentieth century, resistance to the subordination of source to residence as the means of allocating residual income has been reflected in the evolution of their domestic tax policies.13 there have also been official statements rejecting the oecd tp principles and declaring the potential need for development of a new model treaty reflecting source country considerations. the resultant specter of double or multiple taxation to mnes, and consequent need for relief via the mutual agreement procedures of bilateral treaties or 10 a discussion of the league of nations model treaty and the development of the arm’s length standard is beyond the scope of this paper. for a thorough discussion of the genesis of these foundational premises to modern international tax law along with the substantial mischief that the adherence to these principles creates, see bret wells & cym lowell, tax base erosion and homeless income: collection at source is the linchpin, 65 tax l. rev. 535 (2012). 11 as will be seen below, it was a colossal mistake because the league of nations assumed that all countries would adopt the same tax policies and rates. see parts xi and xii. 12 see supra note 8. 13 see oecd transfer pricing, supra note 6, at ¶¶ 2.06[4][a], 2.06[4][c], 12.01[5]. 2013] income tax treaty policy in the 21st century: 7 residence vs. source domestic foreign tax credit mechanisms, has given rise to tax base defense concerns of both mnes and their residence countries.14 as will be developed below,15 the league of nations model was constructed from distinct policy judgments: (i) source country should tax local operations; (ii) residual income should be earned by the residence country; (iii) the presence of an interim holding company in a country should cause that country to be treated as a residence country; (iv) subsidiaries, by themselves, should not be treated as permanent establishments of the offshore parent company; and (v) tp is to be applied on a separate account basis (collectively, the “foundational premise”). as a consequence of these elements, the effective tax rate planning paradigm of mnes has been to utilize the existing treaty and tp policies to earn a material portion of their combined income in lowor no-tax jurisdictions.16 taxation is a cost of doing business and, like all other costs, it is a critical element of competition in all industries that must be managed and controlled. what was envisioned as an allocation of taxing rights in favor of residence countries has resulted in the creation of “homeless income” (income that is not effectively taxed in either the source country or the ultimate residence country via full domestic net basis taxation).17 the resultant perceived tax base erosion in both residence and source countries has been addressed by an ever-spreading range of domestic tax regimes (controlled foreign corporation, foreign tax credit, earnings stripping, and so on), as well as anti-avoidance principles, annual tp documentation requirements, aggressive examination techniques, and severe penalty policies.18 b. homeless income while the foundational premise resulted in allocation of the primary right to tax residual income to residence countries, it also, ironically enough, spawned the phenomenon of homeless income. the irony is further heightened in the current period as these same residence countries have largely abandoned worldwide taxation of mne activities.19 this frames an interesting irony: the residence countries that established the foundational premise have largely eschewed taxation of extra-territorial income. the 14 see oecd transfer pricing, supra note 6, at ¶ 12.04. 15 see infra parts iii – viii. 16 see offshore profit shifting and the u.s. tax code: hearing before the permanent subcomm. on investigations of the s. comm. on homeland sec. and gov'tal affairs, 112th cong. (2012). the global popular and financial press have also traced these debates. see, e.g., charles duhigg & david kocieniewski, how apple sidesteps billions in taxes, n.y. times, apr. 29, 2012, at a1; john d. mckinnon & scott thurm, u.s. firms move abroad to cut taxes: despite ’04 law, companies reincorporate overseas, saving big sums on taxes, wall st. j. (aug. 28, 2012) available at http://online.wsj.com/article/sb10000872396390444230504577615232602107536.html. 17 see wells & lowell, homeless income and tax base erosion, supra note 10, at 537–38. see also edward d. kleinbard, stateless income’s challenge to tax policy, tax notes int’l, oct. 29, 2012, at 499. 18 a summary of the tp principles in each of more than 70 countries is collected in oecd transfer pricing, supra note 6, at ch. 14. 19 the united states is now the last large major industrial country to not have a territorial tax regime. see price waterhouse coopers, pwc reviews u.k. finance bill provisions on foreign profit repatriation, 2009, available at tax doc. 2009-10308, 2009 wtd 87-22; see also tom neubig & barbara m. angus, japan’s move to territorial contrasts with u.s. tax policy, 54 tax notes int’l 252, 252 (2009) (pointing out that the u.s. is becoming increasingly isolated). others scholars have forcefully made the case that the united states’ adherence to a worldwide tax regime, when all of its other major trading partners utilize a territorial tax regime, puts the united states out-of-step with the global economy and creates a significant competitive handicap. see michael s. knoll, the corporate income tax and the competitiveness of us industries, 63 tax l. rev. 771, 771–72, 787–88, 793 (2010). 8 columbia journal of tax law [vol.5:1 result is a windfall: income that is taxed nowhere by nobody. our treaties were premised on the concept of allocating income to prevent double taxation, but the result is that they have achieved double non-taxation. the absurdity of the result should be the benchmark of the flaws in the existing treaty paradigm. in other words, homeless income is a consequence of the foundational premise. residence countries sought to extract residual income from source countries in the economic world of the 1920s. they also had a vision of common tax regimes in all countries. this did not occur, facilitating the evolution of interim holding companies in low tax countries. to top it off, the former residence countries have largely abandoned the taxation of extra-territorial income for their own tax base defense reasons, as they have become source countries themselves. as noted in the introduction above, tension in the world of international taxation has grown. mnes are routinely attacked for aggressive and effective tax rate planning techniques. the response of the mne community has been, appropriately, that “we follow the rules that have been developed by public and private deliberations over a long period of time. if those policies are deemed to no longer articulate appropriate intergovernmental policies, then the time has come to develop new policies. we will be delighted to be active participants in this process. our request is that common principles be applied to all competitors in the global economy.”20 the essential issue is that source countries, as well as residence countries that no longer seek to tax extra-territorial income, increasingly insist on taxing income based on the source of the underlying economic activity, not on the residence of the parent company (or interim holding company). there are at least three explanations for the current reality, which will be developed further through much this article: 1. post-world war i politics: the imposition of residence as an allocation criteria was largely a product of post-world war i international politics. the world has changed dramatically in the interim. former “colony” countries are now economic powerhouses; 2. interim holding companies: the residence concept had, from its inception, a serious flaw. it did not take into account interim holding companies in low tax jurisdictions; and 3. one-sided transfer pricing: tp principles evolved on a onesided basis –i.e., testing, typically, the “routine side” of transactional flows on the source country side, so that residual income would flow to the other side (the residence country side).21 20 in this regard, it is appropriate to note that in the proceedings of the u.s. senate permanent subcommittee on investigations hearings on offshore profit shifting and the u.s. tax code in september 2012, there was roundhouse criticism of several prominent u.s. mnes and their effective tax rate planning strategies. the mnes had provided detailed information prior to the hearings. at the hearings, the mne executives were candid. in essence, they advised that: (i) their tax strategies were designed to comply with existing global laws and regulations; (ii) meet competitive considerations relating to tax as a cost (i.e., a mne cannot compete against a competitor with a materially lower effective tax rate, as tax is typically one of, or the highest, expense of companies); and (iii) openness to participate in a global process to develop new principles that will apply to themselves and their competitors. offshore profit shifting and the u.s. tax code, supra note 16. 21 in this context, “one-sided” tp methodologies test the financial results of related party transactions by focusing on one party to the transactions and the financial results of that party, as opposed to a “two-sided” analysis that would focus on both or all parties to the transaction and their combined income 2013] income tax treaty policy in the 21st century: 9 residence vs. source as a result of these factors, many mnes experience the following attitude of tax authorities in source countries: “if you want to do business in my country, you will pay tax on my terms; if you do not like my terms, do not come to my country; others will take your place.” c. development of a current treaty model the political and economic tension surrounding international taxation principles in the early twenty-first century is ripe for resolution. just as the world needed to prepare for new realities following world war i, today there is genuine need to reexamine tax policy determinations to assure that there is reasonable balance to achieve the international economic and taxation goals of the world for the current millennium. the issues that will need to be addressed in such a process are appropriately framed by the positions of the groups that play important roles in the current international taxation world. there are at least six groups with distinct voices: 1. oecd: traditionally composed of developed countries, which sponsors the model tax treaty and commentary, together with transfer pricing guidelines, that are the standard of the world. 2. un: often assisting developing or emerging countries, which has just issued its own transfer pricing manual intending to consistently apply the oecd guidelines for the benefit of developing/emerging countries (i.e., source countries).22 3. world bank, non-governmental organizations (“ngos”), and related group: often speaking on behalf of emerging countries and their need for tax revenue to continue development. 4. icc: composed of both residence and source countries, which undertook the initial modern treaty formulation process in 1920. 5. brics and developed source countries: not happy with principles of either oecd or un, and certainly no longer emerging countries. 6. mnes: are stakeholders. their fiduciary responsibility to shareholders and investors, as well as their duty to residence and source countries, is to conduct business, including payment of tax, in accordance with internationally agreed upon rules and norms of conduct as implemented in the respective countries in which they conduct business. they must also responsibly address the reality that tax is a major cost and competitors often enjoy comparative advantage in applicable taxation regime. in this article, we trace the evolution of the current model income tax treaty framework from its origins in 1920. much of the actual history has been buried in the archives of the icc and league of nations. when the debates of the 1920s are viewed from the vantage point of the early twenty-first century economic world, and the relating to such transactions. the significance of these methodologies is developed in part ii.a infra, via an illustration. 22 see united nations, practical manual on transfer pricing for developing countries (2012). 10 columbia journal of tax law [vol.5:1 disparate voices of residence and source countries, we draw two conclusions. first, the issues debated in the 1920s remain vital today. second, those issues are in desperate need of being revisited and reformulated to restore balance for the future. today there is far more controversy surrounding international taxation and tp than is necessary to assure reasonable allocation of taxing jurisdiction among all countries to facilitate global job creation and economic growth. as is often the case, study of the historic evolution of our international tax treaty principles may provide illumination for the future, including answering the “what’s missing” question noted in the introduction. ii. mercantilist paradigm in the post-world war i period when we examine the origins of current tax treaty policy, we need to imagine the world as it was in the 1920s. the paradigm of commerce and international taxation was a company resident in a residence country (let’s call it “imperialco”) with an affiliate in an under-developed source country that was a colony of the residence country (“colonyco”). a global war just ended, with the residence country having enormous debt. there was a material flow of commerce between the imperialco and colonyco. for the most part, the former transferred to the latter capital, technology, and access to global markets. colonyco responded by producing commodities and goods for imperialco and its global markets. the residence country was a creditor and the source country a debtor. more specifically, the situation could be described as follows:23 imperialco is incorporated and has its home office in england. the year is 1925. imperialco is in the textile business requiring a ready supply of cotton, a raw material not grown in england. imperialco has a global organizational structure with subsidiaries based within the cottonproducing british commonwealth countries such as india. it also has manufacturing facilities in important commercial regions of the world (india and elsewhere), as well as shipping companies that transport raw materials and finished products to global commercial markets. all these operations are based in the colonies, with affiliates conducting business using capital and technology provided by imperialco. in return, the affiliates pay interest and royalties to imperialco, which are deducted for colony income tax purposes. to the extent that excess cash remains in colony affiliates after local expenses and taxes, such income is distributed to imperialco via dividends. the policy issue for consideration was how income from these activities (functions and risks) should be shared between imperialco and colonyco or, in today’s terms, the residence and source countries. as will be developed below, the framework of taxation that evolved in the 1920s was based on the mercantilist belief that imperial countries were the source of capital and know-how while the colonies were passive suppliers of goods or services with little value added functionality. as a result, the right to tax residual income belonged to the residence countries of the imperial companies (england in this example). source countries (india in the example) were allowed to tax 23 the following hypothetical is adapted from mitchell b. carroll, allocation of business income: the draft convention of the league of nations, 34 colum. l. rev. 473 (1934) (giving example of cotton and other goods produced in india to be sold abroad). 2013] income tax treaty policy in the 21st century: 11 residence vs. source only routine profits deemed earned therein and impose withholding taxes on certain types of outbound payments. the tax planning strategies of imperialco utilized in this mercantilist paradigm would likely be along the following lines: raw materials (raw cotton) or processed goods would be purchased from the colony country company (“indiaco”) at the lowest price possible consistent with providing indiaco the capital needed to continue operations (“supply chain transactions”). movable tangible property (machinery and equipment) could be leased by imperialco, with leasehold payments made by indiaco (“lease transfer payments”). capital could be provided via loans from imperialco, with interest payments made by indiaco (“interest transfer payments”). know-how to the extent required could be provided in the form of licenses with royalties paid by indiaco (“royalty transfer payments”). services provided by imperialco would be paid for via service fees (“service transactions”). the net result of these transactions was that imperialco would have the ability to transfer the residual indian profits out of india at a minimal indian tax cost, leaving only routine operating profits in indiaco. these arrangements can be depicted as follows: mercantilist paradigm example a. application of foundational premise much of what can be drawn from the following study of the origins of our current model treaties concerns the evolution of the elements of the foundational premise. before undertaking that discussion, it is appropriate to frame the mercantilist paradigm in a manner to reflect the current structure and tp policies of many mnes which, in turn, produces much of the tension in our international taxation world. for this purpose, assume that imperialco has formed an interim holding company (“holdco”) in a country having a broad treaty network and low domestic income tax rates (let’s call it “holdingland”). the “residual profits” (“residual 12 columbia journal of tax law [vol.5:1 income”)24 noted above are earned by holdco. assume further that colonyco has net sales of 1,000x and incurs costs of 100x in conducting its operations in india, excluding any lease, interest, royalty, or service fees (the “related party payments”) paid to related parties (holdco for purposes of discussion). for indian tp purposes, it is determined that the appropriate tp method to test the margin of colonyco is the cost plus method, and that the arm’s length “plus” is 5%; this is a one-sided transfer pricing method in the sense that the testing is limited to the income that should be received by colonyco for tp purposes.25 this would mean that the financial results of colonyco’s activities prior to consideration of the residual income (ultimately allocated to holdco) would be as follows: illustration a colonyco net sales 1,000 operating expenses – 100 net income 900 under the tp method, colonyco is entitled to earn 5% on its operating expenses, which would mean that its share of the net income would be 5. the balance of the net income (900 – 5 = 895) would be allocated to holdco and paid via the related party payments.26 the allocation of income between the parties would be as indicated in illustration b: illustration b (1) (2) (3) colonyco holdco combined27 gross income 1,000 895 1,000 operating expenses – 100 0 – 100 related party payments – 895 0 0 net income 5 895 900 as noted in part i.a, above, the foundational premise had several elements. in the context of the illustration b, these elements are as follows: (i) source country should tax local operations: this is reflected in column (1) above; 24 see supra note 8. 25 the cost plus method is a one-sided transfer pricing method test, meaning that the arm’s length return of colonyco is determined by testing its functions by margins earned by uncontrolled companies performing similar functional activities, which is easily obtained from data bases of public companies. see oecd transfer pricing, supra note 6, at ¶ 4.04. such methods are the means by which most tp is typically undertaken, especially for documentation purposes in the 70+ countries that require such documentation. 26 for purposes of this illustration, we are ignoring how the related party payments would be characterized under the india – holdingland treaty, which could have other consequences, such as indian withholding taxes. we are also ignoring all other taxation matters, such as consumption tax or application of outbound payment limitations under india law. 27 the combined income is an aggregate of the separate income of colonyco and holdco. see supra note 8. for such purposes, the related party payments are ignored. 2013] income tax treaty policy in the 21st century: 13 residence vs. source (ii) residual income should be earned by the residence country: this is reflected in column (2) above;28 (iii) presence of an interim holding company should be treated as a residence country: this is also reflected in column (2) in the sense that holdco is entitled to receive the residual income); (iv) subsidiaries should not be treated as permanent establishments: achieved by the segregation of column (1) from column (2) for indian tax purposes; and (v) tp is to be applied on a separate account basis: achieved by acceptance by the source country (india) of the results of elements (i) – (iv) the results in illustrations a and b reflect a disconnect between the allocation of income and economic reality. residual income arising from economic activities in source countries like india is allocated away from them. if the resident country were to tax such income, then this misallocation would not create double non-taxation, but resident countries are increasingly unlikely to tax extra-territorial income. the tp policies developed in the mercantile era thus achieve results in today’s reality that were probably not anticipated. as will be developed in the proceeding pages, source countries are in the process of seeking a solution to this state of affairs. a review of the past and the decision points that have led to the current situation in international tax policy provides guidance for a way forward. iii. birth of twentieth century model tax treaty policy world war i ended in november 1918. in that world, all countries had crushing debt burdens and sought to impose taxes wherever possible. the danger of double or multiple taxation was a significant concern of businesses and governments. the icc was formed in paris in 1919 to promote trade and investment, open markets for goods and services, and facilitate the free flow of capital.29 one of the foundational elements of the icc was the elimination of double taxation as indicated in the following early resolution: resolved, that the international chamber of commerce, in meeting duly assembled, composed of representatives of commercial and industrial organizations of the allied countries [victors of world war i], 28 for this purpose, residual income is the share of combined income (column (1) + (column (2)) remaining after allocating to the tp tested party (colonyco in this illustration) its income applying an appropriate one-sided tp method (column(1) using the cost plus method). one potential view of residual income is that it must be attributable to something. but what is it? perhaps its existence testifies to the failure of accounting concepts to reflect economic reality. in this view, if we knew better what the something was we could design accounting policies to accurately reflect its allocation and where it should be taxed. in our own view, the something is simply the obvious flaws in the foundational premise and current model treaties and their implementing tp policy. 29 see the merchant of peace, international chamber of commerce,http://www.iccwbo.org/about-icc/history/ (founded by a “group of industrialists, financiers and traders . . . determined to bring economic prosperity to a world that was still reeling from the devastation of world war i. they founded the international chamber of commerce and called themselves ‘the merchants of peace’. the world had few working international structures in the immediate aftermath of the first of the 20th century's global conflicts. there was no world system of rules to govern trade, investment, finance or commercial relations. that the private sector should start filling the gap without waiting for governments was ground-breaking. it was an idea that took hold.”) (last visited nov. 10, 2013). 14 columbia journal of tax law [vol.5:1 urge prompt agreement between the governments of the allied countries in order to avoid that individuals or companies of any one country may be liable to more than one tax on the same income, taking into consideration that the country to which . . . such company belongs has right to claim the difference between the tax paid and the home tax.30 the icc focused on the double taxation issue as the league of nations organized its own efforts.31 the icc’s initial assembly was held in paris in june 1920,32 which adopted a resolution that “governments of the allied countries should speedily come to international agreements, in order to prevent . . . companies from being compelled to pay tax on the same income in more than one country.”33 the first icc congress was held in london on june 27 to july 1, 1921.34 double taxation was one of the first subjects addressed by the icc.35 the icc considered a set of principles that were debated and ultimately revised.36 30 international chamber of commerce, congress of london 1921, brochure 11, at 3 (brochures 1– 16, available from icc paris archives) [hereinafter 1921 icc proceedings],. see generally michael j. graetz & michael m. o’hear, the ‘original intent’ of us international taxation, 46 duke l.j. 1021, 1066– 74 (1997) (addressing the original icc work as an element of the need for reform of the u.s. international taxation system). 31 there was contact between the icc and the league, including overlapping membership in the double taxation committees. see international chamber of commerce, double taxation (survey of the work of the i.c.c. since the rome congress), brochure 34, at 10 (describing the brussels third congress, june 21– 27, 1925) [hereinafter 1925 icc proceedings]. 32 see business men go abroad, n.y. times, june 6, 1920. 33 international chamber of commerce, icc second congress rome, brochure 25, at 14 (mar. 18– 25, 1923) [hereinafter 1923 icc proceedings]. 34 the proceedings are documented in the 1921 icc proceedings brochures. contemporaneous news accounts explained the significance of the meetings. see favor world board to facilitate trade, n.y. times, june 20, 1921 (attendees to create “a permanent international committee charged with ironing our difficulties arising in the exchange of goods between nationals of different countries . . . .”). 35 1921 icc proceedings, supra note 30, brochure 11 (part i), at 3. the committee was composed of delegates from belgium, france, great britain, italy, netherlands and the united states (john b. robinson of coudert brothers, paris, and robert grant, jr., lee higginson & co.). id. 36 1921 icc proceedings, supra note 30, brochure 11 (part i), at 5. (the originally proposed principles were edited, with deletions crossed-through and added language underlined) as follows: 1st principle. as with regards to the taxation ofn income gained in earned and collected within the country, from whatever its derived (real estate, personal or property, business and professionals), each nation should applywithout prejudice to the question of super-tax36 (impôt global) on income, each country should accord similar treatment to all its tax-payers, whether nationals or both citizens and foreigners, whether resident or non-resident in the country or not. 2nd principle. as with regards to the taxation on incomes earned and collected abroad, from whatever its derived . . . , apart from the question of a total tax on the without prejudice to the super-tax (impôt global) on income, each nation country should applyaccord similar treatment to all taxpayers subject to this tax (i.e. nationalscitizens or foreigners livingresident in the country, nationals living and citizens resident abroad); if this class of income, if total exoneration is not possible, cannot be entirely free from liability to taxation, it should be allowed a big reduction, given the fact that it has already been taxed in the country of origin the object of a considerable rebate in consideration of the tax on such income already levied in the country of origin: tthise principle is already followed in force in certain countries (for example, in belgium, for example, where total relief comes to as much as the rebate amounts to 80%, and in the united states, where the total reliefrebate is granted total in cases of reciprocal treatment). . . . . 2013] income tax treaty policy in the 21st century: 15 residence vs. source in the proceedings,37 the u.s. representative (w.f. gephart) expressed concern about the first principle (place of collection of tax) since “this can be fixed or determined at the desire or option of the taxpayer . . . liability to taxation should not depend upon a characteristic so subject to manipulation.”38 a british representative (sir algernon firth) urged that “tax should be levied where the income is earned . . . .”39 at the end of the discussion, it was agreed that the focus was to achieve “no double taxation.”40 there was also agreement that a committee on double taxation would be assembled, and professor thomas sewall adams from the united states was selected to serve on this committee for the united states.41 the second congress was held in rome in 1923.42 the proceedings noted that additional meetings had been held in the interim, including contacts with the financial commission of the league of nations.43 in these early discussions, the bedrock principle was that where a company does business in more than one country: 1. the profits should be taxed in each country in proportion to the profit realized therein (paragraph 8 of the icc draft 1923 resolution);44 2. if the countries cannot agree, then the allocation would be presumed to be proportional to sales (turn-over) (paragraph 9 of the icc draft 1923 resolution);45 provided that 3. in no case should such proportions exceed the total fixed by the “competent authority in the country of domicile” (residence) (paragraph 10 of the icc draft 1923 resolution).46 in other words, the icc 3rd principle. as with regards total income tax on all categoriesto the super-tax (impôt global) on income of every class . . . it is desirable that each nation country should only levy one tax only foreigners living within its territory, which should only apply to the total income actually earned in the country, excluding income earned in other countries its own citizens without regard to their place of residence. in cases where certain countries cannot adopt the solution they should at least refrain from taxing foreigners resident within their frontiers except by tax applicable solely to the total income earned in the country itself apart from income earned in other countries. 4th principle. it is advisable desirable to see the above mentioned principles given above applied to both individuals and corporate bodies companies, etc., in the same manner as individuals. . . . . the principles were then explored in terms of the laws of each of the participating countries. 37 the us representatives in the proceedings were willis h. booth, john h. fahey, edward a. filene, william butterworth, harry wheeler, and owen d, young. 38 1921 icc proceedings, supra note 30, brochure 18 (part i), at 58. 39 id. at 61. 40 id. at 62. 41 1921 icc proceedings, supra note 30, brochure 19 (part i), at 13. other members were sir algernon f. firth (great britain), mr. o.e. bodington (great britain), dr. j. ph. suyling (netherlands), dr. j.e. claringbould (netherlands), robert grant, jr. (united states), w.f. gephart (united states), and jerome green (united states). the role of adams is discussed extensively in graetz & o’hear, supra note 30, at 1027–33. 42 the us representatives were, as noted above, appointed in 1921, as well as j.b. robinson, a barrister, who had been active in 1921 as well. 43 1923 icc proceedings, supra note 33, brochure 25, at 16. 44 see 1923 icc proceedings, supra note 33, brochure 23, at 34–35. 45 id. 46 id. 16 columbia journal of tax law [vol.5:1 recognized that the combined income of the enterprise would need to be allocated, ultimately on the basis of proportional sales if the countries could not otherwise agree, and subject to agreement by the country of residence (domicile). the above proposed profit-split (or formulary apportionment) approach starts with the basic idea that both countries, the residence country and the source country, have a co-existent interest in the combined income. instead of assigning all rights over that income to one country or another, the above framework sought to ensure that an allocation would be agreed by both countries. they would have flexibility to vary the profit-split methodology, subject to a default formulary apportionment rule in the event that agreement could not be reached. the premises behind this icc proposal were that: (i) the mne was simply a stakeholder and should not bear double taxation; and (ii) residual income should be allocated between the countries on a proportional basis. in the discussions leading to the icc proposal, it was recognized the existence of separate fiscal regimes in each country was a fundamental problem.47 while the problem of allocation of taxing jurisdiction could be resolved by the introduction of uniform fiscal legislation among all countries, this was renounced as “utopian.”48 the only practical response to the double taxation risk in the context of the sovereignty of each country was to provide a framework that sought to assure that income should only be taxed once. the issue, then, was to determine “what constitutes the right of one country to tax the income of a taxpayer in preference to any other country.”49 the following statement at the time framed the issue well: it does not seem probable that there would be serious difference of opinion on this matter. a wide-spread view considers that the country from whose territories the income is derived should in every case have the right to levy a tax thereon. at the same time it is agreed that as regards income derived elsewhere, the country of domicile should have the privileged position.50 the icc delegates contemplated that if a profit-split methodology were accepted by countries under the auspices of the league of nations, the principles would be more likely to be readily accepted by the member nations in their national laws of the countries.51 in addition, it was hoped that a set of regulations would be developed by an “international fiscal commission” along with an administrative appeal process in the country or as an international commission with national court or international court or arbitration review ultimately available.52 the proceedings noted that guidance had been obtained from a variety of sources, including the rome convention between the succession states to the austrohungarian empire in 1921 (the “1921 austro-hungarian treaty”),53 though uncertainty 47 the same is true today as countries attempt to protect their tax base and attack the homeless income problem with ad hoc domestic responses. 48 see 1923 icc proceedings, supra note 33, brochure 25, at 8. 49 id. 50 see 1923 icc proceedings, supra note 33, brochure 25, at 8. as indicated from the above excerpt, the icc contemplated that a system of credits be established between countries except that no country would be expected to give up via foreign tax credit relief more than "half the amount that it could have gained had the income been derived from its own territory." id. at 9. 51 id. at 11. 52 id. at 12–13. 53 id. at 16, 19, 49–52 (including the text of the treaty). 2013] income tax treaty policy in the 21st century: 17 residence vs. source as to the definition of critical terms (such as “domicile”) would need to be addressed. it was recognized that: the necessity for regulating double taxation by means of international conventions becomes more and more apparent, as different countries replace their taxes on real estate by personal taxes on income and fortune.54 in the 1923 discussions, there was a preference for providing that “only income acquired in the country should be affected [subjected to tax by such country],” though there was recognition that national regimes would differ and perhaps a rebate system would be appropriate (such as the foreign tax credit system recently adopted in the united states).55 interestingly, the proceedings included a copy of the 1921 austro-hungarian treaty, which explicitly provided for: (i) taxation by the residence country; and (ii) where there was a presence in another country, each country shall tax the portion of the income produced in its borders.56 the final element of the second 1923 congress was a request from the united states that no formal resolution be adopted, since it had, late in the day, submitted reservations. accordingly, the “question of double taxation [was] referred for further study.”57 a. application of icc approach to the mercantilist paradigm if the icc approach had been developed as the theoretical base for treaty income allocation, as opposed to the foundational premise noted in illustration b above,58 the results would have been entirely different. instead of receiving only a cost plus 5% return using a one-sided tp method, the return to colonyco would be determined by the two-sided tp method testing the combined income. for this purpose, assume that the applicable principles are as noted above from the icc proceedings59 and that india and holdingland have agreed that the allocation of the combined income between colonyco and holdco should be 50:50 (based on pertinent factors, perhaps including “sales”).60 the results would then have been as indicated in illustration c: 54 id. at 19. 55 id. at 46. 56 see 1921 austro-hungarian treaty art. 4, in 1923 icc proceedings, supra note 33, brochure 25, at 50, which provided as follows: income derived from the exercise of any kind of trade or industry is taxed by the state in whose territory the industrial or commercial undertaking has its registered office, even when the latter extends its activities into the territory of another contracting state. if the enterprise has its registered office in one of the contracting states, and in another has a branch, an agency, an establishment, a stable commercial organization, or a permanent representative, each one of the contracting states, shall tax that portion of the income produced in its own territory. therefore the financial authorities of the interested states shall be able to request the tax-payer to hand in general balance-sheets, special balance sheets, and all other documents required by the laws of the said states. 57 see 1923 icc proceedings, supra note 33, brochure 32, at 136. 58 id. at part ii.a. 59 id. at part iii. 60 we note that scholars have suggested approaches similar to the icc proposal. see, e.g., reuven s. avi-yonah, kimberly a. clausing & michael c. durst, allocating business profits for tax purposes: a proposal to adopt a formulary profit split, 9 fla. tax rev. 497 (2009). 18 columbia journal of tax law [vol.5:1 illustration c (1) (2) (3) colonyco holdco combined net sales 1,000 450 1,000 operating expenses – 100 0 – 100 related party payments – 450 0 0 net income 450 450 900 several comments are in order at this point. the icc proposal provided flexibility for countries to refine the default result set forth above. thus, the icc approach was flexible enough to allow a functional analysis to be performed to ensure that the functions actually and substantively performed in the holdco jurisdiction did in fact provide the value contribution assigned to them in the apportionment methodology. if india and holdingland had entered no such agreement, then colonyco, under the icc approach, would have had to report income in india using the default mechanism (such as relative sales).61 b. continuation of the icc work unfortunately, the promising approach originally advocated by the icc was scuttled. as the icc work evolved, the league of nations was getting organized. the icc was in continuing contact with the league, “which is carrying on its work [in these matters], but which has not yet succeeded in collecting the reports which it has entrusted to all known economists.”62 the approach endorsed by the league of nations evolved into a different framework for handling the problem of international double taxation. iv. entry of the league of nations63 the covenant of the league of nations was signed on june 28, 1919, and entered into force on january 10, 1920. 64 work on income tax treaties commenced immediately.65 the fiscal committee of the league of nations commissioned four economists to study the double taxation problem.66 these economic experts faced the same conundrum as the icc had: the allocation of taxing jurisdiction between countries. the economic experts framed the issue more specifically than had the icc first and second congress and stated that the issue involved a conflict of interest between debtor (capital importing) countries and creditor (capital exporting) countries.67 edwin r.a. seligman (one of the four economists) explained the tension that faced these early thinkers in the following terms: 61 a continuing conceptual issue will remain how that 450 million, which is homeless income in the context of illustration c, should be taxed. we review a variety of perspectives on this issue in part xii.f., infra. 62 see 1923 icc proceedings, supra note 33, brochure 25, at 16–17. the league’s economic experts were appointed in february 1921. see 1925 icc proceedings, supra note 31, brochure 34, at 10. 63 see generally bret wells & cym lowell, supra note 10. 64 see treaty of peace with germany (treaty of versailles), u.s.-ger., june 28, 1919, 2 bevans 43. 65 john g. herndon, relief from international income taxation: the development of international reciprocity for the prevention of double income taxation 42 (1932). 66 see 1923 icc proceedings, supra note 33, brochure 25, at 16. 67 league of nations econ. & fiscal comm., report on double taxation submitted to the financial comm., 39-41, 48-49, league of nations doc. e.f.s.73.f.19 (1923) [hereinafter 1923 economic experts report]. 2013] income tax treaty policy in the 21st century: 19 residence vs. source if all the states in the world were in the same relative stage of economic and fiscal development the situation [for reaching agreement on the means to avoid international double taxation] would be far simpler. but under the present conditions some countries are more or less adequately supplied with capital, while others are still in the earlier stages of industrial development. the economic world today is therefore divided into creditor and debtor countries . . . what would be perfectly easy for a creditor state to adopt might be entirely unacceptable to a debtor state. what is true of the obvious conflicting interests in question is also seen when we consider the less obvious but none the less important consequences of a tax system.68 on april 5, 1923, the economists issued their report.69 it posited that double taxation should be avoided by vesting the primary taxing jurisdiction in the country to which the taxpayer owed its “economic allegiance.”70 it identified the following four factors for determining economic allegiance: (1) origin of wealth, (2) situs of wealth, (3) place of enforcement rights to wealth, and (4) where wealth was consumed.71 the report then analyzed four possible approaches for avoiding international double taxation: (option 1) country of residence would concede all taxing jurisdiction to the source state; (option 2) country of source would concede exclusive taxing jurisdiction to the residence state; (option 3) proportional allocation of income between the countries of residence and source; or (option 4) classification of income and an assignment of the primary right to tax such income to the country of residence or source depending on the type of income (the socalled “classification-and-assignment approach”).72 the report unanimously ruled out option 1’s approach of conceding all taxing jurisdiction to the source country because this violated ability-to-pay principles. 73 remarkably, the report expressed a preference for option 2’s approach of exempting all income of a nonresident from any source country taxation and thus ceding all taxing jurisdiction to the country of residence. 74 but the report anticipated that this recommendation would be difficult to adopt because it created an enormous disadvantage to debtor countries,75 so the report offered as a secondary alternative the recommendation to classify income into various categories and then to assign taxing jurisdiction based on the classification (option 4, the classification-and-assignment approach). 76 after discussing its rationale for which jurisdiction should have the primary right to tax each category of income,77 the report summarized its allocation of taxing jurisdiction for each category of income in the following manner: 68 edwin r.a. seligman, double taxation and international fiscal cooperation 14–15 (1928). 69 1923 economic experts report, supra note 67. 70 id. at 20–22. 71 id. at 22–27. 72 id. at 40–42. 73 id. at 48. 74 id. at 48, 51. 75 id. at 48–49. in fact, developing countries in twenty subsequent years proposed their own model tax treaty that would repudiate option 2 and opt for option 1, thus advocating the exact opposite position as the one endorsed by the 1923 economic experts report. see part vii, infra. 76 id. at 49–51. 77 id. at 27–38. 20 columbia journal of tax law [vol.5:1 table 78 category of wealth preponderant element origin79 domicile80 i. land x ii a. mines, oil wells, etc. x ii b. commercial establishments x iii a. agricultural implements, machinery, flocks, and herds x iii b. money, jewelry, furniture, etc. x iv. vessels x (regist) v a. mortgages x (prop’y) x (income) v b. corporate shares x v c. corporate bonds x v d. public securities x v e. general credits x vi. professional earnings x this categorization of the right to tax income is emblematic of the economic relationships of the time. it essentially rests on the foundational belief that parent companies (imperialco in mercantilist paradigm example in section ii) provided the knowledge and capital to conduct operations in foreign countries by local subsidiaries (indiaco). the right to tax income from operations occurring in the source (or colony) country was allocated to the source country (the “origin country” in the table) while taxation authority relating to other income was allocated to the place of residence of the parent company (“domicile country” in the table). this categorization was not based on any analysis of the relative economic contributions of the various business activities to the actual profits earned by the respective companies. in the mercantilist paradigm example in section ii, the classification-andassignment approach would result in indiaco having the right to tax profits attributable to 78 id. at 39. 79 “origin” should be read as source country. 80 “domicile” should be read as residence country. 2013] income tax treaty policy in the 21st century: 21 residence vs. source the production of cotton or its conversion into commercial products. to the extent that profits were earned from the use of capital (corporate bonds), know-how (professional earnings), sale of goods in other countries, or dividends (corporate shares or public securities), the right to tax such items resided in the domiciliary or residence country (imperialco). the 1923 economic experts report recognized that the classification-andassignment approach might misallocate income in a particular case, but the economic experts took comfort in the view that it was unclear at the outset which country would be a net beneficiary from an overly generous allocation of taxing jurisdiction. 81 furthermore, even if overly generous, the 1923 economic experts report advocated that option 2’s maximum allocation to the country of residence with respect to treaties entered into between developed countries that are on “equal footing” would represent a desirable outcome. 82 the report commented in passing that the classification-andassignment approach might provide taxpayers with a de facto tax election due to their ability to create intermediate holding companies in tax-favorable resident jurisdictions, but this did not cause the committee to abandon the approach.83 thus, the categorization methodology set forth in the report failed to address the potential that the economic world could be composed of not only “origin” or “domicile” countries but also third countries that made no economic contribution to the production of income. accordingly, if imperialco in the mercantilist paradigm example had established an international subsidiary in a third country that had no or minimal income tax, in essence, it would be viewed as a residence country. seligman later explained that the objective in the 1923 economic experts report was that “all intangible wealth, except real estate mortgages, should be assigned predominately or wholly, to domicile.” 84 routine business profits could also be transferred away from source country taxation if they were earned in a manner that did not create a permanent establishment (“pe”) in the source country or were not attributable to immovable property.85 the 1923 economic experts report disparaged source-based tax regimes as involving antiquated theories of taxation and predicted that source-based taxation would diminish in importance as semi-developed nations became more industrialized and as modern notions of the pure income tax became more widely understood and appreciated.86 these comments are insightful because they underscore that these economic experts of the time were attempting to introduce a grand experiment designed to transform the world. the organizing principle of these experts and of residence countries formulating the policies of the league of nations was clear: base erode colony countries for the benefit of imperial countries (themselves), the originators of capital and know-how (the “foundational premise”).87 81 id. at 45–46. 82 id. at 48. 83 id. at 49. 84 seligman, supra note 64, at 127. 85 as will be developed below, the term pe refers to, in essence, taxable presence in the source country. 86 1923 economic experts report, supra note 67, at 51. 87 the elements of the foundational premise, as it evolved, in subsequent years, are noted at part vi, infra. 22 columbia journal of tax law [vol.5:1 another important element was that great britain in the 1920’s was a significant net capital exporter88 and attempted to tax resident corporations on a worldwide basis, and so it was in its national interest to promote a solution to international double taxation that allocated taxing jurisdiction over residual income to the residence country and away from the country of source. before addressing the evolution of the classification-and-assignment approach over time, it is helpful to note that the league 1923 economic experts report could have instead recommended that residual income of a global company be apportioned between the residence and source countries based on the relative economic contributions conducted in each country (the icc model approach). the report, however, rejected out of hand the idea of so apportioning residual income because “the methodology has no fundamental basis in economic theory which is capable of easy application.”89 these statements disregarded experience. profit-split or formulary apportionment methodologies were commonly employed in tax treaties at the time.90 the icc had pressed the league to adopt principles consistent with those of the icc draft 1923 resolutions that endorsed a formulary apportionment approach.91 yet, the league 1923 economic experts report contained no serious discussions of these treaties or of the formulary apportionment approach advocated in the icc’s draft 1923 resolutions. the rejection of a profit-split approach by the league 1923 economic experts report was controversial. 88 seligman, supra note 68, at 138 (pointing out that this bias is particularly helpful to creditor countries like england). the united states was in a similar posture. in fact, one u.s. government official testified that at this time the united states exported approximately four times as much capital as it imported. see h. david rosenbloom & stanley i. langbein, united states tax treaty policy: an overview, 19 colum. j. transnat’l l. 359, 366 (1981). 89 1923 economic experts report, supra note 67, at 46. the report recognized that the british imperial government actually utilized this approach, but ascribed its success to “the use of a common language, the existence of a common conception of income so that divergences are of the smallest character, the easy relations that exist of a political character to enable the necessary data to be determined—all these factors would put the easy working of [a profit-split or two-sided tp methodology] at a maximum in the case of the british empire. it is not to be expected that a similar ease in working could be found as between countries with diverse language, diverse income-tax systems, diverse conceptions of income and less effective political connections.” id. at 47. this view of formulary apportionment-type tp methodologies continues to this day in the oecd tp guidelines. see generally oecd transfer pricing, supra note 6, at ¶¶ 1.21, 4.06[3]. nonetheless, formulary apportionment-type methodologies are in common use in the tax world. they are commonly used in u.s. state taxation models, as discussed in part xii.e.2, infra. they are also on the table for broad utilization in the proposed european union consolidated corporate income tax base, which would aggregate an mne's combined income for eu purposes and then apply formulary apportionment principles to allocate the combined income. in this manner, all pertinent functions would be taken into account for income allocation (tp) purposes. 90 mitchell b. carroll, a brief survey of methods of allocating taxable income throughout the world, in lectures on taxation 131, 151–53 & 168–70 (roswell magill ed., 1932) (stating that fractional apportionment was the primary method of resolving double taxation for spain and switzerland and was also used by france; also providing an analysis of how austria, czechoslovakia, hungary, and poland had all formulated significant profit-split methodologies); see also herndon, note 65, at 15 (describing a preexisting germany-holland treaty where income apportionment was used for a railroad between the two countries); seligman, supra note 68, at 138 (recognizing that great britain had employed formulary apportionment methods with respect to its colonies but still maintained that this method was not practical). as indicated below, there is today extensive experience in addressing such issues, principally involving the use of two-sided tp methodology in bilateral advance pricing agreement (apa) or double taxation cases (where one country asserts a claim to a higher share of residual profits and the dispute is resolved through a competent authority treaty resolution process). 91 see 1923 icc proceedings, supra note 33, brochure 25, n. 29, at 10–12. indeed, the icc referred to the principles espoused by seligman, one of the league’s economists. id. 2013] income tax treaty policy in the 21st century: 23 residence vs. source in 1925, the technical experts issued their first report to the league of nations.92 it stated that the residence country93 should be given primary jurisdiction over income but that the source country should have a right to tax income from real property, agriculture, and income from commercial and industrial undertakings.94 furthermore, the league 1925 technical experts report recognized that numerous examples existed of efforts to utilize option 3’s profit-split or formulary apportionment approach, including by great britain with its colonies, by swiss cantons among themselves, and by several countries in central europe in numerous treaties.95 in fact, the report at one point stated that the method of apportioning profits “appeared at first sight to be the one which was most generally in use.”96 notwithstanding the numerous examples of profit-split methodologies and recognition of the risk of artificial allocations of income under a preset classification-andassignment approach, the league 1925 technical experts report summarily rejected the idea of analyzing the possibility of adopting a profit-split methodology, stating that “we do not think that it would be possible to adopt generally such a very complicated [profitsplit methodology] system in the international sphere.”97 this comment was certainly not true at the time because the members of this committee had ample evidence to use to develop profit-split models that would fairly and accurately allocate income between the source and residence countries. by suggesting that a profit-split apportionment approach was too hard, the committee was able to side-step further rigorous inquiry about whether this result could avoid the misallocation issues that the classification-and-assignment approach could create. in any event, the league 1925 technical experts report recommended that work should begin on developing a model income tax treaty along the lines it advocated.98 v. coordination of the league and the icc positions the icc committee on double taxation, chaired by thomas sewall adams, met in may 1925.99 the u.s. delegation included the chairman of the house committee on ways & means (william r. green). 100 the icc committee on double taxation accepted the preference for a residence basis of taxation, with the source country right to 92 w.h. coates, double taxation and tax evasion: report and resolutions submitted by the technical experts to the financial committee of the league of nations, league of nations doc. c.115m.55.1925.ii.a (1925) (hereinafter 1925 technical experts report). 93 id. at 21 (stating that place of residency for a joint stock company meant its place of fiscal domicile, which would be determined as the place where “management and control of the business are situated”). 94 id. at 31. 95 id. at 12–14; see also the 1921 austro–hungary treaty, discussed supra note 56; mitchell b. carroll, methods of allocating taxable income, taxation of foreign and national enterprises vol. iv, league of nations doc. c.425(b) m.217(b) 1933 ii.a. at 57–87 (1933); and the discussion of pre-existing income apportionment schemes supra note 90. as will be indicated below, there is today extensive experience in addressing such issues, principally involving the use of two-sided tp methodology in bilateral advance pricing agreement (“apa”) or double taxation cases (where one country asserts a claim to higher share of residual profits and the dispute is resolved through a competent authority treaty resolution process). 96 1925 technical experts report, supra note 92, at 14. 97 id. 98 1925 technical experts report, supra note 92, at 29. 99 id. at 10–11. 100 id. at 11. 24 columbia journal of tax law [vol.5:1 tax being strictly limited and not entitled to, in essence, impose a profit-split approach on the combined income of the foreign company.101 the third icc congress met in brussels in june 1925,102 five months after the league 1925 technical experts report was published. a delegate from the financial committee of the league of nations also attended.103 the proceedings noted that the league committee of technical experts, following the work of the league’s 1923 economic experts report, had contacted the icc with respect to the views of taxpayers (business).104 the icc group met with the league committee of technical experts in geneva in april 1924 to present its views on double taxation. cooperation between the icc and the league was recited in the proceedings of both.105 the league 1925 technical experts report, issued five months earlier, appears to have overstated the preference of the icc, as least as of the second icc congress in 1923, for residence–based taxation. it may be that this reflected the interim discussions, recited by the icc, in which the icc committee on double taxation deferred to the league’s technical experts. this view is supported by the following statement by t.s. adams who described the “working agreement” between business (the icc) and governments (the league) in the following manner: the working plan for the general elimination of double taxation . . . is based upon the frank recognition of the fact that the income-tax serves two purposes: it must satisfy the claim both of the country or origin and of the country in which the taxpayer resides; part of the income will inevitably be taxed where it is earned and part where the taxpayer resides. this is the first time perhaps that full recognition has been given to the valid claims of the country of origin and the country of residence. the committee of the international chamber very clearly records its conviction that double taxation is particularly pernicious, because the burden is likely to be borne by the borrowing taxpayer or country. it is essential that the interest of the debtor countries and business enterprises obliged to borrow [from the creditor countries and business enterprises, presumed to be at the place of residence], that double taxation should be obviated wherever possible. . . . . with respect to firms doing business in foreign countries, the committee recommends that agencies not an integral part of the enterprises, established on the basis of commission only, should be exempt from taxation in the country where the agency is established, except in so far as the profits of the agent himself are concerned. where the business enterprise maintains in a foreign country a genuine commercial or industrial establishment, the latter is to be taxed upon the profits derived 101 id. at 7–8. italy reserved on the preference for residence, as it had in the league of nations proceedings. it proposed that different rules be applied for taxes in rem (on property) and in personam (everything else, including most cross-border business). see 1925 icc proceedings, brochure 34, at 9 [hereinafter icc brochure no. 34]. 102 see generally icc brochure no. 34, supra note 101.. 103 id. at 10. 104 see id. 105 see id.; see also reference to the work of the icc in 1925 technical experts report, supra note 92. the discussions in geneva are also discussed in icc brochure no. 34, supra note 101, at 34–35. 2013] income tax treaty policy in the 21st century: 25 residence vs. source in the foreign country, but where an agency only is maintained, taxation is to be confined to the agent’s commission.106 in short, the icc eventually accepted that: (1) the primary right to tax profits from cross-border enterprise was in the residence country; (2) the source country could not seek information about profits earned by the enterprise outside the source country (that is, no profit split); and (3) in the case of what became a pe, the source country could tax only the income derived in its country. the rationale for these conclusions seemed to arise from the fact that source countries were presumed to be importers of capital, which would be the fuel to generate profits.107 vi. league of nations evolution as noted, the league of nations commissioned a broader group of technical experts that included the united states (represented by adams108 and assisted by mitchell b. carroll) to create a model income tax convention.109 this group met in april 1927. the british technical expert, sir percy thomas, continued to argue in favor of residencebased taxation as had the league 1923 economic experts report and the league 1925 technical experts report,110 as also accepted by the icc, but finally on the last day of the 106 icc brochure no. 34, supra note 101, at 15; see also id. at 14, 16–17. the text of the actual icc resolutions is consistent with the explanations of t.s. adams, see id. at 17–18, as are the resolutions of the league technical experts. id. at 19–21. the only point of difference between the league of nations and the icc in the geneva meetings concerned the taxation of a foreign enterprise having a “genuine commercial or industrial establishment” in another country. id. at 18 (resolution 4 of the icc). the icc position was that each country could tax only the portion of the income earned its territory. an illustration of this position was offered by the british representative (sir algernon firth): if a man had a commercial establishment (a factory, a shop, a bank) in a foreign country, that country might collect impôts réels on it. if he only had an agent or permanent representative, the foreign country had no rights upon the profits of the firm in that country. fancy the position of a firm having agencies in 20 different countries if it had to present in 20 different fiscal authorities 20 balance sheets. would it be possible for any firm to keep any process secret? the committee admitted that it was unfair that an agent should work in a country and not be taxed there, but they recognized that it would be absolutely impossible for firms to produce the number of balance sheets that would be required if the suggestion of the experts were adopted, and so it was hoped most strongly that the meeting would adopt the [icc] committee recommendation. resolution of the issue was, in essence, deferred to a subsequent league of nations conference that would include a broader range of countries, including germany, the south american countries, and, it was hoped, the united states. see 1925 icc proceedings, supra note 31, brochure 43, at 15, 22. these meetings appear to have been convened in 1927, anticipating resolution in 1928. see international chamber of commerce, resolutions passed at the stockholm congress (june 27–july 2, 1927), brochure 60, at 22. 107 see 1923 icc proceedings, supra note 33, brochure 25, at 7-13. 108 for an excellent work on the contributions made by adams to u.s. income tax policy, see graetz & o’hear, supra note 30.(one of the few academic analyses of the formative work of the league of nations, which was focused on the need for reform of the u.s. international tax regime as opposed to the need for reform of the global treaty models; there is an excellent discussion of the role of source in the formulation of u.s. policy, as well as the “essential dilemma” of residence vs. source). 109 see graetz & o’hear, supra note 30, at 1081. see also reuven s. avi-yonah, “all of a piece throughout: the four ages of us international taxation,” 25 va. tax rev. 313 (2005) (seeming to suggest that mr. carroll was an important collaborator with professor adams); see also the double taxation conference: london, april 5–12, 1927, memorandum from mitchell b. carroll to t.s. adams, at 19 (sept. 26, 1927) (unpublished manuscript available in t.s. adams papers, yale university, box 13, sept. 1926– 1927 folder.) 110 see, e.g., league of nations comm. of experts on double tax’n & fiscal evasion, minutes of the tenth meeting held in london at 5 p.m. on tuesday april 12th, 1927, d.t./8th session/p.v.10(1), at 6–7 (available at t.s. adams collection, yale university, box 16, league of nations apr. 12, 1927 folder.) 26 columbia journal of tax law [vol.5:1 conference a compromise was reached along the lines urged by the newest member of the committee, adams. he advocated that the source country should have the right to impose “impersonal taxes” (that is, withholding taxes) on the various classes of income while the country of residence should provide a foreign tax credit (“ftc”) for the withholding taxes paid to the source country. 111 also, several experts championed a proposal endorsed by the icc that a foreign enterprise should not be considered to have a pe in a source country simply because it transacts business in the source country through an independent agent,112 and the committee adopted this recommendation.113 the impact of this recommendation was to exempt from source country taxation all profits derived by a foreign enterprise through independent agents, 114 but, importantly, branches, affiliate companies, and dependent agents still constituted a pe under the draft convention.115 furthermore, the fiscal committee made it clear that a source country would have no right to tax business profits from industrial and commercial activities on a net basis unless the foreign parent had a pe in the country.116 after making these important clarifications, the fiscal committee issued their report on april 15, 1927, and accompanying their report was a draft model income tax treaty (the “1927 draft model convention”) that utilized the classification-andassignment approach set forth in the league 1923 economic experts report and the league 1925 technical experts report but with the more narrow pe definition.117 in october, 1928, the league of nations’ technical experts met again and issued a final report.118 importantly, each of the potential models continued the classificationand-assignment approach that had by then been repeatedly endorsed. the 1928 model conventions became the benchmark for treaty negotiations in europe, and these model conventions were instrumental in the development of the earliest u.s. tax treaties.119 thus, the classification-and-assignment approach utilized in the 1928 model convention transformed treaty negotiations. once this treaty framework was in place, the balance of power between source and residence countries was significantly changed through a continuing redefinition of the scope of activities that would fall within the purview of a pe and through continuing efforts to minimize the amount of source-based withholding taxes that would apply to cross-border payments. the order of tax treaty principles that were so formulated could be distilled into five principles: 111 see report presented by the comm. of technical experts on double taxation and tax evasion, league of nations doc. c.216m.85.ii.a, at 11 (1927) [hereinafter 1927 technical experts report]; see also memorandum from mitchell b. carroll to t.s. adams, supra note 109, at 19. 112 see league of nations comm. on double taxation and fiscal evasion, minutes of the third meeting held at london on april 6th, 1927 at 3:30 p.m., league of nations, dt/8th session, p.v.3.(1), at 910 (proposal made by m. julliard representing the icc and endorsed by adams) (available in t.s. adams collection, yale university, box 16, league of nations apr. 4-6, 1927 folder.) 113 see league of nations comm. on double tax’n & tax evasion, minutes of the fourth meeting held in london on april 7th, 1927 at 3:30 p.m., league of nations, d.t./8th session/p.v.4.(1), at 2 (proposed change to permanent establishment definition adopted) (available in t.s. adams collection, yale university, box 16, league of nations apr. 7 & 8, 1927 folder.) 114 see memorandum from mitchell b. carroll to t.s. adams, supra note 109, at 6. 115 id. 116 id. 117 1927 technical experts report, supra note 111, at 10–11. 118 report presented by the general meeting of government experts on double taxation and tax evasion, league of nations doc. c.562m.178 1928 ii (1928) [hereinafter league 1928 report]. see generally graetz & o’hear, supra note 30, at 1023–24. 119 see rosenbloom & langbein, supra note 88, at 365. 2013] income tax treaty policy in the 21st century: 27 residence vs. source 1. source country should tax local operations, including property or other pertinent matters. 2. residual income should be earned by the country of residence, which provides the knowledge, capital, and global markets for the business. 3. presence of an interim holding company should be treated as a residence country. 4. subsidiaries should not be treated as a pe120). 5. tp is to be evaluated on a separate account basis (i.e., one-sided tp principles). the model treaties that eventually became the oecd model, and subsequently the un model, are based on these five principles, which comprise the elements of the foundational premise. not surprisingly, the effective tax rate strategies of mnes evolved based on this treaty model, as contemplated in the work of the league of nations. vii. the hungary problem on may 12, 1928, poland and hungary executed a tax treaty that used the framework of the 1927 draft model convention. the hungary-poland tax treaty is notable in that it turned the intended result of that convention on its head by tweaking its terms to give a preference to source-based taxation.121 to achieve this result the treaty provided that income from investments, savings accounts, and securities and all other “floating capital” would be taxed by the country in which the debtor was located (residence country).122 business profits would be apportioned between the countries where a business entity had an establishment, and for this purpose the term “establishment” was defined to include subsidiary corporations that operated in the source country just as the 1927 draft model convention had done.123 furthermore, just like the 1927 draft model convention, the term pe included all permanent representatives of the business entity whether or not the representative had the authority to bind the foreign company.124 the hungary-poland tax treaty went on to provide that the combined income of the nonresident company and its subsidiaries would be apportioned between the two countries based on the relative gross income derived from the various establishments,125 and the combined income would be determined using the general statement of accounts maintained by the business entities.126 furthermore, if these accounts were not reliable, then the two countries would consult one another to determine a fair allocation of the income.127 this approach was, in essence, the 1923 icc model. 120 see discussion in section vii infra. 121 conventions between the kingdom of hungary and the republic of poland for the prevention of double taxation in the matter of direct taxation, may 12, 1928, 123 l.n.t.s. 47; for another contemporaneous attempt to achieve taxation that did not utilize the league of nations’ model treaty, see agreement between spain and italy regulating the fiscal treatment of companies, arts. 4, 5, nov. 18, 1927, 82 l.n.t.s. 27. 122 hungary-poland treaty, supra note 121, at art. 5. 123 id. art. 3. 124 id. 125 id. 126 id. 127 id. 28 columbia journal of tax law [vol.5:1 the broad definition of pe to encompass the business operations of related corporations, the use of the global revenues of the overall related entities, and the use of a profit split based on gross revenues allowed hungary and poland to effectively achieve the option 3 profit-split result that had been formulated (and rejected) in the 1923 economic experts report. all of this was achieved within the framework of the league of nations’ own 1927 draft model convention. in a report dated october 26, 1929, the fiscal committee of the league of nations noted that the hungary-poland convention had utilized the league of nation’s model convention to promote a source-based taxation result.128 as a result, the fiscal committee concluded that the member nations needed a further explanation on how profits from industrial activities should be taxed.129 the next year, in a report issued in may 1930, the fiscal committee of the league of nations definitively adopted its narrower pe definition that excluded independent agents. 130 the fiscal committee then recommended that royalties on patents, copyrights, and other types of intangible property associated with a commercial and industrial undertaking unrelated to real property should be taxed only at the fiscal domicile (residence) of the recipient if the owner of the intangible property did not otherwise have a pe in the source country.131 it then established a subcommittee to determine whether the following further clarifying statement should be added to the pe definition: the fact that an undertaking has business dealings with a foreign country through local company, the stock of which it owns in whole or in part, should not be held to mean that the undertaking in question has a permanent establishment in that country.132 thereafter, the fiscal committee issued a report that set forth a revised draft model convention, which explicitly provided that a pe “does not include a subsidiary company.” 133 the treaty also maintained an exemption for withholding taxes on 128 fiscal comm., report presented to the council on the work of the first session of the comm., league of nations doc. c.516m.175.1929.ii (1929), at 2. 129 id. at 2–3. 130 fiscal comm., report to the council on the work of the second session of the comm., league of nations doc. c.340m.140.1930.ii.a (1930), at 4.. 131 id. at 5-6; fiscal comm., report to the council on the work of the third session on the comm., league of nations doc. c.415m.171.1931.ii.a. (1931) (adopting the proposed principles). 132 fiscal comm., 1930 report, note 124, at 9 (emphasis added). blau, the representative of switzerland, requested that this provision should be considered because the icc had adopted a resolution earlier in 1929 to the same effect. see minutes of the second meeting of the committee of experts on double taxation and fiscal evasion at 4:00 p.m. on thursday, october 17th, 1929, f/fiscal 1st session/p.v.2,(1) league of nations, at 3. the next year, some members pressed for adoption of this clarifying statement without further study, but this proposal was rejected. see minutes of the sixth meeting of the comm. of experts on double taxation and fiscal evasion at 3:30 p.m. on wednesday, may 28th, 1930, f/fiscal/2nd session/p.v.6,(1) league of nations, at 7. instead, the subcommittee that was established to address the allocation of profits would also consider the redefinition of a pe to exclude “affiliated companies.” see minutes of the seventh meeting of the comm. of experts on double taxation and fiscal evasion at 9:30 a.m. on thursday, may 29th, 1930, f/fiscal 2nd session/p.v.7.(1), league of nations, at 30–33 (proposal 4 adopted with flores de lumus’s amendment). 133 fiscal comm., report to the council on the fourth session of the committee, league of nations doc. c.399.m.204.1933.ii.a. (1933), at 6 [hereinafter league 1933 report]. prior to this meeting, adams, a defender of source-based taxation, died unexpectedly on february 8, 1933. the united states asked carroll to replace adams as the u.s. representative to the fiscal committee. mitchell b. carroll, global perspectives of an international tax lawyer 71 (1978). shortly after this meeting, on november 6, 1933, dorn withdrew from the fiscal committee as a result of germany’s decision to withdraw from the league of nations entirely. see fiscal comm., resignation of professor dorn, member of the committee, 2013] income tax treaty policy in the 21st century: 29 residence vs. source royalties.134 furthermore, the report then attacked the hungary treaty’s global, multicompany allocation approach by setting forth an explicit framework for how business profits of a pe should be calculated: the fundamental principle laid down is that, for tax purposes, permanent establishments must be treated in the same manner as independent enterprises operating under the same or similar conditions, with the corollary that the taxable income of such establishments is to be assessed on the basis of their separate accounts.135 the method of relying on separate accounts was defined by carroll in his report submitted to the fiscal committee in the following manner: the method of separate accounting means taking the declaration of income, supported by the accounts of the local branch, as a basis of assessment. this may entail a verification of the accounts and enquiry into the relations between the local branch and other establishments (branches or subsidiaries) of the parent enterprise, which involve, for example, consideration of the price at which goods have been invoiced to the branch and their original cost, and the amounts charged to the branch for services or representing a portion of general overhead expenses.136 carroll went on to state that the method of separate accounts was the method normally followed “in the country which has the largest experience in the taxation of income,” namely the united kingdom, and characterized it as being the method used by countries that have “accountants of the highest professional standing.”137 in its official report, the fiscal committee clarified that the arm’s length standard would be determined by assuming that the pe were a separate entity, thus rejecting the global allocation approach articulated in the hungary-poland treaty.138 in a report issued in june 1935, the fiscal committee endorsed the draft model income tax convention that had been submitted in 1933.139 the 1935 revised draft model treaty “fixed” the pe definition by excluding the mere ownership of subsidiaries and limiting the business profits allocable to a pe to only the profits in the company’s separate accounts.140 the consequence of removing subsidiaries from the definition of a pe, determining business profits allocable to the subsidiary in terms of a stand-alone (or onesided tp) inquiry, essentially ignoring interim holding companies, and exempting royalties from source-based withholding taxation was to create significant tax planning opportunities. by utilizing the investment structure set forth in mercantilist paradigm example, a significant opportunity existed to base erode the colony country, which was league of nations doc. c.677.1933.ii.a. (1933). the departure of adams and dorn, both of whom showed some balance in terms of source-based taxation, occurred mid-stream during the transitional period when the league of nations was moving away from its 1928 model convention and towards the 1935 revised draft model treaty. 134 league 1933 report, supra note 133, at 3–4. 135 id. at 2 (emphasis added). 136 4mitchell b. carroll, league of nations fiscal comm., taxation of foreign and national enterprises 45 (1933) 137 id. at 47. 138 see league 1933 report, supra note 133, at 2. 139 fiscal comm., report to the council on the fifth session of the committee, league of nations doc. c.252m.124.1935.ii.a. (1935), at 3, 5–7. 140 id. at 5-6. 30 columbia journal of tax law [vol.5:1 the desired objective of the framers (principally imperial countries) of the foundational premise.141 carroll would later say that “the advocates of the method of separate accounting as the basic method for allocating taxable income have won a decided victory in the international sphere over the supporters of fractional apportionment” and that fractional apportionment “had been relegated to the place of a last-resort measure in the international sphere.” 142 in applying the arm’s length method, carroll consistently employed transactional methods or one-sided tp methods, as he considered a profit split (a two-sided tp method) as a “rarely used” method that would only be utilized if no other transactional comparable could be found.143 the international paradigm that framed subsequent discussions between developed and developing nations would contain the elements of the foundational premise.144 in concert, these elements of the 1935 revised draft model treaty shifted the balance of power away from source countries and toward the country of residence. member nations were dutifully conforming.145 the net result of the 1935 revised draft model treaty was that the bilateral principles had been established for the legitimacy of residence-based taxation. in the process of developing tp policies to remove residual income from source countries and allocating it to the residence country (including interim holding companies in third countries treated as a residence country) mnes were implementing the policies specifically approved and prescribed by the league of nations. indeed, if they were to have done otherwise, application of the mutual agreement provisions of the model treaties would have enforced such policy orientation. viii. homeless income: the nagging reality check while the residence-based paradigm may have been established, there was a problem. the model encouraged mnes to remove earnings from “floatable capital” out of the source country and create homeless income. the purpose behind the 1928 model tax treaty was to avoid double taxation, not to create non-taxation. yet, the creation of homeless income is exactly what occurred as a result of the five elements noted above.146 a “no taxation result” was viewed as a mistake, a fiscal fraud.147 of course, this was a rather contradictory conclusion to the process that facilitated the creation of homeless 141 see infra parts iv and vi. 142 carroll, supra note 23, at 473, 473 n.4 . the role of carroll should not be underestimated. he drafted model 1-b of the 1928 model tax treaty for adams. carroll, supra note 133, at 32. carroll’s study of attribution of profits was very significant in framing acceptance of the arm’s length standard by the league of nations. see id. at 70–71. he was the president of the fiscal committee of the league of nations from 1938 to 1946. id. at 71. he was the first president of the international fiscal association. id. at 32. carroll was present in the drafting of the 1963 oecd model convention. he was also present in the meetings with stanley surrey to develop the u.n. model treaty. u.n. dep’t of econ. & soc. affairs, tax treaties between developed and developing countries: second report, at 26, u.n. doc. st/eca/137, u.n. sales no. e.71.xvi.2 (1970) [hereinafter 1970 u.n. second report]. carroll was also involved in the actual drafting of the eventual u.n. model treaty. see u.n. dep’t of int’l econ. & soc. affairs, manual for the negotiation of bilateral tax treaties between developed and developing countries, at 7, u.n. doc. st/esa/94, u.n. sales no. e.79.xvi.3 (1979) [hereinafter 1979 u.n. manual]. 143 see carroll, supra note 23, at 483, 485–86. 144 see infra section iv. 145 see fiscal comm., supra note 139, at 3-4 (stating that “existence of model treaties of this kind has proved of real use” and showing the number of treaties that are now conforming to the model treaty). 146 see supra part vi. 147 fiscal comm., report to the council on the sixth session of the committee, league of nations doc. c.450m.266 1936 ii.a. (1936), at 1. 2013] income tax treaty policy in the 21st century: 31 residence vs. source income, as noted above. in response to the then growing problem, on october 9, 1936, the assembly of the league of nations adopted the following stinging resolution: the assembly, considering that efforts to reduce the obstacle to the international circulation of capital must not have the effect of increasing fiscal fraud; . . . . requests the fiscal committee to pursue vigorously its work for the avoidance of double taxation as far as possible, and also its work on the subject of international fiscal assistance, in order to promote practical arrangements calculated, as far as possible, to put down fiscal fraud.148 thus, soon after the fiscal committee had dismantled the source-country tools to levy taxes on residual income related to movable capital (i.e., the foundational premise),149 the fiscal committee found itself being questioned by the assembly about whether it had done enough to ensure that fiscal fraud (that is, homeless income) was being addressed with sufficient vigor. the fiscal committee agreed that tax evasion was achieved through income from movable capital. it was then faced with a choice. it could recognize that the taxpayer’s right to choose the country of residence represented a de facto tax election which, when coupled with the elimination of source country taxation, allowed the taxpayer to create homeless income. alternatively, it could double-down on its deference to residencebased taxation. the fiscal committee refused to alter its mindset, and instead proposed that each country should adopt domestic rules to address the problem of movable income. the response was a clear lack of interest in a country developing an infrastructure to track movable capital for a third country when there was no financial benefit that would inure to that country.150 recognizing that there was “insuperable opposition” to this solution, the fiscal committee suggested that a second-best solution would be to adopt exchange-ofinformation agreements as part of the tax treaty network, though it held out little hope that this was a comprehensive solution.151 thus, the fiscal committee admitted that its only solution to the homeless income problem was unworkable. nonetheless, it remained unwilling to change its policy of promoting residence-based taxation over source-based taxation.152 this ultimately led to the evolution of outbound (such as controlled foreign corporation (“cfc”), ftc, and related regimes) and inbound (such as earnings-stripping, thin capitalization, anti-avoidance, and related regimes) domestic legislation, often not subject to resolution in treaty-based dispute resolution procedures.153 148 id. at 1 (emphasis added). 149 see supra part iv. 150 id. at 2. 151 report presented by the fiscal committee to the council during its seventh session of the committee, league of nations doc. c.490 m.331 1937 ii.a. (october 16, 1937), at 2. 152 the u.n. ad hoc group of experts would later comment that this discussion of international tax evasion was the last in-depth discussion of tax evasion and avoidance in international forums until the 1970s. see u.n. dep’t of int’l econ. & soc. affairs, tax treaties between developed and developing countries: eighth report, at 7–8, u.n. doc. st/esa/101, u.n. sales no. e.80.xvi.1 (1980) [hereinafter 1980 u.n. eighth report]. 153 the relationship of these outbound and inbound regimes to tax base defense in the 21st century is discussed at wells & lowell, homeless income and tax base erosion, supra note 10, at 584–94. 32 columbia journal of tax law [vol.5:1 ix. compounding the mistake of homeless income interestingly, the icc, after being silent on the subject of double taxation since 1925, addressed the subject of homeless income in 1951.154 it noted that a country should draw its tax frontier vis-à-vis foreigners so as to exempt from domestic taxation a broad range of essentially base-stripping mechanisms. in addition, a country should also not inquire “into the total income of the non-residents.”155 in recognition of the flaw in the foundational premise of residence-based taxation caused by intermediary companies (i.e., homeless income), the icc proposed that “intermediary countries” should be treated as the residence country and should not tax subsequent distributions of income.156 this proposal was submitted to the fiscal commission of the then new united nations.157 in essence, the icc proposed that an intermediary country, even if it had no or a low effective tax rate, should be treated as the residence country. this emboldened effort to obtain explicit protection for a low-taxed intermediate holding company structure demonstrates that homeless income tax planning had by this time become well understood and of significant importance to the business community. in any event, the icc 1951 proposal had been an element of the foundational premise from inception, but in 1951 is was clearly and explicitly framed. x. policy evolution in the 1951 – 2012 period in the period since 1951, global tax treaty policy has stood still. there have been domestic tax base defense efforts in the form of ever-tightening cfc, ftc, earningstripping, and related outbound and inbound regimes, as well as a global effort to police the perceived base-stripping activities of mnes via the introduction of broad-based tp documentation, examination, and penalty regimes.158 the near universal questioning of the extant model tax treaty policy was germinated by the tensions noted at the beginning of this article.159 in this regard, it is also worth noting, though beyond the scope of this article, that many former residence countries, including most oecd member countries, are increasingly adopting policies designed to attract economic activity to their own borders and abandoning efforts to impose domestic taxation of an extra-territorial basis (such as the outbound and inbound regimes noted above). this is plainly evident in the current international taxation proposals in the united states of the obama administration as well as proposals being considered on a bi-partisan basis in congress, which include conversion of the current global taxation model to a “territorial” model, utilization of a “patent-box” regime to provide lower domestic taxation for creation, in essence, of jobs related to intellectual property.160 indeed, one of the most pervasive u.s. tax regimes of 154 see unilateral relief from double taxation, icc statement and report of the comm'n on taxation 1951 [hereinafter 1951 unilateral report]. 155 id. at 2. 156 see 1951 unilateral report, supra note 154, at 10–11. 157 see 1951 unilateral report, supra note 154, at 11. 158 see oecd transfer pricing, supra note 6, at ch. 14 (listing the requirements of 70+ countries). 159 see supra part i. 160 see lowell et. al, u.s. international transfer pricing, supra note 2, at ¶ 2.02[22]. 2013] income tax treaty policy in the 21st century: 33 residence vs. source recent vintage is the so-called fatca imposition of withholding taxes on u.s. source investment income.161 these evolutions stand as mute testimony to the reality that the world has changed since the 1920s. the former source-colony countries have in many cases become residence-imperial countries, as many creditor countries of that era have become debtor countries. in the mercantilist paradigm noted above,162 a case could certainly be made that, in many respects, india has taken the place of england (as has china taken the place of the united states). xi. foundational premise under original icc approach as noted above, 163 the foundational premise had several elements. these elements would have been entirely different under the original icc approach as follows: 1. source country should tax functions actually performed in that country local operations; 2. residual combined income should be allocated between earned by the country of source and the country of residence by agreement of the countries or on the basis of a specified factor; 3. presence of an interim holding company should be ignored or treated as the source country and its treaty partner country determine treated as a residence country; 4. treatment of subsidiaries susidiaries should not be treated as permanent establishments is no longer relevant; and 5. tp is to be applied on a combined basis. needless to say, had the oecd and un model treaties been developed based on these principles, the tension of today would be quite different. xii. policy evolution in the future as in the post-world war i period, there is today a global need for economic growth. designing policies to generate growth is complex. certainly, one important element is international tax policy. all members of the international taxation community have a common interest in finding a solution to the current tension that is appropriate to the economics and realities of the early twenty-first century, not trying to continually paper-over the policies of the early twentieth century. in view of the history of the current oecd and un model treaties, it is not surprising that there is tension between source countries, residence countries, the oecd, the un, and mnes with respect to international taxation. it is inevitable that, in due course, there will be systematic re-examination of global tax treaty policy. hopefully, this will occur in a context where all countries, residence, source, or otherwise, can come together and craft an order of global taxation that fits the world as it is. the forum for these discussions will remain to be determined. as the process evolves, we respectfully submit that there are several conceptual challenges that will need to be thoughtfully addressed, including the following: 161 see hiring incentives to restore employment act of 2010, pub, l. no. 111-147, 124 stat. 71. see generally cym lowell & mark r.martin, u.s. international taxation: practice & procedure ¶ 7.05[1][f] (2012). 162 see supra part ii. 163 see supra parts ii.a and vi. 34 columbia journal of tax law [vol.5:1 a purpose of the foundational premise the first conceptual challenge is to recognize that the existing model treaties, and the original tp rules to implement those treaties, were purposefully skewed. prior to the work of the league of nations, several treaties had engaged in profit-split or formulary apportionment methodologies. 164 this was in earlier times the dominant method of allocating income from cross-border activities. homeless income should not survive in such a world and appears not to have existed under such methodologies. rather, income was allocated to the country where the underlying economic activity occurred. pe concepts were not relevant, as they are largely a function of the foundational premise. the victors of wwi wanted to reshape the world into their mercantilist mindset. their solution was that residual income should belong to the country of residence, not to the country where the economic activity occurred. one-sided tp methods served their purpose because source countries would focus only on the in-country subsidiary as the “tested party” to be allocated a routine return. all residual income by default went to the residence country (the “untested party” to use consistent tp terminology) without principled examination of overall function, risk, or investment. 165 it is important to recognize that this was a purposeful step that served the interest of the capital exporting nations which wanted to maximize the potential allocation of residual income to their own countries. the discussion in the original archives is amazingly frank.166 in other words, the original “earning strippers” (when viewed from the standpoint of source countries of today) were the government officials of capital exporting nations circa 1920s. to a significant extent, the governments that now pillory mnes for creating homeless income were the framers of the mercantilist approach to international taxation that created the opportunity in the first place. can the residence countries of yesteryear evolve to embrace a new model? the answer to this conceptual issue is clear. it is in the affirmative and has already occurred, as most of these countries have already embraced a territorial model, as will be noted below.167 b. source country emergence to residence country another conceptual challenge to serious re-engineering of our model treaties is the economic migration of many source (or colony) countries from the 1920s period, in which the foundational premise was born, to their current status as residence (capital exporting) countries. for example, india was the model colony country in the 1920s discussions.168 like the other brics and many source countries of today, it is a serious economic power intent upon defending its own tax base, just as were the original residence countries in the 1920s. 164 see supra part vii. 165 see double taxation, in international chamber of commerce, resolutions passed at the stockholm congress (june 27–july 2, 1927), brochure 60, ch. v, at 21. the terminology in the text is stated in current terms adapted from the words actually used in 1927. 166 mr. carroll would later say that “the advocates of the method of separate accounting as the basic method for allocating taxable income have won a decided victory in the international sphere over the supporters of fractional apportionment” and that fractional apportionment “had been relegated to the place of a last-resort measure in the international sphere.” carroll, supra note 23. see also discussion of the importance of mitchell b. carol, supra note 142. 167 see supra part xii. 168 see supra parts ii and iii. 2013] income tax treaty policy in the 21st century: 35 residence vs. source this emergence is a transformative element of the treaty policy dialogue. many of these countries are not oecd members. the challenge here is likely to be which countries will be the driving forces in determining the appropriate treaty policy for the future. will it be the oecd, the un, a new organization reflecting the interests of the brics and source countries, or a communal effort of all of parties? c. territorial taxation: a confusing race to the bottom a third conceptual challenge is the trend toward territorial taxation.169 in such a world, a residence country relinquishes its right, under the foundational premise, to assert taxation on residual income from economic activities that have no nexus to its jurisdiction other than stock ownership. this process, which results from countries competing with one another for mne headquarters locations, amounts to an international race to the tax bottom.170 from a treaty policy standpoint, this is rather confusing. the residence countries of the post-world war i era demanded the foundational premise. as the economic world evolved, including the emergence of former source countries as residence countries, many of the authors of the foundational premise have abandoned its critical objective of taxing foreign source income. have these countries already abandoned the foundational premise? d. secret world provides guidance for the way forward? in the real world of today, major tp controversies between treaty countries are inevitably resolved via the mutual agreement provisions of the model treaties.171 the proceedings are commonly referred to as involving the competent authorities, referring to the tax officials of the respective countries who are competent (authorized) to resolve potential double taxation cases. in our experience in handling such cases around the world, the inevitable result is reached by the respective countries undertaking two-sided tp analysis to determine the appropriate amount of income to be allocated to its own domestic companies (i.e., subjected to domestic taxation). the results of these proceedings are necessarily secret, in the sense that there is no publication of the results (which are confidential taxpayer information), except in the form of broad statistical reports which are meaningless as a practical matter. on the other hand, those actually involved in the process (as private or public parties) understand that the essential concepts of the original icc proposal reflect the means by which real cases are actually resolved. in other words, there may be lip service to the foundational premise, but it is not followed in inter-governmental negotiations. in other words, competent authorities, unaided by unworkable policy paradigms, have been left to fend for themselves to develop administratively workable concepts to resolve complex cases. this process is actually efficient in most developed countries, though it is just beginning in the brics and many other source countries. 169 see lowell et al., u.s. international transfer pricing, supra note 2, at ¶ 2.02[22]. 170 see, e.g., jacques malherbe, philippe malherbe, hank verstraelen & pascal fues, business operations in belgium, 953 tax mgmt. portfolio (bna) at v.g(setting forth special tax incentives to attract mne headquarter functions to beligium); john ryan, robert o’shea & aidan fahy, business operations in the republic of ireland--taxation, 965 tax mgmt. portfolio (bna) at xi.c (providing overview of various holding company incentives, headquarter incentives, financing incentives, and intellectual property incentives for mnes in ireland). 171 see richard m. hammer et al., oecd transfer pricing, supra note 6, at ¶¶ 12.03 and 12.05. 36 columbia journal of tax law [vol.5:1 can the competent authority model serve as a useful guide in developing treaty policy for the future? e. perceptions of homeless income as noted earlier, there are today persistent drumbeats pillorying mnes for their global effective tax rate planning policies. the essential question here is whether such criticism is appropriate. whether one’s answer is affirmative or negative is largely irrelevant from a global tax treaty policy standpoint. why? because the behaviors in question were specifically encouraged by the league of nations model and enshrined in the current oecd and un models. the result has been the growth of homeless income. perhaps the most difficult conceptual challenge for treaty and international tax policy in the future will center around how to address homeless income. in illustration c,172 we framed homeless income in terms of the allocation to holdco. we assumed that india and holdingland had agreed that the allocation between the two countries should be 50:50, which allocated 450 to holdco. in the absence of such agreement, the icc approach would have required an allocation of the combined income on a notional basis such as sales. for purposes of discussion, assume that the 450 allocated to holdco is subject to a low rate of taxation in holdingland. in this event, the treaty policy question will be how the homeless income should be addressed. the answer will likely depend on the perspective of the respondent. 1. resident country perspective a residence country may perceive that any global income not subjected to taxation or covered by treaty should be fully subject to tax by it with appropriate foreign tax credit relief provided. there is significant scholarly support for this perspective.173 there are practical problems with this perspective. one is that residence countries have never treated their domestic mnes in a consistent manner. rather, there are material differences in the international taxation regimes of almost all residence countries. the result has been competitive advantage or disadvantage depending on where a mne is incorporated. 172 see supra part ii.a. 173 there are a number of variations on the proposal to simply tax all mne income on a current basis without deferral. see jasper l. cummings, jr., consolidating foreign affiliates, 11 fla. tax rev. 143, 195–96 (2011); robert j. peroni, j. clifton fleming, jr. & stephen e. shay, reform and simplification of the u.s. foreign tax credit rules, 31 tax notes int’l 1177, 1207 (2003); robert j. peroni, j. clifton fleming jr. & stephen e. shay, getting serious about curtailing deferral of us tax on foreign source income, 52 smu l. rev. 455, 458 (1999); see, e.g., reuven s. avi-yonah, to end deferral as we know it: simplification potential of check-the-box, 74 tax notes 219, 224 (1997); asim bhansali, globalizing consolidated taxation of united states multinationals, 74 tex. l. rev. 1401, 1422 (1996); daniel j. frisch, the economics of international tax policy: some old and new approaches, 47 tax notes 581 (1990); jane g. gravelle, foreign tax provisions of the american jobs act of 1996, 72 tax notes 1165 (1996); robert a. green, the future of source-based taxation of the income of multinational enterprises,79 cornell l. rev. 18, 75 (1993); john mcdonald, anti-deferral deferred: a proposal for the reform of international tax law, 16 nw. j. int'l l. & bus. 248, 281 (1995); peter merrill & carol dunahoo, ’runaway plant' legislation: rhetoric and reality, 72 tax notes 221, 221 (1996); stephen e. shay, revisiting u.s. antideferral rules, 74 taxes 1042, 1061 (1996); joseph isenbergh, perspectives on the deferral of u.s. taxation of the earnings of foreign corporations, 66 taxes 1062, 1063 (1988); lee a. sheppard, last corporate taxpayer out the door, please turn out the lights, 82 tax notes 941, 944 (1999). but see, james r. hines, the case against deferral: a deferential reconsideration, 52 nat’l tax j. 385, 401–02 (1999). 2013] income tax treaty policy in the 21st century: 37 residence vs. source in addition, if a residence country attempts to tax homeless income, taxpayers have the ability to simply “elect out” of that particular country and incorporate in a more taxpayer-friendly jurisdiction.174 since the country of residence is effectively a taxpayer election as to which many countries acquiesce, there is international competition to attract multinational headquarter companies. a driving feature of this effort is the provision of incentives for such relocation. in this regard, the movement to a territorial model175 reflects a determination by such residence countries to trade their theoretical ability to tax extra-territorial income to attract high-paying, white-collar headquarter and research jobs to their country. any single country cannot realistically stand alone in the wake of this race to the bottom. an effort to do so is likely futile and serves only to disadvantage that country vis-à-vis competitive jurisdictions. accordingly, even if one accepts that residency-based taxation as a conceptual solution for homeless income in an ideal world, the real world has already largely abandoned the model.176 2. source country perspective a source country is likely to believe that it should be able to tax residual income arising from functional activity taking place in its country. this is reflected in the tax policies increasingly asserted by the brics countries. 177 the brics have recently announced an initiative to develop a cooperate approach on issues related to international taxation, transfer pricing, exchange of information, and tax evasion and avoidance.178 source countries may be uniquely situated to enact tax rules that treat all economic competitors in its marketplace similarly.179 for example, if a source country (such as holdingland in illustration c180) were concerned about the possibility that profits allocated to holdco might be homeless income, then it could adopt a rule to re 174 the powerful tax benefits afforded to inversion transactions, in which a mne changes its place of residence, inevitably for tax reasons, from a high tax to a low tax country, reflects that the last days of the existing paradigm are at hand as mnes can self-help themselves into a territorial result either through their own inversion transactions or face the prospect of acquisition by foreign competitors. in either scenario, there will be an expansion of homeless income. 175 see supra note 170. 176 one element of a future treaty policy debate addressing homeless income will be the role of regimes that have evolved over the past 60 years to “backstop” the residence country tax bases out of concern that the tp rules were not adequate for this task. such regimes include the so-called controlled foreign corporation rules of many residence countries, as well as other related regimes. it is to be hoped that an effective resolution of the homeless income matter would eliminate the need for these complex and overlapping regimes. 177 see supra notes 7–8. 178 see press info. bureau, gov't of india ministry of fin., heads of the revenue of brics countries identifies seven areas of tax policy and tax administration for extending their mutual cooperation; joint communique issued after two day meeting of the heads of revenue of brics countries,january 18, 2013 (announcing the cooperation agreement between brazil, russia, india, china, and south africa), reprinted at 2013 wtd 15-27, tax doc. 2013-1498. 179 the increasing boldness of source countries, particularly the brics, to apply their own transfer pricing rules is becoming increasingly obvious. see, e.g., comm, of experts on int'l cooperation in matters, practical manual on transfer pricing, e/c.18/2012/crp.1 (october 2012), available at http://www.un.org/esa/ffd/tax/documents/bgrd_tp.htm. chapters 1-9 of this manual were written by the un committee on experts and the transfer pricing approaches advocated therein largely support the oecd approach to transfer pricing. chapter 10 was written by select bric countries and the principles articulated in this chapter 10 are fundamentally inconsistent with the principles advocated in the first nine chapters. 180 see supra part ii.a. 38 columbia journal of tax law [vol.5:1 allocate any profits allocated to holdco back to colonyco if the holdco profits were are not subject to meaningful resident country taxation.181 alternatively, the source country could subject all 900 of profits in illustration c to taxation by employing “force of attraction” concepts with foreign tax credit relief provided for taxes paid by holdco in the resident country.182 3. mne perspective mnes reacted to the foundational premise in a manner to achieve their effective tax rate objectives, including taxing maximum advantage of the potential benefits of homeless income. can mnes as a group accept a new paradigm that would eliminate, over time, the benefits of their homeless income generating models? hopefully, the multinational community would be a willing and active participant in the process.183 the ultimate concern of business is likely to be the presence of a level playing field, so that no one company is disadvantaged vis-à-vis its competitors due to geographic location or other non-business considerations. 4. oecd/un perspective homeless income has arisen from the structure of the existing model treaties, as discussed throughout this article. the oecd and un have been the global leaders in treaty policy in modern times. will they, together or separately, be willing to initiate or embrace an updating of model treaty policies to reflect the world of the 21st century? conclusion for the reasons noted immediately above, the treaty model of the post-world war i era is bound to undergo evolution. at this point in time, it appears that no group is happy with its consequences. the original residence countries have largely abandoned its benefit, source countries of the 1920s reject the model outright, the g-8 and g-20 have proclaimed that inappropriate effective tax rate policies have been spawned by the foundational premise, emerging countries and their supporters or financiers decry the impact of existing models upon their economic growth potential, and mnes are stuck in the middle, pilloried for following the rules.184 in short, the likelihood of future life of policies developed for the self-benefit of the economic powers of an earlier era (when airplanes were a novelty, franklin roosevelt and winston churchill were mere boys, and the sinking of the titanic was recent, unbelievable news) seems remote. in the inevitable re-examination process, there will be a fascinating range of political, economic, and business issues to be addressed. tax administrations will need to ascertain how their resources can be redeployed to foster economic growth. mnes will 181 such a proposal would be very similar to the “throw-back rules” that apply in several states in the united states where income that is apportioned to a particular state is “thrown back” to the first state if the state of initial apportionment does not seek to tax such apportioned profits. see generally walter hellerstein, the quest for ‘full accountability’ of corporate income, 63 st. tax notes 627 (2011); hamilton, mtc launches projects on associate nexus, throwback rule, tax analysts, doc. no 201116136 (2011). 182 before the enactment of the foreign investors tax act of 1966, pub. l. no. 89-809, 80 stat. 1539, a so-called “force of attraction” rule applied so as to tax all of the u.s. income as business income at graduated rates. see generally thomas bissell, u.s. income taxation of nonresident alien individuals, 907 tax mgmt. portfolio (bna) at ii. 183 see wells & lowell, supra note 10. 184 see supra part xii. javascript:top.docjs.no_prev_doc_in_search_results() javascript:top.docjs.next_hit(1) 2013] income tax treaty policy in the 21st century: 39 residence vs. source need to assess the impact of new treaty concepts on their global effective tax rate planning models. finally, organizations such as the oecd and un will need to assess the impact of such developments on their own role in international taxation. the critical question is who will initiate the evolution to come. all countries are anxious to protect their respective tax bases. at the present time, it appears that the brics and source countries have planted their stake in the sand, rejecting the existing order and declaring an intention to update the rules that apply to their own tax base defense. the oecd appears to be principally driven by the need to defend its member country tax bases, hoping, no doubt, that brics and source countries will ultimately follow its lead.185 if it fails to heed the needs of the evolving order (brics and source countries), the hegemony of the oecd may be lost in the process. as always, the study of history provides illumination for the future, provided that the lessons are not forgotten or ignored. the learning that can be derived from the policies developed in the 1920s is that tax revenues will follow treaty policy design. 185 see supra note 4. note designing a legal vehicle for social enterprises: an issue spotting exercise aurélien loric abstract social entrepreneurship is at the juncture of creative capitalism and social innovation. it aims at combining the best of two sectors, and thus is cramped in the traditional vehicles designed for either world in isolation. although the social bottom line of these enterprises can usually meet the broad charitable purpose requirement of the internal revenue code, tax-exempt vehicles have proven to be unable to hose the financial one. conversely, the advantages of for-profits stem from their flexibility, but their failure to receive funding from tax-exempts and the lack of a social enterprise brand have made it necessary to design new vehicles.  columbia law school ll.m. degree candidate, ‘13 2013] designing a legal vehicle for social enterprises: 101 an issue spotting exercise i introduction: societal innovation and the definition of social enterprise ....................................................................................... 102 the call for creative capitalism .................................................................... 102 a lack of uniform definition ........................................................................ 103 ii the charitable nonprofit: a vehicle unsuited for the social enterprise business model..................................................................... 104 characterizing social entrepreneurship from its business model .................... 104 the tax-exempt entity: an appealing but rigid framework to host a social business ......................................................................................................... 106 the economic bottom line: a financial return irreconcilable with the constraints of the third sector ....................................................................... 107 iii the shareholder primacy myth, a barrier to corporate social activism? .......................................................................................... 111 the overall absence of statutory provisions .................................................. 111 the fiduciary duty to prioritize shareholders’ value ..................................... 112 iv being trapped between two worlds: the challenge of capitalizing social enterprises .......................................................... 115 raising capital from the for-profit sector: identifying the practical barriers .. 115 benefitting from charitable contributions and grants: the tax barriers ........ 116 attracting foundation dollars: the program-related investment experiment . 119 v new designs for old tools: why the early legal and structural innovations were not enough ................................... 121 constituency statutes: an inconclusive effort to protect stakeholder interests 121 tandem entities, an attempt to combine the two worlds ............................. 122 vi combining the two sectors in hybrid vehicles ........................... 124 the benefit corporation, an initiative toward responsible businesses.......... 124 1. the general public benefit: a purpose broadly construed ...................... 124 2. enforcing the public purpose, an uncertain balance between adverse considerations ......................................................................................... 126 the l3c, a vehicle specially tailored for social enterprises ......................... 127 1. an attempt to attract foundation dollars ................................................ 127 2. the statutory balance between conflicting bottom lines, an answer to the governance challenge ............................................................................. 129 3. a federal barrier to the state scheme: the pri problem ......................... 130 vii conclusion: creative capitalism calls for innovative legislators ................................................................................................... 131 102 columbia journal of tax law [vol.5:100 i introduction: societal innovation and the definition of social enterprise the call for creative capitalism in his closing comments at the stanford commencement in 2005, steve jobs called on the graduates to “stay hungry. stay foolish.” 1 turning negative adjectives into positive ones, his address was an encouragement to innovate, a wish that graduates be eager to make unconventional decisions. this vision fits what, by nature, entrepreneurs are expected to do: think outside of the box to create something new. about two years later, in his commencement speech at harvard university, bill gates pushed for “a more creative capitalism” that would “stretch the reach of market forces so that more people can make a profit, or at least make a living, serving people who are suffering from the worst inequities.”2 studies reveal that u.s. corporations allocate billions of dollars to social causes: the “giving in numbers: 2012 edition” survey, based on data from 214 companies, including 62 of the top 100 companies in the fortune 500, reveals that the sum of contributions across all its respondents in 2011 was $19.9 billion (in cash and product giving). 3 these contributions are expressions of the theory of corporate social responsibility, “a broad concept that describes a business's obligation to interact with society in a socially responsible way.”4 however, corporate social responsibility treats the contribution to public good as incidental to the profitmaking activity, whereas bill gates suggests that companies could primarily and profitably promote social causes. such a use of business strategies to promote public welfare purposes has increasingly been referred to as social entrepreneurship, and in many ways it has been responding to both of these exhortations long before they were formulated. as early as in 1963, bill drayton began to entertain the model of change that bill gates praised in 2007, a model that “combine[s] the pragmatic and results-oriented methods of a business entrepreneur with the goals of a social reformer.”5 in 1980, he structured this commitment through ashoka, a nonprofit that “aims to find change-making leaders around the world, provide them with support and modest ‘social venture capital,’” thus creating a “community for people seeking to make change, encouraging them to inspire, mentor and challenge each other to come up with the best ideas in social innovation.”6 in 1974, muhammad yunus started giving out “micro-loans” to the poor in bangladesh, helping them create “the spark of personal initiative and enterprise necessary to pull themselves 1 steve jobs, ceo, apple computer, commencement address at stanford university (june 12, 2005) (transcript available at http://news.stanford.edu/news/2005/june15/jobs-061505.html). 2 bill gates, chairman, microsoft inc., commencement address at harvard university (june 7, 2007) (transcript available at http://news.harvard.edu/gazette/story/2007/06/remarks-of-bill-gates-harvard commencement-2007/). 3 giving in numbers 2012 edition 4, comm. encouraging corporate philanthropy, http://cecp.co/pdfs/giving_in_numbers/gin2012_finalweb.pdf (last visited sep. 22, 2013). however, when considered as a percentage of the profits of these companies, these contributions are a modest commitment to social welfare. 4 z. jill barclift, corporate social responsibility and financial institutions: beyond dodd-frank, banking & fin. services pol'y rep., january 2012, at 13, 14 (2012). 5 caroline hsu, entrepreneur for social change, u.s. news & world report (oct. 31, 2005), available at http://www.usnews.com/usnews/news/articles/051031/31drayton.htm. 6 tom dawkins, huffington post gamechangers poll recognizes ashoka community, ashoka.org (nov. 5, 2009), https://www.ashoka.org/story/6142. 2013] designing a legal vehicle for social enterprises: 103 an issue spotting exercise out of poverty.”7 in 1983, he carried on, founding the grameen bank – literally “the village bank” – on principles of trust and solidarity.8 since the 1980s, this phenomenon has dramatically expanded as the traditional division of the society into three sectors – for-profit, government and nonprofit – began to seem unable to adequately address the broad array of social challenges. social entrepreneurship has led to the emergence of a fourth sector, somewhere in between the for-profit and the nonprofit sectors.9 a lack of uniform definition social entrepreneurship has been thriving for four decades and is increasingly recognized as a game changer – the 2006 nobel peace prize was awarded jointly to muhammad yunus and grameen bank "for their efforts to create economic and social development from below".10yet so far it has no legal definition. thus, it is the social entrepreneurship movement itself that elaborated its description. consequently, it is commonly acknowledged that the topic lacks “a clear and concise definition” as “[c]onservative or exclusionary classifications of social entrepreneurship vary widely from publication to publication . . . .”11 in 2008, paul c. light noted that recent scholarship had offered an inventory of more than 20 definitions for social enterprise.12 yet, the social enterprise alliance’s contribution to the definition of social entrepreneurship is of particular interest, since it is a “membership organization for the diverse and rapidly growing social enterprise sector in north america.”13 it defines social enterprises as “businesses whose primary purpose is the common good” and that use “the methods and disciplines of business and the power of the marketplace to advance their social, environmental and human justice agendas.”14 pursuant to this definition, social enterprises have three characteristics that distinguish them from other types of businesses, nonprofits and government agencies: they directly address social needs, the common good is their primary purpose, and their 7 biography of dr. muhammad yunus, grameen.com, http://grameen.com/index.php?option=com_content& task=view&id=329&itemid=363 (last visited nov. 8, 2013). 8 id. (“in bangladesh today, grameen has 2,564 branches, with 19,800 staff serving 8.29 million borrowers in 81,367 villages. on any working day grameen collects an average of $1.5 million in weekly installments. of the borrowers, 97% are women and over 97% of the loans are paid back, a recovery rate higher than any other banking system. grameen methods are applied in projects in 58 countries, including the us, canada, france, the netherlands and norway.”). 9 see thomas kelley, law and choice of entity on the social enterprise frontier, 84 tul. l. rev. 337, 340 (2009); see also alissa mickels, beyond corporate social responsibility: reconciling the ideals of a for-benefit corporation with director fiduciary duties in the u.s. and europe, 32 hastings int'l & comp. l. rev. 271, 279 (2009). 10 the nobel peace prize 2006, nobelprize.org, http://www.nobelprize.org/nobel_prizes/peace/laure ates/2006/ (last visited sep. 22, 2013). other examples of this public recognition include business week 's annual publication of i ts l ist of america's most promising social entrepreneurs since 2008. see john tozzi, america's most promising social entrepreneurs 2011, bloomberg businessweek (jul. 19, 2011), available at http://www.businessweek.com/smal lbiz/content/jun2011/sb20110621_158462.htm. 11 ryan j. gaffney, hype and hostility for hybrid companies: a fourth sector case study, 5 j. bus. entrepreneurship & l. 329, 332 (2012) (quoting matthew f. doeringer, fostering social enterprise: a historical and international analysis, 20 duke j. comp. & int’l l. 291, 292 (2010)). 12 paul c. light, the search for social entrepreneurship 3 (2008). 13 the case for social enterprise alliance, social enterprise alliance, https://www.se-alliance.org/why# whatwereallabout (last visited sep. 22, 2013). 14 id. 104 columbia journal of tax law [vol.5:100 commercial activity is a strong revenue driver.15 such a broad definition encompasses enterprises addressing needs “as diverse as human ingenuity.”16 whereas this definition conveys a broad understanding of social entrepreneurship, it also emphasizes a characteristic that is essential to its legal analysis: “unlike traditional business models, any profit that flows to individuals is incidental to the social enterprise’s primary purpose.”17 indeed, in the united states the definition of social entrepreneurship “focus[es] on generating income for organizations that provide services typically thought of as being provided by the nonprofit sector.”18 this focus reflects what has come to be called the double bottom-line of social enterprises: they further the dual and co-equal purposes of making profit and contributing to the public good.19 neither of these coobjectives is incidental to the other, 20 hence the idea of a double bottom-line. consequently, social entrepreneurs seek both an economic return on investment and a social one. the very difficulty social entrepreneurs face relates to this double bottom-line return. part ii explains why tax-exempt nonprofits do not meet the needs of this peculiar business model. part iii then delineates the effect of the so-called shareholder primacy doctrine on social enterprises that adopt a corporate form. part iv then develops the governance and funding challenges that stem from the capitalization of a for-profit social enterprise. part v subsequently outlines the main attempts to adapt the traditional vehicles to these challenges. part vi finally describes the main hybrid vehicles, which try to combine the two sectors in a single entity. ii the charitable nonprofit: a vehicle unsuited for the social enterprise business model this part first offers an overview of the business model that social enterprises usually pursue. then it outlines why traditional tax-exempt nonprofits fail to address this business plan. characterizing social entrepreneurship from its business model the characteristics of social enterprise business models pertain to their double bottom line. first of all, they are organized for the primary purpose of addressing a social issue. this mission is not subsidiary to their business activity; it is its very motive. hence, social outcomes are as important as economic objectives in the decision-making process. this first element is essential to determine whether a tax-exempt vehicle might be used, and it distinguishes social enterprises’ business models from those of traditional for-profit enterprises, in which an incidental part of the enterprise’s activity may be allocated to the public good. 15 id. 16 id. 17 keren g. raz, toward an improved legal form for social enterprise, 36 n.y.u. rev. l. & soc. change 283, 289 (2012). 18 matthew f. doeringer, fostering social enterprise: a historical and international analysis, 20 duke j. comp. & int'l l. 291, 292 (2009-2010). 19 see linda o. smiddy, symposium introduction: corporate creativity: the vermont l3c & other developments in social entrepreneurship, 35 vt. l. rev. 3, 5 (2010). 20 see briana cummings, benefit corporations: how to enforce a mandate to promote the public interest, 112 colum. l. rev. 578, 581-82 (2012); see also dana brakman reiser, symposium: corporate creativity: the vermont l3c & other developments in social entrepreneurship, blended enterprise and the dual mission dilemma, 35 vt. l. rev. 105, 105 (“[a]chieving and governing truly blended enterprise means consistently serving two masters."). 2013] designing a legal vehicle for social enterprises: 105 an issue spotting exercise secondly, the social enterprise activity in and of itself addresses a social issue: the business is part of the solution to the social problem, as opposed to a mere fundraising tool. for instance, generation water, a los angeles-based social enterprise, furthers three aims: restoring landscape and promoting water saving, preparing young adults with the skills necessary to lead the transition to a sustainable economy, and creating economic value through these social missions. 21 the business itself is therefore favoring the development of a sustainable economy. this second element distinguishes social enterprises from taxexempt enterprises that use business-like activities merely to provide funds for their charitable undertakings, 22 although tax-exempts sometimes further charitable goals through such activities.23 a third characteristic of social enterprises relates to the way they finance their activity. while traditional tax-exempts rely mostly on philanthropy, social enterprises aim at sustaining their activity through earned income. 24 this financial self-sufficiency guarantees a consistent cash flow, whereas grants and donations can vary greatly from one year to another. nonetheless, even though the objective of social enterprises is to become self-sufficient with earned income, they have to explore other funding opportunities during start-up and expansion stages. the question of where social entrepreneurs expect to find their capital for a given venture is a central one. if they contemplate charitable contributions and grants, a taxexempt entity might be considered – alone or in combination with a for-profit. however, because they expect to create economic value through their activity, social entrepreneurs usually also want to access capital from market investors.25 in such a situation, social entrepreneurs may need to form a for-profit – alone or in combination with a tax-exempt. incidental to this question is the determination of the economic return that founders or investors expect from the venture. a tax-exempt organization, in and of itself, does not allow founders a share in the profit, other than in form of a reasonable salary.26 therefore, since social enterprises’ business plans usually include equity-based financing, implying at the very least equity distributions and liquidity, a for-profit must be part of the legal structure. consequently, social enterprises should be financially flexible in order to obtain grants and donations as well as traditional equity-based or bank funding. further, this financial flexibility also allows social enterprises to access a peculiar source of capital known as “impact investments,” which are investments made “into companies, organizations, and funds with the intention to generate measurable social and environmental impact alongside a financial return.”27 as a result, social entrepreneurs 21 our story, generation water, http://www.generationwater.org/meet/story (last visited sep. 22, 2013). 22 see, e.g., raz, supra note 17, at 291 ("if the business exists solely to provide funding to the organization, then it is not a social enterprise. however, if the business is essential to solving the problem that the organization aims to tackle, then it could be considered a social enterprise."). 23 see infra part ii.c. 24 see, e.g., raz, supra note 17, at 294 (“once a social enterprise establishes itself, if it is successful as a business, the revenue it generates will cover it costs.”). 25 see, e.g., john walker, a financing gap, echoing green, http://www.echoinggreen.org/blog/financinggap (last visited nov. 8, 2013). 26 this results from the inurement rule and private benefit doctrines. see infra part ii.c. 27 global impact investing network: impact investing, global impact investing network, http://www.thegiin.org/cgi-bin/iowa/investing/index.html (last visited sep. 22, 2013). 106 columbia journal of tax law [vol.5:100 must search for legal forms or combinations adaptable enough not to deprive them of any funding opportunity. a fourth element of the business model pertains to the governance issues resulting from these various sources of funding. a social enterprise may bring together actors as different as entrepreneurs, traditional investors, impact investors and philanthropic contributors. each of them has different expectations: one may ask for a higher rate of return, while another may be more focused on controlling the venture or assuring that it furthers its social mission. thus, the double bottom line, which implies co-equal financial and social returns, also leads to a financial structure that presents governance and funding challenges. this broad overview of social enterprises’ business models reveals two constraints flowing from their double bottom line: social enterprises aims at being financially flexible while ensuring that their social mission prevails over mere profit-maximization. this double constraint renders traditional tax-exempt organizations hardly practicable for social enterprises. the tax-exempt entity: an appealing but rigid framework to host a social business under section 501 of the internal revenue code, the tax-exempt sector can be divided into two categories. on the one hand there are the section 501(c)(3) entities, which are organised and operated exclusively for certain exempt purposes.28 the term “charitable organizations” is used to identify them both because “charitable” is the residual exempt purpose they can further and because the u.s. supreme court ruled that all section 501(c)(3) organizations must meet “certain common law standards of charity.” 29 the charitable world is itself divided between public charities and private foundations depending, essentially, on the width of the organization’s financial support.30 indeed, while public charities are broad publicly-supported nonprofits, the funding sources of private foundations are more limited.31 on the other hand, there are the “noncharitable nonprofits,” which are organized under sections 501(c)(4)-(25).32 these entities “may roughly be described as carrying forward the private interests of their members.”33 even though the distinction is not absolutely accurate, it is often stated that the former provide “public benefit” while the latter provide “mutual benefit.”34 28 these exempt purposes are charitable, religious, educational, scientific, literary, testing for public safety, fostering national or international amateur sports competition, and preventing cruelty to children or animals. see 26 u.s.c. § 501 (2012) 29 bob jones univ. v. united states, 461 u.s. 574, 586 (1983). the legal meaning of charitable purpose is further broadly construed: see treas. reg. § 1.501(c)(3)-1(d) (2008). 30 see internal revenue serv., applying for 501(c)(3) tax-exempt status 5, available at http://www.irs.gov/pub/irs-pdf/p4220.pdf ("every organization that qualifies for tax-exempt status under section 501(c)(3) of the irc is further classified as either a public charity or a private foundation. under section 508(b) of the irc, every organization is automatically classified as a private foundation unless it meets one of the exceptions listed in sections 508(c) or 509(a)."). 31 see, e.g., james j. fishman & stephen shwarz, nonprofit organizations 722 (4th ed. 2010) (stating that public charities "share the characteristic of ‘publicness’ in that they rely on public support or are accountable to a broad constituency."). 32 id. at 41. 33 id. 34 id. 2013] designing a legal vehicle for social enterprises: 107 an issue spotting exercise while charitable and non-charitable nonprofits are both tax-exempt, there are a number of advantages that only charitable organizations enjoy.35 most notably, 501(c)(3) status provides eligibility to receive tax-deductible charitable contributions. 36 thus, charitable organizations are more likely to benefit from individual and corporate donors, as they will be entitled to deduct their donations.37 further, this status guarantees grantmaking institutions, and particularly foundations,38 that the organization is a permitted beneficiary under the internal revenue code.39 overall, the 501(c)(3) status also operates as a brand by identifying the organization’s activity as a proper social mission. thus, charitable organizations, and particularly public charities, can attract resources that are appealing for social enterprises. indeed, at least until charitable organizations reach the profitability stage, their social bottom line, which usually meets the broad definition of charitable activity, could incentivize them to structure the venture as a tax-exempt organization to attract charitable contributions and grants. however, the business model previously discussed seems incompatible with the requirements that an entity must meet to qualify as a public charity. the economic bottom line: a financial return irreconcilable with the constraints of the third sector nonprofit organizations are not automatically tax-exempt. a nonprofit is required to apply for the exemption, and it will be granted only if the entity meets a variety of criteria.40 a comprehensive study of these requirements is beyond the scope of this paper. however, a brief overview of the tensions between some of them and the double bottom line is helpful to understand why a genuine social enterprise cannot qualify as a tax-exempt nonprofit. to qualify for tax-exempt status pursuant to section 501(c)(3) of the internal revenue code, a nonprofit must be organized and operated exclusively for exempt purposes as set forth in that section, and none of its earnings may inure to any private shareholder or individual.41 the treasury regulations provide a twofold test to determine whether a nonprofit meets these requirements.42 on the one hand, the nonprofit must pass a formalistic “organizational test,” which scrutinizes the language of its organic documents. 43 under this test, the articles of 35 for a broad overview of these advantages, see fishman, supra note 32, at 42-43. see also internal revenue serv., supra note 31, at 2 ("an irs determination of 501(c)(3) status is recognized and accepted for other purposes. for example, state and local officials may grant exemption from income, sales or property taxes. in addition, the u.s. postal service offers reduced postal rates to certain organizations."). 36 i.r.c. § 170(a) (2012). 37 under §170 of the internal revenue code, deductibility of contributions to a public charity is higher than deductibility of contributions to a private foundation. however, the federal gift and estate tax treatment of gift and bequest to public charities and private foundation is the same, pursuant to i.r.c. §§ 2055, 2522. 38 this point is developed infra regarding the difficulties that corporations face to attract foundation grants. see infra part iv.b. 39 see internal revenue serv., supra note 31, at 2. 40 see internal revenue serv., supra note 31, at 5. 41 treas. reg. § 1.501(c)(3)-1(a) (2008). 42 id. 43 see fishman, supra note 32, at 315. 108 columbia journal of tax law [vol.5:100 organization must limit the purposes of such an organization44 to one or more exempt purposes; and not expressly empower the organization to engage, in a substantial way, in activities which in themselves are not in furtherance of one or more exempt purposes.45 this requirement is easy to meet, as the articles can be as broad as the purposes set forth in section 501(c)(3). for example, it is enough for the articles to state that the organization is formed for charitable purposes within the meaning of section 501(c)(3).46 thus, the organizational test, at this stage, does not bar public charities from hosting social enterprises.47 another part of the organizational test is nonetheless of more difficulty to them. pursuant to treasury regulations, the articles must constrain the organization, upon dissolution, to distribute its assets to another 501(c)(3) or the federal or state government for public purpose.48 thus, it is impossible for a 501(c)(3) to distribute its assets to its members or shareholders upon dissolution. on the other hand, the treasury regulation establishes an operational test that essentially paraphrases the statute requirements.49 of most interest is the concession that “an organization will be regarded as operated exclusively for one or more exempt purposes only if it engages primarily in activities which accomplish one or more of such exempt purposes . . . .”50 thus, a public charity can further nonexempt purposes as long as they represent an insubstantial part of its activities. the treasury regulation further provides that: an organization may meet the requirements of section 501(c)(3) although it operates a trade or business as a substantial part of its activities, if the operation of such trade or business is in furtherance of the organization's exempt purpose or purposes and if the organization is not organized or operated for the primary purpose of carrying on an unrelated trade or business, as defined in section 513.51 as a result, when a public charity carries on a business-like activity, assessing whether the primariy purpose requirement is met first necessitates asking if the business is in furtherance of the organization’s exempt purpose. if it is, then even a substantial business activity will not jeopardize the exempt status. if it is not, a substantial business activity will jeopardize the exempt status, while an insubstantial one will only trigger an additional tax. in other terms, an organization “can engage in a trade or business so long 44 the organization must be a corporation, an unincorporated association, a trust, community chest, fund, or foundation. organizational test internal revenue code section 501(c)(3), internal revenue serv. (aug. 7, 2013), http://www.irs.gov/charities-&-non-profits/charitableorganizations/organizational-test-internal-revenue-code-section501(c)(3). 45 treas. reg. § 1.501(c)(3)-1(b)(1)(i) (2008). 46 treas. reg. § 1.501(c)(3)-1(b)(1)(ii) (2008). 47 even though treas. reg. § 1.501(c)(3)-1(b)(1)(iii) prohibits the articles from authorizing the nonprofit to engage in a manufacturing business otherwise than as an insubstantial part of its activities, it is more a drafting constraint at the stage of the organizational test than a substantive one. 48 treas. reg. § 1.501(c)(3)-1(b)(4) (2008). 49 see fishman, supra note 32, at 317. 50 treas. reg. § 1.501(c)(3)-1(c)(1) (2008). 51 treas. reg. § 1.501(c)(3)-1(e) (2008). 2013] designing a legal vehicle for social enterprises: 109 an issue spotting exercise as it furthers the organization’s tax-exempt purpose and, if it does not, so long as it does not constitute the primary purpose of the organization.”52 this issue is critical for social enterprises. it stems from their business model that they aim at achieving social outcomes through their very business activity. the core of the notion of social entrepreneurship is that “social entrepreneurs use business acumen to do well and do good.”53 the generation water example54 accurately illustrates this point: the business activity contributes to the development of a sustainable economy through the employment of young workers to restore landscapes and promote water saving. consequently, a genuine social enterprise typically conducts a business-like activity as its primary purpose. thus, social enterprises that want to adopt a public charity vehicle must ascertain that their business activity adequately furthers an exempt purpose. to determine whether the business activity furthers an exempt purpose, the treasury regulation first refers to section 513 of the internal revenue code that defines “unrelated trade or business” for the application of the unrelated business income tax. section 513 defines “unrelated trade or business” as any trade or business the conduct of which is not substantially related to the tax exempt purpose, aside from the need of such organization for income or funds or the use it makes of the profits derived.55 treasury regulation section 1.513-1 provides more guidance in the definition of unrelated trade or business. pursuant to the regulation, a business is related to exempt purposes only where the conduct of the business activities has a causal relationship to the achievement of exempt purposes (other than through the production of income).56 it is then substantially related only if the causal relationship is a substantial one, i.e. if the business activity contributes importantly to the accomplishment of those exempt purposes.57 whether a business-like activity importantly contributes to an exempt purpose thus requires a fact-intensive inquiry and highly depends on the circumstances.58 to this end, the regulation indicates that when assessing this “important contribution” criterion, the size and extent of the activities involved must be considered in relation to the nature and extent of the exempt function which they purport to serve.59 indeed, the scale of the business activity must not exceed what is reasonably necessary for performance of the exempt purpose.60 if the business is carried on at a larger scale than what the needs of the exempt function reasonably require, then this business is unrelated to the exempt purpose.61 as a consequence, if this activity is a primary one in the organization, then the tax-exempt status will be jeopardized.62 although this understanding of the regulations “loosely links the exemption qualification question with the ubit relatedness standard,” it underscores the issues that double bottom 52 cameron holland, engaging in a trade or business as a 501(c)(3) organization, http://cameronholland.co m/engaging-in-a-trade-or-business-as-a-501c3-organization/ (last visited nov. 8, 2013). 53 raed elaydi, do well and do good: how social entrepreneurship is changing the world, roosevelt rev., fall 2012, at 18, 19, available at http://www.roosevelt.edu/~/media/files/pdfs/rooseveltreview /rrfall2012_pdf.ashx 54 see generation water, supra note 21. 55 i.r.c. § 513(a) (2012). 56 treas. reg. § 1.513-1(d)(2) (1983). 57 id. 58 id. 59 treas. reg. § 1.513-1(d)(3) (1983). 60 id. 61 id. 62 otherwise, the exempt status is not affected but the gross income from this unrelated activity, i.e. that portion of the activities in excess of the needs of exempt functions, will be subject to the unrelated business income tax. see 26 u.s.c. § 511 (2012); 26 u.s.c. § 512 (2012); 26 u.s.c. § 513 (2012). 110 columbia journal of tax law [vol.5:100 line entities face if they adopt a 501(c)(3) vehicle. notably, they often conduct their business activity at a larger scale than reasonably needed for their exempt purpose as they aim at creating economic wealth along with social benefits.63 further, this area of tax law is particularly blurry and fact-specific. as a result, even if there is a strong argument that the business activity importantly contributes to the exempt purpose, the internal revenue service often applies “an amorphous ‘all the facts and circumstances’ smell test that never even mentions the ubit.”64 under the so-called “commerciality doctrine,”65 the focus is on the nature of the activity, i.e. whether the business has a “commercial hue.”66 as a result, although there is no bright line in this area, the stronger the business logic is in the conduct of the organization’s activity, the weaker the tax-exempt status gets.67 in any case, because double bottom line entities equally, or co-primarily, aim at making profit and achieving social outcomes, they are more likely to fall outside of courts’ tolerance for business-like activities.68 another part of the operational test presents even greater challenges to social enterprises’ business model. the treasury regulation forbids the inurement of the organization’s earnings to insiders, i.e. persons having a personal and private interest in the activities of the organization.69 the related private benefit doctrine, which was articulated in a landmark u.s. tax court opinion,70 expressly states that the prohibition is not limited to these insiders. thus, the private benefit rule prevents 501(c)(3)s from providing any substantial benefit to outsiders, who are labelled “disinterested persons”71 by the court. as a result, the inurement and private benefit doctrines, along with the dissolution constraints, effectively prevent section 501(c)(3) organizations from substantially benefiting private interests at any time.72 this “non-distribution constraint”73 underscores the fact that taxexempts have no owners, and thus their benefits must be reinvested in their public endeavors. this constraint is particularly harmful to social enterprises as it limits their access to capital. indeed, section 501(c)(3) organizations cannot generate a return to venture capitalists, neither during the activity nor at the dissolution of the entity, and their 63 see fishman, supra note 32, at 572. 64 id. 65 see holland, supra note 53. 66 better bus. bureau v. united states, 326 u.s. 279, 283 (1945). 67 for a summary of the factors the courts and the internal revenue service have considered for the application of this doctrine, see holland, supra note 53. 68 id. (noting that “the presence of a single non-educational purpose, if substantial in nature, will destroy the exemption regardless of the number or importance of truly educational purposes,” and hence because “an important if not the primary pursuit of petitioner's organization is to promote not only an ethical but also a profitable business community,” “the exemption is therefore unavailable to petitioner.”) 69 treas. reg. § 1.501(c)(3)-1(c)(2) (2008). 70 am. campaign acad. v. comm’r, 92 t.c. 1053 (1989). 71 id. at 1069 (“we use ‘disinterested‘ to distinguish persons who are not private shareholders or individuals having a personal and private interest in the activities of the organization within the meaning of section 1.501(a)-1(c), income tax regs.”). 72 while beyond the scope of this paper, it must be noted that the internal revenue service and the courts view inurement and private benefit doctrines are distinct ones, notably as to the consequences of disregarding them. see, e.g., am. campaign acad. , 92 t.c. at 1068; canada v. commissioner, 82 t.c. 973, 981 (1984); aid to artisans, inc. v. commissioner, 71 t.c. 202,215 (1978); church of ethereal joy v. commissioner, 83 t.c. 20, 21 (1984); goldsboro art league, inc. v. commissioner, 75 t.c. 337, 345 n.10 (1980). 73 the term originated with henry hansmann. see henry b. hansmann, the role of nonprofit enterprises, 89 yale l. j. 835 (1980). 2013] designing a legal vehicle for social enterprises: 111 an issue spotting exercise funding is thus limited to donations, grants and self-generated incomes, along with traditional loans. as a result, even in cases where the tax-exempt social enterprise is permitted to further a business-like activity under the operational test, the non-distribution constraint would prevent the entity from generating a financial return to its founders and investors. thus, a genuine social enterprise will not adopt a tax-exempt vehicle since the dual bottom line implies not only financial profitability but also financial returns to investors.74 while a tax-exempt vehicle could attract substantial charitable funding, it fails to address the diversity of interests represented in a social enterprise. iii the shareholder primacy myth, a barrier to corporate social activism? it is commonly taught that a director's duty is to prioritize the creation of shareholder wealth over other considerations. part a explains that this duty does not merely stem from statutory provisions. part b then briefly clarifies how directors’ fiduciary duties catch the shareholder primacy doctrine. the overall absence of statutory provisions in 1962, milton friedman wrote that, in a free economy, “there is one and only one social responsibility of business – to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud.”75 along with smith, friedman considers that corporations are ill equipped to address social issues, and thus instead of diversifying the interests they further they should specialize in the efficient maximization of profit. this specialization – corporations make profit whereas the government addresses social interests – would in turn maximize the overall welfare.76 the merits of this theory need not be discussed here. of greater relevance is whether the economic apprehension of corporations has resulted in a legal framework limiting their ability to further social purposes. states’ corporate statutory laws are mostly silent on this issue. for instance, section 102(a)(3) of delaware general corporation law only requires that the purpose of the corporation be to engage in “any lawful act or activity.”77 section 3.01 of the model business corporation act provides that corporations shall have the purpose of “engaging in any lawful business unless a more limited purpose is set forth in the articles of incorporation.”78 thus, the broadly defined statutory purposes of corporations do not prevent them from engaging incidentally, or even primarily, in social activities that do not seek the maximization of profit. interestingly enough, the american law institute (ali’s) principles of corporate governance depart from state laws: section 2.01 provides that “a corporation should have as its objective the conduct of business activities with a view to 74 other constraints limit the use of a 501(c)(3) vehicle for social enterprises, such as the interdiction of selfdealing or the prohibition of political activity. some of these can be circumvented notably through the adoption of a 501(c)(4) nonprofit. however, a comprehensive study of these limitations is not necessary since this development on tax-exempt nonprofits only aims at underscoring that they suffer from an inflexible business model hardly compatible with the financial bottom line of social enterprises. 75 milton friedman, capitalism and freedom 133 (1962). 76 thomas donaldson, corporations and morality 68-69 (1982). 77 del. code ann. tit. 8, § 102 (west 2013). 78 model bus. corp. act § 3.01 (2008). 112 columbia journal of tax law [vol.5:100 enhancing corporate profit and shareholder gain.”79 ali’s principles nonetheless admit exceptions to this profit-based conduct when the corporation either takes into account ethical considerations reasonably related to the responsible conduct of its business, or allocates a reasonable amount of its resources to listed social purposes.80 thus the ali’s principles only authorize corporations to depart from their profit maximization purpose incidentally. this is scarcely compatible with the double bottom line that social entrepreneurs seek since it only enables corporations to develop a corporate social responsibility practice. however, although they undeniably are of doctrinal interests, these principles have no binding force. thus, statutory corporate law, in and of itself, is not a sufficient source to require corporations to further exclusively or primarily wealth maximization. rather, this theory seems to stem from the “legal principles of agency, property rights, 81 and contract,82 all of which are intertwined in the corporate form.”83 the fiduciary duty to prioritize shareholders’ value indeed, the agency relationship between board members and shareholders84 has been widely construed as directing the formers (the agents) to maximize the wealth of the latters (the principals.) the foundation of this shareholder primacy theory is traditionally traced back to dodge v. ford motor co.85 in which the michigan supreme court ruled that “it is not within the lawful powers of a board of directors to shape and conduct the affairs of a corporation for the merely incidental benefit of shareholders and for the primary purpose of benefiting others.” 86 this stems from the premise that “a business corporation is organized and carried on primarily for the profit of the stockholders,” and “the powers of the directors are to be employed for that end.”87 hence the idea of a shareholder primacy model of corporate governance, in which directors’ actions must primarily aim at increasing shareholders’ profits.88 even though it is sometimes argued that dodge is a “doctrinal oddity,”89 it is more widely understood as “an accurate statement of the form, if not the substance, of the current law that describes the fundamental purpose of the 79 am. law inst., principles of corporate governance, § 2.01 (1994). 80 id. 81 see barnali choudhury, serving two masters: incorporating social responsibility into the corporate paradigm, 11 u. pa. j. bus. l. 631, 635-36 (2009) (“under [the property] theory, the corporation is seen as the property of the shareholders and the corporate managers, as the agents of the shareholders, are obliged to act to advance the latter's financial interests."). 82 see id. at 637 (stating that under the contractarian theory, "profit maximization is the goal of the corporation because this is the expectation, or 'bargained for right,' under which shareholders have implicitly contracted with the corporation.”) 83 john tyler, negating the legal problem of having “two masters”: a framework for l3c fiduciary duties and accountability, 35 vt. l. rev. 117, 129 (2010). 84 see, e.g., aronson v. lewis, 473 a.2d 805, 811 (del. 1984) ("the existence and exercise of directors' power carries with it certain fundamental fiduciary obligations to the corporation and its shareholders."), overruled by brehm v. eisner, 746 a.2d 244 (del. 2000). 85 204 mich. 459 (1919). 86 id. at 684. 87 id. 88 see, e.g., edward b. rock, corporate law through an antitrust lens, 92 colum. l. rev. 497, 546 (1992). 89 lynn a. stout, why we should stop teaching dodge v. ford, 3 va. l. & bus. rev. 163, 166 (2008). 2013] designing a legal vehicle for social enterprises: 113 an issue spotting exercise corporation.”90 under this view, any profit reinvested in the social endeavor conflicts with shareholders’ interest in increasing the financial return on their equity investment.91 it is not necessary, for the purpose of this paper, to precisely define the content of directors’ fiduciary duties. corporations being creatures of states, the fiduciary duties of their directors vary depending on the location of their incorporation. yet, a broad overview of how delaware has implemented the shareholder primacy model is appropriate since this state is legal home for more than 50% of all publicly-traded companies in the united states, including 63% of the fortune 500,92 and its case law is influential nationwide. the specific substance of directors’ fiduciary duties needs not be stated here. of more interest is the delaware supreme court’s focus on whether directors are entitled to further nonprofitmaximising considerations. in this matter, delaware courts’ deference to directors’ judgement depends on the context of their decision. section 141(a) of delaware general corporation law provides that “the business of every corporation organized under this chapter shall be managed by or under the supervision of a board of directors.”93 accordingly, in the day-to-day management of the business directors are entitled to the business judgement rule, pursuant to which courts defer to their determination that the action taken was in the best interest of the company. 94 thus, the rule is both a substantive standard of review and a procedural burden of proof. under the former, “where the business judgment presumptions are applicable, the board’s decision will be upheld unless it cannot be attributed to any rational business purpose.”95 under the latter, the rule “places the burden on the party challenging the board’s decision to establish facts rebutting the presumption.”96 hence, in the day-to-day decision-making, the business judgement rule grants director great latitude to undertake social actions as courts defer to their determination that it furthers the overall interest of the corporation.97 in some specific circumstances however, courts apply a higher standard of review requiring directors to establish a closer relationship between shareholders’ benefit and other constituencies’ interests. first, when defensive measures are adopted in a takeover context, delaware courts have scrutinized directors’ decisions under the so-called heightened or reasonableness 90 jonathan r. macey, a close read of an excellent commentary on dodge v. ford, 3 va. l. & bus. rev. 177, 178 (2008). 91 see, e.g., doeringer, supra note 18, at 304. 92 about agency, delaware.gov, http://corp.delaware.gov/aboutagency.shtml (last visited nov. 8, 2013). 93 del. code ann. tit. 8, § 141(a) (west 2013). 94 see, e.g., aronson v. lewis, 473 a.2d 805, 812 (del. 1984) (stating that the business judgment rule creates "a presumption that in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company"). 95 in re walt disney co. derivative litig. v. eisner, 906 a.2d 27, 74 (del. 2006) (quoting sinclair oil corp. v. levien, 280 a.2d 717, 720 (del. 1971)); see also orman v. cullman, 794 a.2d 5, 20 (del. ch. 2002) ("the judgment of a properly functioning board will not be second-guessed and absent an abuse of discretion, that judgment will be respected by the courts."). 96 unitrin, inc. v. am. gen. corp., 651 a.2d 1361, 1373 (del. 1995). 97 see, e.g., steven j. haymore, public(ly oriented) companies: b corporations and the delaware stakeholder provision dilemma, 64 vand. l. rev. 1311, 1327-28 (2011) ("in fact, directors can connect virtually every business decision to a rationally related benefit to the company, absent waste of corporate proceeds."); robert a. ragazzo, unifying the law of hostile takeovers: bridging the unocal/revlon gap, 35 ariz. l. rev. 989, 1030 (1993) ("modern law allows directors to consider the interests of nonshareholder constituencies as long as the impact on shareholders is not excessive."). 114 columbia journal of tax law [vol.5:100 scrutiny. indeed, under unocal98 and its progeny,99 to benefit from the business judgement rule directors must first prove that they had reasonable grounds for believing that a danger to corporate policy and effectiveness existed; and then that the defensive measures are reasonable in relation to the threat posed. on various occasions, courts ruled that directors might consider the interests of constituencies distinct from the shareholders when addressing a takeover threat, provided nonetheless that there was “some rationally related benefit accruing to stockholders”100 or that so doing bore “some reasonable relation to general shareholder interest.”101 therefore, despite a reduced leeway there is still room for social considerations under the heightened scrutiny. it is in another context, namely the sale of the corporation, that the shareholder primacy theory truly applies. under revlon102 and its progeny, when a company is at auction103 the directors’ only duty becomes to maximise shareholders’ value. in such a context, revlon explicitly directed that “concern for non-stockholder interests is inappropriate.”104 that is why in 2000 ben & jerry’s directors felt they had to accept unilever’s bid, although it would undoubtedly jeopardize the corporation’s double bottom line.105 indeed, they accepted its offer while lesser bidders would have better continued ben & jerry’s social endeavours.106 as a result, the duty to prioritize shareholders’ value over non-shareholders’ considerations is absolute only in the narrow situations in which revlon is triggered. thus, the acquisition setting aside, directors enjoy some leeway to undertake social actions, in delaware107 and elsewhere.108 further, the corporation entity is traditionally construed as 98 unocal corp. v. mesa petroleum co., 493 a.2d 946 (del. 1985). 99 see, e.g., omnicare, inc. v. ncs healthcare, inc., 818 a.2d 914 (del. 2003); moran v. household international, inc., 500 a.2d 1346 (1985); paramount communications, inc. v. time, inc., 571 a.2d 1140 (del. 1990). 100 revlon, inc. v. macandrews & forbes holdings, inc., 506 a.2d 173, 182-83 (del. 1986). 101 mills acquisition co v. macmillan, inc., 559 a.2d 1261, 1982 (del. 1989). 102 revlon, 506 a.2d at 173. 103 the court of chancery recently summarized the triggering circumstances of revlon: “[u]nder binding authority of our supreme court as set forth in qvc and its progeny, revlon duties only apply when a corporation undertakes a transaction that results in the sale or change of control . . . a change of control 'does not occur for purposes of revlon where control of the corporation remains, postmerger, in a large, fluid market.'” in re synthes, inc. s'holder litig., 50 a.3d 1022, 1048-49 (del. ch. 2012) (quoting in re nymex s'holder litig., no. 3621-vcn, 2009 del. ch. lexis 176, at *5 (del. ch. sept. 30, 2009). 104 revlon, 506 a.2d at 182. 105 antony page & robert a. katz, freezing out ben & jerry: corporate law and the sale of a social enterprise icon, 35 vt. l. rev. 211, 212 (2010); see also jill bamburg, getting to scale: growing your business without selling out 57 (2006) ("virtually every mission-driven entrepreneur knows the sad ending to the tale of ben & jerry's: the forced sale of one of the country's premier socially responsible businesses to a giant multinational clearly focused on the financial bottom line."). 106 katherine r. lofft et al., are hybrids really more efficient?, bus. l. today, sept. 21, 2012, at 1. 107 see, e.g., janet e. kerr, sustainability meets profitability: the convenient truth of how the business judgment rule protects a board's decision to engage in social entrepreneurship, 29 cardozo l. rev. 623, 668 (2007) ("however, the existing framework of corporate governance law allows for social impact considerations. under the laws of corporate governance, specifically the duty of care as protected by the business judgment rule, board decisions are protected."). 108 see, e.g., a. p. smith mfg. co. v. barlow, 97 a.2d 186, 190 (n.j. 1953) (“corporate contributions to princeton and institutions rendering the like public service are, if held within reasonable limitations, a matter of direct benefit to the giving corporations, and this without regard to the 2013] designing a legal vehicle for social enterprises: 115 an issue spotting exercise a “contract-based form of business organization” in which the shareholder-primacy model is merely a default rule. 109 consequently, shareholders could contract around directors’ duty to maximize profits through adequate charter provisions. however, they have shown little tendency to do so,110 certainly due to practical and tax barriers that add to the legal framework uncertainties. iv being trapped between two worlds: the challenge of capitalizing social enterprises part a delineates the challenges that social enterprises encounter to raise funding on the market place. part b subsequently describes the tax provisions that prevent forprofit social enterprises from receiving charitable contributions and grants. part c finally underscores the issues they confront to attract the one foundation investment that is available to them, namely the program-related investment. raising capital from the for-profit sector: identifying the practical barriers in the traditional binary legal framework, it is difficult for double bottom line forprofits to efficiently brand their social commitment. while each social enterprise can individually signal itself as such, there is a lack of, and hence a need for, a unified and identifiable marketable brand.111 indeed, branding and positioning social enterprises on the market place has long been identified as the key to raising capital and building customer loyalty. 112 social enterprises are frequently confused with corporate philanthropy or corporate social responsibility models, in which social endeavors are merely incidental to the financial bottom line, and often serve marketing purposes as well.113 thus, by telling the difference between “a good company and just good marketing,”114 a recognizable brand could attract consumers and investors equally interested in social and financial returns. screening double bottom line for-profits is the key to attracting sustainable and responsible investments. sustainable and responsible investing (sri)115 considers both the investor's financial needs and an investment’s impact on society so as to build wealth in underserved communities or a more sustainable world while earning competitive extent or sweep of the donors' business. the benefits derived from such contributions are nationwide and promote the welfare of everyone anywhere in the land.”) 109 see macey, supra note 92, at 179. 110 id. 111 see, e.g., michael d. gottesman, from cobblestones to pavement: the legal road forward for the creation of hybrid social organizations, 26 yale l. & pol'y rev. 345, 351 (2007). 112 see, e.g., jason mogus, it's all about them: branding and positioning your social enterprise to build customer loyalty, presentation at the 2007 canadian social enterprise conference (jan. 29, 2007), available at http://www.socialenterprisecanada.ca/en/learn/nav/resourcelibrary.html?page=resourcedetail.tpt&i ddoc=321058. 113 see kelley, supra note 9, at 362. 114 frequently asked questions, b corps for non-profits, http://www.bcorpsfornonprofits.com/faq (last visited nov. 8, 2013). 115 sri is also referred to as mission investing, responsible investing, double or triple bottom line investing, ethical investing, sustainable investing, or green investing. see, e.g., sustainable and socially responsible investing, blue summit wealth management, http://www.bluesummitwealth.com/investing/ (last visited nov. 8, 2013). 116 columbia journal of tax law [vol.5:100 returns.116 sri mutual funds have significantly grown over 20 years117 and they now use a wide spectrum of investment products, “from stocks and bonds, to savings, checking and other banking accounts, to venture capital.”118 as a result, although social entrepreneurs are confident in the development of this source of funding, they emphasize the need for a distinctive brand for the fourth sector to be adequately screened by sri funds.119 attracting alternative capital is further desirable as social enterprises face practical difficulties to attract funds commonly available to for-profits at their start-up and expansion stages. traditional investors have returns on investment objectives to meet regardless of whether the business achieves – incidentally or primarily – social welfare missions;120 whereas social enterprises need what is sometimes called “patient capital,” which aims at “slow but steady growth.”121 hence, their difficulties to commit to market-rate returns undermines their access to traditional investors. a second practical barrier, once the capital is raised, pertains to the “challenge of locking assets into the social enterprise stream.”122 social entrepreneurs aim at ensuring that the capital they raised remains dedicated to the social endeavours. however, the pressure of the market could incentivize managers to focus more on financial returns than on the social accomplishments in the actual running of the business. further, the ben & jerry case is an accurate example of the threat that a change in ownership poses to the social bottom line. no law prevents the new controlling entity from allocating the corporation’s capital primarily or exclusively to profit maximization.123 thus, as a matter of credibility as well as to incentivise sri investments, social entrepreneurship would benefit from the development of asset lock mechanisms. benefitting from charitable contributions and grants: the tax barriers federal tax law also operates as a barrier to social accomplishments by for-profits as it denies them access to financial resources available to tax-exempt nonprofits. first, individual and corporate donations and gifts are only deductible when made to 501(c)(3) nonprofits.124 as a result, for-profits do not receive charitable contributions, although their social bottom line triggers some sympathy in the general public. further, for-profits hardly obtain funding from private foundations. broadly defined, a foundation is “a fund of private wealth established for charitable purposes, often in perpetuity.” 125 foundations are usually construed as grant-making institutions, as opposed to public charities that actually operate a charitable program.126 in 116 sri basics, us sif, http://www.ussif.org/sribasics (last visited nov. 8, 2013). 117 id. (“as of 2012, there were 333 mutual fund products in the us that consider environmental, social, or corporate governance (esg) criteria, with assets of $640.5 billion. by contrast, there were just 55 sri funds in 1995 with $12 billion in assets.”) 118 performance and sri investments, us sif, http://ussif.org/resources/performance.cfm (last visited nov. 8, 2013). 119 see kelley, supra note 9, at 359. 120 victor fleischer, urban entrepreneurship and the promise of for-profit philanthropy, 30 w. new eng. l. rev. 93, 94 (2007) ("the greater challenge facing urban entrepreneurs is convincing investors that they will receive a sufficient return on their investment."). 121 see kelley, supra note 9, at 354. 122 id. at 359. 123 see, e.g.. allen r. bromberger, social enterprise: a lawyer's perspective, http://www.perlmanandperlma n.com/publications/articles/2008/socialenterprise.pdf (last visited oct. 27, 2013) (underscoring that “[a] change in ownership or control – or a drop in earnings – can bring everything down.”). 124 see supra part ii.b. 125 see fishman, supra note 32, at 703. 126 id. 2013] designing a legal vehicle for social enterprises: 117 an issue spotting exercise many ways, due to congressional defiance over foundations,127 their federal tax treatment is less favorable than the federal tax treatment of public charities. indeed, a variety of excise taxes and penalties limits their ability to engage in activities such as self-dealing,128 excess ownership in a business enterprize,129 jeopardy investments130 or expenditures for non-charitable purposes.131 the minimum distribution requirement is here of particular interest. pursuant to section 4942 of the internal revenue code, private foundations must make a certain amount of qualifying distributions each year, and failure to do so triggers a burdensome excise tax. these qualifying distributions are essentially charitable contributions, as defined in section 170(c)(2)(b) of the internal revenue code; hence contribution to forprofit social enterprises would not be included in the foundation-qualified distributions. further, section 4945 lists a number of expenditures that are subject to heavy tax penalties due to their inconsistency with the foundation public interest purpose. prohibited expenditures notably include grants to any organization that is not a public charity or an operating private foundation unless the private foundation exercises expenditures responsibility to ensure that the grant is used only for charitable purposes.132 therefore, for-profits are virtually excluded from foundations’ grant-making programs. hence foundations, under the federal tax framework, are more likely to contribute to for-profits through traditional investment from their endowment funds. their leeway is however limited by a burdensome tax on investments that jeopardize their exempt purpose.133 according to the treasury regulation, the jeopardy rule is triggered when the “foundation managers . . . have failed to exercise ordinary business care and prudence, under the facts and circumstances prevailing at the time of the investment, in providing for the longand short-term financial needs of the foundation to carry out its exempt purposes.”134 the regulation further indicates how the standard of care and prudence must be construed135 and how to determine whether the investment of a particular amount jeopardizes the carrying out of the exempt purposes.136 as a result, risk-averse foundations will not invest in social enterprises at their early or expansion stages, as the risk of such investment might trigger the jeopardy rule. they would rather invest in traditional widely 127 id. 128 i.r.c. § 4941 (2012). 129 i.r.c. § 4943 (2012). 130 i.r.c. § 4944 (2012). 131 i.r.c. § 4945 (2012). 132 i.r.c. § 4945(d)(4) (2012). 133 i.r.c. § 4944 (2012). this tax is equal to 10 percent of the amount so invested for each year in the taxable period, and a penalty is also imposed on any foundation manager that knowingly participated in the jeopardy investment. additional taxes can be triggered as well if the foundation does not take remedial measures. id. 134 treas. reg. § 53.4944-1(a)(2) (1973). 135 id. (“in the exercise of the requisite standard of care and prudence the foundation managers may take into account the expected return (including both income and appreciation of capital), the risks of rising and falling price levels, and the need for diversification within the investment portfolio (for example, with respect to type of security, type of industry, maturity of company, degree of risk and potential for return).”). 136 id. (“the determination whether the investment of a particular amount jeopardizes the carrying out of the exempt purposes of a foundation shall be made on an investment by investment basis, in each case taking into account the foundation's portfolio as a whole. no category of investments shall be treated as a per se violation of section 4944.”). 118 columbia journal of tax law [vol.5:100 held corporations, which although not particularly committed to public welfare offer a secure return on investment. the treasury regulation clearly illustrates this point in the example (1), which provides: a is a foundation manager of b, a private foundation with assets of $100,000. a approves the following three investments by b after taking into account with respect to each of them b's portfolio as a whole: (1) an investment of $5,000 in the common stock of corporation x; (2) an investment of $10,000 in the common stock of corporation y; and (3) an investment of $8,000 in the common stock of corporation z. corporation x has been in business a considerable time, its record of earnings is good and there is no reason to anticipate a diminution of its earnings. corporation y has a promising product, has had earnings in some years and substantial losses in others, has never paid a dividend, and is widely reported in investment advisory services as seriously undercapitalized. corporation z has been in business a short period of time and manufactures a product that is new, is not sold by others, and must compete with a well-established alternative product that serves the same purpose. z's stock is classified as a high-risk investment by most investment advisory services with the possibility of substantial long-term appreciation but with little prospect of a current return. a has studied the records of the three corporations and knows the foregoing facts. in each case the price per share of common stock purchased by b is favorable to b. under the standards of paragraph (a)(2)(i) of this section, the investment of $10,000 in the common stock of y and the investment of $8,000 in the common stock of z may be classified as jeopardizing investments, while the investment of $5,000 in the common stock of x will not be so classified. b would then be liable for an initial tax of $500 (i.e., 5 percent of $10,000) for each year (or part thereof) in the taxable period for the investment in y, and an initial tax of $400 (i.e., 5 percent of $8,000) for each year (or part thereof) in the taxable period for the investment in z. further, since a had actual knowledge that the investments in the common stock of y and z were jeopardizing investments, a would then be liable for the same amount of initial taxes as b.137 in this example, z’s case is particularly relevant as many social enterprises at their early stage offer promising but risky investments. even though example (2)138 provides some guidance for such investments to be ruled out of the jeopardy rule, the guarantees139 it requires to this end are often difficult to meet for start-ups. the federal tax rules hence “support a bizarre paradox for private foundations: a foundation can give its money away to an organization supporting the foundation’s mission, but if it makes a risky but ‘promising’ investment in support of its mission, the foundation faces the threat of penalty 137 treas. reg. § 53.4944-1(c) (1973). 138 id. 139 id., indicating that z’s management must have demonstrated capacity for getting new businesses started successfully and z must have received substantial orders for its new product. 2013] designing a legal vehicle for social enterprises: 119 an issue spotting exercise taxes.”140 this is because the jeopardy rule is generally indifferent to the purpose of the entities in which the foundation invests. thus, only social enterprises that have reached, if not profitability, at least a high level of certainty that they will be profitable, can access funding from foundation. attracting foundation dollars: the program-related investment experiment the jeopardy rule contains an interesting exception for program-related investments (pris),141 which are somewhere in-between foundation grants and traditional investments. the regulation provides three criteria for an investment to qualify as a pri.142 the primary purpose of the investment must be to accomplish a charitable purpose,143 the production of income or the appreciation of property must not be a significant purpose, 144 and the investment cannot further any political or lobbying purpose at all.145 the regulation then provides that the investment is made primarily to accomplish a charitable purpose if it significantly furthers the accomplishment of the private foundation's exempt activities and it would not have been made but for such relationship between the investment and the accomplishment of the foundation's exempt activities.146 in addition, it is specified that whether the organization is a 501(c)(3) entity is irrelevant; thus a for-profit social enterprise carrying out a charitable purpose could be the recipient of a pri.147 besides, the regulation indicates that although “whether investors solely engaged in the investment for profit would be likely to make the investment on the same terms as the private foundation”148 is relevant to determine if a significant purpose of the investment is the production of income or the appreciation of property, a substantial return on investment shall not be conclusive evidence of such significant purpose absent other factors.149 as a result, private foundations can escape the jeopardy rule through risky program-related investments in the charitable bottom line of social enterprises. indeed, the regulation examples (1) to (6) 150 describe some of the various means granted private foundations under the pri exception to invest in business entities, from making a loan to purchasing stock. an investment only needs to comply with the above-mentioned requirement to qualify under the pri exception. then, once it has been determined that an investment is “program-related,” it shall not cease to qualify as such as long as changes in the form or terms of the investment are made primarily for exempt purposes and not for any significant purpose involving the production of income or the appreciation of property.151 notably, changes made to protect the foundation’s investment do not ordinarily affect the pri 140 cass brewer, repeal ir § 4944 to encourage investment in social enterprise, socent law (feb. 25, 2013), http://socentlaw.com/2013/02/repeal-irc-%c2%a7-4944-to-encourage-investment-in-socialenterprise/. 141 i.r.c. § 4944(c) (2012). 142 treas. reg. § 53.4944-3(a)(1) (1972). 143 treas. reg. § 53.4944-3(a)(1)(i) (1972). 144 treas. reg. § 53.4944-3(a)(1)(ii) (1972). 145 treas. reg. § 53.4944-3(a)(1)(iii) (1972). 146 treas. reg. § 53.4944-3(a)(2)(i) (1972). 147 id. 148 treas. reg. § 53.4944-3(a)(2)(iii) (1972). 149 id. 150 treas. reg. § 53.4944-3(b) (1972). 151 treas. reg. § 53.4944-3(a)(3)(i) (1972). 120 columbia journal of tax law [vol.5:100 qualification.152 however, despite the illusive simplicity of this test, private foundations tend to seek a preliminary determination from an internal revenue service private letter ruling that a given investment qualifies as a pri.153 indeed, an investment that does not qualify as such would trigger the heavy tax of the jeopardy rule, and because previous private letter rulings have no precedential value, risk-averse foundations usually seek a discrete service’s approval, although it is not required, before initiating a program-related investment.154 the use of pris further triggers the foundation’s duty to exercise expenditures’ responsibility with respect to the investment155 in order for it not to be considered as taxable expenditure. the expenditures’ responsibility implies that the foundation must exert all reasonable efforts and establish adequate procedures to see that the grant is spent solely for the purpose for which it was made, to obtain full and complete reports from the grantee on how the funds are spent, and to make full and detailed reports with respect to such expenditures to the secretary.156 the regulations first provide that “a private foundation is not an insurer of the activity of the organization to which it makes a grant”157 and will thus be considered as exercising “expenditure responsibility” under section 4945(h) as long as it exerts all reasonable efforts and establishes adequate procedures to comply with its requirements. however, the regulation then goes on with a number of requirements and specifies various duties that apply to foundations with regard to the making of pris.158 they can be clearly outlined in 3 steps: the first step is the preinvestment inquiry into the organization that will potentially receive the pri. if after following the regulation guidelines the foundation believes the reasonableness standard for the inquiry has been met, the foundation must establish and follow a procedure with the recipient organization to ensure that the pri is used for the proper purposes. finally, the foundation must submit complete and accurate reports to the irs about the status of the pri in accordance with the regulations.159 the making of a pri thus represents a heavy administrative burden for private foundations. they have to design a two-tier reporting system, between the recipient organization and the foundation, and between the foundation and the internal revenue service. besides, as was said above, foundations usually seek a private letter ruling before making a pri. thus, pris generate significant transactional, legal, administrative and 152 id. 153 james p. joseph & andras kosaras, new strategies for leveraging foundation assets, tax'n of exempts, july/aug. 2008, at 24 (emphasizing that “if an investment meets the requirements, it can qualify as a pri. irs approval is not required but foundations considering more complex pris may find it prudent—despite the time and costs involved—to seek approval from the irs, given the lack of precedential guidance on pris.”). 154 id. at 24, n.16 (underscoring that “much of the ‘law‘ on pris comes from private letter rulings that offer some insights into how the service may treat a particular investment. however, letter rulings can be relied on only by the taxpayer requesting the ruling and have no precedential authority.”) 155 i.r.c. § 4945(d)(4) (2012). 156 i.r.c. § 4945(h) (2012). 157 treas. reg. § 53.4945-5(b)(1) (1973). 158 treas. reg. § 53.4945-5(b)(4) (1973). 159 christopher c. archer, private benefit for the public good: promoting foundation investment in the “fourth sector” to provide more efficient and effective social missions, 84 temp. l. rev. 159, 168 (2011). 2013] designing a legal vehicle for social enterprises: 121 an issue spotting exercise monitoring costs, and therefore are not widely used,160 with the result that most for-profit social enterprises hardly benefit from private foundation funding. v new designs for old tools: why the early legal and structural innovations were not enough this part first develops the early adaptation of the legal framework in an attempt to account for stakeholder interests. it then goes on with a description of tandem entities, which amount to a practical combination of the tax-exempt and the for-profit worlds. constituency statutes: an inconclusive effort to protect stakeholder interests in the flourishing takeover context of the 1980s,161 and with the development of the unocal and revlon doctrines in the nationally influential delaware case law, public corporations started lobbying for statutory authorisation to consider stakeholder interests.162 in the wake of a 1983 pennsylvania statute, a number of states adopted statutes elucidating the application of the business judgement rule when stakeholder considerations conflicted with shareholder interests. these statutes are usually referred to as “corporate constituency statutes,” “nonshareholder constituency statutes,” or “stakeholder statutes,” and a majority of the states have adopted them as of today.163 these statutes all have in common that the consideration of stakeholder interests is permissible but not mandatory,164 although an earlier version of the connecticut statute provided for the compulsory consideration of various stakeholder interests.165 the connecticut unique provision was repealed, and the new version now provides that directors may consider, in determining what they reasonably believe to be in the best interests of the corporation, the interests of the corporation's employees, customers, creditors and suppliers, as well as community and societal considerations.166 the pennsylvania statute is another great example of this permissive aspect. it provides: [i]n discharging the duties of their respective positions, the board of directors, committees of the board and individual directors of a domestic corporation may, in assessing the best interests of the corporation, consider the effects of any action upon employees, upon suppliers and customers of the corporation and upon communities in which offices or other establishments of the corporation are located, and all other pertinent factors. the consideration of those factors shall not constitute a violation of section 512 (relating to standard of care and justifiable reliance).167 as a result, whether nonshareholder interests ought to be considered and to what extent remains in directors’ discretion. although it gives them enough flexibility to engage in corporate social responsibility actions, and it is useful to this end, it fails to answer the 160 see, e.g., gottesman, supra note 113, at 350; heather sertial, hybrid entities: distributing profits with a purpose, 17 fordham j. corp. & fin. l. 261, 267 (2012). 161 anthony bisconti, the double bottom line: can constituency statutes protect socially responsible corporations stuck in revlon land?, 42 loy. l.a. l. rev. 765, 780-81 (2009). 162 douglas m. branson, corporate governance "reform" and the new corporate social responsibility, 62 u. pitt. l. rev. 605, 636 (2001). 163 bisconti, supra note 163, at 768. 164 branson, supra note 164, at 636. 165 see conn. gen. stat. ann. § 33-313(e) (1994) (repealed 1997). 166 conn. genn. stat. ann. § 33-756 (1997). 167 15 pa. cons. stat. ann. § 516 (2013) 122 columbia journal of tax law [vol.5:100 branding, capitalizing and lock asset concerns previously identified. indeed, these statutes are better construed as tools protecting directors when they consider stakeholder interests: they merely allow such considerations, in contexts that vary greatly from state to state depending on the scope of each statute. accordingly, these provisions do not vest any additional rights in shareholders or stakeholders, and their impact has been somewhat innocuous in the case law. 168 most notably, the new york constituency provision expressly provides that it does not create any additional duties for directors.169 indeed, constituency statutes neither require directors to prioritize stakeholder interests over those of shareholders, nor provide for enforcement or standing devices to compel directors to consider such interests.170 consequently, they are insufficient to preserve the social bottom line of the fourth sector: a compulsory requirement that directors consider stakeholder interests must be sought elsewhere. tandem entities, an attempt to combine the two worlds social entrepreneurs have long tried to combine the flexibility of for-profits with the funding opportunities of tax-exempt nonprofits. indeed, some entrepreneurs – or more accurately their lawyers – have questioned the soundness of having to choose between these two worlds.171 instead, they argue, social entrepreneurs could form both a charitable nonprofit and a for-profit: the former would host the social bottom line while the latter would carry out the business. 172 these dual entities, often referred to as “tandem structures”173 or “cross-sector partnerships,”174 would allow the social business to enjoy the branding feature and charitable contributions and grants available to the 501(c)(3)s while conducting the business in a flexible entity. two main models of tandems have been identified: the “nonprofit parent model,” in which the for-profit is owned and managed by the nonprofit;175 and the “social business mutual benefit model,” in which the for-profit manages the tax-exempt.176 however, both of these structures are cumbersome and require comprehensive legal and tax expertise, as well as extensive administrative monitoring, to ensure that the tax-exempt status is not jeopardized.177 further, it must be noted at the outset that the situation here contemplated is different from a mere joint venture between a tax-exempt and a for-profit, in which the tax-exempt usually pre-exists the joint venture and serves a broader charitable purpose. in these ordinary joint ventures, the very concern of the internal revenue service and of courts is that the business shall not become the primary activity of the nonprofit.178 168 see bisconti, supra note 163, at 790 (“courts seem to be interpreting constituency statutes to essentially add nothing to the existing law.”). 169 n.y. bus. corp. law § 717(b) (mckinney 2013). 170 see tyler, supra note 84, at 135. 171 ingrid mittermaier et al., operating in two worlds: tandem structures in social enterprise, 26 no. 1 prac. tax law. 5, 6 (2011). 172 id. 173 see, e.g., id. 174 see, e.g., ashley schoenjahn, new faces of corporate responsibility: will new entity forms allow businesses to do good ?, 37 j. corp. l. 453, 459 (2012). 175 gautam jagannath, using nonprofits to serve charitable goals of social businesses in the united states: circumventing the lack of recognition of the social business model in the federal tax code, 32 pace l. rev. 239, 256 (2012). 176 id. 177 id. at 257. 178 id. at 253. 2013] designing a legal vehicle for social enterprises: 123 an issue spotting exercise in the case of a tandem social enterprise, there is a strong relation between the business and the charitable purpose. the business is not merely ancillary to the charitable mission, as a pharmacy would be to a hospital. further, founders and investors aim at retaining control over the venture as well as at getting some financial return while achieving social goals.179 although these two aspects are profoundly intertwined in a social enterprise, a tandem structure requires maintaining distinct entities. 180 from a governance standpoint, the two entities must conduct their affairs separately, hold distinct board meetings, and maintain legal walls between each other to protect their respective liabilities.181 in addition, it is necessary to avoid a total overlap on boards’ composition of the two entities.182 it is required that the tax-exempt be turned primarily on charitable purposes, therefore disinterested directors are arguably needed to approve the conflicting interests transactions between the two entities.183 in a significant private letter ruling,184 the internal revenue service required that the tax-exempt parent demonstrate that the subsidiary had a substantial business purpose and a separate corporate existence from its parent, and gave some guidelines to this end. as a result, the irs and the courts have particularly scrutinized tax-exempts that provide a market for a corporate business controlled by their officers.185 the service notably requires that the for-profit subsidiary have an independent board from the tax-exempt parent and that the key officers of both companies be different.186 these constraints stem from the private benefit and inurement doctrines,187 which prohibit the tax-exempt entity from being dedicated to benefiting the for-profit and its investors. tandem entities therefore do not offer social entrepreneurs a governance structure flexible enough to accommodate their peculiar needs. the burden of creating two organizations, and of losing control over one of them or otherwise risking substantial tax liability, usually greatly exceeds the advantages that the combination of the two entities represents.188 the tandem structure further fails to address the branding problem that social enterprises face: the two types of investments – traditional capital on the one hand, and charitable contributions and grants on the other hand – are kept into separate entities that “present different faces to different sectors of society.”189 thus, the two entities loosely appear as an innovative social enterprise as a whole and are hardly marketable as such. eventually, the for-profit enterprise has an existence of its own, and this can lead to difficulties when it is intended to subsidize the tax-exempt nonprofit entity. first, a donation exceeding ten percent of the corporation’s taxable income is taxed at the corporate income tax rate.190 thus, independent directors are less likely to donate amounts that would not be deductible and that, further, might engage their fiduciary duties for waste of corporate assets. the delaware general corporation law expressly authorizes directors 179 see, e.g., schoejahn, supra note 176. 180 see mittermaier et al., supra note 173. 181 see id. at 8–10. 182 id. 183 see id. at 8. 184 i.r.s. priv. ltr. rul. 9542045 (july 28, 1995). 185 see, e.g., church by mail, inc. v. commissioner, 765 f.2d 1387 (9th cir. 1985); i.r.s. priv. ltr. rul. 201044016 (2010). 186 see, e.g., i.r.s. priv. ltr. rul. 9542045 (july 28, 1995). 187 see supra –part ii.c. 188 see kelley, supra note 9, at 365. 189 see kelley, supra note 9, at 366. 190 i.r.c. § 170 (2012). 124 columbia journal of tax law [vol.5:100 to engage in charitable donations.191 yet, even though there is no formal requirement that the donation be limited in size, courts have only upheld “reasonable” donations.192 further the delaware supreme court ruled that in examining the merits of a claim alleging corporate waste, “the provisions of the internal revenue code pertaining to charitable gifts by corporations furnish a helpful guide” to assess the reasonableness of the donation.193 as a result, “it appears that in most situations, for-profit public corporations donating more than 10% of their profits to a nonprofit would be opening up themselves to liability from a derivative suit, essentially foreclosing this scheme as a viable option for social enterprises.”194 although only some of the constraints weighing on tandem entities are outlined in this part, they underscore that this structure is contrary to the convergence of business and charitable missions that social entrepreneurship embodies. this is so notably because the extensive non-distribution constraint and the related private benefit doctrine limit the possibility for a social entrepreneur to be the leader of both the business entity and its charitable counterpart. further, the uncertainty is great in this area as the internal revenue service proceeds with a case-by-case analysis instead of establishing a bright line rule, usually basing its decision loosely on “all the facts and circumstances.” 195 hence, circumventing these constraints demands expertise and formalism that are scarcely consistent with the business-like flexibility that social entrepreneurs seek to introduce in the charitable world. vi combining the two sectors in hybrid vehicles the previous parts have outlined why the tension between for-profits and nonprofits to host social enterprises has turned in favor of the for-profits. central in this conflict was the flexibility that social entrepreneurs need to conduct their business. however, some issues remain at least partially unaddressed by for-profit vehicles, namely the branding, funding and governance challenges. various legislators thus attempted to answer the expectations of responsible entrepreneurs who, especially in the wake of the 2008 financial crisis, were seeking to “re-buff the notion of ‘corporate greed’ by diversifying their revenue streams and/or balancing their profitmaking with socially responsible motives.” 196 accordingly, a number of states enacted legislation that incentivized for-profits to consider social interests, without the heavy constraints of the tax-exempt sector, through hybrid vehicles. two main vehicles have been created thus far: the benefit corporation (part a), and the l3c (part b). the benefit corporation, an initiative toward responsible businesses 1. the general public benefit: a purpose broadly construed at the outset of this subpart, the benefit corporation must be distinguished from the certified b corporation – also called b corp. while the former is a legal form, the latter is a label granted by b lab, a 501(c)(3) nonprofit devoted to serving “a global movement of entrepreneurs using the power of business to solve social and environmental 191 del. code ann. tit. 8, § 122(9) (2013). 192 e.g., theodora holding corp. v. henderson, 257 a.2d 398, 405 (del. ch. 1969). 193 kahn v. sullivan, 594 a.2d 48, 61 (del. 1991). 194 see doeringer, supra note 18, at 304–05. 195 see archer, supra note 161, at 185. 196 see lofft et al., supra note 108. 2013] designing a legal vehicle for social enterprises: 125 an issue spotting exercise problems.”197 the b corp label guarantees that the certified entity meets a high standard of overall social and environmental performance, along with transparency and accountability constraints.198 once they are labelled as b corps, these entities gain access to a portfolio of services and support from b lab.199 thus, benefit corporations are not necessarily certified as b corp, and entities need not be organized as benefit corporations to get certified. consequently, whereas b lab’s initiative provides a solution to the branding issue and an easier access to funding, the certification does not in and of itself vest any rights or standing in shareholders or stakeholders whose social expectations are deceived. maryland was the first state to pass a benefit corporation statute in april 2010.200 since then, eleven other states have enacted similar statutes, and fifteen more have introduced such legislation.201 because maryland’s initiative inspired its sister states, its statute is particularly relevant to understand how legislators tried to deal with the social enterprise innovation and why they fell short of adequately addressing its challenges. maryland’s benefit corporation statute, as well as its counterparts, broadly aims at ensuring that benefit corporations are socially valuable through three means. first, it requires that the benefit corporation further “the purpose of creating a general public benefit”202 and specifies this general purpose in its charter,203 possibly along with one or more specific benefits.204 however, the notion of “general public benefit” is defined loosely as “a material, positive impact on society and the environment, as measured by a third-party standard, through activities that promote a combination of specific public benefits.”205 these specific benefits are then largely construed206 and could be as broad as “providing individuals or communities with beneficial products or services” or “increasing the flow of capital to entities with a public benefit purpose.” as a result, a food company that would engage in a significant donation program to charities along with providing food packages to the poor could qualify as a benefit corporation under this first criterion although its primary activity would be focused on profit maximization. hence, while the benefit corporation can be an appropriate vehicle for a social enterprise, its wide definition is better construed as aimed to host all kinds of responsible businesses. indeed, the benefit corporation allows the creation of double bottom line enterprises but does not require it: while a general public benefit purpose must exist, it does not have to be equal to the profitmaking purpose. 207 therefore, a benefit corporation can be turned primarily, although not exclusively, to profit maximization. further, a general public purpose, such as donating to charities, is distinct from a social mission accomplished through a business 197 the non-profit behind b corps., http://www.bcorporation.net/what-are-b-corps/the-non-profit-behind-bcorps (last visited nov. 8, 2013). 198 id. 199 id. 200 anne field, first-ever study of maryland benefit corps released, forbes.com (jan. 25, 2013, 12:25 pm), http://www.forbes.com/sites/annefield/2013/01/25/first-ever-study-of-maryland-benefitcorps-released/. 201 benefit corp information center, state by state legislative status, http://www.benefitcorp.net/stateby-state-legislative-status (last visited nov. 8, 2013).. 202 md. code ann., corps. & ass’ns, § 5-6c-06(a)(1) (west 2013). 203 id. 204 md. code ann., corps. & ass’ns, § 5-6c-06(a)(2) (west 2013). 205 md. code ann., corps. & ass’ns, § 5-6c-01(c) (west 2013) 206 md. code ann., corps. & ass’ns, § 5-6c-01(d) (west 2013) 207 benefit corp information center, what are the requirements?, http://benefitcorp.net/for-business/ what-are-the-requirements (last visited nov. 8, 2013). 126 columbia journal of tax law [vol.5:100 activity. while a social mission would undoubtedly be a general public purpose, the latter is a broader notion than the former. in other terms, the benefit corporation fails to “distinguish between a business that chooses to be generally responsible and a business that binds itself to a specific social mission.”208 the second and third means then aim at ensuring that the benefit corporation is actually meeting the public benefit requirement. 2. enforcing the public purpose, an uncertain balance between adverse considerations as a second means to ensure the beneficial externalities of the corporation, the statute creates an affirmative duty for directors to consider stakeholder interests in their decision-making. community, societal and environmental considerations are expressly included in this constraint.209 thus, the statute expands the traditional fiduciary duties to command that directors in their decision-making, in any context,210 consider non-financial interests.211 directors are hence shielded from liability when they further such interests212 even though their decisions are contrary to mere profit maximization objectives. conversely, directors’ failure to comply with these extended fiduciary duties could trigger their liability. the main question is thus: who is to enforce these provisions? the statute does not go so far as to create a third party right of action. to the contrary, it expressly denies it.213 hence, only shareholders and directors have a right of action, either for “violation of or failure to pursue or create general or specific public benefit”; or for violation of the director’s extended standard of conduct. 214 however, courts have yet to decide to what extent directors can privilege general or specific public benefits over profitmaking. indeed, the statute indicates that directors must consider such benefits in determining what they “reasonably believe[] to be in the best interests of the benefit corporation.”215 thus, the board’s main duty remains to act in the overall best interest of the corporation; hence the question of whether their liability is triggered by a decision that, despite furthering a general or public benefit, greatly undermines the profitability of the corporation. however, whatever the answer is, directors are statutorily immune from liability when they reasonably perform these extended duties.216 as this “reasonable performance” standard also remains to be interpreted by the courts, the threshold of public benefit or shareholder profit underperformance that would trigger directors’ liability is unclear. nonetheless, a total leeway for directors to sacrifice benefits to social endeavors would deter traditional investors from capitalizing a benefit corporation. therefore, whether the courts will construe the benefit corporation as a device for shielding directors from liability or as a tool for allowing shareholders to enforce public benefit purposes is yet to be determined. the latter case still supposes that at least some shareholders will be socially driven enough to sue for enforcement of the benefit purpose, 208 see raz, supra note 17, at 303. 209 md. code ann., corps. & ass’ns, § 5-6c-07(a)(1) (west 2013). 210 benefit corp information center, supra note 210. hence, even in the takeover context non-financial interests shall be considered. 211 benefit corp information center, benefit corporation white paper, http://www.benefitcorp.net/forattorneys/benefit-corp-white-paper (last visited nov. 8, 2013). 212 md. code ann., corps. & ass’ns, § 5-6c-07(c) (west 2013). 213 md. code ann., corps. & ass’ns, § 5-6c-07(d) (west 2013). 214 benefit corp information center, supra note 210. 215 md. code ann., corps. & ass’ns, § 5-6c-07(a)(1) (west 2013). 216 md. code ann., corps. & ass’ns, § 5-6c-07(c) (west 2013). 2013] designing a legal vehicle for social enterprises: 127 an issue spotting exercise as the intended beneficiaries of the benefit corporation will not have any right of action.217 hence a concern that “[w]hile helpful in encouraging socially-conscious business decisions by protecting directors, the statute provides little protection for the mission itself. the broad, unchecked discretion vested in management can result in over-reaching and opportunism at the expense of the social benefit.”218 however, the benefit corporation’s actions are not entirely unchecked. the third way that the maryland statute ensures that some public benefits are achieved is a transparency check on the board’s decisions. indeed, the corporation must deliver to each stockholder an annual benefit report descripting its public benefit achievements and assessing its overall corporate social and environmental performance against a third-party standard.219 further, the report must be made available on the corporation’s website or, if it does not have a website, the report must be provided to any person that requests it without charge.220 however, while the independence of the third party and the transparency of its standard are statutorily guaranteed,221 the assessment of the corporation’s performance is made by the board itself.222 thus, this reporting mechanism might not be sufficient to ensure that benefit corporations act in compliance with their alleged public benefit purpose. on its face, the concept of the benefit corporation addresses the social enterprise’s branding challenge through a legal form that is inherently tilted toward public benefit and a reporting system that publicly assesses the accomplishment of such benefit. consequently, the branded enterprise should attract more diverse sources of capital, notably responsible investments.223 however, because the statute does not strike a decisive balance between the conflicting interests at stake, whether this scheme will actually work in practice now depends notably on the courts’ answer to the enforceability issue.224 the l3c, a vehicle specially tailored for social enterprises 1. an attempt to attract foundation dollars in 2008, vermont enacted the first low-profit limited liability company (l3c) statute. 225 rather than creating a new form, the l3c legislation was enacted as an amendment to the llc act, so as to take advantage of the llc flexibility and of the existing body of law regarding its governance.226 the l3c was publicly construed as “a cross between a nonprofit organization and a for-profit corporation” 227 and designated as a 217 see, e.g., raz, supra note 17, at 306. more importantly, the statute neither solves nor gives any guidance for the case where shareholders themselves disagree upon the furtherance of, or the extent to which directors should further, the benefit purpose. id. 218 id. at 305. 219 md. code ann., corps. & ass’ns, § 5-6c-08(a) (west 2013). 220 md. code ann., corps. & ass’ns, § 5-6c-08(c) (west 2013). 221 see md. code ann., corps. & ass'ns § 5-6c-01 (west 2013). 222 md. code ann., corps. & ass’ns, § 5-6c-08(a) (west 2013). 223 for pris, however, benefit corporations face the same difficulty as l3cs. 224 see, e.g., schoenjahn, supra note 176, at 472 (“to make this entity more effective, courts would have to strike a delicate balance between protection for boards of directors and protection for shareholders.”). 225 vermont secretary of state, low-profit limited liability company, http://www.sec.state.vt.us/corps/dobiz/llc/llc_l3c.htm (last visited nov. 6, 2013). 226 see, e.g., robert lang & elizabeth carrott minnigh, the l3c, history, basic construct, and legal framework, 35 vt. l. rev. 15, 20 (2010) 227 low-profit limited liability company, vermont secretary of state, http://www.sec.state.vt.us/corps/dobiz/llc/llc_l3c.htm (last visited nov. 6, 2013). 128 columbia journal of tax law [vol.5:100 double-bottom-line entity seeking a low profit along with charitable or educational goals.228 since 2008, a number of states have adopted l3c statutes,229 but the vermont l3c remains the most popular one. 230 while there are currently over 903 l3cs nationwide, 231 the effectiveness of this model is questionable the main purpose of the l3c is “to signal to foundations and donor directed funds that entities formed under this provision intend to conduct their activities in a way that would qualify as program related investments.”232 this approach is obvious in the relevant part of the vermont statute, which provides: (27) “l3c” or “low-profit limited liability company” means a person organized under this chapter that is organized for a business purpose that satisfies and is at all times operated to satisfy each of the following requirements: (a) the company: (i) significantly furthers the accomplishment of one or more charitable or educational purposes within the meaning of section 170(c)(2)(b) of the internal revenue code of 1986, 26 u.s.c. § 170(c)(2)(b); and (ii) would not have been formed but for the company's relationship to the accomplishment of charitable or educational purposes. (b) no significant purpose of the company is the production of income or the appreciation of property; provided, however, that the fact that a person produces significant income or capital appreciation shall not, in the absence of other factors, be conclusive evidence of a significant purpose involving the production of income or the appreciation of property. (c) no purpose of the company is to accomplish one or more political or legislative purposes within the meaning of section 170(c)(2)(d) of the internal revenue code of 1986, 26 u.s.c. § 170(c)(2)(d). (d) if a company that met the definition of this subdivision (27) at its formation at any time ceases to satisfy any one of the requirements, it shall immediately cease to be a low-profit limited liability company, but by continuing to meet all the other requirements of this chapter, will continue to exist as a limited liability company. the name of the company must be changed to be in conformance with subsection 3005(a) 228 id. 229 robert lang, americans for community development, the l3c – background and legislative issues 5, (2009), available at http://www.americansforcommunitydevelopment.org (“because it is a variant form of llc, the l3c is now legal in all 50 states as a result of legislation signed into law in vermont in april 2008, michigan in january 2009, the crow indian nation in january 2009, wyoming in february 2009, utah in march 2009, the oglala sioux in july 2009, illinois in august 2009, maine in april 2010, louisiana in june 2010, north carolina in august 2010 and rhode island in june 2011. an l3c from any of these states, like a delaware corporation, can be used anywhere. the l3c bill is now active in the legislatures of many states.”). 230 intersector partners, l3c, l3c tally, http://www.intersectorl3c.com/l3c_tally.html (last visited nov. 6, 2013). 231id. 232vermont secretary of state, low-profit limited liability company, http://www.sec.state.vt.us/corps/dobiz/llc/llc_l3c.htm (last visited nov. 6, 2013). 2013] designing a legal vehicle for social enterprises: 129 an issue spotting exercise of this title.233 thus, l3cs can be characterized as twofold hybrid entities. first, they inherently further a double bottom line: they must be organized for a business purpose that significantly leads to the accomplishment of a charitable or educational outcome. second, the entity aims at combining traditional investments with donation funds. 2. the statutory balance between conflicting bottom lines, an answer to the governance challenge the hybrid l3c aims at reconciling paradigms that are inherently conflicting: the for-profit value maximization quest and the tax-exempt charitable mission. fiduciary duties of directors operating in these two worlds are wildly different, notably because nonprofit directors are focused principally on the success of the charitable mission and do not seek mere profit maximization.234 to avoid this conflict, where either the board is paralyzed or is granted so much deference as to allow departure from the charitable purpose – which is exactly the concern with the benefit corporation – the statute itself strikes the balance in favor of the charitable purposes.235 indeed, the l3c must significantly further a charitable purpose,236 and no significant purpose must be the production of income.237 hence, although the l3c can distribute profits, its primary objective must be to accomplish its social purpose through the conduct of its business. this statutory prioritization of the social mission thus goes beyond mere contractual arrangements by transforming directors’ fiduciary duties.238 further, in comparison with for-profit corporations, directors are not only required to consider public benefit purposes, but to prioritize social outcomes over profit making.239 this is consistent with the notion that social enterprises’ profits result from their social endeavors– profit making is authorized, even if substantial earnings stem from the business activity, but they must be subordinate to the social mission. hence the l3c adequately apprehends the social enterprise double bottom line, and addresses its branding and governance challenges. accordingly, the l3c allows various kinds of investors to join 233 vt. stat. ann. 11, § 3001(27) (west 2013). 234 harvey j. goldschmid, the fiduciary duties of nonprofit directors and officers: paradoxes, problems, and proposed reforms, 23 j. corp. l. 631, 641 (1998) (“the obligation of nonprofit directors and officers with respect to the corporation's mission creates a more difficult and complex decisionmaking process for them than for their for-profit peers. for-profit directors and officers are principally concerned about long-term profit maximization. while nonprofit directors and officers keep economic matters in mind, they are principally concerned about the effective performance of the nonprofit's mission. it would be entirely in accordance with their duty of care and business judgment responsibilities, for example, for the directors of a nonprofit hospital to accept a low bid from one of several suitors because the chosen bidder would provide a far higher level of public benefit or service to the community. in most instances, a for-profit board would not have—and should not have—such freedom.”). 235 see tyler, supra note 84, at 141. 236 vt. stat. ann. 11, § 3001(27)(a) (west 2013). 237 vt. stat. ann. 11, § 3001(27)(b) (west 2013). 238 see tyler, supra note 84, at 161. 239 vt. stat. ann. 11, § 3001(27)(d) (west 2013). if it turns out that they do not, the statute provides that the l3c will continue to exist as an llc for instance if the economic interest becomes a primary purpose or once the charitable purpose is accomplished. this provision strikes a balance between the need for the l3c to be a social enterprise brand – i.e. to guarantee that the entity primarily furthers social outcomes and thus attracts responsible investors – and the practical concern that the loss of the l3c status could jeopardize a profitable business if it led to its automatic dissolution, which would deter traditional investors. id. 130 columbia journal of tax law [vol.5:100 in the venture. indeed, the vehicle offers “a degree of clarity and consistency that should provide reasonable confidence to investors, managers, creditors, policy-makers, and regulators that the form is legally viable for the appropriate circumstances.”240 3. a federal barrier to the state scheme: the pri problem the main purpose of the l3c legislation is to accommodate social enterprises’ particular need for diversified sources of funding.241 more specifically, the l3c aims at attracting private foundations, which would accept below market returns through pris, along with investors seeking market-rate returns.242 pris and grants would indeed permit l3cs to pay market-rate returns to their market investors.243 this scheme is based on an uneven allocation of risks: foundations could accept the highest risk with the lowest return under the pri, thus making the other investments more secure and attractive.244 hence, the idea behind the l3c is to enable social enterprises to benefit from the “tranching of investments.”245 foundations are at the bottom level, or “tranch,” of the investment scheme by making early high-risk low-return investments. then, at the middle tranch, responsible investors agree to below-market returns. eventually, these investments subsidize the upper tranch of the schemes, in which traditional investors are paid market-rate returns. this tranching scheme, however, presupposes that the l3c statute incentivizes foundations to invest through pris. therefore the whole idea behind the l3c statute is to signal to foundations and to the internal revenue service that this vehicle qualifies as a pri recipient, and thus to reduce their transactional costs.246 indeed, the statutory language reproduces the internal revenue code requirement: both the l3c 247 and the pri 248 must further purposes described in section 170 (c)(2)(b), and no significant purpose of the company or of the program can be the production of income or the appreciation of property. nonetheless, although the vermont statute replicates the language of the internal revenue code and of the treasury regulation,249 it has not made it easier for foundations to invest in l3c social enterprises. this is because the l3c is a state vehicle, whereas the pri is a creature of federal tax law. thus, the internal revenue service continues to rule on a case-by-case basis whether a particular investment qualifies as pri, either in advance through a private letter ruling or after it has been made and reported. hence, although the l3c is a good fit for pris, the service has no preference as to the entity that receives the investment.250 in other words, the service is “structure agnostic,”251 as it only wants “to insure [sic] that the recipient organization uses the money for an acceptable exempt purpose and holds the 240 see tyler, supra note 84, at 161. 241 see, e.g., raz, supra note 17, at 298. 242 see, e.g., id. 243 see id. 244 see daniel s. kleinberger, a myth deconstructed: the “emperor’s new clothes" on the low-profit limited liability company, 35 del. j. corp. l. 879, 883-84 (2010). 245 id. at 895. 246 id. at 885. 247 vt. stat. ann. 11, § 3001(27) (west 2013). 248 i.r.c. § 4944 (2012). 249 treas. reg. § 53.4944-3(a) (2013). 250 for instance, the l3c scheme can be reached through a regular llc by drafting the operating agreement so that it reproduces treas. reg. § 53.4944-3. 251 karen woods, americans for community development, l3cs and the irs, available at http://www.americansforcommunitydevelopment.org(last visited nov. 6, 2013). 2013] designing a legal vehicle for social enterprises: 131 an issue spotting exercise investing foundation responsible for monitoring compliance.”252 as a result, the reduction on transactional and monitoring costs has not happened. despite the charitable purpose and the transparency of the l3c, state legislation on its own cannot create new opportunities for pris. consequently, the main interest of the l3c for social entrepreneurs rests in its branding aspect and the fiduciary responsibility of the company to further its charitable mission. in short, l3cs provide a legal branding without the burdensome structure of tax-exempt organizations. vii conclusion: creative capitalism calls for innovative legislators social entrepreneurship is at the juncture of creative capitalism and social innovation. it aims at combining the best of two sectors, and thus is cramped in the traditional vehicles designed for either world in isolation. although the social bottom line of these enterprises can usually meet the broad charitable purpose requirement of the internal revenue code, tax-exempt vehicles have proven to be unable to host the financial one. indeed, tax-exempt nonprofits cannot distribute profits to investors if they suffer a burdensome federal oversight as well as substantial limitations on their activities. conversely, the advantages of for-profit vehicles stem from their flexibility. they can raise capital on the market and organize their ownership structure as they see fit. they are free to engage in a number of activities that are either prohibited or highly regulated when carried out by tax-exempt nonprofits. however, the uncertainty as to the extent to which social purposes can be furthered by corporations, as well as the failure of the for-profit world to receive funding from tax-exempts and the lack of a social enterprise brand have made it necessary to design new vehicles. hence, the development of the social enterprise movement has caused an increasing number of states to “revisit a binary or 'either/or approach' to organizational structures.”253 hybrid vehicles thus aim at enabling mission-driven for-profits to access a broad array of funding sources and to commit their capital to social endeavors. by adopting hybrid vehicles, social entrepreneurs brand their enterprises as committed to public interest purposes, even though the degree of this commitment varies depending on the legal form chosen. they further escape the significant non-distribution and disclosure constraints that weigh heavily on tax-exempt organizations. consequently, their business-like flexibility along with their public identification as mission-driven creatures should favor investors’ confidence and consumers’ loyalty. nonetheless, various obstacles stand in the way of this speculative scheme. first, these new forms remain widely untested by the courts. how the balance between the two bottom lines will be struck is still an open question, particularly regarding the benefit corporation. further, there is a lack of uniformity in the forms that are authorized nationwide. different states have different answers to the social enterprise challenges: while some states have refused to create any hybrid form, others have adopted several mission-driven vehicles in their own legislation. california, for instance, created the flexible purpose corporation254 in addition to its benefit corporation255: the former offers greater flexibility than the latter in the furtherance of public benefits through lighter 252 id. 253 see lofft et al., supra note 108. 254 cal. corp. code § 2600 (west 2013). 255 cal. corp. code § 14610 (west 2013). 132 columbia journal of tax law [vol.5:100 qualifying and reporting constraints.256 the state of washington followed the same trend with the adoption of a new type of for-profit corporation, the social purpose corporation, as of june 7, 2012.257 in many ways, the social purpose corporation looks like a lighter version of the benefit corporation as well.258 this lack of uniform approach nationwide results in a lessened readability of the hybrid model and make it harder for social entrepreneurs and their investors to navigate between the forms it encompasses. consequently, the availability of nonprofit, for-profit and hybrid vehicles must be viewed as a menu from which social entrepreneurs can choose the form that is better suited for their own business model. because social entrepreneurship rests on an innovative combination of the for-profit and charitable worlds, there is hardly one legal form that adequately fits the whole multiplicity of its variants. the preliminary issue that states should resolve is to better define social entrepreneurship, particularly regarding its mission, capitalizing and governance components. understanding these challenges is the key to designing an appropriate legal form. then, as for the state of delaware regarding public corporations, the practice of these hybrid vehicles will direct social entrepreneurs and investors toward legislation that better reflects their expectations. it will then be up to the relevant market to make its determination. after all, social entrepreneurship is just another creature of capitalism. 256 see, e.g., hansonbridgett, flexible purpose corporation vs. benefit corporation, http://www.hansonbridgett.com/publications/articles/2012-09-flexible-purpose.aspx (last visited nov. 6, 2013). 257 wash. rev. code ann. § 23b.25.005 (2013). 258 see, e.g., network for business innovation & sustainability, b corporations, benefit corporations and social purpose corporations: launching a new era of impact-driven companies 4 (oct. 2012), available at http://ecozome.com/wp-content/uploads/2012/10/bcorp_wp_distribution.pdf (“the social purpose corporation enables companies to pursue social and environmental goals alongside their efforts to provide financial returns. however, washington’s spc bill imposes a lighter set of verification and reporting requirements on companies than is required in a typical benefit corporation bill.”). articles the use of cross-border corporate profits and losses and “global corporate tax information”: a game theory approach carlo garbarino abstract the paper, proposes a game theory approach based on a concept of global corporate tax information and analyzes the unilateral strategies a country can select from to regulate cross-border profits and losses in its capacity as a residence-country or as a source-country. a description of the strategies available to residence-countries when there is no exchange of global corporate tax information is developed in section 2. section 3 then looks at the interactions of those unilateral strategies of residence and source countries when there is no exchange of global corporate tax information, and shows that they lead to a stable uncooperative equilibrium as the result of "dominant strategies." section 4 emphasizes the strategic importance of global corporate tax information insofar as it is conducive to effective cooperation in enforcement that prevents aggressive strategies by global taxpayers and shows that such coordination can be backed by multilateral commitment. section 4 also demonstrates that the common consolidated corporate tax base ("ccctb") can be viewed as a multilateral method for the exchange of global corporate tax information if approved by at least nine eu countries (i.e. the minimum number of parties required under the “enhanced cooperation” procedure.) section 5 concludes by proposing that the u.s. could become a party to pre-existing multilateral systems for exchange of global corporate tax information such as the ccctb.  professor of law, bocconi university, milan; hauser global visiting faculty, nyu law school, 2013; visiting professor of law, university of michigan law school, 2008, 2011, 2012; visiting professor of law, university of florida school of law, 2011; visiting professor, university of san paulo, 2010; visiting scholar, university of michigan law school, 2009; visiting professor, sorbonne university, paris, 2005, 2007; visiting scholar, yale law school, 1987-1988. the author gratefully acknowledges comments from reuven avi-yonah, joshua blank, yariv brauner, daniel shaviro, mitchell kane, and alan sykes. 134 columbia journal of tax law [vol.5:133 i. consolidation of cross-border profits and losses: a game theory approach to exchange of global corporate tax information ...................................................................................................... 135 ii. unilateral tax strategies of residence and sourcecountries in respect to cross-border profits and losses ..... 145 iii. the interactions of unilateral countries' policies: dominant strategies and uncooperative behavior ........................................ 150 iv. the coordination of residence and source countries based on the exchange of global corporate tax information: the ccctb model ...................................................................................................... 155 v. the extension of the ccctb as a multilateral treaty on exchange of global corporate tax information ...................... 160 2014] the use of cross-border corporate profits and losses 135 i. consolidation of cross-border profits and losses: a game theory approach to exchange of global corporate tax information profits and losses should, in theory, fall under the tax jurisdiction of the country where they have been generated. shifting profits and losses across borders through purposeful planning shields profits earned in high-tax jurisdictions from their natural tax rates and allows losses to be transferred and used to reduce the effective rate on profits located elsewhere. this is one of the techniques that lead to the creation of what has been denominated "stateless income."1 an emerging international policy issue, the shifting of profits and losses prevents the attainment of essential benchmarks of tax neutrality, according to which income should be taxed in the jurisdiction where it is generated.2 the oecd, in a 2011 report entitled “corporate loss utilization through aggressive tax planning,” noted that due to the recent financial and economic crisis, global corporate losses have become enormous.3 in a subsequent 2013 report, it provided a definition of "base erosion and profit shifting" (beps), 4 an even wider phenomenon which has attracted the attention of governments5 and the eu.6 this recently escalated in major 1 "stateless income" has been defined as income that is "derived for tax purposes by a multinational group from business activities in a country other than the domicile of the group’s ultimate parent company, but which is subject to tax only in a jurisdiction that is not the location of the customers or the factors of production through which the income was derived, and is not the domicile of the group’s parent company." edward d. kleinbard, stateless income, 11 fla. tax rev. 699, 701 (2011). 2 see, e.g., fadi shaheen, international tax neutrality: reconsiderations, 27 va. tax rev. 203, 211, 213‒14 (2007) (surveying and evaluating various theories of tax neutrality and proposing best satisfying capital export neutrality); joel slemrod, location, (real) location, (tax) location: an essay on mobility’s place in optimal taxation, 63 nat’l tax j. 843, 844 (2010) (examining the nature and proper role of mobility in optimal taxation); george r. zodrow, capital mobility and capital tax competition, 63 nat’l tax j. 865, 881 (2010) (exploring the extent of tax competition for mobile capital). 3 organization for economic co-operation and development ("oecd"), corporate loss utilisation through aggressive tax planning (paris, 2011) (exploring the strategic use of corporate losses, how such strategies can frustrate the purposes of legislators, and giving recommendations for tax administrators and tax policy officials). see also d.r. post & kelly stals, the tax treatment of corporate losses: a comparative study, 40 intertax 232 (2012) (detailing a 50 country survey concerning the tax treatment of corporate losses and responding to the oecd report regarding the use of aggressive tax planning to use corporate losses). 4 for the definition of "base erosion and profit shifting," see oecd, addressing base erosion and profit shifting, paris, 2013. see also kimberly a. clausing, the revenue effects of multinational firm income shifting, tax notes 1580‒1586 (2011); dhammika dharmapala & nadine riedel, earnings shocks and tax-motivated income-shifting: evidence from european multinationals, 97 j. pub. econ. 95‒107 (2013); clement fuest & nadine riedel, tax evasion and tax avoidance in developing countries: the role of international profit shifting (oxford university centre for business taxation, working paper 10/12, june 2010), available at http://eureka.bodleian.ox.ac.uk/3257/1/wp1012.pdf. 5 see, e.g., the rt hon george osborne mp, chancellor of the exchequer, hm treasury, britain and germany call for international action to strengthen tax standards (nov. 5, 2012), available at https://www.gov.uk/government/speeches/statement-by-the-chancellor-of-the-exchequer-rt-hon-georgeosborne-mp-britain-germany-call-for-international-action-to-strengthen-tax-standards. in that statement german finance minister wolfgang schäuble and british chancellor of the exchequer george osborne have called on the g20 countries to coordinate efforts to prevent profit shifting by companies of all nationalities and to protect the global corporate tax base. id. the same issues were discussed at the 2012 g20 los cabos summit. group of twenty ("g20"), los cabos summit leader’s declaration, (jun. 19, 2012), https://www.g20.org/sites/default/files/g20_resources/library/g20_leaders_declaration_final_los_cabos.p df; g20, g20 finance ministers and central bank governors mexico february 2012 communiqué (feb. 25‒ 26, 2012), https://www.g20.org/sites/default/files/g20_resources/library/250212_finance_ministers_and_central_bank _governors.doc. 136 columbia journal of tax law [vol.5:133 corporate tax cases involving multinationals. in the us, similar cases were brought to the attention of the public 7 and have been scrutinized by the u.s. senate permanent subcommittee on investigation.8 similar issues have been discussed in the uk and other countries.9 these losses raise tax compliance risks, in particular if global multinational firms operating through affiliate companies (hereinafter "global taxpayers") turn to aggressive cross-border tax planning as a means of increasing and/or accelerating tax relief. the overall effect of this type of tax planning is to erode the corporate tax base of many countries because beps pursued through the utilization of cross-border profits and losses often takes advantage of a combination of features of tax systems of home and host countries. this implies that it may be very difficult for any single country, acting alone, to effectively combat these beps behaviors.10 the crux of the problem therefore is twofold: on the one hand, national tax authorities do not have access to information concerning the profits and losses of non-resident companies, and, on the other hand, global taxpayers, such as multinational firms, are capable of exploiting this information gap by carrying out aggressive tax planning that reduces their overall effective rates. national tax authorities have access to information on domestic corporate profits or losses, but can obtain information on foreign corporate profits or losses only if there is a tax information exchange agreement with the relevant foreign country. by contrast, global taxpayers do not face territorial information limits and have access to relevant tax data on a global scale. this asymmetry of information enhances arbitrage opportunities for global taxpayers. as noted by the oecd, "while these corporate tax planning strategies may be technically legal and rely on carefully planned interactions of a variety of tax rules and principles, the overall effect of this type of tax planning is to erode the corporate tax base of many countries in a manner that is not intended by domestic policy. this reflects the fact that beps takes advantage of a combination of features of tax 6 press release, general secretariat of the council, european council 22 may 2013 conclusions, euco 75/1/13 rev 1 (may 23, 2013). 7 see, e.g.,david kocieniewski, series, but nobody pays that, n.y. times, mar. 25‒dec. 30, 2011, available at topics.nytimes.com/top/features/timestopics/series/but_nobody_pays_that/index.html; charles duhigg & david kocieniewski, how apple sidesteps billions in taxes, n.y. times, apr. 28,2012, at a1; jesse drucker, google 2.4% rate shows how $60 billion lost to tax loopholes, bloomberg, oct. 21, 2010, available at http://bloom.bg/gfqvem; jesse drucker, irs auditing how google shifted profits offshore to avoid taxes, bloomberg, oct. 13, 2011, http://bloom.bg/pa3m73; robert s. mcintyre et al., citizens for tax justice with the institute on taxation and economic policy , corporate taxpayers and corporate tax dodgers 2008-10 (2011), available at www.ctj.org/corporatetaxdodgers/corporatetaxdodgersreport.pdf; kevin a. hassett & aparna mathur, american enterprise institute for public policy research , report card on effective corporate tax rates: united states gets an f, tax policy outlook no. 1, (2011), available at www.aei.org/files/2011/02/09/tpo-2011-01-g.pdf.; series, the great corporate tax dodge, bloomberg, (may 13, 2010‒oct. 27 2013), available at http://topics.bloomberg.com/the-great-corporate-tax-dodge. 8 offshore profit shifting and the u.s. tax code – part 1 (microsoft and hewlett-packard): hearing before the permanent subcomm. on investigation of the s. comm. on homeland sec. and governmental affairs, 112th cong. 781 (2012); offshore profit shifting and the u.s. tax code – part 2 (apple): hearing before the permanent subcomm. on investigation of the s. comm. on homeland sec. and governmental affairs, 113th cong. 90 (2013). 9 public accounts committee, hm revenues and customs: annual report and accounts 201112, tax avoidance by multinational companies, 2012-3, h.c. 716 (u.k.). see also, jim pickard & vanessa houlder, google and starbucks face tax questions, fin. times, oct. 30, 2012, available at http://on.ft.com/q4w7wu; juliette garside, amazon paid £3m tax on £4bn uk sales, the guardian, may 15, 2013, available at http://gu.com/p/3fpgb/tw. 10 oecd, addressing base erosion and profit shifting, supra, note 5, at 7-8. 2014] the use of cross-border corporate profits and losses 137 systems which have been put in place by home and host countries. this implies that it may be very difficult for any single country, acting alone, to effectively combat beps behaviors."11 governments, therefore, assign strategic value to tax information that concerns cross-border corporate profits and losses; information is generally available by request under article 26 of the oecd model convention,12 but the type of tax information that is considered here is that which can be obtained from systems that allow the consolidation by a single company of corporate profits and losses reported by affiliated companies resident in different countries. such a consolidating company must be in a position to pool together the relevant financial and tax data on profits and losses reported by the consolidated companies and compute consolidated profit and losses on the basis of common rules. this data is available to tax authorities of multiple countries. such information needed to consolidate cross-border corporate profits and losses is referred to here as "global corporate tax information." there is clearly the need for coordinated solutions to be adopted on a multilateral basis relying on the free exchange of global corporate tax information, but there is no established method for sharing such information. currently, individual countries do not have access to such information and resort to policies to regulate global taxpayers' use of profits and losses that interact with those of other countries. this article relies on elementary concepts of game theory to provide a simplified model of the strategic behavior of those agents (countries), as each national (i.e. unilateral) tax policy interacts with the others in an environment in which global corporate tax information becomes a strategic asset for effective tax enforcement.13 more precisely each country must choose from a range of unilateral strategies concerning cross-border consolidation of profits and losses. in the stylized model proposed here, a "unilateral strategy" is a predetermined "program of play" that commands what kind of regulation to take in response to every strategy available to other countries. this situation can be technically defined as a "game," i.e. a term of art used to denote a situation in which at least one agent can act to maximize its utility only by anticipating the responses to its actions by one or more other agents by resorting to a unilateral strategy. game theory is an important tool for an agent, such as a country,14 who confronts situations where the best unilateral strategy depends on expectations about what one or more other agents will do, and the other agents' best unilateral strategies depend on what the original agent does. the model considers two stages of play. in the first stage, countries do not exchange global corporate tax information and therefore resort to unilateral strategies to regulate cross-border consolidation of profits and losses that maximize their interests. in the second stage, countries exchange global corporate tax information and eventually abide by common rules embodied in binding legal instruments that reflect and enhance an existing level of spontaneous coordination achieved in the first stage. 11 oecd, addressing base erosion and profit shifting, supra, note 5, at 45. 12 oecd model tax convention on income and capital 2010. 13 game theory has become a massive tool for rational decision-making in all sort of field and it is not the case here to review the basic literature. very useful and comprehensive accounts for the layman are: binmore kenneth, rational decisions (2009), and avinash dixit & barry nalebuff, thinking strategically (1991). for applications of game theory to law, see douglas baird, robert gertner & randal picker, game theory and the law (1994). 14 the concept that complex institutions such as governments or countries can meaningfully be modeled as autonomous agents was introduced by schelling in his seminal work thomas schelling, strategy of conflict (1960). 138 columbia journal of tax law [vol.5:133 the intuition behind this account is twofold. first, if certain conditions are met, interactions between unilateral strategies of different countries in the eu might result in a stable equilibrium in which there is a coordinated exchange of global corporate tax information instrumental to the cross-border tax consolidation of profits and losses of affiliated companies. this would occur for example in the common consolidated corporate tax base ("ccctb") approach,15 under which each company’s (or branch's) individual tax results are computed and consolidated in accordance with common eu rules.16 second, the us could move towards such a coordinated approach by becoming a party to a multilateral agreement on the exchange of global corporate tax information, while at the same time pursuing its own unilateral tax policies concerning cross-border profits and losses either in the direction of a territorial system or in the direction of mandatory worldwide consolidation. for obvious reasons, it would be impossible to map the interactions of these strategies of all countries, so this study examines a sample of countries, specifically the fifteen member states of the eu before the accession of the new member states in 2005. from that sample, the study extrapolates wider conclusions, relying on a straightforward application of concepts of game theory, and also considers the policy options which could be taken by the us in respect to cross-border corporate profits and losses and beps. the paper has the following structure. after a concise discussion of the game theory approach that will be exposed in this first section, the paper will go on to analyze the unilateral strategies a country can select from to regulate cross-border profits and losses in its capacity as a residence-country or as a source-country.17 a description of the strategies available to residence-countries when there is no exchange of global corporate tax information is developed in section 2. section 3 then looks at the interactions of those unilateral strategies of residence and source countries when there is no exchange of global corporate tax information, and shows that they lead to a stable uncooperative equilibrium as the result of "dominant strategies." section 4 emphasizes the strategic importance of global corporate tax information insofar as it is conducive to effective cooperation in enforcement that prevents aggressive strategies by global taxpayers and 15 proposal for a council directive on a common consolidated corporate tax base (ccctb), sec (2011) 315 final (mar. 16 2011). ccctb superseded a previous approach proposed by the european commission called home state taxation, under which small and medium enterprise were allowed to compute their companies’ taxable profits according to the tax rules of the home state of the parent company or head office in accordance with the rules of the home state. 16 according to article 7 where a company qualifies and opts for the system provided for by the ccctb directive it shall cease to be subject to the national corporate tax arrangements in respect of all matters regulated by that directive unless otherwise stated. in particular, chapters iv, v and vi of the directive provide common rules respectively for calculating the tax base, for timing and qualifications, and depreciation of fixed assets. on the determination of common base see iida jaatinen, ias/ifrs: a starting point for the ccctb?, 40 intertax 260–269 (2012); judith freedman & graeme mcdonald, the tax base for ccctb: the role of principles, in michael lang et al., common consolidated corporate tax base 217 ‒270 (2008). 17 this concept of residence and source country in respect to cross-border corporate profits and losses will be defined precisely infra, and is slightly different from the standard concept adopted by international tax law according to which every country has the right to impose both residence-based taxation on the worldwide income of its own residents and source-based taxation on income sourced within its borders by non-resident persons. on source tax jurisdiction see for example: restatement (third) of the foreign relations law of the united states §§ 411–12 (1986); reuven s. avi-yonah, international tax as international law: an analysis of the international tax regime 2 (2007); stephen e. shay, j. clifton fleming, jr. & robert j. peroni, the david r. tillinghast lecture: "what’s source got to do with it?"— source rules and u.s. international taxation, 56 tax l. rev. 81, 88–106 (2002). 2014] the use of cross-border corporate profits and losses 139 shows that such coordination can be backed by multilateral commitment. section 4 also demonstrates that the ccctb can be viewed as a multilateral method for the exchange of global corporate tax information if approved by at least nine eu countries (i.e. the minimum number of parties required under the "enhanced cooperation" procedure.)18 section 5 concludes by proposing that the u.s. could become a party to pre-existing multilateral systems for exchange of global corporate tax information such as the ccctb. the remaining part of this section first explains why cross-border corporate profits and losses are generally not consolidated under the rules of a single country, and then defines more precisely the concept of global corporate tax information within the game theory model used here. the eu and the us belong to a common policy cluster in which the offsetting of profits and losses of domestic affiliated companies (so called "domestic tax consolidation") is generally allowed, although under different approaches. fiscal unity is adopted in the us and in the majority of eu countries considered here,19 and provides for a systematic pooling by the consolidating company of the profits and losses of the domestic consolidated companies. the same pooling occurs in the variation of fiscal unity in which accounting consolidation is a requirement for tax consolidation. 20 in group relief, there is a transfer of losses from loss-companies to profitable affiliated companies that are resident in the same country (the united kingdom and ireland), while in group contribution there is a transfer of profits from profitable companies to losscompanies in the group that are resident in the same country (finland and sweden). these variants of domestic tax consolidation share a common policy approach, despite the different techniques that are actually implemented, i.e. they allow the offsetting of profits and losses of different companies of a group that are resident in the same country. the view that is taken here is that domestic consolidation essentially takes the form of cooperative correlative adjustments between affiliated companies that are based on a complete sharing of information by those companies with national tax authorities about the corporate profits and losses that are consolidated. for example, those are consolidated by a single company together with all relevant information (in fiscal unity), or otherwise profits/losses are transferred to affiliated companies that can be monitored at the domestic level (in group relief and group contribution). this sharing of information causes simplifications that essentially result from the application of correlative adjustment mechanisms which allow the pooling together of the tax positions of affiliated companies resident in the same country without concessions to the tax sovereignty of other countries.21 18 for details about the enhanced cooperation procedure see infra note 41. 19 fiscal unity is adopted in the u.s. under the requirement that domestic affiliates be owned by the consolidating company at 80% of the voting power and value of the stock of a domestic. irc § 1504(a) (2012); treas. reg. § 1.861-11t(d)(6) (2012). similar rules are found for example in france, italy, spain, portugal, austria, germany, the netherlands, luxembourg, denmark. 20 the only country that adopts this approach is germany, as austria has abandoned it in favor of fiscal unity. 21 there are other tax design goals that are achieved, at domestic level, by the model of domestic taxation that are ancillary to the offsetting of profits and losses, such as no or limited taxation of capital gains and losses on shares/assets transferred intra-group between resident companies, the exemption of intra-group domestic dividends, the elimination of withholding taxes on flows of income paid between resident companies belonging to the group, as well as the removal of limitations to the deduction of financing expenses incurred in relation to tax exempt participation if certain conditions are met. 140 columbia journal of tax law [vol.5:133 these kinds of correlative adjustments are not, however, generally achieved when the affiliated companies are resident in different countries, because cross-border profits and losses create acute coordination problems due to the lack of exchange of global corporate tax information. first, the inclusion in the residence-country of the losses of foreign affiliated companies or permanent establishments (hereinafter "pes") triggers the erosion of the national tax base, something that cannot occur in fully domestic tax consolidation. in the us, erosion is achieved through the so called "earnings stripping" strategies that shift profits from one country to another via intragroup deductions/income inclusions, typically through intercompany interest, fees, rents, or royalties,22 but also through outright attribution to the us tax jurisdiction of foreign losses. these techniques show that source rules governing the allocation of the deductibility of interest risk become artificial constructs insofar as they allow base erosion by extracting profits from higher to lower rate jurisdictions.23 second, the losses of a foreign affiliated company or pe may be used in the country where the affiliated company or pe is located (through carry forward, carry back, local tax consolidation or other local techniques), and then also used in the country where the controlling company is located (through fiscal unity or group relief).24 in the us, "dual consolidated loss" rules limited the ability of us companies to claim the same loss deduction in two different countries,25 but the 2007 revisions to the treasury regulations clarified that interest paid between a so called "check-the-box" disregarded entity and its parent could not give rise to a prohibited dual consolidated loss, even though that loss was deducted against the income of two consolidated groups26; this effectively opened the door to double dipping for those companies that were pursuing such a goal.27 the third concern about cross-border consolidation is that losses of foreign affiliated companies or pes may be artificially created for the purposes of offsetting domestic profits, but may not be directly audited by the tax authorities of the countries 22 see: harry huizinga, luc laeven & gaetan nicodeme, capital structure and international debt shifting, 88 j. fin. econ. 80 (2008); mihir a. desai, c. fritz foley & james r. hines jr., a multinational perspective on capital structure choice and internal capital markets, 59 j. fin. 2451 (2004); tim edgar, jonathan farras & amin mawant, foreign direct investment, thin capitalization, and the interest expense deduction: a policy analysis, 56 can. tax. j. 803, 810 (2008); tim edgar, policy forum: interest deductibility restrictions — expecting too much from reop?, 52 can. tax. j. 1130 (2004); julie h. collins & douglas a. shackelford, global organizations and taxes: an analysis of the dividend, interest, royalty, and management fee payments between u.s. multinationals’ foreign affiliates, 24 j. acct. & econ. 151 (1998). 23 see richard j. vann, taxing international business income: hard-boiled wonderland and the end of the world, 2 world tax j. 305–43 (2010). michael j. graetz, a multilateral solution for the income tax treatment of interest expenses, 62 bull. int'l tax. 486, 489 (2008), recommends in effect a global multilateral treaty to apportion interest expense on pure fungibility of assets principles to all members of an affiliated group of companies, without regard to the identity of the particular affiliate that actually borrowed the funds. 24 the oecd, corporate loss utilisation through aggressive tax planning, supra note 4, at 42‒43 has focused on this issue. 25 the double dip of losses was generally achieved by consolidating in the u.s. a dual resident losscompany, as such company was also contributing its losses within a domestic consolidation in the other country. 26 according to the check-the-box rules introduced in 1997, a foreign person can elect whether to be treated as a partnership (i.e., a pass-through entity) or a corporation for u.s. federal tax purposes, and there are exceptions only for certain listed forms of organizations in various countries which are always classified as corporations. treas. reg. §§ 301.7701-1–301.7701-3 (2011) (as originally adopted in t.d. 8697, 1997-1 c.b. 215). before 1997 there was entity classification regulations on a case-by-case basis. 27 treas. reg. § 1.1503(d) (2007). 2014] the use of cross-border corporate profits and losses 141 where the company that benefits from such offsetting is located. by the same token, profits of foreign affiliated companies or pes may be artificially created for the purposes of offsetting them with the losses of other companies.28 the game theory model used here is aimed at showing that individual countries could effectively address these asymmetries of information. the model relies on the concept of global corporate tax information which should be distinguished from the broader concept of "tax information" relating to individual taxpayers, particularly in respect to their passive income held in foreign bank accounts.29 at the domestic level, tax information is generally available to tax authorities through the use of their enforcement powers, but becomes scarce when it involves taxpayer facts or circumstances that occur outside the territory of the tax authority. such foreign tax information has become extremely valuable. in the current international tax regime, the residence-country has the power to tax the income of its tax-residents produced in a different source-country. there is a risk of moral hazard because of the asymmetry of information, as taxpayers may decide to under-report (or not report) in their country of residence (residence-country) their income produced in the source-country. this opportunistic behavior is generally incentivized by the fact that the residence-country cannot enforce its extra-territorial tax claims in the territory of the source-country, meaning the likelihood of apprehension is dramatically lower. certain source-countries offer low or no taxation to non-residents investing in that country and do not cooperate with residence-countries in respect to the enforcement of the claims.30 under-reporting (or no reporting) and diversion of investment toward low tax countries is further intensified by the high mobility of certain types of income, such as passive or financial income, as well as by the obfuscation of relevant tax information created by certain source-countries through bank secrecy and other forms of confidentiality, methods used by source-countries specifically to attract foreign investment.31 if a country is a low-tax jurisdiction it will act in most cases as a source-country and very seldom will have an interest in obtaining tax information from residence 28 an abusive use of final losses rule has been encountered in a scheme in which a resident company with a loss-making pe in another eu member state was converted into a partnership. for the latter state’s taxation purposes, as a result of the conversion, the pe was considered to be liquidated and subsequently re-established. the effect was that the hidden reserves of the pe were considered to be realized and the resulting income was offset against the loss carry-forward of the pe. concurrently, the parent company claimed in its tax return a deduction for the remaining loss carry-forward of the pe from its income referring to case c-414/06, lidl belgium gmbh & co kg v fa düsseldorf-mettmann, 2008 e.c.r. i-03601, according to which the country of the parent company must allow the deduction of the foreign pe losses when they become final. in addition, in the financial year following the conversion, the pe amortized goodwill and set up a reserve, causing a significant loss and thus shifting the loss carry-forward from the terminated to the re-established business. see oecd, corporate loss utilisation, supra note 4, at 55). 29 tax information is the knowledge communicated or received concerning taxpayers’ particular facts or circumstances which has a strategic value because it allows agents (governments, tax authorities) to make choices that yield higher expected payoffs/utility than they would obtain from choices made in the absence of information. 30 mihir a. desay,c. fritz foley & james r. hines jr., do tax havens divert economic activity?, 90 econ. letters, 219 (2006); mihir a. desay, c. fritz foley & james r. hines jr., the demand for tax haven operations, 3 j. pub. econ., 513-531 (2006); dhammika dharmapala & james r. hines, which countries become tax havens?, j. pub. econ. 93(2009), 1058‒68; dhammika dharmapala, what problems and opportunities are created by tax havens?, 24 oxford rev. econ. pol'y 661‒79 (2008). 31 see u.n. office for drug control & crime prevention, financial havens, banking secrecy and money laundering (1998). 142 columbia journal of tax law [vol.5:133 countries, while if a country is a high-tax jurisdiction it will act in most cases as a residence-country and very often will have an interest in obtaining tax information from source-countries, where its own resident taxpayers may have produced income. the game, then, revolves around resident countries trying to get information from sourcecountries, rather than a reciprocal "exchange" of information. in spite of the language of article 26 of the oecd model convention, this is essentially an asymmetric game, without full reciprocity. of course two countries may symmetrically exchange information concerning income of individual taxpayers and this occurs when each country, over repeated games, can be at times a residence-country and at times a sourcecountry in respect to such income. this is basically the situation covered by article 26 of the oecd model convention which assumes that the two countries have reciprocal interests. this asymmetric game led to a situation in which the strategic interests of the high-tax residence-countries clashed with the strategic interests of the low-tax sourcecountries, which has been labeled by high-tax residence-countries as a kind of "uncooperative behavior" that not only stifles the extraterritorial enforcement of the tax laws of the residence-countries, but also hinders the achievement of their favored strategies for taxing foreign income. resident countries have pushed for a characterization of low-tax source-countries as "tax havens"32 and this has been actively pursued by high-tax residence-countries (typically oecd countries).33 the oecd has waged a campaign to enhance the exchange of information and to force uncooperative jurisdictions to make available the relevant information, regardless of domestic constraints (banking confidentiality laws, for example). 34 the us has also taken a unilateral stance in pursuing its strategic interests by enacting sections 1471 to 1474 of the internal revenue code (the foreign account tax compliance act or "fatca") in 2010, which require foreign financial institutions to report information on financial accounts of us persons and foreign entities by 2015. fatca is a unilateral move to force foreign financial institutions to disclose their us accountholders or pay a steep penalty for nondisclosure. the result is that foreign financial institutions, to comply with fatca, may be forced to violate the laws of the jurisdiction in which they are located. in stark contrast with the asymmetric game played by governments concerning tax information – for example a request by the residence-country to the source-country about individual tax accounts ‒ the game played in respect to global corporate tax information tends to be a symmetric game. this is because, in the current beps scenario involving aggressive strategies by corporate taxpayers with operations truly at multicountry level, each country, over repeated games, can be at times a residence-country and at times a source-country in respect to cross-border corporate profits and losses. 32 see, e.g., caorline doggart, tax havens and their uses (2002); lorrain eden & robert t. kudrle, tax havens: renegade states in the international tax regime?, 1 law & pol'y, 100 (2005); anthony s. ginsberg, international tax havens (1997); mykola orlov, the concept of tax haven: a legal analysis, 32 intertax 95‒111 (2004). 33 of course there were other major non-tax reasons that drove the fight against tax havens. see, e.g., donat masciandaro, global financial crime: terrorism, money laundering, and offshore centres, 181‒218 (2004); wolfgang schön, tax competition in europe (2003); jae-myong koh, suppressing terrorist financing and money laundering (2006). 34 oecd, tax co-operation: towards a level playing field, (2006); oecd, tax cooperation: towards a level playing field(2007); oecd, countering offshore tax evasion (2009); oecd, tax co-operation 2009: towards a level playing field (2009). 2014] the use of cross-border corporate profits and losses 143 when a country acts as a residence-country in respect to cross-border corporate profits and losses, it limits the erosion of the national base, carried by resident persons through certain consolidation techniques that pursue the inflows of foreign losses or profits at the level of the parent company located in the residence-country. when a country acts as a source-country in respect to cross-border corporate profits and losses, it limits the erosion of national base carried by non-resident persons through consolidation techniques in which domestic profits or losses of affiliated companies located in a sourcecountry are transferred to parent companies located abroad. a given country can be at times a residence or a source country in respect to the operations of multinational groups and such a country has an incentive to exchange information to better protect its own interests in all cases (i.e. when it acts as a residence-country and when it acts as a sourcecountry). as a result the game is really about the reciprocal exchange of information among countries, unlike the asymmetric game played in respect to general tax information about individual taxpayers. in conclusion, in respect to cross-border corporate profits and losses, there is (i) a conflict of interests between governments seeking to protect their own tax bases and global taxpayers seeking to minimize their effective tax rates through beps and stateless income techniques, and (ii) a common interest among governments to protect themselves from beps and stateless income techniques carried out by global taxpayers. as reciprocity is incentivized in the sharing of global corporate tax information, it is reasonable to assume that, for each individual country, the value of that information exceeds the value that can be extracted from merely unilateral strategies that do not enhance cooperation. this assumption informs the rest of this article, and suggests that an individual country that has access to global corporate tax information can counteract beps more effectively. in particular the lack of access to global corporate tax information hinders the capability of tax authorities of a given country to prevent (i) the erosion of the tax bases that results from the import (or export) of foreign generated profits and losses, (ii) the dual use of losses, and (iii) the artificial creation of income. by contrast, the availability of global corporate tax information on a multilateral basis would enable countries to effectively enforce rules that prevent these aggressive strategies. certain additional assumptions are made in respect to the first stage of the stylized game theory model used here. first, it is assumed that initially agents (i.e. countries) do not communicate and therefore cannot purposefully cooperate. only in the subsequent stage are communication and cooperation factored into account, during repeated interactions. second, it is assumed that agents act "rationally," in line with a simplified game-theoretic logic. 35 third, it is assumed that at every point where a decision is made an agent knows everything that has happened in the game up to that point. fourth, it is assumed that such a game is a simultaneous-move game in which agents choose their strategies at the same time. in stage two, the first assumption (that agents do not communicate and do not cooperate) is relinquished and therefore binding (bilateral or multilateral) agreements based on communication and cooperation leading to exchange of global corporate tax information are contemplated. 35 although game theory is not an empirical account of the motivations of actual agents, under the utility and rationality constraint it is able to provide a simplified account at least of rational expectations for the likely behavior of agents. 144 columbia journal of tax law [vol.5:133 these assumptions set up a simplified model in which policy makers are fully informed of the strategies about cross-border profits and losses that are simultaneously adopted by other countries. it is obvious that the actual interdependence of national tax strategies in this regulatory context is more complex than what is suggested by this model. in reality there can be imperfect information, biases in the perception of moves made by other countries, and sequential processes in which countries choose their strategies one after the other. yet the simplified model reflects the fact that countries interact on a continuous basis over time and thus play so called "repeated games," in which they expect to face each other in similar situations on multiple occasions.36 these repeated games are played with future games in mind, and this can significantly alter their outcomes and equilibrium strategies. in such a multi-player situation, countries initially develop their own unilateral tax policies, and then consider the reactions of other countries over time.37 in this process, cooperation and coordination thus are two progressive phases of a comprehensive process: cooperation can be minimally defined as the working together of at least two agents (i.e. countries) to achieve a common end, while coordination involves the working together of more than two agents (i.e. countries) in order to exchange information. coordination, thus, may emerge in a world of agents (such as countries) who operate without central authority and interact repeatedly. this is now a common view that stems from the seminal work of robert axelrod, in which he has shown that cooperation can get started in a world of unconditional defectors and evolve from small clusters of individual agents who base their cooperation on reciprocity. cooperation, once established within a cluster of agents, becomes a full-fledged form of coordination and can protect itself from invasion by less cooperative strategies played by other individual agents, maintaining the prevalence of the cooperative strategy.38 one would think that coordination must imply "friendship" and "foresight" as essential elements of a purposive behavior. however, game theory proposes that coordination, in certain situations, can be initially achieved simply out of the combinatorial effects of interactions of individual agents pursuing their own goals, such as countries pursuing unilateral tax strategies (of course such cooperation can then be enshrined in binding legal obligations.) moreover, while coordination appears to be inherently unstable, game theory proposes that it can be established as a stable equilibrium over repeated games that involve information and unilateral benefits for each actor. this kind of equilibrium is usually defined as an evolutionarily stable equilibrium.39 this concept captures two basic ideas: that an equilibrium strategy should be stable against small invasions by "mutants" playing some other strategy, and that communication solves coordination problems. according to this approach, some 36 on the concept of repeated games in legal contexts see, baird, supra note 13, at 159‒87. 37 the use of game theory in international law has been proposed by andrew t. guzman, a compliance-based theory of international law, 90 calif. l. rev. 1823, 1831,1858 (2002), and applied to international tax law by tsilly dagan, the tax treaties myth, 32 n.y.u. j. int’l l & pol. 939 (2000). 38 robert axelrod, the evolution of cooperation 59‒69 (1984). 39 this concept was originally developed in natural sciences. see john maynard smith, evolution and the theory of games (1982), and then it spread to social sciences, see, e.g., john harsanyi & reinhard a. selten, general theory of equilibrium selection in games (1988); j. w. weibull, evolutionary game theory, 59 j. econ. theory, 57–84 (1995); jorgen weibull, evolutionary game theory (1995). 2014] the use of cross-border corporate profits and losses 145 threshold number of cooperating agents, who all choose a single strategy, can create a stable equilibrium impervious to occasional mutations.40 a multi-country coordination strategy regarding cross-border consolidation of profits and losses can be effectively imposed by a binding legal instrument through which global corporate tax information is shared. this coordination among several countries would typically occur through a multilateral treaty, and within the eu tax compact, through enhanced cooperation (which requires the approval of a minimum number of nine member states).41 a game theory approach shows that the ccctb multilateral agreement is effectively the codification of the naturally occurring outcome of the interaction of unilateral strategies of countries in respect to the regulation of cross-border corporate profits. sections 2‒5 therefore will describe those strategies available to residence and source countries, while the final sections 6‒9 will discuss how the interactions of those strategies play out. ii. unilateral tax strategies of residence and sourcecountries in respect to cross-border profits and losses existing domestic tax consolidation approaches (fiscal unity, group relief, and group contribution) limit, from the perspective of residence-countries, the use of crossborder profits and losses because the information needed about them to apply correlative adjustments on a cross-border level is not accessible to the residence-country. this approach is also adopted by the u.s. as well by other countries that exempt the profits of foreign pes, although there are some exceptions and is defined here as the "nonrecognition pattern," because it limits the recognition of cross-border profits and losses.42 these regimes achieve coordination at the domestic level through correlative adjustments based on the sharing of relevant corporate tax information between the consolidated companies and the local tax authorities, but are inadequate to achieve 40 on the evolution of cooperation see robert axelrod & douglas dion, the further evolution of cooperation, 242 sci., 1385–90 (1988); robert axelrod & william d. hamilton, the evolution of cooperation, 211 sci., 1390–96 (1981); robert boyer & andre orlean, how do conventions evolve?, 2 j. evol. econ., 165–77 (1992); jack hirshleifer & juan carlos martinez coll, what strategies can support the evolutionary emergence of cooperation?, 32 j. conflict res., 367–98 (1988). 41 enhanced cooperation was initially introduced by the treaty of amsterdam (1999), which created the formal possibility of a certain number of member states establishing a concerted action between themselves on matters covered by the treaties, using the institutions and procedures of the european union. the european council made those provisions less restrictive when the union was enlarged to 27 member states, and thus the treaty of nice (2003) facilitates enhanced cooperation. the right of veto which the member states enjoyed has been eliminated (except in the field of foreign policy), the number of member states required for launching the procedure has changed from the majority to nine member states, and the procedure’s scope has been extended to the common foreign and security policies. the general provisions applicable to enhanced cooperation have been grouped together in title vii of the treaty on european union. on enhanced cooperation see csaba toro, the latest example of enhanced cooperation in the constitutional treaty: the benefits of flexibility and differentiation in european security and defence policy decisions and their implementation, 11 eur. l. j., 641-656 (2005); norberto nuno gomes de andrade, enhanced cooperation: the ultimate challenge of managing diversity in europe: new perspectives on the european integration process, 40 intereconomics/rev. eur. econ. pol'y 201‒16 (2005); allemand frédéric, the impact of the eu enlargement to economic and monetary union: what lessons can be learnt from the differentiated integration mechanisms in an enlarged europe?, 11 eur. l. j., 586‒617 (2005); v. costantinesco, les clauses de coopération renforcée, le protocole sur l'application des principes de subsidiarité et de proportionnalité, 1997 rev. trim. droit eur. 755. 42 this approach is found for example in france, italy, spain, portugal, austria, germany, the netherlands, luxembourg, finland, sweden, the united kingdom, ireland, and denmark. similar rules are also found in the u.s. 146 columbia journal of tax law [vol.5:133 coordination at the cross-border level through similar correlative adjustments which require exchange of global corporate tax information (for details, see infra table 1). fiscal unity (the u.s. belongs to this cluster) does not include foreign losses, and similarly in group relief the transfer of losses is not recognized, either in the country of the recipient, or in the country of the transferor. in group contribution, transfers of foreign profits by foreign affiliated companies are not recognized in the country of the recipient and are not deductible in the country of the transferor. in those systems such restrictions create disparities of treatment between, respectively, comparable resident recipients (for transfers from resident or from non-resident recipients), and comparable domestic transferors (for transfers to resident or to non-resident recipients). these limitations of domestic tax consolidation systems are essentially due to the lack of access to global corporate tax information, so a few oecd countries (such as france, italy and denmark) have adopted an elective mechanism of international tax consolidation (hereinafter "elective itc"), or, in a more limited form, a consolidation of foreign pes which relies on unilateral measures for collecting such information. this approach ‒ defined here as the "recognition pattern" ‒ relies on unilateral collection by the residence-country of information on foreign corporate profits and losses that is achieved by imposing on foreign consolidated companies significant reporting duties to the domestic consolidating. in itc, the offsetting of profits and losses of all companies of the group, even those resident in different countries, occurs upon election in the country of residence of the ultimate consolidating company, pursuant to the rules of that country. the same effect is obtained with respect to branches, but without election, when consolidation of foreign pes is allowed. thus both in the elective itc and in the mandatory consolidation of foreign pes there is offsetting of profits and losses of foreign companies or branches. the goal of elective itc and consolidation of foreign pes is achieved by relinquishing the tax deferral on profits or losses of foreign consolidated branches/companies and, as a result, consolidated branches/companies resident in different countries are allowed to offset profits and losses if certain requirements are met. thus, elective itc and consolidation of foreign pes are mechanisms in which the profits and losses of consolidated branches/companies are subject to worldwide taxation in the country of residence of the consolidating company, on the basis of extra-territorial tax jurisdiction and unilateral collection of global corporate tax information. in both systems, the profits and losses of non-resident consolidated branches/companies are first taxed in the countries where they are located and then in the country of residence of the consolidating company. this results in an overlap of tax jurisdictions which is remedied by a foreign tax credit in the residence-country, by the consolidating company.43 the unilateral strategies adopted by residence-countries regulating the consolidation of cross-border profits and losses are summarized in table 1. 43 in addition to the offsetting of losses and profits of companies of the group resident in different countries, the model of elective itc has several intra-group features that are ancillary to the global offsetting of profits and losses, such as no or limited taxation of capital gains and losses on shares/assets transferred cross-border between companies resident in different countries, and exemption of cross-border intra-group dividends. the ccctb model shares these features with elective itc, but also it includes the apportionment of income by a formula based on labor, assets and sales, that prevents the need of a foreign tax credit mechanism in the country of the consolidating company. 2014] the use of cross-border corporate profits and losses 147 residencecountry inflow of foreign losses44 inflow of foreign profits45 nonrecognition a  fiscal unity  group relief  group contribution  exemption of foreign pes b  fiscal unity  group relief  group contribution  exemption of foreign pes recognition c  elective itc  consolidation of foreign pes  (mandatory worldwide consolidation)  (modified group relief) d  elective itc  consolidation of foreign pe  (mandatory worldwide consolidation)  (modified group contribution) unilateral strategies of the residence-countries (table 1) the unilateral strategy of a residence-country to limit the inflow of foreign losses from foreign companies to affiliated companies resident in that country is achieved by the methods indicated in cell a of table 1. that unilateral strategy is pursued: (i) in countries that adopt fiscal unity through explicit non-recognition of the inflow (i.e. consolidation) of losses of foreign affiliated companies (while such an inflow is allowed for domestically consolidated companies), (ii) in countries that adopt group relief through explicit non-recognition of losses transferred by foreign affiliated companies (while such transfers are allowed for domestic affiliated companies), and (iii) in countries that adopt group contribution in all cases, because that system focuses on the transfer of profits, so it does not need an explicit non-recognition rule on the transfer of losses (by domestic or foreign transferors). the same unilateral strategy is achieved in countries that adopt the exemption of foreign pes, but there might be exceptions. the unilateral strategy of a residence-country to limit the inflow (i.e. consolidation) of foreign profits from foreign companies to affiliated companies resident in that country is achieved by the methods indicated in cell b of table 1. that strategy is pursued: (i) in countries that adopt fiscal unity through explicit non-recognition of the inflow of profits of foreign affiliated companies (while such an inflow is allowed for domestic consolidated companies), (ii) in countries that adopt group contribution through explicit non-recognition of profits transferred by foreign affiliated companies (while such transfers are allowed for domestic affiliated companies), and (iii) in all cases where a country adopts group relief, because that system focuses on the transfer of losses, so it does not need an explicit non-recognition rule on the transfer of profits (by domestic or 44 foreign losses from the perspective of the residence-country are generated in the sourcecountries where the affiliated/controlled companies or the pe are located. 45 foreign profits from the perspective of the residence-country are generated in the sourcecountries where the affiliated/controlled companies or the pe are located. 148 columbia journal of tax law [vol.5:133 foreign transferors). the same strategy is achieved in countries that adopt the exemption of foreign pes, although there might be exceptions. in the us, foreign corporate profits are not included on a current basis, but are fully consolidated when repatriated as dividends. the unilateral strategy of a residence-country to allow the inflow of foreign losses from foreign companies to affiliated companies resident in that country is achieved by the methods indicated in cell c of table 1. more precisely, that unilateral strategy is pursued: (i) in countries that adopt elective itc and (ii) in countries that adopt the consolidation of foreign pes (of course that strategy would be attained by worldwide mandatory tax consolidation and therefore that approach is included in table 2, but in parentheses.) notably, the recognition pattern is never pursued in countries that adopt group contribution, because that system focuses on the transfer of profits, and therefore, always bars the transfer of losses (by domestic or foreign transferors.) this recognition of foreign losses, in theory, could be achieved in countries that adopt group relief by extending to foreign affiliated companies the transfer of losses domestic affiliated companies are allowed (modified group relief.) such extraterritorial extension of tax jurisdiction, however, is problematic because it might conflict with the domestic rules of source-countries which prohibit deduction of losses transferred to foreign persons. the same result is obtained by mandatory worldwide consolidation. there are no actual instances of these two recognition patterns, and therefore they are included in table 2 within parentheses. the unilateral strategy of residence-countries to allow the inflow of foreign profits from foreign companies to affiliated companies resident in that country is achieved by the methods indicated in cell d of table 1. that unilateral strategy is achieved: (i) in countries that adopt elective itc and (ii) in countries that adopt the consolidation of foreign pes (of course that strategy would be attained by worldwide mandatory tax consolidation and therefore that approach is included in table 2, but in parentheses). notably, this strategy is not pursued in countries that adopt group relief because that system focuses on the transfer of losses and therefore always bars the transfer of profits (by domestic or foreign transferors). the recognition of foreign profits, in theory, could be achieved in countries that adopt group contribution by extending to foreign affiliated companies the transfer of profits that is allowed for domestic affiliated companies (modified group contribution), but this extra-territorial extension of tax jurisdiction conflicts with the interest of the source-country to tax those profits and disallow their deduction. the same result is obtained by mandatory worldwide consolidation. there are no actual instances of these two recognition patterns, and therefore they are included in table 2 within parentheses the tax design choice source-countries face is different from that of residencecountries as they have to decide whether or not to recognize, for tax purposes, the effects of cross-border transfers of domestic losses or profits to an affiliated company located in the residence-country, when such losses or profits are generated by affiliated companies located in the source-country. this issue is usually addressed by straightforward prohibitions of migrations of losses/profits to and from the source country and this creates disparities of treatment between, respectively, comparable resident recipients (for transfers from resident or from non-resident recipients), and comparable domestic transferors (for transfers to resident or to non-resident recipients). group relief (the united kingdom and ireland) adopts unqualified prohibitions on the transfer/receipt of losses to/from foreign affiliated companies. group contribution (sweden and finland) 2014] the use of cross-border corporate profits and losses 149 adopts a similar prohibition of transfer/receive profits to/from foreign affiliated companies, although some source-countries adopt an explicit mechanism that provides for local consolidation in the source-country of pes or companies owned by foreign companies.46 in conclusion, group relief and group contribution are the typical strategies that source-countries adopt to prevent the erosion of the national tax base. by contrast, when a country that adopts fiscal unity (or elective itc) acts as a source-country, no specific rule is available to limit migrations of domestic profits and losses and therefore fiscal unity is not able either to protect the interests of a sourcecountry or to allow the source-country to cooperate with the residence-country should a taxpayer resident in that country use the losses generated in the source-country. this makes possible the double use of the losses of affiliated companies located in sourcecountries adopting fiscal unity; those losses can be used in the source-country under domestic fiscal unity and at the same time may be recognized in the residence-country (for example if losses of a foreign pe are included in domestic consolidation in the residence-country where the parent company is located.) the us also adopts domestic fiscal unity and therefore lacks an effective strategy to prevent the double use of losses generated within the us when it acts as a source-country. a country that adopts fiscal unity can be targeted by taxpayers that exploit the source-based local use of losses by "double-dipping" on those losses through consolidation in the residence-country as well. the unilateral strategies of source-countries that regulate the consolidation of global profits and losses are summarized in table 2. sourcecountry outflow of domestic losses47 outflow of domestic profits48 nonrecognition a  group relief  group contribution b  group relief  group contribution recognition c  (modified group relief )  (modified group contribution) d  (modified group relief )  (modified group contribution) unilateral strategies of the source-countries (table 2) the unilateral strategy of the source-country to limit the outflow of domestic losses in the direction of residence-countries is achieved by the methods indicated in cell a of table 2: (i) in countries that adopt group relief, by not allowing the transfer of 46 nikolaj bjørnholm & anne becker-christensen, the new danish tax consolidation regime, 46 eur. tax'n 47 (2000). 47 domestic losses from the perspective of the source-country are generated in that country where the affiliated company is located. 48 domestic profits from the perspective of the source-country are generated in that country where the affiliated company is located. 150 columbia journal of tax law [vol.5:133 domestic losses to affiliated companies located in residence-countries (while allowing the transfer of domestic losses to affiliated companies located in the same source-country), (ii) in countries that adopt group contribution in all cases, because that system focuses on the transfer of profits so it always bars the transfer of losses by (domestic or foreign) transferors. the unilateral strategy of the source-country to limit the outflow of domestic profits to foreign affiliated companies is achieved by the methods indicated in cell b of table 2: (i) in countries that adopt group contribution, by not allowing the transfer of domestic profits to affiliated companies located in residence-countries (while allowing the transfer of domestic profits to affiliated companies located in the same sourcecountry), (ii) in countries that adopt group relief, because that system focuses on the transfer of losses so it always bars the transfer of profits by (domestic or foreign) transferors. the outflow of domestic losses or profits could be, in theory, recognized by a modified version of group relief and group contribution (see cells c and d of table 2), by allowing the transfer of domestic losses or profits to affiliated companies located in residence-countries, but in the sample of this study there are no actual instances of that policy, except for the top-down impact of ecj decisions (consequently in table 2, modified group relief and contribution are in parenthesis). iii. the interactions of unilateral countries' policies: dominant strategies and uncooperative behavior sections 2 has described the unilateral strategies of residence and source countries in respect to cross-border consolidation of profits and losses. this section discusses how the unilateral strategies of residence-countries interact with those of source-countries in the form of a stylized game described by a matrix that shows the outcomes in terms of the agent's utility functions for every possible combination of strategies the agents (i.e. countries) might use. individual countries generally adopt consolidation regimes that are aimed at offsetting domestic profits and losses, but do not encompass cross-border issues of migrations of profits and losses; moreover there is no sharing of global corporate tax information to counteract beps. no country has so far cut the gordian knot and adopted a mandatory worldwide consolidation system that includes both foreign corporate profits and losses in a comprehensive way. instead, residence-countries and source-countries adopt various unilateral strategies, and as a result there is a high number of possible bilateral situations these situations are described by a multiple-entry matrix in which the columns represent all the strategies that can be adopted by the residence-countries (fiscal unity, group relief, group contribution elective itc, consolidation/exemption of foreign pes – see supra table 1), and the rows represent all the strategies that can be adopted by the source-countries (group relief and group contribution – see supra table 2). a residence-country adopting fiscal unity may interact with a source-country adopting group-relief, a residence-country adopting group contribution may interact with a sourcecountry adopting fiscal unity, and so on. among the numerous combinations of tax policies let us consider by way of an example a situation in which both the residence and the source country adopt group relief as a method to offset profits and losses at the domestic level, i.e. they allow the transfer of losses only between domestic affiliated companies. so in this case the two countries initially do not have information on reciprocal corporate profits and losses and have to decide whether losses should be transferred to a non-resident or recognized by a resident 2014] the use of cross-border corporate profits and losses 151 recipient when the transferor of those losses in not resident. note that the losses viewed by the source-country as "domestic" are viewed by the residence-country as "foreign." for example, the losses of a company resident in the source-country and controlled by a company resident in the residence-country are "domestic losses" in the source-country (i.e. the losses of an affiliated domestic company) and "foreign losses" in the residencecountry (i.e. the losses of an affiliated foreign company). this situation is depicted in table 3 below. the source-country can adopt two unilateral strategies: one strategy is to protect the national tax base (the domestic losses are non-deductible by the transferor resident in the source-country), and the other strategy is not to protect the national tax base (the domestic losses are deductible by the transferor resident in the source-country). the residence-country can also adopt two unilateral strategies: one strategy is to protect the national tax base (the foreign losses go unrecognized by the recipient resident in the residence-country), and the other strategy is not to protect the national tax base (the foreign losses go recognized by the recipient resident in the residence-country.) each cell of the matrix shows the payoffs to both agents when the intersecting strategies (protect/not protect) are played. the source-country's payoff appears as the first number of each pair, the residence-country's as the second (for example in cell b of table 3 the source-country has a payoff of 4 and the residence-country has a payoff of 0). the payoffs are defined here under a prisoner’s dilemmain that they reflect a situation in which a unilateral strategy is selected by an agent regardless of the strategy of the other agent.49 the assumption is that, initially, countries do not communicate and do not have information about reciprocal corporate profits and losses. if the countries, however, were able to communicate, they would be in a position to implement at a cross-border level the same correlative adjustments (deduction by transferor, recognition by recipient) that are achieved at the domestic level when information about domestic corporate profits and losses is fully shared by consolidated companies and national tax authorities. in fact, the exchange of information would enhance tax authorities' enforcement capabilities as both countries would be in a position to prevent the aggressive tax planning techniques that generate their policy concerns (erosion of the national tax base, double use of losses, and creation of artificial profits/losses). if there is sharing of information on reciprocal corporate profits and losses the two countries can apply correlative adjustments at domestic and cross-border level and there is no risk of arbitrage on asymmetric information by taxpayers. in that situation, deduction of losses could be disallowed only in abusive schemes, for example when losses are artificially created in the source-country and transferred to the residencecountry solely for the purposes of setting them off with corporate profits. so information about reciprocal corporate profits and losses is highly prized by the actors of the game (i.e. residence and source countries.)50 in this prisoner’s dilemma game payoffs are established to reflect the value in the residence and source country of information about reciprocal domestic profits and losses and therefore are determined in these four basic situations. 49 baird, supra note 14, at 6-14. 50 the oecd has repeatedly observed how information is relevant in counteracting aggressive tax strategies. see, e.g., oecd, hybrid mismatch arrangements: policy and compliance issues (2012); oecd, tackling aggressive tax planning through improved transparency and disclosure (2011). 152 columbia journal of tax law [vol.5:133  there is no exchange of information about reciprocal corporate profits and losses, the sourcecountry protects it own tax base without while the residencecountry does not protect its own tax base (i.e. losses are not deducted in the sourcecountry but are recognized in the residence-country), the payoff for the source-country is 4 (and for the residence-country is 0);  there is exchange of information about reciprocal corporate profits and losses, and both countries do not protect their own tax bases (i.e. allow a cross-border correlative adjustment: losses deducted in the source-country are recognized in the residence-country), the payoff for both countries is 3.  there is no exchange of information about reciprocal corporate profits and losses, and both countries do not protect their own tax bases (i.e. losses are neither deducted in the source-country nor recognized in the residence-country), the payoff for both countries is 2 (this payoff is lower than 3 because there is no correlative adjustment);  there is no exchange of information about reciprocal corporate profits and losses, the source-country does not protect its own tax base while the residencecountry country protects it own tax base (i.e. losses are deducted in the source-country but are not recognized in the residence-country), the payoff for the residence -country is 0 (and for the source-country is 4). table 3 depicts a prisoner’s dilemma situation in which each agent unilaterally evaluates its possible actions by comparing the payoffs in each column, since this shows each agent which action is preferable for each possible action by the other agent. both countries adopt group relief residence-country protects tax-base foreign losses not recognized by the recipient residence-country does not protect tax-base foreign losses recognized by the recipient source-country protects taxbase domestic losses not deductible by the transferor a 2, 2 b 4, 0 source-country does not protect taxbase domestic losses deductible by the transferor c 0, 4 d 3, 3 2014] the use of cross-border corporate profits and losses 153 an example of a prisoner's dilemma game in respect to cross-border losses (table 3) let us start with the two situations that give the highest or lower unilateral payoff (cell b and c). in these two situations there is no exchange of information about reciprocal corporate profits and losses. in cell b, the source-country does not recognize the deduction of the losses of domestic affiliated companies, but those losses, after transfer to the recipient, are recognized in the residence-country. in this interaction the source-country fully protects its tax base by not recognizing the outflow of domestic losses (payoff: 4.) the residence-country does not protect its tax base at all; the inflow of foreign losses is not limited because the losses are recognized in the residence-country (payoff: 0.) this interaction is favorable only for the source-country when it acts in such a capacity with a payoff of 4 (but when that country acts as a residence country it will get a payoff of 0.) by contrast, in cell c, the residence-country does not recognize the receipt of transferred losses of a foreign affiliated company, but those losses are deductible by the transferor in the source-country. in this interaction the source-country does not protect its tax base at all because the outflow of foreign losses is not limited, as the losses are deductible in the source-country (minimum payoff: 0.) the residencecountry fully protects its tax base by not recognizing the inflow of foreign losses (maximum payoff: 4.) this interaction is favorable only for the residence-country when it acts in such a capacity with a payoff of 4 (but when that country acts as a sourcecountry it will get a payoff of 0.) let us now look at two intermediate situations (cell a and d.) in cell a, neither the residence-country nor the source-country allows, respectively, the deduction (by the transferor) and the recognition (by the recipient) of losses. in this interaction the sourcecountry protects its tax base because the losses are not deductible in the source-country (payoff: 2), and the residence-country protects its tax base by not recognizing the inflow of foreign losses (payoff: 2.) this is not a correlative adjustment because, in light of the fact that there is no exchange of information about reciprocal corporate profits and losses, both countries renounce to apply the group relief based on deduction/recognition of losses. finally, cell d represents the interaction in which both countries cooperate and exchange information on reciprocal corporate profits and losses thereby eliminating information asymmetries. this relies on the assumption that each country can be at times a residence or a source country, so that each country has an incentive to exchange information to better protect its own interests in all cases (i.e. when it acts as a residencecountry and when it acts as a source-country.) as a result, the residence-country and source-country allow, respectively, the deduction (by the transferor) and the recognition (by the recipient) of losses. in this interaction the source-country does not protect its tax base because the losses are deductible in the source-country, but also the residencecountry does not protect its tax base because it recognizes the inflow of foreign losses, and there is exchange of information about reciprocal corporate profits and losses. this interaction ensures an intermediate payoff of 3 for both countries. the payoff is higher than that of the interaction of cell a (in which the individual payoff was 2 for each agent) because, in light of the fact that the two countries fully exchange information on reciprocal corporate profits and losses, there is a correlative adjustment (i.e. group relief) in a cross-border situation combined with cooperation in enforcement. 154 columbia journal of tax law [vol.5:133 in the prisoner’s dilemma described at table 3, the best unilateral strategy is defined for each country by looking at the payoffs. let us start with the source-country. if the residence-country does not recognize foreign losses for the recipient, then the source-country gets a payoff of 2 by not allowing the deduction of losses by the transferor (cell a), and a payoff of 0 by allowing the deduction of losses by the transferor (cell c). by contrast, if the residence-country recognizes foreign losses for the recipient, then the source-country gets a payoff of 4 by not allowing the deduction of losses by the transferor (cell b), and a payoff of 3 by allowing the deduction of losses by the transferor (cell d). therefore the source-country is better off not allowing the deduction of losses by the transferor regardless of what the residence-country does. the residence-country, meanwhile, evaluates its actions by comparing its own payoffs in each row. the residence-country comes to the same conclusion that the source-country does, i.e. that it is better off not recognizing the losses (coming from the foreign transferor) in the hands of the recipient, regardless of what the source-country does. wherever one strategy of an agent is superior to another strategy against every possible strategy available to the opponent, the first strategy strictly dominates the second one. the unilateral strategies that intersect at cell a (not allowing the deduction of losses by the transferor in the source-country; not recognizing the foreign losses for the recipient in the residence-country) strictly dominate the other strategy available to each player. the strategies of the source-country and the residence-country in cell a are therefore dominant strategies from an unilateral standpoint. both agents know this about each other, and thus there is no temptation to depart from these strategies, with the result that both agents will not cooperate by way of a correlative adjustment. the sourcecountry will not allow the deduction of domestic losses by the transferor, and the residence-country will not recognize the foreign losses for the recipient. there is mutual defection as the agents do not cooperate. the foregoing is just an example of a type of interaction (both countries adopting group relief.) the multiple-entry matrix showing all of the interactions of residence and source countries is not diagrammed here in its entirety for brevity’s sake. it suffices to say that there are numerous interactions which are similar to the one depicted in table 3, in which it unilaterally pays off to adopt an uncooperative strategy based on unilateral dominant strategies. in those cases, each country is indifferent to the unilateral strategy of the other country when deciding which strategy to select. consider, for example, a residence-country adopting fiscal unity (consolidation of domestic profits and losses) interacting with a source-country adopting group relief or group contribution (transfer of losses between domestic affiliate companies.) the inflow in the residence-country of foreign profits and losses of affiliated companies located in the source-country is an issue exclusively for the residence-country (i.e. whether these foreign profits and losses should be tax-consolidated by the controlling company), but not for the source country which is indifferent to what the residence-country does. the profits and losses (that for the source-country are domestic profits and losses) are in all cases not subtracted from the national tax base of the source-country, both when the residence-country recognizes them and when it does not. in practice, the dominant strategy of the source-country is to prohibit the deduction of those profits and losses if transferred to a foreign recipient regardless of what the residence-country does. at the same time the dominant strategy of the residence-country is not to recognize the foreign corporate regardless of what the source-country does. 2014] the use of cross-border corporate profits and losses 155 if one, in turn, in the same interactions, looks at the perspective of the sourcecountry (adopting either group relief or group contribution), then the outflow of domestic profits and losses of affiliated companies located in the source-country is an issue exclusively for the source-country (i.e. whether these domestic profits and losses transferred to foreign affiliated companies should be deductible in the source-country), but not for the residence-country, which is indifferent to what the residence-country does. those profits and losses (that for the residence-country are foreign profits and losses) are not included in the national tax base of the residence-country in all cases. in practice, the dominant strategy of the residence-country is to prohibit the inflow of those foreign profits and losses in all cases regardless of how the source-country acts and at the same time the dominant strategy of the source-country is not to allow the transfer of domestic profits and losses without regard to what the residence-country does. these two unilateral dominant strategies basically amount to uncooperative behavior from both players: the two countries do not exchange information about reciprocal corporate profits and losses and do not cooperate in enforcement, so there might be cases in which losses are used twice (i.e. are consolidated in the residence-country and in the source-country) or never used (i.e. are not consolidated either in the residence-country or in the sourcecountry). in these numerous situations, the residence-country and the source-country are unilaterally better off not cooperating, a typical outcome of the prisoner's dilemma. the best strategy, in the jargon of game theory, is a strictly dominant strategy that is always worth taking by a single agent from a unilateral perspective, despite the fact that cooperation would lead to a higher payoff for both agents. in this setting, the pair of dominant strategies of the two agents (mutual defection) is said to be the "solution" to the game, which is the unique nash equilibrium of the game. 51 the preference for a dominant strategy over a dominated strategy is a minimum requirement of economic rationality. this implies that if a game has an outcome that is a unique nash equilibrium that must be its unique solution. this is the reason why in most of the interactions of unilateral strategies concerning cross-border profits and losses, countries currently adopt a dominant strategy. in table 3, that intersection of uncooperative strategies is indicated in cell a, b, and c, which gives in all cases a total payoff of 4 for an uncooperative behavior of both players, while cell d gives a total payoff of 6 for a cooperative behavior of both players. that simplified situation is not far from the real setting in which countries do not exchange information about reciprocal corporate profits and losses, and thus do not share common rules in respect to cross-border consolidation of profits and losses, but rather pursue their own policies without communicating/cooperating. iv. the coordination of residence and source countries based on the exchange of global corporate tax information: the ccctb model if the interactions of strictly dominant strategies do not imply exchange of information about reciprocal corporate profits and losses and result in a prisoner’s dilemma equilibrium, how can countries ever cooperate? the answer is that over 51 the so called “nash equilibrium” was introduced in the seminal works by john nash, nobel prize winner in economics who extended and generalized von neumann and morgenstern's pioneering work. a set of strategies is at a nash equilibrium when it is the case that no agent could improve its payoff, given the strategies of all other agents in the game, by changing its own strategy. this idea is related to the concept of strict dominance: a strategy is a nash equilibrium strategy only if it is dominant (in other terms no strategy could be a nash equilibrium strategy if it is strictly dominated). see baird, supra note 14, at 19‒24. 156 columbia journal of tax law [vol.5:133 repeated interactions, countries play the role of both source-country and residencecountry, so that communication and the resulting cooperation become possible when countries realize that there is a loss generated by non-cooperation that might be remedied by cooperation, achieved through communication and backed by commitment. moreover, in the current uncooperative setting of countries that rely only on unilateral dominant strategies that prevent the cross-border shifting of profits and losses, global taxpayers avoid the unilateral rules of those individual countries by using aggressive tax planning that takes advantage of information mismatches. the most effective tool to counteract such abuses and arbitrages is the possibility for countries to fully exchange information of reciprocal corporate profits and losses thereby cooperating in enforcement. in this situation, correlative adjustments linking the domestic methods of tax consolidation become possible in a cross-border situation. in the model used here, the countries envisage that the interactions will be repeated for an indefinite period of time on the basis of reciprocity and thus engage in some form of agreed-upon coordinated action that leads to the highest possible global payoffs afforded by the game. relying on the game diagrammed in table 3, it is easy to see that the highest global payoff that could be achieved is the intersection of strategies in cell d: a cooperative interaction which implies exchange of information that allows cross-border correlative adjustments in which each agent gets a payoff of 3,52 with a global payoff of 6.53 the initial setting of the prisoner’s dilemma dictates that such a payoff cannot be achieved because it is not a dominant strategy, but a rational policy maker can identify a way out from that deadlock of non-cooperation. it is therefore possible for countries to achieve the tax regulation of cross-border consolidation of profits and losses through either (i) sets of bilateral agreements, or (ii) a single multilateral agreement, thereby creating an international tax regime.54 bilateral agreements pursue solutions that can be attained by two countries on the basis of reciprocity through agreed-upon correlative adjustments based on the exchange of information about reciprocal corporate profits and losses. those situations that were described as uncooperative equilibria of the game can thus be transformed into agreedupon cooperative solutions that afford the highest global payoffs. for example, the very same two countries adopting group relief that were stuck in the uncooperative solution of cell a of table 3, by communicating, can develop inter-dependent agreed-upon mechanisms when the deduction of foreign losses transferred from the source-country to the residence-country (an inflow of foreign losses from the perspective of the residencecountry) is matched by a correlative adjustment in the other country, i.e. the deduction of domestic losses in the source-country (an outflow of domestic losses from the perspective 52 in that cooperative interaction the domestic losses in the source-country are deductible by the transferor, and the foreign losses are recognized by the recipient in the residence-country. 53 if there is an uncooperative interaction that prevents cross-border correlative adjustments (cell a), then they each get a payoff of 2. if there is an uncooperative interaction favorable to the source-country (cell b), then the source-country gets a payoff of 4 (full protection of its tax base) and residence-country gets a payoff of 0 (no protection at all of its tax base). the reverse situation occurs when there is an uncooperative interaction favorable to the residence-country (cell c). 54 the view that there is an actual international law regime that transcends national interests operating in a mere coordination game dominated by unilateral strategies is advocated in reuven avi yonah, international tax as international law supra note 18 at 2‒8; diane m. ring, prospects for a multilateral tax treaty, 26 brook. j. int'l law 1699 (2001); hugh ault, the importance of international cooperation in forging tax policy, 26 brook. j. int'l law 1693 (2001); paul r. mcdaniel, trade and taxation, 26 brook. j. int'l law 1621 (2001). 2014] the use of cross-border corporate profits and losses 157 of the source-country). in this case bona fide transactions would be accepted and arbitrage prevented. for example, the transfer to the residence-country of losses that are artificially created in the source-country solely for the purposes of setting them off with corporate profits would not be allowed. similar uncooperative strategies can occur in other combinations of unilateral dominant strategies that can be transformed into cooperative mechanisms. for example, when two countries adopt group contribution the two strategies become inter-dependent agreed-upon strategies when the taxation in the residence-country of the foreign profits transferred from the source-country (an inflow of foreign profits from the perspective of the residence-country) is matched by a correlative adjustment in the other country, i.e. the deduction of domestic profits in the source-country (an outflow of domestic profits from the perspective of the source-country). similar inter-dependent agreed-upon strategies also occur when two countries exchange information, do not adopt the same system of domestic tax consolidation, but the residence-country adopts elective itc, mandatory worldwide tax consolidation, or consolidation of foreign pes. when the residence-country adopts these types of extra-territorial consolidation, and the sourcecountry adopts either group relief or group contribution, the transfer of, respectively, losses or profits from the source-country is matched by a correlative adjustment in the residence-country in the form of a consolidation of those losses or profits by the consolidating company. these inter-dependent arrangements require bilateral agreements, which in theory could be pursued through protocols to existing tax treaties or by entering ad hoc agreements. this approach might be problematic as clauses that provide for exchange of information about cross-border consolidation of profits and losses are not included in the oecd model treaty, and therefore a multilateral approach would be more feasible. the ccctb constitutes a first attempt of such a multilateral approach to the sharing of corporate global tax information.55 the ccctb is usually seen as a substantive consolidation mechanism of crossborder corporate profits and losses as the consolidated taxable profits are determined in accordance to common eu provisions 56 on the basis of an all-in-all-out rule which mandates that all the companies of the group which have certain requirements are consolidated. 57 the tax bases of the members of a group are consolidated by the 55 in its explanatory memorandum within the ccctb proposal, supra note 16, at 9, the commission indeed acknowledged that rules of such a proposed directive would be ineffective if each member state applied its own system and that the nature of the subject requires a common approach, basically on three grounds, as single set of rules is needed (i) for computing, consolidating and sharing the tax bases of associated enterprises across the union, (ii) for affording cross-border loss relief, tax-free intragroup asset transfers and the allocation of the group tax base through a formula, and (iii) for simplifying administrative procedures. 56 according to articles 6(1) and 104(1) of the ccctb proposal. id. on the election mechanism, see johanna hey, ccctboptionality, in lang et al., common consolidated corporate tax base, supra note 17, at 93‒114. 57 the perimeter is defined by articles 54 and 55. article 54 defines qualifying subsidiaries as immediate and lower-tier subsidiaries in which the parent company holds: (a) a right to exercise more than 50% of the voting rights; and (b) an ownership right amounting to more than 75% of the company’s capital or more than 75% of the rights giving entitlement to profit. article 55 deals with the formation of groups and provides that a resident taxpayer shall form a group with: (a) all its pes located in other member states; (b) all pes located in a member state of its qualifying subsidiaries resident in a third country; (c) all its qualifying subsidiaries resident in one or more member states; (d) other resident taxpayers which are qualifying subsidiaries of the same company which is resident in a third country and fulfils the conditions of 158 columbia journal of tax law [vol.5:133 consolidating company, and when the consolidated tax base is negative, the loss is carried forward and set off against the next positive consolidated tax base (article 56). by contrast, the positive consolidated tax base is apportioned among the countries of the consolidated companies in accordance with a formula based on assets, sales, and labor (articles 86 to 102).58 so the ccctb model treats the group as a single entity for tax purposes.59 this is achieved by relinquishing the principle of tax deferral with regard to the tax positions (profits or losses) of foreign controlled companies.60 game theory however shows that the ccctb can be viewed as a multilateral method for the exchange of global corporate tax information at the eu level because it amounts to an institutional framework that relies on qualified corporate intermediaries – the consolidating and consolidated companies – and allows the full availability of global corporate tax information at a regional (eu) level. in terms of information sharing the ccctb in fact operates as follows. each single participant opts for the ccctb by giving notice to the competent authority of the member state in which it is resident, and the consolidating company gives notice to the tax authority of its country of residence, which becomes the principal tax authority.61 each participant company files its tax return with the competent authority of its country of residence, while the consolidating company files the consolidated tax return with the principal tax authority in its country of residence.62 the consolidated tax return includes all relevant global corporate tax information, inter alia, the identification of all group members, the calculation of the tax base of each group member and of the consolidated tax base, and the calculation of the apportioned share/ tax liability of each group member. 63 the consolidated tax return and supporting documents filed by the consolidating company are stored on a central database to which all the competent authorities have access, but also each participant company keeps records and supporting documents in sufficient detail for audits to be carried out and provides all information relevant to the determination of its tax liability.64 article 2(2)(a). see jan van de streek, the ccctb concept of consolidation and the rules on entering a group, 40 intertax 24–32 (2012); mario tenore, requirements to consolidate and changes in the level of ownership, in lang et al., common consolidated corporate tax base, supra note 17, at 465‒84. 58 articles 86 to 102 of the ccctb proposal, supra note 16, at 49, 55. see also ccctb proposal, supra note 16, at 5 (explanatory memorandum). on the apportionment mechanism in general see michael kobetsky, the case for unitary taxation of international enterprises, 62 bull. int'l tax. 201‒15 (2008); louis thomas marchlen, selected issues on interstate apportionment of corporation income tax in the us: a model for europe?, 38 intertax 163‒66 (2010). 59 according to article 103 the tax liability of each group member is the outcome of the application of the national tax rate to the apportioned share, adjusted according to article 102 (items deductible against the apportioned share), and further reduced by the deductions provided for in articles 76 (interest and royalties and any other income taxed at source. ccctb proposal, supra note 16, at 44, 55. 60 according to article 57 the tax bases of the members of a group are consolidated, and when the consolidated tax base is negative, the loss is carried forward and are set off against the next positive consolidated tax base. ccctb proposal, supra note 16, at 38. when the consolidated tax base is positive, it is shared in accordance with articles 86 to 102 (apportionment of the consolidated tax base). ccctb proposal, supra note 16, at 49‒55. see valerio antonelli & raffaele d’alessio, from consolidated profitand-loss account to group tax base: a ccctb perspective, in lang et al., common consolidated corporate tax base, supra note 17, at 485‒517. 61 article 74 of the ccctb proposal, supra note 16, at 43. 62 article 109 of the ccctb proposal, supra note 16, at 57. 63 article 110 of the ccctb proposal, supra note 16, at 57. 64 articles 115 and 117 of the ccctb proposal, supra note 16, at 60. 2014] the use of cross-border corporate profits and losses 159 the ccctb also introduces significant simplifications for groups operating at a pan-eu level that are essentially a consequence of the sharing of global corporate tax information by the participating countries.65 these simplifications are attained by taxneutralizing intra-group transactions in three major areas. first, under the ccctb proposal rules, cross-border transfers of shares/assets of companies belonging to the group do not lead to the recognition of taxable capital gains and losses, as these gains and losses are recognized only when shares/assets are sold by a company of the group to third parties. 66 second, the ccctb proposal recognizes that intra-group cross-border dividends are exempt for the recipient corporate shareholder to prevent double taxation.67 third, the ccctb proposal neutralizes aggressive transfer pricing techniques because in such a multi-country consolidation there is no need to shift profits from high to low tax jurisdictions, a feature drawn from the european experience that may inspire the u.s. to adopt worldwide tax consolidation.68 unfortunately, a multilateral solution like the ccctb, in the form of a directive, is not feasible in the eu context as it would require the unanimous consent of 27 member states. there is, however, a possibility that the ccctb will be approved through enhanced cooperation. enhanced cooperation would require a minimum of nine member states.69 the evolutionary argument that is advanced here is therefore the following: should the path of enhanced cooperation be pursued, approval would be facilitated by the fact that a set of common operative rules of consolidation of cross-border profits/losses 65 the explanatory memorandum of the ccctb proposal, supra note 16, remarks that businesses operating across national borders will benefit both from the introduction of cross-border loss compensation and from the reduction of company tax-related compliance costs, and notes that allowing the immediate consolidation of profits and losses for computing the eu-wide taxable bases is a step toward reducing overtaxation in cross-border situations and thereby towards improving the tax neutrality conditions between domestic and cross-border activities to better exploit the potential of the internal market. 66 in respect to the explanatory memorandum of the ccctb proposal, supra note 16, the commission has noted that a key obstacle in the single market today involves the high cost of complying with transfer pricing formalities using the arm's length approach, and that transaction-by-transaction pricing based on the "arm's length" principle may no longer be the most appropriate method for profit allocation. 67 according to article 11(c) and (d) of the ccctb proposal received profit distributions and proceeds from a disposal of shares are exempt from corporate tax. ccctb proposal, supra note 16, at 22. article 59(1) also provides that in calculating the consolidated tax base, profits and losses arising from transactions directly carried out between members of a group are ignored. ccctb proposal, supra note 16, at 39. 68 on the critical aspects of transfer pricing in the u.s. market see reuven s. avi-yonah, between formulary apportionment and the oecd guidelines: a proposal for reconciliation, 2 world tax j. 3, 3-5 (2010); reuven s. aviyonah, the rise and fall of arm’s length: a study in the evolution of u.s. international taxation, 15 va. tax rev. 89 (1995); yariv brauner, cost sharing and the acrobatics of arm’s length taxation, 38 intertax 554 (2010): yariv brauner, value in the eye of the beholder: the valuation of intangibles for transfer pricing purposes, 28 va. tax rev. 79 (2008); michael c. durst, it’s not just academic: the oecd should reevaluate transfer pricing laws, 57 tax notes int'l 247 (2010); michael c. durst, the two worlds of transfer pricing policymaking, 61 tax notes int'l 439. 69 see, e.g., eric kemmeren, ccctb enhanced speed ahead for improvements, 39 intertax 208‒ 11 (2011); leon bettendorf, albert van der horst, ruud a. de mooij & hendrik vrijburg, corporate tax consolidation and enhanced cooperation in the european union, 31 fiscal stud. 453‒79 (2010); nerudovà danuse, the possible introduction of ccctb via enhanced cooperation: some open issues, 46 eur. tax'n 187‒96 (2006); bob van der made, european union: a new dawn for further eu tax harmonization, 22 int'l tax rev. 45 (2011); hendrik vrijburg, 50 years of eu corporate income tax harmonization initiatives: is enhanced cooperation the solution? (sep. 29, 2011) (unpublished ph.d. dissertation), available at http://repub.eur.nl/res/pub/26838/thesis_vrijburg.pdf; leon bettendorf, michael p. devereux, albert van der horst, simon loretz & ruud de mooij, corporate tax harmonization in the eu, 25 econ. pol'y 537‒90 (2010). 160 columbia journal of tax law [vol.5:133 among a sufficient number of member states (at least nine) has already emerged. 70 those member states that already have common rules in this area would be willing to enter into a multilateral binding directive, thereby overcoming the current uncooperative situations that have been highlighted in section 3, using the prisoner’s dilemma approach. a multilateral agreement would overcome the need for unanimous consensus among a higher number of parties (all 27 member states) required for the approval of eu directives.71 v. the extension of the ccctb as a multilateral treaty on exchange of global corporate tax information as there is currently no established method for sharing global corporate tax information, the us like other countries has resorted to unilateral strategies to regulate us global firms' use of profits and losses. the us thus interacts with other countries in an environment in which such information is a strategic asset for effective tax enforcement. in respect to corporate cross-border profits and losses, the us acts as a residence-country and at times as a source-country. when the us acts as a residencecountry, it limits the extraction of the national base by us firms who employ techniques to import foreign profits and losses to parent companies in the us. by contrast, when the us acts as a source-country, it limits the extraction of national base carried by non-us firms through consolidation techniques in which us profits or losses from affiliated companies located in the us are transferred to parent companies located abroad. in both cases the us can be the target of aggressive strategies pursued by global taxpayers, resulting in the erosion of the us tax base, double use of losses, and artificial creation of profits/losses. therefore the us could protect its national interests by exchanging information concerning those situations in all cases (i.e. when it acts as a residence-country and when it acts as a source-country). this could be achieved by access to global corporate tax information through a multilateral system which would allow the us to counteract more effectively those strategies pursued by us-based global taxpayers that exploit asymmetries of information and various kinds of mismatches. it is worth considering the current us regime and how it could be improved by exchange of information in respect to cross-border profits and losses of foreign branches and affiliated companies. the us currently uses a domestic approach to fiscal unity72 and therefore when it acts as a residence-country, the corporate losses of foreign affiliates are not recognized in the us, in line with the principle of tax deferral.73 the same 70 in respect to the concept of "operative rules," see carlo garbarino, an evolutionary approach to comparative taxation, 57 am. j. comp. l. 677 (2009). 71 consolidated version of the treaty on the functioning of the european union art. 113, may 9, 2008, 2008 o.j. (c 115) 47. 72 see supra note 20. 73 on the principle of tax deferral see reuven s. avi-yonah, globalization, tax competition, and the fiscal crisis of the welfare state, 113 harv. l. rev. 1573 (2000); reuven s. avi-yonah, obama’s international tax plan a major step forward, 123 tax notes 735 (2009); u.s. treasury dep't, the deferral of income earned through u.s. controlled foreign corporations: a public study (2000), available at http://www.treasury.gov/resource-center/tax-policy/documents/subpartf.pdf; robert j. peroni, j. clifton fleming, jr. & stephen e. shay, getting serious about curtailing deferral of u.s. tax on foreign source income, 52 smu l. rev. 455 (1999); reuven s. avi-yonah, comment on peroni, fleming and shay, “getting serious about curtailing deferral of u.s. tax on foreign source income”, 52 smu l. rev. 531 (1999); reuven s. avi-yonah, to end deferral as we know it: simplification potential of checkthe-box, 74 tax notes 219 (1997); asim bhansali, globalizing consolidated taxation of united states multinationals, 74 tex. l. rev. 1401 (1996); j. clifton fleming, jr. & robert j. peroni, reinvigorating tax expenditure analysis and its international dimension, 27 va. tax rev. 437 at 528–41 (2008); robert j. 2014] the use of cross-border corporate profits and losses 161 approach is adopted for branches with the "branch loss recapture rules" under which the losses of a foreign pe cannot be deducted against us-source income, except to the extent that they exceed foreign source income generated by the taxpayer’s profitable foreign pes.74 with the privilege of deferral, a us person can conduct profitable business or investment activities through a company located in a country where corporate taxes are lower than in the us (most countries qualify because the us corporate rate is one of the highest) without paying us residual tax until the foreign corporation distributes its profits and foreign losses are not recognized in the us.75 thus, us shareholders can defer substantial amounts of us residual taxes and reinvest those amounts in foreign operations but cannot directly use foreign corporate losses. the current us regime of elective deferral, combined with anti-deferral limitations (such as the subpart f rules), has traditionally been presented as the balancing of capital export neutrality (“cen”)76 and international competitiveness objectives,77 but lately it has been shown that the deferral privilege ends up operating as a tax "subsidy" that rewards us persons who locate corporate operations in low-tax foreign countries. the result: the deferral may operate to exempt entirely us low-taxed income until that income is repatriated.78 peroni, deferral of u.s. tax on international income: end it, don’t mend it—why should we be stuck in the middle with subpart f?, 79 tex. l. rev. 1609 (2001); robert j. peroni, the proper approach for taxing the income of foreign controlled corporations, 26 brook. j. int'l l. 1579 (2001); h. david rosenbloom, from the bottom up: taxing the income of foreign controlled corporations, 26 brook. j. int'l l. 1525 (2001); stephen e. shay, revisiting u.s. anti-deferral rules, 74 taxes 1042 (1996). 74 i.r.c. § 904(f)(5) (2012). a similar rule is found in germany and has be the focus of an ecj case. case c-415/06, sew (stahlwerk ergste westig) gmbh, 2007 e.c.r. i-0015. 75 see, e.g., staff on joint comm. on taxation, 110th cong., economic efficiency and structural analyses of alternative u.s. policies for foreign direct investment 3, 14 (2008); charles h. gustafson, robert j. peroni & richard crawford pugh, taxation of international transactions 3, 21–2, 443–45 (2006). 76 the cen standard was originally based on the idea that the efficiency should be evaluated from a worldwide welfare perspective by ensuring production efficiency which implies convergence of pretax returns; see peggy brewer richman, taxation of foreign investment income: an economic analysis (1963); peggy b. musgrave, united states taxation of foreign investment income: issues and arguments (1969); rosanne altshuler, recent developments in the debate on deferral, 87 tax notes 255 (2000). cen is defined by devereux as a standard that "implies that (a) the international tax system will not distort the location decisions of any individual investor, (b) the pretax rate of return in all jurisdictions will be the same (production will be efficiently organized), but (c) investors in different jurisdictions may face different post-tax rates of return on their investment, and hence different incentives to save." michael p. devereux, taxation of outbound direct investment: economic principles and tax policy considerations, 24 oxford rev. econ. pol'y 698 at 701 (2008). 77 see nat'l foreign trade council, international tax policy for the 21st century 56, 59, 93, 126 (2001); u.s. treasury dep't, the deferral of income earned through u.s. controlled foreign corporations, see supra note 74, at 22; u.s. treasury dep't, international tax reform: an interim report 7–8 (1993); 1 u.s. treasury dep't, tax reform for fairness, simplicity, and economic growth 142 (1984), available at http://www.treasury.gov/resource-center/taxpolicy/documents/tres84v1all.pdf. the commentators that disfavor tax deferral are concerned with capital export neutrality and/or locational neutrality. see, e.g., reuven s. avi-yonah, the logic of subpart f: a comparative perspective, 79 tax notes 1775 (1998); stephen e. shay, revisiting u.s. anti-deferral rules, see supra note 74, at 1061, 1063. 78 see: j. clifton fleming, jr., robert j. peroni & stephen e. shay, worse than exemption, 59 emory l. j. 79, 96-98 (2009); staff of joint comm. on tax'n, alternative policies, supra note 76, at 16; terrence r. chorvat, ending the taxation of foreign business income, 42 ariz. l. rev. 835, 844 (2000). 162 columbia journal of tax law [vol.5:133 this has generated a so called "lock-out effect," i.e. us multinationals keep their profits abroad because of the tax benefits of deferral.79 studies by economists have evaluated various issues related to this situation, such as restraints on management's ability to absorb cost resources and problems for shareholders trying to optimize their portfolios.80 there is no extant evidence that us multinationals face a capital constraint caused by the lock-out effect, but the cost of deferral is rapidly increasing because firms are running out of feasible ways to reinvest the sums accumulated abroad.81 lock-out effects are less relevant for other oecd countries which adopt an exemption on foreign un-repatriated corporate profits that does not incentivize retention of those profits abroad. since the us adopts fiscal unity (consolidation of domestic profits and losses), when it interacts with source-countries that also unilaterally adopt a domestic tax consolidation system (such as fiscal unity, group relief or group contribution) the result is a prisoner's dilemma where uncooperative strategies prevail (described supra at section 3.) for example, when the us is interacting with a source-country adopting group relief (transfer of losses between domestic affiliate companies) such as the uk, the inflow in the us of uk corporate profits and losses of affiliated companies located in the uk is not allowed and the us treatment is not interdependently linked to the uk treatment of losses. those profits and losses (that for the uk are domestic profits and losses) are in all cases not deducted from the uk tax base. in practice in a prisoner’s dilemma situation the dominant strategy for the us is not to recognize the uk corporate profits and losses regardless of what the uk does. at the same time, the dominant strategy of the uk is to prohibit the deduction of those profits and losses if transferred to a us recipient regardless of what the us does. these two unilateral dominant strategies amount to an uncooperative behavior of both players: the us and uk do not exchange information about reciprocal corporate profits and losses and do not cooperate in enforcement, so there might be cases in which the uk losses are used twice (i.e. are consolidated in the us and in the uk) or never used (i.e. are not consolidated either in the us or in the uk). this is an example of a recurrent situation: when the us interacts with unilateral strategies of other source-countries, it is stuck in an uncooperative outcome that does not include the exchange of information on corporate profits and losses. however, in some cases the us system unilaterally allows a certain amount of consolidation of foreign corporate profits and losses by adopting a variation to a worldwide consolidation approach referred to as international tax consolidation82. first, the us essentially adopts the consolidation approach for the profits of branches, as it purports to tax foreign-source business income at the same rates that apply to us-source 79 the accumulated earnings of foreign subsidiaries of u.s. resident parent companies totaled roughly $1 trillion in 2008 and today total approximately $1.4 trillion, after net extraordinary dividends in 2005 of about $312 billion in response to the one-year repatriation tax holiday offered by internal revenue code section 965. see economic recovery advisory board, the report on tax reform options 82, available at www.whitehouse.gov/sites/default/files/microsites/perab_tax_reform_report. 80 see a. desai & james r. hines jr., old rules and new realities: corporate tax policy in a global setting, 57 nat'l tax. j. 937 (2004); harry grubert, comment on desai and hines, “old rules and new realities: corporate tax policy in a global setting”, 58 nat'l tax. j. 263 (2005); mihir a. desai & james r. hines, jr., reply to grubert, 58 nat'l tax. j. 275 (2005). 81 lisa bryant-kutcher, lisa eiler & david a. guenther, taxes and financial assets: valuing permanently reinvested foreign earnings, 56 nat'l tax. j. 699, 702‒03 (2008); edward d. kleinbard, stateless income, supra note 1 at 767. 82 see supra section 2. 2014] the use of cross-border corporate profits and losses 163 business income. this suggests that foreign-source losses should be deductible against us-source corporate profits. so when the so called "branch loss recapture rules" do not apply, us taxpayers are encouraged to concentrate loss-generating activities in foreign pes, as the losses are passed through directly to the us. once foreign activities become profitable, us taxpayers are encouraged to transfer those activities to controlled foreign corporations, in order to defer us tax on the foreign-source income.83 second, foreign corporate losses and other deductions may be transferred to the us domestic tax jurisdiction by multinational firms that thereby capture "tax rents."84 the result is that the system morphs into a territorial system as the deferral becomes a final exemption that incentivizes companies to refrain from distributing dividends back to the us and allows the use of foreign corporate losses through purposeful tax planning.85 there are different ways in which these tax rents are achieved. for example, interest expenses attributable to a foreign subsidiary are deducted both in the country of the subsidiary and in the us (country of residence of the company) by applying the "check-the-box" rules.86 according to those rules, an eligible person that has but one owner, and which elects pass-through treatment, is disregarded as a separate entity for us federal tax purposes. its activities are treated as a sole proprietorship, branch, or division of its owner.87 as a result, us firms are allowed to bypass subpart f rules by electing, solely for us tax purposes, to treat a foreign corporate subsidiary as a tax-transparent vehicle, rather than a separate taxable person to which the rules of subpart f might apply.88 in practice, check-the-box rules allow attribution of foreign corporate profits or losses by electing transparency of foreign vehicles. in such schemes, losses attributable to a foreign transparent vehicle are available to offset income of the parent company, but at the same time the transparent vehicle may also deduct the interest expense against the income of other companies resident in the same country.89 another example of a tax rent that leads to the creation of losses in the us acting as the residence-country, is when us companies deduct costs in the us which are not 83 these schemes are counteracted by the so-called "branch loss recapture rules," according to which prior losses of the pe are attributed to the us parent when the pe's assets are transferred to a controlled foreign company. see i.r.c. § 367(a)(3)(c)(2012); treas. reg. § 1.367(a)-6t (2013); boris i. bittker & james s. eustice, federal income taxation of corporations and shareholders ¶ 15.81[1][c] (7th ed. 2006); charles h. gustafson, robert j. peroni & richard crawford pugh, taxation of international transactions, supra note 76, at 15. 84 competition among source-countries pushes multinational firms to move taxable profits from high-tax to low-tax jurisdictions while, at the same time, securing high-tax country pre-tax returns. this implies that multinational firms, but not wholly-domestic firms, can capture the higher pre-tax returns found in high-tax countries, but pay low taxes on them by shifting the locus of taxation of those high pre-tax returns to a low-tax jurisdiction. on this concept of "tax rents," see kleinbard, supra note 1, at 752–57 (2011). 85 see kleinbard, supra note 1, at 716‒27 (2011); j. clifton fleming, jr. et al., supra note 79. on the exemption as a relief from double taxation of foreign income see yariv brauner, an international tax regime in crystallization, 56 tax l. rev. 259, 284‒87 (2003); gustafson et. al., supra note 76, at 15. 86 on these aspects see robert j. peroni, steven a. bank & glenn e. cove, cases and materials on taxation of business enterprises 40–48, 804–21 (4th ed. 2012). 87 when a check-the-box election is made in respect of a wholly-owned subsidiary, the subsidiary is referred to as a "disregarded entity" because its separate juridical status is ignored for all u.s. tax purposes as the subsidiary is treated as an extension of its sole corporate owner. 88 see offshore profit shifting and the u.s. tax code – part 1 and 2, supra note 9. 89 treas. reg. § 301.7701-3 (2006). before 1997, most interest income (or other income items deducted by the payor) earned by a foreign subsidiary domiciled in a low-tax jurisdiction were characterized as subpart f and therefore were taxed immediately in the u.s. see also oecd, supra note 4, at 58. 164 columbia journal of tax law [vol.5:133 related to profits taxable in the countries where the deduction is claimed.90 for example, a multinational firm's systematic use of domestic borrowing erodes the us corporate tax base because the firm's interest expense is deductible in the us, while the resulting foreign corporate profits are not accounted for, because of deferral. in practice, taxation on profits is deferred, while deduction of related costs is anticipated through an arbitrage mechanism in which the costs that generate exempt profits are deducted.91 so the fact that in certain cases the us law allows deductions properly allocated to un-repatriated, foreign-source income enhances the deferral benefit by producing a worse-thanexemption negative tax rate.92 to counteract this phenomenon, as well as the lock-out effect, the president's 2005 advisory panel on tax reform proposed an exemption for active foreign-source income. symmetrically, the panel's proposal would disallow domestic deductions for costs directly allocated to exempt foreign-source income, as well as interest (allocated under a worldwide apportionment approach) and overhead expenses allocated to exempt foreign-source income.93 when the us in all the instances described above allows effective consolidation in the us of foreign corporate profits and losses, and interacts with a country that is adopting a domestic tax consolidation system which unilaterally protects its own tax base, the us has a dominant unilateral strategy which may not protect us tax base. for example if the source-country does not allow the transfer of domestic profits and losses (this respectively occurs in group contribution and group relief), those foreign corporate profits and losses are recognized by the us irrespective of what the source-country does. because in these cases there is no exchange of information with the other country about reciprocal corporate profits and losses, there can be dual use of losses (for example losses are used in the source-country and also consolidated in the us, or foreign profits are exempted but related costs are deductible in the us). as a result, the us and other countries that use fiscal unity are targeted by taxpayers that "double dip" by using profits and losses locally in the source-country and then use those same profits and losses again while consolidating in the us (residence-country). the us, however, is not always a residence-country in respect to cross-border profits and losses. it acts as source-country when foreign investors establish pes or affiliated/controlled companies in the us. us corporate profits and losses may be used to achieve tax optimization at global level, in certain cases with a detrimental effect for the us. in those situations the us lacks an effective strategy to prevent the double use of losses generated within the us. the reason for this is that the domestic fiscal unity approach adopted in the us does not include rules that prevent the use of domestic 90 see, for example, offshore profit shifting and the u.s. tax code – part 1 and 2, supra note 9. 91 on the mismatch between exempt profits and deductible costs see: harry grubert & rosanne altshuler, corporate taxes in the world economy: reforming the taxation of cross-border income, in fundamental tax reform: issues, choices, and implications 319, 328 (john w. diamond & george r. zodrow eds., 2008); michael j. graetz & paul w. oosterhuis, structuring an exemption system for foreign income of u.s. corporations, 54 nat'l tax j.771, 781 (2001). 92 clifton fleming, jr. et al., supra note 79, at 116. 93 the national foreign trade council, comments to the president's advisory panel on tax reform, available at http://govinfo.library.unt.edu/taxreformpanel/comments/_files/usinternationaltaxsystem.pdf, at 102–105, 132–35, 239–43. see also harry grubert, enacting dividend exemption and tax revenue, 54 nat’l tax j. 811 (2001). 2014] the use of cross-border corporate profits and losses 165 corporate profits and losses in another residence-country and, as a result, the us is not capable of cooperating with residence-countries to prevent the dual use of losses.94 when acting as a source-country, this problem is exacerbated when the us, as a resident-country, also interacts with source-countries that adopt domestic fiscal unity because also in that case there can be dual use of losses. in conclusion, if there is no exchange of information and the us acts as a residence-country in respect to cross-border corporate profits and losses, the us cannot fully protect its tax base. likewise, if there is no exchange of information and the us acts a source-country, it cannot cooperate with other countries to prevent the double use of corporate profits and losses. in both cases the reason for the lack of coordination is that the us is stuck in uncooperative outcomes which do not allow access to global corporate tax information. there is clearly a need to recalibrate the us system of taxation of multinational groups to limit aggressive tax strategies by global taxpayers and the us could effectively pursue that goal by seeking access to global corporate tax information. the political process leading to a change of the status quo of the tax treatment of us-based multinationals is, at best, unpredictable at this stage. however, assuming that a consensus could be reached on a change of the current situation, the broad policy choice would be, in theory, between a worldwide tax consolidation system and a territorial tax system. these alternatives will not be discussed in details here, but the point is that, although each of these alternatives adopts a radically different solution to the tax treatment in the us of cross-border corporate profits and losses, under both of them the us would have an incentive gain access to global corporate tax information. a worldwide tax consolidation system would fully include foreign corporate profits and losses, on a current basis, in the taxable base of the us, net of related expenses, and provide relief from double taxation through a foreign tax credit. this system would require the rollback of the existing deferral principle because foreign corporate profits and losses would be included in the us taxable base on a current basis, and subject to the same u.s. corporate tax rate. worldwide consolidation would therefore need to include rules to prevent effective corporate inversions. the major issue with mandatory worldwide consolidation is the tax competitiveness of us firms because us firms would face the same us tax rate everywhere and they would not enjoy the same after-tax rate of return on investment reaped by their competitors in source-countries when those competitors are ultimately exempt in their residence-countries that adopt the territorial system.95 94 other source-based consolidation system have an outright prohibition of extraction of corporate profits and losses. for example in group relief (uk and ireland) there is a prohibition to transfer all kinds of profits to all kinds of entities and a prohibition to transfer domestic corporate losses to foreign affiliate companies. by the same token in group contribution (sweden and finland) there is a prohibition to transfer all kinds of losses to all kinds of entities and a prohibition to transfer domestic corporate profits to foreign affiliate companies. 95 it is however reasonable to expect that, once the impact of aggressive tax planning that erodes the us base is significantly limited by a worldwide consolidation approach, a convergence of after-tax returns would intervene. in a scenario dominated by tax competition among source-countries in which one residence-country, such as the us, fully adopts a single rate for worldwide consolidated profits that is aligned with median weighted average tax rates, after-tax returns on net business income would in fact tend to converge around a single global rate, so that both cen and con would be satisfied from the perspectives of the us. cen would be satisfied because us firms would face the same after-tax returns everywhere and con would be satisfied because in source-countries foreign and domestic investors would face the same after-tax opportunities. 166 columbia journal of tax law [vol.5:133 mandatory worldwide consolidation, however, offers some important advantages over the current system of deferral in respect to the tax treatment of cross-border corporate profits and losses.96 first, as worldwide consolidation would include both foreign corporate profits and losses, it would cure the current asymmetry in which foreign corporate profits are includable in the us tax base when repatriated, while foreign corporate losses are not directly recognized.97 second, worldwide consolidation would address aggressive tax strategies that are aimed at the erosion of the us corporate tax base for the simple reason that profits shifted to low-tax foreign jurisdictions would still be taxed in the us, i.e. the country of residence of the consolidating company. third, worldwide consolidation would dismantle the idiosyncratic us mechanism in which repatriations of foreign profits as dividends is, in practice, prevented because those profits would be taxed in the us (i.e. the country of residence of the consolidating company) regardless of their repatriation as dividends, while foreign losses would be generally deductible. fourth, worldwide consolidation would mitigate the problem of expense allocations because it would allow the deduction of domestic and foreign expenses attributable to taxable income. finally, worldwide consolidation would solve transfer pricing problems, because there would be no advantage in using aggressive transfer pricing strategies to move profits from the us to low-tax foreign affiliates. the tax erosion of the us corporate base is endogenously created by the us through the compounded effect of the deferral system and the erosion techniques pursued by us global firms.98 so, the us is in a position to reverse that situation unilaterally, without the need to negotiate the apportionment of profits and losses with other countries (and this implies that the us does not have to rely on multilateral approaches on the apportionment of tax base, such as that adopted by the ccctb.) the fact that in the oecd area the us is the residence-country whose corporate tax base is most eroded by aggressive tax strategies of its own multinational firms99 is a major reason for the us to introduce a worldwide tax consolidation system rather than a territorial one. the worldwide tax consolidation option certainly would provide a systemic approach to the tax treatment in the us of cross-border corporate profits and losses, but obviously faces major political hurdles mainly in respect to the tax competiveness issues, so that the policy debate recently has shifted to the other basic overhaul option, the territorial tax system. 100 a territorial system would in theory fully disallow the consolidation of foreign corporate profits and losses and the expenses related to such exempted income and therefore would align the us with the strategies adopted by most eu countries which exempt repatriated dividends by loosely relying on "capital import 96 for an analysis of mandatory worldwide tax consolidation see kleinbard, supra note 1, at 152‒71 97 both the territorial system and worldwide tax consolidation attain symmetry in respect to foreign corporate profit and losses, as in the former case they are both excluded, and in the latter case they are both included. 98 data can be found in offshore profit shifting and the u.s. tax code – part 1 and part 2, supra note 9 . 99 on such techniques see kleinbard, supra note 1, at 728‒49; clifton fleming, jr. et al., supra note 79, at 110‒45. differently from the situation in the eu area, in the u.s. there is almost complete overlap between the residence of ultimate parent companies (barring corporate inversions) and the residence of the effective shareholders, and thus worldwide corporate taxation in the u.s. can be viewed as a form of worldwide taxation of the firm’s individual owners resident in the u.s. 100 see, e.g., harry grubert & rosanne altshuler, fixing the system: an analysis of alternative proposals for the reform of international tax (april 1, 2013) (unpublished manuscript), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2245128. 2014] the use of cross-border corporate profits and losses 167 neutrality" ("cin".)101 in a territorial system us residents would be treated differently depending on the location of their income but would compete with foreign companies in the source-country at the same tax rates.102 a variant of the territorial system that has been proposed is a system of formulary apportionment for taxing the corporate income of multinational firms. under this proposal, the us tax base for multinational corporations would be calculated based on a fraction of their worldwide income, determined by the share of their worldwide sales that occur in the us. only the portion of corporate profits commensurate with the apportionment formula would be consolidated.103 the move toward a territorial system has been advocated by desai and hines on the basis of a new standard denominated "capital ownership neutrality" ("con".) they point out that the traditional cen model assumes that (i) an outbound direct investment by a us firm is completely replaced by an inbound direct investment of a foreign firm and (ii) the us income tax liability incurred by that inbound investment is identical to the tax revenues that would have been obtained had the us multinational made the domestic investment. desai and hines propound that con requires that "world welfare is maximized if the identities of capital owners are unaffected by tax rate differences."104 in practice, they argue that decisions by us investors ‒ specifically acquisitions of target assets in other countries ‒ should not be distorted by the higher us taxes that affect those us investors. consequently, con suggests that the us should adopt a variation of the territorial tax system in which foreign income would be exempted, deductions incurred by the us parent company related to the production of that foreign income would be allowed, and foreign corporate losses would not be fully consolidated. a proposal for national neutrality that, like the con approach, looks to protect us competitiveness, would adjust the nature of the foreign tax credit by making us taxpayers indifferent between paying foreign taxes and us taxes. taxes paid to the us increase us revenues and make a bigger contribution to the welfare of us taxpayers than taxes paid to foreign governments. so it has been argued that it is preferable for us taxpayers to pay us taxes rather than foreign taxes, and thus the standard of "national neutrality" which makes foreign taxes deductible (rather than creditable) should be 101 according to cin a firm should face the same tax burden in operating in a foreign country as do its domestic competitors in that foreign country. cin, therefore, implies taxation only in the source-country under a territorial system adopted the residence-country. cin would promote worldwide welfare by ensuring that investments are made on the basis of after-tax income at country level and implies a convergence of after-tax returns; see michael s. knoll, reconsidering international tax neutrality, 64 tax l. rev. 99, 119‒ 21 (2011). 102 clifton fleming, jr. et al., supra note 79, at 149‒50; j. clifton fleming, jr., robert j. peroni & stephen e. shay, some perspectives from the united states on the worldwide taxation vs. territorial taxation debate, 3 j. austl. tax teachers ass'n35, 44 (2008); lawrence lokken, does the u.s. tax system disadvantage u.s. multinationals in the world marketplace?, 4 j. tax'n global transactions 43 (2004). 103 reuven s. avi-yonah, kimberly a. clausing & michael c. durst, allocating business profits for tax purposes: a proposal to adopt a formulary profit split, 9 fla. tax rev. 497, 498 (2009); reuven s. avi-yonah & ilan benshalom, formulary apportionment— myths and prospects, 3 world tax j. 371, 380‒81 (2011); see also julie roin, can the income tax be saved? the promises and pitfalls of adopting worldwide formulary apportionment 61, 171–75, 182–85 (2008). 104 mihir a. desai & james r. hines jr., evaluating international tax reform, 56 nat'l tax j. 488, 494-96 (2003); mihir a. desai & james r. hines, jr., old rules and new realities: corporate tax policy in a global setting, see supra note 77, at 956-57. 168 columbia journal of tax law [vol.5:133 adopted.105 under national neutrality, like under the proposed territorial system, foreign corporate profits and losses would not be consolidated. why then both the worldwide consolidation and the territorial approach, in spite of radical differences, would incentivize the us to become a party to a multilateral system of sharing of global corporate tax information? worldwide tax consolidation would obviously require us parent companies to pool the relevant financial and tax data on profits and losses reported by the consolidated companies and compute consolidated profit and losses on the basis of common rules. this would be accomplished by unilaterally imposing reporting requirements on foreign affiliate companies, but of course there would also be an interest for the us to rely on a multilateral system of global corporate tax information established at the international level. the territorial system would not require systemic consolidation of tax data, but may include minimum taxes on foreign active income, 106 with the practical consequence that it also would require reporting of foreign corporate profits to us tax authorities, so that also in a territorial option the us would have an interest to rely on a multilateral system of global corporate tax information. the game theory perspective adopted here shows that the ccctb is essentially a multilateral treaty that relies on qualified corporate intermediaries – the consolidating and consolidated companies – to achieve the full sharing of global corporate tax information by the participating countries. thus the us might request eu assistance in amassing global corporate tax information. in exchange the us would provide similar information relating to us operations of eu-based firms to eu tax authorities or to the authorities of individual member states. this reciprocity could be accomplished through a treaty between the eu and the us which would be connected with the ccctb framework. in the ccctb system, each eu-participant allows other eu participants full access to relevant information about domestic corporate profits and losses, and, in exchange, is allowed to tax a portion of consolidated profits on the basis of the apportionment formula. in a potential treaty for the sharing of global corporate tax information between the us and the eu, however, there would be no need to apply the apportionment formula because the quid pro quo would be simply the exchange of global corporate tax information between the us and the eu. in conclusion, there are at least four good reasons why the us should subject itself to such a multilateral treaty on the exchange of global corporate tax information. first, such a treaty would not limit in any manner the scope of us territorial and extraterritorial tax jurisdiction as it would only concern the sharing of information. second, the multilateral regulation of exchange of global corporate tax information would not pose the daunting problems faced by fatca as it would essentially rely on the sharing by the us and other treaty partners of accessible accounting and tax data normally managed by corporations in oecd countries. third, multilateral regulation of exchange of global corporate tax information would provide assurance to the us that other countries would cooperate, without the need to resort to the treaty-based exchange of 105 see: daniel shaviro, why worldwide welfare as a normative standard in u.s. tax policy?, 60 tax l. rev. 155, 178 (2007); daniel shaviro, the case against foreign tax credits, 3 j. legal analysis 65, 74-77 daniel shaviro, the rising tax-electivity of u.s. corporate residence, the david r. tillinghast lecture, nyu school of law (sept. 21, 2010), in 64 tax l. rev. 377, 393, 393 n. 43; kimberly a. clausing & daniel shaviro, a burden-neutral shift from foreign tax creditability to deductibility?, 64 tax l. rev. 431 (2011). 106 see, e.g., harry grubert & rosanne altshuler, supra note 101, at 8‒13, 35‒40. 2014] the use of cross-border corporate profits and losses 169 information contemplated by article 26 of the oecd model convention. finally, as the interactions would be repeated over time the us could count on the expected behavior of eu countries based on the incentives of reciprocity. microsoft word 4 hasen.docx 120 articles legal transitions and the problem of reliance david m. hasen* this article analyzes the literature on legal transitions. the principal focus is taxation, but the analysis generalizes to other areas. i argue that the theoretical apparatus developed by scholars active in the legal transitions area suffers from significant conceptual shortcomings. these shortcomings include the unwarranted assimilation of legal to factual change, the naturalization of conventional arrangements, and the disregard of the distinction between making law and finding it. as a consequence, the recent literature offers an analysis that is unable either to explain actual transitions or to provide an adequate theory of how legal change should take place. in the end, the older view of legal transitions is more capable than the newer one of providing an adequate normative and positive framework for understanding legal transitions. i. introduction ............................................................................... 121 ii. legal transitions ...................................................................... 124 a. in general .............................................................................. 124 b. the case for immediately effective, uncompensated transitions ............................................................................. 130 c. nominal retroactivity ........................................................... 132 iii. the apparatus of recent transitions analysis .................. 135 a. entitlement rules and transition rules ................................ 136 * professor of law, penn state university. i thank curtis bridgeman, neil buchanan, bill gentry, michael graetz, alex raskolnikov, dan shaviro and participants at a number of talks, as well as the editors of the columbia journal of tax law, for helpful comments and criticism. i remain solely responsible for any errors. 2010] legal tra'sitio's 121 b. implications of the entitlement rule-transition rule dichotomy ............................................................................. 137 1. transitions vs. transition rules ....................................... 137 2. relevant anticipations ..................................................... 139 3. implied vs. express transition rules .............................. 139 4. scientific developments are not legal transitions. ...... 140 iv. criticism ....................................................................................... 141 a. analogy of legal transitions to factual developments ....... 142 b. problems with a single transition “norm” .......................... 145 1. retroactive relief—naturalization of the market ........... 146 2. announcement date relief—new interpretations as new law .......................................................................... 151 c. the conventional nature of legal regimes ......................... 153 v. reliance and reasonable expectations ............................... 155 a. the new view critique of reliance...................................... 157 b. the positive case for reliance .............................................. 161 1. first case: change in material circumstances ............... 163 2. second case: change in legislative judgment .............. 164 (a) first variation: same elected body ........................ 164 (b) second variation: subsequently elected body ....... 167 c. the linguistic basis of reliance ........................................... 169 vi. conclusion .................................................................................. 170 i. introduction the academic literature on legal transitions has grown substantially over the last twenty-five years.1 its subject is the proper timing of legal change: when a new legal rule is announced, what rules or norms should govern the time at which the rule comes into force? further, what relief, if any, should be made available to those who suffer an unexpected loss from the change, and what charge, if any, should be imposed upon those who enjoy an unanticipated windfall from it?2 if congress passed legislation 1. seminal treatments include those of michael graetz, legal transitions: the case of retroactivity in income tax revision, 126 u. pa. l. rev. 47 (1977) [hereinafter graetz, legal transitions], and louis kaplow, an economic analysis of legal transitions, 99 harv. l. rev. 509 (1986) [hereinafter kaplow, economic analysis]. more recently, daniel shaviro has provided a comprehensive analysis of legal transitions with an emphasis on tax transitions. see daniel shaviro, when rules change: an economic and political analysis of transition relief and retroactivity (2000). additional extensive discussion is found in 13 j. contemp. legal issues, the first issue of which compiles papers delivered at a symposium on legal transitions. 2. see louis kaplow, transition policy: a conceptual framework, 13 j. contemp. 122 columbia jour'al of tax law [vol. 1:120 tomorrow raising the top marginal tax bracket to seventy percent, should that rate apply only to income earned from tomorrow forward; only to income earned from some later date forward; or to some income already earned as well as to income yet to be earned? further, would it be appropriate to offer relief to taxpayers who planned the timing of their income on the assumption that the old marginal brackets would persist for some period of time? one of the notable features of the recent transitions literature is the consequentialist orientation it has adopted in answering these questions.3 rather than focus on the fairness or reliance aspects of various possible transition rules, scholars currently active in the area have typically adopted an anticipations-oriented approach that focuses on the efficiency consequences of various possible transition norms. from this perspective, the transition question becomes: what set of expectations about the effective date of future, as yet unknown changes to legal rules and about possible “transition relief” produces socially optimal pre-transition conduct among individuals who will be affected by such changes? the general answers upon which scholars writing in the area have settled are that norms of immediate effect (or, in some cases, earlier) and no transition relief produce optimal results.4 consistent with this orientation, the recent literature has taken as broad a perspective as possible on the scope of the transition question.5 when the focus is on expectations, the transition question arises in any setting in which norms regarding the timing of changes to legal entitlements may have an effect on pre-change expectations and, hence, conduct. these settings include not only changes to positive law, but also judicial reinterpretation of the law, administrative rule making, and even announcements of administrative policy, such as, for example, the federal reserve chair’s pronouncements on the health of the economy.6 in each, governmental action produces a change to legal entitlements (or to legal issues 161, 163–68 (2003) [hereinafter kaplow, transition policy]. 3. see, e.g., kyle d. logue, legal transitions, rational expectations, and legal progress, 13 j. contemp. legal issues 211, 216 n.5 (2003) [hereinafter logue, legal transitions]. 4. see, e.g., kaplow, economic analysis, supra note 1, at 551 (“the economic analysis presented thus far generally favors a transition policy of nominally prospective implementation of changes in government policy with no transitional relief.”); shaviro, supra note 1, at 229 (generally proposing no transition relief for “policy change retroactive taxes”—i.e., for transitions where the new steady-state rule has different content that the prior one). 5. see, e.g., saul levmore, changes, anticipations, and reparations, 99 colum. l. rev. 1657, 1658 (1999) [hereinafter levmore, changes]. 6. see kaplow, economic analysis, supra note 1, at 517 (citing, among others, “changes in monetary and fiscal policy” as instances of legal transitions). 2010] legal tra'sitio's 123 expectations regarding legal entitlements), and in each, expectations about the effective date of any such future change have an impact on the prechange conduct of affected parties. thus, one commentator has defined the term legal transition as the resolution of any uncertainty regarding future legal rules to the extent that the uncertainty affects decisions made currently.7 another has defined it as any change to legal entitlements.8 in this article, i argue that the conceptual apparatus that supports the approach just described is flawed, and that the transitions analysis that rests on it is in many ways unpersuasive as a consequence.9 because the literature begins by assimilating all manner of changes to entitlements to a single model of quasi-factual change, it elides distinctions that are needed to explain background assumptions that the literature tacitly makes but cannot support. these assumptions are both necessary for, but inexplicable within, a model that understands legal transitions as closely akin to marketbased or natural change. if the assumptions are abandoned, the market model of legal change on which so much of the transition analysis rests collapses. if the assumptions are retained, the distinctions among the various types of legal change that the recent literature tends to dismiss need to be retained, and if these are retained, many of the tenets of the older view discarded under the newer view regain their vitality. as important as what i argue below is what i do not argue. i do not claim that the “new view” transitions literature has advanced wildly implausible normative or empirical claims, or that there is nothing to be gained from the anticipations-oriented approach. nor, conversely, do i suggest that proponents of the “old,” reliance-based view identified the correct set of transition norms. rather, the claims here are that the current literature is analytically deficient, to some extent schizophrenic, and largely unable to generate defensible propositions about transition norms that are different from those of, and not better understood within, the “old view” of legal transitions that it rejects. the analytical deficiencies include a failure to develop consistent definitions of such key concepts as “transition,” “legal transition,” and “transition norm”; the schizophrenia consists in the reliance of “new view” theorists on some of the same transition practices that they 7. id. at 512. 8. see shaviro, supra note 1, at 25–26. 9. others have criticized the recent transitions literature as unhelpful, though generally on different grounds. see, e.g., michael doran, legislative compromise and tax transition policy, 74 u. chi. l. rev. 545 (2007). in a similar vein, mark ramseyer and minoru nakazato have opposed the now dominant view that transition relief is typically a bad idea by arguing that a requirement of grandfather relief when the law changes enables congress to insulate itself from lobbying groups interested in retaining prior, presumably worse, law. see mark ramseyer & minoru nakazato, tax transitions and the protection racket: a reply to professors graetz and kaplow, 75 va. l. rev. 1155 (1989). 124 columbia jour'al of tax law [vol. 1:120 criticize; and the literature’s inability to generate novel and defensible claims is evidenced by its failures to account for the differing transition defaults operative in the adjudicative and legislative arenas, and to demonstrate that a reliance-based view is unable to reach correct results on the question of the proper default norms for changes to positive law and for judicial decisions that adopt new rules. part ii sets out a brief history of the of the transitions literature and describes the currently dominant “new view” approach to legal transitions. part iii examines the assumptions on which the new view relies and reformulates that view in a way that makes explicit its conceptual underpinnings; the principal purpose of this exercise is neither to defend nor to criticize the new view, but instead to offer an account that adequately operationalizes it. part iv offers a criticism of the new view account of legal change as so reformulated, and part v extends the criticism to the arguments that new view scholars have made against reliance as a basis for certain forms of transition relief. ii. legal transitions a. in general the legal transitions literature asks the question: what norm or norms should govern the relationship between the time at which a change in law is announced and the time at which the change becomes effective? subsidiary questions are whether and what kind of relief or penalties should apply to individuals who are affected by the change because of pre-change decisions they made in reliance on the old rule. should individuals adversely affected receive transition relief in the form of grandfathering, phased implementation or some other method, or should they simply absorb the costs that result from unanticipated legal change? similarly, should the unintended beneficiaries of legal change have some or all of the benefits taxed away?10 the literature’s paradigmatic example is the repeal of the exclusion 10. for each of these questions, the issue is what to do about the consequences of the transition that result from its having been unanticipated, not about the gains or losses that different individuals experience as a result of the new legal rule on a steady-state basis. thus, the fact that labor may be less favorably taxed under a consumption tax than under an income tax does not by itself create a transition issue on the shift from an income tax to a consumption tax. however, to the extent that individuals, prior to the transition, allocated more of their resources to the future production of labor income on the assumption that the income tax would continue indefinitely, a transition issue does arise on the shift to a consumption tax. see kaplow, economic analysis, supra note 1, at 516. 2010] legal tra'sitio's 125 from gross income of interest earned on certain municipal bonds.11 if congress repealed the exclusion tomorrow with an immediate effective date, certain parties would be adversely affected by their failure to anticipate the repeal at the time they made decisions that are affected by it. an individual who purchased a thirty-year tax-exempt bond last year would suffer a substantial transition loss, because virtually all of the benefit of the exclusion would be lost.12 similarly, states and municipalities would suffer transition losses to the extent they had committed resources to future projects on the assumption that they would be able to finance those projects with future borrowing at a low interest rate. analogously, holders of taxable debt would enjoy an unanticipated windfall because the value of the debt would rise. had any of these parties been aware of the impending repeal at the time they were making the relevant investment decisions, they likely would have acted differently. if congress thought issuers or holders of municipal bonds should be protected from the losses that arise on unanticipated repeal, then congress could adopt an effective date of the new rule far into the future, make some sort of relief available for pre-repeal investors, or both. for example, the repeal could be implemented in steps (such as by removing the exclusion for a fraction of the interest initially, with greater fractions removed in subsequent years), or it could be applied only to bonds issued after the enactment date.13 conversely, if one thought that investors’ and issuers’ anticipation of new law would produce better outcomes overall than does their reliance on the availability of relief, one might favor immediate or even explicitly retroactive application of a repeal with little or no transition relief. prior to michael graetz’s influential work on tax transitions, what has since become known as the “old view” of legal transitions held sway.14 under the old view, the norm that changes to positive law should take effect 11. i.r.c. § 103 (2010). graetz made this example the focus of his analysis, and subsequent authors have done so as well. see graetz, legal transitions, supra note 1, passim; kaplow, economic analysis, supra note 1, at 515–16; saul levmore, the case for retroactive taxation, 22 j. legal stud. 265, 266 n.3 (1993) [hereinafter levmore, retroactive taxation] (“the tax-exempt bond example is a favorite of the legal transition literature.”); kyle d. logue, tax transitions, opportunistic retroactivity, and the benefits of government precommitment, 94 mich. l. rev. 1129, 1133 [hereinafter logue, tax transitions] (“the classic illustration of these concepts involves the repeal of the exemption for interest on state and local bonds.”); shaviro, supra note 1, at 5–8. 12. see graetz, legal transitions, supra note 1, at 54–57, for a detailed discussion of the consequences of such an un-grandfathered repeal. 13. see graetz, legal transitions, supra note 1, at 52–53, for a discussion of possible effective dates. 14. shaviro, supra note 1, at 2–3. 126 columbia jour'al of tax law [vol. 1:120 no earlier than on the date of enactment, or in certain cases the date of public announcement,15 typically rested either on the conventional idea that fairness demanded that individuals subject to the law be able to know what it is before they act, or on the belief that one’s inability to rely on the law at the time one made decisions affected by it created substantial inefficiencies.16 further, it was widely accepted that transition relief was appropriate for certain types of legal change, such as the repeal of a tax preference or, more generally, of any legal rule that on enactment represented an invitation to act in a certain way. by contrast, the norm of retroactivity for judicial decisions was thought to rest on the basis that adjudication clarifies what the law already is; as a consequence, no unfair change to the rules arises when a new interpretation is announced.17 moreover, at least the scope of uncertainty in any particular statute that might be resolved by subsequent decisional law was limited, so that the adverse incentive effects from the possibility of retroactively applied judicial “new rules” were minimal. graetz’s 1977 article marked a turning point in the scholarly approach. he argued that in the tax context, neither fairness nor efficiency considerations supported the widespread use of delayed effective dates or transition relief when the tax law changed.18 broadly stated, graetz adopted a two-pronged attack to the transition relief norm. first, he noted that almost any legal transition is likely to have ramifications for many parties beyond the typical beneficiaries of relief.19 for example, the rules permitting accelerated depreciation for physical capital affect not only purchasers of favorably treated capital but also manufacturers of it, who are likely to increase production in response to stimulated demand. a repeal of the accelerated depreciation rules might be grandfathered for pre-repeal purchasers, but no existing norm would suggest that manufacturers who, prior to repeal, had invested in plant and equipment to construct favorably treated capital also would enjoy transition relief. 15. not uncommonly, changes to positive law or to “legislative” rules are nominally retroactive to the date of announcement in the congressional record or the federal register. see, for example, edwin s. cohen, the administration’s interim program of tax reform and tax relief, 47 taxes 325 (1969), for a discussion of an example of this type of retroactivity. in the typical case, such changes address perceived failures of the pre-change regime to give effect to the intent of congress or the relevant agency on the legal question in issue. such changes, though legislative in form, are more akin to interpretive clarifications of prior law than to a genuine shift in policy. 16. see, e.g., martin s. feldstein, on the theory of tax reform, 6 j. pub. econ. 77, 93–94 (1976). 17. see graetz, legal transitions, supra note 1, at 49–50, 73–79; kaplow, economic analysis, supra note 1, at 515. 18. see graetz, legal transitions, supra note 1, at 63–87. 19. id. at 56–57. 2010] legal tra'sitio's 127 second, graetz argued that even on its own terms a norm of extensive transition relief could not be justified according to any of the standard measures ordinarily used to evaluate tax rules, including efficiency, reliance, horizontal equity, vertical equity, and social contract theories of government.20 for example, the notion that a norm of transition relief avoided inefficient precautionary behavior by investors who would not take offered tax preferences at face value made unwarranted empirical assumptions about the costs of requiring individuals rather than the government to bear transition losses. graetz argued that in light of both the generally accepted view that markets are efficient and the fact that legal changes are probabilistic events that affect the value of investments just as other unknowns do, it was more reasonable to assume that transition costs would be minimized if investors bore transition risk and spread it through markets than if the government bore the risk and spread it to the populace generally.21 similarly, the idea that reliance interests justified or required strong norms of non-retroactivity was largely question-begging. what constitutes reasonable reliance is itself a question that needs to be settled on the basis of other principles, since expectations are not free-floating but rest on actual practices.22 because none of the standard fairness arguments supported a strong non-retroactivity norm, the case seemed weak on reliance grounds as well.23 underlying these two arguments was graetz’s more basic and farreaching insight that the distinction between retroactivity and prospectivity on which so much of the older literature relied was in many ways arbitrary. once one recognized that transition gains and losses arise because rules that take effect in the future have an effect on the consequences of past conduct, 20. id. at 63–87. 21. in particular, actors would accept or decline the “invitation” based in part on their assessments of the likelihood that preference would be repealed at a time or in a way that would adversely affect their investment. whether and when such a repeal would occur often would be no more predictable by the enacting legislature than by those to whom it applied. graetz, legal transitions, supra note 1, at 64–66. 22. for an extension of the argument, see kaplow, transition policy, supra note 2, at 170. 23. graetz’s criticisms of the reliance theory included the following: (1) the extent of reliance depends on individual assessments of the probability of legal change that can vary from person to person and that in the end provide no stable benchmark for assessing whether the reliance is reasonable; (2) the reasonableness of reliance depends on developments that change the calculation of whether reliance is reasonable; (3) apparently formal distinctions (such as whether the possibility of future repeal is made express or not) in the framing of legislation can affect the reasonableness of reliance; (4) relief tends to protect only a subset of those who relied on the old law; and (5) individual reliance on the possibility that a provision will be enacted does not seem different from reliance on a provision that is enacted and then quickly repealed, yet reliance in the former case does not entitle individuals to relief when the provision is not enacted. graetz, legal transitions, supra note 1, at 74–78. 128 columbia jour'al of tax law [vol. 1:120 the notion that legal change that was expressly directed at past conduct (socalled nominal retroactivity) differed categorically from legal change that was only “forward looking” seemed mistaken. if a forward-looking, ungrandfathered repeal of the municipal bond interest exclusion has nearly as great an effect on a purchaser who bought a 30-year municipal bond in the year before repeal as would an expressly retroactive repeal, the only difference between the two types of transition would seem to be in degree. the victim of nominally retroactive repeal suffers a loss of all 30 years of exclusion of interest on the bond, while the victim of the nominally prospective repeal loses just 29 years – a difference of but three percent. graetz observed that it is hard to see why this difference ought to matter all that much in analyzing the effective dates of new rules.24 as a consequence, in thinking about possible transition rules, there was no reason in principle why new rules might not take effect immediately, and even in some cases retroactively, even if the rules were “legislative” rather than judicial, or articulations of “policy” rather than mere interpretations. stated otherwise, if any change other than one that occurs so far in the future that all pre-change reliance interests are protected raises a retroactivity concern, it would appear that we are already committed to retroactivity in legal change even when the new rule is prospective only. therefore, we should not be especially solicitous of parties who bear transition costs because the law changes. subsequent commentary has generally carried forward graetz’s observations as a basis on which to make the case against a norm of extensive transition relief.25 equally significantly, scholars have appropriated graetz’s analogy of legal transitions to other market-based changes as a basis upon which to expand the analysis to all forms of legal change. for example, louis kaplow describes a legal transition as any unanticipated change in the expected value of legal entitlements that results from government action.26 under this definition, legal transitions include not only changes to positive law, but also judicial and administrative 24. see graetz, legal transitions, supra note 1, at 49–50. 25. see logue, legal transitions, supra note 3, at 216–20 (reviewing the new view approach to legal transitions). 26. see kaplow, economic analysis, supra note 1, at 517. the “government action” qualification is arguably not explicit, though kaplow discusses it at various points in the exposition. see, e.g., id. at 517–18 (discussing changes in “government policy”). further, if the qualification is not assumed, it becomes impossible to distinguish legal transitions from other kinds of transitions or events, such as those brought about by private actors. for a criticism of the definition as overbroad to the point of including virtually all activity that takes place or has consequences over time, see frederick schauer, legal development and the problem of systemic transition, 13 j. contemp. legal issues 261, 263–65 (2003). see also discussion infra part iii.a. 2010] legal tra'sitio's 129 decisions, executive actions, and even statements of policy, as long as, in each case, they were not fully anticipated before they became effective.27 further, because the definition includes resolution of any uncertainty (or the creation of any uncertainty) with respect to the future value of a present entitlement, a transition issue arises for kaplow even if no actual change to a rule or policy has taken place.28 thus, the filing of a lawsuit on the basis of a novel legal theory would raise a transition issue, even if the lawsuit ultimately were found non-meritorious (a second transition issue). other scholars have adopted similar approaches. dan shaviro poses the transition question as arising under essentially the same circumstances as kaplow does.29 kyle logue characterizes a legal transition as occurring whenever there is an unexpected change to legal entitlements.30 thus, as under kaplow’s view, legal transitions arise both when the positive law changes and when a new interpretation of existing law comes into effect. logue also argues that legal transitions arise on scientific discoveries, if the discovery has the effect of altering legal entitlements. as an example, the discovery that asbestos causes cancer was a form of legal transition because it affected the legal entitlements of (among others) asbestos manufacturers, even though it did not involve “a change in the substantive liability rule.”31 the motivation for this expansive interpretation of the concept of a legal transition derives from the consequentialist orientation of the new view. when expectations are the concern, the type of change to legal entitlements becomes largely immaterial, because the prospect of any type of change affects expectations. consequently, the distinctions among types of legal change become matters of degree, not of kind:32 changes to positive law are likely to be more sweeping than changes to decisional law, and actors are less likely to be able to anticipate their magnitude and direction.33 conversely, positive law changes tend to be forward-looking (in form), whereas judicially created legal transitions have nominally 27. the requirement of unexpectedness also implies that many transitions in the conventional sense do not raise transition issues. for example, a change to tax rates scheduled to take effect in one year does not raise a transition issue. 28. see kaplow, economic analysis, supra note 1, at 517; see also kaplow, transition policy, supra note 2, at 165 n.5. 29. see shaviro, supra note 1, at 25–26. 30. see logue, legal transitions, supra note 3, at 211–12. 31. id. at 250. 32. see kaplow, economic analysis, supra note 1, at 516; see also logue, legal transitions, supra note 3, at 239–42. 33. see graetz, legal transitions, supra note 1, at 63–65 (noting that the law may change in unpredictable ways as tastes and other conditions change). 130 columbia jour'al of tax law [vol. 1:120 retroactive effect.34 these differences will have varying effects on the extent to which actors likely to be affected by the prospect of change will insure against it, but that is all. apart from these differences, the various modes of legal change seem to differ only in formal or otherwise inessential particulars. as kaplow puts the point, “[t]o private parties, gains are gains, losses are losses, and taxation and compensation of gains and losses have the same cost or benefit regardless of the original source of the effects being mitigated.”35 b. the case for immediately effective, uncompensated transitions on the basis of the preceding account of legal transitions, kaplow offered a powerful and influential argument for enactment-date effectiveness of most legal change, and against almost all forms of transition relief. the argument rests on two fundamental similarities shared by all legal transitions: that they raise the question of absorbing the costs of uncertainty, and that they appear to be no different in principle from ordinary market risks that investors must bear ex ante.36 because it is easy to show under a wide range of assumptions that the most efficient method for absorbing market risk is private ordering, kaplow argued that from an efficiency perspective these features of legal transitions made the case against delayed effect and strong forms of transition relief practically overwhelming.37 he also argued that even enactment-date effectiveness should give way to nominal retroactivity in certain cases, such as where the prior regime turned out to have been undesirable during the period it was in effect.38 the efficiency argument for the superiority of private ordering over government relief in the market risk context is straightforward. consider kaplow’s example of the prospective builder or owner of a house on a flood plain.39 an individual who must bear the costs of a flood in the first instance can be expected to make the efficient decision about whether and how to bear them—by absorbing the loss if the individual builds or owns and the flood occurs, by purchasing insurance (or self-insuring), or by 34. shaviro, supra note 1, at 112. 35. kaplow, transition policy, supra note 2, at 177. 36. see kaplow, economic analysis, supra note 1, at 515–19. following kaplow, i use the term “market risk” to include “all risks—including the risk of natural events such as floods—not caused by uncertainty concerning future government policy.” id. at 533 n.62. 37. see id. at 541–42. 38. whether nominal prospectivity constitutes transition relief is a point of contention. see infra part iv. 39. see kaplow, transition policy, supra note 2, at 177–79. 2010] legal tra'sitio's 131 building or owning elsewhere. by contrast, builders and owners who can rely on a general policy of government relief from losses due to floods can be expected to over-invest in houses on flood plains because they do not need to bear the cost of a flood if it occurs. in effect, government insurance creates an externality by providing a costless put option for those who invest on land in flood plains.40 further, privately arranged risk-shifting and risk-spreading are almost certain to be superior to government-provided relief because the latter does not distinguish among the different levels of risk tolerance of different private actors. turning to legal transitions, it would appear that transition risk should be borne in the first instance by private actors because the possibility of a legal transition, like that of a flood, is a foreseeable probabilistic event that has an effect on the market value of investments.41 there are two aspects to the efficiency gain of requiring investors to bear transition losses. first, private insurance remains more efficient than government relief, for the same reasons that it is superior in the case of market-based events. where investors must bear the costs of legal change in the first instance, they will spread or shift risk so that it is optimally allocated between themselves and others. second, forcing private investors to bear the risk of legal change will lead to beneficial pre-transition anticipation of future law, as long as it is reasonable to suppose that the law is improving. while this assumption has been aptly described as “heroic,”42 it is at least reasonable as a working assumption or a first approximation. thus, if we think that strict product liability in tort provides a better regime than negligence for risk-bearing and -spreading, a transition norm that does not permit manufacturers to rely on transition relief will encourage them to act as though strict liability applied avant la lettre. indeed, the prospect of retroactive application of such a regime is likely to have still greater beneficial effect. such pre-transition changes in conduct produce welfare gains apart from the savings that private insurance provides over transition relief.43 40. one might object that forcing such individuals to bear these costs unfairly penalizes those who may lack the means to purchase insurance or to rebuild, possibly through no fault of their own. the usual response is that such hardships are due to preexisting distributive inequities that should be dealt with in other ways, such as through taxand-transfer programs that are not keyed to specific losses. programs of this nature do not effect distributive objectives by means of inefficient subsidies. see id. 41. graetz himself raised this point, but it has been more fully developed in the later literature. see graetz, legal transitions, supra note 1, at 65–66. 42. levmore, changes, supra note 5, at 1662. 43. see logue, legal transitions, supra note 3, at 217 n.10 for authorities. 132 columbia jour'al of tax law [vol. 1:120 c. 'ominal retroactivity more recently, shaviro has offered an in-depth analysis of tax transitions and retroactive relief in his book, when rules change.44 shaviro’s work is marked by subtlety, analytical rigor, and generality in its relaxation of the assumptions that law is generally improving and that legislators act benevolently.45 however, although the book deepens and expands upon the analyses that graetz, kaplow and other new view theorists have developed, it does not abandon their conceptual underpinnings.46 rather shaviro adopts the welfarist orientation of the new view47 as well as the new view’s skepticism regarding the significance of popular distinctions, such as that between nominally retroactive and nominally prospective legal change.48 shaviro’s discussion of the anti-nominal retroactivity (anr) norm in the tax context offers a particularly clear explication of the grounds for this skepticism.49 the anr norm is simply the prevailing idea that tax legislation ought not apply with expressly retroactive effect. shaviro’s discussion purports to show that the anr norm does not rest on any categorical distinction between nominally retroactive and nominally prospective transition rules, but instead “is strongly rooted in popular sentiment, legislative practice, and perhaps even the constitution as the courts are likely to interpret it.”50 shaviro begins by acknowledging the appropriateness of the anr norm for what he calls “rules of the road,” or matters of pure convention.51 these are cases in which the problem that a legal rule solves is primarily one of coordinating conduct among persons, rather than optimally conforming their conduct to an externally-given constraint. it does not much matter whether everyone drives on the left or the right; what matters is that everyone drives on the same side. similarly, it does not matter 44. shaviro, supra note 1. 45. see id. at 64–91. 46. as an example of refinement, shaviro disaggregates the idea of a transition tax (or subsidy) from that of transition risk. the former is the component of a transition reflecting an expected overall reduction (increase) in returns from an anticipated rule change offered without transition relief, while the latter is simply the effect that uncertainty about the future has on asset values, even though on an ex ante basis the expected value of an asset subject to a future rule change remains constant. see shaviro, supra note 1, at 27–32. 47. “this book’s framework is utilitarianism.” id. at 4. 48. see id. at 104. 49. see id. at 104–10. 50. id. at 104. shaviro’s analysis thus may be thought of as developing observations first made by graetz and later developed by kaplow and others on this point. 51. id. at 104–05. 2010] legal tra'sitio's 133 whether the default taxable year begins january 1 or july 1; what matters is that the default applies to everyone in a given class. it might seem that to acknowledge a set of cases in which the anr norm would be inappropriate concedes the basic point, for if the anr norm were entirely arbitrary, then it should have no proper application to any category of legal transitions other than by chance. but shaviro’s point seems to be simply that rules of the road should not have retroactive effect at all, be it through nominal retroactivity or through nominal prospectivity that does not provide relief. accordingly, when a rule of the road is adopted or altered, there is no particular reason either for the new rule to apply with nominally retroactive effect, or for transition relief not to be provided to those who relied on the old rule.52 an arbitrary rule whose content is that it functions as a coordinating device typically provides no particular clue to individuals subject to it that they should anticipate its change. more importantly, no efficiency gain from eliminating retroactivity is likely to arise by dispensing with the anr norm or transition relief for such cases, because the gains derive from the coordination of parties with each other, not from conforming the conduct of the parties to an independent state of affairs to which the rule responds. shaviro contrasts rules of the road with tax rules whose significance consists at least in part in their furtherance of some independent policy.53 despite the fact that the anr norm extends to most such rules, the difference in real terms between express retroactivity and express prospectivity is, in his view, essentially arbitrary for the nowfamiliar reasons first identified by graetz and developed by kaplow.54 as shaviro puts it, neither the apparent effect nor the apparent command of the anr norm bars retroactive application of new legal rules. the apparent effect of the norm is to cause each period’s events to be taxed under the rules in force at the time rather than at a later time; its apparent demand is that a prior period’s events not be revisited by applying a later period’s rules to them. shaviro notes two objections to the norm. the first is that the tax law often takes account of economic events many years after they occur.55 a simple example is the taxation of accrued capital gain or loss on an asset 52. although shaviro does not expressly state that new rules of the road should be accompanied by transition relief, he elsewhere argues for transition relief for “accounting rule changes”—that is, changes that do not involve an alteration of legal entitlements on a steady-state basis. id. at 53–54 (explaining accounting rule changes), 102–03 (arguing for transition relief for such changes). rules of the road would seem to fall into this category. 53. id. at 105–07. 54. id.; see supra part ii.b. 55. shaviro, supra note 1, at 106. 134 columbia jour'al of tax law [vol. 1:120 in the year of disposition of the asset rather than in the years in which, and at the rates at which, the gains or losses economically accrued. the second is that “completed” transactions from prior years may have been undertaken because of future tax benefits that could be repealed on a nominally prospective basis, before the taxpayer has a chance to reap the benefits of the pre-repeal decision.56 this is the example of a prospective and ungrandfathered repeal of the interest exclusion on municipal bonds. shaviro argues that because the tax rules under such subsequent regimes have an effect on the tax consequences of transactions completed in prior periods, “mere accounting considerations govern the definition of nominal retroactivity.”57 that is, nominal retroactivity differs from nominal prospectivity only in arbitrary accounting details, because both apply to alter the consequences of past conduct. ultimately, shaviro concludes that “[n]ominal retroactivity is inherently a formal, rather than a substantive, economic category.”58 shaviro’s view can perhaps be made clearer upon consideration of the argument that is sometimes made that nominally retroactive statutes differ from prospective ones in that the former apply to completed conduct and in this regard cannot function as guides to conduct,59 whereas nominally prospective changes can so function. consider the significance of this distinction with regard to the consequences of a pre-transition act. as previously discussed, if b purchased tax-exempt bonds prior to the repeal of the interest exclusion, the fact that the new rule is prospective only does not mean that it does not apply to consequences of the pre-transition conduct, just as a nominally retroactive rule would. there appear to be only two differences. first, the nominally retroactive statute applies to conduct, not just to its consequences, and second, its extent will be greater because it will apply to all the consequences of pre-enactment conduct (back to the effective date of the new rule); the nominally prospective enactment applies only to current and future consequences. the second point is conceded by all, but if the issue is that there is a categorical distinction between nominal and merely “effective” retroactivity, the question of degree does not matter. the first point similarly loses its significance if one assumes that the purpose of the conduct—for example, the purchase of tax-exempt bonds—is to realize the consequences. where the only concern is with the value yielded by the investment, there appears to be no reason to place independent significance on preserving the rules 56. id. 57. id. 58. id. at 107. 59. one example is stephen r. munzer, retroactive law, 6 j. legal stud. 373 (1977). 2010] legal tra'sitio's 135 applicable to the conduct itself.60 likewise, if a nominally retroactive enactment reaches back into the past, it appears that a nominally prospective enactment also reaches back and does so in the same way: the nominally prospective enactment reaches back into the past as to its consequences, which is what actually matters about that conduct subject to the enactment. iii. the apparatus of recent transitions analysis based on the preceding discussion, one might summarize the main points of the new view as follows. legal change is just like any other random event that individuals need to take into account in arranging their affairs. as a consequence, all unexpected changes to legal entitlements raise the same basic issue, which is that parties who made investments on the assumption that prior entitlement rules would continue to hold suffer gains or losses because the assumption was false. because this characteristic of legal change is not meaningfully different from market change, and because the optimally efficient rule for managing market risks is private ordering, or self-help, private ordering should apply to managing legal transition risk as well. further, under the assumption that law is generally positive in direction, a norm of self-help encourages efficient anticipatory modifications to behavior that are absent under a norm of government relief. if it is a bad idea to provide a tax exclusion for interest on municipal bonds, then investors facing the possibility of repeal of the exclusion without transition relief will have a greater incentive not to invest in the bonds solely for tax reasons than will investors expecting transition relief on any subsequent repeal. the incentive will be greater still if the prospect of a nominally retroactive repeal is in play. conversely, while transition relief may confer benefits such as providing welfare-enhancing redistribution, these benefits can be more efficiently provided through other mechanisms, such as transfer payments or progressive taxation. finally, although problems of public choice raise additional concerns, it is not at all clear that they point in favor of a norm of transition relief; in fact they may suggest that absence of relief is closer to the optimal norm.61 this part focuses more closely on the distinctions that the recent transitions literature has drawn in reaching these conclusions. the objects are, first, to formulate more precisely the conceptual framework that is implicit in the new view and, second, to draw out some of the implications of the view that may not have been recognized by its proponents. 60. kaplow, transition policy, supra note 2, at 165. 61. shaviro, supra note 1, at 64–91. 136 columbia jour'al of tax law [vol. 1:120 a. entitlement rules and transition rules the new view understands legal transitions as occurring whenever there is a change to legal entitlements. implicit in the account is a distinction between legal entitlements and rules that specify when distinct entitlements hold. thus, the rule that interest earned on municipal bonds is excluded from gross income specifies an entitlement, as does its opposite. similarly, a rule that, for example, loans for medical school will be forgiven for doctors working in low-pay practices constitutes an entitlement rule, as does the rule that such loans must be repaid according to their nominal terms. if the bond interest exclusion or the favorable rule on medical school loans were repealed, a rule likely would apply that specifies when the respective entitlement rules hold. that specification could be express, or it could be implicit through the operation of some default rule, such as one stating that changes to positive law are understood to take effect on the date of enactment in the absence of explicit legislation to the contrary. whether express or tacit, such a rule is a transition rule.62 stated more generally, transition rules are meta-rules that specify the temporal relationship between or among distinct entitlement rules.63 under this model, one could reformulate a repeal of the bond interest exclusion taking effect one year after enactment as follows: entitlement rule 1: interest on municipal bonds is excluded from gross income. entitlement rule 2: interest on municipal bonds is not excluded from gross income. transition rule: entitlement rule 1 shall be effective until one year from the date hereof, and entitlement rule 2 shall be effective for all 62. stephen munzer introduced a similar distinction in an early article, though it is not precisely the same as that here. see munzer, supra note 59, at 388 (“the legal status of an act depends not on something inherent to that act, but on the relation the act has to the law or laws governing its status.”). the entitlement-transition rule distinction also is arguably implicit in eric chason’s treatment of legal transitions. see eric chason, the economic ambiguity (and possible irrelevance) of tax transition rules, 22 va. tax rev. 615, 620 (2003) (defining transition rules in temporal terms and characterizing the definitions as formal). 63. kaplow analyzes the question in terms of changes to the scheduled legal landscape rather than to future entitlement rules, a formulation broad enough to capture situations in which future law features planned changes to entitlement rules. kaplow, transition policy, supra note 2, at 165 n.5. i dispense with a consideration of known future variation in law, because an evaluation of it would require introduction of considerable complexity without altering the basic argument. the complexity results from having to distinguish between entitlements that change where, by hypothesis, the change does not raise a transition issue, from entitlement changes that do. 2010] legal tra'sitio's 137 dates on or after one year from the date hereof. framed in terms of the distinction between entitlement rules and transition rules, the transition question is a third-order meta-question about a second-order meta-rule: what (third-order) policy or norm should govern the (second-order) transition rules that determine when certain (first-order) entitlement rules apply?64 a number of answers, of course, are possible. one is that the date the new rule is announced (the “announcement date”) and the date it becomes effective (the “effective date”) should be the same; another is that the announcement date should precede the effective date by some interval (delayed effective date); a third would be the opposite: that the effective date should precede the announcement date by some amount of time (nominal retroactivity). other possibilities include having distinct transition rules for distinct groups (i.e., what is commonly termed “transition relief”): delayed effective dates to the extent that the investor holds investments that were subject to the old rule on the announcement date (grandfathering), and, perhaps, announcement date effectiveness for all others. b. implications of the entitlement rule-transition rule dichotomy several observations about the method of conceptualizing legal transitions as changes to entitlement rules are in order. for the most part, these observations do not call into question the new view approach to legal transitions, but they do illustrate the ways in which the new view literature has elided important questions that it has raised. they also make possible a more rigorous analysis of the approach the new view has developed. 1. transitions vs. transition rules the first observation is that the existence of a legal transition does not imply the existence of a transition rule. this conclusion follows from the definition of a transition rule as the rule specifying the time at which two distinct entitlement rules apply to a type of arrangement.65 it is 64. the meta-character of the transition question has been noted in the literature. see, e.g., id. at 169 (“[t]he [subject of transition] involves a sort of meta-problem.”). the literature also has addressed the still higher-order question of what the appropriate transition to the appropriate transition policy should be. see kaplow, economic analysis, supra note 1, at 557–60; kirk j. stark, the elusive transition to a tax transition policy, 13 am. j. tax pol. 145 (1996). 65. again, this definition was needed in order to support a conception of legal transitions capacious enough to include all alterations to legal entitlements, no matter their provenance, as the new view literature requires, while excluding changes to the value of 138 columbia jour'al of tax law [vol. 1:120 logically possible for there to be no rule, express or tacit, that specifies when two inconsistent entitlement rules apply. in such a case, the new entitlement simply supplants the old one and applies at all times on the separate basis that the actions of currently empowered legal actors supersede the actions of legal actors no longer in power.66 while the absence of a transition rule does not ordinarily obtain in practice, it is important to keep in mind the analytical distinction so that it is possible to formulate the transitions problem accurately, as conceived by the new view—after all, it might be desirable in some circumstances to do away with transition rules entirely. (recall that it was the dissatisfaction with the conventional understanding of legal transitions as changes to positive law that gave rise to the need for a definition that is neutral with regard to the time and manner of any changes to legal entitlements.) one example that illustrates the idea of a transition without a transition rule is the analogous case of a change to scientific understanding—the shift, perhaps, from the ptolemaic to the copernican view of the solar system. when the copernican view supplanted the ptolemaic, there was of course no notion that the ptolemaic had been correct at some time in the past; rather the thought was that the copernican view had always been correct; it merely had not been recognized as such. the notion that a transition rule would apply in such a circumstance is meaningless. a second, more familiar, example is that of ordinary judicial interpretation of positive law. if a court announces a new interpretation of a statute, the new interpretation may purport to explicate the true meaning of the statute—at least under a conventional view of adjudication, sometimes referred to as the declaratory theory.67 because the court’s interpretation states the meaning at the time of the conduct to which it applies, the interpretation typically applies with at least some retroactive force. of course it does not literally apply with full retroactivity, but the reasons typically are grounded in separate policy considerations such as finality, not in the notion that the court’s interpretation says what the law means now investments that result from events that fall short of actual rule changes. a more conventional understanding of legal transitions would view them as changes to positive law (and perhaps “legislative regulations”) and therefore could bundle together what i have called the entitlement rule and the transition rule in the definition of legal transition. 66. one might counter that the rule obtained by the later-enacted or -adopted rule, rather than the earlier, constitutes a transition rule, but this rule simply specifies the source of law, not the determination of when law that emanates from that source applies. i thank scott shapiro for alerting me to this issue. 67. see munzer, supra note 59, at 374 (“under [the declaratory theory], if a court ‘overrules’ an earlier decision, it does no more than declare what the law has always been and apply it to the case at hand.”). there are serious difficulties with the declaratory theory, but the notion that judicial interpretation offers a pronouncement of what the statute or rule was at the time of conduct in question need not rely on the declaratory theory. 2010] legal tra'sitio's 139 but not at other times.68 2. relevant anticipations the second observation about the new view’s way of formulating the concept of a legal transition is that if no transition rule were the norm, the relevant anticipation (setting aside the fact that investors are mortal) would not be of the next legal change, but of the ultimate change to the “best” legal regime, or at least to the final one. the reason is that in the absence of a transition rule, the full retroactivity of every legal rule would nullify the prophylactic measures that investors would take with respect to all intermediate legal changes. this follows, again, from the distinction between entitlement rules and transition rules that is presupposed in the new legal transitions literature. if only entitlement rules change when legal change occurs, then no temporal limitation on the new entitlement rule applies; the rule has full retroactive effect and the detriments and/or windfalls from the new regime apply to all time periods, past and future. for example, suppose it turns out that the “best” tax regime is some form of consumption tax, and it is assumed that legal change is positive in direction. if no transition rules operated in legal change, then investors who are farsighted enough to recognize the ultimate direction of the law should not react to an intermediate repeal, under the current income tax, of the preference on municipal bonds by investing in other assets until the market price of muni bonds drops to reflect the anticipated repeal, even though investors will be subject to tax on all interest they have ever received on such bonds when that repeal occurs. although the preference repeal would cause investors to pay tax on the preference and indeed with full retroactivity, that change would itself be nullified when the final shift to a consumption tax occurs, again with full retroactivity. 3. implied vs. express transition rules third, a transition rule need not be express to be in effect. returning to the municipal bond interest example, repeal of the exclusion for all interest accrued from the date of enactment forward would constitute adoption of a new entitlement rule and a transition rule, whether the effective date were spelled out in the statute or simply assumed under a default rule. the repeal would provide both a new rule about bond interest (that it is included in gross income) and a rule about the extent to which the 68. see, e.g., u.s. v. kubrick, 444 u.s. 111, 117 (1979) (identifying finality concerns that support statutes of limitations). 140 columbia jour'al of tax law [vol. 1:120 old rule continued to apply to bond interest (that it remained valid for preenactment dates).69 thus, the legislative norm that in the absence of an express transition rule or effective date, new legislation takes effect on the date of enactment constitutes a transition rule, assuming that a legal transition is defined as the literature has defined it.70 similarly, the constitutional ban on ex post facto criminal legislation71 creates a mandatory transition rule for federal criminal statutes, in the sense of a limitation on retroactive application. conversely, the default norm for judicial decisions is that no transition rule operates (apart from a separately provided statute of limitations and a separate rule for already decided cases), so that the absence of an express transition rule gives rise to full retroactivity for all cases not already settled or beyond the applicable statutes of limitations. 4. scientific developments are not legal transitions. finally, note that even the expansive definition of a legal transition offered here does not appear to embrace factual or scientific developments that have a bearing on legal entitlements, contrary to the claims of some new view theorists such as logue.72 to illustrate the idea that the category of legal transitions includes such developments, logue uses the example of newly discovered scientific evidence demonstrating that a product causes a 69. whether default norms operate in specified contexts to limit the effect of change temporally is a separate issue that merely goes to expectations that have developed and the reasons for them; it does not go to the nature of legal transitions themselves. for example, many legal changes ordinarily have retroactive effect. the most common example is a new judicial interpretation of any pre-existing legal rule or doctrine. see shaviro, supra note 1, at 112–15. 70. see, e.g., id. at 112 (“it has long been a truism that ‘statutes operate only prospectively, while judicial decisions operate retrospectively.’” (quoting rivers v. roadway express, inc., 511 u.s. 298, 311–12 (1994))). again, the notion that the absence of an express transition rule implies that a default transition rule is in effect follows from the demands of the welfarist conceptual apparatus. a more conventional understanding of the concept of a legal transition would permit one to view a transition rule as in effect only when the effective date departed from the legislative default. this understanding, however, would be based on the notion that a change to positive law is a different kind of thing from a new interpretation of existing law. if one is prepared to make that distinction, then one may consistently go on to view the change from the preto the post-enactment regime as intrinsic to a legal transition, and therefore to view transition rules as applying only when an exception is made to the general rule of date-of-enactment effectiveness. 71. u.s. const., art. i, § 9, cl. 3. 72. logue, legal transitions, supra note 3, at 211; c.f. kaplow, economic analysis, supra note 1, at 524 (discussing a product discovered to be unsafe on the basis of new scientific evidence). 2010] legal tra'sitio's 141 certain type of harm.73 in the example, he assumes that an underlying strict liability regime is in place and does not change.74 he analyzes a court’s decision to accept the new causation theory for the first time as a legal transition because the decision changes legal entitlements and the change was the result of a governmental action to accept the new theory.75 the difficulty with this analysis is that the change to legal entitlements resulting from a scientific development appears to be no different from the change that such a development brings to the market value of an investment; only the governmental actor responsible for enforcing it differs. suppose a owns a copper mine and it is discovered that copper is particularly useful in a new computer chip manufacturing process. the value of a’s entitlement increases dramatically because the price of copper has risen. but this value will be accorded to a only on the assumption that the legal system will continue to protect a’s property rights in the mine. the difference between this case and the products liability case is only the operative legal regime—property rights in one, and tort in the other. in each case, the legal regime continues to do what it always did, which is to assign legal entitlements and obligations according to an unchanged set of rules. unless one is prepared to say that the discovery of the new use for copper creates a new entitlement rule, it appears one cannot say that the new theory of causation in tort does either. iv. criticism with a more precise definition in hand of the concept of a legal transition as it is understood by scholars under the new view, it becomes possible to evaluate the view more directly. in this part i examine two of its aspects: first, the claim that legal transitions are closely akin to factual or market changes, and second, the tacit assumption that legal transition norms can be evaluated apart from certain questions of political legitimacy and authority. the arguments made in this part give rise to a third set of questions that i take up in part v: whether the new view in fact has much to say about legal transitions that has not already been said before. the sequence of the discussion is intended to be progressive. the second argument developed in this part builds on the first, while the analysis of part v follows naturally from the considerations discussed in this part. once it becomes clear that legal transitions are not closely akin to factual changes, it becomes incumbent on new view theorists to offer a defense of 73. logue, legal transitions, supra note 3, at 239–41. 74. id. 75. id. at 239–40. 142 columbia jour'al of tax law [vol. 1:120 the new view that does not depend on the analogy. when that defense fails, the doubt of the extent to which the new literature has made significant contributions to our understanding of legal transitions becomes salient. a. analogy of legal transitions to factual developments i have previously noted that scholars in the legal transitions area have relied on the analogy between legal and factual change to support a norm of enactment date effectiveness. kaplow offers perhaps the clearest statement of the analogy: [w]here the focus is on private actors and government substantive policy is taken to be optimal, governmentcreated risk and risk due to market or natural forces, as well as government mitigation of such risk, are almost precisely analogous. to private parties, gains are gains, losses are losses, and taxation and compensation of gains and losses have the same cost or benefit regardless of the original source of the effects being mitigated. likewise, market relief for risk—whether through explicit insurance arrangements or implicitly, such as through diversified financial ownership—is in principle equally effective regardless the source of the risk.76 as kaplow’s statement makes clear, the analogy is meant to function as more than a casual observation about the parallels between legal and market transition risk. rather, it amounts to a restatement of his “demonstration that uncertainty concerning government policy is analytically equivalent to general market uncertainty.”77 the distinction between entitlement and liability rules developed in 76. kaplow, transition policy, supra note 2, at 177. for other statements, see michael j. graetz, retroactivity revisited, 98 harv. l. rev. 1820, 1825 (1985) [hereinafter graetz, retroactivity revisited] (“the costs of uncertainty in the law do not seem necessarily different in kind or in magnitude from the costs of uncertainty in markets . . . .”); see also logue, legal transitions, supra note 3, at 221 (noting the reasonableness of the market analogy assuming investors are rational). 77. kaplow, economic analysis, supra note 1, at 520. see also kaplow, transition policy, supra note 2, at 179 (“because government-created risk is analogous in relevant respects to market and natural risks and because government mitigation of gains and losses is inefficient with regard to the latter, it follows that it must be inefficient with regard to the former.”); chason, supra note 62, at 616–17 (describing the graetz-kaplow view as based on the analogy between the risk of repeal and the risk of market-based or casualty losses). 2010] legal tra'sitio's 143 part iii provides useful purchase on the question of whether the analogy is accurate or persuasive. as explained there, entitlement rules specify underlying legal rights and obligations, and transition rules specify the temporal conditions under which the former apply. this highly generic definition of legal transitions follows from the requirement that all forms of legal change or development be grouped together without regard to the nature or authority of the decision-maker initiating the transition or to what gives rise to the decision-maker’s decision. although a conventional understanding of legal change would not need to insist on abstracting entitlements from meta-rules regarding their temporal application, that course is unavailable under the new view because of the expansive concept of transitions it adopts as a result of the focus on anticipations. once the distinction between entitlement rules and transition rules is accepted, however, it becomes apparent that a legal change has a different kind of effect from a factual or market-based development, because factual and market changes do not reach back into the past (or, for that matter, stretch infinitely into the future) in the way that a mere change in entitlement rules does. unlike an uncompensated legal change regarding the availability of government relief for floods, the fact of the flood itself does not mean that flooded land was always flooded. nor, for that matter, does it mean that the land became flooded sometime “before” the flood (in analogy to a partially retroactive legal change) or sometime after it (in analogy to a delayed effective date for a new legal rule). the “announcement” date of the change to entitlements, in the case of a factual change, is typically the same as the change itself. when it is not (as when there is warning that a change will come), it still occurs on some particular date, prior to which it had not occurred. from the proposition that a legal transition implies only a change to entitlement rules, it follows that the most one can say about the similarity of legal change to factual or market change is that a legal transition plus a transition rule that takes effect on the announcement date is “almost precisely analogous” to market change.78 only that combination of change to entitlement rule and transition rule mimics a factual change, because only that combination preserves the essential feature of factual change that need not be present in legal change: the fact that the change is its own announcement. the problem, of course, is that this formulation demonstrates that the analogy is entirely question-begging to the extent it purports to support a presumption of enactment date effect without transition relief, since the issues in the transitions literature are precisely whether the new rule should take effect on the announcement date or on 78. kaplow, transition policy, supra note 2, at 177; see also supra part iv.a. 144 columbia jour'al of tax law [vol. 1:120 some other date and whether transition relief should be available. in other words, the analogical argument assumes its conclusion. if one presupposes that a legal change is just like a factual change, then a legal change by definition occurs on its date of announcement, and it should not be surprising that the most efficient way to deal with it is the same as the most efficient way to deal with natural or market-based changes. but the question, of course, is whether the announcement date should be the same as the effective date. indeed, it is precisely the fact that the announcement date of a new legal rule can differ from its effective date that there is even a transitions question in the first place. consequently, to say that a transition norm of having identical effective and announcement dates is like a factual change is merely to state the consequence of one possible transition norm: announcement date effectiveness. it does nothing to justify the transition norm itself. one can state the point in the converse: if it were possible to have unexpected factual developments take place on a date different from their “occurrence,” would one assume that the optimal date would be the occurrence date? one might accept these observations but counter that they reflect a merely semantic point: if one defines transition rules as meta-rules that determine the temporal extension of entitlement rules, then of course any legal transition that is not fully retroactive will be accompanied by a transition rule and in that sense by transition “relief.” is it not possible to resolve the problem by saying that a legal transition consists of a change to an entitlement rule plus a transition rule, which may or may not be explicit? the argument would then be that legal changes, so defined, are just like factual developments. they happen unannounced, taking effect from some date forward, and we expect investors to deal with them through market mechanisms. the problem with this claim is that it is false. legal changes differ from factual developments only in that they can apply retroactively or prospectively rather than when they are announced; as stated above, factual developments are neither prenor post-announced. to say that investors should bear the costs of legal transitions on analogy with natural or marketbased uncertainty disregards both the flexibility inherent in legal change, which is that there is in principle much control over the effective-date timing of the new entitlement rule, and the fact that it is just this flexibility that gives rise to the “transition question” in the first place. if the flexibility were lacking, there would be no transition debate, because all changes to legal entitlements would (necessarily) occur on the date of announcement, or perhaps on some other date, but in any case on a date over which one had 2010] legal tra'sitio's 145 no control.79 in short, the validity of the analogy presupposes the decision that the best transition rule is the default rule for changes to positive law, yet the analogy is used to justify that decision. b. problems with a single transition “'orm” ultimately, the difficulties with the analogy of legal change to factual or market-based change point to the crux of the problem with the anticipations-based literature. as argued below, the failure to appreciate fully either the flexibility or the limitations inherent in the power to adopt a transition rule means that the new view literature fails to account for what is distinctive about legal transitions. on the limitations side, it fails to recognize that the markets that provide efficient methods for managing risks and internalizing costs, and that serve as models for a legal transition norm of announcement-date effectiveness, themselves depend upon the existence of a stable legal regime that presupposes limits on possible transition norms. some of the norms advocated in the recent transitions literature do not take cognizance of these limits. put differently, certain transition norms, including a universal norm of enactment-date effect with no transition relief, would undermine regime stability and, hence, would vitiate or destroy the markets that are supposed to function as models for managing risk in the first place, including “transition risk.” on the flexibility side, the new view fails to appreciate the distinctive benefits that different transition “norms” can offer depending upon the different type of, and justification for, the adoption of a new entitlement rule. for example, there may be distinctive and systematic reasons favoring greater retroactivity for judicial action than for legislative action, and these reasons may relate to the type of legal change that the respective legal actors initiate, rather than, for example, to the capacity of the respective institutions to adopt “good” or “bad” law or to be influenced by rent-seeking or other undesirable behavior.80 if one insists on treating all 79. note that kaplow himself does not accept the analogy fully, for if transition uncertainty were “analytically equivalent to general market uncertainty,” kaplow, economic analysis, supra note 1, at 520, the notion that it might occasionally be appropriate to make certain new rules nominally retroactive would be false, contrary to kaplow’s assertion. id. at 551 (“sometimes new legal rules should be made fully retroactive: they should be applied to time periods before the enactment date, even as to investments no longer in existence.”). 80. the quality of the new entitlement as better or worse than the old one and the differing possibilities for compromise of the legal actor’s efforts to act for a public benefit, depending on the legal actor implementing the change, are the two bases that writers in the new view have identified as reasons for different transition norms. thus, kaplow acknowledges that different norms for different types of government actor may be appropriate, but he does not ground the observation in the different natures of what the actor 146 columbia jour'al of tax law [vol. 1:120 forms of government action as essentially the same, these distinctive reasons become invisible. in the following two subparts, i illustrate the limitations point by considering the consequences of extending the default rules that apply to judicial decisions to positive law, and the flexibility point by considering the reverse extension. these potential extensions (or some other uniform norm) should seem natural under a conception of legal change that insists on effacing the distinctions among judicial, executive and legislative decisions, because, under that conception, whatever the correct norm or norms should be, they should not depend upon which government actor initiates the change, but upon which rule provides the proper incentives to legal actors.81 1. retroactive relief—naturalization of the market consider first the consequences of extending the judicial rule of nominal retroactivity to positive law. new view scholars have noted that such a norm would have a chilling effect on investors, for the obvious reason that investors would lack confidence that the rules on which they relied in arranging their affairs would in fact be the rules applicable to their affairs.82 unless investors could be sufficiently certain either that current law would not be changed unfavorably, or that if it did change, the retroactive effect would not extend far enough back to reach their earlier conduct, they would be unlikely to commit their resources in ways that would otherwise be efficient. for example, taxpayers under a steady-state income tax can be expected to allocate their resources in ways that favor current consumption to a greater extent than do taxpayers under a steadystate consumption tax.83 unless taxpayers believe they can make an accurate prediction of the likelihood that a future transition to a consumption tax will occur and will apply retroactively to pre-change does; rather the focus is on the susceptibility of different government actors to different forms of suboptimal behavior. kaplow, transition policy, supra note 2, at 190–200. 81. levmore, changes, supra note 5, at 1672. to be clear, here i abstract from considerations relating to “good government” concerns that might counsel in favor of different norms for different government actors. see supra note 80. rather the question is whether the distinctive types of activity that different government decision-makers engage in might support different transition norms for these actors. on this point the literature is silent. 82. see, e.g., levmore, retroactive taxation, supra note 11, at 277–78; shaviro, supra note 1, at 21–22. 83. for a general description of the incentive effects of income and consumption taxes, see joseph bankman and david a. weisbach, the superiority of an ideal consumption tax over an ideal income tax, 58 stan. l. rev. 1413 (2006). 2010] legal tra'sitio's 147 decisions, they are apt to adopt a wait-and-see attitude and to refrain from committing resources either way. this analysis, while technically correct, is importantly incomplete. first, it is hard to square with new view theorists’ general skepticism about the significance of the distinction between nominally retroactive legal change and nominally prospective change that has retroactive effects. moreover, it has not been universally accepted. for example, kaplow argues in favor of a norm of nominal retroactivity when prior law was bad law for the period it was in effect.84 more to the point, however, a nominal retroactivity norm would do more than make investors hesitant to make new investments for fear of expropriation of gains on repeal; it would create enough uncertainty in the stability of established law to make reliance on markets as a means of managing risk unreasonable altogether. indeed, it would make investors question the validity of the legal regime itself, and, moreover, in ways that a norm of enactment-date effectiveness would not, even if the impact on investments in the latter case were systematically comparable to those in the former. the difficulty stems from the fact that a norm of retroactivity of positive law is inconsistent with the idea that law-making institutions derive their authority from consent.85 consider that a genuinely retroactive pronouncement, such as a new rule for taxation of a prior year’s income, does not merely call into question the firmness of any rule that one might follow presently. it also implies that the currently operative legislature has departed from the rules that determine who is the legislator; in particular, it has usurped the role of the body that was authorized to act as legislator during the period to which the nominally retroactive enactment applies. in effect, individuals under the prior regime lived under no law. while that period has of course passed, individuals in the current regime, anticipating the possibility of future nominal retroactivity, find themselves under no law at all. further, they also find that they were actually not under law to the extent they also were under prior law. the point may be illustrated through the following example. suppose a neighbor appears at your doorstep with the pronouncement that he has just proclaimed himself the law on the basis of his decision to amend the constitution, and that among other new rules taking immediate effect is 84. kaplow, economic analysis, supra note 1, at 551 (arguing that a “new rule” should be applied retroactively when the new rule is better tailored than the old rule to the circumstances that previously obtained). 85. see harold m. hochman, rule change and transitional equity, in redistribution through public choice 320, 331 (hochman and peterson eds., 1974) (noting the problem of violation of consent that arises in the similar case in which earlier generations set fixed rules for later ones). 148 columbia jour'al of tax law [vol. 1:120 one that transfers all of your property to him. you might counter that his proclamation has no legal effect because he hasn’t followed the rules set forth in the constitution that provide for its amendment to make him the new legislator, but he replies that he has amended those as well. though fanciful, the example highlights what is problematic about the case of nominally retroactive legislation. it, like the example, has a boot-strapping quality. a prior legislature, elected to govern during a prior term, followed procedures set forth in the relevant legal document to establish the law that would apply during that period. later representatives (chosen by others) have now determined that that law did not apply during that period. if that is true, then the substantive law operative during the putative tenure of the prior legislature was not established by its electorate; it was established by a subsequent electorate. the difficulty is that if law derives from consent, then law that is not established with the consent of the electorate is not really law for the electorate, any more than the law of latvia is the law of england. the enactment of such retroactively effective legislation can only have been through a valid exercise of authority (rather than through force) if either the subsequent legislature validly amended the rules that determine who was authorized to promulgate substantive law during the prior period, or the legislature in office during that period authorized the subsequent legislature to override its enactments. in other words, nominal retroactivity cannot go “all the way down” but must instead be grounded in some procedure that is not itself open to retroactive revision. by hypothesis, the subsequent legislature did not follow the procedures set forth in the relevant document that would permit retroactivity of the change to a legal entitlement. therefore, in order for the retroactive legislation to have been valid, the principle that later legislatures may retroactively revoke prior legislation must have been implicit in the earlier enactment. if so, the case would be distinguished from that of the neighbor, for whom no consent to adopt new rules is implied. the problem with this argument is that once the idea is accepted that a subsequent legislature can read tacit terms into prior legislation, there is no way to limit this principle to the substantive statutory law; it could apply equally to any subsequent statement that purports to set forth who is entitled to say what the law is, including the neighbor’s claim about the earlier constitution.86 86. this observation may help to explain the courts’ oft-stated view that retroactivity that extends to the beginning of the current legislative period raises no constitutional question, but retroactivity extending much beyond it does. see u.s. v. carlton, 512 u.s. 26, 38 (1994) (o’connor, j., concurring) (“a period of retroactivity longer than the year preceding the legislative session in which the law was enacted would raise, in my view, serious constitutional questions.”). 2010] legal tra'sitio's 149 the basic point may be stated as follows. from a conceptual standpoint, at the top of the chain of authority must lie express, not merely tacit, agreement by everyone who would be bound.87 that agreement cannot be amended in ways inconsistent with its express terms other than by unanimous consent; otherwise, any subsequent change lacks authority for those who do not consent. this principle does not mean that even the highestlevel document cannot have procedures for amendment that call for less than unanimity, but it does mean that a departure from the rules for amending the highest-level document that are set forth in that document would be invalid for anyone who opposed it.88 a proponent of the new view might respond to this argument by raising the claim discussed previously: the significance to private actors of their conduct is the results that it produces and not the means by which they are produced.89 from this perspective, whether a new rule applies with nominal retroactivity or merely affects the consequences of completed pretransition conduct going forward does not particularly matter. since the retroactive effect of nominally prospective changes is not inherently problematic, it is not clear why we care about nominal retroactivity. in other words, it does not matter whether the new rule affects new conduct or the consequences of conduct that were its raison d’être. this argument, however, simply assumes the conclusion that the distinction between preannouncement-date conduct and its future consequences is not significant, because it assumes that legal rules do not depend upon consent to function. if a transition norm vitiates that consent, there is literally no legal order; it becomes impossible to act in any way other than as one in something like a state of nature. another possible objection is that only a transition norm of nominal retroactivity to positive law would call government legitimacy into question, and that kind of nominal retroactivity is a relative rarity. but, 87. the claim is similar to rousseau’s observation in on the social contract that legitimate rule must be unanimously authorized. see jean-jacques rousseau, on the social contract 52 (roger d. masters ed., judith r. masters trans., 1978) (1762) (“the law of majority rule is itself an established convention, and presupposes unanimity at least once.”). 88. one could refine the point as follows: certain tacit rules conceivably could be derived, but they must derive from features of a relevant bargaining situation such that no agent in that situation could rationally oppose them; identifying rules of this sort is the subject of social contract theory. see, e.g., john rawls, a theory of justice (1971). it is difficult to see how one such rule would ever include an authorization for a legislature to override a previous legislature with respect to the rules the previous legislature adopted for the period during which it was to govern, unless the terms permitting such an override were already expressly agreed to before the override occurred. 89. see supra part ii.b. 150 columbia jour'al of tax law [vol. 1:120 again, the new view is predicated on the idea that the difference between nominally retroactive and nominally prospective legal change is largely illusory.90 the distinction is said to be material only in the sense that nominally retroactive changes are likely to have a greater effect on the magnitude of the legal change than are nominally prospective changes.91 either of two possible conclusions follows. one is that there is, in fact, a significant distinction between nominal prospectivity and nominal retroactivity that is not captured in the difference between the size of the effect of either on the market value of investments. the other would be that even a norm of nominal prospectivity raises the stability question, since certain nominally prospective changes can greatly alter the value of prechange investments. the former would demand a reconsideration of the decision to differentiate nominal prospectivity from nominal retroactivity on purely quantitative grounds, while the latter seems to be false: in many cases, nominal prospectivity does not raise the same difficulties that nominal retroactivity does, as evidenced by the fact that the strength of the anr norm is not matched by any comparable norm for purely prospective legal change.92 these points may be summarized as follows. from the perspective of the private investor, the significance of the anr norm lies not simply in the fact that it prevents application of new rules to investments already made. it is that it gives expression in a particularly vivid manner to the idea that, as a general matter, law under organized government derives from consent.93 if law were the means by which an independently authorized or naturally existing sovereign implemented its commands (such as a philosopher king, for example), then neither instantaneously promulgated nor retroactively extended legislation would raise a transition issue, apart from the question of incentive effects amply discussed in the literature.94 90. see kaplow, economic analysis, supra note 1, at 515–16; levmore, retroactive taxation, supra note 11, at 266–78. see also stark, supra note 64, at 154 (“given individuals’ forward-looking behavior, the difference between prospective laws and retroactive ones is really just a matter of degree, not of kind.” (summarizing graetz’s view)). 91. see graetz, retroactivity revisited, supra note 76, at 1826. 92. in some cases, nominal prospectivity does raise difficulties similar to those raised by the nominal retroactivity case. in particular, where there is no meaningful change between the circumstances of enactment and those of repeal, failure to provide some form of transition relief starts to look like nominal retroactivity. these reasons are explored in the next part. 93. see munzer, supra note 59, at 391 (“a retroactive law makes it difficult or impossible to act with knowledge of the applicable law. the strongest way of putting this is to say that if a law is retroactive, it logically cannot guide behavior with respect to the act whose legal status is altered.”). 94. it should be noted, however, that if the law had this character, it is still not clear that any incentive problem would exist. if government’s authority is predicated on its 2010] legal tra'sitio's 151 but where law is a means of government by consent, the strict separation between the law-giver and the persons subject to law does not hold, and the idea that laws need not be guides to conduct, which, in a certain sense, investors apply to themselves, gives way. if law is law because it is consented to, then a transition norm that vitiates consent vitiates law. 2. announcement date relief—new interpretations as new law if the hypothetical extension of the rule for judicial interpretations to positive enactments illustrates the failure of the new view to appreciate the limitations that apply to the choice of transition norms, the inflexibility of the new view emerges upon consideration of the converse case: extension of the default norm of nominal prospectivity to judicial decisions that announce new interpretations of existing rules.95 the difficulty here is that it becomes impossible under the new view to make out a reason for differing transition norms corresponding to differing methods of propounding new rules, because, as previously discussed, the method by which the government adopts a new rule is considered to be a formal or arbitrary feature of the rule. in conventional or “old view” terms, the basis for retroactivity of judicial relief is, of course, that the pronouncement of a new interpretation merely states what the law already was, or perhaps more realistically states the “best” or “appropriate” interpretation among a small number of candidates.96 to be sure, in some circumstances that notion is a fiction,97 but the norm, and certainly the justification commonly offered for the norm, conforms to the idea.98 under the new view, the rule for judicial “new wisdom, then subjects should simply follow its commands. rapid changes in the law would not supply a basis for reticence about taking advantage of preferences, because the changes would be correct. 95. for purposes of the discussion, i assume that parties would continue to have an incentive to bring suit even where relief depended upon adoption of a novel and therefore nominally prospective interpretation of existing law, since the question here relates to the different matter of the larger consequences of a prospectivity norm. the principle could be implemented by providing for a government payment to the aggrieved party where the court found for the plaintiff on the basis of a novel interpretation of the law. 96. see munzer, supra note 59, at 374–75; shaviro, supra note 1, at 112. 97. a salient example is the california supreme court’s adoption of a strict liability standard for product defects. greenman v. yuba power prods., inc., 59 cal. 2d 57 (1963). 98. see shaviro, supra note 1, at 112 (“to some extent, the nominally retroactive application of judicial decisions is logically inherent in what we call the judicial function.”); see also, e.g., rivers v. roadway express, 511 u.s. 298, 312–13 (1994) (“it is this court's responsibility to say what a statute means, and once the court has spoken, it is the duty of other courts to respect that understanding of the governing rule of law. a judicial construction of a statute is an authoritative statement of what the statute meant before as well 152 columbia jour'al of tax law [vol. 1:120 rules” therefore presents a puzzle: why have retroactivity for these rules if a norm of nominal prospectivity should operate for positive law? if the same general considerations apply regardless of the form in which a legal transition occurs, it becomes difficult to explain different defaults for different types of government action. while some new view scholars have noted that different norms for different types of cases may be appropriate, they have generally defended the idea with reference to the substance of the underlying rule, not the form in which the new rule is promulgated. for example, as previously mentioned, kaplow supports a norm of nominal prospectivity without transition relief for transitions that respond to changed circumstances, but he argues for a norm of retroactive application of new rules “when the justification for a reform suggests that the prior activity was undesirable.”99 needless to say, both a court and a legislature (as well as an administrative agency or any other policy-making entity) can be confronted with either type of case. the case for retroactivity of judicial interpretation, however, has nothing to do with whether the prior activity was undesirable. it has to do with the fact that judicial action purports to be a statement of what the law is, even though on occasion the statement may reflect a court’s view of what it ought to be.100 at all events, the uncertainty that adjudication resolves is very different from legislative uncertainty. uncertainty about the content of law is a feature of any legal system for the simple reason that no law can contain a full specification of all cases to which it applies.101 that is why, as contrasted with legislation, adjudication typically resolves a legal question in favor of one among a very small number of possible interpretations. each of these interpretations is typically known to the litigants not only before trial but, in the ordinary case, at the time at which they engage in the relevant conduct. hence it is in this setting, much more than in the legislative setting, that the case for retroactivity is strongest. where the legal risk is quantifiable beforehand, it is much easier to insure against it. the fact of limited possible interpretive outcomes also places as after the decision of the case giving rise to that construction.”); id. at 313 n.12 (“[w]hen this court construes a statute, it is explaining its understanding of what the statute has meant continuously since the date when it became law.”). 99. kaplow, economic analysis, supra note 1, at 551. see also logue, tax transitions, supra note 11, at 1154–58 (distinguishing the case for transition relief on the basis of whether congress has acted opportunistically or not, and on the basis of the leastcost avoider in the case of transitions motivated by the discovery of new information). 100. see, e.g., scott j. shapiro, the “hart-dworkin” debate: a short guide for the perplexed 41–52 (university of michigan law school working paper no. 77) (developing a positivist account of disagreement over theoretical legal principles), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=968657 (last visited may 14, 2010). 101. id. at 16. 2010] legal tra'sitio's 153 much less strain on concerns about rule of law than would the possibility of open-ended retroactive application of new law, which can in principle have any content. finally, unlike positive law, in which it may make sense for the party controlling its content to take account of the consequences of changes to the content, new judicial interpretations are an inherent part of the content, in the sense that any statement of a rule has possible ambiguity. in short, because the new transitions literature disregards the different nature of the uncertainty that legislation and adjudication resolve, the distinctive justification for retroactive application of judicial interpretation becomes unintelligible for the new view. that justification is ultimately the same one that applies to rules more generally, which is that parties nominally subject to them should, in fact, be subject to them, even if there is by necessity some uncertainty in their content in borderline cases.102 in this regard, the “new” legal rule that a tribunal may announce does not raise the same concerns that nominally retroactive legislation does, because it is grounded in the nature of law generally. indeed, both the anr norm and the norm of nominal retroactivity for judicial decisions seem to derive from the nature of law, or at least the nature of law as a means of rule by consent. where nominal retroactivity as a norm for legislation is inconsistent with rule through law by consent, nominal retroactivity as a norm for adjudication arises from the basic incompleteness of any law. c. the conventional 'ature of legal regimes both of the problems of the new view literature described in the preceding subparts point to a fundamental failure of proponents of the new view to appreciate the conventional nature of law and therefore the institutional context in which the transitions question arises at all. on one hand, as artificial institutions, legal regimes are instantiations of convention or agreement, and agreement is not subject to natural constraints. the absence of natural constraint means that legal transitions can occur at times different from their announcement dates and indeed at times that depart from the announcement dates in ways that vary depending upon the types of conventional settings in which the transition arises. while scholars writing from a new-view perspective have of course entertained the possibility of a norm for legal transitions that incorporates some amount of relief and some amount of retroactivity, the literature has generally settled on a norm of 102. marbury v. madison, 5 u.s. (1 cranch) 137, 177 (1803) contains probably the most famous articulation of this principle in the constitutional law context. see also william blackstone, commentaries on the laws of england 69 (1765) (stating that the court’s duty was not to “pronounce a new law, but to maintain and expound the old one.”), quoted in munzer, supra note 59, at 374. 154 columbia jour'al of tax law [vol. 1:120 enactment-date effectiveness because it cannot identify the institutional reasons that would support a different date—namely, either prospective effectiveness (or some transition relief variant thereof) for reliance-based reasons when they might apply, or retroactive effectiveness for nominal transitions that in fact further the principle or purpose of an already-enacted rule. in short, the literature is unable to comprehend the variation that arises from different institutional settings, rather than from either different substantive settings, such as whether the underlying rule was good or bad, or from the varying propensities of different actors to be subject to nonsocially optimizing conduct because of capture, principal-agent problems, and the like.103 on the other hand, as artificial institutions of a certain sort, legal regimes cannot be instantiations of just any convention. they must be instantiations of conventions that are consistent with the terms of the implicit bargain upon which the regime rests. by naturalizing the circumstances within which legal transitions occur—for example, by assuming the existence of well functioning markets no matter what the legal regime—the transitions literature fails to appreciate the relationship between transition norms and the set of legal institutions and relationships that depend, in part, on those norms and that provide the framework within which conventional arrangements, including markets generally and insurance markets in particular, appear natural and are able to function. as a result, the literature fails to appreciate an important set of considerations at stake in adopting one set of norms rather than another in different transition settings; it is able to comprehend the differences among possible norms only in terms of the impact on private expectations under the assumption that private expectations will not differ, for systematic reasons, depending upon which governmental actor initiates the legal transition it is not able to comprehend the varying impact of possible norms on the persistence of the conventions that must persist for the legal regime to exist at all. these problems may be summarized with the observations that the transitions question arises from the conventional nature of law and that any attempt to answer that question without due regard for the distinctive nature of convention is apt to fail. one could justifiably say, perhaps with some irony, that the “nature” to which the new-view analysis appeals in analyzing the legal transitions question (namely, markets) would not exist if a set of conventions that themselves presuppose certain constraints on transition norms were not also in place. these conventions are both more fragile and 103. for sample discussions of non-socially optimizing conduct, see generally shaviro, supra note 1, at 64–91. 2010] legal tra'sitio's 155 more flexible than that nature: more fragile in that they place limits on transition “norms” that might otherwise appear more efficient, and more flexible in that, unlike the natural events to which they are inappropriately analogized, they may occur at times different from their “announcement.” the conventional source of the transition problem is also the reason why the appeal to the rules for market-based change as a basis for legal transition policy is fundamentally unavailing. if what must be taken as given is the possibility that the two dates differ (and it must if the transition issue is to arise at all), then the appeal to the solution of having the dates be the same where that solution presupposes that they are the same offers no help whatever in analyzing the transition problem. v. reliance and reasonable expectations none of the observations made in the preceding part imply that the actual policy recommendations of the recent transitions literature are incorrect. nor, conversely, does the fact that the law occasionally has been applied in ways inconsistent with principles that support political stability refute the observations made there, because the question is what an appropriate transition norm should be, not what consequences follow from the fact that the government occasionally has deviated from one norm or another. what the observations do imply, however, is that any particular transition norm must be evaluated with a view to the impact it will have both on “investor” incentives and on the conditions that permit investors to react to incentives effectively under law. when the new-view literature is evaluated according to these criteria, it turns out that its recommendations tend to be either uncontroversial—that is, not particularly different from those of the “old view”—or questionable. in the end, the recent transitions literature has little to say that is both new and true.104 in this part, i develop these claims through an examination of the 104. there appears to be some recognition of this claim in the literature. for example, in his review of shaviro’s book on legal transitions, logue notes that the “concrete policy payoff” of shaviro’s extended argument is ultimately disappointing. kyle d. logue, if taxpayers can’t be fooled, maybe congress can: a public choice perspective on the tax transition debate, 67 u. chi. l. rev. 1507, 1509 (2000) (internal quotation marks omitted). similarly, barbara fried notes that the philosophical literature grounded in “luck egalitarianism,” which is not significantly distinguishable in orientation from the “old view,” has reached more or less the same set of policy recommendations as the new view. barbara fried, ex ante/ex post, 13 j. contemp. legal issues 123, 124 (2003) (“the organizing premise of luck egalitarianism . . . that a just state would equalize the effects of brute luck on individual endowments, but leave individuals to bear the consequences (good and bad) of their choices . . . has led luck egalitarians to more or less the same conclusion that ‘rational expectations’ economists have reached on welfarist grounds . . . .”). 156 columbia jour'al of tax law [vol. 1:120 case for transition relief under nominally prospective legal change. prospective change is the focus here because i have already argued that the transition literature’s arguments for nominally retroactive rules, or more accurately its arguments for what is actually wrong with nominal retroactivity of positive law, are unpersuasive.105 the first subpart reviews the charge that reliance-based arguments for transition relief are circular. commentators have tended to make the conventional argument for reliance against which this charge has been raised in two distinct settings, a fact typically unnoticed in the recent transitions literature: to oppose the nominal retroactivity of positive law, and to advocate transition relief for a limited class of nominally prospective changes to the law.106 i argue that although different justifications for the reliance argument apply in the two settings, the blanket criticism offered under the new view has tended to collapse the cases because new view scholars reject the idea that there is a meaningful distinction between nominal retroactivity and nominal prospectivity that has retroactive effect.107 the discussion in the previous part has indicated why the distinction is meaningful and why reliance on the notion that legal transitions will not generally be nominally retroactive is reasonable. the second subpart demonstrates that the case for reliance as a basis for certain forms of relief from nominally prospective legal change is perfectly sensible as well. as a general matter, many types of legal rules can be analogized to conditional quasi-promises of one sort or another. where the original rule has this character, the question is whether the conditions that would justify an uncompensated departure from the continued operation of the rule obtain. if they do not, then relief—what is called “transition relief”—is generally appropriate. if they do, all bets are off and no transition relief would seem to be required—at least by the terms of the original promise, though other reasons for relief might exist. underlying all of this is the view that reliance as a norm that ought to play some role in the analysis is not entirely arbitrary. the fact that reliance cannot justify itself does not mean that it is arbitrary. rather, as argued below, reliance derives its role from the nature of language. if words are to mean something, then they must be able to be relied upon under certain circumstances. the question is what those circumstances are. 105. see supra part iv. 106. see, e.g., kaplow, economic analysis, supra note 1, at 522 n.26 (citing commentary). 107. see supra part iii. 2010] legal tra'sitio's 157 a. the 'ew view critique of reliance as previously discussed, under the new view, “transition relief” should generally be denied because it creates an undesirable government externality.108 the asserted parallel to market-based uncertainty is said to justify this principle, while reliance and reasonable-expectations arguments are said not to weigh in the other direction, because reliance and reasonable expectations are second-order principles that depend upon underlying practices.109 if absence of relief were the expectation, then reasonable reliance would not supply a basis for relief. i have argued that the positive part of the argument—the analogy of legal change to market-based changes—fails because various aspects of the legal regime on which markets depend cannot be assumed to persist under certain transition norms, such as a norm of extensive retroactivity to positive law.110 more generally, i have suggested that the positive case for a norm of no relief, to the extent it rests on the analogy, is conceptually flawed because it presupposes the transition rule it purports to justify.111 in this subpart, i focus on the charge of circularity as applied to the reliance norm. as contrasted with the positive case that, for example, kaplow and graetz make for no transition relief,112 this negative part of the argument is perfectly valid as far as it goes. one cannot justify transition relief on the basis of reasonable reliance or rational expectations without justifying the practice upon which the expectations are based, for if the practice were different, then rational expectations and reasonable reliance would differ too.113 therefore one would need to justify the underlying practice in order to defend the reliance principle. 108. kaplow, economic analysis, supra note 1, at 531. see also graetz, legal transitions, supra note 1, at 77–78; graetz, retroactivity revisited, supra note 76, at 1823– 24; and shaviro, supra note 1, at 2–3, for further discussion of this issue. kaplow also considers and rejects other arguments that might support transition relief. these include forcing the government to internalize harms, more fairly distributing the burdens and benefits of government, and maintaining horizontal equity. kaplow, transition policy, supra note 2, at 170. i do not discuss them here. 109. see supra part iii. 110. for purposes of this discussion, i bracket the point made earlier that kaplow does not articulate a well-defined concept of transition relief. see supra part iii.a. 111. see supra part iv.a. 112. see supra part iii. 113. in essence, in kaplow’s view the most that could be said about the expectations argument is that it raises the question of the proper transition to the proper transition regime. kaplow, economic analysis, supra note 1, at 557–60. kaplow notes that the questions this issue raises are distinct from those of the proper “steady state” transition policy. since it is currently reasonable to expect transition relief, it may not be appropriate to move to another transition norm without offering second-order transition relief. id. 158 columbia jour'al of tax law [vol. 1:120 the important point about this criticism is that, in principle, it is not inconsistent with the old view. stated somewhat differently, a proponent of the old view is not committed to extensive relief for nominally prospective changes to positive law as a general matter, or even to the idea that transition relief should operate as a default for such transitions. these conclusions should not be surprising, since the validity of the circularity charge does not depend upon anything about either the consequentialist view of legal transitions or the anticipations-oriented approach. for the same reason, the suggestion that the old view uncritically favors transition relief on the basis of reliance represents something of an overstatement.114 old-view scholars have not typically offered free-floating reliance arguments in favor of transition relief for nominally prospective transitions. although not always clearly articulated, the arguments for such relief (as contrasted with relief from nominally retroactive enactments) generally have applied to a relatively narrow range of enactments. graetz’s discussion of reliance arguments in the prior literature is illustrative of the tendency to group together reliance arguments made against nominal retroactivity with reliance arguments made against the failure to provide transition relief for nominally prospective transitions. graetz quotes the following statement by edwin s. cohen, assistant secretary of the treasury for tax policy during the first nixon administration, in support of his claim about the predominance of the oldview way of thinking: [p]rovisions have been deliberately kept in the tax law over many years, and they constitute standing invitations for taxpayers to erect new buildings, drill for oil, or embark on programs of charitable contributions. even if we should conclude that it would be unwise to continue some of these benefits or if we should alter some of them, it would not be appropriate to remove the preference precipitously after taxpayers have embarked on programs which they might not have adopted except for these provisions.115 114. graetz, retroactivity revisited, supra note 76, at 1823 (“in short, the argument asserts that people have a right to protection merely because either they now expect such protection or they expected such protection when they entered into a transaction; their expectations allegedly create a right and their asserted rights legitimate their expectations.”); kaplow, transition policy, supra note 2, at 170 (“[i]t is increasingly recognized that arguments based on actors’ reliance on and expectations concerning existing law are circular and otherwise deficient.”). 115. graetz, legal transitions, supra note 1, at 74 (quoting cohen, supra note 15, at 327). 2010] legal tra'sitio's 159 graetz goes on to observe that “[a]n argument in this form, without more, ends analysis.”116 but the observation, while true, is of limited relevance. rarely have arguments for reasonable reliance been made simply on the basis that reliance alone justifies relief. indeed cohen’s statement represents a quite limited call for reliance-based relief. as the latter part of the quotation intimates, cohen is discussing the repeal or limitation of specific items of tax preference, not all proposed changes to the tax law, a point confirmed by other parts of his text.117 in fact, in the same statement to congress, cohen advocates some changes to existing law that would be effective retroactive to the date he made the statement.118 the reason for this limited retroactivity is that the provisions to which it applies are intended to correct unintended errors contained in, or opportunities for abuse offered under, prior law.119 thus, if cohen is guilty of anything regarding the reliance argument, it is his failure to identify which of the conventional justifications for protection of reliance interests apply when congress repeals tax preference items on the basis of new policy judgments. a similar example is found in kaplow’s work. he states: one of the most commonly noted arguments against allowing private actors to bear losses resulting from changes in government policy is that they reasonably relied on preexisting law in making investment decisions. many legal theorists, however, have long recognized the circularity of such arguments, which implicitly assume that it is reasonable to expect laws never to change . . . .120 116. id. 117. graetz omits the first word of the first sentence quoted: “these.” it refers to what cohen calls “the major tax preferences.” cohen, supra note 15, at 327. they include such items as accelerated depreciation deductions, tax incentives for oil exploration, and charitable-contribution deductions. id. 118. see, e.g., id. at 336 (“we believe that the distortions of income tax liability involved in [so-called abc transactions involving mineral production payments], and increasing utilization in various extractive industries, indicate that these distortions should be terminated promptly . . . . we recommend, therefore, that this provision be enacted as promptly as possible and be effective with respect to transactions consummated, or covered by a binding contract entered into, on or after april 22, 1969 [i.e., the date cohen delivered the statement to the house ways and means committee]. the industries involved have had adequate notice that the tax treatment of production payments was under reconsideration.”). 119. id. at 346–47. 120. kaplow, economic analysis, supra note 1, at 522 (footnotes omitted). 160 columbia jour'al of tax law [vol. 1:120 although kaplow notes that whether reliance is in fact appropriate depends on the circumstances of each case, he does not explore what factors are or should be relevant in the various cases. rather he tends to discount the reasonableness of reliance altogether.121 perhaps ironically, one reason that new view scholars may have tended to overstate the role reliance arguments play under the old view is their insistence on regarding nominally retroactive enactments as essentially similar to nominally prospective enactments that have retroactive effects. once one has effaced the distinction between nominally prospective and nominally retroactive legal change, there is not much point in distinguishing between old-view discussions in which reliance is featured as a defense to nominal retroactivity from those in which it is raised as a defense to transition relief understood in the conventional, that is, forwardlooking, sense. indeed, many of the discussions to which the new-view theorists point as examples of excessive deference to reliance arguments concern nominally retroactive statutes, not transition relief offered in the context of nominally prospective legal change.122 but the old view does not efface the distinction between nominally retroactive legal change and the purportedly retroactive effects of nominally prospective legal change, for the reasons discussed previously. as a consequence, the old view’s near-blanket rejection of nominal retroactivity on reliance grounds is perfectly compatible with a much more skeptical view of reliance as a basis for transition relief.123 the distinction seems simply to be lost on new view 121. id. at 525. see also kaplow, transition policy, supra note 2, at 170 (“although commonplace in most transition settings, it is increasingly recognized that arguments based on actors' reliance on and expectations concerning existing law are circular and otherwise deficient.”). 122. for example, three of the four commentaries that kaplow cites in support of the pervasiveness of the reliance norm are expressly concerned with the validity of reliance arguments against nominally retroactive legislation. see kaplow, economic analysis, supra note 1, at 522 n.26 (citing committee on tax policy, tax section, new york state bar association, retroactivity of tax legislation, 29 tax law. 21, 22–23 (1975); note, setting effective dates for tax legislation: a rule of prospectivity, 84 harv. l. rev. 436, 439–42 (1970); alan s. novick & ralph i. petersberger, retroactivity in federal taxation: part ii, 37 taxes 499, 499–504 (1959). the fourth commentary adduces reliance as a basis for compensation in the case of prospective changes to zoning laws. id. (citing developments in the law: zoning, 91 harv. l. rev. 1427, 1494–96 (1978)). even here, however, the cited author notes that the strength of the reliance argument varies with the nature of the zoning ordinance on which it is based. id. at 1495–96. in their counterpart discussions of the old view of reliance, graetz and logue cite some of the same literature. see graetz, legal transitions, supra note 1, at 73 n.78; logue, tax transitions, supra note 11, at 1136 n.27. 123. see, e.g., cohen, supra note 15, at 346 (advocating an effective date of the date of announcement before committee for a provision designed to correct an error in the tax law). 2010] legal tra'sitio's 161 scholars.124 correlatively, and not surprisingly, the idea that reliance interests support transition relief for all nominally prospective changes to the tax law does not appear ever to have been seriously entertained by anyone, a point well recognized in the transitions literature itself. for example, changes in tax rates,125 including rates on capital income, never have been accompanied by relief, and serious arguments for relief for such changes have not been made. similarly, provisions designed to address arrangements that comply with the law but do not produce tax results considered appropriate often have been enacted with at least some retroactive effect.126 outside of the tax area, various changes to the legal landscape routinely have substantial adverse impacts on individuals who have relied on prior law, but the idea that congress should make extensive grandfathering relief available is not entertained. in short, the types of legal change for which reliance-based transition relief (as opposed to reliancebased relief against nominally retroactive legislation) has been advocated have generally been considered changes to provisions that invited reliance for reasons other than the mere fact that they were law. b. the positive case for reliance in this subpart i argue that the same considerations that support distinguishing between market-based transitions and legal transitions support the introduction of a concern with reliance. in the end, the concern rests on an acknowledgment that legal rules, and hence changes to legal rules, derive from authority that is based in large measure on consent. this feature of legal rules is to be contrasted with unanticipated market-based changes, which simply happen. consent implies that whoever has authority to effect a legal change of one type or another has the authority on the basis 124. graetz remarks that “[t]he evaluation of claims for transitional relief should be guided not by the existence of expectations, but rather by some independent normative vision of what people should be entitled to expect.” graetz, retroactivity revisited, supra note 76, at 1823. the statement is true, but without more, it does not demonstrate that reliance arguments may not succeed in explaining why transition relief should be offered in certain circumstances. 125. although most ordinary income is taxed in the year earned, and hence does not raise a transition question assuming there is no nominal retroactivity to a later change in law, a long-term contract entered into under prior law would raise a transition issue. thus, a taxpayer who entered into a multi-year contract when the applicable marginal was 25% would not be thought entitled to have that rate grandfathered if rates went to 35% before the term of the contract. 126. see note, setting effective dates for tax legislation, 84 harv. l. rev. 436, 438– 42 (1970) (noting retroactive aspects of tax legislation). 162 columbia jour'al of tax law [vol. 1:120 of some sort of agreement, however attenuated, between those who promulgate the new rule and those who are subject to it. to the extent that the presence or absence of transition relief bears on reasonable assumptions about the government actor’s conformity with that agreement, reliance may or may not be appropriate. underlying this view is the assumption that some positive case for reliance exists, for the circularity critique of reliance demonstrates that the fact of reliance cannot, by itself, establish the reasonableness of reliance. at its core, this positive case is the same in the transitions setting as in others. it is simply that if an announced legal rule is to have an effect on the conduct of parties to whom it purports to apply, they must have some basis to believe in a correspondence between that statement of the rule and the rule that turns out to apply in fact.127 in other words, they must believe it is the actual rule. if the expectation of correspondence is lacking, the statement of the rule would be pointless. this expectation is a feature of language and represents a second difference between natural or marketbased change and legal change. whereas the fact of natural change simply presents itself to investors who must deal with it, the “fact” of legal change depends for its facticity upon the acceptance of those to whom the statement of the legal rule applies. a statement of the rule must have some basis to be trusted if it is to be accepted as the actual rule. that, of course, does not mean the statement is to be taken as true no matter what. there may be explicit or implicit caveats on the circumstances in which it will continue to be the rule, but if there are no norms whatever that limit the authority of the lawmaker to withdraw or change the rule, then there is no basis to consider the statement of the rule to be true in the first place.128 these observations indicate that the question is how the fact that a legal change concerns prospectively rather than retroactively effective rules alters the case against protection of reliance interests. what is it about the fact that a new rule is made to operate solely with nominally prospective 127. the reliance argument is sometimes framed as resulting from a notion of quasicontract between the government and private actors. it is better framed as resulting from a quasi-promise, both because reliance damages can arise out of promissory obligations and because there is no analog to consideration in contract that runs from those subject to legal rules to those who promulgate them. 128. indeed one could reasonably characterize the central task of modern political theory beginning with hobbes as finding a way to ensure that and which statements of legal rules may be relied upon. see, e.g., thomas hobbes, leviathan 129 (michael oakeshott ed., 1962) (arguing that security is possible only in civil society in which a single legislator has the power to announce and enforce the law); immanuel kant, perpetual peace and other essays 79 (humphrey trans.1983) (arguing that the concept of right requires a sole legislator possessing unlimited power to impose coercive law as long as it is not selfcontradictory as law). 2010] legal tra'sitio's 163 effect, rather than with expressly retroactive effect as well, that justifies less solicitude for expectations regarding the fixity of legal rules? why, in short, is changing the future different from changing the past? the following sections address these questions by focusing on the possible causes of legal change. notably, one of these sources—a change in circumstances—can occur solely going forward, whereas the other, a change in judgment about the advisability of a rule can occur both going forward and going back. in order to illustrate the basis for limited claims of reliance, in the following subparts i explore its role in two settings, with the second setting, in turn, having two variations of its own. each of the two broader settings involves the repeal of the municipal bond interest exclusion. throughout, i assume that congress initially adopted the exclusion because congress had concluded that state activities should be subsidized by the federal government on a steady-state basis and that the exclusion was an appropriate method for doing so. the question is whether transition relief should accompany a repeal of the exclusion. 1. first case: change in material circumstances under the old view, it would seem that whether repeal of an incentive provision such as the interest exclusion for municipal bonds merits some sort of transition relief depends upon the reasons for the repeal. suppose in the first case that congress repeals the exclusion in response to an unforeseen change of material circumstances, such as a need to raise revenue. under these circumstances it does not seem that transition relief should be expected, though one could imagine reasons why in any particular case it might be made available. in this setting, one could well say—and it seems for reasons well documented in the literature, it would be preferable to say—that no transition relief should be in the offing absent significant distributional or other considerations that would make relief a good idea, because it remains unclear why relief should presumptively apply when the conditions under which it makes sense to offer the preference no longer obtain. there is no obvious reason why investors ought not to be charged with assuming the risk that if circumstances make the law a bad idea, they ought not be entitled to enjoy the benefits of the law.129 after all, the decision to offer the preference was made, implicitly or not, on the basis that the circumstances made the preference a good idea. there is never certainty about the future, and it is difficult to see why the government, rather than investors, presumptively ought to absorb the costs 129. shaviro, supra note 1, at 48. 164 columbia jour'al of tax law [vol. 1:120 of unexpected developments that make existing law non-optimal. 2. second case: change in legislative judgment contrast the preceding situation to this second case, in which repeal rests upon a new policy evaluation of essentially the same basic circumstances. here the material conditions that were thought to support the preference have not changed; rather congress has reconsidered the wisdom of the initial decision to offer the preference under those circumstances. this case presents, in turn, two variations. the first is where the same legislative body is in place at all relevant times, while in the second a subsequently elected legislature initiates the transition. (a) first variation: same elected body in the first variation, the same elected body both enacts and repeals the tax preference—again, with no change in material conditions. the critical issue in this setting is the fact that the passage of time really should play no normative role. as a first step in the analysis, consider the difference between a preference that provides benefits on an immediate basis, such as the deduction for certain research and experimentation expenditures,130 and a preference the benefits of which materialize over time, such as the bond interest exclusion. if the research and experimentation deduction were enacted in year 1 and repealed prospectively in year 2, all of the benefits expected from expenditures already made by the time of the repeal would have been realized. by contrast, a prospective, non-grandfathered repeal of the bond interest exclusion would preclude investors from reaping any of the benefits expected to be realized in the future.131 despite these different timing results, it is by now a familiar truth that on a steady-state basis the two methods of providing a benefit differ only in formal terms.132 assuming no 130. i.r.c. § 174 (2010). 131. see supra part iii.b. 132. this result is a statement of the so-called cary brown theorem. cary brown, business income taxation and investment incentives, in income, employment and public policy: essays in honor of alvin h. hansen 300 (1948). it depends upon certain simplifying assumptions that are not relevant to the present analysis, such as that the relevant tax rates are the same at all times and that the investor can make full, current use of the deduction for the initial investment. kaplow discusses this equivalence, as well as the economic equivalence between a nongrandfathered repeal of benefits that had been anticipated to accrue in the future and the same repeal coupled with taxing back benefits that had been provided as an up-front subsidy. 2010] legal tra'sitio's 165 change in law, one could offer the same benefit that the bond interest exclusion provides by permitting a deduction for the purchase price of the bond in the year of purchase and taxing all subsequent returns (principal and interest) as they are received.133 under either model, the relevant investor decision occurs in the pre-repeal period, but under the deductioninclusion model, a prospective, non-grandfathered repeal would not preclude realization of any benefits that investors would be awaiting under the interest exclusion model. in this context, the material equivalence of the two methods under steady states, coupled with the previously made argument against the propriety of nominal retroactivity, seems to indicate that grandfathering is appropriate on repeal where congress chooses to make the form of the preference require its persistence into future periods in order to be fully realized. the obvious response to this argument is that it seems to prove too much, for the same could be said of the case previously described, in which repeal takes place under changed circumstances. in that setting it was suggested that congress’s decision to implement the tax benefit in the form of an interest exclusion rather than as an up-front deduction signaled that investors are at risk of no relief in the event of repeal.134 the argument just offered, however, suggests that the equivalence under certain background assumptions of an up-front deduction with an exclusion over time means the same total benefits should be made available on repeal in either case. it therefore might seem that both claims cannot be correct, but this suggestion rests upon a failure to account for the decisive difference that the different background conditions make for the two cases. it is precisely the fact that a forward-looking preference presupposes appropriate material conditions that makes appropriate a presumption of no relief when these conditions change. in other words, a forward-looking preference signals that congress intends the preference to be available only as long as the conditions that make it appropriate persist. as long as there is no change in material circumstances, the forward-looking preference and the immediate preference remain indistinguishable, for the risk assumed under the see kaplow, transition policy, supra note 2, at 188–89. see also shaviro, supra note 1, at 218 (noting the equivalence in the methods for the municipal bond case). 133. consider a taxpayer in the 30% tax bracket who earns $100 and uses the after-tax proceeds to purchase a ten-year municipal bond that pays 10% annually. under the interest exclusion regime, she pays $30 in tax on her earnings, purchases a $70 bond, receives $7 annually in untaxed interest, and receives her $70 back at term tax-free. under the deduction regime, she pays no tax on the $100 of earnings, purchases a $100 bond, earns $10 annual interest on which she pays $3 tax, and receives her $100 back at term, at which time she pays $30 in tax. 134. see generally logue, tax transitions, supra note 11, at 1181–94, for a discussion of methods by which congress might bind itself to transition relief. 166 columbia jour'al of tax law [vol. 1:120 forward-looking preference has not materialized, and it was that risk that justified the presumption against transition relief. one might accept that a difference between changed material circumstances and changed legislative judgments has some significance for transition policy, but query why investors might not also assume the risk of no relief in the changed-judgment case when a preference is adopted on a forward-looking rather than an immediate basis. the difficulty is that if such a presumption obtained, then the enactment of a tax preference whose benefits extended to future periods would rationally be viewed as equivalent, at the front end, to congress’s saying that it does not want to provide the preference on a steady-state basis under the existing facts, for if it did it would have made the preference available as an immediate deduction. it is entirely unclear why such a signaling presumption should operate. it needlessly limits congress’s ability to offer tax benefits in the form it prefers, when congress can limit the benefits on enactment directly, simply by sunsetting the preference or by making it otherwise conditional. for although a deduction and an exclusion may be the same on a steadystate basis, they have different properties with respect to transition periods, and congress might well prefer to plan for the possibility of changed material circumstances in designing the tax preference; removing the presumption that any forward-looking preference comes with a risk of uncompensated change even where material conditions do not change leaves that flexibility available. consider that where a change in circumstances makes the preference a bad policy idea, having offered the exclusion is cheaper than having offered the deduction precisely because the exclusion’s benefits materialize later than the deduction’s; the forgone revenue under the exclusion is always less than under the deduction as long as any bonds are outstanding on the repeal date. because a rejection of the presumption of no relief when relevant circumstances have not changed does not entail rejecting the presumption when they have changed, there is no benefit to be had from adopting the presumption. note, further, that the availability of means by which to make relief tentative other than by having a presumption of no transition relief when the facts have not changed makes the decision not to offer transition relief in this context irrational. there is literally no relevant difference on a steadystate basis between the deduction method and the exclusion method, and given that the case under consideration involves no material change to the facts, the potential penalty of non-grandfathered repeal would indeed depend upon “mere accounting considerations,”135 because what obtains is, 135. shaviro, supra note 1, at 106. shaviro uses the quoted language to describe the definition of nominal retroactivity. 2010] legal tra'sitio's 167 in effect, a steady state. and this equivalence indicates, in turn, that failure to provide grandfathering relief in the no-change-of-circumstances case is analytically equivalent to nominally retroactive taxation. in other words, the relevant difference between prospective repeal without relief and retroactive taxation is that one can rationally consider investors to have assumed the risk of changed material circumstances that may make current law sub-optimal, but not that they have assumed the risk of a mere change of mind. and the reason they have not assumed it illustrates the relevance of reliance. if words (statutes, rules, etc.) are to have meaning, then in the absence of a change to the circumstances in which they are set forth, one must be able to rely on them. the assumption of the former risk is what justifies a presumption of no relief on repeal when circumstances do change. the new transitions literature has made this point, but it has not adequately distinguished between that case and the change-of-mind case.136 where there are no changed circumstances, the difference between changes that illicitly reach back into the past and those that account for new present and future conditions disappears, because the past and the future are relevantly the same. the implication of the equivalence, however, runs in the opposite direction from that assumed by the new transitions literature: where conditions do not change, forward-looking un-grandfathered repeal, at least of incentive provisions, is analytically equivalent to illicit nominal retroactive taxation. (b) second variation: subsequently elected body under the second variation of the case in which material circumstances have not changed, the question is whether the analysis runs differently if the repealing body differs from the enacting body. more precisely, the question is whether this difference changes the reasonableness of a presumption that investors do not run the risk of an uncompensated repeal of a preference where the material conditions supporting its prior enactment have not changed. the analysis under first variation indicated that failure to offer relief was not rational, because there is no advantage to be gained from the presumption that relief would not be forthcoming. a significant difference does exist, however, between that case and the case in which a new legislature repeals the preference. it is to be found in the parallelism between the latter situation and nominally 136. kaplow, for example, notes that where changes to the facts (as opposed to a reevaluation of the wisdom of a rule) give rise to a legal transition, retroactive effectiveness would not be appropriate. kaplow, economic analysis, supra note 1, at 551. see, e.g., supra note 131 and accompanying text. 168 columbia jour'al of tax law [vol. 1:120 retroactive positive law. the principal objection to such law, it will be recalled,137 was that it supplanted the elected legislature with a different, and unauthorized, legislative body. the converse problem arises in the present case. where the previously enacted tax preference materializes during future legislative periods, a requirement of relief on repeal (where material circumstances have not changed) threatens to supplant the current legislature with the past one. in the extreme, the present legislature would be precluded from doing anything at all in the absence of a change in material circumstances, if offering relief under prior law required its extension sufficiently far into the future.138 the same considerations also indicate that the rationality objection to the presumption of no relief in the same-legislature case does not apply here. the rationality objection rests on the assumption that a rational legislature, though it may change its mind, makes provision for doing so ex ante, when it enacts a provision. under that assumption, a legislature rationally signals a decision to make preferences tentatively available under steady-state conditions expressly, by enacting a provision for a limited period of time, rather than by entertaining a presumption of no relief on repeal. once the assumption is abandoned that the same legislature that enacts the provision repeals it, no inference about the course of future legislative conduct follows from the enactment of a relief provision in one form rather than another. accordingly, no inconsistency or irrationality automatically results from a failure to provide relief on repeal of a forwardlooking tax preference where material conditions have not changed. by the same token, the problem of potentially binding future legislatures does not point to an automatic presumption of no relief where the repealing legislature differs from the enacting one, but rather to the need for a balancing of considerations. on one hand, prior legislatures ought not be considered to bind future legislatures on matters of policy judgment. on the other hand, the same considerations of flexibility operate in this setting as in the same-legislature setting. since investors know that legislatures change periodically, the same questionable incentives would be created if all bets were automatically off with every election. at the other extreme, an obvious effort to lock in changes in law by enacting forward-looking 137. see supra part iv.b. 138. thus, one could imagine a case in which a late-term congress passes a suite of relief provisions all of which materialize over ten or more years, and where the reason for passing the provisions in this form was to lock in current legislative judgments. this example has a parallel in the case of executive action, where an executive about to leave office issues or finalizes a large number of orders and regulations to entrench its policy preferences. see nina mendelson, agency burrowing: entrenching policy and personnel before a 'ew president arrives, 78 n.y.u. l. rev. 557 (2003). 2010] legal tra'sitio's 169 reforms that necessarily materialize over long periods of time ought not be respected by a future legislature that wishes to pursue different priorities or takes a different view of the effectiveness of prior policies. hence one would expect to find a variety of outcomes in this setting, depending upon the particular circumstances under which the preference was enacted. a final point is in order here, and it illuminates one reason that no clear transition norms have in fact emerged, and why they are unlikely to. in this subpart i have assumed that one can divide cases according to whether or not relevant material circumstances have changed. in practice, the classification of actual cases is likely to be contested because circumstances are constantly changing, and it will frequently be an open question whether the circumstances that have changed are material to a change in law. wholly apart from concerns of public choice—paying off constituencies, log-rolling and the like—the question of relief is contestable simply because of the difficulties in classifying cases. hence one would expect to see what one does see in the transition context: a variety of transition rules for seemingly similar cases. c. the linguistic basis of reliance i have argued that some basis for reliance is implicit in any statement of a legal rule, because it is a requirement of a statement of what the rule is that it be able to be relied upon under at least some circumstances. if language did not have this character, it would be meaningless. accordingly, the question for reliance analysis becomes what those circumstances are. the fact that some basis for reliance is presupposed in any statement of the rule does not mean that reliance is always or even mostly appropriate. it simply means that one must distinguish the cases in which reliance is or should be implied from those in which it need not. the preceding discussion has suggested what the outer limits of a rational norm of no reliance would be. it is a possible rational norm that all bets are off when the circumstances under which a prior rule was adopted have changed. that is, there is nothing incoherent about an implicit norm that legal rules may be relied upon only as long as the conditions that gave rise to their adoption obtain. but i also have noted that a change in material circumstances is not the only occasion for a change in legal rules. sometimes rules change simply because the legislator has changed its mind about the advisability of the rule even though the circumstances that gave rise to the rule have not changed. in that case, a refusal to protect reliance interests when the rule changes, at least where it is the same legislator that adopted the original rule, becomes inconsistent with the idea that the 170 columbia jour'al of tax law [vol. 1:120 legislator rationally states the legal rule in the first place. it is not really distinguishable from someone’s pronouncing that p, and then immediately pronouncing that not-p. that is, there is something incoherent in an implicit norm that says legal rules may never be relied upon, or may not be relied upon when they are reversed by the same legislator that adopted them when there has been no relevant change to the conditions under which they were adopted. if that were not the case, then one could not rely, for example, on the statements made by anyone, including in a contract or, for that matter, in any other setting. the new view theorists, by failing to distinguish between these different circumstances of legal change, reach the conclusion that a norm of no reliance could be perfectly coherent and that for other reasons, it may well be. there is some irony in the fact that that view is to some extent undermined by their own occasional acknowledgment that a norm of nominal retroactivity would frustrate investor expectations:139 if there is no significant difference, other than in degree, between nominal retroactivity and nominal prospectivity, then there ought not be a concern about adopting a norm of nominally retroactive legislation if reliance interests are circular and not independently justifiable. conversely, if that concern is valid, then it ought to apply with nearly equal force to uncompensated, nominally prospective change, the only difference being the aforementioned one of degree.140 in that case reliance lives. because the new view does not pay sufficient heed to the distinction between a change in facts and a change in the rule that applies to those facts, it is unable to explain why either its concerns about nominally retroactive rules ought not apply to protect reliance interests or, conversely, why a norm of nominal retroactivity ought not apply to changes in positive law. for what is quintessential to a nominally retroactive change, but is typically absent in a nominally prospective change, is that circumstances have not changed at all: the past is what it is. vi. conclusion the new transitions literature does not appear to offer particularly robust policy recommendations. for the most part, the recommendations are either consistent with those that a proponent of the old view might offer, or questionable. i have argued that the principal reason for the failings of 139. see, e.g., levmore, retroactive taxation, supra note 11, at 278 (observing that repeated use of retroactive taxation would undermine its usefulness as a surprise to raise tax revenue efficiently). 140. see supra part ii.a. 2010] legal tra'sitio's 171 the literature is that it does not pay heed to the specific conditions under which legal transitions occur. these conditions are importantly conventional, and because they are conventional, the preconditions to the conventions must be satisfied if the conventions are to persist; if the preconditions do not persist, then law itself is called into question. the old view gives expression to the preconditions in recognizing, even if not always with sufficient precision, the relevance of the distinction between nominally retroactive and nominally prospective legal change, or between law-making and law discernment.141 in something of an irony, the analogy the new transition literature uses to justify a particular set of norms holds only because these conventionally established conditions obtain and thereby appear natural, but the conditions themselves would not obtain if the rules the new transitions literature offers for many cases became transition norms. the considerations developed here also suggest that if the authority of the lawmaker did not depend for the most part on the convention that the lawmaker expresses the will of a consenting body, most of the difficulties described in this article would disappear. in that case, transition norms would not affect the conditions that make action under law possible, because they would not call into question the regime that individuals must presuppose in order for law and institutions that depend on law, such as markets, to exist. however, the connection between political and legal authority on one hand, and the will of the individuals subject to law on the other, is more than incidental to the existence of the legal regime. the connection means that transition norms are both more limited and more flexible than the recent transitions literature has recognized. they are more limited because they must respect the idea that law derives from an electorate that is self-governing. both nominal retroactivity in many circumstances, and immediate nominal prospectivity in fewer circumstances, are inconsistent with this idea. transition norms are more flexible because they may vary according to the type of legal transition that different institutions, based upon different conventions, engage in. in one sense, these criticisms can be traced back to a fundamental tenet of the new transitions literature, articulated first by graetz, developed by kaplow, and given perhaps its most comprehensive explication by shaviro. this is the idea that new rules have a retroactive effect when they have an impact on the future consequences of decisions made prior to the adoption of the rule. the idea that such transitions “reach back into the past,” in shaviro’s formulation, implies that one cannot meaningfully distinguish between legal transitions that apply by their terms to completed 141. see, e.g., novick & petersberger, supra note 122, and authorities cited therein. 172 columbia jour'al of tax law [vol. 1:120 conduct and those that apply to the present and future consequences of completed conduct—conduct that projects itself into, and assumes the risks of, future developments, whether they be changed material circumstances or different lawmakers with different policy judgments. it is on the basis of this view that the new transitions literature downplays, if it does not dismiss, the distinction between nominal retroactivity and nominal prospectivity that has retroactive effect. the considerations developed in this article explain why it is sensible to draw a distinction in kind between forward-looking reforms and nominally retroactive ones, and why one might want to reserve the term retroactive for the latter as well as, perhaps, for future consequences of past actions where the distinction between past and future is irrelevant—no change in facts and no change in lawmaker. future consequences always depend upon future conditions, whereas past consequences and conduct depend upon nothing; they are complete. it is often appropriate to impute to investors an assumption of the risk that the future will differ from the past, but not that the past does not turn out to be what it was. the considerations developed here also suggest that the newer transitions literature has not offered much by way of advance over the older view. i have argued that two pillars of the new view – the ideas that legal transitions are closely akin to market changes and that an appeal to reliance interests is circular – are importantly mistaken. once one removes these pillars, it is not clear that much remains of the new view’s general prescriptive edifice. whether a rule of no relief is appropriate in the legislative setting would seem to depend, as it always has, on whether it made sense for those subject to the old rule to rely on its persistence. in other words, it is a question that cannot be answered apart from an examination of the facts in any particular case. similarly, whether a difference in default rule ought to obtain between legislative and judicial action would seem to depend, as it always has, on the significance of the distinction between making law and finding it.142 where does all of this leave us? prior to the development of the new view, the general orientation of the transitions literature seems to have been that the question of the appropriate transition rule was to be answered on a case-by-case basis.143 in other words, the idea that there might an optimal transition norm seems not to have been entertained. the newer literature seeks, instead, to develop a framework for analysis that largely eschews any examination of the particular circumstances of any given 142. see munzer, supra note 59, at 374–75. 143. this is the general assumption that cohen makes. see novick & petersberger, supra note 122, at 500. 2010] legal tra'sitio's 173 change in favor of a search for transition norms. the arguments developed in this article suggest, however, that the question of the optimal transition norm is no more meaningful than is the question, “what is the best law?” neither can be answered in the abstract, because neither is a question of norms. rather, each is a question that must be approached in light of circumstances, and addressed to the new challenges as they arise. sugin3-1-1 articles tax expenditures, reform, and distributive justice linda sugin* abstract tax reform is coming, and it will be an important part of any plan to avert national fiscal disaster. the president’s fiscal commission recently presented a proposal for comprehensive tax reform that will form the basis for serious legislative discussion. at the center of that proposal is elimination of “tax expenditures,” which are provisions in the tax law that operate like direct government spending. they include the charitable deduction, the home mortgage interest deduction, the exclusion for employerprovided health insurance, the child credit, the earned income credit, education credits and deductions, the tax preference for retirement savings accounts like iras and 401(k) plans, and dozens of others. this article argues that elimination of tax expenditures is a flawed approach to tax reform. tax expenditures are not an undifferentiated mass, but reflect a wide variety of federal policies, each of which requires independent evaluation. before policymakers can decide whether to abolish tax expenditures, they need to know a lot more than the tax expenditure budgets currently reveal about what tax expenditures do, who benefits from them, and how much revenue could be raised by their repeal. they also need to decisively identify which provisions are tax expenditures, a perennial source of disagreement. this article argues that proposals to repeal tax expenditures reflect a normative preference for efficiency over equity, the traditional twin goals of tax policy, squandering the tax law’s unique role in economic justice. * professor, fordham law school. i am grateful to the participants in the tax policy center conference, starving the hidden beast, the university of colorado school of law tax policy workshop, the loyola law school tax policy colloquium, and particularly edward kleinbard, daniel shaviro, and benjamin zipursky for comments on earlier drafts. 2 columbia journal of tax law [vol.3:1 i.
 introduction........................................................................................................ 3
 ii.
 how tax expenditures became the problem ...................................... 7
 a.
 tax expenditures and reform were always linked, but now we really need the money .............................................................................................................. 7
 b.
 the current tax reform proposals ..................................................................... 10
 c.
 tax expenditures and budget policy................................................................... 14
 iii.
who really benefits from tax expenditures? ................................ 17
 a.
 we are ignorant about who really benefits from tax expenditures............... 17
 1.
 where are the distributional tables?........................................................... 17
 2.
 the real incidence of tax benefits matters.................................................. 19
 3.
 subsidies should be distinguished from incentives .................................... 23
 b.
 distributional neutrality is not distributive justice ........................................... 26
 c.
 the distributional effects of tax expenditures have changed ......................... 28
 iv.
the tax expenditure budget cannot bear the responsibility for reform........................................................................................................... 31
 v.
 reformers privilege efficiency over equity................................... 35
 a.
 taxes are bad for growth.................................................................................. 36
 b.
 efficiency is the new normal in the tax expenditure baseline ......................... 37
 c.
 tax expenditures affect the fairness of the tax rates ...................................... 39
 vi.
reform must heed the lesson of tax expenditure analysis .. 40
 vii.conclusion .......................................................................................................... 42
 2011] tax expenditures, reform, and distributive justice 3 i. introduction a ballooning federal deficit and growing populist hostility to taxation has lawmakers talking seriously about tax reform. today’s internal revenue code1 is dizzyingly complex, unfair, and impedes economic prosperity. it also fails to raise sufficient revenue to avert fiscal disaster.2 serious proposals for tax reform are on the table, and they share a simple, fundamental approach to reshaping the law: strip the code of the myriad special deductions, credits and exclusions that allow individuals and corporations to reduce their tax liability. without these preferences for particular types of income or expenditure, taxable income and tax payments would be higher for many taxpayers. these provisions, known as “tax expenditures,”3 include many provisions that taxpayers have become accustomed to taking for granted. they include the charitable contribution deduction, the home mortgage interest deduction, the exclusion for employer-provided health insurance, the child credit, the earned income credit, education credits and deductions, and the tax preference for retirement savings accounts like iras and 401(k) plans.4 they are called “tax expenditures” because they achieve the same objectives as direct federal spending, but they are administered through the tax law. they are unlike “real” tax provisions that are necessary to accurately measure taxpayer income; without them, the tax law could still carry out its revenue collection function. only the mechanism for administration distinguishes tax expenditures from direct expenditures — instead of the government allocating funds for particular programs, tax expenditures allow taxpayers to reduce their tax payments by participating in various activities. tax expenditure provisions were adopted to incentivize particular activities or to reduce the burden on certain individuals, families or businesses. for example, the home mortgage interest deduction was added to the code in order to encourage homeownership. it operates as a federal subsidy for home mortgages because the deduction reduces the tax liability of mortgage holders. on account of the deduction, an individual’s mortgage interest burden is reduced by an amount equal to the mortgage holder’s interest payment multiplied by his marginal rate of tax.5 in total, the government estimates that tax expenditures are responsible for over one trillion dollars of revenue loss each year.6 to help put that number in perspective, it 1 i.r.c. (west supp. 2010). 2 congressional budget office, pub. no. 4212, reducing the deficit: spending and revenue options 1 (2011). 3 see congressional budget act of 1974, pub. l. no. 93-344, § 3, 88 stat. 297, 299. this act mandated the preparation of a tax expenditure budget and defined tax expenditures as “revenue losses attributable to provisions of the federal tax laws which allow a special exclusion, exemption, or deduction from gross income or which provide a special credit, a preferential rate of tax, or a deferral of tax liability.” 4 the list of tax expenditures also includes numerous tax preferences for businesses, such as capital expensing, research credits, and deferral of certain types of income. this article is primarily concerned with the effects of tax expenditures on individuals. 5 to illustrate, consider a taxpayer with an annual mortgage interest payment of $20,000. if his marginal rate of tax is 35%, the deduction saves him $7,000 in tax. if the government sent him a check for $7,000 and increased his tax liability by $7,000, he would be in the same economic position as he is with the deduction. a 20% marginal rate taxpayer would save only $4,000, but the analysis would remain the same. 6 thomas hungerford, cong. research serv., rl34622, tax expenditures and the federal budget 13 (may 26, 2010) (“in 2009, it was estimated that tax expenditures amounted to about $1 4 columbia journal of tax law [vol.3:1 exceeds the total amount that the federal government spends through direct discretionary appropriations.7 tax expenditures not only operate to reduce tax liabilities of taxpayers, they sometimes entitle individuals to transfer payments through the tax administrative apparatus.8 because they are the equivalent of direct spending programs, reductions in tax due to tax expenditures increase the size of government.9 they are essentially public programs that are managed by the internal revenue service. this is in contrast with reductions in tax rates, which shrink the extent of government involvement in the private sector. tax reform has become virtually synonymous with simplification, understood as (1) broadening the tax base by repealing tax expenditures, and (2) lowering the statutory rates. because they are better conceptualized as spending than taxing, reformers treat tax expenditures as extraneous to the fundamental purposes of the tax law: accurately measuring income and collecting revenue. two important proposals reflecting this fundamental idea have been released in the last few months, and they will lay the framework for future discussions of tax reform in congress.10 the president’s fiscal commission, led by erskine bowles and alan simpson,11 embraced the approach most enthusiastically: it proposed drastic reductions in the statutory rates and repeal of all tax expenditures in the code.12 in fact, the fiscal commission’s proposed simplification was so sweeping that it did not identify the numerous individual tax expenditure provisions to be repealed, but instead erased them all with a single stroke. it named the proposal the “zero plan,”13 and its main tax reform objective was elimination of all tax expenditures. similarly, the bipartisan policy center’s debt reduction task force, led by pete domenici and alice rivlin, followed the same basic approach of lowering rates and repealing tax expenditures.14 although it does not propose to lower rates as much as the fiscal commission’s proposal, according to the bipartisan policy center’s plan, cutting tax expenditures will finance 38% of the plan’s debt reduction by 2020.15 trillion….”); see staff of joint comm. on tax’n, 111th cong., estimates of federal tax expenditures for fiscal years 2009-2013 (joint comm. print 2010). 7 see office of mgmt. & budget, exec. office of the president, fiscal year 2012: historical tables 167 tbl.8.7, 346 tbl.15.4 (2010). 8 approximately 40% of filers paid no income tax in 2009. the “refundable” credits authorize the government to send them checks through the tax system. see roberton williams, who pays no income tax, 123 tax notes 1583, 1583 (2009). 9 donald marron & eric toder, measuring leviathan: how big is the federal government?, presentation at loyola law school: starving the hidden beast: new approaches to tax expenditure reform (jan. 14, 2011), http://events.lls.edu/taxpolicy/documents/panel2marrontodersizeofgovernmentpresentationfinal01-06-11.pdf (analyzing the role of tax expenditures in measuring the size of government). 10 see infra part ii.b for an analysis of these two plans in greater detail. 11 it was bipartisan in that the members are associated with both republicans and democrats. 12 nat’l comm’n on fiscal resp. & reform, the moment of truth 29 (2010). the proposal does contemplate the possibility of retaining the earned income tax credit, a child credit, and some tax preferences for mortgage interest, health insurance, charitable giving and retirement savings. see id. at 30. 13 id. at 29. 14 bipartisan pol’y ctr., restoring america’s future 31 (2010). the recommendation differed importantly in proposing a value-added tax to supplement the much simplified income tax in the proposal. 15 see id. at 15. nine percent of debt reduction is projected to come from new revenues, and 54% from spending cuts. of course, if tax expenditures are treated as government spending, 92% of the total projected debt reduction comes from spending cuts. 2011] tax expenditures, reform, and distributive justice 5 the tax reform act of 1986,16 which followed the recommendations of the treasury department’s comprehensive study, 17 exemplified this base-broadening conception of tax reform. nevertheless, in the 1986 round of reform, the middle class’s most beloved tax expenditures, such as the charitable deduction and the home mortgage interest deduction, were never seriously on the cutting block. today’s attack on tax expenditures is more radical than 1986’s because tax reform must achieve more today than it did in 1986, when the sole goal of tax reform was improvement in the tax law. tax reform was purposely separated from deficit reduction—the parameters for the 1986 legislation included a requirement that the new law raise the same amount of revenue as the prior law. to the contrary, tax reform today is inextricably linked to deficit reduction, so overhauling the tax system is only partially about improving the efficiency and fairness of the tax law, and more prominently about addressing the country’s long-term fiscal challenges by increasing total revenue and reducing total expenditures. there are only two ways to increase revenue within the constraints of the current tax system’s design: broaden the base by including more in the determination of what is taxed, or increase rates.18 the tax base and the tax rates are the only moving parts in the system that we have. the 1986 tax reform was devoted entirely to reducing rates, slashing them almost by half.19 the current combination tax reform/deficit reduction proposals reduce rates, rather than increase them to raise revenue. consequently, the reform proposals need to offer a drastic expansion of the tax base as a way to finance both increased revenue demands and a rate reduction. compared to current law, repealing all tax expenditures enormously expands the universe of what gets taxed. without tax expenditures, there are no tax-free fringe benefits,20 no tax deferral for retirement savings, 21 no child credits, 22 no capital-investment expensing, 23 and no preferential rates for capital gains and dividends.24 all of these provisions, and many dozens of others, are included in the list of tax expenditures compiled by the joint committee on taxation.25 other more radical proposals for tax reform discussed since 1986 have recommended a much broader tax base accompanied by historically low rates,26 including 16 tax reform act of 1986, pub. l. no. 99-514, 100 stat. 2085. 17 office of the secretary department of the treasury, tax reform for fairness, simplicity, and economic growth, at xi (1984). there have been other excellent tax reform reports over the years. see, e.g., president george w. bush’s 2005 advisory panel on fed. tax reform, simple, fair and pro-growth: proposals to fix america’s tax system (2005) (proposing significant simplification of the tax system, and consequently, reduction of tax expenditures, but not to the extent of the current proposals). 18 beyond the constraints of the current system’s design is the introduction of new taxes, such as a national retail sales tax or value-added tax. this is what the bipartisan policy center has suggested. see bipartisan pol’y ctr., supra note 14, at 30. 19 the highest individual statutory rate immediately after that reform was 28%, although actual marginal rates were as high as 33% for some taxpayers. prior to the reform, the highest statutory rate was 50%. the highest rate today is 35%. 20 see i.r.c. § 132 (west supp. 2010). 21 see i.r.c. § 401 (west supp. 2010). 22 see i.r.c. § 24 (west supp. 2010). 23 see i.r.c. § 179 (west supp. 2010). 24 see i.r.c. § 1(h) (2006). 25 see staff of joint comm. on tax’n, 111th cong., estimates of federal tax expenditures for fiscal years 2009-2013, at 8-9 (joint comm. print 2010). 26 compared to a generation ago, rates are historically low now. when congress mandated a tax expenditure budget in 1974, the highest marginal rate was 70%. marginal rates have been as high as 92%. 6 columbia journal of tax law [vol.3:1 replacing the current system with some form of a consumption tax, 27 but they have never been enacted. tax returns filed on a postcard have intrigued the public imagination, and would leave no physical space for special deductions or credits. repealing tax expenditures is not the unique agenda of either the political left or right; rather, there is a call for a simpler tax system across the political spectrum. thus, a consensus seems to be developing that tax expenditures are the stumbling block preventing sensible taxation and are responsible for uncontrollable government spending.28 a broad effort to rein in tax expenditures is undoubtedly a good idea. nevertheless, this article advocates moderation, and argues that those who support a “zero plan” for tax reform have too simplistic an understanding of tax expenditures, and too naïve an approach to tax reform.29 first, the conception of reform that eliminates tax expenditures erroneously treats them as an undifferentiated mass, and ignores the important role that some of them play in federal policy. not all tax expenditures are giveaways to rent-seeking special interests and bad federal policy. congress must pay as much attention to the purposes and effectiveness of individual tax expenditures, and evaluate them on a program-by-program basis, as they do in making decisions about whether to discontinue direct spending programs. some tax expenditures may be worth their costs, if they achieve important policy goals. as part of that critique, this article argues that we know precious little about what tax expenditures do and how they affect individuals. the data that the government provides about tax expenditures sheds too little light on the issues that are important in deciding whether they are desirable elements of the law. today’s tax reform debate needs a new kind of tax expenditure budget30 that would better inform policymakers about the nature of the benefits that individuals obtain from tax expenditures, who really enjoys benefits, and who would bear the economic loss that would follow their repeal. second, in this round of reform, revenue is central. to that end, this article challenges the assumption implicit in the tax expenditure budgets about how much revenue would be raised if all tax expenditures were eliminated. the revenue loss data that the government compiles do not sufficiently acknowledge that taxpayers would change their behavior to avoid paying tax, frustrating revenue-raising efforts after tax expenditure repeal. third, any legislative effort that relies on the distinction between tax expenditures and structural provisions in the law is bound to get lost in the morass over the definition of a tax expenditure. ever since the term “tax expenditure” was coined, see federal individual income tax rates history: income years 1913-2010, tax foundation (dec. 22, 2010), http://www.taxfoundation.org/files/fed_individual_rate_history-june2010.pdf. 27 see, e.g., robert hall & alvin rabushka, the flat tax, at xiv (2nd ed. 1995); neal boortz & john linder, the fairtax book 70-71 (2005). see also president’s advisory panel on fed. tax reform, supra note 17, at xiv. 28 see nat’l comm’n on fiscal resp. & reform, supra note 12, at 28. 29 entitlement spending, particularly health-care spending, is more important to the long-term fiscal challenge than are tax expenditures. the fiscal commission acknowledged this in its report: “federal health care spending represents our single largest fiscal challenge over the long-run. as the baby boomers retire and overall health care costs continue to grow faster than the economy, federal health spending threatens to balloon. under its extended-baseline scenario, cbo projects that federal health care spending for medicare, medicaid, the children’s health insurance program (chip), and the health insurance exchange subsidies will grow from nearly 6 percent of gdp in 2010 to about 10 percent in 2035, and continue to grow thereafter.” see id. at 36. 30 the tax expenditure budgets compiled currently provide revenue loss information for a list of tax expenditures and very limited other data. see infra section ii.c. 2011] tax expenditures, reform, and distributive justice 7 there has been disagreement about which provisions count as tax expenditures.31 the two government compilers of tax expenditure budgets, the joint committee on taxation and the treasury department, disagree about the provisions to include in the list. any version of tax reform that relies on this distinction places more pressure on the definition than it can bear. the tax expenditure budget was not designed to be the final arbiter of desirable law; it was meant to be an informational tool for congress, the president, and other interested observers. it is a mistake to make it the critical source for tax reform because as an informational tool, it lacks a normative foundation. finally, this article questions the unstated normative position of the tax reform proposals. while the proposals acknowledge the need for revenue and the desirability of improving efficiency and economic growth, the tax law’s role in promoting equity is largely ignored. this is an unfortunate oversight because taxation is uniquely suited to promote economic justice. particularly where other aspects of the law aim for efficiency, the tax law’s role in fostering a fair distribution of wealth and income is particularly important. policymakers may need to balance efficiency losses against equity gains, and tax expenditures that promote equity may be worth retaining despite the costs in revenue and economic distortion. the article proceeds as follows. the next section, part ii, provides background that explains the relevant history of tax expenditure analysis and the recent proposals for reform that rely so heavily on repealing tax expenditures. part iii critiques the tax reform proposals in particular, and the status quo concerning tax expenditures more generally. the serious problems that have long been present in the tax expenditure budget are illuminated by the tax reform debate, but the critiques developed here about the dearth of information concerning tax expenditures transcend that debate. if we are to continue compiling tax expenditure budgets, we need to start collecting a lot more data about who benefits from tax expenditures and whether they are effective in achieving their purposes. part iv explains why the tax expenditure budget lacks the vigor to support tax reform, and part v explores whether efficiency has overshadowed equity in the debate about tax expenditures and reform. the article concludes with a return to the basic principles of tax expenditure analysis, and considers how policymakers might use those principles in the tax reform process. ii. how tax expenditures became the problem a. tax expenditures and reform were always linked, but now we really need the money tax expenditures, such as the charitable deduction and the exclusion for employee fringe benefits, have been part of the income tax since its earliest days, but they were not identified as such until 1967 when then-assistant secretary of the treasury for tax policy, stanley surrey, introduced the term in a speech.32 over the course of the next few years, surrey developed the idea in a series of articles and a book, which he 31 see, e.g., douglas a. kahn, accelerated depreciation – tax expenditure or proper allowance for measuring net income?, 78 mich. l. rev. 1, 12 (1979) (accelerated depreciation); renee judith sobel, u.s. taxation of its citizens abroad, 38 vand. l. rev. 101, 102-103 (1985) (special treatment of foreign earned income); edward a. zelinsky, tax policy v. revenue policy: qualified plans, tax expenditures and the flat, plan level tax, 13 va. tax rev. 591, 592-593 (1994) (pension taxation); douglas a. kahn & jeffrey s. lehman, tax expenditure budgets: a critical view, 54 tax notes 1661, 1663-4 (1992) (lower rates in a progressive system, and deductions for blind and elderly). 32 see stanley s. surrey, pathways to tax reform: the concept of tax expenditures, at vii (1973). 8 columbia journal of tax law [vol.3:1 called pathways to tax reform, linking tax expenditures and tax reform together in the minds of all observers from the beginning. surrey’s purpose was to reveal provisions of the tax law as expenditures rather than taxes, so that congressional analysis of expenditure policy would also include these tax provisions. in order to enable lawmakers to consider tax expenditures along with direct expenditures, a list of provisions that qualified as tax expenditures needed to be compiled, and in 1968, surrey’s treasury department created the first tax expenditure budget. a few years later, congress mandated that tax expenditure budgets be prepared along with the regular budget, and it has since been prepared annually by both the treasury department as part of the president’s annual budget 33 and the joint committee on taxation. 34 the analysis developed as part of the tax expenditure concept demanded that a tax provision that operates like a spending provision be analyzed as a spending provision, and subject to the same scrutiny as direct allocations. it is no coincidence that the concept was developed in conjunction with a commitment to reforming the tax law, and the tax expenditure concept was an important part of the tax reform act of 1976, the first major tax legislation following the mandated preparation of tax expenditure budgets. surrey was skeptical of these provisions, and his treasury was opposed to using the tax law to implement social policy, believing that direct programs were a better alternative.35 surrey was particularly concerned about the unfair effects of tax expenditures. in pathways for tax reform, he wrote: it is clear, then, that most tax incentives have decidedly adverse effects on equity as between taxpayers at the same income level, and also, with respect to the individual income tax, between taxpayers at different income levels. as a consequence of these inequitable effects, many tax incentives look, and are, highly irrational when phrased as direct expenditure programs structured the same way. indeed, it is doubtful that most of our existing tax incentives would ever have been introduced, let alone accepted, if so structured, and many would be laughed out of congress.36 surrey was thus concerned about both the horizontal inequity and vertical inequity caused by tax expenditures. the horizontal inequity involved unfairness between taxpayers in the same economic position where one taxpayer could reduce tax by using incentive provisions and the other could not. the vertical inequity arose from the treatment of taxpayers at different economic levels; higher-income taxpayers enjoyed greater benefits from deductions than did low-income taxpayers because the value of their deductions were higher on account of their higher tax rate. this produced an “upside-down effect” in which higher-income taxpayers received more subsidy than lower-income taxpayers engaged in the same level of the same activity.37 taxpayers too 33 see office of mgmt. & budget, exec. office of the president, analytical perspectives, budget of the united states, fiscal year 2012 (2011), available at http://www.whitehouse.gov/omb/budget/analytical_perspectives. 34 the joint committee prepares its tax expenditure budget as a stand-alone document. 35 see stanley surrey & paul mcdaniel, tax expenditures 2 (1985). 36 surrey, supra note 32, at 136. 37 for example, the mortgage interest deduction is generally available, but a taxpayer in the 35% bracket has an after-tax cost of only 65 cents on the dollar, while a taxpayer in the 15% bracket has an aftertax cost of 85 cents on the dollar. a deduction operates to reduce tax at the taxpayer’s marginal rate. it is 2011] tax expenditures, reform, and distributive justice 9 poor to pay any tax were left out of the benefits provided through the tax system because they could not avail themselves of any tax incentives.38 on account of these issues, surrey was quite critical of tax expenditures overall. congress has, to some extent, taken surrey’s criticisms of the design of tax expenditures to heart. under current law, there are some tax expenditures that are designed as credits rather than deductions. this design addresses the “upside-down” effect 39 of deductions—benefitting high-income taxpayers more than low-income taxpayers—that concerned surrey. a credit reduces tax by a dollar amount so that the value of a credit is not dependent on one’s marginal rate of tax. for example, the child tax credit40 is worth $1000 to every taxpayer with a child. some credits under current law also ameliorate the non-taxpayer problem that troubled surrey, allowing individuals who are too poor to have any tax liability to receive government subsidy through the tax system. for example, the american opportunity tax credit41 provides a credit for college expenses that is “refundable,”42 which means that the government will send taxpayers checks, even if they have no tax liability. the term “refundable” is slightly misleading because, in these cases, there is nothing to refund; the government simply funds the expenditure. however, congress has been quite stingy in authorizing refundable credits.43 at the same time, congress has embraced tax expenditures and increased their number. the treasury department included 165 tax expenditure items in its 2010 list,44 while the earliest budgets had less than a third that many.45 as a percentage of gdp, tax expenditures were almost 6% of gdp when the government started measuring them, and are now over 7%. 46 as a percentage of gdp, they declined significantly for a few years following the tax reform of 1986, but have inched up since then.47 in 2009, they constituted 22.5% of total federal expenditures.48 that’s a lot, considering that 46.9% of spending was mandatory.49 discretionary defense spending was 14.1% and discretionary non-defense spending was a mere 12.5% of total spending.50 upside-down for tax expenditures intended to operate as subsidies because the low-rate taxpayer is presumably more needy, on account of lower income, than is the high-rate taxpayer. 38 see surrey, supra note 32, at 136. 39 see surrey & mcdaniel, supra note 35, at 71. 40 i.r.c. § 24 (west supp. 2010). 41 i.r.c. § 25a(i) (west supp. 2009). this provision is effective through 2012. tax relief, unemployment insurance reauthorization and job creation act of 2010, pub. l. no. 111-312, § 103, 124 stat. 3296. 42 i.r.c. § 25a(i)(6) (west supp. 2009). the maximum credit is $3,000, but only 40% of it is refundable. 43 see infra section iii.c for a fuller discussion of refundable credits. 44 see office of mgmt. & budget, exec. office of the president, analytical perspectives, budget of the united states, fiscal year 2010, at 303-306 (2009), available at http://www.gpoaccess.gov/usbudget/fy10/pdf/spec.pdf. 45 there were fifty-four in the 1972 budget prepared jointly by the treasury department and the joint committee on taxation. see staff of joint comm. on internal revenue tax’n, 92d cong., estimates of fed. tax expenditures 4-5 (joint comm. print 1972). 46 see hungerford, supra note 6, at 4 fig.2. 47 id. 48 id. at 5 fig.3. 49 mandatory spending includes entitlement programs like social security, medicare and medicaid, which accounted for 29.6% of total spending in 2009. id. at 5. 50 id. at 5 fig.3. 10 columbia journal of tax law [vol.3:1 these numbers illustrate why tax expenditures have become the focus of tax reform in a tax reform climate that is inseparable from the pressure of deficit reduction. surrey’s project was successful in convincing people that tax expenditures are really spending programs that are placed in the tax law, so tax expenditures are an irresistible source of funds. but some tax expenditures are effective and efficient spending programs, and alternative direct spending programs would be inferior institutional choices. for example, the earned income tax credit piggybacks on the core functions of the tax system, delivers its benefits with little cost, and reaches more intended recipients than an alternative program would. it is a program that may be more effectively administered through the tax system than through a direct spending program, so the code may be the ideal place for that federal policy.51 if tax reform is focused on improving the tax law for its own sake, tax expenditures that are well designed and effectively implemented in the tax system are desirable. but if tax reform is in service of revenue, tax expenditures become an easy target. it is not surprising that the deficit reduction/tax reform proposals are covetous of the 22.5% of total federal spending that has been loosely buried in the code. b. the current tax reform proposals the fiscal commission’s proposal for tax reform is part of its larger vision to invest where necessary to stay competitive, maintain a national safety net, and cut all excess spending.52 its overarching project was to determine how to get the national fiscal house in order, and deal with what it identified as the problem of a “crushing debt burden.”53 the commission’s formidable goals were (1) deficit reduction, (2) reducing the size of the public sector,54 (3) stabilizing debt levels, (4) ensuring social security solvency, and (5) reducing tax rates. the plan it presented was most ambitious, including discretionary spending cuts, entitlement reform, and budget process reform, in addition to tax reform. the commission’s plan was quite specific in some of its recommendations. for example, in its proposal to cut discretionary federal spending, it suggested reducing federal travel budgets and freezing the pay of members of congress.55 in its treatment of health-care savings, it proposed a specific reform of the medicare cost-sharing rules and cuts in payments to hospitals for medical education.56 it also included recommendations about payments to states for abandoned mines and fcc spectrum auctions—pretty detailed stuff for such a big report.57 but in other ways, the recommendations were quite vague, such as suggesting honest budgeting for catastrophes, and requiring the president to propose annual limits on war spending.58 the recommendations for tax reform were somewhat inconsistent with the goals of the project overall. the first goal for tax reform was “sharply reduc[ing] tax rates,”59 even though lower tax rates make it harder to raise the revenue required to address the 51 see david a. weisbach and jacob nussim, the integration of tax and spending programs, 113 yale l.j. 955, 961 (2004). 52 nat’l comm. on fiscal resp. & reform, supra note 12, at 12. 53 id. at 6. 54 the report proposes to cap revenue at 21% of gdp and bring spending to that level. id. at 14. in 2010, outlays were at 23.8% of gdp. id. at 16. but revenues were only 15%. id. at 10. 55 id. at 26. 56 id. at 37-38. 57 id. at 46. 58 id. at 22-23. 59 id. at 14. 2011] tax expenditures, reform, and distributive justice 11 current debt burden and reduce the deficit that we face. the report acknowledges that more revenue and less spending are both necessary parts of a responsible fiscal plan. however, reducing rates narrows the policy choices for increasing revenue–the only place to find increased revenue (without introducing other taxes) is in including more in the tax base. consequently, the report recommends broadening the tax base. 60 unfortunately, the pressure placed on the base is extraordinary when the objectives include both lowering rates and raising significant amounts of revenue. this explains why the commission’s recommendation starts by proposing the repeal of all tax expenditures in the code;61 the broader the base, the more revenue collected. without any tax expenditures, the fiscal commission concluded that rates could be 8%, 14%, and 23%, and still raise $80 billion for deficit reduction.62 that represents a very substantial rate cut compared to the current law rates of 10%, 15%, 25%, 28%, 33%, and 35%.63 the report failed to explain how it determined the amount of revenue that the broader tax base raises, and the commission may be too optimistic about how much revenue the government can raise solely from base broadening. tax expenditures are incentives. if they successfully encourage taxpayers to do things they would not otherwise do, then they are effective incentives. if they are, we might expect that removal of an incentive would discourage a taxpayer from continuing the behavior that was previously encouraged. consider, for example, the charitable contribution deduction. it may encourage taxpayers to give to charity. a taxpayer in the 35% bracket who donates $100 to charity saves $35 in taxes. the tax expenditure budget includes that $35 as revenue loss to the federal treasury because the congressional budget act of 1974 defined tax expenditures as “revenue losses.”64 however, the tax expenditure budget itself makes clear that the estimates of revenue loss included in the budget would “not necessarily equal the increase in federal revenues (or the change in the budget balance) that would result from repealing these special provisions.”65 if that is the case, then it is important to know how the fiscal commission determined the amount of revenue that would be increased on account of tax expenditure repeal. the actual revenue raised could be much less than projected, depending on the effectiveness of the incentives and the post-reform rates. john buckley recently suggested that “[individual] tax expenditure estimates grossly overstate the potential revenue” associated with their repeal, while corporate tax expenditure estimates may underestimate the revenue that could be raised by their repeal.66 in addition, the proposal to repeal all tax expenditures is inconsistent with the commission’s more nuanced approach to discretionary spending. discretionary spending and tax expenditures are policy alternatives. as surrey pointed out, tax expenditures are not part of the “structural provisions necessary to implement the income tax” but are “governmental financial assistance programs carried out through special tax provisions rather than through direct government expenditures.”67 while the fiscal commission explicitly supported investments in education, infrastructure, and research and 60 id. at 28. 61 id. at 29. 62 id. at 29-30. 63 i.r.c. § 1 (west supp. 2008). 64 see supra note 3. 65 office of mgmt. & budget, supra note 44, at 298. 66 john l. buckley, tax expenditure reform: some common misconceptions, 132 tax notes 255, 259 (2011). 67 surrey, supra note 32, at 6. 12 columbia journal of tax law [vol.3:1 development,68 it failed to notice that this type of investment is subsidized through tax expenditures that the plan would repeal.69 the fiscal commission offered an “illustrative” tax reform plan that would retain a few tax expenditures and finance them with rates of 12%, 22% and 28%. the plan would retain the earned income tax credit and the child tax credit as they are under current law, and pared down tax expenditures for mortgage interest, charitable giving, employer-provided health insurance, and retirement savings. these retentions follow the commission’s stated principle to protect the truly disadvantaged;70 the earned income tax credit operates to increase the take-home pay of low-income taxpayers who work. however, it is not clear how the other retained tax expenditures further the commission’s central goals. the exclusion for employer-provided health insurance is the single most costly tax expenditure, so its repeal would contribute significantly to revenue.71 while this article demurs in endorsing specific tax expenditures, it offers a process for analyzing which to retain by emphasizing incidence and equity. the bipartisan policy center’s report is quite similar to the fiscal commission’s. like the fiscal commission, the bipartisan policy center considered restraining the federal debt as the major challenge to be addressed.72 its mission was equally ambitious, balancing the budget, fixing social security, addressing rising healthcare costs, and containing discretionary spending. its tax reform proposal resembles the fiscal commission’s in many ways. most important for purposes of this article, the cornerstone of its tax reform is repeal of almost all tax expenditures. the report blames tax expenditures for excessive complexity, reducing productivity, making the tax system unfair, and encouraging fraud.73 its tax reform plan sets rates at 15% and 27%, somewhat higher than the zero option plan, but in the range of the fiscal commission’s illustrative plan. like the illustrative plan, it also retains income support for low-income taxpayers, pared down benefits for home mortgages, charitable contributions, and retirement savings, and taxes capital gains and dividends at ordinary rates.74 some elements of the bipartisan policy center’s plan are innovative. for example, the subsidy for charitable contributions would be paid directly to charities, rather than to taxpayers, as under current law.75 this approach would provide a federal subsidy for all charitable giving, unlike current law, which requires taxpayers to itemize deductions (instead of claiming the standard deduction) in order to claim charitable contribution deductions.76 the bipartisan policy center plan would repeal the standard deduction and the personal exemptions, but in their place, it would provide an earnings 68 nat’l comm. on fiscal resp. & reform, supra note 12, at 12. 69 for example, education subsidies are in various provisions of the code. see i.r.c. § 25a (west supp. 2010); i.r.c. § 117 (2006); i.r.c. § 221 (2006); i.r.c. § 222 (west supp. 2010); i.r.c. § 529 (west supp. 2009); i.r.c. § 530 (west supp. 2008). there is a tax credit for research and development. see i.r.c. § 41 (west supp. 2010). 70 nat’l comm’n on fiscal resp. & reform, supra note 12, at 12. 71 see office of mgmt. & budget, supra note 33, at 252. that tax expenditure alone is projected to cost over a trillion dollars over the five-year budget window in the most recent estimate, 2012-16. 72 see bipartisan pol’y ctr., supra note 14, at 2. 73 see id. at 31. 74 id. at 128. the report includes a complete list of all tax expenditures that would be retained. id. at 130. 75 id. at 34. 76 it would not, however, solve the problem of capture of the benefit by donors. see infra part iii.a.3. 2011] tax expenditures, reform, and distributive justice 13 credit for all wage earners77 that would prevent a low-income taxpayer from owing tax on his first dollar of earnings. most importantly, the plan proposes that a new “debt reduction sales tax” be adopted to raise revenue.78 its design closely resembles the value added taxes currently in use in all oecd countries, and would be imposed at a rate of 6.5% starting in 2013. while the report is highly critical of tax expenditures, the drst alleviates some of the pressure on tax expenditures to do all the work. the bipartisan policy center presented its plan as a combination of spending cuts, tax expenditure cuts, and new revenues. a chart included in the report appears to show that approximately half the money comes from the spending side and half the money comes from the tax side. in 2020, 9% of the debt reduction is from new revenues (offset by rate cuts), 38% is from tax expenditure cuts, and 54% is from spending cuts.79 however, clear understanding of tax expenditures makes it apparent that only 9% is really from new sources of revenue and the rest is from cuts in spending, whether from the discretionary side of the direct budget or the tax expenditure side of the tax system. it is important to know whether the revenue comes from cutting programs or from raising taxes because the individuals affected are likely to be different. the recent congressional insistence on reducing spending, but not raising taxes, as a condition to raising the debt ceiling, severely limited the government’s choice for sources of funds, and will require significant cuts to government programs.80 but there seems to be an insurmountable political opposition to tax increases.81 the fiscal commission’s tax reform plan included the goal of maintaining or increasing progressivity.82 in order to achieve that goal, while also reducing rates, capital gains and dividends would have to be taxed at ordinary rates, which the illustrative plan does.83 retention of the earned income tax credit is also imperative in the proposed tax reform to conform with the commission’s distributional goals. the bipartisan policy center did not include progressivity as one of its prime objectives, but it did state, in its summary of recommendations, that its proposed reforms would make the tax system more progressive,84 and its plan also taxes capital gains and dividends at the same rate as ordinary income. the tax policy center has done a distributional analysis of both plans, under various baselines and with a variety of statutory reforms.85 compared to current policy, the fiscal commission’s plan reduces after-tax income at every income level,86 but the share of federal taxes goes down slightly for higher income taxpayers and goes up 77 bipartisan pol’y ctr., supra note 14, at 35. 78 id. at 38-39. 79 id. at 15. 80 congressional budget control act of 2011, pub. l. no. 112-25, § 251(b)(2)(a), 125 stat. 239, 241 (2011). this act committed to reducing the federal deficit by $2.1 trillion over 10 years, but much of the detail is left to be determined by a joint congressional committee. 81 see, e.g., editorial, ideology trumps economics, n.y. times, july 12, 2011, at a22. 82 nat’l comm. on fiscal resp. & reform, supra note 12, at 28. 83 id. at 31. the joint committee and the treasury disagree about whether the preferential rate for capital gains and dividends is a tax expenditure. the joint committee includes it in its list, but the treasury does not on the grounds that the preferential rates are offset by the double taxation of corporate income. 84 bipartisan pol’y ctr., supra note 14, at 17. 85 see tax pol’y ctr., deficit reduction proposals (2010), available at http://www.taxpolicycenter.org/taxtopics/deficit-reduction-proposals.cfm. 86 see tax pol’y ctr., “chairmen’s mark” option 1: the zero plan variant retaining the child tax credit and earned income tax credit table t10-0252 (2010), available at http://taxpolicycenter.org/numbers/content/pdf/t10-0252.pdf. 14 columbia journal of tax law [vol.3:1 for lower income taxpayers.87 this is a reduction in progressivity as measured by one of the standard definitions under which progressivity increases only if tax shares for higher income taxpayers increase. 88 an alternative approach to measuring changes in progressivity looks at relative changes in after-tax income, rather than tax shares.89 according to the distributional tables prepared by the tax policy center, after-tax income goes down for everyone, but in a somewhat inconsistent way, with the fourth (second highest) quintile seeing the smallest percentage reduction.90 the bipartisan policy center’s proposal appears to be more progressive than the fiscal commission’s. only the top quintile would see an increase in its percentage share of federal taxes paid under their proposal.91 additionally, after tax-income would not be reduced at all for the bottom quintile, but would be reduced by an increasing proportion in each quintile as income goes up, increasing progressivity compared to the baseline.92 c. tax expenditures and budget policy the approach to tax reform that repeals all (or almost all) tax expenditures in the name of deficit reduction is consistent with the traditional approach to the tax expenditure budget—as a tool of budget policy. repealing all tax expenditures helps achieve the goals of those concerned that tax expenditures are an invisible, illegitimate, and unchecked hemorrhaging of federal funds. it treats tax expenditures as a source of funds to be garnered for proper federal goals. this was the way that surrey imagined the tax expenditure budget would function when he first advocated it, 93 and the budget itself reflects that approach. the design of the tax expenditure budget mimics that of the larger federal budget, organized by administrative function, and detailing revenue loss on account of each item.94 it allows tax benefits to be readily compared to direct spending. congress can study the budgets, evaluate the efficacy of the spending, and decide when to replace a tax provision with a direct spending provision or repeal it altogether. tax expenditure analysis—the 87 see id. the tables do not explain their results, but the overall effect of the changes is complex, with reduced rates offsetting greater income inclusion. the tax policy center did not run distributional analyses for the most extreme version of reform presented in the report, the pure zero option. however, the tax policy center’s analysis shows variations depending on the treatment of payroll taxes, in addition to income taxes. see tax pol’y ctr., final report’s “illustrative tax reform plan” (2010), available at http://www.taxpolicycenter.org/taxtopics/fiscal_commission_table_guide.cfm. 88 see martin sullivan, how to read tax distribution tables, 90 tax notes 1747, 1749 (2001) (describing distributionally neutral tax cuts as proportionate to tax burden). 89 william gale & peter orszag, bush administration tax policy: distributional effects, 104 tax notes 1559, 1560 (2004) (describing a distributionally neutral change as one that gives everyone the same percentage change in take-home income). 90 see tax pol’y ctr., supra note 86. 91 tax pol’y ctr., bipartisan policy center tax reform plan against current policy baseline, table t10-0249 (2010), available at http://taxpolicycenter.org/numbers/content/pdf/t100249.pdf. 92 see id. 93 see stanley surrey & paul mcdaniel, the tax expenditure concept and the budget reform act of 1974, 17 b.c. indus. & com. l. rev 679, 679 (1976) (“[t]ax subsidies constitute a form of government spending and thus are essentially linked to the methods of government spending traditionally covered in budget documents.”). 94 both the joint committee on taxation and the treasury department follow this design. thus, the budget includes a heading, for example, of “national defense” and lists therein the tax expenditures for national defense and the estimated revenue cost of each specific provision. the treasury also includes a list of the largest tax expenditures, in descending order, which is a more useful organization for those interested in tax reform. 2011] tax expenditures, reform, and distributive justice 15 exercise of evaluating a tax program by reference to spending goals—was intended to be the mechanism by which policymakers could decide whether a tax-based spending program was desirable.95 inclusion in the list of tax expenditures provided the signal that a provision required scrutiny as spending. surrey clearly expected that application of tax expenditure analysis to many provisions included in the list would lead policymakers to decide that the provision was not an appropriate way to spend federal funds.96 as a matter of budget policy, the challenge presented by tax expenditure analysis was to justify individual provisions of the code as legitimate spending of federal funds. the initial roadblock to the budget-policy approach was convincing people that these provisions should be analyzed the same way as direct spending, rather than as simple tax reductions.97 eventually, the equivalence between tax expenditures and direct spending became widely accepted, and the debate shifted to how tax expenditures should be integrated into budget policy—who should decide about tax-based spending, and the level of review to which tax expenditures should be regularly subjected.98 unfortunately, the vision for integrating tax expenditure review into the budget process never came to pass in any substantial way, and the proliferation of tax expenditures is a by-product of that failure. instead of fostering cooperation between the substantive congressional committees and the tax-writing committees, the tax-writing committees have become “a congress within the congress,”99 legislating on all matters of federal policy and spending federal funds without coordinating with appropriating committees. from the perspective of budget policy, tax expenditure analysis has been a complete failure, and wiping the slate clean seems like an appropriate response. wholesale repeal is a quick and effective way to remove the power of the tax-writing committees over federal spending—it effectively returns power to the substantive committees over their areas of expertise. but it is not a permanent solution standing alone. while repeal slows down the work of the tax committees, without significant legislative change governing the procedures for adopting and reviewing tax expenditures, the tax committees can be expected to return to their old ways.100 from a budget policy perspective, the new provisions adopted might better reflect current priorities, and the overall gains might be worthwhile, but repeal might simply create new opportunities for lobbyists and the legislators who love them.101 95 see surrey & mcdaniel, supra note 35, at 99-117. 96 see surrey, supra note 32, at 234-35 (discussing the upside-down subsidy of the homemortgage interest deduction). 97 even the treasury department was skeptical a decade after surrey’s introduction of it. see office of mgmt. & budget, exec. office of the president, special analysis g, budget of the united states government 3 (1983) (embracing the notion that the tax expenditure idea implies that the government has a claim to 100% of a taxpayer’s resources). 98 see, e.g., linda sugin, tax expenditure analysis and constitutional decisions, 50 hastings l.j. 407 (1999) (arguing against constitutionalizing the tax expenditure concept). 99 edward kleinbard, the congress within the congress: how tax expenditures distort our budget and our political processes, 36 ohio n.u. l. rev. 1, 3 (2010). 100 this is why professor kleinbard has proposed framework legislation for tax expenditures. see edward kleinbard, tax expenditure framework legislation, 63 nat’l tax j. 353, 378-379 (2010). 101 see, e.g., richard doernberg & fred mcchesney, doing good or doing well?: congress and the tax reform act of 1986, 62 n.y.u. l. rev. 891 (1987); edward mccaffery & linda cohen, shakedown at gucci gulch: the new logic of collective action, 84 n.c. l. rev. 1159 (2006); edward zelinsky, james madison and public choice at gucci gulch: a procedural defense of tax expenditures and tax institutions, 102 yale l.j. 1165 (1993). 16 columbia journal of tax law [vol.3:1 contrary to the views of those concerned that tax expenditures undermine budget policy, this article takes the position that tax expenditures are more important in tax policy than in budget policy. specifically, tax expenditures can and must play a key role in affecting the distribution of the benefits and burdens of government.102 achieving distributional fairness was long thought to be a central normative function of tax policy,103 and tax expenditures play an important part in the fairness of the tax system overall. even if there were complete consensus on the exact amount of revenue to be raised from the tax system, there would still be a lively tax policy discussion about where that revenue should come from. tax policy is important because it contains the discussion about who pays; it reflects our judgments about who is entitled to the rewards of society and how much individuals owe one another. consequently, it is troubling that the current discussion of tax reform pays virtually no attention to how the tax expenditures that are primed for repeal affect the distribution of the tax burden or the benefits from government. the call for repeal of tax expenditures is driven primarily by efficiency and increasing simplicity.104 from the perspective of distributive justice, tax expenditures are an important component in the institutional structure of government levies and outlays. tax expenditures provide an important bridge between the distributional analysis of taxes and the distributional analysis of spending. from this perspective, any proposal to summarily repeal all tax expenditures is unintelligible because it fails to acknowledge that the distributional effects of tax expenditures are not simply a by-product of budget policy, but part of their purpose.105 shifting the tax reform debate to questions of equity will be difficult because equity in taxation is often treated as an underappreciated value. because of that, we currently lack the basic tools to measure the distributional effects of the tax system. if tax expenditures are to be the major focus of tax reform—as they seem to be— it is imperative that policymakers better understand what tax expenditures do and for whom. the distributional effects of tax expenditures are not part of the tax reform debate because the issues that we treat as relevant to tax reform have ignored the question of who really benefits from tax expenditures. but before congress simply repeals all tax expenditures, it must identify the winners and losers from each and every one. it must also evaluate the effects of each provision relative to its purpose to determine whether a provision is effective in carrying out a desirable federal policy. evaluation on these grounds is necessary for deliberative decision making about tax expenditures. revenue effects are important, but they are only one piece of the tax reform analysis. with the information available today, it is impossible to make any intelligent decision about repealing tax expenditures. 102 this is the issue for distributive justice as understood by liberal political theory. see generally linda sugin, a philosophical objection to the optimal tax model, 64 tax l. rev. 229 (2011). 103 john stuart mill, principles of political economy 917-24 (batoche books 2001) (1848). 104 see david kocieniewski, i.r.s. watchdog calls for tax code overhaul, n.y. times, jan. 6, 2011, at b3 (noting that the i.r.s.’s taxpayer advocate recommends simplification but acknowledges that tax expenditures benefit everyone). 105 the fiscal commission’s “zero plan” eliminates all tax expenditures, including the earned income tax credit and the child tax credit and proposes rates of 8%, 14% and 23%. nat’l comm’n on fiscal resp. & reform, supra note 12, at 29. 2011] tax expenditures, reform, and distributive justice 17 iii. who really benefits from tax expenditures? we need to know a lot more about tax expenditures before deciding whether it’s a good idea to eliminate them. the distributional effects of tax expenditures have not been part of the tax reform debate because the issues that we treat as relevant to tax reform—revenue, economic growth, and efficiency—ignore the question of who benefits from tax expenditures. it is time to change that and take the role of tax expenditures in the distribution of government benefits and burdens more seriously. tax expenditures have become indispensible to understanding federal policy, but their distributional analysis has not improved, despite their increasing importance to public spending. public fairness depends on both taxing and spending because it is the sum total of these government activities that define the relationship of individual contributions and public entitlements. similarly, the level of effective progressivity depends on income shares, tax shares, and public benefit shares.106 tax expenditures are equivalent to both government spending programs and reductions in taxes that individuals owe, so they are relevant to both parts of the necessary inquiry into overall public fairness. to measure the real total level of progressivity, both government benefits and tax burdens must be taken into account, and changes to current law must be evaluated by measuring the consequences to individuals of tax cuts or increases as well as changes in public benefits of every type. a. we are ignorant about who really benefits from tax expenditures 1. where are the distributional tables? distributional tables present data about households in different income groups. they may show the effective rate of tax applicable to households at different income levels or the percentage share of total tax payments made by households in different categories. more narrowly, they may show how many households at different income levels claim the standard deduction or the dollars claimed as deductions for mortgage interest or charitable contributions. distributional tables are often organized by quintile, so that 20% of all households are aggregated, and data about their tax liability displayed. the tax policy center’s analysis of the tax reform proposals107 breaks out the highest quintile into smaller categories because the top 1% is a very different population from the top 20%; data about the top 20% might not present an accurate picture of the situation for the very top earners. distribution tables are important because they show how the law affects taxpayers at different points along the income spectrum, and consequently how progressive aspects of the system are. distributional tables for tax expenditures could show various things. the purpose of distributional tables for tax expenditures would be to indicate how much taxpayers in different income classes claim in tax expenditure benefits. most simply, distributional tables could show the dollar value of deductions, exclusions, and other preferences claimed by taxpayers in different income classes. alternatively, they could indicate the relative shares of total deductions, exclusions or other preferences, the relationship of total income to tax expenditures claimed, or any other data that might be relevant when comparing how the tax system affects taxpayers at different income levels. 106 eugene steuerle, can the progressivity of tax changes be measured in isolation?, 100 tax notes 1187, 1187-88 (2003). 107 see supra notes 85-91. 18 columbia journal of tax law [vol.3:1 the treasury version of the tax expenditure budget provides no distributional data, and the joint committee’s report includes data on only a handful of provisions. the most comprehensive recent analysis of individual income tax expenditures concluded that all income groups benefit from tax expenditures.108 high-income taxpayers benefit more than low-income taxpayers in both dollar amounts and as a percentage of their income.109 however, low-income taxpayers benefit more in relation to the taxes they pay.110 the study, conducted by the tax policy center, provided significantly more information than any government source, but still did not include business tax expenditures, which would have increased the distribution of benefits to high-income taxpayers.111 the government was more forthcoming with distributional data in the early tax expenditure budgets than it is today. in the first budget, prepared jointly by the joint committee and the treasury, there were forty-three distributional estimates included in the presentation. the next budget included forty-five items in the distributional tables. in 1975, the joint committee/treasury included no distribution numbers, apparently because the drafters of the report had insufficient time to compile them.112 but a few months later, the 1976 compendium prepared for the senate budget committee included fifty distribution tables.113 distributional data was provided for virtually all of the individual provisions included in the tax expenditure budget; corporate provisions were excluded to avoid making assumptions about which individuals to assign the benefits in the corporate tax.114 although these early budgets included distribution data for so many items, the informational value of that data was somewhat limited because the reports did not include income distribution data that would help to evaluate the data provided on the tax expenditures. the data included the total revenue loss to taxpayers in different income classes as well as the percentage of taxable returns in each income class, but it did not include the total income in each class or nontaxable returns.115 total revenue loss is not an accurate measure of benefit.116 nevertheless, it is clear from the early budgets that high-income taxpayers disproportionally benefited from tax expenditures, and tax expenditures connected to investment income were more skewed to high-income taxpayers than other tax expenditure provisions.117 according to the tax policy center study, it is still true that investment preferences are most beneficial to high-income taxpayers.118 for 2007, the preferential rates on capital gains and dividends were enjoyed by the “top 1 percent of taxpayers and provide[d] little income gain for anyone else.”119 108 leonard burman, christopher geissler & eric toder, how big are total individual income tax expenditures and who benefits from them?, 98 am. econ. rev. 79, 82 (2008) (analyzing 2007 data). 109 id. 110 id. 111 id. at 79, 80 n.2. 112 staff of joint comm. on tax’n, 94th cong., estimates of federal tax expenditures 5-6 (joint comm. print 1975). 113 staff of s. budget comm., 94th cong., tax expenditures compendium of background material and individual provisions 4 (comm. print 1976). 114 id. 115 unlike today, in those years, the tax policy center did not supplement the government’s data with additional distribution tables. 116 see staff of joint comm. on tax’n, 103d cong., methodology and issues in measuring changes in the distribution of tax burdens 3 (joint comm. print 1993). 117 see id. 118 burman et al., supra note 108, at 79-80. 119 id. at 82. 2011] tax expenditures, reform, and distributive justice 19 the joint committee has long included about a dozen distribution tables in its analysis.120 but the items that are included in the recent tables and appear most favorable to the rich, such as the mortgage interest deduction, are not the ones that appeared most favorable to the rich in the early budgets. in 1981, consistent with the tax policy center’s analysis for 2007, the joint committee’s analysis showed that the preference for capital gains provided an enormous benefit for high-income taxpayers.121 the most recent budget included no distribution table for any investment-related tax expenditure,122 and the treasury no longer treats the preference for capital gains as a tax expenditure.123 the joint committee’s choice to include distribution tables for more social-policy flavored tax expenditures, but not for investment preferences, clearly skews the distribution tables so that current tax expenditures appear more favorable to lowerincome taxpayers than is warranted. a more extensive distributional analysis of investment provisions would provide a more balanced impression of the distribution of tax expenditures overall. a more detailed set of information would be helpful to policymakers in evaluating who benefits from tax expenditures. in addition, an integrated distributional analysis of taxes and spending would give a more complete picture of the benefits and burdens of government.124 2. the real incidence of tax benefits matters while distributional tables are helpful, they can also be misleading because they measure dollars claimed on tax returns. the person who reduces her tax on account of a tax expenditure provision may not actually be any better off than she would have been without the tax expenditure. we need to know the real incidence of the benefits — who is actually made better off on account of the tax provision. there are no distributional tables prepared by anyone that provides this information, but it is crucial to understanding the true effect of tax expenditures on individuals. consider this example. the tax law might allow a deduction for installing energy-saving windows. such a provision would constitute a tax expenditure. assume that prior to such a deduction being adopted into law, energy saving windows cost $1,000 120 in 1981, there were 12 provisions in the tables, and in 2010, there were still 12. see infra notes 121-122. 121 staff of joint comm. on tax’n, 97th cong., estimates of federal tax expenditures for fiscal years 1981-1986, at 19 (joint comm. print 1981). 122 staff of joint comm. on tax’n, 111th cong., estimates of federal tax expenditures for fiscal years 2009-2013, at 49-54 (joint comm. print 2010). the items included in the 2010 distribution tables are: medical deduction, real estate tax deduction, salt deduction, charitable deduction, child care credit, eitc, social security exclusion, child credit, education credits, student loan interest deduction, mortgage interest deduction, and the negative tax expenditure for phase out of the personal exemption. 123 in 2004, the treasury stopped treating the preferential rates for capital gains and dividend as tax expenditures, even though they had been designated that way since the first budget was prepared in 1972 (in fact, in the first budget, the capital gains preference was the largest single item). in changing the treatment, the administration explained that the double taxation of corporate income under a system with a separate corporate tax was being offset by the reduced taxation of capital gains and dividends, making the preference an integral part of that structure, rather than a tax expenditure that provided a special rate for income from particular sources. office of mgmt. & budget, exec. office of the president, analytical perspectives, budget of the united states, fiscal year 2004, at 138-39 (2003), available at http://www.gpoaccess.gov/usbudget/fy04/browse.html. 124 the joint committee never models the effects of spending programs. see staff of joint comm. on tax’n, 103d cong., methodology and issues in measuring changes in the distribution of tax burdens 40 (joint comm. print 1993). see also gale & orzsag, supra note 89 (arguing that progressivity can only be measured with both taxes and spending). 20 columbia journal of tax law [vol.3:1 each. enactment of the deduction should encourage people to buy energy-saving windows. an individual in the 35% bracket bears an after-tax cost of only $650 for a $1,000 window because she can reduce her tax liability by $350 by buying it. in this example, the taxpayer enjoys both the nominal (statutory) incidence and real (economic) incidence because she claims the deduction on her return and is really $350 better off on account of it. but the price of windows might rise on account of the deduction. if the price rises to $1,100, then the taxpayer saves $385 on account of the deduction. but she is not $385 better off because she had to pay $100 more for the window. the producer of the window enjoys that $100 benefit and the purchaser’s benefit is only $285. the nominal incidence is all on the purchaser, but the real incidence in this example is split between the producer and the consumer. in its recent comprehensive review of tax expenditures, the joint committee claimed that the principal utility of tax expenditure analysis “appears to have been as a tool of tax policy and tax distributional analysis.”125 the tax expenditure budget is an informational tool, but it fails to provide the relevant information necessary to decide whether a provision should be repealed because real incidence is essential information. the tax expenditure budget is unlikely to become an effective tool of tax distributional analysis without incidence data about all tax expenditures. in the early reports, when the distributional tables were most extensive, the provisions that were excluded from the tables were those with indeterminate incidence; the staff did not want to make assumptions about the individuals who would have paid the tax if a business incentive was repealed.126 similarly in the recent distributional analysis by the tax policy center, business and investment-related tax expenditures, whose beneficiaries may be hard to identify because the nominal taxpayer may not be the beneficiary, were excluded from the analysis.127 in 1993, the joint committee undertook a project to better present accurate distributional data and produced a report, but the tax expenditure budgets have not followed through on the ideas presented there and the empirical work does not seem to have been attempted.128 the distributional data in the joint committee’s budget follows the revenue cost model of the tax expenditure budget. but loss of economic well-being is not the same as revenue collected from tax.129 better distributional data that measures real costs and benefits to people will make the tax expenditure budget more relevant to the core concerns of tax policy. information about who benefits from a tax expenditure should be considered at least as important as information about how much revenue might be raised on a provision’s repeal. unfortunately, only the latter information is available in the government data. from a distributional perspective, we have to understand both what we are spending on, and who benefits from that spending.130 these are two separate pieces of information, and the tax expenditure budget would ideally provide both, even where the 125 staff of joint comm. on tax’n, 110th cong., a reconsideration of tax expenditure analysis 6 (joint comm. print 2008). 126 see s. budget comm., 94th cong., tax expenditures: compendium of background material on individual provisions 4 (comm. print 1976). 127 see burman, et al., supra note 108. 128 staff of joint comm. on tax’n, 103d cong., methodology and issues in measuring changes in the distribution of tax burdens (joint comm. print 1993). 129 id. at 26. 130 this is what daniel shaviro’s proposed methodology tries to do. see daniel shaviro, rethinking tax expenditures and fiscal language, 57 tax l. rev. 187 (2004). 2011] tax expenditures, reform, and distributive justice 21 analysis is more complex than the hypothetical windows in the simple example above. take the classic tax expenditure example of the exclusion for interest on municipal bonds. the tax expenditure budget treats this exclusion as a tax expenditure because interest income is generally included in taxable income; § 103 is an exception to that rule.131 but it would be a mistake to assume that the benefit in the budget goes to the holders of the bonds who are not required to include the interest. the exclusion was adopted to provide a subsidy for state and local governments. the reduced interest rate paid by municipalities is an implicit tax on holders. if the entire exclusion were a transfer from the federal government to the states, then holders would get no real benefit from owning municipal bonds, and policymakers might want to maximize that benefit. however, for tax-exempt bonds, it is well known that the benefit does not flow entirely to issuers because issuers need to pay a premium rate of interest in order to attract sufficient purchasers.132 it also flows to high-bracket taxpayers who receive a windfall interest rate from municipal bonds compared to the after-tax rate of taxable bonds of equal risk.133 the real policy issue in the § 103 exemption is not the exclusion for the interest earned by all the taxpayers receiving it, but the benefit to states and windfalls to high-rate holders. the tax expenditure budget could provide more useful information if it quantified these benefits, which policymakers could consider in designing the provision and deciding whether it should be retained in the tax law. we make the mistake of believing that the individuals who benefit from a tax expenditure are the ones who would pay tax if the provision did not exist. it follows from the way that the tax expenditure budget measures revenue loss: by considering how much the nominal taxpayer would owe if not for the provision. but this is a mistake. revenue losses attributable to particular taxpayers do not imply that those taxpayers actually receive windfall benefits. consider the exclusion for employer-provided health insurance. because of its enormous revenue cost, it must be on the table in discussions of tax reform, and it is already scheduled to be pared down—though not eliminated—under the health care reform legislation adopted last year.134 workers do not pay tax on the value of health benefits their employers give them. the revenue-cost approach treats this tax expenditure as a benefit to workers. but it might not really make workers better off because tax-free fringe benefits allow employers to pay their workers less money, and workers may not value the benefits as much as they cost.135 the exclusion’s repeal might 131 the reconsideration report treats it as an exception to the code’s general rules and the traditional tax expenditure budget treats it as an exception from the normal tax, but the result is the same. see staff of joint comm. on tax’n, 110th cong., estimates of federal tax expenditures for fiscal years 2008-2012, at 16 (joint comm. print 2008). this was the only budget prepared applying the methodology introduced in the reconsideration report. see staff of joint comm. on tax’n, 110th cong., a reconsideration of tax expenditure analysis 6 (joint comm. print 2008). 132 for example, if corporate bonds pay 10%, then municipal bonds of equal risk should pay 6.5% if they are marketed to 35% rate holders. in fact, municipalities generally have to pay somewhat more than 6.5% in order to attract sufficient buyers, making 35% rate holders prefer municipal bonds to equivalent corporate bonds solely for tax reasons. 133 see boris bittker, equity, efficiency, and income tax theory: do misallocations drive out inequities? 16 san diego l. rev. 735, 744 (1979). 134 patient protection and affordable care act, pub. l. no. 111-148, § 9001(a), 124 stat. 119, 84854 (2010). 135 for example, $100 of health insurance is worth more than $100 cash wages on account of the exclusion. a worker in the 15% bracket only has $85 cash after paying tax on the cash, but still has $100 of insurance. but employers know this and may reduce the fringe benefit by the tax savings so that workers only get $85 in health insurance. the benefit of the exclusion goes to the employers, who are able to save 22 columbia journal of tax law [vol.3:1 only impose transition losses on workers, depending on how wages would adjust to the repeal. the exclusion might actually benefit employers more than employees, so employers might be the losers if the tax benefit is removed. with the tax expenditure provision, employees receive the benefits tax-free, but employers can pay less in wages on account of the exclusion. if the exclusion allows employers to pay less in total compensation, then the repeal of the exclusion could make employees demand more cash wages, increasing employer costs, which might be borne by owners or customers of firms, and not employees, as the revenue-loss approach suggests. there are two levels at which we need to understand incidence in approaching tax reform. first, the standard incidence question looks at real, economic incidence and not just nominal incidence. second, and most important for reformers contemplating legislative change, is who would be harmed by repeal. the answer to these questions might be the same, but not necessarily. and for some provisions, the answer to the first inquiry might be nobody if the market has completely competed away the benefit, making the second inquiry the only relevant one in deciding whether the repeal is good policy. the second question is crucial in any reform that repeals tax expenditures because repeal may cause asset values to decline, producing losses for individuals. for example, the home mortgage interest deduction may have been completely competed away in the market long ago and capitalized into the price of housing. in that case, the real beneficiaries of the deduction would be limited to those who owned homes at the time the provision was adopted because their home rose in value on the adoption and they paid a price that did not account for any anticipated tax deduction. even if the tax benefit has not been completely competed away, it is unlikely that the revenue loss, and the taxpayers to whom that revenue loss is attributed in the tax expenditure budget, accurately measures the benefits enjoyed by the provision now. repeal may create losers out of people who never enjoyed an unwarranted windfall. before we reduce the tax benefits for mortgage interest, we should know who will suffer the greatest loss in home value on account of the change. loss in asset value is unlikely to be uniform across all taxpayers or all homes, and it may not be concentrated at the top of the income spectrum, even if the highest earners garner the greatest dollars of revenue loss from the deduction (as the joint committee’s distributional tables show). the mortgage interest deduction may be more fully capitalized into the price of moderate housing than expensive housing because rich people have houses that cannot be fully financed within the million dollar limit of § 163(h)(3). if owners of more modest houses will see the largest percentage drop in the value of their homes from repeal of the deduction, policymakers should be aware of that. currently, there is no attempt to determine who would lose the most asset value on account of a change in the law, and therefore there is no consideration of such losses in the design of legislation. this is an unfortunate lacuna in the tax reform discussion. eliminating tax expenditures today, without incidence data, would be a cynical gesture. but congress might find it politically irresistible for that reason. it made a similar gesture in 1986 when it increased the corporate tax. in 1986, the individual income tax—which is salient for individual taxpayers—was reduced. simultaneously, the corporate tax—which is hidden from view of the individuals who bear the burden of it— paid for that reduction. corporations are not human, so they cannot bear the burden of $15 in costs. workers who have insurance on their spouse’s plan, for example, don’t receive even the $85 value from the fringe benefit and would be better off with an even lesser amount of cash. 2011] tax expenditures, reform, and distributive justice 23 taxation. instead, individuals with relationships to corporations bear the real incidence of the corporate tax. unfortunately, there is no definitive determination of who that is, whether shareholders, employees, or consumers. reducing individual taxes and raising corporate taxes was a sleight of hand that made individuals believe that their taxes were reduced, even if their burden was not, because they paid for that reduction by bearing the burden of the increased corporate tax. it is possible that incidence data cannot be collected for some (many?) tax expenditures. economists, not lawyers, will need to carry out the formidable task this analysis demands.136 nevertheless, the inability to compile real distributional incidence analyses would be relevant in deciding what to do about particular provisions. if it is impossible to know the incidence for a particular tax or provision, then policymakers might want to reconsider implementing that provision. the cynical approach to tax reform is to impose the tax whose incidence is unknown, in the hope that people will fail to notice it or believe it does not fall on them. but the tax provision with unknown incidence is the one we should be wary of, and tax reform should make burdens and benefits from the tax system more, rather than less, transparent. 3. subsidies should be distinguished from incentives connected to the question of incidence is the distinction between subsidies and incentives, a distinction that has never been clearly drawn in the discussion of tax expenditures. a subsidy provides an economic benefit to a person or makes something cheaper for him, while an incentive induces a person to behave in a particular way. it matters who gets the subsidy, but not who is incentivized. in its comprehensive study of tax expenditures, the joint committee called its biggest category “tax subsidies,” but it described “social spending” in that category as either subsidizing or inducing behavior,137 as though the distinction was not important. this is a mistake. for policymakers, it should matter whether a provision is a subsidy or an incentive because the measurement of a program’s success depends on the purpose it has. if a provision is designed to provide a subsidy for particular people (like families with children) because congress wanted to ensure they had sufficient resources, it is important that the market not shift the tax benefit to other people (who do not have children). if congress’s goal was instead to increase certain types of activity in the economy, market shifting of benefits would be less of a concern. thus, it is important to know whether a provision actually operates as a subsidy or as an incentive, and who is subsidized or incentivized, and the tax expenditure budget would be a more useful informational tool if it provided this information. an incentive for one taxpayer could operate as a subsidy for another. recall the example of the energy-saving windows in the last section and how the real incidence shifted, in part, from the consumer to the producer. the tax expenditure in that example was an incentive for the consumer, but a subsidy for both the producer and the consumer. to continue with that example, consider the effects on incentives and subsidies if the 136 the joint committee on taxation undertook a comprehensive analysis of how distribution tables should be compiled, analyzing all the relevant issues, including the definition of economic burden of tax, the framework for measuring burden, the time horizon for measuring, shifting of burdens in the market, and the distinction between burden and revenue collected. assumptions need to be made, even in the most rigorous approach. see staff of joint comm. on tax’n, 103d cong., methodology and issues in measuring changes in the distribution of tax burdens (joint comm. print 1993). 137 staff of joint comm. on tax’n, 110th cong., estimates of federal tax expenditures for fiscal years 2008-2012, at 6 (joint comm. print 2008). 24 columbia journal of tax law [vol.3:1 price of the windows rose to $1,538. in that case, there would be no subsidy for the consumer at all. the consumer would claim a deduction of $1,538 for the cost of the windows, saving $538 in tax, and bear the same $1000 after-tax cost that she had prior to the adoption of the provision. while the tax deduction might continue to operate to incentivize the behavior by making it appear advantageous, it really provides no benefit to the taxpayer. for lower bracket taxpayers, the energy-saving windows tax expenditure could actually operate as a negative subsidy (i.e., a tax). if a market adjustment fully captures the benefits at the 35% bracket level so that price rises to $1,538, a 25% bracket taxpayer has an after-tax cost of $1,154, $154 more than he would have paid if the tax law had never included the provision. of course, in this case, the lower-bracket taxpayer should not feel encouraged by the tax law to purchase these windows, but that assumes that he understands that the market has shifted the entire benefit away from him. policymakers should be more concerned with understanding incidence for subsidies than for incentives because subsidies constitute value transfers to particular individuals or institutions. if congress wants to subsidize individuals, it should know whether the intended individuals receive the benefit, or whether they lose it to third parties in the market. at the same time, policymakers must be concerned with the effects of incentives because that will indicate whether the law is successful in producing its intended goals for society. consider how these analyses are related by thinking about the education subsides in the code. congress may want to provide a subsidy for education because students and their parents have a difficult time affording it and may suffer from devoting too many of their resources to it. the subsidy would alleviate a financial burden on a needy group, reflecting a distributional policy judgment about students and their families. if the price of education rises in response to the tax benefits,138 the subsidy objective is frustrated. on the other hand, congress may want to provide an incentive for education because the american population is too ignorant to produce the goods and services necessary for economic growth and prosperity. if that is the goal, it may not matter which individuals get educated as long as a sufficient number do. that policy does not have a distributional objective since it is not designed to provide benefits to identifiable people. in that case, the incentive is enacted to produce a particular market effect that corrects for a market failure in which too few individuals are educated. if more people become educated, the policy is a success, regardless of who enjoys the benefit of the foregone tax revenue. if taxpayers perceive education to be cheaper on account of the tax credits (even if it was not), so enroll when they otherwise would not have, then the incentive is effective even though they are not subsidized. alternatively, if educational institutions provide better education because they have more resources per student, the policy goal of increasing the knowledge of the workforce may be accomplished. so, the education provisions in the code may be good policy, but it depends on what the policy is. the distributional story reflects an equity concern, while the market failure story reflects an efficiency concern. when government designs and 138 there is some concern that educational institutions may have captured the tax benefits by raising tuition, but there is little evidence of it. see elaine maag, david mundel, lois rice & kim rueben, tax pol’y ctr., subsidizing higher education through tax and spending programs (2007), available at http://www.taxpolicycenter.org/uploadedpdf/311453_education.pdf. while prices can change for many reasons, economists can sometimes identify correlations between prices and taxes when changes occur in the law. for example, changes in rates of subsidy under the charitable contribution deduction have been correlated with changes in levels of giving. see, e.g., jane gravelle & donald marples, cong. research serv., r40518, charitable contributions: the itemized deduction cap and other fy2011 budget options 4-8 (2010). 2011] tax expenditures, reform, and distributive justice 25 implements policies like the education credits, it should know whether the policy is a failure if the benefits do not reduce the cost for the nominal taxpayers, or if the same number of people engage in the activity regardless of the provision. the joint committee used the charitable contribution deduction as an example of a subsidy or incentive, without concern for which it is.139 it might be either, or both, and it matters which it is. if the deduction is an incentive that causes donors to increase their gifts by at least as much as the tax benefit,140 it is an incentive to the donor and a subsidy to charity. policymakers might then want to tweak the provision to adjust the overall level of support for the work of charities. the bipartisan policy center’s design for the charitable credit reflects the assumption that the tax savings is an extra amount for the charity because it proposes that the government send matching grants to the charities.141 but donors might not allow the charities to have the tax savings. in the bipartisan policy center’s scheme, taxpayers might reduce their contributions on account of the matching grant. under current law, in which charitable gifts entitle donors to a deduction,142 taxpayers might not increase their gifts on account of the tax benefits that they will receive. they may have decided how much to give without regard to the tax consequences. many non-itemizers make gifts to charity, so it is clear that an incentive is not necessary to induce them to give. if donors give exactly what they would have given without the deduction, then the deduction provides no incentive. however, there is still a subsidy for itemizers who claim the charitable deduction because there is a reduction in tax on account of the gift. but the incidence of the subsidy is on the donors themselves— i.e., it rewards them for giving to charity.143 that might be desirable if public policy is to reward virtue, but it is more likely that policymakers would be dubious about the provision if the tax benefits subsidize donors rather than charitable organizations. surrey’s upside-down subsidy critique of tax expenditure analysis assumes that the nominal claimant of the deduction is the beneficiary of the subsidy. a subsidy for charitable donors, at their marginal rate of tax, means that the rich receive greater subsidy per dollar of donation than do the poor. but if the organizations receive the subsidy (whether directly, as in the bipartisan policy center’s proposal, or indirectly through the donor grossing up the gift), the tax rate of the donors is not relevant to the distributional analysis. rather, the beneficiaries of the charity are the relevant group in the distributional analysis. if the organization receives the benefit of the subsidy, the extent to which the taxpayer increases his contribution is what matters.144 139 staff of joint comm. on tax’n, 110th cong., estimates of federal tax expenditures for fiscal years 2008-2012, at 6 (joint comm. print 2008). 140 see mark p. gergen, the case for a charitable contributions deduction, 74 va. l. rev. 1393, 1404 (1988). 141 see bipartisan pol’y ctr., supra note 14, at 33-34. 142 i.r.c. § 170 (west supp. 2010). 143 for example, if a taxpayer in the 30% bracket would give $100 to charity in the absence of a deduction, consider what he would do with the deduction. if he increases his contribution to $143, then the deduction incentivizes him and subsidizes the charity because the after-tax cost to him is the same as before and the charity gets the tax benefits. if he still gives $100, then the deduction is no incentive but subsidizes him because it reduces his after-tax cost of the gift to $70. 144 the code’s longstanding deduction for the fair market value for appreciated property has, during times of high tax rates, clearly operated as a subsidy to high-bracket donors, even if it also provided an incentive. consider high tax rates: if t paid tax at 70% and donated property worth $10,000 with a basis of $1,000, t is entitled to a $10,000 deduction worth $7,000 in tax savings and has no income to include. 26 columbia journal of tax law [vol.3:1 the fiscal commission included a somewhat novel proposal for charitable contributions in the illustrative plan (the zero plan would abolish tax benefits for charitable giving). it proposed a 12% nonrefundable credit, subject to a 2% adjusted gross income floor.145 this design limits two things about the charitable credit. first, the value is uniform for all taxpayers, regardless of marginal rate.146 second, a taxpayer’s first gifts are non-creditable because only amounts in excess of 2% of income would be eligible for the credit. this is a high floor, and it reveals the fiscal commission’s assumption that the provision would operate as either an incentive or a subsidy for large gifts, but not for small gifts. it suggests that taxpayers who give less than 2% of their adjusted gross income are either inelastic givers or do not give until it hurts, but that taxpayers either need a push (incentive) or deserve a reward (subsidy) if they give above that floor.147 if they are treating the provision as an incentive, then below the floor, the design of the provision presumes that the deduction is a subsidy for the taxpayer, so it is not desirable policy. b. distributional neutrality is not distributive justice the terms commonly used to describe the distributional effects of tax changes are misleading, and policymakers need a more precise understanding of the effects of trading tax expenditures for rate cuts. a “distributionally neutral” change in the tax law is one in which tax shares do not change. in other words, if the third quintile pays 10% of total tax prior to a change in the law, a distributionally neutral change would continue to collect 10% of total tax from the third quintile.148 total taxes may go up or down as part of the change, but if the share of taxes remains the same, the change is distributionally neutral. distributional neutrality does not imply normative equality. first, a distributionally neutral change that significantly raises revenue might impose a disproportionate burden on low-income taxpayers, even if their tax shares remain the same. this is standard welfare analysis: a dollar of tax is more burdensome to a lowincome taxpayer than a high-income taxpayer. consider x and y. x has $10 in income and y has $100 in income. before the change, assume that x pays $1 and y pays $15 in tax. a distributionally neutral change that raises everyone’s taxes might take $4 from x and $56 from y.149 this leaves x $6 and y $44. if subsistence requires $8, then x is much worse off after this change than is y, even though the change is distributionally neutral. as a result, distributional neutrality is not necessarily normatively neutral because such changes have effects on individuals at different income levels that must be selling the property would have produced a $9,000 taxable gain, which would have incurred a $6,300 tax liability, netting t only $3,700 on the sale. t gets a substantial windfall—almost double the value—by giving the property to charity rather than realizing the gain. even with a preferential capital gains rate cutting the tax in half, the gift nets t more than the sale. gift: $7,000 tax savings. sale: $10,000 proceeds – $3,150 tax = $6,850 cash. since tax savings is as good as cash to taxpayers with sufficient income, t has a $150 windfall, even where the gain is taxed at half the rate of ordinary income. 145 nat’l comm’n on fiscal resp. & reform, supra note 12, at 31. 146 it would not be available to non-taxpayers because it is not refundable. this distinguishes the bipartisan policy center’s provisions, which provide a matching grant to charities regardless of the donor’s tax situation. 147 the congressional budget office estimates that total donations would generally decline with a floor, but that the tax subsidy would decline by much more. a floor retains the incentive to give above the floor. see cong. budget office, pub. no. 4030, options for changing the tax treatment of charitable giving 10 (2011). 148 see sullivan, supra note 88. 149 this change holds x constant at 6.25% and y at 93.75% of total tax paid, with $16 total before the change and $60 after (with tax liabilities rounded to nearest dollar). this is what tax shares are about. 2011] tax expenditures, reform, and distributive justice 27 defended on fairness grounds. second, a distributionally neutral change redistributes within income categories, rather than across them. for example, if x and y each earn $100, a distributionally neutral change could increase x’s tax liability by $20 and reduce y’s by the same $20. there are individual winners and losers from distributional changes, but they occur within income cohorts. for these reasons, distributional neutrality is not necessarily normatively neutral because such changes have effects on individuals within income levels that also must be defended on fairness grounds. policymakers must look beyond distributional neutrality to establish equitable treatment of individuals. from this perspective, it is important to know the characteristics of the individuals who bear the burdens of distributionally neutral changes to decide if the government is favoring particular choices that individuals make. do people with children receive benefits that are not available to those without? do twoworker families receive benefits compared to one-worker households? are older people taxed less on their income? more educated people? people who live on the coasts or in cities? these are all dimensions of difference among individuals and it is not “neutral” to move the tax burden among them as long as tax paid by individuals who happen to inhabit the same income quintile remains a constant share of taxes paid. instead, the tax reform debate must be more explicit about what characteristics are relevant to determining tax burdens. a just government might reduce the tax burden on families with children as a way to alleviate the costs of children, but it should be explicit and purposeful in taxing them less than families without children. income is clearly part of the relevant measure, but not sufficient to determine a just tax. some tax expenditures are adjustments that congress has used to distinguish taxpayers, and we must be careful that tax reform does not sacrifice any precision that has been honed in determining abilities to pay. grouping by income in distributional analyses is also problematic when wealth might be a more relevant measure for fairness. all the distributional analyses performed by the joint committee measure with reference to income, even when the tax at issue is levied on another base.150 for example, a sales tax is imposed on consumption, but the distributional analysis of a sales tax in the methodology used by the joint committee allocates the burden by income group as an implicit tax on earning. it does the same thing for wealth taxes.151 this is helpful in comparing different types of taxes to one another because it gives a standard measure common to all of them. but determining a just division of the benefits and burdens of government requires more than comparisons according to income. income is not an ultimate arbiter of difference along which all differences can be measured. particularly where we are looking at tax payments, consideration of wealth is as relevant as income. distributionally neutral tax changes highlight the importance of the definition of income cohorts. given the increased income inequality that has developed over the last generation, we should be more discerning at the top. there is a world of difference between the top 5% and the top 1%,152 and even the top tenth of 1%, so that any change 150 see staff of joint comm. on tax’n, 103d cong., methodology and issues in measuring changes in the distribution of tax burdens 9 (joint comm. print 1993). 151 id. at 10. 152 in the tax policy center’s analysis, the top 5% has an average income of $443,618, the top 1% has an average income of $2,262,666 and the top 0.1% has an average income of $9,870,712. the breaks are as follows: top 5%, $270,410; top 1%, $701,245; and top 0.1%, $3,209,498. see tax pol’y ctr., 28 columbia journal of tax law [vol.3:1 that increases the taxes of the top 1% while reducing the rest of the top 5% is not a distributionally neutral change; it is an important change in the level of progressivity given the background of income shares. distributional analyses must be sensitive to the levels at which income significantly changes a person’s options in life. quintiles are likely too wide at both the bottom and the top, but in the middle, they may be adequate. the tax policy center’s analyses of the tax reform proposals currently on the table are significantly more sensitive to this problem than the government’s numbers,153 but nobody has tried to understand where income breaks really matter for well-being or ability to pay tax. tax reformers must grapple with the fact that any reform will make certain individuals losers. taking the tax reform act of 1986 and our history since its adoption as a model, we can expect a reintroduction of tax expenditures after wiping the slate clean in a major reform.154 if the return of tax expenditures is inevitable,155 then the costs to individuals of their repeal must be measured against the temporary efficiency gains their repeal will foster. reform must tolerate losses for some individuals as the price for greater overall gains. but we cannot know whether increased efficiency is worth the cost if we are in the dark about precisely what the costs are, which individuals will bear them, and what the costs are buying. the current discussion is incomplete in ignoring that these costs exist. c. the distributional effects of tax expenditures have changed while we are ignorant about so many aspects of tax expenditures, there are some things that we can be confident about. one is that tax expenditures are different today than they were forty years ago, and they are widely available to people at all income levels. nina olson, the national taxpayer advocate, recently wrote in her annual report to congress: there is a widespread belief that the influence of “special interests” is the biggest roadblock to comprehensive tax reform. there is no doubt that many provisions in the tax code benefit narrow groups of taxpayers . . . . but the dirty little secret is that the largest special interests are us—the vast majority of u.s. taxpayers. virtually all of us benefit from certain exclusions from income, deductions from income, or tax credits (collectively known as “tax expenditures”).156 despite the broad enjoyment of tax expenditures, they continue to be burdened by the reputation that surrey gave them. he believed that tax expenditures were undeserved giveaways to high-income taxpayers.157 his project of identifying and measuring tax expenditures was inseparable from his idea that they should be repealed. distribution of federal tax change by cash income percentile, proposal in 2022 evaluated at 2018 income levels, available at http://taxpolicycenter.org/numbers/content/pdf/t10-0249.pdf. 153 see tax pol’y ctr., supra note 87. the joint committee’s 2010 distributional tables define the top category as $200,000 and up. staff of joint comm. on tax’n, 111th cong., estimates of federal tax expenditures for fiscal years 2009-2013, at 48-54 (joint comm. print 2010). 154 see hungerford, supra note 6. 155 given the dynamic between lobbyists and congress, they probably are. see richard l. doernberg & fred s. mcchesney, doing good or doing well? congress and the tax reform act of 1986, 62 n.y.u. l. rev. 891, 925 (1987) (offering a model of tax legislation that produces constant statutory change). see also mccaffery & cohen, supra note 101, at 1233-35. 156 taxpayer advocate serv., 2010 annual report to congress 9 (2010). 157 see surrey, supra note 32, at 134-38. 2011] tax expenditures, reform, and distributive justice 29 surrey’s tax expenditure budget was intended to increase their transparency by naming and quantifying them. consistent with surrey’s preference for a more progressive, purer income tax, the earliest budgets included distributional information that showed tax expenditures primarily benefiting the rich by favoring income from capital as well as various personal expenditures.158 tax expenditure reform was properly understood as part of the comprehensive income tax agenda of left-leaning reformers.159 that story is more complex today. the advent of refundability—disbursing federal money to individuals who owe no income tax—has dramatically expanded the potential reach of federal policy administered through the tax law, and tax expenditures now include crucial programs for the poor. for decades, families with the lowest incomes were mostly left out of tax benefit largesse, but the recent growth of refundable provisions has changed that.160 when the tax expenditure budget was first designed, there were no refundable provisions in the income tax.161 in 2010, there were five that provided transfers to individuals too poor to owe tax: the earned income tax credit,162 child credit,163 american opportunity tax credit,164 first-time homebuyer credit,165 and make work pay credit.166 the 2008 distribution tables included in the joint committee’s budget167 show a subtle, but distributionally important, shift from the early versions. while the mortgage interest deduction and the charitable contribution deduction still provide disproportionate benefits to high-income taxpayers, the distributional tables also include other tax expenditures that are more beneficial to lowand middle-income taxpayers. the eitc is the starkest example: including the refundable portion of the credit, taxpayers with incomes below $20,000 enjoyed half the total dollar value of the credit, while taxpayers earning over $200,000 received none.168 the education credits and the student loan interest deduction similarly produced no benefit to taxpayers in the highest income category. while very low-income individuals received scant benefit from those provisions, taxpayers with incomes below $75,000 enjoyed more than half the total dollar benefit of both those education subsidies. the effect of refundability (i.e., the amount of transfers in excess of tax liability) of the five provisions for 2010 was estimated to be $102.7 billion.169 while this number 158 see supra part iii.a.1. 159 see shaviro, supra note 130, at 201. 160 the joint committee’s 2008 budget separated the refundable portion of tax expenditures from the nonrefundable portion and included a total of about $300 billion in transfers to the poor over the five-year window. while significant, that total transfer to poor people is dwarfed by a single tax expenditure, the $680 billion subsidy of employer-provided health insurance to tax-owing taxpayers. tax expenditures total over a trillion dollars annually. see staff of joint comm. on tax’n, 110th cong., estimates of federal tax expenditures for fiscal years 2008-2012, at 50, 56 (joint comm. print 2008). 161 the eitc was first adopted in 1975 as a temporary measure, and the maximum credit was $1,452. see john karl scholz, taxation and poverty: 1960-2006, 25 focus 52, 54 (2007). 162 i.r.c. § 32 (west supp. 2010). 163.i.r.c. § 24 (west supp. 2010). 164 i.r.c. § 25a (west supp. 2010). 165 i.r.c. § 36 (west supp. 2010) (expired april 30, 2010). see staff of joint comm. on tax’n, 112th cong., list of expiring federal tax provisions, 2010-2020, at 2 (joint comm. print 2011). 166 id.; i.r.c. § 36a (west supp. 2009) (expired 2010). 167 staff of joint comm. on tax’n, 111th cong., estimates of federal tax expenditures for fiscal years 2009-2013, at 48-54 (joint comm. print 2010). 168 this is not a surprise, though it should be noted that the distribution tables use an expanded definition of income. see id. at 49-54. 169 see id. at 46, n.4. 30 columbia journal of tax law [vol.3:1 is relatively small compared to the total tax expenditures for the year, it is substantial enough to have weight in the debate over tax expenditures, particularly from the perspective of total federal benefits for low-income americans. the latest numbers available are from 2008, but it is reasonable to expect that the distribution of tax expenditure benefits to low-income taxpayers will increase in the 2009 and 2010 statistics. in those years, the education credit was larger and refundable, the earned income credit was increased for taxpayers with three or more children, and the threshold for refundability of the child credit was lower.170 at the same time that congress has been adding more tax-based spending programs targeted to low-income taxpayers, it has limited various tax expenditures for high-income taxpayers by instituting income phaseouts and caps.171 the code also includes provisions that claw back tax benefits from high income taxpayers,172 such as the alternative minimum tax173, the phaseout for personal exemptions174 and itemized deductions.175 the most recent budget includes a distribution table that shows a negative tax expenditure (i.e., a penalty) on account of the phaseout of personal exemptions for high-income taxpayers and those subject to the alternative minimum tax. the table indicates that taxpayers earning over $200,000 incur about 90% of this tax penalty.176 other changes in the underlying tax base that increase tax expenditure benefits to lower income individuals include growth in above the line tax expenditures that can be enjoyed regardless of whether a taxpayer itemizes deductions.177 low-income taxpayers rarely itemize deductions because those deductions must exceed the standard deduction for itemizing to be worthwhile.178 in all, the latest tables show a substantially different distribution of tax expenditures than did the early tax expenditure budgets. today, some of the most progressive features of the tax law are tax expenditures. repealing all tax expenditures would mean ending the largest anti-poverty cash entitlement program.179 according to the congressional research service, virtually all the federal support for housing, a majority of support for education, training, and employment, and a substantial amount for income security were provided through tax expenditures.180 these developments show that a subtle shift has taken place, and an attack on tax expenditures is no longer a rebuke solely to hidden largesse for the rich, as it may once have been. this shift also indicates that tax reform that eliminates tax expenditures may have to be paired with new direct 170 these provisions have been extended through 2012. tax relief, unemployment insurance reauthorization, job creation act of 2010, pub. l. no. 111-312, § 103, 124 stat. 3296, 3299 (2010). 171 e.g., i.r.c. § 25a (west supp. 2010) (phaseout for education credits); i.r.c. § 24 (west supp. 2010) (phaseout for child credit); i.r.c. § 32 (west supp. 2010) (phaseout for eitc). 172 these may be understood as rate adjustments. see infra part v.c. 173 i.r.c. § 54 (west supp. 2009, i.r.c. § 56 (west supp. 2010). 174 i.r.c. § 151 (2006). 175 i.r.c. § 68 (2006). this phaseout is currently repealed through 2012. tax relief act of 2010, § 101. 176 staff of joint comm. on tax’n, 111th cong., estimates of federal tax expenditures for fiscal years 2009-2013, at 54 (joint comm. print 2010). 177 see, e.g., i.r.c. §§ 62(a)(2), (17), (18), (19) (west supp. 2010). 178 for 2011, the standard deduction is $5,800 for single taxpayers and $11,600 for married taxpayers. i.r.s. news release ir-2010-127 (dec. 23, 2010). 179 christine scott, cong. research serv., rl31768, the earned income tax credit: an overview 1 (2010). 180 thomas hungerford, cong. research serv., rl33641, tax expenditures: trends and critiques 14-16 (2008). 2011] tax expenditures, reform, and distributive justice 31 spending programs to replace the safety net that these tax provisions currently offer. it might be good policy design to replace some of these programs with direct spending alternatives, but the total revenue savings from tax reform will be significantly less if tax expenditures are replaced with direct spending, than if they are simply repealed.181 the extension of tax expenditures to provide greater benefits to lower income individuals has apparently made them more objectionable to more people, rather than more acceptable to surrey’s successors. the contemporary attack on tax expenditures comes from across the political spectrum,182 and tax expenditures currently reflect policies that run the gamut from increasing the international competitiveness of u.s. companies and encouraging business investment to alleviating the costs of children and making work pay for low-income wage-earners. in short, there are tax expenditures for everyone to hate. nevertheless, it is bizarre to imagine that such a diverse set of provisions could be uniformly repugnant to so many people. these diverse federal policies would never be lumped together and repealed if they did not share the administrative mechanism of the tax system. the fiscal commission and bipartisan policy center were significantly more reflective in considering cuts in direct spending than they were in considering cuts in tax-based spending. congress must approach tax reform with the same attention to detail. iv. the tax expenditure budget cannot bear the responsibility for reform any proposal to eliminate all tax expenditures puts more pressure on the definition of what constitutes a tax expenditure than it can bear. until now, the tax expenditure budget has primarily been an informational tool.183 but the repeal of all tax expenditures makes that budget the litmus test for acceptable tax rules, a burden too heavy for an informational project. even prior to the current plans to remove all tax expenditures, the tax expenditure budget has been a hit list for lawmakers searching for revenue,184 and categorization as integral to the revenue-raising function has protected a provision from that search.185 to hang tax reform on an informational document elevates the purpose that the document serves, and as the stakes rise, there is likely to be even less consensus on the provisions to be included as tax expenditures. if provisions of the tax law are to be divided into tax expenditures, which are bad, and provisions that make up the necessary structure of the tax, which are good, then a sharp line between those categories must be drawn. for example, a tax based on net 181 the total tax expenditure for the earned income tax credit for 2008-2012, including both the refundable and nonrefundable portions, was estimated to be $250 billion. see staff of joint comm. on tax’n, 110th cong., estimates of federal tax expenditures for fiscal years 2008-2012, at 50, 58 (joint comm. print 2008). 182 on the right, see martin feldstein, the ‘tax expenditure’ solution for our national debt, wall st. j., july 20, 2010; bruce bartlett, spending through the tax code, forbes, may 28, 2010; n. gregory mankiw, the blur between spending and taxes, n.y. times, nov. 20, 2010, at bu5; on the left see limiting tax expenditures must be part of congress’s efforts to balance the budget, citizens for tax justice (apr. 22, 2010), http://www.ctj.org/pdf/taxexpenditures.pdf; jason levitis, nicholas johnson, & jeremy koulish, ctr. on budget & pol’y priorities, promoting state budget accountability through tax expenditure reporting (2009). the government agrees. see u.s. gov’t accountability office, gao-11-318sp, opportunities to reduce potential duplication in government programs, save tax dollars, and enhance revenue (2011). 183 see sugin, supra note 98, at 413. 184 tax expenditures are often regarded as “payfors” in the budget process. see kleinbard, supra note 99, at 3. 185 see sugin, supra note 98, at 413-17. 32 columbia journal of tax law [vol.3:1 income must include structural provisions that are necessary to measure net income accurately, such as a deduction for business expenses. without that deduction, the tax would be imposed on gross receipts, not net income. but there are many provisions that are not as easily categorized as business expenses, like the treatment of the family and the separate corporate and individual income taxes. even within business expenses, some costs, such as business meals, are only partially connected to the production of income and partially connected to personal consumption, so their categorization as structural is not completely accurate. the treasury and joint committee have alternative approaches to accelerated depreciation, a business expense, and whether it should be treated as normal. despite decades of trying, nobody has been able to decisively draw the line between structural provisions and tax expenditures, and the topic continues to be contested today. the joint committee on taxation and the treasury department each prepare a tax expenditure budget, and the items included in the two versions do not entirely overlap.186 as long as the government has been compiling the tax expenditure budget, critics have challenged the “normal” baseline against which it measures spending for a range of reasons. 187 boris bittker immediately found nothing normatively attractive about the normal tax.188 others quibbled about which provisions should be treated as normal, even though they accepted the income-centric definition of normal that the early budgets adopted.189 some suggested that all provisions in the code should be evaluated like tax expenditures.190 there have always been provisions excluded from the list because they are administratively necessary, even where they provide benefits or incentives that might otherwise count as departures from the normal baseline, such as the realization rule.191 in 1983, the treasury staff challenged the baseline used in the earlier budgets with publication of its special analysis g.192 in that report, surrey’s key insight about tax expenditures—that some tax provisions are equivalent to direct outlays—was tested.193 the report reduced the definition of tax expenditures to “tax subsidies,” which it defined as provisions that apply to a narrow class of taxpayers or transactions and are exceptions from general provisions.194 the result was a redefined baseline that stopped treating items as tax expenditures if they constituted elements “necessary to make the tax operational.”195 the most significant changes made to the treasury baseline at that time 186 the joint committee analyzes the ways in which its estimates differ from treasury’s, including some differences in the base and differences in calculations of the estimates. see staff of joint comm. on tax’n, 111th cong., estimates of federal tax expenditures for fiscal years 2009-2013, at 19 (joint comm. print 2010). 187 see generally clifton j. fleming & robert j. peroni, reinvigorating tax expenditure analysis and its international dimension, 27 va. tax rev. 437 (2008) (noting that despite numerous criticisms of tax expenditure analysis, the government continues to use this tool). 188 see boris bittker, a comprehensive tax base as a goal of income tax reform, 80 harv. l. rev. 925, 931-934 (1967). 189 see thomas d. griffith, theories of personal deductions in the income tax, 40 hastings l.j. 343, 352 (1989); william d. andrews, personal deductions in an ideal income tax, 86 harv. l. rev. 309 (1972). 190 see douglas a. kahn & jeffrey s. lehman, tax expenditure budget: a critical view, 54 tax notes 1661, 1664-65 (1992). 191 see surrey & mcdaniel, supra note 35. 192 office of mgmt. & budget, supra note 97. 193 id. at 3. 194 id. at 5. 195 id. at 3. 2011] tax expenditures, reform, and distributive justice 33 was treating accelerated depreciation and graduated rates for corporations as basic structural features of the tax law. the treasury made additional changes to the definition of the baseline tax in 2004.196 at that time, it stopped treating the preferential rates for capital gains and dividend as tax expenditures, even though they had been designated that way since the first budget was prepared in 1972 (in fact, in the first budget, the capital gains preference was the largest single item). in changing the treatment, the administration explained that the double taxation of corporate income under a system with a separate corporate tax was being offset by the reduced taxation of capital gains and dividends, making the preference an integral part of that structure, rather than a tax expenditure that provided a special rate for income from particular sources.197 this was a major challenge to the reference law baseline from special analysis g, in which the treasury had explicitly chosen to continue treating the capital gains preference as a tax expenditure. the 2004 report included a table of negative tax expenditures (i.e., tax penalties) that treats the tax on corporate profits as a negative tax expenditure.198 the $25 billion negative number for that item dwarfed most other items in the budget.199 also in 2004, the treasury budget included a small but important change in measuring the tax expenditure from accelerated depreciation under the normal tax. in 1983, the reference law baseline was adopted without any tax expenditure for accelerated depreciation, but the 2004 change replaced the prior benchmark of straight-line depreciation in the normal tax method with an inflation-adjusted economic depreciation.200 the revised estimates were much smaller than under the prior approach, and were negative in some years. although the treasury’s explanation makes clear that the negative tax expenditures do not mean that the law provides slower depreciation than economic depreciation would prescribe, the obvious conclusion to draw from the tables is that depreciation is too slow and the tax law is penalizing those subject to it. the explanation that the numbers are a product of cash-flow accounting201 is unlikely to be understood by most people interested in the tax expenditure budget. that budget discontinued measuring the tax expenditure for depreciation under the old system, depriving readers of comparative data202 and minimizing the appearance of benefits to taxpayers investing in capital projects. during the last decade, treasury has tweaked other aspects of the tax expenditure budget and its analysis as well. for example, in 2006, it started including imputed income from home ownership as a tax expenditure.203 in 2005, treasury included a discussion of tax expenditures compared to regulation, as well as direct spending,204 196 office of mgmt. & budget, supra note 123. i critiqued these changes more fully in linda sugin, sustaining progressivity in the budget process, 45 b.c. l. rev. 1259, 1274-1282 (2004). 197 office of mgmt. & budget, supra note 123, at 138-139. 198 id. at 139-140. 199 it included shareholder level tax on dividends paid and capital gains realized out of earnings taxed at the corporation, and corporate tax on inter-corporate dividends and corporate capital gains on stock sales. id. at 110, 140. 200 id. at 137-138. 201 id. at 138. 202 id. at 138 n.31. 203 office of mgmt. and budget, analytical perspectives, fiscal year 2006, at 356 (2005). 204 office of mgmt. and budget, analytical perspectives, fiscal year 2005, at 300-302 (2004). 34 columbia journal of tax law [vol.3:1 enlarging the discourse from the joint committee’s more rigid approach that considered direct spending as the paradigm against which tax expenditures should be determined.205 in recent years, critics favoring a move to consumption taxation have challenged the income-centric approach that continues to inform the tax expenditure budgets today.206 in that vein, a more fundamental challenge to tax expenditure analysis was presented in the treasury’s appendices, starting in 2004.207 in that report, treasury included an analysis of tax expenditures in a consumption tax, reviewing its traditional list under a consumption tax model.208 it deemed some provisions to be tax expenditures under both approaches, others not to be tax expenditures under a consumption tax and a remaining few to be debatable. the analysis called into question the propriety of including many provisions in the budget, but did not offer a comprehensive alternative pursuant to the alternative baselines.209 the most recent development in the debate over the tax expenditure baseline was the joint committee’s reconsideration report.210 concerned that disagreement over the underlying conception that supported the tax expenditure budget undermined the integrity of the budget produced, the joint committee presented a new approach to tax expenditures that treated the tax law as moderately coherent to determine which provisions are included in the budget. its first (and only) budget using the new methodology was released a few months later. the reconsideration report was a comprehensive project, and it offered a new taxonomy and a new baseline that was designed to be devoid of any normative content. in fact, it dispensed with the notion of a single, coherent baseline altogether. rather than compile the budget by asking which provisions in the code are exceptions from an extrinsic and idealized normal tax as surrey and the joint committee had traditionally done, the new methodology generated the budget by extrapolating from the tax law itself. a new category of “tax subsidies” was generated by reference to discernible general rules of current law; the general rules thereby became a new baseline.211 the joint committee did not explain how it decided which provisions constitute the general rules, and there is no clear principle that the report adopted that would provide predictability and consistency.212 inferring from the first budget implementing the report, general rules are those that have been around a long time, have broad sweep, and do not create structural distortions.213 the general rules are 205 the joint committee’s long-held position was that tax provisions providing less favorable treatment than a normal income tax are not within the statutory definition of a tax expenditure. see staff of joint comm. on tax’n, 108th cong., estimates of federal tax expenditures for fiscal years 20042008, at 3 (joint comm. print 2003). 206 see bruce bartlett, the end of tax expenditures as we know them?, 92 tax notes 413, 414415 (2001); see also shaviro, supra note 130, at 189. 207 later treasury reports continued the presentation. see office of mgmt. and budget, supra note 123, at 314-322. 208 id. at 130-140. 209 these appendices are critiqued in sugin, supra note 196, at 1276-1282. 210 staff of joint comm. on tax’n, 110th cong., a reconsideration of tax expenditure analysis (joint comm. print 2008). 211 tax subsidies are provisions that are “deliberately inconsistent with an identifiable general rule of the present tax law . . . and collect[] less revenue than does the general rule.” staff of joint comm. on tax’n, 110th cong., a reconsideration of tax expenditure analysis 9 (joint comm. print 2008). 212 the joint committee modeled the baseline on the work of seymour fiekowsky. see id. 213 the report introduced the concept of “tax-induced structural distortions.” that category consists of general rules of the code that “materially affect economic decisions in a manner that imposes substantial economic efficiency costs” such as the distinction between debt and equity. see staff of joint comm. on 2011] tax expenditures, reform, and distributive justice 35 not unlike the normal baseline used in the old analysis, so the tax expenditure budget under the reconsidered approach resembled prior versions. regardless of the merits of these numerous critiques of—and changes to—the normal baseline that forms the basis of the tax expenditure budget, they do indicate that there has not been consistent support for a single baseline among important constituencies in congress, the treasury department, and the larger tax community. the changes that have been made to both the official tax expenditure budgets reveal the malleability of the baseline and its unavoidable politicization. consequently, any project to use that baseline as the model for tax reform stands on shaky ground. more importantly, these developments show that there is little normative power in the baseline today. enacting tax reform that carries out such a baseline would lack a coherent conception of distributive justice, an important foundation for any tax system. v. reformers privilege efficiency over equity tax reform that eliminates tax expenditures from the code favors efficiency over equity. efficiency improves both because tax expenditures distort taxpayer choice among activities and investments, and because removing tax expenditures broadens the base and allows rates to be reduced. replacing tax expenditures with rate cuts reduces the tax law’s interference in market transactions. it is a deceptively attractive solution to our fiscal problems because we can see the cut in rates that we enjoy, but the benefits and burdens of tax expenditure repeal are less transparent.214 the sacrifice of equity for efficiency is not new with these recent deficit reduction proposals. there has long been a trend toward treating efficiency as the prime normative goal of tax policy.215 efficiency seems more precise, has a clear direction and presents itself as a mathematically pure objective.216 though lip service is often paid to equity, the heart of tax reform has been increasingly about efficiency. the tax reform act of 1986 is a good example. in that paradigm of tax reform, statutory rates were cut, and incentives to engage in investments solely for tax savings were removed from the law.217 it had been wasteful for the tax law to encourage investors to build empty shopping centers and office buildings all over america. nevertheless, there were winners and losers in the tax reform act of 1986, and policymakers need to be concerned with fairness to the individuals who are affected by reform. both the fiscal commission proposal and the bipartisan policy center proposal follow this model, trading tax expenditures for rate cuts. in fact, the insistence on rate cuts reveals a greater interest in increasing efficiency than in deficit reduction, the ostensible goal of the project. the fiscal commission’s recommendation to cap revenue at 21% of gdp218 was also extraneous to the task of deficit reduction, but revealing as to the real objective of the reform. although the bipartisan policy center included a “national debt reduction sales tax”219 as a way to address the revenue concern, like the tax’n, 110th cong., estimates of federal tax expenditures for fiscal years 2008-2012, at 1, 13 (joint comm. print 2008). 214 see supra part iii.2. 215 boris bittker considered himself an “old turk” equity sympathizer in 1979, when a new generation of efficiency theorists was on the rise. see bittker, supra note 133, at 737. 216 see james repetti, democracy and opportunity, 61 vand. l. rev. 1129, 1130-1131 (2008). 217 § 469 suspended the deductions from business activities in which taxpayers did not actively participate. see tax reform act of 1986 § 501. see also i.r.c. § 469 (2006). 218 nat’l comm’n on fiscal resp. & reform, supra note 12, at 14. 219 bipartisan pol’y ctr., supra note 14, at 31. 36 columbia journal of tax law [vol.3:1 fiscal commission, it largely seized this moment of opportunity for tax reform to primarily make the system more efficient. it described its proposed tax as “simple, progrowth.”220 a. taxes are bad for growth efficiency as a goal is a normative choice that has never been fully justified for tax policy. it embodies an unreflective belief that economic growth is good and that market results are just. only on the fringes of tax policy does anyone question this belief.221 while market defenders argue to banish distributional concerns from economic regulation, leading welfarists believe that the tax system is the proper place for such concerns.222 economic regulation has generally eschewed distributional concerns in favor of growth,223 which is a sensible approach only as long as the distributional issues are better handled by an institution designed to handle them well—like the tax system. if economic regulation is designed to maximize growth and the tax system is designed to maximize growth, there is precious little opportunity to focus on distribution. nevertheless, there is a growing interest in the real world in designing taxation for growth. in the editorial pages of the wall street journal, daniel henninger recently argued that the primary purpose of taxation should be promoting economic growth.224 unfortunately, growth is an incoherent standard for a tax system. by definition, taxation produces “excess burden” or “deadweight loss,” which is an efficiency cost that arises as a by-product of moving resources from private hands to public coffers.225 any attempt to avoid a tax creates an efficiency loss. taxation always reduces the net individual rewards from economic activity and thereby burdens that activity. the only way to avoid excess burden is through lump-sum taxation, such as a head tax that is fixed regardless of economic activity.226 every tax system actually in use impedes growth in some way, so a growth norm favors repeal of every existing tax. income taxes reduce the gains from earning income, so repealing an income tax would promote more work and investment, and consequently growth. consumption taxes deter consumption, so repealing a consumption tax would promote demand, and consequently growth. wealth taxes reduce the accumulation of wealth, so repealing a wealth tax would better promote savings, and consequently growth. tax policy for growth is best achieved without taxes at all, so growth is an inapt norm for tax reform. tax expenditures are purposely inefficient. they are adopted precisely because they encourage individuals and businesses to engage in activities they would not 220 id. at 29. 221 see liam murphy & thomas nagel, the myth of ownership: taxes and justice 103109 (2002). neither author is a tax lawyer or economist. the most prominent recent tax debates, such as the income vs. consumption tax debate, have focused largely on efficiency. see, e.g., joseph bankman & david weisbach, the superiority of an ideal consumption tax over an ideal income tax, 58 stan. l. rev. 1413, 1414 (2005-2006); chris william sanchirico, a critical look at the economic argument for taxing only labor income, 63 tax l. rev. 867, 870-871 (2010). 222 see louis kaplow & steven shavell, why the legal system is less efficient than the income tax in distributing income, 23 j. legal stud. 667, 667-68 (1994). 223 see, e.g., a. mitchell polinsky, an introduction to law and economics 124-127 (2d ed. 1989). 224 daniel henninger, what are taxes for?, wall st. j. (dec 16, 2010), http://online.wsj.com/article/sb10001424052748704828104576021672925440698.html. 225 see david f. bradford, untangling the income tax 174-207 (1986). 226 see richard musgrave and peggy musgrave, public finance in theory and practice (5th ed. 1989). 2011] tax expenditures, reform, and distributive justice 37 undertake in the absence of tax inducement, the very definition of an inefficient tax provision. it is not surprising that economists are predisposed against them,227 but it is curious that they are criticized on account of that inefficiency. the normative goal of an efficient tax is at odds with the normative goals of a tax containing special incentives and preferences, and an inefficient tax is only bad public policy if the appropriate norm is efficiency. if congress has national security reasons for discouraging dependence on fossil fuels, for example, it is reasonable for it to incentivize the development of alternative power sources, even though such incentives distort the market. if congress believes that two families with the same income have different taxpaying abilities if one family has children in college, it might reduce tax in connection with the costs of college, even though that distorts the market for education. government creates costs in the course of achieving public policies unrelated to revenue collection, and we generally know to consider the benefits to be gained through those policies and balance them against the costs. discussions of tax reform seem to have forgotten that the inefficiencies produced by tax expenditures might be outweighed by their beneficial effects on other values, such as the distribution of the benefits and burdens of government. the problem is broadly endemic in all discussions of tax reform, but particularly prominent in the debate about tax expenditures. the tax law is as complex as it is because, at its best, congress has attempted to make distinctions among taxpayers. these distinctions may be inefficient, but they are not necessarily bad. b. efficiency is the new normal in the tax expenditure baseline the most important recent analysis of tax expenditures adopted the efficiencyfirst perspective. in 2008, the joint committee on taxation did a comprehensive investigation of the analysis used to consider tax expenditures228 and designed a new approach for identifying tax expenditures that chose efficiency as its unstated normative framework. the joint committee’s discussion adopted the economist’s perspective that tax expenditures are presumptively illegitimate because inefficient, 229 and accepted welfare economics as the criteria for analysis.230 by adopting a welfarist paradigm in discussing tax expenditures, which are inherently inefficient, the report demanded that equity benefits overcome efficiency detriments to maximize welfare overall.231 in addition, in applying the new approach, the joint committee stated that “efficiency is an 227 congressional research service economist jane gravelle said: “i have to admit the first thing that flowed to my mind when i was going to address the question of ‘do tax incentives work,’ is i hope not, because the vast majority of them are really not consistent with what, you know, an economist would suggest.” tax analysts, transcript of proceedings at the 2006 tax analysts conference series: tax incentives–do they work, and are they worth the cost? (april 6, 2006), http://www.taxanalysts.com/www/conferences.nsf/keylookup/kbun7faurd?opendocument&link=transcript. 228 staff of joint comm. on tax’n, 110th cong., a reconsideration of tax expenditure analysis (joint comm. print 2008). 229 the report acknowledged that economists are generally opposed to tax expenditures because they interfere with the market, making tax expenditures presumptively problematic going into the analysis. id. at 49. 230 id. 231 even if tax expenditures were not presumptively inefficient, welfare economics still might not be the best tool for judging them. welfare economics presents one, narrow view of equity that should have to compete with other conceptions of a fair society before it is incorporated as the standard for evaluating tax expenditures. welfare economics reflects a particular conception of good government policy grounded in utilitarian principles. equity-promoting tax policy might not be welfarist at all, so tax expenditure analysis might better reflect a different standard. 38 columbia journal of tax law [vol.3:1 inherently more neutral construct than is equity”232 in a project in which neutrality was the stated goal.233 in the report, the joint committee created a new category of tax provisions, which it called “tax-induced structural distortions,” that had not existed in prior tax expenditure budgets. it described tax-induced structural distortions as general rules of the code that “materially affect economic decisions in a manner that imposes substantial economic efficiency costs.”234 by using efficiency costs as the standard, the definition for tax-induced structural distortions makes an efficient tax the hypothetical alternative baseline, replacing the traditional normal (income) tax base that surrey had designed in compiling the early tax expenditure budgets. in this revised approach, only efficiency matters. equity concerns for tax-induced structural distortions were completely absent from the joint committee’s analysis. the joint committee defended its choice of efficiency as the sole criterion for analyzing tax-induced structural distortions because it concluded that only its category of “tax subsidies” raises equity issues. it defined tax subsidies as provisions that are “deliberately inconsistent with an identifiable general rule of the present tax law . . . and that collect[] less revenue than does the general rule.”235 the report distinguished the normative framework for tax subsidies from that applicable to tax-induced structural distortions by concluding that the latter are mostly about taxation of capital income where “efficiency goals loom largest.”236 applying efficiency as the normative standard is inadequate for tax-induced structural distortions and any other tax provision. contrary to the joint committee’s conclusion, the taxation of capital income presents one of the most important equity issues in the tax system; full taxation of capital income would significantly increase the share of taxes paid by the rich. both tax reform proposals include capital gains and dividends as ordinary income because that treatment is crucial to the overall progressivity of the plans. the joint committee offers the distinction between debt and equity as an example of a tax-induced structural distortion.237 from an efficiency perspective, the law should be consistent in their tax treatment, whether we tax them both in full (or double) or exempt them both from tax. however, from an equity standpoint, it may make a big difference whether we tax them both in full (or double) or exempt them both from tax because the rich and poor are likely to be affected differently, and individuals have different consequences depending on their holdings. at the other end of the spectrum, if efficiency is neutral and neutrality is the goal in designing taxation, we should expect that norm to spill over into all categories of tax provisions, even those that are designed to address distributional issues. and in fact, the joint committee’s report was concerned with efficiency in the tax subsidy category. for example, the report noted that there is a connection between the refundable provisions 232 id. at 42. 233 id. 234 id. at 10. for the only tax expenditure budget to implement this approach, see staff of joint comm. on tax’n, 110th cong., estimates of federal tax expenditures for fiscal years 2008-2012, at 7 (joint comm. print 2008). 235 staff of joint comm. on tax’n, 110th cong., a reconsideration of tax expenditure analysis 9 (joint comm. print 2008). 236 id. at 42. 237 id. at 41. 2011] tax expenditures, reform, and distributive justice 39 (like the eitc and child credit) and income distribution, but it was primarily concerned with targeting and incentives,238 both of which are efficiency concerns.239 c. tax expenditures affect the fairness of the tax rates the privileging of efficiency over equity constricts the analysis of tax expenditures to focus too narrowly on the definition of the tax base. tax expenditures, along with rates and exemptions, must be part of a discussion of overall tax progressivity. in a debate about tax fairness, the effects of tax expenditures on relative burdens must be made apparent. redistributive tax expenditures reflect other concepts of justice that might not be wealth-maximizing, but deserve serious consideration as public policy goals. for example, the earned income tax credit may be best understood as a basic guaranteed minimum for productive members of society,240 the education credits may be best understood as providing equal opportunity for economic success, 241 and the exclusion for health insurance may be best understood as an elevated public value in bodily integrity that is more important than protecting individual property interests. these provisions may also produce positive economic effects, but even if they do not, they might be good public policy. in addition, some tax expenditures may be best understood as a legitimate part of the rate structure, rather than as a problem in the tax base. rates are uniformly treated as part of the general rules of the code, so that the existing rate schedule at any time is part of those rules and never a tax expenditure.242 therefore, rate changes over time would never appear in the tax expenditure budget. rates are about individuals and their burdens, so they need to be evaluated on those terms. the efficiency norm is inapt as applied to decisions about the effective rates of tax that individuals bear. efficiency may be relevant to setting marginal rates,243 but policymakers must set effective rates as well as marginal rates. this may be the best way to conceptualize the role of the earned income tax credit in the system overall, since it allows the lowest-income workers to enjoy a negative rate of tax. similarly, the child tax credit may be about adjusting burdens on families with children. the negative tax expenditures that have recently appeared in the tax expenditure budgets may also be best understood as part of the structure of distributing burdens to individuals. these negative tax expenditures include the phaseout of the personal exemption and the double taxation of corporate income. designating the phaseout of the personal exemption as a negative tax expenditure in the budget, as the joint committee did in its report,244 suggests that high-income taxpayers subject to that phaseout are being overtaxed. but that phaseout could be understood instead as part of the rate structure, as the joint committee treated the personal exemption and standard deduction as zero-bracket amounts.245 if rates are outside tax expenditure analysis, as this 238see id. at 6. 239 efficiency and equity are related in that inefficiencies can sometimes change the distribution of tax benefits. see bittker, supra note 133, at 744. 240 it is an alternative to the minimum wage. see daniel shaviro, minimum wage, the earned income tax credit, and optimal subsidy policy, 64 u. chi. l. rev. 405, 408 (1997). 241 this is what professor repetti considers the core normative value in our system. see repetti, supra note 216, at 1131. 242 see surrey & mcdaniel, supra note 35, at 3. 243 this is what the optimal tax model determines. 244 staff of joint comm. on tax’n, 110th cong., estimates of federal tax expenditures for fiscal years 2008-2012, at 37 (joint comm. print 2008). 245 id. 40 columbia journal of tax law [vol.3:1 approach suggests, and the personal exemption is a matter of rates, then its reduction is not a negative tax subsidy, but an increase in rates. while that rate increase may be hidden from public scrutiny by its design as an exemption phaseout, it is still essentially a rate adjustment. because tax expenditure analysis treats rates as distinguished from the base, it is important to properly identify rate elements and base elements. reduced rates on particular investments are subsidies to those investments, but increased rates to particular individuals are simply rates. the phaseout of exemptions is about burdens on individuals on account of their total income, so it should be treated as part of the rate structure, where fairness controls. vi. reform must heed the lesson of tax expenditure analysis repealing all tax expenditures misunderstands the demands of tax expenditure analysis—that policymakers consider each tax expenditure to decide whether the policy is desirable and whether the mechanism is the best one for carrying out that policy.246 surrey’s key insight—that spending through the tax code is the same as direct spending—has gained widespread acceptance, even among those who might prefer to see these provisions as simple tax cuts.247 lawmakers who frame their favorite policies as tax provisions clearly understand the equivalence, and the academic literature generally treats it as a fact.248 tax expenditure analysis has been singularly powerful in providing reasoning to critics of tax incentives across the political spectrum; such critics regularly argue that tax expenditures should be subject to the same scrutiny as direct expenditures, if not repealed.249 the fiscal commission report is inconsistent in its adoption of tax expenditure analysis. while it identifies tax expenditures as spending, it fails to subject them to the standards for spending reductions that it applies to direct spending in the rest of the report, contrary to the central lesson of tax expenditure analysis. undifferentiated repeal of tax expenditures fails to do the rigorous work that surrey’s key insight demands. the commission engages in a much more thoughtful and measured approach to cutting discretionary spending and entitlement spending than it does for tax-based spending. instead, the report seeks to eliminate spending through the tax law simply because it is administered through the tax law. this is not a consistent or principled approach to cutting spending and it misunderstands what tax expenditure analysis demands. if we are to take the lessons of tax expenditure analysis to heart and analyze tax expenditures on the same terms as direct spending, we need to understand that repealing 246 see surrey & mcdaniel, supra note 35 (arguing that cutting tax expenditures are the best way to reduce government spending); fleming & peroni, supra note 187, at 444-45. 247 see, e.g., feldstein, supra note 182; see also mankiw, supra note 182. 248 david weisbach and jacob nussim offer a framework for considering federal programs that dispenses with the tax expenditure methodology, but adopt this key component as part of the starting point because they consider how to determine when the tax law is the appropriate vehicle for a spending policy. weisbach & nussim, supra note 51, at 958. edward kleinbard considers how the budget process can be improved through this insight. see kleinbard, supra note 100. i considered the constitutional implications of this insight. see sugin, supra note 98. the treasury’s 2007 budget moved beyond the taxing/spending analysis to compare tax expenditures to regulation. see office of mgmt. & budget, analytical perspectives, budget of the united states, fiscal year 2007, at 300-302 (2006). 249 see, e.g., bruce bartlett, spending through the tax code, forbes.com (may 28, 2010), http://www.forbes.com/2010/05/27/finance-economy-tax-code-opinions-columnists-brucebartlett_print.html; citizens for tax justice, judging tax expenditures 4 (2009), available at http://www.ctj.org/pdf/judgingtep1109.pdf; gen. accounting office, gao/ggd/aimd-94-122, tax expenditures deserve more scrutiny 2 (1994), available at http://archive.gao.gov/t2pbat3/151813.pdf. 2011] tax expenditures, reform, and distributive justice 41 tax expenditures will not produce the $1 trillion in revenue that tax expenditures currently cost. this is true for a variety of reasons. first, a tax expenditure may carry out a policy that congress will want to replace with a direct spending program. second, the revenue cost of tax expenditures cannot be added up to produce a total revenue loss (or recoupment) because tax expenditures may interact in a way that misstates total revenue loss when aggregated.250 third, scoring of tax expenditures may be mistaken because of projected behavioral effects. fourth, tax expenditures in the form of exclusions and deductions are dependent on tax rates, which would be lower in a code without any tax expenditures. tax expenditures differ from each other because they reflect different spending policies, and consequently cannot be treated as monolithic. rather than repealing all tax expenditures, it might be helpful to categorize tax expenditures along the lines of the following four categories: (1) modifications to the base that reflect reasonable differences about the ideal baseline, such as provisions that make the system more consumption-tax like and less income-tax like; (2) provisions that correct market failures or cognitive biases of taxpayers; (3) giveaways to powerful interests and special constituents; and (4) provisions that adjust levels of disposable real income of individuals. each statutory provision demands categorization and then analysis on its own terms. only the provisions in category 3 are clear candidates for quick repeal. category 1 may be the least appropriate to place on the reform chopping block because these provisions most closely resemble the ones that we treat as integral to the tax system. 251 these are provisions that make the tax system a hybrid incomeconsumption tax, and they are in the code because there is no consensus on an ideal tax base. the baseline in the tax expenditure budget does not represent an ideal to achieve, but rather a reference for information. the provisions in the code that provide tax benefits to retirement savings, such as 401(k) plans and roth iras, as well as the deductions for capital investment, 252 fit into this category. while they may be characterized as tax expenditures, their function in the law is to modulate the income base. there is no shortage of debate on what the best tax base is, and calling these provisions tax expenditures and repealing them on that ground ignores the much more substantive discussion of this issue taking place in the academic literature.253 elimination of the provisions that fall in category 2 could undermine the growth goals that are so prevalent in the debate about tax reform today.254 these provisions are designed to improve efficiency, so they should be welcomed by the tax reformers who care most about growth and efficiency. for example, tax benefits for development of alternative energies fall in this category. individuals fail to account for the environmental and political costs of fossil fuels, but alternative energy is too expensive to compete with the artificially low price of fossil fuels. tax benefits for alternative energies alter the market price to make such energies more competitive. correcting market failures improves efficiency, so provisions that fall into this category should not be repealed in the quest for efficiency. 250 see office of mgmt. & budget, supra note 44, at 2. 251 to borrow from special analysis g, these may be elements “necessary to make the tax operational.” see office of mgmt. & budget, supra note 97, at 3. 252 i.r.c. §§ 168(k), 179 (west supp. 2010). 253 the income tax/consumption tax debate is the most enduring in all tax policy. see, e.g., bankman & weisbach, supra note 221; sanchirico, supra note 221. 254 see supra part v.a. 42 columbia journal of tax law [vol.3:1 category 4 includes all the provisions that adjust for taxpaying ability along any dimension. it includes credits for earners,255 child-related breaks of all kinds,256 special provisions for the elderly and blind,257 state and local taxes,258 medical expenses,259 and perhaps charitable contributions.260 evaluating these provisions requires a politicalphilosophical discussion about what each provision does and how it fits into the social fabric. some of this discussion has been taking place in the academic literature, but not in the current discussion of tax expenditure repeal and reform. child tax benefits, for example, reveal ideas about family and community.261 payments per child, like the child tax credit,262 reflect the notion that families with children have less ability to pay tax and that children are entitled to support from other members of society beside their parents. these are the provisions that affect the core concerns of tax policy—what individuals and society owe to each other. these are the provisions that give meaning to who is rich and who is poor in our society, and they are crucial to have as part of the tax system. vii. conclusion this article is a challenge to those who would take the quick route to tax reform by repealing all tax expenditures. it argues that tax expenditures do not share enough characteristics to warrant common treatment, and those who would repeal them all have failed to understand the role they play in federal policy. the movement towards tax reform primarily for growth and efficiency is inconsistent with the demands of tax policy. the most distinctive role for tax policy is in distributive justice, and tax expenditures are a crucial mechanism for achieving fairness in the allocation of government benefits and burdens among individuals. this article calls for recognizing tax expenditures as the important distributive tool that they are, and demands greater understanding of the role of tax expenditures in achieving fairness. the debate on tax reform needs to be informed by a richer understanding and much more data than we have today about what tax expenditures do, who benefits from them, and who would bear the inevitable losses that would result from their repeal. 255 i.r.c. § 32 (west supp. 2010). 256 i.r.c. §§ 21, 24, 36c, 129, 151(c) (west supp. 2010). 257 i.r.c. § 63(f) (2006). 258 i.r.c. § 164 (west supp. 2010). 259 i.r.c. §§ 106, 213 (west supp. 2010). 260 i.r.c. § 170 (west supp. 2010). see andrews, supra note 189. 261 see generally anne l. alstott, no exit: what parents owe their children and what society owes parents (2005) (discussing the fairness of a tax system where the childless subsidize the costs of those who freely decide to have children). 262 i.r.c. § 24 (west supp. 2010). realization and progressivity ilan benshalom* kendra stead** abstract the realization requirement is the income tax’s original sin. although longstanding, it is widely considered the main source of tax complexity, inequity, and economic distortion. despite these problems, realization is also considered a fundamental element of modern income tax regimes. it is explained early in most federal income tax courses as necessitated by problems of asset valuation and taxpayer liquidity. to the dismay of certain professors, this explanation usually generates little class discussion. more worrisome, it is also widely accepted outside the classroom— prompting few political objections or normative academic inquiries. the goal of this article is to provide a normative framework that allows policymakers to better understand the role of the realization requirement. it makes two related arguments. first, with respect to certain emotionally non-fungible (personal) assets, the realization requirement is normatively justified because the market price is not a good indication of the assets’ value to their owners. second, contrary to the traditional view of realization as a regressive element, taxing only these personal assets upon realization would promote income tax progressivity. this article’s normative approach provides a basis for developing a more effective and coherent redistributive income tax policy. this analysis contributes to the broader tax reform debate and opens a novel theoretical inquiry with respect to the distributive impact of different types of errors. * associate professor hebrew university. ll.b. hebrew university of jerusalem, ll.m. university college london, ll.m. & j.s.d. yale law school. we are thankful to the following people for all of their comments and suggestions along the way: reuven avi-yonah, edna benshalom, gadi benshalom, tom brennan, assaf hamdani, sharon hannes, stephanie hoffer, susan morse, david pozen, and edward zelinsky. we would also like to thank participants of the university of toronto faculty of law tax policy workshop for their very helpful comments. we would like to extend special thanks to ben alarie, avital benshalom, david enoch, lee fennell, alon harel, sarah lawsky, debra lefler, daphna lewinsohn-zamir, jacob nussim, diane ring, and eyal zamir for their detailed comments. most of all, we would like to thank avihay dorfman and david gamage for their invaluable framing and substantive comments. ** j.d. northwestern university school of law. i would like to thank ryan sniatecki, scott lerner, and jonathan conon for their thoughtful comments. 44 columbia journal of tax law [vol.3:43 introduction ............................................................................................................ 45
 i.
 the realization requirement—costs and endurances of an achilles’ heel .................................................................................................... 49
 a.
 the function and social costs of the realization requirement ......................... 49
 b.
 technical in nature—the valuation liquidity consensus................................. 53
 ii.
 with it or without it? existing approaches to realization.... 55
 a.
 without it: a less realization-based income tax regime................................ 55
 b.
 with it: some hidden justifications for realization ........................................... 57
 c.
 the policy costs of a theoretical debate............................................................ 60
 iii.
a normative defense for realization—promoting income tax progressivity..................................................................................................... 61
 a. 
 tax and redistribution: at the crossroads of philosophy and public finance... 62
 b.
 market price, personal assets, and interpersonal comparisons.......................... 63
 c.
 realization as a progressively distributed tax benefit ...................................... 69
 d.
 advantages and limitations of the proposal ....................................................... 72
 iv.
the road ahead—preliminary policy implications..................... 78
 a.
 taking the first step: a modest real-world reform proposal.......................... 79
 b.
 future avenues of research ................................................................................ 81
 conclusions............................................................................................................... 84
 2011] realization and progressivity 45 introduction imagine a legal arrangement that transfers a huge percentage of the federal budget to wealthy americans, is inefficient, results in complexity, and encourages dishonesty. further imagine that when called upon to explain the arrangement’s objectives, policymakers, professionals, and academics merely shrug and reply that it is technical in nature and driven by administrative convenience. would you expect the arrangement to last for even a day? certainly not if it were part of the federal spending budget. however, the realization requirement has created exactly such a situation in the federal income tax context for over a century. this article critiques the academic literature dealing with realization and offers a new understanding of the requirement’s function: realization is another way to promote distributive justice within the tax regime. this insight provides policymakers a normative basis from which to combat the realization requirement’s negative effects in a principled way. it also raises the broader question of the role that the market prices of various assets should have in determining distributive policies. the realization requirement means that tax liability is assessed only when assets are exchanged on the market, and not, as an “ideal” income tax would dictate, when the market values of assets change.1 this seemingly simple requirement is the most “well established, and yet so widely criticized” attribute of our income tax regime.2 it has been called the achilles’ heel of the income tax3 and is widely considered to be the primary source of distributional inequity and complexity in the tax system.4 our main argument is that, contrary to the widely held view that the realization requirement is merely an administrative rule, realization is actually normatively justified with respect to certain assets—emotionally non-fungible (personal) assets. personal assets are those assets for which there is a high probability that the subjective value individuals attribute to them differs significantly from the market value. we argue that taxing these assets only upon realization helps the income tax to better achieve its professed objective of progressivity. a preliminary example demonstrates the realization requirement’s normative basis. consider two family vacation albums, the first made by a talented professional photographer and the second created by her spouse, a lawyer. the photographer’s album is filled with well-composed landscape shots and insightful portraits that many galleries would love to display, whereas the lawyer’s is comprised mostly of poorly framed shots of distracted children that even the grandparents tire of. nevertheless, both the photographer and the lawyer seem to derive the same amount of subjective value from their albums. 1 michael j. graetz & deborah h. schenk, federal income taxation: principles and policies 154 (6th ed. 2009); mary louise fellows, a comprehensive attack on tax deferral, 88 mich. l. rev. 722, 723-29 (1990); david m. hasen, a realization-based approach to the taxation of financial instruments, 57 tax l. rev. 397, 400 (2004); david m. schizer, realization as subsidy, 73 n.y.u. l. rev. 1549, 1551 (1998); daniel n. shaviro, an efficiency analysis of realization and recognition rules under the federal income tax, 48 tax l. rev. 1, 12 (1992); david a. weisbach, a partial mark-to-market tax system, 53 tax l. rev. 95, 95 (1999). 2 schizer, supra note 1, at 1551. 3 see william d. andrews, the achilles’ heel of the comprehensive income tax, in new directions in federal tax policy for the 1980s, at 278, 280 (charles e. walker & mark a. bloomfield eds., 1983) (calling the realization requirement the achilles’ heel of income taxation). 4 see infra part i.a. 46 columbia journal of tax law [vol.3:43 it seems intuitively wrong to increase the tax liability of the photographer only because her album has considerable market value. that is, as long as both albums are sitting on coffee tables in the family’s living rooms, it seems unreasonable to increase the photographer’s tax liability for the year simply because her personal album could fetch thousands of dollars, especially if she has no interest in selling it. however, under what is often described as an ideal income tax, the photographer would pay taxes in the year she compiled the album, because the album has the effect of increasing her net worth. but taxing her for the value of the album’s photos becomes completely reasonable if she sells the exclusive rights to the photos, in which case it would be difficult to distinguish it from any other work she sells.5 with respect to the album, realization does not increase or diminish the value or the nature of the photos—at least to the photographer. it only changes the type of the asset from a personal to a commercial one. this change signals that the asset’s value to the taxpayer is not different from its market value. we expand the example slightly to demonstrate why the realization requirement cannot be normatively justified with respect to all assets. imagine that the photographer and the professor each hold a hundred shares of apple stock and that the stock has increased significantly in value over the past year. the fundamental (and intuitive) difference between the owners’ perceptions of their photo albums (personal assets that will likely never be sold) and their stocks (investment assets that they hold solely for financial reasons) suggests that it would not be wrong to tax them for any wealth increase associated with the stock, even if they chose not to sell this year. currently, the realization requirement shields both types of wealth accumulation from taxation until the asset is sold, but we argue that this delay is only justifiable with respect to the category of personal assets, such as the photo album. recognizing this overlooked function of the realization requirement—allowing taxpayers to defer taxes on unique personal assets—provides policymakers with a valuable point of departure when deciding which assets should be subject to realization and which should not. articulating a normative basis for the requirement is certainly timely, as recent policy proposals claim the problems of realization prevent the income tax from meeting its distributive and efficiency goals, arguing that policymakers should abandon the income tax altogether and shift to a (less progressive)6 consumption tax system.7 scholars have debated the merits of realization for some time but mostly from the standpoint of assessing the practicalities of moving away from it. some, such as daniel shaviro and edward zelinsky, view realization as a necessary and manageable weakness.8 others, such as noel cunningham, deborah schenck, daniel halperin, 5 see infra part iii.b (arguing that her acceptance of the market value would be a signal that the market price is a good indicator for measuring her economic well-being). 6 chris w. sanchirico, a critical look at the economic argument for taxing only labor income, 63 tax l. rev. 867 (2010). however, some scholars claim that the inherent regressivity of the consumption tax base could be balanced, and perhaps even reversed, by a much more progressive rate structure. see edward j. mccaffery & james r. hines, the last best hope for progressivity in tax, 83 s. cal. l. rev. 1031 (2010). 7 see joseph bankman & david weisbach, consumption taxation is still superior to income taxation, 60 stan. l. rev. 789, 789–91 (2007); daniel n. shaviro, replacing the income tax with a progressive consumption tax, 103 tax notes 91 (2004). see also william d. andrews, a consumptiontype or cash flow personal income tax, 87 harv. l. rev. 1113, 1115–16 (1974). 8 see shaviro, supra note 1, at 66; edward a. zelinsky, for realization: income taxation, sectoral accretionism, and the virtue of attainable virtues, 19 cardozo l. rev. 861, 862 (1997). 2011] realization and progressivity 47 david shakow, and david weisbach, think that the income tax should gradually shift away from realization.9 as policymakers consider decreasing the set of assets subject to realization, they should be guided by some commonly accepted baseline principles. although scholars disagree about the proper role of realization moving forward, there is consensus on three main issues. first, most of the income tax’s shortcomings are a direct result of the realization requirement.10 therefore, as long as realization is part of the income tax regime, problems of complexity, planning, inequity, and inefficiency are inevitable.11 second, there can be no practical income taxation without realization, so at least some assets will always be taxed only upon realization.12 third, all tax scholars, with the exception of david schizer,13 seem to accept that realization has no theoretical or policy underpinnings and that it is merely a second-best solution driven primarily by concerns about asset valuation and taxpayer liquidity.14 this article challenges the third of these views and raises some important implications regarding the other two. it calls for applying the realization requirement in a fundamentally different way and suggests some substantial, yet feasible, policy reforms that would allow the tax system to better achieve its distributional objectives. it expands upon a previous article that deals with the taxation of earning capacity, examining how tax policy can be advanced with respect to the realization principle.15 admittedly, from a “pure” income tax perspective, taxing personal assets only upon realization rather than as their market value changes provides their owners with deferral and other tax benefits.16 however, we argue that these benefits may be justified because they are progressively distributed.17 the intuition behind this argument is that 9 see noël b. cunningham & deborah h. schenk, taxation without realization: a “revolutionary” approach to ownership, 47 tax l. rev. 725, 799–800 (1992); daniel halperin, saving the income tax: an agenda for research, 24 ohio n.u. l. rev. 493, 501 (1998); david j. shakow, taxation without realization: a proposal for accrual taxation, 134 u. pa. l. rev. 1111, 1114-15 (1986); weisbach, supra note 1, at 99. 10 see cunningham & schenk, supra note 9, at 728; edward d. kleinbard & thomas l. evans, the role of mark-to-market accounting in a realization based tax system, 75 taxes 788, 789 (1997) (identifying realization as the root of many tax evils). see also joseph bankman, what can we say about a wealth tax?, 53 tax l. rev. 477, 477 (2000); fred b. brown, “complete” accrual taxation, 33 san diego l. rev. 1559, 1559 (1996); deborah h. schenk, taxation of equity derivatives: a partial integration proposal, 50 tax l. rev. 571, 631–32 (1995); shakow, supra note 9, at 111–13. 11 for example, the realization requirement is often cited as the main reason for capital gains. see terrence r. chorvat, ambiguity and income taxation, 23 cardozo l. rev. 617, 647 (2002); edward j. mccaffery, a new understanding of tax, 103 mich. l. rev. 807, 896 (2005) (arguing that under an incomewith-realization tax, some preference for capital gains is needed). a recent realization-related debate concerns the profit interest compensation of hedge fund managers. the main issue was whether the managers received something of value before cashing their profits. see victor fleischer, two and twenty: taxing partnership profits in private equity funds, 83 n.y.u. l. rev. 1, 5 (2008). 12 see halperin, supra note 9, at 503; deborah h. schenk, a positive account of the realization rule, 57 tax l. rev. 355, 364-65 (2004); shakow, supra note 9, at 1144; shaviro, supra note 1, at 7; zelinsky, supra note 8, at 876. 13 see schizer, supra note 1, at 1552–53. 14 see, e.g., halperin, supra note 9, at 499; schenk, supra note 12, at 355–56; schenk, supra note 10, at 629; shakow, supra note 9, at 1114; weisbach, supra note 1, at 95. 15 see ilan benshalom & kendra stead, values and (market) valuations: a critique of the endowment tax consensus, 104 nw. u. l. rev. 1511 (2011). 16 see supra note 1. for a comprehensive analysis of this point, see part i.a. 17 this is true even if the market value of family albums (and other personal assets) owned by high net worth individuals may be greater than the value of albums owned by most taxpayers. see infra part iii.c–d. 48 columbia journal of tax law [vol.3:43 granting a tax benefit to personal assets requires imposing higher effective tax rates on other assets—namely, investment capital assets. hence, if the tax system shifts to taxing personal assets upon realization and non-personal investment assets upon market-price fluctuation, the system would become more progressive. this is because data about the distribution of assets strongly suggests that personal assets comprise most of low and medium income households’ assets while investment and capital assets are disproportionately owned by affluent taxpayers.18 by addressing realization as a question of distributive justice, this article connects existing tax practices to the theoretical bases of redistribution: the questions of what policymakers should seek to redistribute and how they should best measure it. it is worth emphasizing the difference between our approach and the more canonic arguments with respect to realization. the bulk of the literature focuses on the difficulty of determining the market value of illiquid assets and describes the arbitrary tax assessments that would result from valuation error. this article makes the point that the problem of assessment errors would still be relevant with respect to personal assets even if all assets had a verifiable market price. we are concerned less with the consequences of inaccurate tax assessments and more with how different types of inaccuracies impact distribution. accordingly, the article highlights a consequence of errors that has not yet been addressed. we contend that even if we had efficient markets for all assets, this improved accuracy would not be free of errors. including personal assets within the income tax base would decrease mistakes with respect to the market price valuations, but increase the probability of error with respect to the subjective value taxpayers attach to different assets. 19 the increased probability of that type of error would not be distributionally neutral, increasing the relative tax burden on low and middle income taxpayers. this analysis leads to the conclusion that realization may be justified with respect to personal assets but not with respect to investment assets. the implication of this conclusion is that policymakers should consider applying the requirement very differently by taxing investment assets as they appreciate or depreciate in value rather than when they are sold. such a reform would significantly reduce the income tax’s current problems by making it less distortive, more consistent, and more equitable. this article explains why such a system would not be any more difficult to maintain than the current tax regime, which also applies special rules to investment assets. hence, while our proposal raises some concerns, it also offers an administratively and politically plausible alternative that could be used to maintain the income tax as an effective wealth redistribution tool. before launching into a full discussion of realization, we provide a brief overview of the broad issues reached in this article. part i describes the function and impact of the realization requirement, explains why it is the major source of income tax difficulties, and clarifies why it is viewed as solely the byproduct of tax administrative constraints. part ii explores the academic literature with respect to realization. it shows that all leading approaches are similarly incomplete because all view realization only as a 18 see infra appendix and notes 46, 114. 19 in other words, this suggests that market price is a tool—a proxy—for getting at individuals’ economic well-being. however, as a proxy it should only be used when there are good reasons to believe it correlates well with well-being. 2011] realization and progressivity 49 necessary evil. it then argues that no reasonable income tax regime can be devised without understanding that realization can be justified in its own right. parts iii and iv develop this article’s analysis—the former develops the normative framework, and the latter extracts its policy implications. part iii begins by explaining the difficulty of making interpersonal comparisons in a redistributive tax regime. it then establishes two normative pillars of realization: the particular difficulty of making interpersonal comparisons with respect to personal assets and the progressivity gained by taxing only personal assets on a realization basis. it ends by discussing a possible theoretical criticism of this article’s proposal—namely whether there are alternative ways to better attain tax progressivity. part iv explains the policy reform implications of this article’s normative analysis. it also elaborates upon some empirical questions and points to some potential avenues of future research. we close with several brief conclusions that highlight this article’s policy and theoretical contributions. i. the realization requirement—costs and endurances of an achilles’ heel the realization requirement emerged in the early twentieth century and soon became a foundational attribute of all income tax regimes.20 in the united states, the requirement got an early endorsement from the supreme court, which found that imposition of the federal income tax was constitutionally limited to only realized gains.21 the court soon retreated from that position, however, and scholars widely agree that realization is not constitutionally mandated.22 in fact, congress has successfully adopted many tax arrangements that impose taxes on unrealized profits.23 this part briefly explains the realization requirement’s operation, the tension it creates within the income tax, and its significant social costs. it then presents the canonic explanation for how this “achilles’ heel” of the income tax has endured in spite of its shortcomings.24 a. the function and social costs of the realization requirement this subpart describes the realization requirement as a transaction (rather than an income) tax and explains the enormous social costs this transactional element imposes upon the current regime.25 a simple example may help illustrate how the realization requirement is implemented. in 1991, a hypothetical relative of ours invested his small inheritance and pension savings in one company: aig. in 2001, the price of his shares had increased fifteen fold, and the hypothetical relative was doing great. not feeling any obligation to save, he was vacationing in the caribbean, avoiding cheap hotels, taking big mortgages on his new york apartment and florida mansion, considering early retirement, and 20 see helvering v. horst, 311 u.s. 112, 115 (1940); cottage sav. ass’n v. comm’r, 499 u.s. 554, 559 (1991). see also i.r.c. § 1001(a) (2006). 21 eisner v. macomber, 252 u.s. 189 (1920). 22 see marvin a. chirelstein, federal income taxation 73 (11th ed. 2009); terrence r. chorvat, perception and income: the behavioral economics of the realization doctrine, 36 conn. l. rev. 75, 82 (2003) (providing a short survey of the erosion of the realization requirement’s constitutional protection); cunningham & schenk, supra note 9, at 742. 23 this includes the tax arrangements that governed the taxation of pass-through entities in the 1950s (subchapters k and s in the internal revenue code) and the rules that govern the taxation of certain traded commodity futures and financial institutions. chorvat, supra note 22, at 83-86 (describing these examples). 24 see andrews, supra note 3, at 280. 25 see bankman, supra note 10, at 479; cynthia blum, new role for the treasury: charging interest on tax deferral loans, 25 harv. j. on legis. 1, 93–94 (1988); weisbach, supra note 1, at 97. 50 columbia journal of tax law [vol.3:43 planning to buy his kids new cars. at family parties, we would all gossip about his wife, saying how lucky she was to marry such a clever investor. by 2011, however, things have radically changed for the hypothetical relative—the caribbean seems as distant as the moon, the kids have to take out huge student loans, he rarely attends family festivities, and when his ex-wife does, we all gossip about how unfortunate she is to have married such a reckless speculator. over the last twenty years, the hypothetical relative’s life has been a roller coaster, yet one thing has remained stable: his tax liability. because of the realization requirement, he paid no income taxes and received no deductions with respect to his holdings in aig throughout those years. in contrast, under a “mark-to-market” tax regime, the unfortunate relative would have been required to pay taxes (and been able to deduct losses) as the value of his investments changed. mark-to-market tax treatment may not seem intuitive, but it is sensible because the gains and losses of the hypothetical relative reflected real changes in his economic purchasing power.26 true, he could not have paid his grocery bills with aig stock, but he could have sold any amount of the stock at any point in order to do so. more importantly, he borrowed against the stock and used the loan proceeds for consumption.27 simply put, while his stock was not equivalent to money, it was viewed by this relative, and basically everyone else, as being almost as good. it is widely accepted among economists and tax professionals that taxpayers’ economic incomes increase as their assets appreciate, not just when those assets are sold.28 to the extent that individuals’ increase in wealth is a good proxy for their wellbeing—and therefore a relevant benchmark for taxation—taxpayers’ realized gains and cash flows are (from a pure income tax perspective) beside the point.29 the principle that all accretions to wealth should be measured by an income tax creates an interesting tension. if policymakers wish to use the income tax to generate revenue, they should try to avoid giving it a transactional dimension, meaning that taxation should not depend on when taxpayers choose to put assets on the market.30 transactional elements are problematic because taxpayers can time and structure exchanges and sales. that is, transactional taxation gives taxpayers considerable ability to control how and when to pay the taxes. 26 there may be some question over how sensible it is to collect taxes and then turn them back when losses appear if there is significant value fluctuation and a progressive tax rate is employed. see jeffrey b. liebman, should taxes be based on lifetime income? vickrey taxation revisited (december 2003) (unpublished manuscript), available at http://www.ksg.harvard.edu/jeffreyliebman/vickreydec2003.pdf. 27 see mccaffery, supra note 11, at 888. 28 this concept calculates taxpayers’ income in a given period by measuring their overall consumption and net increase in the fair market value of their assets. haig-simons taxation focuses on asset appreciation and depreciation, not on whether the assets were sold. it would therefore not include a realization requirement. see henry c. simons, personal income taxation: the definition of income as a problem of fiscal policy 50 (1938); robert m. haig, the concept of income—economics and legal aspects, in the federal income tax 1, 7 (robert m. haig ed., 1921). 29 there is a wide consensus that an ideal income tax would adopt the haig-simons concept of the income tax base. see, e.g., graetz & schenk, supra note 1, at 97; fellows, supra note 1, at 723–24; stephen b. land, defeating deferral: a proposal for retrospective taxation, 52 tax l. rev. 45, 48 (1996); schenk, supra note 10, at 631–32; michael j. stepek, the tax reform act of 1986: simplification and the future viability of accrual taxation, 62 notre dame l. rev. 779, 785–86 (1987); weisbach, supra note 1, at 95. this concept calculates taxpayers’ income in a given period by measuring their overall consumption and net increase in the fair market value of their assets. 30 see shaviro, supra note 1, at 1–2. 2011] realization and progressivity 51 the current realization-based income tax system aims to levy tax according to individuals’ incomes, but in fact it relies on transactional realization triggers that may have nothing to do with income.31 this tax regime, however, is not truly transactional either, because it requires that assets appreciate in value for the tax to be triggered. under the current system, taxes are only paid if a transaction occurred and gains were realized. this dual requirement grants taxpayers the ability to structure their transactions to attain certain tax advantages that would not be available to them in either a pure income tax regime or a pure transactional tax regime.32 the inherent conflict between the measurement of actual income and the transactional element of realization makes the current realization-based income tax unworkable. policymakers find it difficult to generate broad rules that reconcile the two notions and are therefore unable to generate coherent rules explaining what types of transactions amount to a realization event.33 in terms of efficiency, the realization requirement leads well-informed and selfinterested taxpayers to sub-optimally invest their resources in order to attain higher aftertax returns.34 the realization requirement also distorts the timing of asset dispositions.35 taxpayers can also defer the recognition of gains but selectively sell depreciated assets to enjoy the value of their losses—a practice typically referred to as strategic trading.36 the potential for manipulation introduced by the realization requirement compels the tax authority to introduce complex loss-limitation rules to protect the revenue base. these rules disallow the deduction of losses incurred with respect to certain investments, thus making them inherently riskier and deterring some (potentially less well-advised) taxpayers from making those investments.37 finally, the realization requirement results in significant revenue loss that has to be compensated for—either by inefficient higher marginal tax rates38 or lower (sub-optimal) public investment.39 in terms of complexity and uncertainty, the transactional element introduced by the realization requirement materially complicates the income tax’s implementation.40 policymakers’ attempts to rein in problems stemming from the realization requirement are the hidden drivers of many notoriously complex provisions and regulations. in terms of deferral, the attempt to tax individuals only on their realized gains and losses raises the 31 see, e.g., david m. schizer, balance in the taxation of derivative securities: an agenda for reform, 104 colum. l. rev. 1886, 1893 (2004) (describing one method by which wealthy taxpayers can reduce their tax liability that is not available to those with less planning advice and fewer assets). 32 unless there are strong non-tax considerations involved, taxpayers will exercise these tax options in a way that increases their overall profit. schizer, supra note 1, at 1555–63 (adding that realization allows taxpayers to blunt the penalty of inflation in a tax regime that assigns tax liabilities according to nominal amounts). see, e.g., myron s. scholes et al., taxes and business strategy: a planning approach 185–89 (4th ed. 2009) (discussing the ability of businesses to choose between two inventory accounting methods in order to minimize their tax liability without affecting their actual business practices). 33 david a. weisbach, line drawing, doctrine, and efficiency in the tax law, 84 cornell l. rev. 1627, 1633–45 (1999). 34 scholes et al., supra note 32, at 70–73, 107–08; fellows, supra note 1, at 727; weisbach, supra note 1, at 100. 35 see scholes et al., supra note 32, at 5. 36 shaviro, supra note 1, at 4. 37 land, supra note 29, at 51. 38 see infra notes 170–172 and accompanying text. 39 see ilan benshalom, the dual subsidy theory of charitable deductions, 84 ind. l.j. 1047, 1064–70 (2009) (discussing what comprises an optimal allocation of public goods). 40 stepek, supra note 29, at 779. 52 columbia journal of tax law [vol.3:43 question of when investors in companies actually realize the profits of their investments. in fact, two of the most complex areas of law, corporate and partnership taxation, would be almost completely unnecessary absent the realization requirement.41 as mentioned, any realization-based income tax regime needs loss-limitation rules to protect its revenue base against strategic trading.42 over the years, many loss-limitation rules have been enacted to curb tax planning with respect to income generated from passive investments and financial assets.43 the rules formulated, however, are so staggeringly complex that commentators have voiced skepticism as to whether they can be enforced in even a marginally coherent way.44 as difficult as these issues are, the above examples are just the tip of the iceberg in terms of realization’s costs. in terms of equity, this distortion and complexity significantly reduce the ability of the income tax to effectively promote fairness objectives. if the income tax is expected to tax individuals according to changes in their economic well-being, then the realization requirement is an obvious obstacle. first, it provides a tax deferral benefit to successful investors who enjoy real, unrealized gains and (through loss-restriction rules) denies deductions to investors who suffer and realize actual losses. second, since unrealized gains are frequently associated with capital assets, realization reduces the effective tax rate on capital.45 because the majority of capital assets are owned by affluent taxpayers, the realization requirement provides a tax benefit that is primarily skewed toward the wealthy.46 consequently, in the current tax regime, the realization requirement is justly viewed as an inherently regressive feature that hinders the income tax’s wealth redistribution objectives.47 the realization requirement and its byproducts undermine the integrity of the income tax regime in almost every respect. instead of promoting distributive justice and ensuring efficient allocation of resources, the realization requirement and its host of problems create the perception that the tax code is a wasteful and arbitrary body of law. the discontinuities created by the requirement have given rise to a socially wasteful tax 41 fellows, supra note 1, at 728; jeffrey kwall, the uncertain case against the double taxation of corporate income, 68 n.c. l. rev. 613, 628–630 (1990); land, supra note 29, at 54; schenk, supra note 12, at 369 (“if c corporations and pass-through entities were valued annually, almost all of subchapters c, s, and k could be repealed.”). 42 see supra note 36 and accompanying text. 43 the mobility and fungibility of those assets, along with financers’ unlimited ability to infinitely slice and dice them, lead to fears that tax planners can structure cash flow positions without realizing income. graetz & schenk, supra note 1, at 623–26; ilan benshalom, how to live with a tax code with which you disagree: doctrine, optimal tax, common sense, and the debt equity distinction, 88 n.c. l. rev. 1217, 1219–20 (2010). 44 the passive loss restrictions and various constructive ownership and sale requirements with respect to financial instruments are additional examples of the remarkably complex rules that aim to control selective loss realization. graetz & schenk, supra note 1, at 391–93. 45 noël b. cunningham, the taxation of capital income and the choice of tax base, 52 tax l. rev. 17, 41 (1996). 46 see g. william domhoff, wealth, income, and power, who rules america? (last updated nov. 2011), http://sociology.ucsc.edu/whorulesamerica/power/wealth.html, for distributional tables showing that, in 2004, the top 1% of u.s. citizens in terms of net worth controlled 34.3% of the country’s overall wealth; george r. zodrow, economic analyses of capital gains taxation: realizations, revenues, efficiency and equity, 48 tax l. rev. 419, 492–93 (1993). 47 chorvat, supra note 22, at 91. see generally david kamin, what is a progressive tax change?: unmasking hidden values in distributional debates, 83 n.y.u. l. rev. 241 (2008) (discussing different criteria for what may be considered a progressive change in the tax system). 2011] realization and progressivity 53 planning industry.48 given realization’s obvious and harmful faults, one can only wonder why policymakers have not seriously considered any meaningful alternative. b. technical in nature—the valuation liquidity consensus tax academics widely perceive the realization requirement as having little, if any, theoretical or policy justification. nevertheless, contemporary tax scholarship rarely takes on the requirement, adopting a “cross we must bear” approach to its problems. realization’s endurance is generally explained in terms of two tax-administration concerns: problems of low taxpayer liquidity and the technical difficulty of valuing assets.49 this subpart briefly explains and evaluates these views. with respect to liquidity, realization makes the tax collection process relatively easy because it avoids the tax-without-cash problem. assets are typically exchanged for cash, so taxpayers have the necessary cash to cover the tax liability at the time of sale.50 in contrast, a mark-to-market regime may force cash-poor taxpayers to sell assets to pay their tax liabilities on unrealized profits. hence, a mark-to-market system would require policymakers and tax authorities to undertake a politically unpopular and legally complicated position of dealing with some taxpayers’ inability to produce the cash necessary to pay taxes. much of the political traction of the income tax relates to the way it considers taxpayers’ ability to pay and, through the realization requirement, does not disrupt taxpayers’ affairs by requiring them to sell assets or borrow money to pay their taxes. problems associated with taxpayers’ liquidity could be dealt with in a mark-tomarket system. while low liquidity is not a completely manufactured problem, leading scholars have convincingly argued that problems associated with liquidity are not substantial enough to justify the broad imposition of the realization requirement.51 for example, under a mark-to-market regime, taxpayers would be likely to structure their investment and borrowing transactions in ways that addressed liquidity concerns by making sure that they had sufficient funds to pay their taxes. 52 additionally, lawmakers could provide exceptions with respect to certain assets (e.g., residential homes, closely held corporations). such provisions would assure that liquidity-constrained taxpayers who owned certain appreciated assets were not required to pay the tax until they sold the asset.53 these exceptions could be structured so that when the assets are eventually sold, the gains are taxed at nominal rates (as occurs under the current tax regime). alternatively, they could be taxed at higher effective tax rates that tried to capture the value of deferral.54 48 weisbach, supra note 1, at 131; david a. weisbach, ten truths about tax shelters, 55 tax l. rev. 215, 222–26 (2002). 49 see chorvat, supra note 22, at 91–92; schenk, supra note 12, at 360–70 (exploring these justifications and concluding that neither completely explains the requirement); shakow, supra note 9, at 1118; shaviro, supra note 1, at 5, 12–13; weisbach, supra note 1, at 95–96; zelinsky, supra note 8, at 879. 50 schenk, supra note 10, at 630. 51 see, e.g., schenk, supra note 12, at 360–65; shakow, supra note 9, at 1167–76; weisbach, supra note 1, at 96. 52 schenk, supra note 12, at 362. 53 shakow, supra note 9, at 1167–76. but see zelinsky, supra note 8, at 892 (noting that the internal revenue service may find it very difficult to evaluate taxpayers’ liquidity). 54 as mentioned earlier, the deferred payment grants taxpayers the benefit of enjoying the time value of money. see supra notes 45–47 and accompanying text. the economic value of this benefit to the taxpayer could easily be computed through basic finance theory principles. while the tax assessment could be made on an annual basis, the taxes could be paid only when the asset was sold. the tax liability would be 54 columbia journal of tax law [vol.3:43 the stronger argument in support of the realization requirement is that a mark-tomarket regime would require burdensome annual asset appraisal. a coherent tax that accounted for accrued gains and losses would involve huge administrative costs associated with valuation.55 even the scholars who are most optimistic about the prospect of abolishing the realization requirement and shifting to a mark-to-market regime agree that certain types of intangible assets are very difficult, perhaps impossible, to value with sufficient accuracy.56 this difficulty raises significant questions about whether valuation provided by taxpayers could be trustworthy—a serious concern in a tax regime dependent on self-assessment.57 if the realization requirement were abolished, one could expect a significant increase in the amount of fact intensive, valuation related litigation between tax authorities and taxpayers.58 the realization requirement avoids these valuation problems because the price an unrelated buyer pays for the asset in a market exchange provides a strong indication of the asset’s actual value. by focusing only on the price garnered in actual transactions, a realization-based income tax allows tax authorities and taxpayers to avoid lengthy, costly, and inaccurate valuation processes. however, this type of audit accuracy comes at a cost. in order to rely on unrelated parties’ willingness to pay, tax authorities must wait, often ignoring significant gains for many years. unlike problems of liquidity, problems of valuation remain a major obstacle to implementing a mark-to-market income tax regime. while not denying their salience, we note that valuation problems are likely to play an increasingly smaller role in tax policy moving forward. first, the problem of valuation is constantly decreasing because the scope of information markets is rapidly growing, and asset valuation methods are improving over time. in fact, because of these two phenomena, many assets that once were considered impossible to value now have established market prices.59 second, the investment patterns of society have shifted.60 rather than investing in concentrated private ventures, individuals now invest large shares of their wealth in diversified portfolios of publicly traded assets.61 this shift means that far more of the wealth held by individuals has an established market price. furthermore, certain taxpayers, especially firms, already engage in fair market valuation of their assets for tax and non-tax reporting purposes.62 this does not suggest that a shift calculated with reference to the nominal gain and the economic value of deferring the tax payment. shakow, supra note 9, at 1176. 55 see schenk, supra note 10, at 630. 56 see brown, supra note 10, at 1587 (discussing the difficulties of determining the value of human capital assets). see also shakow, supra note 9, at 1157–58 (suggesting that intangibles should not fall within the scope of his proposed mark-to-market regime). 57 see zelinsky, supra note 8, at 887–88. 58 schizer, supra note 1, at 1594–95. see also zelinsky, supra note 8, at 881–82. 59 see david schmudde, responding to the subprime mess: the new regulatory landscape, 14 fordham j. corp. & fin. l. 709, 711 (2009) (describing the rise of the mortgage-backed securities market, which was once considered illiquid). see also cass r. sunstein, group judgments: statistical means, deliberation, and information markets, 80 n.y.u. l. rev. 962, 971–74 (2005) (describing valuation strategies in information markets). 60 see michael j. graetz & itai grinberg, taxing international portfolio income, 56 tax l. rev. 537, 542–45 (2003). see also katherine pratt, the debt-equity distinction in a second-best world, 53 vand. l. rev. 1055, 1057 (2000) (describing the development of two alternative theories of the firm as a result of the dispersion between public ownership of debt and stock). 61 see graetz & grinberg, supra note 60, at 547–54. 62 for example, under the securities exchange act (1934), the securities and exchange commission requires all public corporations to report financial statements according to the general accounting principles. 15 u.s.c. § 78(m) (2006). additionally, treasury regulation § 1.861–9t(h) gives tax 2011] realization and progressivity 55 to a mark-to-market regime would not involve significant problems and administrative costs related to valuation difficulties. it does signify, however, that the marginal costs of producing the extra valuations necessary for such a shift may be considerably lower today than they were in the past and, if the above trends continue, are likely to be still lower in the future. the mitigation of liquidity and valuation problems is undoubtedly the strongest explanation for the presence of the realization requirement in all income tax regimes. however, this subpart questions whether problems of valuation and liquidity justify the requirement’s broad application.63 this inquiry is necessary because the administrative concerns surrounding valuation and liquidity currently foreclose any normative or policy discussion about the appropriate role of the realization requirement. that realization undermines the redistributive function of the income tax regime, which is one of the most effective redistributive tools of modern liberal democracies,64 should be a point of concern. in our view, policymakers may find it beneficial to seriously reconsider the much deeper normative discussion of how realization promotes or impedes the income tax’s distributive objectives.65 ii. with it or without it? existing approaches to realization given the consensus that there is no normative justification for the realization requirement,66 the current theoretical discourse has centered on whether there is a way to remove the requirement while keeping the income tax. this part identifies and evaluates two general approaches within contemporary literature. the first advances the notion that the income tax regime is so irreparably broken because of the realization requirement that a shift toward a mark-to-market regime is desirable. the second argues that such a shift would be unwise because the comparative costs of the alternatives to realization may be higher than initially meets the eye. this part reviews and critically assesses both approaches, observing that their proponents disagree about one issue: the comparative costs of the realization requirement and various mark-to-market regimes. both approaches accept the notion that the realization requirement merely represents an answer to administrative difficulties associated with liquidity and valuation. yet, as the final subpart argues, this acceptance is problematic because there are social costs to a century of stagnation in the tax discourse with respect to the realization requirement. a. without it: a less realization-based income tax regime commentators have advanced many proposals to reduce the tax distortions and inequities of the realization requirement.67 while they differ significantly, each proposal benefits to u.s. multinationals that allocate their interest deductions—which requires them to undertake annual fair market valuation of all their domestic and foreign assets. treas. reg. § 1.861-9t(h) (2009). 63 see halperin, supra note 9, at 499. 64 see linda sugin, theories of distributive justice and limitations on taxation: what rawls demands from tax systems, 72 fordham l. rev. 1991, 2013–14 (2004). 65 many prominent scholars have argued that the realization requirement has no normative basis. see, e.g., cunningham & schenk, supra note 9, at 742; halperin, supra note 9, at 499; schenk, supra note 10, at 629; shakow, supra note 9, at 1114. 66 see supra note 14. 67 see generally blum, supra note 25, at 93–94 (assessing the desirability and feasibility of using an interest charge to compensate taxpayers’ deferral); cunningham & schenk, supra note 9 (advocating for the application of a presumptive tax on imputed income at the risk-free treasury rate to split ownership interests); fellows, supra note 1, at 728 (offering a proposal for retrospective accrual taxation based on the assessment 56 columbia journal of tax law [vol.3:43 contends that realization cannot be justified while simultaneously arguing that it should not be eliminated altogether. the argument underlying proposals for a shift to a mark-to-market regime is relatively straightforward and compelling. because they see no normative justification for the realization requirement, the commentators argue that the income tax regime should minimize realization’s social costs by limiting its role. to do this, policymakers should engage in a cost–benefit analysis to determine whether it is possible to tax the value fluctuation of certain assets independent of realization. this approach emphasizes that the administrative costs associated with valuation are often overstated. many assets, particularly publicly traded instruments, are actually quite easy to value. this argument becomes stronger as public markets continue to grow in both scope and scale,68 and the relative size of portfolio investment continues to grow as well.69 advocates of broader mark-to-market taxation also emphasize that a tax based on changes in asset value would not require annual valuation of every asset. there are a number of ways to indirectly reduce the tax benefit of deferral and the problem of lock-in without annual valuation of all assets.70 further, inaccuracies in any one year would correct themselves over time and even out when the asset was ultimately sold, and since more assets would be valued, the impact of mispricing any specific asset would be greatly diminished.71 diminishing the costs of the realization requirement would reduce some of its social costs and would result in a broader, more comprehensive tax base,72 which would allow policymakers to maintain the same level of revenues while reducing high marginal tax rates (and their associated work disincentives).73 of when the asset appreciates in value); land, supra note 29, at 47 (proposing a form of retrospective taxation that grants the government an equity share in the time-adjusted gains at the time of the sale); david s. miller, a progressive system of mark-to-market taxation, 109 tax notes 1047 (2005) (arguing that affluent individuals, public companies, and medium-sized private companies would be required to mark-to-market their publicly traded property and derivatives); weisbach, supra note 1 (examining whether it is feasible to expand mark-to-market taxation to cover most liquid assets while leaving hard-to-value assets such as real estate and small businesses on the realization system). 68 benshalom & stead, supra note 15, at 1557. 69 see graetz & grinberg, supra note 60, at 542–45. 70 periodic assessment and reliance on presumptive statistical appraisals should provide a good proxy for changes in taxpayers’ portfolios. furthermore, exemptions for low value assets (e.g., consumer durables), could also reduce administrative costs without significant revenue implications. see shakow, supra note 9, at 1121–23. a mark-to-market regime could also be administered through special arrangements for assets for which valuation seemed completely implausible. extremely difficult to value assets—such as artwork—could be taxed on a realization basis with measures to correct for deferral. another possibility would be to use an ex post retrospective approach that taxed the value of deferral—meaning that when the assets were sold the tax liability would be calculated based on certain assumptions with respect to when the value accumulated. for example, tax authorities could operate under a rebuttable assumption that assets had straight-line appreciation. taxpayers who realized profits later would face higher nominal tax liabilities, because they would be taxed on the assumed tax value of money they attained by deferring realization. alternatively, investments could face presumptive tax on their expected return—investors would have to pay a tax on their expected benefits, and the total tax liability could later be modified according to the actual price at which the asset was realized. for such a proposal see edward d. kleinbard, designing an income tax on capital, in taxing capital income 165 (henry j. aaron et al. eds., 2007). 71 see shakow, supra note 9, at 1118. 72 see weisbach, supra note 1, at 122. for example, expanded use of mark-to-market methods would call into question the need for non-recognition transactions and favorable capital gains rates. 73 see, e.g., joseph bankman & thomas griffith, social welfare and the rate structure: a new look at progressive taxation, 75 calif. l. rev. 1905, 1921 (1987). 2011] realization and progressivity 57 the argument for a shift to a mark-to-market regime is undeniably strong,74 but also materially incomplete. it fails to give sufficient weight to two important points. first, none of the proposals advocates a shift to a comprehensive mark-to-market regime, and the claim that comprehensive mark-to-market taxation would be beneficial says little, if anything, about whether a shift to a partial regime would be positive. a partial markto-market regime covering fifty percent of assets would not be likely to eliminate fifty percent of the problems associated with the realization requirement. in fact, as described in the next part, it would likely give rise to new problems. the overall advantages of a partial mark-to-market regime are therefore somewhat speculative. second, none of these approaches explains why the realization requirement should not be eliminated altogether through mark-to-market auditing when there is no problem of valuation. b. with it: some hidden justifications for realization most advocates of the realization requirement support it only on a second best basis.75 they advance two lines of argument: the costs of the requirement are not as high as they seem and the alternative to the realization requirement, a partial mark-to-market regime, would introduce new, deeper problems. both of these arguments engage in a hypothetical cost–benefit analysis in an effort to determine whether a shift from the current system to a partial mark-to-market regime is justified. much like the arguments in favor of a mark-to-market regime, this analysis provides little insight into the policy goals the realization requirement may promote. after discussing these two lines of argument, this subpart surveys and evaluates the relatively recent policy argument made by david schizer in favor of realization.76 the first set of arguments stresses that there are two types of efficiency considerations—preand post-investment. 77 the realization requirement obviously distorts post-investment considerations of whether to engage in a sale or exchange of an asset. however, if imposed uniformly on all assets, it does not necessarily reduce the efficiency of pre-investment decisions between different investment opportunities and consumption.78 proponents of the pre-versus-post-investment arguments contend that because the realization requirement does not distort pre-investment decisions, the problems with it are overstated.79 this analysis has two main weaknesses: it assumes that the realization requirement is the only rule that could be broadly applied and that the realization requirement's distortion of post-investment decisions is low. in recent years, both assumptions have been called into question. first, experimentation with partial mark-to-market regimes shows that these regimes are administrable and that they could thus be systematically and coherently applied.80 second, the development of new 74 see schizer, supra note 1, at 1601 (acknowledging that a repeal of realization is not totally unadministrable). 75 see shaviro, supra note 1, at 5. see also schizer, supra note 1, at 1564–65 (referring to all arguments, other than his own, justifying realization). 76 see infra notes 92–102 and accompanying text. 77 see shaviro, supra note 1, at 24–26. 78 in fact, to the extent the realization requirement provides tax advantages for investment, it may also help correct a bias of the income tax for saving and against consumption. see shaviro, supra note 1, at 27. 79 see chorvat, supra note 22, at 101–12 (surveying the behavioral economics literature, which points out that taxpayers may not take full advantage of the realization requirement's incentives because of other non-tax considerations and behavioral attributes). 80 see i.r.c. §§ 475 (2006), 1256 (west supp. 2010) (enacted in the 1990s and imposing mark-tomarket taxation on segments of the financial sector). 58 columbia journal of tax law [vol.3:43 financial instruments has introduced new pressures on the current tax regime by allowing aggressive tax planners to push the boundaries of realization-based rules to new frontiers.81 a different, and perhaps stronger, argument emphasizes that realization’s social costs may be lower than those of any feasible mark-to-market regime.82 the advantages of a full mark-to-market regime would not flow to a partial one, which would remedy some problems only at the cost of aggravating others.83 because no reform proposal suggests applying a comprehensive mark-to-market regime,84 taxpayers would have obvious incentives to be in one category,85 and complex line-drawing rules would be required to reduce manipulation.86 another argument for maintaining the requirement contends that most individuals do not consider unrealized gains as real.87 according to some research in behavioral economics, individuals seem to distinguish between realized (real) and unrealized (paper) gains and significantly discount the latter for purposes of evaluating their wealth or welfare.88 this process of “mental accounting” goes a long way toward explaining the requirement’s endurance. 89 these common perceptions about the realization requirement are important in terms of legitimacy and compliance, two crucial elements in the current self-reporting regime.90 yet the popular perception observation fails to explain why, and more importantly, how this vague notion of popularity should guide policymakers.91 moreover, since paper gains (and losses) are only discounted and not disregarded altogether, mental accounting at best suggests that unrealized gains should not be fully taxed—not that they should be completely ignored. for example, if the general public discounts paper gains by 30%, then 70% of the change in value should be taxed on a mark-to-market basis. to be clear, we do not reject the public perception argument. as parts iii and iv demonstrate, we explain and, to a certain extent, justify it. our only point here is that simply claiming the public wants a rule provides policymakers with little if any guidance as to how to structure good tax policy. 81 these rules allow taxpayers to diversify their risks and cash out their investments without selling their assets and realizing the associated gains. see generally daniel shaviro, risk-based rules and the taxation of capital income, 50 tax l. rev. 643 (1995) (explaining how financial derivatives allow taxpayers to attain certain tax arbitrages). 82 zelinsky, supra note 8, at 939. 83 these new problems would include computation complexity (in the case of retrospective taxation); valuation cost for non-traded assets; and, most importantly, vexing line-drawing problems between assets taxed only upon realization and those taxed only upon appreciation. 84 zelinsky, supra note 8, at 863. see also infra note 121. 85 informed taxpayers would seek to be in the realization category when they had assets with unrealized profits (so that they could defer the tax payment) and in the mark-to-market category when they had depreciated assets (so that they would be able to deduct their losses without waiting for realization). the difference between realization assets and mark-to-market assets would result in significant inefficiencies because it would create huge pre-investment distortions in the allocation of resources. zelinsky, supra note 8, at 915. 86 zelinsky, supra note 8, at 904–05. 87 chorvat, supra note 22, at 893. 88 id. at 77. 89 id. at 77; schenk, supra note 12, at 355–56. 90 zelinsky, supra note 8, at 903. 91 for example, it is not clear to us that public perception would favor a situation in which affluent individuals reduced their tax liabilities by realizing losses while borrowing against their appreciated assets. 2011] realization and progressivity 59 the observation that the realization requirement corresponds with public preferences underlies the only recent piece suggesting a policy justification for the requirement. in an insightful article, david schizer argues that the realization requirement should be understood as a politically credible investment subsidy.92 he suggests that, by allowing deferral and strategic trading, the realization requirement reduces the effective tax on investments.93 it therefore should be viewed as one of many tax incentives that congress uses to promote investment. realization is unique among these incentives because of its political credibility. unlike other subsidies for investment, the realization requirement has a relatively stable history,94 has no significant political opposition,95 and complements administrative needs of tax authorities.96 hence, schizer contends that investors perceive this subsidy as credible and stable, and unlike other subsidies, it is unlikely to be changed by future legislation. since investors see little likelihood of realization’s repeal, they are not expected to discount the value of its tax benefits. despite the imperfections of the realization subsidy,97 the lack of discounting by taxpayers makes the subsidy more efficient (from the government’s perspective) in achieving the goal of changing taxpayers’ investment behavior.98 schizer offers a compelling argument that realization is a subsidy for investment. we are, however, skeptical, as to whether the case can be made that realization is a good or unique subsidy for investment. schizer illustrates his claim that the realization requirement is a credible and legitimate subsidy by comparing it to the fluctuating policy of lower tax rates on capital gains. however, this comparison is only one of the many possible. first, it is important to note that the favorable capital gains rate applies only to individuals (and not to corporations), while the realization requirement applies to all taxpayers.99 there seem to be other equally credible ways of directing a subsidy toward individuals—e.g., encouraging pension-saving vehicles, 100 encouraging home equity savings through the home interest deduction, and providing certain exemptions for gains on the sale of residential homes and closely held small businesses.101 history informs us that these targeted saving incentives are credible and stable102 and unlike a broad realization requirement, they carry more concrete and narrowly tailored social benefits. furthermore, their costs in terms of regressivity and dead-weight loss may be easier to control than those of the realization requirement. 92 schizer, supra note 1, at 1554 (assuming the political will to use the tax system to tax subsidize private investment). 93 schizer, supra note 1, at 1552. 94 id. at 1580–82. 95 id. at 1601–02, 1606–08. 96 id. at 1592–95. 97 schizer claims that the criticism against realization could be applied against any tax subsidy for saving. id. at 1574, 1617, 1624. 98 id. at 1574. if the value of the tax benefit were not discounted, the government would have to provide less of it to encourage the desired change in investment behavior. 99 sections 1(a) and 1(h) of the internal revenue code prescribe different individual tax rates on income and on capital gains while i.r.c. § 11 lays a uniform tax rate on all corporate earnings capital. 100 charlotte crane, honoring expectations about taxes: are roth iras different?, social science research network, at 2–4 (nov. 12, 2009), available at http://ssrn.com/paper=1505120 (explaining why the pension benefits are typically politically stable). 101 i.r.c. §§ 121, 163(h) (west supp. 2010). 102 lawrence zelenak, the federal retail sales tax that wasn't: an actual history and an alternate history, social science research network 82, 88 (oct. 12, 2009), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1487631 (observing that both the home mortgage and the pension saving tax benefits have always been part of the income tax regime in the united states). 60 columbia journal of tax law [vol.3:43 second, and more notably, schizer also overlooks the possibility that a partial mark-to-market regime could offer a more credible incentive for investment and risktaking because of the way such a tax system would treat losses.103 as mentioned,104 the various loss-limitation rules create significant disincentives for risk-taking and investment and generate huge compliance costs.105 even a partial mark-to-market regime would make many loss-limitation rules unnecessary because whatever was taxed on a mark-to-market basis would take into account all unrealized gains and all unrealized losses—so taxpayers would not even have to dispose of an asset to deduct their losses.106 this fundamental characteristic of mark-to-market taxation is perhaps the most credible investment and risk-taking subsidy imaginable. c. the policy costs of a theoretical debate the standstill in the debate about the realization requirement—with most commentators accepting that it is unjustified but virtually impossible to replace—has produced some troubling outcomes. tax policy has stagnated as the intellectual resources devoted to its development have been channeled almost entirely into preventing the abuses made possible by realization. it would be naïve to expect that every aspect of a tax regime would be anchored to an explicit, principled policy objective. however, realization is not just another aspect of the tax regime. as the above analysis suggests, it is the most significant and problematic feature of the current income tax. the costs associated with the inability to link realization to any policy objective cannot, therefore, be overstated. within tax scholarship, disagreement over how to accommodate a transactional realization requirement has enhanced support for the idea of abandoning the income tax altogether. the notion that the realization requirement is indispensable to an income tax, 107 in spite of its serious costs, has prompted calls that favor shifting to a consumption–wage tax that would exempt all the income derived from investments and savings .108 such a tax focuses on certain wage-paying and/or consumption transactions that are easy to observe and define while completely exempting investment and savings from taxation. since affluent individuals hold most of the capital assets that would become exempt under a consumption–wage tax, such a shift would reduce tax complexity 103 terrence r. chorvat, apologia for the double taxation of corporate income, 38 wake forest l. rev. 239, 242, 283 (2003) (explaining that by allowing deduction of losses the income tax functions as a type of insurance); deborah h. schenk, saving the income tax with a wealth tax, 53 tax l. rev. 423, 430– 35 (2000) (arguing that loss limitation rules are more likely to have a regressive impact because taxpayers with less diversified portfolios and without tax advice will tend to suffer capital losses without being able to offset them); david a. weisbach, the (non)taxation of risk, 58 tax l. rev. 1 (2004); lawrence zelenak, the sometimes-taxation of the returns to risk-bearing under a progressive income tax, 59 smu l. rev. 879, 891–95 (2006). 104 land, supra note 29, and accompanying text. 105 see ilan benshalom, supra note 39 (discussing what comprises an optimal allocation of public goods); walter blum & harry kalven, the uneasy case for progressive taxation, 19 u. chi. l. rev. 417, 427–31, 437–39 (1952);land, supra note 29, at 51; shaviro, supra note 1, at 4. 106 leandra lederman, the entrepreneurship effect: an accidental externality in the federal income tax, 65 ohio st. l.j. 1401, 1435–44 (2004). 107 david f. bradford, fixing realization accounting: symmetry, consistency and correctness in the taxation of financial instruments, 50 tax l. rev. 731, 769 (1995); david m. schizer, frictions as a constraint on tax planning, 101 colum. l. rev. 1312, 1314–15 (2001). 108 andrews, supra note 7, at 1115–16. see generally bankman & weisbach, supra note 7, at 78991 (supporting dan shaviro’s arguments in favor of the consumption tax). 2011] realization and progressivity 61 at the expense of reducing its progressivity.109 because of the realization requirement, the current tax regime’s treatment of investment returns is arbitrary.110 thus, shifting to a consumption tax would actually sacrifice very little in terms of progressivity. in the united states today, and in the developed world more generally,111 the notion of tax progressivity has strong policy justifications and garners considerable political support.112 if tax progressivity is a worthy goal, then the consumption tax is an undesirable answer to the predicament of realization.113 instead of throwing the baby out with the bathwater, it is time to critically reconsider the role of the realization requirement in contemporary income tax policy and theory. iii. a normative defense for realization—promoting income tax progressivity this article advances the notion that realization is tied to the progressivity of the income tax base and can therefore be seen as part of a broader attempt to promote wealth redistribution. it approaches the normative arguments for realization by asking what should happen if policymakers could accurately and costlessly observe the market price of all assets. that is, if valuation were no obstacle, would we want to subject all assets to mark-to-market taxation and, if not, why? the main argument is that while errors will occur under any system, not all errors are equal. if a primary goal of the system is redistribution, we should consider the distributive impact of different types of errors. the first subpart explains the fundamental relationship between tax policy and redistribution. the second subpart argues that the realization requirement is normatively justified, but only with respect to certain emotionally non-fungible (personal) assets. personal assets are broadly defined as assets for which the market price provides an inconsistent indication of the value taxpayers assign to them. with respect to these assets, the market price offers but a poor proxy for well-being and therefore should not be used by the tax regime for interpersonal comparisons. the third subpart asks what course of action policymakers should take knowing the high likelihood of error in measuring economic well-being by the market price of personal assets. it suggests that policymakers committed to income tax progressivity may choose to tax personal assets only upon realization. this analysis acknowledges that the taxation of personal assets only upon realization should be seen as a tax benefit. however, we argue that unlike most tax benefits, this benefit is relatively progressive in nature, favoring primarily the middle (rather than the upper) class. this is because personal assets comprise a disproportionately high percentage of less affluent taxpayers’ assets but a considerably smaller percentage of affluent individuals’ assets.114 the fourth subpart replies to the 109 advocates of the consumption tax recognize that exempting the yields for saving and investment would have a somewhat regressive impact but argue that all distributional and revenue effects of the exemption could be corrected through higher marginal tax rates. bankman & weisbach, supra note 7, at 791–94. the notion that a consumption tax system could be completely revenue and distributionally neutral has been convincingly challenged. daniel halperin, concluding comment, in taxing capital income, supra note 70, at 309, 310–11; sanchirico, supra note 6. 110 see analysis supra part i.a. 111 see infra note 162. 112 see infra notes 156–163 and accompanying text. 113 see infra notes 167–170 and accompanying text. 114 arthur b. kennickell, a rolling tide: changes in the distribution of wealth in the us, 1989– 2001, in int’l perspectives on household wealth 19, 53–54 (edward n. wolff ed., 2006) (showing the distribution of assets by personal wealth in 2001: while personal assets consisted of 78% of total assets held 62 columbia journal of tax law [vol.3:43 major potential criticisms of our approach. it argues that making the income tax base more progressive by applying the realization requirement to personal assets has some significant advantages over other means of promoting tax progressivity. a. tax and redistribution: at the crossroads of philosophy and public finance it is necessary to clarify the scope of this article because questions of redistribution involve complicated notions of philosophy and public finance. any type of redistributive regime is based on two fundamental policy decisions: what should be distributed and how it should be measured by the tax regime. the two are obviously related, with the latter becoming virtually impossible to directly address when the currency of justice (i.e., what should be distributed) is intangible and difficult to observe (e.g., utility). hence, policymakers have to rely on proxies rather than try to measure the currency of justice directly.115 unsurprisingly, there is strong disagreement among scholars about the proper distributive justice benchmark for measuring and remedying disadvantages. political philosophers have suggested a number of such “currencies” through which well-being should be measured, including opportunities,116 primary goods,117 and capabilities.118 even though this article cannot resolve this question, it adopts the terminology of the literature that focuses on the distribution of welfare as a subjective measurement of wellbeing.119 it does so because the welfarist terminology is consistent with most of the tax literature.120 when policymakers wish to formulate an effective distributive scheme, there is an obvious mismatch between what they seek to redistribute (e.g., welfare) and what they are actually measuring, taxing, and distributing (e.g., income). hence, the current income tax regime is a result of the difficulty of directly observing how much economic wellbeing (e.g., in terms of welfare) individuals have and of the belief that income is considered a good proxy for economic well-being. by households in the bottom half of the wealth distribution, they comprised only about 10% of the total wealth of the top 1% of households). 115 daniel n. shaviro, inequality, wealth, and endowment, 53 tax l. rev. 397, 398–403 (2000). 116 see generally ronald dworkin, what is equality? part 2: equality of resources, 10 phil. & pub. aff. 283 (1981) (providing leading article on equality of resources). 117 see john rawls, a theory of justice 54 (1999) (arguing that justice requires equal distribution of primary goods such as rights, liberties, income, and wealth). 118 for the leading texts on capabilities, see generally martha c. nussbaum, frontiers of justice: disability, nationality, species membership (2006); amartya sen, development as freedom (1999). 119 welfarism evaluates social choices solely according to how they affect the well-being of society’s members. matthew d. adler & chris william sanchirico, inequality and uncertainty: theory and legal applications, 155 u. pa. l. rev. 279, 282 (2006). in contrast to utilitarianism, welfarism may take into account inequality of well-being across individuals. id. at 296–97. like utilitarianism, it focuses on individual utility/welfare as a measurement of well-being and does not take into consideration concepts of “rights” or “fairness.” id. at 282. 120 adler & sanchirico, supra note 119, at 282–83; louis kaplow, the income tax versus the consumption tax and the tax treatment of human capital, 51 tax l. rev. 35, 39 (1995); shaviro, supra note 115, at 398–403; david a weisbach, a welfarist approach to disabilities, social science research network 9, 43–44 (aug. 23, 2007), http://ssrn.com/abstract_id=1008985. nevertheless, it is important to stress that this article’s analysis is not limited to the redistribution of welfare and could be extended to other objective egalitarian benchmarks. 2011] realization and progressivity 63 this article considers whether the market prices of different assets are good proxies for economic well-being. from a philosophical perspective, it is clear that there can be many cases in which the objective market price may not provide a good indicator for a subjective benchmark such as welfare. in these cases, relying on assets’ market prices for tax purposes becomes problematic because it leads to redistributive errors. this article’s analysis adopts a public finance, rather than a philosophical, approach to this problem. it assumes that if large-scale redistribution is warranted, making some type of assessment of individuals’ well-being is inevitable. it also acknowledges that market price is policymakers’ main source of information, so that some errors are inevitable as well. we then identify categories of assets for which one could expect to find a significant mismatch between market price and what the tax system is aiming to redistribute. in other words, this article considers when market price is not an adequate proxy for well-being (and other potential currencies of justice) and evaluates the implications of that mismatch for the realization requirement. b. market price, personal assets, and interpersonal comparisons this subpart advances the claim that the realization requirement is normatively justified with respect to certain types of personal assets. for those assets, the market price may be an inherently inaccurate proxy for value and therefore should not be relied upon from a tax perspective. the analysis begins with the observation that there is one point upon which everyone seems to agree: personal assets could not be taxed on a mark-to-market basis under any politically feasible tax regime.121 in many cases personal assets may be difficult to value—e.g., old family furniture, real estate in places with low exchange activity. however, many personal assets are very easy to value—for example, real estate in certain cities, old cars, horses in the family stables, certain collectable items (e.g., stamp collections). the intuitive case against taxing these assets on a mark-to-market basis derives from the notion that market price may not adequately reflect their true value to taxpayers. advocates of shifting to a mark-to-market regime focus on publicly traded instruments, arguing that exceptions could be made for hard-to-value personal assets. advocates of the realization requirement stress that valuation and liquidity concerns would make it difficult to tax closely held companies, certain farms, and real estate under a mark-to-market regime. this article takes a different approach and questions what makes the mark-tomarket taxation of certain assets so unappealing and asks if the answer helps explain the normative base of the realization requirement. this type of inquiry may help policymakers start succeeding in what they so far have failed in doing—promoting consistent general rules for applying the realization requirement. there are only two pieces that touch upon the above inquiry. the first is by louis kaplow, who examined how human capital would be taxed under an ideal income tax, which would include a tax on unrealized earnings.122 kaplow did not make this 121 cunningham & schenk, supra note 9, at 801–02; fellows, supra note 1, at 781; halperin, supra note 9, at 503; schenk, supra note 12, at 364; shakow, supra note 9, at 1144, 1153–54, 1158–60; shaviro, supra note 1, at 7; zelinsky, supra note 8, at 876, 889. 122 louis kaplow, human capital under an ideal income tax, 80 va. l. rev. 1477 (1994) [hereinafter kaplow, ideal income tax]. see also louis kaplow, on the divergence between “ideal” and 64 columbia journal of tax law [vol.3:43 inquiry to determine whether there is something unique about human capital that justifies applying the realization requirement to it. instead, he argued that those advocating for a shift to an ideal income tax, which like a mark-to-market regime would tax changes in value, should account for how human capital would be treated under such a regime. in his opinion, if human capital received special realization-based treatment, 123 the advocates for the mark-to-market regime would have the burden of explaining why.124 some commentators have read kaplow’s argument not as an inquiry into whether the realization requirement is justified but more as a question as to whether an income tax should be imposed on capital assets.125 the second is a recent article by the authors of this article that deals with the taxation of earning capacity as a point of intersection between public finance and political philosophy theories.126 that article suggests that the market price for earning-capacity endowment is not an adequate benchmark for a tax-transfer regime. earning capacity should not be perceived as a cash asset that individuals can simply use, because the decision of how to work is multilayered and also driven by preferences, moral convictions, and needs. in essence, we argued that the market value of earning capacity was insufficient as a normative foundation for the tax-transfer regime. in this article we expand upon that preliminary analysis to determine how it can advance tax policy with respect to the realization principle in general. we agree with kaplow that a pure mark-to-market income tax regime would require taxing the value fluctuation of all assets, including human capital.127 we also agree with him that a rigorous mark-to-market regime would include other types of assets, such as personal belongings, residential homes, and family businesses. we broadly classify personal assets as assets in which there is a high probability that taxpayers’ subjective value is radically different (that is, significantly higher)128 than the assets’ market value.129 the higher personal value attached to these assets is prohibitive—that is, it renders the possibility of trading them on the market very unlikely. even though it is impossible to comprehensively define emotionally non-fungible assets, one can think of them as assets conventional income-tax treatment of human capital, 86 am. econ. ass’n papers & proceedings 347 (1996). 123 kaplow, ideal income tax, supra note 122, at 1512–14 (arguing that this is a consumption tax treatment). for a different view, see benshalom & stead, supra note 15, at 1542–49. 124 kaplow, supra note 120, at 36–37 (clarifying what his objectives were after claiming that they were misunderstood). 125 lawrence zelenak, the reification of metaphor: income taxes, consumption taxes and human capital, 51 tax l. rev. 1, 5 (1995); kaplow, supra note 120, at 38–39 (firmly disclaiming zelenak’s view). 126 benshalom & stead, supra note 15, at 1527–29. 127 kaplow, ideal income tax, supra note 122, at 1504. 128 it is important to note that the revealed preference of owners is that they value all of their assets (not just their personal assets) as worth more than the market price—since otherwise they would sell them. for this reason we define personal assets as those assets were there is a high probability that the subjective value is significantly higher than the market value. 129 some may find this argument similar to a line of property law literature developed by margaret radin, which claims that personal assets constitute part of individual personhood. see margaret j. radin, property and personhood, 34 stan. l. rev. 957, 958 (1982). however, we think that this article’s argument is different and easier to accept. rather than arguing that personal assets are inherently different, we merely observe that people attach different values to them so that the trading costs (or the costs of detachment) with respect to these assets are often very high. while there seems to be strong recognition that these costs exist, there is some literature suggesting that they are often given excessive weight. see stephanie m. stern, residential protectionism and the legal mythology of home, 107 mich. l. rev. 1093, 1110–24 (2009) (making such an argument with respect to residential homes). 2011] realization and progressivity 65 of personal use or those that involve significant human capital contributions of the taxpayer or of his relatives.130 this definition is somewhat crude and overinclusive, since not every asset that comprises private consumption or has human capital embedded in it has prohibitive personal trading costs. for example, the new york times is a publicly traded company, yet it is controlled by the ochs-sulzberger family. should the shares of the family be considered personal while all other shares are non-personal? should all members of the family be considered as involved with the corporation or only those that have invested their human capital? this issue is of crucial importance, since much of the wealth owned by affluent taxpayers is in the form of equity investment in closely held businesses, which arguably could be considered personal assets.131 the above questions are indeed vexing, but we believe that a more precise definition is not necessary at this stage. as we discuss in part iv, with a few refinements, the broad definition we provide for personal assets suffices for the purposes of promoting real-world reform recommendations.132 hence, to develop the normative argument, this part assumes it is possible to distinguish between emotionally non-fungible (personal) assets and other assets. while the task of translating this argument and its conclusions to concrete policy measures is taken up in detail only in part iv, it is worthwhile to note a few of our conclusions to assure the skeptical reader of the practical value of our argument. first, investment assets, which are already defined in the code for many purposes, and are (almost by definition) non-personal, could be taxed on a mark-tomarket basis. this partial shift to a mark-to-market regime would be a significant and administrable reform, which would not require a full definition of personal assets. second, to accommodate revenue, distributional considerations, and concerns over tax avoidance, we suggest that tax authorities cap the amount of personal assets that should be taxed only upon realization at a certain fair market value.133 our analysis departs from the notion that even though there are significant differences from person-to-person as to what assets are emotionally non-fungible, there are categories of assets whose values are very unlikely to have such idiosyncratic psychological components (e.g., publicly traded assets held by portfolio investors).134 similarly, there are broad categories of items—such as inherited family jewelry, homes, and self-created artwork—for which we can reasonably assume a substantial gap between taxpayers’ subjective value and the market price. with respect to these emotionally nonfungible personal assets, the existence of this value gap can be assumed with relatively great certainty, but the size of this gap varies heterogeneously and is not observable. while many people may view their grandmother’s wedding veil as a precious heirloom, only few would consider it priceless, most would be willing to sell it eventually if offered enough money, and some would sell it immediately for the highest bid a craigslist post could drum up. any attempt to base tax treatment on the market value of these assets would carry a serious risk of error. an example may help to show why the market price is a poor indication of the value of personal assets. imagine two individuals, both of whom value their kidneys, 130 the tax code employs a somewhat similar definition of which relatives count as related parties and accordingly employs special rules for transactions between them. see i.r.c. § 267 (west supp. 2010). 131 see kennickel, supra note 114, at 53–55. see also infra appendix. 132 see infra notes 185–199 and accompanying text. 133 see infra notes 205–206. 134 see infra note 142 and accompanying text. 66 columbia journal of tax law [vol.3:43 family homes, and employment as law professors as priceless.135 the market, however, values the kidney of one professor as worthless (not because she is not healthy but simply because there are very few, mostly poor people who could receive a transplant from her) and the other’s as worth one million dollars (again not because she is particularly healthy but because she happens to have a kidney that is in high demand by silicon valley ceos). in the same manner, the market assesses a negative value to one’s home (because a correctional facility is being built nearby) and a value of one million dollars to the other’s home (because a new technological park is being built fifteen minutes away). furthermore, their human capital is priced dramatically differently by the market: while the former has the skills to be a successful human and labor rights lawyer, earning close to minimum wage, the other possesses the capacity to be a generously compensated tax planner to high net worth individuals. while the well-being of these two individuals seems to be rather similar, their tax liabilities under a full mark-to-market tax regime would be radically different because the personal assets they own, which neither of them intends to put on the market, are quite differently priced. most people would probably consider this type of interpersonal comparison arbitrary and unreasonable for tax purposes, because the essence of the price signal is what others will pay for assets if they were put on the market. in contrast, the market price would offer a valid proxy for well-being if each of the professors chose to sell these personal assets. when the professors choose to sell their family homes, they signal that they accept that the market valuation of the properties is greater or equal to the subjective values they assign to them. this acceptance of the market equilibrium validates the market price as a good proxy for their economic wellbeing, and this validation makes it a relevant benchmark for tax redistribution. this analysis does not mean to suggest that, with respect to all personal assets, a voluntary transaction is always an indicator of well-being.136 on aggregate, however, the market return for the actual use or sale of personal assets offers a good proxy for economic wellbeing, which is not the case when the market price is hypothetical. for tax purposes, it is difficult to draw a meaningful interpersonal comparison of well-being by focusing only on the market value of personal assets. in the context of these assets, the market value offers only a poor proxy for individual well-being because the subjective value of how to use these personal assets is determined by a complicated metric. in contrast, market pricing is a one-dimensional process that aggregates the maximum cash flow a certain asset could be expected to yield if put on the market. simply put, the market values of assets such as our human capital are poor indicators of our well-being and therefore should not be used by the tax system for interpersonal comparisons. 135 since for many economically oriented readers the term “priceless” would seem naïve or hypocritical, one can assume for the purposes of this article that priceless equals “anything around 5 million dollars.” 136 for example, one can assume that if the professors did sell their kidneys they would do so out of dire need—so that any market return on this sale would likely fall short of being a reliable proxy for their economic well-being. this claim is valid, and as we discuss in the next subpart, there may be times in which certain assets should be exempt altogether rather than taxed upon realization. however, such exceptions leave the main premise unshaken. 2011] realization and progressivity 67 welfare, as mentioned, is not the only possible currency of justice,137 and some important theories indeed rely on more objective measurements of economic wellbeing.138 our example assumes that both professors derive similar welfare from their personal assets, but this assumption is not necessary. one can reasonably argue that both professors are similarly positioned, in objective terms, regardless of how they value their personal assets. each of them has a primary residence that she was able to choose, a job that allows her to meet her financial objectives and promote her intellectual interests, and a healthy body. to accept our analysis, one has only to accept that the market price does not capture all of the objective value associated with certain assets—not that redistribution of welfare is the only benchmark of equality. put differently, if one agrees that both professors are similarly situated in objective terms, then the conclusion must follow that the market price is an objective measure of their economic ability but not necessarily the only or the best objective measurement policymakers can or should employ to determine that ability.139 to be clear on this point, the market price is a social construct and therefore not “correct” when it assesses google stock or “wrong” when evaluating more personal assets. the difference is not that google stock has a price and personal assets are “beyond pricing.”140 instead, the claim is that the tax authorities’ ability to make meaningful interpersonal comparisons is much greater when considering the price of google stock than it is for the market price of personal assets. individuals may invest in google stock for a number of different reasons—speculation, risk-diversification, or belief in the company’s corporate values. however, for most shareholders, google shares are primarily investment assets—and as such are not very different from money because they primarily represent consumption power.141 investment assets, of course, are not the only type of assets that could be valued independently from the decision to use them. money, for example, is in most cases simply a piece of paper that enumerates fungible and homogeneous units that represent individuals’ comparative abilities to participate in market exchanges. it is very unlikely that certain individuals would attach special immeasurable utilities to homogeneous and 137 see ilan benshalom, the new poor at our gates: global justice implications for international trade and tax law, 85 n.y.u. l. rev. 1, 34–36 (2010) (providing a brief review of the distributive justice literature). 138 see supra notes 116–118 and accompanying text. 139 one can say that, even in objective terms, the market does not always adequately reflect the value of certain assets—such as shelter and food security, or mobility. one can further accept that tax authorities have difficulties observing whether individuals attach these values to assets and, more importantly determining the relative “price” of these values. see generally sen, supra note 118 (providing a set of nonmoney-equivalent goods that are required for individuals to establish worthwhile lives). 140 the beyond pricing argument is typically identified with the non-commodification critique. the core of the argument presented in the non-commodification literature is that for some things (such as human organs or sex) voluntary market exchanges are inappropriate because they are dehumanizing, are never really voluntary, and/or have significant negative externalities. see tsilly dagan, itemizing personhood, social science research network 7-9 (apr. 21, 2009) http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1345391 (summarizing this literature). see also margaret j. radin, contested commodities (1996) (providing one of the key texts on this topic). we believe that our argument has little to do with this literature, the core of which argues that certain things should not be on the market. this article emphasizes the difficulties of making interpersonal comparisons with regard to some emotionally non-fungible assets, many of which could be put on the market without incident or outcry. 141 see radin, supra note 129, at 959–60 (providing a somewhat similar argument that personal property is not replaceable). 68 columbia journal of tax law [vol.3:43 fungible cash assets.142 accordingly, the market assessment of the worth of monetary assets seems valid when making interpersonal comparisons of individuals’ well-being for tax purposes. money and human organs lie on two ends of the continuum—everything else falls in between. when an asset is closer to the money side of the continuum, it is easier to see how its market value can serve as a proxy for well-being. it is therefore reasonable to assign tax liability for that asset’s fluctuation in value according to a markto-market regime. the assignment of mark-to-market tax liability seems less justifiable for assets closer to the personal asset end of the continuum. there may be a lot of very difficult cases in between, but it is possible to envision some preliminary classification rules. primary residences could be categorically treated as personal assets as could small family businesses, which are likely to embody a great deal of psychological value and non-diversified risk taking. other categories of emotionally non-fungible assets may include assets employed in active trade or businesses with respect to which taxpayers invest a considerable amount of their time. in contrast, portfolio holdings in publicly traded corporations and other entities with a large number of owners are generally emotionally fungible. these types of distinctions may seem too vague and impractical at first, but, as we discuss later, they align well with various distinctions on which the current tax regime already relies.143 no liberal egalitarian regime aspiring to engage in redistribution can avoid interpersonal comparisons. that interpersonal comparisons are unavoidable, however, does not mean that all interpersonal comparisons are alike. in part i.a, we discussed why it is problematic for an income tax regime to base tax assessments upon interpersonal comparisons made only with respect to realized gains. in this subpart we modify this observation by arguing that, when it comes to personal assets, the market price of an unrealized asset is not a good indicator of well-being. in this respect, it is worth emphasizing the following points. first, taxpayers can attach higher (subjective) value to all assets—and not necessarily just to personal assets. however, from a public finance perspective, the important thing is that gaps between subjective and market value are more likely to occur with respect to personal assets. second, if subjective value is unobservable, policymakers cannot know how heterogeneous it is.144 so if two taxpayers own residential homes with the same market price, tax authorities will be unable to distinguish between the taxpayer who values her home as priceless and the taxpayer who values his home at $1,000 over the market price. hence, with respect to personal assets that are likely to have higher subjective than market values, tax policymakers operate in a scenario of extreme uncertainty. third, some commentators may argue that since all assets will eventually be taxed on their market price, the difference between a mark-to-market and a realizationbased income tax regime is merely one of timing.145 hence, if policymakers tax all personal assets on a mark-to-market basis, the only difference between this regime and a realization-based regime would be that the former would eliminate the arbitrary advantage of deferral. this objection overlooks that many (and maybe even most) personal assets would never be realized. a great many personal assets, from family 142 experimental behavioral economics suggests that people do not attach special value for assets held primarily for exchange purposes. see daniel kahneman, et al., experimental tests of the endowment effect and the coase theorem, 98 the j. of political eco. 1325, 1328 (1990). 143 see infra notes 187–191. 144 this comment is relevant only to well-being and not to more objective “currencies” of justice. 145 we wish to thank jacob nussim for bringing this forceful argument to our attention. 2011] realization and progressivity 69 farms to jewelry, are often transferred by gift or bequest. hence, the market is not the ultimate appraiser of many unrealized personal assets, which leaves policymakers with the difficulties associated with the unobservable varied subjective values attached to those assets. finally, we do not wish to deny that fluctuation in personal assets’ market values provides some relevant information about individuals' economic well-being. recall the example of the two professors. it is difficult to deny that the professor with the more valuable home and higher earning capacity is at least in some ways better off than her peer.146 we argue, however, that more information is not necessarily better if it affects policymakers’ tax decisions in a way that does not seem to correspond with what the tax system is trying to achieve. the relevant tax policy inquiry, therefore, is neither whether the market value of personal assets is equivalent to well-being (it obviously is not) nor whether it is a proxy for well-being (it obviously is). the relevant question is whether market value is a good proxy for well-being—and this subpart has established why the proxy value of the market price is poor with respect to emotionally non-fungible assets. if the realization principle is justified only with respect to personal assets, it follows that this normative constraint does not apply, or applies with much less force, with respect to other assets. the upshot of this analysis is that if policymakers consider income to be a good benchmark for redistributive taxation, then there may be a case for adopting a hybrid mark-to-market-realization tax regime. this regime would tax certain assets, namely investment assets, under a mark-to-market system while taxing personal assets on a realization basis. the next subpart argues that in the context of such a regime, the realization requirement offers a reasonable policy tool to assure the progressivity of the income tax base. part iv explains the fundamental attributes of such a hybrid income tax regime and suggests a realistic proposal for reform that offers improvements over the current realization-based regime in terms of complexity, equity, and revenue. c. realization as a progressively distributed tax benefit this subpart establishes why a hybrid tax regime that taxes personal assets on a realization basis and other (namely, investment) assets on a mark-to-market basis would help promote a more progressive redistribution of income in society. the key point is that personal assets represent a larger portion of the wealth of low and (especially) medium-income taxpayers than of the wealthy.147 put differently, such a regime would promote progressivity because investment assets, which categorically are not personal assets, are disproportionally held by affluent taxpayers. therefore, providing a tax benefit to personal assets, and not to other assets, would make the tax system as a whole more progressive. this claim should be integrated with the claim of the above subpart rather than understood as free standing. having a progressive income tax does not require giving realization-based treatment to personal assets. however, given the difficulty of using the market value of personal assets as a proxy for well-being, taxing only those assets upon realization should be viewed as a progressive move. if confined to personal assets, the realization treatment would still be a tax benefit and would continue to cause some distortions and inequities. however, given that personal assets comprise a much greater component of non-affluent individuals’ resources, it would be, overall, a 146 most notably, the professor with the more valuable assets can offer them as collateral to creditors and borrow at a lower interest rate or rely on them in cases of emergency. 147 see kennickel, supra note 114, at 53–55. see also infra appendix. 70 columbia journal of tax law [vol.3:43 progressively distributed tax benefit. this subpart only argues that limiting the application of the realization requirement to personal assets makes the tax base more progressive. the more complicated task of discussing why tax progressivity is warranted, and whether taxing personal assets only upon realization comprises a sound policy to achieve progressivity, is left for the next subpart. at the outset it is clear that even though personal assets are not unique to less affluent taxpayers, they comprise a much larger proportion of those taxpayers’ wealth. for example, in a pure mark-to-market system both joe six pack and bill gates would be taxed on the change in market value of their identical golden wedding rings. assume that gates values his ring at $500,000, joe values his at $5,000, and each ring has a market value of $500. the strength of the mark-to-market approach is that it avoids inquiries about subjective value and focuses solely on the market price as an objective and value free way to measure economic ability. the important point, however, is that even if both rings were identical, exempting them from mark-to-market treatment would not result in a distributional wash. the truth is that gates’s ring represents a much smaller percentage of his overall wealth than joe’s ring does for him. hence, in a revenue-neutral setting, where taxes forgone have to be raised somewhere else within the system, granting a tax benefit to wedding rings so that both would be taxed only upon realization would increase gates’s effective tax burden. if the government wants to maintain a constant level of spending without adding new taxes, and is not able to tax wedding rings and other personal assets that both joe and gates have, it would have to increase tax rates on other types of assets—namely investment assets—that only gates has.148 the costs of detachment from one’s personal assets are not unique to wedding rings. for example, if instead of a wedding ring one thinks about identical baseball card collections, gold watches, or old family farms, one will get to precisely the same intuitive results. high detachment costs characterize basically all types of personal assets including human capital, homes, and small family businesses. a tax professor values his job partly because he values the freedom and flexibility that many tax planners do not have. many elderly people do not wish to move to different apartments or retirement homes because leaving their homes is emotionally costly to them. from a neo-classical economic perspective, these costs represent (some out of many) common factors that impact the supply curve. in terms of progressivity, the example of humble golden wedding rings is not very representative. the case for the progressivity of applying the realization requirement to personal assets may be much more complicated with respect to other types of assets—e.g., human capital, family farms, residential real estate. generally, wealthy taxpayers tend to have a higher number of (more valuable) personal assets than poor and middle-class taxpayers. hence, the progressivity tax benefit is questionable, since much of it would not be directed towards the lower economic quintile of society. middle class individuals have much of their wealth concentrated in home equity, private closely held businesses, and human capital. allowing all or some of these assets to be taxed only 148 a more formal explanation would stress the following. income (i) could be defined as the net consumption (c) and savings/investment (s) in a given period of time. therefore, if i=δc+δs, an income tax regime that provided a tax benefit for private consumption would shift the burden to savings and investment, and an income tax that provided a tax benefit to savings and investment would shift the tax burden to consumed income. 2011] realization and progressivity 71 upon realization would provide a tax benefit that is less progressive than what gates’s and joe’s wedding bands may suggest. the above observation is evidently true, but it fails to capture the core of the argument presented. first, when discussing income tax progressivity, it is important to bear in mind that low-income taxpayers play a relatively minor part in this debate. personal exemptions, tax credits, and low marginal tax rates mean that low-income taxpayers pay little or no taxes.149 even though assessing what people have may also be important for transfer purposes,150 when it comes to taxes, the question of allocating the tax burden is primarily a tradeoff between the middle class (whose wealth is primarily in the form of human capital and other personal assets) and the upper class (who also have significant amount of investment assets). second, policymakers should question whether, given the difficulty of taxing personal assets on a mark-to-market basis, the advantages of a mark-to-market regime should be abandoned altogether. more specifically, they should inquire whether there are reasonable ways to achieve the distributional advantages of the mark-to-market regime without subjecting personal assets to it. if savings and investment assets were taxed on a mark-to-market basis, the effective tax rate on them would rise. therefore, the option of subjecting these assets to mark-to-market taxation promotes a relatively progressive alternative to the current regime. indeed, under our proposal the realization treatment of personal assets would continue to benefit the middle class, but by the same token, mark-to-market taxation of investment assets would increase the tax burden on wealthy individuals.151 such a markto-market regime would eliminate the benefits of tax planning, strategic trading, and deferral opportunities with respect to capital assets. it would therefore result in a higher effective tax rate on investment assets (if tax rates on them remain the same as on personal assets) as well as more transparent, equitable, and efficient taxation of such assets. implementing this type of selective realization requirement for personal assets would position the income tax more as an elite tax—a notion that is not in any way new.152 by exploring the unique case of certain personal assets, we argue that not all errors are distributionally equal and that policymakers should take errors other than incorrect market valuations into account. tax systems rely on market valuation because it is a proxy for economic well-being. however, in certain cases the market price offers only a weak proxy, so relying on it is an error in itself. by highlighting the different 149 see michael j. graetz, 100 million unnecessary returns: a fresh start for the u.s. tax system, 112 yale l.j. 261, 270 fig.5 (2002). 150 the relationship between measurement of economic ability for transfer and tax purposes is not always the same. see anne l. alstott, the earned income tax credit and the limitations of tax-based welfare reform, 108 harv. l. rev. 533, 535 (1995) (suggesting there may be serious disadvantages to using the same measurement of economic well-being for tax and transfer purposes); benshalom & stead, supra note 15, at 1530–31; lawrence zelenak, taxing endowment, 55 duke l.j. 1145, 1179–80 (2006). 151 as mentioned, savings and capital accumulation are characteristics of the upper quintile of society. see supra note 46 and accompanying text. 152 prior to world war ii, the vast majority of the middle class was exempt from the income tax altogether. see generally carolyn jones, class tax to a mass tax: the role of propaganda in the expansion of the income tax during world war ii, 37 buff. l. rev. 685 (1989) (explaining the dynamic of making the income tax to a mass tax). lately, there have been some calls to re-establish the income tax as an elite tax while introducing a federal consumption tax to replace the income tax revenues from the middle class. see graetz, supra note 149, at 281–99. 72 columbia journal of tax law [vol.3:43 distributional impact of various types of errors, this article hopes to add a new analytic consideration to the discussion of realization. this argument deviates from traditional tax analysis, which associates base progressivity with a broad and comprehensive base—one that employs few exceptions and exemptions.153 the ability of the income tax base to promote wealth redistribution is a combination of two major factors: the tax base (what is taxed) and the rate structure (how much is taxed). any income tax regime can make a change in one of these factors and remain distributionally neutral if it modifies the other factor. for example, if the top marginal tax rates are increased for households earning more than $250,000 a year, the income tax would become more progressive unless the tax base were adjusted. this adjustment could take a number of forms—exempting certain types of savings (e.g., college savings) or providing benefits to certain consumption activities (e.g., new, hybrid cars) that affluent households are more likely to engage in. in this respect, this article offers an intellectual supplement to the traditional perception of tax base progressivity. rather than arguing for a comprehensive benefit-free tax base, it contends that a progressive tax base could be attained by endorsing a tax benefit that is progressively allocated. this is precisely what we have argued with respect to applying the realization requirement only to personal assets. such a deviation from a pure mark-to-market income tax regime would make the tax base more progressive because the tax benefit would be allocated to the owners of personal assets— assets that represent a larger portion of the wealth of less affluent individuals than of the rich. as mentioned, taxing individuals according to their economic well-being requires certain interpersonal comparisons, which may be inherently inaccurate.154 however, not all tax assessment inaccuracies are created equal. this article introduces this insight to the realization-mistake literature, showing that the costs of certain realization inaccuracies may disproportionally fall on low and medium-income taxpayers in a way that undermines the notion of tax progressivity. d. advantages and limitations of the proposal a few lines of criticism may be deployed against this argument. first, on a very basic level, some may contend that the income tax regime should not promote values of progressivity and wealth redistribution among taxpayers. second, even for those who accept that tax progressivity is a worthy policy goal, there is still a question of whether the tax system should become more progressive. third, it is not clear that granting a realization tax benefit to personal assets is the best way to promote tax progressivity. the realization requirement features some fundamental arbitrariness, so embracing it makes redistribution inherently inaccurate. similarly, other mechanisms (e.g., allowing higher personal exemptions or employing higher marginal tax rates) could prove to be as effective. fourth, if personal assets are held in a progressive manner, there is the question of why their taxation should be deferred by the realization principle rather than completely exempt or simply taxed at lower rates. in capsule form, our answers to these criticisms are that with respect to the first and second lines of criticism, we point out that while the desirability of tax redistribution goes beyond the scope of this paper, there is strong theoretical and popular support for a 153 see shaviro, supra note 1, at 4; stanley s. surrey, tax incentives as a device for implementing government policy: a comparison with direct government expenditures, 83 harv. l. rev. 705, 720–26 (1970). 154 see supra note 115 and accompanying text. 2011] realization and progressivity 73 certain level of tax progressivity. the third and fourth potential criticisms question whether this article’s proposal is the proper way to structure income tax progressivity to effectively promote redistributive objectives. the reply to these questions stresses one core idea. this article does not try to propose the adoption of a theoretically clean yet impractical model. instead, it seeks to suggest how tax policymakers can try to improve the current redistributive tax arrangements in the messy reality in which they operate. in this context, applying the realization requirement to personal assets is a realistic measure that reasonably balances distributional objectives with efficiency, revenue, and tax administration concerns. the first line of criticism highlights two different questions inherent in the debate over tax progressivity: whether wealth redistribution is a desired objective and whether the tax system is the proper way to promote redistribution. these questions are extremely broad, so this article can merely point to the relevant political philosophy and tax theories addressing them. most contemporary liberal political theories are explicitly egalitarian to some degree.155 this means that they do not categorically accept the fairness of the distribution of assets by the market and that they justify coercive state action to attain wealth redistribution. progressive wealth distribution is typically not a goal in itself, but only a proxy for meeting a distribution of something more fundamental (e.g., welfare or resources, as explained in part iii.a). even though the distributional question involves many factors and nuances,156 it is generally accepted that promoting goals of wealth redistribution justifies coercive state action.157 philosophers and tax scholars tend to agree that, if wealth redistribution is explicitly incorporated into the social welfare function, the tax regime is an effective and efficient way of promoting it.158 this overall consensus does not downplay the serious normative questions as to whether this means that a just tax system has to be progressive.159 it also does not claim that achieving distributive justice is or should be the only or the primary objective of the tax regime. it does however, reflect the notion that the tax system comprises a key, and some would say the prominent, element within 155 see benshalom, supra note137, at 10–18. 156 id. at 34–36 (surveying these different layers). 157 see robert nozick, anarchy, state and utopia 149–74 (1974) (providing one notable exception). 158 see charles o. galvin & boris i. bittker, the income tax: how progressive should it be? 38–54 (1969) (arguing that income tax progressivity is necessary to offset certain regressive tendencies in other federal, state, and local taxes); bankman & griffith, supra note 73, at 1946-47 (saying that income tax progressivity is typically explained by proportionate sacrifice and the declining marginal utility of money); thomas d. griffith, progressive taxation and happiness, 45 b.c. l. rev. 1363, 1364 (2004) (supporting progressive taxation on account of social science research that tries to estimate the marginal effect of wealth on individual happiness); kaplow, supra note 120, at 39; louis kaplow & steven shavell, should legal rules favor the poor? clarifying the role of legal rules and the income tax in redistributing income, 29 j. legal stud. 821 (2000) (arguing that the tax-transfer regime redistributes in a way that results in comparatively less economic distortion than other legal rules); kamin, supra note 47, at 244 (explaining how different measures of progressivity relate to different theories of distributive justice); sugin, supra note 64, at 2013–14. but see kyle logue & ronen avraham, redistributing optimally: of tax rules, legal rules, and insurance, 56 tax l. rev. 157, 208 (2003) (arguing against kaplow and shavell that the distinction between tax rules and legal rules is not always that clear). for an example of regressive tendencies in federal spending, see julia lynn coronado et al., the progressivity of social security, national bureau of economic research (feb. 2000), http://www.nber.org/papers/w7520 (concluding that social security taxes are regressive in part because lower income individuals have shorter average life spans than higher income individuals). 159 see liam murphy & thomas nagel, the myth of ownership 8 (2002). 74 columbia journal of tax law [vol.3:43 the arsenal of tools that policymakers have to promote redistribution of wealth.160 this suggests that modern liberal states should consider employing a progressive tax regime to meet their wealth-redistribution objectives.161 the use of progressive taxation also seems to carry significant support among the american public.162 the second type of criticism asks whether more progressivity is warranted. the reply to this criticism is that the current proposal does not contribute to the discussion of how progressive the tax system should be, but rather to the discussion of how a progressive tax system should be designed. policymakers could use our proposal to make the tax system more progressive, or they could use it to maintain a distributionally neutral tax regime—by, for example, reducing marginal tax rates, which would make the tax rate structure less steeply progressive.163 the third line of potential criticism against our argument questions whether providing a realization-based income tax treatment to personal assets is the best way to promote income tax progressivity. this criticism would stress that there are other, potentially more accurate ways to assure that the income tax regime has an overall progressive effect. one of the biggest concerns is that giving a special realization treatment to personal assets, such as family farms and closely held family corporations, would encourage taxpayers to overinvest in them. the brief reply is that policymakers should not be asking whether providing realization tax treatment to personal assets would be the perfect way to promote tax progressivity. instead, the key inquiry is what course of action policymakers should take given the normative difficulty of drawing interpersonal comparisons with respect to the market price of personal assets.164 the more difficult it becomes to observe what we are trying to distribute, the more inaccurate and susceptible to abuse and the less redistributive the tax regime becomes. even if policymakers can observe the market price of personal assets, there would be questions of how much it could help them to promote redistribution. the high probability that taxpayers attribute higher, yet heterogeneous, subjective values to personal assets raises questions of whether and how the market price signal of personal assets should be used for redistributive tax purposes. in the context of our argument, policymakers who want to use the tax regime to redistribute wealth and have only the market price of assets to do so face four alternatives.165 one is to maintain the current realization-based income tax regime and endure the enormous social costs associated with taxing all assets on a realization basis.166 the second alternative is to tax all assets on a mark-to-market basis—thus paying the costs of inaccuracy and perhaps regressivity of taxing personal assets based on their market value. the third alternative would be to limit taxation to observable assets, to exempt personal assets altogether, or to shift to a more easily observed tax base—e.g., 160 see sugin, supra note 64, at 2014 161 see kamin, supra note 47, at 253. 162 see michael j. graetz, taxes that work: a simple american plan, 58 fla. l. rev. 1043, 1048– 52 (2006). 163 see supra note 153. see also infra notes 173–175 and accompanying text. 164 this dilemma is an extension of a more general tradeoff that was identified by joel slemrod and christian traxler. joel b. slemrod & christian traxler, optimal observability in a linear income tax, social science research network 8 (dec. 2010), http://ssrn.com/paper=1534586. 165 there are of course numerous other options if policymakers are willing to rely on factors other than the market price. for a thorough discussion of this topic, see infra note 214 and accompanying text. 166 see supra part i.a. 2011] realization and progressivity 75 wages or consumption.167 this, however, would narrow the tax base and require very high marginal tax rates to attain redistribution.168 the fourth alternative, which this subpart explores, is to provide realization-based tax treatment only to those (personal) assets that are difficult to tax on a mark-to-market basis. as established, if the realization requirement were applied only to personal assets, the tax base would become more progressive overall. we concede that this method of attaining progressivity raises some concerns. in its crude form, the realization requirement is not sensitive to the amount of personal assets individuals may have—allowing the middle class to relish the majority of the tax benefit. furthermore, as discussed in the next part, it would create incentives to over-invest in personal assets, which would result in tax-avoidance opportunities and complex administrative countermeasures. most importantly, by adopting realization as a way to promote progressivity, this article’s proposal inevitably accepts some of its inherent timing arbitrariness. given these difficulties, it is important to examine whether higher personal exemptions or higher marginal tax rates can (by themselves) better achieve income tax progressivity. policymakers should therefore compare our proposal with a universal mark-to-market regime, which attains progressivity by adjusting the tax rate and level of personal exemptions rather than by providing realization treatment to personal assets. tax progressivity is typically associated with the progressive tax rate structure rather than with the progressivity of the tax base.169 in fact, many of the arguments against progressivity relate to the social costs associated with the progressive rate structure as a method rather than to its underlying objective of promoting economic equality.170 it has been convincingly argued that progressive tax rate structures with high marginal tax rates cause or aggravate many of the notorious income tax complexities171 and that they generate significant work and investment disincentives.172 the actual behavioral impact of tax rate progressivity has been disputed,173 but it is difficult to deny that high progressive tax rates produce distortive incentives and taxplanning opportunities. it is therefore widely accepted that tax rate progressivity’s major drawback is the unavoidable tradeoff between allocating the tax burden equitably and reducing overall social productivity. 174 the high social costs of attaining overall progressivity of the tax system through high marginal tax rates suggest that policymakers would be wise to explore other means of achieving this goal. in the context of this inquiry, tax policy analysis should focus on how to make the tax base more progressive. a more progressive base would allow policymakers to decrease high marginal tax rates 167 see supra notes 107–110 and accompanying text. 168 see supra note 153 and accompanying text. 169 see graetz & schenk, supra note 1, at 34–35 (providing an overview the discussion of why a progressive tax rate structure may be justified). 170 see walter blum & harry kalven, supra note 105, at 417, 427–31. 171 id. at 430–31. 172 id. at 437–39 (noting that under a progressive tax regime, gains may be taxed at higher rates than the rates in which losses are given deductions and that high marginal rates significantly reduce the monetary reward of the most productive workers—giving them serious disincentives to work an additional marginal hour of work). 173 see bankman & griffith, supra note 73, at 1944–45 (arguing that the impact of progressive tax rates has been overstated). 174 blum & kalven, supra note 170 105, at 444. 76 columbia journal of tax law [vol.3:43 and thereby reduce the overall costs of employing a tax-driven wealth redistribution scheme.175 taxing personal assets on a realization basis is not the only way to make the income tax base more progressive. allowing for personal exemptions that are sensitive to economic hardship would also make the tax base more progressive as a whole.176 if this is true, a general mark-to-market regime could cover all assets (including personal assets), while personal exemptions could make the income tax more progressive. it seems, however, that even a carefully structured mark-to-market regime that provides relatively generous personal exemptions would result in problematic interpersonal comparisons. for example, as long as it relies upon the market price of personal assets as a benchmark, such a regime would impose a higher effective tax rate on the professor with the valuable assets than on her colleague with the less valuable ones. finally, while we recognize that granting realization treatment only to personal assets would undoubtedly distort ownership patterns, there are reasons to believe that the impact of these distortions would not be huge. because of the high subjective value taxpayers attach to personal assets (and the costs of detaching from them), one can view most taxpayers as being neither short nor long on those assets.177 in other words, the ability of taxpayers to manipulate their holdings of these assets to achieve a tax advantage exists but is limited. taxpayers may not be as tax efficient when it comes to holding of personal assets—for example, if the taxpayer sells a residential real estate property, she becomes short on that property. while she can rent for a while, the costs of shifting in and out from a residential property are high, which drives down the likelihood of manipulation. additionally, while granting realization treatment only to personal assets may result in overinvestment in businesses that fall under the personal asset category, there are other ways to address these concerns.178 the fourth criticism, that exempting personal assets altogether or subjecting them to a lower rate is more consistent with this article’s claim that they are progressively distributed, is the most difficult objection. one may wonder why a sale of a personal asset should trigger a tax at all. if a taxpayer sells a personal asset, which he initially valued significantly more than the market price, it may be because he is actually less well-off. for example, a taxpayer may have bought a residential home, enjoyed it very much, and been unwilling to sell it. after a while, however, he may have found out that he was not that fond of the house anymore and may have sold it for its fair market value. in other words, the taxpayer sold his personal asset because he experienced a loss of utility with respect to it. because the realization event is a byproduct of a utility-loss (rather than gain), making it a trigger of taxation seems utterly unfair. we have two replies to this concern. the first is that in public finance the focus is on rough justice rather than upon particular circumstances. hence, as mentioned in part iii.a, we focus on the distribution of personal assets as a class of assets rather than on the changes in the specific price of an asset. since personal assets comprise a bigger 175 see bankman & griffith, supra note 73, at 1909–10 (making a related argument that the progressive tax rates are not sufficient to promote overall tax progressivity if the tax base is not sufficiently progressive). 176 blum & kalven, supra note 170, at 506–11. 177 we thank michael smart for this observation. 178 for example, promoting risk diversification (e.g., regulated investment vehicles for retirement) and capping the benefit realization so that it only applies to a certain amount of personal assets. see supra note 102. see also infra notes 205–206. 2011] realization and progressivity 77 share of low to medium-income taxpayers’ assets, then giving them an advantageous tax treatment would result in increased progressivity, even if in the case of a specific asset it may be difficult to see why the sale justifies triggering a tax. the second reply is that, as noted, in some extreme cases there may be a good reason to exempt the returns for personal assets altogether.179 however, in most cases there seems to be a strong case for taxing the income generated from the sale and use of personal assets. for example, it seems unreasonable to tax individuals according to the market value of their human capital. although many healthy women can work as gestational surrogates, the market valuation of this ability is a poor indication of their economic well-being.180 the argument changes if a specific individual makes a voluntary decision to work as a surrogate. 181 the monetary returns for surrogacy are not fundamentally different from those received through other employment options. if society chooses income as the relevant benchmark for measuring economic well-being, different sources of income should be treated the same.182 in this context, the realization principle operates to avoid problematic interpersonal comparisons with respect to human capital, while making sensible comparisons with respect to income actually earned. it is important to stress that this article’s analysis neither advocates nor rejects the notion that personal assets should be subject to a different tax rate—or even to a form of retrospective taxation.183 it merely suggests that even if the market price of assets is easy to observe, a mark-to-market tax regime should not apply to personal assets. to accept our argument, one need not subscribe to the notion that realization-based treatment of personal assets provides an a priori superior way of promoting income tax progressivity. instead, one need only accept that a mark-to-market regime has important benefits and that these benefits are not completely erased if some assets are exempt from it. the skeptical reader should further agree that, given the difficulties of drawing interpersonal comparisons with respect to the market price of personal assets, there are some important benefits of excluding them from the mark-to-market regime. additionally, one should accept that there are high social costs to progressive tax rate structures with high marginal rates. given these costs, policymakers should be willing to consider achieving income tax progressivity through a combination of measures— including the enhancement of the progressivity of the base. a realization requirement 179 selling wedding rings and other types of personal assets could signal extreme hardship, so it may be reasonable to exempt them altogether, given that the money received for them is not an adequate benchmark for interpersonal comparisons for well-being. see supra part iii.b. 180 benshalom & stead, supra note 15, at 1542–49. 181 see generally bridget j. crawford, taxing surrogacy, social science research network (aug. 30, 2009), http://ssrn.com/paper=1422180 (making the case for taxing surrogacy). it is true that the decision to work as a surrogate may not be random—but rather an option chosen particularly by non-affluent women. debora l. spar, the baby business: how money, science, and politics drive the commerce of conception 73 (2006). furthermore, while personal preferences play a role in every employment decision, certain jobs (e.g., migrant labor) and economic decisions (e.g., selling body organs) are held or made only by very poor people. e.g., catherine waldby & robert mitchell, tissue economies: blood, organs, and cell lines in late capitalism 161 (2006). 182 see generally brian galle, tax fairness, 65 wash. & lee l. rev. 1323, 1327 (2008) (arguing that fairness prescribes taxing different sources of income equally). 183 for discussion of retrospective taxation, see supra note 70. retrospective taxation would reduce the value of deferral and would de facto impose a higher effective rate on realized personal assets. therefore, because this article does not discuss what the effective tax rate on personal assets should be, we leave the question of retrospective taxation, its theoretical justifications and political viability, for a future paper. 78 columbia journal of tax law [vol.3:43 that is confined to personal assets would provide a tax benefit, which would erode the theoretical ideal income tax base but would do so in an overall progressive way. the conclusion of this analysis is that there is a strong normative argument for shifting the current realization-based income tax system towards a decidedly more hybrid regime. this hybrid system would distinguish between personal assets, which would be taxed upon realization, and emotionally fungible assets (namely, investment assets), which would be taxed under a mark-to-market regime. such a tax regime would broaden the tax base to include almost all investment assets and would make the income tax more progressive, efficient, and resistant to tax planning. despite the above, critics may legitimately argue that there are other, theoretically superior, ways of promoting tax progressivity. nevertheless, we argue two things. first, as we stress in this subpart, every tax (and transfer) distributive scheme involves certain social costs,184 so that the optimal redistributive policy may require using different elements rather than relying on a few of them extensively. second, as the next part suggests, tax policy should be pragmatic and not merely theoretically correct. the potential shift to a more hybrid income tax regime involves a number of complicated issues. hence, the normative justification for a hybrid tax regime does not automatically justify an actual shift to such a system. the next part discusses how our proposal could help establish a better, more progressive tax system that would not require a complete overhaul of the existing income tax. iv. the road ahead—preliminary policy implications this part examines how this article’s normative analysis could be meaningfully integrated into current tax arrangements. taking a radically different view of realization, this article offers only the foundational normative argument for a hybrid income tax regime. it is part of a much broader project that seeks to re-examine how a more progressive and efficient income tax base should be structured, so a detailed policy proposal lies beyond the scope of the current analysis. instead, the discussion below seeks to draw attention to two major points. first, it briefly explains how our argument supports a concrete and immediate change in the current tax regime—the taxation of all investment assets on a mark-to-market basis. this proposal’s main benefits are that it broadens the income tax base while expanding its progressivity, it does not increase complexity because our current income tax regime already distinguishes investment assets and applies special rules to them, and it reduces much of the manipulation and economic dead weight loss associated with the realization requirement. put differently, this article’s proposal builds on a distinction already made by the current realizationbased income tax regime but derives more value from it without adding much complexity to the system. second, proposing mark-to-market taxation of investment assets is only the first and most straightforward option for reform—but not, by any means, the only policy implication of this article’s analysis. offering the novel category of emotionally nonfungible (personal) assets as a way to determine the tax treatment of assets suggests many more avenues of research. this part outlines the main trajectories of likely future research and positions them within the scholarly literature. 184 see generally lee a. fennell, interdependence and choice in distributive justice: the welfare conundrum, 1994 wisc. l. rev. 235 (1994) (reviewing the difficulties of using welfare distributive programs to reduce poverty and inequality due to labor market disincentives). 2011] realization and progressivity 79 a. taking the first step: a modest real-world reform proposal the category of emotionally non-fungible personal assets may seem vague and difficult to monitor. while this may be true, there is at least one category of assets that clearly cannot be identified as personal: investment assets. therefore, at the very minimum, our analysis suggests that investment assets should be taxed on a mark-tomarket basis. the advantages of such a system are straightforward—with respect to investment assets, all the problems mentioned in part i.a would be eliminated. investment assets are the easiest vehicle for manipulating the realization requirement, particularly through inefficient practices such as strategic trading. 185 mark-to-market treatment would eliminate tax barriers to the efficient allocation of investment assets and allow taxpayers to attain certain investment goals—such as risk diversification—without triggering a tax liability. furthermore, investment assets are disproportionately held by affluent taxpayers, so subjecting them to mark-to-market taxation would deny them the tax benefit of realization for these assets, thereby increasing the progressivity of the income tax base.186 we can anticipate two main difficulties with such a proposal, neither of which is insurmountable. the first is how to define investment assets, and the second is how our proposal would manage issues of valuation and liquidity. with respect to the first problem, the category of investment assets should include individuals’ portfolio investment in financial markets, debt instruments, and any non-control equity holdings in entities.187 it is important to note that the current tax regime already employs rules that distinguish investment assets from other types of assets.188 these rules are biased against investment assets because they prevent taxpayers from using deductions generated by investment activity to offset the income derived from ordinary trade and business or as compensation for services.189 congress and the u.s. treasury enacted these rules as a response to one of the most basic tax planning strategies in a realization-based income tax regime:190 the acceleration of deductions generated by investment activity to reduce tax liability on income derived from other sources.191 the upshot of this discussion is that 185 see supra note 36 and accompanying text. 186 see supra note 46 and accompanying text. 187 given its limited scope, this article cannot address the imposition of the corporate tax. it is, however, worthwhile to note that a regime that employs a corporate tax on all large corporations would probably be subject to mark-to-market taxation on the entity level. see generally michael s. knoll, an accretion corporate income tax, 49 stan. l. rev. 1 (1996) (arguing for computing corporate income tax this way). 188 one example is the passive loss limitations discussed below. another set of rules can be found in i.r.c. § 163 (west supp. 2010), which limits the interest deduction of interest payments made to support investment assets. 189 see i.r.c. § 469 (2006) (providing broad limitations for losses from “passive” activities). the limitations of i.r.c § 469 and its associated regulations set out mechanical rules for determining whether an investment activity is active or passive, including the number of hours the investor dedicates to the activity. the rules were extremely effective at eliminating tax shelters marketed to individuals. see graetz & schenk, supra note 1, at 414–15; mccaffery, supra note 11, at 907. 190 see marvin a. chirelstein & lawrence a. zelenak, tax shelters and the search for a silver bullet, 105 colum. l. rev. 1939, 1951 (2005). 191 see lawrence zelenak, when good preferences go bad: a critical analysis of the anti-tax shelter provisions of the tax reform act of 1986, 67 tex. l. rev. 499, 501 (1989). in the once prominent individual tax shelter industry, high-income earners would purchase non-control shares in businesses solely for the deductions the businesses generated. a dentist in a high tax bracket, for example, might purchase a share in a sham real estate investment using nonrecourse debt solely to take advantage of depreciation 80 columbia journal of tax law [vol.3:43 while it can certainly be difficult to make distinctions between types of holdings, this difficulty is not fatal to our proposal. in fact, the current tax regime makes such distinctions all the time. with respect to the problems of valuation and liquidity, we concede that they might remain a source of concern under this proposal. instead, we argue that policymakers can address those problems much more easily in the context of investment assets than with respect to all assets. many investment assets are traded and therefore are relatively liquid and easy to value. as noted earlier, we believe that liquidity problems are not detrimental to this proposal because the current literature has identified the need to make exceptions in such limited cases of low taxpayer liquidity.192 valuation is the main explanation for why the realization requirement has endured as a second best alternative193 and probably remains the main impediment to adopting a mark-to-market regime.194 nevertheless, the notion that valuation will always render the mark-to-market alternatives impractical is likely to eventually fail. if one assumes that public markets will continue to grow in both scope and scale195 and advancements in computation and data analysis will continue to grow at an increasing rate, then the implication of this is that the market prices of a growing number of assets will be more easily determined and observed in the foreseeable future.196 hence, the notion that tax authorities would be able to value and tax assets under a mark-to-market income tax regime is realistic for an increasingly large proportion of investment assets.197 because current income arrangements rely on the ability to distinguish between investment assets and other assets, using these same distinctions to promote a hybrid mark-to-market regime would not add significant complexity to the system. in other words, the costs of distinguishing between investment assets and other assets are already present in the current income tax regime. while our proposal does not reduce these costs, it achieves many advantages of the mark-to-market regime, appears to be administratively feasible (if not now, then in the near future), and reduces the complexity of many other rules,198 along with much of the revenue loss and waste associated with tax planning. in terms of future research, we believe that the above proposal for taxing all investment assets on a mark-to-market basis would be a significant improvement over the current regime but is not necessarily the ideal solution. even though it is difficult to determine the precise efficiency and distributional outcomes of a hybrid regime, we deductions generated by the investment. before the 1986 tax reform act, those deductions could offset (even to the point of wiping out) the taxpayer’s dentistry income. section 469 of the internal revenue code and the associated regulations virtually eliminated these transactions by creating bright line rules to distinguish between ordinary and passive income and prohibiting passive deductions from being used to offset ordinary gains. among other requirements, i.r.c. § 469 demands that a taxpayer materially participate in an investment activity in order for proceeds from the activity to be considered ordinary income. in actuality, the provisions establish clear (and arguably arbitrary) tests for what amounts to material participation (based mainly on the amount of time spent in the activity). 192 see supra notes 51–54 and accompanying text. 193 see schenk, supra note 12, at 365-66. 194 id. at 369. 195 see benshalom & stead, supra note 15, at 1557. 196 see schenk, supra note 12, at 374. 197 see supra note 70 (discussing how administrative costs of valuation could be reduced by nonannual and statistical valuation). 198 see supra note 72. 2011] realization and progressivity 81 believe that a more nuanced distinction between emotionally non-fungible assets may be possible. 199 this article’s analysis establishes why limiting realization benefits to personal assets would increase distributional fairness and calls for expanding mark-tomarket treatment to non-personal assets. however, the remainder of this part stresses that the benefit of such an expansion should be weighed against its social costs.200 b. future avenues of research in suggesting a new category of personal assets, we lack empirics to propose any bolder tax reform proposal than what we have outlined with respect to investment assets. however, we believe that it is worthwhile to consider some potential areas in which this article's normative analysis could be developed. earlier, we described the realization literature as dealing with the consequences of tax assessment mistakes.201 however, as we explained, market valuation issues should become less of a problem over time—a fact that only highlights the problem with personal assets. if the long feared mistakes in market price assessment are indeed becoming less common, then the relative role of mistakes with respect to taxpayers’ subjective values of personal assets would increase. put differently, we believe that as market valuation of both personal and non-personal assets becomes more accurate, policymakers will more frequently have to confront the problem we identified: taxpayers’ economic well-being from personal assets is not accurately reflected in the assets’ market prices. future research on this topic requires empirical inquiry about the relative proportions that personal assets represent in the overall pool of assets. however, it should also focus on theoretical inquiries with respect to tax policy. another important issue in shifting to a hybrid regime is how tax authorities should distinguish between personal and nonpersonal assets. we first explain the main theoretical threads of the topic and then elaborate on how they affect our argument for a hybrid mark-to-market realization regime. by their very nature, partial mark-to-market regimes differentiate the tax treatment of certain assets and taxpayers. this differentiation may result in discontinuities that carry potential for distortions and inequities.202 the key element in determining whether a shift to a partial mark-to-market regime would be beneficial is whether tax authorities could easily distinguish between types of assets. this is because such a shift would require tax authorities to develop a set of coherent and consistent recognition rules to distinguish between assets that should be taxed on a mark-to-market basis and those that should not. the benefits and administrability of a partial mark-tomarket tax regime would turn on the precision of the recognition rules and the elasticity of demand for specific assets. applying mark-to-market taxation to assets that are very elastic—perhaps because there are many non-mark-to-market assets that can easily substitute for them—would be difficult or counterproductive. if taxpayers could 199 mark p. gergen, the effects of price volatility and strategic trading under realization, expected return and retrospective taxation, 49 tax l. rev. 209, 216 (1994). 200 deborah h. schenk, an efficiency approach to reforming a realization-based tax, 57 tax l. rev. 503, 504 (2005) (arguing that not every movement away from realization towards accrual taxation is desirable and that each step should be judged by its revenue gains and efficiency costs). 201 see supra part iii.b. 202 taxpayers have incentives to tax plan against the fractional hybrid regime. schenk, supra note 200, at 519-24. for example, taxpayers could include much of their debt within the scope of the mark-tomarket regime while shifting their appreciated assets outside of it. see shakow, supra note 9, at 1165–66; weisbach, supra note 1, at 128. 82 columbia journal of tax law [vol.3:43 costlessly transition to a substitute, most would try to do so, which would result in no social gain in terms of revenue, efficiency, or equity.203 in this type of situation it may be advisable to either avoid mark-to-market taxation of the asset or include some of its substitutes as well.204 an example could help identify some of the main difficulties of drawing a distinction between assets in a hybrid income tax regime, which taxes all non-personal assets on a mark-to-market basis. consider gill bates, a young businesswoman who created a start-up internet company that captured a significant market share. even though the company made an initial public offering, bates continues to manage the company and maintains significant holdings in its stock. bates could argue that even though the shares are liquid and easy to value, their (substantial) appreciation should only be taxed upon realization. for years, she has invested her human capital in the corporation and plans to continue doing so. accordingly, there seems to be a lot of truth in the claim that her holding in the corporation’s stock is an emotionally non-fungible asset. allowing bates’s holdings to be taxed only upon realization would, nevertheless, be problematic from a number of perspectives. first, taxing her holdings in the corporation only upon realization would have significant costs in terms of revenue and progressivity.205 second, if her holdings were not taxed on a mark-to-market basis, she would have incentives to try and manipulate her tax liabilities. for example, she could overinvest in the assets that could be labeled as emotionally non-fungible and defer the tax payment on their appreciation. she could use the corporation to attain risk diversification by retaining the corporation’s earnings and using them to buy a diversified portfolio so that her holdings in the corporation partially reflected the value of this portfolio.206 this, as mentioned, would result in misallocation of resources, less risk diversification, more administrative and compliance costs, and all the flaws of the current realization regime. it is important to note that this example is not an indication that a hybrid tax regime is impossible to implement but rather a demonstration of the fact that pushing a single principle to an extreme can present complex questions that may not apply across the board. admittedly, our analysis suggests that emotionally non-fungible assets should be taxed only upon realization in order to prevent errors related to subjective valuation. the analysis does not in any way suggest that preventing this type of error is the only objective of the tax system. revenue, distributive, and tax enforcement objectives may require that this goal be balanced against other values. in the case of bates, these considerations may require that her ability to claim realization treatment for emotionally non-fungible assets be capped at a certain dollar amount. this capping, however, would still recognize the basic point advanced by this analysis: realization is a normative component of how a liberal society values individual well-being and promotes redistribution. 203 see schenk, supra note 200, at 527–28. 204 see gergen, supra note 199, at 211 (suggesting that putting only publicly traded assets in the mark-to-market regime would make it administrable but would nevertheless have troubling consequences because it would create a bias for non-publicly traded assets). 205 this concern is substantial given that much of the wealth of high net worth taxpayers is in the form of closely held business equity. see kennickel, supra note 114, at 53–55. see also infra appendix. 206 in this case, holding a share in a corporation is a close substitute to holding a diversified portfolio. 2011] realization and progressivity 83 as one commentator has noted, the weaknesses of both pure realization and pure mark-to-market regimes leave policymakers with no option but to balance between them.207 a hybrid regime requires line drawing between similar assets—a practice that is always difficult and somewhat arbitrary.208 wherever the line is drawn, assets on each side will be assigned different tax treatment in spite of their strong similarities.209 nevertheless, a frictionless tax regime is not a possibility, so line drawing will always be a significant component of tax policy debates.210 accordingly, any future research exploring the nature of a hybrid mark-to-market regime will have to evaluate whether the line drawing associated with the research is comparatively easier or less distorting than those associated with the one it seeks to replace. we wish to end by noting a set of broader policy issues to which this article’s argument relates. first, with respect to the income-tax-versus-consumption-tax debate, if an effective hybrid income tax regime could be developed along the lines suggested by this article, then recent calls of some leading tax scholars to abandon the income tax are premature and misleading.211 although the realization requirement is indeed inherent to income taxation, limiting its role to personal assets can reduce many of the problems of the income tax and sustain it as a much more progressive and effective fiscal instrument. second, a shift to a more hybrid mark-to-market tax regime highlights other vexing tax policy questions, particularly with respect to the budgeting process. a markto-market tax regime would have to take account of more gains during economic booms and more losses during economic downturns, and would therefore require a very strong political commitment to prudent countercyclical spending.212 additionally, a shift to a hybrid mark-to-market tax regime would call into question the desirability of taxing income rather than wealth. third, from a historical perspective, it seems as though much of the justification for taxing income in the first place was the necessity of relying on the realization event to determine the actual value of assets. there are, of course, independent arguments for why income rather than other tax bases such as consumption or wealth should be taxed.213 however, once the historical connection between income and the realization requirement is weakened, the question of whether income tax is the most appropriate tax base merits re-examination. finally, and most importantly, we have argued that current tax literature relies on tax administration difficulties with respect to valuation of assets to justify the realization requirement. this article’s argument is a byproduct of tax authorities’ inability to use the market price as a good proxy to determine the well-being (or other currencies of justice) associated with an asset. one may observe that our argument can also be viewed as an 207 schenk, supra note 12, at 396. 208 benshalom, supra note 43, at 1259–71; weisbach, supra note 33, at 1631. 209 this of course assumes that some attributes of the tax code are politically fixed. see weisbach, supra note 33, at 1631–32. 210 see generally weisbach, supra note 33 (claiming that line drawing problems are inherent to tax law). 211 see generally bankman & weisbach, supra note 7 (arguing that a consumption tax is desirable on the grounds that the income tax cannot meet its distributional objectives). see also mccaffery & hines, supra note 6. 212 needless to say, such a commitment does not exist in the current political arena. daniel n. shaviro, taxes, spending, and the u.s. gov’t’s march toward bankr. 116–47 (2006). 213 see, e.g., alvin warren, would a consumption tax be fairer than an income tax?, 89 yale l.j. 1081, 1093-94 (1980). 84 columbia journal of tax law [vol.3:43 administrative constraint. after all, we start by explaining that the main problem with realization, as it is perceived today, is the difficulty of making accurate market price valuations. our claim is that this ability to make accurate market valuations may change over time and that the real problem is the inability of tax authorities to measure the subjective value (or utility) that individuals derive from personal assets. one can claim that policymakers’ capacities to observe utility may change over time. these two types of constraints should be distinguished. the current market valuation constraint is something that technology can change, and is actually in the process of changing. as a field in finance, asset pricing constantly advances, so that an increasing number of assets can be consistently and cheaply priced. this is not the case with the gap-in-value argument because technology cannot help us measure welfare and other benchmarks of economic well-being. for this reason, policymakers cannot avoid making some normative assumptions about how to measure well-being for tax purposes.214 this article cannot explore this point, but it is important to note that, ideologically, we would welcome a discussion about the limits of market price as a proxy. such a discussion would depart from what seems to be the current orthodoxy within tax law, which focuses almost exclusively on the virtues of the market price as an objective, value neutral measurement of economic well-being. conclusions the above analysis explains why realization should play a normative role in modern income tax regimes. this role intimately relates to the way liberal egalitarian societies should promote notions of distributive justice. rather than summarizing our points, we wish to highlight the article’s main contribution to legal literature discussing tax-distributive schemes. first, the dominant role of the realization requirement in the income tax framework indicates that administrative difficulties will not stifle a normative-distributive analysis of its function. the income tax regime is a vital instrument for achieving redistribution in liberal democracies, so academics and policymakers should see a concrete distributive analysis of its attributes as a necessity. second, by emphasizing the importance of the difference between market and subjective valuation with respect to certain personal assets, this article encourages a new paradigmatic thinking about realization. the enormous social costs associated with realization should prompt serious consideration of how to advance a progressive hybrid income tax regime. such a regime would not be flawless but would attain the preferred level of tax-redistribution in a much more efficient and equitable way. finally, this article calls for a re-examination of the role that market price plays in contemporary tax theory. this is not to suggest that market price and its related efficiency implications offer no value but simply that reality is far more nuanced. market price is just one way to describe individuals’ economic well-being for distributive purposes, but there are other objective and subjective ways. good policymaking requires trying, to the extent possible, to make the best account of them all. 214 for example, policymakers could say that the value of a taxpayer’s personal assets should be calculated based on the market price of the asset multiplied by a factor that is correlated with the taxpayer’s overall wealth. in this scenario, bill gates’s ring would be valued at a higher rate than joe six pack's—even if they had the same market price. appendix: asset distribution tables by income level 2001: demonstrating the proportional holdings of personal, investment and business asset classes by different groups of taxpayers. distribution of all assets: assets and liabilities as a share of total assets by percentile groups of distribution of wealth (%) 215 all 0-50 50-90 90-95 95-99 99-100 #1 total financial assets 42.2 19.1 35.9 50.7 47.9 45.1 #2 total of non-financial assets (home equity+ "other assets" + investment real estate) 57.8 80.9 64.1 49.3 52.1 54.9 #3 investment in non-residential real estate 4.2 1.6 4.2 4.7 6.1 4.6 #4 investment in residential real estate 4.7 0.5 2.3 3.7 7.1 6.5 #5 investment in the equity of a (closely held) business 16.9 1.1 5.6 9.5 18 33.5 distribution by category #6 total of investment assets (1+3+4) 51.1 21.2 42.4 59.1 61.1 56.2 #7 total of non-business personal assets (2-3-4-5) 32 77.7 52 31.4 20.9 10.3 #8 total of business assets (5) 16.9 1.1 5.6 9.5 18 33.5 total assets (6+7+8) 100 100 100 100 100 100 215 see kennickel, supra note 114, at 53–55. tax-exempt hospitals and their communities susannah camic tahk  abstract hospitals in the u.s. have long been able to obtain exemption from federal income tax because they meet the requirement known as the standard of “community benefit.” yet lawmakers and scholars know virtually nothing about the actual workings of tax-exempt hospitals, or about whether, how, and to what extent they deliver benefits to their communities. within the last five years, however, irs tax return forms have started asking hospitals to quantify these benefits, as well as to give detailed information about their financial practices with respect to their patients. these new questions coincide with new requirements for tax-exempt hospitals put in place as part of the 2010 affordable care act. the new tax return data offer a first-time opportunity to evaluate the workings of tax-exempt hospitals from the perspective of both the traditional requirements for tax-exempt hospitals and the 2010 healthcare reforms of the affordable care act. this article analyzes data from all tax-exempt hospitals in the u.s. in 2012 to show that tax-exempt hospitals differ widely in their provision of community benefits (and financial practices). in particular, these activities vary systematically in relation to their different notions of “community” and the characteristics of the communities where the hospitals are located. this evidence demonstrates that tax-exempt hospitals seem to be responding to the specific needs of their own communities when allocating their resources among different community-benefit activities. the data show, in addition, that while tax-exempt hospitals are generally adopting the financial policies that congress and the irs are requesting, hospital financial aid policies also vary by community. these findings raise several fundamental questions for lawmakers and tax policy scholars in the era of the affordable care act. in particular, the findings suggest that lawmakers need to grapple seriously with how they allow tax-exempt hospitals to define their communities. for example, is it appropriate for tax-exempt hospitals merely to benefit a narrowly defined community or should they operate in terms of a broader understanding of community? in light of the new data presented, this article considers these questions and outlines several alternatives to the “community benefit” standard to address them.  assistant professor of law, university of wisconsin law school. thanks to chas camic, fred goldberg, andy grewal, heinz klug, alex reid, alex tahk, bill whitford, the participants in the university of wisconsin law school faculty workshop, and the members of the fall 2008 tax policy & health care in america seminar at new york university school of law for useful suggestions and discussions. in addition, thanks to the graduate school at the university of wisconsin and a university of wisconsin summer research fellowship for funding; and to jordan behmke, patrick kearney and angela n. muñoz for excellent research assistance. all errors are my own. 34 columbia journal of tax law [vol.6:33 i. introduction ............................................................................................... 35 ii. legal framework for tax-exempt hospitals ............................ 37 a. general requirements for tax-exempt organizations ........................................ 37 b. traditional hospital-specific requirements for tax-exemption ........................ 38 1. nature of traditional hospital-specific requirements ................................. 38 2. criticisms of traditional requirements for tax-exempt hospitals .............. 40 c. additional hospital-specific requirements for tax-exemption under the affordable care act ............................................................................................. 44 1. community health needs assessments ......................................................... 44 2. financial policies ......................................................................................... 46 iii. questions, literature, data, and methods ................................. 48 a. questions asked .................................................................................................. 48 b. relationship to previous scholarship .................................................................. 49 c. dataset and variables .......................................................................................... 54 d. statistical models used ....................................................................................... 57 iv. results ............................................................................................................ 58 v. discussion ...................................................................................................... 73 vi. evaluation of traditional and new affordable care act requirements ............................................................................................... 77 vii. conclusion .................................................................................................... 85 2014] tax-exempt hospitals and their communities 35 i. introduction at the present time, half of u.s. hospitals are exempt from federal income tax. to merit that exemption, hospitals must, under current tax law, benefit their communities. this tax exemption for hospitals is worth approximately $12 billion a year and allows hospitals to raise $5.3 billion in tax-deductible contributions annually. 1 as a result, the exemption plays a key role in providing health care in the u.s. however, the legal framework that allows hospitals to earn their tax exemption, known as the “community benefit” standard, has long been controversial. its critics have decried the standard as overly vague, and they have argued that it does not distinguish between tax-exempt hospitals and their for-profit counterparts. however, between 2008 and 2010, congress and the irs, for the first time in decades, revisited the legal framework for tax-exempt hospitals and began instituting changes. the patient protection and affordable care act, better known as the health care reform bill (the “affordable care act,” or the “aca”), pub. l. 111-148, 124 stat. (2010), has now put some of these changes into place. in doing so, the aca has catapulted institutions that have never before been in the national limelight into the center of political debate. suddenly, tax-exempt hospitals have become a focal point of federal lawmaking efforts. having lived so much of its previous history on the periphery, however, the taxexempt hospital sector is, for the most part, a virtual black box. as political leaders, legislators, pundits, and tax scholars debate the future provision of health care, they have consequently been left to guesswork about tax-exempt hospitals. proceeding in the absence of adequate data about the tax-exempt hospital sector, congress and the irs have, nevertheless, made dramatic changes to the rules that taxexempt hospitals must follow. already in 2008, the irs began to compel tax-exempt hospitals to provide concrete data on the ways in which they (purportedly) worked to benefit their communities. on this new irs “schedule h,” which tax-exempt hospitals are now required to fill out each year as part of the tax filing process, hospitals must now quantify their specific community-enhancing projects. in addition, they must provide detailed data on a variety of different practices that govern how they interface with their communities. for instance, hospitals must now describe to the irs each year what types of financial aid they make available and how they attempt to collect debts from patients who do not pay bills in full. furthermore, as part of the affordable care act, congress has set forth an additional set of requirements that both mandates and prevents certain activities on the part of tax-exempt hospitals. these new rules govern how tax-exempt hospitals may bill patients for services, offer financial aid, collect debts, and solicit information from communities about their needs. in the past several years, the irs promulgated draft regulations under these new rules, which the agency plans to finalize this year. these changes present a first-time opportunity to analyze the workings of taxexempt hospitals on the basis of comprehensive empirical evidence. american hospitals have been exempt from federal income tax since the tax’s beginnings more than a century ago, but the effects of this costly exemption have remained unknown. 1 sara rosenbaum & josh margulies, tax-exempt hospitals and the patient protection and affordable care act: implications for public health policy and practice, 126 pub. health rep. 283, 283 (2011). 36 columbia journal of tax law [vol.6:33 however, the new schedule h data finally provide a long-overdue way of examining what hospitals are actually doing to merit their exemption. answers given by hospital administrators to the schedule h questions enable us to see how well the traditional and revised legal frameworks are working and how they are affecting different types of hospitals around the country. they enable us to ask what hospitals are doing to benefit their communities. are hospitals in fact responding to the needs of their communities? what kinds of financial aid policies have hospitals enacted? how generous are they? how do hospitals bill their patients and collect on those bills? the data analysis presented in this article takes a first step toward answering these questions. the analysis is based on schedule h data for all tax-exempt hospitals in the u.s. in 2012. using these data, the article shows that the ways in which hospitals satisfy the requirements of the current law varies significantly by community. the community benefit standard appears to mean different things to hospitals in different communities. some hospitals focus on providing community benefits as tax law has traditionally defined them: free or discounted care including medicaid shortfalls, subsidized clinics and other direct-health interventions, education for aspiring health professionals, and medical research. hospitals that provide more community benefits tend to be large and located in more densely populated communities with populations living just above the poverty line. other hospitals emphasize what the irs calls “community building” activities. these activities center on what public health scholarship calls the “social determinants of health.” among them are improved housing, economic conditions, environmental factors, and jobs. hospitals that focus on community building also tend to be large, but are located in communities where residents are more likely to have private insurance. in addition to uncovering community patterns in the services that hospitals provide, the schedule h data also highlight differences in the types of community-related practices in which hospitals engage. across all communities, hospitals are now uniformly adopting the financial aid and debt collection practices that congress and the irs will soon be requiring. however, the specifics of those practices also vary by community. in particular, the availability of financial aid for care diverges across communities. in densely populated communities, where insurance rates and incomes are high, often in states that themselves have relatively stringent laws for tax-exempt hospitals, hospitals are more likely to offer free or discounted care to patients at higher income levels. the data indicate further that the types of debt collection practices that have long worried lawmakers are also associated with certain community traits. in particular, small hospitals in predominantly white communities are more likely to use what the irs views as “extraordinary” debt collection actions. taken together, these findings have major implications for lawmakers seeking to evaluate the legal framework for tax-exempt hospitals in terms of both its traditional and new aca components. in particular, this research suggests that, at the current time, hospitals are responding primarily to the needs of their immediate communities. under the current legal standard, which gives hospitals broad latitude to define and decide how to improve their own communities, hospitals are behaving in accordance with the law. the tax policy question then becomes whether is it appropriate merely to ask hospitals to enhance their own communities as they see them. what effect does the current standard for tax exemption have on poor and disadvantaged communities? should the federal tax law impose a broader standard of community on all hospitals, requiring them to take into account the needs of those outside of that community? this article weighs several 2014] tax-exempt hospitals and their communities 37 proposals that might either expand the legal definition of community or require hospitals to move beyond it. readers may be surprised that questions such as whether hospitals bill needy patients for their medical care are matters that fall within the scope of federal tax law. the fact that the irs is the agency responsible for deciding whether a hospital can place a lien on a patient’s house may seem counterintuitive. however, using tax law to regulate social policy matters such as free health care and debt collection constitute a major part of a larger recent trend toward using tax law to conduct social policy. 2 in particular, congress is increasingly relying on the tax code to fight poverty and to meet the needs of poor and near-poor individuals. setting rules about how hospitals relate to disadvantaged patients and communities is one significant example of this phenomenon. this article proceeds in six parts. part ii details the current legal framework for tax-exempt hospitals, explaining what its requirements are, how these developed, and how they have been modified under the aca. part iii reviews the literature on this subject. it then describes the data and methods on which the empirical analysis in this article is based. part iv presents the results of the data analysis, and part v discusses these. part vi considers the tax lawmaking implications of the data analysis, and part vii concludes. ii. legal framework for tax-exempt hospitals the current legal framework for tax-exempt organizations has three components as it pertains to hospitals. first, tax-exempt hospitals must follow the general irs requirements for tax-exempt organizations. second, tax-exempt hospitals must comply with a series of hospital-specific rules that have developed over the past hundred years, particularly the controversial community benefit standard. third, tax-exempt hospitals must follow the new requirements set forth in the affordable care act and the regulations promulgated thereunder. this part briefly describes each of these components and discusses some of the common criticisms of how the law treats taxexempt hospitals. a. general requirements for tax-exempt organizations organizations “organized and operated” for certain purposes may be exempt from federal income tax. 3 the most high-profile group of exempt organizations, and the group into which most tax-exempt hospitals fall, consists of “charitable, religious, educational, and scientific entities,” otherwise known as “charitable organizations,” “charities,” or “§ 501(c)(3) organizations.” 4 organizations “organized and operated” for one of these purposes receive two major tax benefits. first, these charities do not generally have to pay federal income tax on their net income. second, individuals and corporations may deduct, within certain limits, donations to these charities. 5 when discussing “tax-exempt organizations,” this article will hereafter be referring to charities. 2 see generally susannah camic tahk, everything is tax, 50 harv. j. on legis. 67 (2013). 3 see i.r.c. §§ 501(c), 527–28 (2012). 4 boris i. bittker & lawrence lokken, federal taxation of income, estates & gifts ¶¶ 100.1.1–100.1.2 (2014), available at 1997 wl 440008. 5 i.r.c. § 170; (west supp. 2013); see also staff of joint comm. on tax’n, 109th cong., historical development and present law of the federal tax exemption for charities and other tax-exempt organizations (joint comm. print 2005), available at http://1.usa.gov/1d8t5wf. http://1.usa.gov/1d8t5wf 38 columbia journal of tax law [vol.6:33 a charity must be “organized and operated” exclusively for purposes that are “religious, charitable, scientific” in nature or include “testing for public safety, literary, or educational purposes, or to foster national or international amateur sports competition . . . , or for the prevention of cruelty to children or animals” as amplified in subsequent regulations. 6 notably, this list does not mention health care. the hospital-specific rules described in part i.b are what make § 501(c)(3) applicable to hospitals. the text of § 501(c)(3) also includes the “organizational” and “operational” tests for charitable status, 7 which govern the operating documents of a charity as well as its daily operations. 8 in addition to the organizational and operational tests, a charity must observe a complete ban on “private inurement.” 9 this rule prevents a charity from distributing any of its assets as profits to shareholders. 10 the charity must also comply with the ban on “private benefit.” 11 to do that, in addition to serving its above-described charitable purpose, the organization must “serve[] a public rather than a private interest.” 12 this means that the organization must benefit the broader public, rather than any particular individual or narrowly defined small group. two additional requirements for charities set limits on political activities and mandate compliance with the “public policy” doctrine, which stands for the general rule that charities may not operate in ways that run contrary to “public policy.” 13 finally, a charity’s activities may not become overly “commercial.” 14 hospitals exempt from tax under § 501(c)(3) must comply with all of these general rules for organizations that are exempt under that provision. in addition, as the next two subparts will discuss, tax-exempt hospitals must follow a series of hospitalspecific rules. b. traditional hospital-specific requirements for tax-exemption 1. nature of traditional hospital-specific requirements hospitals have been able to qualify for tax exemption according to longstanding historical practice, later set forth explicitly in irs guidance. the following subpart will briefly trace the development of the rules that make tax-exempt status available to certain hospitals. the federal income tax law that congress passed in 1894 allowed certain “charitable” organizations to be exempt from tax. this initial definition emphasized charitable expenses that were incurred for various categories of poor people. at the time, hospitals, particularly larger hospitals, which had their roots in almshouses, did in fact serve as refuges for the poor. 15 as a result, after the 1894 statute and its successor, the 6i.r.c. § 501(c)(3) (2012); treas. reg. § 1.501(c)(3)-1(d)(2) (as amended in 2014). 7 bittker & lokken, supra note 5, ¶ 100.2. 8 treas. reg. § 1.501(c)(3)–1(b), (c) (as amended in 2014). 9 i.r.c. § 501(c)(3) (2012); see also id. § 4958; treas. reg. § 1.501(c)(3)-1(f)(2)(ii) (as amended in 2014). 10 i.r.c. §§ 501(c)(3), 4958. (2012). 11 i.r.c. § 501(c)(3) (2012). see also lloyd hitoshi mayer & joseph r. ganahl, taxing social enterprise, 66 stan. l. rev. 387, 409 (2014). 12 treas. reg. § 1.501(c)(3)-1(d)(1)(ii) (as amended in 2014). 13 id. 14 see, e.g., asmark inst., inc. v. comm’r, 101 t.c.m. (cch) 1067 (2011). 15 nina j. crimm, evolutionary forces: changes in for-profit and not-for-profit health care delivery structures; a regeneration of tax exemption standards, 37 b.c. l. rev. 1, 10–11 (1995) (citing 2014] tax-exempt hospitals and their communities 39 1913 income tax statute, passed, standard irs practice treated hospitals as charitable and consequently as eligible for tax exemption. 16 however, as the twentieth century progressed, hospitals broadened their patient pool to include more non-indigent patients and came to rely more heavily on paying patients. 17 to address the problem of whether hospitals could still qualify for tax exemption, in 1953 the irs issued administrative guidance, rev. rul. 56-185. in this ruling, the irs held that hospitals could be exempt from tax if they met several criteria. 18 most notably, hospitals had to be “operated to the extent of [their] financial ability for those not able to pay for the services rendered and not exclusively for those who are able and expected to pay.” 19 the ruling clarified that, although they could charge patients for services if the patients were able to pay, hospitals would have to use the revenues so earned to defray operating expenses while not denying care to individuals unable to pay. 20 in the 1960s, however, congress passed two programs designed to pay directly for health care for the needy: medicare and medicaid. 21 irs staff believed that because medicare and medicaid would now cover the health care costs of the poor, hospitals should no longer have to do so. 22 one staffer later told researchers that “officials at ‘other agencies’ convinced him that hospitals would only care for the poor if they participated in medicare and medicaid.” 23 as a result, he “concluded that existing tax law, with its requirement of free or below-cost care, was obsolete.” 24 responding to these changes in the health care landscape, the irs in 1969 issued a consequential new ruling, rev. rul. 69-545, 25 in which, the irs adopted what has come to be known as the community benefit standard. 26 under this standard, hospitals could charles rosenberg, the care of strangers: the rise of america’s hospital system 5, 18, 116–65 (1987)); marshall w. raffel & norma k. raffel, the u.s. health system: origins and functions 241–46 (3d ed. 1980); stanley joel reiser, medicine and the reign of technology 152 (1978); paul starr, the social transformation of american medicine 145–79, (1982); william h. williams, america’s first hospital: the pennsylvania hospital, 1751-1841, at 2 (1976); robert s. bromberg, the charitable hospital, 20 cath. u. l. rev. 237, 239 (1970); henry hansmann, the evolving law of nonprofit organizations: do current trends make good policy?, 39 case w. res. l. rev. 807, 810–11 (1988-89); rosemary stevens, “a poor sort of memory”: voluntary hospitals and government before the depression, 60 milbank memorial fund q.: health & society 551, 552–55 (1982). 16 see, e.g., crimm, supra note 15, at n.140 (citing i.t. 2421, 7-2 c.b. 150 (1928)). 17 gabriel o. aitsebaomo, the nonprofit hospital: a call for new national guidance requiring minimum annual charity care to qualify for federal tax exemption, 26 campbell l. rev. 75, 86 (2004) (citing j. rogers hollingsworth & ellen jane hollingsworth, controversy about american hospitals: funding, ownership, and performance 66–67 (1987)). 18 rev. rul. 56-185, 1956-1 c.b. 202. 19 id. 20 id. 21 john d. colombo, the role of access in charitable tax exemption, 82 wash. u. l.q. 343, 348 (2004). 22 id. at 348-349. 23 id. at 348 (citing daniel m. fox & daniel c. schaffer, tax administration as health policy: hospitals, the internal revenue service, and the courts, 16 j. health pol., pol’y & l. 251, 261–62 (1991)). 24 fox & schaffer, supra note 23 at 261–62. 25 rev. rul. 69-545, 1969-2 c.b. 117. 26 id. for use of the term “community benefit standard” and information about how it has taken hold, see, eefor example, james j. fishman & stephen schwarz, nonprofit organizations cases & materials 384–85 (2d ed. 2000); thomas k. hyatt & bruce r. hopkins, the law of tax-exempt healthcare organizations 15, 529–32 (2d ed. 2001); colombo, supra note 21, at 347; and crimm, supra note 15, at 44–45. 40 columbia journal of tax law [vol.6:33 qualify for tax exemption even if they did not offer care to patients unable to pay. in fact, rev. rul. 69-545 explicitly “remove[d]” the earlier ruling’s “requirements relating to caring for patients without charge or at rates below cost.” 27 instead, the 1969 ruling stated that, to merit exemption, hospitals must provide services beneficial to their communities. the ruling went on to provide an illustrative and non-exhaustive list of factors that might distinguish tax-exempt hospitals from their for-profit counterparts. these distinguishing factors included: (1) a community board, (2) an emergency room available even to patients unable to pay, (3) a medical staff open to all doctors and (4) a willingness to treat recipients of medicare and medicaid. 28 from that time to the present, rev. rul. 69-545 and its community benefit standard have defined the basic legal requirements for tax-exempt hospitals, as they do to this day. the irs clarified the 1969 ruling somewhat in 1983, holding that tax-exempt hospitals need not provide emergency care to qualify for tax-exempt status. 29 since then, the irs has issued some additional guidance that provides insight into the agency’s understanding of the community benefit standard. perhaps most surprisingly, in 2001 the irs issued nonprecedential internal guidance for field agents auditing tax-exempt hospitals that sheds further light on the agency’s views about the community benefit standard. 30 the guidance suggested that, rev. rul. 69-545 notwithstanding, the irs believes that the community benefit standard does obligate tax-exempt hospitals to provide a certain amount of care for the poor. 31 further, in another internal document, a tax policy update issued in 2002, the irs indicated that absent an emergency room, a hospital policy regarding charity care is a “highly significant factor” in determining whether the hospital meets the community benefit standard, and that even without a charity care policy, exempt hospitals should provide some free or discounted care. 32 although the 2002 document is not binding legal authority, it does suggest that, when evaluating whether hospitals qualify for exemption, the irs might in practice examine hospitals’ practices regarding patients who are unable to pay. 2. criticisms of traditional requirements for tax-exempt hospitals the irs’s longstanding approach to regulating tax-exempt hospitals, as embodied in the community benefit standard, has been controversial since the irs first set it forth in rev. rul. 69-545. while the criticisms have touched on a variety of issues, several interlinked themes have emerged. in particular, critics have alleged that the community benefit standard is overly vague and that it does not impose sufficient affirmative duties on tax-exempt hospitals. the community benefit standard, many observers have argued, does not adequately distinguish tax-exempt hospitals from their for-profit counterparts. relatedly, the community benefit standard does not differentiate between tax-exempt hospitals that provide significant financial aid to patients and tax 27 rev. rul. 69-545, 1969-2 c.b. 117. 28 id. 29 rev. rul. 83-157, 1983-2 c.b. 94. 30 i.r.s. nat’l office field serv. mem., 200110030, (feb. 5, 2001) [hereinafter fsa 200110030]. for discussion of this fsa, see douglas m. mancino, the impact of federal tax exemption standards on health care policy and delivery, 15 health matrix 5 (2005). 31 fsa 200110030, supra note 30. 32 lawrence m. brauer et al., internal revenue serv., exempt organizations continuing professional education (cpe) technical instruction program for fiscal year 2002, topic d: update on health care 173 (2002), available at http://www.irs.gov/pub/irs-tege/eotopicd02.pdf. 2014] tax-exempt hospitals and their communities 41 exempt hospitals that offer very little, or perhaps none at all. as a result, the standard allows hospitals to diverge substantially in terms of how they treat patients who are unable to pay. in recent decades, critics of the community benefit standard have also contended that it permits financial policies that are not appropriate for tax-exempt hospitals. the following part 1.b.ii will briefly summarize some of these common criticisms. one frequent attack on the community benefit standard centers on its vagueness, or the fact that it simply does not provide hospitals with enough guidance about what they can and cannot do to stay exempt. to take just a few examples, health law professor mary crossley has written that “the vagueness of the existing federal community benefit standard and its historically lax enforcement mean that we do not really know what or how much beneficial conduct flows from the tax exemption and its forgone revenue, or whether that conduct is closely related to improving access and health outcomes for the uninsured or other groups.” 33 similarly, health policy analysts corey davis, jessica curtis, and anna dunbar-hester have written that, lacking “clear or consistent laws governing the requirements for achieving and maintaining nonprofit status, hospitals have largely been left to determine for themselves what activities qualify as community benefit.” 34 lawyer cecilia jardon mcgregor has also argued that “[t]he lack of specific criteria has been identified as a major problem concerning tax exemption for non-profit health care organizations.” 35 in addition to the vagueness critique, many commentators on the community benefit standard have argued that it does not sufficiently distinguish between tax-exempt hospitals and their for-profit counterparts. in practice, these critics say, most for-profit hospitals could satisfy the community benefit standard just as easily as a tax-exempt hospital. most famously, testifying before the ways & means committee in 2005, thenirs commissioner mark everson stated, “what we have seen since 1969 has been a convergence of practices between the for-profit and nonprofit hospital sectors, rendering it increasingly difficult to differentiate for-profit from not-for-profit health care providers.” 36 making the same point while arguing that the irs should replace the community benefit standard with a legal standard focused on increasing access to health care, legal scholar and expert on tax-exempt hospitals john colombo has observed that tax-exempt hospitals generally charge for providing health care to nearby communities, which “is exactly what for-profit hospitals and other providers do.” 37 law and public health professor jessica berg has similarly contended that, like tax-exempt hospitals, “[f]or-profit hospitals also provide charity care, assume some bad debt, and may have shortfalls in compensation from government programs; thus, there are serious 33 mary a. crossley, non-profit hospitals, tax exemption and access for the uninsured, 2 pitt. j. envtl. & pub. health l. 32–36 (2008). 34 corey s. davis et al., leveraging the patient protection and affordable care act’s nonprofit hospital requirements to expand access and improve health in low-income communities, 45 clearinghouse rev. 403, 406 (2012). 35 cecilia m. jardon mcgregor, comment, the community benefit standard for non-profit hospitals: which community and for whose benefit?, 23 j. contemp. health l. & pol’y 302, 318 (2007). 36 the tax-exempt hospital sector: hearing before the h. comm. on ways & means, 109th cong. 9 (2005) (statement of mark everson, comm’r of internal revenue serv.) [hereinafter tax-exempt hospital sector]. 37 colombo, supra note 21, at 369. 42 columbia journal of tax law [vol.6:33 questions about whether these categories function as an appropriate gauge of community benefit to justify tax-exempt status.” 38 related to the failure of the community benefit standard to distinguish between tax-exempt and for-profit hospitals is the standard’s inability, according to some critics, to differentiate between those hospitals that supply substantial assistance for financially troubled patients and those hospitals that do not. in 2009, the irs itself surveyed 544 tax-exempt hospitals about the community benefits they provided and, in its report, raised this issue. 39 the irs found that “[t]here was considerable diversity in the demographics, activities, and financial resources among the respondent hospitals.” 40 further, the irs identified a small subgroup of tax-exempt hospitals that seemed to be supplying most of the free or discounted care and other types of community benefits, observing that “[u]ncompensated care and aggregate community benefit expenditures were unevenly distributed among hospitals and concentrated in a relatively small group.” 41 along similar lines, in 2008 the general accounting office issued a report showing that different hospitals measure their community benefits in substantially different ways, thereby producing substantially different results. 42 echoing the findings of the irs and gao reports, professor berg has also observed that tax-exempt hospitals account for free and discounted care through procedures that vary significantly in how generous they are to patients unable to pay. 43 along similar lines, writing in the temple law review, health care lawyer leah snyder batchis described a series of (unsuccessful) lawsuits against tax-exempt hospitals regarding their refusal to give free or discounted care to uninsured patients. 44 in these lawsuits, the plaintiffs argued that these hospitals, while complying with language of rev. rul. 69-545, actually violated the more general requirement that tax-exempt organizations serve the public interest. 45 another common critique of the community benefit standard alleges that it allows hospitals to engage in financial practices that are inappropriate for tax-exempt organizations. these practices primarily include charging inflated rates to uninsured patients and then aggressively attempting to collect those patients’ debts. this critique emerged from a series of articles in the wall street journal in 2004. 46 these articles 38 jessica berg, putting the community back into the ‘community benefit’ standard, 44 ga. l. rev. 375, 390 (2010). 39 see generally internal revenue serv., irs exempt organizations (te/ge) hospital compliance project final report (2009) [hereinafter irs hospital report], available at http://www.irs.gov/pub/irs-tege/frepthospproj.pdf. 40 id. at 3. 41 id. at 4. 42 see u.s. gov’t accountability office, gao-08-880, nonprofit hospitals: variation in standards and guidance limits comparison of how hospitals meet community benefit requirements (2008). 43 berg, supra note 39, at 388. 44 see generally leah snyder batchis, comment, can lawsuits help the uninsured access affordable hospital care?: potential theories for uninsured patient plaintiffs, 78 temp. l. rev. 493, n.104 (2005) (citing complaint at 6, hutt v. albert einstein med. ctr., no. 04-3440, 2004 wl 1732445 (e.d. pa. july 21, 2004)). 45 id. at 506–07. 46 lucette lagnado, anatomy of a hospital bill: uninsured patients often face big markups on small items; ‘rules are completely crazy', wall st. j. (sept. 21, 2004, 12:01 am), http://online.wsj.com/news/articles/sb109571706550822844 [hereinafter lagnado, anatomy]; lucette lagnado, hospitals try extreme measures to collect their overdue debts: patients who skip hearings on 2014] tax-exempt hospitals and their communities 43 documented how tax-exempt hospitals were often charging uninsured patients rates off of a maximum-price “chargemaster” price schedule. 47 government and private insurance companies would negotiate substantial discounts off of those rates for covered patients. 48 however, uninsured patients, unable to negotiate discounts with hospitals, would receive bills for the entire amounts. 49 the wall street journal series further documented how, when the patients were not able to pay, the tax-exempt hospitals would move to collect those debts, often with the help of private collection agencies, sometimes using practices such as garnishing wages, placing liens on houses or cars or arresting patients. 50 following those articles, both the senate finance committee and the house ways and means committee held hearings to probe these problems. 51 much of the testimony at these hearings was highly critical of tax-exempt hospitals for their billing practices. for example, the executive director of a virginia legal services organization told stories of clients who had received inflated bills even from tax-exempt hospitals that had financial aid policies, but failed to make patients aware of those policies. 52 in response to these and similar criticisms, lawmakers have proposed several changes to the legal framework for tax-exempt hospitals. in particular, legislators have developed several proposals. first, in the early 1990s, in connection with a series of hearings and a gao report very similar to the 2008 irs report, two members of congress introduced legislation to tighten and make more specific the rules for taxexempt hospitals. representative edward roybal’s plan would have mandated that taxexempt hospitals maintain “open door” policies, and spend 50% of the value of their tax exemptions on unreimbursed charity care and 35% on unspecified “community benefits.” 53 representative brian donnelly’s bill would have obligated tax-exempt hospitals to provide uncompensated care of at least 5% of their annual gross revenues. 54 in the alternative, tax-exempt hospitals could maintain exemptions by serving as the only hospitals in their communities, taking certain percentages of patients on medicare or medicaid, or devoting 10% of their gross revenues to “qualified services to the community.” 55 the first decade of this century also saw two legislative proposals regarding taxexempt hospitals. in 2006, representative bill thomas introduced a bill that would have required tax-exempt hospitals to charge no more than $25 per medically necessary visit to patients with annual household incomes up to 100% of the federal poverty line. additionally, tax-exempt hospitals would have been unable to charge patients whose household incomes were between 100% and 200% of the federal poverty line more than bills are arrested; it’s a ‘body attachment’, wall st. j. (oct. 30, 2003, 12:01 am), http://online.wsj.com/news/articles/sb106745941349180300 [hereinafter lagnado, extreme measures]. 47 lagnado, anatomy, supra note 46. 48 id. 49 id. 50 id.; lagnado, extreme measures, supra note 46. 51 see generally taking the pulse of charitable care and community benefits at nonprofit hospitals: hearing before the senate comm. on fin., 109th cong. (2006) [hereinafter taking the pulse]; tax-exempt hospital sector, supra note 36. 52 taking the pulse, supra note 51, at 16-18 (statement of ray hartz, executive director, legal aid society of eastern virginia, inc., norfolk, va). 53 h.r. 790, 102d cong. (1991). 54 h.r. 1374, 102d cong. (1991). 55 h.r. 1374, 102d cong. (1991). 44 columbia journal of tax law [vol.6:33 health insurers’ average rate for care. 56 then, in 2007, senator chuck grassley released a “discussion draft” of potential legislative proposals that he was considering—a draft that would have large ramifications. the draft included a series of new rules for tax-exempt hospitals, among them, changes to hospitals’ financial policies and a mandatory charity care minimum equal to 5% of revenues. 57 of these various proposals to reform the legal framework for tax-exempt hospitals, the roybal, donnelly and thomas plans never moved beyond draft stage. the grassley discussion draft, however, while never actually becoming law, set the stage for the new rules for tax-exempt hospitals contained in the affordable care act. as subpart ii.c will now describe, the law that eventually passed adopted some form of senator grassley’s recommendations both about financial aid policies and about “community health needs assessments”—a consequential idea that was new to the discussion. notably, the aca did not include any quantitative thresholds for charity care or community benefits. c. additional hospital-specific requirements for tax-exemption under the affordable care act in 2010, as part of the aca, congress passed new legislation governing the behavior of tax-exempt hospitals. these rules followed in the steps of senator grassley’s discussion draft. the new rules concerned hospitals’ financial policies and methods of assessing their communities’ needs. the following subpart ii.c.1 will briefly describe the aca’s framework regarding tax-exempt hospitals, including the related draft regulations that the irs and the treasury department have subsequently promulgated. 1. community health needs assessments first, the affordable care act required tax-exempt hospitals to conduct, every three years, a “community health needs assessment” (a “chna”). 58 under these new rules, the hospital must also adopt an implementation strategy to meet the community health needs identified through the chna. 59 the legislation specifies that the chna must take into account input from persons who represent the broad interests of the community “served by the hospital facility” including those with special public health expertise. 60 the hospital must publicize the chna “widely.” 61 hospitals that fail to meet this requirement must pay a $50,000 excise tax. 62 in april of 2013, proposed regulations came out regarding the community health needs assessment requirement. 63 (the irs and the treasury department plan to publish final regulations by the end of 2014.) 64 because some version of the proposed regulations will soon go into effect, they merit special attention for the purposes of this article. the proposed regulations address a number of issues emerging from the new 56 h.r. 6420, 109th cong. (2006). 57 see senate committee on finance—minority, tax exempt hospitals: discussion draft, tax notes today, july 18, 2007, at 140. 58 i.r.c. § 501(r)(3)(a)(i) (2012). 59 i.r.c. § 501(r)(3)(a)(ii) (2012). 60 i.r.c. § 501(r)(3)(b)(i) (2012). 61 i.r.c. § 501(r)(3)(b)(ii) (2012). 62 i.r.c. § 4959 (2012). 63 community health needs assessments for charitable hospitals, 78 fed. reg. 20523 (proposed apr. 5, 2013). 64 david van den berg, irs hopes to publish final charitable hospital regs by year-end, tax notes today, apr. 15, 2014. 2014] tax-exempt hospitals and their communities 45 statute. of particular importance, the irs and the treasury department considered how a hospital should identify its “community” for the purposes of assessing these communities’ needs. specifically, the proposed regulations provide a hospital facility with the flexibility to take into account all of the relevant facts and circumstances in defining the community it serves, including the geographic area served by the hospital facility, target populations served (for example, children, women, or the aged), and principal functions (for example, focus on a particular specialty area or targeted disease). 65 the earlier draft regulations had noted that, “the treasury department and the irs would expect a hospital facility’s community to be defined geographically but that, in some cases, the definition might also take into account target populations served or specialized functions.” 66 consequently, the earlier regulations had requested “comments” on whether the irs and treasury “should define the geographic community of a hospital facility as the metropolitan statistical area (msa) or micropolitan statistical area (µsa) in which the facility is located or . . . the county in which the facility is located.” 67 however, the later proposed regulations explained that many of the comments the irs and treasury had received supported a “facts-and-circumstances approach” to defining community and “recommended against a definition based on specified geographic boundaries.” 68 advocates of this more flexible approach observed that, “each hospital facility is in the best position to determine its community.” 69 politically defined boundaries such as msas or counties might not, according to the comments, accurately represent the group the hospital serves. 70 on the other hand, the proposed regulations do express concerns, apparently shared in some comments to the earlier draft, about “ensuring that hospital facilities assess and address the needs of medically underserved, low-income, and minority populations in the areas they serve.” 71 in response, the proposed regulations specify that a hospital facility may not “define its community in a way that excludes medically underserved, low-income, or minority populations who are part of its patient populations, live in geographic areas in which its patient populations reside or . . . otherwise should be included” based on the hospital’s selected definition of community. 72 hospital facilities can only exclude these groups from their preferred definition of community if “they are not part of the hospital facility’s target populations or affected by its principal functions.” 73 the proposed regulations define “medically underserved populations” as those “experiencing health disparities or at risk of not receiving adequate medical care as a result of being uninsured or underinsured or due to geographic, language, financial, or other barriers.” 74 65 community health needs assessments for charitable hospitals, 78 fed. reg. at 20529. 66 id. at 20528. 67 id. at 20529. 68 id. 69 id. 70 id. 71 id. 72 id. 73 id. 74 id. 46 columbia journal of tax law [vol.6:33 the proposed regulations go on to give more detail about what the chnas and associated required implementation strategies must involve. the regulations also provide substantial information about how hospitals must document their chnas and implementation plans. 75 for example, hospitals must “identify the organizations that provided input into the chna and summarize the nature and extent of that input,” including a description of “the medically underserved, low-income, or minority populations being represented by the organizations or individuals providing input.” 76 2. financial policies the affordable care act also contains provisions relating to the financial policies of tax-exempt hospitals. under new sec. 501(r)(4), tax-exempt hospitals must establish specific types of written financial assistance policies and written policies relating to emergency medical care. 77 additionally, the aca’s new rules for tax-exempt hospitals and their financial policies limit these hospitals’ ability to charge uninsured patients at inflated rates. in particular, under the aca, a tax-exempt hospital may not charge to the bills of financial-aid-eligible patients amounts for medically necessary care that are greater than the “amounts generally billed” (“agb”) to insured patients. 78 further, tax-exempt hospitals may not bill at chargemaster rates. 79 then, when a taxexempt hospital moves to obtain payment from patients, the hospital must “make reasonable efforts” to determine whether an individual is eligible for financial aid before engaging in “extraordinary collection actions” against the individual. 80 in 2012, the irs and the treasury department issued proposed regulations under these statutory provisions. 81 again, the irs has since announced its intent to finalize these regulations by the end of 2014. 82 the proposed regulations deal with a number of issues arising under the new statutory language about financial policies. for one, the proposed regulations clarify that neither they nor the statute restrict the substance of taxexempt hospitals’ financial assistance policies. no law “mandate[s] any particular eligibility criteria” for assistance. 83 the proposed regulations do set forth the steps a taxexempt hospital has to take to publicize and implement its financial assistance policy. 84 these regulations also take up the issue of how tax-exempt hospitals must calculate charges for financial-aid-eligible patients. 85 turning to the problems of bill payment, the proposed regulations cover in detail permissible debt collection activities under the aca requirements. grappling with a controversial issue, the treasury department and the irs have set forth practices that constitute “extraordinary collection actions.” 86 these include any “actions taken by a hospital facility against an individual related to obtaining payment of a bill . . . that require a legal or judicial process.” 87 the proposed regulations list as examples placing a 75 id. at 20531-23222. 76 id. at 20532. 77 i.r.c. § 501(r)(4) (2012). 78 i.r.c. § 501(r)(5)(a) (2012). 79 i.r.c. § 501(r)(5)(b) (2012). 80 i.r.c. § 501(r)(6) (2012). 81 additional requirements for charitable hospitals, 77 fed. reg. 38148 (proposed june 26, 2012). 82 van den berg, supra note 64. 83 additional requirements for charitable hospitals, 77 fed. reg. at 38151. 84 id. at 38152–53. 85 id. at 38151–55. 86 id. at 38155–56. 87 id. at 38156. 2014] tax-exempt hospitals and their communities 47 lien on an individual’s property, foreclosing on an individual’s real property, attaching or seizing a bank account or other personal property, commencing a civil action, causing an arrest, subjecting an individual to a writ of body attachment, and garnishing wages. 88 extraordinary collection actions also include reporting a debt to a credit agency and selling a debt to a third party, even though neither of these things may require a legal or judicial process. 89 however, merely turning a debt over to a collection agency without actually selling the debt does not count as an extraordinary collection action. 90 neither does refusing care to a patient because the patient has previously failed to pay a bill in full. 91 the regulations clarify in great detail what “reasonable efforts” the hospital has to take to determine financial aid eligibility that tax-exempt hospitals have to take before they can engage in one of the extraordinary collection actions. 92 this new aca framework for tax-exempt hospitals diverges in several important respects both from the law that came before it and from the reform proposals of the 1990s and 2000s. by providing such specific rules governing the minutiae of the practices of tax-exempt hospitals, the aca requirements are a far cry from the pre-2010 world in which tax-exempt hospitals had near-complete freedom to decide how they would comply with the laws for tax exemption. on the other hand, the aca, unlike any of the previous reform proposals, does not obligate tax-exempt hospitals to provide any set amount of charity care or community benefit. instead, the aca legislation and its regulations are almost entirely procedural. hospitals must take carefully orchestrated steps to solicit community feedback, and they must follow many prescribed steps in dealing with patients who may need free or discounted care. however, the law does not include much by way of substantive requirements. for instance, with regard to the chnas, the new law leaves it up to hospitals if and how they will address whatever needs the chnas identify. to take an extreme example, an asset-rich tax-exempt hospital could conduct a chna by soliciting feedback at one community meeting. at that meeting, perhaps a social-service agency might explain that 80% of local residents live below the poverty line and have medical debts from that hospital that they are unable to pay. the hospital would have to report in its chna that the social-service agency gave feedback as part of the chna process, and that report arguably would have to reveal what the feedback was. however, then, in the chna or implementation strategy, the hospital could write that, in its judgment, it was financially unable to provide any free care or reduce any outstanding debts. the hospital would have fulfilled its obligation under the chna rules. similarly, under the new rules, a tax-exempt hospital could have a financial aid policy that says, “we do not offer free or discounted care.” the hospital could then still bill a poor patient at chargemaster rates. if the patient did not pay, the hospital would have to make sure he or she is ineligible for financial aid, which would presumably be an easy decision under a policy that says no one is eligible for free or discounted care. after making and documenting that determination, the hospital could foreclose on the patient’s house, again having fully complied with the new law. 88 id. 89 id. 90 id. 91 id. 92 id. at 38156-59. 48 columbia journal of tax law [vol.6:33 that is not to say that most tax-exempt hospitals, or even any tax-exempt hospital, would behave in this way. in designing the affordable care act, members of congress may have believed, perhaps correctly, that requiring certain procedural steps makes hospitals more likely to decide on their own to implement programs that respond effectively to the needs of poor communities, to adopt generous financial aid policies, and to refrain from extraordinary collection actions. however, because congress did not choose to enact substantive community benefit requirements, the broad question remains: after the 2010 reforms, what are hospitals doing to benefit their communities? more narrowly, are hospitals in fact responding to the needs of their communities? what kinds of financial aid policies have hospitals enacted? are any of these policies associated with increased levels of free or discounted care? are hospitals regularly engaging in extraordinary collection actions? part iii attempts to address these previously unanswered questions using a comprehensive set of new empirical data. part iii lays the groundwork for this analysis by elaborating on these questions, examining previous scholarship on the topic, and describing the data and methods of the study. iii. questions, literature, data, and methods part iii will discuss the data and methods that are the basis of this article’s empirical analysis of tax-exempt hospitals. part iii.a will describe the specific questions that this analysis addresses. part iii.b will briefly examine previous scholarship relating to these questions. part iii.c will describe the dataset the article uses, and part iii.d will explain the statistical models employed to analyze the data. a. questions asked this article uses newly available data from schedule h to irs form 990, the tax-exempt organization’s annual tax return, to assess, in light of the ongoing debate over the aca, what types of community benefits tax-exempt hospitals are currently providing and what kinds of financial aid and debtcollection policies they have adopted. the schedule h data provide a timely opportunity to address these questions. schedule h is a schedule that all tax-exempt hospitals must file as part of their annual obligation to file tax returns. it asks hospitals for detailed information regarding the financial assistance and other community benefits they provide; their “community-building activities”; their bad debt and collections policies; and their individual facilities. 93 the irs first required schedule h in 2008. 94 before 2008, hospitals did not have to report at the federal level any information about their community benefits or financial policies. 95 hospitals merely filled out the same tax return as any other tax-exempt organization. as a result, before 2008, no comprehensive data was available about how and to what extent tax-exempt hospitals were meeting the community benefit standard or what financial policies they might have in place. even the irs itself, when it set out to study the problem of tax-exempt hospitals in the mid-2000s had to rely on a survey sent 93 internal revenue serv., sched. h, form 990 (2013), available at http://www.irs.gov/pub/irsprior/f990sh--2013.pdf. 94 schedule h: prior year products, internal revenue serv. http://apps.irs.gov/app/picklist/list/priorformpublication.html?resultsperpage=200&sortcolumn=sortorder& indexoffirstrow=0&criteria=formnumber&value=990+%28schedule+h%29&isdescending=false (last visited aug. 24, 2014). 95 internal revenue serv., instructions for form 990 and form 990-ez (2007), available at http://www.irs.gov/pub/irs-prior/i990-ez--2007.pdf. 2014] tax-exempt hospitals and their communities 49 out only to a subset of hospitals. the survey method, in addition to the problem of capturing only a fraction of the tax-exempt hospital sector, did not allow direct comparisons among hospitals, because the hospitals lacked clear definitions of terms such as “community benefit.” in the instructions to the schedule h, however, the irs implemented standard definitions for the different figures hospitals now have to report. as a result, schedule h for the first time offers a complete and comprehensive look at the tax-exempt hospital sector, its community benefits and its financial practices. this article uses a large schedule h dataset from 2012 to answer two broad questions emerging from the traditional and new legal requirements for tax-exempt hospitals. the first deals with community benefits, the second with hospital policies, and practices. first, and most basically: how much community benefit are tax-exempt hospitals now providing? specifically: (i) which types of benefits are most common? (ii) do these benefits differ according to the characteristics of hospitals and of the communities where the hospitals are located? and (iii) do benefits vary according to types of hospital policies or practices? second, in what financial policies are tax-exempt hospitals actually engaging? within that, are certain types of policies associated with certain community or hospital characteristics? these questions arise directly from the traditional and new aca requirements for tax-exempt hospitals. as discussed above, the traditional requirements adopt a broad notion of community benefit. this raises the question: given latitude to select the type and amount of community-related endeavors in which they engage, how much community work will hospitals choose to do? which particular activities will they select? now the aca has grafted the criterion of the concept of community responsiveness onto this traditional notion of community benefit. the chna provisions described above suggest that, in deciding what to do for their communities, hospitals should be weighing their communities’ particular needs. the idea that a hospital should be responsive to its community raises the question: are certain community characteristics associated with the ways in which hospitals choose to relate to their communities? for instance, will a hospital in a rural community select a different package of community activities than a hospital in an urban community? the new requirements also supplement the traditional community benefit standard by emphasizing hospitals’ financial policies. however, at the time congress passed the aca, legislators had no comprehensive data on how common the regulated practices were among hospitals. as a result, the question remains: among these controversial practices and policies, which types are actually pervasive? then, in terms of these financial questions and the community responsiveness criterion, how do hospital policies and practices vary by community characteristics? b. relationship to previous scholarship to date, questions about what tax-exempt hospitals are doing to benefit their communities have produced few answers—and even fewer points of agreement among researchers. perhaps because no comprehensive data was available prior to the schedule h, legal scholarship itself has not generally approached the topic of tax-exempt hospitals from an empirical perspective. this article is the first of which i am aware that assesses either the traditional or the new requirements for tax-exempt hospitals using data analysis of the tax-exempt hospital sector. insofar as studies have explored questions about tax-exempt hospitals and community benefits empirically, that scholarship has come not from the legal academy, 50 columbia journal of tax law [vol.6:33 but from the field of public health research. even here, however, only three studies of which i am aware have tapped at all into the schedule h data. among these, the primary study, which appeared in the new england journal of medicine in 2013, offered suggestive preliminary observations about some of schedule h’s community-benefit estimates. 96 specifically, in this study, public health professor gary young and his collaborators found that, in fiscal year 2009, tax-exempt hospitals spent 7.5% of their operating expenses on “community benefits,” as defined on the schedule h. 97 if hospitals had been allowed to add bad debt to this calculation, that figure would have risen to 11%. 98 of these expenditures, more than 85% went to charity care and “other patient care services.” 99 of the remaining community benefit expenditures, hospitals spent about 5% on community health improvements. 100 hospitals in the top decile for spending on community benefits devoted approximately 20% of operating expenses to community benefits, while hospitals in the bottom decile spent approximately 1%. 101 further, professor young and his collaborators found that hospitals that provided one type of community benefit were not more likely to provide another kind of benefit. 102 they also found that those hospitals that covered more of (what they called) “patient care” expenses tended to be in states that had community benefit reporting regimes. 103 in addition, hospitals that supplied more of (what the authors called) “community service” expenses tended to be teaching hospitals that were also the sole hospitals in their communities. 104 hospitals in the west provided more community benefits generally. 105 aside from these results, however, young and his collaborators were unable—using county-level demographic data—to find “any pattern of differences between hospitals that provided a relatively high level of community benefits and those that provided a relatively low level.” 106 a second study based on schedule h data examined whether community benefits vary by state. 107 in this case, health policy scholars erik bakken and david kindig found significant differences across states. 108 specifically, tax-exempt hospitals in wyoming, colorado, and vermont spent most on community benefits, devoting more than 11% of hospital resources to them. north dakota hospitals had the lowest state average at 3.76%. 109 turning to per capita figures, the authors calculated the national average community benefit at $119 per person annually, but with a range from $30 per capita in alabama to $335 per capita in vermont. 110 96 gary j. young et al., provision of community benefits by tax-exempt u.s. hospitals, 368 new eng. j. med. 1519 (2013). 97 id. at 1519. 98 id. at 1526. 99 id. at 1519. 100 id. 101 id. 102 id. at 1523. 103 id. 104 id. 105 id. 106 id. 107 erik bakken & david kindig, does nonprofit hospital community benefit vary by state?, j. pub. health mgmt. & prac. (forthcoming 2014). 108 see generally id. 109 id. at 3. 110 id. 2014] tax-exempt hospitals and their communities 51 the third study using schedule h data focused only on california tax-exempt hospitals. this research found that, in 2009, aggregate community benefit expenses amounted to 11.5% of hospitals’ total operating expenses. 111 “uncompensated care” made up 53.7% of the total. hospitals varied widely in their community benefit totals. the lowest quartile in terms of community benefit expenditures spent less than 7% of these on community benefit, whereas hospitals in the top quartile spent 16% or more. charity care ranged from 0% to 6.3% of operating expenses. this study also provided descriptive statistics for each of the other categories of community-related activities on the schedule h. before the schedule h data became available, a handful of other scholars also examined tax-exempt hospitals and community benefits. using a variety of state-level rather than national-level datasets, however, their studies produced an assortment of discrepant findings. in 2009, for instance, health policy researchers brad gray and mark schlesinger used 2001 data from maryland to get a picture of hospital community-related activity in at least one state. 112 the gray and schlesinger study found that reported community benefit spending increased after maryland implemented a community benefit reporting requirement. 113 the maryland data also showed that “the amount and forms of community benefit activities var[ied] widely among hospitals.” 114 also using the maryland data, public health professor simone rauscher singh found that nonprofit hospitals do not make tradeoffs among different types of community benefits. 115 taking a more normative stance, health policy scholars gloria bazzoli, jan p. clement, and hui-min hseih used data from california and florida to contend that hospitals were failing to provide “adequate” community benefits (except insofar as the researchers counted bad debt and medicare shortfalls toward their totals). 116 however, in earlier work, bazzoli and her team found that tax-exempt hospitals did in fact provide more community benefits than did their for-profit counterparts. 117 pharmacology professor amy davidoff and her collaborators arrived at the same conclusion, 118 as did 111 simone rauscher singh, community benefit in exchange for non-profit hospital tax exemption: current trends and future outlook, 39 j. health care fin. 32, 35 (2013). see generally daniel b. rubin et al., evaluating hospitals’ provision of community benefit: an argument for an outcomebased approach to nonprofit hospital tax exemption, 103 am. j. pub. health 612 (2013) (exploring schedule h critically, but not independently analyzing its data). 112 bradford h. gray & mark schlesinger, charitable expectations of nonprofit hospitals: lessons from maryland, 28 health aff. w809, w810 (2009). 113 id. at w814. 114 id. at w815. 115 simone rauscher singh, not-for-profit hospitals’ provision of community benefit beyond charity care: is there a trade-off between free medical care and other health services provided to the community?, 39 j. health care fin. 42 (2013). 116 gloria j. bazzoli et al., community benefit activities of private, nonprofit hospitals, 35 j. health pol., pol’y & l. 999 (2010). 117 gloria j. bazzoli et al., the influence of health policy and market factors on the hospital safety net, 41 health services research 1159 (2006). 118 amy j. davidoff et al., the effect of changing state health policy on hospital uncompensated care, 37 inquiry 253 (2000). 52 columbia journal of tax law [vol.6:33 the congressional budget office 119 and public health expert kenneth thorpe and his coauthors. 120 in contrast to these findings, economist helen schneider—defining “adequate” community benefit using the sum of for-profit hospital uncompensated care and the federal and state income taxes they paid—found that tax-exempt hospitals were not providing enough in terms of community benefit. 121 along similar lines, public health researchers michael morrisey, gerald wedig, and mahmud hassan argued that 20% to 40% of nonprofit hospitals provided insufficient uncompensated care relative to a forprofit benchmark. 122 human ecologist sean nicholson and his collaborators reached consistent conclusions, 123 as did economists edward norton and douglas staiger, 124 as well as health researcher janet sutton and her team. 125 other scholars assessed tax-exempt hospitals’ community benefits by evaluating whether tax-exempt hospitals provide access to services that for-profit hospitals do not. in a series of papers, legal scholar and health economist jill horwitz found that nonprofit hospitals are particularly likely to provide less profitable health services, including many, like mental health services, that communities may desperately need. 126 in another study, business school professor regina herzlinger and economist william krasker found that, in terms of the scope of hospital services, the number of emergency room visits and participation in health professions education, nonprofit hospitals were not generally different from for-profit hospitals. 127 in a similar study, however, health policy scholars barbara arrington and cynthia haddock reached the opposite result. 128 a few studies have attempted to use state-level or other limited datasets to determine why some tax-exempt hospitals provide more community benefits than others. for example, health administration scholars alva o. ferdinand, josué patien epané, and 119 cong. budget office, pub. no. 2707, nonprofit hospitals and the provision of community benefits, (2006), available at http://www.cbo.gov/sites/default/files/cbofiles/ftpdocs/76xx/doc7695/12-06-nonprofit.pdf. 120 kenneth e. thorpe et al., the impact of hmos on hospital-based uncompensated care, 26 j. health pol., pol’y & law 543 (2001). 121 helen schneider, paying their way? do nonprofit hospitals justify their favorable tax treatment?, 44 inquiry 187 (2007). 122 michael a. morrisey et al., do nonprofit hospitals pay their way?, 15 health aff. 132 (1996). 123 sean nicholson et al., measuring community benefits provided by for-profit and nonprofit hospitals, 19 health aff. 168 (2000). 124 edward c. norton & douglas o. staiger, how hospital ownership affects access to care for the uninsured, 25 rand j. of econ. 171 (1994). 125 janet p. sutton et al., the role of private hospitals in the california healthcare safety net: a comparison of charitable contributions reported by the for-profit and non-profit hospitals in 1998, 2 pub. pol’y brief h series 6 (2002). 126 see generally jill r. horwitz & austin nichols, what do nonprofits maximize? nonprofit hospital service provision and market ownership mix, (nat’l bureau of econ. research, working paper no. 13246, 2007), available at http://www.nber.org/papers/w13246.pdf; jill r. horwitz, does corporate ownership matter? service provision in the hospital industry, (nat’l bureau of econ. research, working paper no. 11376, 2005), available at http://www.nber.org/papers/w11376.pdf; jill r. horwitz, nonprofit ownership, private property, and public accountability, 25 health aff.w308 (2006); jill r. horwitz, why we need the independent sector: the behavior, law, and ethics of not-for-profit hospitals, 50 ucla l. rev. 1345 (2003). 127 regina e. herzlinger & william s. krasker, who profits from nonprofits?, harv. bus. rev., jan.-feb. 1987, at 93. 128 barbara arrington & cynthia carter haddock, who really profits from not-for-profits?, 25 health services res. 291 (1990). 2014] tax-exempt hospitals and their communities 53 nir menachemi relied on american hospital association survey data to argue that religious hospitals engage in a significantly higher number of community-benefiting activities than other hospital ownership types. 129 this team also found that all hospitals increased their average amount of community benefits during times of economic growth, and that organizational size, teaching facilities, and urban location were all associated with higher levels of community benefits. 130 another public health team found, also using american hospital association survey data, that hospitals with “community health” and “community-based quality” orientations, as identified through features like a mission statement discussing community issues, were more likely to provide community benefits than hospitals without these orientations. 131 a different study found that community orientation itself varied by hospital characteristics and tended to be more significant in hospitals that are large, part of a network of hospitals, dependent on managed care, and located in communities with diffuse community activities. 132 in a study with significant policy implications, business school professor frances kennedy and her collaborators employed data from texas to explore the impact of a 1993 texas law that required tax-exempt hospitals to expend a fixed level of net revenue (generally 4%) on charity care to find that the law had actually led to a decrease in the total amount of charity care provided. 133 relatedly, using american hospital association survey data, a team of public health researchers considered states that had passed laws governing tax-exempt hospital community benefits. 134 this study found that, on average, nonprofit hospitals in the ten states with some type of community benefit law reported significantly more community health orientation activities than nonprofit hospitals in the forty other states. 135 in addition, for-profit hospitals in the ten states with laws/guidelines reported significantly more community health orientation activities than did the investorowned hospitals in the forty other states. 136 the same researchers examined similar issues in 2009 with slightly different results. 137 several other studies have looked at particular aspects of the notion of community benefit. for instance, pediatrics professor peter szilagyi and his collaborators examined community engagement by academic health centers and also proposed a formal framework for evaluating this practice. 138 medical school professor 129 alva o. ferdinand et al., community benefits provided by religious, other nonprofit, and forprofit hospitals: a longitudinal analysis 2000-2009, 39 health care mgmt. rev. 145 (2014). 130 id. at 151–52. 131 gregory o. ginn & charles b. moseley, community health orientation, community-based quality improvement, and health promotion services in hospitals, 49 j. of healthcare mgmt. 293 (2004). 132 e. jose proenca et al., community orientation in hospitals: an institutional and resource dependence perspective, 35 health serv. res. 1011 (2000). 133 frances a. kennedy et al., do non-profit hospitals provide more charity care when faced with a mandatory minimum standard?:
evidence from texas, 29 j. acct. & pub. pol’y 242 (2010). 134 gregory o. ginn & charles b. moseley, the impact of state community benefit laws on the community health orientation and health promotion services of hospitals, 31 j. health pol., pol’y & l. 321 (2006). 135 id. at 321. 136 id. 137 gregory o. ginn et al., community benefit laws, hospital ownership, community orientation activities, and health promotion services, 34 health care mgmt. rev. 109 (2009). see also charles b. moseley et al., the long-term coercive effect of state community benefit laws on hospital community health orientation, 7 nev. j. pub. health 14 (2010). 138 peter g. szilagyi et al., evaluating community engagement in an academic medical center, 89 acad. med. 585 (2014). 54 columbia journal of tax law [vol.6:33 lloyd michener and two teams of researchers also assessed ways in which academic health centers can respond to community needs. 139 behavioral and community health scientist jessica burke and her collaborators considered a range of hospital community engagement projects that had been proposed in print and found that hospitals had formally evaluated very few of them. 140 public health scholar jeffrey alexander and his team looked at the efforts of hospitals to be accountable to their communities and found that freestanding hospitals were more likely to achieve accountability through governance structures, whereas system-affiliated hospitals preferred to do so through active boards. 141 c. dataset and variables to put our knowledge of tax-exempt hospitals on more solid empirical foundations, this article uses newly available schedule h data to answer questions about tax-exempt hospitals, the benefits they provide, and their financial practices. 142 consequently, the primary source of data consisted of irs form 990 and its attached schedule h for tax year 2012. i focused on 2012 because it was the most recent year for which complete data was available. i obtained these data from guidestar, an organization that collects, digitizes, and sells information on the entire population of u.s. tax-exempt organizations’ forms 990 and attached schedules. because the data consist of the entire population, sampling issues did not arise. the dataset i received from guidestar included schedule h data from 2636 taxexempt hospitals nationwide. upon inspection, however, i saw that some of these materials actually pertained to tax years other than 2012, so when i removed those observations, i had a total of 2158 forms 990 and their schedules h. to correct for human error, for the primary quantitative variables in which i was interested, i reviewed the hospitals’ entries to determine whether entries that were supposed to be the sums or quotients of other entries actually were. this process revealed a handful of what i believed to be data entry errors, in which case i pulled the individual form 990 or schedule h in question and, where appropriate, filled in what should have been the correct answer. i also looked for similar data-entry errors with regard to variables that were not sums or quotients. occasionally, fixing what seemed to be an unreasonable answer to a question required either pulling the original form 990 or schedule h (to fill in the correct answer) or finding other relevant documentation from the hospital in question—for instance, its financial aid policy—to supply a sensible response to the question. i then merged the hospital irs filings with the data from the 2008-2012 five-year american community survey from the u.s. census bureau. 143 past studies of taxexempt hospitals have used data reported for broad geographic regions, such as counties, to measure the characteristics of the communities where hospitals are located. however, 139 lloyd michener et al., aligning the goals of community-engaged research: why and how academic health centers can successfully engage with communities to improve health, 87 acad. med. 285 (2012); j. lloyd michener et al., improving the health of the community: duke’s experience with community engagement, 83 acad. med. 408 (2008). 140 jessica g. burke et al., what can be learned from the types of community benefit programs that hospitals already have in place?, j. health care for poor & underserved, feb. 2014, at 165. 141 jeffrey a. alexander et al., community accountability among hospitals affiliated with health care systems, 78 milbank q. 157 (2000). 142 from this point forward, when referring to tax-exempt hospitals, i will use the shorthand “hospitals,” because all hospitals in the dataset are tax-exempt. 143 american community survey: 2012 data release, u.s. census bureau, http://www.census.gov/acs/www/data_documentation/2012_release/ (last visited aug. 24, 2014). 2014] tax-exempt hospitals and their communities 55 the patient base at many hospitals, particularly in urban areas, draws more heavily from neighborhoods immediately surrounding the hospitals than it does from entire counties. for example, in chicago, the university of chicago hospital, located on the city’s historically impoverished south side, serves a community distinct from the one served by northwestern hospital—north shore, located across the metro area from the south side in the wealthy suburb of evanston. in order to capture intra-urban community differences such as these, i matched each hospital with the specific census tracts that fell within five miles. for the purposes of this study, those census tracts in the five-mile radius constituted the hospital’s community. i then created composite demographic variables for each of these communities using the american community survey data. specifically, for each community, i obtained a measure of the percent of its population that is black and hispanic (“percent black” and “percent hispanic”), the percent of its population living below 100% of the poverty line (“percent below 100 fpl”), the percent of its population living between 100149% of the poverty line (“percent 100-149 fpl”), the average age of its residents (“age”), its population density (“population density”), the percent of its population with private insurance (“percent privately insured”) and the percent of its population with public insurance (“percent publicly insured”). i then matched these demographic data with their hospitals. following this, i merged the hospital and american community survey data with a dataset available from the hilltop institute at the university of maryland-baltimore county, which contains information about the laws in each state governing nonprofit hospitals and their community benefit. 144 this dataset included the following variables. “unconditional requirement” measures whether the state in which the hospital is located requires all hospitals in the state to provide some community benefits, broadly defined. 145 “conditional requirement” measures whether the state in question made its tax or regulatory benefit conditional on whether the hospital provided community benefits. 146 “mandatory minimum” measures whether the state required a hospital to provide a quantifiable amount of community benefit each year. 147 next, i collected a series of variables from the form 990 and the schedule h. i used these to measure the institutional characteristics of hospitals, as well as to obtain the community-activity and financial-policy information. the institutional-level variables i collected were as follows: “gross receipts” (header, line g), which measured each hospital’s gross receipts, “profitability” (part i, line 19) which measured each hospital’s revenues less expenses, and “donations” (part viii, sum of lines 1a, 1b, 1c, 1f, and 1g on form 990), which measured each hospital’s amount received in private donations. 148 then, i collected variables that would measure each hospital’s community activities. here, i used every such variable available on the schedule h. as a result, all the line numbers from this point forward refer to lines on the schedule h. the first group were the charity care expenses, expressed as a percent of each hospital’s total expenses: 144 univ. of md.-balt. cnty., hilltop inst., community benefit state law profiles comparison, hilltop inst., http://www.hilltopinstitute.org/hcbp_cbl_state_table.cfm, (last visited aug. 24, 2014). 145 univ. of md.-balt. cnty., hilltop inst., about the community benefit state law profiles, hilltop inst., http://www.hilltopinstitute.org/hcbp_cbl_about.cfm (last visited aug. 24, 2014). 146 id. 147 id. 148 internal revenue serv., instructions for form 990 return of organization exempt from income tax, at 9-10 (2013) available at http://www.irs.gov/pub/irs-pdf/i990.pdf. 56 columbia journal of tax law [vol.6:33 “uncompensated care” (part i, line 7a(f)), or financial assistance provided at cost, 149 “medicaid costs” (part i, line 7b(f)), 150 and “other costs” (part i, line 7c(f)), or the costs of other government health programs such as the state children’s health insurance program. the next group of variables consisted of the other “community benefit expenses,” again each expressed as a percent of the hospital’s total expenses. the first of these “other community benefit” variables was “community health improvements” (part i, line 7e(f)), which included the costs of programs for the purpose of improving community health or “achiev[ing] a community benefit objective.” 151 examples include scholarships for community members and nurse education. 152 the next variable in the group was “health professions education” (part i, line 7f(f)), which included costs of degree programs for health professionals. 153 the third variable of this set was “subsidized health services” (part i, line 7g(f)), which included the costs of clinical programs that meet a community need and operate at a loss. 154 the fourth was “research” (part i, line 7h(f)) which included the costs of research that enhances public knowledge. 155 the fifth was “hospital contributions”(part i, line 7i(f)), which included the costs of donations the hospital made to other programs. 156 the sixth variable in the group was “total benefits” (part i, line 7k(f)), the sum of all of these “other community benefits” variables plus the three charity care variables. the next variables measuring community benefit were the “community building” variables. each of these measured the extent to which the hospital in question was incurring costs to address social, rather than medical, determinants of health. again, each was expressed as a percent of the hospital’s total expenses. the irs views “community building” as technically separate from “community benefit,” although, colloquially, community building would seem to be a type of community benefit. as a result of the irs’s view, community building activities are separate on the schedule h from the community benefit activities and do not count toward the community benefit total. to give a sense of what counts as community building, the first community building variable, “physical improvements” (part ii, line 1(f)), included costs to provide and rehabilitate housing for vulnerable populations. 157 the second, “economic development” (part ii, line 2(f)), included costs of helping small businesses in vulnerable neighborhoods and creating job opportunities in areas of need. 158 the third, “community support” (part ii, line 3(f)), included the costs of childcare, mentoring, violence prevention, and public health emergency activities. 159 the fourth, “environmental improvements” (part ii, line 4(f)), included the costs of addressing environmental hazards that affect the local community. 160 the fifth, “leadership development and training for 149 internal revenue serv., instructions for schedule h (form 990) at 12 (2013), available at http://www.irs.gov/pub/irs-pdf/i990sh.pdf. 150 id. at 14. 151 id. at 15. 152 id. at 17. 153 id. 154 id. at 18. 155 id. 156 id. at 20. 157 id. at 4. 158 id. 159 id. 160 id. 2014] tax-exempt hospitals and their communities 57 community members” (part ii, line 5(f)), included the costs of training community members in conflict resolution, civic, cultural, or language skills. 161 the sixth, “coalition building” (part ii, line 6(f)), included the costs of working with community partners on community health issues. 162 the seventh, “community advocacy” (part ii, line 7(f)), included the costs of supporting policies to advance public health. the eighth, “workforce development” (part ii, line 8(f)), included the costs of recruiting health professionals to underserved agencies. 163 the ninth, “other community building” (part ii, line 9(f)), included the costs of any other activities in which the hospital engaged that might protect its community’s health and safety. 164 the final, “total community building” (part ii, line 10(f)), was an aggregate of all of the “community building” variables. 165 finally, i collected variables assessing whether hospitals had certain financial policies in place. here, i used the answers to every policy question on the schedule h. these policies pertained, among other things, to whether hospitals had adopted financial aid and emergency care policies, what debt collection policies hospitals had in place, and the thresholds at each hospital above which free and discounted care were available. d. statistical models used to begin, i used descriptive statistics to determine, as a general matter, how much in total community benefits, as well as in total community building costs, taxexempt hospitals were providing. i also used descriptive statistics to describe the eligibility levels for free and discounted care at each hospital. i then used a series of ordinary least squares (“ols”) multiple-regression models to estimate which community and hospital characteristics were associated with those factors. 166 an ols model estimates the relationship between different variables in a data set. to illustrate: an ols model could help interpret the relationship between lung cancer (the “dependent” variable) and smoking (the “independent” variable) in the following manner. with data about how many people have died from lung cancer in a given year and how many cigarettes that population consumed, an ols model can provide an estimate of the number of deaths associated with each cigarette smoked. 167 the number of deaths associated with each cigarette smoked would be called the coefficient that the statistical model calculates. if the coefficient for “cigarettes smoked” were, say, 3, that would mean that every cigarette smoked was associated with an additional three deaths. coefficients in ols models can also be negative. if the coefficient for “cigarettes smoked” were -3, that would suggest some very healthy cigarettes at work. specifically, that coefficient would mean that, for the group of smokers under study, every cigarette smoked was associated with 3 fewer deaths. an ols model can also disentangle the relationships among multiple factors. to return to the cigarette example, with additional data about how many cheeseburgers the population consumed, the ols model can show an estimate of the number of deaths 161 id. 162 id. 163 id. at 20–21. 164 id. 165 id. 166 for a description of this model and how to interpret its results, see david s. moore et al., introduction to the practice of statistics 611–42 (8th ed. 2014) and edward r. tufte, data analysis for politics and policy 65–163 (1974). 167 tufte, supra note 166, at 78. 58 columbia journal of tax law [vol.6:33 associated with each cigarette smoked and with each cheeseburger eaten. in this situation, the statistical model calculates a coefficient for each variable analyzed. if the coefficient that the model generated for “cigarettes smoked” was 3 and the coefficient that the model generated for “cheeseburgers eaten” was 1, that would mean that every cigarette smoked was associated with another three deaths, and every cheeseburger eaten was associated with one additional death. the ols coefficients provide a best guess as to the relationship between the variables. the coefficients themselves do not tell us anything about the certainty of that relationship or the effect of chance. to analyze whether mere chance might have produced the relationship, we turn to the concept of statistical significance. if a coefficient is statistically significant, then it is unlikely that there is no actual relationship between the variables. returning to the smoking example, if the coefficient of 3 is statistically significant, the likelihood is small that mere chance produced that value. in the tables i present, asterisks denote statistically significant coefficients. in this study, i used ols models to determine which hospital and community characteristics (the independent variables) were associated with which levels of community building and community benefit activities (the dependent variables). next, i examined hospitals’ current financial policies using descriptive statistics and a technique called principal components analysis, followed by a series of additional ols models to determine which hospital and community characteristics (the independent variables) were driving variations in debt collection policies (the dependent variables). the results of these models are described in part iv below. iv. results to begin with the central question, i examined the total community benefit provided by each hospital. the results are shown in the histogram in figure 1. 2014] tax-exempt hospitals and their communities 59 figure 1: community benefit spending totals by frequency this histogram shows substantial variation in the amount of total community benefit (schedule h, part i, line 7(k)(f)) that tax-exempt hospitals provide, ranging from 0% to 100% of total expenses. however, most hospitals spend between 5% and 10% of total expenses on community benefits. as described above, these totals include charity care costs (the costs of free and uncompensated care) along with the costs of direct community health interventions, health professions education, and medical research. they do not include bad debt or any of the community building activities. next, i performed the same analysis on total community building activities. the results are shown in figure 2. figure 2: community building spending totals by frequency this histogram shows the variation in the amount of total community building costs (schedule h, part ii, line 10(f)) provided by tax-exempt hospitals. this histogram makes evident how much less hospitals spend on community building than on community benefit. even though the community building totals include a number of different activities, most hospitals spend between 0% and 1% of total expenses on community building, with the vast majority spending less than 0.1%. percent of total expenses f re q u e n c y 0 5 0 0 1 0 0 0 1 5 0 0 0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% percent of total expenses f re q u e n c y 0 5 0 1 0 0 1 5 0 2 0 0 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% 60 columbia journal of tax law [vol.6:33 the data in figures 1 and 2 raise the further question of how spending in these two large categories—community benefit and community building—is divided among different subcategories of spending. in other words, what percentage of hospital spending goes toward each of the activities in the larger categories? table 1: breakdown of community benefit and community building spending statistic mean st. dev. min median max uncompensated care 2.58% 4.83% 0.00% 1.77% 100.00% medicaid costs 3.29% 3.68% 0.00% 2.55% 61.58% costs of other gov. program s 0.27% 1.47% 0.00% 0.00% 31.69% total charity care 6.01% 6.33% 0.00% 5.04% 100.00% community health improvements 0.40% 1.75% 0.00% 0.15% 76.43% health professions education 0.61% 1.25% 0.00% 0.07% 10.62% subsidized health services 1.16% 2.73% 0.00% 0.00% 42.28% research 0.22% 1.59% 0.00% 0.00% 43.74% hospital contributions 0.21% 0.96% 0.00% 0.03% 24.17% total other benefits 2.60% 4.10% 0.00% 1.23% 76.43% total community benefits 8.58% 7.48% 0.00% 7.45% 100.00% physical improvements 0.02% 0.27% 0.00% 0.00% 7.70% economic development 0.01% 0.20% 0.00% 0.00% 7.32% community support 0.03% 0.24% 0.00% 0.00% 10.31% environmental improvements 0.001% 0.01% 0.00% 0.00% 0.41% community leadership 0.002% 0.02% 0.00% 0.00% 0.75% coalition building 0.01% 0.11% 0.00% 0.00% 4.72% community advocacy 0.02% 0.16% 0.00% 0.00% 4.54% workforce development 0.03% 0.17% 0.00% 0.00% 4.18% total community building 0.11% 0.48% 0.00% 0.002% 10.31% 2014] tax-exempt hospitals and their communities 61 table 1 presents the means, standard deviations, medians, minimum values, and maximum values for each of the community benefit and community building variables. as was perhaps evident from the histograms in figures 1 and 2, the total charity care and total community benefit figures vary substantially, with the top performers providing charity care equal to 100% of total expenses. as the data indicate, the median amount of spending for charity care is 5.04%, while the mean is 6.01%. these figures just exceed the minimum threshold that senator grassley’s discussion draft legislation would have required had it become law. adding in the other community benefit variables raises the mean value to 8.58% of total expenses and the median to 7.45% of total expenses. of the non-charity-care community benefit variables, community health improvements, health professions education, and hospital contributions have median values above 0%. that indicates that most hospitals engage in some amount of each of these activities. however, while research and subsidized health services have maximum values of 42.28% and 43.74%, revealing that at least one hospital (perhaps a small handful) is spending substantial amounts on these two endeavors, the median value for both of these variables is 0%. most hospitals are spending nothing on research or subsidized health services. turning to the community building figures, the mean amount spent by a taxexempt hospital on community building equals 0.11% and the median is 0.0002%. as the histograms show, hospitals are spending substantially less on community building than they are on community benefit activities. no single community building activity has a median value above 0%. the community building activity with the highest mean value is workforce development, but this value is merely 0.03%. the community building activities with the highest maximum values are physical improvements and community support. at least one hospital spent 7.7% of its total expenses on physical improvements and at least one spent 10.31% of its total expenses on community support. next, i attempted to determine what was driving the variation in spending on community benefit and community building. i observed that more spending on community benefit was not correlated with more spending on community benefit. 168 only six hospitals were in the top hundred for both types of spending. in other words, hospitals that spent more on community building were not especially likely to spend more on community benefit and vice versa. that raised two questions. were any hospital or community characteristics associated with more spending on community benefit? were any such characteristics associated with more spending on community building? to answer these questions, i ran the above-described ols models. the first set of models—models 1, 2, and 3—used total community benefit spending as the dependent variable. total community benefit was the aggregate of all community benefit variables, so hospitals with more community hospitals should be the hospitals identified in the factor analysis as spending more on each of the individual variables. the results of the ols model are given in table 2. 168 the correlation coefficient was 0.13. 62 columbia journal of tax law [vol.6:33 table 2: total community benefit spending according to hospital and community characteristics model 1 model 2 model 3 unconditional requirement 0.107 0.090 0.102 (0.068) (0.071) (0.070) conditional requirement -0.052 -0.024 -0.023 (0.064) (0.067) (0.067) mandatory minimum 0.056 0.005 -0.003 (0.081) (0.084) (0.085) mandated level 0.010 -0.030 -0.045 (0.052) (0.052) (0.052) gross receipts (logged) 0.132 * 0.078 * 0.076 * (0.017) (0.020) (0.020) profitability (millions) -0.0001 -0.0002 -0.0002 (0.0005) (0.0004) (0.0004) number of facilities (logged) -0.054 -0.033 -0.034 (0.050) (0.053) (0.053) donations (millions) 0.002 * 0.003 * 0.003 * (0.001) (0.001) (0.001) percent publicly insured -0.243 -0.894 -0.784 (0.567) (0.615) (0.614) percent privately insured -0.214 -0.440 -0.376 (0.581) (0.618) (0.617) population density (thousands per sq. mi.) 0.017 * 0.017 * 0.017 * (0.006) (0.005) (0.006) age -0.005 -0.012 -0.012 (0.008) (0.008) (0.008) percent black -0.206 -0.280 -0.264 (0.189) (0.200) (0.200) percent hispanic -0.126 -0.300 -0.278 (0.247) (0.262) (0.261) percent below 100 fpl 0.166 -0.151 -0.118 (0.698) (0.744) (0.746) percent 100-149 fpl 2.726 * 2.281 2.406 (1.148) (1.231) (1.236) free care eligibility 0.081 * (0.039) discounted care eligibility 0.043 (0.023) intercept 0.412 2.218 * 2.136 * (0.707) (0.778) (0.780) observations 2,158 1,755 1,752 r 2 0.066 0.060 0.058 2014] tax-exempt hospitals and their communities 63 note: * p<0.05 these results indicate which hospital and community characteristics were associated with higher spending on community benefit. the table shows three models. model 1 does not include any of the variables measuring hospital policies. after running model 1, i also wanted to assess the extent to which hospital policies such as debt collection practices or the content of financial-assistance policies might be associated with higher levels of spending on community benefit. the hospital-policy variables tend to be highly correlated with each other (i.e., a hospital that makes its financial aid policy widely available is more likely to have a policy authorizing debt collection actions), so i included only one of them in a regression model at a time. none of these policies came close to a significant relationship to total community benefits except for two: free care eligibility, the variable that indicates the percentage above the federal poverty line under which free care was available (i.e., free care was available for patients with incomes below 200% of the poverty line); and discounted care eligibility, the variable that indicates the percentage above the federal poverty line under which discounted care was available (i.e., discounted care was available for patients with incomes below 400% of the poverty line). for this reason, table 2 only shows the results of the models that included free care eligibility and discounted care eligibility. model 2 includes free care eligibility, and model 3 includes discounted care eligibility. 169 model 1, which did not include either of the policy variables, indicates that four specific hospital or community characteristics were significantly associated with higher spending on community benefits: gross receipts, donations, population density, and percentage of the population with incomes in between 100% and 149% of the federal poverty line. for example, gross receipts had a coefficient of 0.132, which meant that, for the mean hospital, a 10% increase in gross receipts was associated with a 0.008% increase in expenses devoted to total community benefits. 170 overall, these data showed that hospitals in the category providing more community benefits tended to be larger hospitals in more urban communities with residents living just above the poverty line. in models 2 and 3, gross receipts, donations, and population density were still significantly and positively associated with the percentage of expenses devoted to total community benefit. model 2 showed that free care eligibility was also positively and significantly associated with total community benefit. that means that hospitals that provide free care at higher income levels are more likely to devote more of their expenses to community benefits. in this model, percent 100-149 fpl was positively associated with community benefit spending, but slightly below the statistical significance threshold. 171 that raises the possibility that some or all of the effect of having more community members in that income range on community benefit spending may not be independent of the free care policy. in other words, having more community members in that income range may directly cause hospitals to spend more on community benefit. 169 in each of these models, i applied a square-root transformation to the dependent variable to reduce the skew in the dependent variable. this has the benefit of reducing the impact of what appeared to be a handful of substantial outliers. 170 the reason the effect size is 0.02 rather than 0.132 is because, as discussed, to reduce the effect of outliers, i used a square-root transformation of the dependent variable. that means that the reported coefficients do not by themselves represent the marginal effects of the independent variables. instead, that i have to take the derivative of the ols function to determine the marginal effect of the dependent variable in each case, which is how i arrived at these effect sizes. 171 the effect was significant using a one-tailed test. 64 columbia journal of tax law [vol.6:33 having more community members in that income range may also cause hospitals to adopt financial aid policies with higher thresholds. this result suggests that both of these effects are probably present to some extent. model 3 shows that a higher threshold for the discounted care policy was associated with a greater percent of expenses devoted to community benefit. however, the effect was not quite significant. again, in model 3, percent 100-149 fpl had a positive but not quite significant effect on community benefit spending. again, this suggests a potential indirect effect. perhaps part of the reason that the existence of community members in that income range is associated with higher spending on community benefit is because having more members in that income range makes hospitals more likely to adopt generous discounted-care policies. those generous discounted-care policies may in turn be associated with an increase in community benefit spending. next, i examined which hospital and community characteristics were associated with the hospitals that devoted larger amounts to community building activities. total community building aggregated all of the individual community benefit variables, so i used that as the dependent variable in an ols model. table 3 presents the results. 2014] tax-exempt hospitals and their communities 65 table 3: total community building spending according to hospital and community characteristics model 4 unconditional requirement 0.036 * (0.018) conditional requirement -0.035 * (0.016) mandatory minimum -0.016 (0.021) mandated level -0.001 (0.013) gross receipts (logged) 0.020 * (0.005) profitability (millions) -0.0001 (0.0001) number of facilities (logged) -0.019 (0.013) donations (millions) -0.00004 (0.0002) percent publicly insured 0.017 (0.147) percent privately insured 0.335 * (0.151) population density (thousands per sq. mi.) -0.001 (0.001) age 0.001 (0.002) percent black -0.061 (0.049) percent hispanic 0.021 (0.064) percent below 100 fpl -0.004 (0.181) percent 100-149 fpl -0.339 (0.297) intercept -0.306 (0.183) observations 2,158 r 2 0.027 note: * p<0.05 66 columbia journal of tax law [vol.6:33 these results show that higher spending on community building is significantly associated with being in a state with an unconditional community benefit requirement, with higher gross receipts, and with a higher rate of privately insured individuals. being in a state with a conditional community benefit requirement is associated with lower spending on community building. in short, the data suggest that hospitals in the group spending more on community building tended to be larger and in communities whose residents had private insurance. next, i turned to the question of hospitals’ financial policies. to begin, i examined hospitals’ free and discounted care policies. i started with this issue for two reasons. first, the above analysis of community benefit expenditures suggested that higher free and discounted care thresholds were associated with higher spending on community benefit. given this, determining which hospitals are likely to have higher thresholds offers a further way to understand the variations in community benefit spending across hospitals. second, the new aca regulations are an effort to require hospitals to standardize most of the financial policies they report on the schedule h. in this transition period, not all hospitals have adopted the aca policies and regulations yet, but, presumably, almost all hospitals eventually will. however, these policies and regulations do not govern the free and discounted care thresholds. while both the senator thomas and senator grassley proposals would have required hospitals to provide free or discounted care to patients with incomes below certain percentages of the poverty line, the aca legislation allows hospitals the freedom to set the thresholds as they choose. for this reason, hospital practice regarding the thresholds is allowed to vary widely, and vary widely it does. further, even as the aca regulations take effect, the thresholds may continue to vary in the years to come. that raises the question of why such wide variation exists. the histograms in figures 4 and 5 below show this variation in free and discounted care eligibility. 2014] tax-exempt hospitals and their communities 67 figure 4: hospital free care eligibility levels by frequency figure 5: hospital discounted care eligibility levels by frequency these histograms show wide variation in eligibility levels for free and discounted care across hospitals. the majority of hospitals provide free care for patients with incomes between 100-200% of the poverty line. however, some hospitals require incomes below 100% of the poverty line for free care, and a very small handful allow patients with incomes at 600% of the poverty line to qualify for free care. the discounted care thresholds vary even more substantially. while the largest number of hospitals give discounts on care to patients with incomes up to 400% of the poverty line, significant numbers of hospitals use thresholds around 200% and 300% as well. a few hospitals offer discounts at up to 1000% of the poverty level. to determine what was driving this variation, i ran ols models in which the dependent variables were the thresholds for free and discounted care, and the independent variables were community and hospital characteristics. table 4 presents the results. percent of federal poverty guidelines f re q u e n c y 0 2 0 0 4 0 0 6 0 0 8 0 0 0% 100% 200% 300% 400% 500% 600% percent of federal poverty guidelines f re q u e n c y 0 1 0 0 2 0 0 3 0 0 4 0 0 5 0 0 0% 100% 200% 300% 400% 500% 600% 700% 800% 900% 1000% 68 columbia journal of tax law [vol.6:33 table 4: free and discounted care thresholds according to community and hospital characteristics free care eligibility discounted care eligibility model 7 model 8 unconditional requirement 0.233 * 0.206 * (0.044) (0.072) conditional requirement -0.047 -0.052 (0.042) (0.069) mandatory minimum 0.183 * 0.495 * (0.052) (0.086) mandated level -0.044 0.248 * (0.032) (0.054) gross receipts (logged) 0.066 * 0.153 * (0.012) (0.020) profitability (millions) 0.001 * 0.0004 (0.0003) (0.0005) number of facilities (logged) -0.021 -0.035 (0.033) (0.055) donations (millions) 0.002 * 0.00003 (0.001) (0.001) percent publicly insured 1.051 * -0.476 (0.381) (0.632) percent privately insured 0.764 * 0.139 (0.383) (0.635) population density (thousands per sq. mi.) 0.011 * 0.014 * (0.003) (0.006) age -0.001 -0.008 (0.005) (0.009) percent black 0.516 * 0.511 * (0.124) (0.205) percent hispanic 0.777 * 1.017 * (0.162) (0.268) percent below 100 fpl -1.008 * -2.748 * (0.462) (0.765) percent 100-149 fpl -0.909 -4.611 * (0.765) (1.266) intercept -0.273 1.483 (0.483) (0.801) r 2 0.140 0.197 note: * p<0.05 2014] tax-exempt hospitals and their communities 69 the results for model 7 show that a number of hospital and community characteristics are significantly associated with having higher thresholds for free care. specifically, a state-level unconditional community benefit requirement, a state-level mandatory minimum level of community benefit, gross receipts, profitability, donations, percentage publicly insured, percentage privately insured, population density, percentage black, and percentage hispanic all correspond to a higher threshold for free care. percentage below the poverty line is negatively associated with a higher free care threshold. for instance, in terms of effect sizes, being in a state with an unconditional community benefit requirement is associated with a 23.3% increase in the free care threshold. being in a state with a mandatory minimum amount of community benefit is associated with an 18.3% increase in the free care threshold. overall, the hospitals that provide free care above higher income thresholds tend to be larger and more profitable and tend to receive higher levels of private donations. these hospitals are likely to be located in states with their own community benefit thresholds, as well as in urban areas with higher percentages of black and hispanic community members. however, these hospitals are not necessarily those dealing with notably disadvantaged populations. in fact, these hospitals are more likely to be located in communities where residents have insurance and are above the poverty line. turning to model 8, the results show that being in a state with an unconditional community benefit requirement, as well as with a mandatory minimum level of care, is significantly associated with a higher discounted care threshold. being in a state with rules about free and discounted care thresholds is also significantly associated with a higher discounted care threshold. gross receipts, population density, percentage black and percentage hispanic are also significantly associated with higher discounted care thresholds, and percentage below the poverty line is significantly associated with lower discounted care thresholds. next, i examined the other financial policy variables on which the schedule h gathers data. first, i considered whether hospitals are in fact adopting these policies, many of which are explicitly required by the proposed regulations. the others are policies that the irs presumably seeks to encourage by asking about on the form. table 5 shows the extent to which hospitals are enacting these policies. 70 columbia journal of tax law [vol.6:33 table 5: hospital financial policies by percent of hospitals adopted policy percent did the organization have a financial aid policy? 98.02% if yes, was it a written policy? 97.36% did the organization budget amounts for free or discounted care provided under the financial assistance policy? 90.31% did its expenses exceed budget? 55.51% was the organization unable to provide some care as result? 0.88% have a financial aid policy? 82.56% used federal poverty guidelines to determine eligibility for providing free care? 79.74% used fpg to determine eligibility for providing discounted care? 74.80% explained the basis for calculating amounts charged to patients? 78.02% income level? 74.58% asset level? 50.18% medical indigence? 49.34% insurance status? 45.33% uninsured discount? 45.55% medicaid/medicare? 42.91% state regulation? 30.13% other? 11.63% explained the method for applying for financial assistance? 81.67% did the organization prepare a community benefit report during the tax year? 77.71% if yes, did the organization make it available to the public? 73.61% have a billing/collections policy? 77.80% did the hospital facility have a policy in place requiring emergency medical assistance regardless of eligibility for financial assistance? 79.21% did the hospital calculate charges for financial-aid-eligible patients using one of these methods? lowest negotiated commercial insurance rate? 5.07% average of three lowest negotiated commercial insurance rates? 9.12% medicare rates? 9.60% other? 10.22% did the hospital charge any financial-aid-eligible patients more than amounts generally billed? 3.35% 2014] tax-exempt hospitals and their communities 71 did the hospital charge any financial-aid-eligible patients any amounts equal to their gross charges? 13.44% these numbers show that most of the policies that the irs is either regulating directly or seeking to encourage are actually becoming widespread among tax-exempt hospitals. over 98% of tax-exempt hospitals, for example, have financial aid policies and about 97% of these policies are in writing. approximately 82% of hospitals have an emergency care policy stating that they do not discriminate on the basis of financial aid eligibility. only about 3% of hospitals charged aid-eligible patients above amounts generally billed (although thirteen of them billed patients using gross charges). the only policies exhibiting substantial variation are policies where, under the new aca regulations, tax-exempt hospitals get a choice as to the content of a policy. for example, the regulations do not specify whether hospitals should calculate aid eligibility using income, assets, medical indigence, insurance status, medicare/medicaid, or some other item. on the schedule h itself, the irs lists all of these options and indicates no preference among them. perhaps as a result, while income is the most common means of determining eligibility (74.58% of hospitals use it), hospitals are fairly evenly split among the other options. similarly, while most hospitals appear not to have yet selected which of the prescribed methods they will use to charge aid-eligible patients, no clear favorite option has emerged. about 5% of hospitals use the lowest negotiated commercial rate, about 9% use an average of the three lowest negotiated commercial rates, about 9% use the medicare rate, and about 10% use an unspecified other method. after examining at these descriptive statistics, i ran a few preliminary models to determine whether any hospital or community characteristics seemed to be driving what variation does exist here. however, no clear patterns emerged. given that the policies listed in table 7 showed little variation, this was not a surprising result. perhaps more surprisingly, i did not observe any relationship between any of the policy types and a hospital’s levels of community benefit and community building. after looking at the policy variables generally, i focused more closely on the debt collection variables. i chose to look more carefully at debt collection policies because both congress and numerous commentators had emphasized them so heavily in the decade leading up to the aca. in terms of debt collection practices, most hospitals in this study did not have policies explicitly authorizing them to engage in extraordinary collection actions against patients whose aid eligibility had not yet been determined. similarly, most hospitals did not carry out any extraordinary collection actions against patients without first checking to see if the patients were eligible for aid. however, about 200 hospitals checked “yes” to having some such policies in place or having engaged in one of these actions. i then carried out a principal components analysis to combine all of the different variables relating to debt collection into a single measure of debt collection practice. then, to determine whether these debt-collecting hospitals displayed any particular hospital-level or community characteristics, i ran another ols model, the results of which are shown in table 6. the dependent variable here is “debt collecting,” which is a measure, derived from the principal components analysis, of the extent to which the hospital belonged to this debt-collecting group. 72 columbia journal of tax law [vol.6:33 table 6: extraordinary collection actions according to hospital and community characteristics model 9 unconditional requirement -0.003 (0.046) conditional requirement 0.135 * (0.043) mandatory minimum -0.140 * (0.054) mandated level 0.144 * (0.035) gross receipts (logged) -0.025 * (0.012) profitability (millions) -0.0001 (0.0003) number of facilities (logged) 0.023 (0.034) donations (millions) -0.0004 (0.0004) percent publicly insured 0.242 (0.379) percent privately insured 0.996 * (0.389) population density (thousands per sq. mi.) -0.002 (0.004) age -0.006 (0.005) percent black -0.445 * (0.126) percent hispanic -0.353 * (0.165) percent below 100 fpl 0.530 (0.467) percent 100-149 fpl -0.477 (0.768) intercept 0.193 (0.473) r 2 0.037 2014] tax-exempt hospitals and their communities 73 note: * p<0.05 these results show that conditional requirement and percent privately insured were both positively associated with whether a hospital was a debt-collecting hospital. mandatory minimum community benefit, gross receipts, percent black and percent hispanic were all negatively associated with debt-collecting behavior. in other words, being in a state with a conditional community benefit requirement was associated with a 13.5% increase in a hospital’s degree of debt-collecting behavior, while a 1% increase in the percent of the population with private insurance was associated with a 1% increase in the hospital’s degree of debt-collecting behavior. v. discussion part v analyzes the results described in part iv. to do so, it first considers the results regarding community benefit and community building activities; it then examines the results regarding hospital financial policies. turning first to the topic of community benefit and community building activities, the 2012 schedule h data considered here show that tax-exempt hospitals spend an average of 8.5% of total expenses on community benefits, with a median of 7.45%. these results are in line with the only previous study to report a community benefit average using all of the schedule h data. that earlier study, which used 2009 data, found an average community benefit of 7.5%. 172 the higher figure for 2012 may represent a modest but genuine increase in the amount of hospital community benefit activity during the three intervening years. during this time, the passage of the aca increased scrutiny of tax-exempt hospitals, so they may have increased their community benefit activity as a response. additionally, during this period, hospitals became accustomed to reporting their community benefit activities. the requirement to explain their community benefits spending to the irs each year may have made hospitals more eager to provide benefits that they could list on the form. the researchers who looked at maryland community benefit data before and after maryland enacted community benefit reporting requirements identified this effect, so seeing it at the federal level would not be surprising. 173 in addition, the data here showed that the median amount of total charity care provided by hospitals was equal to 5.04% of their expenditures, with a mean of 6.01%. these figures just exceed the minimum threshold that senator grassley’s 2009 discussion draft legislation would have required had it become law. the data did show a fair amount of variation in community benefit spending, which in part derived from variation in the charity care measures. this means that senator grassley’s bill likely would have forced some hospitals to increase their charity care to reach the 5% minimum. however, as in texas after the passage of its mandatory minimum community benefit law, other hospitals might have dropped their charity care percentages to conform to the statutory mean. whether these effects would have balanced themselves out or would have led to a net increase or decrease in charity care remains unknown. as a result, it is difficult to compare the current 6.01% mean to the mean that would have been mandated had the grassley discussion draft become law. the data here also revealed substantial variation in hospitals’ spending on community benefit versus community building activities. in particular, the data 172 young et al., supra note 96, at 1526. 173 gray & schlesinger, supra note 112 at w814. 74 columbia journal of tax law [vol.6:33 suggested that one group of hospitals was especially likely to concentrate its spending on one or more community benefits, while a different group of hospitals was likely to concentrate on one or more community building activities. the hospitals in the two different groups were in two different types of surrounding communities—and different communities have different needs. the data suggested that in struggling urban areas, hospitals focus more on providing community benefits, but in richer areas hospitals may turn their focus elsewhere. that is to say, the hospitals providing more community benefits were located in particular types of communities. their communities were more densely populated and had more residents living close to, but not below, the poverty line—i.e., more “near poor” residents who fell within 100-149% of the poverty line. additionally, the hospitals themselves tended to be larger. in some ways, these findings were not surprising. for one, they echoed the conventional wisdom, sometimes cited in passing in the congressional hearings, that smaller and more rural hospitals are less likely to engage in substantial amounts of community benefit activities as traditionally defined. 174 similarly, the 2009 irs report found that hospitals providing “critical access” to health care in rural communities supplied less charity care than other hospitals. 175 however, no literature of which i am aware has previously identified a link between community benefit spending and percent of “near-poor” residents in the surrounding community. the current study introduced two important modifications that may have helped uncover this connection. first, this study used a more sensitive measure of “community” than other studies have used. as described earlier, past studies generally defined community on the basis of county-level data. by replacing this measure with one based on immediate census tracts, this study may have highlighted previously ignored ways in which hospitals respond to the needs of communities in close proximity. in particular, some hospitals have explained publicly that they define their communities using roughly five-mile radii. 176 this suggests that using census tract units, rather than counties, to obtain population data corresponds to how at least some hospitals view their own communities. second, while many prior studies assessed the effect on hospital spending of overall community income, or of community poverty rates, no study included in its analysis the possible effect on spending of the presence of the “near-poor” group. however, this group may be important to understanding the dynamics of community benefit spending. in the u.s., prior to the aca’s individual mandate, the poorest individuals received medical coverage through medicaid or other public programs. however, workers in lower-wage jobs who exceeded the eligibility thresholds for medicaid may not have had any insurance at all. as a result, those in this near-poor group may be the patients most in need of charity care, and hospital spending may be a response to this need. in addition, “near-poor” americans may have been particularly likely in 2012 to be under-insured. under-insured patients also present substantial charity care needs. elizabeth warren’s work on individual bankruptcy suggests that a 174 taking the pulse, supra note 51 (statement of scott a. duke, ceo, glendive medical center, glendive, mt). 175 irs hospital report, supra note 39, at 39–41. 176 see infra part v. 2014] tax-exempt hospitals and their communities 75 great deal of medical debt arises among individuals who have some health insurance. 177 insofar as communities contain an under-insured near-poor group, local hospitals may respond by increasing their provision of free or discounted care. turning now to the community building data, my analysis here suggests that hospitals that perform well with regard to community building are also larger, but that they are located in communities with particularly high private insurance rates and in states that have unconditional community benefit requirements. overall, however, very few hospitals are spending substantial amounts on community building. as noted, the mean total amount spent on community building equals 0.11%, with 0.0002% as the median. many hospitals engage in no community building activities. one likely reason that larger hospitals in areas with more privatelyinsured individuals provide most of these community building activities is that these hospitals may simply not have the charity care needs of larger hospitals in other communities. however, in the current political environment, larger hospitals in communities with more of privately-insured individuals may still feel pressure to get involved in their communities somehow, especially in ways that are not as expensive as providing free care to patients who are not experiencing grave financial distress. the pressures that hospitals feel to participate in their communities may be most acute in states that themselves have community benefit requirements. the states associated with higher community building rates are states where hospitals must provide some community benefit, but there is no minimum amount. states with these general requirements often define community benefit broadly so that it would encompass what the irs itself calls community building. these community building activities, which so far tend not to consume much by way of hospital resources, would probably not be an effective way of meeting a minimum standard. however, community building could offer a promising approach for hospitals that, by reason of shifting industry norms or state regulation, need to display a nonzero degree of community engagement in a community that does not need much charity care. this article’s other main finding with regard to community benefit and community building relates to the role of free and discounted care. unsurprisingly, hospitals that provide free and discounted care up to higher thresholds seem to be devoting more resources to charity care. the data do not reveal the direction of the causal effect, however. perhaps some hospitals deliberately set out to be particularly charitable and develop policies to further this goal. these altruistically oriented hospitals might set their free and discounted care thresholds high so as to offer free and discounted care to as many patients as possible in service of this intentional charitable mission. or, perhaps hospitals that provide free and discounted care to individuals with incomes farther above the poverty line simply wind up seeing more patients who are eligible for financial aid. simply by virtue of following their policies, these hospitals end up having to spend more on charity care. regardless of the direction of the causal arrow, the data showed no connection between high thresholds for free and discounted care and the number of poor or near-poor residents in the surrounding communities. in fact, poverty rates were negatively (and 177 see generally melissa b. jacoby & elizabeth warren, beyond hospital misbehavior: an alternative account of medical-related financial distress, 100 nw. u. l. rev. 535 (2006); melissa b. jacoby et al., rethinking the debates over health care financing: evidence from the bankruptcy courts, 76 n.y.u. l. rev. 375 (2001). 76 columbia journal of tax law [vol.6:33 significantly) associated with high free care thresholds. one reason for this may be that hospitals in poor communities, notwithstanding many patients qualifying for medicaid, have pressing financial needs that arise from practicing in a community with few resources. as a result, these hospitals cannot afford to provide free and discounted care to patients at, say, 500% of the poverty line. it is also possible that in high-poverty communities, most hospital patients are close to the poverty line and, as a result, the hospitals see no reason to establish free care policies for patients at income levels they rarely encounter. the data on free and discounted care policies lead into another set of this article’s findings: those concerning hospital policies. the article identified several instances of association between hospital and community characteristics, on the one hand, and high thresholds for free and discounted care, on the other hand. certain statelaw variables, notably an unconditional community benefit requirement and a state-level mandatory minimum level of community benefit, are associated with higher thresholds. by itself, this finding is not surprising. hospitals in states that regulate community benefit may have needed to establish particularly generous free and discounted care policies either to meet “industry norms” within the state or to comply with an actual mandatory minimum amount. these findings may make particular sense in light of the fact that public and private insurance rates are also associated with higher thresholds for free care. if a hospital’s patients are mostly insured, then to meet a mandatory minimum threshold the hospital may have to increase the pool of patients eligible for free care. larger hospitals in more urban and in more diverse communities are also more likely to have higher thresholds for free and discounted care—a pattern that fits with the view (cited earlier) about small rural hospitals. some hospitals may believe they are serving their communities best by simply providing access to health care to an area that would not otherwise have it. these hospitals may not view providing free or discounted care as an important part of their mission. the data presented here on hospital policies further show that hospitals in all types of communities are adopting the practices that congress, the irs, and the treasury department have requested in terms of billing and financial aid. sections 501(r)(4)-(6) of the internal revenue code, the statutory provisions that govern financial policies, do not go into effect until the taxable year beginning on or after the date when the irs and treasury publish their proposed regulations as final or temporary regulations. 178 the proposed regulations do specify that taxpayers may rely on them until final or temporary regulations are issued, 179 but the proposed regulations do not carry legal authority. 180 as a result, tax-exempt hospitals are not currently required to have policies such as a written financial aid policy or a nondiscriminatory emergency care policy. nonetheless, most hospitals across all community types are already adopting the policies that the schedule h asks about, and most of which sec. 501(r) and its regulations will eventually mandate. with this mandate looming, hospitals may have decided to get an early start for fear that saying “no” now to one or more of the irs’s policy questions may serve as an audit flag for the irs or may send troublesome signals to stakeholders. or hospitals may simply be 178 additional requirements for charitable hospitals, 77 fed. reg. 38148, 38159 (proposed june 26, 2012) (to be codified at 26 c.f.r. pt. 1). 179 id. 180 for a discussion of this issue, see kristin e. hickman, coloring outside the lines: examining treasury's (lack of) compliance with administrative procedure act rulemaking requirements, 82 notre dame l. rev. 1727, 1734 (2007). 2014] tax-exempt hospitals and their communities 77 preparing for the date in the near future when the irs and the treasury department do issue the final regulations. probably hospitals are doing a bit of both. additionally, many hospitals may have had some of these policies in place long before schedule h began asking about them. regardless, to the extent that these financial policies were not present before schedule h, they certainly are now. perhaps because the policies are now so pervasive across all community types, i did not find much by way of a relationship between financial policies and hospital and community characteristics. nor did i see any correspondence between having the financial policies in place and spending more on either the community benefit or community building activities. i found this latter non-relationship somewhat surprising. i had anticipated that hospitals slow to install compliant financial practices might also be reluctant to expend resources on their communities. however, i found no evidence that this is the case. my prior image of a small gaggle of evil hospitals greedily hoarding their revenues while gleefully putting liens on patient homes before checking their financial aid eligibility did not find support in my data. the final finding that emerged from this article’s analysis concerned debt collection practices. the data show that a small group of hospitals is currently authorized to carry out, and does carry out, most of the extraordinary collection actions against patients who may be eligible for financial aid. the only characteristics that these hospitals share are their small size, the lack of racial diversity in their surrounding communities, and their reliance on patients who have private insurance. because engaging in extraordinary collection actions without reviewing financial aid eligibility will soon be illegal, the group of hospitals that is still doing this may not merit particular attention. on the other hand, as noted earlier, many extraordinary collection actions will still be acceptable under the new aca requirements. the hospitals that are currently using extraordinary collection actions to pursue patients who may be eligible for aid may be the same hospitals that will find ways to use extraordinary collection actions in ways that congress has yet to prohibit. for this reason, the hospitals in this group may warrant future attention from lawmakers and scholars. vi. evaluation of traditional and new affordable care act requirements the schedule h data analyzed in part v is of special interest because it provides a previously untapped opportunity to evaluate the legal requirements for tax-exempt hospitals on the basis of comprehensive empirical evidence about tax-exempt hospitals, their community benefits, and their financial policies. health policy scholars gray and schlesinger lauded the arrival of schedule h by saying that, with its appearance on the scene, “debate will begin anew about what should be expected of nonprofit hospitals and charitable organizations more generally.” 181 the schedule h data can also enable congress, the irs, and the treasury department to move from guesswork to fact as lawmakers from these bodies attempt to evaluate and refine the new requirement they have put in place with the affordable care act. the data analysis in this article raises a major question that now confronts lawmakers seeking to evaluate the rules of tax-exempt hospitals: how should the law governing tax-exempt hospitals define the pivotal concept of “community”? the results of this study suggest that how much and what kind of community benefit hospitals 181 bradford h. gray & mark schlesinger, the accountability of nonprofit hospitals: lessons from maryland’s community benefit reporting requirements, 46 inquiry 122, 122 (2009). 78 columbia journal of tax law [vol.6:33 provide are issues that depend heavily on the way in which hospitals delineate their communities. the proposed aca regulations give hospitals broad leeway to define their own communities. as described earlier, the regulations “provide a hospital facility with the flexibility to take into account all of the relevant facts and circumstances in defining the community it serves, including the geographic area served by the hospital facility, target populations served (for example, children, women, or the aged), and principal functions (for example, focus on a particular specialty area or targeted disease).” 182 the one proviso is that a hospital may not “define its community in a way that excludes medically underserved, low-income, or minority populations who are part of its patient populations, live in geographic areas in which its patient populations reside or . . . otherwise should be included” based on the hospital’s selected definition of community. 183 under the aca requirements, every hospital will, for the first time, need to explicitly consider who makes up the community being served. not only this, but hospitals will then have to answer this question publicly in their chnas. hospitals that have already conducted and publicized chnas have taken a variety of approaches to the question. some have defined communities in terms of their counties 184 or as lying within a few miles of their zip codes. 185 some hospitals stipulate the proximate neighborhoods 186 or the municipalities served, 187 and still others incorporate both geographic and demographic markers (i.e., the city of chicago plus children elsewhere in the state of illinois, “members of the entertainment industry working or residing in southern california”). 188 182 community health needs assessments for charitable hospitals, 78 fed. reg. 20523, 20529 (proposed apr. 5, 2013) (to be codified at 26 c.f.r. pts. 1, 3). 183 id. 184 see, e.g., holy cross hosp. of silver spring, md., community health needs assessment 4 (2012), available at http://www.holycrosshealth.org/documents/community_involvement/hch_communityhealthneedsassessm ent_fy13.pdf; meriter health serv., 2012 community health needs assessment 5 (2012), available at http://www.meriter.com/data/content/meriter%202012%20community%20health%20needs%20assessment 1.pdf. 185 see, e.g., advocate trinity hosp., 2011–2013 community health needs assessment 4 (2011), available at http://www.advocatehealth.com/documents/chna/trinitychnareport1-14.pdf; ctr prof’l research consultants, inc., 2012 prc community health needs assessment report 7 (2012), available at http://www.uchospitals.edu/pdf/uch_034998.pdf. 186 see, e.g., bronx-lebanon hosp. ctr., 2013 community needs assessment 1–13 (2013), available at http://www.bronxcare.org/fileadmin/sitefiles/pdf%20files/bronxlebanon_2013_community_health_needs_assessment.pdf; ngozi moses, brooklyn perinatal network et al., the need for caring in north and central brooklyn: a community needs assessment 1 (2013), available at http://www.nylpi.org/wp-content/uploads/bsk-pdfmanager/138_the_need_for_caring_in_central_and_north_brooklyn_04.10.2013_fi nal_repor....pdf. 187 see, e.g., bassett med. ctr., community health needs assessment 1 (2013), available at http://www.bassett.org/gedownload!/2013-bmc-chna.pdf?item_id=182938650&version_id=182938651; kaiser permanente, 2013 community health needs assessment: kaiser foundation hospital— redwood city 12 (2013), available at http://share.kaiserpermanente.org/wpcontent/uploads/2013/09/redwood-city-chna-2013.pdf. 188 see, e.g., ann & robert h. lurie children’s hosp. of chi., community health needs assessment 2013, at 10 (2013), available at https://www.luriechildrens.org/en-us/community/communityhealth-needs-assessment/documents/chna-2013.pdf; motion picture & television fund, community health care needs assessment 11 (2013), available at http://www.mptf.com/file/mptf-documents--part/2013-mptf-community-health-needs-assessment.pdf. 2014] tax-exempt hospitals and their communities 79 while different hospitals will inevitably adopt broader or narrower definitions of community in their chnas, the data here suggest that hospitals are at least partially responsive to their immediately proximate communities. hospitals in urban areas with more residents living just above the poverty line might provide more free care. hospitals in areas with fewer free care needs may be more likely interface with their communities by building physical improvements or enhancing their environments. hospitals in communities where people live below the poverty line may prefer financial aid policies targeted toward patients on the lower end of the income spectrum. these alternatives that this article has identified are perhaps just a few of the ways in which hospitals react to their communities when deciding such issues as how much to spend on community benefit versus community building, and what activities to fund. the fact that hospitals respond to their communities raises the fundamental question for lawmakers: is it acceptable that hospitals in areas with fewer needs may provide fewer community benefits? for example, is it objectionable that hospitals in areas with high rates of private insurance provide limited free care? should those hospitals have to compensate in some way for the fact that their communities have low free care needs? or should a hospital in an area with high insurance coverage be able to satisfy the community benefit standard by simply devoting 0.004% of its annual expenditures to leadership training for local youth? what if a hospital really is located right in the middle of a wealthy community? under current law, that hospital has no clear obligation to do anything for disadvantaged groups. these questions go to the core of the longstanding “community benefit” standard. by its own terms, the standard requires hospitals to serve the interest of “the community.” the contrast drawn in the original irs revenue ruling was between “the community” and private interests. however, “the community” can still be a relatively narrow group. it might be a wealthy suburb or a group of affluent patients who can afford plastic surgery. in a stratified society like the twenty-first century united states, communities often consist largely of individuals who are similar in terms of social class, income, race, or education. to return to an example mentioned earlier in the paper, evanston, illinois, is a substantially different community with very different needs than areas of chicago’s south side. this is not to suggest that hospitals in resource-rich communities are doing something wrong. after all, even if these hospitals are providing very little in terms of the expensive community benefits like free care, they may be responding sensitively and thoughtfully to the needs of their own communities. literature on tax-exempt hospitals has sometimes seemed to assume that hospitals providing low levels of community benefits are behaving inappropriately. after all, these hospitals are receiving valuable tax benefits, and seemingly doing nothing in return. however, these hospitals may be doing exactly what the community benefit standard asked them to do: benefit their immediate communities. in fact, the data here raise the possibility that hospitals in resource-rich areas have a civic orientation. they just may have fewer needs to meet, which brings their community benefit numbers down. most notably, the data here suggest that hospitals in areas with low poverty rates and high levels of insurance coverage are likely to have particularly generous financial aid policies with high thresholds. however, a hospital in a wealthy area that offers free care up to 300% of the poverty line may still end up providing much less free care than a hospital in a lower-income area which makes free care available only for individuals who fall below the poverty line. further, hospitals in 80 columbia journal of tax law [vol.6:33 resource-rich areas may be more likely to provide novel community enhancements that do not cost as much as free care. if a hospital’s clientele consists of patients with good insurance coverage, that hospital might actually have to experiment with community building projects like environmental cleanup or youth training. however, unless a hospital substantially reorients itself away from providing health care and toward, say, cleaning up lakes, these community building activities are likely to be less expensive than the endeavor of providing free or discounted care in an area where many patients cannot pay their hospital bills. yet, there remains something troubling about the fact that the community benefit standard itself imposes substantially different obligations on different hospitals. for one, this violates “vertical equity,” a longstanding tenet of tax policy. stated in broad form, vertical equity holds that tax law should treat differently situated taxpayers differently. 189 vertical equity is the reason many tax scholars believe that individuals with high incomes should pay high tax rates and individuals with low incomes should pay low tax rates. 190 under the community benefit standard, however, tax-exempt hospitals that provide substantial community benefit to their needier communities take the same tax exemption as hospitals that supply very little to their more advantaged communities. that disparity violates broad notions of vertical equity. in addition, the community benefit standard, especially as envisioned under the new aca regulations, imposes what are arguably greater burdens on hospitals in needier communities than on their counterparts in resource-rich communities. when a hospital in a poorer community carefully considers its community’s needs and how to respond to them, it is likely to realize that tackling these needs calls for substantial resource outlays. for example, when a hospital in a working-class suburban community conducts its chna, it may discover that the main health problem facing its community is the need for discounted care. that may be an expensive problem to address, but the community benefit standard is potentially asking the hospital to do just that. doing so might be a substantial burden on the hospital. on the other hand, when a hospital in a small, wealthy rural enclave carries out its chna, it might find that the main health problem facing its community is frequency of drunken skiing accidents. that hospital might be conscientious and seek to respond compassionately to its community needs and to engage in best practices with regard to the community benefit standard. however, even a strict interpretation of the community benefit standard would merely require that hospital to do the best it can to educate the community about the dangers of drunk skiing. that is likely not a substantial burden on the hospital. furthermore, the community benefit standard treats as equivalent community benefit factors that mean something different in different contexts. however, it is not clear that the law should assign the same value to all of them. take again the hypothetical hospital in a wealthy community with high insurance coverage. even if that hospital has a very generous financial aid policy, and even if its charity care and community benefit numbers are high, that hospital may still be in a position to discount care for families at 1000% of the poverty line. that hospital will receive the same tax 189 joseph j. cordes, vertical equity, in the encyclopedia of taxation and tax policy (joseph j. cordes et al. eds., 2d ed.), available at http://www.taxpolicycenter.org/taxtopics/encyclopedia/verticalequity.cfm. 190 id. 2014] tax-exempt hospitals and their communities 81 benefit as a hospital in a lower-income area that uses its charitable dollars providing free care to medicaid beneficiaries and people just barely above the poverty line. is it appropriate for tax law to treat discounted health care for people with household incomes of over $200,000 a year the same way as it treats discounted health care for people living below the poverty line? this latter problem provides a vivid instance of a more general problem that arises when the federal government uses tax law to conduct anti-poverty policy. as i have discussed in earlier work, u.s. tax policy that seeks to address the needs of the poor is often ineffective in reaching the poorest individuals, even as it provides substantial benefits to the middle class or even the upper class. 191 the community benefit standard for tax-exempt hospitals addresses the needs of the poor because it asks hospitals to respond to the needs of the communities. the community benefit standard asks hospitals in needy communities to benefit those communities, but it also subsidizes through tax exemptions substantial benefits that have nothing to do with disadvantaged communities. even the aca regulations, as discussed above, allow room for hospitals to engage in extraordinary collection actions against poor and almost-poor debtors. while insurance coverage rates may rise after the aca’s individual mandate becomes law, many poor and near-poor individuals will still have insurance that covers only part of what could be large medical bills. the new regulations, while taking important steps forward, do not address these problems with the proper definition of community under the community benefit standard. for the first time in the history of the community benefit standard, the new framework does set forth a definition, but it is not one that fixes the problems identified in this article. if anything, the chna component of the new regulations exacerbates these problems. the chna rules convey to hospitals that meeting the community benefit standard involves observing and responding to the needs of the hospital’s own community via the chna. however, as discussed, the chna regulations allow hospitals to delineate their communities as they wish. the chna only requires that, once a hospital chooses its community and records its needs, the hospital put in place a plan to address those needs. the hypothetical hospital that identified and responded to drunken skiing concerns is as compliant with the chna rules as the hospital that identifies and responded to free care needs. by requiring hospitals to respond to the needs that the chna uncovers, the chna framework arguably places a higher burden on hospitals that uncover greater needs than on hospitals that uncover insubstantial ones. unfortunately, there is no policy solution to these problems with the community benefit standard that does not introduce problems of its own. even so, lawmakers have several alternatives available to them in the world of the aca. here, i will discuss a few of them. one, legislators or regulators from treasury and irs could specifically define community—for the purpose either of the community benefit standard generally or of the chna rules—to include disadvantaged populations. right now, the chna rules tell tax-exempt hospitals that they cannot exclude disadvantaged populations that “should” otherwise fall within their communities. however, some hospitals do not have many disadvantaged groups that reasonably fall within their community borders. under these circumstances, the federal regulations could give hospitals an affirmative obligation to draw their community boundaries so as to include some relevant disadvantaged group(s). 191 susannah camic tahk, the tax war on poverty, 57 ariz. l. rev. (forthcoming 2014) (draft at 44–46), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2413233. 82 columbia journal of tax law [vol.6:33 to do this, the regulations could explicitly encourage hospitals in wealthier communities to form partnerships with hospitals in low-income areas and work with these lowerincome hospitals to meet the needs of their communities. this approach has some advantages. it asks hospital decision-makers to think broadly about community and to consider linkages between communities that might be reasonably geographically proximate yet have access to very different resources. such an approach might serve to channel resources to serious problems that need solving, while allowing hospitals with resources the flexibility to determine how best to use those resources to help the disadvantaged. however, this approach also has disadvantages. it would level the playing field among hospitals somewhat but not completely. if, for example, a hospital in wealthy mclean, virginia, satisfies this new obligation by sending volunteers to vaccination day in relatively less well-off prince george’s county, maryland, the hospital in prince george’s county is still going to have to respond to needs far beyond anything that the mclean hospital ever has to face. in addition, this approach would force resource-rich hospitals to expand capacity in ways that go beyond their traditional missions. a florida facility that normally serves wealthy senior citizens with private insurance exclusively might have to stretch outside its standard activities to find an endeavor benefitting a disadvantaged group. furthermore, some hospitals might be genuinely unable to find a disadvantaged group anywhere within a reasonably proximate geographical area. on the other hand, the irs and treasury could consider softer forms of this approach that would not place undue burdens on hospitals in resource-rich communities. regulators could gently prod rather than require. for example, the regulations could simply encourage hospitals to define their communities broadly and in ways that include disadvantaged groups. or, the schedule h could include a question about outreach to disadvantaged groups. in a somewhat different version of this approach, treasury and the irs could impose a particular broad definition of community on tax-exempt hospitals. for example, if a hospital in affluent westchester, new york, had to take as its community the entire new york city metropolitan area, this hospital would at least have to formulate a plan to address the health problems of staten island and the south bronx. this approach has the advantage of simplicity, while again requiring some hospitals in resource-rich communities to use their resources in service of pressing needs elsewhere. furthermore, it would place less pressure on individual hospitals to identify nearby disadvantaged communities if those communities really do not exist. however, on the negative side, the irs and treasury previously considered defining community broadly, but (as described above) they rejected that idea when faced with comments that expressed a preference for a “facts-and-circumstances approach.” 192 the commenters “recommended against a definition based on specified geographic boundaries,” and argued that “each hospital facility is in the best position to determine its [own] community.” 193 in addition, adopting a definition of community, such as the immediate county or metropolitan area, would do more to level the playing field among hospitals in the same urban area than among hospitals that are in geographically remote locations. but, as reported above, the data indicate that urban hospitals are the ones already providing substantial community benefits. 192 community health needs assessments for charitable hospitals, 78 fed. reg. at 20529. 193 id. 2014] tax-exempt hospitals and their communities 83 yet another form of this approach would build off of professor colombo’s work on an “access” standard for tax exemption. colombo proposes replacing the community benefit standard with the requirement that, in exchange for tax exemption, hospitals must provide increased “access” to health care. hospitals could qualify for tax exemption only if they offer “access to services for previously-underserved populations or provide . . . specific services to the majority population that otherwise are not provided by the private sector.” 194 the access standard has the advantage of shedding entirely the problem of defining community. in addition, under the access standard, hospitals whose communities are not disadvantaged could pursue a different obligation: to provide some service that the market does not otherwise offer. hospitals could probably do this without having either to expand their capacity dramatically or to identify some remote disadvantaged group to help. on the other hand, congress, the treasury and the irs have by now been actively considering the problems with the community benefit standard for more than two decades. for reasons i can only speculate about, however, none of these bodies seems to have the political will to overturn the community benefit standard and to replace it with something else. none of the four major legislative proposals—neither that of senator grassley nor those of representatives roybal, donnelly, and thomas—even contemplated removing the community benefit standard. additionally, when congress eventually did pass the aca legislation on tax-exempt hospitals, that legislation did not touch the community benefit standard. for that reason, professor colombo’s idea of putting in place a new and different standard may not be a realistic option at this point. furthermore, the access standard perhaps allows hospitals too much flexibility to offer whatever access-enhancing service they want without having to consider any social needs. the access standard might, for example, allow a hospital to merit tax exemption by opening a new cosmetic surgery wing that permitted a semi-rural community to access procedures never before available. that may not be an activity deserving of a valuable tax exemption, not just because cosmetic surgery is a luxury, but also because no one in that particular community wants it. markets supply services in response to consumer demand. if a market has not previously offered a health service, that may be because no demand for it exists. health procedures for which no demand exists may not be worthy of tax subsidies. an entirely different solution to defining community might be drawn from professor berg’s proposal that tax-exempt hospitals should have to provide population health benefits to the communities in which they operate. 195 this approach offers the upside of asking hospitals even in resource-rich communities to consider activities that provide broad population-wide benefits. furthermore, even communities where individuals have ample health insurance can still use public health interventions around issues like nutrition and sunscreen. the data presented above, however, point to one downside of this approach: it departs from what many hospitals are already doing with regard to community benefit. dollar-wise, most community benefits presently take the form of free or discounted care. asking those hospitals that are not currently spending much on community benefit to devote funds to population health might be an improvement over the status quo. however, for those hospitals that are already devoting substantial resources to free care, asking for additional work on population health might 194 colombo, supra note 21, at 345. 195 see generally berg, supra note 38. 84 columbia journal of tax law [vol.6:33 be unduly burdensome. in addition, the population health approach would not replace the community benefit standard entirely, so it would not remedy many of the problems that the standard currently presents. a completely different solution would be to offer particular tax benefits for certain health-enhancing activities. the idea here would be to tie the amount of the tax subsidy to the amount of benefit that a hospital provided. for example, the irs could offer a refundable tax credit equal to the amount of free care provided to patients below the poverty line. this is similar to law professor nina crimm’s proposal to eliminate the tax exemption for hospitals and instead grant some form of tax-favored treatment to forprofit and not-for-profit health care organizations that engage in worthy activities. 196 one could envision different variants of this proposal that would subsidize different specified activities—perhaps just free care, perhaps every community benefit or community building activity, perhaps some separate list of health-related benefits. on the upside, this approach would directly address the vertical equity problem as well as the longstanding critique that the tax exemption for hospitals has little relationship to the level of benefit that hospitals actually provide. furthermore, it would allow congress not only to identify and respond to the most pressing health needs that the country currently faces, but to design a tax program that directly meets those needs. however, on the downside, as mentioned above, congress does not appear to have the political will to overhaul the community benefit framework entirely, which is what this plan would entail. a less radical version of this proposal would be to maintain the current framework, but to add a credit on top of it. however, tax-exempt hospitals, which do not currently pay income tax on much of their net income, would not be able to use credits against taxable income, and congress has not yet experimented with offering substantial refundable credits in excess of tax liability to tax-exempt organizations. moreover, a credit program would represent a large new federal expense on top of the existing valuable tax exemption for hospitals. still further, congress might experience problems in deciding exactly what to subsidize via a credit. the federal government already has medicaid in place to provide health care for the poor. would the proposed tax-credit serve mostly as a tax benefit for hospitals’ unreimbursed medicaid? if so, why not just increase medicaid reimbursements? or would the credit take a broad approach and subsidize each of the community building activities as well? if yes, that raises the question of why the federal tax code would be paying hospitals, which are supposed to specialize in health care, to develop workforces and clean up the environment. these questions might have good answers, but congress would have to agree on them before enacting a credit plan. as these comments make clear, each potential approach to solving the existing difficulties with the community benefit standard has advantages and disadvantages of its own. among these alternatives, no approach emerges as the clear winner, although each one perhaps has elements that lawmakers might want to consider. regardless of how they choose to proceed, however, lawmakers should recognize and contend with the central fact highlighted in the foregoing analysis of the schedule h data: namely, the enormous extent to which tax-exempt hospitals’ legal obligations and activities depend on how hospitals define their communities. even more, the data suggest that tax-exempt hospitals, on the whole, are already working to respond to the needs of, and to deliver benefits to, their specific communities. what the data show, in other words, is that the 196 see generally crimm, supra note 15. 2014] tax-exempt hospitals and their communities 85 community benefit standard, for all of its flaws, has given hospitals the flexibility to assess and address the needs of their immediate communities. that is exactly what most tax-exempt hospitals are doing. vii. conclusion according to current federal tax law, hospitals merit tax-exempt status insofar as they meet the standard of “community benefit,” a standard that has long been controversial. the article has reported new data on more than 2,100 tax-exempt hospitals. these data on how hospitals actually meet the community standard provide a first-time opportunity to analyze in some depth how hospitals are currently earning their tax exemptions, and to consider how well the legal requirements for tax-exempt hospitals are working. this analysis is particularly important because congress and the irs have recently implemented the affordable care act’s new rules for tax-exempt hospitals. lawmakers are still evaluating the extent to which these rules address existing problems with the community benefit standard, but they have been conducting this evaluation in an information vacuum. this article examined the new schedule h data to determine what tax-exempt hospitals really are doing to benefit their communities and what problems may be emerging which tax law might address. the data analysis suggested that some hospitals, primarily large ones in urban areas with populations living close to the poverty line, are providing substantial amounts of all of the community benefits that tax law currently envisions. at the same time, a different group of hospitals, especially those in areas with high private insurance rates, are engaging in what the irs has called community building activities. in addition, some hospitals have adopted particularly high thresholds for free and discounted care, thresholds that lead to higher amounts of community benefit. further, while hospitals across all of these communities are adopting financial policies designed to comply with the new legal requirements, smaller hospitals in less diverse communities are still engaging in debt collection practices that the new legal requirements aim to discourage. these patterns suggest that, in determining what community work they should undertake, the great majority of tax-exempt hospitals are (at least partially) responding to the needs of their immediate communities. this finding raises a range of policy questions, however, about how hospitals should conceptualize their communities. is it appropriate to allow tax-exempt hospitals to fulfill their community benefit obligations by benefiting communities that already have substantial resources? this article considers that question, and probes several possible ways that lawmakers might address it going forward. narrowing the (massive) self-employment tax gap narrowing the tax gap through presumptive taxation kyle d. logue* & gustavo g. vettori** i. introduction ................................................................................................ 101 ii. a closer look at the tax gap data ................................................. 106 a. what the numbers show (and don’t show) .................................................... 106 b. why we focus on smbs ................................................................................. 110 iii. why the smb tax gap matters and what to do about it . 111 a. why it matters ................................................................................................. 112 b. explaining smb noncompliance ..................................................................... 115 c. obvious potential solutions to the smb tax gap (other than presumptive taxation) .................................................................................................................. 118 iv. introduction to presumptive taxation .................................... 121 a. definitions ........................................................................................................ 121 b. examples of presumptive provisions in the current u.s. tax system ............ 122 v. building a presumptive tax ................................................................. 124 a. the relevant questions.................................................................................... 124 b. choosing a presumptive tax base ................................................................... 125 1. a lump-sum business tax ........................................................................... 125 2. pure gross receipts (or “turnover”) tax ................................................... 127 3. modified gross receipts (mgr) tax: using historical line-of-business profit ratios to estimate net income. ............................................................................ 129 4. taxing asset values.......................................................................................... 135 5. taxing multiple-factors................................................................................... 136 c. of mandatory minimums, optional presumptive regimes, and other variations 137 1. mandatory minimum .................................................................................... 137 2. the ex-post, optional presumptive tax ...................................................... 138 3. variations on the theme.................................................................................. 142 vi. conclusions and caveats ...................................................................... 145 a. general remarks ................................................................................................ 145 a. vat as an alternative...................................................................................... 146 * wade h. mccree jr., collegiate professor of law, university of michigan law school. ** l.l.m., university of michigan law school; doctoral candidate, university of são paulo. the authors wish to thank reuven avi-yonah, alex raskolknikov, chris sanchirico, and joel slemrod as well as the participants at the 2009 summer tax workshop at the university of colorado and the fall 2009 columbia law school tax colloquium for their questions and comments. 2011] narrowing the tax gap through presumptive taxation 101 i. introduction can the united states government significantly reduce the federal tax gap? this question has attracted a great deal of scholarly attention over the years and has been the focus of numerous government reports. the “tax gap” is the official term for the treasury department’s estimate of the difference between what american taxpayers should pay to the federal government in a given tax year (that is, the amount of tax they owe, based on a reasonable interpretation of existing tax laws as applied to particular taxpayers’ circumstances) and what they actually pay.1 this estimate is derived from painstaking and detailed audits of randomly selected returns and it is the best overall benchmark of taxpayer noncompliance we have. according to the most recent numbers (from the 2001 tax year), the annual u.s. tax gap is around $290 billion. this represents a noncompliance rate of roughly 15%.2 it is fair to say, then, that u.s. taxpayers on average remit 15% less in tax to the government than they actually owe.3 that would, of course, mean a compliance rate of 85%, which sounds pretty good for the sort of laws that the federal income tax laws are. if we were talking about murder or armed robbery, a compliance rate of only 85% would obviously be unacceptable. (as a conceptual matter, what would an 85% “compliance” rate in that context even mean?) but if we think of tax laws as being on a par with traffic laws or intellectual property rules (and other laws the violation of which is considered merely mala prohibitum), an 85-percent compliance rate sounds almost respectable. 4 moreover, the tax gap in the united states is probably smaller than the tax gap in most other countries, including other nations with developed economies.5 1 we are using the term pay loosely here. what we really mean is remit. the party with a taxremittance obligation is the party who is required by law to write the check to the government for the amount of the tax. tax noncompliance, therefore, is failure to remit the taxes that one owes. tax payment is a more vague term, sometimes used to mean remittance (as in the text here) and sometimes used to mean “to bear the burden of.” joel slemrod, does it matter who writes the check to the government? the economics of tax remittance. 61 nat’l tax j. 251 (2008). certainly u.s. tax2 irs, united states department of the treasury, reducing the federal tax gap: a report on improving voluntary compliance (2007), available at http://www.irs.gov/pub/irsnews/tax_gap_report_final_080207_linked.pdf. the $290 million figure is actually the “net tax gap.” the “gross tax gap,” which includes tax dollars that are remitted late or only after enforcement action by the irs, is obviously higher. the gross tax gap for the 2001 tax year was around $345 billion. 3 this statistic is sometimes referred to as the “net misreporting percentage” or “nmp.” the nmp is the amount of income misreported divided by the sum of the absolute values of the amounts that should have been reported. treasury, supra note 2, at 12-13. 4 with intellectual property rules, we can at least conceive of what the numerator and denominator would be. for example, the numerator might be the total amount that users of copyrighted material actually paid (directly or indirectly) to the relevant copyright holders for the use of the copyrighted material during a given period of time and the denominator would be the total amount that should have been paid based on a reasonable interpretation of copyright law. we are guessing that copyright holders would be thrilled with a “copyright gap” of only 15%. 5 we say “probably” because no other country calculates the tax gap in precisely the way that the united states does. indeed, few countries make any systematic effort to measure their tax gap at all. sweden has done so, using a methodology very different from that of the united states, and has found an overall noncompliance rate in the neighborhood of 10%. the united kingdom has recently made efforts to measure its tax gap, and it has broken it down into direct taxes (individual and corporate income tax as well as inheritance tax), and indirect taxes (mainly the vat). for direct taxes, the (very rough) range estimate is between 5 and 15% (with a point estimate of around 9%). knowledge analysis and intelligence directorate of her majesty’s revenue & customs, estimation of tax gap for direct taxes 4 tbl. 4.1 (2005), available at http://www.hmrc.gov.uk/research/direct-tax-gaps.pdf. for indirect taxes, noncompliance is estimated to be between 12 and 16%, depending on the year. her majesty’s revenue 102 columbia journal of tax law [vol. 2:100 compliance rates are higher than those in developing countries, which have shadow economies that are much larger, as a fraction of overall gdp, than the one in the united states.6 for all of these reasons, some commentators hold the view that the tax gap is not a serious problem.7 on the other hand, noncompliance is noncompliance. and the united states government could really use all of those unremitted tax dollars. of course, this is always true; there never seems to be enough money to pay for all of our government programs. but the need for tax revenue will grow increasingly acute in the coming years, as the u.s. government moves from stimulus mode into debt-reduction mode and as the country’s obviously unsustainable (even if temporarily necessary) fiscal path becomes impossible even for congress and the president to ignore. 8 any serious attempt to respond to the impending debt crisis will almost certainly entail not only a cut in spending and an increase in tax rates, but also some sort of increased effort to collect tax dollars that are already owed under existing tax laws.9 what’s more, the 15% rate of noncompliance (or “net misreporting percentage”) does not fully capture the problem. if someone told you that the overall violent crime rate in the united states was roughly five reported offenses per 100 inhabitants, would this be enough information to give you a sense of the problem and how best to respond to it? or would you also like to know that in rural areas the violent-crime rate is half the national average; and, in the large cities, it is double the national average? and in certain high-crime areas within high-crime cities, five times the national average? obviously, these more fine-grained estimates of legal “noncompliance” would be important data points as well, as they might provide support for targeted law-enforcement efforts in the high-crime regions. in the same way, the seemingly modest 15% historical tax noncompliance figure is an aggregate average that masks smaller areas of serious abuse. given this context, even a 15% noncompliance rate may prove to be unacceptably high. & customs, measuring indirect tax losses – 2007 at 5 tbl. 2.1 (2007), available at http://www.hmrc.gov.uk/pbr2007/mitl.pdf. 6 see friedrich schneider & dominik h. enste, shadow economies: size, causes, and consequences, 38 j. econ. lit. 77, 82 tbl. 2 (2000) (reporting data suggesting that the united states has one of the smallest shadow economies in the world, even among oecd countries). this point is confirmed with somewhat more recent data in friedrich schneider, the size of the shadow economies of 145 countries all over the world: first results over the period 1999 to 2003 (inst. for study lab., iza discussion paper no. 1431, 2004), available at http://ssrn.com/abstract=636661; and friedrich schneider & robert klinglmair, shadow economies around the world: what do we know? (center for res. mgmt. & arts, crema working paper no. 2004-03, 2004), available at http://www.cremaresearch.ch/papers/2004-03.pdf. this last paper shows an 8.6% average shadow economy size in the united states for 2002/2003, while the oecd average for the same period is 16.4%. brazil, for its part, had an average of 39.8% in 1999/2000, and the latin american countries averaged 41% in this period. african countries averaged 41% and asian countries 26%. id. another study of the brazilian shadow economy came up with a 39.4% estimate. claudio lucinda & paulo arvate, a study on the shadow economy and the tax-gap: the case of cpmf in brazil (2005) (unpublished manuscript presented at the 5th annual meeting of the public choice society), available at http://www.thaigoodgovernance.org/upload/content/296/shadow%20economy%20in%20brazil.pdf. 7 irs and the tax gap: hearing before the h. comm. on the budget, 110th cong. 109 (2007) (statement of chris edwards, director of tax policy studies, cato institute) (“i think to most people, that [compliance rate, 86%] sounds like a pretty high number. we rarely get 100% compliance with any law”). 8 daniel n. shaviro, taxes, spending, and the u.s. government’s march towards bankruptcy (2006). 9 see calvin h. johnson, two years of the shelf project, 126 tax notes 513 (2010). 2011] narrowing the tax gap through presumptive taxation 103 for example, among the most well-studied and closely analyzed topics in the tax field is the problem of corporate tax shelters. tax shelters are extraordinarily complex and highly aggressive (though usually not patently illegal) transactions designed entirely for the purpose of reducing, and in some cases eliminating, the tax liabilities of large corporate or wealthy individual taxpayers. for years these shelters have been a serious concern, both because of the direct loss in tax revenue associated with them and because of the indirect effect on taxpayer morale. that is, when the average small-business owner learns that a bunch of large corporations have been engaging in highly sophisticated and extremely aggressive tax-shelter activity, the sort of aggressive, avoidance-bordering-on-evasion10 as bad as the problem of corporate tax shelters can be, however, it is dwarfed by the level noncompliance – often in the form of outright evasion – among small and medium-sized businesses (“smbs”). transaction that is beyond the financial reach of the average taxpayer, she begins to wonder, why does the government allow this? 11 by far the most serious area of tax noncompliance in the united states, and probably in every other country in the world, is that of smbs, whether these businesses are operated as sole proprietorships, partnerships, or corporations. as we explain in greater detail below, the smb netmisreporting percentage is the primary source of the u.s. tax gap. what is especially surprising about the smb tax gap in the united states is how little it has been studied. in fact, with a few exceptions, smb noncompliance has been largely ignored in the legal literature on the u.s. income tax.12 to be a bit more specific, in this article we suggest the possibility of shifting from the existing income tax regime, which currently is characterized by a large degree of noncompliance, to a system of presumptive taxation of smb income. a presumptive tax imposes a levy on one thing as a proxy for (or rough approximation of) another thing. for example, a tax on some percentage of a business’s gross receipts or its asset values rather than on a precise measure of income might be considered a rough proxy it is the aim of this article to remedy that omission, to focus scholarly attention on the problem of smb tax noncompliance in the united states, and to explore some new, potentially radical solutions. 10 by tax “evasion” we mean intentional noncompliance with the tax laws: the taking of tax positions that the taxpayer knows (or should know) is clearly prohibited by law. the more general term “noncompliance,” by which we mean a tax position that an objective tax expert (say, a court ruling on the position) would say is in violation of the tax laws, includes evasion but also includes lots of tax positions that are not evasion. that is, given the large degree of substantive uncertainty in the tax laws, it is often the case that taxpayers will take positions that are not clearly illegal (that are not evasion) but that, if detected and ruled on by a court, would be found to be examples of noncompliance. thus, noncompliance includes taking tax positions that turn out, when the rules are applied correctly, to be unsupported by the law, even if this is not the taxpayer’s intention. in defining the tax gap, the treasury department seems to be using a concept of noncompliance similar to the one just described. of course, it is possible for taxpayers to take positions that are not clearly illegal but that have a small chance of being upheld if reviewed. for a general discussion of these different types of noncompliance, and how tax penalties should be designed to respond to them, see kyle d. logue, optimal tax compliance and penalties when the law is uncertain, 27 va. tax rev. 241 (2007). 11 we define smbs more precisely below. 12 one important exception to this statement is susan cleary morse, stewart karlinsky & joseph bankman, cash business and tax evasion, 20 stan. l. & pol’y rev. 37 (2009) (reporting on a series of interviews with noncompliant smb taxpayers and their accountants). there has also been an excellent law review article on smb (or self-employment) noncompliance problem in other countries. piroska soos, self-employment evasion and tax withholding: a comparative study and analysis of the issues, 24 u.c. davis l. rev. 107 (1991). 104 columbia journal of tax law [vol. 2:100 for a business income tax. (and as we shall see, some countries employ some version of an smb gross receipts tax, and some use an asset tax.) what distinguishes a presumptive income tax for the purposes of our analysis is that it attempts to tax income in a very rough way, sacrificing accuracy of measurement for a reduction of compliance and enforcement costs. every tax system, of course, trades off accuracy for simplicity to some degree.13 and how much of a sacrifice in accuracy is required depends on the context. the term presumptive tax has traditionally been used to describe tax regimes in environments in which administrative/enforcement costs are unusually high and therefore accuracy of income measurement is unusually expensive. such environments are often found in developing countries, where it is necessary to make unusually large sacrifices in income-measurement accuracy in order to be able to collect any taxes at all.14 indeed, as one commentator put it, “the main virtue of presumptive taxation is that it may be the only effective way to tax small businesses in developing countries.”15 this observation may apply to developed countries as well, or so we argue. that is, given the extremely high enforcement costs associated with a tax on net business income for smbs, this article argues that the most efficient and distributively fair system of smb taxation may include some form of presumptive income tax. put differently, we suggest that when it comes to the taxation of smb income, policymakers in developed economies should consider approaches that have been used successfully by governments in developing economies, where the smb tax noncompliance problems are even more severe. one type of presumptive tax that we focus on (but do not go so far as to endorse) would ground smb tax liability on presumed profits rather than on actual profits. under one particular version of such a system, congress would develop (or would delegate to the treasury department the task of developing) a range of “presumed-profit ratios” for particular categories of businesses. these presumed profit ratios, which would be based on historical experience within those lines-of-business, would be applied to the actual reported gross receipts of smb taxpayers. the primary benefit of such a “modified gross receipts” presumptive tax regime would be that it would dispense with the need to evaluate taxpayers’ individualized (and easily overstated) business expense deductions, as business deductions would not be relevant for the definition of the tax base. this change would dramatically reduce the costs of 13 for early statements by economists of the accuracy-simplicity tradeoff in the tax context, see joel slemrod & shlomo yitzhaki, analyzing the standard deduction as a presumptive tax, 1 int’l tax & pub. fin. 25, 32 (1994) [hereinafter slemorad & yitzhaki, standard deduction] (“whether it is explicit or implicit, all tax systems must trade off the accuracy of tax-base measurement against the cost of that measurement.”); and louis kaplow, the standard deduction and floors in the income tax, 50 tax l. rev. 1, 2 (1994) (“such limits, like the standard deduction, save compliance and administrative costs but sacrifice accurate measurement”). for a more general treatment of the point, see louis kaplow, how tax complexity and enforcement affect the equity and efficiency of the income tax, 49 nat’l tax j. 135 (1996) [hereinafter kaplow, complexity and enforcement]; and louis kaplow, accuracy and complexity in the income tax, 14 j. l. econ. & org. 61 (1998) [hereinafter kaplow, accuracy]. 14 e.g., joel slemrod & shlomo yitzhaki, tax avoidance, evasion, and administration, 3 handbook pub. econ. 1423, 1456 (2002) [hereinafter slemord and yitzhaki, tax avoidance] (noting that presumptive taxes “are a pervasive element in the tax systems of many developing countries”). slemrod and yitzhaki observe that “[t]his kind of tax makes sense in cases where the otherwise desirable tax base is difficult for the tax authorities to measure, verify, and monitor.” id. 15 kenan bulutoglu, presumptive taxation, in imf fiscal affairs dep’t, tax policy handbook (parthasarathi shome ed., 1995). 2011] narrowing the tax gap through presumptive taxation 105 enforcement. part of the administrative-cost savings would come from an expanded use of compulsory withholding, which would include payments to independent contractors as well as payments to other smb taxpayers.16 the beauty of the expanded withholding option is that, by effectively making payers vicariously responsible for the tax obligations of the smb payees, we actually get closer to the social optimum, in terms of efficiency and distribution.17 we should emphasize here that the presumptive-tax proposals discussed in this article are directed primarily at that portion of the u.s. smb noncompliance problem that is attributable to merchant-to-merchant transactions – where one merchant pays another merchant (the latter sometimes being called the independent contractor) for services or goods. it is with respect to those sorts of transactions that the use of presumed profit ratios combined with compulsory withholding can provide the greatest overall improvement in compliance-per-dollar-of-administrative-cost. in addition, our analysis has relevance to the optimal tax treatment of merchant-to-consumer transactions, insofar as those transactions involve creditor debit-card purchases. for such transactions, third-party (credit-card-company) reporting to the irs would insure that the government would have reliable information on at least a significant fraction of the smb taxpayer gross receipts. 18 16 kyle d. logue & joel slemrod, of coase, calabresi, and optimal tax liability, 63 tax l. rev. 797 (2010). with respect to cash transactions, however, there is little to gain (in terms of improved enforcement per administrative dollar spent) by imposing a presumed-profit tax on reported gross receipts. for one thing, in such settings, the merchants receiving payments from consumers often simply understate their gross receipts, which is a problem that our modified-gross-receipts tax obviously cannot easily address. although it is not clear from the existing evidence precisely what fraction of the smb tax underpayment problem is attributable to these very small merchant-to-consumer businesses, many tax commentators believe that it is the dominant source of the problem. we do discuss briefly how presumptive-tax principles might be used to improve compliance in such settings. moreover, we discuss one possible solution to the problem of evasion in cash transactions that has been used in 17 our analysis is entirely consistent with, and borrows heavily from, the part of the optimal tax literature that addresses the tradeoff between accuracy and complexity. see, e.g., nicholas stern, optimum taxes with errors in adminstration, 17 j. pub. econ. 181 (1982). the article owes a special debt to the work of joel slemrod and shlomo yitzhaki on the marginal cost of funds in general and on presumptive taxes in particular, which is cited throughout. a seminal paper on the subject of the efficiency and equity aspects of presumptive taxation is vito tanzi & milka casanegra de jantscher, presumptive taxation: administrative, efficiency, and equity aspects (imf, working paper no. 87/54, 1987). 18 third-party reporting of electronic transactions has recently been adopted in the united states. the housing and economic recovery act of 2008, pub. l. no. 110-289, 122 stat. 2654, created 26 u.s.c. § 6050w (2010) (“returns relating to payments made in settlement of payment card and third party network transactions”), which requires credit and debit card companies and other “payment settlement entities” to file information returns with the irs and the merchant. these returns are to include the merchant's name, address, taxpayer identification number, as well as the gross amount of the transactions the entity processed for the merchant. the provision covers not only credit and debit cards but also thirdparty payment networks such as online payment systems. morse, karlinsky & bankman, supra note 12, find that revenue from credit card transactions is reasonably well reported by small businesses (most of the interviewees in their survey said that they reported those transactions because they suspected that the irs would know about them), while revenue from cash transactions is less well reported. what this suggests is that, in regard to credit-card transactions, if there is to be any income tax evasion, it will likely occur on the deductions side. as discussed in the text, it is deduction-side evasion that the presumptive income tax is designed to address. 106 columbia journal of tax law [vol. 2:100 other countries that is not necessarily related to presumptive tax principles, but can be used in conjunction with them.19 therefore, the article is devoted to developing the idea of a presumptive business income tax alternative to the existing income tax regime that seems to be failing and the article does not consider the possibility of simply replacing the income tax on smbs with a vat, which might be the best alternative. finally, this article takes as given that there is a societal preference for imposing some sort of tax on business income. 20 • what the optimal presumptive tax base would be; the article is organized as follows. part ii provides more data on the tax gap and explains what we mean by an smb. part iii discusses why the tax gap actually matters, putting the problem in terms of efficiency and distributive fairness (which can in turn be put in terms of the “marginal cost of funds”) and explains why some of the most obvious solutions might not be the best response. part iv introduces the idea of the presumptive tax by offering an operational definition of the concept and by identifying some aspects of the existing u.s. income tax regime that have presumptive-tax characteristics. part v provides the basic framework for how to think about designing an smb presumptive tax. in this part we address the following questions: • whether the presumptive tax should be mandatory or optional; • whether (if mandatory) it should be a mandatory minimum only (as with the amt) or a mandatory maximum and minimum; • whether (if optional) the presumptive should be accompanied by a dual-track enforcement regime (where one set of penalties applies to those who opt into the presumptive tax and another for those who do not); and • whether, if adopting a statutory presumptive tax proves not to be a workable idea, it would make sense to make use of presumptive-tax principles as part of the irs audit strategy for smbs. part vi contains our conclusions and some caveats to our analysis. ii. a closer look at the tax gap data a. what the numbers show (and don’t show) consider the most recent data on the federal income tax gap, based on the 2001 tax year. of the $345 billion total gross tax gap for that year, $285 billion is for “underreporting,” which means either the understatement of receipts or overstatement of deductions, exemptions, or credits.21 the other $60 billion of the tax gap ($345 billion minus $285 billion) is attributable to the nonfiling of returns ($27 billion) or the underpayment of taxes that the taxpayer reports as being owed ($33 billion).22 19 see infra note 113 for a discussion of a brazilian regime that uses tax credits to encourage consumers to monitor tax reporting by smbs. of the $285 billion attributable to underreporting (which is our primary concern here), $197 billion is attributable to income tax returns filed by individuals, $30 billion to income tax returns filed by corporations, $54 billion to employment tax returns, and $4 billion 20 below, we explain why a true vat on smbs would suffer from problems of its own. see infra part vi. 21 treasury, supra note 2, at 12. 22 id. 2011] narrowing the tax gap through presumptive taxation 107 to estate tax returns.23 of the $197 billion of the tax gap attributable to individual income tax returns, $109 billion was from individual business income, $56 billion was from understated individual non-business income (understated wages, interest, dividends, and capital gains), and $32 billion was attributable to overstated nonbusiness deductions or exemptions ($15 billion) or credits ($17 billion).24 all of this can be seen in the treasury department’s “tax gap map for the tax year 2001,” reproduced here. notice that, of the $109 billion tax gap attributable to individual business income, $68 billion comes from “non-farm sole proprietor income” – or, smbs operated as sole proprietorships other than farms.25 the remaining $41 billion of individual business income underreporting tax gap is attributable to small farms ($6 billion); rents and royalties ($13 billion); and smbs operated as partnerships, s-corps, or through some sort of trust ($22 billion).26 one fact to take from all of these numbers is the disproportionate amount of the income-tax gap attributable to sole proprietors. in fact, the non-farm, sole-proprietor income-tax gap constituted 19.7% of the overall annual gross federal tax gap for 2001. by contrast, a relatively small amount of the tax gap– roughly 16.2% of the total – was attributable to underreported non-business-related individual income, a category that, 23 id. 24 id. 25 id. at 13. 26 id. 108 columbia journal of tax law [vol. 2:100 again, would include understated wages, tips, interest, and capital gain income.27 another way to see the problem is to focus on the rates of noncompliance. the treasury department calculates an aggregate “net misreporting percentage” (or “nmp”) for various categories of taxpayers by dividing the amount of the income that is misreported by the amount that should have been reported. this later gap is remarkably small, relatively speaking, considering that the total number for non-business individual income is by far larger than the total amount of business income for individuals. 28 and using this figure, there is a good deal of variation in noncompliance rates depending on the type of taxpayer in question. for example, the nmp for non-business individual income is only around 4% and it is less than 1% for wages. by contrast, for non-farm soleproprietor income, the nmp was calculated to be a whopping 57%. that is, individuals who ran their own businesses as sole proprietorships in 2001 remitted, in the aggregate, only 43% of the income taxes they actually owed.29 but that was not the only problem area. the noncompliance rate for farm income was even higher (71%), but the magnitude in revenue terms of the problem there was much smaller (with an underreporting gap of only $6 billion).30 these misreporting percentages far exceed the noncompliance rate attributable to the corporate income tax overall, which in the aggregate was only 18.5%. this estimate for corporate noncompliance, however, combines the noncompliance figures for large and small corporations, and, for reasons discussed further below, we suspect that the rate of noncompliance for the latter would be greater.31 likewise, the noncompliance rate for the category of partnerships and scorps was in the neighborhood of 18%, but we suspect that statistic masks some pockets of serious noncompliance.32 indeed, just as the 15% figure for overall noncompliance hides areas of much more serious noncompliance, even the more fine-grained statistics above tend to mask areas of substantial abuse. take non-farm sole proprietors, for example. the 2001 data reveal that, although sole proprietors as a group are among the least compliant, not all sole proprietors wildly understate their business income. although it is true that (based on the 2001 data) most sole proprietors filing schedule c returns understated their business income to some extent, not all did. in fact, the majority of the understatement 27 id. 28 id. 29 id. 30 this is simply because farm income as a type of individual business income is small relative to other types of smb income. 31 treasury, supra note 2, at 11. according to the treasury tax gap study, small corporations (those with annual revenue of less than $10 million) exhibited a tax gap of $5 billion; whereas large corporations (over $10 million in revenues) had a tax gap of $25 billion. id. the treasury study did not break the corporate nmp down into these two categories, but reported an 18.5% figure for all corporations. we suspect that the noncompliance rate for small corporations is significantly higher than that for large corporations, for reasons we discuss below (including the expectation of greater irs enforcement efforts for large corporate taxpayers, given the obvious economies of scale of doing so). 32 in other words, although the overall average rate of noncompliance for individual returns reporting income from businesses organized in the form of s corporations or partnerships was only 18%, it seems likely that this results from most s corporations and partnerships reporting fairly accurately (with far less than 18% noncompliance) but with relatively few attempting to engage in serious noncompliance (with underreporting considerably greater than 18%). in other words, it seems likely that most of the s corporation and partnership noncompliance is attributable to a relatively small minority of such taxpayers. such an outcome would be consistent with what the treasury department has found with respect to noncompliance among sole proprietors, as discussed in the text immediately below. 2011] narrowing the tax gap through presumptive taxation 109 (around 60%) was attributable to 10% of the schedule c filers.33 what explains this degree of unevenness in noncompliance? as we discuss further below, it may be that most sole proprietors are relatively honest or risk averse or feel bound by social norms to limit the amount of their tax underpayment; whereas, a small subset of sole proprietors are relatively dishonest or less averse to risk or do not feel bound by such norms. this unevenness in noncompliance may also be explained by the fact that some of these sole proprietors have more opportunities to evade than others. in any event, whether the cause is variation in taxpayer honesty, aversion to risk, respect for norms, or opportunities to cheat, it is this unevenness of compliance that creates the inequity (horizontal or vertical) that requires some sort of remedy, as we argue in further detail in part iii below. given that corporations and partnerships face the same sorts of dynamics (that is, they are run by people with different degrees of honest or risk aversion and different levels of respect for norms of legal compliance,) we suspect that a similar degree of unevenness of noncompliance exists among corporations and partnerships. indeed, half of the sole proprietors that filed schedule cs in 2001 that were found to have understatements on their returns understated by less than $900; whereas, the 10% who were the largest offenders understated by $6,200 on average; and the worst 2% understated by over $20,000 on average. one of the key insights, then, of the various studies of the u.s. tax gap is that individually owned businesses are significantly more likely to under-comply with the tax laws than are other types of businesses.34 what the studies do not reveal is precisely what those individually-owned businesses look like. are they mostly businesses that sell directly to consumers, such as local restaurants and corner groceries? or are they mostly independent contractors who provide services and goods to other merchants? earlier studies broke out “informal suppliers” from the larger category of “non-farm sole proprietors,” with the former being described as businesses that sold predominantly to consumers and often engaged in cash transactions.35 unsurprisingly, that study found that the rate of noncompliance was considerably higher for the informal-supplier merchant-to-consumer group (in the neighborhood of 80%) than it was for all other non-farm sole proprietors (closer to 30%).36 some studies estimate that consumer cash payments may represent up to 20% of retail sales transactions in the united states, and most of the smbs evasion could therefore be attributable to the underreporting of these cash receipts. even that study, however, did not make clear what the relative size of the two groups was. and the more recent studies, the ones that look at the 2001 tax year data, make no effort to break down the data in this way. what that means is that we cannot be certain as to what portion of the nonfarmsole-proprietor tax gap involves the type of noncompliance this article focuses on – that of independent contractors who transact primarily with other businesses. 37 33 u.s. gov’t accountability office, gao-07-1014, tax gap: the strategy for reducing the gap should include options for reducing sole proprietor noncompliance, report to the s. finance comm. 13-15 (2007). with respect to 34 treasury, supra note 2. 35 irs, united states department of the treasury, federal tax compliance research: individual income tax gap estimates for 1985, 1988, and 1992, 8 pub. 1415 (1996). 36 id. 37 morse, karlinsky & bankman, supra note 12. the authors, citing david b. humphrey, replacement of cash by cards in u.s. consumer payments, 56 j. econ. & bus. 211, 223 (2004), show that 110 columbia journal of tax law [vol. 2:100 cash transactions, it is likely that those seeking to evade taxes would prefer evading through the understatement of receipts rather than through the overstatement of deductions, because the former facilitates not only income tax evasion but also sales tax evasion. the use of cash also facilitates evasion by a business’s employees and suppliers, which further enhances its appeal as a tax evasion “technology.”38 there is, however, data showing that the overstatement of deductions accounts for almost as large a share of the income tax gap as does the underreporting of receipts. 39 these two phenomena would explain the almost equal proportion of concealed receipts and overstated deductions in the tax gap and, at the same time, the unevenness of the amount of evasion between smb taxpayers. that is, a few smb taxpayers evade a lot by understating cash receipts, and a lot of them evade a little by overstating their deductions. if the picture just painted is accurate, it seems that a sound plan to curb smb evasion should deal with both understatement of receipts and overstatement of deductions. one can even argue that the latter would tend to be the more rapidly growing part of the evasion problem if credit card payments continue to replace retail cash transactions. therefore, as we explain later, the adoption of presumptive taxes (if coupled with other audit mechanisms such as third-party reporting, withholding, and programs capable of monitor cash payments) could be a valuable tool to deal with the smb evasion problem as a whole. considering the likelihood that the substantial use of cash receipts as a means of exchange is unevenly distributed across smbs (that is, only a subset of all smbs receive a significant fraction of their receipts in cash), it is possible to paint the following picture: on the one hand, most of the smb taxpayers who are inclined towards noncompliance (are dishonest or risk preferring or unaffected by compliance norms) are in fact not able to understate much of their receipts because most of their receipts are not in the form of cash. rather, they are in the form of credit or debit-card purchases or checks, which are subject to greater third-party reporting. these potential noncompliers, then, must lean more heavily on a different evasion strategy, that of overstating deductions. there are limits, however, to the extent taxpayers can overstate their deductions; at some point the number and the size of the deductions will raise red flags with the internal revenue service. as a result, these smb taxpayers end up evading less overall than they would if they could also easily understate their receipts with impunity. on the other hand, the subset of smbs who receive most of their receipts in the form of cash can engage in massive concealment of such receipts. b. why we focus on smbs the other fact not revealed in the above-described data is the precise relationship between the rate of noncompliance and the “size” of the taxpayer. for reasons discussed in the next section, our hypothesis (consistent with conventional wisdom) is that noncompliance rates (especially evasion) among business taxpayers cash use in the united states is concentrated in retail sale transactions and that, although credit and debit cards have eroded its use, cash remains an important form of payment. in 2000 cash represented 20% of consumer payments, down from 31% in 1974, and the use of credit and debit cards rose from 13% to 27% over the same period, while check use fell from 56% to 46%. 38 id. in the morse, karlinsky and bankman study, the interviewees expressed a preference for cash receipts and would understate those receipts even if this would not reduce their income tax liability. 39 gov’t accountability office, supra note 33. understatement of receipts composes 55% of the gap, while overstatement of deductions constitutes 45%. morse, karlinsky and bankman recognize this fact, although their research emphasizes the evasion of cash receipts. see supra, note 12. 2011] narrowing the tax gap through presumptive taxation 111 will tend to be negatively correlated with size of the taxpayer, though not necessarily in any sort of continuous (or even precisely predictable) way.40 what do we mean by size here? one obvious measure would be the taxpayer’s total assets. for example, the irs has a special “small business/self-employed” enforcement division that defines small businesses as those having assets less than $10 million.41 so why do we focus on the smb tax gap rather than simply on the small business tax gap? we prefer to include what we call “medium-size” businesses to emphasize the fact that the cutoff between small and large is ultimately arbitrary, to establish that many of the business taxpayers that we are concerned about may have fairly large amounts of assets or annual revenues compared with the average individual taxpayer, and to make clear that the dividing line is not necessarily the one used by the irs to organize its various enforcement divisions. the point is to tailor a presumptive tax regime that targets those business taxpayers most likely to engage in evasion. further, empirical research will be necessary to nail down precisely how that group of taxpayers should be defined. the choice of a $10-million cutoff is, of course, arbitrary; lots of other cutoff points could reasonably have been used. other measures besides total assets also could be used, such as annual revenue or annual income. the point is that large corporate taxpayers, for a number of reasons, are less likely to engage in outright tax evasion than small business taxpayers and the choice of precisely where to draw the line between is (we freely admit) fraught with uncertainty and on some level arbitrary. iii. why the smb tax gap matters and what to do about it 40 giampolo arachi & alessandro santoro, tax enforcement for smes: lessons from the italian experience?, 5 ejournal of tax res., dec. 2007, at 225, available at http://www.atax.unsw.edu.au/ejtr/content/issues/previous/paper3_v5n2.pdf, shows that a firm’s size affects tax enforcement policy in two different ways. first, the costs and returns of auditing depend on the firm size (i.e., there are economies of scale in concentrating audits in large firms that account for a large share of the tax revenues). this issue will be explored in more detail below. second, there can be a relationship between the propensity to evade and firm size. slemrod, for example, notes that closely held small businesses have different motivations for evasion choices than those of public corporations. while small businesses tend to follow the rationale applicable to individuals (see part iii below for the economic analysis on evasion), public corporations should be considered risk-neutral and the analysis should be focused on other kind of stimuli towards evasion (such as principal-agent relationship between managers and shareholders). thus, the compliance analysis of smbs and public corporations would differ and the level of evasion of each of these groups would depend on how they interact with the tax and enforcement systems. see joel slemrod, the economics of corporate tax selfishness (nat’l bureau of econ. research, working paper no. 918, 2004). cowell proposes a model of firm compliance by which evasion would depend on concealment costs (assuming risk-neutrality in all cases). the costs of concealment would increase depending on certain variables, such as the nature of the product (products more visible on the market are harder to conceal), the size and organizational structure of the firm (“firms with a more complex organization are likely to have higher concealment costs: the more people you bring into the plot the greater the security problem you face and the greater the risk of discovery”) and the role of reputation (the more important the brand name, the higher the concealment costs in virtue of the risk of brand defamation in case of engagement in illegal activities). this would indicate a negative relationship between firm size and evasion (i.e., the smaller the firm, the lower the costs of concealment and the higher the level of evasion). see frank a. cowell, sticks and carrots 17 (toyota int’l ctrs. for econ. & related disciplines, discussion paper no. 68, 2003). 41 not surprisingly, among the top “strategic priorities” listed for this division is addressing the tax gap. see irs, small business/self-employed division at-a-glance, http://www.irs.gov/irs/article/0,,id=101001,00.html (last updated aug. 19, 2010). http://www.irs.gov/irs/article/0,,id=101001,00.html� 112 columbia journal of tax law [vol. 2:100 a. why it matters42 before we delve too deeply into potential solutions to the smb tax gap, we should first clearly understand why it is a problem. indeed, if noncompliance opportunities were allocated uniformly across all taxpayers, it is not obvious that noncompliance would be a concern. that is, if the overall 15% tax gap meant that everyone simply paid exactly 15% less than they ostensibly owed under the code, it would be similar to an implicit reduction in tax rates. thus, if the federal statutory effective tax rate were, say, 20% overall (including all federal taxes and all taxpayers), then, assuming a universal and uniform noncompliance rate of 15%, the actual effective tax rate would be closer to 17%. and that might be acceptable. 43 however, if an overall effective rate of 17% were insufficient to generate the level of revenue needed to pay for the desired amount of government spending, policymakers could then simply raise statutory rates until the actual effective rate produced the desired target level of funding.44 but again, as discussed in the previous section, that is not what the actual tax gap looks like. many taxpayers are highly compliant. recall that wage earners tend to pay almost 100% of the taxes they owe on those wages. and again, the highest degree of noncompliance among is smbs or the self-employed (at 57%). 45 to see this point, consider a simple example. say there is a self-employed individual, jim, who has a small consulting business that produces $100,000 of net income, but who knows he can get away with paying very little of what he owes (for reasons having to do with the absence of withholding, little third-party reporting, and the like, which we will discuss further below). in addition, jim feels neither personal guilt nor fear of informal social sanctions when paying as little as he can get away with. so jim pays nothing. joan, however, is a wage earner who makes $100,000 as her only source of income. she pays her whole income tax liability, entirely through withholding. finally, there is jack, who has a small consulting business just like jim’s that produces $100,000 net of expenses. jack could also get away with paying no tax, for the same reasons as jim, but he feels morally obligated to pay his full income-tax liability, and if he makes any errors, they are as likely to be overstatements as understatements of income. what’s more, even among the self-employed, there must be a wide divergence of compliance behavior. that is, there must be some self-employed individuals who feel compelled by personal morality, extreme risk aversion, fear of informal social sanctions, or whatever to comply with the tax laws; and they do. these discrepancies, which are to some extent reflected in the evidence discussed above, produce both unfairness and inefficiency. the disparity between jim and his law-abiding counterparts is obviously unfair. it is one reason why we enforce the tax laws and impose penalties for noncompliance. we have a tax system that is supposed to tax people roughly according to their ability to 42 this section borrows heavily from joel slemrod & jon bakija, taxing ourselves: a citizen’s guide to the debate over taxes (mit press 4th ed. 2008). 43 such a uniform implicit “rebate” of 15% of every taxpayer’s statutory tax liability would of course have its own distributional consequences. it would be equivalent to a tax credit of 15% of each taxpayer’s tax liability, an amount that would obviously increase as the taxpayer’s statutory tax liability increases. 44 as we discuss further below, increasing the statutory rates may increase the tax gap percentage, a fact that would have to be taken into account in setting the statutory rates as well. 45 and then there are the farmers, at 72% noncompliance. treasury, supra note 2, at 13. 2011] narrowing the tax gap through presumptive taxation 113 pay. that is why so much of the tax law is devoted to defining the income tax base accurately – to make sure that individuals of equal net income pay equal tax. (indeed, that is why we have an income tax rather than, say, a head tax). and when this does not happen, when the goal of accurate measurement of income and assignment of tax liability is not achieved, it matters. some would call this a problem of horizontal inequity: not taxing taxpayers of similar ability to pay a similar amount.46 others would say that it is a problem of vertical equity.47 in the example involving jim and joan, the distributive unfairness is clear. the comparison is between two individuals: one who earns his living as a self-employed small business owner, the other who works for wages. and the smb tax gap produces precisely this type of distributive unfairness. moreover, in such situations, the distributional consequences of noncompliance and of various responses to noncompliance are easier to identify. this is because it is generally assumed that the economic burden of an income tax lies predominantly on the income earner. the same should be true, all else equal, if the income in question were earned by a self-employed individual. thus, improving compliance by self-employed individuals should produce an unambiguous improvement in distributional equity, albeit at some cost of enforcement. not all smbs, however, are self-employed individuals. some of them are firms that have multiple owners and multiple employees and even multiple customers. in those cases, the distributional effect of improved compliance is more difficult to determine due a question of tax incidence. that is, if a noncompliant smb with multiple owners and multiple employees and multiple customers is forced to pay more in tax, on whom will the burden of increased compliance ultimately fall – the owners, the employees, or the customers? the answer is not clear. nevertheless, an argument could be made that, if we know nothing of the specific ability to pay of any of the relevant parties, it is better from a distributional perspective to shift a portion of the tax burden from the currently compliant taxpayers (including the owners, employees, and customers of the compliant firms) to the owners, employees, and customers of the presently noncompliant firms. either way, it is a real concern, one that we are apparently willing to spend real resources to eliminate, or at least to reduce. 48 in addition to the distributional problems just discussed, unevenly distributed noncompliance opportunities also produce allocative inefficiency, which may ameliorate some of the distributive inequities just described. once it becomes clear that 46 joel slemrod & shlomo yitzhaki, the costs of taxation and the marginal efficiency costs of funds, 43 imf staff papers 172, 191-92 (1996) [hereinafter slemrod and yitzhaki, the costs of taxation] (discussing the social welfare implications associated with the horizontal equity created by noncompliance). 47 see kaplow, complexity and enforcement, supra note 13; and kaplow, accuracy, supra note 13. 48 of course, if it could be shown that the owners, employees, or customers of noncompliant smbs tend to be poorer on average than those of compliant firms (or that the jims of the world tend to be poorer than the jack’s of the world), then the analysis might be different. indeed, in such a case, we might think of the current smb noncompliance problem as a nicely tailored welfare program or low-income subsidy. we are not aware of any evidence, however, suggesting that this is the case. moreover, it seems that a welfare program of this sort should be explicit in the law, in a structured and straightforward manner, instead of hidden under non-compliance figures. it seems only fair to assume, when talking about curbing evasion, that the tax law did its job correctly when distributing the tax burden, considering all the possible shifts in incidence (of course, this is a utopia, but one has to recognize that assuming otherwise would lead to chaos). thus, the goal of full compliance would be to achieve the distribution tailored by the tax law; if such distribution is not perfect, it should not be altered by evasion, but by a change in the law itself. 114 columbia journal of tax law [vol. 2:100 there are types of jobs or forms of organization that are largely free from federal income taxation (if one is willing to flout compliance norms), then we should expect some changes in the supply of labor and capital. people and resources will tend to move into the areas of the economy and forms of organization with respect to which noncompliance is easiest and thus taxes are lowest,49 of course, it is well understood that there are natural limits to this process of inefficiency crowding out inequity. for one thing, some taxpayers will be too honest or risk-averse to take advantage of the potential noncompliance subsidy if they would only switch from being a wage earner to being a small business owner. in addition, for workers who can easily characterize themselves as either employees or independent contractors, it is not clear that such a shift would affect pre-tax prices in those sectors. and if that is the case, we would be left with the massive inequity as between compliant taxpayers (either wage earners or honest smbs) and the dishonest smbs. which in some cases will affect supply and pre-tax prices in the usual way: that is, parties in those sectors will receive lower pre-tax profits than can be found in the non-tax-favored sectors, a change that will undercut the unfairness inherent in the post-tax differences in return. what this means, however, is that, unless one can argue that smbs produce some sort of beneficial externality to the economy (more on this argument below), there would be too many resources being devoted to these areas of the economy or forms of organization in this picture. this whole fairness/efficiency argument can be put in terms of the public finance economists’ preferred framework for evaluating incremental tax policy changes – the so-called marginal cost of funds (mcf). the basic idea of mcf is simple: assuming the need to raise an additional $1 in taxes, policymakers should identify the marginal social cost of raising that $1 through marginal changes in alternative tax instruments. and then they should choose the one that has the lowest mcf.50 mcf analysis takes into account both efficiency costs (referred to as the marginal efficiency cost of funds, or mecf) and distributional consequences (sometimes denoted dc).51 to see how this works, consider how we might compare the mcf of two different responses to a $1 loss of revenue due to taxpayer noncompliance. one policy response would be to increase the frequency and thoroughness of audits. the other would simply be to replace the lost revenue with a rate increase. raising rates would be inexpensive (relative to increased/enhanced audits) in terms of additional administrative costs, but it would increase the “leakage” of revenue due to the distorting effect of higher marginal tax rates.52 49 arachi & santoro, supra note 40, at 228 (citing simon c. parker, does tax evasion affect occupational choice?, 65 oxford bull. econ. & stat. 379 (2003)), show that “when workers can switch freely between two occupations [i.e. wage earners and self-employment] their preference for selfemployment would depend on the discretion that self-employed workers have in declaring their incomes as opposed to the relative lack of discretion by employees who are subject to withdrawal taxes and third party reporting.” also, a rate increase would produce a negative distributional consequence, 50 for the optimal policy, the mcf for all policy instruments would be equal. in the real world, the best that can probably be done is to figure out which instrument entails the lowest mcf at any given point and, at the margin, use that one. slemrod & yitzshaki, tax avoidance , supra note 14. 51 thus, the mcf for tax instrument i can be written as follows: mcfi = dci × mecfi, where mecfi is the marginal efficiency cost of funds, and dc is the distributional component. 52 the mecf formula that includes administrative, compliance, and excess burden is mecfi = [γ(xi − mri) + ci + mri]/[mri − ai], where xi is the amount of tax that would be collected in the absence of any change in behavior, mri is the marginal revenue actually collected (after distortions), xi – mri is the “leakage” due to the distortions, γ is the social value of the utility the taxpayer is sacrificing at the margin in 2011] narrowing the tax gap through presumptive taxation 115 as the horizontal inequity between compliant and noncompliant taxpayers would increase. by contrast, spending more on tax enforcement (say, funding more numerous and more thorough audits) would dramatically increase administrative costs, which in turn would increase the mecf of that policy response. such an approach would have ambiguous effects on the leakage of revenue, since increased/enhanced audits would, on the one hand, reduce evasion but, on the other hand, cause greater substitution from work to leisure.53 spending more on tax enforcement, however, would have an unambiguously positive, i.e., cost-reducing, effect on the distributional component of the mcf. 54 this last point is the intuition mentioned above, which can be restated as follows: there are social welfare costs (resulting from socially undesirable inequities) associated with requiring or allowing similarly situated taxpayers to pay different amounts of tax, and this is especially so when the party paying less is doing so through noncompliance with the rules. and hence there is social value to eliminating this inequity.55 b. explaining smb noncompliance indeed, if society values equity along this particular dimension highly enough (or, put the other way, if we are sufficiently offended by the inequity associated with non-uniform noncompliance), then the case for increasing the enforcement budget (and perhaps reducing tax rates, keeping overall tax revenues the same) becomes stronger. the next question is why so many smb taxpayers exhibit such comparatively high rates of noncompliance. according to standard deterrence theory, this is no mystery. on this view, taxpayers are rational actors whose decisions regarding legal compliance depend entirely on the likelihood and magnitude of formal legal penalties. accordingly, the answer to the tax noncompliance question is simple: people pay their taxes to avoid being punished by the government, in the form of fines or imprisonment; and if that punishment is not sufficiently probable or large, tax evasion will be the result.56 order to save a dollar of taxes, ci is the marginal private compliance cost associated with the i instrument, ai is the marginal administrative cost, and mri − ai is the net revenue collected at the margin, after the administrative cost of collection. slemrod & yitzhaki, tax avoidance, supra note 14. when taxpayers are deciding whether to understate their income or not (or whether or not to file a return), they simply compare the tax savings attributable to 53 if the government increases its auditing efforts of labor income, it would have the effect, much like raising tax rates on labor income, of raising the price to taxpayers of producing labor income (which is subject to taxation) relative to the price of producing non-labor income or leisure (which is not taxed). this change in relative prices causes substitution away from the taxed activity, which is generally considered allocatively inefficient. 54 this is true even if it turns out that most non-compliers have relatively low incomes. that is to say, if we assume that the tax policymakers have chosen a statutory tax rate that achieves optimal distribution under conditions of full compliance, then any improvement in compliance would by definition be an improvement in the dc number in the mcf formula. put differently, if the optimal distribution of tax burdens calls for low-income earners to pay some taxes, then social welfare is enhanced when those taxpayers actually pay their taxes – even though they are low-income individuals. this is not to say, of course, that the improvement in the distributional component will outweigh the costs of enforcement (or the distortion in behavior) associated with the improved compliance. indeed, that is one of the main implications of the mcf analysis. 55 kaplow, accuracy, supra note 13. 56 see, e.g., michael g. allingham & agnar sandmo, income tax evasion: a theoretical analysis, 1 j. pub. econ. 323 (1972); and shlomo yitzhaki, a note on income tax evasion: a theoretical analysis, 3 j. pub. econ. 201 (1974). this tax enforcement literature, of course, was based in part on the pioneering work by gary becker on criminal law enforcement. see gary s. becker, crime and punishment – an economic approach, 76 j. pol. econ. 169 (1968). 116 columbia journal of tax law [vol. 2:100 evasion with the expected costs of the potential legal sanction, which is the product of the magnitude of the fine and the probability of detection. relative risk aversion plays a role, too, as the taking of an aggressive or clearly illegal tax position is akin to rolling the dice; hence the phrase “playing the audit lottery.” the more averse one is to this sort of risk, the less appealing the noncompliance gamble will be. on this view, the degree of smb noncompliance should simply be a function of the lack of enforcement. and one could argue that such a conclusion is largely consistent with the evidence. recall that the compliance rate for taxes on wages, which are subject to compulsory withholding and third-party reporting, is trivially less than 100%. in contrast, the compliance rate is much lower when there is neither withholding nor third-party reporting.57 and the best explanation for the difference is pure deterrence theory. that is, when there is third-party reporting of payments made to taxpayers, there is an increase in the probability that noncompliance (at least noncompliance in the form of understated receipts) will be found out, as the irs can cross-check information returns submitted by the payers with the tax returns of the payees and investigate discrepancies. this means an increase in the expected legal penalty for those who fail to report payments.58 in addition, compulsory withholding drastically lowers the costs of enforcement, by collecting the tax dollars from parties (for example, large corporate remitters) who, because of their size, are relatively easy enforcement targets for the taxing authority. enforcement against large corporate taxpayers is easier in part because they are much less likely to be judgment proof than the more numerous and much smaller individual payees. that is, they are more likely to be able to pay when the tax bill comes due. 59 in addition, there are economies of scale in tax enforcement. that is, there are certain fixed costs that must be incurred by the tax authority with each audit conducted on a given taxpayer (whether it is an individual or a corporation), which cost can be more economically spread over a larger revenue base with larger corporate taxpayers.60 57 see treasury, supra note 2, at 15. without such mechanisms to improve the likelihood of detection without the necessity of prior audits, smb auditing becomes unlikely. audits in large businesses are justifiable because of the presence of economies of scale: large businesses are smaller in number and at the same time have a large tax bill, making it worthwhile to spend money auditing them. on the other hand, smbs are much larger in number and, individually, have a very low tax bill, making it costineffective to audit them. thus, unless other means of enforcement and detection are used, the enforcement rate (i.e., probability of getting caught) on smbs will be low and they will remain a “hard-to-tax” group that accounts for a large share of the tax gap. 58 numerous studies attribute the compliance-gap difference between smb income and wage income to the existence of third-party monitors. see, e.g., treasury supra note 2. 59 a version of the judgment-proof story has been used to explain wage withholding for income and employment taxes. as one prominent tax expert put it, “[w]ithout a pay-as-you-earn system making the employer a ‘deputy tax collector,’ it would be difficult, if not impossible, to collect taxes from employees who spend their wages as fast as they are received.” boris bittker & lawrence lokken, federal income taxation of income, estates & gifts ¶ 111.5.2 (quoting mcgraw-hill, inc. v. united states, 623 f.2d 700 (ct. cl. 1980)). the same might be said of many small businesses: because there is no withholding from payments made to smbs, collection of the tax at the payee level may be impossible because of judgment-proof concerns. for a fuller discussion of this argument, see logue & slemrod, supra note 16. 60 in addition, larger corporate taxpayers are more likely to be required by non-tax regulators, or perhaps by financial markets, to maintain various records for non-tax regulatory purposes. this will further reduce the administrative costs of tax law enforcement against such large corporate taxpayers. it is also true, of course, that there are economies of scale to tax avoidance, as larger taxpayers can spread the high 2011] narrowing the tax gap through presumptive taxation 117 given this deterrence-based explanation for the divergence in compliance rates, with the worst noncompliance coming from smbs, who are not subject to any sort of withholding regime and extremely expensive to audit en masse, the obvious question is why not simply (a) impose a withholding regime and/or (b) jack up the penalties until the desired level of compliance is reached. we will discuss both of those options in due course. some combination of those two approaches, together with a more focused audit strategy (discussed later in the article), is likely to be a part of any optimal solution. but the analysis is more complex than suggested by this picture of purely self-interested individuals constrained only by the threat of formal legal penalties. the degree of compliance with the tax laws that we see in the united states, even among smb taxpayers, is probably greater than such a simplified deterrence model would predict and this is true notwithstanding the serious noncompliance problem to which this article is addressed. many taxpayers who currently pay taxes could probably evade with almost no legal consequence, owing to low probabilities of detection and low penalties. as poor as smb compliance currently is, in other words, it could be worse, given the very low likelihood of detection. recall the discussion in the previous section of the compliance variation among sole proprietors: a minority of selfemployed individuals and small sole-proprietors have relatively high rates of noncompliance (whereas probably a high percentage of smbs under-comply at least a little). so why do the other smbs not understate their incomes by even more? so why is smb noncompliance not worse than it is? there are a number of possible explanations, all of which we have alluded to in the preceding discussion. for one thing, maybe smb taxpayers overestimate the risk of detection, or perhaps they are highly risk averse. on the other hand, it seems likely that there are forces that constrain self-interested behavior other than the threat of formal legal penalties. people obviously care not only about the possibility of formal legal penalties but also about many other things: they care about what others think of them as well as what others are getting away with. they care about being treated fairly, about not being the only sucker paying his taxes, and about how their tax dollars are being spent.61 they sometimes even care about obeying the law just because it is the law. and they sometimes comply with the law not out of respect for it (or fear of it) but out of pure habit. indeed, if it were not for some of these “softer” factors (factors other than the threat of formal penalties), the smb tax gap might be even larger than it is.62 this broadened deterrence analysis is made more complicated by the fact that formal legal sanctions and informal nonlegal factors affecting human behavior can have complex causal relationships with each other. for example, legal sanctions and nonlegal sanctions can act as complements. when we criminalize some conduct that was previously legal, for example, the change in the formal legal rule will often create a complementary informal sanction against violating the new legal rule, at least within cost of sophisticated tax planning over a larger tax base. outright evasion, however, seems to move in the opposite direction: the larger the taxpaying entity, the more parties there are who must keep secret the fact of evasion, and the more difficult it is to avoid being caught. see generally, morse, karlinsky & bankman, supra note 12 (describing how use of cash-only evasion schemes tends to be limited to very small, often family-only businesses). this is a version of cowell’s concealment costs argument. see cowell, supra note 40. 61 slemrod & bakija, supra note 42. 62 james andreoni, brian erard & jonathan feinstein, tax compliance, 36 j. econ. lit. 818, 822 (1998). 118 columbia journal of tax law [vol. 2:100 communities in which law abidance is highly valued.63 alternatively, legal and nonlegal sanctions can also operate as substitutes. for example, when the introduction of a new formal legal sanction for a given activity (such as a fine for being late to pick up one’s child from daycare) has the effect of “crowding out” or substituting for existing social sanctions against the same activity.64 as a result, tax policymakers should ask whether increased formal fines will improve smb taxpayer compliance or undermine it. for example, if fines for noncompliance were already set very high, then raising them further might simply alienate taxpayers and weaken existing norms in favor of law abidance. (as discussed further below, however, we doubt that this describes the current situation with smb taxpayers). policymakers should also consider whether efforts to increase informal social sanctions for noncompliance might also be helpful, such as a public relations campaign to encourage tax compliance 65 c. obvious potential solutions to the smb tax gap (other than presumptive taxation) or perhaps occasional public shaming for the most egregious (or most notorious) examples of evasion. would such efforts be effective or counterproductive? although definitive answers to any these questions are difficult to come by, no drastic policy changes should be made until there are at least some educated guesses. given all of these considerations, especially the cost associated with a massive increase in auditing of smbs, one obvious potential (and possibly low-cost) solution to the smb tax gap would be to enact compulsory income-tax withholding for business 63 eric a. posner, law and social norms: the case of tax compliance, 86 va. l. rev. 1781 (2002). 64 uri gneezy & aldo rustichini, a fine is a price, 29 j. legal stud. 1, 3 (2000). 65 the results of the “minnesota experiment” provide interesting data on this subject. see joel slemrod, marsha blumenthal & charles christian, the determinants of income tax compliance: evidence from a controlled experiment in minnesota (nat’l bureau of econ. research, working paper no. 6575, 1998). the experiment involved five different groups of minnesota taxpayers. one group was offered enhanced taxpayer assistance. another received a redesigned minnesota income tax return. two additional large groups received “educational” letters from the commissioner of revenue that appealed to their sense of equity or appealed to social norms of compliance. finally, a fifth group was informed by the commissioner that the returns they were about to file, both state and federal, would be “closely examined.” the most interesting results from the experiment lie with the groups that received the letters with audit threats and with moral reminders. lowand medium-income taxpayers responded positively to the audit threats, reporting higher incomes in the following year. within these groups, high-evasion-opportunity taxpayers (those with small business income or farm income) responded with a higher average change in the reported income than low-evasion-opportunity taxpayers. high-income taxpayers, however, did not respond in the same fashion. some of them reported even less tax after receiving the audit letter. slemrod, blumenthal, and christian give two plausible explanations for the behavior of high-income taxpayers. first, it is possible that such taxpayers, after receiving the letter, consulted advisors who then uncovered legitimate ways for the taxpayers to reduce their tax liability. second, some high-income taxpayers may have perceived the audit process as a sort of negotiation in which their reported tax liability is merely their initial “bid.” as for the two groups that received educational letters, one received a letter that was intended to appeal to the taxpayer’s intrinsic sense of moral duty and the other received a letter that emphasized social norms. as it turned out, the first letter had little effect on compliance, whereas the second letter led to some improvement in some cases. stephen coleman, the minnesota income tax compliance experiment: state tax results (munich personal repec archive, working paper no. 4827, 2007), available at http://mpra.ub.uni-muenchen.de/4827/. the department of revenue of minnesota did a follow-up experiment with this second letter confirming this result. stephen coleman, the minnesota income tax compliance experiment: replication of the social norms experiment (2007), available at http://ssrn.com/abstract=1393292. 2011] narrowing the tax gap through presumptive taxation 119 to-business payments. under current u.s. law, businesses are required to withhold income taxes from wage payments to their employees, but they are not required to withhold on payments to independent contractors or to corporations, even small corporations.66 we might simply expand these withholding obligations to include payments to all smbs and the amounts withheld would be credited against the payeetaxpayer’s ultimate tax liability when the payee-taxpayer filled her/its own tax return. the problem with such proposals, however, is that they largely ignore the key difference between wage payments to employees and payments to smbs: business deductions. most employees have relatively few deductible business expenses – at least, business expenses that do not involve third-party oversight, as is the case with reimbursed employee business expenses. therefore, the amount of income taxes withheld from their wages ends up coming close to approximating their ultimate income tax liability.67 if we were to adopt a regime of withholding for business payments to smbs (whether the payees are independent contractors, smallish corporations, or partnerships) and we were to stay with the existing income tax regime, there would likely be some reduction in the overall tax gap, as the amount of understated gross receipts would drop. withholding requirements are obviously a reasonable, albeit incomplete, response to the problem of understated gross receipts. this is not true with smbs, which often have many business expenses. indeed, as the evidence discussed in the previous section makes clear, overstated deductions are a large part of the smb tax gap. 68 another useful tool to curb the understatement of receipts from consumer-to-business transactions would be third-party reporting, such as those from credit-card companies.69 66 there are information reporting requirements for such payments, however. this improvement, however, would likely be offset to some extent by an accompanying increase in the amount or degree of overstated business deductions by smbs. and this increase in overstated deductions would be very difficult (that is, costly) for the irs to police for the same reasons already discussed. again, this is not to suggest that expanded withholding and thirdparty reporting should not be considered a part of the eventual solution to the smb tax gap. indeed, below we suggest exactly that. rather, the point is that it may not be as beneficial overall (from a mcf perspective) as coupling such an expansion of compulsory withholding with a switch to a presumptive tax regime for smbs. 67 this is not always true, of course. some wage earners have other businesses on the side, and for those businesses the problem of overstated deductions would be present. also, in those cases, withholding on wages would not be expected to approximate overall taxable income, and the problem of overstated deductions again would be present. however, one should note that the cause of the overstated deductions, in this case, would be the fact that the wage-earner also runs an smb, which is the core problem dealt with in this article. moreover, many wage earners actually over-withhold, which means they end up filing for a refund. 68 of course, even compulsory withholding will not solve all of the compliance problems in this context, as there will continue to be incentives for payers and payees to cooperate in the effort to evade paying taxes, since the gains from evasion can be shared between the parties. see logue & slemrod, supra note 16, at 50 (showing how the market allocates the gains from tax evasion between parties to the transactions with respect to which the evasion takes place); and morse, karlinsky & bankman, supra note 12, at 58-59 (confirming through interviews that this sort of bargaining to evade taxes occurs in practice). and this problem of coordinated evasion to avoid withholding requirements would also be present with a presumptive tax regime. 69 below we discuss one possible approach to reducing the understatement of cash receipts from smb/consumer transactions. 120 columbia journal of tax law [vol. 2:100 another obvious, possible low-cost response to excessive smb noncompliance would be simply to raise the penalties. in the law-and-economics literature on deterrence, if some behavior is clearly undesirable from a social welfare perspective, the standard solution is to raise the penalties until that behavior is deterred.70 actually imposing much larger penalties for tax evasion (including perhaps criminal penalties) may, however, have unintended consequences. here, the interaction between the formal legal sanction and informal nonlegal sanctions would be important. for example, policymakers would need to ask whether increasing the formal penalty for tax noncompliance would have a complementary or substitutive effect on non-legal social sanctions for such behavior. the answer probably depends on how severe the new penalty is: if taxpayers perceive that tax penalties are being set too high without any reasonable correspondence to the magnitude of the law violation (but rather, say, purely with reference to the probability of detection), it is possible that compliance norms could be eroded. a modest increase in criminal penalties, however, would not likely have such counterproductive effects and might even enhance compliance norms. this might especially be likely if the increase in penalties is targeted at groups of taxpayers who have voluntarily opted to subject themselves to a regime of increased penalties. thus, optimal deterrence on this view can be achieved by a prohibition of the anti-social conduct accompanied by a very large sanction, and the size of the penalty (the cost it should impose on the wrongdoer) should be inversely related to the probability of detection. furthermore, the larger the sanction is, the smaller the probability of detection – that is, the amount spent on catching people – needs to be, which reduces the administrative costs of the system. 71 in sum, it seems likely that at least modest increases in formal monetary penalties and formal nonmonetary penalties (i.e., prison sentences), and imposing those penalties a little more often, could improve smb tax compliance. these solutions, however, have their own problems and alone may not be sufficient. an increased use of jail time might mean higher overall administrative costs, both because of the costs of prison beds but also because of the increased costs of providing due process to a larger number of taxpayers. moreover, jail time costs society in terms of the lost liberty and productivity of the criminals. (of course, if the increased criminal fines are effective, there would also be a reduction in administrative costs insofar as there would be less noncompliance to deal with). increasing monetary fines might, for these reasons, be a better way to go, but there are limits to how much fines can be raised as well. first, the deterrence function of fines is limited by the assets of the noncompliant taxpayers. this is a version of the judgment-proof problem mentioned above. second, as with prison sentences, there will be political resistance to large fines based on probabilities of detection rather than purely on the magnitude of the offense for which the fines are imposed. third, increasing penalties alone has the problem of giving taxpayers additional incentives to spend resources on avoiding those penalties, expenditures which are pure deadweight loss. 72 70 becker, supra note 56, at 191. 71 alex raskolnikov, revealing choices: using taxpayer choice to target tax enforcement, 109 colum. l. rev. 689 (2009). we discuss more on this possibility in part iv below. 72 see chris sanchirico, detection avoidance, 81 n.y.u. l. rev. 1331, 1337 (2006). 2011] narrowing the tax gap through presumptive taxation 121 ultimately, we will suggest a reform that incorporates some aspects of both of these ideas – expanded withholding and higher penalties for noncompliance. but we will suggest that this should be done in combination with a shift to some sort of presumptive tax regime for small and medium-sized businesses. iv. introduction to presumptive taxation a. definitions before we address the pros and cons of any particular presumptive tax solution to the smb tax gap, we should first be clear on what we mean by the concept generally. a number of definitions have been suggested. for example, victor thuronyi has said that a presumptive tax “involves the use of indirect means to ascertain tax liability, which differ from the usual rules based on the taxpayer's accounts.”73 thus, thuronyi emphasizes that a key aspect of any presumptive tax is that it is not based entirely on the taxpayer’s records, which are subject to manipulation and abuse. joel slemrod and shlomo yitzhaki define a presumptive tax involving “tax bases, or indicators, that can serve as proxies for ideal tax bases but which are less easily manipulated and more easily monitored than the otherwise ideal tax base.”74 to get a better sense of the idea, take one example. imagine that policymakers have decided that the ideal tax base is something like “ability to pay.” this definition emphasizes the extent to which a presumptive tax, when designed properly, should approximate the ideal target tax, but at a lower administrative/enforcement cost. 75 73 victor thuronyi, presumptive taxation, in 1 tax law design and drafting 401 (victor thuronyi ed., 1996). bird and zolt contend that a presumptive tax generally is characterized by an “administrative” or “involuntary” assessment. richard m. bird & eric m. zolt, redistribution via taxation: the limited role of the personal income tax in developing countries, 52 u.c.l.a. l. rev. 1627, 1685 (2005). such a tax base would satisfy society’s distributional preferences or values (if we think that those with greater ability to pay taxes should be expected to pay more in taxes) and it would have efficiency advantages (if we think that ability is an innate quality that cannot be altered or manipulated). however, because directly measuring ability is administratively costly (or impossible), the best alternative might be to impose a tax on some proxy for ability, such as annual income. and indeed, a tax on income could be, and often is, thought of as a presumptive tax on ability to pay. but the story doesn’t end there. even if we have decided to tax income instead of ability directly, the task of measuring and monitoring some idealized notion of income will also present an administrative nightmare. this is why any real-world income tax base will necessarily 74 slemrod & yitzhaki, costs of taxation, supra note 46, at 192; see also shlomo yitzhaki, cost benefit analysis of presumptive taxation, 63 finanzarchiv: pub. fin. analysis 311, 312 (2007) [hereinafter yitzhaki, cost benefit analysis] (“in other words, presumptive taxation exists whenever the legislator is using one tax base in order to approximate another tax base.”). in some ways, then, the presumptive tax idea is a repacking of the concept of “tagging,” first introduced in george akerlof, the economics of “tagging” as applied to the optimal income tax, welfare programs, and manpower planning, 68 am. econ. rev. 8 (1978). 75 note that ability to pay may in turn be a proxy for something deeper, like well-being or potential well-being or some other fundamental criterion by which human flourishing can be measured and compared. 122 columbia journal of tax law [vol. 2:100 be only a rough approximation of whatever idealized definition of income serves as the base’s benchmark.76 as slemrod and yitzhaki note, “all taxes are presumptive, to some degree.” 77 true enough. nevertheless, our focus will be somewhat narrower than “all taxes.” we will be looking at real-world regimes that both are intended to be proxies for an income tax and are expressly designed to sacrifice accuracy of measurement to achieve substantially better compliance or lower enforcement costs or both. before we get to these examples, however, it is important to emphasize that the more closely a presumptive tax base approximates the ideal target tax base, the closer the approximation will be to the idealized distributional consequences of that target tax base and the more equitable (whether horizontally or vertically) the tax system will be.78 also, insofar as the presumptive tax uses a proxy for income that is less manipulable (and generally less subject to change) than the ideal definition of income, the presumptive tax actually produces an efficiency advantage over the ideal base. put differently, a good presumptive tax should have some lump-sum element to it.79 and, of course, a good presumptive tax should entail significantly lower administrative costs than does the underlying ideal base.80 b. examples of presumptive provisions in the current u.s. tax system we will return to all of these points below. it is possible to find examples of presumptive tax provisions, in the sense in which we are now using the term, within the current u.s. income tax system. for example, consider the standard deduction. the u.s. system allows individual taxpayers to choose between reducing their adjusted gross income by the sum of their actual itemized deductions or by the amount of the so-called standard deduction, which is a predetermined lump sum amount that varies only according to the taxpayer’s filing status.81 76 it is possible to conceive of the haig-simons definition of income as the theoretical benchmark for the u.s. individual income tax. see, e.g., jonathan gruber, public finance and public policy 498 (2005) (“the benchmark that public finance economists use for defining income is the haig-simons comprehensive income definition, which defines taxable resources as the change in an individual’s power to consume during the year.”) (emphasis in original). the notion that the haig-simons definition of income represents the benchmark against which the existing federal income tax should be judged underlies the concept of the “tax expenditure budget.” see, e.g., staff of joint comm. on taxation, 110th cong., a reconsideration of tax expenditure analysis 19 (comm. print 2008) available at http://www.jct.gov/x-37-08.pdf. some critics of tax expenditure analysis have famously disagreed that the haig-simons definition should be the theoretical benchmark against which the federal income tax should be analyzed. see, e.g., boris i. bittker, accounting for federal “tax subsidies” in the national budget, 22 nat’l tax j. 244 (1969). it is generally thought that the presence of itemized deductions improves the accuracy of measurement of taxpayers’ ability to pay and thus improves the horizontal and vertical equity of the system (for example, by providing deductions for large uninsured medical expenses or casualty losses), such increased accuracy and fairness 77 slemrod and yitzhaki, tax avoidance, supra note 14, at 1457 (“the conceptually pure tax base – be it the flow of income, wealth, sales revenue, or something else – cannot be perfectly measured, and the tax authority is constrained to rely on some correlate of the concept”). 78 and the smaller will be the negative distributional consequences (the dc variable) in the mcf analysis. 79 in mcf terms, the xi – mri term in the numerator of the mecf formula should be smaller under a good presumptive/proxy tax than under the ideal. that is, there should be less leakage, whether from substitution effects or evasion. 80 the ai term in the denominator of mecf should be smaller, increasing the amount of revenue available to spending on public goods. 81 i.r.c. § 63(b) (2010). 2011] narrowing the tax gap through presumptive taxation 123 come at the price of increased compliance and administrative costs. (think of the taxpayers’ costs of maintaining records to support such deductions and of the necessary irs enforcement expenditures to ensure the validity of such deductions). thus, the much simpler and, in a sense, less accurate standard deduction can be understood as a rough (and administratively cheap) approximation of the more finetuned itemized deductions.82 another example of a presumptive tax element in the u.s. system is the alternative minimum tax (“amt”). the amt is a parallel tax system that runs alongside the normal income tax, with the basic difference being that the amt disallows certain deductions, exemptions, and credits that are available under the normal tax and the amt applies a flatter rate structure than does the normal tax. taxpayers are required each year to figure out both their normal and amt tax liability (called their “tentative tax liability”) and remit whichever amount is larger. on the assumption that most of the deductions made available under the normal tax were put there to provide greater accuracy in terms of measuring ability to pay, then, the amt – with its lower enforcement and compliance costs – might be viewed as a type of presumptive tax. 83 in both of these examples, the standard deduction and the amt, notice that the code is using a rough proxy for ability to pay – indeed, an even rougher proxy than is taxable income under the normal income tax rules. that is the idea: to sacrifice some accuracy in measurement for administrative savings and improved enforcement. the reader can probably rattle off a list of other presumptive-tax elements in the internal revenue code. depreciation deductions, for example, which are fixed in the code (to reduce compliance and administrative costs) and bear no precise relationship to actual changes in the value of business assets, have the flavor of a presumptive device. even the 50% limitation on deductions for business meals can be viewed this way, on the theory that the limitation roughly approximates the average non-business element of even business-related meals and, though less accurate, is cheaper than doing an individualized analysis of every case to sort out the personal components from the business components.84 moreover, presumptive tax elements can be found not only in the internal revenue code; they have also been incorporated into the enforcement practices of the and so on. 82 indeed, this is precisely how slemrod and yitzhaki analyzed the standard deduction. slemrod & yitzhaki, standard deduction, supra note 13. as we explain more fully below, the standard deduction would be an example of an ex-post optional presumptive tax, or alternative maximum tax. as it turns out, the standard deduction is a very imprecise proxy for itemized deductions. to see this point, note that the standard deduction for individuals is in the neighborhood of $5,000 and for married couples filing jointly, $10,000. however, the average total itemized deduction taken by individual filers who itemize is around $18,000 and the average total itemized deduction taken by married joint-filers is around $29,000. see roberton williams, tax policy center, income tax issues: how do the standard and itemized deductions compare? 82 (2008), http://www.taxpolicycenter.org/briefingbook/tpc_briefingbook_full.pdf. of course, for many (indeed most) individual taxpayers, their itemized deductions are less than the standard deduction. indeed, that is why roughly 56% of individual taxpayers opt for the standard deduction. id. 83 that is, the amt itself has lower administrative and compliance costs than does the normal tax. one serious problem with the amt is that the administrative and compliance costs it creates must be incurred in addition to the administrative and compliance costs of the normal income tax. as we discuss below, this is a problem generally with mandatory minimum presumptive tax regimes, of which the amt is one example. 84 i.r.c. § 274(n) (2010). 124 columbia journal of tax law [vol. 2:100 irs. for example, so-called advanced pricing agreements result in a type of presumptive taxation of multinational corporations.85 under such agreements, the irs and the taxpayer contractually agree to a particular approach to transfer-pricing and those transfer-pricing agreements, by all accounts, only roughly approximate the multinational corporation’s actual income. another example of presumptive taxation through enforcement policy would be when tax administrators make use of proxies to determine a taxpayer’s income when the taxpayer has no records to support her reported deductions. in such a case, the irs is allowed to “reconstruct” the taxpayer’s income using other sources of data, including information from the bureau of labor statistics or the irs’s own surveys of individuals or firms in comparable businesses.86 even the way in which the u.s. system enforces the tax on tipping can be seen as a presumptive tax of sorts. that is, for large restaurant employers, the amount that must be reported to the irs on w2 forms as tip income paid to wait staff is based on a fixed percentage (8%, to be precise) of the restaurant’s gross receipts, although employeetaxpayers can attempt to justify a lower amount of tax ex post if they can prove their tips were less than that presumed amount.87 the following section examines the different possible designs of a presumptive tax and highlights the key issues policymakers must consider in choosing among them. the point of the discussion is to identify the key structural choices that must be made in setting up such a system and to examine how those choices affect the overall efficiency and distributional consequences of the tax regime. v. building a presumptive tax88 a. the relevant questions of course, it is controversial what the ideal business tax base is. but if we take as given the apparent preference for taxing business income in the united states, then the ideal target for an smb tax is a tax on net income. (it is, after all, the income tax gap that is motivating this analysis89 • what should the smb presumptive tax base be? ). given that assumption, the next question is how best to structure a presumptive tax that aims to approximate such an ideal regime. and that question can be broken into a series of sub-questions. • would the new presumptive tax regime be mandatory or optional? 85 transfer pricing methods themselves, or at least some of the methods, can also be viewed as presumptive provisions. although some methods, such as the comparable unrelated prices (cup) method, aim at getting as close as possible to the arm’s length standard and, thus, to an ability-to-pay income tax base, other methods, such as the formulary apportionment (still not accepted by the oecd and not used by the irs, but currently used by the state of california), intentionally depart from the arm’s length standard, seeking lower administrative and compliance costs. 86 in the case of individual taxpayers, the irs will generally bear the burden of proving the taxpayer’s “reconstructed” tax liability insofar as that reconstruction is based on “statistical information on unrelated taxpayers.” i.r.c. § 7491(b) (2010). the service interprets the quoted phrase as not applying to the service’s own surveys of comparable taxpayers. i.r.s. field serv. adv. 200140078 (oct. 5, 2001). 87 see, e.g., i.r.c. § 6053 (2010). the presumption in this case also operates to invert the burden of proof, which is a common characteristic of legal presumptions in general, but not necessarily of presumptive tax systems. 88 the basic structure of this section borrows heavily from thuronyi, supra note 73; and yitzhaki, cost benefit analysis, supra note 74. 89 part vi of this article will deal with the option of a vat instead of a presumptive income tax. 2011] narrowing the tax gap through presumptive taxation 125 • if the presumptive tax is to be mandatory, would it be a mandatory minimum tax only or is it both a minimum and maximum (or “exclusive”) tax? • if the presumptive tax is to be optional (which of course makes it a maximum tax only), at what point would the taxpayer be required to make the election to be taxed under the presumptive regime rather than under the normal tax: at the beginning of the taxable period or at the end? • would the presumptive tax regime be a formal part of statutory law (as with the amt or the standard deduction), or would it instead be part of the government’s informal, nonstatutory tax-enforcement practices? all of these related questions are taken up below. b. choosing a presumptive tax base the first question is what to tax. in designing a presumptive smb tax, policymakers should select some observable factor or combination of factors that could be used to determine how much each smb taxpayer must remit to the government. again, the object is to choose a base that is easier to monitor and less manipulable than reported income but that sacrifices as little as possible the other main objectives of the tax system – distributional equity or fairness and efficiency. in the design of the presumptive smb tax base, policymakers would have to compare the new tax base to the income tax base in terms of the overall effect on incentives. the income tax, for example, is known for its distortive effects on taxpayers’ work/leisure decisions. would the presumptive tax be equally distortive of those decisions? more so? less so? would the presumptive tax entail other distortions not associated with the income tax? in answering these questions, it is critical that the proposed presumptive tax not be judged against an ideal (fully complied with) smb income tax, but instead should be judged against the actual smb income tax as it works in the real world. in the section that follows, we discuss a number of potential presumptive tax bases. for now, we limit the discussion to presumptive taxes that are both mandatory (non-optional) and exclusive (both maximums and minimums). in the subsequent sections we consider how the analysis of these presumptive tax bases would change if the regime were merely a mandatory minimum or maximum, or if it were made optional. 1. a lump-sum business tax we begin with the simplest presumptive business-tax option one could imagine: a lump-sum tax on all businesses.90 90 thuronyi, supra note 73, at iii.d.3 mentions the possibility of a slightly more refined lumpsum tax that divides taxpayers within a given industry into classes based on turnover, with a fixed tax within each band. taxpayers could also be divided into categories based on the type and amount of capital equipment used in the business. the more distinctions made between the taxpayers to apply a lump-sum presumptive tax in different amounts, the more such tax starts looking like a multiple-factors presumptive tax, which will be analyzed below. the government’s only enforcement task would be to make sure that each business taxpayer actually remitted the fixed amount of presumptive tax it owed. such a tax would be akin to a federal, business licensing fee, where the only requirement to receive a business license would be the payment of 126 columbia journal of tax law [vol. 2:100 the annual fee.91 there would also be some efficiency advantages, efficiency advantages similar to, but not precisely the same as, those associated with a lump-sum tax on individuals. under a head tax, every individual pays the same fixed amount of tax regardless of what she earns, indeed, regardless of any choice the taxpayer makes, other than the choice to leave the taxing jurisdiction. as a result, a head tax is utterly neutral with respect to the work/leisure choice. a lump-sum business tax would be different. only individuals who undertake a business would have to pay the tax. thus, it would be distortive for those taxpayers who happen to be on the fence between deciding whether or not to start a new business. (we are assuming, of course, that the lump-sum business tax would not tax leisure). a lump-sum, presumptive tax, then, has the effect of erecting a barrier to entry for small or unprofitable companies, just as any fixed business cost might act as a barrier to entry. for those individuals who have already made the decision to start a business and paid the fixed tax/fee (that is, those for whom the lump sum tax is now a sunk cost), subsequent decisions (regarding work, leisure, or whatever) would be largely unaffected; at that point, the lump-sum business tax would have the efficiency properties of a head tax. the primary benefit of such a tax would be the relatively low administrative costs. the main problem with a pure, lump-sum business tax is the distributional consequence. any lump-sum tax is highly regressive, assuming there is a range of incomes (or as economists would say, heterogeneity) among taxpayers. the fixed levy would obviously constitute a smaller percentage of income as for high-income or highprofit taxpayers than it would for low-profit (or no-profit) businesses. and some businesses would be pushed out of the market entirely simply because they would have no means to pay the levy. this is another way of stating the barrier-to-entry point mentioned above, which is both an efficiency and a fairness concern. because of these distributional and efficiency concerns, a pure lump-sum business tax of any substantial size is almost certainly out of the question. a lumpsum business tax large enough to fully replace the income tax on smbs would be a nonstarter. nevertheless, a small, lump-sum smb tax, if it were accompanied by a commensurate reduction in federal income tax rates on business income (or if it were made creditable against an outstanding income tax liability), is at least a plausible policy response to the smb noncompliance problem and could conceivably be welfare enhancing. that is, it could, by allowing income tax rates to be lowered, reduce the labor/leisure distortion and thereby the marginal cost of funds. and those efficiency gains might outweigh the distributive costs mentioned above. moreover, there could be some ancillary administrative benefits to the creation of a new comprehensive federal smb licensing fee. such a program might make simpler the task of tracking small businesses that receive payments mostly in cash and often stay entirely off the federal tax roles, a problem that will bedevil even most presumptive tax regimes. however, if we can afford the cost of hiring an army of irs agents to fan out across the countryside to check for valid federal smb business licenses, that would suggest a more direct solution to the smb tax gap than this article is proposing – simply 91 the tax could be limited only to smbs and not applied to larger businesses, but it is not clear what the advantage of that limitation would be. larger business taxpayers, of course, would pay both the lump-sum tax and their regular income tax, which could be somewhat lower because of the existence of the lump-sum tax. 2011] narrowing the tax gap through presumptive taxation 127 increasing the audit budget. in any event, as mentioned, such a fee would not be a significant response to the current large and persistent smb income tax gap. although such taxes have been used in some developing countries where the problem of noncompliance is considerably greater even than in the united states, the amounts have (unsurprisingly) been quite small.92 2. pure gross receipts (or “turnover”) tax another possible presumptive tax, which has the potential to reduce administrative costs dramatically, would be a tax on smbs’ gross receipts.93 there are, of course, well known distributional and efficiency problems with a gross receipts tax, problems that would ultimately disqualify such a tax (in its purest form) as a serious solution to the smb income tax gap in the united states. the flaws are easy to spot. on the distributional side, a business taxpayer’s gross revenues cannot be expected even remotely to approximate that taxpayer’s ability to pay, except by sheer accident. thus, if individual a’s small business brings in revenue of $100,000 but also produces business-related expenses of $100,000, individual a is, from the ability-to-pay perspective, no better off than individual b who spends the year lounging on the beach and earns no income. imagine replacing the existing income tax on those businesses that qualify as smbs with a tax on all revenue received by those businesses during the relevant period with no deductions for business expenses. recall that a large part of the smb income tax gap is attributable to overstated deductions. therefore, the main advantage of a gross receipts or turnover tax would be to eliminate the need for the taxing authority to monitor and verify smb taxpayers’ deductions as well as to eliminate the taxpayers’ need to keep track of their expenses for tax purposes. if such a tax were adopted, it could be administered through a new compulsory withholding regime for payments to smbs, thus minimizing the problem of understated gross receipts. 94 92 pakistan enacted something like this in 1991. the pakistani version was a fixed tax on small businesses, including small shopkeepers, traders, and various other professionals. the tax provided for a fixed charge for all businesses, with the only differentiation being between businesses in rural and urban areas. the point of the tax was explicitly to respond to the government’s inability, at reasonable expense, to reach these small-business taxpayers through the normal modes of taxation. but the amount of the tax was small. ahmad kahn, presumptive tax as alternate income tax base: a case study of pakistan, 32 pak. dev. rev. 991, 997, 1000 (1993); see also thuronyi, supra note 73. thus, a regime that forced a to pay a hefty tax while allowing b to pay nothing would be wildly unfair. or consider individual c, who has the same gross revenue as a for the year ($100,000) but who has essentially no business expenses. few would disagree that it would be unfair, or distributively unjust, to impose on a, who has no net income, the same tax that we impose on c, who has a net income of $100,000. but that is exactly what a pure gross receipts tax would do. it is possible that behavioral changes in response to a pure mandatory gross receipts tax might eliminate some of this distributive unfairness, as investment would shift away from businesses that have high expenses to businesses with relatively low expenses, but it seems likely that the distributional consequence would not be fully eliminated. 93 vito tanzi and milka casanegra de jantscher notice that some francophone african countries that originally had a lump-sum presumptive tax have replaced it with a presumptive tax on gross receipts. tanzi & casanegra de jantscher, supra note 17, at 10-11. the same authors also report that colombia, in 1983, established a general presumption of net income based on gross receipts. id. at 11. 94 individual a would, in fact, be worse off, from a work/leisure perspective. 128 columbia journal of tax law [vol. 2:100 on the efficiency side, a gross receipts tax is a disaster. first, a gross receipts tax would distort all sorts of business decisions, discouraging efficient investments in high-expense but high-profit fields and inducing cost-cutting measures that actually lower pre-tax profits. to see these points, consider investor d, who is trying to decide between investing in either of two businesses: business x, which produces $200,000 in gross receipts and $100,000 in expenses and business y, which produces gross receipts of $100,000 but zero business expenses. each business is assumed to be maximizing the profit available to that business. in a world without taxation, or in a world with an ideal income tax regime that is fully enforced, d would be indifferent as between the two investments, since both options would produce the same net after-tax return. and that is the efficient result; assuming a competitive market, societal wealth is maximized when firms seek to maximize profits, not when they seek solely to minimize costs. under a pure, gross receipts tax, however, there would be an incentive to minimize costs even when doing so might not maximize overall profits. thus, in the case above, under a gross receipts tax, business y would be strongly preferred to business x, even though in a taxless world, investor d would be indifferent as between the two. one might be tempted to conclude that a gross receipts tax at least has the efficiency advantage of encouraging cost cutting, since under such a regime a business can generate additional tax-free income simply by cutting expenses and holding revenue constant. the problem with that suggestion, however, is that a gross receipts tax can encourage cost-cutting that is not profit maximizing from a pre-tax perspective. for example, imagine a taxpayer who is maximizing available profit within her business such that if she reduced her business expenses by $1 she would lose, say, $1.10 in revenue.95 in the absence of taxes, or even under an income tax, she would not do such a thing, as it would reduce her profit. under a gross receipts tax, however, she might. for example, if the gross receipts tax rate were 12%, such a cut would be after-tax worthwhile, though a pre-tax loss.96 in fact, so long as the gross receipts rate is greater than the marginal profit on the last dollar spent on business expenses, the taxpayer would maximize her after-tax profit by continuing to cut costs even though such cost-cutting reduces her pre-tax profits. obviously, a gross receipts tax in this situation would induce inefficient cost cutting.97 another distortion associated with a gross receipts tax is the so-called “cascading” effect. a particular tax is said to cascade when it ends up being imposed at every level of production with no offset or credit for taxes paid at prior levels. thus, under a cascading tax, two businesses that are identical in all respects except for the degree of vertical integration will be taxed very differently, as the more vertically integrated firm will pay a lower gross receipts tax than the less vertically integrated firm, since the gross receipts tax is imposed only on transactions between firms and never on transactions within firms. this leads to purely tax-induced vertical integration of firms within particular industries; and it is obviously inefficient (unless one has a theory for why there should be a tax-induced vertical integration of firms). 95 and if she increased her business expenses by another $1, she would generate, say, only $0.90 in additional revenue. thus, the business is currently maximizing profits. 96 she would save $0.12 from the reduction in taxes, which is greater than the additional $0.10 return on the $1 investment she had been getting. 97 of course, if a taxpayer could cut business expenses without losing any pre-tax revenue (say, when cutting $1 produces a $0.90 loss of revenue), she would have an incentive to do that even without a gross receipts tax. 2011] narrowing the tax gap through presumptive taxation 129 what’s more, neither an income tax nor a consumption tax, at least in their ideal forms, would have this cascading effect, as those taxes (assuming full compliance) are generally neutral with respect to the vertical integration of the firm.98 and finally, a gross receipts tax produces much the same labor-leisure distortion that an income or consumption tax does. thus, if a taxpayer can choose between working another hour and producing taxable gross receipts, on the one hand, or engaging in untaxed leisure, on the other, there will be a tax inducement toward the latter. the distributional and efficiency problems associated with a pure gross receipts tax seem disqualifying. however, it should be kept in mind that the relevant choice is between a poorly enforced smb income tax and a somewhat-better enforced gross receipts tax. 3. modified gross receipts (mgr) tax: using historical line-ofbusiness profit ratios to estimate net income. a. the basic idea if the regular income tax concentrates too much on achieving accuracy in the measurement of smb income while sacrificing too much in terms of ease of enforcement (thus resulting in the current large smb tax gap and a failure to measure income accurately in any event), and if a pure gross receipts tax is unacceptably inaccurate (producing the inefficiencies and distributive inequities described above), perhaps the best approach might be a compromise between the two. specifically, consider a tax regime that requires each smb taxpayer to report her gross receipts for the year just as under the present income tax, but that disallows all business expense deductions and instead imposes presumed profit percentages based on historical average profit ratios within the taxpayer’s line of business.99 these presumed profit ratios could be either set by congress or perhaps promulgated by the treasury department (under authority delegated from congress) and would be based on their study of actual historical profit margins for particular industries and lines of business within industries (based on tcmp-type audits of a random sample of smbs in each industry). 100 these industry-specific presumed profit ratios could be made fixed or variable. if they were fixed, they would presumably be based on the best available evidence of actual industry profit margins at the time the regime was adopted. if they were variable, although they would start off based on the industry profit margins at the time of adoption, they would periodically be updated to reflect more current data, either 98 appendix a includes an example illustrating this difference between a gross receipts tax and either an income or a consumption tax, both of which are, in their ideal forms (including full enforcement and compliance) neutral with respect to the level of vertical integration. there is also an example explaining the cross-border inefficiencies associated with a gross receipts tax. 99 brazil uses an optional system along these lines to tax smbs, as we explain below. 100 this is similar to what is already done under the comparable profit method (cpm) for transfer pricing adjustments. under the cpm, the irs relies on the standard industrial classification, published by the u.s. department of commerce, which classifies all businesses into categories. for all companies within a category, the irs takes the tax returns data and calculates the profit margins, arranging them in a continuum from 0 to 100% (from least to most profitable), thus creating a bell-curve distribution. the area between the 25th and 75th percentiles of this curve is considered “arm’s length” (or presumptively valid) under the cpm method. see reuven s. avi-yonah, international tax as international law: an analysis of the int’l tax regime 215 (2007). 130 columbia journal of tax law [vol. 2:100 through the regulatory process or through direct negotiations with representatives of the various industry groups. the advantage of using the fixed profit ratios is that the available evidence on actual profit margins is likely to be most accurate at the creation of the program. this is because, with the adoption of a presumptive regime, many smb taxpayers might decide not to keep records of their expenses since they would no longer be allowed to deduct their business costs for tax purposes.101 the actual details of an mgr presumptive regime are beyond the scope of this article. however, for the sake of discussion we will work through a simple illustration. start by imagining a regular income tax regime that imposes a 35% levy on all business profits, and assume further that policymakers have decided to impose roughly that level of taxation on smb profits as well. now suppose that, because of the difficulty of policing an smb income tax, policymakers adopt an mgr presumptive tax regime that has, say, five different smb business categories, each with a different presumed profit percentage. for example, all smbs might be grouped into 2%, 10%, 20%, 30%, and 80% profit-percentage categories, again based on past profit experience tweaked for future expectations. under this regime, then, if a business in the 30% presumed-profit category earned $100 of gross receipts during the year it would owe $10.50 (.3 x .35 x 100) in federal smb presumptive income tax. all smbs would be grouped into one category or another based entirely on the historical profit experience for that type of business. how many separate line-of-business presumed profit classes should there be? how specifically and narrowly should they be drawn? these are difficult questions that raise precisely the sorts of tradeoffs between accuracy and simplicity that we discussed above. the more profit-percentage classes there are, the more accurate the approximation to actual income will be, but also the more complex and costly the regime would be to administer. moreover, not only would it be difficult for the tax administrator to enforce a system with many lines of business, but in contrast, the advantage of variable profit ratios is that actual profit margins within various lines of business could change over time; and if such changes could be taken into account, the divergence between the presumptive income tax base and the actual income tax base would be reduced. 101 this concern would be somewhat mitigated if the particular presumptive regime that is adopted is made elective by taxpayers on a year-to-year basis, as discussed in the text below. if an smb taxpayer knew that it would be allowed each year to choose between the presumptive and the regular business income tax, it would have an incentive to keep track of its business expenses. also, it might be possible to incentivize smbs to keep track of their expenses and to make those records available for government audits. for example, most smbs will have non-tax incentives to keep expense records, and if (a) smbs that get audited are paid a subsidy to compensate them for the cost and inconvenience and (b) they are also guaranteed that the data gathered from the audit will not be used to against them (except insofar as they contribute to the general pool of data that might affect the overall presumed profit margins), the resulting incentives might be sufficient to produce reliable updated data on industry-group profit margins. alternatively, if the regime were set up so that the presumed profit ratios could be adjusted over time, presumably such adjustments would come through the normal notice-and-comment rulemaking process. this process would allow input from the representatives of various industry groups who wish to make the case (and present the evidence) that their group’s profit ratio has declined, which should be reflected in the presumed profit for that line of business. there would obviously be a natural asymmetry in such a process, as few line-of-business reps would argue that their business has enjoyed increased profit margins and thus should be subject to higher progressive rates. but this bias in the process is not different in kind from the sort of bias that is built into many notice-and-comment rule-making situations. 2011] narrowing the tax gap through presumptive taxation 131 also it would be difficult for the taxpayer to self-assess which line of business she falls into. our aim here is not to resolve the tradeoff but to highlight it.102 because the mgr regime would be a compromise between an income tax and a gross receipts tax, it would have some of the same advantages and disadvantages of each of those regimes. there would be some but not all of the allocative inefficiency and distributive unfairness associated with a gross receipts tax. 103 thus, because an mgr tax would (by definition) be a function of gross receipts, there would, as with a pure gross-receipts tax, be a tax-based incentive for smbs to minimize costs even in situations in which doing so would not necessarily maximize pre-tax profits; and there would be an incentive to avoid high-cost but high-profit industries. these effects, however, would be smaller than in the case of a pure, gross receipts tax.104 one advantage of such a line-of-business presumed-profit approach to taxing smbs over the current individualized actual-profit approach would be the reduced administrative or enforcement costs, which (ironically) could translate into greater accuracy and therefore improved distributional consequences. under a line-ofbusiness presumed-profit tax, there would be no need for the government to monitor smb taxpayers’ individualized expenses. as a result, it would be relatively easy (i.e., relatively cheap) for the government to enforce remittance of smb tax liabilities. the only information that the irs would need in order to verify a taxpayer’s tax liability would be the taxpayer’s gross receipts for the year and its designated line-of-business. if we combine such a tax with an expanded regime of federal withholding (including payments to independent contractors and small corporations as well as wage payments to employees) and other means of third party reporting (such as credit card payments), it is possible that such a tax on smbs could be a significant improvement over the current regime – that is, it could present a significantly lower mcf. indeed, if the presumed profits under such a regime were even roughly correlated with most smb taxpayers’ actual profits, then the actual taxes remitted, and the accompanying distribution of the tax burden, could end up being much closer to the distributive ideal than is the case under the current individualized (and largely cheated) income tax regime. and the more fine-tuned the line-of-business presumed profit ratios are, the closer the regime would approximate an actual income tax, and the smaller these inefficiencies would be. of course, the more fine-tuning there is, the greater the administrative cost of the regime, and hence the weaker the justification for moving away from current income tax system for smbs. 105 102 note that the irs organizes all business-related income into 20 or so categories, including agriculture, construction, manufacturing, transportation, arts and entertainment, professional services, “other services,” and so on. the object would be to group these together according to historical profit percentages, and to combine them into fewer categories. 103 see appendix a for the cascading effects of the mgr presumptive tax, when compared to taxes on gross receipts, income and consumption. 104 moreover, high-cost but high-profit ventures are not usually undertaken by small businesses. with the possible exception of high-tech start-ups that can attract venture capital investment, such investments usually require the sort of access to large amounts of capital that only big corporations (and certainly not smbs) can manage. 105 the other significant advantage of a mgr presumptive tax regime is the potential savings in compliance costs. again, under a mgr tax, smb taxpayers would not have to justify their business expenses for tax purposes; as a result, they would not have to maintain all of the documentation required to substantiate their expenses, at least not at the level required under current u.s. income tax law. the 132 columbia journal of tax law [vol. 2:100 whether such a regime would actually work and be an improvement over the current system is a question that would turn on, among other things, the accuracy and variability of the irs estimates of mean profit ratios. the more accurate the estimated mean profit ratios for particular lines of business and the less variable the estimates (i.e., the smaller the standard deviation around the mean), the more closely the regime would approximate the actual income-tax ideal. at the extreme, for example, if the historical mean profit ratio for a given line of business were 10%, and the standard deviation within that profit-ratio class were literally zero, there would be essentially no difference between the presumed-income, mgr approach and the regular income tax, except that the former would be much cheaper to enforce. in that case, presumed profits for everyone in that line of business would equal actual profits. such accuracy, of course, would not be achieved. there would inevitably some variation within the profit-ratio classes and the greater the standard deviation within the profit-ratio classes, the greater the inaccuracy of income measurement.106 b. enforcement concerns (and potential solutions) the interesting questions then would be how narrowly these profit-ratio, line-of-business categories can be drawn and at what cost. even if an mgr regime could be designed with relatively narrow and accurate profit-ratio classes, such a regime obviously would not eliminate all smb compliance concerns. for one thing, the problem of understated gross receipts would remain for certain classes of taxpayers – most obviously, businesses that provide goods or services directly to consumers. for those transactions, compulsory payer withholding and information reporting would simply not be feasible, for essentially the same reasons that it does not work to enforce the income tax against the self-employed: there are just too many of them, and they are too small to be worth going after en masse. indeed, this is precisely why state governments that use retail sales taxes always place the primary remittance and information-reporting responsibilities on retail sellers rather than buyers; the compliance and administrative costs of the alternative remittance burden would be prohibitive.107 thus, it should not be surprising that all of the proposals to expand compulsory federal withholding to include payments to ics have been limited to payments made by business clients.108 resulting savings could be significant. the downside of these compliance-cost savings, again, is that over time there would be less taxpayer-specific information regarding actual smb profit margins. this could be a problem if, in the future, tax policymakers wanted to update the presumed profit ratios. still, at least for those independent contractors, self-employed individuals, and small corporate businesses 106 if, for example, the standard deviation within a given profit-ratio class were, say, 4 percentage points (and we assume a normal distribution), it would mean that roughly 32% of the taxpayers within that profit-ratio class have profits for the year that were either below 6% or above 14%. that degree of profit variability within a given presumed profit-ratio class would produce the same types of efficiency and distributional consequences discussed above in connection with a pure gross receipts tax. it would be to a lesser degree, however, since (again assuming a normal distribution) roughly 68% of the taxpayers within that 10% presumed-profit-ratio class would have profits between 6% and 14% – which of course is within 4 percentage points of the mean. that does not measure income with perfect accuracy, but it may come closer than we currently see with the income taxation of smb taxpayers as a class. 107 although placing the remittance burden on the retail sellers instead of on consumers makes enforcement of a retail sales tax viable, it is still the case that a vat, with remittance obligations at every level of production, is generally thought to be the more easily enforced type of consumption tax. 108 likewise, when other countries have expanded withholding to include payments to the self employed, they have limited the withholding requirements to business payers. see generally soos, supra note 12. 2011] narrowing the tax gap through presumptive taxation 133 who receive a significant portion of their payments from business-client payers, expanded compulsory withholding and reporting requirements would be a relatively cheap and simple solution to the problem of understated gross receipts. for those pesky business-to-consumer transactions, something other than expanded compulsory withholding will have to be tried. as mentioned above, insofar as those transactions involve credit-card or debit-card receipts where third-party monitoring can be employed, the problem is somewhat mitigated.109 we have already mentioned that credit-card and debit-card receipts are subject to third-party monitoring, which enables the irs to determine if such receipts have gone unreported by smbs.110 in addition, credit-card reporting may be a useful method of estimating cash income. if the irs were able to determine an average ratio of cash to card receipts (this ratio could be tweaked by types of business, size, region etc.), it could trigger audits on smbs that do not report cash receipts in an adequate proportion to their (already known by the irs) card receipts.111 also, money deposited in (or that flows through) financial institutions leaves a paper trail that could be used to trigger audits by the irs. many smb taxpayers intent on tax evasion, of course, will be careful not to put their unreported cash receipts in the bank. rather, they will spend this money on direct payments to certain suppliers or to employees who have a preference for receiving cash payments.112 thus, other solutions to the problem of cash receipts will need to be tried.113 109 see supra note 18. 110 indeed, the morse, karlinsky & bankman article suggests that most smbs already report these transactions out of fear of getting caught. see morse, karlinsky & bankman, supra note 12. 111 id. 112 id. informal payments and personal consumption might not be able to absorb all the concealed tax receipts, leading some taxpayer to acquire durable consumption assets like boats, cars and housing, or to adopt otherwise lavish consumption standards, such as traveling, hotels, etc. if this is the case, audits based on lifestyle-standards may be a good way to target the taxpayers that underreport receipts. a presumptive tax may also be based on these standards as we will see below, but keeping them as a guideline for auditing, instead of transforming them into an element of the tax base seems more sensible. 113 one jurisdiction in brazil is experimenting with a way to harness both the power of the internet and the self-interest of consumers to help the taxing authorities monitor cash transactions between consumers and businesses. the program is designed to help with the implementation of the brazilian state vat in the state of são paulo, but it could be adapted to aid enforcement of a presumptive smb tax just as well. it works as follows: when an individual (or a legal entity) makes a purchase that is subject to the tax, the purchaser asks the seller to record the purchaser’s taxpayer identification number and give the purchaser the invoice with the seller’s taxpayer identification number. the purchaser can then file a form with the government to receive a credit or cash rebate from the state equal to some percentage of the tax that is paid. this way, if the seller has not paid the tax and recorded the transaction with the government, the purchaser will not get the rebate. to make sure that the seller records the purchase and pays the tax, the government has set up an internet site where the purchaser can go to see if the seller has complied. the beauty of the system is, if the individual has made a purchase and it does not appear on the website, she can report directly to the government that the purchase has occurred. the report can then trigger an audit on the noncompliant seller. the overall effect is that purchasers are induced to ask for the relevant documentation from sellers and sellers, competing for business, are induced to provide that documentation; and the overall enforcement of the tax system is improved. again, this program is used in brazil for vat enforcement, but it could be used in the united states to tighten the control over the reported gross receipts of smbs. if such a program is to work, however, a number of inherent problems would have to be overcome. for example, in the brazilian experience, many consumers have been reluctant to participate because of the fear that the government might somehow use the information against them rather than against the noncompliant sellers. brazil is taking a number of steps to overcome this concern, including 134 columbia journal of tax law [vol. 2:100 in addition to the issue of under-stated gross receipts just discussed, the mgr presumptive income tax would also be subject to other types of evasion and avoidance. for example, smbs could evade by simply disguising their high-profit businesses as low-profit ones. that is, if an smb’s tax liability under the presumptive system depends on its line of business, there would obviously be an incentive to manipulate (or simply to lie about) one’s line-of-business designation. determining whether a taxpayer has assessed her line of business correctly would require some amount of auditing, which would contribute to the administrative costs that the mgr tax is intended to reduce. these costs can be reduced by minimizing the number of lines of business; however, as mentioned, this solution would also reduce the system’s fairness. one relatively cheap means of line-of-business auditing would be to cross-reference taxpayers’ line-of-business tax designations with their business designations for other purposes. for example, if a taxpayer registers as a lawyer with the bar association, it will be difficult for that same taxpayer to self-designate with the tax system as anything other than a lawyer. besides the problem of taxpayers blatantly mischaracterizing their smb’s line of business, there is also the more pedestrian but no less thorny issues of line-drawing in marginal cases. for example, it is safe to assume that an mgr presumptive tax system would presume a higher profit ratio for service providers than for merchandise sellers/producers. but what about an smb that straddles this line? imagine an smb construction contractor who provides both labor and materials for her construction projects. which category should she fall into? the correct answer, of course, would depend on the relation between the cost of the inputs and the value of the service rendered, but we cannot draw the line based on costs, because the whole point of the mgr presumptive system is to ignore the role of expenses in determining the tax base. thus, some objective line must be drawn, and some inequities will necessarily emerge. and of course taxpayers will exercise whatever discretion the rules give them to push these margins in their favor. finally, in addition to the problems of outright evasion and borderline cases, it is inevitable that sophisticated taxpayers would find ways to use an mgr system to engage in tax-planning or tax-sheltering activity. for example, non-smb businesses that are taxed under the regular business income tax but that conduct more than one type of business activity would be tempted to restructure their operations into several smaller businesses, at least one or more of which could be taxed under the relatively low rates of the presumptive tax. moreover, such restructuring would provide taxpayers with the opportunity to engage what amounts to a type of transfer-pricing manipulation under which income is shifting from one business, which is taxed under the normal income tax, to another business, which is taxed under the relatively low presumptive rates. to see this last point, imagine a business that initially produces and delivers merchandise to its customers and is taxed under the regular income tax of 40%. let’s say this business has receipts of $1,000, production costs of $400 (for raw material, labor, machinery depreciation, and the like), and transportation costs of $200 (also for labor and other assorted costs). thus, the pre-tax profit for the business would be $400, which would be taxable under the normal income tax. given an income tax rate corrective advertising campaigns, but these remedial measures (and the program itself) are still too young to be definitively evaluated. 2011] narrowing the tax gap through presumptive taxation 135 of 40%, the final tax liability would be $160, and the after-tax profit would be $240. now let’s say the production and transportation businesses are separated into two different businesses (owned by the same people) and the transportation business qualifies as an smb while the production business remains under the regular income tax. assume further that under the mgr presumptive tax system, transportation smbs are taxed at a 40% rate on a presumed profit of 32% of gross receipts. in this case, the transportation smb would have the same $200 costs as before, but imagine that it would charge the production business $400 for the transportation services that it provides. thus, the transportation smb’s pre-tax profit would be $200: $400 of receipts from the production company less the $200 of expenses. the income tax would then be levied on the transportation company’s presumptive profit, calculated by applying 32% over the receipts of $400. thus, the income tax due by the transportation smb would be $51.20 (i.e. 40%*32%*$400). its after-tax profits would be $148.80. the production business, however, would still have the same $1,000 in gross receipts, but would now have costs of $800 ($400 from production and $400 from transportation). its pre-tax profit would be $200 on which the 40% income tax would be levied. the tax due would be $80 and the after-tax profit of the production business would be $120. adding the transportation smb and the production business’s after-tax profits together, we would end up with $268.80 of after-tax profits. this means that the separation of the two businesses and the shifting of some of the profits to the low-rate presumptive tax generated an extra $28.80 in after-tax profits overall. these are only a few of the numerous ways in which even moderately clever taxpayers would try to exploit the existence of two parallel systems of taxing business income. what this means is that the irs would have to respond in some way by applying section 482 or the economic substance doctrine or some other anti-avoidance rules. and these responses will add complexity to the system, which in turn will add the administrative costs of the regime. 4. taxing asset values an alternative presumptive tax base would be wealth. more specifically, treat some percentage of a smbs’ net asset values as presumptive income. this idea has some merit. indeed, some developing countries do just that, using asset taxes to supplement, or substitute for, the income tax on smbs. and it is an idea that should not be dismissed out of hand for smbs in this country. many of the issues that would need to be addressed here – i.e., the difficulty involved in the valuation of the assets, the fact that the tax is regressive, and so on – have been discussed in the literature on wealth taxes or property taxes generally.114 114 other specific issues (e.g., integration, foreign tax credit and taxation of financial activities) would have to be addressed if one was dealing with a presumptive assets tax as a substitute (or minimum) for the corporate tax. see thuronyi, supra note 73; efraim sadka & vito tanzi, a tax on gross assets of enterprises as a form of presumptive taxation (int’l monetary fund, working paper no. 92/16, 1992) for discussions on the fundamental aspects of this presumptive tax. the upside of such a tax is that asset values correlate with ability to pay, in some ways better even than income does. also, reported asset values are not contingent on reported business expense deductions, which is one of the problems with the income tax. nor would an asset tax require regular estimates of industry or line-of-business profit ratios, which is a problem with modified gross receipts tax. perhaps the most 136 columbia journal of tax law [vol. 2:100 important advantage of using asset values in the context of smbs is that it would respond to the problem of consumer-to-business payments, which even the mgr approach (with compulsory withholding) cannot fully address. arguably, it would be easier for the irs to identify the taxpayers’ assets than to monitor all of her cash gross receipts. it is harder to hide land, buildings, and other property. also, these items are often already being taxed by the state authorities, and the federal government could conceivably piggyback on the state’s enforcement regime. again, some developing countries already do this. the main problem with using an asset tax for smbs, though, is that many smbs have few tangible assets. indeed, the type of businesses for which this type of evasion is most likely (the non-farm sole proprietors), the primary asset is the skill of the sole proprietor/entrepreneur, an asset that is notoriously difficult to value for the purpose of taxation. this is why the international experience shows that presumptive assets taxes are typically used to address problems other than the smb tax gap.115 5. taxing multiple-factors another presumptive tax base of sorts would be to use a multitude of factors that tend to correlate with income. the best example of such a regime, or the one that gets the most attention in the tax literature, is the israeli tachshiv (or, as it is sometimes called, the standard assessments guide). this method of taxing income was introduced in 1954, and, although formally ended legislatively in 1975, was used for several years after that by the israeli taxing authorities as an informal guide to taxing self-employed taxpayers.116 under the tachshiv, the taxation of smbs was based on a sometimes long list of readily identifiable characteristics. included among these characteristics, for example, was the type of business the taxpayer is operating, and not just whether it is a restaurant or a flower shop (although the restaurant/flower-shop distinction was one that mattered) but also the restaurant’s hours of operation, how many waiters it employs, where the building is located, what type of food the restaurant serves, and so on. and there were similarly detailed breakdowns for lots of other types of businesses. all of these factors had been determined to correlate with varying levels of net income and thus were used by the taxing authority to generate a presumed amount of income for each very narrowly defined type of business. and that amount was taxed.117 115 as reported by thuronyi, supra note 73, presumptive assets taxes have been adopted by argentina, colombia, mexico, and venezuela. these taxes, in effect, operate as alternative minimum taxes. additionally, bolivia experimented with replacing its corporate income tax with a presumptive asset tax. in all of these cases, the presumptive tax was not designed to deal with the smb tax gap problem, but to serve as a general means of taxation of corporations or individuals. see also sadka & tanzi, supra note 114 (explaining why developing countries adopted presumptive assets taxes as a minimum tax or as a substitute for the corporate tax); sijbren cnossen & lans bovenberg, fundamental tax reform in the netherlands (ctr. for econ. studies & inst. for econ. research, working paper no. 342, 2000) (commenting on the dutch presumptive capital income tax, which substitutes for a tax on capital gains and is levied at a 30% rate on a 4% presumptive rate of return on individuals’ assets). 116 yitzhaki, cost benefit analysis, supra note 74, at 316. a version of it was also used by spain and turkey as well. thuronyi, supra note 73, at 23 n.65 (citing arye lapidoth, the israeli experience of using the tachshiv for estimating the taxable income, 31 bull. for int’l fiscal doc. 99 (1977)). 117 actually, the tachshiv was never a mandatory exclusive tax, but rather an optional presumptive tax – or alternative presumptive smb maximum tax. see infra. 2011] narrowing the tax gap through presumptive taxation 137 something like this approach could be useful for the taxation of smbs that sell directly to consumers, especially those that do business mostly in cash. the obvious disadvantage of the multiple-factor approach to presumptive taxation is the complexity and high costs of administration. in addition, there would be unfairness and inefficiency if, say, a restaurant of particular type, size, location, number of employees, and such happens to have unusually high business expenses and thus low profits in a given year.118 c. of mandatory minimums, optional presumptive regimes, and other variations but this is the sort of problem that would face any presumptive tax regime. to this point in the analysis we have assumed that the presumptive regime would be mandatory and exclusive, in the following sense: if a business qualifies as an smb (for example, its gross receipts fall below the smb threshold), then that business taxpayer must pay the presumptive tax liability. thus, not only is the regime compulsory, but it is also exclusive in that the presumptive tax liability represents both the taxpayer’s maximum and its minimum federal tax liability. as we have pointed out, such a mandatory-exclusive presumptive regime would entail certain advantages, such as reduced administrative and enforcement costs, but also would come with certain distributional and efficiency disadvantages. it is possible that these disadvantages could be reduced if the presumptive regime were made either optional or, if mandatory, non-exclusive. as we shall see, however, such changes would bring problems of their own. 1. mandatory minimum a mandatory presumptive tax need not be exclusive. the amt, for example, is a mandatory tax, but it is only a mandatory minimum. under the amt, a taxpayer must calculate both her amt tax liability (called her “tentative minimum tax”) and her regular income tax liability and then must pay the higher of the two. a mandatory minimum presumptive smb tax would presumably work the same way.119 what would be the benefits of such an alternative to the mandatory exclusive regime discussed above? for one thing, the mandatory minimum version would be somewhat less regressive than the mandatory exclusive version. smbs whose incomes turn out to be high enough to generate a regular income tax liability in excess of the amount owed on the presumptive amount would face whatever degree of progressivity is built into the income tax regime. for those smbs who end up paying only the thus, a qualifying smb would have to calculate both its presumptive tax liability and its regular, income-tax liability and pay whichever is greater. 118 the system would also be inefficient because it would serve as a negative stimulus towards some expenses and/or investments that are used as tags for the presumptive system, even though such expenses/investments would be profit maximizing in a non-tax world. for example, if the number of tables in a restaurant is decisive for taxation, the taxpayer might decide to use fewer tables because the additional tax burden would exceed the additional profit derived from the extra tables, although in a non-tax world, or even in a regular income tax world, the additional table would be a profit-maximizing decision. see yitzhaki, cost benefit analysis, supra note 74, at 321. 119 this name would be a bit misleading, however. while the current amt is a sort of presumptive tax, it is not a presumptive tax that is directed at the problem of noncompliance. rather, the amt responds to a different type of problem: taxpayers combining a number of (entirely legal) deductions, exclusions, and credits to reduce their regular tax liability to zero – or at least to a very low number. the smb presumptive tax (or alt-smb tax) would be all about dealing with noncompliance, mostly evasion. 138 columbia journal of tax law [vol. 2:100 presumptive tax, however, there would only be the degree of progressivity built into the presumptive regime, whatever that happens to be. thus, with a lump-sum presumptive tax, for those who pay the presumptive tax, there would be no progressivity; with the mrg presumptive tax, there would be some progressivity; and so on. from an efficiency perspective, the results would again be mixed. if we consider only the taxpayers who pay the minimum presumptive amount, the results would be the same as under the exclusive presumptive system, which again would depend on which presumptive base was used. for those taxpayers who end up having to pay the regular income tax, the efficiency concerns would be the same as those presented by an income tax. the one difference might be additional pressure of a potential “cliff effect” for taxpayers whose income levels are close to the regular tax threshold; that is, if an smb’s regular income tax liability would be significantly higher than its presumptive tax liability, the work/leisure distortion may be especially large at the regular-tax/presumptive-tax threshold. the big downside of the mandatory minimum presumptive smb tax is that it does not significantly reduce administrative/enforcement costs associated with policing the smb income tax after the income threshold is surpassed. that is, high-income smbs would still have an incentive to overstate deductions or understate gross receipts in order to avoid paying the income tax. the presence of the mandatory minimum smb tax would limit this incentive but would not eliminate it. the effect might be that most smbs would end up paying the presumptive tax: low-income smbs would pay because it would exceed their income tax liability; and many high-income smbs (those willing to understate their actual tax liability) would end up paying it by default. and only the honest (or well socialized) high-income smbs would pay the regular income tax. what’s more, the government would not be able to prevent this sort race to the bottom from happening unless it could drastically improve its ability to enforce the income tax. but if we could do that cheaply, we would not need the smb presumptive tax in the first place. 2. the ex-post, optional presumptive tax if policymakers find the distributional and efficiency concerns associated with a mandatory presumptive tax unacceptable, there is always the optional or elective approach. consider for example an optional presumptive tax regime that allows a taxpayer to make the choice – whether to opt into the presumptive tax regime or whether to pay the regular income tax liability – at the end of the taxable year. under such an “ex-post, optional regime,” it is obvious that the taxpayer would choose the system that produced the lower tax liability.120 one thing this would mean, of course, is that less revenue would be collected under an elective regime than under a mandatory presumptive regime that employs the same rate structure. to see this, return to our hypothetical tax regime that taxes business profits at 35% and that has five presumed-profit business classes for smbs ranging from 2% to 80%. now assume that a particular line of business falls into the 30% presumed-profit category. if the mgr regime were mandatory, all smb thus, an ex-post, optional presumptive system would be a sort of alternative maximum tax: taxpayers would never pay more than the presumptive tax, but might pay less if their regular income tax liability proved to be lower. 120 this regime is comparable to the current standard deduction in the united states. see discussion, supra note 82. 2011] narrowing the tax gap through presumptive taxation 139 taxpayers in that line of business would expect to pay a presumptive tax of $10.50 on every $100 of gross receipts earned (30% of 35%). if 1000 such smbs each earned $100 of gross receipts for the year, $10,500 would be collected in presumptive tax from the group. of course, the actual profit percentages within this line of business would vary, with 30% perhaps being the mean. as a result, there would be some inaccuracy and unfairness owing to the cross-subsidization within the line-of-business presumptive tax pool, with the degree of cross-subsidization depending on the standard deviation of actual profit percentages within a group. this is just a restatement of the inherent inaccuracy of any presumptive regime that relies on presumed profit ratios. if, however, the regime were made optional, those taxpayers whose actual profits for the year were less than 30% would do better to opt for the income tax, and those whose actual profits were greater than 30% should opt for the presumptive tax. obviously, assuming at least some variation in actual profits within the line of business (as would obviously be the case), less than $10,500 would be collected from the group in this example. and so it would be with an actual optional presumptive tax. how much the revenue from the group would drop below the amount collected under the mandatory presumptive tax would depend on the amount of the variation in profits within the group: the larger the profitability variance within the presumptive pool of smb taxpayers, the larger would be the degree of inaccuracy and distributive unfairness inherent in a mandatory regime. by the same token, greater profit variance within the group would also mean a larger loss of revenue (in comparison with the mandatory exclusive regime) if the regime is instead made optional.121 a similar sort of story could be told about other presumptive tax bases. the same basic point would hold true: relatively high income taxpayers (those who would pay more under the income tax) would opt into the presumptive tax; and relatively low-income taxpayers (those with a lower profit margin than their proxy indicia would suggest) would opt for the income tax in order to pay the lower amount. if policymakers had a particular target level of revenue in mind, then they would have to make up the lost revenue resulting from making the presumptive tax optional from some other source, perhaps by raising rates on all income. so long as they raise rates on both actual income and presumptive income, however, the rate increase should not exacerbate the revenue loss. it should also be clear that, if the presumed profit margins set by the government were to be adjusted periodically to reflect changes in actual line-ofbusiness profit margins, such adjustments should not be based on which smbs opt into the presumptive regime and which do not. if that were done, it would cause a sort of line-of-business, profit-margin “unraveling” akin to what can happen with insurance pools. that is, with an insurance pool, where premiums are set at the average expected costs of the pool, individuals with higher than average expected costs will tend to opt into the insurance pool and individuals with lower-than-average expected cost will opt 121 of course, the actual loss of revenue that an optional presumptive tax would produce when compared with a mandatory exclusive presumptive tax would depend on how close the presumptive profit margins were to the mean within a given line of business. if the presumptive margins are set at the actual mean profit percentage within a line of business, then the degree of variance within that line of business around the mean will be directly related to the loss of revenue on the optional system. however, if the presumptive profit margin were for some reason set below the actual mean profit margin, some variance might not be enough to cause a loss. 140 columbia journal of tax law [vol. 2:100 out.122 an ex-post, optional presumptive tax would also be especially vulnerable to noncompliant taxpayers, those not burdened by conscience or fear of informal sanctions when it comes to gaming the tax system. the above-described self-selection process, where the high-profit businesses opt into the presumptive regime and the lowprofit businesses op out, would occur even if we assume everyone is seeking to comply fully with the tax laws. in addition, those relatively high-profit smbs who are most willing and able to engage in noncompliance would have an extra incentive to opt into the regular income tax regime, where they can use their comparative advantage to exploit the enforcement difficulties associated with the net income taxation of smbs. this incentive would cut in the opposite direction of the incentives facing the compliant, high-income smbs, who would, again, tend to opt for the presumptive tax. and assuming that smb noncompliance under the income tax is difficult to police, we would again see the same sort of inequity that we see today between the tax burden imposed on the compliant and that imposed on the noncompliant. although at least under an optional regime, the high-income, compliant taxpayer would get to pay the lower of her income tax liability or her presumptive tax liability. and because the premium is based on average risks, the premium will rise as adverse selection occurs; and the spiral can continue, as opting out of the pool becomes attractive for more insureds, until at some point either only very high-cost individuals are willing to buy the insurance, or the market entirely unravels. what would prevent this unraveling from occurring with the use of presumed profit margins based on industry means is that the presumed margins would either be fixed (based on the margins at the time the regime is adopted) or they would be updated periodically based on industry-wide data – and not on who opts into or out of the system. as we mentioned above (and discuss in further detail below), the best system for updating presumed profit margins would likely involve negotiations between the irs and industry representatives. the problem of the noncompliant, high-income smbs opting for the regular income tax under an optional presumptive tax might be dealt with by adopting separate penalties for the presumptive tax and the regular income tax. that is, we might imagine a penalty regime that says, if you opt into the presumptive tax regime, assuming you do not fraudulently hide gross receipts or lie about your line of business and assuming you do not engage in any clearly illegal presumptive-tax-shelter activity (described above), you will face a relatively favorable and friendly enforcement environment, one that will also be relatively cheap for the irs to administer. 123 if, however, you are an smb that opts to be taxed under the regular income tax, you will face a more aggressive enforcement environment, with a higher probability of audit and a more searching and intrusive audit if you get audited. also, if you happen to be found guilty of any sort of noncompliance, you would face a very stiff penalty.124 122 this phenomenon, known as adverse selection, arises because of information asymmetry: whereas the insurer can observe only the average expected cost of the pool, individuals are assumed to know if their expected costs are higher or lower than average. of 123 this does not mean, however, that the probability of getting caught under this system is lower than under the regular system. the whole idea is to make the presumptive system easy and cheap to administer, and with a high probability of detection (thus, with no need for high penalties or costly audits). 124 this idea has much in common with alex raskolnikov’s proposal for tailoring enforcement regimes to the type of taxpayer in question. alex raskolnikov, supra note 71, at 689. raskolnikov’s idea is to structure the tax enforcement regime so that it distinguishes between taxpayers who are “gamers” (the ones who are the classic rational actors of standard deterrence theory) and those who are not gamers, who 2011] narrowing the tax gap through presumptive taxation 141 course, the enhanced enforcement under the income tax for smbs would be expensive (as we have said all along), but perhaps enough money could be saved from the lower enforcement costs on the presumptive tax side to fund the increase on the regular income tax side. one difficulty with this suggestion is that it would be hard for policymakers to calibrate the distinctions between the two enforcement regimes such that the appropriate incentives would be created. for example, if the enforcement environment of the presumptive tax regime were made too friendly and cooperative, it might be subject to exploitation – so much so, in fact, that high-profit taxpayers bent on noncompliance would actually do better by opting into the presumptive regime. the more likely outcome, however, is that some of the high-income noncompliers (or gamers) would opt into the presumptive regime, not to exploit the enhanced opportunity to engage in noncompliance but, to the contrary, to avoid the enhanced penalties in the other regime and, simply, to pay the lower tax. and if this happens, it would produce further administrative cost savings that could also be used to fund the increased enforcement efforts under the regular smb income tax. in sum, under the dual-track enforcement regime, two optional and parallel systems of smb taxation would be created. the first one would be the presumptive system, which would be by its nature difficult to game (because of the compulsory withholding and the disallowance of all deductions) and in which high levels of compliance could be achieved even in an environment with low audit costs per taxpayer. the second system would be the regular income tax, which would be structurally easier to game (overstating deductions would still be possible) and where high level compliance could only be reached with either very high penalties or high audit costs per taxpayer. the larger the number of taxpayers that opt into the presumptive system, the higher the amount of resources that would be freed to enforce the regular system, leading to a higher overall compliance environment. having said all of this, what is the benefit of making the presumptive tax expost optional in the first place? the answer is that by doing so we reduce a particular type of inequity: that of taxing the lower-than-average-profit business as if it were an average-profit business. hence, the taxpayer who happens to incur larger expenses in a given year than others in the same line of business (under the mgr tax) or others with the same multi-factor profile (under the tachshiv-like tax) can opt for the more accurate and fine-grained calculation of income under the regular income tax. this would be an especially useful option for start-up firms, which almost always will have lower-thanaverage profits in their early years of operation.125 want to pay their taxes out of a sense of duty or out of habit and have no interest in trying to exploit loopholes or play the audit lottery. those who are in the former group would elect to be subject to what raskolnikov calls the “traditional enforcement regime,” with high penalties, high risk of audits, and the like. those who are in the latter group would face a more cooperative enforcement environment. the reduction of this horizontal inequity is what makes the optional approach so appealing. there is also some enhanced efficiency associated with this approach, if only because, by lowering the overall tax burden (because of the option to pay the lower tax) we reduce the potential work/leisure distortion and the tax-induced incentive towards vertical integration. whether the optional approach makes overall sense, then (compared with, say, the 125 in fact, given this characteristic of start ups, it would make sense, even under a mandatory presumptive tax regime, to make the regime optional for start-up companies for the first several years of their existence. how many years they should get the regular income tax option would be determined by the service and could vary across lines of business. 142 columbia journal of tax law [vol. 2:100 mandatory version of the same tax), would depend on an analysis of whether the particular horizontal equity improvement described above, plus the slight efficiency improvement, would outweigh the various costs identified above, including the loss of revenue.126 3. variations on the theme the ex-ante, optional presumptive tax. would anything change if the election to be taxed under the presumptive tax or the regular income tax had to be exercised ex ante (at the beginning of the year or at the beginning of some period of time, before the taxpayer’s income is known) rather than ex post (after the taxpayer knows her income)?127 in such a case (assuming, of course, that the option cannot be changed during the year), the taxpayer would not base her decision on a comparison of known tax liabilities, but rather on an educated guess as to what her future income may be. still, the analysis would be much the same: taxpayers who expect to have a relatively high income would opt into the presumptive system and taxpayers expecting a relatively low income would opt out. and for those who guess correctly, the analysis of the inequities and inefficiencies would be the same as under the ex-post, optional regime. for those who guess wrong, however, the outcome is mixed. for those who wrongly opt into the presumptive system – i.e., they thought that their tax liability under the regular system would be higher than the presumptive amount, but it ended up being lower – the ex-ante, optional system is more regressive than the ex-post one, though no more regressive than the mandatory approach. for those taxpayers who wrongly opt for the regular system (expecting to have a relatively low income but in fact experiencing a relatively high income), the ex-ante system is more progressive than the ex–post, optional system, and indeed more progressive than the mandatory presumptive regime. that is, the taxpayer essentially would be opting to be taxed under the higher-income, tax regime.128 negotiated approach. rather than imposing a presumptive tax from the top down, with congress and the irs imposing a given set of rules, it might be better (and more feasible) to imagine a greater degree of cooperation between the regulators and the regulatees in this case. in some countries that use presumptive taxes, this approach is taken to the extreme in the following sense: taxpayers are actually allowed to enter into contractually binding agreements with the taxing authority about what their tax liability will be. france, for example, has done this since the 1960s under a system known as the forfait, which has been applied to as many as a million individual taxpayers in a given year. 129 126 the tachshiv, when it was still on the books, was an ex-post optional presumptive regime. now it is an audit strategy with commitment. a forfait-type regime would almost certainly not be administratively feasible for the u.s. tax system, given the large number of smbs involved. still, for some types of presumptive tax regimes, it might be possible to allow large groups of smbs collectively to negotiate some aspect of the presumptive tax with the irs. imagine, for example, an mgr presumptive income tax under which smbs that work within the same line of business could, as a group and through group 127 the brazilian regime is an ex-ante optional mgr presumptive regime. 128 as with the distributional effect, the efficiency effect of taxing people on their ex-ante guess about their ex-post profit situation is also mixed, depending on the direction of the mistakes. 129 see thuronyi, supra note 73. the tachshiv also had some features that representatives from each economic sector could negotiate with the tax agency. see arachi & santoro, supra note 40, at 230. 2011] narrowing the tax gap through presumptive taxation 143 representatives, negotiate the presumptive profit margins for their line of business with the irs. this process, which would be similar to the notice-and-comment rulemaking that already exists, would stimulate smbs to keep track of their business expenses in order to show the irs, in a negotiation, what the average profit margin of their group actually is. if such an approach worked properly, it would make possible regular updating of the mgr presumed profit margins. moreover, such a system would reduce the possibility of taxpayers’ lying to the irs about their line of business (in order to be taxed under a lower mgr margin), because the smbs themselves would police who would be allowed into their group (in order to avoid outsiders having a say with respect to the reported margins). thus, even though individual contracts between individual smbs and the irs are a nonstarter to solve the smb tax gap problem, other types of collectively negotiated outcomes may in fact work. the presumptive tax idea as audit strategy. the irs might also consider using one or another presumptive tax regime as an audit tool for enforcing the existing regular income tax rather than as an actual separate presumptive tax system. under such an enforcement approach, the regular income tax would continue to be the only tax system that would apply to smb taxpayers, but the service would use some presumptive tax formula (one like the mgr or the multi-factor presumptive tax discussed above) to calculate the taxpayers’ hypothetical presumptive tax liability.130 under one version of this audit-strategy approach, the service would (a) tell taxpayers how to calculate their hypothetical presumptive tax liability and (b) credibly commit to audit only those taxpayers who declare income that falls below the hypothetical presumptive amount. the result would be similar to that under the ex– post, optional presumptive tax system discussed above. relatively high-profit smbs (those with high enough profits to generate a tax liability under the regular income tax that is greater than their presumed tax liability) would report only the presumed amount on their income tax return: any less would trigger an audit: any more would subject them to unnecessary taxation, given the administration’s credible commitment not to audit them if they report at least the presumptive amount. on the other hand, smbs with a tax liability below the presumed amount (at least the ones willing to be noncompliant with the statutory law given that tax authority’s stated audit policy) would declare their actual income and expect to be audited, which would be the equivalent of opting out of the presumptive system as discussed above. the import of this analysis is that the tax enforcement authority (the irs) could, by announcing and credibly committing to this sort of presumptive-tax type of audit strategy, roughly approximate the result that could otherwise be achieved only with the legislative adoption of a new optional presumptive tax regime. we say “roughly approximate” because at least some honest taxpayers would see a difference between the presumptive tax audit strategy and the statutory optional presumptive tax regime. that is, these honest (pathologically compliant) high-income taxpayers would be more than happy to opt into a statutorily-provided presumptive regime and forego paying the higher-income, tax liability but would be very reluctant to respond to an announced presumptive-tax, audit policy by gaming the system and declaring less tax than they actually owe under the statute. 130 the israeli system currently uses the tachshiv as a sort of audit strategy. arachi & santoro, supra note 40, at 230. see also thuronyi, supra note 73. 144 columbia journal of tax law [vol. 2:100 if such an approach were to be followed, these new audits of smbs who report income below the presumptive amount would be administratively costly. if enough smbs declare at least the presumed amount (which, as already discussed is inherently cheaper to enforce), however, then audit resources would be freed up and could be redirected towards those who declare income below the presumptive level.131 the previous example assumed that the irs could credibly commit to its audit policy. but what if it couldn’t? in that case, the results might be very different. for example, if the irs publicized its presumptive tax audit strategy and taxpayers initially believed them, then taxpayers willing to be noncompliant would do so. that is, the relatively high-income taxpayers would declare the presumptive amount though, under the statute, they owe more. the problem is that the irs, anticipating this behavior by taxpayers and being unable to pre-commit, would then find it impossible to resist auditing some fraction of the ones who declared the presumptive amount. of course, once the irs discovered some taxpayers who were noncompliant, it would want to stick them for the additional tax and penalties. assuming taxpayers are rational, of course, they will see this bait-and-switch coming; and the high-income gamers, knowing that the irs could not credibly commit to its stated audit policy (or could not be trusted to follow it), would ex ante decide not to declare the presumptive amount – or at least their incentive to do so would be diminished. and the whole point of the audit-policy would be defeated. moreover, as with the optional presumptive tax, there could be an enhanced penalty for the regular income tax system. given the fact that the taxpayers that pay the presumptive amount are under an audit “safe harbor,” a simple increase in penalties for smbs would hit only those that declare amounts lower than the presumptive one, i.e., those that are still under the regular income tax system. of course, an increase in formal penalties for noncompliance would probably have to be enacted by congress. 132 there is also a third possibility. what would happen if the irs used a presumptive audit strategy without the taxpayers’ knowledge of it? this would be another version of the discriminant index function (dif) currently used by the irs (or a mere addition of data and variables to the dif), but specifically targeted at smbs. if taxpayers are (and remain) unaware of the audit strategy used by the irs, they will keep reporting income as under the current system. however, it is possible that several “gamers” who nowadays get away with evasion will start being audited under the new strategy. if that is the case, smbs will perceive a higher enforcement rate and may start evading less. however, it is also possible that over the years (after sequential “games”), taxpayers (and preparers) realize the formula used by the irs to select the returns that will be audited. if that happens, taxpayers might start declaring not more than the presumptive amount and a result similar to the audit policy with commitment would be reached. to avoid this outcome (if, in fact, keeping the presumptive method a secret is more efficient than making it public and credibly committing to it), the irs should make constant updates to the presumptive system and avoid giving away their audit strategy. 131 this is a version of the optimal audit policy with commitment, as portrayed by arachi & santoro, supra note 40, at 229. the authors describe the italian study di settore as an audit strategy with commitment and reach similar conclusions as the ones described above. id. at 237. 132 michael j. graetz, jennifer f. reinganum & louis l. wilde, the tax compliance game: toward an interactive theory of law enforcement, 2 j. l. econ. & org. 1 (1986). 2011] narrowing the tax gap through presumptive taxation 145 vi. conclusions and caveats a. general remarks the aim of this article has been to highlight the primary tax enforcement problem in the united states, that of noncompliant small and medium-sized businesses (“smbs”), and to explore the possibility of a radical solution: shifting away from the current system that attempts to tax the actual individualized income of those businesses and toward a system that taxes only a very rough approximation of business income. this sort of presumptive tax approach has been used for years in developing economies, where the problem of smb noncompliance is even worse. our argument is that the time may have come for taxing smbs in the united states on a presumptive basis as well. but we do not go quite so far as to advocate such a change. as we set out in some detail above, such a shift would amount to a massive tradeoff of accuracy of income measurement for lowered costs of tax enforcement, and more research is needed on both sides of that question. how much of a loss of accuracy would result from the various presumptive-tax regimes discussed above? what would be the enforcement-cost savings? the particular regime that we spend the most time developing is a type of modified gross receipts tax, which would tax smbs on a rough estimate of their annual income using their reported receipts and historical line-ofbusiness profit percentages, coupled with mandatory withholding requirements. there, the key questions would be: how narrowly and accurately can such line-of-business profit percentages be drawn and at what cost? if the answers are very narrowly, very accurately, and very cheaply, then an argument could be made for replacing the income tax for smbs with a mandatory modified gross receipts tax. if, however, the line-ofbusiness, profit-percentages exhibit considerable variability, then making such a regime optional becomes much more appealing because it would reduce (though not eliminate) the unfairness associated with cross-subsidization within the profitpercentage groups. also, if an optional presumptive regime were adopted, serious consideration should be given to imposing a dual-track enforcement regime, under which naturally compliant (non-gaming) taxpayers would be enticed into the presumptive tax system, thereby saving administrative dollars that could be spent on enforcing the income tax against those taxpayers more willing to engage in noncompliance. the changes just described would require a major reform of the internal revenue code. as a more modest alternative that might be able to achieve some of the same results, it might also be worth considering having the irs begin to use presumptive-tax principles as part of their audit strategies. if the service could credibly commit to applying some form of presumptive tax system in its auditing decisions (as part of the discriminate index function, say), and if taxpayers reacted rationally to such an audit policy, the results could be similar to an optional presumptive business income tax. such an approach, however, would have at least two significant problems. first, it would be difficult for the service to make such a commitment credible. second, even if such an approach worked to perfection (the service was able to precommit and taxpayers responded rationally), the way in which such a regime would “work” would be to induce those taxpayers willing to understate their taxes (the gamers or cheaters) to pay only the presumptive amount while the non146 columbia journal of tax law [vol. 2:100 gaming taxpayers with the same level of income would pay the higher income tax liability. many other questions remain as well. for example, what should be done about noncompliant, smb taxpayers who do not receive most of their payments from other businesses (but rather receive payments mostly from individual consumers), and thus for whom compulsory withholding would not be practical. in this article we have suggested some possible ideas, such as the expanded use of third-party reporting, like financial institutions that administer credit and debit-card purchases. (not only are such transactions easier to monitor than cash transactions, they can also be used to estimate the amount of cash being received by businesses). in addition, there are various innovative solutions that might be tried, such as the brazilian experiment with consumer-based monitoring and reporting of smb tax compliance using the internet, although most such experiments are still too young to be definitively evaluated. at the end of the day, for those smbs that tend to do a large fraction of their business in cash, something like the israeli-style, multi-factor approach may be necessary, at least as part of the irs’s auditing strategy. moreover, even if one were persuaded that some sort of new tax enforcement initiative for noncompliant smbs (whether shifting to a presumptive tax or simply raising penalties or having more audits) might make sense in the abstract, it could be argued that now is not the time. small businesses are the primary producers of new jobs in the economy, the argument would go, and the current tax system, under which smbs are essentially allowed to “get away with” substantial noncompliance, amounts to a type of implicit federal tax subsidy for job-creating smbs.133 and this is a good thing. any of the presumptive-tax solutions discussed above, therefore, would undercut that subsidy and further harm the economy. our response to this type of argument is twofold. first, it is actually far from clear that small businesses provide any more job creation (net of “job destruction”) than do larger businesses. at least not so much that they should be singled out for a special subsidy.134 a. vat as an alternative second, even if one disagrees with that conclusion and believes it necessary and appropriate to subsidize small businesses, there are much better (more efficient, more distributively sensible and transparent) ways of subsidizing small businesses than by essentially giving money to the ones that are in industries (or in forms of organization) that find it easiest to evade taxation and those most willing to ignore the law and social norms of legal compliance. there is one critique of our proposal that deserves a separate and sustained response. one could argue that if we are willing to enact a change in the law as radical as the introduction of a presumptive system of income taxation, it would make more sense simply to enact a value added tax (or vat), a change that has been discussed 133 indeed, morse, karlinsky, and bankman found that many smb taxpayers who engaged in evasion were of the view that the irs’s underenforcement in this area was “sound government policy” and equivalent to a small-business subsidy, similar to (and justified in the same way as) direct subsidies to farmers and other industries). see morse, karlinsky & bankman, supra note 12, at 67. some of the interviewees also expressed the view that, if the irs were to require full tax compliance among smbs, many of them would be forced out of business. id. 134 see steven j. davis, john c. haltiwanger & scott schuh, job creation and destruction 57-75 (1997). 2011] narrowing the tax gap through presumptive taxation 147 and advocated by some in the united states for quite some time. it is beyond the scope of this article to discuss all of the pros and cons of the migration from an income-tax regime to a consumption-type tax such as the vat. however, we should say something about the ability of the vat, in comparison with a presumptive tax, to solve the problem of smb tax noncompliance. first, we need to clarify what we mean by a vat and whether we mean for the vat to replace or supplement the income tax. a vat is very much like retail sales taxes, with one important difference: the tax is levied on (or remitted by) taxpayers at every step of the production/sales chain. to avoid a cascading effect of multiple taxes on the same good, each taxpayer within the chain of production is allowed a credit for the amount of vat that has already been remitted by the previous taxpayers in the chain. the advantages of this difference from the retail sales tax, which calls for remittance only on the final retail sale, are twofold. from a fairness perspective, it allows for the vat to be levied on the same overall base as the retail sales tax, i.e., the sale price to the consumer.135 that is the vat. the next question, when comparing the vat to the presumptive tax in addressing the smb gap, is whether we have in mind a complete overhaul of the current income tax system, that is, an outright repeal of the existing income tax and the replacement of it with a vat? or are we talking about the enactment of a vat as a new tax on top of the current income tax? from an enforcement perspective, the vat is superior to the sales tax because it does not focus the remittance obligation exclusively on the retail sellers, which are often the hardest-to-enforce link of the chain. it rather spreads the liability and remittance obligation over all the steps of the chain, making the revenue impact of evasion by one particular taxpayer less relevant. also, the creditnote method provides a useful third-party reporting enforcement tool: a taxpayer is only allowed to claim a vat credit if she has documentation proving that the previous taxpayer on the production/sales chain has effectively remitted the vat. this means that, at least to some extent, taxpayers will self-enforce the vat upon each other and will provide the irs with relevant cross-referenceable data on the receipts/expenses of one another. 136 if it is the latter, then smb income-tax noncompliance would continue to be an issue, simply because the income tax (and the income tax gap) would not cease to exist. although one could argue that the vat enforcement would bring positive externalities to the income tax enforcement,137 135 if one adds all the vat effectively remitted by each taxpayer over a certain production/sales chain – i.e., vat liability minus vat credits – the overall amount of vat remitted is roughly the same as the amount of sales tax that would be remitted if only a sales tax at the same rate had been levied on the sale by the retailer. see appendix a for more details on this. of course, this assumes a vat that allows for instant credit of capital goods (i.e., expensing), which would be the case with a vat that seeks to tax only consumption. see richard a. musgrave & peggy b. musgrave, public finance in theory and practice 441-445 (4th ed. 1984). it is highly uncertain if such externalities would suffice to solve (or relevantly improve) the smb income tax enforcement issues. 136 graetz, reinganum & wilde, supra note 132; reuven s. avi-yonah, the three goals of taxation, 60 tax l. rev 1 (2006); reuven s. avi-yonah, designing a federal vat: summary and recommendations (john m. olin ctr. for l. & econ., working paper no. 104, 2009). 137 for example, we will see below that a credit-invoice based vat would provide the irs with extra third-party reporting, which could be used for income tax purposes, to check some of the taxpayer receipts and deductions. 148 columbia journal of tax law [vol. 2:100 but what if the proposal were to replace the income tax entirely, along with whatever version of our presumptive income tax were to get adopted for smb income, with a vat? then the question of which regime better deals with the smb tax gap would depend heavily on comparative abilities of the presumptive regime and the vat alternative to deal with the two general types of evasion: the overstatement of deductions and understatement of receipts. and this comparison will depend, in turn, on which type of presumptive tax we have in mind. as mentioned above, an mgr presumptive tax would deal with the overstatement of deductions by simply disallowing them and substituting instead a presumed profit based on some measure of average expenses within the relevant line of business. moreover, by means of withholding and third party reporting, it would be able to deal with the understatement of smb’s receipts from other business or credit card receipts from consumers. as we have mentioned, the mgr presumptive tax would have no good answer to the problem of smb evasion through the understatement of cash receipts. conversely, the vat, when applied to smbs, would need to deal with the problem of smbs understating their receipts and overstating their expenses. on the expenses’ side, we concede that there are reasons to believe that the problem of expense overstatements under the vat is less severe than the problem of deduction overstatements under a standard income tax. first, there are fewer vat creditable items than income-tax deductible expenses. (under a vat, deprecation is not deductible, for example; whereas, under an income tax it is). this simple fact means there are fewer opportunities to overstate expenses under the vat. second, vat credits are only allowed for expenses in goods and services that have been taxed by the vat. this means that one taxpayer’s credit is matched with another taxpayer’s vat liability. thus, if the irs has a powerful enough data cross-reference system, overstated credits could ideally be caught on the spot, without the need for auditing. this means that the vat is probably superior to the regular income tax in dealing with the expenses’ (deductions/credits) overstatement problem. however, the vat’s system is not as effective as the disallowance of all deductions by the mgr presumptive tax, simply because no third party reporting mechanism beats the plain removal of the expenses from the equation. on the receipts side, the vat would also count on the credit-note method to provide sufficient self-enforcement and third party reporting that would undermine underreporting on transactions between taxpayers.138 also, the vat could rely on credit card companies’ reporting to deal with business-to-consumer transactions. however, much like the mgr presumptive tax, the vat would not be able to deal with business-to-consumer cash transactions. other presumptive income taxes, such as multiple factor, assets, or lump-sum taxes discussed above might be superior to either the vat or the mgr presumptive tax for dealing with cash transactions and overstated deductions, but would have fairness, efficiency, and even administrability issues of their own, as we have already analyzed earlier.139 138 this would not deal, however, with the judgment-proof issue that income tax withholding would address. in sum, the vat would address some of the smb tax gap issues addressed by presumptive taxes, but not all of such issues and probably not as well as the presumptive systems in some cases. 139 as mentioned in an earlier note, there might be some mechanisms that could deal with the underreporting of cash transactions, be it for income tax, sales tax or vat purposes. 2011] narrowing the tax gap through presumptive taxation 149 if one is truly committed to moving towards a vat, but is concerned about the problem of noncompliance among smb taxpayers, there are other alternatives as well. for example, the vat regime could simply exempt from taxation smb taxpayers whose revenues fall below a certain threshold, or noncompliance by such taxpayers could simply be ignored. this approach has its own disadvantages, as we discussed above in connection with the idea of simply regarding smb income tax noncompliance as a subsidy for smbs.140 in any event, one should note that a vat reform would be much more far reaching than the enactment of any presumptive smb tax. while the presumptive tax reforms would not go beyond the smb issues analyzed herein, a vat reform would affect all taxpayers with major fairness, efficiency, and administrability consequences for all of them. as an alternative, if one wanted to go with a vat but did not want to exempt all smb transactions, it would be possible to adopt a presumptive vat. under such a regime, the presumptive vat would require taxpayers, in calculating their vat remittance responsibility, to rely on some proxy for a business’s expenses, rather than the actual expenses. and the idea would be for this proxy to be something that is substantially easier for the tax authorities to measure and, thus, enforce. then this presumptive deductible amount would be credited to the next taxpayer in the chain of production. such a regime would have much the same advantages and disadvantages of a presumptive income tax regime. 141 140 however, there might be relevant incidence differences between the vat and the income tax that would make a vat smb exemption very different from an income tax smb exemption. thus, although we focused above only on the vat’s ability to deal with smb enforcement, this is just one (minor) point to consider in the debate of a vat reform. 141 these issues have already been reviewed in literature and fall out of the scope of this article. 1. a lump-sum business tax 2. pure gross receipts (or “turnover”) tax 3. modified gross receipts (mgr) tax: using historical line-of-business profit ratios to estimate net income. 4. taxing asset values 5. taxing multiple-factors 3. variations on the theme vi. conclusions and caveats a. general remarks a. vat as an alternative articles breaking the spell of tax budget magic rachelle holmes perkins  abstract to date, tax scholars have responded to the proliferation of so-called temporary or sunset tax expenditure legislation by staking claims either for or against it, focusing on its relative merits and shortcomings. in this article, i argue that these positions are analytically incomplete. rather than address the underlying deficiencies in the budget process that have led to the preference for temporary tax provisions, the advocacy of the use (or non-use) of temporary provisions simply asks which type of provision will yield the least problematic results. this article seeks to help fill a gap in the literature by focusing on remedies meant to address the source of many issues related to both temporary and permanent tax expenditure legislation. in particular, i propose the adoption of a bundle of new budget rules that will work as precommitment devices to restrain lawmakers from exploiting weaknesses in the existing process. i argue that these proposed rules would still give lawmakers the flexibility to adopt either temporary or permanent tax legislation as appropriate. however, the proposed rules would help to decrease opportunities for budget manipulations, impose more fiscal restraint on lawmakers, achieve greater legislative transparency, help loosen the hold of special interest groups on lawmakers, and enhance legislative stability.  assistant professor of law, george mason university school of law. the author would like to thank the participants of the robert a. levy fellows workshop in law & liberty for their helpful feedback. research assistance from kelli cacciotti is gratefully acknowledged. 2 columbia journal of tax law [vol.6:1 i. introduction ........................................................................................... 3 ii. behind the veil: the current budget process for tax expenditures ............................................................................................ 5 a. tax expenditures and tax extenders ............................................................ 5 b. budget rules ............................................................................................. 8 1. overview ............................................................................................. 8 2. paygo ............................................................................................. 10 3. reconciliation and the byrd rule .......................................................... 11 4. senate point of order .......................................................................... 13 iii. the black and white magic of temporary tax expenditures 13 a. budget manipulation ................................................................................ 14 1. front loading with temporary provisions ............................................ 15 2. back loading with permanent provisions .............................................. 17 b. rent extraction ........................................................................................ 19 c. political opaqueness ................................................................................. 20 d. uncertainty and inefficiency ...................................................................... 22 e. dynamic lawmaking? .............................................................................. 23 iv. breaking the spell with new budget rules ................................. 24 a. proposed budget rules ............................................................................. 24 1. disregard sunsets for budget scoring purposes ..................................... 25 2. lock-step paygo .............................................................................. 27 3. mandatory baseline review ................................................................. 27 b. consequences of the proposed budget rules ............................................... 28 1. decrease opportunities for budget manipulation and increase fiscal restraint ............................................................................................ 28 2. maintain legislative flexibility and enhance oversight .......................... 29 3. enhance legislative stability ............................................................... 29 4. achieve greater political transparency ................................................ 30 5. diminish captivity to special interest ................................................... 30 c. potential criticisms .................................................................................. 31 v. conclusion ............................................................................................. 32 2014] breaking the spell of tax budget magic 3 i. introduction over fifty tax expenditure provisions in the internal revenue code reside in an effective tax abyss—neither permanently enacted nor affirmatively repealed. 1 this predicament is a natural byproduct of the so-called “tax extender” legislative phenomenon, whereby tax expenditures are routinely enacted on a temporary basis (typically for one or two years). at the end of their effective period, these provisions are habitually extended, sometimes retroactively. the proliferation of tax extender provisions is not insignificant. it is estimated that the cost of tax extenders each year is approximately $54 billion, and the cost to have these same extenders in effect for the next ten years would cost over $930 billion. 2 the growing prevalence of temporary tax legislation is primarily attributable to vagaries in the budget process that give tax expenditures an advantage over direct spending equivalents and temporary tax provisions an advantage over their permanent counterparts. 3 first, the nominal cost of a tax extender is significantly reduced due to its purported shorter effective period, even if it is anticipated that it will be extended again the following year. moreover, providing offsets necessary to make a temporary provision revenue neutral is far easier than for a permanent provision. with the ten-year budget window typically used for scoring legislation, lawmakers can use ten years of revenue to offset the cost of a single year of tax legislation rather than having to find revenue offsets for a full ten years. this type of budget manipulation is in large part responsible for the explosion of temporary tax legislation in recent years. 4 it is not surprising that the rise of tax extenders has garnered significant attention from both legislators and academics alike. in response to this proliferation of temporary legislation, scholars have come out both for and against the use of temporary provisions as a legitimate legislative tool. 5 in particular, recent analysis has focused on the inherent 1 see staff of joint committee on taxation, list of expiring tax provisions 2013-2024 (jan. 10, 2014), available at https://www.jct.gov/publications.html?func=startdown&id=4540. on december 3, 2014 the house of representatives passed a bill to renew the tax extenders that expired at the end of 2013 until the end of 2014, when they once again will expire. tax increase prevention act of 2014 h.r. 5771. even if approved by the senate, the bill only represents a one-year deal, and congress will have to revisit these same extenders again in 2015. 2 molly f. sherlock, cong. research serv., tax provisions expiring in 2013 (“tax extenders”), table 1 (2013), available at http://www.fas.org/sgp/crs/misc/r43124.pdf (estimating the cost of extending all of the expired provisions to 2014 at $54.2 billion and the cost of extending these same provisions throughout the entire 2014-2023 period at $938.3 billion). 3 rebecca m. kysar, lasting legislation, 159 u. pa. l. rev. 1007, 1011 (2011); william gale and peter orszag, sunsets in the tax code, tax notes at 115 (june 9, 2003), available at http://www.brookings.edu/~/media/research/files/articles/2003/6/09useconomics%20gale/20030609.pdf (noting “[s]unsets are now a de facto element of fiscal policy”). 4 testimony before the subcommittee on select revenue measures of the committee on ways and means, 112th cong. 3-4 (june 8, 2012) (statement of donald b. marron), available at http://www.taxpolicycenter.org/uploadedpdf/1001620-tax-expirers.pdf. 5 see, e.g., kysar, supra note 3 at 1008 (arguing against a presumption for temporary legislation); rebecca m. kysar, the sun also rises: the political economy of sunset provisions in the tax code, 40 ga. l. rev. 335, 339 (2006) (arguing that sunset provisions do not function as “good government” tools); jacob e. gersen, temporary legislation, 74 u. chi. l. rev. 247, 298 (2007) (arguing “there should be a presumptive preference in favor of temporary legislation”); george k. yin, temporary-effect legislation, political accountability, and fiscal restraint, 84 n.y.u. l. rev. 174, 187-94 (2009) (proposing presumption in favor of temporary effect legislation). 4 columbia journal of tax law [vol.6:1 virtues and vices of temporary tax provisions versus their permanent counterparts. 6 most notably, george yin argues that the “enactment of temporary-effect rather than permanent legislation would promote political accountability and may result in greater fiscal restraint.” 7 in contrast, rebecca kysar believes “‘pro-temporary legislation’ scholars understate the costs of such legislation because temporary legislation increases rents from interest groups, entrenches current majoritarian preferences, and produces planning conundrums for public and private actors alike.” 8 she therefore recommends a “policy presumption against temporary legislation.” 9 neither of these diametrically opposed views, however, fully addresses the limitations and faults of our modern day legislative budget process. while there are certainly merits and drawbacks to either type of legislation, in this article i argue that simply focusing the analysis on the preferable length of the tax legislation is insufficient. i believe that a more complete analysis can be achieved by alternatively focusing on determining what types of budget constraints, if any, can best achieve the goals of responsible legislation. in particular, this article proposes budget reforms and explores how these reforms could affect the goals of fiscal restraint, transparency, adaptability, and resistance to capture by private interests, independent of the length of the legislation being used. in order to assess the potential impact that budgetary process constraints could have on the challenges presently plaguing the tax legislative process, this article proposes three primary budgetary framework rules. in particular, i argue that when tax expenditures are scored for budget purposes, they should be presumed to be in effect for the entire applicable budget window, even if they are set to expire prior to the end of the window. this is consistent with what is currently required with respect to mandatory spending programs. 10 moreover, if this presumption is overcome and a temporary tax provision in fact is treated as such, there should be adopted a lock-step pay-as-you-go (paygo) rule which only allows qualifying offsets to be made from revenues generated during the term of the temporary legislation and not from the entire budget window period. lastly, i propose that there should be a baseline review of all permanently enacted legislation at the end of the initial ten-year budget window. if after review the originally projected cost for the succeeding five-year period were more than a specified threshold less than the new projected costs over the same period, then congress would have to find new revenue offsets for the legislation or risk sequestration. i believe that if implemented, these proposed rules could have significant consequences on the tax legislative process and help set the stage for more responsible tax legislation. specifically, these rules would yield a more nuanced use of temporary 6 edward kleinbard has addressed a related, but different, issue with tax expenditure legislation— the preference of tax expenditure legislation versus direct spending measures caused by defects in the current budget framework process which make tax expenditures less salient to the public. tax expenditure framework legislation, usc center in law, economics and organization research paper no. c10-1 (april 6, 2010), available at http://ssrn.com/abstract=1531945. 7 yin, supra note 5, at 253. 8 kysar, supra note 3, at 1008. 9 id. 10 the congressional budget office (cbo) currently follows guidelines in the now-expired provisions of the balanced budget and emergency deficit control act of 1985 and the congressional budget and impoundment control act of 1974, which ignore sunset provisions for any legislation with annual costs in excess of $50 million. cbo, the budget and economic outlook: fiscal years 2014 to 2024, at 14 (2014), available at http://www.cbo.gov/sites/default/files/cbofiles/attachments/45010-outlook2014_feb.pdf. 2014] breaking the spell of tax budget magic 5 legislation that would maximize its benefits while limiting situations where it is more commonly abused. these rules would impose more fiscal discipline on lawmakers while preserving the ability to tailor the term of legislation to specific situations—leaving in place lawmakers’ current ability to capitalize on benefits of both shortand long-term tax legislation where appropriate. these rules would also increase fiscal transparency as to the true cost of legislation and prohibit the manipulation of estimates achieved by phaseouts and other budget window manipulations. lastly, they would work to diminish, at least relative to the current system, the ability of politicians to extract rents from special interest groups. part ii of this article discusses the current budget process for federal tax expenditures, and in particular explores how the current rules have helped spur the rise of the use of temporary tax legislation. part iii outlines the important pros and cons of both temporary and permanent tax expenditure legislation, including their effects on budget estimations and transparency, rent extraction, and legislative stability and flexibility. part iv outlines three proposed changes to the current budgetary process. it also describes both the advantageous consequences and potential criticisms of the proposals. part v concludes. ii. behind the veil: the current budget process for tax expenditures a. tax expenditures and tax extenders the congressional budget and impoundment control act of 1974 (budget act) defines tax expenditures as “revenue losses attributable to provisions of the federal tax laws which allow a special exclusion, exemption, or deduction from gross income or which provide a special credit, a preferential rate of tax, or a deferral of tax liability.” 11 thus, tax expenditures include any targeted tax provision that provides benefits to a particular subset of taxpayers. 12 these expenditures are indistinguishable from direct expenditures in many respects and are often used in lieu of direct mandatory and discretionary spending programs. 13 for example, if congress wanted to encourage the proliferation of smartphone devices, it could enact a special tax deduction or credit for purchasers of smartphones. likewise, it could directly subsidize the manufacturers or distributors of smartphone devices. in either instance, federal dollars are being used to try to achieve a certain policy goal. the only difference is that one proposal uses the tax system and the other does not. the use of tax expenditures as a legislative tool has grown dramatically over the past two decades. 14 their use, however, is not always a result of a deliberate determination that the tax system is the best method to deliver government interventions. when tax laws are intended to generate immediate impacts in response to emergency 11 congressional budget and impoundment control act of 1974, 2 u.s.c §622(3) (1974). the concept of tax expenditures was popularized by stanley surrey, former assistant secretary of the treasury, in his book pathways to tax reform: the concept of tax expenditures (harvard university press, 1973). 12 staff of joint committee on taxation, estimates of federal tax expenditures for fiscal years 2012-2017 (2013), available at https://www.jct.gov/publications.html?func=startdown&id=4504. 13 thomas l. hungerford, cong. research serv., tax expenditures and the federal budget, at 2 (2011), available at http://www.fas.org/sgp/crs/misc/rl34622.pdf; eric j. toder, tax cuts or spending – does it make a difference?, 53 nat’l tax journal 1, 361 (sept. 2000). 14 u.s. gov’t accountability office, key issues: tax expenditures, available at http://www.gao.gov/key_issues/tax_expenditures/issue_summary#t=0. 6 columbia journal of tax law [vol.6:1 situations, such as the housing mortgage crisis, the use of the tax system to deploy government funds can be an efficient vehicle for intervention because an infrastructure is already in place to quickly administer the program. for example, emergency tax legislation was adopted in response to hurricane katrina, to, among other things, provide extended carryback rules of certain losses incurred, provide additional exemptions for individuals housing displaced persons, and giving businesses tax credits for providing inkind housing to displaced employees. 15 in other instances, however, tax expenditures are used when it is not evident there is any advantage in doing so. 16 as shown in chart a below, in terms of relative magnitude, tax expenditures now account for nearly $1.3 trillion in federal spending each year, comprising about one quarter of total federal expenditures. tax expenditure spending now exceeds national spending on social security, medicare and medicaid, and discretionary defense spending. chart a 17 the increased use of tax expenditures, generally, can in part be tied specifically to the increased use of tax extenders. the term “tax extenders” refers to the subset of tax expenditure provisions that are passed for short-term periods (typically one or two years), but nevertheless are routinely extended upon their expiration. in 2013, there were over ninety such provisions on the books with over fifty of them expiring on december 31, 2013. 18 to date, none of these provisions has been extended, although it is anticipated 15 the katrina emergency tax relief act of 2005, pub. l. no. 109-73 (2005); the gulf opportunity zone act of 2005, pub. l. no. 109-135 (2005). 16 kleinbard, supra note 6, at 2 (“by excluding tax expenditures from the reach of most budget framework processes, congress privileges tax expenditures over explicit spending… tax expenditures in fact have become the preferred vehicle for delivering new spending programs — even appropriation-equivalent programs — in cases where the tax system offers no particular advantage as the delivery mechanism.”). 17 staff of joint committee on taxation, estimates of federal tax expenditures for fiscal years 2014-2018 (aug. 5, 2014), available at https://www.jct.gov/publications.html?func=download&id=4663&chk=4663&no_html=1; hungerford, supra note 13. 18 staff of joint committee on taxation, supra note 1. 2014] breaking the spell of tax budget magic 7 that nearly all of them will be extended retroactively in some form (which is why they are also more aptly termed by some as the “tax expirers”). 19 together, these tax extenders accounted for almost $50 billion of tax expenditures for the fiscal 2013 budget year. 20 the quintessential tax extender is the research and experimentation (r&d) credit. 21 although the r&d credit expired on december 31, 2013 and thus is currently technically in legislative limbo, to-date its renewal has been all but automatic. in fact, it has already been extended fifteen times since 1981. 22 why then has this provision not been permanently enacted? why does congress go through the process of passing new r&d credit legislation every year or two when there seems to be a pervasive political consensus over the past thirty years in favor of granting the credit? the simple answer is that the existing legislative budgeting construct makes it advantageous to do so. as more fully described below, when new legislation is introduced, its revenue effects must be scored by the congressional budget office (cbo) and joint committee on taxation (jct)—generally for fiveand ten-year budget window periods. 23 the cost of the proposed legislation is equal to the difference between the total expected government revenues without the legislation enacted (the “baseline”) and the total expected government revenues with the legislation enacted. 24 this so-called “scoring” of legislation is intended to give legislators an estimate of the expected fiscal impact the proposed legislation will have on the federal budget. with respect to tax expenditures, when permanent legislation is proposed, the scoring (rightfully) assumes that the legislation will be in effect for the entire budget window period. thus, the estimated annual cost of the enacted legislation is included in the scoring for each year of the applicable budget window. on the other hand, if a temporary provision is proposed, the scoring assumes that the provision will only remain in effect until its expiration date, even if it has (as in the case of the r&d credit for instance) been routinely renewed. thus, the scoring of the provision will only include the estimated costs of the legislation for those years during the budget window for which the proposed legislation is scheduled to be in effect. so, for example, if a temporary twoyear tax expenditure is proposed, the scoring will only include costs associated with the provision for that two-year period. this budget rule for temporary tax expenditures is in direct contrast to how mandatory spending programs are scored. if any proposed mandatory spending program contains a provision that has annual costs in excess of $50 million, it is treated as remaining in effect throughout the entire budget window period, even if the enabling 19 in fact, on april 3, 2014 the senate finance committee approved a bill to extend almost all of the expired tax provisions for two years at a projected cost of $85 billion. expiring provisions improvement reform and efficiency (expire) act (2014), available at http://www.finance.senate.gov/newsroom/chairman/release/?id=43dc8d45-2748-4b19-820d-20f6c0be506d. 20 center on budget and policy priorities, paying for “tax extenders” would shrink projected increase in debt ratio by one-third, (dec. 9, 2013), available at http://www.cbpp.org/cms/?fa=view&id=4058. 21 also referred to by some as the “r&e” credit. 22 u.s. senate committee on finance, business investment and innovation, at 3 (april 11, 2013), available at http://www.finance.senate.gov/imo/media/doc/04112013%20business%20investment%20and%20innovation 3.pdf. 23 see h.r. res. 5, 111th cong. §2(j) (2009); s. con. res. 21, 110th cong. §201(a) (2007). 24 id. 8 columbia journal of tax law [vol.6:1 statute expires prior to the end of the budget window. 25 as a result, from a scoring perspective, there is no up-front advantage to enacting a temporary mandatory spending provision, because all non-de minimis legislation is assumed to endure even if by its terms it is scheduled to sunset. 26 the different scoring procedures for these two approaches can produce drastically different results. for example, the typical two-year extension of the r&d tax credit is estimated to result in federal outlays of $15 billion. 27 on the other hand, if the r&d credit were to either be made permanent or if it were to be scored as permanent (like a mandatory program would be), its ten-year cost would total nearly $100 billion. 28 thus, when lawmakers are trying to comply with paygo principles and enact revenue neutral legislation, a two-year r&d credit will only need to be offset with new spending cuts or revenue sources totaling $15 billion rather than $100 billion. this scoring advantage that tax expenditures are afforded in the budget legislative process, combined with other procedural advantages discussed below, have spurred the increased use of temporary tax provisions as a legislative tool. b. budget rules in order to give a more complete picture of the budgetary backdrop that governs this process, i will first briefly discuss the basic practices governing the budget process. i will then talk about specific budgetary rules that impact the enactment of tax expenditures by creating biases for temporary provisions, such as the paygo and byrd rules. 1. overview every year congress funds discretionary spending programs through the annual appropriations process. 29 these programs include national defense, homeland security, transportation, agriculture, education, and general government operations. 30 certain rules and procedures govern the consideration of appropriations measures, which are under the jurisdiction of the house and senate appropriations committees. 31 the majority of direct spending programs are funneled through this annual process, whereby congress reviews and approves the amount of spending for these programs for the upcoming year. 32 how much, if any, funding is available for a particular program during a fiscal year typically is dependent on how much funding it receives in the appropriations process. in contrast, mandatory spending programs (also known as entitlement programs) are not subject to this annual appropriations review. rather, funding is open-ended with the amounts paid out being a function of the number of eligible claimants and the amount each claimant is entitled to receive under the specific program. 33 once created, these 25 see cong. budget office, supra note 10. 26 as discussed more fully below in part iv.a.1, there is an exception to statutory paygo for emergency legislation. 27 the committee for a responsible fed. budget, the tax breakdown: tax extenders (mar. 26, 2014), available at http://crfb.org/blogs/tax-break-down-tax-extenders. 28 id. 29 sandy streeter, cong. research serv., the congressional appropriations process: an introduction, 4 (2007), available at http://www.senate.gov/reference/resources/pdf/97-684.pdf. occasionally appropriations will cover a multi-year period. 30 id. 31 id. 32 id. 33 id. 2014] breaking the spell of tax budget magic 9 programs generally are entitled to spend whatever funds are required under their statutory terms and no additional spending authorization is needed from congress. examples include social security, food stamps, federal retirement programs, medicare, and medicaid. 34 these provisions are typically enacted on a permanent basis (i.e. there is no definitive end date for the provision expressly provided in the statute and the program will continue unless action is taken to repeal the existing law). government spending is also achieved through a third mechanism, which does not fall squarely into either category: tax expenditures. these may be enacted on a permanent or temporary basis, and, although subject to approval by the congressional tax committees, are not subject to the annual appropriations process governing discretionary spending programs. 35 similar to entitlement programs, the funding for tax expenditures is generally open-ended with amounts paid out being a function of the number of eligible taxpayers entitled to receive particular tax benefits and the dollar value of the actual benefits. each year, the jct is required to furnish to the house committee on ways and means and the senate committee on finance a tax expenditure budget containing estimates of tax expenditures over the following five-year period. 36 these estimates are prepared in conjunction with the staff of the office of tax analysis (ota) in the department of the treasury. 37 although technically an official part of the budget process, the tax expenditure budget is solely informational and does not provide any constraints or directives with respect to congressional spending. 38 funding for any particular tax expenditure program continues automatically unless legislative action is taken to modify or repeal the underlying statutory provision. as a result, congressional attention and focus on the budgetary impact of a given tax expenditure primarily occurs only upon the provision’s initial enactment. although select temporary tax provisions have been regularly in use since the 1970s, it was not until the economic growth and tax relief reconciliation act of 2001 (egtrra) when acts of tax legislation were passed that sunsetted in their entirety. 39 until 2001, most proposed tax expenditures were permanent and were therefore treated the same as other types of mandatory spending programs for budget scoring purposes. 40 from the outset, the scoring of these permanent tax expenditures included their costs throughout the full ten-year budget window. since egtrra, however, the use of temporary tax provisions has greatly increased. this increase can be directly attributable to the advantageous budget manipulations that are possible with temporary tax expenditure items. 41 by enacting temporary rather than permanent tax legislation, 34 hungerford, supra note 13, at 2 (“in some instances, such as for the medicaid program, funding is provided in the annual appropriations acts, but the appropriations committees do not effectively control it.”). 35 yin, supra note 5, at 183-4. 36 the budget act requires cbo and the department of the treasury to annually publish detailed lists of tax expenditures. this report is also furnished to the house and senate budget committees. see staff of joint committee on taxation, supra note 17, at 1. 37 id. 38 kleinbard, supra note 6, at 2 (“by excluding tax expenditures from the reach of most budget framework processes, congress privileges tax expenditures over explicit spending.”). 39 all provisions in egtrra had an expiration date of december 31, 2010. economic growth and tax relief reconciliation act of 2001, pub. l. no. 107-16, §901(a), 115 stat. 38, 150 (2001). 40 yin, supra note 5, at 183-4. 41 kysar, supra note 5, at 340. 10 columbia journal of tax law [vol.6:1 lawmakers are able to manipulate budget windows and scoring calculations to capitalize on peculiarities in the procedural budget rules, such as the paygo and byrd rules. 2. paygo paygo rules generally require that the estimated budget effects of any new or augmented mandatory spending or tax expenditures be “paid for” with offsetting revenue increases or spending cuts. 42 thus, the paygo rules are intended to impose fiscal restraint on lawmakers by requiring that new spending or revenue reducing legislation be made at least revenue-neutral. persistent concerns about the vast federal budget deficit have only heightened congressional and public pressure to enact revenue-neutral or revenue-increasing legislation. the paygo rules do not apply to discretionary spending, which is controlled and limited by the amount of appropriations made available in the annual budget resolution. 43 however, paygo principles are applied to both mandatory spending and tax expenditure proposals. the paygo rules were first imposed through the budget enforcement act of 1990, and extended in 1993 and 1999 until they ultimately expired in 2002. 44 in 2010, the statutory pay-as-you-go act 45 was passed by congress and signed into law by president obama, making paygo once again mandatory. under the current paygo statute, if legislation is passed that is projected to increase the deficit for either the following fiveor ten-year budget window period, then automatic across-the-board cuts in selected mandatory programs (sequestration) is triggered. 46 although on its face the paygo statute is supposed to apply to tax expenditures and mandatory spending rules with equal force, in practice it does not. the scoring mechanisms and statutory exceptions significantly compromised the paygo statute’s ability to damper tax expenditure legislation. they specifically excluded many of the tax extender provisions by incorporating into the budget baseline trillions of dollars in tax expenditures, including many of the egtrra and the jobs and growth tax relief reconciliation act of 2003 (jgtrra) tax cuts, as well as the costs of extending alternative-minimum-tax (amt) relief and permanently reenacting the estate-tax exemption at 2009 levels. 47 as a result, only new tax expenditures proposed in excess of these baseline amounts will result in deficit increasing budget scoring that requires revenue offsets to avoid sequestration. the house of representatives and senate also each have their own internal set of paygo rules. under both sets of internal rules, proposed legislation must be revenueneutral over both a fiveand ten-year budget window. 48 these internal rules have no force of law and can be waived (for example, the rules were waived in order to pass the 2007 and 2008 amt relief for individuals), 49 but do provide a procedure for objecting 42 office of budget management (omb), the statutory pay-as-you-go act of 2010: a description, available at http://www.whitehouse.gov/omb/paygo_description/. 43 id. 44 omnibus budget reconciliation act of 1990, pub. l. no. 101-508, 104 stat. 1388 (1990); omnibus budget reconciliation act of 1993, pub. l. no. 103-66, 107 stat. 312 (1993); balanced budget act of 1997, pub. l. no. 105–33, 111 stat. 251 (1997). 45 statutory pay as you go act of 2010, p.l. 111-39, 124 stat. 8 (2010). 46 specified exemptions from sequestration include social security, most unemployment benefits, veterans’ benefits, interest on the debt, medicaid, food stamps, and federal retirement. omb, supra note 42. 47 accordingly, when many of these tax cuts and the amt patch were made permanent, no new offsets were needed because their projected costs were already included in the baseline. 48 kleinbard, supra note 6, at 16. 49 id. at 19. 2014] breaking the spell of tax budget magic 11 congress members to raise points of order against their colleagues when the paygo rules have been violated. 50 the house of representatives and senate each have internal procedural rules for waiving the point of order. while the senate requires a three-fifths vote of all members (i.e. sixty votes), the house of representatives only requires a simple majority of the rules committee. 51 if the point of order is sustained, it will serve to strike the paygo violating proposal from the bill. 52 as discussed more fully below in part iii.a, the paygo rules are easily subject to manipulation through the use of temporary tax expenditure provisions. unlike mandatory spending programs, temporary tax expenditure provisions are only scored as having revenue effects associated with the provision being enacted throughout its proposed duration rather than throughout the entire budget window period. thus, if tax expenditure legislation is only enacted for a oneor two-year period, it will require far fewer offsets to satisfy paygo than if it were permanently enacted. for example, a twoyear extension of the r&d credit may be scored as costing $15 billion (its two-year estimated cost), rather than $100 billion (its projected cost over the full ten-year budget window). in order to comply with paygo, legislators need only identify $15 billion of revenue sources in order for the proposed two-year bill to move forward. 3. reconciliation and the byrd rule the budget act was enacted to establish the congressional budget process. 53 it established the senate and house budget committees as well as the congressional budget office (cbo). 54 the budget act provides for the annual adoption of a concurrent budget resolution, which may include reconciliation instructions directing one or more committees to propose changes to existing laws in order to conform federal spending, revenue and debt targets to the budget resolution. 55 the budget act created a fast-track process for these so-called reconciliation bills, which propose the changes in law pursuant to the reconciliation instructions. 56 the expedited process restricts the time limits for debate and thereby removes the threat of filibuster, an obstructive parliamentary practice whereby members opposed to the proposed bill can extend debate in order to delay or prevent a vote entirely. 57 in order for a proposed bill to receive the benefit of the reconciliation process and avoid filibuster, congress must pass a budget resolution for each budget category setting forth limitations on spending (a “section 302 spending allocation”), and any provision that exceeds the allocation must be coupled with a revenue-raising provision. 58 house and senate points of order enforce this procedural reconciliation rule. 59 as originally conceived, the reconciliation process was intended to provide a way to expedite spending and revenue bills in order to bring down the deficit. 60 however, 50 id. 51 u.s. senate committee on the budget, budget points of order (2014), http://www.budget.senate.gov/republican/public/index.cfm/points-of-order. 52 id. 53 budget act, supra note 11. 54 id. at §§ 101-102 and 201. 55 bill heniff, jr., cong. research serv., the congressional budget process timetable, 2 (2008), available at http://www.senate.gov/reference/resources/pdf/98-472.pdf. 56 budget act, supra note 11, at §§ 310(c). 57 debate time is limited to 20 hours in both the senate and house of representatives. 58 kysar, supra note 3, at 1020. 59 budget act, supra note 11, at §§ 310(c). 60 kysar, supra note 3, at 1019. 12 columbia journal of tax law [vol.6:1 because by its terms the 1974 budget act merely references only “changes” to spending and revenue amounts and not specifically to decreases or increases in such amounts, savvy congressional members realized that the reconciliation process could be used to fast-track deficit-increasing legislation. 61 in fact, in 2001 congress passed egtraa through the reconciliation process with estimated costs of over $1 trillion, sidestepping any chance of filibuster. 62 the byrd rule, named after senator robert byrd, was introduced in 1985 as an additional internal rule in the senate intended to prevent senators from attaching unrelated bills to the reconciliation bill. 63 the byrd rule establishes a point of order against such extraneous provisions. importantly, one of the categories of unrelated provisions that cannot be attached to reconciliation bills are any provisions that decrease revenues beyond the applicable window of the budget resolution. 64 if the presiding officer sustains the point of order, the offending provision is struck from the bill, but the rest of the legislation remains. 65 tax expenditure provisions that are temporary in nature are advantageous in the reconciliation process in two ways. first, temporary tax expenditures are more likely to make it into the reconciliation process because their lower estimated costs make it easier to satisfy the section 302 budget allocation limits. because temporary tax provisions are scored by giving effect only for their statutory enactment periods, their scored costs will be lower than an otherwise similar permanent piece of tax legislation or a temporary mandatory spending provision. moreover, any legislation that exceeds the allocation must be coupled with a revenue-raising provision, so the lower the scored cost of a proposed expenditure, the fewer offsetting revenue-raising provisions will be needed to offset it. second, because the byrd rule will be triggered if a bill results in budget outlays beyond the budget window of the resolution, sunset provisions can be used on tax expenditures to prevent invocation of the byrd rule. if a tax expenditure is proposed as permanent legislation, it will have projected costs beyond the applicable budget window and can be struck from the reconciliation bill by raising a point of order. however, no matter how high the anticipated cost of a tax expenditure bill, as long as it does not generate costs beyond the budget window, it will not be subject to the byrd rule. for this reason, the entire egtraa was sunsetted before the end of the reconciliation budget 61 robert dove, former u.s. senate parliamentarian 1981-1987, c-span, use of senate filibuster (mar. 12, 2010), available at http://www.c-span.org/video/?292506-1/use-senate-filibuster (00:50-00:53). 62 kysar, supra note 3, at 1020 (“although the original intent of the reconciliation process was to provide an easier path to enact deficit-reducing legislation, in 2001, republicans won a procedural battle by passing one of the largest tax cuts in history, egtrra, through the reconciliation process in order to avoid a filibuster.”); see also gale and orszag, supra note 3, at 1154 (noting that the byrd rule itself did not necessitate the sunset provisions, rather the lack of support from 60 senators required to waive the rule necessitated the sunset). 63 robert keith, cong. research serv., the budget reconciliation process: the senate’s “byrd rule” (2010), available at http://democrats.budget.house.gov/sites/democrats.budget.house.gov/files/documents/reconciliation.pdf; cheryl d. block, pathologies at the intersection of the budget and tax legislative process, 43 b.c. l. rev. 863, 874 (2002). 64 id. 65 budget points of order, supra note 51. provisions that are removed from reconciliation legislation as a result of a byrd rule objection are sometimes referred to as “byrd droppings.” yin, supra note 5, at 215. 2014] breaking the spell of tax budget magic 13 window in order to avoid invocation of the byrd rule. 66 since egtraa, numerous tax provisions have been passed as temporary legislation and been able to sidestep application of the byrd rule. 67 4. senate point of order the senate more recently enacted another point of order (spo), aimed at budget distortions that can occur when proposed legislation is expected to have revenue effects outside of the original budget window period. when permanent spending legislation is enacted, revenue neutrality only has to be achieved for the relevant fiveand ten-year window periods in order to avoid invocation of the paygo rules. however, many provisions have enormous budgetary consequences beyond the first ten years of enactment. under the current budget rules, there is no mechanism requiring a reevaluation or re-neutralization of existing spending provisions whose costs greatly exceed projected offsetting revenue sources. the spo tries to manage deliberate attempts by lawmakers to escape the reach of paygo rules by back loading the revenue outlays of proposed legislation to periods beyond the budget window. under the spo, senators can raise an objection and block consideration of legislation that is projected to result in net outlays in excess of $5 billion in any one of the four successive ten-year periods beginning after the initial ten-year budget window. 68 again, at least three-fifths (or sixty) votes are necessary to waive the point of order. 69 while the spo may provide a deterrent for passing legislation with significant projected costs beyond the budget window, it has little to no effect on temporary tax legislation. in fact, it provides an incentive for lawmakers to make tax expenditures temporary. if temporary tax legislation is proposed, the costs will be front loaded in the budget window and will have no projected effect beyond the initial ten-year budget window period. they will thus be able to escape the reaches of the spo. iii. the black and white magic of temporary tax expenditures as suggested above, temporary tax expenditures are prized gems of lawmakers for a number of reasons. first, they are easier to manipulate for budget scoring purposes. they can escape the reaches of any applicable paygo rules by requiring fewer offsets to achieve revenue-neutrality, as well as sidestep the byrd rule and spo. second, when tax expenditures are enacted as temporary provisions, there are more opportunities for lawmakers to extract rents from private parties that are eager to ensure the renewal of their favored tax break. third, tax expenditures also enjoy a certain political opaqueness that can enhance opportunities for political maneuvering and make it easier to target benefits towards private interests. 70 targeted benefits to select industries or taxpayers 66 kysar, supra note 3, at 1021; rudolph g. penner, urban institute and brookings institution tax policy, taxes and the budget: what are extenders? briefing book (feb. 15, 2008), available at http://www.taxpolicycenter.org/briefing-book/background/taxes-budget/extenders.cfm. 67 see, e.g., jobs and growth tax relief reconciliation act of 2003 (jgtraa), pub. l. no. 108-27, §§107, 303, 117 stat. 752, 755-56, 764 (most provisions were set to expire between 2004 and 2009). 68 budget points of order, supra note 51, at 2. 69 id. at 1. but see yin, supra note 5, at 224 (“it seems doubtful that estimates of the long-term budget effects of proposals increasing and decreasing the deficit can be made with sufficient precision to carry out the point of order.”). 70 kleinbard, supra note 6, at 5 (“existing tax expenditures hide in plain sight, appearing in the operative budget resolution only as an undifferentiated component of baseline revenues. the low salience of 14 columbia journal of tax law [vol.6:1 that are buried in the internal revenue code are much less transparent to the general public and when passed often receive less congressional scrutiny than targeted mandatory spending provisions. 71 moreover, some politicians may prefer the use of expiring tax provisions because they are able to essentially consent to a tax increase by taking no affirmative legislative action on an expiring tax extender. 72 lastly, temporary tax provisions can, in theory, provide more opportunity for legislative review and refinement. if a statute expires and is up for renewal, legislators have an opportunity (whether or not utilized) to assess the effectiveness of the rule and adjust, amend or discontinue the provision to the extent it is not fulfilling its original objectives. 73 while there may be certain political and legislative advantages to temporary tax legislation, there are countervailing costs. fiscal accountability and legislative stability can be significantly compromised as a result of the budget manipulations. enacting temporary legislation may obscure the true long-term costs to legislators of provisions that in substance are intended to remain permanent (for example the r&d credit), as well as result in deeper current tax cuts than may otherwise be made. moreover, if a tax provision is intended to affect taxpayer behavior but its legislative fate is constantly in limbo, as is the case for the current fifty plus expired tax extenders, taxpayers may over or under-respond to the provision. in addition, while decreased transparency may be beneficial from the perspective of politicians, it also makes it harder for the public to monitor and hold accountable political actors. as a result, the voting public may not be fully aware of the decisions being made by their elected officials. a. budget manipulation the current legislative budget rules, described in part ii.b above, are subject to two primary forms of manipulation by lawmakers. first, by using temporary tax legislation, lawmakers are able to limit the estimated costs of a proposed bill for scoring purposes. this makes it much easier to find necessary offsets to achieve revenue-neutral legislation in accordance with the paygo rules. it also makes it much easier for a proposed tax expenditure to take advantage of the reconciliation process and avoid invocation of the byrd rule. second, because paygo constraints are only confined to a finite time horizon (typically a fiveor tenyear budget window), permanent legislation that has substantial back loaded costs is able to seemingly satisfy revenue-neutrality upon enactment, even if over time it results in significant deficit increases. the byrd rule is only applicable to legislation proposed as part of a reconciliation bill. 74 the spo tries to tax expenditures, when compared with the spending programs for which they substitute, affects not only public perceptions but also congressional consideration.”). 71 see generally, id. at 6-7. 72 rather, they will just let the beneficial tax provision die, in substance causing an increase in tax revenues. howard gleckman, can expiring tax provisions save the budget talks? forbes (nov. 8, 2013), available at http://www.forbes.com/sites/beltway/2013/11/08/can-expiring-tax-provisions-save-the-budgettalks/. 73 in fact, some commentators argue that sunsets should be used as a way to prevent obsolete laws from remaining on the books. thomas merrill, the federalist society 2011 national lawyers convention, 16 tex. rev. l. & pol. 339, 343 (spring 2012) (citing generally guido calabresi, a common law for the age of statutes (1982); guido calabresi, the nonprimacy of statutes act: a comment, 4 vt. l. rev. 247 (1979); jack davies, a response to statutory obsolescence: the nonprimacy of statutes act, 4 vt. l. rev. 203 (1979)). 74 see keith, supra note 63 and accompanying text. 2014] breaking the spell of tax budget magic 15 address this by requiring revenue neutrality for each of the successive four decades after the initial budget window, 75 but as illustrated below, this rule can also be manipulated. the problem with these budget manipulations is that they enable lawmakers to skew the impact that proposed provisions will have on the overall fiscal health of the nation. 76 as illustrated below, if temporary provisions are enacted that are in fact intended to be permanent in nature, as is the case with most of the tax extenders, then lawmakers are able to both reduce the amount of offsets necessary for revenue neutrality and to push out those lesser offsetting revenues to the latter years of the budget window. not only does this practice systematically understate the full fiscal impact of the underlying tax expenditure, but it also allows legislators to make larger current tax cuts or increase spending in other programs because more current revenue streams are available to offset spending. in a time when fiscal restraint and attention to deficit reduction are touted as top national priorities, lawmaking budget practices that serve to undermine these goals are problematic. 1. front loading with temporary provisions the single largest driver behind the proliferation of temporary tax provisions, or tax extenders, is the ability to reduce the upfront estimated costs of the provisions. 77 unlike the scoring estimates for mandatory spending provisions, which ignore sunset provisions for spending programs with current-year costs of greater than $50 million, 78 the scoring estimates for tax expenditures treat a provision as becoming inactive on the sunset date. 79 this is true whether or not a renewal of the tax expenditure is expected at that time. because a tax expenditure is more likely to be passed if it is packaged as revenue neutral, a lower estimated cost over the budget window through the use of an early expiration date provides two advantages, as illustrated in chart b below. it lowers the amount of revenue sources or spending cuts that are needed in order to offset the expected cost. it also provides more offsetting years in the budget window to find those revenue sources and spending cuts. examples of tax extenders in this category include the r&d credit, the subpart f exception for active finance income, and numerous energy incentives. 80 even when lawmakers would like to make these provisions permanent, they find it too expensive to do so. offsetting revenue sources are just not available to make their permanent enactment fiscally or politically viable. in fact, renewing the existing tax extenders for one year will impose an estimated cost of $54 billion. 81 in contrast, if these same extenders are made permanent, they will cost a projected $938 billion over the full tenyear budget window. 82 75 budget points of order, supra note 51, at 2. 76 gale and orszag, supra note 3, at 1554 (“as sunsets have come to dominate the tax code, the official budget projections have become increasingly divorced from reality). 77 marron, supra note 4, at 6. 78 see cong. budget office, supra note 10. 79 marron, supra note 4, at 6. 80 id. at 3-4. 81 sherlock, supra note 2, at 6 (tbl.1). 82 id. 16 columbia journal of tax law [vol.6:1 chart b: budget manipulation using temporary provisions 83 as illustrated in chart b, legislative option a represents a proposed tax expenditure’s estimated cost over a twenty-year fiscal period. under the current legislative rules, option a would be scored as having an official cost of $35 billion over the initial ten-year budget window and would require lawmakers to find $35 billion of additional revenue or spending cut sources in order to make the proposal revenue neutral. if bundled with legislative option d, option a would satisfy the paygo requirements. legislative option b represents the estimated cost of enacting the same tax expenditure, except that the provision expires after two years. under the current budget scoring rules, option b would only have an official cost of $5 billion that would need to be offset, even if it was expected that the same provision would be extended throughout fiscal years three through ten. not only does option b have a lower “official” cost than option a, but lawmakers are able to use ten fiscal years (years 1-10) to generate offsets for only two fiscal years of outlays (years 1-2). if a revenue generating provision was also proposed and was estimated to generate $5 billion during fiscal years 9 and 10, such as option e, it would be unable to fully offset option a because the total official 83 chart b assumes the applicable budget window period covers ten fiscal years. 2014] breaking the spell of tax budget magic 17 revenues generated for the budget window would only be $5 billion in comparison to the official cost of option a of $35 billion. on the other hand, the same revenue provision could be used to offset option b and paygo would be satisfied. moreover, the byrd rule and spo would be satisfied because there would be no scored revenue effects for option b beyond the initial ten-year budget window period. the disparity between opportunities for budget manipulation with option a and b endure even if, as illustrated with option c, the same tax expenditure is continuously extended through a series of temporary provisions. even though each time the tax expenditure is extended it will have to be fully offset with a revenue raising provision, the renewed tax expenditure will gain additional budget window years during which to find offsetting revenues. as a result, revenue neutrality can be significantly more distorted than it can be with an equivalent permanent piece of legislation. for example, if upon the expiration of option b, congress enacts identical legislation with option c, it will be able to use fiscal years 3 through 12 (the then applicable ten-year budget window) to find offsetting revenues. as such, it could use option f to couple with option c in order to make it revenue neutral and satisfy paygo. note none of the revenues for option f accrue during the original ten-year budget window. if the same provision is similarly extended through the end of fiscal year 10 and is in each instance paid for with revenues generated during the last two-years of the then applicable budget window, then by the end of fiscal year 10, a significant gap in revenues will occur. the actual cost of the tax expenditure (assuming the projections are accurate and remain constant) will be identical to those in option a where the legislation is made permanent from the outset. fiscal years one through ten will incur a total cost of $35 billion. however, the only revenue raised during this period would be $5 billion (through option d). this tax expenditure would create a $30 billion budget deficit over the initial ten-year period. by contrast, if instead option a were enacted, it would require at the outset $35 billion of revenue to offset its cost during the initial ten fiscal years and no deficit would be created. it is also worthwhile to note that if legislators pass the $35 billion revenue raiser option d along with option b, which will soak up only $5 billion of revenue offsets, congress will be able to enact an addition $30 billion of spending provisions and still satisfy the current paygo and revenue neutrality principles. this is true even if, as discussed above, the full cost of the tax expenditure contained in option b will be $35 billion if it is continuously reenacted for the full ten-year fiscal period. if option a were instead enacted making the tax expenditure permanent, or if option b were scored the same as option a (which it would be if it were a mandatory spending program), then option d would be fully offset by the tax provision and no additional revenues would be available to offset other spending programs. 2. back loading with permanent provisions another problem with limiting the inclusion of a proposed provision’s budget impact to a finite window is that revenue effects that take place outside the relevant budget window period are ignored. because the baseline assumes permanent legislation will continue forever, once enacted, the cost of permanent legislation beyond the end of the initial budget window essentially disappears from the legislative process. 84 thus, a proposed provision can be scored at the outset as revenue neutral for paygo purposes, 84 yin, supra note 5, at 204. 18 columbia journal of tax law [vol.6:1 even if the purported offsetting provision is not expected to generate any revenues outside of the initial ten-year budget window and the expenditure is projected to continue to generate substantial outlays. likewise, if a permanent tax expenditure becomes much more costly than originally projected (or conversely if projected revenue offsets end up falling short), there is no automatic process to recalibrate that provision’s neutrality and ballooning deficits can result. the spo can help mitigate the issues related to the former problem, but not the latter. if a permanent tax expenditure is paired with a revenue generating provision that is only expected to raise revenues prior to the end of the initial ten-year budget window, the spo may be triggered. the spo can be invoked if other offsetting provisions are not available for the outer years and projected deficits exceed $5 billion in any of the subsequent four ten-year budget windows. 85 if, on the other hand, deficits are incurred because expected projected outlays were too high or inflows were too low, the spo will not be implicated. although the spo’s focus is on the time period outside of the initial budget window, the determination of whether or not the spo is triggered is made at the time the enacting bill is deliberated and no automatic subsequent redeterminations are made. accordingly, if subsequent budget shortfalls do occur as a result of the legislation, congress will on its own have to initiate a completely new bill to either amend or enact legislation that either reduces the outlays generated by the existing tax expenditure provision or raises new offsetting revenues. proponents of tax expenditure legislation can also exploit the use of finite budget windows by either delaying the effective date of the legislation and/or back loading major outlays of the provision until late in the budget window. 86 as illustrated in chart c below, these strategies will decrease the amount of offsets necessary for neutrality. chart c: budget manipulations using permanent provisions 87 as depicted in chart c, option x represents a baseline case of the scoring of a permanently enacted tax expenditure projected to generate $25 billion of costs during 85 budget points of order, supra note 51, at 2. 86 similar manipulation is possible with all permanent spending provisions. 87 chart c assumes the applicable budget window period covers ten fiscal years. 2014] breaking the spell of tax budget magic 19 each ten-year fiscal period. in order to make option x satisfy paygo, lawmakers will have to come up with $25 billion of offsets to cover the official ten-year cost of the provision upon enactment. on the other hand, if the same tax expenditure is enacted, but lawmakers push back the effective date for two years, as in option y, they will only have to find $20 billion of offsets to comply with paygo. this option may be attractive to lawmakers who will be able to take credit for enacting a particular tax cut, while at the same time reducing the amount of revenue offsets they will be required to produce in order to get the bill through congress. note, options x and y will require an equal amount of offsets in fiscal years eleven through twenty in order to avoid invocation of the spo. specifically, they will have to come up with at least $20 billion in revenue sources or spending cuts for fiscal years eleven through twenty in order to avoid triggering the $5 billion spo shortfall threshold. 88 option z, however, avoids this problem. by combing the tactics of legislative back loading (or phase-ins) with a sunset provision, option c both reduces the present offset cost of the proposed tax expenditure and avoids application of the spo. option z’s official cost is $20 billion for the initial ten-year budget period (the same as option y). however, unlike option y, even if no other offsetting revenues are available for fiscal years eleven through twenty, the spo cannot be invoked because the projected deficits in years eleven through twenty do not exceed $5 billion. moreover, the aboveillustrated scoring of option z is only available with respect to a tax provision, because any other type of mandatory spending provision will be scored the same as option y because only the phase-in (and not sunset) will be respected for scoring purposes. 89 b. rent extraction another common complaint with the way tax expenditures, in particular, are treated under the current budget rules is that they create an environment that encourages the extraction of rents by lawmakers. the fact that offsets are required for all tax expenditures creates a fierce competition among special interest groups, each hoping that it is not harmed by any trade offs that must be made for the sake of revenue neutrality. 90 lobbyists for particular industries or interest groups therefore seek to pay rent to lawmakers (in the form of campaign contributions and votes) in order to encourage them to extend or propose special tax breaks or to prevent them from closing beneficial loopholes. because the proposals will need to be revenue neutral, the offsetting spending reductions or revenue increases can come at the expense of a politically inactive minority or a diffuse majority. a diffuse majority may not have an incentive to fight the proposed change because the individual cost to each member is relatively minor. while this type of rent extraction is a problem frequently encountered in politics in general, it is particularly troublesome in the tax expenditure context for several reasons. because of the ever-increasing use of temporary rather then permanent tax legislation, politicians are often able to demand payment at predictably frequent intervals. 91 many favored tax benefits are continually in legislative jeopardy, and even if there is only a small chance that a provision will not be renewed, lobbyists will still pay 88 see budget points of order, supra note 51, at 2. 89 see cong. budget office, supra note 10. 90 kysar, supra note 5, at 365 (“[b]y either requiring offsets to tax expenditures or demanding sequesters, the budget rules create competition between interests in tax benefits and thus guarantee the possibility, although at times remote, of lapse, especially if interest group activity on behalf of the threatened provision ceases.”). 91 id. 20 columbia journal of tax law [vol.6:1 rents for fear that if they are inactive, their benefits may be crowded out by other more motivated interest groups. 92 for example, if businesses rely on the r&d credit and it is only extended in oneor two-year increments, then even though businesses may be relatively certain that the credit will continue to be re-enacted (as it has been fifteen times), they will not be willing to take a chance that non-action will cause the provision to lapse. as such they continue to pay rent. this fear is particularly warranted in the current legislative environment where politicians are increasingly willing to break out of their predictable budget norms. 93 although businesses should be equally concerned about the threat of repeal in the case of permanently enacted legislation, the likelihood of legislative action is much smaller because enough momentum would have to be generated in order to get actionable repeal legislation on the floor to change the status quo. 94 when provisions are automatically set to expire, on the other hand, the legislative fate of a provision is already on the table. affected taxpayers are repeatedly put in economic limbo as they await the determination of their legislative fate. as long as the present value of the threatened benefits from the expiring legislation exceeds the current lobbying costs, rational interest groups will continue to lobby legislators for targeted tax expenditures. 95 the shorter the enactment period for a particular piece of tax legislation, the more frequently the giveand-take rent extraction game can be played between legislators and their affected constituents. c. political opaqueness another issue with tax expenditures of any duration is that they tend to have a less than transparent role in the budget process. 96 they therefore often assist in obscuring legislators’ behavior from the voting public. 97 for example, if a minority-targeted tax provision is pushed through the reconciliation process in a revenue-neutral way, it can be fast-tracked through the legislative process with little to no debate or oversight by the substantive congressional committees. 98 as discussed above, temporary tax provisions are able to capitalize on the reconciliation process more easily because they are scored in 92 but see yin, supra note 5, at 244 (arguing that even if “a credible threat could be made relatively costlessly through, for example, the mere sponsorship of a bill or issuance of a press release, it is not clear why legislators would prefer to threaten temporary, as opposed to permanent, action. the latter would presumably present a more harmful outcome to the interested groups and therefore should generate greater returns to forestall the threatened action.”). 93 for instance, the threat of sequestration, or automatic across-the-board federal spending cuts, at one time seemed so onerous that many predicted congress would never actually let it happen. however, in fiscal 2013 lack of congressional action led to sequestration. 94 manoj viswanathan, sunset provisions in the tax code: a critical evaluation and prescriptions for the future, 2009 fed. b.a. sec. tax’n rep. 14, 21 (“any law enacted by congress has some probability of getting overturned; however, this baseline probability of statute repeal is fairly low.”), citing guido calabresi, a common law for the age of statutes 6 (1982); kysar, supra note 5, at 365 (stating “repeal, unlike a lapse after sunset, requires affirmative action by congress and, thus, endangerment to the status quo is greater in the sunset context”). 95 id. at 367 (“these scenarios are problematic in that they bolster the competitive advantages of an organized minority, thereby increasing the likelihood of a reduction in social welfare due to the greater costs imposed on the poorly organized majority.”). 96 kleinbard, supra note 6, at 5. 97 deborah h. schenk, exploiting the salience bias in designing taxes, 28 yale j. on reg. 253 (2011). 98 kleinbard, supra note 6, at 6-7. 2014] breaking the spell of tax budget magic 21 such a way that makes achieving revenue neutrality and avoiding the byrd rule and spo much easier than it is for their mandatory spending program counterparts. 99 moreover, specialized tax provisions are considered to be less salient (or obvious) to the public than equivalent direct spending measures. 100 it is well established that the internal revenue code is a complex labyrinth of rules that leaves even the most seasoned tax professionals at times scratching their heads. not surprisingly, legislators have found that it is much easier to hide targeted legislation benefiting their favorite interest groups among the morass of existing tax rules than it is to propose a stand-alone traditional spending provision. indeed, it is sometimes impossible to determine from the face of a tax statute what subset of taxpayers are actually affected by its terms and what any impact would be. 101 for instance, the average voter may not understand the economic impact that adjusting the phase-in or phase-out levels of a particular deduction will have or to what extent the double-declining balance depreciation method will favorably impact taxpayers versus the straight-line method. 102 on the other hand, if a law is proposed to give a particular industry group cash subsidies through a mandatory spending program, the economic transfer of money from the fisc to the interested group may be much more transparent to the voting public at large. similarly, the temporary nature of tax provisions can provide a further dimension to obscure politically motivated behavior. for example, fiscal conservatives have been known to favor temporary tax expenditures because when necessary, they are able to consent to tax increases without taking affirmative legislative action for which their constituents may negatively judge them. 103 rather, if a tax expenditure expires, the politician may simply fail to act to renew the provision. this inaction will result in an overall increase in tax revenues, but optically the public perception of the politician would presumably be much more favorable than it would if he or she voted favorably for a bill increasing taxes. the diminished political transparency of tax expenditures can lead to several problems. first, diminished transparency can result in a diminished ability to successfully motivate political opposition at the time of enactment. this can cause even more funds to be funneled to targeted interest groups that are able to effectively capture legislative actors by paying rents. the diffuse majority will be less able to detect, and thus respond, to the passage of special targeted tax provisions. as a result, the organized minority will be able to reap economic gains at the expense of the more disorganized majority. if a targeted tax provision results in an increased economic burden to the average taxpayer that is so small they would not rationally organize to oppose the provision even if they were aware of it, the reduced salience of targeted tax provisions still diminishes the ability of constituents to exercise checks and balances on their elected officials. if legislators are aware that their behavior is not evident to the voting public, they may be 99 see discussion in section iii.a supra. 100 kleinbard, supra note 6, at 6-7; schenk, supra note 97. 101 schenk, supra note 97, at 257. 102 the double-declining balance depreciation method significantly accelerates depreciation deductions as compared to the straight-line depreciation method. 103 gleckman, supra note 72 (“there is no chance that gop lawmakers will accept tax increases, but maybe they would accept revenue by passively conceding the quiet death of scores of temporary tax cuts that are due to expire at the end of this year.”). 22 columbia journal of tax law [vol.6:1 even more likely to act in ways that are contrary to the interests of the majority of their constituents. d. uncertainty and inefficiency the uncertainty in a tax extender’s legal status caused by the persistent use of temporary legislation not only encourages increased political rent seeking, but also creates significant planning and implementation problems for lawmakers and affected taxpayers alike. when the legal status of an extender is unclear, it makes it extremely difficult for affected businesses and individual taxpayers to plan ahead. over fifty tax extenders are sitting in legislative limbo, including the r&d credit, the subpart f exception for active financing, and the deduction for state and local taxes. 104 while it is anticipated that they all will be extended in some form, given the current hostile budget environment, nothing is guaranteed. 105 even if all of the extenders are renewed, congressional staffers have indicated that congress will not act on legislation until the end of the year. 106 when extenders are intended to encourage particular taxpayer behaviors, such as innovation with the r&d credit, their purpose is in large part undermined when the affected constituents are not sure whether or not they will be entitled to the benefits of the provision. 107 for example, one of the tax extenders that expired at the end of 2013 was a provision allowing educators to deduct up to $250 of unreimbursed expenses for books, supplies, and computers used in the classroom. 108 it is not guaranteed that this provision will be retroactively extended to apply to educator expenses incurred in 2014 as well. 109 because the legislation was not renewed prior to the start of the 2014-2015 school year for elementary and secondary education schools, teachers had to prepare for the classes as if the deduction was not available. 110 while there are teachers who may spend the same amount of money on their classroom supplies with or without the deduction, there are certainly those for whom the amount, and/or quality of expenditures they make would change if they knew those expenses were deductible. thus, even if the tax extenders are renewed retroactively, the incentives created by these provisions have been undermined. 111 moreover, retroactivity can lead to significant costs and added compliance complexities with interim financial reporting. 112 when a significant tax credit, such as the 104 see supra note 1. 105 see supra note 19. 106 national council of state housing agencies, camp continuing tax reform discussions as senate prepares to extend expiring tax provisions (2014), available at http://www.ncsha.org/blog/campcontinuing-tax-reform-discussions-senate-prepares-extend-expiring-tax-provisions. 107 see marron, supra note 4, at 2. 108 i.r.c. § 62(a)(2)(d) (effective for taxable years 2002 through 2013). 109 internal revenue service, topic 458 – educator expense deduction (aug. 18, 2014), available at http://www.irs.gov/taxtopics/tc458.html (“the educator expense deduction expired december 31, 2013. you may claim it on your tax year 2013 tax return. under current law, the deduction is not available for tax years after 2013.”). 110 elisabeth hulette, teachers lose deduction for school supplies, the virginian-pilot (jan. 20, 2014), available at http://hamptonroads.com/2014/01/teachers-lose-deduction-school-supplies. (“according to a survey by the national school supply and equipment association, teachers spent $485 of their own money, on average, on supplies during the 2012-13 school year.”). 111 id. 112 joe harpaz, the real cost of the r&d tax credit expiration, forbes (feb. 13, 2014), available at http://www.forbes.com/sites/joeharpaz/2014/02/13/the-real-cost-of-the-rd-tax-credit-expiration/; see also marron, supra note 4, at 2. 2014] breaking the spell of tax budget magic 23 r&d credit, is expected to, but has not yet been, renewed retroactively, tough decisions have to be made. companies have to determine whether to book the credit in their accruals or wait until the legislation is actually renewed, thereby skewing their interim financial results. 113 a study of public companies that rely on the r&d credit revealed that they have less accurate earnings estimates on average by about four cents per share due to the expired credit. 114 there are real financial costs being incurred as a result of the legislative uncertainty being created by the persistent use of temporary tax provisions. e. dynamic lawmaking? although the lack of certainty of an expiring provision may result in certain inefficiencies, one purported advantage of temporary tax provisions is that they can more readily achieve dynamic lawmaking that is both reflective of the current majority preferences and responsive enough to adjust to intervening social and economic changes. 115 their natural termination is supposed to invite re-deliberation of whether or not the provisions, as enacted, are meeting their purported objectives or whether their objectives have been completed. in this way, laws that no longer serve their stated purpose or have any relevance are cleansed from the statutory books. while this account of the advantages of temporary legislation is potentially favorable, unfortunately, tax extenders rarely have been able to achieve any of the benefits that can accrue from their temporary status. first, most of the tax extenders are not passed because of lawmakers’ desires to have temporary versus permanent legislation as such. 116 rather, their temporary status is a byproduct of preferences in the congressional budget rules. 117 when tax extenders expire en masse (such as the fifty plus tax extenders that expired at the end of 2013), none are given due consideration upon renewal. 118 lawmakers are not examining each extender, piece-by-piece, to assess their individual merits. instead, the expired or expiring provisions are typically cobbled together in a single extender bill and not given any significant individual consideration or assessment. 119 113 id. 114 emily chasan, firms may take hit from expired r&d tax credit, wall st. j., jan. 3, 2014 (citing study conducted by jeffrey hoopes, an assistant professor at ohio state university’s fisher college of business). 115 in fact, advocacy for temporary legislation dates back to the founding era. 116 gale and orszag, supra note 3, at 1153 (“in principle, sunsets might be justifiable under certain circumstances. sunsets are appropriate for policies that are designed to be—and should be—temporary. they may also provide flexibility in policymaking, and be useful in focusing policymakers’ attention on fiscal issues. in practice, however, none of these potential justifications appears to be the motivation for the recent dramatic expansion in sunsets.”). 117 id. (“recent sunsets have been motivated by the desire to manipulate budget rules and hide the likely costs of new tax cuts.”); see generally discussion supra part ii.a. 118, testimony before the u.s. senate finance committee, hearing on extenders and tax reform: seeking long-term solutions, 112th cong. at 2 (jan. 31, 2012) (statement of rosanne altshuler) (“[p]olicymakers may impose expiration dates on provisions so that they can periodically evaluate their effectiveness. in this case an expiration date can be seen as a mechanism to force policymakers to consider the cost and benefits of the special tax treatment and possible changes to increase the effectiveness of the policy. this reasoning is compelling in theory, but has been an absolute failure in practice as no real systematic review ever occurs. instead of subjecting each provision to careful analysis of whether its benefits outweigh its costs, the extenders are traditionally considered and passed in their entirety as a package of unrelated temporary tax benefits.”). 119 id. 24 columbia journal of tax law [vol.6:1 moreover, as discussed above in connection with rent seeking, many of the temporary provisions are not reflective of the majority’s present preferences, but rather they are byproducts of deals struck with motivated minority groups. 120 as such, rather than providing a fluid process by which laws are able to responsively change to shifting dynamics affecting the target of the legislation, temporary provisions are more frequently used as avenues for legislators to gain additional rents from a concentrated and motivated minority and to mitigate the effects of the budget rules. iv. breaking the spell with new budget rules as outlined above, the current budget rules create incentives that are driving congressional behavior. by scoring tax expenditures differently than other direct spending programs, they create a preference for using tax law as the vehicle for government intervention, even when it would not otherwise be advantageous to do so. for example, other government agencies may have better knowledge, staff, and resources to fund, influence, and monitor the legislated issue more directly than the irs. moreover, the present tax expenditure budget rules do not adequately enforce fiscal restraint because the rules are easily manipulated to avoid paygo through the use of phase-ins and sunsets. 121 these manipulations can create an artificial preference for using temporary tax legislation to enact government expenditures. as discussed above, the use of temporary legislation itself can lead to other problems such as increasing the opportunities for political rent seeking and introducing undue uncertainty and administrative burdens. 122 i propose that a fundamental problem with tax expenditure lawmaking is not the use of temporary or permanent legislation per se. rather, it is the current framework of budgetary rules that govern the creation of the tax laws. congress has repeatedly demonstrated that it is unable to exercise reasonable discretion and engage in optimal lawmaking practices without the constraints of some type of precommitment device governing their actions. 123 that is, without ex ante rules in place restricting or directing their behavior, they are often unable to resist pressures to act in their own self-interest rather than the interests of their constituents. as such, rather than add to the existing analysis examining which type of rules, temporary or permanent, will cause the least amount of damage under the current budgetary framework, in this article, i explore whether more ideal tax expenditure rulemaking can be achieved by modifying the underlying rules themselves. i propose three budget rules and explore the envisioned consequences that these rules would have on the current budget process. i conclude that if implemented, this bundle of proposed budget process modifications could yield more ideal tax legislation by instilling more fiscal restraint, reducing opportunities for rent seeking, achieving greater political transparency, and enhancing legislative stability while retaining legislative flexibility. a. proposed budget rules i propose three different modifications to the current budget rules: (i) a presumption for budgetary scoring purposes that tax expenditure legislation will endure throughout the applicable budget window, whether or not the provision is set to expire prior to the end of the window; (ii) if this presumption is overcome and the sunset of a tax 120 see discussion supra part iii.b. 121 see discussion supra part iii.a. 122 see discussions supra part iii.b and d. 123 kysar, supra note 5. 2014] breaking the spell of tax budget magic 25 expenditure is given effect, it will have to comply with a more rigorous lock-step paygo requirement unless it is designated as emergency legislation; and (iii) a mandatory review of all permanent tax expenditures will be required after their initial ten-year period of enactment. in examining the consequences that these proposals could have on congressional lawmaking, i conclude that together these rules could enable lawmakers to make more disciplined deliberations and trade offs when enacting tax expenditure legislation. 1. disregard sunsets for budget scoring purposes in order to weaken the preference for tax expenditure legislation over direct spending in the budget process and to strengthen adherence to paygo principles, i propose that sunset provisions should be disregarded presumptively for purposes of scoring tax expenditures. 124 accordingly, whether or not a proposed piece of tax legislation is set to expire prior to the end of the applicable budget window, it would be scored by assuming the legislation is in effect throughout the entire budget period. currently, the cbo scores both mandatory and tax expenditures in accordance with procedures set up by the now-expired balanced budget and emergency deficit control act of 1985. 125 pursuant to this act, early expiration dates of proposed legislation are ignored for all spending programs with annual costs in excess of $50 million. 126 all other proposals, including tax expenditures, are scored under the presumption that any early expiration provision takes effect, even if the provision has already been repeatedly extended. 127 as illustrated above in chart b, this scoring practice can create a preference for using the tax expenditure model over other forms of direct government intervention. 128 through the use of sunset provisions, lawmakers can significantly decrease the estimated costs of proposed temporary tax legislation, push offsetting revenues to later fiscal years, and free up existing or proposed revenue streams to offset additional spending initiatives or tax cuts. i propose that tax expenditure legislation should be scored under principles similar to their direct spending counterparts. specifically, if any tax expenditure is projected to have costs in any year in excess of $50 million (i.e. more than a relatively de minimis amount), then any sunset provision presumptively will be disregarded and the proposed legislation will be scored as if the legislation is in effect for the entire applicable budget window. for example, in chart b above, this proposed scoring rule would require that legislative option b score as having projected costs for the ten-year budget window of $35 billion, which is identical to option a, the permanent but otherwise equivalent legislation. the projected cost of option b is well above the $50 million threshold, and accordingly the proposed statutory sunset after year two would be disregarded. unlike the current budget system, for paygo purposes there would be no advantage for proposing option b over option a. 124 donald marron has also suggested this revision to current practice. see marron supra note 4, at 2. see also gale and orszag, supra note 3, at 1554 (“cbo treats mandatory spending provisions that expire as though they will be granted a continuance and should do the same for tax provisions.”). 125 cong. budget office, supra note 10. 126 congressional budget and impoundment control act of 1974, 2 u.s.c §622(3) (1974). 127 id. 128 as noted by edward kleinbard, the preference for tax expenditures over mandatory spending programs is also attributable to the lack of attention and oversight tax provisions receive in the budget process as compared to their direct spending program counterparts. kleinbard supra note 6, at 5. 26 columbia journal of tax law [vol.6:1 in some instances, disregarding the sunset date for a proposed tax expenditure may not be warranted because the legislation may be proposed in response to an emergency or may otherwise be in fact inherently temporary in nature. requiring offsets for years during which the proposed legislation is not intended to be in effect would be unduly onerous and likely not reflective of the anticipated costs of the provision. as such, i believe that it should be a rebuttable presumption that sunset provisions are ignored for scoring purposes. however, the presumption should only be overcome if proposed legislation is deemed “emergency legislation” under the existing congressional budget rules 129 or if congress otherwise concludes that the proposed legislation’s purpose and effect is to specifically address a “temporary challenge.” 130 an emergency legislation exemption from the budget rules already exists in congress for purposes of the paygo statute. 131 it provides that if a provision is designated as an emergency under the statutory paygo act, then neither the cbo nor omb can include the projected budgetary effects of the provision in its estimates. 132 as such, no offsetting revenues are required for emergency legislation. for example, emergency provisions directly targeted towards helping victims of natural disasters or acts of terrorism will be exempted from the presumptive rules and excluded from the scoring estimates, assuming congress designated them as such. 133 even if there is not an emergency, congress should be able to obtain an exemption from the mandatory full budget window scoring if they are able to sustain a “temporary challenge” designation supported by cbo estimates. a temporary challenge designation will only be able to be made if the outlays and effects of a targeted piece of legislation are not expected or projected to exceed a certain number of years (e.g. four years). for example, current temporary provisions, such as the provision to allow homeowners to exclude from income the forgiveness of underwater mortgage debt, would have to fall within the temporary challenge designation in order to escape the presumption. in making this determination, the cbo would have to analyze whether the projected outlays and effects of the legislation are of an inherently finite nature to warrant temporary challenge classification. procedural backstops should be put in place to safeguard against any potential abuse or over-use of the temporary challenge designation by congress. for instance, there should be a limit on the number of times and active legislative years a particular provision can be deemed a “temporary challenge.” 134 however, because, as discussed below, temporary challenge legislation is subject to a more rigorous lock-step paygo rule, the ability for lawmakers to engage in budget manipulations will be limited in any event. 129 congress may exempt the budgetary effects of a provision in legislation from certain enforcement procedures by designating the provision as an “emergency” provision. if so designated, the provision’s projected spending and revenue effects are not counted for purposes of enforcing the budget rules. cong. research serv., emergency designation: current budget rules and procedures (jan. 6, 2011), available at http://www.fas.org/sgp/crs/misc/r41564.pdf. 130 marron, supra note 4, at 7. 131 statutory paygo act of 2010, 2 u.s.c. § 933(g) (2010) (providing that any legislation affecting direct spending or revenues designated as an emergency requirement shall not be counted for purposes of projecting the budgetary effects of the legislation). 132 id. at § 933(g)(4). 133 id. at § 933(g). for example, emergency tax expenditure legislation was enacted to help victims of hurricane katrina and 9/11. see supra note 15. 134 for example, a provision should only be eligible to get temporary challenge status up to two times or for up to a total of four consecutive active legislative years. any further proposals would not be able to take advantage of the exclusion and all further sunset dates would be disregarded for scoring purposes. 2014] breaking the spell of tax budget magic 27 on the other hand, current provisions such as the r&d credit and the deduction for state and local taxes would not be excluded from the reaches of the mandatory scoring rule because they would not be proposed in response to an emergency and they would not qualify for temporary challenge status. accordingly, if they were once again proposed through a temporary extension, under the proposed budget rule they would be scored as having revenue impacts for the entire applicable budget window. 2. lock-step paygo if the presumption for full budget window scoring is overcome through the designation of a “temporary challenge,” the temporary tax provision should be scored as such and projected costs should take into account the sunset provision. this will allow temporary challenge legislation to require fewer offsets to achieve revenue neutrality. however, temporary challenge provisions should have to adhere to what i call a “lockstep paygo” requirement. 135 lock-step paygo will only allow qualifying offsets to be made from revenues generated during the term of the temporary legislation and not from the entire budget window period. 136 for example, if a temporary challenge tax expenditure is only proposed to be in effect for two years, lawmakers would have to come up with revenue offsets or spending decreases from that same two year period. if option b in chart b was proposed and was able to secure temporary challenge status, unlike the current budget rules, it could not use option e to offset the expenditures and satisfy lock-step paygo. rather, $5 billion of revenue sources would have to be found from fiscal years one and two. this rule would thereby mitigate the ability of legislators to finance current expenditures with future revenue streams and thus help instill more fiscal restraint. 3. mandatory baseline review lastly, i propose that there should be a baseline review of all permanently enacted legislation at the end of the initial ten-year budget window. if the difference between the original projected costs for the succeeding five-year period is more than some threshold amount (e.g., $2 billion) 137 less than the new projected costs over the same five years, congress will need to find new offsets for the difference or risk sequestration. as mentioned above, the jct provides an annual tax expenditure report to both chambers of congress. 138 this report is currently used for informational purposes only and serves no active role in the budget process. this report contains estimates for tax expenditures projected to exceed $50 million over the immediately ensuing five-year period. importantly, when putting together these projections, the jct takes into account statistics from recent returns. thus, over time these estimates reflect the historical impact that the provision has actually had since its enactment. i believe that this tax expenditure report could serve as the basis for the mandatory review process. 135 i do not believe that emergency legislation should be subject to this requirement. emergency legislation would be exempt from the paygo requirements. 136 see also marron, supra note 4, at 7. 137 the threshold amount would be highly dependent on the level of fiscal restraint congress would want to precommit itself to. the lower the threshold, the more likely it would be that they would have to rebalance the costs of an existing tax expenditure, and vice-a-versa. this number is relatively consistent with the $5 billion spo requirement, which covers a ten-year budget window. 138 see supra, note 36 and accompanying text. 28 columbia journal of tax law [vol.6:1 a weakness of the current budget process is that it only includes, and thus requires offsets for, costs projected to be incurred over a ten-year budget window. additional budget costs incurred after this period are not taken into account because they become folded into the budget baseline. therefore, the true budgetary impact of any proposed permanent legislation is understated to the extent that actual costs exceed projected costs. 139 the spo attempts to get senators to consider projected escalating costs that may occur outside the initial ten-year budget window by requiring projected deficits not to exceed $5 billion over each of the following four ten-year periods. 140 however, to the extent that projected costs are significantly understated relative to actual costs, there currently is no specific mechanism in place to force congress to recalibrate the budget. instituting a mandatory review would prevent existing legislation that has significant underestimated or unforeseen costs from being permanently rolled into the budget baseline. moreover, it would force congress to affirmatively acknowledge the accumulation of escalating deficits. lawmakers would have to act by finding new offsets for the existing provision or be forced to scale back the current level of provided benefits. even if instead congress chose to overturn or waive this budgetary rule, 141 lawmakers would still have to acknowledge the budgetary problem and could not simply continue on with its proverbial head in the budgetary sand. b. consequences of the proposed budget rules if implemented, these budget rules would yield a more nuanced use of temporary legislation that would maximize their benefits while limiting situations where they are more commonly abused. the rules would impose more fiscal discipline on lawmakers while preserving the ability to tailor the term of legislation to specific situations—leaving in place the ability to capitalize on benefits of both shortand long-term tax legislation, where appropriate. these rules would increase fiscal transparency as to the true cost of legislation and prohibit the manipulation of estimates achieved by phase-outs and budget window and baseline manipulations. lastly, they would potentially diminish, at least relative to the current system, the ability of special interest groups to extract rents from politicians. 1. decrease opportunities for budget manipulation and increase fiscal restraint the proposed bundle of budgetary rules should limit the ability of lawmakers to manipulate budget scoring. as discussed above, if sunsets are disregarded for budget scoring purposes, lawmakers would have to fully account and find revenue offsets for the total cost of the proposed tax expenditure over the full ten-year budget window. in chart b, above, assuming that no emergency or temporary effect exception applied, option b, which sunsets after two years, would be scored the same as option a. not only would legislators have to acknowledge the full $35 billion cost of the tax expenditure over the initial ten-year budget window, but they would also have to find $35 billion of revenue offsets in order to satisfy paygo. this is drastically different from the $5 billion of 139 yin, supra note 5, at 193. 140 see supra discussion in part ii.b.4. 141 see infra discussion in part iv.c. 2014] breaking the spell of tax budget magic 29 offsets they would have to find during the initial ten-year budget period if they merely extended option b every two years. 142 even if a tax expenditure were deemed to satisfy the temporary challenge exception, the lock-step paygo requirement would still limit lawmakers’ ability to create significant gaps between the tax expenditures and offsetting revenue sources. for example, even if option b met the temporary challenge standard, revenue offsets would have to be found during years one and two. likewise, if it were renewed after the first two years for another two-year period, as in option c, unlike with the current budget rules, option f would not be able to offset it. lock-step paygo would require the revenue offsets to come from years three and four. as a result, under the proposed rules, if the tax expenditure in option b was repeatedly renewed, it would have to generate the same amount of offsets during the first ten fiscal years as would option a. the only difference is that rather than having to come up with the full $35 billion of offsets upfront, renewing the legislation piecemeal would enable lawmakers to stage the funding of the expenditure throughout the ten-year budget window. 2. maintain legislative flexibility and enhance oversight although the proposed budget rules mandate more stringent scoring practices for temporary tax provisions, they do not preclude the ability to tailor the term of any legislation to specific situations where appropriate. although the mandatory scoring of legislation for the full ten-year budget window would seemingly create a de-facto preference for permanent legislation, in situations where temporary legislation is more justified, there would be no such preference. specifically, in situations where legislators face temporary challenges and need to enact tax expenditures that are specifically designed to apply for a finite period of time, the more onerous mandatory scoring rule would be waived. in these situations, temporary provisions would actually have an advantage because they would have more favorable budget scoring than their permanent counterparts and would require fewer available revenue offsets. to the extent that current budget preferences in favor of temporary provisions are reduced or neutralized, perhaps only tax expenditures which are purposely and appropriately temporary in nature will remain so. no longer being crowded out in the renewal process by scores of other expiring provisions, more deliberative action and reflection could be taken with respect to their implementation. with over fifty currently expired tax extenders waiting in legislative limbo, it is hard to imagine that due consideration will be given to each one. moreover, even with respect to permanent tax provisions, more opportunities for reevaluation and oversight would exist because of the proposed mandatory baseline review. if a provision is becoming significantly more costly than originally anticipated, lawmakers will be forced to examine the source of the increased cost and find ways to either generate more revenues or scale back the benefits provided under the existing legislation. 3. enhance legislative stability to the extent fewer tax expenditures are enacted in temporary form and are instead enacted as permanent provisions, this would lead to greater legislative stability. 142 as discussed above, if the tax expenditure in legislative option b was merely extended every two years, lawmakers could always find offsets for the renewed legislation (as illustrated in option c) by finding revenue raisers in the latter years of the then-applicable budget window (e.g. option f). if they did this, then only $5 billion of revenue offsets would have to be generated during the first ten fiscal years, even if the tax expenditure was in effect throughout the entire period. 30 columbia journal of tax law [vol.6:1 as discussed above, taxpayers have a really difficult time planning their behavior and transactions around legislation that is constantly either in legislative jeopardy or limbo. 143 this undermines the efficacy of the enacted tax provision, and creates an inefficient and unstable legislative environment. at the beginning of the 2014-2015 school year, teachers had to purchase school supplies for their classrooms without knowing whether there would be a retroactive extension of the educator expense deduction. 144 even if the deduction is ultimately extended retroactively, teachers may have already spent less than they otherwise would have on supplies for their students if they knew there would be a deduction available to offset their costs. 145 further complications exist for business where interim reporting and forecasting requires firms to make determinations about their current and projected financial positions. 146 as discussed above with respect to the r&d credit, money, and opportunities can be lost and company valuations can be skewed when important tax provisions are subjected to the legislative merry-go-round caused by the continuous cycle of expiring and renewing tax provisions. these types of real world consequences can be mitigated to the extent that more permanent legislation is put in place. by removing the preference for temporary tax expenditures in the budget process, more tax legislation may be enacted without sunsets, providing more legislative stability. 4. achieve greater political transparency the proposed rules would also enhance political transparency. the budget rules would make it more difficult for lawmakers to obscure the full costs of their proposed legislation by artificially sunsetting provisions. scoring tax legislation for a ten-year period does not fully reflect the true cost of a proposed expenditure because it does not take into account the costs projected outside of the budget window. however, it provides a much clearer reflection of the overall fiscal burden than is portrayed by breaking up the projected outlays into smaller oneor two-year pieces that are more easily digested by the general public. moreover, by requiring the temporary challenge designation in order to overcome the presumptive full budget window scoring requirement, lawmakers would have to reveal to the public the underlying expected duration of the proposed tax provision at the outset. in addition, by conforming the scoring for tax expenditures to the scoring requirements for mandatory spending programs, one of the built-in preferences for using the tax code to achieve government spending would be removed. this could lead to more federal spending being proposed and administered through mandatory spending programs. as discussed above, federal spending through the irc is often less salient to the general public. 147 taking spending programs out of the tax system that do not naturally belong there (but may be there only because of the budgetary advantages afforded tax expenditures), could enhance political transparency with respect to federal spending. 5. diminish captivity to special interest 143 see supra discussion in part iii.d. 144 to the extent the provision is intended to encourage teachers to fill in supply gaps that are not covered by their respective schools, the deduction may underachieve its purpose. 145 see supra notes 106 and 107 and accompanying text. 146 harpaz, supra note 112. 147 see supra notes 98 through 100 and accompanying text. 2014] breaking the spell of tax budget magic 31 lastly, these proposed rules would help diminish the ability of lawmakers to extract rents from special interest groups. under the present system, politicians are able to predictably extract rents from interest groups benefiting from targeted tax provisions that are perpetually under the threat of expiration. 148 it is true that these same groups surely would have an interest in securing the passage of favorable permanent legislation and would presumably be willing to pay more for that privilege (including payments to ensure that the favorable provisions would not subsequently be repealed). however, it is arguably reasonable to assume that over time the ability to extract rents with perpetual temporary legislation is greater than that with respect to equivalent permanent legislation. 149 more opportunities to bargain with an industry’s legislative future can lead to greater opportunities to extract rents. c. potential criticisms notwithstanding the potential benefits of the proposed budget framework rules, there are some potential concerns with and criticisms of the proposal. first, because of the endogenous nature of the budget rules, there is always the legitimate concern that congress will choose not to follow them. statutory budget rules have the peculiar status of not being binding on congress, even though they are duly passed and signed into law. 150 they are instead given the same status as internally adopted congressional budget rules. 151 as such, either the house of representatives or the senate may at any time modify or waive the application of internal procedural rules. 152 nevertheless, the budget rules are still believed to have some effect as precommitment devices and in fact affect legislative outcomes. 153 therefore, it is reasonable to assume that the proposed modifications to the existing budget rules will affect the legislative budget process as well. another potential criticism of the proposed budgetary framework is that it is a second-best solution to universal tax reform. tax reform would be the ideal way to deal with many of the underlying issues with the budget process and would help stabilize, at least temporarily, the tax laws. however, the likelihood of a complete overhaul of the tax code happening in the near future is unclear at best. 154 even if the tax laws were completely updated, that solution by itself is also incomplete. inevitably, new tax 148 see supra discussion in part iii.b. 149 kysar, supra note 3, at 1020. but see yin, supra note 5, at 244 (arguing that even if “a credible threat could be made relatively costlessly through, for example, the mere sponsorship of a bill or issuance of a press release, it is not clear why legislators would prefer to threaten temporary, as opposed to permanent, action. the latter would presumably present a more harmful outcome to the interested groups and therefore should generate greater returns to forestall the threatened action.”). 150 the supreme court has given special deference to these congressional framework rules due to concerns about separation of powers and the rulemaking clause of the constitution. kysar, supra note 3, at 1022. 151 id. 152 in fact, when senator byrd proposed his amendment (the byrd rule) to the budget act in order to impose restraint on the senate’s growing practice of adding extraneous items to reconciliation bills, it was approved by a vote of 96-0. michael w. evans, the budget process and the “sunset” provision of the 2001 tax law, 99 tax notes 405, 409 (apr. 21, 2003), citing 131 cong. rec. 28974 (oct. 24, 1985). not only did senators overwhelmingly decide to subject themselves to a precommitment device, but also since that time they have followed the letter of the rule (even though they have repeatedly used sunset legislation to undermine the purported spirit of the rule). see also kleinbard, supra note 6, at 6-7. 153 id. at 6. 154 although there is always a seemingly growing push for tax reform, the internal revenue code has not been overhauled since 1986. 32 columbia journal of tax law [vol.6:1 expenditure provisions would be introduced and a firm procedural framework would still need to be in place in order to prevent the newly reformed tax laws from devolving back to their present state. new rules would be subject to the same budgetary pressures that exist under the present law, and the proposed rules would help maintain any ground gained with a new tax regime. v. conclusion the increased use of temporary tax expenditures by lawmakers has exposed defects in the underlying legislative budget rules. lawmakers are able to use combinations of sunsets, phase-ins, sliding budget windows, and baseline manipulations in order to diminish and obscure the true projected cost of their proposals. although congress is ultimately left in the position of having to police itself in order to regain more fiscal restraint, by using strategically tailored precommitment devices, it may be able to achieve more sound legislative outcomes. indeed, implementation of more nuanced budget rules is necessary in order to better combat the countervailing pressures that lawmakers face from well organized special interest forces and to ensure that congress is able to improve the country’s long-term fiscal health. * associate professor, depaul university college of law. i would like to thank benjamin alarie, bradley borden, alex edwards, victor fleischer, anthony infanti, calvin johnson, jeffrey kwall, andrea monroe, gregg polsky, emily satterthwaite, and participants at the university of toronto‘s james hausman tax law and policy workshop for their helpful comments on earlier versions of this article and related work. all mistakes are, of course, my own. articles taxing publicly traded entities emily cauble* abstract publicly traded entities are generally treated as corporations for u.s. tax purposes. under various exceptions, however, publicly traded entities may obtain special treatment if they earn predominately certain specified types of qualifying income. this article examines potential rationales for granting special tax treatment to certain publicly traded entities. as the analysis in this article will show, many of the potential rationales are unconvincing. in addition, to the extent that some rationales may be persuasive, the current rules are not designed in a way that best comports with these potential justifications. therefore, reform is needed. to reform the current system, this article proposes narrowing the scope of what may be classified as qualifying income so that special tax treatment is bestowed upon publicly traded entities only when warranted by underlying policy justifications. specifically, this article proposes that income that is classified as qualifying income under current law should not be classified in that manner unless it is earned by holding a publicly traded asset. in addition, current law grants favorable treatment to all income earned by a publicly traded entity if and only if the entity earns predominately qualifying income. this article assesses whether tax law should, instead, grant special tax treatment to only qualifying income earned by a publicly traded entity, but with the special treatment applying regardless of whether the entity earns predominately qualifying income. ultimately, this article concludes that, on balance, concerns about complexity justify continuation of a regime under which beneficial treatment applies to all income earned by a publicly traded entity if and only if the entity earns predominately qualifying income, provided that the scope of what may be classified as qualifying income is narrowed in the manner proposed by this article. columbia journal of tax law [vol.6:147 148 i. introduction ............................................................................................ 149 ii. current taxation of publicly traded entities ......................... 152 a. exempt publicly traded partnerships ........................................................... 153 b. real estate investment trusts...................................................................... 154 c. recent expansion of exempt publicly traded partnerships and real estate investment trusts ....................................................................................... 155 iii. potential justifications for current taxation of publicly traded entities........................................................................................ 162 a. why public trading? .................................................................................. 162 b. why qualifying income? ............................................................................ 164 iv. troubling aspects of current taxation of publicly traded entities........................................................................................................ 168 a. overly broad definition of qualifying income ............................................. 169 b. arbitrariness .............................................................................................. 171 c. manipulability ............................................................................................ 173 v. proposed reforms ................................................................................... 173 a. the proposed reforms better guard against easy manipulation by taxpayers ... ............................................................................................................ 176 b. should the rules also be made less arbitrary? ......................................... 178 1. how to implement an alternative regime ............................................... 179 2. the new regime would not necessarily eliminate the negative effects of arbitrariness ........................................................................................ 180 3. the new definition of qualifying income partially mitigates the negative effects of arbitrariness ......................................................................... 180 vi. conclusion ................................................................................................ 181 2015] taxing publicly traded entities 149 i. introduction publicly traded entities are generally treated as corporations for tax purposes. under various exceptions, however, publicly traded entities may obtain special treatment if they earn predominately certain specified types of qualifying income. 1 recently, the use of sophisticated tax structuring techniques has precipitated an expansion in the universe of entities that obtain special tax treatment. this phenomenon has caught the attention of the popular press. on august 9, 2014, for instance, the new york times published an article, ―a corporate tax break that‘s closer to home,‖ highlighting a recent trend--a growing number of businesses reduce their tax liability by organizing themselves as real estate investment trusts (―reits‖). 2 likewise, on april 22, 2013, an article titled ―restyled as real estate trusts, varied businesses avoid taxes‖ occupied the front page of the new york times. 3 the article contained additional discussion of this recent trend. 4 although businesses that primarily earn income from real estate have long been formed as reits, increasingly businesses that have earnings other than traditional real estate income make use of the tax benefits of the reit structure. 5 the new york times article from april mentioned several examples of this new generation of reits, including a company that owns and operates prisons and a company that owns casinos. likewise, the wall street journal published an article, ―more firms enjoy tax free status,‖ on january 10, 2012. that article featured another current development--a surge in the number of public ly traded partnerships that avoid entity-level tax by predominately earning certain types of qualifying income (typically investment income). 6 although nothing is new about the ability of publicly traded partnerships to avoid entity-level tax when they mainly earn investment income, the wall street journal article focused on new publicly traded partnerships that are decidedly different. unlike their traditional counterparts, these new publicly traded partnerships manage to avoid entity level tax notwithstanding the fact that they earn substantial amounts of non-qualifying income. the wall street journal article provided several examples of this new breed of publicly traded partnerships, including a publicly traded firm that specializes in running cemeteries and publicly traded 1 under current law, publicly traded entities that earn more than a small amount of non-qualifying income are not the only types of entities that are automatically treated as corporations for tax purposes. see treas. regs. §§ 301.7701-2(b)(1), (3)–(8) (describing entities that must be treated as corporations). for instance, under current law, an entity is automatically treated as a corporation for tax purposes if it is organized under a federal or state statute that describes or refers to the entity as incorporated or as a corporation, body corporate, or body politic. see treas. regs. §§ 301.7701-2(b)(1). therefore, an incorporated publicly traded entity is automatically treated as a corporation regardless of the type of income that it earns in most cases. consequently, this article‘s discussion of special treatment granted to certain publicly traded entities that earn primarily qualifying income is, for the most part, focused on unincorporated publicly traded entities. however, an incorporated entity that met various eligibility requirements could qualify as a real estate investment trust (a ―reit‖) for tax purposes. see i.r.c. § 856(a)(3). therefore, this article‘s discussion of publicly traded reits could include incorporated entities. 2 gretchen morgenson, a corporate tax break that’s closer to home, n.y. times, aug. 9, 2014. 3 nathanial popper, restyled as real estate trusts, varied businesses avoid taxes, n.y. times, apr. 22, 2013, at a1. 4 id. for additional discussion, see, e.g., telecom firm announces latest tax-free reit spin-off transaction, 2014 tax notes today 146-1 (jul. 30, 2014); lee a. sheppard, can any company be a reit?, 2013 tax notes today 160-2 (aug. 19, 2013). 5 id. 6 john d. mckinnon, more firms enjoy tax free status, wall street journal, jan. 10, 2012. columbia journal of tax law [vol.6:147 150 partnerships that share in the income earned by private equity fund sponsors, such as blackstone group, l.p. and kkr & co., l.p. 7 the growing number of reits and publicly traded partnerships that avoid entitylevel tax has troubled the irs. the increasing prevalence of non-traditional reits prompted an irs working-group study to examine the topic of reit classification. 8 the irs also called a temporary halt to issuing private letter rulings involving publicly traded partnerships in order to further study the topic. 9 at the same time, in may 2014, the treasury proposed regulations that would expand the definition of what constitutes real property for purposes of the reit qualification rules, making the regulations consistent with guidance that has been issued by the irs in private letter rulings. 10 these trends have also attracted congressional attention. recently, for instance, the committee on ways and means proposed reforms under which publicly traded partnerships would only qualify for exemption from entity-level tax if they primarily earned income from activities related to mining and natural resources. 11 that proposal was not the first congressional proposal that would have limited the circumstances in which publicly traded partnerships can avoid entity-level tax. 12 in addition to addressing publicly traded partnerships, the committee on ways and means proposed measures that would make it more difficult for existing businesses to restructure themselves as reits, and that would hinder the ability of taxpayers to use tax structuring techniques to obtain reit qualification. 13 in order to place these recent trends in context, this article examines potential rationales for granting special tax treatment to certain publicly traded entities that earn predominately qualifying income. as the analysis in this article shows, many of the potential rationales are unconvincing. in addition, to the extent that some rationales may be persuasive, the current rules are not designed in a way that best comports with these potential justifications. for instance, legislative history suggests that special treatment is granted to qualifying income because owners of the publicly traded entity could earn qualifying income directly. 14 based on this rationale, the scope of what currently constitutes qualifying income is much too broad because many types of income that 7 id. 8 see, e.g., amy s. elliott, companies report irs may have suspended reit conversion rulings, 2013 tax notes today 111-4 (jun. 10, 2013). 9 see, e.g., tax analysts, irs has stopped ruling on publicly traded partnership qualifying income, 2014 tax notes today 61-4 (mar. 31, 2014). 10 reg-150760-13. for further discussion, see willard b. taylor, closing the gap between private letter rulings and regulations, 144 tax notes 597 (aug. 4, 2014). 11 committee on ways and means, tax reform act of 2014, discussion draft, section-by-section summary, section 3620, available at http://waysandmeans.house.gov/uploadedfiles/ways_and_means_section_by_section_summary_final_022614 .pdf. 12 for instance, senators max baucus and charles grassley proposed legislation in 2007 that would have limited the scope of the exempt publicly traded partnership rules. s. 1624, 110th cong. (2007). for further discussion of the legislation, see victor fleischer, taxing blackstone, 61 tax l. rev. 89, 104-20 (2008). for further discussion of lawmakers‘ consideration of reform to the tax treatment of large partnerships, see, e.g., martin a. sullivan, economic analysis: why not tax large passthroughs as corporations, 131 tax notes 1015 (2011). 13 committee on ways and means, tax reform act of 2014, discussion draft, section-by-section summary, sections 3631, 3635 available at http://waysandmeans.house.gov/uploadedfiles/ways_and_means_section_by_section_summary_final_022614 .pdf. 14 see infra part iii.b. 2015] taxing publicly traded entities 151 owners of a publicly traded entity could not earn directly are classified as qualifying income. therefore, reform is warranted. to reform the current system, this article proposes narrowing the scope of what may be classified as qualifying income so that special tax treatment is bestowed upon publicly traded entities only when warranted by underlying policy justifications. specifically, this article proposes that income that is classified as qualifying income under current law should not be classified in that manner unless it is earned by holding a publicly traded asset. 15 furthermore, income earned by a publicly traded entity that is ―carried interest‖ should never constitute qualifying income. 16 as discussed below, ―carried interest‖ is a percentage of the profits generated by a private equity fund, real estate fund, or hedge fund that is earned by the fund‘s sponsor. in addition to containing an overly broad definition of ―qualifying income,‖ current law grants favorable treatment to all income earned by a publicly traded entity if and only if the entity predominately earns qualifying income. this article assesses whether tax law should, instead, grant special tax treatment to only qualifying income earned by a publicly traded entity, but with the special treatment applying regardless of whether the entity earns predominately qualifying income. 17 ultimately, the article concludes that, on balance, concerns about complexity justify continuation of a regime under which beneficial treatment applies to all income earned by a publicly traded entity if and only if the entity predominately earns qualifying income, provided that the scope of what may be classified as qualifying income is narrowed in the manner proposed by this article. the reforms proposed by this article would create a more rational system than what currently exists. furthermore, these reforms would have the additional benefit of eliminating the effectiveness of the wasteful, elaborate tax structuring techniques employed by the new generation of reits and publicly traded partnerships recently featured in the popular press. this article proceeds as follows. part ii describes the current state of law. it discusses how publicly traded entities are treated for tax purposes, it describes the special tax treatment granted to certain publicly traded entities, and it explains the new tax structuring techniques used by entities to qualify for special tax treatment. part iii explores potential justifications for current law. part iv highlights some troubling 15 for discussion of this proposal in the context of the publicly traded partnership rules, see emily cauble, redefining qualifying income for publicly traded partnerships, 145 tax notes 107 (2014). 16 for discussion of this proposal in the context of the publicly traded partnership rules, see cauble, supra note 15, at 46. 17 this question has been raised briefly in earlier work. see emily cauble & gregg d. polsky, the problem of abusive related-partner allocations 16 fla. tax rev. 479, 518 (2014) (―while a full ventilation of this broader concern is left for another day, it is worth noting that the critical issue appears to be whether the tax system should, in the context of publicly traded entities (1) always tax qualifying income at the entity level, (2) never tax qualifying income at the entity level, or (3) sometimes tax qualifying income at the entity level depending on the amount of non-qualifying income earned by the entity—a factor that is sometimes within the entity‘s control if it avails itself of sophisticated tax planning. our current system can be described as using the third approach, which seems to be the worst of the three options‖); emily cauble, was blackstone’s initial public offering too good to be true?: a case study in closing loopholes in the partnership tax allocation rules, 14 fla. tax rev. 153, 202-203 (2013) (mentioning the possibility that congress could enact a rule for publicly traded partnerships that would, in all cases, subject only nonqualifying income to corporate-level tax). this article builds upon that earlier work by undertaking a thorough analysis of this question in the context of considering rationales for granting special tax treatment to certain entities. columbia journal of tax law [vol.6:147 152 aspects of the current taxation of publicly traded entities, illustrating how current law is not well suited to achieve any of the conceivable rationales for granting special treatment to certain publicly traded entities. part v describes and evaluates the reforms proposed by this article. ii. current taxation of publicly traded entities although many business entities can elect to be treated as partnerships or corporations for tax purposes, certain entities must be treated as corporations. 18 for example, entities that are publicly traded typically must be treated as corporations for tax purposes. 19 an entity that is listed on an established securities exchange, like the new york stock exchange, is publicly traded. 20 in addition, even if interests in an entity are not traded on an exchange, if, given all the facts and circumstances, owners are readily able to buy, sell, or exchange their interests in a manner that is economically comparable to trading on an established securities market, the entity generally will be treated as a corporation for tax purposes. 21 if an entity is treated as a corporation for tax purposes, generally the entity itself will be subject to tax (―entity-level tax‖). 22 furthermore, owners of the entity may be subject to tax when they sell ownership interests in the entity or receive certain distributions from the entity. 23 if an entity is treated as a partnership for tax purposes, the entity will not be subject to tax. instead, any items of tax income, gain, loss, or deduction recognized by the entity will be passed through to the entity‘s owners for the owners to 18 treas. regs. §§ 301.7701-3(a) (providing ability to elect tax classification to many entities); 301.7701-2(b)(1), (3)–(8) (describing entities that must be treated as corporations). because this article is focused on publicly traded entities, it uses the term ―corporation‖ to refer to an entity that is treated as a c corporation for tax purposes. certain closely held entities can opt for treatment as s corporations, which would lead to tax treatment different from the treatment of corporations described in this article. 19 i.r.c. § 7704. 20 i.r.c. § 7704(b)(1). 21 i.r.c. § 7704(b)(2); treas. reg. § 1.7704-1(c). transfers that are not recognized by the entity and certain other transfers will be disregarded when determining whether the entity is publicly traded. see treas. reg. §§ 1.7704-1(d), 1.7704-1(e). furthermore, the treasury regulations provide safe harbors, and an entity that is not traded on an established securities market and that qualifies for a safe harbor will be deemed to not be publicly traded. the safe harbors include the private placement safe harbor and the lack of actual trading safe harbor. the private placement safe harbor applies to an entity if interests in it are issued in a transaction that need not be registered under the securities act of 1933 and the entity does not have more than 100 owners at any time. see treas. reg. § 1.7704-1(h). an entity resides within the lack of actual trading safe harbor if not more than two percent of the total interests in the entity are transferred during any given year. see treas. reg. § 1.7704-1(j). 22 see i.r.c. § 11. this discussion assumes that the entity is not an s corporation, a justifiable assumption within the realm of publicly traded entities because an entity with more than 100 owners cannot qualify as an s corporation. i.r.c. § 1361(b)(1)(a). 23 see i.r.c. § 301 (addressing distributions from corporations); i.r.c. § 1001 (regarding gain from sale of ownership interests). certain owners may not be subject to tax as a result of distributions or sale of interests in the entity. for instance, assuming the ownership interest held is not debt -financed, tax-exempt owners generally would be exempt from tax on any dividend income and capital gain income resulting from distributions or sale of interests in the entity. i.r.c. §§ 512(b)(1), 512(b)(5), 514. in addition, in most cases, non-u.s. owners would generally be exempt from u.s. tax on any capital gain income resulting from distributions or sale of interests in the entity. a non-u.s. individual or corporation is generally only subject to u.s. tax on capital gain income if the income is effectively connected with a u.s. trade or business. i.r.c. §§ 871(b)(1), 882(a)(1). income from trading in stocks and securities for a taxpayer‘s own account is generally not treated as effectively connected to a u.s. trade or business. i.r.c. § 864(b)(2)(a)(ii). u.s. withholding tax might apply to dividend income paid to non-u.s. owners, but, depending on the facts, the rate of tax may be reduced by treaty. http://web2.westlaw.com/find/default.wl?mt=208&db=1016188&docname=26cfrs1.7704-1&rp=%2ffind%2fdefault.wl&findtype=l&ordoc=0354920277&tc=-1&vr=2.0&fn=_top&sv=split&tf=-1&referencepositiontype=t&pbc=4e7f8f5b&referenceposition=sp%3b4b24000003ba5&rs=wlw13.01 http://web2.westlaw.com/find/default.wl?mt=208&db=1016188&docname=26cfrs1.7704-1&rp=%2ffind%2fdefault.wl&findtype=l&ordoc=0354920277&tc=-1&vr=2.0&fn=_top&sv=split&tf=-1&referencepositiontype=t&pbc=4e7f8f5b&referenceposition=sp%3b4b24000003ba5&rs=wlw13.01 http://web2.westlaw.com/find/default.wl?mt=208&db=1016188&docname=26cfrs1.7704-1&rp=%2ffind%2fdefault.wl&findtype=l&ordoc=0354920277&tc=-1&vr=2.0&fn=_top&sv=split&tf=-1&referencepositiontype=t&pbc=4e7f8f5b&referenceposition=sp%3ba83b000018c76&rs=wlw13.01 http://web2.westlaw.com/find/default.wl?mt=208&db=1016188&docname=26cfrs1.7704-1&rp=%2ffind%2fdefault.wl&findtype=l&ordoc=0354920277&tc=-1&vr=2.0&fn=_top&sv=split&tf=-1&referencepositiontype=t&pbc=4e7f8f5b&referenceposition=sp%3ba83b000018c76&rs=wlw13.01 2015] taxing publicly traded entities 153 take into account directly when computing their own taxable income. 24 thus, treatment as a corporation generally involves two levels of tax--both an entity-level tax and an owner-level tax. 25 by contrast, treatment as a partnership involves only one level of tax, the tax imposed at the owner level. 26 for example, assume a business earns $100 of pretax income. 27 if the business were conducted through an entity treated as a partnership for tax purposes, the entity would bear no entity-level tax, and the individual owners of the business could bear total tax liability of 40% of $100, or $40. thus, after tax, $60 of income would remain. if, instead, the business were conducted through an entity treated as a corporation for tax purposes, the entity would incur tax liability of 35% of $100, or $35. when the entity distributed the remaining $65, the individual owners would incur total tax liability of 20% of $65, or $13, leaving only $52 of after-tax income (less than the $60 amount that remained in the case of the partnership). a. exempt publicly traded partnerships as discussed above, typically a publicly traded entity must be treated as a corporation for tax purposes, treatment that subjects its income to two levels of tax. however, certain entities (―exempt publicly traded partnerships‖) can be treated as partnerships for tax purposes notwithstanding the fact that the entities are publicly traded. in order to constitute an exempt publicly traded partnership, the entity must predominately earn certain types of ―qualifying income.‖ 28 in particular, at least 90 percent of the entity‘s gross income must be ―qualifying income.‖ 29 ―qualifying income‖ includes dividend income, interest income, capital gain income, and certain other types of investment income. 30 in addition, ―qualifying income‖ includes income from activities related to mining and natural resources. 31 certain types of income are excluded from the definition of ―qualifying income‖ if they are earned in particular ways. for instance, interest is not qualifying income if it is derived in the conduct of a financial or insurance 24 see i.r.c. § 701. tax-exempt owners generally would be subject to tax on the income only if the underlying income earned by the partnership is unrelated business taxable income. see i.r.c. § 512(c). nonu.s. investors would be subject to u.s. tax if the underlying income earned by the partnership was effectively connected with a u.s. trade or business or was u.s. source income of certain types, but, in other cases, non-u.s. investors would generally be exempt from u.s. tax. 25 see supra notes 22-23 and accompanying text. 26 see supra note 24 and accompanying text. 27 this example also assumes that the underlying income earned by the business is ordinary income, all the individual owners of the business are subject to a tax rate of 40 percent on ordinary income, all the individual owners of the business are subject to a tax rate of 20 percent on dividend income, and the corporate tax rate is 35 percent. 28 see i.r.c. § 7704(c). in order to obtain partnership classification, the entity also must not be automatically classified as a corporation under certain other provisions. see treas. regs. §§ 301.7701-2(b)(1), (3)–(8) (describing entities that must be treated as corporations). 29 i.r.c. § 7704(c). 30 i.r.c. § 7704(d). 31 specifically, the term ―qualifying income‖ also includes ―income and gains derived from the exploration, development, mining or production, processing, refining, transportation . . ., or the marketing of any mineral or natural resource . . .‖ i.r.c. § 7704(d)(1)(e). columbia journal of tax law [vol.6:147 154 business. 32 in addition, interest and rent that are contingent upon profits do not constitute qualifying income, subject to certain exceptions. 33 because an exempt publicly traded partnership is treated like a partnership for tax purposes, it avoids entity-level tax. instead of subjecting income to tax at the entity level, any items of tax income, gain, loss, or deduction recognized by the entity will be passed through to the entity‘s owners for the owners to take into account directly when computing their own taxable income. 34 b. real estate investment trusts a publicly traded entity can also avoid subjecting its income to two levels of tax if the entity achieves classification as a real estate investment trust (a ―reit‖). a reit is generally treated as a corporation for tax purposes. however, unlike an ordinary corporation, a reit is entitled to deduct dividends that it pays to its shareholders for purposes of computing the reit's income that is subject to tax at the reit level. 35 therefore, unlike an ordinary corporation, a reit can avoid entity-level tax by distributing all of its income to its owners. 36 32 see i.r.c. § 7704(d)(2)(a). regarding this carve-out, legislative history accompanying the adoption of the publicly traded partnership rules states that ―interest is not treated as passive-type income if it is derived in the conduct of a financial or insurance business. thus, for example, interest income from the conduct of a banking business is not treated as passive-type income, as deriving interest is an integral part of the active conduct of the business.‖ h.r. rep . no. 100-391 (1987). 33 see i.r.c. §§ 7704(d)(2)(b), 7704(d)(3). regarding these limitations on the definition of ―qualifying income,‖ legislative history accompanying the adoption of the publicly traded partnership rules states that ―[i]nterest or rent (or other amounts) contingent on profits involves a greater degree of risk, and also a greater potential for economic gain, than fixed (or even a market-indexed) rate of interest or rent, and thus is more properly regarded as from an underlying active business activity.‖ h.r. rep . no. 100-391 (1987). 34 see i.r.c. § 701. certain owners may not be subject to tax on the income allocated to them. tax-exempt owners would not be subject to tax if the underlying income earned by the partnership is not debt-financed and constituted dividend income, interest income, capital gain income, or other types of income generally excluded from the scope of unrelated business taxable income. in 1993, congress repealed a rule under which income allocated to a tax-exempt partner from a publicly traded partnership was always unrelated business taxable income. following the repeal, it appears that publicly traded partnerships that are treated as partnerships for tax purposes receive the same treatment as other partnerships. in general, income allocated to a tax-exempt partner by a partnership is unrelated business taxable income only if the underlying income earned by the partnership is unrelated business taxable income. see i.r.c. § 512(c). non-u.s. investors would be subject to u.s. tax if the underlying income earned by the partnership was effectively connected with a u.s. trade or business or was u.s. source income of certain types, but, in other cases, nonu.s. investors would generally be exempt from u.s. tax. 35 see i.r.c. § 857(b). 36 u.s. owners of the reit that are not tax-exempt will generally be subject to tax on the dividend income. tax-exempt owners of the reit, however, will generally be exempt from tax on the resulting dividend income as long as their ownerships interests in the reit are not debt-financed. see rev. rul. 66-106, 1966-1 c.b. 151. notwithstanding the fact that tax-exempt owners would generally be exempt from tax, a pension plan that owned a large stake in a reit whose stock was overly concentrated in the hands of pension plans would be subject to tax on distributions to the extent that the reit‘s underlying income would be unrelated business taxable income if earned directly by the pension plan. see i.r.c. § 856(h). a public reit is not likely to be pension-held. non-u.s. owners will not be subject to u.s. tax on gain recognized from selling interests in a reit as long as either: (1) ownership of the reit is sufficiently concentrated in the hands of u.s. persons to make the reit domestically controlled or (2) the reit is publicly traded and the non-u.s. owner owns 5 percent or less of the reit. see i.r.c. § 897(h)(2), (c)(3). u.s. withholding tax could apply to dividend distributions by the reit to non-u.s. owners, but the rate of tax may be reduced by treaty. 2015] taxing publicly traded entities 155 in order to obtain reit status, an entity must pass two income tests and an asset test, in addition to complying with other requirements. 37 the first income test requires that at least 75 percent of the entity‘s gross income must consist of rent from real property, interest on obligations secured by mortgages on real property or on interests in real property, and other enumerated types of income related to real estate. 38 the second income test requires that the entity derive at least 95 percent of its gross income from dividends, interest, rents from real property, and other specified types of investment income. 39 an entity passes the asset test if at least 75 percent of the value of its assets is represented by real estate assets, cash and cash items (including receivables), and government securities. 40 c. recent expansion of exempt publicly traded partnerships and real estate investment trusts as described above, while most publicly traded entities are subjected to corporate tax treatment, publicly traded entities that earn predominately specified types of qualifying income benefit from potentially more favorable tax treatment. in particular, special treatment is bestowed upon exempt publicly traded partnerships and reits. 41 although publicly traded entities that predominately earn qualifying income have long availed themselves of the ability to achieve exempt publicly traded partnership status, entities that earn substantial amounts of non-qualifying income increasingly utilize sophisticated tax structuring techniques to achieve the same status. likewise, entities that earn more than traditional real estate related income are increasingly achieving reit classification through use of similar techniques. figure 1 below illustrates the structure increasingly used by publicly traded entities to maintain exempt publicly traded partnership status despite earning significant amounts of non-qualifying income. 42 37 for other requirements, see i.r.c. §§ 856-57. 38 i.r.c. § 856(c)(3). 39 i.r.c. § 856(c)(2). 40 i.r.c. § 856(c)(4)(a). 41 special treatment is also bestowed upon other specialized types of entities. for instance, entities that meet certain requirements can elect to be treated as regulated investment companies (―rics‖) for tax purposes. i.r.c. § 851. similar to a reit, a ric can deduct the dividends that it pays to its shareholders. i.r.c. § 852(b)(2). full discussion of rics is beyond the scope of this article. however, it should be noted that, at least in the case of rics that earn much of their income from investing in publicly traded assets, the proposal made by this article is not inconsistent with the fact that special tax treatment is granted to those rics. 42 for further discussion of this structure, see, e.g., cauble, supra note 17 at 159-69; cauble & polsky, supra note 17; fleischer, supra note 12 at 101-03. columbia journal of tax law [vol.6:147 156 figure 1: exempt publicly traded partnerships in this structure, the publicly traded partnership is an entity that is traded on an established securities market. in order to maintain classification as an exempt publicly traded partnership, at least 90 percent of the publicly traded partnership‘s gross income must be qualifying income. 43 in order to ensure that the publicly traded partnership meets this test, only qualifying income is earned directly by the publicly traded partnership or allocated directly to the publicly traded partnership by subsidiary partnerships. 44 because this income is allocated directly to or earned directly by the publicly traded partnership, it retains its original character, and thus, all income the publicly traded partnership directly receives is qualifying income. 45 any non-qualifying income is earned by either ―u.s. subsidiary‖ (an entity formed in the united states) or ―non-u.s. subsidiary‖ (an entity formed outside of the united states). 46 both of these entities are treated as corporations for u.s. tax purposes, and each of these entities is wholly owned by the publicly traded partnership. because they are corporations, when these entities distribute cash, the publicly traded partnership 43 see supra part ii.a. 44 for further discussion of this structure, see, e.g., cauble, supra note 17 at 159-69; cauble & polsky, supra note 17; fleischer, supra note 12 at 101-03. 45 ―character‖ of income refers to the type of income. for instance, if a subsidiary partnership earned dividend income and allocated such income to the publicly traded partnership, the publicly traded partnership would recognize dividend income. 46 for further discussion of this structure, see, e.g., cauble, supra note 17 at 159-69; cauble & polsky, supra note 17; fleischer, supra note 12 at 101-103. qualifying income u.s. subsidiary publicly traded partnership non-qualifying income non-u.s. subsidiary non-qualifying income 2015] taxing publicly traded entities 157 recognizes dividend income or capital gain income. 47 dividend income and capital gain income are types of qualifying income. 48 thus, non-qualifying income earned by u.s. subsidiary and non-u.s. subsidiary is converted into qualifying income before it reaches the publicly traded partnership, and u.s. subsidiary and non-u.s. subsidiary are interposed in the structure solely to achieve the result of converting non-qualifying income into qualifying income. 49 as a result, the publicly traded partnership earns 100 percent qualifying income because its income consists of qualifying income earned directly (or through partnerships), dividend income received from u.s. subsidiary or non-u.s. subsidiary, and capital gain income earned as a result of owning interests in u.s. subsidiary or nonu.s. subsidiary. 50 consequently, regardless of the mix of qualifying and non-qualifying income earned in any particular year, the publicly traded partnership will always qualify for the exception from corporate tax treatment because at least 90 percent of its income (in this case, 100 percent of its income) will be qualifying income. 51 finally, u.s. subsidiary will pay entity-level tax on the income it earns (which is the non-qualifying income that is funneled through u.s. subsidiary). therefore, entitylevel tax is not completely avoided. however, in order to reduce u.s. subsidiary‘s tax liability, the publicly traded partnership likely loans funds to u.s. subsidiary and charges u.s subsidiary interest. 52 as a result, u.s. subsidiary can deduct this interest expense, reducing its taxable income. 53 moreover, the interest income received by the publicly traded partnership from u.s. subsidiary is qualifying income and, consequently, does not jeopardize its ability to earn predominately qualifying income. 54 there are limits on the extent to which u.s. subsidiary‘s taxable income can be reduced by interest deductions. if the publicly traded partnership charged an interest rate that was higher than a market rate, for instance, the loan from the publicly traded partnership to u.s. subsidiary could be re-characterized, for tax purposes, as an equity interest in u.s. subsidiary. accordingly, the payments made by u.s. subsidiary would not be 47 in particular, to the extent that the distribution does not exceed the corporation‘s available earnings and profits, the publicly traded partnership will recognize dividend income. i.r.c. §§ 301(c)(1), 316. if the distribution does exceed earnings and profits, the publicly traded partnership could potentially recognize gain from the sale of stock in the corporation, which would be capital gain income. i.r.c. § 301(c)(3)(a). the tax treatment of a shareholder of a non-u.s. corporation could differ from what is described in the text if the non-u.s. corporation earned passive income. in such a case, special ―antideferral‖ rules could apply. however, assuming only active income is allocated to non-u.s. subsidiary, the anti-deferral rules would not apply to the exempt publicly traded partnership structure. 48 i.r.c. § 7704(d). 49 see id. 50 see supra notes 44-49 and accompanying text. 51 for further discussion of this structure, see, e.g., cauble, supra note 17 at 159-69; cauble & polsky, supra note 17; fleischer, supra note 12 at 101-03. 52 for further discussion, see, e.g., cauble, supra note 17 at 165; cauble & polsky, supra note 17; fleischer, supra note 12 at 102. 53 see i.r.c. § 163 (providing for an interest deduction). 54 see i.r.c. § 7704(d)(1)(a). it is worth noting that certain other payments that would be deductible by the u.s. subsidiary would not be treated as qualifying income if paid to the publicly traded partnership. specifically, rent received from a related taxpayer is treated as non-qualifying income except in certain circumstances. i.r.c. § 7704(d)(3) (defining rent by reference to section 856(d) with certain modifications) and i.r.c. § 856(d)(2)(b) (providing that rent excludes amounts received from related taxpayers except in certain circumstances). columbia journal of tax law [vol.6:147 158 respected as deductible interest payments for tax purposes. 55 nevertheless, subject to certain restrictions, interest deductions can reduce u.s. subsidiary‘s tax liability. non-u.s. subsidiary pays no entity-level tax on the non-qualifying income it earns. non-u.s. subsidiary, as a non-u.s. corporation, is subject to u.s. tax only on u.s. source-income and income effectively connected with a u.s. trade or business. 56 non-u.s. subsidiary only earns income that is neither u.s. source nor effectively connected with a u.s. trade or business. 57 as a result, non-u.s. subsidiary incurs no u.s. tax liability. thus, although u.s. subsidiary pays entity-level tax on the nonqualifying income it earns after reducing the amount of that income by allowable interest deductions, no entity in the structure pays entity-level tax on the qualifying income earned directly by the publicly traded partnership, and non-u.s. subsidiary pays no entity-level tax on the non-qualifying income it earns. by contrast, if the publicly traded partnership did not employ this structure, less than 90 percent of its gross income would be qualifying income, and it would be treated as a corporation for tax purposes. 58 as a result, all of its income (qualifying and non-qualifying) would be subject to entity-level tax. for one concrete example of the use of this technique, consider the structure utilized by blackstone group l.p. blackstone is a private equity firm that sponsors various real estate funds, hedge funds, and private equity funds (blackstone, the fund sponsor, is referred to below as ―the blackstone firm‖). 59 as a fund sponsor, the blackstone firm receives management fees and a percentage of the profits generated by each fund (referred to as ―carried interest‖). blackstone group l.p. is entitled to receive a share of whatever the blackstone firm receives—by way of management fees or carried interest—from the various funds that it sponsors. 60 blackstone group l.p. is a publicly traded partnership listed on the new york stock exchange. 61 blackstone group l.p. utilizes a structure similar to the one shown in figure 1 to ensure that at least 90 percent of its gross income constitutes qualifying income so that it obtains exemption from mandatory corporate tax treatment. 62 some of the carried interest earned by blackstone group l.p. currently constitutes qualifying income. for instance, assume the blackstone firm sponsors a private equity fund that sells stock in a portfolio company, generating gain that is 55 likewise, if u.s. subsidiary were too thinly capitalized, some of the debt could be recast as equity for tax purposes. furthermore, section 163(j) could limit the amount of interest deductible by u.s. subsidiary if the owners of the publicly traded partnership are not subject to tax on the interest. 56 i.r.c. §§ 881–882. 57 for further discussion, see, e.g., cauble, supra note 17 at 165-66; cauble & polsky, supra note 17. 58 see supra part ii.a. 59 the blackstone group l.p., registration statement (form s-1) at 1 (mar. 22, 2007), http://www.sec.gov/archives/edgar/data/1393818/000104746907002068/a2176832zs-1.htm (hereinafter blackstone s-1). 60 id. at 10. 61 id. at 17. 62 id. at 202 (―we intend to manage our affairs so that we will meet the qualifying income exception in each taxable year. we believe we will be treated as a partnership and not as a corporation for u.s. federal income tax purposes. simpson thacher & bartlett llp will provide an opinion to us based on factual statements and representations made by us, including statements and representations as to the manner in which we intend to manage our affairs and the composition of our income, that we will be treated as a partnership and not as an association or publicly traded partnership (within the meaning of section 7704 of the code) subject to tax as a corporation for u.s. federal income tax purposes.‖). 2015] taxing publicly traded entities 159 classified as capital gain. as a result of this transaction, some of the carried interest allocated to the blackstone firm will receive capital gain treatment. 63 therefore, some of the income earned by blackstone group l.p. will be classified as capital gain and thus constitutes qualifying income. 64 any carried interest to which blackstone group l.p. is entitled that is already qualifying income will be earned by blackstone group l.p. through pass-through entities so that the income retains its classification as qualifying income (just as qualifying income is earned directly by the publicly traded partnership in figure 1). 65 blackstone group l.p. is entitled to receive some non-qualifying income. for instance, management fees are non-qualifying income. in addition, some carried interest earned by blackstone group l.p. is non-qualifying income if, for instance, the blackstone firm sponsors a fund that earns income from providing services and allocates some of that income to the blackstone firm as carried interest. rather than earning nonqualifying income directly or through pass-through entities, blackstone group l.p. earns any non-qualifying income through subsidiaries that are treated as corporations for u.s. tax purposes (just as the publicly traded partnership in figure 1 earns any non-qualifying income through u.s. subsidiary and non-u.s. subsidiary). 66 because these subsidiaries are corporations for u.s. tax purposes, when blackstone group l.p. receives distributions from the subsidiaries, blackstone group l.p. recognizes qualifying income in the form of dividend income or capital gain. 67 thus, by funneling any non-qualifying income through these subsidiaries, blackstone group l.p. effectively converts what would otherwise be non-qualifying income into qualifying income. some of the corporate subsidiaries are formed in the united states and, thus, are treated as u.s. corporations for tax purposes (like u.s. subsidiary in figure 1). 68 these subsidiaries are subject to corporate-level tax on the income they earn. however, blackstone group l.p.‘s offering documents leave open the possibility that blackstone group l.p. could loan funds to these subsidiaries and charge them interest. 69 the interest 63 carried interest is structured as a partnership interest that entitles its holder to receive profits earned by a partnership. consequently, the person or entity that holds the right to carried interest will be allocated a share of income earned by the partnership. moreover, because the character of income allocated to a partner depends on the character of income earned by the partnership, the character of carried interest depends on the type of underlying partnership income allocated to the person or entity that receives carried interest. i.r.c. § 702(b). 64 i.r.c. § 7704(d)(1)(f) (defining qualifying income to generally include capital gain). 65 blackstone s-1, supra note 59 at 203 (stating that the subsidiaries of blackstone group l.p. that are treated as disregarded entities for tax purposes – blackstone holdings iii gp l.p. and blackstone holdings iv gp l.p. – ―will invest directly or indirectly in a variety of assets and otherwise engage in activities and derive income that is consistent with the qualifying income exception‖). 66 id. at 202–04 (stating that blackstone group l.p. intends to meet the qualifying income exception in each taxable year, and that blackstone group l.p. owns interests in certain subsidiaries that are treated as u.s. corporations for tax purposes--such as blackstone holdings i gp inc. however, blackstone group l.p., as the holder of blackstone holdings i gp inc.‘s common stock, ―will not be taxed directly on earnings of entities [it] hold[s] through blackstone holdings i gp inc.‖ rather, when blackstone holdings i gp inc. makes distributions, blackstone group l.p. will recognize dividend income and, potentially, capital gain.). 67 id. also, as long as the subsidiary that is formed outside the united states does not earn income that would constitute subpart f income, the subpart f regime will not apply to income earned through the non-u.s. corporate subsidiary. 68 id. at 202-03 (describing two corporate subsidiaries that are formed in the united states-blackstone holdings i gp inc. and blackstone holdings ii gp inc.). 69 or, perhaps a disregarded entity owned by blackstone group l.p. could loan money to a corporate subsidiary, with the same tax effect as a direct loan from blackstone group l.p. see id. at 61 columbia journal of tax law [vol.6:147 160 received by blackstone group l.p. would be qualifying income and thus, would not jeopardize its ability to qualify for exemption from corporate tax treatment. 70 at the same time, the subsidiaries can deduct the interest when computing their taxable income, reducing the amount of non-qualifying income earned by the subsidiaries that is subject to corporate-level tax. 71 one of the corporate subsidiaries is formed outside of the united states and thus, is treated as a foreign corporation for u.s. tax purposes (like non-u.s. subsidiary in figure 1). 72 it appears that this subsidiary earns any non-qualifying income that is not u.s. source income and is not effectively connected with a u.s. trade or business. 73 as a result, the non-u.s. subsidiary is not subject to u.s. corporate-level tax on any of the income that it earns. 74 figures 2 and 3 below illustrate structures increasingly used by entities seeking reit classification. in particular, figure 2 depicts a structure used by reits that own and operate prisons, and figure 3 portrays a structure used by reits that own casinos. 75 figure 2 in the structure depicted in figure 2, the reit owns prison buildings and grants to government entities the right to use the prison buildings to house inmates. 76 in exchange, the government entities pay the reit a fee calculated on a per-day, per-inmate basis. 77 in private letter rulings, the irs has ruled that this fee will be treated as rent from real property and, therefore, is qualifying income for purposes of both reit income tests. 78 in exchange for a fee paid by the government entities, the taxable reit (―the wholly-owned subsidiaries of the blackstone group l.p. will concurrently with the reorganization and may from time to time thereafter enter into intracompany lending arrangements with one another.‖). this statement may or may not refer to using debt to reduce corporate-level tax paid by the u.s. corporate subsidiaries. 70 i.r.c. § 7704(d)(1)(a) (defining qualifying income to generally include interest). 71 see i.r.c. § 163 (providing for an interest deduction). the ability to deduct interest would be subject to certain limitations. for example, if a corporate subsidiary were too thinly capitalized, some of the debt could be recast as equity for tax purposes. likewise, if blackstone group l.p. charged an interest rate that was higher than a market rate, the debt could be recast as equity for tax purposes. furthermore, section 163(j) could limit the amount of interest deductible by the corporate subsidiary if the owners of the blackstone group l.p. are not subject to tax on the interest. 72 blackstone s-1, supra note 59 at 204. 73 id. at 204 (―blackstone holdings v gp l.p. is taxable as a foreign corporation for u.s. federal income tax purposes. blackstone holdings v gp l.p. is expected to be operated so as not to produce eci. its income will not be subject to u.s. federal income tax to the extent it has a foreign source and is not treated as eci.‖). 74 id. 75 for additional discussion of these structures, see cauble & polsky, supra note 17. 76 plr 201320007. 77 id. 78 see, e.g., plr 201320007. reit taxable reit subsidiary prison 2015] taxing publicly traded entities 161 subsidiary (the ―trs‖) provides various services such as security, food services for inmates, medical and dental care for inmates, and inmate transportation. 79 the trs is taxed at an entity level on the income it earns, but it can earn income that would be nonqualifying income if earned directly by the reit without jeopardizing the reit‘s ability to pass the income tests. in order to ensure compliance with the reit qualification tests, the reit‘s interest in the trs cannot exceed 25 percent of the value of the reit‘s assets. 80 figure 3 in the case of a reit that owns a casino, as portrayed in figure 3, the reit owns a casino building and leases the building to a non-reit (an unrelated company). 81 the non-reit operates the casino and pays the reit rent that is in part fixed and in part based on revenues earned from operating the casino. the rent received by the reit is qualifying income. 82 leasing the casino to an entity that is unrelated to the reit ensures that the payments under the lease are treated as rent for purposes of the reit income tests, because amounts paid by lessees that are related to a reit are not treated as rent, unless certain requirements are met. 83 following a spin-off of its copper and fiber-optic lines into a separate, publicly traded reit, a structure similar to that shown in figure 3 will be used by windstream holdings, inc. (a publicly traded telecom company). 84 the reit will lease the assets back to windstream so that it can continue to use them in its operations. virtually any company that holds significant real estate assets could use a similar approach. in summary, publicly traded entities increasingly use elaborate tax structuring techniques to obtain classification as exempt publicly traded partnerships or reits. 79 id. in some cases, the charge for services is not separately stated, so the government pays the entire amount to the reit, and the reit pays the trs a fee for providing the services. 80 i.r.c. § 856(c)(4)(b)(ii). 81 this structure is similar to the structure used by penn national gaming inc. after engaging in a spin-off. for a description of the spin-off and the private letter ruling obtained by penn national gaming inc., see robert willens, analyzing penn national gaming’s groundbreaking irs ruling, 2013 tax notes today 239-10 (sept. 16, 2013). 82 rent from real property does not include an amount that depends on the income or profit derived from property by any person; however, an amount will not be excluded from rent solely because it is based on a fixed percentage or percentages of receipts or sales. i.r.c. § 856(d)(2)(a). furthermore, penn national gaming received a private letter ruling stating that the amount paid by the non-reit would be treated as rent from real property. see willens, supra note 81. 83 see i.r.c. § 856(d)(2)(b) (setting forth the general rule that payments from related persons are not treated as rent); i.r.c. § 856(d)(5) (providing that constructive ownership rules will apply when determining whether a person is related to a reit); i.r.c. § 856(d)(8) (describing limited circumstances in which amounts received from a related person can be treated as rent). 84 for additional discussion of this transaction, see, e.g., thomas gryta & ryan knutson, windstream cleared to cut taxes by forming a reit; irs allows firm to classify its phone lines as real estate, wall street journal online (july 30, 2014). reit unrelated non-reit casino building rent lease columbia journal of tax law [vol.6:147 162 although the structuring techniques used vary from case to case, they have a common theme. in order to maintain the entity‘s desired classification, the entity does not directly earn any non-qualifying income, but instead this income is earned by a corporate subsidiary or by an unrelated corporation. iii. potential justifications for current taxation of publicly traded entities as described above, recent years have witnessed an expansion of the universe of publicly traded entities that employ tax structuring techniques in order to benefit from special tax treatment traditionally reserved for entities that earn predominately qualifying income. this trend has not gone unnoticed. the popular press, the irs, and members of congress have each given the matter attention, sometimes calling for reforms that would halt the current expansion or otherwise limit the ability of publicly traded entities to escape corporate tax treatment. 85 in order to place the recent trends in context and evaluate the wisdom of enacting reform, this section will examine potential rationales for the current state of the law. in particular, this section will first address the question of why publicly traded entities are generally subject to corporate tax treatment. next, this section will discuss rationales that might justify granting special tax treatment to publicly traded entities that earn predominately qualifying income. a. why public trading? fundamentally, explaining why publicly traded entities are generally subject to corporate level tax is a difficult task because there is no consensus regarding why the corporate tax system exists at all or why only some business entities are subject to it. 86 indeed, legal scholars, economists, and others have long advocated for reform to the corporate tax system that would integrate the entity-level tax and the tax that applies to shareholders, eliminating the double tax system. 87 however, starting with the premise that, as a practical matter, the corporate tax system will continue to exist and that only some business entities will be subject to it, some scholars have explained the establishment of public trading as the boundary between business entities that must be subject to the corporate tax system and other business entities by noting that taxpayers have a difficult time avoiding the public trading boundary. 88 85 see supra notes 3-12 and accompanying text. 86 see, e.g., sullivan, supra note 12 (―what should be the dividing line between businesses subject to corporate tax and those that should be exempt? that's not an easy question given that there is no economic justification for the corporate tax in the first place.‖). 87 a discussion of the arguments in favor of corporate tax integration is beyond the scope of this article. for some discussion of this topic, see, e.g., joseph m. dodge, a combined mark-to-market and pass-through corporate-shareholder integration proposal, 50 tax l. rev. 265, 269 (1995); r. glenn hubbard, corporate tax integration: a view from the treasury department, 7 j. econ. persp . 115, 117-19 (1993); charles e. mclure, integration of the personal and corporate income taxes: the missing element in recent tax reform proposals, 88 harv. l. rev. 532, 540-41 (1975); alvin warren, the relation and integration of individual and corporate income taxes, 94 harv. l. rev. 719, 725 (1981). 88 see, e.g., calvin h. johnson, replace the corporate tax with a market capitalization tax, 117 tax notes 1082, 1084 (2007); fleischer, supra note 12 at 107 (―searching for a coherent normative justification for taxing publicly traded entities as corporations is not a satisfying endeavor. . . . when congress enacted the ptp rules in 1987, it concluded that ptps that conduct an active business look enough like corporations to be treated as such for tax purposes. broadly speaking, the rules tend to operate under a benefit theory: in exchange for accessing public equity markets, one must pay a corporate-level tax on profits. because the normative case for having a corporate tax at all is rather weak, the line drawing in this 2015] taxing publicly traded entities 163 taxpayers cannot easily avoid the public trading boundary because the demand for public trading is based on strong non-tax considerations. thus, entities may be unlikely to forgo public trading in order to avoid entity-level tax. 89 entities that are publicly traded tend to be businesses that benefit from economies of scale, so that large businesses have an advantage over small businesses. 90 large businesses benefit from widely dispersed equity ownership, and widely dispersed equity owners of large businesses benefit from liquidity. widely dispersed equity ownership is necessary to raise the amount of capital required by a large business, assuming that any given shareholder does not want to invest a large amount. any given shareholder will want to hold a diverse pool of investments and therefore will not want to invest a large amount in any given company. 91 further, widely dispersed equity owners of large businesses benefit from liquidity because, being unable to effectively monitor business decisions made by a large business in which they own a small stake, equity owners demand the security afforded by the ability to easily exit the business by selling their shares. 92 in addition, liquidity helps equity holders maintain a diverse portfolio, because liquidity allows an equity holder to easily rebalance his or her portfolio if changes in the share price of one corporation results in the company representing an undesirably large portion of the equity holder's overall portfolio. 93 because equity holders have strong non-tax reasons to demand liquidity, entities cannot easily abandon public trading in order to avoid corporate tax treatment. selecting a feature as a trigger for imposing corporate tax, like public trading, which is difficult to forgo potentially serves two underlying goals. first, the corporate tax system will raise more tax revenue if taxpayers cannot easily avoid it. indeed, fear that taxpayers would conduct businesses through entities treated as partnerships for tax purposes rather than corporations, leading to erosion of the corporate tax base, was the primary reason why congress enacted legislation providing that publicly traded partnerships are generally area tends to be pragmatic, not principled.‖); david a. weisbach, line drawing, doctrine, and efficiency in the tax law, 84 cornell l. rev. 1627, 1629-30 (1999) (―the check-the-box regulations eliminated the four-factor test and moved the line between partnerships and corporations to public trading. . . . the argument for abandoning the four-factor test is that it was enormously inefficient. it merely caused people to shift their organizational structures without collecting any tax. the check-the-box regulations try to draw a line--public trading--that is more difficult to avoid. because fewer taxpayers will change their behavior to avoid the new line, it is potentially more efficient. . . . regardless of the merits of this argument (a subject that will be explored in greater depth below), what is important about the check-the-box regulations is that they drop traditional doctrinal concerns and instead focus on efficiency.‖). 89 see, e.g., rebecca s. rudnick, who should pay the corporate tax in a flat tax world?, 39 case w. res. l. rev. 965, 986 (1989) (―it is the value of liquid equity as perceived by the market that justifies a double tax. liquidity attracts investors who value the exit rights or the financial strategies that can be pursued with liquid equity ownership.‖); id. at 1103-06 (discussing value of liquidity to shareholders). 90 see, e.g., anthony p. polito, advancing to corporate tax integration: a laissez-faire approach, 55 s.c. l. rev. 1, 19-20 (2003). 91 see, e.g., jane g. gravelle & laurence j. kotlikoff, the incidence and efficiency costs of corporate taxation when corporate and noncorporate firms produce the same good, 97 j. pol. econ. 749, 757 (1989) (―[g]iven that some enterprises are large, why should they have more than a very small number of owners? the answer here appears to involve a number of factors: diversification of risk, the desire to limit liability, information costs of becoming fully informed about all the activities of a large enterprise, and liquidity.‖). 92 see, e.g., rudnick, supra note 89 at 1121-22 (explaining that a market for liquid shares helps owners to monitor managers more effectively). 93 see, e.g., rudnick, supra note 89 at 986, 1103-06, 1114-15. columbia journal of tax law [vol.6:147 164 treated as corporations for tax purposes. 94 second, selecting public trading as the boundary for the corporate tax system may distort taxpayers‘ decisions less significantly than selecting a boundary that is easier to avoid, which could improve the efficiency of the tax system. 95 however, selecting public trading as the boundary does not necessarily lessen the extent to which the tax system distorts taxpayers‘ decision making. on the one hand, because entities have strong non-tax reasons to maintain liquidity for their owners, they are unlikely to relinquish public trading in order to avoid corporate tax. on the other hand, if an entity does forgo public trading, the change in that entity‘s behavior will be quite drastic. thus, the public trading line is less likely to cause distortions than a more easily avoided line, but when it does cause distortions, those distortions will be more severe. 96 in summary, if some but not all business entities will be subject to corporate tax, some test must be selected to sort between entities that will and will not be subject to corporate tax. adopting public trading as the test may be justified on the grounds that taxpayers have strong non-tax reasons to demand public trading. therefore, taxpayers cannot easily circumvent the test. 97 b. why qualifying income? as discussed above, congress opted to impose the corporate tax system on publicly traded entities; however, congress provided exceptions for certain publicly traded entities that predominately earn qualifying income. 98 for instance, special treatment is bestowed upon exempt publicly traded partnerships and reits, and, in order to obtain classification as an exempt publicly traded partnership or a reit, an entity must predominately earn certain types of qualifying income. 99 94 see h.r. rep . no. 100-391, pt. 2, at 1065 (1987) (―the recent proliferation of publicly traded partnerships has come to the committee's attention. the growth in such partnerships has caused concern about long-term erosion of the corporate tax base. to the extent that activities would otherwise be conducted in corporate form, and earnings would be subject to two levels of tax (at the corporate and shareholder levels), the growth of publicly traded partnerships engaged in such activities tends to jeopardize the corporate tax base.‖). 95 see, e.g., weisbach, supra note 88 at 1630 (―the check-the-box regulations try to draw a line-public trading--that is more difficult to avoid. because fewer taxpayers will change their behavior to avoid the new line, it is potentially more efficient.‖). 96 see, also, weisbach, supra note 88 at 1669–70 (―[w]e cannot simply interpret the models as suggesting that lines in the tax law should be made harder to avoid. a line can be too hard to avoid, at least from an efficiency perspective. this can happen because there are two components in the deadweight loss triangles (or marginal deadweight loss trapezoids): the width (reflecting elasticity) and the height (reflecting the size of the tax). taxing a low-elasticity item too high is not optimal. we can think of these dimensions as the number of taxpayers that shift their behavior (the width) and the social cost (loss of consumer surplus) for each shift (the height). if a line is too hard to avoid, there may be few shifts, but each shift will have a large cost.‖). 97 imposing the corporate tax system on publicly traded entities has also been justified on the grounds that applying a pass-through tax regime to publicly traded entities would be too difficult. see, e.g., h.r. rep . no. 100-391 (1987) (―[b]ecause of the trading in interests, these partnerships present unique administrative difficulties and enforcement concerns if the tax law relating to partnerships is applied to them. the partnership tax rules under present law contemplate an entity in which the identity of the investors is known and transfers of interests are easily identifiable, and public trading in partnership interests does not conform to this model.‖). for further discussion of this concern, see, e.g., karen c. burke, passthrough entities: the missing element in business tax reform, 40 pepp . l. rev. 1329, 1342–43 (2013). 98 see supra parts ii.a. and ii.b. 99 see supra parts ii.a. and ii.b. 2015] taxing publicly traded entities 165 justifying the special treatment afforded to entities that predominately earn qualifying income is a challenging exercise. as others have observed, given the lack of a convincing justification for the corporate tax system, we should not be particularly surprised by the lack of a clear rationale for the rules governing when it applies. 100 the difficulty of rationalizing the exceptions for entities that mainly earn qualifying income is further exacerbated by the fact that there is no consistent definition of qualifying income that applies for all purposes--for instance, income that is qualifying for purposes of the exempt publicly traded partnership rules may not be qualifying for purposes of the reit rules and vice versa. 101 furthermore, in some cases, the special tax treatment granted to certain publicly traded entities may merely represent unprincipled giveaways to politically powerful interest groups. for instance, recently proposed reforms that would have narrowed the scope of the exempt publicly traded partnership rules nevertheless maintained an exception for publicly traded entities that predominately earned income related to mining and natural resources. 102 along similar lines, perhaps reflective of the lack of a principled policy justification, the house report that accompanied the adoption of the exempt publicly traded partnership rules explained exceptions for certain types of income as rooted merely in tradition. in particular, the report stated: [c]ertain types of natural resources and rental real estate activities have commonly or typically been conducted in partnership form, and the committee considers that disruption of present practices in such activities is currently inadvisable due to general economic conditions in these industries. the committee does not intend to treat tax benefits from such activities more favorably than under present law, but at the same time considers it inappropriate to subject net income from such activities to the two-level corporate tax regime to the extent the activities are conducted in forms that permit a single level of tax under present law. 103 100 see, e.g., fleischer, supra note 12, at 111 (―blackstone's strongest argument is to push for a principled distinction between firms that are subject to the corporate tax and firms that are not. it can argue that the exceptions swallow the rule. oil and gas and other natural resources firms often qualify as ptps despite conducting some active business activities. the policy rationale is unclear . . . . similarly, many real estate firms operate without paying a corporate-level tax, either through the ptp rules (which allow certain rental activities to qualify as passive income) or the reit rules. congress created a special rule for reits, § 856(i)(1), which allows them to ‗cleanse‘ small amounts of ‗bad‘ income through a taxable reit subsidiary, much like the blocker entity in the flow-through structure. insurance companies, cooperatives, and other industry groups have their own methods of managing corporate tax liability. why not blackstone? there is no normatively satisfying answer to this question.‖); george k. yin, the future taxation of private business firms, 4 fla. tax rev. 141 (1999) (―the nature-of-income limitations for rics, reits, remics, fasits, and publicly traded partnerships may simply be part of the tax law's condition for permitting such publicly traded entities to obtain pass-through treatment . . . . because there is no consensus regarding why the income of public firms should be taxed twice, it is not surprising that the exact nature of these restrictions cannot be explained from first principles. instead, one might simply conclude that a limitation may be needed in order to maintain the integrity of the double tax system as applied to public firms, whether such a system can be justified or not.‖). 101 willard b. taylor, “blockers,” “stoppers,” and the entity classifications rules, 64 tax law. 1 (2010) (suggesting the development of a single definition of qualifying income for reits, ptps and other purposes); willard b. taylor & diana l. wollman, why can’t we all just get along: finding consistent solutions to the treatment of derivatives and other problems, 53 tax law. 95 (1999) (containing further discussion regarding the idea of a unified definition of qualifying income). 102 see supra note 11 and accompanying text. 103 h.r. rep . no. 100-391, pt. 2, at 1066 (1987). the report does not articulate this concern in terms of mere tradition but instead describes continued favorable treatment of publicly traded entities in columbia journal of tax law [vol.6:147 166 although many of the exceptionally beneficial tax rules governing particular publicly traded entities may be based merely on political considerations, legislative history also suggests three potential policy justifications for granting special tax treatment to entities that earn predominately qualifying income. ultimately, though the existing rules are a poor fit for each of the three justifications, and more accurately targeted rules could better serve the goals articulated by legislative history. regarding the first justification, the house report that accompanied the adoption of the exempt publicly traded partnership rules mentions that dividend income is treated as qualifying income because dividend income is received from an entity treated as a corporation for tax purposes that may, itself, be subject to corporate-level tax. 104 thus, dividend income may be included on the list of types of qualifying income to prevent subjecting the same income to an additional level of tax. this rationale, however, is not a convincing explanation for the special tax treatment granted to publicly traded partnerships that predominately earn qualifying income. if the publicly traded entity receiving the dividend income were treated like a corporation for tax purposes, a more narrowly crafted rule could exempt the dividend income from an additional level of tax. in particular, in certain circumstances, internal revenue code section 243 allows a corporation that receives dividend income to deduct all or a portion of the dividend income when computing the recipient corporation‘s taxable income. 105 if congress wanted to entirely exempt dividend income from an additional level of tax, congress could modify section 243 so that, when it applied, the recipient corporation could take a deduction equal to the entire amount of dividend income that it received. 106 the existing rules regarding qualifying income, which encompass much more than dividend income, are an overly broad and, therefore, inaccurate mechanism for achieving the objective of exempting dividend income from an additional level of tax. regarding the second justification, the house report that accompanied the adoption of the exempt publicly traded partnership rules states: in general, the purpose of distinguishing between passive-type income and other income is to distinguish those partnerships that are engaged in activities commonly considered as essentially no more than investments, certain industries as necessary to avoid ―disruption of present practices‖ given general economic conditions. however, any change to tax law could have economic consequences for those affected by the change. thus, this concern could be raised in connection with any tax reform proposal. 104 id. at 1068 (―[t]he rationale for imposing an additional corporate-level tax on investments in publicly traded partnership form is less compelling, because . . . the income has already been subject to corporate-level tax, in the case of dividends. . . .‖). 105 i.r.c. § 243 (2012). furthermore, by contrast to the qualifying income rules, section 243 is more precisely targeted at the objective of preventing the imposition of an additional level of tax on dividend income paid by an entity that is subject to entity -level tax. first, section 243 is more precise because it is limited to dividend income and does not apply to other types of income (such as interest, rent, etc.) that have not already been taxed. second, not all dividend income is received from an entity that is, itself, subject to corporate-level tax, and restrictions on the dividends received deduction are intended to limit it to dividend income paid by an entity that is subject to tax. see, e.g., i.r.c. § 243(a) (―in the case of a corporation, there shall be allowed as a deduction an amount equal to the following percentages of the amount received as dividends from a domestic corporation which is subject to taxation under this chapter.‖). 106 currently, section 243 allows the recipient corporation to deduct 70 percent of the dividend income, unless the recipient corporation owns a large stake in the corporation from which the dividend income is received, in which case the recipient corporation can deduct a larger percentage of the dividend income, up to 100 percent in some cases. i.r.c. § 243 (2012). if congress wanted to entirely exempt dividend income from an additional level of tax, section 243 could be modified to expand the circumstances in which the recipient corporation can deduct 100 percent of the dividend income it receives. 2015] taxing publicly traded entities 167 and those activities more typically conducted in corporate form that are in the nature of active business activities. in the former case, the rationale for imposing an additional corporate-level tax on investments in publicly traded partnership form is less compelling, because purchasers of such partnership interests could in most cases independently acquire such investments. 107 this statement suggests that qualifying income ought to include only passivetype income that owners of the publicly traded partnership could earn directly, rather than indirectly by purchasing interests in a publicly traded entity. granting special tax treatment to qualifying income for this reason may be based on the notion that, if the owners did earn the income directly, it would not be subject to corporate-level tax. therefore, according to this rationale, it should not be subject to corporate-level tax when the owners earn it indirectly through a publicly-traded entity. 108 this rationale may be convincing in the case of income that owners of the publicly traded entity could, in fact, earn directly. however, the current definition of ―qualifying income‖ is much broader than what this rationale warrants because it includes many types of income that owners of an entity could not earn directly, as discussed in more detail below. 109 the legislative history accompanying the adoption of the reit rules suggests a third rationale that may explain granting more beneficial tax treatment to certain publicly traded entities. in particular, the legislative history suggests that congress wanted to provide small investors with an avenue to invest in real estate without holding the real estate through an entity that was subject to corporate-level tax. 110 given that an individual who is not particularly wealthy can afford to own only a small interest in real estate, such an individual can only invest in real estate through a publicly traded entity. thus, without the special reit provisions, such an individual could only invest in real estate through an entity that was subject to entity-level tax. by contrast, a wealthy individual who can afford to own a large stake in real estate could invest, along with a small number of other wealthy individuals, in a real-estate-owning entity treated as a partnership for tax purposes. the reit provisions result in greater parity between the tax treatment of partnerships that own real estate (a vehicle that is functionally available to only the very wealthy) and publicly traded entities that own real estate (a vehicle that is accessible to individuals other than the very wealthy). this rationale, however, is only convincing if individuals of modest means do, in fact, invest in publicly traded reits to a significant extent, which is doubtful. 111 107 h.r. rep . no. 100-391, pt. 2, at 1068 (1987). 108 more precisely, given the manner in which the rules are implemented, the income is not subject to corporate tax when earned indirectly through a publicly traded entity as long as the entity earns primarily qualifying income. 109 see infra part iv.a. 110 h.r. rep . no. 2020, 86th cong., 2d sess. 3 (1960) (―[r]eal estate investment trusts . . . constitute pooling arrangements whereby small investors can secure advantages normally available only to those with larger resources. these advantages include the spreading of the risk of loss by the greater diversification of investment which can be secured through the pooling arrangements; the opportunity to secure the benefits of expert investment counsel; and the means of collectively financing projects which the investors could not undertake singly.‖). for more detailed discussion of the debate surrounding the adoption of the reit rules, see bradley t. borden, reit reform alternatives. 111 this is particularly doubtful because, to the extent that ordinary individuals hold investments in publicly traded reits, they likely do so through pension plans or other tax-exempt vehicles. thus, if the reit were treated like a regular corporation for tax purposes, only one level of tax would be incurred currently--the entity-level tax. a tax-exempt investor, like a pension plan, would generally not be subject to columbia journal of tax law [vol.6:147 168 furthermore, the objective of offering more tax-favorable investment opportunities to individuals of modest means would be better served by reform targeted at such individuals. for instance, introducing more graduated tax rates on capital gain income would do more to assist individuals of modest means than granting special tax treatment to reits, particularly given that many wealthy investors avail themselves of the tax benefits of the reit vehicle. thus, despite statements in the legislative history about providing more equal access to tax-favored investments in real estate, the reit rules, in reality, seem to do a poor job of achieving equality for investors with modest resources but a much better job of simply favoring the real estate industry. 112 in summary, it is not entirely clear why publicly traded entities that earn predominately qualifying income receive more favorable tax treatment than other publicly traded entities. the political influence of certain industries doubtlessly provides part of the explanation. 113 some rationales offered by legislative history would be better served by more precisely targeted measures. for instance, concerns about subjecting dividend income to an additional level of tax could be addressed, and to some extent already are addressed, by provisions limited to dividend income. likewise, the reit rules are a very imprecise mechanism for providing tax-favored investment opportunities to individuals of modest means. one potential rationale remains – the notion that corporate-level tax should not be imposed upon income that owners of the publicly traded entity could earn directly. this rationale may have merit. however, it would be better served by differently designed rules, as proposed in part v below. iv. troubling aspects of current taxation of publicly traded entities as discussed above in part ii, although most publicly traded entities are subject to the corporate tax system, current law grants special treatment to publicly traded entities that earn predominately qualifying income. the potential policy justifications for this special treatment were explored in part iii, leading to the conclusion that only one potentially convincing explanation exists--the idea that corporate-level tax should not be imposed on income that owners of the publicly traded entity could earn directly. given this analysis, there are several troubling features of the current taxation regime applicable to publicly traded entities. first, the current definition of qualifying income is far too broad—it includes much income that owners of a publicly traded entity could not earn directly. second, current law grants special treatment to all income earned by a publicly traded entity if and only if the entity earns predominately qualifying income. under the publicly traded partnership rules, for instance, if at least 90 percent of a publicly traded partnership‘s gross income consists of qualifying income, the partnership may obtain classification as an exempt publicly traded partnership so that it avoids entity-level tax on all of its income. by contrast, if only 89.99 percent of the publicly traded partnership‘s gross income was qualifying income, the same partnership would be subject tax as a result of receiving distributions from the corporation or selling stock in the corporation. see supra note 23. thus, at the time the income is earned and distributed by the publicly traded entity, the ordinary individual‘s investment through a pension plan into a corporation leads to one level of tax, and one level of tax would also be incurred if a wealthy individual held real estate through a partnership. 112 see also, morgenson, supra note 2 (―an expanding reit universe may not seem that troubling. but it is a prime example of what‘s so bad about our tax code: special rules that favor certain taxpayers over others.‖). 113 see supra notes 102-103 and accompanying text. 2015] taxing publicly traded entities 169 to entity-level tax on all of its income. thus, the current rules result in what is sometimes called a ―cliff effect‖ in that small non-tax changes can result in drastic tax changes. 114 this cliff effect is problematic because it causes the tax treatment of publicly traded entities to be somewhat arbitrary, and this arbitrary treatment encourages wasteful tax planning. third, as discussed above, publicly traded entities are increasingly engaging in sophisticated tax planning strategies in order to qualify as exempt publicly traded partnerships or reits. this has transpired because the current tax rules are easily manipulated, and, thus, they invite wasteful, elaborate tax structuring. each of these problematic features of current law is discussed in more detail below. a. overly broad definition of qualifying income as discussed above, the only convincing justification articulated by legislative history suggests that qualifying income ought to include only income that owners of the publicly traded entity could earn directly. the current definition of ―qualifying income‖ is much more expansive than what is warranted by this justification. 115 in particular, in many cases, the current definition mischaracterizes as ―qualifying income‖ items that could not be earned by the owners of a publicly traded entity directly. to illustrate the overly broad nature of the current definition of qualifying income, consider the income earned by blackstone group l.p. as discussed above, the blackstone firm is a firm that sponsors various hedge funds, private equity funds, and real estate funds. 116 in exchange, the blackstone firm receives management fees and carried interest (a percentage of the profits earned by each fund). blackstone group l.p. is a publicly traded partnership that is entitled to receive a portion of the management fees and carried interest earned by the blackstone firm. 117 some of the carried interest is classified as qualifying income under the current, overly broad definition of that term, despite the fact that owners of blackstone group l.p. could not earn the income directly. 118 when a private equity fund sponsored by the blackstone firm acquires a portfolio company, the blackstone firm‘s management will often dedicate much time and effort to making decisions about how the portfolio 114 for criticism of cliff effects in tax generally, see lily l. batchelder, what should society expect from heirs? the case for a comprehensive inheritance tax, 63 tax l. rev. 1, 91 n.303 (2009); karen c. burke & grayson m.p. mccouch, death without taxes?, 20 va. tax rev. 499, 531 (2001); glenn e. coven, taxing corporate acquisitions: a proposal for mandatory uniform rules, 44 tax l. rev. 145, 174-75 (1989); deborah l. paul, the taxation of distressed debt investments: taking stock , 64 tax law. 37, 40 (2010); clinton g. wallace, the case for tradable tax credits, 8 n.y.u. j.l. & bus. 227, 234 (2011); lawrence zelenak, doing something about marriage penalties: a guide for the perplexed, 54 tax l. rev. 1, 59 (2000); lawrence zelenak, taxing gains at death, 46 vand. l. rev. 361, 416-17 (1993). for further discussion of gradual versus discontinuous rules, see, e.g., andrew blair-stanek, tax in the cathedral: property rules, liability rules, and tax, 99 va. l. rev. 1169 (2013). 115 for additional discussion of the overly broad nature of the definition of ―qualifying income‖ in the publicly traded partnership context, see, cauble, supra note 15. for ease of discussion, i refer to one definition of ―qualifying income‖ in the text. in reality, there are multiple definitions as the term is defined in the publicly traded partnership context in a different way from the manner in which it is defined in the reit context. 116 see supra note 59 and accompanying text. 117 see supra notes 60–61 and accompanying text. 118 see also fleischer, supra note 12, at 109–10 (―public investors cannot independently acquire a general partnership investment in a blackstone fund or a share in blackstone‘s deal advisory or restructuring business. this indicates that blackstone is not merely acting as a conduit, but rather is conducting active business activities.‖). columbia journal of tax law [vol.6:147 170 company should be restructured in order to increase the return the fund can earn from selling the company. 119 there is no reason to believe that the owners of blackstone group l.p. would have the ability or the inclination to devote similar time and efforts on their own. therefore, the owners of blackstone group l.p. could not earn, directly, the carried interest generated from sale of the portfolio company. even if we disregard the blackstone firm‘s management‘s active involvement in restructuring a portfolio company, it is also true that funds sponsored by the blackstone firm can acquire non-publicly traded assets that require large investments, such as ownership interests in privately held portfolio companies. owners of blackstone group l.p. could not have acquired these non-publicly traded assets directly given that they, individually, invest only small amounts. therefore, owners of blackstone group l.p. could not directly earn the carried interest attributable to sale of a privately held portfolio company. finally, even in the case of any carried interest that may be attributable to a fund‘s sale of publicly traded stock, owners of blackstone group l.p. could not have earned the carried interest directly. if the underlying stock is publicly traded, owners of blackstone group l.p. could acquire a direct interest in the underlying stock. however, carried interest represents the blackstone firm‘s entitlement to profits earned by a fund that are not attributable to the blackstone firm‘s capital investment. therefore, an owner of blackstone group l.p. could not simply purchase a small interest in the underlying publicly traded stock owned by a fund in order to mimic the economic consequences of holding, indirectly, a share of a profit‘s interest in the fund. purchasing a small interest in the underlying stock would allow the individual to earn the profits generated by the stock, but holding a direct interest in the underlying stock would also expose the individual to the risk of losing the capital invested unlike holding a right to carried interest generated from sale of the stock. stated differently, although owners of blackstone group l.p. could, directly, acquire an interest in the underlying publicly-traded stock owned by a fund sponsored by the blackstone firm, they could not directly acquire a share of the blackstone firm‘s right to carried interest, which is the asset that they, in fact, own indirectly through blackstone group l.p. 120 blackstone group l.p. and other publicly traded partnerships in the same industry are not the only publicly traded entities earning income that is classified as qualifying income despite the fact that owners of the entity could not earn the income directly. rather, blackstone group l.p. and similar publicly traded partnerships merely represent the most recent wave of publicly traded entities that benefit from the overly broad definition of qualifying income. many, more traditional publicly traded entities also avail themselves of the advantages of the qualifying income definition‘s excessive scope. for example, publicly traded partnerships that earn income from energy-related operations and mining engage in activities characterized by economies of scale. thus, these publicly traded partnerships invest in assets that require large capital outlays--assets 119 for further discussion of active involvement by private equity fund sponsors, see, e.g., steven m. rosenthal, private equity is a business: sun capital and beyond, 140 tax notes 1459 (2013). 120 see also cauble, supra note 15, at n.46; fleischer, supra note 12, at 109–10 (―public investors cannot independently acquire a general partnership investment in a blackstone fund or a share in blackstone‘s deal advisory or restructuring business. this indicates that blackstone is not merely acting as a conduit, but rather is conducting active business activities.‖). 2015] taxing publicly traded entities 171 that owners of the publicly traded partnership could not acquire directly. 121 likewise, publicly traded partnerships that invest in real estate and reits use their vast resources to acquire ownership interests in real estate that owners of the publicly traded entity could not acquire directly. b. arbitrariness even if the definition of qualifying income were properly limited to include only the types of income that owners of a publicly traded entity could earn directly, the current rules are flawed in another respect. in particular, as discussed above, the current design of the rules governing publicly traded entities results in a cliff effect--a small change in the amount of non-qualifying income earned by a publicly traded entity can result in a large change to the entity‘s tax consequences. thus, for instance, if 90 percent of a publicly traded partnership‘s gross income is qualifying income, the partnership receives very different tax treatment than an otherwise identical partnership that earns slightly less qualifying income. if a publicly traded entity earns $100 million in taxable income, for instance, a slight change in the percentage of qualifying income earned by the entity could make the difference between the entity owing $35 million or $0 in entity-level tax, assuming a 35% corporate tax rate. mandating that extreme tax changes follow from minor non-tax changes results in arbitrariness, 122 and this arbitrariness is problematic because it undermines any underlying goals that the tax rules might serve. 123 whatever policy goals might have 121 the legislative history surrounding the adoption of the publicly traded partnership rules seems to acknowledge that the special treatment granted to energy and mining partnerships cannot be justified based on the principle that owners could earn the income directly. the legislative history explains the treatment of these partnerships as, instead, based merely on tradition. see supra note 103 and accompanying text. this explanation, however, is not satisfactory as a policy matter. 122 one might argue that treating a publicly traded entity differently from a non-publicly traded entity is also arbitrary. to some extent, this may be true. however, as discussed above, public trading is a significant feature for non-tax reasons. see supra part iii.a. therefore, there are significant non-tax differences between an entity that is publicly traded and one that is not. 123 rules that create cliff effects might also be criticized for distorting taxpayers‘ decisions. consider, for instance, the following example. a publicly traded partnership has earned $899 of qualifying income and $100 of non-qualifying income in a given year. the partnership will earn one more dollar of income before the year closes. if the additional dollar is non-qualifying income, the partnership will not obtain classification as an exempt publicly traded partnership because less than 90 percent of its gross income will be qualifying income. if the additional dollar is qualifying income, then the partnership may obtain classification as an exempt publicly traded partnership, resulting in significant tax savings. assuming a tax rate of 35 percent and assuming that the partnership has no available deductions, classification as an exempt publicly traded partnership results in the partnership owing $0 in tax liability rather than $350 in tax liability. in this example, the partnership has a very strong tax motivation to earn one dollar of qualifying income rather than one dollar of non-qualifying income. this strong tax incentive could encourage the taxpayer to earn one dollar of qualifying income even when there are good non-tax reasons to engage, instead, in the activity that would generate non-qualifying income. although rules that produce cliff effects can distort taxpayers‘ decisions, it is not clear that gradual rules would distort decisions to a lesser extent overall. under a gradual rule that provides that all non-qualifying (and no qualifying income) is subject to entity-level tax, the decisions of a partnership under the facts of the example just described will be less subject to distortion than such decisions would be under current law. under current law, the taxpayer incurs $350 of tax liability by earning one dollar of non-qualifying income so tax consequences almost certainly will dissuade the taxpayer from engaging in the activity that generates that income. by contrast, under a gradual rule, the taxpayer would only incur an additional thirty -five cents of tax liability and thus might still undertake the activity despite the tax consequences. however, compared to current law, a gradual rule could cause even greater distortions in the decisions of partnerships that earn well over 90 percent qualifying income, for example. under current law, such partnerships can earn one dollar of non-qualifying income or one dollar of qualifying income without incurring any entity -level tax. thus, tax consequences columbia journal of tax law [vol.6:147 172 prompted congress to grant special tax treatment to entities that earn predominately qualifying income, it is highly unlikely that these goals are best served by granting extremely different treatment to two entities when the only difference between the entities is that qualifying income represents 90 percent of the gross income of one entity but 89.99 percent of the gross income of the other entity. 124 hence, the goal of granting special treatment to income that owners of the publicly traded entity could earn directly would be served better by less arbitrary rules. even if qualifying income were defined appropriately to include only income that owners of the entity could earn directly, this justification suggests that qualifying income earned by any publicly traded entity ought to be exempt from the corporate tax system regardless of the amount of qualifying income earned by the publicly traded entity. consider, for instance, a publicly traded entity that earns interest income from investing in u.s. treasury securities--income that owners of the entity could earn directly because they have ready access to the u.s. treasury securities through the public markets. the fact that the owners of the entity could earn this income directly becomes no more true if the income is earned by a publicly traded entity that earns mainly qualifying income rather than by a publicly traded entity that earns mainly active business income. publicly traded partnerships that earn income that is close to the 90 percent threshold likely will be sufficiently sophisticated to monitor the amounts of income earned to ensure that the 90 percent test is met. furthermore, if a publicly traded entity earns qualifying income in an amount large enough to justify the structuring costs, it can earn the non-qualifying income through a corporate subsidiary or unrelated corporation so that its qualifying income escapes corporate-level tax. for instance, if a publicly traded entity earns 60 percent qualifying income and 40 percent non-qualifying income, it can set up a corporate subsidiary through which it will funnel the non-qualifying income so that its qualifying income can maintain exemption from corporate-level tax, similar to the structure used by the new wave of exempt publicly traded partnerships discussed above. 125 therefore, the arbitrariness of the rules ultimately might not affect the tax consequences experienced by publicly traded entities. 126 however, the arbitrariness is problematic because it induces taxpayers to engage in costly tax planning to exempt qualifying income from corporate-level tax. 127 the tax planning could be costly for a will not distort the decision between the two types of income. under a gradual rule, such partnerships could earn one dollar of qualifying income without incurring any entity -level tax but would incur thirty-five cents of entity-level tax as a result of earning one dollar non-qualifying income. thus, as compared to current law, a gradual rule could cause greater distortions in the decisions made by partnerships with well over (or well under) 90 percent qualifying income. for a similar discussion, see david a. weisbach, formalism in the tax law, 66 u. chi. l. rev. 860, 873–74 (1999). 124 it could be that congress adopted a 90 percent threshold for reasons of administrative convenience. as discussed below, additional complexity would arise under a system in which qualifying income is always subject to one level of tax while non-qualifying income earned by a publicly traded entity is subject to two levels of tax. see infra part v.b.1. 125 see supra part ii.c. 126 furthermore, if a publicly traded partnership did miss the 90 percent threshold by a narrow margin, as a practical matter, the publicly traded partnership nevertheless might not face corporate tax treatment because the irs might not enforce the tax consequences mandated by i.r.c. § 7704. for discussion of the irs‘s unwillingness to enforce the harsh consequences mandated by tax rules that cause cliff effects, see andrew blair-stanek, tax in the cathedral: property rules, liability rules, and tax, 99 va. law rev. 1169, 1205–06 (2013). 127 for further discussion of the wastefulness of tax planning, see, e.g., david a. weisbach, ten truths about tax shelters, 55 tax l. rev. 215, 222-25 (2002). for discussion of this concern in the context of the tax structuring utilized by publicly traded partnerships to channel their non-qualifying income through 2015] taxing publicly traded entities 173 variety of reasons. for instance, there may be cases in which a publicly traded entity could function more efficiently if one entity handled both the operations that generate qualifying income and those that generate non-qualifying income. in order to achieve favorable tax consequences, however, the entity must sacrifice some operational efficiency to ensure that the non-qualifying income is earned by a subsidiary corporation or an unrelated corporation. c. manipulability under current law, the tax treatment of a publicly traded entity depends critically on whether the entity earns predominately qualifying income. if the entity is willing to engage in elaborate tax structuring, the amounts of qualifying and non-qualifying income earned by the entity are often within its control because the entity can convert nonqualifying income into qualifying income by earning the income through a subsidiary corporation, or the non-qualifying income could be earned by an unrelated corporation. thus, the current test is easy to manipulate as long as the entity engages in tax structuring. 128 the arbitrariness and manipulability of the current rules work hand in hand to encourage elaborate, potentially costly tax structuring. the arbitrariness of the rules provides the incentive for the tax structuring, and the manipulability of the rules enables it. v. proposed reforms as discussed above, only one potentially convincing justification explains why more favorable tax treatment is bestowed upon publicly traded entities that earn predominately qualifying income -namely, the notion that corporate-level tax should not be imposed on income that owners of the publicly traded entity could earn directly. given this justification, the current definition of qualifying income is far too broad -it includes much income that owners of a publicly traded entity could not earn directly. therefore, congress should amend the definition of ―qualifying income‖ to provide that income that would otherwise be classified as qualifying is no longer classified in that manner unless it is earned by holding an asset that was publicly traded during the publicly traded entity‘s entire holding period for the asset. 129 furthermore, corporate subsidiaries, see, e.g., bradley t. borden, notable partnership articles from 2013, 143 tax notes 1513 (2014) (―others might be troubled by the structure because tax law appears to require a partnership to create a complicated ownership structure and jump through several unnecessary and inefficient hoops to obtain tax treatment that the law seems to condone.‖). 128 this is not, of course, the only context in which taxpayers utilize tax structuring. even some of the techniques used by publicly traded partnerships and reits are similar to techniques used in other contexts. for instance, just as a publicly traded partnership might earn non-qualifying income through a u.s. corporate subsidiary to convert the non-qualifying income into qualifying income, a tax-exempt organization might earn income that would otherwise be unrelated business taxable income through a blocker corporation to convert the income into capital gain income or dividend income. however, at least in the tax-exempt context, rules exist that limit the ability for the tax-exempt organization to loan funds to the subsidiary, charge the subsidiary interest that reduces the subsidiary‘s corporate tax liability, and earn interest income that the tax-exempt organization claims is not unrelated business taxable income. in particular, if a taxexempt organization receives a specified payment (defined to include any interest, annuity, royalty, or rent) from a controlled entity, the tax-exempt organization must treat the payment as unrelated business taxable income to the extent that the controlled entity can deduct the payment against income that would be unrelated business taxable income if earned by the tax exempt organization. i.r.c. § 512(b)(13) (2012). 129 for additional discussion of this proposal in the context of publicly traded p artnerships, see cauble, supra note 15. in the case of income allocated to a publicly traded entity from a partnership (or through several tiers of partnerships), whether or not the income is generated by holding a publicly traded columbia journal of tax law [vol.6:147 174 income earned because of a publicly traded entity‘s (or a subsidiary partnership‘s) right to carried interest should never be qualifying income. 130 restricting the definition of qualifying income in this manner would better align the definition of qualifying income with the goal of granting special treatment to income that owners of the publicly traded entity could earn directly. this is true because owners of the publicly traded entity could earn income directly only when the asset that generates the income is, itself, publicly traded and only if the income is not carried interest. 131 asset would be determined by looking to the asset held by the lowest tier partnership from which the income was allocated. 130 for discussion of this proposal in the context of the publicly traded partnership rules, see cauble, supra note 15 at n. 46. given that rights to receive carried interest are not publicly traded, this additional restriction might, at first, appear redundant once qualifying income is defined to exclude any income that is not earned by holding a publicly traded asset. however, the additional restriction is necessary given the manner in which carried interest is treated under current law. current law treats the right to receive carried interest from a partnership as a partnership interest. assume, for example, that the blackstone firm sponsored a hedge fund that earned capital gains from a sale of publicly traded stock, and the blackstone firm received, as part of its carried interest, a share of those gains. as a result, blackstone group l.p. could earn capital gains income from a sale of the underlying publicly traded stock that was allocated to it through several tiers of partnerships. the lowest tier partnership from which the income was allocated would be the hedge fund itself, and the asset held by the hedge fund that generated the gains would be publicly traded stock. thus, if the definition of qualifying income included capital gains earned from sale of a publicly traded asset, this income would constitute qualifying income even under the revised definition, given that, in the case of income allocated to a publicly traded entity from a partnership (or through several tiers of partnerships), whether or not the income was generated by holding a publicly traded asset would be determined by looking to the asset held by the lowest tier partnership from which the income was allocated. see supra note 129. thus, to ensure that this income is not treated as qualifying income, the definition of qualifying income should be further restricted by providing that income earned because of a publicly traded entity‘s (or a subsidiary partnership‘s) right to carried interest can never be qualifying income. 131 even when an asset is publicly traded, if the publicly traded entity holds a diversified pool of investments, an owner of the publicly traded entity could not, without incurring significant transaction costs, achieve the same level of diversification through direct acquisition of interests in the underlying assets. thus, even a publicly traded entity that owned publicly traded assets would still allow its owners to achieve something they could not achieve, as easily, through direct ownership. in this way, a publicly traded entity that invests primarily in liquid securities serves a function similar to the purpose served by many regulated investment companies (―rics‖). it is also true that, even if an asset is publicly traded, owners of the publicly traded entity might lack the financial expertise to engage in the same investment strategies used by the entity, without obtaining potentially prohibitively costly expert advice. the same could be said of investors in rics, and rics obtain exemption from entity -level tax. thus, in these two ways (allowing less costly diversification and allowing owners to benefit from the financial expertise of a shared adviser), publicly traded entities that invest primarily in liquid securities allow their investors to earn income that they could not, as a practical matter, earn directly. nevertheless, publicly traded entities that invest primarily in liquid assets ought to receive exemption from corporate-level tax for at least two reasons. first, some practical limitations on the owners‘ ability to earn the same income directly can be ignored in order to develop an administrable test of what can constitute qualifying income. second, publicly traded entities that allow owners to hold a diversified pool of investments in liquid securities provide their owners with a cost -effective way to diversify their investment portfolios. providing a means of easy diversification is a worthwhile policy objective that warrants exemption from corporate-level tax even if, once every practical factor is considered, the owners could not earn the income directly. it could be argued that reits serve the same funct ion of allowing diversification and that this function justifies their special tax treatment. however, the current reit rules do not require that an entity hold a diversified pool of real estate assets in order to qualify as a reit. there are some requirements that ensure that a reit does not hold an overly concentrated share of its assets in certain securities. see i.r.c. §§ 856(c)(4)(b)(i)-(iii) (2012). however, there are no comparable requirements related to a reit‘s real estate holdings. as an alternative to adopting the reforms proposed by this article that would effectively preclude publicly traded entities from qualifying as reits, the reit rules could be reformed to better ensure that they serve the purpose of facilitating diversification. for instance, 2015] taxing publicly traded entities 175 stated differently, unless the underlying asset owned by a publicly traded entity is, itself, publicly traded, individuals who invest small amounts in the publicly traded entity lack the financial resources to obtain a direct interest in the underlying asset and, therefore, lack the ability to directly earn the resulting income. likewise, individuals who invest small amounts in a publicly traded partnership that is entitled to a portion of the carried interest earned by a private equity fund sponsor are not able to acquire, directly, rights to carried interest. restricting the definition of qualifying income in the manner proposed by this article is also consistent with the idea that corporate tax is imposed on publicly traded entities because taxpayers, for non-tax reasons, cannot easily relinquish public trading given that liquidity has value. 132 in particular, if a publicly traded entity earns income from holding a publicly traded asset, then the publicly traded entity does not add any value by providing liquidity with respect to that asset; owners of the publicly traded entity can already hold liquid interests in the asset directly. if the publicly traded entity were subject to entity-level tax on income earned from holding such an asset, owners of the publicly traded entity could avoid the entity-level tax by simply holding the asset directly. in other words, because the entity is not providing liquidity in any meaningful sense, its owners might hold direct interests in its underlying assets in order to avoid corporate-level tax. by contrast, if a publicly traded entity earns income from holding a non-publicly traded asset, then the entity is adding value by providing liquidity that could not already be obtained by holding the asset directly. in that case, imposing entity-level tax upon the entity would be less likely to induce its owners to no longer hold interests in the entity. adopting the proposed, restricted definition of qualifying income would cause a loss of exemption from the corporate tax system for many publicly traded entities. 133 for instance, publicly traded partnerships that earn income primarily from energy-related activities, mining, or real estate would no longer qualify for exemption fr om corporatelevel tax. in addition, most entities that are currently designated as reits could no longer qualify for reit treatment. furthermore, the new definition of qualifying income would have significant effects on publicly traded partnerships like blackstone group l.p., as discussed in more detail in part v.a. better aligning the definition of qualifying income with underlying policy goals addresses one of the troubling aspects of the current tax rules applicable to publicly traded entities--the overly broad scope of the current definition of qualifying income. 134 this part will proceed by demonstrating that the proposed revision to the definition of qualifying income would also address an additional troubling aspect of the current state of the law by making the rules less susceptible to manipulation by taxpayers. finally, this part will conclude with an analysis of whether additional reform should be instituted to make the rules less arbitrary. reits could be subject to a diversification requirement. furthermore, some of the recent expansions in the definitions of what constitutes qualifying income for reit purposes could be reversed. 132 for further discussion, see supra notes 88-96 and accompanying text. 133 indeed, given that this proposal potentially allows so few publicly traded entities to maintain exemption from corporate-level tax, administrative convenience might weigh in favor of simply providing that all publicly traded entities are subject to corporate-level tax unless they qualify for exemption under the ric rules or other regimes. any entities that would have continued to receive exemption from corporatelevel tax under the new definition could, perhaps, instead be covered by the ric rules (or, more accurately, a modified version of the ric rules that would accommodate the entities). 134 for discussion of this problem, see supra part iv.a. columbia journal of tax law [vol.6:147 176 a. the proposed reforms better guard against easy manipulation by taxpayers under current law, if an entity is willing to engage in elaborate tax structuring, the amounts of qualifying and non-qualifying income earned by the entity are often within its control because the entity can convert non-qualifying income into qualifying income by earning the income through a subsidiary corporation, or an unrelated corporation could earn non-qualifying income. this technique is exemplified by the structure used by blackstone group l.p., discussed above. 135 under the revised definition of qualifying income, taxpayer manipulation would be less likely. consider the case of blackstone group l.p. under the revised definition, all of the carried interest earned by blackstone group l.p. would become non-qualifying income. once all of its income is non-qualifying income, blackstone group l.p. can no longer benefit from the tax structuring currently used. 136 consider, instead, the case of a publicly traded partnership that invests in publicly traded securities and privately placed debt or equity securities. under current law, this entity can obtain exemption from corporate-level tax. under the proposed reforms, the income earned from privately placed debt or equity securities becomes nonqualifying income. 137 if this income is more than an insignificant portion of the entity‘s income, the entity will become subject to corporate-level tax. 138 135 see supra part ii.c. 136 it is worth noting that the proposed reforms would affect the current owners of blackstone group l.p. and not the principals of the blackstone firm who sold their rights to carried interest and management fees in the initial public offering. however, the proposed reforms would also prevent similar private equity firms from benefiting from the use of similar structures in connection with future public offerings. 137 capital gains from sale of stock in privately held portfolio companies would be non-qualifying income even if the gain was recognized by taking the portfolio company public. for the income to constitute qualifying income, the asset generating the income must have been publicly traded during the publicly traded entity‘s entire holding period. this requirement is warranted because only when this requirement is met could owners of the publicly traded entity have made the same investment and earned the same gains directly. 138 this result is justified because the entity is providing its owners with liquid access to otherwise illiquid assets. in addition, given that many of its assets are not publicly traded, owners of the entity who may, individually, invest small amounts could not earn the income directly. therefore, imposition of corporate-level tax is warranted. imposing corporate-level tax in the case of equity securities becomes potentially problematic only if they represent equity interests in entities treated as corporations for tax purposes so that imposing the tax raises the possibility of subjecting the same income to corporate-level tax more than once. this concern, however, is better addressed by means other than treating the income as qualifying income. after all, treating the income as qualify ing income does nothing to address the concern unless the entity earning the income earns primarily qualifying income, which will not always be the case. other means of addressing this concern could include, in the case of dividend income, a tool such as the dividends received deduction in i.r.c. § 243. if congress wanted to entirely exempt dividend income from an additional level of tax, i.r.c. § 243 could be modified to expand the circumstances in which the recipient corporation can deduct 100 percent of the dividend income it receives as discussed above. see supra notes 105-106 and accompanying text. some income might also be subject to more than one level of corporate tax as a result of the publicly traded entity that is treated as a corporation earning capital gains from selling shares of corporate stock. it should be noted that this possibility exists under current law, and this article‘s proposal exacerbates the pre-existing problem only because it treats gains from sale of stock in a privately held corporation as non-qualifying income. most entities that are privately held need not be treated as corporations for tax purposes, at least if they are organized as unincorporated entities. therefore, if the publicly traded entity that holds stock in the privately held company is treated as a corporation for tax purposes, any additional duplicative corporate-level tax resulting from this proposal‘s change to the definition of qualifying income could be avoided by treating the privately held company as a partnership for tax purposes. there may be reasons why the other owners of the company want to form it as an incorporated 2015] taxing publicly traded entities 177 a publicly traded partnership that invested in publicly traded securities and privately placed securities might attempt to manipulate income classification by funneling non-qualifying income through corporate subsidiaries, using a structure similar to that used currently by some exempt publicly traded partnerships, shown above in figure 1. however, doing so would not achieve the results obtained by these exempt publicly traded partnerships under current law. in particular, under the revised definition of qualifying income, dividend income and capital gains income earned as a result of receiving distributions from the non-publicly traded corporate subsidiaries (like u.s. subsidiary and non-u.s. subsidiary in figure 1) would become non-qualifying income. 139 in addition, if the publicly traded partnership earned interest income paid on debt issued entirely to it by a corporate subsidiary (like u.s. subsidiary in figure 1), the interest would not be interest on publicly traded debt, and, therefore, would be nonqualifying income under the new definition. the revised definition would not, of course, put an end to all tax planning. however, it would put an end to some of the aspects of the current structuring that are the most troubling. following adoption of the revised definition of qualifying income, a publicly traded partnership that invested in publicly traded securities and privately placed debt or equity securities might use a different structure. in particular, rather than forming one publicly traded partnership that owned publicly traded assets and privately held assets, taxpayers might form and offer interests in two entities. the first entity, a publicly traded partnership, would earn income from publicly traded assets. as a result, the first entity could maintain exemption from corporate tax treatment even under the new definition of qualifying income. the second entity would own privately placed debt and equity securities, and, as a result, the second entity would not obtain exemption from mandatory corporate tax treatment and would be subject to corporate-level tax on all of its income. in order to reduce its tax liability, this second entity might issue debt to the public so that it incurred deductible interest expense. to some extent, the tax consequences resulting from formation of these two entities would mimic the result achieved by the structuring available under current law (funneling non-qualifying income through corporate subsidiaries, along the lines of what is done by some exempt publicly traded partnerships as shown in figure 1). however, results of the new structure are importantly different in two respects. first, under current law, more income constitutes qualifying income and therefore escapes corporate-level tax, due to the overly broad current definition of qualifying income. for instance, capital gains income, dividend income, and interest income earned from privately placed debt and equity securities are classified as qualifying income under current law but as nonqualifying income under the proposed reforms. second, in the structure used following adoption of the proposed reforms, the debt issued by the entity that earns non-qualifying income is issued to the public, whereas, in the structure currently used, a publicly traded entity or want to hold interests in an entity treated as a corporation for tax purposes. their goals could still be achieved. in particular, an incorporated entity owned by the other owners of the business could form an entity treated as a partnership for tax purposes that owned and operated the business. the incorporated entity and the publicly traded entity treated as a corporation for tax purposes could own interests in this operating partnership. through this structure, the other owners of the business achieve their goal of investing through an incorporated entity treated like a corporation for tax purposes, and income that is earned by the publicly traded entity treated as a corporation for tax purposes is not subject to more than one level of corporate tax. 139 assuming that the income earned through any non-u.s. corporate subsidiary is not subpart f income, the publicly traded entity could, nevertheless, defer paying tax on the income until the subsidiary made distributions to it. columbia journal of tax law [vol.6:147 178 entity, like the publicly traded partnership in figure 1, may hold debt that is issued by its wholly-owned corporate subsidiary. in the revised structure in which the debt is publicly traded, market forces ensure that a market rate of interest dictates the interest paid on the debt, and thus, the interest expense deducted by the corporation. this is not the case with debt issued to a publicly traded entity by its wholly-owned subsidiary. 140 b. should the rules also be made less arbitrary? as proposed above, the definition of qualifying income should be modified so that income is only qualifying income if it would constitute qualifying income under current law and it is earned by holding a publicly traded asset. furthermore, carried interest should never constitute qualifying income. this reform better aligns the definition of qualifying income with the goal of granting special treatment to income that the owners of a publicly traded entity could earn directly. in addition the revised definition would be less susceptible to taxpayer manipulation. if, however, tax law continued to grant special treatment to all income earned by a publicly traded entity if and only if the entity earned predominately qualifying income (within the meaning of the new definition), then tax law would still result in arbitrary consequences. a small change in the amount of non-qualifying income earned by a publicly traded entity could still cause a drastic change in the entity‘s tax consequences. to make the results less arbitrary, tax law could instead grant special tax treatment to only qualifying income earned by a publicly traded entity, but the special treatment would apply regardless of whether the entity earned predominately qualifying income. 141 this section will explore how such a system might be implemented. the discussion reveals that the complexity of the system likely warrants maintaining the current regime under which beneficial treatment applies to all income earned by a publicly traded entity if and only if the entity earns predominately qualifying income, provided that the scope of what may be classified as qualifying income is narrowed in the manner proposed by this article. 140 under current law, if the debt is issued entirely to the publicly traded partnership and if the rate of interest is higher than a market rate on debt, the irs could re-characterize the debt as equity and disallow an interest deduction. achieving that result, however, requires the irs rather than the market to take action. furthermore, to ensure that the debt must truly be publicly traded in order for interest to constitute qualifying income, anti-abuse rules could be adopted in connection with the new definition of qualifying income that provided, for instance, that an asset would not be treated as publicly traded unless the asset was widely held. 141 under current law, publicly traded entities that earn more than a small amount of non-qualifying income are not the only types of entities that are automatically treated as corporations for tax purposes. see treas. regs. §§ 301.7701-2(b)(1), (3)–(8) (describing entities that must be treated as corporations). the extent to which the reform considered in this part v.b would affect the taxation of existing entities would depend, in part, on whether other modifications were made to the list of entities automatically treated as corporations for tax purposes (and on whether the reform considered in part v.b would apply to these entities). for instance, under current law, an entity is automatically treated as a corporation for tax purposes if it is organized under a federal or state statute that describes or refers to the entity as incorporated or as a corporation, body corporate, or body politic. see treas. reg. §§ 301.7701-2(b)(1). if this continued to be the case and if all income earned by such entities was subject to the corporate tax system, then many existing entities would be subject to the current corporate tax system notwithstanding implementation of the reform considered in part v.b. for the reform considered in part v.b to have broader effects, incorporated entities could be removed from the list of entities automatically treated as corporations for tax purposes so that income earned by an incorporated entity would be subject to double tax only if the entity was publicly traded and only if the income was non-qualifying. 2015] taxing publicly traded entities 179 1. how to implement an alternative regime a system that subjected all qualifying income earned by a publicly traded entity to one level of tax and all non-qualifying income earned by a publicly traded entity to two levels of tax could be implemented in at least three different ways. 142 none of the three methods is simple. under the first method, any qualifying income earned by the entity would be taxed under a pass-through regime (so that the entity itself would not be subject to tax on the income but the owners of the entity would be taxed on the income directly) while any non-qualifying income would be taxed under a corporate tax regime (so that the income would be taxed at the entity level and the owner level). the design of the first method is not completely unprecedented. in the context of u.s. tax rules applicable to non-u.s. corporations, for instance, a similar design is employed. in particular, if a non-u.s. corporation is a ―controlled foreign corporation,‖ some, but not all, of the corporation‘s income will be taxed under a pass-through regime. 143 therefore, existing rules could be used as a baseline for designing new rules in the publicly traded entity context. however, the controlled foreign corporation rules only apply in a situation in which the ownership of a corporation is fairly concentrated in the hands of a small number of owners. 144 this makes application of the rules mechanically simpler in the context in which they are currently used, compared to a context in which an entity is widely held and its ownership changes frequently. under the second method, a publicly traded entity would be subject to entitylevel tax on all of its income. however, the publicly traded entity would be entitled to a deduction for dividends paid but only to the extent that the dividends were attributable to qualifying income earned by the entity. under the third method, a publicly traded entity would be subject to entity-level tax on all of its income. however, the owners of the publicly traded entity would be exempt from tax on dividends paid, but only to the extent that the dividends were attributable to qualifying income. under either the second or third method, in order to determine the extent to which a dividend was attributable to qualifying income or non-qualifying income, the new regime might assume that the amount of the dividend paid from qualifying income would equal the same proportion of the entity‘s income that was qualifying income over some period of time. alternatively, the new regime might assume that qualifying (or non-qualifying) income was always distributed first. any of the three methods would involve significant mechanical complexity. furthermore, even though large publicly traded entities might be well equipped for handling mechanical complexity, the new regime‘s complexity would also burden the irs given that it would need to monitor for compliance with the new rules. 145 142 the choice among these three different methods is not trivial. for instance, the tax consequences for non-u.s. investors or tax-exempt investors that hold interests in the publicly traded entity could vary depending on which method was utilized. 143 any u.s. shareholder in the corporation pays tax under a pass-through regime with respect to any subpart f income earned by the corporation. see i.r.c. § 951 (2007). 144 see id.; i.r.c. § 957 (2004). 145 furthermore, if each publicly traded entity would continue to have the ability to elect to be treated as a corporation for tax purposes, and if this election continued to result in the entity paying corporate-level tax on all of its income, the availability of this election would address taxpayer complaints and alleviate taxpayer concerns about complexity because taxpayers who judged the mechanics of the new columbia journal of tax law [vol.6:147 180 given the complexity of the new regime, it should not be adopted. first, it is unclear that the new regime would eliminate the negative effects of arbitrariness, and second, limiting the scope of the definition of qualifying income, as proposed by this article, ameliorates, to some degree, the negative effects of arbitrariness, even if special treatment is only granted to qualifying income if an entity earns primarily qualifying income. each of these two observations is discussed in more detail below. 2. the new regime would not necessarily eliminate the negative effects of arbitrariness as discussed above, because publicly traded entities are sophisticated, the main negative consequence of granting special treatment to qualifying income only when an entity earns primarily qualifying income is that the regime induces entities to engage in costly, wasteful tax planning. for instance, an entity might sacrifice operational efficiency by implementing a structure in which all non-qualifying income was earned by an unrelated entity so that the entity‘s qualifying income could obtain exemption from corporate-level tax. even if congress adopted a new regime under which beneficial treatment was always bestowed upon qualifying income, regardless of whether an entity earned more than insubstantial amounts of non-qualifying income, taxpayers could still have some incentive to earn non-qualifying income through a separate corporation, depending on how the regime was implemented. for instance, earning non-qualifying income through a separate corporation could ensure that, when the corporation issued debt to the public and incurred interest expense, the interest expense would be deducted from non-qualifying income only. if qualifying and non-qualifying income were earned by the same entity, some of the tax benefit of any interest expense might be lost if the entity deducted some of it from qualifying income. 146 3. the new definition of qualifying income partially mitigates the negative effects of arbitrariness as discussed above, beneficial treatment is only bestowed upon qualifying income once the amount of qualifying income earned by a publicly traded entity crosses an arbitrary threshold. in the context of rules that affect sophisticated taxpayers, the primary negative effect of this arbitrary feature may be the fact that it encourages taxpayers to engage in wasteful tax planning. however, even if this arbitrary feature remains, narrowing the scope of qualifying income as proposed by this article may address the concern about wasteful tax planning in two ways. first, as discussed in part v.a, under the new definition of qualifying income, taxpayers will have a more difficult time manipulating the characterization of income as qualifying income or non-qualifying regime to be too onerous could opt for treatment under existing law. the availability of the elect ion would not, however, alleviate complexity faced by the irs when monitoring compliance with the new regime. 146 whether this would occur would depend, in part, on how the new regime was implemented. furthermore, other mechanical aspects of the new regime could affect whether taxpayers continued to have an incentive to segregate qualifying income from non-qualifying income. for instance, assume the regime was implemented by using either the second or the third method described above in part v.b.1. further, assume that the amount of any dividend paid from qualifying income was determined either by considering the proportion of the entity‘s income that was qualifying income over some period of time or by assuming that non-qualifying income was always distributed first. in addition, assume that a taxpayer intends to currently distribute its qualifying income but may retain its non-qualifying income for some period of time. given those assumptions, earning exclusively qualifying income through one entity would have tax benefits. in particular, it would ensure that all dividends paid by that entity were treated as attributable to qualifying income so that all dividends received favorable tax treatment. 2015] taxing publicly traded entities 181 income. therefore, some of the existing avenues for engaging in wasteful tax planning will be available no longer. second, once the scope of what constitutes qualifying income is narrowed, it may be the case that fewer publicly traded entities earn sufficient amounts of qualifying income to justify the costs they would incur to engage in tax structuring. in summary, the complexity inherent in an alternative system as well as the fact that an alternative system might not eliminate the incentives to engage in tax planning likely warrant maintaining the current regime under which benef icial treatment applies to all income earned by a publicly traded entity if and only if the entity earns predominately qualifying income. this is particularly true because, if the scope of what may be classified as qualifying income is narrowed in the manner proposed by this article, the rules will become less susceptible to manipulation. under current law, the arbitrariness and manipulability of the applicable rules work hand in hand to encourage elaborate, wasteful tax structuring. the arbitrariness of the rules provides the incentive for the tax structuring, and the manipulability of the rules enables it. by making the rules less susceptible to manipulation, the adoption of a narrower definition of qualifying income would prevent taxpayers from engaging in wasteful tax structuring, even if the arbitrariness of the rules still provides some incentive to engage in such tax structuring. vi. conclusion under current law, publicly traded entities are generally subject to the corporate tax system unless they earn predominately qualifying income, in which case all of their income is exempt from corporate-level tax. the only convincing policy justification for granting special treatment to qualifying income suggests that qualifying income should include only income that owners of the publicly traded entity could earn directly. yet, the current definition of qualifying income grants special treatment to much income that owners of a publicly traded entity could not earn directly. this system is difficult to justify on policy grounds and invites taxpayers to engage in elaborate tax structuring in order to transform non-qualifying income into qualifying income. to address these problems, this article proposes that income that is classified as qualifying income under current law should not be classified in that manner unless it is earned by holding a publicly traded asset. in addition, carried interest should not constitute qualifying income. note a new theory of taxpayer standing james r. parks  abstract flast v. cohen, decided by the supreme court in 1968, articulated a narrow exception to the general rule that merely being a taxpayer does not provide the necessary standing to challenge an expenditure of government funds alleged to violate the constitution. since the time of flast, the court has steadily narrowed the exception, retreating from the underlying rationale of the flast decision—a trend most recently observable in the court’s decision in arizona school tuition organization v. winn. this note proposes a new test for taxpayer standing which aims to preserve the doctrine, while remedying some its ills. under this note’s proposed test, taxpayer standing is appropriate when the following three factors are met: (1) the taxpayer’s status as a taxpayer bears a reasonable relationship to the challenged expenditure of government funds in question; (2) it is of practical necessity because the political system is structurally ill-equipped to provide a remedy for those who object to a particular expenditure of government funds alleged to violate the constitution, or the taxpayer is a member of the class for whom the especial benefit of a constitutional limitation is intended to directly run; and (3) where no other plausible party has standing to challenge the alleged violation, leaving it functionally irremediable.  columbia law school j.d. candidate 2015. i would like to thank my faculty adviser, professor philip hamburger for his help, and allyson mackavage for inspiring this note. 2014] a new theory of taxpayer standing 119 i. introduction .................................................................................................... 120 ii. background ...................................................................................................... 120 a. early cases and flast v. cohen ......................................................................... 122 b. hein, winn, and the development of the flast exception ................................. 123 iii. the problem ...................................................................................................... 128 a. no taxpayer standing ....................................................................................... 128 b. unacknowledged jurisdictional defects ............................................................ 129 c. unavailability of other remedies ..................................................................... 131 iv. solution .............................................................................................................. 131 a. why have taxpayer standing at all? .............................................................. 131 b. non-justiciability ............................................................................................... 134 c. an analogy to ultra vires corporate actions .................................................. 136 d. a new theory of taxpayer standing ................................................................ 137 1. reasonable relationship to challenged expenditure ................................. 137 2. political remedy ......................................................................................... 139 3. functional irremediability .......................................................................... 141 4. applying the whole test .............................................................................. 142 e. shortcomings of the test ................................................................................... 145 v. conclusion ........................................................................................................ 145 120 columbia journal of tax law [vol.6:118 i. introduction since flast v. cohen, the supreme court has held open a narrow exception to the general rule of standing that merely being a taxpayer is insufficient grounds to invoke the judicial power to challenge an expenditure of government funds alleged to violate the constitution. 1 the test articulated in flast is that the taxpayer-plaintiff must show two things in order to merit standing. “first, the taxpayer must establish a logical link between that status and the type of legislative enactment attacked,” and “[s]econdly, the taxpayer must establish a nexus between that status and the precise nature of the constitutional infringement alleged.” 2 since that case, however, the supreme court has made a steady retreat from the underlying rationale of the flast decision by narrowing the scope of the exception, most recently in arizona school tuition organization v. winn. 3 some members of the court (justices scalia and thomas) would repudiate the decision in flast altogether and completely deny taxpayer standing. 4 my note focuses on a new theory of taxpayer standing that remedies the ills of the flast doctrine without resorting to the extreme remedy suggested by justices scalia and thomas. under this theory, taxpayer standing, which is to say, standing arising solely out of a plaintiff’s status as a taxpayer, is appropriate where: (1) the taxpayer’s status as a taxpayer bears a reasonable relationship to the expenditure of government funds in question; (2) it is of practical necessity because the political system is structurally ill-equipped to provide a remedy for those who object to a particular expenditure of government funds alleged to violate the constitution, or the taxpayer is a member of the class for whom the especial benefit of a constitutional limitation is intended to directly run; and,(3) where no other plausible party has standing to challenge the alleged violation, leaving it functionally irremediable. part ii of this note discusses the current jurisprudence on taxpayer standing. part iii states the problem and explains why the current doctrine is problematic. part iv develops this new theory of taxpayer standing and demonstrates that it preserves the utility of the flast doctrine in making the guarantees of the constitution, especially the establishment clause, effective without falling prey to the same criticisms leveled against the flast line of cases. ii. background article iii, section 2, clause 1 of the constitution lays out the limits of the judicial branch in our constitutional system: 5 the judicial power shall extend to all cases, in law and equity, arising under this constitution, the laws of the united states, and treaties made, or which shall be made, under their authority;—to all cases affecting ambassadors, other public ministers and consuls;—to all cases of admiralty and maritime jurisdiction;—to controversies to which the united states shall be a party;—to controversies between two 1 392 u.s. 83 (1968). 2 id. at 102. 3 131 s. ct. 1436 (2011). 4 id. at 1449-50. 5 justiciability does not begin and end here, however. some limits on the judicial power are embedded in the notion of the relationship among the three branches of the federal government embodied in the constitution and are not readily found in the case or controversy clause—for example, the political question doctrine. 2014] a new theory of taxpayer standing 121 or more states;—between a state and citizens of another state;— between citizens of different states;—between citizens of the same state claiming lands under grants of different states, and between a state, or the citizens thereof, and foreign states, citizens or subjects. this clause has been named the case or controversy clause, and it has been read to impose the requirement that the judicial power of article iii courts is constitutionally limited to ‘cases’ and ‘controversies.’ chief justice warren characterized this clause as “limit[ing] the business of federal courts to questions presented in an adversary context and in a form historically viewed as capable of resolution through the judicial process,” and as assigning the judicial branch a particular role and scope in our tripartite system of governance so that it may not unduly interfere with the operations of the other branches of the federal government. 6 to ask whether an exercise of the power given to the judicial branch by our constitution is proper in a given context is to ask about its justiciability. justiciability, as chief justice warren writes, is “a concept of uncertain meaning and scope,” which lacks “fixed content,” is not “susceptible of scientific verification,” and is subject to “many subtle pressures” which tend to blur constitutional and policy considerations. 7 to ask whether a particular plaintiff has standing to bring a particular claim before an article iii court is one way of asking whether that particular claim, in relation to that particular plaintiff, is justiciable (although it is not to ask whether the underlying claim is justiciable, for although the party at hand may not be proper, others might be). standing is often regarded as a particularly thorny problem in the law, because it is affected by the “same vagaries that inhere in justiciability” and often serves as shorthand for all of the various elements of justiciability. 8 these difficulties notwithstanding, the supreme court has generally adhered to a relatively simple rule for standing, synthesized and expressed in lujan v. defenders of wildlife: the “irreducible constitutional minimum of standing contains three elements”: (1) “the plaintiff must have suffered an ‘injury in fact’ – an invasion of a legally protected interest which is (a) concrete and particularized . . . and (b) actual or imminent, not conjectural or hypothetical”; (2) “there must be a causal connection between the injury and the conduct complained of – the injury has to be ‘fairly. . . trace[able] to the challenged action of the defendant and not . . . th[e] result [of] the independent action of some third party not before the court’”; and (3) “it must be likely as opposed to merely speculative, that the injury will be redressed by a favorable decision” (internal quotations and citations omitted). 9 while this rule generally serves to sensibly cabin judicial power and limit the judiciary’s ability to pass judgment in a purely advisory way, on an issue that is moot or unripe, in litigation that is friendly, or in cases where the controversy is feigned or collusive in nature, it is also seemingly hostile to the idea of taxpayer standing qua taxpayer. strict 6 flast, 392 u.s. at 95. 7 id. 8 id. at 98. 9 lujan v. defenders of wildlife, 504 u.s. 555, 560-561 (1992). 122 columbia journal of tax law [vol.6:118 standing requirements may even leave some otherwise justiciable claims irremediable for want of a party who has standing. the phrase “taxpayer standing” will be used in this note to refer to the concept of standing to challenge an exercise of the congressional taxing and spending power arising solely out of the taxpayer’s status as a taxpayer. suits which rely upon a theory of taxpayer standing challenge the expenditure of state or federal funds that the taxpayer believes violate the constitution. this is not the only way in which taxpayers may have standing to challenge federal laws or actions, of course; taxpayers may, inter alia, contest their tax liability or directly challenge the constitutionality of the collection of a tax. 10 a. early cases and flast v. cohen the first modern case to grapple with the issue of taxpayer standing was frothingham v. mellon, decided in 1923. 11 in that case, frothingham attacked a law passed by congress, the maternity act, on the grounds that it was unconstitutional and would thus increase her tax burden without due process of law. 12 the court ruled that frothingham lacked standing to pursue the action on the theory that her interest in the moneys of the treasury was too minute, and the effect upon her future taxation as a result of the expenditure of these funds was too “remote, fluctuating, and uncertain,” to permit an appeal to the court. 13 they held that the case at bar was distinguishable from past precedents permitting a single taxpayer to “sue to enjoin an illegal use of the moneys of a municipal corporation” because the taxpayer’s interest there is “direct and immediate” and the injunction appropriate. 14 underpinning the ruling was the belief that the court did not possess the “power per se to review and annul acts of congress on the ground that they are unconstitutional.” 15 this belief made the fine distinction that what the court was actually doing in a case where the enforcement of a legal right conflicted with an unconstitutional law was enjoining the actions of the official, the statute notwithstanding, rather than holding the law itself unconstitutional. 16 putting aside the metaphysical complexities of the decision, the core ruling that merely being a taxpayer was always insufficient to challenge an act of congress was well established until the case of flast v. cohen in 1968. in flast, taxpayers sued to enjoin the expenditure of federal funds to purchase materials for parochial schools under the elementary and secondary education act of 1965 on the grounds that such expenditure was contrary to the establishment clause of the first amendment. 17 the court ruled that the taxpayers in this case had standing, overruling what was thought to be a broad prohibition on taxpayer standing from frothingham, relying primarily upon the unique nature of the establishment clause. 18 in the opinion of the court, chief justice warren noted that the decision in frothingham could be read to express either a constitutional prohibition on taxpayer suits or pragmatic considerations of judicial self-restraint. 19 given the reasons provided in frothingham, 10 follett v. town of mccormick, s.c., 321 u.s. 573 (1944). 11 262 u.s. 447 (1923). 12 id. 13 id. at 487. 14 id. at 486. 15 id. at 488. 16 id. 17 flast v. cohen, 392 u.s. 83, 85-87 (1968). 18 id. at 103-04. 19 id. at 92-93. 2014] a new theory of taxpayer standing 123 that the taxpayer interest was minute or remote, and that allowing the suit to continue would open the floodgates of litigation, the latter was the more sound reading. 20 the court found no general constitutional bar to taxpayer suits but laid out two factors, which must be satisfied for such suits to proceed to address the concerns expressed in frothingham. “first[ly], the taxpayer must establish a logical link between that status and the type of legislative enactment attacked,” and “[s]econdly, the taxpayer must establish a nexus between that status and the precise nature of the constitutional infringement alleged.” 21 the first arm of the test is to ensure that a taxpayer may only challenge the constitutionality of exercises of the taxing and spending clause. 22 therefore, taxpayers do not have standing to challenge incidental expenditures of funds ancillary to the administration of essentially regulatory statutes. 23 the second arm of the test demands that the taxpayer show that the challenged law exceeds a specific constitutional limitation put on the exercise of the taxing and spending power, not merely that the law is generally beyond the powers delegated to congress. 24 simply put, the taxpayer’s claim in these cases must be that his or her tax money was “extracted and spent in violation of specific constitutional protections against such abuses of legislative power.” 25 in flast, the supreme court held that the establishment clause of the first amendment specifically limited the taxing and spending power conferred on congress by article i, section 8. 26 in the majority opinion, chief justice warren stated that the taxpayers seemed to present the same issues of minuteness and remoteness as those in frothingham, but were nonetheless permitted to go on with their suit. this was based on the theory that the establishment clause is special insofar as it was intended to prohibit the expenditure of, to use james madison’s words, even “three pence” of personal taxpayer money to fund the establishment of a state religion, to favor one religion over another, or even to support religion in general. 27 although chief justice warren was careful to note that his decision did not foreclose the possibility of other specific limitations on the taxing and spending power being later announced, 28 his ruling and the concurrence by justice fortas, who doubted whether there were any other types of congressional expenditures which could be challenged by a litigant solely on the basis of being a taxpayer, 29 cemented the establishment clause as a special part of the constitution for the purpose of taxpayer standing. b. hein, winn, and the development of the flast exception in the time since flast, a number of rulings have been handed down which show a general retreat, holding that most taxpayer suits are barred for lack of standing in somewhat varying procedural postures. these cases include hein v. freedom from religion foundation, in which no standing was found where a taxpayer attempted to challenge federal executive actions funded by general appropriations; 30 and valley forge christian college v. americans united for separation of church and state, in which 20 id. at 93. 21 id. at 102-03. 22 u.s. const. art. i, § 8. 23 see flast, 392 u.s. at 103-05. 24 see id. at 104-05. 25 id. at 106. 26 see id. 27 id. at 104. 28 id. at 105. 29 id. at 115 (fortas, j., concurring). 30 551 u.s. 587 (2007). 124 columbia journal of tax law [vol.6:118 standing was also denied where a taxpayer attempted to challenge an agency decision to transfer federal land pursuant to the property clause. 31 scholarly commentary has been mixed on the influence of flast and the meaning of the subsequent case law. 32 specific limitations on the congressional power to tax and spend were not found in the statement and account clause 33 or the incompatibility clause. 34 in hein, the court held that federal expenditures by means of executive discretion to spend from a general congressional appropriation did not permit suits predicated upon taxpayer standing. 35 in the majority opinion, justice alito reasoned that when the challenged expenditures “were not expressly authorized or mandated by any specific congressional enactment,” the resulting “lawsuit is not directed at an exercise of congressional power . . . and thus lacks the requisite ‘logical nexus’ between taxpayer status ‘and the type of legislative enactment attacked.’” 36 this was distinguished from a previous case in which the court found a sufficient nexus between the taxpayer’s status as a taxpayer and a congressional exercise of the taxing and spending power when administrative disbursements were made pursuant to an agency’s particular statutory mandate. 37 the court declined to extend the holding in flast, which was focused solely upon congressional action, to discretionary executive branch expenditures or to government spending as a whole on the theory that flast was a “narrow exception” to the general bar on taxpayer standing which sensibly cabins taxpayer suits. 38 alito argues that the facts of hein make clear that the flast decision correctly prohibits taxpayers from challenging speeches, proclamations, and conferences which otherwise praise religion or the activity of religious people and organizations to prevent federal courts from “superintend[ing], at the behest of any federal taxpayer, the speeches, statements, and myriad daily activities of the president, his staff, and other executive branch officials,” or from turning the federal courts into “forums for taxpayers ‘generalized grievances’ about the conduct of government.” 39 finally, justice alito acknowledges that if the executive branch were to use the funds from a general appropriation to say, build a church or hire clergy, then this ruling does not preclude all potential challenges, as there is likely a party with standing to challenge the expenditure based upon more than mere taxpayer status. 40 justice kennedy, concurring in the decision, echoed justice alito’s concern that an expansion of flast to executive branch expenditures pursuant to general congressional appropriations would lead to undesirable “constant intrusion upon the 31 454 u.s. 464 (1982). 32 see note, taxpayer suits and the aggregation of claims: the vitiation of flast by snyder, 79 yale l.j. 1577, 1577 (arguing that snyder vitiates flast); joel fifield, no taxation without separation: the supreme court passes on an opportunity to end establishment clause exceptionalism: hein v. freedom from religion foundation, inc., 127 s. ct. 2533 (2007), 31 harv. j.l. & pub. pol’y 1195, 1207 (arguing that hein was a missed opportunity to unify taxpayer standing law); note, standing in the mud: hein v. freedom from religion foundation, inc., 42 akron l. rev. 1277, 1278 (arguing that the supreme court has continually provided “perplexing decisions in taxpayer standing cases”). 33 u.s. v. richardson, 418 u.s. 166 (1974). 34 schlesinger v. reservists comm. to stop the war, 418 u.s. 208 (1974). 35 hein, 551 u.s. at 608-09. 36 id. 37 id. at 606-08. 38 id. at 608-09. 39 id. at 611-12. 40 id. at 614. 2014] a new theory of taxpayer standing 125 executive realm.” 41 his concurrence adds the further insight that even where parties have no standing to sue, members of the legislative and executive branches “are not excused from making constitutional determinations in the regular course of their duties,” and they “must make a conscious decision to obey the constitution whether or not their acts can be challenged in a court of law and then must conform their actions to these principled determinations.” 42 justice scalia, concurring in the judgment, argues that the court has two choices in the present matter: (1) flast “should be applied (at minimum) to all challenges to the governmental expenditure of a general tax revenues in a manner alleged to violate a constitutional provision, specifically limiting the taxing and spending power”; or (2) “flast should be repudiated.” 43 justice scalia argues that flast should be repudiated because both the ‘wallet injury’ and ‘psychic injury’ theories do not work. sufficiently alleging a ‘wallet injury’ is infeasible because it would require satisfying the traceability and redressability prongs of the standing analysis by showing that the plaintiff’s tax bill would have been lower had the allegedly forbidden expenditure not been made and that the government will, “in response to an adverse court decision, lower taxes rather than spend the funds in some other manner.” 44 on the psychic injury, such a theory does not work because a “taxpayer’s purely psychological displeasure that his funds are being spent in an allegedly unlawful manner” cannot ever be “sufficiently concrete and particularized to support article iii standing.” 45 this is the case because taxpayers seeking relief that is not concrete and particularized by alleging only general grievances can only expect relief that “no more directly and tangibly benefits him than it does the public at large.” 46 these grievances, he argues, have their remedy in the political process, not through the courts. in his dissent, justice souter echoed justice scalia’s argument that there was no principled reason not to extend the flast decision, if it is good law, to executive branch expenditures. as the establishment clause applies just as equally to executive branch expenditures as it does to legislative exercises of the taxing and spending power, to permit executive branch use of appropriated funds to accomplish an unconstitutional end would mean that “establishment clause protection would melt away.” 47 where justice souter and justice scalia differ is on the issue of whether flast should be abandoned or maintained. justice souter argued that to deny standing because of the vagueness of the plaintiff’s injury in these cases would repudiate prior case law which held, for example, that “being forced to compete on an uneven playing field based on race (without showing that an economic loss resulted)” or “living in a racially gerrymandered electoral district” was sufficient for standing, even though these injuries were no more concrete than seeing one’s tax dollars spent on religion. 48 to deny standing in these cases, he implies, is to fail to grasp the subtleties of intangible harms and is to repudiate the sensible conclusion the 41 id. at 617 (kennedy, j., concurring). 42 id. at 618. 43 id. at 618 (scalia, j., concurring). 44 id. at 619. 45 id. at 633. 46 id. at 634. 47 id. at 640 (souter, j., dissenting). 48 id. at 642. 126 columbia journal of tax law [vol.6:118 court drew in flast: “[w]hen the government spends money for religious purposes a taxpayer’s injury is serious enough to be ‘judicially cognizable.’” 49 the most recent ruling on the matter came in arizona school tuition organization v. winn, 50 where the court held that taxpayers lacked standing to challenge a system of tax credits for contributions to school tuition organizations (stos), which provide scholarships for students attending private schools, many of which are religious. 51 taxpayers alleged that the system of sto tax credits violated the establishment clause of the first amendment (as applied to the states through the fourteenth amendment). in the opinion of the court, justice kennedy held that the taxpayers did not meet the conditions of the flast exception permitting standing. justice kennedy read flast to demand that money be extracted and spent in order for taxpayers to have standing, and that in the case of tax credits, a credit is not sufficiently like extraction and spending to justify use of the exception. additionally, justice kennedy argued that tax credits do not implicate individual taxpayers in sectarian activities. unlike flast (where a dissenting taxpayer knows that his or her money is being extracted and spent to contribute to an establishment in violation of his or her conscience) a tax credit does not extract and spend a conscientious dissenter’s funds in violation of the establishment clause or force a taxpayer to give up even three pence of his property for such a project. in the case of tax credits, the taxpayer lacks a sufficient connection between his or her status as a taxpayer and the injury because the causal connection between the dissenting taxpayer and the alleged establishment is nonexistent and any financial injury remains speculative. taxpayers here failed to give the necessary causal story of the injury. while the state makes stos possible, private citizens set up the stos and contribute to them, and the stos themselves decide where to allocate funds (and some stos are non-sectarian). in this way, private individuals make the choice to support religious institutions, rather than the government (it is not “fairly traceable to the government” 52 ). any injunction against the sto system would reduce the funding to the stos in question but would not affect tax liabilities of taxpayers who choose not to contribute to a religious sto. the injunction would, therefore, not redress the putative injury, and the plaintiffs would lack standing. justice kennedy reads cases since flast to have confirmed justice fortas’s statement that taxpayer standing should only be permitted in the case of the establishment clause. 53 although cases like winn reached the merits without being dismissed for lack of standing (including a previous incarnation of the winn case which went all the way up to the supreme court), justice kennedy argues that those cases do not mention standing, and therefore should not be taken to have anything material to say about standing, relying upon the proposition that “[w]hen a potential jurisdictional defect is neither noted nor discussed in a federal decision, the decision does not stand for the proposition that no defect existed.” 54 49 id. at 643 (quoting allen v. wright, 468 u.s. 737, 752 (1984)). 50 131 s. ct. 1436 (2011). 51 taxpayers may give $500 for individuals and $1000 for married couples to an sto of their choice and receive a tax credit. 96% of stos support parochial schools. id. at 1448. 52 winn, 131 s. ct. at 1448. 53 id. 54 id. at 1448-49; see infra part iii (b), for a fuller discussion of unacknowledged jurisdictional defects. 2014] a new theory of taxpayer standing 127 justice scalia, with whom justice thomas joined concurring in the opinion, argues that this whole line of jurisprudence is misconceived and that he would overrule flast thereby removing any exceptions permitting standing. the concurrence is scarcely a paragraph long, but justice scalia, in that space, argues that “[u]nder a principled reading of article iii, [the struggles the majority and dissent have in ruling] are unnecessary” because “flast is an anomaly in our jurisprudence, irreconcilable with the article iii restrictions on federal judicial power that our opinions have established.” 55 therefore, he would “repudiate that misguided decision and enforce the constitution.” 56 in her dissent, justice kagan argues that the majority is hopelessly formalistic to the point of reading the flast decision out of the law, at least for clever lawmakers. 57 the thrust of her argument is that, if flast is to be taken seriously, tax expenditures (tax credits, targeted tax breaks, and the like) cannot be treated any differently than appropriations because they are functionally the same. 58 different treatment in courts would permit a legislative body to easily switch between them to avoid an establishment clause challenge, allowing them to do an end-run around the flast decision. 59 justice kagan criticizes the central distinction the majority makes between “extraction and spending” and tax expenditure as relying upon a cherry-picked notion of what the flast decision purports to say. she argues that flast does not mean to say that taxpayers have to be able to directly trace any one particular tax dollar which they have paid to the government to an improper funding of religion in violation of the establishment clause in order to have standing to challenge the constitutionality of the expenditure. 60 rather, in her opinion, all a taxpayer must do is claim that the government has exercised the taxing and spending power in violation of the establishment clause. 61 the taxpayer need not directly trace any particular tax dollar that he or she has paid to the challenged disbursement because the evil that the establishment clause means to prevent has already happened – namely, that the taxing and spending power has been used to favor one religion over another, or to promote religion generally. justice kagan argues that the winn holding permitting the government to cloak their social agenda as a tax expenditure instead of an appropriation to avoid the threat of challenge from taxpayers is just as absurd as holding that a taxpayer would be barred from challenging an exercise of the taxing and spending power if the government agreed to not use that particular taxpayer’s dollars to fund religion. 62 in either scenario, the harm which the establishment clause meant to prevent has been accomplished because regardless of whose taxpayer money is spent, the government has used it to establish religion. 63 bolstering this argument is the historical point that the particular tax which james madison, the architect of the establishment clause, objected to so vehemently when he wrote memorial and remonstrance against religious assessments was exactly this sort of tax. 64 the tax at issue there allowed those objecting to government funding for religious schools to opt out and put their tax dollars into a fund 55 winn, 131 s. ct. at 1450 (scalia, j., concurring). 56 id. 57 id. at 1451 (kagan, j., dissenting). 58 id. at 1455. 59 id. at 1451. 60 id. at 1459. 61 id. at 1451. 62 id. at 1459. 63 id. 64 id. at 1461. 128 columbia journal of tax law [vol.6:118 the government would use to support non-religious county schools. 65 although the particulars may differ slightly between this case and that at issue in winn, the intuitive force of the analogy is strong. as was the case in madison’s time, in winn an individual objecting taxpayer’s money will not go to support a religious school, but the government is still using the tax system to establish religion. iii. the problem this section describes the premise of this note, namely, that taxpayer standing as a doctrine is constitutionally permissible but broken in its present form and therefore in need of a new formulation. part a outlines the contrary position that taxpayer standing should never be permitted. part b discusses previous taxpayer standing cases, which have been allowed to proceed to final judgment where jurisdictional defects were allowed to pass sub silentio. part c briefly outlines the result if taxpayer standing is wholly disallowed: that there may well be no remedy for aggrieved taxpayers in certain situations. a. no taxpayer standing some jurists and commentators believe that taxpayer standing is never permissible. 66 the consistent refrain from this camp has been that taxpayer standing is inconsistent with the constitutionally irreducible minimums that have been developed through the court’s article iii jurisprudence. 67 plaintiffs are thought, generally, to have two lines of argument when it comes to alleging an injury in these cases. first, they can allege that they have suffered real financial harm because their tax bill would actually be lower if the challenged conduct were to be enjoined. the supreme court has been quick to reject this argument as grasping and speculative because taxpayers have not been held to have a sufficiently large interest in the federal treasury to permit standing out of a concern for the fisc. 68 furthermore, the court has been skeptical that the government would lower taxes as a result of any judicial action, making the specific tax burden argument unworkable. 69 if the challenged conduct were to be enjoined, the government may create a different but similar program or may simply choose to spend the funds somewhere else. either way, it is highly speculative to say that the overall tax burden of any taxpayer would be lower. the court aptly makes these points in frothingham. 70 second, plaintiffs may allege a psychic injury arising out of a violation of the establishment clause (or other part of the constitution). 71 critics of taxpayer standing have argued that this injury is not concrete and particularized enough to justify standing (in that relief would not particularly benefit any one taxpayer any more than any other citizen), and that the taxpayer really only expresses a general grievance about the operation of government. 72 the argument goes that general grievances should not be resolved in the judiciary, but rather through the political process. 73 65 id. 66 see hein v. freedom from religion foundation, 551 u.s. 587, 618 (2007) (scalia, j., concurring) (repudiating taxpayer standing doctrine entirely). 67 id. 68 frothingham v. mellon, 262 u.s. 447, 487 (1923). 69 id. 70 id. 71 hein, 551 u.s. at 619. 72 id. at 593. 73 id. at 636. 2014] a new theory of taxpayer standing 129 many of the arguments for eliminating taxpayer standing, like much of the standing doctrine, blend constitutional and pragmatic concerns seldom differentiating one from the other. 74 insofar as a constitutional barrier is concerned, little attention has been given to the constitutional terms of “cases” and “controversies.” 75 this is not altogether surprising, as the limitations on standing contained in the constitution are broadly put and require a good deal of work to be defined. 76 given the vagueness of the constitution on this point, it is almost certainly true that the framers intended the judiciary to come up with a doctrine, perhaps grounded in the historical common-law, that attempts to outline the contours of a case or controversy such that law suits can be sensibly cabined. it is an open question whether courts should follow this implicit invitation and attempt to move beyond the words “case” or “controversy” to consider pragmatic concerns, or attempt to parse their “true” meaning through explication of the constitutional text. even if it is agreed that “case” or “controversy” should be the beginning and end points for standing, it is certainly not implausible to think that the constitutionally irreducible minimums that the court has identified for standing are implicit in the words “case” or “controversy” themselves, such that weighing pragmatic and other concerns when deciding on standing is proper constitutional law. 77 acknowledging that the framers may have intended, or that the constitution and common sense likely compel, the weighing of pragmatic concerns in determining whether something should be labeled a “case” or “controversy” apt to adjudication in the courts, those who argue against taxpayer standing by eliding the distinction between pragmatic and “constitutional” (meaning a formalistic reading of the words “case” or “controversy” themselves) should not be condemned out of hand, because those arguments may well be one and the same. this note’s new theory of taxpayer standing uses pragmatic reasoning in interpreting article iii’s standing requirements to cabin the doctrine of taxpayer standing itself by weighing prudential reasons. therefore it would be subject to similar criticism if considering such pragmatic concerns were not justified. 78 b. unacknowledged jurisdictional defects that a number of cases likely having jurisdictional defects have been allowed to proceed to judgment on the merits without mention of the standing issue is a key indicator of the weakness in the current taxpayer standing doctrine. 79 despite the general proposition that the court has “an obligation to assure [itself] of litigants’ standing under article iii,” 80 the current position of the supreme court concerning these cases is that, “when questions of jurisdiction have been passed on in prior decisions sub silentio, this 74 flast v. cohen, 392 u.s. 83, 97 (1968). 75 justice scalia’s citation to de tocqueville in the hein case aside. see infra note 82. 76 see, e.g., stephen m. griffin, pluralism in constitutional interpretation, 72 tex l. rev. 1753 (exploring the validity of pluralism in constitutional interpretation, suggesting that no one mode of interpretation will ever suffice). 77 see lujan v. defenders of wildlife, 505 u.s. 555, 560-561 (1992). 78 see u.s. const. art. iii,(the necessity of consideration of pragmatic concerns in part iii.d, infra). 79 see hibbs v. winn, 542 u.s. 88 (2004) (holding that tax anti-injunction act did not bar taxpayer suit, without mentioning taxpayer standing issue); mueller v. allen, 463 u.s. 388 (1983) (permitting taxpayers to challenge constitutionality of a tax deduction without mentioning standing issue); comm. for public ed. & religious liberty v. nyquist, 413 u.s. 756 (1973) (permitting taxpayer challenge to school aid statute without mentioning standing issue); hunt v. mcnair, 413 u.s. 734 (1973) (permitting taxpayer challenge to south carolina statutory scheme of aid to colleges without mentioning standing); walz v. tax comm. of the city of new york, 397 u.s. 664 (1970) (permitting realty owner to challenge, on a taxpayer theory, tax exemptions for religious organizations without mentioning standing). 80 daimlerchrylser corp. v. cuno, 547 u.s. 332, 340 (2006). 130 columbia journal of tax law [vol.6:118 court has never considered itself bound when a subsequent case finally brings the jurisdictional issue before us.” 81 this means that “[w]hen a potential jurisdictional defect is neither noted nor discussed in a federal decision, the decision does not stand for the proposition that no defect existed.” 82 justice kennedy has justified this position practically, arguing “the court would risk error if it relied on assumptions that have gone unstated and unexamined.” 83 all of that notwithstanding, the patchy application of this jurisdictional barrier presents some evidence of implicit disagreement or confusion concerning the present doctrine. 84 if the doctrine of taxpayer standing that has grown out of flast really were so clear, then courts should have no problem applying the relevant standard, especially when doing so would reduce the burden on all parties by dismissing litigation at the very outset of cases. poor conformity with what appears to be a relatively simple rule, in spirit at least, is evidence for one or both of the following two propositions: (1) flast is confusing, and therefore is not applied when it should be; or (2) flast does not conform with intuitive notions of justice, and therefore its poor application indicates implicit disagreement with its holding. 85 it is difficult to divine which of these two forces is at work in any particular case. either way, the consistent ability for jurisdictional defects to pass sub silentio indicates that the current doctrine is broken. this idea is supported by the failure of the supreme court to rule on the issue of taxpayer standing in hibbs, when the case first came before the court. the court held that the tax anti-injunction act did not bar the suit. 86 justice kennedy deals with this shortcoming in hibbs’s second iteration using a mere in-line citation: “cf. hibbs v. winn, 542 u.s. 88, 124 s.ct. 2276, 159 l.ed.2d 172 (reaching only threshold jurisdictional issues).” 87 this is both an unsatisfying explanation of what happened in the first iteration and an invitation to ask whether some jurisdictional issues are not threshold issues. it is absurd to attempt to define a jurisdictional barrier imposed by statute 88 as somehow logically prior to one embedded in the constitution itself. if the basic requirements laid out in article iii were not satisfied, it is impossible to see how the tax anti-injunction act matters at all—the case should simply have been dismissed for lack of standing. hibbs v. winn would have been the perfect time to indicate that the plaintiffs’ first trip to the supreme court was all for naught, regardless of the applicability of the tax antiinjunction act, because they lacked standing to bring their claim anyway. 89 instead, the decision does not address the issue of standing. in fact, in none of the three opinions which were filed does the word ‘standing’ appear at all. if the judicial sensibilities of the justices of the supreme court were so offended by the specter of taxpayer standing in the second time around, it is baffling that none of them had anything to say about it the first 81 hagans v. levine, 415 u.s. 528, 533 n.5 (1974). 82 ariz. sch. tuition org. v. winn, 131 s. ct. 1436, 1448 (2011). 83 id. at 1449. 84 see, e.g., jeff todd, undead precedent: the curse of a holding ‘limited to its facts,’ 40 tex. tech. l. rev. 67 (explaining that decisions are sometimes limited to their facts because of a later judicial determination that they were wrongly decided). 85 id. 86 hibbs v. winn, 542 u.s. 88 (2004). 87 ariz. sch. tuition org. v. winn, 131 s. ct. 1436, 1448 (2011). 88 hibbs, 542 u.s. 88 (2004). was concerned with the applicability of the tax anti-injunction act to the same facts. 89 remember the principle laid out in daimlerchrylser corp. v. cuno, 547 u.s. 332, 340 (2006), which said that the court must assure itself of litigants’ standing under article iii. 2014] a new theory of taxpayer standing 131 time the case came before the court. it is especially remarkable given the limited number of cases the court takes on. there is a slim likelihood that the same plaintiffs would reach the court twice, much less to resolve yet another jurisdictional question. c. unavailability of other remedies taxpayer standing may be an imperfect doctrine, but it is necessary in certain situations because of the unavailability of other remedies. take, for example, the case of the tax credits at issue in winn. 90 if the plaintiffs there are prohibited from bringing suit to challenge the tax credit, there are no other parties with proper standing. the acting solicitor general for the united states, as amicus curiae in support of the petitioner arizona school tuition organization, acknowledged this fact at oral argument in front of the supreme court. 91 as no other direct procedural or administrative remedy is available, the only remedy has to come from the political process. there are good arguments supporting the proposition that general grievances against the government should not be adjudicated in the courts. allowing general grievances to be adjudicated in courts could result in turning the judiciary into a constant, overreaching, and odious monitor of the functioning of the other branches of government. 92 however, the political process should not be entrusted with remedying all ills. if the conduct at issue truly violates the establishment clause, and is the functional equivalent of conduct which could fairly be challenged in court, it would be to exalt form over substance and effectively abdicate the responsibility of enforcing the constitution to call the challenged conduct nonjusticiable. 93 iv. solution a. why have taxpayer standing at all? before laying out any theory of taxpayer standing, it is necessary to refute the argument that justice scalia voices in winn and hein that taxpayer standing should not exist at all because the injury alleged in such cases is not concrete and particularized, but rather expresses a general grievance not certain to be remedied by the sought-after relief. 94 the contention that the injury alleged in taxpayer standing cases is not concrete and particularized is foundationally weak and fails to grasp the real crux of taxpayer 90 winn, 131 s. ct. 1436. 91 transcript of oral argument at 8, ariz. sch. tuition org. v. winn, 131 s. ct. 1436 (2011) (no. 09-987). 92 hein v. freedom from religion foundation, 551 u.s. 587, 593 (2007). 93 the effect of the winn decision can be seen in state taxpayer standing doctrine. for example, in missouri there is reason to believe that the doctrine has been tightened in conformity with the majority’s reasoning in winn to disallow taxpayer suits. see manzara v. state, 343 s.w.3d 656 (mo. banc 2011) (holding that taxpayers did not having standing to challenge redeveloper tax credit as a matter of missouri constitutional law, relying upon winn). 94 hein, 551 u.s. at 633-634. this, of course, is tantamount to saying that there is no “case” or “controversy” here. justice scalia is content to let alexis de tocqueville do some of the arguing in an important passage in hein where he quotes de tocqeuville as having written that “judicial censure, exercised by the courts on legislation, cannot extend without distinction to all laws, for there are some of them that can never give rise to the sort of clearly formulated dispute that one calls a case.” a. de tocqueville, democracy in america 97 (h. mansfied & d. winthrop transls. and eds. 2000). justice scalia, realizing that by repudiating the flast doctrine wholly he is saying that there is no case here, throws the onus onto this de tocqueville quote in the hein case rather than say it himself. three points bear making: (1) what de tocqueville wrote should have no bearing upon what the supreme court thinks of taxpayer standing, (2) he wrote in french, and (3) he may well have been speaking metaphorically about whether you can call certain suits “cases.” 132 columbia journal of tax law [vol.6:118 standing cases. to allege that the government has used its funds to violate the establishment clause is both concrete, in that it identifies a real, albeit intangible harm, and particularized, in that the harm is being worked upon the individual taxpayer. 95 as justice souter argues in hein, standing was conferred in cases where parties were being forced to compete on an uneven playing field as a result of race (with no corresponding economic loss) or were harmed by living in a gerrymandered district. 96 these examples surely represent no more concrete harms than seeing the government spend tax dollars in violation of the establishment clause. merely because the harm is being distributed amongst all taxpayers does not mean that the injury is not “particularized.” connecting particularity with generality is a poor way of conceptualizing the animating spirit of the particularity requirement because it foists a false dichotomy on readers—“particular” versus “general.” the opposite of “particular” is not “general”; rather, it is “nonspecific.” harms can be both general and particular if they affect all people equally. it is not irrational to say that where all taxpayers are harmed equally, they all possess standing because they have suffered individually, and therefore have a particularized injury, although the conduct complained of afflicts them all in common. holding that particular is incommensurate with general is like saying that the victims of a mass tort have only suffered a general and not particularized harm. each individual victim has suffered a particular injury as a result of the tortious conduct, although it may well affect each in the class of affected persons equally. if an injury is not particular that really means it is nonspecific, which is to say that it is unclear if the plaintiff who has brought the suit has suffered a specifically personal and cognizable injury. some psychic harms, like those arising from violations of the establishment clause, are both specified, in that they are individualized and are alleged with particular facts, and are cognizable, in that they represent a violation of a legally recognized right. in such cases, the harm is particularized. when the harm is a general psychic harm, but a person has not individually suffered that harm, then the harm is not sufficiently particular to that person. although the conduct may well have been sufficient to engender real harm, it has not done so for that person. 97 on justice scalia’s point that general grievances should not be aired in court, plaintiffs in taxpayer standing suits are indeed presenting broad complaints about the 95 see, william p. marshall & gene r. nichol, not a winn-win: misconstruing standing and the establishment clause, 2011 sup. ct. rev. 215, 232. (arguing for a robust understanding of cognizable harms, including psychic harms in the case of the establishment clause). 96 hein, 551 u.s. at 642. 97 see, federal election commission v. akins, 524 u.s. 11, 24 (1998). one might say, in response to this, that merely pleading that you have suffered the requisite psychic harm is enough to get over this hurdle. that may be correct. however, this does not mean that violations of the establishment clause or other parts of the constitution which cause purely intangible and psychic harms should therefore not be cognizable (see supra note 90)—these cases just present situations in which the ‘particular’ harm requirement is not particularly high. in some cases, alleging particular harm, like in the case of a mass tort where a plaintiff alleges physical injury will present a real hurdle, in that the plaintiff will have to show that he or she has suffered the complained of injury. merely because the “particularized” injury requirement may not present a serious hurdle in taxpayer standing cases is not a good reason to deny standing. justice breyer ably makes some of the points i make in this section in federal elections commission v. akins: “often the fact that an interest is abstract and the fact that it is widely shared go hand in hand. but their association is not invariable, and where a harm is concrete, though widely shared, the court has found ‘injury in fact.’” in other words, generality does not disqualify a claim; the abstractness which often goes with it creates the problem. justice breyer also makes the analogy to mass tort claims and interference with voting rights claims as examples of generalized harms which are nonetheless concrete enough to confer standing. 2014] a new theory of taxpayer standing 133 manner in which the government is spending money, but they are coupled with an individualized complaint about how their tax dollars are spent and comes in a special context. insofar as taxpayers, and not citizens at large, may properly possess standing to challenge an exercise of the taxing and spending power or other expenditure of government funds, their status as a taxpayer guarantees that there is a direct relationship between that status and the complained of injury. when these complaints arise in the context of the establishment clause, taxpayers can only allege a grievance which is general because the establishment of religion is not an act which is typically targeted, in any meaningful sense at least, at a particular person or group of persons. it would be nonsensical to hold that complaints which can be characterized as “general” cannot be used to challenge conduct alleged to violate the establishment clause because that would be tantamount to holding that the establishment clause cannot be judicially enforced at all. 98 reduced to its simplest form, justice scalia’s argument is that the judiciary lacks the power to invalidate exercises of the taxing and spending power that violate the establishment clause because there is no perfect party to bring suit and remedy the violation. what this argument fails to grasp is the fundamental difference between proper taxpayer standing cases and the general class of cases where the perfect party to bring suit cannot be found. in the latter cases, the inability to find the proper plaintiff suggests that there has been no harm, 99 and in the former cases, the inability to find the proper plaintiff suggests that the harm is not one which is easily cognizable. if tax expenditures and appropriations are functional equivalents, 100 the conclusion follows that the harm that each can cause is the same. 101 the only problem is that it is difficult to attach the harm to a particular citizen. in some cases, this difficulty will be enough to bar suit because the harm complained of is not the proper type of harm (e.g., when congress passes a poorly conceived and injurious law that is nevertheless constitutional) or because the harm is de minimis, and thus is not felt by any particular citizen acutely enough (e.g., expenditures to religious institutions in pursuit of a legitimate regulatory regime). 102 however, there are cases where the harm complained of is uniquely constitutional and of the proper magnitude, but for which there is no perfect plaintiff to bring suit. 103 in these cases, it would be sensible to have a doctrine that permits taxpayers qua taxpayers to challenge unconstitutional exercises of the taxing and spending power when there is no other remedy reasonably available. 98 justice ginsburg aptly makes this point in the oral argument of ariz. sch. tuition org. v. winn. see transcript of oral argument at 8, ariz. sch. tuition org. v. winn, 131 s. ct. 1436 (2011). 99 see, e.g., u.s. v. fruehauf, 365 u.s. 146, 157 (1961) (re-affirming the prohibition against advisory opinions because they fail to present a “clash of adversary argument”). 100 see winn, 131 s. ct. at 1455. 101 courts should be careful not to dismiss establishment clause harms as those which arise from the paranoid delusions or political machinations of religious zealots and militant atheists. see marshall, et. al., supra note 96, at 232-47 (explaining how the establishment clause was designed to protect against psychic injury and elucidating the types of cognizable psychic injury, including denominational harms, “corruption” harms, and others). 102 flast v. cohen, 392 u.s. 83, 102 (1968). 103 see, e.g., winn, 131 s. ct. at 1455 (holding that even assuming the taxpayers were sufficiently harmed, issues of redressability and causation pre-empted the court from finding that the taxpayers had standing). 134 columbia journal of tax law [vol.6:118 it can be said in response to this contention that suits predicated upon taxpayer standing are really just advisory opinions masquerading as legitimate suits. 104 to that, there are two retorts. first, in cases where the taxing and spending power is being challenged by a taxpayer solely upon the basis of his or her taxpayer status, there is a reasonably direct link between the complained of behavior (uses of government funds or preferences) and the plaintiff’s taxpayer status. whatever else may be said about them, these suits are not purely advisory. 105 second, any impression that these suits are asking for decisions which are advisory, and thereby asking the judiciary to unduly encroach upon the legitimate domain of the legislature, is a result of the unique nature of the harm and not because of judicial overreach. in many situations, the legislature has manipulated the system, whether consciously or not, to make it difficult to identify a suitable plaintiff. however, the essential character of the violation has not changed, whether it is classified as a tax credit or tax expenditure (or any other like switch). there is no reason to think the types of conduct taxpayers have heretofore challenged invoke a particularly sensitive domain that the judiciary should label non-justiciable. allowing pedestrian tax expenditures to be unchallengeable is to exalt form over substance and to unduly shackle the judiciary to rank formalism. b. non-justiciability rather than create an exception to the standing doctrine, some would simply leave many questions that can be reached only by allowing taxpayer standing (e.g., the tax credit in winn) 106 outside of the reach of the courts—which is to say, nonjusticiable. 107 this argument invokes the strong form of justiciability, that the underlying controversy is simply something that the judiciary is not competent to rule upon, rather than the weak form of justiciability, that the proper parties are not before the court or that the issue is unripe or moot, but not that the underlying issue is non-justiciable. 108 an advisory opinion may, of course, touch upon political questions that are themselves nonjusticiable, but their major weakness is that they are non-justiciable in the weak form because the proper party is not present although the underlying issue is suitable for adjudication in the courts. casting taxpayer standing cases as falling prey to the same objections as advisory opinions fails to recognize that the characterization has transmuted a relatively weak form of non-justiciability (one that is concerned about the messenger) into a much stronger one (one that precludes any discussion of the message). unlike the prohibition on advisory opinions generally, a characterization of taxpayer standing as advisory would lead to the preclusion of litigating the underlying issue. this is not to say 104 advisory opinions are not permissible as a matter of the oldest and highest authority, notwithstanding the english practice. see hayburn’s case, 2 u.s. 408, 409 (1792) (holding that the attorney general could not solicit the supreme court, ex officio and without an application from any particular person, for a writ of mandamus to compel the execution of an act of congress); john jay, correspondence & public papers of john jay, vol. 3, 486-89. (henry p. johnston, a.m. ed., 1st ed., 1891). 105 see evan tsen lee, deconstitutionalizing justiciability: the example of mootness, 105 harv. l. rev. 603, 644 (1992) (arguing that the term “advisory opinion” has been used widely and confusingly to discuss both a constitutional bar and a pragmatic bar, but that the only constitutional bar to advisory opinions comes in the case of pre-enactment/pre-action review or a political question and that decisions in cases of mootness, un-ripeness, and lack of standing are not constitutionally barred). 106 winn, 131 s. ct. at 1436. 107 hein v. freedom from religion found., 551 u.s. 587, 618 (2007). 108 see jonathan r. siegel, a theory of justiciability, 86 tex. l. rev. 73, 129-138 (2007) (arguing that mootness, ripeness, advisory opinions, and standing are non-justiciable in a weaker way than the political question doctrine in a purpose-based approach to justiciability). 2014] a new theory of taxpayer standing 135 that there would be no remedy for the grievances taxpayers assert in these cases; the remedy would just have to be political in some fashion. 109 there is good reason to think that not all constitutional questions are justiciable. the issue must be ripe and not moot, the parties truly adverse, and the issue not solely hypothetical (which is to say, not advisory). 110 outside of these, there are good reasons for invoking the strong form of non-justiciability. in the supreme court’s political question jurisprudence, it has identified six factors for determining whether an issue should not be decided upon in the courts: (1) “a textually demonstrable constitutional commitment of the issue to a coordinate political department”; (2) “a lack of judicially discoverable and manageable standards for resolving it”; (3) “the impossibility of deciding without an initial policy determination of a kind clearly for nonjudicial discretion”; (4) “the impossibility of a court’s undertaking independent resolution without expressing lack of the respect due coordinate branches of government”; (5) “an unusual need for unquestioning adherence to a political decision already made”; or (6) “the potentiality of embarrassment from multifarious pronouncements by various departments on one question.” 111 the following have been found to be political questions not apt to adjudication in the courts: what constitutes a republican form of government under the guarantee clause, 112 what constitutes an indian tribe, 113 the mode of amending the federal constitution, 114 and the nature of impeachments. 115 as they relate to taxpayer standing, none of these six factors weigh towards invoking a strong form of non-justiciability with respect to those underlying issues that can only be reached through taxpayer standing suits. as a threshold matter, the second factor, a lack of judicially discoverable and manageable standards, is merely judicial lipservice to the idea of a restrained judiciary and has no real meaning. as the court has succeeded in giving meaning to nebulous concepts like “due process,” 116 what lurks within the ninth amendment, 117 and the shadows and penumbras cast by the various constitutional amendments, 118 it is not unreasonable to think that a judicial standard for taxpayer standing is “discoverable” and “manageable.” plainly, factor five, an unusual need for unquestioning adherence to a prior political decision, is inapplicable to taxpayer standing—that factor is for such weighty matters as foreign policy and the prosecution of a war or armed conflict. factors four (due respect to coordinate branches of government) and six (potential for multiple pronouncements by various departments on one question) are also inapplicable to taxpayer standing—there is no other branch of government equipped to rule upon the constitutionality of a general assessment or tax expenditure, so there is no risk of multiple pronouncements or a lack of respect for coordinate branches. factor one (textually demonstrable commitment to another branch) is inapplicable as the 109 see discussion infra part iii.d.2 (discussing possibility of political remedies in this situation). 110 see siegel, supra note 109, at 129-38 (considering a purpose-based approach to justiciability which preserves many of the traditional categories of justiciability). 111 baker v. carr, 369 u.s. 186, 217 (1962). 112 luther v. borden, 48 u.s. 1 (1849). 113 u.s. v. holliday, 70 u.s. 407 (1865). 114 coleman v. miller, 307 u.s. 433 (1939). 115 nixon v. united states, 506 u.s. 224 (1993). 116 see, e.g., herbert hovenkamp, the political economy of substantive due process, 40 stan. l. rev. 379 (1988) (discussion of substantive due process). 117 see griswold v. connecticut, 381 u.s. 479, 499 (1965) (holding that the right of marital privacy is a “personal right ‘retained by the people’ within the meaning of the ninth amendment”). 118 id. at 484 (holding “that specific guarantees in the bill of rights have penumbras, formed by emanations from those guarantees that help to give them life and substance”). 136 columbia journal of tax law [vol.6:118 constitution does not obviously lodge responsibility on this matter in any branch, least of all the legislative or executive branches. finally, factor three (need for nonjudicial policy determination) is inapplicable—the court managed to rule upon the constitutionality of what amounts to the functional equivalent of a tax credit (winn) in flast without having to make any sort of non-judicial policy determination. 119 given the inapplicability of the underlying rationale of the political question doctrine, to some of the underlying questions of taxpayer standing which would otherwise be rendered non-justiciable, there is good reason to think that a judicial remedy should exist. this is especially true where the political system is structurally ill-equipped to give a political remedy to the aggrieved taxpayer. 120 c. an analogy to ultra vires corporate actions when a corporation has exceeded the legal authority granted to it by its charter, an ultra vires derivative action may be brought by shareholders to enjoin the conduct, or, in extreme cases, an action may be brought quo warranto by the state attorney general to dissolve the corporation. 121 such an action protects minority interests in the corporation from being subjugated to those of the majority by allowing the minority party to step into the shoes of the corporation to enforce the guiding principles of the charter that govern their association. 122 not only can the minority shareholders bring a suit on behalf of the corporation to enjoin ultra vires conduct, it is a longstanding rule that an ultra vires action cannot be ratified by the shareholders of a corporation, as it was never within the authority of the corporation to engage in that conduct in the first place. 123 this further protects minority shareholders from the intense pressure that the majority shareholders may use in the attempt to get minority shareholders to vote for ratification in order to cleanse the ultra vires conduct. the rationale behind the procedural safeguards that have been put in place to enforce the rights of minority viewpoints in the corporate context applies, and with much greater force, to the constitutional question at hand. the constitution, much like a corporate charter, governs the association between government (analogous to the directors and officers of a corporation) and citizens (analogous to shareholders). while the constitution is meant to preserve and promote democratic ideals, including that of majority rule, it contains an unmistakable countermajoritarian strain, which is meant to protect the interests of minority viewpoints. amongst other things, these protections include the preservation of the right not to have to contribute to a government that establishes a religion. if, in the corporate context, minority shareholders are empowered to enforce the guarantees of the foundational document that governs their association with other shareholders and with management by 119 flast v. cohen, 392 u.s. 83 (1968). 120 this is incorporated into the test articulated in part iii.d, infra. 121 today, most corporations (other than municipal corporations) have as their purpose something like, ‘‘any lawful purpose . . .” as such, the only truly ultra vires action for these corporations is an illegal action. kent greenfield, ultra vires lives! a stakeholder analysis of corporate illegality (with notes on how corporate law could reinforce international law norms), 87 va. l. rev. 1279, 1307 (2001) (explaining the continued vitality of the ultra vires doctrine in modern corporate law); comment, quo warranto and private corporations, 37 yale l.j. 237, 239 (1927) (relating quo warranto proceeding to the corporate context). 122 see greenfield, supra note 122, at 1304-07 (noting that the ultra vires doctrine protected shareholders by limiting corporate activities to those enumerated in the charter and that a sole dissenting shareholder could sue to enjoin ultra vires actions, even if all other shareholders assented). 123 cal. nat’l bank v. kennedy, 167 u.s. 362, 367 (1897) (citing both to american and english cases holding for the proposition that an ultra vires action cannot be ratified). 2014] a new theory of taxpayer standing 137 employing unique procedural mechanisms (the derivative action) and by enshrining counter-majoritarian principles into the fabric of corporate law (the idea that ultra vires actions cannot be ratified), then there is equal or better reason to protect citizens with minority viewpoints from violations of the foundational document that is the bedrock of our society by providing them with counter-majoritarian principles (the establishment clause) and unique procedural mechanisms (taxpayer standing). d. a new theory of taxpayer standing this new theory of taxpayer standing conceives of all questions of standing as constitutional questions. insofar as an examination of standing requires pragmatism to be sensible at all, such considerations cannot be divorced from the project of constitutional interpretation — pragmatic concerns are baked into the analysis of whether the legal conclusions of “case” or “controversy” are affixed to a particular dispute, rendering it apt to adjudication in the courts. this test for taxpayer standing is informed by pragmatic concerns, but it is not any more antithetical to constitutional interpretation than any other attempts to use pragmatism to define the boundaries of the standing doctrine. this is a more sensible route than separating “constitutional” from “pragmatic” types of standing requirements. separating those requirements, makes the doctrine even more complicated by imposing two different types of barriers, as the court acknowledges it has done in elk grove unified school district v. newdow. 124 forcing would-be litigants to jump through an additional hurdle not required by the constitution to vindicate constitutional rights is simply improper. if no pragmatic limitation can be found in article iii itself, it should not be imposed upon prospective plaintiffs. 125 hence, this note proposes the theory that taxpayer standing is appropriate where: (1) the taxpayer’s status as a taxpayer bears a reasonable relationship to the expenditure of government funds in question; (2) it is of practical necessity because the political system is structurally ill-equipped to provide a remedy for those who object to a particular expenditure of government funds alleged to violate the constitution or the taxpayer is a member of the class for whom the especial benefit of a constitutional limitation is intended to directly run; and (3) where no other plausible party has standing to challenge the alleged violation, leaving it functionally irremediable. 1. reasonable relationship to challenged expenditure the flast test expresses broadly the same concerns as this first prong. it says that the taxpayer must do two things to have standing: (1) “establish a logical link between [status as a taxpayer] and the type of legislative enactment attacked”; and (2) “establish a nexus between that status and the precise nature of the constitutional infringement alleged.” 126 the main problem with the flast test is that it is turbid and confusing. the first part of the test is meant to express the idea that a party can only challenge exercises of the taxing and spending clause of the constitution. this part of the test is unclear and without a sound foundation. as justice scalia and justice souter argue in hein, whether the expenditure of government funds were to be effected by the executive branch, pursuant to a general appropriation, or the legislative branch as a direct exercise of the taxing and spending power, the establishment clause (or any other part of the 124 542 u.s. 1, 11 (2004). 125 but see judge posner, who appears to approve of these separate requirements, in american bottom conservancy v. u.s. army corps of engineers, 650 f.3d. 652, 655-656 (7th cir. 2011). 126 flast v. cohen, 392 u.s. 83, 102 (1968). 138 columbia journal of tax law [vol.6:118 constitution) can be violated just the same. 127 in keeping with the criticism of the winn decision articulated in part ii.c, courts should not exalt form over substance, especially when it may allow an end-run around the establishment clause. were the legislature to give a general appropriation subject to executive discretion with full knowledge that the executive branch would use that money to violate the establishment clause, the courts should not be prevented from adjudging the expenditures to be unconstitutional regardless of formalistic distinctions. 128 even if such a scheme were not at issue, the fear expressed in hein that the power of the judiciary would be improperly expanded by turning courts into constant monitors of governmental functions is ameliorated by the remaining two prongs of the test articulated in this note. 129 the second prong of the flast test incorporates the idea that “the taxpayer must show that the challenged enactment exceeds specific constitutional limitations imposed upon the exercise of the congressional taxing and spending power and not simply that the enactment is generally beyond the power delegated to congress by art. i, § 8.” 130 this part of the test makes sense as a limitation on purely advisory opinions or as attempting to cabin the scope of taxpayer suits, such that taxpayers cannot challenge laws which have nothing to do with the use of their tax dollars. it does not make sense, however, when used to limit the scope of taxpayer suits to only establishment clause challenges. if taxpayer standing should not be permitted under parts of the constitution other than the establishment clause, then the most rational way to find this limitation is not to argue that those other parts of the constitution do not place specific limitations on the power of congress under the taxing and spending power. indeed, the other limitations contained within the first amendment, the second amendment, the fifth amendment, and all of the other parts of the constitution place specific limitations upon congress’ power, including their power under the taxing and spending power. the reason taxpayers should not be able to challenge laws which are alleged to violate those parts of the constitution comes either (1) from the fact that a taxpayer’s status as a taxpayer does not bear a reasonable relationship to the challenged law (think of a law which allowed federal prosecutors to hold people to account for capital offenses without a presentment of indictment by grand jury, which is plainly in violation of the fifth amendment, but which lacks a reasonable relationship to a taxpayer’s status qua taxpayer); or (2) from the fact that taxpayer standing is not necessary because a better party would have standing. in sum, taxpayer standing may be appropriate only in cases of establishment clause violations, but that is not because other parts of the constitution do not place specific limitations upon congress’ power under the taxing and spending power; rather, it is because either the challenged conduct bears no reasonable relationship to the plaintiff’s status as a taxpayer or taxpayer standing is unnecessary because of another party who would otherwise have standing. requiring only that the taxpayer’s status as a taxpayer bear a reasonable relationship to the challenged governmental expenditure does away with much of the confusion in the flast test without sacrificing any of its animating spirit. additionally, it has the added benefit of avoiding the formalistic line-drawing which has led to the absurdity attendant to exalting form over substance. surveying some of the key cases in 127 hein v. freedom from religion found., 551 u.s. 587, 618 (2007) (scalia, j., concurring) (souter, j., dissenting) (plurality opinion). 128 hein, 551 u.s. at 618. 129 see infra parts iii.d.2 and iii.d.3 (giving the two other prongs of the test). 130 flast, 392 u.s. at 102-03. 2014] a new theory of taxpayer standing 139 this area, like winn, 131 which presented a state tax credit alleged to violate the establishment clause, asking whether the taxpayer’s status as a taxpayer bears a reasonable relationship to the challenged conduct yields a clear answer: yes. in the flast case, 132 the use of government money to buy textbooks and otherwise support religious education bears a sufficiently reasonable relationship to the plaintiff’s status as a taxpayer to confer standing. in frothingham, 133 although the maternity act may not present a particularly good case, the expenditure of government funds by an administrative agency bears a reasonable enough relationship to the plaintiff’s status as a taxpayer to confer standing. in hein, 134 the president’s praise for religious-based organizations and speeches which used religious imagery, although perhaps costing the federal government something, did not bear a reasonable enough relationship to the plaintiff’s status as a taxpayer to confer standing. a criticism might be leveled that this approach packs some elements of judgment on the merits of a case into this analysis, but merits are not always necessary to determine that a reasonable relationship does not exist and consideration of some of the merits may not always be unadvisable (this same criticism has been leveled at the supreme court’s pleading requirements jurisprudence). 135 in valley forge, 136 the transfer of government-owned real property to religious institutions is not different enough to justify denying standing, because real property requisitioned as part of a taking and compensated out of the federal coffers implicates the same interests so far as the taxpayer is concerned as other types of extraction and disposition. remember, this survey of taxpayer standing cases has only been examined with regards to the first prong of this note’s test—there may well be other reasons to deny standing that come from the other two prongs. 2. political remedy the second prong of this test articulates that standing should be conferred where it is of practical necessity because the political system is ill-equipped to provide a remedy for those who object to a particular expenditure alleged to violate the establishment clause or any other part of the constitution. the supreme court has acknowledged in its equal protection jurisprudence that insular or discrete minorities who lack political power sometimes merit additional protection in the form of intermediate or strict scrutiny. the factors for granting heightened scrutiny were well collected by the second circuit in windsor v. united states. 137 the second circuit said that the following considerations are relevant: (1) “whether the class has been historically subjected to discrimination”; (2) “whether the 131 ariz. sch. tuition org. v. winn, 131 s. ct. 1436 (2011). 132 flast, 392 u.s. 83. 133 frothingham v. mellon, 262 u.s. 447 (1923). 134 hein v. freedom from religion found., 551 u.s. 587 (2007) 135 see ashcroft v. iqbal, 556 u.s. 662 (2009); bell atlantic corp. v. twombly, 550 u.s. 554 (2007). academic angst reached its peak with articles such as: adam n. steinman, the pleading problem, 62 stan. l. rev. 1293, 1295 (arguing that federal pleading standards are “in crisis”); brian s. clarke, grossly restricted pleading: twobly/iqbal, gross, and cannibalistic facts in compound employment discrimination claims, 2010 utah l. rev. 1101, 1141 (arguing that twombly/iqbal has effectively destroyed the viability of compound employment discrimination claims); arthur r. miller, from conley to iqbal: a double play on the federal rules of civil procedure, 60 duke l.j. 1, 2 (arguing that our very democratic ideals are threatened by these decisions); and many others. 136 valley forge christian coll. v. ams. united for separation of church and state, inc., 454 u.s. 464 (1982). 137 windsor v. united states, 699 f.3d 169 (2d cir. 2012). 140 columbia journal of tax law [vol.6:118 class has a defining characteristic that frequently bears a relation to ability to perform or contribute to society”; (3) “whether the class exhibits obvious, immutable, or distinguishing characteristics that define them as a discrete group”; and (4) “whether the class is a minority or politically powerless.” 138 this is not to say that immutability and political power are dispositive—minors and aliens deserve strict scrutiny despite either being mutable or having political power. if the scales of justice can be manipulated in the final judgment on the basis of whether the party is a member of a discrete or insular minority, or otherwise merits such treatment, surely it is not too reaching to say that a pragmatic doctrine like standing should be sensitive to similar concerns. this part of the test should not be interpreted to say that just because it is difficult to obtain relief through the political system, this part is satisfied; rather, the requirement encompasses only those situations in which the political system is structurally illequipped to provide a remedy, parallel to those situations in which insular or discrete minorities are thought to lack power in equal protection jurisprudence. for example, the affordable care act (“obamacare”) 139 may well be difficult to repeal through the exercise of the political process and taxpayers may think that it is unconstitutional (and may still think so after the health care cases), 140 but that does not mean that the political system is structurally ill-equipped to provide a remedy. what is structurally illequipped to provide a remedy in the context of this test is a nuanced point, but generally, when, as a result of the fact that a taxpayer is a member of an insular minority or has immutable qualities possessed by the relevant group to which he or she belongs (the group to which the constitutional violation is particularly offensive) that taxpayer has less than the typical amount of political power. then, the taxpayer may not be able to get effective relief through the political process and the political system is structurally illequipped to provide that relief. the foregoing is not meant to say that a plaintiff must necessarily be a member of an insular or identifiable minority in order for taxpayer standing to be proper. in situations where the plaintiff is a member of the class for whom the especial benefit of a constitutional limitation is intended to directly run, taxpayer standing may be proper. for example, those who object to the establishment of a national religion, despite being a member of the religion that the government intends to establish may satisfy the second prong of this test. this is to be contrasted with the situation in frothingham, where the taxpayer objected to the expenditure of federal funds in support of mothers. 141 she was neither a member of an insular or identifiable minority for whom the political system was ill-equipped to provide a remedy, nor was she a member of the class for whom the especial benefit of the constitutional limitation she invoked (the tenth amendment) was intended to directly run (the direct benefit runs to the states, and then to the people, the ultimate beneficiary of all constitutional limitations). 142 there are two ways of conceiving of such an approach: (1) that as a result of the specific constitutional limitation in question, it may be assumed that the dissenter is a member of a politically weak group for whom the constitutional limitation was put in place to protect; or (2) for those whom the 138 id. at 181 (internal quotations and citations omitted) (gathering factors from bowen v. gilliard, 483 u.s. 587 (1987) and city of cleburne v. cleburne living ctr., 473 u.s. 432 (1985)). 139 patient protection and affordable care act of 2010, pub. l. no. 111-148, 124 stat. 119. 140 nat’l fed’n of ind. bus.v. sebelius, 132 s. ct. 2566 (2012). 141 frothingham v. mellon, 262 u.s. 447 (1923). 142 id. 2014] a new theory of taxpayer standing 141 benefit was specially intended to directly run to, their interest in the enforcement of that constitutional limitation is particularly important and meaningful. this part of the test is meant to protect those groups for whom violations of the constitution, especially the establishment clause, are particularly odious and for whom it would be difficult to effectively petition the political branches of government for relief. it is also meant to track the idea that taxpayer standing is a last resort of sorts, that should only be conferred when there is reason to suspect that constitutional violations will otherwise go un-remedied. looking at key cases of interests, it is fairly clear that in flast, winn, and valley forge, the plaintiffs are members of the class for whom the benefit of the constitutional limitation embodied in the establishment clause was intended to run (and likely satisfied the structurally ill-equipped requirement, anyway). in the cuno case, an alleged violation of the commerce clause does not satisfy the second prong of this test, as the political system is adequately equipped to provide a remedy for improvident exercises of legislative power under the commerce clause, and the benefit was not intended to run to the plaintiffs in particular. 143 the court picked up this logic when it argued that “[w]hatever rights plaintiffs have under the commerce clause, they are fundamentally unlike the right not to contribute three pence . . . for the support of any one religious establishment,” and disallowed a comparison between different parts of the constitution at such a high level of generality as to sap them of all relevant differences. 144 3. functional irremediability the third prong of this test formulates the requirement that where no other plausible party has standing (and where the other two prongs of the test are met), taxpayer standing should be permitted because, otherwise, constitutional violations would be left functionally irremediable. the supreme court has taken a dim view to this sort of argument, particularly in schlesinger v. reservists comm. to stop the war, where the court said: “the assumption that if respondents have no standing to sue, no one would have standing, is not reason to find standing.” 145 in valley forge, the court explained that position thusly: “implicit in [this argument] is the philosophy that the business of the federal courts is correcting constitutional errors, and that ‘cases and controversies’ are at best merely convenient vehicles for doing so and at worst nuisances that may be dispensed with when they become obstacles to that transcendent endeavor.” 146 this argument is wrongheaded and cynical in the extreme both about taxpayer standing and the job of federal courts. justice rehnquist appears to be actively mocking the conception of the courts which holds that they serve a useful purpose in society by helping to correct errors in the foundational document meant to protect the freedoms of the people against the encroachments of the government. to say that the courts should not attempt to correct constitutional violations when possible, to imply that that is not a “transcendent” or worthy endeavor, or to argue that allowing taxpayer standing will bring down the system of checks and balances are all 143 daimlerchrysler corp. v. cuno, 547 u.s. 332. (2006). 144 id. at 347. the court’s implication in cuno that the commerce clause does not provide a specific limitation upon the state’s taxing and spending powers is incorrect—it most certainly does. 145 418 u.s. 208, 227 (1974). 146 valley forge christian college v. americans united for separation of church and state, inc., 454 u.s. 464, 489 (1982). 142 columbia journal of tax law [vol.6:118 wrong and cynical. if the guarantees of the constitution are allowed to become a dead letter on the theory that insular minorities or those with unpopular viewpoints should only have recourse through the political system, a grave mistake has been made. it is naïve to believe that the political system will listen to them; aggrieved taxpayers should not be forced to content themselves with the frustration and the false hope that politicians will fix their problems in order to get the full benefit of the rights to which they are entitled. this is not meant to imply that the case or controversy requirement embedded in article iii should be dispensed with wantonly when standing is difficult to find, or when, all things considered, no party should have standing to sue. the case or controversy requirement undoubtedly serves a useful function in cases where the issues are moot, unripe, or where the parties are not actually adverse. in cases like winn, however, where the challenged expenditure bears a reasonable relationship to the taxpayer’s status as a taxpayer, and a political remedy is difficult to obtain, it is definitely relevant in analyzing the standing doctrine that no other party would have standing to challenge the government expenditure in question. as has been argued, the question of standing should be (and, in fact, is) sensitive to pragmatic concerns, 147 and insofar as this test formulates a practical concern that a constitutional violation would be allowed to go un-remedied because of formalism (even if it is useful formalism), the question of whether any party would have standing to challenge a government expenditure alleged to be unconstitutional is an important consideration. this is not to say that solely because there is no party with standing, there should therefore be a judicial remedy; there are certainly situations in which general grievances about the conduct of government should not be entertained in the judiciary. these cases are weeded out by various prongs of this note’s test. 4. applying the whole test this section will apply the test formulated in this note to the key cases in part i. in summary, the test for taxpayer standing proposed here-in is as follows: 1. the taxpayer’s status as a taxpayer bears a reasonable relationship to the expenditure of government funds in question, 2. it is of practical necessity because the political system is structurally ill-equipped to provide a remedy for those who object to a particular expenditure of government funds alleged to violate the constitution, or the taxpayer is a member of the class for whom the especial benefit of a constitutional limitation is intended to directly run, and 3. where no other plausible party has standing to challenge the alleged violation, leaving it functionally irremediable. in frothingham, the first important case on taxpayer standing, the taxpayer challenged the maternity act as a violation of the tenth amendment which would thereby deprive her of her property (via taxation) without due process of law. 148 while the case is undoubtedly weak on constitutional grounds, prong (1) of this test is satisfied—the exercise of the taxing and spending power to extract and spend money is undoubtedly reasonably related to the taxpayer’s status as a taxpayer. where the case fails is in prong (2), as the political system is not structurally ill-equipped to remedy the 147 see supra notes 63-67 and 112-113. 148 frothingham v. mellon, 262 u.s. 447 (1923). 2014] a new theory of taxpayer standing 143 alleged violation (amongst other things, the states have an obvious interest in enforcing the limits of federalism), nor is frothingham a member of the class to whom the especial benefit of the limitation laid out in the tenth amendment was intended to directly run. in flast, the taxpayer challenged expenditures under the elementary and secondary education act of 1965 to purchase materials for parochial schools as a violation of the establishment clause. 149 prong (1) of this test is satisfied—the exercise of the taxing and spending power to extract and spend money on materials for parochial schools is reasonably related to the taxpayer’s status as a taxpayer. prong (2) of this test is also satisfied, as taxpayers are members of the class for whom the benefit of the establishment clause was intended to directly run. furthermore, the political system is ill-equipped to provide an effective remedy for those who object to the use of federal funds for parochial schools, because parochial schools are a deeply ingrained and taxpreferred part of society. finally, prong (3) of this test is satisfied. if taxpayers were to not have standing to challenge the expenditures, then no one would—certainly not the schools that receive the funds, probably not the schools that share the receipt of funds under the elementary and secondary education act of 1965 with the parochial schools, and likely not any other potential party. in hein, the taxpayer challenged political speeches, rallies, and conferences which praised the good works of religious charities. 150 it is difficult to draw a line at which point the use of federal dollars in connection with something having a religious character becomes large enough to bear a reasonable relationship to a taxpayer’s status as a taxpayer. challenging the praise of religious organizations’ good works which comes with associated de minimis costs 151 (or is truly ancillary to the administration of a legitimate administrative program) fails prong (1) of this test. speeches and conferences which aim to reach out to religious organizations to help society function better and for which the main harm alleged is a symbolic one, simply do not create an injury that bears closely enough upon the taxpayer’s interest qua taxpayer. to say otherwise would be to sap any meaning out of the “reasonable relationship” requirement in the first prong of the test. it is a fact of society that the government must deal with religious organizations to maximize its effectiveness—not every such interaction rises to the level of concern to the taxpayer qua taxpayer. if however, prong (1) was satisfied, the suit fails on prong (2). although the plaintiffs at issue have the same character as those in flast, merely being the especial beneficiary of the constitutional limitation is not always enough by itself, as such a status is part of the general proposition that the focus of the concern is that the political system is structurally ill-equipped to remedy the alleged violation. as a result, when there is little reason to suspect that the political system is ill-equipped to remedy the alleged violation, but the plaintiff is part of the benefitted class (everyone for the establishment clause), taxpayer standing is not appropriate. here, there is little reason to believe that the political system is ill-equipped to remedy the executive branch’s partnership with religious organizations or positive rhetoric about them (there are elections after all). if, for the sake of argument, hein’s plaintiff passes prong (2), then on prong (3), there is reason to think that if the taxpayers at issue do not have standing to sue, then no 149 flast v. cohen, 392 u.s. 83 (1968). 150 hein v. freedom from religion found., 551 u.s. 587 (2007). 151 id. (describing the cost of this executive speech as de minimis because only costs associated were ancillary costs, such as the cost of the conference). 144 columbia journal of tax law [vol.6:118 one does (unless congress itself had standing to sue over the executive’s improper use of general appropriations funds). if hein’s plaintiff indeed passes this prong, and thereby the test, then maybe the test allows a borderline frivolous case to reach the courts. this is not necessarily the worst result. if the doctrine surrounding the establishment clause, born out of the idea that a taxpayer should not be forced to spend even three pence on the establishment of religion, does not occasionally permit borderline frivolous lawsuits, then either we have the perfect test on our hands or, more likely, we have one that is overly restrictive. in valley forge, the taxpayer challenged the transfer of real property owned by the government to religious institutions. 152 like it or not, prong (1) of this test is likely to be satisfied. wary of the risk of exalting form over substance, it must follow that real property transfers to religious institutions can violate the establishment clause just as easily as the transfer of cash in the form of a subsidy or a tax expenditure. insofar as the transfers are not de minimis or a truly ancillary part of a legitimate regulatory regime, which they are not, they satisfy prong (1). so far as prong (2) is concerned, there is little likelihood of a political remedy (no one is going to take away those pieces of land from the religious institutions to which they have been granted), and the taxpayers are the class for whom the establishment clause was intended to especially benefit. on prong (3), no one else would have standing to challenge the transfer of land to the religious institutions: those who were excluded from the program likely lack a cognizable claim and those religious institutions themselves who were awarded land have suffered no injury. although it is undesirable to have the judiciary meddling in how the federal government disposes of wartime property gained through eminent domain, there is a countervailing interest in seeing that such disposal does not turn into the tacit establishment of religion through transfers under the guise of merely enacting a necessary government divestment function. in the cuno case, taxpayers challenged the award of a state tax credit to incentivize car companies to stay in toledo, ohio under a theory of state law similar to a challenge under the commerce clause. 153 on prong (1), significant tax breaks to automobile companies certainly bear a reasonable relationship to the taxpayer’s status qua taxpayer. where the case fails, however, is prong (2). there, it makes little sense to say that the government is structurally ill-equipped to provide a remedy because the plaintiff is a member of an insular or discrete minority or that the plaintiff taxpayer possesses an unusually strong interest in personally enforcing the commerce clause (as the benefit of the commerce clause only indirectly flows to the taxpayer; recall the criticism of high level abstraction in cuno). 154 in winn, the taxpayer challenged a state tax credit alleged to be in violation of the establishment clause. 155 tax expenditures like the tax credits at issue are the functional equivalents of subsidies, and are therefore reasonably related to the taxpayer’s status as a taxpayer. hence, prong (1) is satisfied. prong (2) of this test is satisfied for exactly the same reasons as it was in flast. 156 finally, prong (3) of this test is satisfied—the acting solicitor general, arguing as amicus curiae in support of the petitioner, arizona school 152 valley forge christian coll. v. ams. united for separation of church and state, inc., 454 u.s. 464 (1982). 153 daimlerchrysler corp. v. cuno, 547 u.s. 332 (2006). 154 id. at 347. 155 ariz. sch. tuition org. v. winn, 131 s. ct. 1436 (2011). 156 see discussion supra part iii.d.3. 2014] a new theory of taxpayer standing 145 tuition organization, acknowledged that there would be no party with standing to challenge the constitutionality of the scheme, and there is really no reason to doubt that assertion. 157 as justice ginsburg shrewdly pointed out, “the underlying premise of flast v. cohen [is] that the establishment clause will be unenforceable unless we recognize taxpayer standing.” 158 the decision in winn is a step towards formalism that erects a barrier making the enforcement of the establishment clause more difficult. rather than allow the establishment clause to rot on the paper on which it was written, permitting taxpayer standing when the three prongs of this test are met is a rational and fair way of balancing article iii’s case or controversy requirement and the necessity that the guarantees contained within the constitution come to fruition. e. shortcomings of the test it might fairly be said that this test will not provide a more usable framework than the flast test (and will invite the same problems of indeterminacy) because it is more complicated and because it asks for a greater weighing of pragmatic factors traditionally eschewed by judges. while this may be true, the fact remains that the flast test simply does not work, and insofar as this test attempts to respond to the underlying concerns that motivated the initial formulation of taxpayer standing and allows taxpayers meaningful access to relief from alleged constitutional violations, it would be a step forward in taxpayer standing jurisprudence. what is more, it would not be unduly difficult to administer. although each prong presents a separate difficulty (does the expenditure bear a reasonable relationship? is a political remedy highly unlikely as a matter of structural factors? would the wrong be functionally irremediable?), it is not beyond the capabilities of judges to grasp the core concerns that have motivated the doctrine of taxpayer standing and apply a test better tailored to those issues. at the end of the day, is it preferable to debate the metaphysics of a government program in the attempt to see whether we can fairly infer a nexus between that program and the taxpayer, or are we better served by asking ourselves whether challenges of government expenditures, regardless of how they come, bear a reasonable relationship to a taxpayer’s status as a taxpayer, and if so, whether we would be depriving taxpayers of needed relief from alleged violations of their constitutional rights by denying standing? to vindicate the rights and protections in the constitution, we are better off with the latter. v. conclusion the doctrine of taxpayer standing is a historical departure from the general doctrine of standing. specifically, in that it can be read to loosen certain traditional requirements of standing (for example, the injury need not be quite so immediate and particular and there is some reason to be dubious about the effectiveness of the relief in reducing tax liability). however, it is not a departure from the more deeply rooted and general principle that every violation of the constitution should, in principle, have a remedy which is reasonably accessible (whether that be political or judicial). 159 the flast test as applied in winn deprived taxpayers of any practical remedy. to hold that taxpayer 157 transcript of oral argument at 8, ariz. sch. tuition org. v. winn, 131 s. ct. 1436 (2011). 158 id. at 8. 159 this is to be distinguished from the idea that every wrong in society has a constitutional remedy, a proposition for which there is ample authority to doubt. see, e.g., mueller v. gallina, 311 f. supp. 2d 606, 609 (2004). the law is clearly not intended to punish every violation of the moral law. however, every violation of the federal constitution should, in principle, has a remedy contemplated by the constitution, unless the guarantees of the document are drained of any meaning. this remedy need not be judicial. 146 columbia journal of tax law [vol.6:118 standing is effectively barred is to deny taxpayers a necessary outlet for remedying constitutional violations. the constitution has been read to impose a system of checks and balances where the judiciary plays a crucial role in ensuring that the rights of average citizens are not unduly infringed upon. in cases such as winn and flast, taxpayers who are denied standing have no reasonable political alternative and thus are denied any effective relief from abuse in our constitutional system. while the flast test might be broken, there is still good reason to have a narrow doctrine that sometimes permits standing which arises solely out of a taxpayer’s status as a taxpayer. the new test of taxpayer standing proposed in this note attempts to pick up the animating spirit of the flast decision, while avoiding some of the interpretive hurdles and apparent confusion that plague it. a more nuanced and comprehensive approach makes it unnecessary to go to the extremes that have led some to suggest that taxpayer standing should not exist at all. under this note’s test, taxpayer standing is appropriate when three factors are met: (1) the taxpayer’s status as a taxpayer bears a reasonable relationship to the expenditure of government funds in question; (2) it is of practical necessity because the political system is structurally ill-equipped to provide a remedy for those who object to a particular expenditure of government funds alleged to violate the constitution, or the taxpayer is a member of the class for whom the especial benefit of a constitutional limitation is intended to directly run; and (3) where no other plausible party has standing to challenge the alleged violation, leaving it functionally irremediable. if applied, this new test would do away with some of the useless formalism that has arisen as a result of the flast decision, provide a clearer picture of the underlying concerns motivating the doctrine of taxpayer standing, and still provide necessary judicial relief for violations of the constitution, especially the establishment clause, which would otherwise be functionally irremediable. 91 essay complex tax legislation in the turbotax era lawrence zelenak* when tax returns were prepared with pencil and paper—in an era now gone forever—congress did not impose income tax provisions of great computational complexity on large numbers of taxpayers, in the belief that it was unreasonable to require average taxpayers (or their paid preparers) to struggle with computationally complex provisions. as return preparation software gradually replaced the pencil in recent decades, the complexity constraint weakened and eventually disappeared. congress has responded by imposing unprecedented computational complexity on large numbers of taxpayers— primarily through the expanded scope of the alternative minimum tax and the proliferation of phase outs of credits, deductions, and exclusions. this response would not be problematic, if the only objection to computational complexity were the difficulty of performing the calculations—a difficulty overcome by the widespread adoption of software. unfortunately, computationally complex provisions generally constitute bad tax policy, even apart from computational concerns. for taxpayers faced with a welter of computationally complex provisions, the income tax is a black box, the inner workings of which are beyond their comprehension. this undermines both the political legitimacy of the tax system and the ability of taxpayers to engage in informed tax planning. in response to the demise of the complexity constraint, argues this essay, congress should develop a self-imposed constraint against the enactment (or survival) of computationally complex provisions of widespread applicability. * pamela b. gann professor of law, duke law school. author email: zelenak@law.duke.edu 92 columbia journal of tax law [vol. 1:91 introduction............................................................................................ 92  i. return preparation software: a brief history............ 94  ii. substantively attractive computationally complex provisions: more than a theoretical possibility? ........................................................................... 95  iii. the role of software in facilitating the enactment of bad tax policies........................................ 98  a.  the alternative minimum tax.......................................... 99  b.  phase-outs........................................................................ 104  iv. is there a structural solution?................................... 116  conclusion............................................................................................. 118  introduction in the past thirty years, computer software has revolutionized the preparation of federal income tax returns.1 when all returns were prepared by hand, congress was greatly constrained in its ability to impose computationally complex provisions on large numbers of taxpayers. taxpayers preparing their own returns would have objected vociferously to the computational burden. taxpayers resorting to paid preparers would have objected to the price demanded by paid preparers to wrestle with complexity. even return preparation firms might have objected—despite the increased demand for their services—if they could not find enough employees able to perform the required calculations. with few returns now prepared by hand, however, the computational complexity constraint on the income tax rules applicable to large numbers of taxpayers has virtually disappeared. with only a few luddites clinging to their pencils, and with computers available to perform calculations of any degree of complexity in milliseconds, the practicalities of return preparation impose virtually no limitations on the computational complexity to which congress may subject the average taxpayer. to be clear: software provides only modest assistance in handling complexity in record keeping and data entry, but once the data are entered there are no complexity constraints concerning how the tax rules may instruct the computers to slice and dice the data to produce tax bills. if congress wants to subject millions of taxpayers to multiple overlapping phase-outs of various deductions and credits, if congress wants to impose the alternative minimum tax on half the taxpaying population, or if congress desires tax 1. for the history of the introduction and adoption of return preparation software, see infra notes 2–13 and accompanying text. 2010] complex tax legislation in the turbotax era 93 rate schedules featuring hundreds of different marginal tax rates, it can now achieve its goals. in the turbotax era, mere computational complexity does not rule out any legislative innovation. whether this is a boon or a curse is debatable. on the boon side, it may be possible to identify substantively attractive but computationally complex tax reforms, which would have been impractical in the pencil-andpaper era, but which can and should be enacted in the age of turbotax. on the curse side, however, it may be that computationally complex tax rules are usually bad rules for reasons other than mere computational complexity, that the complexity constraint of bygone days served a valuable function by preventing the enactment of such rules, and that congress may respond to the elimination of the constraint by enacting a myriad of computationally complex and substantively indefensible provisions. worse yet, perhaps congress has already so responded. part i of this essay offers a brief history of how return preparation software routed the humble pencil. part ii considers whether the elimination of the computational complexity constraint might lead to the enactment of substantively desirable tax policies that were previously impractical. it concludes that the theoretical possibility exists, but that it is frustratingly difficult to identify any concrete examples. part iii considers whether the disappearance of the complexity constraint has facilitated the enactment of tax rules that are objectionable apart from their computational complexity. it argues that provisions of major computational complexity and widespread applicability usually constitute bad tax policy even when computers are available to do all the number crunching. such provisions render the take system opaque to the average taxpayer, making it impossible for taxpayers to evaluate whether their tax liabilities are generated by a fair set of rules, and making it impossible for taxpayers to engage in informed tax planning. it concludes that the elimination of the complexity constraint has led to the enactment of a number of objectionable provisions, and that it will continue to do so unless congress succeeds in replacing the complexity constraint with self-restraint. part iv considers mandatory “tax complexity analyses” of current law and of proposed legislation, which congress has required since 1998. it argues that this structural reform has had little or no effect in constraining complexity, and that there is no reason to expect it to be any more effective in the future. part iv is a brief conclusion. it contends that what is needed is not structural reform, but a basic change in attitudes—in hearts and minds— among the members of congress. this may be too much to hope for—but if it is, then there is no hope. the conclusion urges congress to adopt, in the place of the complexity constraint, an informal presumption against the enactment (or survival) of computationally complex provisions of 94 columbia journal of tax law [vol. 1:91 widespread applicability, on the grounds that such provisions generally constitute bad tax policy even when software is available to handle all the computations. i. return preparation software: a brief history the earliest tax return preparation software was developed by a handful of small companies in the late 1970s and early 1980s.2 the early adopters were overwhelmingly paid preparers, rather than taxpayers preparing their own returns. for example, in 1982 jackson hewitt—now the nation’s second largest tax preparation service, but then just a small business in virginia—took the radical step of using self-developed software to prepare all its customers’ returns.3 by 1987, about a quarter of all paid preparer returns were being produced on computers.4 newspaper and magazine stories about the possibility of self-preparers using software did not appear until 1983.5 data do not exist on the extent of software use by selfpreparers in the 1980s, but according to a leading expert on the growth of the use of return preparation software “[i]t is reasonable to infer that very few self-preparers used software” even towards the end of the decade.6 the greatest growth in the use of return preparation software occurred from the mid-1980s to the mid-1990s. only 13% of all individual returns had been prepared on computers in 1987,7 but 67% of all returns for tax year 1997 were computer-prepared.8 this included 87% of paid preparer returns and 45% of self-prepared returns.9 much of the growth in 2. don nunes, computer programs aid tax return preparation, wash. post, feb. 14, 1983, at 23. 3. daniel b. grunberg, case study: information technology at jackson hewitt tax service, 15 j. of consumer marketing 282, 283 (1998). 4. eric toder, changes in tax preparation methods, 1993-2003, 107 tax notes 759, 759 (2005) (reporting that 13% of all 1987 returns were prepared on computers, that 48% of all individual taxpayers used paid preparers, and that “very few” self-preparers used software). 5. nunes, supra note 2; ellen benoit, the tax preparation revolution, forbes, jan. 17, 1983, at 69. more stories appeared the following year. david e. sanger, software for doing your own return, n.y. times, mar. 4, 1984, at 76; john w. hazard, doing your taxes by computer, u.s. news & world report, mar. 19, 1984, at 86; william d. marbach, now, the electronic tax man, newsweek, mar. 19, 1984, at 106. 6. toder, supra note 4, at 759 (toder’s comment refers specifically to 1987). 7. id. at 759. 8. data release, taxpayer usage study, 1997, statistics of income bulletin 131, 131 (summer 1998). 9. author’s calculations, based on id. at 135 tbl.1. of all individual returns for 1997, 54% were prepared by paid preparers, and 46% by taxpayers themselves. author’s 2010] complex tax legislation in the turbotax era 95 software use during this period was attributable to the pencil-to-software transition by industry giant h&r block. block did not use return preparation software at all until 1990,10 and did not complete the transition to software until 1993.11 by tax year 2006 (the most recent year for which data are available), 89% of all individual returns were prepared on computers.12 this included 98% of paid preparer returns and 71% of self-prepared returns.13 in light of the seemingly inexorable trend, it is very likely that the data for returns for tax year 2008, when they become available, will indicate that fewer than one return in ten is now being prepared using pencil and paper. ii. substantively attractive computationally complex provisions: more than a theoretical possibility? it is not necessarily a bad thing that tax return computational complexity no longer serves as a constraint on federal income tax legislation. perhaps there are some tax reform proposals lurking in the wings, which in the pre-turbotax era would have been too computationally complex to enact, but which would have been good tax policy apart from their computational complexity. if so, tax return preparation software has now overcome the complexity problem, and the proposals can and should be enacted. the story of the demise of the rule of 78s in the wake of the widespread availability of financial calculators provides an analogy. before the availability of inexpensive financial calculators, the irs permitted taxpayers to calculate interest by the inaccurate-but-easy-to-apply rule of 78's.14 in 1982 hewlett-packard introduced the hp 12c, the world’s first calculations, based on id. at 135 tbl.1. 10. h&r block, inc., 1991 annual report 10 (reporting that block “field tested” return preparation software in two company-owned districts and a small number of franchise operations in 1990). 11. h&r block, inc., 1993 annual report 2 (“for the first time, our income tax services in the u.s. were fully automated in fiscal 1993, enabling us to provide computerized tax returns to virtually all of our clients.”). 12. internal revenue service, tax year 2006 taxpayer usage study, report 16, available at http://www.irs.gov/taxstats/article/0,,id=184856,00.html (last visited feb. 14, 2010). 13. author’s calculations, based on id. of all individual returns for 2006, 63% were prepared by paid preparers and 37% by taxpayers themselves. author’s calculations, based on id. 14. rev. rul. 72-100, 1972-1 c.b. 122, 1972 wl 30448 (permitting the use of the rule of 78's to calculate interest with respect to installment notes with terms of sixty months or less). http://www.irs.gov/taxstats/article/0,,id=184856,00.html 96 columbia journal of tax law [vol. 1:91 mass-market handheld financial calculator.15 the following year the irs issued a revenue ruling stating that the rule of 78's “lacks economic substance because it fails to reflect the true cost of borrowing,” and concluding that the rule could no longer be used to calculate interest for purposes of the federal income tax.16 the ruling did not mention the advent of the hp 12c, but it is unlikely that the appearance of the ruling shortly after the appearance of the calculator was a coincidence. perhaps something similar might now happen in response to the near-ubiquity of tax preparation software; perhaps some superior tax legislative policies requiring complex tax return calculations can now be enacted. it is easy enough to acknowledge the theoretical possibility that such policies might exist. it is much more difficult to think of concrete examples of such policies. two possibilities come to mind, but both are far from compelling. the first is the introduction of continuously variable marginal tax rates. when optimal tax analysts investigate the attributes of the tax-and-transfer systems that would maximize various social welfare functions under various conditions, they generally find that the optimal income tax features continuously varying marginal tax rates, so that each dollar of a taxpayer’s income would be taxed at a different rate.17 prior to the development and widespread use of return preparation software, implementation of such a tax rate structure would have been impossible, no matter how compelling the theoretical case in its favor. today, software could handle the computational complexity with ease. should congress respond to the near-ubiquity of return preparation software by enacting continuously varying marginal tax rates? probably not. optimal tax analysts generally find that the social welfare improvements from continuously varying rates, in comparison with a limited number of tax brackets—or, indeed, with a single (“flat”) rate—are quite modest.18 and these modest improvements do not take into account 15. tim carvell, the product hewlett-packard couldn’t (and shouldn’t) kill, fortune, dec. 9, 1996, at 40. 16. rev. rul. 83-84, 1983-1 c.b. 97, 1983 wl 190117. the ruling was accompanied by a narrow exception, permitting the continued use of the rule of 78's in connection with certain short-term consumer loans. rev. proc. 83-40, 1983-1 c.b. 774. 1983 wl 189227. the exception survived for more than a decade, before it was finally “obsoleted”. rev. proc. 97-37, 1997-2 c.b. 455, 1997 wl 430911. 17. see, e.g., matti tuomala, optimal income tax and redistribution 95–99 (1990) (presenting optimal marginal tax rate curves based on a variety of social welfare functions and factual assumptions; in most simulations the marginal tax rate rises through the bottom ten percent of the wage distribution, but declines thereafter). 18. the seminal work on optimal income tax analysis is james mirrlees, an exploration in the theory of optimum income taxation, 38 rev. econ. stud. 175 (1971). as later scholars have noted, mirrlees made the surprising “discovery . . . that, at least in the cases he considered, the optimal non-linear tax structure was approximately linear!” joel 2010] complex tax legislation in the turbotax era 97 the negative effects of continuously varying rates, in terms of taxpayer confusion and incomprehension, and in terms of frustration of tax planning (which requires knowledge of one’s marginal tax rate or rates). once the negative effects were factored in, the detriments of continuously varying rates would probably outweigh the benefits, even with return preparation software doing all the computational heavy lifting. one prominent optimal tax study, concerning the relative merits of a flat tax and a two-bracket system concluded, “[t]he benefits of allowing two brackets rather than one are very sensitive to the parameterization of the problem and may or may not be sufficient to justify the additional administrative cost.”19 if the optimal tax benefits of something as simple as a two-bracket system may not be worth the trouble caused by the introduction of the second bracket, it is not likely that the optimal tax benefits of continuously varying rates would be sufficient compensation for the inevitable incomprehension and interference with tax planning. many taxpayers would not understand either the policy justification for or the mechanical operation of continuously varying rates, and even taxpayers who did understand the rate structure in theory would be unable to determine their effective marginal tax rate(s) for planning purposes. for another example of a tax policy, the realization of which might be promoted by the spread of return preparation software, consider proposals to eliminate income tax marriage penalties on two-earner couples by allowing spouses to file separate returns (using the section 1(c) rates applicable to single persons, rather than the unfavorable section 1(d) rates currently applicable to married persons filing separate returns) if their combined separate return liabilities are less than their joint return liability. a bill permitting optional separate filing passed the senate in 1999, but never became law.20 in an era of pencil-and-paper tax return preparation, it would have been a serious objection to optional separate filing that it requires a couple to prepare three tentative returns—one joint and two separate—in order to determine whether joint filing or separate filing produces the lower tax liability. with taxpayers in 1999 in the midst of the transition from pencils to software, this objection still had some force. it would, however, have almost no force today. if one believed in 1999 that optional separate filing would be good tax policy, but for the need to prepare three tentative returns, then in 2009 one should whole-heartedly support optional separate filing. preparing and comparing three tentative returns is no challenge for software. slemrod, shlomo yitzhaki, joram mayshear, & michael lundholm, the optimal twobracket linear income tax, 53 j. pub. econ. 269, 270 (1994). 19. slemrod et al., supra note 18, at 285. 20. taxpayer refund act of 1999, s. 1429, 106th cong., § 201. 98 columbia journal of tax law [vol. 1:91 unfortunately, the case for optional separate filing is weak, even in 2009. for one thing, optional separate filing not only introduces the computational complexity of tentative returns, it also introduces the noncomputational complexity of allocating income, deduction, and credit items between the spouses for purposes of the separate returns. software offers no assistance in dealing with complexity of this sort. more fundamentally, there is a powerful argument that optional separate filing would be bad tax policy on the merits, even if it created no complexity of any kind. the objection is that optional separate filing is philosophically incoherent.21 the standard policy justification for having joint returns at all—rather than simply requiring all married persons to file separate returns under the same rate structure applicable to unmarried persons—is that married couples function as economic units, so that two married couples with the same combined income should have the same tax liability regardless of the division of the incomes between the spouses in each marriage. but consider two equal-income couples under an optional separate filing regime. in one marriage, all the income is earned by one spouse, while in the other marriage half the income is earned by each spouse. the former couple will file a joint return, while the latter couple will file two separate returns and pay less tax. the purpose of a joint return system is to impose equal tax on equal income couples, but optional separate filing fatally undermines that purpose. to sum up: in theory, the near-universal use of return preparation software might facilitate the introduction of desirable tax rules previously impeded by computational complexity. it is extremely difficult, however, to identify even one compelling example of such a rule. it is much easier to identify examples of the opposite phenomenon—bad tax policies the introduction of which would have been impeded by computational complexity in the pencil-and-paper era, but which survive and flourish in the age of turbotax. the next section of this essay considers this phenomenon. iii. the role of software in facilitating the enactment of bad tax policies under current law, the major sources of computational complexity impacting large numbers of taxpayers are the alternative minimum tax (amt) and the phase-outs of various deductions, exclusions and credits for 21. for a fuller development of the argument against optional separate filing based on philosophical incoherence, see lawrence zelenak, doing something about marriage penalties: a guide for the perplexed, 54 tax l. rev. 1, 17–19 (2000). 2010] complex tax legislation in the turbotax era 99 taxpayers with incomes above the various phase out thresholds. as detailed below, the impact of both the amt and of phase-outs has increased dramatically over the same period that software has supplanted the pencil as the dominant return preparation tool. it would probably be impossible to prove a direct causal connection between the ascendancy of software and the increasing computational complexity of the average tax return. indeed, a major theme of this essay is that increasing complexity does not inevitably follow from the spread of software; congress can and should replace the computational complexity constraint on tax legislation with selfrestraint. nevertheless, there is good reason to suspect that it is no accident that the increase in tax return complexity has coincided with the triumph of return preparation software.22 this section begins by examining the amt, and then turns to phase-outs. it demonstrates how both the amt and phase outs have expanded as software usage has increased, and explains why both the expanding reach of the amt and the proliferation of phase outs are bad policy, even if no one ever again prepares a tax return without computer assistance. a. the alternative minimum tax the minimum tax was introduced in 1969, more than a decade before the first computer-prepared tax return.23 the purpose was to ensure that taxpayers with high economic incomes could not avoid substantial tax liabilities by aggressively exploiting exclusions, deductions, and credits.24 since 1978, the minimum tax has taken the form of an “alternative” minimum tax.25 having computed her regular tax liability by applying the regular tax rates to her regular taxable income, the taxpayer must calculate her tentative minimum tax by applying the amt tax rates to her amt tax base, which is defined as her alternative minimum taxable income (“amti”) in excess of the amt exemption amount.26 the rules defining 22. it is not possible here to disprove alternative explanations for the increase in tax return complexity. perhaps, for example, congress has recently become persuaded that the pursuit of an equitable distribution of tax burdens requires an increase in computational complexity, and congress would have so decided even if tax return software had not been available to handle the computations. occam’s razor, however, strongly favors the explanation suggested in the text—that the widespread availability of return preparation software eliminated the complexity constraint and congress responded by enacting widely applicable tax laws of unprecedented computational complexity. 23. tax reform act of 1969, pub. l. no. 91-172, §301, 83 stat. 487, 580–81. 24. s. rep. no. 313, 99th cong., 518–19 (2d sess. 1986). 25. revenue act of 1978, pub. l. no. 95-600, § 421, 92 stat. 2763, 2871–72. 26. i.r.c. § 55(b)(1) (2009). 100 columbia journal of tax law [vol. 1:91 amti disallow a number of tax preferences (exclusions and deductions) that are permitted for purposes of the regular tax.27 if the tentative minimum tax exceeds the taxpayer’s regular tax liability, she must pay that excess as her amt liability (in addition, of course, to paying the regular tax).28 amt calculations greatly increase the difficulty of pencil-and-paper tax return preparation, but if the taxpayer (or her paid preparer) uses software the computational difficulties vanish. in 1970 (the first year in which the minimum tax applied), only 20,000 taxpayers were subject to the minimum tax.29 the number of affected taxpayers generally increased in subsequent years—albeit with large year-to-year fluctuations in both directions.30 by far the greatest increase in the number of taxpayers subject to the amt, however, has occurred in the past decade. the number of taxpayers subject to the amt more than tripled from 1.3 million in 2001 to 4.0 million in 2005.31 the primary cause of this increase was the fact that the 2001 and 2003 reductions in the regular income tax32 (some of which were phased in over several years) were not accompanied by parallel reductions in the amt.33 as taxpayers’ regular tax liabilities declined over the decade and their tentative minimum taxes did not, many taxpayers’ tentative minimum taxes exceeded their regular tax liabilities for the first time. in most cases, these were not the truly wealthy taxpayers who were the original targets of the minimum tax. in 2007, 3.6% of taxpayers with cash incomes in the $100,000 to $200,000 range were subject to the amt, as were 47.0% of taxpayers with cash incomes in the $200,000 to $500,000 range, and 57.2% of taxpayers with cash incomes ranging from $500,000 to $1,000,000.34 by contrast, only 37.3% of taxpayers with cash incomes above $1,000,000 27. i.r.c. § 55(b)(2) (2009). 28. i.r.c. § 55(a) (2009). 29. greg leiserson & jeffrey rohaly, the individual alternative minimum tax: historical data and projections, updated june 2008, tax policy center 10, tbl.2 (june 25, 2008), available at http://www.taxpolicycenter.org/publications/url.cfm?id=411703 (last visited feb. 14, 2010). 30. see id. tbl.2. 31. see id. tbl.2. in 2006 4.0 million taxpayers were again subject to the amt, and in 2007 (the most recent year for which data are available) the tax applied to 4.1 million taxpayers. id. 32. economic growth and tax relief reconciliation act of 2001, pub. l. no. 107-16, 115 stat. 38 (2001); jobs and growth tax relief reconciliation act of 2003, pub. l. no. 108-27, 117 stat. 752 (2003). 33. gregg a. esenwein, congressional research service, report for congress: the alternative minimum tax for individuals: legislative initiatives and their revenue effects (crs/rs 22563) (updated may 22, 2007), at 1 (on file with columbia journal of tax law). 34. leiserson & rohaly, supra note 29, at 11 tbl.3. 2010] complex tax legislation in the turbotax era 101 amt. worksheets, and making the seemingly endless calculations required to were subject to the amt.35 the two leading amt preference items today are not the sort of wealthy, investor tax preference items at which the amt was originally targeted. in 2006, state and local tax deductions constituted 70.57 percent (by dollar amount) of all amt preferences, and personal exemptions constituted another 19.05 percent.36 the amt exemption amount is not indexed for inflation (unlike the analogous provisions of the regular tax), but congress has been enacting annual amt “patches” in lieu of a permanent fix for this problem.37 if congress should ever fail to enact a “patch,” the number of taxpayers affected by the amt would increase tremendously, to more than 30 million.38 no one can state with certainty whether congress would have been willing to subject almost three million more taxpayers (the difference between 1.3 million in 2001 and 4.1 million in 2007) to the amt in this decade, in a world of pencil-and-paper tax return preparation. it is reasonable to surmise, however, that in that alternate universe, complaints of computational complexity would have been a serious impediment to the exclusion of the amt from the tax reductions of 2001 and 2003. but with more than four out of five returns for tax year 2001 prepared on computers,39 and with the expectation that the dominance of software would only increase over time, congress had no reason to fear major taxpayer objections to the computational complexity of the expanding the question remains: if the computational complexity of the amt is no longer a problem in the turbotax era, what is wrong with imposing the amt on millions—or even tens of millions—of taxpayers? when it urged the repeal of the amt in its 2005 report, the president’s advisory panel on federal tax reform (“panel”) condemned the amt solely on the basis of computational complexity: “eliminating the amt would free millions of middle-class taxpayers . . . from filing the forms, preparing the 35. id. at 11. 36. tax policy center, amt preference items, 2002, 2004–2006 1, available at http://www.taxpolicycenter.org/taxfacts/displayfact.cfm?docid=468 (last visited feb. 14, 2010). 37. see, e.g., american recovery and reinvestment tax act of 2009, pub. l. no. 1115, §1012, 123 stat. 115 (enacting the amt “patch” for 2009). 38. leiserson & rohaly, supra note 29, at 11 tbl.3 (estimating that 34.8 million taxpayers will be subject to the amt in 2010 in the absence of a “patch” for that year). 39. according to the internal revenue service, 80.16% of 2001 returns were prepared on computers. internal revenue service, tax year 2001 taxpayer usage study, report 14, available at http://www.irs.gov/taxstats/article/0,,id=184856,00.html (follow “2002” link under “archives”) (last visited feb. 14, 2010). http://www.irs.gov/taxstats/article/0,,id=184856,00.html 102 columbia journal of tax law [vol. 1:91 determine their amt liability.”40 somehow the panel missed the fact that very few taxpayers (or their paid preparers) actually wrestle with these forms, worksheets, and calculations, because the vast majority of amt returns are now prepared on computers (and virtually all are likely to be computer-prepared in the near future). if this is the only objection to a burgeoning amt, then there is really no meaningful objection. tax historian joseph thorndike shares the view of this essay that, as a political matter, computationally complex tax provisions of wide applicability can survive and flourish in the turbotax era, and he ruefully predicts that the amt—which he excoriates as “a bad tax, a blight on the nation’s revenue structure”—will not “cause enough pain to ensure its own demise.”41 like the panel, however, thorndike does not explain what is so objectionable about the amt, when millions of computers stand ready to do all the number-crunching. despite his lack of explanation, thorndike is right—the amt is a bad tax, even with those millions of computers at the ready. the fundamental problem is that the amt turns the tax system into a black box for those taxpayers to whom it applies. turbotax or a paid preparer will tell the taxpayer his overall tax liability, but the taxpayer may not focus on the portion of that liability attributable to the amt. even if the taxpayer happens to notice the amount of his amt, he will almost certainly not understand the derivation of that figure. to that taxpayer, the tax system is a black box, producing a tax liability through some incomprehensible process. there are two serious objections to a black-box tax system. the first objection is grounded in civics. as charles mclure has noted, a black-box tax system is “hardly a recipe for good governance in a democracy.”42 if taxpayers do not have at least a rough idea of the process through which their tax liabilities are determined, they can have no way of evaluating the fairness of the tax system, as applied either to themselves or to others.43 taxation without comprehension is as inimical to democracy as 40. president’s advisory panel on federal tax reform, simple, fair, and pro-growth: proposals to fix america’s tax system, 211 tax notes today 14 (nov. 2, 2005). 41. joseph j. thorndike, the great noncrisis of the amt, 107 tax notes 245 (2005). 42. charles e. mclure, jr., economics and tax reform: 1986 and now, 113 tax notes 362 (2006). 43. the workings of the amt are not completely opaque to a highly observant turbotax user. turbotax features a small box near the top of the computer screen, which keeps a running score of the taxpayer’s underpayment or overpayment on the assumption that the taxpayer has already made all data entries. it can be a disturbing experience for a turbotax user subject to the amt to enter a five-figure state and local tax deduction and see the number in the small box change only a little or not at all. 2010] complex tax legislation in the turbotax era 103 taxation without representation.44 the second objection relates to the ability of taxpayers to engage in well-informed basic tax planning, and to respond appropriately to the many incentives congress has embedded in the tax laws. if a taxpayer is unable to determine whether he is subject to the amt until after the end of the tax year (that is, until after the return has been prepared), he will be unable to determine whether his marginal tax rate is that of the regular tax or that of the amt. as a result, he will be unable to determine (for example) his after-tax cost of charitable giving, or his after-tax return from earning extra income. worse yet, in the case of amt preference items, the taxpayer will be unable to determine whether the favorable regular tax treatment of those items is available to him. a taxpayer may take out a second mortgage, relying on the deductibility of interest on home equity indebtedness under the regular tax,45 only to be blindsided by the nondeductibility of such interest under the amt.46 or a taxpayer may buy a house in a highproperty-tax jurisdiction, relying on the income tax deductibility of the property tax,47 only to lose the deduction under the amt.48 or consider a taxpayer who bought a hybrid car before 2009, expecting to receive a widely-advertised tax credit, only to discover too late that the credit was not allowed for purposes of the amt and that the amt applied to the taxpayer.49 if amt taxpayers are induced to engage in behavior which is taxfavored under the regular tax—either not realizing they are subject to the amt, or not realizing that the tax preference is not available under the amt—the result is manifestly unfair. the other possibility is just as troubling—that taxpayers not subject to the amt may fail to respond to incentives in the regular income tax, based on an awareness that the incentives do not apply under the amt and a fear that they may be subject to the amt. as austan goolsbee has commented, a black box tax system 44. see lawrence zelenak, justice holmes, ralph kramden, and the civic virtues of a return filing requirement, 61 tax l. rev. 53, 71–72 (2007) (arguing that the income tax return filing requirement can have the “civic virtue” of making taxpayers conscious of the distribution of the costs of government, but that that benefit is lost if taxpayers perceive the income tax “as a black box, producing income tax liabilities through the use of incomprehensible rules that taxpayers have no reason to assume are fair”). 45. i.r.c. § 163(h)(3)(c) (2009). 46. i.r.c. § 56 (b)(1)(c)(i) (2009). 47. i.r.c. § 164(a)(2) (2009). 48. i.r.c. § 56(b)(1)(a)(ii) (2009). 49. see lawrence zelenak, of prius buyers, blue states, consumer energy credits, and the alternative minimum tax, 109 tax notes 657 (oct. 31, 2005). as recently amended, §30b(g)(2) now provides that the hybrid vehicle credit may be claimed against the amt as well as the regular tax. 104 columbia journal of tax law [vol. 1:91 wreaks havoc with tax incentives: if people do not understand the incentives embodied in the system, they will not respond to them. on the one hand, this makes the system efficient and nondistortionary . . . . on the other hand, the ability to influence behavior was exactly the policymakers’ point in creating the complex tax system to begin with. in the long run that purpose would be lost.50 perhaps the costs of a black-box amt of widespread applicability would be worth bearing, if the amt served a sufficiently important purpose that could not be served in some simpler fashion. but applying the amt to millions of less-than-wealthy taxpayers, largely by reason of their living in high-tax states or having children, does nothing to serve the original purpose of the amt (that is, to ensure that wealthy taxpayers could not avoid substantial income tax liabilities by aggressively taking advantage of various tax preferences).51 and neither congress nor commentators have suggested any new policy rationale for the tax as it currently exists—other than mere revenue raising, which could be pursued more simply and more rationally in any number of other ways. b. phase-outs the use of phase-outs in the income tax dates back at least to the 1954 code.52 section 214 of the 1954 code allowed a deduction for up to 50. austan goolsbee, the turbotax revolution: can technology solve tax complexity?, in the crisis in tax administration 124, 138 (henry j. aaron & joel slemrod eds., 2004). 51. see supra note 24 and accompanying text. 52. provisions which allow deductions only to the extent expenditures exceed some specified percentage of adjusted gross income (agi), and provisions which phase-in benefits as income increases, both resemble phase-outs in terms of computational complexity, taxpayer confusion, and the production of effective marginal tax rates different from statutory marginal tax rates under i.r.c. §1. because of these similarities, analysts frequently discuss percentage-of-agi floors and phase-ins along with phase-outs. see, e.g., staff of the joint comm. on taxation, 105th cong., present law and analysis relating to individual effective marginal tax rates jcs-3-98 (1998). floors and phase-ins are not considered here, however, because—in sharp contrast with phase-outs— they have not proliferated as the use of return preparation software has expanded in recent decades. the three significant percentage-of-agi floors in the individual income tax are the 7.5% floor applicable to medical expenses (internal revenue act of 1954, pub. l. no. 83591, §213(a), 68a stat. 3, 69 (imposing a 3%-of-agi floor; under current i.r.c. §213(a) the floor is 7.5%)), the 10% floor on personal casualty losses (tax equity and fiscal 2010] complex tax legislation in the turbotax era 105 $600 of dependent care expenses, but reduced the otherwise allowable deduction (in the case of taxpayers filing a joint return) by the amount by which adjusted gross income (agi) exceeded $4,500.53 a second phaseout was added to the income tax with the introduction of the earned income tax credit (eitc) in 1975.54 a qualifying taxpayer with exactly $4,000 of earned income was entitled to a $400 credit. the credit was reduced, however, by 10 percent of the amount by which the taxpayer’s income exceeded $4,000 (with the phase-out thus completed at $8,000). phase-outs remained rare in the income tax until the 1980s. legislation enacted in 1983 phased out half of the exclusion of social security benefits from gross income, pursuant to a complex formula.55 the tax reform act of 1986 added a provision designed to phase out the benefit of personal exemptions and the benefit of the 15 percent tax bracket (as compared to the 28 percent tax bracket).56 the provision imposed a special tax equal to five percent of the excess of the taxpayer’s taxable income over a specified phase-out threshold (based on filing status), with the maximum special tax liability limited to the tax reduction attributable to personal exemptions and the 15 percent bracket.57 for taxpayers in the responsibility act of 1982, pub. l. no. 97-248, §203(a), 96 stat. 324, 422 (now codified at i.r.c. §165(h)(2))), and the 2% floor applicable to miscellaneous itemized deductions (tax reform act of 1986, pub. l. no. 99-514, §132, 100 stat. 2085, 2113-16 (now codified at i.r.c. §67)). the two significant phase-ins are the phase-in of the earned income tax credit (tax reduction act of 1975, pub. l. no. 94-12, §204, 89 stat. 26, 30-32 (now codified at i.r.c. §32(b))), and the phase-in of the refundability of the child tax credit (economic growth and tax reconciliation act of 2001, pub. l. no. 107-16, §201(c), 115 stat. 38, 46 (now codified at i.r.c. §24(d))). as explained later in this essay (see supra notes 87-92 and accompanying text), in recent years congress has used phase-outs for two purposes: to impose hidden marginal tax rate increases on all or nearly all taxpayers in particular income ranges, and to target new tax benefits to lowerand middle-income taxpayers. because neither percentage-of-agi floors nor phase-ins are well suited to either of these purposes, the removal of the complexity constraint has not prompted a flurry of floor and phase-in legislation. 53. internal revenue act of 1954, pub. l. no. 83-591, §214, 68a stat. 3, 70-71. 54. tax reduction act of 1975, pub. l. no. 94-12, §204, 89 stat. 26, 30-32 (now codified at i.r.c. §32). the 1975 version of the eitc was a temporary provision, but congress made the credit permanent in 1978. revenue act of 1978, pub. l. no. 95-600, §103, 92 stat. 2761, 2771. 55. the formula reduced the exclusion by the amount by which the sum of the taxpayer’s modified adjusted gross income and half of the taxpayer’s social security benefits exceeded a “base amount” ($25,000 for unmarried taxpayers, and $32,000 for taxpayers filing joint returns). social security amendments of 1983, pub. l. no. 98-21, §121, 97 stat. 65, 80-82 (now codified at i.r.c. §86(c)). 56. tax reform act of 1986, pub. l. no. 99-514, §101(a), 100 stat. 2085, 2097-98 (formerly codified at i.r.c. §1(g)). 57. the 1986 act also introduced an analogous phase-out of the amt exemption amount. tax reform act of 1986, pub. l. no. 99-514, §701(a), 100 stat. 2085, 2320-22 (now codified at i.r.c. §55(d)(3)). 106 columbia journal of tax law [vol. 1:91 phase-out range the official marginal tax rate was 28 percent, but the effective marginal tax rate—considering both the official rate and the phase-out—was 33 percent. once the phase-out was completed (that is, once the benefits of the personal exemptions and the 15 percent bracket had been fully taxed away), the effective marginal tax rate dropped to 28 percent. as is typically the case with phase-outs, the result was an effective marginal tax rate “bubble”, with taxpayers in the phase-out range subject to higher effective marginal tax rates than taxpayers at both lower and higher income levels. the 1986 act also introduced an income-based phase-out of the ability to make deductible individual retirement account (ira) contributions, applicable to active participants in tax-favored employmentbased retirement plans.58 phase-outs became a significant feature of the income tax in the 1980s, but the most dramatic growth in phase-outs occurred in the following decade. in 1990 congress repealed the five percent phase-out tax of the 1986 act,59 only to replace it with two new phase-outs. one of the new phase-outs reduced otherwise allowable itemized deductions by the lesser of (1) three percent of the excess of agi over $100,000, or (2) 80 percent of otherwise allowable itemized deductions.60 the other phase-out reduced the dollar amount of otherwise allowable personal exemptions by two percentage points for each $2,500 by which the taxpayer’s agi exceeded a specified threshold amount (based on filing status).61 in 1993 congress revisited the exclusion of social security benefits, providing for the phase-out of 85 percent of the exclusion for some taxpayers.62 the banner year for phase-outs was 1997, in which congress introduced the child tax credit,63 the hope scholarship and lifetime learning credits,64 the deduction for interest on student loans,65 roth iras,66 and educational 58. tax reform act of 1986, pub. l. no. 99-514, §1101(a), 100 stat. 2085, 2411-14 (now codified at i.r.c. §219(g)). 59. omnibus budget reconciliation act of 1990, pub. l. no. 101-508, §11101(b), 104 stat. 1388, 1388-404. 60. omnibus budget reconciliation act of 1990, pub. l. no. 101-508, § 11103(a), 104 stat. 1388, 1388-406 (now codified at i.r.c. § 68). 61. omnibus budget reconciliation act of 1990, pub. l. no. 101-508, § 11104(a), 104 stat. 1388, 1388-407 (now codified at i.r.c. § 151(d)(3)). 62. omnibus budget reconciliation act of 1993, pub. l. no. 103-66, § 13215, 107 stat. 312, 475-76 (now codified at i.r.c. § 86(a)(2)). 63. taxpayer relief act of 1997, pub. l. no. 105-34, § 101(a), 111 stat. 788, 796-98 (now codified at i.r.c. § 24). 64. taxpayer relief act of 1997, pub. l. no. 105-34, § 201(a), 111 stat. 788, 799-803 (now codified at i.r.c. § 25a). 65. taxpayer relief act of 1997, pub. l. no. 105-34, § 202(a), 111 stat. 788, 806-08 (now codified at i.r.c. § 221). 66. taxpayer relief act of 1997, pub. l. no. 105-34, § 302(a), 111 stat. 788, 825-28 2010] complex tax legislation in the turbotax era 107 savings accounts67—each with its own phase-out provision, reducing or eliminating the ability of higher-income taxpayers to claim the tax benefit. in 1998, in response to the proliferation of phase-outs, the staff of the joint committee on taxation published a lengthy report describing and evaluating income tax provisions “that can result in a taxpayer’s effective marginal tax rate deviating from the statutory marginal tax rate.”68 the staff identified eighteen such phase-out provisions.69 some of the provisions were highly specialized and affected few taxpayers, but others were of widespread applicability. the staff reported the number of taxpayers whose marginal tax rates were affected by the various phase-out provisions: 11.7 million by the phase-out of the eitc, 5.0 million by the partial phase-out of the exclusion of social security benefits, 4.5 million by the limitation on itemized deductions, 1.6 million by the partial phase-out of the dependent care credit, 1.5 million by the phase-out of eligibility to make deductible ira contributions, 1.4 million by the phase-out of personal exemptions, and 1.2 million by the phase-out of the hope scholarship and lifetime learning credits (combined).70 because of its focus on effective marginal tax rates, the staff provided no estimates of the numbers of taxpayers with incomes above the various phase-out ranges, whose tax liabilities were increased by the phase-outs but whose effective marginal tax rates were not. the pace of phase-out legislation slowed after 1997, and in 2001 congress even made a show of repealing two prominent phase-outs—the limitation on itemized deductions and the phase-out of personal exemptions.71 however, in the spirit of st. augustine praying for chastity— “give me chastity and self-control, but not just yet”72— congress delayed the repeals for many years. the repeals had no effect until 2006. in 2006 and 2007 they reduced the otherwise applicable phaseout amounts by one-third, and in 2008 and 2009 by two-thirds. the repeal is fully effective in 2010—but only in 2010, because the repeals (in (now codified at i.r.c. § 408a). 67. taxpayer relief act of 1997, pub. l. no. 105-34, § 213(a), 111 stat. 788, 813-16 (now codified at i.r.c. § 24). 68. staff of the joint comm. on taxation, supra note 52. 69. id. at 4-9 chart 1. altogether, the staff identified twenty-two provisions that could cause effective marginal tax rates to differ from statutory rates. the non-phase out provisions were a small number of percentage-of-agi floors on deductions and phase-ins of tax benefits. floors and phase-ins are discussed earlier. see supra note 52. 70. staff of the joint comm. on taxation, supra note 52, at 4–7 chart 1. 71. economic growth and tax relief reconciliation act of 2001, pub. l. no. 107-16, § 102, 115 stat. 38, 44 (relating to the phase-out of personal exemptions), § 103, 151 stat. 38, 44-45 (relating to the limitation on itemized deductions). 72. st. augustine, confessions 173 (garry wills trans., 2006). 108 columbia journal of tax law [vol. 1:91 common with all the 2001 tax reductions) are scheduled to “sunset” at the end of this year.73 congress continues to enact new phase-outs from time to time, although not at the pace of the 1990s. for example, the first-time homebuyer credit enacted in 2008 is subject to an income-based phaseout,74 as was the one-time “recovery rebate” created by 2008 legislation.75 in addition to enacting new phase-outs, congress has designed some phaseout provisions so that their impact increases over time without the need for additional legislation. these are the phase-out provisions with agi thresholds that are not indexed for inflation; the most important example is the phase-out of the child tax credit, the phase-out thresholds of which have remain unchanged ($110,000 for taxpayers filing joint returns, and $75,000 for unmarried taxpayers) since enactment.76 in 1998 only 0.6 million taxpayers had effective marginal tax rates affected by the phase-out of the child tax credit.77 comparable data are not available for recent years, but with the thresholds badly eroded by inflation it is probable that several times that many taxpayers are affected today.78 data on the numbers of taxpayers affected by the various phaseouts is much harder to come by than data on the number of taxpayers affected by the amt. although the 1998 report of the staff of the joint committee on taxation included a comprehensive analysis of the numbers of taxpayers with effective marginal tax rates affected by the various provisions as of 1998,79 nothing comparable is available for more recent years. it is clear, however, that in the aggregate, phase-outs impact a tremendous number of taxpayers. according to the national taxpayer advocate (nta), more than 60 million returns of individuals for tax year 2004 were “affected by one or more phaseouts,” as were more than 70 million returns for tax year 2006.80 the total number of individual returns 73. economic growth and tax relief reconciliation act of 2001, pub. l. no. 107-16, § 901, 115 stat. 38, 150. 74. housing and economic recovery act of 2008, pub. l. no. 110-289, § 3011(a), 2888-91 (codified at i.r.c. § 36). 75. economic stimulus act of 2008, pub. l. no. 110-185, § 101(a), 122 stat. 613, 613-15 (codified at i.r.c. § 6428). 76. i.r.c. § 24(b) (2009). 77. staff of the joint comm. on taxation, supra note 52, at 6 chart 1. 78. if the thresholds had been adjusted for inflation since 1998, the $75,000 threshold would now be approximately $98,000, and the $110,000 threshold would now be approximately $144,000. bureau of labor statistics inflation calculator, available at http://data.bls.gov/cgi-bin/cpicalc.pl (last visited feb. 14, 2010). 79. staff of the joint comm. on taxation, supra note 52, at 4–9 chart 1. 80. national taxpayer advocate, 2006 annual report to congress 470 (2006); national taxpayer advocate, 2008 annual report to congress 410 (2008). there is an important ambiguity in the nta’s statistics. it is unclear whether the numbers reflect only those taxpayers with effective marginal tax rates affected by phase-outs (as in the case of 2010] complex tax legislation in the turbotax era 109 for tax year 2006 was 138.4 million,81 so according to the nta most returns were affected by phase-outs. because there is considerable overlap in the income ranges over which the various phase-outs operate,82 many taxpayers have effective marginal tax rates influenced by more than one phase-out. from the history recounted above, it is apparent that the complexity constraint did not prevent the enactment of some phase-outs during the pencil-and-paper era of tax return preparation. the 1954 enactment of the phase-out of the dependent care credit and the 1975 enactment of the phaseout of the eitc predate even the earliest use of return preparation software, and the phase-outs of the 1986 act were introduced when only about one return in eight was prepared on a computer.83 it is impossible to say whether taxpayers and their paid preparers would have tolerated the profusion of widely applicable phase-outs in the current income tax—and especially the simultaneous applicability of several phase-outs to the same taxpayer—if return preparation software had never been developed. it seems unlikely, however, that it is merely a coincidence that by the time of the phase-out-strewn taxpayer relief act of 1997, 67 percent of all staff of the joint comm. on taxation, supra note 52, at 4–9 chart 1), or whether the numbers also include taxpayers with incomes above the phase-out ranges of the various credits. if the nta’s numbers reflect only those taxpayers with phase-out-affected marginal tax rates, then the total number of taxpayers affected by phase-outs must be even higher than the numbers reported by the nta. 81. i.r.s. individual income tax returns 2006, publication 1304 (rev. 07-2008), at 2 tbl.a. 82. consider, for example, the following 2009 phase-out ranges applicable to taxpayers filing joint returns. for 2009 (or any other year, given the absence of an inflation adjustment), the phase-down range for the dependent care credit was $15,000 to $43,001. i.r.c. § 21(a)(2) (2009). for the phase-out of the child tax credit (which also lacks an inflation adjustment), the phase-out range was $110,000 to 129,001 for taxpayers with one qualifying child, $110,000 to $149,001 for taxpayers with two qualifying children, $110,000 to $169,001 for taxpayers with three qualifying children, and so on. i.r.c. § 24(b) (2009). for the eitc, the 2009 phase-out range for a couple with two qualifying children was $21,420 to $45,295. rev. proc. 2009-21, § 4.06, 2009 irb lexis 147. the 2009 phase-out range for the hope scholarship credit was $160,000 to $180,000. i.r.c. § 25a(i)(4) (2009). the 2009 phase-out threshold for the limitation on itemized deductions was $166,800. rev. proc. 2008-66, § 3.11, 2008-2 c.b. 1107. (because of the unusual design of this phase-out, there is no generally applicable higher end of the phase-out range.) the 2009 phase-out range for personal exemptions was $250,000 to $372,700. rev. proc. 2008-66, § 3.19(2), 2008-2 c.b. 1107. the 2009 phase-out range for eligibility to make deductible ira contributions (for active participants in employment-based retirement plans) was $89,000 to $109,000. notice 2008-102, 2008-2 c.b. 1106. the 2009 phase-out range for the deductibility of interest on student loans was $120,000 to $150,000. rev. proc. 2008-66, § 3.23, 2008-2 c.b. 1107. for eligibility to make contributions to roth iras, the 2009 phase-out range was $166,000 to $188,000. notice 2008-102, 2008-2 c.b. 1106. 83. toder, supra note 4, at 759. 110 columbia journal of tax law [vol. 1:91 individual returns were prepared on computers.84 the growing use of return preparation software does not lead inexorably to the proliferation of phase-outs. congress might choose to resist the phase-out impulse despite the removal of the complexity constraint. the 2001 semi-repeal of the limitation on itemized deductions and of the phase-out of personal exemptions—fully effective only for the single year of 201085—provides evidence of at least a limited legislative ability to resist. in deciding whether to resist, congress should ask with respect to phase-outs the same sort of questions it should ask with respect to the amt. in a world in which tax return computational complexity is no longer an issue, is it nevertheless important to repeal many, most, or all phase-outs? what, if anything, is objectionable about phase-outs if computers are able and willing to do all the number crunching? the answers are basically the same as the answers to the parallel questions concerning the amt. like the amt, phase-outs turn the income tax into a black box, imperiling both the political legitimacy of the income tax and the ability of taxpayers to engage in informed tax planning. if phase-outs make it difficult or impossible for taxpayers to understand the process by which their tax liabilities are determined (especially when phase-out confusion interacts with amt confusion), taxpayers can have no confidence that their own tax liabilities and the tax liabilities of their fellow citizens are being determined by fair rules. and if taxpayers do not understand the phase-out rules—both the rules in the abstract, and how the rules apply in their particular circumstances—their tax planning ability is severely compromised. the tax planning problem can take two different forms. a standard critique of phase-outs is that they impose hidden marginal tax rate increases, thereby leading taxpayers to overestimate their after-tax returns to additional labor effort.86 spouses in the phase-out range of the child tax credit, for example, may know their official marginal tax rate (under i.r.c. § 1) is 25 percent, and so may assume that their after-federal-income-tax income from earning an additional $1,000 will be $750—not realizing that the phase-out of the child tax credit increases their effective marginal tax rate to 30 percent and decreases the after-tax benefit of the additional $1,000 to $700. this critique takes as a given the existence of the creditgenerating activity (in this case, having a “qualifying child” for purposes of 84. data release, supra note 8, at 131. 85. see supra notes 71–73 and accompanying text. 86. see, e.g., staff of the joint comm. on taxation, supra note 52, at 99; richard schmalbeck & lawrence zelenak, federal income taxation 39 (2d ed. 2007); robert j. peroni, reform in the use of phase-outs and floors in the individual income tax system, 91 tax notes 1415, 1431 (2001). 2010] complex tax legislation in the turbotax era 111 the child tax credit), and treats the production of the additional income as the marginal activity affected by the phase-out. although the fact is much less commonly noted, the planning effects of a phase-out are quite different—but no less objectionable—if the amount of the taxpayer’s pre-tax income is taken as the given and the existence (or dollar amount) of the credit-generating activity is treated as the tax-influenced decision. suppose, for example, spouses are trying to determine whether they can afford to send their child to a private college. they rely on the existence of the hope scholarship credit in their analysis, only to discover—too late to be used in their decision-making process—that they are entitled to a diminished credit, or no credit at all, because of the phase-out. in this case, the unfairness of the phase-out provision relates not to a disguised marginal tax rate increase, but to an illusory tax incentive. if phase-outs further sufficiently important tax policy goals, they might constitute good tax policy on balance, despite their unfortunate black box effects. in that case, the removal of the complexity constraint by the growth in computer-assisted tax return preparation would be a commendable development. in fact, however, the policy arguments in favor of phase-outs are weak. in analyzing the policy merits of phase-outs, the first step is to distinguish between two different legislative motivations for the enactment of different phase-out provisions. one group of phase-outs is characterized by a cynical legislative purpose—to impose hidden tax rate increases on large numbers of taxpayers with incomes at or above the phase-out ranges, without encountering the political opposition that would arise in response to a straightforward increase in tax rates. the second group consists of phaseouts that are motivated by sincere (albeit generally misguided) legislative concerns about limiting the cost to the fisc of tax expenditure programs and about targeting those programs to income groups where the need is greatest. only two phase-outs belong unambiguously in the first group—the limitation on itemized deductions and the phase-out of personal exemptions. there are two defining features of phase-outs in this category; both features must exist for a phase-out clearly to fit the category. first, a phase-out of this sort applies to tax benefits that are so widely available (but for the phase-out) that the effect of the phase-out closely approximates an increase in the tax rates applicable to all taxpayers with incomes in or above the phase-out range. this is true of both the limitation on itemized deductions87 and the phase-out of personal exemptions.88 it is not true of 87. the vast majority of taxpayers with incomes at or above the phase-out range itemize deductions, and even more would do so but for the limitation on itemized deductions. see generally reed shuldiner & david shakow, lessons from the limitation on 112 columbia journal of tax law [vol. 1:91 most other phase-out provisions. for example, in any given year most taxpayers do not incur child care expenses, incur higher education expenses, buy a home for the first time, pay interest on student loans, or contribute to iras. the second defining feature of a cynically-inspired phase-out is that the existence of the tax benefit subject to the phase-out predated the enactment of the phase-out—thus demonstrating that congress did not originally consider the phase-out an intrinsic part of the design of the tax benefit. itemized deductions existed for decades before the enactment of the limitation on itemized deductions, and personal exemptions were in the income tax long before the introduction of their phase-out. by contrast, most other phase-outs—including those of the child tax credit, the hope scholarship and lifetime learning credits, the eitc, the first-time homebuyer’s credit, the deduction for interest on student loans, and eligibility to contribute to roth iras—were part of the original enactments of the tax benefits to which they relate.89 there is nothing to be said in defense of type-one (cynical) phaseout provisions. they produce complexity and confusion, and they are motivated by a congressional intent to deceive. if one takes seriously the 2001 semi-repeal of these provisions90—delayed, phased in, and temporary—it seems that not even congress itself approves of these phaseouts. according to the staff of the joint committee on taxation, the 2001 congress believed that both the limitation on itemized deductions and the phase-out of personal exemptions were “unnecessarily complex way[s] to impose taxes and that the ‘hidden’ way in which [both provisions] raise[] marginal tax rates undermines respect for the tax laws.”91 the bottom line on type-one phase-outs is clear. they are an unmitigated tax policy disaster, with no place in a well-designed tax system. as a political matter, however, they may be able to survive in an environment in which software has eliminated the computational complexity constraint. the legislative motivation for type-two phase-outs is very different. when congress enacted the original eitc in 1975, the inclusion of a phase-out was undoubtedly driven by a sincere desire to limit the eitc’s wage subsidy to those families most in need of assistance, and to control the itemized deductions, 93 tax notes 673 (2001) (detailed empirical analysis of taxpayers subject to the limitation on itemized deductions). 88. any taxpayer subject to the exemption would be able to claim at least one personal exemption—for herself or himself—but for the phase-out. 89. for the histories of these and other phase-out provisions, see supra notes 52–78 and accompanying text. 90. see supra notes 71–73 and accompanying text. 91. staff of the joint comm. on taxation, general explanation of tax legislation enacted in the 107th cong., 13-14 (jcs-1-03) (2003). 2010] complex tax legislation in the turbotax era 113 overall cost of the eitc program.92 similar concerns about targeting and controlling program costs explain the inclusion of phase-outs in the original enactments of many other tax benefits, including the child tax credit, the hope scholarship and lifetime learning credits, the student loan interest deduction, the first-time homebuyer’s credit, and the recent recovery rebates. recognizing the much more commendable motivation underlying type-two phase-outs, commentators who call for immediate repeal of typeone phase-outs are generally more accepting of type-two phase-outs. robert j. peroni, for example, flatly states that the limitation on itemized deductions and the phase-out of personal exemptions “should both be repealed as should all other phase-out provisions that are designed to increase the progressivity of the tax system.”93 in sharp contrast, he concludes that type-two phase-outs have a legitimate place in the income tax: “the most appropriate use of phase-out . . . provisions is as a means of targeting the tax provision in question to reach a group of taxpayers in a specified income range.”94 in fact, however, the substantive case against type-two phase-outs closely resembles the substantive case against type-one phase-outs. despite legislative good intentions, a type-two phase-out produces the same deleterious black box impacts as a cynically motivated type-one phase-out. but does not a type-two phase-out, unlike a type-one phase-out, serve legitimate targeting and cost control purposes? it does not, at least on the assumption that congress has the option to modify the official tax rate schedule (under i.r.c. § 1) in lieu of phasing out a newly-enacted tax benefit. to illustrate, suppose the adoption credit of current law95 did not exist, and that congress is contemplating the creation of an adoption credit. congress is willing to accept only some specified level of revenue cost with respect to the credit. instead of controlling the cost by enacting the credit with a phase-out, congress could enact the credit without a phase-out and simultaneously increase marginal tax rates under i.r.c. § 1 (presumably focusing on the marginal rates applicable to higher-income taxpayers) so that the net revenue cost of the credit and the increase in the official tax rate schedule equals the revenue cost congress would have been willing to 92. the committee reports emphasized the congressional desire to target the credit at low-income wage earners. s. rep. no. 94-36, at 33 (1975), reprinted in 1975-1 c.b. 590, 595; h.r. rep. no. 94-19, at 10, reprinted in 1975-1 c.b. 569, 573–74. 93. peroni, supra note 86, at 1433. 94. id. at 1434. 95. i.r.c. § 23 (2009). the credit is phased out for higher-income taxpayers. i.r.c. § 23(b)(2) (2009). 114 columbia journal of tax law [vol. 1:91 accept in the case of a phased-out credit. this approach avoids the black box problems inherent in phase-outs,96 and does so at no greater net revenue cost than the alternative phased-out version of the credit. under this approach the adoption credit would be available to high income taxpayers, but it is not apparent why that should be objectionable as long as the accompanying adjustments to the official tax rate schedule impose an appropriate tax burden on high income taxpayers as a group (taking into account that some high income taxpayers will benefit from the new credit). if one takes the reasonable position that, ceteris paribus, a high income taxpayer with adoption expenses should have a modestly lower tax liability than a high income taxpayer without such expenses, the availability of the credit to high income taxpayers is not merely unobjectionable; it is desirable. in short, a credit without a phase-out, but accompanied by an appropriate adjustment in the official tax rate schedule, has several virtues and no vices. it avoids all the evils of phase-outs, limits the net revenue loss to the desired amount, does not produce vertical inequity, and distinguishes appropriately at all income levels between taxpayers with and without adoption expenses.97 a phase out would be necessary only if, for some strange reason, it was considered appropriate to distinguish between taxpayers with and without adoption expenses at moderate income levels but not appropriate to distinguish between taxpayers with and without adoption expenses at high income levels. replace adoption expenses with any other category of expenditures currently eligible for a phased-out deduction or credit, and the above analysis indicates that phase-outs of those other deductions and credits are also not needed to control costs or target benefits. there are, however, two qualifications to the above analysis. first, the analysis assumes congress is able to revise the official tax rate schedule as readily as it can enact a phase-out. if rate schedule adjustments are politically constrained while phase-out enactments are not, it is possible that the enactment of a phased-out tax benefit may constitute better policy 96. assuming the amended tax rate schedule of i.r.c. § 1 follows the standard approach of marginal tax rates increasing with income, this approach also avoids the effective marginal tax rate “bubbles” typically caused by phase-outs. 97. daniel shaviro has made this point particularly clearly and forcefully. phase-outs, he explains, “reflect[] a fundamental misunderstanding—widely shared in the academic literature—of basic design principles. . . . [p]haseouts raise questions of overall tax and transfer allocations between households—not of program cost or benefit targeting. eliminating the phaseout on a revenue-neutral basis would simply mean that some taxpayers’ marginal tax rates would drop while others’ would increase, permitting implementation of a rate structure that might make more sense overall.” daniel shaviro, the minimum wage, the earned income tax credit, and optimal subsidy policy, 64 u. chi. l. rev. 405, 408–09 (1997). 2010] complex tax legislation in the turbotax era 115 than the only politically viable alternatives (that is, not enacting the tax benefit in any form, or enacting the tax benefit without either a phase-out or an adjustment to the official tax rate schedule). second, in the case of the phase-out of a provision of wide applicability, such as the eitc, it is conceivable that the effective marginal tax rates produced by the combination of the official tax rate schedule and the phase-out might happen to be appropriate on the merits. although congress has never shown any interest in enacting an official tax rate structure featuring a marginal tax rate “bubble” akin to that produced by the combination of the official rate structure and the eitc phase-out—with taxpayers in the phase-out range subject to higher effective marginal tax rates than taxpayers above the phase-out range—optimal tax analysis may provide some support for that sort of effective marginal tax rate structure. simulations designed to determine the marginal tax rate structure that maximizes a chosen social welfare function98 commonly produce rising marginal tax rates at low income levels and declining marginal tax rates at moderate and high income levels.99 of course, it would be the sheerest accident if the effective marginal tax rates produced by a conceptual error (that is, the belief that the eitc must be phased out to target benefits or control costs) happened to be close to the optimal rate structure produced by a completely different analysis. the bottom line on type-two phase-outs is that, although the congressional motivations for their enactment are benign, on the merits they are generally just as objectionable as the cynically-motivated type-one phase outs. to the extent that computational complexity served as an impediment to the enactment of type-two phase-outs in the era of penciland-paper tax return preparation, the complexity constraint had a favorable tax policy impact. with the elimination of that constraint in the age of turbotax, some replacement for the constraint must be found to control (or, better yet, to reverse) the proliferation of type-two phase-outs. 98. the social welfare function may be utilitarian (with the well-being of the lessadvantaged members of society given no special weight), or a rawlsian-style maximin (aimed at maximizing the well-being of the least-advantaged members of society), or anything in between. lawrence zelenak & kemper moreland, can the graduated income tax survive optimal tax analysis?, 53 tax l. rev. 51, 52–53 (1999). 99. see, e.g., louis kaplow, the theory of taxation and public economics 15758 (princeton university press 2008); tuomala, supra note 17, at 95–99; daniel n. shaviro, welfare, cash grants, and marginal rates, 59 smu l. rev. 835, 850 (2006). the intuition behind these results is that high marginal rates at lower income levels raise tax revenue available for social welfare-enhancing redistribution from higher income taxpayers for whom those rates are not marginal, and that the efficiency cost of high marginal rates at low income levels is modest because those rates are inframarginal for most of the taxpayers to whom they apply. zelenak & moreland, supra note 98, at 54–55. 116 columbia journal of tax law [vol. 1:91 developing a satisfactory replacement for the complexity constraint may be even more difficult in this context than in the contexts of the amt and type-one phase-outs. in the cases of the amt and type-one phase-outs, congress is well aware that the provisions are bad policy, and all that is needed to replace the complexity constraint is the development of a legislative backbone. even that may be easier said than done, but it is a less daunting task than in the case of type-two phase-outs. congress must first be persuaded that type-two phase-outs constitute bad tax policy, before it can be expected to develop the spine necessary to reject them. iv. is there a structural solution? it would be nice, at this point in the essay, to propose a structural reform in the tax legislative process as a replacement for the complexity constraint formerly imposed by the burden of tax return calculations. the proposal might call for mandatory complexity analyses of proposed tax legislation, for the purpose of heightening legislative awareness of complexity concerns and encouraging congress to look with skepticism upon proposals with high complexity costs. as it happens, however, congress enacted this structural reform more than a decade ago, and it appears to have done little or no good. section 4022(a) of the internal revenue service restructuring and reform act of 1998 requires the irs commissioner to furnish congress annually with “an analysis of the sources of complexity in the administration of the federal tax laws,” including recommendations for reducing complexity.100 section 4022(b) of the 1998 act requires the joint committee on taxation to provide congress with a “tax complexity analysis” of proposed tax legislation reported by the house ways and means committee, the senate finance committee, or a conference committee, if the proposed legislation includes any provision “which has widespread applicability to individuals or small businesses.”101 it will not surprise anyone familiar with the explosive growth of tax expenditures in the years following the institutionalization of tax expenditure budget analysis102 that the structural reforms of 1998 have done little or nothing to bring tax complexity under control. the irs issued its 100. internal revenue service restructuring and reform act of 1998, pub. l. no. 105206, § 4022(a), 112 stat. 685, 785. 101. id. at 785–86. 102. for a history and critical analysis of the tax expenditure budget concept, see staff of the joint comm. on taxation, a reconsideration of tax expenditure analysis (comm. print 2008). for the current tax expenditure budget, see staff of the joint comm. on taxation, estimates of federal tax expenditures for fiscal years 2009–2013 (comm. print 2010). 2010] complex tax legislation in the turbotax era 117 first section 4022(a) report in 2000, highlighting the amt as one of just three sources of complexity discussed in the report.103 a year later, congress responded by enacting massive reductions in the regular income tax without corresponding reductions in the amt, thereby greatly increasing the number of taxpayers who would be subject to the amt in later years.104 the joint committee on taxation did its job under section 4022(b) with respect to the 2001 legislation. it alerted congress that by 2010 an estimated “18 million additional individual income tax returns . . . would be affected by the alternative minimum tax” as a result of the proposed 2001 regular tax reductions,105 but this did not dissuade congress from enacting the proposed regular tax reductions. congress seemed to be mocking the very complexity analyses it had mandated only three years earlier. the story is not quite so grimly amusing in the case of phase-outs. as noted earlier,106 the banner year for the enactment of phase-outs was 1997—a fact that might suggest that the tax complexity analyses required by the 1998 legislation restrained the growth of phase-outs in later years. this seems unlikely, however. for this interpretation to be persuasive, there would have to be some explanation as to why section 4022 was effective in restraining the growth of phase-outs even as it was dramatically ineffective in restraining the growth of the amt. no such explanation comes to mind. moreover, as recounted earlier, congress has continued to enact new phase-outs in recent years (albeit not at the record-setting pace of 2007),107 and has shown little interest in simplifying the law by repealing existing phase-outs.108 the problem is that the structural reforms of 1998 cannot force congress to be serious about resisting tax complexity. this is illustrated by the fact that congress does not even take the trouble to ensure that it receives the input called for by the 1998 legislation. the irs commissioner has never filed another complexity report after the “first annual” report of 2000, and there is no indication in the public record that 103. internal revenue service, annual report from the commissioner of the internal revenue service on tax law complexity, 128-40 tax notes today (2000). the other sources of complexity discussed in the report were estimated taxes and filing status determinations. 104. for a description and discussion of the effect of the 2001 legislation on the growth of the amt, see supra notes 32–35 and accompanying text. 105. h.r. rep. no. 107-84, at 329 (2001) (conf. rep.). 106. see supra notes 63–67 and accompanying text. 107. see supra notes 74–75 and accompanying text. 108. as noted earlier (see supra notes 71–73 and accompanying text), the phase-outs of §§ 68 and 151(d)(3) are scheduled to be eliminated only for the single year of 2010. 118 columbia journal of tax law [vol. 1:91 anyone in congress has complained.109 the joint committee on taxation does provide complexity analyses of proposed legislation from time to time, but it is quite willing to declare—in dubious circumstances--that a proposed provision lacks “widespread applicability” and thus is not subject to the complexity analysis requirement. the joint committee decided, for example, that a proposed first-time homebuyers’ credit (with a phase-out provision) was not subject to complexity analysis because it would not be widely applicable.110 in short, the structural reform approach has already been tried, and has failed. the structural reform cannot serve as an adequate replacement for the now-vanished computational complexity constraint, because congress can—and does—simply ignore the information provided to it by the reform (in those cases in which it even receives the required information). what is needed is not a structural reform, but a changing of congressional hearts and minds. i hope that is not a counsel of despair. conclusion in the era of pencil-and-paper tax return preparation, congress refrained from imposing provisions of great computational complexity on large numbers of taxpayers, out of concern that it was unreasonable to require average taxpayers (or their paid preparers) to wrestle with computationally complex provisions. as return preparation software gradually replaced the pencil, the complexity constraint weakened and eventually disappeared. congress has responded by imposing unprecedented computational complexity on large numbers of taxpayers. this would not be problematic, if the only objection to computational complexity were the difficulty of performing the required calculations without software. unfortunately, computationally complex provisions generally constitute bad tax policy for reasons other than computational 109. the irs national taxpayer advocate (nta) regularly discusses tax complexity in her annual reports to congress. see, e.g., national taxpayer advocate, 2008 annual report, supra note 80, at 3–14. there is no indication, however, that this is intended as a substitute for the commissioner’s annual complexity reports. the nta is distinct from the commissioner, complexity is just one of many issues addressed by nta reports, and nta reports are not pursuant to the same legislative mandate as the commissioner’s complexity reports. i.r.c. § 7803(c)(2)(b) (2009) (requiring the nta to report annually to congress, and including a list of topics to be addressed by the annual reports). 110. see, e.g., h.r. rep. no. 110-606, at 72 (2008) (conf. rep.) (indicating that the joint committee on taxation declined to provide a tax complexity analysis of a bill containing a number of tax provisions, including a first-time homebuyer’s credit with a phase-out, on the grounds that the bill contained no provisions of “widespread applicability”). 2010] complex tax legislation in the turbotax era 119 difficulties. such provisions turn the income tax into a black box, the inner workings of which are incomprehensible to the average taxpayer, thereby undermining both the democratic legitimacy of the tax system and the ability of taxpayers to engage in informed tax planning. structural reform—the mandating of “tax complexity analyses” of existing law and proposed legislation—has been tried and has (predictably) failed. in response to the demise of the complexity constraint, congress must develop a self-imposed constraint, an informal presumption against the enactment (or survival) of computationally complex provisions of widespread applicability. its goal should be a set of income tax rules under which anyone armed with basic arithmetical skills and a calculator, and with no exotic items of income, deduction, or credit, could easily prepare his or her own tax return with pencil and paper. this should be the goal not because taxpayers will or should return to pencil-and-paper return preparation, but because adhering to this standard ensures tax system transparency, which is crucial for both the political legitimacy of the tax system and for tax planning. it is far from clear that congress, freed of the complexity constraint in the turbotax era, can summon the political will to resist the lure of tax complexity. in that possibility, however, lies the only hope for a computationally simpler income tax. microsoft word 8-2-raskolnikov.docx introduction a guide to the guide to the republican better way plan alex raskolnikov† this special issue of the columbia journal of tax law is bound to have both an immediate impact and a lasting significance. the immediate impact is assured because the sole focus of this issue is the tax plan proposed by the congressional republicans as part of their broad reform agenda called a better way: our vision for a confident america.1 as this issue goes to print, the better way plan (or the plan for short) is being debated in the white house, on capitol hill, in the press, in academic circles, think tanks, the u.s. chamber of commerce, and all major law and accounting firms, as well as in many other places. for anyone thinking through the implications of the plan, this issue is a must read. at the same time, the contributions in this issue will provide a lasting benefit to the tax policy community. even though the intellectual foundations of the tax system proposed in the plan were laid decades ago, the core ideas underlying the plan have never been considered, tested, and scrutinized nearly as rigorously and comprehensively as they are now. simply put, the level of intellectual capital that is being invested in analyzing the plan is extraordinary. this issue combines some of the best applied work on the subject to date. so it will benefit academics, policymakers, and practitioners thinking about the tax systems similar to the one proposed in the plan for decades to come. this issue is a guide to the plan based on what we know so far, and this introduction is a guide to the issue. readers familiar with the basics of the plan and interested in a comprehensive list of questions, concerns, and uncertainties it raises should start with michael graetz’s the known unknowns of the business tax reforms proposed in the house republican blueprint. the list of unknowns is long and daunting. some will not be resolved until after the plan is put in place, for better or worse. others will need † wilbur h. friedman professor of tax law, columbia law school. 1 the entire agenda is available at: http://abetterway.speaker.gov. 114 columbia journal of tax law [vol.8:113 to be addressed in the legislative drafting process. even for those, it is far from clear how to answer many critical questions. why should we expect anything different from an attempt to enact a system that does not exist—and has never existed—anywhere in the world? readers who would like to get a firmer grasp of the plan, its intellectual history, its ideal version, and the deviations from that ideal reflected in the actual proposal cannot do better than reading david weisbach’s contribution: a guide to the gop tax plan—the way to a better way. as the title suggests, professor weisbach offers solutions to some of the problems created by the plan. he also highlights the areas where finding solutions will be difficult and time consuming. and he points out several unnecessary, complicating, and intellectually incoherent features in the plan’s current version. one hopes that professor weisbach’s cogent critique would convince policymakers to abandon these features. reuven avi-yonah and kimberly clausing also investigate the challenges that the plan’s enactment will present, but they focus on the international issues. they argue, convincingly, that the plan will violate the u.s. obligations under the rules of the world trade organization. professor graetz expresses a similar view, and professor weisbach acknowledges the issue. but if you want to read the relevant clauses and parse them as a wto lawyer might, you should go to avi-yonah’s and clausing’s piece. the other international issue that these authors consider is whether the plan would violate u.s. income tax treaties, and what are the likely consequences if it does. what if you think that numbers speak louder than words? then the contribution by the tax policy center experts is for you. len burman, jim nunns, ben page, jeff rohaly, and joe rosenberg present their estimates of the revenue and distributional effects of the plan in an analysis of the house gop tax plan. their analysis includes dynamic scoring estimates generated in collaboration with the penn wharton budget model. these are not the only estimates available now, and there is little doubt that new estimates will appear in the future. it is worth noting, however, as martin sullivan has done in the pages of tax notes, that if the past experience is any guide, the official dynamic revenue estimate that may be eventually produced by 2017] a guide to the gop tax plan 115 the joint committee on taxation is likely to be fairly close to the one offered by the tax policy center.2 last, but certainly not least, david miller offers a perspective of a sophisticated tax lawyer. his contribution gives the reader— especially a legislative drafter—a glimpse of what to expect once the tax bar engages with the new rules. the picture is far from rosy. moreover, the tax planning possibilities that miller identifies are, no doubt, just a tip of the iceberg. nor is there any doubt that tax planning around the plan’s new rules is already underway, even though these rules are only hypothetical at this point. this brings us full circle to professor graetz’s main takeaway: enacting a tax system that is literally unprecedented is fraught with risks. the plan offers a dramatic reform and raises many difficult questions. this special issue of the columbia journal of tax law will serve as an invaluable educational tool for those studying the plan or working to improve it. it will also serve as a guide for those brave enough for forge ahead. 2 martin a. sullivan, new tpc models challenge the tax foundation, 153 tax notes 7, 10-11 (2016). the committee for a responsible federal budget shares sullivan’s view. see committee for a responsible federal budget, how much does the house gop tax plan cost? (mar. 8, 2017), http://www.crfb.org/blogs/how-much-does-house-gop-tax-plan-cost [perma.cc/nw7l-3ly3]. formatted-johnson articles the future of american tax administration: conceptual alternatives and political realities steve r. johnson* * university professor, florida state university college of law, sjohnson@law.fsu.edu. i thank the participants in the conference at which this paper originally was discussed: the march 2015 tax policy symposium: reforming the irs sponsored by the university of minnesota law school corporate institute forum on taxation and regulation. © 2016 johnson. this is an open-access publication distributed under the terms of the creative commons attribution license, https://creativecommons.org/licenses/by/4.0/, which permits the user to copy, distribute, and transmit the work provided that the original authors and source are credited. 6 columbia journal of tax law [vol.7:5 i. intersecting forces and current crisis .............................................. 8 a. the perfect storm .................................................................................................. 8 1. declining budget ............................................................................................. 9 2. increasing revenue responsibilities ............................................................. 10 3. increasing non-revenue responsibilities ..................................................... 11 4. cumulative impact ........................................................................................ 12 b. consequences ....................................................................................................... 12 1. formal guidance .......................................................................................... 13 2. informal guidance ........................................................................................ 14 3. enforcement .................................................................................................. 14 4. workforce ...................................................................................................... 15 5. training ......................................................................................................... 16 6. technology .................................................................................................... 16 7. revenue ......................................................................................................... 17 ii. doubting obvious solutions ..................................................................... 18 a. “just become more efficient” ............................................................................. 19 b. “just give the irs more money” ........................................................................ 19 iii. other theoretically available solutions ...................................... 22 a. radical tax revision ........................................................................................... 22 b. feature modification ............................................................................................ 23 1. reduce the number of pass-through regimes ............................................. 24 2. eliminate the ordinary income-capital gains distinction .......................... 24 3. abolish the accumulated earnings tax ........................................................ 25 4. revise treatment of tax-exempt entities ..................................................... 25 5. other proposals ............................................................................................ 26 c. moving non-revenue functions outside irs .................................................... 27 d. harmonizing u.s. and foreign tax rules ........................................................... 28 e. revamping tax lawmaking ................................................................................ 29 1. choosing feasibility over theoretical perfection ........................................ 29 2. improving the legislative process ................................................................ 30 f. changing incentives ............................................................................................ 30 1. attitudes of taxpayers ................................................................................... 30 2. attitudes of third parties .............................................................................. 31 3. attitudes of irs .............................................................................................. 32 g. greater use of technology .................................................................................. 32 iv. realities and new realities ....................................................................... 33 a. realities ............................................................................................................... 34 b. “realities” ............................................................................................................ 34 c. what to do ......................................................................................................... 35 2016] the future of american tax administration 7 when their environments change markedly, individuals and species adapt or they cease to be. this principle holds institutionally as well as biologically. history is littered with both discarded enterprises (such as the children’s crusade, the hanseatic league, and the golden horde) and successful transformations (such as the evolution of much of the holy roman empire into modern germany). the internal revenue service now stands at the precipice of an uncertain future. with considerable justification, the irs considers itself as being among the most successful revenue collection organizations in the world.1 whether that characterization will remain accurate in the future will depend on how the irs deals, and is allowed to deal, with intersecting trends threatening to cripple the ability of the irs to perform its core mission of revenue collection. part i of this article describes this intersection, which has reached crisis proportions.2 the workload of the irs—both in revenue collection and especially in adventitious missions congress has chosen to assign to the irs—has burgeoned in recent decades. at the same time, the resources allocated to the irs by successive congresses and administrations—never fully adequate—have declined in inflation-adjusted terms and, in recent years, even in nominal terms. part i also notes the most visible manifestations of the intersection of these trends: decreases in key irs activities and results almost across the board, with consequent substantial losses to the federal fisc. two obvious and “easy” possible fixes immediately leap to mind: (1) the irs should become more efficient and/or (2) congress should appropriate more money for the irs. both of these approaches have roles to play. however, part ii explains why neither alone nor the two together can be fully satisfactory. theoretically, there are a number of different ways to relax the anaconda grip of the irs’s workload and budget squeeze. some would require legislation. others could be implemented without statutory change. part iii sketches some of the alternatives. it also notes precedents for some of them as well as obstacles to and potential disadvantages of their adoption. part iv examines reasons why desirable reforms have not yet been implemented. there are plenty of plausible ideas. our failure to implement the best ideas results in part from intellectual failures (clinging to policy preferences and ways of thinking that make little sense in the current environment) but in larger part from political and bureaucratic realities. reforms advantageous to the country would forfeit privileges and opportunities cherished by key congressional and executive actors. while it would be naive to discuss tax administration without awareness of the hampering realities, it would be unduly pessimistic to quit the field in despair. constellations in the political firmament are in constant motion. changes not currently 1 two decades ago, former commissioner cohen wrote: “with all of its faults, and there are many, [the modern irs] is still one of the best systems of administration in the world. i have gone all over the world . . . and everywhere our system is admired. only here is it derided.” sheldon s. cohen, the erwin n. griswold lecture, 14 am. j. tax pol’y 113, 115 (1997). more recently, current commissioner koskinen describes the irs as “the world’s largest financial institution, [which] continues to play a pivotal role in funding the united states government and enforcing the nation’s tax laws.” john a. koskinen, letter from the commissioner, in internal revenue service data book 2014, at iii. 2 rhetorical inflation is a hallmark of our age in which events even mildly felicitous are described as “great” or “awesome” and events only mildly inconvenient are considered to be “devastating.” the word “crisis” drips from american lips far too cavalierly. yet i believe it is an appropriate description of the subject at hand. see text accompanying notes 45 to 48, infra. 8 columbia journal of tax law [vol.7:5 feasible may become feasible later. recent history has shown that long-blocked changes can suddenly become politically viable. that being so, how should the tax community proceed? i suggest two principles. first, tax administrators, practitioners, and scholars should continue to think and talk about the merits of ideas unhampered by the thought that they might not be feasible. in public policy generally, and in tax policy in particular, realities are temporary, not perpetual. we should build the intellectual case for good ideas in preparation for the time when changing political or economic dynamics redefine the boundaries of feasibility. second, bad ideas as well as good ones can suddenly emerge as serious candidates for adoption. the tax community must be alert to these threats and respond to them rapidly and energetically. if accepted as an excuse for inertia, the notion that it would never be adopted may be the precursor to a professional lifetime of regret when the terrible idea, unopposed, actually wins adoption. i. intersecting forces and current crisis this part i explores two dimensions. first, it describes the “perfect storm” that has produced the current crisis in tax administration in the united states. second, it charts the consequences, the particular harms inflicted by this perfect storm. a. the perfect storm it is often said that the mission of the irs is to collect the revenue needed to run the federal government, but this is imprecise. it is not the irs’s role to wring every dollar it can out of the citizenry by whatever means necessary, fair or foul. instead, as the irs itself acknowledges: [i]t is the duty of the service to carry out [tax] policy by correctly applying the laws enacted by congress; to determine the reasonable meaning of various [internal revenue] code provisions in light of the congressional purpose in enacting them; and to perform this work in a fair and impartial manner, with neither a government nor a taxpayer point of view.3 properly executing this duty requires the irs to balance many desiderata, including: • providing “taxpayers top quality service by helping them understand and meet their responsibilities,”4 • “[a]pplying the tax law with integrity and fairness to all,”5 • collecting “the proper amount of tax revenue at the least cost,”6 • “[c]ontinually improving the quality of [its] products and services,”7 • “[p]erforming in a manner warranting the highest degree of public confidence in [the irs’s] integrity, efficiency and fairness,”8 and • being “vigorous in requiring compliance with law and . . . relentless in [attacking] unreal tax devices and fraud.”9 3 rev. proc. 64-22, 1964-1 c.b. 689. 4 2002-2 c.b. ii. 5 id. 6 1996-1 c.b. ii. 7 id. 8 id. 9 1976-1 c.b. ii. 2016] the future of american tax administration 9 no human institution ever achieves its goals perfectly.10 but the ability of the irs to achieve even satisfactory levels of performance has been put into severe question by the confluence of three trends: (1) substantial declines in the irs’s budget, (2) expansion of workload in the irs’s core revenue collection function, and (3) ever-expanding other responsibilities placed by congress on the irs, that is, responsibilities not essentially connected to revenue collection but deriving instead from non-revenue priorities. these trends are described below. 1. declining budget we are not accustomed to the budgets of government agencies—especially key government agencies11—declining. but the budget of the irs has dropped, not just in real (that is, inflation-adjusted) terms but also in nominal (stated dollar amount) terms.12 agencies cry for greater funding more frequently than newborns cry for milk. sometimes agencies’ budgetary wails are valid, sometimes they are not. it is fair to say, however, that the underfunding of the irs is not new but is of long standing.13 what is new is the severity of budget cuts suffered recently by the irs. in the period 2010 to 2015, the irs’s budget was slashed by a total of $1.2 billion, more than 17%. 14 in a joint letter to the senate committee on appropriations and the house committee on appropriations, seven former commissioners of internal revenue stated: “none of us ever experienced, nor are we aware of, any irs appropriations reductions of this magnitude over such a prolonged period of time.”15 the most recent budget, enacted in the consolidated appropriations act of 2016,16 “freezes most funding for the irs at the fiscal year 2015 level,” although it does provide “an additional $290 million targeted solely for taxpayer services to ensure that the agency 10 certainly, that is true of taxation. “the wisdom of man never yet contrived a system of taxation that operates with perfect equality.” andrew jackson, quoted by peter j. reilly, some presidential words on federal income taxes, forbes, aug. 15, 2012, at 7, http://www.forbes.com/sites/peterjreilly/2012/08/15 /some-presidential-words-on-federal-income-taxes [https://perma.cc/jt6b-eh2v]. 11 the critical significance of the irs to the enterprise of governing the united states cannot be doubted. bull v. united states, 295 u.s. 247, 259 (1935) (“[t]axes are the life-blood of government, and their prompt and certain availability an imperious need.”); see also united states v. kimbell foods, inc., 440 u.s. 715, 734 (1979) (“that collection of taxes is vital to the functioning, indeed existence, of government cannot be denied.”). the irs collects about 93% of federal receipts. u.s. gov’t accountability office, irs 2016 budget: irs is scaling back activities and using budget flexibilities to absorb funding cuts 1 (2015). 12 for a chart comparing irs funding (1) as recommended by the irs oversight board, (2) as requested by the president, and (3) as actually appropriated by congress, all for fiscal years 2009 to 2015, see treasury inspector general for tax administration, reduced budgets and collection resources have resulted in declines in taxpayer service, case closures, and dollars collected 1 (may 8, 2015). 13 “historically, the lack of a political constituency has contributed to a level of funding for [united states] tax administration which almost certainly is far less than optimal.” michael c. durst (reporter), report of the second invitational conference on income tax compliance 12 (1988). i have been beating this drum for over a decade. see steve johnson, the 1998 act and the resources link between tax compliance and tax simplification, 51 u. kan. l. rev. 1013 (2003). 14 letter from mortimer m. caplin, sheldon s. cohen, lawrence b. gibbs, fred t. goldberg, jr., shirley d. peterson, margaret m. richardson & charles o. rossotti to senators thad cochran and barbara a. mikulski & representatives harold rogers and nita m. lowey (nov. 9, 2015) (on file with author) [hereinafter seven commissioners letter]. collectively, the seven former commissioners served for fifty years in administrations of both major political parties. 15 id. 16 h.r. 2029, 114th cong. (1st sess. 2016). 10 columbia journal of tax law [vol.7:5 responds to taxpayer questions in a timely manner, and to improve fraud detection and prevention and cybersecurity.”17 however, this increase is contingent on the irs reporting to congress quarterly on the irs’s plans for the use of these funds.18 in any event, $290 million does not come close to offsetting pre-2016 irs budget cuts. 2. increasing revenue responsibilities the irs’s workload in its core revenue functions has grown and will continue to grow. first, even if the internal revenue code (the “code”) changed not a wit, the population of the united states grows every year and the number of businesses in the united states grows in most years. “[i]n real terms, [the fiscal year 2016 projected] funding level is less than the irs’s enacted level in fy 1991, 25 years ago, when there were 38 million fewer individual taxpayers, only about half as many business tax returns, and a far less complicated tax code.”19 second, the code does change—a lot.20 every year, congress adds numerous new code provisions and substantially modifies numerous existing provisions.21 each change requires creation or alteration of irs forms and explanatory publications, sometimes necessitates revised regulations or other guidance,22 and compels training or retraining of irs employees throughout the organization.23 third, globalization guarantees that transnational tax enforcement and administration will be a major and enduring part of the irs’s future. over a trillion dollars a day flow across international boundaries.24 the ease with which international capital flows can be effected guarantees that some taxpayers—both americans and others—will attempt to evade their tax obligations through concealed foreign arrangements. 25 in addition, of course, legal transactions involving both inbound and outbound economic 17 house appropriations committee, fy 2016 omnibus – financial services appropriations 1 (2016), http://appropriations.house.gov/ [https://perma.cc/jmn7-nrea]. 18 h.r. 2029, supra note 16, at division e, title i. 19 letter from anne wall, assistant treas. sec’y for legislative affairs, to sen. robert p. casey, at 3 (nov. 12, 2015) (on file with author). 20 the changes may be to either the substantive or procedural tax law. for discussion of the demands created by the procedural changes enacted in the internal revenue service restructuring and reform act of 1998, pub. l. no. 105-206, 112 stat. 685 (1998) (partially codified in scattered sections of the code), see johnson, supra note 13, at 1039-44. 21 see, e.g., cohen, supra note 1, at 114-15; supra note 3; seven commissioners letter, supra note 14, at 4. 22 in 1974, there were 1,500 pages in the code compared to about 5,500 pages in 2014. in 1974, there were about 12,100 pages of treasury tax regulations compared to over 44,000 pages in 2014. jonathan h. adler, how the irs has changed since 1974, wash. post (apr. 2, 2014), https://www.washingtonpost .com/news/volokh-conspiracy/wp/2014/04/02/how-the-irs-has-changed-since-1974/ [https://perma.cc /xw2n-z2dm]. 23 see, e.g., nicole duarte, new programs strain irs resources, budget, tax notes, jan. 3 2011, at 63 (“congress in 2010 enacted numerous tax law changes and new tax-related programs and enforcement initiatives. . . . congress’s work managed to leave the [irs] with a potentially overwhelming slate of new initiatives to administer.”). 24 see reuven s. avi-yonah, globalization, tax competition, and the fiscal crisis of the welfare state, 113 harv. l. rev. 1573, 1585-86 (2000) (citing studies); see also peter d. sutherland, sharing the bounty, the banker, nov. 1998, at 16 (estimating that international capital flows exceed trade flows by 60 to 1). 25 the irs is embroiled in a long-running effort to crack down on americans evading u.s. taxes through use of undisclosed foreign bank accounts. for part of the saga, see kathryn keneally & charles p. rettig, the end of an era: the irs closes in on offshore bank accounts, j. tax prac. & proc., apr.-may 2009, at 11. 2016] the future of american tax administration 11 activity pose challenging transfer pricing,26 subpart f,27 sourcing,28 foreign tax credit,29 and other tax issues.30 often these issues involve disparities between u.s. and foreign tax regimes or conflicting interpretations of bilateral tax treaties.31 the united states has responded to the challenges of cross-border tax issues through more aggressive use of irs summonses,32 information exchange provisions in tax treaties and agreements,33 and an expanding array of code provisions.34 as necessary as serious international enforcement is, one must recognize its costs. because of distance, political sensitivities, and the uncertainties of where principal targets are located, overseas efforts are more time-consuming and expensive.35 a major current initiative, the foreign account tax compliance act (fatca), 36 is consuming vast amounts of irs resources.37 3. increasing non-revenue responsibilities we think of the irs as a revenue-raising agency, but that monocular image does not reflect current reality. a binocular view is more accurate. the irs collects revenue, to be sure, but it also expends a substantial part of its energy, money, and human resources on administering a host of initiatives having no essential connection with its revenue functions.38 for example: the continual enactment of targeted tax provisions leaves the irs with responsibility for the administration of policies aimed at the environment, conservation, green energy, manufacturing, innovation, education, saving, retirement, health care, child care, welfare, corporate governance, export promotion, charitable giving, governance of tax exempt organizations, and economic development, to name a few.39 26 i.r.c. § 482. 27 i.r.c. §§ 951-964. 28 i.r.c. §§ 861-865. 29 i.r.c. §§ 901-909. 30 see, e.g., yariv brauner, an international tax regime in crystallization, 56 tax l. rev. 259 (2003); diane m. ring, one nation among many: policy implications of cross-border arbitrage, 44 b.c. l. rev. 79 (2002). 31 see, e.g., s. rep. 445, 100th cong., 2d sess. pt. xii h1, technical corrections to the tax reform act of 1986 (discussing the relationship between u.s. tax treaties and the code). 32 see, e.g., united states v. bank of nova scotia, 691 f.2d 1384 (11th cir. 1982), cert. denied, 462 u.s. 1119 (1983), further proceedings, 722 f.2d 657 (11th cir. 1983), appeal after remand, 740 f.2d 817 (11th cir. 1984), cert. denied, 469 u.s. 1106 (1985). 33 for example, article 26 of the u.s. model income tax treaty provides for exchange of information and administrative assistance between the irs and the treaty partner’s tax authority. the united states has tax treaties of varying degrees of coverage with approximately 70 other countries. 34 see, e.g., i.r.c. §§ 982 (formal document requests), 6038a (information as to certain foreignowned corporations) & 6038c (information with respect to foreign corporations engaged in u.s. business). for discussion of these and other devices, see john a. townsend, larry a. campagna, steve johnson & scott a. schumacher, tax crimes 327-30 (2d ed. 2015). 35 see, e.g., u.s. dep’t of state circular, obtaining evidence abroad, 739 pli/lit 1095, 1098 (2006). 36 pub. l. no. 111-147, 124 stat. 71, 97 (codified at irc §§ 1471 et seq.). 37 see, e.g., seven commissioners letter, supra note 14, at 3. 38 see, e.g., kristin e. hickman, administering the tax system we have, 63 duke l.j. 1717 (2014). 39 pamela f. olson, woodworth memorial lecture: and then cnut told regan . . . lessons from the tax reform act of 1986, 38 ohio n.u. l. rev. 1, 12-13 (2011) (citations omitted); see also lawrence b. gibbs, loving v. irs: treasury’s authority to regulate tax return preparers, tax notes, oct. 21, 2013, at 331, 334 (“one of the biggest changes in the federal tax area in the last twenty-five years has been the 12 columbia journal of tax law [vol.7:5 the irs has been charged with vast additional burdens of rulemaking, information processing, and enforcement with respect to the affordable care act (“aca”), enacted in 2010.40 this program “contains an extensive array of tax law changes that, absent added funding, will present budgetary challenges for the irs in the coming years.”41 it is now more accurate than alarmist to warn that “congress’s repeated utilization of the irs to serve functions beyond its traditional revenue raising mission has reached a tipping point that threatens to undermine substantially the viability of the irs’s primary mission as the nation’s tax collector.”42 4. cumulative impact could the irs meet its revenue-collection responsibilities without significantly enhanced funding? probably yes—if it were able to shed its non-revenue functions. could the irs shoulder both its revenue duties and its currently assigned adventitious duties? there would be agency expertise, organization, and institutional culture concerns, but probably yes—if congress were to greatly increase funding for the irs. the problem is the simultaneity and compounding effects of the three trends. according to former commissioners, “these reductions in irs appropriations are difficult to understand in light of the fact that, at the same time these reductions have occurred, the congress repeatedly has passed major tax legislation to substantially increase the irs workload.”43 commissioner koskinen offered this example: “the disconnect between our funding levels and our responsibilities is illustrated by the fact that, just three days after cutting our budget by almost $350 million, congress passed legislation requiring the irs to design and implement two new programs by [a designated date].”44 b. consequences the “terrible trifecta” described above sounds ominous, but is it really? what, if any, have been the particular, adverse repercussions of the current trends? seven former commissioners of internal revenue have said that currently “the irs is stretched to the breaking point to cope with tax enforcement challenges attributable to global and domestic changes that are impacting our tax system.” 45 the current commissioner has warned that “now, we are at the point of having to make very critical increasing number of socio-economic spending programs that have been run through the internal revenue code.”). 40 patient protection and affordable care act of 2010, pub. l. no. 111-148, 124 stat. 119 (2010) (codified as amended in scattered sections of the united states code), amended by the health care and education reconciliation act of 2010, pub. l. no. 111-152, 124 stat. 1029 (2010). 41 treasury inspector general for tax administration, implementation of fiscal year 2013 sequestration budget reductions 5 (june 12, 2014); see also letter from representatives jason chaffetz, jim jordan & mark meadows to john koskinen (jan. 29, 2014) (on file with author); william hoffman, irs may miss 12 million taxpayer calls in 2015, tax notes, june 16, 2014, at 1263, 1264 (according to john dalrymple, irs deputy commissioner for services and enforcement, the irs anticipated receiving 11 million calls in 2015 from taxpayers confused by aca provisions) (“this is complicated stuff. . . . [it] is complicated for us; it’s complicated for taxpayers.”). 42 kristin e. hickman, pursuing a single mission (or something closer to it) for the irs, 7 colum. j. tax l. 169, 173 (2016). 43 seven commissioners letter, supra note 14, at 3. 44 prepared remarks of john a. koskinen, commissioner, internal revenue service, before the tax executives inst. 65th mid-year conference 4 (washington, d.c.) (mar. 24, 2015) (on file with author). 45 id. 2016] the future of american tax administration 13 performance tradeoffs”46 and has stated, “i am deeply concerned about the ability of the irs to continue to fulfill its mission if the agency lacks adequate funding.”47 another treasury official echoed: “this reduced funding has directly led to deterioration in the ability of the irs to conduct its mission . . . . a sustained deterioration in taxpayer services combined with reduced enforcement activity creates serious long-term risk for the u.s. tax system.”48 but, of course, “the sky is falling” rhetoric is central to the playbook of administrative agencies trying to defend or enhance their budgets. with how large a pinch of salt, then, should we take the above dire assessments? seven dimensions suggest that the commissioners’ concerns should not be dismissed out of hand. they involve (1) formal guidance, (2) informal guidance, (3) enforcement, (4) workforce, (5) training, (6) technology, and (7) revenue. 1. formal guidance treasury and the irs provide critical guidance to taxpayers through both force-oflaw regulations and a variety of guidance documents, such as revenue rulings, revenue procedures, notices, announcements, and private letter rulings.49 resource constraints in recent years have caused the irs to delay or abandon important regulation projects50 and to scale back substantially its issuance of revenue rulings51 and private letter rulings.52 this contraction may well continue. relating to legal guidance, [the irs has] had to limit what [it] can do on business tax issues, and guidance needed for specialized areas may suffer as a result . . . . [i]t should be clear to everyone that chief counsel’s office will have to reprioritize projects as it continues to lose staff. [chief counsel is] down about 200 attorneys since 2009.53 46 written testimony of commissioner john a. koskinen before senate finance comm. on irs budget & current operations 3 (feb. 3, 2015). 47 written testimony of commissioner john a. koskinen before house oversight and government reform comm. on irs operations 1-2 (mar. 26, 2014), https://www.irs.gov/uac/newsroom/writtentestimony-of-commissioner-koskinen-before-the-house-oversight-and-government-reform-committeeon-irs-operations. 48 letter from anne wall, treas. assistant sec’y for legislative affairs, to sen. michael b. enzi 2 (aug. 19, 2015) (on file with author). 49 for discussion of these and other types of irs guidance, see steve johnson, jerome borison & samuel ullman, civil tax procedure ch. 1 (3d ed. forthcoming 2016). 50 see, e.g., alison bennett, foreign tax credit splitter rules slowed by resource constraints, irs official says, 33 tax mgmt. wkly. rep. 1696 (dec. 11, 2014); lydia beyoud, staffing declines in passthroughs division likely to result in smaller guidance plan, 33 tax mgmt. wkly. rep. 694 (may 16, 2014). 51 irs issued 636 revenue rulings in 1974, but only 50 in 2013. see adler, supra note 22. the slack was partly taken up by issuance of more notices, although notices typically receive somewhat less exacting review. in the early 1980s, the irs issued between 200 and 400 revenue rulings, but only 10 to 20 notices each year. recently, the irs has been issuing around 50 revenue rulings, but around 100 notices each year. the irs considers notices to be on the same plane of authority as revenue rulings. rev. rul. 90-91, 1990-2 c.b. 262. courts, however, seem to give notices less weight. see, e.g., bmc software, inc. v. comm’r, 780 f.3d 669, 675-76 (5th cir. 2015); costantino v. trw, inc., 13 f.3d 969, 980-81 (6th cir. 1994) (both refusing to defer to irs notices). 52 the irs issued about 14,000 private letter rulings in 1974 but fewer than 2600 in 2013. id. see also rev. proc. 2003-48, 2003-2 c.b. 86 (adding “business purpose” to the list of topics on which the irs will not rule). 53 koskinen, supra note 44, at 4-5. 14 columbia journal of tax law [vol.7:5 2. informal guidance according to ken armstrong, “the reduction in irs toll-free phone lines, walk-in taxpayer assistance centers . . . in all areas of taxpayer correspondence, and a decrease in its workforce along with reductions in training and information technology have significantly diminished service to taxpayers.” 54 in fiscal year 2013, only 61% of taxpayers seeking to reach an irs customer service representative by telephone got through, down from 87% in fiscal year 2004.55 by 2015, the figure dropped to under 50%.56 almost 20 million phone calls from taxpayers to the irs went unanswered in 2013.57 those that did get through had long wait times, [which] rose from 12.8 minutes in 2013 to 20.3 minutes during the first four months of 2014. . . . those expecting correspondence did not fare better. during 2013, the irs was unable to process 53 percent of its adjustments correspondence within 45 days, its standard timeframe.58 the practitioner priority service used to be a popular device by which taxpayers’ representatives could obtain information on an expedited basis. but “[t]he pps level of service has been frustrating to say the least. many [enrolled agents] report frequently receiving messages that due to high volume, irs cannot accept their calls and others have waited hours for service.”59 as always, of course, one must ask whether the numbers tell the whole story. a standard ploy in the strategy of agencies conducting guerrilla warfare against budget cuts is to cut good—or at least visible and popular—programs rather than wasteful ones, that is, to pare muscle rather than fat, as a way of leveraging howls of constituent indignation into restoration of funding. one cannot say with certainty whether and to what extent the irs has slashed taxpayer service rather than other activities as part of such a strategy, but the possibility exists.60 3. enforcement no one knows for sure how much tax that should have been paid goes uncollected. the irs estimates that the annual tax gap—the difference between what taxpayers should have paid and what they paid timely—is $450 billion. the largest component ($376 billion) reflects taxpayers underreporting their liabilities on their returns. an additional 54 ken armstrong, service matters, 33 tax mgmt. wkly. rep. 1646 (2014); see also national taxpayer advocate, 2013 annual report to congress (dec. 31, 2013). 55 catherine rampell, charting the decline in service at the irs, n.y. times (jan. 11, 2014), http://taxprof.typepad.com/taxprof_blog/2014/01/ny-times-2.html [https://perma.cc/m22w-bed3]. 56 koskinen, supra note 44, at 3. during the 2015 filing season, “the irs answered only 38 percent of calls and those taxpayers able to reach the irs experienced average wait times of over 23 minutes.” wall, supra note 19, at 2. 57 national treasury employees union, press release, june 17, 2014, at 2 (on file with author). 58 id. 59 letter from lonnie garry, president of nat’l ass’n of enrolled agents, to commissioner john a. koskinen, sept. 18, 2014 (on file with author). the average wait was 32.5 minutes. nteu press release, supra note 57, at 2. 60 the irs has told congress that “the only way to address these issues [of the impact of budget cuts on the quality of taxpayer services] is for congress to provide the irs with the additional funding.” wall, supra note 19, at 1. well, maybe not. the irs has considerable, though not unlimited, flexibility in how it allocates appropriated funds and splits funds among activities. see government accountability office, supra note 11, at 5-6. 2016] the future of american tax administration 15 $28 billion is based on taxpayers who are legally obligated to, but do not, file returns. the remaining $46 billion consists of reported but unpaid tax liabilities.61 in short, there are abundant targets for more robust tax enforcement. yet key enforcement activities have contracted, not expanded, in recent years. overall, between 2010 and 2015, irs enforcement dropped by 20%.62 for example: • as noted in subpart i.a. above, information gathering and enforcement involving transnational activities are of great and growing importance. fatca is a central strategy for reducing cross-border evasion of u.s. taxes. the irs has enough resources to accept the tsunamis of forms and reports that fatca requires—but perhaps not enough to actually read, process, and act on the information contained in the fatca reports.63 • similarly, to facilitate cross-border enforcement, the irs has long stationed employees in key global commerce hubs, but, for budgetary reasons, the irs has closed its offices in beijing, london, paris, and frankfurt.64 • in 2014, the irs performed 100,000 fewer examinations of individual taxpayers, dropping individual audit coverage rates to historic lows.65 • the appeals office is a critical part of the irs because it resolves numerous cases that otherwise would have to be docketed for trial. because of budget cuts, however, some cases now are handled by offices remote from the taxpayer’s residence, without face-to-face contact, and less expeditiously.66 • in fiscal year 2013, “[c]ollection activities initiated by the irs, such as taxpayer liens, levies, and property seizures, declined by approximately 33 percent.”67 4. workforce like most organizations, the irs’s biggest expense is compensation of its employees. this is hardly surprising. “in order to perform the service’s critical functions, in the face of complex and constantly changing tax laws, a sufficient staff must be recruited and properly trained.”68 yet the irs has “been forced to significantly reduce the size of its workforce. . . . between fy 2010 and the end of fy 2014, the number of irs employees has been reduced 61 treasury inspector general for tax administration, supra note 12, at 2 & n.3. 62 house approves broad spending plan with cuts to irs, 33 tax mgmt. wkly. rep. 1695 (dec. 11, 2014). 63 jennifer depaul, koskinen says budget cuts affect fatca administration, tax notes, at 1408 (mar. 31, 2014). 64 irs statement, jan. 14, 2015 (on file with author). 65 written testimony of commissioner john a. koskinen, internal revenue service, before the house ways and means comm., subcomm. on oversight, the 2014 filing season and improper payments (may 7, 2014) (on file with author). 66 see, e.g., letter from michael hirschfeld, chair of the american bar ass’n section of taxation, to senators tom udall and mike johanns & representatives ander crenshaw and jose e. serrano (july 21, 2014) (on file with author) (“the ability of taxpayers to resolve cases administratively has also been negatively affected by decreased funding”). 67 treasury inspector general for tax administration, supra note 12, at 2. 68 hirschfeld, supra note 66, at 3. 16 columbia journal of tax law [vol.7:5 by approximately 13,000 full-time positions, with about 9,500 coming from front-line enforcement personnel.”69 demographic trends make these losses particularly difficult to absorb. [they] come at a time when the irs workforce is aging, with nearly 52% of irs employees now over the age of 50 and 24% already eligible to retire. three years from now, 38% of irs employees will be eligible to retire. this loss of irs knowledge and experience is alarming, particularly in light of the fact that, out of a present workforce of about 85,000 employees, the irs has only about 3,400 employees under the age of 30 and only 384 employees under the age of 25 . . . .70 5. training having a large workforce will not suffice (and indeed may create more problems than it solves) if employees lack relevant knowledge. knowledge may come from experience or from training. yet many of the irs’s most senior personnel are choosing retirement,71 and the irs has suffered “dramatic curtailments in training, travel, office space, and outside contracts.” 72 this country’s tax laws have not become 85% less complicated.73 yet, between 2009 and 2014, the irs’s training budget was slashed by 85%.74 6. technology each year, the irs processes around 145 million tax returns, issues over 100 million refunds, 75 makes hundreds of millions of assessments, and generates untold millions of audit letters, collection letters, notices, bills, and other correspondence. to operate effectively, the irs needs efficient and reliable information systems. however, as a result of its own poor performance as well as lean budgets,76 the irs is forced to rely on aging, outmoded it systems that sometimes do not interface with each other.77 inadequate technology also imperils the irs’s ability to effectively execute 69 treasury inspector general for tax administration, supra note 12, at 2. the seven former commissioners put this attrition at 15,000. see seven commissioners letter, supra note 14, at 2. the workforce of the irs’s criminal investigation division has dropped to its lowest level in four decades. see exclusive: irs enforcement agent numbers could drop to lowest levels since 1970s, reuters (aug 25, 2014), http://finance.yahoo.com/news/exclusive-irs-enforcement-agent-numbers-111711058.html [https:// perma.cc/ya2g-zema]. 70 seven commissioners letter, supra note 14, at 2-3. john dalrymple, irs deputy commissioner for services and enforcement, described the ongoing “brain drain” of retiring irs employees as “a real critical problem.” quoted by hoffman, supra note 41, at 1264; see also duarte, supra note 23, at 63 (“[e]xperienced irs staff, and especially managers, are in short supply.”). 71 hirschfeld, supra note 66, at 3. 72 treasury inspector general for tax administration, supra note 12. 73 indeed, “congress almost annually over the last 25 years has passed legislation that has imposed additional burdens on irs tax collection and administration.” seven commissioners letter, supra note 14, at 4. 74 written statement of nina e. olson, national taxpayer advocate, hearing on identity theftrelated tax fraud, before the house comm. on oversight and government reform, subcomm. on government operations 4 (aug. 2, 2013). 75 wall, supra note 19, at 2 (citing information from the national taxpayer advocate). 76 see armstrong, supra note 54 (“throwing money at it and staffing won’t solve the impending . . . administration burdens on the irs unless it has direction.”). 77 wall, supra note 19, at 2; duarte, supra note 23, at 63; see also koskinen, supra note 44, at 4 ([the irs is] “experiencing delays to critical it projects, with very old technology running alongside more modern systems.”). 2016] the future of american tax administration 17 the non-revenue functions congress has chosen to vest in the irs. for example, “without proper technology and staffing, the [aca] reporting and funding system is doomed to failure.”78 the threat is not just to the irs. it potentially implicates the peace and financial security of most of the adult population of the united states: the americans who deal with the irs. combatting tax-based identity theft and fraud is a major goal of the irs.79 in 2015, there were unauthorized attempts to access taxpayer information using the agency’s “get transcript” online application.80 this was the most publicized incident but far from the only one. “[t]he irs continues to experience about one million attempts each week to hack into its main information technology system. although the irs has so far successfully thwarted these attacks, [they emphasize] that the irs taxpayer assistance and irs information technology resources are severely underfunded.”81 7. revenue viewed from the traditional perspective, raising revenue—the correct amount of revenue determined by congress—is the central criterion on which irs performance should be evaluated. the “perfect storm” intersection of trends described above has eroded the irs’s ability to collect tax liabilities and threatens more damage in the future. supporters of the irs find it ironic that congress has reduced funding for the main federal agency that actually turns a profit. the rule-of-thumb statistic is “that for every $1 invested in the irs budget, it produces $4 in enforcement revenue, which is a $4-to-$1 return on investment.”82 accordingly, the irs estimates that, for 2014, “it would have returned to the federal government over $2 billion more in collections had we received the remaining $500 million that our budget was cut as a result of the sequester.”83 the 4-to-1 ratio is neither a ceiling nor a floor. everything depends upon the particular use to which the irs will put additional funds, which may explain why the irs sometimes offers different return-on-investment figures.84 some in congress, however, 78 armstrong, supra note 54. 79 see, e.g., prepared remarks of commissioner of internal revenue john koskinen, before the national press club 7 (apr. 2, 2014). 80 see, e.g., michael s. schmidt, hacking of tax returns more extensive than first reported irs says, n.y. times (aug. 17, 2015), http://www.nytimes.com/2015/08/18/us/politics/hacking-of-tax-returnsmore-extensive-than-first-reported-irs-says.html [https://perma.cc/vve5-7ytt ] (“[h]ackers had gained access to the tax returns of more than 300,000 people, a far higher number than the agency had reported previously.”). 81 seven commissioners letter, supra note 14, at 4. 82 written testimony of commissioner john a. koskinen, internal revenue service, before the subcommittee on financial services and general government on the fy 2015 irs budget 11 (apr. 7, 2014). 83 id. see also written testimony of john a. koskinen, commissioner, internal revenue service, before the house ways and means comm., subcomm. on oversight, the 2014 filing season and improper payments 5 (may 7, 2014) (estimating a revenue loss of almost $3 billion). the 4 to 1 ratio was derived by dividing the additional revenue brought in by the irs as a result of enforcement activities by the irs’s budget. thus, in fiscal year 2013, irs enforcement collected about $53 billion from a budget of about $12 billion, a rate of return somewhat over 4 to 1. see id. at 1-2. 84 e.g., john koskinen, commissioner’s message on the budget 2 (feb. 2, 2015) (“for every dollar invested in these programs, there can be returns ranging from 6-to-1 and even up to 20-to-1 for some initiatives”); john koskinen, quoted by senator ron wyden, statement on budget challenges 2 (jan. 14, 2015) (7 to 1). 18 columbia journal of tax law [vol.7:5 have lost faith in these oft-repeated figures, and it may be the path of wisdom to eschew precise quantification.85 the other possible effect is more subtle and conjectural but—were it to come to fruition—would be even more grave. the irs examines only a small percentage of returns filed, typically under one percent.86 at such low coverage, it is essential that the returns taxpayers file bear some reasonable correlation to economic reality.87 what causes taxpayers to comply or not comply with the tax laws is a complex web of self-interest, social signal, and personal morality.88 even a gradual deterioration of compliance would be dangerous.89 each 1% drop in compliance costs the federal treasury about $30 billion annually.90 the “tipping point” theory posits that a point can be reached at which taxpayer alienation from the system or taxpayer disdain for tax enforcement becomes so pervasive that a general culture of tax compliance could flip “virtually overnight” into a general culture of noncompliance.91 some fear we are at, or near, that point now.92 i do not share that fear, but the magnitude of the stakes inspires caution. commissioner koskinen has warned that the budget-driven “erosion in audit coverage . . . is deeply worrisome . . . especially for a system like ours that depends on voluntary compliance.”93 ii. doubting obvious solutions in an increasingly complicated and thoroughly politicized society, few things are more treasured by americans than simplistic explanations that allow us to keep, indeed fortify, our preconceptions. the woes of the irs have been on the radar screen of public discourse long enough that two camps have formed as to what the appropriate solution to them might be. committed members of both camps may have the same reaction—although for quite different reasons. the common reaction may be “there’s no need to overthink this. there’s a pretty easy answer to the perfect storm problem.” for those in the anti-irs camp, 85 see, e.g., hirschfeld, supra note 66, at 3 (stating simply that irs enforcement produces “a substantial increase” in collections and that reduced funding may yield “significantly lower tax collections”); see also national taxpayer advocate, 2013 annual report to congress, executive summary 21 (dec. 31, 2013). 86 in fiscal year 2014, for example, the irs examined seven tenths of one percent of all returns filed. irs data book tbl. 9a (2014). 87 such “self-assessment” is the bedrock of our system of taxation. see, e.g., united states v. rodgers, 461 u.s. 677, 683 (1983); irs proc. reg. § 601.103(a) (2009). 88 the literature on tax compliance is immense. see, e.g., robert boylan, richard j. cebula, maggie foley & douglass izard, implications of recent federal personal income tax increases for income tax evasion, tax revenues, and budget deficits, 6 wm. & mary pol’y rev. 1 (2014); sarah b. lawsky, modeling uncertainty in tax law, 65 stan. l. rev. 241 (2013); leandra lederman, the interplay between norms and enforcement in tax compliance, 64 ohio st. l. j. 1453 (2003); j. manhire, toward a perspective-dependent theory of audit probability for tax compliance models, 33 va. tax rev. 629 (2014). 89 see, e.g., cohen, supra note 1, at 117 (“the audit rate in 1964-68 was about 4.5 to 5 percent, compliance was over 90 percent; today the audit rate is less than one percent and compliance is only about 80 percent. think there is a correlation? i do.”). 90 john koskinen, quoted by william hoffman, koskinen warns of house irs budget impact in 2015, tax notes, at 919 (aug. 25, 2014). 91 see eric kroh, u.s. seen as in danger of tumbling over “compliance cliff”, tax notes, at 909 (aug. 25, 2014) (quoting richard lavoie). 92 see jeremy scott, the precarious state of voluntary compliance, tax notes, at 893 (aug. 25, 2014). 93 koskinen, supra note 44, at 5. 2016] the future of american tax administration 19 the easy answer might be “despite budget cuts, the irs still has a big budget. it just has to use it better by prioritizing and becoming more efficient.” for those in the pro-irs camp, the easy answer might be “just open the purse strings. congress should give the irs the budget it needs.” there is a kernel of truth in both of these views. neither simplistic approach can provide the full answer, however. the anti-irs agenda lacks flexibility: most easy efficiencies already have been wrung out of the system. the pro-irs agenda could perpetuate bad behavior: the agency’s recent woes reflect serious management failures, as well as budgetary and workload pressures. to open wide the appropriations spigot would remove pressures and incentives for constructive change within the agency. this is not to suggest that the irs be put on a budgetary starvation diet, but rather to suggest that the “just throw more money at it” approach which is often preferred in this country would be shortsighted in this context. a. “just become more efficient” recent budget and workload stresses have caused the irs to improve its efficiency in a number of ways.94 no doubt, some additional opportunities for efficiencies exist, but there are practical limits. no organization of 85,000 (or even fewer) participants—whether public or private—has yet or ever will achieve perfect efficiency. it flouts experience to demand that which has never been attained. the seven former commissioners observed: some have argued that the irs can solve these problems by simply becoming more efficient. this argument ignores the reality that the irs is already, by far, the most efficient tax collection agency among large countries in the world. . . . [t]he amount the irs spends to collect a dollar in taxes is approximately half the average amount spent by all oecd countries. germany, france, england, canada and australia all spend as much as two or three times the amount the irs does to collect a dollar of revenue.95 b. “just give the irs more money” in light of the harms described in part i of this article one might, at first glance, be deeply puzzled as to why congress has been decreasing the irs’s budget. this behavior could seem extremely short-sighted, the government “cutting off its nose to spite its face.” writing to the chairs and ranking members of congress’s principal tax-writing committees, seven former commissioners of the irs remarked with evident exasperation: [w]e fail to understand how it makes any logical sense to continue to reduce, rather than increase, the irs budget . . . . [w]e do not understand why anyone with present and projected debts and annual losses as large as 94 “the irs does need to be as efficient as possible and we now saved over $200 million a year as a result of efficiencies instituted over the past few years.” koskinen, supra note 44, at 4. the commissioner added: “but we’re now at a point where further cuts may make us seem more efficient, but we’re actually going to be a lot less effective.” id. for details as to recent efficiencies, see written testimony of john a. koskinen, commissioner, internal revenue service, before the senate finance committee, irs budget and current operations 3 (feb. 3, 2015) (describing real estate management, printing, postage, and other reforms). 95 seven commissioners letter, supra note 14, at 5 (citing the 2013 biannual comparative analysis of tax administration by the organization for economic cooperation and development); see also john koskinen, quoted by william hoffman, koskinen warns of house irs budget’s impact in 2015, tax notes, at 919-20 (aug. 25, 2014) (“we’re beyond the stage where we can pretend we can keep doing the same amount of work with less resources”). 20 columbia journal of tax law [vol.7:5 those of the united states would refuse to pay for telephone assistance to people trying to fulfill their tax obligations, would turn their back on $8 billion annually in additional revenue, or would fail to make an investment that offers a return equal to at least four times the amount invested. for those reasons, we respectfully call upon each of you to support and work to accomplish the passage of [significantly enhanced] irs appropriations.96 anyone who cares about good tax administration will understand the former commissioners’ view, but there is another side of the story. the irs has had a string of embarrassing, damaging, and highly publicized failures in recent years attributable to its institutional culture, management structure, and incompetence, not just to inadequate resources. it is at least arguable that congress should use its “power of the purse” to induce bureaucratic reforms within the irs. these points are developed below. in 2013, controversy erupted about alleged irs targeting of conservative and libertarian groups for special, burdensome review of their applications for tax-exempt status.97 accusations, apologies, firings, and investigations occupied much of the news cycles for years thereafter.98 criminal charges have not been brought. whether overt or subtle political influences led to “targeting” of these groups is beyond the possibility of conclusive proof or disproof. but our interest should go deeper. assume no criminality or partisan motivation of any kind. we are still left with appalling incompetence by the irs, both in the training and supervision that caused poor handling of the applications and especially in the inept or deceptive nature of the irs responses to the investigations.99 responsible persons on both sides of the political aisle accept this. senator orrin hatch, chair of the senate of finance committee, finds in the scandal “gross mismanagement at the highest levels of the irs.”100 senator ron wyden, ranking member of that committee, concurred: “[t]he two of us [senators hatch and wyden] certainly agree that there is evidence of vast bureaucratic bumbling at the irs.”101 as damaging as that saga was, it has had company. for example, in any organization of size, some employees will violate the rules or even break the law. the irs cannot fairly be criticized for human failings of its employees. it can, however, properly be taken to task for failing to properly discipline miscreant employees. yet, “[i]n recent years, the irs has paid millions of dollars in bonuses and given tens of thousands of paid vacation hours to employees with recently substantiated conduct issues and disciplinary actions, including bonuses to 1,100 employees owing back taxes.”102 in addition, the irs has rehired hundreds of seasonal employees despite their prior misconduct, including 96 seven commissioners letter, supra note 14, at 5-6. 97 see i.r.c. § 501(c)(4). 98 for detailed discussion of the controversy, see leandra lederman, irs reform: politics as usual?, 7 colum. j. tax l. 36 (2016). 99 “the agency’s performance during the tea party scandal has been defensive, dilatory, and less than fully honest.” joseph j. thorndike, stop blaming the irs for problems it didn’t create, tax notes, at 115 (july 14, 2014). 100 quoted in committee press release, finance committee releases bipartisan irs report 2 (aug. 5, 2015) (on file with author). 101 wyden floor statement on finance committee investigation of irs handling of applications for tax-exempt status, at 2 (aug. 5, 2015) (on file with author). 102 letter from senator orrin hatch to john koskinen (jan. 29, 2015) (on file with author). 2016] the future of american tax administration 21 willfully failing to file their own returns, gaining unauthorized access to taxpayer information, falsifying official forms, and misusing irs property.103 other irs failures have included: • sending incorrect information to 800,000 taxpayers as to aca,104 • multiple examples of waste in irs conferences and training programs,105 • paying millions to contractors who have failed to pay large tax debts they owe to the federal government,106 and • failing to effectively monitor claims for deductions and credits in widely abused programs.107 the irs sometimes is criticized unjustly, but “[i]n recent years, its list of failures and transgressions is long and serious.”108 commissioner koskinen acknowledged that “there has been a loss of confidence among taxpayers and particularly within congress in regard to the way we manage operations.”109 when an agency performs badly and the administration fails to impose the appropriate corrections, the most important tool available to congress is the power of the purse. it was in the exercise of that constitutional authority110 that congress says it acted to rein in irs abuses.111 one may fairly ask whether congress’ parsimony was proportional to the irs’s derelictions. the harms described in part i may involve too much pain for too little gain. 103 treasury inspector general for tax administration, additional consideration of prior conduct and performance issues is needed when hiring former employees (feb. 5, 2015). 104 see, e.g., peter sullivan & sarah ferris, feds sent incorrect tax information to people on obamacare, the hill (feb. 20, 2015), http://thehill.com/policy/healthcare/233315-incorrect-taxinformation-sent-to-800000-people-on-obamacare [https://perma.cc/da3b-pjhj]. 105 see, e.g., prepared remarks of danny werfel, principal deputy commissioner, before the 2013 irs nationwide tax forum, at 4 (july 30, 2013) (on file with author). 106 see, e.g., stephen dinan, irs breaking federal law in paying contracts to tax cheats: audit, wash. times (june 24, 2015), http://www.washingtontimes.com/news/2015/jun/24/irs-breaks-federal-lawpaying-contracts-tax-cheats/?page=all [https://perma.cc/8eb5-7jtz]. 107 see, e.g., hadley malcolm, irs flubs $5.6b in tax credits, usa today, may 6, 2015, at 5b (reporting a treasury inspector general for tax administration study finding that the irs issued more than $5.6 billion in faulty education tax credits to about 3.6 million taxpayers in 2013). 108 thorndike, supra note 99, at 115; see also dave camp, former chair of the house ways and means committee, quoted by william hoffman, koskinen achieving mixed results so far, tax notes, at 233 (july 21, 2014) (“since my time in congress, i have never seen an irs so broken.”) 109 written testimony of john a. koskinen, commissioner, internal revenue service, before the house oversight and government reform comm. on irs operations 2 (mar. 26, 2014). 110 see u.s. const. art. i, § 8, cl. 1 & § 9, cl. 7; see, e.g., helvering v. davis, 301 u.s. 619, 908 (1937). 111 [t]he irs has exhibited a litany of questionable practices and expenses over the past five years . . . . [a]fter five years of budget cuts or freezes, i would hope that the irs has turned a new leaf . . . . . . . . we deliberately lowered the irs’ funding to a level to make them think twice about what they were doing and why. ander crenshaw, chair, subcomm. on financial services and general government, house comm. on appropriations, opening statement as prepared, oversight hearing—internal revenue service 2 (feb. 25, 2015). 22 columbia journal of tax law [vol.7:5 that question is hard to answer. the principle, however, stands. control of the budget is the traditional and most effective means available to congress to punish agency failures and to encourage improvements. in light of the irs’s dubious recent performance, surrender of this tool would be unwise. that being so, “just give the irs whatever it wants or needs” may be an obvious, but not necessarily a desirable, response to the current crisis. iii. other theoretically available solutions we saw in part ii that two “obvious” solutions—increased irs efficiency and appropriating more money without fixing the irs’s bureaucratic problems—are not by themselves reliable pathways out of the current morass. in this part iii, we consider other approaches which may, as substitutes for or complements to the obvious approaches, move our tax system forward. one could float armadas on the oceans of ink that have been spent describing the countless proposals that have been offered to improve the substantive and procedural rules of federal taxation.112 identifying, explaining, and evaluating the numerous suggestions (meritorious and not) would be an encyclopedic effort, well beyond the limits of this article. here, it will suffice to note the families of alternatives and sketch the approaches that, by design or happy accident, might ease the current crisis. the families of proposals discussed below are (1) radical tax revision, that is, replacing some or all existing federal taxes with other taxes, (2) eliminating or modifying features of existing taxes, (3) moving non-revenue functions outside the irs, (4) harmonizing u.s. and foreign tax rules, (5) revamping tax lawmaking, (6) changing incentives, and (7) relying more heavily on technology. a. radical tax revision wholesale or partial replacement of the income tax or other current major federal taxes is a perennial topic in tax discourse. interest in the topic crests and falls in waves, but the sea is never wholly still. most suggested alternatives are one or another version of a consumption tax, such as the value-added tax, progressive consumption tax, and some versions of the so-called flat tax.113 it is hard to become extremely excited about the prospects for fundamental reform. anyone experienced in taxation has heard many times “this time, it’s really going to happen!” but it almost never does, making it hard to join the parade when the next banner of supposed inevitability sallies past.114 112 some of the many possibilities are discussed in jonathan barry forman & roberta f. mann, making the internal revenue service work, 17 fla. tax rev. 725 (2015) (enumerating both changes that would require congressional action and administrative actions that could be taken by either treasury or the irs without legislation, with the goal of designing a tax system administrable at even modest levels of funding); steve r. johnson, reforming federal tax litigation: an agenda, 41 fla. st. u. l. rev. 205 (2013) (detailing proposed changes as to tax trial and appellate structure and doctrine). 113 for a discussion of several such alternatives, see alan viard, fundamental tax reform: a comparison of three options, taxprof blog (jan. 25, 2016) http://taxprof.typepad.com/taxprof_blog/2016 /02/viard-presents-fundamental-tax-reform-a-comparison-of-three-options-today-at-georgetown.html [https:// perma.cc/59th-b9jz]. 114 from a distance, tax reform reflects the shimmering frontier of american economic policy . . . . up close, however, the picture dims. for reasons both economic and political, the idea of a fundamental overhaul that closes loopholes, lowers rates and simplifies the tax code faces a deeply uncertain future regardless of who controls the white house and congress in 2017. 2016] the future of american tax administration 23 the issues typically debated with respect to replacements for the income tax involve progressivity, revenue-raising capacity, and effect on economic growth. presumably, the ultimate decision as to whether to embrace replacements will turn on those considerations more than on their effect on administrability. however, administrability is part of the debate.115 would a consumption-based partial or complete alternative to the income tax ameliorate the current crisis? in the short term, no. the enormous transitional challenges of moving from one system to another would exacerbate immediate stresses.116 the longterm effect would depend on design choices. our income tax does entail mind-numbing complexity. in part, this is because “a neutral, scientific measure of taxable income is a mirage. . . . [t]he income tax structure cannot be discovered, but must be constructed; it is the final result of a multitude of debatable judgments.”117 but that would also be true of any alternative system. the choices made can produce complexity regardless of the starting point. the current income tax is complicated in part because of so called “tax expenditures,” in effect, subsidies to various persons or activities necessitated by defining ability to pay.118 similar pressures would likely find outlets in any replacement system.119 for example, persons and activities could be favored in a consumption tax through elaborate exemptions, different rates of tax, timing rules, and rebate or credit mechanisms. the current income tax also is complicated by the engrafting of consumption-based features, such as deferring the imposition of tax on retirement savings.120 indeed, what we call our “income” tax actually is a mix of income-based and consumption-based provisions in roughly equal measure.121 if an income tax can be hybridized, so can a consumption tax. it all depends on design details, which can change over time.122 nothing guarantees that a fundamental alternative to the income tax would ultimately be easier to administer than the present system. b. feature modification john harwood, despite pledges, tax reform remains an elusive goal, n.y. times (feb. 2, 2016), http:// www.nytimes.com/2016/02/03/us/politics/despite-pledges-tax-reform-remains-an-elusive-goal.html [https:// perma.cc/3yu9-y346]. 115 for example, michael graetz has argued for partial replacement of the income tax by a value added tax in order to eliminate the need for lowand middle-income taxpayers to prepare, and for the irs to process, 100 million tax returns each year. michael j. graetz, 100 million unnecessary returns: a simple, fair and competitive tax plan for the united states (2008). 116 see, e.g., cohen, supra note 1, at 124 (noting “the god-awful task of how to move from the old system to the new”); viard, supra note 113, at 33-45. 117 boris i. bittker, a “comprehensive tax base” as a goal of income tax reform, 80 harv. l. rev. 925, 925, 985 (1967). 118 see generally douglas a. kahn, a proposed replacement of the tax expenditures concept and a different perspective on accelerated depreciation, 41 fla. st. u. l. rev. 143 (2013). approximately one quarter of the spending of the federal government consists of tax expenditures. national taxpayer advocate, 2 annual rep. to congress, 2010, at 101-04 (dec. 31, 2010). they exceed $1 trillion a year. nina e. olson, more than a “mere” prepare: loving and return preparation, tax notes, at 767 (may 2, 2013). 119 see, e.g., cohen, supra note 1, at 118, 122. 120 see, e.g., i.r.c. §§ 219, 401-420. 121 see, e.g., william d. andrews, a consumption-type or cash flow personal income tax, 87 harv. l. rev. 1113, 1117 (1974); lawrence a. zelenak, will the federal income tax have a bicentennial?, 41 fla. st. u. l. rev. 275, 275 (2013). 122 similarly, were congress to enact a “flat” tax, one wonders how long it would remain flat. 24 columbia journal of tax law [vol.7:5 simplifying tax burdens on the irs might be too costly if doing so seriously eroded other important tax values. however, numerous proposed changes to aspects of our current tax system would arguably improve the substance of the law as well as facilitate administration. here are some candidates. 1. reduce the number of pass-through regimes so-called c corporations are separate taxpayers from their shareholders, 123 creating the possibility of double taxation of corporate profits paid out to shareholders as dividends. this can be avoided if the entity is formed instead as an s corporation or as a partnership. under subchapters s and k of the code, s corporations and partnerships generally do not themselves pay tax on their profits but instead pass the tax through to the shareholders or partners.124 why do we need two pass-through regimes? there are situations in which s corporations have advantages partnerships do not, and there are other situations in which partnerships (including multi-member limited liability companies, which are usually taxed as partnerships) have advantages over s corporations.125 thus, eliminating one or the other pass-through form (or melding the two forms) would be unpopular with the politically potent small business sector. nonetheless, one may well ask whether the extra flexibility is important enough to saddle the tax system with considerable costs in terms of administrability. subchapter k is hideously complex, indeed is often beyond the capacity of taxpayers to understand and of the irs to enforce.126 for that reason, i would abolish subchapter k (in the main) and keep subchapter s.127 some others would make the opposite choice—abolishing subchapter s and retaining subchapter k.128 the absence of consensus is one factor propping up the current regime of two pass-through systems. whichever approach were taken, the tax system would be improved by paring the number of pass-through regimes. 2. eliminate the ordinary income-capital gains distinction for individual taxpayers, long-term capital gains are usually treated favorably compared to ordinary income.129 for all taxpayers, capital losses are usually treated unfavorably compared to ordinary losses.130 the advantages and disadvantages of treating capital gains and losses differently from ordinary gains and losses have been debated for 123 see i.r.c. § 11. 124 i.r.c. §§ 701 (partnerships), 1363(a) (s corporations). 125 the choice-of-entity literature is vast. see, e.g., john w. lee, choice of small business tax entity: facts and fictions, 87 tax notes 417 (2000). 126 the distressingly complex and confusing nature of the provisions of subchapter k present a formidable obstacle to the comprehension of these provisions without the expenditure of a disproportionate amount of time and effort even by one who is sophisticated in tax matters with many years of experience in the tax field. foxman v. comm’r, 41 t.c. 535, 551 n.9 (1964), aff’d, 352 f.2d 466 (3d cir. 1965). in the half century since the tax court penned this gloomy assessment, subchapter k has become more, not less, impenetrable. 127 see steve r. johnson, the e.l. wiegand lecture: administrability-based tax simplifications, 4 nev. l.j. 573, 589-96 (2004). 128 see, e.g., walter d. schwidetzky, integrating subchapters k and s—just do it, 62 tax law. 749 (2009). 129 compare i.r.c. § 1(h), with i.r.c. § 1(a)-(d). 130 see i.r.c. §§ 1211-12. 2016] the future of american tax administration 25 generations,131 and different judgments have been made at different times. the distinction did not exist in our tax law until 1921. in 1986, the distinction was repealed but was reinstated a few years later. at other times, the requisite holding period for long-term status, the size of the differential, and limiting rules all have varied. 132 my own preference—a minority view133—would be to abolish the differential. capital gains policy is determined principally by considerations other than administrability. but it is worth noting that, were we ever to bury the distinction and not later exhume it, the burdens on the irs would be greatly eased. the code is festooned with provisions that exist only to keep in some state of repair the fence between ordinary and capital.134 these sections require regulations, revenue rulings, private letter rulings, audits, and litigation. abolition of the distinction would be a major move in obviating the current crisis. 3. abolish the accumulated earnings tax the accumulated earning tax (aet) imposes a penalty tax on corporations that accumulate profits beyond the reasonable needs of the business instead of paying them out as dividends.135 determining what constitutes such reasonable needs requires extensive factual inquiry. at the end of the day, the irs often loses because (1) the taxpayers have superior access to the facts and (2) courts are often reluctant to second-guess the business judgment of the taxpayer.136 as a result, it is likely that, on net, the irs loses money when it tries to enforce the aet, at least when opportunity costs are taken into consideration. the irs often invests hundreds of agent hours in aet examinations, appeals, and litigation, yet recovers little or nothing. relevant statistics may not exist and, if they do, have not been publicly released. it is likely, however, that the irs’s assumed “$4 of extra tax collected for every $1 of extra irs budget” return on investment137 is not achieved in aet examinations. instead, the irs should invest its time in other audit areas where that return on investment can be achieved. the aet wastes the time of the irs, and because of opportunity costs, it hurts the federal fisc. therefore, the aet should be abolished.138 4. revise treatment of tax-exempt entities certain organizations are generally exempt from the federal income tax. 139 “originally, only two types of organizations—charities and fraternal benefit societies— were exempt . . . . today, there are more than 29 different types of tax-exempt entities in section 501(c) alone and by some counts more than 70 in all.”140 131 see, e.g., william d. popkin, introduction to taxation 45-49 (5th ed. 2008). 132 for this history in brief, see id. at 46-47. 133 but i have some illustrious company. see, e.g., daniel halperin, commentary: a capital gains preference is not even a second-best solution, 84 tax l. rev. 381 (1993); edward j. mccaffery, the holy grail of tax simplification, 1990 wis. l. rev. 1267, 1295-95; joseph a. snoe, tax simplification and fairness: four proposals for fundamental tax reform, 60 alb. l. rev. 61, 66-85 (1996). 134 among scores, if not hundreds, of examples, see i.r.c. §§ 1211-1259. 135 i.r.c. §§ 531-537. 136 see, e.g., welch v. helvering, 290 u.s. 111, 113 (1933). 137 see supra text accompanying notes 83-86. 138 for a more detailed discussion, see johnson, supra note 127, at 603-8. 139 see i.r.c. §§ 501-513. 140 david s. miller, reforming the taxation of exempt organizations and their patrons, 67 tax law. 451, 451 (2014). 26 columbia journal of tax law [vol.7:5 the area is huge, and policing it places heavy burdens on the irs.141 yet the area remains a trouble spot in tax administration. the very size of the enterprise is daunting; key definitions sometimes are vague; 142 and there are recurring tensions between enforcement and other important values, such as privacy, free expression of ideas and of religion, and facilitation of socially useful work.143 befitting the importance of the issues, a large literature has arisen. numerous proposals—some complementary, some not—have been offered, including narrowing the categories of exemption, less rigorous oversight, more rigorous oversight, and increasing the transparency of irs regulation of the area.144 where the needle stops in reform of this area will have significant implications for the amelioration or exacerbation of the current crisis. 5. other proposals numerous other simplification proposals are advanced on a frequent basis. helpful sources include the following: • academic commentary,145 • “blue ribbon” commission reports,146 • bar reports,147 • accounting society reports,148 • the annual reports to congress by the national taxpayer advocate, • the so-called greenbooks issued by the treasury explaining tax changes in the administration’s annual budget proposals,149 141 in 2013, there were nearly 1.5 million organizations recognized under § 501(c), and the irs devoted 842 full-time equivalent employees to the area. lloyd hitoshi mayer, “the better part of valour is discretion”: should the irs change or surrender its oversight of tax-exempt organizations?, 7 colum. j. tax l. 80, 84, 87 (2016). 142 see, e.g., aba retirement funds v. united states, 759 f.3d 718, 721 (7th cir. 2014). 143 the scandal involving irs review of § 501(c)(4) applications from conservative-leaning groups, see supra text accompanying notes 97-101, reflects the sensitivity of these trade-offs. 144 see, e.g., roger colinvaux, political activity and tax exemption: a gordian knot, 34 va. tax rev. 1 (2014); mayer, supra note 141; miller, supra note 140; donald b. tobin, the internal revenue service and a crisis of confidence: a new regulatory approach for a new era, 16 fla. tax rev. 429 (2014); george k. yin, saving the irs, 2014 tax notes today 87-5 (may 6, 2014). 145 see, e.g., joseph m. dodge, some income tax simplification proposals, 41 fla. st. u. l. rev. 71 (2013) (advancing over 50 suggestions). 146 see report of the president’s advisory panel on federal tax reform, simple, fair and progrowth: proposals to fix america’s tax system (nov. 2005); report of the national commission on fiscal responsibility and reform, the moment of truth (dec. 1, 2010). nothing came of these reports. perhaps this is unsurprising. commissions usually are for kicking the can down the road, not for solving problems. see, e.g., cohen, supra note 1, at 118 (“when a problem is too difficult to solve, punt to a commission”). 147 the american bar association section of tax, new york state bar tax section, and other tax professional organizations and individuals submit numerous proposals to congress, the treasury, and the irs. the government submissions of the aba tax section are available at http://www.americanbar.org /groups/taxation/policy.html [https://perma.cc/m73r-k3ml]. 148 see, e.g., american inst. of certified public accountants press release, aicpa sends tax reform suggestions concerning individuals to senate finance committee working group (mar. 19, 2015) (on file with author). 149 see, e.g., department of the treasury, general explanations of the administration’s fiscal year 2017 revenue proposals (2016). 2016] the future of american tax administration 27 • occasional study reports by the president, treasury, and irs,150 and • congressional reports.151 c. moving non-revenue functions outside irs subpart i.a.3. above noted that one aspect of the “terrible trifecta” is the imposition on the irs of the burdens of administering legions of initiatives that, although lodged in the code, have no essential connection with revenue collection. a direct response would be to remove these initiatives from the purview of the irs, lodging them instead in agencies more natural to the programs in question. this may not always be the right course. for instance, the earned income tax credit (“eitc”)152 is one of the federal government’s largest anti-poverty programs.153 because it is directed at the working poor, who have received wages and have paid taxes, it may be that the easiest way to administer the eitc is through tax returns, putting the program in the irs’s court. nonetheless, the eitc is problematic from an administrative standpoint. because of the complexity of the eitc, there is a high error rate, including innocent error and outright fraud. the irs estimates that 24% of all eitc payments are made in error, resulting in improper payments of between $124 billion and $148 billion between fiscal year 2003 and 2013.154 the code may be the best home for the eitc, but it is not a good home. the case for lodging other non-revenue initiatives in the code may be weaker. as noted in subpart i.a.3., the aca is creating immense strains on the irs.155 there is no programmatic logic under which the aca is naturally linked to the code. the shared responsibility payment156 could have been structured as a penalty outside the code.157 as an alternative to fully shifting some non-revenue functions to other agencies, in some instances, program administration might be improved by more cooperative interaction between the irs and other relevant agencies.158 other concerns about irs administration of the aca also have been expressed. it requires irs employees to make decisions “unrelated to [their] traditional expertise and skill set.”159 moreover, “[f]or important and well-understood reasons, the irs operates with a great deal of independence from other agencies. . . . [d]irect participation of the 150 see, e.g., president’s tax proposals to the congress for fairness, simplicity, and growth (1985). 151 see, e.g., house comm. on ways & means, tax reform act of 2014, discussion draft, sectionby-section summary (2014). 152 i.r.c. § 32. 153 the eitc and the related additional child tax act engender refunds exceeding $90 billion a year. treasury inspector general for tax administration, existing compliance processes will not reduce the billions of dollars in improper earned income tax credit and additional child tax credit payments 5 (sept. 29, 2014). 154 id. 155 see also staff report, house comm. on oversight and government reform, making sure targeting never happens: getting politics out of the irs and other solutions 14-16 (july 29, 2014). 156 i.r.c. § 5000a. 157 this fact is underlined by the odd rules governing enforcement of the shared responsibility payment. unlike normal tax provisions, the irs is prohibited from asserting criminal penalties on account of willful nonpayment of the shared responsibility payment and may not use liens or levies to collect it. i.r.c. § 5000a(g)(2). 158 government accountability office, low-income housing tax credit: joint irs-hud administration could help address weaknesses in oversight (july 2015). 159 national taxpayer advocate, 2010 annual rep. to congress 20 (dec. 31, 2010). 28 columbia journal of tax law [vol.7:5 service in a major non-tax administration initiative has the potential to erode the historic independence of the service.”160 divesting the irs of at least some of its non-revenue functions would liberate resources for improved irs administration of its core functions. hopefully, this would obviate unwise attempts to shift core duties out of the irs. 2004 legislation authorized the irs to enter into contracts with private companies to collect assessed but unpaid taxes.161 the program was discontinued in 2009. given the unimpressive results the first time around, occasional calls to reinstate private tax collection at the federal level should be disregarded.162 the proper role of the irs in administering the aca and other non-revenue initiatives163 entails many questions beyond the scope of this article. however, the possibility of shifting non-revenue initiatives outside the irs requires serious discussion as a response to the current crisis in tax administration. d. harmonizing u.s. and foreign tax rules historically, countries showed little enthusiasm for helping other countries enforce their tax laws.164 however, in a relatively short span of time, attitudes have changed. the world’s economically leading countries all realize that, by legal or illegal means, many of their nationals are using transnational transactions to avoid or evade domestic tax liabilities. recognition of the common interest in preventing this evasion has led to increasing international tax cooperation. regular and ad hoc bilateral and multilateral contacts are being established, and information exchange among revenue authorities grows apace.165 therefore, the question naturally arises whether cooperation in enforcing national laws should and will morph into some degree of harmonization of tax laws. to the extent their laws are the same, countries will find cooperation easier and more fruitful.166 a prominent experiment along these lines is the base erosion and profit shifting (beps) initiative of the organization for economic cooperation and development, an attempt to overcome divergences of national tax systems in order to better control transfer pricing abuses by multinational enterprises. formidable obstacles to such efforts exist, including notions of national sovereignty and divergent national economic interests.167 in 160 statement of mark w. everson, former commissioner, internal revenue service, irs: enforcing obama care’s new rules and taxes, hearing before house comm. on oversight and government reform, 112th cong. (2012). 161 american jobs creation act of 2004, pub. l. no. 108-357, § 881(e), 118 stat. 1418, 1625 (2004). 162 see, e.g., national taxpayer advocate, 2013 annual rep. to congress 97-99 (2013). 163 for example, the irs’s administration of energy-related tax expenditures has not been especially impressive and has imposed significant burdens on the irs. see forman & mann, supra note 112, at 775-79. 164 one manifestation of this was the so-called revenue rule followed, in law or in fact, in most countries. see, e.g., pasquantino v. united states, 544 u.s. 349, 360-68 (2005). 165 some of these efforts are described by koskinen, supra note 44, at 5-7. 166 for an ambitious move in this direction, see henry ordower, utopian visions toward a grand unified global income tax, 14 fla. tax rev. 361 (2013). 167 for a description of the beps project and barriers to its success, see ali qassim, analysts: beps project won’t work without u.s., 34 tax mgmt. wkly. rep. 1042 (aug. 17, 2015); see also mindy herzfeld, a quick overview of the beps project, tax notes, june 2, 2014, at 987. 2016] the future of american tax administration 29 a survey of 2500 businesses in 38 countries, only 23% of respondents thought that beps will be successfully implemented.168 others are more optimistic.169 international legal harmonization, even if it ultimately gains momentum, will take too long and will be too piecemeal to provide immediate help with the current crisis. however, in the long term, it will be interesting to see whether converging international tax administration interests trump or yield to diverging national economic and political interests. e. revamping tax lawmaking congress in writing code sections and treasury in writing regulations sometimes cling to habits that, over time, compromise efficient tax administration. numerous examples could be adduced. here are some possible changes to achieve attitudinal or structural correction of the processes of writing tax rules. 1. choosing feasibility over theoretical perfection often, the rule maker—whether it be congress writing a tax statute or treasury writing a tax regulation—must choose between two competing conceptions of the enterprise. one approach is to create so detailed and nuanced a rule that, if it is accurately understood by taxpayers and the irs, will fully and precisely capture the balancing of interests chosen by the decision maker. the second approach is to write a simpler rule that is a bit less nuanced and precise but is more readily understandable by taxpayers, their advisers, and the irs. congress and the treasury sometimes choose the former approach and other times choose the latter.170 in my view, congress and the treasury too often choose the former. the assumption behind this choice seems to be that the way something is written inside the washington beltway is the way it is applied by taxpayers, their representatives, and irs field agents outside the beltway. this assumption is a flight from reality. in many instances, the complexity of the rule as written defies the comprehension and the ability to implement of mere mortals. when that happens, taxpayers make the best guess they can. this best guess may not accord with the best guess of irs agents, leading to unnecessary and wasteful administrative appeals and litigation. consider three examples, all drawn from subchapter k, governing income taxation of partnerships and their partners. first, when a person renders services to a partnership and receives a profits-only interest in the partnership as compensation, does that person have an immediate inclusion into income? this issue has generated confusion—inside the government as well as outside it—for decades. in one case, the irs asserted additional tax in such a case on a particular theory and won in the tax court. defending against the ensuing appeal, the department of justice conceded that the theory that had prevailed in the tax court was erroneous but defended the result on a different theory. the circuit court rejected that new theory and held for the taxpayer.171 168 see qassim, supra note 167 (reporting on a survey by grant thornton); see also jeremy scott, beps project faces rough future in congress, tax notes, june 9, 2014, at 1063; lee a. sheppard, the beps hybrid draft and the euro, tax notes, june 9, 2014, at 1085. 169 see qassim, supra note 167 (beps “is a thoughtful and impressive response” to “overcoming divergence of tax systems” and “shows international tax cooperation at its best.”) (quoting british tax consultant stephen fiamma). 170 as examples of the latter approach (less precise but more understandable), see i.r.c. §§ 63(c), 102(c), and 152(e), all discussed by johnson, supra note 127, at 584-88. 171 campbell v. comm’r, 59 t.c.m. 236 (1990), rev’d, 943 f.2d 815, 818 (8th cir. 1991). 30 columbia journal of tax law [vol.7:5 second, when a partner engages in transactions with her partnership, the tax treatment depends on which characterization under code section 707 applies. in one case, the irs prevailed in the tax court on the basis of the particular categorization it argued for.172 however, in a later revenue ruling involving similar facts, the irs held that that categorization—the one the irs had persuaded the tax court to accept—is wrong.173 third, when liquidating payments are made to a retired partner or the estate of a deceased partner, the tax treatment depends on the characterization under section 736. according to the tax court, to dispel “any lingering doubt [about] the distressingly complex and confusing nature of . . . subchapter k . . . one has only to reread section 736 in its entirety.”174 congress and the treasury would materially ease the irs’s burdens in administering the tax laws by more frequently giving up a mote of nuance, of theoretical perfection in the statute or regulation in favor of a rule that taxpayers and irs agents can more readily understand and apply.175 “[t]he most ingenious tax policy proposal really isn’t worth very much if it cannot be successfully administered by the irs.”176 2. improving the legislative process our traditional conception is that “[t]axation is a legislative function, and [at the federal level] congress . . . is the sole organ for levying taxes.”177 not surprisingly, there is no end of criticism of how congress has performed this function.178 the literature is not wanting for suggestions for how congress can improve this performance. by way of example and not necessarily of endorsement, professors forman and mann propose (1) creating a permanent loophole-closing commission and (2) requiring congress to provide greater detail in tax statutes, instead of delegating the task to the treasury for regulation-writing.179 these and other proposals are not uncontroversial. for example, professors hines and logue propose that congress delegate more, not less, of the tax lawmaking power to treasury.180 f. changing incentives ends can be achieved by commands supported by coercive power. or they can be achieved through attitudinal changes, by aligning incentives and perceptions so that selfinterest and the public interest walk together. below are some proposals of the latter type that might be useful in easing the current crisis. 1. attitudes of taxpayers numerous aspects of current american tax administration make life harder on taxpayers than is warranted by the resulting benefit to the government. among the bolder 172 pratt v. comm’r, 64 t.c. 203 (1975), aff’d in part & rev’d in part, 550 f.2d 1023 (5th cir. 1977). 173 rev. rul. 81-300, 1981-2 c.b. 143, 144. 174 foxman v. comm’r, 41 t.c. 535, 551 n. 9 (1964), aff’d, 352 f.2d 466 (3d cir. 1965). 175 see johnson, supra note 127, at 582-88; see also forman & mann, supra note 112, at 803-04 (urging the treasury to issue simplifying regulations). 176 george k. yin, the most critical issue facing tax administration today—and what to do about it 1 (june 27, 2014), http://ssrn.com/abstract=2459592 [https://perma.cc/ap53-aw69]. 177 nat’l cable television ass’n v. united states, 415 u.s. 336, 340 (1974); see u.s. const. art. i, § 8, cl. 1. 178 see, e.g., michael doran, tax legislation in the contemporary u.s. congress, 67 tax l. rev. 555 (2014). 179 forman & mann, supra note 112, at 789-92. 180 james r. hines, jr. & kyle d. logue, delegating tax, 114 mich. l. rev. 235 (2015). 2016] the future of american tax administration 31 possible changes is “presumptive taxation.” under this approach, a taxpayer’s liability would be computed not on actual income but on various “easily verifiable external factors” that would serve as proxies for income.181 for instance, “a tax on some percentage of a business’s gross receipts or its asset values rather than a precise measure of income might be considered a rough proxy for a business income tax.”182 the approach could be employed as the legally conclusive measurement, or the result of its use could establish a rebuttable presumption, allowing taxpayers to prove actual taxable income to overcome the proxy-based presumption.183 if used only presumptively, the expectation is that many taxpayers would simply go along with the proxy result, as a way to avoid the expense and annoyance of maintaining records and preparing returns.184 another approach would be moving to a “return free” system. under it, at least some taxpayers—such as those whose income is captured fully by withholding on wages reported on form w-2—could have their liabilities computed by the irs from the reported sources.185 the effort of that calculation by the irs likely would be offset by savings in avoiding the need to process the now unnecessary returns. penalty reform also could be guided by putative effects on policy. some have argued that current penalties are badly designed both in amount and in application, with the result that they do not encourage, and may even undercut, taxpayer compliance.186 in addition, the reasonable cause defense to tax penalties187 may encourage taxpayers to take aggressive tax return positions, relying on dubious advice from lawyers or accountants to deflect possible penalties. the defense may need to be adjusted to curb this possibility.188 2. attitudes of third parties knowledgeable third parties can be important allies for the irs. this already is reflected in the tax “whistleblower” initiative,189 which, after a slow start, appears to be growing.190 in a somewhat parallel vein, commentators have proposed authorizing qui tam suits in tax matters,191 creating a climate in which tax advisers will discourage taxpayers from participating in tax shelters,192 and applying pressure against aggressive tax planning 181 kathleen delaney thomas, presumptive collection: a prospect theory approach to increasing small business tax compliance, 67 tax l. rev. 111, 114 (2013). 182 kyle d. logue & gustavo g. vettori, narrowing the tax gap through presumptive taxation, 2 colum. j. tax l. 100, 105 (2011). 183 victor thuronyi, presumptive taxation, in 1 tax law design and drafting (1996). 184 just as some taxpayers under the present income tax select the standard deduction even though itemizing might yield somewhat higher deductions. 185 see, e.g., forman & mann, supra note 112, at 804-06. 186 see, e.g., national taxpayer advocate, 2 2008 annual rep. to congress 2 (2008). 187 see, e.g., i.r.c. § 6664(c). see generally leandra lederman, stephen mazza & steve johnson, surcharges and penalties in tax law: united states (2015), http://ssrn.com/abstract=2635133 [https://perma .cc/24ll-efzp]. 188 see, e.g., steve r. johnson, a modest proposal to improve tax compliance: curbing penalty protection opinions (2008), http://ssrn.com/abstract=1285282 [https://perma.cc/7nu7-vwte]. 189 i.r.c. § 7623; see, e.g., matthew r. stock, note, tax whistleblower statute: obtaining meaningful appeals through the appropriate scope of review, 42 fla. st. u. l. rev. 819 (2015). 190 total awards paid under the program grew from about $344 million and $310 million in fiscal years 2013 and 2014, respectively, to over $501 million in fiscal year 2015. irs whistleblower office, fiscal year 2015 report to congress (2016). 191 see, e.g., joshua d. rosenberg, the psychology of taxes: why they drive us crazy, and how we can make them sane, 16 va. tax rev. 155, 209-18 (1996). 192 see, e.g., richard lavoie, deputizing the gunslingers: co-opting the tax bar into dissuading corporate tax shelters, 21 va. tax rev. 43 (2001). 32 columbia journal of tax law [vol.7:5 and reporting by removing privacy protections from some corporate tax return information.193 similarly, the irs’s attempt to bring unregulated tax return preparers “in from the cold” first by an invalidated mandatory regulation194 and now by a voluntary (incentivized) program195 attempts to adjust the knowledge and the motivation of such preparers to prepare and file accurate returns. 3. attitudes of irs it is hard to change institutional culture. however, as a small silver lining in a large dark cloud, the substantial personnel turnover the irs has been experiencing196 may facilitate this change. “responsive tax administration” focuses on “regulatory tools and approaches designed to move beyond a one-size-fits-all framework [hopefully to] gain voluntary compliance by regulated parties.”197 a large literature on it already exists.198 especially in the current environment, the big objection, of course, is that limited resources are incompatible with tailored, contextualized treatment of taxpayers. some scholars have addressed this concern, offering approaches to allow better targeting without the cost of case-by-case discretionary enforcement.199 g. greater use of technology technology, of course, is already central to tax administration. two of the pillars of the current income tax are withholding200 and third-party information reporting.201 “technological improvements have made [these] more efficient, which has allowed these mechanisms to become more pervasively used.”202 technology links to other possible avenues, described above, of response to the current crisis. for example, the beps project203 “should consider automating the exchange of country-by-country reporting data to avoid overburdening tax administrators with the task of evaluating thousands of individual requests per year.”204 193 joshua d. blank, reconsidering corporate tax privacy, 11 n.y.u. j.l. & bus. 31 (2014). 194 loving v. irs, 742 f.3d 1013 (d.c. cir. 2014), aff’g 917 f. supp. 2d 67 (d.d.c. 2013); see e.g., steve r. johnson, loving and legitimacy: irs regulation of tax return preparation, 59 vill. l. rev. 515 (2014). 195 annual filing season program, fs-2014-8, ir-2014-75 (june 2014). 196 see text accompanying notes 68 to 70 supra. 197 leigh osofsky, some realism about responsive tax administration, 66 tax l. rev. 301 (2012). 198 id. at 301-02. 199 see, e.g., leandra lederman & ted sichelman, enforcement as substance in tax compliance, 70 wash. & lee l. rev. 1679 (2013) (advocating probabilistic enforcement); alex raskolnikov, revealing choices: using taxpayer choice to target tax enforcement, 109 colum. l. rev. 689 (2009) (urging differentiating taxpayers based on their taxpaying motivation and urging creation of two different enforcement regimes, inducing taxpayers to choose between them). 200 see ajay k. mehrotra, “from contested concept to cornerstone of administrative practice”: social learning and the early history of u.s. tax withholding, 7 colum. j. tax l. 144 (2016). 201 compliance rates correlate closely with how robust information reporting is. see irs, tax gap for tax year 2006, overview (2012), https://www.irs.gov/pub/newsroom/overview_tax_gap_2006.pdf [https://perma.cc/s3tw-zq8h]. most proposals for better tax compliance urge expansion of such reporting. see, e.g., forman & mann, supra note 112, at 792-94. 202 jeffery h. kahn & gregg d. polsky, the end of cash, the income tax, and the next 100 years, 41 fla. st. u. l. rev. 159, 159 (2013). 203 see text accompanying notes 167 to 169 supra. 204 john koskinen, quoted by william hoffman, koskinen urges oecd to consider tax administrations in beps, tax notes, june 9, 2014, at 1096. 2016] the future of american tax administration 33 the irs believes that technological innovation is central to the future of tax administration.205 in particular, it is looking to “big data” analytics to improve irs services in a range of areas,206 and even more innovative applications may become possible.207 but a snake or two may lurk even in a new technology-driven garden of eden. first, of course, the heavier the reliance on technology, the greater the harms if that technology is compromised. achieving and maintaining a first-class maintenance and security apparatus will be essential. second, technology must be kept the servant and not allowed to become the master. the goal must be to use the capabilities to allow the irs to better adapt to taxpayers—in all their variety—not to demand that taxpayers take on uniform shape most congenial to systems design and parameters. the poor and powerless too often are not present in, and are ignored by, conversations about tax reform.208 the irs has assured us of its intention to, “[t]hrough the use of sophisticated analytics, . . . uncover insights that will allow us to better serve underserved populations.”209 however, the irs also says that “[t]axpayer expectations and behaviors indicate a preference towards online self-service.”210 no doubt many taxpayers have such a preference. but not all do. for various reasons, some do not want, or want but cannot obtain, modern computing capability, and some will actually want to talk with a real, live person. hopefully, the irs will not use the preferences of some to relegate others to tax service oblivion.211 iv. realities and new realities part iii sketched general directions and some specific proposals that might, if properly designed, ease the crisis created by the perfect storm intersection of flat or declining irs budgets, growing irs revenue-related workloads, and foisting upon the irs major responsibilities not essentially connected to the irs’s revenue-collection function. in the context of particular possibilities, part iii noted relevant political considerations. we now turn to political realities on a more general plane, considering them from three perspectives: (1) acknowledging the reality of perverse political incentives, (2) noting 205 see, e.g., douglas shulman (former commissioner of internal revenue), shulman addresses major trends affecting tax administrations, tax notes, may 19, 2014, at 835. 206 new irs strategic plan emphasizes better it, “big data” to improve taxpayer services, 33 tax mgmt. wkly. rep. 887 (july 7, 2014) [hereinafter big data]. 207 see, e.g., kahn & polsky, supra note 202, at 171 (“on the one hand, the increasing prevalence of electronic payment systems should bolster the income tax by substantially reducing the tax gap and mitigating the distortions caused by the cash economy. on the other hand, technological innovation and the corresponding evolution of attitudes towards privacy could make a progressive retail sales tax quite feasible, which might spell the end of the income tax.”). 208 see, e.g., cohen, supra note 1, at 119-20 (“we don’t even know average taxpayers. we are only dealing with the upper three or four percentage of taxpayers. yet we all seem to assume that what we see is the universe.”). 209 see big data, supra note 206, at 887. other goals are to “improve our demand planning capabilities, identify potential fraud schemes and more quickly detect noncompliance.” id. (quoting irs 2014-2017 strategic plan). 210 see id.; see also irs electronic tax administration advisory comm., annual rep. to congress 2 (june 2015) (“the nature of this demand [by taxpayers for irs services] is also changing, as taxpayers increasingly prefer digital self-service to phone and paper methods.”). 211 lest a future version of william jennings bryan be forced to deliver a jeremiad: “you shall not press down upon the brow of labor this web of wireless thorns. you shall not crucify humankind upon a cross of cyber conformity.” (i apologize to the memory of the great commoner and to all who hold dear his july 9, 1896 “cross of gold” speech). 34 columbia journal of tax law [vol.7:5 that, given the impermanence of everything political, today’s reality may be tomorrow’s memory, and (3) in light of the above, suggesting an appropriate role for those interested in the solvency of tax administration in the united states now and in the future. a. realities everywhere and always, public policy is driven in part by the public interest and in part by personal interest (what is sometimes called “public choice”).212 it is of course true that ideas with much public interest merit fail because of public choice perversities.213 examples abound. congress often “strings out” desirable changes rather than implementing a whole agenda at one time because doing so is a way to raise pac contributions over many years, not just one. part of congress’ recent hostility to the irs may well be based on principle,214 but the unscrupulous have incentive to keep the issue alive rather than solve it. inadequate irs technology and training budgets guarantee future irs “screw-ups,” and each such event is the chance for media exposure, new fund-raising letters, and guaranteed applause lines in stump speeches. nearly everyone speaks urgently of the need to simplify our tax laws.215 but “[t]ax simplification has no constituency.”216 when a lawyer or politician is put to the choice of supporting (1) a simple tax rule that does nothing for, or even hurts, a client or important constituent or (2) a complicated rule that is very much in the client’s or constituent’s pocketbook interest, the “smart money” knows where to place its bet.217 and, of course, self-interest does not stop at the water’s edge. beps faces and future international tax harmonization initiatives will face great pressure from parochial, national interests.218 b. “realities” only an incorrigible optimist would ignore the preceding barriers to the making and maintaining of good tax policy. but only an incorrigible defeatist—and one with little knowledge of tax history—would assume that obstacles are forever. political forces are always in motion, so political realities are always temporary. even enduring tendencies can be swamped, if only for a brief window of opportunity, but the march of events. consider some examples: • the “bracket creep” phenomenon (tax bills rising because of the effects of inflation) offered real benefits to politicians: (1) rising revenues not requiring voting for tax increases and (2) the chance to be a hero to the voters by periodically voting for tax cuts only partly offsetting bracket 212 a classic study of this interaction as to the historic tax reform act of 1986 is daniel shaviro, beyond public choice and public interest: a study of the legislative process as illustrated by tax legislation in the 1980s, 139 u. pa. l. rev. 1 (1990). see also julie a. roin, united they stand, divided they fall: public choice theory and the tax code, 74 cornell l. rev. 62 (1988). 213 see, e.g., cohen, supra note 1, at 123 n.10 (noting the demise of one tax legislative process reform which “like all really good ideas was left fallow”). 214 see subpart iii.b. supra. 215 but see, e.g., samuel a. donaldson, the easy case against tax simplification, 22 va. tax rev. 645 (2003). 216 cohen, supra note 1, at 118. 217 see id. at 115-16. 218 see text accompanying notes 167 to 169 supra. 2016] the future of american tax administration 35 creep. and yet bracket creep was banished from the code a generation ago and has not returned.219 • politicians benefit (in the form of campaign contributions) from annually renewing annually popular tax breaks. yet congress recently voted to make some renewals permanent.220 • the value-added tax was once considered political poison. yet many presidential candidates—republican presidential candidates—now are proposing them.221 c. what to do many a fair flower of reform has been crushed under the hard heels of selfish interest and callous indifference. but there is personal satisfaction in fighting the good fight, even if it is against long odds.222 and the good does sometimes triumph despite the odds. if major reform is unlikely, piecemeal gains can be won.223 those who are friends of good tax administration might find the following course realistic without being fatalistic: (1) continue to advocate for good ideas, creating an intellectual record that can justify change at the opportune moment; (2) when the winds of public choice opposition blow hard, husband energy and avoid discouragement; (3) when the gale subsides or when political circumstances direct the wind in favorable direction, seize the moment to push hard for the changes already justified intellectually; and (4) compromise but not to the point of sacrificing core principles of taxation. what are those principles? many sets have been offered. professor, later judge, sneed’s seven principles of taxation are always worth remembering. 224 other commentators have offered different or more particularized lists.225 so have political leaders of both parties.226 the irs has established a ten-part taxpayer bill of rights.227 regardless of the stresses of the moment, even those as acute as the current “perfect storm,” tax discourse and action should always trench firmly in solid principles. to endure, to flourish over the long term, so pervasive and crucial a function as financing the government must rest on principles, not expediency. despite the crisis, we should eschew anything momentarily seductive that would imperil the enduringly sound. 219 see i.r.c. §§ 1(f), 63(c)(4). 220 h.r. 2029, protecting americans from tax hikes act, 114th cong. (1st sess. dec. 2015). 221 see paul caron, value-added tax catches on in republican presidential race, wall st. j. (nov. 12, 2015), http://www.wsj.com/articles/value-added-tax-catches-on-in-republican-presidential-race1447374891 [https://perma.cc/sd69-6rss]. 222 “the idea of tax nirvana seems always to elude us. but like don quixote, the quest is the thing.” cohen, supra note 1, at 122. 223 see id. at 123 (for this reason, seeing himself as “a raging incrementalist” in tax policy). 224 (1) adequate revenue, (2) administrability, (3) horizontal fairness, (4) economic stability, (5) distributional fairness, (6) market-oriented economy, and (7) political order. joseph t. sneed, the criteria of federal income tax policy, 17 stan. l. rev. 567, 568 (1965). 225 see, e.g., johnson, supra note 112, at 244-46 (criteria as to tax procedural reform). 226 see, e.g., president’s framework for business tax reform 1 (feb. 2012) (five elements of business tax reform); kevin brady, chair, house ways and means comm., keynote address, tax council policy institute symposium 3-4 (feb. 12, 2016) (on file with author). 227 irs pub. 1, your rights as a taxpayer (rev. dec. 2014). microsoft word 6 nussim.docx 218 to confuse and protect: taxes and consumer protection jacob �ussim* imperfect information may cause rationally bounded individuals to make consistent mistakes. this paper focuses on potential misperception of prices. consumers may underestimate the full price of tax-exclusive prices and hence overconsume goods and services. countries with a significant consumption tax base (for example, a valueadded tax) regulate tax-inclusive price presentation to overcome consumers’ biases and thus to protect consumers. the united states is considering the adoption of a federal consumption tax base and therefore may be similarly expected to regulate tax-inclusive price presentation. based on a theory of optimal taxation, this paper explains why tax-exclusive rather than tax-inclusive prices can be socially desirable. to the extent that taxexclusive pricing confuses consumers who then ignore nonindicated taxes and overconsume, consumers may be better off. the argument is counterintuitive, in particular for consumer-protection advocates: confusion is actually good for consumers. the paper investigates several potential justifications for tax-inclusive pricing, and shows that a reasonably accepted rationale is rather limited in scope and unrelated to consumer-protection motivations. finally, the paper extends the analysis to income-based taxes and to misleading non-tax (marketing) practices. introduction .......................................................................................... 219 i. price indication regulation and tax-inclusive pricing .................................................................................. 223 a. price indication regulation .............................................. 223 * assistant professor, bar-ilan university, israel. comments are welcome: jnussim@mail.biu.ac.il. the article benefited from discussion and comments by ben alarie, lily batchelder, massimo d’antoni, yuval feldman, ed iacobucci, frank pedersen, and eric zolt, and from participants in the tax law and policy workshops at the university of toronto and at the hebrew university, as well as the law and economics workshop at tel aviv university. i am grateful to nyu’s hauser global law program for its support. 2010] tax-exclusive prici�g 219 b. justifying tax-inclusive regulation ................................ 226 ii. taxation and efficiency .................................................. 234 iii. implications for price indication regulation ............ 237 iv. justifying tax-inclusive price systems ....................... 242 a. facilitating market competition ...................................... 243 b. psychological heterogeneity and redistribution ............. 244 c. complexity costs ............................................................. 247 d. regulatory taxation ......................................................... 249 v. extensions ........................................................................... 253 a. income-based taxes ......................................................... 253 b. demand-increasing market strategies ............................. 255 conclusion ............................................................................................. 258 introduction imperfect information causes individuals to make mistakes. due to imperfect rationality, individuals’ mistakes may become consistent—i.e., biased—and hence decrease their welfare further.1 the literature on consumer behavior offers many examples of consumers’ mistakes that are considered systematic misperceptions.2 sellers may utilize recognized consumer biases to their own advantage and further hurt consumer welfare. accordingly, legal intervention may be warranted, ranging from information regulation through standard regulation to price and quality 1. this paper adopts a welfarist approach under which the atomic unit of analysis is individual welfare or well-being. see generally louis kaplow, the theory of taxation and public economics 348–58 (2008) (describing the welfarist methodology) [hereinafter kaplow, theory of taxation]; louis kaplow & steven shavell, fairness versus welfare 15–38, 381–464 (2002) (same). 2. this literature is extensive. a few examples are oren bar-gill, seduction by plastic, 98 nw. u. l. rev. 1373 (2003) (discussing consumers’ biases in the credit card market); alon harel & ehud guttel, matching probabilities: the behavioral law and economics of repeated behavior, 72 u. chi. l. rev. 1197 (2005) (investigating legal applications of the probability-matching bias); john d. hanson & douglas d. kysar, taking behavioralism seriously: the problem of market manipulation, 74 n.y.u. l. rev. 630 (1999) (reviewing causes for consumers’ misperception and potential abuses of such biases by market participants); cass r. sunstein, boundedly rational borrowing, 73 u. chi. l. rev. 249 (2006) (discussing biases that lead to excessive borrowing, and their potential legal responses); yuval feldman & doron teichman, are all “legal dollars” created equal?, 102 nw. u. l. rev. 223 (2008) (showing experimentally how various characteristics of legal payments affect perception of value); russell b. korobkin, the endowment effect and legal analysis, 97 nw. u. l. rev. 1227 (2002) (investigating the application of the endowment effect in legal contexts); timur kuran & cass r. sunstein, availability cascades and risk regulation, 51 stan. l. rev. 683 (1998) (discussing the possibility of distorted perception due to the process of collective belief formation). 220 columbia jour�al of tax law [vol. 1:218 controls.3 taxes may also introduce problems of partial information and bounded rationality. in the political market, voters (i.e., political consumers) may lack the relevant and accurate information about their tax burden (and received public benefits) and hence make mistakes in their choice of political representatives (i.e., political sellers). if, in addition, voters lack full rationality, they may make consistent mistakes in assessing their tax burdens and accordingly in voting for the preferred political candidate. the “fiscal illusion” hypothesis contends that voters systematically underestimate tax burdens (and overestimate public benefits).4 similar to the product market, politicians can exploit voters’ ignorance and impose higher taxes (or provide fewer public goods), to their own benefit and to the detriment of individuals. yet, the empirical validity of the fiscal illusion hypothesis is still doubtful.5 but imperfect tax information may also benefit—and hence may be utilized by—market participants rather than political representatives. partial information about consumption taxes (for example, sales taxes, value-added taxes) and consumers’ bounded rationality can increase suppliers’ profits at the expense of consumers. consumers may consistently underestimate the price of goods and services when information about consumption taxes is imperfect. specifically, when prices of goods and services are stated tax-exclusive—that is, prices exclude sales tax—consumers may perceive prices to be lower than they actually are, and thus increase their demand for such goods and services. this potential phenomenon is somewhat similar to the effect of price partitioning, under which prices of good and services are partitioned into several components like subscription, shipping and handling, and processing fees.6 sellers increasingly use price partition strategies in the market with the purpose of increasing consumer demand, and hence market prices and sellers profits—again, at the expense of consumers’ welfare.7 sellers’ ability to additionally partition consumption taxes probably 3. again, the literature is ample. see, e.g., jeffrey j. rachlinski, the uncertain psychological case for paternalism, 97 nw. u. l. rev. 1165, 1177–1206 (2003) (supplying a partial list of articles on the topic). 4. see, e.g., james buchanan, public finance in democratic process 126–43 (1967) (suggesting the fiscal illusion hypothesis and discussing its applications). 5. see infra note 59. see also infra notes 166–70 and accompanying text. 6. see infra notes 69–77 and accompanying text. see also vicki g. morwitz et al., the price does �ot include additional taxes, fees, and surcharges: a review of research on partitioned pricing (working paper 2009), available at http://ssrn.com/abstract=1350004 (last visited may 14, 2010) (reviewing the price partitioning literature) [hereinafter morwitz, price does �ot include]. 7. see, e.g., morwitz, price does �ot include, supra note 6, at 4–10. 2010] tax-exclusive prici�g 221 generates a similar effect, and indeed businesses invariably oppose taxinclusive price regulation.8 european countries commonly adopt relatively high consumption tax (i.e., vat) rates and are therefore well aware of such consumer confusion or biases due to tax-exclusive price presentation. accordingly, most european countries regulate price presentation through their consumer protection laws, and in particular require tax-inclusive price presentation.9 other oecd countries like canada and australia are facing increasing political demand to adopt such regulatory measures.10 since the income (rather than consumption) tax base traditionally has dominated the us tax system, no similar concern has been introduced so far in this country. but expected changes in the american tax base mix may divert attention to price presentation issues. first, state sales taxes are rising (though they are still lower than european vat).11 second, and more importantly, in the last three decades, pressure has been building up in academia and government (in particular, the treasury) toward the adoption of a federal consumption tax base, whether as a replacement of or as a supplement to the federal income tax.12 proposals take the form of a national retail tax or national value-added tax.13 a federal consumption tax system would impose considerably higher tax rates and burdens than current state sales taxes,14 and most likely would introduce a similar public demand for european-style consumer protection regulation in the form of tax-inclusive prices. this article reevaluates the “consumer protection” hypothesis— that is, that regulation of tax-inclusive prices would increase social welfare since consumers underestimate tax-exclusive prices and hence tend to overconsume. it raises the opposite, counter-intuitive argument: to the extent that non-included taxes confuse consumers, who tend to under-estimate taxexclusive market prices (and hence over-consume), consumers may be better off. put more bluntly, consumer protection laws may better protect consumers by confusing or misleading them by allowing—or even dictating—tax-exclusive prices rather than prescribing clear and non 8. see infra note 36 and accompanying text. 9. see infra notes 18–21 and accompanying text; see also council directive 98/6, 1998 o.j. (l 080) (ec) [hereinafter directive 98/6]. 10. see, e.g., trade practices legislation amendment bill, no. 3 (2006) (aus.); trade practices amendment (clarity in pricing) (2008) (aus.); see also proposed canadian bill no. 101, involving a reform of tax-inclusive pricing, available at http://www.assembly.pe.ca/bills/pdf_first/63/2/bill-101.pdf (last visited may 14, 2010). 11. see infra notes 27–29 and accompanying text. 12. see infra notes 31–32 and accompanying text. 13. see infra notes 32–33 and accompanying text. 14. see infra note 34 and accompanying text. 222 columbia jour�al of tax law [vol. 1:218 confusing tax-inclusive prices. the argument is built on an efficiency analysis of taxation. deceiving consumers by making them perceive market prices of goods and services as if no taxes were imposed puts them in a situation similar to a notax world, but where, in fact, they do pay taxes. that is, by confusing consumers we can lure them to make choices as if no taxes existed, even though, ultimately, they actually pay taxes. the social advantage of this kind of partially informed choice is the elimination (or restriction) of the welfare-reducing substitution effect due to taxes (although it may generate other welfare reducing effects). being unaware of taxes saves individuals from the distortive effect of taxation, which diminishes each individual’s utility and thus reduces social welfare. to be considered socially desirable, tax-inclusion regulation may therefore rest on a different rationale. a few alternative rationales are suggested, of which only one seems to have a normative bite. only to the extent that commodity taxes are designed to achieve certain control of behavior (i.e., pigouvian-like taxes) can tax-inclusive regulation be justified. the justification, then, is more limited in scope than what might be initially believed, and, as this article argues, is unrelated to consumer protection. finally, this article extends the analysis of “consumer confusion” in two ways. first, this article discusses potentially similar effects under income taxes. for example, wages can be stated as inclusive or exclusive of wage taxes. the tax-inclusive (that is, gross of tax) options in this case may confuse workers and affect choices over work and leisure (and hence consumption). the second extension discusses potential market-based options that may improve social welfare, given the distortionary effect of taxes. in particular, demand-increasing marketing strategies may create social value in a second-best optimal tax world. this article is divided into six sections. section i presents the issue of price indication regulation, and in particular, its tax-inclusive pricing component. it then discusses the suggested rationale of the regulation. section ii introduces the basic efficiency analysis of taxation that serves as the basis for the main argument of this article, which is presented in section iii. section iii argues that the suggested justification for tax-inclusive pricing regulation is misconceived and may actually support tax-exclusive pricing. section iv considers other potential rationales for tax-inclusive pricing, and concludes generally that only pigouvian tax schemes can support such price regulation, which in turn suggests that the scope of tax-inclusive pricing is more limited. section v offers a few extensions to the analysis of sections ii and iii concerning income taxation and marketing strategies. section vi concludes. 2010] tax-exclusive prici�g 223 i. price indication regulation and tax-inclusive pricing a. price indication regulation the stated goal of consumer protection laws is to protect consumers against deceptive, unfair, or fraudulent practices in the marketplace.15 a familiar component of consumer protection regulation is “price indication” rules.16 these rules typically specify the cost items that should be included in advertised prices, such as, costs of necessary packaging or delivery costs.17 the function of price indication rules is to provide consumers with full, accurate, and clear information of the full sale prices of goods. the purpose, seemingly, is to diminish consumer confusion and improve consumer consumption choices.18 price indication regulation is prevalent in europe. in 1998, the e.c. promulgated a price indication directive that directed member states to adopt certain minimum price indication rules in their national consumer protection laws.19 a few european countries adopted price indication regulations in their consumer protection laws long before the e.c. directive was proposed, and other counties followed suit.20 similar regulation is found in consumer protection laws (as well other laws) of non-european countries, such as new zealand21 and israel.22 australia has been trying in recent years to amend its trade practices act of 1974 in a similar manner.23 this article focuses on the tax component of price indication 15. see, e.g., bureau of consumer protection, federal trade commission, available at http://www.ftc.gov/bcp/about.shtm (last visited may 14, 2010). 16. see generally brian w. harvey & deborah l. parry, the law of consumer protection and fair trading 372–383 (4th ed. 1992). 17. see, e.g., directive 98/6, supra note 9; code of practice for traders on price indications, 1988, s.i. 1988/2078, part 2, ¶ 2.2.4 (eng.) [hereinafter code of practice for traders]. 18. directive 98/6, supra note 9, ¶¶ 1, 6. 19. id. 20. see hans schulte-nolke & leonie meyer-schwickerath, price indication directive (98/6), in ec consumer law compendium 581, 584 (2007). in the u.k., for example, courts interpreted the trade description act 1968 to require the inclusion of vat and excise taxes in presented prices. see, e.g., richards v. westminster motors ltd., r.t.r. (1976) 88 (holding that the presentation of a minibus’s price, which excluded taxes, contravened existing law). this interpretation was later made explicit by the consumer protection act, 1987 (eng.) and the code of practice for trader on price indications, supra note 17. 21. see, e.g., alan a. tait, value-added tax: international practice and problems 357 (int’l mon. fund 1988). 22. see consumer protection law, 5741–1981, 35 lsi 298 (1980–81) (isr.). 23. see, e.g., trade practices legislation amendment bill, supra note 10 (aus.); trade practices amendment, supra note 10 (aus.). 224 columbia jour�al of tax law [vol. 1:218 regulations. typically, price indication regulations require that all taxes— such as a sale tax or vat—be included in the presented price.24 this is the rule, for example, in european countries and in several other countries, such as israel and china.25 canada has been considering tax-inclusive price presentation for more than a decade.26 interestingly, in the u.s., no price indication regulation has been proposed and prices are tax-exclusive—that is, sales taxes are not included in presented prices. the difference in consumer protection reactions between europe and the u.s. is most likely due to substantial differences in consumption tax burdens.27 consumption tax rates are much higher in european countries; vat rates in europe range from 7.6% (switzerland) to 25% (denmark, norway, sweden) with an average vat rate of 19.5%,28 while the highest state sales tax rate in the u.s. only recently reached 8.25% (california).29 additionally, the state sales tax base in the us is narrower than the typical european vat base. indeed, the tax inclusion issue is expected to become much more important for american consumers in the future. first, sales taxes are generally rising.30 second, and more significantly, a federal consumption tax— whether in the form of national retail sales tax or national vat—is being seriously considered in the u.s. an academic preference for consumption 24. directive 98/6, supra note 9, art. 2. 25. for israel, see consumer protection law, supra note 22, §§ 17a, 17b. 26. in canada, prices are tax-exclusive. since 1997, a harmonized sales tax (hst) has been adopted in three canadian provinces (nova scotia, new brunswick, newfoundland and labrador) as well as quebec. see http://www.cra-arc.gc.ca/tx/bsnss/tpcs/gsttps/gnrl/hw-eng.html (last visited may 14, 2010). under the hst, prices are supposed to include taxes. however, this part of the hst has not yet come into effect. in late 2008, canadian bill no. 101, supra note 10, was presented for consideration in prince edward island; the bill proposes a reform of tax-inclusive pricing. 27. for example, it can be argued that the difference is in the political reaction to the “fiscal illusion” effect. under the “fiscal illusion” hypothesis, individual voters may be unaware of the true tax burden if prices are presented inclusive of consumption taxes. a lower tax rate (in the u.s.) may be more susceptible to the fiscal illusion effect then the european higher vat rate. see, e.g., wallace e. oates, on the �ature and measurement of fiscal illusion: a survey, in taxation and fiscal federalism: essays in honour of russell matthews 65, 67–68 (geoffrey brennan ed., australian university press 1988). see also infra notes 58–60 and accompanying text. 28. see centre for tax policy and administration, oecd tax database, table iv.1, http://www.oecd.org/document/60/0,3343,en_2649_34533_1942460_1_1_1_1,00.html (follow “table iv.1” hyperlink) (last visited may 14, 2010). rates are presented for 2007. see also council directive 2006/112, arts. 96, 97, 2006 o.j. (l 347) 1, 40 (ec) [hereinafter council directive 2006/112] (demonstrating the common system of value-added tax). 29. see the tax foundation, state sales, gasoline, cigarette, and alcohol tax rates by state, 2000–2009, http://www.taxfoundation.org/taxdata/show/245.html (last visited may 14, 2010) [hereinafter state sales]. rates are presented for 2009. 30. id. 2010] tax-exclusive prici�g 225 tax base has been building for more than three decades.31 government agencies have been attentive and devised several plans for the introduction of consumption taxes into the u.s. tax system.32 these proposals have been debated and scrutinized for quite some time now.33 replacing the federal income tax system with a national retail sales tax would require a consumption tax rate in the range of 30%.34 31. the literature is voluminous. see, e.g., nicholas kaldor, an expenditure tax (george allen & unwin ltd. 1955) (1958); alan j. auerbach & lawrence j. kotlikoff, dynamic fiscal policy 55–87 (cambridge univ. press 1987); david bradford, the case for a personal consumption tax, in what should be taxed: income or expenditure? a report of a conference sponsored by the fund for public policy research and the brookings institution 75, 75–110 (joseph a. pechman ed., 1980); william andrews, a consumption-type or cash flow personal income tax, 87 harv. l. rev. 1113 (1974); michael graetz, implementing a progressive consumption tax, 92 harv. l. rev 1575 (1979); alvin warren, would a consumption tax be fairer than an income tax?, 89 yale l. j. 1081 (1980); robert e. hall & alvin rabushka, the flat tax (hoover inst. press 2d ed. 1995); joseph bankman & thomas griffith, is the debate between an income tax and a consumption tax a debate about risk? does it matter?, 47 tax l. rev. 377 (1992); barbara h. fried, fairness and the consumption tax, 44 stan. l. rev. 961 (1992); john k. mcnulty, flat tax, consumption tax, consumption-type proposals in the united states: a tax policy discussion of fundamental tax reform, 88 cal. l. rev. 2095, 2117–2125 (2000); david bradford, a tax system for the twenty-first century, in toward fundamental tax reform 1 (alan j. auerbach & kevin a. hassett eds., aei press 2005); michael j. graetz, 100 million unnecessary returns: a fresh start for the u.s. tax system, 112 yale l .j. 261 (2002); edward j. mccaffery, a �ew understanding of tax, 103 mich l. rev. 807 (2005); joseph bankman & david a. weisbach, the superiority of an ideal consumption tax over an ideal income tax, 58 stan l. rev 1413 (2006); daniel shaviro, beyond the pro-consumption tax consensus, 60 stan l. rev 745 (2007). 32. see, e.g., david f. bradford & the u.s. treasury tax policy staff, blueprints for basic tax reform (tax analysts 2d ed. 1984); gregg a. esenwein & jane g. gravelle, the flat tax, value-added tax, and national retail sales tax: overview of the issues (cong. res. rep., libr. of cong. 2004) (discussing the consumption tax base option for the u.s.); jane g. gravelle, the advisory panel’s tax reform proposals (cong. res. rep., libr. of cong. 2006) (same); see also a list of legislative proposals in james m. bickley, a value-added tax contrasted with a national sales tax 4–6 (cong. res. rep., libr. of cong. 2004). 33. see, e.g., john l. mikesell, the american retail sales tax: considerations on their structure, operations, and potential as a foundation for a federal sales tax, 50 nat’l tax journal 149 (1997) (discussing the consumption tax base option for the u.s.); john buckley & diane lim rogers, is a �ational retail sales tax in our future? 104 tax notes 1277 (sept. 13, 2004) (same). 34. see, e.g., william g. gale, the required tax rate in a �ational retail sales tax, 52 nat’l tax j. 443, 455–56 (1999) (arguing that required tax-inclusive rate would be over 50% and the required tax-exclusive rate would be over 100%); william g. gale, the �ational retail sales tax: what would the rate have to be?, 107 tax notes 889, 896, 898–99 (may 16, 2005) (estimating consumption tax rates much higher than 30%); charles mclure, testimony before the president’s advisory panel on tax reform (2005), available at http://govinfo.library.unt.edu/taxreformpanel/meetings/meeting-05_11-12_2005.html (last visited may 14, 2010). a choice of mixed income and consumption tax bases would permit 226 columbia jour�al of tax law [vol. 1:218 b. justifying tax-inclusive regulation there is no clear indication of the rationales for tax-inclusion regulation. the e.u. directive, for example, indicates that price indication is required in order to assure precise, transparent, and unambiguous information for consumers concerning prices.35 the rationale for price indication regulation seemingly falls squarely within the general purpose of consumer protection laws. if prices of goods and services are not presented clearly and do not include all necessary expenses incurred by consumers who purchase goods or services, consumers may be confused or misled. in particular, in the tax inclusion case, consumers may perceive the price to be lower than the actual cost, because they do not consider non-stated (or separately stated) taxes. that is, consumers may tend to purchase more than they would have if prices were clearly stated and all relevant taxes were included.36 as a result, consumers purchase goods and services even where the marginal benefit from such a purchase is lower than the marginal cost. this confusion diminishes consumer utility, which, in turn, diminishes social welfare. a preventive regulatory measure in the form of price indication supposedly eliminates this confusion and is thus welfareincreasing the necessary condition for price indication regulation is, thus, that consumers are confused in a particular manner—i.e., they under-value the real price. it is not entirely clear that consumers indeed under-value the prices of goods and services if prices are not stated clearly. this is an informational problem facing consumers. consumers may not possess the required complete information about purchase prices (and taxes), or may a lower consumption tax rate. 35. see, e.g., directive 98/6, supra note 9. 36. additional support for such anticipated consumer confusion can be derived from the consistent objections of retailers and producers to tax-inclusive pricing initiatives. (formally, retailers and producers argue that implementing tax-inclusive pricing is more costly.) see, e.g., john f. due & john l. mikesell, sales taxation: state and local structure and administration 30–31 (johns hopkins univ. press 2d ed. 1994); raj chetty et al., salience and taxation: theory and evidence, 99 am. econ. rev. 1145, 1150 (2009) (reporting that managers of a large california grocery chain expected tax-inclusive prices to reduce sales). consider also retailer opposition to canadian bill no. 101 (can.), supra note 10; see, e.g., submission by the retail council of canada to the prince edward island standing committee on community affairs and economic development: review of bill 101 (feb. 17, 2009), available at http://webcache.googleusercontent.com/search?q=cache%3a5pmfthpsw3wj%3awww.ret ailcouncil.org%2fadvocacy%2ffinancial%2fsubmissions%2fsubmission_pei_taxinpricing. pdf+submission%2c+by+the+retail+council+of+canada%2c+to+the+prince+edward+isl and+standing+committee+on+community+affairs+and+economic+development&hl=en &gl=us (last visited may 14, 2010). 2010] tax-exclusive prici�g 227 not adequately process the information they have gathered. gathering and processing information are costly undertakings in terms of effort, time, and money. for example, under a tax-exclusive price system, a consumer may not know the exact sales tax or value-added tax that applies to a good she intends to buy;37 or, even if she knows the applicable tax rate, she may not calculate the tax-inclusive price correctly or may be reluctant to make any calculations. the lack of price information confuses consumers; as a result, consumers may make mistakes. yet, it is not necessarily correct that consumers will always be mistaken in a specific manner—by under-valuing prices. the lack of complete and fully processed information about prices may lead to overestimation, or, on average, to accurate estimations, rather than undervaluation of prices. facing uncertainty about (tax-inclusive) prices, individuals are not necessarily expected to under-estimate real prices. in particular, risk-averse individuals are expected to over-value uncertain tax burdens or uncertain tax-inclusive prices.38 an additional explanatory component is required to make the under-valuation prediction (i.e., a biased mistake) theoretically valid. one must explain why consumers tend to under-value prices in the face of uncertain pricing. why are consumers unaware of their under-valuation mistakes and why do consumers not learn or de-bias themselves over time? in the tax context, it should be made clear why we should not expect consumers to be aware that, or to learn why, under a tax-exclusive price system, total prices are actually higher. it seems that the most promising theoretical venue for a “consumer under-valuation” hypothesis is cognitive biases and errors. a growing psychological and behavioral economics literature investigates human cognitive limitations and heuristics, and shows how they affect individual choices in the marketplace.39 various kinds of biases and heuristics are 37. at least in one field experiment, however, consumers demonstrated rather accurate knowledge of non-indicated sales taxes. see generally chetty et al., supra note 36. 38. indeed, it should be clear that tax-inclusion regulation cannot be about uncertainty—i.e., consumers being uncertain of exact taxes. had risk-averse consumers faced uncertain total prices, they would have purchased less rather than more, compared with a situation in which they had full information. sellers, then, would have had strong incentives to reduce uncertainty. no regulatory intervention would have been required. similarly, such regulation does not target a reduction in information costs—i.e., arguably, gathering, processing, and distributing information is cheaper for producers/retailers than for consumers due to economies of scale. where retailers/producers can save costs for consumers, they have a strong profit-maximizing incentive to do so, as it provides them with competitive advantage. again, regulation would not be required. 39. the psychological and behavioral economics literature is vast. see generally, e.g., advances in behavioral economics (colin camerer et al. eds., 2004). 228 columbia jour�al of tax law [vol. 1:218 revealed on the basis of experiments, many of which can be suggested as a source of consumer biases in evaluation of prices or demand for goods, given any amount of available information. these biases may theoretically explain why consumers do not rationally optimize their choices, and in particular, why consumers tend to under-value prices in certain situations regardless of available information. the following discussion presents a few examples of cognitive biases that might explain consumer underevaluation of tax-exclusive prices. the presentation or framing of prices and costs may affect individual decisions.40 excluded consumption taxes may be less visible, salient, available, or accessible,41 and thus are ignored, to a certain extent, in making choices.42 individuals may present limited attention to available information.43 also related is anchoring bias, which describes the tendency to anchor evaluation to a starting point and a subsequent failure to adjust appropriately, making the estimation biased towards the anchor.44 a tax-exclusive price may function as such an anchor, and consumers may fail to adjust to imposed taxes. mental accounting may posit a claim for mental separation between prices and additional taxes in consumption decision-making.45 partitioning a single 40. see, e.g., amos tversky & daniel kahneman, the framing of decisions and the rationality of choice, 211 science 453, 454–58 (1981); amos tversky & daniel kahneman, rational choice and the framing of decisions, 59 j. of business s251, s257– 71, s272–73 (1986) (challenging the rational account of human behavior). 41. see, e.g., daniel kahneman, maps of bounded rationality: psychology for behavioral economics, 93 am. econ. rev. 1449 (2003) (discussing the effects of saliency and accessibility on behavior). 42. see amy finkelstein, e-ztax: tax salience and tax rates (nat’l bureau of econ. research, working paper no. 12924, 2007); edward j. mccaffery & jonathan baron, thinking about tax, 12 psychol. pub. pol’y & l. 106, 108–127 (2006) (making the case for an isolation effect being a central cognitive bias) [hereinafter mccaffery & baron, thinking about tax]. but cf. george loewensteint & ted o’donoghuett, “we can do this the easy way or the hard way”: �egative emotions, self-regulation, and the law, 73 u. chi. l. rev. 183, 199 (2006) (arguing that non-salient taxes may be preferable since they save taxpayers the psychic costs of paying taxes). 43. see, e.g., stefano dellavigna, psychology and economics: evidence from the field, 47 j. econ. literature 315, 348–53 (2009). indeed, inattention may be considered rational—that is, as a rational response to the costly gathering and processing of information. chetty et al., supra note 36, at 1165–66; see also raj chetty, adam looney & kory kroft, salience and taxation: theory and evidence 28–35 (nat’l bureau of econ research, working paper no. 13330, 2007), available at http://www.law.yale.edu/documents/pdf/intellectual_life/07_leo_salience_and_taxation. pdf (last visited may 14, 2010). 44. see, e.g., amos tversky & daniel kahneman, judgment under uncertainty: heuristics and biases, 185 science 1124, 1128–30 (1974) (discussing the anchoring bias); gretchen b. chapman & eric j. johnson, incorporating the irrelevant: anchors in judgments of belief and value, in heuristics and biases 120, 120–23 (thomas gilovich et al. eds., 2002) (same). 45. see, e.g., amos tversky & daniel kahneman, choices, values, and frames, 39 2010] tax-exclusive prici�g 229 cost into multiple smaller amounts—such as dividing the tax-inclusive price into a tax-exclusive price plus tax—may drive individuals to under-value the actual cost.46 individuals also tend to be tenaciously optimistic,47 which can imply that consumers may be optimistic about the burden of unknown tax costs.48 more than thirty years into behavioral economic research, it seems that there is almost no irrational behavior that cannot be theoretically explained by certain recognized psychological phenomena. but, such cognitive limitations function differently in different situations, and short of empirical evidence, there is no guarantee that any of the suggested biases provides an explanation for consumer under-valuation of tax-exclusive prices. recent public economics research examined potential misperceptions and biases in the tax sphere.49 experiments reveal various biases concerning taxes. for example, taxpayers react to tax salience;50 am.psychol. 341, 346–48 (1984); richard thaler, mental accounting matters, 12 j. of behavioral decision making 183, 188–203 (1999) (explaining the mental accounting heuristic and presenting evidence of its effect). 46. see generally, e.g., edward j. mccaffery & jonathan baron, the humpty dumpty blues: disaggregation bias in the evaluation of tax systems, 91 org. behavior and human decision processes 230 (2003) (discussing instances of disaggregation bias in tax law) [hereinafter mccaffery & baron, humpty dumpty blues]; see also infra notes 69–77 and accompanying text. 47. see, e.g., david a. armor & shelley e. taylor, when predictions fail: the dilemma of unrealistic optimism, in heuristics and biases 334, 334–36 (thomas gilovich et al. eds., 2002) (reviewing and discussing the optimism bias). 48. yet because over-optimism generally stems from a propensity to use past experience to evaluate future events—see id. at 338—one might expect that consumers would learn quickly, over multiple market transactions, that consumption taxes are additionally imposed. 49. see, e.g., edward j. mccaffery, cognitive theory and tax, 41 ucla l. rev. 1861 (1994) (surveying a range of heuristics and biases in evaluating taxes) [hereinafter mccaffery, cognitive theory]; mccaffery & baron, thinking about tax, supra note 42 (same); edward j. mccaffery & jonathan baron, the political psychology of redistribution, 52 ucla l. rev. 1745 (2005) (same); edward j. mccaffery & joel slemrod, toward an agenda for behavioral public finance, in behavioral public finance 3 et seq. (edward mccaffery & joel slemrod eds., 2006) (same); aradhna krishna & joel slemrod, behavioral public finance: tax design as price presentation, 10 int’l tax and pub. fin. 189 (2003) (discussing various kinds of misperceptions resulting from presentation manipulation); leonard burman & mohammed adeel saleem, hidden taxes and subsidies, 100 tax notes 1437 (september 15, 2003) (discussing and presenting tax rules that translate into tax rates); jeffrey b. liebman & richard j. zeckhauser, schmeduling (2004) (unpublished manuscript) (on file with harvard university) (suggesting two biases— spotlighting and ironing—that affect reactions to taxes); brian galle, hidden taxes (2009) (unpublished manuscript) (on file with author) (surveying potential effects of non-salient taxes). 50. see generally rupert sausgruber & jean-robert tyran, tax salience, voting and 230 columbia jour�al of tax law [vol. 1:218 individuals perceive equivalent direct and indirect taxes differently;51 individuals misperceive the distributional effects of tax systems,52 and the progressivity of disaggregated tax schemes;53 framing and labeling taxes affects taxpayer reaction;54 taxpayers misperceive tax liabilities;55 individuals confuse marginal tax rates with average tax rates;56 and tax deliberation (discussion paper no. 08-21, department of economics, university of copenhagen, 2008), available at http://econpapers.repec.org/paper/kudkuiedp/0821.htm (last visited may 14, 2010) (showing that tax salience affects buyers’ choice between buyer and seller taxes); edward j. mccaffery & jonathan baron, isolation effects and the �eglect of indirect effects of fiscal policies, 19 j. behavioral decision making 289 (2006) (arguing that hidden taxes are preferred over transparent taxes). 51. rupert sausgruber & jean-robert tyran, testing the mill hypothesis of fiscal illusion, 122 public choice 39, 41–54 (2004) (showing that the burden of less visible taxes is underestimated); tomer blumkin et al., are income and consumption taxes ever realty equivalent? evidence from a real-effort experiment with real goods (cesifo working paper no. 2194, 2008), available at http://www.cesifo.de/doccidl/cesifo1_wp2194.pdf (last visited may 14, 2010) (observing that individuals make different work-leisure choices when they face equivalent direct and indirect taxes). 52. see generally joel slemrod, the role of misconceptions in support for regressive tax reform, 59 nat’l tax j. 57 (2006) (presenting evidence of public misconception that high-income individuals will pay more taxes under a regressive tax system), available at http://ntj.tax.org/wwtax/ntjrec.nsf/b217dba3d2128d018525715e00592788/$file/article %2003-slemrod.pdf (last visited may 14, 2010). 53. mccaffery & baron, humpty dumpty blues, supra note 46 (showing that people evaluate aggregated and disaggregated income tax schedules differently). 54. mccaffery & baron, thinking about tax, supra note 42, at 117–19 (arguing that labeling equivalent levies as “tax” or “payment” affect individual choices); see also generally asa lofgren & katarina nordblom, puzzling tax attitudes and labels, 16 applied econ. letters 1809 (2009) (labeling a gasoline tax as a carbon dioxide tax diminishes individuals’ unfavorable view of the tax); edward j. mccaffery & jonathan baron, framing and taxation: evaluation of tax policies involving household composition, 25 j. econ. psychol. 679 (2004) (suggesting that the framing of tax issues affects individual choices); catherine c. eckel et al., an experimental test of the crowding out hypothesis, 89 j. pub. econ. 1543 (2005) (framing public transfers to charities as forced contributions crowds out private giving); steffen kallbekken & stephan kroll, do you not like pigou, or do you not understand him? tax aversion in the lab (2007) (working paper) (on file with author) (studying experimentally the effect on voters of labeling an environmental levy as a tax); kilian bizer, framing effects in taxation: an empirical study using the german income tax schedule, 16 eur. j. pol. econ. 843 (2000) (book review) (book author stefan traub experimentally examines the framing effect of child tax credits in germany). 55. norman gemmell et al., tax perceptions and preferences over tax structure in the united kingdom, 114 econ. j. f117, f118–24 (2004). 56. liebman & zeckhauser, supra note 49, at 15 (analyzing the welfare effects of such confusion); naomi e. feldman & peter katuscak, should the average tax rate be marginalized? (cerge-ei working paper series 304, 2006), available at http://ideas.repec.org/p/cer/papers/wp304.html (last visited may 14, 2010) (presenting empirical support). 2010] tax-exclusive prici�g 231 incidence becomes dependent on statutory incidence.57 unfortunately, however, to date, there is little empirical support for consumer under-valuation of tax-exclusive prices. one source that may provide indirect support is the “fiscal illusion” literature. the “fiscal illusion” hypothesis states that voters systematically misperceive fiscal factors that may significantly alter their fiscal choices; in particular, voters under-estimate their tax burden.58 yet, empirical evidence of the fiscal illusion hypothesis is inconclusive.59 furthermore, the exclusion of taxes from prices is actually considered as a de-biasing mechanism for fiscally delusional taxpayers.60 alternatively, support for a “consumer under-valuation” hypothesis can be potentially drawn from a growing amount of empirical evidence on price presentation.61 these studies examine consumer behavioral effects— i.e., demand for goods—due to price presentation manipulation.62 designing price presentation can affect consumer perception of value and cost—in particular, due to framing effects and hence (increase) their demand for products, while prices do not change.63 although unrelated to taxes, these studies may provide indirect support for the effect of taxexclusive presentation on taxpayers.64 for example, reference prices (that 57. see generally rudolf kerschbamer & georg kirchsteiger, theoretically robust but empirically invalid? an experimental investigation into tax equivalence, 16 econ. theory 719 (2000). cf. rainald borck et al., tax liability side equivalence in experimental posted offer markets, 68 s. econ. j. 672, 672 (2002); arno riedl & jean-robert tyran, tax liability side equivalence in gift-exchange labor markets, 89 j. of pub. econ. 2369, 2369 (2005). 58. see buchanan, supra note 4, at 126–43. 59. the fiscal illusion literature is voluminous. see, e.g., wallace e. oates, on the �ature and measurement of the fiscal illusion: a survey, in studies in fiscal federalism 441 (w.e. oates ed., edward elgar 1991) (discussing the different versions of the fiscal illusion hypothesis and examining empirical studies); brain e. dollery & andrew c. worthington, the empirical analysis of fiscal illusion, 10 j. of econ. surv. 261, 261 (1996) (same). a related hypothesis is the “flypaper effect,” and its empirical validity is similarly inconclusive. compare james r. hines, jr. & richard h. thaler, anomalies: the flypaper effect, 9 j. of econ. persp. 217 (1995), with elizabeth becker, the illusion of fiscal illusion: unsticking the flypaper effect, 86 pub. choice 85 (1996). 60. see infra section vi for further discussion. 61. for review and analysis of various studies, see aradhna krishna et al., a metaanalysis of the impact of price presentation on perceived savings, 78 j. of retailing 101 (2002); maggie wenjing liu & dilip soman, behavioral pricing, in handbook of consumer psychology 659 (curtis p. haugtvedt, paul m. herr & frank r. kardes eds., 2008). 62. see, e.g., krishna et al., supra note 61, at 101–03; liu & soman, supra note 61, at 672–76. 63. krishna et al., supra note 61, at 106–09. 64. krishna & slemrod, supra note 49, originally introduced price presentation research into tax. 232 columbia jour�al of tax law [vol. 1:218 is, the use of consumers of a certain standard or reference point to evaluate purchase prices) influence consumers’ decisions.65 accordingly, one may conjecture that lower, tax-exclusive prices may be evaluated more positively by consumers when compared to any reference point. another example is different forms of variation in prices. varying prices in absolute dollar amounts or percentage points affects consumers’ perception differently.66 it may teach us how ad valorem commodity taxes, which function as a percentage increase in price, would affect consumers when added to tax-exclusive prices. another piece of indirect evidence comes from a study of the effect of vehicle personal property taxes (vppt) on individuals’ decisions to buy/replace a car.67 based on a mail questionnaire, this study argues that the vppt plays a weak role in carbuying decisions, and conjectures that either price partition or mental accounting are the behavioral reason for this outcome.68 yet, the most relevant strand of price presentation studies are of price partitioning—i.e., presenting the price as a set of mandatory surcharges rather than one all-inclusive price.69 aggregating and disaggregating final prices affect consumers’ choices.70 the theoretical 65. see, e.g., richard thaler, mental accounting and consumer choice, 4 marketing sci. 199, 204 (1985) (modeling the effect of reference prices through the use of prospect theory) [hereinafter thaler, mental accounting and consumer choice]; russell s. winer, behavioral perspectives on pricing: buyers’ subjective perception of price revisited, in issues in pricing: theory and research 35, 35–37 (timothy m. devinney ed., 1988); daniel s. putler, incorporating reference price effects into a theory of consumer choice, 11 marketing sci. 287, 287 (1992) (modeling reference price formation within consumer choice theory and studying it empirically); richard a. briesch et al., a comparative analysis of reference price models, 24 j. of consumer res. 202, 202 (1997) (testing empirically several theoretical explanation for the effect of reference price). 66. see, e.g., vicki g. morwitz et al., divide and prosper: consumers’ reactions to partitioned prices, 35 j. marketing res. 453, 456 (1998) (presenting experimental evidence of more accurate reaction to additions of absolute amount to price than percentage additions) [hereinafter morwitz et al., divide and prosper]; shih-fen s. chen et al., the effects of framing price promotion messages on consumers’ perceptions and purchase intentions: research perspectives on retail pricing, 74 j. retailing 353, 355 (1998) (showing experimentally how different presentations of price reductions affect choices). 67. richard l. ott & david m. andrus, the effect of personal property taxes on consumer vehicle-purchasing decisions: a partitioned price/mental accounting theory analysis, 28 pub. fin. rev. 134, 134 (2000). 68. id. at 138–39. 69. marco bertini & luc wathieu, attention arousal through price partitioning, 27 marketing sci. 236, 236 (2008). 70. see, e.g., thaler, mental accounting and consumer choice, supra note 65, at 208– 13 (suggesting on the basis of prospect theory that price aggregation and disaggregation affect consumers’ perceptions and decisions); timothy b. heath et al., mental accounting and changes in price: the frame dependence of reference dependence, 22 j. consumer res. 90 (1995) (testing experimentally the mental accounting hypothesis for various price 2010] tax-exclusive prici�g 233 source of the integration/partition effect can be found in either consumers’ mental accounting,71 or in anchoring effect and costly adjustments.72 among the price partitioning studies, particularly interesting are those that examine the effect of disaggregation of surcharges—such as shipping and handling, additional components, and warranty.73 it turns out that in wide range of cases partitioning surcharges increase consumers’ demand.74 actually, one study experimentally examined reaction to partition of sales taxes and found similar results—that is, partitioning prices and sales tax does not decrease demand.75 additional direct support for under-valuation of tax-exclusive prices comes from one recent study by chetty et al.76 chetty et al. change strategies). 71. see, e.g., thaler, mental accounting and consumer choice, supra note 65, at 201– 04 (introducing mental accounting into consumer choice modeling and suggesting implication for pricing strategies); see also generally hyeong min kim & luke kachersky, dimensions of price salience: a conceptual framework for perceptions of multidimensional prices, 15 j. product & brand mgmt. 139 (2006) (conjecturing different forms and effects of price salience). 72. see manoj thomas & vicki morwitz, heuristics in numerical cognition: implications for pricing (nov. 13, 2007) (unpublished manuscript, on file with author) (discussing several heuristics that apply to price presentation). 73. see, e.g., tanjim hossain & john morgan, ...plus shipping and handling: revenue (�on) equivalence in field experiments on ebay, 6 advances in econ. analysis & pol’y art. 3 (2006) (presenting experimental evidence of increased demand in reaction to disaggregation of shipping and handling costs of goods on ebay); morwitz et al., divide and prosper, supra note 66, at 454–61 (presenting experimental evidence of increased demand in reaction to price partitioning); dipankar chakravarti et al., partitioned presentation of multicomponent bundle prices: evaluation, choice and underlying processing effects, 12 j. consumer psychol. 215 (2002) (showing experimentally that demand for a good increases upon disaggregation of the price of a warranty and additional components of the good). however, the demand-increasing effect of price partition is not conclusive. see generally, e.g., hyeong min kim, the effect of salience on mental accounting: how integration versus segregation of payment influences purchase decisions, 19 j. behav. decision making 381 (2006) (showing that price partitioning diminishes demand when price components are salient); bertini & wathieu, supra note 69 (showing that price partitioning increases consumer attention to product attributes). 74. see hossain & morgan, supra note 73, at 24–25; morwitz et al., divide and prosper, supra note 66, at 460–62; chakravarti et al., supra note 73, at 225–26. but see kim, supra note 73, at 387–88 (showing that price partitioning diminishes demand when price components are salient); cf. bertini & wathieu, supra note 69, at 244–45 (showing that price partitioning increases consumer attention to, and thus valuation of, product attributes). 75. see lan xia & kent b. monroe, price partitioning on the internet, 18 j. interactive marketing 63, 65–68 (2004). 76. chetty et al., supra note 36 (showing that tax salience affects the demand for grocery products). another relevant empirical study is presented in finkelstein, supra note 42. finkelstein shows that paying road tolls electronically, rather than in cash, which arguably make tolls less salient, diminishes sensitivity to tolls. yet, surveying drivers indicates that they overestimate the non-salient road tolls. 234 columbia jour�al of tax law [vol. 1:218 attempted to empirically examine consumer differential reaction to taxexclusive and tax-inclusive prices. they conducted a field experiment, under which prices of a limited set of products in a northern california grocery store were presented both exclusive and inclusive of sales tax over three weeks (while prices are, in general, tax-exclusive). consumers reacted to the price partitioning and purchased less when the product price included sales tax.77 notwithstanding limited empirical support, this article adopts the prediction that consumers will under-value tax-exclusive prices, because, as explained in this section, this is the essential presumption of price indication regulation. although the author does not necessarily subscribe to this view, consumers’ biased price evaluation is necessary for price indication regulation. hence, it is assumed here that in the absence of such regulation, consumers will over-consume. this article argues that such price under-estimation and resulting over-consumption can actually be welfare-increasing. that is, to the extent consumers are indeed confused and misled by tax-exclusive prices and cannot de-bias themselves, they can be better off. in order to appreciate this argument, let us briefly review the efficiency analysis of taxes. ii. taxation and efficiency taxes generate inefficiency (or excess burden); that is, they diminish individual utility by inducing a change in individual behavior.78 when individuals are induced to act differently than they would have in a no-tax world, they are not as well off as before. assuming that individuals optimize their behavior when no taxes exist, any deviation from this behavior due to government intervention must be utility-reducing. for example, income taxation typically induces individuals to work less then they would have had no such taxes been imposed.79 for analytical reasons, economists break up individual reaction to 77. the results of this study are presumably sensitive to its design. first, the study was conducted in a “tax-exclusive environment.” that is, u.s. consumers are used to taxexclusive price presentation and may have been confused by the mere change in the environment rather than the form of price presentation. second, the study was conducted over a limited set of products, and in particular, over a limited period of time. these facts exacerbate the mentioned effect. overall, chetty et al. might have only measured a “shock” effect or the reaction of consumers to new transaction costs in analyzing a new pricing system. 78. harvey s. rosen, public finance 304–24 (7th ed. 2005); joseph e. stiglitz, economics of the public sector 518–47 (3d ed. 1999). 79. rosen, supra note 78, at 402–05; stiglitz, supra note 78, at 535–47. 2010] tax-exclusive prici�g 235 taxes (or price changes, in general) into two components, denoted as an “income effect” and a “substitution effect.”80 the income effect represents the change in taxpayer behavior solely due to the change in wealth.81 tax payments reduce taxpayer wealth, which in turn, induces taxpayers to act differently. for example, lower-wealth individuals may forego luxuries, or exchange expensive forms of behavior (such as vacationing in the caribbean) with cheaper substitutes (such as a vacation at home); lowerwealth individuals may also increase their labor effort to (partially) make up for the loss of wealth. the income effect is inevitable. if taxes are to be collected from individuals, their wealth must correspondingly decrease.82 there is nothing individuals can do to avoid incurring the reduction in wealth due to tax payments. because (i) any tax payment of a certain amount generates an identical income effect—that is, reduces taxpayer wealth identically, and (ii) the reduction in taxpayer wealth corresponds to an increase in public revenue, the income effect is ignored in the social welfare (or efficiency) analysis.83 put differently, the excess burden—i.e., reduction in social welfare—due to the income effect is nil, or at least identical for equal-revenue taxes, and hence uninteresting in the analysis of various tax schemes. note that this is not to say that the mere payment of any tax is not welfare reducing for taxpayers. it is. but it can be ignored in a revenue-neutral analysis for the above reasons.84 the substitution effect, on the other hand, is designable. the substitution effect describes changes in taxpayer behavior due to changes in relative prices.85 taxes may change relative prices—or, in other words, the relative attractiveness—of different activities and modes of behavior. individuals react to such changes by moving away from relatively expensive activities toward relatively cheaper modes of behavior.86 in the case of income taxation, for example, higher taxes on wages would induce 80. see, e.g., hal r. varian, microeconomic analysis 119–22, 160–63 (3d ed. 1992); rosen, supra note 78, at 311–12. 81. economists measure the monetary consequence of the income effect to individual utility by the “equivalent variation.” see varian, supra note 80, at 160–63; rosen, supra note 78, at 307. 82. this paper ignores the expenditure side of the state—i.e., benefits individuals receive from the government. 83. stiglitz, supra note 78, at 520–22. 84. furthermore, the individual change in behavior described by the income effect is actually welfare-increasing, given the reduction in personal wealth due to tax payments. that is, if individuals did not change their choices due to a reduction in their available resources, they would be worse off (again, given a certain tax obligation). see infra note 104 and accompanying text. 85. stiglitz, supra note 78, at 520–21. 86. id. 236 columbia jour�al of tax law [vol. 1:218 individuals, inter alia, to work less and consume more leisure.87 the relative prices of effort (work) and leisure change due to wage taxes.88 property taxes, as another example, increase the price of housing and hence make consumption of housing services less attractive.89 individuals react by partially substituting housing consumption (for example, smaller and lower quality apartments) with other kinds of consumption or with leisure.90 this tax-induced change in behavior is also welfare-reducing; individuals act differently than their optimal choice due to taxes. various equal-revenue taxes may cause different substitution effects. the extent to which individuals change their behavior through substitution in reaction to taxes—and accordingly the extent to which their utility is diminished—is not identical for different equal-revenue taxes.91 the substitution effect of diverse equal-revenue taxes differently affects social welfare. thus, the social engineering task—to the extent that efficiency is important—is to design taxes so that the substitution effect is minimized. economists denote the perfectly-efficient tax measure as a “lumpsum tax” or first-best optimal tax.92 a lump-sum tax is defined as a tax measure that does not generate a substitution effect.93 the only induced change in individual behavior under a lump-sum tax is due to the diminution of wealth—that is, an income effect.94 a typical—though not perfect—example is a head tax that does not change the relative prices of any activities (besides immigrating and dying). that is, individuals cannot change their behavior or choice of activities in order to reduce the head tax burden. nothing they do (again, besides immigrating or dying) will change their tax liability. but, adopting a lump-sum tax is considered socially undesirable since it is insensitive to distributional concerns. individuals with different characteristics, which are considered relevant distributional concerns (such as income, wealth, consumption, health), may bear equal tax burdens under a lump sum tax system.95 thus, imperfectly efficient tax—denoted as the second-best optimal tax96—is sought. income and consumption tax bases, 87. see supra note 79 and accompanying text. 88. see supra note 79 and accompanying text. 89. rosen, supra note 78, at 521–30. 90. id. at 525–27. 91. see supra note 80 and accompanying text. 92. see stiglitz, supra note 78, at 462–63. 93. id. 94. id. 95. agnar sandmo, asymmetric information and public economics: the mirrleesvickrey �obel prize, 13 j. econ. perspectives 165, 166–70 (1999). 96. id. 2010] tax-exclusive prici�g 237 for example, are two non-lump-sum tax schemes that typically serve as potential candidates for a second-best optimal tax measure. the secondbest optimal tax generates a substitution effect that is minimized for a given distributional (or other) objective.97 all else equal, the excess burden under a first-best optimal tax scheme is smaller than under a second-best optimal tax scheme, which in turn is smaller than under any other tax option. the straightforward conclusion from this review of taxation and efficiency is that, holding all else equal (for example, distributional concerns), we are better off with taxes that minimize the excess burden (that is, minimize inefficiency). for example, if the public requires additional resources of 100, we are better off designing a tax measure that minimizes its effect on individual behavior. a head tax of 100 is probably the best choice in these terms. if a lump-sum tax is unavailable, a secondbest tax measure that minimizes the excess burden of collecting 100 is preferable. the welfare difference between a lump-sum tax and any other kind of tax—both generating 100 in revenue—is the excess burden generated by taxes other than lump-sum tax. while both kinds of taxes generate an identical income effect—i.e., they both equally reduce taxpayer wealth—only the latter also changes relative market prices and hence generates a welfare-reducing substitution effect. iii. implications for price indication regulation as reviewed in section i, price indication regulations adopted by consumer protection laws of european (and other) countries impose an obligation to include all consumption taxes in the sale price.98 the underlying presumption for the regulation of tax-inclusive prices is consumer ignorance, confusion, or misdirection by tax-exclusive prices. in particular, consumers may be induced to consume more—that is, as if no (or lower) taxes are imposed on consumption—as they ignore non-included taxes. accordingly, assume, for simplicity, that consumers completely ignore non-included taxes in their consumption choices. individuals then act as if their consumption is untaxed, although ultimately (i.e., at the cashier) they pay taxes. since individuals ultimately pay consumption taxes, their wealth diminishes, but they perceive no change in (relative) market prices due to consumption taxes; they ignore the effect of such taxes on prices. if consumers perceive no change in relative market prices due to 97. id. 98. supra section i.a. 238 columbia jour�al of tax law [vol. 1:218 consumption taxes, they act as if no such taxes were imposed. thus, individual ignorance or confusion eliminates the substitution effect. if individuals overlook the effect of consumption taxes on relative market prices, no excess burden is generated. the conclusion, then, is that absolute individual confusion or ignorance of commodity taxes’ effect on market prices transforms distortive, imperfectly efficient consumption taxes into perfectly efficient, lump-sum-like taxes. perceiving no change in relative market prices prevents substituting among different individual behaviors and hence eliminates excess burden. in this respect, individuals are better off.99 complete individual confusion or misdirection due to tax-exclusive prices improves well-being and thus, social welfare. consumption taxation with no perceived effect on relative market prices is similar to a perfectly efficient tax measure; it is similar to a lump-sum tax (of equal revenue).100 this conclusion may seem counter-intuitive. to further investigate the underlying intuition, this article proffers the following stylized example: assume (i) a representative individual-taxpayer, (ii) only two commodities in society—c and l, and (iii) commodity l cannot be taxed (for example, leisure). assume that the government wishes to collect $100 from each (representative) individual, and in order to achieve this fiscal need, the government imposes (or increases) tax on the consumption of commodity c.101 if the individual ignores the effect of the tax on the price of c—for instance, because she is confused by tax-exclusive price representation—then her consumption choices, given her lower wealth, would not change. her consumption would only change due to the fact she is $100 poorer. although relative market prices of consumption (or work) and leisure have changed, a confused taxpayer behaves as if no such change has occurred. that is, the effect of such an increase in consumption taxes in this situation is equivalent to a $100 lump-sum tax. on the other hand, if the individual notices the change in relative prices due to a consumption tax, then not only would she change her behavior due the income effect (i.e., being $100 worse off), but she also changes her behavior due to the substitution effect. she will further substitute the untaxed commodity (l) for the taxed commodity (c). ignoring tax liability, substituting the consumption of l for c reduces the 99. see also chetty et al., supra note 36, at 1166–76 (making a similar argument based on formal modeling of social welfare). 100. but see infra notes 104, 105 and accompanying text. 101. if more than two commodities are available for consumption, the analysis is similar as long as at least one commodity (such as leisure) is untaxable. the government then typically chooses a certain uniform increase in commodity taxes (across all goods and services). 2010] tax-exclusive prici�g 239 taxpayer’s well-being. the reason is that before taxes, individuals optimize their consumption, which implies that the marginal utility (per $1) of consuming c equals the marginal utility (per $1) of consuming l. accordingly, given decreasing marginal utility of consumption, the additional utility from the further consumption of l is lower than the lost utility of diminished consumption of c. so why does the taxpayer choose to substitute l for c? the reason is that the tax savings from such substitution is larger than the loss of utility. paying a higher tax-inclusive price for c is not worth as much as the non-lost utility of keeping the same consumption choice. because relative prices have changed while relative utilities of consumption remain the same, the taxpayer is better off substituting between c and l. this is correct to the extent that the tax rate is constant; however, the tax rate actually is not constant. if the government sets the commodity tax on c to yield $100 revenue, and the taxpayer, at least partially, substitutes c with l, revenue will be lower than $100. the taxpayer actually avoids paying the full $100 by substituting. so, the government will increase the tax burden on c in order to collect the entire $100 that is required. assuming, realistically, that the government sets a budgetary goal—denoted in economic parlance as “revenue neutral” analysis102—the taxpayer will eventually pay $100 in taxes. the more the taxpayer substitutes away from the taxed commodity, the higher the imposed consumption tax will be. at the end of the day, the taxpayer pays $100 in taxes and partially substitutes away from the taxed commodity (c). the taxpayer’s utility is thus lower due to a non-optimal consumption mix, and she still carries a $100 tax burden. the taxpayer would have been better off had she not substituted away from the taxed commodity. then her wealth would have decreased by $100, but her utility from consumption (given her wealth) would not have changed; her consumption utility would have been maximized. put differently, whereas the income effect of $100 is supposedly unavoidable, the reduction in individual utility due to the substitution effect is avoidable if individuals refrain from substituting taxed and non-taxed commodities (or activities/behaviors). the conclusion thus far, then, is that taxpayers are better off being confused and misled regarding the effect of commodity taxes on consumption prices—for example, by tax-exclusive pricing. informed individuals react to adjustments in relative market prices due to taxes, which in turn diminish their utility. put more bluntly, if an individual had the choice ex ante, she would opt for the confusing/misleading tax 102. louis kaplow, taxation and redistribution: some clarifications, 60 tax. l. rev. 57, 74–75 (2007). 240 columbia jour�al of tax law [vol. 1:218 exclusive pricing system; she would elect to be “tricked.” this may sound annoying to individuals, as “tricking” them apparently denies them of their freedom of choice to a certain degree; to this extent, it is indeed correct. the freedom, or ability to choose one’s own optimal behavior intelligibly allows her to pay less (or avoid paying) taxes. but once individuals understand that at the end of the day they cannot pay less taxes, since the government (that is, society) requires certain revenue, the only outcome of their freedom of choice is an adverse change in behavior (to avoid paying taxes) with no reduction in tax burden. hence, individuals are better off being “tricked” or being denied such freedom to choose. by extrapolation, society at large—or the aggregate utility of individuals—is better off by being completely misled by tax-exclusive prices.103 accordingly, if consumer confusion or misleading is the underlying justification for price indication regulation, the policy prescription—that is, design of regulation—may better be the opposite. if consumers are indeed misled by tax-exclusive prices and form choices as if there is no tax—and hence no adjustment to relative prices—then not only should retailers not be forced to indicate tax-inclusive prices, but society may actually be better off by making retailers state prices exclusive of taxes. this can be a social welfare-increasing strategy. yet, two important caveats are in order: one concerns differential biases, and the other, the income effect. the analysis so far assumed that individuals uniformly misperceive non-included taxes. but it is arguable that consumer misperception varies across consumption items and that consumers may be differentially aware to taxes on different goods, under a tax-exclusive price system (for example, being fully aware of excluded taxes on one good while being unaware of excluded taxes on another). in particular, consumers may be better aware, or invest further effort in becoming aware of non-included taxes on expensive goods.104 consumers may tend to take the extra effort required to overcome their bias (for example, by using specialized assistance) and find out the relevant taxes when they buy a house or a car. if consumers are aware of non-indicated 103. there might be political, and hence social, ramifications to such a misleading policy. these types of potential adverse political outcomes should be generally accounted for, and may reverse the policy recommendation, though not the analysis and its conclusion. yet, if such “consumers misleading” policy is clearly designed for the benefit of consumers, as explained in this section, no such adverse political outcomes should be expected. see also a related discussion of the fiscal illusion hypothesis in section vi, infra. 104. this may also be the case for recurring consumption goods; multiple identical transactions may induce consumers to acquire tax information. in this case, since typically recurring transactions are inversely correlated with transaction prices (i.e., low-price transactions are much more common then high-price transactions), the conclusion might be that misperception of taxes does not vary systematically across consumption items. 2010] tax-exclusive prici�g 241 taxes to varying degrees across consumption items, their choices will be distorted. that is, perceived relative prices are different than the relative market prices in a no-tax world. this means that while tax-exclusive prices allow avoiding (or reducing) one kind of distortion between work and leisure, another kind of distortion is generated—a distortion between the consumption of various goods. misperceiving non-included taxes avoids (or diminishes) the former kind of distortion but may also cause the latter. avoiding the distortion across consumption goods by tax-inclusion pricing would restore the work-leisure distortion. it is unclear a priori which of the two choices is welfare maximizing. a second caveat relates to the income effect. the welfare implications of changes in behavior due the income and substitution effects are different. as explained above, revised choices due the substitution effect, given revenue-neutrality, are welfare reducing since individuals will be better off not changing their behavior while paying the same amount of tax. the implications of the income effect on individual welfare are different. individuals are better off changing their behavior due to the income effect—i.e., due to a decrease in wealth. whether an individual wealth decreases due to consumption taxes, theft, donation, or any other reason, she will be better off adjusting (that is, optimizing) her behavior accordingly. unlike the change in behavior due to adjusted relative market prices (i.e., the substitution effect) that offers a representative individual no utility under a revenue-neutral system, changing her behavior due the fact she is poorer is beneficial. indeed, as explained above, the income effect is unavoidable as taxpayers pay the tax and in fact become poorer. but what if individuals are unaware of their decrease in wealth? if confused individuals are unaware of non-indicated consumption taxes, they may also be unaware that their real wealth (or purchasing power) has decreased due to such taxes, although they actually pay taxes. given individual (nominal) income, lower market prices increase her real income; she can consume more with the same amount of resources. hence, individual underestimation of market prices due to ignorance of sales taxes is equivalent to individual overestimation of real income. in simple words, if individuals believe market prices are lower than actual, they feel richer; they feel they can purchase and consume more than they can actually do using their income.105 this implies that the income effect may not come 105. for example, assume an individual's nominal income is 1,000 with which she can purchase baskets of goods and services that are subject to a uniform commodity tax. assume the after tax price of such a basket is 500, while the pre-tax price is 400. the individual can actually purchase two baskets of goods and services; that is, her real income can be measured by two baskets. but if the individual ignores the effect of commodity taxes 242 columbia jour�al of tax law [vol. 1:218 fully into effect: individuals may make their consumption (and work) choices ignoring the fact that their real wealth is lower due to consumption taxes. misperceiving individual budget constraint impairs one’s ability to optimize her (consumption and work) choices. the implication is not overconsumption, as individuals cannot consume more than their resources allow them to, but distorted consumption. misperceiving real income may cause non-optimized consumption. for example, it may be conjectured that inter-temporal consumption choices will be distorted as confused individuals over-consume initially (e.g., during working years) only to find out later (e.g., retirement) they were left with resources that cannot fulfill their consumption plans. thus, ignoring the income effect can hurt individual utility. if individuals ignore the reduction in real wealth due to non-indicated consumption taxes, then tax-exclusive prices do not necessarily raise social welfare. although consumer confusion may generate a counter-effect to the substitution effect, it may also prevent them from adjusting their consumption to a lower wealth level. these two opposing effects on social welfare should be traded off, and hence no conclusion on price indication can be a priori correct. to sum up, misperception of non-included commodity taxes offers a social benefit in the form of avoided (or reduced) substitution between work and leisure. but underestimation of market prices may also generate social costs either due to differentiated misperception of prices or due to non-optimized consumption choices where real income is overestimated. overall, it is unclear a priori if consumers are better off by tax-inclusion. in particular, confusing consumers by tax-exclusive pricing may actually improve their well-being and hence social welfare. iv. justifying tax-inclusive price systems concluding that potential under-estimation of prices due to nonindicated taxes cannot necessarily justify price indication regulation, the question is whether a different rationale for tax-inclusive pricing can be suggested. this section presents four potential justifications, all which are based on the informational premise of consumer under-estimation bias: encouraging competition, wealth distribution, information costs, and regulatory taxation. this section generally concludes that only tax-based regulatory goals can support inclusion of taxes in prices, which implies a much narrower basis for tax-inclusive price regulation. on prices, she will believe she is able to purchase and consume 2.5 baskets. 2010] tax-exclusive prici�g 243 a. facilitating market competition full information about prices is obviously important for market competition.106 the e.u. directive on price indication explains that “transparent operation of the market and correct information is of benefit to consumer protection.”107 where prices are stated clearly, consumers are better able to compare prices among producers of goods and providers of services, hence fostering competition among producers/providers, which is, in turn, to the benefit of consumers.108 price indication rules, therefore, can be justified as a regulatory tool that fosters market competition. the competition rationale properly supports, for example, unit pricing, which is an important component of price indication regulation. providing consumers with processed information that can be easily compared across similar products—such as price per unit of weight or volume—quite reasonably advances competition for the benefit of consumers. but, the competition rationale is irrelevant to the tax inclusion issue. whether all prices include or exclude taxes does not affect competition. relative prices rather than absolute prices are important for competitive forces, and relative prices are the same regardless of whether the tax is included in the price or not. the competition rationale is consequential only to the extent that products or services are subject to different tax burdens. there are two general instances of differentiated tax burdens schemes: various services and products may carry different tax burden (or rate), or similar goods may be subject to different tax burden across different countries. the first scenario is discussed later.109 in the second case, differentiated cross-border tax burdens cause relative prices under tax-inclusive and tax-exclusive price systems to diverge. if, for example, a certain good is traded in two countries and is subject to a different vat rate—say 10% in one jurisdiction and 20% in the other. if the before-tax price of the good is 100 in both countries (relative prices are 1-to-1), the tax-inclusive prices of the good may be 110 and 120 (relative prices are 11-to-12). but notice that tax-exclusive prices in this scenario create no efficiency costs since 106. george stigler, the economics of information, 69 j. polit. econ. 213, 213–220 (1961) (showing the effect of price information on market price dispersion). 107. directive 98/6, supra note 9; see also organisation for economic co-operation and development (oecd), price transparency 2001, daffe/clp (2001) 22, available at www.oecd.org/dataoecd/52/63/2535975.pdf (last visited may 14, 2010). 108. see robert pitofsky, beyond �ader: consumer protection and regulation of advertising, 90 harv. l. rev. 661, 670–71 (1977) (discussing the beneficial effect of truthful advertising on competition). 109. see infra part iv.d. 244 columbia jour�al of tax law [vol. 1:218 consumers are not induced to change their consumption (or work) behavior. confused consumers may be induced to spend more on a product in the higher-vat country. this is a problem of transfer between countries, rather than an inefficiency or excess burden problem.110 that is, the social welfare of these two countries, taken together, is not affected by taxexclusive pricing systems.111 b. psychological heterogeneity and redistribution thus far only a representative consumer was examined; that is, the implicit assumption was that all consumers are identical in their underestimation of tax-exclusive prices. but, consumers’ biased estimation may be heterogeneous. certain consumers may not be misled by tax-exclusive pricing or can de-bias themselves; other consumers may under-estimate prices more excessively. heterogeneous effects of tax-exclusive prices on consumer price valuation can generate distributive outcomes, which might be socially important enough to allow for regulation of tax-inclusive prices.112 the distributive outcome is caused by different reactions—that is, changes in behavior—of various individuals. assume that there are only two types of individuals—b, who is fully biased by tax-exclusive prices, and u, who is completely unbiased. b is blind to any change in relative market prices due to consumption taxes, while u is fully aware of such changes and adjusts her behavior accordingly. following our analysis above, assume that the government imposes commodity taxes in order to collect a certain required amount of revenue. if no individual changes her behavior due to the substitution effect (i.e., changes in relative market prices), the government would collect the required revenue. but if one of the individuals (u) further changes her behavior—that is, substituting newly taxed commodities with others—she will reduce her tax liability. 110. see infra note 112 and accompanying text. 111. indeed, underestimation of non-included taxes may weaken tax competition among jurisdictions. see generally john wilson, theories of tax competition, 52 nat’l tax j. 269 (1999). 112. another argument is based on the assumption that consumer protection laws should redistribute among consumers and producers or retailers. if consumers are ignorant of commodity taxes, they react inelastically to taxes, which, in turn, implies that they will carry the entire incidence of taxes. then, informing consumers of taxes by explicit indication in prices causes changes in the tax incidence, relieving consumers of a portion of the tax burden and passing it on to producers/retailers. hence, tax-inclusion regulation may redistribute from producers to consumers. yet the redistributive rationale of consumer protection laws is fairly doubtful. compared with the tax and transfer systems, consumer protection regulation is an extremely inferior mechanism of wealth redistribution. 2010] tax-exclusive prici�g 245 the government then must increase the imposed commodity tax burden in order to collect the required revenue. at the end of the process, the government will collect the intended total amount of taxes, but the burden will be divided differently between the two types of individuals. individual b will incur a larger burden of the commodity tax then he would have had if individual u were similarly confused by the tax-exclusive price; individual u will correspondingly bear a smaller portion of the tax burden. u’s ability to change her behavior due to the change in relative market prices makes her better off so long as the “avoided” taxes are paid also by others—that is, by type b individuals. type b individuals face higher market prices due to the consumption choices of type u individuals. thus, in effect, under tax-exclusive pricing, individual heterogeneity (in confusion or bias) distributes resources from the more biased toward the less biased. the important questions, then, are whether such a distributional outcome is socially disturbing and whether it requires regulatory control. numerous cross-subsidies among individuals exist in the market, and most are not necessarily considered socially undesirable to an extent that requires regulatory intervention. for example, accident insurance contracts create cross-subsidization between clumsy and skilled individuals113 and short distance commuters cross-subsidize long distance commuters through equal payments for (non-toll) roads; and astute investors or businessmen are more successful, in particular, at the expense of poorly performing investors or businessmen. these cross-subsidies among individuals do not require a regulatory fix. it is far from being obvious that redistribution is required also along individuals with different psychological biases. not every kind of human non-uniformity requires regulatory intervention. individuals are different in many dimensions; some are considered more attractive or dress better, while others require extra hours of sleep at night.114 society does not consider every kind of inequality to be worthy of redistribution. typically, redistribution is considered socially desirable along few individual features, such as income (or wealth or consumption), health, and family size.115 113. michael rothschild & joseph stiglitz, equilibrium in competitive insurance markets: an essay on the economics of imperfect information, 90 q. j. of econ. 629, 630– 37 (1976). 114. cf. lee anne fennell, willpower and legal policy, 5 annual rev. of l. and social sci. 91, 102 (2009) (suggesting that problems of willpower or self-control might raise redistributive concerns since they affect individual well-being). 115. these individual characteristics are considered proxies of individual ability, which is unobservable directly. it is unclear that biased perception of tax-exclusive prices is any proxy of lower ability. see also shaviro, supra note 31, at 758 (arguing, in passing, that “ability” for tax (or social welfare) purposes may include individual ability to derive utility from consumption). furthermore, even if one adopts an ability-to-pay criterion, it is unclear 246 columbia jour�al of tax law [vol. 1:218 therefore, considering potential correlations between psychological biases and any of the mentioned individual features is interesting. psychological biases might be negatively correlated with education level or intelligence quotient (iq), which could be considered as partial proxies for income. but on the other hand, the opportunity costs of self-debiasing resources (such as time and effort) are positively correlated with income as the time value of high-income earners is higher. thus, theoretical prediction is unattainable.116 empirical evidence on these potential correlations is scarce. the limited existing evidence indicates that lowincome or low-educated individuals acquire less information and make more mistakes,117 but they are not necessarily more vulnerable to psychological biases.118 furthermore, it makes little sense to redistribute along a non-perfect proxy of income, while redistribution along income can be accomplished directly through an income tax system.119 the conclusion, then, is that only to the extent that it is socially desirable to redistribute across psychological biases—regardless of income or wealth—can taxinclusive price regulation be justified.120 however, note that this would not how confusion about market prices or tax burdens affects a taxpayer’s ability to pay. for example, would an ability-to-pay advocate support equal tax liability for a high-income biased consumer and low-income rational consumer? 116. galle, supra note 49, at 49–54, claims that the distributive effects of cognitive biases and rational inattention are presumably different, with the tendency of cognitive biases to generate a regressive outcome, while the rational inattention induces a more progressive outcome. i fail to see why the two opposing effects described in the text would not be equally at work under both rational and non-rational descriptions of behavior. see also supra note 43. 117. see, e.g., oren bar-gill & elizabeth warren, making credit safer, 157 u. penn. l. rev. 101, 164–65 (2008) (pointing out that survey studies in the mortgage industry that show that lower-income and less-educated consumers are more likely to make mistakes). 118. see, e.g., marianne bertrand et al., what’s psychology worth? a field experiment in the consumer credit market (2005) (unpublished manuscript) (on file with author); marianne bertrand et al., behavioral economics and marketing in aid of decision making among the poor, 25 am. marketing assoc. 8, 8–9 (2006) (arguing that although poor and rich individuals may exhibit the same behaviors, the effect on the poor may prove more crucial since the poor face tighter constraints. this observation implies that the value of debiasing to the poor is higher); see also chetty et al., supra note 36, at 35. 119. see mitchell a. polinsky, an introduction to law and economics 117–27 (aspen publishers 1989) (explaining that non-tax redistribution is haphazard and can be contracted around); richard craswell, passing on the costs of legal rules: efficiency and distribution in buyer-seller relationships, 43 stan. l. rev. 361, 368–85 (1991) (analyzing distributional outcomes of legal rules in consensual relationships); jacob nussim, redistribution mechanisms, 3 rev. of l. and econ. 323, 333–35 (2007) (emphasizing the institutional component of redistribution); see also generally louis kaplow & steven shavell, why the legal system is less efficient than the income tax in redistributing income, 23 j. of l. stud. 667 (1994) (arguing that non-tax redistribution of wealth generates double distortion). 120. additionally, protecting biased consumers through regulation may crowd out 2010] tax-exclusive prici�g 247 be a consumer protection concern but an issue of redistribution. consumers are not necessarily protected by such regulation; non-biased consumers are actually hurt. c. complexity costs tax-exclusive prices impose complexity costs on rational consumers since consumers are required to gather and process information in order to make rational consumption decisions. the applicable tax rates must be revealed and the tax-inclusive prices computed. these activities are complicated—that is, costly. reallocating the informational burden from consumers to retailers would most likely reduce complexity costs. retailers are the cheapest information producers. by indicating taxinclusive prices, retailers act as a joint representative of consumers, and relieve them of information costs. rather than having each and every consumer bear the informational burden in each and every transaction, retailers can undertake the informational responsibility by adopting a taxinclusive price system. but if consumers are indeed rational and would hence carry the informational burden under a tax-exclusive price system,121 no consumer protection regulation is required. market forces would most likely induce retailers to present tax-inclusive prices. competing retailers can gain competitive advantage by providing consumers with costly information. if it is indeed cheaper for retailers to provide information by adopting taxinclusive prices, they maintain a profit-maximizing incentive to do so. no protective regulation is required. on the other hand, if consumers are completely confused by taxexclusive prices, and completely ignore non-indicated taxes, then no complexity costs are induced. no information is gathered or processed by consumers, and the lack of such information is ignored. thus, tax-inclusive price regulation saves no complexity costs. on the contrary, it raises social complexity since it requires retailers to produce information which is not demanded by consumers, and thus saves no costs for consumers. in the personal incentive to educate and debias oneself. see jonathan click & gregory mitchell, government regulation of irrationality: moral and cognitive hazards, 90 minn. l. rev. 1620, 1627–41 (2006). 121. rational consumers do not necessarily invest in the gathering and processing of information. if information costs are higher than their expected benefit, it is rational to refrain from such tasks. but it does not imply that consumers avoid these (complexity) costs. rather, they minimize these costs. instead of bearing the actual information costs, consumers would bear the reduction in utility due to the absence of information (e.g., mistakes, uncertainty). see also supra note 43. 248 columbia jour�al of tax law [vol. 1:218 absence of regulation, retailers would choose not to indicate taxes since biased consumers would not be willing to pay for such information (through higher market prices). this market solution is socially superior. the more interesting case is of heterogeneous consumers (as was presented in the preceding section). consumers’ cognitive abilities may vary: some consumers are fully rational, some are less rational, and some are completely fooled by tax-exclusive prices. in this case, society will likely be better off if retailers undertake the informational burden as long as the set of non-biased consumers is sufficiently large. only if sufficiently enough (non-biased) consumers incur complexity costs, it is socially beneficial to have retailers produce information by including taxes in prices. the question is if regulating tax-inclusive prices gets us closer to the socially preferable outcome than allowing for undisturbed market forces. no absolute a priori theoretical answer can be provided to this question. but it does seem in general that the market solution is more likely to minimize informational costs (that is, complexity) and hence is a superior solution socially. stiglitz and salop investigated a general case of consumer information costs—in their model, positive search costs. if consumers have to invest resources in search for products, producers gain certain monopolistic power and can utilize it for their advantage at the expense of consumers. for example, if it is costly to compare prices of all producers, then in reality fewer producers compete on relevant segments of the market, and hence competition is impaired, which in turn leads to higher market prices. stiglitz and salop showed that where price information is costly for some consumers—that is, positive search costs—a competitive market reaches competitive price equilibrium if there are enough fully (costlessly) informed consumers.122 the fully informed consumers drive down market prices by inducing suppliers to reduce their prices in order to gain their market share—i.e., the market share of fully informed consumers.123 that is, if the market share of informed consumers is not too small, producers will compete on their share and accordingly reduce market prices to the benefit of all consumers. put differently, competitive market prices do not necessitate full information by all market participants, but by a sufficiently large subset of them. the same analysis can be applied to the tax-inclusion issue. non 122. see steven salop & joseph stiglitz, bargains and ripoffs: a model of monopolistically competitive price dispersion, 44 rev. of econ. studies 493, 499–502 (1977); see also alan schwartz & louis l. wilde, intervening in markets on the basis of imperfect information: a legal and economic analysis, 127 u. pa. l. rev. 630, 640–51 (1979). 123. salop & stiglitz, supra note 122, at 499–502. 2010] tax-exclusive prici�g 249 biased consumers are fully aware of non-included taxes and therefore gain from simplified tax-inclusive prices. it saves them complexity costs. a sufficiently large share of non-biased consumers would hence induce retailers to post prices inclusive of tax. retailers are better off stating taxinclusive prices since they try to gain, and hence compete over, the share of non-biased consumers. yet, if the share of non-biased consumers in the market is excessively small, retailers would choose to ignore non-biased consumers, present tax-exclusive prices, and make an extra profit thanks to biased consumers. this result is, in general, socially desirable. as described above, producing information through tax-inclusion is socially beneficial only for non-biased consumers. it saves them personal information costs, but only to them. accordingly, a smaller share of nonbiased consumers in the economy makes tax-inclusive prices socially undesirable, since unneeded information is produced and complexity is actually increased. only to the extent there are enough non-biased consumers, information production by retailers via tax-inclusive prices is socially beneficial. indeed, it seems that market forces are generally in accord with the social goal: a larger share of rational consumers requires tax-inclusive pricing, and indeed market forces would drive retailers to include taxes in prices, whereas a smaller share of non-biased consumer requires no superfluous information costs, and, as stiglitz and salop explain, market forces probably would not induce retailers to include taxes in stated prices. tax-inclusive regulation, then, cannot be easily justified on the basis of information costs. d. regulatory taxation a small, designated subset of commodity taxes retains a regulatory function: control of behavior.124 in particular, negative externalities—such as pollution—can be constrained by taxes.125 these taxes are also denoted as pigouvian taxes or corrective taxes, the purpose of which is to change or restrain certain socially undesirable behavior.126 examples include taxes on carbon emissions, fuel, congestion, tobacco, and alcohol.127 effective pigouvian taxes must be fully considered by taxpayers to change individual behavior in a socially desirable manner. thus, under-valuation of pigouvian taxes dilutes their regulatory effectiveness. in contrast to revenue-producing taxes, with behavior-control taxes, the substitution 124. see generally lawrence h. summers, the case for corrective taxation, 44 nat’l tax j. 289, 289–92 (sept. 1991). 125. id. at 290. 126. id. at 289–90. 127. see, e.g., state sales, supra note 29. 250 columbia jour�al of tax law [vol. 1:218 effect is most desirable. in this context, price indication regulation is required only for corrective taxes which apply to a very limited set of commodities (for example, carbon emissions, alcohol). this analysis of price indication regulation partially conforms to the u.s. practice. while state sales taxes are not included in commodity prices, excise taxes are included in, for instance, alcohol prices.128 however, the use of regulatory taxation might be somewhat wider and is related to differential tax rate systems. vat systems in european countries and sales tax systems in u.s. states tend to evolve into a nonuniform tax rate system.129 although policy-makers usually prefer a uniform consumption tax rate,130 in practice, several subsets of consumption goods and services—such as newspapers, medical care and products, and food—might be completely exempted from commodity taxes or sustain a lower tax rate.131 generally, there are three reasons to adopt a differentiated rate scheme: regulation of behavior, redistribution, and complexity.132 128. see, e.g., chetty et al., supra note 36, at 1158 (discussing the effects of excise and sales taxes on alcohol sales). 129. see copenhagen economics, study on reduced vat applied to goods and services of the member states of the european union 39 (2007) [hereinafter copenhagen economics], available at http://ec.europa.eu/taxation_customs/resources/documents/taxation/vat/how_vat_works/rates /study_reduced_vat.pdf (last visited may 14, 2010). 130. see, e.g., the president’s advisory panel on federal tax reform, simple, fair, and pro-growth: proposals to fix america’s tax system 198 (2005), available at http://govinfo.library.unt.edu/taxreformpanel (follow “final report issued” hyperlink; then follow “chapter eight nine” hyperlink) (last visited may 14, 2010) [hereinafter president’s advisory panel] (stating that the “vat should be imposed at a single uniform rate”); due & mikesell, supra note 36, at 27; council directive 2006/112, supra note 28, arts. 96, 97 (requiring and establishing standard vat rates); henry j. aaron, introduction and summary, in the value-added tax: lessons from europe 1, 8–9, 16 (henry j. aaron ed., 1981). 131. see, e.g., due & mikesell, supra note 36, at 75–88; mikesell, supra note 33, at 154–55 (listing exemptions by category and state); liam p. ebrill et al., the modern vat 68–100 (2001) (discussing complexity and administrability in chapter 5, experience and recommendations in chapter 6, and rate differentiation in chapter 7); ronald john hy & william l. waugh jr., state and local tax policies: a comparative handbook 31–32, 91–100 (1995) (giving examples of sales tax exemptions); council directive 2006/112, supra note 28, art. 98, annex iii (applying reduced rates from article 98 to certain goods and services listed in annex iii); see also richard m. bird & pierre-pascal gendron, the vat in developing and transitional countries 211 (2007) (discussing arguments for and against tax salience in the context of taxing a broad base of services). 132. see, e.g., james m. bickley, value-added tax: concepts, policy issues, and oecd experiences 18–20 (novinka books 2003) (explaining that redistribution concerns trigger differentiated vat rates); alan schenk & oliver oldman, value-added tax: a comparative approach 54 (2007) (arguing that both redistribution and behavior regulation 2010] tax-exclusive prici�g 251 (i) regulating behavior: if the use of public transportation, or the use of energy saving appliances, or distribution of information by newspapers is considered valuable for society (for example, because it generates positive externalities), the government may attempt to encourage its consumption, or at least, not to excessively discourage it through consumption taxes. a lower vat rate on energy saving appliances or books is a kind of subsidy for socially beneficial behavior.133 given a vat system, lower rates act as pigouvian subsidies; their function is to encourage particular individual behavior. similar to the pigouvian taxes case, the reaction of individuals to the tax incentive—i.e., the substitution effect—is important. to the extent that the purpose of differentiated vat rates is to encourage behavior, society is better off when individuals are fully aware of the encouragement and fully react to it.134 individuals should not be confused in this case, and thus, tax-inclusive prices are justified. in this case, not only should the prices of preferred goods be taxinclusive, but also prices of all other taxed goods and services. in order for consumers to appreciate the lower tax burden on preferred goods, they must be aware of the relatively higher tax burden on non-preferred goods. therefore, in the case of differentiated vat rates based on the pigouvian subsidy (or tax) rationale, a system-wide tax-inclusive pricing method is justified. the result of this analysis is that, given consumer confusion by taxexclusive prices, if a differentiated tax rate is desirable in order to regulate consumption behavior, then tax-inclusive prices offer social value. however, we should still be aware of the loss of social welfare due to nonregulatory, undesirable substitution. the social value of regulating behavior should be traded off against the social loss due to substitution by consumers who consume non-preferred goods. it is not a priori clear that the first (regulatory) effect outweighs the second (distortive) effect. furthermore, it is plausible that in certain cases society will be better off if cause differentiated tax rates); alan tait, value-added tax, �ational, in the encyclopedia of taxation and tax policy 422, 422–23 (joseph j. cordes et al. eds., 1999) (suggesting that complexity and redistribution drive european countries to adopt differentiated tax rates). 133. see copenhagen economics, supra note 129, at 5, 32–33. 134. the same rationale applies to other less-prevalent arguments based on efficiency and merit goods. a differentiated commodity tax rate may prove superior on efficiency grounds due to differentiated association with leisure. see, e.g., w.j. corlett & d.c. hague, complementarity and the excess burden of taxation, 21 rev. of econ. studies 21 (1953). it may also prove superior due to substitution with non-taxed homemade consumption. see, e.g., copenhagen economics, supra note 129, at 20–21. additionally, to the extent that certain goods—such as books, music, cultural events—are considered “merit goods,” society may wish to encourage their consumption through lower tax burdens. see id. at 32–33; tait, supra note 21, at 69 et seq. in these cases, the rationale similarly applied—i.e., society is better off if individuals are fully aware of, and react to, the reduced tax. 252 columbia jour�al of tax law [vol. 1:218 encouragement (or discouragement) of behavior will be accomplished outside the vat/rst (retail sales tax) system. given consumer confusion under a tax-exclusive commodity tax system, by using a separate tax (or subsidy) instrument,135 or a non-tax regulating instrument, society can enjoy both welfare-increasing effects—that is, lump-sum-like tax and regulation of individual behavior—rather than choose one or the other. (ii) redistribution: equity preferences seem to be a principal reason for imposing lower consumption tax rates on certain subsets of consumption.136 examples include food, housing, public transport, and utilities.137 because poor taxpayers’ incomes are largely used for the purchase of basic consumption goods, imposing a lower tax on these goods generate a progressive effect. for a similar reason, higher tax rates are sometimes levied on certain luxuries.138 (iii) complexity: adopting differentiated commodity tax rates can be socially advisable if it proves to be too complicated (i.e., costly) to tax every kind of good or service. certain goods or services may be difficult to tax, or taxes on these goods or services may be difficult to enforce (for example, due to monitoring or measurement difficulties). for example, services and intangible property are typically not taxed under u.s. state sales tax for this reason;139 financial services are not always taxed under vat systems for a similar reason.140 it should be clear, following the analysis so far, that, to the extent that consumption tax rates are differentiated due to either redistribution or complexity issues, the tax-exclusive pricing option may actually be reinforced. a differentiated consumption tax rate scheme creates additional, excessive substitution toward low-tax commodities. assuming that substitution is socially undesirable—because the reason for tax exemption is redistribution or complexity rather than directing behavior— 135. excise taxes (and subsidies) such as those mentioned above (e.g., taxes on alcohol, gas, and pollution) are designed as a separate consumption tax mechanism. that is, it might be possible to have a uniform-rate consumption-tax system under which taxes are not included in prices, along with an additional system of specific excise taxes and subsidies that are included in prices. 136. see copenhagen economics, supra note 129, at 29–33. 137. id.; tait, supra note 21, at 58–68. 138. louis kaplow, income taxation and government policy (harvard law school john m. olin center for law, economics and business discussion paper series no. 518, at 4 2005), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=825568 (last visited may 14, 2010). 139. mikesell, supra note 33, at 155–57; kirk j. stark, the uneasy case for extending the sales tax to services, 30 fla. st. u. l. rev. 435, 451–58 (2003) (investigating the problems of broadening the sales tax to encompass services). 140. see, e.g., tait, supra note 21, at 92–99. 2010] tax-exclusive prici�g 253 society might be better off with a “misleading” tax-exclusive price system.141 under this system, certain commodities are not burdened by taxes, while taxes on the remainder of commodities are ignored due to confusion. this results in no distortion due to redistribution or complexity; a differentiated tax rate can help the poor or relieve complexity, while inducing no substitution toward the non-taxed or lower-taxed commodities.142 in sum, the principal theory supporting the notion of tax-inclusive pricing is most likely based on a specific goal of regulating behavior. acknowledging this helps us draw two conclusions. first, the scope of prescribing tax-inclusive pricing is more limited than what is envisioned under the “consumer confusion” hypothesis. consumption taxes are mostly designed with non-regulatory goals in mind.143 second, price indication laws should not necessarily aim to prevent consumer confusion in general, but may rather attempt to reinforce the regulatory function of taxes. a corollary of this conclusion is that the focal location of tax-inclusive regulation should be within tax law, rather than in consumer protection law. v. extensions a. income-based taxes the price of effort—that is, work—is typically stated gross-of-tax and the tax burden on work effort is not separately stated. accordingly, a consistent approach to individual cognitive biases—which supports a “consumer confusion” hypothesis—would posit an analogous argument in the individual-worker case: “worker confusion” or “worker over-valuation” hypothesis. suppliers of work may be confused or misled by gross-of-tax salaries that are offered in the market. an individual who offers her human capital in the market may be misled to believe that the return is higher than it actually is net of wage taxes, and hence would choose to work (and invest 141. although it is not a necessary result under the theory of second-best, there is no reason to believe, in this case, that the additional tax distortion (i.e., due to complexity or redistribution) may increase welfare. 142. admittedly, the same caveats (see supra text accompanying notes 104, 105) similarly apply to this case. 143. the analysis focused only on public-interest-based reasons for designing a differentiated tax scheme—i.e., regulating behavior, redistribution, and complexity. privateinterest reasons—e.g., assisting a particular industry—may be suggested as well. to the extent that private interests influence the design of consumption taxes, the conclusion is similar: taxes should not be included in prices because the differentiated tax rate would cause an unwanted substitution effect. 254 columbia jour�al of tax law [vol. 1:218 in human capital) too much. a “worker protection” measure can take the form of “salary indication” regulation that requires presentation of only netof-tax salaries. presumably, the reason that no “salary indication” regulation is advocated is its relative complexity. because income taxes are far from uniform across equal-income taxpayers, net-of-tax indications would require gathering and processing individual information (some which may be private) for every wage offer.144 this article offers an additional rationale for gross-of-tax wage presentation. if workers are completely confused by gross-of-tax wages (and are being paid with sufficient frequency), they are better off. misled workers will supply effort (and invest in human capital) as if no income taxes are imposed; they will not substitute leisure for work. complete ignorance of wage taxes will transform a second-best optimal tax scheme into first-best optimal lump-sum taxes. like “tricking” consumers, “tricking” workers may improve social welfare. furthermore, the potential drawbacks of misperceived commodity taxes are largely absent from a (generally equivalent145) wage tax.146 first, the effect of wage taxes is uniform across consumption items, and hence misperception of taxes cannot distort choice among consumption possibilities. second, the potential distortion to the income effect due to ignored taxes is most likely much smaller under a wage tax. wage taxes directly reduce taxpayers’ nominal income, and hence real income. a taxpayer, who is completely ignorant of levied wage taxes, still has access to an independent source of budgetary information—for example, checking her wallet or bank account. whether or not a taxpayer is aware of the wage taxes she pays, she can be easily informed of her budget or net income. individuals do not aggregate tax payments in order to calculate net available income. in order to make correct (consumption and work) choices, individuals just check how much resources (for example, money) they own at each relevant point of time. even where individuals are not aware of levied taxes, they are still typically aware of the amount of money they possess. as long as a taxpayer adjusts her behavior to her net income status, it does not matter if her income is lower due to taxes or any other reason, and being aware of tax payments is irrelevant. that is, the income effect is most likely fully accounted for by a taxpayer who completely misperceives wage taxes. the only necessary constraint is that the taxpayer net income 144. interestingly, in italy, wages are commonly stated in net-of-tax terms. 145. see louis kaplow, taxation and risk taking: a general equilibrium perspective, 47 nat’l tax j. 789, 793–94 (1994) [hereinafter kaplow, risk taking]. 146. see supra notes 104, 105 and accompanying text. 2010] tax-exclusive prici�g 255 actually diminishes due to wage taxes; that is, it depends on the frequency of wage tax payments. it makes some difference whether wages are being paid weekly, biweekly, monthly or yearly. assume, for example, that an employee is being paid a biweekly salary of, say $5,000 before income taxes, where a flat 30% wage (or income) tax applies. at the beginning of a two weeks work, a confused employee may plan her consumption given an expected increase of $5,000 to her net income. once she gets her salary, her bank account shows an increase of $3,500 only (due to income taxes). assuming individuals do not ignore net income information obtained from their bank account, her consumption choices can be distorted only to the extent of $1,500. that is, she might make wrong consumption choices thinking (constantly) she is $1,500 richer. such distortion to the income effect is most likely negligible. indeed, had salaries been paid on a yearly basis, she may (constantly) overestimate her net income by $36,000 (=$120,000 annual salary times 30% tax rate).147 accordingly, frequent payments of wage taxes minimize the distortion in individual consumption choices due to the income effect. this analysis may be further expanded to other components of an income tax base. for example, interest, dividend or rent income may also be presented net-of-tax. again, stating the return to capital investment or loans gross-of-tax may confuse taxpayers; they may believe the gain is higher than the actual net-of-tax return, and hence tend to excessively invest or provide credit. furthermore, unlike wage taxes, in various jurisdictions interest and dividend tax rates are flat rather than graduated, which make it quite simple to indicate returns net-of-tax.148 the repeated argument in this article is that stating returns in gross-of-tax terms may thwart the substitution effect in these cases if taxpayers are confused, and hence may minimize the excess burden. b. demand-increasing market strategies the discussion and analysis in this article may take us even further beyond the tax-exclusive/inclusive question. for the purposes of this subsection, ignore the previous discussion of confusion and misperception of non-included taxes. specifically, assume that either an optimal and perfectly perceived consumption tax (like vat or sales tax) or a wage tax 147. in reality, wages taxes are paid frequently (weekly, biweekly, or monthly) due to the withholding at source mechanism. 148. the situation grows further complicated upon the assumption that payers of income may also be confused and misperceive the deductions to which they are entitled (for payments of interest or salary). 256 columbia jour�al of tax law [vol. 1:218 exists, or both—that is, a second-best optimal tax system that (optimally) distorts behavior due to the substitution effect described above. additionally, assume a uniform (rather than differentiated) consumption tax rate or a proportional wage tax rate, which are actually equivalent.149 accordingly, the tax induced distortion is of labor and leisure: under either tax system, individuals similarly tend to work less (and consume less in the market) and alternatively consume more leisure. now, focus on the uniform commodity tax scheme. it is secondbest optimal due to the labor-leisure distortion, which is absent under a lump-sum tax. under a lump-sum tax, the demand for consumption (and correspondingly, supply of work) is higher since substitution effect is nil.150 therefore, exogenously increasing consumers’ demands, holding all else constant, counteracts the substitution effect and is thus a welfare-increasing strategy. indeed, as discussed above, confusing or deceiving consumers who consequently ignore the imposed tax can be considered as one such strategy. another strategy might be spontaneously offered by the market. sellers of goods and services are involved, to a large extent, in increasing consumer demand for their products. marketing tactics, advertising, price presentation, etc. are all attempts by sellers to gain market share among a limited pool of consumers and to increase demand without reducing prices. these demand-increasing strategies are based not just on revealing necessary information to the consumer, but also on consumer confusion or misperception. marketing methods are often developed to exploit the cognitive biases of consumers. the marketing literature presents and examines a wide range of such marketing strategies that are employed in the market. a few examples of price presentation strategies were presented in section ii.151 numerous other examples are available in the marketing literature.152 for example, nine-ending prices prove to affect sales;153 different promotional forms influence demand differently;154 149. see, e.g., kaplow, risk taking, supra note 145, at 791–94 (discussing the equivalence between a uniform commodity tax and a proportional wage tax). 150. see supra note 92 and accompanying text. 151. see supra notes 61–74 and accompanying text. 152. see generally thomas t. nagle & reed k. holden, the strategy and tactics of pricing: a guide to profitable decision making 265 et seq. (4th ed. 2006). 153. see generally, e.g., mark stiving & russell s. winer, an empirical analysis of price endings with scanner data, 24 j. consumer res. 57 (1997) (showing experimentally the price underestimation effect of prices ending with the digit 9); robert m. schindler & patrick n. kirby, patterns of rightmost digits used in advertised prices: implications for �ine-ending effects, 24 j. consumer res.192 (1997) (same); manoj thomas & vicki morwitz, penny wise and pound foolish: the left-digit effect in price cognition, 32 j. consumer res. 54 (2005) (same); eric anderson & duncan simester, effects of $9 price endings on retail sales: evidence from field experiments, 1 quantitative marketing and economics 93 (2003) (suggesting, based on field experiments, that the effect of 9 2010] tax-exclusive prici�g 257 temporal price framing may reduce the perceived cost of consumption;155 comparative price advertising increase consumers’ demand by raising their perceived reference price.156 generally, marketing strategies that exploit consumer cognitive biases may be deplored as misleading and deceiving. but, regulating such market behavior may not necessarily be socially wise given the existence of commodity (or wage) taxation. these demand-increasing strategies offer a social value. they offer potential offsets to the demand-reducing effect of second-best optimal taxes. misleading consumers in a manner that increases their demand for products is effectively no different than generating an under-estimation of commodity prices. that is, in a no-tax world, such marketing strategies are welfare reducing as they induce excessive consumption (and work). but if distortive consumption taxes are employed, the extra consumption (and work) induced by these marketing strategies becomes restorative rather than excessive. this article does not necessarily advocate misleading consumers in order to increase their demand for consumption. in particular, the difference between consumer under-estimation due to tax-exclusive prices and marketing strategies is that only under the former there may be a good reason to believe that consumers will be uniformly confused across all commodities.157 marketing strategies, on the other hand, may differentially affect the consumption of different products. such a differentiated effect generates its own distortion—i.e., substitution across commodities.158 the purpose of this discussion is to elucidate to consumer endings is informational). 154. see, e.g., david m. hardesty & william o. bearden, consumer evaluations of different promotion types and price presentations: the moderating role of promotional benefit level, 79 j. retailing 17, 18–22 (2003) (comparing the effects of price discounts and bonus packs); chen et al., supra note 66, at 357–69 (comparing the effects of price discounts and coupons); see also generally indrajit sinha & michael f. smith, consumers’ perceptions of promotional framing of price, 17 psychol. & marketing 257 (2000) (arguing that the framing of deals—i.e., price reduction versus volume promotion—affects perception). 155. see generally, e.g., john t. gourville, pennies-a-day: the effect of temporal reframing on transaction evaluation, 24 j. consumer res. 395 (1998) (showing experimentally and theorizing the effect of temporal framing of pricing). 156. see generally, e.g., dhruv grewal et al., the effects of price-comparison advertising on buyers’ perceptions of acquisition value, transaction value, and behavioral intentions, 62 j. marketing 46 (1998); larry d. compeau & dhruv grewal, comparative price advertising: an integrative review, 17 j. pub. policy & marketing 257 (1998). 157. see supra notes 104, 145–46 and accompanying text. 158. additionally, the extent to which marketing strategies mislead consumers and increase demand is also important. marketing strategies should not be allowed to have an excessive effect on demand (though intuitively it seems to be far from excessive given current tax rates in developed countries). 258 columbia jour�al of tax law [vol. 1:218 protection regulators the positive effect of market-based strategies based on consumer confusion, where consumption or wage taxes exist. the demandincreasing marketing strategies described above (and others) should not necessarily be on the front line of consumer protection regulation; they are not all bad. conclusion rather than restating the analysis and conclusions of this article, this final section discusses a few closely related issues. first, on the issue of methodological approaches, this article adopts a welfarist method. under a welfarist methodology, legal rules are evaluated according to their effect on social welfare, which is the aggregate of individual well-being.159 clearly, other methods of analysis are possible, such as “rights” or entitlement approaches that can be based on the kantian idea of personal autonomy. consumers, under a “rights” approach, are entitled to certain regulatory protection regardless of any competing considerations—such as social welfare.160 another potential approach is based on the concept of community/public values. in this context, consumer protection regulation promotes values such as honesty and fairness, and contributes to the development of trust and confidence in society.161 one may alternatively adopt a theory of liberal values,162 promote collective desires and aspirations,163 attempt to redesign individual preferences,164 stress various public policy goals,165 etc. under any of the non-welfarist approaches, the analysis and conclusion may change. the welfarist analysis in this paper can provide advocates of other approaches with a social welfare benchmark 159. see generally kaplow, theory of taxation, supra note 1, at 348–58 (describing the welfarist methodology). 160. see, e.g., richard b. stewart & cass r. sunstein, public programs and private rights, 95 harv. l. rev. 1193, 1232–36, 1307–16 (1982) (discussing the concept of entitlement as affecting the relationship between private rights and public law); richard b. stewart, regulation in a liberal state: the role of �on-commodity values, 92 yale l. j. 1537, 1556–59 (1983) (discussing the concept of entitlement as a basis for regulation). 161. see, e.g., stewart & sunstein, supra note 160, at 1238. 162. see, e.g., stewart, supra note 160, at 1566–87 (presenting and applying a noncommodity approach to regulation). 163. see cass r. sunstein, after the rights revolution: reconceiving the regulatory state 57–60 (1990). 164. see id. at 64–67. 165. see, e.g., marshall s. shapo, a representational theory of consumer protection: doctrine, function and legal liability for product disappointment, 60 va. l. rev. 1109, 1369–88 (1974) (using various public policy criteria to evaluate a suggested approach to consumer protection). 2010] tax-exclusive prici�g 259 against which other non-welfarist considerations can be weighed. a closely related issue to this paper’s discussion is the fiscal illusion hypothesis, which maintains, inter alia, that taxpayers misperceive certain non-salient or hidden taxes.166 it is a political hypothesis, and its concern is the political outcome where voter-taxpayers under-value their tax burden. for example, an excessively large government is expected under the fiscal illusion hypothesis.167 even though the empirical validity of the hypothesis is questionable,168 it does seem to weigh on contemporary tax policy and design.169 for example, it is argued that tax-inclusive prices under a vat system hide the commodity tax burden from taxpayers who observe only final prices, and hence may not be aware of included taxes.170 accordingly, the “consumer protection” and “fiscal illusion” hypotheses appear to contradict each other. the “consumer protection” hypothesis assumes that consumers under-value the commodity tax burden under a tax-exclusive price system, while the “fiscal illusion” hypothesis argues that consumers under-value the tax burden under a tax-inclusive price system. these contradicting hypotheses are not easily reconciled. this article argues against the “consumer protection” hypothesis, and hence incidentally relieves this alleged tension. finally, also related are issues of paternalism and de-biasing through law. paternalism has long been a source of regulation.171 the paternalistic justification for governmental intervention in the market has recently gained considerable force with the flood of studies examining cognitive errors and limitations.172 the understandable uneasiness with 166. see supra note 4. another related political conjecture is the tax aversion hypothesis, which asserts that people are averse to taxes and that hidden taxes circumvent such cognitive bias. see, e.g., mccaffery, cognitive theory, supra note 49, at 1878 (“[t]here may be a phenomenon of ‘tax aversion,’ akin to but distinct from loss aversion, whereby individuals attach disproportionate disutility to government extractions perceived or labeled as ‘taxes’”). see also supra note 54 in its entirety. 167. buchanan, supra note 4, at 126–143. 168. see supra note 27. 169. for example, the u.s. president’s advisory panel (2005) was reluctant to fully support a federal vat system, inter alia, on the basis of fiscal illusion. see president’s advisory panel, supra note 130, at 204; see also bird & gendron, supra note 131, at 210–12. 170. president’s advisory panel, supra note 130, at 204; see also bird & gendron, supra note 131, at 210–12. 171. see, e.g., stephen breyer, regulation and its reform 33–34 (1982) (indicating that paternalism may justify regulatory measures). 172. see, e.g., rachlinski, supra note 3 (reviewing and critiquing studies that support paternalistic interventions on the basis of cognitive biases); edward l. glaeser, paternalism and psychology, 73 u. chi. l. rev. 133 (2006) (explaining on the basis of incentives and political theory why cognitive errors should rarely require paternalistic reaction). 260 columbia jour�al of tax law [vol. 1:218 paternalism has led scholars to suggest “softer” paternalistic interventions,173 such as debiasing through law.174 in these respects, this article presents a unique legal situation. a paternalistic approach, built on consumer protection reasoning, would prescribe tax-inclusive pricing. however, as this article shows, such a measure—based on the cognitive limitation of individuals—may actually diminish consumer well-being. de-biasing in this context is not necessarily desirable. under-valuation of tax burdens might be generally a welfareincreasing bias. if any paternalistic measure is to be considered—although none is advocated by this article—it might be one that supports bias, rather than de-bias, in consumer under-valuation of taxes. to conclude, tax-inclusive price regulation may appear, at first glance, to be the socially appropriate response to consumer under-valuation errors: regulation of tax-inclusive pricing presents no constitutional obstacles;175 it is simple to implement;176 it seems to present no potential 173. see cass r. sunstein & richard h. thaler, libertarian paternalism is �ot an oxymoron, 70 u. chi. l. rev. 1159, 1184–88 (2003) (suggesting an approach of steering individuals in a direction that improves their welfare); richard h. thaler & cass r. sunstein, nudge: improving decisions about health, wealth, and happiness (2008) (same); j.d. trout, paternalism and cognitive bias, 24 law & phil. 393, 425–33 (2005) (advising using individuals’ biases to improve their welfare); ted o’donoghue & matthew rabin, optimal sin taxes, 90 j. pub. econ. 1825, 1827–36 (2006) (arguing that given selfcontrol biases in consumption, corrective taxes can improve social welfare); colin camerer et al., regulation for conservatives: behavioral economics and the case for “asymmetric paternalism”, 151 u. pa. l. rev. 1211, 1219–33 (2003) (describing “asymmetric paternalism” which benefits biased individuals with little effect on non-biased individuals). compare glaeser, supra note 172, at 149–56 (warning against soft paternalism). 174. see, e.g., linda babcock et al., creating convergence: debiasing biased litigants, 22 law & soc. inquiry 913 (1997) (proposing a procedure to debias litigants’ self-serving biases); christine jolls & cass r. sunstein, debiasing through law, 35 j. legal stud. 199, 206–24 (2006) (suggesting legal reforms that would tend to debias individuals who suffer from bounded rationality); mccaffery, cognitive theory, supra note 49, at 1935–36 (suggesting certain ways of debiasing biased taxpayers). debiasing procedures have been examined in the psychological literature as well. see, e.g., judgment under uncertainty: heuristics and biases, pt. viii (daniel kahneman et al. eds., 1982). 175. see, e.g., pitofsky, supra note 108, at 671–73. 176. tax inclusion as information regulation is considerably simpler than most other kinds of information regulation. see, e.g., howard beales et al., the efficient regulation of consumer information, 24 j. l. & econ. 491, 513–31 (1981) (suggesting regulatory measures that aim at providing missing market information); paul h. rubin, information regulation, in 3 encyclopedia of law and economics 271 (boudewijn bouckaert & gerrit de geest eds., 2000) (discussing the advantages and limitations of information regulation); see also generally clifford winston, the efficacy of information policy: a review of archon fung, mary graham, and david weil’s full disclosure: the perils and promise of transparency, 46 j. econ. literature 704 (2008) (presenting a skeptical view of information regulation). 2010] tax-exclusive prici�g 261 problems of government (regulatory) failure;177 and it appears to be an appropriate case for ex ante regulation.178 nonetheless, this article shows that consumer under-valuation of taxes can be beneficial for consumers, and therefore, to the extent that tax-exclusive pricing induces undervaluation, it can be socially desirable. thus, if consumers under-estimate tax-exclusive prices—whether for the short run only or whether only a portion of consumers are biased—society may be better off. if consumers are actually not confused or misled by tax-exclusive prices and can easily or quickly educate and debias themselves, then tax-inclusive prices are also unnecessary. the case for tax-inclusive pricing regulation, therefore, is weaker than commonly believed and can be justified on a much narrower scope. 177. see, e.g., charles wolf, markets or governments: choosing between imperfect alternatives chs. 4, 5 (1989) (discussing government failures and their causes); sunstein, supra note 163, ch. 3 (1990) (same); james q. wilson, bureaucracy: what government agencies do and why they do it (1989) (closely studying bureaucratic failures); richard a. posner, theories of economic regulation, 5 bell j. econ. & mgmt. sci. 335 (1974) (analyzing public choice theories of regulation). 178. see, e.g., steven shavell, liability for harm versus regulation of safety, 13 j. legal stud. 357 (1984). the u.s. as tax haven? aiding developing countries by revoking the revenue rule samuel d. brunson* abstract over the years, many oecd countries, including the united states, have identified tax havens as a significant problem, and have acted to limit the ability of their taxpayers to use tax havens to reduce their taxes. the united states has implemented tax regimes, including subpart f and the passive foreign investment company rules, and disclosure regimes, such as the recently-enacted fatca rules, to prevent u.s. taxpayers from taking advantage of tax haven jurisdictions. but the intersection of a number of u.s. tax rules, it turns out, makes the united states an attractive place for foreigners to invest—and hide—their money. principal among these is the revenue rule, an eighteenth-century common law rule that prevents the united states from recognizing and enforcing foreign tax judgments. as a result, if a foreign taxpayer hides money in the united states and fails to pay taxes at home, her government has no recourse to satisfy the tax debt with the taxpayer’s u.s. assets. such hidden money disparately impacts developing countries by reducing their ability to finance government through developing tax infrastructure, and instead forcing them to remain dependent on foreign aid. the revenue rule stands in stark contrast to the general default rule that u.s. courts will enforce foreign final judgments. but the revenue rule is not grounded in any compelling policy considerations. moreover, to the extent that the u.s. revokes the revenue rule, not only will the u.s. aid other countries—including, especially, developing countries—but it may receive reciprocal aid in collecting taxes from u.s. taxpayers with assets held overseas. this article argues that the u.s. should revoke the revenue rule, both from a moral obligation to aid developing economies in becoming self-sufficient and to receive reciprocal aid in collecting taxes being held overseas. * assistant professor, loyola university chicago school of law. i would like to thank the participants at the university of kentucky college of law developing ideas workshop, the eighth annual junior tax scholars workshop, the 2013 law & society annual meeting, and classcrits vi. i would also like to thank loyola university chicago school of law for its summer research stipend and jamie brunson for her support. 2014] the u.s. as tax haven? 171 i. introduction .................................................................................................... 172 ii. capital flight from developing countries .................................... 173 a. tax havens ........................................................................................................ 174 b. capital flight to the united states ..................................................................... 177 iii. enforcing foreign judgments in u.s. courts .................................. 179 iv. the revenue rule ........................................................................................... 182 a. roots of the revenue rule ................................................................................ 182 b. the revenue rule today................................................................................... 183 c. rationales for the revenue rule ........................................................................ 185 v. a framework for revocation: policy considerations ............ 187 a. other potential reforms, while meritorious, are less achievable ................. 188 b. reciprocity and revocation ............................................................................... 190 c. economic imperialism ....................................................................................... 193 d. u.s. citizens and the end of the revenue rule................................................. 195 vi. a framework for revocation: administrative considerations ............................................................................................... 196 a. judicial inquiries ................................................................................................ 196 b. using treaties to revoke the revenue rule ..................................................... 196 c. jurisdictional issues ........................................................................................... 199 d. evaluating the foreign country’s revenue judgment ...................................... 200 e. final judgment ................................................................................................... 202 f. u.s. citizen exceptionalism .............................................................................. 203 vii. .............................................................................................................. conclusion .................................................................................................................................. 205 172 columbia journal of tax law [vol.5:170 i. introduction nobody likes tax havens.1 no country in the organization for economic cooperation and development (“oecd”), at any rate. in 2000, the oecd released a blacklist of tax havens that had not cooperated with its attempts to eliminate harmful tax practices.2 it gave those thirty-five countries one year to reform their harmful practices, at which point member states would begin to impose sanctions on the remaining blacklisted tax havens.3 while nearly a decade and a half has passed since the oecd began its crackdown on tax havens, they still exist, and u.s. taxpayers continue to funnel money through tax havens to reduce their taxes. the u.s. loses an estimated $40 billion to $70 billion in governmental revenues annually to taxpayers’ abusive use of tax havens. 4 major u.s. corporations, including microsoft, hewlett-packard, and apple, have faced public condemnation at disclosures that they have used tax havens to avoid u.s. taxes.5 the u.s. has enacted a number of tax provisions intended to check taxpayers’ ability to reduce their taxes through the use of tax havens. subpart f, for example, taxes certain u.s. shareholders currently on their share of a foreign corporation’s income, while the passive foreign investment company rules eliminate the benefits of deferral on offshore passive investments. as i’ve previously written, the united states imposes punitive taxes on certain tax haven investments even when the investor is acting in a manner consistent with congressional intent.6 but what if the united states is a tax haven? or, more specifically, what if federal tax law makes the united states an attractive place for foreign individuals to hide their money?7 though it sounds counterintuitive, even the oecd has acknowledged that member states (including the united states) engaged in certain harmful tax practices.8 if in fact the united states is offended by and committed to attacking tax havens, it must address those parts of its tax law that make it attractive to foreign persons who want to hide assets from their governments. one easy way to reduce the attractiveness of the u.s. to tax evaders—while not discouraging legitimate foreign investment—would be to revoke the revenue rule, which prevents u.s. courts from enforcing foreign tax judgments. without the revenue rule, individuals evading taxes in their home countries would risk losing the assets they had hidden in the united states; foreign taxpayers current on their foreign taxes, on the other hand, would face no such risk. as a result, the united states could help other countries—and especially developing countries—at 1 this is not completely true, of course. some privacy advocates and libertarian think tanks argue that tax havens, among other things, promote tax competition, thus reducing the rates of tax and spending of high-tax countries. see, e.g., david d. stewart, privacy advocates praise tax evasion, 125 tax notes 649, 649 (2009). 2 robert goulder, oecd releases tax haven blacklist, 88 tax notes 32, 32 (2000). 3 id. 4 samuel d. brunson, repatriating tax-exempt investments: tax havens, blocker corporations, and unrelated debt-financed income, 106 nw. u. l. rev. 225, 237 (2012). 5 see editorial, "a" is for avoidance, n.y. times, may 26, 2013, at sr10 ("rampant corporate tax avoidance may not be illegal, but that doesn't make it right or fair."). 6 see brunson, supra note 4, at 271 ("however, congress clearly never intended for tax-exempt entities to pay taxes on their investment income. moreover, the irs has blessed investment by a tax-exempt entity through offshore blocker corporations as being nonabusive."). 7 see infra notes 51–77and accompanying text. 8 see goulder, supra note 2, at 33–34 (listing the u.s. foreign sales corporation regime as a harmful tax practice). 2014] the u.s. as tax haven? 173 minimal expense to itself, while acting consistently with its desire to protect its own revenue from countries engaging in harmful tax practices. this article proceeds as follows. part ii discusses tax havens. it looks specifically at the legal regimes that allow a country to act as a tax haven. it also discusses the ways in which tax havens impede developing countries from establishing the administrative capacity to collect the revenue they need to become self-sufficient. it finally describes ways in which the united states resembles a tax haven, imposing little, if any, tax on certain types of u.s.-source income earned by foreigners, with significant secrecy, and with its unwillingness to enforce foreign tax judgments. part iii then discusses the ways in which victorious foreign litigants can enforce non-revenue money judgments awarded by foreign courts in the u.s. part iv looks at the revenue rule, which prevents u.s. courts from recognizing or enforcing foreign revenue judgments. i conclude that there is no compelling justification for maintaining the revenue rule, and that the revenue rule should be revoked in the interest of international tax fairness. parts v and vi then provide a framework for how such revocation should proceed. part v goes through a number of policy issues that must be considered in the process of eliminating the revenue rule, including why its revocation is a better solution to the problem of the u.s. as tax haven than other solutions. finally, part vi looks at the practical and administrative aspects of revoking the revenue rule. ii. capital flight from developing countries every year, developing countries lose hundreds of billions of dollars to capital flight. in 2010, the center for international policy estimated that developing countries lost between $783.2 billion and $1.138 trillion in illicit capital flight alone.9 to put this amount in context, developing countries receive only about $70 billion in official development assistance, and about $250 billion in foreign direct investment, annually.10 capital flight, moreover, creates real problems for developing countries.11 for purposes of this article, the most salient effect of capital flight is its ability to undermine a developing country’s tax system and public finances.12 "tax evasion undermines the funding of the state and, thus, the legitimacy associate with the state through the delivery of public services[.]"13 developing countries rely on capital taxes for a large percentage 9 dev kar & sarah freitas, global financial integrity, illicit financial flows from developing countries: 2001–2010, at 6, available at http://iff.gfintegrity.org/documents/dec2012update/illicit_financial_flows_from_developing_countries_20 01-2010-highres.pdf. 10 peter reuter, policy and research implications of illicit flows, in draining development? controlling flows of illicit funds from developing countries 483, 484 (peter reuter ed. 2012). 11 among other things, it removes from developing countries assets that could be invested, it can encourage rent-seeking, and can negatively affect a country’s balance of payments. a. albakin & j. whalley, the problem of capital flight from russia, 22 world econ. 421, 433–34 (1999). at the extremes, capital flight can even destabilize an economy or trigger international chain reactions. id. at 421. 12 gov’t comm’n on capital flight from poor countries, tax havens and development 10 (2009). 13 max everest-phillips, the political economy of controlling tax evasion and illicit flows, in draining development? controlling flows of illicit funds from developing countries 69, 71 (peter reuter ed. 2012). 174 columbia journal of tax law [vol.5:170 of their tax receipts; as capital disappears from the country, either the government’s revenue decreases or it must impose higher taxes on a narrower tax base.14 for developing economies to grow, they must pursue a policy of "strong public investment," which will allow them to develop the necessary infrastructure and skills to support future growth.15 this public investment requires money. developing countries have a number of ways that they can obtain revenue, including selling natural resources,16 obtaining foreign aid,17 and taxing their citizens and residents.18 though developing countries can fund infrastructure and other programs using money from any of these sources, arguable, to fully develop, a country needs tax revenue. a country that cannot effectively collect taxes faces significant limitations on "the extent to which [it] can provide security, meet basic needs or foster economic development."19 with widespread poverty, developing countries need social insurance programs more than developed countries.20 they need to invest in education, which many believe key to development.21 and some developing countries need tax revenue to ensure the survival of government.22 and developing countries’ need for an effective tax regime may go beyond merely funding essential infrastructure: arguably, "bargaining over tax is the basis of the social contract between the state and its citizens and a key building block in the development of democracy."23 a. tax havens half of world trade passes through tax havens, including half of bank assets and one-third of foreign direct investment.24 in the mid-2000s, an estimated $11 trillion (or one-third of the world’s gdp) in assets were held in tax haven jurisdictions. 25 approximately a "quarter of global wealth is stashed in havens."26 although the secrecy inherent in tax haven makes it difficult to know for certain, these assets likely include a significant portion of the capital flight from developing countries. 14 gov’t comm’n on capital flight from poor countries, supra note 12, at 10. perhaps for this reason, foreign borrowing increases concurrently with capital flight. valerie cerra, et al., robbing the riches: capital flight, institutions and debt, 44 j. dev. studies 1190, 1197 (2008) ("many studies find that an increase in foreign borrowing, particularly by the public sector, is concurrent with outflows by domestic residents and firms."). 15 commission on growth & development, the growth report: strategies for sustained growth and inclusive development 34 (2008), available at http://siteresources.worldbank.org/extpremnet/resources/4899601338997241035/growth_commission_final_report.pdf. 16 id. at 8. 17 id. at 1. 18 id. at 35–36. 19 deborah a. bräutigam, introduction: taxation and state-building in developing countries, in taxation and state-building in developing countries: capacity and consent 1, 1 (deborah a. bräutigam et al. eds. 2008). 20 reuven s. avi-yonah, globalization, tax competition, and the fiscal crisis of the welfare state, 113 harv. l. rev. 1573, 1640 (2000). 21 id. at 1640–41. 22 id. at 1640. 23 paul collier et al., managing resource revenues in developing economies, 57 imf staff papers 84, 104 (2010). 24 lee a. sheppard, a tax haven by any other name, 131 tax notes 1111, 1111 (2011). 25 john cristensen & richard murphy, the social irresponsibility of corporate tax avoidance: taking csr to the bottom line, development, sept. 2004, at 37, 39. currently the international monetary fund recognizes more than sixty tax haven jurisdictions. id. at 39–40. 26 sheppard, supra note 24, at 1112. 2014] the u.s. as tax haven? 175 in spite of the centrality of tax havens in the global economy, attempts to define what constitutes a tax haven generally "devolve into some form of totality of the circumstances analysis . . . or, even worse, an 'i know it when i see it' approach"27 broadly speaking, though, a tax haven is a "low-tax jurisdictions that provide investors opportunities for tax avoidance."28 various organizations, including the international monetary fund,29 the oecd,30 the tax justice network,31 and even the u.s. congress,32 have published lists of tax haven jurisdictions. the lists of tax havens tend to include primarily non-oecd nations, including various caribbean islands, bermuda, hong kong, singapore, jersey, and mauritius.33 the oecd has attempted to move beyond merely knowing tax havens when it sees them. it listed four key factors for identifying harmful preferential tax regimes: low or zero effective tax rate, ring-fencing, lack of transparency, and lack of effective information exchanges.34 a tax haven jurisdiction, the oecd explained, would "be characterized by a combination of a low or zero effective tax rate and one or more other" key factor.35 in evaluating the first factor—whether a country has a low tax rate—the oecd looks not only at the statutory rate, but at the way the country defines its tax base.36 it does not, however, delineate what constitutes harmfully low tax rate and what does not. some countries, such as bermuda and anguilla, impose no income tax, and clearly meet this criterion.37 other countries that impose taxes, such as ireland and switzerland, have nonetheless been accused of being tax havens.38 ireland has a corporate tax rate of 12.5 27 adam h. rosenzweig, why are there tax havens?, 52 wm. & mary l. rev. 923, 940 n.49 (2010). 28 mihir a. desai et al., the demand for tax haven operations, 90 j. pub. econ. 513, 514 (2006). 29 see ronen palan, tax havens and the commercialization of state sovereignty, 56 int’l org. 151, 151 n.1 (2002) ("an international monetary fund (imf) study lists nearly seventy tax havens . . . ."). 30 jane g. gravelle, tax havens: international tax avoidance and evasion, 62 nat. tax j. 727, 728 (2009) ("the organisation for economic co-operation and development (2000) created an initial list of tax havens."). 31 id. at 731–32. 32 id. at 728–29. 33 see id. at 729 (listing countries on various tax haven lists). though not all tax havens are islands, islands represent the prototypical tax haven. some commentators argue, though, that the biggest island tax havens are manhattan and london. see, e.g., marshall j. langer, harmful tax competition: who are the real tax havens?, 21 tax notes int’l 2831, 2832–33 (2000). 34 oecd, harmful tax competition: an emerging global issue 27 (1998), available at http://www.oecd.org/dataoecd/33/0/1904176.pdf [hereinafter, oecd, harmful tax competition]. though the oecd calls these "harmful preferential tax regimes," they serve essentially the same function as tax havens. see id. at 8 ("the report is intended to develop a better understanding of how tax havens and harmful preferential tax regimes, collectively referred to as harmful tax practices, affect the location of financial and other service activities, erode the tax bases of other countries, distort trade and investment patterns and undermine the fairness, neutrality and broad social acceptance of tax systems generally."). because "tax haven" is not a term of art, but is a more familiar terminology than "harmful preferential tax regime," i will use the two terms interchangeably in this article. 35 id. 36 id. at 26. 37 alex cobham, tax havens and illicit flows, in draining development? controlling flows of illicit funds from developing countries 337, 340 (2012). 38 see, e.g., id. (tax havens include "countries with low taxation (e.g., switzerland, the channel islands)"); jeremy scott, apple and ireland try to win spin battle with the senate, 139 tax notes 1089, 1089 (2013) ("psi chair carl levin basically called ireland a tax haven . . . ."). 176 columbia journal of tax law [vol.5:170 percent, while switzerland taxes corporate income at a rate of 8.5 percent.39 while both rates are comparatively low—in 2013, the average oecd corporate tax rate was about 23 percent40—it is not clear why 8.5 percent or 12.5 percent is the appropriate cut-off for a low tax rate. a tax haven’s low tax rates do not apply to everybody, though. as its second factor, the oecd looks at whether a country ring-fences its preferential rates to ensure that they get the revenue they need. "ring-fencing" means that the tax haven prevents residents from benefiting from the lowor no-tax regime, while preventing foreigners from accessing domestic markets.41 that is, they "offer a zero tax rate to nonresidents who park their money there but tax residents fully."42 ring-fencing their preferential tax regime allows tax haven jurisdictions to attract foreign capital with the promise of low or no taxes while concurrently raising revenue to fund governmental services by collecting taxes from residents. the third factor requires a lack of transparency. a transparent tax regime clearly lays out how the tax applies to taxpayers and makes the details of the regime available to the tax authorities of other interested countries.43 a tax regime lacks transparency when, for example, the "tax laws are negotiable or employed selectively in favor of foreign investors as a matter of practice."44 this lack of transparency can arise as the result of favorable administrative rulings that allow a particular sector to pay less tax, special administrative practices, or even a country’s decision not to enforce its tax laws against certain taxpayers.45 the oecd’s final key factor is that a tax haven lacks the ability or willingness to effectively exchange information.46 this lack of effective information exchange can result from secrecy laws.47 switzerland, for example, has strict bank secrecy laws, the violation of which can result in criminal sanctions.48 similarly, cayman islands law makes revealing certain financial information a criminal offense.49 even where a country 39 andrew pike, u.s. taxes corporate income at comparatively low rate, 134 tax notes 1533, 1546 (2012). 40 http://www.oecd.org/tax/tax-policy/tax-database.htm#c_corporatecaptial (follow the "basic (non-targeted) corporate income tax" link for an excel spreadsheet containing tax rates). 41 joann m. weiner & hugh j. ault, the oecd’s report on harmful tax competition, 51 nat. tax j. 601, 604 (1998). that is, they "offer a zero tax rate to nonresidents who park their money there buy tax residents fully." 42 nicholas shaxson, treasure islands: uncovering the damage of offshore banking and tax havens 12 (2011). 43 oecd, harmful tax competition, supra note 34, at 28. 44 keith engel, tax neutrality to the left, international competitiveness to the right, stuck in the middle with subpart f, 79 tex. l. rev. 1525, 1559 (2001). 45 oecd, harmful tax competition, supra note 34, at 28–29. 46 id. at 29. 47 id. 48 kristen a. parillo, switzerland, u.s. sign fatca agreement, 138 tax notes 803, 803 (2013). under a recently-enacted intergovernmental agreement, however, entities subject to the agreement (including swiss banks) can disclose certain information to the u.s. without violating secrecy laws. id.; see agreement between switzerland and the united states of america for cooperation to facilitate the implementation of fatca, art. 2(7), (9), u.s.-switz., feb. 14, 2013, available at http://www.treasury.gov/resource-center/taxpolicy/treaties/documents/fatca-agreement-switzerland-2-14-2013.pdf (including “custodial institutions” within the definition of financial institutions subject to fatca). for more on these intergovernmental agreements, see infra notes 208–222 and accompanying text. 49 shaxon, supra note 42, at 101 ("fearing that field would spill his clients’ secrets, exposing the caymans to a major international scandal, an oppressive new secrecy law was drafted, the now infamous 2014] the u.s. as tax haven? 177 does not require its financial institutions to maintain depositor secrecy by law, however, it still may lack effective information exchange where, for example, its administrative policies or practices do not allow for such exchange, or even where the country is just uncooperative with other countries.50 b. capital flight to the united states even though the oecd has laid out criteria to determine whether a country acts as a tax haven, its definition is underinclusive. most notably, the definitions used to classify countries as tax havens "exclude some of the practices of developed countries that are oecd members,"51 with the oecd "spell[ing] out a contorted definition of tax havens that excluded its own members."52 among other things, oecd countries have preferential tax regimes, exempt certain types of income earned by nonresidents from taxation, and refuse to share information with other countries.53 countries classified as tax havens have pointed to this hypocrisy, arguing that "when it comes to secrecy, money laundering, and tax fraud," the u.s. and the u.k. represent the most significant offenders.54 the united states has long functioned as a repository for foreign assets. with the repeal of u.s. tax on portfolio interest paid to non-u.s. persons in the 1980s, latin american money began to flow into u.s. bank accounts and other u.s. portfolio investments.55 by 2011, about $240 billion of latin american wealth had found its way to the united states, primarily miami and new york.56 in fact, in 2009 the u.s. topped the list of countries that served as homes for private foreign deposits in total dollar amount, with nonresidents holding nearly $2.2 trillion in private deposits in the u.s.57 at first blush, thinking of the united states as a tax haven makes no sense. nonresident alien individuals and entities pay taxes on their u.s. source trade or business income at the same marginal rates that apply to u.s. taxpayers.58 currently the u.s. has the highest marginal corporate tax rate of oecd countries, at 35 percent,59 and with a top confidential relationships (preservation) law, making it a crime punishable by prison to reveal financial or banking arrangements in the caymans."). 50 oecd, harmful tax competition, supra note 34, at 29–30. 51 karen b. brown, harmful tax competition: the oecd view, 32 geo. wash. j. int'l l. & econ. 311, 315 (1999). 52 andrew p. morriss & lotta moberg, cartelizing taxes: understanding the oecd’s campaign against "harmful tax competition", 4 colum. j. tax l. 1, 38 (2012). 53 see, e.g., langer, supra note 33, at 1236. 54 charles gnaedinger, u.s., cayman islands debate tax haven status, 123 tax notes 543, 543 (2009). see also langer, supra note 33, at 2832 ("even worse, most oecd member states are guilty of egregious unfair tax competition that is much more serious and harmful than that of which the oecd is complaining."). 55 avi-yonah, supra note 20, at 1584–85. 56 boston consulting group, global wealth 2012: the battle to regain strength 11 (2012), available at https://www.bcgperspectives.com/images/bcg_the_battle_to_regain_strength_may_2012_tcm80-106998. pdf. moreover, asian-pacific residents held $200 billion in the u.s., while residents of the middle east and africa held another $40 billion in the u.s. id. 57 ann hollingshead, global financial integrity, privately-held, non-resident deposits in secrecy jurisdictions 15 (mar. 2010), available at http://www.gfip.org/storage/gfip/documents/reports/gfi_privatelyheld_web.pdf. the next two largest holders of private foreign deposits were the cayman islands and the u.k., with about $1.5 trillion each. id. 58 i.r.c. §§ 871(b)(1), 882(a)(1) (2012). 59 diana furchtgott-roth, corporate tax reform should come first, 137 tax notes 901, 902 (2012). 178 columbia journal of tax law [vol.5:170 individual marginal rate of 39.6 percent,60 the u.s. seems an unlikely repository for foreign tax-evaders. moreover, foreign persons are subject to a 30 percent flat tax on their u.s. source passive income.61 as such, using the u.s. as a tax haven appears downright laughable. however, u.s. tax law exempts significant portions of foreigners’ u.s. source income from taxation. for more than ninety years, nonresident aliens and foreign corporations have owed no u.s. tax on interest they earn on bank deposits in u.s. banks.62 as a result, nonresidents hold hundreds of billions of dollars in u.s. bank deposits.63 in addition, nonresident aliens and foreign corporations who receive u.s.source "portfolio interest" owe no taxes on that interest,64 even though u.s. persons holding the same securities would owe taxes on the interest.65 nonresident aliens can also hold u.s. equity securities in their portfolios with minimal u.s. tax consequences. true, a nonresident alien owes a 30 percent tax on her dividends from u.s. corporations, 66 but provided she invests for growth rather than income, she can essentially eliminate her tax liability. this is because the internal revenue code generally requires a realization event before it will tax asset appreciation, so an investor who holds non-dividend-paying u.s. securities as they appreciate pays no taxes on that appreciation.67 moreover, if a nonresident alien chooses to realize that income, she will still pay no u.s. taxes. the tax law sources gains from the sale of personal property—including securities—to the residence of the seller. 68 if our nonresident alien sells her shares of u.s. securities, then, any gain she realizes will be foreign-source gain. but the u.s. generally only taxes non-resident aliens on their u.s.source passive income, ignoring any foreign-source passive income they might have.69 as a result of the confluence of rules governing the taxation of a foreign person’s interest and capital gains, a nonresident alien can invest broadly in the united states without subjecting herself to any significant u.s. taxation. moreover, the u.s. has 60 i.r.c. § 1(a) (2012). 61 id. §§ 871(a), 881. 62 id. § 871(i)(1), (2); see also langer, supra note 33, at 2833 ("bank deposits held by foreign persons have been effectively exempt from u.s. income tax since 1921."). 63 langer, supra note 33, at 2833. 64 i.r.c. § 871(h)(1) (2012). "portfolio interest" includes interest on government bonds, notes, treasury bills, and many corporate bonds. langer, supra note 33, at 2834. 65 i.r.c. § 61(a)(4) (2012). 66 i.r.c. § 871(a)(1)(a) (2012). moreover, the paying corporation must withhold this tax from the dividend and pay it over to the government. id. § 1441(a) (2012). this ensures that even though the recipient of the dividend is outside of the jurisdiction of the united states, the government can collect the tax revenue. 67 see jeffrey l. kwall, when should asset appreciation be taxed?: the case for a disposition standard of realization, 86 ind. l.j. 77, 79 (2011) ("the u.s. income tax . . . has always embraced a realization requirement, thereby deferring the taxation of asset appreciation until the occurrence of a realization event . . . ."). the code has a small handful of situations in which, rather than wait for a realization event, taxpayers mark their assets to market. see, e.g., i.r.c. §§ 475 (mark-to-market mandatory for brokers in securities and commodities, elective for traders), 1256 (certain futures and foreign currency contracts and certain options marked to market), 1296 (elective mark-to-market for owners of passive foreign investment companies). 68 i.r.c. § 865(a) (2012). 69 see i.r.c. § 871(a)(1) (2012) (imposing taxes on income received from u.s. sources). 2014] the u.s. as tax haven? 179 effectively ring-fenced these provisions—they do not apply to u.s. citizens or residents, who must pay taxes on their worldwide income (including interest and capital gains).70 the united states resembles non-oecd tax havens in other respects, as well. absent some sort of treaty obligation, the i.r.s. cannot disclose tax information to foreign governments.71 moreover, even if the i.r.s. faced no legal bar on disclosing taxpayer information, it could not disclose information that banks do not provide.72 and the law only began to obligate banks to report to the i.r.s. their interest payments to nonresident alien account holders in 2013.73 that obligation was enacted, moreover, not in the interest of increasing transparency, but so that foreign governments would enter into information exchange agreements with the u.s. pursuant to the foreign account tax compliance act.74 even with the increased information that the i.r.s. may be able to provide to foreign governments, nonresidents still hide assets in the u.s. in 2009, the tax justice network published its first financial secrecy index. 75 the u.s. topped its list of secretive jurisdictions, largely because states like delaware, florida, nevada, and wyoming "offer high levels of banking secrecy to non-residents, and have no requirement for details of beneficial ownership of corporations and trusts to be placed on public record."76 finally, even if a foreign government discovered its citizen or resident has assets hidden in the united states, either through its own efforts or because of i.r.s. disclosure, it has no way to access those assets if the citizen or resident has evaded her taxes. the law of the united states includes the common law revenue rule, which prevents u.s. courts from enforcing foreign tax judgments.77 iii. enforcing foreign judgments in u.s. courts in general, u.s. courts both recognize and enforce foreign judgments. litigants who have received a judgment from a foreign court have "little trouble convincing courts in the united states to recognize and enforce that judgment."78 the restatement (third) of foreign relations law explains that, in general, judgments of foreign courts are "conclusive between the parties, and [are] entitled to recognition in courts in the united 70 see, e.g., susan c. morse, tax compliance and norm formation under high-penalty regimes, 44 conn. l. rev. 675, 702 (2012) ("it is perfectly clear that u.s. citizens and residents must pay u.s. taxes on their worldwide income, including income that accrues to an offshore account."). 71 i.r.c. § 6103(a), (k)(4) (2012); see also langer, supra note 33, at 2835. 72 see letter from mark j. mazur, assistant secretary (tax policy), to senator rand paul (oct. 10, 2012), 2012 tax notes today 201-18. 73 treas. reg. § 1.6049-4(b)(5) (2012). 74 see t.d. 9584, 2012-20 i.r.b. 901 ("these regulations will facilitate intergovernmental cooperation on fatca implementation by better enabling the irs, in appropriate circumstances, to reciprocate by exchanging information with foreign governments for tax administration purposes."); see infra notes 208-222 and accompanying text. 75 john christensen, the hidden trillions: secrecy, corruption, and the offshore interface, 57 crime, l. & soc. change 325, 329 (2012). 76 id.at 335. not everybody is sanguine about calling the u.s.—or these particular states—tax havens, of course. see, e.g., howard m. liebman, letter to the editor, tax haven claim overstated for u.s. states, 54 tax notes int’l 147, 147 (2009) ("without wishing at all to cast aspersions on any government leader, i think it overstates the case rather seriously to claim that delaware, nevada, and wyoming are tax havens."). 77 see pasquantino v. united states, 544 u.s. 349 (2005). 78 william j. kovatch, jr., recognizing foreign tax judgments: an argument for the revocation of the revenue rule, 22 hous. j. int’l l. 265, 266 (2000). 180 columbia journal of tax law [vol.5:170 states."79 even though the judgments of foreign courts are not entitled to full faith and credit in the united states, recognizing and enforcing them furthers public policy by ensuring an end to litigation.80 exceptions exist, of course. defendants have a number of defenses against recognition that they can present.81 if the defendant demonstrates that the foreign country does not have impartial tribunals or procedures that comport with due process, or that the foreign court did not have jurisdiction over the defendant, u.s. courts cannot recognize or enforce the judgment.82 moreover, defendants can present additional defenses, including that the cause of action or the judgment contravenes u.s. public policy, that give u.s. courts the option of not recognizing or enforcing the judgment.83 state law governs the recognition and enforcement of foreign judgments, which could provide for significant variation, notwithstanding the restatement, in the recognition and enforcement of foreign judgments.84 the actual variation, though, is slight: all states either follow a common law standard derived from hilton v. guyot,85 or they have adopted a version of uniform act governing the recognition of foreign judgments.86 in hilton, the supreme court established the common law rule that foreign judgments can be recognized and enforced by u.s. courts where there has been opportunity for a full and fair trial abroad before a court of competent jurisdiction, conducting the trial upon regular proceedings, after due citation or voluntary appearance of the defendant, and under a system of jurisprudence likely to secure an impartial administration of justice between the citizens of its own country and those of other countries, and there is nothing to show either prejudice in the court, or in the system of laws under which it was sitting, or fraud in procuring the judgment, or any other special reason why the comity of this nation should not allow it full effect.87 in addition to these criteria, the supreme court held that foreign judgments would only be enforced by u.s. courts if the foreign country enforced u.s. judgments; international law, it held, "is founded upon mutuality and reciprocity."88 if the foreign judgment met these criteria, the merits of the case should not be retried in a u.s. court.89 rather, absent the defendant’s demonstrating that the judgment was unfair, courts generally find foreign judgments presumptively valid.90 79 restatement (third) of foreign rel. l. § 481(1) (1987). 80 restatment (second) of conflict of laws § 98 cmt. b (1971). 81 id. § 482 cmt. 1. 82 id. § 482(1). 83 id. § 482(2)(d). 84 cedric c. chao & christine s. neuhoff, enforcement and recognition of foreign judgments in united states courts: a practical perspective, 29 pepp. l. rev. 147, 148 (2001). 85 159 u.s. 113 (1895). 86 chao & neuhoff, supra note 84, at 148; see infra notes 96-97 and accompanying text. 87 hilton, 159 u.s. at 202. 88 id. at 228. 89 id. at 203. 90 chao & neuhoff, supra note 86, at 149. 2014] the u.s. as tax haven? 181 states that followed the common law often faced a problem, however: foreign countries did not always understand that u.s. courts would enforce foreign judgments.91 if the foreign country did not believe that the state’s courts would enforce foreign judgments, it would often refuse to enforce judgments from the state’s courts.92 the national conference of commissioners on uniform state laws drafted the uniform foreign money-judgments recognition act of 1962 (ufmjra) to respond to this concern. the drafters intended for the ufmjra to codify the common law, not to change it.93 by doing so, they believed, foreign governments would be more likely to recognize the judgments of u.s. courts by providing a statutory basis to which foreign courts could look in determining whether a state court granted reciprocity.94 more than four decades later, the commissioners drafted the uniform foreign-country money judgments recognition act (ufcmjra) to update, clarify, and correct problems with the ufmjra.95 seventeen states, the district of columbia, and the virgin islands have enacted some version of the ufmjra, 96 while seventeen states have adopted the ufcmjra.97 in states that have adopted either of the uniform acts, courts treat foreign judgments as enforceable, unless the defendant can prove a reason for non-enforcement.98 as a practical matter, the method of enforcing a foreign judgment is determined under state law, and can vary from state to state.99 the uniform acts, however, provide some sense of order. the ufmjra provides that foreign judgments will be enforced in the same method as sister-state judgments would be enforced.100 the drafters of the ufcmjra decided to simplify the method even more, writing that a foreign country money judgment "is enforceable in the forum state in accordance with the procedures for enforcement in the forum state and to the same extent that a judgment of the forum state would be enforceable."101 no uniform procedure exists for a successful foreign plaintiff 91 see, e.g., barbara kulzer, recognition of foreign country judgments in new york: the uniform foreign money-judgments recognition act, 18 buff. l. rev. 1, 1 (1968) ("their concern has not been so much with the substantive law now in force in most of the states but with the comprehension—or lack of it— of that law on the part of foreign countries."); adolph homburger, recognition and enforcement of foreign judgments: a new yorker reflects on uniform acts, 18 am. j. comp. l. 367, 370 (1970) (the common law recognition of foreign judgments "a serious problem of communication between two legal systems, one grounded on the doctrine of precedent and the other on the supremacy of code law."). 92 ronald a. brand, enforcement of foreign money-judgments in the united states: in search of uniformity and international acceptance, 67 notre dame l. rev. 253, 255 (1991) ("in the international arena, enforcement of united states judgments overseas is often possible only if the united states court rendering the judgment would enforce a similar decision of the foreign enforcing court."). 93 kulzer, supra note 91, at 5. 94 13 u.l.a. (pt. ii) 40 (2002). 95 13 u.l.a. (pt. ii) 27 (supp. 2012). 96 id. at 39. 97 id. at 18. 98 unif. foreign money-judgments recognition act § 3, 13 u.l.a. (pt. ii) 49 (2002); unif. foreign-country money judgments recognition act § 4(a), 13 u.l.a. (pt. ii) 26 (supp. 2012). 99 see robert v. von mehren, enforcement of foreign judgments in the united states, 17 va. j. int'l l. 401, 404 (1977) ("consideration of u.s. procedures and remedies available to enforce foreign judgments is complicated by the fact that each of the fifty states has its own detailed rules governing these matters."). 100 unif. foreign money-judgments recognition act § 3, 13 u.l.a. (pt. ii) 49 (2002) ("the foreign judgment is enforceable in the same manner as the judgment of a sister state which is entitled to full faith and credit."). 101 unif. foreign-country money judgments recognition act § 7 cmt. c, 13 u.l.a. (pt. ii) 37 (supp. 2013). 182 columbia journal of tax law [vol.5:170 to have a u.s. court enforce a foreign judgment.102 in many states that have adopted one of the uniform acts, however, plaintiffs may choose to initiate the enforcement through an expedited procedure (such as a motion for summary judgment) rather than filing a complaint.103 iv. the revenue rule one significant exception exists to u.s. courts’ willingness to enforce foreign money judgments: tax judgments. "under the 'revenue rule,' the courts of the united states are under no obligation to recognize or enforce a foreign tax judgment."104 beyond merely having no obligation, though, the revenue rule may in fact prohibit u.s. courts from recognizing foreign tax judgments. 105 and codification of the enforcement of foreign judgments did not affect the revenue rule; as part of the codification, the ufmjra removed judgments for taxes from its definition of a "foreign judgment,"106 while the ufcmjra states that it does not apply to judgments for taxes.107 a. roots of the revenue rule the revenue rule traces its roots to the english common law. in two cases in the eighteenth century, lord mansfield established in dicta that english courts would not enforce foreign tax judgments. in holman v. johnson, a case resolving a contractual dispute, mansfield wrote that "no country ever takes notice of the revenue law of another."108 then, four years later, he held that a ship’s avoiding french customs duties did not constitute fraud because "[o]ne nation does not take notice of the revenue laws of another."109 although originally dicta, the revenue rule continued to play a part in british law and, even today, continues to be the law of the united kingdom.110 moreover, the united states imported the revenue rule as part of its common law.111 originally, u.s. courts applied the revenue rule even to tax judgments from sister states.112 in 1935, though, 102 restatement (third) of foreign rel. l. § 481 cmt. g (1987). 103 id. 104 kovatch, supra note 78, at 267. 105 according to the restatement, courts’ nonrecognition of foreign tax judgments is permitted, but is not required. restatement (third) of foreign rel. l. § 483 cmt. a. it is not clear, however, that the restatement is correct; even as the supreme court narrowed the scope of the revenue rule in pasquantino, it explained that the revenue rule "prohibited the collection of tax obligations of foreign nations." pasquantino v. united states, 544 u.s. 349, 361 (2005). 106 unif. foreign money-judgments recognition act § 1(2), 13 u.l.a. (pt. ii) 44 (2002). 107 unif. foreign-country money judgments recognition act § 3(b)(1), 13 u.l.a. (pt. ii) 23 (supp. 2012). 108 holman v. johnson, 98 eng. rep. 1120, 1121 (1775). 109 planche v. fletcher, 99 eng. rep. 164, 165 (1779). 110 see generally brenda mallinak, the revenue rule: a common law doctrine for the twentyfirst century, 16 duke j. comp. & int’l l. 79, 89–92 (2006). 111 id. at 84 ("state courts adopted the revenue rule as part of the common law heritage inherited from england . . . ."). 112 see, e.g., henry v. sargeant, 13 n.h. 321, 331 (1843) ("it is said that the court will not notice the penal laws, or the revenue laws, of another state."); state of colorado v. harbeck, 133 n.e. 357, 359 (1921) ("under the due process clause of the united states constitution, where the delinquents are nonresidents of the taxing state and outside its jurisdiction, so that no personal liability or enforceable duty may be established as against them, and where the property involved is without the taxing state, so that no res exists upon which the taxing state may impose a lien, the state is powerless to collect the tax in its own courts, and powerless to invoke the aid of a sister state to collect its revenue."). 2014] the u.s. as tax haven? 183 based on the full faith and credit clause of the constitution, the u.s. supreme court eliminated the revenue rule’s prohibition on enforcing tax judgments as between states.113 in 1979, the ninth circuit addressed whether the supreme court’s decision in milwaukee also eliminated the revenue rule with respect to foreign governments. her majesty the queen ex rel. british columbia v. gilbertson concerned several u.s. citizens who engaged in logging in british columbia.114 the government of british columbia assessed tax on their logging income, and filed a certificate of assessment in the supreme court of british columbia.115 this certificate of assessment had the same effect as a final judgment under british columbia law.116 british columbia then filed a suit in the united states seeking recognition and enforcement of the tax judgment.117 british columbia argued that the same reasoning that overturned the revenue rule between sister states should apply to eliminate the revenue rule with respect to tax judgments of foreign governments, too.118 the court held, however, that the constitution contains "no provision similar to the full faith and credit clause . . . which would require that the courts of this country extend full faith and credit to the judgments of a foreign country."119 as a result of the revenue rule, the court held that it could not enforce canada’s tax judgment.120 when the ninth circuit affirmed the continuing validity of the revenue rule, it pointed to both its long history as a part of the law and the valid reasons that originally underlay (and continue to underlie) its existence.121 at the same time, it said that if the rule were to be changed, that would be the role of the "policy-making branches of our government."122 in general, however, the policy-making branches of government have made no move toward changing the revenue rule. 123 congress has not passed any legislation that would permit courts to enforce foreign tax judgments.124 b. the revenue rule today not content with merely passively permitting the revenue rule to continue, in several instances, the government has expressly acted to perpetuate it. the 2006 model income tax convention, for example, does not include any provisions permitting the enforcement of tax judgments.125 likewise, of the united states’ sixty-eight income tax 113 milwaukee cnty. v. m.e. white co., 296 u.s. 268, 279 (1935) ("we conclude that a judgment is not to be denied full faith and credit in state and federal courts merely because it is for taxes."). 114 597 f.2d 1161, 1162 (9th cir. 1979). 115 id. 116 id. 117 id. at 1163. 118 id.at 1164 n.8. 119 id. 120 id. at 1166. interestingly, though the court did not rely on reciprocity, it pointed out that canadian law also includes the revenue rule, and canadian courts have refused to enforce u.s. tax judgments. id. 121 her majesty the queen ex rel. british columbia, 597 f.2d at 1166. 122 id. 123 the united states has embraced five exceptions by treaty. see infra note 249 and accompanying text. 124 see, e.g., joint committee on tax’n, tax compliance and enforcement issues with respect to offshore accounts and entities 43 (2009) ("although its vitality and scope have been questioned, . . . the [revenue rule] doctrine remains a cornerstone of all common law jurisdictions . . . ."). 125 lee a. sheppard, will u.s. hypocrisy on information sharing continue?, 138 tax notes 253, 254 (2013) ("the u.s. treaty with canada contains an 'assistance in collection' article, which does not appear in the u.s. model treaty, in addition to the standard information exchange article."). 184 columbia journal of tax law [vol.5:170 treaties currently in force,126 only five include provisions permitting the enforcement of foreign tax judgments.127 moreover, the u.s. originally ratified treaties with four of the five countries in the 1930s and 1940s. 128 by the 1950s, the senate had become disillusioned with the collection provisions, and declined to ratify new treaties with collection provisions.129 and the government’s perpetuation of the revenue rule does not limit itself to passively perpetuating a model treaty that does not include a collection provision. in 1989, the u.s. signed the oecd convention on mutual administrative assistance in tax matters, the first multilateral tax treaty of its kind.130 the convention includes provisions requiring signatories to assist in the collection of taxes on behalf of other signatory countries. 131 the united states, however, adopted a reservation to the reciprocal collection provisions.132 by adopting this reservation, the united states surrendered its ability to require other parties to the treaty to provide assistance in collecting u.s. taxes.133 the united states apparently decided, however, that the value of the revenue rule outweighed the value of any revenue other countries could help it recover. as recently as 2005, the supreme court confirmed the continuing viability of the revenue rule. in its decision in pasquantino v. united states,134 the supreme court had to determine whether a scheme to defraud the canadian government of tax revenue violated the federal wire fraud statute. 135 while in new york, carl and david pasquantino ordered liquor from discount stores in maryland by phone.136 then, to avoid the heavy canadian excise taxes on imported liquor, they hired others to smuggle the liquor over the canadian border.137 though the jury found them guilty, and the court of appeals eventually agreed, the pasquantinos claimed that they had not committed wire fraud.138 because the revenue rule prevents the u.s. from "tak[ing] cognizance of the revenue laws of canada,"139 they argued, the wire fraud statute should be construed "to except frauds directed at evading 126 allison christians, how nations share, 87 ind. l.j. 1407, 1419 (2012). 127 attorney gen. of canada v. r.j. reynolds tobacco holdings, inc., 268 f.3d 103, 115 (2d cir. 2001). 128 brenda mallinak, the revenue rule: a common law doctrine for the twenty-first century, 16 duke j. comp. & int’l l. 79, 94 (2006). 129 id. at 95. 130 marian nash leich, u.s. practice, 84 am. j. int’l l. 237, 245 (1990). 131 oecd convention on mutual administrative assistance in tax matters art. 11, june 28, 1989, 27 i.l.m. 1160. 132 136 cong. rec. s13,295 (daily ed. sept. 18, 1990) (ratifying convention except "[t]hat the united states will not provide assistance in the recovery of any tax claim, or in the recovery of an administrative fine, for any tax"); see also council of europe treaty office, list of declarations made with respect to treaty no. 127 (2014), available at http://conventions.coe.int/treaty/commun/listedeclarations.asp?nt=127&cv=1&na=&po=999&cn=99 9&vl=1&cm=9&cl=eng. 133 see jt. comm. tax’n, explanation of proposed convention on mutual administrative assistance in tax matters 22 (1990) ("a party that has made a reservation is not permitted to require another party to observe that reserved provision of the convention."). 134 544 u.s. 349 (2005). 135 id. at 353. 136 id. 137 id. 138 id. at 353–54. 139 id. at 354. 2014] the u.s. as tax haven? 185 foreign taxes."140 they failed, however, to convince the supreme court, which found that the case law did not establish that the revenue rule barred the united states from punishing criminal conduct, even where an element of that conduct is failure to pay taxes to a foreign country.141 this was not, the court held, "a suit that recovers a foreign tax liability, like a suit to enforce a judgment."142 because this was a criminal prosecution, and not an attempt to enforce a foreign tax judgment, the revenue rule did not apply here. although the supreme court confirmed that the revenue rule still prevents u.s. courts from enforcing foreign tax judgments, it also limited the scope of the revenue rule. the pasquantinos argued not only that an attempt to defraud a foreign government of tax revenue could not support a wire fraud conviction, but that their prosecution did, in fact, enforce canada’s tax judgment. if the court upheld their conviction, they pointed out, the mandatory victims restitution act of 1996143 would require them to pay the lost tax revenue to canada.144 effectively, then, by convicting them of wire fraud, the u.s. also aided canada in its collection of tax revenue, in derogation of the revenue rule. while the supreme court acknowledged that the pasquantinos would have to pay to canada the tax liability they had attempted to evade, the court did "not think it matters whether the provision of restitution is mandatory in the prosecution."145 the purpose of the restitution requirement was to "mete out appropriate criminal punishment," 146 a purpose not at odds with the revenue rule. under pasquantino, it appears that u.s. courts have the ability to aid foreign governments with their collection of taxes provided such collection is merely a secondary result of permissible judicial action. c. rationales for the revenue rule the rationale proffered to justify the revenue rule has changed significantly since its inception. originally, courts used the revenue rule to diminish "the commercial disruption caused by the high tariffs" of the eighteenth century.147 by the middle of the twentieth century, though, the rationales for the revenue rule had shifted. in its modern form, commentators explain that the revenue rule principally works to prevent "judicial evaluation of the policy-laden enactments of other sovereigns,"148 avoid giving domestic effect to the foreign policies embodied in revenue laws,149 and avoid forcing courts to evaluate the validity of foreign tax regimes, an inquiry that u.s. courts understandably lack competence to perform.150 essentially, the principal current justification for the revenue rule is that not enforcing foreign judgments prevents u.s. courts from impinging on foreign countries’ sovereignty by reviewing their revenue laws.151 140 id. at 359. 141 id. at 362. 142 id. 143 18 u.s.c. §§ 3663a-3664 (2012). 144 pasquantino, 544 u.s. at 365. 145 id. 146 id. 147 pasquantino v. united states, 544 u.s. 407, 366 (2005). 148 id. at 368. 149 id. at 369. 150 id. at 370. 151 see, e.g., mallinak, supra note 110, at 123–24 ("the concern that underlies, at least in part, the revenue rule is that courts are reluctant to engage in evaluation of another state’s decision to raise revenue in any particular way or to discourage or encourage behavior through social engineering in the tax system."); kovatch, supra note 78, at 277 ("the justification for the revenue rule, as stated by judge learned hand, is to avoid the examination of the revenue laws and policies of other nations by u.s. courts."); richard e. smith, 186 columbia journal of tax law [vol.5:170 this justification rings hollow, though. in non-revenue contexts, u.s. courts routinely evaluate foreign judgments, and then enforce them or refuse to enforce them.152 in enforcing foreign judgments, u.s. courts must make judgments about the enforcement of or policies underlying foreign law. if a foreign plaintiff asks a u.s. court to recognize and enforce a foreign judgment other than a tax or a penal judgment, the court can and does evaluate, among other things, the fairness of the tribunal and whether the cause of action on which the plaintiff won the judgment violates u.s. public policy. 153 neither courts nor commentators, in laying out the justification for the revenue rule, have explained why evaluating foreign revenue laws is more sensitive than, for example, evaluating foreign contract law or a foreign court’s fairness. whether the u.s. court looks at revenue laws or other laws or procedures, should it decline to enforce the judgment, the u.s. court impinges on the sovereignty of the foreign country. and u.s. courts do, where appropriate, refuse to enforce foreign judgments, even where such refusal challenges a foreign country’s sovereignty. in bank melli iran v. pahlavi,154 for example, pahlavi, the sister of the former shah of iran, had signed a number of promissory notes held by two iranian banks.155 as a result of the iranian revolution, the shah and his family fled iran; the banks brought collection actions against pahlavi in iranian courts.156 the banks obtained default judgments of $32 million against her and sought to enforce those judgments under the california uniform foreign moneyjudgments recognition act.157 pahlavi filed a motion to dismiss, claiming the courts had not provided for due process of law.158 the court of appeals found the iranian courts’ judgments deficient: "pahlavi could not expect fair treatment from the courts of iran, could not personally appear before those courts, could not obtain proper legal representation in iran, and could not even obtain local witnesses on her behalf." 159 because the iranian justice system lacked even the most rudimentary due process, u.s. courts would not enforce the judgment.160 moreover, u.s. courts do not limit their careful scrutiny to judgments emanating from hostile states.161 even defendants from our allies can raise affirmative defenses to final judgments from their home countries. recently, u.s. courts have refused to recognize and enforce several final judgments from mexican courts.162 in one, pegaso note, the nonrecognition of foreign tax judgments: international tax evasion, 1981 u. ill. l. rev. 241, 256 (1981) ("the most persuasive argument against recognition of foreign nation tax claims or judgments is that the courts’ public policy review will inevitably lead to selective enforcement of such claims, creating the possibility of offending a foreign government and hindering the conduct of foreign relations."). 152 see infra section error! reference source not found.. 153 i.r.c. § 482(1), (2)(d) (2012). 154 58 f.3d 1406 (9th cir. 1995). 155 id. at 1408. 156 id. 157 id. 158 id. 159 id. at 1413. 160 id. 161 hossein mousavian, an opportunity for a u.s.-iran paradigm shift, wash q., winter 2013, at 129, 138 (both 2012 presidential candidates identifying iran as u.s.’s chief middle eastern threat). 162 timothy g. nelson, down in flames: three u.s. courts decline recognition to judgments from mexico, citing corruption, 44 int’l law. 897, 913 (2010). 2014] the u.s. as tax haven? 187 sued bell helicopter for breach of contract in mexico city civil court. 163 pegaso ultimately won, and both companies provided the mexican trial court with expert damage reports.164 the experts’ damages calculations differed by more than $10 million, though, so the judge appointed an independent expert.165 bell claimed that the judge did not follow mexican law in selecting the independent expert, and that the expert solicited a bribe from bell.166 when bell refused to pay the bribe, the expert issued a report finding damages that exceeded even those calculated by pegaso’s expert.167 the delaware court found that it could not enforce the mexican judgment, inasmuch as the evidence indicated it had been fraudulently obtained, with both the judge and the expert acting illegally.168 in a second mexican judgment involving judicial fraud, u.s. courts also refused to enforce the foreign final judgment. 169 richard greene and john robert burke started a restaurant and cantina in cabo san lucas, mexico.170 the business soon ran into trouble, and burke allegedly signed an i.o.u. for $250,000.171 greene eventually filed a lawsuit in the court of first instance in cabo san lucas, and, burke alleged, he bribed the judge to enter the i.o.u. into the court system without informing burke.172 by the time a u.s. court was asked to enforce the judgment, evidence existed indicating that not only had green bribed the judge, but later the judge had become greene’s attorney.173 moreover, the settlement agreement had other serious problems.174 as a result, the u.s. court held that the judgment was "so deficient—or to use judge blackburn’s term, 'riddled'—with questionable features, irregular court proceedings, disputed legitimacy and contested translations, an absence of due process and, yes, evident fraud, that the court cannot conclude that [it is] valid, legitimate or that [it] should not be set aside."175 in each of these cases, a u.s. court judged whether a foreign court’s decision resulted from a fair process. in determining that the judges had acted fraudulently and that defendants had not received due process, the u.s. courts judged the actions of foreign government actors. notwithstanding the sovereignty of these foreign nations, the u.s. courts decided not to recognize and enforce their final judgments. there is no reason to think that u.s. courts would not similarly exercise such judgments when asked to enforce foreign revenue claims. the sovereignty justification for the revenue rule thus appears to fall flat. v. a framework for revocation: policy considerations as discussed above, the revenue rule does not present the sole, or perhaps even the most significant, obstacle to foreign governments’ preventing tax evasion by their citizens and residents. why, then, do i advocate eliminating the revenue rule, rather than 163 transportes aeroeos pegaso, s.a. de c.v. v. bell helicopter textron, inc., 623 f. supp. 2d 518, 523 (d. del. 2009). 164 id. at 524. 165 id. at 524–25. 166 id. at 525–26. 167 id. at 526. 168 id. at 538. 169 in re burke, 374 b.r. 781, 784 (bankr. d. colo. 2007). 170 id. 171 id. at 785. burke denied ever signing an i.o.u., though he admitted to having signed blank letterhead, onto which the i.o.u. may have later been written. id. at 786. 172 id. at 787–88. 173 id. at 796. 174 id. 175 id. at 800. 188 columbia journal of tax law [vol.5:170 tackling these other problems? primarily because there are justifications for the other rules, or federalism impediments to reforming them. the justifications for the initial creation of the revenue rule, on the other hand, no longer have the same relevance in today’s economy, and the federal government could statutorily eliminate the revenue rule. moreover, the fact that the united states has effectively eliminated the revenue rule in five treaties indicates that, notwithstanding its common law pedigree and age, the revenue rule is not an irrevocable piece of u.s. law. a. other potential reforms, while meritorious, are less achievable congress could, if it desired, repeal the various exclusions for interest income received by nonresident aliens. such a repeal seems unlikely, though. interest on bank deposits has been exempt in the hands of nonresident aliens for a long time, in spite of attempts to repeal it. the reasoning behind the exemptions—to facilitate the flow of foreign funds into the u.s.—seems as relevant today as it has been in the past. moreover, congress has expanded, rather than contracted, the types of interest income exempt from u.s. taxation. more than ninety years ago, congress exempted nonresident aliens from paying taxes on bank deposit interest they received.176 the revenue act of 1921177 exempted nonresident aliens from paying taxes on interest earned from u.s. bank deposits to "encourage deposits in american banks by nonresident aliens." 178 the treasury department testified that these deposits were often related to business transactions, and that exempting the interest would aid foreign and international trade. 179 by 1966, congress decided to repeal this exemption, questioning whether interest paid to nonresident aliens on u.s. bank deposits, "which is so clearly derived from u.s. sources, should . . . escape u.s. taxation."180 recognizing that repealing this exclusion could affect the amount of foreign direct investment in the u.s., however, congress delayed the implementation of the repeal.181 ultimately, instead of going through with the repeal, congress chose to make the exemption for bank deposit interest permanent, 182 presumably after "considering the impact that the removal of this exemption would have on the balance-of-payments."183 moreover, in 1984, congress expanded the types of u.s.-source interest nonresident aliens could receive tax-free by enacting the portfolio interest rules.184 the portfolio interest rules exempt nonresident aliens from tax on certain u.s.-source interest income they receive. 185 congress passed these rules to facilitate u.s. companies’ 176 see martin-montis v. comm’r, 75 t.c. 381, 384 (1980). 177 pub. l. no. 67-98, 42 stat. 227 (1921). 178 hearings on h.r. 8245 before the s. comm. on finance, 67th cong. 65 (1921) (statement of dr. t.s. adams, tax advisor, treasury dep’t). 179 id. 180 foreign investors tax act of 1966, h.r. 13103, 89th cong., reprinted in 1966-2 c.b. 1059, 1066. 181 id. ("at the same time, however, your committee realizes that an immediate alteration of the present source rule might have a substantial adverse effect on our balance of payments. to meet these two quite different problems your committee has adopted the provisions of the house bill which repeal this special foreign-source rule (exclusion from taxable u.s. income) but also postpone the effective date of the repeal until after 1971."). 182 martin-montis v. comm’r, 75 t.c. 381, 384 (1980). 183 h.r. 13103, supra note 180, at 1066. 184 deficit reduction act of 1984, h.r. 4170, 98th cong. § 127 (1984). 185 i.r.c. § 871(h) (2012). 2014] the u.s. as tax haven? 189 borrowing from foreign lenders on the eurobond market.186 because borrowers on the eurobond market must pay interest net of taxes, u.s. borrowers would have to pay interest and, in addition, taxes, raising their borrowing costs.187 to avoid these additional borrowing costs, u.s. corporations formed offshore finance subsidiaries to borrow without facing u.s. withholding taxes.188 concerned that taxing portfolio interest paid to nonresident aliens would impair the flow of foreign money to u.s. businesses, congress chose to exempt it instead.189 congress has had the chance to impose taxes on u.s.-source interest flowing to nonresident aliens. not only has it decided to keep the exemption, it eventually expanded the types of interest exempt from u.s. taxation. congress’s actions demonstrate its belief that reducing the tax burden on foreigners increases the inflow of foreign money to u.s. borrowers and banks, and that receiving foreign portfolio investment is desirable. because the justification for exempting interest paid to foreigners from taxation has proven durable and convincing, congress is unlikely to change it solely to prevent tax evasion by foreign persons. this aspect of the u.s. tax system is therefore likely to continue to be attractive for foreigners who want to hide their assets from their governments. congress is also unlikely to eliminate the secrecy available to the owners of business entities in some states. in the united states, state governments, rather than the federal government, provide the bulk of regulation of business entities.190 and states have 'strong interests in regulating their corporations' internal affairs." 191 since the 1930s, scholars have debated whether state-regulated corporation law leads to a race to the bottom or to the top,192 but, either way, states, and not the federal government, have controlled how much a non-publicly-traded business entity must disclose about its ownership structure.193 the federal government is unlikely to try to overrule state laws to help foreign governments discover tax evaders. unlike the preceding issues, the federal government can easily overrule the revenue rule. all congress needs to do is pass a law permitting (or requiring) courts to enforce foreign governments’ tax judgments; statutory law "displaces any conflicting common law rules."194 not only can the u.s. overrule the revenue rule: it has done so in a handful of situations. eliminating the revenue rule would do no harm to the united states. in fact, it could actually assist the i.r.s. in collecting taxes from united states taxpayers hiding assets in foreign countries. 186 staff of joint comm. on tax’n, 98th cong., 2d sess., general explanation of the revenue provisions of the deficit reduction act of 1984 389 (joint comm. print 1984). 187 id. 188 id. 189 id. at 391. 190 lucian arye bebchuk, federalism and the corporation: the desirable limits on state competition in corporate law, 105 harv. l. rev. 1437, 1438 (1992). 191 douglas g. smith, a federalism-based rationale for limited liability, 60 ala. l. rev. 649, 668 (2009). 192 see lawrence a. cunningham, a new product for the state corporation law market: audit committee certifications, 1 berkeley bus. l.j. 327, 364 & n.116 (2004). 193 see dep’t of the treasury financial crimes enforcement network, the role of domestic shell companies in financial crime and money laundering: limited liability companies 8–9 (2006), available at http:// www.fincen.gov/llcassessment_final.pdf. 194 daniel a. farber & philip p. frickey, in the shadow of the legislature: the common law in the age of the new public law, 89 mich. l. rev. 875, 888 (1991). 190 columbia journal of tax law [vol.5:170 b. reciprocity and revocation that the u.s. could revoke the revenue rule does not mean that it will. it has had openings to do so in the past and, with the exception of the u.s.-canada income tax treaty, has chosen not to. if the revenue rule went away, some portion of the foreigners hiding their assets from their home governments would move those assets to another country that provided secrecy, low taxes, and that would not enforce foreign judgments. to keep foreign investment, would seem to entail a race to the bottom, with every country (the united states included) trying to offer a better tax package to attract foreign investment.195 even if capital-importing countries engage in a race to the bottom, though, the u.s. should not, as a normative matter, permit foreigners to use it as a tax haven.196 although each country fundamentally and necessarily exercises sovereignty over its own tax system, the oecd, in its attempts to control harmful tax competition, has begun to articulate in implied international social contract.197 under this implied social contract, countries have the responsibility of "creating a level playing field for all countries."198 to the extent that the u.s. works to attract foreign investment by undercutting other countries’ tax regimes, the u.s. violates this implied social contract. but justifying the repeal of the revenue rule need not rest solely on the united states altruistically following an implied international norm. abolishing the revenue rule could provide tangible benefits to the united states. in determining whether it will enforce another country’s non-revenue judgments, courts often look at whether the other country would reciprocally enforce its judgments.199 if the united states revoked the revenue rule and began to enforce foreign countries’ tax judgments, other countries would potentially reciprocate, enforcing u.s. tax judgments against assets in those countries. reciprocity is neither necessary nor sufficient, of course, to cause other countries to enforce u.s. tax judgments. british common law, for example, does not require reciprocity for courts to enforce foreign judgments.200 likewise, in the united states, it appears that reciprocity is not absolutely necessary. 201 even though reciprocity is 195 see, e.g., rosenzweig, supra note 27, at 954 ("[m]ost of the incentive-based analyses of tax havens in the legal literature . . . assume[s] a 'race to the bottom' model that can be resolved through common interests in cooperation."); michael littlewood, tax competition: harmful to whom?, 26 mich. j. int'l l. 411, 413 (2004) ("one problem with this strategy is that it might lead to a 'race to the bottom.' if one country seeks to attract foreign investment by offering preferential tax treatment . . ., other countries might be more generous still."). 196 kovatch, supra note 78, at 282–83 ("the united states should not allow itself to be used as a haven for those who have rightfully incurred a tax liability in another nation and wish to evade that liability."). 197 allison christians, sovereignty, taxation and social contract, 18 minn. j. int'l l. 99, 101–02 (2009). 198 id. at 127. 199 see, e.g., her majesty the queen in right of province of british columbia v. gilbertson, 597 f.2d 1161, 1163-64 (9th cir. 1979) ("before comity may be extended, generally there is a requirement of reciprocity, which is the principle that the courts of one jurisdiction will recognize a judgment from a second jurisdiction only if the courts of the second jurisdiction would recognize a judgment from the first jurisdiction's courts."); hilton v. guyot, 159 u.s. 113, 227 ("[t]he rule of reciprocity has worked itself firmly into the structure of international jurisprudence."). 200 dow jones & co. v. harrods, ltd., 237 f. supp. 2d 394, 429 n.136 (s.d.n.y. 2002). 201 see restatement (second) of conflict of laws § 98 cmt. f (1988) ("except when otherwise required by local statute, the great majority of state and federal courts have extended recognition to judgments of foreign nations without regard to any question of reciprocity."). 2014] the u.s. as tax haven? 191 unnecessary in the u.s., however, courts still evaluate whether the foreign country would reciprocate, at least in the revenue context.202 moreover, even if the united states and britain do not require reciprocity, many countries do require it before they will enforce foreign judgments.203 if the u.s. decided to revoke the revenue rule through treaties, rather than through a change in domestic law, reciprocity would assume a central role in the revocation. the terms of bilateral income tax treaties are reciprocal, at least formally.204 if the u.s. agreed to enforce a treaty partner’s tax judgments, that treaty partner would simultaneously agree to enforce u.s. tax judgments. the multilateral treaty context illustrates even more strongly the centrality of reciprocity. the oecd convention on mutual administrative assistance in tax matters expressly allows for signatories to take a reservation to the mutual enforcement provisions. 205 if a country makes such a reservation, however, it cannot require other signatories to enforce its tax judgments, even if they took no such reservation.206 moreover, recent history indicates that even a unilateral decision by the united states to enforce foreign tax judgments could affect significant worldwide change. in 2010, in the wake of the ubs tax-evasion scandal, congress passed the foreign account tax compliance act (“fatca”).207 fatca requires foreign financial institutions to report information about accounts held by u.s. persons and about foreign entities with significant u.s. ownership.208 the reportable information includes, among other things, identifying information about the owner of the account and the balance of the account.209 foreign financial institutions that failed to make the disclosures required under fatca would face a 30 percent withholding on certain payments from withholding agents.210 the united states indicated that it could, by virtue of the coercive value of fatca’s withholding provisions, use fatca to obtain information about hidden foreign accounts unilaterally. 211 rather than asking foreign governments to share information, the u.s. would leverage "the combined weight of u.s. financial markets and financial institutions that must, as a practical matter, do business in the u.s. marketplace" 202 her majesty the queen in right of province of british columbia, 597 f.2d at 1165–66 ("while reciprocity may no longer be a requirement, it certainly remains a factor which may be considered in deciding whether to recognize a foreign country’s judgment for taxes."). 203 dow jones & co., 237 f. supp. at 429 n.136 ("[reciprocity] remains a recognized practice or consideration in giving recognition to judgments or proceedings of [non-british] sovereign states."). 204 diane ring, democracy, sovereignty and tax competition: the role of tax sovereignty in shaping tax cooperation, 9 fla. tax rev. 555, 584 (2009). the formal reciprocity may not always translate into reciprocal treatment, though, if one of the countries is a net capital exporter, while the other is a net capital importer. id. 205 oecd convention on mutual administrative assistance in tax matters art. 30(1)(b), supra note 131. 206 id. art. 30(5) ("a party which has made a reservation in respect of a provision of this convention may not require the application of that provision by any other party . . . ."). 207 itai grinberg, the battle over taxing offshore accounts, 60 ucla l. rev. 304, 334 (2012) ("in 2010, following the ubs scandal and president obama's campaign commitment to crack down on offshore tax evasion, the u.s. congress enacted sections 1471 to 1474 (generally known as fatca) of the internal revenue code."). 208 i.r.c. § 1471(b) (2012). 209 id. § 1471(c). 210 id. § 1471(a). 211 lee a. sheppard, getting serious about offshore evasion?, 125 tax notes 493, 493 (2009) ("[fatca] continues the unilateral approach to address tax evasion by u.s. residents."). 192 columbia journal of tax law [vol.5:170 to force compliance.212 but even as the u.s. implemented fatca, it appears to have understood the problematic nature of such unilateral action.213 in mid-2012, emily mcmahon, acting treasury assistant secretary for tax policy, acknowledged that complying with fatca could conflict with some countries’ laws, including laws prohibiting financial institutions from disclosing information about account holders. 214 the u.s. could resolve these problems by entering into intergovernmental agreements.215 the united states, france, germany, italy, spain, and the united kingdom issued a joint statement proposing an alternative, and less problematic, framework. 216 instead of each foreign financial institution providing information directly to the u.s., a country could enter into an agreement in which its financial institutions would report the required information to their government, which would, in automatically provide that information to the i.r.s.217 the u.s. would provide reciprocal promises to its partner countries.218 and this bilateral approach to fatca appears to be working: the u.s. has held discussions about intergovernmental fatca agreements with more than seventy-five countries.219 these discussions have resulted in nine agreements so far.220 what began as a unilateral move by the united states to address tax evasion by u.s. persons is transforming into a multilateral attempt to disclose hidden financial accounts. 221 similarly, by revoking the revenue rule, either unilaterally or through bilateral or multilateral treaties, the u.s. could encourage other countries to likewise enforce foreign tax judgments. providing developing economies with the ability to satisfy their tax 212 grinberg, supra note 207, at 336. 213 among other problems with the unilateral imposition of fatca, it does not give foreign governments any control of what information their resident financial institutions must provide to the u.s., how the u.s. collects that information, or how the u.s. can use the information. david t. moldenhauer, fatca and fiscal sovereignty, 132 tax notes 528, 529 (2011). moreover, its withholding provisions could "create a precedent for other countries to use confiscatory taxation of the global financial system as a tool to achieve their own tax or foreign policy goals." id. at 530. 214 shamik trivedi, fatca final regs expected by summer’s end, mcmahon says, 135 tax notes 1559, 1559 (2012). 215 id. 216 press release, u.s. dep’t of treasury, joint statement from the united states, france, germany, italy, spain and the united kingdom regarding an intergovernmental approach to improving international tax compliance and implementing fatca (feb. 7, 2012), available at http://www.treasury.gov/resource-center/tax-policy/treaties/documents/fatca-joint-statement-us-fr-gerit-sp-uk-02-07-2012.pdf. 217 id. 218 id. note, however, that the reciprocity offered by the united states may not be perfect. under current law, fatca demands more information from other countries than the u.s. is capable of providing to them. stephen nauheim & nils cousin, the evolving fatca guidance, 54 tax mgmt. memorandum 163, 177 (2013). although the united states has promised to pursue legislation and regulations that would provide its counterparties with the same level of information it requires from them, "it is less certain whether such changes are feasible." id. 219 randall jackson, aba section of taxation meeting: treasury looking to accelerate iga creation, 139 tax notes 889, 889 (2013). 220 as of june 11, 2013, the u.s. had entered into intergovernmental fatca agreements with the united kingdom, denmark, mexico, ireland, switzerland, norway, spain, germany, and japan. u.s. dept. of the treasury, fatca-archive, http://www.treasury.gov/resourcecenter/tax-policy/treaties/pages/fatca-archive.aspx (last visited aug. 16, 2013). 221 see itai grinberg, emerging countries and the taxation of offshore accounts 12 (april 22, 2013) (unpublished manuscript) ("indeed, a number of technical features of the model i [intergovernmental agreement] are structured to allow fatca to become a global model."). 2014] the u.s. as tax haven? 193 judgments with assets held offshore will help them develop the tax-collection infrastructure they need to truly become independent of foreign assistance. c. economic imperialism although recognizing and enforcing any foreign judgments risks evaluating foreign legal regimes, and thus impinging on foreign sovereignty, refusing to enforce revenue judgments also arguably prevents economic imperialism by the united states. repealing the revenue rule would risk economic imperialism if it pressured developing countries to enact tax regime that conformed with u.s. standards. and foreign countries—especially developing countries—would risk feeling this pressure if they believed that the u.s. would enforce their tax judgments, but only if they enacted a u.s.style income tax. if they believed that u.s. courts would refuse to enforce tax laws that differ to radically from the u.s. tax regime, or that are not based on u.s. conceptions of tax fairness, developing economies would face significant pressure to design tax systems that look like the u.s.’s, even where they would prefer to impose tax in a different manner. the risk of large economies forcing smaller economies to adopt specific tax regimes is very real. in an explicit example of economic imperialism, the oecd has attempted to force tax havens to adopt specific tax policies.222 at the same time, policies that may not intend to force foreign countries to adopt (or reject) certain taxes may, nonetheless, impose a developed country’s tax preferences on a developing country. the united states, for example, allows taxpayers to take a credit for income, war profits, and excess profits taxes they pay to foreign governments.223 to qualify as a creditable tax, however, the foreign tax’s "predominant character" must be "that of an income tax in the u.s. sense."224 empirical evidence indicates that non-creditable taxes have a significant impact on foreign direct investment in a country.225 effectively, then, capital-importing countries that want u.s. persons to invest in their domestic industries face some pressure to enact income taxes in the u.s. sense in place of these non-creditable taxes, even if they would prefer to raise revenue in a different manner. moreover, the u.s.’s ability to discriminate against specific tax regimes by finding that they do not have the predominant character of a u.s. income tax is not just hypothetical. historically, many latin american countries have imposed so-called "soak-up" taxes.226 but under the treasury regulations, soak-up taxes—that is, taxes where the amount due is determined by reference to the maximum foreign tax credit a taxpayer can receive—do not qualify as income taxes in the u.s. sense.227 u.s. taxpayers 222 see richard k. gordon, on the use and abuse of standards for law: global governance and offshore financial centers, 88 n.c. l. rev. 501, 534 (2010) ("another major complaint was more substantive, that the oecd, by imposing domestic tax policies on small offshore jurisdictions was practicing 'economic imperialism' and discriminating against 'small states.'"). 223 i.r.c. § 901 (2012). 224 treas. reg. § 1.901-2(a)(ii) (2012). 225 mihir a. desai, c.fritz foley, & james r. hines jr., foreign direct investment in a world of multiple taxes, 88 j. pub. econ. 2727, 2742 (2004). 226 walter f. o’connor, tax on foreign banks: how times have changed, 15 int’l tax j. 323, 330 (1989). 227 treas. reg. § 1.901-2(c)(1) (2012). essentially, a country that passes a soak-up tax uses another country’s foreign tax credit to shift the cost of the tax from the taxpayer to the taxpayer’s home government. assume, for example, that costa rica has a soak-up tax. a u.s. corporation earns $100 in costa rica. because the united states taxes its residents on their world-wide income, the corporation will owe $35 of taxes to the u.s. i.r.c. § 11 (2012). it can receive a foreign tax credit, however, for any qualifying foreign 194 columbia journal of tax law [vol.5:170 cannot, therefore, credit soak-up taxes against their u.s. tax liability. this creates a real dilemma for developing countries in designing their tax regimes. in costa rica, for example, a significant portion of the economy relies on u.s. investment.228 in 1972, costa rica enacted a soak-up provision permitting its tax administrator to exempt a foreign taxpayer from paying all or part of her costa rican taxes if she could demonstrate that she did not get a foreign tax credit in her home country.229 the exemption was rarely invoked, however.230 nonetheless, in 2003, the i.r.s. announced that the costa rican withholding tax was a soak-up tax, and thus ineligible for the foreign tax credit.231 as a result, the costa rican tax administration issued a ruling amending its tax law. 232 because costa rica needed u.s. investment, it yielded to the u.s.’s vision of appropriate taxes at the expense of its preferred tax regime. a developing country would be justified in reading the u.s. position on soak-up taxes as applying more broadly than to just the foreign tax credit. in those rare occasions where the u.s. has abrogated the revenue rule, one factor it has considered has been the structure of the foreign country’s tax. for example, when the united states and canada decided to include a collection assistance provision in their tax treaty,233 the government "carefully considered whether and to what extent extraterritorial tax enforcement was advisable."234 the negotiators found the similarities between u.s. and canadian tax laws and procedures "of critical importance." 235 a developing country could logically conclude, reading this explanation, that if it wanted the u.s. to recognize and enforce its tax judgments, it, too, should enact an income tax patterned after the u.s. federal income tax. limiting taxpayers to taking a foreign tax credit for u.s.-style income taxes paid to foreign governments may make sense; the foreign tax credit exists to prevent taxpayers from paying tax on the same income twice.236 paying a non-income tax—a sales or property tax, for example—to a foreign government and income tax to the u.s. government does not cause a taxpayer to pay taxes on the same income twice, and thus income taxes it pays. id. § 901(a). the foreign tax credit reduces the corporation’s u.s. tax liability dollar for dollar. see michael j. graetz & michael m. o’hear, the "original intent" of u.s. international taxation, 46 duke l.j. 1021, 1045 (1997). thus, the corporation would be indifferent to taxes if costa rican taxes did not exceed $35, because, with the foreign tax credit, its net tax liability would be $35. the only difference would be the recipient of those tax dollars. 228 humberto pacheco & diego salto, costa rica’s soak-up tax provision, 46 tax notes int'l 59, 59 (2007). 229 id. 230 id. 231 rev. rul. 2003-8, 2003-1 c.b. 290. 232 pacheco & salto, supra note 228, at 59. 233 see infra notes 247-251 and accompanying text. 234 attorney gen. of canada v. r.j. reynolds tobacco holdings, inc., 268 f.3d 103, 121 (2d cir. 2001). 235 department of the treasury, technical explanation of the protocol amending the convention between the united states of america and canada with respect to taxes on income and on capital signed at washington on september 26, 1980, as amended by the protocol signed at ottawa on july 14, 1983 and the protocol signed at washington on march 28, 1984 art. 15, available at http://www.irs.gov/pub/irs-trty/canatech.pdf [hereinafter treasury technical explanation]. 236 see shannon weeks mccormack, tax shelters and statutory interpretation, 2009 u. ill. l. rev. 697, 714 (2009) ("the basic notion behind the [foreign tax] credit is to mitigate double taxation—that is, prevent taxpayers from having to pay taxes on the same income twice, once in a foreign jurisdiction and again in the united states."). 2014] the u.s. as tax haven? 195 provides no reason to allow a foreign tax credit for non-income taxes. and yet even this provision puts pressure on developing countries to eliminating non-conforming taxes. if developing countries believed that the u.s. would only recognize and enforce their tax judgments if their tax systems mimicked the u.s. tax system, they would presumably feel significant pressure to enact a u.s.-style tax system. to prevent such economic imperialism, any revocation of the revenue rule would have to make clear, in a convincing manner, that u.s. courts’ willingness to recognize and enforce foreign tax judgments would not be predicated on the foreign country having a familiar tax system.237 d. u.s. citizens and the end of the revenue rule congress’s principal objection to revoking the revenue rule seems to lie in an aversion to enforcing tax judgments against u.s. citizens. even in the five treaties in which the u.s. has agreed to abrogate the revenue rule, the united states generally will not aid in the collection of taxes owed by u.s. citizens and certain corporate residents.238 when the united states considered ratifying the convention on mutual administrative assistance in tax matters, the joint committee on taxation noted that some people argued that a reservation on the issue of enforcing foreign tax judgments "[was] appropriate, in that the united states should not be obligated to help all the potential signatory governments of the convention collect their uncontested tax claims against u.s. residents or to collect their claims against their own residents."239 the joint committee on taxation failed to explain why, however, the united states should not help collect tax claims against u.s. citizens and residents. provided the foreign country imposes the tax in a fair manner and uses a fair judicial process to come to the final judgment, there is no compelling policy reason to refuse to enforce the tax judgment. when courts enforce non-revenue judgments, they do not differentiate between citizen-defendants and non-citizen defendants. to the extent a u.s. citizen earned income reasonably taxable by a foreign country, there is no reason why she should not pay that tax. moreover, the united states does not protect its citizens from foreign tax obligations. when a u.s. person earns income taxable by a foreign country, nothing in 237 for a discussion of how the law could fairly and non-coercively evaluate unfamiliar tax regimes, see infra section error! reference source not found..error! reference source not found.. 238 convention for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income and capital, u.s.-fr., art. 28(5), aug. 31, 1994, s. treaty doc. no. 103-32 ("the assistance provided for in this article shall not be accorded with respect to citizens, companies, or other entities of the contracting state to which application is made . . . ."); convention for the avoidance of double taxation and the preservation of fiscal evasion with respect to taxes on income, u.s.-den., art. 27(8)(a), aug. 19, 1999, t.i.a.s. no. 13,056 (no assistance "where the taxpayer is an individual, the revenue claim relates to a taxable period in which the taxpayer was a citizen of the requested state"); convention for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, with exchanges and notes, u.s.-neth., art. 31(4), dec. 18, 1992, 2291 u.n.t.s. 3 ("the assistance provided for in this article shall not be accorded with respect to the citizen, corporations, or other entities of the state to which application is made . . . ."); convention for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, u.s.-swed., art. 27(4), sept. 1, 1994 ("the assistance provided for in this article shall not be accorded with respect to the citizens, companies, or other entities of the state to which the application is made . . . .); convention with respect to taxes on income and capital, u.s.-can., art. xxvi a(8)(a), sept. 26, 1980, t.i.a.s. 11,087 (no assistance "[w]here the taxpayer is an individual, the revenue claim relates to a taxable period in which the taxpayer was a citizen of the requested state."). 239 joint committee on tax’n, explanation of proposed convention on mutual administrative assistance in tax matters 8 (1990). 196 columbia journal of tax law [vol.5:170 u.s. law waives her obligation to pay taxes on that income. even tax treaties, which work to limit the double taxation of the same income, acknowledge that a foreign country can tax a u.s. person in certain circumstances.240 provided the u.s. person acted in a way that subjected her to the jurisdiction of the foreign tax law, she owes the foreign taxes. although the u.s. does not shield its citizens from paying foreign taxes, the u.s. does have revenue reasons to prefer not to enforce foreign tax judgments against residents. the u.s. allows taxpayers to apply a credit against their u.s. taxes in the amount of foreign taxes they pay.241 to the extent the u.s. enforced a foreign tax judgment, then, the taxes the u.s. collected on behalf of the foreign sovereign would reduce u.s. revenue dollar for dollar.242 because the foreign tax credit would reduce u.s. revenue, enforcing a foreign tax judgment against a u.s. citizen or resident would cost the u.s. government money. as such, even as it repeals the revenue rule, the u.s. may have a legitimate incentive to carve out of its enforcement obligation taxes owed by citizens.243 vi. a framework for revocation: administrative considerations a. judicial inquiries to avoid economic imperialism, any repeal of the revenue rule would need to cabin the inquiries u.s. courts can make. specifically, courts being asked to recognize and enforce foreign tax judgments must be limited to two inquiries. first, they can look at the fairness of the judicial procedure in the foreign country. if the procedure would not qualify for enforcement under the current common law or the applicable uniform act, it should not qualify in the revenue context. second, courts should have the ability to look at the actual imposition of the tax. in general, the united states should not make judgments about foreign tax systems. defendants should, however, have the ability to demonstrate that the tax was targeted specifically at them, rather than being generally applicable. if the tax captured a small group of people for a purpose contrary to u.s. public policy and one without a revenue explanation (e.g., because of their political beliefs, rather than because of their level of income or their business organization), a u.s. court should be able to decline to enforce the tax judgment. b. using treaties to revoke the revenue rule treaties represent a natural starting point for revoking the revenue rule. the united states is a signatory of the oecd convention on mutual administrative assistance in tax matters,244 which provides for mutual assistance in collecting taxes.245 more than sixty countries, including a number of developing economies in latin america 240 see, e.g., united states model income tax convention of 2006 art. 16(1) (allowing treaty partner to tax income of u.s. entertainers and athletes earned in the treaty country). 241 i.r.c. § 901(a) (2012). 242 id. 243 for a discussion of how to respond to the incentives raised by the foreign tax credit, see infra section error! reference source not found..error! reference source not found.. 244 see oecd, status of the convention on mutual administrative assistance in tax matters and amending protocol—19 march 2014 [hereinafter, status of the convention], available at http://www.oecd.org/tax/exchange-of-tax-information/status_of_convention.pdf (listing signatories to the convention). 245 oecd convention on mutual administrative assistance in tax matters art. 11, supra note 131. 2014] the u.s. as tax haven? 197 and africa, have either signed the convention or stated their intention to sign the convention.246 if the united states eliminated its reservation, it would, through a single action, eliminate the revenue rule with respect to all of the countries that had signed the oecd convention. and, as an additional benefit, the united states would enjoy a network of countries willing to enforce its tax judgments. alternatively, the united states could revoke the revenue rule on an individualized basis through bilateral tax treaties. models exist for how to draft such a provision. the oecd model tax treaty includes a provision requiring mutual assistance in enforcing revenue claims.247 moreover, even without the oecd model, the united states already has five tax treaties—with france, denmark, sweden, the netherlands, and canada—that provide for assistance in collecting taxes.248 these five treaties use similar language; that language could serve as a model for further revoking the revenue rule on a country-by-country basis.249 and the u.s. government may be more comfortable addressing the revenue rule on a country-by-country basis. a protocol to the u.s.-canada tax treaty providing for the mutual enforcement of tax judgments entered into effect in 1995,250 shortly after the u.s.’s 1991 ratification of the oecd convention.251 in contrast to its reservation in the convention, the u.s.-canada tax treaty provided for mutual enforcement of tax judgments.252 the joint committee on taxation explained that the reservation may have been appropriate in the context of a multilateral agreement.253 in the context of a bilateral treaty, on the other hand, the united states can evaluate the other country’s taxes, both 246 see status of the convention, supra note 244. 247 oecd model tax convention on income and on capital art. 27 (2010) ("the contracting states shall lend assistance to each other in the collection of revenue claims.'). moreover, looking to the oecd model treaty makes sense; though the u.s. has its own model tax treaty, it has based various of its treaties on oecd tax treaties. see nat. westminster bank, plc v. united states, 512 f.3d 1347, 1352 (fed. cir. 2008) ("the 'entire context' of the 1975 treaty is informed by, and is based on, the office of economic cooperation and development’s . . . 1963 draft double taxation convention on income and capital.”). 248 attorney gen. of canada v. r.j. reynolds tobacco holdings, inc., 268 f.3d 103, 116 n.11 (2d cir. 2001). the united states signed treaties with the first four of these countries in the 1930s and 1940s; by the end of the 1940s, the senate "sought to limit the extent to which united states courts and agencies would be obligated to render foreign tax collection assistance." id. at 116. 249 u.s.-france income tax treaty art. 28, supra note 238 (“the contracting states undertake to lend assistance and support to each other in the collection of the taxes to which this convention applies . . . in cases where the taxes are definitively due according to the laws of the state making the application.”); u.s.denmark income tax treaty art. 27, supra note 238 (“the contracting states undertake to lend assistance to each other in the collection of taxes referred to in article 2 (taxes covered), together with interest, costs, additions to such taxes, and civil penalties, referred to in this article as a ‘revenue claim.’”); u.s.netherlands income tax treaty art. 31, supra note 238 (“the states undertake to lend assistance and support to each other in the collection of the taxes which are the subject of the present convention, together with interest, costs, and additions to the taxes and fines not being of a penal character.”);u.s.-sweden income tax treaty art. 27, supra note 238 (“the contracting states undertake to lend assistance and support to each other in the collection of the taxes to which this convention applies, together with interest, costs, and additions to such taxes.”); u.s.-canada income tax treaty art. xxvia a, supra note 238 (“the contracting states undertake to lend assistance to each other in the collection of taxes referred to in paragraph 9, together with interest, costs, additions to such taxes and civil penalties, referred to in this article as a ‘revenue claim’.”). 250 attorney gen of canada, 268 f.3d at 119. 251 benjamin berk, et al., united states activities of foreigners and tax treaties, 45 tax law. 1391, 1393 (1992). 252 u.s.-canada income tax treaty art. xxvi a, supra note 238. 253 joint committee on tax’n, explanation of proposed protocol to the income tax treaty between the united states and canada 42–43 (1995). 198 columbia journal of tax law [vol.5:170 substantively and from a procedural perspective, as well as evaluating broader policy issues.254 renegotiating its existing treaties would require a significant investment of time and effort by the united states. still, such renegotiation is at least possible. 255 renegotiating income tax treaties would not significantly help developing countries establish their revenue systems, however, unless the united states had treaties with developing countries. and, by and large, the united states does not.256 of the roughly 62 countries with which the united states has entered into tax treaties, only 16 are developing countries.257 this lack of tax treaties with developing countries does not result solely from the united states’ lack of interest in such treaties.258 structurally, though, tax treaties generally give preference to the residence country’s tax claim.259 countries that export capital and services in roughly similar amounts believe their revenue losses under the treaty will be roughly equivalent to their revenue gains.260 developing countries, however, tend to be net capital importers, and thus the source, rather than the residence, countries.261 inducing them to enter into a treaty often requires concessions that either decrease the treaty’s ability to eliminate double taxation (the primary goal of treaties)262 or reduces revenue for the united states without the reciprocal increase that developed countries generally expect from their treaties.263 as such, as long as the united states will only relinquish the revenue rule as part of a bilateral income tax treaty, the revenue rule will continue to impede developing countries’ requests that the u.s. enforce their tax judgments.264 254 id. at 43. 255 see, e.g., anthony c. infanti, curtailing tax treaty overrides: a call to action, 62 u. pitt. l. rev. 677, 686–87 (2001) (congress believes "it is 'extremely difficult' to renegotiate treaties."). 256 see, e.g., adam h. rosenzweig, thinking outside the (tax) treaty, 2012 wis. l. rev. 717, 721 (2012) ("the problem is that certain countries, and in particular smaller, less developed countries, generally have not entered into tax treaties, at least not with the united states . . . ."); lee a. sheppard, will u.s. hypocrisy on information sharing continue?, 138 tax notes 253, 255 (2013) ("latin american countries mostly don't sign treaties with the united states, and for good reason. they don't like giving up tax jurisdiction over the affiliates of american multinationals that would do business in their countries even without tax treaties."). 257 allison d. christians, tax treaties for investment and aid to sub-saharan africa: a case study, 71 brook. l. rev. 639, 666 (2005). 258 see rosenzweig, supra note 256, at 723 ("but no matter how many times the wealthier countries 'roared their terrible roars and gnashed their terrible teeth and rolled their terrible eyes and showed their terrible claws' in an attempt to force the other countries to sign on to a global tax information sharing regime, they just seem to continue to say, no!"). 259 christians, supra note 257, at 661. 260 id. at 660. 261 id. at 661. 262 id. at 665 ("the consequence of preserving source-country taxation to overcome non-reciprocal capital flows, however, is that it undermines the relief of double taxation ostensibly sought as the primary purpose for entering into the treaty in the first place."). 263 one reason that developing countries are unwilling to negotiate tax treaties with the united states is that the united states is unwilling to include tax sparing provisions in its treaties, while developing countries are often unwilling to sign tax treaties that do not include tax sparing. see h. david rosenbloom & stanley i. langbein, united states treaty policy: an overview, 19 colum. j. transnat'l l. 359, 392 (1981). 264 if the u.s. continues to prefer to eliminate the revenue rule on a country-by-country basis using bilateral treaties, it may have an alternative route to the income tax treaty. since the 1980s, the u.s. has pursued tax information exchange agreements ("tieas") with certain developing countries. bruce zagaris, the procedural aspects of u.s. tax policy towards developing countries: too many sticks and no carrots?, 35 geo. wash. int’l l. rev. 331, 331 (2003). the u.s. currently has tieas with twenty-nine 2014] the u.s. as tax haven? 199 c. jurisdictional issues even with the revenue rule out of the way, a foreign government may face some impediments in its enforcement of foreign tax judgments. in the first instance, the foreign country would need to determine the forum in which it sought recognition and enforcement. in the second instance, it would need to demonstrate that the court it chose had jurisdiction to hear its claim. a foreign country could request enforcement of its tax judgments in state courts or, in most cases, in federal courts.265 to sustain the case in federal court would require either diversity jurisdiction or federal question jurisdiction. 266 diversity jurisdiction requires that the defendant be a citizen of a state and that the amount of the tax judgment exceed $75,000.267 federal question jurisdiction, on the other hand, would require that federal law or a treaty provide for the enforcement of foreign tax judgments.268 either way, absent the revenue rule, u.s. courts would clearly have jurisdiction if the defendant were a u.s. citizen or resident who had not paid her foreign taxes. until now, however, even where the u.s. has agreed to enforce another country’s tax judgments, it has not agreed to enforce those judgments against u.s. citizens.269 the united states’ continued refusal to enforce judgments against u.s. citizens would not matter, even in federal courts, if states chose to revoke the revenue rule—in recognizing foreign judgments, most courts have held, a federal court looks to state law.270 if foreign governments could only collect tax judgments from u.s. citizens and residents, though, revoking the revenue rule would provide little help to developing countries. in the more common case, the defendant will be a nonresident hiding assets in the u.s. where the defendant is neither a citizen nor a resident of a state, the question of jurisdiction becomes significantly more difficult. the foreign country could probably not avail itself of diversity jurisdiction, because diversity jurisdiction requires that, where the plaintiff is a foreign country, the defendant be a "citizen[] of a state."271 countries. jeremiah coder, officials say cross-border discovery is slow, cumbersome, 138 tax notes 1397, 1397 (2013). if developing countries are willing to enter into tieas, perhaps including mutual assistance provisions in tieas would allow the u.s. to use bilateral treaties to eliminate the revenue rule in a targeted matter. alternatively, it is possible that an offer from the united states to eliminate the revenue rule through a bilateral income tax treaty could function as a carrot, encouraging developing countries to negotiate tax treaties in spite of the united states’ unwillingness to include tax sparing and without undermining the relief of double taxation. 265 john r. wilson, note, coming to america to file suit: foreign plaintiffs and the forum non conveniens barrier in transnational litigation, 65 ohio st. l.j. 659, 669 (2004) ("foreign plaintiffs may choose to file their claims in state courts, which have jurisdiction over most types of lawsuits, or in federal courts . . . ."). 266 brand, supra note 92, at 263 n.32 ("most federal cases involving enforcement of foreign judgments arise under diversity jurisdiction. exceptions include those cases arising under federal law, for which 'federal question jurisdiction' exists."). 267 28 u.s.c. § 1332(a) (2012). 268 id. § 1331 ("the district courts shall have original jurisdiction of all civil actions arising under the constitution, laws, or treaties of the united states."). 269 see infra notes 238–300and accompanying text. 270 restatement (second) of conflict of laws § 98 cmt. c (1988) ("the consensus among the state courts and lower federal courts that have passed upon the question is that, apart from federal question cases, such recognition is governed by state law and that the federal courts will apply the law of the state in which they sit."). 271 28 u.s.c. § 1332(a)(4) (2012). 200 columbia journal of tax law [vol.5:170 for a court to have personal jurisdiction over a defendant, the supreme court does not require that the defendant be present within the jurisdiction. 272 she must, however, "have certain minimum contacts with it such that the maintenance of the suit does not offend 'traditional notions of fair play and substantial justice.'"273 in the end, the defendant must "purposefully avail" herself of the jurisdiction before a court can exercise personal jurisdiction over her.274 the personal jurisdiction requirement would appear to significantly impede a foreign government’s ability to enforce tax judgments against assets its residents have hidden in the united states, even if the u.s. revoked the revenue rule and allowed courts to enforce foreign tax judgments. even without personal jurisdiction, however, the existence of hidden assets in a state should generally provide a u.s. court with jurisdiction to recognize and enforce foreign judgments. a state can exercise judicial jurisdiction in some cases to seize assets within the state if it otherwise would have jurisdiction.275 additionally, the supreme court has held that "when claims to the property itself are the source of the underlying controversy between the plaintiff and the defendant, it would be unusual for the state where the property is located not to have jurisdiction."276 in the case of a final judgment for taxes due by a person hiding assets in the united states, the claim is for the hidden assets, and their presence in a state generally provides in rem jurisdiction. even if the presence of the assets were insufficient to create jurisdiction underlying a claim, however, the supreme court allows that "a state in which property is located should have jurisdiction to attach that property, by use of proper procedures, as security for a judgment being sought in a forum where the litigation can be maintained consistently with international shoe." 277 either way, even where the defendant is a nonresident alien, if she hides assets in the u.s., u.s. courts have jurisdiction to enforce foreign tax judgments. d. evaluating the foreign country’s revenue judgment courts have proven adept at evaluating the procedure leading to foreign judgments. while final judgments from foreign courts are presumptively conclusive,278 where the defendant can demonstrate that the foreign process was unfair, fraudulent, or otherwise compromised, the u.s. court can decline to recognize and enforce the judgment.279 and it appears that u.s. courts do, in fact, evaluate the fairness of the process and do, in fact, decline to recognize and enforce fraudulent judgments, judgments that lacked due process, and other judgments that violated u.s. public policy.280 there is no reason to believe that courts that have the ability to evaluate procedural fairness in non-revenue cases would lose that ability where the underlying judgments were for unpaid tax liabilities. revenue claims potentially implicate a second layer of fairness, though: the fairness of the imposition of the foreign tax. unlike foreign contract claims, where the parties presumably negotiated at arm’s length and came to a mutually-agreeable solution, 272 int’l shoe co. v. wash., 326 u.s. 310, 316 (1945). 273 id. (quoting milliken v. meyer, 311 u.s. 457, 463 (1940)). 274 hanson v. denckla, 357 u.s. 235, 253 (1958). 275 restatement (second) of conflict of laws § 66(1)(a) (1988). 276 shaffer v. heitner, 433 u.s. 186, 210 (1977). 277 id. at 210. 278 restatement (third) of foreign relations law § 481(1) (1987). 279 id. § 482. 280 see supra notes 154–174and accompanying text. 2014] the u.s. as tax haven? 201 tax laws are enacted and enforced by the sovereign. though some taxpayers may, by virtue of being voters, have some indirect input into the tax laws, the tax laws do not represent an explicit agreement between taxpayers and the government. as such, it would appear necessary for a u.s. court to look not only at the fairness of the judicial procedure, but the fairness of the imposition of the tax in the first instance. with an inquiry into the fairness of a foreign tax, u.s. courts would begin to enter perilous waters. such an evaluation, with no explicit parameters, would create a significant risk of infringing on a country’s sovereignty. here, rather than just determining if fair procedure occurred, u.s. courts would evaluate whether the country had designed an appropriate law. the foreign country could see a u.s. court’s refusing to enforce a tax judgment on the grounds that the tax system did not meet u.s. public policy as a direct challenge to its right to make its own laws. moreover, judging the fairness of a foreign tax system risks economic imperialism. the safest way for a foreign country to demonstrate that its tax system met u.s. standards of fairness would be for that country to adopt a u.s.-style income tax. a law revoking the revenue rule could cabin these problems, even as it left discretion to judges to make this evaluation. for example, it could limit the permissible inquiries a court could make into the fairness of the tax system. a foreign tax system would presumably be unfair, for example, if it imposed tax, or determined the amount of the tax, based on the taxpayer’s identity. additionally, if the tax law provided no mechanism for appeal of a tax determination, u.s. courts could determine that the tax law was unfair and decline to enforce the judgment. alternatively, if the u.s. found crafting such rules too burdensome, it could, instead, opt to use a blacklist or a whitelist. if the u.s. opted for a blacklist, it would determine which countries did not have a fair tax system, and it would not enforce tax judgments from those countries. alternatively, if the u.s. chose to implement a whitelist, it would determine the countries with presumptively fair tax systems, and would generally enforce tax judgments from those countries (subject, of course, to the affirmative defenses available to any defendant in any enforcement suit). the foreign tax credit and the subpart f provisions of the tax law currently blacklist certain countries. corporate income earned in these blacklisted countries is automatically treated as subpart f income,281 and u.s. taxpayers cannot take a foreign tax credit for taxes paid to blacklisted countries.282 a country finds itself on this blacklist if the u.s. does not recognize it, if the u.s. has severed diplomatic relations or does not conduct such relations, or if the secretary of state has designated it as repeatedly providing support for acts of terrorism.283 a country can come off of the blacklist in one of two ways: first, the secretary of state can certify to the secretary of the treasury that the country no longer meets the criteria for inclusion.284 second, the president can waive the criteria if the president determines such waiver is, among other things, in the national interest of the united 281 i.r.c. § 952(a)(5) (2012). 282 i.r.c. § 901(j)(1)(a) (2012). 283 id. § 901(j)(2)(a). 284 id. § 901(j)(2)(b)(ii). 202 columbia journal of tax law [vol.5:170 states.285 though fourteen countries have found themselves on the blacklist at one time or another, currently the blacklist contains only five countries.286 the foreign tax credit/subpart f blacklist would not work for revenue rule purposes, however. the purpose of such a list associated with the revocation of the revenue rule would be to establish which countries’ tax procedures were insufficiently fair to warrant u.s. enforcement of tax judgments. a country’s inclusion on the foreign tax credit/subpart f blacklist, on the other hand, has nothing to do with its tax law; instead, countries find themselves on the list because of other bad actions. if the u.s. implemented a blacklist or a whitelist, it would need to lay out clear steps a country could take to get off of, or on to, the list. moreover, the administrator of the list should be responsive and flexible, so that the list can change quickly when a country meets the specified criteria. the foreign tax credit/subpart f blacklist does not appear to have that flexibility: it has not changed since 2005.287 while it is possible that none of the countries’ positions have changed in a manner that warrants their removal, such a slow rate of change nonetheless does not seem to fit the needs of a revenue rule blacklist or whitelist.288 e. final judgment as part of the revocation of the revenue rule, the u.s. government would need to determine procedures for the recognition and enforcement of foreign tax judgments. tax judgments are not exceptional, though—they differ from other judgments only in subject matter. as a result, no reason exists why the procedures for recognizing and enforcing a tax judgment should differ materially from the procedures currently in place for recognizing and enforcing other foreign judgments. like the enforcement of non-revenue judgments, the enforcement of revenue judgments should provide for an expedited judicial procedure to enforce the judgment.289 notwithstanding the expedited procedure, though, the defendant should have the ability to raise certain affirmative defenses.290 and, importantly, a country seeking enforcement should exhaust present and final judgments so that u.s. courts do not need to adjudicate the merits of the dispute.291 final judgment may appear to be a high hurdle for requesting mutual assistance. in the u.s., the i.r.s. can assess a taxpayer’s taxes.292 within sixty days after making the assessment, it must provide notice to the taxpayer of her unpaid tax and demand the payment.293 if she fails to pay, the united states automatically gets a lien against all of her property and rights to property in the amount of the liability plus interest, penalties, and other additional amounts.294 all of this happens without any judicial intervention. 285 id. § 901(j)(5)(a). 286 rev. rul. 2005-3; 2005-1 c.b. 334. 287 id. 288 even if the u.s. figured out a viable way to both create and maintain the blacklist or whitelist, such a regime would still risk encouraging jurisdiction-shopping among people intent on hiding their income. the jurisdiction-shopping issue would not be too large an impediment, however: avoiding the u.s. enforcement of a tax judgment would require an individual to subject herself only to the tax jurisdiction of blacklisted countries or of countries not on the whitelist. while she may be willing to do so, doing business in a way that avoids such jurisdiction generally represents real economic choices, not just formal structuring. 289 see supra note 103 and accompanying text. 290 see supra notes 91–83 and accompanying text. 291 see supra notes 78–79and accompanying text. 292 i.r.c. § 6201(a) (2012). 293 i.r.c. § 6303(a) (2012). 294 i.r.c. § 6321 (2012). 2014] the u.s. as tax haven? 203 moreover, if, after the notice and demand, she continues to decline to pay, the i.r.s. can collect the taxes by levy or by seizure.295 in the end, then, the i.r.s. has the ability to collect unpaid taxes without requiring a final judgment. notwithstanding the ability to administratively collect taxes, though, requiring a final judgment before helping to collect a foreign tax accords with the united states’ current practice. in each of the tax treaties providing for collection assistance, the tax claim of the requesting country must be "finally determined."296 for a tax to be "finally determined," not only must the country have the right to collect the revenue (which the u.s. can have at the administrative level), but "all administrative and judicial rights of the taxpayer to restrain collection in the applicant state have lapsed or been exhausted."297 in addition to roughly corresponding to the united states’ current practices, requiring a final judgment from the other country before enforcing a tax judgment offers further safeguards to ensure that the tax is fair. rather than trusting a foreign administrative agency, u.s. courts can rely on at least a second review of the tax assessment. f. u.s. citizen exceptionalism as a practical matter, repealing the revenue rule except in the case of u.s. citizens does not create significant problems. as long as the defendant in a foreign tax judgment can demonstrate that she was a u.s. citizen at the time the tax became due, the legislation revoking the revenue rule can provide that u.s. courts will not recognize or enforce the foreign tax judgment. if, however, for fairness or other reasons, we believe that the revenue rule should be revoked entirely, such complete revocation is still feasible. in addition to the federal revocation of the revenue rule as applied to noncitizens, individual states could revoke their versions of the revenue rule for u.s. citizens. although the ufmjra and the ufcmjra, adopted by many states, have codified the revenue rule, the states have generally not adopted the acts wholesale. instead, states have tailored the acts to their own situations, making certain alterations as they saw necessary.298 the states could further alter these laws to eliminate the revenue rule altogether. moreover, states do not risk the same revenue loss as the federal government: the vast majority of states do not allow their residents to take a credit for taxes paid to foreign governments against their state income taxes.299 295 i.r.c. § 6331(a), (b) (2012). 296 convention for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income and capital, with exchanges of notes, u.s.-fr., art. 28, aug. 31, 1994, 1963 u.n.t.s. 67; convention for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, with protocol, u.s.-den., art. 27(2), aug. 19, 1999, t.i.a.s. no. 11089; convention for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, with understanding and exchange of notes, u.s.-neth., art. 31(2), dec. 18, 1992, 2291 u.n.t.s. 3; convention for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, with exchange of letters, u.s.-swed., art. 27(2), sept. 1, 1994, t.i.a.s.; protocol amending the convention of september 26, 1980, with respect to taxes on income and capital, with exchange of letters, u.s.-can., art. xxvi a(2), june 14, 1983, t.i.a.s. no. 11087. 297 treasury technical explanation art. 15, supra note 235. 298 see, e.g., richard j. graving & jon h. sylvester, is the uniform foreign money-judgments act potentially unconstitutional? if so, should the texas cure be adopted elsewhere?, 25 geo. wash. j. int'l l. & econ. 737, 739 n.9 (1992) ("[t]he versions [of the ufmjra] adopted in some states depart significantly in certain respects from the uniform model law."). 299 seven states have no personal income tax, and therefore no credits against taxes. carol rosenberg & kim reuben, state individual income tax rates, 127 tax notes 697, 697 (2010) ("alaska, florida, nevada, south dakota, texas, washington, and wyoming do not tax personal income . . . ."). of the 204 columbia journal of tax law [vol.5:170 as a practical matter, however, states may not have sufficient incentive to allow foreign governments access to their courts to collect revenue claims. perhaps, if a state enforced foreign revenue judgments, the foreign country would likewise enforce the state’s tax judgments. though there is no data available on the amount of revenue states lose as a result of their citizens hiding money offshore, state tax revenue is significantly lower than federal revenues.300 consequently, states likely lose significantly less revenue than the federal government. and with less money at stake, states have less incentive to seek reciprocity. as a result, placing the primary emphasis for revoking the revenue rule at the federal level makes more sense than revoking it at the state level. at the federal level, such revocation would require the passage of a single law, rather than requiring fifty legislatures, acting independently, to each revoke the revenue rule. such a federal revocation would likely not apply to u.s. citizens, based both on the language of the current treaties in which the u.s. has agreed to enforce foreign judgments and on the potential revenue loss to the government resulting from the foreign tax credit. such federal revocation would not prevent a state from also revoking its revenue rule. as a secondary matter, some states may want to ensure that foreign courts will enforce their tax judgments, contribute to developing countries’ establishing effective tax infrastructure, or ensure that they contribute to the implied social contract.301 irrespective of whether or how the federal government permitted the enforcement of foreign tax judgments, such a state could allow its courts to enforce foreign tax judgments against both citizens and non-citizens. remaining forty-three states and the district of columbia, only six allow their residents to deduct taxes paid to any foreign country. ala. code § 40-18-21(a)(1) (2013); ariz. rev. stat. ann. § 43-1071(a) (2013); haw. rev. stat. § 235-55 (2013); iowa code § 422.8(1) (2013); mont. code ann. § 15-30-2302(1)(a) (2013); n.c. gen. stat. § 105-153.9 (2013). maine allows a foreign tax credit for taxes paid to subdivisions of foreign countries that are equivalent to u.s. states. me. rev. stat. ann. tit. 36, § 5217-a (2013). massachusetts and michigan permit a credit for canadian taxes, and new york and vermont allow a credit for taxes paid to canadian provinces. mass. gen. laws ann. ch. 62, § 6(a) (2013); mich. comp. laws ann. § 206.255(1) (west 2013); n.y. tax law § 620(a) (mckinney 2013); vt. stat. ann. tit. 32, §5825(a) (2013). the remaining thirty-two states and the district of columbia do not provide a credit for foreign taxes. ark. code ann. § 26-51-504(a)(1) (west 2013); cal. rev. & tax code § 18001(a) (west 2013); colo. rev. stat. ann. § 39-22-108(1) (west 2012); conn. gen. stat. ann. § 12-704(a)(1) (west 2013); del. code ann. tit. 30, §1111(a) (west 2013); d.c. code § 47-1806.04(a) (2008); ga. code ann. § 48-7-28 (west 2013); idaho code ann. § 63-3029(1) (west 2013); 35 ill. comp. stat. ann. 5/601(b)(3) (west 2011); ind. code ann. § 6-3-3-3 (west 2013); kan. stat. ann. § 79-32,111(a) (west 2013); ky. rev. stat. ann. § 141.070(1) (west 2013); la. rev. stat. ann. § 47:33(a) (2013); md. code ann., tax-gen. § 10-703(a) (west 2013); minn. stat. ann. § 290.06, subd. 22 (west 2013); miss. code ann. § 27-7-77(1) (west 2012); mo. ann. stat. § 143.081(1) (west 2013); neb. rev. stat. ann. § 77-2730(1) (west 2013); n.h. rev. stat. ann. § 77:4 (2013); n.j. stat. ann. § 54a:4-1(a) (west 2013); n.m. stat. ann. § 7-2-13 (2013); n.d. cent. code § 57-38-30.3(4)(a) (west 2013); ohio rev. code ann. § 5747.05(b) (west 2013); okla. stat. ann. tit. 68, § 2357(b)(1) (west 2013); or. rev. stat. ann. § 316.082(1) (west 2013); 72 pa. cons. stat. ann. § 7314(a) (west 2013); r.i. gen. laws ann. § 44-30-18(a) (west 2013); s.c. code ann. § 12-6-3400(a)(1) (2013); tenn. code ann. § 67-2-122 (west 2013); utah code ann. § 59-10-1003 (west 2013); va. code ann. § 58.1-332(a) (west 2013); w. va. code ann. § 11-21-20(a) (west 2013); wis. stat. ann. § 71.07 (west 2014). 300 in 2011, the states collectively collected about $268 billion from their individual income taxes. u.s. census bureau, quarterly summary of state and local government tax revenue (2012), available at http://www2.census.gov/govs/qtax/2012/q4t2.xls. by contrast, the federal government collected approximately $1.1 billion in individual income taxes, or four times as much. cong. budget office, the u.s. federal budget: a closer look at revenues (2012), available at http://www.cbo.gov/sites/default/files/cbofiles/attachments/bs_revenues_print.pdf. 301 see supra notes 196–197 and accompanying text. 2014] the u.s. as tax haven? 205 vii. conclusion the united states does not need to be a tax haven. it does not need to shield taxpayers in developing countries from paying their tax liabilities while, at the same time, providing foreign aid to those countries. by permitting developing countries to collect taxes from their citizens, the u.s. would help them develop self-sustaining revenue. the easiest and most immediate step the u.s. could take in this direction is to revoke the revenue rule. every state in the united states already stands willing to enforce most foreign judgments, whether under the common law or by statute. tax judgments are not so different that they should be excluded; moreover, the justifications that supported the creation and continuance of the revenue rule are no longer compelling. not only is revoking the revenue rule easy; it is also virtually costless to the united states. eliminating the zero rate of tax on interest paid to nonresident aliens on bank accounts and portfolio interest would discourage foreigners from putting money in u.s. banks or investing in portfolio debt instruments. changing the source rules for capital gains would make nonresident aliens think twice before investing in passive u.s. assets, including the securities of u.s. companies. but eliminating the revenue rule will not discourage legitimate investment. true, the u.s. will no longer represent an attractive location for nonresident aliens to hide assets from their governments. in a world without the revenue rule, if their governments find the assets hidden in the united states, they will be able to use those assets to satisfy their taxpayers’ unpaid taxes. but because the nonresident aliens presumably paid little, if any, tax in the united states, losing that tax haven-style investment will not significantly affect the united states’ revenue collection. moreover, eliminating the revenue rule would not discourage nonevasive foreign investors from investing in the united states. still, a couple questions potentially remain. why should the u.s. discourage individuals from hiding assets here? although those assets do not provide tax revenue for the government, they presumably increase market liquidity and provide benefits to other investors by increasing the value of their investments. rather than revoke the revenue rule, the u.s. could double down, becoming a full-blown tax haven itself.302 becoming a tax haven, though, would violate the implied international social contract. it would demonstrate significant hypocrisy from a country that invests so much in preventing its own taxpayers from taking advantage of tax havens. and it would prevent other countries from helping the u.s. collect taxes from taxpayers hiding their assets offshore. as a corollary, the willingness of the u.s. to enforce foreign tax judgments would allow other countries to reciprocally recognize and enforce u.s. tax judgments. would u.s. enforcement of foreign tax judgments really help developing countries, though, or would the tax evaders merely shift assets to another tax haven jurisdiction? if evaders merely shifted the location of their hidden assets, the united states’ revocation of the revenue rule would not have significantly improved developing countries’ revenue collection. the answer is not clear. presumably, individuals hiding assets in the u.s. have a reason to prefer investment in the u.s. to investment in other jurisdiction that provide 302 though not a common proposal, recently representative devin nunes advocated changing the corporate income tax in a way that would "make the u.s. the largest tax haven in human history." ramesh ponnuru, how to make america a global tax haven, bloombergview (mar. 25, 2013, 6:30 pm), http://www.bloomberg.com/news/2013-03-25/how-to-make-america-a-global-tax-haven.html. 206 columbia journal of tax law [vol.5:170 secrecy, low taxes, and non-enforcement of foreign judgments. the other reasons may be sufficient for foreign evaders to keep their money in the united states, even without the revenue rule. if such reasons turned out to be insufficient, though, the intergovernmental fatca agreements and negotiations demonstrate that effecting change in the united states can lead to international change. the united states’ willingness to enforce foreign tax judgments, whether unilaterally or by treaty, could similarly spread to other jurisdictions, crowding out the ability of tax evaders to hide their assets in a place that will not enforce tax judgments. the revenue rule serves no legitimate purpose in the current world. as a moral and as an economic matter, the united states should repeal the revenue rule and enforce foreign tax judgments. microsoft word haile4-2.docx articles sales tax exceptionalism andrew j. haile* abstract there is something different about the state sales tax, or so it seems based on judicial decisions creating unique jurisdictional and apportionment standards for the tax. this article explores the concept of “sales tax exceptionalism,” and assesses whether the special treatment afforded to the sales tax is justified by the theoretical foundations of the tax. in particular, the article examines whether theoretical justifications exist for the jurisdictional standard applied to the sales tax (a “physical presence” standard), as compared to the “economic presence” standard applied to the corporate income tax. ultimately, the article concludes that only weak theoretical justifications support the different jurisdictional standards, and that recent changes to many states’ corporate income taxes further undercut the notion of “sales tax exceptionalism.” * associate professor, elon university school of law. the author would like to thank kirk j. stark, gregg polsky, darien shanske, david gamage, rebecca morrow, and the participants at the 2012 junior tax scholars’ workshop for their comments on this article. 2013] sales tax exceptionalism 137 i. sales tax exceptionalism .......................................................140 a. jurisdictional differences—the concept of “substantial nexus” .......140 1. substantial nexus in the sales tax context ....................................141 2. substantial nexus in the corporate income tax context ...............144 b. apportionment—another instance of sales tax exceptionalism ........149 1. apportionment in the gross receipts tax context .........................151 2. apportionment in the sales tax context.........................................153 3. judicial bases for sales tax exceptionalism..................................155 ii. assessing the theoretical basis (or lack thereof) for sales tax exceptionalism .......................................................158 a. theoretical foundations for the sales tax ............................................160 b. theoretical foundations for the corporate income tax .......................162 c. lack of solid theoretical justifications for different nexus standards166 iii. the increasing peculiarity of different nexus standards for the sales tax and the corporate income tax ....................................................................................................168 138 columbia journal of tax law [vol. 4:136 introduction inconsistencies persist in the area of state taxation. for example, different jurisdictional standards apply to different types of taxes. a state may impose its sales tax on a retailer only if the retailer has a “physical presence” in the state, but the vast weight of authority holds that a retailer need only establish an “economic presence” before the state may assert its corporate income tax. the u.s. supreme court has twice considered the issue of sales tax jurisdiction, and has confirmed the physical-presence standard in both instances.1 while the supreme court has yet to address the jurisdictional scope of the state corporate income tax, several state courts have done so, and those courts have generally held that an economic presence suffices to subject a retailer to the corporate income tax.2 different standards also apply with respect to tax apportionment depending on the type of tax involved. the u.s. supreme court clearly delineated the different apportionment standards in a pair of cases involving how the sale of bus tickets was to be taxed. with respect to a state’s gross receipts tax (which the supreme court subsequently characterized as “a variety of tax on income”),3 the court held that the bus company must apportion the gross income received from the sale of bus tickets among the states the bus passes through en 1 this is despite significant criticism of the physical-presence standard. see quill corp. v. north dakota, 504 u.s. 298, 327–28 (1992) (white, j., dissenting) (criticizing the court’s retention of the physical-presence rule under the commerce clause, because “in today’s economy, physical presence frequently has very little to do with a transaction a state might seek to tax”); john a. swain, state income tax jurisdiction: a jurisprudential and policy perspective, 45 wm. & mary l. rev. 319, 329–44 (2003) (discussing critiques of quill). but see edward a. zelinsky, rethinking tax nexus and apportionment: voice, exit, and the dormant commerce clause, 28 va. tax rev. 1 (2008) (defending the physical-presence standard, at least until congress acts to overturn quill). 2 see, e.g., geoffrey, inc. v. s.c. tax comm’n, 437 s.e.2d 13 (s.c. 1993); lanco, inc. v. director, div. of tax’n, 879 a.2d 1234 (n.j. super. ct. app. div. 2005); gen. motors corp. v. city of seattle, 25 p.3d 1022 (wash. ct. app. 2001); comptroller of the treas. v. syl, inc., 825 a.2d 399 (md. 2003); geoffrey, inc. v. okla. tax comm’n, 132 p.3d 632 (okla. civ. app. 2006); kfc corp. v. iowa dep’t of revenue, 792 n.w.2d 308 (iowa 2010); a&f trademark, inc. v. tolson, 605 s.e.2d 187 (n.c. ct. app. 2004); kmart properties, inc. v. tax’n and revenue dep’t of the state of n.m., 131 p.3d 27 (n.m. ct. app. 2001), rev’d on other grounds, 131 p.3d 22 (n.m. 2005); tax comm’r v. mbna america bank, n.a., 640 s.e.2d 226 (w. va. 2006). but see j.c. penney nat’l bank v. johnson, 19 s.w.3d 831 (tenn. ct. app. 2000). what exactly constitutes economic presence, however, has been the subject of some variation among states and local taxing authorities. see adam b. thimmesch, the illusory promise of economic nexus, 13 fla. tax rev. 157 (2012) (discussing the economic nexus standard and proposing federal intervention to ensure a uniform standard). 3 okla. tax comm’n v. jefferson lines, inc., 514 u.s. 175, 190 (1995). see also moorman mfg. co. v. bair, 437 u.s. 267, 281 (1978) (brennan, j., dissenting) (“i agree with the court that, for purposes of constitutional review, there is no distinction between a corporate income tax and a gross-receipts tax.”). 2013] sales tax exceptionalism 139 route to its final destination.4 in effect, a state’s gross receipts tax applies only to the portion of a bus ticket price attributable to miles traveled within that state. in contrast, the court held that, for sales tax purposes, the price of a bus ticket need not be apportioned among the states through which the bus passes. instead, the state where the ticket is sold is permitted to apply its sales tax to the full price of the ticket, even though a portion of the price is attributable to service provided in other states.5 with respect to both jurisdiction and apportionment, courts have treated the sales tax differently than other taxes, creating, though not expressly articulating, a form of “sales tax exceptionalism.” as for the different jurisdictional treatment of the sales tax, the court initially based the physicalpresence standard on concerns over the potential burden that would be imposed on businesses by requiring them to comply with varying sales tax requirements in thousands of different tax jurisdictions (at last count, there were over 9,600 different state and local sales tax jurisdictions in the united states).6 that concern has been mitigated in recent years, however, through coordinated efforts made by many states to unify and simplify their sales tax statutes, as well as by technological advances that make sales tax compliance less onerous now than at the time the supreme court established the physical-presence jurisdictional standard. as for apportionment, the supreme court has justified treating the sales tax differently than other taxes by concluding that the sales tax poses less risk of duplicative taxation than other taxes—in particular the gross receipts tax and the corporate income tax. this article examines whether “sales tax exceptionalism” makes sense, particularly in the context of a state’s authority to impose sales tax collection obligations on remote retailers. it does so by first asking whether the theoretical justifications for the sales tax and the corporate income tax weigh in favor of treating the taxes differently for jurisdictional purposes. the article contends that only tenuous theoretical justifications support different jurisdictional standards for the taxes. the article then goes on to argue that there has been a “convergence” of the corporate income tax and the sales tax, as states increasingly adopt the single-sales factor method of apportioning their corporate income taxes. this convergence renders the different jurisdictional standards for the taxes increasingly unjustifiable. 4 central greyhound lines, inc. v. mealy, 334 u.s. 653, 663 (1948). 5 okla. tax comm’n, 514 u.s. at 175. 6 the proper role of congress in state taxation: ensuring the interstate reach of state taxes does not harm the national economy: hearing on h.r. 3179 before the h. comm. on the judiciary, 112th cong. 2 (2012) (statement of joseph henchman, vice president, legal & state projects, tax foundation), available at http://judiciary.house.gov/hearings/hearings%202012/henchman%2007242012.pdf 140 columbia journal of tax law [vol. 4:136 the article proceeds through the analysis described above by first introducing the concept of sales tax exceptionalism in part i. it does so by examining the different judicial treatment given to the sales tax for jurisdictional and apportionment purposes. part ii then considers the theoretical foundations for the sales tax and the corporate income tax to assess whether sales tax exceptionalism has defensible theoretical moorings. after concluding in part ii that the theoretical foundations for the taxes provide at best a weak justification for their different jurisdictional treatment, part iii explains why the convergence of the sales and corporate income taxes further undercuts the distinct jurisdictional standards applied to the two taxes. the ultimate goal of the article is to further the academic literature criticizing sales tax exceptionalism, at least in the context of jurisdictional standards, by presenting a new argument against sales tax exceptionalism based on the convergence of the corporate income tax and the sales tax. i. sales tax exceptionalism there is something different about the sales tax—or so it seems, based on judicial decisions that have treated the sales tax differently than other taxes. this section examines those decisions in the jurisdictional and apportionment contexts. a. jurisdictional differences—the concept of “substantial nexus” in complete auto transit, inc. v. brady,7 the supreme court held that, for a state tax to survive dormant commerce clause review, the tax must satisfy a four-part test. the complete auto test requires that the tax “[1] is applied to an activity with a substantial nexus with the taxing state, [2] is fairly apportioned, [3] does not discriminate against interstate commerce, and [4] is fairly related to the services provided by the state.”8 the jurisdictional limit of a state tax is effectively determined by the first and fourth prongs of the complete auto test,9 with the first prong (the “substantial nexus” prong) receiving the greater weight of both judicial and scholarly attention.10 one leading commentator has defined 7 430 u.s. 274 (1977). 8 id. at 279. 9 the second and third prongs of the complete auto test ensure that a state does not attempt to shift its tax burden onto out-of-state residents. see quill, 504 u.s. at 313 (“the second and third parts of that analysis, which require fair apportionment and non-discrimination, prohibit taxes that pass an unfair share of the tax burden onto interstate commerce.”). 10 id. (“the first and fourth prongs, which require a substantial nexus and a relationship between the tax and state-provided services, limit the reach of state taxing authority so as to ensure that state taxation does not unduly burden interstate commerce.”). articles abound addressing the “substantial nexus” prong of the complete auto test. see, e.g., richard d. pomp & michael j. mcintyre, state taxation of mail-order sales of computers after quill: an evaluation of mtc bulletin 95-1, 11 st. tax notes 140 (1996) (stating that quill “creates an unfair competitive bias against in-state merchants that collect the sales tax”); robert d. plattner, quill: 10 years after, 25 2013] sales tax exceptionalism 141 “nexus” as “the connection that a state must have with a person, property, transaction, or activity in order for a state to exercise its taxing power constitutionally over such person, property, transaction, or activity.”11 under complete auto, a taxpayer must have “substantial” nexus with a state before the state may assert its taxing jurisdiction over the taxpayer. one reason for the extensive scholarly attention given to the issue of nexus is that courts have reached different conclusions as to what constitutes substantial nexus depending on the type of tax involved. 1. substantial nexus in the sales tax context the supreme court has on two occasions ruled that, for sales tax purposes,12 a taxpayer has “substantial nexus” only if the taxpayer has an in-state physical presence. the two cases—national bellas hess v. illinois13 and quill v. north dakota14—involved practically identical disputes: states attempting to st. tax notes 1017 (2002) (describing the quill decision as “a blunder of major proportions”). far fewer articles address the “fairly related” prong. see, e.g., phillip m. zinn, the requirements of “substantial nexus” and “fairly related” under the commerce clause, 2007 st. & loc. tax law. 59 (2007); r. douglas harmon, judicial review under complete auto transit: when is a state tax on energy-producing resources “fairly related”?, 1982 duke l.j. 682 (1982). 11 walter hellerstein, a primer on state tax nexus: law, power, & policy, 55 st. tax notes 555 (2010). 12 the cases discussed in this section technically involved the states’ use taxes rather than their sales taxes. these are different taxes serving complementary purposes. states have their own individual definitions of the sales tax and the use tax, and these may differ from state to state. the multistate tax commissioner (mtc) has provided a general definition of the sales tax as “a tax imposed with respect to the transfer for a consideration of ownership, possession or custody of tangible personal property or the rendering of services measured by the price of the tangible personal property transferred or services rendered and which is required by state or local law to be separately stated from the sales price by the seller, or which is customarily separately stated from the sales price . . .” the multistate tax comm’n compact, suggested state legislation & enabling act, art. ii, ¶ 7. the mtc’s definition of the use tax is “a nonrecurring tax, other than a sales tax, which (a) is imposed on or with respect to the exercise or enjoyment of any right or power over tangible personal property incident to the ownership, possession or custody of that property or the leasing of that property from another including any consumption, keeping, retention, or other use of tangible personal property and (b) is complementary to a sales tax.” the multistate tax comm’n compact, art. ii, ¶ 8. because the nexus requirements for sales tax and use tax have been stated by the supreme court to be the same, i use the more familiar term “sales tax” rather than “use tax” throughout this article. see quill, 504 u.s. at 314 (“although we have not, in our review of other types of taxes, articulated the same physical-presence requirement that bellas hess established for sales and use taxes, that silence does not imply repudiation of the bellas hess rule.”) (emphasis added); id. at 315 (“whether or not a state may compel a vendor to collect a sales or use tax may turn on the presence in the taxing state of a small sales force, plant, or office.”). see also jerome r. hellerstein & walter hellerstein, state taxation ¶ 12.01 (3rd ed.) (“the term ‘sales tax’ embraces a large variety of levies in force in the united states” including “‘compensatory use tax.’”). 13 national bellas hess v. illinois, 386 u.s. 753 (1967). 14 quill, 504 u.s. at 298. 142 columbia journal of tax law [vol. 4:136 require retailers to collect sales tax even though the retailers were mail-order companies that had no physical presence in the states. the retailers in both cases argued that by doing so the states exceeded the constitutional limits of their taxing authority. in bellas hess, the earlier of the two cases (decided in 1967), the court held that illinois’ attempt to require the remote retailer15 to collect sales tax violated both the due process clause and the commerce clause of the u.s. constitution. in its opinion, the court did not delineate its analysis of the two constitutional provisions,16 but grounded its decision on the concern that if every one of the nation’s thousands of taxing jurisdictions imposed similar tax collection requirements, “[n]ational interstate business” would be “entangle[d] . . . in a virtual welter of complicated obligations . . . .”17 twenty-five years after bellas hess, in quill, the court again considered whether a state could constitutionally require sales tax collection by “a taxpayer whose only connection with customers in the state [was] by common carrier or the united states mail.”18 quill overturned bellas hess to the extent that the earlier case relied on the due process clause as a basis for finding that a state exceeded its authority in requiring remote retailers to collect sales tax.19 in the time between the decisions in bellas hess in 1967 and quill in 1992, the court’s due process jurisprudence had evolved and no longer required a litigant to have an in-state physical presence to satisfy the due process standard of “fair warning [that its] activity may subject [it] to the jurisdiction of a foreign sovereign.”20 15 according to the court, the taxpayer in bellas hess “does not maintain in illinois any office, distribution house, sales house, warehouse or any other place of business; it does not have in illinois any agent, salesman, canvasser, solicitor or other type of representative to sell or take orders, to deliver merchandise, to accept payments, or to service merchandise it sells; it does not own any tangible property, real or personal, in illinois; it has no telephone listing in illinois and it has not advertised its merchandise for sale in newspapers, on billboards, or by radio or television in illinois.” 386 u.s. at 754 (adopting the illinois supreme court’s description of the taxpayer’s lack of contacts with the state). the court further characterized the taxpayer’s connection with customers in illinois as only “by common carrier or the united states mail.” id. at 758. 16 the court stated, “these two claims are closely related. for the test whether a particular state exaction is such as to invade the exclusive authority of congress to regulate trade between the states, and the test for a state's compliance with the requirements of due process in this area are similar.” id. at 756. 17id. at 759–60. at the time of bellas hess, the court stated that there existed over 2,300 taxing jurisdictions in the united states. id. at 759 n.12 (citing rep. of the spec. subcomm. on state tax’n of interstate commerce of the h. comm. on the judiciary, maryland h.r.rep.no. 565, 89th cong., 1st sess., 827 (1965)). interestingly, by the time of the quill decision in 1992, the court noted that there were “6,000-plus taxing jurisdictions” in the united states. quill, 504 u.s. at 313 n.6. 18 quill, 504 u.s. at 301. 19 id. at 308. 20 id. (“[i]t matters little that such solicitation is accomplished by a deluge of catalogs rather than a phalanx of drummers: the requirements of due process are met irrespective of a 2013] sales tax exceptionalism 143 the quill court extended this more expansive due process standard beyond the personal jurisdiction context to the tax context and found that the remote retailer in question had adequate notice, from a due process perspective, that its commercial activities in north dakota would subject it to the state’s taxing authority.21 the quill court affirmed bellas hess, however, with respect to the previous determination that the commerce clause requires physical presence before a state may constitutionally impose a sales tax collection obligation.22 the court provided several reasons for maintaining the physical-presence standard under the commerce clause: (1) the benefits resulting from a bright-line rule, such as fostering investment, minimizing uncertainty, and reducing litigation;23 (2) the stability resulting from adherence to stare decisis;24 (3) the avoidance of “thorny questions concerning the retroactive application of [sales and use taxes that] might trigger substantial unanticipated liability for mail-order houses”;25 and (4) the deference given to congress to exercise its commerce clause power and ultimately decide the appropriate nexus standard for remote commerce.26 thus, despite the shift in its due process jurisprudence to a more expansive approach and despite acknowledgment by the quill majority that the “physical presence” nexus standard had shortcomings,27 the court in quill affirmed the standard under the commerce clause. quill has become increasingly important in recent years due to the rapid expansion of ecommerce.28 because of the increasing loss of tax revenues resulting from the growth of remote commerce, some states have made legislative attempts to circumvent the physical-presence standard and require remote retailers to collect corporation's lack of physical presence in the taxing state.”). see william joel kolarik, untangling substantial nexus, 64 tax law. 851, 881 (2011) (laying out the court’s justifications for shifting from pennoyer’s physical-presence test for personal jurisdiction to international shoe’s broader jurisdictional test). 21 see brannon p. denning, due process and personal jurisdiction, 64 st. tax notes 837 (2012) (arguing that the supreme court may favor a return to a more restrictive due process standard) (citing j. mcintyre machinery, ltd. v. nicastro, 131 s. ct. 2780 (2011)). 22 504 u.s. at 317–18. 23 id. at 315–16. 24 id. at 317. 25 id. at 318 n.10. 26 id. at 318. 27 see, e.g., id. at 315 (conceding that “[l]ike other bright-line tests, the bellas hess rule appears artificial at its edges”). 28 see u.s. census bureau, u.s. dep’t of commerce, 2010 e-commerce multisector data tables (released may 10, 2012) at historical table 5, “u.s. retail trade sales – total & e-commerce: 1998–2010,” available at http://www.census.gov/econ/estats/2010/all2010tables.html (showing total u.s. e-commerce retail trade at $74.2 billion in 2004 and $168.9 billion in 2010). 144 columbia journal of tax law [vol. 4:136 sales tax.29 in addition, in the wake of quill numerous states streamlined and coordinated their sales tax statutes in an attempt to convince congress to exercise its commerce clause power and overturn the judicially created physical-presence standard.30 in spite of these efforts, however, congress has declined to act and physical presence remains the existing standard for a state to impose a sales tax collection obligation on retailers. 2. substantial nexus in the corporate income tax context professor john swain put it succinctly when he wrote, “there is no ‘bellas hess’ of corporate income tax jurisprudence.”31 in other words, no u.s. supreme court case expressly sets forth a nexus standard for the corporate income tax, as bellas hess did for the sales tax.32 while the supreme court in quill intimated that the physical-presence standard applies only in the sales tax context,33 it did not expressly state this limitation.34 thus, state courts have been left to divine the supreme court’s intention with respect to whether the physicalpresence standard applies outside the sales tax context. generally speaking, state courts have read quill as limiting the standard to the sales tax. my purpose in 29 see, e.g., n.y. tax law § 1101(b)(8)(vi) (mckinney 2012) (new york’s “amazon law”); colo. rev. stat. § 39-26-102(3)(b)(ii) (2011) (colorado’s use tax reporting statute); cal. rev. & tax code § 6203(c)(1) (west 2011) (california’s “affiliate nexus” statute). 30 following quill, several states joined together to make their sales tax statutes more uniform and simple, thereby hoping to refute one of the supreme court’s rationales for upholding the physical-presence standard in quill—the “virtual welter of complicated obligations” making up the state and local sales tax system in the united states. quill, 504 u.s. at 313 n.6. these efforts resulted in the streamlined sales & use tax agreement. see infra note 107; see also streamlined sales tax governing board, inc., http://www.streamlinedsalestax.org/index.php?page=about-us (last visited aug. 14, 2012) (“the goal of this effort is to find solutions for the complexity in state sales tax systems that resulted in the u.s. supreme court holding (bellas hess v. illinois and quill corp. v. north dakota) that a state may not require a seller that does not have a physical presence in the state to collect tax on sales into the state.”); zelinsky, supra note 1, at 38–39 (“[a] fundamental goal of the [streamlined sales & use tax] project is to persuade congress that the states participating in the project have made it easier for firms to comply with such states’ sales and use tax laws.”). 31 john swain, state income tax jurisdiction: a jurisprudential and policy perspective, 45 wm. & mary l. rev. 319, 363 (2003). 32 perhaps one reason for the absence of a controlling supreme court decision with respect to corporate income tax jurisdiction is the existence of p.l. 86-272 (the interstate income act of 1959), which prohibits states from imposing their income tax on retailers whose only contact with a state is to solicit the sale of tangible personal property. pub. l. 86-272, 73 stat. 555 (1959) (codified at 15 u.s.c. §§ 381–384 (2012)). 33 again, i am using “sales tax” as shorthand for sales and use tax. see supra note 12. 34 see quill, 504 u.s. at 314 (“although we have not, in our review of other types of taxes, articulated the same physical-presence requirement that bellas hess established for sales and use taxes, that silence does not imply repudiation of the bellas hess rule.”); id. at 317 (“in sum, although in our cases subsequent to bellas hess and concerning other types of taxes we have not adopted a similar bright-line, physical-presence requirement, our reasoning in those cases does not compel that we now reject the rule that bellas hess established in the area of sales and use taxes.”). 2013] sales tax exceptionalism 145 this section is not to justify that conclusion, as others have already ably done.35 instead, my purpose is only to explain that most courts have applied a different nexus standard for the income tax than for the sales tax, thereby establishing sales tax exceptionalism in the jurisdictional context. the topic of corporate income tax jurisdiction has frequently arisen in the area of intellectual property licensing, and the south carolina supreme court issued the seminal opinion on this issue just one year after the u.s. supreme court’s decision in quill. in geoffrey, inc. v. south carolina tax commission,36 the south carolina supreme court held that the state had constitutional authority to require geoffrey, inc., a subsidiary of toys r us (“geoffrey”), to pay income tax in south carolina despite its lack of physical presence in the state. geoffrey was a delaware corporation with no employees, offices, or tangible property in south carolina.37 geoffrey owned and licensed trademarks, among them the “toys r us” name, to toys r us stores operating in several states, including south carolina. under the terms of the licensing agreement, geoffrey received “a royalty of one percent of the net sales by [toys r us], or any of its affiliated, associated, or subsidiary companies, of the licensed products sold or the licensed services rendered under the licensed mark.”38 south carolina sought to tax the share of this royalty income attributable to toys r us operations in the state. despite its lack of any physical presence in south carolina, the south carolina supreme court held that geoffrey satisfied complete auto’s “substantial nexus” requirement. the court characterized geoffrey’s reliance on the physical-presence standard of bellas hess as “misplaced.”39 without much discussion or support, the court stated, “it is well settled that the taxpayer need 35 professor swain gives a particularly insightful analysis of the proper nexus standard for the corporate income tax in his article. swain, supra note 31. professor denning also summarizes the major arguments against the physical presence requirement in a recent article as follows: [the physical presence standard] belied a formalism inconsistent with both the court’s personal jurisdiction cases and its embrace of pragmatism in other areas of interstate taxation. moreover, the argument goes, the presence of de facto exemption from tax for remote sellers violates principles of sound tax policy, unfairly burdens ordinary bricks-and-mortar retailers, and has—with the rise of electronic commerce— deprived state and local governments of billions of dollars in tax revenue. brannon p. denning, due process and personal jurisdiction, 64 st. tax notes 837, 841 (2012). 36 437 s.e.2d 13 (s.c. 1993). 37 id. at 15. in fact, geoffrey had no full-time employees at all. id. at 15 n.1. 38 id. at 15 (internal quotation marks omitted). 39 id. at 18. in making this statement, the south carolina supreme court cited to quill as “not[ing] that the physical presence requirement had not been extended to other types of taxes.” id. at 18 n.4. 146 columbia journal of tax law [vol. 4:136 not have a tangible, physical presence in a state for income to be taxable there. the presence of intangible property alone is sufficient to establish nexus.”40 several subsequent intellectual property licensing cases have followed geoffrey’s lead by holding that the physical-presence standard does not apply to the corporate income tax.41 some of these cases have provided more extensive discussion than geoffrey of the reasons for applying a different nexus standard to the corporate income tax than to the sales tax. in particular, the north carolina court of appeals in a&f trademark, inc. v. tolson42 gave a far more detailed explanation of why it refused to apply the physical-presence standard in a case with essentially identical facts to geoffrey. first, the north carolina court noted that “the tone in the quill opinion hardly indicated a sweeping endorsement of the bright-line test it preserved, and the supreme court’s hesitancy to embrace the test certainly counsels against expansion of it.”43 second, the court reasoned that “retention of the bellas hess test [in quill] was grounded, in no small part, on the principle of stare decisis and the ‘substantial reliance’ on the physicalpresence test, which had ‘become part of the basic framework of a sizable industry.’”44 according to the court, neither of these considerations—stare decisis nor industry reliance—applied in the context of the corporate income tax, therefore distinguishing the case from quill.45 third, the north carolina court explained that “there are important distinctions between sales and use taxes and income and franchise taxes,” and these differences favored limiting the physical-presence standard to the sales tax.46 specifically, the court stated that sales tax cases requiring physical 40 id. at 18. the only support the south carolina supreme court provided for this statement were a pre-bellas hess supreme court case (int’l harvester co. v. wis., 322 u.s. 435 (1944)), a new mexico supreme court case (am. dairy queen corp. v. tax’n & revenue dep’t, 605 p.2d 251 (1979)) that made no mention of bellas hess, and a statement from professor hellerstein’s state tax treatise (see hellerstein, supra note 12). while these sources certainly support the court’s conclusion, one would think that with quill decided just a year before, the south carolina court would have provided a more thorough discussion of its reasoning in limiting the physical-presence requirement to the sales tax context. 41 see, e.g., kfc corp. v. iowa dep’t of revenue, 792 n.w.2d 308 (iowa 2010); capital one bank v. comm’r of revenue, 899 n.e.2d 76 (mass. 2009) (adopting a flexible economic substance analysis rather than physical-presence test in context of financial institution excise tax); tax comm’r of w. va. v. mbna america bank, 640 s.e.2d 226 (w. va. 2007); geoffrey, inc. v. okla. tax comm’n, 132 p.3d 632 (okla. civ. app. 2006); lanco, inc. v. dir., div. of tax’n, 879 a.2d 1234 (n.j. super. ct. app. div. 2005); sec’y, dep’t of revenue, state of la. v. gap (apparel), inc., 886 so.2d 459 (la. ct. app. 2004); borden chems. & plastics v. zehnder, 726 n.e.2d 73 (ill. app. ct. 2000). 42 605 s.e.2d 187 (n.c. ct. app. 2004). 43 id. at 194. 44 id. 45 id. 46 id. 2013] sales tax exceptionalism 147 presence “‘were based on the vendor’s activities in the state, whereas’ the income and franchise taxes in the instant case are based solely on ‘the use of [the taxpayer’s] property in th[is] state by the licensee[s]’ and not on any activity by the taxpayers in the state.”47 in other words, the sales tax applies to a taxpayer’s activity in the taxing state—the sale of goods into the state—but the dispute in a&f trademark involved only the use of a taxpayer’s trademark property in the state—not any activity by the taxpayer in the state. because the issue in a&f trademark was not based on the taxpayers’ activity in north carolina, but rather on the taxpayers’ receipt of income from the use of the taxpayers’ property in this state by a commonly controlled third party, ‘it would [be] inappropriate and, indeed anomalous . . . [to determine] nexus by [the taxpayers’] activities or [their] physical presence’ in north carolina.48 in essence, the court seems to be saying that the income north carolina sought to tax resulted from the use of the taxpayer’s intangible intellectual property in the state, so it would be incongruous to require the taxpayer’s physical presence as a requirement to taxing that income. put simply, why require physical presence to tax income derived from intangible (i.e., nonphysical) property? finally, the court also pointed out structural differences between the income tax and the sales tax that justified different treatment, including (1) that the sales tax “can make the taxpayer an agent of the state, obligated to collect the tax from the consumer at the point of sale and then pay it over to the taxing entity”;49 and (2) the state income tax is usually paid only once a year, to one taxing jurisdiction and at one rate, “[but] a sales and use tax can be due periodically to more than one taxing jurisdiction within a state and at varying rates.” 50 in the court’s opinion, these structural differences rendered the corporate income tax less administratively burdensome to taxpayers than the sales tax. based on these reasons, the north carolina court “reject[ed] the contention that physical presence is the sine qua non of a state’s jurisdiction to tax under the commerce clause for purposes of income and franchise taxes.”51 rather, the court held that “where a wholly-owned subsidiary licenses trademarks to a related retail company operating stores located [in a state], there 47id. (quoting jerome r. hellerstein, geoffrey and the physical presence nexus requirement of quill, 8 st. tax notes 671, 676 (1995)). 48 605 s.e. 2d at 195 (quoting hellerstein, supra note 47, at 676). 49 id. 50 id. 51 id. 148 columbia journal of tax law [vol. 4:136 exists a substantial nexus with the state sufficient to satisfy the commerce clause.”52 not all state courts have reached the same conclusion as a&f trademark to limit quill’s physical presence standard to the sales tax,53 though most have.54 moreover, those few courts that have extended the physical-presence requirement beyond the sales tax have provided scant support for that result, as illustrated by the conclusory rationale given by the texas court of appeals in finding that an out-of-state corporation lacked substantial nexus with the state for franchise tax purposes: while the decisions in quill and bellas hess involved sales and use taxes, we see no principled distinction when the basic issue remains whether the state can tax the corporation at all under the commerce clause. as construed in quill and bellas hess, when the corporation conducts its activity solely through interstate commerce and lacks any physical presence in the state, no sufficient nexus exists to permit the state to assess tax.55 likewise, another state court to apply the physical presence standard outside the sales tax context justified that result by claiming a lack of authority to do otherwise: “any constitutional distinctions between the franchise and excise 52 id. 53 see, e.g., j.c. penney nat’l bank v. johnson, 19 s.w.3d 831, 839 (tenn. ct. app. 1999) (stating, in a discussion of the proper nexus standards for tennessee’s corporate franchise and excise taxes, that “[w]hile it is true that the bellas hess and quill decisions focused on use taxes, we find no basis for concluding that the analysis should be different in the present case”); acme royalty co. v. dir. of revenue, 96 s.w.3d 72, 75 (mo. 2002) (finding no income tax nexus for delaware holding companies that had no “property, payroll, or sales, in the state or missouri”); gen. motors corp. v. city of seattle, 25 p.3d 1022 (wash. ct. app. 2001) (holding that the physical-presence standard does not apply to seattle’s business & occupation tax, but agreeing with the j.c. penney court that the standard does apply to franchise taxes). 54 at least one court has also applied the less rigorous “economic presence” standard outside the context of intellectual property licensing. see tax comm’r of the state v. mbna am. bank, n.a., 640 s.e.2d 226 (w. va. 2006) (finding nexus for income and franchise tax purposes for a bank with no in-state physical presence); but see id. at 239 (benjamin, j., dissenting) (“the reality is that the united states supreme court has not generally treated the question of state authority to tax interstate commerce as turning on the specific type of tax involved. rather, the united states supreme court has focused instead on the effect of the tax which the taxing state seeks to levy on interstate commerce, regardless of the type of tax . . . . it would be a strange constitutional doctrine that would countenance one nexus standards for sales and use taxes under the commerce clause, and a more relaxed nexus standard for corporate net income and other state taxes.”). 55 rylander v. bandag licensing corp., 18 s.w.3d 296, 300 (tex. app. 2000). 2013] sales tax exceptionalism 149 taxes presented here and the use taxes contemplated in bellas hess and quill are not within the purview of this court to discern.”56 of those courts that have applied quill’s physical presence standard beyond the sales tax context, none has answered the arguments for limiting quill set forth in either the a&f trademark decision or in the academic literature.57 nevertheless, as stated at the outset of this section, for present purposes we need not determine which side has the better argument. we need only recognize that most courts considering the issue have applied different nexus standards depending on the type of tax involved, with a significant majority limiting the physical presence standard to the sales tax context. b. apportionment—another instance of sales tax exceptionalism in addition to the “substantial nexus” requirement, the complete auto test also requires that a state tax be “fairly apportioned.”58 as mentioned in the introduction, the supreme court has reached different results with respect to the apportionment requirement depending on the type of tax involved. before discussing the supreme court case law, however, a more detailed explanation of apportionment may prove helpful. “apportionment” refers to the method by which “the measure of a tax is divided by formula . . . based on the use of selected factors for attributing the tax base to the states in which the taxpayer uses its property, carries on its activities, or earns income.”59 in other words, apportionment divides a tax base among multiple states, each of which has a claim to tax the activity or property in question. apportionment is most easily illustrated in the context of the income tax. a state may not, of course, tax all of a taxpayer’s income simply because the state has personal jurisdiction over the taxpayer.60 if it could, duplicative taxation would be pervasive, as every state with jurisdiction over a taxpayer (and there may be many) could seek to tax the full amount of the taxpayer’s taxable income. as a result, the same income would potentially be subject to taxation multiple times.61 56 j.c. penney, 19 s.w.3d at 839. see also am. online, inc. v. johnson, no. m200100927-coa-r3-cv, 2002 wl 1751434 at *2 (tenn. ct. app. 2002) (moderating the court’s holding in j.c. penney by stating that nexus does not necessarily equate to physical presence in all instances or “j.c. penney would simply substitute ‘physical presence’ for ‘nexus’ as the first prong of the complete auto transit test”). 57 see swain, supra note 31 (arguing to limit the physical presence requirement to the sales and use tax). 58 complete auto transit inc. v. brady, 430 u.s. 274, 279 (1977). 59 hellerstein & hellerstein, supra note 12, at ¶ 8.05. 60 see id. at ¶ 8.02[1] (discussing taxpayers’ constitutional right to a division of the tax base among states). 61 see cent. r.r. co. of pa. v. pennsylvania, 370 u.s. 607, 612 (1962) (“[m]ultiple taxation of interstate operations . . . offends the commerce clause.”); hellerstein & hellerstein 150 columbia journal of tax law [vol. 4:136 to prevent this from happening, states are constitutionally required to use some method of dividing a taxpayer’s income so that only that share of income attributable to activities performed by the taxpayer within a state is subject to that state’s tax.62 this method of dividing the taxpayer’s income is known as “apportionment.” while relatively simple in theory, apportionment constitutes one of the most tricky and controversial aspects of state taxation.63 for example, assume a corporate taxpayer (“taxpayer”) has most of its manufacturing operations in state a, all of its warehousing facilities in state b, and the majority of its sales in state c. how should states a, b, and c divvy up taxpayer’s taxable income so that each state applies its income tax to that state’s fair share, but no more than its fair share, of taxpayer’s income?64 traditionally, states have answered this question by using a three-factor formula.65 the formula calculates a ratio, which is then applied to the taxpayer’s total taxable income to apportion a constitutionally acceptable share of income to the taxing state. the three-factor formula is intended to approximate the value derived from a taxpayer’s in-state activities, and therefore the amount of the taxpayer’s income attributable to (and taxable by) the state.66 the apportionment supra note 12 at ¶ 8.01 (“under the court's contemporary commerce clause doctrine, a taxpayer has the right to a division of the tax base if it can demonstrate that it is taxable . . . in another state. this conclusion follows inexorably from the principle that the commerce clause protects a multistate taxpayer from the risk of multiple taxation.”). 62 see j.d. adams mfg. co. v. storen, 304 u.s. 307, 311 (1938) (“the vice of the statute as applied to receipts from interstate sales is that the tax includes in its measure, without apportionment, receipts derived from activities in interstate commerce; and that the exaction is of such a character that if lawful it may in substance be laid to the fullest extent by states in which the goods are sold as well as those in which they are manufactured.”). 63 the difficulty of apportioning income fairly has been acknowledged by the supreme court, which has gone so far as to state that “[a]llocating income among various taxing jurisdictions bears some resemblance . . . to slicing a shadow.” container corp. of am. v. franchise tax bd., 463 u.s. 159, 192 (1983). see also underwood typewriter co. v. chamberlain, 254 u.s. 113, 120–21 (1920) (“the legislature, in attempting to put upon this business its fair share of the burden of taxation, was faced with the impossibility of allocating specifically the profits earned by the processes conducted within its borders.”). 64 see goldberg v. sweet, 488 u.s. 252, 260–61 (1989) (“[t]he central purpose [of complete auto’s apportionment requirement] is to ensure that each state taxes only its fair share of an interstate transaction.”). 65 an alternative to the “factor” approach described here is for states to use “separate accounting” as the method for determining the amount of income attributable to a corporation’s activities in an individual state. under separate accounting, income is assigned to a state “by hypothesizing the income which would have been earned in that state if the corporation’s in-state activities had been conducted by an independent entity dealing with the rest of the corporation on an arm’s-length basis.” zelinsky, rethinking tax nexus and apportionment: voice, exit, and the dormant commerce clause, 28 va. tax rev. 1, 13 (2008). 66 formula apportionment (as the use of the three-factor formula is called) is “employed as a rough approximation of a corporation’s income that is reasonably related to the activities conducted within the taxing state.” moorman mfg. co. v. bair, 437 u.s. 267, 273 (1978). 2013] sales tax exceptionalism 151 ratio is determined by averaging the proportion of the taxpayer’s in-state payroll, property, and sales, relative to the taxpayer’s total payroll, property, and sales.67 during the 1950s, almost every state used these same three factors—payroll, property, and sales—to apportion income. this consistency resulted from the promulgation of the uniform division of income for tax purposes act (uditpa) in 1957.68 under uditpa, each of the three factors receives equal weight in determining the percentage of a taxpayer’s income that should be apportioned to the taxing state.69 so, for example, if taxpayer has 30% of its property, 50% of its payroll, and 10% of its sales in state a, then 30%70 of taxpayer’s taxable income would be apportioned to, and taxable by, state a. 71 assuming taxpayer’s total taxable income were $100,000, state a would apply its income tax to $30,000 of taxpayer’s income. as with nexus, however, the approach to apportionment differs depending on the type of tax involved. but unlike nexus, this difference has been clearly articulated by the u.s. supreme court in a pair of cases involving essentially identical facts but different taxes. 1. apportionment in the gross receipts tax context in central greyhound lines, inc., of new york v. mealey,72 the court held that new york’s gross receipts tax, as applied to a new york-based subsidiary of greyhound lines (“greyhound ny”), violated the commerce clause because the state failed to apportion the tax base (the bus company’s gross income) among new york and the other states through which the company’s buses traveled. instead, new york sought to apply its gross receipts 67 the supreme court gave a succinct explanation of three-factor apportionment in moorman: the three-factor formula yields a percentage representing an average of three ratios: property within the state to total property, payroll within the state to total payroll, and sales within the state to total sales. [this percentage is] multiplied by the adjusted total net income to arrive at . . . taxable net income [apportioned to the taxing state]. this net income figure is then multiplied by the tax rate to compute the actual tax obligation of the taxpayer. id. at 270 n.3. 68 as discussed further below, at its height uditpa’s three-factor formula was in effect in all but two states with corporate income taxes. see infra part iii, discussing moorman. 69 unif. division of income for tax purposes act § 9 (1957). 70 averaging these three factors under uditpa’s three-factor apportionment formula, so that 30% = [(30% + 50% + 10%)/3]. 71 see darien shanske, a new theory of the state corporate income tax: the state corporate income tax as retail sales tax complement, 66 tax l. rev. 101, 109–11 (2012) (providing concise explanation of state corporate income tax apportionment). 72 334 u.s. 653 (1948). 152 columbia journal of tax law [vol. 4:136 tax to greyhound ny’s total gross income, even though 43% of the mileage traveled by the company’s buses “lay in new jersey and pennsylvania.”73 the bus routes at issue in central greyhound originated and terminated in new york, but passed through new jersey and pennsylvania en route to their final new york destination. because the routes both started and ended in new york, the new york court of appeals had found that the gross income greyhound ny received from ticket sales did not implicate “interstate commerce,” and therefore did not require apportionment.74 the supreme court disagreed with this conclusion. to characterize the routes as intrastate just because they started and ended in new york was “to indulge in a fiction,” according to the court.75 instead, the court found that because the routes involved a significant amount of travel through states other than new york, the ticket sales constituted interstate commerce.76 after making this initial determination that the bus routes at issue implicated interstate commerce, the court expressed concern over the possibility of duplicate taxation if new york were allowed to tax the full amount of greyhound ny’s gross income.77 the court reasoned that if new jersey and pennsylvania—the other states through which greyhound ny’s buses traveled— made “appropriately apportioned claims against that substantial part of the business of appellant to which they afford protection, we do not see how on principle and in precedent such a claim could be denied.”78 in other words, new york sought to apply its gross receipts tax to all the gross income generated by sales of bus tickets traveling not only through new york but also through new jersey and pennsylvania. the court found, however, that these other states had legitimate claims to tax a portion of greyhound ny’s gross income.79 because of the risk that multiple states would tax the same income, the court required apportionment of new york’s gross receipts tax based on “the mileage [traveled] within the state” by greyhound ny’s buses.80 with 57.47% of the total mileage of the journeys over the routes in question traversed within new york, and 73 id. at 660. 74 id. at 655 (stating that the new york court of appeals “proceeded to pass upon the constitutional issues and expressly held that ‘there is no constitutional objection to taxation of total receipts here. this is not interstate commerce.’”). 75 id. at 659. 76 id. at 655–56 (“it is too late in the day to deny that transportation that leaves a state and enters another state is ‘commerce . . . among the several states.’”). 77 see kolarik, supra note 20, at 866 (“‘[f]air apportionment’ concerns the risk of multiple taxation—the idea that a state may only tax the portion of a transaction that is fairly attributable to that state.”). 78 central greyhound, 334 u.s. at 662. 79 in fact, pennsylvania did assert its own gross receipts tax against a share of the bus company’s gross income. see id. at 662. 80 id. at 663. 2013] sales tax exceptionalism 153 42.53% of the total mileage traversed within new jersey and pennsylvania,81 the court only permitted new york to apply its gross receipts tax to 57.47% of greyhound’s gross income. the remaining 43.53% was left for pennsylvania and new jersey to tax (or not, should those states so choose).82 thus, with respect to a state’s gross receipts tax, the court requires apportionment among the states in which services are provided. in central greyhound, that apportionment was based on the in-state versus out-of-state mileage traveled by the taxpayer’s buses. the court likewise requires apportionment of net income in cases involving the state corporate income tax, 83 though the apportionment typically is based on factors other than miles traveled.84 consequently, for both gross receipt and corporate income tax purposes, the court requires apportionment based on in-state versus out-of-state factors. 2. apportionment in the sales tax context because of the similarity of the facts involved, the court’s later decision in oklahoma tax commission v. jefferson lines, inc.,85 stands in stark contrast with central greyhound. jefferson lines had failed to “collect or remit the sales taxes for tickets it had sold in oklahoma for bus travel from oklahoma to other states.”86 after the bus company filed for bankruptcy, oklahoma filed a proof of claim, arguing that the company owed sales tax on these ticket sales.87 jefferson lines countered that central greyhound precluded oklahoma from imposing its sales tax on the bus ticket sales, since “some of th[e] value [from the sales] derives from bus travel through other states.”88 jefferson lines further argued 81 id. at 662. 82 id. at 663. 83 see, e.g., mobil oil corp. v. comm.’r of taxes of vt., 445 u.s. 425, 436 (1980) (“it long has been established that the income of a business operating in interstate commerce is not immune from fairly apportioned state taxation.”) (emphasis added). see also hellerstein & hellerstein, supra note 12, at ¶ 8.02[2][b] (disagreeing with state court decisions allowing unapportioned taxation of banks’ income). the court has never had to deal expressly with a state’s attempt to tax the unapportioned income of a multistate corporation. see hellerstein & hellerstein, supra note 12, at ¶ 8.02[3] (explaining that because all states with corporate income taxes provide for apportionment, “the supreme court has never had occasion to address directly the question whether a state may tax the unapportioned net income of a domestic corporation that does business in, or derives income from, other states”). 84 as explained above, the income tax is typically apportioned according to some combination of property, payroll, and sales that a taxpayer has in the taxing state. see supra note 67. 85 okla. tax comm’n v. jefferson lines, inc., 514 u.s. 175 (1995). 86 id. at 178. the gross income at issue in central greyhound related to tickets for travel both originating and ending in new york, though the routes involved passed through bordering states on their way to their ultimate new york destination. 87 id. 88 id. 154 columbia journal of tax law [vol. 4:136 that allowing oklahoma to impose its sales tax “presents the danger of multiple taxation . . . because any other state through which a bus travels while providing the services sold in oklahoma [would] be able to impose taxes of their own upon jefferson or its passengers for use of the roads.”89 despite its holding in central greyhound, the court upheld the imposition of oklahoma’s sales tax on the full price of the tickets at issue in jefferson lines. after reviewing holdings from various cases involving the apportionment of other types of taxes (including the gross receipts tax in central greyhound), the court explained that the sales tax was different: in reviewing sales taxes for fair share [i.e., apportionment] . . . we have had to set a different course. a sale of goods is most readily viewed as a discrete event facilitated by the laws and amenities of the place of sale, and the transaction itself does not readily reveal the extent to which completed or anticipated interstate activity affects the value on which a buyer is taxed. we have therefore consistently approved taxation of sales without any division of the tax base among different states, and have instead held such taxes properly measurable by the gross charge for the purchase, regardless of any activity outside the taxing jurisdiction that might have preceded the sale or might occur in the future.90 the court further explained its distinct treatment of the sales tax by identifying the “freedom of purchase” as the activity constituting the basis for applying the sales tax, and noting that a purchase occurs in only one state. therefore, the court reasoned, the risk of duplicate taxation, which played such a central role in the court’s decision to require apportionment in central greyhound, was found not to apply in the sales tax context: “the taxable event [with respect to the sale of services, such as the bus service at issue in jefferson lines] comprises agreement, payment, and delivery of some of the services in the taxing state; no other state can claim to be the site of the same combination.”91 consequently, the court found the concern over duplicative taxation inapplicable in jefferson lines.92 this distinguishing factor led the court to reach a different conclusion than it had in central greyhound. the court in jefferson lines held that the sales tax need not be apportioned among the states, but rather that the state in which the sale occurs may apply its sales tax to the full, unapportioned 89 id. 90 id. at 186. 91 id. at 176. see also id. at 188 (stating that the “taxable event” in jefferson lines, the sale of the bus ticket in oklahoma, was “wholly local”). 92 id. at 191 (“in sum, the sales taxation here is not open to the double taxation analysis on which central greyhound turned, and that decision does not control.”). 2013] sales tax exceptionalism 155 price of the good or service purchased.93 thus, unlike the gross receipts and corporate income taxes, which require apportionment, the sales tax does not.94 3. judicial bases for sales tax exceptionalism the judicial decisions treating the sales tax differently for jurisdictional and apportionment purposes ultimately reach their results based on administrative and structural considerations. in particular, the supreme court established the physical presence standard in bellas hess due in large part to its concern that allowing thousands of taxing jurisdictions each to require remote retailers to collect sales tax would burden interstate commerce and “entangle” multi-state businesses in a “virtual welter of complicated obligations.”95 upon reconsideration of the substantial nexus standard in quill, the court also expressed concern over the potential retroactive application of the sales tax if the court were to change from physical presence standard, particularly in light of the reliance by the mail-order industry on that standard during the twenty-five years since the court’s decision in bellas hess.96 in contrast, the state courts that have held economic presence to suffice as “substantial nexus” for corporate income tax purposes have characterized the income tax as less administratively burdensome than the sales tax. for example, the north carolina court of appeals in a&f trademark noted that a “state income tax is usually paid only once a year, to one taxing jurisdiction and at one rate, [but] a sales and use tax can be due periodically to more than one taxing jurisdiction within a state and at varying rates.”97 thus, the state courts have focused on the fact that the simpler administrative aspects of the corporate income tax impose less of a burden on interstate commerce than the sales tax. state courts have also expressed less concern over the reliance by remote retailers on an established nexus standard in the corporate income tax context, since no supreme court case has firmly established such a standard.98 93 id. at 184–91 (discussing apportionment). 94 the sales tax is not the only tax that the court has found not to require apportionment. in goldberg v. sweet, 488 u.s. 252 (1989), the court held that illinois’ telecommunications excise tax also did not require apportionment. in reaching that holding, the court agreed with illinois that the excise tax “has the same economic effect as a sales tax.” id. at 262 (“the tax at issue has many of the characteristics of a sales tax.”). 95 quill corp. v. n. d. ex rel. heitkamp, 504 u.s. 298, 313 n.6 (1992) (quoting national bellas hess, inc. v. dep’t of revenue of ill., 386 u.s. 753, 759–60 (1967)). 96 quill, 504 u.s. at 317 (“[t]he bellas hess rule has engendered substantial reliance and has become part of the basic framework of a sizable industry.”). 97 a&f trademark, inc. v. tolson, 605 s.e.2d 187, 195 (n.c. ct. app. 2004) (quoting kmart props, inc. v. taxation and revenue dep’t. of n.m., 139 n.m. 177, 185 (n.m. ct. app. 2001)). 98 a&f trademark, 605 s.e.2d at 194 (“[s]ince the physical-presence requirement has never been established by judicial precedent for other forms of taxation [than the sales tax] . . . , we 156 columbia journal of tax law [vol. 4:136 in the apportionment context, the court’s decision to require apportionment for the gross receipts tax but not for the sales tax turned primarily on concern over the potential for duplicative taxation with the former tax but not with the latter.99 because oklahoma was the only state in which the sale of the bus tickets and provision of some of the services related to that sale occurred, the court found that oklahoma was also the only state that could legitimately apply its sales tax to the transaction in jefferson lines.100 in contrast, the court in central greyhound acknowledged that, because a share of the receipts were attributable to bus services provided in pennsylvania and new jersey, those states could rightfully apply their own gross receipts taxes to the bus ticket sales in question in central greyhound.101 this would, of course, result in duplicate taxation if new york were permitted to apply its gross receipts tax to the full sales price of the bus tickets. none of the decisions—bellas hess, quill, the state court cases addressing the nexus standard for the corporate income tax, central greyhound, or jefferson lines—discussed the theoretical foundations for the taxes at issue or whether those foundations support different treatment of the taxes. such a discussion is warranted, however, for several reasons. first, in assessing judicial rules such as the substantial nexus rules relating to the sales tax and the corporate income tax, it only makes sense to ask whether those rules are consistent with the theories underlying the taxes involved. second, technological and legal changes may now render obsolete some of the judicial rationale for the different treatment given to the sales tax and the corporate income tax in earlier jurisprudence.102 for example, the court would almost certainly need to reconsider the burden argument relied on so heavily in bellas hess—and carried forward, though relied on to a lesser degree, in quill—if it heard a comparable case today.103 since dismiss the possibility that analogous substantial reliance, as contemplated in quill, exists in this case.”). 99 see central greyhound lines of n.y. v. mealey 334 u.s. 653, 662 (1948) (“if new jersey and pennsylvania could claim their right to make appropriately apportioned claims against that substantial part of the business of appellant to which they afford protection, we do not see how on principle and in precedent such a claim could be denied.”); okla. tax comm’n v. jefferson lines, inc., 514 u.s. 175, 190 (1995) (“the taxable event comprises agreement, payment, and delivery of some of the services in the taxing state; no other state can claim to be the site of the same combination.”). 100 jefferson lines, 514 u.s. at 191. moreover, because every state with a use tax provides a credit for sales tax paid in any other states, none of the other states through which the jefferson lines bus passed could apply their use tax to the ticket purchase. 101 central greyhound, 334 u.s. at 662. 102 see infra section ii.c. 103 see waltreese carroll, tax academics diverge on constitutionality of colorado’s “amazon” law, 2012 st. tax today 128-1 (july 3, 2012) (quoting professor edward zelinsky as stating that “although quill is controlling law, it is an opinion that many believe would be decided differently if the u.s. supreme court were ruling today.”). 2013] sales tax exceptionalism 157 1967, when bellas hess was decided, and even since 1992, when the court decided quill, technological advances have made it simpler to track and determine sales tax liability.104 moreover, several commercial providers now offer sales tax calculation services for businesses, whereas this service was virtually nonexistent even a decade ago.105 but perhaps most importantly, almost half the states have made substantial efforts to conform their sales tax statutes and thereby make sales tax collection by remote retailers significantly less onerous. in particular, twentyfour states have joined the streamlined sales and use tax agreement (the “ssuta”), a multi-state compact established in direct response to the quill court’s assessment that the sheer number of sales tax jurisdictions (and the variability of statutes and ordinances within those jurisdictions) would create an undue burden on interstate commerce if remote retailers were required to collect sales tax.106 the ssuta seeks to mitigate this burden by requiring, among other things, that member states (1) designate a single entity for administration of both state and local taxes, so that taxpayers need file returns with only one administrative body;107 (2) maintain uniform tax bases and tax definitions for both state and local sales tax purposes;108 (3) notify sellers of changes in the state sales tax laws;109 (4) provide and maintain a database of all sales tax rates for all 104 saul hansell, amazon plays dumb in internet sales tax debate, n.y. times bits blog (feb. 13, 2008, 12:47 pm), http://bits.blogs.nytimes.com/2008/02/13/amazon-plays-dumb-ininternet-sales-tax-debate (reporting the statement by netflix ceo reed hastings that complying with sales and use tax collection requirements is “not very hard”). see also pricewaterhousecoopers, retail sales tax compliance costs: a national estimate (2006), available at http://www.bacssuta.org/cost%20of%20collection%20study%20%20sstp.pdf (estimating average compliance cost for sales tax collection at 0.13% of taxable sales for large businesses (over $10 million in annual sales); 0.32% of taxable sales for mid-sized businesses (between $1 million and $10 million in annual sales); and 0.82% of taxable sales for small businesses (between $150,000 and $1 million in annual sales)); but see patrick m. byrne and jonathan e. johnson, iii, the rights and wrongs of taxing internet retailers, wall st. j., july 24, 2012, at a15 (stating that it took their company, overstock.com, a “team of 20–30 experienced it professionals over five months to install, test and integrate the software that lets us properly calculate use tax in one additional state,” at a cost of $1.3 million). 105 see streamlined sales tax governing bd., inc., “certified service providers,” available at http://www.streamlinedsalestax.org/index.php?page=certified-service-providers (listing certified service providers that provide sales tax calculation and collection services for retailers) (last visited aug. 15, 2012). 106 see streamlined sales tax governing bd., inc., “about us,” http://www.streamlinedsalestax.org/index.php?page=about-us (last visited aug. 15, 2012). 107 streamlined sales tax governing bd., inc., streamlined sales & use tax agreement (“ssuta”) § 301(a) (amended may 24, 2012), available at http://www.streamlinedsalestax.org/index.php?page=modules. 108 id. § 302. 109 id. § 304(a). 158 columbia journal of tax law [vol. 4:136 jurisdictions levying taxes within the state;110 and (5) provide and maintain a database that assigns each five-digit and nine-digit zip code within a member state to the proper tax rates and jurisdictions.111 the ssuta also relieves sellers from liability if they collect the wrong amount of sales tax while relying on the database information provided by the states.112 in sum, the ssuta goes a long way toward simplifying and coordinating the collection and payment of sales tax in the twenty-four member states. yet despite these developments, the physical-presence standard applicable to the sales tax might still find support in the tax’s theoretical underpinnings. if so, the physical-presence standard should continue to control. thus, the next section explores the theoretical foundations for the sales tax and the corporate income tax and then asks whether those foundations support different jurisdictional standards for the taxes. ii. assessing the theoretical basis (or lack thereof) for sales tax exceptionalism of course, the “primary, intended, real effect of any general revenueraising tax,” such as the corporate income tax or the sales tax, is “to curtail some part of the private consumption of economic resources that would otherwise occur, in order to free those resources for public use, including redistribution to the poor.”113 in other words, taxes are, at their heart, meant to transfer resources from the individual to the state and fund state services, which may include the redistribution of wealth. the corporate income tax and the sales tax both seek to accomplish this goal, but they do so by taxing different aspects of economic wellbeing. as explained by professor michael mcintyre, a taxpayer’s economic well-being may be measured by the following components: “(1) personal consumption; (2) realized income; (3) imputed income from home ownership; and (4) undistributed income derived from ownership of shares in a corporation.”114 states typically tax each of these components of economic wellbeing through their sales tax, individual income tax, property tax, and corporate income tax, respectively.115 in effect, then, the sales tax serves as a tax on personal consumption, which constitutes one measure of a taxpayer’s economic well-being. the 110 id. § 305(e). 111 id. § 305(f). 112 id. § 306(a). 113 william d. andrews, a consumption-type or cash flow personal income tax, 87 harv. l. rev. 1113, 1165 (1974). 114 michael j. mcintyre, thoughts on the future of the state corporate income tax, 25 st. tax notes 931, 932 (2002). this definition ultimately derives from the haig–simon definition of income: “personal consumption plus the net change in wealth over the taxable period.” id. at n.6 (citing henry simons, personal income taxation 59 (1938)). 115 id. at 932. 2013] sales tax exceptionalism 159 corporate income tax targets undistributed corporate income, another measure of taxpayer wealth. in taxing undistributed income, the corporate income tax also prevents taxpayers from using corporations as income shielding devices.116 in short, the sales tax and the corporate income tax each tax different aspects of an individual’s economic well-being. both taxes also serve another purpose, at least in theory. the sales tax and corporate income tax both operate as charges imposed on taxpayers by the state for the privilege of participating in an orderly marketplace.117 the sales tax has been characterized by the supreme court as “a tax on the freedom of purchase.”118 as such, the tax may be viewed as compensating the state for allowing the exercise of that freedom by providing a marketplace in which purchasers may acquire goods and services. 119 likewise, the corporate income tax may be viewed as “a charge on corporations for providing them with a market in which to sell their goods and services and providing them with the infrastructure needed to produce those goods and services.”120 thus, courts have justified the imposition of both taxes based on the orderly marketplace that the state provides for commerce.121 116 at the federal level, the accumulated income penalty serves this explicit purpose. 117 this theory of taxation—that the state is justified in collecting taxes based on the benefits provided by the state to taxpayers—is known as the “benefit theory.” in addition to justifying the imposition of state taxes, the benefit theory also serves as a limit on the states’ ability to tax. the supreme court long ago said that a state may not exact a tax unless the tax “bears fiscal relation to protection, opportunities and benefits given by the state.” wis. v. j.c. penney co., 311 u.s. 435, 444 (1940). this concept is presently embodied in complete auto’s fourth prong, that a state tax must be “fairly related” to the services provided by the state. complete auto transit inc. v. brady, 430 u.s. 274, 274 (1977). 118 mcleod v. j.e. dilworth co., 322 u.s. 327, 331 (1944). 119 the sales tax is typically charged against the purchaser, rather than the retailer, and the retailer simply serves as the state’s agent for collecting the tax. see hellerstein & hellerstein, supra note 12, at ¶ 12.01 (explaining that even in states denominating their tax as a “vendor tax,” the economic incidence of the tax typically falls on the consumer). 120 mcintyre, supra note 114, at 933. 121 see, e.g., a&f trademark inc. v tolson, 605 s.e.2d 187, 192 (n.c. app. 2004) (“[b]y providing an orderly society in which the related retail companies conduct business, north carolina has made it possible for the taxpayers to earn income pursuant to the licensing agreements.”); geoffrey, inc. v. s.c. tax comm’n, 437 s.e.2d 13, 22 (s.c. 1993) (“by providing an orderly society in which toys r us conducts business, south carolina has made it possible for geoffrey to earn income pursuant to the royalty agreement.”); mcintyre, supra note 114, at 934 (“the states have contributed to the creation and maintenance of a marketplace where corporations can sell goods at a profit. they have also contributed to the creation of the infrastructure— educated workforce, roads, utilities, courts, police, and so forth—needed for the production of goods and services.”). this same “benefits” argument has been discussed in cases involving the sales tax. for example, in his dissent in quill, justice white argued that north dakota was justified in asserting its sales tax because: 160 columbia journal of tax law [vol. 4:136 while the corporate income tax and the sales tax both serve at least three common purposes—raising funds for the state, taxing economic well-being, and taxing the benefit of an orderly marketplace provided by the state122—each also serves distinct purposes, as further discussed below. the reason for exploring these distinct purposes is to assess whether the different theoretical bases for the taxes justify the different jurisdictional standards that courts have afforded them. a. theoretical foundations for the sales tax the sales tax is a form of consumption tax. as such, the sales tax may be justified under a number of theories. first, the sales tax applies only to that portion of an individual’s economic well-being that is actually put to use (i.e., consumed). it allows savings to escape taxation, or at least defers taxing savings until those savings are eventually consumed. this has the theoretical benefit of eliminating the deadweight loss from a tax on savings and should increase savings rates. 123 academics have frequently cited the pro-savings effects of consumption taxes as a justification for them,124 though this may be viewed more as a criticism of the income tax rather than as a theoretical justification for consumption taxes.125 perhaps another way to think of this theory, then, is that [a]n out-of-state direct marketer derives numerous commercial benefits from the state in which it does business. these advantages include laws establishing sound local banking institutions to support credit transactions; courts to ensure collection of the purchase price from the seller's customers; means of waste disposal from garbage generated by mail-order solicitations; and creation and enforcement of consumer protection laws, which protect buyers and sellers alike, the former by ensuring that they will have a ready means of protecting against fraud, and the latter by creating a climate of consumer confidence that inures to the benefit of reputable dealers in mail-order transactions. quill corp. v. north dakota, 504 u.s. 298, 329 (1992) 122 the academic literature indicates that of these three, the revenue-raising purpose was foremost in the minds of state policymakers when the states first enacted general sales taxes in the early 1930s. see, e.g., john f. due & john l. mikesell, sales taxation: state and local structure and administration 1 (2d ed. 1994) (“the sales tax was initially a desperation measure, borne out of the inability of states in the depression years of the 1930s to finance basic functions from existing sources, and the pressure on the states to transfer the property tax to the local governments.”). 123 see barbara h. fried, fairness & the consumption tax, 44 stan. l. rev. 961, 962 (1992). 124 see zelenak, infra note 131, at 605–06; warren, infra note 133, at 1097–101; andrews, supra note 113, at 1173 (stating, though not necessarily agreeing, that “it seems to be assumed that the net effect of the shift toward a consumption base would favor saving”). 125 a lengthy and robust debate has taken place in the academic literature regarding the superiority of the consumption tax or the income tax. see carolyn c. jones, treatment of gratuitous transfers: unraveling the case for a consumption tax, 29 st. louis u. l.j. 1155, 1160 (1985) (“the debate on whether the income or consumption tax is more fair has been relatively lengthy in time and number of pages.”). 2013] sales tax exceptionalism 161 the sales tax serves beneficial policy purposes in what it does not do (tax savings), in addition to what it does do (provide a revenue source for the state). more “affirmative” theories as to why we tax consumption also exist. for example, professor carolyn jones has characterized consumption taxes, such as the sales tax, as utility-based taxes.126 according to professor jones, a taxpayer derives “utility”—pleasurable experience or perceptions 127 —from consumption and “any utility generating transaction should be taxed.”128 thus, one justification for taxing consumption is that consumption results in utility to the consumer,129 and it is this utility that is in fact taxed.130 another rationale for the sales tax, known as the “common pool” theory, is somewhat more abstract than either the pro-savings or utility theories. under the common pool theory, taxes should apply when a taxpayer converts scarce resources to “private preclusive use.”131 this theory, which has been traced back to writings by thomas hobbes,132 provides that “unconsumed resources are left in a common pool” and “it is inappropriate to tax a person until he withdraws his resources [from the common pool] for personal consumption.”133 in other words, savings should not be taxed while remaining in the common pool, where the savings benefit society generally. according to this theory, resources in the common pool “can be characterized as socially desirable in that the capital so supplied will increase both future production and the future productivity of 126 id. at 1171. in her article, professor jones was discussing a cash-flow consumption tax rather than a sales tax, but the justifications for the tax discussed in her article and repeated here apply to both types of taxes. see id. at 1156 (distinguishing the consumption tax from the sales tax or value-added tax based on a progressive rate structure). 127 id. at 1162. 128 id. at 1168. 129 in the context of voluntary transactions, a taxpayer would presumably not enter into a transaction unless the result of the transaction (the good or service received) exceeded the taxpayer’s utility in simply maintaining the status quo and not entering into the transaction. 130 of course, each individual may experience a different level of “utility” from a given experience. any practical consumption tax must use an objective measure of utility, since an individualized measure would be unworkable. for the sales tax, the measure of utility is the market price of the good or service purchased. 131 lawrence zelenak, commentary: the reasons for a consumption tax & the tax treatment of gifts and bequests, 51 tax l. rev. 601, 605 (1996) (identifying as a rationale of consumption tax that “taxation should reach only ‘private preclusive use’ of scarce resources”). 132 the common pool theory derives from hobbes’ question: “for what reason is there, that he which laboureth much, and sparing the fruits of his labour, consumeth little, should be more charged, then he that living idly, getteth little, and spendeth all he gets; seeing the one has no more protection from the commonwealth, than the other?” thomas hobbes, leviathan 226 (m. oakeshott ed. 1960). 133 alvin warren, would a consumption tax be fairer than an income tax?, 89 yale l.j. 1081, 1094 (1980). 162 columbia journal of tax law [vol. 4:136 workers.” 134 it is only upon that withdrawal from the common pool for individual consumption that taxation is justified. some commentators have criticized the common pool theory as failing to “capture the reality of existing legal relationships in our society.”135 after all, the common pool is only “common” in the sense of being the aggregate of unconsumed resources. legal restraints prevent anyone other than the owner of specific assets within the common pool from acquiring those assets.136 despite its detractors, the common pool theory continues to appear in the academic literature and, along with the pro-savings and utility theories, serves as one of the primary justifications for consumption taxes like the sales tax.137 b. theoretical foundations for the corporate income tax scholars have provided several justifications for the corporate income tax. one holds that the corporate income tax “reflects the belief that corporations . . . constitute distinct, taxable entities separate from their investors.”138 under this theory, a corporation is taxed separately from its shareholders because of its particular corporate characteristics. as explained by professor marjorie kornhauser: corporate characteristics of free transferability of interests, continuity of life, limited liability and centralized management . . . emphasized the distinction between the corporation and its shareholders. corporate liability was not shareholder liability. the life of the corporation was independent of that of its shareholders. as corporations grew and ownership became separated from management, shareholders became increasingly passive and lost a sense of identification with the corporation. the corporation became a separate entity.139 the idea that a corporation is an entity separate from its owners seems almost an afterthought today, but, as explained by professor kornhauser, during the last quarter of the nineteenth century and at the beginning of the twentieth century, the issue was subject to serious debate, with opponents of the corporate 134 id. 135 id. 136 id. at 1095 (“that pool is not collectively owned, but held privately by shareholders whose shares are simply their claims on unconsumed product.”). 137 see, e.g., lawrence zelenak, debt-financed consumption and a hybrid incomeconsumption tax, 64 tax l. rev. 1, 5–6 (2010) (discussing the common pool theory and its critique). 138 steven a. bank, a capital lock-in theory of the corporate income tax, 94 geo. l.j. 889, 890–91 (2006). 139 see marjorie e. kornhauser, corporate regulation and the origins of the corporate income tax, 66 ind. l.j. 53, 61 (1990). 2013] sales tax exceptionalism 163 tax characterizing corporations as an aggregate of the individual owners.140 it was only after years of sustained debate that “[l]egal theory . . . veered toward a natural entity theory in the corporate area.”141 thus, one possible explanation for the corporate income tax is that the corporation constitutes a separate and distinct entity from its shareholders, with rights and privileges that justify the government (be it federal or state) imposing a tax on the entity.142 of course, the limited liability granted to corporate shareholders is one of those privileges, and the double taxation resulting from the corporate income tax may be viewed as the “cost” of the state allowing this benefit.143 a second theory of the corporate income tax proposes that the tax serves the more mundane purpose of acting as a tax withholding and collection mechanism for corporate shareholders.144 this theory, as explained by professor steven bank, contends that “the corporate income tax was originally adopted as a substitute or ‘proxy’ for taxing corporate shareholders directly.”145 the need to collect taxes at the entity level, rather than individual shareholder level, came about as a result of the expanded use of the corporate form during the late nineteenth century. with that expansion, states recognized the inadequacy of general property taxes in detecting and taxing stock holdings. pursuant to the general property taxes in effect at the time, shareholders were required to selfreport the value of the corporate stock they owned. as one might expect, gross understatements of value were common (when shareholders reported their stock 140 id. at 58–60 (describing the debate about aggregate or entity theory with respect to the corporation during the progressive era). interestingly, although the idea that a corporation is an entity separate from its shareholders is widely accepted today, recent corporate theory also views corporations as a nexus of contracts. see id. at 136 (“[t]oday's pet theory, the economic theory of the firm as a nexus of contracts between individuals, tends to eliminate the corporation as an entity.”). 141 see id. at 61. 142 president taft alluded to the separate entity theory as support for the enactment of the federal corporate income tax in 1909. in a message to congress, president taft wrote that the proposed corporate tax was “an excise tax upon the privilege of doing business as an artificial entity and of freedom from a general partnership liability enjoyed by those who own the stock.” reuven avi-yonah, corporations, society, and the state: a defense of the corporate tax, 90 va. l. rev. 1193, 1218 (2004) (quoting 44 cong. rec. 3344 (1909) (statement of president taft)). 143 see avi-yonah, supra note 142, at 1205–06 (“the [corporate income] tax is conceived as a payment in return for the benefits of incorporation, such as limited liability.”). 144 steven a. bank, entity theory as myth in the origins of the corporate income tax, 43 wm. & mary l. rev. 447, 450–52 (2001) (“[t]he corporate income tax was originally adopted as a substitute or ‘proxy’ for taxing corporate shareholders directly.”). president taft’s statement to congress in support of the 1909 corporate income tax also mentioned the administrative benefit of collecting tax from the corporation rather than from individual shareholders as a reason to enact the corporate income tax: “[the corporate income tax] imposes a burden at the source of the income at a time when the corporation is well able to pay and when collection is easy.” 44 cong. rec. 3344 (1909) (statement of president taft). 145 bank, supra note 144, at 452. 164 columbia journal of tax law [vol. 4:136 holdings at all).146 professor bank explains, “tax evasion was so prevalent toward the end of the nineteenth century that it ‘was often perpetrated openly and defiantly.’”147 both the federal and state governments recognized the need to collect taxes at the income source (the corporation), rather than from individual shareholders. as stated in a wisconsin state tax commissioner report in 1903: the wealth of the country in personalty consists largely of investments in corporate securities, stocks, and bonds in railroad and other corporations which are not and cannot be reached for taxation to the holders by the severest and most inquisitorial laws. the taxation of corporations as legal entities is the only recourse.148 thus, the purpose of the corporate income tax was to facilitate collection of taxes that shareholders were otherwise failing to pay. under a third theory, the corporate income tax originated as a means of checking the expansion of corporate power. according to the proponents of this theory, the corporate income tax serves as “a regulatory tool to publicize and control the wealth and power of corporate managers and owners.”149 this theory has been espoused by professor reuven avi-yonah, who points out that: [corporate] resources are managed by individual corporate managers, and their control over such resources gives them significant economic, social, and political power. in that sense, imposing a corporate tax that reduces the economic resources available to corporate managers also reduces the power of corporate management.150 professor avi-yonah provides a detailed historical account of the enactment of the federal corporate income tax in 1909. in recounting that history, he quotes at length the rationale given by president taft for his support of the tax: another merit of this tax is the federal supervision which must be exercised in order to make the law effective over the annual accounts and business transactions of all corporations. while the 146 see id. at 508–15. 147 id. at 519. 148 roswell c. mccrea, a suggestion on the taxation of corporations, 19 q.j. econ. 498, 499 n.1 (1905) (quoting a representative of the wisconsin state tax commission (1903)). 149 ajay mehrotra, the public control of corporate power: revisiting the 1909 corporate tax from a comparative perspective, 11 theoretical inquiries in l. 492, 494 (2010). see also kornhauser, supra note 139 (arguing that the corporate excise tax of 1909 constituted an attempt to regulate corporations). 150 avi-yonah, supra note 142, at 1211. interestingly, professor bank has argued that corporate management has essentially acquiesced in corporate taxation because the resulting double taxation “helps persuade shareholders to allow managers to retain earnings and invest them free of substantial monitoring.” bank, supra note 144, at 535. 2013] sales tax exceptionalism 165 faculty of assuming a corporate form has been of the utmost utility in the business world, it is also true that substantially all of the abuses and all of the evils which have aroused the public to the necessity of reform were made possible by the use of this very faculty. if now, by a perfectly legitimate and effective system of taxation, we are incidentally able to possess the government and the stockholders and the public of the knowledge of the real business transactions and the gains and profits of every corporation in the country, we have made a long step toward that supervisory control of corporations which may prevent a further abuse of power.151 according to professor avi-yonah, the corporate income tax was intended to “regulate management directly by reducing corporate wealth” and thereby “restricting managerial power.” 152 the perceived need to restrict corporate power arose because of the unprecedented consolidation of power during the early years of the twentieth century from “a system of owner/manager enterprises operating in a largely unregulated competitive market to a system dominated by a relatively few large, mostly non-owner managed corporations in a regulated competitive market.”153 professor avi-yonah argues, “to tax the powerful trusts was seen as the beginning of a federal power to regulate and potentially destroy them.”154 finally, professor bank has more recently presented another theory for corporate taxation—that the corporate income tax originated as a means of dealing with the threat to tax revenues resulting from “capital lock-in.”155 capital lock-in refers to “the corporation’s ability to commit both capital and the earnings from capital to the firm so that it may not be recovered by shareholders, or the creditors of shareholders, in the absence of action by the firm’s board of directors.”156 bank contends that lock-in allowed for greater confidence in corporate stability by preventing a corporate investor from “unilaterally 151 avi-yonah, supra note 142, at 1219 (quoting 44 cong. rec. 3344 (1909) (statement of president taft)). 152 id. at 1225. 153 kornhauser, supra note 139, at 55. 154 avi-yonah, supra note 142, at 1231. professor avi-yonah goes on to explain that the need to control corporate power persists today and “therefore that the corporate tax is justified as a means to control the excessive accumulation of power in the hands of corporate management, which is inconsistent with a properly functioning liberal democratic polity.” id. at 1244. 155 steven a. bank, a capital lock-in theory of the corporate income tax, 94 geo. l.j. 889 (2006). 156 id. at 891–92. 166 columbia journal of tax law [vol. 4:136 withdraw[ing] his share of the business by placing the power both to dispose of firm assets and to distribute profits in the hands of a board of directors.”157 with the increasing separation between ownership and management that resulted from the prevalence of diffuse and widespread stock ownership, corporations were viewed as more stable than business entities such as partnerships that are subject to withdrawal demands by their owners. according to bank, the corporate income tax “served as a pro-business compromise between the retained earnings penalty that could result from partnership or accrual-style taxation and the indefinite deferral that would result from having only a distributions tax.”158 thus, the corporate tax allowed corporations to retain the benefit of greater stability through capital lock-in, but also prevented perpetual tax deferral by applying a tax to undistributed earnings. c. lack of solid theoretical justifications for different nexus standards the various theoretical foundations for the sales tax and the corporate income tax provide, at best, a tenuous justification for the taxes’ different nexus standards. most of the theoretical foundations for both taxes have no apparent connection to the issue of their jurisdictional scope. the one exception is professor avi-yonah’s theory that the corporate income tax was intended to serve as a check on potentially expansive corporate power, though ultimately this theory also fails to provide a direct justification for the different jurisdictional standards between the sales tax and the corporate income tax.159 in essence, professor avi-yonah has characterized the corporate income tax as an attempt by legislators to regulate and control corporate influence.160 that same justification could be cited to justify a more expansive jurisdictional scope for the corporate income tax than for the sales tax. and, in fact, the economic presence standard generally applicable to the corporate income provides a broader taxing jurisdiction than the physical presence standard applicable to the sales tax. this is illustrated by the taxation of some of the nation’s largest internet retailers. despite millions of dollars of sales in individual states, these internet retailers avoid sales tax obligations under quill but face income tax liability under the broader economic presence doctrine.161 157 id. at 892. 158 id. at 894. 159 avi-yonah, supra note 142, at 1196 (arguing that the corporate income tax, when adopted in 1909, “was viewed primarily as a regulatory device to limit the power of management”). 160 id. at 1249 (“the corporate tax is justified as a way for a liberal democratic state to limit excessive accumulations of power in the hands of corporate management, which is inconsistent with both democratic and egalitarian ideals.”). 161 of course, even the largest internet retailers may also avoid state corporate income tax liability if they come within the safe harbor provided by p.l. 86-272 (the interstate income act of 1959, codified at 15 u.s.c. §§ 381-384). this, however, is a statutory protection afforded to 2013] sales tax exceptionalism 167 if professor avi-yonah is right, and the corporate income tax serves the regulatory purpose he suggests, then a broader jurisdictional reach for the tax (as compared to the sales tax) may make sense. after all, the theoretical justifications for the sales tax (utility-based taxation and the common pool theory, in particular) fail to establish the same type of broader societal purpose for the sales tax. the pro-savings nature of the sales tax does provide a policy-oriented justification for the tax, but not one that has a connection to the jurisdictional scope of the tax. rather, as previously noted, the pro-savings argument really addresses the issue of whether consumption taxes (including the sales tax) are preferable to income taxes, not whether these taxes should have the same jurisdictional standards as the income tax.162 but justifying the different jurisdictional standards of the sales tax and the corporate income tax by citing to the regulatory nature of the corporate income tax is subject to serious criticism. first, there is the question of whether the corporate income tax in fact serves the regulatory purpose professor aviyonah suggests. at least one notable commentator, professor bank, has argued that corporate managers actually support the corporate income tax because it allows them to retain greater financial resources (and therefore greater potential power and influence) within the corporation than they would otherwise be able to do if there were no corporate income tax.163 consistent with this argument, professor bank contends that without a corporate income tax, shareholders would require distributions from the corporations in which they invest more than they currently do.164 moreover, even if professor avi-yonah is correct and the income tax does reduce corporate power, the question remains as to whether taxation constitutes the most effective means of accomplishing this goal. perhaps more companies that sell only tangible goods, and does not amount to a constitutional standard, like the physical presence standard established in bellas hess and affirmed in quill. moreover, because many of the largest internet retailers like amazon also sell intangible goods (such as cloud computing services), they should not benefit from p.l. 86-272 and should be paying corporate income tax to the states. see shanske, supra note 71, at 157 (arguing that amazon has nexus with california despite p.l. 86-272 and the state should “get to it” collecting corporate income tax from the internet retailer). 162 in addition, if the regulatory justification for the corporate income tax is correct, the theory would seem to have increased relevance in light of the supreme court’s recent decision in citizens united v. f.e.c., 558 u.s. 310 (2010). in citizens united the court held that the first amendment prohibits restrictions on independent political expenditures by corporations. following that decision, several commentators expressed concerns over the potential increase of corporate influence on the political process. the broader jurisdictional scope of the corporate income tax allows for a counterbalance to the corporate influence that these commentators predict. 163 steven a. bank, entity theory as myth in the origins of the corporate income tax, 43 wm. & mary l. rev. 447 (2001). 164 id. 168 columbia journal of tax law [vol. 4:136 direct regulation, through greater disclosure requirements under the securities law for example, would operate more effectively in checking corporate power. additionally, if taxation itself constitutes an indirect means of reducing corporate influence, the jurisdictional scope of the tax used to curtail that corporate influence is one step further removed from the purported goal of corporate regulation. in short, there may be a connection between the regulatory theory for the corporate income tax and the broader scope given that tax than given the sales tax, but the connection is both controversial and tenuous. in contrast, a consistent trend in the area of state taxation (discussed in the next section) argues strongly in favor of aligning the tax jurisdiction of the sales tax and the corporate income tax. iii. the increasing peculiarity of different nexus standards for the sales tax and the corporate income tax the disparate jurisdictional treatment of the sales tax and the state corporate income tax seems increasingly peculiar in light of a “convergence” between the two taxes in recent years. this convergence has occurred because of the move to apportion the income tax based exclusively on sales, with no weight given to the other traditional apportionment factors of payroll and property. as discussed above, states traditionally allocated taxable income among states according to the three-factor (payroll, property, and sales) formula set forth in uditpa.165 the theory behind the traditional three-factor formula was that the factors “appear in combination to reflect a very large share of the activities by which value is generated,” and the value derived by the taxpayer’s activities in a state is what the income tax seeks to tax.166 uditpa assigned equal weight to each of the factors in apportioning a taxpayer’s income.167 over time, however, many states have moved away from the three-factor apportionment method, choosing instead to focus more heavily, or even exclusively, on the sales factor.168 in fact, as of may 2012, at least twenty-two states have either already 165 at one point, forty-four out of forty-six states imposing a corporate income tax used uditpa’s three-factor formula to apportion income. see moorman mfg. co. v bair, 437 u.s. 267, 284 n.1 (1978). 166 container corp. of am. v. franchise tax bd., 463 u.s. 159, 183 (1983). 167 unif. division of income for tax purposes act § 9. see also hellerstein & hellerstein, supra note 12, at ¶ 8.06 (discussing the history and justification for the three-factor formula). 168 the move away from uditpa’s traditional three-factor test by some, but not all, states defeats one of the purposes of uditpa—uniformity. see kirk j. stark, the quiet revolution in u.s. subnational corporate income taxation, 23 st. tax notes 775, 777 (2002) (“uditpa is designed to remedy the problem of inconsistent state statutes concerning the taxation of multistate corporations.”). of course, the three-factor formula is not the only possible approach 2013] sales tax exceptionalism 169 converted or are in the process of converting to what is called a “single-sales factor” (“ssf”) apportionment method.169 under ssf apportionment, payroll and property are given no consideration in the apportionment of a taxpayer’s income. revisiting our earlier example in which taxpayer had 30% of its property, 50% of its payroll, and 10% of its sales in state a, state a would be entitled to tax only 10% of taxpayer’s income under an ssf apportionment scheme (the proportion of taxpayer’s sales in state a), rather than the 30% taxable under the traditional three-factor formula.170 why would a state change to ssf apportionment?171 relative to the traditional three-factor formula, ssf apportionment benefits companies which have in-state employees and facilities and which export a significant percentage of their products to purchasers in other states. it penalizes companies with little or no in-state employees or facilities that sell their goods into the taxing state.172 in other words, ssf apportionment favors “in-state” companies and places a greater tax burden on “out-of-state” companies relative to the uditpa regime. to illustrate this, consider again our hypothetical taxpayer. taxpayer had to apportion 30% of its taxable income to state a under the traditional three-factor formula but only 10% under ssf apportionment. if taxpayer instead had only 5% of its property and payroll in state a but made 50% of its sales in the state to apportionment. for example, connecticut previously used a single-factor property formula, which the supreme court upheld in underwood typewriter co. v. chamberlain, 254 u.s. 113 (1920). according to the supreme court, “states have wide latitude in the selection of apportionment formulas and . . . a formula-produced assessment will only be disturbed when the taxpayer has proved by ‘clear and cogent evidence’ that the income attributed to the state is in fact ‘out of all appropriate proportion to the business transacted . . . in that state,’ or has ‘led to a grossly distorted result.’” moorman, 437 u.s. at 274. any apportionment formula, however, must meet the court’s “internal consistency” and “external consistency” requirements. see okla. tax comm’n v. jefferson lines, inc., 514 u.s. 175, 185 (1995) (discussing these requirements). states have also used formulas other than uditpa’s three-factor formula or a single-sales factor formula to apportion income. 169 fed’n of tax adm’rs, “state apportionment of corporate income” (revised january 1, 2013), available at http://www.taxadmin.org/fta/rate/apport.pdf. the supreme court upheld iowa’s single-sales factor apportionment in moorman. iowa’s ssf apportionment formula was not adopted in connection with the recent trend. rather, it has been in place since 1934, when iowa first adopted its income tax. see moorman, 437 u.s. at 283 n.2. 170 see supra note 70. 171 as stated by justice powell in his dissent in moorman, “a sales-only formula is probably the most illogical of all apportionment methods, since ‘the geographic distribution of a corporation’s sales is, by itself, of dubious significance in indicating the locus of either’ a corporation’s sources of income or the social costs it generates.” 437 u.s. at 292 n.7 (powell, j., dissenting). 172 as explained by justice powell in dissenting against the court’s decision to uphold iowa’s ssf apportionment formula in moorman, “the effect of iowa’s [ssf] formula . . . is to penalize out-of-state manufacturers for selling in iowa and to subsidize iowa manufacturers for selling in other states.” id. at 284. 170 columbia journal of tax law [vol. 4:136 (i.e., if taxpayer were more of an “importer” with respect to state a), 50% of the company’s taxable income would be apportioned to state a. in effect, a state with ssf apportionment assigns no income tax cost to a corporation’s facilities and employees located in the state.173 by using only the sales factor to calculate the apportionment ratio, a state effectively imposes its income tax on corporations based solely on the burden borne by the state of providing a market for the corporations’ goods. this operates to benefit in-state companies (those with property and employees in the state) and, conversely, to penalize out-ofstate companies (those that take advantage of the state’s market, but have no instate property or employees).174 theoretically, then, a state with ssf apportionment should have a tax advantage in convincing corporations to locate or retain their employees and facilities in the state, since there is no income tax cost to the corporations for doing so.175 from the state’s perspective, despite the possibility of lower apportionment ratios than under the traditional three-factor formula, shifting to ssf apportionment may make sense in the competition to attract businesses and the jobs that come with them. but what does ssf apportionment have to do with sales tax exceptionalism? the trend toward ssf apportionment argues against treating the income tax and the sales tax differently since the change to ssf apportionment may be viewed as a convergence of the two taxes. this convergence results because, as recognized by professor charles mclure in 1977, “state corporation taxes levied on multistate firms have essentially the same effects as discriminatory state taxes on corporate payrolls, property, or sales (at origin or destination), if the profits of the firm are allocated among the states for tax purposes on the basis of formulas including payrolls, property, and sales.”176 or, as more recently explained by professor darien shanske: [a] tax apportioned based on factors (like the cit [corporate income tax]) is actually (in some situations) just a tax on those factors. in the traditional case therefore, the state cit 173 as between the market state and the production state, an ssf formula attributes full value to the market state and none to the production state. 174 see justice powell’s dissent in moorman for another numerical example of how an ssf apportionment scheme benefits in-state companies to the detriment of out-of-state companies. 437 u.s. at 284 n.2. 175 see elliott dubin, changes in state corporate tax apportionment formulas and tax bases, 55 st. tax notes 563 (2010). cf. shanske, supra note 71, at 113–15 (arguing that california’s experience may not bear out the positive economic effects of a shift to ssf apportionment). of course, other taxes, including property taxes and unemployment insurance, still apply to create some tax cost for having property and employees in a state. 176 charles e. mclure, jr., state corporate income tax: lambs in wolves’ clothing? 1, (off. of tax analysis, working paper no. 25 1977). see also charles e. mclure, jr., revenue sharing: alternative to rational fiscal federalism?, 19 pub. pol’y 472 (1971). 2013] sales tax exceptionalism 171 decomposes into a tax on corporate property, employment and sales. by shifting to the ssf, the states are moving only to tax the income earned from corporate sales, which makes the cit a kind of sales (i.e., consumption) tax, albeit one placed (at least in the first instance) on the seller rather than on the consumer.177 consider an example. assume that taxpayer, a remote internet retailer, makes 10% of its sales in state a, a state with ssf apportionment. assume further that state a has a flat 7% corporate income tax rate. if taxpayer has total taxable income of $1,000,000, it will owe $7,000 in income tax to state a. if, however, taxpayer makes 15% of its sales in state a, under these same assumptions it will owe $10,500 in income tax to the state. taxpayer’s total taxable income has not changed: it remains $1,000,000. nevertheless, its income tax liability in state a has changed, based solely on the amount of sales in that state. in effect, it is the sales, just as much as the taxable income, that drives the corporate income tax liability in state a. as illustrated by this simple example, an ssf-apportioned income tax may effectively operate like a sales tax, though with taxable income as the tax base rather than sales price. professor mclure provided a rigorous mathematical proof showing that “the sales-related portion of the state profits tax is a disguised tax on the corporation’s sales, especially in states in which the firm does a small fraction of its business.”178 even with this mathematical proof, however, both mclure and shanske acknowledge the limits that exist in equating a factor-based tax with a tax on those factors. for example, mclure notes that corporate income tax “applies only to sales, payrolls, and property in the corporate sector of the economy, and distorts choices on sales and production in that state away from the corporate form of organization.”179 mclure also recognizes that with the income tax, the tax rate may vary according to profitability, whereas the traditional retail sales tax applies at a static rate. professor shanske identifies four limits to the convergence of the corporate income tax and the sales tax, the first and fourth of which overlap with 177 shanske, supra note 71, at 116–17. see also stark, supra note 168, at 779 (stating that, with respect to the traditional three-factor formulary apportionment, “rather than viewing the [corporate income tax] as a tax on corporate income per se, it is perhaps more appropriate to view it as three separate taxes: a property tax, a payroll tax, and a tax on the company’s gross receipts”); but see michael mcintyre, thoughts on the future of the state corporate income tax, 25 st. tax notes 931 (2002) (arguing that there are important differences between a retail sales tax and a corporate income tax apportioned under a sales-only formula, including breadth of application and uniformity of rate). as explained by mcintyre, “a corporate tax never operates as a broad-based sales tax because the rate of the ‘sales’ function of profits and the tax does not apply to unincorporated businesses.” id. at 947 n.16. mcclure and shanske acknowledge this point, as discussed below. 178 mclure, supra note 176, at 17. 179 id. 172 columbia journal of tax law [vol. 4:136 those highlighted by professor mclure: (1) the corporate income tax only applies to corporations, not other business forms (similar to mclure’s first point, above); (2) a corporation must do business in multiple states for apportionment to apply; (3) the income tax only applies to corporations with net income (and, unlike the sales tax, not to those with losses); and (4) “the apportionment formula is not the same as taxing the transaction itself” as various factors, such as the location of a corporation’s profits and sales, may ultimately determine the tax burden on a corporation.180 on this last point, for example, if a corporation’s sales are “bunched” geographically into a single state, a higher marginal income tax rate may apply to the sales than if they were evenly spread among states. thus, an ssf-apportioned corporate income tax is not identical to a sales tax, but in many ways it is similar.181 and so, if we accept mclure’s and shanske’s arguments that a tax apportioned according to discrete factors replicates a tax on the factors themselves (at least to some degree and under certain circumstances), the question arises as to why an income tax apportioned solely according to a corporation’s proportion of in-state sales should be treated any differently than a sales tax. after all, if the income tax simply mimics a sales tax, why have different jurisdictional standards for the two taxes? the answer is that the two taxes should not have different jurisdictional standards and that the current state of the law has become outdated, especially considering the technological and legal developments that have taken place since bellas hess (1967) and even since quill (1992).182 but if the corporate income tax has become more like the sales tax as a result of the trend toward single sales factor apportionment, perhaps courts should adopt the physical-presence standard for both taxes (as currently applies to the sales tax) rather than expand the economic-presence standard applied by most courts to the corporate income tax. the arguments for the benefits of economic presence over physical presence as the controlling nexus standard for both the corporate income tax and the sales tax has been capably set forth by other commentators,183 and i do not intend to repeat them here. my goal has instead been to demonstrate (1) that the concept of sales tax exceptionalism, 180 shanske, supra note 71, at 117. 181 furthermore, as professor shanske contends, an ssf-apportioned income tax serves as a complement to the retail sales tax. it reaches transactions and taxpayers that would be captured by a theoretically pure sales tax but escape the relatively narrow retail sales taxes found in most states. see shanske, supra note 71, at 118–22. 182 see waltreese carroll, can technology lessen the tax burdens on interstate commerce, 2012 st. tax today 143-2 (2012) (quoting charles collins, vice president of governmental affairs at automatic data processing, inc.—one of six certified service providers under the ssuta—as stating that “technology has moved in a direction that has alleviated the burdens at issue in quill”). 183 swain, supra note 31. 2013] sales tax exceptionalism 173 though not expressly labeled as such, has come about as a result of judicial decisions treating the sales tax differently than other taxes; (2) that the concept, at least in the context of jurisdictional standards, has little theoretical justification; and (3) that the trend toward single sales factor apportionment undercuts the different nexus standards applicable to the sales tax and the corporate income tax. conclusion legislation to extend the physical-presence standard to the corporate income tax has been introduced to congress;184 so has legislation to apply the economic-presence standard to the sales tax.185 most academic commentators (including this one) support the latter approach, but either of these changes would be more theoretically defensible than continuing the current jurisdictional inconsistency in state tax law—all the more so given the convergence between the corporate income tax and the sales tax resulting from the widespread adoption of single-sales factor apportionment. 184 see business activity tax simplification act, s. 1726, 110th cong. (2007); business activity tax simplification act, h.r. 5267, 110th cong. (2008). 185 see main street fairness act, s. 1452, 112th cong. (2011); marketplace equity act, h.r. 3179, 112th cong. (2011). marketplace fairness act, s. 1832, 112th cong. (2011). microsoft word 06 burke, the sound and the fury of carried interest reform.docx 1 articles the sound and fury of carried interest reform karen c. burke * introduction .............................................................................................. 1 i. private equity funds: allocations and distributions .......................................................................... 7 a. understanding the business arrangements that prompted proposed § 710 .................................................... 7 b. economic risk of loss and deemed taxes ....................... 12 c. timing of distributions and disguised loans ................... 14 d. earned capital .................................................................... 17 ii. proposed §§ 710 and 83 ......................................................... 19 a. ordinary income treatment ............................................... 19 b. joint-tax perspective and § 83 .......................................... 23 c. compensatory options versus profits interests ................ 30 iii. earned capital—the bifurcation approach ................ 33 a. earned capital .................................................................... 34 b. cash salary reinvestment plan ......................................... 35 c. shortcomings of capital accounts .................................... 41 conclusion ............................................................................................... 44 introduction of all the proposals advanced in recent years to reform subchapter k, the part of the internal revenue code (“irc” or “code”) governing partnership tax, perhaps none has generated more acrimony and confusion * warren distinguished professor of law, university of san diego school of law. the author wishes to thank especially mark gergen, michael schler, david walker, and george yin for helping to clarify her thinking about the carried interest problem. the author acknowledges generous research support from the university of san diego school of law. this research was not supported by funding from any outside source. 2 columbia jour�al of tax law [vol. 1:1 than the pending carried interest legislation contained in proposed § 710.1 while reformers have framed the issue of taxing the compensatory portion of a service partner’s return as ordinary income in terms of distributive justice, critics have been quick to invoke the rhetoric of class warfare to fend off reform.2 in the most elementary terms, the carried interest legislation would tax some (but not all) of a service partner’s share of partnership profits as ordinary income.3 even at this basic level, however, the contours of the proposed legislation are ambiguous. indeed, the reform is sometimes misdescribed as taxing “distributions” rather than “distributive shares” as ordinary income, a distinction that is fundamental.4 moreover, the precise tax advantage of carried interest arrangements depends crucially on whether one adopts a “joint-tax” perspective or focuses more narrowly 1. unless otherwise indicated, all statutory references to the internal revenue code (i.r.c.) are to the i.r.c. as currently in effect. references to proposed § 710 (prop. § 710) refer to the version introduced by representative sander levin in april 2009. h.r. 1935, 111th cong. (2009) [hereinafter levin bill]. see also tax extenders act of 2009, h.r. 4213, 111th cong. (2009). the current legislation is similar to the alternative minimum tax relief act of 2008, h.r. 6275, 110th cong. (2008). the senate finance committee held relevant hearings on july 11, 2007, and july 31, 2007. s. finance comm., hearing on carried interest (2007) [hereinafter senate hearings], available at http://finance.senate.gov/sitepages/hearing071107.htm (part i) and http://finance.senate.gov/sitepages/hearing073107.htm (part ii) (last visited feb. 14, 2010). the house ways and means committee held a hearing on sept. 6, 2007. h. ways & means comm., hearing on fair and equitable tax policy for america’s working families (2007) [hereinafter house hearing], available at http://waysandmeans.house.gov/hearings/transcript.aspx?newsid=10305 (last visited feb. 14, 2010). 2. see, e.g., victor fleischer, two and twenty: taxing partnership profits in private equity funds, 83 n.y.u. l. rev. 1, 5 (2008) (“distributive justice, of course, is also a concern.”); house hearing, supra note 1 (statement of victor fleischer), at 7 (“a few professors have been retained by the private equity industry to argue for the status quo; there may be a handful of others who independently support the status quo, but they are few and far between.”); howard e. abrams, taxation of carried interests: the reform that did �ot happen, 40 loy. u. chi. l.j. 197, 227 (2009) (“professor fleischer framed the carried interest issue largely in class-warfare terms, with private equity and hedge managers as the bad guys.”). 3. the proposed reform bears a superficial resemblance to proposals set forth by mark gergen nearly two decades ago that would tax service partners on compensation when they receive disproportionate allocations relative to their capital account balances. see mark p. gergen, reforming subchapter k: compensating service partners, 48 tax l. rev. 69, 105 (1992) (claiming that the proposed system would be “very much like subchapter s”). 4. see fleischer, supra note 2, at 59 (describing the legislative proposal as “treat[ing] carried interest distributions as ordinary income”). a partner is taxed on his distributive share of partnership income when realized at the partnership level, whether or not distributed. see i.r.c. § 702(a) (2009) (inclusion of distributive share); cf. i.r.c. § 731 (2009) (taxing distributions). to the extent that earnings are not currently distributed, accounting for “reinvested” implicit salary greatly complicates the actual operation of the proposed legislation. 2010] the sou�d a�d fury of carried i�terest reform 3 on the service partner’s opportunity for deferral and conversion.5 apart from the merits of carried interest legislation, there is also considerable dispute over whether such reform is likely to raise significant amounts of revenue.6 the administration’s budget proposals for fiscal year 2010 contain a carried interest provision that appears to adopt the general framework of h.r. 1935 (the levin bill) introduced in 2009.7 under this approach, a service partner’s distributive share of income would be recharacterized as ordinary income, regardless of whether such income would otherwise be treated as lower-taxed capital gain or dividend income at the partnership level.8 the proposal would also treat gain on sale of a service partner’s interest as ordinary income, subject to certain exceptions.9 as the reason for the change, the budget proposal refers to the “unfair and inefficient tax preference” resulting from allowing service partners to “receive capital gains treatment on labor income,” particularly in view of the “recent explosion of activity among large private equity firms.”10 in its present form, the levin bill reflects key recommendations of the partnership tax bar which has intensely scrutinized the technical operation of the carried 5. the leading article applying a joint-tax perspective in the context of partnership profits interests is chris william sanchirico, the tax advantage of paying private equity fund managers with profit shares: what is it? why is it bad?, 75 u. chi. l. rev. 1071 (2008). other commentators have employed a similar joint-tax perspective in the corporate area. see generally michael s. knoll, the section 83(b) election for restricted stock: a joint tax perspective, 59 smu l. rev. 721 (2006); david i. walker, is equity compensation tax advantaged?, 84 b.u. l. rev. 695 (2004). 6. see, e.g., michael s. knoll, the taxation of private equity carried interests: estimating the revenue effects of taxing profit interests as ordinary income, 50 wm. & mary l. rev. 115, 161 (2008) (concluding that, even in the absence of “alternative structures to undo the effect of any reform,” carried interest legislation is likely to raise “relatively little revenue”). see also u.s. dep’t of the treasury, general explanations of the administration’s fiscal year 2010 revenue proposals 128 (may 2009) (table 1) [hereinafter greenbook]. this article does not discuss the plethora of anti-abuse rules intended to prevent circumvention of the proposed legislation. 7. see greenbook, supra note 6, at 23–24. unlike the levin bill which specifically targets investment service partnerships, the administration’s proposal would apparently apply broadly to all service partnerships. see staff of joint comm. on tax’n, description of the revenue provisions contained in the president’s fiscal year 2010 proposal 120–22 (sept. 2009) (jcs-2-09) (noting issues related to the “complexity, administrability and scope” of the administration’s broader proposal). 8. see greenbook, supra note 6, at 23. a profits share taxed as ordinary income to the service partner would also be subject to self-employment tax. see id. to prevent circumvention of the legislation through use of separate entities, the budget proposal would treat income or gain from a “disqualified interest” as ordinary income. see id. at 24. 9. see id. at 23 (treating gain on sale as ordinary income to the extent that such gain is not attributable to invested capital). 10. id. 4 columbia jour�al of tax law [vol. 1:1 interest proposals.11 by contrast, academic proponents of carried interest legislation have generally suggested that the technical problems are solvable and need not impede reform.12 the partnership tax bar’s recommendations would add flexibility and electivity while making the proposed legislation considerably more complex. the emerging consensus seems to be that the current legislation has “the potential to be workable” if only congress heeds the partnership tax bar’s recommendations to remedy existing defects.13 in view of the often highly-charged and polemical nature of the carried interest debate, it is important to understand the most significant policy and technical choices underlying the current legislation. despite the intuitive appeal of taxing service partners at ordinary income rates on labor income, the case for reform is much more nuanced and the proposed solution considerably more complex than has sometimes been suggested.14 economically, use of a carried interest arrangement rather than salary does not actually convert ordinary income into capital gain but rather merely reallocates different types of income among partners, while leaving unchanged aggregate capital gain at the partnership level. to use a simple example, assume that a partnership has $100 of capital gain and can choose to pay deductible salary of $20 to an investment manager or, alternatively, reallocate $20 of the partnership’s capital gain to the investment manager. in this instance, the carried interest arrangement substitutes capital gain (the manager’s share of partnership profits) for ordinary compensation income but deprives investor partners of an equal and offsetting compensation deduction (or capitalized expense). in light of the furor over carried interests, it may be worth emphasizing that such income reallocation generally does not offer a jointtax advantage (or disadvantage) if all parties are taxed at the same rates on ordinary income and capital gain.15 the reallocation affects the amount of 11. see generally new york state bar association tax section, report on proposed carried interest legislation and fee deferral legislation (sept. 28, 2008) [hereinafter nysba report]; aba section of taxation, comments on h.r. 2834 (nov. 13, 2007) [hereinafter aba comments]. 12. see, e.g., mark p. gergen, a pragmatic case for taxing an equity fund manager’s profits share as compensation, 87 taxes 139, 149 (2009) (noting that “[m]any of the problems that have been raised . . . are technical in nature and solvable”). 13. see paul carman, taxation of carried interests, 87 taxes 111, 134 (2009); see also michael l. schler, taxing partnership profits income as compensation income, 119 tax notes 829, 853 (2008) (describing the current approach as a “practical solution to a difficult problem”). 14. see sanchirico, supra note 5; david a. weisbach, the taxation of carried interests in private equity, 94 va. l. rev. 715 (2008); see also schler, supra note 13, at 853 (noting that “complexity will be inevitable”). 15. to illustrate, assume that all parties are taxed on capital gains at 15% and on 2010] the sou�d a�d fury of carried i�terest reform 5 taxes paid, respectively, by the manager and investors (the manager pays less tax and the investors pay more tax) but total taxes remain unchanged. because aggregate tax liability is the same, the parties may be expected to alter payments to each other so that their net income (after taxes) remains constant.16 if the investors are tax-exempt (or tax-indifferent), however, the carried interest arrangement decreases the service partner’s tax without any offsetting increase in the other partners’ tax.17 notwithstanding the tax tensions among same-taxed partners that normally suffice to limit such taxadvantageous income reallocation, reformers have claimed that the private equity model revealed fundamental flaws in the taxation of partnership profits interests.18 ordinary income at 35%. the two alternative compensation arrangements (carry versus cash) result in the same aggregate tax liability ($15); under the carried interest arrangement, the investment manager pays $4 less tax ($3 versus $7) but taxable investors pay $4 more tax ($12 versus $8): taxable income tax liability carried interest salary carried interest salary investment manager 20 cg 20 oi 3 7 taxable investors 80 cg 100 cg – 20 oi 12 15 – 7 total 100 cg 100 cg 15 15 16. regardless of which party bears the nominal tax burden, a compensation arrangement is neutral as long as the parties’ aggregate tax liability is the same. see, e.g., ethan yale & gregg d. polsky, reforming the taxation of deferred compensation, 85 n.c. l. rev. 571, 580 (2007); alan d. viard, the taxation of carried interests: understanding the issues, 61 nat’l tax j. 445, 450 (2008) (noting that “the parties can and should alter their payments to each other” to keep net income unchanged). 17. by comparison, use of carry (rather than cash) reduces the partners’ aggregate tax liability by $4 when the investor partners are tax-exempt: tax liability carried interest salary investment manager 3 7 tax-exempt investors 0 0 total 3 7 the reduction in the partners’ aggregate tax liability is equal to the 20 percentage point gap between the investment manager’s rate on ordinary income (35%) and rate on capital gains (15%). the relevant rate gap for tax-exempt investors is zero, i.e., they bear no tax on capital gain or ordinary income; thus, the income reallocation saves joint taxes equal to the entire difference ($4) between the investment manager’s capital gain tax ($3) and ordinary income tax ($7). see sanchirico, supra note 5, at 1114 (noting significance of difference in the partners’ rate gaps). 18. see fleischer, supra note 2, at 4 (claiming that “the status quo is untenable as a matter of tax policy”). 6 columbia jour�al of tax law [vol. 1:1 although some commentators have argued that private equity carried interests might be used even if they offered no particular tax advantages,19 part i of this article suggests that these tax-motivated arrangements were clearly vulnerable under existing partnership rules that seek to limit capital-gain conversion and joint-tax minimization. part ii of the article examines critically the compromise approach of § 710, together with the partnership tax bar’s recommended amendment of § 83. touted as a simple solution to conversion and deferral, the recharacterization approach of § 710 may simply mask the inherent problems of distinguishing between labor and capital income when a service partner’s earnings are reinvested in the partnership and give rise to “qualified capital.”20 tracking the separate labor and capital components of a service partner’s return when earnings are reinvested is part of a much larger problem when a business owner-manager invests both services and capital in an enterprise. this problem is exacerbated to the extent a service provider can receive a partnership profits interest tax free and be recognized as a partner even though his claim to a share of the partnership’s capital is contingent on a performance goal. from the partnership tax bar’s perspective, the current legislation offers a long-awaited opportunity to disentangle treatment of profits interests from § 83, the general provision governing deferred compensation.21 given the joint-tax incentives that § 710 provides to overstate investment return (and understate compensatory return), part iii concludes that a better approach may be to treat a service partner’s profits share entirely as ordinary income even if implicit salary is reinvested in the partnership’s business, by analogy to the treatment of restricted stock or nonqualified options. while allaying the concerns of the partnership tax bar may be a practical imperative, it is abundantly clear that § 710, if enacted, will be neither simple nor straightforward. given the political salience and technical opacity of the carried interest problem, congress might be well advised to delegate to treasury authority under existing provisions to address capital-gain conversion rather than enact a complex statute of 19. see weisbach, supra note 14, at 726 (suggesting that “the structure of these funds is no more tax-driven than any typical investment”). 20. see prop. § 710(c)(2)(a) and (c) (exempting from ordinary income treatment reasonable allocations attributable to a service partner’s qualified capital, including previously-taxed but undistributed earnings). the qualified capital exception under the levin bill was expanded in response to recommendations of the partnership tax bar; it is not clear whether the administration’s budget proposal follows this approach. 21. see proposed § 83(a)(4) (treating the fair market value of a profits interest as equal to its liquidation value (zero) and deeming the recipient to have made a § 83(b) election). the revision to § 83 was added to the levin bill as a new “section 1” that appears immediately before “section 2” containing proposed § 710. 2010] the sou�d a�d fury of carried i�terest reform 7 uncertain scope and effectiveness. i. private equity funds: allocations and distributions if the tax advantage of private equity managers is properly viewed as a special form of joint-tax arbitrage, it is essential to understand how the partnership rules facilitate or limit such joint-tax minimization. a typical private equity fund is a self-liquidating partnership: both investors and the investment manager receive cash distributions at roughly the same time as the partnership recognizes gain from sale of investments and allocates that gain among partners. because the manager typically does not reinvest capital earned from services in the partnership, taxing distributive shares may be equivalent to taxing distributions. if the fund is insufficiently profitable when it liquidates, the manager may be required to return only unearned after-tax distributions which represent essentially interest-free loans from the investor partners.22 given the highly unusual nature of private equity arrangements that are structured to provide tax benefits to managers that are often intentionally opaque even to investors, it may be hazardous to draw any generalizations concerning how traditional partnership profits interests should be taxed. a. understanding the business arrangements that prompted proposed § 710 although the structure and business model of private equity funds have attracted considerable public attention, the operation of the tax provisions is generally less well understood.23 the typical business arrangement is as follows. assume the general partner (gp) of a private equity fund is an individual who provides management services, and the investors (lp) are tax-exempt entities (unless otherwise specified).24 the 22. see infra notes 57–61 and accompanying text. 23. this article does not discuss hedge funds, which share some common characteristics with private equity funds but raise distinct tax issues. since hedge funds typically generate mainly short-term capital gain (taxed at the same rate as ordinary income), they arguably do not pose the same problem. see adam h. rosenzweig, �ot all carried interests are created equal, 29 nw. j. int’l l. & bus. 713, 715 (2009). 24. in reality, the general partnership interest is likely to be held by a management company organized as a partnership or an llc; the equity owners of the management company are private equity professionals. since the management company is a flowthrough entity, the tax consequences are generally the same as if the private equity professionals held the general partnership interest directly. the investors are likely to be a composite of tax-exempt entities (e.g., private and governmental employee benefit plans and 8 columbia jour�al of tax law [vol. 1:1 fund is organized as a partnership (p), although the result would generally be the same if p were instead an llc taxed as a partnership. p seeks to acquire control of portfolio companies, increase the value of the portfolio companies, and “monetize” the return on lp’s investment over a period of several years.25 gp receives solely a profits interest in exchange for services; since gp contributes no capital to p, there is no need to bifurcate gp’s interest between a capital and a profits component.26 over time, gp will acquire a capital interest in p to the extent of gp’s share of any previously taxed but undistributed profits; if all profits are distributed currently, gp never acquires a capital interest. prior to liquidation, gp shares in distributions to the extent that current realized gains exceed the aggregate excess of losses over gains on investments sold in prior years.27 p imposes a clawback obligation on gp to the extent that gp has a negative capital account on liquidation attributable to “unearned” distributions.28 the following example illustrates the typical business arrangement and the close economic resemblance between a profits interest and an option. example (1)—earned carry. in exchange for managing p’s business, gp receives a 20% profits interest; lp contributes $40 million and is entitled to the remaining 80% of p’s profits. lp is not entitled to a preferred return or minimum return on investment (“hurdle rate”). in year 1, p makes four portfolio investments (a, b, c, and d) of $10 million each. at the end of year 2, p sells a for $15 million; at the end of year 3, p sells university endowments), foreign individuals, and wealthy u.s. individuals. this article ignores the possibility that some portion of u.s. tax-exempt investors’ return may be unrelated business taxable income (ubti). see i.r.c. § 512 (2009). 25. see fleischer, supra note 2, at 8–9. since lp is “locked into” p until disposition of all the portfolio companies, lp’s capital is returned only as p distributes proceeds from the sale of individual portfolio companies. see knoll, supra note 6, at 122–23. 26. to ensure partner status, gp would typically contribute capital (1%); gp would also be entitled to a management fee (2%). if the rights of gp’s capital interest are identical to those of lp’s, the price paid by lp provides a proxy for the fair market value of gp’s capital interest. cf. carman, supra note 13, at 124–25 (comparing non-u.s. solutions to the carried interest problem, including allowing non-service partners to invest in carried interest units). 27. see andrew w. needham & anita beth adams, private equity funds, 735 b.n.a. tax mgmt. portfolio a-8 to a-9 (2005) (describing “realized aggregation” method). other approaches to the timing of distributions may be more or less favorable to gp. see jack s. levin, structuring venture capital, private equity, and entrepreneurial transactions ¶ 1003 (2008). 28. the clawback obligation is a contingent recourse obligation to repay all or a portion of distributions received prior to liquidation so that gp’s cumulative distributions coincide with the profit-sharing formula. see james m. schell, private equity funds: business structure and operations 1-9 (1999). if gp is organized as a limited liability entity, lp may insist on guarantees to ensure that the contractual obligation is satisfied. see id. at 2-26. 2010] the sou�d a�d fury of carried i�terest reform 9 b for $8 million; and at the end of year 4, p sells c for $12 million. finally, at the beginning of year 5, p sells d for $10 million and liquidates. at the end of year 2, p realizes gain of $5 million on sale of a ($15 million less $10 million basis). to recoup lp’s investment in a, p distributes the first $10 million of sales proceeds to lp; the remaining $5 million is distributed $4 million to lp and $1 million to gp (in the same manner as the realized gain of $5 million is allocated). even though gp receives a distribution of $1 million at the end of year 2, gp’s carry is not “earned” until lp’s aggregate invested capital is fully returned.29 prior to liquidation, the partnership recognizes net gain of $5 million ($5 million gain on a less $2 million loss on b plus $2 million gain on c and zero gain on d). overall, gp receives $1 million (the earned carry) and lp receives $44 million ($40 million plus 80% of the $5 million net gain). in economic terms, gp’s profits interest is indistinguishable from an option, i.e., the ability to benefit from an increase in appreciation without risking capital.30 if gp had an option on 20% of the net increase in the value of p ($5 million), gp would recognize $1 million of ordinary income upon exercise of the option; the tax would be deferred from grant until exercise of the option; all of the partnership’s capital gain would be taxed to lp, and p would be treated as paying over compensation of $1 million to gp on exercise of the option, with a corresponding deduction (or capitalized expense).31 under the profits alternative, gp’s carry of $1 million is instead taxed entirely as long-term capital gain, saving gp the difference between the capital gain rate and the ordinary income rate. by comparison to an economically equivalent option, profits treatment accelerates taxation of gp, since gp is taxed when partnership income is allocated to him (whether or not distributed). despite acceleration of the tax, profits treatment produces a more favorable tax result overall because it allows gp to convert ordinary income into capital gain. moreover, profits treatment permits gp to extract early cash distributions tax free that may nevertheless need to be repaid later. despite the economic resemblance of a profits interest to an option, the internal revenue service (“service”) will generally respect the partner status of a service provider who receives a profits interest falling within the 29. see schell, supra note 28, at 2-21 (noting that the profitability of the investment cannot “be known with certainty until [p] is liquidated and wound up”). 30. see knoll, supra note 6, at 133 (noting that “a carried interest is effectively a call option.”). a profits interest closely mimics a nonqualified stock option (nqso) or incentive stock option (iso). see fleischer, supra note 2, at 4. 31. upon exercise of the option, the holder acquires a capital interest; grant of the option is not a taxable event. see treas. reg. §§ 1.83-7(a) (as amended in 2004), 1.83-6(a) (as amended in 2003). 10 columbia jour�al of tax law [vol. 1:1 administrative guidelines of revenue procedures 93-27 and 2001-43.32 a private equity carried interest does not, however, fall within the literal terms of the administrative safe harbor, since the holder typically receives both a capital interest and a disproportionate profits interest.33 nevertheless, taxpayers may claim that the carried interest can be bifurcated into separate capital and profits components for purposes of qualifying the profits interest under the safe harbor.34 alternatively, taxpayers may simply claim a zero value based on the confused state of current law, relying on the government’s perceived unwillingness to challenge even patently erroneous valuations.35 if receipt of the profits interest is not taxed up front, gp is taxed on his distributive share of partnership profits under the normal flowthrough rules of § 702(b).36 when lp is tax exempt (or otherwise tax indifferent), gp essentially “swaps” ordinary income for capital gain at no tax cost to lp, since a deduction for gp’s implicit salary would be worthless to lp.37 32. see rev. proc. 93-27, 1993-2 c.b. 343; rev. proc. 2001-43, 2001-2 c.b. 191. in 2005, the service issued proposed regulations addressing compensatory transfers of partnership interests. see proposed regulations on partnership equity transfers for services, reg-105-346-03, 70 fed. reg. 29,675 (may 24, 2005) [hereinafter reg-105-34603]; notice 2005-43, 2005-1 c.b. 122 (containing proposed revenue procedure). the 2005 proposed regulations were generally consistent with the service’s prior administrative guidance, which would have become obsolete had the proposed regulations become final. 33. see carman, supra note 13, at 114 (noting that a carried interest does not “literally fall within” the safe harbor); cf. fleischer, supra note 2, at 12 (“the typical carried interest finds ample shelter in the proposed rules.”). by allowing a liquidation-value election for all compensatory partnership interests (capital or profits), the 2005 proposed regulations would have extended safe harbor treatment to certain carried interest arrangements not covered by the prior administrative rule. 34. while it might seem “illogical” to construe the service’s administrative guidance narrowly not to permit bifurcation, adopting “the rational, taxpayer-friendly, more expansive reading” would represent a significant change in the status quo. levin, supra note 27, ¶ 1006 at 10-19. 35. see campbell v. comm’r, 943 f.2d 815 (8th cir. 1991) (holding value of profits interest was too speculative). in 2001, the service adopted a surprisingly pro-taxpayer position by extending the favorable liquidation-value rule even if a profits interest is substantially nonvested at grant and no § 83(b) election is made. see rev. proc. 2001-43, 2001-2 c.b. 191 (deemed § 83(b) election). 36. under § 83 principles, the service partner could be taxed on the fair market value of the profits interest upon receipt. because of valuation difficulties, however, the front-end approach of taxing gp upon receipt of the interest is not a realistic alternative. see h.r. rep. no. 110-728 at 17 (2008) (§ 710 “takes a different approach”). under current law, gp has no back-end ordinary income upon vesting of the interest, assuming a taxpayer-favorable resolution of the liquidation-value issue under the service’s administrative guidance. see levin, supra note 27, ¶ 1006 at 10-20. 37. see sanchirico, supra note 5, at 1078, 1115–16 (“the true tax advantage [of a carried interest] over other arrangements is the ability to swap tax character with partners who are differently taxed.”). unless gp is taxed differently from lp, there is no tax 2010] the sou�d a�d fury of carried i�terest reform 11 jointly, lp and gp improve their economic situation solely at the expense of the government. since a profits interest does not actually convert capital gain into ordinary income but rather merely reallocates capital gain among the partners, the arrangement may appear technically to be outside the elaborate § 704(b) regulations governing when partnership allocations will be respected. this type of joint-tax arbitrage would, however, clearly violate the § 704(b) regulations if it involved an actual swap of equal amounts of ordinary income and capital gain.38 the § 704(b) tax-avoidance test is merely a subset of the general § 701 anti-abuse rule, which permits the service to treat a partnership as an aggregate (rather than an entity) to properly reflect income.39 indeed, § 707(a)(2)(a) addresses the problem of compensatory allocations and distributions intended to circumvent other limitations—including the capitalization requirement and conversion of ordinary income into lower-taxed income.40 despite this array of anti-abuse rules aimed at joint-tax arbitrage, the carried interest debate has been popularly framed mainly in terms of the one-sided advantage to gp who defers tax and converts ordinary income into capital gain.41 other commentators have perceived that the tax advantage of profits interests involves essentially reallocation of capital gain among taxable and tax-exempt (or tax-indifferent) partners, but have nevertheless failed to recognize that such joint-tax minimization offends advantage to the carried interest. see id. at 1114 (noting that it is “not a difference in tax rates per se, but a ‘difference in differences’” that matters). 38. see treas. reg. §§ 1.704-1(b)(2)(iii)(a) (overall tax-effect rule), 1.7041(b)(2)(iii)(b) (as amended in 2008) (character allocations that shift tax consequences); see also i.r.c. § 751 (2009) (prohibiting shifting of ordinary income and capital gains). because the swap is merely a putative swap—the prohibited shifting of tax consequences is embedded in the structure of the transaction rather than p’s formal allocation provisions— the assumption is that § 704(b) is not violated. 39. see treas. reg. § 1.701-2 (1995); senate hearings, supra note 1, at 2 n.4 (statement of charles i. kingson, july 31, 2007) (“if the partnership anti-abuse rule has any bite, use of a partnership to claim capital gain from performing services should have been high on the list. but conflicts apparently prevented even bar associations from raising this.”). 40. i.r.c. § 707(a)(2)(a) may be understood narrowly to avoid reaching private equity managers’ compensation. see weisbach, supra note 14, at 731–32 (explaining that § 707(a)(2)(a) applies only to distributions not subject to substantial entrepreneurial risk); see also gergen, supra note 3, at 77 (“the line [§ 707(a)(2)(a)] draws relates poorly to the real policy concern, and the line is poorly drawn.”). cf. american law institute, federal income tax project: subchapter k, proposals on the taxation of partners 155–64 (1984). 41. see sanchirico, supra note 5, at 1077 n.14 (noting that the joint-tax perspective “is oddly neglected in the treatment of private equity profits interests”); knoll, supra note 6, at 126–27 (noting that “the tax consequences . . . should be evaluated globally, for all parties to a transaction, not just for one party in isolation.”). 12 columbia jour�al of tax law [vol. 1:1 fundamental principles of partnership taxation.42 because the reform debate largely overlooked existing partnership anti-abuse rules, congress may have failed to fully appreciate alternative solutions. b. economic risk of loss and deemed taxes in the carried interest debate, the fundamental issue is whether gp should be respected as a partner even though his interest is in all respects essentially identical to that of an option holder. as a putative profits holder, gp has a right to share in future appreciation if p increases in value above $40 million but bears no risk of loss except for the contingent obligation to restore “excess” distributions.43 if p initially realizes investment gains and subsequently incurs investment losses, the early distributions to gp may exceed 20% of p’s aggregate gains over p’s life cycle, triggering the clawback provision. the function of the clawback provision is to align the parties’ respective economic interests, particularly given gp’s control over the timing of gain recognition, and to achieve cumulative aggregation of gains. example (2)—unearned carry. the facts are the same as in example (1), except that p sells d for only $5 million, triggering a $5 million loss ($5 million less $10 million basis). overall, p just breaks even (ignoring the time value of money); since p has no cumulative profits, gp’s entire $1 million of distributions should apparently be clawed back.44 in reality, gp’s clawback is often limited to after-tax distributions. typically, gp takes the position that the clawback obligation should be reduced by reference to a hypothetical tax rate, often determined by reference to the highest tax rate applicable to the income earned. assume that p employs a “net-of-tax” formula that reduces the clawback by reference to an assumed marginal rate of 25%.45 in this event, gp must return the lesser of (1) 42. indeed, one commentator concluded just the opposite: namely, that the partnership rules give carte blanche to partners to reallocate income to minimize taxes and to avoid other restrictions. see viard, supra note 16, at 459 (“the reallocation is an application of economy-wide partnership tax rules.”). 43. more precisely, losses are allocated in the same manner as prior allocations of profits until such losses have offset all previously allocated profits; any additional losses are allocated 100% to contributed capital. 44. if gp restored $1 million to p, lp would receive $6 million on liquidation ($5 million from sale of d and $1 million from gp’s contribution). cumulatively, lp would receive $40 million and gp would receive zero. 45. see needham & adams, supra note 27, at a-10 to a-11; paul h. asofsky & andrew w. needham, u.s. private equity funds: common tax issues for investors and other participants, 630 pli/tax 1275, 1308 (2004) (“most fund clawback provisions net the maximum clawback against taxes attributable to the carried interest allocations. how 2010] the sou�d a�d fury of carried i�terest reform 13 excess carry distributions ($1 million) or (2) the aggregate after-tax distributions received by gp ($1 million less 0.25 x $1 million). in gp’s view, it would be unfair to require return of more than $0.75 million, since gp should not be required to give up more than he actually retained after tax.46 in effect, lp pays gp’s hypothetical taxes by foregoing full return of lp’s committed capital. if the hypothetical tax rate exceeds gp’s effective marginal tax rate, the net result is that gp earns a positive return even though lp’s return is negative. on sale of d, gp is allocated loss up to the amount of the clawback obligation ($0.75 million); on liquidation, gp repays the unearned carry (net of taxes) by restoring the $0.75 million deficit in his capital account (rather than the full $1 million distribution). to create the proper deficit balance for gp, p simply “backs into” the desired amount.47 under a target-allocation approach, the partnership’s allocations are determined after gains and losses are realized, taking into account the partnership’s distribution “waterfall.” technically, target or “forced” allocations do not comply with the capital account requirements of the § 704(b) regulations, since distributions govern capital accounts (rather than the reverse).48 while target allocations flunk the § 704(b) safe harbor rules, they may (or may not) satisfy the alternate “partner’s interest” test.49 if p disregards capital account balances on liquidation, however, the validity of the prior allocations should be subject to challenge. if gp’s clawback obligation is reduced by deemed taxes paid, it might appear that it should also be increased by reference to any offsetting tax benefits received by gp. typically, however, the clawback provision ignores the tax benefit to gp from the capital loss generated by the clawback itself.50 since gp derives a tax benefit only if gp has unrelated funds compute this offset, however, varies widely in the industry.”). the hypothetical tax rate is intended to achieve “rough justice” among all of the partners, without looking to any partner’s particular tax circumstances. for example, if gp has unrelated losses that offset gp’s income from p, gp’s effective tax rate will be lower than the deemed tax rate. 46. in this event, lp recovers only $39.75 million (rather than $40 million). the missing $0.25 million is the amount of taxes (at the hypothetical tax rate) paid on the $1 million of net gain allocated to gp (prior to sale of d). 47. under a target allocation approach, items of income and loss are allocated in a manner that should cause gp’s capital account to equal the amount that gp would receive (or be required to contribute) on liquidation. see needham & adams, supra note 27, at a16 (noting that target allocation “plugs” the required change in capital account balances over the relevant period). 48. see treas. reg. § 1.704-1(b)(2)(ii)(b) (as amended in 2008). the regulations warn that invalid allocations may give rise to appropriate tax consequences under §§ 61 and 83. see treas. reg. § 1.704-1(b)(1)(iv) (as amended in 2008). 49. see treas. reg. § 1.704-1(b)(1)(i) (as amended in 2008). 50. see needham & adams, supra note 27, at a-10. while the potential tax 14 columbia jour�al of tax law [vol. 1:1 capital gains to offset the capital loss on liquidation, the clawback provision arbitrarily treats gp’s tax benefit as zero. if gp can fully utilize the capital loss, gp receives a windfall at the expense of lp. because measuring gp’s actual tax benefit is administratively difficult or because gp has superior bargaining power, lp may be willing to accept the risk of such a windfall.51 to summarize, lp bears the entire economic risk of loss if p fails to earn a positive return on lp’s invested capital over the life of the partnership. even though gp initially receives a distribution of $1 million in year 2, gp is obligated in example (2) to return only the net after-tax distribution (without interest) in year 5. under the terms of the partners’ arrangement, the actual burden of the taxes paid on gp’s share of partnership gain falls on lp, not gp. consistent with the underlying economics, lp furnishes the partnership’s entire capital and effectively bears the tax burden attributable to gain allocated to gp to the extent that gp fails to earn carry. there is a strong argument that gp should not be respected as a partner if, in a worst-case scenario, lp effectively bears the burden of taxes nominally imposed on gp and the underlying arrangement is intended merely to reduce the parties’ joint-tax liability.52 allocating $1 million of gain to gp in year 2 allows gp to swap ordinary compensation income for capital gain, even though repayment of the net after-tax distribution leaves gp no worse off than if the entire gain were allocated to lp. c. timing of distributions and disguised loans the partnership’s allocation provisions determine how gain or loss is shared among the partners when realized by the partnership. by contrast, the distribution provisions determine when partners will actually receive cash from the partnership. if income has previously been taxed to a partner, the corresponding distributions are generally tax free.53 depending on the consequences vary, the funding of the clawback obligation will generally result in a shortterm capital loss to gp; non-corporate taxpayers are not permitted to carry back capital losses in order to offset capital gains in prior years. see i.r.c. §§ 1211(b), 172(d) (2009). 51. see needham & adams, supra note 27, at a-10. to mitigate the likelihood of a clawback arising, p may choose to “write down” any unrealized losses in assets not yet sold and treat such losses as if actually incurred. 52. if lp bears the burden of the taxes nominally imposed on gp’s allocable share of profits, gp’s willingness to be taxed on such implicit salary is not economically meaningful. while the assumption that no carry is earned may seem counterintuitive if investors expect assets to be sold for an amount in excess of their carrying cost, the § 704(b) capital-account analysis nevertheless tests the validity of allocations based on a hypothetical worst case. see treas. reg. § 1.704-1(b)(2)(ii) (as amended in 2008). 53. see i.r.c. § 731 (2009). 2010] the sou�d a�d fury of carried i�terest reform 15 substance of the parties’ economic arrangement, however, a purported distribution may represent a disguised payment for services or an implicit loan and be taxed accordingly.54 from gp’s perspective, the timing of distributions is apparently paramount. gp is likely to resist strenuously the notion of deferring distributions until all of p’s assets are sold and p is wound up. since the clawback obligation is unsecured, however, lp risks that gp will lack sufficient funds to restore excess carried interest distributions. this credit risk could be solved by requiring escrow of all or a portion of gp’s distributions until lp has received a return of all prior contributions.55 nevertheless, private equity funds rarely follow this approach, perhaps based on the implicit assumption that “unrealized investments will generate proceeds at least equal to their carrying value.”56 like the provision concerning deemed taxes paid, the distribution methodology is a function of the parties’ relative bargaining power. as an economic matter, gp’s preference for early distributions may nevertheless be somewhat puzzling. in theory, the timing of distributions should be irrelevant, since adjustments to the terms of the parties’ arrangement are possible to reflect the present value of accelerated or deferred distributions.57 indeed, gp should be able to borrow against his share of undistributed profits to replicate the cashflow consequences of accelerated distributions.58 while often overlooked in the carried interest debate, the choice of distribution rules may significantly enhance gp’s overall compensation. gp effectively borrows at no interest from lp in exchange for a contingent recourse liability to repay unearned distributions upon liquidation. the § 704(b) capital account rules do not identify implicit loans among partners or require interest to be charged on deficit restoration obligations; nor does gp’s interest-free borrowing fall within the rules of § 7872 for belowinterest loans.59 the valuable no-interest loan embedded in the opaque and manipulable distribution rules may help to reinforce gp’s preference for 54. see, e.g., i.r.c. § 707 (2009). 55. schell, supra note 28, at 2-27 (noting that the escrow approach “is strongly resisted”); see also kate litvak, venture capital limited partnership agreements: understanding compensation arrangements, 76 u. chi. l. rev. 161, 177 (2009) (describing the escrow approach as least favorable from gp’s perspective, since gp “has, in effect, made an interest-free loan to investors”). of course, gp could be credited with interest on the escrowed amounts. see asofsky & needham, supra note 45, at 1310. 56. schell, supra note 28, at 2-21. 57. see litvak, supra note 55, at 176. 58. cf. id. (noting sponsors’ claim that “borrowing from outside lenders against future income [would be] prohibitively expensive”). 59. see treas. reg. § 1.704-1(b)(2)(ii)(c) (as amended in 2008). cf. i.r.c. § 7872 (2009) (governing interest-free loans generally between employees and employers). 16 columbia jour�al of tax law [vol. 1:1 early distributions.60 by using a profits interest (rather than an economically equivalent option), gp gains access to implicit interest-free loans as well as the opportunity to convert ordinary income into capital gain; thus, the tax advantage alone may be only a partial explanation of gp’s desire for a carried interest arrangement. since drafting the intricate distribution provisions is preeminently the task of tax lawyers, even sophisticated parties may not fully comprehend the economic import of these ordering rules.61 if p held back carried interest distributions, it would nevertheless provide for tax distributions to gp sufficient to pay gp’s deemed taxes on allocated income. to eliminate the possibility that a service partner will incur tax liability in excess of distributions for a particular period, the nearly universal practice is to require priority tax distributions to address timing problems.62 the business justification for mandatory tax distributions is that taxes on the firm’s entire income must be paid before determining any economic profit.63 if the enterprise were operated in corporate form, the tax would be incurred at the corporate level, effectively burdening the return to the preferred interest. similarly, lp should be entitled to its preference (return of capital and any hurdle rate) only after setting aside cash sufficient to pay taxes on the firm’s income. given the parties’ interest in maximizing joint after-tax returns, the nominal tax burden should be allocated in whatever manner minimizes the partners’ joint-tax liability.64 under existing § 707(a)(2)(a), congress delegated authority to treasury to distinguish disguised payments from true distributive shares.65 under that provision, a purported allocation and distribution may be recharacterized as a nonpartner payment. if gp were treated as a nonpartner, p’s entire income would be reallocated to lp and lp would be deemed to transfer $1 million to gp in year 2 as compensation or a 60. see litvak, supra note 55, at 163 (“[t]he interest-free loan is both opaque and highly valuable.”). 61. see id. at 196 (referring to distribution rules as possible evidence of “contractual complexity . . . used to increase stealth compensation”). 62. see schell, supra note 28, at 2-23 (noting that “acceptance of this minimal distribution is all but universal”). 63. while the partnership model eliminates an entity-level tax, mandatory tax distributions mimic the result under the corporate model. see robert p. rothman, translating corporate concepts into the language of llcs, 61 tax law. 161, 174–76 (2007). the tax distribution provision is less important if gp receives current distributions, but it nevertheless affects the clawback calculation. 64. see sanchirico, supra note 5, at 1143 (noting that the nominal incidence does not affect “real tax burdens, given the adjustability of wages and salaries”). 65. for the origins of § 707(a)(2)(a), see karen c. burke, back to the future: revisiting the ali’s carried interest proposals, 124 tax notes 242, 243–44 (2009). 2010] the sou�d a�d fury of carried i�terest reform 17 disguised interest-free loan. in example (1), if the purported distribution were treated as a loan (leaving aside possible imputed interest under § 7872), gp would be taxed on ordinary income of $1 million upon liquidation of p, since gp’s obligation to repay the loan is eliminated; the result would be the same as if gp were treated as holding an option exercisable immediately prior to liquidation of p.66 nonpartner treatment under § 707(a)(2)(a) would thus eliminate gp’s ability to convert salary into capital gain but would potentially permit longer deferral, by analogy to an option exercised upon liquidation of the partnership. d. earned capital in the baseline case of a self-liquidating private equity partnership, taxing distributions and taxing distributive shares may seem to be a distinction without a difference. thus, it is perhaps easy to understand how the recharacterization approach—treating a profits allocation as ordinary income—popularly came to be confused with taxing distributions, not distributive shares. if earnings are never accumulated for later distribution, the service partner does not acquire any “earned capital.” in the context of a private equity fund, the problem of earned capital—income taxed to a service partner as ordinary income and reinvested in the enterprise—simply does not arise because all profits are distributed currently. since many partnerships routinely reinvest earnings, however, complex adjustments are necessary when distributions are deferred.67 if earnings from services are reinvested in the enterprise, some mechanism is needed to track separately the labor and capital components of a service partner’s future return. indeed, the partnership tax bar has seized the opportunity to “improve” reform by meticulously working out the logical consequences of an earned capital exception, injecting further complexity and electivity. the notion of earned capital, however, assumes that a service partner who has a forfeitable interest should nevertheless be recognized as a partner. treating such a service provider as a partner is contrary to the 66. in example (2), reallocating partnership income entirely to lp would eliminate the $0.25 million of tax, since the investment return would be taxed at lp’s zero rate; if lp loaned the full $1 million interest-free to gp, gp would repay the entire amount (rather than only $0.75 million) on liquidation. 67. see nysba report, supra note 11, at 28 (noting that, unlike private equity funds, “other funds, in particular hedge funds and many real estate funds, routinely reinvest previously-taxed earnings in new portfolio investments.” in response to the bar’s comments, the current proposal carves out an exception for investment returns to earned capital; simply put, such investment returns are subtracted from gp’s profits share and taxed as capital gain. see infra notes 132–154 and accompanying text. 18 columbia jour�al of tax law [vol. 1:1 normal rules of § 83, the general provision governing receipt of property in connection with services.68 in light of the potential conflict between § 83 and the partnership rules, the partnership tax bar has long sought a special rule that would exempt a profits holder whose interest is forfeitable from the normal operation of § 83. from the partnership tax bar’s perspective, the ordinary income approach favored by reformers is nothing new. historically, the ordinary income approach harkens back to proposals by william mckee and others in the 1970’s as a compromise solution to the potential conflict between § 83 and the partnership rules.69 while reformers perhaps unwittingly borrowed the ordinary income approach as a solution to the carried interest problem, the mckee proposal antedated the modern capital account system. the complex capital account system makes it possible, in theory, to track the separate labor and capital components of a service partner’s interest when earnings from services are reinvested in the partnership. indeed, it may be possible to refine the mckee proposal to take into account previously taxed and reinvested salary as a source of future capital gains, by “disaggregating” a service partner’s return into separate labor and capital components. yet capital accounts may be a shaky foundation for reform, and the earned capital exception may be a misnomer. when gp has solely a profits interest contingent on a performance goal, the fundamental issue is whether gp or lp should be treated as owning partnership capital that generates an investment return taxed as capital gain.70 if, upon closer inspection, § 710 is not the simple solution touted by reformers, a better approach may be to deny partner status to a service provider who is essentially in the same position as an option holder. 68. section 83 requires a person who receives property in connection with performance of services to include the value of such property in income when such property first becomes “transferable” or is no longer subject to a “substantial risk of forfeiture.” see i.r.c. § 83(a)(1) (2009). in the absence of a § 83(b) election, the taxable event occurs when the transferred property becomes substantially vested. see treas. reg. § 1.83-3(b) (as amended in 2005). prior to vesting, the transferor (not the transferee) is treated as the owner of such property. see treas. reg. § 1.83-1(a)(1) (as amended in 2003). 69. see infra notes 108–111 and accompanying text. 70. see senate hearings, supra note 1 (statement of charles i. kingson, july 31, 2007) (“the debate over carried interests should be seen as part of a derivative free-for-all, a sort of financial check-the-box regime, in which people can choose between the tax attributes of owning or not owning property.”). kingson was apparently the only witness who suggested that an investment manager’s return should already be taxed as ordinary income under current law. id. see also charles i. kingson, carried interests: an outdated term?, 123 tax notes 627 (2009) (“a bill to tax hedge fund managers on their share of the profits as ordinary income probably loses revenue . . . [a] statute ratifies their previous position.”) [hereinafter kingson, carried interests: an outdated term?]. 2010] the sou�d a�d fury of carried i�terest reform 19 ii. proposed §§ 710 and 83 although hardly novel, the recharacterization approach of § 710 follows broadly the proposal of reformers who argued that a service partner’s distributive share should be treated as ordinary income from compensation. rather than address joint-tax minimization by reallocating income between service providers and investors, the recharacterization approach affects the treatment of only one party to the transaction. such an approach is theoretically flawed but arguably represents an appealing political compromise: it preserves the status of a service provider as a partner, suspends the taxable event until profits are allocated to the service provider, and treats investor partners no less favorably than under current law.71 consistent with the “technical” recommendations of the partnership tax bar, the levin bill amends § 83 to provide a statutory exception for profits interests (the zero-value approach), offering an unwarranted valuation subsidy for valuable profits interests. section 710 would be both complex and easily avoidable: tax-exempt investors and service providers would have a joint-tax incentive to opt out of § 710 by restructuring a profits interest as an economically equivalent option to achieve yield exemption and longer deferral. a. ordinary income treatment in the reductionist version of the story told to congress, the undertaxation of gp—who earns compensation for services but is taxed at the capital gains rate—creates a fundamental problem of distributive justice.72 such undertaxation is attributable to a “quirk” of partnership tax law that treats receipt of a profits interest as nontaxable, thereby allowing deferral and conversion.73 rather than challenge the partner status of a service provider who holds an option-like interest, reformers focused narrowly on the characterization rule of § 702(b). under that rule, the character of income in the hands of the partnership determines the character 71. see nysba report, supra note 11, at 14. 72. see house hearing, supra note 1 (statement of victor fleischer, sept. 6, 2007, at 4) (to some, “the most compelling point is simply one of distributive justice.”). while the proposed legislation might offer fresh opportunities for gamesmanship, such challenges were viewed as surmountable. id. at 7 (“[t]hese details can be ironed out, and we should not let the private equity industry’s threat of further gamesmanship justify inequities and inefficiencies in the current law.”). 73. fleischer, supra note 2, at 5 (describing the “quirk in the partnership tax rules [that] allows some of the richest workers in the country to pay tax on their labor income at a low effective rate”). 20 columbia jour�al of tax law [vol. 1:1 of the income in the hands of the partner. indeed, such “conduit” treatment has long been perceived to be at the heart of the partnership tax rules.74 faulting the conduit rule as the source of capital-gain conversion, reformers proposed a simple solution to redress a serious inequity: recharacterize income passed through to gp as ordinary income.75 consistent with this solution, § 710 overrides the long-standing character flow-through rule under § 702 and treats disproportionate allocations to gp as ordinary income (or loss).76 simply stated, the net effect is to increase the tax rate on gp’s implicit salary from 15% to 35%, without altering the tax consequences to lp.77 the tradeoff for increasing the tax rate on gp is preserving intact the existing favorable treatment of lp.78 proposed § 710 exempts from ordinary income treatment an allocation that reflects a reasonable return on a service partner’s “qualified capital interest.”79 qualified capital consists initially of the amount of money, the fair market value of any property contributed to the partnership, and the amount (if any) taxed to the service partner upon receipt of a profits interest.80 upward (or downward) adjustments must be made to a service partner’s share of qualified capital to reflect net income (or net loss) as well 74. see george k. yin & karen c. burke, partnership taxation 47 (2009) (noting that courts refer to § 702(b) as the “conduit rule”). 75. see fleischer, supra note 2, at 51 (referring to “ordinary-income method”); senate hearings, supra note 1 (statement of mark p. gergen, july 11, 2007) (“there is a fairly simple solution to the problem of the taxation of carried interests . . . . the capital accounts system . . . makes this fairly easy to do.”); id. (“the capital account makes it possible to identify when a distributive share is compensation.”). 76. compare i.r.c. § 702(b) (2009) (character of any item included in partner’s distributive share “shall be treated as if such item were realized directly from the source from which realized by the partnership”) with prop. § 710(a)(1) (“notwithstanding section 702(b),” any net income or loss “shall be treated as ordinary income [or] ordinary loss.”). 77. assuming that most lps are tax exempt, the one-sided change in the tax treatment of gp would result in a net increase in revenue. see knoll, supra note 6, at 129 (noting that untaxed investors provide at least 50% of private equity capital). carried interest allocations recharacterized as ordinary income would also be subject to social security and medicare taxes as self-employment income. see prop. § 710(a)(1)(a); i.r.c. § 1402 (2009). 78. see schler, supra note 13, at 839 (noting that prop. § 710 approach “is theoretically incorrect, but on balance it is a reasonable and generally pro-taxpayer result”). 79. see prop. § 710(c)(2)(a)(i)–(ii) (allocations must be made “in the same manner” as allocations made to non-service partners that are “significant” in comparison to allocations made to service partners); prop. § 710(c)(2)(c) (defining a qualified capital interest). see also nysba report, supra note 11, at 20–24 (describing the “reasonable allocation” requirement under prior versions of the carried interest legislation). 80. see prop. § 710(c)(2)(c) (2009). a service partner’s qualified capital will initially be zero (the liquidation value of the profits interest), unless the partner owns a separate capital interest. see prop. § 710(c)(2)(c)(ii) (treating as qualified capital the amount of income included under proposed § 83 upon grant). 2010] the sou�d a�d fury of carried i�terest reform 21 as distributions of cash and property.81 if all earnings are distributed currently, gp never acquires qualified capital from retained earnings (“earned capital”), and § 710 has the same net result as taxing all distributions to gp as ordinary income. in all other situations, the operation of § 710 is much more complex. since gp is treated as receiving compensation, it might appear logical to tax p’s income entirely to lp, with an offsetting compensation deduction.82 section 710 does not follow that logical approach: it alters the character of the income allocated to gp but does not reallocate income between gp and lp.83 since lp is taxed on only 80% of the partnership income, lp receives the equivalent of a deduction in the form of a reduced share of capital gain.84 if lp is tax exempt, lp is indifferent to the loss of a worthless deduction. if lp is a taxable individual and the expense is immediately deductible, § 710 is potentially punitive. the net detriment to lp is equal to the difference between the ordinary income rate and the capital gain rate on the implicit salary. section 710 essentially provides an election to obtain a deduction for gp’s implicit salary. to take advantage of this election, the parties must simply pay cash (rather than carry) to gp. this elective workaround exposes a fundamental flaw: under § 710, it is not possible to ensure consistent treatment of the parties regardless of whether cash or carry is used.85 81. any net income is generally treated as ordinary income attributable to services; any net loss is generally treated as ordinary loss to the extent of amounts previously taxed as ordinary income. see prop. § 710(a)(1)(a) and (b); see also prop. § 710(c)(2)(c)(iii)(ii) (2009) (reduction for net losses and distributions). the loss limitation would be layered on top of existing loss limitation rules. see i.r.c. §§ 704(d), 465, 469, and 470 (2009). 82. when § 707(a)(2)(a) applies, the defective allocation is disregarded and the related items of income (or loss) are reallocated to the other partners, who may also be entitled to a current (or capitalized) deduction for compensation. see joint comm. on tax’n, 98th cong. 2d sess., general explanation of the revenue provisions of the deficit reduction act of 1984, 227–28 (comm. print 1984); s. prt. no. 98-169, at 227–29 (1984); h.r. rep. no. 98-432, at 1218–20 (1984) (conf. rep.). it is not clear how prop. § 710 would be coordinated with § 707(a)(2)(a). 83. see schler, supra note 13, at 838–39 (contrasting the recharacterization/exclusion approach with the inclusion/deduction approach). under current law, taxable individual investors’ share of capital gain is partially offset by capital gain shifted to the service partner as compensation for investment services. see knoll, supra note 6, at 157–58 (noting that investors are taxed like any other investor in a capital asset). 84. denial of a deduction to the investors may be justified on the ground that it “avoids the situation in which individual investors get the tax benefit of concurrent capital gain income and an ordinary deduction.” gergen, supra note 12, at 149 n.2. see also knoll, supra note 6, at 157 (allowing an ordinary deduction would potentially convert “private equity limited partnership interests [into] tax-advantaged assets”). 85. while the option of paying cash to gp offers “a cheap and easy design around” the proposed legislation, there are no practicable alternatives to prevent such self-help measures. 22 columbia jour�al of tax law [vol. 1:1 it is useful to compare the recharacterization approach of § 710 with the entity approach of § 707(a)(2)(a) which would treat the partnership as paying compensation to gp as a third-party service provider. under the inclusion/deduction approach of § 707(a)(2)(a), lp would include p’s entire income and would deduct (or capitalize) the implicit salary.86 when gp’s implicit salary is capitalized, taxing lp on only 80% of overall gain achieves roughly the same result as under § 707(a)(2)(a).87 under the § 707(a)(2)(a) approach, lp would be forced to include all of p’s income with a potential offsetting deduction. by contrast, the § 710 approach omits the final step of forcing lp to deduct or capitalize the expense. if the implicit salary would be a disallowed expense, the recharacterization/exclusion approach of § 710 treats lp too generously by giving lp the equivalent of a deduction.88 the net result is that § 710 will often result in unwarranted bonuses or penalties, subject to transactional elections to vary the results to minimize the parties’ joint taxes. when lp is tax exempt (or otherwise tax indifferent), § 710 eliminates the joint-tax windfall resulting from conversion of ordinary income into capital gain.89 under current law, both gp and taxable individual lps have an incentive to structure compensation as carry rather than as a fee to avoid the § 212 limitation on the deductibility of investment-type expenses.90 if expenses passed through to individual taxable investors are properly treated as § 212 expenses, they may result in gergen, supra note 12, at 140; cf. id. (suggesting treating compensation contingent on profits “as an allocation of those profits however the payment is formally characterized”). 86. both § 707(a) payments and § 707(c) payments are subject to the capitalization requirement of § 263. if the partnership is required to capitalize a salary payment (or the deduction is disallowed), § 707(a)(2)(a) prevents conversion of long-term capital gain into ordinary income. for example, assume that p has $100 of long-term capital gain, of which $20 is taxed to gp. if the $20 of implicit salary is capitalized, p’s deduction is eliminated, leaving lp with $80 of long-term capital gain ($100 less $20 basis offset) and gp with $20 of ordinary income. 87. see knoll, supra note 6, at 128 n.78 (discussing uncertainty under current law concerning whether investment fees (paid in cash upfront) would be deductible immediately or capitalized and amortized over time); sanchirico, supra note 5, at 1076 n.13 (assuming fees would be immediately deductible); weisbach, supra note 14, at 732 (concluding that payments “would not likely have to be capitalized”). 88. cf. sanchirico, supra note 5, at 1127 (noting that permanent disallowance is unlikely, since the partnership’s business can be restructured to ensure that “the limited partner is able at some point to deduct at least some portion of his distributive share” of the imputed salary expense) (emphasis added). 89. since corporate partners do not benefit from lower capital gains rates, they are generally indifferent between an ordinary income deduction and reduced capital gain. see sanchirico, supra note 5, at 1124–25; knoll, supra note 6, at 130. 90. see i.r.c. § 212 (2009) (treating investment expenses of individual taxpayers as additional itemized deductions). 2010] the sou�d a�d fury of carried i�terest reform 23 a worthless itemized deduction.91 by allowing a deduction-equivalent to lp, § 710 attempts to “finesse” the § 212 issue.92 while overly generous, this approach could be viewed as “simplifying” the treatment of taxable individual investors by not forcing them to include an additional amount in income (their portion of gp’s implicit salary) and then claim an offsetting deduction. although some commentators have suggested that the § 212 limitation may be difficult to defend as a matter of tax policy, taxable individual investors should not be allowed an undeserved windfall.93 even if the partnership claims to be conducting an active trade or business, investment-type expenses attributable to a limited partnership interest, by analogy to a security, should arguably be treated as § 212 expenses. b. joint-tax perspective and § 83 although some reformers claim that the existing treatment of partnership profits interests is fundamentally untenable as a policy matter, this issue may be a “red herring.”94 the tax treatment of profits interests appears anomalous mainly if one focuses narrowly on gp’s one-sided conversion and deferral. from a joint-tax perspective, the existing 91. see i.r.c. §§ 67, 68, and 56(b) (2009). if the partnership qualifies as a “trader” rather than an “investor,” § 162 may apply to management expenses passed through to investors. cf. rev. rul. 2008-39, 2008-2 c.b. 252 (management fees paid by upper-tier partnership were not § 162 expenses; fees passed through to investors as separately-stated § 212 expenses). even if the partnership is a trader, the § 469 passive loss limitations may apply to an individual investor. see i.r.c. § 469 (2009). 92. gergen, supra note 12, at 140 (“code sec. 710 tries to finesse this issue.”). since “many of the funds targeted by the [legislation] do not engage in a ‘trade or business’ at all,” the proposed legislation is clearly overly generous to investors. nysba report, supra note 11, at 69 n.184. 93. cf. sanchirico, supra note 5, at 1105 (suggesting that avoidance of the § 212 limits may be “quite different normatively” since the disfavored treatment of investment expenses “is not itself easy to justify as a policy matter”). while managers’ outsized salaries may be an especially attractive target for reform, the case for preserving taxable individual investors’ current favorable treatment needs to be made explicitly, not as a backhanded criticism of § 212. see susan kalinka, rev. rul. 2008-38 and rev. rul. 2008-39: above the line, below the line and even further below the line, 87 taxes 23 (2009) (proposing to treat all passive investors the same whether they invest in securities directly or through a hedge fund); andrew w. needham & christian brause, 736 b.n.a. tax mgmt. portfolio a-59 to a-63 (2007) (discussing uncertainties concerning a hedge fund’s “trader” status). 94. sanchirico, supra note 5, at 1082 (describing flawed tax treatment of profits interests as “something of a red herring”). whatever its defects, current law is clearly rooted in considerations of administrability, not an intent to “subsidize activity carried out in the partnership form.” ronald j. gilson & david m. schizer, understanding venture capital structure: a tax explanation for convertible preferred stock, 116 harv l. rev. 874, 913 (2003). 24 columbia jour�al of tax law [vol. 1:1 treatment of partnership profits interests generally does not give rise to a tax advantage (or disadvantage) if all parties are taxed at the same rates on ordinary income and capital gains. it is important to consider the tax treatment of partnership profits interest within the broader spectrum of alternative compensation arrangements. the differing tax treatments of these alternative compensation forms can be illustrated graphically as follows: gp’s profits share gp lp profits interest (current law) cg (realization) no deduction option oi (exercise) cg (realization) ordinary deduction (exercise) § 710 oi (realization) cg (realization) no deduction § 707(a)(2)(a) oi (distribution) cg (reallocation) ordinary deduction (payment) from a joint-tax perspective, profits interests and options are generally not tax advantaged when lp and gp are taxed at the same rates. in the case of a profits interest, the tax benefit to gp, who reports capital gain rather than ordinary income as partnership profits are realized and allocated, is precisely offset by the tax detriment to lp, who reports less capital gain but loses an ordinary deduction.95 from a joint-tax perspective, a compensatory partnership option is not globally tax advantaged because gp’s entire compensatory return is taxed as ordinary income, offset by a deduction to lp, and the partnership’s entire investment return is taxed to lp. similarly, under the service’s administrative guidance for valuing a profits interest upon receipt, there may be no joint-tax advantage if both lp and gp are taxed at the same rates.96 if lp is tax exempt (or otherwise tax 95. see sanchirico, supra note 5, at 1076, 1082 (concluding that the tax advantage enjoyed by private equity fund managers “is most fundamentally a form of ‘joint-tax arbitrage’” rather than “a matter of wholesale conversion and deferral”); knoll, supra note 6, at 128; weisbach, supra note 14, at 732–33 (“[t]he only real difference between use of an explicit salary and the use of a carried interest relates to having tax-exempt investors.”). 96. one commentator has recently faulted reformers for failing to identify the § 83(b) election as a source of inequity in the taxation of equity-based deferred compensation. see philip f. postlewaite, fifteen and thirty five — class warfare in subchapter k of the internal revenue code: the taxation of human capital upon the receipt of a proprietary interest in a business enterprise, 122 tax notes 503, 531 (2009). from a joint-tax perspective, however, a § 83(b) election is likely to be tax advantageous only if the employer 2010] the sou�d a�d fury of carried i�terest reform 25 indifferent), however, the fundamental premise of safe harbor treatment is flawed, since lp suffers no offsetting detriment in the form of a forgone compensation deduction.97 as discussed below, the service’s liberal administrative guidance on profits interests was arguably never intended to sanction the type of capital-gain conversion that prompted reformers’ ire. rather, safe harbor treatment should be limited to those situations in which there is little room for abuse because sufficient tax tension exists between the partners. ironically, it was quite clear to sophisticated partnership practitioners, though perhaps not to congress, that private equity arrangements were not literally protected under the service’s administrative guidance. on the one hand, practitioners perhaps hoped and believed that regulations proposed in 2005 (and never finalized) would retroactively sanction the aggressive position that receipt of such carried interests was tax free. on the other hand, reformers demanded a statutory solution to a problem flowing from overly generous administrative rules that never had the force of law. if the problem was administrative in nature, however, the solution may well be for congress to direct treasury to use existing regulatory and statutory tools to address the underlying problem. while generally following the service’s prior administrative guidance, the 2005 proposed regulations impose formal conditions concerning the taxation of profits interests more consistent with the general structure of § 83.98 under the proposed regulations, two elections must be made to ensure partner status: an election to treat the value of the interest (capital or profits) as equal to the amount the service provider would receive on an immediate deemed liquidation of the partnership (the liquidation-value election) and an election to include the value of a nonvested interest in income (a § 83(b) election).99 the proposed regulations sanction nonrecognition of gain or loss at the partnership level when a partnership transfers a compensatory partnership interest or is effectively tax-exempt; in this situation, “the parties can generate a large tax benefit from undervaluing the employer’s shares and making the election.” see knoll, supra note 5, at 745. 97. while the lack of any offsetting tax detriment should be sufficient grounds to exclude such arrangements from safe harbor treatment, current law may present a closer issue. see staff of the joint comm. on tax’n, present law and analysis relating to tax treatment of partnership carried interests and related issues 54 (sept. 4, 2007) (jcx 6207) (querying “whether it is appropriate to permit the general partner to have favorable tax treatment premised on an offsetting tax disadvantage to limited partners when, by virtue of the limited partners’ tax status, no such disadvantage results.”). 98. see reg-105-346-03, supra note 32, preamble. under the proposed 2005 regulations, the liquidation-value election is available only if services are performed for the issuing partnership. 99. see id. 26 columbia jour�al of tax law [vol. 1:1 option.100 under the so-called “circle-of-cash” theory, the partnership may be deemed to transfer cash compensation to the service partner who then recontributes the cash to the partnership in exchange for a capital interest. the 2005 proposed regulations do not explicitly adopt the circle-of-cash theory; without any analysis or discussion, the preamble states merely that deferring partnership-level gain is “more consistent with the [nonrecognition] policies underlying section 721” than would be a recognition rule.101 the 2005 proposed regulations were controversial because they contradicted prior authority that was generally viewed as requiring nonservice partners to recognize gain on exchange of a partnership capital interest for services.102 while the partnership tax bar has generally extolled the nonrecognition result–by analogy to § 1032 when a corporation transfers stock as compensation for services–such treatment is surprisingly difficult to reconcile with the legislative history and statutory structure of § 721.103 thus far, the carried interest legislation does not address the controversial issue of partnership-level gain recognition when a service partner receives a capital interest (or exercises a compensatory option).104 now that § 710 has implicitly reopened these issues, however, it seems 100. see prop. reg. § 1.721-1(b)(2), 70 fed. reg. 29675 (may 24, 2005). if the partnership revalues its assets in connection with the service partner’s admission, built-in gain or loss in the partnership’s assets is preserved, under § 704(c) principles, for later recognition by the non-service partners. see treas. reg. § 1.704-1(b)(2)(iv)(f)(5)(iii) (as amended in 2008); see also treas. reg. § 1.704-1(b)(4)(i) (as amended in 2008). 101. reg-105-346-03, supra note 32, preamble. 102. under the prevailing view prior to issuance of the proposed 2005 regulations, transfer of a capital interest in exchange for services results in recognition of gain or loss at the partnership level. see, e.g., yin & burke, supra note 74, at 278. the partnership is allowed a deduction (allocated to the non-service partners) equal to the amount included in the service partner’s income. see treas. reg. § 1.83-6(a)(1), (a)(4) (as amended in 2003) (capitalization requirement). 103. see generally martin j. mcmahon, recognition of gain by a p’ship issuing an equity interest, 109 tax notes 1161 (2005) (arguing that nonrecognition treatment is inconsistent with the legislative history of § 721); cf. douglas a. kahn, the proper treatment of the transfer of a compensatory partnership interest, 62 tax law. 1, 51–56 (2009) (criticizing mcmahon’s view). 104. see monte a. jackel & robert j. crnkovich, partnership deferred compensation and carried interests, 123 tax notes 351, 353 (2009). a prior version of prop. § 710 required partnership-level gain recognition on a distribution of appreciated property to a service partner, but the provision was revised to limit gain recognition solely to the service partner. see carol kulish harvey & eric lee, a technical walk through the carried interest provisions contained in chairman rangel’s tax reform proposal, 86 taxes 77, 93 (2008) (discussing former version of prop. § 710(b)(4)); nysba report, supra note 11, at 31–32. as the partnership tax bar clearly perceived, partnership-level gain recognition under prop. § 710 would have been inconsistent with the proposed 2005 regulations which defer the historic partners’ gain recognition on transfer of a capital interest for services. 2010] the sou�d a�d fury of carried i�terest reform 27 likely that the partnership tax bar may seek the opportunity to obtain a statutory override to the gain recognition rule. if so, § 710 may become the excuse for achieving yet another longstanding goal of the partnership tax bar—namely, to create a special nonrecognition rule for partnerships when property is transferred in exchange for services. in response to comments from the partnership tax bar, the carried interest bill would significantly amend § 83.105 the revision to § 83 is very brief and essentially adds two special rules for partnership interests distinct from all other types of property subject to § 83. first, except as provided by regulations, the fair market value of a partnership interest issued for services (whether a capital or profits interest) would be treated as equal to the liquidation value of the interest (as determined under a hypothetical sale at the time of grant). second, the recipient of the interest would be deemed to make a section 83(b) election unless the recipient specifically elected not to have section 83(b) apply. the net effect of these changes is that the recipient of a nonvested profits interest would obtain all of the benefits of partner status at no tax cost, without even bothering to make a § 83(b) election. such largesse would no longer depend on dubious administrative guidance but would instead be codified as an amendment to § 83. since a compensatory partnership interest is nearly always structured as a profits interest (rather than a capital interest), the deemed § 83(b) election achieves a taxpayer-favorable result (zero value), subject to an election out.106 in the unlikely event that the service partner receives a capital interest, the liquidation-value rule prevents “whipsawing” of the government: the recipient could not claim a lower discounted value based on fair market value, while non-service partners claimed a deduction (or capitalized expense) based on the higher liquidation value.107 the proposed rules are extraordinarily favorable to taxpayers who would nearly always prefer to structure compensation as a nontaxable profits interest rather than a taxable capital interest. indeed, if there were any serious likelihood that a compensatory interest would be structured as a capital interest, the 105. proposed § 83(a)(4)(a) and (b) contained in section 1 of the levin bill, supra note 1. see nysba report, supra note 11, at 8 (recommending amendment of § 83 to permit or require use of liquidation value). 106. in effect, the deemed election would free service partners and non-service partners from the burden of making two elections: a liquidation-value election and a § 83(b) election. see nysba report, supra note 11, at 27–28 (suggesting “a clear statutory basis for liquidation value” is necessary to allow partnerships to make the liquidation-value election on behalf of partners “free of the procedural constraints of the currently-proposed safe harbor”). 107. while a profits interest has a liquidation value of zero by definition, the liquidation-value of a capital interest may exceed its fair market value discounted to reflect lack of marketability and other factors. 28 columbia jour�al of tax law [vol. 1:1 partnership tax bar would presumably demand valuation discounts to reflect lack of marketability and control. formally, receipt of a compensatory partnership profits interest would continue to be subject to § 83. nevertheless, the zero-value rule and deemed § 83(b) election would effectively exempt partnership profits interests from entanglement with § 83. since 1969, much of the partnership tax bar has strenuously resisted the notion that § 83 should apply in the partnership area.108 as william mckee noted in 1977, the “potential conflict between § 83 and subchapter k is more than skin-deep . . . . [t]reating a person as a partner prior to the lapse of a substantial risk permits the § 83 scheme to be subverted and manipulated to the advantage of a canny taxpayer.”109 indeed, mckee recommended a “compromise solution” under which the normal partnership rules would “simply give way to § 83, so that all income included in the distributive share of a partner [whose interest is forfeitable] would be treated as compensation income, regardless of its character as determined at the partnership level.”110 proposed § 710 is strikingly similar to mckee’s compromise proposal, but would often afford even more taxpayer-friendly treatment by recharacterizing some (but not all) of a profits share as ordinary income.111 as a policy matter, the issue is whether profits interests should be exempt from the normal rule of § 83 applicable to all other transfers of property for services. the zero-value rule provides an unjustifiable valuation subsidy to recipients of profits interests in comparison to other types of non-partnership equity compensation.112 since enactment of § 83, congress has codified the rules for taxing deferred compensation under § 409a, which applies in both the corporate and partnership contexts.113 the 108. e.g., william s. mckee et al., federal taxation of partnerships and partners ¶ 5.08[3][a] at 5-44 to 5-45 (1977) (referring to § 83 as “inspired primarily by dissatisfaction with prior law relating to transfers of corporate stock to employees” and warning of “unexpected consequences” if applied to transfers of partnership interests). for a contemporary view of § 83 along similar lines, see abrams, supra note 2, at 208–11, 221. 109. mckee, supra note 108, at ¶ 5.08[3][b] at 5-50. 110. id. at 5-50 to 5-51. 111. although mckee’s proposal applied only to a forfeitable interest, a profits interest contingent on a performance goal is forfeitable under § 83. see treas. reg. § 1.83-3(c)(1) (as amended in 2005). 112. see gilson & schizer, supra note 94, at 907–09 (noting that current rules immunize aggressive valuation for safe harbor interests). cf. postlewaite, supra note 96, at 515 (claiming that “the tax treatment of a profits interest is neither unique nor extraordinary.”). 113. if § 409a applies, deferred compensation may be required to be included in income prior to the year of payment; in addition, the deferred income may be subject to a 20% exercise tax and interest charges. see i.r.c. § 409a(1)(a) and (b) (2009). profits interests do not typically limit rights to receive distributions in a manner that would satisfy the requirements of § 409a. see carman, supra note 13, at 115. 2010] the sou�d a�d fury of carried i�terest reform 29 § 409a regulations treat the valuation of illiquid stock in a start-up corporation as reasonable only if the fair market value is determined under a reasonable valuation method that takes relevant factors into account.114 under these valuation guidelines, the liquidation-value methodology is patently unreasonable: it ignores factors relevant to valuation and creates a fictional liquidation that bears no relationship to the parties’ intent. this fictional approach may well encourage misvaluation in related areas in which the liquidation-value methodology would be clearly abusive.115 if the concern is merely to coordinate § 710 with existing law, a much narrower fix should suffice that would not override the general principles of § 83 in the partnership context.116 since § 83 was added in 1969, congress has enacted significant legislation—including § 409a and most recently § 457a—accelerating income and imposing penalties in the case of certain deferred compensation arrangements.117 these complex provisions potentially impact the treatment of compensatory profits interests and amounts recharacterized as ordinary income under proposed § 710.118 if congress proceeds further with the carried interest legislation, it will be necessary to consider carefully the interactions between these provisions and § 710. more broadly, the issue is whether a compensatory partnership interest should be treated like other property for purposes of § 83 and related provisions governing deferred compensation arrangements. since the current entity classification rules greatly narrow the substantive differences between partnerships and corporations, it is not clear why profits interests should be treated so differently from nonqualified stock options which they 114. see treas. reg. § 1.409a-1(b)(5)(iv)(b)(1) and (2) (2007). 115. see, e.g., gilson & schizer, supra note 94, at 908 n.113 (suggesting possibility of “wrapping” a corporation in a partnership); karen c. burke & grayson m.p. mccouch, family limited partnerships: discounts, options, and disappearing value, 6 fla. tax. rev. 649, 671–72 (2004) (noting that “value . . . disappears from the transfer tax base under existing law as a result of inconsistent valuation assumptions”). 116. see prop. § 710(c)(2)(c). if both prop. § 710 and § 83 apply, the concern is apparently that the fair value of a profits interest could potentially be taxed twice. see aba comments, supra note 11, at 16–17. alternatively, the concern may be that the liquidationvalue presumption is inconsistent with the language of § 83 concerning the “fair market value” of an interest. see harvey & lee, supra note 104, at 98, 102 n.97. 117. i.r.c. § 457a addresses deferral of compensation paid by a tax-indifferent party (such as a foreign corporation located in a tax haven whose income is not subject to u.s. tax). in this situation, deferral of the service-provider’s income is not offset by any tax detriment to the payor. 118. the levin bill no longer provides that recharacterized income will be treated as compensation for performing services. see carol kulish harvey & james b. sowell, proposals on carried interests, business entities 4, 10 n.22 (july/august 2009) (suggesting that this change may be intended to “ameliorate” problems that could otherwise arise under §§ 409a and 457a). 30 columbia jour�al of tax law [vol. 1:1 resemble.119 in summary, there has been virtually no public discussion of the proposed amendment to § 83 based on the partnership tax bar’s recommendations. while the proposed amendment may be portrayed as merely codifying the service’s prior administrative guidance, it overrides general § 83 principles applicable to all other transfers of property for services. if the service’s prior administrative guidance was excessively lenient and arguably helped to give rise to the carried interest problem, the solution should not be to codify such guidance in the guise of reform. allowing easy access to partnership status for profits holders who own option-like interests will only lead to yet more complicated partnership rules to prevent abusive trading of tax characteristics. such complexity will inevitably spill over into routine non-abusive transactions while rendering subchapter k even more inaccessible and opaque except to highly-skilled partnership tax specialists who have the ability to exploit intricate rules for the benefit of their clients. safe harbor treatment for profits interests should be reserved for non-abusive arrangements in which the tax tensions between the partners provide an adequate safeguard against joint-tax minimization. c. compensatory options versus profits interests because partnership profits interests and options are often close economic substitutes, it is useful to consider how § 710 might affect the choice between these alternative forms of compensation. under current law, profits interests are typically viewed as more tax efficient than compensatory partnership options.120 even though the profits holder is taxed currently on his share of partnership income, the character of the income may be capital rather than ordinary. by contrast, the option holder defers taxation until exercise of the option but is taxed entirely on ordinary income at the time of exercise. if § 710 operates as intended, however, it would eliminate the profit holder’s benefit of capital-gain conversion, without altering the timing of income recognition. section 710 would thus dramatically alter the relative tax efficiency of these alternative forms of compensation.121 a profits holder would be taxed sooner than an option 119. see treas. reg. §§ 301.7701-2 (as amended in 2009), 301.7701-3 (as amended in 2007) (elective classification of eligible business entities as corporations or partnerships). 120. see generally james sowell, partners as employees: a proposal for analyzing partner compensation, 90 tax notes 375 (2001) (discussing use of options to ensure employee status). 121. proposed § 710 apparently does not apply to a compensatory option to acquire a partnership interest. see prop. § 710(d) (disqualified interests); schler, supra note 13, at 852 2010] the sou�d a�d fury of carried i�terest reform 31 holder but would no longer enjoy any conversion benefit. an option should thus prove relatively more tax-efficient than a profits interest, since the service provider would defer recognition of ordinary income until exercise of the option and all interim investment return would be taxed solely at lp’s zero rate.122 sensibly, the parties should opt out of § 710 if option treatment produces a better joint-tax result. example (3)—european option alternative. building on the same facts in example (1), assume that gp’s profits interest is restructured as a european option exercisable immediately prior to liquidation of p. the receipt of the option is tax free, since the option lacks a readily ascertainable fair market value.123 under current law, tax-exempt lp is taxed on p’s entire gain of $5 million realized prior to exercise of the option, since gp is not treated as a partner. upon exercise of the option, gp recognizes ordinary income of $1 million (the liquidation value of gp’s acquired capital interest) and lp receives a worthless ordinary income deduction (or offsetting capital loss) to reflect the compensation paid to gp.124 since lp is tax exempt, the investment return on p’s assets is entirely untaxed and gp defers recognition of ordinary income until liquidation. from gp’s perspective, a compensatory option is tax advantaged because it permits deferral of the tax (the equivalent of yield exemption) until exercise of the option.125 if gp instead received a profits interest and were taxed under § 710, gp would be taxed on $1 million of ordinary income in year 2 equal to gp’s 20% share of p’s $5 million of gain. thus, profits treatment would accelerate the ordinary income tax on gp’s compensation even though gp’s carry is not actually earned until year 5. if the goal is to minimize the parties’ joint-tax liability, the most sensible strategy would be to treat gp as an option holder, so that all investment return is taxed at lp’s zero rate. stated differently, structuring gp’s compensation as a profits interest in example (1) saves taxes only because (noting confusion concerning application of prop. § 710(d) to options to acquire stock). 122. the proposed 2005 regulations request comments concerning whether an antiabuse rules is needed in such circumstances. see reg-105-346-03, supra note 32, preamble, § 1. 123. see treas. reg. § 1.83-7(a) (as amended in 2004). 124. lp’s basis is initially increased to $45 million ($40 million plus $5 million gain); if the expense were capitalized, lp would recognize a $1 million capital loss ($44 million distribution less $45 million basis) upon liquidation. 125. gp is treated in the same manner as an employee who receives a nonqualified stock option (nqso) and defers ordinary income from grant until exercise of an option. see walker, supra note 5, at 711 (positing an employee’s “hypothetical outside investment in an nqso” and noting that “deferral effectively eliminates the tax on the outside investment return”). 32 columbia jour�al of tax law [vol. 1:1 it allows conversion of gp’s salary into capital gain. if conversion is no longer possible under § 710, an option minimizes joint taxes because it allows yield exemption and longer deferral. as illustrated in example (1), current-law profits treatment also allows gp to borrow interest-free from lp, subject to a potential clawback of unearned carry. in terms of the partners’ economic arrangement, a european option is not economically equivalent to a profits interest unless gp can borrow explicitly (without interest) from lp to replicate the cashflow consequences of early distributions. if gp borrows explicitly from lp, the “loan” may be treated as a below-market interest loan under § 7872.126 gp would have imputed income (the foregone interest) potentially offset by an imputed interest deduction (the deemed interest payment).127 if the interest income and deduction offset each other, the net result is that gp defers recognition of ordinary income until liquidation, when gp exercises the option and repays the loan principal.128 thus, gp may be able to replicate the cash-flow consequences of profits treatment if the arrangement is restructured as an option coupled with an explicit (rather than implicit) loan. taxing gp upon exercise of a european option is equivalent to taxing gp’s compensation as a nonpartner payment under § 707(a)(2)(a) and deferring inclusion until distribution.129 setting aside the issue of capital-gain conversion, deferral of gp’s income inclusion is essentially no different from the result that gp could obtain through a contractual deferred compensation arrangement, as long as gp is willing to incur a substantial 126. section 7872 applies to a below-market loan between an employer and an employee or between an independent contractor and the person for whom such contractor provides services. see i.r.c. § 7872(c)(1)(b) (2009). it also applies to a below-market loan between a “partnership and a partner . . . acting other than in his capacity as a member of the partnership.” prop. treas. reg. § 1.7872-4(c)(1), 50 fed. reg. 33553, 33560 (aug. 20, 1985). see also prop. treas. reg. § 1.7872-4(e), 50 fed. reg. 33553, 33561 (aug. 20, 1985) (tax-avoidance loan). 127. if applicable, the investment interest limitation under § 163(d) could limit gp’s ability to obtain an ordinary income deduction for the deemed payment of interest. see i.r.c. § 163(d) (2009). see also i.r.c. § 163(d)(4)(b)(iii) (2009) (affording election that effectively permits the deduction for investment interest to offset only gain taxed at the 15% rate). if gp is treated as using the deemed loan principal in a trade or business or has sufficient “net investment income” from other sources, the § 163(d) limit is not binding. see sanchirico, supra note 5, at 1141 n.181. 128. of course, an explicit loan from lp to gp might expose implicit subsidies embedded in the opaque distribution rules when a profits interest is used. see supra notes 57–61 and accompanying text. 129. under current law, gp is likely not treated as having constructively received amounts that are merely credited to his capital account, unless gp has a right to withdraw such amounts immediately. see, e.g., rev. rul. 60-31, 1960-1 c.b. 174. but see i.r.c. § 707(c) (2009) (potentially accelerating the timing of gp’s inclusion). 2010] the sou�d a�d fury of carried i�terest reform 33 risk of forfeiture.130 indeed, gp could obtain the same deferral benefit if he received a restricted capital interest, since the partnership’s investment return prior to vesting of gp’s interest would be taxed entirely to lp. in this light, it is strange that congress should enact a complex statutory fix while allowing the parties freely to opt out of § 710 to minimize their jointtax liability when lp is tax-exempt. by focusing narrowly on gp’s one-sided deferral and conversion, reformers failed to consider the ready availability of deferral through alternative compensation arrangements such as options and restricted capital interests. although § 710 could conceivably be viewed as an antideferral provision, this view does not make sense if alternative compensation arrangements permit yield exemption and even longer deferral than profits interests. as a practical matter, the parties should opt in or out of § 710 depending on whether that provision minimizes taxes by comparison to alternative compensation forms. to understand the joint-tax incentives under § 710, it is essential to understand the operation of the earned capital exception when implicit salary is reinvested in the enterprise and distributions are deferred. iii. earned capital—the bifurcation approach unlike the manager of a private equity fund, service partners in traditional partnerships typically receive cash distributions only after the investor partners’ capital has been repaid. when a service partner receives implicit salary and leaves the previously taxed salary in the partnership, the service partner’s share of partnership capital will increase each year. indeed, the full complexity and unadministrability of § 710 only becomes apparent once one examines the partnership tax bar’s technical solution to the problem of earned capital that congress initially overlooked. under this bifurcation approach, a single profits stream would be divided annually into separate components consisting of labor return and investment return on reinvested implicit salary. the partnership tax bar has devised a truly ingenious and wonderfully complex solution that purports to disentangle the separate components of a service provider’s return: a service provider would be taxed on a constantly shifting mix of ordinary income from labor and capital gain from labor converted into earned capital. unfortunately, the existing capital account system is wholly inadequate to prevent 130. see sanchirico, supra note 5, at 1131–33 (discussing deferral alternatives); id. at 1133 (suggesting the strictures of § 409a are “orthogonal” to the carried interest debate because they are only intended to affect “attempts to end run the requirement [that the] promise of future payment remain subject to creditors’ claims”). 34 columbia jour�al of tax law [vol. 1:1 understatement of compensatory return (and overstatement of investment return), and the government lacks resources to police self-serving misvaluations. the preferable approach, assuming § 710 is enacted, would be to treat a service partner’s entire profits share as ordinary income. a. earned capital section 710 rests on an elaborate fiction: gp is deemed to own qualified capital before gp actually earns such capital under the terms of the partners’ economic arrangement. if gp’s right to carry is contingent on attainment of a performance goal, profits allocations to gp cannot have substantial economic effect under the § 704(b) regulations governing allocation of items of income and loss among partners.131 the reason why such allocations cannot have substantial economic effect is quite simple: if the service partner forfeits his interest, he will never bear the burden or receive the benefit of the income and loss allocated to him. nevertheless, § 710 treats each allocation of profits to gp as a closed transaction with respect to a portion of gp’s profits interest.132 under this closed transaction approach, gp is treated as owning an increasing share of partnership capital from reinvested earnings even though gp may ultimately forfeit such capital. when gp is taxed on implicit salary and leaves the salary in the firm, § 710 treats the arrangement as a cash salary reinvestment plan, analogous to a deferred compensation arrangement in which an employee invests through an employer.133 surprisingly, § 710 did not originally include any exception for earned capital. quite correctly, the partnership tax bar criticized this omission as inconsistent with distributive-share treatment under the normal rules of subchapter k. in response to the bar’s comments, the current bill expands the definition of qualified capital to include earned capital attributable to retained earnings, thereby increasing the complexity of the partnership rules which are “already formidably complex.”134 crediting gp 131. see treas. reg. § 1.704-1(b)(2) (as amended in 2008). under the 2005 proposed regulations, special allocations to a service partner while his interest remains subject to forfeiture may be deemed to have economic effect if the partners agree to elaborate “forfeiture allocations.” prop. treas. reg. § 1.704-1(b)(4)(xii), 70 fed. reg. 29675, 29681 (may 24, 2005). 132. by contrast, a dividend on unvested stock (absent a § 83(b) election) is treated as compensation income. see treas. reg. § 1.83-1(a)(1) (as amended in 2003). 133. see sanchirico, supra note 5, at 1141 (referring to cash salary reinvestment plan); gergen, supra note 12, at 140 (referring to a “‘compensation reinvestment plan’ akin to a dividend reinvestment plan”). 134. nysba report, supra note 11, at 19; id. at 21 (arguing that the former definition of invested capital was “far too restrictive” and would “grossly overstate” the ordinary 2010] the sou�d a�d fury of carried i�terest reform 35 with earned capital attributable to reinvested salary is a logical corollary of § 710's hybrid approach. in the partnership tax bar’s view, treating gp’s reinvested salary as earned capital simply avoids the need for a taxprompted distribution followed by a contribution of the distributed amount. this rationale may not be quite right, however, since gp’s earned capital would not necessarily be burdened with the cost of the carried interest itself.135 rather, the bifurcation approach disaggregates gp’s return without having any affect on the other partners. this peculiar approach is a byproduct of the decision to leave lp’s treatment unchanged under § 710. because gp is entitled to an investment return on reinvested salary, the earned capital exception is central to the operation of § 710. in effect, § 710 subdivides gp’s profits share into separate streams of income and taxes less than gp’s entire profits allocation as ordinary income. the disaggregation (or carve out) approach has no counterpart under existing subchapter k: gp’s entire profits share is reduced by the carved out investment return on previously-taxed salary, and only the reduced profits share is taxed as ordinary income. consistent with the fundamental tradeoff that leaves lp’s treatment unchanged, disaggregation affects only the character of gp’s overall return (not the actual dollars received by gp). section 710 decomposes gp’s profits share into two streams of income, consisting of ordinary income (sourced to gp’s profits interest) and an investment return (sourced to reinvested salary).136 over time, a portion of p’s investment return is shifted from lp to gp, as gp acquires an increased proportional interest in partnership capital attributable to retained earnings. b. cash salary reinvestment plan taxing the compensatory and investment components of a service income element of a service partner’s interest). the earned capital exception can be viewed as simply an extension of the broader problem of determining proportionality when a service partner acquires both a capital interest and a disproportionate profits interest. 135. see harvey & sowell, supra note 118, at 9 n. 20. if gp actually “purchased” an additional capital interest in p by reinvesting salary, the consequences would be as follows: (1) lp would be entitled to 80% of p’s entire investment less x% attributable to gp’s newlyacquired interest, (2) gp’s x% of the investment return would be stacked on top of gp’s undiminished profits share and (3) gp would be treated as paying salary to himself. clearly, the parties do not intend this result. 136. unless gp is treated as having two separate partnership interests, the concept of earned capital makes little sense. nevertheless, prop. § 710 retains the concept of a unitary partnership basis. see joel scharfstein, proposed carried interest legislation: the interaction of invested capital and book-ups, 87 taxes 151, 153 (2009) (proposing an approach under which a service partner would be treated as having “two interests, a pure invested capital interest and a pure noninvested capital interest”). 36 columbia jour�al of tax law [vol. 1:1 partner’s return may be viewed as posing familiar problems of deferred compensation when an employee invests deferred salary through an employer. if gp actually received cash compensation (rather than carry) and reinvested the cash compensation in the partnership, gp would be entitled to an investment return taxed potentially as capital gain. as illustrated below, the imputed cash salary reinvestment plan is equivalent to (1) taxing gp on the discounted present value of gp’s implicit salary at ordinary income rates and (2) taxing gp (at gp’s rates) on investment gain (otherwise taxable to lp at a zero rate) that accrues on gp’s reinvested salary at the rate of return earned by p. since gp is taxed at a higher rate than tax-exempt lp, shifting investment income from lp to gp should, in theory, be tax disadvantageous. the extra tax burden should be equal to the capital gain tax (at gp’s rate) on the shifted investment income that would otherwise be taxed at lp’s zero rate. if § 710 actually increases the partners’ joint-tax liability, however, the partnership could potentially work around § 710 by substituting an option for a profits interests. if such substitution does not occur, one reason may be that § 710 would provide opportunities to understate the compensation component of gp’s return, saving taxes equal to the difference between the ordinary income tax rate (35%) and the capital gain rate (15%). stated differently, § 710 could reintroduce similar capital-gain conversion opportunities as under existing profits treatment. from the government’s perspective, § 710 may thus be less advantageous than taxing gp in the same manner as an option holder. deferring tax until exercise of an option is equivalent to taxing investment return at a zero rate but taxing gp’s implicit salary and the earnings on such implicit salary at ordinary income rates. leaving aside who is taxed on the investment return (lp or gp), option treatment does not permit capital-gain conversion because the total amount received on exercise is taxed at ordinary income rates. example (4)—coinvestment by gp and government. at the beginning of year 1, gp and lp form p, an investment partnership. gp receives a 20% interest in p’s profits (with a liquidation value of zero); lp contributes $100 and is entitled to the remaining 80% of p’s profits. p’s assets double in value each year, and p realizes gain of $100 in year 1, $200 in year 2, and $400 in year 3. all profits are retained until liquidation of p at the end of year 3. upon formation, lp owns all of p’s capital. on december 31, year 1, p pays implicit salary of $20 to gp (20% x $100 gain) taxed entirely as ordinary income. in each subsequent year, gp is allocated 20% of profits ($40 in year 2 and $80 in year 3). under the cash salary reinvestment plan, gp is credited with earned capital of $20 from gp’s share of year 1 profits; at the rate of appreciation of the 2010] the sou�d a�d fury of carried i�terest reform 37 partnership’s assets, gp’s earned capital of $20 would grow to $80 ($20 x 2 x 2) at the end of year 3. thus, gp’s share of year 2 profits is taxed partly as ordinary income ($20) and partly as capital gain ($20, i.e., the investment return on gp’s unwithdrawn salary from the prior year). gp’s share of year 3 profits is again taxed partly as ordinary income ($20) and partly as capital gain ($60, i.e., the investment return on gp’s unwithdrawn salary from both prior years).137 if the tax on gp’s salary is deferred, the result is that gp will eventually be taxed at ordinary income rates on the accumulated amount (both the original compensation and investment return) when withdrawn from the partnership. deferral of the tax means that gp and the government effectively become co-investors in p; as a co-investor, the government should be entitled to 35% of gp’s pretax investment in the partnership.138 at the end of year 1, gp contributes $13, and the government contributes $7 ($20 x 0.35) to p; together, they own $20 of p’s total capital of $200 (10%) and lp owns the remaining $180 (90%). since p’s assets double in value each year, gp earns an investment return of $39 ($13 in year 2 and $26 in year 3) on his invested capital of $13; and the government earns an investment return of $21 ($7 in year 2 and $14 in year 3) on its invested capital of $7.139 at the end of year 2, gp contributes an additional $13 and the government contributes an additional $7 (35% x $20) to p; together they own $60 of p’s total capital of $400 (15%), and lp owns the remaining $340 (85%).140 during year 3, gp earns an investment return of $13 and the government earns an investment return of $7 on the additional contributions. at the end of year 3, p pays 137. the $60 of investment return in year 3 can be viewed equivalently as gp’s 15% proportionate share based on relative capital accounts ($60/$400) of the partnership’s total profits ($400); alternatively, the $60 of investment return can be viewed as twice gp’s capital account balance at the end of year 2 ($60), since the partnership’s assets double in value each year. see infra note 142 and accompanying text. 138. see, e.g., david elkins & christopher h. hanna, taxation of supernormal returns, 62 tax law. 93, 95–97 (2009) (exploring the “partnership view” under a cash-flow consumption tax). 139. each partner’s invested capital and return on invested capital would be as follows: capital contribution (end yr 1) return on capital (yr 2 and yr 3) gp 13 13 + 26 gov 7 7 + 14 total 20 60 140. gp’s implicit year 2 salary of $20 is equal to gp’s entire year 2 profits share of $40 (20% x $200 profit) less the $20 imputed investment return for year 2 (10% x $200 profit). 38 columbia jour�al of tax law [vol. 1:1 implicit salary of $20 to gp and immediately liquidates.141 upon liquidation of p, gp and the government are entitled to the amounts in their respective capital accounts ($140 total, or 20% of $700 increase in p’s value) and lp receives the remainder ($660).142 now, it is possible to compare the results under the cash salary reinvestment plan and an economically equivalent option. if gp and the government are treated as co-investors, gp receives tax free the amount in his capital account ($91) and the government receives the amount in its capital account ($49). if gp instead held a european option and gp’s compensatory return were taxed on exercise, the after-tax consequences to gp and the government would be identical.143 the amount in the government’s capital account represents the future value of the deferred tax on the compensation component of gp’s return. the $49 of tax on gp’s salary does not yet reflect tax owed on gp’s investment return. the cumulative investment return to gp is $52 ($39 + $13) and the cumulative investment return to the government is $28 ($21 + $7). the tax on gp’s investment return is $7.80 ($52 x 0.15), i.e., $80 x 0.0975.144 the government’s investment return ($28) is not a tax; instead, it is merely the government’s return as a co-investor.145 the total investment return ($80) is the sum of the investment return on each co-investor’s capital account. 141. gp’s implicit year 3 salary of $20 is equal to gp’s entire year 3 profits share of $80 (20% x $400 profit) less the $60 imputed investment return for year 3 (15% x $400 profit). 142. the partners’ respective capital accounts are as follows: capital accounts gp gov gp/gov lp initial 0 0 0 100 end yr 1 13 7 20 180 end yr 2 39 21 60 340 end yr 3 91 49 140 660 143. on exercise of the option, gp would receive $140 (20% x $700 increase in p’s value) and would owe tax of $49 (35% x $140), leaving gp with $91 ($140 less $49 tax). 144. the tax of $7.80 on gp’s portion of the investment return is equal to the tax on the entire investment return ($80) times 0.0975, i.e., 0.15 x (1 – 0.35); it is assumed that the investment return is taxed entirely at the end of year 3. see walker, supra note 5, at 762–63 (proposing special surtax on the gain component of equity compensation payouts at the special rate of 9.75% to replicate the effect of taxation at the date of grant). proposed § 710 could be viewed as imposing “surrogate taxation” of the investment return attributable to gp’s reinvested implicit salary when lp is tax exempt. see daniel i. halperin, interest in disguise: taxing the time value of money, 95 yale l.j. 506, 523 (1986) (explaining substitute tax approach). yet, prop. § 710 applies whether or not lp is tax exempt. 145. see elkins & hanna, supra note 138, at 96. 2010] the sou�d a�d fury of carried i�terest reform 39 to summarize, the cash salary reinvestment plan divides gp’s return into two components: a compensatory component and an investment component. the investment component consists of the yield (at p’s rate of return) on gp’s reinvested salary. gp’s total compensatory return ($140) is taxed as ordinary income under both the cash reinvestment plan and option alternative. the only difference is that, under the cash salary reinvestment plan, the investment return on gp’s reinvested salary is taxed to gp (at capital gain rates), thereby curtailing the benefit of yield exemption. by opting out of § 710, however, gp can restore yield exemption if he receives an option rather than a profits interest. under the option alternative, all of the investment return is taxed at lp’s zero rate, leaving gp in the same position as an employee who defers compensation through a tax-exempt employer. the co-investment analogy illustrates that if § 710 operated according to its goals, it would tax gp on the discounted present value of his compensation income, while imputing an investment return (taxed as capital gain) on gp’s reinvested salary. in present-value terms, current and deferred taxation of the compensation component of gp’s return should be equivalent.146 since the tax is imposed on the augmented payout, deferring taxation of gp’s implicit salary does not necessarily leave the government worse off: the “loan” from the government is “repaid at an interest rate reflecting the taxpayer’s rate of return on investment.”147 under § 710, a portion of the investment return is shifted from lp to gp (and taxed at gp’s rate); as a result, the government collects a capital gain tax on the investment return on reinvested salary that it would otherwise forego if the parties had structured the transaction as a european option. the “extra” capital gain tax is simply the tax on the investment return on gp’s reinvested salary which would compound tax free if gp were permitted to invest through lp (gp’s tax-exempt employer).148 since this type of jointtax arbitrage occurs whenever compensation is deferred and the employer is tax exempt, however, it is not clear that § 710 is needed to address this 146. by analogy to a traditional ira, deferring the tax on gp’s salary and taxing the accumulated amount is equivalent to taxing the initial salary and exempting the investment return. see william d. andrews, a consumption-type or cash flow personal income tax, 87 harv. l. rev. 1113, 1126 (1974) (“[d]eferring the tax is the equivalent of imposing the tax initially, but exempting any subsequent profit due to continued investment of what is left after payment of the tax.”); walker, supra note 5, at 711. 147. halperin, supra note 144, at 532; id. at 533 (noting that the government “does not necessarily lose when it ‘lends’ by deferring inclusion of an employee’s income” if the private parties earn a higher rate of return). 148. see id. at 539–50 (suggesting that the tax advantages of nonqualified deferred compensation could be significantly curtailed by taxing currently—at the employee’s rates— the investment income earned on the deferred compensation). 40 columbia jour�al of tax law [vol. 1:1 problem.149 if one objects to gp’s ability to obtain ira-like yield exemption when lp is tax-exempt, then the problem is not necessarily cured by § 710 which merely encourages a shift from profits treatment to option treatment. once again, the problem of joint-tax arbitrage results not from a flaw in the treatment of profits interests but rather from gp’s ability to exploit lp’s tax-exempt status. if lp were taxable, option treatment would not result in any joint-tax advantage (or disadvantage) because investment return would be fully taxed. whether the investment return is taxed at lp’s rate or gp’s rate is a matter of indifference if both parties are same taxed, since someone must always be taxed on the investment return. example (4) ignores all of the problems of valuing p’s illiquid assets, the timing of gain accrual, the reasonableness of returns to qualified capital, and the passthrough of losses. as a partner, gp benefits from the ability to use losses that are worthless to lp. in addition, gp’s share of subsequent losses is treated as ordinary to the extent of prior ordinary income taxed to gp under § 710. once the passthrough of losses is taken into account, the parties’ joint-tax burden may be significantly less under § 710 than if gp held a european option. example (5)—loss passthrough. the facts are the same as in example (4), except that the operation of p is extended to include an additional year (year 4) in which p realizes a loss of $300, allocated $60 to gp and $240 to lp. overall, p realizes a net gain of $400 ($700 gain less $300 loss). if p liquidates at the end of year 4, gp earns carry of $80 (20% x $400 net gain). gp’s share of the capital loss is likely treated as an ordinary loss and allowed to the extent that such loss does not exceed the excess (if any) of “aggregate net income with respect to” gp’s service interest for all prior years over “the aggregate net loss with respect to such interest not disallowed [under § 710] for all prior partnership taxable years.”150 if the capital loss of $60 is treated as an ordinary loss that offsets gp’s ordinary income from all prior years ($60), gp is taxed on net capital gain of $80.151 given the lack of any mechanism for separating gp’s 149. in the corporate context, a taxable employer can effectively invest tax free on behalf of an employee by investing in its own securities and holding the stock for the employee’s benefit—rather than issuing the stock directly to the employee; the employer’s gain on its own stock is nontaxable under § 1032. see id. at 540. 150. see prop. § 710(a)(2)(a). 151. gp’s overall return is as follows: y1 yr2 yr3 yr4 oi 20 20 20 (60) cg 20 60 2010] the sou�d a�d fury of carried i�terest reform 41 service interest and gp’s qualified capital interest, it seems likely that gp is taxed on net capital gain of $80, since (ordinary) losses offset (ordinary) income.152 by contrast, if gp held a european option, gp would recognize $80 of ordinary income (20% of $400 net increase in p’s value) at the end of year 4. since gp performs the identical services, gp should be taxed equivalently in both situations; otherwise, lp and gp derive a joint-tax benefit from structuring the transaction formally as a profits interest rather than a european option. if p is sufficiently profitable on a net basis, gp will eventually receive compensation measured by the amount of p’s total profits (not a reduced percentage of p’s profits augmented by an imputed investment return on gp’s reinvested salary). despite the carefullycontrived optics, the capital credited to gp can be viewed as remaining lp’s capital on which lp is entitled to an investment return. if the transaction were held open, gp’s entire share of profits would be taxed as ordinary income (not as a mix of ordinary income and capital gain).153 even if some portion of gp’s return is from earned capital, the “best compromise” may be to treat gp’s entire profits interest as ordinary income.154 alternatively, if gp were willing to forego current allocation of losses, gp’s profits share could be structured as a european option (or vesting capital interest). c. shortcomings of capital accounts when previously taxed implicit salary is reinvested in the partnership, a mechanism is needed to track the separate labor and capital components of the service provider’s future return. some reformers have suggested that the capital account system would permit tracking of a service partner’s compensatory and investment return over the life of the 152. if the loss of $60 is instead treated as incurred “with respect to” gp’s qualified capital interest, it would offset an equivalent amount of capital gain (rather than $60 of ordinary income), leaving gp with ordinary income of $60 and capital gain of $20 overall. cf. scharfstein, supra note 136, at 154 (suggesting that gp should lose the ability to claim an ordinary loss if gp’s retained earnings are treated as invested capital). 153. gp would be treated essentially as annually exercising a stock appreciation right (sar) as profits are allocated. see senate hearings, supra note 1 (statement of charles i. kingson, july 31, 2007) (analogizing profits interest to a series of sars). 154. see weisbach, supra note 14, at 755 n.91 (noting that, even if a portion of gp’s return “is capital income in the sense that it represents returns that are left in the business rather than taken out each year as salary,” the “best compromise [may be] to treat it all as labor income exactly as we do in the case of restricted stock or nonqualified options”). 42 columbia jour�al of tax law [vol. 1:1 partnership.155 the obvious difficulty, however, is that the elaborate capital account system was never intended to serve this function. instead, it is intended merely to police allocations among partners that seek to minimize joint taxes. since partnerships are not required to maintain capital accounts in accordance with the elaborate rules of § 704(b), many (perhaps most) do not. the “intellectual revolution” built around capital-account analysis remains highly imperfect and it would require a tremendous infusion of government resources to ensure even minimally adequate compliance.156 as the experience with the § 704(b) regulations amply demonstrates, the ability of sophisticated planners to abuse even wellcrafted rules should not be underestimated. the capital account rules are not designed to police valuation abuses that § 710 would invite.157 jointly, lp and gp will often have a common incentive to overstate the capital component (and understate the compensation component) of gp’s return. it is well understood, under current law, that “[a]sset valuation is the achilles heel of the system of capital accounts analysis.”158 without adversity of interests, it is impossible to police self-serving valuations intended to understate or overstate asset values. the partnership tax bar has suggested that future regulations should permit bookups (or bookdowns) of invested capital, expanding opportunities for misvaluation; requiring mandatory gain recognition on a revaluation to “temper the incentive to revalue” does not seem a practicable response to this problem.159 in assessing the merits of the § 710 approach, one should focus on the existing passthrough system, which bears little resemblance to the ideal 155. see senate hearings, supra note 1 (statement of mark p. gergen, july 11, 2007). 156. see lawrence lokken, as the world of partnership taxation turns, 56 smu l. rev. 365, 369 (2003) (suggesting that the “intellectual revolution [in capital account analysis] will not become a revolution in the practical reality of partnership taxation”); cf. mark p. gergen, the end of the revolution in partnership tax?, 56 smu l. rev. 343 (2003). 157. to address the problem of special allocations, a recent ali project considered but rejected the notion of reforming capital accounts to take into account time value of money concerns and proper adjustments for risk. see generally george k. yin & david j. shakow, american law institute, federal income taxation project, taxation of private business enterprises: reporters’ study (1999). 158. gergen, supra note 156, at 362. by rendering subchapter k even more complex and opaque, prop. § 710 may undermine the prospects of more thoroughgoing reform while exacerbating the need for such reform. 159. gergen, supra note 12, at 146 (suggesting immediate gain recognition on a revaluation as a “simple way to temper the incentive to revalue”); cf. nysba report, supra note 11, at 5 (inviting future regulatory guidance concerning “adjustment[s] to existing invested capital to reflect any unrealized gain or loss related to such invested capital” on a subsequent contribution or distribution). the current rules explicitly permit a revaluation of partnership property only when the parties can realistically be expected to have “sufficiently adverse interests.” see treas. reg. § 1.704-1(b)(2)(iv)(h) (as amended in 2008). 2010] the sou�d a�d fury of carried i�terest reform 43 envisioned by some reformers. within the current system of flexible allocations backstopped by an array of anti-abuse rules, imputing a reasonable return on reinvested salary based on capital account balances may merely mask the fundamentally insoluble problem of separating returns to labor and investment.160 without a baseline of proportionate allocations, it is impossible to tell whether an allocation is disproportionate.161 special allocations are permitted based on the notion that partners should be free to allocate items among themselves in a manner that matches the flexibility of their business arrangement. the underlying presumption is that such flexibility is tolerable because the partners are likely to have adverse interests. the notion of offsetting benefits and detriments—the justification for allowing flexible allocations under subchapter k—is the antithesis of the § 710 approach which alters only the tax consequences to service partners. congress has barely begun to consider the myriad challenges of integrating § 710 with the already excessively intricate provisions of partnership tax. for example, congress would need to coordinate § 710 with the collapsible partnership rules of § 751 governing sales of interests and disproportionate distributions.162 when a service partner’s interest is sold, it would be necessary to bifurcate the amount realized between the ordinary-income and capital-gain components even though gain at the partnership level consists solely of capital gain.163 except on sale of an interest, congress seems quite oblivious to the potential shifting of ordinary income and capital gain with respect to the service partner’s interest.164 while § 710 refers expressly to § 751(a) governing sales of partnership interests, it ignores § 751(b), the companion provision governing 160. see david a. weisbach, professor says carried interest legislation is misguided, 116 tax notes 505, 510 (2007) (“the levin bill simply glosses over [the] central problem, hiding its complexities behind a rule that allocations must be reasonable.”). 161. see weisbach, supra note 14, at 756 (“there is no way to draft laws or regulations that identify any potential service component to the capital allocation.”); id. (noting that challenges by the service would be expensive and time-consuming, with the service having “little chance of winning except in egregious cases”); see also rosenzweig, supra note 23, at 729 (discounting the possibility that “adding the additional complexities of the partnership accounting rules into the mix will lead to a more rational or implementable solution” to the problem of blended returns to labor and capital). 162. see i.r.c. § 751(a) (2009) (sales), § 751(b) (2009) (disproportionate distributions). a disposition of a service partner’s interest would trigger recognition of ordinary income notwithstanding otherwise applicable provisions. see prop. § 710(b)(1). 163. see gergen, supra note 12, at 146 (“it is not clear how a [service partner’s] overall book gain should be spread across a mix of gain and loss assets. and so on.”). 164. there would clearly be an incentive to specially allocate ordinary income (or shortterm capital gain) to the service partner’s carried interest. see aba comments, supra note 11, at 21; see also nysba report, supra note 11, at 59 n.151. 44 columbia jour�al of tax law [vol. 1:1 distributions of partnership property.165 since 1954, a central tenet of subchapter k has been the need to prevent shifting of capital gain and ordinary income among partners.166 there is no justification for allowing such shifting within the return of a single partner (gp), often with no detriment to the other partners. indeed, § 710 would likely provide an opportunity for partnership tax bar to demand repeal of § 751(b). conclusion in response to the partnership tax bar’s recommendations, the current version of carried interest legislation would expand the concept of qualified capital and revise § 83 to entrench an unwarranted valuation subsidy for partnership profits interest. the underlying notion is that § 710 is a substitute for the generally applicable rules of § 83 governing transfers of property for services. by contrast, this article suggests that § 710 will often understate the compensation component of a service provider’s return by taxing less than all of a profits interest as ordinary income and providing an incentive to the parties to overstate the capital component attributable to earned capital. by amending § 83 to codify a pro-taxpayer valuation rule for profits interests (zero value), the carried interest legislation affords separate but not equal treatment of partnership deferred equity compensation.167 even though academic commentators have sought to clarify the joint-tax benefits of carried interest arrangements, the current legislation pursues a solution premised narrowly on the one-sided advantage to gp. the pragmatic argument in favor of § 710 is that taxing at least some portion of gp’s compensation as ordinary income represents an adequate tradeoff for preserving the current favorable treatment of lps.168 the 165. this omission is perhaps not surprising since reformers conspicuously failed to mention § 751(b). see, e.g., senate hearings, supra note 1 (statement of mark p. gergen, july 11, 2007) (referring only to § 751(a)). cf. prop. § 710(b)(4) (distributions of appreciated property “with respect to” a service partner’s interest). 166. while conceding the need for § 751(a), the partnership tax bar generally views § 751(b) as too complex and ripe for repeal. see generally karen c. burke, origins and evolution of § 751(b), 60 tax law. 247 (2007) (discussing 1954 reform and professor william d. andrews’ more recent proposals). 167. while prop. § 710 is more favorable to service providers than mckee’s 1977 proposal, the latter predated the capital account regime of which mckee was the architect. see supra notes 108–11 and accompanying text; see also abrams, supra note 2, at 197 (“[m]any have come before, with essentially the same arguments leading to the same proposed solutions.”). 168. if one considers hedge funds, the “tradeoff” may be more apparent than real. since gp’s profits (as hedge fund manager) consist mostly of short-term capital gain (already 2010] the sou�d a�d fury of carried i�terest reform 45 recharacterization approach is neither simple nor straightforward: it will often yield illogical results and inevitably collide with other provisions of subchapter k. having helped to identify important defects in the current proposal, the partnership tax bar seems increasingly reconciled to § 710's recharacterization approach should reform go forward. nevertheless, a “workable” solution from the bar’s perspective may be quite different from a coherent or administrable reform. indeed, the current proposal’s unintended effects, electivity, and lack of transparency illustrate why it is essential to consider tradeoffs and implementation from a joint-tax perspective.169 while one commentator has dismissed the proposed reform as “a bad idea badly executed” that deserves to fail, the dynamics of carried interest legislation are considerably more complex.170 having confidently identified the underlying problem as one-sided conversion and deferral, well-intentioned reformers suggested the purportedly simple solution of recharacterizing a service partner’s share of partnership income. unable to craft workable rules implementing this simple solution, congress turned to the partnership tax bar which recommended changes that would complicate yet further the existing partnership rules, without adequately addressing potential joint-tax arbitrage. indeed, under the administration’s budget proposal, the carried interest legislation could potentially affect service partners in all partnerships, inflicting considerable damage on routine business arrangements that pose little or no potential for abuse. rather than enact complex legislation of uncertain scope, congress should consider delegating authority to treasury under existing provisions to address capital-gain conversion and limit advantageous trading of tax characteristics. taxed essentially like ordinary income), prop. § 710 would affect mainly the character of gain (ordinary or capital) on sale of a hedge fund manager’s interest. cf. kingson, carried interests: an outdated term?, supra note 70, at 127 (current case law refutes the claim that sale of “contracts to manage [a] hedge fund” results in capital gain). 169. from a “global” perspective, it is important to consider the government’s limited resources to enforce any solution without diverting attention from other partnership abuses. see walker, supra note 5, at 699 n.10 (adopting the term “global” to describe the employeremployee joint-tax perspective and specifically referring to “the third actor in this play, the treasury”). 170. abrams, supra note 2, at 227. quantifying the personal income tax benefits of backdating: a canada – us comparison ryan a. compton  christopher c. nicholls  daniel sandler  lindsay m. tedds  abstract this paper contrasts the post-tax returns of backdated at-the-money options to currently-dated in-the-money options (with the same strike price as the backdated options) and demonstrates that a canadian executive can earn a significantly larger after-tax return from backdated options compared to a us executive. we tie this to the favorable canadian tax treatment of executive options relative to their treatment in the united states. the comparison suggests that the personal tax regime may have been one of the factors which impacted the desire to receive backdated options in lieu of other forms of compensation in canada but not so in the united states.  associate professor, department of economics, university of manitoba, winnipeg, manitoba, canada. compton@cc.umanitoba.ca  stephen dattels chair in corporate finance law, faculty of law, western university, london, ontario, canada. cnichol8@uwo.ca  professor, faculty of law, western university, london, ontario, canada, and senior research fellow of the tax law and policy research institute, monash university, melbourne, australia. dsandler@uwo.ca  assistant professor, school of public administration, university of victoria, victoria, british columbia, canada. ltedds@uvic.ca the authors would like to thank participants of the deloitte centre for tax education and research, tax policy research symposium, tax expenditures and public policy in comparative perspective, and shadow economy, tax evasion, and social norms for helpful comments. the authors would also like to gratefully acknowledge the financial support from the social sciences and humanities research council (standard research grant #410-2009-1955) and the research support of chris hannesson. 2012] quantifying the tax benefits of backdating 145 i. introduction .................................................................................................... 146 ii. tax policy and the demand for backdated options ................. 150 a. canadian personal income tax rules for executive stock options ................. 151 b. us tax rules for executive stock options ....................................................... 152 c. tax regime and backdated options .................................................................. 157 iii. quantifying the benefits of backdating: examples ................. 158 a. example 1—exercise and sale on same date................................................... 159 b. example 2—vest over five years, sale on same date as exercise ................ 162 c. example 3—vest over five years, sale in same year as exercise ................. 162 d. example 4—vest over five years; sale more than one year after exercise 164 iv. conclusion ........................................................................................................ 171 appendix ..................................................................................................................... 173 146 columbia journal of tax law [vol.3:144 i. introduction the practice of backdating executive stock options has received significant attention in the u.s. financial 1 and legal 2 literature, and has recently begun to be discussed in the canadian legal literature. 3 backdating, in its most basic form, is the use of hindsight to selectively pick a local low point in a stock’s trading price and issue executive stock options stipulating the selected date as the grant date when, in fact, the options are granted at a later date. because the backdated options’ strike price is lower than the market price on the actual grant date, the recipient has received something of greater monetary value (even if the options have not yet vested) than a correctly dated atthe-money option. 4 companies could reward executives with cash compensation or additional properly dated and priced incentive awards, including options, rather than engage in dubious backdating practices. 5 it is clear that there must be reasons other than greed that have led so many to backdate executive options. 6 academics, regulators, and 1 see generally randall a. heron & erik lie, what fraction of stock option grants to top executives have been backdated or manipulated?, 55 mgmt. sci. 513 (2009) (estimating “that 13.6% of all option grants to top executives during the period 1996-2005 were backdated or otherwise manipulated.”); erik lie, on the timing of ceo stock option awards, 51 mgmt. sci. 802 (2005) (discussing how corporate executives are becoming more adroit at timing stock option awards to their advantage); m. p. narayanan & h. nejat seyhun, the dating game: do managers designate option grant dates to increase their compensation?, 21 rev. fin. stud. 1907 (2008) (discussing the phenomenon of managers backdating or forward-dating stock options to maximize profitability depending on whether the stock price is rising or falling). 2 see generally m. p. narayanan, cindy a. schipani & h. nejat seyhun, the economic impact of backdating of executive stock options, 105 mich. l. rev. 1597 (2007) (discussing the value loss to shareholders of companies involved in backdating); david i. walker, unpacking backdating: economic analysis and observations on the stock option scandal, 87 b.c. l. rev. 561 (2007) (discussing the economics of backdating and the attributes of companies under investigation). 3 see generally ryan a. compton, daniel sandler & lindsay m. tedds, options backdating: a canadian perspective, 47 can. bus. l. j. 363 (2009) (analyzing the practice and prevalence of backdating in canada and the legal, tax, and policy implications of the practice). 4 the terms at-the-money, out-of-the-money, in-the-money, and not-in-the-money refer to when the exercise price of the option equals, exceeds, is below, and is at or above the market price of the underlying stock. 5 see compton et al., supra note 3, at 370-71 (discussing backdating in the u.s. and canada in detail). in summary, backdating is permitted in the u.s. if no documents are falsified, shareholders are duly notified, the company’s earnings and tax statements properly account for the backdating, and since 2004, both the individual and the company adhere to i.r.c. § 409a. see i.r.c. § 409a (2006). in reality, these conditions have seldom been met. in canada, companies listed on the toronto stock exchange (tsx) may not backdate at all, as the exchange requires all option awards of listed companies to be granted not-in-themoney. see infra note 9. companies listed on the tsx venture exchange (tsx-v) may grant in-the-money options but may not backdate under any conditions. 6 similarly, the manipulation of stock options in the past may today encourage the use of a different incentive award, such as a restricted stock unit. a restricted stock unit is an unsecured promise to grant a set number of shares according to a vesting schedule, but only if forfeiture requirements, such as termination of employment or failing to meet performance goals, have not been triggered. see mark p. cussen, how restricted stock and rsus are taxed, investopedia (feb. 10, 2012, 1:48 pm), http://www.investopedia.com/articles/tax/09/restricted-stock-tax.asp (providing a more expansive definition). more research is required to identify whether other forms of incentive-based awards are indeed being manipulated. in addition, other pricing behavior may have supplanted backdating. for instance, betty wu finds that the incidence of option repricing has increased in the united states and that repricing seems to be associated with advantageous and temporary changes in a company’s stock price. betty wu, is ceo stock option backdating or otherwise manipulation another form of option repricing?, 12 (social science 2012] quantifying the tax benefits of backdating 147 practitioners alike have tried to gain a better understanding of these incentives and the roles they have played in the backdating scandal; however, there is as of yet no consensus regarding the causes of backdating. 7 this is problematic because policy, legislative, or regulatory changes are unlikely to be effective if the root causes are unknown. untangling the causes of backdating will remain elusive unless each factor is considered in detail using evidence from different regimes. the first step in untangling the causes of backdating 8 is to acknowledge that the backdating phenomenon must be driven by both supply and demand factors. from the supply side, the question is what motivates a firm to grant a backdated option, and from the demand side, what motivates an executive to demand (or, at the very least, accept) a backdated option? both sets of motivations arise from the quantitative and qualitative benefits, costs, and risks of issuing and receiving backdated options. most of the research to date has focused on supply side factors (e.g., accounting treatment, securities regulations, and corporate taxation), 9 while there has been little discussion of demand research network, working paper, 2012). based on this evidence, wu postulates that option repricing may have replaced backdating at some firms. see id. at 23. 7 in addition, there is a paucity of empirical evidence about the incidence of backdating by canadian firms. see infra note 21. 8 some observers, including the sec, have concluded that backdating is a thing of the past due to increased corporate governance, higher perceived enforcement, and tightened reporting requirements. however, this conclusion appears to be premature since there is evidence which shows that backdating, while restricted, is still ongoing. in her empirical study, wu demonstrates that option backdating is not associated with weak corporate governance, thereby questioning the influence of corporate governance provisions in the sarbanes-oxley act of 2002 (“sox”) on backdating activities. wu, supra note 6, at 5-6. other scholars question the effectiveness of enforcement in curbing backdating since only about 140 companies in the united states are under federal investigation, yet empirical research indicates that the number of companies that have backdated options are in the thousands. see james bickley & gary shorter, stock options: the backdating issues, tax notes today, march 23, 2007, lexis 2007 tnt 57-17, at 16. in addition, edelson and whisenant review a sample of companies and suggest that, based on this sample, over 500 companies engaging in stock option award practices consistent with backdating remain undetected. rick edelson & scott whisenant, a study of companies with abnormally favourable patterns of executive stock option grant timing 20 (social science research network, working paper, 2009). see infra note 65 for further discussion of enforcement. in the united states, the sec reporting regulations were changed in 2002 to reduce the reporting period for stock option grants to two days. sarbanes oxley act of 2002, pub. l. no. 107-204, 116 stat. 745, § 403, 788-89. heron and lie show that with the introduction of this new two-day reporting period, the return pattern associated with backdating is much weaker. randall a. heron & erik lie, does backdating explain the stock price pattern around executive stock option grants? 83 j. fin. econ. 271, 273 (2007). in a later study, heron and lie show the percentage of unscheduled grants backdated or manipulated fell dramatically following the introduction of the two-day rule. heron & lie, supra note 1, at 514. both studies note, however, that late filings continue to show a strong return pattern consistent with backdating, leading these authors to conclude that the efficacy of reporting requirements requires not only that grant award disclosures be filed on time but be filed at all. heron & lie, supra note 8, at 294; heron & lie, supra note 1, at 524. despite simplified filing regimes, lax enforcement of the filing rules translates into a not insignificant number of insider reports being filed late or not at all. see bickley & shorter supra, at 16; lara e. muller, stock option backdating: is the government’s response enough to eliminate the problem or is it still a work in progress? 51 santa clara l. rev. 331, 349-50 (2011). 9 on the supply side, a frequently cited driver of both the use of stock options in compensation packages and backdating in the united states is the corporate tax treatment of non-qualified stock options (“nsos”), which permits corporations to deduct nsos for tax purposes. while on the surface this argument has some merit, particularly when considered within the framework of tax shelters (which, according to michael graetz, “are deals done by very smart people that, absent tax considerations, would be very stupid”), recent evidence suggests that the corporate tax treatment of nsos was likely not a cause of backdating since options in general, and backdated options specifically, tend to be granted by companies with low profitability and little evidence of tax sheltering behavior. michael j. graetz, tax reform unraveling, 21 j. econ. persp. 148 columbia journal of tax law [vol.3:144 side factors. while understanding the propensity to backdate undoubtedly requires insight on the supply side factors to backdating (as it is the firms that ultimately grant executive stock options), without demand there would be no supply. therefore understanding the drivers that influence demand is critical to understanding the whole story behind backdating of executive stock options. the question of demand requires consideration of what an executive receives in monetary value from a backdated option (i.e., an option that appears to be an at-themoney option with an earlier grant date but is, in fact, in-the-money on the actual grant date) compared to a currently dated at-the-money option. there are two different points in time at which this value can be considered. the first point in time is the grant date. at that time, the black-scholes option pricing model 10 (or a variant of this model) could be used to estimate the monetary value that an executive actually receives when granted a backdated stock option. 11 however, regardless of the black-scholes value of a backdated option (relative to an at-the-money option) at the time of receipt, what is ultimately of interest for executives is the benefit that backdating provides in monetary value, assuming they eventually exercise the options. we therefore focus on the value at exercise (and eventual sale of the shares) and demonstrate the role the income tax regime plays in determining the after-tax value to the executive. this article considers in detail the potential role of personal income taxation in influencing demand for backdated options in canada relative to the united states. considering the role of the personal income tax treatment of executive options is important because taxes may influence the demand by executives for backdated options by altering the options’ after-tax monetary value. 12 in limiting the scope of this article in this way, we are not suggesting that taxation is the single most important factor in determining demand or that supply factors are not important. instead, we are simply 69, 83 (2007); see also jeri seidman & bridget stomberg, stock-based compensation and tax sheltering: are they negatively related due to incentives of tax benefits? 4 (mccombs research paper series, working paper no. acc 03-11, 2011). other supply factors also affect the ability of a corporation to grant in-the-money options that have the same before-tax value as backdated at-the-money options. for example, a company listed on the tsx cannot grant discounted stock options. toronto stock exchange group inc., tsx company manual § 613 (2007). in contrast, u.s. stock exchanges permit in-the-money stock options provided that they are properly disclosed to shareholders, documents have not been falsified, and the options are reflected as such in the company’s statement of earnings. see compton et al., supra note 3, at 370 (discussing the differences between u.s. and canadian stock exchange requirements, as well as relevant supply side factors that help explain the phenomenon in each country). 10 fischer black & myron scholes, the pricing of options and corporate liabilities, 81 j. pol. econ. 637, 637-52 (1973). the black-scholes model is a generally accepted, albeit limited, method for calculating the theoretical value of an employee stock option. the basic intent of the model is to calculate the probability that an option will mature in-the-money (i.e., the value of the stock option today is the sum of all the probability-weighted payoffs at maturity, assuming that the asset returns follow a log normal distribution so that the sum of all the option payoffs at maturity multiplied by the probability of the occurrence of those payoffs is the value of the option today, ignoring discounting) by considering six variables: grant date; exercise price; option maturity; risk-free rate of interest for the option period; share’s price volatility; and (if applicable) dividend yield. see id. the drawback of the black-scholes model is that it is based on the assumption that options can only be exercised at maturity (known as european-style options) and that the options are transferable. other shortcomings include the fact that the interest rate and volatility are constrained as constants in the model and that the underlying stock is assumed to move according to a random walk. 11 see walker, supra note 2, at 581-82. 12 see infra appendix i (discussing a simple algebraic representation of the role that discounting and taxes play in determining the value of a stock option). 2012] quantifying the tax benefits of backdating 149 advocating that a thorough explanation of the causes of backdating necessitates in-depth consideration of each relevant factor in turn and its potential contribution to backdating. 13 we appreciate that income tax treatment is one piece of a larger puzzle that constitutes demand for backdated options by executives. another piece is the insider reporting obligations imposed upon some executives by securities regulations. 14 given a lenient disclosure regime for reporting the grant and exercise of stock options, 15 as some have argued currently exists in canada, 16 backdating could easily go undetected. greed is often cited as the motive for backdated options. 17 however, while greed could account for a desire for higher compensation, it cannot account for the form that such compensation takes. as executives could lawfully be paid equivalent amounts in cash (or properly dated options), it does not seem likely that greed is, at least by itself, a primary motivator for backdating. a better motivator may be the fact that backdated options are a form of what bebchuk and fried have called “stealth compensation.” 18 other considerations may affect backdating behavior, such as penalties and concomitant costs if the backdating is caught, 19 including penalties arising from income tax reassessments and actions by securities regulators, as well as attorneys’ fees, loss of employment, and potential loss of reputation. 20 in order to assess the role of personal income taxation in backdating stock options, this study provides a comparative analysis of the personal income tax regime for executive stock options in canada and the u.s. 21 it is important to understand the 13 some argue that a multilateral approach is more appropriate when examining issues surrounding stock option backdating. see, e.g., amin mawani, cancellation of executive stock options: tax and accounting income considerations, 20 contemp. acct. res. 495, 499-500 (2003). but in order to be able to determine which factors need to be incorporated into the multilateral approach, a detailed unilateral approach is required. this is a common approach in the literature not only in this topic area, but most topic areas. that is, we take the approach of examining the role that personal income tax policy plays in determining the monetary value of a backdated stock option, ceteris paribus. 14 see bickley & shorter, supra note 8, at 11; compton et al., supra note 8, at 474. 15 see compton et al., supra note 8, at 489. 16 id. 17 the former chair of the sec, arthur levitt, has stated that backdating “represents the ultimate in greed.” charles forelle & james bandler, five more companies show questionable options pattern, wall st. j., may 22, 2006; see also geoffrey manne & joshua d. wright, backdating options and why executive compensation is not all about norms, 2 corp. governance l. rev. 385, 392 (2006); kristina minnick & mengxin zhao, backdating and director incentives: money or reputation?, 32 j. fin. res. 449, 450-51 (2009). 18 see lucian a. bebchuk & jesse m. fried, executive compensation as an agency problem, 17 j. econ. persp. 71, 79 (2003) (defining stealth compensation as the practice of blurring or even concealing the total amount of compensation). 19 see compton, supra note 3, at 383-86. 20 nevertheless, some studies have found little evidence of reputational penalties resulting from backdating scandals. see yonca ertimur et al., reputation penalties for poor monitoring of executive pay: evidence from option backdating, 104 j. fin. econ. 118, 119 (2012). 21 the existing backdating literature focuses almost exclusively on the u.s. see compton, supra note 3, at 391. we argue that a more complete understanding of the causes of backdating requires research that looks beyond the u.s. we believe that contrasting canadian and u.s. regimes and evidence, at a minimum, can help elucidate the causes of backdating. in addition, such comparative work can also help uncover whether backdating activities are path-dependent and context specific, thereby providing policy lessons from and for other jurisdictions. for example, comparing and contrasting insider reporting obligations in a number of countries finds that placing the reporting onus on the corporation rather than the individual may have played a role in the lack of backdating in the u.k. and australia. see compton et al., supra note 8, at 483, 490. since current regulations and enforcement in the u.s. have failed to completely 150 columbia journal of tax law [vol.3:144 differences in these rules, particularly the extent to which these differences affect the after-tax return to a canadian executive compared to a u.s. executive of backdated options. in the united states, the entire benefit realized by the employee at the time of exercise of most executive stock options is included in income, 22 while in canada, assuming certain conditions are met, the benefit is taxed at the same effective rate as capital gains (and thus is subject to a lower tax rate than if taxed as regular employment income). part ii considers these personal income tax rules in detail. in particular, the relevant personal income tax rules in the two countries are compared and contrasted to demonstrate the role these rules may play in determining the demand for backdated options in the two countries. 23 as will be shown, this is potentially an important component in the decision of executives to accept backdated stock options and may provide an additional incentive for executives to demand them in canada. ii. tax policy and the demand for backdated options the taxation of stock options varies significantly between canada and the united states. 24 in this part we summarize the differences, focusing on backdated options and incorporating a discussion of recent u.s. changes regarding the taxation of discounted stock options enacted in 2004 on the heels of the enron, worldcom, and tyco scandals. eradicate the backdating problem, this suggests a continued lack of understanding of the drivers of the behavior and that further policy interventions are required. see id. at 489-90. 22 this is because most executive stock options issued in the u.s. are nsos. 1 edward f. koren et al., estate tax & personal financial planning § 2:68 (2012). 23 while beyond the scope of this paper, we note a few things concerning the corporate taxation of executive stock options in the united states that have no counterpart in canada. in particular, it has been suggested that corporate tax may increase the proclivity to backdate in the united states, but not in canada, because u.s. corporations can deduct the value of most stock option benefits whereas canadian corporations cannot. we disagree with this view. subject to the possible application of § 162(m) of the internal revenue code (“i.r.c.”) (which restricts a public corporation’s ability to deduct more than $1 million in compensation paid to the corporation’s ceo and next four highest paid officers), u.s. corporations are entitled to a deduction for employee stock options only if the employee is required to report the stock option benefit as an income inclusion. see i.r.c. § 162(m) (west supp. 2011). not-in-the-money options are not subject to § 162(m) whereas in-the-money options are. thus, a corporation is generally entitled to a deduction for nsos and incentive stock options (“isos”) where the shares are sold within one year after the options are exercised. nsos may or may not be subject to the limitation in § 162(m) depending on what makes them nsos, while isos held less than one year would not be subject to § 162(m) (because isos cannot be granted in-the-money). see id. however, regardless of how long the stock acquired pursuant to isos are actually held, it seems fair to assume that at the time of grant of the iso, the employer could not expect a deduction, since no deduction is available if the ultimate share sale qualifies for iso treatment. therefore from the employer’s perspective, there seems to be no preference accorded to backdated options that appear to be isos and currently dated options that are, in fact, isos. from the corporation’s perspective, the backdating preference would appear to be limited to nsos that are granted—or, more precisely, appear to be granted—not-in-the-money (i.e., stock options in excess of the $100,000 per year threshold for isos). this is because the corporation is definitely entitled to deduct the value of such options when included in income by the employee without the potential application of § 162(m). see i.r.c. § 422(d) (2006). a second issue is that backdated options, assuming they are discovered, are necessarily nsos and the employer would be entitled to a deduction, subject to the limitation in § 162(m). see i.r.c. § 162(m) (west supp. 2011). however, the deduction is only of value to the corporation if it is otherwise subject to tax (i.e., it is profitable). nonetheless, many of the corporations that were cited for backdating in the united states were in the high-tech sector and may well not have been profitable. see walker, supra note 2, at 566. in sum, it is our view that corporate taxation would have had little impact on the propensity to backdate in the united states. 24 see generally daniel sandler, the tax treatment of employee stock options: generous to a fault, 49 can. tax j. 259 (2001) (discussing how stock options in canada are more likely to be taxed under more favorable rates than they are in the united states). 2012] quantifying the tax benefits of backdating 151 a. canadian personal income tax rules for executive stock options personal income taxation of stock options in canada is notably less complex and more generous from the employee’s perspective than in the united states. the applicable tax rules for stock options granted by publicly-traded companies are set out in section 7 and paragraph 110(1)(d) of the canadian income tax act. 25 section 7 pertains to the value and timing of the employment income inclusion and paragraph 110(1)(d) provides a deduction equal to one-half (reduced to one-fifth for the purposes of computing minimum tax 26 ) of the income inclusion if certain conditions set out therein are met. all employee stock options share the same general tax treatment in two areas. first, unlike employment income (e.g. annual salary or bonus income), which is taxable in the year it is received, there are no tax consequences when stock options are granted or when they vest; rather, under subsection 7(1), a tax liability does not arise until the time the option is exercised, at the earliest. 27 the amount that must be included in income from employment upon exercise (or later, if certain conditions are met) is equal to the difference between the fair market value of the stock on the date the option is exercised and the strike price. second, upon the sale of the stock acquired pursuant to the option, the difference between the proceeds of disposition of the stock and the fair market value of the stock on the date the option is exercised is taxed as a capital gain or capital loss, as the case may be. under section 38 of the i.t.a., the taxable portion is calculated as onehalf of the capital gain or capital loss. 28 there are, however, several exceptions to the general rules described above that affect both the amount and timing of the inclusion. one exception concerns stock options granted by a canadian-controlled private corporation (“ccpc”). under subsection 7(1.1), if certain conditions are met, the inclusion of the employment income benefit is deferred until the time that the shares are sold. 29 in addition, there is a deduction equal to one-half of the inclusion if either the option strike price is equal to or greater than the fair market value of the share at the time of the grant (section 110(1)(d)) or if the shares acquired on exercise are held for a minimum twoyear period before sale (paragraph 110(1)(d.1)). 30 as the backdating scandal mainly involves public corporations, we do not consider the tax treatment of options issued by ccpcs further. 25 income tax act, r.s.c. 1985, c. 1 (5th supp.), as amended (“i.t.a.”), s. 7, 110(1)(d). 26 minimum tax serves a similar purpose to alternative minimum tax in the united states, although it is imposed only on individuals (other than certain trusts). see infra note 39. minimum tax is charged at the lowest marginal tax rate (currently fifteen percent) on an individual’s adjusted taxable income less the individual’s basic exemption (currently $40,000). adjusted taxable income is, essentially, taxable income adding back all or part of various specified tax preferences. for the purposes of adjusted taxable income, the tax preference in paragraph 110(1)(d) is recomputed to be two-fifths of the amount otherwise deducted under that provision (i.e., two-fifths of one-half of the stock option benefit). see i.t.a., s. 127.52(1)(h)(ii)(b). in the event that minimum tax exceeds tax otherwise payable, the excess may be carried forward seven years to reduce tax otherwise payable. given that the minimum tax rate is a flat rate equal to the lowest marginal rate, relatively few higher-paid employees would be subject to minimum tax even if they have substantial stock option benefits (assuming that the stock option benefits are their only tax preference). 27 i.t.a., s. 7(1). 28 i.t.a., s. 38(a). from 1972 to 1988, the inclusion rate for capital gains and losses was one-half. in 1988, the rate rose to two-thirds and in 1990 the rate was subsequently increased to three-quarters. in february 2000 the rate was decreased to two-thirds and in october 2000 it was further decreased to one-half. 29 i.t.a., s. 7(1.1). 30 even if both conditions are met, stock options granted by ccpcs qualify for either a deduction under paragraph 110(1)(d) or paragraph 110(1)(d.1) but not both. i.t.a., s. 110(1)(d), 110(1)(d.1). in addition, to qualify for the deduction under paragraph 110(1)(d), the option must be for “garden variety” 152 columbia journal of tax law [vol.3:144 for options issued by a public corporation, one-half of the stock option benefit is deductible under paragraph 110(1)(d) if three conditions are met: (1) the option strike price is equal to or greater than the fair market value of the share at the time of the grant; (2) the optioned shares are “plain vanilla” common shares; and (3) the employee deals at arm’s length with the employer. 31 in addition, for options issued by public corporations after february 27, 2000, and exercised prior to 4:00 p.m. (est) on march 4, 2010, 32 the employment income benefit is deferred until the time the shares are sold if the following conditions, stipulated in subsections 7(8) to (16) of the i.t.a. are met: (1) the recipient is a canadian resident; (2) the underlying shares are traded on a canadian or foreign prescribed stock exchange; and (3) the individual is entitled to the deduction under paragraph 110(1)(d). 33 the deferral, however, is limited to the first $100,000 worth 34 of options per year of vesting. b. us tax rules for executive stock options in the united states, the taxation of employee stock options depends on their characterization as non-statutory stock options (“nsos”) or statutory stock options, which includes incentive stock options (“isos”) and employee stock purchase plans (“espps”). 35 there is no difference in the treatment of options granted by a public corporation and a private corporation. 36 in order for an option to be treated as an iso, a number of requirements must be met including: (1) the exercise price must not be less than the fair market value of the stock at the time of the grant; (2) the exercised shares must be held for the longer of two years from the grant date or one year from the exercise date; and (3) the combined value, as determined by the fair market value of the underlying shares on the grant date, that can be acquired for the first time in any calendar year (i.e., in the year of vesting) cannot exceed us $100,000. 37 for an iso, there are no income tax consequences until the time the shares are sold, 38 unless the alternative minimum tax (“amt”) 39 applies. upon the common shares and the employer and employee must deal at arm’s length both before and after the exercise of the options. i.t.a., s. 110(1)(d). 31 i.t.a., s. 110(1)(d). 32 in the march 4, 2010 federal budget, it was announced that subsections 7(8) to (15) of the i.t.a. will be repealed with effect for options exercised after 4 p.m. on that day. sustaining canada’s economic recovery act, r.s.c. 2010, c. 25, s. 39. 33 i.t.a., s. 110(1)(d). 34 the value is based on the fair market value of the underlying shares at the time the options are granted. 35 see generally i.r.c. § 83 (2006) (tax rules applicable to nsos); i.r.c. § 421 (2006) (tax rules applicable to isos); i.r.c. § 422 (2006) (further tax rules applicable to isos). espps are generally not of interest with respect to the backdating discussion since they are not granted to employees, but rather the employer’s shares are made available to all employees to purchase through payroll deductions. consequently, our discussion will be limited to isos and nsos. 36 see i.r.c. §§ 83, 421, 422 (2006). 37 i.r.c. §§ 422(a)(1), (b)(4), (d)(1) (2006). to the extent that the value (so determined) of the stock options exceeds us $100,000, the excess options are treated as nsos. see i.r.c. §§ 422(d)(1), 83 (2006). 38 see i.r.c. § 421(a)(1) (2006). 39 the amt is a tax designed to ensure that no taxpayer—whether individual or corporate—may disproportionally benefit from certain tax preferences. see §§ i.r.c. §§ 56, 58-59 (2006); i.r.c. 55, 57 (west 2011). thus, a taxpayer must pay the greater of (i) his or her regular tax liability or (ii) his or her tentative minimum tax liability, calculated under the amt rules. see i.r.c. § 55 (west 2011). to be precise, the amt imposed is the amount by which the tentative minimum tax liability exceeds the regular tax liability. id. the tentative minimum tax liability is calculated by recomputing regular tax liability, first by 2012] quantifying the tax benefits of backdating 153 sale of the shares, the difference between the sale price and the exercise price under the option is treated as a capital gain, and since the shares must have been held for at least one year, the gain is taxed at the long-term capital gains rate of fifteen percent. 40 an option award that does not, at the time of grant, meet the requirements of an iso is taxed as an nso. 41 if an nso has a readily ascertainable fair market value at the time of grant, the difference between the option’s value and the amount paid by the grantee is taxed as income in the year of the grant or in the year that the option is exercised, depending on the taxpayer’s election. 42 however, in order for an option to have a readily ascertainable fair market value it must be either publicly traded or meet the following four conditions: (1) be transferable; (2) be exercisable in full on the grant date; (3) not be subject to any conditions that affect the value of the option (e.g., vesting and transferability restrictions); and (4) the fair market value of the underlying share must be readily determinable. 43 since nsos are not generally publicly traded and fail to meet any of the first three conditions, most nsos are not taxable at grant. if an employee exercises options that are otherwise qualified as isos but then disposes of the shares within one year of exercise or within two years of when the options were granted, the employee stock option benefit (as determined above for a nso) is not included in income until the time of sale of the shares and the difference between the sale proceeds and the fair market value of the shares at the time of exercise is taxed as a short adding back to taxable income tax preference items and by making certain adjustments in order to determine the alternative minimum taxable income (“amti”), then by applying the appropriate amt rate to the amount by which amti exceeds the taxpayer’s exemption amount. i.r.c. § 55(b) (west 2011). the amt rate for individuals is 26% of such amount up to $175,000 and 28% of any excess. i.r.c. § 55(b)(1) (west 2011). for individuals, the exemption amount depends on whether the individual is married and filing a joint return (in which case the amount is $45,000) or is a surviving spouse ($45,000) or is single ($33,750). i.r.c. § 55(d) (west 2011). the exemption amount begins to be phased out when amti exceeds a threshold ($150,000 for a married individual filing a joint return; $112,500 for a single individual). id. the deferral of the income inclusion for an iso is an adjustment in computing amti, resulting in the addition to regular taxable income in the tax year in which the option is exercised of an amount equal to the difference between the fair market value of the shares and the exercise price of the option. i.r.c. § 56(b)(3) (2006). however, where the exercise of the option and the sale of the shares occur in the same year, and the sale price for the shares is less than the value of the shares at the time the option was exercised, iso treatment is not available since the holding period requirement has not been met. the amount included in income (for both regular tax and amt purposes) is the difference between the sale price of the share and the strike price under the option. i.r.c. §§ 56(b)(3); 422(c)(2) (2006). the long-term capital gains rate remains applicable for amt purposes; in other words, the reduced rate is not treated as a tax preference for amt purposes. i.r.c. § 1(h) (2006); i.r.c. § 55(b)(3) (west 2011). certain amt may be carried forward and applied to reduce the general tax payable in subsequent years (to the extent that the general tax exceeds the tentative alternative minimum tax liability for the subsequent year). see i.r.c. § 53 (2006 & supp. iii 2009) (allowing carry forward for a credit for the prior year’s minimum tax liability that resulted from certain timing differences). see infra subpart iii.d (illustrating in example 4 the effect of amt); see generally francine j. lipman, incentive stock options and the alternative minimum tax: the worst of time, 39 harv. j. on legis. 337 (2002) (providing a detailed discussion of the amt and its application to isos). 40 i.r.c. § 1(h) (2006). prior to 2003, the long-term capital gains rate was generally 20%. in 2003, the rate was reduced to 5% for individuals in the lowest two income brackets and 15% for all others. in 2008, the long-term capital gain rate for individuals in the lowest two tax brackets (currently 5% and 15%) was further reduced to zero. these reduced rates are currently effective until the end of 2012. tax relief, unemployment insurance reauthorization, and job creation act of 2010, pub. l. no. 111-312, 124 stat 3296 (extending reduced rates from the end of 2010 until the end of 2012). 41 see i.r.c. §§ 83, 422(d)(1) (2006). 42 i.r.c. § 83(a)-(b) (2006). 43 treas. reg. § 1.83-7(b)(2) (as amended in 2004). 154 columbia journal of tax law [vol.3:144 term capital gain. 44 short-term capital gains are taxed at the individual’s ordinary income tax rate. 45 however, if the shares decline in value between the time of exercise and the time of sale, then the employee benefit is limited to the difference between the sale proceeds and the strike price under the option. 46 prior to the introduction of § 409a to the code in late 2004, if the fair market value of an nso was not readily ascertainable at the time of grant, no income was recognized for tax purposes until the option was exercised, regardless of whether or not the options were in-the-money on the grant date. 47 in either case, upon exercise, the amount included in income (and subject to tax at normal tax rates as compensation income) was equal to the difference between the strike price and the fair market value of the stock on the date of exercise. 48 this amount was also added to the basis of the stock for capital gains purposes. 49 any further taxation was deferred until the underlying shares were sold, when the gain or loss—i.e., the difference between the sale price and the fair market value on the exercise date—was taxed as a capital gain or loss. 50 if the shares were held for one year or less, the gain was taxed as a short-term capital gain (taxable at regular marginal rates) whereas if the shares were held for more than a year, the applicable rate was the long-term capital gains rate, which is currently fifteen percent. 51 this tax treatment remains applicable to options provided that they are not inthe-money at the grant date. following corporate and accounting scandals such as enron, tyco, and worldcom, the american jobs creation act of 2004 added § 409a to the code, 52 which radically changed the taxation of deferred compensation, including discounted stock options. 53 i.r.c. § 409a provides in part: § 409a. inclusion in gross income of deferred compensation under nonqualified deferred compensation plans (a) rules relating to constructive receipt (1) plan failures (a) gross income inclusion (i) in general.—if at any time during a taxable year a nonqualified deferred compensation plan— (i) fails to meet the requirements of paragraphs (2), (3), and (4), or 44 i.r.c. § 421(b) (2006). 45 see i.r.c. § 1(h) (2006); i.r.c. § 1222 (west 2011). 46 see i.r.c. § 421(b) (2006). 47 see i.r.c. §§ 409a; 83(e) (2006). 48 see i.r.c. § 83 (2006). 49 see id. 50 see i.r.c. § 1221 (2006). 51 see i.r.c. § 1(h) (2006); i.r.c. § 1222 (west 2011). 52 american jobs creation act of 2004, pub. l. no. 108-357, § 885, 118 stat. 1418, 1635-42. 53 although the new regime was effective october 2004, corporations were essentially given until december 31, 2006, to modify any unvested and unexercised stock options to ensure compliance with § 409a by increasing the exercise price to the fair market value of the stock on the grant date; however, if any payments were made to compensate employees for the revised option exercise price, these payments were subject to § 409a. see i.r.c. § 409a (2006). 2012] quantifying the tax benefits of backdating 155 (ii) is not operated in accordance with such requirements, all compensation deferred under the plan for the taxable year and all preceding taxable years shall be includible in gross income for the taxable year to the extent not subject to a substantial risk of forfeiture and not previously included in gross income. (ii) application only to affected participants.—clause (i) shall only apply with respect to all compensation deferred under the plan for participants with respect to whom the failure relates. (b) interest and additional tax payable with respect to previously deferred compensation (i) in general.—if compensation is required to be included in gross income under subparagraph (a) for a taxable year, the tax imposed by this chapter for the taxable year shall be increased by the sum of— (i) the amount of interest determined under clause (ii), and (ii) an amount equal to 20 percent of the compensation which is required to be included in gross income. (ii) interest.—for purposes of clause (i), the interest determined under this clause for any taxable year is the amount of interest at the underpayment rate plus 1 percentage point on the underpayments that would have occurred had the deferred compensation been includible in gross income for the taxable year in which first deferred or, if later, the first taxable year in which such deferred compensation is not subject to a substantial risk of forfeiture. i.r.c. § 409a applies to a broad range of deferred compensation, although it also provides a number of exceptions, including employee stock options that are granted notin-the-money. 54 however, in-the-money options (including backdated options that appear to be not-in-the-money options) are caught by the section. under § 409a(a)(1)(a), the “compensation deferred under the plan” must be included in the employee’s gross income “for the taxable year to the extent not subject to a substantial risk of forfeiture and not previously included in gross income.” 55 in addition to the income inclusion, § 409a(a)(1)(b) provides that the tax payable on such income is increased by “premium interest tax” 56 plus an “additional tax” (commonly referred to as a penalty tax) equal to twenty percent of the compensation required to be included in gross income. 57 generally speaking, a taxpayer must include in income an amount attributable 54 see supra note 4 (discussing the difference between in-the-money and not-in-the-money options). 55 i.r.c. § 409(a)(1)(a) (2006). 56 in-the-money options will not be subject to premium interest tax. premium interest tax is computed only for the period from the time of vesting to the time that § 409a is breached. see i.r.c. § 409a(a)(1)(b)(ii) (2006). since in-the-money options breach § 409a when granted (i.e., at the time of vesting, if the options are vested at the time granted, or otherwise prior to vesting), there is no period during which premium interest tax is computed. 57 i.r.c. § 6662(a) (west 2011). 156 columbia journal of tax law [vol.3:144 to a grant of in-the-money stock options in the year that the options vest and in every subsequent year up to and including the year of exercise (to the extent not included in income in a previous year). neither § 409a nor the final regulations issued to date under the statute specify the amount included in income (and the basis for the additional tax). however, the proposed regulations indicate that the amount to be included is the intrinsic value of the option on the last day of the employee’s taxation year in which the option vests and any subsequent year in which a vested option remains unexercised, and, in the year of exercise, the actual value on the exercise date. 58 the income inclusion and penalty tax apply regardless of when (or if) the options are ultimately exercised. 59 in effect, § 409a provides for income inclusion (and a corresponding penalty tax) in each year following the year in which an option vests, and until and including the year of exercise, depending on the value of the underlying shares on december 31 (or the date that the options are exercised in) of the subsequent year. 60 58 see prop. treas. reg. § 1.409a-4(b)(6), 73 fed. reg. 74.380, 74.399 (dec. 5, 2008). prior to the issuance of the proposed regulation, the irs had issued notice 2005-1 setting forth the irs’s initial guidance on the provision. i.r.s. notice 2005-1, 2005-1 c.b. 274. neither that notice nor the final regulations released on april 10, 2007 (applicable to taxation years beginning after december 21, 2008) addressed the calculation of the amount included in income under § 409a. interim guidance in notice 2006-100 (applicable to the 2005 and 2006 taxation years) provided that the intrinsic value of a vested stock option on the year-end of the employee (i.e., december 31) is the basis for the income inclusion, premium interest tax (if applicable) and additional tax, assuming that the options were not modified to avoid the application of § 409a. i.r.s. notice 2006-100, 2006-2 c.b. 1109. the preamble to the proposed regulation states in part: “the treasury department and the irs recognize that the spread [i.e., intrinsic value] generally is less than the fair market value of the stock right, which is used for purposes of determining the amount taxable under other code provisions . . . . however, because these types of stock rights typically will fail to comply with section 409a(a) in multiple years, a taxpayer who holds such a stock right generally will be required to include amounts in income under section 409a in more than one taxable year. therefore, the treasury department and the irs believe that it is more appropriate to use the spread for purposes of applying section 409a(a) to stock rights.” prop. treas. reg. § 1.409a-4(b)(6), 73 fed. reg. 74.380, 74.386 (dec. 5, 2008). 59 if the options expire unexercised—in other words, the employee’s right to the deferred income is permanently lost—the employee is entitled to a deduction at that time equal to the amounts previously included in income under § 409a. however, there is no deduction for the additional tax previously assessed. see 2008-51 i.r.b. 1297, 1336-37 (dec. 22, 2008). 60 consider the following simple example. suppose that on december 31, 2009, an employee of xco receives 30,000 employee stock options at an exercise price of $10 per share. the options have a tenyear life and one-third of the options each vest on december 31 of 2010, 2011, and 2012. suppose that the shares have a fair market value on december 31, 2009, of $12 per share (i.e., the options are granted in-themoney or, alternatively, the options may be backdated to an earlier date (such as december 1, 2009) when the fair market value of the shares was $10 per share). because the options were in-the-money on december 31, 2009, the actual grant date, they would be subject to tax under § 409a. see i.r.c. § 409a (2006). suppose that on december 31, 2010, the xco shares are trading at $14 per share. on that date, 10,000 options vest (i.e., are no longer subject to a substantial risk of forfeiture). because the options were in-the-money on december 31, 2009, they would be subject to tax under § 409a. see id. consequently, the employee must include in gross income in 2010 the amount of $40,000 ($4 per share × 10,000 shares), which would be subject to tax at the employee’s marginal rates. in addition, the employee would have to pay an “additional tax” of $8,000 (20% of $40,000). no premium interest tax is payable. see supra note 56. suppose further that on december 31, 2011, when an additional 10,000 options vest, the fair market value of the shares of xco is $17 per share. the employee would have to include $100,000 in income in 2011 [$7 × 20,000 – $40,000 (the amount included in 2010)]. this amount would be subject to tax at the employee’s marginal rate and, in addition, the employee would have to pay a tax of $20,000. finally, suppose on december 31, 2012, when the final 10,000 options vest, the shares of xco are trading at $15 per share. the employee would have to include $10,000 in income for that year [$5 × 30,000 – $140,000 (the aggregate amounts included in income in 2011 and 2012)] plus $1,000 additional tax. in a subsequent year in which the options remain outstanding, if the shares of xco are trading above $15 per share, the employee may be subject to 2012] quantifying the tax benefits of backdating 157 c. tax regime and backdated options based on the above discussion, the most preferential compensation regime from an executive’s tax perspective in either canada or the united states is one in which the options are granted not-in-the-money (or for our purposes, backdated to appear as such). in canada, not only is there no super-inclusion or penalty tax regardless of the option’s exercise price relative to the value of the shares on the option grant date, but also provided that the options are at-the-money (or backdated to appear as such), only onehalf of the option benefit is included in income for tax purposes regardless of the length of time that the shares are held after exercise. 61 this demonstrates a clear tax advantage for stock option compensation, provided that the options are granted not-in-the-money (or reported as such). in canada, employees who receive backdated stock options, the equivalent of inthe-money options (assuming that the fair market value of the shares on the real grant date exceeds the strike price under the option), may be reassessed by the canada revenue agency not only to deny any deduction claimed under paragraph 110(1)(d), but also to include the employee benefit from the option in income in an earlier year than that in which the employee reported the benefit (and offsetting deduction) for tax purposes. such reassessment would also include interest, compounded daily at a relatively high rate. furthermore, an employee who knowingly received backdated options and reported them as if they were not-in-the-money could be subject to penalties 62 for gross negligence and perhaps even charged with tax evasion. 63 further income inclusion and additional tax under § 409a. finally, suppose in 2017, the employee exercises the options when the shares are trading at $21 per share (and on no previous december 31 had the trading price of xco shares reached that amount), the employee would be required to include in income $330,000 less the aggregate amounts included in gross income under § 409a in previous years, plus additional tax at the rate of 20% on such amount. see i.r.c. § 409a (2006). 61 see i.t.a., s. 110(1)(d). 62 the expected cost of any such penalties would presumably be a consideration in whether or not an executive decides to engage in backdating. in canada, an executive faces a penalty amounting to 50% of the increase in tax payable caused by the backdating in that taxation year (assuming that the improper reporting on the part of the employee amounts to gross negligence). i.t.a., s. 163(2). in the united states, the penalty would likely be less than in canada, as it is calculated as 20% of the underpayment of tax in that taxation year for negligence or disregard of the rules or regulations, or 40% of the underpayment of tax in the case of a gross valuation misstatement. see i.r.c. §§ 6662(a), (h) (west 2011). the underpayment of tax in the united states will likely be less than in canada because backdating provides less of a benefit in the united states. see compton et al., supra note 3, at 373-74. in addition to quantifying the penalty, it is important to consider the probability of such a penalty being applied. given the evidence to date, it is more likely that an executive in the united states will be caught for backdating options than an executive in canada. if the backdating is not caught by securities regulators, it is highly unlikely that the canada revenue agency will independently investigate possible backdating behavior. canada’s securities regulators are generally considered to be less aggressive in investigating backdating behavior than the united states’ securities and exchange commission. furthermore, the internal revenue service has given backdated stock options specific recognition as a tier i issue for its large and mid-size division. i.r.s. treas. dir. lmsb 04-0407-036 (june 15, 2007). the heightened probability of being caught by either regulatory body in the united states likely contributes to the decreased incidence of backdated or manipulated option grants in the united states, ceteris paribus. see also infra note 65 and accompanying text (discussing the positive correlation between compliance and the size of penalty if caught). 63 the implications of this could reach even further since it previously has been found that noncompliant corporations are three times more likely than compliant corporations to be managed by executives who have evaded personal taxes. see david joulfaian, corporate tax evasion and managerial preferences, 82 rev. econ. & stat. 698, 698-99 (2000). 158 columbia journal of tax law [vol.3:144 in the united states, employees who receive backdated isos or backdated nsos are, in fact, receiving deferred compensation subject to tax under i.r.c. § 409a. in addition, isos that are backdated do not meet the necessary requirements for preferential tax treatment (assuming that the shares are held for at least a year after exercise) and instead must be treated as backdated nsos for tax purposes. however, rank and file employees who receive isos may not be aware they were granted discounted stock options and could be reassessed on the basis that a tax liability arose in the year the options vested (and subject to an income inclusion and additional tax under i.r.c. § 409a) in addition to the year the shares are ultimately sold. the relative share values at the time of vesting (and december 31 of each year that vested options remain unexercised) give rise to significant tax differences upon exercise or sale. the corporation’s executives may have knowingly received backdated options and reported them as if they were at-the-money. in addition to the accelerated reporting under i.r.c. § 409a, such executives could be subject to gross negligence penalties and perhaps charged with tax evasion. 64 based on the standard model of tax evasion by allingham and sandmo, 65 where compliance is positively associated with the size of penalty assessed if caught, one might expect that the punitive consequences of i.r.c. § 409a should have reduced the incidence of backdating in the united states. however, there continues to be some evidence of backdating in the united states, 66 suggesting that executives may perceive there to be a low risk that the irs will apply i.r.c. § 409a to backdated options. iii. quantifying the benefits of backdating: examples to demonstrate the tax consequences of backdated options in each country, consider the following example. an executive at a publicly traded company is the recipient of an option grant for 30,000 shares which expires ten years after the date of the grant. this award is dated as having been granted on october 16 when the share price was $14.25, but in reality was granted on november 30 when the share price was $18.40. for simplicity and ease of comparison, we assume that the individual faces a marginal tax 64 see supra note 62 and accompanying text. 65 see generally michael g. allingham & agnar sandmo, income tax evasion: a theoretical analysis, 1 j. pub. econ. 323 (1972) (discussing how compliance with reporting regulations increases as penalties for evasion increase). the allingham-sandmo model has been extended in a number of dimensions over the last thirty years. see generally kim border & joel sobel, samurai accountant: a theory of audit and plunder, 54 rev. econ. stud. 525 (1987) (discussing the positive relationship between a tax collector’s threat of audit and a taxpayer’s truthful income reporting); helmuth cremer, maurice marchand & pierre pestieau, evading, auditing and taxing: the equity-compliance tradeoff, 43 j. pub. econ. 67 (1990) (analyzing the social welfare elements of tax parameters that try to maximize compliance); dilip mookherjee & ivan p.l. png, optimal auditing, insurance and redistribution, 104 q. j. econ. 399 (1989) (incorporating the role of moral hazard in the penalty-compliance analysis); isabel sanchez & joel sobel, hierarchical design and enforcement of income tax policies, 50 j. pub. econ. 345 (1993) (analyzing the role that hierarchy within the government plays in setting compliance-conscious tax policies); suzanne scotchmer, audit classes and tax enforcement policy, 77 am. econ. rev. 229 (1987) (analyzing the regressive bias of a compliance scheme that consists of different audit classes); greg trandel & arthur snow, progressive income taxation and the underground economy, 62 econ. letters 217 (1999) (arguing that the source of one’s income can contribute to one’s likelihood of successfully avoiding penalties for underreporting); harry watson, tax evasion and labor markets, 27 j. pub. econ. 231 (1985) (discussing how different labor markets have different potentials for tax evasion). for an additional survey of this literature, see james andreoni, brian erard, & jonathan feinstein, tax compliance, 36 j. econ. literature 818, 818-19, 823-25 (1998); joel slemrod & shlomo yitzhaki, tax avoidance, evasion, and administration, in 3 handbook of public economics 1423, 1429-36 (a. j. auerbach and m. felstein eds., 2002). 66 see supra note 8 and accompanying text. 2012] quantifying the tax benefits of backdating 159 rate of twenty-nine percent in both countries. it is also assumed, in the case of the u.s. executive, that such options expire or are all exercised prior to the introduction and application of i.r.c. § 409a. 67 for the purposes of demonstrating the impact, if any, of minimum tax in canada and amt in the united states, it is assumed that the executive has gross taxable income not derived from any issuance, exercise or sale of stock options or the underlying stock, of $150,000 and does not benefit from any tax preference other than the preference (if any) associated with employee stock options. based on this assumption, minimum tax will not apply in any of the examples and amt will apply only in the fourth example. each example compares four scenarios in each country: (1) at-the-money backdated options; (2) at-the-money currently dated options; (3) fixed value options; and (4) currently dated in-the-money options with the same strike price as the backdated options (i.e., if the employee properly reported the backdated options for tax purposes). they each set out in the last row the “canadian advantage,” if any, that the canadian executive receives compared to his u.s. counterpart in the same scenario. in all cases where an advantage exists (except the fourth example, where the advantage stems from the application of amt in the u.s. in the year of exercise), it is due exclusively to the deduction that the canadian executive enjoys under i.t.a. paragraph 110(1)(d), for which there is no u.s. equivalent. a. example 1—exercise and sale on same date the first example assumes that the individual exercises the options and sells the resulting shares on the same date, which is a common occurrence. 68 the sale price of the shares on the date of exercise is $22.77. table 1 summarizes the tax consequences of this example in canada and the united states. 67 although § 409a was introduced in 2004, corporations were given until the end of 2006 to bring unvested and unexercised stock options into compliance with § 409a. see supra note 53. 68 see, e.g., jennifer n. carpenter & barbara remmers, executive stock option exercises and insider information, 74 j. bus. 513, 514 (2001); eli ofek and david yermack, taking stock: equity-based compensation and the evolution of managerial ownership, 55 j. fin. 1367, 1368 (2000). the exception to this general trend occurred prior to may 1991 in the united states when insiders had to hold the stock they acquired through option exercise for six months. see carpenter & remmers, supra. 160 columbia journal of tax law [vol.3:144 table 1: summary of tax implications from examples 1 and 2: exercise and sale on the same date canada us at-the-money backdated at-the-money reduced share in-the-money at-the-money backdated at-the-money reduced share in-the-money at exercise/sale at exercise/sale # of options 30,000 30,000 23,234 30,000 30,000 30,000 23,234 30,000 exercise price $14.25 $18.4 $18.4 $14.25 $14.25 $18.4 $18.4 $14.25 sale price $22.77 $22.77 $22.77 $22.77 $22.77 $22.77 $22.77 $22.77 total income benefit $255,600 $131,100 $101,533 $255,600 $255,600 $131,100 $101,533 $255,600 deduction $127,800 $65,550 $50,766 $n/a n/a n/a n/a taxable income benefit $127,800 $65,550 $50,766 $255,600 $255,600 $131,100 $101,533 $255,600 tax owed $37,062 $19,010 $14,722 $74,124 $74,124 $38,019 $29,444 $74,124 net employee benefit $218,538 $112,091 $86,810 $181,476 $181,476 $93,081 $72,088 $181,476 canadian advantage (%) 20.42 20.42 20.42 2012] quantifying the tax benefits of backdating 161 for a canadian executive, if the option is “successfully” reported as an at-the-money grant awarded on october 16 with a strike price of $14.25, then the income benefit subject to tax is calculated as the difference between the fair market value of the shares on the date of exercise and the strike price multiplied by the number of options awarded, which is $255,600. the individual claims a deduction under paragraph 110(1)(d), which reduces the income inclusion to $127,800. as the sale price is equal to the price of the shares at the time the options were exercised, there is no capital gain or loss to report. the individual faces a tax liability of $37,062, and the net aftertax benefit to the executive is $218,538. this is reported in the first column of table 1. if, instead, the option had been properly dated as november 30 and had an associated strike price of $18.40 (the fair market value on that date), then the individual would have reported an income benefit of $131,100, claimed the deduction under paragraph 110(1)(d), which would have reduced the overall income inclusion to $65,550, resulting in a tax liability of $19,009.50 and a net after-tax benefit to the employee of $112,091.50. this example assumed that the option plan is based on receiving a fixed number of shares (30,000) as part of a fixed-share option plan. however, as an additional wrinkle, column 3 considers the difference in value of backdating if the employer used a fixed-value option plan. under a fixed-value option plan, an executive is given a fixed dollar amount of options (rather than a fixed number of options). in this example, it is assumed that under a fixed-value option plan the executive is to receive $241,050 worth of options. 69 if the options are granted on november 30 with a strike price of $18.40, this would give the executive 23,234 options, while if the executive received the options backdated to the october 16 strike price of $14.25, he or she would receive 30,000 options. this represents a twenty-nine percent increase (6,767) in the number of options received as a result of backdating. thus, if the corporation awarded fixed-value options, then at the strike price of $18.40, the individual would have only received 23,234 options (rather than 30,000 options), which when exercised would have resulted in $14,722.22 of tax liability and a net aftertax benefit of $86,810.36. finally, if the executive properly reported the backdated options as in-the-money options for tax purposes, thereby forgoing the deduction under paragraph 110(1)(d), the tax liability would have been $74,124 and the net after-tax benefit would have been $181,476. in summary, the after-tax benefit to the canadian executive of a backdated option is higher than in any other case. in fact, the after-tax value of the backdated option is $37,062 higher than if the option were reported as being in-the-money and $106,447.50 higher than an at-the-money option granted on november 30. if the corporation issued fixed value options, then had the option been properly awarded on november 30 rather than reported as being awarded on october 16, the individual would have received 23,234 options priced at $18.40 rather than 30,000 priced at $14.25 and would have obtained an after-tax benefit of $86,810.36, the lowest of all cases. in considering the case of the u.s. executive, since the individual exercised the options and sold the shares on the same day, this is a disqualified disposition of an iso, and therefore the options would be taxed as nsos and the income inclusion for the u.s. executive is included in the same taxation year as the disposition of the shares. in all cases, the resulting tax liability is greater than or equal to the tax assessed in canada, assuming equivalent marginal rates. the most interesting point of this example is that prior to the introduction of i.r.c. § 409a, the net after-tax 69 we have assumed this amount for ease of calculation. 162 columbia journal of tax law [vol.3:144 benefit enjoyed by the executive is identical for the backdated option reported as an at-the-money option and the currently dated in-the-money option with the same $14.25 strike price. because there is no deduction in the united states comparable to paragraph 110(1)(d) of the i.t.a., the tax payable in these two cases is the same ($74,124), resulting in an after-tax benefit of $181,476. this example suggests that until the introduction of i.r.c. § 409a, and for tax purposes only, a u.s. executive would have been indifferent between backdated options and discounted options, but would have preferred either of these to at-the-money options granted on november 30. the example also implies that the personal income tax regime in canada may cause an individual to prefer a backdated option over any other option type. 70 in the united states, on the other hand, prior to the introduction of i.r.c. § 409a, an individual would have been indifferent between a backdated option and an in-the-money option. b. example 2—vest over five years, sale on same date as exercise in the second case, we extend our example to include the fact that the options vest at a rate of one-fifth (or 6,000 options) per year over five years. we maintain the assumption that the exercise date is the same as the date of sale. in this case, the tax treatment (and after-tax benefit) in both canada and the united states is identical to that in example 1. 71 c. example 3—vest over five years, sale in same year as exercise in the third case, we extend example 2 by changing the sale date to a date later in the same year as the exercise date. the price of the underlying shares on the exercise date is still $22.77, and the sale price is assumed to be $25. table 2 summarizes the tax consequence of this example in canada and the united states. 70 while significant empirical research has been done on backdating in the united states, there has been almost no empirical work on this subject published in canada. to our knowledge, compton et al., supra note 3, remains the only academic study on backdating in canada, arguing that “[t]his void is likely not reflective of the lack of backdating or option timing in canada” but that “[t]he primary reason for this dearth of research in canada can be attributed to the differences in the availability of empirical data necessary to examine backdating in the united states and canada.” compton et al., supra note 3, at 366, 376. for example, siskinds llp, a canadian law firm specializing in class actions, has investigated stock option awards of a number of companies trading on the tsx and has found evidence of backdating behavior or other stock option manipulation in thirty-five companies and is investigating suspicious behavior in twentyfive others. julius melnitzer, manipulation ‘serious problem’, fin. post, sept. 19, 2007, at fp1. in addition, investment researchers found evidence of options timing among s&p/tsx 60 companies: “on average, prices were 50 basis points higher 10 days before the grant date, and more than 100 basis points higher 15 days after the grant date.” sam la bell & chris silvestre, veritas investment research, stock option backdating: could it happen here? 3 (2006). finally, a number of canadian companies have voluntarily and proactively, albeit quietly, launched internal reviews of their options granting procedures. see compton et al., supra note 3, at 378. however, the options dating practices of only a handful of companies have garnered media attention in canada. 71 had these options been issued or outstanding after 2004, the tax treatment in the united states would be radically different (and more severe) for in-the-money options due to the application of i.r.c. § 409a. see supra subpart ii.b and accompanying notes. 2012] quantifying the tax benefits of backdating 163 table 2: summary of tax implications from example 3: sale on different date in same year as exercise canada us at-the-money backdated at-the-money reduced share in-the-money at-the-money backdated at-the-money reduced share in-the-money at exercise at exercise # of options 30,000 30,000 23,234 30,000 30,000 30,000 23,234 30,000 exercise price $14 $18 $18 $14 $14 $18 $18 $14 fmv at exercise $23 $23 $23 $23 $23 $23 $23 $23 total income benefit $255,600 $131,100 $101,533 $255,600 $255,600 $131,100 $101,533 $255,600 deduction $127,800 $65,550 $50,766 $n/a n/a n/a n/a taxable income benefit $127,800 $65,550 $50,766 $255,600 $255,600 $131,100 $101,533 $255,600 taxable income benefit $37,062 $19,010 $14,722 $74,124 $74,124 $38,019 $29,444 $74,124 tax owed $218,538 $112,091 $86,810 $181,476 $181,476 $93,081 $72,088 $181,476 net employee benefit $30,000 $30,000 $23,234 $30,000 $30,000 $30,000 $23,234 $30,000 at sale at sale sale price $25 $25 $25 $25 $25 $25 $25 $25 gain on shares $66,900 $66,900 $51,812 $66,900 $66,900 $66,900 $51,812 $66,900 taxable gain on shares $33,450 $33,450 $25,906 $33,450 n/a $66,900 $51,812 $66,900 tax owed on gain $9,701 $9,701 $7,513 $9,701 $19,401 $19,401 $15,025 $19,401 total tax owing $46,763 $28,710 $22,235 $83,825 $93,525 $57,420 $44,470 $93,525 total net employee benefit $275,738 $169,290 $131,109 $238,676 $228,975 $140,580 $108,875 $228,975 canadian advantage (%) 20.42 20.42 20.42 4.24 164 columbia journal of tax law [vol.3:144 in canada, if the options are exercised and sold in the same tax year, then the employee income benefit inclusion (and offsetting deduction under paragraph 110(1)(d), if applicable) is identical to that described in example 1. in addition, the employee realizes a capital gain 72 on the disposition of the shares, only one-half of which is subject to tax. in this example, the capital gain for all but the reduced share option award is $66,900 [30,000 × ($25.00 – $22.77)], giving rise to a taxable capital gain of $33,450. this amount is taxed at the individual’s marginal tax rate (assumed to be twenty-nine percent) for a total tax owing on the capital gain of $9,700.50. the capital gain for the reduced share option award is $51,811.82 for a total tax owing on the taxable portion of the gain of $7,512.71. because the tax treatment of the capital gain does not vary according to the underlying option characteristics, it does not affect the conclusions reached regarding the tax benefit of backdated options in example 1. the highest after-tax benefit arises from the backdated at-the-money options, and the lowest from the fixed-value options granted on november 30 based on the $18.40 strike price. in the united states, since the executive held the shares for less than a calendar year, the individual will again not benefit from iso treatment. for all the cases (ignoring the implications of i.r.c. § 409a 73 ), the employee benefit is the same as that summarized in table 1. in addition, due to the sale price of $25.00, the employee realizes a capital gain of $66,900 on the disposition (the same amount as in canada), except that because the employee held the shares for less than a year, the capital gain is a short-term capital gain and is subject to tax at the same marginal tax rate as other income (assumed to be twenty-nine percent). d. example 4—vest over five years; sale more than one year after exercise in the fourth example, we extend example 3 by changing the sale date to be more than one year after the exercise date. the price of the underlying share on the exercise date is still $22.77, and the eventual sale price is assumed to be $25, the same as in example 3. table 3 summarizes the tax consequence of this example in canada and the united states. in canada, as the options are exercised and sold in different years, we now have to consider the role of the deferral introduced in 2000, assuming that the options are exercised prior to march 4, 2010. 74 the amount that may be deferred is limited to the benefit arising on $100,000 worth of stock options per year of vesting (based on the fair market value of the underlying stock when the options were granted). in the first scenario—backdated options that are reported as being at-the-money—the maximum number of stock options vesting in any one year that can benefit from the deferral is 7,017, which is calculated by dividing the $100,000 limit by $14.25, the purported fair market value of the underlying stock when the options were granted. since only 6,000 options vest each year, the entire employee benefit arising on the exercise of all 30,000 options is deferred from the year that the options are exercised until the year of sale. upon the sale of the stock, the individual includes the deferred income benefit in his income, claims the fifty percent deduction under 72 the gain realized is assumed to be a capital gain rather than an ordinary gain, although this characterization may be a matter of some dispute. see generally daniel sandler, the adventure in venture capital: capital gains vs. ordinary income, 42 tax notes int’l 621 (2006) (discussing the history in the common law system of failing to completely distinguish between ordinary income and capital gains). 73 as in example 2, i.r.c. § 409a would radically alter the tax treatment of in-the-money options. 74 see i.t.a., s. 7(1.1). 2012] quantifying the tax benefits of backdating 165 paragraph 110(1)(d) of the i.t.a., 75 and pays the tax owing on the taxable income benefit in the amount of $37,062 and the taxable capital gain of $9,700.50. the total tax paid is $46,762.50 and the net employee benefit is $275,737.50. the absolute quantum of the benefit is the same as in example 3, not taking into account the time value of money. in this example, however, since the tax on the stock option benefit is deferred until a later year (since the shares are sold in a later year), the relative quantum of the benefit is greater than in example 3. if instead, the option had been properly dated as november 30 and had an associated strike price of $18.40, then the deferral is calculated using the fair market value at grant of $18.40 rather than $14.25. consequently, the maximum number of stock options vesting in any one year that can benefit from the deferral is 5,434, which is calculated by dividing the $100,000 limit by $18.40. since this number is less than the 6,000 options that vest each year under this plan, not all of the stock option benefit arising in the year of exercise can be deferred until the year of sale. the maximum benefit that the individual can defer is $118,732.90 [5 × 5,434 × ($22.77 – $18.40)]. the individual defers this amount to the year in which the shares are sold, but must include the remaining employee benefit ($12,367.10, representing the difference between the total employee benefit of $131,100 and the maximum deferral of $118,732.90) in the year of exercise. in the year of exercise, the individual can claim the fifty-percent deduction under paragraph 110(1)(d) of the i.t.a., 76 reducing the amount added to taxable income to $6,183.55 with associated tax liability of $1,793.23. since the stock has not been sold at this time, the executive must pay this tax liability from other income; the amount is small enough that this should not be onerous. upon the sale of the stock, the individual includes the deferred stock option benefit in income, claims the 50% deduction under paragraph 110(1)(d) of the i.t.a., 77 and pays the tax owing on the stock option benefit in the amount of $17,216.27 and the taxable capital gain of $9,700.50. the absolute quantum of the economic benefit to the employee in this scenario is the same as in example 3, but part of it must be paid at exercise rather than being deferred to the year in which the shares are sold (so that, as in the case of the backdated at-the-money options, the relative quantum of the benefit is greater than in example 3). under the reduced share option, the outcome is similar to the first scenario in this example, with the individual deferring the full stock option benefit until the year of sale. 78 in the case of the in-the-money option award, the individual cannot defer the income inclusion beyond the time the options are exercised. at exercise, the individual must report the full income benefit of $255,600 and pay tax amounting to $74,124. since the stock has not been sold at this time, the executive must pay this much larger tax liability from other income sources. but when the shares are ultimately sold, the individual pays only the tax owing on the capital gain. 75 see i.t.a., s. 110(1)(d). 76 see id. 77 see id. 78 see i.t.a., s. 7(1.1). 166 columbia journal of tax law [vol.3:144 table 3: summary of tax implications from example 4: sale more than one year after exercise canada us at-the-money backdated at-the-money reduced share in-the-money at-the-money backdated at-the-money reduced share in-the-money at exercise at exercise # of options 30,000 30,000 23,234 30,000 30,000 30,000 23,234 30,000 exercise price $14.25 $18.4 $18.4 $14.25 $14.25 $18.4 $18.4 $14.25 fmv at exercise $22.77 $22.77 $22.77 $22.77 $22.77 $22.77 $22.77 $22.77 total income benefit $255,600 $131,100 $101,533 $255,600 $255,600 $131,100 $101,533 $255,600 income benefit deferral $255,600 $118,733 $101,533 n/a $255,600 $118,733 $101,533 n/a net income benefit at exercise/ vesting $$12,367 $$255,600 $$12,367 $$255,600 deduction n/a $6,184 n/a n/a n/a taxable income benefit at exercise $6,184 $255,600 $255,600 tax owed at exercise $$1,793 $$74,124 $$3,586 $$74,124 us amt $71,568 $67,982 $28,429 $ 2012] quantifying the tax benefits of backdating 167 at sale at sale sale price $25 $25 $25 $25 $25 $25 $25 $25 gain on shares $66,900 $66,900 $51,812 $66,900 $322,500 $185,633 $153,344 $66,900 taxable gain on shares $33,450 $33,450 $25,906 $33,450 $322,500 $185,633 $153,344 $66,900 tax owing on gain $9,700.50 $9,701 $7,513 $9,701 $48,375 $27,845 $23,002 $10,035 deferred income $255,600 $118,733 $101,533 n/a n/a n/a n/a n/a deduction $127,800 $59,366 $50,766 n/a n/a n/a n/a n/a taxable income benefit at sale $127,800 $59,366 $50,766 n/a n/a n/a n/a n/a tax owing on income benefit $37,062 $17,216 $14,722 n/a n/a n/a n/a n/a amt credit (if any) $38,340 $17,810 $8,495 tax owed at sale $46,763 $26,917 $22,235 $9,701 $10,035 $10,035 $14,507 $10,035 total tax paid $46,763 $28,710 $22,235 $83,825 $81,603 $81,603 $42,936 $84,159 total net employee benefit $275,738 $169,290 $131,109 $238,676 $240,897 $116,397 $110,409 $238,341 canadian advantage (%) 14.46 45.44 18.75 0.14 168 columbia journal of tax law [vol.3:144 a backdated option does not qualify for the deferral. if an executive reports a backdated option as an at-the-money award, exercises and sells it in different years, and does not report the stock option benefit in the exercise year (i.e., the executive claims the deferral), then the individual is underpaying taxes in the exercise year by $74,124. in addition, in the sale year when the stock option benefit is recognized, the executive is also improperly reporting the deduction under paragraph 110(1)(d). thus, employees who receive backdated stock options may be reassessed not only to deny any deduction claimed under paragraph 110(1)(d), but also to include the full stock option benefit in an earlier year than that in which the employee reported the benefit for tax purposes. such reassessment would also include interest, compounded daily at a relatively high rate. furthermore, if the executive knew of the backdating, he or she may be subject to gross negligence penalties and could even be charged with tax evasion. 79 in the united states, the significant difference between this example and example 3 is that, in this case, the options meet the holding period requirement for iso treatment. 80 recall that the first scenario involves backdated options with an exercise price of $14.25, purportedly the fair market value of the shares at the time of grant. in that scenario, not only is there no stock option benefit in the year of exercise, but also the entire gain (the difference between the ultimate sale price of $25 per share and the strike price of $14.25 per share) is a long-term capital gain and is subject to tax at the preferential rate of fifteen percent. 81 thus, the only tax obligation faced by the individual in the absence of amt, discussed below, is tax of $48,375 in the year of sale, leaving an after-tax benefit to the employee of $274,125, only marginally less than the after-tax benefit in canada. the deferral of the benefit from the year the options are exercised is a tax preference for amt purposes. 82 for the purposes of computing the u.s. executive’s amt liability, the amount of the stock option benefit in the year the option is exercised, $255,600 (30,000 × [$22.77 – $14.25]), is included in the computation of alternative minimum taxable income (“amti”). the impact of the amt is that the u.s. executive’s tax liability is essentially accelerated to the year the option is exercised and is subject to amt at a relatively high rate (26-28%, depending on the amount of amti). 83 for illustration purposes in table 3, we have assumed that the executive’s compensation in addition to the stock option benefit is high enough both to make the amt rate associated with the stock option benefit twenty-eight percent and to eliminate the benefit of the exemption amount for amt purposes. 84 thus, the tentative minimum tax associated with the deferral would be $71,568 (twenty-eight percent of $255,600) although the amt payable would likely be somewhat less. 85 as a consequence, the tax payable by the employee in the year of 79 see supra note 62. 80 see i.r.c. §§ 421(a), 422(b) (2006). 81 see i.r.c. § 1(h) (2006). 82 see supra note 39. see also i.r.c. § 56(b)(3) (2006). 83 see i.r.c. § 55(b) (west 2011). 84 see i.r.c. § 55(d) (west 2011). assuming that the individual is married and files a joint return, the amti must be at least $330,000 to eliminate the exemption amount. 85 in our example, if the executive’s effective marginal tax rate of twenty-nine percent applies to a sufficient portion of the taxpayer’s income (for regular income tax purposes), then the amt payable would be approximately one percent less than $71,568 (and, as the income subject to a marginal tax rate exceeding twenty-eight percent increases, the amount of amt decreases). because of the various factors that can affect amt, we have assumed for illustration purposes in table 3 that amt is equal to the tentative minimum tax payable. see supra note 39. 2012] quantifying the tax benefits of backdating 169 exercise is dramatically higher in the united states than in canada—and will have to be paid from other sources of income if the employee wishes to avoid selling any shares acquired in that year. the amount of amt can be carried forward and applied as a credit in subsequent years to the extent that the executive’s regular tax liability in that year exceeds the tentative minimum tax for that year. 86 assuming there is significant income taxed at the highest marginal rate (assumed to be twenty-nine percent), there would be a tax saving each year (i.e., at least the one-percent difference between the amt rate and the regular tax rate). in the year the shares are sold, the amt liability is computed on the assumption that the cost base of the shares for amt purposes is $22.77 rather than the $14.25 cost assumed for regular tax purposes. however, because the long-term capital gains tax rate of fifteen percent is applicable for both amt and regular tax purposes, the amt credit available that year will, in effect, be limited to fifteen percent of the benefit included in income in the year of exercise rather than the full amt paid that year. 87 thus, the amt liability in the year of exercise may act as more than an anti-deferral mechanism; it acts as a real cost in this case to the extent that the credit cannot be fully utilized by the time the shares are sold. as indicated in table 3, the canadian executive enjoys a net employee benefit of almost $35,000, or 14.5% more than the u.s. executive. 88 in the second scenario in the united states, only 5,434 options per year of vesting qualify for iso treatment. 89 since this is less than the 6,000 options that vest each year under this plan, the excess options (566 per year) are treated as nsos, with the stock option benefit on these options subject to tax in the year of exercise. 90 consequently, in the year of exercise, the stock option benefit on 27,170 exercised options will be deferred until the year in which the shares are sold for regular income tax purposes, with the balance 91 subject to tax in the year of exercise. 92 subject to amt, the result is similar to that in canada, except that there is no equivalent to the deduction under paragraph 110(1)(d) of the i.t.a., so that the entire $12,367.10 is subject to tax in the year of exercise at the employee’s marginal tax rate. 93 for amt purposes, however, the entire stock option benefit (including the 5,434 options that qualify for iso treatment) is included in income in 86 see i.r.c. § 53(b) (2006). 87 see i.r.c. § 55(b) (west 2011). assuming that the executive’s compensation in addition to the stock option benefit is high enough to make the amt rate twenty-eight percent (on income other than the long-term capital gain) and to eliminate the benefit of the exemption amount, the amt payable on the long-term capital gain will be $10,035 [15% × 30,000 × ($25 – $22.77)] compared to the regular tax of $48,375, so that $38,340 of the amt credit carried over from the year of exercise could be applied to the extent that it has not been previously used. in other words, approximately 53.5% (far less than all) of the amt credit carried over from the year the options were exercised could be applied in the year of sale to reduce the regular tax otherwise owing that year. see i.r.c. § 55 (west 2011); i.r.c. § 56 (2006). 88 see supra table 3. 89 see i.r.c. §§ 421(a), 422(a)-(b) (2006). 90 see i.r.c. § 83 (2006). 91 in this scenario, the benefit on 2,830 options. 92 see i.r.c. §§ 421(a), 422(d) (2006). 93 id.; see also i.r.c. § 55(b) (west 2011); i.r.c. § 56(b)(3) (2006). 170 columbia journal of tax law [vol.3:144 the year of exercise, dramatically increasing the tax liability in that year. 94 thus, for amt purposes, the tentative minimum tax payable would be the same as in the first scenario. 95 in the year of sale in the second scenario, the deferred stock option benefit will form part of the long-term capital gain realized by the employee, so that for regular income tax purposes the employee benefits not only from a deferral of this income inclusion, but also from the application of the long-term capital gains tax rate of fifteen percent. 96 the $185,632.90 long-term capital gain in the year of sale is made up of $179,322 97 plus $6,310.90. 98 this amount is subject to tax at the rate of fifteen percent, for a tax liability of $27,845. 99 as in the first scenario, the amt liability in the year the shares are sold is computed on the assumption that the cost base of the shares for amt purposes is $22.77 rather than the $14.25 cost assumed for regular tax purposes. 100 assuming that the executive’s compensation in addition to the stock option benefit is high enough for an amt rate of twenty-eight percent to apply on income other than the long-term capital gain, and is high enough for the benefit of the exemption amount to be eliminated, the amt payable on the longterm capital gain will be $10,035, 101 compared to the regular tax of $27,845. therefore, $17,810 of the amt credit carried over from the year of exercise could be applied to the extent that it has not been previously used. 102 due to the significant amt liability in the year of exercise, which is only partially creditable in the year of sale, the u.s. executive is in a substantially worse position than the canadian executive. 103 under the reduced share option scenario in the united states, the regular income tax treatment in the year of exercise is similar to that in the first scenario, with the individual deferring the full stock option benefit until the year of sale. however, for amt purposes, the entire stock option benefit is included in amti. 104 based on the same assumptions as in the preceding scenarios, the amt liability would be $28,429 in the year of exercise. 105 in the year of sale, the regular tax liability would be $23,002 compared to an amt liability of $14,507, so that an amt credit of $8,495 could be applied to reduce the tax liability to $14,507. 106 again, the resulting after-tax benefit to the employee is significantly less than that in canada. 107 94 see supra note 39 and accompanying text. 95 see supra note 39 and accompanying text (the amt payable will be somewhat less than the tentative minimum tax payable); see also supra table 3 (for illustrative purposes, the amt is assumed to be the difference between $71,568 tentative minimum tax payable and the $3,586 regular tax payable on the 2,830 options). 96 see i.r.c. § 1(h) (2006). 97 the gain realized on the 27,170 (5 × 5,434) isos, calculated as [27,170 × ($25 – $18.40)]. see i.r.c. § 421(a) (2006). 98 the gain realized on the 2,830 (5 × 566) nsos, calculated as [2,830 × ($25 – $22.77)]. see i.r.c. § 83(a) (2006). 99 see i.r.c. § 1(h) (2006). 100 see i.r.c. § 56(b)(3) (2006). 101 15% × 30,000 × ($25 – $22.77) = $10,035. see i.r.c. §§ 55(b), (d) (west 2011). 102 see i.r.c. § 53(a) (2006). 103 see supra table 3 (the canadian executive enjoys a net employee benefit of almost $53,000, or 45.4% more than the american executive in this scenario). 104 i.r.c. § 56(b)(3) (2006). 105 see supra pp. 158-59 (discussing the assumptions behind the preceding examples). 106 see supra table 3. 107 the canadian executive realizes $20,700 after tax, or 18.75% more than the u.s. executive. see id. 2012] quantifying the tax benefits of backdating 171 finally, the in-the-money option scenario does not benefit from iso treatment, so the entire stock option benefit is subject to tax in the year of exercise at the employee’s marginal tax rate (and therefore no amt will be payable). 108 however, the gain realized on the ultimate sale of the shares is a long-term capital gain that is taxed at the fifteen percent preferential rate. 109 the after-tax benefit to the u.s. employee in this one scenario is only marginally less than that in canada. 110 the fourth example demonstrates that the potential impact of the amt can more than offset the preference for isos in the united states so that only in relatively few circumstances 111 is an american executive in a similar (or perhaps better) position than a canadian executive. this example also highlights another phenomenon, not explored in this paper, of “exercise backdating.” 112 for u.s. executives, exercise backdating could mean the difference between iso treatment and nso treatment (but in the year the stock was sold, as it would be a disqualified disposition of isos) for up to $100,000 worth of options per vesting year. 113 for canadian executives, exercise backdating is unlikely to occur because there is no holding period requirement in canada in order to benefit from the preferential treatment in paragraph 110(1)(d). 114 in fact, exercise backdating would only result in an increased after-tax benefit when the employee is not entitled to a deduction under paragraph 110(1)(d). 115 exercise backdating is thus likely a phenomenon limited to the united states. iv. conclusion the goal of this paper was to highlight the significant effect of personal income taxes on the after-tax returns to backdated options held by canadian executives relative to u.s. executives. indeed, as the examples in the previous section indicate, canadian executives by and large are financially better off than their u.s. counterparts from employee stock options in all cases. 116 this holds true even for options that benefit from iso treatment in the united states, due to the 108 see i.r.c. §§ 83, 421(a), 422(b) (2006). 109 see i.r.c. § 1(h)(1)(c) (2006). 110 see emmanuel saez & michael veall, the evolution of high incomes in northern america: lessons from canadian evidence, 95 am. econ. rev. 831, 837, 845 (2005) (in fact, the after-tax benefit in this scenario could be higher in the united states than in canada because the marginal tax rate faced by most executives in canada is significantly higher than twenty-nine percent so that even though only one-half of the stock option benefit and one-half of the capital gain are included in income, the effective rate of tax on the benefit would likely exceed fifteen percent). 111 in the case of in-the-money options (the fourth scenario) as well as in situations where the executive has a sufficiently large amount of non-stock option income to eliminate or minimize the impact of amt. 112 dan dhaliwal et al., taxes and the backdating of stock option exercise dates, 47 j. acct. & econ. 27, 2729 (2009) (describing “exercise backdating” as the practice of reporting the exercise of stock options at an earlier time, and perhaps lower price, than the actual exercise date of the options). 113 see i.r.c. §§ 83(a), 421(a), 422 (2006). 114 see i.t.a., s. 110(1)(d). 115 in the case of in-the-money options (as distinct from backdated at-the-money options), which are almost never purposefully granted to canadian executives in any event due to stock exchange restrictions. see supra note 5. 116 see supra part iii (as illustrated in examples). 172 columbia journal of tax law [vol.3:144 application of amt. 117 this analysis also shows that personal income tax may have played a role in executives’ willingness to accept backdated options in canada but not in the united states. 118 our results raise an important policy question as to why executive stock options are treated in canada essentially as an investment rather than as compensation, 119 even when the options are exercised and sold at the same time. perhaps it is time for canada to rethink this deduction, either to eliminate it completely or to attach a holding period requirement similar to that in the united states. 120 finally, the discussion above indicates that there is a need to empirically investigate the incidence of backdating among canadian companies. no comprehensive study has been done on the extent to which backdating exists in canada, as has been done in the united states. is backdating a widespread problem in canadian financial markets or is it limited to only a handful of companies? similarly, no comprehensive study has been done to determine if backdated stock options have been supplanted by an alternative incentive award, such as restricted stock units (whether manipulated or not) or another nefarious pricing behavior such as the opportunistic timing of stock option repricing. 121 this investigation is necessary to inform policymakers of whether their existing efforts to combat option backdating have been successful, and whether they need to shift gears toward targeting more contemporary forms of fraudulent compensation practice. with respect to tax policy, another angle worth considering is how various changes to the canadian i.t.a. may have impacted the extent of backdating. 122 finally, investigating backdating in canada will provide results that will be useful not only for those in canada, but also to inform those interested in examining backdating in the united states. 117 see i.r.c. § 55 (west 2011). 118 see generally ryan a. compton et al., backdating, tax evasion, and the unintended consequences of canadian tax reform, 59 tax notes int’l 671 (2010) (discussing the link between canadian tax reform and stock option backdating). 119 see i.t.a., s. 110(1)(d). 120 see sandler, supra note 24, at 270-71 (suggesting such a rethinking back in 2001). see also liberal party of canada, your family. your future. your canada. 1, 11 (2011), available at http://cdn.liberal.ca/files/2011/04/liberal_platform.pdf (in the run-up to the 2011 federal election, the liberal party of canada, promised to limit the deduction to $50,000 annually by arguing that “[c]urrently, 8,000 canadians who earn more than $500,000 a year deduct an average of $400,000 from their taxable income based on stock options. many other taxpayers are claiming much more modest amounts. but those 8,000 high earners are receiving three-quarters of the total claimed under the stock option deduction . . . . the change will . . . return approximately $600 million to the public purse over two years.”). 121 such pricing behavior could take place as a result of responses by policymakers in canada and the united states to concerns about backdated stock options. 122 for example, there may be increased evidence of backdating following the introduction in 1984 of paragraph 110(1)(d) or the extension of the deferral of the stock option benefit in 2000 to public company employees. 2012] quantifying the tax benefits of backdating 173 appendix a key driver behind this paper is to isolate the role taxes may play in the returns from backdating and their influence on the decision by an executive to accept a backdated stock option in lieu of some other form of compensation (options or otherwise) as well as her decision to report a backdated option for tax purposes. to further clarify beyond the main text, consider the factors that determine the monetary return from a stock option for a single share that has been exercised and then subsequently sold (v) at the same time or later in the same tax year: 123 v = (pe – px)(1 – τy) + (ps – pe)(1 – τg) (1) where pe represents the price of the underlying share at option exercise, px is the option exercise price, τy is the tax rate on the income benefit associated with the option exercise, ps is the price of the stock once finally sold, and τg is the tax on any gains arising over the period the share was acquired and then eventually sold. equation (1) is essentially composed of two parts: (a) the income benefit accrued when the option is exercised (assuming that the exercise price is less than the existing market price), which is taxed at rate τy; and (b) the capital gain realized from the time the options are exercised to the time the acquired stock is sold, which is taxed at rate τg. in the case where the option is exercised and sold on the same day, the gain is zero since ps = pe. px represents the exercise price associated with a given executive stock option. however, in the context of backdating, it is important to deconstruct px into two components: (a) the true price of the underlying stock at the time the executive stock option is granted (pt); and (b) the discount due to backdating (δ). px = pt – δ (2) this allows us to see clearly that in the case of no backdating, δ = 0 and therefore px = pt; the exercise price associated with the grant is equal to the true price of the underlying share at the time the options were granted. this is referred to as a “currently priced option.” in the case of δ > 0, the exercise price for the grant is lower than the actual share price at the time of the grant because px < pt. if it is claimed that the option was granted when the price was trading at px, then we have a “backdated option.” to account for this information, we can restate equation (1) as follows: v = (pe – pt + δ)(1 – τy) + (ps – pe)(1 – τg) (3) our interest lies in demonstrating three factors that affect the returns from a stock option (once it is exercised and the underlying stock is then sold): τy, τg, and δ. taking the derivative of (3) with respect to these three variables in turn yields the following: 123 this restriction eliminates the possibility of isos. the focus of this article is to understand the influence of taxes on backdating in canada, and canada does not have the equivalent of an iso. 174 columbia journal of tax law [vol.3:144 = (1-τy) > 0 (4) = –(ps – pe) < 0 (5) = –(pe – pt + δ) < 0 (6) equation (4) demonstrates that, assuming τy < 1 (i.e., the tax rate is less than one hundred percent), returns increase the larger the discount of the exercise price relative to the actual trading price on the day the option was granted (i.e., the more the option exercise price was backdated). this of course is the general principle behind backdating: lower the exercise price relative to the trading price at the time of grant to gain a higher return, and so this positive relationship between δ and v is fully expected. it shows that a backdated option will be preferred to a currently dated option. our focus, however, lies on the role taxes may play in determining the demand for a backdated option. there are two tax rates to consider: first, the tax related to the gain, and second, the tax related to the income benefit. in equation (5) we see a negative relationship between tax (τg) and returns to the executive, where τg represents the tax on capital gains accruing after exercising the option and holding the stock until sale. it is evident that this portion of the return is unrelated to the backdating discount, and so requires no further elaboration in the context of backdating. equation (6) is the equation of most interest in terms of the potential relationship between tax and the benefit from backdating. equation (6) demonstrates that a negative relationship exists between τy and v; the lower the tax on income received through exercising an option grant, the higher the return. as discussed in the main text, however, in canada different effective tax rates apply to the income benefit based on the reported presence of δ, whereas in the united states the same tax rate applies regardless. the effective rate of taxation with respect to the income benefit from stock options is higher in the united states than in canada, as canadians can claim a deduction equal to fifty percent of the income inclusion. but this reduced rate only applies if δ = 0, or the option is reported as such. 124 that is, equation (3) applies to the pre-i.r.c. § 409a environment in the united states whereas the situation in canada is better represented as follows: v = i[δ ≤ 0](pe – pt + δ)(1 – τy0) + i[δ > 0](pe – pt + δ)(1 – τy1) + (ps – pe)(1 – τg) (7) where i[·] is an indicator function that takes the value of one when the statement in the square brackets is true and zero when it is false. the relevant part of the value of the income benefit is then triggered by the indicator function for whether the option is discounted or not, as this can result in tax differences (τy0 vs. τy1) which can provide the tax incentive for an individual who receives a backdated option in canada to report it as though it were not. 124 see i.t.a., s. 7, 110(1)(d). 2012] quantifying the tax benefits of backdating 175 it follows that the canadian regime, where τy0 < τy1, rewards backdating 125 —or, more correctly, rewards backdating if the strike price reported for tax purpose is px and not pt. in terms of the decision to accept a backdated versus an in-the-money option, until recently in the united states an executive would be indifferent between the two options 126 whereas a canadian executive would not be indifferent. 127 as a result of the lower tax rate in canada on the income benefit of the option, a canadian executive is able to “capture” a greater amount of the backdated return than the u.s. executive. 125 the executive earns a higher after-tax return from a misreported backdated option in canada than in the united states. 126 the tax rate on the two would be identical. 127 canadian executives would prefer a misreported backdated option with the available income tax deduction, effectively lowering their tax rate, which is not available for an in-the-money option. microsoft word azam8-1.docx articles minimum global effective corporate tax rate as general anti-avoidance rule rifat azam* * radzyner school of law, idc herzliya, associate professor of law; columbia law school, adjunct associate professor of law, scholar-in-residence. i am grateful to columbia law school as well as professor david schizer, professor zohar goshen and professor avery katz for their warm hospitality and valuable support of my scholarship and teaching at columbia law school. i am thankful to professor itamar rabinovich, dr. ariel roth, dr. michael koplow, dr. erika falk and the israel institute for their wonderful faculty exchange and teaching fellows program that generously supported my time at columbia university. i appreciate the special contribution of my research assistant, deborah plum, to this article. 6 columbia journal of tax law [vol.8:5 i. introduction ........................................................................................................ 7 ii. the challenge: international corporate tax avoidance ...... 13 a. the current international corporate tax regime on american multinationals . 13 b. avoiding the regime ........................................................................................... 17 c. the data ............................................................................................................... 19 iii. the united states response to the challenge ................................ 22 a. ending deferral: current worldwide taxation ................................................... 23 b. ending worldwide taxation: sole territorial taxation ...................................... 24 c. in between worldwide & territorial taxation .................................................... 25 d. minimum taxation .............................................................................................. 27 e. limiting corporate inversions ............................................................................. 28 f. modifying the u.s. bilateral tax treaty law ..................................................... 30 iv. the g20/oecd international response in the beps project ........ 31 v. the proposed minimum global effective corporate tax rate as general anti-avoidance rule ............................................................ 35 a. the proposal ........................................................................................................ 35 b. the justifications of the proposal ........................................................................ 38 1. endless possibilities of international corporate tax avoidance ................. 38 2. effectiveness of technical general anti-avoidance rules ........................... 39 3. reducing the lock out effect ........................................................................ 44 4. limiting profit shifting .................................................................................. 45 5. u.s. competitiveness ..................................................................................... 46 6. fairness ......................................................................................................... 47 7. economic efficiency ...................................................................................... 49 8. political feasibility ....................................................................................... 49 9. constructive unilateralism ........................................................................... 51 c. comparisons: the proposal & other proposals of minimum taxation .............. 52 1. former president obama’s 19% minimum tax on future foreign income 52 2. shay, fleming & peroni interim minimum tax ............................................ 53 3. grubert & altshuler minimum tax versions ................................................ 54 d. exploring counter arguments ............................................................................. 54 1. the presumption of illegitimate tax avoidance based on low effective corporate tax rate is too strong ................................................................. 54 2. unilateralism & contradiction with treaty law .......................................... 55 vi. conclusion .......................................................................................................... 55 2017] minimum global effective corporate tax rate 7 but there are some areas where we just have to be honest -it has been difficult to find agreement over the last seven years. and a lot of them fall under the category of what role the government should play in making sure the system’s not rigged in favor of the wealthiest and biggest corporations. and it's an honest disagreement, and the american people have a choice to make. i believe a thriving private sector is the lifeblood of our economy. i think there are outdated regulations that need to be changed. there is red tape that needs to be cut. … but after years now of record corporate profits, working families won’t get more opportunity or bigger paychecks just by letting big banks or big oil or hedge funds make their own rules at everybody else’s expense. middle-class families are not going to feel more secure because we allowed attacks on collective bargaining to go unanswered. food stamp recipients did not cause the financial crisis; recklessness on wall street did. immigrants aren’t the principal reason wages haven’t gone up; those decisions are made in the boardrooms that all too often put quarterly earnings over long-term returns. it’s sure not the average family watching tonight that avoids paying taxes through offshore accounts. the point is, i believe that in this new economy, workers and startups and small businesses need more of a voice, not less. the rules should work for them. and i'm not alone in this. this year i plan to lift up the many businesses who’ve figured out that doing right by their workers or their customers or their communities ends up being good for their shareholders. and i want to spread those best practices across america. that's part of a brighter future. (barack obama, former president of the united states)1 i. introduction more than $2 trillion of foreign profits generated by american multinationals is purposefully locked out of the united states2 in order to avoid u.s. taxation upon repatriation and to benefit from the deferral rule of the u.s. internal revenue code,3 which allows u.s. corporations with controlled foreign corporations (cfcs) to defer taxation of the foreign-sourced active income of the cfc subsidiary until it is repatriated 1 former president obama, final state of the union, (jan. 12, 2016) (http://www.whitehouse.gov/sotu) (19:40-22:45); http://www.whitehouse.gov/the-pressoffice/2016/01/12/remarks-president-barack-obama-%e2%80%93-prepared-delivery-state-union-address [http://perma.cc/cjn6-2j2g]. 2 see parking a-lot overseas, credit suisse (mar. 17, 2015), http://doc.research-andanalytics.csfb.com/docview?language=eng&format=pdf&source_id=em&document_id=1045617491&ser ialid=jhde13pmaivwzhranjgldcv3rbekre9uz%2bzu3zxtqu0%3d [http://perma.cc/8bfz-r7tz] (last visited nov. 29, 2016); john l. campbell et al, u.s. multinational corporations’ foreign cash holdings: an empirical estimate and its valuation, (2014), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2277804; republican staff, s. fin. comm., comprehensive tax reform for 2015 and beyond (2014). 3 i.r.c. § 951-965. 8 columbia journal of tax law [vol.8:5 through dividend distributions to the u.s. parent company. 4 several american multinationals, including apple and google, used irish and dutch and tax haven subsidiaries in tax planning schemes to reduce their american and worldwide tax liability substantially.5 just recently, the european commission has concluded that ireland violated the eu state aid rules by granting undue tax benefits of up to €13 billion to apple, allowing apple to pay substantially less tax than other businesses. the commission determined that ireland must recover the illegal aid.6 the u.s. responded by supporting apple and all u.s. multinationals in this litigation.7 as the examples above indicate, american multinationals regularly design intricate tax planning schemes within the confines of the internal revenue code and its regulations in order to legally avoid corporate tax.8 furthermore, by disconnecting their tax jurisdiction from their economic jurisdiction, these multinationals are succeeding in substantially reducing their global effective corporate tax rate to as low as 15% for taxes paid to the u.s. government and 19% for taxes paid to the u.s. and foreign governments combined.9 while their economic jurisdiction is in the u.s. and other developed and high tax countries, their tax jurisdiction is located in countries which allow for partial and even complete tax avoidance through the use of several loopholes including intracompany loans, transfer pricing, and tax havens. in 2010, more than 70% of u.s. corporate foreign profits were located in bermuda and the cayman islands.10 these results are not representative of u.s. policy but rather of the failure of the u.s. international tax regime and, more generally, the failure of the world international tax 4 see stephan shay, the truthiness of lockout: a review of what we know, 146 tax notes 1393 (2015). 5 see edward kleinbard, stateless income, 11 fla. tax rev. 699 (2011); jesse drucker, google 2.4% rate shows how $60 billion is lost to tax loopholes, bloomberg (oct. 21, 2010), http://www.bloomberg.com/news/articles/2010-10-21/google-2-4-rate-shows-how-60-billion-u-s-revenuelost-to-tax-loopholes [http://perma.cc/v849-nqua]. 6 state aid: ireland gave illegal tax benefits to apple worth up to €13 billion, eur. commission, http://europa.eu/rapid/press-release_ip-16-2923_en.htm [http://perma.cc/l39e-nh3p] (last visited nov. 29, 2016). 7 see dep’t. of the treasury, white paper, the european commission’s recent state aid and investigations of transfer pricing rulings (2016), http://www.treasury.gov/resource-center/taxpolicy/treaties/documents/white-paper-state-aid.pdf [http://perma.cc/6eg7-suu2]. see also romero tavares, bret bogenschneider, marta pankiv, the intersection of eu state aid and u.s. tax deferral: a spectacle of fireworks, smoke, and mirrors, 19(3) fla. tax rev. 121 (2016); shafi khan niazi, an account of recent activity of the european commission on applying state aid rules to income taxes: in retrospect and prospect (2016); liza lovdahl gormsen, eu state aid law and transfer pricing: a critical introduction to a new saga, 10 j. of eur. competition l. & prac. 1039 (2016); elizabeth jone, state aid in the eu through tax rulings and transfer pricing (2016). 8 see edward kleinbard, through a latte, darkly: starbucks’s stateless income planning, tax notes 1515, 1535 (jun. 24, 2013); antony ting, itax – apple’s international tax structure and the double non-taxation issue, brit. tax rev. (2014), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2411297; charles duhigg, david kocieniewski, how apple sidesteps billions in taxes, n.y. times (apr. 29, 2012), http://www.fiaeofnevada.org/wp-content/uploads/applesidestepsbillions-nyt-may2012.pdf [http://perma.cc/psx8-ktdv] (last visited nov. 27, 2016); robert wood, twitter follows apple, google, and facebook to irish holy grail, forbes (oct. 20, 2013) http://www.bloomberg.com/news/articles/201010-21/google-2-4-rate-shows-how-60-billion-u-s-revenue-lost-to-tax-loopholes [http://perma.cc/awe77fuw] (last visited nov. 27, 2016). 9 see gabriel zucman, the hidden wealth of nations: the scourge of tax havens (2015). 10 see i.r.s., statistics of income (2014). u.s. corporations and their controlled foreign corporations: number, assets, receipts, earnings, taxes, distributions, subpart f income, and related party transactions, by selected country of incorporation of controlled foreign corporation, tax year 2010. 2017] minimum global effective corporate tax rate 9 regime. according to one recent estimate, these failures cost the u.s. treasury about $130 billion a year.11 therefore, the urgent and pertinent challenge is to combat international corporate tax avoidance, in the u.s. and worldwide. this challenge places the economy, society, and democracy at risk.12 as thomas pikety put it clearly: it is our basic social contract that is at stake. if middle-class taxpayers feel that they are paying higher effective tax rates than those at the top of the pyramid, if small and medium-size businesses feel that they are paying more than our largest companies, then there is a serious risk that the very notion of fiscal consent – which is at the core of modern democracies – will fall apart altogether.13 therefore, it is not surprising that this challenge occupies the headlines of leading newspapers.14 this issue has dominated public debate in the more formal or political arena and has also captivated the attention and interest of an increasingly involved and demanding general public.15 it is one of the top priority of policy makers in 11 see zucman, supra note 9, stephanie sikes & robert verrecchia, externalities of corporate tax avoidance (2014), http://www.mccombs.utexas.edu/~/media/files/msb/departments/accounting/tarc/2014/sikes%20verrec chia%20paper.pdf [http://perma.cc/x2sw-jg45]. 12 see zucman, supra note 9; sikes, supra note 11. 13 thomas piketty, foreword to gabriel zucman, the hidden wealth of nations: the scourge of tax havens (2015). 14 see, e.g., the great corporate tax dodge, bloomberg, http://topics.bloomberg.com/the-greatcorporate-tax-dodge/ [http://perma.cc/rd2p-wl6j] (last visited nov. 29, 2016), charles duhigg & david kocieniewski, how apple sidesteps billions in taxes, n.y. times (apr. 28, 2012), http://www.nytimes.com/2012/04/29/business/apples-tax-strategy-aims-at-low-tax-states-and-nations.html [http://perma.cc/t8se-8psh]; jesse drucker, google revenues sheltered in no-tax bermuda soar to $10 billion, bloomberg (dec. 10, 2012), http://www.bloomberg.com/news/2012-12-10/google-revenuessheltered-in-no-tax-bermuda-soar-to-10-billion.html; richard waters, microsoft’s foreign tax planning under scrutiny, fin. times (jun. 7, 2011), http://www.ft.com/cms/s/2/0880cd54-90a1-11e0-953100144feab49a.html#axzz2sl7hviaz [http://perma.cc/6h6t-8ek8]; the new york times published an interactive look at what s&p 500 companies paid in corporate income taxes – federal, state, local and foreign – from 2007 to 2012 according to s&p capitol iq, across u.s. companies, tax rates vary greatly, n.y. times, http://www.nytimes.com/interactive/2013/05/25/sunday-review/corporate-taxes.html?ref=sunday [http://perma.cc/hgp7-yv8h] (last visited nov. 29, 2016); offshore shell games 2015, citizens for tax just., http://ctj.org/ctjreports/2015/10/offshore_shell_games_2015.php#.vqldypkrjpg [http://perma.cc/4vd7-qgu6] (last visited nov. 29, 2016), pulling the plug: how to stop corporate tax dodging in europe and beyond, oxfam, http://www.oxfam.org/sites/www.oxfam.org/files/file_attachments/bn-pulling-plug-corporate-tax-eu-190315en.pdf [http://perma.cc/bsg5-ydpd] (last visited nov. 29, 2016). 15 see tax justice blog, tax just. network, http://www.taxjustice.net/ [http://perma.cc/2arll8l3] (last visited nov. 29, 2016); am. for tax fairness, http://www.americansfortaxfairness.org/ [http://perma.cc/3dm5-vlh2] (last visited nov. 29, 2016); tax justice blog, citizens for tax just., http://ctj.org/ [http://perma.cc/b9xw-ws3b] (last visited nov. 29, 2016); the tax policy blog, tax found., http://taxfoundation.org/blog [http://perma.cc/8gqg-byvg] (last visited nov. 29, 2016); forstater, maya & ramachandran, vijaya, how much do we really know about multinational tax avoidance and how much is it really worth?, ctr. for global dev. (dec. 7, 2015), http://www.cgdev.org/blog/how-much-do-wereally-know-about-multinational-tax-avoidance-and-how-much-it-really-worth [http://perma.cc/wh3jgm7t]; paul buchheit, 6 facts about corporate tax avoidance, inst. for pol’y stud. (oct. 1, 2015) http://inequality.org/6-facts-corporate-tax-avoidance/ [http://perma.cc/s48d-2qlf]. 10 columbia journal of tax law [vol.8:5 the u.s., the eu, the oecd and globally.16 most american presidential candidates propose international corporate tax reform in their campaigns.17 despite the resistance that such proposals continue to face, it seems that, after extensive debates by congress, reform is imminent – even if limited in scope.18 on several occasions, including his fy 2016 budget, former president obama proposed to expand the corporate tax base by eliminating subsidies and loopholes, and to reduce the main corporate tax rate bracket from 35% to 28%.19 in addition, he proposed to partially end deferral by imposing a minimum corporate tax rate of 19% on deferred income whether repatriated or not. this minimum tax aims to reduce the incentives for tax avoidance and to keep investments in the united states.20 former president obama’s reform proposal added to a broad spectrum of proposals that have been made.21 the current international environment in which the u.s. policy and reform proposals are being offered is particularly interesting and unique because the organization for economic cooperation and development (oecd) had published the final base erosion and profit shifting (beps) reports22 on october 5, 2015 and the eu recently launched its own action plan for fair and efficient corporate taxation in the 16 see, e.g., jane g. gravelle, tax havens: international tax avoidance and evasion, cong. res. serv. (jan. 15, 2015), http://www.fas.org/sgp/crs/misc/r40623.pdf [http://perma.cc/p9ky-8nhv]; eur. commission, the fight against tax fraud and tax evasion, http://ec.europa.eu/taxation_customs/taxation/tax_fraud_evasion/index_en.htm [http://perma.cc/g7umpwax]; u.k. government policy: tax evasion and avoidance, gov.uk, http://www.gov.uk/government/policies/tax-evasion-and-avoidance [http://perma.cc/7wa7-rv84]; u.k. leads international efforts to clampdown on tax avoidance, gov.uk, http://www.gov.uk/government/news/ukleads-international-efforts-to-clampdown-on-tax-avoidance [http://perma.cc/b2f5-2y9m]; un economic and social council president urges stronger cooperation to thwart tax evasion and avoidance, http://www.un.org/apps/news/story.asp?newsid=52530#.vr-ia_krjpg [http://perma.cc/e3cr-5f8] un committee of experts on international cooperation in tax matters, http://www.un.org/esa/ffd/tax/ [http://perma.cc/577k-j6ph]. 17 tax found., comparing the 2016 presidential tax reform proposals, http://taxfoundation.org/comparing-2016-presidential-tax-reform-proposals [http://perma.cc/zuk2-9wg6]. 18 jeffrey kupfer, jonathan ackerman & rosanne altshuler, how tax reform can get done in 2016, cnbc (jan. 21, 2016), http://www.cnbc.com/2016/01/21/how-tax-reform-can-get-done-in-2016commentary.html [http://perma.cc/y7sh-edvf] “speaker of the house paul ryan announced he will make tax reform—often considered a noble cause but a futile exercise —a priority in the upcoming year. ’instead of a tax code that all of us can live by, we have a tax code that none of us can understand,’ he said last month, speaking at the library of congress. ‘the only way to fix our broken tax code is to simplify, simplify, simplify. close all those loopholes and use that money to cut tax rates for everyone.’”; john harwood, despite pledges, tax reform remains and elusive goal, n.y. times (feb. 2, 2016), http://www.nytimes.com/2016/02/03/us/politics/despite-pledges-tax-reform-remains-an-elusivegoal.html?partner=rssnyt&emc=rss&_r=0 [http://perma.cc/8clr-gz9y]. 19 as known, the u.s. corporate tax rate includes several gradual marginal rates according to the taxable income of the corporate. however, most corporates fall within the 35% rate bracket. 20 see dep’t. of the treasury, general explanations of the administration’s fiscal year 2016 revenue proposals (2015), available at http://www.treasury.gov/resource-center/taxpolicy/documents/general-explanations-fy2016.pdf [http://perma.cc/2e54-abg6]. 21 see jane gravelle, cong. research serv., rl34115, reform of u.s. international taxation: alternatives (2015). 22 beps 2015 final reports, oecd, http://www.oecd.org/tax/aggressive/beps-2015-finalreports.htm (last visited nov. 5, 2016) [http://perma.cc/lc6n-llyp]. 2017] minimum global effective corporate tax rate 11 eu as well as the anti-tax avoidance package.23 the oecd beps reports propose national, bilateral and multilateral rules on fifteen actions. generally speaking, the oecd rules fall into the following three main categories: (i) the general anti-avoidance rule to limit tax avoidance through treaty abuses by denying tax treaty benefits if obtaining any such treaty benefits was one of the principal purposes of any arrangement or transaction;24 (ii) the specific anti-avoidance rules that target specific avoidance strategies and try to neutralize them as effectively as possible, such as limiting interest deductibility and transfer pricing; and (iii) the disclosure and transparency rules that intend to provide tax authorities with the required information in order to apply the antiavoidance norms and limit international corporate tax avoidance, such as the mandatory disclosure regime in action 1225 and the country-by-country reporting regime in action 13.26 the u.s. participated actively in the beps process and discussed these actions and their implications on several occasions. still, it does not seem that the u.s. is going to implement the oecd proposals.27 however, the u.s. cannot ignore the oecd proposals as they signify substantial impending changes to the realm of international taxation. in this article, i propose to add a new provision to the u.s. internal revenue code that adopts a minimum global effective corporate tax rate that will serve as a general anti-avoidance rule and is targeted toward international corporate tax avoidance. according to this proposed new section, if the global effective corporate tax rate of any american multi-national corporation (mnc) is below 15%, the mnc will then be 23 generally speaking, the eu is trying to reform the corporate tax framework in the eu in order to tackle tax abuse, ensure sustainable revenues, and support a better business environment in the single market. to this end, the eu is considering several measures including re-launching the common consolidated corporate tax base (ccctb), enacting general anti-avoidance directive, increasing transparency, improving eu coordination. action plan on corporate taxation, eur. commission, http://ec.europa.eu/taxation_customs/taxation/company_tax/fairer_corporate_taxation/index_en.htm [http://perma.cc/9heg-zzg4] (last visited nov. 5, 2016); anti-tax avoidance package, eur. commission, http://ec.europa.eu/taxation_customs/taxation/company_tax/anti_tax_avoidance/index_en.htm [http://perma.cc/cz6d-6la6] (last visited nov. 5, 2016). 24 preventing the granting of treaty benefits in inappropriate circumstances, action 6 – 2015 final report, oecd, http://www.oecd.org/tax/preventing-the-granting-of-treaty-benefits-in-inappropriatecircumstances-action-6-2015-final-report-9789264241695-en.htm [http://perma.cc/mc6n-aqjh] (last visited nov. 5, 2016). 25 mandatory disclosure rules, action 12 – 2015 final report, oecd, http://www.oecd.org/tax/mandatory-disclosure-rules-action-12-2015-final-report-9789264241442-en.htm [http//perma.cc/wh5y-rkzp] (last visited nov. 5, 2016). 26 transfer pricing documentation and country-by-country reporting, action 13 – 2015 final report, oecd, http://www.oecd.org/tax/transfer-pricing-documentation-and-country-by-country-reportingaction-13-2015-final-report-9789264241480-en.htm [http://perma.cc/4p3g-vjwh] (last visited nov. 5, 2016). 27 see daniel shaviro, oecd-beps: should the u.s. be worried (dec. 18, 2015), http://www.law.nyu.edu/sites/default/files/upload_documents/shaviro-revised%20oecd-beps.pdf [http://perma.cc/23ka-y5sl]; the oecd base erosion and profit shifting report: should the united states be worried? (dec. 18, 2015), american enterprise institute, http://www.aei.org/events/the-oecd-baseerosion-and-profit-shifting-report-should-the-united-states-be-worried/ [http://perma.cc/fd7w-fxrv]; see also: gary hufbauer et al., the oecd’s “action plan” to raise taxes on multinational corporations, peterson inst. for int’l. econ., working paper 15-14 (sept. 2015). 12 columbia journal of tax law [vol.8:5 required to close the gap and pay the u.s. treasury up to the minimum.28 for purposes of my proposal, the global effective corporate tax rate will be calculated according to the ratio between the global corporate tax paid and the global earnings and profits (e&p) in the financial statements of the mnc.29 the tax imposed according to my proposed rule is an interim liability that serves to limit tax avoidance schemes on international transactions. i argue that this rule is expected to reduce the incentives for international tax avoidance because all mncs will be liable for the minimum global effective corporate tax rate no matter which tax-planning scheme is used. in my opinion, this regime improves the fairness and efficiency of the u.s. international corporate tax regime while protecting and maintaining the competitive position of american mncs in the global digital economy. i contend that my proposal is politically feasible in the u.s. because the u.s. must act in order to protect its base and its multinationals in the new international environment. without u.s. response, other unilateral or international responses are likely to negatively affect u.s. interests as the state aid cases of apple and other u.s. multinationals reveal. my proposal is feasible since it is consistent with the ideology and interests of both democrats and republicans. furthermore, the obama administration has already proposed a similar minimum tax, and the similarities between my proposal and that of the administration outweigh the differences.30 i use former president obama’s minimum taxation proposal to support the political feasibility of my minimum taxation proposal, but at the same time, i argue that my proposal is distinct and more appropriate than former president obama’s proposal and other proposals of minimum taxation such as the shay, fleming and peroni interim minimum tax31 and the grubert, altshuler minimum tax versions.32 if the united states adopts this proposed rule, it will substantially contribute, through “constructive unilateralism”, to international tax reform that will better equip the global community to meet the challenges of a twenty-first century digital economy. 33 this article contributes to a timely issue of international taxation. it brings a fresh perspective on the debate about international corporate tax avoidance. my proposal is innovative and distinct from current discourse and other proposals. little attention has been given by scholars of international corporate tax avoidance to the extensive literature and comparative experience available that addresses: (i) the impact of corporate tax 28 compare jeremy scott, obama's foreign earnings tax: 19% minimum doa but deemed repatriations key, forbes (feb. 5, 2015, 2:43 pm), http://www.forbes.com/sites/taxanalysts/2015/02/05/obamas-foreign-earnings-tax-19-minimum-doa-butdeemed-repatriations-key/#58d1046f25f1 [http://perma.cc/hk36-tsp4] with richard rubin & jonathan allen, obama wants a new tax on u.s. companies' overseas profits, bloomberg (jan. 31, 2015 7:07 pm), http://www.bloomberg.com/news/articles/2015-02-01/obama-said-to-propose-taxes-on-foreign-earningsoffshore-profit [http://perma.cc/5x7q-bthg]. 29 there are a number of methods that could be (and are) often used to define “effective corporate tax rate”, but i have selected this method and will explain my reason in part v below. 30 see dep’t. of the treasury, supra note 20. 31 see stephen e. shay, clinton fleming, & robert j. peroni, designing a 21st century corporate tax – an advance u.s. minimum tax on foreign income and other measures to protect the base, 17 fla. tax rev. 699 (2015). 32 see harry grubert & rosanne altshuler, fixing the system: an analysis of alternative proposals for the reform of international tax, 66(3) nat’l tax j. 671 (2013). 33 see reuven avi-yonah, constructive unilateralism: us leadership and international taxation, public law and legal theory research paper series (2015). 2017] minimum global effective corporate tax rate 13 avoidance at the national level and (ii) the government’s attempts to limit such behavior, particularly through regulatory reform.34 my proposal deviates from the current puzzling situation in that it utilizes the significant insights that this literature provides in order to improve reform efforts at the international level. therefore, rather than proposing an entirely new scheme that addresses the challenges presented by international corporate tax avoidance in an isolated manner, my proposal uses relevant experiences at the domestic level in the united states and in other countries as a foundation. following this introduction, part ii describes the current u.s. rules of international taxation on outbound and inbound transactions as well as the interaction between these rules and (i) the bilateral rules provided by the u.s. treaty network and (ii) the international norms such as the oecd norms. furthermore, part ii analyzes the challenges faced by the u.s. and the global tax regime as a result of international corporate tax avoidance. data is provided to illustrate the impact. part iii explores the current american responses to this challenge. part iv briefly describes the oecd international response through the beps project and examines the interactions between the american responses and the oecd responses. in part v, i present my proposal in detail, as well as the philosophy and justifications behind it. i compare my proposal to other proposals of minimum taxation, and i respond to counterarguments. i end my article with a brief conclusion. ii. the challenge: international corporate tax avoidance a. the current international corporate tax regime on american multinationals three main sources of tax norms determine the tax outcomes of american multinationals on their global activity and profits. the first is the domestic law of both the home country (i.e., the u.s.) and the source country.35 the second is tax treaty law implemented by the u.s. network of bilateral tax treaties36 based mainly on the u.s. model income tax convention and model technical explanation.37 the third, which is more controversial, relates to international tax norms as developed in customary international tax law or in the treaty network in addition to different documents and guidelines of the oecd and other international organizations.38 the way in which these three sources of tax norms interact is complex.39 34 see part v, section b.2 supra. 35 the “source country” refers to the country where the income is earned. 36 united states income tax treaties – a to z, i.r.s. (feb. 22, 2016), http://www.irs.gov/businesses/international-businesses/united-states-income-tax-treaties-a-to-z [http://perma.cc/zx4j-rw96]. 37 the u.s. model income tax convention and model technical explanation, i.r.s. (nov. 23, 2015), http://www.irs.gov/individuals/international-taxpayers/the-u-s-model-income-tax-convention-andmodel-technical-explanation [http://perma.cc/4l5p-8gec]. 38 see reuven avi-yonah, international tax as international law, 57 tax l. rev. 483 (2004). 39 see reuven avi-yonah, international tax as international law: an analysis of the international tax regime (2007). 14 columbia journal of tax law [vol.8:5 the u.s. domestic tax law is a hybrid regime that combines worldwide taxation and territorial taxation.40 to mitigate double taxation of the foreign-source income of u.s. corporations, the u.s. domestic tax law allows, subject to conditions and limitations, a credit for foreign income taxes. the worldwide pillar, as it applies to corporations, imposes u.s. taxation on u.s. corporations. a u.s corporation is defined as a corporation that is incorporated in the u.s.41 under the “check-the box” regulations, a business entity is generally eligible to choose how it is classified for federal tax law purposes, as a transparent pass-through or opaque entity.42 once defined as a domestic u.s. entity, the entity is subject to current u.s. taxation on its u.s. and foreign source income. however, by investing abroad through foreign subsidiaries, u.s. corporations are able to defer the current u.s. taxation of foreign source income generated through these foreign corporations until such earnings are, if at all, repatriated to the united states as dividends from the foreign subsidiary to the u.s. parent corporation. subpart f of the code provides a set of anti-deferral rules and subjects “subpart f income” of controlled foreign corporations (cfcs) to current u.s. taxation.43 according to section 951, every u.s. shareholder of a cfc shall include in his gross income his pro rata shares of the corporation’s subpart f income. but other foreign income of cfcs continues to enjoy deferral.44 in 2004, as a response to the first wave of corporate inversions, congress enacted section 7874 of the code, which serves as an anti-avoidance rule. in corporate inversions, an american parent company is replaced by a parent company in a 40 see generally on the u.s. international tax regime, reuven avi-yonah, diane ring, yariv brauner, u.s. international taxation (3rd ed., found. press 2010); michael graetz, foundations of international income taxation (2003); joseph isenbergh, international taxation: u.s. taxation of foreign persons and foreign income (4th ed. 2006); joel d. kuntz & robert r. peroni, u.s. international taxation (1991); adrian ogley, the principles of international tax: a multinational perspective (1993); sol picciotto, international business taxation: a study in the internationalization of business regulation; michael graetz & michael o’hear, the “original intent” of u.s. international taxation, 46 duke l. j. 1021 (1997); reuven s. avi-yonah, the structure of international taxation: a proposal for simplification, 74 tex. l. rev. 1301, 1303 (1996); robert a. green, the future of source based taxation of the income of multinational enterprises, 79 cornell l. rev. 18 (1993); charles i. kingson, the coherence of international taxation, 81 colum. l. rev. 1151 (1981). 41 26 u.s.c § 7701(a)(4)(west 2012); 26 u.s.c § 7701(a)(5)(west 2012). 42 see treas. reg. § 301.7701-1, et seq; see i.r.s. (2016), http://www.irs.gov/irm/part4/irm_04061-005.html [http://perma.cc/a2sf-vddg] victor fleischer, if it looks like a duck: corporate resemblance and check-the-box elective tax classification, 96 columbia law review 518-556 (1996); thomas hayes, checkmate, the treasury finally surrenders: the check the box treasury regulations and their effect on entity classification, 54 wash. & lee l. rev. 1147 (1997); henry j. lischer, elective tax classification for qualifying foreign and domestic business entities under the final check-the-box regulations, 51 s.m.u. l. rev. 99 (1997-1998); lawrence lokken, whatever happened to subpart f? u.s. cfc legislation after the check-the-box regulations, 7 fla. tax rev. 185 (2005); steven dean, attractive complexity: tax deregulation, the check the box elections and the future of tax simplification, hofstra l. rev. 2 (2006); heather m. field, checking in on “check-the-box”, 42 loy. l.a. l. rev. 451 (2008). 43 see also, the passive foreign investment company (pfic) regime (i.r.c. §1291-§1298) that imposes current u.s. taxation on passive income of foreign investment company. 44 see robert j. peroni, j. clifton fleming, jr., stephen e. shay, getting serious about curtailing deferral of u.s. tax on foreign source income, 52 smu l. rev. 455 (1999) (discussing the legislative history and development of deferral and anti-deferral rules and proposing pass through technique for ending deferral); robert peroni, deferral of u.s. tax on international income: end it, don’t mend it—why should we be stuck in the middle with subpart f? 79 tex. l. rev. 1609 (2001); keith engel, tax neutrality to the left, international competitiveness to the right, stuck in the middle with subpart f, 79 tex. l. rev. 1525 (2001). 2017] minimum global effective corporate tax rate 15 jurisdiction with low corporate taxes.45 after the inversion, the un-repatriated foreign earnings of the u.s. company’s remaining foreign subsidiaries can be more easily utilized without triggering a taxable repatriation. once there is a non-u.s. parent, foreign subsidiaries can simply loan their trapped cash to the new foreign parent, or use it to buy company stock, in what are commonly referred to as “hopscotch transactions.”46 section 7874 of the irc denies certain tax benefits of a typical inversion transaction by deeming the new top-tier foreign corporation to be a domestic corporation for all federal tax purposes.47 this specific anti-avoidance rule generally applies to a transaction in which, pursuant to a plan or a series of related transactions: (1) a u.s. corporation becomes a subsidiary of a foreign-incorporated entity or otherwise transfers substantially all of its properties to such an entity; (2) the former shareholders of the u.s. corporation hold (by reason of the stock they had held in the u.s. corporation) 80% or more (by vote or value) of the stock of the foreign-incorporated entity after the transaction; and (3) the foreign incorporated entity, considered together with all companies connected to it by a chain of greater than 50% ownership (that is, the “expanded affiliated group”), does not have substantial business activities in the entity’s country of incorporation, compared to the total worldwide business activities of the expanded affiliated group.48 as to the territorial taxation pillar of the u.s. law, it imposes current u.s. tax liability on u.s. sourced income, determined according to source rules for each category of income, of nonresident aliens and foreign corporations (“inbound activities”).49 the u.s. tax rules for u.s. activities of foreign taxpayers apply differently to two broad types of income: the first type is u.s.-source income that is “fixed or determinable annual or periodical gains, profits, and income” (“fdap income”). fdap income generally is subject to a 30% gross-basis withholding tax. much fdap income and similar income is, however, exempt from withholding tax or is subject to a reduced rate of tax under the 45 as described recently in a congressional research service paper, “a corporate inversion is a process by which an existing u.s. corporation changes its country of residence. post-inversion the u.s. corporation becomes a subsidiary of a foreign parent corporation. corporate inversions occur through three different paths: the substantial activity test, merger with a larger foreign firm, and merger with a smaller foreign firm. regardless of the form of the inversion, the typical result is that the new foreign parent company faces a lower home country tax rate and no tax on the company’s foreign-source income.” donald j. marples & jane g. gravelle, cong. res. serv., r43568, corporate expatriation, inversions, and mergers: tax issues 3 (2014). 46 see edward kleinbard, tax inversions must be stopped now, wall st. j. (july 21, 2014, 8:20 am), http://www.wsj.com/articles/edward-d-kleinbard-tax-inversions-must-be-stopped-now-1405984126 [http://perma.cc/mr46-as83]; inverse logic, the economist (jun. 21, 2014) http://www.economist.com/news/business/21604555-rush-firms-fleeing-america-tax-reasons-set-continueinverse-logic [http://perma.cc/h4fy-zbwu]; kimberly clausing, corporate inversions, tax pol’y ctr. (2014) http://www.taxpolicycenter.org/uploadedpdf/413207-corporate-inversions.pdf [http://perma.cc/uuk7-x968]; omri marian, home country effects of corporate inversions, 90 wash. l. rev. 1 (2015). 47 on corporate inversions, see, joint comm. on tax’n., present law and issues in u.s. taxation of cross-border income, jcx-42-11, 50 (sept. 6, 2011), eric talley, corporate inversions and the unbundling of regulatory competition, 101 va. l. rev.1649 (2015). 48 see charles h. gustafson, robert j. peroni, richard crawford pugh, taxation of international transactions: materials, text and problems 844-849, (2011); jefferson vanderwolk, inversions under section 7874 of the internal revenue code: flawed legislation, flawed guidance, 30 nw. j. int’l. l. & bus. (2010). 49 see mitchell kane, a defense of source rules in international taxation, 32 yale j. on reg. 311(2015). 16 columbia journal of tax law [vol.8:5 code or a bilateral income tax treaty.50 the second type is income that is “effectively connected with the conduct of a trade or business within the united states” (“eci”). eci income is generally subject to the same u.s. tax rules that apply to business income derived by u.s. persons. that is, deductions are permitted in determining taxable eci, which is then taxed at the same rates applicable to u.s. persons. the second source of tax norms that influence the tax outcomes of u.s. multinationals’ global profits is bilateral tax treaty law. the u.s. has its own model income tax convention and model technical explanations.51 based on this model, which is used as a starting point in bilateral treaty negotiations, the u.s. signed tax treaties with a number of foreign countries.52 under these treaties, residents of the treaty partners are taxed at a reduced rate, or are exempted on certain items of income they receive from sources within the territory of the other partner. the treaties also set rules of relief from double taxation in accordance with the provisions and subject to the limitations set by u.s. law.53 most u.s. income tax treaties contain what is known as a “saving clause”, which prevents a citizen or resident of the contracting state from using the provisions of a tax treaty in order to avoid taxation of income sourced in his home country. 54 most u.s. income tax treaties also include a limitation on benefits provision.55 this provision is an anti-treaty shopping provision that intends to prevent residents of third countries from benefiting from what is intended to be a reciprocal agreement solely between the two countries that are party to the treaty. the provision limits the entitlement of treaty benefits to a “qualified resident” and rather than basing this defined term on a determination of purpose or intent, the provision sets forth a series of objective tests. therefore, a resident of a contracting state that satisfies one of the tests will receive benefits regardless of its motivations in choosing its particular business structure.56 in addition to the u.s. model tax convention, the oecd has developed a model convention with respect to taxes on income and on capital.57 based on this model, a network of bilateral tax treaties has been signed between countries throughout the world. the oecd has also issued guidelines on the convention and on several specific issues of cross border taxation throughout the years.58 these international tax norms influence the 50 the united states has set forth its negotiating position on withholding rates and other provisions in the united states model income tax convention of november 15, 2006 (the “u.s. model treaty”). because each treaty reflects considerations unique to the relationship between the two treaty countries, treaty withholding tax rates on each category of income are not uniform across treaties. 51 see supra note 38. 52 see supra note 37. 53 u.s. model income tax convention article 23 (2006). 54 u.s. model income tax convention article 1 §4 (2006). 55 u.s. model income tax convention article 22 (2006). 56 see ruth mason, u.s. tax treaty policy and the european court of justice, 59 tax l. rev. 65 (2005); leonardo castro, u.s. policy against treaty shopping – from aiken industries to anti-conduit regs: critical view of current double-step approach in light of tax treaties’ objectives and purposes, 31 va. tax rev. 297 (2012); john bates, daniel m. berman, raphaël gani, daniel gutmann, takashi imamura, gideon klugman, alexander rust, limitation on benefits articles in income tax treaties: the current state of play, 41 intertax 6&7 (2013). 57 oecd, model tax convention on income and on capital 2014 (30 oct. 2015), http://www.oecdilibrary.org/taxation/model-tax-convention-on-income-and-on-capital-2015-full-version_9789264239081-en [http://perma.cc/czm3-8y24]. 58 see tax publications by date, oecd, http://www.oecd.org/tax/bydate/ [http://perma.cc/a9fq8mgy]. 2017] minimum global effective corporate tax rate 17 domestic and bilateral treaty law of many countries. additionally, american multinationals are influenced by these norms in a few significant ways. first of all, their foreign subsidiaries are often directly subject to bilateral tax treaties enacted according to the oecd model. second, foreign domestic tax law and practice is influenced by the oecd and indirectly subjects the u.s. multinationals and their cfcs to these norms. therefore, international tax norms clearly serve as influential and interpretive guidelines in a variety of contexts and constitute a third source of influence over the tax outcomes of american multinationals’ global activity and profits.59 b. avoiding the regime within the described regime, american multinationals use several schemes to avoid u.s. taxation, which typically involve utilization of foreign jurisdictions that have low or no taxation at all in order to reduce their overall global effective corporate tax rate. the most basic and frequently used scheme is to “lock out” overseas profits in order to avoid taxation upon repatriation. there are a number of negative outcomes that stem from the lock out effect and influence the u.s. economy and society.60 in order to use these profits without tax outcomes, u.s. multinational invert to foreign parental structure and exploit “hopscotch transactions”. 61 another well-known tax planning scheme is the “double irish dutch sandwich” used by google and other high tech multinationals.62 in 2003, before its initial public offering (ipo), google established an irish subsidiary, google ireland holdings (gih) with dual residency: ireland residency as the place of incorporation for purposes of u.s. tax law and bermuda residency as the place of “its mind and management” for purposes 59 see avi-yonah, supra note 39. 60 see lockout: flawed u.s. tax structure keeps trillions offshore that could be invested here, h. comm. on ways and means (aug. 5, 2015), http://waysandmeans.house.gov/lockout-flawed-u-stax-structure-keeps-trillions-offshore-that-could-be-invested-here/ [http://perma.cc/z6db-vw6k]; the tax break-down: preferential rates on capital gains, comm. for a responsible fed. budget (aug. 27, 2013), http://crfb.org/blogs/tax-break-down-preferential-rates-capital-gains [http://perma.cc/qx33-asbq]. 61 see mihir a. desai & james r. hines, jr., expectations and expatriations: tracing the causes and consequences of corporate inversions, 55 nat’l tax j. 409, 418-20 (2002); cathy hwang, the new corporate migration: tax diversion through inversion, 80 brook. l. rev. 807 (2015); reuven avi-yonah & omri y. marian, inversions and competitiveness: reflections in the wake of pfizer/allergan, u. mich. pub. l. res. paper no. 488, 6 (2015), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2703576, a list of inversion transactions is available at http://media.wix.com/ugd/b391a0_3f1cb05f51d8441ea0e595410365a47f.pdf [http://perma.cc/4g3u-xdlj]; for an example of media coverage of a recent inversion, see michelle fay cortez, medtronic strategy takes shape after biggest inversion ever, bloomberg (jan. 26, 2015, 6:13 pm), http://www.bloomberg.com/news/articles/2015-01-26/medtronic-s-strategy-takes-shape-after-biggestinversion-ever [http://perma.cc/ne75-sl7t]; trefis team, medtronic to go ahead with covidien deal despite reduced tax benefits, forbes (oct. 8, 2014 1:39 pm), http://www.forbes.com/sites/greatspeculations/2014/10/08/medtronic-to-go-ahead-with-covidien-dealdespite-reduced-tax-benefits/ [http://perma.cc/fd6w-xgud]; medtronic’s tax inversion lesson, wall st. j. (aug. 13, 2014 8:45 am), http://www.wsj.com/articles/medtronics-tax-lesson-1407883241 [http://perma.cc/wdw4-p8r7]. 62 see edward kleinbard, stateless income, 11 fla. tax rev. 699, 706 (2011). 18 columbia journal of tax law [vol.8:5 of irish tax law.63 google inc. entered into a cost sharing agreement with its wholly owned subsidiary, under which gih acquired the rights to google inc.’s search and advertising technologies and other intangibles for the territory of europe, the middle east and africa (emea). the payment for these rights was approved in an advance pricing agreement (apa) with the internal revenue service, which accepted the payment as reflecting the arm’s length price of the rights at that time. gih licensed the intangible rights of the emea territories to its dutch subsidiary (“google bv”) which in turn licensed the rights to its subsidiary, google ireland limited (gil). gil collects billions of dollars of advertising revenues from the use of those rights in the emea territories. those billions are subject to the 12.5% irish corporate income tax but gil deducts large royalty payments made to google bv for the rights. google bv will pay irish tax on these royalty payments but it deducts almost the same amounts paid to gih. google bv exists because royalties paid directly from an irish company to a bermuda company are subject to irish withholding tax but that tax does not apply to an eu resident company, such as google bv. gih, in turn, is not paying any tax on these royalties as it is considered a bermuda resident for purposes of irish tax law and thus pays no irish tax, no u.s. tax as it is considered irish resident for purposes of the u.s. tax law, and no bermuda tax. the end result of this scheme is almost zero tax on billions of dollars income from the use of google inc.’s search and advertising technologies in the emea territories. in this scheme, in order to protect a preferred low-priced ip transaction from future price intervention, google exploited the apa procedure by entering into the agreement at early stage of the business, when there was a huge gap of information between the company and the irs. google used the jurisdictions of ireland and bermuda, with low or no corporate taxes, as well as the lack of coordination between irish and american residency rules, to shift income to low or no tax jurisdictions without having to shift the proportionate amount of economic activity to these jurisdictions. furthermore, google exploited the eu withholding exemption rule to reduce the withholding tax and the deduction of royalties within the same group. in this tax avoidance scheme, google inc. produced “stateless income” and substantially reduced its tax bill in its resident country and source countries where it economically advertises and produces income.64 these examples and many others are intended to illustrate and clarify that there are endless possibilities of corporate tax avoidance in international transactions. this is because there are many holes in the current domestic u.s. law governing the taxation of international transactions that can be exploited to avoid taxation, such as deferral, the check the box regulations or the definition of corporate residency. additionally, there are a significant number of holes in the treaty network and worldwide international tax regime because each jurisdiction in the world is sovereign to determine its own tax law and several jurisdictions enact low or no tax regimes for the specific purpose of attracting 63 recently, section 43 of the finance act of 2014 changed the irish law. all corporations incorporated in ireland after january 1, 2015 will be deemed to be irish corporations, regardless of the location of their headquarters. however, bilateral treaties between ireland and other jurisdictions that codify the management test, such as those with malta and united arab emirates, are exempted. finance act 2014 (act no. 37/2014) (ir.), http://www.irishstatutebook.ie/eli/2014/act/37/enacted/en/pdf [http://perma.cc/77nvlf4h]. the results of these changes on the avoidance strategy are not fully clear yet. 64 kleinbard, supra note 62, at 707-13. 2017] minimum global effective corporate tax rate 19 foreign investors, and there is not enough coordination between the tax jurisdictions. as a result, the holes in the treaty network and in the worldwide international tax regime can also be used to avoid taxation, especially corporate tax by multinationals in the global digital economy. thus, the greatest challenge is limiting, if not eliminating, international corporate tax avoidance, which threatens democracy, and the global economy and society, in a timely and appropriate manner. 65 in this paper, i concentrate on the u.s. its international tax regime and multinationals as the leading economy and player in the international tax arena. c. the data the data on international corporate tax avoidance is immense.66 a recent document by twenty-four international tax experts addresses current tax reform efforts in congress, and includes a comprehensive and precise summary of the data, as well as a bibliography of some of the best scholarly research to date showing how the current tax system enables u.s. firms to pay relatively low effective corporate tax rates.67 the experts open by emphasizing that u.s. corporations are more profitable than ever, with $1.8 trillion in profits in the second quarter of 2015 alone. their profits as a share of gdp – at 9.8% – are nearly at all-time highs. however, their u.s. taxes as a share of gdp are just 2%, near all-time lows. additionally, u.s. corporate taxes as a share of federal revenue have plummeted from 32.1% in 1952 to 10.6% in 2014. according to the irs statistics of income, 17% of u.s. corporate foreign earnings and profits in 2010 were earned in corporations incorporated in bermuda and the cayman islands.68 jason furman, the former chairman of the president’s council of economic advisers, seized on this—when, addressing a group of law students at nyu, he said, “i feel safe in saying that the fact that, in 2010, u.s.controlled foreign corporation profits represent 1,578% of bermuda’s g.d.p. and even 15% of the netherlands’ g.d.p. probably does not simply reflect business decisions made for purely business reasons”.69 i will concentrate on studies of effective corporate tax rates, as i find these studies most related to my proposal, although they use several and different methods for defining and measuring the effective corporate tax rate.70 generally speaking, effective corporate tax rate is understood, backward looking, as the ratio of corporate income tax paid to a pre-tax measure of corporate profit over a given period of time. a study 65 see sikes, supra note 11. 66 for a survey on such data see, zucman, supra note 9; oecd, addressing base erosion and profit shifting, annex b (feb. 12, 2013); kevin s. markle & douglas a. shackelford, the impact of headquarter and subsidiary locations on multinationals’ effective tax rates, 28 tax pol’y & econ. 33 (2014). 67 see am. for tax fairness, 24 international tax experts address current tax reform efforts in congress (september 25, 2015), http://americansfortaxfairness.org/files/24-international-tax-experts-letterto-congress-9-25-15-final-for-printing.pdf [http://perma.cc/77nv-lf4h]. 68 u.s. corporations and their controlled foreign corporations by selected country of incorporation of controlled foreign corporation, tax year 2010, i.r.s., http://www.irs.gov/uac/soi-tax-statscontrolled-foreign-corporations [http://perma.cc/c5b5-kgkl]. 69 patricia cohen, a startling look at how profits elude the taxman, n.y. times (sept. 30, 2014), http://www.nytimes.com/2014/10/01/upshot/a-startling-look-at-how-profits-elude-thetaxman.html?abt=0002&abg=0&_r=0 [http://perma.cc/tr9j-3qa5]. 70 don fullerton, which effective tax rate? 2 (nat’l. bureau econ. res., working paper no. 1123, 1983). 20 columbia journal of tax law [vol.8:5 undertaken by citizens for tax justice with the institute on taxation and economic policy looked at the profits and u.s. federal taxes of the 288 fortune 500 companies that have been consistently profitable in each of the five years between 2008 and 2012. some of the key findings of this study are as follows: as a group, the 288 corporations examined paid an effective federal income tax rate of just 19.4% over the five year period – far less than the statutory 35% tax rate; (ii) twenty-six of the corporations, including boeing, general electric, priceline.com and verizon, paid no federal income tax at all over the five year period; and (iii) a third of the corporations (93) paid an effective tax rate of less than 10% over the period. of those corporations with significant offshore profits, two thirds paid higher corporate tax rates to foreign governments where they operate than they paid in the u.s. on their u.s. profits.71 harry grubert’s recent study analyzed data from a sample of 754 large nonfinancial u.s. based mnc’s obtained from the u.s. treasury’s corporate income tax files. among several interesting findings, this study found that the average effective foreign tax rate declined from 21.26% in 1996 to 15.86% in 2004. the check the box rules enacted in 1997 seem to have contributed about 1 to 2 percentage points of the approximate 5-percentage point decline in foreign effective tax rates. lower foreign effective tax rates had no significant effect on a company’s domestic sales or on the growth of its worldwide pre-tax profits; lower taxes on foreign income do not seem to promote “competitiveness”.72 according to the u.s. government accountability office, profitable u.s. corporations paid u.s. federal income taxes of about 13% of their pre-tax worldwide income in 2010, the most recent year for which are available.73 kimberly clausing found that in 2011, nearly half of all u.s. foreign profits (46.5%) were held in just seven taxhaven countries with effective tax rates of less than 6.5%.74 among the interesting findings of gabriel zucman is that in 2013, the effective u.s. corporate tax rate was 15% for taxes paid to the u.s. government and 19% for taxes paid to u.s. and foreign governments. out of the roughly 10 point decline in effective tax rates between 1998 and 2013, about two thirds or more of the decline is attributable to increased profit shifting to 71 robert s. mcintyre et. al., the sorry state of corporate taxes, citizens for tax just. (2014), http://www.ctj.org/corporatetaxdodgers/sorrystateofcorptaxes.pdf [http://perma.cc/a52g-gfmz]; see also robert s. mcintyre et. al., corporate tax payers and corporate tax dodgers 2008-2010, citizens for tax just. (2012), http://www.ctj.org/corporatetaxdodgers/corporatetaxdodgersreport.pdf [http://perma.cc/wm9l-8fnt]. 72 harry grubert, foreign taxes and the growing share of u.s. multinational company income abroad: profits, not sales, are being globalized, 65 nat’l. tax j. 247, 278-79 (2012). see also harry grubert, intangible income, intercompany transactions, income shifting, and the choice of location, 56 nat’l. tax j. 221 (2003). 73 u.s. gov’t accountability off., gao-13-520, corporate income tax: effective tax rates can differ significantly from the statutory rate 1 (2013). 74 kimberly a. clausing, the nature and practice of capital tax competition 10 (2015), http://poseidon01.ssrn.com/delivery.php?id=193021116117101007096093084119077018050053039063074 0591070201170740260131250980121220620551151110181200510310880200810240000290110050290230 6511312209206709203000102803005709409810111006810411201310712312311712512200409208301001 2089074066008008003115&ext=pdf [http://perma.cc/5luw-gqw2]. 2017] minimum global effective corporate tax rate 21 low-tax-jurisdictions.75 zucman estimates u.s. tax losses in the amount of $130 billion a year and his two figures (below) clarify and summarize the data clearly and sharply:76 chart a chart b 75 gabriel zucman, taxing across borders: tracking personal wealth and corporate profits, 28 j. econ. perspectives 121, fig. 5 at 132-33 (2014). 76 zucman, supra note 75, at 106, 108. 22 columbia journal of tax law [vol.8:5 in their recent study, heckemeyer and overesch present a meta-analysis covering twenty-five studies on corporate profit-shifting behavior. 77 among the several contributions, they examined which channel is the leading profit shifting channel and concluded: “our results indeed provide evidence that the two profit shifting channels, corporate financial policy and tax motivated adjustments of related party transactions, are not equally important. in particular, we find some tentative evidence that the volumes of shifted tax bases are to a large extent, i.e. two thirds, driven by firms’ non-financial intercompany transactions. from the point of view of national governments and tax administrations, this finding can have important implications. the extent of tax base erosion is not determined by the mere responsiveness of the shifting strategies, but also by the tax base volume effectively shifted via the respective channels. regardless of whether anti-avoidance measures are at all desirable, the discussion on multinational profit shifting and anti-avoidance legislation is very much centered on the financial strategies of firms. given our findings, doubts remain as to whether this policy matches the true proportion, in terms of the lost taxable bases, of the two shifting channels. if policy makers want to effectively restrict profit shifting opportunities of multinational enterprises (mnes), restricting transfer pricing and royalties remains a challenging task in anti-tax-avoidance legislation as well.”78 iii. the united states response to the challenge there is, generally, agreement among scholars and politicians that the current system is broken, but at this point no widely accepted solution has been found. the continuous debate about how best to fix this broken system focuses on a number of challenges including international corporate tax avoidance. at the heart of this controversy is the important underlying question what should the system achieve?79 the scope of current proposals is wide ranging, with suggestions to end deferral and adopting “current worldwide taxation” at one end of the spectrum and ending worldwide taxation in favor of adopting sole “territorial taxation” at the other end. in between these two extremes, several other proposals have been made.80 in this part, i will explore and analyze the united states response and the main proposals made and actions taken with an emphasis on the challenge presented by international corporate tax avoidance. for purposes of this article, i assume that the u.s. will not adopt either extreme (current worldwide taxation or sole territorial taxation) and will continue its 77 jost h. heckemeyer & michael overesch, multinationals’ profit responses to tax differentials: effect size and shifting channels (ctr. for eur. econ. res., discussion paper no. 13-045, 2012). 78 id. at 27. 79 see daniel shaviro, fixing u.s. international taxation (2015); david weisbach, the use of neutralities in international tax policy (2014); michael graetz, taxing international income: inadequate principles, outdated concepts, and unsatisfactory policies, 26 brook. j. int’l. l. 1357 (2001). 80 i don’t consider here those proposals that call pass through corporate tax or replacement of the corporate tax altogether. my article and proposal is made within the framework of corporate tax. therefore, i am not going to engage here in the debate about ending corporate tax or adopting vat in the usa. see alan viard, fundamental tax reform: a comparison of three options (2016) http://www.law.georgetown.edu/faculty/symposia-lectures/tax-law-public-finance/upload/threefundamental-tax-reform-options-revised-jan-25-2016.pdf [http://perma.cc/ll4z-kc37]; michael graetz, 100 million unnecessary returns: a simple, fair and competitive tax plan for the united states (2007); reuven avi-yonah, from income to consumption tax: some international implications, 33 san diego l. rev. 1329 (1996). 2017] minimum global effective corporate tax rate 23 hybrid regime while also reducing the corporate tax rate. however, for purposes of understanding my proposal, and the current tax environment surrounding discussions of international tax reform, it is important to comprehend the ideology underlying current worldwide taxation and sole territorial taxation 81 , as well as the distinguishing characteristics of each system and the systems in between. a. ending deferral: current worldwide taxation the proposal to end deferral and adopt current worldwide taxation has been raised several times by policy makers82 and scholars.83 the classic economic justification for such regime relies on the idea of capital export neutrality (cen). according to the principles of cen, if the home country subjects all income to current worldwide taxation, investment decisions will be made based on efficiency and profit maximization rather than tax planning. this will result in increasing world welfare.84 current worldwide taxation is also justified because the home country inevitably contributes to the production of foreign income and should therefore benefit from a proportionate share of tax revenue associated with such foreign income. furthermore, the lack of taxation that stems from any regime that does not implement current worldwide taxation risks the internal source tax base of the united states. finally, despite arguments to the contrary made by those who oppose current worldwide taxation, it will not put the u.s. multinationals at a competitive disadvantage, as long as the rate is appropriate. 85 in fact, 81 see, e.g. klaus vogel, worldwide vs. source taxation of income – a review and re-evaluation of arguments, 8 intertax 216, 216-229 (1988); paul mcdaniel, territorial vs. worldwide international tax systems, which is better for the u.s.?, 8 fla. tax rev. 283 (2006-2008); adam rozenzweig, source as a solution to residence, 17(6) fla. tax rev. 471 (2015) (who tries to mitigate the contradiction between source and residence and proposes a new legal and doctrinal approach to international tax by using the source rules to define the residency of an entity for tax purposes). 82 president kennedy administration proposal in 1961 (federal tax system message from the president of the united states, 107 cong. rec. 6456, 6458 (1961)); press release, sen. wyden & sen. coats, the bipartisan tax fairness and simplification act of 2011, http://www.wyden.senate.gov/imo/media/doc/wyden-coats%20two%20pager%20final1.pdf [http://perma.cc/by48-9467] (requiring that a u.s. shareholder include as a deemed dividend its share of the current foreign earnings of cfc’s and the distinction between subpart f income and non-subpart f income is eliminated and proposing legislation that provides several specific provisions to address potentially abusive transactions). 83 see robert j. peroni, j. clifton fleming, jr. & stephen e. shay, getting serious about curtailing deferral of u.s. tax on foreign source income, 52 smu l. rev. 455 (1999). (i agree that ending deferral is justified but it does not seem feasible and all attempts to end deferral had failed so far). 84 see peggy b. musgrave, u.s. taxation of foreign investment income: issues & arguments (1969). 85 see reuven s. avi-yonah & nicola sartori, sys. on int’l taxation & competitiveness: foreword, 65 tax l. rev. 313 (2012); michael s. knoll, the connection between competitiveness and international taxation, 65 tax l. rev. 349 (2012); jane g. gravelle, does the concept of competitiveness have meaning in formulating corp. tax pol’y?, 65 tax l. rev. 323 (2012); reuven s. avi-yonah & yaron lahav, the effective tax rates of the largest u.s. and eu multinationals, 65 tax l. rev. 375 (2012); brian j. arnold, a comp. persp. on the u.s. controlled foreign corp. rules, 65 tax l. rev. 473 (2012); eric toder, int’l competitiveness: who competes against whom and for what?, 65 tax l. rev. 505 (2012); melissa costa & jennifer gravelle, taxing multinational corps: average tax rates, 65 tax l. rev. 391 (2012); kimberly a. clausing, in search of corp. tax incidence, 65 tax l. rev. 433 (2012); kevin s. markle & douglas a. shackelford, cross-country comparisons of the effects of leverage, intangible assets, and tax havens on corp. income taxes, 65 tax l. rev. 415 (2012); bret wells & cym lowell, tax base erosion and homeless income: collection at source is the linchpin, 65 tax l. rev. 535 (2012). 24 columbia journal of tax law [vol.8:5 current worldwide taxation is required to achieve fairness in the comprehensive taxation system of any country.86 in my opinion, current worldwide taxation would likely reduce the lock-out effect, as it will minimize the incentive to keep profits outside of the u.s. however, although current worldwide taxation might reduce the opportunities of international tax arbitrage, it is unlikely that ending deferral will reduce all tax avoidance incentives or schemes. most tax avoidance schemes rely heavily on the fact that many non-u.s. jurisdictions adopt beneficial, low-or-nonexistent tax regimes. therefore, as long as these tax haven regimes continue to exist, international tax avoidance will continue even after ending deferral. in fact, current worldwide taxation will likely increase the incentive to invert in order to benefit from these tax havens and avoid worldwide taxation. b. ending worldwide taxation: sole territorial taxation in recent years, several prominent scholars and policy makers have proposed ending u.s. worldwide taxation and adopting sole territorial taxation.87 in this system, foreign income of u.s. corporations and their subsidiaries, together with the dividend income received from them, are fully exempted from u.s. taxation and subject to taxation only by the foreign source country according to its laws. the economic justification for the exemption relies on the criteria of capital import neutrality (cin) and capital ownership neutrality (con). according to the standard of con: “world welfare is maximized if the identities of capital owners are unaffected by tax rate differences”.88 the usual policy recommendation to achieve con is for countries to adopt territorial tax systems.89 supporters of territorial taxation argue that as a result of u.s. worldwide taxation, u.s. multinationals likely face a higher tax burden on foreign investments than multinationals based in other oecd jurisdictions, which leads to the weakening of u.s. 86 see j. clifton fleming, jr., robert j. peroni & stephen e. shay, fairness in international taxation: the ability-to-pay case for taxing worldwide income, 5 fla. tax rev. 299 (2001); nancy h. kaufman, fairness and the taxation of int’l income, 29 l. & pol’y in int’l. bus. 145 (1998); ruth mason & michael knoll, what is tax discrimination?, 121 yale l.j. 1014 (2012); michael j. graetz & alvin c. warren, jr., income tax discrimination: still stuck in the labyrinth of impossibility, 121 yale l.j. 1118 (2012). 87 see harry grubert & john mutti, taxing international business income: dividend exemption versus the current system 67 (2001); president’s advisory panel on tax reform, simple, fair, & pro-growth: proposals to fix america’s tax system 239-244 (1985); nat’l comm. on fiscal resp. & reform, the moment of truth (2010); s. 2091, 112th cong. (2d sess. 2012) (proposing a participation exemption system under which a deduction is permitted for 95% of the qualified foreign-source portion of dividends a domestic corporation receives from its cfcs); baucus unveils proposals for int’l tax reform, s. comm. on fin., (nov. 19, 2013), http://www.finance.senate.gov/newsroom/chairman/release/?id=f946a9f3d296-42ad-bae4-bcf451b34b14 [http://perma.cc/s8qk-dp3z] (proposing a dividend exemption system by means of a 100% deduction for the foreign-source portion of dividends received from cfcs by domestic corporations that are 10% u.s. shareholders of those cfcs and that have satisfied a one year holding period requirement). 88 see mihir desai & james r. hines jr., evaluating int’l tax reform, 56(3) nat’l tax j. 487, 488 (2003); see also mihir a. desai & james r. hines jr., old rules and new realities: corporate tax policy in a global setting, 57 nat’l tax j. 937 (2004). 89 see mihir a. desai, new foundations for taxing multinational corpos., 82 taxes 39, 48 (2004). 2017] minimum global effective corporate tax rate 25 multinationals’ competitive position and lost investment opportunities. proponents argue that sole territorial taxation is needed to protect the competitiveness of u.s. multinationals in international markets as most other developed countries, such as japan and the uk, have successfully adopted sole territorial regimes.90 no doubt that sole territorial taxation has a lot of merits. this regime would reduce the lock-out effect since u.s. multinationals could repatriate their foreign sourced income without triggering a taxable realization event. their decisions on repatriations and investments would be made according to economic considerations. in addition, territorial taxation would reduce the incentives for inversions and keep corporations in the united states legally and economically. however, i am more convinced by the arguments made by opponents of such a regime.91 the data really proves that u.s. multinationals do not suffer any competitiveness disadvantage from worldwide taxation. exempting their foreign income would just reduce their u.s. tax bill (on foreign income) to zero and would probably also reduce their u.s. tax bill on their u.s. income, as they would aggressively shift more profits abroad. this increased profit shifting would pose a serious risk to the u.s. tax base, a problem many jurisdictions that use a sole territorial regime currently face, as indicated by the oecd beps project. therefore, implementing sole territorial taxation will not solve the challenge of international corporate tax avoidance. rather, it will simply change the leading methods of avoidance from lock out and inversions to profit shifting. thus, i do not believe that sole territorial taxation is the appropriate response to the challenge of international corporate tax avoidance. in addition, it does not seem that such a regime is politically feasible in the united states despite the republican support of territoriality. in any case, even in sole territorial taxation, an additional and separate norm or rule is essential to protect the tax base and limit avoidance. i argue that my proposed norm of a minimum global effective corporate tax rate would be appropriate and useful both in a sole territorial tax regime and in a worldwide taxation regime. c. in between worldwide & territorial taxation as the debate between worldwide and territorial taxation continues, it seems that a compromise between the two regimes is more likely than one being selected over the 90 see philip dittmer, a global perspective on territorial taxation, tax found. (2012), http://taxfoundation.org/article/global-perspective-territorial-taxation [http://perma.cc/m5wt-uyzf]. 91 see letter from 24 international tax experts to congress (sept. 25, 2015), http://americansfortaxfairness.org/files/24-international-tax-experts-letter-to-congress-9-25-15-finalfor-printing.pdf [http://perma.cc/c8jq-ja4s] (addressing current tax reform efforts in congress). 26 columbia journal of tax law [vol.8:5 other.92 in his recent book, shaviro argues that neither territorial taxation nor worldwide taxation addresses the fundamental problems at hand.93 instead, shaviro supports a “unilateral national welfare perspective” and proceeds to propose that the u.s. enact a worldwide system in which foreign taxes are only deductible, rather than credited as they are currently.94 this proposal would definitely change the outcomes of the regime substantially but it would not change the realities of international corporate tax avoidance. as professor avi-yonah argues because of the u.s.’s prominent and influential role within the global economy, a policy that replaces the foreign tax credit with a deduction could be very harmful. professor avi-yonah, and others, have advocated for a profit split regime that allocates the profits of multinationals through a formula that mainly accounts for, or focuses on, the place and volume of sales.95 recently, the eu called for implementation of formulaic apportionment in a renewed proposal to adopt a common consolidated corporate tax (ccct).96 formulaic apportionment has a lot of merits and supporters but has also been subject to considerable criticism and rejection.97 i do not believe that the u.s. will adopt such a system or that the international community could design and agree upon a formula in order to adopt such a regime. based on this reality, i assume that countries will continue to adopt different rules, including the leading arm’s length principle in variety of versions, with limited coordination, and as a result international tax avoidance will continue. hence, it is necessary to design separate and unilateral rules to balance 92 i categorize two policy makers proposals in this mid category: option z of former chairman baucus’s staff discussion drafts for international tax reform (http://www.finance.senate.gov/newsroom/chairman/release/?id=f946a9f3-d296-42ad-bae4-bcf451b34b14) [http://perma.cc/rmq7-qgxz] which in a complex technique would either tax on a current basis cfc income from products and services sold into foreign markets at 80% of the u.s. corporate tax rate with full foreign tax credits, or currently tax at the full rate only 60% of such active income. a reduced tax rate, payable over eight years would also be imposed on un-repatriated cfc earning from periods before the effective date of the proposal. the second policy maker proposal in this category, is the proposal made by chairman camp’s tax reform act of 2014 (http://waysandmeans.house.gov/uploadedfiles/statutory_text_tax_reform_act_of_2014_discussion_dra ft__022614.pdf) [http://perma.cc/8gtm-7yva]. this act establishes a participation exemption system for foreign income. this exemption is effectuated by means of a 95% deduction for the foreign-source portion of dividends received from certain foreign corporations (“specified 10% owned foreign corporations”) by domestic corporations. but, additionally, in complex technique that stems from the intention to prevent tax avoidance, it results in imposing around 15% u.s. tax on foreign income from the exploitation of intangible property. 93 see shaviro, supra note 79. 94 see daniel n. shaviro, splitting the baby: an intermediate tax rate for repatriations of foreign source active bus. income? proceedings. 95 annual conference on taxation and minutes of the annual meeting of the national tax association, 294 (2002) (raising the idea of an intermediate tax rate for repatriations of foreign source active business income for debate and consideration). 95 see reuven s. avi-yonah, kimberly a. clausing & michael c. durst, allocating business profits for tax purposes: a proposal to adopt a formulary profit split, 9 fla. tax rev. 497 (2009); reuven r. avi-yonah, the structure of international taxation: a proposal for simplification, 74 tex. l. rev. 1301 (1996); reuven s. avi-yonah, the rise and fall of arm’s length: a study in the evolution of u.s. int’l taxation, 15 va. tax rev. 89 (1995); reuven s. avi-yonah, territoriality: for and against, u. mich. pub. l. res., paper no. 29 (2013), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2256580. 96 see fact sheet, questions & answers on the ccctb re-launch, eur. commission (jun. 2015), http://europa.eu/rapid/press-release_memo-15-5174_en.htm [http://perma.cc/dwc9-7kjd]. 97 see julie roin, can the income tax be saved? the promises and pitfalls of adopting worldwide formulary apportionment, 61 tax l. rev. 169, 172–73 (2008). 2017] minimum global effective corporate tax rate 27 targeting international tax avoidance with the need to respect the variety of international tax regimes and each country’s tax sovereignty. d. minimum taxation “america’s system of business taxation is in need of reform” is the opening statement of former president obama’s framework for business tax reform from 2012. the framework aims to support the competitiveness of american businesses and to increase incentives to invest and hire in the united states by lowering the corporate tax rate from 35% to 28%, cutting tax expenditures, and reducing complexity, while being fiscally responsible. 98 the framework rejects the proposal of sole territorial system because it will give corporations greater incentives to shift profits and because such system could “exacerbate the continuing race to the bottom in international tax rates”.99 instead, the framework requires companies to pay a minimum tax on overseas profits. according to this proposal, “foreign income deferred in a low-tax jurisdiction would be subject to immediate u.s. taxation up to the minimum tax rate with a foreign tax credit allowed for income taxes on that income paid to the host country. this minimum tax would be designed to balance the need to stop rewarding tax havens and to prevent a race to the bottom with the goal of keeping u.s. companies on a level playing field with competitors when engaged in activities which, by necessity, must occur in a foreign country”.100 in his budgets throughout his last term as president, including the fy 2016 budget, former president obama reaffirmed his 2012 framework for business tax reform with some modifications and elaborations. among the other provisions, the budget includes a one-time, mandatory 14% tax on previously untaxed foreign income and a 19% minimum tax on future foreign income.101 minimum taxation has been addressed and analyzed in the literature.102 for example, harry grubert and rosanne altshuler examine and compare several reform proposals including four different versions of a minimum tax on foreign income: (a) a country-by-country minimum tax of 15% on active income with a credit for the effective foreign rate up to the 15% threshold. dividends from both countries would be subject to the minimum tax and those above the minimum would be fully exempt, including dividends from previously taxed income; (b) a per-country minimum tax with dividend exemption, but a current deduction against the minimum tax base for real investment in the location; (c) a minimum tax at the overall foreign level at a higher rate; and (d) an overall minimum tax with expensing of current investment against the taxable u.s. base. in their analysis, the minimum tax would be calculated using a five-year average of foreign taxes paid in relation to earnings & profits (e&p). the expensing under the country-by-country minimum tax (b) and under the overall minimum tax (d) is intended to make the forward looking u.s. effective tax rate on the normal return to investment zero while the forward looking effective tax rate (etr) on the excess return bears a total tax, including both the foreign and u.s. components, of at least 15%. 98 see white house & dep’t. of the treasury, the president’s framework for business tax reform (feb. 2012). 99 white house, supra note 98, at 14. 100 white house, supra note 98, at 14. 101 see dep’t. of the treasury, supra note 20. 102 see harry grubert & rosanne altshuler, fixing the system: an analysis of alternative proposals for the reform of int’l tax, 66(3) nat’l. tax j. 671 (2013); shay, supra note 31. 28 columbia journal of tax law [vol.8:5 in analyzing and comparing these four proposals the authors use the following criteria: competitiveness, the impact on the lockout effect; changes in the incentives to shift income; the distortion of investment incentives and whether the reform is consistent with a more efficient allocation of worldwide capital; revenue; complexity; tax planning incentives beyond income shifting; and incentives to expatriate. they use an effective tax rate simulations methodology that shows the effect of different policies on several important behavioral margins.103 they conclude: compared to the other schemes, we find that the per-country minimum tax with expensing for real investment has many advantages with respect to these margins. the per-country minimum tax offsets the increased incentives for income shifting under pure dividend exception and is better than full inclusion in tailoring companies’ effective tax rates to their competitive position abroad. no u.s. tax burden will fall on companies that earn just a normal return abroad. the per-country minimum tax is basically a tax on large excess returns in low-tax locations, cases in which the company probably has less intense foreign competition . . . in addition, the overall minimum tax seems a serious alternative deserving consideration.104 i am convinced that minimum taxation is the right direction. however, my philosophy and justifications for minimum taxation differ from those already mentioned, as do the details of my proposed method of implementation. in part v, i will present my own proposal of minimum taxation and elaborate on the proposal, its philosophy and justifications, while also acknowledging counterarguments and making comparisons to other proposals for minimum taxation. e. limiting corporate inversions the enactment of section 7874 in 2004 was a response to the first wave of corporate inversions, after long debate in congress and failure of non-tax measures. section 7874 succeeded in limiting naked inversions by treating an inverted corporation as “domestic” if it is 80% owned by shareholders of the former domestic parent (hereinafter “the 80% threshold”). however, if the former shareholders own less than 60%, then the inversion falls outside the reach of section 7874 (hereinafter “the 60% threshold”). 105 in addition, the inversion is excluded from section 7874 if the affiliated group of the newly inverted foreign corporation has “substantial business activities” in the foreign country.106 in between these two thresholds (60%-80%), section 7874 imposes u.s. tax on the “inversions gains” which generally refer to certain gains from transfers related to the inversion transactions. however, this section, as any other section, includes loopholes 103 grubert & altshuler, supra note 102, at 685. 104 id. at 708-09. 105 see michael s. kirsch, the congressional response to corporate expatriations: the tension between symbols and substance in the taxation of multinational corporations, 24 va. tax rev. 475 (2005). 106 under recent regulations (treas. reg. § 1.7874-3 (2015)), this exception is met if 25% of the expanded affiliated group’s employees, assets, and gross income are located in where the foreign corporation is organized. 2017] minimum global effective corporate tax rate 29 that enable multinationals to work around the anti-inversion rule by simply avoiding the thresholds of applicability and/or fulfilling the standards necessary for exclusion. in response, the treasury is trying to strengthen section 7874 and limit these avoidance strategies. in notice 2014-52107, the treasury expressed its intention to issue regulations that: disregard certain stock of a foreign acquiring corporation that holds a significant amount of passive assets for purposes of the ownership continuity test ratio, meaning transactions with foreign corporations without active businesses are no longer possible; disregard certain non-ordinary course distributions by the u.s. company, also for purposes of the ownership continuity test ratio, meaning u.s. companies cannot attempt to shrink their size in advance of a transaction; change the treatment of certain transfers of the stock of the foreign acquiring corporation – such as in a spin-off – so that the transfers will not qualify for the section 7874 “expanded affiliated group” exception, meaning a u.s. company will not be able to use a spin-off to effectuate a redomiciliation.108 in notice 2015-79, the treasury and the irs expressed their intent to issue regulations under section 7874 to provide that an expanded affiliated group (eag) cannot have substantial business activities in the relevant foreign country when compared to the eag’s total business activities, unless the foreign acquiring corporation is subject to tax as a resident of the relevant foreign country, because this is the premise underlying the substantial business activities exception of section 7874. therefore, exploiting the exception without paying tax to the foreign country contradicts the purpose of section 7874 and such activity should be curtailed. in addition, notice 2015-79 provides that in certain cases when the foreign parent is a tax resident of a third country, stock of the foreign parent issued to the shareholders of the existing foreign corporation is disregarded for purposes of the ownership requirement, thereby raising the ownership attributable to the shareholders of the u.s. entity, possibly above the 80% threshold.109 in addition to strengthening the current rules and thresholds, scholars supported substantial changes to handle corporate inversions. i totally agree with shaviro who supported the enactment of an “exit tax” that “could be based on the amount of u.s. tax that the company would have paid had it repatriated all of its earnings just before the change in legal status occurred.”110 recently, avi-yonah and marian expressed their support of the exit tax. although their preferred solution would be to change corporate tax residency rules, they acknowledge that it is not politically feasible and therefore they state that the exit tax would be a second best solution for the issue of corporate 107 i.r.s. notice 2014-52, 2014-42 i.r.b. 712. 108 for further discussion of these regulations, see reuven s. avi-yonah, a world turned upside down: reflections on the ‘new wave’ inversions and notice 2014-52, u. mich. pub. l. & legal res. paper series 421 (2014), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2502513h [http://perma.cc/b794udrn]. 109 i.r.s. notice 2015-79, 2015-49 i.r.b. 775; see cathy hwang, the new corporate migration tax diversion through inversion, 80 brook. l. rev. 807 (2015) (discussing the motives behind inversions, the treasury responses and further policy considerations); edward kleinbard, “competitiveness” has nothing to do with it, 144 tax notes 1055 (2014); scott a. hodge, irs data contradicts kleinbard’s warnings of earnings stripping from inversions, the tax found. (sept. 2, 2014), http://taxfoundation.org/blog/irs-datacontradicts-kleinbard-s-warnings-earnings-stripping-inversions [http://perma.cc/fu5p-6bma]. 110 see daniel shaviro, understanding and responding to corporate inversions, start making sense (july 28, 2014), http://danshaviro.blogspot.com/2014/07/understanding-and-responding-to.html [http://perma.cc/h353-w4ma]. 30 columbia journal of tax law [vol.8:5 inversion.111 in a special and unique contribution to the tax debate on corporate inversions, and its interactions with corporate law, 112 eric talley supported bundling tax law and corporate governance.113 in my opinion, the most effective and appropriate measure to limit corporate inversions is the “exit tax.” f. modifying the u.s. bilateral tax treaty law the united states is also responding to the issue of international corporate tax avoidance by changing its bilateral tax treaty law as well. recently, following the publication of draft updates,114 the treasury published a new 2016 u.s. model income tax convention.115 the new convention includes a “subsequent changes in law” article, which denies treaty benefits “if at any time after the signing of this convention, the general rate of company tax applicable in either contracting state falls below 15% with respect to substantially all of the income of resident companies, or either contracting state provides an exemption from taxation to resident companies for substantially all foreign source income.” the 2016 convention addresses a “special tax regime,” which is broadly defined to include almost every regime that provides a preferential effective rate of taxation. the operative outcome of the special tax regime, according to the proposal, is the denial of treaty benefits to items of income (interest (article 11), royalties (article 12) and other income (article 21)) if the resident of the other contracting state (the residence state) beneficially owning the interest, royalties or other income, is related to the payer of such income, and benefits from a special tax regime in its residence state with respect to the particular category of income. the treasury emphasizes that “the application of the term ‘special tax regime’ in articles 11, 12 and 21 is consistent with the tax policy considerations that are relevant to the decision to enter into a tax treaty, or to amend an existing tax treaty, as articulated by the commentary to the oecd model, as amended by the base erosion and profits shifting initiative.”116 111 see reuven s. avi-yonah & omri marian, inversions and competitiveness: reflections in the wake of pfizer/allergan, u. mich. pub. l. & legal res. paper series, 488 (2015), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2703576 [http://perma.cc/5pca-elep]. 112 see mitchell a. kane & edward b. rock, corporate taxation and international charter competition, 106 mich. l. rev. 1229 (2008). 113 see eric l. talley, corporate inversions and the unbundling of regulatory competition, 101 va. l. rev. 1649 (2015). 114 dep’t. of the treasury, new article 28: subsequent changes in law (may 20, 2015), http://www.treasury.gov/resource-center/tax-policy/treaties/documents/treaty-subsequent-changes-in-law5-20-2015.pdf [http://perma.cc/svj4-qjvs]; dep’t. of the treasury, new article 3 paragraph 1(i) definition of special tax regime, http://www.treasury.gov/resource-center/taxpolicy/treaties/documents/treaty-special-tax-regimes-5-20-2015.pdf [http://perma.cc/y6sl-6kdu]; press release, dep’t. of the treasury, treasury releases select draft provisions for next u.s. model income tax treaty (may 20, 2015), http://www.treasury.gov/press-center/press-releases/pages/jl10057.aspx [http://perma.cc/2fyl-m4zg]. 115 dep’t. of the treasury, resource center: treaties and tieas, http://www.treasury.gov/resource-center/tax-policy/treaties/pages/treaties.aspx [http://perma.cc/c4lx3q8b]; dep’t. of the treasury, united states model income tax convention (feb. 17, 2016), http://www.treasury.gov/resource-center/tax-policy/treaties/documents/treaty-us model-2016.pdf [http://perma.cc/pl9l-k7nk]. 116 new article 3 paragraph 1(i) definition of special tax regime, supra note 114, at 2. 2017] minimum global effective corporate tax rate 31 these treaty-based specific anti-avoidance rules to limit international corporate tax avoidance, impose u.s. tax liabilities on foreign entities by unilaterally changing existing treaties. i do not think that this is appropriate. changes to treaties should be made through negotiations between the treaty partners and not unilaterally. however, the u.s. of course has full authority to determine the tax outcomes of u.s. multinationals and their worldwide income. still, that is not enough in the current global digital economy. the u.s. should interact with the changes in the international tax arena, particularly with the oecd beps project.117 iv. the g20/oecd international response in the beps project the starting point of the g20/oecd beps action plan118 is that globalization has opened up opportunities for mnes to minimize their tax burden, harming governments, individuals and businesses.119 the action plan states that taxation is at the core of countries’ sovereignty, but also acknowledges that in some cases the interaction between differing domestic tax rules leads to gaps and frictions. the international standards and international collaborative efforts have sought to address these frictions in a way that respects tax sovereignty, but the remaining gaps continue to weaken the system’s efficacy. these weaknesses put the existing consensus based framework at risk, and a bold move by policy makers is necessary to prevent worsening problems. therefore, the oecd beps action plan concludes that fundamental changes are needed to effectively prevent double non-taxation, as well as cases of no or low taxation associated with practices that artificially segregate taxable income from the activities that generate it. new international standards must be designed to ensure the coherence of corporate income taxation at the international level. “a realignment of taxation and relevant substance is needed to restore the intended effects and benefits of international standards, which may not have kept pace with changing business models and technological developments.”120 on october 5, 2015, after almost three years of extensive work (including publishing drafts and deliverables 121 and wide discussions, consultation and public 117 deputy assistant secretary for international tax affairs robert b. stack, said upon publication of the proposed changes to the u.s. model income tax treaty: “the draft provisions we are releasing for comment today reflect the fact that the tax regimes of our treaty partners are more likely to change over time than they have in the past, and that they sometimes change in ways that encourage base erosion and profit shifting or beps, by multinational firms. treaties exist to eliminate double taxation, not to create opportunities for beps, and today’s updates fully take account of the new international tax environment. the draft provisions also articulate steps that would help prevent our treaty network from encouraging inversion transactions.” press release, supra note 114. 118 oecd, action plan on base erosion and profit shifting (2013), http://www.oecdilibrary.org/taxation/action-plan-on-base-erosion-and-profit-shifting_9789264202719-en [http://perma.cc/h9q7-fwtb]. for further discussions of the action plan, see hugh j. ault, wolfgang schon, & stephen e. shay, base erosion and profit shifting: a roadmap for reform, 68 bull. int’l tax. 275 (2014). 119 action plan, supra note 118, at 8. 120 action plan, supra note 118, at 13. 121 oecd, beps 2014 deliverables, http://www.oecd.org/ctp/beps-2014-deliverables.htm [http://perma.cc/u9d4-nnqa]. 32 columbia journal of tax law [vol.8:5 participation) the oecd published the final reports on all fifteen actions.122 these reports propose tax norms on all fifteen actions to be adopted into domestic tax laws, bilateral tax treaties and a hybrid multilateral instrument. the proposed norms can be roughly organized in taxonomy of three classifications: first, general anti-avoidance rule: action 6 introduces a general antiavoidance rule to prevent abuses of bilateral tax treaties. according to this rule, in article x paragraph 7: notwithstanding the other provisions of this convention, a benefit under this convention shall not be granted in respect of an item of income or capital if it is reasonable to conclude, having regard to all relevant facts and circumstances, that obtaining that benefit was one of the principal purposes of any arrangement or transaction that resulted directly or indirectly in that benefit, unless it is established that granting that benefit in these circumstances would be in accordance with the object and purpose of the relevant provisions of this convention.123 i clearly support the general anti-avoidance rule, but my difficulty with the proposed rule is that the standard it uses is based on “purpose” and this test, as the domestic experience teaches us, necessitates a problematic level of administrative discretion and costly litigation.124 second, specific anti-avoidance rules: these rules are the core of the oecd proposals as they target specific and common channels used to avoid taxation. for example, action 1 considers the addition of “significant digital presence” as a nexus to establish source taxation in a global digital economy.125 action 2 develops several specific anti-avoidance rules for domestic law to neutralize the effect of hybrid mismatch arrangements and includes changes to the oecd model tax convention to address such 122 the action plan included 15 actions as follows: (1) address the tax challenges of the digital economy; (2) neutralize the effects of hybrid mismatch arrangements; (3) strengthen cfc rules; (4) limit base erosion via interest deductions and other financial payments; (5) counter harmful tax practices more effectively, taking into account transparency and substance; (6) prevent treaty abuse; (7) prevent the artificial avoidance of pe status; (8,9,10) assure that the transfer pricing outcomes are in line with value creation; (11) establish methodologies to collect and analyze data on beps and the actions to address it; (12) require taxpayers to disclose their aggressive tax planning arrangements; (13) re-examine transfer pricing documentation; (14) make dispute resolution mechanisms more effective; (15) develop a multilateral instrument. action plan supra note 121 at 14-24. 123 preventing the granting of treaty benefits in inappropriate circumstances, oecd publishing (2014), at 66. 124 see hm revenue & customs v. mayes [2011] ewca (civ) 407; macniven v. westmoreland invs. ltd. [2001] ukhl 6.; w.t. ramsay ltd v. inland revenue comm’rs. [1982] stc 174.; antony seely, tax avoidance: a general anti-abuse rule, house of commons library, briefing paper number 06265, at 27-33 (2016), http://researchbriefings.parliament.uk/researchbriefing/summary/sn06265 [http://perma.cc/h88t-fpuc]. 125 addressing the tax challenges of the digital economy, oecd publishing (2014), http://www.oecd.org/ctp/addressing-the-tax-challenges-of-the-digital-economy-9789264218789-en.htm [http://perma.cc/kbv2-b5vb]. for further discussion of e-commerce taxation, see rifat azam, global taxation of cross-border e-commerce income, 31 va. tax rev. 639 (2012); rifat azam, e-commerce taxation and cyberspace law: the integrative adaptation model, 12(5) va. j.l. & tech. 1 (2007); reuven avi-yonah, international taxation of electronic commerce, 52 tax l. rev. 507 (1996-1997); orly mazur, taxing the cloud, 103 cal. l. rev. 1 (2015). 2017] minimum global effective corporate tax rate 33 arrangements.126 action 3 considers many options for the design of cfc rules that would prevent beps and puts forth some recommendations on the “building blocks” that are necessary for effective cfc rules.127 in action 4, the oecd proposes to set general interest limitation rules which limit interest deductibility either by fixed ratio or group ratio, as already used or experienced by some countries.128 third, disclosure and transparency rules: the oecd uses disclosure and transparency as an important regulatory tool in coping with beps. action 12 provides a modular framework that enables countries without mandatory disclosure rules to design a regime that fits their need to obtain early information on potentially aggressive or abusive tax planning schemes and their users.129 the country-by-country reporting under action 13 is a new regime that imposes a duty on multinationals to report annually, and for each jurisdiction in which they do business, the amount of revenue, profit before income tax, and income tax paid and accrued. multinationals are also required to report their total employment, capital, retained earnings, and tangible assets in each tax jurisdiction and to describe the structure and business activities of each entity in the jurisdiction. the oecd report includes a model template130 for the country-by-country report.131 126 neutralising the effects of hybrid mismatch arrangements, oecd publishing (2014), http://www.oecd.org/tax/neutralising-the-effects-of-hybrid-mismatch-arrangements-action-2-2015-finalreport-9789264241138-en.htm [http://perma.cc/9ppg-a8xr]. 127 designing effective controlled foreign company rules, action 3 2015 final report, oecd publishing, paris (2015), http://www.oecd.org/tax/designing-effective-controlled-foreign-company-rulesaction-3-2015-final-report-9789264241152-en.htm [http://perma.cc/cj5y-gexf]. 128 limiting base erosion involving interest deductions and other financial payments, action 4 – 2015 final report, oecd publishing, paris (2015), http://www.oecd.org/tax/limiting-base-erosioninvolving-interest-deductions-and-other-financial-payments-action-4-2015-final-report-9789264241176en.htm [http://perma.cc/9jzv-hv47]. 129 mandatory disclosure rules, action 12 2015 final report, oecd publishing, paris (2015), http://www.oecd.org/tax/mandatory-disclosure-rules-action-12-2015-final-report-9789264241442-en.htm [http://perma.cc/t6zl-hnhs]. 130 transfer pricing documentation and country-by-country reporting, action 13 – 2015 final report, oecd publishing, paris (2015), http://www.oecd.org/tax/transfer-pricing-documentation-andcountry-by-country-reporting-action-13-2015-final-report-9789264241480-en.htm [http://perma.cc/a8s4jepw]. on january 27, 2016 thirty-one nations signed the agreement to enable automatic sharing of countryby-country information. see a boost to transparency in international tax matters: 31 countries sign tax cooperation agreement to enable automatic sharing of country by country information, oecd (jan. 27, 2016), http://www.oecd.org/tax/a-boost-to-transparency-in-international-tax-matters-31-countries-sign-tax-cooperation-agreement.htm [http://perma.cc/6ges-gbg3]. 131 the u.s. already incorporates disclosure and transparency in its tax avoidance efforts as seen in its mandatory disclosure regime and recent enactment of fatca in 2010. see foreign account tax compliance act (fatca), dep’t. of the treasury, http://www.treasury.gov/resource-center/taxpolicy/treaties/pages/fatca.aspx [http://perma.cc/4jxp-de3q]; eric j. snyder, fatca and the broader tax crackdown, 21 (6) trusts & trustees 596 (2015), http://tandt.oxfordjournals.org.ezproxy.cul.columbia.edu/content/21/6/596.full [http://perma.cc/c7naf2lx]; joshua d. blank & ruth mason, exporting fatca (n.y.u. ctr. for l., econ & org., working paper no. 14-05, 2015) http://ssrn.com/abstract=2389500 [http://perma.cc/zre2-lbe6]. the u.s. disclosure and transparency rules are among the most developed in the world and have had substantial global influence. i have several insights and contributions concerning disclosure and transparency as anti-avoidance measures but will leave that for another opportunity. 34 columbia journal of tax law [vol.8:5 the prospects of the beps project are complex. 132 some proposals are progressing and are expected to be widely accepted and implemented such as the proposals on country-by-country reporting and the proposals on transparency and information exchange to handle individual tax evasion and the proposals on mutual agreement procedures (map) to solve treaty disputes in timely manner. amendments to the oecd model treaty and to the oecd transfer pricing guidelines are expected to be implemented at the oecd soft law level and they will probably have some indirect impact on bilateral treaty law and case law. beyond these particular proposals, i do not expect further effective implementation or that the g20/oecd beps project will substantially impact the international tax regime. the main challenges of tax competition and corporate tax avoidance are therefore likely to continue to prevail and will require different solutions. one of these solutions is unilateral solution by the united states. the united states participated in the oecd beps project and influenced the project and its outcomes. furthermore, as one of the major players in the field of international tax and leaders of the global economy, the u.s. publicly supported the project in several political announcements.133 but, as gary hufbauer and others have argued, the proposals “would be detrimental to the united states, though some are harmless and a few are actually useful”.134 i agree with shaviro who argued that the oecd-beps project is perceived as “anti-u.s. companies” and would be opposed by both republicans and democrats, and that large amount of money will be deployed as needed in support of this opposition. according to shaviro, the united states will 132 see reuven s. avi-yonah & haiyan xu, evaluating beps, harv. bus. l. rev. (forthcoming 2016), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2716125 [http://perma.cc/m24r-5wfp]; reuven s. avi-yonah, full circle? the single tax principle, beps, and the new us model (mich. pub. l. & legal res. paper series, paper no. 480, 2015), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2673463 [http://perma.cc/l6hz-x9xs]; itai grinberg, breaking beps: the new international tax diplomacy (geo. l. working paper, 2015), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2652894 [http://perma.cc/qk7b-thwd]; eva eberhartinger & matthias petutschnig, practicing experts’ views on beps: a critical analysis, wu int’l tax’n res. paper series, 27 (2015), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2683552 [http://perma.cc/h5jj-gskb]; the beps monitoring group, overall evaluation of the g20/oecd base erosion and profit shifting (beps) project, http://bepsmonitoringgroup.files.wordpress.com/2015/10/general-evaluation.pdf [http://perma.cc/d4v6jeye]; zucman, supra note 9, at 5-6 (2015); michael devereux & john vella, are we heading towards a corporate tax system fit for the 21st century? 35(4) fiscal stud. 449-75 (2014). 133 former president obama, for example, signed the g-7 leaders declaration (schloss elmai, germany) from june 8, 2015 which declares that “we are committed to achieving a fair and modern international tax system which is essential to fairness and prosperity for all. we therefore reaffirm our commitment to finalize concrete and feasible recommendations for the g20/oecd base erosion and profit shifting (beps) action plan by the end of this year. going forward, it will be crucial to ensure its effective implementation, and we encourage the g20 and the oecd to establish a targeted monitoring process to that end. we commit to strongly promoting automatic exchange of information on cross-border tax rulings. moreover, we look forward to the rapid implementation of the new single global standard for automatic exchange of information by the end of 2017 or 2018, including by all financial centres subject to completing necessary legislative procedures. we also urge jurisdictions that have not yet, or not adequately, implemented the international standard for the exchange of information on request to do so expeditiously.” g-7 leaders’ declaration, g-7 (jun. 8, 2015), http://www.whitehouse.gov/the-press-office/2015/06/08/g-7leaders-declaration [http://perma.cc/3c9s-crxk]. 134 see gary hufbauer et al., the oecd’s “action plan” to raise taxes on multinational corporations, peterson inst. for int’l econ., working paper no. 15-14 (sept. 2015), http://piie.com/publications/wp/wp15-14.pdf [http://perma.cc/pm78-e8bm]. 2017] minimum global effective corporate tax rate 35 continue in its tax reform efforts at its own pace and with its own method, and “whatever happens to our rules depends on our own internal processes and debates”.135 i believe that the united states cannot ignore these proposals as they indicate significant changes within the international environment. these proposals will influence other countries to some extent and will certainly influence american multinationals in their global business activity. the united states is taking and should continue to take the new international environment into consideration while designing its domestic tax law and its bilateral tax treaty law on international transactions. however, in addition to taking these international changes and proposals into account, i call on the u.s. to step up and play a much more influential role in the international arena. in my opinion, the united states is the most powerful and influential country in the international tax arena. i do not agree with itai grinberg and joost pauwelyn who argued that “in most other fields, non-cooperation by the united states would be fatal. not so in international tax, where the bargaining power of the u.s. is relatively weak and multilateral discussions without u.s. support can constrain u.s. national interests”.136 the bargaining power of the united states in international tax law is very strong. the unilateral influence of the united states is called by robert kudrle, “vertical diffusion: from the practices of a single state to the international system via the oecd”.137 namely, that the unilateral practices of the united states turn into international law via the oecd. similarly, reuven avi-yonah, called this influence, “constructive unilateralism,” in the sense of unilateral actions by the united states that turn into international law in constructive manner. in the same line of thinking, i argue that the unilateral action by the united states is one important way to handle international corporate tax avoidance, and therefore, i propose unilateral domestic u.s. general antiavoidance rule to combat corporate tax avoidance. v. the proposed minimum global effective corporate tax rate as general anti-avoidance rule a. the proposal the starting point of my proposal is that the u.s. is interested in protecting its corporate tax base while maintaining the competitive position of u.s. multinationals. the united states will act unilaterally to protect its base and fulfill its international tax policy, while taking into account the new international environment. although my proposal is also appropriate for territorial tax systems, my proposal assumes that the united states will continue with its use of a worldwide taxation system. loopholes will continue to exist in any system of international taxation and multinationals will continue to use these loopholes to reduce their tax liability through an endless variety of tax 135 shaviro, supra note 27 (video available at http://www.aei.org/events/the-oecd-base-erosion-andprofit-shifting-report-should-the-united-states-be-worried/). 136 see itai grinberg & joost pauwelyn, the emergence of a new international tax regime: the oecd’s package on base erosion and profit shifting (beps), 19(24) asil insights (2015), http://www.asil.org/insights/volume/19/issue/24/emergence-new-international-tax-regimeoecd%e2%80%99s-package-base-erosion-and [http://perma.cc/4c8w-qdjz]. 137 see robert kudrle, the oecd and the international tax regime: persistence pays off, 16(3) j. of comp. pol’y analysis: res. & practice, 201-15 (2014). 36 columbia journal of tax law [vol.8:5 planning strategies. specific anti-avoidance rules that target these strategies will continue to play an important role in combating this behavior, but these individual rules alone are not enough to face the challenge and it would be more appropriate and effective to look at the overall global effective tax rate and target bottom lines rather than targeting individual methods of international corporate tax avoidance. according to my proposal, the u.s. congress would enact a new section in the internal revenue code that would adopt a general anti-avoidance rule, which imposes a minimum global effective corporate tax rate on u.s. corporations. according to this proposed rule, if the global effective corporate tax rate of any u.s. multinational and its cfc’s falls below 15%, the u.s. corporation will be required to close the gap and pay the irs up until the minimum (15%) tax on its global profits as an interim liability. this system continues the current distinction between u.s. sourced income and foreign sourced income. u.s. source income will continue to be fully taxed by the united states and foreign source income of u.s. corporations will also continue to be fully and currently taxed according to the usual rules. as to foreign source income of u.s. cfc’s, as long as it bears below 15% global effective corporate tax rate, then it will be taxed immediately up until the minimum by the united states. several measures have been used to define effective tax rate in the literature.138 these measures were categorized into six types: first, average effective corporate tax rate, defined as the observed corporate taxes divided by correctly measured corporate income. second, average effective total tax rate which is defined as the observed corporate taxes plus property taxes plus personal taxes on interest and dividends, divided by total capital income. third, marginal effective tax wedge, defined as the expected real pre tax rate of return on a marginal investment, minus the after-tax return to the corporation. fourth, marginal effective corporate tax rate, defined as the marginal effective corporate tax wedge divided by the pre-tax return (tax-inclusive rate) or by the corporation’s post tax return (tax exclusive rate). fifth, marginal effective total tax wedge, defined as the expected real pre-tax rate of return on a marginal investment, minus the real after tax return to the saver who provides the finance. sixth, marginal effective total tax rate, which is defined as the marginal effective total tax wedge divided by the pre-tax return (tax inclusive rate) or by the saver’s post tax return (tax exclusive rate).139 for purposes of my proposal, i use a measurement of an average effective corporate tax rate, not a marginal one. this is because average effective corporate tax rate is more relevant to assuming tax avoidance than marginal effective corporate tax rate that is more related to decisions of the corporate itself on new investments and 138 see, e.g., george plesko, an evaluation of alternative measures of corporate tax rates, 35 j. of acct. & econ. 201-26 (2003); gaetan nicodeme (2001): computing effective corporate tax rates: comparisons and results (econ. papers working paper series, june 2001), http://mpra.ub.unimuenchen.de/3808/ [http://perma.cc/b5wz-3zet]; don fullerton, the use of effective tax rates in tax policy, 39(3) nat’l tax j. 285-92 (sep. 1986); david bradford & charles stuart, issues in the measurement and interpretation of effective tax rates, 39(3) nat’l tax j. 307-16 (sep. 1986); gillian spooner, effective tax rates from financial statements, 39(3) nat’l tax j. 293-306 (sep. 1986); boris bitker, effective tax rates: fact or fancy?, 122 u. pa. l. rev. 780-809 (1974). 139 see don fullerton, which effective tax rate? (nber working paper series, paper no. 1123), http://www.nber.org/papers/w1123 [http://perma.cc/vlb3-tce2]. 2017] minimum global effective corporate tax rate 37 their marginal cost and return.140 average effective corporate tax rate is also the simplest measurement and definition of effective tax rate although it has its own difficulties. one author141 pointed out some of these difficulties: (a) u.s. tax as a proportion of corporate income could omit foreign taxes already paid; (b) profits measured for tax purposes differ from profits measured for financial reporting; and (c) actual taxes in any year may not be related to profits in that year, due to carry forwards of previous credits or losses, and carry backs of current credits or losses. in order to mitigate this difficulty, it might be required to average over several years of taxes in the numerator and of profits in the dominator.142 i define global effective corporate tax rate to be the tax actually paid on foreign income of cfc’s to any jurisdiction in the globe divided by the global profits as it appears in the financial reports of the cfc’s (earnings & profit). in this definition and calculation, i use the paid tax rather than the accrued tax since i see deferral as part of the problem that shall be handled and limited by looking at the actual tax paid. this measurement is made on a global basis rather than country-by-country or entity-by-entity basis. by this definition, i overcome the mentioned criticism of omitting foreign taxes already paid, since these taxes are taken into account and integrated in my formula. this calculation is made each year for the same year and i do not recommend taking longer periods of time into account for purposes of the calculation because i prefer increased simplicity to more accuracy. i use the simple definition because i believe it achieves the proposed goal to limit international corporate tax avoidance and impose fair and effective taxation on the global income of u.s. multinationals while keeping and protecting an appropriate level of competitiveness. i choose 15% as the minimum rate because it is not too low or too high which makes it appropriate to achieve its purposes and because it has already been raised in relevant contexts. still, i want to emphasize that other minimum rates could be adopted during the political process of legislation. this does not and should not affect the core of my proposal since the core is selecting an effective minimum—whether it is 15% or another figure—as the political/professional processes of debating and legislating yield. this taxation presumes that a u.s. multinational that does not meet the minimum tax on the global profits of its cfcs is engaged in international corporate tax avoidance and, therefore, shall pay the minimum to the united states as the resident country of the parent corporation. however, this tax liability is an interim liability that intends to limit international corporate tax avoidance. therefore, although no tax credit is given for foreign taxes paid at the current taxation point, such taxes are taken into account in the formula for purposes of calculating whether the corporation has reached the minimum corporate tax required, and, if not, the corporation is required only to add and pay up to the minimum rather than having to pay the full minimum of 15% in addition to current foreign taxes. upon determination of the final tax liability, the foreign tax credit will be given as well as a credit for the minimum tax paid as an interim liability. 140 see roger gordon, laura kalambokidis & joel slemrod, a new summary measure of the effective tax rate on investment (nber working paper series, working paper 9535, 2003), http://www.nber.org/papers/w9535 [http://perma.cc/2e9e-vjrh]. 141 see seymour fiekowsky, pitfalls in the computation of “effective tax rates” paid by corporations (dep’t of the treasury, ota paper 23, 1977). 142 see leonard g. rosenberg, the taxation of income from capital123-84 (a.c. harberger & m.j. bailey, eds., 1969). 38 columbia journal of tax law [vol.8:5 to clarify my proposal, i would like to implement it on the following example: chart c the current u.s. domestic law imposes current tax liability according to the regular corporate tax rate (35%) on the u.s. profits (200) and the foreign profits (100) of the u.s. corporation (“u.s. co.”), but all the global profits of the subsidiaries are not taxed under the current system. although they are cfcs, their profits are not considered subchapter f income and, therefore, any tax liability is deferred until repatriation. obviously, u.s. co. is locking out, or trapping, substantial amounts of foreign profits in the irish subsidiary to avoid u.s. taxation upon repatriation. b. the justifications of the proposal 1. endless possibilities of international corporate tax avoidance united states multinationals, and actually most multinationals, have endless opportunities for international corporate tax avoidance. the strategies discussed throughout this article, of lock out, corporate inversions, double irish dutch sandwiches, tax havens, profit shifting, profit stripping, ip licensing, transfer pricing, interest deductions, and treaty shopping are only a few examples of endless possibilities of international corporate tax avoidance. while avoiding international corporate tax, u.s. multinationals legally exploit u.s. domestic tax law, foreign tax law, and tax treaty law effectively the entire system of international taxation. given these realities and understanding of the challenge, it is extremely difficult to tackle each method of tax avoidance individually. upon the enactment, or amendment of, any specific antiavoidance rule many new work-around tactics will inevitably be developed. as dave 2017] minimum global effective corporate tax rate 39 hartnett, during his time as director general at hm revenue & customs so clearly described it, when utilizing this type of target specific reform strategy, we are effectively “squeezing the balloon in one area only to see a new bulge emerge in another”.143 this is especially true, in the current global digital economy, where sovereign countries compete to attract mobile capital and investments. it is impossible to fully coordinate between so many jurisdictions with such conflicting interests. in sum, international tax loopholes will always exist and be exploited. therefore, any effort to tackle international corporate tax avoidance must look at the comprehensive picture and target the bottom lines. this is exactly the idea behind my proposed minimum global effective corporate tax rate as general anti-avoidance rule. the rule looks at the overall picture and if the bottom line is below the minimum tax, the law intervenes and imposes the minimum as an appropriate and clear-cut norm of taxation set by the legislator that must be respected and fully implemented. it represents a clear-cut statement, a “red line” of the legislator so to speak, and taxpayers cannot go below this red line under any circumstances. 2. effectiveness of technical general anti-avoidance rules the united states judiciary has long been an activist in interpreting tax laws, fashioning a number of anti-avoidance doctrines to reflect the presumed intent of congress in enacting the income tax laws. these doctrines are known under the names “substance over form, step transaction, business purpose, sham transaction, and economic substance”.144 the doctrines do not have an explicit grounding in specific language of the statute. these doctrines, which are overlapping, have been developed gradually by the courts, and their contours are indistinct. because their application is controversial, and because they are grounded in the specific fact patterns of decided cases, it is impossible to precisely describe them or to predict with certainty when they will apply.145 for example, the “economic sham” doctrine generally means that transactions performed solely for tax avoidance reasons are disregarded for tax purposes. however, even after long experience, the courts have not worked out precisely how this doctrine is applied. 143 dave hartnett, then director general at hm revenue & customs in a speech in 2005 (address to ciot as part of 75th anniversary celebrations, 19 july 2005). see also oxford u. ctr. for bus. tax’n, tax avoidance, december 2012 (in particular, 17-20). 144 see joseph bankman, the economic substance doctrine, 74 s. cal. l. rev. 5 (2000); david m. schizer, frictions as a constraint on tax planning, 101 colum. l. rev. 1312 (2001); symposium, business purpose, economic substance and corporate tax shelters, 54 smu l. rev. 37 (2001); symposium, corporate tax shelters, 55 tax l. rev. 125 (2002); ralph s. rice, judicial techniques in combating tax avoidance, 51 mich. l. rev. 1021 (1953); marvin a. chirelstein, learned hand’s contribution to the law of tax avoidance, 77 yale l.j. 440 (1968); alvin c. warren, the requirement of economic profit in tax motivated transactions, 59 tax mag. 985 (1981); kenneth w. gideon, mrs. gregory’s grandchildren: judicial restriction of tax shelters, 5 va. tax rev. 825 (1986); joshua rosenberg, tax avoidance and income measurement, 87 mich. l. rev. 365 (1988); assaf likhovski, the duke and the lady: helvering v. gregory and the history of tax avoidance adjudication, 25 cardozo l. rev. (2004). 145 for an economic analysis of these norms and line drawing in tax law generally, see david weisbach, an economic analysis of anti-tax-avoidance doctrines, 4(1) am. l. & econ. rev. 88, 88-115 (2002); david weisbach, ten truths about tax shelters, 55(2) tax l. rev. (2002); david weisbach, formalism in tax law, 66 u. chi. l. rev. (1999); david weisbach, an efficiency analysis of line drawing in tax law, 29 j. of legal stud. 71 (2000); philip a. curry, claire a. hill & francesco parisi, creating failures in the market for tax planning, 26 va. tax rev. 943 (2007); yehonatan givati, walking a fine line: a theory of line drawing in tax law, 34 va. tax rev. 469-502 (2015). 40 columbia journal of tax law [vol.8:5 several factors affect the judicial decision making in these cases. in a very interesting study of these factors on corporate shams cases, blank and staudt concluded: “our empirical results run counter to the conventional wisdom that judges do not follow predictable patterns when deciding corporate abuse cases. we uncover a collection of factors that systematically lead supreme court justices to favor (or disfavor) the government in the controversies that appear on the court’s docket. by explaining the judicial decision making process and the factors linked to specific judicial outcomes, we believe that our study will increase knowledge and understanding of the law that governs and defines corporate abuse. this more nuanced understanding of corporate tax law, in turn, should have important practical implications for private practitioners, government lawyers, and policymakers.”146 to overcome some of the ambiguity of the “economic substance doctrine,” for example, congress enacted in 2010 section 7701(o) of the irc which codifies147 the tests of the “economic substance doctrine” in these words: “(1) application of doctrine: in the case of any transaction to which the economic substance doctrine is relevant, such transaction shall be treated as having economic substance only if — (a) the transaction changes in a meaningful way (apart from federal income tax effects) the taxpayer’s economic position, and (b) the taxpayer has a substantial purpose (apart from federal income tax effects) for entering into such transaction.” this section contributed some clarifications on the implication of the doctrine but, still, there is a lot of ambiguity.148 additionally, the irs didn’t really try to use section 7701(o) or the common law doctrines to tackle tax avoidance in international transactions. the main usage of these tools had focused on internal tax avoidance transactions. for these two main reasons, ambiguity and internal usage, the effectiveness of section 7701(o) and the common law doctrines in combating international corporate tax avoidance was limited. but their effectiveness in combating domestic corporate tax avoidance was much better.149 146 see josh blank & nancy staudt, corporate shams, 87 n.y.u. l. rev. 1641, 1708 (2012). 147 in her article, tax abuse lessons from abroad, 65 smu l. rev. 551 (2012), orly sulami argued that section 7701(o) of the internal revenue codes, codifies the economic substance doctrine and constitutes a version of general anti avoidance rule (gaar). see also jerome libin, congress should address tax avoidance head-on: the internal revenue code needs a gaar, 30 va. tax rev. 339 (2010) (analyzing section 7701(o) and calling to move forward and adopt a gaar). 148 see bret wells, economic substance doctrine: how codification changes decided cases, 10 fla. tax rev. 411 (2010); orly sulami, tax abuse – lessons from abroad, 65 smu l. rev. 551 (2012); philip sancilio, note: clarifying (or is it codifying) the notably abstruse: step transactions, economic substance, and the tax code, 113 colum. l. rev. 138 (2013). 149 see david weisbach, an economic analysis of anti-avoidance doctrines (john m. olin law & econ. working paper no. 99, 2002), http://m.law.uchicago.edu/files/files/99.daw_.tax-avoidance-new.pdf [http://perma.cc/87gc-pra5], arguing that we can view tax shelters as a problem of defining the tax base. shelters arise because of the difficulty of specifying or observing the base perfectly. they are, effectively, inadvertent omissions from the tax base. that is, we might have thought we were taxing income or consumption, but it turns out that if taxpayers buy and sell exotic derivatives in the right combination or change the corporate structure in the right way, taxes are not due. the tax base is narrower than we thought. this affects the elasticity of taxable income just like any other omission from the tax base. anti-avoidance doctrines affect the ability of taxpayers to shift into shelters and, therefore, are a policy tool that affects the elasticity of taxable income and the efficiency of the tax system. as these doctrines are strengthened, the elasticity of taxable income goes down (in absolute value). by reducing the marginal elasticity of taxable income, the doctrines increase the efficiency of the tax system. because the doctrines cannot perfectly identify tax avoidance, however, they induce a distortionary response by taxpayers, who may structure shelters to avoid the doctrines. this distortionary effect reduces their efficiency. the net benefit should be set equal on the margin to the marginal administrative cost of the doctrines. 2017] minimum global effective corporate tax rate 41 the united states could, and should, learn from the positive experience of other jurisdictions, such as canada, australia150 , israel151 , and recently the uk152 , who successfully combated domestic tax avoidance strategies by enacting a general antiavoidance rule. the united states should also improve the ambiguity of the gaars and their limited use to combat international corporate tax avoidance.153 in canada, for example, the gaar is codified in section 245 of the canadian income tax act in very broad and vague words that consider almost any tax benefited transaction to be an “avoidance transaction” unless another bona fide purpose is proved.154 drawing the lines according to the canadian gaar in section 245 involves judicial discretion and results in some uncertainty.155 in their empirical study of the canadian tax court gaar decisions, jinyan li, thaddeu and hwong found that: “first, gaar has been a game changer, albeit a modest one, with respect to the courts’ approach to tax-avoidance cases. second, while considerable uncertainty remains with respect to the application of gaar, a pattern in judicial decisions appears to be emerging. third, there are indications that a judicial smell test is at play in some gaar 150 see chris atkinson, general anti-avoidance rules: exploring the balance between the taxpayer's need for certainty and the government's need to prevent tax avoidance, 14 j. austl. tax’n (2012); g. t. pagone, tax avoidance in australia (2010); jeffrey waincymer, the australian tax avoidance experience and responses: a critical review, in tax avoidance and the rule of law 247 (1997); julie cassidy, to gaar or not to gaar: that is the question: canadian and australian attempts to combat tax avoidance, 36 ottawa l. rev. 259-313 (2004-2005); susan morse, robert deutsch, tax anti avoidance law in australia and the united states, 49 int’l law 111 http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2807077 [http://perma.cc/mj7k-ew3n]. 151 see assaf likhovski, formalism and israeli anti-avoidance doctrines in the 1950’s and 1960’s in studies in the history of tax law 339 (2004). 152 see report by graham aaronson qc, gaar study: a study to consider whether a general antiavoidance rule should be introduced into the uk tax system (2011), http://webarchive.nationalarchives.gov.uk/20130605083650/http:/www.hmtreasury.gov.uk/d/gaar_final_report_111111.pdf [http://perma.cc/wz5m-uksj]; see also antoney seely, tax avoidance: a general anti avoidance rule, house of commons library, briefing paper number 06265 (may 13, 2015), http://researchbriefings.parliament.uk/researchbriefing/summary/sn06265 [http://perma.cc/h2xw-4tdc]; tax law review committee, tax avoidance (nov. 1997), http://www.ifs.org.uk/comms/comm64.pdf [http://perma.cc/58mr-3xp6]; trace bowler, tax law review committee, countering tax avoidance in the uk: which way forward (feb. 2009). 153 see rosenblatt, paulo, general anti-avoidance rules for major developing countries (2015); mcmechan, robert, economic substance and tax avoidance: an international perspective, (2013); simpson, edwin and stewart, miranda, sham transactions (2013); brown, keren, a comparative look at regulation of corporate tax avoidance, (2012). 154 the literature on the canadian gaar is very rich and includes for example: david g. duff and harry erlichman, eds., tax avoidance in canada after canada trustco and mathew (2007); nathalie goyette, countering tax treaty abuses: a canadian perspective on an international issue (1999); william i. innes, patrick j. boyle, and joel a. nitikman, the essential gaar manual policies, principles and procedures (2006); david dodge, a new and more coherent approach to tax avoidance, 36(1) can. tax j. 1-22 (1988); brian j. arnold and james r. wilson, the general anti avoidance rule—part 1, 36(4) can. tax j. 829-87 (1988); brian j. arnold and james r. wilson, the general antiavoidance rule—part 2, 36:5 can. tax j. 1123-85 (1988); and john r. owen, statutory interpretation and the general anti-avoidance rule: a practitioner’s perspective, 46(2) can. tax j. 233-73 (1998); brian j. arnold, policy forum: confusion worse confounded—the supreme court’s gaar decisions, 54(1) can. tax j. 167-209 (2006); brian kearl and bruce lemons, gaar in the tax court after canada trustco: a practitioner’s guide 55(4) can. tax j. 745-76 (2007). 155 see jinyan li “economic substance”: drawing the line between legitimate tax minimization and abusive tax avoidance, 54(1) can. tax j. 23 (2006); brian arnold, the long, slow, steady demise of the general anti-avoidance rule, 52 can. tax j. 488 (2004). 42 columbia journal of tax law [vol.8:5 decisions; in particular, judicial decision making in gaar cases appears to have been influenced by the judge’s attributes, including experience on the tax court, gender, pre appointment experience, and regional ties.”156 the uk law changed dramatically upon the enactment of general anti abusive rule in the finance act of 2013.157 the adoption of a gaar in the uk was based on the recommendations of the aaronson committee.158 leading tax scholars and economists in the uk have supported gaar for many years.159 this new gaar counteracts “abusive tax arrangements” which is defined based on the purpose of the arrangement and its reasonable course of action.160 this shift in the uk from judicial doctrines to a statutory gaar is extremely important because the shift was made after years of experience with using specific anti-avoidance rules and disclosure rules as instruments in combating tax avoidance.161 the uk experience can serve as a valuable model for the adoption of a gaar in the united states. this is exactly the argument that i am making here. the uk and other jurisdictions’ experiences prove that there is additional value in codifying general anti 156 see jinyan li, thaddeus hwong, gaar in action: an empirical exploration of tax court of canada cases (1997-2009) and judicial decision making, 61 can. tax j. 321 (2013). 157 see tax avoidance: a general anti-abuse rule, house of commons library, parliament.uk (apr. 2016), http://researchbriefings.parliament.uk/researchbriefing/summary/sn06265 [http://perma.cc/akq6-8bz3]. 158 see report by graham aaronson qc, gaar study: a study to consider whether a general anti avoidance rule should be introduced into the uk tax system (2011), http://webarchive.nationalarchives.gov.uk/20130321041222/http:/www.hmtreasury.gov.uk/d/gaar_final_repo rt_111111.pdf [http://perma.cc/4xp6-alsy]; see also antoney seely, tax avoidance: a general anti avoidance rule (house of commons library, briefing paper number 06265 (may 13, 2015), http://researchbriefings.parliament.uk/researchbriefing/summary/sn06265 [http://perma.cc/xz95-rmqp]; tax law review committee, tax avoidance (nov. 1997), http://www.ifs.org.uk/comms/comm64.pdf [http://perma.cc/y329-vcn8]; trace bowler, tax law review committee, countering tax avoidance in the uk: which way forward (feb. 2009). 159 see judith freedman, defining taxpayer responsibility: in support of a general antiavoidance principle, brit. tax rev. 332 (2004); see also judith freedman, gaar as a process and the process of discussing a gaar, brit. tax rev. 1, 22-27 (2012); michael devereux, judith freedman and john vella, tax avoidance, oxford u. ctr. for bus. tax’n, http://www.sbs.ox.ac.uk/sites/default/files/business_taxation/docs/publications/reports/ta_3_12_12.pdf [http://perma.cc/82zw-49dc] michael devereux, judith freedman and john vella, the disclosure of tax avoidance schemes regime, oxford u. ctr. for bus. tax’n (http://www.sbs.ox.ac.uk/sites/default/files/business_taxation/docs/publications/reports/dotas_3_12_12. pdf [http://perma.cc/p2rd-aqr9]. 160 see tax avoidance: general anti-abuse rule, gov.uk (jan. 2016), http://www.gov.uk/government/publications/tax-avoidance-general-anti-abuse-rules [http://perma.cc/hza7kh98]. 161 see antony seely, tax avoidance: a general anti avoidance rule – background history (1997-2010) (house of commons library (may 13, 2015), http://researchbriefings.parliament.uk/researchbriefing/summary/sn02956 [http://perma.cc/2fur-alye]. 2017] minimum global effective corporate tax rate 43 avoidance rules.162 they add to, and enhance, the specific anti-avoidance rules that are already being used, which are effective in combating tax avoidance at the national or domestic level, but are limited in scope when addressing international tax concerns and are often ambiguous.163 we have learned a lot about fighting domestic tax avoidance164 and this experience could, and should, be used to help combat international corporate tax avoidance through gaars. i call on congress to pass a gaar. my proposed general anti-avoidance rule does not use vague and discretional terms such as “purpose” or “abuse.” instead, it uses very technical criteria: minimum global effective corporate tax rate. my proposed gaar clearly focuses on, and targets, international corporate tax avoidance, since it examines the global corporate effective tax rate and makes sure that it does not fall below the minimum. as a result of these modifications, it is expected to be an effective, and unambiguous, tool in combating international corporate tax avoidance. i do not agree with arnold and wilson, who argued that the effectiveness of gaar’s on combating international tax planning is limited.165 they analyzed three case studies that involve: an inbound treaty shopping in which the objective was to reduce source country tax; an outbound transfer of intellectual property in which the objective was to reduce residence country tax; and an outbound u.s. tower financing structures designed to reduce both source and resident countries’ tax. they applied the canadian specific and general anti-avoidance rules, as interpreted by the canadian courts, on these cases to examine the effectiveness of the canadian anti-avoidance regime in combating these international tax planning schemes. they found that “the anti-avoidance rules of most countries primarily target aggressive tax planning in the domestic context rather than in the international context. … [t]he efficacy of a gaar in curbing international tax planning is far from clear”166 and that “to date, with few exceptions, the crown has fared poorly in gaar cases where it has asserted that treaty benefits should be denied in tax-avoidance cases.”167 they argued that “[w]ith respect to international tax avoidance, even a combination of specific anti-avoidance rules and a gaar may be insufficient; an effective response to international tax avoidance requires coordinated international action by governments, as discussed in connection with the oecd’s beps project.” 168 162 the eu believes in gaar’s as an effective instrument to handle tax avoidance. in 2012 the commission published an action plan to strengthen the fight against tax evasion and two sets of recommendations that were assigned to further discussions and implementation at the platform for tax good governance. the first recommendation, on measures intended to encourage third countries to apply minimum standards of good governance in tax matters, which focused on transparency, exchange of information and lists of non-cooperative jurisdictions based on some criteria. this recommendation has developed in march 2015 to a “transparency package” that includes several channels of transparency and exchange of information between ms including automatic exchange of information on tax rulings. the second set of recommendations, on aggressive tax planning, which recommended member states to adopt a general anti-abuse rule to counteract aggressive tax planning practices which fall outside the scope of their specific anti-avoidance rules; see platform for tax good governance, eur. commission, http://ec.europa.eu/taxation_customs/taxation/gen_info/good_governance_matters/platform/index_en.htm [http://perma.cc/jku3-8rzl]. 163 see tim edgar, building a better gaar, 27 va. tax rev. 833 (2008). 164 see david weisbach, ten truth about tax shelters, 55 tax l. rev. 215, (2001-2002). 165 see brian j. arnold & james r. wilson, aggressive international tax planning by multinational corporations: the canadian context and possible responses, 7 ssp res. papers (2014). 166 id. at 18. 167 id. at 48. 168 id. at 28. 44 columbia journal of tax law [vol.8:5 however, “the key issue presented by the oecd’s beps project is whether oecd member countries and other countries with large economies will be willing to take coordinated action against aggressive international tax avoidance. given the current political paralysis prevailing in the united states, it seems unlikely that the u.s. will be able to take any effective action in this regard even if the u.s. government concludes that such action is desirable. without action by the u.s., it seems unlikely that canada, and other smaller countries, would be willing to take any significant action to curtail aggressive tax planning by their multinationals that might risk placing them at a competitive disadvantage vis-à-vis american multinationals.”169 i argue that it is the effectiveness of the current gaars, and their interpretation and implementation by courts on international tax avoidance, that is limited but it is not a general argument against gaars and international tax planning. the details and the design of a gaar determine its effectiveness. based on this understanding, i propose a well-designed gaar to combat international tax avoidance. i agree that the u.s. is the leading player and that, therefore, if the u.s. adopts my proposal, this will encourage other countries to adopt it as well, which will make a substantial contribution to curtailing international corporate tax avoidance on a global scale. based on former president obama’s proposed minimum tax, and other minimum tax proposals in the u.s., it seems feasible, and reasonable, for the u.s. to adopt my proposal addressing political feasibility and constructive unilateralism, which i will elaborate on in later sections. 170 3. reducing the lock out effect the proposed regime is expected to reduce the lock out effect since the tax burden on un-repatriated profits will rise and the gap between the tax burden on unrepatriated profits and on repatriated profits will decrease, meaning less tax benefits of lock out. this is especially true as long as the proposals and plans of reducing the u.s. corporate tax rate from 35% to around 25% are implemented. the repatriation holiday of 2004 proved that u.s. multinationals are interested in repatriation and are ready to pay a tax price for repatriation as long as the price is low.171 of the roughly 9,700 companies that had cfcs in 2004, 843 corporations took advantage of the drd, repatriating $362 billion, of which $312 billion was eligible for deduction.172 the companies that chose to take advantage of section 965 and repatriate earnings in excess of their baseline averages were overwhelmingly large, multinational companies. the average total year-end assets of participating firms were more than $24 billion, and the average amount repatriated was roughly $429 million. those firms were predominantly in mature industries.173 169 id. at 56. 170 section v(b)(9)&(10). 171 section 965, enacted as part of the jobs act in october 2004, allowed a u.s. corporate shareholder (uss) to elect, for one tax year, to receive an 85% dividends received deduction (drd) on qualifying dividends received from its controlled foreign corporations. that allowance would generally reduce the effective tax rate on repatriated earnings to 5.25% (irs, irc 965 dividend repatriation audit guidelines, lmsb-0808-043, doc 2011-16107, 2011 tnt 143-47 (aug. 27, 2008). 172 melissa redmiles, the one-time received dividend deduction, 27 statistics of income bulletin 102 (2008). 173 see id., roy clemons & michael r. kinney, an analysis of the tax holiday for repatriation under the jobs act, tax notes 758 (2008). 2017] minimum global effective corporate tax rate 45 the same is true the other way around. if the benefit of lock out is around 10%, then u.s. multinationals are expected to prefer repatriation. as the economic literature reveals, currently, u.s. multinationals do not repatriate foreign cash to avoid the u.s. repatriation tax.174 it is proved that locked out cash due to repatriation tax costs leads managers to invest overseas, but these investments are less value enhancing, possibly reflecting agency issues. in other words, the cost of lock out is not just tax revenue losses but also economic losses as result of distorting investment decisions.175 therefore, reducing lock out would raise both tax revenues, as well as economic benefits, because the corporate decisions are expected to be motivated more by economic efficiency considerations than tax efficiency considerations, which will reduce the lockout distortions.176 but, it is not clear, whether these economic benefits include investments in the united states and job creation since the experience of the 2004 tax holiday illustrated that firms that chose not to repatriate had more growth investment opportunities in the united states and invested more in growth in the years following the holiday. it has also been shown that there was no statistically significant increase in spending in research and development, capital expenditures, and acquisitions among the repatriating firms. the only statistically significant increase in spending by those firms was in share repurchases, suggesting the repatriated funds merely replaced funds that had already been allocated for investment, and that those funds, now freed up, were returned to shareholders.177 4. limiting profit shifting my proposed regime is also expected to reduce profit shifting from a u.s. parent company to its foreign subsidiaries located in no, or low, tax jurisdictions, as well as profit shifting between the foreign subsidiaries from higher to lower tax jurisdictions. this is because all the profits of all the cfcs on global basis would be subject to the minimum tax. hence, the tax benefits of profit shifting are very much reduced. no matter where the profits are located, as long as they bear less than 15%, the minimum tax will have to be paid, which is calculated on a global bases and does not differentiate between the different jurisdictions. therefore, the incentives to shift profits between jurisdictions are substantially lowered. as the literature reveals, profit shifting activities are very sensitive to changes in tax rates.178 in a recent study, dowd, landefeld and moore found that, “for u.s. multinational companies, the effect on profits reported in a foreign subsidiary of a 1 174 see c. fritz foley, jay c. hartzell, sheridan titman & gary twite, why do firms hold so much cash? a tax-based explanation, 86 j. of fin. econ. 579, 579-607 (2007). 175 see michelle hanlon, rebecca lester & rodrigo verdi, the effect of repatriation tax costs on u.s. multinational investment, 116 j. of fin. econ. 179, 179-196 (2015). 176 see mihir desai, c. fritz foley & james r. hines jr., repatriation taxes and dividend distortions, 54 nat’l tax j. 829, 829–851 (2001). 177 see roy clemons & michael r. kinney, an analysis of the tax holiday for repatriation under the jobs act, tax notes, 759 (2008); see also donald j. marples & jane g. gravelle, tax cuts on repatriation earnings as economic stimulus: an economic analysis, crs report for cong., cong. res. serv. (2011). 178 see harry grubert & john mutti, taxes, tariffs and transfer pricing in multinational corporate decision making, 73 rev. of econ. & stat., 285, 285-293 (1991); james r. hines & eric m. rice, fiscal paradise: foreign tax havens and american business, 109 q.j. econ. 149, 149-182 (1994); jost h. heckemeyer & michael overesch, multinationals' profit response to tax differentials: effect size and shifting channels, 45 zew discussion papers 13 (2013). 46 columbia journal of tax law [vol.8:5 percentage point increase in the net of tax rate (that is, a tax decrease in a foreign country) depends crucially on whether the country has a low rate or a high rate. under the linear specification, a 1 percentage point reduction in the tax rate would result in a 1.4% increase in reported profits, regardless of whether the original tax rate was at 5% or 30%. however, under the quadratic specification, a change in the tax rate from 5% to 4% results in 4.7% increase in profits while a change from 30% to 29% results in a 0.7% increase in profits. we estimate that reported profits in bermuda, the cayman islands, ireland, luxembourg, the netherlands, and switzerland would decline by more than $100 billion in 2010 had these countries had statutory tax rates of 29% and average tax rates of 17%. this is nearly double the response we would get using a more traditionally estimated elasticity.”179 these and other tax havens are not expected to increase their tax rates but the home countries of multinationals could do that indirectly through my proposed minimum tax regime. this regime increases the effective tax rate on tax haven incomes and therefore, as the study reveals, is expected to limit profit shifting and the profits in tax havens would decline substantially. profit shifting would also be further limited as long as the oecd beps project moves forward and other countries implement the measures proposed by the oecd beps project in their domestic law or in their bilateral tax treaty network. i specially believe in two measures of the oecd to reduce profit shifting: the general anti-avoidance rule in action 6 concerning treaty abuse and the transparency and country-by-country reporting regimes in reports 12 & 13 of the oecd. obviously, further adoption of my proposed minimum global effective corporate tax rate as a gaar in other jurisdictions (especially leading developed countries) unilaterally or multilaterally by the oecd would substantially contribute to the goal of limiting international profit shifting. 5. u.s. competitiveness “competitiveness” is used extensively in the tax policy debate in connection to the nations as well as the corporations within them, although it seems more appropriate and convincing to debate the competitiveness of corporations.180 the definition of competitiveness is not totally clear, nor is its role in the international tax debate. 181 roughly speaking, it means the ability of the u.s. multinationals to compete with their counterparts on investments and market shares globally. it is the idea of enabling u.s. multinationals to invest, and sell and expand their share in the markets of the global economy. to accomplish that, supporters argue that the united states should exempt its corporations on their foreign income while opponents argue that such an exemption is not needed because the competitiveness of u.s. multinationals is not threatened or significantly weakened as a result of the u.s. tax law. as the data reveals, the argument that u.s. corporate tax rules make u.s. mnes less competitive in foreign markets compared with european and japanese mnes is 179 see staff of joint comm. on tax’n, 114th cong., profit shifting of u.s. multinationals (jan. 6, 2016). 180 see paul krugman, competitiveness: a dangerous obsession, foreign aff. (mar. 1994) 28; eric toder, international competitiveness: who competes against whom and for what?, 65 n.y.u. tax l. rev. 505, 509 (2012). 181 see michael s. knoll, the connection between competitiveness and international taxation, 65 n.y.u. tax l. rev. 349, 351 (2012); jane gravelle, does the concept of competitiveness have meaning in formulating corporate tax policy?, 65 n.y.u. tax l. rev. 323, 325 (2012). 2017] minimum global effective corporate tax rate 47 generally wrong. 182 i completely agree with the convincing argument that “[c]ompetitiveness has nothing to do with this,” as professor kleinbard expressed clearly.183 u.s. multinationals plan their tax strategies because they want to increase profits by reducing costs, including tax costs. this is a simple and natural behavior for any multinational because corporations are meant to maximize their profits. this behavior does not stem from the fact that the u.s. corporate tax rate is high or because u.s. multinationals suffer any additional burdens that impact their competitive position. they avoid taxation and will continue to do so no matter what the u.s. corporate tax rate is, as long as there are ways to substantially reduce their tax bill. it should not surprise any policymaker that multinationals are doing their best to avoid international corporate tax and lower their effective taxation or that they are succeeding impressively.184 the problem is that policymakers in the united states, and all over the world, have not responded to this exploitation of the current international tax regimes in a timely or effective manner. they must do so now. my proposal is not expected to negatively affect the competitiveness of the u.s., or its domestic corporations, since the added tax burden is a low rate (15%) below the average corporate tax rate in most oecd and developed countries. in any case, u.s. multinationals are dominant in their fields of business and have substantial business advantages over their competitors that will enable these companies to maintain their share of the global markets (even if required to pay this proposed minimum tax) while contributing to the u.s. budget and the fairness of the u.s. tax system and society. these advantages will also contribute to the competitiveness of u.s. multinationals in comparison to other multinationals from territorial systems and in the relatively small real economy markets located in tax havens. 6. fairness the current situation is obviously unfair in many respects. it is unfair in terms of the low tax burden on big multinationals in comparison to the high tax burden on local corporations, small and medium as well. it is unfair in terms of the comparison between multinationals and individuals. while multinationals bear a one-digit tax burden, individuals are paying more than 30% tax rates. it is not surprising that the public is 182 reuven s. avi-yonah & yaron lahav, the effective tax rates of the largest u.s. and eu multinationals, 65 n.y.u. tax l. rev. 375, 377; brian j. arnold, a comparative perspective on the u.s. controlled foreign corporation rules, 65 n.y.u. tax l. rev. 473 (2012); melissa costa & jennifer gravelle, taxing multinational corporations: average tax rates, 65 n.y.u. tax l. rev. 391, 408 (2012). 183 see edward kleinbard, competitiveness has nothing to do with it, 144 tax notes 1055 (2014). 184 see kevin s. markle & douglas a. shackelford, cross-country comparisons of the effects of leverage, intangible assets, and tax havens on corporate income taxes, 65 n.y.u. tax l. rev. 415, 415 (2012). 48 columbia journal of tax law [vol.8:5 demonstrating and expressing this frustration in the streets and the media.185 the problem of fairness is serious and must be solved.186 i argue that my proposal improves the system in terms of fairness as well. my proposal reduces the tax gap between big multinationals and small/mediumsized local corporations. the tax burden on big multinationals is expected to be no less than 15%, which makes it fairer in comparison with small/medium-sized local corporations. these small/medium corporations are very important to american society and the economy, and fair taxation of these corporations is an interest that the united states accepts and should advance.187 my proposal tries to reduce the tax gap between multinationals and individuals, while admitting that there is difference between corporations and individuals for many reasons. corporations will continue to pay less taxes, but only to a limit, and the limit is the minimum global effective corporate tax rate. in my proposal, the jurisdiction to impose the minimum 15% tax is given to the resident country because the source country consciously chose not to act on its first right of taxation. furthermore, in my opinion, under such circumstances, when the source country operates effectively as a tax haven, it seems more equitable to grant the right of taxation to the home country, because the home country, and its laws, are what enabled the multinational to create and benefit from a global business. this allocation of taxation is also justified, because it gives incentives for resident countries to adopt the proposed regime. in the long run, it might also produce a race to the top, since residence countries will be increasingly interested in adopting the regime and setting a minimum rate in order 185 see tax just. blog, http://www.taxjusticeblog.org/ [http://perma.cc/2arl-l8l3] (last visited sept. 28, 2016); tax just. network, http://www.taxjustice.net/ [http://perma.cc/2arl-l8l3] (last visited sept. 28, 2016); am. for tax fairness, http://www.americansfortaxfairness.org/ [http://perma.cc/3dm5vlh2] (last visited sept. 28, 2016); citizens for tax just., http://ctj.org/ [http://perma.cc/b9xw-ws3b] (last visited sept. 28, 2016); the tax policy blog, tax found., http://taxfoundation.org/blog [http://perma.cc/yw3d-92f6] (last visited sept. 28, 2016); maya forstater & vijaya ramachandran, how much do we really know about multinational tax avoidance and how much is it really worth?, ctr. for global dev. (jul. 12, 2015), http://www.cgdev.org/blog/how-much-do-we-really-know-about-multinationaltax-avoidance-and-how-much-it-really-worth [http://perma.cc/82m6-68fg]; tax sanity, facebook, http://www.facebook.com/taxsanity/ [http://perma.cc/vx7l-4cwh]. 186 “it’s clear that any proposal for bipartisan tax reform should restore fairness to the tax code. currently, the tax code is riddled with loopholes that were systematically inserted by special interests resulting in the ability for large, multinational corporations to shift their tax responsibilities to small businesses, domestic businesses and average taxpayers. this creates winners and losers, where the winners are lawyers, accountants, tax advisors, and the losers are average taxpayers. we must correct this systemic unfairness where certain players manipulate our tax laws to their own advantage.” email from the fact (financial accountability and corporate transparency) coalition to s. comm. on fin. apr. 15, 2015), http://thefactcoalition.org/wpcontent/uploads/2015/04/factcoalition.submission.senatefinance.businessinternationalworkinggroups.p df [http://perma.cc/j3sk-cjdg]. 187 see press release, white house, statement by the president on national small business week (may 12, 2014), http://www.whitehouse.gov/the-press-office/2014/05/12/statement-president-national-smallbusiness-week [http://perma.cc/73w9-89g6]; mirit eyal-cohen, why is small business the chief business of congress?, 43 rutgers law j. 1 (2012); mirit eyal-cohen, down sizing the little guy myth in legal definitions, 98 iowa law rev. 1041 (2013); mirit eyal-cohen, legal mirrors of entrepreneurship, 55 b.c. l. rev. 719 (2014); ronald f. wilson, federal tax policy: the political influence of american small business, 37 s. tex. l. rev. 15, 28 (1996) (discussing the impact and influence of small business organizations); irwin l. kellner, a bright forecast for small businesses, n.y. times (jun. 24, 1984) (supporting the idea that small businesses are the business of our country); mansel g. blackford, a history of small business in america (2d ed. 2003). 2017] minimum global effective corporate tax rate 49 to get the right of taxation as the resident country. finally, from an administrative point of view, it is easier and more efficient to have the resident country set, and impose, the minimum rate, since it is the only country that has all the information about the global incomes of its residents and has the ability to take into consideration the global circumstances of taxpayers and, thus, to impose a fair and effective minimum tax according to the proposed regime. in sum, the international tax regime did not intend to produce “stateless income” or “homeless income” or “double non-taxation” or extremely low effective tax rates but rather intended to tax income at least once (the single tax principle). minimum global effective corporate tax rate is meant to keep this exact principle entirely enact and to limit extreme cases of low effective corporate tax rates. this will substantially contribute to the goal of making the u.s. international tax regime more equitable. 7. economic efficiency obviously, economic efficiency considerations have dominated the international tax literature since its beginning. 188 both sides of the debate relied on economic efficiency to support their positions. proponents of worldwide taxation argue that it is economically justified according to the criteria of cen, while proponents of territorial taxation argue that it is economically justified based on cin and con criteria. however, these theoretical economic models did not solve the complexities of international taxation in the global digital economy of the twenty-first century. i agree with the criticism concerning the role of these criteria in fixing and designing the international tax regime. reality is very complicated and different from the pure theoretical models, and policy should be made according to a very wide scope and complex set of considerations. for all these and other difficulties, the role of economic efficiency arguments in my proposal is limited. i mainly try to follow current ideologies of efficiency and limit any infringement of these ideologies. it seems to me that the proposed minimum tax follows these directions of thought. 8. political feasibility 188 see thomas horst, a note on the optimal taxation of international investment income, 94 q.j. econ. 793-798 (1980); thomas horst, the optimal taxation of international investment income: reply, 97 q.j. econ. 381 (1982); michael keen & hannu piekkola, simple rules for the optimal taxation of international capital income, 99 scandinavian j. econ. 447-461 (1997); joel slemrod et al., the seesaw principle in international tax policy, 65 j. pub. econ. 163 (1997); james r. hines jr., the case against deferral: a deferential reconsideration, 52 nat’l tax. j. 385 (1999); michael keen & david wildasin, pareto-efficient international taxation, 94 am. econ. rev. 259 (2004); james hines, reconsidering the taxation of foreign income, 62 tax. l. rev. 269-298 (2009). 50 columbia journal of tax law [vol.8:5 after long discussions and debates, international corporate tax reform seems to be imminent, though it might be a limited rather than comprehensive reform.189 former president obama and his administration made substantial progress in the process, and his view is very clear as was explicitly expressed in his final state of the union on january 12, 2016, which was quoted at the beginning of this article. president trump supported ”[e]nd[ing] the deferral of overseas corporate income but preserv[ing] the foreign tax credit [and] [e]nact[ing] a deemed repatriation of foreign income at a 10% rate”. the public is not satisfied with the current situation where corporations are exploiting the system and avoiding taxation. the unfairness of the current situation where individuals, mainly middle-class individuals, are bearing the brunt of the tax burden while corporations are paying so little tax is intolerable. the public has expressed its opinions clearly through the media and later may do so through the elections. recent polling shows that the public feels strongly that corporations need to step up and contribute their fair share. for instance, by a 79% to 17% margin, voters want to “close tax loopholes to ensure that american corporations pay as much on foreign profits as they do on profits made in the united states.” by an 82% to 9% margin, voters believe that “reform[ing] the tax system by closing corporate loopholes and limiting deductions for the wealthy” should be used to “reduce the budget deficit and make new investments” rather than to “reduce tax rates on corporations and the wealthy.”190 i agree with avi-yonah and xu that “if nothing is done, multinationals will avoid the corporate tax. if that happens, ordinary middle class americans will be reluctant to pay their taxes. our tax system is built around voluntary cooperation; if most americans refuse to cooperate, the irs could not force them to do so. as the greek experience has recently demonstrated, once a tax culture of non-payment is established, it is very hard to change. we need to do something about avoidance before it is too late.” 191 considering the political realities and public opinion, i do not believe that supporters of any extreme solution, such as ending deferral or shifting entirely to territorial taxation, will be fully victorious in the battle. in my understanding, limited and modest reforms or a compromise between the two extremes are likely much more feasible. my proposal is intended to provide exactly that. it makes big changes but still works within the current regime and is, therefore, limited and modest with regard to the underlying fundamental policy concepts and ideals. former president obama’s administration, as mentioned, proposed and advanced a version of minimum taxation regime. president trump also supports deemed 189 “speaker of the house paul ryan announced he will make tax reform—often considered a noble cause but a futile exercise —a priority in the upcoming year. ‘instead of a tax code that all of us can live by, we have a tax code that none of us can understand,’ he said last month, speaking at the library of congress. ‘the only way to fix our broken tax code is to simplify, simplify, simplify. close all those loopholes and use that money to cut tax rates for everyone.’” jeffrey kupfer et al., how tax reform can get done in 2016, cnbc (jan. 21, 2016, 2:44 pm) http://www.cnbc.com/2016/01/21/how-tax-reform-can-get-done-in-2016commentary.html [http://perma.cc/6h7k-l3pg]; john harwood, despite pledges, tax reform remains an elusive goal, n.y. times (feb. 2, 2016), http://www.nytimes.com/2016/02/03/us/politics/despite-pledgestax-reform-remains-an-elusive-goal.html?partner=rssnyt&emc=rss&_r=0 [http://perma.cc/b5ez-hwnc]. 190 polling questions on key corporate tax issues, americans for tax fairness (jul. 21, 2014), http://www.americansfortaxfairness.org/files/polling-questions-on-key-corporate-tax-issues.pdf [http://perma.cc/uts3-awpv]. 191 reuven s. avi-yonah & haiyan xu, evaluating beps, harv. bus. l. rev. (forthcoming 2016), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2716125 [http://perma.cc/jw5a-282r]. 2017] minimum global effective corporate tax rate 51 repatriation in the rate of 10%. these proposals and the surrounding political correspondence indicate political support for an idea of minimum taxation, as introduced in my proposal. i argue that my proposal is the appropriate compromise that meets the overlapping interests between republicans and democrats. republicans would be happy with the lowered corporate tax rate of 25%. in return, they will need to compromise their demand for territorial taxation by accepting their own proposal of deemed repatriation, not as a transitional provision, but as a permanent law that imposes intermediate tax liability until repatriation at a rate of 15% rather than their proposed rate of 10%. the minimum 15% tax is de facto similar to a deemed repatriation tax. however, it is not identical for several reasons. it is independent in the sense that it produces an independent and separate tax liability; it is conditional, depending on the global effective tax rate, and it is an interim liability because upon repatriation, full taxation will be imposed. this compromise would satisfy the democrats to the best of my understanding. this is because it de facto keeps worldwide taxation and ends deferral partially rather than fully. it lowers the statutory corporate tax rate, but at the same time, it increases the effective corporate tax rate, mainly on multinationals. it will level the playing field between multinationals and local small/medium-sized corporations as well as between corporations and individuals. it is a balanced compromise between the interests of corporations and the public. in sum, i advocate the political adoption of my proposed minimum global effective corporate tax rate as a general anti-avoidance rule in the internal revenue code by the congress, the sooner the better. 9. constructive unilateralism constructive unilateralism is a creative term introduced by professor avi-yonah to reflect the role of the united states in the international arena of taxation. in this role, the united states has acted unilaterally and introduced international taxation rules in its domestic law and model tax treaty, such as the foreign tax credit, the cfc rules, and fatca. these rules gained international adoption and constructively contributed to the development of the world’s international tax regime. according to avi-yonah, historically, most of the advances in international taxation occurred when the u.s. has led the efforts, not because it has followed in the footsteps of other countries. positive results can be expected if the u.s. maintains its leadership by “constructive unilateralism.”192 i wholeheartedly agree with this argument and believe that the u.s. could, and should, continue to play this role in the context of limiting international corporate tax avoidance. however, i do not entirely agree with the recent move of avi-yonah toward more global multilateralism. global multilateralism can be an option that would contribute substantially in solving difficult issues of international taxation, but that is for the long run, not the short run. similarly, i also do not agree with zucman’s multilateral proposals in the short term, although we share the same notion and argument that “the united states and europe can advance alone in reforming the taxation of companies. it is up to them to choose the way in which they wish to tax multinationals. an eu-us accord would build 192 see reuven s. avi-yonah, constructive unilateralism: us leadership and international taxation, u. of mich. pub. l. & legal theory res. paper series, paper no. 463 (jun. 2015), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2622868 [http://perma.cc/x7s9-huda]. 52 columbia journal of tax law [vol.8:5 the foundation for a global base taxation that would put an end to the large scale shifting of profits to tax haven countries.”193 at this stage, i believe that the u.s. could, and should, act unilaterally while still taking into account the inevitable, and necessary, changes being made at the international level. the u.s. cannot ignore the oecd beps project and must take it into account in setting its unilateral rules by trying to limit any prominent contradictions and by respecting and cooperating with the oecd beps ideas to the extent possible. the u.s. cannot ignore the substantial actions of the eu, including the eu action plan for fair and efficient corporate taxation in the eu and the most recent anti-tax avoidance package published on january 28, 2016.194 if the u.s. does not act, it will be led by all the other institutions and jurisdictions that have been making substantial changes in recent years. traditionally, it is better for the u.s. to keep its leadership in international taxation by appropriately handling the most important and urgent challenge of international corporate tax avoidance. i expect that if the u.s. adopts my proposal, more countries will follow the u.s., as happened before through the processes of constructive unilateralism. by fixing the u.s. system of international taxation unilaterally through the adoption of my proposed minimum global effective corporate tax rate, the united states will make an important and effective contribution to fixing the global system of international taxation in the twenty-first century. c. comparisons: the proposal & other proposals of minimum taxation 1. former president obama’s 19% minimum tax on future foreign income as mentioned earlier, on several occasions, including in his fy 2016 address, former president obama proposed a one-time mandatory 14% tax on previously untaxed foreign income and a 19% minimum tax on future foreign income. there are some similarities between this proposal and my proposal. both proposals believe normatively that a minimum tax rate is required because going below the minimum is unfair and not appropriate. however, there are many differences between the proposals. first, the main philosophy and purpose behind former president obama’s proposal is limiting deferral while the main philosophy and purpose behind my proposal is to design a general antiabuse rule focused on international tax avoidance to limit tax avoidance. second, former president obama’s proposal is built on a statutory corporate tax rate, while my proposal is built on effective corporate tax rate. third, former president obama’s proposal examines the american tax rate only, while my proposal examines the global effective tax rate. fourth, former president obama’s proposal imposes a final minimum tax, while 193 see zucman, supra note 9, at 112-113. 194 the package contains anti-tax avoidance rules in six specific fields: a general anti-avoidance rule, exit tax, cfc rules, deductibility of interest, and a switch over clause and a framework to tackle hybrid mismatches. see eur. commission, action plan on corporate taxation (jun. 2015), http://ec.europa.eu/taxation_customs/taxation/company_tax/fairer_corporate_taxation/index_en.htm [http://perma.cc/j7xt-3dzx]; anti tax avoidance package, eur. commission, (jan. 2016), http://ec.europa.eu/taxation_customs/taxation/company_tax/anti_tax_avoidance/index_en.htm [http://perma.cc/b5jt-a45r]. 2017] minimum global effective corporate tax rate 53 my proposal imposes the minimum tax as a general anti-avoidance norm for the current point of time with the final tax outcomes being determined later upon repatriation. this last point is very important. my proposal does not intend to reduce the corporate tax on foreign income to 15%, and it would not do so because the tax liability according to the proposal is meant to be an interim liability until repatriation. furthermore, my proposal does not include any tax holiday concerning previous earnings, while former president obama’s proposal is meant to reduce the u.s. corporate tax on foreign income to 19% and grant a repatriation holiday of 14%. for this exact reason, in their september 25, 2015 opinion, the twenty-four international tax experts opposed an extreme reduction of the tax burden and a generous tax holiday.195 2. shay, fleming & peroni interim minimum tax in analyzing former president obama’s minimum tax, stephen shay, clifton fleming, and robert peroni criticized former president obama’s minimum tax proposal and argued that it risks the u.s. tax base since it imposes final reduced tax liability on foreign income. 196 as an alternative, they proposed an interim minimum tax. in their opinion, “[t]he preferred approach to strengthening the cfc rules is to adopt an interim minimum tax equal to a material percentage of the u.s. corporate rate. the minimum tax amount would be determined on a country-by-country basis, taking into account each cfc with positive earnings and the foreign income tax paid. the intent would be to impose an “additional tax amount” that would cause the effective rate of tax on earnings from each country to be not less than the minimum tax rate. the cfc would be deemed to distribute the amount of earnings that, when included in the income of its u.s. shareholder, would result in u.s. tax equal, in the aggregate, to the additional tax amount. the earnings deemed distributed would thereafter constitute previously taxed earnings. sections 959 and 961 would apply to prevent a second taxation of these earnings. this minimum tax reform should be accompanied by the enactment of provisions that would reduce the incentive for a u.s. parent corporation to shift its tax residence abroad. the reduced incentives to shift income to a low-taxed cfc and the increased amount of previously taxed earnings, by imposition of the minimum tax, would mitigate the incentive to hold excess earnings offshore and thereby ameliorate the lockout problem. although implementation of an interim minimum tax proposal as described in this article would be second best to ending deferral, our preferred reform, it would be a material improvement over current law.”197 my proposal is also an interim rather than final minimum tax regime. however, i use a global basis rather than per-country basis. this is an important difference that stems from the fact that my focus is different than the focus of the authors. my focus is tax avoidance globally, while their focus is ending deferral and taxing foreign income as similarly as domestic income. therefore, it is not surprising that they propose a minimum tax rate that is very close to the corporate statutory tax in the u.s., while i 195 see 24 international tax experts address current tax reform efforts in congress, am. for tax fairness (sept. 25, 2015), http://americansfortaxfairness.org/files/24-international-tax-experts-letterto-congress-9-25-15-final-for-printing.pdf [http://perma.cc/fl5f-6hwt]. 196 see shay, supra note 31. 197 id. at 722-23. 54 columbia journal of tax law [vol.8:5 propose a minimum global tax rate that represents a good indicator of tax avoidance activities and takes into account corporate tax rates globally. in addition, the authors’ proposal imposes the tax liability on the u.s. shareholders. to do so, it considers the profits as deemed dividends, whereas my proposal imposes a new tax liability at the u.s. corporate level rather than the u.s. shareholder level, without any deemed construction, rather as a new and independent interim tax liability. 3. grubert & altshuler minimum tax versions as mentioned earlier, grubert and altshuler discussed four versions of minimum tax in great detail and conclude that country-by-country minimum tax with current deduction of real investment is the appropriate regime.198 i agree with their analysis concerning the merits and advantages of minimum tax regimes in reducing profit shifting and imposing fair and efficient tax on cross border income. however, i differ, and disagree, on a few aspects and details: first, my philosophy and main concern is international corporate tax avoidance, and therefore, i am focused on developing a general anti-avoidance rule to cope with these practices. second, my minimum tax is imposed on any return, normal and excess, while they limit and design their preferred minimum tax regime to excess returns. third, my minimum tax is an interim tax, while their minimum tax is final. fourth, i support a global minimum tax rather than countryby-country minimum tax for several reasons. although they argue that overall minimum tax is worth further consideration, they ultimately support a country-by-country minimum tax. d. exploring counter arguments 1. the presumption of illegitimate tax avoidance based on low effective corporate tax rate is too strong one of the main expected arguments against my proposal is that it uses a global effective corporate tax rate as a definite proxy of illegitimate corporate tax avoidance and that that proxy is not always accurate. i agree that a low effective tax rate is not an inclusive and definite indicator of illegitimate tax avoidance. i accept that in some cases of a low global effective tax rate such rates are completely legitimate and do not necessarily represent any tax avoidance scheme. it is true that the presumption is too strong, but the considerations of simplicity, certainty, and avoidance of administrative discretion outweigh the counterargument. in the tradeoff, i prefer a simple and strong presumption, even at the expense of a few limited unfair cases or generalizations in lieu of a complex rebuttable presumption that necessitates a case-by-case examination and involves administrative discretion as well as high administrative and litigation costs. above that, at the root of my proposal is not just the idea of preventing tax avoidance, but also the idea that the minimum tax is the red line, at least as an interim liability, that we as an american society are requiring from our corporations as their fair taxation and contribution to the american economy, society, and democracy. 198 see grubert supra note 32. 2017] minimum global effective corporate tax rate 55 2. unilateralism & contradiction with treaty law it might be argued that unilateral change of tax outcomes resulting from laws of other countries is inappropriate and contradicts treaty-based obligations. my boundaries in this regard are clear and strict. as long as a country is changing the tax outcomes of its residents, it can do so unilaterally. any country has the full right to determine the tax outcomes of its multinationals on their worldwide income no matter what the tax rules of the other jurisdictions may be. however, countries could not, and should not, unilaterally change the tax outcomes of residents of other countries in contradiction to a treaty that is in effect. the oecd references these same boundaries as well. the oecd confirmed recently that domestic legislation or case law that adopts general anti-abuse rules do not contradict treaty law since treaties themselves aim to prevent treaty abuse. 199 vi. conclusion the united states’ international corporate tax system is broken. the world international corporate tax regime is broken. the challenge of international corporate tax avoidance is undoubtedly one of the most serious issues within these broken systems. implementing international tax policy law that protects the fairness of taxation is of the utmost importance, not only for purposes of meeting the needs of a twenty-first century global digital economy, but also for purposes of safeguarding the very structure and essence of the american society and democracy. thus, the united states must fix the system sooner than later. i propose and call for enacting a new general anti-avoidance rule according to which if the global effective corporate tax rate of any u.s. multinational and its cfcs is below the minimum of 15%, the u.s. multinational shall pay the irs the tax gap up until the minimum on its global income as an interim and independent tax liability. i argue that this proposal would contribute substantially to the current efforts to cope with international corporate tax avoidance. adopting this proposal will improve the fairness of taxation, thereby strengthening and protecting american democracy, its economy, and society. finally, if the u.s. continues in its tax leadership role through constructive unilateralism, it will prompt effective and efficient advancement and improvement of the global international corporate tax regime, which will better equip the global community to meet the challenges of the twenty-first century. 199 oecd, preventing the granting of treaty benefits in inappropriate circumstances, action 6 2015 final report 85-88 (2015), http://www.oecd.org/tax/preventing-the-granting-of-treaty-benefits-ininappropriate-circumstances-action-6-2015-final-report-9789264241695-en.htm [http://perma.cc/eu7u2hjz]. articles doing too much: the standard deduction and the conflict between progressivity and simplification john r. brooks ii  abstract in u.s. federal income tax, the standard deduction, along with the personal exemptions, provides taxpayers with a minimum amount of untaxed income, effectively creating a ―zero bracket amount.‖ for historical and political reasons, however, the standard deduction also operates as a simplified substitute for the itemized deductions, such as the deductions for extraordinary medical expenses, charitable contributions, and home mortgage interest. this seemingly reasonable compromise in fact leads to substantial, and surprising, conceptual complexity. in particular, close analysis of each of the two roles shows that their effects, and related criticisms, are often contradictory, which in turn makes it difficult, if not impossible, to have coherent policy debates regarding the proper roles of the standard deduction and the personal deductions. this flawed compromise between progressivity and simplification is not necessary. we can replace the standard deduction with a true, independent zero bracket amount and a floor under the itemized deductions while staying revenueand distribution-neutral. this would effectively divorce the two roles of the standard deduction—zero bracket amount and simplification of the itemized deductions—leading to more coherence in individual income taxation and giving more flexibility to policymakers. this article proposes further to disaggregate the single floor under the itemized deductions into multiple, independent floors under each itemized deduction. this also would lead to greater coherence and flexibility in tax system design. while creating multiple floors would marginally increase complexity for some taxpayers, the costs of such complexity are justified in light of the benefits of more accuracy and coherence.  associate professor of law, georgetown university law center. j.d., harvard law school, 2006; a.b., harvard college, 1998. i am grateful for helpful comments and suggestions from jennifer birdpollan, joshua blank, lilian faulhaber, victor fleischer, daniel halperin, louis kaplow, and alvin warren, and also to participants in workshops at harvard law school, georgetown university law center, syracuse university college of law, university of washington school of law, tulane university law school, seton hall law school, rutgers school of law-newark, louisiana state university law center, and the law & society 2010 conference. 204 columbia journal of tax law [vol.2:203 i. introduction ................................................................................................ 205 ii. current law and history of the standard deduction ........... 209 a. current law ................................................................................................... 209 b. the original standard deduction: 1944-1964 ................................................. 210 c. the introduction of progressivity and the breakdown of deduction coherence: 1964-1977 ............................................................................................................ 212 d. the zero bracket amount—but only in name: 1977-1986 ............................ 216 e. the current era: 1986 to today ..................................................................... 218 iii. a critique of the standard deduction ............................................ 218 a. the equivalence of a standard deduction and an exemption (or zba) plus a floor..................................................................................................................... 219 b. mixing income measurement with progressivity ............................................ 220 1. simplification: no zba ............................................................................ 222 2. progressivity: zba equal to the standard deduction amount ................... 224 3. hybrid: zba less than the standard deduction amount .......................... 226 4. other views ............................................................................................. 227 c. policy debate distortion................................................................................. 228 1. unresolved political debates ................................................................... 228 2. distorted political incentives ................................................................... 229 3. inefficient subsidies ................................................................................. 230 4. undermining respect ............................................................................... 231 d. summary ........................................................................................................ 231 iv. a proposal: the zero bracket amount ............................................. 232 a. replace the standard deduction with a zero bracket and floors ..................... 232 b. examples and complications .......................................................................... 233 c. flat or variable zba ...................................................................................... 235 d. the decreasing benefit of simplification ....................................................... 237 1. simplification as a goal of tax policy ...................................................... 237 2. the cost of itemizing................................................................................ 239 3. summary .................................................................................................. 242 e. policy benefits of tax floors ......................................................................... 242 v. conclusion .................................................................................................... 246 2011] doing too much 205 i. introduction the standard deduction 1 is a provision of the u.s. individual income tax system that serves two purposes: first, it provides for a minimum amount of untaxed income, thus acting as an element of progressivity. second, it provides a simplified alternative to the itemized deductions for taxpayers with relatively low itemizable expenses, thus relieving them of the record-keeping and computational burden of itemizing deductions. 2 having one provision serve each of these purposes is a compromise, but it is a compromise that is unreasonable and unnecessary. the essence of the problem is that these two purposes—progressivity and simplification—are in conflict. the progressivity purpose, by which i mean the goal of having higher-income taxpayers pay a higher share of income tax via a progressive rate structure and other provisions, is served by having a relatively large amount of otherwisetaxable income go untaxed, through what is in essence a zero-percent tax bracket made of the standard deduction and personal exemptions. i refer to this as the ―zero bracket amount‖ or ―zba.‖ 3 thus, the standard deduction and the personal exemptions allow for an unmarried taxpayer with no dependents in 2010 to pay no tax on the first $9350 of adjusted gross income, of which $5700 is due to the standard deduction. 4 as a result of this and other provisions, 43% of taxpayers pay no income tax at all. 5 the simplification purpose, by which i mean the goal of limiting complexity and allowing for more straightforward tax computation (by the taxpayer) and easier enforcement of compliance (by the government), is served by allowing some taxpayers to substitute a single standard deduction for the many itemized deductions when those deductions would otherwise be small and thus too burdensome to calculate (and examine) relative to the benefit from doing so. as noted above, in 2010 the standard deduction for an unmarried taxpayer is $5700—meaning that the taxpayer would not itemize deductions if his itemized deductions would be less than $5700. as a result of this, nearly two-thirds of taxpayers do not itemize deductions and instead take the standard deduction. 6 1 see i.r.c. § 63(c) (2010). 2 to compute taxable income a taxpayer subtracts the greater of the standard deduction or the itemized deductions. i.r.c. § 63(b), (e) (2010). the itemized deductions are those deductions allowable under chapter 1 of the internal revenue code other than those allowable in calculating adjusted gross income under § 62 and those for personal exemptions under § 151. i.r.c. § 63(b) (2010). see infra part ii.a. 3 for simplicity, i generally disregard the existing personal exemptions under § 151 throughout this article when speaking of a zba. nonetheless, the personal exemptions provide an important complication of the issues discussed herein, namely because (a) they already function as a ―pure‖ zba, that is, without any simultaneous simplification purpose, and (b) they provide that the effective zba varies with family size. 4 the standard deduction for 2010 for an unmarried taxpayer is $5700. rev. proc. 2009-50 § 3.11(1), 2009-45 i.r.b. 617. the personal exemption in 2010 is $3650. id. at § 3.19. this assumes adjusted gross income below $166,800 for a single taxpayer; above that amount, the personal exemption amount begins to phase out, rev. proc. 2008-66 § 3.19(2), 2008-45 i.r.b. 1107, though the phase-out did not apply for 2010, rev. proc. 2009-50 § 2.08, 2009-45 i.r.b. 617. a married couple with two children does not pay tax on $28,000 of agi, $11,400 of which is due to the standard deduction. rev. proc. 2009-50 §§ 3.11(1), 3.19. the exemption phase-out for a married couple is $250,200. rev. proc. 2008-66 § 3.19(2). the $28,000 figure includes $2000 in child tax credits. see i.r.c. § 24(a) (2010). 5 tax policy center, tax units with zero or negative tax liability, 2009-2019, available at http://www.taxpolicycenter.org/numbers/content/pdf/t09-0202.pdf. 6 in 2007, the standard deduction was claimed on 63.3% of tax returns. justin bryan, internal revenue serv., individual income tax returns, 2007, statistics of income bulletin, 2009, at 7, available at http://www.irs.gov/pub/irs-soi/09fallbulindincomeret.pdf [hereinafter 2009 soi bulletin]. 206 columbia journal of tax law [vol.2:203 the problem with having one provision play both a progressivity and simplification purpose is that those two purposes are in conflict. in particular, it is just not possible for a single tax provision to consistently play both a simplification and progressivity role at the same time. if tax is a product of a tax base and a tax rate, one provision cannot define both the base and the rate, at least not well. if the standard deduction reduces taxable income—by approximating the itemized deductions—then it is defining the base; but if it is stating an amount of taxable income not subject to tax—a zba—then it is part of the rate structure. it cannot do both simultaneously without causing taxpayers to face disparate tax bases and effective rate structures. 7 analysts and commentators tend to see the standard deduction and personal exemptions as primarily a tool of progressivity—as part of the rate structure. 8 but in grafting this tool of progressivity onto what was once a pure simplification provision, congress inadvertently created of a provision of surprising complexity. indeed, it is actually quite difficult to conceptualize a system where a single standard deduction provision plays both a progressivity and a simplification role. one way to view it is that the standard deduction is essentially a zba that phases out with the amount of itemized deductions—the greater the expenses, the lower the ―net‖ excess of the standard deduction over itemized deductions. 9 another view is that the standard deduction is really a flat zba plus a floor under itemized deductions—all taxpayers benefit from a flat zba, but no itemized deductions are allowed below a floor equal to the same amount as the zba. although the same computational result follows in each case, these views are largely contradictory, incorporate different assumptions about the relative priority of progressivity versus simplicity, lead to different criticisms of the tax system, and, importantly, imply different policy responses. for example, the first view implies that all taxpayers receive the tax benefit of the itemized deductions on the first dollar of itemizable expense, but that the system violates horizontal equity 10 because taxpayers with the same agi might face different, and likely regressive, effective zbas. the second view implies the opposite: that many taxpayers are not receiving a tax benefit from their itemizable expenses, but that there is no harm to horizontal equity from the distribution of the zba. thus, one can essentially choose whichever view of the standard deduction, and corresponding criticisms, one wants. this lack of a shared conception of the role of the standard deduction makes it difficult to resolve important tax policy questions, such as those related to low-income tax relief or to the itemized deductions themselves. how to discuss extending the charitable contributions deduction to non-itemizers when it is not entirely clear that they do not already get the benefit of that deduction? how to discuss the proper size of a zba when we cannot say with precision what its size actually is? to put this in concrete terms, suppose a non-itemizer says, ―i think it’s unfair that i don’t get a tax benefit from my charitable contributions.‖ one might respond, ―but you 7 see infra part iii. 8 see, e.g., staff of joint comm. on tax’n, 110th cong., a reconsideration of tax expenditure analysis 22 (joint comm. print 2008) [hereinafter a reconsideration of tax expenditure analysis] (―the jct staff views the personal exemptions and the standard deduction as defining a zero-rate bracket . . . .‖). 9 see infra part iii.b.4. 10 horizontal equity captures the notion that similar taxpayers should face similar tax burdens. see infra note 183. 2011] doing too much 207 do—you get the standard deduction instead, which is an even better deal.‖ the nonitemizer might respond, ―then i think it’s unfair that i get less benefit from the standard deduction than someone who gives less to charity.‖ one might respond to this, ―no, you get the same benefit—everyone gets the value of the standard deduction, which is really a zero bracket amount—it’s just that neither of your expenses are high enough to qualify for a tax deduction on top of that.‖ an absurd circular conversation, to be sure, but in a sense this is where our public discourse regarding the standard deduction is since we have no way of deciding which of these views is proper. in addition to the conceptual incoherence, the current structure of the standard deduction likely results in a suboptimal choice of the actual standard deduction amount. for example, under the current standard deduction the zba is the same size as the simplified substitute for the itemized deductions. but why must these amounts be the same? it is almost certain that the optimal amounts would not be equal to each other, since they are driven by independent policy considerations. the optimal substitute for the itemized deductions might only be a few thousand dollars—much more than that and it no longer seems too costly for a taxpayer to manage—yet our desire for progressivity pushes the standard deduction as high as $5700 for an individual. conversely, the optimal zba is likely greater than $5700, or even $9350, 11 yet the attempt to balance simplicity and accuracy forces the amount down. by forcing ourselves to pick one number, we likely miss both our progressivity target and our simplification target by a lot. this is just one example of the ways in which policymakers lack the flexibility to make targeted policies due to having only a single crude tool. despite the relative significance of the standard deduction, surprisingly little has been written analyzing its effects in depth. there are vastly more articles in the legal literature discussing the merits and problems of the itemized deductions 12 —despite the fact that the standard deduction affects nearly twice as many taxpayers as the itemized deductions. 13 perhaps this is because the itemized deductions raise questions about tax expenditures, targeted policy goals, and economic incentives that do not at first appear to be present with the standard deduction. perhaps it is also because there is some general understanding that simplification and progressivity can be at odds, 14 in the standard deduction and elsewhere. what is lacking, and what this article provides, is a full articulation of the problems and their implications, and a clear proposal for reform. in particular, existing commentary tends not to fully address the fact that the standard deduction embodies two contradictory purposes, that each purpose implies a particular set of criticisms, and that any particular criticism of the standard deduction necessarily 11 the 2010 poverty-level income was $10,830 for a single person and $22,050 for a family of four. delayed update of the hhs poverty guidelines for the remainder of 2010, 75 fed. reg. 45628-02 (aug. 3, 2010). 12 i know of only two articles in the legal literature that primarily discuss the standard deduction. louis kaplow, the standard deduction and floors in the income tax, 50 tax l. rev. 1 (1994) [hereinafter kaplow, standard deduction]; allan j. samansky, nonstandard thoughts about the standard deduction, 1991 utah l. rev. 531. samansky’s article is the only one i know that directly challenges the structure of the standard deduction. others include some of the criticisms of the standard deduction that i discuss here. see, e.g., glenn e. coven, the decline and fall of taxable income, 79 mich. l. rev. 1525, 1556-64 (1981); alan l. feld, fairness in rate cuts in the individual income tax, 69 cornell l. rev. 429, 441 (1983); theodore p. seto & sande l. buhai, tax and disability: ability to pay and the taxation of difference, 154 u. pa. l. rev. 1053, 1088-93 (2006); see also kaplow, standard deduction, supra, at 3 & n.10 (noting a similar lack of literature). 13 see 2009 soi bulletin, supra note 6, at 7. 14 see infra part iv.1. 208 columbia journal of tax law [vol.2:203 implies a particular view of the standard deduction’s primary role. 15 it is this conceptual problem that is at the core of this article’s criticism of the standard deduction. this article further proposes to solve that problem by separating the progressivity and simplification purposes of the standard deduction. first, congress should implement a true, independent zba (whether in the form of an actual zero-percent tax bracket or a larger personal exemption 16 ) and replace the standard deduction with an explicit floor under the itemized deductions. this would effectively divorce the progressivity and simplification roles now combined in a single provision, without affecting tax revenue or overall distribution of tax burdens. 17 it would positively affect horizontal equity by making the determination of the proper amount of tax-free income independent of the amount of itemizable expenses. furthermore, it would allow policymakers greater flexibility in targeting low-income tax relief, since they could adjust the zba without affecting tax deductions. 18 in addition, rather than a single floor under the itemized deductions, the floor itself should be disaggregated into multiple, independent floors under each itemized deduction. this would separate the determination of the proper deduction amount for a given itemizable expense from the amounts of any other itemizable expenses. it would thus positively affect horizontal equity by treating all taxpayers the same with respect to a given category of itemizable expense. this article further argues that deduction floors have particular, and underused, tax policy benefits, since they can allow policymakers to more effectively manage deductions by adjusting floors to optimize trade-offs between simplicity, revenue, incentives, and equity for each given deduction. while disaggregating the floors would introduce some new complexity in return-preparation, that complexity is more than balanced by the benefits, given that the floors would also continue to serve simplification by limiting the situations where expenses are deductible. while others, most notably louis kaplow, 19 have discussed the general computational equivalence between a standard deduction and a floor, and factors to consider in choosing between them, this article goes further by making the affirmative normative case for the superiority of disaggregated floors over the current standard deduction. this article proceeds as follows. part ii reviews the current operation of the standard deduction and its history, especially its shift from a pure simplification measure to one that one that was commandeered to play a progressivity role. part iii provides a comprehensive critique of the standard deduction, focusing on the conceptual contradictions between simplification and progressivity. part iv introduces the reform 15 see, e.g., infra notes 93, 100, 101, & 126 and accompanying text. an important exception to this is seto, supra note 12, at 1088-93, which describes the tension in the dual purposes of the standard deduction in the course of making an argument for a tax system that more effectively measures ability to pay. see also feld, supra note 12, at 441 (briefly noting the standard deduction’s ―double duty‖ problem). 16 see supra note 3. an important difference between the two is that the total exemption amount increases with number of dependents. thus the balance between the two (and other provisions, such as the child tax credit, i.r.c. § 24 (2010)) ought to reflect policy decisions about the proper amount of untaxed income relative to family size. such considerations are beyond the scope of this article. 17 see infra part iii.a. 18 readers knowledgeable in the history of the standard deduction will recall that for a period from 1977 to 1986 the standard deduction was in fact labeled the ―zero bracket amount‖ and existed in the rate structure. to be clear, that version of the zba was not an independent zba in the sense that this article uses the term; it still operated in almost exactly the same way as the current standard deduction that is the subject of this article. see infra part ii.d. 19 see kaplow, standard deduction, supra note 12. 2011] doing too much 209 proposal and discusses the additional advantages of disaggregated deduction floors as a policy tool. it also addresses the primary argument in favor of the standard deduction— administrative simplicity. part 0 concludes the article. ii. current law and history of the standard deduction before turning to the detailed criticisms of the standard deduction, this article first sets out the changes in the standard deduction over its 60-plus years in the tax code. the criticisms that follow in part iii largely result from the fact that, for historical and political reasons, a zero bracket was grafted on to what began as a pure substitute for the itemized deductions. while the standard deduction has operated in essentially its current form since 1977, the earlier versions of the standard deduction were quite different. in particular, the original standard deduction in 1944 was calculated as a percentage of agi, rather than a flat amount. as discussed below, this important feature made the original standard deduction almost entirely a simplification measure. however, in the 1960s and 70s, policymakers became more concerned about low-income tax relief, particularly in the face of high inflation, and the standard deduction appeared to be the most straightforward way to target that relief. thus began a period of gradually grafting more progressivity-centric features onto the standard deduction and chipping away at the earlier simplification-centric features. while policymakers have been generally explicit about their intent to turn the standard deduction into a vehicle for low-income tax relief, they do not appear to have considered the downsides, discussed in part iii, nor the alternatives, discussed in part iv. a. current law under current law, the amount of an individual’s income subject to tax (―taxable income‖) is calculated, by default, by subtracting the standard deduction and the deductions for personal exemptions from adjusted gross income (―agi‖). 20 thus, the standard deduction provides for an amount of agi that is untaxed. in 2010, the basic standard deduction amounts were $5700 for a single taxpayer or for a married taxpayer filing separately, $11,400 for a married couple filing a joint return, and $8300 for a taxpayer filing as a head of household. 21 instead of using the standard deduction, however, a taxpayer can elect to ―itemize,‖ that is, to take certain other deductions in lieu of using the standard deduction. 22 deductions are amounts subtracted from gross (or adjusted gross) income in order to calculate taxable income. they generally represent expenses that are either believed to be properly subtracted from earnings before determining what is ―income‖— such as expenses in the production of income—or believed to be worthy of subsidizing 20 i.r.c. § 63(b) (2010). agi, in turn, is calculated by deducting certain amounts from gross income. i.r.c. § 62 (2010). the tax code also provides for the exclusion of certain amounts from the definition of ―gross income.‖ i.r.c. §§ 61(b), 101-140 (2010). 21 rev. proc. 2009-50 § 3.11(1), 2009-45 i.r.b. 617. the standard deduction amounts are indexed to inflation and thus adjusted annually. i.r.c. § 63(a)(4) (2010). the standard deduction provisions also provide for other adjustments. for the aged and blind the standard deduction is increased by $1100. i.r.c. § 63(c)(1)(b), (c)(3), (c)(4), (f) (2010); rev. proc. 2009-50 § 3.11(3). the amount increases to $1400 for an unmarried taxpayer who is not a surviving spouse. id. for a person claimed as a dependent on another’s tax return, the basic standard deduction is, for 2010, the greater of $950 or $300 plus the individual’s earned income, up to the typical basic standard deduction amount described above. i.r.c. § 63(c)(5) (2010), rev. proc. 2009-50 § 3.11(2). the principal purpose of this reduction is to reduce opportunities for tax avoidance by parents shifting investment income to their children. see 2 boris i. bittker & lawrence lokken, federal taxation of income, estates, and gifts ¶ 30.5.2 (3d ed. 2000). 22 i.r.c. § 63(b), (e) (2010) (on election to itemize). 210 columbia journal of tax law [vol.2:203 via the tax code—such as charitable contributions. deductions for individuals are generally grouped into two categories: ―above-the-line‖ deductions from gross income to calculate agi, and ―below-the line,‖ or itemized, deductions from agi to calculate taxable income. it is these below-the-line, or itemized, deductions for which the standard deduction is a substitute. the above-the-line deductions are available to all taxpayers, while the below-the-line deductions are taken only by those whose itemizable expenses exceed the relevant standard deduction amount. this structure results in a taxpayer deducting from agi an amount no less than the standard deduction in computing tax, and often more, if the taxpayer’s itemized deductions exceed his standard deduction amount. the most important itemized deductions for individuals are for state and local taxes, 23 mortgage interest, 24 medical expenses, 25 charitable contributions, 26 certain expenses in the production of income (typically relating to investments, income-producing property, and other non-business activity), 27 unreimbursed employee expenses, 28 and casualty and theft losses. 29 this article uses the terms ―below-the-line deductions‖ and ―itemized deductions‖ interchangeably. it uses the term ―itemizable expense‖ to refer to the expense itself, as distinguished from the respective itemized deduction, which may differ in amount from the expense itself, or may not be available at all. b. the original standard deduction: 1944-1964 during world war ii, the united states faced an enormous need to raise revenue, which in turn led to an expansion of the income tax beyond the small percentage of highincome taxpayers that it had previously reached. 30 while high-income taxpayers generally had the sophistication to navigate the complexities of the tax system, congress was concerned that this was not necessarily the case for the new middleand low-income taxpayers. in 1944, congress made some of the war-time tax increases permanent, but alongside those it also expanded a simplified tax system and instituted the ―optional standard deduction.‖ the optional standard deduction was set at 10% of agi, up to a maximum of $500 for single taxpayers, $1000 for married taxpayers filing jointly 31 (or roughly $6250/$12,500 in 2011 dollars 32 ). taxpayers with agi less than $5000 23 i.r.c. § 164 (2010). 24 i.r.c. § 163(a), (h) (2010). 25 i.r.c. § 213 (2010). the deduction for medical expenses is limited to amounts above 7.5% of agi. i.r.c. § 213(a) (2010). 26 i.r.c. § 170(a)(1) (2010). the deduction for charitable contributions can be no more than 50% of a taxpayer’s ―contribution base‖ (and possibly less). i.r.c. § 170(b)(1) (2010). ―contribution base‖ is agi computed without regard for any net operating loss carryback to the taxable year under § 172 (2010). i.r.c. § 170(b)(1)(g) (2010). 27 i.r.c. § 212 (2010). 28 i.r.c. § 162(a) (2010). section 212 and 162 deductions (among others) are subject to the 2% of agi floor on miscellaneous itemized deductions. i.r.c. § 67 (2010). 29 i.r.c. § 165 (2010). the losses are limited to amounts above $100 per casualty and only to the extent the total losses exceed 10% of agi. i.r.c. § 165(h) (2010). 30 the percentage of households subject to the income tax grew from 5% to 74% during the period. see lawrence h. seltzer, the personal exemptions in the income tax 62 tbl. 9 (1968). the percentage dropped to 56% in 1946. 31 individual income tax act of 1944, pub. l. no. 78-315, § 9(a), 58 stat. 231, 236. the cap was later increased to $1000 for single taxpayers. revenue act of 1948, pub. l. no. 80-471, § 302(a), 62 stat. 110, 114. 32 inflation calculations performed herein using the bureau of labor statistics inflation calculator. bureau of labor statistics, cpi inflation calculator, http://www.bls.gov/data/inflation_calculator.htm (last visited apr. 16, 2011). 2011] doing too much 211 (~$62,500 in 2011)—and thus those below the cap on the percentage standard deduction 33 —computed tax according to simplified tax tables, while those with agi greater than $5000, and all those with itemizable expenses greater than 10% of their agi, computed tax themselves. congress estimated that no more than 20% of taxpayers would compute their own tax, with everyone else using the tax tables. 34 along with the introduction of the standard deduction, congress also created the concept of ―adjusted gross income,‖ or agi. 35 congress believed that for purposes of determining the correct percentage standard deduction, it was necessary to allow first for some deductions to all taxpayers. in particular, congress distinguished between business-related deductions, which were deductible from gross income in computing agi—they were placed ―above the line‖—and all others, for which the optional standard deduction would be a substitute, which were deductible from agi in computing taxable income—they were placed ―below the line.‖ 36 the new above-the-line deductions that all taxpayers would use in calculating agi included those for expenses attributable to a trade or business or to rents and royalties; to deductible employee expenses (such as meals and lodging while traveling on business); 37 and to losses from the sale or exchange of property. 38 the intent was to come up with an income measure that put wage-earners on similar footing as business owners for purposes of then calculating the percentage standard deduction. the senate report accompanying the bill stated that the deductions thus permitted to be made from gross income in arriving at adjusted gross income are those which are necessary to make as nearly equivalent as practicable the concept of adjusted gross income, when that concept is applied to different types of taxpayers deriving their income from varying sources. . . . for example, in the case of an individual merchant or store proprietor, gross income under the law is gross receipts less the cost of goods sold; it is necessary to reduce this amount by the amount of business expenses before it becomes comparable, for the purposes of . . . the standard deduction, to the salary or wages of an employee in the usual case. 39 the remaining deductions—those now ―below the line‖—would thus be those that could be expected to be relatively uniformly distributed across all taxpayers, regardless of source of income. the below-the-line deductions for which the standard deduction would substitute included those for interest, state and local taxes, charitable 33 for simplicity, this article uses the term ―percentage standard deduction‖ to refer to a standard deduction calculated as a percentage of agi (as opposed to a flat minimum or maximum standard deduction). 34 s. rep. no. 78-885, at 4 (1944). in 1944, 82% of returns claimed the standard deduction. see samansky, supra note 12, at 532-33 (citing irs data). by 1950, the percentage still remained 80%. statistics of income historical table 7: standard, itemized, and total deductions reported on individual income tax returns, tax years 1950-2009, i.r.s., http://www.irs.gov/pub/irs-soi/histab7.xls (last visited apr. 16, 2011). 35 individual income tax act of 1944 § 8(a), 58 stat. at 235. 36 see h.r. rep. no. 78-1365, at 3 (1944) (noting that agi is ―in general . . . gross income less business deductions‖). 37 employee travel expenses were moved below the line by the tax reform act of 1986, pub. l. no. 99-514, § 132(b)(1), 100 stat. 2085, 2115. 38 individual income tax act of 1944 § 8(a), 58 stat. at 235. 39 s. rep. no. 78-885, at 24-25 (1944). 212 columbia journal of tax law [vol.2:203 contributions, and medical expenses. 40 through the 1954 code, 41 the structure of the standard deduction remained relatively unchanged. in the reports accompanying the 1944 act, congress nowhere identified progressivity or reducing the tax burden on low-income taxpayers as a goal of the legislation; instead, congress focused entirely on simplification. 42 this is consistent with the design of the provision: itemizable expenses tend to increase with income, so it follows that a simplified substitute for the expenses would also increase with income (while an element of progressivity certainly would not). 43 c. the introduction of progressivity and the breakdown of deduction coherence: 1964-1977 in 1964—twenty years after the standard deduction was introduced— progressivity finally appeared in the design of the standard deduction. with the revenue act of 1964, congress created the ―minimum standard deduction,‖ which was intended ―to remove from the tax rolls those persons with minimum incomes and also to provide those with incomes just slightly above these levels a somewhat larger tax reduction than is made available generally through the rate cuts.‖ 44 this is the first time a progressivity goal was articulated in the legislative history of the standard deduction, and the first time that the standard deduction provision was used to ensure some baseline amount of untaxed income. the new minimum standard deduction was calculated as $200 plus $100 for each dependency deduction (or ~$1420/$710 in 2011). 45 a taxpayer could take the larger of the minimum standard deduction, or the percentage standard deduction (officially renamed the ―10-percent standard deduction‖). 46 the result was that all taxpayers could get at least $900 (~$6400 in 2011) of income tax-free—a $300 minimum standard deduction plus the $600 personal exemption—even if that amount was greater than 10% of their agi. in 1969, the connection to progressivity was made even more explicit. in the tax reform act of 1969, congress renamed the ―minimum standard deduction‖ the ―low 40 the original standard deduction was also a substitute for certain tax credits: foreign tax credits, credits with respect to taxes withheld at the source under then-section 143(a) (relating to interest on tax-free covenant bounds), and all credits against net income with respect to interest on certain government obligations. see individual income tax act of 1944 § 9(a), 58 stat. at 236. 41 internal revenue code of 1954, pub. l. no. 83-591, 68a stat. 3. 42 the stated goals of the legislation were ―1. to relieve the great majority of taxpayers from the necessity of computing their income tax. 2. to reduce the number of tax computations. 3. to simplify the return form. 4. to decrease the number of persons required to file declarations of estimated tax. 5. to eliminate some of the difficulties and uncertainties in the making of estimates required for declarations.‖ h.r. rep. no. 78-1365, at 1 (1944); see also s. rep. no. 78-885, at 1 (1944) (same). 43 non-itemizers with agi over $5000 faced a fixed standard deduction of $500. this could be seen as small element of progressivity, since these taxpayers would be treated to a somewhat steeper effective rate schedule than those with agi under $5000. however, these taxpayers were earning more than twice the median income and thus in a relatively high income cohort. see bureau of the census, current population reports: consumer income: family and individual model income in the united states: 1945, at 1 (1948), available at http://www2.census.gov/prod2/popscan/p60-002.pdf (reporting 1945 median family and individual income as $2379). furthermore, many, if not most, of these taxpayers could be expected to be itemizers. thus, the percentage of taxpayers subject to a fixed standard deduction was likely small enough not to affect overall progressivity more than marginally. 44 h.r. rep. no. 88-749, at 1333 (1964). 45 revenue act of 1964, pub. l. no. 88-272, § 112(a), 78 stat. 19, 23. the $1000 cap remained in place. the $100 per dependent was in addition to the existing deductions for personal exemptions under i.r.c. § 151 (1964). 46 id. 2011] doing too much 213 income allowance‖ and redesigned it to be precisely the poverty level of income. thus, taxpayers could be assured of paying no tax on incomes at or below the poverty level. the low income allowance was $1100 (~$6600 in 2011), 47 so that a taxpayer faced no tax for income less than $1700 (~$10,200 in 2011) plus each additional $600 dependency deduction, 48 which, according to congress, was exactly what the then-department of health, education and welfare estimated to be poverty level income. 49 this was an $800 (~$4800 in 2011) increase over the minimum standard deduction put in place only five years earlier. simplification purposes continued to drive other changes, however. 50 by 1969, higher medical costs, interest rates, and states taxes; increased homeownership; and more expensive homes had eroded the reach of the percentage standard deduction. 51 where 82% of returns took the standard deduction in 1944, only 59% did in 1965. 52 to counter this, the 1969 act gradually increased the percentage standard deduction from 10% of agi, capped at $1000 (as it had been since 1948 53 ), to 13% of agi, capped at $1500, for the 1971 tax year, 14%/$2000 in 1972, and 15%/$2000 thereafter. 54 the joint committee on taxation estimated that this would increase the percentage of taxpayers taking the standard deduction from 58% to 70%, 55 thus simplifying tax return preparation for a significant number of taxpayers. 56 47 the initial low income allowance was actually quite a bit more complicated. for the 1970 tax year, part of the low income allowance phased out as incomes increased above the poverty level. tax reform act of 1969, pub. l. no. 91-172, § 802(a), 83 stat. 487, 676-77. the phase-out could potentially have allowed for an additional degree of progressivity by shrinking the effective zero bracket amount as income rose. however, the phase-out was to be in effect only for the 1970 and 1971 tax years. § 802(e), 83 stat. at 678. for 1971 onward, the bill provided that the low income allowance would simply be a flat $1050. furthermore, the phase-out provision was eliminated for the 1971 tax year by the revenue act of 1971. pub. l. no. 92-178, § 203(a), 85 stat. 497, 511. this was done in order to accelerate tax relief because of the ―depressed economic conditions.‖ h.r. rep. no. 92-533, at 7 (1971). the end result is that for all but one year the low income allowance was a fixed amount of tax-free income given to all taxpayers, regardless of income. 48 a single taxpayer received his own $600 dependency deduction plus the low income allowance of $1100. 49 h.r. rep. no. 91-413, at 205-06 (1969), reprinted in 1969-3 c.b. 200. prior to 1969, the minimum amount of tax-free income (the standard deduction plus dependency deductions) was $900 for a single taxpayer, an amount which jumped to $1700 in 1969. there were thus a large number of taxable returns below the poverty level before the 1969 change. see staff of the joint comm. on tax’n, 91st cong., general explanation of the tax reform act of 1969, at 218 (joint comm. print 1970) [hereinafter 1969 bluebook] (5.2 million taxable returns below poverty level in 1969). 50 see, e.g., h.r. rep. no. 94-658, at 3-6 (1976); text at infra notes 51-55. 51 1969 bluebook, supra note 49, at 216. 52 id. the introduction of the minimum standard deduction in 1964 accounted for a slight increase in use of the standard deduction, from 56% in 1963 to 58% in 1965. 53 see supra note 31. 54 tax reform act of 1969, pub. l. no. 91-172, § 802(a), 83 stat. 487, 676-77. 55 1969 bluebook, supra note 49, at 218. 56 in 1971, the increases for 1973 to 15% of agi and $2000 were accelerated to 1972, along with other tax-relief provisions, in order to provide tax relief during an economic recession. see h.r. rep. no. 92533, at 7-8 (1971). the 1971 act also increased the low income allowance to $1300 (~$7100 in 2011), though the committee reports attributed this increase to inflation, not further tax relief; the allowance was still pegged at the poverty level of income. id. at 8. in 1975, the percentage standard deduction was nudged up again to 16% of agi, up to $2400 ($2800 for joint filers) (~$9800/$11,500 in 2011), while the low income allowance was increased to $1700 ($2100 for joint filers) (~$7000/$8600 in 2011). revenue adjustment act of 1975, pub. l. no. 94-164, § 2(a)(1), (b), 89 stat. 970, 970-71; tax reform act of 1976, pub. l. no. 94-455, § 401(b), 90 stat. 1520, 1556 (making temporary changes permanent). 214 columbia journal of tax law [vol.2:203 as the standard deduction became more entrenched, the 1944 distinction between business-related and personal deductions for purposes of calculating agi began to break down. significantly, almost none of the important deductions for individuals added after 1954 were added below the line, despite the fact that many, if not most, related to personal expenditures rather than costs associated with a trade or business. one of the earliest personal deductions added after the creation of the standard deduction was the deduction for job-related moving expenses. the revenue act of 1964 added the deduction above the line, thus making it deductible to all taxpayers, itemizers and non-itemizers alike. 57 the house committee report states that it added the deduction above the line in part because, where the expenses were large, ―it occurred to your committee that it would be undesirable to, in effect, make taxpayers choose between taking this deduction and the standard deduction in lieu of itemized personal deductions.‖ 58 the reasoning here is faulty, for some of the reasons discussed infra in part iii.b, 59 but regardless it could also apply to any personal deduction—any nonitemizer must ―choose between‖ itemizing and taking the standard deduction. a potential response is that moving expenses occur irregularly, unlike charitable deductions, mortgage interest, and state taxes, and that placing them below the line would force some non-itemizers to learn the full set of itemization rules for one year simply because of one large, non-recurring expense. thus they would be forced to ―chose between‖ continuing simply to be non-itemizers and getting the benefit of the deduction. but the same argument could be applied to the deduction for extraordinary medical expenses or casualty losses, which are also likely to be non-recurring. 60 more importantly, even if placing moving expenses above the line could be justified on simplification grounds, it is not consistent with the original 1944 distinction between aboveand below-the-line expenses. recall that above-the-line deductions were originally those that would be appropriate in order for agi to be a relatively uniform base from which to calculate the percentage standard deduction fairly across different types of taxpayers. 61 job-related moving expenses are more like the expenses of a wage 57 revenue act of 1964, pub. l. no. 88-272, § 213(a) (creating new § 217), (b) (adding § 217 deduction to agi calculation in § 62), 78 stat. 19, 50-52. 58 h.r. rep. no. 88-749, at 48 (1963). 59 in particular, it confuses the simplification and progressivity effects described infra in part iii.b. by stating that a taxpayer must ―choose between‖ the two, congress is implicitly rejecting the idea that making the moving expenses deduction subject to the standard deduction would be de facto making it subject to a floor. were the expenses below the line, there would be no ―choice‖ because the only expenses properly deductible would be those that exceeded the standard deduction floor. the statement is thus not consistent with a zero-bracket view of the standard deduction. on the other hand, the simplification view ought to cut off any fairness arguments of this type, since a non-itemizer is, by definition, always getting a better deal than he would if he were instead to itemize. furthermore, adding below-the-line deductions would narrow the gap between the standard deduction and actual below-the-line expenses, which, as discussed infra in part iv.1, has positive equity effects. these effects may be offset in part by the increase in complexity as more taxpayers are pushed to being itemizers, so the overall equity effects are unclear. perhaps these issues are why the committee chose to describe making the moving expenses deduction subject to the standard deduction ―undesirable‖ rather than ―unfair.‖ 60 see infra notes 197-198 and accompanying text. the casualty loss deduction at the time did not have an overall floor (only the $100 per-loss floor), i.r.c. § 165(c)(3) (1964), and thus likely was used more often than today’s deduction subject to a floor of 10% of agi, i.r.c. § 165(h) (2010). however, the medical expense deduction in effect in 1944 was subject to a 5% floor. individual income tax act of 1944, pub. l. no. 78-315, § 8(c), 58 stat. 231, 235. 61 see supra text accompanying notes 35-40. 2011] doing too much 215 earner than a business-owner, and thus should not have been used in calculating agi, under the 1944 definition. placing moving expenses above the line thus effectively lowered the percentage standard deduction amount available to that taxpayer compared to a similarly situated taxpayer who did not move. 62 another example is the deduction for alimony paid. prior to 1976, 63 the deduction was below the line and thus subject to the standard deduction. in the tax reform act of 1976, congress moved the deduction above the line, stating only: the committee believes that the splitting of income or assignment of income through the payment of alimony is not properly treated under current law which permits only an itemized deduction for alimony. instead, the committee believes it is more appropriate to take the payment of alimony into account as a deduction in arriving at adjusted gross income, rather than as itemized deductions which are generally limited to personal expenses. as a deduction from gross income, the alimony deduction would be available to taxpayers who elect the standard deduction as well as to those taxpayers who elect to itemize their deductions. 64 because prior to 1976 alimony was below the line, the pre-1976 standard deduction effectively included an estimate of alimony payments, at least to the degree it includes any of the itemized deductions. thus moving the deduction above the line without any change in the standard deduction 65 effectively gave alimonypayers an additional subsidy on top of the already existing effective tax-free treatment. 66 but the existence of the standard deduction obscured this effect. it could be argued, as the senate finance committee appears to in the above passage, that it is important for the alimony deduction to match the inclusion of alimony as gross income under § 71, but that same argument could apply to mortgage interest, medical expenses, or other personal expenditures that can be matched with income of other taxpayers. because alimony payments are recurring, we would not have the same concern about one-time itemizers that we would in the moving expense case. but only a minority of taxpayers pay alimony, so how can it be fair that an alimony-payer and a non-alimonypayer face the same standard deduction, if alimony is below the line? but, again, the same can be said for homeowners, residents of high-tax states, large charitable donors, etc. as with moving expenses, the key is that agi began as a relatively coherent concept in the context of the percentage standard deduction, but over time began to lose that coherence as more and more personal deductions were placed above the line. and as it lost that coherence, the argument for grouping disparate items under the standard deduction weakened as well. 62 suppose a taxpayer in 1965 had $500 in moving expenses. this would lower his agi by $500, which would in turn lower his percentage standard deduction by $50. thus the net deduction is actually only $450. if this taxpayer were a non-itemizer with total itemizable expenses close to the itemization threshold, he would have been better off had moving expenses been placed below the line, since he may have been able to deduct more than $450 of his expenses. 63 the statutory predecessor to § 215 was enacted in 1942. revenue act of 1942, pub. l. no. 77753, § 120(b), 56 stat. 798, 816-17. 64 s. rep. no. 94-938(i), at 124-25 (1976). the finance committee report seems to be implying that it is important for the § 215 deductions to match the § 71 inclusions, but that same argument would apply, e.g., to mortgage interest, medical expenses, or other personal expenditures that can be matched with income of other taxpayers. 65 indeed, rather than decrease the standard deduction, the 1976 act made permanent the increases in 1971 and 1972. see tax reform act of 1976, pub. l. no. 94-455, § 401(b)(1), 90 stat. 1520, 1556. 66 an alternative way to view this benefit is as an increase in the net amount by which the standard deduction exceeds deductible expenditures. see infra part iii.b.1. 216 columbia journal of tax law [vol.2:203 d. the zero bracket amount—but only in name: 1977-1986 in 1977, congress simplified the standard deduction, but in so doing it also pushed the standard deduction farther away from its original simplification purposes and more toward being a zero bracket. just prior to the 1977 changes, the standard deduction consisted of a minimum standard deduction (the low income allowance), a percentage standard deduction (at that time 16% of agi), and a cap on the total standard deduction. this was a relatively confusing patchwork, particularly given that the minimum and maximum standard deductions were only $700 apart. 67 perhaps recognizing that the existing framework had become unwieldy and that the standard deduction had been effectively playing a strong zero-bracket role since 1969, congress replaced the framework with one flat standard deduction, much as we have today under current law. however, instead of treating the standard deduction as a deduction from agi, as was in effect prior to 1977 (and after 1986), congress created the ―zero bracket amount‖ and built the deduction into the tax tables, the rate schedules, and the definition of ―taxable income.‖ 68 the changes allowed for the first $2200 ($3200 for joint returns) (~$8000/$11,700 in 2011) to be tax-free. 69 making the change explicit, congress redesignated the standard deduction the ―zero bracket amount.‖ 70 to be clear, the 1977 standard deduction/zba was not a true, independent zba in the sense used in this article. itemized deductions were still subject to this standard deduction/zba. in particular, the only itemized deductions allowable in computing taxable income were those that were in excess of the standard deduction/zba. 71 for those taxpayers that, for one reason or another, were not entitled to the full standard deduction/zba, such as a dependent of another, the concept of the ―unused zero bracket amount‖ allowed for the amount by which the standard deduction/zba exceeded itemized deductions to be added back into taxable income, effectively denying such taxpayers any benefit of the standard deduction/zba, 72 much as under current law. 73 in its report on the bill, the senate finance committee switched back and forth between calling this provision by its new name, the zero bracket amount, and simply calling it a standard deduction, highlighting the fact that the concepts were effectively interchangeable. 74 67 see supra note 56 and accompanying text (noting a low income allowance of $1700 and a percentage standard deduction capped at $2400 in 1975). 68 tax reduction and simplification act of 1977, pub. l. no. 95-30, § 102(a), 91 stat. 126, 135-36. 69 while a decrease from the 1976 maximum standard deduction of $2400, this was also an increase in the amount of tax-free income for low-income taxpayers, since the prior low income allowance was $1700. see tax reform act of 1976 § 401(b)(1), 90 stat. at 1556. congress estimated that 7.3 million more taxpayers would become non-itemizers as a result of the change, 3.7 million more returns would become entirely nontaxable, and that the total number of itemizers would be reduced from 31% to 23%. s. rep. no. 95-66, at 50 (1977). 70 see tax reduction and simplification act of 1977 § 102(a), 91 stat. at 135; s. rep. no. 95-66, at 51 (―conversion of standard deduction into zero bracket amount and floor under itemized deductions‖). 71 the 1977 act redefined taxable income for individuals as ―adjusted gross income (1) reduced by the sum of (a) the excess itemized deductions, and (b) the deductions for personal exemptions provided by § 151, and (2) increased (in the case of an individual for whom an unused zero bracket amount computation is provided by subsection (e)) by the unused zero bracket amount (if any).‖ tax reduction and simplification act of 1977 § 102(a), 91 stat. at 135. 72 see id. 73 see supra note 21. 74 ―the house bill eliminates the present minimum, percentage and maximum standard deductions and replaces them with what is, in effect, a flat standard deduction. . . . by incorporating the flat standard 2011] doing too much 217 nonetheless, by replacing the percentage standard deduction with a flat standard deduction, the 1977 act removed one of the few remaining pure simplification features of the standard deduction. furthermore, by adding the standard deduction to the rate schedules, congress made clear the effect of a standard deduction, namely, that it functions as a floor on itemized deductions. instead of calculating taxable income by subtracting itemized deductions, the code after 1977 provided for subtracting only the excess of itemized deductions over the standard deduction/zba. the senate finance committee titled the section of its report on this provision of the act, ―conversion of standard deduction into zero bracket amount and floor under itemized deductions.‖ 75 it is thus ironic that congress named primarily simplification purposes in making the changes. 76 while these changes allowed for a greater amount of tax-free income to low-income people, the shift from a standard deduction to a zero bracket seems to have been motivated out of belief that the simplifying provision—the standard deduction—had itself become too complex. because the percentage standard deduction occupied a relatively narrow slice of itemizable expenses, the belief was that simply making it flat would remove a large degree of complexity, with relatively little negative effect. as discussed in the next section, this was not the case. from 1977 to 1986 there were few changes to the structure of the standard deduction/zba itself. in 1978, the amounts were increased to $2300 for single taxpayers, and $3400 for joint taxpayers. 77 the change was made to offset the effects of inflation, 78 but because of continuing inflationary erosion, the amounts were ultimately indexed to inflation by the economic recovery tax act of 1981. 79 the 1981 act also contained a particularly glaring example of the breakdown of the distinctions between aboveand below-the-line deductions. the act provided that, for a four-year period, charitable contributions would be moved partly above the line, thus making them partially deductible in calculating agi. 80 the 1944 distinction between business-related deductions—placed above the line—and personal deductions—placed below—is, admittedly, fuzzy at the margins. nonetheless, charitable contributions are perhaps the purest example of personal deductions, having almost no business or incomeproducing purpose. 81 placing the charitable contribution above the line while keeping, e.g., the miscellaneous itemized deductions below the line is difficult to justify. furthermore, as in the case of alimony, 82 since the standard deduction was already intended to include an estimate of charitable contributions—as it had since 1944— deduction in a zero rate bracket in the tax tables and rate schedules, the house bill eliminates the need for the separate concept of the standard deduction in the code and the subtraction of the standard deduction in computing tax liability.‖ s. rep. no 95-66, at 50-51 (1977). 75 id. at 51. 76 see id. at 4-5, 15; h.r. rep. no. 95-27, at 38-39 (1977). 77 revenue act of 1978, pub. l. no. 95-600, § 101(b), 92 stat. 2763, 2769-70 (1978). 78 see h.r. rep. no. 95-1445, at 30 (1978). 79 economic recovery tax act of 1981, pub. l. no. 97-34, § 104(a), 95 stat. 172, 188-89. 80 in 1982 and 1983 the non-itemizer deduction in calculating agi was limited to 25% of the amount donated, and the deduction was capped at $100. in 1984, it was 25% and $300. there was no cap in 1985 and 1986, though only 50% of donations were allowed in 1985. the full amount would be deductible in 1986, but there would be no deduction in years following. economic recovery tax act of 1981 § 121(a), 95 stat. at 196. 81 this is not to argue that they are not properly deductible in calculating personal income, however. that discussion is beyond the scope of this article, but has been discussed in great detail elsewhere. see supra note 99. 82 see text at supra notes 63-65. 218 columbia journal of tax law [vol.2:203 moving the deduction above the line essentially allowed non-itemizers to get double the tax benefit. e. the current era: 1986 to today congress’s intent in creating the zero bracket amount in 1977 and moving the calculation of taxable income to the tax tables and rate schedules was ostensibly simplification. however, commentators realized fairly early that the change likely introduced too much additional complexity in exchange for relatively little simplification benefit. 83 the value of the change to non-itemizers was relatively small—just the removal of one straightforward subtraction step, since they no longer had to separately subtract the standard deduction. indeed, that benefit could have been achieved without altering the rate schedule and the definition of taxable income at all, since the tables themselves could have given tax net of the standard deduction (as they did prior to 1977). the change to the rate schedule and the definition of taxable income, therefore, was really only a simplification for the estimated 4% of taxpayers who were both non-itemizers (since those who were itemizers would perform that subtraction step anyway) and whose incomes would have exceeded the income ceilings on the tax tables, since they were the only taxpayers who would have necessarily had to do the additional subtraction step. 84 in exchange for that minor benefit, the change to the rate schedules and the definition of taxable income required a number of technical and conforming changes to the then-effective code provisions dealing with net operating losses, lump-sum distributions, short tax-year computations, percentage depletion limitations, trust distributions, income sourcing, capital losses, income averaging, and others. 85 commentators quickly determined that they preferred that the standard deduction be treated as a deduction from income, rather than a zero bracket. 86 in 1986, congress relented and created the basic structure for the standard deduction as it still exists today. 87 iii. a critique of the standard deduction in this section, this article discusses the principal problems with the standard deduction. first, it notes the theoretical problems with having a single provision serve both a simplification purpose and a progressivity purpose, and especially that such a dual role leads to conflicting policy arguments for and against the current standard deduction. second, it notes that partly as a result of these conflicts, the standard deduction exerts a significant destabilizing force on policy debates regarding definitions of income and the proper role of deductions. 83 see, e.g., gene o. sjostrand, why not go back to the standard deduction, 56 taxes 265, 265 (1978); donald c. marshall & james e. parker, zero bracket approach adversely affects income averaging, 56 taxes 179, 188 (1978). 84 see s. rep. no. 95-66, at 48 (1977) (―to prevent itemizers whose tax table income is above the table ceiling levels from being required to subtract the floor on itemized deductions from their income, the bill builds the floor into the rate schedules, as well as the tax tables, as a zero rate bracket. taxpayers not using the tax tables will subtract their personal exemptions from tax table income in order to determine taxable income, against which the rate schedules are to be applied. as a result of this change, the present law concept of taxable income is redefined to reflect the floor under itemized deductions.‖); sjostrand, supra note 83, at 265; marshall & parker, supra note 83, at 188. 85 s. rep. no. 95-66, at 55-59; see sjostrand, supra note 84, at 265-66. 86 see, e.g., aba tax section recommendation no. 1979-9, 32 tax law. 1482, 1482-83 (1979); see also bittker & lokken, supra note 21, ¶ 30.5.1. 87 tax reform act of 1986, pub. l. no. 99-514, § 102(a), 100 stat. 2085, 2099. 2011] doing too much 219 a. the equivalence of a standard deduction and an exemption (or zba) plus a floor the discussion that follows relies on the equivalence between (1) a standard deduction and (2) an exemption (or zba) 88 plus a floor under itemized deductions, each of the same amount as the standard deduction. to see this equivalence, consider the following example. suppose there is a tax system, t, much like ours, with a standard deduction of $10,000, and where taxpayers deduct the larger of the standard deduction or their total itemized deductions. and suppose there is another tax system, t', which is the same as t, except that there is no standard deduction, a $10,000 exemption (or zba) for all taxpayers, and a $10,000 floor under the itemized deductions—expenses are only deductible to the extent they exceed $10,000. there is a single tax rate of 50% in both systems. example 1a: tp has agi of $100,000 and deductible expenses of $20,000. under t, tp itemizes, since his expenses are greater than the standard deduction. his taxable income is thus $100,000 $20,000 = $80,000, and his total tax is .5 * $80,000 = $40,000. under t', tp can only deduct $20,000 $10,000 of expenses, but gets a $10,000 exemption. his taxable income is thus $100,000 $10,000 $10,000 = $80,000, and his total tax is again .5 * $80,000 = $40,000. example 1b: if on the other hand tp has no deductible expenses, then, under t, he deducts only the standard deduction amount. his taxable income is thus $100,000 $10,000 = $90,000, and his total tax is .5 * $90,000 = $45,000. under t', he receives only the exemption. his taxable income is thus $100,000 $10,000 = $90,000, and his total tax is again .5 * $90,000 = $45,000. the result is thus the same for the taxpayer under either t or t'. this is true generally for any choice of agi, floor and exemption amounts, and standard deduction amount, provided that the floor and exemption amounts are both equal to the standard deduction amount. 89 thus, if we simply replaced the standard deduction with a zba of 88 note that an exemption and a zero bracket amount are equivalent. whether you subtract an amount from income or multiply that amount by 0%, the result is the same—that amount goes untaxed. i use an exemption here to simplify the calculations. 89 to see this more generally suppose taxes are determined by the equation t = t(i – d) where t is the tax rate, i is adjusted gross income and d is the greater of itemized deductions id or the standard deduction sd. suppose that the calculation of tax is changed to introduce an exemption amount e, and a floor f under itemized deductions, such that deductions d' are equal to id – f if id > f, and 0 otherwise. taxes would then be determined by the equation t' = t(i – e – d') if we set t = t' then 220 columbia journal of tax law [vol.2:203 the same amount and instituted a floor on total itemized deductions of the same amount, we would have a system precisely equivalent to our current system. b. mixing income measurement with progressivity the standard deduction performs two functions. first, it is a substitute for the itemized deductions for those with relatively few itemizable expenses, in order to lower the administrative costs—for the taxpayer and the government—of trying to measure the expenses precisely. second, it is an element of progressivity, providing, along with the personal exemptions, for a portion of income that is not taxed. the problems with the standard deduction arise because neither of the above statements is entirely accurate— indeed, that would be impossible. the standard deduction cannot both lower taxable income and provide for some amount of taxable income to be untaxed (or at least not well, as we will see). in other words, a single provision is being used both to define the tax base and as part of the rate structure applied to that base, and that is simply contradictory. if the standard deduction is a substitute for itemized deductions in calculating taxable income, then it cannot also act as a zba with respect to an amount of taxable income equal to the deductions—in essence, part of the zba has already been ―used up.‖ 90 even though the result might be computationally equivalent—in either case, the tax on the relevant amount is zero—the policy implications and criticisms are quite different depending on whether one sees the standard deduction primarily as a substitute for the itemized deductions—that is, whether it is part of the tax base calculation—or as an element of progressivity—that is, whether it is part of the rate structure. what commentary exists on the standard deduction understands that the dual role creates problems, and it discusses some, but not all, of the associated problems discussed here. but the commentary largely fails to explain that particular criticisms are associated with particular assumptions about the primary role of the standard deduction, and it frequently lumps together criticisms d = e + d' = e + id – f thus, when id ≥ sd id = e + id – f or e = f (1) furthermore, when id < sd, d' must equal 0, because otherwise we would have the equation sd = e + id – f which cannot be true if e = f but id < sd. thus sd = e + d' = e + 0 = e (2) therefore, combining results (1) and (2), the two tax systems are equivalent if and only if sd = e = f, or where the standard deduction amount in the first scenario is equal to the floor and to the exemption (or zba) in the second scenario. for a similar derivation see kaplow, standard deduction, supra note 12, at 5-6. 90 note that the contradiction is not because calculating the tax base involves subtraction while applying a tax rate involves multiplication; a zba can be implemented either through the rate structure or as a larger personal exemption. rather, the contradiction is in having the zba also substitute for items that are independently deducted from the tax base. 2011] doing too much 221 that derive from contradictory assumptions. 91 for example, a leading treatise states that as a result of the standard deduction a non-itemizer does not get a tax benefit from his charitable contributions, medical expenses, or casualty losses—a criticism that, as discussed below, only applies if we view the standard deduction primarily as an element of progressivity 92 —but that a fixed standard deduction ought to be replaced with one calculated as a percentage of agi—an appropriate solution only if we see the standard deduction as primarily an element of simplification. 93 the problem and the solution are unrelated. to show the contradiction, i imagine two extreme, but computationally equivalent, cases: one, in which congress has effectively decided not to have a zero bracket at all—to tax the first dollar of income—and to have the standard deduction act entirely as a substitute for the itemized deductions; and a second, in which congress has effectively decided to have a zero bracket amount—a zba—exactly equal to the standard deduction, but to have a floor on combined itemized expenses also exactly equal to that standard deduction. i also examine a third case, where the zba is implicitly fixed at some amount less than the full standard deduction. as i will show, the policy criticisms vary significantly depending on this choice of frame. it is important to note at the outset that these cases are revenueand distributionneutral; a given taxpayer’s tax return would not be affected by this choice of frame. the purpose of this exercise is not to argue that one or the other view changes anything computationally—as shown in part iii.a, supra, the two are equivalent. rather, the purpose is to show the contradictory criticisms that result from the two frames, and to ask what conclusions, if any, we can draw about the current system’s trade-offs between progressivity and simplification. 94 91 it should be noted that the standard deduction is a compromise between simplification and progressivity, and thus both sets of criticisms can, in a sense, be partially true at the same time. but this only underscores the conceptual complexity of the standard deduction and its effect on debates regarding the personal deductions. 92 while it is the case that a non-itemizer’s charitable giving is not subsidized at the margin, it is not the case that the encouragement to give is ―wholly absent‖ for a non-itemizer if we consider the standard deduction to be largely or entirely a substitute for the itemized deductions, and not a zba. see text at infra note 100. 93 bittker & lokken, supra note 21, ¶ 30.5.1. the treatise notes that this fix would ―not have the progressivity effects of the present deduction,‖ id., which is partly an acknowledgement of the conflict. but the treatise identifies the progressivity effects as the phase-out of a variable zba as one’s itemizable expenses increase. id. under this view of the standard deduction only the net amount of the standard deduction above itemizable expenses is the zba. because itemizable expenses tend to track income, the treatise argues, the zba tends to be largest for those with the least income, and disappears for those with higher income. id. thus, the loss of progressivity under the treatise’s proposal comes from losing a variable zba that phases out with a proxy for income. id. however, this interpretation of the current standard deduction implies that the standard deduction does act, in part, as an approximation of the itemized deductions (since the zba portion of the standard deduction is only that amount in excess of the itemized deduction), and this is in conflict with the treatise’s primary criticism of the standard deduction. in other words, seeing the standard deduction as a variable zba that phases out with the level of itemizable expenses implies that a non-itemizer is getting the benefit of a deduction for her itemizable expenses (though at the expense of a larger zba). see also samansky, supra note 12, at 555 (making a similar error in saying that ―[t]he most troubling consequence of the standard deduction is that it systematically deprives most moderate income persons of any tax benefit from charitable contributions‖). 94 although the legislative history does not show that congress engaged with these arguments when they were expanding the standard deduction, one person did raise many of the same arguments discussed herein in congressional testimony during consideration of the tax reform act of 1969. a summary of testimony by norman ture (an ―uncompromising advocate of supply-side economics and an architect of the 222 columbia journal of tax law [vol.2:203 1. simplification: no zba first, consider the case where the standard deduction is not intended to provide for some amount of untaxed income—no zero bracket—but where the standard deduction is entirely a simplified substitute for the itemized deductions. in theory, this allows for lower administrative costs to both the taxpayer and the government. the taxpayer does not have to worry about record-keeping or difficult calculations, 95 and the government does not face the risk of miscalculations or the higher cost of ensuring compliance. but taxpayers and the government are paying a high price for this benefit. the standard deduction, in this simplification-centric view, acts as a payment by the government to taxpayers in exchange for taxpayers waiving their right to itemize. 96 viewed in this way, the payment is grossly over-generous and distributed exactly backwards. a non-itemizer with low itemizable expenses and a non-itemizer with high itemizable expenses each get exactly the same gross amount from the government in exchange for not itemizing. but net of their itemizable expenses, the payments are distributed upside down: the taxpayer with the least to benefit from the itemized deductions receives the largest net payment, while the taxpayer with the most to gain receives the least. 97 example 2: tp1 and tp2 each have agi of $50,000. tp1 has $1000 in itemizable expenses; tp2 has $4000. the standard deduction is $5000. the tax rate is 50%. because the taxpayers could deduct their itemizable expenses to calculate taxable income, tp1’s net gain from instead taking the standard 1981 tax cut,‖ irving molotsky, norman ture, architect of the 1981 tax cut, dies at 74, n.y. times, aug. 13, 1997, at a21) stated that increasing the standard deduction would ―move directly contrary to improving horizontal equity, so long as provisions for itemizing deductions remain in the law‖; that ―[i]n effect, the standard deduction permits two taxpayers in the same family circumstances and with the same [agi] to pay the same tax even though incurring substantially different amounts of itemizable expenses‖; that ―the argument regarding simplification is substantially overstated from the taxpayers’ point of view‖; that the argument that the standard deduction ―would reduce tax liabilities . . . really is an argument for reducing effective tax rates for [low-income] taxpayers. . . [which] would be better accomplished by reducing the statutory tax rates in the relevant income range‖; and that ―the presumption that itemized deductions contribute to fairness . . . is open to challenge,‖ and if they do, then the deductions should ―not . . . be constrained by such devices as [variable floors] or the [1969] proposal to raise the price for itemizing.‖ staff of the joint comm. on tax’n, 91st cong., summary of testimony on the standard deduction 4-5 (joint comm. print 1969) (testimony of norman b. ture), reprinted in 21 tax reform – 1969: a legislative history of the tax reform act of 1969, doc. no. 67 (bernard d. reams, jr., ed., 1991). 95 it is possible that the standard deduction actually increases complexity for taxpayers on the margin of being itemizers, since they may bear the costs of record-keeping and computation but still fail to exceed the threshold (or, alternatively, fail to itemize when they should have). in practice, it is likely that many taxpayers do not itemize unless they have expenses exceeding the standard deduction by an amount approximating the costs associated with itemizing. see mark m. pitt & joel slemrod, the compliance cost of itemizing deductions: evidence from individual tax returns, 79 amer. econ. rev. 1224, 1224 (1989) (estimating the cost of itemizing via forgone reductions in tax liability). 96 technically, a taxpayer must elect to itemize deductions, though that election is not limited to those with expenses greater than the standard deduction. see i.r.c. § 63(e) (2010). 97 bittker & lokken characterize this net payment differently. instead of seeing it as a windfall payment for waiving the right to itemize, they describe it as a variable zba that shrinks as income goes up. bittker & lokken, supra note 21, ¶ 30.5.1; see infra part iii.b.4. while there may be some vertical equity benefits of having such a variable zba, it still would violate horizontal equity in the way that i discuss. 2011] doing too much 223 deduction is $2000, while tp2’s is only $500, even though tp2 has given up a greater amount of itemized deductions. if we believe that the itemized deductions are proper in measuring haig-simons income, 98 then the standard deduction is functionally an instrument of regressivity in the simplification-centric case, since taxpayers with lower taxable income receive lower tax benefits. example 3: the same facts as in example 2. using the itemized deductions, tp1 has taxable income of $49,000, and tp2 has taxable income of $46,000. if they use the standard deduction, each taxpayer instead has taxable income of $45,000. using the standard deduction, tp1 lowers her taxable income by $3000 more than tp2 does, and thus receives a net benefit that is $1500 more than tp2’s, despite having a higher ―true‖ taxable income. note, however, that the conclusion that the net payments are distributed backwards is not dependent on our view of whether the personal deductions are proper in measuring income. even if the deductions are viewed entirely as subsidies, 99 the government is simply paying the wrong people—it pays the most to those with the lowest cost of itemizing and the least to give up. while not necessarily regressive, the payments still appear inequitable and wasteful, if only because of their arbitrary distribution. some have called the denial of itemization a taxpayer equity issue by arguing that it privileges, say, charitable spending by one kind of taxpayer over another. 100 but 98 ―personal income may be defined as the algebraic sum of (1) the market value of rights exercised in consumption and (2) the change in value of the store of property rights between the beginning and end of the period in question.‖ henry c. simons, personal income taxation: the definition of income as a problem of fiscal policy 50 (1938). under this definition, a deduction is proper if the expense should not be considered consumption. see william d. andrews, personal deductions in an ideal income tax, 86 harv. l. rev. 309, 313-14 (1972). thus, a taxpayer with more deductions has a lower ―true‖ income than a taxpayer with the same gross income but fewer deductions. 99 the literature over whether a particular deduction is proper in measuring haig-simons income or otherwise measuring ability to pay, or is instead a subsidy—or ―tax expenditure‖—is rich, though ultimately unresolved for many of the deductions. see, e.g., stanley s. surrey, pathways to tax reform: the concept of tax expenditures (1973); andrews, supra note 98; boris i. bittker, income tax deductions, credits, and subsidies for personal expenditures, 16 j.l. & econ. 193 (1973); thomas d. griffith, theories of personal deductions in the income tax, 40 hastings l.j. 343 (1989); jeffrey h. kahn, personal deductions—a tax ―ideal‖ or just another ―deal‖?, 2002 l. rev. m.s.u.-d.c.l. 1; daniel n. shaviro, rethinking tax expenditures and fiscal language, 57 tax l. rev. 187 (2004); victor thuronyi, tax expenditures: a reassessment, 1988 duke l.j. 1155 (1998); david a. weisbach & jacob nussim, the integration of tax and spending programs, 113 yale l.j. 955 (2004). this article does not intend to wade into this debate. as noted in the accompanying text, the arguments herein are valid regardless of which view one takes. even if all the personal deductions are tax expenditures, it remains the case that those deductions are used to define the tax base, however that concept might vary from ideal haig-simons income, and variations from that base should not be as arbitrary as the standard deduction makes them. that being said, some discussions in this article assume that certain deductions, such as those for extraordinary medical expenses and casualty and theft losses, are more likely to be proper under a haig-simons definition, while others, such as that for mortgage interest, are more likely to be tax expenditure subsidies. 100 see coven, supra note 12, at 1562; samansky, supra note 12, at 544; see also bittker & lokken, supra note 21, ¶ 30.5.1. 224 columbia journal of tax law [vol.2:203 that is not the case in the simplification-centric scenario, since non-itemizers are getting a better deal—the full value of what would have been their itemized deductions plus an additional exemption amount. indeed, by granting that additional exemption, the government is still somewhat subsidizing charitable giving, even if it not at the margin. because this is the no-zba case—where we take as fixed the intent to tax the first dollar of taxable income—the baseline comparison should be to a tax system with no standard deduction and no zero bracket. it follows that the grant of an additional deduction on top of that would in most cases increase charitable giving among those who receive that benefit, since the taxpayer has more after-tax dollars to spread around. in economics terminology, the taxpayer’s budget constraint has shifted such that consumption of most goods—including charitable giving—will increase, despite the fact that there is no change in the after-tax marginal cost of giving. therefore, the actual equity issue in the no-zba case is the distribution of these tax windfalls. if the windfall is the payment for the denial of itemization, then the windfalls are being distributed exactly in reverse—congress effectively decided to provide non-itemizers with a generous tax benefit in order to have a more simplified tax system, but that benefit is distributed inequitably among non-itemizers; those with high itemizable expenses get relatively little benefit, while those with low itemizable expenses get a large benefit. 101 2. progressivity: zba equal to the standard deduction amount now consider the case where the intent of the standard deduction is to be a zba—to provide for an amount of taxable income that is subject to a 0% tax rate. because the standard deduction is linked to the itemized deductions, a zba equal to the standard deduction amount implies a floor on itemized deductions also equal to that standard deduction amount 102 —taxpayers can only deduct itemizable expenses in excess of the standard deduction amount. 103 this progressivity-centric case is somewhat easier to understand, since floors already apply to a number of the itemized deductions 104 and because of the clear congressional intent for the standard deduction to play a 101 although samansky is critical of this inequity, supra note 12 at 544, he suggests that if all itemized deductions were proper in measuring income—if all affected ability to pay and none were ―tax expenditures‖—then this system might in fact be justified for simplification reasons, since the sum of the itemizable expenses is a coherent measure of a taxpayer’s ability to pay. id. at n.85. he therefore ties at least part of his criticism of the standard deduction to the fact that many itemized deductions do not actually address ability to pay. this is an example of why it is necessary to bifurcate the effects of the standard deduction, since this conclusion does not follow in the simplification-centric case. indeed, if itemizable expenses did not alter a taxpayer’s ability to pay, then we ought to feel more comfortable that the net payments are distributed arbitrarily, since the difference in ability to pay between a non-itemizer with high itemizable expenses and one with low itemizable expenses is smaller than the difference in their actual itemizable expenses. the greater the difference in ability to pay between these two taxpayers, the less comfortable we should be with the inequitable distribution of the net standard deduction tax benefit. in short, it is preferable that the net payments be distributed arbitrarily rather than regressively. see also kaplow, supra note 12, at 11 n.28. but see jeffrey h. kahn, beyond the little dutch boy: an argument for structural change in tax deduction classification, 80 wash. l. rev. 1, 36 (2005) (arguing that the simplification benefits exceed the cost to equity). 102 see infra part 0. 103 the existence of the implied floor still adds some simplicity to this frame, of course—removing the floors entirely would generate substantially more complexity. however, there may be many other policy reasons for having a floor beyond just simplicity. see infra part 0 104 see, e.g., i.r.c. §§ 165(h)(2) (2010) (floor of 10% of agi on casualty losses), 213(a) (2005) (floor of 7.5% of agi on medical expenses, going to 10% in 2013). 2011] doing too much 225 progressivity role. 105 but there are several problems with this current view. first, there is little reason for the floor for itemized deductions to be equal to the zba; the proper amount of itemized deductions should not relate to the proper amount of untaxed income. second, there is no good reason why the ability to deduct one kind of expense depends on other, unrelated expenses. why should the size of one’s mortgage determine whether or not one can deduct charitable contributions? 106 here, the faulty equity argument mentioned in the prior section regarding the different treatment of itemizable expenses 107 becomes more relevant, since the tax code is distributing the benefits of itemization arbitrarily. it is important to be precise here, though: this equity problem is not with the standard deduction per se. combining unrelated deductions is not objectionable when the standard deduction is substituting for those deductions and is by definition equal or greater than the total of those deductions. what is objectionable is applying a single floor to a group of personal deductions in order to determine the availability of any deduction. third, there are already existing floors that serve particular purposes, but by lumping all the personal deductions into one category, the purposes of those floors become blurred and muted. for example, the floor for the medical expense deduction could be said to exist primarily because our concern is with people who are abnormally unhealthy. as william andrews argued, the distribution of medical expenses can be seen as the distribution of differences in health, and treating those with bad health as ―consuming‖ health care would be equivalent to taxing them based on that health. 108 but there is still some baseline level of health care that everyone uses, even in good health. therefore, the 7.5% of agi floor for medical expenses 109 could be said to crudely limit the deduction to those in bad health. 110 but any careful calibration of the floor to measure bad health is wasted for non-itemizers, because the amount above the floor just gets tossed back into the mix to be subject to the standard deduction floor. example 4: tp1 has agi of $50,000 and $5000 in medical expenses; tp2 is the same but also has $5000 in mortgage interest. the standard deduction is $5000. since 7.5% of tp1’s agi is $3750, only $1250 of tp1’s medical expenses will be considered the extraordinary costs of bad health and thus be deductible—but because that is her only deductible expense, it will not end up being deducted because she has not surpassed the overall standard deduction floor. tp2, however, has surpassed the standard deduction floor due to her mortgage interest, and thus she may take the additional $1250 deduction, despite having equally bad health as tp1. 105 see supra part ii.c. 106 see kaplow, standard deduction, supra note 12, at 27-29; samansky, supra note 12, at 548. 107 see supra note 100 and accompanying text. 108 andrews, supra note 98, at 335. but see louis kaplow, the income tax as insurance: the casualty loss and medical expenses deductions and the exclusions of medical insurance premiums, 79 cal. l. rev. 1485, 1486, 1505-06 (criticizing analysis that focuses on definitions of what is ―income‖ or ―consumption‖). 109 supra note 104. 110 this is a gross simplification, of course, not least because having the floor be a percentage of agi implies that rich taxpayers with, say, cancer are healthier than poor taxpayers with cancer. this issue is discussed more fully infra in part 0 226 columbia journal of tax law [vol.2:203 so if any of the 63% of taxpayers who take the standard deduction 111 get sick, then congress’s determination of what expenses constitute bad health simply does not apply to them. 112 this argument is related to the argument that the standard deduction distributes the benefits of itemized deductions arbitrarily, but the issue here is system design rather than equity—the work that the itemized deduction floors are supposed to be doing is wasted. 3. hybrid: zba less than the standard deduction amount at this point, a reader would be justified in questioning whether either of the extreme cases described above reflects how the standard deduction was intended—likely a mix of the two was intended, where the government does desire some non-zero zba, but at an amount less than the full standard deduction amount. 113 while this may seem reasonable, it requires introducing substantial additional complexity, bordering on absurdity, to keep the dual roles fully bifurcated and still get the same result as under the current system—so much so, that it is impossible to believe that this is how congress intended the standard deduction to be viewed. first, it requires separating the deduction amount from the itemization threshold such that the deduction amount is less than the threshold amount above which one is allowed to itemize, with that deduction equal to the difference between the threshold and the zba. 114 second, it would require that itemizers only be allowed to deduct their expenses above a floor equal to this implied zba. example 5: assume that instead of a standard deduction of $5000, there is a zba of $4000 and a deduction of $1000 given to those whose itemizable expenses do not exceed a threshold of $5000. those whose expenses do exceed $5000 are permitted to deduct all expenses above a floor of $4000. thus a non-itemizer (one whose expenses do not exceed $5000) is not taxed on a) $4000 plus b) an additional $1000 (total of $5000), while an itemizer (one whose expenses exceed $5000) is not taxed on a) $4000 plus b) the amount of his itemizable expenses above $4000 (total of at least $5000). this is equivalent to having no zba while allowing non-itemizers a standard deduction of $5000 and allowing itemizers to fully deduct their itemizable expenses. while the mental gymnastics required to think coherently about this mid-zba option ought to alarm us, this scenario has some theoretical support, even if it would be administratively impossible. louis kaplow, in discussing the effects of separating a standard deduction from an itemization threshold, notes that having a deduction less than the threshold is likely to be more accurate, and thus have lower equity costs, than having the deduction equal to a threshold. 115 a standard deduction that does not play a zba role 111 2009 soi bulletin, supra note 6, at 7. 112 see bittker & lokken, supra note 21, ¶ 30.5.1 (noting this problem). 113 see supra part ii.c. 114 for a full discussion of separating a standard deduction from its threshold, see kaplow, standard deduction, supra note 12, at 12-19. 115 see id. 2011] doing too much 227 is in essence an estimate of the non-itemizers’ itemizable expenses. to minimize the error cost of that estimation, we should use the mean of the distribution of itemizable expenses as the optimal standard deduction amount, 116 and if itemizable expenses cluster toward $0 for non-itemizers, as is plausible, 117 then the optimal standard deduction may actually be less than half of the threshold. 118 on the other hand, this interpretation reintroduces the asymmetry between itemizers and non-itemizers that was effectively removed in the simplification-centric and progressivity-centric cases. in this hybrid case, we deny a deduction to itemizers for expenses below $4000, but also provide an additional $1000 of deductions to non-itemizers with expenses below $5000 (most of whom would have expenses below $4000). in other words, non-itemizers could deduct an estimate of their expenses below $4000 (the $1000 standard deduction), while itemizers could not deduct any amount below $4000. furthermore, in this hybrid case we have each of the costs discussed in the simplificationand progressivity-centric cases, though each is somewhat lower in magnitude. the net standard deduction payments continue to be distributed inequitably, with those with the lowest itemizable expenses receiving the greatest benefit. moreover, the single floor and its arbitrary connection to the zba remain. 4. other views there are yet more ways to conceptualize the dual roles of the standard deduction. i briefly note two others here. as with the frames presented above, each of these frames also implies its own set of criticisms. one could describe the difference between the standard deduction amount and actual itemizable expenses as a variable zba that shrinks as itemizable expenses grow. 119 one could attempt to justify this structure by noting that itemizable expenses tend to rise with income, and so the zba would tend to shrink as income grew. i focus on the above conceptions because they allow the clearest bifurcation of the simplification and progressivity roles. moreover, conceiving of the standard deduction as a zba that phases-out with itemizable expenses is flawed. first, if the intent is to have a zba phase out as income rose, then it should be indexed to agi or another income measure, not itemizable expenses. second, while itemizable expenses may tend to rise with income generally, the distribution of expenses at a given income level is more likely to reflect the opposite—the higher the expenses, the more limited the ability to pay. thus we end up with the same criticisms as in part iii.b.1. 120 116 see id. at 14 & n.38. 117 see id. at 14-15 & n.39. 118 if non-itemizers have itemizable expenses evenly distributed between zero and some threshold t, then the mean amount of expenses would be t/2. however, if the expenses cluster toward zero, the mean would be somewhat less than t/2. see id. at 14-15. kaplow’s analysis becomes more complex when he introduces the likely taxpayer responses to having a deduction less than a threshold. first, because there is a greater advantage to exceeding the threshold than under the current system, more taxpayers will do the necessary calculations, thus decreasing the simplification benefit. second, having a deduction less than a threshold may introduce excessive incentives for taxpayers to boost their itemizable expenses to get over the threshold or to cluster their expenses in alternate years. these costs would likely push the optimal deduction to be higher than the mean of non-itemizers’ itemizable expenses. see id. at 17-19. 119 see bittker & lokken, supra note 21, ¶ 30.5.1. 120 note that even though this view appears to allow for both simplification and a zba, it still has the effect of denying the taxpayer an effective marginal incentive to increase spending, since instead of 228 columbia journal of tax law [vol.2:203 another possible interpretation of the standard deduction is that it effectively creates two different tax bases and rate structures. 121 itemizers—generally higher income taxpayers—are taxed based on taxable income and using a graduated rate structure that does not have a zero bracket, 122 while non-itemizers—generally lower income taxpayers—are taxed on the basis of agi, but with a rate structure that includes the zero bracket. in other words, instead of calling the standard deduction a trade-off between itemizing and simplifying, we can call it trade-off between a lower tax base and a zero bracket. in essence, the two distinct frames presented in parts iii.b.1 (no zba) and 2 (high zba) are both true at the same time, but for different taxpayers. 123 c. policy debate distortion the prior section addressed theoretical and conceptual incoherence of the current standard deduction. now, i turn to the practical effects of that incoherence. first, the fact that it is doing ―double duty‖ 124 as an income measurement tool and a zba means that we cannot resolve issues relating to the equity of particular personal deductions. second, the fact that the personal deductions hit a minority of taxpayers means that most voters will not have the proper incentives to care about these provisions, which in turns enables interest groups to capture the political process. third, it minimizes and distorts the ability of itemized deductions to motivate certain behavior, such as contributing to charity. finally, by introducing additional arbitrariness and by adding to the erosion of a clearly identifiable tax base, the standard deduction may aid in undermining respect for the tax system. this increases enforcement costs and makes it more difficult for the government to raise revenue in the future. 1. unresolved political debates consider the potential expansion of the charitable deduction to non-itemizers, proposed most recently in 2005. 125 a large part of the public argument for doing so was that it is ―unfair‖ to allow the deduction for some people and not for others. 126 but that criticism implicitly assumes that the standard deduction is really a zba, not a simplified tool for measuring income. if the standard deduction is intended to be a proxy for personal deductions like the charitable deduction, then non-itemizers are already getting the full benefit of their charitable deductions—and then some. 127 but to many taxpayers, it probably does not feel like they are getting the benefit, and in part they are right, since they do not feel the incentive effects of the tax deduction at the margin. 128 this disparate providing a subsidy by lowering taxable income, the increase in spending shrinks the effective zba. indeed, that would result in a marginal penalty, rather than a marginal subsidy. 121 see coven, supra note 12, at 1558-59. at the time coven was writing, the percentage standard deduction was still in place, so he characterized the trade-off as itemizers being taxed on taxable income while non-itemizers were taxed on 84% of agi, but with the same rate structure. 122 ignoring personal exemptions and similar provisions. 123 note that there are still more ways of framing an analysis of the standard deduction, for example as a presumptive tax. see, e.g., joel slemrod & shlomo yitzhaki, analyzing the standard deduction as a presumptive tax, 1 int’l tax & pub. fin. 25 (1994); see also supra note 91. 124 feld, supra note 12, at 441. 125 tax relief act of 2005, s. 2020, 109th cong. (2005). 126 see, e.g., independent sector, fact sheet on the charitable deduction changes for itemizers and non-itemizers in s.2020, the tax relief act of 2005, at 2, 4 (on file with author). some have argued that this would motivate increased overall charitable giving, but the evidence is mixed. see, e.g., jane g. gravelle, cong. research serv., rl 31108, economic analysis of the charitable contribution deduction for non-itemizers 5-6 (2005). 127 see supra text accompanying note 100. 128 moreover, they may in fact feel a tax penalty rather than a tax subsidy. see supra note 120. 2011] doing too much 229 treatment lends support to oversimplified fairness arguments about extending the charitable deduction, even though whether the current deduction is in fact unfair is indeterminate. indeed, as discussed above, under the simplification-centric view, the lump-sum benefit of a large standard deduction likely does partially subsidize charitable giving and other itemizable expenses. 129 moreover, if congress ended up extending the charitable contribution to nonitemizers, as they have in the past, 130 they may feel increased pressure to do the same for the other itemized deductions. after all, it would be just as ―unfair‖ to deny the benefits of the deduction for state and local taxes to a majority of taxpayers. 131 the advantage of such bills is that they may end up de facto answering the question of what, exactly, the standard deduction is intended to do. the more below-the-line deductions move above the line, the more the standard deduction is doing the work of a zba. 132 but it would be preferable if those questions were answered through a reasoned policy analysis, rather than just as a byproduct of political forces that the standard deduction distortions helped create in the first place. and the ad hoc way in which deductions are placed below or above the line has already removed much of the original coherence between those two categories of deduction. 133 2. distorted political incentives it is not just the equity arguments that are distorted. the political debate itself is skewed because only some taxpayers will receive any direct benefit as a result of incremental change in the itemized deductions. 134 one can see this in, for example, the debates around the home mortgage interest deduction. although the issue is complicated, there is some general acceptance that the home mortgage interest deduction is more of a tax expenditure than a tool in properly measuring income. 135 as such, it is an ―upside down‖ subsidy, 136 since those with higher marginal tax rates receive larger subsidies as a percentage of their interest expense than those with lower marginal rates. repealing the mortgage interest deduction or replacing it with a tax credit would thus seem to be consistent with general equitable principles, but the conventional wisdom is that the 129 see supra note 120. 130 see supra note 80 and accompanying text. 131 the ―fairness‖ argument is somewhat different in the case of state taxes, since the argument would not be focused on the ―fairness‖ of whether the government provided an incentive to the taxpayer’s marginal state-tax dollar, since taxes arguably are not voluntary expenditures in the way that charitable deductions are. but see brian galle, federal fairness to state taxpayers: irrationality, unfunded mandates, and the ―salt‖ deduction, 106 mich. l. rev. 805, 812 n.29 (2008); louis kaplow, fiscal federalism and the deductibility of state and local taxes under the federal income tax, 82 va. l. rev. 413, 417 (1996). a non-itemizer is unlikely to argue that it is not fair for an itemizer to be given an incentive to pay more state taxes than she is. rather, the more politically salient argument is simply the disparate treatment of different taxpayers. 132 the fewer below-the-line deductions there are, the more the standard deduction becomes a de facto zba. 133 see supra part ii.c. 134 see samansky, supra note 12, at 547-48. 135 see, e.g., office of mgmt & budget, analytical perspectives, budget of the united states, fiscal year 2007, at 288, available at http://www.gpoaccess.gov/usbudget/fy07/browse.html (including the mortgage deduction on official list of tax expenditures). 136 see surrey, supra note 99, at 37. but see simons, supra note 98, at 112 (criticizing the failure to tax imputed rent); kahn, supra note 99, at 48-49 (noting that the mortgage interest deduction can be justified as neutralizing the bias between purchasing a home with one’s own funds versus borrowed money, as a result of the failure to include imputed rent in income). 230 columbia journal of tax law [vol.2:203 mortgage interest deduction cannot be touched. 137 one possible reason for this is that those who currently take the mortgage interest deduction would immediately see their tax bill increased as a direct result, but non-itemizers might not see any direct change, at least at first. in other words, the change initially would harm the current beneficiaries, but not directly benefit non-itemizers (or non-homeowners in general). even if a repeal were accompanied by, say, a lowering of tax rates in order to be revenue neutral, the benefits would likely be spread out—including going to those who had seen their interest deduction lowered—and thus not felt as strongly by non-itemizers, even if they knew that those benefits were a result of the repeal. and a distributionally neutral adjustment would heavily favor rich renters. 138 repeal is politically unlikely in that situation. furthermore, as samansky has noted, 139 the effect can also cut in the other direction. while the standard deduction may make it more difficult to repeal some personal deductions that ought to be repealed, it can also give the government cover when trying to repeal personal deductions that perhaps should stay. during the debates over the tax reform act of 1986, 140 the reagan administration argued that the state and local tax deduction should be repealed in part because its benefit fell on so few people. 141 samansky writes: [a]ny policy justification for the itemized deductions became irrelevant after it was recognized that most individuals could not deduct them. the issue became one of political power, including consideration of the effect of the tax burden on various groups and states. it is unlikely that attempts to rationalize the itemized deductions can obtain much political support under these circumstances. 142 in short, the standard deduction has the effect of minimizing policy arguments related to the itemized deductions and elevating the effects of political and interest group pressure. 3. inefficient subsidies the standard deduction also has the effect of minimizing any well-intentioned incentives written into the code. whether the tax code should be used to penalize or subsidize particular behavior unrelated to measurement of income has long been a 137 see, e.g., mortgage tax deduction is safe, bush says, l.a. times, feb. 18, 2006, at c2; see also jeffrey h. birnbaum & alan s. murray, showdown at gucci gulch: lawmakers, lobbyists, and the unlikely triumph of tax reform 57 (1987) (discussing political pressures that resulted in the mortgage interest deduction remaining in the tax code after the tax reform act of 1986, despite the repeal of the deduction for other personal interest). 138 since rich renters would share the benefit of a rate reduction in order to make up for the loss of the mortgage interest deduction by taxpayers in the same income cohort, which could be quite large because of the upside-down nature of the subsidy. 139 samansky, supra note 12, at 547-48. 140 tax reform act of 1986, pub. l. no. 99-514, 100 stat. 2085. 141 see samansky, supra note 12, at 548; see also birnbaum & murray, supra note 137, at 12829. this is not to argue that the deduction for state and local taxes is or is not a ―tax expenditure,‖ only that, if it were proper in measuring income, that argument would be difficult to put forth when only a minority of taxpayers receive the deduction. see generally galle, supra note 131; kaplow, supra note 131. 142 samansky, supra note 12, at 548. 2011] doing too much 231 debated issue, 143 but there is no doubt that the code is so used. but if those incentives are in the form of itemized deductions, then at best they hit only around 35% of taxpayers. 144 the existence of the standard deduction thus undermines an incentive’s efficacy. and the problem is compounded by the existing deduction floors, such as the 7.5% of agi floor for medical expenses. the combination of the standard deduction and the existing floors may create many complex or even perverse incentives. 145 increasingly, congress is structuring tax incentives as tax credits 146 or placing them above the line. 147 this avoids the standard deduction problem, but creates another by making the tax code more complicated (when the point of the standard deduction was simplification) and less coherent (since it is no longer clear why some provisions merit above-the-line treatment while others do not). for example, the deduction for contributions to health savings accounts is above the line, 148 while the deduction for medical expenses is below; 149 the deduction for work-related expenses incurred by teachers is above the line, 150 while that for most other work is below. 151 4. undermining respect finally, there is the issue of overall respect for the tax system. as discussed above, the current system could be seen as two different tax systems: non-itemizers are taxed on agi, but with a rate structure that includes zero bracket, while itemizers are taxed on taxable income, but with a rate structure that does not include a zero bracket. 152 while the computational results are the same in either frame, the change in perspective could be profound. if middle-income taxpayers see themselves as being taxed on a different tax base than high-income taxpayers, it could undermine belief in the tax system as fundamentally fair. even if the zero bracket is a fair trade-off for a higher tax base in terms of overall tax benefit, there still may be a belief that vertical equity has been compromised. it is beyond the scope of this paper—and perhaps impossible—to tie the tax gap or current anti-tax movements directly to any disrespect bred by the standard deduction. but it certainly does not help. d. summary in part ii, this article showed the historical progression of the standard deduction from a purely simplifying provision to one that plays an increasingly important progressivity role. as that part shows, there has been a clear congressional intent to have some relatively large amount of untaxed income. in this part presented two extreme versions of the standard deduction—one in which it functioned entirely as a simplification measure with no zba role and one where it was entirely a zba (plus a floor under the itemized deductions). it also presented several other ways of framing the standard deduction: as a combination of zba and simplified substitute for the itemized 143 see supra note 99. 144 see supra note 6. 145 whereas the standard deduction alone forces different, unrelated deductions to be considered together, adding a floor calculated as a percentage of agi adds a third dimension—income—to the mix. it is difficult to predict the effects of this mish-mash given the diversity of taxpayers. 146 e.g., i.r.c. §§ 21 (expenses for dependent care necessary for employment), 25a (hope and lifetime learning credits) (2010). 147 e.g., i.r.c. §§ 62(a)(17), 221 (interest on education loans) (2010). 148 i.r.c. §§ 62(a)(19), 223 (2010). 149 i.r.c. § 213 (2010). 150 i.r.c. § 62(a)(2)(d) (2010). 151 i.r.c. § 162 (2010). 152 see supra part iii.b.4. 232 columbia journal of tax law [vol.2:203 deductions (involving a separation of the standard deduction amount and the threshold above which such deduction can be taken); as a variable zba that phases out with itemizable expenses; and as two distinct tax bases and rate structures depending on the amount of itemizable expenses. of these different views, the most coherent is the progressivity-centric, high-zba view—that the standard deduction is simply a zba coupled with a single floor under the itemized deductions. the flaws in the other views are too great to withstand scrutiny, and the current structure of the standard deduction is too far divorced from those view’s purposes. 153 the progressivity-centric view is also most consistent with the legislative history and congress’s intent to allow for a large amount of untaxed income, especially to low-income persons. 154 as shown in part iii.b.2, this high-zba view is not without flaws, but as shown in the following section, it is also the easiest to fix. iv. a proposal: the zero bracket amount in what follows, the article proposes and discusses a reform to the standard deduction and the itemized deductions: replace the standard deduction with a true zero bracket amount, independent of any implied floor on itemized deductions, and disaggregate that single implied floor into explicit floors on individual deductions. this would address most of the criticisms in part iii with only a marginal increase in complexity. this part also discusses why floors such as those proposed here have particular tax policy benefits. a. replace the standard deduction with a zero bracket and floors the two largest drivers of the problems i have discussed in part iii are, first, the combination of income-measurement and zba functions—combining a definition of the tax base with a tax rate schedule—and, second, the grouping of unrelated deductions under one standard deduction. to fix these problems requires two steps. first, the single standard deduction should be separated into a true, independent zba and a separate floor under the itemized deductions. this change would make explicit what is already the case in the minds of most analysts and commentators: that the standard deduction operates primarily as an element of progressivity—a zba. 155 it would be consistent with congress’s explicit intent for the standard deduction to play a zba role. 156 it would separate the determination of the proper amount of untaxed income—the zba—from the proper amount of itemized deductions, while still retaining the overall progressivity of the current system. it would thus positively affect horizontal equity by making the determination of the proper amount of tax-free income independent from the amount of itemizable expenses a taxpayer has. finally, it would allow policymakers to more effectively target tax relief, since they would have the ability to do so simply with adjustments to the rate structure without affecting tax deductions and credits. 153 that is, a simplification-centric standard deduction ought to be designed as a percentage of agi. see supra parts ii.b, iii.b.1. a variable zba ought to be designed to phase out with income, not itemized deductions. see supra part iii.b.4. the proposal that follows depends on adopting the progressivity-centric view explicitly, but that does not mean that it is the only solution. if, e.g., one preferred a simplificationcentric view, then one could propose a percentage standard deduction, as bittker and lokken do. see supra note 21, ¶ 30.5.1. 154 see supra part ii.c. 155 see supra note 8. 156 see supra part ii.c. 2011] doing too much 233 second, rather than a single floor under the itemized deductions, the floor itself should be disaggregated into multiple, independent floors under each itemized deduction. 157 this would separate the determination of the proper deduction amount for a given itemizable expense from the amounts of any other itemizable expenses. it would thus positively affect horizontal equity by treating all taxpayers the same with respect to a given category of itemizable expense. it would allow policymakers to more effectively optimize deductions for itemizable expenses, since they could adjust the floors to optimize trade-offs between simplicity, revenue, incentives, and equity for each deduction. and it would largely remove the no-longer-coherent distinction between above-the-line and below-the-line deductions. this distinction was meaningful when the standard deduction was intended primarily to approximate personal deductions, but since that has not been the case since at least 1977, the distinction now only leads to more arbitrariness in the tax code. 158 the strongest arguments against such a reform are as follows: first, it would entail some additional complexity; this criticism is addressed in part 0. second, that it would have some negative distributional changes as a result of the interaction of multiple floors, as shown in part 0; this criticism is addressed in part by the affirmative argument for the benefits of tax floors, presented in part 0. b. examples and complications to see how this proposal would work in practice, consider the following simplified example. suppose a standard deduction sd covered deductions for expenses a, b, c, and d. if a taxpayer had expenses such that a + b + c + d < sd, then he would take sd as the deduction rather than itemize a, b, c, and d. as shown above, this is equivalent to having an itemized deductions floor equal to sd and a zero bracket (or exemption) equal to sd. 159 however, suppose instead of the single floor we create separate floors a, b, c, and d for each of the deduction categories. that is, if a taxpayer 157 note that the same effect could be achieved simply by creating multiple standard deductions and leaving the current rate structure untouched. see supra part iii.a. the problems associated with combining income-measuring and progressivity functions would remain, however. 158 note that this does not necessarily mean removing the concept of agi from the tax code entirely. the tax code currently uses agi for a number of purposes, such as limitations, floors, and phaseouts on existing deductions, credits, and other benefits. see, e.g., i.r.c. §§ 21(a)(2) (phase out of dependent care credit), 24(b) (phase-out of child tax credit), 36c(b)(2) (phase out of adoption expenses credit), 67(a) (2% of agi floor on miscellaneous itemized deductions), 68(a) (overall limitation on itemized deductions), 213(a) (7.5% of agi floor on medical expense deduction), 408a(c)(3) (limitation on contributions to roth iras) (2010). for these provisions agi plays a role similar to its role in the early years of the standard deduction, namely as a relatively uniform base from which to calculate a rule of general applicability (here, the relevant phase-outs; in 1944, the percentage standard deduction). neither gross income nor taxable income provides a satisfying replacement in the case of deduction phase-outs—gross income, because its meaning varies so much across different types of income, as congress noted in 1944, see supra text accompanying notes 35-40; taxable income because the calculation becomes circular when a deduction used in calculating taxable income itself phases out with taxable income. it would add substantial complexity to have to calculate taxable income without regard for a certain deduction in order to determine the applicable deduction amount, particularly across many different deductions. thus some sort of agi concept could still play a role. however, its importance and salience to the average taxpayer would be substantially reduced, and policymakers would no longer feel such intense pressure to move deductions above the line. thus under this proposal agi could return to being a more coherent and uniform measure across all taxpayers. on the other hand, with the important exception of § 68, the agi-based phase-outs apply largely to credits, rather than deductions, and thus we might ask whether the deductions that we limit or phase out for progressivity reasons might not work better as tax credits, which would avoid the circularity problem. 159 see supra part iii.a; see also kaplow, standard deduction, supra note 12, at 6. 234 columbia journal of tax law [vol.2:203 had expenses such that a < a, b < b, etc., then he would not itemize those expenses. a taxpayer would only itemize the amount by which a exceeded a, b exceeded b, etc. for taxpayers with low itemizable expenses, little complexity would be added. but some previous non-itemizers with expenses approaching the standard deduction may find themselves itemizing in some cases. suppose that we initially set the individual floors such that a + b + c + d = sd (and create a new zba equal to sd). suppose further that there is a taxpayer with expenses a + b + c + d < sd, such that a < a, b < b, and c < c, but d > d. such a taxpayer would be under the floors for a, b, and c but would itemize her d expenses under the new regime. her total itemized deductions would thus be d – d, which would be equivalent to deducting an amount sd + (d – d) > sd under the old regime. example 6: suppose that we replace a $10,000 standard deduction with a $10,000 zba and with floors of $2500 on each of deductions a, b, c, and d. tp has expenses such that a = $0, b = $100, c = $1000, and d = $7900. tp’s total expenses are less than $10,000, and thus tp would have taken the standard deduction under the old regime. however, now tp’s expenses on d exceed that floor of $2500. tp continues to get the benefit of the $10,000 reduction in taxable income (now in the form of a zba), but can reduce taxable income further by the amount by which tp’s d expenses exceed $2500, i.e., $5400. therefore tp will face tax on $5400 less of income under the new regime than under the old regime (assuming no other changes). in addition to becoming a partial itemizer, which would introduce some additional complexity, the taxpayer in the example would also have less taxable income under the new regime than the old, even though the total of the new floors equals the old single standard deduction. thus, the introduction of the floors effects both simplification and this taxpayer’s tax burden. as louis kaplow notes, the choice of thresholds and floors in this context will always affect the degree of simplification and the distribution of tax burdens within the same income class, even if revenue and overall progressivity are held constant. 160 to see the effect on relative tax burdens, suppose there are two taxpayers with the same income and the same total of itemizable expenses, but one of whom has an even distribution of expenses across all the categories, while the other has expenses concentrated all in one category. suppose further that both taxpayers were itemizers under the old regime, but only by a narrow margin. if we set the total of the floors equal to the old single standard deduction, the second taxpayer would see her taxes decrease 160 see kaplow, standard deduction, supra note 12, at 6-12 (―these effects [a change in tax burdens and simplification] should dictate policy on thresholds [or floors] because such effects are inherent: they arise regardless of whether or how one adjusts [the zba]. by contrast, effects on revenue and the overall income distribution are, in principle, wholly independent of how thresholds [or floors] are set: any such effects of changing a threshold can be nullified if that is desired or can be achieved by adjusting [the zba] without changing the threshold [or floor].‖). 2011] doing too much 235 while the first would see little or no change, despite their having the same taxable income if floors were not considered. example 7: assume the same standard deduction and floors as the prior example. tp1 has itemizable expenses a = b = c = d = $2600. tp2 has itemizable expenses a = b = c = $0, and d = $10,400. under the prior regime with a standard deduction of $10,000, each is an itemizer and reduces his taxable income by $10,400. under the new regime, tp1 can deduct $100 of each of his expenses, the amount by which each exceeds the $2500 floor. thus, tp1 continues to reduce his taxable income by a total of $10,400 ($10,000 zba plus $400 total itemized deductions). tp2, however, can take itemized deductions of $7900, the amount by which his d expenses exceed the $2500 floor. thus tp2 can now lower his taxable income by a total of $17,900, or $7500 more than tp1 and more than under the prior regime. but if we raised the total of the floors so that the second taxpayer would have no change in her taxes, then the first taxpayer who had been itemizing with flat expenses narrowly above the old standard deduction would no longer be able to itemize and would lose the net of that amount over the new zba of sd. example 8: the same facts as the prior example, except that the new floors are set at $7500 instead of $2500. under this regime, tp2 would have itemized deductions of only $400, the amount by which his d expenses exceed the $7500 floor. thus, tp2 can reduce his taxable income by $10,400, the same amount as under the prior regime. but tp1 can no longer itemize, and thus can lower his taxable income by only $10,000 (the zba) rather than $10,400. increasing exemptions or the zba would not change the relative tax burdens, since such progressivity changes would apply to both taxpayers equally. there will thus necessarily be some changes in distribution within income classes, even if overall distribution of the tax burden between income classes can be held constant. 161 some calibration would therefore be required to optimize simplicity, horizontal equity, and revenue. these optimal values for the new floors would probably be such that their sum is greater than sd to avoid creating too many new partial itemizers, and any effects that this would have on tax burdens for those who would otherwise have itemized should be made up for in the rate structure or personal exemptions, such as by having an initial zba greater than sd. c. flat or variable zba an additional feature of this reform proposal is that the system could be adjusted to provide additional progressivity without explicitly raising rates. this is explicitly the case with the increase in personal exemptions with family size. but in addition, the zero bracket could itself phase-out with income, 162 which would cause a flattening of the 161 see kaplow, standard deduction, supra note 12, at 9-10. 162 currently, the standard deduction could be viewed as a zero bracket that phases out with itemized deductions, which in turn are partly correlated with agi. however, as discussed throughout, that is 236 columbia journal of tax law [vol.2:203 marginal rates that apply to higher-income taxpayers, such that the marginal and average tax rates converge somewhat, particularly when considering the itemized deduction phase-out. 163 to be clear, however, such changes are equivalent to raising marginal rates during the phase-out period. 164 thus, the advantage to doing so through the zba (or variable deduction floors, as discussed in part 0, infra) is really one of political economy and optics, rather than substance. in the 1960s, when policymakers effectively changed the standard deduction from being primarily a simplification of the itemized deductions to being the ―low income allowance‖ equal to poverty-level income, 165 a major reason for doing so was a belief that the standard deduction would allow for more targeted tax relief. instead of simply creating a zero bracket (or increasing exemptions), which would apply to everyone, the government decided, in effect, to have a zero bracket that phased out with itemized deductions, as a rough proxy for income. this was said to be ―the most equitable and efficient method available of directing tax relief to persons in the lowest income ranges.‖ 166 in other words, the concern was that merely adding a zero bracket (or increasing exemptions) would be less progressive than increasing the standard deduction. yet, as discussed here, that is simply not the case when the zero bracket is accompanied by a floor (or floors) on the itemized deductions. 167 as noted above, one can actually an imperfect proxy and has negative horizontal equity effects. if the intent is to have the zba phase out with income, then we should just do that. 163 i.r.c. § 68 (2010). 164 a phase-out based on agi is essentially an increase in marginal tax rates on agi. if an additional dollar of income results in a loss of $x in tax benefits (in the form, e.g., of an increase in the floor on a deduction or a decrease in the zba), that is equivalent to a tax of $x on that marginal dollar. 165 see supra part ii.c. 166 u.s. treasury department, 91st cong., tax reform studies and proposals, pt. 2, at 127 (joint comm. print 1969), reprinted in 22 tax reform – 1969: a legislative history of the tax reform act of 1969, supra note 94, doc. no. 102; see also president’s 1963 tax message: hearings before the h. comm. on ways and means, 88th cong. 15 (1963) (―one way to provide relief to low-income taxpayers . . . would be to raise the personal exemption above its present level of $600. this is an extremely costly approach, however, and one which would not fulfill our objective of giving relief where it is needed most.‖), 42-43 (treasury secretary c. douglas dillon noting that merely increasing exemptions would ―offer[] greater tax savings the higher the income of the taxpayer, thus wasting much of the revenue that it would cost if [low-income tax relief] were to be achieved through this route‖), 195 (treasury staff noting that increasing the standard deduction would allow ―[t]he benefits of the proposal [to] be distributed in favor of persons with low incomes. persons with high and middle incomes will find the provision of no benefit. equivalent relief to low-income taxpayers granted in the form of an increase in the per capita exemption would involve a much greater loss of revenue and would provide the greatest tax savings where they are least needed.‖), reprinted in 26 internal revenue acts of the united states: revenue acts of 1953-1972 with legislative histories, laws, and congressional documents, pt. i (bernard d. reams, jr., ed., 1985). 167 it is odd that treasury in 1963 did not offer this as an alternative, since the 1963 proposals contain, in addition to the increase in the standard deduction, a separate floor on the itemized deductions, for many of the same reasons discussed in this article. see president’s 1963 tax message, supra note 166, at 19 (―i, therefore, recommend that itemized deductions, which now average about 20 percent of adjusted gross incomes, be limited to those in excess of 5 percent of the taxpayer's adjusted gross income. this 5-percent floor will make $2.3 billion of revenue available for reduction in individual tax rates. at the same time incentives to homeownership or charitable contributions will remain. in fact, this tax program as a whole, providing as it does substantial reductions in federal tax liabilities for virtually all families and individuals, will make it easier for people to meet their personal and civic obligations. this broadening of the tax base which permits a greater reduction in individual income tax rates has an accompanying advantage of real simplification.‖). 2011] doing too much 237 achieve more progressivity (that is, more focused effective rate increases) though this article’s proposal via the combination of a variable zba and variable floors. 168 d. the decreasing benefit of simplification the primary argument in favor of keeping the standard deduction is simplification. as of 2007, 63.3% of taxpayers take the standard deduction, 169 which partially accounts for the fact that 32.6% of individual tax returns are nontaxable. 170 forty-two percent of tax returns are the simplified 1040ez or 1040a forms. 171 all of this allows for relatively low compliance costs, both on the part of taxpayers and the government. given the complexity of the tax system as a whole, we should be wary of anything that would upset these achievements. however, the simplification value of the standard deduction is overstated. first, tax simplification itself has costs, which are better understood today than when the standard deduction was first enacted. second, the costs of itemizing likely have dropped as technology and third-party reporting has eased the record-keeping and calculation requirements. third, the change proposed above—adding a zba and floors to the itemized deductions—results in only marginally more complexity than the current system. 1. simplification as a goal of tax policy simplification has been a goal of tax policy for almost as long as we have had an income tax, 172 yet scholars have in recent years pushed back on this somewhat. 173 this article does not intend to step fully into this debate; it intends only to note that the ground in the debate has shifted somewhat, and that current thinking about the value of simplification points towards relatively limited simplification benefit from the standard deduction. commentators typically point to three types of tax complexity: compliance complexity, transactional complexity, and rule complexity. 174 the standard deduction, and the reform proposal in this article, primarily implicate compliance complexity. 175 168 furthermore, while having a zero bracket that phases out with itemized deductions may have some progressivity from a vertical equity standpoint, to the degree that incomes correlate with itemizable expenses, it has negative horizontal equity effects for taxpayers within the same income class. see supra part iii.b.1. 169 2009 soi bulletin, supra note 6, at 7. 170 id. at 22, table 1. 171 michael parisi, individual income tax returns, preliminary data, 2008, statistics of income bulletin, winter 2010, at 5, 12, available at http://www.irs.gov/pub/irs-soi/10winbulindincretpre.pdf. 172 see, e.g., edward j. mccaffery, the holy grail of tax simplification, 1990 wis. l. rev. 1267 (1990); martin j. mcmahon, jr., individual tax reform for fairness and simplicity: let economic growth fend for itself, 50 wash. & lee l. rev. 459 (1993); deborah h. schenk, simplification for individual taxpayers: problems and proposals, 45 tax l. rev. 121 (1989); stanley s. surrey & gerard m. brannon, simplification and equity as goals of tax policy, 9 wm. & mary l. rev. 915 (1968). 173 see, e.g., steven a. dean, attractive complexity: tax deregulation, the check-the-box election, and the future of tax simplification, 34 hofstra l. rev. 405 (2005); samuel a. donaldson, the easy case against tax simplification, 22 va. tax rev. 645 (2003); louis kaplow, accuracy, complexity, and the income tax, 14 j. l. econ. & org. 61 (1998) [hereinafter kaplow, accuracy]. 174 see, e.g., dean, supra note 173, at 412; schenk, supra note 172, at 127; david f. bradford, untangling the income tax 266-67 (1986). 175 transactional complexity generally describes the lengths that taxpayers sometimes go to in order to structure transactions in tax-efficient ways. rule complexity refers to the difficulty in interpreting some aspects of the law. neither is likely to affect low-income taxpayers most of the time, and hardly ever in 238 columbia journal of tax law [vol.2:203 indeed, the costs largely boil down to increased computation and record-keeping. thus, when people speak of the admittedly daunting complexity of the income tax system generally, such invocations do not do a lot of work in supporting the standard deduction, which addresses only a small source of relatively limited complexity. 176 in addition, when commentators discuss complexity for individual taxpayers, they tend to cite elements such as the alternative minimum tax; 177 the earned income tax credit; 178 or the complexities related to domestic relations, dependents, and child care. 179 rarely do itemized deductions make the list. 180 in addition, this article’s proposal arguably decreases rule complexity, at least for those taxpayers who are not certain whether their itemized deductions will exceed the standard deduction. while the current system has a single rule for determining when deductions are available, combining unrelated deductions for purposes of satisfying that rule means that it is relatively difficult for some taxpayers to determine whether a given marginal expense will be deductible. if a taxpayer on the cusp of itemizing wished to know whether her next charitable contribution, say, would push her over the standard deduction (and thus be subsidized, allowing her to increase the amount donated), she would have to estimate her likely state taxes for the year, out of pocket medical expenses, and the like. it is much simpler to only consider the total charitable contributions for the year, and whether the next donation will cause her to exceed the charitable contributions deduction floor. admittedly many itemizers know well ahead of time that they will be itemizing, usually based on their mortgage interest payments, but for some taxpayers disaggregating the floors likely makes the system more transparent, and allows the incentive effects of the deductions to be more salient. finally, complexity in the service of accuracy has particular equity benefits, namely the reduction of the risk of over(or under-) taxation. louis kaplow has described this in terms of the risk premium: the value of accuracy to an individual is equivalent to what the individual would be willing to pay to insure against the risk of paying the wrong tax. 181 assuming decreasing absolute risk aversion, ―the value of accuracy will be greater for low-income individuals.‖ 182 in other words, accuracy in the relation to their use of the standard deduction or itemized deductions. an exception to this might be in trying to determine whether a particular expense qualifies as deductible. 176 by contrast, recall that the first standard deduction approximated not only the itemized deductions but a number of complex tax credits, including the foreign tax credit. see supra note 40. 177 see, e.g., joseph disciullo, aicpa tax simplification report includes amt, estate tax reform, 125 tax notes 409 (2009); sam goldfarb, complexity of amt leads to administrative errors, tigta says, 120 tax notes 641 (2008). 178 see, e.g., taxpayer advocate service, national taxpayer advocate 2007 annual report to congress, vol. ii, 94-118 (2007). 179 see generally, e.g., schenk, supra note 172. 180 this may be in part a result of the forces discussed in part 0, supra. the itemized deductions have seen relatively little political meddling, in part due to the limited effect that changes to them would have on the majority of individual taxpayers. and where there has been substantial added complexity related to itemized deductions—such as in the rules for evaluating particular charitable gifts, see i.r.c. § 170 (2010); treas. regs. §§ 1.170a-1 et seq.—the rules are unlikely to create complexity for middleand low-income taxpayers. 181 kaplow, accuracy, supra note 173, at 62-63. kaplow also discusses the efficiency benefits from accuracy, namely that a more accurate income tax keeps the labor-leisure distortion to a minimum. id. at 63. 182 id. if risk aversion is highest at lower incomes—because of their relatively lower ability to afford over-taxation errors—then they would pay a greater premium to insure against that risk. kaplow writes that for a standard logarithmic utility function, a given fixed error would have a ten times greater 2011] doing too much 239 service of greater equity yields real benefits to taxpayers, particularly the lower-income taxpayers more likely to use the standard deduction. 183 of course, the standard deduction could be said to result in under-taxation of individuals, since by definition those who take the standard deduction have itemized deductions less than the standard deduction (or at least less than the standard deduction plus the cost of itemizing). thus it is not quite as simple as just pointing to a quantification of the benefit of accuracy. leaving aside the question of whether taking the under-taxation view repeats the conceptual errors discussed in part iii.b, 184 however, recall that under this article’s proposed reform, the additional complexity is largely in the form of marginally more computation and record-keeping for some subset of current nonitemizers. putting forth that effort will, in many cases, result in reduced taxation for that individual compared with doing nothing under this article’s proposed reform (and likely compared with the current status quo, if there is no adjustment to the zba size or the rate structure)—thus resulting in a very real benefit. again, the purpose of this discussion is not to argue whether the standard deduction’s simplification benefits are net positive or negative; the argument is that the small increase in complexity for a subset of current non-itemizers under this proposal is likely offset in part, and perhaps in whole, by the benefits to those taxpayers. 2. the cost of itemizing to put this in concrete terms, consider the likely costs of additional computation 185 and record-keeping. first, in an age of computer-aided tax return utility cost on a person with an income of $10,000 than on a person with an income of $100,000. this error cost could be even greater due to the sometimes large marginal tax rates on low-income individuals due to welfare program phase-outs. id. at 66. 183 kaplow’s equation of the accuracy benefit and the risk premium quantifies the benefits of vertical equity—that is, the benefit from not being taxed as if one were richer. this formulation likely also encompasses the horizontal equity concern that is said to motivate at least some of the itemized deductions, and that this article argues are some of the major harms of the standard deduction. the horizontal equity concern is that the standard deduction causes taxpayers with the same ―true‖ income to be taxed differently— which is another way of saying that a lower-income person has been taxed too much. kaplow is critical of horizontal equity as an independent norm, since the basic proposition of equal treatment of equals follows necessarily from compliance with vertical equity. louis kaplow, horizontal equity: measures in search of a principle, 42 nat’l tax j. 139 (1989); louis kaplow, a note on horizontal equity, 1 fla. tax rev. 191 (1992). but see richard a. musgrave, horizontal equity, once more, 43 nat’l tax j. 113 (1990) (arguing that horizontal equity has independent meaning in a second-best world). the more rigorous statements of horizontal equity as an independent norm tend to relate to the effects of tax changes on similarly situated individuals. that is, where two individuals have the same utility given a certain tax (or in the absence of a tax), horizontal equity requires that they be equally well off following a change in the tax. see, e.g., martin feldstein, on the theory of tax reform, 6 j. pub. econ. 77, 83 (1976). cast in these terms, the horizontal equity problem with the standard deduction is that taxpayers who might have had the same utility levels in the absence of the standard deduction, but different itemized deductions, no longer have the same utility level when the standard deduction is introduced. see supra part iii.b.1. but the difficulty with this conception is treating the existence of the itemized deductions as a given. since some itemized deductions reflect income measurement or ability to pay, while others reflect pure subsidies (and yet others a mixture of the two), it cannot be said with any rigor what the baseline utility level ought to be. 184 taking the view that non-itemizers are under-taxed is implicitly adopting a no-zba, simplification-centric view of the standard deduction. 185 i include in this the complexity effects of simply having the longer form necessary to calculate the various floors. however, a key benefit of computer-aided tax preparation is that form length alone is increasingly irrelevant. 240 columbia journal of tax law [vol.2:203 preparation, computational complexity is less and less of a burden on taxpayers. 186 in 2006, the most recent tax year for which data is available, 89% of tax returns were computer-prepared, 187 and the percentage has been rising steadily. 188 computer preparation is not without cost, of course. all but the most basic turbo tax software for 2010, for example, costs at least $20. 189 the average minimum fee for basic professional preparation is $79, 190 but can go up quickly. however, since 2002 the irs has had a ―free file‖ program, under which private companies have agreed to provide free computer-aided preparation and filing for taxpayers with agi less than $58,000. 191 this is in addition to the long-standing volunteer income tax assistance (vita) and tax counseling for the elderly programs, under which volunteers provide tax help, preparation, and filing for lowand middle-income taxpayers, and those 60 or over. 192 in all, access to computer-aided preparation is likely available to nearly all taxpayers at little or no cost. the cost of record-keeping and entering the information is somewhat harder to pinpoint. one study put the average cost of itemizing in 1982 at $43, or roughly $100 in 2011 dollars, though for taxpayers with income less than $25,000 in 1982 (~$57,000 in 2011), costs were $25 (~$57 in 2011) or less. 193 however, these cost estimates include the computational and return-preparation costs now largely being offset by software. furthermore, the growth of third-party reporting and the like has eased the record-keeping burden. for home mortgage interest, for example, taxpayers that pay over $600 in interest in a given tax year toward their bank-financed mortgage will receive a statement from their bank showing how much interest they paid during the year. 194 the cost of itemizing is relatively small—holding onto the statement, knowing where to enter it, etc. 195 homeowners might have two or three statements to deal with, considering home equity lines or second homes, but that is hardly a daunting number. 186 see generally lawrence zelenak, complex tax legislation in the turbotax era, 1 colum. j. tax l. 91 (2010). 187 internal revenue service, tax year 2006 taxpayer usage study report 16 (2007), available at http://www.irs.gov/taxstats/article/0,,id=184856,00.html [hereinafter 2006 taxpayer usage study report]. see zelenak, supra note 186, at 95. this percentage includes electronically filed returns, but even looking only at paper-filed returns, 83% of forms 1040 were prepared by computer. id. 188 88% of tax year 2005 returns were prepared by computer. 2006 taxpayer usage study report, supra note 187. to compare, just over 67% of tax year 1997 returns were prepared by computer. internal revenue service, taxpayer usage study 1997 data release 1 (1998), available at http://www.irs.gov/pub/irs-soi/97tpus.pdf. 189 turbotax, http://turbotax.intuit.com (last visited apr. 10, 2011). for 2010 the turbo tax free version applied only to 1040-ez returns, with state returns costing extra. the more deduction-focused ―basic‖ and ―deluxe‖ versions cost $20 and $30, respectively (not including state returns). 190 national association of tax professionals, 2010 tax professional study 6 (2010), available at http://www.natptax.com/public documents/join natp/2010 fee study sample.pdf. 191 see free file: do your federal taxes for free, i.r.s., http://www.irs.gov/efile/article/0,,id=118986,00.html (last visited apr. 11, 2011). 192 see free tax return preparation for you by volunteers, i.r.s., http://www.irs.gov/individuals/article/0,,id=107626,00.html (last visited apr. 16, 2011). 193 pitt & slemrod, supra note 95, at 1229. 194 see i.r.c. § 6050h(d) (2010) (requiring mortgagee to furnish mortgagor with statement showing interest paid); treas. reg. §§ 1.6050h-1, -2 (as amended in 2000). 195 in fairness, the cost of itemizing mortgage interest is rarely raised as a concern because most people with mortgage interest itemize. see president’s advisory panel on tax reform, simple, fair, and pro-growth: proposals to fix america’s tax system 74 (2005) [hereinafter tax reform panel] (stating that 54% of homeowners who pay mortgage interest receive a tax benefit from the deduction). fifty2011] doing too much 241 state and local taxes often are similarly well-documented, though there might be more than two or three numbers to deal with. employees receiving w-2s have the information handed to them, while independent contractors and the self-employed can look at last year’s tax returns (and refunds) to see how big a check they wrote during that tax year. for real estate and other property taxes, homeowners generally receive bills from the city or town showing the taxes due. if a taxpayer pays the taxes directly, he needs to keep track of when he did so (since taxes might have been billed at the end of the year, but not due until the next); if, as is common with home mortgages, the taxpayer’s bank pays the taxes out of escrow, they typically provide that information to the taxpayer. on the margins there may be people with more complicated state-tax situations, but for most people, state taxes are relatively straightforward and well documented. 196 in the case of medical expenses and casualty and theft losses, the largest expenses, such as an elective surgery or a car theft, are not likely to be recurring 197 and would involve relatively little record-keeping. 198 on the other hand, unreimbursed employee business expenses are more likely to be more recurring and greater in number. so itemization of these expenses may be more of a burden. but that burden is also likely to be borne by more sophisticated taxpayers, who may already be keeping records of their income-producing activities in order to measure profit. furthermore, because these expenses are generally agreed to be properly deductible in measuring income, this is likely a case where the accuracy arguments carry more weight than the simplification arguments. 199 the inequity of having one’s, say, charitable deduction determined by the size of one’s mortgage may be easier to swallow if we believe that both deductions are essentially handouts from the government. 200 but where someone clearly has expenses of earning income that should lower her tax, tying the ability to do so to the size of her mortgage or state taxes is less acceptable. simplification may be the most justified for the charitable contributions deduction, since many people give small, unor poorly documented amounts to charity, such as cash in the church collection plate or used clothing to thrift shops. but for many gifts, charities already have in place a system of receipts and documentation in order to four percent is only a narrow majority, however, so a large number of taxpayers could still face some incremental complexity. 196 as an alternative, we could require states and municipalities to issue a statement showing the total of all taxes paid in a given year. this would impose some additional cost, but it likely would not be unreasonable given that the information ought to be easily compiled by the relevant tax authorities. states already provide taxpayers with forms 1099-g to document any state tax refunds paid during the tax year. 197 someone with a chronic medical condition might have costs that would routinely break the 7.5% agi floor—but such a person is also likely to be insured (realistically, an uninsured chronically ill person is not likely to be able to bear those costs ongoing) and thus not bear the brunt of the costs himself. 198 elderly insured taxpayers may be an exception to this. whereas most insured taxpayers are unlikely to spend enough in prescription and doctor-visit copayments to exceed the 7.5% of agi threshold, the combination of a high number of copayments plus relatively low income mean that elderly insured taxpayers may exceed it more often. (though the elderly also have a higher standard deduction, and thus a higher floor on the total of their itemized deductions. see supra note 21.) the staff of the joint committee on taxation does not include copayments by the insured elderly in its discussion of common § 213 deductions. see staff of the joint comm. on tax’n, 110th, tax expenditures for health care 23 (joint comm. print 2008) [hereinafter tax expenditures for health care]. 199 see supra notes 181-183 and accompanying text. 200 see supra note 101. 242 columbia journal of tax law [vol.2:203 serve current itemizers. 201 perhaps some giving that had been ad hoc would move into these more organized settings following a change—writing an annual check to one’s church, for example, instead of dropping cash in the collection plate. whether this would affect the overall character of giving is beyond the scope of this article, but any change probably would not be dramatic. however, given that the charitable deduction faces perhaps the most political pressure to be moved above the line—and, indeed, was at least partially above the line from 1982 to 1986 202 and was nearly made so again in 2005 203 —it seems that public opinion does not consider the additional complexity to be large. 3. summary the previous two subsections argue that the costs of itemizing are not large and may be justified much of the time. in addition, under this article’s proposal, the costs themselves are limited. first, replacing the standard deduction with floors will not cause most current non-itemizers to begin itemizing. many non-itemizers will continue to have itemizable expenses below the floor for a given deduction. second, those that do begin itemizing are likely to do so for only a fraction of the total categories of deduction, perhaps only one. this limits the costs further, since they would not have to bear the full record-keeping costs that current itemizers do. 204 ultimately, however much additional complexity is created is an empirical question that depends on the size of the zba and the floors, and thus requires additional research. e. policy benefits of tax floors this section address an additional argument in favor of this proposal, separate from the benefits of separating the progressivity and simplification purposes of the standard deduction, namely the particular policy benefits of using floors. as noted above, we can achieve the same effect as a floor with a combination of a standard deduction and a change in exemptions, 205 and the same is true at the level of the individual itemized deductions—rather than having disaggregated floors, we could create disaggregated independent standard deductions for each of the itemized deductions and end up in the same place in terms of distribution and revenue. 206 yet floors have a number of advantages over individual standard deductions from a policy standpoint. in particular, floors can be designed to support the underlying policy goals of a particular deduction. the size of the floor, how it is calculated, its distributional effects, etc., can all be tailored to dovetail with the nature and purpose of the deduction itself. part iv.b presented a simplified example using fixed floors totaling close to the current standard deduction amount. but actually choosing the type and magnitude of floor would likely be the most difficult part of reform. a floor for a deduction can exist for a number of different reasons. it can be purely to simplify calculation and recordkeeping, by denying small deduction amounts. 201 see treas. reg. § 1.170a-13(a)(1)(ii) (as amended in 1996) (naming tax receipt from donee charitable organization as one form of required proof of donation for purposes of claiming the § 170 deduction). 202 see supra note 80 and accompanying text. 203 see supra note 125. 204 a current itemizer must keep records across all categories of itemizable expense in order to get the full benefit. for example, a taxpayer who buys a home must begin keeping records not only of mortgage interest, but also of charitable contributions and other itemizable expenses, even though those expenses may not have changed with the home purchase. 205 see supra part iii.a. 206 see generally kaplow, standard deduction, supra note 12. 2011] doing too much 243 but it could also be designed to limit tax avoidance behavior, or to optimize the trade-off between incentives and revenue (because the last dollar of spending may need more encouragement than the first, the government may want to focus its money there), 207 or to pinpoint the true effect on income (as with the floor on the medical expense deduction and the costs of bad health 208 ), or perhaps simply to limit the revenue effects of deductions we would like to remove but cannot for political reasons. consider further the use of floors to try to measure income more accurately. in the examples in part iv.b, the disparities between the two taxpayers are less under high floors than low floors. but this does not necessarily mean that high floors are the more equitable solution. if a floor exits purely for simplification reasons, then there is a clear trade-off with equity. 209 but if we believe that only expenses above the floor should be deductible in the first place, then it is not actually the case that our two taxpayers have the same taxable income in the view of the government, and our concerns about horizontal equity are less pressing. furthermore, any adverse effect on horizontal equity that this article’s proposal would have is less than under the current structure, where taxpayers with the same level of, say, charitable contributions are treated differently. each personal deduction is independent of the others, and they each accomplish different things. some are clearly measuring income, some are clearly tax expenditures, some are a little of both. some are more valuable from a policy standpoint, some are less. the fact that a taxpayer with high expenditures on a particular itemizable expense gets some additional benefit is not unreasonable if that benefit is a result solely of the provisions of that particular deduction and the policies that guide it. although there are likely to be some tax windfalls handed out, at least they would not be arbitrary. 210 for the most part, the floors currently in place on the itemized deductions are variable and calculated as a percentage of agi, rather than being fixed. variable floors have the appeal of being more progressive, but they may not be appropriate for the given type of expense. for example, the floor of 7.5% of agi on medical expenses seems inappropriate if the purpose of the deduction is to treat extraordinary medical expenses as reflecting an endowment of bad health rather than consumption. having the floor be a percentage of agi implies that rich taxpayers with, say, cancer are healthier than poor 207 kaplow criticizes the idea that a floor can effectively subsidize only ―extraordinary‖ expenses, since, as he shows, a floor is equivalent to a standard deduction, provided that there are offsetting adjustments to exemptions or the rate structure. kaplow, standard deduction, supra note 12, at 3 n.12. thus a floor can have the same effect as a standard deduction, namely to provide an additional deduction to those with low itemizable expenses, which is contrary to the purpose of deducting only extraordinary expenses. but the source of the equivalence is the offsetting adjustment to exemptions or the rate structure. here, i am looking instead at what results from taking as fixed a high zba equal to the standard deduction. the particular level of any floor on deductions should be a separate determination based on congress’s view about the role of the particular deduction. if the zba reflects a fixed amount of untaxed income, then adjustments to the deduction floors, given that fixed zba, would indeed reflect a policy to subsidize only extraordinary expenses. 208 see andrews, supra note 108 and accompanying text. 209 see infra part iv.1. 210 mismeasurement errors as a result of floors do tend to partially cancel each other out, allowing for some equity benefit to having a single floor (in terms of lowering the total degree of mismeasurement). see kaplow, standard deduction, supra note 12, at 27-28 & n.80 (noting, however, that the ―main virtue of grouping items‖ is simplification). nonetheless, there are other policy considerations beyond accuracy in the choice of floor, as discussed herein. 244 columbia journal of tax law [vol.2:203 taxpayers with cancer. 211 a fixed floor thus seems more appropriate for deductions that are more about income measurement than subsidization. put another way, one could view the variable floor on extraordinary medical expenses as a crude approximation of a tax credit, rather than a deduction, for expenses above some fixed floor. example 9: suppose annual medical expenses above $3000 are universally those attributable to bad health, and that there are two taxpayers each with $9000 in medical costs. tp1 has agi of $40,000 (such that 7.5% of agi is $3000) and is in a 20% bracket. tp2 has agi of $80,000 (such that 7.5% is $6000) and is in a 40% tax bracket. tp1 will be able to deduct $6000 of medical expenses, for a net tax benefit (at his 20% rate) of $1200. tp2 will be able to deduct $3000 of medical expenses, for a net tax benefit (at his 40% rate) also of $1200. this is equivalent to both taxpayers receiving a 20% tax credit on the $6000 that, by assumption, is the cost of their bad health. 212 but tax credits tend to be more favored for tax expenditure subsidies than income-measuring deductions. 213 thus, again, arguably a variable floor is inappropriate for an income-measuring deduction like that for extraordinary medical expenses. the same logic applies to the 2% floor on miscellaneous itemized deductions and the 10% floor on casualty and theft losses. indeed, under a pure haig-simons definition of income, there is an argument that the miscellaneous itemized deductions and the deduction for casualty and theft losses should not face a floor at all. for income-measuring deductions, floors should represent the thresholds above which certain expenses should no longer be treated as voluntary consumption but instead should be treated more as differences in endowments. thus, the floor on medical expenses can be said to reflect a decision that only extraordinary medical expenses should be deductible. the case for a floor on the miscellaneous itemized deduction and the casualty and theft loss deduction is less clear. the miscellaneous itemized deductions are generally for expenses related to the production of 211 it is a simplification to say that extraordinary medical expenses do not correlate with income at all. it is very likely that a wealthy taxpayer with an illness consumes more medical services than a poorer taxpayer with the same illness (and thus may actually be healthier). but in most cases, the expenses of the wealthy taxpayer will be borne by insurance. on the margins, there may be some taxpayers who purchase their own insurance and choose to under-insure so as to get the benefit of partial deducibility of medical expenses. see kaplow, supra note 108, at 1487; tax expenditures for health care, supra note 198. but see tax expenditures for health care, supra note 198, at 23 (―in practice, however, it is unlikely that those individuals who do not purchase health insurance will have the liquidity to pay medical expenses that are a large portion of their annual income.‖). according to the staff of the joint committee on taxation, the deduction is taken largely for unor under-covered medical expenses, such as metal health care, dental care, and nursing home care. id. in 2007, 91% of the returns claiming the deduction reported agi less than $100,000 (accounting for 68% of the total tax expenditure). id. at 22. 212 the numbers in this example were obviously chosen to get an equivalent result. this is unlikely to be the result in most actual cases. the larger point is that having a variable, and increasing, floor offsets to some degree the ―upside-down‖ subsidy inherent in a deduction, and thus has some credit-like features. 213 see, e.g., surrey, supra note 99, at 98-100. 2011] doing too much 245 income, and casualty and theft losses are clearly subtractions from wealth, which should be deductible under a pure haig-simons income tax. 214, 215 a variable floor would, however, be more appropriate for the mortgage interest and charitable deductions. the mortgage interest deduction especially is the classic example of surrey’s ―upside-down subsidy,‖ whereby the subsidies increase with marginal rates and thus with income. providing a variable floor mutes that effect, by roughly approximating a tax credit with a fixed floor. assuming mortgage interest tracks income, a variable floor also provides a more treasury-efficient way to target the marginal dollar of spending, since fewer of the dollars below the floor are subsidized. 216 under the current system, floors do not appear to be used in this way, and rather seem to be used for a combination of revenue and tax-avoidance reasons. this is likely due, again, to the distorting effect of the standard deduction. consider the floor for medical expenses. under the patient protection and affordable care act, 217 the 7.5% floor for medical expenses was raised to 10%, likely with the primary purpose of raising revenue to pay for health care reform 218 —the joint committee estimates that raising the floor will generate about $15.2 billion from 2010-2019. 219 while there may be policy reasons (other than revenue) for wanting a higher floor, 220 the 7.5% floor has been in place since 1986, 221 so it is only in the face of a pressing need for health care–related revenue that the floor was adjusted. arguably a more broadly based floor would be a less tempting source of cash if it were explicitly intended to capture the point at which medical expenses should be considered in measuring a taxpayer’s ability to pay. the use of floors to further specific policy goals need not be limited only to the current itemized deductions. this article’s proposal would remove much of the distinction between aboveand below-the-line deductions. 222 were that to happen, there would be little reason to confine the use of floors to the below-the-line deductions. as noted in parts ii and 0, the distinction between aboveand below-the-line deductions has 214 see, e.g., bittker, supra note 99, at 197. but see daniel i. halperin, valuing personal consumption: cost versus value and the impact of insurance, 1 fla. tax rev. 1 (1992) (challenging the deductibility of losses, particularly where there is asymmetric tax treatment of consumption gains and losses); kaplow, insurance, supra note 108, at 1500-04. 215 a variable floor is somewhat more defensible with respect to these income-measuring deductions for simplification reasons, however. if we provide a floor purely to relieve some taxpayers and the government from the burden of itemization, then it is reasonable for the floor to increase with income. higher income taxpayers are more likely to incur itemizable expenses, and likely place a higher cost on the time that would be spent to itemize. 216 this is not to say, of course, that adding a variable floor to the mortgage interest deduction is preferable to replacing it with a tax credit or repealing it altogether; it is only to say that, were the deduction retained, a variable floor would alleviate some of its flaws. the president’s advisory panel on tax reform proposed replacing the mortgage interest deduction with a 15% tax credit. supra note 195, at 70-75. 217 patient protection and affordable care act, pub. l. no. 111-148, § 9013(a). 218 see martin vaughan, senate looks to trim tax break for personal medical costs, wall st. j., june 22, 2009 (discussing proposal as a revenue-raiser). 219 staff of the joint comm. on tax’n, 111th cong., estimated effects of the revenue provisions contained in the ―patient protection and affordable care act‖ 1 (joint comm. print 2009). 220 for example, the fact that health costs as a percentage of income are rising implies that any floor should rise as well in order to continue to target the same group of taxpayers. see vaughan, supra note 218 (quoting henry aaron on this rationale). 221 tax reform act of 1986, pub. l. no. 99-514, § 133(a). 222 but see supra note 158. 246 columbia journal of tax law [vol.2:203 gradually eroded over the years, such that many above-the-line deductions are just as deserving of floors as the current below-the-line deductions. furthermore, even if the optimal floor is fixed rather than variable (and thus the same effect could be achieved with an independent standard deduction), floors continue to have additional policy benefits. first, their perceived effects line up with their actual effects. to put this another way, recall that one of the primary criticisms this article directs at the standard deduction is that it appears to be both a zero bracket and a substitute for the itemized deductions at the same time, and that this leads to confusion in policy debates and in the public mind. 223 most analysts may think of the standard deduction (and personal exemptions) as a zba combined with a floor under the itemized deductions, 224 but it requires an analytical step or two to see that, something most taxpayers are not prepared to do. on the other hand, using a floor makes this effect explicit in the minds of taxpayers and less-informed policymakers. for example, a high floor makes clear to a taxpayer that there is a policy judgment to subsidize only extraordinary expenses. if, instead of a floor, we used a high standard deduction (and a correspondingly lower zba) that policy judgment would not be as apparent. second, floors provide for more straightforward calibration over time, both of the floors themselves and also of the zba. using floors, rather than standard deductions, requires a substantial independent zba. this would give policymakers some slack with which to adjust both the proper amount of untaxed income and the proper amount of tax deduction. if, instead, we used standard deductions, there would be a much smaller independent zba, which would allow only more limited policy adjustments lest overall progressivity be affected. v. conclusion despite being a major source of distortion in the tax code, the standard deduction has received relatively little close analysis and criticism. perhaps the lack of attention is because tax policymakers and commentators believe they understand its weaknesses, but its ubiquity and importance still merit a closer review than it has been given to date. upon such a review, there is little to support its continued existence. the compromise between simplification and progressivity at the core of the standard deduction leads to conceptual incoherence and adversely affects equity, progressivity, tax incentive policy, tax reform, and overall clarity of the tax code, all in the name of simplicity. and the benefit of that simplicity is overstated, and declining. instead, congress ought to repeal the standard deduction and replace it with an independent zero bracket amount and with independent floors for each itemized deduction. treating each itemized deduction separately would mean taxpayers in the same income class would be treated the same with respect to each deduction; deductions of one type would no longer be dependent on other, unrelated deductions; the tax code would move closer to using true taxable income as a base for all taxpayers; tax incentive policy would be more effective; policy debates over the personal deductions would be more substantive; and the overall sense of the tax code’s fairness would improve. in addition, whatever progressivity role the standard deduction played could be easily played by either a true zero-percent tax bracket or expanded personal exemptions. 223 see supra part 0. 224 see a reconsideration of tax expenditure analysis, supra note 8. microsoft word 8-3-field.docx fostering ethical professional identity in tax: using the traditional tax classroom heather m. field* abstract * professor of law & eucalyptus foundation chair, university of california hastings college of the law. i appreciate the opportunity to present this project at the university of washington symposium on protecting taxpayer rights, at the american tax association teaching & curriculum conference, and at a uc hastings teaching roundtable. i thank the event participants and kate bloch, scott fruehwald, daniel lathrope, manoj viswanathan, and alina ball for their feedback. 216 columbia journal of tax law [vol.8:215 will a tax lawyer in private practice help taxpayers comply or help taxpayers cheat? will a government tax lawyer respect or abuse taxpayer rights? answers to these questions turn, at least in large part, on the lawyer’s ethical professional identity—the lawyer’s philosophy of lawyering, which reflects her values, her sense of responsibility to others, and her self-concept of who she is (and wants to be) as a member of the legal profession. according to recent reports on legal education reform, commentators, and the aba, law schools must do more to help students develop their ethical professional identities. this is particularly important in tax law, where lawyers’ ethical professional identities can affect compliance and revenue collection, tax morale and taxpayer rights, and the reputation of the tax profession. however, there is a dearth of resources for faculty members who want to leverage their traditional tax classrooms to help future tax lawyers develop their professional identities and learn to exercise professional judgment within the boundaries of the applicable ethical rules. so how can doctrinal faculty members help aspiring tax lawyers develop and implement their professional identities? this article describes exercises for the traditional tax classroom that are intended to (a) enable each student to identify and justify her developing lawyering philosophy, and (b) empower each student to implement her lawyering philosophy in her career. by empowering professors to help their students become more thoughtful, principled tax advisers, this article advances the goal of building a community of ethical tax professionals, both taxpayer-side and government-side, that serves taxpayers well. i. introduction .................................................................................................... 219 ii. understanding professional identity & its benefit ................. 222 a. what is professional identity? ........................................................................... 222 b. why invest in developing students’ professional identity? ............................. 225 1. developing good judgment ........................................................................ 225 2. improving law student & lawyer well-being ........................................... 225 3. strategizing for meaningful employment ................................................... 227 4. meeting client needs & expectations ........................................................ 227 5. being deliberate & explicit about law school’s impact on students’ professional identity ................................................................................... 227 6. satisfying accreditation standards ............................................................. 228 iii. focusing on the traditional tax classroom to foster ethical professional identity ............................................................... 228 a. what context? traditional lecture/seminar classes. ...................................... 228 1. not just a topic for pr classes or clinics ................................................. 228 2. the value of subject-matter specificity ...................................................... 230 b. what subject? tax. ........................................................................................... 231 1. ethical professional identity is particularly important in tax ................... 231 2. appreciating the range of potential professional identities for tax lawyers 236 iv. employing exercises to engage students in reflection & discussion about ethical professional identity in tax practice ............................................................................................................... 240 a. student learning outcomes ............................................................................... 241 b. exercise, part 1 – what is your tax lawyering philosophy & why? ............. 241 1. homework to stimulate self-reflection ....................................................... 241 2. class discussion to engage & challenge ................................................... 244 3. substance of the discussion ........................................................................ 246 c. exercise, part 2 – what does your professional identity mean for your tax career? ............................................................................................................... 249 1. setting up the discussion ........................................................................... 249 2. substance of the discussion ........................................................................ 250 3. wrapping up the exercise .......................................................................... 255 v. tackling some challenges of the exercises ................................. 255 a. managing class time ........................................................................................ 256 b. adjusting for class size .................................................................................... 256 c. targeting the appropriate class level .............................................................. 257 d. ensuring sufficient background regarding tax-related ethics rules/standards 257 e. deepening & enriching professional identity development ............................ 258 1. additional readings .................................................................................... 258 218 columbia journal of tax law [vol.8:215 2. involving practitioners ................................................................................ 258 3. role-play ..................................................................................................... 259 4. reflection essays ......................................................................................... 260 5. a stand-alone course ................................................................................. 260 f. assessing learning & engagement ................................................................... 260 g. influencing student choices .............................................................................. 261 vi. conclusion ........................................................................................................ 262 vii. appendix a: sample practice scenarios that might present professional identity challenges ...................................................... 263 2017] fostering ethical professional identity in tax 219 “the reality is that most of us practicing tax today have long since compromised our integrity. but if we care about future generations we need to face the fact that tax practice turns our best and brightest into little more than well-paid tax cheats. [i question] whether it is even possible to be a person of integrity and still engage in a lucrative tax practice.”1 i. introduction who will today’s tax law students be as legal professionals? how will they build sustainable, impactful, and ethical careers in tax law? students should develop an ethical professional identity, and law schools must help students in this endeavor. the carnegie report of 2007 argued that law schools must incorporate professional identity development into legal education.2 the clea report, another 2007 report on legal education reform, also highlighted professional identity formation as a core objective for legal education.3 these reports led to a flurry of academic articles and books about professional identity formation,4 and at least six schools have now 1 jeffery l. yablon, as certain as death: quotations about taxes (2010 edition), tax notes today 72-9, 244 (2010) (quoting lawyer paul streckfus). 2 william m. sullivan et al., carnegie found. for the advancement of teaching, educating lawyers: preparation for the profession of law 14 (2007), http://archive.carnegiefoundation.org/pdfs/elibrary/elibrary_pdf_632.pdf [https://perma.cc/5d3r-kf8t] [hereinafter carnegie report] (calling this the third apprenticeship or the “third element of the framework . . . for an integrated legal education”); william m. sullivan et al., carnegie found. for the advancement of teaching, summary: educating lawyers: preparation for the profession of law 6 (2007), http://archive.carnegiefoundation.org/pdfs/elibrary/elibrary_pdf_632.pdf [https://perma.cc/775hz39f] [hereinafter carnegie summary] (arguing law schools need to provide more “effective support for developing ethical and social skills. students need opportunities to learn about, reflect on and practice the responsibility of legal professionals. . .[and law schools should do more to] engage the moral imagination of students as they move toward professional practice”). 3 roy stuckey et al., clinical legal education ass’n, best practices for legal education: a vision and a road map (2007), http://www.cleaweb.org/resources/documents/best_practices-full.pdf [https://perma.cc/gyd7-ajt4] [hereinafter clea report]. 4 see, e.g., e. scott fruehwald, developing your professional identity, creating your inner lawyer (2015); neil w. hamilton, roadmap: the law student’s guide to preparing and implementing a successful plan for meaningful employment (2015) [hereinafter, “hamilton, roadmap”]; e. scott fruehwald, developing law students’ professional identities, 37 u. la verne l. rev 1 (2015); neil hamilton & jerry organ, thirty reflection questions to help each student find meaningful employment and develop an integrated professional identity (professional formation), 83 tenn. l. rev. 843 (2016); martin j. katz, teaching professional identity in law school, 42-oct colo. law. 45 (2013); benjamin v. madison iii & larry o. natt gantt ii, the emperor has no clothes, but does anyone really care? how law schools are failing to develop students’ professional identity and practical judgment, 27 regent u. l. rev. 339 (2014-15); verna e. monson & neil w. hamilton, entering law students’ conceptions of an ethical professional identity and the role of the lawyer in society, 35 j. legal prof. 385 (2011); susan swaim daicoff, lawyer, form thyself: professional identity formation strategies in legal education through “soft skills training, ethics, and experiential courses, 27 regent u. l. rev. 205 (2014-15); david i.c. thomson, “teaching” formation of professional identity, 27 regent u. l. rev 303 (2014-15). 220 columbia journal of tax law [vol.8:215 adopted student learning outcomes to the effect that “students should develop a personal code of ethics/moral core to guide discretionary professional decision-making”.5 the preamble to the model rules of professional conduct echoes this effort by encouraging lawyers to develop guiding principles to help them make difficult decisions.6 and the increased focus on professional formation and ethical professional identity is now incorporated into the recently revised aba accreditation standards, which require law schools to prepare students “for effective, ethical and responsible participation as members of the legal profession.”7 but how do law school professors actually do this? how do we help students develop their ethical professional identities? certainly, this is part of clinical legal education, where students grapple with ethical decisions when representing real clients and reflect on who they want to be as lawyers.8 and professional identity is also often taught as part of professional responsibility courses.9 traditional law school classrooms, however, also provide opportunities to build students’ professional identities. integrating into the traditional law school classroom the notion of professional identity is part of teaching ethics throughout the curriculum. it reinforces concepts discussed elsewhere, it encourages students to see ethics and identity considerations as pervasive rather than sequestered in ethics courses, and it helps students appreciate ethics and identity issues in the context of the subject matters to which they might dedicate their careers. but most doctrinal textbooks focus on substance and do not emphasize professional identity.10 and thus it can be quite labor-intensive for individual 5 hamilton, supra note 4 at 3. 6 model rules of professional conduct, preamble par. 9 (8th ed., 2015) (“within the framework of these rules, however, many difficult issues of professional discretion can arise. such issues must be resolved through the exercise of sensitive professional and moral judgment guided by the basic principles underlying the rules. these principles include the lawyer's obligation zealously to protect and pursue a client's legitimate interests, within the bounds of the law, while maintaining a professional, courteous and civil attitude toward all persons involved in the legal system.”). 7 american bar association, aba standards and rules of procedure for approval of law schools 2016-17 section 301(a), http://www.americanbar.org/content/dam/aba/publications/misc/legal_education/standards/2016_2017_aba_s tandards_and_rules_of_procedure.authcheckdam.pdf [https://perma.cc/2859-udub] [hereinafter “aba standards”]; see also aba standards 302(c) (reflecting the third apprenticeship from the carnegie report and explaining that students should develop competency in the “exercise of proper professional and ethical responsibilities to clients and the legal system”). the emphasis on ethics in both standard 301 and 302 was added in 2014. see american bar association, overview of changes to the standard for approval of law schools, http://www.americanbar.org/content/dam/aba/administrative/legal_education_and_admissions_to_the_bar/co uncil_reports_and_resolutions/overview_of_changes.authcheckdam.pdf [https://perma.cc/7jrc-p4z4]. 8 see carnegie report, supra note 2, at 145-47; charlotte s. alexander, learning to be lawyers: professional identity & the law school curriculum, 70 md. l. rev. 465, 466-72 (2011); daicoff, supra note 4, at 217-219; kelley s. terry, externships: a signature pedagogy for the development of professional identity and purpose, 59 j. legal educ. 240 (2009). 9 see carnegie report, supra note 2, at 147-51; daicoff, supra note 4, at 210. schools are also increasingly developing professional development and professional formation programs. see, e.g., hamilton, roadmap, supra note 5 (describing such a program). however, these programs may focus more on professionalism or employment-readiness rather than on the related, but distinct and narrower, notion of ethical professional identity. see also generally larry o. natt gantt ii & benjamin madison iii, teaching methods and examples to help students develop a professional identity (carolina academic press 2016). 10 one counter-example is the carolina academic press – context and practice series which includes “‘professional identity reflection questions’ in the context of teaching the subject matter of the 2017] fostering ethical professional identity in tax 221 professors to figure out how to incorporate professional identity development into their traditional classrooms.11 nevertheless, the effort is important, particularly in subject areas such as tax law where lawyers’ ethical professional identities can affect compliance and revenue collection, tax morale and taxpayer rights, and the reputation of the tax profession. moreover, investing in ethical professional identity development helps to empower lawyers to make good decisions in the most difficult circumstances, 12 such as when representing a client who wants to take aggressive tax positions. for example, a “hired gun” lawyer13 would assist a client with tax planning that is supported by only substantial authority (i.e., that she thinks is not likely to succeed), whereas a “legalist” lawyer14 would withdraw from that representation. and professional identity considerations are relevant even for lawyers at the beginning of their careers, and even in a tight job market. for example, imagine a junior tax lawyer who wants to build a career in which she takes a legalist approach to tax lawyering (i.e., helping clients take positions only if they are more likely than not to succeed on the merits). what should she do if she is working for a partner who wants her to assist with a tax strategy for which there is only “reasonable basis” (2025% chance of success on the merits)? there are many more examples in which having a strong sense of professional identity could help the tax lawyer make these types of difficult discretionary decisions in a principled way.15 thus, the goal of this article is to provide strategies for integrating professional identity development exercises into the traditional tax classroom.16 in doing so, this article advances our understanding of how to help students develop ethical professional identity, particularly for those students interested in pursuing a career in tax.17 and this article helps casebook”. larry o. natt gantt ii & benjamin w. madison iii, teaching knowledge, skills, and values of professional identity formation, in building on best practices: transforming legal education in a changing world 253-270, note 103 (deborah maranville et al., eds.) (2015). that series, however, does not include a tax law book. see carolina academic press, context and practice series titles, http://www.cap-press.com/books/ms/166 [https://perma.cc/8762-hjvu]. 11 see paula schaefer, integrating professionalism into doctrinally-focused courses, in building on best practices: transforming legal education in a changing world 271-79 (deborah maranville et al. eds., 2015). 12 for example, one practitioner, after hearing a presentation of this paper, commented to me that, in his almost thirty-year career as a corporate tax lawyer, the issues that implicated professional identity were harder than any substantive tax issue that he ever faced. 13 see infra part iii.b.2.a. 14 see infra part ii.b.2.c. 15 see infra appendix a (positing several other scenarios that might pose professional identity challenges for junior tax lawyers) and part iv.c.ii.a (discussing the relevance and value of the professional identity inquiry in a market where jobs are scarce). 16 notably, this article does not advance a normative preference for what type of ethical professional identity students should adopt. rather, this article helps faculty members facilitate students’ guided and thoughtful self-discovery, but a faculty member who wants to steer students toward a particular normative approach can easily modify the exercises described herein. see infra part v.g. (discussing such modifications). 17 the textbooks on tax ethics do incorporate notions of ethical professional identity, at least to some extent. see, e.g., michael hatfield, the ethics of tax lawyering (3d ed. 2015); linda galler & michael b. lang, regulation of tax practice (2d ed. 2016); bernard wolfman et al., ethical problems in federal tax practice (5th ed. 2015); donald b. tobin et al., problems in tax ethics (2009). however, these texts are generally intended for courses specifically on tax ethics. in contrast, this article focuses on other tax courses (e.g., corporate tax, partnership tax, tax seminars), where ethical and identity considerations are ancillary rather than central to the course’s objective. it is much less common for 222 columbia journal of tax law [vol.8:215 to answer the call for “plug and play” curriculum18 that faculty can use to advance the student learning objective of teaching ethical professional identity formation.19 in addition, given that professional identity development is equally important for practicing tax lawyers, they can use this article as a self-study tool, and the exercises herein can be used for cle workshops.20 part ii of this article provides background by elaborating on the concept of “professional identity” and explaining why this is an important part of legal education. part iii then argues for incorporating professional identity pedagogy into a specific context— the traditional tax classroom. part iv provides an exercise that can be used in any upper-division tax course to integrate professional identity building into the traditional tax classroom; a reader primarily interested in the specific exercises might want to skip directly to this part. part v identifies several challenges with integrating a professional identity module into the tax classroom and discusses variations and alternatives to help professors overcome or mitigate these challenges. this enables tax professors to tailor the experience to their goals and their students’ needs. part vi concludes. ultimately, the goal of this article is to try to empower tax faculty to help students reflect seriously on who they are and who they want to be as soonto-be lawyers in the tax profession. ii. understanding professional identity & its benefit a. what is professional identity? ethical professional identity (also referred to as “professional identity”)21 is part of the carnegie report’s third apprenticeship, in which students engage in the “exploration and assumption of the identity, values, and dispositions consonant with the fundamental purposes of the legal profession.”22 the carnegie report explains that, “professional identity is, in essence, the individual’s answer to questions such as, who am i as a member texts for such courses to have modules focused on professional identity. thus, this article is intended to provide such a module for use in most any upper-division tax course. 18 hamilton & organ, supra note 4, at 39. 19 part of the reason that i wrote this up into a scholarly article rather than just pursuing these student learning objectives in my own classrooms is to share the teaching innovation, as recommended by carnegie. carnegie summary, supra note 2, at 11 (encouraging “substantive knowledge about teaching and learning [to] be built upon and shared publicly over time, in the fashion of traditional academic scholarship, rather than being gained and lost anew with each individual teacher.”). i was inspired to do this in response to questions that i received when presenting my recent article, aggressive tax planning & the ethical tax lawyer, in which i argue that “a lawyer seeking to pursue a career as an ethical tax planner should identify and implement her philosophy of lawyering to help her make [ ] difficult discretionary decisions in a principled way.” heather m. field, aggressive tax planning & the ethical tax lawyer, 36 va. tax rev. 261 (2017). people at multiple different workshops asked me how i would teach the students to do that. in response, i often described the exercises that i explain herein, and i received encouraging comments about the utility of the exercises i describe. thus, i thank the people who inquired for inspiring this piece. 20 i will be providing cle workshops based on this article starting in spring 2017. 21 the terms “ethical professional identity” and “professional identity” are used interchangeably herein on the premise that “professional identity” (at least as understood herein) is developed within the boundaries of the relevant ethical rules. as discussed further in part iii.b.2, the lawyering philosophies offered herein as possible approaches to professional identity generally provide lawyers guidelines for how to exercise their discretion within the ethical constraints imposed on lawyers generally and on tax lawyers in particular. 22 carnegie summary, supra note 2 at 8. 2017] fostering ethical professional identity in tax 223 of this profession? what am i like, and what do i want to be like in my professional role? and what place do ethical-social values have in my core sense of professional identity?”23 since the publication of the carnegie report, scholars have tried to clarify and expand upon the definition of professional identity. for example, professor martin j. katz explains that, “[p]rofessional identity is the way a lawyer understands his or her role relative to all of the stakeholders in the legal system, including clients, courts, opposing parties and counsel, the firm, and even the legal system itself (or society as a whole).”24 professor daisy hurst floyd explains that, “[p]rofessional identity refers to the way that a lawyer integrates the intellectual, practical, and ethical aspects of being a lawyer and also integrates personal and professional values.”25 professor susan swaim daicoff explains that, “[p]rofessional identity here is meant to encompass one’s values, preferences, passions, intrinsic satisfaction, emotional intelligence, as well as one’s preferred professional best practices.” 26 scott fruehwald explains that professional identity involves, among other things, lawyers’ ability to “reflect on their roles within social contexts and systems” and to “self-define as a professional with a moral core of responsibility and service to others.” 27 more broadly, he explains that “professional identity is a lawyer’s personal legal morality, values, decision-making process, and selfconsciousness in relation to the practices of the legal profession (legal culture). it provides the framework that a lawyer uses to make all a lawyer’s decisions.”28 and professors benjamin v. madison and larry o. natt gantt explain succinctly that, “professional identity . . . encompasses a person’s self-concept, values, and philosophy of lawyering.29 to understand the goal of this article, it is important to differentiate the concept of professional identity, as used herein, from the related concepts of professional formation, professionalism, and ethics. professional identity is part of the larger notion of “professional formation,” which is “focused on helping each law student to take ownership over her own professional development.” 30 professor neil hamilton writes extensively regarding professional formation, including in his book, roadmap: the law student’s guide to preparing and implementing a successful plan for meaningful employment. 31 he explains that professional formation “helps each student [and helps faculty and staff help students] . . . understand how taking ownership over her own proactive professional development toward excellence at the competencies needed to serve others well will help the student realize her goal of self-sufficiency.”32 professor hamilton and professor jerry organ highlight two “professional formation learning outcomes”: that “each student demonstrate an understanding and integration of 1. proactive professional development toward excellence at all the competencies needed to serve clients and the legal system well; [and] 2. an 23 carnegie report, supra note 2, at 135. 24 katz, supra note 4, at 45. 25 daisy hurst floyd, practical wisdom: reimagining legal education, 10 u. st. thomas l.j. 195, 201 (2012). 26 daicoff, supra note 4, at 206-07. 27 fruehwald, supra note 4, at 9-10. 28 fruehwald, supra note 4, at vii. 29 madison & gantt, supra note 4, at 341. 30 neil w. hamilton, professional formation with emerging adult law students in the 21-29 age group: engaging students to take ownership of their own professional development toward both excellence and meaningful employment, 2015 j. prof. law. 125, 125 (2015). 31 hamilton, supra note 4. 32 hamilton, supra note 30, at 139. 224 columbia journal of tax law [vol.8:215 internalized deep responsibility to clients and the legal system.”33 thus, professional formation incorporates concepts of self-directed learning and self-sufficiency, and not merely the sense of self and how the self relates to clients, the profession and society, which is the focus of professional identity. of course, having a strong sense of self—who you are and want to be as a lawyer—can empower a student to become a self-directed learner who is a self-sufficient professional able to serve others. thus, any effort to develop student’s professional identity is part of helping them with their professional formation, but professional formation is a much broader concept. professionalism, which is also part of professional formation, is distinct from professional identity. professor martin katz explains the distinction well: professionalism relates to behaviors, such as timeliness, thoroughness, respect towards opposing counsel and judges, responding to clients in a timely fashion . . . professional identity relates to one’s own decisions about those behaviors (which sounds like overlap, but it’s not), as well as a sense of duty as an officer of the court and responsibility as part of a system in our society that is engaged in upholding the rule of law.34 ethics is similarly distinct from professional identity. legal ethics refers to the rules and standards that govern the behavior of lawyers, whereas professional identity refers to the way in which an individual lawyer engages with and implements those ethical rules in actual practice.35 indeed, courses on legal ethics and professional responsibility typically focus primarily on the model rules of professional conduct, as part of preparing students to pass the multistate professional responsibility exam.36 but the model rules, and often courses focused primarily on teaching the model rules, focus on “minimal standards of competency” and what it takes to “avoid sanctions”.37 in contrast, teaching professional identity would “explore how the values of the profession may lead lawyers through their practical judgment to resolve competing values”38 and would “help students begin to develop their own philosophy of lawyering to deal with the difficult questions they will face in the practice of law.”39 that said, although legal ethics and professional identity are not coextensive, an individual lawyer’s professional identity should be bounded by the ethical rules because ethical practice is not merely “a matter of individual conscience and therefore individual choice.”40 in addition, the notions of both professionalism and ethics provide students with external guidelines about the right things for lawyers to do and the right way for lawyers to behave. i hope that students internalize these notions, but a student can demonstrate professionalism and ethics without doing so. but professional identity is internal; “professional identity engages lawyers at a deeper level because it challenges lawyers to 33 hamilton & organ, supra note 4, at 1. 34 katz, supra note 4, at 45 (citing thomson, supra note 4). 35 see carnegie report, supra note 2, at 148-150. 36 madison & gantt, supra note 4, at 374. 37 id. 38 id. 39 nathan m. crystal, using the concept of “a philosophy of lawyering” in teaching professional responsibility, 51 st. louis u. l.j. 1235, 1235 (2007); see also madison & gantt, supra note 4, at 376 (endorsing an exercise based on crystal’s work). 40 frederic g. corneel, ethical guidelines for tax practice, 28 tax law. 1, 1 (1970). 2017] fostering ethical professional identity in tax 225 internalize principles and values such that their professional conduct flows naturally from their individual moral compasses.”41 b. why invest in developing students’ professional identity? helping students to build their professional identities produces several benefits. 1. developing good judgment having a sense of professional identity helps law students and lawyers exercise good judgment so they can make difficult discretionary decisions in principled ways.42 if a lawyer has clear and strong notions of who she is as a lawyer and of how she balances her competing duties to clients, the legal system, society, and self, she is more able to make decisions under pressure in a way that reflects those values.43 without those internal guiding principles, the student/lawyer would “muddle through, developing an ad hoc [approach]” for discretionary decision-making.44 and without an ethical professional identity, she may be less able to withstand pressure from clients, colleagues or others, and the lawyer may not have the tools she needs to make good judgments in difficult situations.45 of course, good judgment and a sense of professional identity are developed over the course of a career. no law student can graduate law school with fully formed professional identity and perfect judgment, but law schools can help students begin to build these critical characteristics for success and can help students understand how to develop these skills and attributes over the course of their careers. developing good judgment for resolving difficult discretionary decisions is important even for junior lawyers because, for example, supervising attorneys can ask junior lawyers to do things that make the junior lawyers uncomfortable.46 moreover, many students will lack the mentorship during their early practice years that could help them build strong senses of professional identity. this may be because many students go into solo or very small firm practices where the students lack professional mentors to help them develop their identity as lawyers. even larger firms, which are increasingly bottom-line driven, seem to invest less today in professional development and mentorship of junior lawyers. thus, by doing more in law school to help students build their understandings of who they are as legal professionals and of what that identity means for their decision-making and judgment, law schools can help bridge this gap.47 2. improving law student & lawyer well-being for students, building their professional identity can also help counteract the adverse impact that law school has been demonstrated to have on student well-being. 41 madison & gantt, supra note 4, at 345. 42 see field, supra note 19, at 297-99. 43 see fruehwald, supra note 4, at 36-38 (discussing the role of identity and values on the ability to exercise “practical wisdom”). 44 nathan m. crystal, developing a philosophy of lawyering, 14 notre dame j.l. ethics & pub. pol’y 75, 93 (2000); see also crystal, supra note 39, at 1240. 45 gantt & madison, supra note 10, at 259 (“the exercise of [solid and prudent] wisdom emanates from a person’s character”); see also jennifer k. robbennolt & jean r. sternlight, behavioral legal ethics, 45 ariz. st. l.j. 1107, 1157-64 (2013) (recommending that, to avoid judgments that lead to ethical lapses, lawyers should “reflect regularly on core values” and “try to anticipate ethical dilemmas and to specifically plan and rehearse our responses ahead of time”). 46 see infra part iv.c.2.b and appendix a (presenting and discussing situations that could challenge a junior lawyer’s ability to implement her professional identity). 47 see madison & gantt, supra note 4, at 356. 226 columbia journal of tax law [vol.8:215 research links this decline in law student well-being to the significant motivational shifts that law students experience during law school, going from more “intrinsic values and motivations” to more “extrinsic orientations” that value external markers of success such as grades and salaries.48 this research echoes broader research that demonstrates that “when intrinsic values and motivation dominate a person's choices she tends to experience satisfaction and well-being, whereas when extrinsic values and motivation are most important to her she will experience angst and distress.”49 thus, by fostering professional identity, which, by definition, reflects an individual’s internal values, motivations, and sense of self, professors can try to refocus student attention on the intrinsic motivations that brought students to law school and that can help guide students to more satisfying law school experiences.50 in particular, this focus can help students understand the substantive material and skills learned in classes through the lens of who they are as people and who they want to be as lawyers, which could lead to a greater sense of satisfaction and engagement with law school. this benefit may continue when the students become lawyers. having a clear sense of professional identity can help a lawyer maintain “her personal integrity [and] inner moral compass,”51 which can lead to making judgments that better align with the lawyer’s values.52 research demonstrates that, for lawyers, practicing in accordance with their values and being driven in their work by internal motivations are correlated with greater happiness and well-being,53 which means that lawyering grounded in one’s ethical values “may ultimately make the practice of tax law a more sustainable and personally satisfying career.” 54 moreover, greater lawyer well-being helps to create a virtuous cycle of improved productivity, ethics and professionalism.55 without attention to professional identity development, law schools may be “setting [young lawyers] up for dissatisfaction and soul-searching in their early practice lives.”56 thus, to the extent that we can help students harness their internal concepts of who they are and want to be as lawyers, we may 48 lawrence s. krieger, the inseparability of professionalism and personal satisfaction: perspectives on values, integrity and happiness, 11 clinical l. rev. 425, 433 (2015) (citing kennon m. sheldon & lawrence s. krieger, does legal education have undermining effects on law students? evaluating changes in motivation, values, and well-being, 22 behav. sci. & law 261 (2004)). 49 id. at 429. 50 id. at 438 (encouraging faculty to model and encourage intrinsic pursuits); see also lawrence s. krieger, institutional denial about the dark side of law school, and fresh empirical guidance for constructively breaking the silence, 52 j. legal educ. 112, 122-29 (2002). 51 paul brest & linda krieger, on teaching professional judgment, 69 wash. l. rev. 527, 530 (1994); see also am. bar ass’n section of legal educ. and admissions to the bar, legal education and professional development – an educational continuum: report of the task force on law schools and the profession: narrowing the gap 204 (1992) (citing “a lawyer’s personal sense of morality” as an important guide and identifying “promoting justice, fairness, and morality in one’s own daily practice” and a fundamental value of the profession). 52 see supra part ii.b.1. 53 lawrence s. krieger & kennon m. sheldon, what makes lawyers happy?: a data-driven prescription to redefine professional success, 83 geo. wash. l. rev. 554, 617-18 (2015). 54 field, supra note 19, at 301; see also patrick j. schiltz, on being a happy, healthy, and ethical member of an unhappy, unhealthy, and unethical profession, 52 vand. l. rev. 871 (1999) (connecting ethical practice to health and happiness); madison & gantt, supra note 4, at 343, 348-50 (discussing the “connection between forming ethical professional identity and the degree of fulfillment a lawyer finds in practice”). 55 krieger & sheldon, supra note 53, at 622. 56 carnegie report, supra note 2, at 138. 2017] fostering ethical professional identity in tax 227 help them become lawyers who are able to implement their values in practice, thereby helping them to build more fulfilling and sustainable careers in the law. 3. strategizing for meaningful employment cultivating in students a sense of professional identity is also a valuable part of helping students create a roadmap for meaningful employment. having an appreciation for the varied approaches that lawyers can take toward lawyering57 and developing an understanding of which approach(es) resonate for him/her can help a student determine what practice specialties, what practice settings, and which employers are likely to be good fits for him/her.58 in turn, this can contribute to a student’s ability to formulate a plan for obtaining employment, articulate to a prospective employer why the student is the right hire, 59 and land a position that is more likely to empower the student to practice in accordance with her professional identity. indeed, the broader professional formation literature encourages law schools to help students develop professional identity as a part of helping students with employment outcomes.60 moreover, research suggests that one reason why people leave their jobs is because of mismatches between their personal value systems and the institution’s value system.61 thus, if a student can land a job with an employer whose values match hers in the first instance, that may help her find greater job satisfaction and longevity. this could happen through luck, but a student can increase her chances of finding a good employment fit if she has thought carefully about her lawyering philosophy. 4. meeting client needs & expectations further, a lawyer with a strong sense of professional identity is better able to serve her clients. this is for several reasons, one of which being that she can articulate and explain how she approaches her role as a lawyer.62 having a clear professional identity and an articulable lawyering philosophy will make the lawyer better able to identify both the clients whose needs she is likely (and unlikely) to be able to meet. this can help her determine which clients to represent and which representations to decline. moreover, by discussing her lawyering approach with a prospective client, a lawyer can “help set client expectations for the representation and can help the client understand how to be a better consumer of her legal services.”63 this, “in turn increases the likelihood that the client will be satisfied with the advice provided”64 and with the nature of the lawyer/client relationship and interaction throughout the course of the representation.65 5. being deliberate & explicit about law school’s impact on students’ professional identity in addition, as the carnegie report explains, “law schools play an important role in shaping their students’ values . . . as well as their understanding of their roles and 57 id. at 131-32. 58 see, e.g., infra part iv.c.2.a. 59 hamilton, roadmap, supra note 4, at 53 (articulating your “value proposition”). 60 see, e.g., id.; hamilton & organ, supra note 4, at 35-36 (posing several professional identityrelated questions as part of the “reflection questions to help each student find meaningful employment”). 61 kazi firoz alam, ethics in new zealand organizations, 12 j. bus. ethics 430, 438 (1993). 62 see crystal, supra note 44, at 93. 63 field, supra note 19, at 299. 64 id. 65 see stephen l. pepper, counseling at the limits of the law: an exercise in the jurisprudence and ethics of lawyering, 104 yale l.j. 1545, 1601-07 (1995) [hereinafter, “pepper, counseling”] (explaining how the client experience can differ with lawyers who have different approaches to lawyering). 228 columbia journal of tax law [vol.8:215 responsibilities as lawyers”.66 the law school experience affects students’ senses of their professional selves regardless of whether professors are deliberately trying to affect students’ professional identity.67 but if law schools are not deliberate and thoughtful about how they want to impact students’ professional identity, “legal education may inadvertently contribute to the demoralization of the legal profession and the its loss of a moral compass.”68 thus, a better approach is to acknowledge that law school can have a significant impact on students’ professional identities and then to take that into account when designing curriculum and teaching classes.69 by being deliberate and explicit about law schools’ impact on professional identity, law professors and law schools can at least attempt to foster the development of students’ professional identity in a way that will serve students well. 6. satisfying accreditation standards lastly, investing in the development of students’ professional identities can and should be part of a law school’s efforts to meet the aba’s accreditation standards.70 coursework focused on professional identity formation is particularly relevant to aba standard 301, which requires that schools prepare students “for effective, ethical, and responsible participation as members of the legal profession” and aba standard 302, which requires, among other things, that schools advance student competency in the “exercise of proper professional and ethical responsibilities to clients and the legal system.” 71 both of those aba standards were revised in 2014 to reflect a stronger emphasis on ethics and on the three apprenticeships discussed in the carnegie report.72 these revisions call for increased emphasis on ethics and professional development, and one way that law schools can be responsive to these recent changes is to dedicate more time to helping students develop their ethical professional identities. iii. focusing on the traditional tax classroom to foster ethical professional identity a. what context? traditional lecture/seminar classes. law schools often try to foster professional identity through experiential courses and courses on professional responsibility. although these opportunities are critical to the development of students’ professional identity, traditional classrooms also present opportunities to help students develop practice-area specific notions of professional identity. 1. not just a topic for pr classes or clinics although professional identity may be taught as part of a professional responsibility course, integrating professional identity development into traditional lecture 66 carnegie report, supra note 2, at 139. 67 daicoff, supra note 4, at 220; see also carnegie report, supra note 2, at 139. 68 carnegie report, supra note 2, at 140. 69 id. at 30, 131-32. 70 of course, it is preferable for law professors to be internally motivated to take on the task of aiding students with their professional identity development. see infra part ii.b.2. (discussing internal versus external motivation). i hope that this article helps to articulate the value proposition for such an effort. however, the external motivation provided by the aba standards also provides a reason to invest in helping students develop their professional identities. 71 aba standards, supra note 7. 72 aba, overview of changes, supra note 7, at paragraph 5. 2017] fostering ethical professional identity in tax 229 and seminar classes73 is part of teaching ethics pervasively across the curriculum.74 this is necessary because professional responsibility courses may not comprehensively teach the ethical rules and fully foster the development of professional identity.75 a 2 or 3 unit ethics course provides only a limited amount of time, and most courses in professional responsibility focus on the ethical rules, which are the minimum standards to which legal professionals must adhere, and not on professional identity, which is critical for the exercise of discretionary decision-making within the boundaries of what the ethical rules allow.76 similarly, although professional identity formation is often an important part of experiential education,77 clinics and externships are trying to teach multiple important practice skills. although students will now be required to take at least six units of experiential courses78 and although that addition will increase students’ exposure to a variety of practice skills, ethical professional identity is only part of what clinics, externships and simulations teach. the responsibility for professional identity development is something that all faculty, not just clinical faculty, can and should bear. moreover, learning is generally more effective if reinforced multiple times, and this is equally true with respect to professional identity development.79 thus, even if professional responsibility courses and clinics/externships do spend some time on professional identity development, reinforcing these concepts in lecture/seminar classes provides students with the opportunity to revisit and deepen their understandings of what it means to operationalize the rules of ethics in a way that aligns with their values.80 professional identity, values and judgment are developed over the course of a lawyer’s career, and thus, encouraging students to revisit these notions more than once in a law school career helps to start students on a path of iterative lifetime learning and reflection about who they are as legal professionals.81 in addition, allocating time in a lecture or seminar course to the development of ethical professional identity communicates a statement of value to students. specifically, the fact that ethics and professional identity formation are valuable enough to merit time and attention even beyond the traditional course on professional responsibility and even beyond experiential courses demonstrates that these concepts are important to legal studies generally and ought not be cabined to clinical or ethics-specific education. moreover, devoting time to professional identity in lecture and seminar courses signals that these concepts are important to doctrinal professors (and not merely clinical or ethics-specific 73 by “traditional classes” or “doctrinal classes,” i refer to subject-matter specific lecture or seminar classes that are intended to impart particular substantive information. this contrasts with clinics, externships, or other skills classes that are explicitly intended to teach lawyering skills. 74 carnegie report, supra note 2, at 151-52. 75 daicoff, supra note 4, at 210. 76 see carnegie report, supra note 2, at 147-51. 77 see supra note 8. 78 aba standard 303(a)(3). 79 see hamilton, roadmap, supra note 4, at 208 (citing studies supporting use of “repeated opportunities throughout the curriculum with respect to professional formation”). 80 see id.; gantt & madison, supra note 10, at 255. 81 see madison & gantt, supra note 4, at 355 (the habit of self-reflection is important for “ongoing growth in a lawyer’s professionalism”). 230 columbia journal of tax law [vol.8:215 professors) and that the doctrinal professors believe that these concepts should be similarly important to students. 2. the value of subject-matter specificity incorporating ethical professional identity development into lecture/seminar courses also provides subject-matter specific context for the ethical dilemmas and decisionmaking. both the carnegie report and the clea report emphasize the value of “contextbased education”82 that “weave[s] together disparate kinds of knowledge and skill”83 and encourage “courses that directly explore the identity and roles of lawyers, the difficulties of adhering to larger purposes amid the press of practice, and the way professional ideals become manifest in legal careers.” 84 commentators similarly advocate for the incorporation of professional identity development into “subject-matter focused doctrinal courses”. 85 this is, in part, because lawyers in different practice areas can face different types of ethical dilemmas, although there may be some common dilemmas within a particular field. situating ethical dilemmas in the context of a student’s practice area of interest makes the challenge more concrete, and thus more personal and relevant, for students.86 “including specific exercises in doctrinal courses beyond the course in professional responsibility encourages students to see the professional values at issue in different doctrinal areas and how as lawyers they will be called upon in various settings to make decisions in the face of competing values.”87 further, the value of context-specific professional identity development is an additional reason why this type of education cannot be relegated to clinics. although clinics and externships play an important role in professional formation, schools cannot have clinical opportunities in every subject matter. in particular, most schools do not have tax clinics (i.e., the particular doctrinal focus of this article), and even among schools that do have tax clinics, only a limited number of students can participate. thus, tax clinics and externships cannot generally be depended upon to provide all tax-interested students with opportunities to develop their context-specific ethical professional identities. doctrinal tax classes, whether in lecture or seminar format, have a much broader reach. incorporating professional identity considerations into subject-matter specific classes can also enhance student learning in those classes. in addition to helping students shift toward the mindset of an aspiring practitioner, incorporating professional identity considerations into a doctrinal course can “enhance [students’] understanding . . . of the law of the course” and “keep them fully engaged in the doctrinal subject matter.”88 some doctrinal textbooks adopt these insights and include reflection questions or other problems that are intended to engage students on professional identity questions in 82 clea report, supra note 3. 83 carnegie summary, supra note 2, at 9 (noting that “demands of an integrative approach require both attention to how fully ethical-social issues pervade the doctrinal and lawyering curricula and the provision of educational experiences directly concerned with the values and situation of the law and the legal profession.”). 84 carnegie report, supra note 2, at 147. 85 see, e.g., thomson, supra note 4, at 326; madison & gantt, supra note 4, at 397. 86 thomson, supra note 4, at 323-26. 87 gantt & madison, supra note 10, at 267. 88 schaefer, supra note 11, at 271. 2017] fostering ethical professional identity in tax 231 the particular doctrinal context. 89 however, this is still relatively uncommon among doctrinal textbooks.90 particularly where the textbooks do not include professional identity modules, it can require significant “additional preparation and thought to introduce professionalism [and professional identity development] issues into [doctrinal] courses.”91 thus, the goal of this article is to make that process easier for professors who want to add a professional identity component to their tax courses. b. what subject? tax. this article focuses on helping students develop their professional identity as aspiring tax lawyers. thus, this section will explain why this task is particularly valuable in the tax area, and then will articulate several different potential lawyering philosophies that students or practitioners could adopt as foundational for their ethical professional identity in tax practice. 1. ethical professional identity is particularly important in tax the development of ethical professional identity is particularly important for future tax lawyers.92 this is for several reasons including the impact of each practitioner’s professional identity on (a) compliance and revenue collection, (b) tax morale and taxpayer rights, (c) the reputation of the tax profession, and (d) how she operationalizes the taxspecific rules of ethics and standards of practice. i. compliance & revenue collection the manner in which a tax adviser approaches her role can have an important impact on compliance and revenue collection. the resource constraints of the irs93 lead to a relatively weak enforcement mechanism,94 meaning that compliance and revenue collection depend heavily on taxpayer self-assessment,95 which in turn depends on tax 89 see gantt & madison, supra note 10, at 267 note 103 (listing particular text series that tend to incorporate professional identity considerations). 90 note that this is not a serious criticism of the many excellent textbooks available today. textbook authors have the challenging task of presenting complex material for student learning, so they understandably focus primarily on teaching the relevant substantive law. 91 schaefer, supra note 11, at 271-79 92 see, e.g., john s. dzienkowski & robert j. peroni, the decline in tax adviser professionalism in american society, 84 fordham l. rev. 2721, 2747 (2016) (arguing for “increased emphasis on ethics in training tax professionals”). 93 national taxpayer advocate, annual report to congress 2014, at 12-15, available at http://taxpayeradvocate.irs.gov/media/default/documents/2014-annual-report/volume-one.pdf [https://perma.cc/73y3-qce4] [hereinafter, nta report 2014] (discussing declining irs resources in comparison to the irs workload). 94 for example, only approximately 0.7 percent of all 2014 tax returns were audited by the irs. irs 2015 data book, at 21, available at https://www.irs.gov/pub/irs-soi/15databk.pdf [https://perma.cc/8cvj-yzyt]. in addition, private rights of action are generally not available to supplement government enforcement in the tax area. 95 see michael doran, tax penalties and tax compliance, 46 harv. j. on legis. 111, 142-44 (2009) (discussing the self-assessment system). 232 columbia journal of tax law [vol.8:215 advice provided by tax professionals.96 a tax practitioner’s professional identity can affect whether she is willing to assist clients in particular transactions.97 for example, when advising a client who wants to take an aggressive position (e.g., one for which there is only substantial authority or reasonable basis), a “hired gun” tax adviser (i.e., who views herself as someone who implements the action directed by the client)98 is likely to help the client take the aggressive position, whereas a “legalist” tax adviser (i.e., who believes it is her responsibility to help clients take only those positions that are more likely than not to be correct)99 will try to dissuade the client from taking that aggressive position. the advice from the lawyer may change the way the client reports, thereby affecting compliance and revenue collection.100 the lawyer’s approach matters even if you assume perfect enforcement (i.e., assuming that, if the client takes the more aggressive approach, the irs audits the client and wins). this is because, even if, after audit, the correct amount of tax is ultimately collected with interest, the aggressive reporting that was supported by the hired gun tax adviser required that the irs expend resources on the enforcement action. had the tax adviser’s guidance led the client to report in a more conservative/compliant way in the first instance (and assuming that the more conservative reporting approach reflected more indicia of honesty and/or compliance such that the irs opted not to audit the taxpayer), the irs could have used those enforcement resources elsewhere.101 and given that there are finite enforcement resources and given that the treasury estimates that each additional $1 available for enforcement would result in the collection of $4 of revenue, 102 more compliance by taxpayers puts fewer demands on those finite enforcement resources, enables more efficient deployment of those resources, and leads to more aggregate revenue collected.103 another example involves the tax shelter industry. tax professionals who were more willing to be aggressive played an important role in tax shelters. these tax lawyers wrote opinions and otherwise assisted in the planning and marketing of products that turned 96 see, e.g., dzienkowski & peroni, supra note 92, at 2733 (discussing the impact of tax advisers on taxpayers’ use of tax shelters in the self-assessment environment). 97 see victor fleischer, options backdating, tax shelters, and corporate culture, 26 va. tax rev. 1031, 1061 (2007); see also field, supra note 19, at 280-96 (illustrating how tax practitioners with different lawyering philosophies might handle the same matters in very different ways). 98 see infra part iii.b.2.a. 99 see infra part iii.b.2.c. 100 see, e.g., ken devos, an investigation into the ethical views and opinions of australian tax practitioners of different affiliations, 20 n.z. j. tax law & pol’y 169 (2014) (tax adviser’s advice has a strong influence on taxpayer behavior). 101 of course, not every audit is triggered based on red flags; some audits are random. even if the taxpayer is chosen for a random audit, the enforcement expenses will be lower if the taxpayer took a more conservative position because there would be less to fight about and because the audit would be likely to be resolved more quickly and with less time/effort from the irs. thus, even taking into account the possibility of a random audit (or an audit based on a red herring), a taxpayer who takes a more conservative position most likely requires fewer enforcement resources than a taxpayer who takes a more aggressive position. 102 irs, prepared remarks of commissioner koskinen before the aicpa (nov. 3, 2015) available at https://www.irs.gov/uac/prepared-remarks-of-commissioner-koskinen-before-the-aicpa [https://perma.cc/4sf8-bnl8]. 103 this example assumes that the aggressive position was not so aggressive so as to merit penalties. thus, no additional resources are recouped through penalty assessment. the resource analysis would be somewhat different if penalties are collected, but even when penalties are collected, they are often not sufficient to compensate the government for the cost of the enforcement action. 2017] fostering ethical professional identity in tax 233 out to be non-compliant.104 had these professionals conceived of their roles as tax lawyers differently (e.g., as including a stronger duty to the system), they might not have become involved with these matters. indeed, a large segment of the tax bar did not assist with tax shelters.105 perhaps this is just because their clients were not interested in shelters, but perhaps this is at least in part because of these lawyers’ professional identities—for example, as advisers who celebrate compliance more than they celebrate innovative tax minimization strategies.106 ii. tax morale & taxpayer rights not only does the tax lawyer’s approach to lawyering affect compliance and collections, but it also affects a taxpayer’s experience of the tax system. this, in turn, impacts the taxpayer’s belief in the integrity of the tax system, and the taxpayer’s compliance behavior going forward. the ethical professional identities of both the taxpayer’s lawyer and any government lawyer with whom the taxpayer interacts can affect tax morale and taxpayer rights. impact of the taxpayer’s lawyer the professional identity of the taxpayer’s lawyer is informed by the lawyer’s beliefs about her duty to the revenue system, and over the course of representing her client, the lawyer is likely to communicate those beliefs, in some way, to her client. this communication can occur if and when a lawyer counsels the client about whether to proceed with (and whether the lawyer will help the client proceed with) an aggressive tax strategy. this communication can occur in the way that the lawyer frames the taxes (e.g., as a civic duty from which the taxpayer gains or as an economic loss).107 and this communication can occur through conversations about issues such as the client’s obligation to pay taxes, the client’s obligation to disclose positions, the client’s ability to minimize taxes due, and how the client’s situation compares to others. the way in which the lawyer approaches these issues can affect the client’s perception of social norms of taxpaying.108 all of these client conversations, which can impact the client’s tax morale, are informed by and reveal the lawyer’s philosophy of lawyering. these communications are likely to be quite different depending on the lawyer’s lawyering philosophy. for example, the client of a lawyer who believes in advancing client autonomy and is quite comfortable helping clients take aggressive positions will receive very different messages than will the client of a lawyer who believes in only helping clients take actions and positions that are more likely than not to comply with the letter and spirit of the law. these messages could have very different impacts on the tax morale of the clients going forward. indeed, professor marjorie kornhauser has explained that “[s]trengthening the identification of tax professionals with the integrity of the tax system can improve their willingness to cooperate with the irs. . . . this would also signal to clients a tax compliance 104 tanina rostain & milton c. regan, jr., confidence games: lawyers, accountants, and the tax shelter industry (2014) (recounting how tax professionals enabled the tax shelter industry). 105 see, e.g., peter c. canellos, a tax practitioner's perspective on substance, form and business purpose in structuring business transactions and in tax shelters, 54 smu l. rev. 47, 55-57 (2001) (discussing the regular tax bar versus the tax shelter bar); rostain & regan, supra note 104, at 63-72. 106 cf. linda m. beale, tax advice before the return: the case for raising standards and denying evidentiary privileges, 25 va. tax rev. 583, 595-99 (2006) (describing practitioner cultures that celebrate innovative tax reduction strategies). 107 marjorie e. kornhauser, a tax morale approach to compliance: recommendations for the irs, 8 fla. tax rev. 599, 607-09 (2007). 108 id. at 612-13. 234 columbia journal of tax law [vol.8:215 norm that could have a ripple effect on their clients, who respect and identify with these professionals.”109 that is, the tax lawyer’s professional identity can affect the tax morale of the lawyer’s clients. impact of the government lawyer the ethical professional identities of government lawyers can also affect taxpayer morale and respect for taxpayer rights. this is because a government lawyer’s professional identity can impact how she approaches an enforcement action. for example, does she conceive of her role as one where she should represent the government as aggressively as possible so that she can collect as much revenue as possible from each particular taxpayer? does she view her role as one where she should only try to collect that amount of money that is clearly owed to the government? or does she conceive of her role as one where a key part of the purpose of the enforcement action is to help taxpayers understand what it means to comply with the law? there are many other possible approaches, but each could lead to potentially very different interactions with taxpayers, which could affect taxpayer rights. for example, a lawyer who believes that her role requires that she represent her client as aggressively as possible (thereby collecting the most amount of money possible on behalf of the government) might take an overly aggressive approach to an audit or to collections, which could impinge on taxpayer rights, including “the right to pay no more than the correct amount of tax” and the “right to a fair and just tax system”.110 further, the government lawyer’s approach to her role in the enforcement proceeding could influence whether the taxpayer perceives there to be “procedural fairness” and whether the taxpayer feels that she is “being treated with respect, politeness and dignity by tax authorities,” both of which are important factors in tax morale.111 “[i]ndividuals’ direct contacts with the tax authority greatly influence their perception of whether an authority is legitimate and procedurally fair”, which affects tax morale.112 a government lawyer’s philosophy of lawyering affects how she approaches her interactions with taxpayers. and although any audit is inherently adversarial, the government lawyer’s approach can make a difference in the experience that the taxpayer has throughout the audit.113 in addition, a government lawyer’s approach to her role can affect the tax morale of taxpayers beyond just the one(s) with whom the lawyer has direct contact. this is because “[w]hen there are accusations of bias or heavy-handed actions by the tax agency, these reinforce the already deep concerns the u.s. taxpayer bears toward taxes, such concerns going back to the nation’s founding.”114 although some accusations of bias or heavy-handedness are misplaced, other such accusations may be caused by government 109 id. at 614. 110 irs publication 1, https://www.irs.gov/pub/irs-pdf/p1.pdf [https://perma.cc/68ey-myfv]. 111 kornhauser, supra note 107, at 614. 112 id. at 615. 113 of course, the taxpayer’s experience of the government lawyer’s behavior may be filtered through the lens of the taxpayer’s lawyer. thus, the taxpayer’s tax morale may be more affected by how her lawyer explains what is likely to happen to her upon audit or by how her lawyer describes the behavior of the government lawyer, than by the government lawyer’s actual actions. but this still, at least in part, comes back to professional identity, albeit of the taxpayer’s lawyer and not of the government’s lawyer. 114 nta report 2014, supra note 93, at xii. 2017] fostering ethical professional identity in tax 235 lawyers who have overly aggressive concepts of their roles.115 thus, the actions of a particular government lawyer, which are necessarily informed by her professional identity, can have reverberating effects. iii. reputation of the tax profession the reputation of the tax law profession, as a whole, depends on the behavior of the individual lawyers within the industry, which is informed by each lawyer’s professional identity. lawyers, as a group, do not enjoy a particularly good ethical reputation or public image,116 and tax lawyers are no exception. commentators have lamented the decline in professionalism and ethics of the tax bar.117 tax shelters, while certainly not the only cause of this negative reputation, have also “provided grounds to distrust [tax] lawyers and the organizations in which they practice.”118 and media portrayals of tax lawyers reinforce the notion that tax professionals help clients cheat on their taxes.119 but the ethics of the profession is just an aggregate of the ethics of the individual practitioners.120 thus, the way in which each individual tax practitioner operationalizes the rules of ethics and standards of practice, particularly when dealing with difficult discretionary decisions, can matter both for the individual practitioner’s reputation and for the reputation of the profession. for example, professor rostain argued that a shift in how cpas perceived their professional duties contributed to the rise of the tax shelter industry, 121 which has diminished the tax profession’s reputation for ethics and trustworthiness. just as the behavior of individual practitioners can harm the reputation of the tax profession, so too can individual actions (including through the organizations for which they work) contribute to the rehabilitation of the profession’s reputation for ethics.122 “a significant factor in tax professional conduct involves the way [] highly educated individuals embrace a professional identity that ties their obligations to the integrity of the tax system.”123 having a strong sense of professional identity and understanding what is 115 the use of private debt collection services, which the irs will resume in spring of 2017, may exacerbate this problem. see david van den berg, irs will resume private debt collection next spring, 2016 tax notes today 187-7 (sept. 27, 2016). in part, this could be because the private collection agencies have collection as their core mission. this business identity likely diverges from the approach that the irs would embrace, and pcas may be more aggressive and less responsive to taxpayer concerns as a result. national taxpayer advocate, objectives report to congress 2017, at 85, available at http://taxpayeradvocate.irs.gov/media/default/documents/2017-jrc/area_of_focus_2.pdf [https://perma.cc/95jk-v33y]. 116 see, e.g., aba section on lit., public perceptions of lawyers consumer research findings (april 2002); deborah rhode, expanding the role of ethics in legal education and the legal profession (2000) available at https://www.scu.edu/ethics/focus-areas/more/resources/expanding-the-role-ofethics-in-legal-education/ [https://perma.cc/9l6m-ajgd]. 117 see, e.g., sheldon pollack, tax professionals behaving badly, 105 tax notes 201 (oct. 11, 2004); anthony c. infanti, eyes wide shut: surveying erosion in the professionalism of the tax bar, 22 va. tax rev. 589 (2003) (ably “providing concrete evidence of an erosion in the professionalism of the tax bar”); dzienkowski & peroni, supra note 92. 118 rostain & regan, supra note 104, at 6. 119 see, e.g., adam davidson et al., what’s the easiest way to cheat on your taxes? n.y. times magazine (apr. 3, 2012). 120 see rostain & regan, supra note 104, at 6-7. 121 tanina rostain, sheltering lawyers: the organized tax bar and the tax shelter industry, 23 yale j. on reg. 77, 89 (2006). 122 rostain & regan, supra note 104, at 7. 123 dzienkowski & peroni, supra note 92, at 2738. 236 columbia journal of tax law [vol.8:215 required to implement that professional identity can help practitioners navigate difficult discretionary decisions such as whether to assist with a potentially aggressive tax strategy. thus, by helping students to develop a strong sense of ethical professional identity, law schools help those students in their individual careers, and law schools can also help contribute to rebuilding the ethics and reputation of the profession. iv. tax-specific ethics rules & standards another reason why ethical professional identity is particularly important in tax practice is that tax lawyers are subject to tax-specific ethical rules and standards beyond the general rules of professional responsibility that apply to all lawyers. these additional rules include, among other things, the penalty provisions in the code124 and standards articulated in circular 230. the tax advising framework created by these tax-specific ethics rules and standards elevates the importance of each tax lawyer’s ethical professional identity. in part, this is because these rules explicitly allow tax lawyers to advise clients to take positions that the tax lawyer believes are likely to be incorrect under the law. generally, the lawyer is allowed to do this without risking a penalty as long as the position meets a minimum level of strength, such as “substantial authority” or “reasonable basis” (with disclosure).125 thus, it is important that a tax practitioner determine whether and to what extent she is willing to advise taxpayers on those types of aggressive positions. for example, perhaps she does not want to be the type of lawyer who advises on particularly aggressive approaches. she might decide that she will not do everything that the tax-specific ethics rules and standards allow her to do. perhaps she prefers to help only clients who are taking positions that she believes are more likely than not to succeed on the merits, and she will decline to represent clients who want to be more aggressive. if, on the other hand, she is willing to advise on matters that are less likely than not to succeed, she must determine how aggressive she is willing to be, and she must determine how she views the penalty provisions. for example, does she view the penalty provisions as outer boundaries beyond which she will not go? or does she view the penalty provisions as provisions that could trigger the imposition of an additional cost that would need to be taken into account in any cost/benefit analysis when a client is determining whether to proceed with a particular strategy? the lawyer’s determination of how she wants to proceed within the discretion afforded by the tax-specific ethics rules should be informed by the tax lawyer’s philosophy of lawyering—her understanding of who she is and wants to be as a tax lawyer. and so that she can increase the likelihood that she will stay true to her vision of lawyering, she must consider these issues outside of the context of immediate client pressure and business exigencies.126 that is, she should reflect upon and develop a strong sense of her ethical professional identity as a tax lawyer. 2. appreciating the range of potential professional identities for tax lawyers a tax lawyer can adopt one (or more) of several different philosophies of lawyering as the basis of her ethical professional identity. a brief summary of lawyering 124 see, e.g., irc §§6694, 6700, 6701, 6707a. 125 see, e.g., irc §6694; treasury dept. circular 230 §10.34. 126 field, supra note 19, at 297-98. 2017] fostering ethical professional identity in tax 237 philosophies, as relevant in the tax field, is as follows. this summary is based on very thoughtful and voluminous literature on lawyering and professionalism,127 and thus, the below admittedly sacrifices nuance for brevity.128 i. hired gun the “hired gun” tax lawyer takes a “client-centered approach” in which the lawyer “seeks to effectuate the client’s goals, whatever those goals are.”129 the lawyer will take whatever actions are necessary to advance those goals, as long as “the action does not clearly violate a rule or ethics or other law.”130 a hired gun approach does not necessarily mean that the lawyer will facilitate aggressive tax strategies (or, if working on behalf of the government, take a particularly aggressive approach to enforcement), but this approach does “reflect[] a willingness to empower even aggressive [clients].”131 ii. moralist alternatively, a lawyer’s sense of morality may be her guiding principle. under this approach, the “client defers to the lawyer, and the lawyer takes what he believes to be the right direction: the lawyer is concerned with others and is concerned that the client do the right thing. the lawyer acts as guru, making the moral choices for the client.”132 the lawyer will only help clients take positions that the lawyer believes are morally just. “in tax [practice], a philosophy of morality would likely reflect a strong ideological component. . . . of course, there is a continuum of ideologies, both with respect to specific issues and with respect to our taxing system in general, and a tax [practitioner’s] personal 127 see., e.g., geoffrey c. hazard, jr. et al., the law of lawyering (4th ed., 2016); the good lawyer: lawyers’ roles & lawyers’ ethics (david luban ed. 1983); deborah l. rhode, in the interests of justice: reforming the legal profession (2000); thomas l. shaffer & robert f. cochran, jr., lawyers, clients, and moral responsibility (2d ed., 2009); william h. simon, the practice of justice (1998); w. bradley wendel, lawyers and fidelity to law (2010); robert w. gordon, the independence of lawyers, 68 b.u. l. rev. 1, 26-30 (1988); david luban, the lysistratian prerogative: a response to stephen pepper, 11 am. b. found res. j. 637 (1986); thomas d. morgan, thinking about lawyers as counselors, 42 fla. l. rev. 439 (1990); daniel t. ostas, legal loopholes and underenforced laws: examining the ethical dimensions of corporate legal strategy, 46 am. bus. l.j. 487, 488 (2009);pepper, counseling, supra note 65; stephen l. pepper, the lawyer’s amoral ethical role: a defense, a problem, and some possibilities, 11 am. b. found. res. j. 613 (1986) [hereinafter, “pepper, amoral”]; gerald j. postema, moral responsibility in professional ethics, 55 n.y.u. l. rev. 63, 73 (1980); deborah l. rhode, ethical perspectives on legal practice, 37 stan. l. rev. 589 (1985); murray l. schwartz, the professionalism and accountability of lawyers, 66 cal. l. rev. 669 (1978); william h. simon, the ideology of advocacy: procedural justice and professional ethics, 1978 wis. l. rev. 29; william h. simon, ethical discretion in lawyering, 101 harv. l. rev. 1083 (1988) [hereinafter, “simon, ethical discretion”]; richard wasserstrom, lawyers as professionals: some moral issues, 5 hum. rts. 1 (1975); w. bradley wendel, civil obedience, 104 colum. l. rev. 363 (2004); margaret ann wilkinson et al., mentor, mercenary or melding: an empirical inquiry into the role of the lawyer, 28 loy. u. chi. l.j. 373 (1996). 128 for a more detailed discussion of these different lawyering philosophies and how they would be applied in the tax advising context, see field, supra note 19, at 280-96. 129 field, supra note 19, at 282; see also shaffer & cochran, supra note 127; pepper, amoral, supra note 127. 130 crystal, supra note 39, at 1241; see also, e.g., pepper, amoral, supra note 127, at 626 (“and if ‘the law’ is manipulable and without clear limits on client conduct, that aspect of the law should be available to the client.”); schwartz, supra note 127 (arguing that lawyers should act as “zealous partisans” on behalf of their clients). 131 field, supra note 19, at 282. 132 shaffer & cochran, supra note 127, at 3, 30-41; see also the good lawyer, supra note 127, at 118. 238 columbia journal of tax law [vol.8:215 morality could lead her to be conservative or aggressive, depending on the particular issue.”133 iii. legalist the “legalist” approach to tax lawyering demands that the lawyer “adopt the perspective of an unbiased, well-informed judge” and act in accordance with “what a goodfaith interpretation of the legal rule would require in an ideal world without problems of proof, political bias, or unequal wealth.” 134 “under this approach, a tax [practitioner] should only assist the client in taking actions that the tax [practitioner] believes are allowed under the best interpretation of the law and are more likely than not to succeed on the merits if challenged.”135 iv. “authority conception of the law” under the approach referred to as the “authority conception of the law,” the lawyer “treat[s] [the law] as an inherently valuable achievement of a pluralistic democracy.”136 the lawyer accepts and seeks to apply the law as society has agreed upon because this approach treats the law, as enacted, as embodying society’s collective moral judgment.137 in the tax context, “the authority conception of the law would arguably conceive of both the substantive tax law and the circular 230 regulations reflecting standards of practice to reflect the collective moral judgment of society. that is, tax law contains substantive rules and meta-rules about how to comply with the substantive rules.”138 as a result, she would view the “threshold at which the law imposes penalties . . . to be the outer limit of society’s collective moral judgment about what interpretations of the law are within the range of plausibility and are thus ethical.” 139 thus, the tax lawyer who adopts the authority conception of the law would be willing to help a client be more aggressive than the legalist tax lawyer, but she would not be willing to assist with any matter that is likely to result in penalties. v. friend/counselor “under the friend/counselor approach, the lawyer collaborates with the client and provides in-depth counseling in an effort to help the client make a well-considered decision, taking into account all relevant factors, including moral considerations.”140 the friend/counselor will encourage the client to take into account a wide variety of considerations, including third party interests, even if the client had not originally expressed interest in such matters; the friend/counselor “raises any other considerations 133 field, supra note 19, at 286. 134 ostas, supra note 127, at 516-18; simon, ethical discretion, supra note 127, at 1090, 1096-98 (the lawyer should advance internal legal merit and take responsibility for the “substantive validity of the decision”). 135 field, supra note 19, at 289 (citing wendel, supra note 127, at 396-98; and citing beale, supra note 106, at 593). 136 wendel, supra note 127, at 366. 137 id. at 382-85. 138 field, supra note 19, at 291 (citing wendel, supra note 127). 139 id. at 292 (citing michael c. durst, the tax lawyer’s professional responsibility, 39 u. fla. l. rev. 1027, 1059-64 (1987)). 140 field, supra note 19, at 293; see also morgan, supra note 127; wilkinson, supra note 127, at 376-78; shaffer & cochran, supra note 127, at 46-50. 2017] fostering ethical professional identity in tax 239 that the [practitioner] thinks ought to be part of the analysis.”141 in the tax context, this would include advising the client to take into account the client’s impact “on the fisc and on the overall taxing system (e.g., tax morale)” and to take into account “non-tax consequences, including things like adverse public relations or business reputation damage that could befall the client as a result of the tax choice.”142 ultimately, this approach reflects a collaborative process, in which the lawyer helps the client make a good decision, taking a wide variety of considerations into account. vi. self-interest a self-interested lawyer gives advice and takes actions “that minimize the risk that the lawyer would be subject to professional discipline, liability for malpractice, loss of fee or other economic loss, or damage to reputation.”143 in the tax context, the self-interested lawyer would be conservative or aggressive depending on the personal interests that she is trying to maximize. for example, she might approach advising to avoid being subjected to penalties or she might approach her role aggressively if she thinks that will maximize her revenue stream by attracting more business. “ultimately, this approach focuses on the lawyer’s level of risk aversion or risk seeking, and this puts the interests of the lawyer ahead of the interests of the client, which is problematic under the general ethics rules applicable to all lawyers.”144 vii. other approaches & combinations there are other possible approaches as well, and different approaches can be combined. for example: the friend/counselor approach, in particular, is easily combinable with the hired gun, legalist, and authority conception approaches. with any of these combinations, the lawyer would take the friend/counselor approach as a primary guideline and then use the other approach to provide the outer limit on how aggressive the lawyer is willing to be (and why). thus, if a client, after discussions with the friend/counselor wants to pursue a strategy for which there is only substantial authority, the lawyer who uses a combination of the friend/counselor and hired gun approaches would likely assist, but the lawyer who uses a combination of the friend/counselor and legalist approaches would not.145 viii. the “right” approach the foregoing lawyering philosophies reflect different possible professional identities for tax lawyers. there is no consensus in the literature about which approach is the one “right” approach for lawyers, in general or in tax in particular.146 each of the foregoing approaches (except the purely self-interested approach) reflects a reasonable guideline for ethical practice. until a consensus is reached regarding the “right” approach 141 field, supra note 19, at 293. 142 id. at 293-94. 143 crystal, supra note 39, at 1244-45, 1254. 144 field, supra note 19, at 295. 145 id. at 296. 146 see, e.g., shaffer & cochran, supra note 127 (presenting very different possible lawyering approaches); crystal, philosophy, supra note 44, at 76 (explaining that “[t]he discretionary nature of practice demands that lawyers adopt a philosophy of lawyering[, y]et the lack of professional consensus means that lawyers receive little guidance about how to go about developing such a philosophy.”). 240 columbia journal of tax law [vol.8:215 to ethical professional identity (something that is quite unlikely to occur), lawyering philosophy and professional identity remain deeply personal matters on which practitioners will understandably differ. iv. employing exercises to engage students in reflection & discussion about ethical professional identity in tax practice for a professor who is persuaded that (a) helping students develop their individual professional identities is a valuable endeavor, (b) doing so is of particular importance in tax law, and (c) the traditional tax classroom should be leveraged as part of this effort, the next question is, “how?” unfortunately, existing resources are limited.147 there are good materials for teaching tax ethics, but those materials generally focus on teaching the tax rules and standards of practice; to the extent that these materials implicate professional identity issues, the materials are designed for tax ethics courses and are generally not designed to be excerpted and used in other tax courses.148 further, textbooks for traditional substantive tax courses generally focus (understandably so) on teaching the substantive law rather than on helping students determine how to handle difficult discretionary decisions that may arise when using that substantive law to advise clients. thus, this section tries to fill the resource gap by describing exercises that i developed and used for my upper-division tax classes149 in an effort to help students answer the very personal questions of, “who am i as a member of [the tax] profession? . . . [w]hat do i want to be like in my professional role [as a tax lawyer]? and what place do ethicalsocial values have in my core sense of [tax] professional identity?”150 the pedagogical approach described in this section is certainly not the only approach to fostering ethical professional identity in the traditional tax classroom, and it may not necessarily be the “right” or “best” approach. but these exercises are grounded in the research about professional formation, draw on the lessons from learning theory,151 and have worked well with my students.152 thus, my modest goal is to contribute to our collective ability to help our tax students with the challenge of professional identity development. i encourage tax 147 but see, e.g., thomas j. purcell iii, integrating tax ethics into the first tax course, the tax adviser (nov. 1, 2013). 148 see supra note 17. 149 i have used a version of this exercise each of the past six times i have taught my upper-division tax seminar, and i have twice used a shortened approach to this exercise in my business (combined corporate and partnership) tax class. specifically, in my business tax course, i only run the first part of the exercise, and i use only a subset of the statements. see infra part v.a. (discussing how to shorten the exercise). in my business tax class, i engaged this discussion immediately after i ran one of the experiential practicesimulation exercises that i use in that class. see heather m. field, experiential learning in a lecture class: exposing students to the skill of giving useful tax advice, 9 pitt. tax rev. 43 (2012) (describing the experiential exercises that i use in my business tax course). the experiential exercise for the partnership portion of the course usually causes some students to make an ethical error (such as advising the client to take a position on the hope that the client will not get audited), which easily connects to a discussion of the ethics rules and of ethical professional identity. 150 carnegie report, supra note 2, at 135 (raising these questions in a general context). i place these questions into the tax-specific context. 151 see infra part iv.b.2.b. 152 see supra note 17 (providing additional context for the inspiration for this piece). 2017] fostering ethical professional identity in tax 241 professors to adapt the below as they believe will best advance their pedagogical goals and best fit with their courses. a practitioner who wants to invest in her own professional identity development can self-administer the exercises, engaging in self-reflection and discussion with colleagues, and the exercises can also be used as the basis for cle workshops. a. student learning outcomes as a result of these exercises, each student will be able to identify and justify her developing lawyering philosophy, and each student will be able to appreciate what it means to implement her lawyering philosophy in her career. more specifically, the first part of the exercise will enable students to (a) articulate a philosophy of tax lawyering that reflects both her personal values and her concept of the role she wants to fill as a tax lawyer, and (b) demonstrate an understanding of how her ethical professional identity balances her duty to clients with her duty to the system. the second part of the exercise will enable each student to develop an appreciation for what it means to operationalize her professional identity in tax practice, and will enable each student to develop strategies to overcome challenges that might test her ability to implement and stay true to her lawyering philosophy. as explained below, these objectives are accomplished through individual student reflection and professor-facilitated class discussion. as discussed later in part v, the student learning objectives can be furthered by supplementing the reflection and discussion with readings, reflection papers, and other exercises. b. exercise, part 1 – what is your tax lawyering philosophy & why? the first part of the exercise consists of homework to stimulate self-reflection about tax lawyering values and philosophies, followed by professor-facilitated class discussion. this section describes the homework, explains how i set up the class discussion, and provides an overview of the substantive discussion/analysis that the exercise is intended to produce. 1. homework to stimulate self-reflection the homework assigned in advance of the relevant class session provides students with a list of statements about tax lawyering values and approaches. each student is instructed to think carefully about the statements, reflect on who she is as an individual and as a member of the legal profession, determine the degree to which she agrees or disagrees with the statements, and prepare to explain the reasons behind her response (considering issues like which values are implicated by the statements and what impact the statements could have on a wide variety of stakeholders).153 as part of the reflection process, i encourage students to listen to their gut reaction to each statement and then think about both why they had that gut reaction and whether that gut reaction reflects who they really 153 neil hamilton & verna monson, legal education’s ethical challenge: empirical research on how most effectively to foster each student’s professional formation (professionalism), 9 u. st. thomas l.j. 325, 350-53 (2011) (part of ethical decision-making is identifying all potential approaches to a problem and considering all stakeholders who would be affected by each approach). 242 columbia journal of tax law [vol.8:215 want to be.154 the homework also asks students to describe their philosophy of tax lawyering. the statements are as follows:155 1. i would be willing to assist a client with a position that is more aggressive than a position that i would be willing to take on my own tax return (with respect to the same issue). 2. i would be willing to take a position on my own tax return that is more aggressive than a position with which i would be willing to assist a client (with respect to the same issue). 3. i believe that it is my responsibility to ensure that my clients comply with the tax law (at least with respect to matters on which i am advising them). 4. i believe that my duty as a tax practitioner is to my client, limited only by a duty to uphold the letter of the law.156 5. generally speaking, my loyalties are first to the tax system and then to the taxpayer.157 6. i believe in resolving ambiguities in the law in my client’s favor.158 7. i believe in only advising my client to take tax positions that i think are the “correct answers” under the law (i.e., that are more likely than not to be sustained on the merits if challenged). 8. i believe in only advising my client to take tax positions that i think are the “right things to do” (i.e., that reflect my sense of morality and justice). 9. i believe in advising my client to take any tax positions that are not frivolous. 10. i believe that tax is like golf. in golf, almost any rule infraction is cause for disqualification of the golfer. in tax, if i advise in a way that causes me to be (or causes my client to be) penalized by a tax authority (i.e., a serious infraction), i have failed to ethically discharge my responsibilities as a tax lawyer.159 the last part of the homework is open-ended, and it asks students to fill in the blank in a statement that says, “i would describe my tax lawyering philosophy as 154 cf. daniel kahneman, thinking fast & slow (2011). 155 there are several surveys that different researchers have used to assess the ethical perspectives of practitioners. several of the questions listed here are based, in part, on these instruments. 156 this statement is derived from rex l. marshall et al., the ethical environment of tax practitioners: western australian evidence, 17 j. bus. ethics 1265, 1272 (1998) (mean 5.17, just over “slightly agree” on a 7 point likert scale). 157 this statement is based on the test statements in (a) brian spilker et al., client advocacy in the global economy: a comparison of u.s. and indian tax professionals, available at http://ssrn.com/abstract=1908959 [https://perma.cc/sx67-v9b4], and (b) internal revenue service, survey of tax practitioners and advisors, 1986 (questions 10(a) and 10(b)), available at https://catalog.archives.gov/id/1135749 [https://perma.cc/wm55-nt5e]. 158 this statement is based on (a) spilker et al., supra note 155, (b) irs survey, supra note 155 (question 12(a), statement 14); and (c) devos, supra note 98 (question 10(a)). 159 the opposite framing of this question is, “i believe that tax is like basketball. in basketball, if you never get a foul called on you then you aren’t playing aggressively enough. in tax, i believe that if my clients and i don’t occasionally get penalized by the tax authorities then i haven’t been representing my clients aggressively enough.” more students may be familiar with basketball than with golf, and i used to use the basketball analogy as the statement for students to evaluate. however, the golf analogy matches up better with a lawyering philosophy, and i support (and hope my students will support) the golf analogy more than the basketball analogy. thus, framing the question using the golf analogy is more instructive for students in 2017] fostering ethical professional identity in tax 243 ______________________.” as background for this part of the task, i typically assign all or part of my article, aggressive tax planning & the ethical tax lawyer, which describes several different tax lawyering philosophies.160 for purposes of this last part of the homework, students are invited to select among the various lawyering philosophies described in the reading, to identify a combination of those options, or to articulate a different approach that resonates with them. note that this assignment assumes that students have sufficient background about the tax-specific ethics rules and standards reflected in the penalty provisions of the code and in circular 230. it is also helpful if students have taken or are concurrently taking the general course in professional responsibility. to the extent students lack either of these pieces of background, supplemental reading or lectures can be provided to fill the gap.161 when distributing the homework, it is important to explain to students the objective of the assignment and class session because these are quite different from most of their law studies, which focus on building substantive knowledge or legal skills. thus, when distributing the homework, i explain that the assignment and the next class are intended to enable them to begin to discover and to articulate their professional identity as tax lawyers—that is, who do they want to be as tax lawyers? i also articulate what i believe to be the exercise’s value to students. specifically, if a student develops a strong sense of her professional identity, she can (a) better understand what practice setting is likely to be a good fit for her (and better make the case to her desired employer as to why she would be a good hire); (b) increase the likelihood that she will behave ethically as a tax practitioner because she will have a framework to help her exercise good judgment when faced with difficult discretionary decisions in practice; and (c) improve her ability to discharge her duties to her clients while maintaining her own well-being and building a sustainable tax career. the last caveat that i give when assigning the homework is to remind students that there are generally not objectively “right” or “wrong” answers to the their professional identity development. thanks to nathan fox, a student who worked with me on an independent study project several years ago, for the ideas for both the golf and basketball statements. 160 field, supra note 19. the first few times i did a version of the exercise described herein, i gave only excerpts because i was still developing the project. that approach may actually be better than assigning the full article, which is, admittedly, on the long side. i also plan to write a shorter practitioner-oriented summary of the different tax lawyering philosophies and the arguments that might lead a practitioner to adopt one over another. once written, that might serve as a useful, shorter reading assignment to prepare students to engage in a conversation about lawyering philosophy. one could also assign the text from part iii.b.2 infra, which provides brief summaries of different lawyering philosophies. 161 see infra parts v.b.1. & v.d. 244 columbia journal of tax law [vol.8:215 questions that we will discuss and that what matters is what is “right” to each of them as individuals.162 2. class discussion to engage & challenge i. structuring the discussion at the beginning of the class session, i distribute a paper survey that asks the students (i) to rate the degree to which they agree or disagree with the statements and (ii) to briefly describe what they believe is their philosophy of tax lawyering.163 for purposes of rating the degree to which they agree or disagree with the statements, the survey provides a 6-point likert scale. using this scale achieves two goals. first, it demands that students take a position because the survey does not offer a “neutral” or “neither agree nor disagree” option. second, it differentiates students based on the intensity of the agreement or disagreement because students have the option to choose from “strongly agree”, “agree”, and “slightly agree” (or disagree). students are then divided, based on their viewpoints, into small groups for discussion. students can be divided based on their responses to any of the statements or based on their choice of lawyering philosophy. i generally look for issues that have the greatest divergence of views in order to stimulate the most robust discussion.164 an instructor can also divide students into groups using students’ responses to the question/statement that the professor believes is most important to students’ professional identity development. regardless of the specific questions used to divide the students, the key is to group students with similar perspectives together. each small group should discuss the reasons for their answers, and the students are advised that, after the small group discussions, the entire class will discuss. thus, students should be prepared to articulate the reasons for their approach, and students should anticipate counter-arguments and reasons that others might have different views. to help focus the small-group discussions, i typically highlight for the students the question(s) that i used for purposes of grouping the students. after the small group discussions, i facilitate a discussion among all of the students about the particular statement or choice of lawyering philosophy. this discussion asks students to articulate their views, to consider the points made by others, to reflect on the extent to which those points resonate with them, and to explain why points made by others do or do not resonate strongly. before embarking on the large group discussion, i reiterate the professional identity development goal of the exercise, the benefits of developing professional identity, and my belief that lawyering philosophy/professional identity is a 162 one exception may be statement #9. with respect to the other statements, some professors might believe that certain answers are better than others. i have my own answers to the questions posed, and i do have particular hopes about how the students will respond. but i believe that these questions are intended to facilitate a process of self-discovery, rather than being intended to produce students with particular perspectives with which i agree. see infra part v.g. (discussing the challenge of balancing students’ self-discovery with the professor’s desire to encourage students to adopt a particular approach to tax lawyering). 163 if there is a large class, the survey could be part of the homework, and it could be required to be submitted 24 hours before the start of the class session. this would enable the professor to group students by viewpoints before the class session. 164 this is one reason why i ask students to respond to all ten statements. with so many statements, there is quite likely to be at least a few on which student opinions diverge significantly. 2017] fostering ethical professional identity in tax 245 very personal matter for which there is no objectively “right” answer.165 i also remind students that, as they figure out who they want to be as lawyers, they should reflect on the discussion and that it is okay to be affected by, and adopt a different approach because of, the discussion. i typically allocate one hour to this discussion. however, this often means that i have to cut off robust discussion because of time. ii. key pedagogical techniques the structure of this reflection and discussion exercise employs a few key pedagogical techniques that contribute to learning and personal growth. first is individual reflection; reflection contributes to self-awareness, which is particularly important for professional formation.166 in particular, getting students to reflect on the values and people affected by decisions is an important part of ethical decision-making.167 thus, the professor should do whatever she can to encourage each student to take the exercise seriously and to invest in the personal process of asking tough and probing questions about herself. second is active engagement. in this exercise, the active engagement is the inclass small-group and large-group discussions.168 “when students actively engage . . . and reflect on that process, they develop personal understanding” and “those personal understandings, having been entirely generated within the student’s mind, become a part of who the students are.”169 active engagement through professor-facilitated peer-based discussions pushes students to “negotiate[e] meaning with their peers[, which] produces learning. . . . [this] expose[s] students to multiple perspectives and, as a result, students develop complex approaches and understandings.”170 the professor-facilitation of this process helps to ensure that students stay within ethical boundaries and that students consider various dimensions of the ethical decision-making process when discussing how to make discretionary decisions within those boundaries.171 given the importance of active engagement, professors should try to ensure that each student participates in the discussion. third is “fostering each student’s habit of actively seeking feedback, dialogue with others about the tough calls, and reflection.”172 professional identity development requires 165 even as students are encouraged to articulate opposing views, it is critical to ensure classroom feels safe and non-judgmental to “foster open but respectful dialogue.” gantt & madison, supra note 10, at 266. 166 fruehwald, supra note 4, at 1 (emphasizing the need for students working on professional identity development to reflect and “think hard about yourself”); gantt & madison, supra note 10, at 263; hamilton, roadmap, supra note 4, at 203-04 (citing neil w. hamilton, fostering professional formation (professionalism): lessons from the carnegie foundation’s five studies on educating professionals, 45 creighton l. rev. 763, 783-85 (2012) (discussing carnegie reports on pedagogy)). 167 gantt & madison, supra note 10, at 266-67; see also hamilton & monson, supra note 151, at 350-53. 168 writing assignments also provide valuable opportunities for active engagement. see infra part v.e.3 & 4. 169 michael hunter schwartz, a review of teaching and learning theory in building on best practices: transforming legal education in a changing world 67-72, at 69 (deborah maranville et al., eds.) (2015) (citing michael hunter schwartz, et al., teaching law by design (2009)). 170 id. 171 hamilton, roadmap, supra note 4, at 203-04 (emphasizing professor-facilitation). 172 id. 246 columbia journal of tax law [vol.8:215 an iterative process of reflection and refinement. although a class session can do much to foster the development of students’ ethical professional identities, it is useful to help students see that this is an issue to which they will need to return again and again. one small way to do that is to ask students, at the end of the discussion, how their thinking about their lawyering philosophy has changed as a result of the discussion.173 another way is to try to return to these concepts throughout the semester by reintegrating them into the class discussion later in the semester if and when the application of a substantive tax rule to a hypothetical situation is ambiguous. 3. substance of the discussion substantively, the goal of the exercise is to help students discover, build, and justify their professional identities as tax lawyers. each of the reflection statements push students to think about a particular aspect of their personal and lawyering values. specifically, statements 1 and 2 require students to understand their baseline assumptions about their personal risk appetite and that of their clients, statements 3-6 provide different models for balancing a lawyer’s competing duties, and statements 7-10 gauge a student’s willingness to be aggressive and, more broadly, help students frame their roles as tax lawyers. all of these statements are part of an individual’s lawyering philosophy. thus, the larger question about lawyering philosophy integrates the issues highlighted by the individual statements. ultimately, reflection on each of the statements should enable students to articulate their personal lawyering philosophy and reasons for adopting it. i. risk tolerance – clients vs. self statements 1 and 2 push students to reflect on how aggressively they approach their own personal taxes and to understand that their clients might have very different tolerances and appetites for risk. 174 whether a student is very conservative, relatively aggressive, or somewhere in between when preparing her own tax returns, she should acknowledge her personal bias about how to deal with uncertain tax positions, be able to explain why she takes that approach,175 and think about how she would deal with a client who has a very different approach to risk.176 for example, does a student who is very conservative in her own tax life feel comfortable representing a client who wants to be somewhat aggressive? if so, how does the student reconcile that difference? or does the student with little personal tolerance for tax risk prefer to represent clients with a similar approach to risk? if so, what does that mean for the type of tax law she ought to practice and for the practice setting in which she 173 see infra part v.e.4. 174 when i refer to “risk”, i mean the chance that an uncertain position might or might not be sustained on the merits if challenged. i am not referring to audit risk or the risk of non-detection. 175 interestingly, students often come to the same answer about their personal risk appetite, but for very different reasons. for example, both (i) a student who is highly risk averse and (ii) a student who views paying her rightful share of taxes (without efforts to minimize this burden or get around the law) as part of the collective social contract, are likely to be conservative on their own tax returns, but for very different reasons. and they are quite likely to differ as to whether they would be willing to assist more aggressive clients. indeed, they may be well-advised to take different career paths in order to enable each to practice in accordance with her values. see infra part iv.c.2.a. 176 this is an important part to giving useful tax advice. heather m. field, giving useful tax planning advice, 134 tax notes 1299 (mar. 5, 2012). 2017] fostering ethical professional identity in tax 247 would be most comfortable? and how will she handle (or avoid representing) more aggressive clients? a brief discussion about potential differences between a client’s and a lawyer’s personal risk tolerance can often be a relatively easy way to get students talking. ii. balancing competing duties statements 3 through 6 articulate a few ways that students might consider balancing their duties to clients and the tax system. these statements are intended to provoke thought and discussion about alternative ways to strike this balance and about the rationale for taking different approaches. all of the statements challenge students to grapple with the questions of (i) whether they, as future tax lawyers, owe any special duty to the revenue system, (ii) if so, why, and (iii) if so, how they should balance that duty with their duty to their clients. on one hand, students may argue that tax lawyers have a “duty to protect the revenue”177 and that their duty to their clients must be balanced against “the public’s interest in a sound tax system.”178 students taking this position may argue for this duty to the system (i) because the government lacks sufficient resources to enforce the tax laws comprehensively and, thus, cannot be assumed to be a reliable adversary;179 (ii) because revenue collection in the u.s. relies heavily on self-assessment, and taxpayer compliance in this self-assessment system relies heavily on advice provided by tax advisers;180 (iii) because tax lawyers, by helping to ensure compliance with the tax laws, “play an important role in helping to pay for a civilized society and in upholding the democratic social consensus embodied in the tax system;” 181 and (iv) because a well-functioning tax system is the source of the tax adviser’s livelihood,182 among other reasons. on the other hand, students may argue that tax lawyers do not have a special duty to the revenue system and that they only need to adhere to the rules of ethics and to “obey and uphold the law,” just like any other lawyers.183 these students might argue that any special duty to the tax system could also adversely affect their ability to be loyal to their clients.184 each of the statements provides a different vision of what that balance would entail. while statements 3 and 5 reflect a strong sense of duty to the system,185 statements 177 durst, supra note 139, at 1047-48. 178 linda galler, the tax lawyer’s duty to the system, 16 va. tax rev. 681, 688, 693 (1997); see also, e.g., beale, supra note 104, at 639. 179 see, e.g., crystal, teaching, supra note 37, at 1243 (citing william simon’s work) 180 see supra part iii.b.1. 181 dzienkowski & peroni, supra note 92, at 2722-23 182 see, e.g., william h. simon, after confidentiality: rethinking the professional responsibility of the business lawyer, 75 fordham l. rev. 1453 (2007). 183 camilla e. watson, tax lawyers, ethical obligations, and the duty to the system, 47 u. kan. l. rev. 847, 850 (1999). 184 see, e.g., id.; david j. moraine, loyalty divided: duties to clients and duties to others—the civil liability of tax attorneys made possible by the acceptance of a duty to the system, 63 tax law. 169 (2009). 185 statement 3 sometimes provokes a discussion about what it means to “comply” with the law. students understanding “comply” to mean “take the position that is more likely than not to be correct” balance competing duties differently than students who understand the term “comply” to mean “follow the rules about when disclosure of a position is required” (e.g., disclose if the position has only reasonable basis). in my experience, students generally understand “comply” in the former sense, as in “take the position that is the “right” answer under the law”, which reflects a reasonably strong sense of duty to the system. 248 columbia journal of tax law [vol.8:215 4 and 6 both reflect a strong client-advocacy approach186 regarding “gray area” issues (e.g., where the spirit and letter of the law conflict or where the law is ambiguous). there are certainly many other ways to frame the balance between duty to clients and duty to the system and/or to the rule of law, and students can develop their own articulation of how they, in principle, would balance competing duties. a different way to frame the question for students is to ask each student to complete the following exercise: “when dealing in grey areas of the tax laws, where on this scale do you think your loyalties are?”187 please make an “x” on the scale to indicate where you believe your loyalties are. “completely with the tax authorities completely with your clients” ultimately, whether students believe that they owe a special duty to the revenue system or whether they conclude that their duty to the “system,” as a tax lawyer, is no greater than any other lawyer’s duty to the rule of law, students should be able to articulate why they reach that conclusion. they should discuss what it means to discharge that duty (whether to the tax system in particular, or to the rule of law in general) while also discharging their duty to their client. iii. the bigger picture – who are you as a tax lawyer? statements 7-10 reflect different models of lawyering. these statements help students move from their analysis of how to balance competing duties (discussed above) to a broader articulation of their over-arching lawyering philosophy. statement 7 reflects a legalist approach, statement 8 reflects a moralist approach, statement 9 reflects a very aggressive hired gun approach,188 and statement 10 reflects an “authority conception of the law” approach.189 the last part of the homework provides students with a more open-ended opportunity to articulate their lawyering philosophies. regardless of which statement(s) (if any) resonate with students and regardless of how a student ultimately describes her approach to tax lawyering, students should be able to explain why they gravitate toward their particular approach. this explanation is likely to draw heavily on the factors relevant to the student’s assessment of how to balance the duty to clients and the duty to the system.190 this discussion is also likely to take into account the government/taxpayer resource imbalance, the operation of our self-assessment system, and the role of tax advisers in compliance.191 the discussion may also reflect students’ concerns about the reputation of the profession192 and how they will be perceived 186 see j. david mason & linda garrett levy, the use of the latent constructs method in behavioral accounting research: the measurement of client advocacy, 13 advances in tax. 123 (2001). 187 irs survey, supra note 157 (question 10(a), which gave a scale of 1-6). 188 notably, if taken to the extreme, this approach could subject both the client and the adviser to penalties, and could constitute a violation of the circular 230 rules. 189 depending on how one interprets the term “infraction”, this statement could alternatively be understood to reflect a legalist approach. 190 see infra part iv.b.3.b. 191 see infra part iii.b.1.a. 192 see infra part iii.b.1.c. 2017] fostering ethical professional identity in tax 249 (and how they will perceive themselves)193 as part of the tax profession. further, the discussion will be informed by students’ views about the fairness and complexity of the tax system, and about how well government uses the tax dollars collected, among other considerations. as part of this larger discussion, i encourage students to articulate and challenge their assumptions about the role they envision. for example, most students approach the analysis from the perspective of being a lawyer in private practice. how might a student’s approach change if the government was her client? in addition, many students assume that they are advising in a prospective planning context. how might a student’s approach change if the student was advising in a retrospective controversy context or in a pure compliance context where the facts have already occurred and the only question is about how to report them? and many students assume that their clients have bona fide business reasons for the matter with which they are seeking assistance. how might a student’s approach change if the client’s primary motivation for seeking advice is clearly tax reduction? ultimately, discussions of the various statements and of student’s lawyering philosophies all bleed together. this is by design because the specific statements about lawyering values and approaches are intended to help students discover who they are and want to be as lawyers. the hope is that, at the end of the discussion, students will be better able to articulate a vision for who they want to be as a tax lawyer, and students will be able to articulate why that guiding principle reflects their values and the values of the profession. c. exercise, part 2 – what does your professional identity mean for your tax career? once each student can articulate her tax lawyering philosophy, she should begin to think about what that professional identity means for her career. the second part of the exercise is intended to help students operationalize their vision of tax lawyering. again, this goal is achieved through a series of reflection questions and professor-facilitated discussions in which students should actively engage.194 1. setting up the discussion two key questions engage students on these issues. first, i ask what a student’s professional identity means for the type of job she wants to pursue. second, i ask students to envision ways in which their tax practice could test their ability to adhere to their professional identity, and i ask students how they would respond in those situations. i typically spend one hour on this discussion, and i engage in this discussion with students immediately after the discussion from the first part of the exercise. the two parts of the exercise could, however, be separated in time; they need not occur in the same 2hour class session. however, part 1 (in which students work to figure out their lawyering 193 i have had a number of students express to me concern about joining a profession that helps people reduce their taxes. some of these students came to law school because of their interest in social justice and public good, and they wonder whether they are “selling out” and whether it is possible to “still be a good person” if they do tax work. in response, i try to encourage students to consider carefully the sector and practice area in which they choose to work; perhaps students with these concerns should consider working for the government. see infra part iv.c.2.a. i also encourage students to try to articulate (and then implement) a statement of professional identity and purpose that resonates with them. for example, a student who cares about social justice seemed more able to accept her interest in a tax career when she viewed her potential role as one in which she “helps taxpayers to comply with the law and pay their fair share.” 194 see supra part iv.b.2.b. (discussing key pedagogical techniques). these pedagogical approaches are equally applicable to the second part of the exercise. 250 columbia journal of tax law [vol.8:215 philosophies and reasons for adopting their approach) must occur before part 2 of the exercise, which focuses on operationalizing the professional identity they developed in part 1. the second part of this exercise technically contains two distinct parts—using professional identity to find the “right” job and implementing professional identity in practice in the face of challenges. the remainder of this section elaborates on both in order to help each student explore what it would mean for her to practice in accordance with her ethical professional identity. 2. substance of the discussion i. using professional identity to find a job/employer that is a “good fit” the question presented to students in this part of the exercise is, “what does your professional identity mean for what type of career you would like to pursue? consider practice sector (e.g., private practice vs. government), practice area (e.g., business tax planning, estate tax planning, controversy), and particular employer within a sector and practice area.” students are, again, divided into small groups and asked to reflect upon and discuss the question within their groups. then, the students reconvene as a group and engage in a professor-led discussion. the professor might want to invite a representative from the career office to join the large-group discussion in order to provide resources and suggestions in response to student questions and comments. students should discuss the wide range of practice sectors and practice areas for tax lawyers. practice settings can include law firms (large, medium, and small), accounting firms (again ranging in size), government (federal, state, local), non-profits, in-house settings, academia, the judiciary, and more. 195 practice areas can include planning (business, estate, international, etc.), compliance, controversy (on behalf of taxpayers or on behalf of the government; at the administrative level or at the court level), policy/drafting (legislation or regulations), and more.196 some students might conclude that their lawyering philosophies and specific lawyering values lead them to particular options. for example, a student who feels an overriding sense of duty to the tax system might want to pursue a career in government. and a student who adopts a moralist approach might be particularly interested in a career in academia, with a non-profit or in-house with a business that shares her values, in government where she can help with the creation of legislation and regulations, or doing lobbying to bring about changes to the law. for many students, however, their lawyering philosophies will fit reasonably well with a variety of practice areas and practice settings. for these students, the harder question will be identifying which employers within particular practice settings/areas are “good fits” for the type of tax lawyer that the student wants to be. students should brainstorm about how a student might ascertain whether a particular employer is likely to share the student’s approach to tax lawyering. students are likely to come up with a wide variety of strategies, including (i) studying the employer’s 195 american bar association section of taxation, careers in tax law: perspectives on the tax profession and what it holds for you (john gamino et al., eds.) (2009). 196 id. 2017] fostering ethical professional identity in tax 251 website to learn about how the employer perceives its role;197 (ii) asking others in the industry (e.g., alumni mentors) about the reputation of the particular employer; and (iii) researching whether the employer (if a law firm or accounting firm) has been involved in tax shelter-related litigation. students are also likely to want to ask questions of the people who work at the employer. questions could include, among others, asking (i) about the lawyers’ lawyering philosophies; (ii) about the type of work they do and the type of clients they represent; (iii) if they ever faced an ethical dilemma with a client and how they handled it; (iv) if they ever advised on a matter with only substantial authority or reasonable basis; (v) about the procedures within the firm for making difficult decisions (e.g., about opinions); and (vi) about which traits and achievements are valued at the firm and lead to advancement. students may also discuss when in the process they should bring up these questions; many will argue for waiting until after they receive an offer. of course, one challenge for students is that the job market remains lackluster, so many students do not have the luxury of choosing among multiple job offers. thus, some students take whatever job offer they get. as a result, students may question whether there is real value to an inquiry about how a student’s lawyering philosophy matches up with that of a prospective employer. there are several reasons why i think professional identity still matters in the job search process even if jobs are scarce. hopefully, a professor-facilitated discussion about the utility of professional identity in the job search process can elicit these reasons, and others, from the students. first, if a student has an understanding of her lawyering philosophy by the beginning of her 2l or 3l job search process, she can try to target practice sectors and particular employers that she perceives might be good fits for her. second, professional identity can be relevant to the interview process because understanding a prospective employer’s approach to tax lawyering can help the student present herself in a way that would be most attractive to the employer (assuming, of course, that the employer’s approach to lawyering matches the student’s). by understanding an employer’s needs and values and by understanding the student’s own strengths and values, the student will be better able to articulate the “value proposition” that the student provides to the employer.198 further, the student can use the insights gleaned from her professional identity inquiry to help demonstrate that she has thought carefully about what it means to be an ethical practitioner, which is a competency valued by employers.199 third, even if the student does not have her choice of jobs, the student’s lawyering philosophy can help guide the student in building her career in the long-term. if she understands what her professional identity means for the type of job she wants to have in the long run, she can strategize about how to leverage the first opportunity (i.e., to learn as much as she can in the first job while navigating potential professional identity challenges that might arise) in order to make herself as marketable as possible for the position that she 197 for example, a website that says, “you’ll pay less taxes with us” reflects a very different lawyering philosophy than a website that says “we will help you get your taxes right”. websites are often not so explicit and dramatically different, but there is still information to be gleaned from how a firm presents itself. 198 hamilton, roadmap, supra note 4, at 54, 178-79 (important to be able to “effectively communicat[e one’s] value” to a prospective employer”). 199 see marjorie m. shultz & sheldon zedeck, predicting lawyer effectiveness: broadening the basis for law school admission decisions, 36 law & soc. inquiry 620 (2011) (including “integrity/honesty” and “self-development” as important competencies for lawyers). 252 columbia journal of tax law [vol.8:215 believes will be a better fit. further, she can use her understanding of her professional identity to help her identify, and position herself well for, those longer-term opportunities. fourth, even if a student accepts a job with an employer that approaches lawyering differently than the student does, understanding her future employer’s approach will give the student information about what her experience is likely to be with the particular employer. to the extent that the employer’s approach is quite different from the student’s, the student can invest more in developing strategies for coping with potential challenges to her ability to implement her lawyering philosophy. ii. imagining being tested & strategizing to successfully navigate ethical professional identity challenges the question presented to students in this part of the exercise is, “what situations in practice could test your ability to implement your approach to ethical tax lawyering, and what strategies might you employ in order to navigate those challenges?” more broadly, the issue for this part of the discussion is what a student should do if she discovers, after working for an employer, that her approach to lawyering and her employer’s approach to lawyering (or at least her supervisor’s approach to lawyering) are in conflict. this is important, not only for the lawyer’s own values and sense of well-being,200 but also because even junior lawyers must take personal responsibility for practicing in an ethical manner; they cannot abdicate responsibility for their own ethics by merely deferring to the judgment of supervisors.201 navigating ethical professional identity challenges in practice can be quite difficult. thus, “[l]aw teachers who want to help students develop ethical decision-making must also teach students how to develop the courage and motivation needed to follow through with their decisions.”202 indeed, in order to try to avoid ethical lapses, lawyers should “try to anticipate ethical dilemmas and to specifically plan and rehearse [their] responses ahead of time.”203 thus, this part of the exercise focuses on these objectives. explicit challenges to professional identity to explore these issues, students are, once more, divided into small groups and asked to try to envision a professional scenario that would test a junior lawyer’s ability to practice in accordance with her professional identity. students should also brainstorm about how they might respond to such a scenario. to the extent that students struggle to come up with scenarios that present professional identity challenges, the professor can provide sample hypothetical scenarios. appendix a provides some sample scenarios that can serve as the basis for discussion.204 students should be able to articulate why a particular scenario might test a lawyer’s ability to continue to practice in accordance with her professional identity. indeed, some 200 see supra part ii.b.2. 201 see hazard, supra note 127, at ch. 46 (responsibilities of a subordinate lawyer). 202 gantt & madison, supra note 10, at 268 (citing thomas lickona, educating for character 57-58 (1991)). 203 robbennolt & sternlight, supra note 45, at 1157-42. 204 alternatively, the professor could assign reading that relays the story of mike hammersley, who became a whistleblower in connection with tax shelter transactions. see tanina rostain, travails in tax, in legal ethics: law stories 108-117 (story of hammersley); see also infra part v.e.1. 2017] fostering ethical professional identity in tax 253 scenarios might challenge certain lawyers but not others depending on the individual lawyer’s approach to tax lawyering. once students identify the challenge, each student should refer back to her lawyering philosophy and to her reasons for wanting to pursue a career that adhered to that particular guiding principle. reflecting back on those values and on how her actions could affect all relevant stakeholders should give her guidance about what her professional identity would lead her to do in the particular scenario.205 this is the process of using one’s professional identity as a framework for principled decision-making.206 of course, the reality of practice is not so easy, so a key part of the ethical challenge is about how to honor that professional identity (and the values motivating the professional identity) in the particular employment setting, with all that the lawyer’s practice and personal realities entail. thus, students should discuss various strategies they might employ in the particular setting. although the scenarios may vary, the skills and strategies needed to respond effectively are often quite similar regardless of the specific scenario. students are generally predisposed to trying to find a way to navigate the scenario while staying employed and continuing with career advancement at the particular employer. this is completely understandable given the challenging job market, given the amount of student debt that most junior lawyers have, and given the family and other personal responsibilities that they may bear. thus, the focus of the conversation is generally on how to navigate the professional identity within the existing work environment. that said, changing jobs is always an option if a lawyer cannot make the existing situation work, and it is important for students to be willing and able to make the tough decision to leave an employer if necessary. even in that situation, most lawyers will want to try to keep their current jobs until they find a new job. this means that even a lawyer who is trying to change jobs will need to have strategies to navigate the current challenge in the existing work environment. when considering strategies that would enable the student to navigate the challenge within the work setting, students often suggest reaching out to mentors, both inside and outside of the employer, to get advice. when seeking advice from mentors who work for the same employer, students are generally more comfortable seeking advice from someone who is not involved in the particular matter. students also often suggest having an open conversation with their supervisor, but this requires quite a bit of tact in order to push back against a supervisor in a way that does not seem insubordinate. for example, students suggest asking open-ended questions to elicit more information, in an effort to try to understand the reasons behind the supervisor’s instruction. often, open communication, guided by good advice from mentors, will help resolve the issue. to the extent that challenges remain, a junior lawyer may reach out to her firm’s ethics committee (if there is one) to get advice. if the ethical challenge comes from a structural or institutional issue within the employer, the lawyer might try to bring about change within the employer. for example, she could have a conversation with her supervisor about the rationale behind the employer’s policies and procedures with her supervisor. she could also raise these questions with the ethics or opinion committees at the firm (if there are such committees), and she could try to get herself appointed to such committees. she could also volunteer to help prepare or lead a workshop for her 205 recall that a key part of ethical decision-making involves reflecting on values and on the impact the decision may have on others. gantt & madison, supra note 10, at 266-67. 206 field, supra note 19, at 297-99. 254 columbia journal of tax law [vol.8:215 department or group to discuss the procedures or approaches that concern her and that she hopes to help change.207 as to her day-to-day work, the lawyer could try to get more assignments from other supervisors whose lawyering approaches (or in other practice areas where the lawyers’ lawyering approaches) might more closely match hers. alternatively, she might try to get assigned to client work for clients who have goals that are more aligned with hers. for example, if she takes a legalist approach, she might try to do more work for clients that are seeking conservative advice. these strategies for navigating the day-to-day work might be effective for a while, but if there are several lawyers at the employer who continue to practice in a way that is not in accord with the lawyer’s lawyering philosophy, she should consider carefully whether she wants to remain at the employer for a significant part of her career. for example, she may be content to stay for a period of years, but she might not want to become a partner with these other lawyers. in that case, she should think carefully about the 5 to 10 year trajectory for her career. the foregoing are not the only strategies available to help a junior lawyer navigate a situation that challenges her sense of ethical professional identity. however, explicitly identifying several different strategies can help empower a student to become a lawyer who has the courage to try to make principled ethical decisions.208 subtler challenges to effective implementation of professional identity students should also be reminded that not all tests to one’s professional identity are as explicit as those in appendix a. sometimes, a lawyer’s professional identity or her ability to implement her professional identity can be adversely affected in small increments that can add up over time. these more subtle influences can include (a) norms from the lawyer’s employer, broader professional community, or social community; (b) client influences, including the mere desire to please a client and the lawyer’s possible increasing identification with the client over time; and (c) cognitive biases.209 these factors can lead to flawed decision-making, where lawyers inadvertently fail to live up to their own professional identities and where they “end[] up — perhaps unwittingly — crossing lines that they did not want to cross.”210 acknowledging these risks is an important first step in counter-acting them.211 thus, it can be useful to engage students in a discussion about strategies that can help them stay grounded in their professional identity over time despite these subtle influences. ideas might include (i) posting a clear statement of professional identity at 207 she need not explain that her concerns motivate her offer to assist with such matters. it is okay to merely explain that she cares about ethics or about understanding how the firm handles the particular policy/procedure, and that she wants to make a contribution to the firm on such matters. often, engaging the discussion within the group will elicit comments from others, possibly more senior and more well-established people, who share her same concerns. this is one technique for a junior person to jumpstart a potentially tricky conversation without putting herself on the line as the first objector. 208 in addition, it is possible that a lawyer will be unable to reconcile successfully her ethical professional identity with what her employer and client are asking her to do. she may choose to leave her job as a result. but she may also choose to stay and compromise her values, if even for a short time. that can be an incredibly painful and difficult experience, but it is better to make an intentional decision to compromise oneself, taking into account the costs and benefits of doing so, rather than inadvertently taking preventable actions that lead to regret. 209 id. at 310-17. 210 id. at 310. 211 robbennolt & sternlight, supra note 45, at 1156-57. 2017] fostering ethical professional identity in tax 255 one’s workstation as a regular reminder of one’s core tax lawyering values;212 (ii) being explicit with colleagues and clients about one’s lawyering philosophy; 213 (iii) always asking oneself what could go wrong or be wrong with the particular analysis/approach (i.e., as if the lawyer worked for the irs or as if the lawyer was a newspaper journalist);214 and (iv) becoming engaged with professional organizations whose lawyering approaches resonate with the lawyer (thereby reinforcing, rather than skewing, the lawyer’s sense of professional identity). further, the lawyer should be wary of red flags, including phrases such as “just this once,” “the [other] firm did it” and “it’s so close, maybe it doesn’t make a difference,” which could suggest she is compromising on her professional identity.215 in addition, students should be encouraged to reflect regularly on their professional identities and on how they have implemented their lawyering philosophy. regular reflection can help students stay true to their preferred lawyering approaches and can empower them make different decisions in the future in order to practice more closely in accordance with their values (that is, if they realize that they should have done something differently). moreover, the student “should also reflect on whether her experiences change her perspective on the type of tax adviser she wants to be. lawyering philosophies may evolve over time, so it is important to continue to reflect on whether a choice made in the past about guiding principles for practice continue to reflect the lawyer’s vision of the ethical tax planner she wants to be.”216 3. wrapping up the exercise ultimately, these exercises are intended to enable each student to (a) identify and justify her tax lawyering philosophy and (b) appreciate how her lawyering philosophy can help her to navigate ethical decision-making challenges throughout her career. of course, a two-hour workshop cannot result in a fully formed professional identity, nor can it ensure that students have comprehensively considered the full range of potential discretionary decision-making situations that might test her sense of ethical professional identity. but these exercises can give students a much greater appreciation for how they might approach a tax law career in a way that reflects their values. and these exercises can give each student a foundation in her own ethical professional identity, on which the student can reflect as her law school education and professional career progress. the hope is to give each student the tools to “build a defensible, morally-coherent tax [] career of which she can be proud.”217 v. tackling some challenges of the exercises incorporating the above exercises into my classrooms does present challenges, and i expect that others may have similar experiences. some challenges are primarily 212 id. at 1158-59. 213 field, supra note 19, at 318; see also, e.g., frederic g. corneel, guidelines to tax practice second, 43 tax law 297 (1990) (providing a sample statement of a firm’s guidelines to practice, which reflect a firm-level lawyering philosophy); robbennolt & sternlight, supra note 45, at 1168-71; linda k. trevino et al., behavioral ethics in organizations: a review, 32 j. mgmt. 951, 967 (2006). 214 see, e.g., gary klein, performing a project premortem, harv. bus. rev. (sept. 2007) available at https://hbr.org/2007/09/performing-a-project-premortem. 215 field, supra note 19, at 319-20 (“these red flags do not mean that a lawyer is doing (or about to do) something unethical, but each should heighten the lawyer’s awareness of the risk that she could be crossing the line into an action that violates her lawyering philosophy. by using these red flags as triggers to reconsider the analysis before proceeding, she may be able to avoid unintentional lapses in judgment.”). 216 id. at 320. 217 id. at 321. 256 columbia journal of tax law [vol.8:215 logistical: class time, class size, class level, and background regarding the tax ethics rules. other challenges go to the core of the learning objectives: deepening and enriching professional identity development, assessing student progress, and influencing student choices. this section will discuss these challenges and will provide variations and alternatives to help faculty members proceed with fostering ethical professional identity despite the challenges. a. managing class time instructional minutes in any course are precious, and the professional identity exercises consume class time. as described above, the exercises take approximately two full hours, with one hour devoted to each part of the exercise. the discussions could easily fill more time if available. allocating two hours to this activity does take time away from substantive instruction, but i believe that the tradeoff is worthwhile because ethical professional identity goes to the heart of who each student will be as a practitioner. this is about the principles that will guide how students use the substantive law over the course of their careers and about how students will operationalize their values in practice. i believe that developing this skill is worth sacrificing an hour or two of substantive coverage, but others may disagree. to minimize class time, a professor could run only the first part of the exercise in the class and either omit the second part or offer the second part as an optional extracurricular class meeting (e.g., as a brown-bag lunch after class one day). to minimize the use of class time even further, both parts of the exercise could be done outside of regular class time, possibly as optional enrichment in connection with the course. alternatively, the exercises could be separated from the traditional classes and run as a purely voluntary professional development workshop (or series of workshops), possibly offered in collaboration with the school’s career office. i think that this is less effective because, if the programming is optional, it has much narrower reach, and it likely attracts only those students who have already been thinking about their professional identities and not the students who are in most need of some guidance about professional identity. that said, some opportunity to develop ethical professional identity is better than none. b. adjusting for class size these exercises are clearly easier to administer in smaller class settings. i used these modules in classes of no more than 30 students, and i think that 10-20 is probably the ideal size. for professional formation, reflection and active engagement in discussion are critical to the learning process, and with a larger the class, it is harder to get all students to engage actively.218 there are several ways to deal with the challenge posed by larger classes. one is to have all students participate in the small group discussions, but ask only 1/3 of the students to participate in each of the three major “whole-class” discussions (identifying/justifying professional identity, using professional identity to find an employer that is a “good fit”, and implementing professional identity in the face of challenging ethical situations). then, each student will have participated in at least one of the three “whole-class” discussions, but each such “whole-class” discussion will be more 218 see also supra note 163 (suggesting that, for a large class, the students submit the survey in advance so that the professor can assign small-groups for discussion before class). 2017] fostering ethical professional identity in tax 257 manageable because it will only involve 1/3 of the class. a second approach is to recruit additional facilitators for the “whole class” discussion and to break the class up into multiple groups in order to run multiple simultaneous “large-group” (no longer “whole class”) discussions, each with its own facilitator. perhaps another tax faculty member, a student who participated in the exercise in a prior year, and/or an alum who practices tax could serve as a co-facilitator. a third approach is to add a requirement that each student write a reflection paper after the class session. with this approach, all students will actively engage with the learning process at least in written form, even if they did not each participate actively in the class discussion. a fourth approach is to divide the large class into 3-5 manageable sized groups and require each such group meet with the professor outside of class to engage in the discussions. this is much more time-intensive for the instructor, but it can provide a high quality personalized experience for each student. c. targeting the appropriate class level class level and interest in tax are also very important. students need meaningful tax background in order to engage effectively with these exercises, and these exercises are most likely to resonate with students who have at least considered the possibility of pursuing a career in tax law. thus, i have only used these exercises in upper-division advanced tax courses.219 i do not use any version of these exercises in tax 1.220 in particular, i have used these exercises most frequently in an advanced tax seminar consisting of 3ls who have taken multiple tax classes, but i have also employed versions of these exercises in my corporate and partnership tax classes. tax-interested students may take multiple advanced tax classes. thus, if professors are enthusiastic about incorporating professional identity exercises into tax classes, students may encounter the exercises multiple times. that can be useful because learning, particularly for any type of professional formation, is an iterative process.221 it would be helpful, however, to coordinate coverage so that student learning will be reinforced rather than repeated. for example, coordination could mean that certain reflection statements are used in one such class and other reflection statements are used in the other class. or perhaps the conversation focuses on different statements in the different courses. similarly, coordination could ensure that different challenging scenarios are discussed in the different courses. d. ensuring sufficient background regarding tax-related ethics rules/standards these exercises assume that students have a basic understanding of the tax-specific rules of ethics, including the basic penalty provisions and at least an introduction to circular 230. many students will have had some introduction to these rules in tax 1, which is another reason to run these exercises in advanced tax classes rather than in tax 1. this background is important for multiple reasons. first, students must be able to distinguish between things that are prohibited under the ethics rules from things that are 219 this implements a carnegie recommendation that professors use the 2l and 3l years more effectively to help students with practice-oriented learning and to enable students to “work with faculty and peers in serious, comprehensive reflection on their educational experience and their strategies for career and future professional growth.” carnegie summary, supra note 2, at 8-9. 220 it might be interesting, however, to integrate part of the first half of the exercise into a tax 1 class to get students thinking about what it might mean to translate the tax 1 content into actual practice. that said, the exercises discussed herein are designed primarily for upper-division tax classes. 221 thomson, supra note 4, at 323 (arguing this learning needs to be “regular and repeated”). 258 columbia journal of tax law [vol.8:215 allowed but that require difficult discretionary decisions (i.e., for which ethical professional identity would be helpful). second, students need this background in order to understand the different lawyering philosophies as relevant in tax practice (e.g., so that they appreciate the concept of “substantial authority” for understanding the “authority conception of law” approach). if students do not have the relevant background, the professor can add another 1-2 hour session on these topics before engaging with the professional identity exercises. in order to convey this background information without allocating another 1-2 hours of class time, the professor could prepare a flipped classroom-style video lecture that students would watch as homework in advance of the class session in which the professional identity exercises will occur. in order to make sure that students actually watch the video and internalize at least the basics of the rules, a short multiple-choice quiz could be administered via the class webpage at the end of the tax ethics video lecture. e. deepening & enriching professional identity development although the exercises described herein can contribute meaningfully to a students’ development of their ethical professional identities as tax lawyers, there is a limit to how much can be accomplished in two hours. if an instructor is willing to allocate more instructional and/or out-of-class time, there are many opportunities to deepen students’ learning and further build both their ethical professional identities and their abilities to abide by those identities in practice. this section describes a few such ideas. 1. additional readings students could be assigned additional reading in preparation for the first part of the exercise. this reading could include various articles that argue for different perspectives on lawyering in general222 or tax lawyering in particular.223 insights gleaned from these readings could meaningfully inform the discussions. alternatively, the additional reading assigned could constitute stories illustrating real ethical dilemmas faced by tax lawyers in practice.224 one great example is tanina rostain’s travails in tax, in legal ethics: law stories, which, as part of a larger discussion about tax shelters, tells the story of mike hammersley who faced difficult ethical challenges in practice and ultimately became a whistleblower.225 these stories could enrich both the discussion about discovering one’s ethical professional identity and the discussion about the challenges of adhering to one’s professional identity in the face of tremendous pressure. 2. involving practitioners practitioners could provide additional insight for students. a professor could invite selected practitioners to speak on a panel in class, and the professor could pose to the practitioners a series of questions intended to enable the practitioners to discuss their 222 see, e.g., supra note 127 (citing several possible resources); crystal, supra note 44. 223 george cooper’s article, the avoidance dynamic: a tale of tax planning, tax ethics, and tax reform, 80 colum. l. rev. 1553 (1980), provides a wonderful illustration about how different philosophies of lawyering can result in different approaches to the same situation. see also, e.g., corneel, supra note 213 (discussing guidelines for implementing the ethical rules); durst, supra note 139. 224 gantt & madison, supra note 10, at 268 (encouraging the use of stories to illustrate ethical decision-making in action). 225 rostain, supra note 204, at 108-117 (story of hammersley). alternatively, a professor could assign one or more chapters from rostain and regan’s book confidence games. rostain & regan, supra note 104. 2017] fostering ethical professional identity in tax 259 approaches to lawyering, the reasons for those approaches, and challenges to those approaches that they have experienced in practice. incorporating practitioners into the discussion of ethical professional identity can help make these issues more concrete for students and can help students see, even more clearly, the relevance of the inquiry to their future practices. of course, the professor would need to select the practitioners carefully in order to make sure that they represent a range of views, to make sure that they can clearly articulate the rationale for their perspectives, and to ensure that they have compelling and instructive stories to share. another approach would be to require that students interview one or two practitioners about their lawyering philosophies, about the rationale for their particular approaches, and about ethical challenges they have experienced in practice.226 students could be asked to write up a brief summary of the interviews. one benefit of this approach is that it is self-directed, meaning that students take responsibility for their own learning, which is a valuable skill in and of itself. again, incorporating practitioners could help students more clearly see the relevance of the exercise to their future practices. however, there are risks because students might interview practitioners whose approaches to lawyering dramatically diverge from the approaches that the professor hopes the students will adopt. and to the extent that the relevant practitioners have not spent much, if any, time thinking about how they approach lawyering, that could suggest to the students that the goal of the exercise lacks value. that said, if there is class discussion after the students engage in practitioner interviews, students can share their experiences, which are likely to be very diverse, and the professor can reframe the inquiry in light of the experiences that the students shared. 3. role-play various role-play situations could be created in order to push students to articulate what they have learned.227 for example, students could role-play scenarios in which the student is asked, in an interview, to describe the type of lawyer she is or to describe how she approaches her role as a lawyer. this interview could be with a prospective employer, with a client, or with the media (e.g., a bar journal writer doing a profile on the lawyer). the professor or another student can serve as the interviewer, asking follow-up questions where appropriate. in addition, students could role-play in a scenario that tests a lawyer’s ability to implement her ethical professional identity.228 the more realistic the professor can make the role-play scenario, the more powerful the experience is likely to be for the student and for any other students who are watching. an alternate approach would be to ask students to write a script for the particular scenario in which the junior lawyer interacts with the client or a senior lawyer.229 the students could be encouraged to make the scenario as 226 crystal, supra note 39, at 1248. 227 scott fruehwald recommends this approach. see fruehwald, supra note 4, at 27; fruehwald, supra note 4, at 226. 228 see, e.g., appendix a (providing a few such scenarios that could be turned into role-plays). 229 see daicoff, supra note 4, at 214-16. george cooper’s article reflects a version of this type of project, and this article could be updated for today’s tax laws and tax advising environment. cooper, supra note 223. 260 columbia journal of tax law [vol.8:215 difficult but as realistic as possible for the junior lawyer and to try to provide the junior lawyer with the words to respond. students could then perform the script for the class. because role-playing requires that students actually inhabit the role of the junior lawyer, this can be more realistic, challenging, and impactful than merely engaging in a discussion about how the junior lawyer could or should respond in a particular situation. 4. reflection essays in addition, students could be required to write reflection papers in response to one or more components of the exercise.230 these can be in response to particular prompts, or they can be open-ended, merely asking students to reflect on what the exercise meant to them. reflection essays can help ensure that each student is actively engaging with the material. further, if the exercise is broken up over time (e.g., part 1 is done in the first half of the semester and part 2 is done in the second half of the semester) and if students complete reflection essays for each part, the essays may also help the professor to see the extent to which the student is growing and deepening her learning over time. 5. a stand-alone course the exercise described herein, together with some of the foregoing ideas about additional strategies for deepening learning, could constitute a stand-alone course on ethical professional identity in tax. there are models for stand-alone professional identity formation courses,231 and a course could be created for students who are interested in careers in tax. alternatively, an institution could create a two-part course, where the first part of the course is for a large group of students and addresses professional identity issues generally, and where the second part of the course breaks students into smaller groups by practice-area interest (e.g., tax) in order to grapple with professional identity issues that might arise in the subject-specific context. the experience of a stand-alone professional identity course (whether focused entirely on the tax context or whether part general and part tax-focused) could be profound for the student participants. however, unless such a course is required by the institution, the course would reach only those students who choose to invest in developing their ethical professional identity, rather than reaching (albeit to a more limited extent) all of the students who enroll in a particular subject-matter course. f. assessing learning & engagement another challenge with professional identity development exercises is assessment.232 one tool for formative assessment is to assign a reflection paper after the class discussion. 233 as discussed above, the prompt could be based on either part of the exercise, or if the parts of the exercise are administered separately, a reflection paper could be assigned after each part. 234 for summative assessment, an exam or take-home paper assignment could include a short essay question that involves an ambiguous question of 230 see daicoff, supra note 4, at 211-13. 231 see, e.g., thomson, supra note 4, at 319-20 (describing two stand-alone courses on professional identity; fruehwald, supra note 4, at 16 (advocating for such a class); see also, e.g., gantt & madison, supra note 9 (a text for teaching such a class). 232 neil w. hamilton, assessing professionalism: measuring progress in the formation of an ethical professional identity, 5 u. st. thomas l.j 470 (2008) (discussing methods for measuring growth in ethical professional identity); monson & hamilton, supra note 4 (same). 233 see daicoff, supra note 4, at 211-13. 234 see supra part v.e.4. 2017] fostering ethical professional identity in tax 261 substantive law and asks the student to explain how two different lawyers, each with a different philosophy of lawyering (e.g., a hired gun and a legalist) would advise the client. from the perspective of assessing institutional program outcomes, data from the law student survey of student engagement (lssse) could provide insight about the extent students learn ethics in traditional classes and about how effective they believe that learning to be.235 lssse data could also provide insight into the extent to which students believe their law school experiences contributed to their integrity, commitment to the public good, capacity for moral reasoning, and ability to handle the stress of law practice.236 this data, if tracked over time for students who participate in particular courses where ethical professional identity development efforts are undertaken, can provide insight into the effectiveness of the exercises. these are a couple of possible ideas, but admittedly, assessing learning is a continuing challenge, particularly with a topic that is so personal. g. influencing student choices there is a tension between the desire to provide each student with the platform to discover her own professional identity and the desire to influence the way in which each student conceives of her role as a future tax lawyer. in particular, some professors may want to encourage students to internalize a greater sense of duty to the system.237 this is understandable because, among other reasons, many of the benefits of investing in the professional identity development of aspiring tax lawyers (e.g., compliance, tax morale, reputation of the profession) depend on those lawyers embracing ethical professional identities that provide an effective counterweight to overly aggressive clients.238 the exercise exerts this influence to some degree. first, the exercise raises for students the notion of a duty to the system and engages students in a conversation about whether such a thing exists and what it might entail. students may have had very little exposure to this concept before the exercise (and may get very little exposure to this notion from work experience in private practice). thus, the mere discussion of these issues raises their salience and potential impact. second, the exercise affirms for students that their personal values matter. the exercise presents the ideas that lawyers can decline representations that do not reflect who they want to be as lawyers and that lawyers can counsel clients in favor of taking more conservative positions even if clients initially express a desire to be aggressive. since many students come to law school with some desire to make the world a better place, this exercise articulates a path through which they can do so, even if they pursue a career in private tax practice. third, the reflection statements embody a slightly more conservative worldview,239 which means that the class 235 carole silver et al., unpacking the apprenticeship of professional identity and purpose: insights from the law school survey of student engagement, 17 j. legal writing inst. 373, 388-95 (2011). 236 id. at 400-04. 237 see, e.g., david m. schizer, enlisting the tax bar, 59 tax l. rev. 331, 370-71 (2006) (citing richard lavoie, deputizing the gunslingers: co-opting the tax bar into dissuading corporate tax shelters, 21 va. tax rev. 43 (2001), and explaining that “richard lavoie urges legal academics to use their bully pulpits, inculcating students with a sense of their professional duty to the system, so that they will be faithful to this imperative after they graduate.”). 238 see supra part iii.b.1. 239 for example, compare statement #10 (re: golf) with the alternate statement that i used to employ (re: basketball). see supra note 159. 262 columbia journal of tax law [vol.8:215 discussions will be anchored around these perspectives. the more aggressive the statements, the more they may lead to more aggressive outcomes for students. because this is a self-discovery exercise that is based on student reflection and engagement in discussion, i think it is important that the instructor not lecture about how she believes students should conceive of their roles. thus, i tend to take a relatively light hand when steering the conversation because i want students to be true to who they are rather than to the people they think i want them to be. moreover, i have seen the exercise in action, so i trust that the exercise as described above, coupled with inherent sense of right and wrong that most students have, is enough to help students make thoughtful and balanced determinations about how they want to approach their roles as tax lawyers. however, an instructor who wants to exert more influence over the conversation can certainly do so by modifying the reflection statements, by posing only certain statements for reflection, by focusing the conversation on certain reflection statements rather than others, and/or by asking questions that will steer the discussion toward notions of greater responsibility to the system.240 also, the more an instructor can get students to articulate arguments in favor of more conservative approaches to ethical professional identity, the more she creates social norms within the classroom and more powerful those arguments may be for the rest of the students. ultimately, it is challenging to strike the right balance between (a) fostering self-discovery and articulation of students’ personal values and (b) influencing students to become the type of tax lawyers that we believe the profession needs. vi. conclusion certainly, there is room for improving my exercises, and i continue to tweak my approach. despite the challenges, i have received positive feedback from students about the impact of these exercises on their careers and lives, and i strongly believe that this investment in my students’ ethical professional identities is worthwhile. i hope that, by sharing my arguments for using the traditional tax classroom as a vehicle for fostering professional identity and by explaining, step-by-step, how i have tried to do so, i can encourage others to build on what i have done, and i can help them invest in the professional identity development of their own students. in this way, i hope to make a small contribution, both to our students as they try to build ethical careers and to the tax profession as a whole. 240 further, if the instructor leverages alumni or other tax practitioners in the discussion, she can choose those individuals who embody the ethical professional identity that she wishes to foster among her students. see supra part v.e.2. (discussing options for incorporating practicing attorneys into the exercise). 2017] fostering ethical professional identity in tax 263 vii. appendix a: sample practice scenarios that might present professional identity challenges 1. you have been working with a partner on a matter for a client, and you and the partner disagree about the strength of the tax position that the client wants to take (i.e., likelihood of success on the merits if challenged). the partner thinks the position is more likely than not to succeed.241 you disagree because you think that the partner’s reading of the code is too technical and fails to take into account the intent of the law. you are also concerned about the potential application of the economic substance and step transaction doctrines. the partner acknowledges these concerns but still thinks she can opine at a “more likely than not” level. what do you do? why? a. [follow-up: the client told you that, if you cannot get to the more likely than not opinion, she will fire your firm and go to another firm that will render the opinion. this is a big client for the firm, and your bonus and ability to advance in the firm is based on (a) the number of hours you bill to ongoing clients and (b) the role that you play in retaining clients and keeping them happy.] 2. your firm has a practice group that comes up with (potentially aggressive) tax reduction strategies (e.g., investment structures, financial products) that can be offered to clients who are seeking to reduce their taxes. the head of that practice group has taken notice of your outstanding work as a junior tax associate, and she has asked you to join her practice group. if you join the practice group, the practice group’s work will consume the vast majority of your time. you have heard that members of the practice group tend to get very good bonuses. what do you do? why? 3. you have just been assigned to a new matter. in your first meeting with the partner, she explains to you that you will be helping to determine whether there is substantial authority or just a reasonable basis for a position that a client wants to take. the partner says that the firm and the client are hoping that you can help them reach a “substantial authority” opinion because the client definitely does not want to disclose. what do you do? why? 4. you just left a partner’s office after you and the partner had a conversation with the client about the tax treatment of a particular transaction that the client wants to undertake. you think that the partner glossed over the degree of legal uncertainty and the amount of downside risk (penalties, etc.) when counseling the client. 241 this and other hypotheticals (particularly 3-6) can be made more specific to a given course in which they are used. for example, in a partnership tax course, the hypothetical could be modified to say that the substantive issue is whether a transaction will be treated as a disguised sale under section 707. in a corporate tax course, the hypothetical could be modified to say that the substantive issue is whether a redemption will meet the test in section 302(b)(1) and be treated as a sale/exchange or whether the redemption will be treated as a section 301 distribution. 264 columbia journal of tax law [vol.8:215 assume that you and the partner agree that there is substantial authority for the position, but you think that it is a “very close call.” [if you prefer, you can assume that you and the partner agree that the position is more likely than not to succeed on the merits, but again, you think it is a “very close call.”] what do you do? why? 5. you are working on a matter in which your firm is about to render a tax opinion. the opinion is written and ready to go. as the junior associate, you are working on the “backup memo” (i.e., the memo to the file documenting the legal basis for the firm’s opinion), and you discover a new fact that you think alters the analysis and undermines the opinion’s strength. if the firm does not render the opinion at the agreed-upon level of certainty, the deal will not close, and the client and the firm will both lose a lot of money. what do you do? why? a. [follow-up: assume you raised the new fact with the partner, and she told you, “i don’t think that is particularly probative. minimize it in the backup memo.”] 6. you are working on a matter that requires that your firm render a tax opinion, and your firm has a policy that all tax opinions must be reviewed by a second partner who has not otherwise been involved in the matter. the partner you with whom you are working has tasked you with getting the second partner review for the opinion on which you have been working. she told you to get partner x’s signoff on the opinion because “he’ll agree”, and she told you, “definitely don’t take this to partner y because he’ll put up a big stink about the opinion, which will just rack up more fees and potentially blow up the transaction.” assume that you and the partner with whom you have been working agree that it is a very close call as to whether the opinion can be rendered at the desired level of certainty, but you both believe you “can get there”. what do you do? why? 2017] fostering ethical professional identity in tax 265 7. you work at a small tax planning firm, and individual is your firm’s biggest client. you help represent individual in connection with the tax planning for his sole proprietorship business; you/your firm do/does not represent him with respect to his non-business affairs. you have developed a good relationship with individual, but you know that individual holds grudges against people that “have wronged him.” last night at a dinner that you and individual both attended, individual (after a few glasses of wine) bragged to you that he recently won $50,000 at an underground poker game, and with a wink, he said, “and uncle sam will never know!” you know that the $50,000 is taxable to him. what do you say, and why? a. [follow up: what if, later that evening, he asks you what you think the chances are that he will get audited for this year? what do you say, and why? would it make a difference if he asked about his audit risk at a subsequent business meeting when you were discussing the business’s tax planning?] 8. you work for the irs, and you just took over handling a controversy with a taxpayer. two sources of deficiencies were raised by the person who previously handled the matter.242 you believe that the government’s case with respect to issue #1 is very strong, but that your case on issue #2 is quite weak. specifically, on issue #2, you think the government’s argument is not frivolous, but you think that it is pretty clear that the taxpayer’s position should prevail. you think that, if you proceed with both issues, taxpayer is likely to agree to pay the deficiency on issue #1 if you drop issue #2, which you would be willing to do. but if you proceed with only issue #1, you think that the taxpayer will continue to fight the proposed deficiency. what do you do, and why? 242 to add context, considering the following additional facts, which would be most relevant in a corporate tax or taxation of financial instruments course. “the first issue alleges that the taxpayer, a corporation, improperly took a current deduction for an expenditure that should have been capitalized. the second issue alleges that the taxpayer’s interest deductions on a particular instrument were improper because the instrument is properly characterized as equity rather than debt.” as with the other hypotheticals, the factual context for the scenario can be tailored to whatever aspects of tax are taught in the particular course. the earned income tax credit, low-income workers, and the legal aid community jonathan p. schneller * adam s. chilton ** joshua l. boehm *** abstract the earned income tax credit (“eitc”) is the largest u.s. welfare program, with twenty-four million low-income americans receiving $60 billion of disbursals in 2009. through the eitc, working americans with little or no tax liability can receive up to nearly $6,000 in refundable tax credits each year. over the past two decades, policymakers have increasingly favored the eitc over direct-transfer welfare programs, citing its lower administrative expense (as recipients “self-certify” by filing taxes) and incentives for recipients to work. despite its political appeal, the eitc suffers deep structural flaws. largely because eitc claimants have little guidance in navigating the difficult filing process, they are subject to high rates of irs audits and rescission of benefits with penalties and interest. this proliferation of eitc-related controversies has created an immense need for legal assistance, yet low-income tax law largely remains a peripheral concern within the legal aid community. in this article, we suggest a comprehensive and achievable set of reforms that the irs and legal services organizations can enact to improve the eitc’s efficacy and fairness. we first describe how the complexity of eitc eligibility criteria creates a tremendous burden for low-income americans, as they frequently lack advice in tax filing and cannot afford legal representation in the event of a controversy with the irs. we then outline measures that the irs should implement to make the eitc more accessible and understandable to those qualifying for the credit, reducing the chance of an audit and loss of benefits. in particular, we focus on improving the tax filing process, making eitc audits more manageable for recipients, instituting less adversarial procedures for eitc-related tax court proceedings, and changing certain organizational structures within the irs. finally, we propose several practical ways that the legal aid community can enhance its support of eitc recipients confronting an irs audit or tax court action. most importantly, we argue that eitc assistance warrants greater congressional funding and higher strategic and budgetary priority within legal aid organizations, given that the eitc is now far larger than the direct-transfer welfare programs on which legal aid lawyers have traditionally focused. * law clerk, justice elena kagan, u.s. supreme court. ** ph.d. candidate, harvard university department of government. *** j.d., harvard law school, 2012. the authors would like to thank senior lecturer jeanne charn of harvard law school, dean martha minow of harvard law school, tamara borland, director of the low income tax clinic at iowa legal aid, and james j. sandman, president of the legal services corporation, for their helpful comments and suggestions. 2012] the eitc, low-income workers, & the legal aid community 177 i. introduction .................................................................................................... 178 ii. administering welfare through the tax system: background to the eitc .......................................................................................................... 179 a. history and structure ......................................................................................... 179 b. self-certification: costs and benefits ............................................................... 181 c. a legal labyrinth: navigating the eitc audit and appeal processes ............ 186 1. high error and audit rate .......................................................................... 187 2. irs audit process ........................................................................................ 187 3. importance of representation ..................................................................... 191 iii. irs reforms to protect the rights of america’s working poor .................................................................................................................................. 194 a. evaluating and reforming the structure of the irs .......................................... 195 b. changing the eligibility structure of the earned income tax credit ................ 197 c. changing the application for the earned income tax credit ........................... 198 d. reforming the audit process used with earned income tax credit claimants 200 e. moving toward a non-adversarial alternative to tax court ........................ 202 iv. the need for increased involvement from congress and the legal aid community ................................................................................... 203 a. limited assistance programs and the eitc ...................................................... 204 b. expanding and improving low income tax clinics ......................................... 208 c. deepening legal aid programs’ involvement with tax matters ...................... 209 d. the civil gideon movement and the eitc ....................................................... 211 v. conclusion ........................................................................................................ 214 178 columbia journal of tax law [vol.3:177 i. introduction in 1997, college of william and mary government professor christopher howard published the hidden welfare state. 1 howard’s book described a phenomenon of which many savvy observers were already aware: a prominent and growing proportion of american social policy was being implemented through the tax code, using tax expenditures, via mechanisms such as refundable tax credits. 2 programs such as the earned income tax credit, the targeted jobs tax credit, and the home interest mortgage deduction all served social welfare objectives, but did so stealthily, through tax provisions rather than cumbersome eligibility regimes associated with traditional welfare. in this article, we explore one of the programs that howard’s study emphasized: the earned income tax credit. the eitc has, since the mid-1990s, been a prominent component of the american social welfare landscape. as we detail in part ii below, annual eitc expenditures dwarf the funds disbursed through traditional welfare programs such as the temporary assistance to needy families (“tanf”) program. and, as a number of commentators have noted, the use of the tax system to administer the eitc has led to a number of pathologies not associated with traditional welfare. writing in 1995, professor anne alstott noted that “[t]he tax system's limitations render the eitc inherently inaccurate, unresponsive, and vulnerable to fraud and error in ways that traditional welfare programs are not.” 3 more recent commentators have focused on ways in which tax administration produces onerous and arguably unfair burdens for the lowincome workers seeking to claim the benefits to which they are entitled under the program. 4 our article chronicles the burdens that the eitc imposes upon low-income claimants and examines the implications of these burdens. in particular, we focus on how the legal aid community should respond to the eitc’s status as the nation’s preeminent social welfare program. two recognitions are crucial to our project. the first is that the eitc’s tax-based regime is uniquely burdensome for low-income taxpayers. the program uses self-certification via the filing of a tax return, making taxpayers responsible for determining and verifying their eligibility. having provided no ex ante assistance in determining eligibility, the program then employs a harsh, and arguably punitive, array of auditing and adjudicative techniques that challenge taxpayer eligibility ex post. taxpayers unable to prove their eligibility to the irs in a variety of correspondenceintensive and often adversarial processes are called upon to repay the benefit they received, with interest and penalties. 5 this system is uniquely challenging to low-income taxpayers who may lack the skills required to navigate the tax return and audit processes. the second key recognition upon which we build is the eitc’s centrality in the american social welfare landscape. we argue that the legal aid community has allowed the “hidden welfare state” to remain hidden, moving too slowly to develop a robust 1 christopher howard, the hidden welfare state (1997). 2 id. at 3 (noting that tax expenditures devoted to social welfare projects cost approximately $400 billion in 1995). 3 anne l. alstott, the earned income tax credit and the limitations of tax-based welfare reform, 108 harv. l. rev. 533, 535 (1995). 4 see, e.g., leslie book, the irs’s eitc compliance regime: taxpayers caught in the net, 81 or. l. rev. 351 (2002); george k. yin et al., improving the delivery of benefits to the working poor: proposals to reform the earned income tax credit program, 11 am. j. tax pol. 225 (1994). 5 see bryan t. camp, the failure of adversarial process in the administrative state, 84 ind. l.j. 57, 105 (2009). 2012] the eitc, low-income workers, & the legal aid community 179 capacity to assist low-income taxpayers in navigating the vagaries of the eitc. while the legal aid community has not wholly neglected the eitc—programs such as the legal aid society of orange county’s development of the i-can! software are laudable initiatives 6 —it has not accorded the eitc the degree of attention one would expect for the nation’s largest welfare program. the result is a status quo in which low-income workers must navigate the complexities of the nation’s largest welfare program with a bare minimum of legal assistance. in the pages that follow, we argue both that the eitc’s administration should be reformed to make it better suited to the needs of its low-income clientele, and that the legal aid community should respond to the centrality of the eitc in american welfare policy by devoting greater resources and energy to assisting eitc claimants. we proceed in four parts. part ii describes the rise of the eitc and details the various aspects of tax administration that render the eitc difficult for low-income taxpayers. part iii takes an internal approach to the problem, discussing and analyzing various structural reforms to the program and irs administration that would serve to soften the program’s harsh edges. part iv takes an external approach, discussing steps that congress and the legal aid community can and should take in response to the eitc’s ever-growing prominence. part v concludes. ii. administering welfare through the tax system: background to the eitc in this part, we discuss the difficulties that the eitc poses for low-income individuals who seek the credit. in particular, we focus on how the program’s tax-based administration presents unique legal challenges for low-income individuals that are different from those associated with traditional welfare. to do so, this part proceeds in three sections. first, we provide background to the eitc, focusing on the program’s history and structure. we emphasize the unique choice to use applicant self-certification via the submission of a tax return as the means for determining each claimant’s eligibility for the credit. second, we discuss the costs and benefits of the eitc’s reliance on selfcertification. we focus in particular on how self-certification imposes significant burdens on claimants, who are required to certify their compliance with complex eligibility guidelines and given minimal assistance in doing so. third, we discuss the irs’s audit, appeal, and tax court processes with a focus on how ill-fitted these processes are to the skills and life experiences of unrepresented, low-income eitc recipients. the account we provide in this section illustrates that the eitc’s use of tax administration—both through reliance on self-certification to make ex ante eligibility determinations and through reliance on audits and tax court to make ex post judgments of taxpayer compliance—imposes legal obstacles on low-income workers that merit the attention of the legal aid community. a. history and structure the eitc was enacted in 1975 as a relatively modest wage-subsidy and payrolltax offset for low-income workers, implemented largely to provide a degree of economic relief in the face of a significant recession. 7 the credit was not initially viewed as a major piece of social policy. it was implemented as a temporary measure and renewed 6 see infra part iv.a. 7 see dennis j. ventry, jr., the collision of tax and welfare politics: the political history of the earned income tax credit, in making work pay: the earned income tax credit and its impact on america’s families 15, 25 (bruce d. meyer & douglas holtz-eakin, eds. 2001). 180 columbia journal of tax law [vol.3:177 annually for several years in the mid-1970s before policymakers began to recognize its potential as a long-term fixture on the american social policy landscape. 8 the credit had a number of features that made it politically and ideologically attractive to policymakers in an era when the orthodoxies of the welfare state were increasingly questioned by commentators such as nyu professor of politics and public policy lawrence mead. 9 most notable is the fact that, unlike the cash disbursements of traditional welfare, the eitc could be framed as tax relief that provided work incentives to families. 10 that is, the eitc was successful in large part because politicians viewed it as “a work-oriented alternative to existing welfare programs.” 11 the welfare reform movement that began in the late 1970s fundamentally transformed expectations of the eitc. as dennis ventry explains: “the eitc would emerge from the welfare reform discussions at the end of the 1970s forever transformed. it would no longer constitute simply a modest work subsidy; rather it would represent an antipoverty device that could potentially raise the income of all working americans above the poverty line.” 12 the eitc gained increasing political salience, benefiting from a major expansion in 1986. 13 in 1996, when the personal responsibility and work reconciliation act replaced the aid to families with dependent children (“afdc”) with short-term state-administered welfare under the tanf program, the eitc took on an increasingly prominent role, emerging as the largest anti-poverty program in the united states. 14 since 1994, federal spending on the eitc has been consistently higher than spending on traditional federal welfare programs such as afdc and its successor, tanf. by fiscal year 2009, eitc benefits paid out to low income tax filers accounted for over $60 billion in federal spending, compared to under $25 billion in federal spending on tanf. 15 to illustrate the long-term magnitude of this shift, eitc disbursals in 1980 were approximately $5 billion, whereas afdc outlays were approximately $18 billion. however, the winding path by which the eitc emerged as a major social welfare program has possibly obscured the program’s true significance from poverty lawyers. these lawyers have historically viewed welfare litigation as a significant aspect of their mission, but they have not widely adjusted their focus in recognition of the fact that a significant proportion of this nation’s welfare system is now administered through the tax code. and this failure to acknowledge the importance of the tax code to low-income workers is a mistake: as the following sub-sections illustrate, the eitc requires millions 8 id. at 25-26. 9 see lawrence m. mead, the new politics of poverty: the nonworking poor in america (1993) (criticizing american welfare state as giving rise to undeserving class of nonworking poor); lawrence m. mead, beyond entitlement: the social obligations of citizenship (1985) (arguing that welfare benefits should be conditioned on willingness to work). see generally brendon o’connor, a political history of the american welfare system 93-238 (2004) (describing conservative attacks on the liberal welfare state and the emergence of a “conservative” welfare system). 10 see ventry, supra note 7, at 26 (discussing 1979 joint committee on taxation report on the eitc). 11 dennis j. ventry jr., welfare by any other name: tax transfers and the eitc, 56 am. u. l. rev. 1261, 1266 (2007). 12 ventry, supra note 7, at 26. 13 see id. at 32-34. 14 id. at 34. 15 urban inst. & brookings inst., tax facts, tax policy center, http://www.taxpolicycenter.org/taxfacts/displayafact.cfm?docid=266 (last visited july 12, 2011). 2012] the eitc, low-income workers, & the legal aid community 181 of low-income americans to engage the tax system each year, imposing significant burdens on them in the form of a daunting application process and an often-punitive, exceedingly complex auditing regime. the challenges of applying for the eitc are a product of the fact that the credit is processed through the federal income tax system. 16 because the eitc operates as a refundable tax credit, in order to claim it, taxpayers file annual tax returns (even if they have no tax liability) and, in the process, use the credit to reduce their liability below zero. 17 the amount that is claimed below zero is then paid to the taxpayer in the form of a tax refund. 18 in this system, potential beneficiaries are responsible for both initially declaring their eligibility for the benefit and determining the size of the benefit to which they are entitled. taxpayers claiming refundable tax credits, like the eitc, typically have their returns subjected to routine, mechanical scrutiny for mathematical error. the eitc’s reliance on applicant self-certification is arguably the program’s defining administrative feature, and is in stark contrast to the universal pre-certification regimes employed by traditional welfare programs. 19 the eitc’s method for calculating the refund claimed by an individual filer can be quite complex. 20 in general, the potential size of the eitc that can be claimed by an individual filer varies based on the taxpayer’s income and the number of “qualifying children” that a claimant has. 21 specifically, the credit is calculated by multiplying the filer’s earned income by a credit percentage tied to “qualifying children” who are claimed as dependents by the filer. 22 the credit then eventually flattens and phases out after certain earning thresholds have been reached. 23 these general requirements are subject to exceptions and qualifications based on the nature of the income, the relationship with the children claimed, and the claimant’s marital and employment statuses. 24 b. self-certification: costs and benefits in this subpart we address both the advantages and disadvantages of employing the tax code to administer the eitc. there are four benefits that eitc advocates often claim as a result of this administrative form: first, high participation rates among eligible 16 see alstott, supra note 3, at 535 (noting that “because the eitc is a tax-based transfer program, it faces significant institutional constraints that are not present in traditional welfare programs.”) (emphasis added). 17 see lily l. batchelder et al., reforming tax incentives into uniform refundable tax credits, in policy brief 3-4 (brookings inst., ser. no. 156, aug. 2006) (arguing that more than one-third of american households do not have income tax liability in any given year). 18 see id. (arguing that the optimal delivery mechanism for all socially valued incentives embedded in the tax code is the uniform refundable tax credit). 19 see ventry, supra note 11, at 1274-75; leslie book, preventing the hybrid from backfiring: delivery of benefits to the working poor through the tax system, 2006 wisc. l. rev. 1103, 1129 (noting that eitc recipients “are not made to go through the eligibility and verification gauntlet in the same manner as other benefits’ recipients.”); lawrence zelenak, tax or welfare? the administration of the earned income tax credit, 52 ucla l. rev. 1867, 1869 (2005) (the eitc’s self-certification “is in sharp contrast with the universal practice in welfare programs, such as food stamps and temporary assistance for needy families (tanf), in which the claimant must establish her eligibility to the satisfaction of a welfare bureaucracy before receiving any benefits.”). 20 see generally book, supra note 4, at 361-63 (explaining that the tax credit is measured by multiplying the taxpayer’s earned income up to a specific amount by a credit percentage). 21 see i.r.c. § 32(b) (2006) (prescribing method for calculation of eitc). 22 see book, supra note 4, at 362. 23 see i.r.c. § 32(b)(1)(a)-(b) (2006) (describing the phase-out formula). 24 see book, supra note 4, at 362. 182 columbia journal of tax law [vol.3:177 individuals; second, reduced administrative costs; third, reduced stigma for program participants; and fourth, the political advantage of enshrining entitlement programs in the tax code, rather than in highly visible and politically controversial direct expenditures. however, these advantages are not unqualified, and the eitc entails significant disadvantages as well. as will be detailed below, these disadvantages involve significant burdens for the low-income workers who are expected to navigate the eitc’s byzantine eligibility apparatus with a minimum of legal assistance. first, the eitc boasts a higher participation rate than other social programs that provide support for low-income families. 25 one commentator has claimed that the eitc can boast participation rates as high as eighty-nine percent. 26 this is higher than comparable estimates for the food stamps program, for instance, in which participation is currently estimated at seventy percent. 27 scholars generally attribute this increased participation rate to the eitc’s use of self-certification, which does away with timeconsuming and potentially humiliating visits to welfare offices. 28 and, indeed, for many eitc proponents, the eitc’s high levels of participation are among the program’s most valuable features. 29 however, it should be noted that there is a lack of empirical work definitively connecting the eitc’s pre-certification regime to its participation rate: it is possible, for instance, that the eitc enjoys high levels of participation because it targets low-income workers, who may be more likely to have the skills and initiative to apply for benefits than do those who are both destitute and unemployed. 30 second, another putative advantage of self-certification is the eitc’s relatively low administrative costs when compared to traditional welfare programs, which typically require that potential recipients be pre-certified prior to the disbursement of benefits. 31 pre-certification requires the programs’ administering agencies to employ a large number of street-level intake workers in field offices around the country. potential recipients typically must meet with these intake officials multiple times prior to certification, and then often have annual meetings for recertification. 32 this stands in contrast with the self-certification process by which eligible individuals claim the eitc on their tax returns. the result is that the eitc is administered at a dramatically lower overall cost than traditional welfare programs. scholars have estimated that the irs is able to 25 see, e.g., jeffrey b. liebman, who are the ineligible eitc recipients?, 4 nat. tax j. 1165, 1183 n.34 (2000). 26 ventry, supra note 11, at 1265. 27 see id. 28 see, e.g., david a. weisbach & jacob nussim, the integration of tax and spending programs, 113 yale l.j. 955, 1010 (2004) (“the eitc has a high participation rate but also a high overpayment rate. these facts are likely due to the lack of a precertification process.”). 29 see zelenak, supra note 19, at 1915. 30 however, tanf also includes work conditions, suggesting that the eitc’s work condition alone cannot explain its high participation rates. see noah d. zatz, what welfare requires from work, 54 ucla l. rev. 373, 376 (2006) (describing tanf’s work requirements). 31 see alstott, supra note 3, at 534 (noting that advocates have argued that “because the eitc is part of the federal tax system, it is simpler and cheaper to administer than programs run by the welfare bureaucracy . . . .”). 32 see janet holtzblatt, choosing between refundable tax credits and spending programs, 93 proc. ann. conf. on tax’n 116, 119 (2000) (“almost all food stamp applicants must visit a state office in person during regular business hours to apply for benefits. further, all claimants must complete a lengthy application . . . and provide extensive documentation to support the claim. over 40% of food stamp applicants make two or more trips to the state office to complete the initial application process.”) 2012] the eitc, low-income workers, & the legal aid community 183 administer the eitc at a total cost that is 1-2% of benefits paid out. 33 this is substantially less than the rate for tanf, which is currently at ten percent of benefits paid, or the food stamps program, which is estimated to devote roughly 20-25% of its budget to administration. 34 third, the eitc’s pre-certification regime may reduce the social stigma associated with traditional direct spending welfare programs, which require beneficiaries to engage in routine visits to welfare offices for face-to-face eligibility interviews. 35 however, there is a significant lack of empirical support for the proposition that the eitc is less stigmatizing than traditional welfare. scholars have noted that tax-based welfare may also contain stigmatizing effects. 36 and recent outrage in conservative media circles about the fact that some taxpayers enjoy no (or negative) tax liability suggests that the tax system may be still susceptible to the stigmas associated with traditional welfare. 37 finally, another claimed advantage of the eitc is that tax expenditures travel a different path through congress than do direct outlays. because the amount of federal dollars spent annually on the eitc depends on the amount of benefits claimed by filers, the program does not require large outlays in the appropriations process through congress. moreover, welfare benefits administered through the tax system are less visible and thus less politically controversial than are welfare benefits administered through traditional bureaucracies. 38 unfortunately, there are also substantial costs to administering welfare through the tax system. the most prominent such cost is a massive non-compliance epidemic, as reliance on self-certification by applicants increases the potential for both deliberate fraud and inadvertent error. the irs estimates that for tax year 2004, between $9.6 billion and $11.4 billion in erroneous eitc payments were made, approximately a quarter of the $41.3 billion in eitc claims paid for that year. 39 a 2002 study of eitc payments in tax year 1999 found similarly high rates of noncompliance, estimating that the irs made between $8.5 billion and $9.9 billion in erroneous payments (between twenty-seven percent and thirty-two percent of that year’s total eitc payments). 40 the fact that as much as a third of the program’s benefits are diverted to ineligible recipients suggests 33 see, e.g., zelenak, supra note 19, at 1884. 34 id. at 1881-1882. 35 see alstott, supra note 3, at 534 (noting that eitc advocates have argued that administering the program through the tax system “affords greater dignity and privacy to beneficiaries.”); see also nat’l taxpayer advocate, running social programs through the tax system, 2 2009 ann. rep. to cong. 75, 78, 87 (2009). 36 see weisbach & nussim, supra note 28, at 1004 n.152 (“[s]tigma effects may arise under the tax system as well.”); see also timothy m. smeeding et al., the eitc: expectation, knowledge, use, and economic and social mobility, 53 nat’l tax j. 1187, 1189 (2000) (“there are several possible explanations . . . including . . . employees’ unwillingness to inform the employer of eitc eligibility due to stigma effects . . . .”). 37 see also, e.g., david leonhardt, yes, 47% of households owe no taxes. look closer. n.y. times, apr. 13, 2010, at b1 (describing how lack of tax liability of low-income americans has “become a popular talking point on cable television and talk radio.”). 38 see jacob s. hacker, the divided welfare state 42-44 (2002) (arguing that “private social benefits” administered through the tax code “are often characterized by both low visibility and low traceability.”). 39 memorandum from michael r. phillips, deputy inspector gen. for audit, dep’t of the treas., to nancy a. nakamura, comm’r, wage and inv. div., internal revenue serv. 1 (dec. 31, 2008). 40 internal revenue serv., dep’t of the treas., compliance estimates for earned income tax credit claimed on 1999 returns 3 (2002). 184 columbia journal of tax law [vol.3:177 that claims regarding the program’s relatively low administrative costs should be met with skepticism. a related cost involves the imposition of a filing requirement on millions of taxpayers who would otherwise not be obligated to file a tax return. it is estimated that forty-seven percent of individual taxpayers do not have an obligation to file returns because they have either a zero or negative tax liability for the year. 41 also, many of the individuals who are forced to file tax returns to claim the benefits of the eitc lack the sophistication of wealthier taxpayers, and as a result, completing the return imposes a burden upon them. 42 this burden is especially acute given the eitc’s complex eligibility requirements, which may exceed the capabilities of many low-income workers. in 1997, the american institute of certified public accountants (“aicpa”) described the credit’s eligibility criteria as “nightmare of eligibility tests, requiring a maze of worksheets.” 43 the institute noted that application for the credit requires a claimant to consider: nine eligibility requirements; the number of qualifying children—taking into account relationship, residency and age tests, the taxpayer’s earned income—taxable and non-taxable; the taxpayer’s adjusted gross income (“agi”); the taxpayer’s modified agi; threshold amounts; phase out rates; and varying credit rates. 44 aicpa’s statement concluded that: while congress and the irs may expect that the aicpa and its members can comprehend the many pages of instructions and worksheets, it is unreasonable to expect those individuals entitled to the credit (who will almost certainly not be expert in tax matters) to deal with this complexity. even our members, who tend to calculate the credit for taxpayers as part of their volunteer work, find this area to be extremely challenging. in fact, we have found that the eitc process can be a lot more demanding than completing the schedule a – itemized deductions, which many of our members complete on a regular basis for their clients. that taxpayer confusion over these eligibility criteria is a widespread phenomenon, as illustrated by the fact that, in 1999, about $2.1 billion in erroneous eitc claims were made by taxpayers who should have employed a filing status of “married filing separately,” which renders a taxpayer automatically ineligible for the credit. 45 the fact that such a large number of eitc claimants select a filing status that renders them automatically ineligible for the credit suggests widespread difficulty in navigating the credit’s complex eligibility criteria, and further indicates that the above-discussed noncompliance epidemic is attributable, at least in part, to taxpayer confusion rather than deliberate fraud. 41 roberton williams, who pays no income tax?, 123 tax notes 1583 (2009). 42 see yin et al., supra note 4, at 263-64. 43 american institute of certified public accountants, tax simplification recommendations, 97 tni 95-21 (1997). 44 id. 45 see internal revenue serv., supra note 40, app. at c-2. 2012] the eitc, low-income workers, & the legal aid community 185 given these complexities, it is not surprising that many eitc claimants choose to have their returns prepared professionally. 46 in tax year 2003, seventy-one percent of all eitc returns were prepared by a third party, and a higher proportion of eitc filers use paid preparers than do middleand upper-income taxpayers. 47 however, the fact that eitc filers rely so heavily on external preparation appears to expose them to incompetent or unscrupulous agents who, aware that the eitc can often result in a sizeable payout, promise large refunds as an incentive to use their services, and often issue predatory refund anticipation loans (“rals”) to eitc claimants. 48 in low-income communities, for instance, return preparation services have arisen to facilitate eitc claimants’ purchases at various retail outlets and car dealers. 49 such services have obvious incentives to deem any given taxpayer eligible for eitc, and, not surprisingly, paid preparers are associated with a troublingly high rate of erroneous eitc claims: socalled “brokered non-compliance.” 50 moreover, these preparers are often fly-by-night in nature and, as such, are often no longer in business when their mistakes are discovered by irs auditors. 51 taking a long-overdue step, the irs published a rule in september 2010 that requires paid preparers to register and comply with a set of competency standards. 52 it will be critical for the irs to follow through with vigorous and uniform enforcement of this rule. currently, too few eitc claimants are taking advantage of the irs’s volunteer income tax assistance (“vita”) program, which consists of trained community volunteers who offer free tax help to lowand middle-income individuals—typically, those making under $50,000 per year. 53 even though the vita staff members are not tax professionals, several features of the program still make it a superior option to paid preparation for most eitc claimants. first, vita staff must undergo a rigorous training program and pass qualifying examinations in order to prepare returns for various individuals. for example, passing a basic exam allows a volunteer to prepare most individual and family returns, but passing a more advanced exam is required to prepare more complicated returns, such as those involving higher education credits or selfemployment. second, there is a dual-layer review process in vita preparations, in which the initial preparer’s work is always checked by a more experienced volunteer before the return is filed. finally, and most importantly, vita is free, allowing the eitc 46 see stephen d. holt, keeping it in context: earned income tax credit compliance and treatment of the working poor, 6 conn. pub. int. l.j. 183, 199-200 (2007). separately, and beyond the scope of this article, eitc claimants’ need for tax preparation may well pose a normative concern insofar as they are effectively paying a fee for their welfare entitlements. 47 see id. at 199. 48 see janet spragens & nina olson, tax clinics: the new face of legal services, 88 tax notes 1525, 1526 (2000); see also holt, supra note 46, at 200. 49 see holt, supra note 46, at 201. 50 see danshera cords, paid tax preparers, used car dealers, refund anticipation loans and the earned income tax credit: the need to regulate tax return preparers and provide more free alternatives, 59 case w. res. l. rev. 351, 368 (2009) (defining “brokered noncompliance” as “noncompliance facilitated by a paid preparer” and speculating that “[b]rokered noncompliance may be particularly serious among eitc recipients . . . .”). 51 see spragens & olson, supra note 48, at 1526. 52 furnishing identifying number of tax return preparer, 75 fed. reg. 60309 (sept. 30, 2010) (amending 26 c.f.r. parts 1 and 602). 53 free tax preparation for you by volunteers, internal revenue serv., http://www.irs.gov/individuals/article/0,,id=107626,00.html (last visited feb. 3, 2012). 186 columbia journal of tax law [vol.3:177 claimants to keep more of their entitlement benefits. paid preparation, by comparison, can cost eitc claimants hundreds of dollars. 54 for the purposes of this article, though, perhaps the most important drawback of the eitc’s tax administration derives from the fact that when eitc claimants—who are responsible for certifying their own eligibility—erroneously claim to be eligible, they are required to engage the irs’s complex “deficiency process” encompassing correspondence audits, the irs office of appeals, and united states tax courts. 55 taxpayers who are unsuccessful in vindicating their claims through this daunting process are required to repay the benefit they have received, with interest, and often with penalties as well. 56 this susceptibility to legal penalties or loss of benefits, which will be discussed in the following section, is especially concerning in light of inadequate legal representation for eitc claimants. in sum, administering this anti-poverty regime through the tax system, despite its lower cost to the government, can come at significant personal expense to claimants, who are more susceptible to erroneous deprivation of their entitlements when compared to participants in other welfare programs. 57 c. a legal labyrinth: navigating the eitc audit and appeal processes here we chronicle the unique dilemmas that confront low-income workers who become enmeshed in the irs’s enforcement process. such workers face a cumbersome and often harsh bureaucracy, which they are forced to navigate, usually without assistance. failure to convince the irs of the correctness of a tax return can result in the taxpayer’s being compelled to repay the eitc benefit, with interest and penalties. 58 two points are crucial in considering the audit and appeals process described below. first, as low-income workers, eitc claimants audited by the irs are often not equipped—in terms of education, resources, or expertise—to demonstrate their compliance with the eitc’s complex criteria. second, the phenomenon described below, in which an eitc claimant is compelled to engage the irs’s audit and appeals process, is not a rarity. indeed, the irs has instituted a number of initiatives under which eitc claimants are more likely to be audited than middleand upper-income taxpayers. following a political firestorm over compliance in the mid-1990s, the proportion of irs audits targeting eitc claimants began a dramatic increase. 59 by 2004, an eitc household was 1.76 times more likely to be audited than a household with an annual salary over $100,000, and in 2005 a full forty-three percent of irs audits of individual taxpayers involved an eitc claim. 60 54 by way of example, the cedar rapids, iowa vita site reports that local commercial tax preparers charge an average of $175 per return and an additional $125 per hour for preparation. volunteer income tax assistance, central cedar rapids weed and seed, http://www.crweedandseed.com/current%20programs/vita/vita.html (last visited aug. 30, 2011). 55 see i.r.c. §§ 6211-6216 (2006). 56 see generally bryan t. camp, the failure of adversarial process in the administrative state, 84 ind. l.j. 57, 105 (2009) (citing the national taxpayer advocate finding that accumulation of interest and penalties often equal or exceed the original amount in dispute). 57 see book, supra note 4, at 352 (“the eitc is excessively complicated in its application and can have significant and sometimes unforeseen consequences on the lives of those who are the provision's beneficiaries, largely the working poor, of whom great numbers are racial minorities and women.”). 58 see supra note 56. 59 see janet holtzblatt & janet mccubbin, issues affecting low-income filers, in the crisis in tax administration 148, 159 (henry j. aaron & joel slemrod, eds., 2004). 60 see id. (“[w]hile audit rates have generally fallen, the odds of being audited have increased for low-income filers relative to other filers. in 1988 the audit rate among 1040a nonbusiness filers with 2012] the eitc, low-income workers, & the legal aid community 187 in this section, we first discuss the high error rate associated with eitc claims. we then examine the correspondence audits and tax court adjudication to which eitc claimants are subjected when suspected of error. finally, we examine the importance of representation during the audit process, as well as the inadequacy of current programs, such as the low-income tax clinic program that provides representation to low-income taxpayers. 1. high error and audit rate in the previous section’s discussion of eitc noncompliance, we detailed the high error rate of eitc claims and the erroneous payments that result. politicians have occasionally invoked these error rates as evidence that the eitc is broken and rife with fraud. 61 in 1995, for instance, senator william roth proposed legislation to reduce the eitc, claiming that it was “probably the most abused program on the books.” 62 accordingly, congress’s efforts to deter and detect taxpayer abuse have focused disproportionately on eitc recipients, notwithstanding the relatively low amount per eitc controversy. 63 even though other methods for tax evasion—including corporate tax shelters, failure to pay corporate income taxes, and the misuse of pass-through entities to hide income—result in far more tax evasion than the eitc in absolute dollar terms, tax compliance efforts have centered so predominantly on low-income earners that by 2003 a taxpayer earning less than $25,000 was more likely to be audited than a taxpayer earning more than $100,000. 64 eitc claimants comprise over one-third of all individual irs audits and are audited at triple the rate (2.1% in fiscal year 2008) of non-eitc taxpayers. 65 congress has authorized substantial funding—approximately $150 million annually—for auditing eitc compliance in recent years, and has enacted numerous enforcement measures specifically for the eitc as well. 66 if an eitc claim is found to be deliberately erroneous, the irs can block subsequent eitc claims for ten years, and even if negligence (rather than outright fraud) is the underlying reason, claims can nonetheless be blocked for two years. 67 furthermore, congress has tightened the number of eligible children who can be claimed as qualifying dependents under the eitc, and has imposed particularized due diligence standards on eitc preparers. 68 2. irs audit process the high prevalence of error in the eitc and the heightened enforcement efforts that have resulted raise concerns as to the processes that the irs uses to detect and adjudicate cases of suspected error. unfortunately, the irs’s elaborate audit process does positive income below $25,000 was 1.03%, while the average audit rate among all filers was 1.57%. by 2000 the audit rate was 0.49% for all taxpayers, but it was 0.6% among 1040a nonbusiness filers with income under $25,000 and 1.4% among eitc claimants.” (footnote omitted)); holt, supra note 46, at 190-91. 61 see book, supra note 19, at 1105-07. 62 dana milbank, republican senator and two of his constituents illustrate debate on tax break for working poor, wall st. j., aug. 16, 1995, at a12. 63 see leslie book, the poor and tax compliance: one size does not fit all, 51 kan. l. rev. 1145, 1152 (2003). 64 id. at 1158. 65 nat’l taxpayer advocate, beyond eitc: the needs of low income taxpayers are not being adequately met, 1 2009 ann. rep. to cong. 110, 114 n.27 (2009). 66 see book, supra note 4, at 418. 67 see holt, supra note 46, at 194. 68 see book, supra note 63, at 1146. 188 columbia journal of tax law [vol.3:177 not appear particularly well-suited to detect instances of noncompliance. in 2007, when irs auditors denied the eitc and claimants requested reconsideration, forty-three percent of claimants ultimately received the eitc at an average amount of ninety-six percent of what they claimed on their original returns. 69 these statistics—which suggest that the irs’s initial auditing process is only slightly more accurate than a coin toss—not only reveal serious structural flaws in irs auditing, but also, as we will argue in the next section, underscore the need for effective representation for eitc claimants who face potential denial of benefits. as the national taxpayer advocate has argued, “[g]iven the significant barriers encountered by eic taxpayers during the audit process, one must consider whether many audited taxpayers are truly ineligible for ei[t]c, or whether they were just unable to successfully navigate the irs audit process.” 70 after an eitc claimant is targeted for an irs audit, the information-gathering process is generally conducted on a “correspondence” basis through the mail, rather than in a “field,” face-to-face format. 71 while correspondence audits are likely less intimidating to claimants than field audits, they pose significant disadvantages in terms of the ultimate outcomes—especially with respect to accuracy and fairness—of eitc determinations. 72 for several important reasons, a mail-based audit system is ill suited for low-income taxpayers. first, eitc claimants are much more likely than other taxpayers to be transient or homeless. 73 this creates multiple problems for correspondence audits. 74 because they change domiciles frequently (and often do not provide forwarding information to the post office or the irs), transient or homeless eitc claimants are simply less likely than other taxpayers to receive the items that irs auditors mail to them. 75 many of the working poor also spend intermittent periods of time in cars, motels, friends’ or relatives’ houses, or temporary shelters, making it very difficult for the irs to conduct an effective correspondence audit of their tax returns. 76 considering that such audits can last for months, a claimant’s transience can easily disrupt an audit that is already underway, particularly insofar as multiple addresses complicate the document-gathering process. 77 for instance, the process for proving a qualifying child’s residency—which is the most common eitc error—requires a number of forms, such as school and medical records, which must have fully consistent data or a satisfactory and detailed explanation of any inconsistencies for the irs to grant approval. 78 on a related point, the abstruse classifications used in the eitc compound the difficulties that claimants face when responding to document requests. the national taxpayer advocate has consistently found that the eitc eligibility rules, especially those 69 see nat’l taxpayer advocate, the irs correspondence examination process does not maximize voluntary compliance, 1 2009 ann. rep. to cong. 158, 160 (2009). 70 nat’l taxpayer advocate, irs earned income credit audits—a challenge to taxpayers, 2 2007 ann. rep. to cong. 94, 108 (2007). 71 see holt, supra note 46, at 191 (noting that “[m]ost eitc reviews are correspondence audits . . . .”). 72 see id. 73 see book, supra note 4, at 393. 74 see id. at 395. 75 id. 76 see id. at 394-95. 77 id. at 395. 78 id. 2012] the eitc, low-income workers, & the legal aid community 189 for reporting family status for purposes of the eitc, are difficult for claimants to interpret correctly. 79 again, the qualifying child issue illustrates this complexity: a taxpayer’s child can be qualifying under the dependency exemption but not for the eitc, or vice versa. the lack of a uniform definition of qualifying child confuses claimants unfamiliar with the tax system, who often understandably assume that there is no reason why their children would somehow not be “qualifying” if they, as parents, could qualify themselves. 80 beyond the substantive complexity of eitc rules and required documents, eitc claimants are often unsure which documents the irs actually wants. one national taxpayer advocate study found, for instance, that roughly half of taxpayers subject to a correspondence audit contacted the irs by phone or in person to clarify what forms they needed to send in. 81 additionally, more than half of audited eitc claimants reported difficulties in obtaining the requested documents, and nearly half of the same group did not understand why the documents were requested in the first place. 82 furthermore, the national taxpayer advocate’s research shows that low-income taxpayers not only have inadequate access to computers, but also below-average computer literacy, thus complicating their ability to use the irs’s website (on which the agency relies heavily to convey information to taxpayers) as an additional means for answering questions about their obligations with respect to a correspondence audit. 83 eitc claimants are also far more likely than the average taxpayer to have english literacy problems, whether as a result of educational disadvantages or from speaking english as a second language. 84 although there are no studies explicitly associating low literacy with poor eitc correspondence response rates, one could reasonably draw from the results of a 1990 census report—which demonstrated that an individual’s literacy skills were linked to the accuracy of census returns—in surmising that a similar effect likely applies to the eitc. 85 these taxpayers face obvious difficulties in responding to an irs correspondence audit. for instance, they often lack the ability to understand what documents are required to satisfy certain gaps in their tax filing. 86 given that mail-based audits rely on a claimant’s willingness to respond (and to clarify points of misunderstanding before doing so), they are particularly ineffective in cases where taxpayers are fearful of government interaction. 87 this problem is prevalent in cases involving recent immigrants, who are often concerned that by challenging the government over a tax controversy, they will entangle themselves in an immigrationrelated matter as well. 88 and even if these claimants were to contact the irs in person or via telephone to clarify an audit question, the irs has no budget for translators, creating another barrier to fair and effective audit resolution. 89 79 see, e.g., nat’l taxpayer advocate, supra note 65, at 114. 80 see book, supra note 4, at 399. 81 nat’l taxpayer, advocate, supra note 69, at 160. 82 nat’l taxpayer advocate, supra note 70, at 95. 83 see nat’l taxpayer advocate, supra note 65, at 130. 84 book, supra note 4, at 394. 85 see id. at 397. 86 id. 87 see spragens & olson, supra note 48, at 1526. 88 id. 89 id. 190 columbia journal of tax law [vol.3:177 finally, there is a marked disparity in the burdens that an irs audit imposes on low-income taxpayers when compared to their middle or upper-income counterparts. while the latter can often delegate the task to a lawyer or accountant, and are bothered only with respect to the costs associated with that assistance and any additional tax liability (likely to be a small percentage of their financial resources), low-income taxpayers must typically deal with the irs on their own time and without professional expertise. 90 these burdens can be considerable. in 2007, for instance, more than half of eitc-audited taxpayers who reported submitting all of the irs’s originally requested documentation also received a request for additional documentation. 91 likewise, more than half of audited claimants reported that the irs either took over a month to acknowledge receipt of their documentation or provided no acknowledgment at all. in her inaugural testimony to congress in 2001 as the national taxpayer advocate, nina olson remarked that if the irs “subjected middle class and more affluent taxpayers to the kind of intrusive inquiries we routinely subject a taxpayer to in an ei[t]c audit, the entire ei[t]c audit program would be shut down in response to taxpayer complaints.” 92 no less problematic than the irs’s audit process is the use of u.s. tax court to resolve cases in which an eitc claimant fails an audit. eitc claimants have their disputes referred to tax court as a result of the culmination of the irs’s “deficiency procedure.” 93 if, after auditing, the irs determines that tax filers’ true tax liability exceeds their self-reported tax liability, they are deemed to be “deficient.” the irs can then choose to then send the taxpayer a “notice of deficiency.” 94 after receiving the notice, taxpayers who desire a formal hearing on their claim have ninety days to seek a hearing before a u.s. tax court. 95 the procedure that is followed in tax courts closely resembles the procedures used in federal district court bench trials. 96 cases are tried before special trial judges, using rules of procedure similar to the federal rules of civil procedure, and attorneys from the office of the irs counsel represent the government. if the amount in dispute is less than $50,000 for a given tax year, as is typically the case with eitc claimants, tax filers are able to invoke the small case procedures that are provided for in the tax court’s rules of practice and procedure. 97 these proceedings, which are often referred to as “s” cases, are specifically designed to accommodate pro se representation. to facilitate that goal, there are several changes to normal procedure. those include not requiring the taxpayer to file a reply brief and trials “conducted as informally as possible consistent with orderly procedure.” 98 despite the procedures that are afforded to eitc claimants in “s” cases, the process is still inherently adversarial. in these adversarial proceedings, 90 see book, supra note 4, at 392-93. 91 nat’l taxpayer advocate, supra note 70, at 95. 92 see book, supra note 4, at 424. 93 see i.r.c. §§ 6211-6216 (2006). 94 see i.r.c. § 6213 (west 2011). 95 id. 96 see michael i. saltzman, irs practice and procedure, 1.06[1] (rev. 2d ed. 2002) (discussing the mechanics of designating a case to be treated as a small tax case). 97 see david m. richardson, jerome borison & steve johnson, civil tax procedure 222 (2d. ed. 2008). 98 u.s. tax ct. r. 174(b); see also u.s. tax ct. r. 173(c) (noting that a reply is necessary only if the court orders a reply), 174(c) (noting that neither briefs nor oral arguments are required unless by court order). 2012] the eitc, low-income workers, & the legal aid community 191 there is strong burden of proof placed on the defendant and they are expected to zealously represent themselves. 99 while the “s case” procedure is likely to ameliorate certain difficulties that lowincome litigants face in a formal adversarial setting, there is still a fundamental incongruity between the tax court’s use of adversarial process and the eitc’s predominantly low-income, pro se clientele. as barbara bezdek noted in commenting on similarly informal adversarial processes used in baltimore rent courts, “the rule-oriented court talk expected and privileged by judges in low-level courts bears little or no relation to people’s natural narratives. the rules of courtroom discourse are seldom explained to those witnesses expected to conform to them.” 100 lucie white similarly notes that civil litigation “evoke[s] feelings of terror for many poor people,” 101 who: perceive litigation as an alien or even hostile cultural setting. the talk and ritual of litigation constitute a discourse and a culture that are foreign to most poor people. poor people obviously do not speak in the same dialect that lawyers, judges, and elite businesspeople use. furthermore, their courtroom speech is routinely interrupted by lawyers and judges who use threatening tones in ordering them when not to talk and what not to say. their stories are interpreted by black-robed authorities on the basis of rules that are rarely explained and norms that they seldom share. 102 this dynamic is evident in reported tax court cases adjudicating eitc compliance, as when a tax court judge criticized a taxpayer who appeared to have difficulty speaking english with “vague and inconsistent assertions,” 103 or when a judge summarily dismissed the testimony of an eitc claimant’s low-income witnesses as conclusory, vague, and biased by the taxpayer’s interests. 104 in short, just as it is troubling to expect low-income taxpayers to navigate the complexities of the internal revenue code without assistance, it is likewise troubling to subject them to correspondence-based audits and adversarial adjudication when they are suspected of noncompliance. 3. importance of representation in general, legal services organizations have not assisted eitc claimants in navigating the legal complexities of an irs audit—or, for that matter, in handling any subsequent proceeding or adjudication. 105 this is partly because the importance of tax law pertaining to low-income taxpayers is a relatively recent development, driven predominantly by the rapid growth of the eitc over the past few decades. before the eitc, poor people had little to no interaction with the tax system, so there was no reason for legal services and pro bono lawyers to offer tax-related advocacy. but now, as the eitc has developed into the country’s largest vehicle for delivering welfare benefits, it 99 see camp, supra note 5, at 89. 100 see barbara bezdek, silence in the court: participation and subordination of poor tenants’ voices in legal process, 20 hofstra l. rev. 533, 588 (1992). 101 lucie e. white, mobilization on the margins of the lawsuit: making space for clients to speak, 16 n.y.u. rev. l. & soc. change 535, 543 (1987). 102 id. at 542-43 (footnotes omitted). 103 see diaz v. comm’r, 87 t.c.m. (cch) 1420 (2004). 104 see baker v. comm’r, 91 t.c.m. (cch) 949 (2006). 105 see spragens & olson, supra note 48, at 1525. 192 columbia journal of tax law [vol.3:177 has radically reshaped the legal challenges confronting poor americans and created a need for tax representation for low-income taxpayers. this need has been hard to meet for several reasons. first, tax law is widely perceived as a complex, isolated discipline that demands considerable specialization. 106 given the resource constraints on many legal services organizations, it may be difficult to hire personnel with such expertise (or even to justify doing so, given that the salary could go toward a generalist who could handle a broader range of client matters). 107 also, the tax bar—which practices in a realm traditionally viewed as “rich people’s law”—has generally not emphasized low-income issues or focused on pro bono services in a systematic way. 108 largely because the eitc’s complexity makes it so difficult for claimants to manage the audit process themselves, the availability and quality of representation are often crucial factors in determining the outcome of an audit. in 2004, low-income taxpayers with representation were twice as likely as their non-represented counterparts to emerge from an irs audit with no change in their claimed eitc, at rates of 41.5% and 23.1%, respectively. 109 those with representation, moreover, retained 44.8% of the eitc on average, as opposed to only 25.3% for unrepresented taxpayers. 110 the type of representation also matters. for instance in 2004, claimants represented by an attorney or cpa retained their eitc amount in full 45.8% of the time, while being disallowed their entire amount at a rate of 48.5%. 111 this stands in contrast to claimants represented by actuaries, law and accounting students, family members, and employees of the claimant’s organization, who retained their full eitc entitlement in just 35.4% of cases and lost the entire benefit 59.1% of the time. 112 while these statistics show, perhaps unsurprisingly, that advocates with more relevant and advanced training have more success in representing eitc claimants, the more important question at present is whether eitc claimants are at least receiving some sort of representation. this is because the vast majority of claimants (98.2%) still do not have any representation during an irs audit, and, as noted above, the outcome differential is much greater between represented and non-represented taxpayers than it is among types of represented taxpayers. 113 additionally, the largely all-or-nothing nature of an eitc audit heightens the stakes of having representation: only around five percent 106 see book, supra note 4, at 412 (“lawyers tend to view tax law as an isolated discipline, requiring great specialization due to the area’s complexity, both substantively and procedurally.”). see generally paul l. caron, tax myopia, or mamas don’t let your babies grow up to be tax lawyers, 13 va. tax. rev. 517 (1994) (discussing the popular misconceptions of tax law and tax attorneys). 107 see, e.g., algodones associates, the american bar association legal needs study, http://www.algodonesassociates.com/legal_services/assessing_needs/abalegal.htm (last modified oct. 9, 1998) (documenting the many legal needs facing america’s poor without mentioning tax issues either as a concern or a priority). 108 see book, supra note 4, at 412 (noting that the tax bar has not been broadly involved in providing pro bono services); see also spragens & olson, supra note 48, at 1529. 109 nat’l taxpayer advocate, eitc examinations and the impact of taxpayer representation, 1 2007 ann. rep. to cong. 222, 226 (2007). 110 id. 111 nat’l taxpayer advocate, supra note 70, at 94, 110. 112 id. 113 id. at 94 n.1, 97. 2012] the eitc, low-income workers, & the legal aid community 193 of cases result in a reduction of eitc benefits, as opposed to a total preservation or denial. 114 congress has taken some steps to fill the representation gap for eitc claimants. the irs restructuring and reform act (“rra”) of 1998, in relevant part, established a $6 million program within the irs that provided matching grants up to $100,000 to law and business school clinics and other 501(c)(3) organizations that provide free tax law assistance to low-income taxpayers. 115 these groups, known as low-income taxpayer clinics (“litcs”), can represent taxpayers in disputes with the irs, provide outreach and education to taxpayers who speak english as a second language (“esl”), or both. 116 the irs’s national taxpayer advocate office has administered the litc program since 2003. 117 of the 162 litcs operating in 2009, twenty clinics dealt with esl issues only, while forty-five clinics focused on irs controversies alone and ninety-seven clinics offered both services. 118 in 2008, litc-based advocates worked for 30,648 taxpayers on a total of 37,391 issues, opening 10,142 cases (of which 1,804 were submitted to the u.s. tax court). 119 litcs are the principal option for low-income taxpayers seeking representation during an irs audit; in light of the above discussion of how important representation is in ensuring that audit outcomes are fair and accurate, litcs clearly play an essential role in the eitc framework. however, there are serious limitations on the efficacy of litcs as currently structured and administered. similar to legal services organizations more broadly, litcs likewise suffer from a lack of financial resources in meeting demand for their assistance. 120 compared with the amount of funding dedicated to compliance and enforcement of the eitc (roughly $150 million annually), the roughly $10 million annual outlay for litcs is relatively small. 121 moreover, irs employees who deal with eitc claimants cannot simply refer them to the nearest litc for assistance, in light of government ethics rules prohibiting employees from recommending specific attorneys or accountants or from endorsing any “product, service, or enterprise.” 122 the irs deputy ethics official has interpreted these rules to mean that irs employees can provide taxpayers with contact information for particular litcs only if the taxpayer specifically asks, citing litcs’ similarity to law firms insofar as they have a fiduciary responsibility to the taxpayer, provide legal advice, and represent taxpayers in court. 123 the national taxpayer advocate, nina olson, has disagreed with this assessment, arguing that litcs’ congressional authorization, public-service orientation, and target population of low 114 id. at 108. 115 spragens & olson, supra note 48, at 1525. 116 nat’l taxpayer advocate, supra note 65, at 117. 117 nancy s. abramowitz, thinking about conflicting gravitational pulls: litcs: the academy and the irs, 56 am. u.l. rev. 1127, 1129 (2007). 118 nat’l taxpayer advocate, supra note 65, at 117. 119 id. 120 see, e.g., book, supra note 4, at 418. 121 low income taxpayer clinic grant recipients announced, internal revenue serv. (apr. 21, 2009), http://www.irs.gov/newsroom/article/0,,id=206743,00.html. 122 hearing on the 2008 tax return filing season, irs operations, fy 2009 budget proposals, and the national taxpayer advocate’s 2007 annual report to congress before the subcomm. on oversight of the h. comm. on ways and means, 110th cong. 29 (2008) (written statement of nina e. olson, nat’l taxpayer advocate). 123 id. 194 columbia journal of tax law [vol.3:177 income taxpayers distinguishes them sufficiently from law firms to warrant an exemption from referral restrictions. 124 iii. irs reforms to protect the rights of america’s working poor in part ii of this article, we explored the development of the eitc into america’s largest anti-poverty program and the shortcomings in the system that make it difficult for the working poor to both claim and protect the benefits that they are entitled to under the program. essentially, the working poor are asked to certify their own eligibility for a welfare benefit without any assistance. if suspected of non-compliance, the working poor often must enter, without counsel, into a demanding adjudicative process with harsh, borderline-punitive consequences for recipients who fail to convince the irs of their eligibility. two potential avenues toward reform may alleviate these problems. the first has to do with the administration of the program itself. it is conceivable that the irs could undertake administrative reforms aimed at rendering the process of ex ante eitc application and ex post eitc adjudication more humane. the second is ameliorative in nature and involves the legal services community. assuming that the irs does not undertake to comprehensively reform the mechanisms for certification, delivery, and audit of the eitc, congress and the legal services community can recognize the centrality of the eitc for millions of low-income working families, and take steps to make legal aid for low-income taxpayers a greater priority. this part of the article addresses the former of these two options—irs reforms aimed at rendering the eitc process more humane. in turn, in part iv we will address the latter option and advocate specific steps that congress and the legal services community can take in response to the recognition that the eitc is among the central pillars of american welfare policy. since a decision has been made to use the tax system to implement one of the nation’s largest welfare programs, considerations of both efficient administration and fair treatment would seem to counsel that significant changes be made to the current structure of the irs to make the benefit easier for potential eitc claimants to both initially claim and subsequently protect during audits and tax court proceedings. the case for such reforms is intuitive: even if one does not linger on the harsh consequences described in part ii of this article, there is simply no reason to believe that an irs administrative apparatus that evolved to collect taxes from middleand upper-income taxpayers would serve as a fair or efficient medium for administering a welfare program for low-income workers. accordingly, we will examine five areas where the irs should implement changes to its structure, policies, and procedures to help ease the legal burdens that irs processes and procedures place on eitc claimants. first, we will discuss the need to reexamine and reconsider the structure of the irs. second, we will explore the possibility of splitting the eitc into two distinct benefits. third, we will analyze the possibility of reforming the eitc tax filing process, and the potential benefits of a “ready file” system. fourth, we will offer reforms to modify the auditing of eitc claimants. fifth, we will present a proposal to employ less adversarial procedures for the tax court proceedings applied to eitc claimants that are deemed “deficient” following an audit. these reforms, if adopted either individually or in concert, would represent a substantial step toward helping to ease the burden that the eitc places on america’s working poor. 124 id. at 33. 2012] the eitc, low-income workers, & the legal aid community 195 a. evaluating and reforming the structure of the irs the decision to administer the eitc through the tax system has large implications for the overall mission of the internal revenue service. in 2010, the congressional budget office estimated that, between 2009 and 2013, the eitc will result in roughly $250 billion in foregone revenue. 125 this means that administering social welfare programs will come to be a more significant part of the irs mission, and changes should be made to the structure and nature of the irs to reflect that reality. despite the fact that the irs is now the agency charged with delivering america’s largest welfare program, the irs’s core mission remains to collect revenue. currently, the irs collects ninety-six percent of all federal tax receipts. 126 moreover, the irs’s primary institutional goal is addressing the “tax gap,” which is the difference between the amount of taxes due and the amount of taxes actually collected. 127 this emphasis frustrates the goals of using the tax system for social policy in two ways. first, the most reliable current estimate of the magnitude of the annual gross underreporting gap comes from 2001, when it was calculated at $345 billion. 128 of this total, $285 billion was from incorrect reporting on tax returns (as opposed to failure to file or pay). 129 the individual income underreporting gap was approximately $197 billion of the $285 billion total. 130 in contrast, the amount of incorrectly claimed credits, including the eitc, was only $17 billion. 131 this means that incorrectly claimed credits account for less than five percent of the total tax credits, which is a relatively minor fraction of the total. 132 second, the emphasis on closing the tax gap also motivates the irs to attempt to crack down on non-compliance instead of promoting participation in programs. these two goals are often in conflict with each other, and the mission and culture of the irs often leads to the collection and compliance activities of the irs overshadowing the social policy objectives of programs such as the eitc. as a result, the irs should reevaluate its mission statement to acknowledge its dual roles of promoting tax compliance and delivering social programs. new zealand is an illustrative example of how this can occur, as highlighted by the u.s. national taxpayer advocate. 133 in 2004, new zealand passed a comprehensive social welfare program aimed at combining support to families with incentives to work that is administered through the country’s tax system, inland revenue. 134 this reform “had three key objectives: making work pay, ensuring income adequacy, and supporting 125 congressional budget office, pub. no. 4220, trends in federal tax revenues and rates 12 (2010), available at http://www.cbo.gov/ftpdocs/119xx/doc11976/2010-1202_incometax_chartbook.pdf. 126 see, e.g., internal revenue serv., dep’t of the treas., update on reducing the federal tax gap and improving voluntary compliance 2 (2009); nat’l taxpayer advocate, supra note 35, at 92. 127 see nat’l taxpayer advocate, supra note 35, at 92. 128 internal revenue serv., supra note 126, at 4. 129 id. 130 id. 131 id. 132 see nat’l taxpayer advocate, supra note 35, at 82-83 (noting that “approximately 55 percent . . . of the individual underreporting gap . . . came from understated net business income, such as unreported receipts and overstated expenses for self-employed taxpayers . . . [compared to] only about nine percent . . . from overstated tax credits.”). 133 id. at 87. 134 see taxation (working for families) act 2004 (n.z.), available at http://www.legislation.govt.nz/act/public/2004/0052/latest/whole.html (last visited aug. 30, 2011). 196 columbia journal of tax law [vol.3:177 people . . . into paid work.” 135 since this changed the mission of inland revenue to create a greater emphasis on delivering benefits, instead of promoting compliance, a comprehensive “analytical redesign process” was undertaken. 136 this process helped to change the culture, structure, and emphasis of the agency to recognize the new dual mission. although the reforms have only been in place a few years, initial econometric research has suggested that new zealand’s reforms have resulted in increases in employment and hours worked due to the tax reforms. 137 in america, despite the fact that the eitc has existed since the mid-1970s and been a major part of our welfare system since mid-1990s, the irs has yet to undergo a reform process that recognizes the importance of the social programs that congress has chosen to deliver through the tax system. 138 given the importance of the eitc to american welfare policy, this is a necessary step that should be considered to transform the irs from an organization predominantly concerned with enforcement to an agency with the separate roles of revenue collection and social policy administration. although these reforms may dramatically transform the irs, the federal reserve can provide an example of an institution that has successfully adopted two theoretically conflicting missions. 139 under the federal reserve reform act of 1977, it is the dual mission of the federal reserve to promote production and employment while curbing inflation. 140 although the federal reserve’s dual role has come under attack recently by members of congress who feel that the focus should be solely on keeping inflation low, 141 these criticisms appear to highlight the fact that the federal reserve has internalized the importance of both parts of its mission. 142 135 joanne hames, facilitating fertility and paid work: contemporary family-friendly policy initiatives and their social impacts in australasia, 34 soc. pol’y j. n.z. 25, 29 (2009). 136 see nat’l taxpayer advocate, supra note 35, at 87. 137 john fitzgerald, tim maloney, & gail pacheco, the impact of recent changes in family assistance on partnering and women’s employment in new zealand, 42 n.z. econ. papers 17, 48 (2008) (stating that their study “provide[s] some evidence of employment increases and more solid evidence of work hours increases for those working due to the family assistance policy change.”). 138 see nat’l taxpayer advocate, supra note 35, at 87. the national taxpayer advocate has also proposed changing the reporting structure of the irs to adopt a more “programmatic approach.” id. at 95. although reforms of this nature might ultimately be necessary for the irs to be able to successfully close the tax gap while still promoting legal participation in social programs that are administered through the tax system, evaluating the strength of these claims would ultimately require a more thorough study of the existing irs organizational structure. 139 see 12 u.s.c. § 225(a) (2006) (establishing that the monetary policy objectives of the federal reserve are to “maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”); aaron steelman, the federal reserve’s ‘dual mandate’: the evolution of an idea, fed. res. bank of richmond econ. brief 1 (dec. 2011), available at http://www.richmondfed.org/publications/research/economic_brief/2011/pdf/eb_11-12.pdf (stating that the mandate to promote maximum employment while keeping inflation low can be conflicting). 140 see id. 141 see sewell chan, republican proposal takes aim at fed’s dual role, n.y. times, nov.16, 2010, at b3 (quoting representative mike pence of indiana, stating that: “[i]t is time to return the federal reserve to the singular mission of protecting the fundamental strength and integrity of the american dollar.”) 142 as aaron steelman of the federal reserve bank of richmond has recently pointed out, the idea that the federal reserve is responsible “for both securing the value of the nation’s currency as well as promoting employment” has been “prominent during most of its existence.” steelman, supra note 139, at 5. steelman also highlights how the federal reserve has largely remained faithful to balancing its two mandates even where public sentiment strongly favors one goal over the other (e.g., in times of high inflation or high unemployment). see id. 2012] the eitc, low-income workers, & the legal aid community 197 if the irs were to recognize the importance of delivering social programs— specifically the eitc—to its mission, it could undertake a variety of experiments to address the myriad incongruities that, as part ii makes clear, currently bedevil the program’s administration. 143 the ultimate success or failure of the specific reforms discussed in sub-parts b-e may ultimately be reliant on thoroughgoing structural reforms that vest responsibility for eitc in an administrative structure focused on social policy. b. changing the eligibility structure of the earned income tax credit in addition to reevaluating the mission of the irs, the structure of the eitc should also be altered to allow for greater participation in the program. currently, eligibility for the eitc reflects two basic considerations: income and family structure. 144 the result is that individuals hoping to apply for a refundable tax credit due to their low income must also provide information on how many months of the year they have custody over children, or other complicated information about their overall eligibility. this causes several distinct problems. 145 first, this requirement makes the application more burdensome and deters many applicants who are intimidated by the process. second, the verification process is more difficult because confirming eligibility for the eitc requires examining income and family structure, which are two separate inquiries. third, requiring applicants to provide information on both issues increases the likelihood that they will make a mistake, and thus increases the frequency of audits and denied claims. to address these problems, the eitc could be broken into two separate tax credits: a “worker credit” and a “family credit.” this approach has been advocated by the national taxpayer advocate in its 2005 and 2008 annual reports to congress, 146 and was reiterated by the national taxpayer advocate in testimony to the senate in 2011. 147 this approach was also endorsed by the president’s advisory panel on federal tax reform in 2005. 148 the united kingdom has split its equivalent of the eitc into two separate, smaller tax credits that mirror this proposal: the “working tax credit” and the “child tax credit.” 149 the national taxpayer advocate has argued that such a divided credit would entail a number of advantages. first, breaking the eitc into two separate credits would simplify the process by which the working poor apply for tax benefits. as previously noted, potential claimants are required to provide information on both their income and family status. if the process is reformed so that potential applicants are able to claim a “worker credit” without also being forced to apply for the “family credit,” many 143 see book, supra note 4, at 382. 144 see nat’l taxpayer advocate, supra note 35, at 90. 145 see generally id. at 90-91 (describing family status eligibility as a difficult fact and circumstances based assessment). 146 nat’l taxpayer advocate, tax reform for families: a common sense approach, 1 2005 ann. rep. to cong. 397, 397-406 (2005); nat’l taxpayer advocate, simplify the family status provision, 1 2008 ann. rep. to cong. 363, 363-69 (2008). 147 hearing on complexity and the tax gap: making tax compliance easier and collecting what’s due before the committee on finance of the united states senate, 112th cong. 1 (2011) (written statement of nina e. olson, nat’l taxpayer advocate). 148 president’s advisory panel on federal tax reform, simple, fair and pro-growth: proposals to fix america’s tax system (2005). 149 see tax credits, hm revenue & customs, http://www.hmrc.gov.uk/taxcredits/index.htm (last visited aug. 30, 2011). 198 columbia journal of tax law [vol.3:177 additional eligible workers may apply each year. this is because potential claimants often have confusing family structures and relationships, and are unsure how to document them on their tax return. on the other hand, workers often know much more precisely whether their earned income would meet the requirements of a “worker credit.” as a result, the reformed self-certification process would not scare off potential applicants by reframing their eligibility for the overall credit into two separate inquiries. additionally, dividing the credit into two payments would have the benefit of lowering incentives to cheat or provide misinformation on the application, because applicants will be more aware of the fact that they can still be eligible for part of the benefit without meeting other eligibility requirements. second, a divided benefit would help improve the verification process for claimants’ eligibility. assessing income eligibility for the program is undertaken in part through electronic verification of income data submitted on applicants’ w-2 forms. this electronic checking is identical to the verification that is done for individuals claiming a standard deduction who do not also claim the eitc. the more difficult eligibility verification, however, is determining family status. for example, to claim a qualifying child, a claimant must meet four tests: (1) a relationship test, (2) a residency test, (3) an age test, and (4) a support test. 150 verifying any of these tests requires the irs to collect additional data. the irs, as a result, has great difficulty assessing these elements of eligibility for the credit (such as whether a child lived with the claimant or with another parent). separating the eitc into two separate credits would disentangle the simple task of verifying eligibility based on income from the complex task of verifying eligibility based on family structure. finally, creating two separate credits in place of the eitc would also streamline the auditing process. during the auditing process, individuals are asked to provide information on various aspects of their eligibility for the credit. 151 if, however, the irs only has questions on one of the credits being claimed, the audit would be less intimidating and require less information. this has the advantage of both decreasing the total number of audits that need to be performed, and also increasing the number of eligible applicants that are able to keep their refund despite being audited. this is critical given the eitc audit process’s daunting requirements and alarmingly high error rate, which causes a significant number of taxpayers to lose their benefits during the auditing process simply because they have difficulty complying with the audit’s requirements. 152 if there were fewer audits needed to administer two separate tax credits, and the audits that were to occur required less information, it is likely that fewer qualifying low-income families would lose the benefit of this program. c. changing the application for the earned income tax credit one of the primary reasons that the eitc has higher participation rates than other social welfare benefits is that most adult americans file tax returns. 153 given this reality, the burden of claiming the eitc is minimal compared with the burden of filing a separate application that is required for most other welfare benefits. 154 additionally, the 150 see i.r.c. § 32 (2006). 151 see book, supra note 4, at 381. 152 nat’l taxpayer advocate, earned income tax credit audit reconsideration study, 2 2004 ann. rep. to cong. (2004). 153 id. at 88. 154 id. 2012] the eitc, low-income workers, & the legal aid community 199 perceived burden is lower due to the eitc’s self-certification process, under which potential claimants only have to interact with the government directly if they are subject to an audit. that said, despite the fact that most adults do file tax returns, it is estimated that in 2009 forty-seven percent of all individual taxpayers do not have an obligation to file tax returns because they have either a zero or negative tax liability. 155 as a result, by choosing to administer this welfare benefit for low-income workers through the tax system, the government is imposing the potentially significant burden on many eitc claimants of filing a tax return that they would otherwise not be required to file. given that this is often a burden for eitc tax filers, the irs should take steps to simplify the tax return that individuals with no tax obligation are required to complete. as part of that goal, the irs should take steps to develop a “ready return” modeled on the program that was developed in california in 2005. 156 a “ready return” program recognizes the reality that there is usually little need for a taxpayer to fill out information on her income or to complete complicated math. income data from w-2 forms are submitted to the irs by employers who withhold their employees’ taxes. currently, when a tax filer completes a tax return, the irs checks the information provided by the filer against the information provided by the employer. 157 this system, however, can be beneficially inverted. instead of asking tax filers to submit the information for the irs to double check, “ready return” programs present tax filers with pre-populated forms that contain their individual income information that are submitted by their employers. tax filers then simply confirm that the information submitted by their employers is accurate and comprehensive. 158 in california, the “ready return” is only available to individuals filing very simple tax returns who do not claim many deductions or sources of interest income. 159 although this may prevent the “ready return” from serving as an overall fix for the tax return system, it should not prevent the development of a similar system to serve eitc claimants, who typically do not have complicated sources of income. 160 as a result, the irs should be capable of developing a program where low-income tax filers can update their eitc applications each year by simply confirming the information that the government has on their income, living, and family situations. this reform would reduce the burden of self-certification, and, by lowering the eitc’s error rate, reduce administrative costs spent on audits. it would also help supplement the irs’s ongoing efforts to promote free tax preparation assistance to low-income taxpayers through the vita volunteer program, as discussed in part ii. 155 williams, supra note 41, at 1583. 156 see joseph bankman, simple filing for average citizens: the california ready return, 107 tax notes 1431 (2005). 157 id. 158 see, e.g., cal. franchise tax bd., your california tax return may be ready and waiting for you, ca.gov, https://www.ftb.ca.gov/readyreturn/?wt.mc_id=individuals_online_readyreturn (last visited july 12, 2011). 159 id. 160 see general explanation of the administration’s fiscal year 2005 revenue proposals, dep’t of the treas., 88 (feb. 2004), http://www.treasury.gov/resource-center/tax-policy/documents/bluebk04.pdf (stating that most eitc claimants do not have income covered by the most complicated of the eitc’s three income tests, which encompasses various kinds of investment income). 200 columbia journal of tax law [vol.3:177 d. reforming the audit process used with earned income tax credit claimants restructuring the way that the irs conducts audits of tax returns where the eitc is claimed would help to make the eitc fairer. 161 as previously discussed, after an eitc claimant is targeted for an irs audit, the audit is typically conducted on a correspondence basis; moreover, eitc claimants are both more likely to be audited than high-income taxpayers, and more likely to have difficulties with the auditing process. 162 the irs should thus enhance the audit process of eitc claims by lowering hurdles that arise from communications issues, documentation requirements, and the audit process’s reliance on correspondence. 163 first, steps should be taken to improve the communication between the irs and the eitc claimant during the auditing process. an eitc correspondence audit typically starts with a letter informing an eitc claimant that he or she is being audited. in 2007, the national taxpayer advocate service conducted a comprehensive survey of 754 different taxpayers who had been audited because of issues surrounding their 2004 tax year eitc claims. 164 in the survey, less than a third of the respondents felt that the initial notification letter that they had received was easy to understand, and only half felt that, after reviewing the letter, they knew what they were expected to do. 165 given their confusion, over ninety percent of the respondents contacted the irs about their audits to try to gain more information. 166 this illustrates that most eitc claimants are left overwhelmed and confused by the irs’s current communication process. there are also several ways to clarify the means of correspondence. to make the standard form letter easier to understand, national taxpayer service studies could help determine what wording, structure, and information ought to be included in the letter. 167 the initial notification letter, and all subsequent communications, should also include the name of a single case officer who can be contacted with any questions that audited parties might have after receiving written communications that they find confusing. the case officer should, whenever possible, also take the affirmative step of phoning the claimant after a notification letter has been mailed. finally, every notification letter and communication ought to include information on the benefits of obtaining representation during the auditing process. additionally, the current regulation forbidding the irs from proactively referring taxpayers to litcs 168 should be abolished, and case officers should be empowered to provide contact information for any nearby litcs so that audited parties are aware of the 161 see, e.g., book, supra note 63; nina e. olson, minding the gap: a ten-step program for better tax compliance, 20 stan. l. & pol’y rev. 7 (2009). 162 see holt, supra note 46, at 190-91 (defining “high-income” individuals as those earning $100,000 and greater). 163 see nat’l taxpayer advocate, supra note 70, at 94 (noting that “barriers faced by taxpayers during eic audits may be divided into three primary categories: communication, documentation, and process.”). 164 id. at 100. 165 id. at 95. 166 id. 167 see, e.g., taxpayer advocacy panel, 2005 ann. rep. 4, 32 (2005); nat’l taxpayer advocate, a comprehensive strategy for addressing the cash economy, 2 2007 ann. rep. to cong. 27-30 (2007). 168 see supra notes 122-123 and accompanying text. 2012] the eitc, low-income workers, & the legal aid community 201 assistance that is available. 169 similarly, once an audited claimant has retained the services of an litc, the litc officials should not be barred from communicating with the claimant about his or her current tax year issues, as is now the case. in addressing past year controversies, litc officers are frequently undoing errors committed by thirdparty tax preparers. 170 perversely, then, this rule encourages a situation where, after the litc solves the past year’s problem, claimants often return to their familiar tax preparers and undergo the same type of audit the following year. in addition to improving communication during the auditing process, measures should also be adopted to clarify the documentation required to resolve the audit. the national taxpayer advocate’s survey indicates that fifty-nine percent of the respondents identified difficulty obtaining the necessary documentation, and only fifty-five percent of respondents indicated that they even understood “how the documents would answer the irs’s questions about the eitc claim.” 171 for example, eitc claimants are often asked to provide documentation that their child was enrolled in a local school to prove that their child meets the residency requirement for a qualifying child under eitc’s guidelines. frequently, eitc respondents then submit documentation proving that their child was in school for the previous school year, forgetting that to prove this fact for the previous tax year, they need to provide documentation that their child was enrolled in both the spring and fall semesters (spanning two school years). 172 as a result, the initial notification letter should be modified to provide a simple and explicit checklist of the documentation that is required for the audit. the listed documentation should give specific, concrete examples of all documentations required to complete the correspondence audit. even if the audited eitc claimants understand what is being requested, they often have difficulty obtaining the proper documentation. in 2004, the irs piloted the use of affidavits from reliable third parties when an eitc claimant was unable to find appropriate documentation for the child residency requirement. 173 under this pilot program, if an eitc claimant was audited and unable to find appropriate documentation for that requirement, he or she could submit a form completed by a school administrator, social worker from another agency, clergy member, or other reliable third party. the irs agent conducting the audit was then able to follow up with the third party and quickly confirm information about the claimant’s family status and living situation. although this system is certainly prone to error, and there is the possibility that the affidavit could be fabricated, the national taxpayer advocate service’s 2009 annual report to congress indicated that “the affidavit is the most effective and accurate means of proving eligibility and the taxpayers prefer the affidavit to providing documents, records, or letters.” 174 given that the pilot program appears to have been a success, the irs’s 2004 169 it should be noted that the irs is currently barred from referring taxpayers to litcs by law. the taxpayer assistance act of 2010 is currently before the house ways and means committee, and among other changes, would allow the irs to begin referring taxpayers to litcs. see generally congress introduces bill to help taxpayers cope with irs, accounting today for the web cpa (apr. 13, 2010) (discussing the taxpayer assistance act of 2010, which will allow irs employees to refer taxpayers to litcs), http://www.webcpa.com/news/congress-introduces-bill-help-taxpayers-cope-irs-53885-1.html. 170 email from tamara borland, dir., iowa legal aid’s low income tax clinic, to joshua boehm (aug. 8, 2011, 18:51 cst) (on file with authors). 171 see nat’l taxpayer advocate, supra note 70, at 106. 172 id. at 97. 173 internal revenue serv., dep’t of the treas., rep. on fiscal year 2005 tests, at iii (2007). 174 nat’l taxpayer advocate, supra note 35, at 97-98. 202 columbia journal of tax law [vol.3:177 pilot program should be expanded and adopted as the norm during correspondence audits of eitc claimants. third, the irs should take steps to reform the audit process so that eitc claimants are not under the impression that they are subject to the correspondence audit process alone. in the national taxpayer advocate’s 2007 survey, over seventy percent of respondents would have preferred a system other than correspondence to resolve their audit, 175 despite the fact that those audited have a right to request that they instead be subject to a “face to face” audit instead of simply being subject to the correspondence process. 176 this right is difficult for those audited to assert, however, because they are not typically notified of this right in initial communications and do not know how to assert the right. as a result, the initial notification letter should also be modified so that it informs audited tax filers about their right to a “face to face” audit, and includes a checklist of the steps that must be taken to assert that right. 177 this reform, along with the others suggested, may increase the overall costs of the auditing process. but since a decision has been made to use the tax system to administer one of the primary social welfare programs for the working poor, these rights should not be denied simply because individuals are unable to understand what is being asked of them in the process, what documentation is required to resolve the audit, and what rights they have during the audit. this is especially critical given the national taxpayer advocate’s admission that a “lack of representation during an audit puts eitc taxpayers at an inherent disadvantage over those taxpayers who are represented.” 178 e. moving toward a non-adversarial alternative to tax court given the above discussion of the difficulties low-income taxpayers encounter in engaging the tax court’s adversarial adjudicative processes, a system that would be both more normatively fair and produce less incongruous results should be adopted. 179 an excellent model exists in another welfare context: social security disability insurance (“ssdi”) adjudication. ssdi proceedings, which are “inquisitorial” rather than “adversarial” in nature, are distinct in a number of ways that may prove beneficial if transposed to the eitc context. first, the ssdi adjudication is presided over by an administrative law judge (“alj”). 180 the alj plays the roles of advocate for the government, advocate for unrepresented defendants, and adjudicator who makes a decision in the case. 181 second, the cases are far less formal. they are typically conducted in a small conference room with only the alj, the defendant, and representatives or witnesses for the defendant present. 182 as a result, the proceedings are 175 nat’l taxpayer advocate, supra note 70, at 95. 176 see id. at 116. 177 id. 178 id. at 97. 179 see generally jonathan p. schneller, the administration of tax expenditures: the case of the earned income tax credit, 90 n.c. l. rev. (forthcoming 2012) (arguing that the adversarial procedures of the u.s. tax court are ill-suited to eitc controversies, due to claimants’ resource constraints, and advocating instead for a more inquisitorial, administrative model of adjudication). 180 ronald a. cass, colin s. diver & jack m. beermann, administrative law: cases and materials 598 (5th ed. 2006). 181 see fred davis & james reynolds, profile of a social security disability case, 42 mo. l. rev. 541, 549-50 (1977); see also jon c. dubin, torquemada meets kafka: the misapplication of the issue exhaustion doctrine to inquisitorial administrative proceedings, 97 colum. l. rev. 1289, 1325 (1997). 182 see cass, diver & beermann, supra note 180, at 598. 2012] the eitc, low-income workers, & the legal aid community 203 less intimidating to low-income workers who are fearful of the government and formal proceedings. 183 moving to a model similar to the one used in ssdi adjudications for eitc claimants who are deemed “delinquent” after irs audits would have several distinct advantages. first, it would help to alleviate the inequities that are suffered because eitc claimants have limited access to counsel for the tax court proceedings. moreover, it would help to ensure that in at least one stage in the process, there is a government advocate helping eitc claimants to present their side of the story. it would also create potential efficiencies because the proceedings would require a single government employee, instead of the judges, attorneys, and court staff who are currently used for “s” cases in tax court. and finally, the ssdi approach would allow for a flexible adjudicative inquiry in which aljs could have follow-up meetings and take it upon themselves to consult with social workers, school officials, or clergy members who understand the circumstances of the eitc claimant. to be sure, ensuring the neutrality of the alj proceedings will also depend greatly on how burdens of proof are allocated; careful consideration must be given to what testimony and facts the alj must elicit before denying benefits. 184 properly designed, the features of an alj system are far better suited to the needs and capabilities of low-income litigants, and their application in the eitc context should be considered accordingly. iv. the need for increased involvement from congress and the legal aid community while the irs-centered reforms proposed in the previous section have varying levels of political feasibility, the legal aid community may be better placed to enact timely and meaningful changes that benefit eitc claimants, given its core mission to assist the poorest americans. to that end, this part discusses discrete initiatives available to the legal aid community that can address current pathologies in the eitc. as will be discussed below, the legal aid community is already achieving substantial gains in promoting awareness and developing easier methods for potential eitc claimants to file federal tax returns. yet it must still take additional steps to offer representation during the auditing process and tax court proceedings, where, as noted above, there remains a great unmet need for legal assistance. to be sure, legal aid organizations are in the midst of an extraordinarily difficult fiscal situation, 185 and are already forced to turn away as many clients as they are able to help. 186 congress has greatly erred in its decision to cut legal services corporation (“lsc”) funding from $420 million in 2010 to $348 million in 2012. as lsc president james sandman has pointed out, this sharp reduction in resources comes at “a time when low-income families are increasingly seeking legal assistance” in matters implicating fundamental needs, including “domestic violence, foreclosure, veterans’ benefits, and 183 see book, supra note 4, at 401-02. 184 authors’ correspondence with tamara borland, supra note 170. 185 see staff reductions hit legal aid programs, legal servs. corp. (jan. 2012), available at http://www.lsc.gov/media/press-releases/staff-reductions-hit-legal-aid-programs (noting that 13.3% of attorneys will be cut from lsc-funded programs in 2012 and that congressional appropriations for the lsc has decreased from $420 million in 2010 to $348 million in 2012). 186 see documenting the justice gap in america, legal servs. corp. 11 (sept. 2009), available at http://www.lsc.gov/justicegap.pdf. 204 columbia journal of tax law [vol.3:177 other matters.” 187 while congress surely faces tough budgetary choices of its own, we question the wisdom, cost-effectiveness, and morality of weakening such a critical part of the social safety net—precisely when the poorest americans need it most—to garner savings representing a tiny fraction of the federal budget. accordingly, we understand that the observations and recommendations we make in this section may be difficult to effectuate at this particular time. but, even in a tight budgetary context, the importance and scale of the eitc representation shortfall should nonetheless command a greater amount of attention from congress and the legal aid community. in this section, we explore four steps that the legal aid community can take to meet the needs of eitc claimants. first, we examine limited assistance programs that are currently available to eitc claimants. in this discussion, we address the advances that have been made in the last decade, as well as potential steps that can be taken to improve self-help resources for eitc claimants. second, we explore the failure of the modern civil gideon movement to include representation in tax proceedings. third, we analyze the need to increase the resources and enhance the services of litcs. we conclude by arguing that congress should appropriate new budgetary funds to the lsc for assisting in tax cases, notwithstanding austerity pressures, and that lsc grantees should consider ways to reallocate existing resources to tax cases as soon as practicable. the dual recognitions that (1) the eitc has largely displaced traditional welfare in american anti-poverty policy; and (2) the eitc imposes legal burdens arguably more daunting than those associated with traditional welfare, compel a renewed focus on the program by congress and the legal aid community. a. limited assistance programs and the eitc one innovative solution for meeting the needs of potential eitc tax filers is the adoption of limited assistance programs. 188 limited assistance programs are efforts to provide self-represented litigants with the necessary information and resources to be able to effectively resolve their legal disputes without an attorney or other trained professional. 189 examples of limited assistance programs include offering simplified forms, providing pamphlets in a wide range of languages, establishing hotlines with legal information, or even selling “unbundled” legal services. 190 these programs have been increasingly used to fill a wide range of needs across the legal services landscape, and offer several potential benefits over more laborintensive options. first, limited assistance programs free up the time of legal aid lawyers and pro-bono attorneys to work on cases that require high levels of professional training. 191 second, limited assistance programs can have impressive returns to scale 187 see staff reductions hit legal aid programs, supra note 185. it should be noted that another important form of funding for legal aid organizations, interest on lawyers’ trust accounts, has also diminished in recent years due to low interest rates. see karen sloan, perfect storm hits legal aid (jan. 3, 2011), available at http://www.law.com/jsp/nlj/pubarticlenlj.jsp?id=1202476843961&slreturn=1. 188 jeanne charn, legal services for all: is the profession ready?, 42 loy. l.a. l. rev. 1021, 1040 (2009) (using the legal aid society of orange country i-can! program as an example of “one of the most innovative providers of legal services in the country.”). 189 see, e.g., john m. greacen, framing the issue for the summit on the future of self-represented litigation, in summit on the future of self-litigation 21 (2005) (discussing examples of the lsc moving towards facilitating self-representation). 190 id. 191 see charn, supra note 188, at 1058 (“like the solo and small-firm bar, salaried legal aid lawyers should focus on matters that require their extensive professional training and expertise, and leave to lay 2012] the eitc, low-income workers, & the legal aid community 205 because the variable costs are low relative to the fixed costs of initially starting the programs. 192 third, the programs may gain political support more easily due to their emphasis on individualism. fourth, commentators hypothesize that, by playing a larger role in making their own case, clients learn lessons that they are able to use in the future both to avoid conflicts and to help resolve them with less assistance. 193 as a result of these benefits, lsc data currently suggest that three-fourths of all completed legal aid matters involve “advice, referral, or limited assistance.” 194 although the eitc’s complexities often create a need for representation and assistance, limited assistance programs can still play a pivotal role in ameliorating the eitc’s administrative shortcomings. one of the most prominent examples of a limited assistance program designed to help eitc claimants is the legal aid society of orange county’s (“lasoc”) development of its “eic partner” website (www.eicpartner.com). 195 the eic partner website promotes the use of free internet filing software that helps potential claimants file for the eitc. in the 2007 tax year, this service helped over 25,000 individual tax filers, and resulted in nearly $12 million in eitc benefits being paid out. 196 these usage rates continue to improve, and as a result, the lsc recently reported that tax filers from 49 states used the i-can! software and were able to claim $110 million in total refunds. 197 this website and its associated organization serve three key functions. first, the eic partner website provides information for potential eitc filers on how to use i-can!. this software provides online forms and information that allow users from anywhere in the country to file for the eitc while completing their federal tax returns. 198 since the software is free and contains detailed information on common problems confronting low-income taxpayers, it is, for many eitc claimants, a preferable alternative to fee-based preparation software or professional help. although the i-can! software was once only available without charge to eitc-eligible individuals, it is now available to any tax filer, unless the filer also owns a small business or is subject to a few minor exceptions. 199 the software is also able to e-file state tax returns for residents of advocates, and self-help and limited-assistance centers all matters that these service resources can handle appropriately.”). 192 see richard zorza, the future of self-represented litigation: report from the march 2005 summit, national center for state courts 5 (2005), available at http://lawworks1.com/publicfiles/pdf's/futureofprose.pdf. 193 see michael milleman et al., rethinking the full service legal representation mode: a maryland experiment, 30 clearinghouse rev. 1178, 1179 (1997) (“by playing a larger role in resolving the problem, the client also may fully exercise her right to make basic case judgments and learn to avoid future legal problems.”). 194 see charn, supra note 188, at 1032. 195 see id. at 1040. see also legal aid society of orange county, i-can! e-file, i-can! e-file, http://www.icanefile.com (last visited july 12, 2011). 196 legal aid society of orange county, quick summary jan. 14th, 2008 – april 15th 2008, ican! e-file, available at http://www.eicpartner.com/userfiles/i-can%20efile%20and%20800%20number%20summary.pdf. 197 see i-can! e-file hits new high in tax refunds to low-income americans, legal services corporation (march 1, 2011), available at http://www.lsc.gov/media/press-releases/i-can-e-file-hits-newhigh-tax-refunds-low-income-americans (last visited jan. 9, 2012). 198 see charn, supra note 188, at 1040. 199 id.; see also legal aid society of orange county, i-can! e-file, i-can! e-file, http://www.icanefile.org/index.asp?caller= (last visited jan. 9, 2012) (“you can generally use i-can! e-file 206 columbia journal of tax law [vol.3:177 california, montana, michigan, pennsylvania, and new york. 200 in the 2007 and 2008 tax years, eic partner conducted an online survey that users were asked to complete after using the program to complete their tax returns. in that survey, fifty-nine percent of respondents indicated that the software was “very easy to use” and fifty-eight percent of respondents indicated that they were “very satisfied” overall with the i-can software. 201 the survey data did indicate one of the limitations of the service: seventy-two percent of respondents indicated that they used the internet daily, and another fifteen percent of respondents indicated that they used the internet weekly. 202 as a result, although this service is quite valuable to many low-income tax filers, its scalability is effectively restricted to the subset of filers with computer proficiency, access, or both. although this does not undermine the potential benefits of the service, it does indicate a limitation in meeting the needs of all eitc tax filers. second, in addition to the eic partner website, the lasoc runs a hotline that potential eitc claimants can call for information. the hotline is a toll-free number that greets callers with an automated message on the eitc, information explaining how to apply, and information regarding access to the i-can! software. 203 at the end of the automated message, callers are prompted to enter their five-digit zip code. after doing so, the callers are notified of free tax service centers in their area. 204 as part of this service, the lasoc actively encourages any organization that is able or willing to provide advice on the eitc to register with the hotline so that its contact information is listed after a caller enters a zip code in its area. 205 in 2008, over 4,400 individuals took advantage of the hotline. 206 third, the eic partner website provides resources for partner organizations seeking to assist eitc claimants. to this end, eic partner develops best practices that it disseminates to organizations that wish to help potential eitc filers claim the benefit. 207 additionally, partner organizations are given a unique url to put on their webpage. any time the url is used for a filer to access the i-can! filing software, the organization that directed the tax filer there is given information for tracking its success in helping individuals claim the eitc. 208 an excellent example of a partnering unless you (or your spouse, if filing together) are in the military, are a church employee, are a non-resident alien, sold real estate or you or your employer have a non-us address.”). 200 see legal aid society of orange county, frequently asked questions, i-can! e-file, http://www.icanefile.org/faq.asp?caller=#13 (last visited jan. 9, 2012). 201 legal aid society of orange county, user survey data 2007/2008 tax year, i-can! e-file, available at http://www.icanefile.org/programs/survey%20data%20april%2015.pdf (last visited jan. 9, 2012). 202 id. 203 legal aid society of orange county, nationwide 800 number, i-can! e-file, available at http://www.eicpartner.com/userfiles/file/i-can!%20e-file%20800%20number%20flyer(3).pdf (last visited jan. 9, 2012). 204 id. 205 id. 206 legal aid society of orange county, supra note 196. 207 legal aid society of orange county, becoming a partner site, i-can! e-file, available at http://www.eicpartner.com/userfiles/file/i-can!%20e-file%20partner%20sites%20flyer%282%29.pdf (last visited july 11, 2011). 208 id. http://www.eicpartner.com/userfiles/file/i-can!%20e-file%20partner%20sites%20flyer%282%29.pdf 2012] the eitc, low-income workers, & the legal aid community 207 organization is the montana legal services association, 209 which has created a website based on the eic partner’s information and software (www.montanafreefile.org). by the 2008 tax season, montana free file helped refund over $3.25 million to i-can! e-file users in the state of montana. 210 of that total, sixty-one percent was from the eitc. 211 this illustrates the success that legal services organizations can have in helping individuals access social benefits that they are due through the tax system. all three of these activities demonstrate how limited assistance programs can be developed to help potential eitc claimants obtain the welfare benefits that they are entitled to without resorting to expensive private tax preparers. the success of i-can! shows that more resources and effort should be devoted to developing and spreading awareness of the eitc assistance that the program makes available. although the lasoc’s development of the eic partner program and i-can! software is a laudable example of “a culture of bottom-up creativity and innovation” in the development of legal services, 212 there are still limits to the organization’s ability to provide legal services to eitc claimants. lasoc’s technical assistance is restricted to questions that users have on how to use the i-can! software, how to check their e-file status, how to enter tax information into the software, and how to amend a rejected return. 213 all other inquiries about one’s tax situation are directed to the irs. 214 accordingly, the organization’s assistance operates exclusively at the filing stage of an eitc claim, and does not extend to eitc claimants who are having their tax returns audited. 215 since, as previously noted, eitc claimants are far more likely to be audited than ordinary taxpayers and benefit dramatically from representation, 216 this is a critical gap in the information and services provided by the “eic partner” organization. as a result, funds should be allocated to help develop information for those eitc filers who are subjected to an audit. first, the eic hotline should be expanded (or a new hotline created) so that eitc claimants subject to an audit can gain access to information on the audit process and the location of the nearest legal aid resource. second, the website should provide clear information on the audit and tax court process. for example, the site could provide examples of the types of documents to submit during correspondence audits to satisfy common irs requests. similarly, the eic partner organization could begin development of audit best practices to complement the filing best practices currently provided to partner organizations. although not an exhaustive list, all of these steps would be relatively straightforward mechanisms to improve the coverage of taxpayer self-help and extend the limited assistance made possible by the eic partner website into the domain of eitc audits and tax court adjudication. as helpful as such programs can be, they are necessarily limited to individuals with the literacy and initiative to attain self-help via navigation of such resources. as one 209 see montana legal services association, 2007-2008 montana legal services association guide to annual implementation and outreach: i-can! e-file, i-can! e-file (sept. 18, 2007), available at http://www.eicpartner.com/userfiles/2007-2008%20i-can%20binder(2).pdf. 210 id. 211 id. 212 see charn, supra note 188, at 1040-41. 213 legal aid society of orange county, how we can help, i-can! e-file, http://www.icanefile.org/help.asp?caller= (last visited jan. 9, 2011). 214 id. 215 see id. 216 nat’l taxpayer advocate, supra note 65, at 119. 208 columbia journal of tax law [vol.3:177 commentator pointed out when discussing the limits of self-help in the tax system, “[s]lightly more than 20% of the population lacks the skills necessary to read a food label, fill out a form, or read a simple story to a child.” 217 a single mother with full-time work and child-rearing responsibilities but lacking internet access may not be wellpositioned to avail herself of limited assistance resources such as the i-can! program. the irs’s vita program, as discussed earlier, is well-placed to remedy this gap. 218 vita’s trained volunteers not only serve a critical role in areas where programs such as eic partner and i-can! are not yet implemented, but can also assist where eitc claimants have access to such technology but are unable or unwilling to use it. many legal services organizations recognize the importance of vita in meeting this demand and make concerted efforts to publicize vita site locations to their clientele; it is critical that they continue to do so. 219 b. expanding and improving low income tax clinics low income tax clinics (“litcs”) can and must play a much greater role with respect to representing eitc claimants who have been targeted for audits. 220 viewed in light of the significant need for and dramatic impact of representation, the federal litc budget of $9.5 million per year is woefully inadequate, 221 both when seen in light of need for legal services and in light of the estimated $300 million a year that eligible eitc claimants are denied due to the lack of representation. 222 litcs handled roughly 37,000 taxpayer controversies in 2008; assuming an litc funding amount of $20 million (a figure which assumes the full budget was disbursed along with matching spending by educational institutions), the average cost per controversy can be estimated at $540. 223 while it is unrealistic, at least in the immediate term, to expect congress to expand the litc program budget in order to provide representation to every claimant, each additional audit representation will, on average, diminish the amount of erroneous deprivation ($623) by more than the cost of that representation ($540). additional expenditures on audit representation will not necessarily pay for themselves; in fact, if such representation is effective, it will actually cost the government more because claimants will be recouping a greater percentage of their eitc entitlements. rather, this comparison illustrates that dedicating more funding to eitc representation would be a cost-effective use of administrative resources. moreover, litc funding might reduce the cost of the irs audit process, because represented and advised parties can be expected to 217 bankman, supra note 156, at 1431. 218 for background information on the vita program, see supra note 54 and accompanying text. 219 authors’ correspondence with tamara borland, supra note 170. 220 the basic structure and function of litcs are discussed in part ii.c.3. 221 nat’l taxpayer advocate, supra note 65, at 117. 222 in a 2007 study, the taxpayer advocate service found that represented and unrepresented taxpayers have nearly identical claim amounts before auditing—a difference of $36—but the average amount disallowed after audit is $587 higher for non-represented taxpayers, yielding an overall disparity of $623 between taxpayers with representation and those without. assuming that non-represented taxpayers would have retained a similarly higher amount of eitc funding post-audit had they been represented, the aggregate deprivation of benefits due to lack of representation can be estimated at over $300 million. nat’l taxpayer advocate, supra note 70, at 97, 112. this figure is derived by multiplying the number of eic audits (517,617) by the overall disparity ($623). 223 this figure is derived by dividing the estimated total eitc budget ($20 million) by the number of issues litcs handle each year (37,000). it should be noted that of these issues, 10,142 cases were opened, of which 1,804 were submitted to the u.s. tax court. it is likely that such cases required a greater expenditure than the average cited here. nat’l taxpayer advocate, supra note 65, at 117. 2012] the eitc, low-income workers, & the legal aid community 209 focus more on salient issues, provide necessary documentation in response to initial irs requests, and handle hearings in an efficient manner. 224 furthermore, the cost of representation must be viewed in the broader context of the policy choices congress made in enacting the eitc. by putting essentially no resources into pre-certification, unlike other welfare programs such as tanf, congress effectively opted for low administrative costs at the expense of error rates, while shifting the costs of compliance from the state to the low-income taxpayer. 225 while congress has devoted significant resources to eitc compliance and enforcement (roughly $150 million annually), when viewed against a backdrop of $10 billion in eitc disbursals to non-qualifying recipients for the 1999 tax year, 226 it seems incongruous that only $10 million has been dedicated to help ensure that qualified audited recipients retain their full benefits by providing representation. c. deepening legal aid programs’ involvement with tax matters the lsc and its local grantees should consider recognizing the eitc’s pervasiveness and undertaking initiatives to assist eitc claimants. the lsc’s latitude to assist eitc claimants is somewhat restricted by its guidelines, which limit eligibility for lsc assistance to individuals with incomes equivalent to 125% of the federal poverty guidelines. 227 however, a significant number of eitc recipients fall within the lsc’s eligibility threshold, as the eitc’s eligibility criteria encompass individuals at well below the guideline. 228 there are two paths for the lsc and grantee organizations to deepen their support for eitc recipients. first, current lsc grantees could expand the range of resources they devote to eitc assistance. to illustrate, recent data suggest that two of the largest legal aid programs in the country, in new york and los angeles, dedicate around one-fifth of their hours toward government benefits retention cases. 229 these include cases where individuals have been deprived of benefits under social security, food stamps, tanf, supplemental security income, and other federal and state-specific welfare programs. 230 these are undoubtedly important issues, and tax problems of eitc claimants are just one of the many legal problems that low-income individuals face each year. after all, there are an estimated “45 million to 75 million lowand moderate 224 see supra part ii.c.2 for a detailed discussion of the confusion that irs audits typically present to eitc claimants. 225 see book, supra note 19, at 1106; david a. super, privatization, policy paralysis, and the poor, 96 cal. l. rev. 393, 434 (2008) (noting that in “cash assistance, food stamps, and medicaid, the government traditionally has borne the costs of helping claimants complete applications” but in the case of the eitc, the government has left much of the “payment for administration to claimants . . . .”). 226 nat’l taxpayer advocate, supra note 70, at 98. 227 see 45 c.f.r. §1611.3(c) (2005). 228 see i.r.c. § 32(b)(2)-(3) (west 2011) (setting forth eitc income eligibility criteria); income level for individuals eligible for assistance, 74 fed. reg. 5620 (jan. 30, 2009) (outlining lsc assistance income thresholds). 229 see funding sources, legal aid foundation of los angeles, http://www.lafla.org/funding.php (last visited dec. 24, 2011); annual report 2009-10, legal servs. n.y.c. 53, available at http://www.legalservicesnyc.org/storage/lsny/pdfs/ls-nyc_annrep_09-10-12-lo.pdf (last visited dec. 24, 2011) (note that the category “income maintenance” represents government benefits). 230 see, e.g., government benefits, legal aid foundation of los angeles, http://www.lafla.org/service.php?sect=govern&sub=main (last visited july 12, 2011); how we help people, legal services new york city, http://www.legalservicesnyc.org/index.php?option=com_content&task=view&id=23&itemid=52#help%20p rotect%20and%20secure%20income (last visited july 12, 2011). 210 columbia journal of tax law [vol.3:177 income people who have legal problems for which interested and competent lawyers might be a benefit.” 231 yet it remains critical to recognize the importance of the “hidden” welfare state in contemporary anti-poverty policies. consider, for instance, that the government benefits litigation budget for new york city’s legal services nyc ($8.9 million in 2009-10) is not significantly less than the entire federal outlay for eitc representation ($9 million as matching funds for litcs). 232 given that litcs can currently represent so few audited eitc claimants—less than two percent, as noted above—legal aid groups might consider allocating some portion of their government benefits litigation funding to help close this yawning representation gap. while again acknowledging that the feasibility and impact of any such shift would likely be modest at present, given stark budget cutbacks at lsc grantees, it is nonetheless important to highlight the severe underrepresentation of eitc claimants (even in relation to other underserved clients). as we suggested earlier, lawmakers ought to recognize that even in times of fiscal austerity, providing legal help to the poorest americans facing eitc challenges— involving benefits that finance basic needs—should remain a high budgetary priority. a more promising path, accordingly, would be for congress to allocate new funding to the lsc and local legal aid societies for assistance of eitc claimants. while lsc grantees choose their own priorities, the lsc could seek a special competitive grant to assist eitc claimants with filing. such funding could enable legal aid societies to serve as a backstop to the automated and self-help measures that they are currently funding and spearheading. there are clear opportunities for legal aid societies to expand and integrate their self-help and limited-assistance tax initiatives, like i-can!, with their core competencies in providing direct legal advice. frequently, lsc grantees encounter clients who are simultaneously trying to resolve prior year controversies while also completing returns for the current year. 233 at present, there is a strict division of funding and responsibilities between legal aid organizations and vita programs, which complicates the resolution of such cases: legal aid attorneys must deal only with the past year problems while referring the client to a vita site to complete the current year’s taxes. 234 to increase efficiency and reduce the risk of error and miscommunication, legal aid attorneys should have the resources and mandate to deal with all of the client’s tax issues in such circumstances. to be sure, any congressional funding increase for pre-filing eitc assistance at legal aid societies would likely engender political criticism because such reform imbues the eitc with greater administrative costs, thus reducing its supposed advantage over other welfare programs like tanf and food stamps. ultimately, though, such funding would likely generate sufficient benefits to outweigh those costs. deeper legal aid involvement with complicated pre-filing eitc cases could augment the salutary effect of i-can!, vita, and self-help by further cutting into the billions of dollars that eitc claimants spend annually on private tax preparation assistance. 235 if eitc claimants 231 james l. baillie, the role of the private bar in a model system for the delivery of legal services, 26 hamline j. pub. l. & pol’y 195, 198 (2005). 232 annual report 2009-10, supra note 229, at 53. low income taxpayer clinic grant recipients announced, internal revenue serv. (feb. 17, 2012), available at http://www.irs.gov/newsroom/article/0,,id=254537,00.html. 233 authors’ correspondence with tamara borland, supra note 170. 234 id. 235 cords, supra note 50, at 376-77. 2012] the eitc, low-income workers, & the legal aid community 211 knew that government-funded advice were available, they would presumably be less inclined to seek assistance from private preparers with high rates of non-compliance. thus, it could be expected that legal aid involvement in pre-tax filing would both ensure that claimants retain a greater portion of the credit to which they are entitled, and reduce erroneous filings encouraged by unscrupulous private preparers. lsc competitive grants could also be targeted at representation in the audit and tax court settings. as noted, some litcs are already run by legal aid groups—as of 2011, roughly one in five were 236 —such close coordination between general legal services and low-income tax representation is laudable and should be encouraged. and certain state legal aid groups, such as legal services of new jersey, already provide some tax services in-house. 237 however, the involvement of legal aid groups in povertylevel tax work is generally very low and must be expanded. 238 one potential barrier may be, as book suggests, that “lawyers tend to view tax law as an isolated discipline, requiring great specialization due to the area’s complexity, both substantively and procedurally.” 239 but as statistics show, the problems that most frequently trigger eitc audits tend to fall within common niches—such as proof of a qualifying child under eitc criteria—thus diminishing the breadth of material to learn. 240 moreover, a number of lsc grantees have recently started or expanded foreclosure representation practices in response to burgeoning demand for such services as a result of the recent housing crisis. this illustrates the ability of legal aid groups to adapt quickly to meet client needs, and to do so in a relatively complicated area of the law. even if the legal aid groups were to expand deeper into tax representation, individual legal aid offices would be required to spend at least 12.5% of their basic field grants to recruit and assist private attorneys to represent low income taxpayer clients, usually on a pro bono basis. 241 more than ten percent of the cases closed in 2007 were assisted by pro bono attorneys. 242 lsc grantees are under no obligation to allocate private attorney-related funding toward any specific field, but if they targeted low-income tax representations with some of those resources, it would help increase the visibility of eitc representation in the professional tax community, and especially in the eyes of private firms looking for pro bono opportunities. firms can give special bonuses to associate hires with tax clinic experience, allow associates to participate directly in government-sponsored representation programs, or handle pro bono cases independently. 243 d. the civil gideon movement and the eitc although the supreme court found a constitutionally guaranteed right to counsel in criminal cases in the landmark 1963 decision gideon v. wainwright, the court denied 236 see internal revenue serv., low income taxpayer clinic list (2011), available at http://www.irs.gov/pub/irs-pdf/p4134.pdf (last visited feb. 19, 2012); see also tax legal assistance project, legal services new jersey law, available at http://www.lsnjlaw.org/aboutlsnj.cfm#tax (last visited july 12, 2011) (example of one such coordination). 237 id. 238 book, supra note 4, at 412. 239 id. 240 id. at 395. 241 budget request fiscal year 2010, legal servs. corp. 14, available at http://www.lsc.gov/sites/default/files/lsc/pdfs/br2010.pdf (last visited aug. 30, 2011). 242 id. 243 spragens & olson, supra note 48, at 1529. 212 columbia journal of tax law [vol.3:177 a constitutional right to counsel in civil cases in the 1981 decision lassiter v. department of social services. 244 as a result, right to counsel in civil cases is a patchwork system with access for the indigent dependent on the available legal services and statutes in individual states. 245 currently, there are only three main categories of cases where most state statutes or court rules provide a right to counsel in civil matters: family law matters, involuntary commitment, and medical treatment. 246 in fact, although individual states provide a right to counsel in a number of other specific situations (guaranteed counsel for military members, cases involving mental health records, and juvenile immigrant status actions, for example), not a single state has a statute or judicial opinion that provides a right to counsel in tax cases. 247 this fact is not surprising in light of the “civil gideon” movement’s core focus on courts. given this emphasis on non-tax matters, the eitc audit process and tax court has not been an element of the current “civil gideon” movement. 248 the fact that representation during tax cases is largely left out of the civil gideon movement is especially critical since many commentators have argued that the movement is better positioned to make gains since the lassiter decision in 1981. 249 one major development in the last decade is the american bar association’s 2006 resolution that endorsed providing “counsel as a matter of right at public expense to low income persons in . . . adversarial proceedings where basic human needs are at stake, such as those involving shelter, sustenance, safety, health or child custody . . . .” 250 as a result of this development, groups representing the american bar association are now able to file amicus briefs in cases that are seeking the right to counsel. 251 also, pilot legislation has been passed in california 252 and proposed in new york to expand the right to counsel. 253 in addition to these statutory and aba initiatives, there is also progress in state court systems toward a guaranteed right to counsel in certain situations. in 2007, an alaska trial court held that the state constitution created a right to counsel for a parent in a custody action when the other parent has private counsel; in 2009, a washington court of appeals held that children have a due process right to counsel in truancy 244 see lassiter v. dep’t. of soc. servs., 452 u.s. 18 (1981). see also gideon v. wainwright, 372 u.s. 335 (1963). 245 see clare pastore, a civil right to counsel: closer to reality?, 42 loy. l.a. l. rev. 1065 (2009). 246 laura k. abel & max rettig, state statutes providing for a right to counsel in civil cases, 40 clearinghouse rev. 245 (2006). 247 id. at 247. 248 see, e.g., national coalition for a civil right to counsel, http://www.civilrighttocounsel.org/ (last visited april 7, 2012). the organization does not make reference to providing tax cases and audits as one of the goals of the organization. 249 see pastore, supra note 245, at 1066. 250 american bar association house of delegates, resolution 112a (2006), available at http://www.americanbar.org/content/dam/aba/administrative/legal_aid_indigent_defendants/ls_sclaid_06a11 2a.authcheckdam.pdf. 251 see pastore, supra note 245, at 1070. 252 kevin g. baker & julia r. wilson, stepping across the threshold: assembly bill 590 boosts legislative strategies for expanding access to civil counsel, 43 clearinghouse rev. 551 (2010). 253 see pastore, supra note 245, at 1068. 2012] the eitc, low-income workers, & the legal aid community 213 proceedings. 254 however, these court-driven gains in civil representation, like their statutory and aba analogues, wholly omit tax assistance from their ambit. addressing the need for civil gideon in the context of the eitc is more complicated than simply asserting that the right to representation during the irs audit process and u.s. tax court proceedings should be guaranteed and funded through government revenue. as previously noted, the recent successes in expanding civil gideon have not been achieved by constitutional arguments or expansion of federal programs. 255 instead, as one commentator has pointed out, the gains of the movement have primarily occurred when state legislatures believe that the proposal will have a net positive impact on the state’s budget, or when arguments about fundamental fairness are advanced by advocacy groups in a way that is persuasive to either the judiciary or public. 256 in the case of eitc claimants subject to audits, it may be possible to advance both rationales for extension of civil gideon rights. a fiscal case for free tax representation could be made if it can be documented, and demonstrated to legislatures, that providing counsel during the eitc auditing process and u.s. tax court proceedings will help to keep potential claimants from resorting to state-provided social services. in addition to reducing reliance on state services, eitc recipients would presumably spend the bulk of their received funds on goods and services in their home state, boosting local economies as well as state sales tax receipts. although it has been extensively documented that eitc claimants with representation are more likely to preserve the benefit of the refund, whether those that are unsuccessful during the audit process are more likely to need expansive state benefits has not been studied. 257 as to the fundamental fairness rationale for the eitc, it is critical to note that a failed eitc audit can have drastic consequences for an eitc claimant. the tax court case of baker v. commissioner illustrates the predicament of a taxpayer who has received the credit and is later deemed ineligible. 258 daniel aaron baker, whose income in the year he claimed the credit was $15,349 and who bore significant childcare expenses for his four-year-old daughter, was required to repay an assessment of $3,556 because he failed to establish that his daughter resided with him over the course of the relevant tax year. 259 the entry of a $3,556 assessment against an individual with an annual income of $15,349 (who also had significant child care expenses) presumably had a disastrous financial impact. such dire ramifications—which one cannot assume are atypical—go to the heart of the aba’s statement that “counsel as a matter of right at public expense” must be provided “to low income persons in . . . adversarial proceedings where basic human needs are at stake, such as those involving shelter, sustenance, safety, health or child custody . . . .” 260 254 see id. at 1069; gordanier v. jonsson, no. 3an-06-887 ci (alaska super. aug. 14, 2007); bellevue school district v. e.s., 199 p.3d 1010, 1017 (wash. 2009). 255 see, e.g., laura k. abel, keeping families together, saving money, and other motivations behind new civil right to counsel laws, 42 loy. l.a. l. rev. 1087, 1110 (2009). 256 id. 257 see nat’l taxpayer advocate, supra note 70, at 108-16. 258 see baker v. comm’r, 91 t.c.m. (cch) 949 (2006). 259 id. 260 american bar association house of delegates, supra note 250. 214 columbia journal of tax law [vol.3:177 in cases where legislatures have been persuaded by concerns of fundamental fairness, it has often been with the assistance of advocacy groups. 261 although some of these groups (such as parental advocacy organizations) have been distinct from the legal aid movement, the most common group of advocates has been lawyers associated with the legal aid movement. 262 this includes “civil right to counsel advocates, civil legal aid attorneys, and bar associations.” 263 for eitc claimants, this fact offers some hope. since there are over 500,000 audits of eitc claimants each year, 264 there would be a great deal to gain for attorneys if legislatures were convinced that eitc claimants should have a government-funded right to counsel during auditing process and tax court proceedings. as a result, the civil gideon movement, and lawyers advocating for increased representation, should take up the entirely reasonable argument that it is normatively unjust to force low income individuals to self-certify that they are eligible to america’s largest welfare program through an exceedingly complex tax return, only to be forced to defend themselves without assistance when they make a mistake, and often lose the benefit for lack of representation. v. conclusion the eitc’s administrative vacuum makes it more onerous for low-income taxpayers to navigate than traditional welfare programs. in this article, we have discussed and analyzed a number of reforms—both internal reforms to the irs and external initiatives for the legal aid community—that could help soften the program’s harsh edge. while some of these reforms may require increased congressional funding at a time when budgets are being slashed across the board, such funding generally pales in comparison to the $10 billion in erroneous payments made under the eitc each year. if the program’s tax-based administration can justify the diversion of such significant resources to non-compliant taxpayers, surely it is appropriate to devote far more modest sums to assist qualifying taxpayers in claiming the benefit to which they are entitled. the proposals in this article should be considered individually. each stands to provide unique benefits, and may well have unique costs as well. what is important is not so much that any one of these proposals be adopted, but to recognize that the eitc’s tax-based administration raises a number of normative concerns in regard to the program’s treatment of low-income taxpayers, and to begin a discussion about how those normative concerns might be addressed. those concerned with providing legal aid to low-income americans must see the “hidden welfare state” for what it is—a prominent, and often problematic reality for millions of low-income americans—and take action accordingly. 261 see abel, supra note 255, at 1112. 262 id. 263 id. 264 see nat’l taxpayer advocate, supra note 70, at 97 (noting that there were 517,617 eitc audits in 2006, which represented 40.3% of the total irs audits of individuals). microsoft word nijenhuis word final 1-5-11 articles new tax issues arising from the doddfrank act and related changes to market practice for derivatives erika w. ijenhuis∗ i. overview of products and tax rules 6 a. description of certain common derivative financial instruments. .................. 6 1. interest rate swaps ............................................................................. 6 2. options, including swaptions ............................................................. 8 3. credit default swaps .......................................................................... 9 4. futures contracts ............................................................................. 12 b. overview of taxation of common otc derivatives ...................................... 12 1. otional principal contracts ........................................................... 12 2. taxation of options .......................................................................... 15 3. taxation of cds ............................................................................... 16 c. overview of section 1256 ................................................................................ 19 d. overview of other special tax rules for derivatives ..................................... 21 1. hedging transactions ....................................................................... 21 2. mark-to-market rules ...................................................................... 23 ii. developments in the markets and the law ............................ 23 a. the clearing process ........................................................................................ 24 1. clearing futures contracts .............................................................. 25 ∗ by erika w. nijenhuis, a partner in the new york office of cleary gottlieb steen & hamilton llp. a prior version of this article, written before the amendment to § 1256 described herein, was published at 127 tax notes 1235 (june 14, 2010), based on a version presented at the tax forum on april 5, 2010 (paper no. 623), and will be republished in the corporate tax practice series (practising law institute 2010). © erika w. nijenhuis. all rights reserved. many thanks to biswarup chatterjee for his assistance with section ii.c of the article, and to donald bendernagel, adrienne browning, michael farber, silas j. findley, viva hammer, laura klimpel, andrea s. kramer, jeffrey maddrey, william paul, larry salva, david h. shapiro, diane g. simons, jonathan silver and michael yaghmour for their comments on earlier drafts of the article. the author advised one of the u.s. cds clearinghouses described below on tax issues in connection with clearing cds, and has represented the securities industry and financial markets association and members thereof regarding the tax issues discussed in this article. the manner in which the derivatives markets operate is complex and evolving. every effort has been made to describe them correctly as of december 2010 by consulting with experts, but it is possible that some aspect of either market practice or the legal rules governing those instruments described herein is inaccurate, as the author is a not a banker or an expert in the non-tax rules governing these markets and instruments. any errors are those of the author. 2 columbia jour al of tax law [vol. 2:1 2. clearing cds.................................................................................... 27 3. clearing interest rate swaps ........................................................... 31 b. summary of dodd-frank’s provisions relating to derivatives ....................... 33 1. definition of “swap” ........................................................................ 33 2. clearing and exchange-trading requirements ............................... 35 3. swap dealers, major swap participants and end-users ................. 36 c. upfront payments. ............................................................................................ 37 1. standardization of coupons – in general ........................................ 37 2. standardization of cds coupons ..................................................... 38 3. other types of upfront payments .................................................... 45 iii. the dodd-frank amendment to section 1256 ........................... 46 a. effect of section 1256 treatment for otc derivatives. .................................. 51 1. interest rate swaps and swap futures contracts ............................ 51 2. interest rate swaps and hedges thereof ......................................... 55 3. benefits of section 1256 treatment .................................................. 58 b. a discourse on the history of section 1256. ................................................... 59 1. construing “regulated futures contract” ...................................... 60 2. the 1983 controversy over the scope of the rfc definition .......... 66 3. history of foreign currency contracts ............................................ 68 4. other service guidance on the scope of the rfc definition ........... 71 c. the dodd-frank amendment to section 1256. ............................................... 74 iv. initial payments 82 a. payment issues ................................................................................................. 83 b. deemed loan issues ......................................................................................... 87 1. “significance” .................................................................................. 87 2. distinguishing between “swaps” ..................................................... 88 3. special attributes of cleared swaps ................................................. 88 c. additional issues for cds ................................................................................ 89 1. do the deemed loan rules apply? .................................................. 89 2. if there is a loan, what are its terms? ........................................... 91 3. what about the proposed swap regulations? ................................. 93 on july 21, 2010, the dodd-frank wall street reform and consumer protection act (“dodd-frank”) was enacted into law.1 doddfrank mandates the most sweeping changes to the u.s. markets for derivative financial instruments in decades. this article discusses a number of u.s. federal income tax issues raised by dodd-frank and related changes to market practice for derivatives. 1 dodd-frank wall street reform and consumer protection act of 2010, pub. l. no. 111-203, 124 stat. 1376. european authorities also are considering sweeping reforms of the european derivatives markets. see, e.g., report on derivatives markets: future policy actions, eur. parl. doc. (2010), available at http://tinyurl.com/langenreport2010; proposal for a regulation of the european parliament and of the council on otc derivatives, central counterparties and trade repositories, eur. comm. doc. (2010), available at http://tinyurl.com/otcregulation. all citations to sections are to the internal revenue code of 1986, as amended (the “code”), or to the treasury regulations promulgated thereunder, other than references to sections of dodd-frank or to sections of this article. 2011] ew tax issues arisi g from the dodd-fra k act 3 as discussed in more detail in section ii.b, below, dodd-frank requires that most over-the-counter (“otc”) derivatives, colloquially referred to as swaps, be cleared through a regulated central counterparty (a “clearinghouse”) and traded on a regulated exchange. historically, otc derivatives generally have been taxed under the conventional realization method of accounting used for stocks, bonds and other securities, while exchange-traded derivatives generally have been taxed under the special rules of § 1256. section 1256 generally requires that contracts within its scope be marked-to-market on an annual basis, and provides that gain or loss from such contracts is capital gain or loss with a 60% long-term and 40% short-term holding period. the most obvious tax question raised by dodd-frank, therefore, is whether the migration of otc derivatives onto exchanges will cause them to become subject to § 1256. at the very last hour of dodd-frank’s marathon progress through congress, this issue was partially addressed through the adoption of an amendment to § 1256 that clarifies that certain types of otc swaps will not become subject to § 1256. notwithstanding this amendment, many questions remain, as the scope of the amendment is not clear. in addition, decisions still to be made by regulators and the market as to how derivatives will be traded are likely to affect the impact of the amendment. factors that may be relevant include (i) which swaps will migrate onto exchanges when; (ii) the effect of what appears to be a forthcoming wider range of products offered by exchanges that constitute “futures contracts” that may compete with swaps; (iii) whether swaps will be traded on traditional securities and commodities exchanges or instead on “swap execution facilities,” a new type of exchange created by dodd-frank; (iv) whether end-users will choose to clear the swaps they enter into; and (v) where the line between “bespoke” swaps not required to be centrally cleared and traded and standardized swaps subject to those requirements will be drawn. those issues generally are outside the scope of this article, but they are briefly adverted to in connection with a discussion of possible guidance on the scope of the § 1256 amendment. this article discusses a range of possible interpretations of the dodd-frank amendment to § 1256, and argues in favor of an interpretation that the amendment covers all notional principal contracts and possibly certain closely related contracts. the article also urges that the treasury department and internal revenue service (“treasury” and “the service,” respectively) provide prompt guidance on this issue, because the scope of the amendment affects not only otc derivatives that migrate in the future to regulated clearing and trading, but potentially also certain kinds of swaps that were being cleared by a central counterparty prior to dodd-frank.2 2 the current treasury/irs “business plan” for the 2010-2011 year includes an item described as “guidance on the application of § 1256 to certain derivative contracts.” department of the treasury, office of tax policy, and internal revenue service, 2010-2011 priority guidance plan (dec. 7, 2010), available at http://www.irs.gov/pub/irs-utl/20102011_pgp.pdf. comments by government officials indicate that this item relates to the dodd-frank amendment. see amy elliott, irs may restrict definition of swap to otional principal contracts (dec. 15, 2010), 2010 tnt 240-3; diane freda, irs may hold to arrow view of futures under dodd-frank wall street reform (dec. 15, 2010), 239 dtr 4 columbia jour al of tax law [vol. 2:1 the article also suggests some further amendments to the internal revenue code that could alleviate pressure on the guidance process. the second set of tax issues addressed by this article are those stemming from the fact that the move towards regulated clearing and trading has and can be expected to have the effect of increasing substantially the number of swaps that are entered into, or deemed entered into, with upfront payments. in the otc markets, most swaps were entered into at-market – that is, with payments required to be made at the thenmarket level – so that it was relatively rare for a swap to have an upfront payment. (this is not true for options, of course, or for certain specific types of swaps.) because centralized clearing both requires and encourages standardization of terms and a ready ability to transfer contracts from one party to another, the move towards centralized clearing results in more frequent upfront payments or possible deemed upfront payments between swap parties. there are long-standing rules governing the treatment of upfront payments on swaps that are classified as “notional principal contracts” (“npcs”). under those rules, such a payment can give rise to a debt obligation between the parties if the payment is “significant.” this issue is of relevance because a deemed loan would give rise to deemed interest income on the debt instrument, which interest would be subject to reporting, withholding and other u.s. federal income tax rules applicable to debt instruments. the existence of a deemed loan might also raise issues under § 956 for some taxpayers.3 the treatment of significant upfront payments on interest rate swaps and most other swaps as deemed loans for u.s. federal income tax purposes is a rule that has been on the books for many years, but has not in practice affected most actual otc contracts. thus, for most swaps, taxpayers’ concerns now have to do with the substantial expansion of an existing regime. these concerns are partly legal—primarily that current law does not provide clear rules for when a deemed loan arises, and does not take into account the special characteristics of centrally cleared swaps— and partly practical, because compliance in a world in which significant upfront payments may be the rule rather than the exception would require taxpayers to modify reporting and withholding practices, and to develop automated systems to distinguish between npcs and options and other types of derivatives not subject to the deemed loan rules. g-3, available at www.bna.com; john herzfeld, guidance on section 1256 contracts under study, irs legal official says (oct. 25, 2010), 204 dtr g-2, available at www.bna.com. 3 these issues are briefly discussed in a submission made by the securities industry and financial markets association (“sifma”) in a letter to treasury and the service requesting guidance on these issues, in particular the potential application of § 956 to deemed loans arising from large initial premium payments on credit default swaps. see letter from sifma to steven a. musher, associate chief counsel (int’l), irs (may 26, 2009), reprinted in 1 taxation of financial products and transactions 2010, ch. 1 (practising law institute 2010). the author and one of her partners represented sifma in preparing that letter. 2011] ew tax issues arisi g from the dodd-fra k act 5 for credit default swaps (“cds”), there are very significant uncertainties as to whether these rules apply at all, and if so how they apply. the question of whether a deemed loan or deemed interest arises under current law as a result of a large initial premium on a standard coupon cds cannot be answered without first answering the question of whether a cds is properly characterized as an option or npc. as that issue is unclear under current law and has been exhaustively discussed elsewhere, this article focuses instead on whether, assuming that a cds is properly treated as an npc, current law could deem one cds counterparty to lend money to the other in a transaction treated for u.s. federal income tax purposes as giving rise to indebtedness. finally, as noted above, the application of § 956, which can have career-ending consequences, could potentially be vastly expanded. this would be unfortunate, to say the least, given that the context is one in which there is no policy reason for § 956 to apply because any upfront payment made under a cleared swap is immediately offset as a cash flow matter by an equivalent amount of cash collateral. it seems fair to expect the government to clarify the rules as to when a deemed loan arises before taxpayers build the necessary systems to track them. and it seems reasonable to hope that the government would clarify that it would not choose to apply § 956 in the offsetting payment case described above. this article therefore recommends a number of areas in which the treasury and service should provide guidance before taxpayers make the investment to build such systems, including (i) clarifying whether and how the rules apply to centrally cleared swaps, (ii) how a deemed loan that arises when a “significant” upfront payment is made on an npc should be taken into account for a centrally cleared swap, (iii) more detailed guidance on when an upfront payment is “significant”, and (iv) whether credit default swaps are subject to these rules. in the interim, regulatory guidance could be provided in the form of a notice stating that nonperiodic payments on swaps, including cds, will not be treated as investments in united states property for § 956 purposes to the extent that they are immediately as a contractual or legal matter offset by an equivalent amount of cash, absent abuse, and a revenue procedure stating that the service will not take the position that taxpayers are obligated to treat upfront payments on cds as deemed loans until guidance is issued to that effect or on other swaps until the meaning of the term “significant” is clarified, again absent abuse. legislative amendments could address the § 956 issue by adding a reference to cash collateral in § 956(c)(2)(j), and by stating an expectation in legislative history that the service will act as described in the second half of the preceding sentence. part i of the article provides an overview of the financial products discussed herein and the tax rules currently applicable to otc derivatives and under § 1256. readers familiar with these products and rules can skip over or skim this part of the article. part ii of the article discusses doddfrank and other changes to the law and market practice for derivatives. part iii of the article then turns to the § 1256 issue, and part iv of the 6 columbia jour al of tax law [vol. 2:1 article discusses the issues arising from upfront payments on centrally cleared swaps. i. overview of products and tax rules. as noted above, otc derivative financial products historically have been subject to the conventional realization method of accounting. when applied to derivatives, those rules can become quite complex, as the basic rules have been overlaid with a hodgepodge of special rules intended to take into account the fact that many derivative financial products resemble, or are comprised of, other such products, the liquidity of many derivatives, and their widespread use as hedges for business risks. part i briefly describes several derivatives that will be referred to throughout this article and the basic rules applicable to them, as well as some discussion of special hedging and mark-to-market rules affecting derivatives. part i also provides an overview of the rules of § 1256. a. description of certain common derivative financial instruments. 1. interest rate swaps. probably the most common type of swap is an interest rate swap. under the terms of a standard interest rate swap, one party agrees to pay amounts determined by reference to a fixed rate, e.g., 6%, and the other party agrees to pay amounts on the same payment dates determined by reference to a floating rate, usually the london interbank offered rate (“libor”). both payments are determined by multiplying the applicable rate by the same “notional principal amount,” a hypothetical amount used to determine the parties’ payment obligations but that is not paid or otherwise transferred between the parties. the sole payments on an at-market interest rate swap are these periodic payments, which typically are made semi-annually, and are netted so that only the difference between the fixed and floating amounts is paid. interest rate swaps are widely used to hedge interest rate risks, for example by an issuer that issues debt or a company with assets or non-debt liabilities that are interest rate-sensitive. because the cost of money is so fundamental an economic factor, and because different parts of the fixed income market operate on the basis of different rate bases, the interest rate swap markets are very liquid, very competitive, and very large. according to the most recent authoritative market survey, there are over a hundred trillion dollars (notional principal amount) of u.s. dollar-denominated interest rate swaps outstanding.4 4 the bank for international settlements reported $347.5 trillion notional principal amount of interest rate swaps outstanding globally at the end of june 2010. while there is no break-out of u.s. dollar-denominated interest rate swaps, if such swaps represented the same percentage of total interest rate swaps as u.s. dollar-denominated interest rate derivatives represented of all interest rate derivatives, there would be about $126 trillion notional principal amount of u.s. dollar-denominated interest rate swaps. karsten von kleist & carlos mallo, bank for int’l settlements, triennial and semiannual surveys: positions in global over-the-counter (otc) derivatives markets at end-june 2010, 16, 18 tbls.1 & 3 (nov. 2010), available at www.bis.org/publ/otc_hy1011.pdf. 2011] ew tax issues arisi g from the dodd-fra k act 7 a foreign currency swap is similar to an interest rate swap, except that one party’s payments are denominated in and determined by reference to one currency and the other party’s payments are denominated in and determined by reference to a second currency. the payments are both fixed rate, and the parties will exchange the principal amount at the end and sometimes at the beginning of the transaction. a swap may combine interest rate and foreign currency risk by providing for the payments in one or both currencies to be based on that currency’s appropriate floating rate, e.g., party a pays 6 percent x $100 million notional principal amount and party b pays a yen floating rate on an amount of yen equivalent at the inception of the trade to $100 million. another common type of foreign currency derivative used to hedge currency risk is a foreign currency forward contract, which generally is a relatively short-term instrument that provides at maturity for a payment determined by reference to the change in value of two specified currencies. an interest rate swap entered into with at-market terms will not have an upfront payment. an interest rate swap entered into with offmarket terms, for example with a 5% rate when the market is 6%, generally will have an upfront payment compensating the party receiving the belowmarket payment (or paying an above-market payment). for example, if a taxpayer wishes to hedge a $100 million debt instrument that it has issued with a 5% coupon into an effective floating rate instrument, it will enter into an interest rate swap with a dealer under which it receives 5% x $100 million and pays libor x $100 million on the interest payment dates for the debt instrument. in addition, the dealer will make an upfront amount to the taxpayer equal to the present value of the foregone stream of 1% payments (6% minus 5%) over the life of the swap. as with other swaps, the market for interest rate swaps historically has been the “over-the-counter” market. the otc market is a modern version of the historic market as a place where parties come to buy and sell their wares. unlike the historic wares offered in securities and other markets, an otc derivative is a contract, negotiated by and entered into between two parties, typically pursuant to standard documentation made available by the international swaps and derivatives association (“isda”). an otc derivative remains for its life a private bilateral contract. this private aspect of otc derivatives had considerable consequences when the credit crisis arose. the principal information publicly available about outstanding otc derivatives is derived from the published financial statements of swap dealers, and from reports by industry organizations, regulators and credit rating agencies. this public information reflects aggregated information at a high level. bank regulators and other regulators of major swap participants have access to more information as part of their regulatory oversight, but no one regulator or government agency has a complete picture of the market. moreover, some major participants in the market have been essentially unregulated or very lightly regulated, most notably aig financial products (“aig fp”), an affiliate of a major insurance company, which for many years was a very large player in the credit default swap (“cds”) market. hedge funds, which are also major market 8 columbia jour al of tax law [vol. 2:1 participants in the swap market, are also largely outside the scope of regulatory oversight. one other important characteristic of the historic swap market is that while customers generally are required to provide collateral to secure a dealer’s credit exposure to the customer, some highly rated participants in the market such as insurance companies were not required to provide collateral to their counterparties unless their credit rating dropped below a specified level. aig fp, for example, apparently fell into the latter category; as a result, when doubts arose as to its ability to pay and a credit downgrade appeared imminent, those doubts were reinforced by the realization that aig fp would be required to post billions of dollars of collateral to its counterparties that it did not have. unfortunately, aig fp was also a hugely significant player in the cds market, so that the potentially disruptive consequences of its demise led to the universal conclusion, at least by governments, that cds and other swaps must be brought into a comprehensive regulatory scheme. the nearcollapse of aig-fp was thus one of the more significant reasons for the enactment of dodd-frank. (it is ironic in this regard that, at least in the view of some observers, the cds trades entered into by aig fp were highly customized cds on asset-backed securities, in enormous size, of a kind that are not currently clearable and, it appears, will not be required to be cleared or traded under dodd-frank.) 2. options, including swaptions. options come in a number of different forms. in a conventional option to purchase (or sell) property, one party, typically called an “option writer” or “option grantor,” grants to another party, an “option holder” or “option purchaser,” the right but not the obligation to compel the option writer to deliver (or purchase) designated property for a particular price (the “strike price”) prior to the option’s expiration. in exchange for this right, the option holder pays a premium, typically, though not necessarily, in the form of an up-front payment. the premium may also be paid over time, usually in equal amounts, although this is less common in the securities markets. the options described in the preceding paragraph are physically settled options — that is, they are written for the sale or purchase of a designated item of property which, if the option is exercised, is delivered or purchased by the writer, and purchased or sold by the holder. options may also be cash settled, defined under the code as “any option which on exercise settles in (or could be settled in) cash or property other than the underlying property.”5 they may also be “net share settled” if the underlying property is shares of stock, in which case the option writer will deliver shares equal in value to the difference between the value of the underlying shares and the option’s strike price.6 5 i.r.c. § 1234(c)(2) (2010). 6 for example, assume that a writes a call option on 100 shares of x pursuant to which b has the right to purchase those shares within the next year for a strike price of $10/share ($1000). at the end of the year, the x shares are trading for $12/share. the option may be settled by (i) a delivering 100 shares to b in exchange for $1000 (physical 2011] ew tax issues arisi g from the dodd-fra k act 9 a “swaption” is an option to enter into a swap with the terms provided for in the option. for example, a swaption might provide the holder the right within the next three months to enter into a 5-year interest rate swap under which the holder would pay semi-annual fixed coupons at a 5.5% rate versus libor, on a notional principal amount of $1 million. a swaption is a common type of derivative in the interest rates market. like other options, a swaption may be physically settled, in which case the parties will enter into the designated swap, or may be cash settled, in which case the option writer will pay the option holder an amount equal to the excess of the value of the swap over a similar swap with then-current market terms. a forward-starting swap is similar, except that it is a forward contract to enter into a swap with specified terms rather than an option to do so. 3. credit default swaps. a conventional single-name cds is a financial contract to transfer credit risk with respect to debt instruments, such as bonds or loans, of a single named issuer (the “reference entity”), typically for a five-year term. like other swaps, cds in the otc market are generally documented using the standardized documentation for derivatives transactions developed by the international swaps and derivatives association (“isda”).7 cds are commonly used to hedge the risk of owning bonds or loans of a particular issuer, termed the “reference entity,” or other credit risk to that reference entity. cds also are widely used to take on credit risk, whether of a particular issuer or a segment of the fixed income market. like all of the other financial instruments described above, therefore, they can be used either to reduce risk or to create it. the merits or demerits of that state of affairs is outside the scope of this article. the parties to a cds contract are referred to as the “protection buyer” and the “protection seller.” the contract frequently but not invariably refers to a specific senior debt instrument (the “reference obligation”) of the reference entity.8 the protection buyer makes one or more payments to the protection seller based on a specified notional principal amount. ordinarily the payments take the form of a stream of periodic payments in a fixed amount, generally referred to as fixed or “premium” or coupon payments. settlement, or “gross” physical settlement), (ii) a paying b $200 ($1200 value of x shares minus $1000 strike price), or (iii) a delivering 16 x shares plus $8 of cash to b (net share settlement; the $8 is the cash value of a 0.67 fractional share). 7 the isda website is a font of information about swaps in general. it includes standardized documentation for many different kinds of swaps, including not only the core transactional documentation (the isda master agreement and a form of schedule to the agreement) but also standardized definitions, credit support documents, and related information. see isda, http://www.isda.org (last visited dec. 30, 2010). 8 an electronic data vendor active in the cds market offers a standardized list of reference obligations for approximately 3000 reference entities. see markit, markit credit indices: a primer (oct. 2010), http://www.markit.com/assets/en/docs/products/data/indices/credit-indexannexes/credit_indices_primer_october%202010.pdf (last visited dec. 31, 2010) markit also provides a wide range of market information about cds and many other kinds of derivatives. 10 columbia jour al of tax law [vol. 2:1 the protection seller in turn agrees that in the case of a default on the reference obligation, or in the case of other specified credit events indicating a decline in the creditworthiness of the reference entity, it will buy from the protection buyer an obligation of the reference entity for its face value (“physical settlement,” by delivery of a “deliverable obligation”) or will make a cash payment to the protection buyer in an amount that represents the decline from par in the fair market value of such an obligation as a result of the credit event (“cash settlement,” by reference to the value of a “valuation obligation”).9 the protection buyer is not required to have suffered a loss on, or to have owned, any obligation of the reference entity at any time in order to receive payment. in the case of cash settlement, a valuation obligation’s fair market value is determined through bids from dealers in that obligation under standard procedures. while market practice has evolved over time, cash settlement for cds (technically, auction settlement) is now the norm. prior to the standardization process described below, there were a number of common variations in the terms of conventional cds, depending on a number of factors including the nature of the reference entity and the local cds market. such variations included the list of credit events (some cds included a “restructuring” credit event, which in turn had multiple definitions used in different contexts), whether they provided for physical or cash settlement, and various mechanics and critical dates such as the termination date of the cds. one of the most important variations in terms related to the coupon on a single-name cds. broadly speaking, the coupon on a single-name cds was determined at the time the parties entered into the contract, in much the same way that the coupon on a newly-issued bond would be determined. (this process is described in more detail in section ii.c, below.) consequently, the coupon on a cds on a particular reference entity entered into on any given day could and generally did differ from the coupon on an otherwise identical cds entered into on a different day. similarly, while the most common tenor for cds was five years, the clock started running when the parties entered into the cds, so that there were no standardized maturity dates.10 as described above, the fed did not wait for the enactment of dodd-frank in order to initiate the restructuring of the cds market. this initiative has led to dramatic changes in the cds market, notably (i) a reduction in the outstanding amount of cds through an industry-wide process of netting cds entered into by multiple dealers against each 9 more technically, the determination of whether a credit event has taken place is determined by reference to any “obligation” of the reference entity, which term includes but need not be limited to the reference obligation. the text simplifies the description of cds settlement provisions in a number of ways. prior to the “big bang” discussed infra note 12, the legal terms of single-name cds in the u.s. markets generally provided for physical settlement, although i understand that in practice the parties usually agreed to cash settlement when a credit event arose. since the “big bang,” auction settlement—that is, cash settlement where the cash price is determined via an auction run by isda—has become the standard form of settlement for most cds. 10 the coupons and maturities of cds on indices of reference entity obligations, e.g., bonds or loans, were more standardized. for a brief description of cds of this kind, see infra note 73. 2011] ew tax issues arisi g from the dodd-fra k act 11 other,11 (ii) the standardization of terms for conventional cds, and (iii) the initiation of clearing of cds. these initiatives were an outgrowth of, or a continuation of, earlier fed efforts to improve the workings of the cds market. the industry-wide netting process began in the fall of 2008. it was referred to as “portfolio compression,” and made evident the difficulties of trying to net cds transactions against each other when they had different terms. the standardization of terms took place in several steps pursuant to a process led by isda starting in the spring of 2009.12 for parties who have adhered to the relevant protocols, the result is that cds entered into since that time have standard terms, including standard coupons (100 basis points or 500 basis points, for cds on north american corporate reference entities), maturities, settlement mechanisms, definitions and many other mechanically and economically significant terms.13 standardization is discussed in more detail in section ii.c.2, below. 11 a fitch report released in 2009 indicates that outstanding notional principal balance of credit derivatives fell in 2009, for the first time since fitch began keeping track in 2003. fitch ratings, credit market research, global credit derivatives survey: surprises, challenges and the future 5 (aug. 2009) (hereinafter “fitch report”). the report attributes the decline to collective efforts of market participants and regulators to reduce notional outstandings by compressing trades, as well as the virtual absence of new structured credit deals. the report also notes that the market is now dominated by singlename cds and index cds, with a decline in cds relating to outstanding collateralized debt obligations and other complex products. 12 the most significant of these steps was the “big bang,” meaning the implementation of a protocol amending isda’s 2003 credit derivatives definitions (which are part of the isda standard documentation for a cds) to provide for the establishment of (i) committees empowered to make final decisions about contract interpretation issues including with respect to credit events, settlement procedures and acceptable deliverable obligations; (ii) a standardized cds settlement procedure; and (iii) a standard look-back window during which a party can claim the occurrence of a credit event or other relevant event, resulting in a standard effective date for cds transactions. while adherence to the protocol was voluntary, it was widespread. see isda, isda announces successful implementation of ‘big bang’ cds protocol; determinations committees and auction settlement changes take effect (apr. 8, 2009), http://www.isda.org/press/press040809.html (over 2000 parties adhered to the new protocol by the time it closed on april 7, 2009). a “small bang” protocol was made available a few months later. adoption of these protocols had the effect not only of setting market standards for new cds but also of amending old cds between adhering parties. 13 the standardization of coupons was not hardwired into documentation like the big bang protocol. instead, isda announced that starting in april 2009 a new contract for cds on north american corporate issuers with standardized terms would be introduced. the new contract would (a) provide for a 100 basis point coupon for investment grade credits and a 500 basis point coupon for high yield credits, (b) provide a calendar of quarterly scheduled termination dates, (c) eliminate restructuring as a credit event, and (d) modify the accrual start date for coupons and provide that all coupons, including the first coupon, would be paid as full coupons regardless of whether the parties entered into the cds in the middle of a coupon accrual period (similar to buying a bond with pre-issuance accrued interest). these changes were expected to be the primary method for trading north american corporate cds going forward. unlike the big bang protocol, these changes did not affect historic trades, although parties were free to amend existing trades to conform to those terms. 12 columbia jour al of tax law [vol. 2:1 finally, the third of these steps was the initiation of clearing of standardized cds in the fall of 2009. the clearing process is described in more detail in section ii.a.2, below. 4. futures contracts. futures contracts are among the oldest types of derivative financial instrument. historically, a futures contract was a contract for the sale of a specified amount of grain or another agricultural commodity, of a specified grade, for delivery at a date several months later. they were developed in order to allow farmers and commodity purchasers to hedge their price risk between the date the contract was entered into and the delivery date. historically they have in practice been very short-dated, with liquidity centered in contracts with a remaining term of one month, two months and three months. in recent decades, the risk classes underlying futures contracts have broadened dramatically, and now include foreign currency, oil and gas and other energy products, metals, stock indices, interest rates, emission allowances and other “environmental” products, real estate indices, and weather indices. unlike otc derivatives, futures contracts are traded on commodities exchanges. thus, a party who wishes to enter into or close out a futures contract does so on a public market where participants can see every trade. futures contracts are also subject to clearing through a central counterparty, which results in the clearinghouse becoming the counterparty to every trade. this process is described in more detail in section iii.a.1, below. clearing is a way of managing credit risk. it also makes it very easy to close out transactions, so that futures contracts in active maturities are very liquid. dodd-frank’s reforms of the derivatives market are intended to expand the transparency, credit risk management and liquidity of the futures markets to include what have been to date otc derivatives. these features come at a price, of course—it can be more expensive to transact through the futures markets than the otc market, and market participants may prefer to negotiate their trades without the full spotlight of the market on them. the latter point has led to a sort of hybrid contract in recent years, in which parties negotiate a contract privately and then submit it to a central counterparty (a clearinghouse that may or may not be associated with a particular exchange) for clearing. that is, such contracts are centrally cleared but not exchange-traded. energy swaps and cds are perhaps the most active contracts of this kind. b. overview of taxation of common otc derivatives. 1. otional principal contracts. an interest rate or foreign currency swap of the kind described above is a “notional principal contract,” or npc. although technically a different set of timing and character rules apply to interest rate swaps than foreign currency swaps, those differences are not significant for purposes of this discussion. the term “notional principal contract” is a tax term of art. the closest term used by non-tax lawyers is “swap,” but there are swaps that do not qualify as npcs. to further confuse matters, the npc timing regulations described below classify npcs into swaps, caps and floors. 2011] ew tax issues arisi g from the dodd-fra k act 13 the term “notional principal contract” or variants on that term are defined in several places in the code and regulations.14 the only comprehensive definition of the term is in treasury regulation § 1.446-3, which provides timing rules for npcs. it defines an npc as “a financial instrument that provides for the payment of amounts by one party to another at specified intervals calculated by reference to a specified index upon a notional principal amount in exchange for specified consideration or a promise to pay similar amounts.”15 because this definition is very broad, the regulation goes on to exclude from its scope a section 1256 contract, a futures contract, a forward contract, an option and debt. accordingly, if a swap constitutes a section 1256 contract or an option, it cannot be an npc for purposes of these timing rules. a cap or floor is a series of options, for example a contract to make a payment on any interest payment date over a specified number of years if market interest rates rise above x percent, equal to [the market rate minus x percent] times a notional principal amount. the regulations classify payments under npcs into three categories: periodic payments, like coupons; nonperiodic payments, such as an upfront payment; and termination payments, which generally are payments to extinguish or assign all or part of an npc. technically, a nonperiodic payment is any payment other than a periodic payment or a termination payment. periodic payments are deductible or includible on a current accrual basis.16 termination payments are taken into account in the year in which an npc is extinguished, assigned or exchanged.17 nonperiodic payments are subject to more complicated rules that are conceptually similar to the oid rules but operate differently. in order to prevent front-loading or back-loading of payments under an npc, the regulations require that taxpayers recognize a nonperiodic payment “over the term of a notional principal contract in a manner that reflects the economic substance of the contract.”18 the regulations then elaborate on this requirement by providing that an upfront periodic payment on an npc generally be spread over the life of the npc in accordance with forward rates (or, in the case of a cap or floor, option premiums) or, more frequently, as a series of level payments over the term of the npc. thus, if the market rate for an npc fixed payment is 6%, and the npc in fact provides for payments at a 5% rate and an upfront payment from the fixed rate payor to compensate the fixed rate payee for the below-market coupon, under the level payment method the upfront payment would be spread over the life of the npc in amounts equal to a 1% periodic payment, and the 14 see, e.g., i.r.c. § 1259(d)(2) (2010) (defining “offsetting notional principal contract”); treas. reg. § 1.863-7(a)(1) (1991). the latter was the first official guidance to use the term “notional principal contract.” 15 treas. reg. § 1.446-3(c)(1)(i) (1994). 16 treas. reg. § 1.446-3(e) (1994). different timing rules may apply if the npc is part of a hedge, straddle or other multiple-position transaction. 17 treas. reg. § 1.446-3(h)(2) (1994). 18 treas. reg. § 1.446-3(f)(2)(i) (1994). 14 columbia jour al of tax law [vol. 2:1 “principal recovery component” of that payment would be treated as a periodic payment on the npc. a back-end payment is first converted into an initial payment through present valuation, after which the same rule applies. under a special rule for npcs that are swaps (but not for caps and floors), if a nonperiodic payment is “significant,” the upfront payment is treated as an amortizing loan providing for level principal and interest payments over the life of the npc, and the npc is treated as entered into at market rates.19 using the example in the prior paragraph, if the upfront payment were significant, it would be treated as a loan from the payor to the payee that is repaid in installment payments equal to 1% periodic payments on the swap, which installment payments are paid at the same time as deemed 6% payments on the npc. to take a simplified example,20 while the actual cash flows would be: -------> upfront payment ($4.21m) a --------------> $5m (5% x $100m) b floating rate x $100m <---------- the deemed cash flows would be: deemed loan a ------------------> loan of $4.21m b $1m (principal +interest) payments <----- deemed swap a --------------> $6m (6% x $100m) b floating rate x $100m <---------- 19 treas. reg. § 1.446-3(g)(4) (1994). the regulation states: “the loan must be accounted for by the parties to the contract independently of the swap. the time value component associated with the loan is . . . recognized as interest for all purposes of the internal revenue code.” the same rule for currency swaps applies via a cross-reference in the relevant regulations. treas. reg. § 1.988-2(e)(3)(iv) (2004). 20 the example assumes that the parties enter into a 5-year interest rate swap with annual payments at a time when a market rate swap would provide for payments at 6% vs. a floating rate, multiplied by a $100 million notional principal amount. at market rates, the fixed rate payor, party a, would pay $6 million annually in exchange for the floating rate payment. because party a will in fact pay only $5 million annually, party a will pay party b an upfront payment of $4.21 million (the present value, using a 6% discount rate, of $1 million/year). under the rules described in the text, (a) party a would be treated as lending $4.21 million to party b, in exchange for annual payments from party b of principal and interest totaling $1 million/year, and (b) party a would be treated as making annual swap payments of $6 million. 2011] ew tax issues arisi g from the dodd-fra k act 15 consequently, the recipient of the upfront payment in this example is treated as paying interest to the payor. moreover, the commissioner may treat any nonperiodic swap payment, whether or not it is significant, as one or more loans for purposes of § 956. as the example above illustrates, these rules were written with interest rate swaps in mind. in the case of an interest rate swap, the relationship between the upfront payment and the foregone, or extra, payments on the swap is mathematically straightforward, once one knows the appropriate discount rate: the upfront payment is simply the present value of the foregone, or extra, payments on the swap as compared to an atmarket swap. these timing rules for nonperiodic payments were adopted initially to prevent taxpayers from refreshing net operating losses by accelerating income through the receipt of upfront payments.21 the interest characterization rule is, to the best of the author’s knowledge, intended to prevent related parties from using upfront payments on swaps as a way for a non-u.s. affiliate in a non-treaty country to lend money to a u.s. affiliate without suffering u.s. withholding tax on the imputed interest. the rules described to this point envision that any nonperiodic payment would be a fixed amount known when entering into the npc. total return swaps on assets, such as equity swaps, however, typically provide for a final payment that is contingent upon the change in value, if any, of the asset over the life of the swap. regulations were proposed in 2004 that would provide specific timing rules for swaps with contingent nonperiodic payments.22 the proposed regulations would require a taxpayer that enters into a swap with a contingent nonperiodic payment to accrue income (or expense) in respect of that final payment. the methodology provided for in the proposed regulations is complex, but essentially requires a taxpayer to determine a hypothetical future contingent payment, to convert that future payment into an upfront payment, and then to treat the upfront payment under the rules described above. 2. taxation of options. an option may be either an option to buy property at a stated “strike” price (a “call” option) or an option to sell property at a stated strike price (a “put” option). the value of the call option in the hands of the purchaser will increase if the value of the underlying property rises above the strike price. the value of a put option in the hands of the purchaser will increase if the value of the underlying property drops below the strike price. the writer of the option is in the opposite economic position. because the purchaser has the right to profit from the option, and the writer may be obligated to lose money on the option, the purchaser pays the writer a premium to compensate the writer for the risk that the latter is taking. for a conventional option, the premium is usually paid in a single lump sum amount, although it may instead be paid over time. 21 see i.r.s. notice 89-21, 1989-1 c.b. 651 (requiring that upfront payments on npcs be taken into account over the life of the contract under a reasonable method of amortization). 22 prop. treas. reg. § 1.446-3(g)(6), 69 fed. reg. 8,886 (feb. 26, 2004). 16 columbia jour al of tax law [vol. 2:1 in general, gain or loss from options is recognized on a wait-andsee (open transaction) basis.23 the purchaser capitalizes the cost of the option premium, and the option writer does not immediately include it in income. if the option is exercised by delivery of the underlying property in exchange for payment of the strike price (physical settlement), for tax purposes the party that buys the property acquires it for an amount equal to the strike price paid plus or minus the option premium. that amount is also the amount realized for the seller of the property. if the option is exercised through cash settlement, no property is delivered, and gain or loss is measured by reference to the difference between the cash settlement amount and the premium paid or received. the option may also expire unexercised, in which case the purchaser will have a loss and the writer will have income equal to the premium. gain or loss recognized by the purchaser of an option is considered to have the same character as the property to which the option relates in the hands of the option purchaser (or would have if acquired by the purchaser).24 thus, in the case of a purchaser of an option on a bond that is or would be held as an investment, gain or loss will be capital. in the case of an option writer, gain or loss from delivery is typically capital. in the case of the termination of an option other than through delivery of the underlying property, the writer’s gain or loss typically is treated as shortterm capital gain or loss, regardless of the term of the contract.25 different rules apply if the taxpayer is a dealer in securities, if the taxpayer is using the option to hedge another position, if the option is a foreign currency option or a “section 1256 contract” (see below), or if other special rules apply. options may also have terms that vary from the fact patterns described above. 3. taxation of cds. cds are important to the issues discussed in this article for several reasons. first, as noted above, the extraordinary significance attributed to the role of cds in triggering the near-collapse of the u.s. financial system and other near-catastrophes— most recently, their alleged role in deepening the financial crisis of the greek economy—has made these once highly exotic and obscure financial instruments the impetus for reform of the derivatives markets in the united states and similar efforts in europe. second, for those same reasons, when the federal reserve bank of new york (the “fed”) determined that reform of the u.s. derivatives markets should move forward without waiting for legislation, it encouraged swap dealers to start by clearing cds.26 the 23 see treas. reg. § 1.263(a)-4(d)(2)(i)(c)(7) (2004); rev. rul. 58-234, 1958-1 c.b. 279; rev. rul. 78-182, 1978-1 c.b. 265. 24 i.r.c. § 1234(a) (2010). 25 i.r.c. § 1234(b) (2010). 26 the second financial product to attract regulatory attention was interest rate swaps. see scott patterson, fannie, freddie touch off swaps scrap, wall st. j., apr. 6, 2010, at c1, available at http://online.wsj.com/article/sb10001424052702304620304575166292806663502.html (reporting that the federal housing finance agency expects fannie mae and freddie mac to start clearing their interest rate swaps by year-end, regardless of whether congress adopts financial reform legislation, and that several exchanges are seeking that business). 2011] ew tax issues arisi g from the dodd-fra k act 17 resulting changes to market practice in the cds market and the tax issues that arose as a byproduct of these changes provide insight into the path ahead. for those same reasons, perhaps, there is reportedly now a renewed interest by the treasury and service in addressing long-standing questions about the tax treatment of cds. the tax rules applicable to cds are unclear, primarily because the proper characterization of cds for u.s. federal income tax purposes is unclear. the service officially acknowledged this uncertainty in notice 2004-52.27 notice 2004-52 describes four possible characterizations of cds: as notional principal contracts (“npcs”), options, or in some cases as insurance or guarantees. there are many thoughtful and insightful comments and articles on the characterization question, both predating and following the notice.28 it is fair to say that the ball has been in the 27 i.r.s. notice 2004-52, 2004-2 c.b. 168. 28 articles discussing the tax considerations relevant to credit default swaps include john n. bush & ahron h. haspel, deciphering the taxation of credit derivatives, 14 j. tax’n investments 33 (1996); bruce kayle, will the real lender please stand up: the federal income tax treatment of credit derivative transactions, 50 tax law. 568 (1997); david z. nirenberg & steven l. kopp, credit derivatives: tax treatment of total return swaps, default swaps, and credit-linked otes, 87 j. tax’n 82 (1997); steven d. conlon, u.s. tax issues relating to credit derivatives, derivatives 203 (may/june 1998); david s. miller, an overview of the taxation of credit derivatives, in 13 tax strategies for corporate acquisitions, spin-offs, joint ventures. financings, and reorganizations ch. 229 (practising law institute 1999); viva hammer & frank kuriakuz, the tax treatment of credit default swap proceeds, 1 derivatives & fin. instruments, july/august 1999, at 210; david s. miller, credit derivatives: financial instrument or insurance? and why it matters, 3 j. tax’n fin. products 31 (winter 2002); david s. miller, distinguishing risk: the disparate treatment of insurance and financial contracts in a converging marketplace, 55 tax law. 481 (winter 2002); edward d. kleinbard, competitive convergence in the financial services markets, 81 taxes 225 (mar. 2003); erika w. nijenhuis, otice 2004-52—one small step forward on credit default swaps, 104 tax notes 1287 (2004); bruce e. kayle, the federal income tax treatment of credit derivative transactions, 21 tax strategies for corporate acquisitions, spinoffs, joint ventures, financings, and reorganizations ch. 429 (practising law institute 2004), reprinted in updated form in 22 tax strategies for corporate acquisitions, spin-offs, joint ventures, financings, and reorganizations ch. 429 (practising law institute 2009); alexander f. peter, characterization of credit default swaps for tax purposes, 8 derivatives & fin. instruments 3 (jan/feb. 2006); nicholas bogos, a risk-based analysis of credit derivatives under ssrp standard (pts. 1-3), 112 tax notes 587, 655, 759 (aug. 2006); kevin j. liss, are credit default swaps really swaps or options for tax purposes? an economics-based approach, 7 j. tax’n fin. products 23 (2008); ari j. brandes, toward a ew framework and a better understanding of credit default swaps, 10 derivatives & fin. instruments 75 (may/june 2008); ari j. brandes, a better way to understand the speculative use of credit default swaps, 14 stan. j.l. bus. & fin. 263 (2009); andrea s. kramer, alton b. harris & robert a. ansehl, the ew york state insurance department and credit default swaps: good intentions, bad idea, 22 j. tax’n & reg. fin. inst. 22 (jan./feb. 2009); david s. miller & shlomo boehm, ew developments in the federal income tax treatment of cdss, 7 j. tax’n fin. products 9 (2009); lawrence lokken, taxation of credit derivatives, available at http://www.taxpolicycenter.org/uploadedpdf/1001350_credit_derivatives.pdf; alan b. munro, revisiting tax considerations regarding credit default swaps, 12 derivatives & fin. instruments 9 (jan./feb. 2010). for comments submitted in response to notice 2004-52 and other subsequent requests for guidance, see letter from david garlock, howard leventhal & alan munro to mark w. everson, irs comm’r (jan. 7, 2005), reprinted in 106 tax notes 855 (feb. 14, 2005); letter from managed funds association to mark w. everson, irs comm’r, re: 18 columbia jour al of tax law [vol. 2:1 service’s court for some time. unofficial comments by officials of the service suggest that the first likely venue for guidance on the characterization issue may be the reproposal of the long-pending proposed regulations on npcs with contingent nonperiodic payments, a project aimed a very different class of financial instruments. these regulations are discussed in section i.b.1, above. the timing of any such guidance is uncertain. this article does not directly address the characterization question but assumes that option and npc are the relevant treatment alternatives. if a cds contract is properly treated as an npc, then the periodic premium payments would be periodic payments, generally required to be taken into account currently on an accrual basis. it is uncertain whether a cash settlement payment ought to be viewed as a termination payment or as a nonperiodic payment, although the author believes that most market participants treat it as a termination payment.29 under these rules, an upfront payment on the cds contract would be treated as a nonperiodic payment that must be amortized in some fashion over the life of the cds. if the cds were considered a swap (and not a cap or floor) and the upfront payment were a significant nonperiodic payment, otice 2004-52 (credit default swaps) (apr. 26, 2005), available at 2005 tnt 87-20; new york state bar association tax section, report on credit default swaps (sept. 9, 2005) , available at http://www.nysba.org/content/contentfolders20/taxlawsection/taxreports/1095report.p df, reprinted in 109 tax notes 347 (oct. 17, 2005); letter from new york state society of certified public accountants re: statement on credit default swaps provided in response to irs otice 2004-52 (nov. 7, 2005), available at 2005 tnt 215-12; letter from sifma to steven a. musher, assoc. chief counsel (int’l) (may 26, 2009), reprinted in 1 taxation of financial products and transactions 2010 ch. 1 (practising law institute 2010). for a number of requests for guidance (or, in one case, no guidance) on credit default swaps prior to notice 2004-52, see letter from capitol tax partners to irs re: otice 2002-22 (guidance priority list) (may 1, 2002),available at 2002 tnt 96-20; letter from capitol tax partners to rob hanson, tax legislative counsel & barbara angus, int’l tax counsel, re: follow-up letter on credit default swaps (july 2, 2002), available at 2002 tnt 148-34; letter from gregory may & robert scarborough to helen hubbard, acting tax legislative counsel & barbara angus, int’l tax counsel, re: guidance on credit default swaps (oct. 1, 2002), reprinted in 2 j. tax’n global transactions 72 (20022003); letter from isda to irs re: withholding taxes on credit default swaps (oct. 24, 2002), available at 2002 tnt 232-21; letter from isda to barbara angus, int’l tax counsel (nov. 21, 2003), available at 2003 tnt 232-17; letter from isda to irs re: otice 2003-26: comments on recommendations for the 2003-2004 guidance priority list (may 2, 2003), available at 2003 tnt 118-26. as discussed in section iv.c.1, below, the tax characterization of “pay as you go” cdss has been raised as an issue in the bankruptcy of a major financial guarantee insurance company. 29 treas. reg. § 1.446-3 defines a “termination payment” as a payment made or received to extinguish or assign all or a proportionate part of the remaining rights and obligations of any party under an npc, and defines a “nonperiodic payment” as any payment other than a periodic payment or a termination payment. treas. reg. § 1.4463(h)(1), (f)(1) (1994). the service also has taken the position, however, that a “final scheduled payment” is not a termination payment even though it by definition extinguishes the parties’ rights and obligations under the npc. prop. treas. reg. § 1.1234a-1(b), 69 fed. reg. 8886 (feb. 26, 2004). it is unclear how a final payment that is provided for in the terms of a contract, but that is not scheduled, such as the cash settlement payment on a cds, fits into this framework. 2011] ew tax issues arisi g from the dodd-fra k act 19 then one party to the swap would be treated as lending money, and the other would be treated as paying interest. in addition, if a cash settlement payment were treated as a nonperiodic payment and not as a termination payment, then it seems likely that the proposed regulations addressing swaps with contingent nonperiodic payments would apply, unless cds are carved out of their scope. as described above, the proposed regulations would require a taxpayer that enters into a swap with a contingent nonperiodic payment to accrue income (or expense) in respect of that final payment. if these regulations applied to cds, they could require a protection buyer to accrue income as a result of the possibility that the protection buyer may receive a settlement payment if there is a credit event with respect to the reference entity. conversely, the regulations could require a protection seller to accrue expense as a result of the possibility that it will have to make a future settlement payment. the proposed regulations clearly were not drafted with cds in mind, however, and it is uncertain whether cds will be included or excluded from the scope of the regulations if and when finalized or reissued in proposed form. among the uncertainties about whether and how these regulations might apply to cds are (a) whether a cds contract is an npc, (b) if so, whether the cds contract would be subject to these proposed regulations, (c) whether the cash settlement payment should be viewed as a nonperiodic payment, rather than a termination payment, and (d) if so, how the regulations should be applied in view of the fact that a settlement payment is uncertain not only in amount (which the regulations envision) but also as to timing (which the regulations do not envision), or for that matter whether it will occur at all (the regulations do not envision a nonpayment of a contingent amount).30 some of these issues are discussed further in section iv.d, below. if, conversely, a cds contract is properly characterized as an option or series of options, it generally would be subject to the rules described in section i.b.2, above.31 c. overview of section 1256. section 1256 was enacted in 1981, as part of a package of rules intended to shut down “tax straddle” transactions in which taxpayers sought to obtain timing and character advantages from taking largely offsetting positions in, generally, futures contracts. as enacted, § 1256 required that “regulated futures contracts” (“rfcs”) be marked to market at year-end, 30 for materials addressing the potential application of these regulations to credit default swaps, see letter from the investment company institute to gregory f. jenner, acting assistant secretary for tax policy, u.s. dep’t of the treasury, and donald korb, chief counsel, irs (july 21, 2004) (on file with author) (letter concerning proposed regulations on notional principal contracts with contingent nonperiodic payments), 2004 tnt 147-14; lee a. sheppard, retail credit derivatives, 105 tax notes 126 (2004); munro, supra note 28. 31 because npcs include interest rate caps and floors, which consist of multiple options, it is conceivable although unlikely that if a cds contract constitutes a series of options, it could be an npc even though a single option cannot be an npc. 20 columbia jour al of tax law [vol. 2:1 meaning that gain or loss on the rfc was required to be taken into account as if the rfc had been sold at year-end. to soften the mark-to-market blow, § 1256 also provided that gain or loss on rfcs would be treated as 60% long-term and 40% short-term, notwithstanding the fact that futures contracts typically have a term of no more than three months. for this purpose, an rfc was defined as a contract (i) that requires delivery of personal property or an interest therein, (ii) with respect to which the amount required to be deposited and the amount which may be withdrawn depends on a system of marking to market, and (iii) that is “traded on or subject to the rules of” a domestic board of trade designated as a contract market by the commodity futures trading commission (“cftc”) or certain other exchanges. at the time, this definition gave rise to no confusion, as it was tailored to the terms of futures contracts trading on cftc-approved exchanges. very generally, a futures contract of this kind was a contract with standardized terms for the future delivery of a commodity, with a single payment made at maturity in exchange for the delivery of the commodity. the contract was traded on an exchange through “open outcry” (traders standing in pits and signaling each other through hand movements) under cftc rules. under the exchange rules, a clearinghouse then interposed itself between the two parties to the contract as effectively a guarantor of the parties’ obligations. as a legal matter, the clearinghouse became the legal counterparty to each side of the transaction. the credit support provided by the clearinghouse was derived from collateral and guarantees provided by the futures commission merchants (the equivalent of brokers in the commodities world) acting for each party, as well as a small amount of initial margin required from both parties to the contract. on a daily basis, as the contract gained or lost value as a result of changes in commodities prices and market expectations, the “losing” party was obligated to put up additional “variation margin” in the form of cash, which cash was deposited in the account of the “gaining” party.32 the definition of rfc as originally enacted was short-lived. in 1982, § 1256 was amended to delete the delivery requirement for rfcs, and to add a new category of financial instruments subject to § 1256, “foreign currency contracts.” a foreign currency contract was defined as a contract that requires delivery of a foreign currency in which positions are also traded through rfcs, that is traded in the interbank market, and that is entered into at a price determined by reference to interbank market prices. section 1256 was again amended in 1984 and 2000 to add three additional categories of contracts subject to § 1256—nonequity options, dealer equity options, and dealer securities futures contracts. dealer equity options are options on single stocks, such as an option on ibm stock, that are traded by options market makers on securities exchanges. the term “nonequity option” is somewhat misleading; it is defined as any listed option that is not an “equity option,” a term that has a narrower meaning 32 the clearing and trading of futures contracts is described in more detail in section ii.a.1, below. 2011] ew tax issues arisi g from the dodd-fra k act 21 than might initially appear. as a result of the historical division of responsibility between the securities & exchange commission (“sec”) (single stocks and narrow-based equity indices) and the cftc (broad-based equity indices), the term covers listed options on broad-based stock indices, like the s&p 500, as well as options on truly nonequity risks like options on commodity futures contracts, options on treasury bond futures, and options on foreign currency futures. dealer securities futures contracts are futures contracts on single stocks, and options thereon, that are traded by taxpayers treated for tax purposes as dealers therein. like rfcs, nonequity options and dealer securities futures contracts are traded on cftc-regulated exchanges. collectively, the contracts subject to § 1256 are now categorized as “section 1256 contracts.” the history of several of these provisions is discussed in more detail in part iii below. d. overview of other special tax rules for derivatives 1. hedging transactions. a very common purpose for entering into a derivative financial instrument is to hedge a risk or exposure deriving either from an asset held or to be held by a taxpayer or a liability issued or to be issued by a taxpayer. while the history of the tax rules for hedging transactions is long and not always untroubled, under current law the tax rules for hedging ordinary business assets or liabilities is fairly straightforward. section 1221(a)(7) provides that the term “capital asset” does not include any “hedging transaction” clearly identified as such no later than the close of the day it was entered into. section 1221(b)(2) defines a “hedging transaction” generally to mean any transaction entered into by the taxpayer in the normal course of the taxpayer’s trade or business primarily to manage risk of price changes, currency fluctuations, or, in the case of liabilities, interest rate risk, with respect to ordinary property or liabilities of the taxpayer. treas. reg. § 1.1221-2 provides more detailed guidance on the implementation of these rules. thus, generally, if a taxpayer enters into a “hedging transaction” and properly identifies it as such, the taxpayer’s gain or loss from the transaction will be ordinary rather than capital. this allows the taxpayer to match the character of its gain or loss from the hedged item and the hedge. corresponding timing rules are provided in treas. reg. § 1.446-4. they generally conform the timing of income or expense from a hedging transaction to the timing of corresponding expense or income from the hedged item. foreign currency hedges generally do not fall within the ambit of § 1221, as they already give rise to ordinary income or loss.33 there are timing and character distinctions, however, between foreign currency swaps, foreign currency forward contracts and foreign currency futures 33 treas. reg. § 1.1221-2(a)(4) (2007) (this section does not apply to determine the character of gain or loss from section 988 transactions). section 988 generally provides rules for taxing foreign currency gain or loss from transactions in foreign currency, foreign currency-linked debt and foreign currency-linked derivatives. 22 columbia jour al of tax law [vol. 2:1 contracts, which are respectively subject to ordinary character/realization method, ordinary character/mark-to-market and capital character/mark-tomarket rules in the absence of any elections.34 accordingly, it may be necessary or useful to make a hedging election for one of these transactions, depending on the item being hedged.35 the tax rules for hedging capital assets are more limited and less favorable. treas. reg. §§ 1.1275-6 and 1.988-5 permit taxpayers to “integrate” certain hedges of debt instruments issued or held by the taxpayer with the debt itself.36 apart from these rules, the principal rules governing hedges of capital assets are the straddle rules of §§ 1092 and 263(g), which are anti-abuse rules of a complex and uncertain nature. additional rules addressing hedges of capital assets are found in other statutory provisions, including §§ 1092(e), 1256(e) and (f)(1), and 475(d)(2)(f), but they generally are narrower in scope and have less specific guidance implementing them than the “hedging transaction” rules described above, or are also anti-abuse rules unfavorable to taxpayers.37 thus, for taxpayers hedging capital assets, it is more difficult to ensure that the timing and character of gains and losses from a hedge match those from the hedged item. consequently, for taxpayers that wish to have such matching, it is more important that the basic tax rules for the hedge and hedged item give rise to similar timing and character results. some taxpayers use derivatives to bridge a gap between their assets and liabilities, typically in cases where the assets are fixed income assets that pay on a different basis or have a different duration or timing of payments than their liabilities, e.g., fixed rate liabilities vs. floating rate assets. in the federal ational mortgage association case, for example, the principal factor in determining the taxpayer’s profit or loss was the spread between the average net yield on its mortgage portfolio and the 34 see i.r.c. § 988(a)(1) (2010) (general rule that foreign currency gain or loss attributable to any “section 988 transaction” is ordinary income or loss); i.r.c. § 1256(b)(1), (2) (2010) (defining any “regulated futures contract” and “foreign currency contract” as section 1256 transactions generally subject to mark-to-market treatment and to capital gain/loss rules unless character otherwise would be ordinary); i.r.c. § 988(c)(1)(b)(iii) (2010) (“section 988 transactions” include any forward contract, futures contract or similar financial instrument that is denominated in or determined by reference to nonfunctional currency); i.r.c. § 988(c)(1)(d)(i) (2010) (i.r.c. § 988(c)(1)(b)(iii) does not apply to regulated futures contracts); i.r.c. § 988(b)(3) (2010) (all gain or loss from section 988(c)(1)(b)(iii) transactions is ordinary). 35 i.r.c. § 988(d) (2010) also provides for special hedging rules for foreign currency. for a discussion of the special rules applicable to foreign currency transactions used as hedges, see john d. mcdonald, ira g. kawaller, l.g. “chip” harter & jeffrey p. maydew, the devil is in the details: problems, solutions and policy recommendations with respect to currency translation, transactions and hedging, 89 taxes (forthcoming mar. 2011). 36 treas. reg. § 1.988-5 (1992) also provides favorable rules for certain hedges of foreign currency payables and receivables. 37 by its terms, the § 1256(e) hedging exception is more limited than the very similar exception under § 1221. for a discussion of a recent ruling illustrating that point, see michael (wei-chin) mou & david h. shapiro, does section 1256 incorporate an inadvertent error exception, 128 tax notes 1159 (sept. 13, 2010). the conclusion reached in that ruling was later modified to take into account other provisions of the code. see chief counsel advice 201046015 (july 14, 2010). 2011] ew tax issues arisi g from the dodd-fra k act 23 average cost of its outstanding debt.38 the taxpayer entered into several types of derivatives in order to hedge its interest rate and duration risk. another type of taxpayer that may use derivatives in this manner is a life insurance company, which may face a gap between the rates or duration on its investment assets and the cash flows it expects to need to pay out on its policies. as the f ma case illustrates, it is crucial for a taxpayer of this kind to be able to treat gains and losses on its hedges as ordinary rather than capital. 2. mark-to-market rules. a taxpayer using a “markto-market” method of tax accounting treats assets or other positions subject to that method as if sold at year-end, generally solely for purposes of determining gain or loss with respect to that position. future gain or loss, whether from a subsequent mark or from disposition, are adjusted to take the recognized gain or loss into account. as anyone with even a cursory understanding of u.s. tax rules knows, mark-to-market is not a customary method of accounting for most taxpayers. that is true even for assets that are easy to value and readily turned into cash, like publicly traded stock. rather, mark-to-market rules generally apply in one of two situations: a taxpayer election or prevention of abuse. examples of mark-to-market rules include §§ 877a (expatriates), 1256, 1260 (constructive ownership rules), and 1296 (modified mark-tomarket rules for passive foreign investment companies).39 a taxpayer that is a “dealer in securities,” however, generally is required to mark its securities to market, under § 475. unlike § 1256, under § 475 gain or loss from positions held in connection with a dealer’s activities as such give rise to ordinary gain or loss. this is to be expected, as gain or loss from ordinary business activities generally is ordinary. in the case of a dealer in securities who transacts in section 1256 contracts as part of the normal course of its business, there is a potential conflict between the general capital gain/loss rules of § 1256 and the general ordinary income/expense rules of § 475. sections 475 and 1256 contain several rules intended to clarify when each rule applies. as discussed in more detail in section iii.a, below, however, these rules may work imperfectly. since a corporate taxpayer generally has no benefit from capital gains under current law, but cannot deduct capital losses except to the extent of capital gains, dealers in securities typically prefer for derivatives that they enter into to be subject to § 475 rather than § 1256. ii. developments in the markets and the law. as described earlier, a number of events, most notably the emergency rescue of aig by the federal government in the fall of 2008, led many government regulators and other policymakers to the conclusion that 38 fed. nat’l mortg. ass’n v. comm’r, 100 t.c. 541 (1993). 39 mark-to-market is also permitted or required by various regulations, including treas. reg. §§ 1.148-6(e)(5) (internal commingled funds), 1.148-9(c)(1)(iv)(b) (allocation rules for refunding issues), 1.1092(b)-3t(b)(6) (identified mixed straddles), and 1.1092(b)4t(c)(5) (mixed straddle accounts). 24 columbia jour al of tax law [vol. 2:1 the cds market, and more generally the otc market for derivative financial instruments, must be transformed so it poses less of a risk to the financial system. among the improvements sought were enhanced market transparency, improved operational processes, a reduction in the level of outstanding trades, and the creation of a single central counterparty for swaps.40 it was also envisioned that there would be a single regulator that would have oversight over the entire system. some of these goals were part of a larger program addressed to the derivatives market as a whole and some were cds-specific. in the united states, the fed took an active role in encouraging dealers in cds to take several steps to advance these goals. the two steps of interest for purposes of this article are the standardization of cds terms in the spring of 2009, which was a prerequisite for the clearing of cds, and the commencement of clearing of cds by two u.s. clearinghouses in the fall of 2009. cds are now also being cleared by several european clearinghouses. the u.s. markets for interest rate swaps are moving in the same direction. to date, all of these steps have been nominally voluntary, although as a practical matter the active involvement of the fed and other regulators has meant that the changes have been adopted on an industrywide basis by swap dealers. dodd-frank now requires that similar steps be taken for other classes of swaps. as described in more detail below, under dodd-frank, most swaps will be regulated, some by the sec and some by the cftc. in addition, most swaps will be cleared through one or more central clearinghouses and most swaps will be traded on regulated exchanges (or “swap execution facilities”) rather than being negotiated in the otc market. as described in more detail below, however, dodd-frank does not require that all swaps be cleared and traded. rather, it permits trading on markets that do not appear to constitute a “qualified board or exchange” for § 1256 purposes, and it allows certain types of parties to swaps to elect whether to clear their swaps or not. accordingly, it seems inevitable that there will exist identical swaps that will be traded on a qualified board or exchange in some cases and that will in other cases exist in the bilateral otc derivatives or other market. a. the clearing process.41 as has been made clear, the clearing of swaps through a central counterparty is now a critical part of the regulatory framework for swaps. it is also critical to understanding the tax issues described in this article. accordingly, before turning to a description of dodd-frank, this section ii.a of the article describes the clearing process. because the transformation of the cds market from an otc market to a market with 40 see ew york fed welcomes further industry commitments on over-thecounter derivatives, fed. reserve bank of n.y. (oct. 31, 2008), http://www.newyorkfed.org/newsevents/news/markets/2008/an081031.html (last visited dec. 31, 2010). 41 see attached diagrams illustrating the clearing process for an interest rate swap or cds negotiated in the otc market. 2011] ew tax issues arisi g from the dodd-fra k act 25 trillions of dollars of cleared contracts may provide insights into future developments for other classes of swaps, the new cds clearinghouses are also described in some detail. the current and imminent state of clearing for interest rate swaps is also briefly described. it is important, as a preliminary matter, to understand the differences between clearing through a centralized clearinghouse and trading on a regulated exchange. to that end, this section discusses the different mechanisms governing futures contracts (which are both exchange-traded and cleared), cds, and interest rate swaps (which may be cleared, but are not currently exchange-traded). very broadly speaking, “trading” has to do with how the parties agree on a price for entering into or terminating a transaction. “clearing” has to do with the centralization and management of risk and the transmittal of payments after the trade is entered into. 1. clearing futures contracts. futures contracts are traded on regulated exchanges. their terms are standard and are set out in the rules of the exchange. mechanically, a customer wishing to acquire the right to buy corn at some point in the future may go to its broker— technically, a “futures commission merchant,” or fcm—who is a member of a regulated exchange. the fcm will take the client’s order and go to the exchange, where the fcm will agree with another fcm to create electronic “buy” and “sell” positions. each position represents one side’s willingness to either accept the obligation to deliver, say, 5000 bushels of a specified type and grade of corn on the specified date at the specified price or to pay the specified price and receive the corn on the specified date. the exchange’s proprietary matching engine then connects individual “buy” positions with matching “sell” positions. once a match is found, the contract is executed, with the parties on either side as counterparties. it should be noted that while the fcm in this example is carrying out customer transactions, the exchange deals only with the fcm and not with the customer. one can analogize this to a stockbroker dealing with a stock exchange on behalf of a client, but the relationship is more complicated because a futures contract is a contract, not an investment in a third party as to which legal and beneficial ownership can readily be split. depending on the circumstances, one may acknowledge the role played by the fcm as the face to each of the exchange and the customer. for most tax purposes, however, the fcm is ignored and the customer is treated as if it were executing the trade on the exchange. that convention will be followed here except where the role of the fcm needs to be distinguished from that of the customer or the exchange. thus, once a futures contract has been executed, the parties to the trade are the customers who are respectively willing to buy and sell corn. this relationship does not last, however, because the trade then must be cleared through the exchange’s central clearinghouse.42 the 42 it should be noted that centralized clearing is not a new idea. in 1925, the chicago board of trade clearing corp. was the first united states clearinghouse, formed to become a counterparty to all transactions then carried out on the chicago board of trade 26 columbia jour al of tax law [vol. 2:1 clearinghouse steps into the shoes of each side of the trade and becomes the party responsible for both the actual delivery of the 5000 bushels of corn to party a and the payment for the corn to party b. at the same time, each party now has a responsibility, not to its original counterparty, but to the clearinghouse, to either deliver the corn (in the case of party b) or provide the payment (in the case of party a). by interposing itself between the parties, the clearinghouse assumes the risk that one party to the transaction will not perform. the clearinghouse manages this risk through several mechanisms: (i) it takes initial margin (usually a small percentage of the purchase price) and subsequently variation margin, as described below, determined by reference to the party’s then-outstanding trades with the clearinghouse, which changes daily; (ii) it nets the fcm’s position in the particular contract, as described below; and (iii) it requires that the fcm provide additional collateral (which becomes part of a “guaranty fund”) and has the right to assess fcms for additional guaranty fund contributions (essentially, contingent collateral) to cover the clearinghouse’s risks.43 in the case of a default by a clearinghouse member—generally only members can be counterparties to the clearinghouse—the clearinghouse attempts to cover any resulting losses by looking first to that member’s margin and collateral. should that be insufficient, however, the clearinghouse can draw upon the collateral provided by other members. if that, too, proves inadequate, the clearinghouse can call upon the guarantees. the risk of failure by a member is thus reduced, through the use of netting and the requirement that the member provide margin and collateral, and mutualized, through the clearinghouse’s right to appropriate the assets of other members. the netting of contracts is possible because the contracts have standardized terms. for example, if on the day after the transaction described above, another customer of fcm a wishes to sell 15,000 bushels of corn pursuant to a futures contract that, but for the quantity and price, has terms identical to the first transaction, fcm a will execute that trade with fcm c. once this contract has been cleared, the clearinghouse will automatically net fcm a’s right to receive 5000 bushels against its obligation to deliver 15,000 bushels into a single obligation to deliver 10,000 bushels in exchange for payment. as a result, at the end of a trading (generally trade in grain futures), and some form of central clearinghouses existed in europe prior to that time. federal reserve governor randall s. kroszner, central counterparty clearing: history, innovation, and regulation, address at the european central bank and federal reserve bank of chicago joint conference on issues related to central counterparty clearing (apr. 3, 2006), http://www.federalreserve.gov/newsevents/speech/kroszner20060403a.htm#f5 (last visited dec. 30, 2010). 43 the initial margin and variation margin requirements apply in the first instance to customers, who pay or receive these amounts to/from their fcms, who in turn generally pay/receive these amounts to/from the clearinghouse. thus, if a futures contract increases in value, one customer will pay variation margin to its fcm, which will pay it to the clearinghouse, which will pay it to the other fcm, which will pay it to the second customer. the netting and additional collateral requirements apply to fcms, not customers, however, although the cost of the additional collateral requirements may be passed on to customers in the form of pricing. 2011] ew tax issues arisi g from the dodd-fra k act 27 day, fcm a will always have a single net position with the clearinghouse with respect to any one type of futures contract, although it will have multiple actual positions because it transacts in multiple types of futures contracts. 2. clearing cds. in contrast to futures contracts, cds are not traded on exchanges. instead, a cds is entered into over-thecounter in a private agreement between two parties. as a result of the standardization process described below, the number of variables to be negotiated is limited, primarily to the market quoted level for the coupon— that is, the coupon that the market would have agreed to prestandardization—and the maturity (“tenor”) of the cds. upon reaching agreement on the terms of their cds, if the cds is of a kind subject to clearing, each party novates its contract with the central clearinghouse, which (as in the futures context) steps between and becomes the counterparty to both parties.44 as in the futures context, this allows the 44 the statement in the text is a highly simplified explanation of the actual process, which differs from the process for futures contracts in several regards. unlike the case with futures, the brokers (dealers) who face customers in the cds market are not always clearinghouse members. consequently, in order to clear a cds, the customer, the executing broker (that is, the swap dealer), and the designated clearing member (which may or may not be the same legal entity as the broker, or an affiliate of the broker) must all cooperate, as the customer-broker transaction will be replaced by a customer-clearing member-clearinghouse transaction. the process for dealing with failures to clear a trade is also different in the futures and cds markets. in the futures market, the parties simply keep trying to clear a trade. if it fails, no trade exists. in the cds market, dealer/dealer trades clear weekly on ice trust and daily on the cme, although both are working on more rapid clearing cycles. in the interim between agreeing to a transaction and clearing it, a bilateral otc contract exists between the dealers. if the trade fails to clear, the bilateral otc contract continues in existence. dealer/customer cds trades work differently. if a trade of that kind fails to clear, there are several different possible outcomes: (i) the designated clearing member may be replaced, (ii) the trade may remain a bilateral otc contract, but likely with different pricing because the credit risk, margin requirements, and possibly regulatory capital requirements are different for otc-only vs. cleared cds, or (iii) the trade may be broken. see isda, recommended common principles for relationships between customer and executing broker (“eb”) and clearing member (“cm”), http://www.isda.org/credit/docs/recommended-common-principles.pdf (last visited dec. 30, 2010). all of this is subject to change as the markets continue to develop. one tax question raised by the clearing process is whether the clearing of a swap will be treated as a taxable disposition of the swap for property differing materially in kind or extent, under § 1001. in the case of newly originated swaps that are intended from the outset to be cleared, this issue appears to be trivial, particularly if as suggested above the terms may change if the swap ultimately is not cleared. under the step transaction doctrine, it should be the case that the cleared swap is treated as the same swap agreed to by the parties. see discussion infra section iii.b.3 (concerning revenue ruling 87-43). rev. rul. 87-43, 1987-1 c.b. 252. the analysis may be different for pre-existing swaps. if pre-existing swaps were submitted for clearing, one would have to consider whether treas. reg. § 1.1001-4 or some other basis for non-recognition treatment applies. the regulation treats an assignment as a non-event for the non-assigning party if the assignment (i) is from one swap dealer to another and (ii) is permitted by the terms of the contract. it is an interesting question whether a clearinghouse could be considered a dealer for this purpose. typically, they would not be, but in other contexts novation to a clearinghouse has been essentially disregarded for u.s. federal income tax purposes so that no consideration has been given to that issue. in this context one might perhaps argue that a clearinghouse serves a function sufficiently similar to that of a dealer to be treated as such for purposes of this rule. 28 columbia jour al of tax law [vol. 2:1 clearinghouse to net out each party’s overall exposure to cds, resulting in a single net position with respect to any particular cds (e.g., a cds on a specified reference entity or a specified series of an index with a specified maturity). in exchange for using the clearinghouse’s services in this way, each party must provide collateral and adjust the amount of that collateral on a daily basis to reflect the party’s net exposure. there is, however, at least one significant economic difference between clearing cds and clearing futures contracts. futures contracts provide for only a single payment at maturity, so the payment made or received when entering into a futures contract reflects simply the difference between the price specified in the futures contract and the market price at that time. cds and other swaps, by contrast, provide for periodic payments. also, cds generally are, and other swaps may well be, entered into with an upfront payment, or are deemed to do so for tax purposes. upfront payments on cleared swaps are described in more detail in section ii.c, below. one last point worth understanding is that in the case of cds clearing, both dealers and certain other major participants in the cds market benefit from the credit support of the clearinghouse. those arrangements are intended to provide assurance that if a clearing member fails, a customer’s cds positions will be transferred to another clearing member and the customer’s margin will be available to transfer together with the customer’s cds positions. the mechanics of these arrangements differ from clearinghouse to clearinghouse.45 as mentioned above, there are currently two u.s. clearinghouses clearing cds, ice trust u.s. and the chicago mercantile exchange (“cme”), in addition to ice clear europe, eurex, and now lch.clearnet in europe. for tax purposes, there are potentially significant differences between how the two u.s. cds clearinghouses are organized and operate. other types of swaps can be expected to be cleared through additional voluntary submission of existing swaps to a clearinghouse would not, however, appear to be permitted by the terms of a standard isda, which require consent by a counterparty to assign a swap except in very limited situations. if the economic terms of the swap were modified in connection with the novation, that also would pose an obstacle to tax-free treatment. a final concern might be that the regulation applies by its terms only to npcs, and so does not literally apply to options and other types of derivative financial instruments. leaving aside for the moment the question of whether economic terms of a swap would change when it is cleared, a more satisfying answer to the non-recognition question could be to conclude that the clearinghouse is essentially simply a guarantor, and consequently that there has been no disposition of a swap when it is cleared. see discussion infra note 132. similar issues could arise in connection with the transfer of a customer’s positions from one clearing member to another in the event of the failure of the original clearing member. one would have to consider in that regard whether the cme-type agency model for clearing customer trades would be less likely to give rise to a taxable disposition than the ice trust-type principal model. see the text below for discussion of these two regimes. 45 for extensive discussion of proposals made by u.s. and european central clearinghouses for protecting cds customers in the event that a clearing member fails, see isda, report to the supervisors of the major otc derivatives dealers on the proposals of centralized cds clearing solutions for the segregation and portability of customer cds positions and related margin, http://www.isda.org/credit/docs/full-report.pdf (last visited dec. 30, 2010) [hereinafter the buy-side report]. these arrangements are briefly described supra note 43. 2011] ew tax issues arisi g from the dodd-fra k act 29 clearinghouses, which may also have different legal and functional structures. (a) ice trust u.s. ice trust u.s. is organized as a new york trust company, and is regulated by the federal reserve and the new york state banking department.46 ice trust is one of several subsidiaries of intercontinentalexchange (“ice”), which operates exchanges in the united states, canada, and europe and also operates several otc markets. ice trust is a standalone clearinghouse for clearing cds. that is, its sole function is to clear, and the sole contracts that it clears are cds. ice trust received regulatory approval from the new york state banking department in december 2008. in march 2009, it received regulatory approval from the fed to provide central counterparty services by clearing cds and from the sec to perform the functions of a clearing agency for cleared cds.47 ice trust began clearing cds in march 2009, and clears both single name cds and index cds. according to ice, the volume of gross notional amount cleared by ice trust exceeded $7 trillion by the end of september 2010, and open interest in cleared cds was just under $500 billion.48 ice trust operates under a set of rules that set out conditions for membership, the terms of the cds that it clears, the details of how clearing takes place, how determinations of various kinds are made, and other related topics. these rules are also standalone, meaning that they relate solely to ice trust. ice reports daily settlement prices, daily trading volume, and endof-day open interest for each cds contract that it trades. ice does not provide other price information for cleared swaps, but bid/ask quotes can be obtained by calling a market participant. 46 in november 2008, the sec, the cftc and the fed executed a memorandum of understanding under which they agreed to cooperate and coordinate in their respective approval, supervision, and oversight of central counterparties (a “ccp”) for cds. the mou notes that a ccp for cds may be one or more of the following: a state-chartered bank that is a member of the fed, a derivatives clearing organization (“dco”) regulated by the cftc, or a “clearing agency” regulated by the sec. memorandum of understanding between the board of governors of the federal reserve system, the u.s. commodity futures trading commission, and the u.s. securities and exchange commission regarding central counterparties for credit default swaps, u.s. dep’t of the treasury, http://www.treasury.gov/resource-center/fin-mkts/documents/finalmou.pdf (last visited dec. 30, 2010). 47 for the new york state banking department approval, see banking department approved intercontinental exchange, inc. to form trust company to clear credit derivatives, state of n.y. banking dep’t, http://www.banking.state.ny.us/pr081204.htm (last visited dec. 31, 2010). the fed approval was granted as a board order, dated march 4, 2009. for the sec approval, see securities exchange act release no. 34-59527 (mar. 6, 2009), 74 fed. reg. 10791 (mar. 12, 2009). the sec order was a temporary order that has since been renewed. as these approvals indicate, ice trust operates, as contemplated by the mou, as a state-chartered bank and as a clearing agency. 48 see clearing: ice trust, intercontinentalexchange, https://www.theice.com/ice_trust.jhtml (last visited dec. 30, 2010). 30 columbia jour al of tax law [vol. 2:1 (b) the cme clearinghouse. the cme is a subsidiary of the cme group, which is a holding company for the cme, the chicago board of trade (“cbot”), the new york mercantile exchange (“nymex”), and the commodity exchange (“comex”). each of these is a separate legal entity that is a contract market designated as such by the cftc (a “designated contract market,” or “dcm”) and operates as a futures exchange. the cme’s clearing operations are a separate division from the exchange, but are housed in the same legal entity as the cme exchange. the cme clearinghouse is separately regulated by the cftc as a “derivatives clearing organization” (a “dco”).49 cme clearing clears for both the cme and cbot. once a cds contract submitted for clearing has been accepted, the cme becomes the legal counterparty to the contract in its capacity as a clearinghouse. in december 2008 the cme certified plans to provide clearing services for cds, and in march 2009, temporary regulatory approval (since renewed) was granted to allow the cme to perform the functions of a clearing agency for cleared cds, subject to various conditions.50 the cme began clearing cds in december 2009, and it now clears index cds. as of the end of september 2010, the cme reported total open interest in cleared cds of $35 million.51 margin provided by clearing members in respect of cds currently is held in a segregated account.52 the cme has 49 a point that may be worth noting in this regard is that the cftc regulates a number of different types of entities, of which dcms and dcos are only two examples. other regulated trading markets include derivatives transaction execution facilities (“dtefs”), which are trading facilities with a lower level of regulation; exempt boards of trade (“ebots”), which limit transactions to selected participants and commodities; and exempt commercial markets (“ecms”), which limit trading to principal-to-principal transactions between selected participants on selected commodities. see generally trading organizations, u.s. commodity futures trading comm’n, http://www.cftc.gov/industryoversight/tradingorganizations/index.htm (last visited dec. 31, 2010); see also andrea s. kramer, financial products: taxation, regulation, and design § 4.02 (types of commodities markets), § 62.01 (discussion of qualified boards or exchanges) (cch 3d ed. 2006); william r. pomierski, special rules for certain energy futures contracts and options, in energy and environmental trading: us law and taxation ch. 18 (andrea s. kramer & peter c. fusaro eds., cameron 2008). additional types of trading markets and related acronyms can be expected to be added as a result of the enactment of dodd-frank. 50 see cftc announces that cme has certified a proposal to clear credit default swaps (dec. 23, 2008), http://www.cftc.gov/pressroom/pressreleases/pr559208.html (last visited dec. 31, 2010); order granting temporary exemptions under the securities exchange act of 1934 in connection with request of chicago mercantile exchange related to central clearing of credit default swaps, 74 fed. reg. 11781 (mar. 19, 2009). as these approvals indicate, the cme clearinghouse operates, as contemplated by the mou, as a dco and as a clearing agency. 51 see cme group, cds market data reports, http://www.cmegroup.com/trading/cds/cds-data.html (last visited dec. 31, 2010). 52 very generally speaking, customers clearing cds through the cme maintain a clearing relationship with a futures commission merchant (an “fcm”), which serves as the customers’ agent and guarantor in respect of cleared cds. from the cme’s perspective, its counterparty for cleared cds consists of each clearing member, with the clearing member acting as agent for unidentified principals—e.g., the customers. thus, the cme clearing arrangements for cds resemble those for futures contracts. under applicable law, fcms 2011] ew tax issues arisi g from the dodd-fra k act 31 submitted a request for permission to commingle this margin with margin securing other types of derivatives traded by the cme. several chapters of the cme rulebook deal with clearing. those rules provide that the exchange shall maintain and operate a clearing house. chapter 8f of the cme rulebook deals with “over-the-counter derivative clearing.” chapter 8f provides rules for submitting an otc trade on clearport and rules providing for the substitution of the cme as counterparty to each side of the trade and the clearing house’s guarantee of cleared trades. chapter 801 of the cme rulebook deals specifically with clearing cds. the cme group reports daily settlement prices, daily volume, open interest and net changes therein for otc swaps. the cme group does not provide bid/ask prices for cleared swaps, as they are not part of the open outcry or electronic trading platform available for futures; instead, bid/ask quotes can be obtained by calling a market participant. 3. clearing interest rate swaps.53 like a cleared cds, a cleared interest rate swap is a privately negotiated contract that is submitted to a clearinghouse. the oldest such clearinghouse is known as lch.clearnet. lch.clearnet is an independent clearinghouse. it clears for many exchanges as well as clearing non-exchange-traded contracts like interest rate swaps. generally must segregate any property received from a customer as margin for various categories of derivatives and hold it in an account identified as a customer account at a qualified financial institution. cftc regulations and cme rules impose this segregation requirement on margin provided by cds customers. ice trust has a different structure. clearing members under ice trust’s clearing framework act as principals vis-à-vis both the clearinghouse and customers, rather than as agents. if a customer executes a cds trade with its clearing member that both parties agree to clear through ice trust, the result of the clearing process is that the clearing member will have three principal trades open – a “customer” trade with ice trust (that is, a clearing member-ice trust trade that is designated as relating to a customer transaction) that is offset by a back-to-back or mirror trade with the actual customer, and a “house” trade with ice trust that is the real risk position for the clearing member. (if the clearing member is not the executing dealer, these arrangements involve four parties rather than three.) thus, from ice trust’s perspective it deals with the clearing member as a principal, and from the customer’s perspective it too deals with the clearing member as a principal. the margin that the clearing member collects from its customer under the mirror trade with the customer can be on-pledged to ice trust, as customer margin, under the “customer” trade that the clearing member has with ice trust. as in the case of the cme, this margin is segregated for the benefit of the customer. for discussion of the operation of these rules and open issues under the law prior to dodd-frank as to how effective they are to protect cds customers, see the buy-side report, supra note 45, pts. iii.a.1 (cme) & iii.a.2 (ice trust); letter from cme group to securities & exchange commission re: request for order exempting certain persons from broker-dealer registration and related requirements, and from clearing agency registration and related requirements (dec. 14, 2009), available at http://www.sec.gov/rules/exorders/2009/34-61164-incoming.pdf; letter from ice trust to securities & exchange commission re: supplemental request for exemption from certain provisions of the u.s. securities exchange act of 1934 with respect to ice trust u.s. llc and its clearing members and request for extension of the march 6, 2009 order (dec. 4, 2009), available at http://www.sec.gov/rules/exorders/2009/34-61119-incoming.pdf. 53 the information under this heading comes primarily from the websites of lch.clearnet, http://www.lchclearnet.com; and idcg, http://www.idcg.com. 32 columbia jour al of tax law [vol. 2:1 lch.clearnet has cleared interest rate swaps since 1999, and currently clears about forty percent of the global interest rate swap market, in fourteen different currencies. according to lch.clearnet’s rules, parties enter into interest rate swaps first under bilateral isda documentation; when cleared by lch.clearnet, the economic terms are preserved but the lch.clearnet becomes the legal counterparty to each trade and the legal terms of the trade become lch.clearnet standard terms. accordingly, unlike cleared cds, the periodic payments made under interest rate swaps cleared by lch.clearnet are not standardized. lch.clearnet’s rules specify payment dates and calculation methodologies for payments and margin determinations. a more recent entrant to the market is the international derivatives clearing house (“idch”), a clearinghouse owned by the international derivatives clearing group (“idcg”), a subsidiary of nasdaq. like the cme, the idch is regulated by the cftc. idcg offers trading in interest rate futures contracts on nasdaq omx, a designated contract market that trades many other types of futures contracts. in addition, idch offers to clear interest rate swaps through exchange for swap transactions in which bilateral interest rate swaps are exchanged for futures contracts that have economic terms identical to the bilateral interest rate swaps. thus, as with lch.clearnet, the cleared instruments do not have standardized terms. unlike lch.clearnet, however, a party that transacts with idch winds up with a contract that is a futures contract as a regulatory matter even though its payment terms are those of a typical interest rate swap. idch first offered this service in december 2008, although it appears that trading has begun only very recently.54 this may reflect the fact that idch currently has only four clearing members, none of whom are swap dealers; rather, idch appears to be oriented primarily towards major participants on the “buy side” or in the futures market. the current volume of open interest appears to be very small.55 idch nets outstanding contracts only if they have the same fixed rate payment and the same maturity.56 the cme began clearing interest rate swaps on october 18, 2010.57 the cme also offers a “swap futures” contract that is similar to its other futures contracts except that the settlement at expiration is determined by 54 see jeremy grant, ewedge swaps deal uses idch for clearing, financial times, sept. 15, 2010, available at http://www.ft.com/cms/s/0/600c9bd0-c0ad-11df-94f900144feab49a.html (reporting that newedge, a futures broker, had brought interest rate swap trades of over $100 million to idch for clearing). 55 the idch website listed nearly 3900 open contracts as of the end of december 2010, but it is not clear to this observer what type of contracts they are. see international clearinghouse derivatives group, idcg swap drop, http://www.swapdrop.com/marketreport.aspx (last visited dec. 31, 2010). 56 idch notice to members (june 25, 2010), available at http://www.idcg.com/pdfs/idch_bulletins/20100625noticetomembers.pdf. 57 see cme group begins clearing otc interest rate swaps (oct. 18, 2010), http://cmegroup.mediaroom.com/index.php?s=43&item=3073&pagetemplate=article (last visited dec. 31, 2010) (announcing the beginning of clearing of interest rate swaps, in conjunction with a “group of premier swap dealers, clearing firms, and buy-side market participants”). 2011] ew tax issues arisi g from the dodd-fra k act 33 reference to the value of an interest rate swap that pays a 4 percent coupon vs. 3-month libor and has a specified maturity and other terms. b. summary of dodd-frank’s provisions relating to derivatives. dodd-frank repeals existing restrictions on the substantive regulation of otc derivatives and establishes a regime of substantially parallel regulation for swaps involving single non-exempt securities, loans and narrow-based security indices—to be administered by the sec—and swaps involving other financial interests and commodities—to be administered by the cftc.58 important questions affecting the tax consequences of these new rules include (i) the types of “swaps” that are subject to these rules, (ii) the types of exchanges that swaps will be required to trade on, and (iii) the parties that are subject to or exempt from these rules, under dodd-frank, swaps and the market participants that enter into them will be subject to comprehensive regulation, in some ways more restrictive than existing regulation of the securities markets. requirements will include: registration and capital, margin and business conduct requirements for swap dealers and major swap participants; mandatory clearing and trading requirements for potentially all standardized swaps; real-time public transaction reporting; and a provision limiting the scope of permitted swap activities that may be conducted by certain swap entities that receive federal assistance. notwithstanding the many complex definitional and other issues that will need to be resolved in order to implement these new rules, they will, for the most part, come into effect roughly one year after enactment. 1. definition of “swap”. the term “swap” is broadly defined to include most widely traded types of otc derivatives, although it excludes certain specified categories of transactions such as options on securities (as determined for securities law purposes). more specifically, the statutory definition of the term “swap” generally includes puts, calls, collars, forwards, a list of 22 specified types of swaps, and any transaction that is or in the future becomes commonly known to the trade as a swap.59 as the list may be relevant to the analysis of the scope of dodd-frank’s amendment to § 1256, it is provided here: (i) an interest rate swap; (ii) a rate floor; (iii) a rate cap; (iv) a rate collar; 58 dodd-frank wall street reform and consumer protection act, pub. l. no. 111203, § 721, 124 stat. 1376, 1658-72 (2010) (amendments to the commodity exchange act, including the definition of “swap”); § 761, 124 stat. 1376, 1754-59 (2010) (amendments to the securities exchange act of 1934, including the definition of “security-based swap”). 59 the definition of “swap” takes four single-spaced pages in the official printed version of dodd-frank. 34 columbia jour al of tax law [vol. 2:1 (v) a cross-currency rate swap; (vi) a basis swap; (vii) a currency swap; (viii) a foreign exchange swap; (ix) a total return swap; (x) an equity index swap; (xi) an equity swap; (xii) a debt index swap; (xiii) a debt swap; xiv) a credit spread; (xv) a credit default swap; (xvi) a credit swap; (xvii) a weather swap; (xviii) an energy swap; (xix) a metal swap; (xx) an agricultural swap; (xxi) an emissions swap; and (xxii) a commodity swap.60 technically, a “swap” is subject to the cftc’s jurisdiction and a “securitybased swap” is subject to the sec’s jurisdiction. for purposes of this article, since the clearing and trading rules applicable to these two categories are parallel, both will be referred to as “swaps.” the definition of “swap” excludes futures contracts, although the distinction between a swap and a futures contract is not entirely clear. it also excludes any foreign currency contract traded on an exchange, presumably to preserve the current regulatory treatment of various foreign currency-linked products now trading on commodities exchanges, and grants authority to treasury to exclude foreign exchange swaps and/or foreign exchange forwards from certain provisions of dodd-frank.61 given the breadth of these definitions, it is clear that at least some “swaps” subject 60 dodd-frank wall street reform and consumer protection act, pub. l. no. 111203, § 721(a)(16), 124 stat. 1376, 1663 (2010) (adding new paragraph 47 to § 1a of the commodity exchange act, 7 u.s.c. 1a). 61 id. the treasury department has requested public comment on whether to exercise this authority. determination of foreign exchange swaps and forwards, 75 fed. reg. 66426 (oct. 28, 2010). a number of financial industry associations and market participants have submitted letters recommending that such contracts be excluded from “swap” treatment to the extent permitted by dodd-frank. 2011] ew tax issues arisi g from the dodd-fra k act 35 to the new rules will be treated as something other than npcs for tax purposes. dodd-frank expressly pre-empts regulation of swaps as insurance under state insurance law, but does not draw a clear distinction between swaps, on the one hand, and insurance products, on the other.62 this prohibition is of particular relevance for cds, as there were a number of efforts by state insurance regulators and legislators after aig fp’s bailout to define cds that are used to hedge risks as insurance, to prohibit any other cds, i.e., to ban “naked” or speculative cds, and to require that a permitted cds be written by an insurance company.63 2. clearing and exchange-trading requirements. swaps subject to mandatory clearing through a central counterparty will be designated by the cftc or sec, as applicable.64 ordinarily it is likely that a clearinghouse will propose that a category of swap be so designated. the agencies may also act on their own initiative, in which case if a clearinghouse does not then decide to clear the swap, transactions in that product would effectively be prohibited. in determining whether a swap should be required to be cleared, the relevant agency must consider various factors, including liquidity, adequate pricing data, effect on mitigation of systemic risk and legal certainty in the event of the insolvency of the clearinghouse. swaps in existence at the time of dodd-frank’s enactment 62 id. § 722(b), 124 stat. 1376, 1673 (2010) (a “swap” shall not be considered to be insurance and shall not be regulated as an insurance contract under any state law), § 767, 124 stat. 1376, 1799-800 (2010) (“security-based swaps” may not be regulated as insurance under state law). 63 historically, cds were not treated as insurance, based largely on a june 2000 opinion from the state of new york office of the general counsel (“nyogc”) that examined a particular type of cds and determined that the absence of an insurable risk rendered cds not insurance. funding agreement securitizations, state of new york office of general counsel (apr. 18, 2000), available at http://www.ins.state.ny.us/ogco2000/rg004181.htm. in late 2008, however, the nyogc announced that it was reconsidering the issue, and testimony from eric dinallo, new york’s superintendent of insurance, before the house committee on agriculture (which oversees the cftc) suggested that cds used for hedging purposes might be regulated as insurance. state of new york, insurance dep’t, office of gen. counsel, “best practices” for financial guaranty issuers, circular letter no. 19 (sept. 22, 2008), available at http://www.ins.state.ny.us/circltr/2008/cl08_19.htm; hearing to review the role of credit derivatives in the u.s. economy: hearing before the h. comm. on agriculture, 110th cong. 79-81 (2008) (statement of eric dinallo, superintendent, insurance department, state of new york), available at http://agriculture.house.gov/testimony/110/h91120/dinallo.pdf. for a discussion of the actions taken by the new york state insurance department, see a. kramer, a. harris & r. ansehl, supra note 28. the insurance regulators of some other states also asserted jurisdiction over cds. state insurance regulators subsequently drafted a model law that, if adopted and not preempted by federal law, would have banned cds unless used to hedge another position and would have required all permitted cds to be written by insurance companies. national conference of insurance legislators, proposed credit default insurance model legislation, available at http://www.ncoil.org/schedule/200930day/annual30day/cdimodel.pdf. 64 the clearing requirements for swaps are in section 723 of dodd-frank. there are parallel rules for security-based swaps in section 763 of dodd-frank. dodd-frank wall street reform and consumer protection act, pub. l. no. 111-203, § 723, § 763, 124 stat. 1376, 1675-82 (2010). 36 columbia jour al of tax law [vol. 2:1 are not subject to mandatory clearing and trading, but may be subject to the margin requirement described below. margin for cleared swaps will be subject to requirements generally similar to those that currently apply to fcms for futures, and a dealer in swaps (but not security-based swaps) will be required to register as a fcm in order to accept such margin.65 swaps that are not cleared also will be subject to initial margin and variation margin requirements imposed by regulators. the level of margin that will be required for such swaps is unclear, but colloquies on the floor of congress indicate that they are intended to be less onerous than the margin requirements for cleared swaps. swaps subject to the mandatory clearing requirement will be required to be traded on a national securities exchange, a designated contract market or new type of regulated trading facility called a “swap execution facility,” unless no exchange or swap execution facility makes the swap available to trade. a swap execution facility is defined as a trading system in which multiple participants have the ability to execute or trade swaps by accepting bids and offers made by multiple participants in the system.66 the agencies are currently considering what types of arrangements will be treated as satisfying this standard. the “unless” clause above may be significant. the cftc and sec are required to prescribe rules defining the universe of swaps that “can” be executed on a swap execution facility.67 the standard to be used in applying this provision is not clear. however, swaps falling outside this universe will be permitted to be executed through any other available means of interstate commerce. thus, it may be the case that some categories of swaps are subject to mandatory clearing but not mandatory trading requirements. 3. swap dealers, major swap participants and endusers. dodd-frank provides specific rules for categories of persons termed swap dealers, major swap participants and end-users.68 swap dealers and major swap participants are subject to the mandatory clearing and trading requirements described above. they must register with the cftc and sec, and are subject to new capital and disclosure requirements. the term “swap dealer” generally includes any person who is a dealer or market maker in swaps or who “regularly enters into swaps with counterparties as an ordinary course of business for its own account”, but not someone who enters into swaps other than as part of a regular business. a non-dealer will be treated as a “major swap participant” if (i) it maintains 65 dodd-frank wall street reform and consumer protection act, pub. l. no. 111203, § 724, 124 stat. 1376 (2010) (adding subsection (f) to § 4d of the commodity exchange act, 7 u.s.c. 1a). 66 id. § 721, 124 stat. 1376 (2010) (adding paragraph (50) to § 1a of the commodity exchange act, 7 u.s.c. 1a). 67 id. § 733, 124 stat. 1376 (2010) (adding subsection (d) to § 5h of the commodity exchange act, 7 u.s.c. 1a). 68 id. § 721, 124 stat. 1376 (2010) (adding paragraph (49) to § 1a of the commodity exchange act, 7 u.s.c. 1a). 2011] ew tax issues arisi g from the dodd-fra k act 37 a substantial position in swaps, other than positions held for hedging or mitigating commercial risk, (ii) its outstanding swaps create “substantial counterparty exposure that could have serious adverse effects on the financial stability of the united states banking system or financial markets,” or (iii) it is a “financial entity” that is “highly leveraged relative to the amount of capital it holds” and maintains a “substantial position” in swaps (whether or not such swaps are held for hedging purposes), unless it is subject to bank capital requirements.69 dodd-frank exempts an “end user” from the mandatory clearing (and therefore mandatory trading) requirements.70 the end user exemption was intended for operating companies that use derivatives to hedge their business risks. an “end user” is defined as a person who (a) is not a “financial entity,” (b) is using swaps to hedge or mitigate commercial risk and (c) notifies the cftc or sec, as applicable, how it generally meets its financial obligations associated with entering into non-cleared swaps. end users may, however, require that a swap be cleared, in which case they may designate the clearinghouse to which the swap is to be submitted. parties that do not fall into these three categories presumably are subject to the mandatory clearing and trading requirements, but not the other regulatory rules applicable to swap dealers and major swap participants. c. upfront payments. an unexpected byproduct of clearing swaps is that it can, and has in the case of cds, give rise to regular upfront payments on those swaps, or potential deemed upfront payments for tax purposes. as described in section i.b.1, above, under the timing rules applicable to npcs, an upfront payment on an npc is required to be taken into account over the life of the npc, will be treated as a deemed loan for u.s. federal income tax purposes if the amount of the upfront payment is “significant,” and may be treated as an investment in united states property whether or not it is “significant.” accordingly, it is useful to understand the causes of upfront payments and the corresponding cash flows that they give rise to. 1. standardization of coupons – in general. if the coupons on a swap eligible for clearing are permitted to be set only at prescribed levels, there will ordinarily be an upfront payment on the swap in order to bring the cash flows of the swap as a whole back to a market level. this was illustrated in section i.b.1, above, for interest rate swaps, where it was assumed that the market level for the fixed leg of an interest rate swap was 6 percent but that the periodic payment on the swap was 5 percent. in the case of interest rate swaps, an upfront payment will be equal to the present value of the difference between the standard coupon and the market coupon over the stated term of the swap. accordingly, determining 69 id. § 721, 124 stat. 1376 (2010) (adding paragraph (33) to § 1a of the commodity exchange act, 7 u.s.c. 1a). 70 id. § 723, 124 stat. 1376 (2010) (adding paragraph (7) to § 2(h) of the commodity exchange act, 7 u.s.c. 1a). 38 columbia jour al of tax law [vol. 2:1 the upfront payment is relatively straightforward, as long as the parties agree on the appropriate discount rate. as described above, currently no clearinghouse clearing interest rate swaps requires standardized coupons. even if a clearinghouse does not require standardized coupons, however, individual trades may be entered into off-market for hedging or other purposes, or conceivably a segment of the market might choose regularly to enter into swaps with standardized coupons in order to more easily net their outstanding swaps and to reduce the costs of maintaining their swap portfolio. for interest rate swaps, therefore, it is uncertain how common it will be for cleared swaps to be entered into with an upfront payment but it does not seem to be an unlikely possibility. as described earlier, the cds market historically traded with market-level coupons in the case of single-name cds, and with a fixed coupon in the case of index cds. as a prelude to the beginning of clearing of cds in the fall of 2009, it was necessary to standardize the legal terms of cds. coupons also were standardized for new cds, as part of the same process. because the process and its results may be relevant for other classes of swaps, that transformation is described below in more detail. 2. standardization of cds coupons.71 as discussed earlier, one significant consequence of the move towards the standardization of the terms of cds is that coupon payments for cds are now either 100 basis points or 500 basis points multiplied by the notional principal amount.72 although the standardization of coupons was adopted as a prelude to clearing cds through a regulated clearinghouse, bilateral cds in the otc market also now use these standardized coupons. it seems reasonable to think that this phenomenon – the adoption by the otc market of conventions used for cleared swaps – will recur, in order to accommodate parties transacting in both markets. this change to the payment terms of cds did not affect the market’s perception of the risk associated with buying or writing protection on a particular reference entity. in more technical terms, the market quoted level for a cds coupon was not affected by the standardization of coupons. as a result, the advent of standardized coupons for single-name cds also brought with it the need for one party to the cds to make an upfront payment to keep the other party whole. to give an example, if the market quoted level of a particular cds was 175 basis points, and the standardized coupon for that swap is 100 basis points, the party that will be making the below-market coupon payments will be obligated to make an upfront 71 i am indebted to biswarup chatterjee of citigroup global markets for his insights into the pricing of cds and the operation of the converter described below, for the examples set forth below, and for reviewing this section of the article. any errors in the discussion are of course mine. possibly it would help if i had understood calculus. 72 this is true for north american corporate reference entities and for emerging market corporate and sovereign reference entities. there are more standard coupon levels for european reference entities. the discussion in this section ii.c assumes that the cds described is a cds on a single north american corporate reference entity. 2011] ew tax issues arisi g from the dodd-fra k act 39 payment to the other party in order to keep it whole. (the payor will receive back an equivalent amount as collateral – more on this below.) upfront payments in the cds market are not entirely new. a cds on an index of reference entities ordinarily fixes a coupon for each series of the index when the composition of the series is fixed. any trades entered into at a later time on that same series of the index will be entered into with the same coupon even if that coupon is no longer at market, in which case one party will need to compensate the other through an upfront payment.73 since most indices create a new series semi-annually, and since the market tends to prefer the “on the run” series, it seems likely that upfront payments were smaller for index cds than is now the case for single-name cds, although there is no information publicly available to confirm this point. unlike interest rate swaps, the determination of an upfront payment on a standard coupon cds is quite complex. it is helpful in understanding the calculation of upfront payments on standard coupon cds to start by discussing the pricing of pre-standardized cds, since upfront payments are determined by “converting” the difference between standard coupons and market-level coupons into a single lump sum payment. (a) coupons on pre-standardized cds. the coupon level for a pre-standardized cds was struck at the market quoted level, determined in a manner similar to determining the yield at which a bond trades. a bond at issuance might have a coupon of 6 percent, for example, in which case one would expect the coupon level for a cds on that bond to reflect the credit spread on the bond, say 4 percent (400 basis points). if the issuer’s financial condition weakened, the bond would trade at a discount, i.e., with a yield greater than 6 percent, and a new cds entered into at that time would have a higher coupon; the reverse would be true if the issuer’s financial condition improved. consequently, a cds entered into on any given day on a particular reference entity could and often did have a coupon different from a cds on the same reference entity on any other day. other terms of the cds, for example maturity date, also could differ. as described earlier, the coupons would be paid over the life of the trade, or until the date of a credit event, if any. on a daily basis, at least one party to the trade (the dealer) would mark the cds to market by reference to the present value of the difference between the original coupon and the now-current market level on which the same cds could be executed. again, this mark-to-market valuation was similar to determining the current 73 an example of such an index is the cdx.na.ig, which is an index of 125 north american investment grade issuers. information about this index is available through markit. see markit indices, http://indices.markit.com/default.asp (last visited dec. 31, 2010). in the case of cds on an index of reference entities, typically the index is reformulated every 6 months to adjust the relative weightings of the index names and/or to add or subtract reference entities so that the index continues to reflect the relevant segment of the fixed income market—much like the process followed for rebalancing and reconstituting standard equity indices. each reformulation is a new “series” of the index. cds trades on the index may reference any series created to that point, although more typically they reference the most recent series. 40 columbia jour al of tax law [vol. 2:1 price for a bond by discounting the cash flows on the bond by current interest rates and credit spreads. the cds had a zero mark-to-market value on the trade date, meaning that the present value of the coupons was equal to the value of the protection provided by the cds. most cds trades matured without ever having credit event settlement payments.74 (b) calculating the upfront payment on a standardized cds. a standardized cds also provides for periodic coupon payments, at the 100 basis points or 500 basis points level. if the current market quoted level for a cds with a standard 500 basis points coupon is 400 basis points, the protection seller will make an upfront payment to the protection buyer to compensate the protection buyer for overpaying coupons by 100 basis points as compared to the market level. if the market coupon for the cds is 550 basis points, the protection buyer will make an upfront payment to the protection seller to compensate the protection seller for the 50 basis points shortfall in standard coupon payments as compared to the market quoted level. thus, an upfront payment may be made by either party to a standardized cds. before turning to the calculation of the upfront payment, it is worth discussing how the market quoted level for a cds is determined. very generally speaking, the market quoted level for a cds is determined primarily by reference to (a) an estimate of the probability of default by the reference entity, and (b) an appropriate (interest rate) discount curve.75 the first of these variables is actually not a single number, as pricing models estimate the probability of default at multiple times during the term of the cds, and those estimates are path-dependent. for example, it may be very unlikely that issuer x will default in years 1 and 2, much more likely in year 3 because the issuer has outstanding debt coming due in that year, and then less likely in year 4 because the issuer will survive to year 4 only if it can manage its liabilities in year 3. 74 i have been advised that historically, a very small percentage of the reference entities for which cds are traded have experienced credit events, and that this is true even taking the credit crisis and recession into account, because (a) cds exist on only a limited number of reference entities, which do not include all of the companies that have failed, and (b) an issuer may be perceived by the market to have failed without triggering a cds credit event, for example if the issuer is rescued from actual failure by being acquired. as of the end of december 2010, isda listed 4 reference entities as having active credit events, and over 50 reference entities with prior credit events, for cds (including loan-only cds) on corporate reference entities. by way of comparison between healthy and troubled markets, there are only 6 credit events listed for the years 2007 (0), 2006 (3) and 2005 (3), which is as far back as the isda information goes, with all of the remainder arising in 2008, 2009 and 2010. see isda credit derivatives determinations committees, http://www.isda.org/credit (last visited dec. 31, 2010). 75 this discussion does not address a cds on a reference entity considered highly likely to default in the near term. the upfront payment on such a cds would be determined primarily by reference to the expected recovery in bankruptcy for a holder of the issuer’s debt. in the market’s jargon, a cds of this kind would be “quoted upfront” or quoted as “points upfront,” rather than quoted using a par spread. the upfront payment generally does not take into account the creditworthiness of the parties. in the case of cleared cds, that is because the clearinghouse becomes the legal counterparty to the trade. in the case of otc-only cds, the parties typically manage credit risk by taking or providing collateral. 2011] ew tax issues arisi g from the dodd-fra k act 41 it is in the nature of things that the two parties to a cds ordinarily will have different judgments about these variables. that is, the reason one party is willing to buy protection and the other is willing to sell protection at a specified market quoted level is because they have different views as to what the “right” market level should be. furthermore, the fact that a cds on reference entity x has the same market quoted level as a cds on reference entity y does not mean that the probabilities of default are the same for x and y. even if all other variables are held constant, if x (as above) is at greatest risk for default in year 3 while y is at greatest risk for default in year 2 but perhaps is considered overall more creditworthy, the shape of the “survival curve” for x and y will differ. the parties to a cds will, therefore, first agree on a market quoted level for a cds, in the same manner as they did prior to cds standardization. they will then “convert” the difference between the agreed market quoted level and the standardized coupon into a single lump sum payment. (the upfront payment also adjusts for the coupon amount that has accrued prior to entering into the trade, a refinement that will be ignored for purposes of this discussion.) calculating the upfront payment is not for the faint of heart. fortunately, in order to avoid disputes, the market has developed a standard “converter” that can be used to convert market coupons into an upfront payment.76 the converter is based on a number of simplifying assumptions with respect to both the terms of a cds and key economic variables.77 as a result, using the converter for a standardized cds is mechanically straightforward – one simply inputs the trade date; whether one is acting as protection buyer or seller; the standardized coupon, maturity date and recovery rate;78 the notional principal amount; and the currency – and out pops a number. note that the simplified assumptions used by the converter with respect to the discount and survival curve are likely to differ from the inputs used by the parties when agreeing on the market quoted level. for example, because the market quoted level for cds on reference entities x and y described above is the same, the converter would assume that the survival curve for reference entities x and y is also the same. this 76 the standard upfront calculator was developed by isda. markit helpfully provides a “converter” on its website that requires inputting only the variables described in the text above. see markit cds, http://www.markit.com/cds (last visited dec. 31, 2010). 77 in particular, the converter uses a yield curve derived from certain money market deposits and interest rate swaps maturing at different times and using flat forward rates to determine the yield for interpolated dates (dates on which no deposit or swap matures). the converter also derives an assumed probability of default for a series of specified dates (the survival curve)—analogous to looking at interest rates for specified dates—and assumes that the probability of default is constant between those dates. the probability of default is determined by reference to the ratio between the risk-free interest rate and the credit spread for the particular reference entity. the assumed yield curve and survival curve are then input into a formula that is beyond me to describe, having cheerfully forgotten all the calculus i ever knew. 78 the “recovery rate” is the amount that a holder of a debt instrument would recover in bankruptcy. for purposes of the upfront calculator, the recovery rate input for senior debt is assumed to be 40%, and for subordinated debt it is assumed to be 25%. 42 columbia jour al of tax law [vol. 2:1 divergence from more realistic assumptions does not matter on the trade date, but as discussed below can affect the amount of variation margin paid during the term of the cds. in the case of an otc-only cds, the parties are not bound to use the same assumptions or methodology as the converter described above in order to determine initial margin for the cds, but typically will in fact follow the isda-recommended guidelines. (c) examples. it is helpful in understanding how the standard converter described above works to see some examples.79 in each of these examples, party a buys protection from bank (and so pays coupons to bank) on xyz corp. as reference entity; the notional amount is $10 million; the cds has a term of 5 years; and the market coupon and the standard coupon differ by 75 basis points. example 1 (standard coupon 75 basis points below market level) • underlying market level 575 basis points, standard coupon 500 basis points • party a1 (buyer of cds) pays $ 244,000 upfront, and pays 500 basis points per year example 2 (standard coupon 75 basis points below market level) • underlying market level 175 basis points, standard coupon 100 basis points • party a2 (buyer of cds) pays $ 335,000 upfront, and pays 100 basis points per year example 3 (standard coupon 75 basis points above market level) • underlying market level 25 basis points, standard coupon 100 basis points • party a3 (buyer of cds) receives (not pays) $ 377,000 upfront, and pays 100 basis points per year it is worth dwelling on these examples for a few minutes. first, if we compare examples 1 and 2, which both involve cases where the market quoted level is 75 basis points above the standard coupon, we see that the upfront payment is less for cds #1, where the standard coupon is 500 basis points than for cds #2, where the standard coupon is 100 basis points. that is because the implied risk that there will be a credit event with respect to the reference entity during the term of the cds is higher for cds #1 than for cds #2. since coupon payments will cease to be paid if there is a credit event, the value of the right to receive the “missing” stream of 75 basis point periodic payments is less for cds #1 than for cds #2. to put this differently, as an economic matter one cannot simply translate the upfront payments on these cds into a 5-year annuity paying 75 basis points on a periodic basis, because the risk that the annuity will be 79 these examples assume that the risk-free interest curve is the same in each case, another “unrealistic” assumption. see attached diagram for illustrations of these examples. 2011] ew tax issues arisi g from the dodd-fra k act 43 cut short is significant enough to affect the value of the annuity. moreover, given the path-dependent nature of the default probability curve, it would be a simplification to treat the upfront payment as representing the present value of a stream of 75 basis point amounts to a fixed date, say year 3 for cds #1 and year 4 for cds #2. consider the example referred to above of issuer x, which may fail in year 3 but if it survives is likely to be in stronger condition in year 4. given those facts, the foregone right to receive 75 basis points in year 4 will have some current value for both cds #1 and #2, but a different value. examples 2 and 3 demonstrate the same point. because the risk of a credit event for cds #3 is considered very low, the value of the upfront payment is higher for cds #3 than for cds #2. moreover, since the coupons party a3 will pay are higher than the true cost of the protection party a3 is buying, party a3 will receive rather than pay the upfront amount. this last point is not unique to cds; the same would be true if party a3 were a party to an interest rate swap and had agreed to pay an above-market coupon. it is less intuitive, however, as one tends to think of party a3 as buying the right to a potential future cash settlement payment on the cds, and therefore as a payor rather than a payee prior to a credit event. (d) mark-to-market; collateral. as described earlier, once the parties have entered into a standardized cds and it has been accepted for clearing, on a going-forward basis the cds will be marked to market on a daily basis. the mark-to-market value of each trade is calculated by estimating the value of the difference between the standard coupon and the underlying market quoted level at which the same trade could be executed on the current date, using the converter to determine the then-value of the cds. the mark-to-market is the same for both parties, positive to one party (treated as the “in-the-money” party) and negative to the other (treated as the “out-of-the-money” party). as described above, variation margin will be paid on a daily basis by the out-of-the-money party to the in-the-money party. a less obvious point is that the need to exchange variation margin (collateral) is created immediately when the parties enter into a standard coupon cds – that is, variation margin for a standard coupon cds reflects not merely changes in value on a going-forward basis, but also the terms of the cds at the very moment when entered into. returning to example 1 above, the cds is off-market by $244,000 when entered into. ignoring the upfront payment, the cds is in-the-money to party a1 (i.e., the cds has “gained” value for party a1 compared to a cds with market level coupons), because party a1 is only required to pay 500 basis points while the market level is 575 basis points. conversely, the cds is out-of-themoney to bank (i.e., the cds has “lost” value for bank). consequently, the day 1 mark-to-market requires bank to provide $244,000 of collateral to party a1. the day 1 cash flows—the upfront payment and the corresponding variation margin—thus net to zero, assuming that the cds is valued at the end of the day at the same market level that it was executed 44 columbia jour al of tax law [vol. 2:1 at during the day.80 this point is potentially of great significance for tax purposes, since in at least some observers’ minds it calls into question whether the conventional rules for upfront payments on npcs should apply to upfront payments on cleared swaps. another way to understand the reason for the immediate and offsetting variation margin payment is that if bank were to go bankrupt immediately after receiving party a1’s upfront payment of $244,000, bank would neither return the foregone stream of 75 basis point payments nor provide any protection to party a1. party a1 would have a claim against bank based on the unwind value or mark-to-market value of the cds contract. party a1 therefore has $244,000 of credit risk to bank, which bank must collateralize by providing initial variation margin. over time, assuming no other changes to the market or the reference entity, party a1 would repay that collateral to bank. because the repayment is determined by reference to daily marks to market, and as described above as a practical matter the default probabilities for a particular issuer vary at different times during the term of the cds, the repayment would not be paid in level 75 basis point amounts. rather, in the case of issuer x described above, relatively small amounts of collateral would be repaid in years 1 and 2, and a larger amount in year 3 if the issuer survives. of course, in reality, the collateral would be adjusted daily to take actual changes in the value of the cds into account. similarly, if other types of swaps with standardized coupons are submitted to a clearinghouse, one can expect that upfront payments will also give rise to an immediate and offsetting payment of initial variation margin. there are two other aspects of the collateral arrangements described in this section ii.c2(b) that have larger implications. the first is that while the bilateral otc market historically has required collateral, usually from a customer to a dealer but not vice versa, except in unusual circumstances, actual collateral arrangements varied from customer to customer, depending on the sophistication of the customer, the level of credit risk it posed and the dealer’s willingness to please the customer. the otc market is now moving towards collateral arrangements that are much closer to those for cleared swaps. accordingly, while upfront payments are becoming more common, the actual net cash flows associated with them may not be. the second is that clearinghouses net outstanding cleared contracts daily, in a manner similar to the netting of futures contracts described in section ii.a.1, above. accordingly, if a dealer enters into a cds today with a notional principal amount of $100 and makes an upfront payment of $7, and tomorrow it enters into an identical but offsetting cds with a 80 if the cds value has changed by the end of the day, the cash flows will not net perfectly. for purposes of the discussion in the remainder of the article, it is assumed that notwithstanding this circular flow of cash, the upfront payment is treated as “real,” unless otherwise stated. a diagram illustrating the cash flows described in the text is attached. 2011] ew tax issues arisi g from the dodd-fra k act 45 notional principal amount of $25 and receives an upfront payment of $2, the clearinghouse will net the dealer’s outstanding contracts so that at the end of the second day it has a single contract with the clearinghouse with a notional principal amount of $75. under these circumstances, it seems reasonable to treat the dealer as having received back $2 of its original $7 on the second day, rather than—as assumed by the npc regulations—over the life of the cds. 3. other types of upfront payments. upfront payments made be made, or possibly deemed made, on cleared swaps for reasons other than standardization. three such circumstances are closing out cleared swaps, “backloading,” and clearing member default. to close out a cleared swap, a party engages in the same process as to enter into one. that is, it agrees with another party on a private bilateral basis to enter into a swap and to submit the swap for clearing. the swap will have terms that offset its existing swap, e.g., if the first swap calls for the party to pay 6 percent x $100 million for five years, the second swap will call for the party to receive 6 percent x $100 million for five years. as described above, the clearinghouse will net those two swaps, leaving the party with a zero net position. if the value of the swap has changed in the party’s favor since the party entered into the first swap, it will have received variation margin on the first swap, which in effect it will be entitled to keep once the swap is closed out. that is, the variation margin will have turned into realized gain. because the new swap offsets the first swap, the party also will be obligated to make an upfront payment on the second swap (which it will get back as variation margin, as described above).81 as a result, although the second swap just closes out the first swap, it looks like a new transaction with a new upfront payment. as a practical matter, it may be difficult to keep track of when a new swap is really a new transaction as opposed to the closing out of an old transaction. and since a swap is likely to have changed in value when it is closed out, upfront payments on close-out swaps are expected to be common. backloading and clearing member defaults may or may not give rise to deemed upfront payments. backloading is the process of moving historic bilateral swaps into a central clearing system. since those swaps will be off-market when cleared, there will be an immediate variation margin payment made. posting cash collateral is a type of deposit or loan (although not an investment in united states property, under § 956(c)(2)(i), at least for dealers). moreover, if the clearing of the swap is treated as a “section 1001 event,” the “new” swap would be deemed to have an upfront 81 that is, assuming that the original swap is now $5 in the money to this party, the party will have received $5 of variation margin on the first swap, will make a $5 upfront payment on the second swap and will receive back $5 of variation margin on the second swap. when all is said and done, the party has $5 that it is entitled to keep outright. 46 columbia jour al of tax law [vol. 2:1 payment.82 a clearing member default raises similar issues, because the defaulting member’s swaps may be transferred to another clearing member. with apologies to the reader for the lengthy and meandering prelude, part iii next turns to the first principal issue discussed in this article, namely the meaning and implications of dodd-frank’s amendment to § 1256. iii. the dodd-frank amendment to section 1256. dodd-frank has sixteen titles covering 849 pages in the official printed version. on the very last of those pages, there is an amendment to § 1256. as this placement suggests, the § 1256 amendment was added to dodd-frank very late in the legislative process, during the conference between the house and senate to reconcile their differing versions of the bill. the legislative history to this amendment consists of a single sentence. the operative provision in the amendment and the legislative history are as follows: amendment: the term ‘section 1256 contract’ shall not include— . . . . ‘‘(b) any interest rate swap, currency swap, basis swap, interest rate cap, interest rate floor, commodity swap, equity swap, equity index swap, credit default swap, or similar agreement.’’.83 legislative history: [title 16] contains a provision to address the recharacterization of income as a result of increased exchange-trading of derivatives contracts by clarifying that section 1256 of the internal revenue code does not apply to certain derivatives contracts transacted on exchanges.84 at a high level, the questions raised by this amendment are (i) what financial instruments are within its scope – more specifically, what constitutes a “similar agreement,” and (ii) whether otc financial instruments outside the amendment’s scope that are traded on an exchange pursuant to dodd-frank currently constitute section 1256 contracts. the 82 see supra note 44, for a discussion of the potential for a deemed exchange of swaps under § 1001 when an existing swap is cleared by a regulated clearinghouse. 83 dodd-frank wall street reform and consumer protection act, pub. l. no. 111203, § 1601, 124 stat. 2223 (2010), amending § 1256(b). section 1256(b) defines the term “section 1256 contract” and provides certain exclusions to that term. 84 h.r. rep. no. 111-517, at 879 (2010) (conf. rep.). 2011] ew tax issues arisi g from the dodd-fra k act 47 rather limited legislative history does not provide a great deal of insight into these questions, but when one takes into account the history of § 1256 and the backdrop to this amendment, some answers suggest themselves. in view of the magnitude of the stakes and the scanty legislative history, however, it is highly desirable that answers be forthcoming from a more authoritative source, meaning the treasury and service. service officials have unofficially acknowledged the importance of these issues and the utility of guidance, so it is possible that enlightenment will be forthcoming. before turning to a discussion of the questions set forth above, therefore, it is worth stopping to consider what policy considerations might inform any such guidance. those considerations might include (i) the administration’s clear preference to limit the scope of § 1256,85 (ii) the reasonably consistent approach taken by congress, the government and the courts over time to interpret the definition of “regulated futures contract” and other types of section 1256 contracts in a manner that limits the definition to the type of financial instruments under consideration by congress when that term was added to the code – this history is discussed in section iii.b, below, (iii) more broadly, the general lack of interest by lawmakers to require taxpayers to mark assets to market notwithstanding the policy arguments that can be made in favor of a broader mark-to-market regime,86 and (iv) the lack of any intent on congress’s part to change the 85 see, e.g., dep’t of the treasury, general explanations of the administration’s fiscal year 2011 revenue proposals 32 (february 2010) (proposing to eliminate 60/40 treatment for dealers in commodities and commodities derivatives), available at https://www.treas.gov/offices/tax-policy/library/greenbk10.pdf. 86 arguments for and against a broader mark-to-market regime have been made by a number of academics and other commentators over the years. see, e.g., yoram keinan, mark-to-market for derivatives, 128 tax notes 1269 (sept. 20, 2010); david s. miller, a progressive system of mark-to-market taxation, 121 tax notes 213 (2008); clarissa potter, mark-to-market taxation as the way to save the income tax—a former administrator’s view, 33 val. u. l. rev. 879 (1999); robert h. scarborough, different rules for different players and products: the patchwork taxation of derivatives, 72 taxes 1031 (1994); david j. shakow, taxation without realization: a proposal for accrual taxation, 134 u. pa. l. rev. 1111 (1986); david a. weisbach, tax responses to financial contract innovation, 50 tax l. rev. 491 (1995); edward d. kleinbard & thomas l. evans, the role of mark-to-market accounting in a realization-based tax system, 75 taxes 788 (1997). the most common arguments raised against a mark-to-market tax regime are concerns about valuation and liquidity. a mark-to-market regime requires the periodic valuation of assets, which can be difficult to value (the valuation concern). the second concern is that taxpayers may not have the cash to pay the tax on property that is marked-tomarket until they sell the property (the liquidity concern). miller, supra note 86, at 213; potter, supra note 86, at 882; shakow, supra note 86, at 1118; weisbach, supra note 86, at 511. advocates of a mark-to-market regime argue that it would combat the perceived inadequacies of realization-based taxation. they argue that the realization requirement creates inequity between taxpayers in the same economic position by applying different rules based on the form rather than the substance of a transaction. the complex rules required to define realization invite abuse, leading to anti-abuse provisions and increasing the overall complexity of the system. a mark-to-market regime, it is said, would decrease the complexity caused by the realization rule. it would also increase the overall fairness of the tax system by more closely approximating the haig-simons measure of income, which equates a taxpayer’s income in each period to consumption plus change in wealth for the period and is seen by many as a superior method of taxation. keinan, supra note 86, at 1279 48 columbia jour al of tax law [vol. 2:1 tax treatment of otc derivatives in enacting dodd-frank. these considerations would suggest a broad reading of the amendment and/or guidance limiting the scope of § 1256 with respect to derivatives not covered by the amendment. relevant considerations might also, however, include (v) acknowledgement that the rationale for imposing § 1256’s mark-to-market rules on the first type of section 1256 contract, regulated futures contract, was based on the existence of daily variation margin – giving rise to ready cash available to pay taxes on a known amount of gain – and that when other contracts become subject to daily variation margin payments similar treatment may be appropriate, and (vi) the lack of any intent on congress’s part to change the tax treatment of contracts now traded on commodities exchanges in enacting dodd-frank. these considerations would suggest a narrower reading of the amendment and/or guidance to the effect that § 1256 does apply to some or all derivatives not covered by the amendment. another consideration that surely should be taken into account are the benefits of having as many derivatives as possible subject to the same tax rules, to prevent whipsaw and arbitrage, although it is unclear whether that militates in favor or against a broad reading of the amendment. 80; miller, supra note 86, at 213-14; potter, supra note 86, at 879; scarborough, supra note 86, at 1048; kleinbard & evans, supra note 86, at 790. of more direct concern to the issues discussed herein, some of those in favor of mark-to-market agree that because of the valuation and liquidity concerns, a pure mark-tomarket regime for measuring all economic gain or loss would be administratively untenable and instead argue for a limited mark-to-market regime for derivatives. one proposal is to require taxpayers who mark gains and losses to market for purposes of gaap to do the same for tax purposes, and allow taxpayers not subject to gaap to elect mark-to-market. because companies subject to gaap have been required to value their derivatives for book purposes since the issue of fas 133 in 1998, such a proposal would not raise the standard valuation concerns. another proposal is to require high-income and high-net-worth taxpayers to mark-to-market derivatives and publicly traded securities. it is argued that concerns about liquidity are not as strong for taxpayers who are capable of borrowing against their securities and derivatives. keinan, supra note 86, at 1279-81; miller, supra note 86, at 213, 216-18; scarborough, supra note 86, at 1048; kleinbard & evans, supra note 86, at 790. other commentators have argued against such limited mark-to-market regimes for derivatives on the basis that they create a lack of consistency, which is unjustified given that the failure of realization-based taxation to deal with deferral is not generally considered to be unacceptable. in addition, if derivatives were marked to market, valuation costs would increase, and the models used to value certain derivatives would be difficult for the service to monitor. others argue that the line between what is and what is not subject to a limited mark-to-market regime would be difficult, if not impossible to draw. it is cautioned that if publicly traded stocks were marked to market, and derivatives based on them were not, taxpayers would simply ‘substitute’ one for the other and shift from positions in stock and securities to derivative positions. further, if some derivatives were subject to mark-tomarket and others were not, a new form of derivative not subject to the system would be easily substituted. potter, supra note 86, at 888-99; deborah h. schenk, an efficiency approach to reforming a realization-based tax, 57 tax l. rev. 503, 527-29 (2004); reed shuldiner, consistency and the taxation of financial products, 70 taxes 781-83 (1992). thus, no harmony has been reached in or outside the academy on the merits of a general mark-to-market regime for derivatives. it is probably fair to say that, to date, tax administrators and legislators have evinced even less interest in such a regime. 2011] ew tax issues arisi g from the dodd-fra k act 49 a final consideration is that wherever the line is drawn, it will be “wrong.” that is, it appears impossible given the current state of the law and the many complexities of dodd-frank to avoid a situation where similar financial instruments may be subject to different tax regimes. such differences may arise, for example, (a) if similar swaps are traded on a designated contract market or national securities exchange, on the one hand, and a swap execution facility, on the other, because the former are and the latter are not, qbes; (b) if one class of swaps is required to be cleared and traded on a regulated market while a class of similar or related swaps is not – examples of this are discussed in section iii.a.1, below; (c) if commodities exchanges offer products subject to § 1256 that compete with similar products covered by the amendment; (d) if similar swaps are entered into by an end-user that does not clear its swaps and another party that does; and (e) if “bespoke” swaps not subject to clearing and trading on regulated markets are hedged with swaps that are subject to those requirements.87 differences of this kind exist today, of course, but it is unfortunate that dodd-frank seems to have multiplied them, as the tools available under the code to mitigate mismatches or prevent taxpayers from taking advantage of them have limitations, as described in section iii.a, below. and these differences are in at least some respects within the power of the government to address, for example by using its power under § 1256(g)(7)(c) to designate swap execution facilities as qbes. but the general point remains that it is difficult to see how to avoid an arbitrary line-drawing of some kind. if that is correct, then a further consideration that may affect guidance is the desirability of drawing a line that is easy to see, for example by declaring that any financial instrument designated by the cftc as a futures contract constitutes a section 1256 contract and that no other financial instruments traded on dodd-frank exchanges, other than certain options and dealer contracts specified in the statute, qualify as such. a better course of action would be for congress to act to alleviate as much of the line-drawing pressure as possible. probably the best solution would be for a considered reevaluation of what the proper scope of § 1256 should be, as that question is properly for congress in the first instance rather than for treasury and the service. alternatively, pending a true overhaul of § 1256, legislative amendments could (a) revise § 475 so that current rule to the general effect that a contract that can be both a section 1256 contract and a § 475 “security” is subject to § 1256 and not § 475 is made elective,88 (b) revise § 1256(d) or (e) to permit taxpayers to elect out of § 1256 treatment for hedges of a capital asset other than a 87 another possibility is that swaps cleared or traded by u.s. taxpayers or controlled foreign corporations on non-u.s. clearinghouses and exchanges may be subject to different rules than those cleared or traded in the united states. issues relating to non-u.s. clearing and trading call deserve further consideration, but will not be addressed in this article. 88 assuming that the amendment had the effect of overriding the character rules of § 1256, an amendment of this kind would address the character whipsaw issues faced by § 475 dealers in securities and traders who elect § 475 treatment, but would not alleviate the timing problems that § 1256 treatment would give rise to for other taxpayers. 50 columbia jour al of tax law [vol. 2:1 “traditional” section 1256 contract,89 or some combination of the above.90 legislation could address swap execution facilities, so that there is no tax (dis)advantage to trading on such a facility compared to a cftc designated contract market or a sec-regulated national securities exchange.91 consideration could also be given to modifying the rules of § 1256 that limit the ability to pass long-term capital gain treatment through to limited partners of dealers organized as partnerships (§ 1256(f)(4)), as those rules now apply only to dealer equity options and dealer securities futures contracts. section iii.c, below, lists and evaluates a number of different interpretations of the scope of the amendment, from narrow to broad, and concludes that the most plausible interpretations of the amendment are that it covers either (i) npcs and cdss, but not other derivatives, or (ii) npcs, cdss, and derivatives so closely connected to those instruments that they should be subject to the same tax rules. it also argues that derivatives outside the scope of the amendment should be treated as section 1256 contracts only if they are clearly instruments of a kind that congress intended to be subject to § 1256, and possibly derivatives so closely connected to those instruments that they should be subject to the same tax rules. those conclusions are informed by reflection on the consequences of drawing the line in various possible places, and by the history of § 1256. before turning to a detailed discussion of the amendment, therefore, sections iii.a and iii.b explore those considerations. 89 an amendment of this kind would have to be evaluated to make sure that it does not open the door to some of the problems that § 1256 was enacted to prevent. one possible approach might be to limit the election to hedges of assets that constitute “actively traded personal property” within the meaning of § 1092, so that the straddle rules would operate to prevent acceleration of losses and conversion of character. it may also be useful to clarify that hedging credit risk comes within the ambit of a hedging transaction within the meaning of § 1221 or any capital asset hedge, as the term “hedging transaction” for an asset hedge is generally defined under § 1221(b)(2)(a)(i) as a transaction that manages “risk of price changes.” while that term is fairly broad, it was not written with the intent of capturing default risk. 90 a prior version of this article suggested that § 1256 be amended expressly to exclude npcs and cds. see nijenhuis, supra note 1, at 1238, at note 9. as discussed infra section iii.c, this is one plausible reading of the dodd-frank amendment to § 1256. the article noted, however, that an amendment of this kind would mean that while cds and other npcs would not be treated as section 1256 contracts, it would not cover all derivative financial instruments now traded in the otc market that may be required under dodd-frank to be cleared and/or traded, such as options. id. this implicit call for broader legislative change obviously failed to have any immediate effect. the author understands that it was not possible under congressional rules to consider any broader changes to the code than the § 1256 amendment without bringing dodd-frank under the jurisdiction of the tax-writing committees. it may be possible, therefore, for future tax legislation to address these issues. 91 there are now various types of trading markets that did not exist when § 1256 was enacted, and that are not qbes—that is, sec-regulated national securities exchanges or cftc-regulated designated contract markets—but that may nevertheless be subject to some form of regulation by securities or commodities regulators. these markets may become obsolete with the passage of dodd-frank. if that is not the case, they too should be addressed. 2011] ew tax issues arisi g from the dodd-fra k act 51 a. effect of section 1256 treatment for otc derivatives. the impact of § 1256 treatment depends partly on the type of financial instrument and partly on the tax characteristics of the taxpayer. for example, is the taxpayer an individual that can benefit from 60/40 treatment or a corporation? is the taxpayer using a realization method of accounting or does the taxpayer mark its positions to market for tax purposes? in order to illustrate what is at stake, this section iii.a considers two hypothetical situations. the first is a taxpayer who is considering one of a number of financial instruments that have the payment terms of an interest rate swap or an economic equivalent thereof and who does not use a mark-to-market method of accounting. the second is a dealer in securities who has a rates book that includes a variety of u.s. dollar interest ratelinked financial instruments. in both of these examples, § 1256 treatment is unfavorable. section iii.a ends with a brief comment on situations where broader § 1256 treatment could be favorable. 1. interest rate swaps and swap futures contracts. a taxpayer interested in interest rate swap economics can of course enter into a conventional privately negotiated bilateral otc interest rate swap. other alternatives, described in section ii.a.3, above, would be to enter into a interest rate swap futures contract of the kind offered by the idcg, whether directly or as a result of an exchange of an interest rate swap for such a futures contract through the idch, or to enter into a swap futures contract of the kind offered by the cme. as described above, the idcg contract has payment terms similar to those of an interest rate swap, that is, periodic exchanges of fixed for floating payments determined by reference to a notional principal amount, while the cme futures contract provides for a single payment determined by reference to the value of a hypothetical interest rate swap.92 under current law, the interest rate swap is subject to the accrual rules described in section i.b.1, above, and as a result of the dodd-frank amendment to § 1256, that will continue to be the case regardless of whether the swap is cleared and/or traded on a regulated market. there is no express guidance on the cme futures contract, but it presumably qualified as a “regulated futures contract” prior to the dodd-frank amendment, and for purposes of this discussion, it is assumed that that treatment continues post-dodd-frank. the puzzle, therefore, is how to characterize the idcg contract post-dodd-frank. is an “interest rate swap” within the meaning of the dodd-frank amendment, or is it a futures contract that qualifies as a “regulated futures contract” subject to § 1256? it is immediately obvious that this question is one that has no “right” answer, or at least no right answer that does not raise new questions. 92 one non-tax question raised by the idcg contract is what defines a “futures” contract as a regulatory matter? is it simply a matter of obtaining cftc approval for such characterization, and subjecting the contract to all the regulatory rules that apply to futures contract? from the uninformed perspective of a tax lawyer, this seems to be the equivalent of sprinkling cftc pixie dust over the contract, particularly if one compares it to an interest rate swap that is cleared and perhaps traded on a similar regulated market. 52 columbia jour al of tax law [vol. 2:1 if the idcg contract is not a section 1256 contract, then there will be a divergence between the tax rules applicable to some futures contracts and to other futures contracts, raising questions about how those lines should be drawn. on the other hand, if the idcg contract is a section 1256 contract, then two contracts that are essentially identical from an economic perspective – the interest rate swap and the idcg contract – will be subject to radically different tax rules, with all of the potential for whipsaw and arbitrage that that raises. it can be expected in that case that taxpayers for whom § 1256 treatment is attractive would migrate to the idcg contract and taxpayers who wish to avoid § 1256 treatment would enter into the interest rate swap. in part for that reason, and in part because of the technical reasons described in section iii.c, below, to this observer the better answer is that the idcg contract should be treated as an “interest rate swap” and not as a section 1256 contract. that conclusion is also based on the fact that § 1256 does not address how periodic payments on a section 1256 contract should be treated. this is hardly surprising in light of the fact that no contract expressly intended by congress to be subject to § 1256 provides for periodic payments. as described below, the application of § 1256 to such a contract would appear to have potentially unfortunate results. as described in section i.b.1, above, under the timing regulations for npcs, a swap characterized as an npc ordinarily would be treated as giving rise to current income or deductions in the amount of the periodic coupon payments and a portion of any upfront payment made or received to enter into the npc. absent an early termination of the swap, therefore, all income and expense from a conventional swap ordinarily is treated as ordinary income and expense. because the definition of an npc in the npc timing rules excludes any section 1256 contract, however, a swap that is classified as a section 1256 contract is not subject to the npc timing rules, including the rules that create deemed loans and deemed interest.93 this makes perfect sense for method of accounting purposes, since both § 1256 and the npc rules deal with timing and there is no reason to apply multiple sets of rules.94 93 treas. reg. § 1.446-3(c)(1)(ii) (1994). 94 however, the government has in the past taken the view in certain contexts that both the “normal” timing rules and also mark-to-market rules should apply to the same financial instruments. under treasury regulation § 1.446-3, § 475 generally overrides the timing regulations’ rules for periodic and nonperiodic payments. it is not clear, however, whether § 475 also overrides the rules that create a deemed loan if there is a significant nonperiodic payment. it may well be the case that it does not, since the author’s understanding is that the principal reason for the deemed loan rule was a withholding tax concern, namely that related parties could use npcs to lend money/pay economic interest to each other without being subject to u.s. withholding tax¸ i.e., in a situation where the party making the upfront payment (the “lender”) is resident in a country that does not have an income tax treaty with the united states providing for a zero rate of withholding tax on interest. see also treas. reg. §§ 1.475(a)-1(a)-1(e), 60 fed. reg. 397, 401 (jan. 4, 1995) (taxpayers required to accrue oid and bond premium before marking debt instruments held as assets to market); treas. reg. § 1.446-3(g)(1), 69 fed. reg. 8886, 8892 (feb. 26, 2004) (mark-to-market election; part of proposed rules for swaps with contingent nonperiodic payments, discussed in section i.b.1, above); treas. reg. § 1.446-3(g)(6), 69 fed. reg. 2011] ew tax issues arisi g from the dodd-fra k act 53 consequently, the timing of income or expense with respect to periodic payments would be governed by the general rules of the code. in view of the fact that the npc timing rules, which are clear reflection of income rules, provide for current accrual of npc periodic payments, one likely answer would be to conclude that a periodic payment on a swap should be accrued on a current basis. as a current income/expense item, the payment would not affect the basis of the swap for purposes of determining gain or loss. furthermore, as in the case, for example, with a bond with accrued interest, the mark-to-market of the swap at year-end should not take into account accrued ordinary income or expense. otherwise, that amount would be double-counted: once as income/expense and once as an increase/decrease in value. assume for example that parties a and b enter into a conventional at-market swap under which party a agrees to pay 6 percent multiplied by $100 million and party b agrees to pay libor multiplied by $100 million, annually (for ease of calculation) for 5 years. during the course of the first year, libor is 4 percent and a net 2 percent coupon accrues and, at or just before year-end, is paid. party a therefore has $2 million of swap expense and party b has $2 million of swap income. if the swap has not changed in value at year-end, the parties will take those amounts into income/expense and nothing else. if, however, the swap also has changed in value in party a’s favor, say by $10 million, party a will have $2 million of ordinary deduction and $10 million of capital gain, while party b will have $2 million of ordinary income and $10 million of capital loss. that is, the coupon payments on this swap are items separate from the mark-to-market gain or loss. this is a highly unusual fact pattern, since typically mark-to-market arises either under § 475 for a dealer or trader for whom any gain or loss is ordinary,95 or under § 1256 with respect to contracts that do not give rise to ordinary income or expense. one very broadly comparable fact pattern is a mixed straddle in which at least one position is ordinary and at least one position is capital; in that case, congress has granted authority to treasury to write regulations mitigating the whipsaw potential.96 a taxpayer in this situation may be concerned not only about ordinary/capital mismatches from the swap itself, but also with timing and possibly character mismatches with and asset or liability that the swap hedges. as described above, interest rate and foreign currency swaps are widely used by corporate and other taxpayers to hedge assets and liabilities, 8886, 8892 (feb. 26, 2004) (requiring creation of deemed loans and then the application of a complex quasi-mark-to-market regime whose principal purpose seems to be to encourage taxpayers to elect to use the “real” mark-to-market regime in subsection (i)). taxpayers have strongly objected to both of these proposed regulations as unnecessarily cumbersome and serving no purpose. 95 it is possible for mark-to-market gain or loss to be capital for a dealer in securities, if the securities in question are not held in connection with the dealer’s activities as a dealer in securities. i.r.c. § 475(d)(3)(b)(ii) (2010). dealers generally take the position, however, that all or most of their activities are connected to their securities dealer activities. 96 i.r.c. § 1092(b)(2)(d) (2010). 54 columbia jour al of tax law [vol. 2:1 including debt, that have interest rate terms or are otherwise interest ratesensitive. in any case where a swap is entered into as a hedge, the taxpayer is likely to wish the timing of its income and expense from the swap to correspond to the timing of the related income and expense from the hedged position. the taxpayer is likely to be unhappy about being required by law to use a mark-to-market method of accounting. the taxpayer that is hedging its position is also likely to find itself subject to the tax straddle rules of § 1092. such a taxpayer would be taxable on mark-to-market gain from the swap, but likely would not be able to deduct mark-to-market losses as a result of economically offsetting gains on the hedged position. assuming that the hedged position is a capital asset, the taxpayer could not make a § 1221 hedging transaction election or a § 1256(e) election to remove the swap from the application of § 1256. depending on the facts, the taxpayer also might not be able to make an integration election under treasury regulation § 1.1275-6, for example because the precision in matching timing and amounts of cash flows required by that section may not be satisfied. the taxpayer could potentially make one of various elections under the straddle rules, including the “identified straddle” election of §1092(a)(2), the “straddle-by-straddle identification” election of § 1092(b)(2)(a)(i)(i) for mixed straddles, or the “mixed straddle account” election of § 1092(b)(2)(a)(i)(ii), but each of these elections have complexities, limitations and disadvantages that make them generally highly imperfect solutions. in many cases, the taxpayer’s best option may be a “mixed straddle” election under § 1256(d) to remove the contract from the scope of § 1256, as § 1256(d) imposes relatively modest conditions. there is no discernible tax policy reason that would favor subjecting taxpayers of this kind to a mark-to-market regime for swaps. indeed, the fact that an onerous anti-abuse rule may well apply if the taxpayer could elect to use a mark-to-market method of accounting for a swap suggests to this observer that uncertainty over the scope of § 1256 should be resolved in favor of not requiring taxpayers to mark their swaps to market. in practice, if a taxpayer’s treasury department consults in advance with its tax department (which should not be assumed to take place as a matter of course), these issues will not be a problem for interest rate swaps, because the taxpayer can always choose to enter into a non-futures interest rate swap. however, the discussion above illustrates the potential problems that could arise if other types of derivatives with periodic income/expense payments were treated as section 1256 contracts. only mischief, whether for the government or for taxpayers, could result from rules under which periodic payments give rise to ordinary income/expense while mark-tomarket payments give rise to capital gain/loss. it is fervently to be hoped that the government will take the view that an express congressional mandate is necessary before taxpayers who will be required by law to transact in swaps in this manner will be subject to arbitrary and capricious rules reminiscent of the treatment of hedging transactions prior to the 2011] ew tax issues arisi g from the dodd-fra k act 55 fannie mae case and the issuance of treasury regulation §§ 1.1221-2 and 1.446-4. 97 2. interest rate swaps and hedges thereof. a second fact pattern that illustrates the anomalies that may arise in a world in which the scope of § 1256 is expanded involves a dealer in securities, within the meaning of § 475, that enters into all of the following types of financial instruments in the ordinary course of its dealer business in interest rate swaps: long and short positions in treasuries, treasury futures contracts and exchange-traded options thereon, the idcg and cme swap futures described above, forward rate agreements, and swaptions. similar issues may arise for electing traders in securities under § 475(f), or possibly for taxpayers who have taken the view that they can elect mark-to-market as a form of self-help under § 446’s clear reflection of income rules, under the general ambit of proposed treasury regulation § 1.446-3(i).98 securities dealers generally do, and electing traders must, treat the mark-to-market gain or loss as ordinary under § 475.99 section 475 provides, however, that a section 1256 contract generally does not qualify as a “security” to which § 475 applies,100 presumably because at the time § 475 was enacted commodity dealers and traders lobbied to remain outside its scope.101 (this § 1256 priority rule 97 the fannie mae case resolved an issue raised by arkansas best, namely whether arkansas best’s general repudiation of the business assets doctrine also overturned the specific holding of corn products that a hedge of inventory could itself be treated as an ordinary asset. corn prod. ref. co. v. comm’r (corn products), 350 u.s. 46 (1955); fed. nat’l mortg. assoc. v. comm’r (fannie mae), 100 t.c. 541 (1993); ark. best corp. v. comm’r, 485 u.s. 212 (1998). if that were the case, taxpayers would be subject to unmanageable whipsaw risk, because it is in the nature of hedges that sometimes they produce losses that would be capital under a broad reading of arkansas best. the fannie mae case concluded that congress had effectively legislatively adopted the corn products doctrine. treasury and the service then threw in the towel and issued treasury regulation §§ 1.1221-2 and 1.446-4 to provide specific rules for hedging transaction. congress then endorsed that result by enacting § 1221(a)(7) and (b)(2), providing statutory rules treating hedging transactions as non-capital assets. congress thus both implicitly and explicitly endorsed the harmonization of character from transactions that hedge ordinary assets or liabilities. 98 prop. treas. reg. § 1.446-3(i) 69 fed. reg. 8886, 8892 (feb. 26, 2004). treas. reg. § 1.446-3(i) generally would permit a taxpayer to mark an npc to market, provided that the npc is actively traded, or the taxpayer marks the npc to market for financial accounting purposes, or the counterparty agrees to provide its tax marks. some taxpayers have taken the position that the proposed regulations, while not currently in effect, demonstrate that marking an npc to market clearly reflects income from the npc, and that taxpayers therefore may mark to market npcs of the kind that would fall within the proposed regulations even if the taxpayer is not subject to § 475. 99 i.r.c. § 475(d)(3) (2010) (generally providing that dealer gain or loss from securities subject to § 475 is ordinary); i.r.c. § 475(f)(1)(c) (2010) (rules similar to rules of § 475(d) apply to electing traders). 100 i.r.c. § 475(c)(2)(e) and the flush language at the end of § 475(c)(2). section 475 applies to securities and, on an elective basis, commodities. the term “security” is defined in § 475(c)(2). 101 the development of the definition of the term “security” as § 475 was being considered by congress is consistent with the presumption in the text. as originally introduced in the house in february 1992, the term was defined to include (i) any derivative financial instrument in securities, but not including any futures contracts, and (ii) any 56 columbia jour al of tax law [vol. 2:1 does not apply to interest rate swaps, foreign currency swaps and equity swaps.) as a result, absent the hedging rules described below or another special rule, a dealer or trader that generally recognizes ordinary gain or loss from its securities activities may be required to recognize capital gain or loss from any section 1256 contracts that it holds. the potential adverse consequences of that are obvious. of the various types of positions described above, the interest rate swaps and the long and short positions in treasuries clearly are not section 1256 contracts; the treasury futures and options thereon and presumably the cme swap futures are section 1256 contracts; and it is uncertain whether the idcg futures contract and, if traded on an exchange, the forward rate agreement and the swaption are section 1256 contracts. the forward rate agreement potentially could be a regulated futures contract, if that term were interpreted broadly, and the swaption could be a non-equity option, unless either constituted a “similar agreement” within the meaning of the dodd-frank amendment to § 1256. thus, a substantial portion of the dealer’s book may consist of section 1256 contracts with the potential for capital losses. there is an escape from this unhappy state of affairs, because a section 1256 contract that hedges a § 475 “security” may itself be treated as a § 475 “security.”102 however, this hedging election is available only if the hedge is clearly identified on the dealer’s records as a § 475 hedge before the close of the day on which it was entered into. as a practical matter, a swap may not hedge a § 475 security, or it may be difficult to determine whether it does so with any certainty, or it may be difficult to do so in a manner that satisfies the close-of-day identification requirement. that is because dealers generally hedge their positions on an aggregate basis rather than on a position-by-position basis. also, the higher the portion of a dealer’s book that consists of section 1256 contracts, the more notional principal contract other than a commodity-linked notional principal contract. daniel rostenkowski, comm. of conference , technical explanation of tax fairness and economic growth bill of 1992, h.r. 4287, 102d cong. (as introduced in the house on feb. 22, 1992). a month later, after consideration by the senate, the npc language was unchanged but the catch-all provision now referred to a derivative financial instrument in any security otherwise described, but not including any contract to which § 1256(a) applies. family tax fairness, economic growth, and health care access bill of 1992, h.r. 4210, 102d cong. (as reported in the senate mar. 9, 1992). the legislative history gives no explanation for the change from “futures contract” to “any contract to which § 1256(a) applies,” but it seems plausible that the change was intended to clarify that the definition excluded futures contracts subject to § 1256, and not other futures contracts. finally, in the conference bill passed later that month (and vetoed by the president), the npc clause was revised to read as it now does, referring to interest rate, currency or equity npcs. daniel rostenkowski, comm. of conference, tax fairness and economic growth bill of 1992, h.r. rep. no. 102-461 (1992) (conf. rep.). 102 i.r.c. § 475(c)(2)(f) (2010); see also § 1256(e) for a broadly similar hedging exception. 2011] ew tax issues arisi g from the dodd-fra k act 57 difficult it may be to establish that any one such contract hedges a nonsection 1256 contract.103 as described above, the principal purpose of § 1256 is to require taxpayers to mark section 1256 contracts to market, and the mandate that gain or loss from section 1256 contracts be treated as long-term and shortterm capital gain was a sweetener intended to mitigate the blow of marking 103 there are some other possible avenues for relief from capital treatment, under § 1256(f)(2) and/or § 1256(f)(3), but as discussed below they do not seem to change the overall picture in any significant way. section 1256(f)(2) provides that § 1256(a)(3) (requiring 60/40 capital gain/loss) does not apply to any gain or loss which, but for such paragraph, would be ordinary income or loss. this provision was enacted at a time when the corn products doctrine, which treated business assets, including hedges, as ordinary rather than capital assets, was considered good law. corn products, 350 u.s. at 53-54. at the time § 1256 was enacted, therefore, a taxpayer using a futures contract to hedge its inventory could treat the gain or loss from the hedge as ordinary, because it would be ordinary absent § 1256 under the corn products doctrine and thus was exempt under § 1256(f)(2) from capital gain/loss treatment. however, the corn products doctrine was repudiated in ark. best. and has effectively been replaced by the hedging transaction rules of § 1221(b)(2) and hedging transaction regulations under § 446. ark. best corp., 485 u.s. at 212-13. the hedging transaction regulations apply to hedges of ordinary assets and liabilities and suffer from practical obstacles to utilization in the dealer context similar to the problems described above with the § 475 hedging exception. section 1256(f)(3) also has a complicated history. prior to the amendment of § 1256 in 1984, market-makers in equity options traded on securities exchanges took the position that they were entitled to ordinary income and loss from their options transactions. the 1984 amendment was intended to limit such treatment to the fact pattern where the taxpayer was also, independently of its option transactions, a dealer in the underlying property. this was accomplished by (i) adding “dealer equity options” as a category of section 1256 contracts, and (ii) adding § 1256(f)(3), which provides that gain or loss from “trading” (this phrase evidently was intended to include market-making in) section 1256 contracts is treated as capital gain or loss, unless the section 1256 contract is held to hedge property loss from which would be ordinary in the taxpayer’s hands. accordingly, if a dealer in swaps is also a dealer in the underlying property, and the swaps hedge that property, it may be possible under this rule for the dealer to have ordinary rather than capital gains and losses from its swap transaction. the relationship between § 1256(f)(2) and § 1256(f)(3) is not entirely clear. they were enacted at different times, for different purposes, and thus it is possible that both are available to swap dealers. if that were the case, then § 1256(f)(2) could provide considerable relief. for example, it could allow dealers to treat the character of gains and losses for swaps entered into in connection with their dealer business as ordinary, under § 475(d)(3). separately, it might alleviate concerns for an option, because under § 1234(a)(1) gain or loss from purchased options would be ordinary if the underlying property would give rise to ordinary gain or loss in the taxpayer’s hands, and under § 1234(b)(3) gain or loss from writing options is ordinary if granted in the ordinary course of the taxpayer’s trade or business of granting options. consequently, under § 1234 gain or loss from dealing in exchange-traded options could be ordinary in the absence of § 1256(a)(3). however, § 1256(f)(3)(a), providing that gain or loss from trading section 1256 contracts is capital gain or loss, was enacted precisely to prevent options marketmakers from taking that position. moreover, § 1256(f)(2) merely provides that § 1256(a)(3) does not apply, while § 1256(f)(3)(a) states that it applies “for purposes of this title.” i.r.c. § 1256(f)(3)(a) (2010). accordingly, it seems quite possible that § 1256(f)(3) overrides § 1256(f)(2), and that relief is available only if a swap hedges an asset (not a liability) that would give rise to ordinary loss in the taxpayer’s hands. see beverly gordon v. comm’r, 73 t.c.m. (cch) 2638 (1997) (rejecting taxpayer argument that hedging rule of § 1256(f)(3) applies because of failure of proof); i.r.s. f.s.a. 1999-1130 (concluding hedging rule of § 1256(f)(3) does not apply to hedges of anticipated liabilities). 58 columbia jour al of tax law [vol. 2:1 to market. given that history, it would not merely serve no tax policy goal to require taxpayers currently marking derivatives to market under § 475 to mark them to market instead under § 1256, it would be positively perverse. moreover, while the exclusion of section 1256 contracts from the definition of the term “security” for § 475 purposes may have originally served to ensure that commodities dealers and traders were not subject to § 475, those taxpayers subsequently had a change of heart and lobbied successfully for an election into § 475 treatment. conceivably, therefore, the service could exercise its regulatory authority under § 475(g) to apply the § 1256 carve-out to the definition of “security” in a more limited manner. for example, the carve-out could be applied, as it does today, for purposes of determining whether a taxpayer such as a market-maker on a commodities exchange or a dealer in fixed income instruments is a § 475 dealer in securities and would be subject to the same rules as is the case today (treating section 1256 contracts as non-“securities” for this purpose). the carve-out could cease to apply once the fixed income dealer was treated as a dealer in securities, however, with the result that any section 1256 contracts the dealer entered into would be treated as § 475 securities. an approach of this kind does not square too easily with the statutory definition of “security,” but in view of the historic and current connection between § 1256 and the commodities markets it is again perverse that electing dealers and traders in commodities treat gain or loss from section 1256 contracts as ordinary under § 475, while dealers and electing traders in securities generally must apply the capital gain/loss rules of § 1256.104 in any event, this hypothetical also demonstrates the benefits of taking a narrow view of the scope of § 1256 going forward. 3. benefits of section 1256 treatment. of course, § 1256 treatment is not always disadvantageous. for individuals who trade derivatives, or who are investors in pass-through entities that trade derivatives, § 1256 treatment can be highly desirable, since it provides 60% long-term capital gain for short-term positions. the significance of this is not trivial, since 60/40 treatment was viewed as the carrot to balance the mark-to-market stick when § 1256 was enacted, and the desire to preserve parity with existing section 1256 contracts has been the principal reason why the list of section 1256 contracts has grown over time. therefore, for taxpayers who can live with mark-to-market treatment, particularly for short-term contracts like most contracts traded on commodities exchanges today, the balance may favor § 1256 in the case of individuals. congress has from time to time acted to limit the extent to which 60/40 treatment is available. for example, in 1984, when dealer equity options were added to the list of section 1256 contracts, congress took care to ensure that options market-makers could not set themselves up as limited partnerships and pass the benefits of 60/40 treatment on to limited partners. 104 electing dealers and traders in commodities mark “commodities” to market. i.r.c. §§ 475(e)-(f) (2010). the definition of this term includes futures contracts and does not exclude section 1256 contracts. i.r.c. § 475(e)(2) (2010). electing dealers and traders in securities mark “securities” to market, which as discussed in the text does generally exclude section 1256 contracts. 2011] ew tax issues arisi g from the dodd-fra k act 59 section 1256(f)(4) provides that gain or loss from dealer equity options allocable to limited partners is always short-term. when dealer securities futures contracts became section 1256 contracts, § 1256(f)(4) was amended to apply to them as well. a natural conclusion is that, absent similar legislative action, traders in swaps treated as section 1256 contracts will be able to use partnerships in order to allow investors to share in long-term capital gains generated from a trading or dealing business. some hedge funds might find such an opportunity attractive. mutual funds might also welcome the opportunity to derive additional long-term capital gain, although absent certainty about whether § 1256 does or does not apply, mutual funds might be more concerned about the lack of certainty about the timing of income than attracted to the potential for long-term capital gain. and query whether taxpayers’ annual year-end quest to accelerate capital losses to offset realized capital gains, or, after a down market, the search for capital gains to offset expiring capital losses, might be facilitated by the existence of similar swaps, some of which are section 1256 contracts and some of which are not. interestingly, it appears that the congressional budget office and joint committee on taxation were of the view that the fisc had more to lose than to gain from § 1256 treatment of cleared and exchange-traded swaps, possibly on the theory that if there is uncertainty about whether § 1256 applies, taxpayers will use that uncertainty to their advantage.105 presumably, the dodd-frank amendment to § 1256 was intended to eliminate that uncertainty and the corresponding revenue loss. and it is certainly the case that the amendment makes clear that large portions of the derivatives market will not be subject to § 1256. it is unclear how large the remaining part of the market is, or how the market will develop in the future. accordingly, section iii.b. next reviews the history of § 1256, with a view to persuading the reader that uncertainty of this kind has historically been resolved by construing § 1256 narrowly. section iii.c. will then argue that a similar approach is appropriate today. b. a discourse on the history of section 1256. the need to look to the history of § 1256 becomes evident if one tries to determine how § 1256 applies to derivatives currently in the market that are not traditional exchange-traded contracts but have some link to an exchange or clearinghouse. since the dodd-frank amendment to § 1256 will take effect for taxable years after the year of enactment, meaning in 105 see letter from congressional budget office to senator christopher dodd (may 3, 2010), available at http://www.cbo.gov/ftpdocs/114xx/doc11476/s3217amendmt.pdf (analyzing effects on direct spending and revenues of the dodd-lincoln substitute bill, projecting an estimated revenue loss of over $1 billion from the possible § 1256 treatment of derivative financial instruments required to be cleared and traded as provided in the bill, and noting “considerable uncertainty” as to the size of the expected revenue losses); see also congressional budget office, cost estimate, h.r. 4173, restoring american financial stability act of 2010, at 7 (june 9, 2010), available at http://www.cbo.gov/ftpdocs/115xx/doc11560/hr4173senatepassed.pdf (same estimate). 60 columbia jour al of tax law [vol. 2:1 2011 for most taxpayers, and since its scope is uncertain, being able to ascertain whether § 1256 applies to such derivatives remains important today and will have some significance in the future. this section iii.b therefore begins by ignoring the dodd-frank amendment and attempting to determine whether § 1256 applies to such derivatives, and in particular whether any of them might constitute a “regulated futures contract.” 1. construing “regulated futures contract”. an rfc is defined under current law as: “a contract – (a) with respect to which the amount required to be deposited and the amount which may be withdrawn depends on a system of marking to market, and (b) which is traded on or subject to the rules of a qualified board or exchange.”106 a “qualified board or exchange” is defined as a national securities exchange registered with the sec, a domestic board of trade designated as a contract market by the cftc, or any other exchange, board of trade, or other market which the secretary determines has rules adequate to carry out the purposes of § 1256.107 on its face, this definition is very broad, as it requires only that “a contract” be traded on a cftcor sec-regulated exchange and be subject to daily variation margin requirements. as discussed in more detail below, this very breadth has raised questions in the past as to whether non-futures contracts, in particular “commodity options,” constitute rfcs. the fact that congress resolved that issue by amending § 1256 to specify when commodity options will and will not be treated as section 1256 contracts suggests that whatever the definition of rfc, it should not apply to every contract traded on a cftc-approved exchange. similarly, the fact that congress amended § 1256 to include foreign currency contracts and nonequity (including foreign currency) options suggests that the rfc definition should not include contracts linked to foreign currencies. instead, the definition should apply to some subset of traded contracts. the logical way to narrow the scope of the definition is to read into the term “a contract” the implied qualification that it is “a [commodity futures] contract,” since those were the only contracts to which the rfc definition applied when it was enacted. as discussed in more detail in section iii.b.3, below, however, while the service appears to have taken that position, there is no authoritative guidance to that effect.108 106 i.r.c. § 1256(g)(1) (2010). 107 i.r.c. § 1256(g)(7) (2010). 108 recent remarks by service officials suggest that guidance to this effect may be forthcoming. see amy s. elliott, irs may restrict definition of swap to otional principal contracts (dec. 15, 2010), available at 2010 tnt 240-3; diane freda, irs may hold to arrow view of futures under dodd-frank wall street reform (dec. 15, 2010), 239 dtr g-3, available at www.bna.com. 2011] ew tax issues arisi g from the dodd-fra k act 61 a further source of uncertainty arises because an rfc is defined as a contract “traded on or subject to the rules of” a qualified board or exchange (“qbe”). the “subject to” (or is it “traded ... subject to”?) language is ambiguous. to focus attention on that ambiguity, it may be helpful to review some of the different kinds of transactions that currently exist that have or may have some connection to a qbe but are not expressly within or outside the scope of § 1256. primarily because it is convenient to do so, the list below mostly describes a number of contracts that have some connection to the cme or its affiliate exchanges, the chicago board of trade (“cbot”) or the new york mercantile exchange (“nymex”).109 the mutual offset system. since 1984, the cme and the singapore exchange (formerly the singapore international monetary exchange, or simex) have been parties to an agreement that allows traders to open a futures contract on one exchange and have it automatically transferred overnight to the other exchange. for example, during simex business hours, a trader could enter into a eurodollar futures contract on simex; when the cme opens, the trader may send the contract to the cme, in which case, once accepted, the simex trade will be offset and the trade will become a position on the cme. from that point forward, the futures contract is identical to any other eurodollar futures contract on the cme. exchange for physical. an exchange for physical (“efp”) transaction is a privately negotiated (that is, otc rather than exchange-traded) and simultaneous exchange of a position in a physical asset for a related futures contract. for example, a party owning live cattle, natural gas or foreign currency may exchange that asset for a futures contract on the same product, provided that the asset satisfies specified conditions. once accepted, the futures contract is identical to any other futures contract traded on the exchange. the general rule for such transactions is in rule 538 of the cbot’s rulebook. exchange for swap.110 an exchange for swap (“efs”) transaction on nymex is like an efp, except that the parties exchange a futures contract vs. a swap rather than a physical asset. typically, such transactions are submitted for clearing within one hour of the parties’ agreement to the terms. in the energy markets, where there are many efs, a standard confirmation states that if the transaction is not accepted for clearing it will be void. such transactions are also subject to cbot rule 538. 109 the information described below is taken primarily from the cme group’s website, www.cmegroup.com. 110 see pomierski, supra note 49, § i.f.5; kramer, supra note 49, § 62.01[b][1]. pomierski and kramer conclude that these contracts constitute rfcs. it appears that nymex also takes that position. 62 columbia jour al of tax law [vol. 2:1 cleared agricultural swap. a cleared agricultural swap is a privately negotiated contract that is submitted to the cme for clearing, as a result of which the cme becomes the legal counterparty to both sides of the contract. these swaps are listed, for clearing only, on the cbot. that is, unlike the transactions described above, the contract does not become a futures contract. there are several variations of such swaps, all of which provide for cash-settlement on expiration in an amount determined in part by reference to the settlement price for a specified futures contract. for each type of swap, cbot rules set forth their terms. not surprisingly, given the pricing connection to futures contracts, these terms generally mimic those of the related futures contract.111 such swaps are also subject to the general provisions of cme rule 8f, which deals with clearing otc derivative contracts. because most of the terms of the swaps, once cleared, are fixed under the rules described above, negotiations are limited, generally to the price, settlement date, and in some cases, one or two other terms. it is understood by the parties that the swap is entered into for clearing, and market practice is to submit the swap for clearing immediately after agreeing to its terms. there is no separate documentation such as a confirmation for the swap before it is cleared. cleared interest rate swap. as described in section ii.a.3, above, a cleared interest rate swap is a privately negotiated contract that is submitted to a clearinghouse such as the cme or lch.clearnet (which does not give rise to a futures contract) or idch (which does). cleared cds – cme. as described in section ii.a.2(b), a cme cleared cds is a privately negotiated contract that is submitted to the cme for clearing in the same manner as described above for cleared agricultural swaps. it does not become a futures contract. cleared cds contracts are subject to cme rule 8f, described above, and specific 111 for example, in a “calendar” swap, one party agrees to pay a fixed price per bushel and the other agrees to pay an amount determined by reference to the settlement price for the futures contract expiring in the stated month of the contract. the cbot rules set forth the expiration date, the unit of clearing (the number of bushels), the minimum price increments, position limits (e.g., the number of contracts net long or net short in any single contract month), the time at which the contracts will be cash settled, and the settlement terms. ice also clears agricultural swaps under similar arrangements. pomierski describes cleared energy swaps on ice that appear to work similarly to the cleared agricultural swaps described in the text. pomierski, supra note 49, at § i.f.5; see also kramer, supra note 49, § 62.01[b][2]. 2011] ew tax issues arisi g from the dodd-fra k act 63 rules addressing the clearing and settlement of cds contracts. the cme permits parties to submit already outstanding bilateral cds transactions for clearing, although the terms of those cds will be restated in standardized terms. cleared cds – ice trust. as described in section ii.a.2(a), above, an ice trust cleared cds is similar to a cme cleared cds. however, ice trust u.s. is a standalone clearinghouse – that is, unlike the cme clearinghouse, its only function is to clear cds.112 the § 1256 tax treatment of these various contracts as “traded on or subject to the rules of” a qbe is clear only with respect to a few of the contracts on the list. in the case of the mutual offset system, revenue ruling 87-43 concludes that contracts traded on simex and transferred to the cme are rfcs.113 the revenue ruling is discussed in more detail in section iii.b.3, below. the gist of the ruling is essentially that under step transaction principles, the taxpayer has entered into an rfc in such a case. these principles would seem to apply to efps and efss that result in futures contracts as well. market participants apparently take that view, but no authority addresses the issue. conversely, the cdss cleared by ice trust are traded on an otc basis and are “subject to the rules of” a clearinghouse only. those rules are independent of any rules of any exchange. a qbe, as described above, means an sec-regulated national securities exchange, a domestic board of trade designated as a contract market by the cftc, or any other market that the treasury determines has rules that are adequate to carry out the purposes of § 1256. a stand-alone clearinghouse fits neither of the first two categories, and ice trust has not been designated by the service as a qbe. accordingly, cdss cleared by ice trust are not “subject to” the rules of an exchange, and are therefore not section 1256 contracts.114 interest rate swaps cleared by lch.clearnet are not section 1256 contracts for the same reason, and the author is aware of no debate over that issue. admittedly, it is possible that the lack of interest in this topic has something to do with historic lack of awareness in the tax community that many interest rate swaps are cleared. the principal conclusion from examining the other contracts on the list is that the statutory language is in need of some gloss. for example, what does it mean to be “traded” on a qbe? that word ordinarily connotes the purchase and sale of an asset. rfcs, however, are not bought and sold in the usual sense. an rfc is a contract that a taxpayer enters into. when 112 ice trust is a joint venture between the intercontinentalexchange (“ice”) and a consortium of dealers. ice operates a number of exchanges, but their operations are separate from those of ice trust. 113 rev. rul. 87-43, 1987-1 c.b. 252. 114 some commentators have speculated about whether this issue was considered when ice trust was formed. as the principal tax advisor on issues relating to the clearing process, i can confirm that it was. 64 columbia jour al of tax law [vol. 2:1 the taxpayer wishes to dispose of its interest in the rfc, it enters into an offsetting rfc, and its original rfc is terminated. this has very much the same effect as if the taxpayer had sold its original rfc to its counterparty in the close-out transaction, but it is technically an offset and neither a sale nor assignment. the definition of “foreign currency contract,” discussed below, also requires that such a contract be “traded in the interbank market,” a market in which contracts also typically are not assigned but instead are entered into and closed out with the original counterparty. that definition also requires that a foreign currency contract be “entered into” at arm’s length at a price determined by reference to the interbank market price, which could be read to suggest that there is a difference between “trading” a contract and “entering into” a contract. one is driven, therefore, to the conclusion that (1) futures contracts and foreign currency forward contracts are not section 1256 contracts because they are not “traded” in the traditional sense, which would hardly be a popular position, (2) that the term “traded” includes entering into a contract, at least under some circumstances, or (3) perhaps that trading does not refer to how an interest in a contract is acquired or disposed of but rather contemplates an active market in which contracts can readily be entered into, closed out and valued—that is, trading has to do with liquidity and valuation.115 there are, however, futures contracts that trade on an exchange in very low volume, and it is hard to believe that would affect their status as section 1256 contracts.116 what then does it mean to be “traded on” a qbe—that is, does the word “traded” have any independent significance, and if so, what is it? another question is what it means to be “[traded] subject to the rules of” a qbe. the phrase could, for example, apply to any contract that is treated as a futures contract on a qbe, even if not originally entered into as such; it could also apply to any contract that has economic terms that depend on the rules that apply to futures contracts; it could also apply to any contract that is subject to any rule that is in the rulebook of a qbe; or it could apply only to some of those or conceivably even more broadly. the first of these seems clearly right, as the discussion of revenue ruling 87-43 below indicates. further indirect support may come from history. while the legislative history of § 1256 does not say where the “subject to” 115 cf. treas. reg. § 1.1092(d)-1(c) (1993) (interest rate swaps treated as “personal property of a type that is actively traded” if contracts based on similar indices are “purchased, sold or entered into” on an established financial market, including an interbank market). this regulation was issued to resolve a similar conundrum. section 1092 and, at the time, section 1234a applied to personal property of a type that is actively traded. the market for interest rate swaps is deep and liquid, but interest rate swaps are not typically assigned from party to party. rather, parties enter into them and close them out. the regulation provides that entering into such swaps in the interbank market qualifies as active trading within the meaning of the relevant statutory provisions. 116 to take a random example, according to the cme website, at the close of business on november 12, 2010, open interest in soybean oil futures expiring march 2012, may 2012 and july 2013 were 6, 8 and 26 contracts, respectively, and none of those contracts traded on that day. cme group, http://www.cmegroup.com/daily_bulletin/preliminary_voi/voireport.pdf (last visited dec. 31, 2010). 2011] ew tax issues arisi g from the dodd-fra k act 65 language comes from, a likely source is the commodity exchange act. the author has been advised by commodity law experts that at the time § 1256 was enacted, exchange for physical transactions existed and were governed by the cea. the “subject to” language therefore may have been intended to refer to futures contracts that are not traded on an exchange but are otherwise identical to, and subject to all the rules governing, other futures contracts. that would not answer the question of how much further the term reaches.117 conversely, the meaning of the term qbe is clear, but may be in need of some rethinking. as described above, the cftc now regulates many different kinds of markets (dcms, dtefs, ebots and ecms, as well as dcos).118 as a policy matter, it is undesirable to treat contracts traded on a dcm as (possible) section 1256 contracts and to treat identical contracts traded on a swap execution facility or another type of regulated market as non-section 1256 contracts. the service has the authority to address this problem by determining that these other markets should be treated as qbes, but that decision surely would be better made by congress. returning to an analysis of the type of contracts on the list above, one could reach the conclusion that cleared agricultural swaps ought to be treated as section 1256 contracts in view of their very close economic connection to futures contracts, the fact that they essentially do not exist prior to being cleared, and the technical point that they are in fact subject to the rules of an exchange because the legal entity that is the cme, as it happens, is both an exchange and a clearinghouse. the last point becomes considerably less attractive, however, when one considers that it is also true of cme-cleared cds. surely it cannot be the case that cme-cleared cds could be section 1256 contracts when ice trust-cleared cds are not? at least it would not be so in a rational world. despairing, therefore, of any technical conclusion to this question, the article turns below to an examination of the history of § 1256. that history is far more illuminating than the statute itself. as it happens, the question of whether the statutory definitions mean what they appear to say has been the subject of repeated inquiry. strikingly, the government’s 117 the dodd-frank act does not directly address the issue, but there is at least one provision that suggests that clearing alone may not be the equivalent of “traded on or subject to” the rules of an exchange. that provision is part of the definition of the key term “swap” in § 721 of the dodd-frank act. it provides that “[a]ny foreign exchange swap and any foreign exchange forward that is listed and traded on or subject to the rules of a designated contract market or a swap execution facility, or that is cleared by a derivatives clearing organization” is subject to the dodd-frank act. the phrase or very close variants of it are used in several other places in the bill, but not ones bearing directly on the issues discussed herein. see see dodd-frank wall street reform and consumer protection act, pub. l. no. 111203, §§ 721, 124 stat. 1376, 1683-84 (2010), 210(c)(8)(d)(iii)(iv), 124 stat. 1376, 1483-84 (2010) (definition of “commodity contract”), 730, 124 stat. 1376, 1701-03 (2010) (modifying large swap trader reporting requirements under commodity exchange act), & 737, 124 stat. 1376, 1722-25 (2010) (modifying position limits under commodity exchange act). 118 see supra note 49. 66 columbia jour al of tax law [vol. 2:1 answer has consistently, with one apparent and temporary oversight to the contrary, been “no.” as described below, the government has interpreted the statutory definitions in light of congressional intent, with the result that they have been read to apply more narrowly than a literal reading would suggest. the one court that has reviewed an issue of this kind has heartily endorsed this narrow approach. 2. the 1983 controversy over the scope of the rfc definition.119 as described above, when enacted in 1981 and as amended in 1982, § 1256 applied only to regulated futures contracts. after the 1982 amendment, § 1256 applied to a “regulated futures contract,” defined as “a contract” that was subject to mark-to-market margin requirements and traded on or subject to the rules of a dcm or other qualified board or exchange. new contracts that then began to trade raised both technical and policy questions about the scope of § 1256, including cash-settled options such as options on a stock index, options on stock index futures contracts and “commodity options.” as described in more detail below, congress revised § 1256 in 1984 to address these issues. among the important goals of these amendments were to ensure that similar products traded on different kinds of exchanges (stock index options as opposed to stock index futures options) were subject to the same rules, and to avoid the proliferation of “mixed straddles” (transactions in which one position is a section 1256 contract but an offsetting position is not). an active debate took place prior to those amendments on both the question of how thencurrent law applied to these new contracts, and also the question of how the law should apply. the part of the debate that is most relevant here concerned whether “commodity options” constituted rfcs under then-current law. a commodity option is a contract under which the writer grants to the holder the right to enter into a futures contract to buy (or sell) a designated commodity for future delivery at the strike price during the option period. accordingly, if the option is exercised, the purchaser of a “call” commodity option enters into a “long” rfc (an rfc to buy a commodity), and the writer of that option enters into the corresponding “short” rfc (an rfc to sell the commodity); the purchaser and writer of a “put” commodity option correspondingly enter into a “short” or “long” rfc, respectively, on exercise. like other options, a commodity option may also expire unexercised. commodity options were traded on cftc-regulated exchanges and thus satisfied the second clause in the definition of rfc. their margin arrangements were more complicated. the grantor of a commodity option must post “good faith” margin, a fixed amount negotiated at the outset, and “premium” margin, an amount equal to the current premium for the margin, 119 for a contemporary description of the issues and the various proposals made to resolve them, see james w. wetzler, the tax treatment of securities transactions under the tax reform act of 1984, 25 tax notes 453 (1984); see also kramer, supra note 49, § 62.03[c], pages 62,027-31 (describing the positions taken by different groups of taxpayers). 2011] ew tax issues arisi g from the dodd-fra k act 67 marked to market daily. the purchaser of the option is not required to deposit additional funds during the life of the contract. in addition, the purchaser is not entitled to receive collateral posted by the grantor during the life of the contract, regardless of any variation in the value of the contract. rather, the collateral remains the property of the grantor, who is entitled to a return on the collateral. thus, the commodity option margin system resembled in some respects the mark-to-market system for futures contracts insofar as grantors of options are concerned, but not insofar as purchasers of options are concerned. thus, it was possible that written commodity options were rfcs but purchased commodity options were not. the new york coffee, sugar and cocoa exchange, inc. (the "csce"), a commodity exchange, took the position that commodity options should be taxed like the futures contracts that underlie these options. the csce argued to the treasury department that the commodity option margin system for option writers was a system of marking to market that fell within the definition of a mark-to-market system for rfcs. the csce conceded that purchased commodity options were not subject to such a mark-to-market system and were not rfcs, but argued that gain or loss on commodity options held by a taxpayer nevertheless should be subject to 60/40 treatment.120 treasury disagreed with that conclusion. in testimony submitted for a hearing before the house ways & means committee, assistant secretary for tax policy john chapoton stated “in our view, commodity options are taxed under the same rules that apply to physical options.” he then summarized the arguments made by the commodities exchanges, and stated “irrespective of policy considerations that may favor this result, we believe that this interpretation of current law cannot be sustained under the present statute.” 121 unfortunately, the basis for treasury’s conclusion was not explained. the joint committee on taxation (the “jct”) prepared a pamphlet for this same hearing that discusses the positions taken by various parties. the pamphlet states “[t]he staff does not believe that [the treatment of 120 the csce argued that under the general option rules of section 1234, gain or loss from the sale or exchange of an option has the same “character” as the property underlying the option (i.e., rfcs), and that because § 1256 determined the character— technically, the holding period—of gain or loss on futures contracts (as 60% long-term and 40% short-term capital gain or loss), the character of gain or loss on purchased commodity options should also be governed by § 1256. these arguments were made in a may 1982 ruling request to the internal revenue service, and a september 1982 memorandum to treasury, copies of which became part of the legislative history of the 1984 amendments to § 1256. letter and supporting memorandum on the tax treatment of options on commodity futures contracts, from donald schapiro on behalf of the coffee, sugar and cocoa exchange to john chapoton, assistant secretary of the treasury (sept. 29, 1982), reprinted as tax notes document no. 82-9883. several securities exchanges submitted memoranda criticizing these arguments and making alternative proposals. 121 federal tax treatment of capital gains and losses: hearing before the h. comm. on ways and means, 98th cong. 1st sess., 31, 32 (1983) (statement of john e. chapoton, assistant secretary for tax policy, dept. of the treasury). 68 columbia jour al of tax law [vol. 2:1 written commodity options as rfcs] was intended by congress in 1981.”122 the pamphlet also expresses similar concerns about the argument that purchased commodity options were entitled to 60/40 treatment.123 as this history indicates, it was clearly treasury’s position and it appears to have been the jct’s position that notwithstanding the broad definition of rfcs all commodity options were subject to the rules applicable to conventional options. thus, treasury expressly rejected the conclusion that a contract (option) traded on a qbe that required parties (writers) to that contract to provide daily margin if the contract lost value and to receive it back if the contract gained value constituted a rfc. moreover, treasury reached this conclusion as a technical matter under then-current law. possible bases for treasury’s position may include: (i) the 1981 legislation clearly did not contemplate options, (ii) the daily margin rules applicable to writers of commodity options did not result in the passing through of that margin to option purchasers, and could never give rise to the net receipt of margin by the option writer, and so was not the type of markto-market system contemplated by congress in 1981, or (iii) the argument made by the commodities exchanges strained credibility because it treated commodity options as rfcs for option writers but not option purchasers. treasury clearly also was concerned about the potential for arbitrage that existed under then-current law because of the uncertainty as to how commodity options should be treated, and wanted to ensure that commodity options were subject to the same rules as rfcs going forward to avoid future arbitrage. treasury’s discussion of arbitrage concerns is separate from its discussion of technical issues, however, which is consistent with the statement quoted above stating that it considered the policy issues separately from its technical analysis. 3. history of “foreign currency contracts. while not directly relevant to the scope of the rfc definition, the government’s position on the scope of the definition of another type of section 1256 contract, foreign currency contracts, is also instructive. foreign currency contracts were added to § 1256 in 1982. a “foreign currency contract” is defined as: “a contract (a) which requires delivery of[, or the settlement of which depends on the value of,] a foreign currency which is a currency in which positions are also traded through regulated futures contracts, (b) which is traded in the interbank market, and 122 staff of joint comm. on taxation, taxation of capital gains and losses: scheduled for hearings before the comm. on ways and means 23, jcs-5283 (nov. 1, 1983). 123 see id. 2011] ew tax issues arisi g from the dodd-fra k act 69 (c) which is entered into at arm’s length at a price determined by reference to the price in the interbank market.”124 the legislative history makes clear that the reason for adding this new class of contract subject to § 1256 was that there were taxpayers trading in both foreign currency futures and foreign currency forward contracts with banks on the same currencies, and that the amendment was intended to eliminate mismatches in timing and character for taxpayers trading in both markets – that is, to avoid mixed straddles.125 in 1988, the service issued private letter ruling 8818010, which concluded that a currency swap on a currency that is traded through the futures market did not fall within the definition of “foreign currency contract.” the plr first concludes that the swap in question satisfies the requirement of clause (a) cited above. the plr then turns to the legislative history of the 1982 amendment, and states that congress intended to bring bank otc forward contracts within the scope of § 1256 because “they are economically comparable to and used interchangeably with” regulated futures contracts. the plr goes on to conclude that currency swaps do not meet this standard, because they account for interest rate differentials through present and continuing exchanges of payments rather than through a single payment at maturity. the plr also notes that congress in 1982 and in later amendments to § 1256 did not refer to currency swaps. on this basis, the plr concludes that the swap fails to satisfy the requirements of clauses (b) and (c), and that the swap therefore does not constitute a “foreign currency contract.” this conclusion is rather remarkable as a technical matter. currency swaps are entered into between banks in the interbank market, and thus are priced by reference to interbank market prices, which is what clauses (b) and (c) require on their face. the plr simply determines that those clauses must be read in light of the legislative history of the term “foreign currency contract,” and that congress’s purpose and its silence with respect to currency swaps (for which no market existed in 1981) properly lead to the conclusion that such swaps are outside the scope of § 1256. perhaps one way to restate the analysis in the plr is that it effectively reads the statutory language “a contract” to mean “a [bank forward] contract.” many practitioners believed that the conclusion in the plr was correct and that its reasoning could be extended to support the further conclusion that foreign currency options traded in the otc market also did not constitute section 1256 contracts notwithstanding the fact that they too are traded between banks in the interbank market and priced by reference to interbank market prices. the issue was, however, uncertain. the 124 this definition, as amended in 1984, is now found in i.r.c. § 1256(g)(2) (2010). the bracketed language was added in 1984, as discussed in more detail below. 125 s. rep. no. 97-592, at 25-28 (1982); h.r. rep. no. 97-986, at 24-26 (1982) (conf. rep.). 70 columbia jour al of tax law [vol. 2:1 government formally addressed that question first in notice 2003-81, and subsequently in notice 2007-71.126 notice 2003-81 designates certain transactions in which taxpayers took offsetting positions in foreign currency options as “listed transactions.” a key part of the intended operation of the transaction was that some of the options were on currencies traded through rfcs, and were treated by the taxpayers described in the notice as “foreign currency contracts,” and some were on currencies not traded through rfcs and thus clearly were not “foreign currency contracts.” the notice states as fact that the otc foreign currency options on rfc-traded currencies constitute foreign currency contracts. the notice contains no analysis of the issue, and it appears likely that at least some of the drafters of the notice did not realize the significance of this statement.127 a mild uproar ensued, as practitioners questioned this off-hand conclusion.128 in 2007, the service reversed its position in notice 2007-71, which modifies notice 2003-81, describes the statement in the earlier notice about foreign currency options as a mistake, and states that the service and treasury do not believe that a foreign currency option on a currency traded though rfcs falls within the definition of “foreign currency contract” and will challenge taxpayers who take that position. the notice’s technical reasoning is somewhat tortuous. the analysis begins by referring to the definition of the term as enacted in 1982, at which time clause (a) quoted above stated that a foreign currency contract “requires delivery of” an rfc-traded currency – that is, there was no reference to cash settlement. the notice then states that an option does not “require” delivery of anything, because of the possibility that the option might not be exercised. this is an interesting point of view, since an option does create legally binding obligations on the writer, notwithstanding the possibility that the writer may not have to perform on exercise. a hypertechnical reader might wonder whether under this analysis a call (but not a put) option becomes a section 1256 contract upon exercise, since at that point the obligation to deliver foreign currency ceases to be contingent. in any event, the notice then goes on to address the 1984 amendment to the definition that modifies the delivery requirement by adding the language “or the settlement of which depends on the value of,” as shown above. the legislative history makes clear that this amendment 126 i.r.s. notice 2003-81, 2003-2 c.b. 1223; i.r.s. notice 2007-71, 2007-35 i.r.b. 472. 127 the service had taken the opposite position in i.r.s. f.s.a. 200025020 (june 23, 2000), reasoning that congress intended to extend § 1256 treatment only to foreign currency forward contracts, and noting that the legislative history to 1984 amendments to the nonequity option rules states that only “certain” foreign currency contracts are treated as rfcs. the fsa also notes that reading “foreign currency contract” broadly to include foreign currency options would effectively override the limitations of §§ 1256(g)(3) and (g)(4), dealing with options listed on a qbe. fsas officially have no authoritative weight whatsoever, and the chief counsel’s office has ceased to issue them. 128 see michael j. feder, l.g. “chip” harter & david h. shapiro, otice 2003-81: are otc currency options 1256 contracts?, 101 tax notes 1470 (2003). 2011] ew tax issues arisi g from the dodd-fra k act 71 was intended to bring cash-settled otc foreign currency forwards on rfctraded currencies within the scope of § 1256. the notice states that there is no indication in the legislative history—again reasoning by reference to silence—that this amendment also was intended to broaden the scope of “foreign currency contract” to foreign currency options.129 finally, the notice cites to the legislative history of certain 1986 amendments to § 988—which is not technically legislative history to a 1982 amendment to § 1256—as confirmation of congress’s understanding of the definition as not covering foreign currency options. in short, the notice also effectively reads the statutory definition as applying to “a [bank forward] contract,” notwithstanding the apparently broad scope of the statutory definition of “foreign currency contract.” the notice thus demonstrates the crucial nature of legislative history and congressional intent in the government’s interpretation of the scope of § 1256. the conclusion reached in the notice was adopted by the tax court in summitt. in a remarkable feat of vision, the court reaches its conclusion based on the plain meaning of the statute, and looks to legislative history only to confirm its conclusion. the “plain meaning” in this case includes the statutory changes made to the definition, thus suggesting that a similar historical view is appropriate with respect to regulated futures contracts. the case helpfully also states that “[w]hen congress has specified the types of contracts that come within the definition of a section 1256 contract, exclusion of others from its operation may be inferred.”130 summitt thus provides at least moral support for the narrow interpretation of § 1256 that this article advocates. 4. other service guidance on the scope of the rfc definition. turning from legislation to regulatory guidance, there are a handful of items of guidance addressing the scope of § 1256’s definitional provisions. to the extent one can extract something from them, they too suggest that the service has interpreted that definition by starting with a sensible conclusion and working backwards to find what support there is in the statutory language. the only published guidance on the scope of the rfc definition is revenue ruling 87-43, which as briefly described above considers whether futures or option contracts established pursuant to the mutual offset system between the cme and a foreign exchange then known as simex are considered “traded on or subject to the rules of” a qualified board or exchange.131 the ruling concludes that contracts executed on one 129 see h.r. rep. no. 98-432, at 1646 (1984). the notice could also have noted that this change was a technical amendment. 130 see summitt v. comm’r, no. 13893-07, 2010 wl 2010950, at *12 (134 t.c. no. 12, may 20, 2010). 131 rev. rul. 87-43, 1987-1 c.b. 252. the options were “nonequity options” of a kind subject to sections 1256(g)(3) and 1256(g)(5) if traded on the cme. sections 1256(g)(3) and 1256(g)(5) provide that any option, other than a right to acquire stock from an issuer, that is “traded on or subject to the rules of” a qualified board or exchange is a 72 columbia jour al of tax law [vol. 2:1 exchange and transferred to the other exchange should be analyzed by reference to the second exchange. thus, futures contracts executed on simex and transferred to the cme constitute regulated futures contracts, and futures contracts executed on the cme and transferred to simex do not. the ruling is based on the step transaction doctrine. because a customer wishing to enter into a futures contract that ultimately will be a cme futures contract originally contacts a clearing member of the cme, the ruling concludes that since the first step in the transaction and the end result are the same as for a contract executed on the cme. under the step transaction doctrine, the intervening steps should be ignored. there is a suggestion in the ruling that the basis for this conclusion is that the futures contract is “subject to the rules of” the cme as if it had originally been executed on the cme because that is how the contract is described in the facts, but the analysis part of the ruling does not make clear whether the futures contract is deemed “traded on” the cme, notwithstanding the fact that it is actually executed on simex, or whether the ruling relies on the “subject to the rules of” leg of the regulated futures contract definition. the ruling states that in determining whether the “traded on or subject to” condition is satisfied, “it is necessary to ascertain the legal relationships that exist between the parties to the transaction.” that statement seems perfectly reasonable. the ruling goes on, however, to describe “the parties” in a way that does not shed much light on larger issues. a key point in the ruling’s reasoning is a statement that in a conventional cme futures contract transaction, the fact that an exchange clearing house is interposed between the original parties to the transaction should be ignored, because “the legal relationship between the investor and the broker remains unchanged.” the meaning of this statement is unclear, particularly given the fact that the interposition of the clearing house between the clearing members has significant real-world consequences. it is also unclear why the statement focuses on the relationship between the investor and the clearing member, since generally the investor is treated for tax purposes as if it had directly entered into the futures contract on the exchange rather than as entering into an independent contract with the clearing member or the clearing house.132 by analogy, it would be rather section 1256 contract as long as it is not an “equity option” (generally, a single-stock option or an option on a narrow-based stock index). 132 every other reference to a clearing house that the author is aware of treats the clearinghouse as a mere intermediary or guarantor. see rev. rul. 85-158, 1958-2 c.b. 175 (clearing corporation guarantees payment); i.r.s. priv. ltr. rul. 88-11-053 (dec. 22, 1987) (clearing organization plays role of intermediary), i.r.s. priv. ltr. rul. 87-18-008 (jan. 14, 1987) (refers to options clearing corporation as guaranteeing options, and treats stock index options as having no issuer), i.r.s. priv. ltr. rul. 83-28-005 (mar. 23, 1983) (assumes that clearing house links buyers and sellers), i.r.s. gen. couns. mem. 37,233 (aug. 25, 1977) (treats clearing organization as merely a mechanism to link buyers and sellers, and not as a real party to a cleared listed option); cf. treas. reg. § 1.6045-1(b) (example 2) (2006) (generally excluding clearing houses from treatment as a broker). it is also our 2011] ew tax issues arisi g from the dodd-fra k act 73 unusual to give controlling weight to the taxpayer’s relationship with its broker if one were analyzing the effects of a purchase of exchange-traded stock, except in highly unusual circumstances. it is possible that the statement is simply intended to convey that for tax purposes the pre-clearing and post-clearing arrangements should not be treated as two separate contracts, and that the pre-clearing contract should instead be viewed as a temporary state of affairs that has no independent significance in analyzing the overall transaction.133 the ruling seems to view the “original parties” to the transaction as the two clearing members, however, which would suggest the reverse, namely that it is the first step rather than the ultimate result that determines whether the transaction is within the scope of § 1256. again, it is hard to square treating the clearing house members as the true parties to the transaction with the tax law’s treatment of the investor as the party that enters into the futures contract. like other § 1256 rulings, therefore, the ruling appears to reach the “right” result through technical reasoning that does not provide a basis for drawing conclusions with respect to other types of contracts or transactions. the best explanation of the ruling’s conclusion may simply be the common sense observation that all cme futures contracts should be treated in the same way regardless of whether they were executed on or off the cme. this is a less formal way of expressing the step transaction doctrine. a field service advice issued in 2000 discusses the meaning of both the terms “regulated futures contract” and “foreign currency contract.”134 unfortunately, the fsa does not describe the actual transactions carried out by the taxpayer, except to say that they were foreign currency contracts in the colloquial sense. the fsa also appears to use the term “futures contract” to include what many people would refer to as a forward contract, which does not add to its clarity. in any event, the fsa appears to take the position that only a “futures contract” can qualify as a rfc, and that a futures contract must be subject to cftc regulation in order to qualify as a rfc. another fsa from 2000 analyzes whether otc foreign currency futures, forwards and options constitute rfcs, and concludes that they do not.135 while this result is hardly surprising, the analysis in the fsa is of interest because it turns on the meaning of the “on or subject to” language in the rfc and nonequity option definitions. the fsa interprets the statutory definition to mean that a contract must be (a) traded on an exchange, apparently testing this at the instant in time when the contract is executed, or (b) traded in a manner that causes the contract to be subject to understanding that clearing houses do not treat themselves for purposes of filing their own tax returns as parties to the transactions they clear. 133 a private letter ruling issued in the same timeframe analyzing the same transactions adds this gloss, stating that the steps involved in the typical exchange clearing process are not analyzed separately but are viewed as component parts of a single transaction. i.r.s. priv. ltr. rul. 87-39-051 (june 30, 1987). 134 i.r.s. f.s.a. 200025020 (mar. 17, 2000). 135 i.r.s. f.s.a. 200041006 (june 23, 2000). 74 columbia jour al of tax law [vol. 2:1 the rules of the exchange on an on-going basis, identifying the required use of a clearing house and the required use of mark-to-market as evidence of the “continuing nature of [the] relationship between the commodity futures contract that was, at one time, traded on the exchange, and the exchange.” the reader will not be surprised to hear that this analysis is based on legislative history. the fsa takes as its premise that congress “created § 1256 based on the actual operation of the futures markets,” and then cites a sentence in a jct report that futures contracts are “subject to the rules” and regulations of the exchange where they are traded. the service’s position thus appears to be that only futures contracts traded on an exchange can be rfcs. if that continued to be the service’s position, cds that were cleared but not exchange-traded would not be treated as section 1256 contracts. this technical analysis does not fully address the issues at hand, however, because the service has never had occasion to consider a contract that is not traded on an exchange but that might nevertheless be considered to be subject to an exchange’s rules. indeed, the fsa’s emphasis on clearing as satisfying the requirement that a contract be subject to the rules of an exchange could point towards a conclusion that cme-cleared cds are “subject to” the rules of an exchange. the more significant lesson from the fsa seems to be that the service will faithfully adhere to what it sees as congressional intent in enacting § 1256. in summary, while there is no guidance on point, in the almost thirty years that § 1256 has been on the books, it has always been interpreted in a manner intended to bring within the scope of that section those instruments that congress specifically identified in legislative history, and to exclude all other instruments. as noted by the tax court in summitt, congress has implicitly approved this approach by leaving the definition of rfc unchanged, and adding additional categories of section 1256 contracts as it thought proper. congress also has made clear that it considers it bad tax policy to create or permit a tax regime in which some contracts are subject to § 1256 while other very similar contracts—here, cleared/traded swaps versus bilateral otc-only swaps with standardized terms—are not. extending that approach here would give rise to a simple conclusion, namely that neither cleared swaps nor exchange-traded swaps constitute section 1256 contracts, until and unless congress speaks to the contrary. returning to the present, the task that still remains undone now that congress has spoken is to divine its meaning. section iii.c. endeavors to do so. c. the dodd-frank amendment to section 1256. the dodd-frank amendment lists nine specific types of derivatives and states that they and “any similar agreement” do not constitute section 1256 contracts. because the precise composition of the list may be important, the list is repeated here, along with two other potentially relevant lists: 2011] ew tax issues arisi g from the dodd-fra k act 75 dodd-frank definition of swap dodd-frank amendment pc definition (i) interest rate swap interest rate swap interest rate swaps (vii) currency swap currency swap currency swaps (viii) foreign exchange swap (vi) basis swap basis swap basis swaps (iii) rate cap interest rate cap interest rate caps (ii) rate floor interest rate floor interest rate floors (iv) rate collar (v) cross-currency rate swap (xxii) commodity swap commodity swap commodity swaps (ix) total return swap (xii) equity swap equity swap equity swaps (x) equity index swap equity index swap equity index swaps (xii) debt index swap (xiii) debt swap (xiv) credit spread (xv) credit default swap credit default swap (xvi) credit swap (xvii) weather swap (xviii) energy swap (xix) metal swap (xx) agricultural swap (xxi) emissions swap agreement known as swap similar agreement similar agreements the dodd-frank definition of swap is both broader and narrower than what is described above. it is broader because the list is only one component of the definition. but it is also narrower, because there are 76 columbia jour al of tax law [vol. 2:1 various carve-outs to the definition. those refinements are for the most part not relevant to this discussion. the npc definition comes from treasury regulation § 1.4463(c)(1)(i). that regulation defines an npc functionally, as a financial instrument with certain payment terms. it then goes on to say “[n]otional principal contracts governed by this section include” the list above. thus, in the npc context, the list is illustrative only, although the illustration helps to illuminate the meaning of the definition. it is obvious from a quick glance at these lists that the dodd-frank definition of swap contains many types of swaps not included in the doddfrank § 1256 amendment, and has some minor differences in wording. it is also obvious that the composition, the wording and the ordering of the list in the amendment precisely tracks the list in the npc regulations, except for the addition of cdss. a natural conclusion that could be drawn is that the § 1256 amendment was intended to refer to npcs and cdss. however, other alternatives have been suggested. among the alternative interpretations of the scope of the § 1256 amendment are: (a) the nine contracts enumerated in the amendment and no others; a “similar” agreement is one essentially identical to one of the nine enumerated contracts; (b) npcs and cdss; a “similar” agreement is an npc that is not specifically enumerated; (c) npcs, cdss and agreements that are similar in that they are based on npcs or cdss, for example a forward or option to enter into an npc; (d) “modern” contracts, i.e., contracts historically traded on commodities exchanges should remain section 1256 contracts, but more recently developed types of derivatives should not become section 1256 contracts; or (e) any swap listed in the definition of dodd-frank; a “similar” agreement is one that is a dodd-frank “swap.” since the doddfrank definition of swap excludes futures contracts, this should be understood to mean all derivatives other than futures contracts and other types of contracts specifically excluded from the dodd-frank definition of swap.136 other alternatives are possible. for example, another possibility would be that the § 1256 amendment applies to any specifically enumerated swap and any other derivative on the same underlying risk. to this observer, the most likely of these alternatives is that the core of the amendment is that it applies to npcs, meaning that alternatives (b) and (c) are the most likely possibilities. to explain this conclusion, a 136 for some discussion of these various alternatives, see amy s. elliott, irs may restrict definition of swap to otional principal contracts (dec. 15, 2010), available at 2010 tnt 240-3. 2011] ew tax issues arisi g from the dodd-fra k act 77 few observations are in order before considering what additional insight the legislative history may provide. the first alternative offers the impression of simplicity but suffers from the fact that it seems entirely arbitrary. why include an equity swap but not a swap on debt instruments? what is the difference between a currency swap and a foreign exchange swap? in view of the fact that agricultural products and natural resources are commodities, what would it mean to include commodity swaps but exclude agricultural swaps, energy swaps and metal swaps? the fact that slightly different wording is used in the § 1256 amendment and the dodd-frank swap definition for interest rate caps and floors also suggests that the drafter of the amendment was not looking to the swap definition. the second alternative has the virtues that on its face it corresponds to existing law (the npc definition) and can be interpreted by reference to well-known rules; it is principled in that it takes into account that § 1256 has no rules for derivatives with periodic payments; and it covers a large part of the derivatives market, which seems like a necessary condition in view of the fact that the amendment eliminated the estimated revenue loss from the derivatives part of dodd-frank.137 however, it is not possible to prove that the correspondence with the npc definition was deliberate.138 this alternative also would exclude derivatives that one might believe should be within the scope of the amendment, as for example swaptions. the third alternative treats the specifically named contracts as npcs and cdss, but takes a broader view of what constitutes a “similar agreement.” the principal difficulty with this interpretation is that it is difficult to articulate the outer boundaries of what constitutes a similar agreement. this is of particular concern when trying to ensure that the definition does not inadvertently turn derivatives that were section 1256 contracts prior to the enactment of dodd-frank into non-section 1256 contracts. if the government were to adopt this alternative, an incremental approach of identifying contracts as they begin to trade on a regulated market as within or outside the scope of the amendment might be the most feasible approach, although that would provide less guidance to taxpayers anticipating the onset of such trading. the fourth alternative would be comforting: “chicago” products would be subject to § 1256, while “new york” products would not. but alas the distinction is not so easy to make. as has been described above, the range of products offered by commodities exchanges has expanded greatly over time. for that matter, so has the range of products available in 137 see congressional budget office, cost estimate, h.r. 4173, dodd-frank wall street reform and consumer protection act, at 4 (june 28, 2010), available at http://www.cbo.gov/ftpdocs/115xx/doc11596/hr4173.pdf (showing virtually no effect on budget revenues or outlays from title vii of dodd-frank). 138 as noted earlier, a prior version of this article, published a few weeks before the amendment appeared in the dodd-frank bill, recommended amending § 1256 to exclude npcs and cdss, among other proposed changes to the code. the author’s views on the proper interpretation of the § 1256 amendment are inevitably affected by this chain of events. readers may draw different conclusions. 78 columbia jour al of tax law [vol. 2:1 the otc market. the result is that even before dodd-frank there were overlaps in products or competing products in both markets. for example, it is possible to take risk positions not only in commodities, interest rates and foreign currency but also in weather and real estate both on commodities exchanges and in the otc markets. the starkest examples of the overlap are the cme and idcg swap futures contracts described above, which offer exchange-traded alternatives to otc interest rate swaps. all of these products existed prior to the enactment of dodd-frank. and it can be expected that the commodities exchanges will continue to develop new products. the distinction between “modern” and “historic” products thus does not provide either a clear or a principled line between contracts that are and are not subject to § 1256. the fifth alternative also offers the promise of simplicity. however, it seems wrong to this observer for several reasons. the first is that if the § 1256 amendment was intended to apply to all dodd-frank swaps, it would have been easier to draft it with a cross-reference. the decision instead to enumerate a list implies that some dodd-frank swaps were not intended to be covered. the fact that the ordering and wording of the list in the amendment and in the definition are different also suggests a different meaning for the amendment. lastly, and perhaps most seriously, this approach is the one most likely to cause derivatives that were thought to be section 1256 contracts prior to dodd-frank into non-section 1256 contracts. there is no reason to believe that dodd-frank was intended to have that effect. indeed, the evidence we have indicates the contrary. as quoted earlier, the single sentence of legislative history to the amendment describes it as “a provision to address the recharacterization of income as a result of increased exchange-trading of derivatives contracts by clarifying that section 1256 of the internal revenue code does not apply to certain derivatives contracts transacted on exchanges.” the most important word in this sentence is “clarifying.” it seems clear that the amendment was intended to ensure that exchange-trading of what is now an otc contract does not in and of itself cause the contract to become a section 1256 contract. that is, it was intended to freeze the status quo for derivatives not currently traded on exchanges. it also seems clear that the amendment was not intended to change the current law tax treatment of any derivative currently traded on an exchange, as such a change would constitute more than a clarification. treating the amendment as freezing the status quo is also consistent with what the author understands to have been the deliberately very limited effect that the amendment was intended to have as a result of the congressional rules governing the process for moving the dodd-frank bill through congress.139 if the analysis above is correct, it has a number of implications for derivatives outside the scope of the amendment. first, if it is a “clarification” to provide that an interest rate swap will not become a section 1256 contract if the swap is traded on a regulated market, that 139 see supra note 90. 2011] ew tax issues arisi g from the dodd-fra k act 79 implies that the interest rate swap did not become a regulated futures contract by reason of that trading. that logic in turn confirms that the term “regulated futures contract” should be given a very limited meaning, as argued earlier based on the prior history of § 1256. a second important implication has to do with the effect under current law of clearing a derivative through a regulated clearinghouse. if it is a “clarification” to provide that trading cdss does not cause them to become section 1256 contracts, it seems likely that cdss do not today constitute section 1256 contracts. after all, if cleared cdss were section 1256 contracts today, then there would be no reason to include them in the amendment. thus, the mere fact that a cds is cleared through a regulated clearinghouse—even one like the cme clearinghouse whose rules are integrally connected to the rules of an exchange—should not cause it to become a section 1256 contract. having extracted this much from the single operative sentence of the § 1256 amendment and the single sentence of legislative history, let us return to some of the conundra we considered earlier in the article. the first was the potential disparities in the tax rules applicable to an interest rate swap, and idcg interest rate swap futures contract and a cme futures contract. the second was the treatment of various instruments in a dealer’s interest rate swap book. a third interesting question is how the § 1256 amendment affects energy swaps. the idcg contract is both a futures contract and an interest rate swap, since no rule tells us that the two are mutually inconsistent.140 the pre-dodd-frank status quo is uncertain, since while the contract is a futures contract it is not a contract of the kind congress envisioned when § 1256 was enacted. indeed, as noted above, the idcg swap futures contract illustrates that the issues raised by the migration of otc contracts into regulated clearinghouses and onto exchanges is not solely the result of dodd-frank. these issues also arise because of the initiatives taken by commodities exchanges to expand the scope of their products. that is, the status quo pre-dodd frank was a moving rather than static object, and thus not easy to freeze. neither statutory language nor legislative history definitively answer the question of how an idcg swap futures contract should be treated. on balance, this author would come to the conclusion that the § 1256 amendment’s statement that an interest rate swap does not constitute a section 1256 contract should be read to override the rules otherwise applicable to futures contracts, at least in a case like this one where the 140 this is a slight overstatement. as bill paul has commented to me several times, the definition of npc in treasury regulation § 1.446-3 excludes a futures contract. if that priority rule applied more generally, the sprinkling of cftc pixie dust over a contract to make it a futures contract could mean that such a contract fell outside the scope of the § 1256 amendment, at least if one believes that that amendment is intended primarily to cover npcs. while acknowledging the technical point, the author does not believe that an obscure regulatory rule intended to ensure that only one set of timing rules applied to a particular contract should be viewed as informing congress’s judgment as to which of those rules should take priority. 80 columbia jour al of tax law [vol. 2:1 futures contract is not of a kind envisioned by congress. that conclusion is based on the history of interpreting § 1256 narrowly, the similarly restrictive intent of the § 1256 amendment, the lack of any rules in § 1256 for contracts with periodic payments, and the desirability of having consistent rules for all interest rate swaps. given the uncertainty of this or any other conclusion with respect to idcg interest rate swap futures contracts, this contract is a prime example of the need for regulatory guidance. if one concludes that the idcg contract is not a section 1256 contract, one might wonder also about the cme swap futures contract. if the § 1256 amendment covers npcs and agreements that are similar because they are linked economically to npcs, even the cme swap futures contract might not qualify as a section 1256 contract. turning to the hypothetical dealer book consisting of interest rate swaps, long and short positions in treasuries, treasury futures and options thereon, cme swap futures, icdg swap futures, forward rate agreement and swaptions, it turns out that certainty is similarly elusive. if the forward rate agreement were cleared and/or traded on a regulated market, without more, it would appear to be outside the scope of the § 1256 amendment except under one of the broader readings, because it is not an enumerated contract and also not an npc. however, if an rfc is limited to contracts that constitute futures contracts, a cleared/traded forward rate agreement would also not come within any of the definitions of a section 1256 contract. if we change the facts and assume that it trades as a forward rate agreement futures contract, then it would be hard to see how the contract could be anything other than a section 1256 contract. the swaption raises a different technical issue. if traded on a regulated exchange, on its face it would appear to constitute a “non-equity option,” a type of section 1256 contract. the legislative history of that definition does not indicate any particular congressional interest in limiting the term “non-equity option” to any specified class of non-equity options, so the history of § 1256 does not provide a basis for excluding it from that definition. a swaption also is not an npc. thus, in order to conclude that a swaption traded on a regulated exchange would not constitute a section 1256 contract, it would be necessary to conclude both that it is a “similar agreement” within the meaning of the § 1256 amendment and that in that case the amendment overrides the definition of non-equity option. this goes beyond the argument made above, that the amendment is intended to address unclear situations and clarify them in favor of non-§ 1256 treatment. here too, regulatory guidance would be welcome. finally, turning to energy swaps, the author confesses some trepidation, as the energy derivatives market is a highly specialized one that the author ventures into only from time to time. accordingly, rather than trying to answer any questions, this discussion will simply point out some relevant considerations. first, in the case of energy swaps that are exchanged for futures contracts, it is hard to see why the dodd-frank § 1256 amendment would have any effect, at least as those contracts are structured today—that is, with a single bullet payment rather than with a 2011] ew tax issues arisi g from the dodd-fra k act 81 payment stream like that of a npc. the only interpretation of the amendment that could change what the author understands to be the current law treatment of such futures contracts as section 1256 contracts is the broadest one, because energy swaps are included in the dodd-frank definition of swap. as noted earlier, however, that definition excludes a contract of sale of a commodity for future delivery. moreover, if pre-doddfrank law was fairly clear that energy futures acquired in exchange for an energy swap were section 1256 contracts, then it would seem to go beyond the scope of the amendment to change that. the treatment of energy swaps that are cleared by a regulated clearinghouse but not exchanged for futures contracts is much less certain. the arguments made above with respect to cleared cdss suggest that clearing alone does not cause a contract to become a section 1256 contract. cdss are however specifically enumerated in the § 1256 amendment. the argument may become more tenuous for other contracts. a potentially contrary argument would be that a contract that looks and smells like a futures contract, but for the fact that it does not trade as one, ought to be subject to the same rules as futures contracts. this argument also has its pitfalls. for example, the “fixed” leg of the idcg’s interest rate swap futures contracts is not actually a fixed amount. instead, it is based on futures prices for a contract with a specified maturity, such as one month or three months. tying the tax treatment of a derivative to whether it has payment terms linked to futures thus does not seem likely to reduce the amount of confusion over how to classify derivatives that share some characteristics of both the otc and exchange-traded markets. in short, any attempt to make sense of the distinction between section 1256 contracts and non-section 1256 contracts seems to be doomed to failure if the goals are to adopt rules that are principled, simple to apply and avoid whipsaw and arbitrage. if one scales back the goals by conceding that it will be impossible to write rules that treat all similar contracts in the same way, so that whipsaw and arbitrage will have to be addressed through some means apart from drawing that line, it may be possible to construct rule that are faithful to the history and, to the extent determinable, policy of the rules of § 1256 along the following lines: rule 1: npcs and cdss do not constitute section 1256 contracts. rule 2: subject to rule 1 (meaning that rule 1 trumps where both rules could apply), futures contracts do constitute section 1256 contracts. rule 3: options on rule 1 contracts are not section 1256 contracts; options on rule 2 contracts are section 1256 contracts. rule 4: other types of contracts (not specifically treated as section 1256 contracts pre-dodd-frank) generally are not section 1256 contracts. one might want to modify this to provide that contracts of a kind eligible to be exchanged for rule 2 contracts and that are cleared by a regulated clearinghouse should be taxed as section 1256 contracts. 82 columbia jour al of tax law [vol. 2:1 if these rules applied, idcg interest rate swap futures, forward rate agreements (if not futures contracts), and swaptions would not be section 1256 contracts; cme swap futures would be section 1256 contracts; and energy swaps not exchanged for futures contracts either would or would not constitute section 1256 contracts depending on how rule 4 was applied. iv. initial payments. this part iv now turns to the other principal issue that is the subject of this article, namely the possibility that the upfront payment on a swap might be treated as a loan for u.s. federal income tax purposes, with the result that payments of interest are deemed to be made between the parties. as discussed in section ii.c, above, it appears likely that there will often be upfront payments, or deemed upfront payments, under cleared swaps for a number of different reasons. an obvious one is that in the case of a swap such as a cds that provides for coupon payments at the standardized level rather than the market quoted level, there will always be an upfront payment in order to bring the aggregate payments under the swap back to a market level. other potential causes of an upfront payment, or deemed upfront payment, are closing out cleared swaps, transfers of existing otc swaps into a clearinghouse, and transfers of existing cleared swaps if an fcm defaults. as described in section i.b.1, above, under treasury regulation § 1.446-3(g)(4), a “significant” nonperiodic payment on a notional principal contract is recharacterized for u.s. federal income tax purposes as a deemed loan from the party making the payment to the recipient that is paid back in installments over the life of the contract. in the case of most otc swaps, these rules are (fairly) clear and have not been problematic for dayto-day business transactions, because it was rare for an upfront payment on interest rate swaps, foreign currency swaps or most other common types of swaps to be paid, or if so, for it to breach the “significance” threshold, whatever that may be. consequently, taxpayers have not developed the internal systems that would be necessary to monitor whether a deemed loan arises and instead have dealt with the issue on a case-by-case basis. in the case of cleared swaps, not only is it more likely that upfront payments will be made on a swap, there are also a number of aspects of clearing that raise additional technical questions about when and whether a deemed loan arises, and if so what its terms are. existing law does not, of course, address those issues. section iv.a discusses whether an upfront payment on a cleared swap is in fact a “payment” for u.s. federal income tax purposes, and if so, to whom it should be considered paid. section iv.b discusses a number of issues having to do with when a deemed loan arises on a cleared swap and if so what its terms are. section iv.c then discusses a number of additional issues that come in to play for cleared cds. in the course of discussion, this part iv also makes a number of suggestions for areas in which guidance would be useful. as this discussion will demonstrate, there are many uncertainties as to whether a deemed loan arises under current law and if so, what its terms are. since taxpayers must file annual tax returns, whether taxpayers that enter into cleared swaps with upfront payments must treat them as giving 2011] ew tax issues arisi g from the dodd-fra k act 83 rise to deemed loans and the determination of how much interest is deemed paid when are not abstract issues. more specifically, deemed loan/interest treatment implicates information reporting rules; withholding tax rules; a variety of rules dealing with interest expense, such as the foreign tax credit rules, treasury regulation § 1.882-5, addressing the allocation of interest expense by foreign banks and other foreign persons doing business in the united states in branch form, and the unrelated business taxable income rules for tax-exempt organizations; the § 475 prohibition on marking one’s own debt to market; and for some taxpayers that enter into off-market swaps, like standardized cds, with their affiliates, potentially § 956. in the view of this author, in view of the fact that taxpayers have found themselves in this uncertain new world as a result of an extraordinary and rapid reshaping of the financial markets, and pursuant to changes in non-tax law and regulatory mandates, it would be an appropriate exercise of discretion on the part of the government to announce that it will not, except in cases of abuse or cases that clearly fall within existing law, require taxpayers to treat an upfront payment on a cleared swap as a deemed loan for u.s. federal income tax purposes until guidance is issued that resolves these uncertainties. a. payment issues before turning to more technical issues, it is worth stopping to consider whether as a matter of economic substance the upfront payment is in fact a “payment” at all for u.s. federal income tax purposes. while this article does not attempt to assess how the danielson doctrine would apply, that question may not be determinative because taxpayers may be held to their form, if adverse to them.141 but even if taxpayers are held to their form here, this question is still worth asking, because it may affect the equities involved in how the government approaches the technical questions discussed below, and because it also is highly relevant to the § 956 issue mentioned above. the fact that in this case taxpayers have not chosen the form in the usual sense, but rather it is the result of guidance, albeit non-binding to date, from regulators also may affect the equities. as described in section ii.c, an upfront payment on a swap due from party a to party b is immediately and automatically reversed as a cash flow matter by a transfer of cash variation margin in the same or a very similar amount from party b to party a. this is not the result of some tax-driven structured arrangement or the result of combining two unrelated or loosely related transactions. rather, it is inherent in the economics of the transaction and in the fundamentals of the structure developed by the industry in response to regulatory imperatives in order to reduce and manage risk. the amounts are the same because one is intended to offset the other as a credit risk matter. in other contexts, one would not doubt that a circular flow of cash, envisioned by the parties and required by the legal 141 see comm’r v. danielson, 378 f.2d 771 (3d cir. 1967). the danielson case generally stands for the proposition that taxpayers will be held to the form they have chosen, absent proof that a different treatment is more appropriate. the level of proof required varies in different circuits. 84 columbia jour al of tax law [vol. 2:1 documents, would be ignored for u.s. federal income tax purposes, even if it were respected for some other purposes such as a foreign tax regime. this is not a typical (if there is such a thing) circular flow of cash, however. the initial variation margin is a posting of collateral, which ordinarily is not treated as a contractual payment. rather, it is a temporary transfer of assets from one party to another that is provided solely for credit support reasons and is expected to be reversed during the course of the transaction. it is economically a loan. thus, if one treated an upfront payment as giving rise to a deemed loan from party a to party b, and the variation margin as a loan in an equivalent amount from party b to party a, the question would be whether, in the absence of abuse, these offsetting loans between the same parties, made at the same time and as integral parts of the same transaction, should be respected as such or should be netted against each other. another way to put the question is whether a 100 percent cash collateralized loan gives rise to indebtedness for u.s. federal income tax purposes, in view of the fact that there has been no extension of credit. one relevant consideration might be that if the two flows of cash were disregarded for tax purposes, the swap would in the first instance appear to be off-market. for example, if the market quoted level for an interest rate swap is 6 percent, but the parties enter into an interest rate swap with a 5 percent coupon, and party a consequently pays a $4,210,000 upfront payment to party b and receives initial variation margin from party b in the same amount, disregarding the two cash flows of $4,210,000 leaves an interest rate swap whose terms provide for off-market coupon payments of 5 percent. however, that swap is only apparently off-market, because there is another cash flow that has not yet been taken into account. the variation margin provided by party b will be marked to market on a daily basis going forward, and will be paid back to party b over time. these daily margin payments are “real,” in the sense that over time they will cause party a to pay the economic equivalent of $4,210,000 to party b. economically speaking, therefore, the periodic payments that party a makes to party b would seem to be the equivalent of a coupon that is partly fixed and partly floating, with the “floating amount” determined by reference to changes in the value of an interest rate swap and potentially either positive or negative on any particular day. this would be an unusual animal, but the concept of using objective financial information to determine the amount of a periodic swap payment is not new.142 on the other hand, there may be taxpayers who would not view the transformation of a simple 6 percent vs. libor interest rate swap into an instrument with a fixed 5 percent coupon and a variable market-based coupon as an improvement over respecting the form of the cash flows. treating the daily margin cash flows in this manner may be a bridge too far. it is one thing to take the view that, at least for some 142 see treas. reg. § 1.446-3(c)(4)(ii) (1994) (defining objective financial information as “any current, objectively determinable financial or economic information that is not within the control of any of the parties to the contract and is not unique to one of the parties’ circumstances”). 2011] ew tax issues arisi g from the dodd-fra k act 85 purposes, offsetting flows of cash should be disregarded. it is a very different thing to take the view that every transfer of margin with respect to a cleared swap should be treated as a payment under the swap. since margin transfers will be made daily, reflecting incremental changes in value of the swap, an approach of that kind would effectively mean that the swap would be marked to market for u.s. federal income tax purposes. while there may be some sympathy for that result – after all, the taxpayer in fact has additional cash in its hands, or has paid out additional cash, and the extent to which swap payments and margin payments are netted by a clearinghouse is more far-reaching than in the otc context – treating a cleared interest rate swap as subject to an effective mark-to-market regime because of margin cash flows seems clearly contrary to congress’s intent in enacting the amendment to § 1256, which was intended to ensure that interest rate swaps and other swaps covered by the amendment continue to be taxed as they were in the otc market. as a general matter, therefore, for a variety of reasons it seems appropriate to treat the upfront payment as “real” for tax purposes. notwithstanding that point, the argument that the upfront payment should be netted to zero or something close to it is particularly compelling when one considers the possible application of § 956. in the example above, if one assumes that party a is a cfc and party b is a u.s. affiliate, it can hardly be argued that the cfc has made any net assets available to the u.s. affiliate. section 956 generally provides that an investment in “united states property” by a controlled foreign corporation may give rise to an inclusion by its u.s. shareholder under subpart f if the cfc has earnings and profits that have not yet been included in the shareholder’s income. “united states property” for this purpose generally includes any obligation of a united states person, with exceptions for obligations of unrelated parties. less technically, § 956 gives rise to a potential deemed dividend from a cfc if the cfc lends money, or is deemed to make a loan, to a related u.s. person. accordingly, if a cfc makes an upfront payment on a swap to a u.s. affiliate there is a potential for a § 956 inclusion. one possible avenue for concluding that there is no investment in united states property could be to conclude that even if a “payment” from the cfc to its u.s. affiliate has taken place, there is no “obligation” of a united states person within the meaning of § 956 because the u.s. affiliate has already transferred a like amount of cash back to the cfc.143 another possible path to that conclusion would be to look to the statutory exceptions to the term “united states property.” section 956 expressly provides two exceptions for transactions in which it is customary to provide collateral. section 956(c)(2)(j) provides in relevant part that united states property does not include an obligation of a u.s. person to the extent that the principal amount of the obligation does not exceed the fair market value of readily marketable securities posted or received as 143 the term “obligation” is not defined in the statute. temp. treas. reg. § 1.9562t(d)(2) (2008) defines it to include any form of indebtedness. 86 columbia jour al of tax law [vol. 2:1 collateral for the obligation in the ordinary course of its business by a united states or foreign person which is a dealer in securities. thus, if the cfc made an upfront payment to a u.s. affiliate of $4,210,000 while the affiliate in turn provided variation margin in the form of readily marketable securities with a value of $4,210,000, and one of the parties was a dealer in securities acting in the ordinary course of its business, there would be no united states property for § 956 purposes. a rational tax regime would not provide a worse result if the variation margin is in a form – cash – that completely offsets the obligation in the first place. now let us reverse the facts, and assume that the u.s. affiliate makes a $4,210,000 upfront payment on an interest rate swap to the cfc, and on the same day the cfc provides $4,210,000 variation margin to the affiliate. section 956(c)(2)(i) provides in relevant part that united states property does not include “deposits of cash made or received on commercial terms in the ordinary course of a united states or foreign person’s business as a dealer in securities. . . ., but only to the extent that such deposits are made or received as collateral or margin for (i) a. . . .notional principal contract [or] options contract.” it should be clear in this case, without regard to the netting argument, that there is no united states property. the next question to consider is who should be treated as the recipient of an upfront payment. as described in section ii.a.1, in practice a derivatives clearinghouse faces its clearing members. as a result, when party a and party b submit a swap negotiated in the otc market to be cleared, each of party a and party b will act through a clearing member, usually an fcm. the flow of payments thus will be from party a to its clearing member to the clearinghouse, and then from the clearinghouse to party b’s clearing member to party b, and vice versa. economically both the clearinghouse and the clearing member are conduits, albeit ones with important legal and economic roles, so that one possible way to treat the transaction for tax purposes would be as if payments were being made from party a to party b. that possibility must almost immediately be rejected as a general matter, at least in the absence of abuse, because once the clearinghouse steps in between parties a and b their economic fates are no longer linked. for example, party b could the next day enter into an offsetting transaction with party c, in which case the clearinghouse would close out both of party b’s swaps and leave party a and party c as the remaining counterparties. it would be both impossible and meaningless to try to match up the parties a, b, c etc. on an on-going basis. since the status of the clearinghouse as the counterparty to all transactions has very significant economic consequences, the logical answer to the question posed above is to treat each party as making payments to and receiving payments from the clearinghouse. there is a hitch here too, though, which is that some in clearinghouse arrangements 2011] ew tax issues arisi g from the dodd-fra k act 87 the clearing members act as agents but in others the clearing members act as principals, for legal purposes.144 the real distinction between these legal statuses is not clear to this author; in practice all clearing members appear to perform some agent-like functions (i.e., passing through payments and margin) and some principal-like functions (i.e., providing credit support to the clearinghouse, being the face to customers). obviously it would be preferable for tax purposes to treat clearing members either always as principals or always as agents. such guidance as there is suggests that clearing members should be treated as agents, but that guidance is neither clear nor definitive.145 treating a clearing member as a mere intermediary would be consistent, however, with § 1256, which implicitly treats taxpayers that transact in futures contracts as directly entering into contracts that trade on a futures exchange – i.e., ignoring the fact that the futures clearinghouse is dealing legally with an fcm rather than the customer - rather than treating them as entering into an off-exchange contract with a fcm. the remainder of the discussion below assumes that an upfront payment on a cleared swap is treated for u.s. federal income tax purposes as a cognizable payment that is made by one party to the swap to a clearinghouse, and by the clearinghouse to the other party to the swap. the remaining discussion also ignores the payment of variation margin, except where specifically stated. b. deemed loan issues as has been adverted to earlier in the article, there are a number of technical and practical issues that require clarification in order to determine when a deemed loan arises as a result of an upfront payment, and what the payment terms of the deemed loan are. they are (i) when an upfront payment is treated as “significant,” because ordinarily only a “significant” nonperiodic payment is treated as giving rise to a deemed loan, (ii) how to distinguish between swaps that are subject to the deemed loan rules and other derivatives that are not, and (iii) how, or whether, to take into account the special characteristics of cleared swaps. 1. “significance”. treasury regulation § 1.446-3 does not define the term “significant.” rather, it illustrates the meaning of the term through two examples, which describe the cash flows on a particular swap and then state that the upfront payment is or is not significant. both examples concern a five-year interest rate swap entered into when the market rate for such a swap is 10 percent vs. libor. in the first example, party g agrees to pay 11 percent rather than 10 percent annually. since party g is paying more than the market rate, party h makes an upfront payment to party g equal to the present value of 1 percent over 5 years.146 this payment is not “significant.” in the second example, party 144 see supra note 52. 145 see supra note 132 and accompanying text. 146 treas. reg. § 1.446-3(g)(6), example 2 (1994). 88 columbia jour al of tax law [vol. 2:1 m agrees to pay 6 percent rather than 10 percent annually. since party m is paying less than the market rate, party m also makes an upfront payment to party n equal to the present value of 4 percent over 5 years.147 this payment is “significant.” consequently, current law answers the question of whether an upfront payment that is either 10 percent or less than the present value of the at-market fixed leg payments on the swap, or 40 percent or more than the present value of the at-market fixed leg payments on the swap, is “significant,” but it provides no guidance for any upfront payment between those two levels. for example, in the case of the interest rate swap that pays 5 percent vs. libor when the market rate is 6 percent vs. libor, the upfront payment is equal to the present value of 1/6, or about 17 percent, of the at-market payments on the fixed leg of the swap. taxpayers should not have to guess whether that payment gives rise to a deemed loan. it is in the government’s interest to clarify that question, to ensure that taxpayers take consistent positions. 2. distinguishing between “swaps.”. the deemed loan rules described above apply only to npcs that are subject to treasury regulation § 1.446-3. actually, they apply only to a subset of such npcs, namely npcs that qualify as “swaps,” as npcs include caps and floors that are not subject to the deemed loan rule. as anyone familiar with derivatives knows, drawing distinctions between different kinds of derivatives is not always easy. accordingly, the boundary between derivatives that are and are not subject to these rules is hazy. resolving where that boundary lies is a task beyond what it is reasonable to either discuss in this article or expect the government to provide guidance on as a general matter. it would be comforting, however, if guidance provided that the service would not challenge a reasonable determination made by the taxpayer for purposes of applying the rules listed at the beginning of this part iv when an upfront payment is made under a cleared swap. 3. special attributes of cleared swaps. the deemed loan rules assume a fairly static universe. that is, they treat an upfront payment on an interest rate swap as if it will economically be paid back over the contractual life of the swap. this is not quite accurate, since there is a special rule that says in the case of a swap subject to extension or termination one looks to the reasonably expected term of the swap rather than the stated maturity.148 but for a swap with no stated extension or termination provisions the loan is treated as payable over the stated term of the swap. while swaps can be and are closed out early, for a swap entered into in the otc market that seems like a reasonable, and the only practical, basis for determining the term of the deemed loan. in the case of cleared swaps, particularly for taxpayers that regularly enter into and close out swaps in high numbers, that approach is 147 treas. reg. § 1.446-3(g)(6), example 3 (1994). 148 treas. reg. § 1.446-3(f)(3) (1994). 2011] ew tax issues arisi g from the dodd-fra k act 89 not so reasonable. under current market practice, this point is particularly relevant to cds, but the more general issue is relevant for other types of swaps as well. as described in section ii.a.2, above, long and short positions in cleared cds are netted on a daily basis. to take an example, assume a dealer on day 1 sells protection under the cds described in example 1 in connection with a customer transaction, and receives the $244,000 upfront payment. on the next day, the dealer buys protection under an identical cds in connection with a second customer transaction. because the market’s perception of the creditworthiness of the reference entity has changed, the dealer pays a $250,000 upfront payment. the clearinghouse will net the two transactions, with the result that the dealer has no outstanding cds, and has paid $6,000 on a net basis. (if in the second transaction the dealer paid $240,000, the transactions would also net, but the dealer would have paid $4,000 on a net basis.) since dealers routinely enter into many transactions, and the clearinghouses net positions on a daily or more frequent basis, the result is that it is impossible to determine for what period of time any upfront payment actually will relate to. indeed, the one thing one can probably be reasonably sure about is that whatever the analysis might be on day 1, it will be modified by the next day’s transaction. similarly, in the case of dealers who operate in such a manner that one affiliate enters into transactions with certain customers but a different affiliate is the one that faces the clearinghouse, so that the first affiliate routinely enters into multiple cds with the other to hedge its position, upfront payments made and received on different days also will regularly net as an economic matter and may net as a legal matter. hedge funds or other active market participants in the swap market also are likely to transact in a manner that results in netting of outstanding contracts on a regular basis. a possible response to these facts would be to shrug. after all, it is not uncommon for issuers of debt to redeem it early, whether voluntarily or pursuant to the terms of the debt instrument. moreover, it is not so easy to see what other rule should be adopted. even if one concluded that an upfront payment for a taxpayer of this kind is really a short-term debt instrument, that would not answer the question of how to determine the amount of interest deemed to accrue on that debt instrument. alternatively, one might conclude that in this setting it is not appropriate to impute a loan or to impute interest, at least for taxpayers of the kind described above. that raises the more general question of why it is appropriate to do so for npcs in the first place. if it is correct that the principal reason for the deemed loan construct is to prevent related parties from avoiding withholding tax on interest, a more narrowly targeted rule could serve that purpose without raising the many questions identified above. c. additional issues for cds. 1. do the deemed loan rules apply? as noted above, the deemed loan rules apply only to npcs that qualify as “swaps,” 90 columbia jour al of tax law [vol. 2:1 and it is unclear whether a cds is properly treated as an npc, an option, or possibly some other kind of miscellaneous derivative financial instrument. for this reason if no other, therefore, the proper treatment of cleared cds with upfront payments is more difficult than for other cleared swaps. as it happens, the question of whether one specific type of cds should be treated as an npc or as an option for u.s. federal income tax purposes has been raised in litigation in bankruptcy court, under circumstances that not only make the answer to that question a do-or-die matter for the taxpayer in question but also may have very significant financial consequences for its counterparties. the bankrupt taxpayer is ambac financial group, inc., a “monoline” insurer. like other u.s. monolines, ambac’s core business was historically to provide financial guarantee insurance to investors in municipal bonds. during the heyday of mortgage securitizations, however, ambac began to write cds on mortgage-backed securities. that expansion of its business proved ill-fated, and ambac engaged first in a number of out-of-court settlements with its cds counterparties and ultimately sought bankruptcy protection. according to ambac’s financial statements, ambac’s court filings and published news reports,149 one of ambac’s most important assets is a $700 million refund that it has received as a result of losses on a type of cds contract known as a “pay as you go” (or paygo) cds. ambac began to write (non-paygo) cds in 1999, through a non-insurance subsidiary. ambac treated these cds as options for tax purposes, and that treatment was reviewed and approved by the irs through 2004. as a result, ambac treated cds premiums received as giving rise to income (presumably capital gain) when the contract was terminated or expired. in 2005 ambac began to write paygo cds, which it also treated as options for tax purposes. in 2007, ambac began to experience losses on its paygo cds. in 2008, ambac adopted the position that paygo cds were properly characterized not as options but instead as npcs, and began to take losses (but not income) on those cds on a current basis in a manner consistent with its recognition of those losses for insurance regulatory purposes. ambac then applied for tentative carryback adjustments based on these net operating losses, and to date has received about $700 million in refunds. in late october of 2010, ambac was contacted by the irs for information about its change of position on the characterization on the 149 the following description is based on those sources, in particular ambac financial group, inc. 2008 annual report 157-62 (income tax note to ambac’s 2008 financial statements), available at http://www.ambac.com/pdfs/87730_ambac10k.pdf; complaint for injunctive relief and declaratory judgment determining amount of tax relief, ambac financial group, inc. v. united states, adversary proceeding 10, (u.s. bankruptcy court, s.d.n.y.) (nov. 9, 2010); jonathan stempel, ambac sues u.s. and says irs may ruin bankruptcy, reuters, nov. 9, 2010, available at http://www.reuters.com/article/idustre6a75ew20101109; erik holm and eric morath, ambac files for chapter 11, wall street journal, nov. 9, 2010, available at http://online.wsj.com/article/0,,sb10001424052748703514904575602911478916800,00.ht ml. 2011] ew tax issues arisi g from the dodd-fra k act 91 paygo cds. the irs also informed ambac that it was questioning the propriety of the tax refunds and was investigating whether to seek to recoup the tax refunds. ambac then realized that under the rules applicable to tentative carryback adjustments, the irs could summarily assess a deficiency, without notice, and impose a levy and attachment on ambac’s assets. ambac concluded that the effect of such a levy and attachment would be to destroy or seriously jeopardize its ability to reorganize. ambac therefore accelerated its bankruptcy filing to early november 2010, and is seeking court orders that would allow it to keep the refunds, among other matters. thus, it is possible that the ambac litigation will provide the first formal insight into the u.s. federal income tax characterization of at least one type of cds, although there are also other issues in the litigation that if resolved adversely to ambac would mean that that issue will not be addressed. ambac presumably believed that it had a sound basis for originally treating the paygo cds as options. the fact that the irs had approved option treatment for its other cds no doubt played a role in that regard. when ambac decided to treat paygo cds as npcs in 2008, however, it did so on the basis of an opinion from one of the “big four” accounting firms, kpmg. the ambac history thus vividly illustrates the uncertain tax status of cds. in the absence of a ruling based on principles that apply to cds generally, uncertainty as to the tax characterization of cds, and therefore whether the deemed loan rules apply, seems like to continue for some time. that question may be informed by the difficulty of determining what the terms of any such deemed loan would be. 2. if there is a loan, what are its terms? the difficulty in determining the terms of a deemed loan arising from an upfront payment on a cleared cds can be illustrated by turning back to the three examples described in section ii.c.2(c), above. each of them involved a cds where the market quoted level differed by 75 basis points from the standardized coupon. however, the upfront payment on each of them was a different amount--$244,000 for example 1, $335,000 for example 2, and $377,000 for example 3. if one now tries to convert the upfront payment back into a stream of payments on a deemed loan for tax purposes, it is difficult to conclude that each of those three different upfront payments should be treated as the equivalent of an annuity or installment loan consisting of the same stream of 75 basis point to maturity. that is, it would be surprising to conclude that if $244,000 represents the present value of a stream of 75 basis points for 5 years, $335,000 also represents the present value of that same stream of payments. as described in the discussion of these examples earlier, the explanation for this discrepancy is that the market does not assume an equal likelihood that the notional stream of 75 basis points would be made for the entire tenor of the cds. a possible way to deal with this inconvenient fact would be to reconvert each upfront payment into a stream of x (not 75) basis points over the maximum life of the cds, in an amount that would differ for each example because each of them reflects the present value of a different 92 columbia jour al of tax law [vol. 2:1 stream of payments. remember, however, that the regulations that treat an upfront payment as a deemed loan also restate the terms of the related swap so that they have market terms. that would not be the case if the deemed loan payments were treated as, hypothetically, 50 basis points for example 1, 60 basis points for example 2 and 65 basis points for example 3. moreover, treating each of these upfront payments as representing a stream of 75 basis points would have the merit of a rule anchored to the real market pricing for these cds. if one therefore assumed that the best answer is to reverse engineer what the market has done, and to treat the upfront payment as repaid in 75 basis point increments over some period of time, new questions arise that would also have to be addressed in any such guidance. since the upfront payments are in different amounts, would each case result in a stream of 75 basis point deemed payments for a different period of time? or would each of them be treated as giving rise to deemed 75 basis points payments for the full tenor of the cds? let us assume that the upfront payment in example 1 ($244,000) would be treated as equivalent to an annuity paying 75 basis point coupons for 3 years, the upfront payment in example 2 ($335,000) would be treated as equivalent to a similar annuity but for 4 years, and the upfront payment in example 3 ($377,000) would be treated as equivalent to a similar annuity but for 4.5 years. what happens if the cds in example 1 survives for more than 3 years? does the deemed annuity continue? or is the cds treated as reissued at year 3? some support for this approach—same payment amount, over different periods—can be found in the npc timing regulations, because they provide that for purposes of recognizing a nonperiodic payment over the term of an npc, the term of an npc that is subject to termination is the reasonably expected term of the contract.150 on the other hand, the deemed loan rule provides that the deemed at-market swap must provide for level payments, which would not be the case if the swap in example 1 remained in existence for more than 3 years unless the swap were treated as reissued at year 3. this approach does not seem like the likely right answer. now let us consider the alternative, under which the annuity is deemed to be payable in all three examples over the full five-year term of the cds. we know that there is uncertainty about whether the annuity will in fact be paid over the entire term, with the highest risk in example 1. given the uncertainty as to whether the “lender” will be “repaid” in full, does the deemed loan give rise to contingent payment debt subject to treasury regulation § 1.1275-4 (one fervently hopes not)? more significantly, is this debt at all? it can be compared to a credit-linked note, with a payout of zero if the credit event arises. or it could be compared to an interest-only obligation (an “io”) on a prepayable debt instrument, where the trigger for terminating payments is not repayment of debt but a credit event. 150 treas. reg. § 1.446-3(f)(3) (1994). the regulation does not specify who determines what the reasonably expected term is, leading to the possibility that different parties to an npc will take different positions. 2011] ew tax issues arisi g from the dodd-fra k act 93 there are, as it happens, some tax rules for ios. for example, ios issued under the remic rules are statutorily treated as debt, like other regular interests in the remic.151 ios can also arise pursuant to the bond stripping rules of § 1286. most ios under current market practice probably provide for payments based on pools of prepayable debt instruments, and thus either explicitly or by analogy can be handled to at least some extent under the rules of § 1272(a)(6). that would not be the case for an annuity deemed to arise under a cds. moreover, the rules for taxing ios are not themselves a model of clarity, as evidenced by a request by the service in 2004 for comments from taxpayers on a variety of issues.152 the request states in its introduction that “remic ios present novel and difficult questions in the application of tax rules that were designed primarily to account for instruments that qualify as debt under traditional tax principles.” similarly, the rules for contingent payment debt instruments reserve on the question of how to treat most timing contingencies.153 in short, while it is quite possible to come up with a scheme under which an upfront payment is reconverted back into an annuity of some kind, and to devise a method for determining what portion of the annuity payments constitute principal and what portion constitute interest, there are at present no rules that do so. equally significantly for taxpayers that might hazard the attempt, there are no real analogies, or at least none with tax treatment that is certain, to which the taxpayer might look to take comfort that its invented method clearly reflects income. in the absence of any guidance from the government on even the most basic of questions on the taxation of cds, and acknowledging that these issues are not easy ones to resolve, it is hard to believe any court would hold taxpayers accountable for not divining what those rules should be, in the absence of some obviously abusive transaction. that is not to say that the government is without power to write rules requiring any one of the alternatives discussed above, or perhaps another one. such rules presumably would be issued over the usual measured timeframe, first in proposed form and then in final form with a delayed effective date to allow taxpayers to modify their computer systems and get their paperwork in order. that is very different, however, from the question of whether current law requires such an approach. 3. what about the proposed swap regulations? an article published earlier this year has pointed out another uncertainty about how to treat an upfront payment on a cds, having to do with the possible application of the proposed regulations dealing with swaps with contingent nonperiodic payments that are described above in section i.b.1.154 as the article explains in some detail, if cds are subject to those rules, and if the effect of such treatment were to require the protection seller to impute an 151 i.r.c. § 860b(a) (2010) (remic regular interest taxed as debt); i.r.c.§ 860g(a)(1)(b)(ii) (2010) (providing authority to treat ios as remic regular interests). 152 i.r.s. announcement 2004-75, 2004-2 c.b. 580. 153 treas. reg. § 1.1275-4(b)(9)(iii) (2004). 154 see alan b. munro, revisiting tax considerations regarding credit default swaps, 1 derivatives & fin. instruments, jan.-feb. 2010, at 9. 94 columbia jour al of tax law [vol. 2:1 expense as a result of the possibility that the protection seller would have to make a settlement payment at some point in the future, the amount of the upfront payment for tax purposes might differ from the cash amount. returning to the example of a cds in which party b as protection seller receives an upfront payment of $335,000, if these rules applied, party b would be required to accrue some expense in respect to the contingent future settlement payment. depending on how that expense is allocated, either the upfront payment might be treated as less than $335,000 or the deemed at-market swap might be treated as paying less to party b than would otherwise be the case. either of these would complicate the effort to determine how to reconvert the upfront payment into an annuity. note further that the proposed regulations would apply only if a cash settlement payment were treated as a nonperiodic payment and not a termination payment, which is not clear. a termination payment is defined generally as a payment to assign or extinguish an npc. proposed regulations make clear (sensibly), however, that a periodic payment that happens to be paid at the maturity of an npc is not a termination payment.155 it is also evident from the proposed regulations that a contingent nonperiodic payment made at the maturity of an npc such as an equity swap is not treated as a termination payment. a termination payment is not, therefore, just any payment that happens to be made at the point when the taxpayer happens to terminate its interest in an npc. rather, the concept seems to be that a termination payment is an unscheduled payment not provided for in the terms of the npc. it has become common, however, for equity swaps to provide express terms under which a counterparty may terminate the swap early. since dealers typically permit their customers to terminate swaps early in any event, the purpose of this provision is primarily to set out the terms under which the early termination payment will be calculated. market practice is to treat these payments as termination payments, which seems right. coming back to cds, then, how should one treat an unscheduled settlement payment that is provided for in the terms of the cds? it seems closer to a termination payment than a nonperiodic payment, but the answer is not clear. 155 prop. treas. reg. § 1.1234a-1(b), 69 fed. reg. 8886, 8898 (feb. 26, 2004). 2011] ew tax issues arisi g from the dodd-fra k act 95 market rate is 6% vs libor step 1 negotiation of bilateral otc swap on $100m notional principal amount clearing an at-market interest rate swap pool of collateral & guarantees a ch dealer b step 2 novation to clearinghouse initial margin initial margin variation margin (agree on terms, e.g., a pays 6%, b pays libor) dealer ba 96 columbia jour al of tax law [vol. 2:1 market rate is 6% vs libor step 1 negotiation of bilateral otc swap on $100m notional principal amount clearing an off -market interest rate swap step 2 novation to clearinghouse a dealer b day 1 a variation margin dealer b $4,210,000 500 bp x npa dealer ba during initial margin initial margin ch $4,210,000 upfront payment (agree on terms, e.g., a pays 5% + $4.21m upfront, b pays libor) libor x $100m ch 2011] ew tax issues arisi g from the dodd-fra k act 97 step 1 negotiation of bilateral otc cds cds clearing pool of collateral & guarantees a ch dealer b step 2 novation to clearinghouse initial margin initial margin variation margin a pb (agree on terms, e.g., a pays 175 bp) dealer b ps 98 columbia jour al of tax law [vol. 2:1 cds coupon standardization example 1 (market level 575 bp; standard coupon 500 bp) dealer ba 500 bp x $100m $244,000 up front example 3 (market level 25 bp; standard coupon 100 bp) dealer ba 100 bp x $100m $377,000 up front example 2 (market level 175 bp; standard coupon 100 bp) dealer ba 100 bp x $100m $335,000 up front 2011] ew tax issues arisi g from the dodd-fra k act 99 cds clearing – putting it together market level 575 bp; standard coupon 500 bp; $100m npa day 1 a variation margin dealer b $224,000 500 bp x $100m dealer baduring initial margin initial margin ch upfront payment $224,000 libor x $100m ch making partnerships work for mom and pop and everyone else emily cauble * abstract entities treated as partnerships for tax purposes cover the spectrum from small mom and pop operations to mammoth enterprises owned by sophisticated partners. designing tax law to govern this diverse array of entities is a challenging exercise since rules that are well suited to provide simplicity for entities at the small, unsophisticated end of the continuum may be poorly designed for preventing manipulation by entities at the large, sophisticated end of the continuum. however, a careful examination of how tax rules can best promote simplicity reveals opportunities for reform that would make the law more appropriate for entities all along the continuum. * visiting assistant professor and academic fellow, university of illinois college of law. my thanks go to amitai aviram, ronald blasi, john colombo, dhammika dharmapala, christine hurt, david hyman, douglas kahn, richard kaplan, amy mccormick, larry ribstein, arden rowell, glen staszewski, suja thomas, and verity winship. i would also like to thank the organizers of the illinois academic fellowship program for their support. 248 columbia journal of tax law [vol.2:247 introduction ...................................................................................................... 249 i. existing law under § 704(c) .................................................................... 251 a. traditional method .......................................................................................... 256 b. traditional method with curative allocations ................................................. 257 c. remedial method ............................................................................................ 259 d. summary of § 704(c) methods ........................................................................ 260 e. anti-abuse rule.............................................................................................. 261 f. other constraints ............................................................................................ 263 g. reverse § 704(c) allocations ........................................................................... 265 h. special rules for securities partnerships ......................................................... 265 1. facts of example 3 ...................................................................................... 266 2. results under an asset-by-asset approach .................................................. 266 3. results under an aggregate approach ........................................................ 267 ii. history of § 704(c) and concerns about unsophisticated partners................................................................................................................ 267 a. original version of § 704(c) ............................................................................ 267 b. justifications offered for the original version of § 704(c) ............................... 269 c. evolution of § 704(c)....................................................................................... 269 iii. existing law under § 754 ..................................................................... 274 a. section 754 elections and built-in gain assets ............................................... 275 b. section 754 elections and built-in loss assets ................................................ 278 c. other constraints ............................................................................................ 281 iv. history of § 754 and concerns about unsophisticated partners................................................................................................................ 281 v. how reforms would make law less susceptible to manipulation by sophisticated partnerships .................................... 282 a. section 704(c) ................................................................................................. 282 b. section 754 ..................................................................................................... 284 vi. the truth about complexity ........................................................... 284 a. ease with which otherwise complex rules are avoided as a mitigating factor ..................................................................................................................... 286 b. length and technical nature of rules as contributing factors ........................ 288 c. conformity to expectations as a mitigating factor........................................... 288 d. uncertainty as a contributing factor................................................................ 290 e. factual information needed as a contributing factor....................................... 291 vii. reforms would simplify law in some respects and, in other respects, make law no more complex ...................................... 291 a. requiring partnerships to use the most accurate method would reduce, or at least not increase, ex ante complexity ................................................................. 291 1. current law does not reduce ex ante complexity by allowing taxpayers to easily avoid an otherwise complex rule ................................................................ 292 2. the proposed reforms would reduce ex ante complexity by making applicable law shorter. ........................................................................................ 293 3. the proposed reforms would not make the applicable rules meaningfully more technical for purposes of ex ante complexity. ............................................ 293 4. the proposed reforms would lead to results that better conform to expectations. ....................................................................................................... 294 5. the proposed reforms would reduce uncertainty. ......................................... 295 2011] making partnerships work for mom and pop and everyone else 249 6. the proposed reforms would not impose any incremental information gathering requirements. ...................................................................................... 296 b. requiring partnerships to use the most accurate method would reduce, or at least not increase, ex post complexity. ................................................................... 296 1. current law does not allow taxpayers to easily avoid an otherwise complex rule. ....................................................................................................... 296 a. section 704(c).......................................................................................... 297 b. section 754 .............................................................................................. 298 2. the proposed reforms would make the law shorter. ...................................... 298 3. the proposed reforms would not make the applicable rules meaningfully more technical. .................................................................................................... 298 4. the proposed reforms would reduce uncertainty. ......................................... 299 5. the proposed reforms would not impose any incremental information gathering requirements. ...................................................................................... 299 c. making the elections universally available ultimately bred more complexity. ... 300 viii. conclusion ............................................................................................... 301 introduction in the context of partnership tax, one frequently repeated storyline involves sophisticated parties exploiting rules designed to accommodate the needs of mom and pop partnerships. for example, in the 1990s, a subsidiary of general electric capital corporation (“gecc”) undertook a transaction to shift the tax consequences of $310 million of taxable income from itself to parties not subject to tax on the income, reducing total tax paid by $62 million. the transaction did not involve shifting economic income from gecc‟s subsidiary to the parties not subject to tax and involved minimal economic risk. the parties‟ tax advisors crafted the transaction in order to take advantage of a tax provision that was designed to serve the needs of unsophisticated partners, as discussed in detail later in this paper. 1 often transactions like this provoke responses from congress or the treasury designed to prevent taxpayers from undertaking similar transactions in the future. the responses of lawmakers invariably further complicate partnership tax law. in 1954, when congress enacted subchapter k (the part of the internal revenue code (“code”) that governs the taxation of partners and partnerships), 2 congress was aware of the fact that many small, unsophisticated entities were treated as partnerships for 1 tifd iii-e, inc. v. united states, 459 f.3d 220 (2d cir. 2006). the mechanics of the transaction, in the context of a simplified version of the facts of the actual case, are described below. see infra note 29. the service challenged the transaction arguing, among other things, that the parties to whom the taxable income was allocated were not really partners since they bore very limited economic risk. most recently, the district court, on remand, held in favor of the taxpayer. tifd iii-e, inc. v. united states, 660 f. supp. 2d 367 (d. conn. 2009). 2 in this paper, i use the term “partnership” to refer to an entity treated as a partnership for tax purposes. even if an entity is treated, for example, as a limited liability company for purposes of business organization law, it could be treated as a partnership for tax purposes provided that it has two or more owners, it has not elected to be treated as a corporation for tax purposes, and it is not required to be treated as a corporation under the publicly traded partnership rules or any other provision. see treas. reg. § 301.77012 (as amended in 2006). 250 columbia journal of tax law [vol.2:247 tax purposes. 3 even today, many partnerships are small entities. 4 thus, lawmakers designing rules to govern partnerships have justifiably expressed concern for the ability of small, unsophisticated partnerships to apply complex rules. however, as transactions like the one described in the preceding paragraph demonstrate, undue focus on the needs of unsophisticated partnerships leads to rules that are ripe for manipulation by sophisticated taxpayers. moreover, it is not that sophisticated taxpayers use partnerships for only tax-motivated transactions. sophisticated taxpayers also use partnerships to carry out transactions motivated by genuine economic goals and large partnerships earn significant income. 5 use of large partnerships has grown, in part, because many hedge funds, real-estate funds, and private-equity funds are organized as partnerships for tax purposes. in addition, in recent years, sponsors that manage such funds, including blackstone, fortress, and kkr, publicly offered interests in entities treated as partnerships for tax purposes. 6 the entities are entitled to receive a portion of the economic return that the sponsors receive from the funds that they manage. 7 as a result of the varied use of partnerships, lawmakers are left with the unenviable task of crafting law that can simultaneously address the needs of unsophisticated partnerships, evolve to combat abuses attempted by sophisticated partnerships, and provide flexibility demanded by sophisticated partnerships operating legitimate businesses. 8 in response to the predicaments that lawmakers face when attempting to accommodate the needs of diverse partnerships, other scholars have suggested bifurcating the law applicable to partnerships. under such proposals, a simplified version of current law would be available only to uncomplicated partnerships, and a more complex version of current law (or, under some variations of the proposal, the rules that currently apply to corporations) would be imposed on all other partnerships. 9 3 thus, for example, the senate finance committee report accompanying the adoption of subchapter k observed that uncertainty in partnership tax was “particularly unfortunate” given the large number of partnerships and given that “the partnership form is much more commonly employed by small businesses and in farming operations than the corporate form.” s. rep. no. 83-1622, at 89 (1954). see also jeffrey l. kwall, taxing private enterprise in the new millennium, 51 tax law. 229, 235–36 (1998) (discussing how the use of partnerships has changed substantially since 1954 when “the prototypical partnership was seen as a small, simple enterprise”). 4 for example, in 2003, 93% of entities treated as partnerships for tax purposes each individually earned less than $1,000,000 of business receipts. see table 2.--number of businesses, business receipts, net income, deficit, and other selected items, by form of business, industry, and business receipt size, tax year 2003, i.r.s., statistics of income division, http://www.irs.gov/pub/irs-soi/03ot2busbr.xls (last visited apr. 22, 2011). 5 for example, in 2003, only 5.5% of business receipts earned by all tax partnerships was earned by tax partnerships that each, individually, earned less than $1,000,000. id. 6 the entities avoid treatment as corporations for tax purposes under i.r.c. § 7704(a) (2010) (treating certain publicly traded partnerships as corporations for tax purposes) by complying with i.r.c. § 7704(c) (2010) (setting forth an exception for certain publicly traded partnerships if 90% or more of their gross income consists of specified types of qualifying income). 7 for further discussion of the changing use of partnerships, see larry e. ribstein, the rise of the uncorporation (2010). see also kwall, supra note 3. 8 partnerships are not unique in this regard. however, the challenges faced in the partnership tax context may be more pronounced because opportunities for abuse are plentiful under a set of tax rules that provide for pass-through taxation (unlike the tax rules that apply to c corporations) and allow for flexible economic arrangements (unlike the tax rules that apply to s corporations). 9 see, e.g., george k. yin, the future taxation of private business firms, 4 fla. tax rev. 141 (1999). see also curtis j. berger, w(h)ither partnership taxation?, 47 tax l. rev. 105 (1991) (proposing restructuring the taxation of entities so that all large businesses (determined based on gross revenues) would 2011] making partnerships work for mom and pop and everyone else 251 in this paper, i propose more modest reform within the confines of one body of law applicable to all partnerships. 10 i argue that useful improvement can be achieved within one set of rules because there are revisions that can simplify the law (making it more suitable for unsophisticated partnerships) and, at the same time, make the law more accurate and, as a consequence, less susceptible to manipulation by sophisticated partnerships. it may seem surprising that there are opportunities to simultaneously make the law more suitable for unsophisticated partnerships and make the law less prone to exploitation by sophisticated partnerships. yet, such opportunities exist. they exist because certain provisions that are intended to make the law simpler for unsophisticated partnerships, in fact, make the law more complicated, as an examination of theories related to legal and tax complexity will demonstrate. in the rest of the paper, i will elaborate upon the points described above, using two specific tax provisions as examples. 11 part i describes the first specific provision of the internal revenue code, § 704(c), a provision that governs tax allocations made with respect to contributed property. part ii discusses the history of § 704(c) and how concern about complexity and unsophisticated partners affected the evolution of § 704(c). part iii describes the second specific provision, § 754, a provision that addresses certain adjustments made to a partnership‟s basis in its assets. part iv discusses the history of § 754 and how concern about imposing burdensome requirements on unsophisticated partners influenced the development of § 754. part v discusses how reforms would make partnership tax law less susceptible to manipulation by sophisticated partnerships. part vi examines considerations that should inform an understanding of what constitutes complexity. part vii applies the considerations discussed in part vi in order to demonstrate that the proposed reforms would simplify the law in some respects (and, in other respects, make it no more complex), resulting in law that is more suitable for unsophisticated partnerships. part viii concludes the paper. i. existing law under § 704(c) section 704(c) is a provision that governs how partners share tax items that a partnership recognizes with respect to certain assets. section 704(c) applies to two different types of property. first, § 704(c) applies to property contributed to a partnership at a time when the value of the property is greater than (or less than) the contributing be taxed like corporations and all small businesses would be subject to a pass-through taxation system); mark p. gergen, the end of the revolution in partnership tax?, 56 smu l. rev. 343, 345 (2003) (“[professor yin] proposes the creation of a simplified pass-through regime – call it k-lite – along the lines of current subchapter s….whatever its precise contours, once k-lite is available, we may demand more from entities that opt for the freedom of k-heavy.”). along similar lines, recent reports have indicated that the current administration may propose reforms under which certain businesses that earn more than $50 million in gross receipts would no longer be eligible for treatment as partnerships for tax purposes and, instead, would be treated as corporations for tax purposes. see, e.g., kim dixon, u.s. mulls making more firms pay corporate, http://www.msnbc.msn.com/id/42856826/ns/business-us_business/ (last visited may 9, 2011). 10 this approach avoids practical difficulties inherent in the bifurcation approach, such as selecting a proxy to accurately distinguish between sophisticated and unsophisticated partnerships. in addition, this approach may be more feasible in that it would involve less drastic reform. the fact that this approach would be less disruptive is particularly appealing given the large number of entities treated as partnerships for tax purposes. 11 other examples could include current law regarding the treatment of the transferor of a partnership interest. 252 columbia journal of tax law [vol.2:247 partner‟s tax basis in the property. the contributing partner generally does not recognize the existing built-in gain (or existing built-in loss) at the time of the contribution. when the partnership later sells the property (or recognizes other tax items, such as depreciation, with respect to the property), § 704(c) requires that the partners share tax gain or loss (or other tax items) in a way that takes into account the built-in gain (or builtin loss) that existed when the property was contributed to the partnership. second, if a new partner joins a partnership at a time when the partnership‟s existing assets contain built-in gains or built-in losses and the partnership revalues its assets to reflect the fact that the new partner buys into the partnership based on the current value of the partnership‟s assets, § 704(c) 12 requires that the partners share future tax gain or loss (or other tax items) recognized by the partnership in a way that takes into account the built-in gain (or built-in loss) that existed in the partnership‟s assets at the time the new partner joined the partnership. this part will describe the mechanics of § 704(c) in detail. when a partner contributes property to a partnership, the partner and the partnership generally do not recognize any gain or loss for tax purposes as a result of the contribution. 13 in order to demonstrate, assume the following facts: example 1. an individual, a, owns a piece of land that a acquired some time ago for $5,000. the value of the land has increased over time so that the land is currently worth $15,000. a and b, another individual, form an entity that is treated as a partnership for tax purposes. a contributes the land and b contributes $15,000 cash to this newly formed ab partnership, each in exchange for a 50% interest in the ab partnership. under the facts of example 1, a will not be required to recognize (and potentially pay tax on) the $10,000 built-in gain that exists in the land at the time of the contribution. 14 however, in order to ensure that the $10,000 built-in gain is preserved to potentially be recognized at a future point in time, the ab partnership will obtain a tax basis in the land equal to $5,000 (a‟s basis in the land), 15 and a will obtain a tax basis in a‟s interest in the partnership equal to $5,000 (a‟s basis in the land). 16 as a result, if a sold his or her interest in the partnership for $15,000 after the contribution, a would recognize $10,000 of tax gain, and if the ab partnership sold the land for $15,000 after the contribution, the ab partnership would recognize $10,000 of tax gain. moreover, a partnership does not itself pay tax at an entity level on income recognized by the partnership but, rather, allocates items of taxable income, gain, loss and deduction among its partners so that its partners will take such items into account for purposes of 12 treas. reg. § 1.704-3(a)(6)(i) (as amended in 2010). allocations in this context are sometimes referred to as “reverse § 704(c)” allocations. 13 i.r.c. § 721 (2010). 14 i.r.c. § 721(a) (2010). 15 i.r.c. § 723 (2010). 16 i.r.c. § 722 (2010). 2011] making partnerships work for mom and pop and everyone else 253 computing their taxable income. 17 consequently, this $10,000 of tax gain recognized by the partnership would be allocated to the partners. 18 regarding how the $10,000 tax gain would be allocated, § 704(c)(1)(a) provides: [i]ncome, gain, loss and deduction with respect to property contributed to the partnership by a partner shall be shared among the partners so as to take account of the variation between the basis of the property to the partnership and its fair market value at the time of the contribution. 19 in other words, under the facts of example 1, if the ab partnership sells the land for $15,000 so that the ab partnership recognizes $10,000 of tax gain, the $10,000 tax gain must be allocated between a and b in a manner that takes into account the difference between the basis of the land ($5,000) and the fair market value of the land ($15,000) at the time a contributed the land to the partnership. 20 section 704(c)(1)(a) leaves to the treasury regulations the task of specifying how allocations should take into account built-in gain or built-in loss that exists in property at the time at which it is contributed to a partnership. 21 the treasury regulations under § 704(c) provide that allocations must be made using a “reasonable method” that is consistent with the purpose of § 704(c). this purpose, according to the treasury regulations, is to “prevent the shifting of tax consequences among partners with respect to precontribution gain or loss.” 22 the treasury regulations describe three methods that are “generally reasonable.” 23 these three methods are the “traditional method,” the “traditional method with curative allocations,” and the “remedial method.” 24 the treasury regulations do not require that partnerships use any particular method and, in fact, the treasury regulations provide that a partnership may use different methods with respect to different items of contributed property as long as the “overall method or combination of methods are reasonable based on the facts and circumstances and consistent with the purpose of section 704(c).” 25 17 i.r.c. §§ 701, 702 (2010). 18 likewise, if the value of the land had declined in value over time prior to the contribution so that, while a acquired the land for $25,000, the land was worth $15,000 at the time of the contribution, a would not be allowed to recognize the $10,000 built-in loss that existed in the land at the time of the contribution. i.r.c. § 721 (2010). in order to preserve the built-in loss, the ab partnership would obtain a tax basis in the land equal to $25,000 (a‟s basis in the land), and a would obtain a tax basis in a‟s interest in the partnership equal to $25,000 (a‟s basis in the land). i.r.c. §§ 722, 723 (2010). as a result, if a sold his or her interest in the partnership for $15,000 after the contribution, a would recognize $10,000 of tax loss, and if the ab partnership sold the land for $15,000 after the contribution, the ab partnership would recognize $10,000 of tax loss to be allocated to a. i.r.c. § 704(c)(1)(c) (2010). 19i.r.c. § 704(c)(1)(a) (2010). 20 if, instead of land, a partner contributes depreciable property to a partnership, § 704(c) also governs the allocation of tax depreciation deductions with respect to the property with the same goal of preventing a shift of tax consequences among partners with respect to pre-contribution gain or loss. see infra note 29. 21 i.r.c. § 704(c)(1)(a) (2010). 22 treas. reg. § 1.704-3(a)(1) (2010). 23 id. 24 id. 25 treas. reg. § 1.704-3(a)(2) (2010). 254 columbia journal of tax law [vol.2:247 finally, the treasury regulations contain an anti-abuse rule, discussed in more detail below, that places some constraints on the flexibility afforded by the regulations. 26 in order to illustrate the operation of the three methods, we return to the facts of example 1 set forth above. if the partnership sells the land for at least $15,000, each of the three methods under § 704(c) would lead to the same result. assume, for example, that the ab partnership sells the land for $20,000 one year after the partnership was formed, and two years after selling the land, the ab partnership liquidates and distributes the cash that it holds ($35,000) equally ($17,500 each) to a and b. when the partnership sells the land for $20,000, the partnership recognizes tax gain of $15,000 (the excess of the selling price over the partnership‟s $5,000 basis in the land). regardless of which of the three § 704(c) methods is used, the ab partnership will allocate this $15,000 tax gain as follows: $12,500 to a and $2,500 to b. the $12,500 of tax gain allocated to a represents the $10,000 of gain that accrued while the land was held by a prior to contributing the land to the partnership plus a‟s 50% share of the $5,000 gain that accrued after the land was contributed to the partnership. the $2,500 of tax gain allocated to b represents b‟s 50% share of the $5,000 gain that accrued after the land was contributed to the partnership. finally, each partner‟s basis in his or her interest in the partnership is increased by the amount of tax gain allocated to that partner upon sale of the land, 27 resulting in a $17,500 basis for each partner. consequently, a and b do not recognize gain or loss as a result of receiving a $17,500 cash distribution on liquidation since the amount of the cash distribution received by each partner equals each partner‟s basis in his or her interest in the partnership. 28 as described above, the results under § 704(c) are not affected by the method elected by a partnership if the contributed land appreciated in value prior to the contribution and the partnership sells the land for an amount at least equal to the land‟s value at the time of contribution. however, if the land appreciated in value prior to contribution and the partnership sells the land for an amount less than the land‟s value at the time of the contribution, the tax results will depend on which method the partnership elects to use for making § 704(c) allocations with respect to the land, and use of the remedial method most reliably ensures that tax consequences will not be shifted from the contributing partner to other partners. moreover, while partners do not expect land to decrease in value after it is contributed to a partnership, the value of contributed land often declines – a fact of which many real estate partnerships were reminded in the recent economic downturn. furthermore, in the case of depreciable property, the method elected by the partnership can affect the allocation of depreciation deductions even if the value of the property does not decline, and in this area as well, the remedial method most consistently guarantees that tax consequences will not be shifted from the contributing partner to a non-contributing partner. 29 26 treas. reg. § 1.704-3(a)(10) (2010). 27 i.r.c. § 705(a)(1)(a) (2010). 28 i.r.c. § 731(a) (2010). 29 this can be illustrated with an example that is a simplified version of the facts of castle harbour. tifd iii-e, inc. v. u.s. (castle harbour), 459 f.3d 220 (2d cir. 2006). assume t and te form an entity that is treated as a partnership for tax purposes. t is subject to u.s. tax on income allocated to t from the partnership, but te is not subject to u.s. tax on income allocated to te from the partnership. t contributes airplanes to the partnership. the airplanes are depreciable. at the time of the contribution, the airplanes are worth $1,000, but the airplanes have a tax basis of $100. furthermore, the airplanes have a remaining depreciation recovery period of one year. te contributes $1 of cash to the partnership. the 2011] making partnerships work for mom and pop and everyone else 255 in order to demonstrate the impact of the particular § 704(c) method elected in a case in which the value of appreciated land declines after contribution to a partnership, assume the following facts: example 1a. an individual, a, owns a piece of land that a acquired some time ago for $5,000. the value of the land has increased over time so that the land is currently worth $15,000. a and b, another individual, form an entity that is treated as a partnership for tax purposes. a contributes the land and b contributes $15,000 cash to this newly formed ab partnership, each in exchange for a 50% interest in the ab partnership. as a result of the contribution, a does not recognize any tax gain. 30 following the contribution, the partnership‟s basis in the land is $5,000, 31 a‟s basis in his or her interest in the partnership is $5,000, 32 and b‟s basis in his or her interest in the partnership is $15,000. 33 one partnership leases the airplanes to a third party and earns $1,000 of rental income for one year. the partnership sells the airplanes for $0 and liquidates in year 10. assume the partnership agrees that, for purposes of determining the partners‟ book capital accounts that will measure the amount each partner is entitled to receive on liquidation of the partnership, all book income and loss will be allocated 99% to te and 1% to t. in year 1, the book items that are allocated 99% to te and 1% to t consist of: (1) book depreciation of $1,000 (measured as: $1,000 beginning book value of airplanes x ($100 tax depreciation/$100 beginning tax basis of airplanes) per treas. reg. § 1.704-1(b)(2)(iv)(g)(3)) and (2) $1,000 of rent received. thus, on net $0 of book gain is allocated 99% ($0) to te and 1% ($0) to t. consequently, capital account balances of t and te remain $1,000 for t (t‟s initial capital account balance since t contributed property worth $1,000) and $1 for te (te‟s initial capital account balance since te contributed $1 of cash) at the end of year 1. as a result, even though 99% of book items are allocated to te, when the partnership distributes the $1,001 of cash that it holds on liquidation, te receives $1 and t receives $1,000. regarding the allocation of tax items in year 1, if the partnership uses the traditional method for making § 704(c) allocations with respect to the airplanes (as the taxpayer did in castle harbour), the results will be as follows. first, because $1,000 of book income attributable to rent received by the partnership is allocated 99% to te and 1% to t, $1,000 of taxable income recognized by the partnership as a result of rent received by the partnership will be allocated 99% ($990) to te and 1% ($10) to t. second, because $1,000 of book depreciation is allocated $990 to te and $10 to t, tax depreciation from the airplanes would be allocated in the same manner if it was available. however, the only tax depreciation available is $100, which is allocated in its entirety to te to get as close as possible to matching the allocation of book depreciation. thus, in total, taxable income is allocated $890 to te who is not subject to tax and $10 to t. if the partnership instead uses the remedial method for making § 704(c) allocations with respect to the airplanes, for one thing, book depreciation of the airplanes would be spread over a longer period of time per treas. reg. § 1.704-3(d)(2). also, the partnership would invent notional tax items of depreciation to match book depreciation allocated to te and equal, offsetting notional tax items of operating income from the airplanes to allocate to t. for the sake of simplicity, if we focus on the second modification made by the remedial method, then total tax items allocated in year 1 would be: $0 to te (which consists of $990 of rental income, $100 of actual tax depreciation, and $890 of notional tax depreciation) and $900 to t (which consists of $10 of actual rental income and $890 of notional operating income from the airplanes). consequently, t‟s taxable income effectively equals $1000 of rental income minus $100 of remaining tax depreciation on the airplanes, and no taxable income is shifted from t (who is subject to tax) to te (who is not subject to tax). if both modifications made by the remedial method are applied, then even under the remedial method, some taxable income could be shifted temporarily from t to te, but the shift would be less drastic than what occurs under the traditional method. 30 i.r.c. § 721(a) (2010). 31 i.r.c. § 723 (2010). 32 i.r.c. § 722 (2010). 33 id. 256 columbia journal of tax law [vol.2:247 year after the partnership was formed, the ab partnership sells the land for $10,000. two years after selling the land, the ab partnership distributes the cash that it holds ($25,000) equally to a and b ($12,500 each). the results under each of the § 704(c) methods are described below. a. traditional method under the facts of example 1a, because the partnership‟s basis in the land is $5,000, the partnership recognizes $5,000 of tax gain upon sale of the land for $10,000. if the partnership uses the traditional method for allocating items under § 704(c) with respect to the land, $5,000 of tax gain will be allocated to a and no tax gain or loss will be allocated to b. in effect, use of the traditional method, under the facts of example 1a, results in a shift from a to b of $2,500 of the $10,000 tax gain attributable to the increase in value of the land that occurred while it was owned by a. prior to a‟s contribution of the land, the land increased in value by $10,000 (to $15,000), and a benefited economically from that increase in value in its entirety because a was able to exchange the land for a 50% interest in a partnership that held assets worth $30,000. subsequent to a‟s contribution of the land to the ab partnership, the value of the land declined by $5,000. because a and b share the economic benefits and burdens of the ab partnership equally, this decline in value will be shared equally by a and b ($2,500 each), so that, for example, when the partnership distributes the cash that it holds ($25,000) in liquidation, each of a and b receive $12,500 ($2,500 less than the value that each contributed to the partnership). consequently, if a and b were each allocated taxable gain and loss in an amount that matched economic gain and loss, a would be allocated $10,000 of tax gain from sale of the land and $2,500 of tax loss from sale of the land (or $7,500 of tax gain from sale of the land on net), and b would be allocated $2,500 of tax loss from sale of the land. however, because the only tax item recognized by the partnership as a result of sale of the land is $5,000 of tax gain, $5,000 of tax gain is allocated to a to get as close as possible to the result described above, while using only tax items actually recognized by the partnership from sale of the land. 34 compared to what should have been allocated to the partners based on their economic gain and loss, a is allocated $2,500 less tax gain than what a should have been allocated, and b is allocated $2,500 less tax loss than what b should have been allocated. in effect, $2,500 of tax gain has been inappropriately shifted from a to b. 35 moreover, while this shift may be temporary, it can, nevertheless, significantly affect the tax consequences experienced by a and b. after the allocation of the $5,000 tax gain from sale of the land to a, a‟s basis in his or her interest in the partnership will 34 limiting the partnership to using tax items actually recognized from sale of the land is called the “ceiling rule.” abiding by the “ceiling rule” is the distinguishing feature of the traditional method. 35 this shift occurs because the $5,000 tax gain recognized by the partnership is effectively the net result of the $10,000 of gain that accrued prior to contribution of the land and the $5,000 of loss that accrued after contribution of the land. netting the two figures results in $2,500 of the tax gain attributable to the precontribution increase in value of the land that economically benefited a offsetting the portion of the tax loss attributable to the post-contribution decline in value of the land that economically burdened b. 2011] making partnerships work for mom and pop and everyone else 257 increase to $10,000, 36 and b‟s basis in his or her interest in the partnership will remain $15,000. if the partnership distributes $12,500 cash to each of a and b in liquidation of the partnership, a will recognize $2,500 of tax gain (the excess of $12,500 cash over a‟s $10,000 basis in his or her interest in the partnership), and b will recognize $2,500 of tax loss (the excess of b‟s $15,000 basis in his or her interest in the partnership over $12,500). 37 the $2,500 tax loss recognized by b corresponds to the $2,500 tax loss from sale of the land that should have been but was not allocated to b at the time of the sale of the land, as a result of shifting $2,500 of tax gain from a to b. likewise, the $2,500 tax gain recognized by a corresponds to the $2,500 tax gain from sale of the land that should have been allocated to a but was instead shifted from a to b. however, recognition of a $2,500 tax loss (or gain) on liquidation by b (or a) does not fully compensate for the earlier shift in tax gain from a to b. for one thing, tax gain and loss from sale of the land could be of a different character, with different resulting tax consequences, than tax gain or loss recognized on liquidation. for another, the tax loss (or gain) on liquidation may be recognized years later if substantial time elapses between sale of the land and liquidation of the partnership. 38 b. traditional method with curative allocations if the only tax item ever recognized by the partnership is the gain from sale of land contributed by a (as is the case under the facts of example 1a), then the traditional method with curative allocations would lead to the same results as the traditional method. however, if the facts are complicated slightly, the two methods lead to different results. in order to demonstrate, assume the following set of facts: example 1b. an individual, a, owns a piece of land (“land #1”) that a acquired some time ago for $5,000. the value of the land has increased over time so that the land is currently worth $15,000. a and b, another individual, form an entity that is treated as a partnership for tax purposes. a contributes the land and b contributes $15,000 cash to this newly formed ab partnership, each in exchange for a 50% interest in the ab partnership. as a result of the contribution, a does not recognize any tax gain. 39 following the contribution, the partnership‟s basis in land #1 is $5,000, 40 a‟s basis in his or her interest in the partnership is $5,000, 41 and b‟s basis in his or her interest in the partnership is $15,000. 42 the partnership uses the $15,000 cash contributed by b to acquire a second parcel of land (“land #2”) for $15,000. consequently, the partnership‟s basis in land #2 is 36 i.r.c. § 705(a)(1)(a) (2010). 37 i.r.c. § 731(a) (2010). 38 for a more complete demonstration of the potential character and timing differences, see tables 7 and 8, supra part ii.c. 39 i.r.c. § 721(a) (2010). 40 i.r.c. § 723 (2010). 41 i.r.c. § 722 (2010). 42 id. 258 columbia journal of tax law [vol.2:247 $15,000. one year after the partnership was formed, the ab partnership sells land #1 for $10,000. subsequently (and in the same tax year as the sale of land #1 or in a subsequent tax year), the partnership sells land #2 for $20,000. two years after selling land #2, the ab partnership distributes the cash that it holds ($30,000) equally to a and b ($15,000 each). under the facts of example 1b, if the traditional method is used, the $5,000 tax gain that results from sale of land #1 is allocated entirely to a, and the tax consequences of $2,500 of the pre-contribution increase in value of land #1 are effectively shifted from a to b, as described above in connection with example 1a. upon sale of land #2, the partnership recognizes $5,000 of tax gain and $5,000 of economic gain. under the traditional method, because a and b share equally the $5,000 economic gain from land #2, 43 they will also share equally the $5,000 tax gain from land #2. after the allocation of $5,000 of tax gain from sale of land #1 to a, $2,500 of tax gain from sale of land #2 to a and $2,500 of tax gain from sale of land #2 to b, a‟s basis in his or her interest in the partnership will increase to $12,500, and b‟s basis in his or her interest in the partnership will increase to $17,500. 44 when the partnership distributes $30,000 of cash equally to a and b on liquidation ($15,000 each), a will recognize $2,500 of tax gain and b will recognize $2,500 of tax loss. 45 as discussed above, while this $2,500 amount corresponds to the amount of tax gain attributable to pre-contribution appreciation in the value of land #1 that was shifted from a to b, recognition of tax gain and loss on liquidation does not fully compensate for the earlier shift because the liquidation may occur in a later year than the year in which the land was sold and the tax gain and loss recognized on liquidation may be of a different character (leading to different tax consequences) than tax gain and loss from sale of the land. if the traditional method with curative allocations is applied to the facts of example 1b, the $5,000 of tax gain recognized on sale of land #1 will be allocated in its entirety to a, like it was under the traditional method. however, unlike the traditional method, under the traditional method with curative allocations, the $5,000 of tax gain recognized upon the sale of land #2 will be allocated in its entirety to a (rather than being allocated $2,500 to each of a and b to match how economic gain from the sale of land #2 is shared). 46 in effect, $2,500 of tax gain from land #2 is shifted from b to a on sale of land #2 to counteract the fact that $2,500 of tax gain attributable to precontribution appreciation in the value of land #1 was shifted from a to b on sale of land #1. after the allocation of $5,000 of tax gain from sale of land #1 to a and $5,000 of tax gain from sale of land #2 to a, a‟s basis in his or her interest in the partnership will increase to $15,000, 47 and b‟s basis in his or her interest in the partnership will remain $15,000. when the partnership distributes $30,000 of cash equally to a and b on 43 this is because the amount each partner will receive on liquidation of the partnership is increased by $2,500 as a result of the fact that land #2 is sold for a $5,000 economic gain. 44 i.r.c. § 705(a)(1)(a) (2010). 45 i.r.c. § 731(a) (2010). 46 allocating the tax gain from land #2 differently than the economic gain (or, more precisely, “book gain,” which, in this case, is the same as economic gain) from land #2 in order to offset the shift in tax gain from land #1 is referred to as a “curative allocation.” see treas. reg. § 1.704-3(c)(1) (2010). 47 i.r.c. § 705(a)(1)(a). 2011] making partnerships work for mom and pop and everyone else 259 liquidation ($15,000 each), a and b will not recognize tax gain or loss as a result of the liquidation. 48 in summary, rather than relying on tax gain and loss recognized on liquidation of the partnership to offset an earlier shift among the partners of tax gain or loss resulting from the sale of contributed property (like the traditional method), the traditional method with curative allocations utilizes tax gain and loss recognized from sale of other assets during the life of the partnership to adjust for a shift among the partners of tax gain or loss arising from the sale of contributed property. consequently, the traditional method with curative allocations potentially mitigates a shift in tax consequences attributable to pre-contribution appreciation or depreciation in asset value more accurately than the traditional method for two reasons. first, the traditional method with curative allocations can potentially offset a shift of tax consequences attributable to pre-contribution change in asset value earlier in time. 49 in example 1b, this is true since the sale of land #2 occurs earlier than the liquidation of the partnership. second, whereas tax gain or loss recognized on liquidation may be of a different character (with different resulting tax consequences) than the tax gain or loss attributable to pre-contribution change in asset value, the treasury regulations require that tax gain or loss that is allocated by the partnership under the traditional method with curative allocations “must be expected to have substantially the same effect on each partner‟s tax liability” as the tax gain or loss attributable to pre-contribution change in asset value. 50 in other words, the allocations described above are only allowed if tax gain from sale of land #2 is of the same character as tax gain from sale of land #1. however, the ability of the traditional method with curative allocations to more effectively mitigate a shift of tax consequences is limited because the partnership may not, in fact, recognize actual tax items that can be used to offset the shift. thus, as mentioned in connection with example 1a above, if the partnership‟s only asset was land #1 and the partnership never recognized a tax item other than the $5,000 tax gain recognized from sale of land #1, the traditional method with curative allocations would lead to the same results as the traditional method. c. remedial method unlike the traditional method, the remedial method does not rely on tax gain or loss recognized on liquidation of the partnership to correct for an earlier shift in tax consequences attributable to a pre-contribution change in asset value, and, unlike the traditional method with curative allocations, the remedial method does not rely on the allocation of actual tax items recognized by the partnership to potentially compensate for such a shift. rather, under the remedial method, the partnership invents purely fictional tax items of precisely the right amount and the right character to ensure that any shift in tax consequences attributable to a pre-contribution change in asset value is completely offset at the exact time that it would otherwise occur. 48 i.r.c. § 731(a). 49 regarding the timing of making curative allocations, the treasury regulations provide that, “the period of time over which the curative allocations are made is a factor in determining whether the allocations are reasonable.” treas. reg. § 1.704-3(c)(3)(ii) (2010). 50 treas. reg. § 1.704-3(c)(3)(iii) (2010). 260 columbia journal of tax law [vol.2:247 in order to illustrate the operation of the remedial method, we return to the facts of example 1a set forth above. in that example, when the partnership sells the land for $10,000, on net, a has realized $7,500 of economic gain with respect to the land. this $7,500 net economic gain can be separated into two components: (1) $10,000 of economic gain that accrued between the time a acquired the land for $5,000 and the time a exchanged the land for a 50% interest in a partnership that held assets worth $30,000 and (2) a‟s 50% share of the $5,000 of economic loss that accrued between the time a contributed the land and the time the partnership sold the land. in total, b has realized $2,500 of economic loss with respect to the land, which represents b‟s 50% share of the $5,000 economic loss that accrued after the land was contributed to the partnership. therefore, if a and b were allocated tax gain and loss in connection with a sale of the land in an amount that precisely matched economic gain and loss realized by each partner, a would be allocated $7,500 of tax gain and b would be allocated $2,500 of tax loss. however, under the traditional method or the traditional method with curative allocations, the partnership allocates $5,000 of tax gain to a since that is the only tax item actually recognized by the partnership. thus, under these methods, a is allocated $2,500 less tax gain than what should be allocated to a, and b is allocated $2,500 less tax loss than what should be allocated to b because $2,500 of tax gain has effectively been shifted from a to b. under the remedial method, on the other hand, the partnership invents a fictional item of $2,500 of tax loss from sale of the land and an equal and offsetting fictional item of $2,500 of tax gain from sale of the land. in addition to allocating $5,000 of actual tax gain to a, the partnership allocates the $2,500 of fictional tax gain to a, so that a recognizes, in total, $7,500 of tax gain, an amount that precisely matches economic gain realized by a. likewise, the partnership allocates the fictional item of $2,500 of tax loss to b, which precisely matches economic loss realized by b. as a result, the partnership shifts no tax gain from a to b. furthermore, because the partnership has allocated tax items to a and b in an amount that matches economic gain and loss realized and the partnership has not shifted any tax gain from one partner to the other, a and b will not recognize any further tax gain or loss when they each receive $12,500 of cash on liquidation. in particular, after the partnership allocates: (i) $7,500 of tax gain from sale of the land to a and (ii) $2,500 of tax loss from sale of the land to b, a‟s basis in his or her interest in the partnership will increase to $12,500, 51 and b‟s basis in his or her interest in the partnership will decrease to $12,500. 52 therefore, when the partnership distributes $25,000 of cash equally to a and b on liquidation ($12,500 each), a and b will not recognize gain or loss as a result of the liquidation. 53 d. summary of § 704(c) methods the results under the three methods, as shown by the examples above, are condensed in the following table. 51 i.r.c. § 705(a)(1)(a). 52 i.r.c. § 705(a)(2)(a) (2010). 53 i.r.c. § 731(a). 2011] making partnerships work for mom and pop and everyone else 261 table 1: summary of § 704(c) methods contributed appreciated land sold for amount at least equal to value at time of contribution contributed appreciated land sold for amount less than value at time of contribution traditional method no shift of tax consequences from a to b shift of tax consequences from a to b on sale of land, mitigated to an extent at time of liquidation traditional method with curative allocations no shift of tax consequences from a to b shift of tax consequences from a to b on sale of land, potentially mitigated to an extent later in life of partnership or on liquidation remedial method no shift of tax consequences from a to b no shift of tax consequences from a to b in summary, the remedial method most reliably carries out the purpose of § 704(c), namely preventing the shifting of tax consequences among partners with respect to pre-contribution gain or loss. 54 in particular, unlike the other methods, the remedial method ensures that, regardless of the amount of actual tax items recognized by the partnership, no such shift will occur. e. anti-abuse rule while the treasury regulations generally allow a taxpayer to select any reasonable method under § 704(c) with respect to each item of contributed property, they constrain flexibility to some extent by providing that: an allocation method (or combination of methods) is not reasonable if the contribution of property . . . and the corresponding allocation of tax items with respect to the property are made with a view to shifting the tax consequences of built-in gain or loss among the partners in a manner that substantially reduces the present value of the partners‟ aggregate tax liability. 55 54 treas. reg. § 1.704-3(a)(1) (2010) (describing the purpose of § 704(c) (2010)). 55 treas. reg. § 1.704-3(a)(10) (2010). other constraints on the flexibility afforded by § 704(c) are discussed below. see infra notes 62-64 and accompanying text. furthermore, the remedial method has been used in abusive transactions (including transactions undertaken by enron), prompting amendments to the regulations under § 704(c). those amendments, finalized in june 2010 provide: “even though a partnership's allocation method may be described in the literal language of [the regulations under § 704(c)], based on the particular facts and circumstances, the commissioner can recast the contribution as appropriate to avoid tax results inconsistent with the intent of subchapter k. one factor that may be considered by the commissioner is the use of the remedial allocation method by related partners in which allocations of remedial items of 262 columbia journal of tax law [vol.2:247 based on the language of the regulation as well as the way § 704(c) operates, it would appear that a partnership will not run afoul of the anti-abuse rule solely because it selects the § 704(c) method that leads to the most favorable tax consequences. for one thing, if the contribution of a particular piece of property is taken as a given, the selection of one method versus another method would generally be motivated solely by the goal of generating the most favorable tax consequences since selecting one method instead of another method does not affect anything other than tax consequences. in other words, once a given piece of property has been contributed, use of the traditional method instead of the remedial method, for example, only affects how tax items are allocated with respect to the property and does not affect how the partners share in any economic benefits and burdens associated with the property. therefore, if the contribution of property is taken as a given, the fact that the partnership opts for the traditional method because it might be expected to shift tax gain from a partner subject to a higher effective rate of tax to a partner subject to a lower effective rate of tax should not, in and of itself, run afoul of the anti-abuse rule. this is so because, in every case in which the selection of the traditional method is based on an analysis of the consequences that will follow from selecting that particular method, the selection must be based on the conclusion that the traditional method will lead to the most favorable tax consequences since the only results that vary across the different methods are tax results. for another thing, the treasury regulations state, “an allocation method is not necessarily unreasonable merely because another allocation method would result in a higher aggregate tax liability.” 56 thus, instead of addressing the issue of which method is selected, it would seem that the anti-abuse rule envisions a situation in which shifting tax consequences to reduce aggregate tax liability was an important factor motivating the contributing partner to contribute the property to the partnership in the first place. 57 it is not clear how significant the goal of reducing tax liability must have been if it was one of multiple motives that influenced the partner‟s decision to contribute property to the partnership. 58 it is also unclear what tax consequences should be used as a baseline for purposes of income, gain, loss or deduction are made to one partner and the allocations of offsetting remedial items are made to a related partner.” t.d. 9485, 2010-26 i.r.b. 771. it should be noted that the abuse in these transactions did not involve shifting tax consequences in a way that was inconsistent with economic consequences, since the remedial method ensures consistency between the two. rather, because the partners were related parties, the partners were willing to shift economic consequences in order to shift tax consequences and obtain a favorable tax result. unrelated parties would not ordinarily be willing to engage in such a transaction. for discussion of the enron transaction, see the discussion of “project condor” in staff of joint comm. on tax‟n, 107th cong., report of the investigation of enron corporation and related entities regarding federal tax and compensation issues, and policy recommendations (joint comm. print 2003). 56 treas. reg. § 1.704-3(a)(1). 57 this is also suggested by the language of the anti-abuse rule itself, since the treasury regulation states that it applies when the contribution of the property “and” the allocation of tax items are made with a view to shifting tax consequences. treas. reg. § 1.704-3(a)(10). in addition, the treasury regulations provide examples in which the use of a particular method is unreasonable because the contribution of the property in the first place is made with a view to shifting tax consequences. see treas. reg. § 1.704-3(b)(2), example 2 (2010); treas. reg. § 1.704-3(c)(4), example 3 (2010). 58 for further discussion, see joel scharfstein, an analysis of the section 704(c) regulations, 48 tax law. 71, 88 (1994) (“although the regulations do not indicate what „with a view‟ means, it must mean something less than „the principal purpose.‟ is a „principal purpose‟ or a „significant purpose‟ required, or will the proscribed view be considered to exist whenever there are tax advantages (or the possibility of tax advantages), and the partners knew about them?”). 2011] making partnerships work for mom and pop and everyone else 263 determining whether or not the contribution of the property and allocation method(s) used substantially reduce the present value of the partners‟ aggregate tax liability. 59 one might think that the tax consequences that would result from using the remedial method should be used as a baseline since the remedial method is intended to ensure that tax consequences of built-in gain or built-in loss are not shifted among the partners. however, the preamble to the treasury regulations indicates otherwise, stating, “[t]he irs and treasury believe that it would be inappropriate to adopt the remedial allocation method as a baseline for measuring whether the partners' aggregate tax liability has been reduced. such a baseline would make the remedial allocation method preeminent, undercutting its elective nature.” 60 moreover, the treasury regulations make explicit that, if a partnership is found to violate the anti-abuse rule, the internal revenue service (“the service”) may not cure the abuse by requiring that the partnership use the remedial method. 61 f. other constraints the code contains other provisions designed to foreclose the ability of potential transactions to circumvent the purpose of § 704(c). for example, §§ 704(c)(1)(b) and 737 prevent partnerships from avoiding the consequences that follow from § 704(c) by distributing property to a different partner than the partner who contributed the property 62 or by liquidating a contributing partner‟s interest prior to sale by the partnership of the contributed property. 63 also, § 704(c)(1)(c) provides that a partnership cannot allocate 59 for further discussion, see id. at 87; laura cunningham, use and abuse of section 704(c), 3 fla. tax rev. 93, 116–17 (1996). 60 t.d. 8585, 1995-1 c.b. 120. 61 treas. reg. § 1.704-3(d)(5)(ii) (2010). 62 to illustrate the operation of § 704(c)(1)(b), assume, for example, a owns a piece of land that a acquired some time ago for $5,000. the land is currently worth $15,000. a contributes the land, b contributes $15,000 cash, and c contributes $15,000 cash to the newly formed abc partnership, each in exchange for a one-third interest in the abc partnership. a does not recognize any gain as a result of the contribution. i.r.c. § 721(a) (2010). the abc partnership‟s basis in the land is $5,000. i.r.c. § 723 (2010). a‟s initial basis in his or her interest in the partnership is $5,000, b‟s initial basis in his or her interest in the partnership is $15,000, and c‟s initial basis in his or her interest in the partnership is $15,000. i.r.c. § 722 (2010). if the partnership sold the land for $15,000, the partnership would recognize $10,000 of tax gain which would be allocated, in its entirety, to a regardless of which method the partnership uses for making § 704(c) allocations. instead of selling the land, assume the partnership distributes the land to b in liquidation of b‟s interest in the partnership, and, in a subsequent year, distributes $15,000 cash to each of a and b in liquidation of the partnership. absent a special rule (and assuming § 751(b) does not apply and assuming that the land is not inventory), no gain or loss would be recognized by the abc partnership, a, b, or c as a result of the distribution. i.r.c. §§ 731(a), 731(b) (2010). b‟s basis in the land would equal $15,000 (b‟s basis in his or her interest in the partnership prior to liquidation). i.r.c. § 732(b) (2010). a recognizes $10,000 of gain upon receipt of $15,000 cash on liquidation of the partnership. therefore, a eventually recognizes an amount of gain equal to the built-in gain that existed when the property was contributed to the partnership. however, the gain is not recognized until liquidation. if the land is distributed to b within 7 years of a‟s contribution of the land to the partnership, however, § 704(c)(1)(b) requires that a recognize $10,000 of gain from a deemed sale of the land at the time at which the land is distributed to b. 63 to illustrate the operation of § 737, assume, for example, a owns a piece of land (land #1) that a acquired some time ago for $5,000. the land is currently worth $15,000. a contributes land #1, b contributes $15,000 cash, and c contributes $15,000 cash to the newly formed abc partnership, each in exchange for a one-third interest in the abc partnership. a does not recognize any gain as a result of the contribution. i.r.c. § 721(a). the abc partnership‟s basis in land #1 is $5,000. i.r.c. § 723. a‟s initial basis in his or her interest in the partnership is $5,000, b‟s initial basis in his or her interest in the partnership is $15,000, and c‟s initial basis in his or her interest in the partnership is $15,000. i.r.c. § 722. the abc partnership acquires an additional parcel of land (“land #2”) for $15,000. if the partnership sold land #1 264 columbia journal of tax law [vol.2:247 any portion of a pre-contribution loss with respect to property contributed to a partnership to a partner other than the contributing partner. 64 thus, § 704(c)(1)(c) limits the shifting of tax losses from the contributing partner to other partners even though § 704(c) is evidently less concerned about shifting tax gains from one partner to another partner despite the fact that shifting tax gains can also reduce tax revenue (as shown in tables 7 and 8 below). this asymmetrical treatment of tax gains and losses is replicated in other areas of tax law. 65 (the land contributed by a) for $15,000, the partnership would recognize $10,000 of tax gain which would be allocated, in its entirety, to a regardless of which method the partnership uses for making § 704(c) allocations. assume, rather than selling land #1, at a time when the value of each parcel of land is still $15,000, the partnership distributes land #2 to a in liquidation of a‟s interest in the partnership. absent a special rule (and assuming § 751(b) does not apply), no gain or loss would be recognized by the abc partnership, a, b, or c as a result of the distribution. i.r.c. §§ 731(a), 731(b). a‟s basis in land #2 would equal $5,000 (a‟s basis in his or her interest in the partnership prior to liquidation). i.r.c. § 732(b). therefore, upon a sale of land #2 for $15,000, a would recognize an amount of gain equal to the built-in gain that existed when land #1 was contributed by a to the partnership. i.r.c. § 737 alters the results just described. if the distribution to a occurs within 7 years of a‟s contribution of land #1 to the partnership, § 737 requires that a recognize $10,000 of gain from a deemed sale of land #1 at the time at which the distribution is made to a, and, as a result of the application of § 737, a would obtain a $15,000 basis land #2. 64 it is unclear how this restriction should be reconciled with the statement in the treasury regulations that the service will not require a partnership to use the remedial method. see treas. reg. § 1.704-3(d)(5)(ii). it appears that, in the case of property contributed with a built-in loss, § 704(c)(1)(c) leads to the same result as the remedial method for all partners other than the partner who contributed the property by providing that, with respect to such partners, the property will be treated as if its tax basis equals its fair market value at the time of the contribution. see i.r.c. § 704(c)(1)(c)(ii) (2010). however, it may be the case that, with respect to the contributing partner, the results are not required to match the results that would follow from the remedial method. for example, assume two individuals, a and b, form a partnership. a contributes land with a basis of $200 and a fair market value of $150 to the partnership in exchange for a 50% interest in the partnership. b contributes $150 cash to the partnership in exchange for a 50% interest in the partnership. the partnership subsequently sells the land for $200. as a result of § 704(c)(1)(c), the partnership will be treated as if its tax basis in the land is $150 for purposes of determining tax gain or loss allocated to b. consequently, b will be allocated $25 of tax gain as a result of the sale. the same result would follow absent § 704(c)(1)(c) if the partnership used the remedial method. in particular, while the partnership would not recognize any actual tax gain or loss (since its basis in the land is $200), the partnership would invent a notional item of $25 of tax gain to allocate to b to match the $25 of economic gain realized by b. section 704(c)(1)(c) has no effect on the basis of the land for purposes of determining tax gain or loss allocated to a, the non-contributing partner. therefore, with respect to a, it seems that, if the partnership uses the traditional method, a would be allocated no tax gain or loss (since the partnership recognizes no tax gain or loss). however, if the partnership uses the remedial method, it seems a would be allocated $25 of tax loss (which consists of $25 tax loss invented to offset the $25 tax gain that is invented to allocate to b). 65 for example, in the case of inter vivos gifts, as a result of the basis rules in § 1015(a), the tax consequences of existing built-in gain can be shifted from the donor to the donee but the tax consequences of existing built-in loss cannot be shifted (for purposes of recognizing a loss). along similar lines, when a shareholder contributes property to a corporation in a transaction that does not lead to recognition of gain or loss as a result of § 351, if the property has a built-in gain, the built-in gain will be preserved at two levels (at the shareholder level, by giving the shareholder a basis in stock received that is less than the fair market value of the stock and, at the corporate level, by giving the corporation a basis in the property contributed that is less than the fair market value of the property). i.r.c. §§ 358(a)(1), 362(a) (2010). however, if property contributed by a shareholder has, in aggregate, a built-in loss, the built-in loss will be preserved either at the shareholder level (by giving the shareholder a basis in stock received that is greater than the fair market value of the stock) or at the corporate level (by giving the corporation a basis in the property contributed that is greater than the fair market value of the property) but not at both levels. i.r.c. §§ 358(a)(1), 362(e)(2) (2010). 2011] making partnerships work for mom and pop and everyone else 265 g. reverse § 704(c) allocations if a new partner joins a partnership at a time when the partnership‟s existing assets contain built-in gains or built-in losses and the partnership revalues its assets to reflect the fact that the new partner buys into the partnership based on the current value of the partnership‟s assets, allocation methods similar to the allocation methods described above must be used to prevent shifting the tax consequences of built-in gains and built-in losses from the existing partners to the new partner. 66 in this context, the tax allocations are sometimes called “reverse § 704(c)” allocations. to illustrate the operation of reverse § 704(c) allocations, assume the following set of facts: example 2. two individuals, a and b, form an entity treated as a partnership for tax purposes. a and b each contribute $5,000 cash to the newly formed ab partnership. the ab partnership acquires a parcel of land for $10,000. the ab partnership‟s basis in the land is $10,000. at a time when the value of the land is $30,000, another individual, c, contributes $30,000 cash to the ab partnership in order to acquire a 50% interest in the partnership. the partnership revalues the land to $30,000 to reflect the partners‟ economic arrangement. if the partnership subsequently sells the land for $30,000, the partnership will recognize a $20,000 tax gain. regardless of which method the partnership uses for making reverse § 704(c) allocations with respect to the land, the partnership will allocate this tax gain to a and b (not c) in its entirety. thus, the tax consequences of the existing built-in gain are not shifted to c. this result appropriately matches the partners‟ economic arrangement because the economic benefit of the $20,000 increase in value of the land is captured by a and b and not c. in other words, if the partnership distributes the $60,000 cash it holds after sale of the land 50% to a and b and 50% to c, a and b collectively receive $20,000 more than they initially contributed to the partnership and c receives only a return of c‟s initial contribution. thus, it is appropriate that a and b, collectively, are allocated $20,000 of tax gain, while c is allocated no tax gain or loss. h. special rules for securities partnerships in general, § 704(c) allocations and reverse § 704(c) allocations must be determined on a property-by-property basis. 67 this requirement is relaxed in the case of reverse § 704(c) allocations made by a “securities partnership,” which is allowed to determine reverse § 704(c) allocations on an aggregate basis across all of its “qualified financial assets.” 68 a “securities partnership” is a partnership that shares all economic gain pro rata among partners based on capital invested (except for a disproportionate share that benefits a partner who provides investment management services) and is either (1) registered as a management company under the investment company act of 1940 or (2) holds qualified financial assets that represent at least 90% of the value of its non-cash 66 treas. reg. § 1.704-3(a)(6)(i) (2010). 67 treas. reg. § 1.704-3(a)(2) (2010). 68 treas. reg. § 1.704-3(e)(3) (2010). 266 columbia journal of tax law [vol.2:247 assets and revalues its assets at least annually. 69 a “qualified financial asset” is personal property (including stock) that is actively traded and, in some cases, certain other property. 70 a typical hedge fund, for example, would qualify as a “securities partnership.” the distinction between an asset-by-asset approach and an aggregate approach is demonstrated by the following example. 1. facts of example 3 the ab partnership qualifies as a securities partnership. the ab partnership owns two assets, both of which are qualified financial assets. two individuals, a and b, formed the ab partnership by contributing $100 each to the partnership in exchange for a 50% interest. a third individual, c, subsequently acquires a 50% interest in the partnership (diluting a‟s interest to 25% and b‟s interest to 25%). the assets held by the partnership at the time c joins the partnership, along with the original cost of each asset, the value of each asset at the time c joins the partnership, the eventual sale price of each asset, and the timing of the subsequent sale of each asset are shown in the table below. table 2: facts of example 3 asset acquisition cost value when c joins eventual sale price time of sale stock 1 $100 $150 $200 year 1 stock 2 $100 $125 $110 year 1 cash (contributed by c) n/a $275 n/a n/a 2. results under an asset-by-asset approach upon sale of stock 1 for $200, the partnership recognizes $100 of taxable gain. because $50 of built-in gain existed with respect to stock 1 at the time c joined the partnership, the partnership must allocate $50 of the tax gain equally to a and b. the remaining $50 tax gain is attributable to gain that accrued after c joined the partnership and, therefore, is allocated 25% to a, 25% to b, and 50% to c, which corresponds to how they share in the $50 of gain economically. upon sale of stock 2 for $110, the partnership recognizes $10 of taxable gain. twenty five dollars of built-in gain existed with respect to stock 2 at the time c joined the partnership and $15 of economic loss accrued with respect to stock 2 after c joined the partnership. tax allocations made upon sale of stock 2 will depend on which method the partnership uses for making reverse § 704(c) allocations with respect to stock 2. if the partnership uses the traditional method, for example, the partnership will allocate $10 of taxable gain equally to a and b and none to c. if the partnership uses the remedial method, though, the partnership will allocate a notional item of 50% times $15 (or $7.50) of tax loss to c (to correspond to the economic loss realized by c) and a notional item of 69 treas. reg. § 1.704-3(e)(3)(iii) (2010). 70 treas. reg. § 1.704-3(e)(3)(ii)(a), (b) (2010). 2011] making partnerships work for mom and pop and everyone else 267 $7.50 of tax gain plus $10 of actual tax gain (or $17.50 of tax gain) equally to a and b (which corresponds to the net economic gain realized by a and b). 3. results under an aggregate approach rather than tracking existing built-in gain asset-by-asset, the partnership simply takes into account the fact that an aggregate built-in gain existed when c joined the partnership. furthermore, upon sale of a given asset, the partnership need not consider the amount of built-in gain that existed with respect to that particular asset when c joined the partnership. these facets of the aggregate approach can simplify the calculations involved, particularly if the partnership holds hundreds of qualified financial assets. if an aggregate approach is used in the example above, the partnership will maintain a revaluation account for each partner reflecting the amount of tax gain that should be allocated to that partner. for each of a and b, at the end of year 1, the balance of the revaluation account will be 50% times $75 (their share of built-in gain that exists when c joins, calculated as $150 value stock 1 when c joins minus $100 acquisition cost stock 1 plus $125 value stock 2 when c joins minus $100 acquisition cost stock 2) plus 25% times $35 (their share of net gain that accrues after c joins, calculated as $200 eventual sale price stock 1 minus $150 value stock 1 when c joins plus $110 eventual sale price stock 2 minus $125 value stock 2 when c joins) or $46.25 in total. for c, at the end of year 1, the balance of the revaluation account will be 50% times $35 (c‟s share of net gain that accrues after c joins) or $17.50. upon sale of stock 1 for $200, the partnership recognizes $100 of taxable gain. this $100 taxable gain will be allocated pro rata to a, b, and c based on the balance of each partner‟s revaluation account or $42 to a, $42 to b, and $15.90 to c. upon sale of stock 2 for $110, the partnership recognizes $10 of tax gain. this $10 taxable gain will be allocated pro rata to a, b, and c based on the balance of each partner‟s revaluation account or $4.25 to a, $4.25 to b, and $1.60 to c. as a result, total allocations of tax gain to each partner from both assets are: (1) $46.25 for a, (2) $46.25 for b, and (3) $17.50 for c. for a and b this corresponds to their 50% share of the $75 of built-in gain that existed at the time c joined plus their 25% share of the additional $35 of net gain that accrued after c joined. for c, this corresponds to 50% of the $35 of net gain that accrued after c joined the partnership. ii. history of § 704(c) and concerns about unsophisticated partners section 704(c) did not always exist in the form described above. in fact, when the part of the code governing the taxation of partners and partnerships was adopted in 1954, applying the principles described above was entirely optional. this part will describe the original version of § 704(c), justifications offered for the original version of § 704(c), and the evolution of § 704(c) from its original form to its current form. as this discussion will show, concerns about imposing complex rules on unsophisticated partners played a key role in the development of § 704(c). a. original version of § 704(c) as originally enacted, § 704(c) provided that tax items recognized by a partnership with respect to property contributed to the partnership would be allocated “in 268 columbia journal of tax law [vol.2:247 the same manner as if such property had been purchased by the partnership.” 71 this general rule applied unless the partnership elected to make allocations in a manner that took into account the difference between the property‟s fair market value and its basis at the time of the contribution. 72 in order to illustrate the operation of the original rule, assume the following set of facts: example 4. a owns a piece of land that a acquired some time ago for $5,000. the land is currently worth $15,000. a contributes the land and b contributes $15,000 cash to the newly formed ab partnership, each in exchange for a 50% interest in the ab partnership. a does not recognize any gain as a result of the contribution. the ab partnership‟s basis in the land is $5,000. a‟s initial basis in his or her interest in the partnership is $5,000, and b‟s initial basis in his or her interest in the partnership is $15,000. the partnership sells the land for $15,000. as a result, the partnership recognizes $10,000 of tax gain from sale of the land. based on the original version of § 704(c), the partnership had two choices. under the general rule, the partnership would allocate the $10,000 of tax gain as if the land had been purchased by the partnership. in other words, the partnership would allocate the tax gain equally ($5,000 each) to a and b since a and b each own a 50% interest in the partnership. 73 this would shift $5,000 of tax gain from a to b since, economically, a has realized a $10,000 economic gain (attributable to precontribution appreciation) and b has realized no economic gain. following the allocation of tax gain of $5,000 to each partner, a‟s basis in his or her interest in the partnership would be $10,000, and b‟s basis in his or her interest in the partnership would be $20,000. if the partnership distributed $30,000 cash equally to a and b on liquidation ($15,000 each), a would recognize $5,000 of tax gain on liquidation and b would recognize $5,000 of tax loss on liquidation. but for character and timing differences (which could be significant), the tax gains and losses recognized on liquidation offset the earlier shift of tax gain from a to b. alternatively, if it chose to do so, the partnership could apply the principles of current § 704(c) by allocating tax gain in a manner that takes into account the difference between the fair market value of the land and the basis of the land at the time of contribution. in that case, all $10,000 of tax gain recognized on sale of the land would be allocated to a, so that no tax gain would be shifted from a to b. 71 i.r.c. § 704(c)(1) (1954). 72 i.r.c. § 704(c)(2) (1954). 73 if the partnership, in fact, planned to use this method, b would likely be willing to contribute less than $15,000 if b were taxable on gain from sale of the land. for simplicity, the example above assumes that b is not taxable on gain from sale of the land. 2011] making partnerships work for mom and pop and everyone else 269 b. justifications offered for the original version of § 704(c) when discussing why it adopted the original version of § 704(c), the senate finance committee stated that the general rule (under which partnerships did not take into account built-in gains and losses) was adopted because “of its extreme simplicity” compared to alternative methods. 74 the general rule was viewed as simple because tax items recognized with respect to contributed property could be allocated in the same manner as all other tax items. 75 the committee‟s concerns about complexity likely arose because of its observation that many partnerships were unsophisticated. as an indication of this underlying rationale, the senate finance committee lamented that uncertainty in partnership tax was “particularly unfortunate” given the large number of partnerships and given that “the partnership form is much more commonly employed by small businesses and in farming operations than the corporate form.” 76 finally, the committee seemed to assume that partners in a partnership would generally be subject to similar effective rates of tax so that shifting tax consequences from one partner to another partner should not raise serious concerns. therefore, the committee was not overly worried about whether or not partnerships employed a method that took into account built-in gains and losses, and, consequently, provided partnerships with the flexibility to decide whether to use such a method. thus, the committee stated, “partners should be free to choose this more complicated rule for dividing basis of property [in other words, the method that takes into account built-in gains and built-in losses] if they desire the more accurate tax results it brings.” 77 however, use of the more accurate method was elective because, in the committee‟s view, whether a partnership used the more complicated and accurate method was “not a matter involving revenue considerations to the government.” 78 c. evolution of § 704(c) over time it became clear that shifting tax consequences from one partner to another was, in fact, a “matter involving revenue considerations to the government.” 79 when partners have significantly different tax profiles, shifting tax consequences among partners can reduce total tax revenue collected, at least if the time value of money is taken into account and, in some cases, even if it is not. in order to illustrate, we return to the facts of example 4 given above and add some additional facts about the partners. in particular, assume that b is subject to a 0% effective rate of tax on tax gain from sale of the land and on tax gain and loss from liquidation of b‟s interest in the partnership. perhaps b is a tax-exempt entity and does not take into account tax gain or loss from sale of the land or liquidation of b‟s interest in the partnership for purposes of computing any tax liability b might owe. alternatively, perhaps b has significant tax losses from other sources that would offset tax gain from sale of the land and make tax loss from liquidation of b‟s interest in the partnership not particularly valuable. assume a, on the other hand, would be subject to a 35% effective 74 s. rep. no. 83-1622, at 90 (1954). 75 id. at 90 (discussing the fact that the sharing of tax items with respect to contributed property is identical to the sharing of tax items with respect to non-contributed property under the general rule). 76 id. at 89. for current statistics regarding size of partnerships, see supra notes 4, 5. 77 id. at 93. 78 id. 79 for further discussion of the evolution of § 704(c), see, e.g., gergen, supra note 9, at 348. 270 columbia journal of tax law [vol.2:247 tax rate on gain from sale of the land but a 15% effective tax rate on gain from liquidation of a‟s interest in the partnership. under this set of facts, the tax revenue collected using the general rule (under which tax gain from sale of the land is allocated equally to each partner) is shown in the following table. table 3: general rule (tax gain from sale of land allocated equally to a and b) year year 1 (sale of the land) year 5 (liquidation of partnership) years 1 and 5 tax gain or loss recognized by a $5,000 gain $5,000 gain tax collected from a $1,750 $750 tax gain or loss recognized by b $5,000 gain $5,000 loss tax collected from b $0 $0 total tax collected $1,750 $750 $2,500 by contrast, the tax revenue collected using the rule that applies current § 704(c) principles (under which tax gain from sale of the land is allocated entirely to a) is shown in the following table. table 4: built-in gain taken into account (tax gain from sale of land allocated entirely to a) year year 1 (sale of the land) year 5 (liquidation of partnership) years 1 and 5 tax gain or loss recognized by a $10,000 gain $0 tax collected from a $3,500 $0 tax gain or loss recognized by b $0 $0 tax collected from b $0 $0 total tax collected $3,500 $0 $3,500 thus, under the facts assumed above, the method used would affect timing of tax revenue collection as well as the total dollar amount of tax revenue collected. the facts of the example could be altered so that, for example, a is subject to a 15% effective tax rate on gain from sale of the land and a 15% effective tax rate on gain from liquidation of a‟s interest in the partnership, while b is subject to a 0% effective tax rate on gain or loss 2011] making partnerships work for mom and pop and everyone else 271 from sale of the land or liquidation of b‟s interest in the partnership. under this set of facts, the tax revenue collected using the general rule (under which tax gain from sale of the land is allocated equally to each partner) is shown in the following table. table 5: general rule (tax gain from sale of land allocated equally to a and b) year year 1 (sale of the land) year 5 (liquidation of partnership) years 1 and 5 tax gain or loss recognized by a $5,000 gain $5,000 gain tax collected from a $750 $750 tax gain or loss recognized by b $5,000 gain $5,000 loss tax collected from b $0 $0 total tax collected $750 $750 $1,500 by contrast, the tax revenue collected using the rule that applies current § 704(c) principles is shown in the following table. table 6: built-in gain taken into account (tax gain from sale of land allocated entirely to a) year year 1 (sale of the land) year 5 (liquidation of partnership) years 1 and 5 tax gain or loss recognized by a $10,000 gain $0 tax collected from a $1,500 $0 tax gain or loss recognized by b $0 $0 tax collected from b $0 $0 total tax collected $1,500 $0 $1,500 thus, under this second set of facts, the same amount of total tax revenue is collected over the life of the partnership ($1500 in total) under either method. however, if the partnership is required to apply current § 704(c) principles, more tax revenue is collected in an earlier year. assuming a 10% discount rate (compounded annually) for purposes of illustration, $750 of tax revenue collected in year 5 plus $750 of tax revenue collected in year 1 is the equivalent of $1262 of tax revenue collected in year 1. 272 columbia journal of tax law [vol.2:247 therefore, if the partnership is required to apply current § 704(c) principles, the value of additional tax revenue collected in year 1 is $1500 minus $1262 or $238. because a shift in tax consequences among partners can affect the amount of tax revenue collected and the timing of tax revenue collection, in 1984, § 704(c) was amended to largely resemble its current form. thus, allocating tax items so as to take into account built-in gain or built-in loss that existed when property was contributed to a partnership was no longer optional. however, the treasury regulations that implement the current rules allow partnerships to select among various methods for making § 704(c) allocations subject to an anti-abuse rule, as described above. moreover, as described above, despite the fact that § 704(c) now requires a partnership to take into account builtin gain or built-in loss when making allocations with respect to contributed property, unless the partnership uses the remedial method, it is still possible for tax consequences attributable to pre-contribution changes in the value of assets to be shifted from the contributing partner to the other partners. the treasury did not require partnerships to use the remedial method (or something similar), in part because the treasury apparently believed it lacked authority to do so. 80 however, even if the treasury was correct in this belief, mandatory use of the remedial method could have been required by congress. aside from the possible limitations on the authority of the treasury, resistance to mandatory use of the remedial method was driven by the same type of concerns that drove congress to adopt the original version of § 704(c). namely, concerns about avoiding complexity impeded the adoption of a mandatory remedial method. one method under consideration leading up to the promulgation of final regulations under § 704(c) was called the “deferred sales method.” the “deferred sales method” was similar to the remedial method and, like the remedial method, it would have ensured that tax consequences attributable to pre-contribution changes in asset value were not shifted away from the contributing partner. in its march 1979 report, the american law institute (“a.l.i.”) did not recommend adopting the deferred sales method as a mandatory method under § 704(c) because of concerns about the method‟s complexity, even though the a.l.i. acknowledged that many partnerships in 1979 were sufficiently sophisticated to handle the complexities of the deferred sales approach. 81 the a.l.i. was concerned about two aspects of complexity. first, the a.l.i. was concerned that applying the method would require partnerships to value property at the time it was contributed to a partnership which could be difficult for properties that lacked readily ascertainable values. 82 moreover, the a.l.i. indicated that a method like the traditional method could 80 for further discussion, see cunningham, supra note 59, at 116 – 17. 81 see american law inst., federal income tax project, subchapter k, proposals for changes in the rules for taxation of partners 153-54 (tent. draft no. 3, 1979) (“the concern with complexity [discussed in 1954] . . . has continuing relevance. nevertheless, it is recognized that many of the partnerships that use subchapter k today are more sophisticated than the partnerships which existed in 1954 and would therefore be better able to handle the complexities of a deferred sale approach.”). id. at 156 (“[t]he valuation difficulties inherent in a deferred sale approach . . . together with the complexity which such an approach was viewed as adding to subchapter k, result in the conclusion that the project would not recommend such a rule.”). 82 id. at 146 (“the most important difficulty with the deferred sale approach is that it requires valuation of all property contributed to a partnership.”). for discussion of why this concern should not preclude adoption of the remedial method (or something similar such as the deferred sales method), see infra notes 158 to 160 and accompanying text. 2011] making partnerships work for mom and pop and everyone else 273 avoid some of the difficulties of valuing a property when it was contributed to a partnership. 83 second, the a.l.i. feared that applying the deferred-sales method would be computationally complex. 84 because the § 704(c) regulations do not require use of the remedial method, tax consequences can still be shifted in a manner that affects timing (and, in some cases, the total dollar amount) of tax revenue collected. to illustrate, assume the following facts: example 5. a owns a piece of land that a acquired some time ago for $5,000. the land is currently worth $15,000. a contributes the land and b contributes $15,000 cash to the newly formed ab partnership, each in exchange for a 50% interest in the ab partnership. the partnership sells the land for $10,000 in year 1. the partnership recognizes $5,000 of tax gain from sale of the land. in year 5, the partnership distributes $25,000 cash equally ($12,500 each) to a and b in liquidation. b is subject to a 0% effective rate of tax on tax gain from sale of the land and on tax gain and loss from liquidation of b‟s interest in the partnership. a, on the other hand, is subject to a 35% rate of tax on tax gain from sale of the land but a 15% rate of tax on tax gain from liquidation of a‟s interest in the partnership. based on the facts of example 5, the tables below show the tax revenue collected under the traditional method and under the remedial method. as the tables below illustrate, selection of the traditional method would result in lower total tax revenue and a delay in collection of tax revenue compared to use of the remedial method. 85 83 id. at 155 (“[t]he ceiling limitation [effectively the traditional method] is to some extent inconsistent with the more correct theoretical result under the deferred sale approach [effectively the remedial method]. . . . despite this illogical element, the ceiling limitation has one important advantage. it restricts any allocation to readily ascertainable factors – the property‟s basis and its sales price. . . . for this reason, a credited value or deferred sale approach with a ceiling limitation [effectively the traditional method] may avoid some of the valuation difficulties that would result under a pure credited value approach [effectively the remedial method].”). for discussion of why this is incorrect, see infra note 159 and accompanying text. 84 id. at 151 (“a deferred sale or credited value approach will probably be perceived as more complex than present law by most taxpayers since it will require more computations.”). for further discussion of the impediments to adopting the deferred sales approach, see andrea monroe, saving subchapter k: substance, shattered ceilings, and the problem of contributed property, 74 brook. l. rev. 1381 passim (2009). for an alternative explanation of why taxpayers are allowed to elect among different methods under § 704(c), see heather m. field, choosing tax: explicit elections as an element of design in the federal income tax system, 47 harv. j. on legis. 21, 60-61 (2010) (arguing that § 704(c) represents an area in which lawmakers allowed for an election because all of the methods are reasonable approaches for implementing congress‟s policy goal but also stating, “nevertheless, congress could have, and possibly should have, simply selected a single method for handling precontribution gains and losses.” id. at 61.). 85 under a different set of facts, the remedial method could result in less tax revenue than the traditional method. this would be the case if, for example, the facts were the same except that a was subject to a lower rate of tax than b. however, in such a case, the parties would likely opt for the remedial method even under current law, so mandating use of the remedial method should not result in tax revenue loss. moreover, because the remedial method results in tax consequences that more accurately reflect economic 274 columbia journal of tax law [vol.2:247 table 7: traditional method year year 1 (sale of the land) year 5 (liquidation of partnership) years 1 and 5 tax gain or loss recognized by a $5,000 gain $2,500 gain tax collected from a $1,750 $375 tax gain or loss recognized by b $0 $2,500 loss tax collected from b $0 $0 total tax collected $1,750 $375 $2,125 table 8: remedial method year year 1 (sale of the land) year 5 (liquidation of partnership) years 1 and 5 tax gain or loss recognized by a $7,500 gain $0 tax collected from a $2,625 $0 tax gain or loss recognized by b $2,500 loss $0 tax collected from b $0 $0 total tax collected $2,625 $0 $2,625 iii. existing law under § 754 section 754 is a provision that allows a partnership to make an election that will generally dictate whether or not the partnership will adjust its basis in its assets following a transfer of an interest in the partnership or following certain distributions made by the partnership. this part discusses the mechanics of § 754 in detail. when one partner sells his or her interest in a partnership to another person, unless a § 754 election is in effect, generally the sale will have no impact on the consequences, the remedial method still results in a more accurate measure of tax liability even in cases in which it results in a lower amount of tax liability. 2011] making partnerships work for mom and pop and everyone else 275 partnership‟s basis in its assets. 86 as a result, if a § 754 election is not in effect, gain attributable to an increase in the value of a partnership‟s assets potentially will be recognized twice for tax purposes – first on sale of an interest in the partnership and second on sale by the partnership of its assets. by making a § 754 election, the partnership effectively eliminates the second, duplicative tax gain. 87 special rules apply in the case of partnerships that hold assets that have declined in value. 88 finally, once a partnership files a § 754 election, the election generally will apply to all transfers that occur in the year with respect to which the election was filed or any subsequent year. 89 a. section 754 elections and built-in gain assets the mechanics of a § 754 election in the context of a partnership that holds assets that have appreciated in value can be more fully demonstrated by an example. for purposes of the example, assume the following facts: example 6. two individuals, a and b, each contribute $100 in exchange for a 50% interest in a newly formed entity treated as a partnership for tax purposes. as a result, each partner will have a basis in his or her interest in the partnership equal to $100. 90 the partnership uses the cash contributed by the partners to acquire a parcel of land for $200, so that the partnership‟s initial tax basis in the land is $200. over time, the value of the land increases. two years after the formation of the partnership, when the value of the land is $300 and the partnership holds no other assets and owes no liabilities, a sells his or her interest in the partnership to c for $150. as a result of the sale, a will recognize $50 of gain for tax purposes, which equals the excess of the amount received from c over a‟s basis in his or her interest in the partnership. 91 c‟s initial basis in his or her interest in the partnership will be $150. 92 if the partnership does not have a § 754 election in effect, the transfer will have no impact on the partnership‟s basis in the land, and, thus, under the facts of example 6, the partnership‟s basis in the land will remain $200. 93 assume, one year after the sale of a‟s interest in the partnership to c, the partnership sells the land for $300. because the partnership‟s basis in the land remained $200, the partnership recognizes $100 of tax gain on sale of the land which is allocated $50 to c and $50 to b. the $50 of tax gain that is allocated to c is effectively a duplication of the tax gain recognized by a on sale of his or her interest in the partnership to c because both items of $50 tax gain are attributable to 86 i.r.c. § 743(a) (2010). 87 i.r.c. § 743(b) (2010). 88 see infra notes 103-105 and accompanying text. 89 i.r.c. § 754 (2010). 90 i.r.c. § 722 (2010). 91 this gain will be capital gain assuming the partnership does not hold the land as inventory and holds no unrealized receivables. i.r.c. §§ 741, 751(a) (2010). 92 i.r.c. § 742 (2010). 93 i.r.c. § 743(a) (2010). 276 columbia journal of tax law [vol.2:247 a‟s share of the increase in value of the land that occurred prior to sale of the partnership interest by a to c. this duplication of tax gain may be temporary. in particular, as a result of the allocation of $50 of tax gain to each partner, each partner‟s basis in his or her interest in the partnership will increase by $50 so that c‟s basis in his or her interest in the partnership becomes $200 and b‟s becomes $150. 94 as a result, if the partnership distributes $150 cash to b and c in liquidation, c will recognize a $50 tax loss at the time of the liquidation (the excess of c‟s basis in his or her interest in the partnership over the amount of cash received) and b will recognize no tax gain or loss. 95 the tax loss recognized by c on liquidation is equal in amount to the earlier, duplicative tax gain recognized by c on sale of the land. however, the tax loss recognized by c may not fully offset the effects of the $50 of tax gain recognized by c on sale of the land if the liquidation of the partnership occurs in a later year than the year in which the land was sold. for one thing, if the $50 of tax loss does reduce c‟s tax liability, it does so in a later year than the year in which c may have incurred tax liability as a result of the sale of the land. therefore, taking into account the time value of money and the fact that applicable tax rates may have changed since the time at which the land is sold, the tax loss may not fully offset the consequences of the tax gain. for another thing, the tax loss is likely a capital loss 96 and, assuming c is an individual, may result in only a limited reduction of tax liability if c does not recognize capital gains in the year in which the partnership is liquidated or in a subsequent year. this is so because capital losses of non-corporate taxpayers can generally only be used against capital gains and up to $3,000 of ordinary income, 97 and excess capital losses of non-corporate taxpayers can generally only be carried forward to succeeding taxable years to be used in those years subject to the restrictions just described. 98 by contrast, if the partnership has made a § 754 election, the transfer of the partnership interest from a to c will have an impact on the partnership‟s basis in the land. in particular, under the facts of example 6, the partnership will increase its basis in the land by $50, which is calculated based on the excess of c‟s basis in his or her interest in the partnership (the $150 paid by c for the interest) over c‟s share of the partnership‟s basis in its assets ($100 or 50% of the $200 basis in the land). 99 however, this increase in basis will be taken into account solely for purposes of determining c‟s tax consequences and will not affect tax gain or loss allocated to b. 100 assume, one year after the sale of a‟s interest in the partnership to c, the partnership sells the land for $300. absent the $50 increase in basis of the land, the partnership‟s basis in the land would have been $200, so that the partnership would have recognized $100 of tax gain. fifty percent of this amount or $50 would be allocated to b, and, even taking into account the basis adjustment, $50 is in fact allocated to b because the basis adjustment affects c and not b. on the other hand, the $50 of tax gain that would have been allocated to c absent an 94 i.r.c. § 705(a) (2010). 95 i.r.c. § 731(a) (2010). 96 id. (flush language) (stating that the tax loss recognized on liquidation will be treated as tax loss recognized by c from a sale of the partnership interest); i.r.c. § 741 (2010) (stating that, except as provided in § 751, tax loss recognized from the sale of a partnership interest will be treated as capital loss). 97 i.r.c. § 1211 (2010). 98 i.r.c. § 1212 (2010). 99 i.r.c. § 743(b) (2010). 100id. 2011] making partnerships work for mom and pop and everyone else 277 upward basis adjustment of $50 is entirely eliminated by the $50 upward basis adjustment, so that no tax gain or loss is allocated to c. thus, unlike what occurs in the absence of a § 754 election, the $50 of tax gain attributable to a‟s share of the increase in the value of the land that occurred prior to a‟s sale of his or her partnership interest to c (and that was recognized by a on sale of his or her interest in the partnership to c) is not recognized a second time by c when the land is sold by the partnership. after the partnership recognizes $50 of tax gain and allocates it to b, b‟s basis in his or her interest in the partnership becomes $150 and c‟s remains $150. thus, if the partnership distributes $150 of cash to each partner on liquidation, neither partner recognizes gain or loss as a result of the liquidation. 101 the tax consequences just described are summarized in the following table. 102 101 i.r.c. § 731 (2010). 102 a similar issue of potential duplication of built-in gain arises when property is distributed by a partnership to a partner. as is true in the case of the transfer of interests in a partnership, the built-in gain will or will not be duplicated depending on whether the partnership has a § 754 election in effect. for example, assume three individuals, a, b, and c each contribute $100 in exchange for a one-third interest in a newly formed entity treated as a partnership for tax purposes. as a result, each partner will have a basis in his or her interest in the partnership equal to $100. i.r.c. § 722 (2010). assume the partnership uses $100 of the amount contributed by the partners to acquire a parcel of land for $100, so that the partnership‟s basis in the land is $100. the partnership holds the remaining $200 contributed by the partners in cash. at a time when the value of the land is $400, the partnership distributes $200 cash to a in liquidation of a‟s interest in the partnership. a recognizes $100 of gain as a result of the distribution (the excess of the amount of cash received over a‟s basis in his or her interest in the partnership). i.r.c. § 731(a) (2010). this $100 tax gain is attributable to a‟s one-third share of the $300 of economic gain that has accrued with respect to the land. in other words, because the land is worth $300 more than its initial acquisition cost, the amount distributed to a in liquidation of a‟s interest must exceed the amount a contributed by one-third of $300 or $100, and because a receives $100 more in cash than the amount a contributed, a recognizes $100 of tax gain as a result of the distribution. if no § 754 election is in effect, the distribution has no impact on the partnership‟s basis in the land. i.r.c. § 734(a) (2010). as a result, if the partnership sells the land for $400 in a subsequent year, the partnership will recognize $300 of tax gain, allocated $150 to each of b and c, and $50 of the amount allocated to each partner represents a duplication of the tax gain recognized by a when a received the cash distribution. if a § 754 election is in effect, then the partnership will increase its basis in the land by $100 to $200. i.r.c. § 734(b) (2010). as a result, if the partnership sells the land for $400 in a subsequent year, the partnership will recognize $200 of tax gain, allocated $100 to each of b and c, and none of the tax gain recognized by a is duplicated. 278 columbia journal of tax law [vol.2:247 table 9: section 754 election and built-in gain assets section 754 election not made section 754 election made tax gain or loss recognized by a on sale of partnership interest to c $50 gain $50 gain tax gain or loss recognized by c on sale of land by partnership $50 gain $0 tax gain or loss recognized by b on sale of land by partnership $50 gain $50 gain tax gain or loss recognized by c on liquidation $50 loss $0 tax gain or loss recognized by b on liquidation $0 $0 b. section 754 elections and built-in loss assets if a partnership‟s assets have a “substantial built-in loss” immediately after the transfer of an interest in the partnership, then the results that would follow from making a § 754 election are mandatory regardless of whether the partnership has made such an election. 103 in other words, in such a case, the partnership is required to take steps to avoid the recognition of the same tax loss a second time. a “substantial built-in loss” exists if a partnership‟s total basis in its assets, in aggregate, exceeds the total value of the partnership‟s assets by more than $250,000. 104 certain large partnerships, for which making basis adjustments would be particularly difficult, are allowed to carry out the purpose of mandatory downward basis adjustments through alternative methods. 105 the following example demonstrates the results of a mandatory downward basis adjustment and the limits on when such an adjustment is required. for purposes of the example, assume the following facts: 103 i.r.c. § 743(b) (2010). 104 i.r.c. § 743(d)(1) (2010). a similar rule applies in the case of downward basis adjustments in connection with the distribution of property. i.r.c. §§ 734(b), (d). 105 making basis adjustments becomes computationally more difficult if a partnership holds multiple assets and if interests in the partnership change hands frequently. this is the case since a separate basis adjustment has to be taken into account for each asset with respect to each transfer. in recognition of this fact, § 743(e) of the code provides that the mandatory downward basis adjustments that would otherwise apply in the case of a “substantial built-in loss” do not apply to an “electing investment partnership,” provided that the partnership establishes that losses are only allocated to the transferee partner to the extent they exceed the loss recognized by the transferor. several open questions remain regarding which entities can qualify as electing investment partnerships and regarding how partnerships can comply with the requirement of establishing that losses are only allocated to the transferee partner to the extent they exceed the loss recognized by the transferor. for further discussion, see kristen j. hangen, economic crisis renews interest in electing investment partnerships, 126 tax notes 945 (2010). regarding the reason for adopting a special rule for electing investment partnerships, the house committee report stated, “the committee was made aware that certain types of investment partnerships would incur administrative difficulties in making partnership-level basis adjustments.” h.r. rep. no. 108-548, pt. 1, at 283 (2004). 2011] making partnerships work for mom and pop and everyone else 279 example 7. two individuals, a and b, each contribute $500,000 in exchange for a 50% interest in a newly formed entity treated as a partnership for tax purposes. the partnership uses the cash contributed by the partners to acquire a parcel of land for $1,000,000. over time the value of the land decreases. two years after the formation of the partnership, when the value of the land is $700,000 and the partnership holds no other assets and owes no liabilities, a sells his or her interest in the partnership to c for $350,000. one year later, the partnership sells the land for $700,000. two years after that, the partnership distributes $350,000 cash to each of b and c in liquidation. because the partnership‟s basis in its assets exceeds the value of the partnership‟s assets by $300,000 immediately after the transfer under the facts of example 7, a substantial built-in loss exists, and the partnership must reduce the basis in the land by $150,000 for purposes of determining c‟s tax consequences. the resulting tax consequences are summarized in the following table. table 10: substantial built-in loss tax gain or loss recognized by a on sale of partnership interest to c in year 2 $150,000 loss tax gain or loss recognized by c on sale of land by partnership in year 3 $0 tax gain or loss recognized by b on sale of land by partnership in year 3 $150,000 loss tax gain or loss recognized by c on liquidation in year 5 $0 tax gain or loss recognized by b on liquidation in year 5 $0 by contrast, if the special rule regarding duplication of built-in losses did not apply and the partnership had not made a § 754 election under the facts of example 7, the resulting tax consequences would be those shown in the following table. 280 columbia journal of tax law [vol.2:247 table 11: tax consequences absent substantial built-in loss rules and absent § 754 election tax gain or loss recognized by a on sale of partnership interest to c in year 2 $150,000 loss tax gain or loss recognized by c on sale of land by partnership in year 3 $150,000 loss tax gain or loss recognized by b on sale of land by partnership in year 3 $150,000 loss tax gain or loss recognized by c on liquidation in year 5 $150,000 gain tax gain or loss recognized by b on liquidation in year 5 $0 in this case, the $150,000 tax loss recognized by a on sale of his or her interest in the partnership to c is duplicated, at least temporarily, because, upon sale of the land, c recognizes tax loss attributable to the same decrease in value of the land that led to a‟s tax loss. the tax consequences of this tax loss recognized by c may be offset when c recognizes $150,000 tax gain on liquidation of the partnership. however, the offset may not be perfect because the tax gain occurs in a later year than the year of the tax loss, and the tax gain could be of a different character, with different resulting tax consequences, than the tax loss. finally, while mandatory downward basis adjustments prevent duplication of losses in cases like the example just described (as shown in table 10), duplication of losses can, nevertheless, occur in some circumstances. for example, in the case just presented, if the built-in loss that existed in the land at the time of the sale of the partnership interest from a to c had been $250,000 or less and a § 754 election was not in effect, then the built-in loss could be duplicated along the lines shown in table 11. a basis adjustment also would not be required if, for example, the partnership held land with a built-in loss of $300,000 at the time of the transfer but also held another asset with a built-in gain of $50,000 at the time of the transfer since the existence of a substantial built-in loss is determined on an aggregate basis across all assets. therefore, a partnership could duplicate a $300,000 loss if it also duplicated a $50,000 gain. in the case of a partnership owned by individuals subject to high marginal rates of tax on ordinary income, for example, this could be a desirable outcome if the built-in gain asset was a capital asset (so that the gain that is duplicated is a capital gain subject to preferential tax rates) and the built-in loss asset is inventory (so that the loss that is duplicated is an ordinary loss that can be used to offset ordinary income subject to higher tax rates). 2011] making partnerships work for mom and pop and everyone else 281 c. other constraints in addition to the rules that apply in cases in which a partnership‟s assets have a “substantial built-in loss”, the anti-abuse regulations that apply for purposes of partnership tax law generally contain examples regarding potentially abusive transactions that involve the failure to make a § 754 election. 106 the examples in the treasury regulations suggest that, if a partnership is formed largely for the purpose of duplicating a tax loss that results from the failure to make a § 754 election, the transaction can be successfully challenged. however, the mere failure to make a § 754 election, in and of itself, will not be considered abusive simply because it results in the duplication of tax loss in a particular situation. as the treasury regulations state, “the electivity of section 754 is intended to provide administrative convenience for bona fide partnerships that are engaged in transactions for a substantial business purpose. . . . congress clearly recognized that if the section 754 election were not made, basis distortions may result.” 107 iv. history of § 754 and concerns about unsophisticated partners as originally enacted, the results that follow from a § 754 election were not mandatory even in cases involving potential duplication of substantial built-in losses. in 2004, congress enacted the rules mandating downward basis adjustments in cases in which a partnership‟s assets have a substantial built-in loss, in order to address concerns about tax-shelter transactions involving intentional duplication of losses. 108 concerns about computational complexity have influenced the hesitation to require basis adjustments in all cases. 109 for example, in a 1980 report recommending making basis adjustments mandatory in all cases, the a.l.i. acknowledged objections that could be made to such a change in the law. one objection was that “unsophisticated partnerships might have to make complex basis adjustments.” 110 the a.l.i. also expressed concern for partnerships at the other end of the spectrum, stating that large partnerships would face complexity if they had to make basis adjustments for “innumerable partners.” 111 106 see treas. reg. § 1.701-2(d), example 8 (2010); c.f. treas. reg. § 1.701-2(d), example 9 (2010). 107 treas. reg. § 1.701-2(d), example 9 (2010). 108 see, e.g., h.r. rep. no. 108-548, pt. 1, at 283 (2004) (“the committee believes that the partnership rules currently allow for the inappropriate transfer of losses among partners. this has allowed partnerships to be created and used to aid tax-shelter transactions.”); s rep. no. 108-192, at 151 (2003) (“the committee believes that the present-law electivity of partnership basis adjustments upon transfers and distributions leads to anomalous tax results, causes inaccurate income measurement, and gives rise to opportunities for tax sheltering. in particular, the failure to make partnership basis adjustments permits partners to duplicate losses and to transfer losses among partners, creating an inappropriate incentive to use partnerships as tax shelter vehicles.”). 109 for an alternative explanation for the § 754 election, see field, supra note 84, at 35-36 (arguing that the purpose of allowing taxpayers to make the § 754 election is to reconcile the differences between tax consequences that result from a sale of an interest in a partnership and tax consequences that result from an economically similar sale by a partnership of an interest in its assets). yet, as professor field observes, this purpose could be served equally well if the results following from a § 754 election were mandatory. id. at 42. professor field also notes that mandatory adjustments may be undesirable because of complexity. id. at 43. 110 american law institute, federal income tax project 81-82 (tentative draft no. 4, 1980). 111 id. 282 columbia journal of tax law [vol.2:247 similarly, in 2004, the house committee report described the limitation of mandatory basis adjustments to cases involving substantial built-in losses as a feature that would preserve “the simplification aspects of the current partnership rules for transactions involving smaller amounts.” 112 interestingly, while the changes ultimately enacted principally resembled the house version of the bill, the senate‟s original version of the bill would have required basis adjustments in all cases. when discussing its proposed bill, the senate report stated: the electivity of these adjustments has become anachronistic and should be eliminated, the committee believes. therefore, this provision makes these partnership basis adjustments mandatory, addressing both loss and gain situations. the bill provides that the partnership basis adjustments remain elective in the limited case of transfers of a partnership interest by reason of the death of a partner because that situation may involve unsophisticated taxpayers and constitutes only a narrow, limited set of transfers. 113 v. how reforms would make law less susceptible to manipulation by sophisticated partnerships as discussed below, partnership tax law could be reformed in ways that would make the rules more suitable for sophisticated partnerships and unsophisticated partnerships at the same time. the way to achieve this goal is adoption of rules that would require more accurate income measurement (such as requiring all partnerships to use the remedial method under § 704(c) and making the adjustments that follow from a § 754 election mandatory in all cases). these reforms would make the law more suitable for sophisticated partnerships because more accurate income measurement makes it more difficult for taxpayers to manipulate tax consequences. 114 this part elaborates on this conclusion as applied to §§ 704(c) and 754. a. section 704(c) while the anti-abuse rule in the § 704(c) regulations likely addresses the most flagrant cases of abuse, 115 it leaves to partnerships the freedom to select a particular § 704(c) method based purely on the goal of reducing tax liability. selecting the method that minimizes tax liability may not constitute abuse, but it may, nevertheless, be undesirable from the standpoint of tax revenue collection and fairness. unlike the antiabuse rule, a mandatory remedial method would bring to an end the ability of partnerships to select a particular method in order to reduce tax liability. 112 h.r. rep. no. 108-548, pt. 1, at 283 (2004). 113 s. rep. no. 108-192, at 189-90 (2004). 114 this is not intended as a broad claim that more accurate income measurement is always desirable or that taxable income should always match economic income as closely as possible. the claim is limited to the context of §§ 704(c) and 754 where more accurate income measurement reduces potential for manipulation by sophisticated taxpayers, which is desirable from the standpoint of tax revenue collection and fairness. for discussion of the impact of tax elections on fairness and tax revenue collection generally, see infra note 117. 115 for a discussion of the potential impact of the anti-abuse rule on a fairly blatant case of abuse, see karen c. burke, castle harbour: economic substance and the overall-tax-effect test, 107 tax notes 1163 (2005). for discussion of a simplified version of the facts of the castle harbour case, see supra note 29. 2011] making partnerships work for mom and pop and everyone else 283 in order to illustrate, we can assume the following facts: example 8. a owns a piece of land that a acquired some time ago for $5,000. the land is currently worth $15,000. a contributes the land and b contributes $15,000 cash to the newly formed ab partnership, each in exchange for a 50% interest in the ab partnership. b is subject to a 0% effective rate of tax on tax gain from sale of the land and on tax gain and loss from liquidation of b‟s interest in the partnership. a, on the other hand, is subject to a 35% rate of tax on tax gain from sale of the land but a 15% rate of tax on tax gain from liquidation of a‟s interest in the partnership. further, assume a and b formed the partnership and a contributed the land entirely for valid business reasons. regardless of the resulting tax consequences, a and b would have decided to form the partnership and have a contribute the land to the partnership. moreover, when the partnership was formed, the partners expected that the land would maintain its value or increase in value. therefore, they expected that the partnership would sell the land for at least $15,000. if the land was sold for at least $15,000, the partnership would recognize at least $10,000 of tax gain on sale of the land, and, regardless of the method selected under § 704(c), the first $10,000 of tax gain would be allocated to a and any additional tax gain would be shared equally. thus, if the land was sold for at least $15,000, tax gain would be allocated in the same manner as economic gain and no shifting of tax consequences would result. therefore, the partners did not expect that the contribution of the land would result in a shift of tax gain from a (who is subject to a high effective rate of tax) to b (who is subject to a 0% rate of tax). 116 consequently, since the land was contributed entirely for business reasons and since the partners did not expect the land to be sold at a price that would allow for a shift of tax consequences, the anti-abuse rule should not apply. that said, assume a and b seek advice regarding which § 704(c) method should be used with respect to the land. furthermore, assume that the land is in fact sold for less than $15,000, contrary to the partners‟ expectations. their advisors could recommend selecting the traditional method in order to shift tax gain from a (who is subject to a high rate of tax) to b (who is subject to a 0% rate of tax). for example, if the land is sold for $10,000, the results under the traditional method versus the remedial method are shown in tables 7 and 8 above. therefore, a and b select the traditional method. they do so not because it is a computationally easier method to apply (even though that appears to be the reason that partnerships were given the flexibility to opt for methods other than the remedial method) but because it leads to more favorable tax consequences. 116 it is likely that taxpayers would rarely set up a transaction to shift tax consequences when the shift in tax consequences would only occur if an asset is sold for a sales price different than its current value. this may explain why the examples of abuse given in the treasury regulations are all examples where the expected shift in tax consequences results from the allocation of depreciation. for discussion of these examples, see supra note 57. see also cunningham, supra note 59 at 117–18 (arguing that the examples in the treasury regulations suggest that the defining feature of cases involving abuse is designing a transaction to take advantage of significant differences between the remaining economic life of an asset and the remaining cost recovery period). 284 columbia journal of tax law [vol.2:247 in summary, while the anti-abuse rule may foreclose the most blatantly taxmotivated transactions, the treasury regulations nevertheless give taxpayers the freedom to select among various allowable methods under § 704(c). this election will generally be used by well-advised taxpayers to reduce potential tax liability. 117 moreover, in some cases, sophisticated partnerships will likely seek tax advice when designing transactions and may still use the flexibility afforded by § 704(c) to carry out tax-motivated transactions but do so with enough business purpose window dressing to escape the antiabuse rules. therefore, offering flexibility is undesirable from the standpoint of tax revenue collection and fairness, and, as discussed below, not well suited to the needs of unsophisticated partnerships. b. section 754 existing rules mandating downward basis adjustments in some cases foreclose the possibility that losses will be duplicated in situations in which a particularly large built-in loss exists, in aggregate. in addition, examples in the anti-abuse regulations may prevent the duplication of losses in cases not covered by the mandatory downward basis adjustment rules if the primary reason for forming a partnership is duplication of losses. nevertheless, the failure to universally mandate basis adjustments may be undesirable from the standpoint of tax revenue collection and fairness. the current rules leave open the possibility that losses can still be duplicated in a way that reduces tax revenue if valid business reasons exist for forming the partnership in the first place (or if taxpayers are able to disguise their tax-avoidance purpose with an engineered business purpose). moreover, well-advised taxpayers will tend to benefit from the elective nature of the rules more often than other taxpayers. 118 therefore, particularly given the other concerns following from the elective nature of the rules described below, mandatory basis adjustments would be preferable to the existing system. vi. the truth about complexity as discussed above, adoption of mandatory rules that would require more accurate income measurement would make partnership tax law less susceptible to manipulation by sophisticated partnerships. historically lawmakers have hesitated to enact these reforms on the grounds that they make the law too complex for unsophisticated partnerships. 119 fortunately, this is not the case, and, in fact, the opposite 117 any time the tax law allows taxpayers to explicitly make an election that affects tax consequences, one concern is that the election will be used in a manner that only reduces tax revenue collected, particularly by well-advised, sophisticated taxpayers. see, e.g., field, supra note 84, at 26, 31 (“the availability of tax planning opportunities is criticized as complex, costly, wasteful, revenue reducing, and inequitable, and these critiques may resonate particularly strongly in the context of explicit elections. . . . [a] well-advised rational taxpayer will almost always exercise the election in a way that minimizes its tax liability, at the expense of the fisc. . . . additionally, an election, while technically available to all eligible taxpayers, may be functionally available only to the wealthiest, most sophisticated group of taxpayers, who can best navigate the complexity of the election process.”); george k. yin, the taxation of private business enterprises: some policy questions stimulated by the “check-the-box” regulations, 51 smu l. rev. 125, 130 (1997) (“if the taxpayer is well-advised, the election, which has ramifications for tax purposes only, will always be to the detriment of the fisc.”). 118 this concern arises in connection with tax elections generally. see supra note 117 and accompanying text. in addition, this concern was noted by the a.l.i. when discussing the § 754 election, the a.l.i. stated, “the present elective system is often a trap for the unwary.” american law institute, federal income tax project 80 (tentative draft no. 4, 1980). 119 see supra parts ii, iv. 2011] making partnerships work for mom and pop and everyone else 285 is true as these reforms would simplify the law in some respects and, in other respects, make the law no more complex. the alternative conclusion (that the proposed reforms would make the law too complex) results from certain misconceptions about complexity. in the next part, i will discuss those misconceptions, but, before doing so, in this part, i will discuss how complexity should be understood, drawing, in part, from literature related to tax complexity and legal complexity generally. legal complexity can be defined to include any features of law that cause costs to be incurred because time, effort, and expertise are required to understand and apply law. as a threshold matter, it is useful to differentiate between two types of complexity, which i will label “ex ante complexity” and “ex post complexity.” costs that follow from ex ante complexity include: (1) the costs that result from steps taken by affected persons to ensure that the decisions they make concerning future activities are the same decisions that they would make if they fully understood the implications of relevant law; and (2) the costs that result because the decisions that affected persons make concerning future activities are not the same decisions that they would make if they fully understood the implications of relevant law. others have noted that rules that are not well understood are unlikely to create the incentives that they are intended to produce. 120 the failure of misunderstood rules to create intended incentives is an example of the second type of cost just listed. costs that follow from ex post complexity include costs of assessing consequences of actions already undertaken or complying with any requirements to report actions already undertaken. in the tax area, one key difference exists between ex ante complexity and ex post complexity. with respect to ex ante complexity, it may not be clear to unsophisticated taxpayers how altering their behavior could affect their tax liability. therefore, unsophisticated taxpayers may not be likely to seek expert advice prior to undertaking activities. with respect to ex post complexity, it generally will be clear to taxpayers that it is necessary to file tax returns to report the results of activities already undertaken. thus, unsophisticated taxpayers are likely to be aware of the need to seek expert advice when preparing tax returns. consequently, while there may be a material difference between unsophisticated partnerships and sophisticated partnerships with respect to ex ante complexity (and therefore a reason to have particular concern for unsophisticated partnerships with respect to this type of complexity), there is less likely to be a material difference between unsophisticated partnerships (who seek expert advice) and sophisticated partnerships with 120 in other words, if people do not understand a rule, the rule is not likely to affect their behavior in the intended manner. see, e.g., lawrence zelenak, complex tax legislation in the turbotax era, 1 colum. j. tax l. 91, 103 (2010) (making the argument in the tax context); susan dynarski & judith scott-clayton, the cost of complexity in federal student aid: lessons from optimal tax theory and behavioral economics 2, (harv. kennedy sch. fac. research working paper series, paper no. rwp06-013, 2006) (making the argument in the context of rules governing federal student aid); austan goolsbee, the turbotax revolution: can technology solve tax complexity?, in the crisis in tax administration 124, 138 (henry j. aaron & joel slemrod eds., 2004) (making the argument in the tax context). in the tax area, scholars have argued that this effect may, at times, be a positive consequence of opaque rules. sometimes tax rules are intended to influence behavior, in which case it is crucial for the rules to be well understood. sometimes tax rules are intended to generate revenue with as little distortion of behavior as possible, in which case opaque rules might reduce distortions. see, e.g., brian galle, hidden taxes, 87 wash. u. l. rev. 59 passim (2009); goolsbee, supra at 138; deborah schenk, exploiting the salience bias in designing taxes 22-23 (n.y.u. law & econ., working paper no. 233, 2010). 286 columbia journal of tax law [vol.2:247 respect to ex post complexity. therefore, there is no reason why ex post complexity would burden unsophisticated partnerships more severely than sophisticated partnerships. 121 if anything, sophisticated partnerships may incur higher costs related to ex post complexity because it may be more difficult to determine the tax consequences of complicated fact patterns typical of sophisticated partnerships. 122 this part elaborates on the foregoing discussion by describing factors that contribute to each type of complexity or mitigate each type of complexity. 123 a. ease with which otherwise complex rules are avoided as a mitigating factor the ease with which otherwise complex rules can be avoided can mitigate both ex ante complexity and ex post complexity. in other words, a rule that raises thorny issues when it applies does not meaningfully contribute to complexity if simple steps can 121 ex post complexity might represent a special concern for a particular type of partnership, namely a small partnership, since, given the relatively fixed nature of costs related to ex post complexity, such costs could impose a larger relative burden on small partnerships. however, small partnerships are not necessarily unsophisticated partnerships. 122 in particular, while many people have remarked on the admitted complexity of partnership tax, some of the most technically difficult rules can be avoided by simple partnerships. see, e.g., philip f. postlewaite, i come to bury subchapter k, not to praise it, 54 tax law. 451, 474 (2001) (stating that an a.l.i. report regarding taxation of private business that criticizes the complexity of partnership tax law “ignores the simplicity of subchapter k in simple business arrangements” and citing to the fact that very simple partnerships can avoid analysis of technical rules specifying when allocations have “economic effect” if they comply with the “economic effect equivalence” test). sections 704(c) and 754 are additional examples of partnership tax rules that tend to become more computationally complex when applied to complicated partnerships. section 704(c) (or, more precisely, reverse § 704(c)) is most difficult to apply to a partnership, such as a hedge fund, that holds a large number of assets and that admits different partners over time who buy into the partnership based on the value of its assets at the time they join. relief for this complexity is granted by allowing securities partnerships to apply reverse § 704(c) on an aggregate basis. see supra notes 67 70 and accompanying text. however, as a demonstration of their ability to cope with complexity, many securities partnerships use an asset-by-asset method even though they would be allowed to use the theoretically simpler aggregate method. see scharfstein, supra note 58, at 94 (“[a] substantial number of securities partnerships now use asset-by-asset tracking. this is made feasible by the availability of computer programs designed for this purpose and the declining cost of computer usage. in particular, assetby-asset tracking is rapidly becoming the norm among major securities partnerships with high minimum investments (e.g., $1 million or more).”). likewise, basis adjustments are the most difficult to apply to a partnership that holds a large number of assets and in which interests are transferred frequently. the a.l.i. and congress have recognized this fact. see supra notes 105 and 111 and accompanying text. 123 a number of factors contribute to complexity or mitigate complexity. factors of particular importance for the analysis in part vii are discussed below. it is possible to label factors that influence complexity differently or categorize concepts relevant to complexity under the heading of different factors. see, e.g., peter h. schuck, legal complexity: some causes, consequences, and cures, 42 duke l. j. 1 passim (1992). the factors listed in this paper are used as a helpful framework to demonstrate each of the ways in which the proposed reforms might affect complexity. using a different framework should not alter the ultimate conclusion that the proposed reforms would promote simplicity, in some respects, and at least not further complexity, in other respects. for example, professor schuck lists four factors that contribute to legal complexity: (1) density (which exists when understanding the rules that apply in a given context requires the expertise of a wide variety of legal specialties), (2) technicality (which exists when understanding and applying rules requires special sophistication and expertise), (3) differentiation (which exists when applicable rules are provided by different sources that have different bases for legitimacy – such as statutes and common law), and (4) indeterminacy or uncertainty. id. at 3-4. if the proposed reforms were analyzed under this framework, they would have no meaningful impact on factors (1) through (3), and they would reduce uncertainty. 2011] making partnerships work for mom and pop and everyone else 287 be taken to ensure that the rule does not apply. 124 this principle is relevant generally as well as in tax. with regard to ex ante complexity, if it were difficult to determine the effects of a rule on future activities but simple to adjust the future activities to ensure that a clearer rule applies, overall ex ante complexity would be fairly low. in tax, for example, under the treasury regulations that govern how entities are classified for tax purposes (the “check-the-box regulations”), certain entities are eligible to elect whether they will be treated as pass-through entities or corporations for u.s. tax purposes. 125 if an entity that is eligible to elect its classification does not file an election, it will be classified based on specified default rules. 126 unless a contrary election is filed, a u.s. domestic entity eligible to make an election is classified as a pass-through entity (i.e., a partnership or a disregarded entity) by default. 127 for non-u.s. entities, the default rule is less straightforward. a non-u.s. entity that is eligible to elect its classification is classified as a pass-through entity by default if at least one of its owners does not have limited liability but is classified as a corporation by default if all of its owners have limited liability. 128 determining with certainty whether or not applicable non-u.s. law provides owners of a non-u.s. entity with “limited liability,” as the term is defined in the u.s. treasury regulations, is not an easy proposition. at the very least, making such a determination would require consulting with and likely obtaining a costly opinion from non-u.s. legal counsel. however, it is unnecessary to incur costs to determine an entity‟s default classification because taxpayers can, instead, take the easy step of filing an entity classification election specifying the desired classification. 129 thus, even when the parties are fairly confident that their intended classification is consistent with the default classification based on their understanding of whether or not the entity offers limited liability, they often file an entity classification election on a protective basis. 130 with regard to ex post complexity, for example, if a given rule required onerous reporting requirements with respect to activities already undertaken but affected persons 124 see, e.g., richard a. epstein, simple rules for a complex world 25-27 (1995). the example professor epstein provides is the rule against perpetuities. thoughtfully examining whether the rule would apply to any given fact pattern can be time consuming, and a person taking such an approach risks reaching the incorrect result at the end of his or her analysis. however, a standard savings clause can be used as an expedient to ensure that the rule will not apply even if it would have applied absent inclusion of the savings clause. id. as professor epstein observes, the same principles apply any time parties can easily contract around a default rule. id. in particular, if contracting around a rule is easy, the rule is not complex as a practical matter even if it would take significant time and effort to understand the rule. 125 treas. reg. § 301.7701-3 (2010). 126 id. 127 id. 128 id. 129 this is not to say that the entity classification rules allow taxpayers to avoid the work of understanding the pass-through tax rules (or the corporate tax rules) because taxpayers can elect to treat an entity as a corporation (or as a pass-through entity). in order to evaluate which classification is desirable, taxpayers need to understand the tax consequences of each classification. however, once a taxpayer decides on the desired classification, the taxpayer can make a protective election in order to avoid the work of determining whether the entity would be treated as a corporation or a pass-through entity in the absence of making an election. 130 a similar example involves filing a protective election to apply the qualified electing fund (“qef”) rules to a non-u.s. corporation if it turns out to be classified as a passive foreign investment company (“pfic”). such elections are frequently filed when it is difficult to determine whether or not the corporation could become a pfic in the future. see, e.g., william m. funk, on and over the horizon: emerging issues in u.s. taxation of investments, 10 hous. bus. & tax l. j. 1, 22 (2010). 288 columbia journal of tax law [vol.2:247 were allowed to take easy steps to avoid the reporting requirements even after the activities have been undertaken, overall ex post complexity would be fairly low. b. length and technical nature of rules as contributing factors more technical rules increase ex ante complexity and ex post complexity, all else being equal. likewise, the length of potentially applicable law contributes to both types of complexity, all else being equal. the length and technical nature of rules contribute to ex ante complexity by making it more difficult to predict the effects of potential future actions. similarly, these factors contribute to ex post complexity by making it more difficult to assess the effects of past actions. other scholars have categorized rules as “technical” when understanding the rules requires special expertise. 131 i use the term in a similar way. thus, rules tend to be more technical when they are described (in statutes, regulations, case law, or other applicable sources) using language that includes terms of art or words defined in particular, unique ways. furthermore, the computational difficulty of rules contributes to their technical nature. in tax, ex post complexity related to computational difficulty can be significantly mitigated through use of computer programs. 132 however, use of computer programs does not necessarily reduce the likelihood that computational difficulty will result in certain costs associated with ex ante complexity. in particular, computationally difficult rules could lead to an increased likelihood of incurring costs that result because the decisions that affected persons make regarding future actions are not the same decisions that they would make if they fully understood the implications of relevant law. 133 nevertheless, as discussed below in part vi.a, computational difficulty does not invariably increase the likelihood of incurring such costs. c. conformity to expectations as a mitigating factor conformity to expectations can mitigate ex ante complexity. in particular, even if a rule is long and technical, as long as the rule conforms to expectations, the rule does not significantly increase the likelihood of incurring costs that result because the decisions that affected persons make regarding future actions are not the same decisions that they would make if they fully understood the implications of the rule. in other words, if a rule conforms to expectations, affected persons should make the same decisions that they would make if they fully understood the implications of the rule, even if the length and technical nature of the rule prevent affected persons from obtaining actual knowledge of the rule‟s specific terms. in order to illustrate, we can make the assumption that a person who runs a business treated as a partnership for tax purposes has some cursory knowledge of partnership tax even though he or she lacks expertise. 134 assume that his or her cursory knowledge encompasses awareness of the fact that partnerships are not taxed at an entity 131 schuck, supra note 123, at 3. 132 see, e.g., zelenak, supra note 120. 133 id. at 103 (arguing that computationally difficult rules turn the tax system into a black box, which is problematic for a number of reasons including the fact that it interferes with the “ability of taxpayers to engage in well-informed basic tax planning, and to respond appropriately to the many incentives congress has embedded in the tax laws.”). 134 this assumption is likely consistent with reality in many cases. 2011] making partnerships work for mom and pop and everyone else 289 level but instead allocate tax items to their partners. however, assume that the person has no knowledge of the highly technical rules that specify how tax items are shared among partners. under the facts assumed, it seems likely that the person would expect that tax items of a partnership would be shared among partners in a way that is consistent with how the partners share in economic gains and losses of the partnership, 135 and the person should have a fairly solid understanding of how economic gains and losses are shared since that is a business matter. the person‟s expectation about the sharing of tax items would work well as a rule of thumb since the consistency between tax and economics is the overall objective of the rules regarding allocation of tax items. thus, the person has a workable understanding of the results of the tax rules. moreover, the person understands the results of the rules fairly well even though the treasury regulations regarding partnership tax allocations are long and technical. 136 because of the length and technical nature of the regulations, the precise parameters of the rules remain unknown to the business person who leaves the computational exercise of applying the rules (i.e. coping with ex post complexity) to his or her tax accountants. nevertheless, the person has an operational understanding of the rules since the result of the rules conforms to the person‟s expectations. as professor zelenak argues, computers cannot solve everything that is wrong with computationally difficult rules because, while computers handle the arithmetic associated with computational difficulty (and thus mitigate ex post complexity), computers do not solve the potential problem of a lack of general understanding of technical rules (and thus have no effect on whether or not affected persons will take the rules into account when planning their activities). 137 as an example of a computationally difficult rule, professor zelenak discusses the phase-out that reduces otherwise allowable itemized deductions by the lesser of: (1) 3% of the excess of adjusted gross income over $100,000; or (2) 80% of otherwise allowable itemized deductions. 138 i would note that the reason computers cannot address the resulting lack of understanding (which can distort decision-making) is that: (1) the rule is formulated in a way that is specific and arbitrary; and (2) the rule is technical. because it is formulated in a way that is specific and arbitrary, the rule cannot be consistent with the expectations of an uninformed person. in other words, there is no reason why an uninformed person would have any intuitive estimate of the exact dollar amount at which a given phase-out sets in or the exact rate at which deductions are phased out because these parameters of the rule are inherently arbitrary. therefore, for a person to be assured of making the decisions he or she would make if he or she understood the rule, he or she would need to have knowledge of the exact specifications of the rule. this knowledge is difficult to obtain since it requires wading through technical rules. 135 such an expectation would be consistent with a general understanding that, subject to numerous exceptions, taxable income is intended to measure economic well being. 136 the applicable regulations under § 704(b) are approximately 70 pages long, and they use specialized terms of art like “capital account” and “substantiality.” 137 zelenak, supra note 120. 138 id. at 106 (citing § 68). 290 columbia journal of tax law [vol.2:247 d. uncertainty as a contributing factor uncertainty contributes to ex ante complexity and ex post complexity, all else being equal. uncertainty arises when a person who has a clear and correct understanding of all available legal authority still cannot confidently predict how the rules apply to a given set of facts. with respect to ex ante complexity, a person affected by uncertain rules has three choices: (1) leave his or her intended future actions unchanged but strive to change applicable law in a way that reduces uncertainty, (2) leave his or her intended future actions and the law unchanged and accept a lack of understanding of the outcome of legal rules (and therefore accept the risk of incurring costs that follow from a failure to design future activities with the relevant legal rules in mind), or (3) leave applicable law unchanged but modify intended future actions so that the consequences of the actions are no longer uncertain. uncertainty contributes to ex ante complexity because, under any of the three options just described, a person governed by uncertain law incurs costs. under the first option, a person incurs costs in order to change applicable law. in tax, such costs could include the expenses associated with obtaining a private letter ruling from the service. under the second option, a person accepts the risk of incurring costs that follow from a failure to design future activities as if the person had the relevant legal rules in mind. under the third option, a person changes his or her actions so that the legal result of his or her actions becomes certain. if the costs of changing a person‟s actions are low, this strategy involves easily avoiding an otherwise complex rule. in tax, for example, as discussed above, 139 a person could modify his or her actions by taking the inexpensive step of filing a protective entity classification election when the results that would follow from a failure to do so are uncertain. however, this third strategy can be costly if the costs of modifying future activities are high. in tax, for example, a taxpayer might face uncertainty regarding whether a given financial interest would be treated as debt or equity for tax purposes. if the taxpayer wants more certainty regarding the tax outcome, he or she may have to modify the economic terms of the instrument, which could be costly if the original terms were optimal for non-tax reasons. with respect to ex post complexity, a person affected by uncertain rules has two choices: 140 (1) work to change applicable law in a way that reduces uncertainty or (2) accept a lack of understanding of the outcome of legal rules (and therefore accept the costs that follow from a failure to report activities properly or insure against such costs). uncertainty contributes to ex post complexity because, under either of these options, a person governed by uncertain law incurs costs. under the first option, a person incurs costs in order to change applicable law. under the second option, a person either accepts costs that follow from a failure to report activities properly or incurs insurance costs. in tax, for example, a person could either accept the risk that his or her reported tax consequences will be successfully challenged (which could lead to penalties) or insure against that risk by, for example, obtaining an expensive legal opinion that could be one factor tending to provide some measure of protection against penalties in some circumstances. 139 see supra notes 125-130 and accompanying text. 140 since the relevant actions have already been undertaken, modifying future activities is no longer an option. 2011] making partnerships work for mom and pop and everyone else 291 e. factual information needed as a contributing factor a legal rule can contribute to ex ante complexity or ex post complexity if determining the proper application of the rule requires persons to gather information. this is only true, however, if the persons would not otherwise have the information readily available. vii. reforms would simplify law in some respects and, in other respects, make law no more complex requiring all partnerships to use the remedial method under § 704(c) and making basis adjustments mandatory regardless of whether a partnership has made an election under § 754 would reduce or at least not increase ex ante complexity and ex post complexity. 141 lawmakers have resisted these reforms on the grounds that the reforms would impose burdensome complexity on unsophisticated partnerships. 142 thus, current law generally allows all partnerships to elect between using the most accurate method (in other words, the remedial method in the context of § 704(c) and basis adjustments in the context of § 754) and using a less accurate method. current law is flawed for three reasons. first, requiring partnerships to use the most accurate method would reduce, or at least not increase, ex ante complexity. second, requiring partnerships to use the most accurate method would reduce, or at least not increase, ex post complexity. third, making the elections universally available ultimately bred more complexity. a. requiring partnerships to use the most accurate method would reduce, or at least not increase, ex ante complexity judged under each of the factors that affect ex ante complexity described above in part vi, mandatory use of the most accurate method would reduce, or at least not increase, ex ante complexity. in terms of the first factor that affects ex ante complexity, the current elective regime does not serve the purpose of allowing taxpayers to easily avoid an otherwise complex rule. regarding length, the proposed reforms would make law shorter. with respect to the technical nature of rules, for unsophisticated taxpayers who do not consult tax advisors prior to engaging in transactions, the effect on ex ante complexity is mitigated by the fact that the proposed reforms would lead to tax results more consistent with expectations. for unsophisticated taxpayers who do consult tax advisors prior to engaging in transactions or for sophisticated taxpayers, the reforms do not increase the technical nature of rules. the proposed reforms also reduce ex ante 141 laura e. cunningham & noel b. cunningham, simplifying subchapter k: the deferred sale method, 51 smu l. rev. 1 (1997) (arguing that the deferred sale method, similar to the remedial method, would be preferable to current law and could significantly simplify current law). see also monroe, supra note 84 (making a similar argument). for additional criticism of the current approach under § 754, see karen c. burke, repairing inside basis adjustments, 58 tax law. 639 (2004). this discussion of complexity is not intended to suggest that tax simplification is a goal that should be pursued without regard to other policy considerations, and, often tax simplification cannot be achieved without undermining other policy goals like fairness and prevention of tax abuse. however, it is also not the case that tax simplification is always at odds with these other goals. in the context of §§ 704(c) and 754, for example, the proposed reforms could simultaneously promote simplicity (or at least not make the law more complex) and further the goals of fairness and prevention of tax abuse. for discussion of the impact of tax elections on these other goals, see supra note 117 and for discussion of the impact of the proposed reforms on these other goals, see supra part v. 142 see supra parts ii and iv. 292 columbia journal of tax law [vol.2:247 complexity by reducing uncertainty. finally, the proposed reforms would not impose any additional information gathering requirements and, thus, would not increase ex ante complexity in that respect. 1. current law does not reduce ex ante complexity by allowing taxpayers to easily avoid an otherwise complex rule ex ante complexity plays a role at the time when taxpayers are deciding whether or not to engage in a given transaction. in the context of §§ 704(c) and 754, for example, ex ante complexity plays a role at the time that taxpayers are deciding whether or not to contribute property to a partnership, at the time that taxpayers are deciding whether or not a partnership should sell property, and at the time that a person is deciding whether or not to acquire an interest in a partnership. ex ante complexity is a measure of: (1) the costs that result from steps taken by taxpayers to ensure that the decisions they reach with respect to these transactions are the same decisions that they would reach if they fully understood the implications of relevant partnership tax law, and (2) the costs that result if the decisions that taxpayers reach with respect to these transactions are not the same decisions that they would reach if they fully understood the implications of relevant partnership tax law. the proposed reforms to § 704(c) could increase ex ante complexity if either of the two types of costs listed above were lower under the current regime in which taxpayers are allowed to elect to use the traditional method (thereby avoiding the remedial method) than under a regime in which taxpayers were required to use the remedial method. however, this is not the case. likewise, it is not the case that either of the two types of costs listed above would be lower under the current regime in which taxpayers are allowed to elect to avoid basis adjustments than under a regime in which taxpayers were required to make basis adjustments. some taxpayers will obtain actual knowledge (either directly or through an advisor) of the consequences that will result from a prospective transaction under applicable partnership tax law. these taxpayers incur the first type of cost related to ex ante complexity described above (in other words, costs that result from steps taken by taxpayers to ensure that the decisions they reach are the same decisions that they would reach if they fully understood the implications of relevant partnership tax law). these taxpayers are likely to be sophisticated taxpayers since they seek tax advice prior to engaging in a transaction and, therefore, they are not the type of taxpayers for whom lawmakers designed supposedly simple rules. in any event, the proposed reforms would, if anything, reduce the costs incurred by these taxpayers. in particular, if the remedial method under § 704(c) is required (or if partnerships are required to make basis adjustments), taxpayers or their advisors only need to predict the tax consequences of a prospective transaction that result from use of the remedial method (or that result if basis adjustments are made). if multiple methods are allowed, taxpayers or their advisors need to predict the tax consequences that would follow from a prospective transaction under each method (or with and without basis adjustments). 143 consequently, the elective 143 this concern is true of many explicit elections that affect tax consequences. see, e.g., field, supra note 84, at 27–30 (describing how elections create complexity because taxpayers must analyze the benefits and burdens of various alternatives); yin, supra note 117, at 130 (“[e]lections are inherently costly and complex for the taxpayer. the taxpayer must incur the transaction cost of evaluating all tax consequences of available options before making an informed choice.”); edward yorio, the revocability of 2011] making partnerships work for mom and pop and everyone else 293 nature of current law does not allow these taxpayers to reduce costs by avoiding the determination of results under the remedial method (or by avoiding the determination of results that follow when basis adjustments are made). other taxpayers will make a decision regarding future transactions without obtaining actual knowledge (either directly or through an advisor) of the consequences that will result from the transactions under applicable partnership tax law. taxpayers that make decisions in this way are likely to be unsophisticated taxpayers and, therefore, precisely the type of taxpayers for whom lawmakers designed supposedly simple rules. such taxpayers avoid the first type of cost related to ex ante complexity (namely, costs that result from steps taken by taxpayers to ensure that the decisions they reach are the same decisions that they would reach if they fully understood the implications of relevant partnership tax law). however, such taxpayers potentially incur the second type of cost related to ex ante complexity (namely, costs that result if the decisions that taxpayers reach are not the same decisions that they would reach if they fully understood the implications of relevant partnership tax law). a taxpayer who makes a decision without actual knowledge of partnership tax law will make the decision based on what he or she expects partnership tax law would provide. therefore, if partnership tax law provides for results that are more consistent with his or her expectations, he or she is less likely to incur the second type of cost related to ex ante complexity. as described below in part vii.a.4, consistency with expectations is more likely to occur under the proposed reforms. 2. the proposed reforms would reduce ex ante complexity by making applicable law shorter. shortening applicable law reduces ex ante complexity by making the tax consequences of future transactions easier to predict (at least for taxpayers who make such predictions based on actual knowledge of partnership tax law obtained directly or through an advisor). the proposed reforms would reduce the length of applicable law. in particular, requiring all partnerships to use the remedial method and requiring all partnerships to make basis adjustments in all cases would reduce the length of applicable statutes and regulations. this is the case since the reforms would obviate the need for provisions that: (1) describe other § 704(c) methods, (2) set forth the process for making a § 754 election, and (3) describe special rules that apply in the case of substantial builtin losses. thus, the proposed reforms would reduce ex ante complexity by making applicable law shorter. 3. the proposed reforms would not make the applicable rules meaningfully more technical for purposes of ex ante complexity. regarding the technical nature of rules, the remedial method may be slightly more computationally difficult than the traditional method. making basis adjustments is, admittedly, more computationally difficult than not making basis adjustments. nevertheless, the proposed reforms would not increase ex ante complexity. federal tax elections, 44 fordham l. rev. 463, 463-65 (1975) (describing how elections generally create complexity). see also lawrence lokken, as the world of partnership taxation turns, 56 smu l. rev. 365, 371 (arguing that requiring partnerships to use the remedial method would “simplify the law by eliminating both any need for taxpayers to evaluate competing options and any need for any anti-abuse rule to disallow overly aggressive uses of the alternative rules.”). see also supra note 129. 294 columbia journal of tax law [vol.2:247 as described above in part vii.a.1, even under current law, a taxpayer who obtains actual knowledge of partnership tax law (either directly or through an advisor) in order to fully evaluate a prospective transaction must cope with the computational difficulty of the remedial method or the computational difficulty of making basis adjustments as part of the process of obtaining a complete picture of future tax consequences. in other words, such a taxpayer would evaluate the tax consequences of the transaction under each of the available methods under § 704(c), including the remedial method. likewise, such a taxpayer would evaluate the tax consequences of a prospective transaction by assuming two alternative possibilities – one possibility that involves making basis adjustments and one possibility that involves not making basis adjustments. because such a taxpayer already evaluates the tax consequences that would follow from a transaction under the remedial method and under the assumption that basis adjustments are made, making the remedial method and basis adjustments mandatory would not exacerbate ex ante complexity for such a taxpayer. likewise, the proposed reforms would not exacerbate ex ante complexity for a taxpayer who makes decisions without actual knowledge of applicable law. this is so because the computational difficulty of applicable law has no effect on such a taxpayer‟s evaluation of future transactions. 4. the proposed reforms would lead to results that better conform to expectations. whether or not rules conform to the expectations of affected persons is most relevant with respect to taxpayers who make decisions regarding future transactions without acquiring actual knowledge of applicable law (directly or through an adviser). when taxpayers have no actual knowledge of applicable law, their decisions about future transactions will be based on their uninformed expectations about what applicable law provides. if these expectations are consistent with actual law, the decisions that the taxpayers make based on their expectations will be the same as decisions they would make if they had a complete and actual understanding of applicable law. therefore, if applicable law conforms to their expectations, these taxpayers will not incur the second type of cost related to ex ante complexity (namely, costs that result if the decisions that taxpayers reach are not the same decisions that they would reach if they fully understood the implications of relevant law). in addition, taxpayers who make decisions with respect to future transactions without acquiring actual knowledge of applicable law do not incur the first type of cost related to ex ante complexity (namely, costs that result from steps taken by taxpayers to ensure that the decisions they reach are the same decisions that they would reach if they fully understood the implications of relevant law). consequently, ex ante complexity will be low for these taxpayers as long as applicable law conforms to their expectations. as discussed above, 144 it seems fair to conclude that most people who own partnership interests, if they gave the matter any thought, would expect that partners in a partnership would share tax items in a way that coincides with how they share economic gains and losses. compared to the traditional method, the remedial method leads to results more consistent with this expectation since the remedial method provides for sharing tax items in a way that better coincides with how partners share economic gain 144 see supra notes 134-135 and accompanying text. 2011] making partnerships work for mom and pop and everyone else 295 and loss, as demonstrated by the examples in part i. similarly, basis adjustments lead to results more consistent with this expectation since basis adjustments result in each economic gain or loss generating only one matching tax gain or loss, as demonstrated by the examples in part iii. thus, the proposed reforms would lead to tax results that better conform to people‟s expectations and consequently would reduce ex ante complexity for taxpayers who make decisions with respect to future transactions without acquiring actual knowledge of applicable law. these taxpayers are more likely to be unsophisticated taxpayers and, therefore, precisely the type of taxpayers for whom lawmakers designed supposedly simple rules. 5. the proposed reforms would reduce uncertainty. the uncertainty inherent in applicable law can increase the costs associated with predicting the tax consequences of potential future transactions. this effect will be most pronounced for taxpayers whose predictions are based on actual knowledge (obtained either directly or through an adviser) of applicable law. such taxpayers will tend to be sophisticated and, consequently, not the type of taxpayers for whom lawmakers designed supposedly simple rules. in any event, the proposed reforms would decrease uncertainty, and therefore simplify the process of predicting the tax consequences of potential future transactions. regarding § 704(c), in some cases, ambiguities can arise under the traditional method in situations in which they do not arise under the remedial method. in other words, there are cases in which a complete and correct understanding of the treasury regulations does not lead to a clear tax result under the traditional method but does lead to a clear tax result under the remedial method. 145 regarding both §§ 704(c) and 754, the proposed reforms would mitigate uncertainty by reducing the number of instances in 145 for example, assume two individuals, a and b, form a new entity treated as a partnership for tax purposes. a contributes land with a tax basis of $750 and a fair market value of $1000, and b contributes $1000 cash. in a subsequent year, when the value of the land has increased to $1200, c contributes $2200 cash for a 50% interest in the partnership (diluting a‟s interest to 25% and b‟s interest to 25%). in a later year, the land is sold for $1100. if the partnership uses the remedial method for making § 704(c) allocations and reverse § 704(c) allocations with respect to the land, then the amount of tax gain and loss that must be allocated to each partner is clear. under the remedial method, each partner is allocated tax gain and loss in an amount that matches net economic gain and loss. net economic gain realized by a is $325 which is made up of (i) $250 gain realized prior to contributing the land to the partnership (ii) 50% of the $200 gain that accrued subsequent to contributing the land to the partnership but prior to c joining the partnership and (iii) 25% of the $100 loss that accrued after c joined the partnership. net economic gain realized by b is $75 which is made up of (i) 50% of the $200 gain that accrued after the partnership was formed but prior to c joining the partnership and (ii) 25% of the $100 loss that accrued after c joined the partnership. net economic loss realized by c is $50 which consists of 50% of the $100 loss that accrued after c joined the partnership. consequently, tax items allocated to each partner under the remedial method are: $325 tax gain to a, $75 tax gain to b, and $50 tax loss to c. the only item actually recognized by the partnership is $350 of tax gain from sale of the land, but the partnership invents a notional item of $50 of tax loss and an offsetting notional item of $50 of tax gain, so that the partnership has, in total, the proper amounts of tax items to allocate ($400 of tax gain and $50 of tax loss). the results if the partnership uses the traditional method for making § 704(c) and reverse § 704(c) allocations with respect to the land are not entirely clear. the only item that the partnership can allocate is $350 of tax gain. none of the gain should be allocated to c since c realized a net economic loss. however, it is not clear whether the tax gain should be allocated: (i) $75 to b (to fully match b‟s net economic gain) and $275 to a ($50 less than net economic gain realized), (ii) $25 to b ($50 less than net economic gain realized) and $325 to a (to fully match a‟s net economic gain) or (iii) in some combination that falls in between options (i) and (ii). 296 columbia journal of tax law [vol.2:247 which taxpayers might engage in transactions that raise the question of whether or not an inherently uncertain anti-abuse rule applies. 146 6. the proposed reforms would not impose any incremental information gathering requirements. the factual information needed to predict the tax consequences of a potential transaction under the remedial method (or if basis adjustments are made) is either the same factual information needed to predict tax consequences of the potential transaction under the traditional method (or without basis adjustments) or is information that the parties would have in any event. consequently, the proposed reforms would not increase ex ante complexity by imposing any additional information gathering requirements. b. requiring partnerships to use the most accurate method would reduce, or at least not increase, ex post complexity. judged under each of the factors that affect ex post complexity described above in part vi, 147 mandatory use of the remedial method and mandatory basis adjustments would reduce, or at least not increase, ex post complexity. in terms of the first factor that affects ex post complexity, the current elective regime does not serve the purpose of allowing taxpayers to easily avoid an otherwise complex rule. regarding length, the proposed reforms would make law shorter. with respect to the technical nature of rules, the effect on ex post complexity of any increase in computational difficulty would be mitigated by technological advances. the proposed reforms also reduce ex post complexity by reducing uncertainty. finally, the proposed reforms would not impose any additional information gathering requirements and, thus, would not increase ex post complexity in that respect. 1. current law does not allow taxpayers to easily avoid an otherwise complex rule. current law appears to be designed in an attempt to reduce ex post complexity by reducing the frequency with which computationally difficult rules apply. in particular, the goal of current law is apparently to allow taxpayers to avoid the computational difficulty associated with the remedial method in favor of the supposedly lesser computational difficulty associated with the traditional method and to allow taxpayers to avoid the computational difficulty associated with basis adjustments. 148 however, current law fails to meet this goal for two reasons. first, as a practical matter, the computational difficulty associated with the remedial method is no greater than the computational difficulty associated with the traditional method, and the computational difficulty associated with making basis adjustments is no greater than the computational difficulty of failing to do so for the reasons discussed in part vii.b.3 below. second, the 146 anti-abuse rules are inherently uncertain because they are, by their nature, open-ended. also, there are a number of unanswered questions regarding the anti-abuse rule in the § 704(c) regulations. see supra notes 58-61 and accompanying text. 147 conformity to expectations is not discussed in connection with ex post complexity because ex post complexity involves evaluating and reporting tax consequences of transactions that have already occurred. accurately reporting tax consequences requires actual knowledge of applicable tax law. therefore, expectations of uninformed taxpayers are not particularly relevant, except to the extent that applicable tax law is easier to interpret when it conforms to expectations. 148 see supra parts ii, iv. 2011] making partnerships work for mom and pop and everyone else 297 elective nature of the rules does not result in taxpayers avoiding the computational difficulty that would be undertaken if taxpayers were required to use the remedial method or make basis adjustments. this second point requires further elaboration. as discussed above, 149 a rule that might otherwise be complex is not, in fact, complex when people can take straightforward steps to avoid application of the rule. in theory, this proposition would suggest that, if the remedial method truly led to more onerous computations than the traditional method, then giving taxpayers the option to elect the traditional method would reduce ex post complexity. in practice, however, providing for an elective regime exacerbates ex post complexity because not only do taxpayers (or more accurately, their advisors) not avoid the work that would be required to compute results under the remedial method, but they also take on the work that would be required to compute results under the traditional method and the work of choosing between the two. in other words, if one method is required, partnerships (or their advisors) only need to apply that method. if multiple methods are allowed and if partnerships desire to make an informed choice about which method to use, partnerships (or their advisors) need to understand how all of the methods operate in order to select the method under which the results will be reported. 150 furthermore, under an elective regime, the service must devote resources necessary to cope with taxpayers using different methods rather than one method. the conclusion that the elective regime does not produce simplification can be more fully illustrated in the context of § 704(c) and § 754. a. section 704(c) it is possible to imagine a scenario under which the elective regime would produce simplification, if the computational difficulty associated with the traditional method truly was lower than the computational difficulty associated with the remedial method. in particular, one might imagine that a partnership that values simplification over the possibility of achieving an optimal tax outcome would attain simplicity by automatically opting for the traditional method, if it were associated with lower computational difficulty, rather than analyzing the results under all possible methods. however, as a practical matter, this scenario is highly unlikely to occur. first, properly reporting tax consequences that follow under the traditional method (like many other aspects of partnership tax law) requires sufficient technical expertise such that it is unlikely that an unsophisticated partnership would apply the traditional method without accounting or legal assistance. second, once an unsophisticated partnership seeks accounting or legal advice, it is likely that the accountant or lawyer will analyze the impact of all available methods. for one thing, the expert may be aware of the fact that reporting under the remedial method is no more difficult than doing so under the traditional method, so the remedial method should not be discarded out of hand. for another, the expert may be motivated by other factors such as a concern that a failure to provide advice about all realistic, available options could lead to the risk of a malpractice claim. 149 see supra notes 124-130 and accompanying text. 150 this concern is true of many explicit elections that affect tax consequences. see supra note 143. 298 columbia journal of tax law [vol.2:247 b. section 754 as is the case regarding § 704(c), an unsophisticated partnership may rely on an expert to analyze the question of whether or not to make a § 754 election. 151 in order to mitigate the risk of a malpractice claim, for example, the expert likely assesses both options. 152 2. the proposed reforms would make the law shorter. regarding length, as discussed above, 153 requiring all partnerships to use the remedial method and requiring all partnerships to make basis adjustments in all cases would reduce the length of applicable statutes and regulations. thus, the proposed reforms would reduce ex post complexity by shortening applicable law that must be analyzed by persons in order to properly report tax consequences. 3. the proposed reforms would not make the applicable rules meaningfully more technical. regarding the technical nature of rules, the remedial method may be slightly more computationally difficult than the traditional method in that it can involve more extensive bookkeeping. making basis adjustments is, admittedly, more computationally difficult than not making basis adjustments. however, with respect to ex post complexity, these effects are mitigated because any additional computations can be automated. likely, the fact that any computations can now be automated through the use of computer programs is a fact that the senate had in mind when it stated that the elective nature of basis adjustments is “anachronistic.” 154 thus, the proposed reforms would not increase the technical nature of rules in a way that meaningfully increases ex post complexity. 151 the question of whether to make a § 754 election to some extent involves ex ante complexity. once the election is made, it will generally apply to all transfers of partnership interests that occur during the taxable year with respect to which the election was filed and any future taxable years. i.r.c. § 754 (2010). therefore, making the election affects tax consequences of transactions that will happen in future years. however, despite the fact that the decision to make the election is, to some extent, forward-looking, even unsophisticated taxpayers may benefit from expert advice in connection with making the decision. this is the case because, at the time that the expert is consulted to evaluate how to report the tax consequences of the sale of a partnership interest, the expert may alert the unsophisticated partnership to the need to make a decision about whether or not to make a § 754 election. 152 moreover, if the expert does take a short cut in the analysis, it is likely that the expert would opt for automatically making the § 754 election (even though that is more computationally difficult). under current law, if the election is made then: (i) tax gains will not be duplicated and (ii) tax losses will not be duplicated. see supra part iii. if the election is not made then (i) tax gains will be duplicated and (ii) tax losses will not be duplicated (unless they are not captured by the substantial built-in loss rules). see supra part iii. therefore, if a shortcut is used in evaluating whether or not to make the election, the result will likely be making the election since (i) it avoids duplication of gains (which is better than what happens if the election is not made) and (ii) losses might not be duplicated in any event. 153 see supra part vii.a.2. 154 see supra note 113 and accompanying text. 2011] making partnerships work for mom and pop and everyone else 299 4. the proposed reforms would reduce uncertainty. as described above, 155 mandatory use of the remedial method and mandatory basis adjustments would decrease uncertainty. with respect to the remedial method, this is true because there are cases in which ambiguities can arise under the traditional method when they would not arise under the remedial method. 156 in addition, both mandatory use of the remedial method and mandatory basis adjustments would mitigate uncertainty by reducing the number of instances in which taxpayers undertake transactions that raise the question of whether or not an inherently uncertain anti-abuse rule applies. 157 as discussed above, reduced uncertainty decreases ex ante complexity because it is easier to decide whether or not to engage in a transaction when it is easier to predict the tax consequences of that transaction. likewise, reduced uncertainty decreases ex post complexity by making it easier to evaluate how to report a transaction once it has occurred. 5. the proposed reforms would not impose any incremental information gathering requirements. regarding §§ 704(c) and 754, partnerships should already have all the information they would need to report tax results under the proposed reforms. therefore, the proposed reforms would not affect this factor contributing to ex post complexity. in the context of § 704(c), one of the reasons the a.l.i. expressed concern about adopting a method similar to the remedial method was that it would require partnerships to value assets when they are contributed to a partnership. however, contrary to the view the a.l.i. seemed to espouse, 158 a partnership would need to value an asset at the time of contribution to the partnership even if the partnership was using the traditional method for making § 704(c) allocations. 159 in addition, a partnership needs to value an asset at the time it is contributed to a partnership in order to effectuate the economic deal among the partners. if a and b form a partnership, where a contributes land to the partnership, b contributes cash to the partnership, and the partners intend to share equally in the economic returns of the partnership, the partners will need to value the land in order to 155 see supra part vii.a.5. 156 see supra note 145 and accompanying text. 157 see supra note 146 and accompanying text. 158 see supra note 83 and accompanying text. 159 the a.l.i. indicated that, under a method like the traditional method, the partnership only needs to know the sales price and the basis of an asset to properly allocate tax items. id. this is simply untrue. to illustrate, assume a owns a piece of land that a acquired some time ago for $5,000. a contributes the land and b contributes cash to the newly formed ab partnership, each in exchange for a 50% interest in the ab partnership. assume the partnership sells the land for $10,000 in year 1. the partnership would recognize $5,000 of tax gain from sale of the land. assume the partnership uses the traditional method under § 704(c) for purposes of making tax allocations with respect to the land. if the land was worth $7,000 when a contributed it to the partnership, then the $5,000 tax gain should be allocated $1,500 to b (b‟s 50% share of the $3,000 increase in value of the land that occurred after it was contributed to the partnership) and $3,500 to a (a‟s 50% share of the $3,000 increase in value of the land that occurred after it was contributed to the partnership plus the $2,000 increase in value that occurred before it was contributed to the partnership). if the land was worth $12,000 when a contributed it to the partnership, then the proper tax allocations are quite different. in particular, all $5,000 of the tax gain should be allocated to a. in summary, simply knowing the sales price and the basis of the land is not enough to determine the proper tax allocations under the traditional method because the proper tax allocations also depend on the value of the property at the time it was contributed to the partnership. 300 columbia journal of tax law [vol.2:247 determine how much cash b should contribute. 160 likewise, in the case of reverse § 704(c) allocations, a partnership needs to value its assets at the time new partners join the partnership in order to determine how much the new partners must contribute for a given interest in the partnership. c. making the elections universally available ultimately bred more complexity. as discussed above, current law does not promote simplicity for unsophisticated partnerships relative to what would result if the law required all partnerships to use the remedial method and make basis adjustments. however, even if current law did promote simplicity for unsophisticated partnerships, only unsophisticated partnerships should be allowed to elect the less accurate (supposedly less complex) method. instead of limiting use of the less accurate method to unsophisticated partnerships, the ability to elect the less accurate method is universally available. in the context of § 704(c), until 1984, universal availability meant allowing all partnerships to avoid applying current § 704(c) principles if they so chose. after 1984, it meant allowing all partnerships to use the traditional method under § 704(c) rather than the more accurate remedial method. in the context of § 754, until 2004, universal availability meant granting all partnerships the option of avoiding making basis adjustments. after 2004, it meant giving all partnerships the flexibility to avoid making basis adjustments except in cases where a substantial built-in loss exists. the universal availability of the elections may reflect oversimplification. in particular, perhaps lawmakers took the view that it would be simpler to make the elections universally available than to attempt to distinguish between sophisticated and unsophisticated partnerships. moreover, lawmakers may have felt justified in doing so since partnerships were historically viewed as entities used by unsophisticated taxpayers. 161 however, as professor david weisbach has argued, lawmakers cannot design tax law based on the most common fact pattern. 162 professor weisbach explains why doing so would be problematic: “uncommon transactions that are taxed inappropriately become common as taxpayers discover how to take advantage of them.” 163 in other words, designing tax law with the typical case in mind results in an unstable system since what was the atypical case will become more typical as taxpayers adjust their transactions to take the rules into account. 160 professor monroe observes that, following the promulgation of the substantial economic effect regulations (which occurred after the a.l.i. issued its report), valuing property at the time of contribution was necessary in order for a partnership to maintain capital accounts in accordance with the substantial economic effect regulations. monroe, supra note 84, at 1433–34. yet, even prior to the issuance of these regulations, partnerships would need to value contributed property in order to properly carry out their economic deal. the a.l.i. report posited a hypothetical in which multiple partners each contribute property to a partnership that is not easy to value but the partners agree to treat the value of each parcel of property as equal. see american law institute federal income tax project, subchapter k proposals for changes in the rules for taxation of partners pt. f(d) (tent. draft no. 3, 1979). however, it is not clear how the partners would agree that the value of the properties were equal without having some reliable estimate of the value of each piece of property. 161 see supra note 3 and accompanying text. 162 david a. weisbach, formalism in the tax law, 66 u. chi. l. rev. 860 (1999). 163 id .at 869. 2011] making partnerships work for mom and pop and everyone else 301 in the context of §§ 704(c) and 754, partnerships might have originally been used by unsophisticated taxpayers who would use the elections, if at all, for the intended purpose of simplification. however, partnership tax rules designed with unsophisticated taxpayers in mind encouraged sophisticated taxpayers to form partnerships so that they could use the elections for the unintended purpose of tax liability reduction. over time, the unintended purpose became the more typical use of the rules. lawmakers took action to limit the ability to use the rules for the unintended purpose (by adopting anti-abuse rules), and anti-abuse rules increased complexity by increasing uncertainty and the length of applicable law. the end result is a system that may be more complex than what would have existed if lawmakers had limited the availability of the election to unsophisticated partnerships. furthermore, because the election does not further simplicity for unsophisticated partnerships, current law is more complex that what would have resulted if lawmakers had required use of the remedial method and required basis adjustments in all cases. viii. conclusion rules intended to simplify partnership tax law in order to cater to mom and pop partnerships have sometimes had the opposite effect – complicating partnership tax law and inadvertently catering to sophisticated partnerships by increasing opportunities for tax planning and abuse. in place of current law, reforms suggested by this paper would simplify partnership tax law, as shown by an examination of how tax rules can best promote simplicity. in addition, the reforms would reduce the potential for tax revenue loss and unfairness inherent under current rules. microsoft word hodaszy article [3] circular argument: what is wrong, and right, with the circular 230 “covered opinion” regulations steven z. hodaszy∗ introduction ................................................................................... 151 i. the definition of a “covered opinion” and the requirements for preparing covered opinions. ...................................................... 154 ii. the development of, and purpose behind, circular 230’s covered opinion regulations. ........................................................... 160 iii. the tax shelter market and the participation of attorneys in abusive tax shelters, which gave rise to the covered opinion regulations. ........................................................... 162 iv. the most common, and most significant, criticisms of the covered opinion regulations ............................................................ 169 a. the regulations are unduly complex .......................................... 170 b. the regulations impose prohibitive time and cost burdens ...... 170 c. the regulations impede communication between attorneys and clients, and prevent delivery of informal or piecemeal advice .......... 171 d. the regulations prevent practitioners from exercising professional judgment in distinguishing between important and unimportant tax issues ..................................................................................................... 172 e. the regulations are far too broad, and they capture much more than the tax shelter advice that they were intended to regulate ........ 174 f. the opt-out procedures and related non-reliance disclaimers also create certain problems ............................................................... 176 g. to address the problems with the non-reliance disclaimers, some commentators have recommended switching to an opt-in system in lieu of the opt-out approach .............................................................. 178 ∗ copyright © 2010 by steven z. hodaszy. the author has more than 17 years of experience as a practicing attorney and has worked in the areas of commercial finance, structured finance, and litigation. he completed an ll.m. in taxation at new york university school of law in 2010. the author wishes to thank professor carlton m. smith, of benjamin n. cardozo school of law and new york university school of law, for his very helpful comments on earlier drafts. he also wishes to express his gratitude to the editors and staff members of the columbia journal of tax law for their many useful insights and their valuable assistance with this article. any errors or omissions and all opinions are, of course, solely those of the author. 2011] circular argume�t 151 v. fixing what is wrong, and keeping what is right, with the covered opinion regulations ............................................................ 179 a. the basic framework of the regulations should be retained .... 179 1. effective regulations should enlist the aid of practitioners in deterring clients from engaging in abusive transactions .............. 180 2. thus far, the covered opinion regulations have effectively created a role for tax practitioners as “gatekeepers” to block abusive transactions ....................................................................... 182 3. new strict liability penalty for transactions without economic substance may undermine the covered opinion regulations’ effectiveness at creating a “gatekeeper” role for tax practitioners, but the regulations should still remain in force ............................ 184 b. “significant purpose” should be defined so that the regulations plainly cover only tax shelter advice, and do not apply to any other tax advice ............................................................................................ 190 c. calls to adopt an opt-in approach should be rejected .............. 192 d. after the regulations are narrowed to apply only to tax shelter advice, the opt-out system should also be done away with .......... 196 vi. conclusion .................................................................................. 202 introduction if there is one thing that virtually all tax attorneys have in common, it is their extreme distaste for the “covered opinion” regulations under treasury department circular no. 230 (“circular 230”).1 those regulations, which are set forth in § 10.35 of circular 230 (the “covered opinion regulations”),2 have been in effect since june 20, 2005,3 and they apply to the provision of written tax advice by any attorney or other practitioner permitted to practice before the internal revenue service (the “irs”).4 when the regulations were first published, they were met with a 1. the circular 230 regulations are set forth at 31 c.f.r., subtitle a, part 10— practice before the internal revenue service. as described in 31 c.f.r. § 10.0 (scope of part), circular 230 “contains rules governing the recognition of attorneys, certified public accountants, enrolled agents, and other persons representing clients before the internal revenue service,” including, inter alia, “rules relating to authority to practice before the internal revenue service” and prescriptions of “the duties and restrictions relating to such practice.” 31 c.f.r. § 10.0 (2010). 2. 31 c.f.r. § 10.35 (2010). 3. circular 230 § 10.35 “applies to written advice that is rendered after june 20, 2005.” 31 c.f.r. § 10.35(g) (2010). 4. circular 230 § 10.35(a) provides that any “practitioner who provides a covered opinion shall comply with the standards of practice in” section 10.35. 31 c.f.r. § 10.35(a) (2010). a “practitioner” for this purpose is defined in circular 230 § 10.35(b)(1) as “any individual described in § 10.2(a)(5).” 31 c.f.r. § 10.35(b)(1) (2010). section 10.2(a)(5), in turn, defines “practitioner” as “any individual described in paragraphs (a), (b), (c), or (d) of § 10.3.” 31 c.f.r. § 10.2(a)(5) (2010). those paragraphs relate to attorneys, certified public accountants, enrolled agents, and enrolled actuaries, respectively. 31 c.f.r. columbia jour�al of tax law [vol 2:150 152 mountain of criticism, and they have not grown more popular in the years since. the covered opinion regulations have been attacked as unduly onerous, overly broad, and inimical to the provision of sound tax advice in a number of ways. as we mark their fifth-year anniversary, we should take the occasion to reexamine the covered opinion regulations and reconsider whether their benefits justify their burdens. after five years, how well do the regulations serve their intended purpose? at the same time, are the regulations’ detriments indeed as great as their many critics assert? should we discard the covered opinion regulations altogether, as some have suggested, or is there some compelling need for oversight of tax opinion practice (or, at least, a portion of that practice) that militates in favor of retaining some version of the regulations? if the latter is the case, how should we improve upon the regulations, so that they fulfill their intended function without causing the harms that their critics allege? finally, to what extent might the need for, the effectiveness of, and the required structure of the covered opinion regulations change as a result of strictliability penalty provisions that were recently added to the internal revenue code (the “code”) in conjunction with the newly-codified economic substance doctrine? this article addresses these questions. the covered opinion regulations impose extensive due diligence obligations and detailed drafting requirements on practitioners with respect to written advice on tax matters. part i of the article outlines these copious rules. the regulations were promulgated in order to combat tax practitioners’ support of abusive tax shelters through the delivery of unsound legal opinions, as noted in part ii. during the rise of the corporate tax shelter market in the 1990s, as described in part iii, a surprising number of tax practitioners employed dubious due diligence, analytical, and drafting techniques to prepare incomplete and misleading tax opinions which concluded that abusive shelters were legitimate. the covered opinion regulations were introduced to stem these unscrupulous and harmful opinion practices. in their current form, however, the covered opinion regulations pose myriad significant, and often unnecessary, obstacles to the practice of tax law. these problems, which have been raised by tax practitioners and tax scholars alike, are discussed in part iv of the article. a practitioner can “opt out” of compliance with the covered opinion regulations in some (though not all) cases, but the opt-out rules present problems of their own. § 10.3(a)-(d) (2010). section 10.3(a) provides that “[a]ny attorney who is not currently under suspension or disbarment from practice before the internal revenue service may practice before the internal revenue service by filing with the internal revenue service a written declaration that the attorney is currently qualified as an attorney and is authorized to represent the party or parties.” 31 c.f.r. § 10.3(a) (2010). 2011] circular argume�t 153 in the face of these concerns, a number of commentators contend that the covered opinion regulations should simply be repealed altogether. many others support the peculiar alternative of replacing the current opt-out rules with an “opt-in” regime, under which the regulations would not apply to any practitioner unless he or she voluntarily chooses to comply. these may be simple and tempting solutions to the hassles that the current regulations pose, but i believe that both of these approaches are ultimately misguided. while they might dispense with unnecessary obstacles to the practice of tax law in general, they would also eliminate necessary impediments to the promotion of abusive tax shelters through dishonest legal opinions. there has to be some meaningful regulation of tax shelter opinions; otherwise, experience indicates that too many practitioners will be enticed by market forces to render unsound opinions in support of illegitimate shelters. up until now, the covered opinion regulations have not only effectively deterred such opinion practices; they have actually established tax practitioners as “gatekeepers” who restrain taxpayers from engaging in abusive transactions. unfortunately, going forward, this “gatekeeper” function might be undermined by a recently enacted strict-liability penalty for transactions without economic substance. yet that result is not a foregone conclusion at this point; and, even if the regulations become unable to do as much in the future to encourage good taxpayer behavior, they will still remain absolutely necessary to impede bad practitioner behavior. for all of these reasons, as detailed in part v.a, i argue that some version of the covered opinion regulations must be retained. however, the regulations’ scope must be narrowed substantially, in order to stop the regulations from intruding into routine tax practice in ways that are unwarranted and counterproductive. perhaps the greatest criticism of the covered opinion regulations is that they are grossly overbroad, applying not only to tax shelter opinions (as originally intended) but to virtually all routine, legitimate tax planning advice, as well. this problem is the worst because it magnifies the effects of all of the others. accordingly, in part v.b of the article, i propose a significant and specific textual reform to the covered opinion regulations that would restrict their focus to opinion practice in the tax shelter area. if this revision were adopted, the problems discussed in part iv would cease to infect all aspects of legitimate tax counseling. instead, the regulations would impose only warranted restrictions on unscrupulous practice in the tax shelter context. part v.c of the article explains why it would be a mistake to adopt the opt-in approach advocated by many commentators, particularly if the covered opinion regulations are appropriately narrowed to cover only tax shelter opinions. part v.d argues that, for similar reasons, the current optout rules should be repealed once the regulations are narrowed in the way that part v.b suggests. granting practitioners an option to avoid compliance with rules proscribing egregious tax shelter opinion practices would be bad policy in any event, but eliminating any such option will be columbia jour�al of tax law [vol 2:150 154 critical to the continued functioning of the regulations if the new strict liability penalty for transactions lacking economic substance becomes the predominant penalty for abusive tax shelters. part vi is the conclusion of the article. i. the definition of a “covered opinion” and the requirements for preparing covered opinions. as every member of the tax bar probably knows all too well, the covered opinion regulations impose extensive, rigorous requirements for written advice (including e-mails) concerning federal tax issues arising from (1) “[a] transaction that is the same as or substantially similar to” any transaction determined by the irs “to be a tax avoidance transaction and identified” as such in published guidance (a “listed transaction”),5 (2) “[a]ny partnership or other entity, any investment plan or arrangement, or any other plan or arrangement, the principal purpose of which is the avoidance or evasion of any tax imposed” under the code (a “principal purpose transaction”),6 or (3) “[a]ny partnership or other entity, any investment plan or arrangement, or any other plan or arrangement, a significant purpose of which is the avoidance or evasion of any tax imposed” under the code (a “significant purpose transaction”),7 if the written advice concerning the significant purpose transaction is (a) “a reliance opinion;”8 (b) “a marketed opinion;”9 (c) “subject to conditions of confidentiality;”10 or (d) “subject to contractual protection.”11 5. 31 c.f.r. § 10.35(b)(2)(i)(a) (2010). 6. 31 c.f.r. § 10.35(b)(2)(i)(b) (2010). 7. 31 c.f.r. § 10.35(b)(2)(i)(c) (2010). 8. under circular 230, “[w]ritten advice is a reliance opinion if the advice concludes at a confidence level of at least more likely than not (a greater than 50 percent likelihood) that one or more significant federal tax issues would be resolved in the taxpayer’s favor.” 31 c.f.r. § 10.35(b)(4)(i) (2010). a “federal tax issue” is defined under circular 230 as “a question concerning the federal tax treatment of an item of income, gain, loss, deduction, or credit, the existence or absence of a taxable transfer of property, or the value of property for federal tax purposes.” 31 c.f.r. § 10.35(b)(3) (2010). in turn, a federal tax issue is “significant” if the irs “has a reasonable basis for a successful challenge and its resolution could have a significant impact, whether beneficial or adverse and under any reasonably foreseeable circumstance, on the overall federal tax treatment of the transaction(s) or matter(s) addressed in the opinion.” id. 9. circular 230 defines written advice to be a “marketed opinion” if the practitioner who provides the advice “knows or has reason to know that the written advice will be used or referred to by a person other than the practitioner (or a person who is a member of, associated with, or employed by the practitioner's firm) in promoting, marketing or recommending a partnership or other entity, investment plan or arrangement to one or more taxpayer(s).” 31 c.f.r. § 10.35(b)(5) (2010). 10. “written advice is subject to conditions of confidentiality if the practitioner imposes on one or more recipients of the written advice a limitation on disclosure of the tax treatment or tax structure of the transaction and the limitation on disclosure protects the confidentiality of that practitioner's tax strategies, regardless of whether the limitation on disclosure is legally binding.” 31 c.f.r. § 10.35(b)(6) (2010). 2011] circular argume�t 155 those three classes of transactions are intended collectively to capture all undertakings that may constitute abusive tax shelters. (one fundamental question is whether they in fact capture much more than that). listed transactions comprise the narrowest of the three groups; they are the transactions that the irs has already identified as abusive. the other two classes are intended to include abusive transactions that the irs has not yet discovered, but wants to stop. in setting parameters as to what is or is not a principal purpose transaction, the regulations make clear that a partnership, other entity, plan or other arrangement does not have a principal purpose of avoiding or evading federal tax “if that partnership, entity, plan or arrangement has as its purpose the claiming of tax benefits in a manner consistent with the [code] and congressional purpose.”12 of course, an undertaking that is not a principal purpose transaction may nevertheless be a significant purpose transaction. indeed, the regulations emphasize that a “partnership, entity, plan or arrangement may have a significant purpose of avoidance or evasion even though it does not have the principal purpose of avoidance or evasion.”13 importantly, in contrast to the principal purpose standards, the regulations do not say that a transaction will not be deemed to have a significant purpose of tax avoidance or evasion if its purpose is to claim tax benefits in a manner consistent with the code and congressional purpose.14 particularly when juxtaposed against that express limitation in the “principal purpose” definition, the absence of such a limitation in defining “significant purpose” suggests that significant purpose transactions may technically include even ordinary, well-established tax minimization strategies that are intended by congress, expressly permitted under the code, and plainly not abusive. while nevertheless troublesome, this omission from the “significant purpose” definition is almost certainly not intended to capture ordinary tax planning in such a way. rather, it is more likely just a result of the fact that the “significant purpose” language in the covered opinion regulations tracks (almost verbatim) the broad definition of “tax shelter” in § 6662 of the code, which imposes accuracy-related penalties on certain underpayments of tax.15 11. circular 230 refers to written advice as subject to contractual protection “if the taxpayer has the right to a full or partial refund of fees paid to the practitioner (or a person who is a member of, associated with, or employed by the practitioner's firm) if all or a part of the intended tax consequences from the matters addressed in the written advice are not sustained, or if the fees paid to the practitioner (or a person who is a member of, associated with, or employed by the practitioner's firm) are contingent on the taxpayer's realization of tax benefits from the transaction.” 31 c.f.r. § 10.35(b)(7) (2010). 12. 31 c.f.r. § 10.35(b)(10) (2010). 13. id. 14. see 31 c.f.r. § 10.35(b)(2)(i)(c) (2010). 15. compare 31 c.f.r. § 10.35(b)(2)(i)(c) (2010) and 31 c.f.r. § 10.35(b)(10) (2010) with i.r.c. § 6662(d)(2)(c)(ii) (2010). see steven m. weiser, circular 230 compliance: a guide for the �on-tax attorney, 34 colo. law. 29, 32 (2005) (noting that columbia jour�al of tax law [vol 2:150 156 written advice that comes within any of the categories outlined above is defined in circular 230 as a “covered opinion.”16 for any written advice that constitutes a covered opinion, the covered opinion regulations set forth stringent standards that the practitioner preparing the advice must meet with respect to (1) finding or assuming the relevant facts, (2) relating the applicable law to the relevant facts, (3) evaluating significant federal tax issues, in particular, and (4) reaching an overall conclusion as to the likely federal tax treatment of the transaction to which the advice relates.17 regarding factual matters, circular 230 requires the practitioner to “use reasonable efforts to identify and ascertain the facts . . . to determine which facts are relevant . . . [and to] consider all facts that the practitioner determines to be relevant.”18 the practitioner is prohibited from “bas[ing] the opinion on any unreasonable factual assumptions,” which include any “factual assumption that the practitioner knows or should know is incorrect or incomplete.”19 nor may the practitioner base the opinion on any unreasonable factual representations, statements or findings of the taxpayer or any other person, including any “factual representation that the practitioner knows or should know is incorrect or incomplete.”20 as a primary example of an impermissible factual assumption or the improper reliance on someone else’s factual representation, the covered opinion regulations specifically provide that a practitioner may not rely on a general assumption “that a transaction has a business purpose or that a transaction is potentially profitable apart from tax benefits,”21 and a practitioner may not rely on a taxpayer’s representation “that a transaction has a business purpose if the representation does not include a specific description of the business purpose or the practitioner knows or should know that the representation is incorrect or incomplete.”22 a covered opinion must identify, in separate sections, each factual assumption that the practitioner makes and each factual representation of the taxpayer on which the practitioner relies.23 the compliance-with-code-and-purpose exception exists under the “principal purpose” standard but not under the “significant purpose” standard). 16. 31 c.f.r. § 10.35(b)(2)(i) (2010). 17. the complete requirements for covered opinions are set forth in 31 c.f.r. § 10.35(c) (2010). 18. 31 c.f.r. § 10.35(c)(1)(i) (2010). relevant facts that must be considered may include facts that “relate to future events if a transaction is prospective or proposed.” id. 19. 31 c.f.r. § 10.35(c)(1)(ii) (2010). as described under circular 230, “[a] factual assumption includes reliance on a projection, financial forecast or appraisal.” id. therefore, circular 230 provides that “[i]t is unreasonable for a practitioner to rely on a projection, financial forecast or appraisal if the practitioner knows or should know that the projection, financial forecast or appraisal is incorrect or incomplete or was prepared by a person lacking the skills or qualifications necessary to prepare such projection, financial forecast or appraisal.” id. 20. 31 c.f.r. § 10.35(c)(1)(iii) (2010). 21. 31 c.f.r. § 10.35(c)(1)(ii) (2010). 22. 31 c.f.r. § 10.35(c)(1)(iii) (2010). 23. see id.; 31 c.f.r. § 10.35(c)(1)(ii) (2010). 2011] circular argume�t 157 once the practitioner appropriately identifies the relevant facts, he or she must relate the applicable law to those facts.24 in so doing, the practitioner not only must consider all relevant provisions of the code and the treasury regulations thereunder, but must also take into account any “potentially applicable judicial doctrines.”25 with certain limited exceptions,26 the practitioner “must not assume the favorable resolution of any significant federal tax issue,”27 and he or she may not “otherwise base an opinion on any unreasonable legal assumptions, representations, or conclusions.”28 moreover, the practitioner’s opinion “must not contain internally inconsistent legal analyses or conclusions.”29 unless the opinion is a “limited scope opinion” as defined under circular 230 § 10.35(c)(3)(v)(a),30 and except to the extent that the practitioner permissibly relies on the legal opinion of another practitioner with respect to certain matters,31 “[t]he opinion must consider all significant federal tax issues,”32 and it “must provide the practitioner’s conclusion as to the likelihood that the taxpayer will prevail on the merits with respect to each significant federal tax issue” so considered.33 in the text of the opinion, the practitioner must describe the reasons for his or her conclusions, “including the facts and analysis supporting the conclusions” or, alternatively, he or she must “describe the reasons that the practitioner is 24. see 31 c.f.r. § 10.35(c)(2)(i) (2010). 25. id. 26. in certain circumstances, a practitioner is permitted to deliver opinions that are limited to the consideration of fewer than all significant federal tax issues, and practitioners may also (within certain limits) rely on the legal opinions of others with respect to some significant federal tax issues. for further discussion of limited scope opinions and permitted reliance on opinions of others, see infra notes 30-31. 27. 31 c.f.r. § 10.35(c)(2)(ii) (2010). 28. id. 29. 31 c.f.r. § 10.35(c)(2)(iii) (2010). 30. circular 230 permits a practitioner to provide written advice on a transaction that covers fewer than all significant tax issues related to the transaction (a “limited scope opinion”) if (1) the taxpayer and the petitioner agree as to the scope of the opinion and (2) they agree that the taxpayer may rely on the opinion for purposes of defending against the assessment of penalties imposed by the code only with regard to the tax issues actually addressed in the opinion. see 31 c.f.r. § 10.35(c)(3)(v)(a)(1) (2010). a limited scope opinion is not permissible, however, if the transaction to which the opinion relates is a listed transaction or a principal purpose transaction or if the opinion is otherwise a “marketed opinion.” see 31 c.f.r. § 10.35(c)(3)(v)(a)(2) (2010). any limited scope opinion must contain a legend stating that, “[w]ith respect to any significant federal tax issues outside the limited scope of the opinion, the opinion was not written, and cannot be used by the taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer.” 31 c.f.r. § 10.35(e)(3)(iii) (2010). 31. in rendering his or her covered opinion, a “practitioner may rely on the opinion of another practitioner with respect to one or more significant federal tax issues” as long as he or she “identif[ies] the other opinion and . . . the conclusions reached” therein, unless “the practitioner knows or should know that the opinion of the other practitioner should not be relied on.” 31 c.f.r. § 10.35(d)(1) (2010). 32. 31 c.f.r. § 10.35(c)(3)(i) (2010). for a description of what constitutes a “significant federal tax issue” under circular 230, see supra note 8. 33. 31 c.f.r. § 10.35(c)(3)(ii) (2010). columbia jour�al of tax law [vol 2:150 158 unable to reach a conclusion as to one or more issues.”34 if an opinion fails to reach a conclusion at a confidence level of at least more-likely-than-not that the taxpayer will prevail on the merits with respect to one or more significant federal tax issues, the opinion must highlight that fact and must prominently state that the taxpayer cannot use the opinion to avoid the imposition of penalties arising from those issues.35 when evaluating a taxpayer’s chance of success on the merits as to any significant federal tax issue addressed in the opinion, the practitioner is specifically prohibited from considering “the possibility that a tax return will not be audited, that an issue will not be raised on audit, or that an issue will be resolved through settlement if raised.”36 a practitioner may not provide a “marketed opinion” at all unless he or she is able to conclude with a confidence level of at least more-likely-than-not that the taxpayer will prevail on the merits with respect to each significant federal tax issue arising from the transaction to which the opinion relates.37 finally, a covered opinion must include “the practitioner's overall conclusion as to the likelihood that the federal tax treatment [that the taxpayer is taking] of the transaction or matter that is the subject of the opinion is the proper treatment,” and the practitioner must describe in the opinion his or her “reasons for that conclusion.”38 alternatively, if a practitioner cannot reach such an overall conclusion, the opinion may generally contain a statement to that effect and, in that case, it must include an explanation “for the practitioner's inability to reach a conclusion.”39 if the opinion is a “marketed opinion,” however, failing to reach such a conclusion is not an option. for any “marketed opinion,” not only must the practitioner reach a conclusion “that the federal tax treatment of the transaction or matter that is the subject of the opinion is the proper treatment,” he or she must do so at a confidence level of at least morelikely-than-not.40 the sanctions that may be levied against practitioners who violate the covered opinion regulations are severe. “[t]he irs has the ability to censure, disbar, or suspend a tax advisor from practice before the irs, and may impose monetary penalties for noncompliance with [those] regulations.”41 circular 230 § 10.50 provides that the secretary of the 34. id. “if the practitioner is unable to reach a conclusion with respect to one or more [significant federal tax] issues, the opinion must state that the practitioner is unable to reach a conclusion with respect to those issues. . . . if the practitioner fails to reach a conclusion at a confidence level of at least more likely than not with respect to one or more significant federal tax issues considered, the opinion must include the appropriate disclosure(s) required under” circular 230. id. the provisions concerning such disclosures are contained in 31 c.f.r. § 10.35(e). 35. see 31 c.f.r. § 10.35(c)(4) (2010), 31 c.f.r. §10.35(e)(4) (2010). 36. 31 c.f.r. § 10.35(c)(3)(iii) (2010). 37. 31 c.f.r. § 10.35(c)(3)(iv) (2010). 38. 31 c.f.r. § 10.35(c)(4)(i) (2010). 39. id. 40. 31 c.f.r. § 10.35(c)(4)(ii) (2010). 41. weiser, supra note 15, at 37. 2011] circular argume�t 159 treasury (and, by extension, the irs, as his or her delegate) may exercise the general authority to “censure, suspend, or disbar any practitioner from practice before the [irs] if the practitioner . . . fails to comply with any regulation” within circular 230, including (without limitation) the covered opinion regulations.42 circular 230 § 10.52 further provides that “[a] practitioner may be sanctioned . . . [for w]illfully violat[ing]” virtually any of the circular 230 regulations,43 or for violating the covered opinion regulations, in particular, either “[r]ecklessly or through gross incompetence.”44 in addition to these sanctions, the american jobs creation act of 2004 (the “jobs act”),45 “permit[s] the irs to impose monetary penalties on a tax practitioner” for violations of the covered opinion regulations.46 “the amount of the monetary penalty can be as much as 100 percent of the gross income derived from the conduct giving rise to the penalty. in other words, the irs can penalize a lawyer for an amount equal to the gross fees received from the provision of the tax advice to the client.”47 furthermore, if the practitioner who provides the sanctionable advice does so on behalf of a firm (or on behalf of any other employer or other entity for which the practitioner acts as agent), and if that firm or other entity knew or reasonably should have known of the practitioner’s conduct, then the firm or other entity is also subject to the same monetary penalties.48 42. 31 c.f.r. § 10.50(a) (2010). “censure,” as referred to in § 10.50, “is a public reprimand.” id. 43. 31 c.f.r. § 10.52(a)(1) (2010). circular 230 § 10.52(a)(1) specifically excludes impositions of sanctions for willful violations of circular 230 § 10.33, which sets forth aspirational (rather than mandatory) best practices for tax advisors. 44. 31 c.f.r. § 10.52(a)(2) (2010). circular 230 § 10.52 was added as part of a substantial set of amendments to circular 230 contained in final regulations that the secretary adopted in december 2004 (the “december 2004 amendments”) (published at 69 fed. reg. 75,839-45 (dec. 20, 2004)). it is unclear whether the “willful, reckless or gross incompetence” standard established under that section sets a minimum threshold for the imposition of sanctions for violations of the covered opinion regulations, or whether sanctions may be imposed for any such violation (even if the violation is not due to willfulness, recklessness or gross incompetence) pursuant to circular 230 § 10.50. on one hand, § 10.50 obviously cannot be ignored; on the other hand, if § 10.52 does not establish such a threshold as to what constitutes sanctionable conduct, then § 10.52 would seem to be largely superfluous in light of the preexisting authority to sanction under § 10.50. 45. american jobs creation act of 2004, pub. l. no. 108-357, 118 stat. 1418 (2004). 46. linda z. swartz & jean marie bertrand, circular 230 and tax shelters in 2008, 857 pli/tax 193, 251 (feb. 2009) (citing § 882(b) of the jobs act, amending 31 u.s.c. § 330(b)). 47. weiser, supra note 15, at 37 (footnote omitted) (citing 31 u.s.c. § 330(b)). 48. see swartz & bertrand, supra note 46, at 251; weiser, supra note 15, at 37. “[f]actors that may be relevant to determining whether a monetary penalty should appropriately be imposed on an employer include (i) the gravity of the misconduct, (ii) any history of noncompliance by the employer, (iii) preventative measures in effect prior to the misconduct’s occurrence, and (iv) any corrective measures taken by the employer after it discovers the misconduct.” swartz & bertrand, supra note 46, at 252 n.226 (citing notice 2007-39, 2007-20 i.r.b. 1243). columbia jour�al of tax law [vol 2:150 160 when providing a significant purpose transaction opinion that is either a “reliance opinion” or a “marketed opinion,” a practitioner can opt out of the requirement to follow the covered opinion regulations if he or she prominently49 places certain disclaimers on the opinion. written advice concerning a significant purpose transaction that otherwise comes within the definition of a “reliance opinion”50 will not be treated as such for purposes of the regulations “if the practitioner prominently discloses in the written advice that it was not intended or written by the practitioner to be used, and that it cannot be used by the taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer.”51 (such a disclosure is referred to herein as a “non-reliance disclaimer.”) advice that would otherwise constitute a “marketed opinion”52 concerning a significant purpose transaction will not be treated as such under the regulations if it prominently contains both a non-reliance disclaimer and a disclosure to the effect that “[t]he advice was written to support the promotion or marketing of the transaction(s) or matter(s) addressed by the written advice [and that the] taxpayer should seek advice based on the taxpayer's particular circumstances from an independent tax advisor.”53 a practitioner cannot opt out of compliance with the covered opinion regulations by including a non-reliance disclaimer (or by any other means) if he or she provides a listed transaction opinion, a principal purpose transaction opinion or a significant purpose transaction opinion that is either subject to conditions of confidentiality or subject to contractual protection.54 ii. the development of, and purpose behind, circular 230’s covered opinion regulations. under 31 u.s.c. § 330, the secretary of the treasury is authorized to regulate the practice of tax representatives before the treasury department.55 in 1966, pursuant to that grant of authority, the secretary 49. the standards for “prominent” disclosure are set forth in circular 230 § 10.35(b)(8). 50. for the definition of “reliance opinion” under circular 230, see supra note 8. 51. 31 c.f.r. § 10.35(b)(4)(ii) (2010). 52. for the definition of “marketed opinion” under circular 230, see supra note 9. 53. 31 c.f.r. § 10.35(b)(5)(ii) (2010). 54. provisions specifying that written advice will not be treated as a covered opinion if the appropriate disclaimers are prominently included are set forth in the definitions of “reliance opinion” and “marketed opinion” and those provisions expressly do not apply in the context of opinions concerning either listed transactions or principal purpose transactions. see 31 c.f.r. §§ 10.35(b)(4)(ii) and 10.35(b)(5)(ii) (2010). no similar rules for excepting written advice from the scope of the “covered opinion” definition exist in the provisions governing listed transaction opinions or principal purpose transaction opinions, nor do they exist within the provisions for opinions subject to conditions of confidentiality or to contractual protection. see 31 c.f.r. §§ 10.35(b)(2)(i)(a), 10.35(b)(2)(i)(b), 10.35(b)(6), and 10.35(b)(7) (2010). 55. weiser, supra note 15, at 29 (citing 31 u.s.c. § 330). 2011] circular argume�t 161 promulgated circular 230, at 31 c.f.r. part 10.56 the general purpose of circular 230 is to set forth rules (1) governing the authority of attorneys, certified public accountants, enrolled agents, and other persons to represent clients before irs, (2) prescribing duties and restrictions of such persons in their practice before the irs, and (3) providing for discipline of any such persons who violate those duties or restrictions.57 since they were originally published, the circular 230 regulations have been amended a number of times.58 the most recent significant amendments to circular 230 are contained in final regulations that the secretary adopted in december 2004 (the “december 2004 amendments”).59 the december 2004 amendments added a number of regulations that establish “aspirational standards of tax practice and . . . standards and requirements concerning the provision of tax advice.”60 among those added standards and requirements are the covered opinion regulations. while those additions arguably would have exceeded the secretary’s original regulatory authority pursuant to 31 u.s.c. § 330, the secretary was granted specific authority to promulgate the covered opinion regulations and the other december 2004 amendments by the jobs act,61 which president bush signed into law in october 2004.62 section 822(b) of the jobs act added 31 u.s.c. § 330(d), “which provides that ‘[n]othing . . . shall be construed to limit the authority of the secretary of the treasury to impose standards applicable to the rendering of written advice . . . which is of a type which the secretary determines as having a potential for tax avoidance or evasion.’”63 at the time when the jobs act became law, treasury had already issued proposed regulations in 2003 that largely mirrored the final december 2004 amendments.64 thus, the jobs act “merely codified what the secretary had already expressed an intention 56. see juan f. vasquez, jr. & jaime vasquez, section 10.35(b)(4)(ii) of circular 230 is invalid (but just in case it is valid, please �ote that you cannot rely on this article to avoid the imposition of penalties), 7 hous. bus. & tax l. j. 293, 298 (2007); weiser, supra note 15, at 29. 57. 31 c.f.r. § 10.0 (2010) (scope of part). 58. see vasquez & vasquez, supra note 56, at 298; weiser, supra note 15, at 29. 59. 69 fed. reg. 75,839-45 (dec. 20, 2004) (cited in weiser, supra note 15, at 29 n.5 and vasquez & vasquez, supra note 56, at 298 n.28). 60. weiser, supra note 15, at 29. 61. american jobs creation act of 2004, pub. l. no. 108-357, § 822(b), 118 stat. 1418 (2004). the grant of such authority apparently was intended to extend only to regulations governing opinions specifically regarding tax shelters, however. see infra note 139 and accompanying text. 62. see weiser, supra note 15, at 29; vasquez & vasquez, supra note 56, at 299-300. 63. vasquez & vasquez, supra note 56, at 300 (quoting pub. l. no. 108-357, § 822(b), 118 stat. 1418, 1587 (2004)). 64. those proposed regulations were published at 68 fed. reg. 75,186 (proposed dec. 30, 2003). columbia jour�al of tax law [vol 2:150 162 to do; that is, regulate the issuance of tax advice with regard to tax shelter transactions.”65 indeed, the purpose behind the covered opinion regulations and the other december 2004 amendments is to “combat tax shelters and enhance public ‘confidence in the honesty and integrity’ of tax professionals.”66 the objective of the covered opinion regulations, in particular, “was to limit the use of opinion letters in tax shelter offerings.”67 more specifically, the covered opinion regulations “are intended to deter taxpayers from engaging in abusive transactions by limiting or eliminating their ability to avoid penalties through inappropriate reliance on a tax advisor’s advice.”68 to accomplish this, the regulations seek to “make it more burdensome for tax professionals to provide written opinions that clients can use in attempting to avoid monetary penalties when their daring attempts to save tax are disallowed.”69 in addition, the covered opinion regulations “are aimed at preventing unscrupulous tax advisors and promoters from marketing abusive transactions to large numbers of customers . . . based on an opinion that fails to consider adequately the facts of the particular transaction.”70 in this regard, the regulations are particularly concerned with discouraging tax attorneys and other tax advisors “from actively promoting aggressive tax avoidance strategies . . . to persons who are not their existing clients.”71 iii. the tax shelter market and the participation of attorneys in abusive tax shelters, which gave rise to the covered opinion regulations. treasury and the irs were spurred to bolster their efforts to combat abusive transactions by the marked increase in tax shelter72 activity during 65. weiser, supra note 15, at 29 (citing 68 fed. reg. 75,186, 75,186-87 (proposed dec. 30, 2003). 66. deborah l. paul, �ew york state bar association tax section report on circular 230, reprinted at 794 pli/tax 9, 15 (oct.-nov. 2007) (quoting preamble to the december 2004 amendments). 67. deborah h. schenk, the circular 230 amendments: time to throw them out and start over, 110 tax notes 1311, 1312 (mar. 20, 2006) (citation omitted). 68. paul, supra note 66, at 15. 69. casey r. law, the circular file: dealing with the 2005 amendments to treasury department circular 230 without contracting disclaimer mania, 76 j. kan. b. ass’n 24, 25 (sept. 2007). 70. paul, supra note 66, at 15. 71. law, supra note 69, at 25. 72. one reason why tax shelters are so challenging to regulate is that they are difficult to define. the code’s definition of “tax shelter” is in § 6662(d)(2)(c)(ii). that definition has been criticized as less than illuminating, because it is too broad and imprecise to provide proper guidance as to whether a particular transaction falls inside or outside of its scope. indeed, it is possible to construe the definition as capturing a wide range of deals that it presumably was not intended to cover. the definition includes any plan or arrangement for which a “significant purpose” is the avoidance or evasion of federal income tax, and that description arguably applies to almost “anything a tax lawyer advises a client to do.” scott 2011] circular argume�t 163 the 1990s. although a large tax shelter market initially developed during the late 1970s and early 1980s, congress “effectively eradicated the first wave of tax shelters” in 1986, when it passed the code provisions that prohibit offsetting ordinary income against passive losses.73 those tax shelters, however, were targeted primarily to middle-income individuals.74 accordingly, the passive loss reforms did little to slow the growth of the market for corporate tax shelters, which flourished over the decade that followed.75 the rise of the corporate tax shelter market stemmed in part from the fact that, during the 1990s, corporate tax departments came under increasing pressure not only to perform traditional legal compliance functions, but also to become profit centers.76 as corporate managements searched for evermore ways to reduce expenses, the drive to find new methods to decrease their firms’ tax liabilities garnered added attention. simply put, “[u]nder a basic cost-benefit analysis, purchasing tax shelters made sense financially.”77 at the same time, changes in the legal and accounting industries in the 1990s increased the willingness of tax attorneys and accountants to participate in the development and promotion of corporate tax shelters.78 law firms “became more entrepreneurial, and ‘consulting’ became one of the largest parts of accounting firm practices.”79 as they increased their focus on consulting, the big accounting firms became among the most active promoters of corporate tax shelters. they developed complex shelters and marketed them to literally hundreds of clients on a contingency-fee basis (the fee being based on the amount of tax saved), often making tens of millions of dollars on a single shelter.80 lawyers who refrained from participating directly in the development and marketing of tax shelters, nevertheless participated in the profits by providing opinion a. schumacher, mac�iven v. westmoreland and tax advice: using “purposive textualism” to deal with tax shelters and promote legitimate tax advice, 92 marq. l. rev. 33, 58 (2008). an often-quoted, more colloquial “tax shelter” definition was introduced by professor michael graetz. professor graetz famously described a tax shelter as “‘[a] deal done by very smart people that, absent tax considerations, would be very stupid.’” id. at 5758 (citation omitted). while that definition well reflects the spirit of what a tax shelter is, it too is of limited help in determining whether a particular transaction constitutes a shelter. 73. tanina rostain, sheltering lawyers: the organized tax bar and the tax shelter industry, 23 yale j. on reg. 77, 83 (2006). 74. id. see also schumacher, supra note 72, at 55 (in contrast to current tax shelters, which “are invested in by high net-worth individuals and corporations . . . the shelters of the 1970s were invested in by thousands of individuals, including middle-class taxpayers”); camilla e. watson & brooks d. billman, jr., federal tax practice and procedure—cases, materials and problems 137 (2005) (discussing “mass-marketing of tax shelters to middle class americans” in the 1970s). 75. see rostain, supra note 73, at 83. 76. see id. at 86. 77. id. 78. see schumacher, supra note 72, at 53. 79. id. 80. see rostain, supra note 73, at 88. columbia jour�al of tax law [vol 2:150 164 letters with respect to the shelters promoted by the accountants.81 “at the height of the shelter market, fees for opinion letters ran into the hundreds of thousands of dollars, with some even commanding $1 million or more.”82 the prospect of such enormous fees made the temptation to traffic in questionable, overly-aggressive tax advice simply too great to resist for a surprisingly large number of professionals.83 while earlier tax shelter activity had previously been confined largely to professionals “at the periphery” of their professions, advisors involved in the more recent shelters “worked for some of the most prestigious accounting and law firms.”84 this unholy alliance between prominent attorneys and accountants produced a rapid proliferation of more sophisticated,85 more potentially lucrative,86 and arguably more abusive corporate tax shelters than had ever been seen before.87 the success of these dubious enterprises depended particularly on the provision of the tax attorneys’ legal opinions. attorneys’ opinions have long been considered to be essential elements of such schemes because, up until now, they have effectively operated as insurance policies against penalties that might otherwise have been assessable under the code against tax shelter investors if the investors’ reported losses from the shelters are disallowed.88 if a taxpayer relies on an attorney’s legal opinion in taking a reporting position that ultimately results in an underpayment of tax, the opinion is generally considered to provide reasonable cause for the underpayment (provided that the opinion meets certain minimum requirements under applicable treasury regulations), and the taxpayer’s reliance thereon is generally considered to constitute action in good faith with respect to the underpayment, for purposes of invoking the exception under § 6664(c)(1)89 to the imposition of a 20% accuracy-related penalty 81. see id. at 92. 82. id. at 94 (citations omitted). 83. see schumacher, supra note 72, at 53. 84. id. at 55. 85. see, e.g., id. at 53-54 (discussing newly developed corporate finance techniques, such as new financial instruments, special-purpose entities and off-shore arrangements used to facilitate corporate tax shelters). 86. see id. at 55 (noting that magnitude of losses claimed by investors in more recent tax shelters “dwarfs” losses generated by 1970s shelters, and citing examples). 87. see generally rostain, supra note 73, at 88-94 (outlining “the rise of the tax shelter market” during the 1990s, providing examples of notable abusive corporate shelters of the period, and discussing the respective roles of attorneys and accountants in the development of the market); meah rothman tell, circular 230: beware the jabberwock!, 80 fla. b. j. 39 (2006) (discussing several high-profile examples of abusive tax shelters promoted by prominent accounting firms and supported by the legal opinions of prominent law firms); schumacher, supra note 72, at 53-56 (describing “the rise of mega tax shelters” and the participation of attorneys and accountants therein). 88. see rostain, supra note 73, at 92-93; schenk, supra note 67, at 1312. 89. section 6664(c)(1) of the code provides that “[n]o penalty shall be imposed under section 6662 or 6663 with respect to any portion of an underpayment if it is shown that there was a reasonable cause for such portion and that the taxpayer acted in good faith with respect to such portion.” i.r.c. § 6664(c)(1) (2010). treasury regulation § 1.6664-4 sets 2011] circular argume�t 165 for underpayments under § 666290 or the 75% fraud penalty under § 6663.91 (similarly, with certain exceptions, reliance on certain legal opinions can be asserted to invoke the heightened reasonable-cause-and-good-faith exception to the 20% accuracy-related penalty under § 6662a(a)92 that has applied since 2004 to understatements arising from “reportable transactions”93). forth rules for whether the reasonable-cause-and-good-faith exception applies in particular circumstances. in general, the rules provide for a facts-and-circumstances-based determination. see treas. reg. § 1.6664-4(b) (2010). there are special rules, however, for determining whether the exception applies in the case of substantial understatement penalties attributable to tax shelter items of corporations. see treas. reg. § 1.6664-4(f) (2010). in addition to the general facts-and-circumstances test, those special rules expressly provide that that reasonable cause may be established through reliance in good faith on the opinion of a professional tax advisor, but only if that opinion meets certain minimum requirements. treas. reg. § 1.6664-4(f)(2) (2010). 90. section 6662 of the code provides, inter alia, for the imposition of a penalty in the amount of 20% of any portion of an underpayment of tax that is attributable to “negligence” (as defined in § 6662(c)) or a “substantial understatement of income tax” (as defined in § 6662(d)). see i.r.c. § 6662 (2010). 91. section 6663 of the code provides for the imposition of a penalty in the amount of 75% of any portion of an underpayment of tax that is attributable to fraud. see i.r.c. § 6663(a) (2010). 92. section 6662a(a) of the code provides for the imposition of a penalty in the amount of 20% of any portion of a “reportable transaction understatement.” see i.r.c. § 6662a(a) (2010). a “reportable transaction understatement” is an underpayment of tax that results from or is facilitated by a reportable transaction, as calculated according to a formula set forth in § 6662a(b). see i.r.c. § 6662a(b)(1) (2010). under § 6664(d) of the code, a penalty under § 6662a will not be imposed “with respect to any portion of a reportable transaction understatement if it is shown that there was a reasonable cause for such portion and that the taxpayer acted in good faith with respect to such portion.” see i.r.c. § 6664(d)(1) (2010). however, to fall within this protection, a taxpayer must meet certain requirements that make the reasonable-cause-and-good-faith exception to the § 6662a penalty somewhat more stringent than the reasonable-cause-and-good-faith exception to the § 6662 and § 6663 penalties provided by § 6664(c)(1) and the treasury regulations thereunder. the § 6664(d) requirements include that (a) the taxpayer adequately disclosed the reportable transaction in question, (b) there was substantial authority for the taxpayer’s tax treatment of the reportable transaction, and (c) the taxpayer reasonably believed that such treatment was more likely than not the proper treatment. see i.r.c. § 6664(d)(3) (2010). the rules relating to what constitutes a “reasonable belief” in this context, including rules specifically addressing legal opinions on which reliance can and cannot be placed, are set forth in § 6664(d)(4). see i.r.c. § 6664(d)(4) (2010). notwithstanding the general rule of § 6664(d)(1), no reasonable cause exception to the imposition of a § 6662a(a) penalty is available in the case of any portion of a reportable transaction understatement that arises from a transaction to which a § 6662(b)(6) penalty applies because the transaction lacks economic substance under the newly-codified economic substance doctrine. see i.r.c. § 6664(d)(2) (2010). for a discussion of the recent codification of the economic substance doctrine, see infra note 99 and accompanying text. for a discussion of the related strict liability penalty for transactions without economic substance, see infra notes 187-99 and accompanying text. 93. a “reportable transaction” is defined under the code as a transaction with respect to which information must be included on a participant’s tax return because the secretary has determined, pursuant to regulations prescribed under § 6011, that the transaction has “a potential for tax avoidance or evasion.” i.r.c. § 6707a(c)(1) (2010). in accordance with those regulations, the irs has promulgated a list of categories of reportable transactions, as columbia jour�al of tax law [vol 2:150 166 of course, there traditionally have been certain exceptions to the availability of legal opinions as penalty defenses, and those exceptions are likely to increase in the future. since 2004, one exception has been that reliance on a legal opinion cannot provide a defense against imposition of the 30% penalty under § 6662a(c) that applies to understatements related to undisclosed reportable transactions.94 moreover, as discussed further below, the extent to which reliance on a legal opinion will be grounds for a reasonable-cause-and-good-faith defense against accuracy-related penalties asserted in any future tax shelter case has recently been called into some question by the march 2010 enactment of the § 6662(b)(6) strict liability penalty with respect to transactions that contravene the newly-codified economic substance doctrine.95 nevertheless, the ability to invoke reliance on a legal opinion as a part of a defense against penalties certainly has been, and potentially will continue to be, 96 a significant consideration for investors contemplating participation in tax shelters. to which a participant must disclose information on a form 8886 filed together with the participant’s return. the categories of reportable transactions are: listed transactions, transactions subject to conditions of confidentiality, transactions subject to contractual protections, loss transactions (i.e., transactions that generate losses in excess of certain specified thresholds, which vary depending on whether the claimant of the loss is an individual, corporation or partnership), and so-called transactions of interest (which are transactions that the same as, or substantially similar to, ones that the irs has specifically identified as having potential for tax avoidance or evasion). see irs instructions for form 8886 (rev. mar. 2010) (reportable transaction disclosure statement) at 1-3. 94. section 6662a(c) of the code provides (or, at least, is intended to provide) for the imposition of a penalty in the amount of 30% of any portion of a reportable transaction understatement arising from a reportable transaction that the taxpayer did not adequately disclose in accordance with regulations under § 6011 (i.e., a transaction that was not disclosed on a form 8886). specifically, § 6662a(c) provides that the 30% penalty applies “to the portion of any reportable transaction understatement with respect to which the requirement of section 6664(d)(2)(a) is not met.” i.r.c. § 6662a(c) (2010). prior to march 30, 2010, § 6664(d)(2)(a) referenced the requirement for adequate disclosure, in accordance with regulations prescribed under § 6011, of relevant facts affecting the tax treatment of an item of income. however, as a result of amendments to § 6664(d) that became effective on march 30, 2010 in connection with the codification of the economic substance doctrine, the former § 6664(d)(2)(a) was redesignated as § 6664(d)(3)(a). compare i.r.c. § 6664(d)(3)(a) (as amended in 2010), with i.r.c. § 6664(d)(2)(a) (2009). in what was presumably a drafting oversight in connection with the march 30, 2010 amendments, the cross-reference in § 6662a(c) was not updated accordingly. nevertheless, the context makes clear that the 30% penalty is still intended to apply to reportable transaction understatements arising from transactions that were not adequately disclosed pursuant to § 6011. (for a description of what constitutes a “reportable transaction understatement,” see supra note 92). the penalty under § 6662a(c) is a strict liability penalty. the reasonable-cause-and-good-faith exception under § 6664(d) is expressly inapplicable in cases where the reportable transaction at issue was not adequately disclosed. see i.r.c. § 6664(d)(3)(a) (2010). this abolition of, inter alia, “penalty protection for opinion letters in connection with reportable tax shelters that are not properly disclosed and are later found to be abusive” was enacted in 2004 as part of the jobs act. rostain, supra note 73, at 108 (citations omitted). 95. see infra notes 187-99 and accompanying text. 96. see infra text accompanying notes 194-99 (discussing potential limits in the irs’s application of § 6662(b)(6) and the corresponding potential for remaining vitality of other 2011] circular argume�t 167 to arrive at a level of comfort they needed in order to deliver opinions on the overly aggressive transactions that they were blessing, tax attorneys in the 1990s often used techniques that skirted the boundaries of sound professional judgment, if not professional ethics.97 first, they adopted a hyper-textual approach to the construction and application of the tax laws. that is, they focused solely on whether the proposed tax treatment of a given transaction could technically be argued to come within the literal terms of the code, without taking account of the legislative history or purpose of the provisions in question, and without giving effect to judicially-created anti-abuse doctrines such as the business purpose and economic substance doctrines.98 (the economic substance doctrine was accuracy-related penalties—which have reasonable-cause-and-good-faith exceptions—in the tax shelter context). 97. prior to the covered opinion regulations under circular 230, the only professional ethical guidance to attorneys specifically in relation to tax shelter opinions was found in the american bar association’s formal opinion 346, which was released in 1982. see a.b.a. comm. on ethics and prof. resp., formal op. 346 (1982). a detailed analysis of formal opinion 346 is beyond the scope of this article. for useful discussions of that opinion, see, e.g., david t. moldenhauer, circular 230 opinion standards, legal ethics and first amendment limitations on the regulation of professional speech by lawyers, 29 seattle u. l. rev. 843, 868-70 (2006); david j. moraine, loyalty divided: duties to clients and duties to others—the civil liability of tax attorneys made possible by the acceptance of a duty to the system, 63 tax law. 169, 182-84 (2009). though one may debate the theoretical superiority or inferiority of the standards set forth in formal opinion 346 relative to the covered opinion regulations, one conclusion is inescapable: the aspirational standards in that opinion had been wholly ineffective at deterring the conduct described below. 98. see rostain, supra note 73, at 94; schumacher, supra note 72, at 56. the business purpose doctrine and the economic substance doctrine are among “a cluster of overlapping doctrines, dating back to the 1930s, that courts . . . developed to disallow the tax benefits of abusive transactions.” rostain, supra note 73, at 84-85. (the substance-over-form and steptransaction doctrines are also in this group). “the economic substance doctrine was, if not formulated, then at least popularized by learned hand in the second circuit’s 1934 decision of gregory v. helvering.” david p. hariton, sorting out the tangle of economic substance, 52 tax law. 235, 241 (1999) (citing gregory v. helvering, 69 f.2d 809 (2d cir. 1934), aff’d, 293 u.s. 465 (1935)). that doctrine has since “played a particularly important role in the government’s fight against corporate tax shelters.” joseph bankman, the economic substance doctrine, 74 s. cal. l. rev. 5, 6 (2000). the doctrine’s basic premise “is that a court may deny the tax benefits achieved by a business transaction where the transaction itself lacks any economic benefit without regard to the tax benefits.” jeffrey c. glickman & clark r. calhoun, the “states” of the federal common law tax doctrines, 61 tax law. 1181, 1183 (2008). in one often cited case, the tax court explained the economic substance doctrine as follows: the tax law . . . requires that the intended transactions have economic substance separate and distinct from economic benefit achieved solely by tax reduction. the doctrine of economic substance becomes applicable, and a judicial remedy is warranted, where a taxpayer seeks to claim tax benefits, unintended by congress, by means of transactions that serve no economic purposes other than tax savings. acm p’ship v. comm’r, 73 t.c.m. (cch) 2189, 2215 (1989), aff’d in part and rev’d in part, 157 f.3d 231 (3d cir. 1998), cert. denied, 526 u.s. 1017 (1999) (quoted in glickman & calhoun, supra note 98 at 1183). thus, the doctrine dictates that a transaction will not be recognized for tax purposes if it does not provide a potential for economic gain to the taxpayer—apart from any tax considerations or consequences. see rostain, supra note 73, columbia jour�al of tax law [vol 2:150 168 codified on march 30, 2010, at § 7701(o) of the code.99 prior to that time, it was strictly a common-law doctrine.) indeed, the attorneys’ opinions often contained express qualifications such as, “‘in giving this opinion, we do not consider the application of the doctrines of economic substance and business purpose.’”100 at 85. the economic substance doctrine consists of two “separate, but interrelated, inquiries.” bankman, supra note 98 at 9 (citing acm p’ship, 157 f.3d at 247-48). the first inquiry is an objective test that focuses on “‘‘whether the transaction has any practical economic effects other than the creation of income tax losses.’’” id. (quoting acm p’ship, 157 f.3d at 248 (quoting jacobson v. comm’r, 915 f.2d 832, 837 (2d cir. 1990))). the second inquiry “explicitly incorporates the business purpose doctrine.” bankman, supra note 98 at 9. the business purpose doctrine “is the subjective inquiry into the taxpayer’s intent to enter into a transaction, and a taxpayer must show that it had an independent nontax purpose for the transaction.” glickman & calhoun, supra note 98, at 1189. in other words, the business purpose doctrine asks: does the taxpayer have a reason—other than tax avoidance—for doing the deal? in short, the transaction will be respected for tax purposes only if the answer is “yes.” see rostain, supra note 73, at 85. over time, courts developed differing views as to whether both the objective and subjective tests always need to be satisfied and whether to respect transactions that satisfy only one of the tests. see sarah b. lawsky, probably? understanding tax law’s uncertainty, 157 u. pa. l. rev. 1017, 1033 (2009). these inconsistencies sparked many calls for the codification of the doctrines over the years. see leandra lederman, w(h)ither economic substance?, 95 iowa l. rev. 389, 391 (2010). ultimately, as discussed below, the economic substance doctrine was incorporated in the code in march 2010. in any event, the economic substance and business purpose doctrines reflect the fundamental theory that tax deductions under the code “should apply only to activities aimed at income generation,” given that the basic aim of the code is to “tax income minus the cost of generating it.” rostain, supra note 73, at 86 (citations omitted). 99. section 7701(o) of the code, entitled “clarification of economic substance doctrine,” was added as part of the health care and education reconciliation act of 2010, which president obama signed into law on march 30, 2010. section 7701(o) provides that “[i]n the case of any transaction to which the economic substance doctrine is relevant, such transaction shall be treated as having economic substance only if—(a) the transaction changes in a meaningful way (apart from federal income tax effects) the taxpayer’s economic position, and (b) the taxpayer has a substantial purpose (apart from federal income tax effects) for entering into such transaction.” i.r.c. § 7701(o)(1) (2010). the new code section defines “economic substance doctrine” as the “common law doctrine under which tax benefits . . . with respect to a transaction are not allowable if the transaction does not have economic substance or lacks a business purpose.” i.r.c. § 7701(o)(5)(a) (2010). the section specifically provides that the threshold question of “whether the economic substance doctrine is relevant to a transaction shall be made in the same manner” as if the new law “had never been enacted.” i.r.c. § 7701(o)(5)(c) (2010). one commentator suggests that this latter provision “should mean that for the most part, the law has not changed.” monte a. jackel, dawn of a �ew era: congress codifies economic substance, 129 tax notes 289, 296 (apr. 19, 2010). however, an express requirement, in all cases, that the present value of a transaction’s reasonably expected pre-tax profit be “substantial” in relation to the present value of the transaction’s expected net tax benefits (see i.r.c. § 7701(o)(2)(a) (2010)) is one change to the common law doctrine. jackel, 129 tax notes at 296. moreover, because the new section does not define what constitutes a change “in a meaningful way” in a taxpayer’s economic position, or what constitutes a “substantial” purpose for entering into a transaction, it is too early to tell whether those concepts introduce any significant changes to the economic substance doctrine. see id. section 7701(o) applies to transactions consummated after march 30, 2010. 100. david m. schizer, enlisting the tax bar, 59 tax l. rev. 331, 362-63 (2006). 2011] circular argume�t 169 second, the attorneys frequently relied on unsupported or unreasonable factual assumptions or factual representations.101 many times, these were general, unsubstantiated representations or assumptions that the transaction in question had a legitimate business purpose apart from tax considerations or that the transaction had the potential to produce economic profit before taking into account any tax effects. for example, an attorney’s opinion would simply state something to the effect that, “‘in giving this opinion, we rely on your representation that there is a realistic possibility to make a pretax profit.’”102 other times, there would just be a blanket assumption in the opinion (without any back-up) that all statements in the offering circular for the tax shelter were correct.103 third, the attorneys would sometimes render “partial opinions, ” in which they would address only some of the federal tax issues arising in a transaction. they would speak to those issues as to which they could reach a favorable conclusion, and they would simply ignore those that were problematic or inconvenient (stating, in the process, that the opinion was limited solely to the matters expressly mentioned).104 because most investors “tended to focus primarily on the opinion’s conclusion that the tax benefits were allowable,” they usually failed to consider the various qualifications and conditions upon which the opinions were rendered, and they were thus “misled into believing that the tax benefits were legitimate.”105 it was in order to eliminate these practices, which had become so widespread and which had facilitated so many abusive tax shelters during the preceding decade, that the december 2004 amendments to circular 230 introduced requirements for tax advisors to consider all relevant facts and to rely only on reasonable factual assumptions and representations, to relate all relevant law (including judicial anti-abuse doctrines) to those facts, and to address all pertinent federal tax issues, when providing covered opinions.106 iv. the most common, and most significant, criticisms of the covered opinion regulations when the covered opinion regulations were first announced, they were met with virtual screams of protest from practicing tax attorneys and tax law scholars, and that criticism has not abated in the years since the regulations took effect. 101. id. at 362. 102. id. 103. see watson & billman, supra note 74, at 137. 104. see id. at 138. 105. id. at 137. 106. see schizer, supra note 100, at 363. columbia jour�al of tax law [vol 2:150 170 a. the regulations are unduly complex as an initial matter, even before considering the substance of the rules that the regulations impose, the language and organization of the covered opinion regulations have been disparaged as unworkably complex. critics maintain that the regulations are unnecessarily complicated, “with numerous defined terms and overlapping standards and definitions.”107 they complain that, before providing any written advice to a client, an attorney must spend an inordinate amount of time sifting through various arcane regulatory provisions to try to figure out which categories his or her opinion may come within, which exceptions or opt-out provisions may be relevant, and which requirements therefore apply to his or her project.108 as a consequence, tax attorneys may actually have to spend more time deciphering the rules that govern their opinions than they spend considering the substance of the tax matters on which they are opining.109 according to the critics, simply forcing tax attorneys to focus so much time and attention on the form and procedure for opinion-giving, when they should instead be thinking about “real” tax issues, may itself diminish the quality of the advice that the attorneys ultimately provide.110 b. the regulations impose prohibitive time and cost burdens from here, things only get worse according to the regulations’ many detractors. assume that a client asks to receive—or that an attorney determines that it would be prudent to provide—written advice with respect to a particular tax matter. if, after combing through the covered opinion regulations, a practitioner concludes that his or her written advice would constitute a covered opinion (as will very often be the case111), then the regulations require the practitioner to provide a full-blown opinion that satisfies the exacting due diligence and drafting standards set forth in circular 230 § 10.35(c).112 of course, if the advice constitutes a “reliance opinion” that relates to a significant purpose transaction, the practitioner can opt out of compliance with the § 10.35(c) regulations by including a prominent non-reliance disclaimer in the opinion.113 however, while such disclaimers have become commonplace, there are significant 107. schumacher, supra note 72, at 63. 108. see, e.g., paul, supra note 66, at 17-18. 109. see id. at 18; schumacher, supra note 72, at 63. 110. see schumacher, supra note 72, at 63; paul, supra note 66, at 17-18. 111. this is because virtually any written tax advice has the potential to come within the broad scope of a significant purpose transaction opinion. 112. see weiser, supra note 15, at 29-30. 113. for a description of what constitutes a “reliance opinion” under circular 230, see supra note 8. it is also possible to opt out of compliance with the circular 230 § 10.35(c) regulations in the case of a “marketed opinion” that relates to a significant purpose transaction by including both a non-reliance disclaimer and certain other disclaimers. for a description of what constitutes a “marketed opinion” under circular 230, see supra note 9. for a description of the covered opinion regulations’ opt-out provisions, see supra notes 49-54 and accompanying text. 2011] circular argume�t 171 drawbacks to them (as discussed further below).114 moreover, the possibility of opting out of compliance with § 10.35(c) does not even exist in the case of opinions related to listed transactions or principal purpose transactions.115 the critics assert that meeting the § 10.35(c) standards greatly increases the time burden associated with providing such tax advice and, therefore, substantially increases the cost of such advice to clients.116 this, in turn, strains the relationship between tax attorneys and their clients. for example, a client who wishes to receive succinct advice on a relatively routine tax planning matter will likely be upset to find that the brief e-mail response that he or she expected will instead have to be a several-page formal opinion, which will take far longer to produce and will cost far more when it finally arrives.117 such experiences may cause clients to conclude “that they cannot rely on their practitioner to offer them advice without producing a document that is formalistic and expensive.” 118 as a result, in at least some instances, clients may become discouraged from seeking tax counsel in the first place.119 c. the regulations impede communication between attorneys and clients, and prevent delivery of informal or piecemeal advice in addition to increasing the cost of tax advice in many instances, some critics charge that the covered opinion regulations (and particularly the § 10.35(c) requirements) impede the normal flow of communications between tax attorneys and their transactional clients because they do not reflect how advice is actually rendered during the course of a deal.120 in short, the argument is that transactional advice—including tax advice—is typically requested and given piecemeal during the gestation of a deal, and the covered opinion regulations make it harder to provide such advice in writing if the transaction in question is within the regulations’ wide ambit. generally, a client’s first request for tax advice will not be a request for a comprehensive opinion addressing all tax issues in a deal, just prior to the transaction’s completion. instead, a client usually seeks advice in many stages, beginning when he or she first “noodles” over a deal’s structure and 114. see infra part iv.f. 115. see supra note 54 and accompanying text. 116. see, e.g., weiser, supra note 15, at 29-30; paul, supra note 66, at 17; schenk, supra note 67, at 1315; vasquez & vasquez, supra note 56, at 295. 117. vasquez & vasquez, supra note 56, at 316 (citing richard m. lipton, attorney comments on proposed circular 230 amendments, 2004 tax notes today 48-41 (mar. 11, 2004). 118. edward f. koren, aba section members comments on circular 230 regs., 2005 tax notes today 90-23 (may 11, 2005) (quoted in vasquez & vasquez, supra note 56, at 316). 119. see schenk, supra note 67, at 1315; vasquez & vasquez, supra note 56, at 316. 120. see paul, supra note 66, at 16, 26-31 (asserting that various examples of “informal” written tax advice should be excluded from the definition of a “covered opinion”). columbia jour�al of tax law [vol 2:150 172 continuing as different variations of the transaction are considered and as deal terms are added and deleted through negotiations.121 the tax questions that arise during this long process often involve significant but discrete issues (as opposed to encompassing all tax aspects of the deal); and they usually call for response that is considered (of course), but also prompt, succinct and informal.122 the problem is that, if such a response is given in writing, and if the transaction is a listed transaction, a principal purpose transaction or a significant purpose transaction (and any deal which is not one of the first two will almost certainly be in the last category), then the brief, informal response on the discrete issue will have to meet all of the heightened due diligence and comprehensive drafting requirements of circular 230 § 10.35(c).123 this is true even if the advice is in electronic form.124 as a result, “there is an increased incentive to use oral advice.”125 in at least some cases, this may be worse for the client because oral advice on complex tax issues is more susceptible to misunderstanding and because the client will be left without a “record” to consult later.126 moreover, in today’s world, “advice that would in the past have been delivered orally is often transmitted by e-mail.”127 “[b]ecause the sender” and recipient “need not be present at the same time[,]” attorneys and clients alike often prefer emails to oral communication, and e-mail has thus become one of the primary ways in which tax and other legal advice is given and received.128 of course, it is often possible to opt out of compliance with the regulations by adding a non-reliance disclaimer to the message, and such disclaimers in attorneys’ e-mails have become ubiquitous. again, however, that option does not exist in every case, and the disclaimers themselves are not without their own problems.129 d. the regulations prevent practitioners from exercising professional judgment in distinguishing between important and unimportant tax issues worse yet, as some commentators have pointed out, the covered opinion regulations may prevent attorneys from providing at least one 121. see id. at 16. 122. id. at 16, 26. 123. see generally 31 c.f.r. § 10.35(a) (2010), 31 c.f.r. § 10.35(b)(2)(i) (2010). but see 31 c.f.r. § 10.35(b)(2)(ii)(a) (2010) (containing an exception to this requirement if the advice in question constitutes preliminary advice). 124. “electronic communications” are expressly included among the types of written advice that can be a “covered opinion” under circular 230. see 31 c.f.r. § 10.35(b)(2)(i) (2010). 125. schenk, supra note 67, at 1315. 126. id. 127. paul, supra note 66, at 26. 128. id. 129. see infra text accompanying notes 152-56 (discussing problems with nonreliance disclaimers). 2011] circular argume�t 173 particularly important component of tax advice at any price or in any form. generally, a covered opinion must consider all “significant federal tax issues” and provide a conclusion as to the likelihood that the taxpayer will prevail on the merits with respect to each such issue.130 this general rule limits a practitioner’s discretion to confine his or her counsel to the issues that he or she believes to be of true and material concern.131 for purposes of the covered opinion regulations, a federal tax issue is “significant” if the irs “has a reasonable basis for a successful challenge and its resolution could have a significant impact, whether beneficial or adverse and under any reasonably foreseeable circumstance, on the overall federal tax treatment of the transaction(s) or matter(s) addressed in the opinion.”132 this “reasonable basis” standard captures a much broader swath of tax issues than did the standard that applied under circular 230 prior to the december 2004 amendments. before those amendments, the former circular 230 § 10.33 required tax opinions to address only those federal tax issues that were subject to “a reasonable possibility of challenge by the” irs.133 as commentator david moldenhauer explains, the prior standard thus “allowed a practitioner to exercise professional judgment in distinguishing between those issues that raised a possibility of challenge, and thus required discussion, and those that did not.”134 “in contrast,” the current “reasonable basis standard” under circular 230 § 10.35 “does not allow for such judgment.”135 moldenhauer notes that, while the “reasonable basis standard” may be appropriate to the evaluation of whether a reporting position is sufficient to avoid penalties, employing that standard “to define the entire range of issues to be 130. 31 c.f.r. § 10.35(c)(3)(i) and (ii) (2010). for a description of what constitutes a “significant federal tax issue” under circular 230, see supra note 8. 131. see moldenhauer, supra note 97, at 860-61. as noted above, there are two exceptions to the general rule. first, a practitioner may rely on the opinion of another practitioner with regard to some significant federal tax issues. see 31 c.f.r. § 10.35(d)(1) (2010). also, limited scope opinions are permissible in some cases. see 31 c.f.r. § 10.35(c)(3)(v)(a) (2010). for further discussion of a practitioner’s ability to rely on others’ opinions and further discussion of limited scope opinions, see supra notes 30-31 and accompanying text. 132. 31 c.f.r. § 10.35(b)(3) (2010). the regulations do not define what constitutes a “reasonable basis for a successful challenge” in this context. law, supra note 69, at 32. however, the treasury regulations promulgated under § 6662 of the code provide that, in the context of a defense against the imposition of an accuracy-related penalty for substantial underpayments of tax, “a ‘reasonable basis’ for a taxpayer’s position is a standard that is ‘significantly higher than not frivolous or not patently improper.’” id. at 32 n.34 (quoting treas. reg. § 1.6662(b)(3)). therefore, assuming that the irs applies the “reasonable basis” standard in the same way under circular 230, the standard “is not satisfied by a return position that is merely arguable or that is merely a colorable claim.” id. (quoting treas. reg. § 1.6662(b)(3)); see also moldenhauer, supra note 97, at 860-61. 133. former 31 c.f.r. § 10.33(a)(4) (1984) (quoted in moldenhauer, supra note 97, at 861). 134. moldenhauer, supra note 97, at 861. 135. id. columbia jour�al of tax law [vol 2:150 174 considered in an opinion requires the practitioner to identify not merely the positions that the irs would most likely raise but rather all positions that the irs might take that are more than merely arguable, colorable, frivolous or patently improper.”136 indeed, a practitioner “must do so even if the position has a low likelihood of success or the irs is unlikely to raise the issue for policy or other reasons.”137 this restriction on an attorney’s ability to separate the wheat from the chaff when advising a client may seriously impede the quality of the advice, and may greatly diminish the client’s interest in receiving it. as another prominent commentator has noted, clients “do not want to read about all potentially significant tax issues. they want their advisors to serve as a filter, to tell them where the real risks are and how they can be addressed.”138 distinguishing between material concerns and theoretical or peripheral ones is a prerequisite to developing and dispensing sound legal advice. to the extent that the “reasonable basis” standard for defining “significant federal tax issues” in covered opinions prevents attorneys from engaging in that fundamental exercise, the covered opinion regulations may therefore substantially diminish the value of the tax counsel that clients receive. e. the regulations are far too broad, and they capture much more than the tax shelter advice that they were intended to regulate by far the most significant criticism of the covered opinion regulations is that they are incredibly overbroad. the intent of the covered opinion regulations is to impose rigorous requirements on legal opinions provided in connection with tax shelters, in order to prevent such opinions from being used to support abusive shelters.139 as written, however, the regulations cover far more than opinions related to tax shelters. this is because the phrase “significant purpose,” as used in circular 230 § 10.35(b)(2)(i)(c) and (b)(10), is so broad that a significant purpose transaction could include virtually any matter as to which a client 136. id. (citing treas. reg. § 1.6662-3(b)(3) (2003)). 137. id. (citation omitted). 138. james m. peaslee, attorney seeks improvements to circular 230 rules, 2005 tax notes today 45-14 (march 9, 2005) (quoted in vasquez & vasquez, supra note 56, at 31617). 139. “[o]ne may argue that that the plain meaning of [§ 822 of the jobs act] clearly authorizes the secretary of the treasury to issue circular 230 addressing written tax advice if [such advice] has ‘a potential for tax avoidance or evasion.’” vasquez & vasquez, supra note 56, at 300 (quoting pub. l. 108-357, § 822(b), 118 stat. 1418, 1587 (2004)). however, “one must look no further than the same tax act to discover that ‘congress deliberately targeted its burdensome opinion standards to situations where there is a risk of shelter activity.’” id. (quoting jeffrey h. paravano & melinda l. reynolds, the �ew circular 230 regulations—best practices or scarlet letter?, 46 tax mgmt. memo 339, 340 (2005)). see also isaac j. roang, to disclaim or �ot to disclaim: irs circular 230 requirements for written advice, 19 geo. legal ethics 937, 946 (summer 2006) (“the [covered opinion regulations] were, presumably, initiated in response to a marketed tax shelter opinion problem.”). 2011] circular argume�t 175 would ever seek tax counsel.140 almost any undertaking in which a tax advisor is consulted could accurately be said to have as a significant purpose the avoidance of income tax, because the “very essence” of providing transactional tax advice is to find ways to make transactions more tax efficient.141 thus, for example, items of written advice concerning such matters as like-kind exchanges, corporate reorganizations, and choices of business entity could all be construed as covered opinions under a literal reading of the regulations’ “significant purpose” language.142 in short, the “significant purpose” advice regulated under circular 230 is not confined to counsel concerning aggressive, potentially abusive endeavors; instead, it encompasses all legitimate tax planning.143 this flaw greatly exacerbates all of the other problems with the covered opinion regulations. because the regulations apply to written advice concerning virtually every tax matter, the issues described above relate to nearly everything that any tax practitioner does. the regulations do not merely impact counsel related specifically to tax shelters (as they were meant to); rather, they impose burdens and restrictions on the provision of practically all tax advice. to fix the problems with the covered opinion regulations, the first and most important step is therefore to correct their scope. the broad reach of the “significant purpose” regulations must be narrowed so that they encompass only tax shelter advice, and nothing more (as proposed in part v.b infra 144). because 140. see supra text accompanying notes 14-15; see also infra text accompanying notes 206-09. 141. see vasquez & vasquez, supra note 56, at 297; see also swartz & bertrand, supra note 46, at 257 (“it is not clear whether structuring a transaction that would otherwise occur for good business reasons in a tax-efficient manner could constitute a significant tax avoidance purpose”); roang, supra note 139, at 947 (covered opinion regulations “go much farther than tax shelters because almost all tax opinions have a ‘significant purpose’ to avoid taxes”). 142. see vasquez & vasquez, supra note 56, at 297; see also paul, supra note 66 (providing various examples of routine tax advice that could be characterized as a having tax avoidance as a “significant purpose”). 143. the irs has made a number of statements indicating that it will not apply the covered opinion regulations in the context of transactions that are not overly aggressive. roang, supra note 139, at 947; see also vasquez & vasquez, supra note 56, at 321-22 (describing various irs statements to the effect that “the literal language of § 10.35 is not what will control”). these statements have been less than reassuring to the tax bar, however. commentators jeffrey h. paravano and melinda l. reynolds have summed up practitioners’ response well: statements by government officials that tax advisors should take comfort in the fact that the circular 230 rules will be enforced in a “reasonable” rather than a literal manner are appreciated but also create a certain amount of horror in the minds of tax practitioners who feel compelled to attempt to comply with the laws as written. if a regulation cannot or will not be enforced pursuant to its terms, the regulation should be changed. jeffrey h. paravano & melinda l. reynolds, the �ew circular 230 regulations—best practices or scarlet letter?, 46 tax mgmt. memo 339, 341-42 (2005) (quoted in vasquez & vasquez, supra note 56, at 322). 144. see infra text accompanying notes 211-14. columbia jour�al of tax law [vol 2:150 176 providing counsel on tax shelters is a decidedly small part of what tax practitioners do, this one change will make any remaining problems with the covered opinion regulations far easier to deal with. it will remove those problems from the center of tax practice to the periphery. f. the opt-out procedures and related �on-reliance disclaimers also create certain problems as mentioned before, a practitioner can opt out of compliance with the due diligence and drafting requirements under circular 230 § 10.35(c) by prominently placing a non-reliance disclaimer on his or her opinion, if the opinion relates to a significant purpose transaction and is a “reliance opinion.”145 opting out is also possible in the case of an opinion that relates to a significant purpose transaction and is a “marketed opinion,” if the opinion contains both a non-reliance disclaimer and certain additional “consumer protection” legends.146 there is no ability to opt out of complying with the regulations if the opinion relates to a listed transaction or a principal purpose transaction, or if the opinion relates to a significant purpose transaction and is either “subject to conditions of confidentiality” or “subject to contractual protection.”147 when the rules permit, opting out of compliance enables a practitioner to avoid the above-described problems that stem from the regulations’ due diligence and drafting requirements. the use of non-reliance disclaimers has thus become extremely widespread in tax practice. indeed, nearly all law firms that provide any tax advice now include non-reliance disclaimers on most of their written correspondence—including literally all of their e-mails—even when the correspondence has nothing to do with a tax matter.148 for example, if an attorney sends you an e-mail asking if you want to grab a beer after work, you are now usually cautioned that the invitation cannot be used as a defense against the imposition of tax penalties. this absurd overuse of non-reliance disclaimers has turned them into objects of ridicule.149 though the firms themselves no doubt recognize the ludicrousness of this approach, they nevertheless “prefer using these blanket disclosure procedures rather than requiring each lawyer to make a determination as to whether a particular written communication is subject to [circular 230’s] due diligence and drafting guidelines.”150 this practice has therefore 145. see supra notes 49-51 and accompanying text. 146. see supra notes 52-53 and accompanying text. 147. see supra note 54 and accompanying text. 148. weiser, supra note 15, at 33; schumacher, supra note 72, at 62-63. 149. for a while, one internet vendor even sold t-shirts, mugs and underwear “emblazoned with the no-penalty-protection mantra.” schumacher, supra note 72, at 63 (discussing the vendor café press, whose website is www.cafepress.com). 150. weiser, supra note 15, at 33. 2011] circular argume�t 177 become almost universal, despite the fact that the irs has strongly objected to it.151 although non-reliance disclaimers have become commonplace as a way to avoid other burdens of the covered opinion regulations, the disclaimers themselves have significant drawbacks. they, too, have therefore garnered much criticism. first, and most obviously, a non-reliance disclaimer prevents an opinion from being invoked as part of a reasonable-cause-and-good-faith defense to the imposition of accuracy-related penalties under § 6662 of the code (or § 6662a(a) of the code, in the case of disclosed reportable transactions) or fraud penalties under § 6663 of the code.152 the potential harm this causes to the opinion’s recipient is self-evident and requires little elaboration. suffice it to say that, if a tax opinion endorses a particular reporting position, and it turns out that the opinion cannot be used to defend against the assessment of penalties arising from that reporting position, the opinion will have been worthless to the client (both as “insurance” and as advice). second, because non-reliance disclaimers have become ubiquitous, it is likely that many clients have come to view the disclaimers as meaningless boilerplate that they can simply ignore.153 of course, this is not a problem in the many instances (like the invitation for a beer) when the disclaimer should be ignored. yet there can be a big problem if a client becomes “trained” to ignore non-reliance disclaimers in formal legal opinions (or other written communications) that contain tax advice. in such cases, clients will fail to recognize the substantial limitations of the advice 151. id. at 33 (citing irs statements reported in 2005 tax notes today116-4 (june 17, 2005)). 152. for a discussion of the accuracy-related penalties under § 6662, the fraud penalty under § 6663, and the reasonable-cause-and-good-faith defense to those penalties under § 6664(c)(1), see supra notes 89-91 and accompanying text. for a discussion of the accuracy-related penalties under § 6662a, which apply to reportable transaction understatements, and the reasonable-cause-and-good-faith defense to the § 6662a(a) penalty that is available under § 6664(d)(1) only in the case of properly disclosed reportable transactions, see supra notes 92-94 and accompanying text. at least one commentator has argued that a non-reliance disclaimer may not actually preclude assertion of the reasonable-cause-and-good-faith defense because treasury has not amended the regulations under § 6664 to provide that opinions that include such disclaimers cannot be used as part of such a defense. see moldenhauer, supra note 97, at 858. such an amendment to those regulations would no doubt add clarity. however, even without such a clarification, it is difficult to imagine a court concluding that reliance on an opinion is a reasonable cause for, or an act in good faith with respect to, a reporting position if the opinion itself expressly provides that it cannot be relied upon to avoid the imposition of penalties. curiously, the commentator also asserts that, even if an opinion “fails to meet the standards for avoiding penalties under code section 6664,” a taxpayer may be able to rely on the opinion as a defense against the negligence penalty under § 6662(b)(1) or the fraud penalty under § 6663. id. it is hard to see how this can be true, given that the sole statutory basis for the reasonable-cause-and-good-faith defense to the negligence and fraud penalties (as well as to the substantial-underpayment penalty under § 6662(b)(2)) derives from § 6664(c)(1). 153. schenk, supra note 67, at 1313; paul, supra note 66, at 17. columbia jour�al of tax law [vol 2:150 178 they receive. legal advice that qualifies for the reasonable-cause-andgood-faith defense against tax penalties is qualitatively different from advice that does not. clients who do not fully appreciate when they are getting the latter, rather than the former, can be severely disadvantaged as a result.154 third, any client who actually pays attention to the disclaimer, and who comprehends its significance, is apt to lose confidence in the advice that he or she has received—and in the practitioner who has provided it. one commentator has offered an interpretation of the typical non-reliance disclaimer that is admittedly cynical, but also undeniably accurate: “even though you have requested and paid for professional tax advice, it will be useless to you if the irs decides to penalize you for relying on it.”155 not only will a client who adopts this interpretation be nonplussed to learn that the disclaimer renders the communication useless as penalty protection; he or she may question whether the advice contained in the communication can be trusted or relied upon for any purpose.156 this is yet another way in which the covered opinion regulations may have the effect of dissuading some clients from seeking tax counsel in the first place. g. to address the problems with the �on-reliance disclaimers, some commentators have recommended switching to an opt-in system in lieu of the opt-out approach to address these disclaimer issues—and to make it even easier to avoid the circular 230 § 10.35(c) due diligence and drafting requirements—many commentators have proposed replacing the opt-out regime under the current regulations with an opt-in regime. this recommendation was the hallmark of the new york state bar association’s comments on the december 2004 amendments,157 and a great number of others have since echoed the suggestion.158 under an opt-in approach, an 154. for one thing, if a client does not realize that a proffered communication will not provide penalty protection, he or she has no meaningful opportunity to purchase an alternative form of covered opinion that would provide such protection. for another, such misunderstandings may lead some clients to try to rely on opinions with non-reliance disclaimers to avoid imposition of penalties, despite the existence of the disclaimers. see schenk, supra note 67, at 1313 (“it seems entirely likely that a client faced with a substantial underpayment penalty will continue to assert that she relied on an attorney’s opinion despite a legend on the opinion.”). unfortunately, any client who does so is likely to be in for a rude awakening. 155. law, supra note 69, at 24. 156. see id.; see also paul, supra note 66, at 17 (“[c]lients may view the banners as heavy-handed, causing them to distrust [practitioners’] advice.”); edward f. koren, aba section members comments on circular 230 regs., 2005 tax notes today 90-23 (may 11, 2005) (quoted in vasquez & vasquez, supra note 56, at 316) (“clients will fear . . . that they cannot rely on the practitioner’s advice due to the existence of the disclaimer language that is prominently displayed.”). 157. see paul, supra note 66. 158. for but a small subset of the other opiners who have recommended an opt-in approach, see, e.g., roang, supra note 139, at 949; schizer, supra note 100, at 363; schenk, 2011] circular argume�t 179 opinion would not be subject to the due diligence and drafting requirements under the covered opinion regulations, no matter what the nature of the transaction to which it relates, unless the opinion expressly states that it is intended to be relied on as a defense against the imposition of penalties under the code.159 non-reliance disclaimers would thus become unnecessary; they would be replaced by affirmative statements (on the relatively few opinions that meet the heightened due diligence and drafting guidelines) to the effect that the related opinions are intended to provide penalty protection. despite its apparent popularity among some practitioners and scholars, this idea should be categorically rejected. for the reasons explained in part v.c, allowing practitioners to “opt in” to compliance with the regulations’ due diligence and drafting requirements, is inimical to the purpose of preventing those practitioners from facilitating abusive tax shelters. v. fixing what is wrong, and keeping what is right, with the covered opinion regulations a. the basic framework of the regulations should be retained in response to the problems with the covered opinion regulations outlined in part iv, at least one prominent legal scholar has concluded that the regulations should be discarded altogether.160 as noted above, a number of other commentators—scholars and practitioners alike—think that the regulations should be revised by replacing the current opt-out regime with an opt-in approach.161 this change, too, would essentially eviscerate the regulations because it would make compliance with them merely voluntary. despite the real and serious concerns that the regulations raise, neither of these alternatives is acceptable, because each would leave a gaping hole in the rules that prohibit abusive tax shelters. as we have seen, tax attorneys, and the opinions they provided, were essential to the rise of the market for abusive corporate tax shelters in the 1990s.162 as recent history also teaches us, efforts at self-regulation through rules of professional ethics and other aspirational best practices have been insufficient to reign in those tax practitioners who would deliver supra note 67, at 1316-18; see also vasquez & vasquez, supra note 56, at 313-14 (quoting published comments of attorneys kenneth horwitz, kenneth gideon, arthur l. bailey, jerald august and guy maxfield). 159. paul, supra note 66, at 18; roang, supra note 139, at 949; vasquez & vasquez, supra note 56, at 314. 160. see generally schenk, supra note 67. 161. see supra part iv.g. 162. for a discussion of the involvement of tax attorneys in abusive corporate tax shelters in the 1990s, the centrality of their opinions to those enterprises, and the dubious techniques they used to prepare those opinions, see supra notes 76-105 and accompanying text. columbia jour�al of tax law [vol 2:150 180 incomplete, misleading or otherwise unreasonable legal opinions in order to facilitate abusive tax shelter transactions.163 regrettably, this experience demonstrates that there is a strong need for the covered opinion regulations, or something akin to them, to curtail the deceitful opinion practices of tax practitioners who otherwise would be tempted to support such transactions. regulatory efforts in this regard thus cannot simply be abandoned. if the current regulations are imperfect—and they certainly are—then we must mend them, not end them. 1. effective regulations should enlist the aid of practitioners in deterring clients from engaging in abusive transactions one obvious threshold goal of any regulations in this area should be to prevent unscrupulous tax practitioners from delivering unsound legal opinions that encourage investors to participate in abusive shelters. however, to deter abusive tax shelters effectively, a regulatory scheme must not only prohibit bad behavior by tax practitioners; it must actually enlist the aid of private practice tax attorneys in reigning in their clients.164 in other words, the regulations must incent tax attorneys to dissuade or inhibit their own clients from engaging in abusive transactions. this is true for at least two reasons. first, the irs simply does not have adequate resources to identify and stop all abusive tax shelter activity on its own.165 there is a mismatch in resources between the private tax bar and government tax attorneys that is reflected both in the low audit rate and, more generally, in the comparatively lean manner in which the government staffs all enforcement matters.166 second, and even more importantly, the government is significantly limited in its access to information. in our system of voluntary compliance, the taxpayer typically controls the flow of tax information to the government, generally reporting only what the irs specifically requests (and usually construing those requests in the narrowest, most self-interested manner).167 as a result, no matter how 163. see, e.g., rostain, supra note 73, at 93 (noting, in a discussion of attorneys’ role in the rise of the 1990s corporate tax shelter market, that “[t]he general standards for tax advice in the regulations did not inhibit lawyers from providing opinions for abusive transactions; nor had the american bar association enunciated stricter standards.”). for more about the inadequacy of professional ethics rules to curb the delivery of unsound legal opinions that facilitate abusive tax shelters, see supra note 97 and accompanying text. 164. see generally schizer, supra note 100; see also schumacher, supra note 72, at 100. 165. for a detailed discussion of the limits of the government’s tax enforcement resources, and the mismatch in resources between the irs and the private tax bar, in particular, see schizer, supra note 100, at 331-45; see also schumacher, supra note 72, at 100 (“the enforcement budget is insufficient for the government to ever fully win the tax shelter war.”) (citations omitted). 166. schizer, supra note 100, at 331. 167. id. at 337 (“[taxpayers] have the further advantage of controlling the flow of information to the government, offering only what the government requests (and, even then, typically construing the government’s request in a self-interested way).”). 2011] circular argume�t 181 many resources it throws at enforcement, the government often may not learn about abusive tax shelters until long after they have been completed. many times, the government will not make the discovery until after a particular type of shelter has proliferated repeatedly throughout the market. it is therefore well recognized that “the irs cannot solve the shelter problem without the help of the bar and tax professionals in general.”168 even relative to other tax professionals, such as tax accountants, tax attorneys are particularly well suited to the role of policing their clients’ tax shelter activity, because of their unique understanding of the judiciallycreated legal doctrines that distinguish between abusive and legitimate transactions.169 judicial constructs such as the business purpose doctrine and the newly-codified economic substance doctrine170 give weight and effect to the fundamental idea that the code is intended to tax income, minus only the cost of generating such income, and that the only legitimate tax deductions are therefore those which arise from activity undertaken with an intent (and reasonable expectation) to generate income.171 as noted above,172 one significant contributor to the rise of the abusive corporate tax shelter market in the 1990s was an increased adherence to hyper-textual interpretations of the tax law, in which overly aggressive transactions were justified on the basis of literal readings of code provisions, without giving any consideration to the economic substance or business purpose doctrines.173 just as ignoring those doctrines was necessary to the completion of the abusive deals of the 1990s, anything that restricts taxpayers to endeavors which have economic substance and a good business purpose will, by definition, curtail unduly aggressive transactions. this is where the expertise of a private practice tax attorney, if properly directed, can be used 168. schumacher, supra note 72, at 100. 169. rostain, supra note 73, at 82 (“tax lawyers are especially suited to this gatekeeping role because of their expertise in the judicially created doctrines that developed to distinguish abusive tax shelters from legitimate tax planning.”); see also id. at 114-15 (“tax lawyers are appropriate gatekeepers because they enjoy in-depth knowledge of cases.”). 170. on may 30, 2010, the economic substance doctrine was codified at i.r.c. § 7701(o). see supra note 99 and accompanying text. the economic substance doctrine was judicially created, however, and prior to § 7710(o), it was a common-law doctrine. see supra note 98. although § 7701(o) introduces some new factors for testing whether a transaction has economic substance, the economic substance doctrine under the code is likely to remain essentially similar to the common law doctrine in many, if not most, significant respects. see jackel, supra note 99, at 296. thus, the newly-codified version of the doctrine continues to incorporate the complexities nuances of the common law doctrine that often require the knowledge and experience of a seasoned tax practitioner to unpack. 171. see rostain, supra note 73, at 84-86; see also supra note 98 (for further detail regarding the economic substance and business purpose doctrines, and the concepts underlying them). 172. see supra notes 97-100 and accompanying text. 173. rostain, supra note 73, at 82, 114. the economic substance was originally a common law doctrine, but (as noted above) was very recently added to the code. for a discussion of the doctrine’s codification, see generally jackel, supra note 99. columbia jour�al of tax law [vol 2:150 182 effectively to stem the tide of abusive shelters. to accomplish this, tax shelter regulations must create strong incentives for a client to seek the attorney’s “blessing” upon a tax shelter transaction, and they must create equally strong incentives for the attorney to condition his or her blessing on a reasoned determination that the transaction has both pre-tax economic substance and a legitimate non-tax business purpose.174 2. thus far, the covered opinion regulations have effectively created a role for tax practitioners as “gatekeepers” to block abusive transactions up until now, the covered opinion regulations have fostered exactly the kind of incentives described above. to create those incentives on the clients’ side, the covered opinion regulations tie to the code provisions and treasury regulations concerning penalties and defenses against penalties. the prospect of an addition to tax in the amount of 20% of any substantial underpayment175 (or 20% of any reportable transaction understatement, in the case of a properly disclosed reportable transaction176) is a significant risk to be considered in the context of any aggressive transaction, and any taxpayer contemplating a tax shelter will be strongly incented to avoid such a penalty. happily, the code allows for a reasonable-cause-and-good faith defense against the imposition of such those penalties.177 in turn, a related treasury regulation expressly provides that—in the case of a penalty that would arise out of a corporate tax shelter—the minimum requirements for such a defense under the code may be met by good-faith reliance on the opinion of a professional tax advisor.178 thus, a client who proposes to engage in a tax shelter has a strong incentive to obtain a legal opinion that meets those requirements. 174. see rostain, supra note 73, at 105-06. in order for such regulations to succeed, it is critical that the interests of attorney and taxpayer be aligned properly. appeals to an attorney’s professional norms or his or her duty to the system may have limited effect, but any regulatory scheme that places the lawyer’s interests at odds with the client’s, is ultimately doomed to failure. see schizer, supra note 100, at 355-71 (discussing the need to align the interests of attorneys and clients by giving attorneys incentives and opportunities to police clients’ involvement in aggressive and potentially abusive transactions). 175. see i.r.c. § 6662(b)(2) (2010). 176. see i.r.c. § 6662a(a) (2010). 177. see i.r.c. § 6664(c)(1) (2010) (providing for a reasonable-cause-and-good-faith exception to the § 6662 and § 6663 penalties); see also i.r.c. § 6664(d) (2010) (providing for a more stringent reasonable-cause-and-good-faith exception to the § 6662a(a) penalty in the case of properly disclosed reportable transactions, but expressly denying the availability of such exception to the 30% penalty under § 6662a(c) applicable in the case of undisclosed reportable transactions). 178. see treas. reg. § 1.6664-4(f) (2010). for further discussion of the treas. reg. § 1.6664-4(f) minimum requirements, see supra note 89. the requirements under the section 1.6664-4 regulations for opinions upon which taxpayers may rely in order to invoke the exception to the § 6662 and § 6663 penalties “are very similar, but not identical, to” the covered opinion regulations. schenk, supra note 67, at 1313. additional standards as to opinions that may not be relied on to invoke the exception to the § 6662a(a) penalty (with 2011] circular argume�t 183 on the attorneys’ side, the circular 230 § 10.35(c) due diligence and drafting standards are all directed at requiring a practitioner to conclude—on the basis of a substantial factual and legal inquiry—that a tax shelter transaction has economic substance and a legitimate business purpose, before he or she delivers an opinion that can be relied upon for penalty protection. in preparing the opinion, the practitioner cannot rely on unreasonable factual assumptions or representations.179 in particular, he or she cannot rely on any blanket assumption or representation that the deal in question has economic substance or a valid business purpose.180 in relating the facts to relevant law, the practitioner is expressly required to consider all “potentially applicable judicial doctrines” (a requirement that is targeted particularly to consideration of the economic substance and business purpose doctrines).181 in so doing, the practitioner must address all significant federal tax issues related to the transaction.182 this prevents him or her from simply glossing over inconvenient obstacles (like economic substance or business purpose considerations) in a “partial” opinion of the sort that was often used in the abusive shelters of the 1990s.183 finally, to be eligible for use as penalty protection, the opinion must reach a conclusion at a confidence level of at least more-likely-than-not that the taxpayer will prevail on the merits with respect to each such significant federal tax issue.184 if the opinion does not meet these basic requirements, it must contain a non-reliance disclaimer, which will preclude the opinion from being usable as a defense against penalties. the sanctions against respect to disclosed reportable transactions) are set forth in § 6664(d). see i.r.c. § 6664(d)(4)(b) (2010). 179. see 31 c.f.r. § 10.35(c)(1)(ii) and (iii). for further discussion of these requirements, see supra notes 18-23 and accompanying text. 180. see 31 c.f.r. § 10.35(c)(1)(ii) and (iii). 181. 31 c.f.r. § 10.35(c)(2)(i). for further discussion of these requirements, see supra notes 24-29 and accompanying text. at the time when the covered opinion regulations were adopted, the economic substance doctrine was strictly a common law doctrine. the doctrine was just codified, at § 7701(o), on march 30, 2010. see supra note 99 and accompanying text. within certain limitations, a practitioner may rely on the opinion of another practitioner with regard to some significant federal tax issues. see 31 c.f.r. § 10.35(d)(1). limited scope opinions are permissible in some cases. see 31 c.f.r. § 10.35(c)(3)(v)(a). however, a limited scope opinion must include a legend expressly indicating that it cannot be used for the purpose of avoiding penalties related to significant federal tax issues that are not specifically addressed in the opinion. see 31 c.f.r. § 10.35(e)(3)(iii). for further discussion of a practitioner’s ability to rely on others’ opinions and further discussion of limited scope opinions, see supra notes 30-31 and accompanying text. 182. see 31 c.f.r. § 10.35(c)(3)(i). for a description of what constitutes a “significant federal tax issue” under circular 230, see supra note 8. 183. for a discussion of “partial opinions” and their use in the abusive corporate tax shelters of the 1990s, see supra text accompanying notes 104-05. 184. if an opinion fails to reach such a conclusion at such a confidence level with respect to any significant federal tax issue, the opinion must prominently disclose that fact and must prominently state that the taxpayer cannot use the opinion to avoid the imposition of penalties arising from such issue. 31 c.f.r. §§ 10.35(c)(4) and 10.35(e)(4). see supra note 35 and accompanying text. columbia jour�al of tax law [vol 2:150 184 practitioners who violate the regulations are considerable,185 and the incentives to meet these due diligence and drafting standards are therefore strong. thus, up until now, the covered opinion regulations have done something even more valuable than to prevent practitioners from delivering unreasonable legal opinions. the regulations have established the attorney as a “gatekeeper” through whom a client must pass in order to complete a tax shelter transaction.186 the client desires a defense against penalties that the transaction might provoke and, at least up to this point, he or she could generally invoke such a defense through reliance on a covered opinion. in order to deliver the opinion that the client needs and wants, the attorney has to determine, inter alia, that the transaction has economic substance and a valid business purpose. in this way, the regulations cause attorneys to prevent (or, at least, impede) their clients from participating in abusive shelters. this, of course, is precisely what the regulations should do. 3. new strict liability penalty for transactions without economic substance may undermine the covered opinion regulations’ effectiveness at creating a “gatekeeper” role for tax practitioners, but the regulations should still remain in force in conjunction with the recent codification of the economic substance doctrine under § 7701(o) of the code,187 congress also added § 6662(b)(6) of the code, which provides for a new accuracy-related penalty in the case of transactions lacking economic substance.188 at the same time, congress amended § 6664(c) of the code to specify that there is 185. for a description of those sanctions, see supra text accompanying notes 41-48. 186. see rostain, supra note 73, at 82 (discussing the efficacy of using attorneys as “gatekeepers” by drawing on their expertise in interpreting and applying the economic substance and business purpose doctrines “to distinguish abusive tax shelters from legitimate tax planning”); see also schizer, supra note 100, at 363 (noting, with approval, the government’s efforts, through circular 230, rely on the tax bar “to monitor clients, and to give opinions (and thus the potential for penalty protection) only when they are deserved”); schumacher, supra note 72, at 101 (“tax advisors must recognize their central role as gatekeepers and their duty to the system”). 187. see supra note 99 and accompanying text. 188. section 6662(b)(6) was added to the code (together with § 7701(o)) as part of the health care and education reconciliation act of 2010, and became effective as of march 30, 2010. section 6662(b)(6) provides that the 6662(a) addition to tax, which is an amount equal to 20 percent of certain underpayments of tax, applies to underpayments of tax attributable to “[a]ny disallowance of claimed tax benefits by reason of a transaction lacking economic substance (within the meaning of section 7701(o)) or failing to meet the requirements of any similar rule of law.” i.r.c. § 6662(b)(6) (2010). under newly-enacted § 6662(i), another related addition to the code, the addition to tax for underpayments attributable to non-economic substance transactions jumps from “20 percent” to “40 percent” of the underpayment, in the case of any transaction described in § 6662(b)(6) “with respect to which the relevant facts affecting the tax treatment are not adequately disclosed in the return nor in a statement attached to the return.” i.r.c. § 6662(i)(1) and (i)(2) (2010). see jackel, supra note 99, at 294 (discussing §§ 6662(b)(6) and 6662(i)). 2011] circular argume�t 185 no reasonable-cause-and-good-faith exception to the § 6662(b)(6) penalty.189 accordingly, a taxpayer cannot rely on any legal opinion—even one that meets all of the circular 230 § 10.35(c) due diligence and drafting requirements—as a defense against imposition of the new penalty for transactions that do not have economic substance. given that one hallmark of an abusive tax shelter is its lack of economic substance, the new § 6662(b)(6) penalty has the potential to apply to virtually all abusive shelter transactions going forward.190 because § 6662(a) of the code provides for the imposition of a single addition to tax for underpayments, only one § 6662(b) penalty may be imposed on a particular underpayment, “even if the underpayment is attributable to more than one kind of misconduct.”191 therefore, since the § 6662(b) penalties do not “stack,” in future tax shelter cases the irs will have to choose between assertion of the § 6662(b)(6) penalty, on one hand, and assertion of either the § 6662(b)(2) substantial underpayment penalty or the § 6662(b)(1) negligence-or-disregard-of-rules penalty, on the other. (in the case of tax shelters that are reportable transactions, the § 6662a reportable transaction underpayment penalties are also potentially applicable.192) in view of the fact that the § 6662(b)(6) penalty is a strict liability penalty (as well as the fact that the amount of the penalty may be increased to 40% of 189. a new § 6664(c)(2) was added to the code, also as part of the health care and education reconciliation act of 2010, effective as of march 30, 2010. section 6664(c)(2) now states that § 6664(c)(1) (which provides for the reasonable-cause-and-good-faith exception to § 6662 and § 6663 penalties, generally) “shall not apply to any portion of an underpayment which is attributable to one or more transactions described in section 6662(b)(6).” i.r.c. § 6664(c)(2) (2010). see jackel, supra note 99, at 294 (discussing § 6664(c)(2)). 190. widespread application of the § 7701(o) economic substance doctrine to tax shelters is plainly to be expected, given that “[t]he common-law economic substance doctrine mostly addresses tax-shelter-type cases.” jeremiah coder & amy s. elliot, some economic substance guidance likely, officials say, 127 tax notes 748, 749 (may 17, 2010) (quoting pricewaterhousecoopers llp managing director monte jackel). because the § 6662(b)(6) penalty could be applied in the case of any violation of § 7701(o), that penalty is therefore at least potentially applicable in all future tax shelter cases. 191. leandra lederman & stephen w. mazza, tax controversies: practice and procedure 480 (3rd ed. 2009). 192. pursuant to § 6662a(e) of the code, both the § 6662a reportable understatement penalty and one of the § 6662(b) substantial underpayment penalties may apply in the same transaction (if the transaction is a reportable transaction). see i.r.c. § 6662a(e)(1)(b) (2010) (providing that a penalty under § 6662(a) may be applied to the excess of a § 6662(b) substantial understatement over the portion of such understatement that constitutes a reportable transaction understatement to which a § 6662a penalty has been applied). even in the case of a reportable transaction understatement, however, the irs has the discretion to apply one of the § 6662(b) penalties (including, of course, the new § 6662(b)(6) penalty), rather than a § 6662a penalty, to the entire understatement. see i.r.c. § 6662(b) (flush language effectively requires choice, with respect to any portion of any underpayment, of only one of a § 6662 penalty, the § 6663 penalty or a § 6662a penalty). moreover, there is no reasonable cause exception to the imposition of a § 6662a(a) penalty in the case of any portion of a reportable transaction understatement that arises from a transaction to which a § 6662(b)(6) penalty applies because the transaction lacks economic substance. see i.r.c. § 6664(d)(2). columbia jour�al of tax law [vol 2:150 186 the related underpayment, in some cases193), the irs would appear to have strong incentives to choose that penalty whenever possible. to the extent that the § 6662(b)(6) penalty supplants other accuracy-related penalties with respect to tax shelters, the effectiveness of the covered opinion regulations in creating a “gatekeeper” role for tax practitioners threatens to be severely undermined. if a covered opinion no longer provides insurance against the most probable accuracy-related penalty to be imposed on a tax shelter, clients will be likely no longer to view the receipt of such an opinion as a prerequisite to entering into an aggressive transaction. (this is particularly true in light of the high transaction costs that the regulations impose on such opinions). in turn, if a client no longer views a covered opinion as a necessity when investing in a tax shelter, then a practitioner’s withholding of such an opinion will no longer function as a strong impediment to the client’s participation in an abusive deal. much of the covered opinion regulations’ deterrent effect on taxpayer behavior will thus be lost. this threatened diminution of the covered opinion regulations’ effectiveness at reigning in taxpayers is plainly regrettable. however, that is not an excuse to call for the regulations to be repealed. first, it is too early to know exactly how—and to what extent—the § 6662(b)(6) penalty will be applied in future tax shelter cases. in response to early concerns raised by tax practitioners, treasury officials have acknowledged that there are “risks inherent in the strict liability penalty imposed by” § 6662(b)(6),194 and that the lack of any reasonable cause defense to the penalty “raises issues for both taxpayers and the irs.”195 193. see i.r.c. § 6662(i) (2010) (providing that the addition to tax under § 6662(b)(6) increases from 20 percent to 40 percent of the underpayment, in the case of any “nonreported noneconomic substance transaction”). in contrast, § 6662a(c) provides only a 30 percent for undisclosed reportable transaction understatements. thus, even in the context of unreported transactions, the irs has incentive to choose the § 6662(b)(6) penalty. 194. crystal tandon, treasury planning guidance on economic substance penalties, 127 tax notes 965 (may 31, 2010) (recounting remarks of bob crnkovich, senior tax counsel (partnerships) in treasury’s office of tax legislative counsel, during a may 2010 practicing law institute seminar in new york concerning the codified economic substance doctrine). 195. jeremiah coder, guidance on economic substance to address uncertainty, 127 tax notes 737 (may 17, 2010) (describing statements made by byron christensen, treasury deputy tax legislative counsel, during a may 2010 district of columbia taxation section luncheon program). the primary risk, and chief concern raised by practitioners, is of course that the imposition of strict liability under § 6664(c) will result in the application of the § 6662(b)(6) penalty even in cases where taxpayers have attempted in good faith to follow the complex (and sometimes ambiguous) rules of the newly-codified economic substance doctrine. attorney bryan c. skarlatos summarized the apprehensions of many tax advisors during a tax controversy forum sponsored by new york university that he cochaired in june 2010. skarlatos “called the codified doctrine amorphous and said the strict liability penalty is a ‘hammer’ waiting to drop on taxpayers despite their best efforts to follow technical tax rules.” jeremiah coder, economic substance guidance will have limited scope, 127 tax notes 1423, 1424 (june 28, 2010). another issue raised by the introduction of the § 6662(b)(6) penalty is the new uncertainty as to which penalty the irs 2011] circular argume�t 187 treasury has indicated that the irs will therefore establish “clear, uniform procedures on how” the § 6662(b)(6) penalty will be applied.196 whether any such procedures will ultimately be set forth in treasury regulations or formal irs guidance pronouncements is as yet unclear.197 predictably, because § 6664(c) clearly and unambiguously provides that there is no reasonable-cause-and-good-faith exception to the § 6662(b)(6) penalty, treasury’s office of tax legislative counsel has emphasized that “it would be inconsistent for treasury to issue guidance providing for a reasonable cause defense.”198 at the same time, however, treasury has repeatedly assured practitioners that the irs will apply § 6662(b)(6) only in “appropriate will apply in a given economic substance case. as treasury deputy counsel christensen has observed, “[a] ‘buffet of penalties’ might attach to a transaction falling under § 7701(o), so it is understandable that tax professionals will want to know what the penalty will be.” coder, 127 tax notes at 737. 196. tandon, supra note 194, at 965. during a may 2010 practicing law institute seminar in new york concerning the codified economic substance doctrine, bob crnkovich, senior tax counsel (partnerships) in treasury’s office of tax legislative counsel, stated that “[w]e clearly understand the novel nature of this strict liability penalty, and we are sensitive to it and we are considering what procedures will be put in place.” id. 197. initial indications were that a formal elucidation of such procedures could be expected, but more recent pronouncements make the possibility of such guidance appear more doubtful. soon after § 7701(o) and § 6662(b)(6) were enacted, treasury officials indicated that there would be forthcoming guidance as to when the § 6662(b)(6) penalty, on one hand, or another of the potentially applicable substantial underpayment penalties, on the other, will be applied to transactions that run afoul of § 7701(o). for example, during a may 2010 district of columbia taxation section luncheon program, byron christensen, treasury deputy tax legislative counsel, told practitioners that application of the § 6662(b)(6) strict liability penalty will be addressed in future guidance. coder, supra note 195, 127 tax notes at 737. similarly, in a may 2010 practicing law institute seminar in new york concerning the codified economic substance doctrine, bob crnkovich, senior tax counsel (partnerships) in treasury’s office of tax legislative counsel, said that “[p]ractitioners can expect economic substance guidance . . . for applying the steep penalties attached to transactions tripped up by” § 7701(o). tandon, supra note 194, at 965. more recently, however, treasury has indicated that only very limited guidance will be issued with respect to the codified economic substance doctrine, and that there may be no formal guidance regarding application of the strict liability penalty. see coder, supra note 195, 127 tax notes at 1423-24 (recounting comments by treasury deputy counsel christensen during a june 2010 tax controversy forum sponsored by new york university). on september 13, 2010, the irs issued its first interim guidance concerning the codified economic substance doctrine and the related penalties. see notice 2010-62; 2010-40 irb 1 (“interim guidance under the codification of the economic substance doctrine and related provisions in the health care and education reconciliation act of 2010”). consistent with that more recent indication, notice 2010-62 “makes no mention of whether and how the irs would implement a uniform penalty procedure for assertions of the harsh strict liability penalty.” amy s. elliot, practitioners blast economic substance guidance, 128 tax notes 1212 (sept. 20, 2010). despite their disappointment with the notice, however, there are practitioners who remain hopeful that the irs may provide further guidance that is more instructive. see id. at 1212 -13 (quoting attorneys cary d. pugh and mark silverman). 198. coder, supra note 195, 127 tax notes at 737 (quoting byron christensen, treasury deputy tax legislative counsel). columbia jour�al of tax law [vol 2:150 188 cases.”199 of course, treasury and the irs are obviously likely to conclude that the most abusive tax shelters are foremost among such “appropriate cases.” nevertheless, to the extent that treasury and the irs adopt procedures that place limits on the application of the § 6662(b)(6) penalty in § 7701(o) cases, there could remain a real possibility that, for any given tax shelter, an accuracy-related penalty other than the § 6662(b)(6) penalty might be imposed. in that case, clients may continue to view the receipt of a covered opinion (which will still provide a defense against those other penalties) as a prerequisite to engaging in an aggressive deal. the “gatekeeper” function of the covered opinion regulations would then remain largely intact. second, even if their ability to deter wrongful taxpayer behavior becomes compromised, the covered opinion regulations will still remain necessary to deter bad practitioner behavior. even if it turns out that legal opinions will no longer provide penalty protection in tax shelter cases, taxpayers (particularly corporate taxpayers) will still typically seek legal advice before entering into an aggressive transaction. indeed, some commentators have argued that a strict liability penalty regime would increase the demand by corporate taxpayers for well-reasoned (and more conservative) advice from tax practitioners before investing in a tax shelter because, under such a regime, such taxpayers would focus more on the substance of the advice being given than simply whether a practitioner is willing to deliver any opinion that could be invoked as a penalty defense.200 199. during a june 2010 tax controversy forum sponsored by new york university, treasury deputy tax legislative counsel byron christensen “said the new section 6662(b)(6) penalty is unique because it lacks a reasonable cause defense, but he assured the audience that the penalty will be asserted only in appropriate cases. the government is interested in ensuring a proper level of oversight and a clear process for applying the penalty, he said. ‘the facts and circumstances must justify assertion of the economic substance doctrine and penalty,’ he added.” coder, supra note 195, 127 tax notes at 1424. previously, during a may 2010 district of columbia taxation section luncheon program, christensen proclaimed that “government and taxpayer interests are best served by ensuring that economic substance penalties are asserted only in appropriate cases.” coder, supra note 195, 127 tax notes at 737. on september 14, 2010, the large and midsize business division of the irs issued an internal examination guidance directive, which states that, “[t]o ensure consistent administration of the accuracy-related penalty imposed under section 6662(b)(6), any proposal to impose a section 6662(b)(6) penalty at the examination level must be reviewed and approved by the appropriate director of field operations before the penalty is proposed.” see lmsb-04-0910-024 (reprinted at 2010 tax notes today 178-47 (sept. 14, 2010)). presumably, this directive reflects some effort by the irs to impose the § 6662(b)(6) penalty only in such “appropriate” cases (whichever those may be). 200. see rostain, supra note 73, at 106-07. for example, the tax section of the new york state bar association has advocated for a strict liability penalty regime, contending that, in the tax shelter context, “the tax ‘dialogue’ between lawyer and client ha[s] become distorted, focusing on whether a lawyer would render an opinion rather than on the underlying merits of the transaction.” id. at 107 (citing n.y. state bar ass’n tax section, report on corporate tax shelters of new york state bar association tax section, at 893 (1999)). the theory underlying this argument is that “[s]trict liability neutralizes the protective effects of legal opinions, thereby putting the burden of avoiding abusive shelters squarely on taxpayers, who will be induced to seek out legal advice that is knowledgeable and conservative.” id. at 106. 2011] circular argume�t 189 such commentators believe that, “[s]ince clients would be unable to purchase penalty protection, they would seek the best legal advice, which lawyers would be motivated to provide.”201 however, while taxpayers might have greater incentive to seek “the best legal advice” before entering into a potentially abusive transaction under a strict liability regime, whether tax practitioners really would always be motivated to deliver such advice is regrettably less certain. in particular, the pro-strict-liability argument fails to consider adequately the incentives of practitioners who represent tax shelter promoters or whose financial interests are tied to the promotion of tax shelters—such as practitioners who deliver marketed opinions, opinions that are subject to conditions of confidentiality, or opinions that are subject to contractual protection. if past is prologue, such practitioners would still be tempted to deliver the kinds of unsound legal opinions that were prevalent in the abusive corporate tax shelters of the 1990s202 in order to lend such transactions an “imprimatur of legitimacy.”203 even if they would no longer provide a defense against penalties imposed on abusive shelters, such legal opinions could still mislead investors into believing that those deals are legitimate.204 to protect against a possible resurgence of such opinion practices, the covered opinion regulations would thus remain necessary even under a strict liability penalty regime. accordingly, the basic framework of the covered opinion regulations should remain intact, and any calls to “throw them out and start over”205 should be rejected. of course, to say that the primary structure of the covered opinion regulations should be retained, is obviously not to say that the problems with the regulations should not be addressed. 201. id. at 107. on this view, such motivation on the part of the lawyers would result from a strict liability regime’s creation of “a market for well-reasoned legal advice that address[es] the legal merits of a transaction.” id. moreover, under this theory, the lawyers’ motivation would be bolstered by the fact that, because a strict liability regime motivates a taxpayer “to consult a tax advisor to obtain substantive legal guidance”, then “[i]f the lawyer’s advice turns out to be wrong on the merits, a taxpayer will have a greater likelihood of success in a subsequent malpractice action” than would be the case if the taxpayer had “obtained the lawyer’s opinion for penalty protection only.” id. at 107-08. 202. for a discussion of the unsound opinions that were used in the abusive corporate tax shelters of the 1990s, such as partial opinions, opinions adopting a hyper-textual approach to statutory construction, and opinions based on unreasonable or unsupported factual representations or assumptions, see supra text accompanying notes 97-105. 203. rostain, supra note 73, at 82. 204. see watson & billman, supra note 74, at 137-38 (describing how tax shelter investors focus on the conclusion of a legal opinion that the tax benefits are allowable, and typically assume that the opinion-giver has considered all pertinent issues and that any assumptions or qualifications in the opinion are legitimate). 205. see, e.g., schenk, supra note 67. columbia jour�al of tax law [vol 2:150 190 b. “significant purpose” should be defined so that the regulations plainly cover only tax shelter advice, and do �ot apply to any other tax advice first and foremost, the scope of the covered opinion regulations should be narrowed so that the regulations apply only to opinions related specifically to tax shelters. the chief problem with the covered opinion regulations is that they apply not only to tax shelter opinions, but also to advice concerning virtually all other tax matters. the onerous due diligence and drafting requirements of circular 230 § 10.35(c) are necessary to curb abusive shelters. as they currently stand, however, those requirements also place unreasonable and unwarranted burdens on the provision of tax advice in connection with practically all legitimate, non-shelter-related tax planning.206 as discussed above, this is because “covered opinions” under the regulations include “reliance opinions” that relate to significant purpose transactions, and the “significant purpose” concept is so broad that it encompasses nearly every tax question that any tax practitioner might ever handle.207 therefore, the first order of business in fixing the covered opinion regulations is to narrow the scope of what constitutes a significant purpose transaction. there is little debate that the “significant purpose” prong of the “covered opinion” definition goes much further than the tax shelter activity that the covered opinion regulations were intended to regulate. indeed, even the irs itself has acknowledged that the current “significant purpose” phrasing is too broad.208 at the same time, the irs has thus far been reluctant to address the problem.209 presumably, this reluctance is borne out of concern that any attempt to reduce the ambit of the “significant purpose” rules may prevent the regulations from reaching potentially abusive activities that somehow escape the listed transaction and principal purpose transaction categories. a call simply to delete the “significant purpose” category, though tempting, is almost certainly a non-starter, because it ignores that legitimate concern. similarly, making “significant purpose” transactions synonymous with “reportable transactions” under § 6707a of the code, though elegant in its simplicity, would not work because the universe of reportable transactions is narrower than the universe of all tax shelters.210 the 206. for further discussion of those burdens, see supra part iv.a-f. 207. see supra part iv.e and text accompanying notes 14-15. 208. swartz & bertrand, supra note 46, at 257 n.240 (“an irs official recently acknowledged that the ‘significant purpose’ definition is ‘too broad.’”) (quoting �amorato says service’s study group to consider changing circular 230 rules, daily tax report, march 6, 2006, at g-9). 209. in fact, “the irs is on record as stating not to ‘expect to see a definition of significant purpose.’” vasquez & vasquez, supra note 56, at 297 (quoting sheryl stratton, aba tax section meeting: tax officials spar with tax bar over circular 230, 107 tax notes 1082, 1083 (2005)). 210. a tax shelter that is not a listed transaction, a confidential transaction, a transaction with contractual protections or a so-called transaction of interest, is not a reportable 2011] circular argume�t 191 challenge, then, is this: how do we narrow the concept of what constitutes a “significant purpose” for purposes of a covered opinion, so that the regulations cease to impose on non-shelter-related advice, but so that they also continue to apply to all potentially abusive transactions? once again, the heart of the answer lies with the business purpose and economic substance doctrines, and with the fundamental precept that informs those doctrines. as noted above, the basic premise underlying the business purpose and economic substance doctrines is that the code is intended to tax income, minus the cost of producing such income.211 the corollary to that foundational rule, which is reflected in the two doctrines, is that the only legitimate tax deductions are those that arise from activity that was intended to—and that could reasonably have been expected to— produce pre-tax economic profit.212 framing the matter in this way provides a clear basis for distinguishing between legitimate tax planning and abusive tax shelters: a transaction is legitimate if any deductions that it creates can be expected to offset income that the transaction itself produces. in contrast, a transaction is an abusive shelter if it is intended to manufacture deductions in order to offset income that derives from other sources. the key is to introduce “significant purpose” language that identifies the latter type of transaction and differentiates it from the former. i submit that this task could be accomplished through a relatively straightforward drafting revision to circular 230’s “covered opinion” definition. specifically, the current language of the “significant purpose” prong of that definition (in circular 230 § 10.35(b)(2)(i)(c)) should be deleted in its entirety and replaced by the following definitional phrase: “any partnership or other entity, any investment plan or arrangement, or any other plan or arrangement, a significant purpose of which is the creation, production or generation of losses or credits in order to reduce, or against which to offset, income from sources other than such partnership, entity, plan or arrangement.” this phrase captures any endeavor that should be deemed abusive, based on the criteria outlined above, but it does not encompass any legitimate tax planning activity. i therefore propose that this italicized language be substituted for the current text of circular 230 § 10.35(b)(2)(i)(c). in conjunction with this change, transaction if it does not generate losses above a certain multi-million-dollar threshold. see irs instructions for form 8886 (rev. mar. 2010) (reportable transaction disclosure statement) at 1-3. the covered opinion regulations should apply in the context of all tax shelter transactions, including those which fall below that high loss threshold. the code recognizes that there are tax shelters which are not reportable transactions, and code provisions distinguish between the two categories. see, e.g., i.r.c. § 6694(a)(2)(c) (2010) (entitled “tax shelters and reportable transactions”) (emphasis supplied). for further discussion of what constitutes a “reportable transaction,” see supra note 93. 211. for a description of the economic substance and business purpose doctrines, and the concepts underlying them, see supra note 98. see also supra note 99 (for a discussion of the economic substance doctrine as recently incorporated in the code). 212. see rostain, supra note 73, at 84-86. for further discussion of these concepts underlying the anti-abuse doctrines, see supra notes 98-99, 170-71 and accompanying text. columbia jour�al of tax law [vol 2:150 192 written advice that is subject to conditions of confidentiality or subject to contractual protection213 should be added as a separate category of “covered opinions” under circular 230 § 10.35(b)(2)(i). opinions with those characteristics simply do not arise in any context other than tax shelters. making these revisions would appropriately narrow the scope of the covered opinion regulations to written advice specifically relating to potentially abusive tax shelters.214 this, in turn, would go a long way toward fixing everything else that is wrong with the regulations. once the regulations’ ambit is appropriately confined to shelter activity, the challenges that the regulations impose with respect to such things as cost burdens, restrictions on informal advice, and the inability to distinguish between significant and insignificant tax issues, would no longer affect anything other than a (very) small subset of tax practice. a practitioner counseling on the next “son of boss” transaction would still have to wrestle with such concerns, but practitioners providing choice-of-entity, corporate reorganization, estate planning, or any other legitimate taxefficient-structuring advice would not. if the requirements imposed by the regulations were imposed only on the delivery of tax shelter opinions, they would no longer be unduly onerous burdens on the provision of routine tax counsel; they would simply be necessary and reasonable restrictions on the historically over-aggressive practices of many tax advisors on potentially abusive transactions.215 c. calls to adopt an opt-in approach should be rejected once the covered opinion regulations are appropriately limited to advice about tax shelters, it would be particularly nonsensical to condition the applicability of the regulations upon a practitioner’s choice to “opt in” to compliance with them. simply put, a regulatory scheme is worthless if it depends on the voluntary consent of those whose activity is to be regulated. in such a scheme, any practitioner who wished to deliver a "partial" opinion that does not address all pertinent legal issues, an opinion based on unreasonable or unsupported factual assumptions or representations, or any of the other variations of unsound, misleading tax shelter opinions that have been used in the past to support abusive shelters, could do so with impunity. of course, under an opt-in approach, a recipient of such an opinion would not be able to rely on the opinion as defense against penalties. the recipient may not realize this, however, because there 213. for a discussion of what it means under circular 230 for an opinion to be subject to conditions of confidentiality or to contractual protection, see supra notes 10-11. 214. in addition to the strong policy reasons for confining the covered opinion regulations to tax shelter opinions, such a narrowing would bring the regulations more plainly within the limits of the congressional grant of authority to the secretary (under § 822 of the jobs act) to promulgate the regulations. see supra note 139 and accompanying text. 215. for an analysis weighing the burdens and benefits of the regulations when applied to tax shelter opinions (and concluding that the former outweigh the latter, thus justifying repeal of the opt-out rules in such cases), see infra text accompanying notes 242-53. 2011] circular argume�t 193 would be no disclaimer on the opinion to warn investors of its uselessness as penalty protection. nor would the recipient otherwise be likely to recognize that the advice in the opinion was fundamentally defective, since the opinion would conclude (subject to arcane qualifications that many readers would simply ignore216) that the tax deductions or credits created by the shelter in question were legitimate and permissible. as a result, an optin regime would make it easier for unscrupulous tax shelter promoters to use such opinions to lend abusive transactions a superficial “imprimatur of legitimacy.”217 for this reason, an opt-in regime is particularly ill-suited to the regulation of marketed opinions that are used to support abusive shelters.218 moreover, if the new strict liability penalty under § 6662(b)(6) of the code becomes the accuracy-related penalty asserted in all or most tax shelter cases,219 adopting an opt-in approach would be tantamount to repealing the covered opinion regulations altogether. under a strict liability regime, the opt-in approach would render the regulations entirely unenforceable because there never would be any reason for a practitioner to “opt in” to compliance with them. the opt-in approach would require a practitioner to comply with the regulations only when he or she intends an opinion to provide penalty protection. obviously, few (if any) practitioners would volunteer to comply when drafting a tax shelter opinion, if he or she could avoid doing so and if the opinion would never be usable as part of a reasonable cause defense against imposition of the § 6662(b)(6) strict liability penalty in any event. since there would be no perceived downside to refraining from opting in when preparing an opinion, an opt-in approach would effectively nullify the covered opinion regulations if § 6662(b)(6) becomes the irs’s penalty of choice for abusive tax shelters. alternatively, to the extent that the other accuracy-related penalties remain viable possibilities in the context of tax shelters, an opt-in approach would weaken the link between tax shelter opinions and the reasonablecause-and-good-faith defense against the imposition of such penalties arising from the shelters being opined on. such an approach would make it easier for a practitioner to persuade a client to accept an opinion that does not offer penalty protection—even when the client has a strong interest in receiving such protection—because the practitioner would no longer have to telegraph, on the face of the opinion, the limits as to what the client is getting. this, in turn, would encourage practitioners to favor their own 216. see watson & billman, supra note 74, at 137-38 (discussing how tax shelter investors concentrate on a legal opinion’s conclusion and assume the appropriateness of the opinion’s qualifications as to legal issues not considered or facts assumed). 217. rostain, supra note 73, at 82. 218. indeed, even the new york state bar association, otherwise one of the staunchest supporters of an opt-in regime, does not support the opt-in approach in the case of marketed opinions. see paul, supra note 66, at 31. 219. for a discussion of § 6662(b)(6), the strict liability nature of the penalty it imposes on transactions that lack economic substance, and the penalty’s potential to undermine the “gatekeeper” effect of the covered opinion regulations, see supra part v.a.3. columbia jour�al of tax law [vol 2:150 194 interests (in not complying with the more exacting due diligence and drafting standards) at the expense of their clients' interests (in establishing a defense against penalties that may result from aggressive transactions). worse yet, it would seriously erode the role of tax attorneys as "gatekeepers" who block their clients' entry into abusive deals.220 clients would still be incented to obtain penalty protection, but practitioners would be far less incented to provide it (because it would become all too easy to avoid the burdens and risks associated with preparing and delivering a covered opinion). as a result, an opt-in regime would destroy the framework that makes the covered opinion regulations effective at curtailing abusive tax shelters. most commentators who favor an opt-in approach stress the benefits of eliminating now-ubiquitous non-reliance disclaimers from practitioners’ written communications.221 as professor deborah schenk has rightly observed, "[t]hat is a peculiarly weak reason to support the optin approach."222 indeed, it becomes an even weaker reason, once the covered opinion regulations are revised to apply only to tax shelter advice. professor schenk offers a different argument in favor of an opt-in regime. she disapproves of a reasonable cause defense to penalties in the first place,223 and she particularly disagrees that legal opinions should be usable in such a defense.224 in short, professor schenk views the defense as “a ‘get-out-of-jail’ option” that provides taxpayers with an undeserved escape from sanctions for violating the law. (she argues, for example, that reliance on a lawyer’s advice is no better an excuse for failing to comply with the tax laws than it is for failing to comply with antitrust or securities law.225) despite these objections, professor schenk nevertheless thinks that, as long as legal opinions are in fact being used as a defense against penalties, the government has a legitimate interest in what those opinions say.226 in considering how to formulate (or reformulate) the covered 220. for a discussion of how the covered opinion regulations use private practice tax attorneys as gatekeepers to impede clients from engaging in abusive deals, see supra part v.a.1-2. 221. see, e.g., paul, supra note 66, at 17-18; schizer, supra note 100, at 363; vasquez & vasquez, supra note 56, at 313-14 (quoting published comments of attorney kenneth gideon). 222. schenk, supra note 67, at 1316 n.22. 223. id. at 1312 (“most people support a broad reasonable cause exception to tax penalties. i am not one of them. i’d favor a strict liability penalty in many cases.”). 224. id. (“i am unimpressed with the argument that a taxpayer should be able to rely absolutely on a lawyer’s opinion. . . . ‘my lawyer told me it was ok’ does not strike me as a sufficient justification for avoiding penalties for behavior congress has chosen to penalize . . . .”). 225. id. 226. id. at 1312, 1313. notwithstanding her opposition to using legal opinions as penalty protection, professor schenk takes the current interpretation of § 6664(c) of the code—to permit reliance on an attorney’s opinion for purposes of reasonable cause defense—“as a given.” id. at 1313. 2011] circular argume�t 195 opinion regulations, she therefore says that the relevant question is: "how better to carry out the appropriate treasury goal of regulating opinions used for penalty protection?"227 by framing the issue this way, professor schenk starts from the premise that the object of the regulations is to prevent taxpayers from avoiding penalties (and, specifically, to use legal opinions to avoid penalties) in instances when they should remain subject to those penalties. she concludes that an opt-in system would be preferable to the optout approach as a way to achieve that goal.228 by confining the covered opinion regulations to opinions that expressly state an intention to be used as penalty protection, professor schenk believes that we could “eliminate much complexity engendered by the current rules” and that we could “retain the extensive rules only for penalty-protection opinions and jettison the rest.”229 under this theory, complexity would be reduced because the more complicated question of which circular 230 § 10.35(c) category an opinion falls within would be replaced by the simpler question of whether penalty protection is expressly sought.230 the various challenges created by the regulations’ due diligence and drafting standards would be also avoided in most cases, because those standards would apply only to the narrow universe of opinions that expressly state that they can be used as a defense against penalties.231 professor schenk's argument has appeal if one accepts her initial premise—viz., that the purpose of the regulations ought to be to curtail the inappropriate avoidance of penalties. that premise is mistaken, however. the point of the regulations is not to curtail the underpayment of penalties; it is to curtail the underpayment of tax. the imposition of penalties is not an end in itself; rather, the threat of penalties is a means to the end of discouraging tax evasion. in one sense, permitting a reasonable cause defense against penalties may seem overly generous to noncompliant taxpayers. to that extent, professor schenk's observations are well taken. however, the availability of such a defense does not function merely as a gift to the undeserving. instead, as discussed above, the possibility of such a defense—and, in particular, the express ability to use a covered opinion as part of such a defense, in the context of a corporate tax shelter—is an essential element of empowering tax attorneys to act as gatekeepers who 227. id. at 1316. 228. id. 229. id. 230. id. (“under an opt-in approach, only one decision would need to be made: is penalty protection sought or not?”). 231. id. (noting that, under an opt-in approach, only an opinion that “states that it is intended to be relied on” would be subject to the covered opinion requirements, and describing how, in other cases, practitioners would not have to be concerned with “fine gradations” in the regulations, such as whether a given transaction is a principal purpose transaction or a significant purpose transaction). columbia jour�al of tax law [vol 2:150 196 impede clients from engaging in abusive shelters.232 because enlisting the aid of the private tax bar in that way is critical to stemming the tide of such transactions,233 the regulations should be written to cover as wide a swath of tax shelter opinions as possible.234 for this reason, moving to an opt-in approach would be exactly the wrong direction to go. d. after the regulations are �arrowed to apply only to tax shelter advice, the opt-out system should also be done away with the reasons for rejecting an opt-in approach also militate in favor of doing away with the opt-out system. a regulatory scheme is of little utility to the extent that it allows those whose activity is meant to be regulated to choose not to be regulated. the primary need for allowing practitioners to “opt out” under the current system is to enable them to navigate around some of the burdens that the covered opinion regulations can otherwise impose on the provision of legitimate tax planning advice, given that a “significant purpose” of almost any such advice is to avoid the payment of tax. if the suggestions in part v.b are adopted and “significant purpose” is defined to refer exclusively to tax shelters, that need falls away. once the covered opinion regulations apply only to tax shelter advice (as they should), they will cease to affect the legitimate tax-efficient-structuring work on which the vast majority of tax practitioners focus the vast majority of their efforts, and the lion’s share of the burdens associated with the regulations will thus disappear on their own (without the need to invoke any “opt-out”). in this beautiful world, the only remaining role for an opt-out provision would be to allow practitioners to escape the purview of the regulations specifically when providing tax shelter advice. in virtually all cases, that is a bad idea. first, if the new § 6662(b)(6) strict liability penalty were to replace the other accuracy-related penalties in the context of tax shelters,235 and if the covered opinion regulations were appropriately restricted to tax shelter opinions, the opt-out rules would completely vitiate the regulations. in a strict liability penalty environment, retaining the opt-out regime would effectively reduce the regulations to a nullity, for much the same reason that 232. for a discussion of the treasury regulation expressly providing that good-faith reliance on the opinion of a professional tax advisor may establish the minimum requirements for the reasonable cause exception to the substantial underpayment penalty attributable to tax shelter items of corporations, see supra notes 89, 178 and accompanying text. 233. see schizer, supra note 100, at 331-45, 355-71. 234. this obviously does not mean that the regulations should not also be narrowed so that they cover only advice concerning tax shelters, and not advice related to legitimate tax planning. see supra part v.b. 235. for a discussion of the new strict liability penalty under § 6662(b)(6) of transactions that lack economic substance under § 7701(o), and how the penalty may affect the covered opinion regulations, see supra part v.a.3. 2011] circular argume�t 197 enacting an opt-in rule would.236 simply put, the regulations would become wholly ineffective because practitioners would almost always choose to opt out of compliance with them. under the opt-out rules, the only requisite for opting out of compliance with the covered opinion regulations when delivering a reliance opinion for a significant purpose transaction is to include a nonreliance disclaimer prominently in the opinion.237 thus, the only consequence of opting out is that the recipient is restricted from invoking the opinion as part of a reasonable cause defense against accuracy-related penalties that the irs may asset against the transaction. obviously, that restriction becomes irrelevant if the accuracy-related penalty that would most likely apply is a strict liability penalty for which there is no reasonable cause defense. in such a case, the recipient would lose nothing by living with the disclaimer and, thus, there would be no practical reason for the practitioner to choose to comply with the regulations when he or she could instead opt out and avoid the costs and burdens of compliance. (it is presumably for this reason, for example, that the current regulations do not permit practitioners to opt out when delivering opinions regarding transactions to which the strict liability penalty under § 6662a(c) may potentially apply.238) 236. for a discussion of the incompatibility of an opt-in rule with the covered opinion regulations under a strict liability penalty regime, see supra text accompanying note 219. 237. see 31 c.f.r. § 10.35(b)(4)(ii) (2010). for an outline of the opt-out rules pertaining to reliance opinions for significant purpose transactions, see supra text accompanying notes 49-51. for a description of what constitutes a “reliance opinion” under circular 230, see supra note 8. 238. section 6662a(c) provides for a penalty in the amount of 30% of a reportable transaction understatement in the case of an undisclosed reportable transaction. see i.r.c. § 6662a(c) (2010). under § 6664(d), there is no reasonable-cause-and-good-faith exception to the § 6662a(c) penalty. see i.r.c. § 6664(d)(3)(a) (2010). (the intent to prevent application of the reasonable cause exception in the case of undisclosed reportable transactions remains clear, despite a drafting oversight in connection with march 30, 2010 amendments to § 6664(d), as a result of which § 6662a(c) erroneously cross-references § 6664(d)(2)(a) rather than § 6664(d)(3)(a). for an explanation as to this drafting error and the intended interplay between §§ 6662a(c) and 6664(d)(3)(a), see supra note 94.) the § 6662a(c) accuracy-related penalty for undisclosed reportable transactions is thus a strict liability penalty. reportable transactions include listed transactions, transactions subject to conditions of confidentiality, transactions subject to contractual protections, loss transactions (i.e., transactions that generate losses in excess of certain specified thresholds) and transactions of interest (which are the same as, or substantially similar to, listed transactions). see irs instructions for form 8886 (rev. mar. 2010) (reportable transaction disclosure statement) at 1-3. correspondingly, there is no permission to opt out of compliance with the covered opinion regulations when drafting an opinion related to a listed transaction, a significant purpose transaction that is subject to conditions of confidentiality, a significant purpose transaction that is subject to contractual protections, or a principal purpose transaction. (it is reasonable to assume that any transaction that is “reportable” by virtue of being a significant loss transaction would most likely be a principal purpose transaction under circular 230 § 10.35(b)(2)(i)(b).) see generally 31 c.f.r. § 10.35(b)(2)(i) (2010); see also supra note 54 and accompanying text (discussing categories of opinions to which the opt-out rules do not apply). thus, the covered opinion columbia jour�al of tax law [vol 2:150 198 similarly, to opt out of compliance when issuing a marketed opinion for a significant purpose transaction, the only additional requirements are to include additional disclaimers stating that the opinion is being used to market the transaction and that investors should consult their own tax advisors.239 if a marketed opinion regarding a tax shelter would not be available as a defense against imposition of the § 6662(b)(6) penalty in any event, the need to include those added disclaimers would most likely be insufficient to dissuade the drafter from opting out of compliance with the regulations. ultimately, if the § 6662(b)(6) penalty turns out to be the penalty applied in all or most future tax shelter cases,240 there will be virtually no disincentive for a practitioner to opt out of compliance with the covered opinion regulations when preparing a tax shelter opinion that would otherwise constitute a reliance opinion or a marketed opinion concerning a significant purpose transaction. if the opt-out rules remain in place, then most (if not all) such opinions will contain irrelevant non-reliance disclaimers, and the regulations will therefore be technically inapplicable to those opinions (because they will not constitute “covered opinions” under circular 230). in this way, the covered opinion regulations will become almost completely enervated. to prevent this, if § 6662(b)(6) becomes the predominant accuracy-related penalty applied to abusive tax shelters, the opt-out rules must be repealed.241 moreover, even assuming that other accuracy-related penalties (to which legal opinions can provide a defense) will retain some vitality in the context of future tax shelters, it would still be a bad idea to retain the current opt-out regime if the covered opinion regulations are narrowed to cover only tax shelter opinions. regulations already restrict the opt-out rules from applying with respect to the delivery of an opinion concerning any type of transaction as to which a strict liability penalty under § 6662a(c) could apply. section 6662a(c) was the only accuracy-related penalty as to which there was no reasonable-cause-and-good-faith exception under § 6664 at the time when the covered opinion regulations were authorized and promulgated. (the jobs act both authorized the covered opinion regulations and enacted §§ 6662a(c) and 6664(d) in 2004.) for further discussion of the § 6662a(c) penalty and the strict liability status of that of that penalty under § 6664(d), see supra note 94 and accompanying text. for a discussion of what constitutes a “reportable transaction” under the code, see supra note 93 and accompanying text. 239. see 31 c.f.r. § 10.35(b)(5)(ii)(b), (c) (2010). for a discussion of the complete requirements for “opting out” in the context of a marketed opinion, including the nonreliance disclaimer and the consumer-protections legends that are needed, see supra notes 49-53 and accompanying text. for a description of what constitutes a “marketed opinion” under circular 230, see supra note 9. 240. for a discussion of this possibility, see supra part v.a.3. 241. cf. jeremiah coder, alexander addresses determination of economic substance relevance, 127 tax notes 1076, 1077 (june 7, 2010) (recounting observation of attorney bryan c. skarlatos that “legal opinions are no longer protection, with the introduction of a strict liability penalty applied to transactions that lack economic substance” and statement by karen gilbreath sowell of ernst & young llp that “[a]s a result of the [economic substance] statute, best practices in opinion writing will have to evolve”). 2011] circular argume�t 199 it would be an especially bad idea in the context of marketed opinions. although the rules currently allow for non-reliance disclaimers to appear in marketed opinions,242 it is difficult to understand the rationale for that. none of the justifications that one might invoke in connection with some other forms of advice would appear to apply in the case of marketed opinions. for example, there cannot be any concern about undue restrictions on the provision of informal or piecemeal advice to a client,243 because marketed opinions, by their very nature, are formal opinions intended to influence the investment decisions of non-clients. nor should there be any worry about a restriction on the ability of practitioners to distinguish between important and unimportant tax issues.244 in fact, just the opposite is true. in the context of marketed opinions, there is a particular need to regulate against the use of misleading “partial” opinions that simply ignore problematic tax questions in order to convey a false sense that the shelter being marketed is legitimate. a requirement to cover all significant federal tax issues is thus especially apt in that case. finally, there is absolutely no justification for concern about cost burdens in the case of marketed opinions. they are, after all, essentially nothing other than advertisements for (often dubious) financial products. these same analyses apply equally well to opinions regarding transactions that are subject to conditions of confidentiality or are subject to contractual protection.245 in addition, as noted above, such transactions (if not properly disclosed and later found to be abusive) are subject to a strict liability penalty under § 6662a(c).246 for all of these reasons, there should be no option to opt out of compliance with the covered opinion regulations when providing those categories of opinions, either. (and, indeed, no such option currently exists.) the remaining question is whether there is any place for an opt-out provision in the case of other sorts of listed transaction opinions, principal purpose transaction opinions, or significant purpose transaction opinions. (just to be clear, the last category refers strictly to transactions that meet the narrow tax-shelter-specific “significant purpose” definition advocated in part v.b above.) are there ever good reasons for allowing practitioners to opt out of the covered opinion regulations when providing any types of tax shelter advice? one particularly bad reason for doing so would be to alleviate cost burdens. keep in mind that we are now talking about a transaction cost to be borne by those who are investigating the boundaries of the most aggressive strategies they can pursue to avoid or evade taxes. such clients deserve thoughtful, professional advice, but they do not deserve much 242. see 31 c.f.r. § 10.35(b)(5)(ii)(a) (2010). 243. see supra part iv.c. 244. see supra part iv.d. 245. for a discussion of what it means under circular 230 for an opinion to be subject to conditions of confidentiality or to contractual protection, see supra notes 10-11. 246. see supra note 238 and accompanying text. columbia jour�al of tax law [vol 2:150 200 sympathy when it comes to matters of expense. attorney casey r. law has summarized this issue particularly well: [a]ssisting a client in taking an aggressive (i.e. legally dubious) tax-saving position is a legally and ethically serious matter; in advising such a client, it is (even apart from circular 230) a very good idea for an attorney to engage in the diligent preparation and careful analysis required for “covered opinions”; and . . . any client who could potentially benefit from such advice has both the financial ability and the moral obligation to pay for it in proportion to the attorney’s labor and risk.247 compromising the cohesion and effectiveness of the covered opinion regulations by allowing practitioners to opt out of complying with them when dispensing tax shelter advice should not be countenanced on the ground that covered opinions are expensive. a more legitimate concern is whether the covered opinion regulations prevent practitioners from providing informal advice from which clients would benefit, or whether they otherwise impede the normal flow of communications between attorneys and clients, in the context of tax shelters.248 the short answer is that they do not. informal communications (such as increasingly prevalent e-mails) and piecemeal items of advice throughout the gestation of a deal are plainly essential to the provision of sound transactional counsel (tax-related or otherwise). however, such advice is almost always already excepted from the “covered opinion” definition under the exclusion for preliminary advice pursuant to circular 230 § 10.35(b)(2)(ii)(a). that section (the “preliminary advice exclusion”) provides that “[a] covered opinion does not include . . . [w]ritten advice provided to a client during the course of an engagement if a practitioner is reasonably expected to provide subsequent written advice to the client that satisfies the requirements of” circular 230 § 10.35.249 the new york state bar association has argued that at least some instances of informal or piecemeal advice may not come within the preliminary advice exclusion because, at the time the advice is provided, “there may be no expectation . . . that formal advice on the topic would be expected.”250 that assertion seems peculiar, particularly in the context of advice concerning corporate tax shelters. there are extremely few, if any, corporate transactional engagements in which the practitioner’s advice consists solely of informal communications and piecemeal snippets. a formal, comprehensive opinion of counsel is almost always a prerequisite to the completion of a complex or significant corporate transaction. thus, the 247. law, supra note 69, at 33-34. 248. for a discussion of concerns that the covered opinion regulations prevent informal advice and impede communications between practitioners and clients, see supra part iv.c. 249. 31 c.f.r. § 10.35(b)(2)(ii)(a) (2010). 250. paul, supra note 66, at 27. 2011] circular argume�t 201 new york state bar association’s contention does not comport with the realities of corporate law practice and is particularly out of place in a discussion of advice concerning corporate tax shelters. (the same is most likely also true in the case of personal deals done by high-net-worth individuals.) accordingly, the only time when ultimate formal advice on a tax shelter should not reasonably be expected is if a proposed transaction is never consummated. in such a case, the entire question is moot, because there are no tax underpayments (and therefore no substantial underpayment penalties from which to be protected) stemming from deals that are never done. in the spirit of clarity and completeness, however, treasury should consider amending circular 230 § 10.35(b)(2)(ii)(a) to state that advice on proposed transactions that are never completed also comes within the scope of the preliminary advice exception. in any event, protecting the normal flow of informal communication and piecemeal advice does not require or justify allowing practitioners to opt out of compliance with the covered opinion regulations when providing counsel concerning tax shelters. next, there is once again the question of having to cover all significant federal tax issues.251 although the problem of “partial opinions” is particularly acute in the case of marketed opinions and opinions that are either subject to contractual protection or subject to conditions of confidentiality, the potential for misusing partial opinions to imbue an aura of legitimacy on an abusive transaction is not confined to those areas. the most effective means by which to combat this problem is to enforce the requirement to cover all significant federal tax issues in the context of all tax shelter advice (other than advice that comes within the preliminary advice exception discussed above). this is not to suggest that the concerns inherent in limiting a practitioner’s ability to distinguish between important and unimportant issues are not real or significant. as discussed above,252 this rule places substantial burdens on both practitioners and clients, and, for this reason, it is imperative that the rule not be applied in anything other than the tax shelter context. in the specific case of tax shelters, however, the trade-offs between the regulation’s burdens and its deterrent effects are unfortunately justified by historical experience. as professor scott schumacher has stated, “[t]he tax shelter boom and related problems could not have occurred without lawyers and accountants. thus, if tax professionals and taxpayers are stymied by the government’s actions in this area, we have ourselves primarily to blame.”253 tax practitioners should not be able to opt out of the covered opinion regulations to avoid covering all significant federal tax issues when advising on tax shelters. 251. this requirement for covered opinions is set forth in 31 c.f.r. § 10.35(c)(3)(i) (2010). for a description of what constitutes a “significant federal tax issue” under circular 230, see supra note 8. 252. see supra part iv.d. 253. schumacher, supra note 72, at 100-01 (citations omitted). columbia jour�al of tax law [vol 2:150 202 for all of these reasons, after the covered opinion regulations are revised to apply only to tax shelter advice, the ability to opt out of compliance with the regulations should be removed. vi. conclusion though some members of the tax bar may suspect otherwise, the covered opinion regulations did not emerge as part of a nefarious plot to wreak havoc on the practice of tax law. rather, the regulations are an unfortunately necessary response to the egregious behavior of tax practitioners whose unsound legal opinions facilitated the rise of abusive corporate tax shelters in the 1990s. the regulations have been effective at curbing abusive shelter activity because they have both proscribed those unscrupulous opinion practices and created incentives that cause practitioners to dissuade their clients from investing in unduly aggressive transactions. it is too bad that the new strict liability penalty for noneconomic-substance transactions may reduce the future effectiveness of those incentives that directly encourage good taxpayer behavior. even if that occurs, however, the covered opinion regulations will remain needed to discourage the bad practitioner behavior that gave rise to their promulgation in the first place. despite their effectiveness and the importance of their role, the covered opinion regulations are not without substantial flaws. in an effort to ensure the covered opinion regulations apply to advice concerning all potentially abusive transactions, the regulations were written so broadly that they unnecessarily impose on virtually all tax advice—even routine advice concerning plainly legitimate tax planning. this has created a number of burdens on the provision of sound tax counsel outside the shelter context, which has disadvantaged practitioner and client alike. to remedy those problems, the scope of the covered opinion regulations must be realigned so that the regulations cover all tax shelter advice, but no other tax advice. this article recommends a specific revision to the definition of a “covered opinion” under the regulations, to accomplish this. if that revision is made, and if the opt-out rules (and the misguided “opt-in” alternative to those rules) are discarded as well, then the regulations will continue to function as an important tool to combat abusive shelter activity without adversely affecting the rest of tax practice. microsoft word 8-2-yonahclausing.docx problems with destinationbased corporate taxes and the ryan blueprint reuven s. avi-yonah* kimberly clausing† abstract with the election of donald trump and the republican party’s domination of congress, house speaker paul ryan’s blueprint for fundamental tax reform requires more careful analysis. the ryan blueprint combines reduced individual rates with a destination-based cash flow type business tax applicable to all businesses. the destination-based business tax at the center of the blueprint has several major problems: it is incompatible with our wto obligations, it is incompatible with our tax treaties, and it will not eliminate the problems of income shifting and inversions it is designed to address. in addition, these proposals generate vexing technical problems that are not easily fixed as well as significant political problems. finally, due to the tax rates that have been proposed, the plan is likely to generate large revenue losses and a less progressive tax system. we conclude by recommending better tax policy solutions to our current corporate tax problems. * irwin i. cohn professor of law, the university of michigan law school, 625 s. state st., ann arbor, mi 48109. † thormund a. miller and walter mintz professor of economics, department of economics, reed college, 3203 se woodstock blvd, portland, or 97202. 230 columbia journal of tax law [vol.8:229 i. introduction .................................................................... 231 ii. is the “better way” proposal compatible with the wto? ............................................................................... 235 iii. what about tax treaties? ......................................... 246 iv. tax avoidance, income shifting and inversions ........................................................................... 247 v. vexing technical problems ..................................... 249 vi. progressivity and revenue effects .................... 251 vii.conclusion ........................................................................ 253 2017] problems with destination-based corporate taxes 231 i. introduction this part describes the ryan proposal in more detail, describing in particular the plan’s destination-basis corporate tax. part ii discusses problems of wto compatibility and trade distortions under this plan. part iii discusses issues surrounding tax treaty compatibility, and part iv discusses the lingering potential for profit shifting under the plan. part v describes technical problems associated with implementing the plan. part vi addresses effects on the progressivity of the tax system and on government revenues, and part vii concludes and offers other suggestions for reform. house speaker paul ryan’s (r-wi) blueprint to reform the tax code is gaining new prominence because of the republican ascendancy in washington following the 2016 election. 1 since president trump is likely to sign any tax reform passed by a republican congress, it is worth serious consideration. the introduction to the ryan proposal (the “blueprint”) states that: this blueprint represents a dramatic reform of the current income tax system. this blueprint does not include a value-added tax (vat), a sales tax, or any other tax as an addition to the fundamental reforms of the current income tax system. the reforms reflected in this blueprint will deliver a 21st century tax code that is built for growth and that puts america first.2 this statement is important, because as will be discussed below, the business part of the proposal can be seen as a modified subtraction method vat. if it were a vat, it would not have problems with tax treaties or with the wto rules. but since it declares itself not to be a vat, and has at least one crucial feature that differs from a vat, it may have problems with both. the individual tax section of the blueprint is not a structural change, although it is quite regressive and would lead to massive budget deficits. 3 it envisages a lower rate structure for ordinary 1 a better way: our vision for a confident america, gop tax reform task force (june 24, 2016), http://abetterway.speaker.gov/_assets/pdf/abetterway-tax-policypaper.pdf [perma.cc/g6b3-ymt3]. 2 id. at 15 (emphasis added). 3 see leonard e. burman, james r. nunns, benjamin r. page, jeffrey rohaly & joseph rosenberg, an analysis of the house gop tax plan, 8 colum. j. tax l. 257 (2017) (estimating that the blueprint would decrease revenue and increase the debt by $3 trillion over the first decade). 232 columbia journal of tax law [vol.8:229 income (up to 33%), a capital gains and dividends and interest rate that is half the rate for ordinary income (up to 16.5%), and abolishing the individual amt and estate tax. for pass-through businesses, the blueprint envisages a rate of 25%, with special provisions to prevent shifting of wage income to pass-throughs.4 a particularly radical portion of the blueprint is the corporate section. in addition to cutting the corporate tax from 35% to 20%, the blueprint envisages three major reforms.5 first, businesses will be allowed to expense capital expenditures, resulting in a zero rate for the marginal return on investment: this blueprint will provide businesses with the benefit of fully and immediately writing off (or “expensing”) the cost of investments. this represents a 0 percent marginal effective tax rate on new investment.6 second, businesses will not be able to deduct net interest expense: under this blueprint, job creators will be allowed to deduct interest expense against any interest income, but no current deduction will be allowed for net interest expense. any net interest expense may be carried forward indefinitely and allowed as a deduction against net interest income in future years.7 third, the blueprint will be destination-based, i.e., be fully imposed on imports (without any deductions) and not imposed at all on exports: this blueprint eliminates the existing self-imposed export penalty and import subsidy by moving to a destination-basis tax system. under a destination-basis approach, tax jurisdiction follows the location of consumption rather than the location of production. this blueprint achieves this by providing for border adjustments exempting exports and taxing imports, not through the addition of a new tax but within the 4 the tax policy center analysis mentions that there would likely be large enforcement problems with these rules, especially given the large rate differential under the plan. see burman et al., supra note 3. nonetheless, they assume that the rules would be enforceable in their revenue analysis. the plan would lose even more revenue absent that assumption. 5 as explained below, if the blueprint proposal reduced profit shifting opportunities as its proponents believe, it is not clear why a rate cut is indicated since the main rationale to cut corporate tax rate is reducing base erosion and profit shifting (beps). 6 a better way, supra note 1, at 25. 7 id. at 26. 2017] problems with destination-based corporate taxes 233 context of the transformed business tax system. the blueprint also ends the uncompetitive worldwide tax approach of the united states, replacing it with a territorial tax system that is consistent with the approach used by our major trading partners.8 this means that imports will be taxed and exports exempted. in addition, the blueprint will enable dividends from foreign subsidiaries of u.s.-based multinationals to be fully exempt, but will maintain the current subpart f provisions for passive income, eliminating only the base company rule and section 956:9 today, all of our major trading partners raise a significant portion of their tax revenues through valueadded taxes (vats). these vats include “border adjustability” as a key feature. this means that the tax is rebated when a product is exported to a foreign country and is imposed when a product is imported from a foreign country. these border adjustments reduce the costs borne by exported products and increase the costs borne by imported products. when the country is trading with another country that similarly imposes a border-adjustable vat, the effects in both directions are offsetting and the tax costs borne by exports and imports are in relative balance. however, that balance does not exist when the trading partner is the united states. in the absence of border adjustments, exports from the united states implicitly bear the cost of the u.s. income tax while imports into the united states do not bear any u.s. income tax cost. this amounts to a self-imposed unilateral penalty on u.s. exports and a self-imposed unilateral subsidy for u.s. imports. because this blueprint reflects a move toward a cash-flow tax approach for businesses, which reflects a consumption-based tax, the united states will be able to compete on a level playing field by 8 id. at 27 (emphasis added). 9 the base company rule, i.r.c. § 954 (2015), provides that selling goods or services through a “base company” in a low-tax jurisdiction triggers u.s. tax to the parent, and i.r.c. § 956 (2007) provides that using income otherwise eligible for deferral to invest in u.s. property (including a loan to the parent) triggers u.s. tax to the parent. the latter rule has been under pressure recently because of the $2.5 trillion in deferred income of foreign subsidiaries of u.s. parents located in low-tax jurisdictions. 234 columbia journal of tax law [vol.8:229 applying border adjustments within the context of our transformed business and corporate tax system. for the first time ever, the united states will be able to counter the border adjustments that our trading partners apply in their vats. the cash-flow based approach that will replace our current income-based approach for taxing both corporate and non-corporate businesses will be applied on a destination basis. this means that products, services and intangibles that are exported outside the united states will not be subject to u.s. tax regardless of where they are produced. it also means that products, services and intangibles that are imported into the united states will be subject to u.s. tax regardless of where they are produced. this will eliminate the incentives created by our current tax system to move or locate operations outside the united states. it also will allow u.s. products, services, and intangibles to compete on a more equal footing in both the u.s. market and the global market.10 the blueprint then addresses the potential wto issue as follows: the rules of the world trade organization (wto) include longstanding provisions regarding the use of border adjustments. under these rules, border adjustments upon export are permitted with respect to consumption-based taxes, which are referred to as indirect taxes. however, under these rules, border adjustments upon export are not permitted with respect to income taxes, which are referred to as direct taxes. this disparate treatment of different tax systems is what has created the historic imbalance between the united states, which has relied on an income tax – or direct tax in wto parlance – for taxing business transactions, and our trading partners, which rely to a significant extent on a vat – or indirect tax in wto parlance – for taxing business transactions. under wto rules, the united states has been precluded from applying the border adjustments to u.s. exports and imports necessary to balance the treatment applied by our trading partners to their exports and imports. with this blueprint’s move toward a consumption-based tax approach, in the form of a cash-flow focused 10 a better way, supra note 1 at 28 (emphasis added). 2017] problems with destination-based corporate taxes 235 approach for taxing business income, the united states now has the opportunity to incorporate border adjustments in the new tax system consistent with the wto rules regarding indirect taxes.11 this approach is similar to the one taken by the 2005 advisory panel on tax reform in the growth and investment tax (git) proposal. under the git, corporations were subject to a cash flow tax with expensing and no deduction for interest, but wages were deductible. the git was destination-based, but for revenue estimating purposes, the revenue associated with border adjustments was disregarded because of concerns about wto compatibility. since the u.s. has a large trade deficit, this represented a difference of $775 billion dollars in revenues over the ten-year budget window.12 according to the tax policy center analysis (2017), the revenue effects of the border adjustment are even larger now, at about $1.2 billion dollars.13 ii. is the “better way” proposal compatible with the wto? under the wto subsidies and countervailing measures (scm) agreement,14 a tax may only be border adjustable if it is an “indirect” tax. a border adjustable “direct” tax is a prohibited export subsidy that can subject the u.s. to trade sanctions. annex i of the scm includes as a prohibited export subsidy:15 (e) the full or partial exemption remission, or deferral specifically related to exports, of direct taxes (58) or social welfare charges paid or payable by industrial or commercial enterprises (59). footnote 58 provides: for the purpose of this agreement: 11 id. (emphasis added). 12 simple, fair, and pro-growth: proposals to fix america’s tax system, report of the president’s advisory panel on federal tax reform (nov. 2005), http://www.treasury.gov/resource-center/tax-policy/documents/report-fixtax-system-2005.pdf [perma.cc/v6hp-nxpw] at 172. 13 burman et al., supra note 3. 14 agreement on subsidies and countervailing measures, 1869 u.n.t.s. 14 [hereinafter scm]. 15 in addition, it is likely that the blueprint would constitute prohibited discrimination against imports and in favour of domestic production under article 3 of the gatt, because foreign businesses exporting to the u.s. would be pressed to move production to the u.s. in order to get a deduction for wages. this is particularly true for manufacturing units in developing countries, where you do not have sufficient local sales to compensate with. see general agreement on tariffs and trade, oct. 30, 1947, 61 stat. a-11, 55 u.n.t.s. 194 [hereinafter gatt]. 236 columbia journal of tax law [vol.8:229 the term "direct taxes" shall mean taxes on wages, profits, interests, rents, royalties, and all other forms of income, and taxes on the ownership of real property; … the term "indirect taxes" shall mean sales, excise, turnover, value added, franchise, stamp, transfer, inventory and equipment taxes, border taxes and all taxes other than direct taxes and import charges.16 footnote 59 provides: the members recognize that deferral need not amount to an export subsidy where, for example, appropriate interest charges are collected. the members reaffirm the principle that prices for goods in transactions between exporting enterprises and foreign buyers under their or under the same control should for tax purposes be the prices which would be charged between independent enterprises acting at arm's length. any member may draw the attention of another member to administrative or other practices which may contravene this principle and which result in a significant saving of direct taxes in export transactions. in such circumstances the members shall normally attempt to resolve their differences using the facilities of existing bilateral tax treaties or other specific international mechanisms, without prejudice to the rights and obligations of members under gatt 1994, including the right of consultation created in the preceding sentence. paragraph (e) is not intended to limit a member from taking measures to avoid the double taxation of foreign-source income earned by its enterprises or the enterprises of another member.17 the business tax regime of the blueprint can be seen as a modified version of a consumption tax–specifically, a subtraction method vat (although the blueprint explicitly denies that it is a vat). specifically, the blueprint imposes tax on cash flow, allows 16 scm, supra note 16 (emphasis added). 17 id. 2017] problems with destination-based corporate taxes 237 expensing of capital expenditures, and disallows net interest expense. all of these are also features of a subtraction method vat.18 however, the blueprint does allow a deduction for wages, while a subtraction method vat would disallow them. this feature makes the ryan tax not wto compatible.19 fundamentally, we need to consider the reason why a vat, whether using a credit-invoice or subtraction method of calculating the tax, is border adjustable. sales taxes, excises and vats are border adjustable because there is no distortion introduced by the tax; goods receive like tax treatment in the domestic market irrespective of where they are produced. both the tax component in exports and the price of imports are measurable, and the border adjustment does not exceed the tax that is levied because (in the case of import) the full tax is levied at the border, and (in the case of exports) the refunded amount in an invoice-credit vat is only the amount that was levied at previous stages, as shown on the invoice. by so limiting border adjustments, the wto reduces opportunities for countries to subsidize exports or overtax imports. the ryan blueprint’s treatment of purchases (including capital and inventory) and labor highlights the difference between a tax on value added and ryan’s tax on an income base. if the factors of production employed at each stage of production and distribution of goods are totaled up, they should equal 18 a subtraction method vat is a cash-flow tax that includes all sales but allows a deduction for all outlays, except for interest and wages. in principle, it has the same tax base as the normal invoice-credit vat, as adopted by most countries. in an invoice-credit vat, tax is paid at each stage of production on the sale price of outputs, with a credit given for tax on inputs. both methods can be origin or destination-based, but all existing vats are destination-based (imports are taxed and exports are exempt). the main difference is administrability: in an invoicecredit vat, no credit is given unless tax was paid on the input, as shown on an invoice. in a subtraction method vat, care must be taken not to allow a deduction unless there is a corresponding inclusion by the provider of goods, services or intangibles. this difference explains why no country has adopted a subtraction method vat. the blueprint proposal is based on a subtraction method vat, but with a deduction for wages. 19 for similar conclusions, see wolfgang schön, destination-based income taxation and wto law: a note (max planck inst. for tax law and pub. fin., working paper no. 03, 2016), http://ssrn.com/abstract=2727628 [perma.cc/t5m3-tndf]; wei cui, destination-based cash-flow taxation: a critical appraisal (sept. 30, 2015) (unpublished manuscript), http://ssrn.com/abstract=2614780 [perma.cc/j6gw-qnmq]; wei cui, destination-based taxation in the house republican blueprint, 173 tax notes today 7 (2016); lee a. sheppard, news analysis: freedom fries: the house republicans’ cash flow tax (section 954 – foreign base company income), 157 tax notes today 1 (2016). 238 columbia journal of tax law [vol.8:229 the retail sales price of the goods. a traditional vat is imposed mainly on two factors of production, labor (about 2/3 of base) and income from capital or rents (extra profits above the normal return to capital). under a sales-subtraction method vat, taxes are collected and remitted to the government by business at each stage of production and distribution. the resulting tax should be equal to the tax imposed on the retail price of taxable goods under a single-stage retail sales tax. purchases taxed at a prior stage of production or distribution are deductible, so that this value is not taxed again. under that method of calculating vat, the cost of labor is not deductible so that this factor of production can be included in the tax base. in contrast, under the ryan blueprint tax, a business can take an immediate deduction for its wage expense, leaving that factor of production out of the tax base. workers bear tax at multiple rates on that labor income under the individual income tax. even if the tax paid by the workers may be viewed as a surrogate for a business’s tax on labor, that surrogate tax cannot be accurately measured and that tax cost does not enter the taxinclusive prices of the business’s outputs. giving a full deduction for labor costs effectively subsidizes exports and overtaxes imports. for example: assume that a domestic grape grower has no business inputs. he has labor costs of 30 and profit of 10. he sells the grapes to a wine producer for 30 + 10 = 40. since labor is deductible, the grape grower pays tax only on his profit. the tax is 10 x 20% = 2, so the tax inclusive price is 40 + 2 = 42.20 the wine producer buys the grapes for 42. she has labor costs of 45 and profit of 15. she sells the wine to a domestic consumer for 42 + 45 + 15 = 102, and pays tax only on the profits of 15 since the other elements are deductible. total tax paid by the wine producer is 15 x 20% = 3, and the tax inclusive price to the consumer is 102 + 3 = 105. if the wine producer instead exports the wine by selling it to a foreign customer, she has 100 in exempt income, or zero income (assuming no other income). she also has 40 + 45 = 85 in deductible costs, so in principle she should get a check from the treasury of 85 x 20% = 17.21 the foreign customer, assuming that his country also charges 20% vat on imports, will pay 100 plus vat of 100 x 20% = 20, and the tax inclusive price will be 120. note that this is a higher 20 in this example, we assume that the tax gets passed on to consumers in the form of higher prices. 21 under the blueprint, net operating losses (nols) are carried forward with an interest charge, rather resulting in an actual refund, but the end result should be the same. still, many exporters may never show positive income under this tax system, so they may not be able to use nols. 2017] problems with destination-based corporate taxes 239 price than the price to the domestic wine consumer, because in the domestic sales the costs of goods sold and the labor are deductible whereas in the foreign sale they are not. now let us compare this to a normal invoice credit vat of 20%. in the domestic case, the grape grower has 30 in labor costs and 10 of profit, and he will charge the wine producer a tax inclusive price of 40 + (40 x 20%) = 48. the wine producer will pay 48 to the grape grower and has 45 of labor costs and 15 of profits, so she will charge a tax inclusive price of 48 + 45 + 15 = 108 minus 8 refund of vat paid on inputs, or 100 + (100 x 20%) = 120. in the export case with an invoice-credit vat, the grape grower still charges the wine producer 48. the wine producer adds labor costs of 45 and profits of 15 and since the wine is exported in a zero rated sale she receives a refund of 8 and the sale price to the foreign consumer is 48 + 45 + 15 – 8 = 100, plus 20% foreign vat or 120. if we compare the two cases, under the ryan tax the domestic consumer pays 105 and the foreign consumer 120. the difference of 15 is the tax on the deductible u.s. labor costs (= (30 + 45) x 0.20). but if the wine producer wants to undercut wine produced in the foreign country, she can easily afford to sell for less than 100. specifically, she could sell for as low as (100 – 17) + 20%, or $99.60 (tax inclusive). this demonstrates the export subsidy, which results from the ability to deduct labor costs in the u.s., whereas such costs are not deductible in the normal vat in the foreign country. under the normal vat, the prices to the domestic and foreign customers are the same (120 domestic, 120 foreign) and there is no check from the treasury other than the refund of vat actually paid. the reason for the export subsidy in the ryan tax is that labor costs are deductible. in theory this should not make a difference if we could be sure that labor is subject to at least a 20% tax rate, since then the deduction and inclusion would offset each other. however, much labor income is taxed at lower rates due to the progressivity of the federal income tax as well as the earned income tax credit. ryan also envisages a zero bracket of the first $24,000 of income and a 12% rate for those currently in the 10 or 15% brackets, so it is likely that many of the employees of the grape grower and the wine producer will be subject to individual tax at less than 20%. thus, the ryan blueprint should be classified as a modified consumption-style tax imposed on an income base. as such, it is not a border adjustable tax under the wto rules, as currently interpreted. if the u.s. treated a ryan-type tax as border adjustable, 240 columbia journal of tax law [vol.8:229 we can expect our international competitors to challenge the tax at the wto before it takes effect. economists, however, argue that exchange rate changes may offset this, because u.s. dollar appreciation would undo the export subsidy.22 but the exchange rate offset will not be perfect since the tax treatment will depend on individual firm circumstances, and the exchange rate only affects the overall prices of imports relative to exports. in particular, different goods will receive the export subsidy to different extents, because not all goods have the same share of labor in their production costs, and different tax rates apply to corporate and pass-through business. yet any exchange rate changes will affect all goods equally. even more important, the literature on exchange rate determination makes any exchange rate offset hardly predictable or clear cut. empirical studies in international finance makes it quite clear that exchange rates movements are divorced from most coherent theories of exchange rate determination. as noted by rogoff:23 the extent to which monetary models, or indeed, any existing structural models of exchange rates, fail to explain even medium term volatility is difficult to overstate. the out-of-sample forecasting performance of the models is so mediocre that at horizons of one month to two years they fail to outperform a naïve random walk model (which says that the best forecast of any future exchange rate is today’s rate). almost incredibly, this result holds even when the model forecasts are based on actual realized values of the explanatory variables.24 this may be due in part to the huge speculative component of exchange rate trading. the foreign exchange market has transactions that exceed $5 trillion each day; the u.s. dollar is involved in 88% of these currency trades.25 compare the size of the world economy, with an annual gdp of about $75 trillion. all of world gdp could be 22 see, e.g., alan j. auerbach & douglas holtz-eakin, the role of border adjustments in international taxation, am. action forum (nov. 30, 2016), http://www.americanactionforum.org/research/14344/ [perma.cc/yy2w-gj6f]. 23 kenneth rogoff, perspectives on exchange rate volatility, international capital flows 441-53 (martin feldstein ed.,1999). 24 id. at 444. 25 see triennial central bank survey: foreign exchange turnover in april 2016, bank for int’l settlements (sept. 2016), http://www.bis.org/publ/rpfx16fx.pdf [perma.cc/2nvk-uavp]. 2017] problems with destination-based corporate taxes 241 purchased with about 15 days of foreign exchange! thus, the bulk of exchange rate trading is not related to the purchase of goods or even assets, but rather to financial market trading. this may help explain why exchange rate movements are difficult to predict with standard theories or macroeconomic models. indeed, macroeconomists have a dismal record of predicting exchange rate movements based on any fundamental theories of exchange rate determination. thus, there should be grave doubts that exchange rate changes will smoothly offset the effects of the border adjustment. the exchange rate offset argument is sometimes made by noting that trade must balance in the long run, or by simply assuming balanced trade. yet while trade must balance in the long run, there is no reason why countries can’t run persistent trade deficits and surpluses. indeed, the united states has experienced a trade deficit for every year of the last 40 years. our persistent trade deficit is due to macroeconomic considerations, and in particular, the fact that u.s. savings are low relative to our private investment desires and government borrowing.26 if nothing changes those macroeconomic variables, then our trade deficit should remain constant, so the exchange rate offset must offset any trade distortions introduced by the tax changes. still, it is far from clear that a tax change of the magnitude imagined here would not affect macroeconomic variables such as savings, investment, tax revenues, and government spending. in addition, many countries do indeed fix their exchange rates, and this will also slow any adjustment to the introduction of the ryan tax.27 auerbach and holtz-eakin recognize that, but they note that most countries do this for reasons of “competitiveness” and therefore could be expected to adjust pegs accordingly.28 we disagree. most countries peg to achieve other macroeconomic goals, and in particular 26 the borrowing that occurs from abroad is the “flip side” of the trade deficit. in particular, basic national income accounting indicates that ex-im (the trade balance) must always equal the sum of the private savings/investment balance (s-i) and the government budget balance of tax revenues relative to government spending (t-g). in the case of the united states, our trade balance is often negative since our savings (s) fall short of demand for loanable funds due to private investment (i) and government borrowing (g-t). 27 in the imf survey of exchange rate regimes, they classify only 29 of 191 countries as freely floating. other countries have other arrangements, including fixed rates, currency boards, and more actively “managed” floats. see annual report on exchange arrangements and exchange restrictions, int’l monetary fund (2014), http://www.imf.org/external/pubs/nft/2014/areaers/ar2014.pdf [perma.cc/l4h7vxzg] 28 auerbach & holtz-eakin, supra note 22. 242 columbia journal of tax law [vol.8:229 to import creditability with respect to monetary policy, to target inflation, to enhance exchange rate stability, etc. it is far from clear that competitiveness is the determinative motive in most cases. (and often pegs will have the opposite effect, when countries intervene to support overvalued currencies.) further, trade contracts are often set in advance in dollar terms, so even if exchange rates were to adjust immediately and fully, there would still be a disruptive lag in terms of effects on those engaged in international trade. this shock could be quite damaging to retailers in the short run. also, if lags in exchange rate adjustment convince trading partners to undertake protectionist trade measures in response, those measures are likely to prove more long-lasting. in addition, one shouldn’t be sanguine about the effects of a large dollar appreciation, as this redistributes wealth away from u.s. owners of foreign assets (since their assets are now worth less in dollar terms) and toward foreign owners of u.s. assets. these wealth effects involve amounts in the trillions of dollars.29 dollar appreciation can also have dire fiscal consequences for emerging economies that are borrowing in dollars; indeed u.s. dollar appreciation played a large contributing role in several past developing country debt crises, including the latin american debt crises of the mid 1980s and the argentine debt crisis and default of 2001.30 we are not aware of any empirical evidence on the exchange rate mechanism, but that should be provided before adjustment is taken on faith. indeed, it seems dangerous to “bet” entire sectors of the economy on such untested grounds, especially when no other major country has adopted this type of corporate tax. the only empirical study, by desai and hines, in fact suggests that trade effects may be counter to expectations. according to desai and hines, “[e]conomic theory implies that exchange rate adjustment prevents destinationbased vats from affecting exports and imports. indeed, this proposition is so well accepted among economists that it has not been subjected to serious prior testing.”31 still, desai and hines found that countries that relied on vats actually had worse export performance 29 see, e.g., alan viard, border tax adjustments won’t stimulate exports, am. enter. inst. (mar. 2, 2009), http://www.aei.org/publication/border-taxadjustments-wont-stimulate-exports/ [perma.cc/65vb-695h]. 30 see michael graetz, the known unknowns of the business tax reforms proposed in the house republican blueprint, 8 colum. j. tax l. 117 (2017). 31 mihir desai & james hines, value-added taxes and international trade: the evidence (nov. 2002) (unpublished manuscript), available at http://pdfs.semanticscholar.org/0245/59563b9d1470c5932a0b858bb9153ab750df.p df [perma.cc/5scz-e7u5]. 2017] problems with destination-based corporate taxes 243 (and also lower imports), and this finding typically (but not always) persists when control variables and country fixed effects are included.32 desai and hines note that the real world features of vats can explain their finding, since vats tend to fall more heavily on traded goods than non-traded goods, and export rebates are often incomplete, thus discouraging trade. these two explanations also likely apply in the ryan tax context. for reasons explained below, the unlikelihood of exporters getting full rebates for their export “losses” are even stronger in the ryan tax context than in a traditional vat,33 and there is reason to believe that the ryan tax will be imposed differentially on tangible goods than on services and intangibles (discussed below).34 there are other wto related problems with the blueprint as well. first, the blueprint explicitly declares up front that it is not a vat but a corporate income tax (“this blueprint does not include a value-added tax (vat), a sales tax, or any other tax as an addition to the fundamental reforms of the current income tax system”). second, the retention of an exemption for dividends from controlled foreign subsidiaries (on top of the destination basis) and subpart f and the imposition of tax on some interest and dividends make the blueprint look more like a corporate income tax. in contrast, vats are purely destination-based and do not apply to any foreign source income, so territoriality is not needed, and financial flows are disregarded. auerbach and holtz eakin argue that: there is an open question whether a destinationbased cash flow tax (dbcft) would be determined to be compliant with the rules of the world trade organization. there are two primary issues here. first, 32 id. 33 under the blueprint, nols are carried forward with an interest charge. this may or may not result in an eventual payment. many exporting firms may not ever show a taxable profit under this system. 34 a final bit of evidence comes from de mooij & keen, discussed within auerbach, et al., destination based cash-flow taxation 20-21 (oxford u. ctr. for bus. tax’n, working paper no. 17/01, 2017), http://eml.berkeley.edu/~auerbach/cbtwp1701.pdf [perma.cc/yvh9-qxl5]. there is evidence that eurozone countries that pursue fiscal devaluations (a combination of increased consumption taxes and reduced business taxes on labor that is similar to a destination-based cash-flow tax) do see a noticeable short-run increase in net exports. see ruud de mooij & michael keen, ‘fiscal devaluation’ and fiscal consolidation: the vat in troubled times (nber, working paper no. 17913, 2012), http://www.nber.org/papers/w17913.pdf [perma.cc/v7k4-5l9g]. this working paper also appears in fiscal policy after the crisis, u. of chicago press 443-85, (alberto alesina & francesco giavazzi eds., 2013). 244 columbia journal of tax law [vol.8:229 wto rules currently limit border adjustments to “indirect” taxes – taxes on transactions (e.g., sales, payroll, etc.) rather than “direct” taxes on individuals or businesses. it is not clear that a dbcft would be successfully characterized as an indirect tax, even though it is economically equivalent to a policy based on indirect taxes (a vat and a reduction in payroll taxes), and even though the distinction between direct and indirect taxes has little meaning and no bearing on any economic outcomes. in addition, there might be concerns under existing wto rules regarding the combination of border adjustments with a deduction for domestic labor costs, since the border adjustment assessed on imported goods applies to the entire cost of the imports, with no deduction for the labor costs that went into the production of these imported goods. some might see this treatment as favoring domestically produced goods over imported ones. but such an inference makes little sense from an economic perspective. again, consider the equivalent policy of introducing a vat and reducing payroll taxes, both elements of which are compatible with wto rules. a reduction in payroll taxes would indeed encourage domestic production and employment to the extent that it lowered domestic production costs. but this is true of any reduction in taxes on us production, and it is difficult to comprehend why international trade rules should dictate the tax rate a country applies uniformly to its own domestic economic production activities.35 given these arguments, one might legitimately query why proponents have not simply suggested replacing the corporate tax with the combination of a vat and a cut in payroll taxes.36 (though to achieve a 20% wage subsidy, one would have to provide more tax relief than a complete elimination of the 15% payroll tax.) still, regardless of the merits of such equivalence arguments, which neglect real world features of modern payroll taxes, it is unlikely that they will sway the wto. wto decisions tend not to respect this type of 35 auerbach & holtz-eakin, supra note 22. 36 the real reason, one suspects, is the widely-held belief in the political implausibility of enacting a vat in the united states. given the wto issue facing any border-adjusted tax that is not a vat, this belief may be misguided. see reuven avi-yonah, the inexorable rise of the vat: is the u.s. next?, 150 tax notes 127 (2016). 2017] problems with destination-based corporate taxes 245 argument even if economists find this “difficult to comprehend.” the whole point of introducing the ryan tax, as auerbach and holtz-eakin concede, is to make the united states into a giant tax haven from the perspective of our trading partners, and induce their multinationals to move operations into the united states.37 given the likely harm to their tax revenues from such a shift following the initial introduction of the ryan tax, our trading partners, and especially the eu, are likely to sue. the result would be years of litigation with an uncertain outcome and potentially very large trade sanctions. recent estimates suggest that dispute could result in retaliatory tariffs sufficient to eliminate over $200 billion in u.s. exports.38 such an outcome would be very worrisome for several reasons. first, we are already in an environment where the gains from trade are being threatened by a president that frequently urges the imposition of tariffs. adding protectionist features to the tax code, even if some economists are convinced that there would be no net effect on prices, risks misunderstanding and increases the probability of retaliatory tariffs. indeed, some countries have already pledged tariff retaliation if the united states moves forward with this plan. protracted and contentious litigation could also reduce the u.s. political backing for the wto, harming both the long-run prospects for an open trading system and our international relations. second, the ambiguities of whether these tax provisions would pass muster with the wto creates a far more uncertain investment climate, making it more difficult for companies to resolve investment and location decisions. further, if there is no assurance that the tax will be retained, that could also hamper the process of exchange rate adjustment. finally, if the wto authorizes trade sanctions in response, such sanctions may lead to an endgame result where the u.s. government complies with the wto by turning the ryan tax into a “normal” vat by denying the deduction for labor. this would make the tax far more regressive than the proposed cash-flow corporate tax it replaces.39 of course, the border adjustment feature could not be dropped without huge revenue losses as well as enormous tax 37 auerbach & holtz-eakin, supra note 22 at 12-14. 38 see, e.g., chad p. bown, wto-consistency of the bta and potential retaliation, presentation at the peterson institute for international economics (feb. 1, 2017), in peterson inst. for int’l econ., http://piie.com/system/files/documents/bown20170201ppt.pdf [perma.cc/43mlr27k]. 39 see sheppard, supra note 19, at 914. 246 columbia journal of tax law [vol.8:229 avoidance and profit shifting problems. absent the border adjustment, the whole structure of the destination-based tax breaks down. iii. what about tax treaties? there are three problems with tax treaties in the blueprint, assuming that the proposed tax is an income tax subject to the treaties. the first problem is that if the business tax is an income tax covered by the treaties and we are serious about taxing on a destination basis goods and services imported into the u.s., we need to do away with the permanent establishment (pe) limitation in article 7, because we need to be able to tax importers without a pe (or physical presence required under domestic law). while we believe that this is a long overdue reform, bringing the income tax treaty into the 21st century and the age of electronic commerce,40 it should be recognized that it involves a massive treaty override of a crucial aspect of the treaty bargain, which was considered and rejected by our treaty partners in the beps context. the second problem is that if the business tax is an income tax, in order to levy it on a destination basis and include all imports, it must be imposed not just on goods and services (under article 7) but also on intangibles that produce royalties (article 12) and other types of deductible payments that can substitute for royalties (e.g., payments on derivatives, generally classified as other income under article 21). while interest and dividends are not deductible, allowing royalties and derivatives to escape the tax on imports invites abuse (since there will always be lower tax jurisdictions). this requires another treaty override that can be avoided if the business tax is a vat. finally, it could be argued that because the ryan tax advantages domestic companies that export from the u.s. over similar foreign companies that import into the u.s., the ryan tax is a violation of the non-discrimination provision of the treaties.41 an important related question is how our treaty partners will react to such sweeping changes and treaty overrides (which they regard as violations of international law). given that the new u.s. tax (20% rate with expensing, territoriality, border adjustments) will create a strong attraction for foreign-based multinationals to shift profits into the u.s., it is likely that they will (a) refuse to give credit for the u.s. tax under tax treaties because (given expensing) it is not an income tax, and (b) apply their cfc rules to u.s. affiliate operations by their 40 reuven avi-yonah, international taxation of electronic commerce, 52:3 tax l. rev. 507 (1997). 41 see sheppard, supra note 19 at 909-10. 2017] problems with destination-based corporate taxes 247 multinationals, which cannot invert in response because of exit taxes. the possible end result could be a collapse of the treaty-based international tax regime, to the disadvantage of u.s. taxpayer who will face increased withholding taxes overseas as well as increased transfer pricing enforcement.42 iv. tax avoidance, income shifting and inversions the better way proposal argues that: taken together, a 20 percent corporate rate, a switch to a territorial system, and border adjustments will cause the recent wave of inversions to come to a halt. american businesses invert for two reasons: to avail themselves of a jurisdiction with a lower rate, and to access “trapped cash” overseas. those problems are solved by the lower corporate rate and the territorial system, respectively. in addition, border adjustments mean that it does not matter where a company is incorporated; sales to u.s. customers are taxed and sales to foreign customers are exempt, regardless of whether the taxpayer is foreign or domestic.43 we do not believe the blueprint proposal will completely stop the incentive for u.s. corporations to shift income overseas, because even with a 20% rate and expensing, rents (for example, from intangibles such as apple’s “irish” profits) can still be located in zero tax jurisdictions and then repatriated tax-free. while this problem can be minimized if it is limited to rents from exploiting foreign markets (which would be exempt even if carried out from the u.s.), we are doubtful that the line between u.s. and foreign markets can be drawn precisely where services and intangibles are concerned, where there can be no enforcement of the tax at the border. even a normal (invoice credit) vat has issues where imports of services and intangibles are concerned, since it is difficult to collect the tax from consumers who are not eligible for deductions or input credits.44 42 see reuven avi-yonah, the international implications of tax reform, 69 tax notes 913 (1995); reuven avi-yonah, from income to consumption tax: some international implications, 33 san diego l. rev. 1329 (1996). 43 a better way, supra note 1 at 26. 44 for the serious problems raised by application of vat to cross-border trade in services and intangibles, see international vat/gst guidelines, oecd (nov. 2015), http://www.oecd.org/tax/consumption/international-vat-gstguidelines.pdf [perma.cc/8tqb-885y] (recommended by the council in september 2016). in an invoice credit vat, exports are zero-rated in the country of origin, so 248 columbia journal of tax law [vol.8:229 moreover, experienced tax practitioners have already suggested ways of gaming the blueprint. for example:45 1. a u.s. pharmaceutical with foreign subsidiaries could develop its intellectual property in the united states (claiming deductions for wages, overhead and r&d), and then sell (i.e., export) the foreign rights to its irish subsidiary (at the highest price possible). the proceeds would not be taxable. ireland would allow that subsidiary to amortize its purchase price. this creates tax benefits in each jurisdiction by reason of the different regimes. if the irish subsidiary manufactures drugs, the profits could be distributed up to the u.s. parent tax-free under a territorial system. if the irish subsidiary is in danger of becoming profitable for irish tax purposes, the u.s. parent would just sell it more ip. 2. if an irish parent owns a u.s. subsidiary, the irish parent can issue debt to fund the purchases of the ip. the u.s. subsidiary then invests the cash to generate more ip (expensing all equipment and deducting all salaries) and sells the ip to its parent. 3. if an irish parent has purchased the u.s. ip rights, it would not want to license the rights to the u.s. a business importer does not get a tax credit on the purchase. if there is an output tax to the final consumer, it is simply charged and paid (like a typical retail sale under the u.s. rst). this means that, unlike the typical vat situation, the entire collection even in a b2b context depends on the final sale to the consumer, and experience with retail sales taxes has illustrated that at high rates this becomes an avoidance problem (as anyone living in states that border states that do not tax sales can attest). the real problem in the b2c domain is simply that there is no jurisdiction to enforce the b2c tax, because there is no jurisdiction over the remote supplier. in the b2b context, the answer is the reverse charge, where the business purchaser self-assesses the tax and therefore gets an input tax credit on any further sale. in the b2c context, relying on the consumer to self-assess the tax amounts to a tax on honesty (like the u.s. state use tax where there is no collection by the remote seller). in general, determining exports and imports and tracking purchases of those engaged in cross-border business is not trivial. it is difficult to judge where services are consumed and to trace location of downloaded services. 45 thanks to david miller for suggesting these. for further elaboration, see david s. miller, how donald trump can keep his campaign promises, grow the economy, cut tax rates, repatriate offshore earnings, reduce income inequality, keep jobs in the united states, and reduce the deficit (tax forum paper no. 680, 2017), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2908207 [perma.cc/2k9h5kdt]. 2017] problems with destination-based corporate taxes 249 subsidiary (income for irish parent under irish tax law and no deduction for u.s. subsidiary). so it just contributes the rights to another u.s. subsidiary. could the u.s. subsidiary amortize the parent's basis under the blueprint? when one u.s. subsidiary licenses to another, no net tax would be paid. any royalties would be taxable to the licensor but deductible for the payor.46 4. how does the blueprint work for services? if a u.s. hedge fund manager provides services to an offshore hedge fund, is that considered an export that is tax exempt? what if the u.s. manager develops a trading algorithm and sells it (or licenses) it to an offshore hedge fund? are the proceeds and royalties exempt? if so, then the hedge fund becomes a giant tax shelter to the manager, because he would not pay 25% on this income – he would pay zero, with no further tax. this is much better than the current carried interest provision, which has attracted bipartisan condemnation because it enables individuals with income of many millions to pay a reduced rate. the blueprint result is much worse. v. vexing technical problems first, this tax system is very difficult to explain to the public or, even, experts. this creates a risk that loopholes will be easier to design due to the deliberate exploitation of the system’s complexity by savvy tax planners and lobbyists. yet if the system is implemented in a more theoretically pure form, without opening the door to loopholes, it is not clear that the mnc business community would support the proposed changes. the net effect would be a tax increase for the intangibleintensive mncs that had previously succeeded in achieving single-digit tax rates by gaming the old system (and shifting u.s. profits abroad). it is also a tax increase for highly-leveraged firms, since debt-financed investments would no longer be subsidized. 46 as miller argues, this example suggests that inversions would in some cases still be valuable. moreover, to the extent the blueprint retains subpart f, inversions can be helpful in avoiding it. for example, if an irish subsidiary of a u.s. parent licenses intangibles to consumers in the u.s. and because it is difficult to enforce the tax on the consumers the irs relies on subpart f to tax the royalties, this rule (which is included in what remains of subpart f in the blueprint) can be avoided by an inversion. 250 columbia journal of tax law [vol.8:229 retailers that import into the u.s. and manufacturers that import parts are likely to object to a new tax system that means they cannot deduct their cost of goods sold. second, there is an increased likelihood that many profitable firms would show losses. this is especially the case for exporters, since they may have deductible expenses, but no taxable revenue. exporting firms with persistent losses will find the credits do them no good, which would affect export incentives. while economists would support a refund system in order to keep tax neutral, there is a large potential for fraud, and politically it seems unlikely that the government could issue large checks to profitable corporations on a permanent basis. the alternative suggested by the blueprint is unlimited carry-forwards, but this doesn’t solve the problem for businesses with losses that may not be offset. and this introduces new trade distortions since the border adjustment is not symmetric. exporting companies could of course merge with non-exporters in order for the losses to be more useful, but inducing a slew of taxmotivated mergers would be inefficient. auerbach and holtz-eakin recognize that this would be a large problem for exporting firms. they suggest allowing firms to use credits to offset payroll taxes, or have a system of refundable border adjustments, but both of these solutions are problematic and difficult to implement.47 third, there are myriad technical problems that remain to be worked out. for example, financial institutions require separate treatment. the pure form of this tax leaves out financial flows entirely. an augmented form of the tax can capture financial transactions in the base, but this would introduce complexity as all companies would need to keep track of financial transactions, as well as whether the transactions occurred with foreign companies. there is also substantial ambiguity between what transactions are real and what are financial, and such ambiguity raises both technical considerations as well as opportunities for tax avoidance.48 fourth, there are likely to be important impacts on state government corporate tax systems, and these have also not been carefully considered. fifth, there are large transition effects associated with moving to a destination-basis cash flow system that would need 47 auerbach & holtz-eakin, supra note 22. 48 for a more detailed treatment of these complex issues, see david weisbach, a guide to the gop tax plan – the way to a better way, 8 colum. j. tax l. 171 (2017). see also auerbach, et al., supra note 34. 2017] problems with destination-based corporate taxes 251 to be carefully considered.49 vi. progressivity and revenue effects an essential problem with the ryan blueprint concerns the tax rates that were chosen. these very low tax rates make the system likely to lose a large amount of revenue in a regressive manner. indeed, the corporate rate chosen is intellectually incoherent. one of the purported advantages of a destination-basis corporate cash flow tax is that it is supposed to curb profit shifting by removing the incentive for shifting profits and activities abroad. but, if that is the case, why is the rate cut needed? if tax burdens truly depend only on the location of immobile customers, why not keep the corporate rate at the same level as the top personal rate? the usual argument for the lower rate relies on the international mobility of income and competitiveness concerns. if such concerns are moot, then there is no reason to tax at a low rate. further, the discrepancy between the top personal rate and the business rate will create new avoidance opportunities as wealthy individuals seek to earn their income in tax-preferred ways, reducing their labor compensation in favor of business income. companies would be inclined to tilt executive compensation toward stock options and away from salary income, and high-income earners would be inclined to earn income through their businesses in pass-through form. the ryan proposal exempts the normal return from capital, giving these returns zero-tax treatment. further, excess returns (profits above the normal level) are taxed through the business tax system, but at rates far lower than the top personal income tax rate. the theoretical rationale for justifying such a favorable tax treatment for rents (excess profits) is simply absent. from an efficiency or an equity perspective, taxing rents at a higher rate makes sense. recent evidence from treasury suggests that now about 75% of the corporate tax base is rents/extra-normal profits; this fraction has been steadily increasing.50 if destination-based taxes are meant to fall solely on rent, this implies a higher ideal optimal tax rate, since taxing 49 absent relief, consumption taxes generate a tax on the initial capital stock; while this is an efficient tax (since it is an unexpected lump sum tax on the capital stock), it is arbitrary. however, attempts to provide relief would be expensive and would reduce the progressivity of the tax system, since the capital stock is concentrated in the upper part of the income distribution. see weisbach, supra note 48. 50 see laura power & austin frerick, have excess returns to corporations been increasing over time?, 69 nat’l tax j. 831, 831-46 (2016). 252 columbia journal of tax law [vol.8:229 rents is far more efficient than taxing labor or capital.51 further, the regressive nature of these tax changes is unjustifiable given the increases in economic inequality over the previous decades and the large surge in the share of income earned by the top 1% of the income distribution. capital income, and rents, are far more concentrated than labor income.52 cutting taxes on capital and rents so dramatically risks further exacerbating recent increases in income inequality. the tax policy center calculates the distributional effect of the ryan plan, which benefits the wealthy disproportionately. the average federal tax rate falls by about 0.4 percentage points for the bottom 80% of the population, but it falls by 3.4 percentage points for the top quintile, and by 9 percentage points for the top 1%. the top 1% receive a tax cut that averages $213,000. the tax cut of the bottom 51 also note that double-taxation arguments are vastly overstated since about three-quarters of u.s. corporate equity income is not taxed at the individual level. see steven m. rosenthal & lydia s. austin, the dwindling taxable share of u.s. corporate stock, 151 tax notes 923, 923-34 (2016); leonard burman & kimberly clausing, is u.s. corporate income double-taxed? 70 nat’l tax j. (forthcoming, sept. 2017) (on file with authors). 52 the u.s. treasury reports that the top 5% of tax units report 24% of income in 1986 (the earliest year available), increasing to 37% in 2012. see internal revenue serv., soi tax stats – individual statistical tables by tax rate and income percentile (aug. 31, 2016), http://www.irs.gov/uac/soi-tax-statsindividual-statistical-tables-by-tax-rate-and-income-percentile [perma.cc/g99fw2e4]. indeed, capital income is much more concentrated that labor income. data from the tax policy center for 2012 indicate that the top 5% of tax units report 68% of dividend income and 87% of long-term capital gains income. t090492 distribution of long-term capital gains and qualified dividends by cash income percentile, 2012, tax policy ctr. (dec. 10, 2009), http://www.taxpolicycenter.org/model-estimates/distribution-capital-gains-andqualified-dividends/distribution-long-term-capital-2 [perma.cc/y4d8-fvsg]. the u.s. treasury also reports data on the top 400 taxpayers. this particularly small group of taxpayers reports 1.48% of total income in 2012, but 0.16% of total wage and salary income, 8.3% of total dividend income, and 12.3% of total capital gain income. internal revenue serv., the 400 individual income tax returns reporting the largest adjusted gross incomes each year, 1992–2013 (dec. 2015), http://www.irs.gov/pub/irs-soi/13intop400.pdf [perma.cc/za26-xm7x]. the overall share of this tiny group has more than doubled since 1992 (when the data series begins). the wage income share has been flat, while the capital gains share has more than doubled, and the dividends share has more than quadrupled. all of these trends occur within a context where the labor share of income is falling relative to the capital share of income. for more discussion of these trends, see kimberly clausing, strengthening the indispensable u.s. corporate tax,” wash. ctr. for equitable growth (sept. 12, 2016), http://equitablegrowth.org/report/strengthening-the-indispensable-u-s-corporatetax/ [perma.cc/dqe8-wumj]. 2017] problems with destination-based corporate taxes 253 80% averages $210.53 finally, the ryan proposal loses large amounts of tax revenue. the business tax features of the proposal are a large share of the tenyear, $3 trillion revenue loss, according to the tax policy center. prior research by auerbach suggests that this type of corporate tax reform would not change revenue very much at the same corporate tax rate, and work by devereux has suggested that the tax base would be smaller under a dbct, but that this could be compensated for by higher rates. under the ryan plan, however, the rate is much lower, leading to large deficits.54 vii. conclusion the ryan blueprint destination-based cash-flow tax is not ready for prime-time. no other country had adopted a similar tax, and as the above analysis makes clear, there are myriad issues that would need to be worked through before any such tax were adopted. these issues are not small: the plan is incompatible with trade rules in a manner which harms our trading partners, it is incompatible with our treaty obligations, it is unlikely to end income shifting, it generates political problems due to large numbers of companies that would experience adverse tax treatment changes, it makes the tax system less progressive at the proposed tax rates, and it is likely to generate large revenue losses. in addition, there are important issues surrounding how exporters with losses would be handled (which could lead to inefficient mergers), how financial firms and financial transactions would be handled, how u.s. state corporate tax systems would be affected, and how the transition to the new tax system would be handled. one pressing problem is that the ryan blueprint is incompatible with wto rules. and this incompatibility is no mere 53 burman et al., supra note 3, at 271 (table 4). 54 some recent work by treasury economists has a somewhat more optimistic view of the tax base under this type of tax system, but the additional size of the base comes entirely from the border adjustment. see elena patel & john mcclelland, what would a cash flow tax look like for u.s. companies? lessons from a historical panel (office of tax analysis, working paper no. 116, 2017). it is important to note that the revenue from the border adjustment is contingent on the u.s. being in a trade deficit position. since trade deficits (and the associated financial borrowing) eventually have to be paid back in the form of trade surpluses, these revenue gains are really being borrowed from future u.s. taxpayers. see alan viard, the border tax adjustment can’t make mexico pay for the wall, aei, (jan. 27, 2017, 10:45am), http://www.aei.org/publication/theborder-tax-adjustment-cant-make-mexico-pay-for-the-wall/ [perma.cc/t8q2tekd]. 254 columbia journal of tax law [vol.8:229 technicality. u.s. trading partners are likely to be hurt in several ways. the effects of the wage deduction render the corporate cash-flow tax different from a vat, and these differences have the net effect of increasing the incentive to operate in the united states, as both proponents and economists recognize. in addition, such a tax system would exacerbate the profit-shifting problems of our trading partners, since the united states will appear like a tax haven from their perspective. if multinational firms shift profits to the united states on paper, this will reduce foreign revenues without affecting u.s. revenues. while economists have argued that exchange rate changes may reduce trade-distorting effects of such tax law changes, there are several reasons to suspect that such exchange rate changes will not be sufficient to neutralize the effects of such a tax law change. first, exchange rate changes are uniform, yet the export subsidy component of the dbct plan would treat different firms differently. second, exchange rate markets are very large, exchange rate movements are not well predicted by economic fundamentals, and many countries fix their exchange rates, all factors that would reduce hopes of smooth countervailing exchange rate adjustment. third, exporting firms may receive incomplete loss offsets, and that would cause trade distortions.55 however, even if these economic effects were disregarded, it is clear that the dbct is on shaky legal ground with respect to both wto rules and our tax treaties. the wto is likely to recognize that this dbct is non-equivalent to a vat, and thus a direct tax, where border adjustments are not allowed. this will likely lead to years of litigation and perhaps an endgame whereby the dbct is simply jettisoned in favor of a vat. this would convert one of the most progressive tax instruments in our tax system into a regressive consumption tax. in the meantime, we are likely to face the prospect of large tariff retaliations by our trading partners, in an environment where the incoming u.s. administration has already provided ample reason to fear trade wars. 55 even if the dollar appreciates fully, there are still serious concerns. exchange rate appreciation generates its own risks to the world economy, generating serious financial vulnerability in a large number of countries that have substantial dollar liabilities. dollar appreciation will also result in a multi trilliondollar deterioration in the u.s. net international investment position, a large wealth redistribution away from u.s. holders of foreign assets and toward foreign holders of u.s. assets. 2017] problems with destination-based corporate taxes 255 given these concerns, we would recommend that congress reject the ryan blueprint. instead, it should focus on a revenue-neutral tax reform that reduces the corporate tax rate and eliminates the major corporate tax expenditures including deferral, taxing accumulated offshore earnings in full. eliminating deferral would eliminate the incentive to earn income in low-tax countries, by treating foreign and domestic income alike for tax purposes. pairing that reform with a lower corporate tax rate need not raise tax burdens on average, although it would create winners and losers among corporate taxpayers. a more fundamental reform would require worldwide corporate tax consolidation; this would better align the tax system with the reality of globally-integrated corporations. taxing foreign income currently also eliminates the incentive to build up large stocks of unrepatriated foreign income, now estimated at $2.6 trillion. this income is often invested in u.s. capital markets, and it increases the creditworthiness of u.s. multinational corporations, who can easily finance worthy investments. but corporations are inhibited from repatriation by the prospect of more favorable tax treatment if they delay, so this makes it difficult for them to return profits to shareholders. indeed these concerns about repatriation are likely to give the multinational business community a large interest in corporate tax reform. settling the future tax treatment of foreign income should be a key goal of these efforts.56 in terms of more incremental reforms, even a per-country minimum tax would be a big step toward reducing profit shifting toward tax havens and protecting the corporate tax base. a minimum tax would currently tax income earned in the lowest tax countries, and work by clausing suggests that 98% of the profit shifting out of the united states is destined for countries with foreign tax rates below 15%.57 other helpful incremental steps include stronger “earningsstripping” rules and anti-corporate inversion measures such as an exit tax. 56 toward this end, the u.s. congress did a great disservice when they enacted a one-time holiday on dividend repatriation as part of the american jobs creation act of 2004. american jobs creation act of 2004, pub. l. no. 108-357, 118 stat. 1418 (2004). ever since, companies have been more likely to delay repatriation in the hope of future holidays (or permanently more favorable treatment). 57 see kimberly clausing, the effect of profit shifting on the corporate tax base in the united states and beyond, 69 nat’l tax j. 905, 905-34 (2016). microsoft word drumbl4-1.docx 94 columbia journal of tax law [vol.4:94 decoupling taxes and marriage: beyond innocence and income splitting michelle lyon drumbl* abstract fourteen years ago, members of congress sympathetically listened as divorcees testified to their struggles to raise children while being pursued by the internal revenue service for tax debts, often unknown to them, that were attributable to their ex-husbands' income. rather than adopting one of many proposals to end joint and several liability, congress instead elected to expand the grounds on which these individuals could seek relief from such liability. since that time, taxpayers have seen a steady expansion of the grounds for so-called “innocent spouse relief” that has evolved through a combination of legislative, administrative, and judicial action. yet the process for relief remains timeconsuming, inefficient, and unpredictable. the majority of initial requests for innocent spouse relief are denied. the taxpayer can appeal administratively and also seek judicial review if relief is denied, but sometimes will spend several years and untold resources in pursuit of a claim that may ultimately be unsuccessful. the process is also a questionable use of internal revenue service personnel, in that it frequently calls upon these employees to address the most intimate aspects of a failed relationship, including spousal abuse, addictions, and mental health problems. these employees often must make a determination based upon a “hesaid, she-said” presentation of the facts—an odd task for an agency charged with enforcing the revenue laws. this article visits the historic rationales for joint and several liability, both in light of the flawed relief process and also in the context of modern-day american society, in which married couples constitute only half of all households and cohabitation is increasingly more common. i conclude that congress should eliminate the “married” filing statuses and require each married individual to file a separate return. if it did so, joint liability and the innocent spouse relief process would both cease to exist. the historical policy justifications for imposing joint and several liability are no longer rational in light of changed demographics and technological advances. rather than an “unusual privilege,” which it was long said to be, filing jointly has become a risky conundrum, particularly for low-income taxpayers. as the nation debates tax reform, it is * associate clinical professor of law and director, tax clinic, washington and lee university school of law. i would like to extend my thanks to the frances lewis law center for research support, as well as the following people who provided helpful feedback at varying stages of the project: robin leblanc, keith fogg, and caroline chen. i also thank emerald smith, william harrison, and darby gooding for their research assistance. 2012] decoupling taxes and marriage 95 appropriate to rethink the policy of retaining the “married” filing statuses in light of the ways in which family structures, society, and the internal revenue code have changed since joint and several liability was introduced in 1938. 96 columbia journal of tax law [vol.4:94 i. introduction......................................................................................................97 ii. how did we get here? (history and purpose of joint filing status) .................................................................................................................103 a. shared risks: tracing the history of joint and several liability......................103 b. examining the stated rationales of joint and several liability: does the intent still make sense in twenty-first century america? ........................................107 1. administrative ease for taxpayers and government..................................107 2. joint liability as the price for the “privilege” of filing jointly ................109 iii. relief is available to some innocent spouses, but at what cost to the system? ......................................................................................110 a. evolution of innocent spouse relief: 1971-1998..............................................111 b. a long way since scudder – further liberalization of innocent spouse relief: 1998-2012 ..........................................................................................................114 iv. solutions – revisiting the treasury department’s recommendation to expand innocent spouse relief instead of eliminate joint and several liability.........................................119 a. a systemic change: mandatory separate returns for all fliers .......................120 b. less comprehensive proposals: proportionate liability, allocated liability, and adoption of the divorce decree ........................................................................121 c. judging with the benefit of hindsight – did treasury make the right recommendation in 1998? the unending inefficiencies of the innocent spouse process ...............................................................................................................121 v. neither the code nor america looks like it did in 1938 (or even 1975): why congress should again revisit the call for mandatory separate filing.....................................................................124 a. a closer look at the changing demographics .................................................125 b. low-income households are disproportionately affected by the filing status options for married persons: why the code should tax the type of household, not the relationship ..........................................................................................127 1. isolating the impact of the earned income credit in the low-income context ...............................................................................................................130 2. isolating the impact of the marriage bonus in the low-income context ..132 c. a brief consideration of how to restructure the earned income credit in an individual filing system....................................................................................133 vi. conclusion ........................................................................................................134 2012] decoupling taxes and marriage 97 i. introduction married taxpayers have two options when filing a federal income tax return: (1) file a joint return, in which case the taxpayers agree to joint and several liability for any tax due;1 or (2) file separate returns by electing the “married filing separately” status. it is estimated that joint returns typically comprise ninety-five percent of the income tax returns filed by married taxpayers.2 the internal revenue code (“code”) does not favor married taxpayers who file separately; except in very unusual circumstances,3 these taxpayers will face a higher tax liability by choosing this filing status.4 thus, it is almost always in a married couple’s collective financial interest to file a joint return. however, if the couple files jointly and then later divorces, the internal revenue service (“service”) can pursue collection efforts for the joint years against either or both taxpayers simultaneously, regardless of which spouse’s income created the liability. one of the simplest and most automated types of collection activity is the refund offset: the service will apply an income tax refund expected from one year (in whole or in part) to satisfy an outstanding tax liability from a different year.5 thus, in many cases involving divorced couples with minor children, the service will seize the sizable refundable tax credits due to the low-to-middle-income custodial parent in satisfaction of a past debt that, while joint, is wholly attributable to the income of the noncustodial parent.6 even if the noncustodial parent is making periodic payments towards the liability, whether voluntarily (under an installment agreement) or involuntarily (through wage garnishment), the refund due to the custodial parent will be automatically seized to further reduce the debt. thus, the custodial parent may end up paying a significant 1 i.r.c. § 6013(d)(3) (2012). 2robert w. wood, the marriage trap, forbes, june 27, 2011, at 110, available at http://www.forbes.com/forbes/2011/0627/money-guide-11-tax-joint-return-irs-wedding-marriage-trap.html. see also tax policy center, return details by marital status, 2005–2009, available at http:/www.taxpolicycenter.org/taxfacts/content/pdf/returns_marital.pdf. the figures were provided in july 2011 by the irs statistics of income division, which reported that of 140,494,127 returns filed for tax year 2009, 53,570,158 were returns of married persons filing jointly, while 2,539,588 were returns of married persons filing separately. 3 it is theoretically possible for a married taxpayer to face a lower tax liability by filing separately, but i have yet to encounter this in practice. for example, if one spouse has significant medical expenses that exceed 7.5% of his or her own adjusted gross income (agi) but not the couple’s total agi, it could benefit the taxpayer to file separately. however, it is possible that the taxpayer will find himor herself subject to the alternative minimum tax, negating the possible tax advantage. 4 this is true for taxpayers at both low and high income levels, though for different reasons. lowincome taxpayers cannot receive the valuable earned income credit if they choose to file separately, even if they would be eligible for the credit if they filed jointly. married middleand high-income taxpayers (those individuals with a taxable income of at least $68,650 in 2010) who file separately are subject to a more progressive income scale than unmarried taxpayers, in that their tax brackets are narrower between rate increases. for example, a married individual filing separately is subject to income tax at the 33% rate starting at $104,625. contrast this to an unmarried individual, who is not subject to the 33% rate until he or she has taxable income of $171,850. at all income levels, married taxpayers lose the benefit of income splitting if they choose to file separately. part iv will examine the disparate treatment of similarly situated individuals in greater detail with a particular focus on those individuals who are eligible to receive the earned income credit. 5 i.r.c. § 6402 (2012). 6 to illustrate how sizable a single parent’s refund can be, imagine a divorced mother of three young children who earns $25,000 as a wage earner. in tax year 2010, assume that the mother files as head of household, claims the children as dependents, and is eligible for both the earned income credit and the child tax credit. (these figures disregard the making work pay credit, which would have been available to her in 2010). she would be due a $6,659 refund even if she had no income tax withheld from her pay in 2010. if the same taxpayer earned only $20,000, she would be due a $7,463 refund. 98 columbia journal of tax law [vol.4:94 portion (and in some cases, all) of the joint tax debt, even if the parties had agreed otherwise under the terms of the divorce.7 this occurs without regard to the parties’ respective income level and ability to pay.8 consider the story of wendy bozick, whose joint liability arose from the “traditional” model of the one-earner household:9 in 2003, her husband gary earned $460,000 from his law practice. ms. bozick, who did not perform significant work outside of the home that year, earned just over $1,000 in 2003. her husband handled all finances; ms. bozick did not have a bank account and her husband did not allow her to use a credit card. her husband gave her cash to buy groceries for the family. he did not allow her to open the mail. as the filing date for their income taxes approached, ms. bozick worried that her husband might not prepare the return. she filed “married filing separately” to report her wages, which she thought she was required to do. ms. bozick owed no tax on her separate return due to her low income. when her husband found out, he became furious, telling her that filing separately rather than jointly would cost the family $17,000. this is because a one-earner, high-income family enjoys the benefit of income splitting, which creates a “marriage bonus”10 as compared to a similarly situated unmarried couple. recognizing this, her husband had a joint return prepared and had her sign it without giving her a chance to examine it. the joint return, which was filed in december 2004, showed the couple had a tax liability of $137,453. ms. bozick petitioned for divorce in july 2005, and mr. bozick died in april 2006. upon his death, the service collected a portion of the joint liability from his retirement plan, but a balance of more than $100,000 remained on the debt. the service turned its collection efforts on ms. bozick to collect the remainder. by this time, she had joined the work force fulltime, but was earning only eight dollars an hour. she was barely supporting herself and her children. 7 a divorce agreement has no effect on the service’s collection of a joint and several liability. the government defends this practice on the grounds that it is not a party to the divorce and that it would be impractical for the service to become involved in divorce settlements. see, e.g., u.s. gov’t accountability office, gao/t-ggd-98-72, innocent spouse: alternatives for improving innocent spouse relief 10 (1998) (“[p]roviding a legal forum where irs and the parties to a divorce could resolve issues relating to both tax matters and divorce proceedings would require a fundamental and extensive change in either federal tax law or state domestic relations law”). notwithstanding the service’s disregard for the couple’s agreement, one spouse may have a legal right of contribution under the divorce decree. 8 see nat’l taxpayer advocate, joint and several liability, fy 2001 ann. rep. to cong. 139 [hereinafter tas report 2001] (showing that when married individuals file a joint return, the primary spouse usually earns significantly more than the secondary spouse). the table in the report shows that this is true at all income levels, but is particularly pronounced at the high end and the low end: in the “under $30,000” income range, 91% of gross income was attributable to the primary spouse; in the “over $100,000” income range, 79% of income was attributable to the primary spouse. id. the numbers in the table are from tax year 1999. id. 9 all facts are taken from the tax court opinion bozick v. comm'r, 99 t.c.m. (cch) 1242 (2010). this case does not hold special significance and i was not involved with this case in any capacity. i chose this case because its facts provide a good illustration of the valuable marriage bonus, the ensuing risks of filing jointly to benefit from that bonus, and the lengthy process for seeking relief from joint liability. 10 a marriage bonus results when a married couple enjoys tax savings by virtue of the joint filing rates. the bonus is most pronounced when one spouse earns a high income and the other has little to no income. the opposite phenomenon is called the “marriage penalty,” which occurs when two spouses earn significant and roughly equal incomes; they pay more income tax than they would in the aggregate if they were unmarried. these concepts are discussed further in part i.a. see also infra note 54. 2012] decoupling taxes and marriage 99 in february 2007, ms. bozick filed a request for “innocent spouse relief,”11 but the service denied her claim in july of that year, stating, among other reasons, that she failed to show that it would be unfair to hold her jointly liable. in accordance with her rights of judicial review, ms. bozick petitioned the united states tax court in october 2007 and told her story again at her march 2009 trial. on march 30, 2010, more than three years after her initial request for relief, the court filed its opinion in her favor and relieved her of this joint income tax liability.12 this article will examine the problems and inefficiencies that arise from joint and several liability and the innocent spouse relief process. in particular, i will examine the peculiar conundrum faced by low-income taxpayers.13 unlike the bozick family, which received a sizable economic benefit by virtue of the joint filing status, a low-income couple generally will receive only a nominal “marriage bonus” attributable to income splitting. as i will explain, married low-income taxpayers face a conundrum because they cannot receive the earned income credit unless they file a joint return, subjecting themselves to joint and several liability.14 meanwhile, if the married couple does file jointly, there is no economic advantage as compared to a similarly situated unmarried and cohabiting couple; in fact, the unmarried couple will typically receive a larger aggregate refund.15 the article will focus on the three reasons i believe the joint filing status should be eliminated and all taxpayers should file as individuals: (1) the rationales for joint filing are less applicable than they once were; (2) congressional attempts to address inequities through innocent spouse relief are a well-intended but fundamentally inefficient solution; and (3) it is necessary to reconsider the policy of retaining the “married” filing statuses in light of the ways in which family structures, society, and the code have evolved since joint and several liability was enacted in 1938. congress should reform the current filing-status structures through a lens of simplicity and demographic reality. the article proceeds from here in four parts. part ii will provide a brief historical context: why and how the u.s. tax system provides different rules and rates for married taxpayers, and the original reasons for imposing joint and several liability on joint returns. within that context, i will discuss why the traditional rationales underpinning joint and several liability are less convincing today. this is particularly true for lowincome taxpayers, as i will discuss. 11 congress first enacted innocent spouse relief in 1971 and has expanded the provisions and the scope of relief repeatedly over time. currently there are three types of relief provided in i.r.c. § 6015. part ii provides a detailed history of innocent spouse relief. 12 as i discuss elsewhere, the process for obtaining relief is typically lengthy and often involves an administrative or judicial appeal. in this case, i should note that the irs denial came quickly and the three year period was attributable in part to ms. bozick having been granted a continuance for her trial date in order to obtain counsel. 13 by “low-income taxpayers” i refer to those taxpayers who are income-eligible to receive the earned income credit. in 2010, a married couple with income up to $48,362 could receive the earned income credit, so long as they filed jointly and had at least three qualifying children. the income limits are lower for couples with fewer or no children. 14 section 7703(b) provides an exception for certain married individuals living apart from a spouse during the last six months of the taxable year and maintaining a household with a child; an individual meeting the requirements of § 7703(b) is not considered married and thus remains eligible for the earned income credit because he or she is permitted to file as “head of household” rather than “married filing separately.” 15 see infra part iv.b. 100 columbia journal of tax law [vol.4:94 part iii will present a detailed overview of the procedures for innocent spouse relief. the innocent spouse relief process is time-consuming, inefficient, and results in inconsistent outcomes. it is not uncommon for a taxpayer to spend several years and untold resources trying to obtain the legal relief he or she seeks.16 the majority of initial requests for innocent spouse relief are denied,17 meaning the taxpayer must pursue an administrative appeal and often judicial review of the claim. in recent years the process has become ever more liberalized, broadening the grounds for relief and the scope of judicial review if relief is denied. in 1998, when congress enacted § 6015(f),18 more taxpayers became eligible for relief and the number of claims increased. since that time, the service has regularly received up to fifty thousand requests for innocent spouse relief a year, and it grants fewer than half of them.19 taxpayers are statutorily entitled to petition the tax court if the service denies the request for relief; innocent spouse appeals are consistently among the ten most litigated tax issues in federal court each year.20 the facts set out in the tax court’s opinion in bozick certainly weighed in her favor and portrayed her in a sympathetic light. yet it took her three years to obtain relief. her administrative request was denied, and one presumes that the irs was unwilling or unable to settle the case in her favor after she filed her tax court petition.21 over the course of three years, imagine how many hours of work must have been devoted to this file: by the irs innocent spouse unit, the tax court, and ms. bozick and her attorney. during that time, ms. bozick endured financial hardship and struggled to raise her children. while i agree with the tax court’s finding in this specific case and support the congressional intent of the innocent spouse provisions generally, i maintain that the process is burdensome to taxpayers and is an inefficient use of administrative and judicial 16 see tas report 2001, supra note 8, at 134 ("given the many steps and legal requirements in the process, even the best case scenario requires 304 days to process a claim for relief under irc § 6015."). 17 see id. at 128 (stating that the irs rejects 49% of claims for not meeting requirements for consideration and only 47.7% of the remaining claims obtain any relief). see also nat’l taxpayer advocate, another marriage penalty—taxing the wrong spouse, fy 2005 ann. rep to cong. 423 (2005) [hereinafter tas report 2005] (citing a 2005 irs report that found innocent spouse relief was granted at the administrative level “on only about 30 percent of all claims”). 18 references to a statute section are to the internal revenue code of 1986, as amended, unless otherwise indicated. 19 in many recent years, the service has reported receiving more than fifty thousand requests for innocent spouse relief. see, e.g., nicola m. white, lawmakers urge irs to review innocent spouse relief regulations, 131 tax notes today 358 (2011); laura saunders, a new push to protect spouses, wall st. j., may 28, 2011, at 9-b.9. a significant number of these requests are immediately rejected for not meeting threshold criteria. of the remaining requests, the relief rate is still low. see, e.g., carla fried, for ‘innocent spouses,’ a helpful shift in i.r.s. policy, n.y. times, feb. 12, 2012, at 11-bu.11 (stating that “22 percent of the 32,000 cases filed each year that qualify for review are granted full relief”). 20 see i.r.c. § 7803(c)(2)(b)(ii)(x) (2012) (mandating that the national taxpayer advocate report to congress annually on the “10 most litigated issues for each category of taxpayers”). innocent spouse relief has appeared on this “top ten” list every year since 2004. see e.g., nat’l taxpayer advocate, the most litigated issues, fy 2011 ann. rep. to cong. 589 (2011) [hereinafter tas report 2011] (listing relief from joint and several liability as the eighth most litigated issue from june 1, 2010, to may 31, 2011). the list includes only those cases for which an opinion is issued; since 2007, more than seventy-five percent of docketed tax court cases are settled each year, and fewer than three percent of docketed cases resulted in trial and decision. id. at 591. thus, the vast majority of docketed cases are therefore not reflected in these annual lists. 21 once a petition is filed with the tax court, cases are automatically sent to an irs appeals office, which concentrates on attempting to settle cases prior to trial. that ms. bozick's trial went forward indicates that the parties were unable to do so. more than seventy-five percent of tax court cases are settled outside of court. supra note 20. 2012] decoupling taxes and marriage 101 resources. moving to an individual filing system would eliminate the need for innocent spouse relief, allowing those resources to be devoted elsewhere. part iv examines some of the solutions previously proposed to address the shortcomings of the innocent spouse relief framework. a chorus of scholars, professional associations, and the national taxpayer advocate has recommended one solution in particular—to eliminate joint and several liability for joint filers.22 this solution would address the first two of my concerns; importantly, it would render the innocent spouse relief process unnecessary, because each spouse would only be liable for tax arising from his or her proportionate income. at the direction of congress, the department of treasury studied this and other proposals in 1998 and issued a comprehensive report of its findings. the report concluded that there were sound policy and practical reasons to retain joint filing and joint and several liability for married couples. instead of adopting the proposals to eliminate joint and several liability, the report recommended modifying the code to accommodate more cases by expanding the grounds for innocent spouse relief.23 congress followed this recommendation, greatly broadening the circumstances under which a joint filer can later apply for relief. as a result, since 1998 there has been a drastic rise in the number of innocent spouse relief claims filed and a corresponding increase in the amount of resources devoted to innocent spouse claims. part iv examines the reasons the treasury department did not believe it was appropriate to replace or reform the joint and several liability standard; with the benefit of hindsight, i evaluate those arguments. while i believe eliminating joint liability would have been a positive solution, i discuss in part v why i believe congress should go even further: it should eliminate joint filing altogether and require all taxpayers to file an individual return of their own income.24 part v will elaborate on the third of the concerns i outlined above, namely, that the code does not properly reflect the demographic reality of twenty-first century america. today there are many more accepted versions of what constitutes a “household” or “family unit” than there were in the mid-twentieth century, making the “married filing jointly” status an antiquated concept. marital status should not be used as a proxy for household composition because this does not match the reality. there are many reasons why it is time for the code to shift away from a system that assumes and favors a married couple with only one spouse in the labor force: the rise of divorced 22 in the 1990s, the recommenders included the american bar association, the american institute of certified public accountants, and other academic commentators. tas report 2005, supra note 17, at 409 n.13; see also dep’t. of the treas., report to the congress on joint liability and innocent spouse issues 34–41 (1998) [hereinafter 1998 treas. report on jl and is], available at http://www.treasury.gov/resource-center/tax-policy/documents/innospos.pdf. 23 id. at 57–58. 24 this article will focus primarily on the concerns of low-income taxpayers, but numerous scholars have argued for mandatory individual filing on a variety of policy grounds. see, e.g., lily kahng, one is the loneliest number: the single taxpayer in a joint return world, 61 hastings l.j. 651, 684 (2010) (arguing that the joint return should be abolished because it penalizes single people). see also james puckett, rethinking tax priorities: marriage neutrality, children, and contemporary families, 78 u. cin. l. rev. 1409, 1434 (2010) (arguing that “[t]he joint return (and special rates for married taxpayers) should be abolished as an incoherent penalty and subsidy of marriage”); edward j. mccaffery, taxing women 19– 23 (1997) (advocating individual filing as more beneficial for women); lawrence zelenak, marriage and the income tax, 67 s. cal. l. rev. 339 (1994) (concluding that mandatory separate returns present the best option among imperfect neutralities); marjorie e. kornhauser, love, money, and the irs: family, income sharing, and the joint income tax return, 45 hastings l.j. 63, 108 (1993) (arguing that individual tax returns would be more equitable). 102 columbia journal of tax law [vol.4:94 individuals and single-parent households; the rise in the number of two-earner households; the significant increase in the number of couples who live together in a household but do not wed; and the unavailability of this filing status for individuals in same-sex partnerships or marriage. my argument—that demographic trends matter—will focus in particular on lowincome taxpayers. it examines how the value of the earned income credit, a refundable credit primarily benefiting parents that was not added to the code until several decades after the joint filing status was introduced, has changed the stakes for low-income taxpayers when deciding upon a filing status. married taxpayers must accept the risks of joint and several liability or else sacrifice eligibility for the refundable earned income credit; choosing the latter may mean the taxpayers forsake thousands of dollars to help support their household. if the couple files jointly and a deficiency is later determined, it is true that the spouse who did not earn the income or claim the deduction causing the unpaid tax can file an innocent spouse request for relief from joint liability. in fact, low-income taxpayers (as ms. bozick was at the time she filed) are especially likely to file for such relief. taxpayers who request innocent spouse relief are disproportionately low-income women who are unmarried; often they are struggling to maintain a home for children.25 most often, it is the ex-wife who requests innocent spouse relief, and she constitutes the lower-earning half of the divorced couple.26 low-income taxpayers qualify for pro bono legal representation in their innocent spouse claims,27 presuming that they know to inquire about such relief and have the time to work with counsel in pursuing it. but it is certainly not an easy, pleasant, or quick process to endure, and there is a high likelihood the taxpayer will not prevail.28 meanwhile, unmarried couples raising children together, a demographic group that has increased at a dramatic rate since 1960,29 do not face a filing dilemma that might result in having to apply for relief from joint liability. those low-income divorcées who have endured the innocent spouse relief request process may find it especially galling to learn that an unmarried couple, in fact, can receive a higher overall earned income credit than a married couple with an identical household income. 25 tas report 2005, supra note 17, at 422 (citing data from tax year 2001). for this statistical reason, i refer to the requesting spouse in the feminine or focus my arguments on women in particular. this is not to suggest that men do not file or succeed with claims for innocent spouse relief; in fact, in one of my first innocent spouse cases i represented an ex-husband who was granted relief at the administrative appeal level. 26 most innocent spouse claims are filed by the lower-earning spouse, which is usually the woman. tas report 2001, supra note 8, at 132. “nearly 90% of the claims filed for relief from joint and several liability are filed by women with earned income that is approximately 25% of the total income on a joint return.” id. at 128. 27 congress funds a low-income taxpayer clinic (litc) program administered by the taxpayer advocate service. this program, which was established in 1998 with the addition of i.r.c. § 7526, provides federal matching grants to non-profit organizations that provide legal representation to income-eligible taxpayers who have a controversy with the internal revenue service. i direct the litc program at washington and lee university school of law, and this article is inspired in large part by my experiences working with these clients. 28 supra note 17. 29 see the nat’l marriage project, the state of our unions: the social health of marriage in america 29 (2003) (charting the 850% increase of unmarried, cohabiting, adult couples living with one or more children under age 15 from the 1960s to 2000; the figure increased from 197,000 in 1960 to 1.675 million in 2000). 2012] decoupling taxes and marriage 103 it would be far more beneficial to married low-income taxpayers if congress were to amend the code so as not to condition the earned income tax credit (or any form of perceived “marriage bonus”) on joint filing. congress can address this conundrum and today’s complex demographic reality without adding further complexity to the code. congress should respond to the calls for a simpler and more coherent code by reducing the number of individual filing statuses from four to two, ignoring marital status while retaining a distinction in the treatment of taxpayers with and without children. ii. how did we get here? (history and purpose of joint filing status) much has been written about the history of joint filing and the rationale behind joint and several liability.30 in order to appreciate the shortcomings and drawbacks of joint and several liability, it is important to first consider why the current system is as it is. a. shared risks: tracing the history of joint and several liability joint and several liability for married taxpayers has been the settled rule of the code since 1938, but it was not always the rule. early revenue laws enacted in 191331 and 191632 imposed taxation on individuals. in 1918, married taxpayers were permitted to file a joint return and could aggregate their income as well as their losses and deductions, but the code left open the question of how to allocate the liability between spouses.33 the idea of joint and several liability originated not with congress, but in an internal office decision known as i.t. 1575, which was published by the bureau of internal revenue in 1923.34 even after the supreme court held otherwise,35 the commissioner took the position that this type of office decision—published by the income tax unit of the bureau with a cautionary note that they “have none of the force or effect of treasury decisions and do not commit the department to any interpretation of the law”—evinced the intent of congress if the underlying revenue acts were reenacted without change.36 thus, even though the code was silent on the issue, in litigation the commissioner repeatedly advanced the position that joint and several liability was “settled administrative practice.”37 in cole v. commissioner, the ninth circuit court of appeals considered the question of joint liability on joint returns and ruled that “spouses are not jointly and 30 for a detailed history of joint and several liability, see 1998 treas. report on jl and is, supra note 22. see also richard c. e. beck, the innocent spouse problem: joint and several liability for income taxes should be repealed, 43 vand. l. rev. 317 (1990) (providing a detailed history of the origins of the joint return, cole, and the subsequent introduction of joint liability); bryan t. camp, the unhappy marriage of law and equity in joint return liability, 108 tax notes 1307 (2005). 31 revenue act of 1913, pub. l. no. 63-16, ch. 16, § ii (a)(1), 38 stat. 114, 166 (1913). 32 revenue act of 1916, pub. l. no. 64-271, ch. 463, § 1(a), 39 stat. 756 (1916). 33 see beck, supra note 30, at 335; see also tas report 2001, supra note 8, at 132. separate rate brackets for joint returns were not introduced until 1948. 34 i.t. 1575, 1923-1 c.b. 144 (1923) (“[w]here a husband and wife filed a joint return they are individually liable for the full amount of tax shown to be due on such return.”). 35 helvering v. n.y. trust co., 292 u.s. 455 (1934). 36 see cole v. comm'r, 81 f.2d 485, 488 (9th cir. 1935) (noting the conflict between the commissioner's arguments and the cautionary notice in the bulletin). 37 id. (citing helvering, 292 u.s. at 467–68). see also comm'r v. rabenold, 108 f.2d 639, 641 (2d cir. 1940) (“[o]nly by implication can such a liability be found in the 1932 act, and taxing laws are not to be extended by implication.”). 104 columbia journal of tax law [vol.4:94 severally liable for a deficiency arising entirely out of the separate income of one of them.”38 louis and frida cole filed a joint income tax return for 1929. at that time, a husband and wife could choose to include their respective incomes on a joint return and be subject to tax on the aggregate income; deductions and credits to which either were entitled would be taken from the aggregate income. after the coles filed their joint return, the service determined a deficiency in the amount of $27,568. the petitioner, who was the executrix of mr. cole’s estate, argued the husband and wife were each “liable only for the proportion of the tax attributable to his share of the aggregate income.”39 the commissioner, following the bureau’s administrative practice of imposing joint and several liability as set out in i.t. 1575, argued that it was “impossible” for the service to prorate the liability because the liability had been calculated on their combined income.40 the board of tax appeals had previously rejected the commissioner’s argument that a husband and wife filing jointly became “a single taxing entity, and as such, ‘the taxpayer.’”41 the commissioner, in his brief in cole, set forth the position that “the husband and wife, must of course, accept this unusual privilege of reducing their taxes as it exists with all of its necessary concomitant conditions and results.”42 the ninth circuit did not agree with the commissioner, finding that any administrative difficulties of apportioning the liability could be overcome; the court pointed out that, in this case, the apportioned liabilities had in fact been stipulated. despite the outcome in cole, the commissioner subsequently persisted in arguing that joint and several liability must attach to a joint filing, as a matter of administrative convenience.43 with the enactment of the revenue act of 1938 (hereinafter “1938 act”), the service finally got its wish: congress added subsection 51(b), which stated “the liability with respect to the tax shall be joint and several.”44 after the 1938 act, the commissioner then began arguing in ongoing litigation involving tax years prior to the effective date of the 1938 act that § 51 “should be deemed merely declaratory of existing law under prior revenue acts.”45 in cole, the commissioner noted the taxpayers reduced their taxes by filing jointly, with the tax being computed on their aggregate income. at the time of cole, joint filing produced a reduction in tax only when one spouse had deductions (including losses) or credits that could offset the income of the other. unlike our present system, in which there are five separate filing statuses and four accompanying rate structures, the tax rates prior to 1948 were uniform for all types of returns. thus, for many married 38 cole, 81 f.2d. at 489. 39 id. at 486. 40 id. at 490. 41 id. (citing gummey v. comm’r, 26 b.t.a. 894, 895–96 (1932)). 42 id. at 487 (emphasis added). 43 see, e.g., uniacke v. comm'r, 132 f.2d 781, 783 (2d cir. 1942) (ruling that joint and several liability did not attach). in a case involving tax year 1936, the court stated: “the argument based on administrative convenience does not impress us . . . . the administrative difficulties resulting from rejecting the commissioner's construction of the statute would seem to be somewhat exaggerated in the argument.” see also estate of hague v. comm'r, 45 b.t.a. 104, 113 (1941) (in which the commissioner argued for joint and several liability for a couple where the income in question was solely the husband’s); rabenold, 108 f.2d at 640. 44 revenue act of 1938, pub. l. no 75-554, ch. 289, § 51(b), 52 stat. 447, 476 (1938). the internal revenue code of 1986, as amended, retains the same language in § 6013(d)(3): “if a joint return is made, the tax shall be computed on the aggregate income and the liability with respect to the tax shall be joint and several.” 45 rabenold, 108 f.2d at 640. 2012] decoupling taxes and marriage 105 couples, the effect of aggregating income was to push the couple into a higher tax bracket, resulting in a higher liability than if the couple had filed as two individuals.46 a couple would not benefit from joint filing unless one spouse had deductions or credits that could offset the income of the other spouse. in unpacking the rationales of joint and several liability, it is important to recognize that the reduction and ensuing “unusual privilege” referred to by the commissioner in cole should not be confused with so-called “income splitting,” which was not a benefit of joint filing until the revenue act of 1948 created a separate rate structure for married couples.47 somewhat ironically, income splitting was a phenomenon that was first enjoyed by married couples who filed separate returns in community property states. under the theory that income earned by one spouse was community property of the other spouse, in 1930 the supreme court ruled in poe v. seaborn that spouses were permitted to file separately and each treat one half of the spouses’ community property income as his or her income for tax purposes.48 thus, if the husband earned $10,000, and the wife did not have any income, each would file a separate return reporting $5,000 of income. joint and several liability did not attach, because the spouses filed separately.49 yet due to the nature of the progressive rate structure, the taxpayers benefitted from the lower rates applicable to the lower income amounts. for a time following seaborn, only taxpayers who lived in community property states enjoyed the benefits of income splitting because each individual was subject to tax on one-half of the couple’s total income. at the same time, taxpayers in common law states who filed a joint return had to aggregate their income, but were subject to tax under the same “steeply progressive” rate structure.50 congress was concerned when a number of states, concerned about the unequal tax treatment of their residents, moved to adopt the community property system.51 to address this disparity, the revenue act of 1948 introduced a new rate schedule for married taxpayers filing a joint return.52 so while congress established joint and several liability for married filers in 1938, it was not until ten years later, in 1948, when the new separate rate schedules were 46 see grant v. rose, 24 f.2d 115, 118–19 (n.d. ga. 1928) (summarizing these advantages and disadvantages), aff'd, 39 f.2d 340 (5th cir. 1930). 47 revenue act of 1948, pub. l. no. 80-471, ch. 168, § 301, 62 stat. 110, 114 (1948). 48 poe v. seaborn, 282 u.s. 101, 118 (1930). 49 state laws in community property states vary as to whether the interests of each spouse are subject to lien or levy by the service. in at least some community property states, the service can collect the separate tax liability of one spouse from the other spouse’s community income. see 1998 treas. report on jl and is, supra note 22. in 1980, congress enacted § 66 to provide limited relief to taxpayers in community property states. section 66, while important to those who live in community property states, is outside the scope of this article. 50 see s. rep. no. 80-1013, at 22 (1948), reprinted in 1948 u.s.c.c.a.n. 1163, 1184 (describing the existing law: “since the rates applied under the income tax are steeply progressive, the same family income divided in two halves by community property law will be taxed far less severely than in a commonlaw state where the whole income is apt to be taxed to one spouse.”). 51 id., at 24–25. the legislative history gives another interesting reason for adopting income splitting in the code: “the incentive for married couples in common-law states to attempt the reduction of their taxes by the division of their income through such devices as trusts, joint tenancies, and family partnerships will be reduced materially. administrative difficulties stemming from the use of such devices will be diminished, and there will be less need for meticulous legislation on the income-tax treatment of trusts and family partnerships.” 52 revenue act of 1948, pub. l. no. 80-471, ch. 168, § 301, 26 u.s.c. §12, 62 stat. 110, 114 (1948). 106 columbia journal of tax law [vol.4:94 introduced, that most taxpayers had an economic incentive to file a joint return.53 significantly, the new rate schedules benefitted all married taxpayers versus their unmarried peers, because at that time the brackets were exactly twice as wide as the rate schedule for unmarried taxpayers. as a result of this structure, a married couple was not worse off in 1948 under the married filing jointly rates than under the individual rates. one spouse’s deductions could be used to offset the income of the other (as in cole), without the couple facing higher rates (as they had prior to the revenue act of 1948). the benefits of income splitting enjoyed by married couples were especially favorable when one spouse (at that time, almost certainly the husband) worked and the other spouse did not. this phenomenon became known as the “marriage bonus.”54 over time, congress recognized that the pendulum had swung too far in favor of married couples. the tax reform act of 1969 created a new, lower rate schedule for unmarried persons to correct the fact that, due to income splitting, an unmarried person’s tax was as much as forty-two percent higher than the tax paid by a married couple filing jointly reporting the same total income as the unmarried person.55 the joint committee on taxation explained in its report accompanying the act: with the new rate schedule for single persons, married couples filing a joint return will pay more tax than two single persons with the same total income. this is a necessary result of changing the income-splitting relationship between single and joint returns. moreover, it is justified on the grounds that although a married couple has greater living expenses than a single person and hence should pay less tax, the couple’s living expenses are likely to be less than those of two single persons and therefore the couple’s tax should be higher than that of two single persons.56 with that rationale underlying the tax reform act of 1969, the “marriage penalty” was born. however, congress did not reconsider the fairness of joint and several liability—if the “privilege” of income splitting was now eroded for many couples, should a spouse still be held liable for the other’s tax liability?57 significantly, congress 53 see beck, supra note 30, at 337 n.78 (citing legislative history showing that, in 1938, when it was rarely the case that a couple would benefit economically by filing jointly, ninety-four percent of married couples filed a joint return) (citing h.r. rep. no. 1040, 77th cong., 1st sess. at 16-17 (1941), reprinted in 1941-2 c.b. 413, 426-27). beck points out that federal income tax rates were low enough in 1938 that it made no difference in most people's tax rates whether they filed jointly or separately; he posits that most of these couples filed jointly for the sake of the convenience of filling out one form rather than two, rather than to achieve tax savings. 54 for a historical examination of marriage bonuses and penalties, see lawrence zelenak, doing something about marriage penalties: a guide for the perplexed, 54 tax l. rev. 1 (2000). zelenak notes that while the 1948 legislation achieved couples neutrality, its purpose was “a delayed response to geographic discrimination between husbands in separate property states and those in community property states.” id. at 4. zelenak notes, as others have, that the goals of progressivity, couples neutrality, and marriage neutrality are incompatible. in both this article and in his article entitled marriage and the income tax, supra note 24, zelenak states his preference for mandatory separate filing. 55 staff of joint comm. on taxation, 99th cong., general explanation of 1969 tax reform act 222 (joint comm. print 1970). 56 id. at 223. 57 in his 1990 article, beck said the following about the introduction of the marriage penalty in the tax reform act of 1969: “the argument that income splitting justifies joint return liability seems hollow for that forty percent of married couples who suffer the marriage penalty. while they may be better off filing 2012] decoupling taxes and marriage 107 seems to envision two types of households in its thinking—that of an unmarried single person, and that of a married couple. what about an unmarried couple living together, sharing household expenses, or any number of nontraditional household units?58 demographically, the number of those households may have been statistically less significant in 1969, but today this is not the case. the rate of cohabitation in the united states is fourteen times higher in 2010 than it was in 1970, and approximately twenty-four percent of children are born to cohabiting couples.59 the legislative intent of certain code provisions thus seems antiquated when viewed in light of the nation’s changed demographics. b. examining the stated rationales of joint and several liability: does the intent still make sense in twenty-first century america? 1. administrative ease for taxpayers and government dating back to the commissioner’s briefs in cole and continuing today, administrative ease has been an oft-cited rationale in support of both joint return filing and joint and several liability.60 the legislative history of the revenue act of 1938, picking up on the arguments made by the commissioner in cole and earlier cases, stated: unless the husband and wife are to be held jointly and severally liable for the tax upon their aggregate net income, it will be necessary for the [irs] to require that their individual incomes and deductions shall be separately stated in the return, in order that their respective income-tax liability may be separately determined. such a requirement would cause considerable hardship upon taxpayers with moderate incomes and would largely eliminate the advantages of the joint return.61 it is true that if the married filing jointly status were eliminated, there would be a sharp increase in the number of returns that the service must process. it is also true that would create an added burden for married taxpayers, who must prepare, or pay for the preparation of, two individual returns rather than one joint return.62 however, technology has come quite a long way since 1938. the service does not process returns by hand, nor do most taxpayers prepare a return with pencil and paper. since 1986, the service has encouraged (and, more recently, mandated in some cases) the electronic filing of income tax returns. these efforts are working. in june of jointly than filing separately, they would be still better off if they had never married, or were divorced. from this vantage point, filing jointly, as ninety-nine percent of married persons do, involves an overall tax detriment, rather than a benefit. if joint return liability were justified on a quid pro quo theory, the liability probably should have been abolished in 1969, when the marriage penalty arose.” beck, supra note 30, at 372. 58 i conclude it is appropriate to reconsider the current structures in light of other code provisions and changing demographics. see infra part iv. 59 the nat’l marriage project, executive summary to why marriage matters: thirty conclusions from the social sciences 1 (3d ed. 2011), available at http://www.americanvalues.org/pdfs/dl.php?name=wmm3es. 60 the treasury department invoked this rationale in its 1998 report eschewing separate filing in favor of expanded innocent spouse reform. see infra part iii. but see comm'r v. uniacke, 132 f.2d 781, 783 (2d cir. 1942) (dismissing the rationale of administrative convenience); comm'r v. rabenold, 108 f.2d 639, 640 (2d cir. 1940) (recognizing the administrative inconvenience of apportioning tax deficiencies between husband and wife). both cases were decided under pre-1938 law. 61 1998 treas. report on jl and is, supra note 22, at 6–7 (citing h.r. 1860, 75th cong. 2d sess., 1939-1 c.b. 749) (emphasis added). 62 id. at 25–27. 108 columbia journal of tax law [vol.4:94 2011, the service announced that it has processed more than one billion total individual tax returns through its electronic filing program. this statistic included more than 100 million individual tax returns (representing 79% of individual income tax returns filed) that were e-filed during the 2011 filing season.63 contrast this with tax year 1998, in which only 19% (25 million out of 123 million) of all individual income tax returns were e-filed.64 in her 2005 annual report to congress, nina olson recommended that congress eliminate joint and several liability and instead require married taxpayers to file a splitcolumn tax return.65 she noted that congress had cited “administrative” reasons when it imposed joint liability in 1938, and that administrative challenges had again been cited as a hurdle by the treasury department in its 1998 study.66 her 2005 report described updates to the service’s computer system and the rise of e-filing as two reasons that those administrative challenges were less significant in 2005 than they were even in 1998.67 she further suggested that, to the extent these administrative challenges remain, they “could also be partially offset by the reduction in, or elimination of, innocent spouse relief” and several other related issues that arise from joint filing.68 one issue of concern is that the trend towards e-filing, however positive for the service, creates a new difficulty in the joint and several liability context because an actual signature is not required on an electronically filed return.69 this facilitates the ability of one spouse to enter the tax information and file the return without the other spouse ever having the opportunity to review or sign the return. similarly, a spouse who reviews and approves a joint return would not know if the other spouse makes subsequent changes prior to filing it. given the structural incentives to file jointly, i believe there will be an increase in this type of “forgery” as e-filing becomes the norm. if the other spouse objects to the filing, the service must undergo a factual determination as to whether the filing spouse forged a signature or merely acted with tacit consent based on past practice within the marriage.70 this is another example of how joint liability creates an additional burden on service resources. the rise of e-filing thus provides two important reasons in support of congress eliminating joint filing: (1) in light of this technological advance, “administrative ease” is no longer a convincing rationale in support of joint return; and (2) it can be very difficult to ensure that both spouses reviewed and consented to a joint return that is filed electronically. 63 internal rev. serv., one billion served: irs e-file passes major milestone, ir-2011-64 (june 9, 2011), available at http://www.irs.gov/uac/one-billion-served:-irs-e-file-passes-major-milestone. 64 nat’l taxpayer advocate, key legislative recommendation: another marriage penalty taxing the wrong spouse, 2005 ann. rep. to cong. 426 (citing irs pub. 55b, data book (mar. 1998) (tables 3 and 4)). 65 id. at 408–09. 66 see infra part iii. 67 nat’l taxpayer advocate, supra note 64, at 425–26. 68 id. at 426. olson mentions community property relief, injured spouse relief, and “numerous other irc provisions that override community property rules in an ad hoc fashion.” id. at 426. while outside the scope of this article, each of these issues exists because of joint and several liability. 69 internal rev. serv., taxpayers who file electronically must use e-signatures, fs2011-07 (jan. 2011), available at http://www.irs.gov/pub/irs-news/fs-11-07.pdf. 70 i.r.m. § 25.15.1.2.4 (mar. 4, 2011) available at http://www.irs.gov/irm/part25/irm_25-015001.html#d0e231 (providing guidance to service employees as to the conditions under which a joint return is invalid). these questions are technically outside of innocent spouse relief, because § 6015 relief is only available when the requesting spouse has signed a joint income tax return. 2012] decoupling taxes and marriage 109 2. joint liability as the price for the “privilege” of filing jointly the “privilege” of filing a joint return is frequently invoked as a justification in support of joint and several liability. interestingly, the use of the word precedes the introduction of income splitting and the concept of the marriage bonus. it dates back at least to cole, when the commissioner spoke of the “‘unusual privilege’ of filing a joint return.”71 the legislative history accompanying the revenue act of 1938 echoed the commissioner’s use of the word “privilege”: section 51(b) of the bill expressly provides that the spouses, who exercise the privilege of filing a joint return, are jointly and severally liable for the tax computed upon their aggregate income. it is necessary, for administrative reasons, that any doubt as to the existence of such liability should be set at rest, if the privilege of filing such joint returns is continued.72 courts emphasized this “privilege” after congress first introduced innocent spouse relief in 1971. in its oft-cited sonnenborn opinion released that same year, the tax court wrote of the privilege as a fact that must be kept in mind when weighing innocent spouse relief: it is important that these provisions be kept in proper perspective. the filing of a joint return is a highly valuable privilege to husband and wife since the resulting tax liability is generally substantially less than the combined taxes that would be due from both spouses if they had filed separate returns. this circumstance gives particular emphasis to the statutory rule that liability with respect to tax is joint and several, regardless of the source of the income or of the fact that one spouse may be far less informed about the contents of the return than the other, for both spouses ordinarily benefit from the reduction in tax that ensues by reason of the joint return . . . . [i]t must be kept in mind that congress still regards joint and several liability as an important adjunct to the privilege of filing joint returns, and that if there is to be any relaxation of that rule the taxpayer must comply with the carefully detailed conditions set forth in section 6013(e).73 these words, written more than forty years ago, have been cited with frequency.74 as discussed in part iii, the innocent spouse provisions have changed considerably since 1971. but that is not all that has changed, in the code or in society generally. if a “price”75 is to be paid by taxpayers for this “privilege,” we must consider to what extent and for whom joint filing remains a privilege today. 71 cole v. comm'r, 81 f.2d 485, 487 (9th cir. 1935). 72 h.r. rep. no. 1860, at 29–30 (1938). 73 sonnenborn v. comm’r, 57 t.c. 373, 380–81 (1971) (discussing why the innocent spouse provisions must be narrowly construed) (emphasis added). section 6013(e) was the innocent spouse provision in effect at the time. as the opinion notes in footnote 3, the innocent spouse provision became law on january 12, 1971, but by virtue of its enacting legislation the relief was applicable to all taxable years to which the internal revenue code of 1954 applied. 74 see, e.g., ogonoski v. comm’r, 87 t.c.m. (cch) 1038; crowley v. comm’r, 70 t.c.m. (cch) 1374; prince v. comm’r, 70 t.c.m. (cch) 309; murphy v. comm’r, 103 t.c. 111 (1994). 75 sonnenborn did not use the term “price” with respect to the privilege, but subsequent courts citing sonnenborn for this principle have used this term. see, e.g., stevens v. comm’r, 872 f.2d 1499, 1503 (11th cir. 1989) (“the rate of tax applied against a given amount of income generally is lower when the 110 columbia journal of tax law [vol.4:94 in the intervening six decades since income splitting was introduced, two major changes to the code have occurred that erode the “unusual privilege” argument: (1) the introduction of the marriage penalty; and (2) the introduction of the earned income credit. changing demographics exacerbate the effects of these changes to the code. if the privilege represents the reduction in tax achieved by joint filing, then it is only a privilege to the extent that such reduction can be accomplished. the so-called “privilege” of filing jointly has no actual value to many married taxpayers versus similarly situated taxpayers who are unmarried and file as single. while the joint filing status may be a “highly valuable privilege” for some, it is certainly not the case for all taxpayers. income splitting is one phenomenon that results in reduction of tax, and is most pronounced in cases where one spouse earns a high income and the other does not work. however, a couple in which both spouses earn a high income is likely to face not a marriage bonus but a marriage penalty; in these cases, the spouses would owe a smaller aggregate tax liability if they were permitted to file as unmarried individuals. arguably, there is no “privilege” for two high-earners who must file as married, yet they are held jointly and severally liable for filing jointly.76 a low-income couple faces a similarly illogical conundrum: their benefit from income splitting is likely nominal as compared to a one-earner high income couple such as the bozicks, but they must accept joint and several liability as a condition of receiving the earned income credit. at the same time, a similarly situated unmarried couple would receive a higher aggregate refund than the married couple. joint filing cannot be said to be a “highly valuable privilege” if the resulting refund is less favorable. part v explores this conundrum in greater detail. iii. relief is available to some innocent spouses, but at what cost to the system? the process affording relief to innocent spouses has become increasingly liberalized over the past forty years, allowing a requesting spouse broader grounds for relief and appeal. this is well intended; if there is to be a system for relief, it should be a comprehensive process that seeks the most equitable outcome. but as we consider the state of the relief process today, let us also flip the “highly valuable privilege” theory of joint liability on its head. considerable resources are devoted to the resolution of these highly factual “hesaid, she-said” marital disputes each year. are these costs really worth the benefits of joint and several liability to the government? in other words, would the service be better off if congress repealed § 6013(d)(3) and adopted a system of separate rather than joint liability for spouses? given the divorce rate, among other factors, would it not be easier income is reported on a joint return than when a husband and wife file separate returns. the price which the law exacts for this privilege is that taxpayers who file a joint return are jointly and severally liable for the amount of tax due, regardless of the source of income reported and notwithstanding the fact that one spouse may be less informed about the contents of the return.”) (citation omitted), aff'g 55 t.c.m. (cch) 135; estate of woodward v. comm’r, t.c. memo 1995-523 (“the privilege of filing a joint income tax return does not come without a price, however. thus, as a general rule, spouses who file joint income tax returns are jointly and severally liable for the full amount of tax due on the combined incomes.”). 76 as mentioned in note 4, supra, in almost all cases married taxpayers face a higher liability if they elect the married filing separately status. this holds true for two high-earners, who face a penalty on a married filing joint return relative to what two unmarried taxpayers would pay in the aggregate yet would be subject to an even higher liability if they elected married filing separately status. 2012] decoupling taxes and marriage 111 and more efficient to treat each taxpayer as responsible for his or her own income tax liability? an overview of innocent spouse relief will provide context to these questions. a. evolution of innocent spouse relief: 1971-1998 for decades prior to 1971, spouses who filed joint returns were held jointly liable for any resulting deficiency or underpayment. to avoid joint liability, a spouse had to show that there was no valid joint return. forgery was one possible defense; where a court found that a signature was forged, it concluded that there was no joint return filed.77 another possible defense was duress, with taxpayers arguing that a return is not joint in the absence of both parties’ voluntary consent. courts acknowledged that duress would be a defense to a joint liability if it was shown that the duress existed at the time the return was signed; however, courts defined duress narrowly and taxpayers were typically unsuccessful in their duress claims.78 in cases where a spouse willingly signed the return, courts had no avenue to provide relief from joint liability, no matter how sympathetic the facts. for example, in scudder v. commissioner, which predated the enactment of the first innocent spouse provision, the petitioner signed a joint return but was unaware that her husband had embezzled money and not reported it on the return. the service held her jointly liable for the resulting deficiency, and the tax court, “with considerable reluctance,” upheld the determination: although we have much sympathy for petitioner's unhappy situation and are appalled at the harshness of this result in the instant case, the inflexible statute leaves no room for amelioration. it would seem that only remedial legislation can soften the impact of the rule of strict individual liability for income taxes on the many married women who are unknowingly subjected to its provisions by filing joint returns.79 this plea did not go unheard. the innocent spouse act of 197180 was said to have reflected the concern of congress “about the ‘grave injustice’ imposed by joint and 77 see e.g., dranow v. comm’r, 27 t.c.m. (cch) 1485 (1968). forgery is to be distinguished from signing someone else’s name with tacit consent. thus if one spouse signs for the other, the court will uphold joint liability where it finds that the non-signing spouse tacitly consented to the signing spouse’s action. see, e.g., abrams v. comm’r, 53 t.c. 230 (1969). 78 see e.g., stanley v. comm’r, 45 t.c. 555, 563 (1966) (holding that the taxpayer “failed to prove the necessary causal relationship between her fear of [her husband] and her signing of the returns”); federbush v. comm’r, 34 t.c. 740, 754–58 (1960), aff’d per curiam, 325 f.2d 1 (2d cir. 1963); estate of aylesworth v. comm’r, 24 t.c. 134, 145–46 (1955) (holding that taxpayer’s abuse at the hands of her husband did not constitute duress). the aylesworth opinion noted: “the filing of joint returns resulted in a substantially reduced tax burden for the couple as a result of the split income provisions, and we should be very slow to conclude that the signature of the wife is to be regarded as having been obtained by fraud or duress.” id. at 146. 79 scudder v. comm’r, 48 t.c. 36, 41 (1967). mrs. scudder appealed to the sixth circuit court of appeals, which disagreed with the tax court that nothing could be done. it remanded the case for further consideration of the innocence of the fraud as a defense. scudder v. comm’r, 405 f.2d 222 (6th cir. 1968). another oft-cited case that included a plea for a legislative fix is wissing v. comm'r, 54 t.c. 1428, 1432 (1970) (“we would welcome a rule which would grant relief to a victimized spouse who has no knowledge of or reason to have knowledge of, and does not benefit from, unreported income, at least where that income is the fruit of a crime. but we regretfully see no way in which this court can or should engraft such a ‘doing equity’ rule on the language of section 6013(d)(3). we think that such a result should properly be accomplished by ameliorating legislation.”), vacated, 441 f.2d 533 (6th cir. 1971). 80 innocent spouse act of 1971, pub. l. no. 91-679, 84 stat. 2063. in 1998, the innocent spouse provisions were amended and moved to § 6015, where they remain today. 112 columbia journal of tax law [vol.4:94 several liability in cases in which, for example, the culpable spouse embezzles funds, fails to report the proceeds, deserts the innocent spouse, and squanders the funds.”81 the legislative history to the 1971 act recognized the inequitable outcomes that sometimes resulted from strict joint and several liability. the senate report on the bill noted that “some . . . judicial decisions have carried pleas for legislative relief” and quoted the above language from the tax court’s opinion in scudder as an example.82 the report stated that “[t]his proposal seeks to correct the unfairness in the situations brought to the attention of this committee and to bring government tax collection practices into accord with basic principles of equity and fairness.”83 to address these concerns, the 1971 act added subsection (e) to § 6013, providing potential relief for a spouse who had filed jointly if: (1) there was omitted income in excess of twenty-five percent of the amount of the gross income reported on the return; (2) this omitted amount was attributable to one spouse; (3) the other spouse establishes that he or she did not know of, and had no reason to know of, such omission; and (4) it would be inequitable to hold the other spouse liable for the deficiency attributable to such omission, taking into account all facts and circumstances, including whether or not the other spouse significantly benefited directly or indirectly from the items omitted from gross income. the notion of an “innocent” spouse has evolved considerably over time, just as the statutory provisions for relief have been liberalized. to qualify for relief under the 1971 act, one truly had to be uninvolved in, and unaware of, his or her spouse’s financial activities and resulting understatement of income on the joint return. moreover, relief was only available if the spouse omitted twenty-five percent or more of his or her income on the return; an otherwise innocent spouse had no relief if the omission were smaller. since its narrowly defined introduction in 1971, the grounds for innocent spouse relief have been increasingly liberalized though legislative amendment and case law. contrast the 1971 standard for innocent spouse relief with that now available under § 6015(f), enacted in 1998, which affords a taxpayer relief if, “taking into account all the facts and circumstances, it is inequitable to hold the individual liable for any unpaid tax or any deficiency (or any portion of either).”84 over time, congress recognized that the early versions of innocent spouse relief were “narrowly drawn and strictly interpreted” and that many former spouses did not qualify for those protections.85 as part of the 1996 taxpayer bill of rights 2 (tbor2), congress directed the treasury department and u.s. government accountability office (gao) to study whether the then-current innocent spouse provisions were providing “meaningful relief in all cases where such relief is appropriate.”86 it also called for studies of: (1) the effects of changing the liability on joint returns from joint and several liability to proportionate liability (meaning “each spouse would be liable only for the income tax attributable to the income of each spouse”87); and (2) the effects of providing 81 staff of joint comm. on tax’n, 105th cong., present law and background relating to tax treatment of “innocent spouses” (joint comm. print 1998) (citing s. rep. no. 91-1537, at 2 (1970)). 82 s. rep. no. 91-1537, at 2 (1970). 83 id. 84 i.r.c. § 6015(f)(1) (2012). 85 h.r. rep. no. 104-506, at 30 (1996). 86 taxpayer bill of rights 2, pub. l. no. 104-168, § 401 (1996). 87 h.r. rep. no. 104-506, at 31 (1996). 2012] decoupling taxes and marriage 113 that the service must be bound in its collection by the allocation of joint liability agreed upon in a divorce decree.88 prior to the passage of tbor2, the treasury department requested public comment on these questions.89 in response, the american bar association (aba) and the american institute of certified public accountants (aicpa) were among the groups that submitted proposals suggesting how joint and several liability should be replaced with proportionate liability. in february 1998, the treasury department issued its report to congress.90 the report concluded that the existing innocent spouse provisions “may not provide ‘meaningful relief in all cases where such relief is appropriate,’”91 and it carefully considered the alternatives to joint and several liability, including the aba and aicpa proposals. however, the report ultimately rejected those proposals and recommended further modifying the innocent spouse provisions “to accommodate more cases” rather than making fundamental changes to the joint and several liability standard.92 congress undertook this task in 1998. in january and february of that year, the senate finance committee held hearings in which innocent spouse reform was one of a number of items examined.93 the resulting compromise between the house and senate, § 3201 of the irs restructuring and reform act of 1998,94 became the new § 6015 of the code. the new section provided alternative forms of relief in three different subsections: 6015(b), (c), and (f). section 6015(b) is a liberalized version of the “traditional” innocent spouse relief applicable to joint filers who could establish that they had no actual or constructive knowledge of the item for the understatement from which they sought relief. section 6015(c) allows an innocent spouse to elect an allocation of the deficiency95 such that his or her liability is limited to the portion of the deficiency attributable only to items allocable to the taxpayer. the electing spouse must be widowed or divorced, legally separated, or living apart (for at least twelve months) from the spouse with whom he or she filed the joint return. the subsection includes anti-abuse provisions to address fraudulent transfers of assets. the innocent spouse cannot have had actual knowledge that the item giving rise to the deficiency was reported incorrectly;96 however, unlike with traditional innocent spouse relief and the expanded § 6015(b), § 6015(c)(3)(c) puts the burden of proof on the service to show that the requesting spouse had actual knowledge. moreover, a requesting spouse who had actual knowledge 88 id. 89 i.r.s. notice 96-19, 1996-1 c.b. 371. 90 see generally 1998 treas. report on jl & is, supra note 22. 91 id. at 57 (quoting taxpayer bill of rights 2, supra note 86). 92 see id. at 58. part iii will examine the treasury department’s arguments in favor of maintaining the joint and several liability standard. 93 see irs restructuring: hearings on h.r. 2676 before the s. comm. on fin.,105th cong. (1998). 94 irs restructuring and reform act of 1998, h.r. 2676, 105th cong. § 3201 (1998) (enacted) [hereinafter 1998 act]; i.r.c. § 6015 (2012). 95 the final version of the bill did not allow for separation of liability for underpayments, as had been proposed by the senate amendment. however, relief for underpayments was made available in § 6015(f). 96 see svetlana attestatova, the bonds of joint tax liability should not be stronger than marriage: congressional intent behind § 6015(c) separation of liability relief, 78 wash. l. rev. 831, 858 (2003) (including an in-depth examination of the meaning of “any item”). 114 columbia journal of tax law [vol.4:94 can overcome this requirement if the spouse is able to establish that he or she signed the return under duress.97 in addition to these two specific, carefully designed statutory provisions, congress also added § 6015(f), which provides the treasury secretary authority to prescribe procedures for relief from joint and several liability if, “taking into account all the facts and circumstances, it is inequitable to hold the individual liable for any unpaid tax or any deficiency.”98 a taxpayer is not eligible for relief under § 6015(f) unless relief is unavailable under §§ 6015(b) and (c).99 significantly, § 6015(f) is the only provision that contemplates relief for an innocent spouse in the case of an underpayment. an underpayment can result when the taxpayer files a correct return indicating a liability due, but encloses only partial payment or no payment at all. the conference report explains the intention “that equitable relief be available to a spouse that does not know, and had no reason to know, that funds intended for the payment of tax were instead taken by the other spouse for such other spouse’s benefit.”100 given its statutory authority under § 6015, the service developed administrative guidance for how it would grant § 6015(f) relief.101 over time, a combination of this and subsequent administrative guidance, tax court opinions, and minor amendments to § 6015 have contributed to a further liberalization of the rules favoring innocent spouses. b. a long way since scudder – further liberalization of innocent spouse relief: 1998-2012 the 1998 act was intended to expand innocent spouse relief and “provide equitable relief in appropriate situations.”102 over the past fourteen years, the service has undertaken administrative efforts to further improve the process. to name just a few examples, the service: (1) developed and revised form 8857;103 (2) centralized the processing and review of the requests in one location—the covington, kentucky, innocent spouse unit;104 and (3) revised letters, publications, and online tools to make married taxpayers more aware of the consequences of joint filing and the availability of innocent spouse relief.105 and in the past fourteen years, spouses who feel it is unfair to 97 prior to 1998, duress was (and still is) a common law defense to joint and several liability. see supra note 78. 98 i.r.c. § 6015(f)(1) (2012). 99 i.r.c. § 6015(f)(2) (2012). 100 h.r. rep. no. 105-599, at 254 (1998) (conf. rep.). 101 the current guidelines are set out in rev. proc. 2003-61, 2003-2 c.b. 296, which superseded revenue procedure 2000-15, 2000-1 c.b. 447. notice 2012-8, 2012-4 i.r.b. 309, introduced a proposed revenue procedure that, if adopted, will supersede revenue procedure 2003-61. see also treas. reg. § 1.6015-5 (2002). 102 h.r. rep. no. 105-599, at 254 (1998) (conf. rep.). 103 the first version of irs form 8857, request for innocent spouse relief (and separation of liability and equitable relief), was released in december 1998 and was a one page form with three pages of instructions. the form has been revised five times since then and is currently under revision again. the most recent version of the form (rev. september 2010) is four pages long and includes five pages of separate instructions. all versions are available at http://www.irs.gov/uac/form-8857,-request-for-innocent-spouserelief. 104 the cincinnati centralized innocent spouse operation (cciso) is located in covington, kentucky, and was established in fiscal year 2001. u.s. gov’t accountability office, gao-02-558, innocent spouse program performance improved; balanced performance measures needed 4 (2002). 105 see, e.g., nat’l taxpayer advocate, the most serious problems encountered by taxpayers, fy 2001 ann. rep. to cong. 67–68. irs publication 971, innocent spouse relief, was originally released in 1998 and revised six times since. the current version (rev. september 2011) is 24 2012] decoupling taxes and marriage 115 be held jointly liable have responded in kind. the service receives an estimated fifty thousand requests for innocent spouse relief annually and grants fewer than half of these requests. 106 following its grant of authority in § 6015(f), the service developed guidance explaining its standards for determining equitable relief. revenue procedure 2003-61107 set out seven threshold eligibility requirements for equitable relief108 and specified circumstances in which equitable relief ordinarily will be granted.109 taxpayers who meet the threshold eligibility requirements but not the specified conditions of section 4.02 might still qualify for relief; the service can consider all facts and circumstances and grant relief if it finds it inequitable to hold the requesting spouse liable for all or part of the deficiency or underpayment.110 the balancing factors include: marital status; economic hardship; legal obligation of the nonrequesting spouse; whether the requesting spouse benefited significantly from the unpaid liability or item giving rise to the deficiency; the requesting spouse’s compliance with income tax laws; spousal abuse; and mental or physical health of the requesting spouse.111 interestingly, another of the balancing factors that the service will consider in determining equitable relief is whether the requesting spouse knew or had reason to know of the underpayment or item giving rise to the understatement.112 this is a significant departure from the pre-1998 innocent spouse relief statute, which required a spouse to show no knowledge or reason have knowledge as one of several conditions for relief. under the equitable relief standard, the service (or the tax court, in its review) can now grant relief from liability to a spouse who had full knowledge of the wrongdoing when he or she signed the return if it feels that the other factors supporting relief warrant it. returning to the bozick case as an example:113 both the service and the tax court concluded that ms. bozick had reason to know that her husband would not pay the $137,453 liability shown on their joint return. the record shows ms. bozick was aware that he was in failing health, had credit card debt, and had a gambling problem. she acknowledged these facts in her divorce petition and also acknowledged that he did not keep up with his quarterly taxes and withholding. the tax court weighed all facts and circumstances in its opinion, including the relief factors listed in revenue procedure 2003-61, but was perhaps most persuaded that it was fair to grant her relief by the fact that “bozick signed a joint tax return only after having been browbeaten into doing so by her husband and after having filed a separate return.”114 pages long. the instructions to form 1040 (tax year 2011) include an explanation of joint and several liability and information about innocent spouse relief; however, at 189 pages, it cannot be assured that taxpayers will read this information in the instructions at the time of filing. the service developed an online innocent spouse tax relief eligibility explorer, which is available on the irs website at http://www.irs.gov/individuals/explore-if-you-are-an-eligible-innocent-spouse. 106 see supra note 19. 107 rev. proc. 2003-61, 2003-2 c.b. 296. 108 id. at § 4.01. 109 id. at § 4.02. 110 id. at § 4.03 (providing a nonexclusive list of eight factors that the service will consider in making its determination). 111 id. 112 id. 113 see supra note 9. 114 bozick v. comm’r, 99 t.c.m. (cch) 1242, 1244 (2010). 116 columbia journal of tax law [vol.4:94 a lot of open questions remained after the 1998 act, even after the service developed its administrative guidance for granting relief. for example, in the years immediately following the 1998 act, the service contended that the tax court lacked jurisdiction to review a denial of equitable relief brought under § 6015(f). the tax court found that it did have jurisdiction over these cases.115 however, in 2006, the ninth circuit held that the court lacked jurisdiction in § 6015(f) underpayment cases where the liability did not arise from a deficiency.116 in december 2006, congress settled this issue by amending § 6015(e) to make clear that the tax court had jurisdiction to review all denials of relief, including § 6015(f) underpayment cases.117 the scope and standard of judicial review have been the subject of litigation in recent years, with the tax court holding that the scope of review could include new evidence introduced by the taxpayer at trial that was not in the administrative record118 and that the proper standard of review in all § 6015 relief cases is de novo.119 despite tax court decisions to the contrary,120 the service continues to argue that the scope of review of § 6015(f) cases should be limited to the administrative record and that abuse of discretion is the proper standard of review.121 the cumulative impact of the 1998 act, the 1996 amendment to § 6015(e), and the tax court holdings on the scope and standard of review has been a great liberalization and expansion of innocent spouse relief over a fourteen year period. this was, of course, what congress had intended when it decided in 1998 to broaden the relief rather than eliminate joint and several liability. but to achieve “equitable” outcomes, each determination necessarily becomes a very fact-intensive inquiry into the personal lives and marriage of the taxpayers. if the nonrequesting spouse responds or intervenes, 115 see, e.g., fernandez v. comm’r, 114 t.c. 324, 332 (2000); ewing v. comm’r, 122 t.c. 32, 36– 38 (2004). 116 comm’r v. ewing, 439 f.3d 1009, 1014 (9th cir. 2006); see also bartman v. comm’r, 446 f.3d 785, 787–88 (8th cir. 2006) (holding that the tax court lacked jurisdiction under § 6015(e)(1) where there was no deficiency). 117 i.r.c. § 6015(e)(1)(a) (2012). 118 ewing v. comm’r, 122 t.c. 32 (2004), vacated, 439 f.3d 1009 (9th cir. 2006). in porter v. comm’r, 130 t.c. 115, 124 (2008) [hereinafter porter i], the tax court revisited the issue and upheld the position that the court may consider evidence introduced at trial even if not included in the administrative record. porter i addressed the scope of review question, but did not resolve the standard of review question; it stated that determination of the scope of review did not depend on the standard of review applied. porter i, 130 t.c. at 122 n.10. 119 see porter v. comm’r, 132 t.c. 203 (2009) [hereinafter porter ii] (revisiting the standard of review question in § 6015(f) cases). following the 1998 act, the court used the de novo standard of review in §§ 6015(b) and (c) cases, but held in butler v. comm’r, 114 t.c. 276, 292 (2000) that abuse of discretion was the appropriate standard of review in § 6015(f) equitable relief cases. in porter ii, the court revisited this question in light of congress’s 2006 amendments to § 6015(e)(1); it concluded that by the language of the amendments, congress intended the court to use a de novo scope of review and standard of review in cases determining relief under § 6015(f). porter ii, 132 t.c. at 208. but see the dissent in porter ii, arguing that congress did not intend in its 2006 amendment to § 6015(e) to change the court’s standard of review from abuse of discretion to de novo. porter ii, 132 t.c. at 233–35 (gustafson, j., dissenting). 120 nat’l taxpayer advocate, legislative recommendations 1, 2011 ann. rep. to cong. 534–35 (2011) (citing as an example torrisi v. comm’r, t.c.m. 2011-235, slip op. at 17 n.15). the taxpayer advocate called upon congress to amend § 6015 to clarify that the tax court’s scope and standard of review is de novo in § 6015(f) cases, stating: “[t]he irs’s position is especially harmful to taxpayers who cannot afford representation or assistance during administrative proceedings, or those who are victims of domestic violence or abuse. the divergence between counsel’s position and that of the tax court creates uncertainty for taxpayers and consumes administrative and judicial resources.” id. at 474. 121 i.r.s. notice cc-2009-021 (june 30, 2009). 2012] decoupling taxes and marriage 117 the service and/or the tax court often must make a judgment in a “he-said, she-said” presentation by the spouses.122 and as already noted, the liberalization of the statute does not mean that all or even most requesting spouses get the relief they seek. the taxpayer advocate’s 2011 annual report to congress included an analysis of forty-three opinions from the tax court or courts of appeals involving relief under § 6015 for the period june 1, 2010 to may 31, 2011.123 of these forty-three cases, most (thirty-four cases, or 79%) involved a reconsideration of the merits as to whether the taxpayer should be granted relief.124 of these cases decided on the merits, the taxpayer was granted full relief in eleven of thirtyfour cases (or 32%) and partial relief in seven cases (21%). the service’s denial of relief was fully upheld by the court in nearly half the cases (sixteen of thirty-four, or 47%).125 a significant number of the forty-three cases analyzed in 2011—fifteen cases, or 35%—involved procedural questions. this is common from year to year. the lantz case126 sparked a closely-watched bout of litigation concerning procedure for innocent spouse relief cases, which eventually led to yet another liberalization of the relief process. at issue in lantz was whether a requesting spouse must request equitable relief under § 6015(f) within two years of the service commencing collection activity on the requesting spouse. the code is clear that a taxpayer requesting relief under § 6015(b) or (c) must do so within this two-year limit,127 but it is silent as to whether there is a time limit for a taxpayer requesting relief under § 6015(f). treasury regulation 1.60155(b)(1), which was promulgated in 2002, extended this two-year limit to taxpayers seeking equitable relief under § 6015(f).128 in lantz¸ the service had rejected the taxpayer’s § 6015(f) claim as untimely because it was not within the two-year limit. the taxpayer argued that regulation section 1.6015-5(b)(1) was an invalid interpretation of the statute; the tax court agreed, found an abuse of discretion because the service did not consider the merits of the taxpayer’s request, and ordered further proceedings to determine whether the taxpayer was entitled to relief.129 the service appealed to the seventh circuit, which reversed and remanded in 2010.130 in cases that would have been appealed to a court of appeals that has not followed the seventh circuit, the tax court continued to hold that the two-year deadline imposed by the treasury regulation was 122 i.r.c. § 6015(h)(2) (2012) provides the nonrequesting spouse the statutory right to respond. while an important procedural safeguard, the process puts the service into the position of fact-finder in a “he-said, she-said” argument between ex-spouses. should the requesting spouse prevail, the nonrequesting spouse has the right to appeal. rev. proc. 2003-19, 2003-1 c.b. 371. 123 nat’l taxpayer advocate, most litigated issues 2, 2011 ann. rep. to. cong. 659 (2011). 124 id. 125 id. 126 lantz v. comm’r, 607 f.3d 479 (7th cir. 2010). 127 see i.r.c. § 6015 (2012). “collection activity” is defined in treas. reg. § 1.6015-5(b)(2)(i) (2002) to mean: “a section 6330 notice; an offset of an overpayment of the requesting spouse against a liability under section 6402; the filing of a suit by the united states against the requesting spouse for the collection of the joint tax liability; or the filing of a claim by the united states in a court proceeding in which the requesting spouse is a party or which involves property of the requesting spouse.” 128 prior to the promulgation of the regulation, the service issued several forms of public guidance announcing its position that the two-year limitation applied to § 6015(f) claims. see i.r.s. notice 98-61, § 3.01(3), 1998-2 c.b. 758; rev. proc. 2000-15, 2000-1 c.b. 447; rev. proc. 2003-61, 2003-2 c.b. 296. 129 lantz v. comm’r, 132 t.c. 131, 150 (2009), rev’d, 607 f.3d 479 (7th cir. 2010). 130 lantz v. comm’r, 607 f.3d 479 (7th cir. 2010). 118 columbia journal of tax law [vol.4:94 invalid.131 the service, meanwhile, continued to appeal in other circuits and win on the issue.132 the two lantz decisions attracted considerable attention among practitioners and academics.133 the taxpayer advocate highlighted this particular issue in her 2010 annual report to congress, criticizing the two-year limit and calling upon congress to amend § 6015(f) to clarify that a taxpayer may request equitable relief at any time before expiration of the period of limitations on collection.134 her recommendation gained momentum in congress, with members of the house and senate sending letters to irs commissioner schulman calling upon the service to reconsider the treasury regulation in light of the intent of the 1998 act. senator baucus, who was a member of the finance committee at the time of the 1998 act, stated in a press release that accompanied one letter to shulman: we made important changes to protect innocent taxpayers seeking relief from their spouses’ liability to ensure fair and equitable treatment. now, we are concerned this two-year limitation denies relief to the very taxpayers the law was designed to help—the innocent spouses unaware of these irs collection activities because of intimidation or deception by their spouse. we must reevaluate these limits so all taxpayers are treated justly and have time to file for tax relief they deserve.135 the letters proved effective. in july 2011, the service announced that it would eliminate the two-year requirement in § 6015(f) cases; it will consider requests for equitable relief if the statutory period for collection remains open.136 commissioner shulman stated in the accompanying press release: “today’s change will help innocent spouses victimized in the past, present, and future.”137 in the year prior to this change in policy, over fifteen hundred requests were disallowed as untimely because relief was not 131 the tax court follows the precedent of a court of appeals in subsequent cases that would be appealed to that particular circuit; as a result, it often rules differently according to where the appeal would lie. see golsen v. comm’r, 54 t.c. 742, 756–57 (1970), aff’d, 445 f.2d 985 (10th cir. 1971). 132 the third and fourth circuits followed the seventh circuit in upholding the regulation. see mannella v. comm’r, 631 f.3d 115, 121–25 (3d cir. 2011); jones v. comm’r, 642 f.3d 459, 465 (4th cir. 2011). the service filed appeals in the second, sixth, and ninth circuits, but later dropped these appeals in light of i.r.s. notice 2011-70, 2011-32 i.r.b. 135 (infra note 136). see coulter v. comm’r, t.c. no. 100309 (stipulated decision nov. 20, 2009), appeal docketed, no. 10-680 (2nd cir. feb. 24, 2010); buckner v. comm’r, t.c. no. 12153-09 (decided may 21, 2010), appeal docketed, no. 10-2056 (6th cir. aug. 18, 2010); and carlile v. comm’r, t.c. no. 011567-09 (decided may 26, 2010), appeal docketed, no. 10-72578 (9th cir. aug. 23, 2010). despite the appeals, the tax court continued to hold the two-year deadline invalid in the circuits that had not yet ruled. see, e.g., pullins v. comm’r, 136 t.c. 432, 441–42 (2011); kelly v. comm’r, 100 t.c.m. (cch) 507, 510 (2010); hall v. comm’r, 135 t.c. 374, 382 (2010). pullins was on appeal in the eighth circuit, and both kelly and hall were on appeal in the sixth circuit; these tax court opinions were filed subsequent to the buckner opinion but prior to i.r.s. notice 2011-70. 133 see, e.g., patrick j. smith, gaps in the seventh circuit’s reasoning in lantz, 2010 tax notes today 186-19 (2010) (criticizing the seventh circuit opinion); bryan t. camp, interpreting statutory silence, 2010 tax notes today 148-6 (2010) (analyzing the tax court’s decision). 134 see nat’l taxpayer advocate, allow taxpayers to request equitable relief under internal revenue code 6015(f) or 66(c) at any time before expiration of the period of limitations on collection and to raise innocent spouse relief as a defense in collection actions 1, 2010 ann. rep. to cong. 377–78 (2010). 135 press release, s. fin. comm., baucus, harkin, sherrod brown call on irs to give innocent spouses more time to file for tax relief (apr. 18, 2011). 136 i.r.s. notice 2011-70, 2011-32 i.r.b. 135. 137 i.r.s. news release ir-2011-80 (july 25, 2011). 2012] decoupling taxes and marriage 119 requested within the two-year limit.138 the new guidance is a taxpayer friendly outcome—and good for a spouse like ms. lantz, whose case would have granted relief on the merits if it had been requested timely—as it will once again broaden the circumstances for relief. an accompanying increase in requests, however, will further burden a system that already receives fifty thousand such requests annually. a few months later, in january 2012, the service released notice 2012-8, which introduced a proposed revenue procedure that would update and supersede revenue procedure 2003-61.139 in the press release accompanying the notice, irs commissioner doug shulman stated, “the irs is significantly changing the way we determine innocent spouse relief. these improvements should dramatically enhance our process to make it fairer for victimized taxpayers facing difficult situations.”140 the notice proposes a procedure for certain streamlined case determinations,141 which sounds as though the service intends to add efficiency to the process. however, it does not specify what is meant by “streamlined.” at the same time, another section of the proposed revenue procedure expands how the service can weigh abuse and financial control in cases involving an underpayment;142 while this potentially broadens the grounds for relief for innocent spouses, it could also make the determination even more fact-intensive. the innocent spouse relief process has evolved considerably since its debut in 1971. relief has been expanded to include more taxpayers, and the taxpayers have been granted more extensive rights of appeal. from a due process standpoint, these evolutions are admirable. congress is sympathetic to the plight of the “innocent spouse,” as was made clear in the hearings and legislative history relating to the 1998 act and again recently by senator baucus.143 so in light of the complicated and time-consuming relief process, why has congress chosen not to fix the root of the problem by eliminating joint and several liability? part iv will offer some perspective, with the benefit of hindsight. iv. solutions – revisiting the treasury department’s recommendation to expand innocent spouse relief instead of eliminate joint and several liability in 1996, congress directed the treasury department to conduct a study of four issues related to joint returns. the three that are relevant to this article included: (1) the effects of changing from a joint and several liability standard to a proportionate liability standard; (2) the effects of allowing the service to be bound in collections efforts by the allocation of joint liability in a divorce decree; (3) whether the innocent spouse provisions in effect at the time “provided meaningful relief in all cases where the relief was appropriate.”144 the treasury department report, which was released in february of 1998, acknowledged that the existing joint and several liability and innocent spouse rules were “imperfect in certain respects.”145 it considered the pros and cons of a number of various proposals to modify or eliminate joint and several liability, and concluded that each of the 138 nat’l taxpayer advocate, unlimit innocent spouse equitable relief, 2 2010 ann. rep. to cong. 11 at n.54 (2010). 139 i.r.s. notice 2012-8, 2012-4 i.r.b. 309. 140 i.r.s. news release ir-2012-03 (jan. 5, 2012). 141 see supra note 139, at § 4.02. 142 see id. at § 4.03(2)(c)(ii). 143 see supra notes 93 and 135. 144 taxpayer bill of rights 2, pub. l. no. 104-168, § 401, 110 stat. 1452, 1459 (1996). 145 1998 treas. report on jl and is, supra note 22, at 2. 120 columbia journal of tax law [vol.4:94 proposals had both advantages and defects. the treasury report opted instead to recommend legislative changes that would “preserve the advantages of the current system and yet afford innocent spouse relief in more situations.”146 specifically, it recommended legislation that would broaden relief in the following ways: automatically suspend collection efforts against one spouse when the other is contesting a proposed joint assessment in tax court; make innocent spouse relief easier to obtain by changing statutory standards to help additional taxpayers, including those with smaller tax bills who are presently ineligible for relief in many cases; give more taxpayers who are denied innocent spouse relief by the irs an opportunity to appeal the decision to tax court, and automatically suspending collection while the tax court considered the appeal.147 before reaching that conclusion and making those recommendations for legislative change, the treasury report considered several alternatives. the report considered the specific advantages and disadvantages of each proposal, including the proposal that i advocate for in part v of the article: to mandate separate returns for all married individuals, thereby eliminating both joint and several liability and joint returns. a. a systemic change: mandatory separate returns for all fliers the report considered the advantages and disadvantages of adopting a mandatory separate return system from the perspective of both the taxpayer and the service. mandated separate return filing is my favored solution because i believe it is unfair to force married filers to choose between joint liability and unfavorable tax treatment. the report commented in a footnote that mandated separate filing would “arguably be inconsistent with horizontal equity, one of the economic goals of taxation, because similar families would be taxed differently based on the division of income between spouses.”148 as i argue below, this argument is antiquated in that it presumes that a family unit consists of a married couple. another primary concern the report raised for taxpayers is that mandated separate filing would increase the administrative burden for couples, who would have to file two tax returns annually instead of one joint return. the report noted that this would be especially burdensome for couples with jointly held income-producing assets or jointly held assets, such as a primary residence, that create a deduction.149 it noted that because a comparatively small number of taxpayers choose the “married filing separately” status, questions arising in those cases were addressed on a case-by-case basis, but that if mandated separate filing were adopted, then “[c]omprehensive rules would need to be implemented, most likely through legislation, to instruct taxpayers and the service on how to allocate any number of items between the spouses.”150 perhaps because the numbers are insignificant relative to joint filers, the report does not address the situation 146 id. at 3. 147 id. at 3. the report also addressed issues related to community property laws and the rule of poe v. seaborn. i have largely ignored the effect of community property laws in this article because i presume that if congress mandated individual filing, it would also legislatively overrule poe v. seaborn. along with a chorus of scholars, taxpayer advocate nina olson has called for the legislative repeal of poe v. seaborn. nat’l taxpayer advocate, key legislative recommendation: another marriage penalty—taxing the wrong spouse 1, 2005 ann. rep. to cong. 407, 409 (2005). 148 id. at 25 n.38. 149 id. at 25–26. 150 id at 26. 2012] decoupling taxes and marriage 121 in which unmarried people own income-producing property jointly, yet file an individual return. from the perspective of irs administration, the report noted that mandatory separate filing would be burdensome insofar as the service would have to process fortynine million additional tax returns annually. however, as i discussed in part ii.b, the irs e-file program has helped to streamline return processing, and the number of taxpayers participating in the e-file program has nearly quadrupled since 1998.151 b. less comprehensive proposals: proportionate liability, allocated liability, and adoption of the divorce decree another line of proposals in the treasury report contemplated preserving joint filing while allowing married couples to separate their joint liability. for example, the aba tax section committee on domestic relations proposed what became known as “back end proportionate liability,” whereby a married couple could allocate and separate a tax liability or assessment in two situations: (1) upon election by one spouse in the case of an underpayment; and (2) “upon the assertion of a deficiency of tax” during an exam.152 thus, married couples would continue to enjoy the benefits of income splitting but in many cases could avoid joint liability attributable to the tax items of the other spouse. aicpa introduced a different proposal, which became known as the “allocated liability standard,” which would permit married taxpayers to file jointly and provide, at their complete discretion, their own agreed-upon allocation of the aggregate liability at filing.153 the report rejected both the aba and aicpa proposals on the grounds that neither would fully eliminate the need for equitable or innocent spouse relief.154 a third proposal would require the service to be bound by the terms of a divorce decree regarding the responsibility for tax liabilities on prior joint returns. congress had considered such a proposal previously but was troubled by the fact that the service is not a party to the divorce proceeding.155 c. judging with the benefit of hindsight – did treasury make the right recommendation in 1998? the unending inefficiencies of the innocent spouse process ultimately, in 1998 congress followed the report’s recommendations and retained joint and several liability while expanding the grounds for innocent spouse relief. in hindsight, was this the right decision? the report raised legitimate concerns about the increased administrative costs to both the taxpayer and the service if a mandatory separate filing service were adopted. however, since the time of the report, e-filing has changed the administrative landscape considerably.156 to the extent that return processing is increasingly automated, the number of returns filed is less relevant than it once was. meanwhile, the expansion of innocent spouse reform has broadened the grounds for relief and created new administrative burdens. the expansion has resulted in a 151 see supra notes 63 and 64. 152 1998 treas. report on jl and is, supra note 22, at 34. the report notes that the aba proposal represented the views of individuals who submitted the comments and did not represent an official position of the aba or its tax section. 153 id. at 38–39. 154 id. at 38, 41. 155 id. at 42 (citing h.r. rep. no. 104-56, at 30 (1996)). 156 see supra part i.b.1; supra note 63. 122 columbia journal of tax law [vol.4:94 corresponding increase in the number of requests for innocent spouse relief, with each request requiring a time-consuming and personalized determination. the service and tax court are now expending significant resources to investigate claims of spousal abuse, economic hardship, and other highly factual non-tax questions such as an individual’s level of knowledge (i.e., which spouse knew what facts about items of income).157 unsurprisingly, given the task at hand, the service has not been getting the results right. in 2007, the treasury inspector general for tax administration (tigta) performed an audit to examine certain procedures that had been established to protect the rights of spouses requesting innocent spouse relief.158 specifically, the procedures were designed to ensure that collection enforcement was suspended against the requesting spouse (but not against the nonrequesting spouse) while the relief request was pending; for example, while the request is under consideration, the requesting spouse’s refund should not be offset to satisfy the joint liability that is at issue. however, tigta found that in twenty-seven percent of the accounts it reviewed, the service had not acted timely to ensure that the proper protections were in place.159 richard c.e. beck, who made a compelling argument for the repeal of joint and several liability in a 1990 article,160 re-examined the issue following the restructuring and reform act of 1998.161 in his re-examination, beck describes the high administrative costs of expanding innocent spouse relief in 1998 (as compared to abolishing joint and several liability). beck cites irs statistics describing how the service created a central processing center for innocent spouse claims and assigned 953 full-time employees to work exclusively on those claims;162 despite this redirection of resources, it took the service an average of 192 days to process claims for relief that were granted at the administrative level and it took an astounding 807 days to process claims that were appealed within the service.163 within the context of the significant resources the service redirected toward innocent spouse relief, beck examined the innocent spouse cases that were litigated in 2005 and found the following: summing up, it seems fair to say that there are now more cases than before the 1998 reforms, and that the law and the decisions are more complex, but that there is no more certainty, consistency or rationality in the case law than before. and because the ratio of wins and losses appears very similar in samples taken nearly twenty years apart, one may perhaps conclude also that the quality and consistency of the administrative dispositions are also no better now than before.164 beck argues that joint and several liability should be repealed because it is a system that lacks any justification and results in an intolerable “tax persecution of 157 see, e.g., beck, infra note 161, at 950–51, 954. 158 treas. inspector gen. for tax admin., the process to separate joint tax accounts for innocent spouse cases has been improved; however, additional actions are needed (2007), available at http://www.treasury.gov/tigta/auditreports/2007reports/200740053fr.pdf. 159 id. at 4. 160 see richard c.e. beck, the innocent spouse problem: joint and several liability for income taxes should be repealed, 43 vand. l. rev. 317 (1990). 161 see richard c.e. beck, the failure of innocent spouse reform, 51 n.y.l. sch. l. rev. 929 (2006–07). 162 id. at 950. 163 id. at 950–51 (citing tas report 2005, supra note 17, at 423). 164 id. at 954. 2012] decoupling taxes and marriage 123 women.”165 he points out that “[t]he united states is virtually the only country in the developed world which insists upon [joint and several liability], even among countries which permit income-splitting to married persons filing jointly.”166 i agree with beck that the 1998 expansion of innocent spouse relief was a failure. i believe that the service should focus its resources on the proper administration of the tax law. congress should not expect the service to investigate or judge intimate questions of family relations. similarly, these cases are a burden on the tax court’s docket, and the court is no better suited to determine “innocence” than the service is. the extensive litigation and advocacy regarding the two-year rule in lantz and its companion cases is only the latest example of the tremendous resources that have been poured into innocent spouse relief. beck argues that the innocent spouse rules will never be satisfactory, because “innocence is an irrational basis for relief and can never be made rigorous or consistent.”167 in response to such critiques by beck and other scholars, stephanie hunter mcmahon conducted an empirical study of innocent spouse decisions to determine whether courts are implementing congress’s legislative intent.168 she aggregated the results from 444 cases and concluded that “courts apply their own interpretation of congressional intent, only loosely confined by the terms provided by the executive agency.”169 mcmahon elaborates on the courts’ interpretation of the factors set out by the treasury department in revenue procedure 2003-61 and describes some of the trends she found in her study. she calls for clearer guidelines to be established by congress and definitions by the treasury department, finding it problematic that “in their opinions judges are neither crafting precise definitions of many of . . . [the terms described in the revenue procedure] nor defining the relative importance of each.”170 mcmahon does not agree with beck’s statement that innocent spouse relief has “degenerate[d] into a global subjective test of whether the spouse seeking relief can move the judge to sympathy,”171 but she does conclude from her study that litigating innocent spouse relief “can be complicated and costly for both taxpayers and the government” and that “[as] with all equity claims, the factors considered by the courts may be inconsistently applied.”172 in my view, the treasury department’s solution of “afford[ing] innocent spouse relief in more situations”173 has fallen short in providing relief, while simultaneously burdening the system with time-consuming claims. it is time for congress to return to the drawing board and reconsider the message that was delivered during the 1998 testimony it heard from those who suffered because of joint liability. instead of expecting the code to resolve complex family dynamics, congress should reassess and take a bold step in the opposite direction: it should stop differentiating taxpayers according to family dynamics. perhaps seventy-five years ago it 165 id. 166 id. at 932. 167 id. at 954. 168 stephanie hunter mcmahon, an empirical study of innocent spouse relief: do courts implement congress’s legislative intent?, 12 fla. tax rev. 629 (2012). 169 id. at 706. 170 id. 171 id. (quoting beck, supra note 161, at 942). 172 id. at 707. 173 1998 treas. report on jl and is, supra note 22, at 3. 124 columbia journal of tax law [vol.4:94 made sense for congress to divide taxpayers into two distinct groups based on marital status. but it is time for congress to disentangle the code from marital status, and this can be accomplished in harmony with a broader movement towards simplification of the code. the solution is to ignore marital status and, in doing so, to reject the long-accepted premise that married couples behave as one economic unit.174 v. neither the code nor america looks like it did in 1938 (or even 1975): why congress should again revisit the call for mandatory separate filing as described in part iv, there are many ways to address the problems that arise from joint and several liability. many of the solutions would not require large scale modifications to the code. one example, contemplated by the treasury department report, is that congress could require the service to respect the allocation of tax liability for past years agreed upon in the divorce decree.175 the service could create a one-page form on which the taxpayers could allocate the liability and sign as part of divorce proceedings; once submitted to the service, the taxpayers’ accounts could be adjusted accordingly.176 this solution would be simple to enact and relatively easy to administer; it is desirable insofar as it would eliminate the need for the innocent spouse process.177 however, it would do so without a thoughtful reconsideration of the rationales of joint and several liability, the policy underlying marital rates, or the various grounds for penalizing taxpayers who file separately. as i will describe in this part, tax policy has not kept pace with demographic changes in the united states and there are important reasons to reconsider the code’s underlying assumptions about households. moreover, the time is ripe for ambitious statutory changes. faced with a growing deficit and following the historic u.s. credit downgrade by standard & poor’s, there is talk among policymakers of fundamentally revisiting the code. since 2010, commentators, politicians, and government officials have increasingly turned their collective attention to the national debt. several tax policy groups, including the bipartisan national commission on fiscal responsibility and reform established by 174 boris bittker examined the code’s treatment of married couples as an economic unit and framed the tensions of the competing neutralities in his well-known 1975 essay, federal income taxation and the family, 27 stan. l. rev. 1389. a number of scholars have since considered these issues and concluded that, notwithstanding the neutrality trade-offs, it would be more equitable to treat each married individual as a separate economic unit. see, e.g., kornhauser, supra note 24, at 108; zelenak, supra note 24; beck, supra note 160, at 382 (arguing that even if couples do pool their resources, this “cannot justify any transfer of tax liability from one spouse to the other”). 175 1998 treas. report on jl and is, supra note 22, at 41–44. 176 this solution presumes that family law judges and practitioners would be consistent about including this form in the divorce proceedings. as a general proposition, low-income clients are less likely to have adequate or comprehensive representation, if any, during divorce proceedings. 177 the 1998 treasury report on joint liability and innocent spouse issues raised a concern that some form of equitable relief might still be necessary if this proposal were adopted, because a tax liability might not arise until after the divorce was finalized. see 1998 treas. report on jl and is, supra note 22, at 44. this is true, but the possibility could be addressed within the proposal. the spouses are in the best position to know which individual benefits most from joint filing, as well as which individual’s return items are more likely to be scrutinized under audit. the standard irs form could stipulate that if it were subsequently discovered that one spouse underreported his or her income, that individual is wholly responsible for any corresponding adjustment in tax. it does not seem unreasonable for one spouse to accept the risk of a subsequent audit or adjustment to liability as part of a divorce settlement; alternatively, the spouses could agree on the form to divide the risk by allocating the tax responsibility evenly. 2012] decoupling taxes and marriage 125 president obama, have released tax reform recommendations. they are united in calling for major changes to the code with a move towards simplification—closing loopholes by eliminating certain deductions in order to broaden the base and in turn reduce individual rates.178 in that spirit, there may be a window of opportunity for fundamental, systemic changes to the code. the proposal to move to mandatory separate returns for all filers, a striking departure from the longstanding u.s. tax system that would eliminate the distinction between married and single filers, would fit within such a call for simplification and could be enacted as part of a broader overhaul of the code. it is a new century; simply put, the united states does not look like it did in 1938 when joint and several liability was adopted. importantly, neither does the code. there are many good policy reasons for congress to revisit the code’s overly simplistic assumptions about households. after a brief examination of the current demographics, i will focus on the unfair conundrum faced by low-income families headed by married couples as one way in which the married filing jointly status is particularly antiquated and counter-productive in today’s america. a. a closer look at the changing demographics in 1993, marjorie kornhauser wrote about the demographic trends at that time, which were already reflecting “the decline of the traditional nuclear family and an increase in the number of divorces, single-parent families, nonmarried cohabitation, and two-earner families.”179 she noted that nonmarital households increased nearly four hundred percent from 1970 to march 1991, 180 leading her to re-examine the concept of “family.” at the same time, kornhauser examined the premise that married couples act as one economic unit by sharing or pooling all income.181 her conclusion, based upon her own empirical study and the work of several others, was that not all married couples pool their assets and the pooling of assets is not confined to married couples.182 she further concluded that even among those couples who profess to pool assets, “in reality the nonearner spouse often does not have equal access to assets; instead the earner controls the money.”183 she concludes, as i do, that the joint return should be abolished.184 in the nearly twenty years since kornhauser’s article, the divorce rate has held steady but the percentage of unmarried cohabitating couples has risen. a recent pew research center analysis of census data revealed that only 51% of adults in the united 178 the nat’l comm’n on fiscal responsibility and reform, the moment of truth, available at http://www.fiscalcommission.gov/sites/fiscalcommission.gov/files/documents/themomentoftruth12_1_201 0.pdf; see also bipartisan policy ctr., restoring america’s future: reviving the economy, cutting spending and debt, and creating a simple, pro-growth tax system, available at http://bipartisanpolicy.org/sites/default/files/bpc%20final%20report%20for%20printer%2002% 2028%2011.pdf. 179 kornhauser, supra note 24, at 66-68 (discussing the “difficulty in defining ‘family’” given the demographic changes in the thirty year period preceding her article). 180 id. at 66 (citing u.s. bureau of the census, statistical abstract of the united states, table 56 (112th ed. 1992)). 181 id. at 80–91 (discussing “empirical studies of asset pooling and control sharing”). 182 id. at 105. 183 id. 184 id. at 65 (“taxation based on the individual comports better with reality, social policies promoting families, tax theory, and economic considerations than the joint return.”). 126 columbia journal of tax law [vol.4:94 states were married in 2010.185 this number represents a record low and a 5% decline in new marriages from the prior year.186 in contrast, 72% of all adults were married in the year 1960. while the rate of marriage has dropped, the census data shows that other types of households, including cohabiting couples, single-person households, and singleparent households, have grown in recent decades. the percentage of divorced or separated adults was 14% in 2010; this number has remained somewhat steady in the past twenty years, though the number represents a stark contrast to the 5% who were divorced in 1960.187 meanwhile, public opinion about marriage mirrors the decline: 39% of americans surveyed in 2010 answered affirmatively when asked the question, “is marriage becoming obsolete?”188 a greater percentage of young adults (44% of those ages 18 to 29) than older adults (32% of those over 65) agreed that marriage is becoming obsolete.189 a greater percentage of adults with a high school education or less (45%) agreed that marriage is becoming obsolete as compared to those adults with a college degree (27% of whom agreed with the statement).190 the pew statistics also reveal a greater divergence over time in marital rates among those with a high school education or less as compared to those with college degrees.191 in 1960, 72% of adults with a high school education or less were married; in 2010, only 47% of this same demographic was married.192 while the rate of marriage has also declined among those with a college degree, the decline is less dramatic: from 76% in 1960 to 64% in 2010.193 why are these changing demographics of relevance? one reason, which i examine in sub-part v.b, is that married low-income taxpayers are disproportionately impacted by their filing status options. a low-income married couple receives little or no benefit from filing jointly as compared to a similarly situated unmarried couple. at the same time, they must accept joint and several liability when they choose this status. if, however, the married couple files separately, there is a punitive outcome: they lose their eligibility to claim the earned income credit. while this conclusion focuses on the example of low-income taxpayers, there are numerous other ways in which changing demographics are rendering the policy assumptions of the code incoherent, and other scholars have argued that the joint return should be abolished for different policy reasons. for example, lily kahng cites changing demographics and the relative increase in the number of single people in her argument that abolishing the joint return is a matter of fairness.194 anthony infanti has also 185 d’vera cohn et al., pew research ctr., new marriages down 5% from 2009 to 2010: barely half of u.s. adults are married—a record low 1 (2011), available at http://www.pewsocialtrends.org/files/2011/12/marriage-decline.pdf. 186 id. 187 id. 188 id. at 10. interestingly, 47% of the unmarried adults who said that marriage is becoming obsolete also said that they would like to get married someday. id. at 11. 189 id. at 10. 190 id. 191 id. at 8. 192 id. 193 id. 194 see kahng, supra note 24. 2012] decoupling taxes and marriage 127 proposed mandatory individual filing, citing changing demographics in his argument for a more inclusive notion of what constitutes a family.195 b. low-income households are disproportionately affected by the filing status options for married persons: why the code should tax the type of household, not the relationship part iii examined the historical rationales for joint and several liability. as the bozick case illustrates, a one-earner married couple with a high income enjoys a tremendous benefit from the income splitting a revisiting the treasury department’s recommendation to expand llowed by the married filing jointly rate structure. but for low-income married couples, the benefits of income splitting are not as measurable. instead it is the eligibility for the earned income credit that is at stake by filing jointly.196 even if one agrees197 that joint and several liability is an acceptable “price” to pay for the benefit of income splitting, one cannot ignore the fact that many low-income taxpayers do not enjoy this benefit. yet they too are held jointly liable, and as noted previously, low-income taxpayers are the most likely to request innocent spouse relief.198 as an illustration of this problem, consider the following four scenarios, each involving the same facts: a married couple has two minor children; they live together all year, which means they must file either a joint return or married filing separately. the code does not permit them to file as single. assume that in tax year 2010,199 the husband earned $25,000. the wife, who worked only part-time, earned $8,000. both taxpayers are wage earners. the following alternative scenarios illustrate how widely the couple’s tax situation varies depending on filing status. scenario 1: if the couple filed “married filing jointly,” the taxpayers would be due a refund of $3,897.200 scenario 2: if the couple filed “married filing separately,” with the husband claiming the two children as dependents, the result is much different: the husband would be entitled to a refund of $1,162,201 while the wife would be due no refund.202 195 anthony infanti, decentralizing family: an inclusive proposal for individual tax filing in the united states, 3 utah l. rev. 605, 607–08 (2010). 196 one might wonder why a spouse would be at all concerned with joint and several liability if the couple is to receive a large earned income credit. after all, if the couple will receive a credit, there is no liability to attach. but this is not always the reality. consider a husband who works as an independent contractor, meaning he is not subject to withholding. assume that he and his wife have children, and that his wife either does not work or is a wage-earner who is subject to proper withholding. without the benefit of the earned income credit and the child tax credit (the latter not being contingent on filing jointly), the couple would have a significant tax liability due to the husband’s absence of withholding, failure to make estimated tax payments, and self-employment tax liability. even with the benefits of such credits, the couple may face a tax liability, but it would be far smaller. thus, the couple is dependent on the earned income credit to reduce what would otherwise be a liability that they likely could not afford. 197 and i do not. 198 tas report 2005, supra note 25. 199 all figures here ignore the making work pay credit, enacted as part of the american recovery and reinvestment act of 2009, which provided a refundable credit of up to $400 per working taxpayer in tax years 2009 and 2010. 200 the calculations assumed that neither taxpayer had any federal tax withholdings. the taxpayers’ preliminary joint tax liability of $703 was eliminated by the child tax credit, meaning no tax was owed. the resulting $3,897 refund is attributable to $1,297 for the additional child tax credit and $2,600 for the earned income credit. 201 his preliminary liability of $838 is offset by the child tax credit. his refund is attributable the additional child tax credit of $1,162. though he would be income eligible if he were unmarried, he will not 128 columbia journal of tax law [vol.4:94 as a household unit, the couple has a far less favorable tax outcome with “married filing separately” status. their aggregate refund is $1,162, which is $2,735 less than they received as joint filers. there are two reasons for this. the primary reason is that taxpayers filing married filing separately are ineligible for the earned income credit, regardless of income level. as joint filers, they received a $2,600 earned income credit on their return. separately, they receive nothing. a second reason, though far less significant as a dollar amount, is that they lost the benefit of income splitting. even though both taxpayers are in the ten-percent bracket for “married filing separately,” the wife “wastes” part of her personal exemption because she only earned $8,000.203 when both spouses aggregated their incomes on a joint return, the husband benefited from the portion of her personal exemption that she didn’t need. but this example illustrates how insignificant the benefit of income splitting is to a lowincome couple: in this case, the tax savings attributable to income splitting was only $135—far less than the amount of the benefit that the earned income credit provided. put differently, in scenario 2, the couple suffered the loss of two benefits of joint filing—income splitting and the earned income credit—with the loss of the latter costing the couple nearly twenty times more in tax savings than the loss of the former. as discussed below, the earned income credit did not exist when congress considered the “benefits” of joint filing status and adopted joint and several liability in 1938; the lawmakers were thinking only of the ability for couples to offset one spouse’s losses against the other’s income. income splitting became a second, justifiable rationale in 1948 when the new rate schedule for married taxpayers was adopted, creating a marriage bonus. but any marriage bonus today because of income splitting is modest for lowincome taxpayers, and is dwarfed in significance by the earned income credit. scenario 3: suppose there is a couple that is similarly situated to the couple in scenarios 1 and 2, but has decided not to marry. they live together as committed domestic partners and raise their two minor children together. their incomes are exactly the same as the other couple. first assume that each individual files as “single,” as they are entitled to do, and that the male partner (the higher earner) claimed both children:204 the male partner would have received a refund of $4,392205 and the female partner would have received a refund of $416.206 as a household, the aggregate refund is $4,808, which is $911 more than the refund that the married couple filing jointly received in scenario 1. why? as a single filer, each taxpayer is eligible for earned income credit based upon their income and without regard to the other taxpayer’s income. thus, their total earned income credit as two single people is $3,646; as a married couple, it was $2,600. the male partner owes slightly more in preliminary tax liability, because he lost the $135 receive any earned income credit because i.r.c. § 32(d) (2012) disallows it for “married filing separately” returns. 202 she has no preliminary liability due to her standard deduction and personal exemption, and she will not receive any refundable credits. 203 her adjusted gross income was $8,000. her standard deduction of $5,700 plus her personal exemption of $3,650 equals a total of $9,350. however, one cannot have a negative taxable income. thus, she could have earned an additional $1,350 before being subject to any tax liability. 204 it would be rational for the partners to allocate the children to the higher earner, because the lower earner benefits considerably less from the corresponding dependency exemptions and child tax credit. 205 the male partner’s preliminary liability of $838 would be eliminated by the child tax credit; his refund of $4,392 consists of a $3,230 earned income credit and a $1,162 additional child tax credit. 206 the female partner’s preliminary liability was $0; her refund is attributable to a $416 earned income credit. 2012] decoupling taxes and marriage 129 benefit of income splitting; however, the $1,046 increase in their household earned income credit well outweighs the household’s $135 tax increase. why do two unmarried taxpayers sharing a household receive a significantly higher earned income credit than a married couple, in a scenario where the household income is exactly the same?207 because the earned income credit is determined by income level and filing status, not by household composition. thus, in scenario 3, we see a disincentive for low-income taxpayers with children to marry. in reality, scenario 4 illustrates how the unmarried couple will likely attain an even larger household tax refund than that shown in scenario 3. scenario 4: if the higher earner of the couple in scenario 3, in this case the male partner, qualifies for “head of household”208 filing status, the father’s refund will be $4,662,209 while the female partner’s refund remains $416. in the aggregate, the couple receives a refund of $5,078, which is $1,181 more than a similarly situated married couple would receive. the wildly disparate results shown in scenarios 1 to 4 show that, under these facts, the hypothetical couple is better off from an income tax perspective if they are unmarried rather than married. if unmarried, they will avoid the pitfalls of joint and several liability. but if married, they cannot do so without being further penalized if they elect separate filing status. it does not make sense to incentivize a married couple to file jointly (thus introducing a potential risk to the “innocent spouse”) while allowing a similarly situated unmarried couple to avoid joint liability yet receive higher refunds. this is one of many reasons for which i conclude that congress must move beyond joint and several liability and joint filing. both the country and the tax code have changed considerably since 1938, and it is time to revisit the suitability of this structure. 207 note that this is not this is not always the case: as the earned income credit phases out according to adjusted gross income, it phases out at a lower adjusted gross income level for unmarried filers than for married filing jointly. for example, in 2010, a head of household filer with two children and an adjusted gross income of $42,000 will receive no earned income credit, while a married filing jointly couple with two children and a combined adjusted gross income of $42,000 will receive a $705 earned income credit. the married filing jointly couple will receive no earned income credit once their adjusted gross income reaches $45,373. 208 see i.r.c. § 2(b) (2012). the father will be eligible because he is unmarried, maintains a household with a qualifying child, and furnishes more than half the cost of maintaining the household. the head of household status was enacted in 1951 as a way to extend tax relief to single persons with dependents: “the income of a head of household who must maintain a home for a child, for example, is likely to be shared with the child to the extent necessary to maintain the home, and raise and educate the child. this, it is believed, justifies the extension of some of the benefits of income splitting. the hardship appears particularly severe in the case of the individual with children to raise who, upon the death of his spouse, finds himself in the position not only of being denied the spouse’s aid in raising the children, but under present law also may find his tax load heavier.” h.r. rep. no. 82-586, at 11 (1951). extrapolating from this congressional intent, it is somewhat illogical then that a two-income unmarried couple raising children together should benefit from a provision intended for single parents. but there is no provision limiting the status to those who maintain a household without support from another adult. this is a further and arguably more egregious example of the “unmarriage bonus” and a result that flies in the face of the policy intended by congress. 209 the father’s rate remains the same regardless of filing status, but the standard deduction for “head of household” in 2010 was $8,400, while the standard deduction for “single” was only $5,700. thus, his taxable income is $2,700 less in scenario 4 than in scenario 3. in turn, this lower taxable income reduces his preliminary tax liability by $270, which creates a corresponding $270 increase in his refundable additional child tax credit. the father’s preliminary tax of $568 is eliminated by the child tax credit, and his $4,662 refund consists of a $3,230 earned income credit and a $1,432 additional child tax credit. 130 columbia journal of tax law [vol.4:94 1. isolating the impact of the earned income credit in the lowincome context scenarios 1 to 4 highlight some disturbing inconsistencies with the intended tax policy, all stemming from the complexity and the value of the refundable earned income credit in its current incarnation. first, why should taxpayers be ineligible for the earned income credit merely because they file separately, if they would meet the income limits for eligibility as a couple? if the couple wishes to preserve separate liability, so as to avoid the types of legal difficulties that arise under joint and several liability, then they must forsake their earned income credit eligibility.210 second, why should an unmarried couple living together receive a higher total earned income credit than a similarly situated married couple? a couple sharing household expenses will face the same household costs irrespective of marital status, but the unmarried couple benefits more in this case. this scenario demonstrates a financial disincentive for the couple to marry. one reason for these inconsistencies in tax policy is that the earned income credit was introduced decades after joint and several liability, and the original purpose and scope of the earned income credit were quite different than what the program accomplishes today. the earned income credit was first introduced in the tax reduction act of 1975, which was a temporary stimulus measure enacted to address the weak economy and high unemployment at the time.211 the earned income credit itself was to be temporary: as originally enacted, it was effective only for tax year 1975.212 the legislative history describes the credit as appearing to have the same two objectives as the work bonus plan that had been proposed several times and not passed: (1) “as a way of decreasing work disincentives” for persons on welfare; and (2) as a way of addressing the regressive nature of social security taxes.213 the maximum earned income credit available in 1975 was $400, and it was available only to low-income taxpayers (both unmarried and married) with a dependent child in their household.214 the credit began to phase out if the taxpayer’s adjusted gross income exceeded $4,000, and a taxpayer with an adjusted gross income of $8,000 or more would receive no credit at all. as is still the case today, 210 in the case of a married couple, both spouses’ incomes must be considered when determining earned income credit eligibility. if, however, the spouses’ aggregate income is within the income limits, it does not seem fair to deny both spouses the earned income credit for filing separately. however, a problem may arise later if one spouse is determined to have understated his or her income. if in fact the husband earned not $25,000 but $50,000, then neither spouse should be eligible under current law. if married taxpayers filing separately were allowed the earned income credit, but were later ineligible due to underreporting by one spouse, it would affect both spouses’ earned income credit eligibility. should the underreporting spouse bear the sole responsibility, including the liability arising from the other spouse’s incorrect receipt of the earned income credit? 211 see generally h.r. rep. no. 94-19 (1975). 212 tax reduction act of 1975, pub. l. no. 94-12, § 209(b), 89 stat. 26, 35. 213 joint comm. on internal revenue tax’n, 94th cong., analysis of the house version of the tax reduction act of 1975 (h.r. 2166) and possible alternatives 33 (comm. print 1975). see also s. rep. no. 94-36, at 11 (1975) (elaborating on the earned income credit as follows: “this new refundable credit will provide relief to families who currently pay little or no income tax. these people have been hurt the most by rising food and energy costs. also, in almost all cases, they are subject to the social security payroll tax on their earnings. because it will increase their after-tax earnings, the new credit, in effect, provides an added bonus or incentive for low-income people to work, and therefore, should be of importance in inducing individuals with families receiving federal assistance to support themselves. moreover, the refundable credit is expected to be effective in stimulating the economy because the low-income people are expected to spend a large fraction of their increased disposable incomes.”). 214 tax reduction act of 1975 § 204. as originally enacted, it appeared in § 43 of the code. the earned income credit is currently found in i.r.c. § 32 (2012). 2012] decoupling taxes and marriage 131 the credit as originally introduced was available to a married couple only if a joint return was filed; a couple filing separately could not receive the credit.215 the earned income credit, of course, was extended beyond the 1975 tax year and has been expanded repeatedly over the years. today it holds an incredibly significant benefit for low-income taxpayers. unlike in 1975, it is currently available even to certain low-income taxpayers who do not have children. the credit is calculated based on income and phases out at different maximum income levels that vary depending on whether a taxpayer is unmarried or married filing jointly; the phase-out levels increase according to whether the taxpayer has no children, one child, two children, or three or more children.216 the amount of the maximum credit increases in the same manner. for example: in 2010, a taxpayer with no qualifying children is eligible to receive a maximum credit of $457, and the credit phases out to zero if the taxpayer’s adjusted gross income is $13,460 or more (or $18,470 if married filing jointly). a taxpayer with one qualifying child can receive up to $3,050, but will receive nothing if the taxpayer’s adjusted gross income is $35,535 or more (or $40,545 if married filing jointly). a taxpayer with two qualifying children can receive up to $5,036, but the credit phases out to zero at an adjusted gross income of $40,363 (or $45,373 if married filing jointly). finally, a taxpayer with three or more qualifying children might receive up to $5,666, with the credit phasing out to zero at an adjusted gross income of $43,352 (or $48,362 if married filing jointly). there is evidence that the earned income credit not only lifts families out of poverty but benefits children in more meaningful ways.217 for example, a recent study by gordon dahl and lance lochner estimated the impact of the increase in family income due to expansions in the earned income credit program.218 dahl and lochner concluded that their data indicated “modest but encouraging effects of family income on children’s scholastic achievement.”219 if one accepts this conclusion as an influencing 215 i.r.c. § 32(d) (2012). the legislative history does not provide a clear rationale for denying a credit to married couples filing separately. one possibility is that congress wanted to keep the credit simple to administer. h.r. rep. no. 94-19, at 30–31 (1975) provides: “the credit is to be calculated on a return-byreturn basis. individuals who are married and filing a joint return are eligible for only one credit on the combined income of both individuals. married individuals filing separate returns are not eligible for the credit.” the senate report 94-36 contains nearly identical language with no further elaboration. s. rep. no. 94-36, at 35 (1975). 216 the provision that increased the earned income credit for a taxpayer with three or more children was enacted as part of the american recovery and reinvestment act of 2009, pub. l. no. 111-5, 123 stat. 115. it was intended as a temporary measure only for tax years 2009 and 2010; however, it was extended through 2012 by the tax relief, unemployment insurance reauthorization and job creation act of 2010, pub. l. no. 111-312, 124 stat. 3296. 217 jimmy charite, indivar dutta-gupta & chuck marr, ctr. on budget & policy priorities, studies show earned income credit encourages work and success in school and reduces poverty (2012) available at http://www.cbpp.org/files/6-26-12tax.pdf. 218 gordon b. dahl & lance lochner, nat’l bureau of econ. research, the impact of family income on child achievement: evidence from the earned income credit (2011) available at http://dss.ucsd.edu/~gdahl/papers/children-and-eitc.pdf. the authors conclude from their baseline estimates that a $1,000 increase in income raises a child’s contemporaneous math and reading test scores by 6% of a standard deviation. they conclude that their estimates “suggest that the effects are larger for children growing up in more disadvantaged families, younger children, and boys.” id. at 1951. see also charite, dutta-gupta & marr, supra note 217, at 2, 8–10 (citing a number of different studies in support of the report’s statement that “[a] small but growing body of research indicates that lifting the incomes of lowincome families helps children in those families do better in school” and is “associated with a significant increase in the child’s earnings in adulthood.”). 219 dahl & lochner, supra note 218, at 1949. 132 columbia journal of tax law [vol.4:94 consideration of tax policy, then it is even more nonsensical to link eligibility for the earned income credit to joint and several liability. 2. isolating the impact of the marriage bonus in the low-income context ignoring the impact of the earned income credit, the marriage bonus is far less pronounced for low-income taxpayers, especially those who can claim exemptions for one or more dependent children, because their rates are relatively low compared to those of high-income taxpayers. yet there are scenarios in which the marriage bonus exists for low-income couples, so it should also be examined as a “privilege” of filing jointly in this context. if congress moved to individual filing, low-income taxpayers would stand to lose whatever marriage bonus attributable to income splitting they now enjoy. the most noticeable marriage bonus would result in a one-earner household with no children.220 staying within the context of low-income earners, imagine that one spouse earned $40,000 and the second spouse earned no income: the marriage bonus would be $1,822, all of which is attributable to income splitting and the extra personal exemption (a childless couple will receive no earned income credit at this income level). this amount is a significant sum for a couple with a household income of only $40,000. however, it is questionable as a matter of tax policy whether the code should incentivize a one-earner household when there are no children. this scenario lacks the obvious compelling factor, namely child rearing, to justify the second earner’s lack of participation in the labor market. meanwhile, the non-earner is left financially vulnerable in the event of divorce or the earner’s death. if congress moved to mandatory separate filing, this couple would lose the $1,822 benefit of income splitting, but the non-earner would not bear the risk of an unforeseen individual tax liability. additionally, the code would no longer provide a disincentive (real or perceived) for the non-earner to enter the labor force by virtue of marital status.221 the marriage bonus is less pronounced if the same couple has two children, such that one spouse earns $40,000 and the second spouse earns no income because he or she has elected to stay at home with their small children. in that case, the amount of the marriage bonus attributable to income splitting and the second spouse’s personal exemption is $1,101 as compared to an unmarried person filing as head of household.222 again, while a high-income one-earner couple would receive a far greater marriage bonus, $1,101 is not an insignificant sum for a low-income couple. ironically, if the second spouse in this example were to work part-time and earn as little as $6,000, the couple would completely phase out of earned income credit eligibility. thus, there are 220 the absence of children means that the couple will not reduce its liability through dependency exemptions, thus the marriage bonus is more pronounced. 221 one could argue that the very existence of an income tax is a disincentive to work. i do not accept this argument, but i do accept the argument that income splitting currently provides a rational incentive for one spouse to work less or not at all, because the additional income negates the marriage bonus as it increases. separate filing would place all individuals in similar situations with respect to income and tax liability, because the existence of the additional income would not impact the liability of a spouse. 222 i have purposely ignored the earned income credit in this calculation so as to make a comparison only of the benefits of income splitting in this case. if the marriage bonus is calculated as including the earned income credit, then the bonus is $2,156, because the married couple filing jointly would receive an earned income credit of $1,126 while the unmarried filer would receive a credit of only $71. this is due to the fact that the income phase out for the credit is higher for married taxpayers. however, if both couples earned $50,000, or if both couples earned $40,000 but had no children, then neither couple would be eligible for the earned income credit. 2012] decoupling taxes and marriage 133 two separate tax disincentives for the second spouse to stay out of the work force in this hypothetical. in any event, the calculus regarding a marriage bonus as a disincentive to work is far more complex when small children are present, because the couple will incur day care costs if the second spouse enters the work force; the second earner will have to earn a certain minimum amount to offset those costs, while simultaneously reducing the marriage bonus (and the earned income credit) with his or her earnings. thus, it is often not rational for low-income families with children to follow the two-earner model. however, there are other ways to address the costs of raising children, whether those costs are borne as day care expenses or the opportunity cost of the second earner staying home. c. a brief consideration of how to restructure the earned income credit in an individual filing system if congress mandated individual filing, it would have to decide how to structure the credits currently available to households headed by married couples. one specific question is whether congress would aggregate the spouse’s separate income for purposes of determining the earned income credit. as noted above, it does not now do so for cohabiting couples. should married couples be treated differently? if one does not accept the premise of marriage as an economic unit, then arguably the code should not aggregate the spouses’ incomes. zelenak examined the pros and cons of this question in his 1994 article, noting that: if a wife of a high income husband earns a few thousand dollars . . . [t]he premises of separate returns—marriage neutrality and the independent economic identities of spouses—indicate that she should be eligible for the credit. but the credit is intended to help the poor, and she is not poor.223 it is true that she is not poor, but congress should not ignore the fact that many marriages end in divorce,224 and she may be better positioned to support herself after a divorce if she maintains a presence in the work force throughout her marriage. furthermore, if her high-earning spouse claimed the children as dependents on his return, as he is likely to do, then her separate entitlement to an earned income credit would be nominal.225 zelenak suggested that, were congress to adopt mandatory individual filing, a better alternative to retaining the current earned income credit system would be to 223 zelenak, supra note 24, at 398–99. he concludes his article by noting that “[t]here is no absolutely right or wrong way to tax married couples . . . . whatever the merits of joint returns may have been for mid-twentieth century america, the joint-return system fits poorly with american attitudes and living patterns at the close of the century.”). id. at 404–05. 224 pew research ctr., the decline of marriage and rise of new families 38 (2010). the report notes that the divorce rate rose sharply after 1960, peaked in 1979, and has declined since that time. the report further suggests that the decline in the divorce rate reflects the simultaneous decline in marriage. id. 225 each child would allow the husband a dependency exemption of $3,700 in 2011. depending on the husband’s income, he may also be eligible for a child tax credit of up to $1,000 in 2011. the wife earning a few thousand dollars, on the other hand, would have no tax liability and would not earn enough to receive any portion of the child tax credit. without qualifying children to claim, her earned income credit could not exceed $464 and might be less; it would roughly offset her fica taxes, which was the original legislative intent of the earned income credit. 134 columbia journal of tax law [vol.4:94 redesign the credit.226 as zelenak notes, george yin and jonathan barry forman proposed a family-based credit that could work well in a separate return system.227 yin and forman contemplated a two-pronged program: an exemption from social security taxes for the working poor, and a refundable credit for low-income taxpayers based on the number of children in the home.228 if congress desires a substantial subsidy for low-income households with children as a matter of tax policy, as the current code supports through refundable credits, it seems reasonable to believe that such a credit could be completely disaggregated from filing status. a married couple should not benefit less from such a subsidy than a cohabiting couple, and a wife should not bear the risk of being held responsible for her husband’s tax shortcomings in a program designed to benefit her children. vi. conclusion when the senate finance committee held its restructuring hearings in 1998, senator william roth opened the discussion on innocent spouse tax rules by highlighting the plight of the low-income ex-wife who was struggling to make it as a single parent: financially insecure, many times struggling as a single parent to raise children, working for an income that is a fraction of what her ex-spouse earns, now she has to confront the often unrelenting internal revenue service. in an effort to acquire revenues owed, the agency will pursue these women with a vengeance. it will garnish wages, place liens against homes, and often jeopardize future relationships because a new person in her life might well be held accountable for her former spouse’s tax problems.229 despite the extensive legislative reform that followed these hearings in 1998 and years of further statutory, judicial, and administrative liberalization of the innocent spouse rules, joint liability continues to adversely impact low-income women. rather than continuing to expand the grounds and factors for relief, subjecting these women to an invasive relief process that takes many months if not years to resolve, congress should revisit its antiquated assumptions about joint filing and move to mandatory individual filing. while this will create ripple effects throughout the code,230 it is also an opportunity to move towards simplification and to update the code in light of the changing demographic realities of the united states. bearing in mind the continued decline of marriage rates (which is most pronounced among the least educated)231 and the potential impact of family income on a 226 zelenak, supra note 24, at 400–01. 227 see george k. yin & jonathan barry forman, redesigning the earned income tax credit program to provide more effective assistance for the working poor, 59 tax notes 951 (1993). 228 id. at 957–60. 229 irs restructuring: hearings on h.r. 2676 before the s. comm. on fin., 105th cong. 142 (1998). 230 many code sections provide special benefits for married couples filing jointly and would need to be amended accordingly. see, e.g., i.r.c. § 121(b)(2) (2012) (providing special rules for joint filers who wish to claim the exclusion on gain from the sale of a principal residence). 231 pew research ctr., supra note 224, at 11 (reporting a gap of sixteen percentage points in 2008 in marriage rates between college graduates (64%) and those with a high school diploma or less (48%)). 2012] decoupling taxes and marriage 135 child,232 it is harmful tax policy to condition a married couple’s eligibility for the earned income credit on the acceptance of joint and several liability while asking a divorcée to turn to an inefficient relief process if the marriage ends. the better answer is to stop penalizing the innocent spouse, embrace demographic reality, and simplify the filing status structure by mandating individual filing. 232 see supra notes 217–19. the impact of gilti and fdii on the investment location choice of u.s. multinationals kartikeya singh & aparna mathur abstract this article analyzes the impact of two new international tax provisions, gilti and fdii, passed under the tax cuts and jobs act, on u.s. multinational corporations’ location of new capital. we analyze whether these rules help retain internationally mobile rents within the u.s. tax base and the associated economic activity within the united states. our analysis suggests that for a wide range of investment profiles (characterized in terms of scale and expected abovenormal returns) for intangible capital, a u.s. mnc can do better by locating a new investment in the united states.  principal, pricewaterhousecoopers. email. kartikeya.singh@us.pwc.com.  resident scholar, economic policy studies, american enterprise institute. email: amathur@aei.org. the authors thank marco fiaccadori, joe murphy and alan viard for helpful comments and discussion on the paper, and cody kallen for research support. the views expressed in this article are solely the authors’ and do not reflect the views of any other person or institution. mailto:kartikeya.singh@us.pwc.com mailto:amathur@aei.org 200 [vol. 10:2 columbia journal of tax law table of content i. introduction 201 ii. taxation of income from capital 202 iii. taxing mobile income via gilti and fdii 206 a. gilti 206 b. fdii 207 c. policy intent of gilti and fdii 208 d. impact of beps 209 iv. firm’s location choice for new investments with gilti and fdii 211 a. the imputed return in the gilti and fdii rules 212 b. intangible capital 214 c. tangible capital 219 v. conclusion 223 2019] 201 the impact of gilti and fdii on the investment location choice of u.s. multinationals i. introduction in this article, we focus on two new provisions addressing the taxation of income from mobile capital, which were passed as part of public law 115-97 (popularly known as the tax cuts and jobs act or tcja) in december 2017. the provision on “global intangible low taxed income” (gilti), which is set forth in new section 951a, is intended to make mobile capital, and the taxable income attributable to such capital, less sensitive to tax rate differentials between the united states and other jurisdictions vying for such capital. 1 to achieve that goal, the provision taxes u.s. taxpayers’ “mobile income” reported outside the united states when the foreign tax rate on the income falls below a minimum threshold. while the gilti provision is intended as the proverbial stick, the provision known by its (less catchy) acronym “fdii” is the accompanying carrot. the provision on fdii —which stands for “foreign derived intangible income,” set forth in new section 250, is intended to motivate both u.s. and foreign multinationals to locate within the united states the mobile income generated from the supply of goods, services, or intangible property that is ultimately used or consumed outside the united states.2 the reactions of foreign governments and commentators to the international tax provisions of the tcja suggest that these provisions (together with the lower corporate tax rate) make the united states more competitive for investment.3 some european union governments have signaled concern that the u.s. provisions may undermine the international system shaped by the oecd’s base erosion and profit shifting (beps) project. 4 , 5 similarly, european commentary points out the u.s.’s improved attractiveness as an investment location relative to european countries, particularly high-tax-rate countries like germany. 6 in contrast, the commentary on such provisions in the united states has been mixed. in particular, some have criticized the gilti provision as not being punitive enough to achieve the desired deterrence and the fdii provision as not providing a strong enough incentive for companies to retain mobile investments in the united states.7 critics have also claimed that the provisions create incentives to locate new investments in tangible assets overseas.8 in particular, and at least on the surface, the design of the two provisions appears to leave open a tax arbitrage opportunity for companies 1 committee print, reconciliation recommendations pursuant to h. con. res. 71, s. prt. 115-20, (december 2017), p. 370. 2 id. at 375. 3 mindy herzfeld, competition or coordination: responses to the tax cuts and jobs act, tax notes, (jan. 16, 2018). 4 id. 5 stephanie soong johnston, eu commission mulls ‘all options’ in wake of final u.s. tax bill, tax notes, (jan. 1, 2018). 6 friedrich heinemann et al., analysis of us corporate tax reform proposals and their effects for europe and germany, 18 (zew ctr. for eur. econ. res., dec. 2017). 7 david kamin et al., the games they will play: an update on the conference committee tax bill, 103 minn l. rev. (2018), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3089423 [https://perma.cc/38wsgldl]. 8 id. 202 [vol. 10:2 columbia journal of tax law to pursue. given this, it also appears to have left open an incentive for competing governments to offer even lower corporate income tax rates to attract investment. in this article, we analyze the effect of the two provisions on the incentives for the location of new investment by u.s. multinational corporations (mncs). in order to do so, we discuss the policy goal of the provisions and how the design of the provisions intends to achieve their policy goals in an environment that has been shaped by the oecd’s beps project.9 our analysis suggests that u.s. mncs may have strong incentives to locate new investments in intangible capital in the united states. further, the provisions do not necessarily significantly sway the location choice for new investments in tangible capital away from the united states. the article is organized as follows. section ii lays out a basic framework to understand the taxation of capital income and its different components. section iii describes gilti and fdii and identifies the underlying policy intent by reference to the framework introduced in section ii. the implications of the post-beps international tax system are discussed in this section as well. in particular, we highlight how non-tax “transaction costs” associated with the location of mobile capital in tax-advantaged jurisdictions have increased post-beps and how this can influence the cost-benefit calculus underlying firms’ investment location decisions. section iv analyzes the gilti and fdii provisions’ effects on investment location decisions of u.s. mncs and examines the validity of the different concerns expressed about these provisions. section v concludes. ii. taxation of income from capital a business’s expected return on an investment can be viewed as comprising two elements. the first is the rate of return available on comparable investments in competitive capital markets. this “normal” rate of return is the opportunity cost of the investment. for an investment to be worth undertaking, its expected cash flows, discounted at the normal rate of return, must not be negative.10 the second potential element in a firm’s expected return is the return in excess of its opportunity cost. such “above normal” returns are usually taken to represent economic rents attributable to one or more unique attributes of the firm.11 the structure of a tax determines whether it taxes only economic rents (or “above normal” returns) or whether it also taxes the normal rate of return. because economic rents are by definition over and above the return necessary to justify the investment, a tax on them does not distort the decision to invest or the level of such investment. in a world without capital mobility, a uniform tax on economic rents across sectors and asset classes is efficient because it imposes no distortion on the overall level of investment and how such investment is allocated across sectors and asset types. however, when economic rents are mobile (i.e. are not “location 9 we express no opinion on the sustainability of these provisions against possible challenge by foreign governments or multilateral organizations under various international agreements. 10 when dealing with a risky investment, the opportunity cost should contain a return for risk bearing (risk premium) over and above the risk-free return necessary to induce delayed consumption. 11 again, in the case of risky investments, ex-post results above the (ex-ante) normal rate of return may simply be the realization of chance rather than rents. 2019] 203 the impact of gilti and fdii on the investment location choice of u.s. multinationals specific”), the location of capital is sensitive to taxes, even if the level of such capital is not.12 such mobile rents typically stem from firm-specific attributes, such as unique intangibles that can give the firm a degree of monopoly power. in our framework we consider a one-dollar investment that starts to generate income one period later.13 the total pre-tax amount (i.e., gross-of-depreciation return) grt expected to be generated by the investment in any future period t is given by equation 1 below, where rt denotes the normal return, ert denotes the economic rent. and dt represents economic depreciation. equation 1 𝐺𝑅𝑡 = 𝑅𝑡 + 𝐸𝑅𝑡 + 𝐷𝑡 assume that the expected rates of return associated with the investment in question are constant over time with the normal rate denoted by r and the rate of economic rents denoted by er. using kt to denote the net capital stock from the original investment carried into the current period, the dollar amount of the normal return in any given period t is r times kt. in turn, kt equals one in the period immediately following the period in which the investment is made. for all subsequent periods, kt is given by equation 2.14 equation 2 𝐾𝑡 = 1 −∑𝐷𝑖 𝑡−1 𝑖=1 similarly, the dollar amount of the economic rents in period t is given by er times kt. given the above, the total pre-tax gross return from the investment in any period t is given by equation 3. equation 3 𝐺𝑅𝑡 = 𝑟𝐾𝑡 + 𝑒𝑟𝐾𝑡 + 𝐷𝑡 we now consider a tax code that allows for immediate expensing of the investment at a tax rate of τ and then levies a tax at the same rate on the subsequent gross returns (gross-ofdepreciation return).15 a well-known property of a tax code that permits immediate expensing of 12 see, e.g., alan j. auerbach et al., taxing corporate income, in dimensions of tax design: the mirrlees review, (james mirrlees et al. eds., 2010). 13 see generally org. for econ. co-operation and dev. (“oecd”), oecd tax policy studies no. 16: fundamental reform of corporate income tax, oecd (2007). for now, we do not distinguish between tangible and intangible capital. for simplicity, we assume that the investment is entirely equity financed. 14 the capital stock will converge to zero under alternative assumptions with regard to depreciation that are standard in such analyses including linear depreciation (i.e., straight line schedule) as well as a constant rate of decay (i.e., geometric schedule). 15 the present discounted value of the after-tax stream of gross returns (gross-of-depreciation return) (i.e., before subtracting out the upfront cost of the investment) is given by the expression: τ+t=1(rkt+erkt+dt)1-τ(1+r)t. 204 [vol. 10:2 columbia journal of tax law capital investments is that such a tax system exempts the normal return from tax.16 the tax benefit that the firm realizes from expensing fully offsets — in present value terms — the subsequent tax the firm pays on the investment’s normal rate of return and the portion of the gross income that covers the depreciation of the investment. the expected stream of the normal returns generated from an investment along with the portion of returns that pay for its depreciation when discounted at the investment’s opportunity cost — i.e., normal rate of return — must, by definition, equal the original investment.17 thus, a tax benefit on that original investment must equate (in expected terms) to the tax payments on the normal rate plus economic depreciation so long as the tax rate remains unchanged over time. note that the above does not imply that the government stands to collect zero tax revenues under expensing when there are no rents to tax. even when economic rents are entirely absent, the total undiscounted tax revenues received by the government would exceed the initial tax benefit of expensing; the government would earn the normal rate of return on the initial tax benefit it offered. under expensing, the government effectively becomes a silent partner in the investment —it defrays a share of the firm’s upfront cost and receives the same share of the subsequent returns.18 when the tax code does not allow for immediate expensing, and instead only permits a deduction equal to the economic depreciation of the investment (or a proxy for such depreciation based on a tax depreciation schedule), the normal rate of return from such investments bears a tax burden.19, 20, 21 there are sound policy reasons to exempt the normal return from tax, in order to avoid the efficiency cost of having a distorted level of investment that is below the optimal level. with the new rules allowing for 100 percent expensing for certain qualified tangible business assets (at least through 2022) under section 168(k), as amended by 13201 of the tcja, the normal return on new investments in those assets is exempt from tax. other things equal, this can stimulate the first term in the expression represents the tax gain in the first period from the immediate expensing of the investment, while the second term is the present discounted value of the stream of gross returns after tax. 16 see oecd., supra note 13. 17 a mathematical proof is available from the authors upon request. 18 with risky returns, the loss offset rules are important. with less than full loss offset, the government falls short of being a true silent partner because it does not participate symmetrically in the upside and downside realizations of the risk. although the change in loss offset rules are an important consideration in the context of p.l. 115-97, we ignore this change in the interest of tractability. 19 a mathematical exposition of this within the framework adopted in this section is available from the authors upon request. 20 if the tax depreciation schedule replicates true economic depreciation, the normal rate of return bears the full extent of the tax. a tax schedule that allows for slower depreciation than the true economic rate imposes a tax on the normal return at a rate greater than the statutory rate. 21 the tax burden on the normal return means that the investment would only be undertaken if the economic rents are sufficient to ensure that the one dollar investment generates at least its opportunity cost on an after-tax basis. if the economic rents generated by an investment decline for each additional dollar of investment, the scale of investment under full expensing will be greater than under a system that only allows for deductibility of the depreciation. under the framework adopted in this section, this would be the case when the constant rate of economic rents (er) assumed for the marginal dollar of investment is a declining function of the scale of inframarginal investment. 2019] 205 the impact of gilti and fdii on the investment location choice of u.s. multinationals investment. 22 with immediate expensing already applying to investments in self-developed intangibles, such as research and development, advertising and marketing, the normal return on such investments should also be exempt from u.s. tax.23 other things equal, the expensing rules would prevent u.s. tax from distorting the level of investments in different classes of business assets. on their own, however, the expensing rules do not address concerns related to the location of such investments. as long as the economic rents from such investments are subject to u.s. tax, differences in the rates of such tax between the u.s. and other jurisdictions can motivate firms to locate their investments overseas. while tax is only one consideration among many and some forms of capital are more mobile than others, the reality of tax competition suggests that taxes are important with regard to the investment location. 24 above-normal profits from intangibles represent the most mobile form of economic rents in an international tax context. furthermore, the cross-border mobility of such rents can take one of two forms. one form is where the “economic activity” underlying such income – to adopt the beps parlance of the oecd – is located in a tax-advantaged jurisdiction along with the concomitant taxable income.25 the other type of cross-border mobility – again, adopting the oecd parlance – is of the “artificial” kind where it is only the taxable income that moves to a low-tax jurisdiction without the corresponding location of the underlying economic activity (i.e., “substance”) in that jurisdiction.26 it is the mobility of the “artificial” kind that has been the focus of the beps project. as such, new measures and guidance specifically aimed at curtailing such separation of taxable income from the underlying economic activity that gives rise to such income in the context of intangible capital constitute a significant part of the project’s output.27 as discussed by the authors previously and further below, the result of this is that there are now higher non-tax transaction costs of locating mobile capital away from jurisdictions that, absent tax considerations, would be the natural home for such capital. 28 it is in this post-beps environment that the gilti and fdii provisions are intended to narrow, and possibly eliminate, tax-rate arbitrage on mobile rents. 22 note that this applies to equity-financed investments in qualified assets. with debt financing – and subject to the rules of i.r.c. § 163(j) – the effective tax on the normal return on such assets may be negative. 23 however, the earlier caveat regarding imperfect loss rules, supra note 18, may be of particular relevance here. 24 michael p. devereux & rachel griffith, evaluating tax policy for location decisions, 10 int’l tax and pub. fin., 107-26 (2003). 25 see oecd, action plan on base erosion and profit shifting 10 (oecd publ’g, 2013) (stating that “[n]o or low taxation is not per se a cause of concern, but it becomes so when it is associated with practices that artificially segregate taxable income from the activities that generate it.” 26 id. see also oecd, aligning transfer pricing outcomes with value creation, actions 8-10 – 2015 final reports (oecd publ’g, 2015). 27 oecd, supra note 25, at 20. in particular, among the objectives covered by action 8 was the development of rules to ensure “that profits associated with the transfer and use of intangibles are appropriately allocated in accordance with (rather than divorced from) value creation . . . .” 28 kartikeya singh & aparna mathur, economic substance requirements and multinational firm behavior, (am. enter. inst. econ., working paper no. 2017-02, 2017). 206 [vol. 10:2 columbia journal of tax law before we turn to those provisions, we make two additional observations. an important distinction between expensing and depreciation is reflected in what constitutes taxable income in any given period when such taxable income is attributable to a prior investment. with immediate expensing, the taxable income (y) resulting from one dollar of investment is -1 in the period during which the investment is made. for any period t after the original period of investment, the taxable income is given by equation 4 and includes the element of the gross return that pays for the economic depreciation of the investment. equation 4 𝑌𝑡 = 𝑟𝐾𝑡 + 𝑒𝑟𝐾𝑡 + 𝐷𝑡 in contrast, under depreciation, the taxable income in period t attributable to a one-dollar investment made in the past is given by equation 5. equation 5 𝑌𝑡 = 𝑟𝐾𝑡 + 𝑒𝑟𝐾𝑡 as described earlier, if the ongoing depreciation (or normal return) of an investment were not taxed under an expensing regime, or if such depreciation (or normal return) were taxed at a rate lower than the rate at which the original investment was expensed, the effective tax on the normal rate of return would be negative in present value terms. the opposite is true – i.e., the normal return bears a positive tax even with expensing – when the subsequent taxation of the normal return (or depreciation) takes place at a rate higher than the original expensing. so far, we have not differentiated between investments in intangible capital and investments in tangible capital. however, a common assumption is that economic rents are usually generated by intangible assets. further, the economic rents attributable to intangible capital are far more mobile (at least from an income tax reporting standpoint) than any rents on tangible capital. finally, we note that the rules of most oecd countries allow expensing for investments in research and development and marketing aimed at generating self-developed intangibles.29 in contrast (and prior to the enactment of the tcja), most oecd countries only allowed for a tax deduction for the depreciation of most forms of tangible capital.30 we now turn to the gilti and fdii provisions and describe their policy objectives in the context of the framework presented here. iii. taxing mobile income via gilti and fdii a. gilti section 951a of the code lays out the rules for gilti and requires that a u.s. corporation include in its taxable income currently the “global intangible low-taxed income” of 29 kyle pomerleau, capital cost recovery across the oecd, 402 tax foundation fiscal fact (2013). 30 id. 2019] 207 the impact of gilti and fdii on the investment location choice of u.s. multinationals all its controlled foreign corporations (cfcs).31 however, section 250 provides a deduction equal to 50 percent of this income.32 with a 21 percent tax rate, and absent any foreign taxes (as well as other limitations), a u.s. corporation will be subject to a 10.5 percent tax rate on the total gilti of its cfcs. gilti is calculated in the aggregate for a given u.s. corporation across all of its cfcs (in proportion to the us shareholder’s equity interest in each such cfc) and excludes income already subject to u.s. tax (such as eci and subpart f income) (as well as certain other exempt categories of income). roughly speaking, a cfc’s income subject to u.s. tax under the gilti provision is an estimate of its overall income from business operations less a “deemed tangible income return.”33 the deemed tangible return equals 10 percent of the cfc’s tax basis in depreciable tangible business assets; that tax basis, which is determined under the section 168(g) alternative depreciation schedule, is termed “qualified business asset investment” (qbai).34 finally, the u.s. shareholder is allowed foreign tax credits for the shareholder’s proportionate share of 80 percent of the cfc’s foreign income taxes that are allocable to the gilti portion of the cfc’s income.35 the gilti rule thereby ensures a minimum rate of tax on a u.s. shareholder’s cfc. in the absence of any foreign taxes, the cfc will be subject to a u.s. tax at the rate of 10.5 percent on its deemed intangible income with all its routine return attributable to tangible property (as proxied by 10 percent of its qbai) being shielded from any u.s. tax. with a positive foreign tax rate, the effective rate of u.s. tax relating to the gilti provision is generally lower than 10.5 percent due to foreign tax credits. b. fdii while the gilti provision seeks to deter tax planning that offshores investments aimed at generating income from foreign consumption or use of property, services or ip, the complementary fdii rules seek to provide an incentive for u.s. corporations to locate such investments and income in the united states. under section 250, a u.s. corporation is “allowed as a deduction” 37.5 percent of that portion of its taxable income that is categorized as foreign derived intangible income. 36 that results in an effective tax rate of 13.125 percent on fdii, as 62.5 percent of such income is subject to the 21 percent u.s. tax rate.37 the computation of a u.s. corporation’s fdii requires steps conceptually similar to the calculation of gilti. starting with the u.s. corporation’s gross income, its total “deduction eligible income” is derived by excluding any income that is already subject to u.s. tax (such as subpart f income and gilti) and certain other forms of income (e.g., dividends received from 31 i.r.c. §951a. 32 for years 2026 and later, this deduction is limited to 21.875 percent. i.r.c §250(a)(3). 33 i.r.c. §951a(b)(1). 34 i.r.c. §951a(b)(2), i.r.c. §168(g). 35 note that the gilti computation starts with an after-tax figure and thus make the tax rules of the cfc’s country, including its capital allowance rules, relevant to the gilti amount. the final amount subject to u.s. tax under the gilti provision is a pre-tax (i.e., taxable income equivalent) figure by way of the i.r.c. § 78 “gross ups”. 36 for years 2026 and later, this deduction is limited to 21.875 percent. i.r.c §250(a)(3). 37 absent potential limitations on foreign tax credits under i.r.c §904 that result from expense allocation rules of i.r.c §861. 208 [vol. 10:2 columbia journal of tax law cfcs, domestic oil and gas income, foreign branch income and financial services income) and then subtracting deductions (including taxes) properly allocable to such gross income.38 from the deduction-eligible income, a “deemed tangible income return” equal to 10 percent times the corporation’s qbai, is subtracted to determine the “deemed intangible income.”39 finally, the fdii is that portion of the deemed intangible income that is attributable to sales of products, provision of services, licenses of ip, etc. for foreign consumption or use.40 c. policy intent of gilti and fdii recall from section ii the policy challenge of taxing economic rents in an open economy. while exempting the normal return from capital taxation serves the goal of an undistorted level of investment, a government is susceptible to losing investment when it seeks to tax the economic rents and a competing government offers a lower tax rate. the challenge is greater when the economic rents in question come from (or can be attributed to) mobile forms of capital such as intangible assets. a policymaker tasked with designing international tax rules to address the challenge posed by mobile economic rents would ideally want to first identify such economic rents within a taxpayer’s overall taxable income. using our expressions for taxable income from equation 4 and equation 5, the portion of a company’s taxable income targeted by such rules should be er times that portion of kt that is made up of intangible capital (under the assumption that intangible capital is mobile and tangible capital is not). however, parsing a firm’s observed taxable income between normal returns and economic rents (and between tangible capital and intangible capital) in an objective manner is a significant measurement problem in practical policy design. the problem is tougher still when the reported taxable income across different jurisdictions has been computed under different capital allowances (e.g., expensing or depreciation deduction for a capital expenditure) and other tax rules. if we view the gilti and fdii provisions as an attempt to identify mobile rents, it is clear that their drafters made certain assumptions and compromises. they assumed that 10 percent is a reasonable proxy for the normal rate of return in nominal terms and that tangible capital generally earns no more than a normal rate of return. assuming minimal rents to tangible capital, subtracting a 10 percent return on tangible capital from taxable income would, under a specific combination of capital allowance rules for the two classes of investment, isolate the returns to intangible capital.41 this would still leave the normal return on intangibles (as well as the portion of the return covering economic depreciation) in the mix but that is not a problem under full expensing of intangible investments. however, as we discuss below, in other situations the design of the provisions will not be able to selectively target economic rents.42 in this setup, the gilti provision is the backstop that ensures that a certain portion of the returns to mobile capital of u.s.mncs remain in the u.s. tax base even when such returns are reported in low-tax foreign jurisdictions (via subsidiaries located in those jurisdictions). further, 38 i.r.c §250(b). 39 i.r.c §250(b)(2)(b). 40 i.r.c §250(b)(4) 41 specifically, this would be the case where full and immediate expensing applies for investments in intangible property but only depreciation is allowed for investments in tangible capital. 42 see sections iv.c and iv.d. 2019] 209 the impact of gilti and fdii on the investment location choice of u.s. multinationals by serving as such a backstop, the gilti rules can help lower the incentive and ability of foreign jurisdictions to engage in tax competition to attract investment from u.s. mncs.43 and yet, while the rules on gilti and fdii reduce the benefit that u.s. mncs can expect from locating mobile capital (and the rents attributable to such capital) in low-tax jurisdictions, they do not entirely eliminate such benefit. at least on the surface, the rules appear to leave open a tax-rate arbitrage window for mobile rents (albeit, a window that is smaller than before). for u.s. mncs, simplified like-for-like comparison of the marginal u.s. tax burden on mobile rents generated from an investment (targeted at supplying non-u.s. markets) suggests that this marginal tax can be no lower than 13.125 percent when located in the united states but can be as low as 10.5 percent when located in a low-tax foreign jurisdiction (other things equal and ignoring other tax attributes specific to each jurisdiction). given the dividend received deduction (drd) under the tcja,44 this means that an incentive to offshore rent-generating mobile capital may still exist among u.s. mncs. jurisdictions may then continue to try and attract investments of u.s. mncs through tax competition (e.g. ip box regimes, lower tax rates, etc.). if this is indeed the case, an opportunity would appear to have been lost from the perspective of the u.s. treasury. d. impact of beps in this section, we show that while such a tax arbitrage may exist, non-tax transaction costs related to beps may narrow, and even eliminate, this gap. locating mobile rents in a taxadvantaged jurisdiction takes more than just a reallocation of “paper profits” for income tax purposes and often requires some measure of change in a business’s operations (such as location of employees, ways of dealing with outside parties, etc.). for profits reported in a jurisdiction to be respected for income tax purposes, the international tax rules require that such reported profits be supported by sufficient “economic substance.”45 absent the requisite economic substance, the company’s cross-border allocation of taxable income is unlikely to be respected and the effective tax on such profits will not be lowered.46 in turn, economic substance – in the context of mobile rent-generating capital such as intangible property (ip) – effectively amounts to observable economic activity in the form of employees that are responsible for performing important functions that have a bearing on the profit-making potential of the relevant ip. to the extent that the united states is the “natural home” of such economic substance for a u.s. mnc in a world without tax considerations – for instance, on account of linkages and network economies with 43 the incentives of jurisdictions offering lower tax rates to attract rents from mobile forms of capital have only been heightened with the oecd’s beps project and the greater substance requirements for cross-border related-party allocations of intangible-related income to be respected. with a higher substance threshold, a government offering lower tax rates on intangible income not only stands to attract more taxable income but also more real economic activity, such as jobs. see kartikeya singh &aparna mathur beps and the law of unintended consequences, tax notes (ta) (sept. 16, 2013). 44 i.r.c §245a. 45 oecd, supra note 26, at 3. 46 id. at 13, 38. 210 [vol. 10:2 columbia journal of tax law other aspects of the company’s business – locating the requisite economic substance in a low-tax jurisdiction will come at an incremental cost. such incremental non-tax costs for the firm would be present to the extent it has to organize its business affairs (e.g., such as the location of its employees and their roles and responsibilities) differently from how it would do so in a no-tax world. any such non-tax costs then represent a leakage from the tax benefit the firm may generate from its investment location choice. the non-tax transaction costs related to international tax planning may be higher still on account of additional compliance and administrative burdens that a u.s. mnc might face when locating rent-generating capital outside of the united states for tax considerations. the additional compliance and administrative burdens can come from having to defend its location choice of ip – a choice that may have the appearance of having been made specifically for tax purposes – to revenue authorities of different jurisdictions that may have an interest in challenging the company’s position in order to appropriate a greater share of tax revenues. it is fair to say that the transaction costs related to international tax planning that a firm faces are higher in the post-beps world than before. from the outset of the beps project, the oecd had identified intangibles – as the quintessential form of mobile capital that can be moved across jurisdictions relatively easily – as a key area where new rules and a tightening of existing rules was needed to curb the ability of multinationals to “artificially” shift profits from high-tax to low-tax jurisdictions.47 correspondingly, the oecd devoted a significant part of its new guidelines, presented in the report on beps actions 8 through 10, to intangibles and the crossborder allocation of taxable income attributable to such intangibles. 48 the new guidelines reinforced the concept of “economic substance” as a way to ensure that whenever a taxpayer asserts a jurisdiction as its location for important intangibles (and taxable income attributable to them), it has to show that it meets a necessary and elevated precondition: the location of employees necessary for the development, management, and exploitation of the intangibles within that same jurisdiction.49 this is intended to minimize (if not entirely eliminate) “artificial profit shifting” where the location of income attributed to a company’s intangibles is disassociated from the location of important people functions.50 in effect, the revised guidelines and standards impose a significant transaction cost on firms’ international tax planning built around the location of intangible capital. so, how do the new rules on fdii and gilti impact the decision margins of u.s. mncs with regard to new investments in an international tax environment shaped by beps? commentary within the us has been mixed. some commentators have argued that the provisions do not do enough to change the “offshoring problem” and recommend “equalizing the minimum tax rate on gilti” and “the reduced rate on exports” to close the tax arbitrage window mentioned above, in particular citing a “tax haven problem”.51 others have noted that the new rules do indeed reduce (although, without completely eliminating) the incentive to offshore investments and also point to the potential effect of gilti being far more punitive than 47 oecd, supra note 25, at 13. 48 see oecd, supra note 26, at 63-92. 49 id. at 38-9. 50 oecd, supra note 25, at 18. 51 kamin et al., supra note 7, at 56. 2019] 211 the impact of gilti and fdii on the investment location choice of u.s. multinationals immediately apparent. 52 , 53 we turn to an analysis of the effects of the gilti and fdii provisions on u.s. mncs’ incentives with regard to the location of new investments. we explicitly incorporate into this analysis non-tax transaction costs that a firm may have to face when considering its location choice. iv. firm’s location choice for new investments with gilti and fdii54 to consider the impact of the provisions, we compare the after-tax net present value (npv) and the internal rate of return (irr) of a new investment when it is located within the united states to when it is located in a low-tax foreign jurisdiction. for simplicity, we assume that the investment generates income entirely from foreign consumption or use. we consider a new $10 million investment in year 0. assuming an economic life of five years and constant straight-line depreciation, the investment starts depreciating in year 1 and is fully depreciated by the end of year 5.55 further, the undepreciated portion of the investment starts to generate returns in year 1 with each year’s return being made up of two components: the normal return equal to 10 percent and economic rents at a rate of 20 percent. the total before-tax return is then 30 percent. the assumption of a high rate of economic rents is appropriate for the types of investment targeted by the gilti and fdii rules. the pre-tax outlays, net capital stock and returns from the investment over its life cycle are shown in table 1. table 1: before-tax outlays, net capital stock and returns (all figures in million usd) for now, we do not distinguish between investments in tangible and intangible capital, with each type analyzed separately below. using equation 4 and equation 5, table 2 shows the tax treatment of the investment in each year under expensing and depreciation. 52 martin a. sullivan, economic analysis: where will the factories go? a preliminary assessment, 158 tax notes 570 (jan 29, 2018). 53 martin a. sullivan, economic analysis: more gilti than you thought, 89 tax notes int’l 587 (feb. 12, 2018). 54 the analysis in this section ignores u.s. state taxes as well as foreign tax credit limitations when computing the u.s. tax on gilti. 55 for simplicity, all cost outlays and income are assumed to occur at the beginning of the year. additionally, the tax depreciation schedule, when relevant, is assumed to conform to true economic depreciation. 212 [vol. 10:2 columbia journal of tax law table 2: taxable income under alternative capital allowance regimes (all figures in million usd) under the assumptions made for this hypothetical investment, taxable income under immediate expensing is identical to the before-tax cash flows. in contrast, with deductibility of depreciation, taxable income is the sum of the normal return and the economic rents. consistent with the discussion in section ii, the expensing regime only imposes a tax on the economic rents in present value terms ($4.8 million) whereas the depreciation regime taxes both the normal return and the economic rents ($7.3 million). a. the imputed return in the gilti and fdii rules before we proceed with our analysis of investment location, we make a slight digression regarding the normal rate of return. the imputed return on depreciable tangible assets (i.e., qbai) set forth in the tcja in the application of the gilti and fdii provisions is an important design feature of gilti and fdii rules and one that has not escaped comment. views on this range from the 10 percent figure having been “pulled out of thin air” and therefore lacking any basis to it being too high “compared to similar provisions in the code, which set returns a few percentage points above the risk free return.”56 we have a different view on this issue. we conjecture that the imputed return on tangible assets chosen in the design of the gilti and fdii provisions is a proxy for the normal rate of return attributable to tangible (and hence, relatively immobile) capital so as to isolate economic rents that accrue to more mobile capital. for equity-financed investments, the normal return is the required market rate of return on equity in the applicable risk class.57, 58 without knowing the specifics of the taxpayer and the investment in question, a reasonable guess for this normal rate of return is the expected return on equity in the overall economy. if one were to use the past to derive an expectation of the future, 56 sullivan, supra note 52. see also kamin et al., supra note 7 at 46. 57 see rachel griffith et al., international capital taxation, in dimensions of tax design: the mirrlees review 914, 926 (james mirrlees et al., eds., 2010). 58 for debt-financed investments, the normal return is the market rate of interest on debt (which is subtracted out of the “net deemed tangible income return” under the gilti and fdii rules since, with the deductibility of interest expense, this portion is already exempt from tax). i.r.c §951a(b)(2)(b). 2019] 213 the impact of gilti and fdii on the investment location choice of u.s. multinationals 10 percent is a close estimate of the average return on the s&p 500.59 this may be the thinking underlying the gilti and fdii rules. in fact, the house ways and means committee’s counterpart to the gilti rules used a rate of seven percent plus a short-term federal interest rate.60 the seven percent figure is a close approximation of the excess of the average historical equity returns over the risk-free rate.61 the house and ways and means committee proposal thus also appears to have used a similar imputed return in its equivalent to the gilti provision as the historical annual return on equity for the s&p 500 (albeit through a slightly different route). the 10 percent imputed return in the gilti and fdii provisions thus may not have been pulled out of thin air. that by itself fails to say whether it is in fact an appropriate figure to use as the imputed return in the provisions. to assess whether the 10 percent imputed return figure is appropriate in the context of its intended purpose –identifying the normal rate of return so as to exempt this (as hypothesized by us) under the gilti provision – requires answering the following question: what discount rate would an (equity) investor use to present value the deductions from projected future taxable income that are available via the deemed tangible return income” (i.e., the imputed return on qbai) under the provision?62 in particular, should the hypothetical investor use a relatively safe rate of return or one that incorporates an equity risk premium? the discount rate that the investor uses is what should be used as the imputed return so as to ensure the desired tax neutrality (i.e., specifically identifying the economic rents so as to leave the normal returns untaxed on a present value basis).63 a relatively safe rate would be appropriate for the imputed return if the “deemed tangible return income” for a given year could be carried forward or back to offset the “tested income” amounts in other years so as to lower the gilti amounts in those years. if this were the case, a u.s. mnc would almost be guaranteed the tax benefit of the imputed return. the only situation under which (an equity investor) in the u.s. mnc would stand to lose the benefit of the imputed return on qbai would be where the relevant cfcs of the company never generate enough tested income for the investor to benefit from the imputed return on qbai. the risk associated with such a situation is akin to that of bankruptcy (of the relevant cfcs). thus, if the gilti provision in the tcja allowed a taxpayer to carry the “deemed tangible income return” forward to offset future gilti liabilities, an investor would discount these future deductions at a rate equal to the risk-free rate plus a default risk premium. taking administrative considerations into account, a rate equal to an average corporate borrowing rate would be reasonable proxy for the imputed 59 see michael santoli, the s&p 500 has already met its average return for a full year, but don't expect it to stay here, cnbc, (june 18, 2018), https://www.cnbc.com/2017/06/18/the-sp-500-has-already-met-itsaverage-return-for-a-full-year.html [https://perma.cc/8u6w-kr5y]. 60 section 4310, tax cuts and jobs act, pub. l. no. 115-97, 131 stat. 2054 (2017). 61 roger j. grabowsi et al., 2017 valuation handbook u.s. guide to cost of capital (2017). 62 for the purposes of this discussion, we focus on the gilti provisions, but the analogous reasoning applies to fdii provisions. 63 the reasoning mirrors that used for purposes of determining the appropriate imputed return used in the allowance for corporate equity (ace) rules adopted in certain countries. the exemption of the normal return from tax is an objective for ace rules (in addition to reducing distortions in debt versus equity financing decisions). see griffith et al., supra note 57, at 977-78. https://www.cnbc.com/2017/06/18/the-sp-500-has-already-met-its-average-return-for-a-full-year.html https://www.cnbc.com/2017/06/18/the-sp-500-has-already-met-its-average-return-for-a-full-year.html 214 [vol. 10:2 columbia journal of tax law return in the provision. this would not be too different from what some commentators have opined that the 10 percent imputed return is too high.64 however, the above applies only if the gilti rules were to allow carryforward of “excess” deemed tangible return income amounts to shield tested income, and thereby reduce gilti, in other years. this is not the case in the actual design of the gilti provision. the gilti amount is lower in any given year by the 10 percent imputed return on qbai when the "tested income" for the u.s. mnc’s cfcs exceeds this imputed amount. however, in the situation where the 10 percent imputed return exceeds the tested income amount, the gilti amount subject to us tax for that year, other things equal, is zero. but the excess of the imputed return over the tested income does not carry forward to shield tested income amounts in future years nor can it be carried back. instead the value of this deduction is limited to the specific year in question and is tied to the realization of the uncertain return in that year.65 this implies that the discount rate an investor would use to calculate the present value of the imputed income on the qbai cannot be a safe rate of return since this deduction is not guaranteed. in turn, this means that the appropriate discount rate the equity investor should apply to calculate the present value of this deduction cannot be too far removed from the discount rate that would apply to calculate present value of the uncertain return. the expected rate of return on equity is therefore not far off from an appropriate candidate for this discount rate. correspondingly, the same rate of return as the imputed return in the provision may not be too far off the mark. certainly, a safe rate of return would not be an appropriate choice for this imputed return. with this slight digression on the normal rate of return out of the way we now turn to the analysis of the location choice of our candidate investment described earlier in the section. b. intangible capital66 for intangible capital, the tax treatment given by column (h) in table 2 is assumed to apply, regardless of the location of the investment. as discussed above, the tax codes of most jurisdictions, including the united states, currently allow immediate expensing of most investments in self-developed intangibles.67 because the expensed investment has zero tax basis, the qbai for purposes of gilti and fdii is zero in each year. if the u.s. mnc locates this investment in the united states, it would benefit from the fdii rules. its total tax liability in years 0 through 5 is shown in table 3. 64 kamin et al., supra note 7, at 46. 65 see prop. treas. reg. § 1.951a-(1)(c)(3)(i)1, 83 fed. reg. 51,072, 51,093 (oct. 10, 2018) (defining “net deemed tangible income return” with respect to a “united states shareholder and a u.s. shareholder inclusion amount means with respect to a united states shareholder and a u.s. shareholder inclusion year, the excess (if any) of—(a) (t)he shareholder’s deemed tangible income return ... for the year, over, (b) (t)he shareholder’s specified interest expense … for the year.”) (emphasis added). see also prop. treas. reg. § 1.951a-(1)(c)(3)(ii), 83 fed. reg. 51,072, 51,093 (oct. 10, 2018) (defining “deemed tangible income return” with respect to a united states shareholder as “10 percent of the aggregate of the shareholder’s pro rata share of the qualified business asset investment ... of each tested income cfc for the year.”) (emphasis added). 66 for a comparison of the united states with other jurisdictions with regard to tax incentives for researchbased intangible investments, see andrew lyon & william a. mcbride, assessing us global tax competitiveness after tax reform (paper presented to nat. tax ass’n 2018 spring symposium, washington, dc, may 17, 2018). 67 for the u.s., this will change for certain types of research and engineering expenses after 2022 when such expenses will have to be amortized for tax purposes over five years. i.r.c. §174 modified with effect for tax years beginning after december 31, 2021 pursuant to i.r.c. §174(e) introduced in p.l. 115-97. 2019] 215 the impact of gilti and fdii on the investment location choice of u.s. multinationals table 3: total tax liability when locating intangible investment in the united states68 (all figures in million usd) in the table, column (j) represents the regular tax liability of the firm in the absence of fdii rules and is simply the taxable income shown in column (h) of table 2 multiplied by the u.s. tax rate of 21 percent. column (k) shows the amount of income that is characterized as fdii.69 because the investment only generates income derived from foreign use and has zero tax basis, the fdii corresponds to the taxable income in each year. column (l) denotes the tax benefit of the fdii deduction, which equals 37.5 percent of each year’s fdii multiplied by the 21 percent u.s. tax rate. finally, column (m) shows the firm’s total tax liability (inclusive of the tax benefit conferred by fdii) as the sum of columns (j) and (l). in this example, over the specific new investment’s entire life cycle, the tax liability equals $0.6 million in present value terms. absent the fdii rules, and given expensing of the investment, the u.s. government would be a silent partner in the entire investment. this means that the normal rate of return from the investment would go untaxed (in present value terms) but all the economic rents would be taxed at the 21 percent rate. with the fdii rules, the u.s. government is a silent partner in only 62.5 percent of the investment. the normal rate of return still remains untaxed and, in addition, now 37.5 percent of the firm’s economic rents are also exempted from u.s. tax. this is the impact of the fdii carrot. now, suppose that the mnc has the choice of locating this investment in a zero-tax foreign jurisdiction. doing so will subject the firm to the gilti rules. the firm’s total tax liability in years 0 through 5 is shown in table 4. table 4: total tax liability when locating intangible investment overseas 68 negative fdii tax benefit figures imply a reduction in u.s. tax liability. 69 the investment outlay in year 0, and the immediate expensing of such investment for tax purposes, means that the deduction reduces the fdii generated from investments of older vintages. said differently, as long as the firm has income from investments made in years prior to year zero (which is labeled as such specifically in relation to the current investment), and the fdii associated with such older investments would have been greater than $10 million (but for the current investment), the marginal impact of the current investment on the firm’s fdii in year 0 is -$10 million. 216 [vol. 10:2 columbia journal of tax law (all figures in million usd) column (n) lists the zero foreign tax liability. column (o) shows the amount of the taxable income classified as gilti, which equals all the foreign pre-tax income because the investment has zero tax basis and does not give rise to qbai. the negative taxable income under gilti in year 0 assumes that this offsets gilti income elsewhere at the level of the relevant u.s. corporate shareholder thereby allowing us to analyze the marginal impact of this investment location decision.70, 71 column (p) shows that the u.s. tax is 10.5 percent of the gross returns. the gilti rules combined with the section 250 deduction that applies to a u.s. shareholder’s gilti income, positions the u.s. government as a silent partner in 50 percent of the firm’s investment – the government effectively allows immediate expensing of 50 percent of the overseas investment and then taxes 50 percent of the gross returns.72 the firm’s tax liability – all of which is on account of gilti – is exactly half of what it would be if it located this investment in the united states and did not have the benefit of fdii. the tax liability is 80 percent of what the firm would pay if it located the investment in the united states and availed itself of the fdii benefit on account of the relative percentage of income subject to u.s. tax under the two cases (i.e., 50% versus 62.5%). ignoring any non-tax costs for now, the firm’s after-tax cash flows from the investment as well as the irr and npv of the investment corresponding to each location choice are shown in table 5. table 5: after-tax cash flows, npv and irr from intangible investment (united states versus overseas) 70 in the situation where this assumption is not met – not an entirely unrealistic possibility – the u.s. tax treatment of the investment would be worse than that of a silent partner. the resulting u.s. tax liability under the gilti provision would correspondingly be significantly higher and would lead to an outcome worse than when it chooses the united states as the investment location. 71 note that the rules on gilti as well as those on fdii correctly isolate the economic rents in this example ($4.8 million in present value terms). the capital allowance rules (i.e., immediate expensing) in both jurisdictions, and the way qbai is computed for the investment in question allow the provisions to achieve this policy objective. 72 i.r.c. § 250(a)(1)(b). 2019] 217 the impact of gilti and fdii on the investment location choice of u.s. multinationals (all figures except percentages in million usd) the values for years 0 through 5 in column (r) in the table represent the difference between before-tax cash flows from column (g) in table 1 and the total tax liability in column (m) from table 3. similarly, column (s) is the difference between column (g) in table 1 and column (q) in table 4. the table shows that the firm’s after-tax irr remains the same regardless of its investment location decision. in each case the u.s. government acts as a silent partner in the investment and leaves the normal return untaxed. the percentage of investment in which the u.s. government “silently” participates is greater and as such, the upfront cost to firm is correspondingly lower when the investment is located in the united states ($8.69 million versus $8.95 million). the subsequent gross returns are taxed more heavily when the investment is located in the united states as well with the result that the investment’s npv is higher when it’s located overseas. the npv analysis appears to confirm the view that the rules on fdii and gilti do not adequately close the tax-arbitrage window for mobile capital.73 however, as discussed above, this may not represent a complete picture of the firm’s decision criteria were it to incur incremental non-tax costs when choosing to locate its mobile capital (e.g., ip) in the foreign jurisdiction (especially when tax arbitrage is the primary motivation for such a decision). such transaction costs may come from having to locate the requisite economic substance – with such requisite level being higher in the post-beps world – away from what would be its optimal location in a world without tax considerations.74 additional compliance and administering efforts (in a world with greater transparency and access to information by taxing authorities) will likely further contribute to such transaction costs. for the candidate investment in our example, a present value of such transaction costs greater than $127 thousand – the difference between the npvs under the two alternative locations – over the life cycle of the investment is enough to tilt 73 if the investment were subject to constant returns to scale, the firm could replicate the investment’s overseas npv in the united states. it could do this by investing an amount that is higher in before-tax terms but that costs the firm the same on an after-tax basis as when it locates the investment overseas (i.e., $8.95 million). 74 see discussion in section iii.d. 218 [vol. 10:2 columbia journal of tax law the balance back in favor of the united states as the favored investment location. this cutoff value for transaction costs amounts to 1.3 percent of the initial investment outlay and 1.7 percent of the npv of the pre-tax gross returns (i.e., $2.4 million in the normal return plus $4.8 million in economic rents). having to spend $127 thousand as a transaction cost when planning and locating an investment of $10 million in a tax-advantaged jurisdiction (which otherwise would not be the natural home of that investment) is not far-fetched. since normal returns are left untaxed regardless of the location, the divergence in the after-tax npv comes purely from the tax burden borne by the economic rents. consequently, this divergence is greater (smaller) the higher (lower) the expected economic rents from the investment. figure 1 shows the “indifference” threshold for transaction costs – expressed as a percentage of the pre-tax present value of gross returns – and how this threshold varies with the rate of economic rents given other assumptions on the investment profile. given other parameters of our example, and allowing the rate of economic rents to vary between 0 percent and 50 percent, the curve in figure 1 represent the level of transaction costs that make the u.s. mnc indifferent between the united states and the zero-tax foreign jurisdiction as its investment location. figure 1: indifference curve for investment location – non-tax transactions costs versus rate of economic rents for any combination of transaction costs and economic rents lying above the “indifference curve” in figure 1, the united states is the preferred location of the investment while the zerotax foreign jurisdiction is the preferred location for transaction cost-economic rent combinations that lie below the curve. the indifference curve itself shifts downwards – increasing the space over which the united states is the preferred investment location – as the foreign tax rate rises above zero. for a foreign tax rate equal to 13.125 percent, the indifference curve for the 2019] 219 the impact of gilti and fdii on the investment location choice of u.s. multinationals candidate investment in our example will coincide with the horizontal axis.75 thus, for a range of investment profiles, the rules on gilti and fdii might leave little or no tax-rate arbitrage opportunity when non-tax transactions costs over the investment’s life cycle are fully incorporated in the firm’s cost-benefit calculus. in particular, new investments with extremely (and possibly, implausibly) high rates of expected economic rents would be the suitable candidates for offshoring to low-tax jurisdictions. other things equal, large scale investments might also be suitable candidates for offshoring. non-tax transaction costs may exhibit some economies of scale and, in absolute terms, may be lower than the “indifference threshold” for extremely large investments with high expected rents. c. tangible capital turning now to the location choice for new investments in tangible capital, the combination of the gilti and fdii rules may provide a motivation for firms to locate tangible property overseas. 76 first, 10 percent of qbai (the tax basis in such tangible property) is removed from fdii, thereby lowering the tax benefit afforded by the fdii deduction. second, and in the same vein, 10 percent of qbai held overseas reduces gilti and thereby reduces the tax’s deterrent impact. to analyze a u.s. mnc’s location choice with regard to new investments in tangible capital we start with the same investment profile as shown in table 1 but which is now assumed to apply to a tangible investment. the assumption of such high economic rents may seem implausible in the context of tangible capital. however, since the perceived benefit from offshoring tangible capital comes from such rents being shielded from u.s. tax by the 10 percent return on qbai (as well as by enhancing the fdii benefit), the assumption of high rents to tangible capital allows us to evaluate the accuracy of that claim in the situation where it would be most likely to hold.77 overseas jurisdictions that are likely candidate locations for tangible capital, such as factories, are unlikely to offer close to zero tax rates. unlike the analysis above for intangible investments, the foreign tax rate assumed in this section is 8.5 percent. our thinking behind this assumption is that the firm will be constrained to retain – for income tax purposes – at a minimum, the normal rate of return in the jurisdiction that houses the physical capital. we take the oecd average corporate tax rate of approximately 25 percent applying to this part of the income that will be reported in the candidate location of the tangible capital.78 we assume an effective tax rate of zero on the economic rents as the best outcome the firm can effectively achieve by separating its location from that of the physical capital assuming it satisfies the types of post-beps considerations and constraints described in the previous section.79 the assumed 75 to reiterate, this ignores section 904 limitations. 76 kamin et al., supra note 7. 77 readers may interpret the assumption as capturing the rate of economic rents in the overall system and not necessarily tied, or attributable to, the tangible system. the overall quantum of rents under such an interpretation bears a relationship to the scale of the tangible investment via the overall scale of operations. 78 corporate tax rates around the world 2018, daniel bunn, fiscal fact 623, tax found., https://taxfoundation.org/corporate-tax-rates-around-world-2018/ [https://perma.cc/z7bx-4l5e]. 79 see discussions in section iii.d. https://taxfoundation.org/corporate-tax-rates-around-world-2018/ 220 [vol. 10:2 columbia journal of tax law foreign tax rate of 8.5 percent on the total income generated from the investment when located overseas represents a rounded approximation of the weighted average tax rate on the normal return and the economic rents. an important consideration with regard to investments in tangible capital is the expensing rules of section 168(k), as amended by section 13201 of the tjca. for investments in certain forms of tangible capital made within the united states between 2018 and 2022, expensing means that the tax treatment of the investment is given by column (h) in table 2.80 in contrast, the tax rules of most jurisdictions allow only a depreciation deduction for investments in tangible capital.81 the tax treatment of the investment when located in a foreign jurisdiction is given by column (i) of table 2. note further, that the qbai in each period, as determined under the section 168(g) alternative depreciation schedule, is assumed to correspond to the actual economic net capital stock shown in column (a) of table 1. following the same order of analysis as before, if the firm locates this investment in the united states and benefits from the fdii rules, its total tax liability in years 0 through 5 is shown in table 6 below. table 6: total tax liability when locating tangible investment in the united states (all figures in million usd) the figures in table 6 are derived in the same manner as those in table 3. the difference between the tables starts with the amount of taxable income that constitutes fdii with the ensuing difference flowing through to the fdii benefit and total tax liability (inclusive of the fdii benefit). in table 6, the fdii is lower in periods 1 through 5 by 10 percent of the qbai (which is now positive in each of these periods under the ads). unlike the example of the intangible investment, the combination of expensing and the form of the investment generates qbai means that the fdii rule does not accurately identify and isolate economic rents. the portion of the income that is identified as fdii ($2.4 million in present value terms) in the 80 our focus on an investment that qualifies entirely for the new expensing rules under the tcja is admittedly a restrictive one. more realistic situations will have only a portion of an investment in a tangible asset – e.g., a manufacturing plant – as qualifying for expensing. 81 pomerleau, supra note 29, at 2. 2019] 221 the impact of gilti and fdii on the investment location choice of u.s. multinationals example falls short of the full extent of the economic rents ($4.8 million) because of the subtraction of the normal return ($2.4 million) ascribed to tangible capital from this pool of income. the 37.5 percent fdii deduction is only a mixed blessing in this case where expensing applies to investments in tangible capital. while the provision exempts 37.5 percent of the economic rents from u.s. tax, it puts 37.5 percent of the normal return back under the burden of the tax which otherwise would be exempt on account of the expensing provision. in our example, the net effect of the fdii deduction is still beneficial given the relative magnitude of the assumed rents. however, as these rents decline to zero, the firm would actually be better off not availing of the fdii provision so as to not dilute the benefit of expensing.82 we surmise that this may be an unintended design flaw in the provision and stems from a failure to correctly identify (in concept) the economic rents as the rightful target for the deduction. when the firm instead locates the tangible investment in the foreign jurisdiction, and under the assumption that the local tax rules of the foreign jurisdiction do not allow for immediate expensing, taxable income is zero in the year the investment is made. neither government does anything to defray the cost of the investment in year 0. given our assumed best case scenario for the firm, the foreign tax is limited to a weighted average rate of 8.5 percent in every subsequent year and the foreign tax liability is shown in column (y) in table 7.83 the u.s. government imposes a tax on 50 percent of the taxable income in years from 1 through 5. however, because the taxable income in each year excludes depreciation (on account of the local capital allowance rules) as well as the normal return (via the 10 percent of qbai exclusion), tax is imposed only on a portion of the economic rents.84 therefore, even in the case of tangible investments, the gilti rules result in the u.s. taxing no more than the economic rents, although that result is achieved via a different route than in the case of intangible investments. in this case, the u.s. also provides a credit for 80 percent of the firm’s foreign tax liability.85 the end result is that the firm’s u.s. tax liability under gilti is lower both in present value and undiscounted terms than in the intangible investment case analyzed previously. 82 note that with lower rents, the firm’s incentive to offshore the investment in pursuit of a lower tax rate also diminishes. 83 comparing the foreign tax liability in column (y) from table 7 with the regular u.s. liability in column (j) from table 3 shows the benefit of expensing. the assumed foreign tax rate is only 40 percent of the u.s. tax rate yet yields a tax liability that is just over 60 percent of the regular u.s. tax liability (before the fdii benefit) in present value terms. 84 the computation of the gilti amount subject to u.s. tax starts with an after-tax amount (i.e., the “net cfc tested income”) from which the imputed return on qbai is deducted. the final gilti amount subject to u.s. tax is a before-tax figure via the section 78 gross-up. the mechanics of this computation – especially the sequencing with regard to the subtraction of the imputed return on qbai – mean that the non-zero foreign tax rates of the provision falls just short of isolating the full extent of the economic rents. 85 we assume that no limitations (e.g., from expense allocation) apply to the foreign tax credits. the allocation of expenses under the rules of i.r.c. §861 can limit the foreign tax credit and thereby subject some foreign income to u.s. tax even when the cfcs foreign tax rate exceeds 13.125 percent. see sullivan, supra note 53. in the context of this analysis, such limitations would increase the u.s. tax on gilti and make the foreign jurisdiction less favorable, other things equal. 222 [vol. 10:2 columbia journal of tax law table 7: total tax liability when locating tangible investment overseas86 (all figures in million usd) analogous to the analysis for the intangible investment, the firm’s after-tax cash flows from the tangible investment and the irr and npv of the investment are shown in table 8. table 8: after-tax cash flows, npv and irr from tangible investment (united states versus overseas) (all figures except percentages in million usd) the expensing and the fdii rules – each of them working only imperfectly with the investment characteristics assumed in our example – combine to provide a better expected after-tax irr for the firm when it locates the tangible investment in the united states versus overseas in the hypothesized candidate foreign jurisdiction. the firm does marginally better from locating the investment overseas in terms of the after-tax npv of the investment – even though the upfront after-tax outlay is higher, the subsequent returns face a lower tax burden. however, this benefit in terms of npv is small – approximately $38 thousand on a $10 million investment and barely 86 the amount shown in column (z) is after the section 78 gross-up (i.e., the amount subject to us tax under the gilti provision). 2019] 223 the impact of gilti and fdii on the investment location choice of u.s. multinationals half a percent of the pre-tax npv of gross returns. furthermore, the benefit declines rapidly as the expected rate of economic rents in the system decline with the balance shifting in favor of the united states for low rates of rents. all of this suggests that the location of tangible capital is likely to be dictated much more by non-tax factors (such as cost/supply of labor, supply-chain considerations, etc.) and the new provisions, by themselves, are unlikely to significantly disadvantage the united states as a location for such investment. iv. conclusion the new gilti and fdii rules have attracted widespread attention. in this paper, we analyze whether these rules help retain internationally mobile rents within the u.s. tax base and the associated economic activity within the united states. we compare investments with the same before-tax profiles in terms of their after-tax irr and npv when made in the united states versus when made abroad. our analysis suggests that for a wide range of investment profiles (characterized in terms of size and expected above-normal returns) for intangible capital, a u.s. mnc can do better by locating the investment in the united states. when non-tax transaction costs are incorporated in the firm’s cost-benefit calculus, the fdii rules provide a significant incentive for u.s. firms to locate new investments within the u.s. and the gilti rules impose a significant-enough burden (by way of u.s. tax) such that a firm’s npv from an investment is greater when locating such an investment within the u.s. than in a low-tax foreign jurisdiction. furthermore, our analysis also suggests that the rules, by themselves, do not dilute the above outcome by providing any significant incentive to locate new tangible capital outside of the united states. our conclusions differ from other commentators’ claim that the gilti and fdii rules do not provide sufficient incentives for firms to locate investments within the us and even have the opposite effect for some investments. an important reason for the difference in our conclusions comes from our explicit consideration of non-tax transactions costs of tax planning in the post-beps global environment and our departure from a single-period perspective in favor of the entire life cycle of the investment. our analysis relies on a simplified and stylized framework and several caveats are applicable. we ignore state taxes in the interest of simplicity but also on account of the uncertainty around what path the states are likely to take with regard to the rules on gilti and fdii. we note however, that incorporating u.s. state taxes in the analysis would likely increase a u.s. multinational’s tax burden on its new investment in either location. by effectively assuming away foreign taxes in the case of intangible investments, we remove the issue of foreign tax credits that come into play with regard to the u.s. tax on gilti. relaxing this assumption is unlikely to alter the direction of our conclusions because it would make a foreign jurisdiction even less attractive relative to the united states. we ignore the impact of the new provision under section 59a on the base erosion and anti-abuse tax, which may make the overseas jurisdiction more unfavorable as an investment location choice. finally, we ignore risk; as noted above, the government is a true silent partner only if it offers perfect loss offsets. under the changes made to section 172 by section 13302 of the tjca, the loss offset provisions for the u.s. are less generous than before and less generous than in many other jurisdictions. the loss 224 [vol. 10:2 columbia journal of tax law offset restrictions are likely to erode some of the benefits of locating a new risky investment in the united states. despite the caveats, the analysis in this article suggests that when looking at the expected after-tax returns from a new investment over its entire life cycle and accounting for non-tax transactional costs, the threat of gilti and the allure of fdii may combine to make the united states a more attractive location of rent-generating investment than might first appear. microsoft word 8-2-weisbach.docx articles a guide to the gop tax plan – the way to a better way david a. weisbach* executive summary the tax reform plan – a better way – put forward by the chairman of the house ways and means committee kevin brady and the speaker of the house, paul ryan would be the most substantial tax reform in the united states since the enactment of the income tax in 1913. at the corporate level, the reform would allow immediate expensing of investments, deny deductions for net interest expense, and eliminate the taxation of income from sales in foreign countries while taxing the full value of imports (together shifting the tax base to a destination basis). at the individual level, the system would tax capital income including interest, dividends, and capital gains at half the rate that wages and salaries are taxed. it would also repeal the estate and generation skipping taxes. these changes would go a long way toward shifting the tax system to taxing consumption rather than income. this paper considers the implementation of the house gop tax plan and addresses issues that will need to be resolved if the plan is to work as intended. the plan is based on, and builds off of, a long history of thinking about consumption taxes. to understand the basic choices made in the plan, it is helpful to understand this history and how consumption taxes work in general. the paper provides a nutshell version of this history. it shows that the plan is essentially the same as the proposal put forward by the tax reform panel convened by president bush in 2005 known as the * walter j. blum professor, the university of chicago law school, and senior fellow, the university of chicago computation institute and argonne national laboratories. send comments to d-weisbach@uchicago.edu. i thank alan auerbach, peter daub, daniel hemel, ed kleinbard, julie roin, steve shay, willard taylor, al warren, and workshop participants at the university of chicago law school for comments. disclosure: i was an outside consultant to the president’s advisory panel on federal tax reform, which proposed a tax reform that closely resembles the gop plan. 172 columbia journal of tax law [vol.8:171 growth and investment tax. that plan, in turn, was a modification of two similar consumption tax proposals, the flat tax and a closely related plan known as the x-tax. and these proposals are modifications of the standard vat used throughout the world. understanding how vats work and the issues they raise, as well as the reason for the various evolutions in the proposals allows us to understand the central issues that will arise in implementing the brady plan. after summarizing this history, the paper turns to the issues that will need to be resolved to implement the plan, focusing on eight sets of issues: (i) the design of the business tax; (ii) the relative tax rates for corporations, partnerships, labor income, and the capital income of individuals; (iii) international tax issues; (iv) the taxation of financial instruments and institutions; (v) the taxation of corporate transactions such as mergers and acquisitions; (vi) deferral and the functioning of the individual-level tax on capital income; (vii) issues relating to the individual tax base such as the mortgage interest deduction; and (viii) problems of transition. some of the problems in the current draft of the brady plan, such as inconsistencies in the design of the corporate tax, are easily fixed. some problems, such as the treatment of pass-through entities and the taxation of major corporate transactions, can be improved with modest substantive changes. others, such as the taxation of financial institutions, will require substantial effort to get right, but approximate solutions exist. finally, some issues, such as the taxation of capital income at the individual level, will not be readily fixed. the basic structure of the plan may not be workable for these issues and resolution of these issues might require structural changes to the plan. overall, i believe that a system following the contours of the house gop tax plan can be made to work, but solving the implementation problems will take time, effort, and compromises. 2017] a guide to the gop tax plan 173 i. introduction .................................................................... 174 ii. description of the proposal .................................... 176 a. business level tax ............................................................. 177 b. international tax rules ....................................................... 178 c. other entities ...................................................................... 179 d. individual level taxation ................................................... 179 e. estate and gift taxation ..................................................... 180 f. revenue and distribution ................................................... 180 iii. how did we get here? .................................................... 181 a. consumption tax basics .................................................... 181 b. the cash-flow or subtraction-method vat ..................... 184 c. destination v. origin basis ................................................. 187 d. the flat tax and the x-tax ................................................. 191 e. destination-based x-tax ...................................................... 193 f. the growth and investment tax plan ................................ 194 g. the brady plan ................................................................... 195 iv. issues and problems with the brady plan ....... 195 a. design of the business tax ................................................. 196 b. tax rates ............................................................................ 203 c. international issues ............................................................. 206 d. financial flows ................................................................... 215 e. corporate transactions ....................................................... 217 f. deferral ............................................................................... 220 g. other individual tax provisions ......................................... 222 h. transition ............................................................................ 223 v. conclusions ...................................................................... 227 174 columbia journal of tax law [vol.8:171 i. introduction the tax reform plan put forth by the chairman of the ways and means committee, representative kevin brady (r-tx) and the speaker of the house, paul ryan (r-wi), if enacted, would be the most substantial tax reform since the original enactment of the income tax in 1913, far exceeding the 1986 reform.1 known as “a better way,” the plan (which i will call the brady plan for short) would shift the corporate tax from a tax on income toward a tax on consumption, from a worldwide system to a territorial system on what is called a “destination basis,” and from a system that allows a deduction for interest expense to a system that at least to some extent ignores financial flows.2 at the individual level, the plan would tax capital income, including interest, dividends, and capital gains, at half of the tax rate on wage income, greatly reducing the tax on capital. combined, the changes to the corporate tax and the individual tax would transform the tax system, shifting strongly toward a consumption base and away from an income base. although it would be a dramatic change from current law, the plan is based on a long line of academic study. it is also based on numerous proposals put forward in the past including a relatively detailed proposal by the tax reform commission created by president bush in 2005.3 and it has similarities to consumption tax systems currently in use elsewhere in the world. we know a reasonable amount about how the system should work. nevertheless, nothing quite like this has ever been tried in the united states or any other developed country. it would be a massive break from the past. to implement the proposal, we would have to resolve numerous issues, some of which are barely mentioned in the current description of the plan and many of which are not mentioned at all. 1 a possible rival is the addition of withholding under the income tax during world war ii, which effectively converted the income tax from a tax on a small minority of wealthy individuals to a tax on most of the population. a second possible rival would be the gradual expansion of the payroll tax to be the dominant tax paid by a large portion of the population. 2 the most recent description of the plan can be found at a better way (june 24, 2016), http://abetterway.speaker.gov/_assets/pdf/abetterway-taxpolicypaper.pdf [perma.cc/9z2n-ne2j]. 3 simple, fair, and pro-growth: proposals to fix america’s tax system, report of the president’s advisory panel on federal tax reform (nov. 2005), http://www.treasury.gov/resource-center/tax-policy/documents/report-fixtax-system-2005.pdf [perma.cc/v6hp-nxpw]. 2017] a guide to the gop tax plan 175 my goal in this paper is to provide a guide to the plan, focusing on how the tax system would be implemented rather than the economic and distributional effects.4 i start by describing the broad contours of the plan based on what is currently publicly available. as noted, the proposal is based on a long history of study of consumption taxation. to understand the structure and reasons for the choices made in the proposal, i next provide an encapsulated version of the history of thinking about consumption taxes, and show how the plan relates to, and is built off of, prior proposals.5 in particular, the brady plan is essentially the same as the “growth and investment plan” proposed by president bush’s tax reform commission.6 that plan itself was built off of a prior proposal by david bradford known as the x-tax,7 and a plan by robert hall and alvin rabushka, known as the flat tax.8 these plans in turn are a modifications of a vat, which is the standard form of consumption taxation used by nations around the world. after showing how the brady plan fits into this history, i examine the issues that will need to be resolved if the plan is to be implemented. i focus on eight sets of issues: (i) the design of the business tax; (ii) the relationship between the tax rates for corporations, partnerships, labor income, and the capital income of individuals; (iii) international tax issues; (iv) the taxation of financial instruments and institutions; (v) the taxation of corporate transactions such as mergers and acquisitions; (vi) deferral and the functioning of the individual-level tax on capital income; (vii) issues relating to the 4 for additional analyses of the plan, see reuven s. avi-yonah & kimberly clausing, problems with destination-based corporate taxes and the ryan blueprint, 8 colum. j. tax l. 229 (2017); leonard e. burman, james r. nunns, benjamin r. page, jeffrey rohaly & joseph rosenberg, an analysis of the house gop tax plan, 8 colum. j. tax l. 257 (2017); elena patel & john mcclelland, what would a cash flow tax look like for u.s. companies? lessons from a historical panel, u.s. dep’t of the treasury off. of tax analysis (jan. 2017), http://www.treasury.gov/resource-center/tax-policy/taxanalysis/documents/wp-116.pdf [perma.cc/273t-wbh5]. 5 the discussion is based largely on two of my prior publications on this topic, david a. weisbach, ironing out the flat tax, 52 stanford l. rev. 599 (2000), and david a. weisbach, does the x-tax mark the spot?, 56 smu l. rev. 201–238 (2003). 6 simple, fair, and pro-growth: proposals to fix america’s tax system, supra note 3. 7 david f. bradford, untangling the income tax (1986); david f. bradford, what are consumption taxes and who pays them?, 39 tax notes 383–91 (1988). 8 robert ernest hall & alvin rabushka, low tax, simple tax, flat tax (1983). 176 columbia journal of tax law [vol.8:171 individual tax base such as the mortgage interest deduction; and (viii) problems of transition. some of the problems i discuss can be readily fixed, but many of the issues that need to be resolved are complex and defy easy solutions. some aspects of the plan may require substantial revision or a completely different approach to be workable. a central problem with the plan is that it tries to straddle the line between an income tax and a consumption tax, inconsistently taking elements of both. in some cases, this generates inconsistent taxation of different types of investments and unnecessary complexity. in other cases, the mix is entirely unworkable. solving these problems by shifting to a pure consumption tax, however, would put the united states in new territory: no developed country has tried to have a pure consumption base for its tax system. although there is a strong impetus to pass a tax reform plan quickly, finding reasonable and durable solutions to many of the issues will take time. this is particularly so because consumption tax approaches to tax issues are very different than income tax approaches, and there is little expertise in the united states on how to approach taxes when the base is consumption. it is easy to make mistakes by relying on an understanding of how income taxes work. for example, deferral is one of the central problems in designing an income tax, but is largely irrelevant in a consumption tax. income tax concepts like basis, inventory, and capitalization of expenses no longer apply. legislative drafters, experienced in income tax design, will have to work hard to avoid importing income tax concepts into a consumption tax. doing so quickly and, possibly, on a partisan basis if tax reform is passed as part of budget reconciliation, will be difficult. nevertheless, i will conclude that with work, a plan following the basic contours of the brady plan can be implemented and, if the right choices are made, may, in many areas, be substantially simpler than current law. ii. description of the proposal the following is a summary of the proposal taken from the june 24, 2016 description of the plan found in the ways & means committee website.9 the description on the website is just a rough outline and has many ambiguities. it is likely that in some places my interpretation is incorrect. moreover, many elements will be changed as the plan is developed in more detail. 9 supra note 2. 2017] a guide to the gop tax plan 177 a. business level tax corporations. the plan makes four key changes to the corporate tax: • the cost of capital expenditures (other than land) would be immediately deductible instead of recovered over time through depreciation deductions. • net interest expense would not be deductible. in effect, interest expense would be treated similarly to dividends, reducing the disparity between debt and equity. nondeductible interest expense can be carried forward and used against interest income in future years. • the tax would be territorial, which means that it would apply only to income from domestic activities. accumulated foreign earnings at the time of the tax, however, would be subject to a one-time tax of 8.75% for cash holdings and 3.5% for other assets, without regard to whether they are repatriated. this transition tax would be payable over an eight-year period. • the tax would be destination-based, which means that sales in foreign countries would not be taxed and imports from foreign countries would not be deductible (or give rise to basis). the plan would also eliminate most special deductions and credits currently allowed to corporations such as the domestic production deduction. it would, however, retain a version of the r&d credit. the tax on this base would be 20%. the plan describes these changes as moving the system towards what is called a cash-flow consumption tax. in a cash-flow consumption tax, firms deduct outflows and include inflows rather than using the usual income tax concepts such as basis, realization, capitalization, and the like. as will be discussed, it is a tax on consumption rather than income. there are, however, a number of statements in the plan that are inconsistent with cash-flow taxation. in particular, the plan says that it will keep inventory accounting. inventory accounting would not be necessary in a cash-flow system because the cost of assets is deducted when purchased or created. the plan also does not allow a deduction for purchases of land, so that expenditures on land are treated differently than other expenditures. in a cash-flow system, all (nonfinancial) expenditures would be deductible. cash-flow consumption taxes are also usually what is called rbased, which means that they ignore financial flows such as borrowing and lending. they tax only real flows, hence the r. an alternative is 178 columbia journal of tax law [vol.8:171 what is called r+f based, which means that the system taxes all real and all financial flows (other than with respect to stock) on a cash-flow basis.10 the brady plan, as described, is consistent with neither of these approaches. in particular, it taxes net interest income but denies a deduction for net interest expense. in an r-based system, interest income would not be taxed. in an r+f system, interest expense (and the principal of loans) would be deductible. moreover, the plan is silent on other financial flows, such as gains and losses from the sale of securities and derivative instruments. it is not clear whether these deviations from an r-based cashflow tax are mistakes or are on purpose. the description of the plan gives no explanation. in part iv.a., i will discuss the problems these deviations from an r-based cash flow system create. pass-through entities. the plan keeps the current law tax rules for pass-through entities. this means that the tax rules for partnerships under subchapter k and for closely-held corporations under subchapter s would remain. the tax base11 for these entities has the same features as the corporate tax base: immediate deduction for capital expenditures, no deduction for net interest expense, territorial taxation, and destination-based cash flow determination. once a pass-through entity computes its tax base and allocates it to its owners, the owners report their amounts on their personal returns. the tax rate for the active earnings of pass-through entities is capped at 25% which means that the applicable rate is the lesser of the owner’s marginal tax rate and 25%.12 because this rate cap applies only to active earnings, passive income of pass-through entities (which is not defined) would presumably be taxed at the owner’s marginal tax rate, not capped at 25%. b. international tax rules as mentioned, the tax would be destination based, which means that exports would not be taxed and imports would be subject to tax. in practice, what this means is that a u.s. company that sells a 10 the r+f base was first described by the meade commission. the structure and reform of direct taxation, inst. for fiscal studies (1978). 11 throughout, rather than using “income” i use “tax base”. if the reform shifts the tax system to a consumption tax, the tax base would not be income, and it is misleading to say that a business computes its income on a cash-flow basis. instead, i will say that a firm computes its tax base, or where grammatically simpler, its earnings. 12 an alternative interpretation of the language in the plan, suggested to me by steve shay, is that pass-through income is taxed at a flat 25% rate. it is not clear which interpretation is correct. 2017] a guide to the gop tax plan 179 good in a foreign country would not include the proceeds in its tax base. conversely, a u.s. company that imports a good would not be able to deduct the cost of the good so that when the good is sold in the united states, its full value is included in its tax base and taxed (as opposed to just the value added in the united states). the plan is also territorial, which means that u.s. corporations are not taxed on income earned in other countries. because sales in other countries and active income earned in other countries are not taxed, most tax rules governing outbound transactions would be repealed. the plan indicates that the foreign personal holding company rules would remain. the plan does not mention which rules governing inbound investments would remain. for example, the plan does not say whether it would retain the withholding rules for dividend payments made to foreigners or the branch profits rules. similarly, the plan does not say which source rules would be retained or how they would be modified. c. other entities the plan does not say how other entities, such as banks, regulated investment companies, insurance companies, real estate investment trusts, remics, and other entities will be taxed. the plan does not mention tax-exempt entities, and i assume that means no changes would be made to their treatment. the plan does not mention the unrelated business income tax, although this would likely be reformed to match the new business tax rules. d. individual level taxation to a great extent, the taxation of individuals under the plan is similar to their taxation under current law. the basic intent seems to be to simplify the ornate structure of taxation that has built up over the years. in particular, the plan would tax wage or labor income at progressive rates, with three brackets, 12%, 25%, and 33%. it would have a large standard deduction, in the range of $24,000 for a married couple, and a combined child credit and personal exemption of $1,500. the amt would be repealed. the plan does not mention payroll taxes, which, i assume, remain as is. many of the features of the tax system for individuals found in current law would remain roughly as is, with unspecified simplifications. for example, the plan says that it will preserve “a” mortgage interest deduction, and that the committee on ways and means will evaluate options to make it more effective and efficient. 180 columbia journal of tax law [vol.8:171 similar language is used for the deduction for charitable donations, the exclusion for employer provided health care, the various education tax benefits, and the various retirement savings provisions found in current law. with the exception of the mortgage interest deduction and the deduction for charitable donations, all itemized deductions would be repealed (which means that the plan would repeal the state and local tax deduction). the earned income tax credit would remain. presumably, the rules defining the scope of taxable compensation, such as the fringe benefit rules, would remain. the most important difference from current law for individuals is that all income from capital, including interest, dividends, and capital gains would be taxed at half the rate applicable to labor income. this change would reduce the highest tax rate on dividends and capitals from 25% (the 20% statutory rate plus the 3.8% surtax on net investment income plus the pease surtax) under current law to 16.5% and the highest tax rate on interest income from 44.6% to 16.5% (a 63% cut). while business taxes are territorial, i assume that the individual capital income tax is not. that is, i assume that dividends, interest, and capital gains, regardless of the source, would be taxed. e. estate and gift taxation the plan would repeal the estate tax and the generation skipping taxes. it is silent on the gift tax, which i take to mean that the gift tax would be retained.13 it does not mention whether it would retain stepped-up basis at death. f. revenue and distribution the description of the plan does not include a revenue estimate or distributional tables. it is not clear whether estimates were used to arrive at the tax rates stated in the plan. if not, the stated tax rates may have to change, possibly significantly, to reach appropriate targets. in particular, the tax policy center estimates that the plan lowers tax receipts by about $3.1 trillion over ten years on a static basis and $3 trillion on a dynamic basis.14 the tax foundation’s static estimate is that the plan would lose $2.4 trillion over ten years, which is roughly 13 the tax policy center analysis made the opposite assumption, that the gift tax will be repealed. see burman et al., supra note 4 at 264. 14 burman et al., supra note 4, at 273 also estimate that the plan would be highly regressive. in its first year of operation (which they assume is 2017), the top 0.1 percent of taxpayers would receive a tax cut of about 16.9 percent of their aftertax income. households in the middle fifth of the income distribution would receive cuts of about 0.5 percent of their after-tax income. the poorest fifth would have tax cuts of 0.4 percent. 2017] a guide to the gop tax plan 181 in the same ballpark, although their dynamic estimate is that the plan would lose only $191 billion, which is effectively revenue neutral.15 these estimates need to be taken as provisional because so many of the details of the plan remain unspecified. for example, the plan does not state how existing basis will be treated once the corporate tax shifts to an expensing system. many of these details will have large effects on tax revenues and also on the distribution of the tax burden. the size of the tax cut and the distributional effects of the plan will likely be headline items in the press coverage of the plan. the focus here, however, is on the structure of the proposed tax system. there are two reasons for this focus. first, there has been little attention to structural issues, and these issues will have first order effects on the operation of the plan and its economic effects. second, the revenue and distributional impacts, while contentious, are, to a great extent, relatively easy issues to resolve by choosing appropriate marginal rates. that is, there may be deep philosophical issues about the right degree of progressivity of the tax system and the right overall level of taxation, but any given resolution of those issues is relatively easy to implement through the choice of the rates. the structural issues may be much more difficult to resolve. iii. how did we get here? to understand the overall structure of the brady plan, we need to understand the proposals for consumption taxation that have been made over the last 40 years. i offer a summary here. more detail can be found in numerous sources.16 a. consumption tax basics 15 kyle pomerleau, details and analysis of the 2016 house republican tax reform plan, tax found. (july 5, 2016), http://taxfoundation.org/details-andanalysis-2016-house-republican-tax-reform-plan/ [perma.cc/88uk-5cgk]. 16 much of the original work was done by david bradford, including his works cited in note 7, david f. bradford, transition to and tax-rate flexibility in a cash-flow-type tax, 12 tax policy econ. 151–172 (1998), david bradford, the x tax in the world economy (2004), and u.s. department of the treasury, blueprints for basic tax reform (1977), which was primarily authored by bradford. other work on implementation of consumption taxes includes william d. andrews, a consumption-type or cash flow personal income tax, 87 harv. l. rev. 1113 (1974); michael j. graetz, implementing a progressive consumption tax, 92 harv. l. rev. 1575–1661 (1979); weisbach, ironing out the flat tax, supra note 5; weisbach, does the x-tax mark the spot?, supra note 5; robert carroll and alan d. viard, progressive consumption taxation: the x-tax revisited (2012). 182 columbia journal of tax law [vol.8:171 individuals can do two things with their income: they can use it for consumption or they can save it. robert haig and henry simons proposed defining income this way, according to its uses. in their formulation, an individual’s income in a given period is his consumption plus his change in net worth or savings. using this same identity, consumption is income minus changes in savings. this means that we can measure consumption by measuring income and allowing a deduction for savings (and an inclusion for withdrawals from savings). an income tax with a deduction for savings (that is, a consumption tax) is simply a tax on cash flows.17 taxpayers have income in a given year, say as salary or gains from investments. this income is an inflow. they subtract from this any amounts they save – their outflows. they pay tax on what is left, which is their consumption. what makes this system so attractive from an administrative and compliance standpoint is that it does not need to use income tax accounting concepts such as realization, basis, depreciation, accrual, inventories, capitalization, and the like. to tax consumption, we just need to measure inflows less outflows. switching to a cash-flow system, therefore, potentially allows substantial simplification of the tax rules. a cash-flow system allows an immediate deduction for savings. students of the tax law will remember that an immediate deduction of an expenditure is, with an exception discussed below, the equivalent of not taxing the return on the expenditure. to illustrate, suppose you purchase a share of stock or a machine for $100 and it produces a return of $110 in one year, for a 10% rate of return. an income tax would give you basis of $100, an amount realized of $110, and gain of $10. at a tax rate of 20%, you would owe $2. a cash-flow system would allow an immediate deduction of the $100 purchase, saving you $20 in taxes.18 you do not have any basis in the asset (because you deducted its cost), so when you get the 17 this observation was first made by nicholas kaldor, expenditure tax (1955). andrews, supra note 16, expanded on and developed the idea. 18 the deduction either reduces taxes you would otherwise owe, or if you do not otherwise owe $20, would, in a pure cash-flow tax, be refundable. the brady plan does not refund losses. instead, it allows unlimited carry forwards with interest, which in economic terms is roughly the same thing. in the example, you would carryforward the $100 loss, increasing it by $10, to have a $110 loss which could be used against the $110 of income. 2017] a guide to the gop tax plan 183 $110 the next year, you have $110 of gain, and owe $22 in taxes. but note that the $22 you owe next year is just the future value of the $20 in taxes that you saved this year (at the 10% market rate of return). in present value terms, you owe no tax. in fact, if you wanted, you could invest the $20 tax savings at the 10% market rate of return and have $22 next year, so that you will have exactly enough to pay the tax.19 in this case, the tax has no effect on you at all: you get the refund, put it in the bank, and take it out of the bank at a future date to pay the tax. your investment is unaffected. therefore, in a cash-flow system, the investment bears no effective tax. as the brady plan puts it, the effective marginal tax rate on new investment in a cash-flow system is zero. note that this is true regardless of the tax rate. if the rate were, say, 70%, the same analysis would hold. the deduction for the initial investment of $100 would be worth $70 and the tax on the return of $110 would be $77. the present value of these flows is $0. because the effective marginal tax rate on new investment is zero, the nominal rate does not matter for new investment. an exception to this conclusion is if the investment produces higher returns than are otherwise available in the market (adjusting for risk).20 these returns are variously called “inframarginal returns,” “rents,” or “economic profits.” to illustrate, suppose that the market rate of return is 10% but the investment has a yield of 20%, so that in one year you get back $120 instead of $110. in the year of the investment, you save $20 in tax. the next year, you have $120 in incoming cash flows, so you owe $24 in tax. the amount you owe, $24, is $2 more than in the $22 owed in the prior case when you only received the market rate of return. the additional $2 is the 20% tax on the $10 you earned that is above the normal market rate of return. if you put your tax refund of $20 in the bank, you would have only $22 next year. you would have to dig into your own pocket to find the additional $2 that you owe. this analysis allows us to describe a consumption tax more precisely (which will end up being important in thinking about the structure of the brady plan). there are two sources of income: income from labor and income from saving and investing. a consumption tax 19 the investment of the $20 would also be deductible, producing $4 of tax savings, which you could also invest. continuing this process, you would eventually be able to invest $25 in tax savings and owe $27.50, the future value of $25, in taxes. 20 the other key assumption is that tax rates stay the same. the effects of changing tax rates are discussed in part iv.h. 184 columbia journal of tax law [vol.8:171 is the same as an income tax except that (because of its cash-flow structure) it exempts the normal return from savings, but not economic profits. a consumption tax, therefore, can be thought of as a tax on labor income and economic profits. there is also, potentially, a third component of a consumption tax, which relates to transition effects. depending on how the transition is managed, a consumption tax might also fall on existing capital. if we think about sources of consumption in the future, one major source is liquidating existing investments, and using the cash to purchase consumption. for example, if you were retiring today, all or almost all of your future consumption would come from your existing investments, not from labor income or economic profits. the brady plan is silent on transition, so i will defer discussion of this issue (including a discussion of why the transition effect can occur). because of the large existing base of capital, a tax on existing capital will substantially affect the overall operation of the tax, so it will be important to resolve the issue. b. the cash-flow or subtraction-method vat an alternative way to tax consumption is to tax consumption purchases at the point of sale, a system known as a retail sales tax.21 if a retailer sells a widget to a consumer for $100, the consumer has $100 of consumption. we can simply have the retailer remit $20 of taxes to the government, thereby imposing a tax on the consumption of the widget. and although it would not be remotely obvious from thinking about a retail sales tax, since it is a tax on consumption just like a cashflow tax is, it too is effectively a tax on labor income and economic profits, plus possibly existing capital depending on the transition rules. the problem with retail sales taxes is that they are relatively easy to avoid: retailers simply sell goods under the counter for cash, sharing the tax savings with their customers. a vat can be thought of as a retail sales tax designed to prevent fraud and to reduce the consequences of any fraud that remains. the way vats do this is by collecting tax at each level of production. to illustrate how a vat works, we must know more about how the widget is produced. suppose that our widget is produced in two stages. a manufacturer builds the widget using labor. its labor costs are $50. the manufacturer then sells the widget to a retailer for $70. 21 retail sales taxes, used in many states, tend to have narrow bases – for example they often exclude services – but retail sales taxes could, at least in theory, apply to the purchase of all consumption. 2017] a guide to the gop tax plan 185 the retailer sells it to the customer for $100 and in doing so, incurs labor costs of $20. table 1 summarizes these numbers. table 1 assumptions manufacturer retailer purchase price $0 $70 labor cost $50 $20 sales price $70 $100 profit $20 $10 a subtraction-method vat is a tax on the cash flow at each stage in production, except there is no deduction for wages and financial flows are ignored. the retailer has a $100 inflow and a $70 outflow (not counting wages), so the retailer has a vat base of $30. if the rate is 20%, the retailer owes $6 in tax. the manufacturer has a $70 inflow and no non-wage, nonfinancial outflows, so it has a vat base of $70 and owes taxes of $14. together, the manufacturer and retailer owe $20, which is the same amount that would be owed under a retail sales tax. therefore, a system that taxes the cash inflows of businesses and allows deductions for purchases of inputs from other businesses (in other words, a cashflow system at the business level) is equivalent to a consumption tax. a vat that measures cash flows, that is, a system that allows a deduction for purchases and an inclusion for sales, is called a “subtraction method” vat. table 2 summarizes the taxes imposed through such a system. table 2 subtraction method vat manufacturer retailer sales $70 $100 less purchases $0 $70 net $70 $30 tax at 20% $14 $6 total tax collected $20 the key difference between a retail sales tax and a vat is that if a business does not participate in the system – it refuses to pay taxes 186 columbia journal of tax law [vol.8:171 and does not claim deductions – the only tax that is lost is the tax at that level of production. for example, under a retail sales tax, if the retailer is a tax cheat and does not file tax returns, all $20 of taxes are foregone. in a vat, the government still collects taxes paid at prior levels, in this case $14. note that the system ignores financial flows. we said nothing about how the retailer or manufacturer financed their businesses, how much stock or debt they had, and so forth. we simply ignored financial flows, which means, among other things that the businesses could not deduct their interest expense. with the exception of the consumption of financial services, discussed below, there is no need to consider financial flows when measuring consumption. because the system only taxes real flows, not financial flows, it is known as an r-based tax. as we will see, consumption can also be measured by including financial flows through a system known as an r+f-based tax. european vats do not work exactly as described in the example. rather than getting a deduction for the cost of their purchases, purchasers get a credit against tax for any tax paid by the seller, under a system known as a credit invoice vat. as we know, however, credits and deductions are the same thing using different units. in a 20% tax, a $20 credit is the same as a $100 deduction. both save you $20 in taxes. going back to the example, in a credit invoice vat, the retailer would have an inflow of $100 and owe a tax of $20 but would get a credit for the $14 of tax paid by the manufacturer, so it would owe $6, exactly as in the cash-flow system. the only difference is that instead of deducting $70, the retailer gets a credit of $14; different language to describe the same thing. the reason european vats use the credit invoice system is the invoices: the retailer gets an invoice from the manufacturer stating that the manufacturer paid $14 in vat on the widget. the retailer can only claim a credit for the purchase of the widget if it gets the invoice. this generates an incentive for the retailer to demand that the manufacturer pay tax, and it creates a paper trail for audits. it also ensures that the system is what i have called “closed.” 22 purchasers only get deductions or credits when sellers have paid a tax on the sale. ensuring that the system is closed has important implications both for the scope 22 weisbach, ironing out the flat tax, supra note 5. 2017] a guide to the gop tax plan 187 of the tax base and for enforcement.23 subtraction method vats could require invoices, but proposals for subtraction method vats almost never do. c. destination v. origin basis: the treatment of crossborder purchases and sales vats around the world are, without exception, destinationbased. in a destination-based system, exports are exempt from tax and imports are taxed. in our example, under a destination-based system, if the retailer sells the widget in canada, it would not have to include the $100 cash inflow. because it does not count its $100 inflow, it has a net outflow for tax purposes of $70, so it would get a $14 rebate from the government. this rebate is known as a border adjustment and destination-based taxes are sometimes called “border adjustable” taxes. the border adjustment offsets prior taxes so that there is no net tax on the sale in canada. this means that goods sold in foreign countries are exempt from u.s. tax. in the other direction, goods produced in foreign countries and sold in the united states are subject to tax. for example, if the retailer bought the good from a canadian manufacturer, it would not get a deduction for its $70 purchase price. when it sells the widget in the united states for $100, the retailer is taxed on the full amount, so it would owe $20 in tax. this means that the tax is the same on imported goods as goods produced in the united states. in both cases, the tax is $20 on a good that ultimately sells for $100. a destination-based tax can be thought of as a tax on domestic consumption regardless of where goods are produced. if a good is produced domestically, there is a tax on the good only if it consumed domestically – border adjustments remove the tax if the good is exported. if a good is produced abroad, it is taxed if it is consumed domestically because border adjustments impose a tax when it is imported. the alternative to a destination-based system is an origin-based system. in this system, domestic producers owe tax on the sale of their goods regardless of where the sale occurs. in the example, there would be $20 of tax on the manufacture and sale of the widget even if it is 23 for example, in a closed system, purchases from tax-exempts or other non-taxpayers are not deductible while in a system that is not closed – what i termed “open” – these purchases are deductible. the tax base is different in the two cases because in a closed system, value added by non-taxpayers is eventually taxed (unless provided directly to individuals for consumption) while in an open system it is not. the brady plan is an open system. 188 columbia journal of tax law [vol.8:171 sold in canada. goods produced abroad would not be taxed when sold here. this would mean that the retailer in our example would be able to deduct the $70 costs of the widget that it imports for sale here and pay tax only on the $30 value added in the united states. an origin-based tax can be thought of as a tax on domestic production regardless of where the goods are sold. goods produced domestically bear a tax even if sold abroad. goods produced abroad do not bear a tax even if consumed domestically. a common reaction to these systems (repeated in the brady plan) is that the destination-based system is better for domestic producers. under a destination-based system, both u.s. and foreign producers face the same tax when they sell goods in the united states. for sales abroad, the tax is removed allowing u.s. producers to compete with foreign producers. with an origin-based tax, goods sold by u.s. producers in a foreign country still bear a u.s. tax. foreign producers selling in their own country do not face a u.s. tax, seemingly giving them an advantage over u.s. producers. similarly, foreign producers selling in the united states would not face a u.s. tax but competing u.s. producers would, again seeming to give foreign producers an advantage. there is, however, a long line of literature showing that this initial reaction is incorrect. rather than repeat the arguments in the literature, i refer readers to the many sources that explain it in detail.24 one intuition for the result is that in present value terms, domestic production (the base of an origin-based tax) and domestic consumption (the base of a destination-based tax) have to be equal. you can trade production today for consumption in the future (generating a trade surplus) or vice versa (generating a trade deficit) but in present value terms, trade has to balance. you can only consume what you have produced. 24 the literature on this issue is extensive, including, for example, martin s. feldstein & paul r. krugman, international trade effects of value-added taxation, in taxation in the global economy 263–282 (1990). for a recent accessible discussion, see alan j. auerbach & douglas holtz-eakin, the role of border adjustments in international taxation, american action forum research paper (2016). note that the comparison in the text is between destination-based and origin-based consumption taxes. the u.s. currently has a source-based income tax. eliminating the current source-based tax, as proposed in the brady plan, would very likely affect location decisions. 2017] a guide to the gop tax plan 189 rather than through trade balance, the equivalence is usually explained in terms of price effects, which, with floating currencies, can be achieved by a change in the relative price of the currency. a destination-based tax increases demand abroad for u.s. goods, strengthening the dollar, which then offsets any apparent advantage for u.s. producers.25 with a 20% tax rate, the dollar would increase by 25% so that an imported good that previously cost $100 now costs $80. 25 michael graetz gives the following illustration, taken from al warren: suppose that the u.s. has an origin-based vat of 10 percent with no border adjustments, and that a u.s. consumer product which costs $100 to produce will sell for $110, including the tax, whether sold in the u.s. or for export. assume that a comparable product is produced in country z and sells for 110z in the local zed currency. assume further that the exchange rate between the u.s. dollar and the z zed is $1 = 1z. finally, for simplicity assume that there are no transportation costs for shipping the products. under these conditions, consumers in the u.s. and z will choose between the two products on the assumption that they will sell for identical prices. consumers in z have the choice of buying the z product for 110z or buying the u.s. product for $110, which will require 110z. similarly, the u.s. consumers can buy either product for $110. a u.s. producer has the choice of selling in the u.s. market for $110 or exporting for 110z, which will yield $110. in either case, the u.s. product will retain $100 after payment of taxes. what will happen if the u.s. replaces its origin based vat with a destination-based vat that exempts exports and taxes imports? initially, the z product appears more expensive to u.s. consumers than the u.s. product because the z product will sell for $121 (the old price of $110 plus the new 10 percent tax) whereas the u.s. will still sell for $110. similarly, the u.s. product now looks less expensive than the z product to country z consumers, because the tax rebate means that the u.s. product can now be exported from the u.s. for $100. the u.s. producer might therefore think it has an advantage in z, where the comparable local product continues to sell for 110z. hence it is often argued that a destinationbased vat would stimulate exports and that an origin-based vat would not. now consider what happens when the u.s. and z consumers start to switch from z products to u.s. products because the latter appear less expensive. that switch would mean that there would be less demand for the z currency by u.s. nationals (who are reducing their imports of the z products) and more demand for the u.s. currency by z nationals (who are increasing their imports of the u.s. product). given this change in demand, the value of the dollar will rise relative to the zed until there is no longer any advantage to switching from z products to u.s. products, given consumer’s preferences relating to matters other than price, which preferences are independent of the tax law. in this simple example, the value of the dollar would rise until $1 could be exchanged for 1.1z. u.s. consumers would then have the choice between buying the u.s. product for $110 (including the tax) or the z product for $100 (which would be exchanged for 110z) plus the 10 percent tax on imports, for a total of $110. z consumers would have the choice between buying the z product for 110z or the u.s. product for $100, which would require 110z. similarly, u.s. producers would be indifferent between selling in z or domestically. 190 columbia journal of tax law [vol.8:171 currency effects, however, do not offset all of the differences between origin and destination-based taxes. in particular, to the extent that there are inframarginal returns, the two are not equal. again, i will leave the details to others, but destination-based systems tax any economic profits u.s. consumers earn from investments abroad (even if made through a domestic multinational corporation) and exempt economic profits that foreign consumers earn in the united states. origin-based taxes are the reverse: they tax u.s. economic profits of foreign producers and exempt foreign economic profits of u.s. producers.26 the equivalence between destination and origin-based taxes (other than for economic profits) is an article of faith for economists, and, as far as i can tell, believed by nobody else. the brady plan, for example, argues that border adjustments will help u.s. businesses compete with foreign businesses. even if you believe that the destination and origin-based systems have the same economic effects, however, there may be good reasons to prefer one over the other because they have different administrative and compliance effects. in taking into account the change in exchange rates brought about by the change in the relative prices of the u.s. and z products due to the introduction of border adjustments, the destination-based vat has no advantage over the originbased vat in terms of stimulating exports. one of the u.s. products exchanges for one of the z products in both the u.s. and country z under both taxes, and the u.s. producer earns the same amount from a sale at home and a sale abroad under either tax. michael graetz, international aspects of fundamental tax restructuring: practice or principle?, 51 u. miami l. rev. 1093–1247 (1997). 26 one intuition for this result is to think of a destination-based system as a cash-flow system for outbound investment. the border adjustments acts like a deduction for flows out of the country and a tax for flows into the country. a cash flow tax will impose a present value tax for inframarginal returns received abroad because the present value of the tax on the inflow will exceed the tax rebate on the outflow. origin-based taxes do not give the deduction on outflows and do not tax inflows so they do not tax inframarginal returns by u.s. consumers. the argument is reversed for inbound investment. although this paper focuses on implementation issues rather than revenue, distributional, or efficiency effects, it is worth noting that the two systems do not raise the same revenue if a nation imposes a consumption tax when it is either a net creditor or a net debtor. to the extent that a nation is a net debtor, it expects to export more in the future than it imports, which means that in present value terms, the origin base is larger than the destination base. in budgetary terms, which only look at a 10-year window and which do not use present values, however, a destination base may raise more money than an origin base, depending on the trade deficit or surplus during the budget window. for example, if the united states expects to run a trade deficit during the budget window, a destination-based tax will raise more revenue in that window. 2017] a guide to the gop tax plan 191 particular, many prefer a destination-based system because it eliminates the problem of transfer pricing. to illustrate why destination-based systems do not face transfer pricing problems, consider again our running example of a manufacturer and retailer but suppose, now, that the retailer is a foreign entity (so it does not bear u.s. tax). under a destination-based tax, any foreign sales are excluded. because the retailer is foreign, when the manufacturer sells to the retailer, the sale is not taxed. the price, therefore, has no effect on the manufacturer’s taxes. the manufacturer pays the same tax on the sale ($0) if the price is $0, the price is $70, or is any other value. under an origin-based tax, the manufacturer pays tax on its sale to the foreign retailer because sales abroad are taxed. the price, therefore, determines how much tax the manufacturer pays. it matters whether the price is $0 or the price is $70. if the manufacturer and retailer are not related, we can rely on the $70 price to be the true price. if the manufacturer and retailer are under common control, however, there may be an incentive to understate the price of the good when sold to the retailer to reduce u.s. taxation. if the price is $70, the manufacturer has a vat base of $70 while if the price is $0, its base is $0. (the foreign retailer would have a correspondingly higher vat base but it is not taxed by the united states because it is foreign.) therefore, origin-based systems require transfer pricing rules while destination-based systems do not. eliminating transfer pricing disputes and the accompanying the massive enforcement resources is a major advantage of a destination-based tax, and the core reason why many recent proposals have been destination-based. d. the flat tax and the x-tax destination-based vats are used through-out the developed world. we know how they work and how to implement them. if the united states were to adopt a destination-based vat, there would be few new implementation problems. we could simply pick from the best practices used in other countries. the problem with vats, however, is that they are regressive. there are a number of different ways we can measure the progressivity of a tax system. the most common way is taxes paid relative to income: we look at the tax paid as a fraction of income at each level of income. vats are regressive when measured this way because the rich consume a lower percentage of their income than the middle-class or the poor so that tax as a percentage of income goes down as income goes up. more generally, because vats are imposed at the business level, they cannot easily be sensitive to the circumstances of individual 192 columbia journal of tax law [vol.8:171 taxpayers, which means that there is no easy way to make a vat progressive. the so-called flat tax and the x-tax modify the vat to reduce, and possibly eliminate, this problem. these systems allow business to deduct wages and salaries, and tax wages and salaries to individuals. because individuals are taxed on their labor income, the tax rate can be based on each individual’s or family’s level of income (and other attributes such as mortgage and education payments, retirement savings, and charitable donations). they allow personalization of the tax and allow the tax to be progressive. (the flat tax, for reasons that are unclear other than to have a rhyming name, would limit the number of tax brackets to two. the x-tax allows the number of tax brackets to be whatever number is needed. because it is the more general of the two, i will below refer to this system as the x-tax.) recall that a consumption tax is a tax on labor earnings and economic profits (and as discussed in part iv.h., possibly existing capital on transition). if labor earnings under the x-tax are taxed at the individual level, the business tax is a tax only on economic profits and possibly existing capital on transition. that is, we can think of the x-tax as an individual-level wage tax and a business-level tax on economic profits and, possibly existing capital. the usual structure of x-tax proposals is to set the businesslevel tax rate to be the same as the highest wage tax rate (which is not what the brady plan does). for example, if the individual wage tax rates were 12%, 25%, and 33%, as in the brady plan, the business tax rate would be set at 33%. the reason is that this eliminates the incentive for high wage earners to take their labor earnings out of the business as profits rather than salary. to illustrate, consider the retailer in our running example and suppose that the owner is the only employee. the retailer has $30 of total proceeds and the owner/worker’s fair wages are $20. if both the retailer and the owner/worker are taxed at 20%, it does not matter whether the earnings are paid as salary or not. either way, there is a 20% tax on $30. if, however, the tax rate on wages and salaries was 33%, any amounts paid as salary would face this higher rate while amounts treated as business profits would face only a 20% rate. there would be an incentive to avoid paying salaries, and directing the funds to workers in other ways, such as through dividends on shares that they own. 2017] a guide to the gop tax plan 193 e. destination-based x-tax the original proposal for the x-tax was origin-based. the reason seems to be that the shift of the wage portion of the base from the business level to the individual level changes how the wto classifies the tax and, therefore, the legality of using a border adjustment. as will be discussed below, under wto law, it may be illegal to have border adjustments in an x-tax for reasons relating to how the tax is classified. wto law only allows border adjustments for “indirect” taxes, which are taxes on businesses. because the x-tax imposes the wage portion of the tax directly on individuals, it may be classified as “direct” tax, and, therefore, may not be border adjusted under the wto. given that destination and origin-based taxes have the same effect on new investment, wto rules might seem to have no economic effect, requiring one approach and disallowing another, both of which end up in the same place. therefore, given possible wto problems, it seemed to make sense to make the x-tax origin-based. as noted, however, origin-based taxes have transfer pricing problems not faced by destination-based taxes.27 destination based systems will, as a result, be easier to administer. moreover, as will be shown below, the distinction made by the wto is non-economic. the x-tax base is the same as the vat base, so it seems ridiculous to allow border adjustments only for a vat. and many countries have vats combined with wage subsidies, so the progressive portion of the wage tax that we find in an x-tax but not a vat should not change the analysis. why should the united states be forced by a treaty designed to promote trade into a tax system that is more difficult to administer and that has no trade advantages merely because it wants to make the tax progressive? based on these considerations, some believe that the wto would not in fact hold that imposing border adjustments in an x-tax is illegal. while this may be wishful thinking – legal systems rarely feel a compulsion to follow economic logic – many believe that if the united states were to adopt a cash-flow system, it should be on a destination basis because of the substantial administrative advantages of using a destination base rather than an origin base. since the early 2000’s, a number of proposals have followed this logic. for example, the bush tax reform commission studied a 27 for additional administrative problems raised by the flat tax, see weisbach, ironing out the flat tax, supra note 5. 194 columbia journal of tax law [vol.8:171 destination-based x-tax. 28 although they ultimately did not recommend this system – they favored a system much closer to the brady plan – they included an extensive discussion of a destinationbased x-tax, showing that it could be revenue and distributionally neutral. moreover, they ultimately recommended a destination-based system very close to the brady plan. similarly a very large study of tax reform in the u.k., known as the mirrlees review carefully studied a destination-based x-tax, and the chapter on the design of corporate taxation recommended this system (although the review as a whole recommended an origin-based system known as an ace, which has effects but operates differently than the x-tax).29 f. the growth and investment tax plan the last step toward the brady plan is the proposal put forth by the bush tax reform commission called the growth and investment tax plan.30 this plan is a destination-based x-tax with the addition of a flat 15% tax rate on interest, dividends, and capital gains at the individual level.31 28 the president’s advisory panel on federal tax reform, supra note 3. the first proposal for this system seems to be stephen roy bond & michael devereux, cash flow taxes in an open economy (2002), http://econpapers.repec.org/paper/cprceprdp/3401.htm (last visited dec 22, 2016). note that the terminology can get confusing because different taxes are often given the same label. in particular, many different systems are called a “destinationbased cash-flow tax.” this description could include a cash-flow vat (i.e., with no deduction for wages or salaries, ignoring cash flows on financial instruments), an x-tax (i.e., a cash-flow vat with a deduction for wages and salaries) and what i will call an r+f cash flow tax. 29 alan j. auerbach, michael p. devereux & helen simpson, taxing corporate income, in mirrlees review, reforming the tax system for the 21st century (2008); james mirrlees et al., tax by design (2011). other studies include michael p. devereux & peter birch sørensen, the corporate income tax: international trends and options for fundamental reform, eur. commission, http://ec.europa.eu/economy_finance/publications/pages/publication530_en.pdf [perma.cc/wsg7-jj74]; michael devereux, issues in the design of taxes on corporate profit, 65 natl. tax j. 709–30 (2012); michael devereux, rita de la feria et al., designing and implementing a destination-based corporate tax, (oxford u. ctr. for bus. tax’n, working paper no. 14/07, 2014); alan j. auerbach, a modern corporate tax (2010); alan j. auerbach & michael p. devereux, consumption and cash-flow taxes in an international setting (nber working paper no. 19579, 2013). 30 the president’s advisory panel on federal tax reform, supra note 3. 31 as noted, the plan also includes a benefit for mortgage interest and the purchase of health care, retirement savings provisions, and a deduction for charitable donations. none of these are in the basic versions of the x-tax. 2017] a guide to the gop tax plan 195 although the reasons for this addition to the destination-based x-tax are not made explicit, it seems that the panel members were concerned about appearances. they showed in their study of the xtax that, properly structured, the x-tax can be revenue and distributionally neutral. nevertheless, even if it is distributionally neutral, it would still allow the very wealthy to pay few, if any, explicit taxes to the government. someone who lived purely off an inheritance would receive no wage income and, therefore, would not have to remit any taxes. while such a person would bear taxes because taxes would be embedded in the price of goods that he purchased and because he may bear a large transition tax, many might view this result as unseemly, particularly in light of concerns about the growth of inequality. as we will see when considering the implementation of the brady plan, it will be difficult to make the combination of an x-tax and a flat rate tax on capital at the individual level work. a tax on capital income has to tax the current return to investments. current law allows some deferral because it waits to impose tax until income has been realized, but it also has a large number of provisions designed to limit deferral. one of the most important anti-deferral mechanisms in current law is the corporate income tax. if an individual buys stock, he is not taxed until dividends are paid or he sells the stock, creating the potential for deferral. the corporate income tax, however, taxes the current returns to the investment, thereby reducing or eliminating the deferral. if businesses are taxed on a cash-flow basis, they allow deferral by design: because businesses deduct the cost of investments, the returns to investment are not taxed. keeping money in a business, therefore, gives indefinite deferral. the mere purchase of a share of stock becomes a tax shelter. g. the brady plan at this point, the connection to the brady plan should be clear: the brady plan is the growth and investment tax plan with minor modifications (plus, as was mentioned, there are some statements in the brady plan which are inconsistent with this approach but it is not clear what to make of them). it is time, therefore, to consider the implementation of the brady plan. iv. issues and problems with the brady plan the discussion above shows that the brady plan is based on a long history of thought and research on consumption taxes. even the purest of these systems has a number of problems, however. moreover, parts of the brady plan seem potentially inconsistent with 196 columbia journal of tax law [vol.8:171 these systems, and most if not all of these inconsistencies generate yet additional problems. in the sections that follow, i discuss the eight most central implementation problems that i see in the brady plan. there are likely many other issues that will also have to be resolved as the legislation moves forward. a. design of the business tax as noted, there are a number of statements in the description of the business-level tax that seem inconsistent with the basic structure of an r-based cash-flow tax. if these statements are inadvertent, they should be fixed. if they are not inadvertent, for the most part they are bad choices and should be reconsidered. inconsistent expensing there are a number of statements that indicate that the plan would not truly be a cash-flow tax. the two most prominent are (1) the explicit statement that purchases of land would not be expensed and (2) the statement that the lifo inventory method would be retained. in a cash-flow system, all non-financial outflows are deductible, including purchases of land and purchases of inventory. it makes no sense to deny deductions for purchase of land and of inventory while allowing a deduction for the purchase of other capital items. if some purchases are taxed on a cash-flow basis and others are taxed on a traditional income tax basis, the effective tax rate on different types of investments will be different. for example, if land is taxed on a traditional income tax basis but machines and buildings are taxed on a cash-flow basis, the effective tax rate on land will be higher than on machines or buildings. this will distort investment patterns and make the tax less efficient. moreover, even if there were a reason for introducing this distortion into the system, it would make the system more complex. one of the great virtues of a cash-flow system is its simplicity. businesses do not need to use complex income tax accounting systems such as lifo, fifo, capitalization rules, or accrual concepts like economic performance. instead, for tax purposes, businesses just deduct cash outlays and include cash inflows. retaining income tax treatment for some investments means retaining most and possibly all of the income tax accounting rules, foregoing one of the major benefits of a cash-flow system.32 moreover, it requires rules to distinguish investments in land from related investments: taxpayers making a joint 32 businesses, however, would likely have to continue to use income accounting for book purposes. 2017] a guide to the gop tax plan 197 purchase of land and improvements have an incentive to allocate the purchase price to the improvements (while sellers would be indifferent). although the statements about inventory accounting and the treatment of land are explicit, in other parts of the plan, the corporate tax is described as a cash-flow tax. i cannot think of a reason for keeping land and inventory on a traditional income tax system while putting machines and other capital expenses on a cash-flow system.33 therefore, i take these statements to be mistakes, and they should be fixed. an alternative reading of the plan is that it is, like current law, a hybrid income-consumption tax system, only shifted more toward the consumption end of the spectrum. the plan might be read as allowing (very) accelerated depreciation and as making an attempt to equalize the treatment of debt and equity. the tax would, for the most part, be an income tax, and the implementation issues with a corporate income tax are well-known. note, however, that if the plan is to keep the corporate tax as an income tax, it is extremely unlikely that the tax could be destination-based because it would almost surely be inconsistent with the wto. given the various descriptions in the plan as a cash-flow tax and the centrality of border adjustments to the plan, in the remainder of the paper, i will assume that the plan would impose a cash-flow tax on corporations. if instead, the plan merely is an income tax with (very) accelerated depreciation for depreciable investments, most of current law would remain. inconsistent treatment of financial instruments separately, there are a number of statements in the plan that indicate that the business-tax portion of the system might not fully ignore financial flows. the draft plan states that net interest expense is not deductible and that any nondeductible interest expense may be carried forward to be used against interest income in a future year. that combined with nothing in the plan indicating that interest and other financial income, such as dividends, gains (and losses) on derivative financial instruments and gains from the sale of stock are exempt creates a strong inference that financial income is taxed. moreover, it does not seem that financial income is taxed on a cash 33 my only guess as to the reason for the apparent treatment of land and inventory is that the drafters of the brady plan viewed expensing as simply accelerated depreciation so that only purchases that were otherwise depreciable would get expensing. this is not the right way to view expensing in a cash-flow system. instead, all non-financial cash flows should be deductible. 198 columbia journal of tax law [vol.8:171 flow basis, so it seems that financial income is taxed under the usual income tax rules. this approach generates a host of problems. earnings on financial investments would be taxed on an income basis while earnings on physical or intangible investments are taxed on a consumption basis. for example, if you invest $100 in a machine that produces $110 in one year, the $10 return is effectively untaxed, as discussed above. if instead you lend the $100 to someone who invests it in the machine and who then pays you $10 of interest in one year, the $10 is taxed.34 the tax base is income when transactions are financed through lending, and the tax base is cash-flow when done directly. there seems to be no reason for disparity, and it may significantly distort how investments are structured. denying deductions for net interest expense while taxing net interest income may also generate problems, particularly for firms that have loans between subsidiaries. if internal capital structures are set up so that interest income exceeds interest expense, the firm would have a tax on purely internal flows. for example, suppose a parent firm is capitalized with $50 of equity and $50 of debt, with the debt instrument paying a 10% rate of return. the parent capitalizes its subsidiary with, say, $30 of equity and $70 of debt for good business reasons. if the subsidiary’s debt also pays an interest rate of 10%, the parent would have, $2 more interest income than interest expense, and would owe tax on this amount. consolidated filing may reduce this problem somewhat, but not all capital structures allow consolidation of all subsidiaries, so the problem will inevitably remain. under current law, corporations are allowed dividends received deduction to eliminate this cascading. there is no indication in the plan, however, that there would be a corresponding interest received deduction. moreover, denying deductions for interest expense but not expenses and losses on other financial instruments creates administrative complexity and incentives to use other financial instruments rather than debt. for example, lease payments will be deductible but equivalent interest payments will not be, creating incentives to lease rather than to own. similar problems will arise with respect to swaps, futures and forward contracts which have embedded time-value of money aspects. to some extent current law faces this 34 note that the borrower’s investment in the machine would be taxed on a cash-flow, so it is effectively untaxed. the borrower would also be denied a deduction for its interest expense. the borrower, in present value terms, therefore, bears no tax and has no deductible expenses. the only net tax on the transaction is the lender’s interest income. 2017] a guide to the gop tax plan 199 problem, and the response is a host of complex rules designed to classify payments as interest or not. all of these rules and likely many more would be needed under the approach of the brady plan because the disparity between interest expense and other expenses will be much more significant than under current law. finally, the taxation of financial flows on an income tax basis is incredibly complex. the current rules for taxing financial instruments are among the most complex and difficult to understand sets of rules in current law. these rules would have to be retained if financial instruments continue to be taxed on an income-tax basis. the plan should take an approach to financial flows that is consistent with the consumption tax approach otherwise used in the plan. the standard approach in cash-flow systems is to ignore financial flows. this generates some problems with respect to the taxation of banks and other financial institutions but otherwise works reasonably well in a large number of tax systems used throughout the world. (i defer the discussion of the taxation of financial institutions to part iv.d.) pass-throughs the brady plan would retain the pass-through regimes of current law but tax active income of pass-throughs at a maximum rate of 25%. it is a mistake to retain the pass-through regimes of current law and, with perhaps an exception for small, sole proprietorships, they should be repealed. instead, all businesses should be taxed the same way. doing so reduces economic distortions and, simultaneously, would simplify the law. to see why, compare the taxation under the brady plan of equivalent investments made, alternatively, through a corporation and through a partnership. suppose that an individual has $100 and can purchase a machine or other asset that costs $100 and returns $110 in one year. if the individual makes the investment through a corporation, the corporation deducts the $100 and includes the $110 and pays no present value tax. when the $110 is distributed, the owner has a $10 dividend and a $100 return of capital,35 and pays a $1.65 tax on the dividend. suppose instead that the individual makes the same investment through a partnership. in this case, the cash flows are attributed to the individual via the normal partnership allocation rules. the individual 35 see part iv.e. for a discussion of the determination of which portion of a distribution is a dividend and which is a return of capital when corporations are taxed under a cash-flow system. 200 columbia journal of tax law [vol.8:171 deducts and includes the $100 expense and $110 return at a 25% rate and bears no present value tax. there is no separate tax on distributions from the partnership. the net result is that the brady plan would retain the current law system in which investments in corporations are taxed at a higher rate than identical investments in partnerships and other pass-through entities. it creates an incentive to avoid using the corporate form. that current law favors partnerships over corporations is a flaw not a feature to be retained. the distortions in investment patterns because of the preference for partnerships over corporations in current law is one of the reasons for the numerous proposals for corporate integration. among other things, these proposals seek to reduce the distinction between the taxation of partnership investments and corporate investments under our current income tax.36 the benefits of reducing the differences in taxation between different business entities would similarly arise under the brady plan. most corporate integration proposals, however, would retain the current system of having separate regimes for partnerships and corporations rather than unifying them in a single business tax regime. although often not clear exactly why this approach is favored, it seems to be that the partnership regime is thought to be superior in theory but too complex to apply in the large, publicly traded corporation context. the partnership system is superior because it taxes partnership income at the owner’s rates while even the most sophisticated corporate integration systems can only approximate this. with the exception of inframarginal returns, the pass-through system under the brady plan does not achieve this goal (and even for inframarginal returns, it does not get it exactly right).37 regardless of the investor’s marginal tax rate on capital income, partnership flows (other than inframarginal returns) are taxed at a zero rate while other capital income of the owner is taxed at a positive rate. a pass-through regime under the brady plan fails the basic reason for having a pass through regime. 36 for example, dep’t of the treasury, integration of the individual and corporate tax systems, taxing business income once (1992); and a.l.i., federal income tax project: integration of the individual and corporate income taxes, reporter’s study of corporate tax integration (1993). 37 inframarginal returns of a partnership will be taxed at the lesser of the partner’s rate and 25%. for partners whose tax rate is below 25% (such as taxexempt investors), the partnership regime taxes them at that rate. for partners whose rate is above 25%, the partnership regime does not tax inframarginal returns at their tax rate. 2017] a guide to the gop tax plan 201 at the same time that they fail to achieve their only plausible economic goal, pass-through regimes introduce significant complexity. retaining the pass-through system means retaining the baroque rules of subchapter k, the rules for subchapter s, and adding additional rules to distinguish active earnings of a pass-through (eligible for the 25% rate) and passive earnings of a pass-through (not eligible for the 25% rate). the solution is to repeal the pass-through regimes and to have a business tax regime which applies to all business operations. all business returns would be taxed the same way: normal returns would be taxed at a 0% rate at the business level and the shareholder’s rate when distributed; inframarginal returns would be taxed at a 20% rate and the shareholder’s rate when distributed. there would be no need for the complex partnership tax rules or for other types of separate systems.38 the only exception is that it may be desirable to have a simple pass-through system for small, informal businesses such as sole proprietorships. if i am otherwise a wage earner but cut some lawns on the side for extra money, at what point does my lawn mowing business have to be treated as a separate business? a simplified regime for small, closely-held businesses (i.e., one owner or maybe family ownership) would allow small business owners to report earnings on their personal return rather than having to file a separate return. losses the brady plan allows net operating losses to be carried forward with interest. if the interest rate used for loss carryforwards is equal to the market rate, this system will have the same present value effect as refundability, but perhaps with a lower potential for fraud. one problem with this approach is that businesses that consistently have tax losses (but have economic gains) will not be able to use their losses, possibly indefinitely. for example, corporations that produce in the united states but sell abroad will consistently have tax losses because foreign sales are not taxed but their production expenses are deductible. they can be wildly profitable but still have legitimate tax losses under a destination-based system. 38 the only argument i can think of for retaining the partnership and other pass-through regimes (other than for small, sole proprietorships) is to tax inframarginal returns of low-bracket investors like tax-exempt entities, at a low rate. this does not seem compelling because these returns are, by definition, above-market returns. moreover, even if it were a desirable goal, it would have to be weighed against the considerations in the text. 202 columbia journal of tax law [vol.8:171 to illustrate, consider the retailer in our running example. it purchases the widget for $70, incurs $20 of labor costs, and sells the widget for $100, making a $10 profit. suppose that it sells the widget in canada. because the sale is foreign, the $100 sales proceeds would not be taxed. the retailer would have a $70 deductible expense for the widget,39 and a $20 wage deduction, but no income. it would have a $90 loss that it cannot use. if its business model is to sell widgets in canada, it will never have taxable receipts to use against this loss. vats are typically refundable, which means that if a corporation has net losses, the government makes a cash payment to the corporation equal to the tax rate multiplied by the loss (20% of $90 or $18 in our example). vats can do this in part because they use an invoice system to track tax payments. the invoice system makes it more difficult to claim a loss without actually incurring one because the taxpayers cannot claim credits (the equivalent of a deduction in a cash-flow system) unless they have an invoice showing taxes were paid by their suppliers. that invoice allows the government to audit the suppliers. fraud is not impossible in this system – there is a business of creating fraudulent invoices – but it is more difficult. x-tax type plans, including the brady plan, tend not to use the invoice system used in vats which means that refundability is more difficult to administer. the likelihood of fraud may be too high to allow refunds for losses.40 a recent treasury study tried to estimate the extent to which firms in a cash flow tax would have losses that they cannot use for long periods of time.41 they looked at firms in the ten-year period from 2004-2013. those firms under the income tax had unused losses equal to 18% of the corporate base. (the percentage is high because the period includes the great recession.) had those firms been taxed during the same period under a destination-based cash-flow tax, unused losses would have been approximately 24% of tax base. unused losses go up by about one-third. to the extent that losses cannot be used, the tax system will distort corporate ownership patterns, creating incentives for noneconomic conglomeration. that is, combining an exporting (or other loss producing business) with a business that has net receipts will allow 39 assuming the treatment of inventory purchases is fixed. 40 for example, carroll and viard, supra note 16, at 78–80, argue that without invoices, an x-tax should not allow refunds. 41 patel & mcclelland, supra note 4. 2017] a guide to the gop tax plan 203 the losses to be used against those receipts. profit-making businesses with large, unused tax losses will become takeover targets. one possible, although limited change that might reduce the problem is to allow losses to be carried back as well as forward. another is to expand the rules for consolidation, by, for example, allowing firms to consolidate with a greater than 50% ownership interest rather than an 80% interest.42 broader consolidation will make it easier for companies generating gains to consolidate with companies generating losses so that the losses can be used. yet another is to allow losses to be used against payroll tax liability. if these changes are insufficient and there are a substantial number of businesses that consistently generate losses, an invoice system like that used in creditinvoice vats should be considered so that losses can be refunded.43 b. tax rates tax rates are of central importance in any tax system. they effect the total revenue raised, the distributional and efficiency effects of the tax system, and tax administration. estimating the total revenue raised and the distributional impacts requires a large model, and i leave that to others. i will focus here on the efficiency considerations for setting the corporate rate and how the corporate rate and individual tax rates relate to one other. a headline of the brady plan is that the corporate rate is reduced from 35% to 20%. lowering the corporate tax rate is thought to be desirable because the u.s. corporate rate is among the highest in the world. u.s. businesses are thought to be at a disadvantage relative to competitors due to this rate, and the recent spate of inversions is possibly in response to the high u.s. corporate tax rate. there is broad support for lowering the corporate tax rate, and the brady plan fulfills this need, in spades. one of the reasons for adopting a destination-based cash-flow consumption tax, however, is that it eliminates the need to lower corporate tax rates in response to international competition.44 the reason is that the tax base is domestic consumption. the tax rate does not affect the location of production, where corporations make their home, or where profits are located, because regardless of these choices, the tax is the same. it depends only on where consumption takes place. the central reason for a lower corporate tax rate is solved in the brady 42 carroll and viard, supra note 16, at 79. 43 invoice systems have a number of other important features that are explored in weisbach, ironing out the flat tax, supra note 5. 44 for additional detail, see auerbach and devereux, supra note 29. 204 columbia journal of tax law [vol.8:171 plan by structural changes. there is, therefore, no reason to lower the tax rate to prevent corporations from relocating or because u.s. corporations face international competition from lower-taxed companies.45 another, independent, reason for lowering corporate tax rates is to encourage investment. leaving aside international competitiveness (i.e., suppose the united states were a closed economy so that only domestic investment mattered), high tax rates on corporate income may make many otherwise profitable investments unwise. lowering the corporate income tax rate improves the efficiency of corporate investments. while this argument might be important in an income tax, it does not apply to a consumption tax. the tax rate on marginal investment is zero in a cash-flow system. there is, therefore, no reason to lower the rate to promote new investment. rather than setting the corporate rate based on competitiveness or investment considerations, there are three much more modest efficiency considerations that need to be taken into account when setting the corporate rate. the first is that a lower rate will reduce the size of the required currency price adjustments and the costs to firms if the adjustments are not complete and quick. that is, a low corporate rate might alleviate the concerns many importing firms have about the required currency price adjustments. second, and offsetting this, we may want a higher rate on economic profits. taxes on economic profits are to a great extent nondistortive and, in some models, desirable. third, the tax rate affects the size of the transition tax, if any. although the effects depend on the transition rules, in general, a higher tax rate means a higher tax on existing capital on transition. aside from these economic considerations, there are administrative reasons for setting the rate because of how it interacts with the tax on labor income and creates incentives to recharacterize income. in a pure x-tax, the corporate rate is normally proposed to be set equal to the highest tax rate on labor income. if the corporate rate is lower than the tax rate on labor earnings, there is an incentive to pay low salaries and to take the money out as corporate earnings. setting 45 because the corporate tax applies to domestic consumption, it could affect the location of consumption. the effects, however, will likely be very small. in particular, there may be an incentive to purchase and consume mobile and expensive items such as yachts and planes abroad to avoid a high u.s. tax, but it is not clear we should want to lower tax rates for all purchases because of these items. 2017] a guide to the gop tax plan 205 the corporate tax rate equal to the marginal rate on labor income eliminates the benefit of recharacterizing wages as corporate earnings. because the brady plan has the additional tax on dividend income, however, equalizing the rates may no longer be desirable for preventing recharacterization of earnings. instead, setting the corporate rate below the highest wage rate may be the right strategy. in particular, (1) conditional on deciding that we want a tax on dividends and other capital income at half of the rate applicable to wages and salaries, and (2) given that the corporate tax rate itself has few economic effects (as just argued), then (3) we might want to set the corporate rate to eliminate the incentive to recharacterize earnings as either salary or as dividends, which means (4) because of the tax on dividends, the corporate rate that achieves this goal will be below the tax rate on wages and salaries. to illustrate, suppose that the brady plan rate structure followed the standard x-tax approach and set the tax rate on corporate cash flow equal to the highest marginal tax rate on wages: the wage rate and corporate tax rate are both 33% and the tax rate on dividends is half of that or 16.5%. suppose that a worker-owned corporation has a $100 receipt which it wants to distribute. because the worker and the owner are the same, the money can equally be distributed as salary or as a dividend. if the corporation pays the $100 as salary, the owner pays $33 in tax, leaving him with $67. if it pays the money as a dividend, the corporation would owe $33 in tax and the owner would pay an additional $11.06 in dividend taxes for a total of $44.06 in taxes, leaving the owner with $54.04, which is less than if the money were paid as salary. there would be an incentive to pay out earnings as salary. a 20% corporate rate, as in the brady plan, eliminates this incentive. if the corporation were to pay out the $100 as earnings, it would owe $20 in tax and the owner would pay an additional $13.20 in tax due to the 16.5% rate on dividends, leaving him with $66.80, which is effectively the same as if the earnings were paid out as salary. the relative rates in the brady plan, therefore, are set consistently with the goal of eliminating the incentive to recharacterize earnings. the major problem with the relative tax rates in the brady plan is the special cap on tax rates for pass-through entities. as argued above, the best approach would be to eliminate the pass-through regime, but if it is to be retained, the tax rate cap should be eliminated. the reason is that the tax rate cap for pass-throughs creates obvious avoidance opportunities (and has no efficiency benefits). 206 columbia journal of tax law [vol.8:171 in particular, the tax rate cap for pass-through income creates an incentive to recharacterize wage and salary income as pass-through income. owners of pass-through entities could do so by paying a below-market salary (taxed at 33%) and increasing the entity’s earnings (taxed at 25%). moreover, individuals who work for corporations could form pass-through entities which provide services to their employers in exchange for fees rather than having their employers pay them wages or salaries. to the extent the fees can be characterized as pass-through income rather than wages or salaries, they will be taxed at a 25% rate rather than 33% rate. to prevent this avoidance, the plan would require pass-through entities to pay reasonable compensation but this rule may be difficult to enforce. abolishing the special rate will have few if any effects on investment but will eliminate incentive to recharacterize cash flows. if both pass-through earnings and salary are taxed at a 33% rate, it will not matter whether a cash flow is characterized as earnings or salary. there would be no need for the reasonable compensation rule and no need to incur the expense of futilely attempting to enforce it. c. international issues international taxation has the potential to be far simpler under a destination-based consumption tax than under an income tax. the tax base under a destination-based consumption is domestic consumption. although not always straightforward, this concept is relatively well understood and has economic meaning. it can be identified by the physical location of the individual engaging in the consumption. the tax base in an income tax is either worldwide income, income earned in a given territory, or a mix of the two. the u.s. system, for example, might loosely be characterized as based on worldwide passive income and repatriated worldwide active income. the location of income (and related expenses), however, is not well defined. there is no underlying economic reality. as a result, the rules can be manipulated both through actual transactions and through relabeling items. capital is highly mobile and can be packaged in an almost infinite variety of investment vehicles to exploit the rules. the rules are then made more complex to combat the avoidance, leading to yet additional more sophisticated avoidance. moreover, if different countries have different rules, taxpayers can take advantage of the differences. even if we could define the location of income and even if countries agreed on the definition, the tax base has to be coordinated with other countries who may also claim to tax those same returns. for 2017] a guide to the gop tax plan 207 example, both the location where production takes place, the source country, and the location where the owner lives, the residence country, may want to tax the same income. the end result of all this is a byzantine tax system and very wealthy tax planners. although it is surely the case that our current tax rules for international income can be improved, i do not think that any set of rules within an income tax would be simple and effective. the underlying concepts are ill-defined, and mobile capital makes it easy to exploit any problems. one of the main benefits of the brady plan is its potential to simplify the international tax rules.46 nevertheless, the international tax aspects of the plan, particularly border adjustments, have more attention than almost any other aspect. below i examine the problem of border adjustments and then turn to other international tax issues. border adjustments recall that the brady plan includes border adjustments. exports are not taxed, which means that an exporter will have domestic costs but no taxable cash flow on its sales, generating a net loss. in our running example, if the retailer purchases the good for $70 and sells it abroad for $100, it does not include the $100 but may deduct the $70, generating $14 of tax savings. this $14 of tax savings is the border adjustment. imports are not deductible. importers will have taxable receipts when they sell their imports in the united states but will not have deductible costs, which means that the full value of goods when imported will be taxed. if the retailer imported the good for $70 and sold it in the united states for $100, it would not be able to deduct the $70 but would be taxed on the $100. for the moment, leaving aside the wage deduction and wage tax (which offset) the importer would owe $20, consisting of the $6 tax on the value it added in the united states and the $14 tax on the value of the good when imported. the $14 tax on import is the border adjustment on import. that is border adjustments are the $14 rebate on export for costs incurred in the united states and the $14 tax on import for value added abroad. 46 note, however, that as discussed in part iv.a., the brady plan seems to retain many elements of an income tax (possibly inadvertently). if these elements are part of the final legislation, many of the current law rules for taxation of international income would also have to be retained. the vast simplification of international tax rules that comes with a consumption base requires consistent use of a consumption base. 208 columbia journal of tax law [vol.8:171 as noted, economists believe that in equilibrium, a destinationbased system (i.e., a system with border adjustments) and an originbased system (one without border adjustments) are equivalent except for how they tax inframarginal returns and on transition. as a result, notwithstanding much of the rhetoric surrounding border adjustments, a decision to have border adjustments should be made based on administrative considerations rather than a belief that one system or the other promotes u.s. businesses relative to foreign businesses.47 to understand the administrative considerations, i list below the benefits and costs of having border adjustments. after going through the costs and benefits, i provide an overall evaluation. the key benefit to border adjustments is that they reduce or even eliminate the transfer pricing problems of current law and that an origin-based consumption tax would face. if the manufacturer in our running example sells the widget to a foreign retailer in an origin-based system, the sales price determines how much tax the manufacturer owes. if the manufacturer sells the widget to the retailer for $50 (when its fair market value was $70), it eliminates $20 from its tax base. if the manufacturer and the retailer are commonly owned, there is no economic cost to lowering the price, generating the transfer pricing problem. with a destination-based system, the sale to the foreign retailer is not taxed regardless of the price, so there is no transfer pricing problem. a similar logic holds for imports: in an origin-based system, raising the price of an import reduces the u.s. tax base while in a destination-based system, it has no effect. eliminating transfer pricing problems is a substantial benefit. recent estimates are that by 2012, the united states was losing between $77 and $110 billion annually due to transfer pricing manipulation.48 this is a large sum by any measure. moreover, it does not include the planning costs, such as paying lawyers, accountants, and bankers, and the economic distortions, such as the costs of relocating capital or individuals to increase the likelihood that transfer prices will be respected. 47 if the united states is a net importer during the 10-year budget window, as is expected, border adjustments will be scored as raising revenue. although i have not seen any official revenue estimates, i understand that this revenue is being used to pay for other aspects of the plan. note, however, that to the extent that border adjustments are imposed at a time when the united states has a trade deficit, they lose rather than raise money in present value terms. any claim that border adjustments raise money is due to an artifact in the scoring rules. 48 kimberly a. clausing, the effect of profit shifting on the corporate tax base in the united states and beyond, 69 nat’l tax j. 905, 905-34 (2016). 2017] a guide to the gop tax plan 209 a second potential benefit of border adjustments is that they eliminate the incentives seen in origin-based systems for tax competition. in particular, in an origin-based system, countries have an incentive to lower tax rates to attract businesses that have mobile, source-based, inframarginal returns. this incentive goes away with a destination-based tax because the location of production has no effect on the level of the tax. there are three key of costs of a destination-based system. the first, which is unique to an x-tax structure like the brady plan, is that border adjustments under such a structure may be contrary to wto law. the problem can be thought of as one of substance versus form. if the income tax elements of the corporate tax discussed above, such as the non-deductibility of land and inventory are eliminated, the substance of the brady plan with border adjustments is entirely consistent with wto law.49 it is effectively the same as destinationbased tax systems used throughout the world. the form, however, may be inconsistent with wto law. the legal question is whether a wto panel would follow the substance or the form of the law. the “form” problem is that under the wto subsidies and countervailing measures agreement, a tax can be border adjustable only if it is an “indirect” tax and not if it is a “direct” tax. a direct tax is a tax on “wages, profits, interests, rents, royalties, and all other forms of income.” an indirect tax includes a vat and all taxes other than direct tax. moreover, border adjustments for an indirect tax are allowed only if they do not exceed the amount of indirect tax levied on like products when sold for domestic consumption. i interpret this latter requirement as a requirement that border adjustments are accurate: rebates on exports cannot exceed previously imposed taxes and taxes on imports cannot exceed taxes that would be imposed domestically. the brady plan and similar plans like the x-tax, look like a vat, which is an indirect tax, except that they have a deduction for wages at the business level and tax wages to individuals. the question is whether this treatment of wages makes the brady plan a direct tax. there seems to be little or no jurisprudence giving further meaning to these terms, and there are no tax systems like the brady plan or the xtax to use as a comparison. many commentators, however, believe that the best reading of these terms is that the brady plan would be a direct tax, ineligible for border adjustments. 49 if these elements are retained, it is hard to see how border adjustments would be consistent with the wto. 210 columbia journal of tax law [vol.8:171 one reason why commentators believe that the brady plan would be a direct tax is that because of the wage deduction, border adjustments would be inaccurate. they could exceed the indirect tax levied on like products when sold domestically. although the accuracy requirement is distinct from the “indirect” requirement, the two are likely related: the inaccuracy of the border adjustments arises because the tax is not purely at the business level. to illustrate why border adjustments would be inaccurate, consider our retailer who sells the widget for $100 to a foreign consumer. the retailer deducts $70 and gets a rebate of $14. the manufacturer that sold the good to the retailer, however, has a tax base of only $20: it has $70 of receipts and $50 of labor costs. it pays a tax of $4. the $50 of labor costs are taxed to the wage earners. the wage earners, however, do not necessary pay $10 in tax. depending on their rates, they may pay more than that or less. if they pay less, the retailer’s border adjustment of $14 exceeds the taxes paid at prior levels of production. moreover, because only indirect taxes count when computing accuracy, and because the wage tax is not an indirect tax, there has only been a $4 indirect tax on the good even though the rebate is $14, clearly violating the accuracy requirement. this argument, however, is purely formal rather than substantive because we can just change the labels without changing the tax that is levied and make the system unquestionably legal. suppose that instead of giving businesses a deduction for wages and salaries and taxing workers on their wages and salaries, we instead imposed a normal vat, with no deduction for wages. wage income would then be taxed at the flat vat rate rather than the desired progressive rates. this vat could clearly be border adjustable because it is an indirect tax and the border adjustment would be accurate. to make the taxation of wage income progressive, we can add a tax credit for low-income workers which offsets the vat in the desired amounts, and, for high-income workers (if their marginal tax rate on wages exceeds the vat rate), impose a tax on those wages to make up the difference. for example, if the vat rate is 20% and we want high-wage earners to pay 33%, we could impose a tax rate of 16.25% on their wages. the corporation would pay them $80 after paying the 20% tax. a 16.25% tax on the $80 of wages would be $13, so the total tax would be $33, or 33% as desired. similarly, we could offer low-wage workers a credit, such as an expanded earned income tax credit or an offset to payroll taxes, to give them the required combined tax rate. this labor income tax/credit system would be 2017] a guide to the gop tax plan 211 entirely separate from the vat. it would, therefore, not affect the border-adjustability of the vat. it is simply a separate, progressive wage tax. this is how european systems work. they have flat rate, border-adjustable vats and separate progressive income taxes. under the x-tax and the brady plan, the two systems are combined because of the wage deduction at the business level and matching inclusion to workers. it is only because the two system are combined that there is an issue of wto legality, but this is a mere formality rather than a substantive difference. the question, therefore, is whether the substance of the brady plan should prevail or its form. i am not sufficiently expert in wto jurisprudence to have a view on the likelihood of success. some authors conclude that the border adjustments would not be allowed under the wto rules, but these authors rely on the formal structure of the plan.50 to get a sense of the risks, it would be nice to have a better understanding of whether, and when, the wto is able to look at the substance of a law rather than its formal rules. there is nothing in the brady plan that violates the substantive goals of the wto. rather than confronting the wto and having to make legal arguments about substance versus form, we could simply adopt the vat/wage tax structure suggested above. for reasons that are unclear to me, however, actually adopting a vat seems to be politically untenable even though, a just demonstrated, there is no economic difference between what is going proposed in the brady plan and the modification just described. an alternative is to modify the labels in the brady plan to increase the likelihood of compliance while not formally adopting a vat. for example, we could retain the current structure but require wage withholding at the corporate rate, rather than setting wage withholding based on each individual’s tax rate. in our example, if wage withholding were mandatory and always at a 20% rate, the manufacturer in the example would have remitted $14 in tax, so the retailer’s rebate will match tax remittance at prior levels of production. in effect, corporations would be required to remit as taxes the same amount that they would remit under a vat, without exception. the 50 avi-yonah & clausing, supra note 4. 212 columbia journal of tax law [vol.8:171 only difference is that a portion of the remittance is called a withholding tax rather than a corporate tax.51 the second cost of border adjustments is the cost of uncertainty about currency adjustments. recall that the switch from current law to a destination-based system requires the dollar to appreciate. consider for example, an importer who currently buys goods from abroad for $95 and sells them domestically for $100, making a $5 profit. under current law, it can offset the $95 of costs against its $100 receipts and pay tax on the net. if the tax rate is 20%, the importer is left with $4. with a destination-based system, it would not be able to deduct the $95 cost of import and it would owe $20 of tax on its $100 receipt. if nothing changed, the tax would greatly exceed its profits. the expectation is that the dollar would appreciate. with a 20% tax rate, the dollar would appreciate by 25%, so that the importer could purchase the good for $76. if this happens, the importer would have $100 in receipts, pay a $20 tax and be left with a $4 after-tax profit. if this happens completely and quickly, nobody would be worse for the wear. the concern is that this will not happen quickly enough or completely. importers are reluctant to rely on economic models when their entire business is at stake. we have more than economic models, however, to give us confidence that the currency adjustments would, in fact, occur. every vat in the world relies on these currency adjustments. if they did not occur, importers in countries with vats would face exactly the same problem that importers are worried about with the brady plan. there are good reasons to be confident in the currency adjustments. the real issue is transition. if the adjustments are slow or uneven, importers could be hurt. while the currency market is deep and liquid, so that one would expect the overall adjustments to be fast, some countries have their currencies pegged to the dollar or attempt to manage their currencies relative to the dollar. these countries would have to repeg or change their dollar targets. this might not happen 51 one cost of this approach is that withholding will be too high for lowincome workers. to the extent these workers may be cash constrained, withholding at too high a rate may not be viable. fixing this problem could be done by reducing withholding for payroll taxes or allowing an advance rebate implemented through debit cards. michael graetz considered both in his tax proposal. michael j. graetz, 100 million unnecessary returns: a simple, fair, and competitive tax plan for the united states (2008). 2017] a guide to the gop tax plan 213 instantly.52 moreover, oil is traded in dollars, so currency adjustments will not affect the relative price of oil. because i view the problem of currency adjustments as one of transition, i discuss mechanisms to ease the transition in part iv.h., where i discuss transition issues more generally. note, however, that the risk of a rocky transition is a substantial cost of border adjustments. incomplete or slow currency adjustments would be disruptive. the third problem with border adjustments is enforcement. vats have experienced two enforcement problems with their border adjustments. one is fake exports used to obtain tax rebates. the brady plan is not refundable, unlike most vats, which reduces this problem. a second problem is avoidance of the tax on import. this is a particular problem for intangibles such as purely electronic goods sold over the internet (e.g., software, videos, and computer games) and services provided from abroad (e.g., accounting or legal services provided remotely). to tax these items, we would need to impose a 20% excise tax on their purchase. collecting such a tax may be difficult, and evasion levels may be high. one central problem with collecting an excise tax on import is that remote sellers do not have a permanent establishment in the united states, so imposing the tax on sellers may not be feasible. imposing the tax on purchasers, which is what states try to do, ineffectively, with use taxes, would also not be simple. one can weigh these costs and benefits differently. for example, the weight given to the wto problems may depend on your reading of wto law, views on the consequences of an adverse ruling, and the feasibility of modifying the plan to reduce the risk of an adverse ruling. importers naturally heavily weigh the risk of slow or incomplete currency adjustments. my overall view, which i hold weakly rather than strongly, is that i believe it is worth having border adjustments. the wto problem and currency adjustments are one-time problems – serious ones to be sure – that with careful management can likely be overcome. relabeling taxes can reduce the formal problem with compliance with the wto without changing the substance of the tax law. transition rules can reduce the risk of slow or incomplete currency adjustments. transfer pricing is a permanent problem. i would rather try to get over 52 perhaps one should not underestimate the ability of people or countries to be irrational, but it is hard to see a reason for not repegging or retargeting. moreover, failing to repeg or retarget would impose tremendous economic pressure on these countries. 214 columbia journal of tax law [vol.8:171 the one-time problems to fix a serious and growing problem that will last indefinitely. other international tax issues: treaties and creditability countries that impose world-wide taxation on domestic companies typically allow the companies to claim a foreign tax credit for income taxes paid abroad. credits are restricted to income taxes, which means that taxed paid under the brady plan may not be creditable. some have suggested that this may be a problem. it is not clear, however, how big the problem would be because the net present value tax in a cash-flow system is zero. the initial reduction in credits when an investment is expensed exactly offsets the increase in credit from the u.s. tax on the return. there would be no need for a crediting system because there is no net tax. separately, the business portion of the brady plan might not qualify as an income tax under our existing network of treaties because the base is consumption. vats, for example, do not quality as income taxes for treaty purposes. treaties are important to u.s. businesses investing abroad because they provide relief from foreign withholding taxes, scale back the tax reach of foreign countries, and prevent discriminatory treatment of foreign investment. foreign businesses, in return, receive similar benefits when investing in the united sates. the question is whether foreign nations will find it in their selfinterest to continue their treaty relationships under the brady plan. because it eliminates u.s. source-based taxation, the brady plan may, by statute, give foreign investors many of the benefits they currently receive by treaty. as a result, treaty partners may not see any need to give up any of their source tax revenues, and, therefore, not see any need to continue their treaties with the united states. foreign nations will have to make the determination of whether they wish to continue their treaty relationships with the united states. in the meantime, the united states should continue to treat the treaties as applying. moreover, the plan should maintain the withholding tax on dividends, so that if a foreign nation terminates their treaty with the united states, the full withholding tax would apply, thereby creating an incentive for foreign nations to continue to treat the treaty as binding. because of treaty nondiscrimination provisions, the united states may not be allowed to impose a withholding tax with treaty countries. if a country were to terminate its treaty with the united 2017] a guide to the gop tax plan 215 states, the withholding tax would kick in, creating an incentive not to terminate the treaty.53 d. financial flows the plan as written distinguishes between interest expense and payments on real assets. if it were fully r-based, it would distinguish financial flows from real flows. regardless of which approach is taken, making these distinctions will generate a number of problems.54 interest v. other payments suppose that the plan only disallowed net interest deductions but otherwise taxed financial flows, which is how the current draft reads.55 the plan would then need rules to determine when a flow is “interest” instead of something else. this problem exists under current law but would be worse under the brady plan because the consequences of being labeled interest would be more severe. to illustrate, suppose that a business wanted to borrow $100 at a 10% interest rate for one year. if it used a financial instrument formally labeled debt to borrow the $100, the $10 of interest that it pays would be non-deductible. suppose instead that it borrowed the following way: it sells short $100 of treasury securities and simultaneously enters into a forward contract to purchase treasury securities in one year for $110. the cash flows on this second transaction are identical to the flows on formal borrowing. the second, however, uses the form of the sale and purchase of securities rather than of a debt instrument. the combined sale and repurchase might be recharacterized as a borrowing because the flows precisely match those of a borrowing. if so, however, it would be straightforward to make the flows mismatch one another to avoid recharacterization but without changing the economics significantly. there will be no easy way around this problem. any set of flows where payments come in before they go out has implicit interest. absent an attempt to impute interest to all flows, there will be ways to hide interest expense in real or other financial flows and generate deductions for what is economically interest expense. real v. financial flows 53 see harry grubert & t. scott newlon, the international implications of consumption tax proposals, 48 nat’l. tax j. 619, 642 (1995). 54 for additional detail, see, chapter 6 in carroll and viard, supra note 16, at 81-101. 55 as discussed above, i am assuming that to the extent the plan taxes financial flows, it does so on an income tax basis, not a cash-flow basis. 216 columbia journal of tax law [vol.8:171 suppose instead that the brady plan were to take the more conventional approach used in vats and in x-tax proposals and ignored all financial flows. under this approach, the tax system would have to distinguish financial flows from real flows. many transactions, however, have elements of both. a typical case is the sale of a good on credit. for example, suppose a retailer sold a good with a fair market value of $100 to a customer and the customer agreed to pay $110 in one year’s time. if interest income is not taxed but sales proceeds are, the retailer will want to characterize the transaction as producing a $100 real inflow (which is taxable) and a $10 interest receipt (which is not taxable). if the value of the good cannot be readily determined, the retailer will have an incentive to overstate the interest, for example, by claiming the value of the good is only $95 and there is $15 of non-taxable interest income, reducing the tax base by $5. problems would also arise with transactions such as forward contracts that can be either cash settled or physically settled. for example, suppose that a corporation entered into a contract for the purchase of a unit of pork bellies in one year’s time for $100. if pork bellies went up in price over the course of the year, the corporation would have a gain on the transaction. in this case, it could cash settle the contract and report it as an excludible financial flow. if pork bellies went down in price, the corporation would have a loss, and it could physically settle the contract, reporting a deductible loss. if the other side of the contract is a taxable entity, its incentives would be the flip, so that any tax advantage to one party is a disadvantage to the other. if, however, the other side were not taxed or were taxed differently than the corporation (say because it is a financial institution using a special regime for financial institutions), their incentives might not offset. the underlying problem is that there is no economic distinction between real and financial flows. the distinction is a tax distinction. nevertheless, vats around the world draw this line, so there is substantial experience with the problems that arise. solutions used in vats should be considered for the brady plan. financial institutions regardless of which approach is taken, the system will have a problem taxing financial institutions. suppose that all financial transactions are ignored. financial institutions buy and sell (or issue) securities and other financial instruments, incurring labor and capital costs to do so. if financial flows are ignored, all they would have would be deductible costs for labor and physical capital (such as 2017] a guide to the gop tax plan 217 buildings and computers). they would generate losses every year even if they are wildly profitable. financial institutions are a substantial portion of the u.s. economy. they include commercial and investment banks, property, casualty, and life insurance and reinsurance companies, securities brokers and dealers, mutual funds, market makers, and traders such as hedge funds. all of these entities would be effectively untaxed, or even generate net losses, in a pure r-based system. an r-based tax system will need a special regime for the taxation of financial institutions. a likely candidate is to tax financial institutions on all flows (other than with respect to stock), both real and financial.56 this system is known as an r+f system and was original devised by a uk tax reform commission known as the meade commission.57 like a cash-flow system on ordinary businesses, an r+f system taxes economic profits and, depending on the transition rules, existing capital. putting financial institutions on an r+f basis requires a definition of financial institutions. this will not be straightforward both because of the wide variety of financial institutions and because ordinary businesses may engage in a large number of financial transactions (such as lending to customers and hedging their risk) so that it may sometimes be difficult to tell when a business is a financial institution. e. corporate transactions the current income tax has a substantial body of law governing corporate transactions such as mergers, stock acquisitions, and corporate divisions. these rules were developed within an income tax and would need to be rethought if the corporate tax base is consumption. consider a corporation that has assets valued at $100 and has a basis in the assets of, say, $70. under current law, if it were to sell all of its assets to another corporation, it would, without special provisions, owe a tax on its $30 of gain. if, however, the asset sale is done just the right way – meeting an endless list of seemingly arbitrary rules – the reorganization provisions of current law allow the corporation to avoid paying tax on its gain. instead, the gain is transferred to the buyer by giving the buyer a $70 basis in the assets rather than a basis equal to its purchase price of $100. similarly, if the 56 for a discussion, see peter merrill & chris edward, cash-flow taxation of financial services, 49 nat’l. tax j. 487 (1996). 57 inst. for fiscal studies, supra note 10, at 230-245. 218 columbia journal of tax law [vol.8:171 corporation were to spin off the assets by incorporating them and distributing the stock of the new corporation to its shareholders, special rules, with yet more complex and arbitrary requirements, allow the spin-off to defer taxation. in a consumption tax system, there is, by operation of the system and without special rules, no net tax on the sale of the assets from one business to another. in the example, the selling business would have a taxable inflow of $100 and the buyer would have a deductible outflow of $100, netting to zero. there is no need for the reorganization rules. moreover, even if desired, there would be no easy way to retain the equivalent of the reorganization rules in a cash-flow system. the current rules operate by not taxing the target corporation and not giving the buyer basis for its costs. instead, the buyer inherits the target’s basis. there is, however, no concept of basis in a cash-flow system. not taxing the seller and not allowing the buyer a deduction does not achieve the same thing as the current law reorganization rules unless there is some way to shift the equivalent of basis – the deduction the seller had when it purchased its assets – to the buyer. in particular, in an income tax, we shift the capitalized cost of the seller’s assets to the buyer by transferring the seller’s basis to the buyer. with a cash flow system this would be very difficult because there is no basis. the seller will have deducted the $70 when the assets were purchased, which could have been many years ago. in fact, taxing the sale to the buyer and giving the seller a deduction can be thought of as the consumption tax equivalent of the reorganization rules because this treatment effectively shifts the prior deduction to the new owner of the assets in the same way that the income tax rules shift the basis. there are two other effects of the reorganization rules under current law. the first is that they allow shareholders to defer taxation of gains when they exchange their shares of a target corporation for the shares of a purchasing corporation. because the brady plan retains the individual-level income tax, the rules would continue to matter for shareholders. it is not clear, however, why it is desirable to allow shareholders to exchange stock in one company for stock in another without paying tax. moreover, even if one could identify circumstances when it is desirable to allow shareholders to defer taxation, it is unlikely that those circumstances would be anything like the cases allowed under current law. and finally, with a low tax rate on capital income, there is little reason to have complex rules that allow deferral. 2017] a guide to the gop tax plan 219 the other effect of the reorganization rules is that they allow corporate tax attributes such as net operating losses and unused tax credits to be transferred from the buyer to the seller. if asset sales were fully taxable under the brady plan, tax attributes would not transfer from target corporations to purchasers. if the target were to liquidate, moreover, the attributes might disappear. structuring the same transaction as a stock purchase would mean that the attributes would remain with the target corporation and potentially be usable by the purchasing corporation via consolidation. the result would be a difference between stock transactions and asset transactions. given that asset purchases in a cash-flow system do not generate net tax, the key effects of reorganization rules would be to defer shareholder gain – something i view as undesirable – and to reduce the disparities between asset sales and stock sales with respect to the carryover of attributes. given how much less is at stake, the best approach, in my view, is to make all corporate transactions taxable and all exchanges of shares taxable, with perhaps an exception for recapitalizations. attributes would carry over in stock transactions but not asset transactions. alternatively, greatly simplified rules could be adopted to allow attributes to be transferred. for example, attributes could be transferred in any transaction in which two companies merge or in which one purchases substantially all of the assets of another (regardless of the consideration). all the other ornate concepts of the current law reorganization rules could be eliminated. the same arguments apply to the rules governing contributions to corporations. these rules rely on shifting the basis of assets to the corporation. without a basis system, these rules may no longer make sense. moreover, in this case, there is no attribute transfer under current law, so special attribute transfer rules would not be needed. the rules defining dividends will also likely need to be revised. the current rules determine whether a distribution is a dividend by whether it comes out of corporate earnings and profits. the earnings and profits account is determined on an income basis. while an income-based earnings and profits account could be retained, doing so would mean that for tax purposes, corporations must compute both income and consumption tax bases and would require retention of many income tax rules. an alternative would be to compute earnings and profits on a cash-flow basis. if this approach were taken, it would only make sense to use a cumulative account rather than the current approach of looking to a current account (and then a cumulative account). to illustrate, suppose that a corporation purchases an asset for $100 in year 1 and 220 columbia journal of tax law [vol.8:171 receives $110 in year 2. on a cumulative basis, it has $10 of earnings which would support a $10 dividend. looking only at year 2 (so looking at the current earnings and profits account, which is what current law does) would give the corporation $110 of earnings, which would then produce a $110 dividend, which is far excess of any measure of corporate earnings. the current corporate tax system also has a number of rules designed to prevent losses from being transferred. for example, if a corporation changes control, it may be limited in its ability to use losses in the future. with a cash flow system, however, losses will be, for the most part, freely transferable simply because of the way a cashflow system works. consider a company with a $100 net operating loss. the company can transfer the loss simply by selling a $100 asset. the selling company will have $100 of taxable receipts, which it can use against the loss and the purchasing company will have a $100 deduction, effectively transferring the loss. the brady plan allows indefinite carryforward with interest, so the incentive to transfer losses will be reduced as compared to current law. on the other hand, under a destination-based cash-flow system, some businesses may be unlikely to be able to use losses for the indefinite future even if they are profitable. in these cases, incentives to transfer losses may remain. given that loss transferability is built into the structure of the system, it may not be desirable to try to retain the current rules against loss transfers. in short, one of the major simplification benefits of the brady plan (if amended to consistently tax consumption) would be to revise and repeal most of the provisions governing major corporate transactions. (and if the pass-through regimes are repealed, the brady plan could eliminate those rules as well.) these rules are not mentioned in the current draft plan. as the plan progresses, this simplification opportunity should be taken. f. deferral the brady plan taxes dividends, interest, and capital gains received by individuals at a rate equal to half of the tax rate applicable to other income. i assume, although the plan is silent, that the reduced rate also applies to flows from similar investments, such as from futures and forward contracts, swaps, options, and other financial instruments as well as non-business investments in property such as speculation in land, minerals, and collectibles. combining this tax on capital income with a cash-flow business-level tax may be challenging. the reason is that capital investments at the business level bear no tax (because of the cash flow 2017] a guide to the gop tax plan 221 system). as a result, funds can be retained at the business level until needed for consumption, at which point they would be withdrawn and taxed. the effect is elective deferral of capital income, allowing capital income to grow tax free during the period of deferral. the bush tax commission’s growth and investment plan had the same problem. they suggested that one or more of current law’s anti-deferral regimes would be needed, but provided no details on how such a system would work. a serious problem with applying these regimes is that they will not be able to apply to funds that are genuinely invested in a business. they try to find “sham” investments, or incorporated pocketbooks, where individuals use shell corporations to hold funds and get deferral without really investing in active businesses. in the brady plan, however, the tax rate on marginal investments is zero, so if funds are genuinely invested in a business, the marginal tax rate on the investment will be zero. anti-abuse rules that disallow the zero marginal rate would be contrary to the basic structure and intent of the tax system. i do not see an easy solution to this problem. there is a basic conflict in the plan between having a cash-flow tax at the business level and a tax on capital income at the individual level. the following approaches might reduce the problem it to some extent: • eliminate stepped-up basis at death. the plan repeals the estate tax but does not mention stepped-up basis at death. proposals to repeal the estate tax are often accompanied by repeal of stepped-up basis at death. getting rid of stepped up basis at death reduces the advantage of deferral. • lower the tax rate on capital income even further. the current plan imposes a top tax rate of 16.5% on capital income. if the rate is even lower, the incentive to plan to get deferral correspondingly goes down. (to retain progressivity, other rates would have to be adjusted.) • impose a mark-to-market regime for publicly-traded securities at a low tax rate. • instead of a mark-to-market regime, impose a regime that is economically equivalent to a mark-to-market regime, such as a system that imputes income based on an assumed return. the only one of these solutions that really solves the problem is a mark-to-market regime or an equivalent. if such a system is not feasible, the best alternative might be to abandon the tax on capital income at the individual level and instead adopt a pure x-tax. the bush commission studied (but did not propose) a pure x-tax. they 222 columbia journal of tax law [vol.8:171 showed that a pure x-tax can be distributionally and revenue neutral, so there is little need for the additional tax on capital at the individual level. the tax on capital income creates terrible enforcement problems and will distort behavior as people seek to avoid it. moreover, to the extent it can be enforced, it is inefficient relative to a pure consumption tax (for, apparently, no distributional benefit). g. other individual tax provisions the brady plan indicates that it may revise many of the provisions that affect the tax liability of individuals, including the mortgage interest deduction, the charitable deduction, the retirement savings provisions, and the exclusion of employer provided health insurance. to a great extent, the choices made with respect to these provisions are independent of the consumption tax structure of the plan. each raises complex issue that may have large effects on the relevant sectors of the economy. because the choices for these provisions are largely orthogonal to the structural issues raised by the brady plan and because the choices are so complex, i do not discuss these issues here, except for following three brief points. first, if interest income is taxed at the individual level at half the individual tax rate and mortgage interest is deductible at the full rate, there will be an obvious arbitrage: increase the size of your mortgage and invest the funds in debt instruments. interest received will be taxed at half the rate interest is deducted, generating net tax losses for no real activity. the same concern applies to investment interest expense. if investment interest expense is fully deductible but interest income is taxed at only half that rate, there are obvious arbitrages. the plan makes clear that net interest expense is not deductible for businesses but says nothing about individuals and investment interest expense. second, the plan eliminates the state and local tax deduction (as well as other itemized deductions other than home mortgage interest and charitable donations). there is a substantial literature on the merits of the state and local tax deduction.58 a decision to repeal it will have important effects on the structure of local government and deserves careful consideration. third, the plan seems to retain payroll taxes. for many families, payroll taxes are the dominant tax. they are also currently about one-third of federal taxes. when we think about the tax rates 58 for example, martin s. feldstein & gilbert e. metcalf, the effect of federal tax deductibility on state and local taxes and spending, 95 j. pol. econ. 710 (1987). 2017] a guide to the gop tax plan 223 applicable to wage income, we need to add in payroll taxes. for example, payroll taxes may alter the incentives to recharacterize capital income as wage income or vice versa. h. transition the brady plan says nothing about the transition to the new system other than it will provide clear rules “to serve as an appropriate bridge from the current tax system to the new system.” the transition to a consumption tax, however, is one of the most important and most difficult aspects of consumption taxation. the literature on transition is massive, and i can only touch on key points here.59 basic economics of transition the transition to a consumption tax is often said to impose a tax on existing capital. there are two ways to see why. the first is definitional: existing capital is a source of consumption. if you have money in the bank, you can withdraw it and buy things. therefore, if the tax is to be on all consumption, it must be on existing capital. the second is transactional. suppose that we have an income tax and that you own an asset worth $100 that you purchased for $100. under the income tax, you would have a basis in the asset of $100 and if the income tax remained in place, you could sell the asset for $100 without tax. suppose that at midnight tonight, we switch to a cashflow consumption tax in which all purchases are deductible and all inflows are taxed. under this system, there is no tax basis. the full amount of any inflow is taxed. the next day, you sell your $100 asset. you have a $100 inflow, which would be fully taxed. the cash-flow tax effectively taxes all existing capital when the capital is sold and used for consumption. whether this is desirable is not a matter of definitions or transactional rules. the question is whether it has desirable efficiency or distributional effects. the argument that it is efficient is that if the switch is unanticipated, the tax on existing capital is lump sum. of course, transition would almost surely be anticipated, so people will take steps to avoid it, such as by accelerating their consumption to be before transition and deferring investments to be after transition. moreover, if the new consumption tax has loopholes, there will be incentives to use those loopholes to avoid the tax on existing capital. nevertheless, while the tax may not be lump sum, it may be reasonably efficient. a tax on transition on existing capital would also have 59 for a survey of the literature, see louis kaplow, capital levies and transition to a consumption tax, in institutional foundations of public finance 112 (alan j. auerbach & daniel shaviro eds., 2008). 224 columbia journal of tax law [vol.8:171 desirable distributional properties because most existing capital is held by wealthy individuals. on the other hand, a tax on existing capital will likely raise vociferous objections. going back to the example, you bought the $100 asset with after-tax cash – that is why you have basis in the asset. if you are asked to pay tax again on the $100, you will surely object, even if the tax is under a new system. existing basis the reason cash-flow systems tax (or can tax) existing capital is because after the transition date, they ignore basis that was created under the now-repealed income tax. in the example given above, you had a $100 basis in your asset before the transition. after the transition, when you sold your asset for $100, you had a $100 cash inflow and could not use your income tax basis against the inflow because the new system does not use basis to compute tax liability. we can, therefore, think of the tax on existing capital as arising because basis under the income tax does not count under a consumption tax. the central issue on transition, therefore, is whether businesses can use their existing basis. the extent to which businesses can use their existing basis determines the extent of transition relief or transition tax. giving transition relief by letting taxpayer use existing basis, however, means that it could be years or decades before the system is fully on a cash-flow basis. moreover, transition relief will be very expensive given the size of the existing capital base, which means that tax rates would have to be much higher than without transition relief. the brady plan says nothing about this, although i think the best reading of the text is that businesses will continue to be able to use existing basis. the text simply says that new investment will be expensed. the bush tax commission tried to take a middle course. they allowed businesses to continue to use their existing depreciation allowances but phased them out over five years. for example, in the second year of the new tax, businesses would be able to use 80% of the basis that they could have used under an income tax, 60% in the third year, and so forth. this approach reduces the extent of transition relief and also ensures that the income tax rules – basis and so forth – can be eliminated after five years rather than having to be retained indefinitely. 2017] a guide to the gop tax plan 225 a way to generalize this system is to allow taxpayers to a recover fraction of their basis in all of their assets (not just depreciable assets) on a fixed schedule. taxpayers would have to declare (and document) their basis and then could recover it (or a fraction) over a set period of time unrelated to the sale of their assets. this would allow any level of desired transition relief depending on the allowed fraction and would allow the system to move immediately to a cash flow basis, eliminating the need for income tax rules. alternatively, basis could remain attached to assets so that it can be used when assets are sold, but would decline over a set period of time. tax rate changes the transition effects of a tax rate change are exactly the same as the transition effects from the initial introduction of a cash-flow tax. consider the example of the $100 investment, and suppose, now, that the investment was made under a cash flow system when the tax rate was 20%. the investment produced a $20 tax saving. a year from now, the investment is sold for $110. if the tax rate were still 20%, the tax due would be $22, which is the future value of the $20 of tax savings. suppose, however, that in the interim, the tax rate was increased to 30%. the tax due would now be $33, $11 more than under the 20% tax. this $11 ($10 in present value terms) is a 10% tax on existing capital. it is a tax on existing capital equal to the tax increase of 10 percentage points. the opposite holds if tax rates go down. taxpayers will receive a subsidy on existing capital equal to the amount by which taxes go down. transition relief is relatively easy for the switch from an income tax to a consumption tax because taxpayers can be allowed to continue to use their existing basis. the problem is much more difficult once taxpayers are in a cash-flow system and tax rates change because there is no basis to use. there is no straightforward way to provide transition relief. failing to provide transition relief for tax rate changes, however, may make the system less efficient because there would be an incentive to time transactions to take advantage of rate changes. in particular, if it is anticipated that rates will go up, there will be an incentive to accelerate consumption to avoid the transition tax. if it is anticipated that rates will go down, there will be a corresponding incentive to delay consumption. these timing effects are inefficient because the tax system is causing individuals to accelerate or defer their consumption. most cash-flow tax proposals ignore this problem, implicitly denying any transition relief for tax rate changes. to the extent we are 226 columbia journal of tax law [vol.8:171 concerned about the transition effects, david bradford proposed an economic equivalent to a cash flow system that uses basis, and, therefore, alleviates transition effects from tax rate changes.60 this system could be adopted if needed, although it is much more complex than a cash flow system. interest deductions the plan would deny interest deductions. while debt issued after the enactment of the plan can take this into account, debt issued previously cannot. denial of interest deductions on existing debt may make many loans non-economic, possible forcing creditors to restructure their debt, a process that may be expensive and difficult. in the worst case, some creditors could be forced into bankruptcy. given the volume of outstanding loans, this is not a small problem. one possibility is to grandfather debt issued prior to the effective date of the law. the problem with this approach is that debt can be outstanding for very long periods of time. treating old debt and new debt differently for long periods of time would be complex. moreover, if old debt gets better treatment than new debt, businesses will have a tax incentive to keep old debt rather than issue new debt even economically this is not desirable. the bush commission recommended a five-year phase-out of interest expense deductions, similar to their phase-out of depreciation deductions. under this approach, interest deductions on all debt, regardless of when issued, are reduced gradually. the effect in each year would be the same as a 20% reduction in tax rates, and businesses have experienced tax rate changes of this size in the past without large disruptions. the tax plan introduced by devin nunes in h.r. 4377 (cited in the brady plan) takes a similar approach. this approach is preferable to grandfathering old debt because it means we do not have to have dual tax systems running indefinitely, which we would need if old debt were grandfathered. border adjustments61 as noted, it will be important to manage the transition to border adjustments so that importers are not adversely affected. recall the 60 david f. bradford, transition to and tax-rate flexibility in a cashflow-type tax, 12 tax pol. & econ. 151 (1998). 61 my focus here is limited to issues of implementation. note, however, that the currency price changes on transition to a destination basis may have substantial economic effects. in particular, u.s. holdings of foreign assets would decline in value and foreign holdings of u.s. assets would appreciate. together, these changes would represent a net wealth loss to u.s. citizens. carroll and viard, supra note 16 at 110-111, provide a discussion. 2017] a guide to the gop tax plan 227 illustration used above: a firm that purchases goods from abroad for $95 and sells them domestically for $100. under current law, the firm would be taxed on its $5 profit. the $95 purchase price would be effectively deductible against its $100 sale proceeds (through basis rather than a deduction but the effect is the same). under a destinationbased tax, the firm would no longer be able to deduct the $95 purchase price and would owe a tax on the full $100 sales proceeds. the tax could easily exceed its profit. as noted, economists argue that currency prices will adjust so that the firm’s position remains unchanged. for example, if the dollar appreciates, the firm could buy the same good for $76, pay a $20 tax and still be left an after-tax profit of $4 (which can be thought of as a $5 pre-tax profit less a 20% tax). one immediate problem is that if the purchase contract is denominated in dollars, the price would not change when dollars appreciate. this means that dollar-denominated purchase contracts would have to be renegotiated. like with debt instruments, renegotiation could take time so that a phase-in of border adjustments may be warranted. the bush commission also argued for a phase-in of border adjustments. the basic idea is that a small border adjustment induces only a small currency price effect. if the currency price effect is slow or incomplete, the harm to importers is modest. this idea is worth considering. a problem is that currency markets may anticipate the phase-in and force the dollar to appreciate faster than the phase-in. in this case, exporters would be hurt. v. conclusions implementing a tax system based on the brady plan will present a substantial challenge. many implementation problems arise because nothing like this has ever been tried by a developed country, not to speak of in a country the size of the united states. it is likely that over time, solutions to most issues will be found. given the substantial number of issues, however, it is naïve to think that the plan can be passed into law quickly. some issues, such as correcting the treatment of land and inventory are straightforward. others, such as the elimination of the regimes for pass-through taxation and rules for major corporate transactions, are conceptually straightforward but will be involve more substantial changes to current law. and others will be difficult. among the most important and difficult issues are the following: • deferral and the collection of the capital income tax on individuals. 228 columbia journal of tax law [vol.8:171 • the legality of border adjustments and possible design changes to improve the odds of compliance with the gatt. • the treatment of financial institutions. • the treatment of businesses that consistently generate tax losses while making economic profits. • distinguishing between real and financial flows, and making a consistent choice to have an r-based system (or an r+f system). • transition. these issues do not have straightforward solutions and will need careful analysis as the legislative process moves forward. microsoft word 8-2-graetz vertical (15).docx the known unknowns of the business tax reforms proposed in the house republican blueprint m i c h a e l j . g r a e t z c o l u m b i a l a w s c h o o l p r o f e s s o r o f l a w 3/28/2017 © 2017 color slides are available for download at: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2910569 118 columbia journal of tax law [vol.8:117 3 table of contents slide no. page no. known knowns introduction 4 119 more like a vat than a corporate tax 5 120 transforming the corporate income tax into a dbcft 6 121 shifting tax to where goods and services are sold 7 122 solves international corporate tax problems 8-9 123-124 a unique tax 10 125 known unknowns effects on prices of goods and services and/or exchange rates 11-12 126-127 the impact of a potential 25 percent rise in the value of the dollar 13-16 128-131 the impact of exchange rate adjustments 17 132 potential price effects 18-19 133-134 potential effects on wages 20 135 impact on trade agreements 21-24 136-9 bilateral income tax treaties 25-26 140-141 a constitutional challenge to dbcft seems inevitable 27 142 the rate of tax matters 28-29 143-144 revenue 30 145 how will state and local governments react 31 146 enactment through the reconciliation process 32 147 accounting treatment 33 148 burdens of the tax 34-35 149-150 different kinds of known unknowns 36 151 losses 37 152 mergers 38 153 differences in taxation of corporations and flow-through entities 39 154 enforcement 40 155 exemptions 41 156 inherently mobile industries 42 157 financial transactions 43 158 taxation of financial institutions 44 159 relationship to individual taxation 45 160 transition 46 161 some alternatives to the dbcft 47 162 appendix: a bibliography 48 163 2017] the known unknowns of the business tax reforms proposed 119 4 the known unknowns of the business tax reforms proposed in the house republican’s blueprint thanks to donald rumsfeld • in 2002, referring to iraq and its relationship to terrorism, donald rumsfeld declared “that there are known knowns, there are things we know we know. we also know that there are known-unknowns, that is to say we know there are some things that we do not know, but there are also unknown-unknowns—the ones that we don’t know we don’t know.” • there was nothing new in what rumsfeld said, and some thought he was uttering evasive gibberish, but rumsfeld’s classifications are quite useful. exploring known unknowns is, for example, much of the work of science. • donald rumsfeld turned out to be a better epistemologist than a defense secretary. • i shall begin briefly with some known knowns about the house blueprint’s proposal then turn to known unknowns. ≠ since both fall into categories of knowns, i am not trying here to be original. 120 columbia journal of tax law [vol.8:117 5 more like a vat than a corporate tax • the business tax reform proposed in the blueprint looks very much like a reform of the corporate income tax, but in reality it is closer to a repeal of the corporate income tax and the substitution of a cousin to a value-added tax (vat). • the blueprint does retain some income tax features not found in a vat; the taxation of net investment income and retention of flow through treatment of partnerships are important examples. • the fact that the republican proposal is more like a value-added tax than an income tax is difficult to explain to the public. • nevertheless, it is important to understand that the house republican business tax reform—often referred to as a destinationbased cash-flow tax (dbcft)—is equivalent to a subtractionmethod valued-added tax with a deduction for wages. • it is surprisingly easy to move from a corporate income tax to a destination-based cash flow tax and to do so in a way that can be characterized by politicians as a reform of the income tax. all it requires is four basic steps: 2017] the known unknowns of the business tax reforms proposed 121 6 transforming the corporate income tax into a dbcft • first, substitute expensing of capital assets for amortization and depreciation deductions and eliminate inventory accounting. • second, eliminate the interest deduction. • third, tax imports by denying any deduction for imported goods or services. • fourth, exempt revenues from exports from inclusion in the tax base. 122 columbia journal of tax law [vol.8:117 7 • rather than taxing where goods or services are produced, or where the company producing them is headquartered, as the corporate income tax now does, impose the tax in the jurisdiction where the goods are purchased (or consumed). • in order to tax goods where they are purchased (or consumed), it is important that imports be subject to tax and that exports be exempt from tax. this is called a border adjustment. the border adjustment in the house republicans’ blueprint is “economically equivalent to a vat, but it should not be labeled one,” house ways and means committee chair kevin brady, r-texas, said january 24. shifting tax to where goods and services are sold 2017] the known unknowns of the business tax reforms proposed 123 8 • this change solves many of the most vexing problems of international taxation of corporate income, problems that have occupied the oecd in its beps project for several years without any satisfactory conclusion. • by imposing tax where goods are sold, where the company is headquartered becomes irrelevant and there is no incentive for u.s. companies to shift ownership to a foreign parent, so called “inversions.” • the difficult issue of determining inter-company prices in related transactions also is minimized for the u.s. government. solves international corporate tax problems 124 columbia journal of tax law [vol.8:117 9 • this tax also eliminates tax advantages of shifting income from intellectual property to a lower-rate tax jurisdiction. • by eliminating the deduction for interest, the tax eliminates the advantage of financing through debt rather than new equity. • the blueprint would eliminate the downward pressure on the u.s. corporate income tax rate. solves international corporate tax problems 2017] the known unknowns of the business tax reforms proposed 125 10 • consumption taxes are used throughout the world. • 167 countries have value-added taxes (vats). • the united states has retail sales taxes; but no vat. • the dbcft of the blueprint does not exist anywhere in the world despite a long history of american economists advocating for such a tax. • as a result, the dbcft does not fit well with our international obligations and arrangements. • moreover, unlike retail sales taxes or value-added taxes, there is no experience or existing legislative model of best practices to look to in designing the tax. • that’s why a long list of known unknowns follows. some of those known unknowns will be resolved by the statute. others will exist even after a president signs legislation putting a dbcft into effect. a unique tax 126 columbia journal of tax law [vol.8:117 11 • enactment of the blueprint would have major effects on some combination of exchange rates and prices, but there is uncertainty about exactly what these effects would be. • some economists (including, e.g., martin feldstein, paul krugman, alan auerbach, and douglas holtz-eakin) predict that the value of the dollar will immediately rise by 25 percent relative to other foreign currencies. •as a result, no price increases would necessarily follow the enactment of the dbcft. • in contrast, economists from financial institutions predict an appreciation of the dollar by about half that magnitude and suggest that it might take several years to occur. effects on prices of goods and services, and/or exchange rates 2017] the known unknowns of the business tax reforms proposed 127 12 • these judgments turn on how flexible exchange rates are and how governments might react to the potential depreciation in the values of their currencies. • these judgments also differ based on different countries’ trade relationships with the united states. • if exchange rates do not rise to fully offset the impact of the dbcft on trade balances, prices are likely to rise. • historically, when value-added taxes have been introduced prices have risen by an amount equal to about 60 percent of the value-added tax rate, but this has varied. because of its deduction for wages, the effects on prices of a dbcft should be smaller than for a vat. for example, citigroup's global chief economist willem h. buiter concludes his lengthy analysis of this issue by saying: so, in the spirit of socrates, we have to say about the exchange rate implications of a bta: i know i know nothing, but at least i know that…. not only do we not know the magnitude of the exchange rate effect of a bta, we don’t even know the sign or direction. effects on prices of goods and services, and/or exchange rates 128 columbia journal of tax law [vol.8:117 13 • the rise in exchange rates, if it occurs, will have a major impact on the values of foreign assets held by u.s. persons and on the value of u.s. assets held by foreigners. •based on the most recent data available, it appears that u.s. holders of foreign assets may lose as much as $4.9 trillion (20% of $24.5 trillion), and foreign holders of u.s. assets might gain as much as $8.1 trillion (25% of $32.5 trillion). •some of the foreign assets held by u.s. persons and entities are dollar-denominated and that would reduce the size of the losses above. • a number of foreign countries have issued dollardenominated sovereign debt and corporations in these countries and elsewhere have issued large amounts of dollar-denominated corporate debt. the impact of a potential 25 percent rise in the value of the dollar 2017] the known unknowns of the business tax reforms proposed 129 14 the impact of a potential 25 percent rise in the value of the dollar • some of these magnitudes follow: ratio of dollar-denominated debt to gdp 2015 country govt (%) nfc (%) govt + nfc (%) brazil 66.2 50.1 116.3 china 43.9 163.6 207.5 india 69.0 51.0 120.0 indonesia 27.0 23.9 50.9 s. korea 37.9 106.0 143.9 malaysia 54.0 67.9 121.9 mexico 43.2 24.8 68.0 south africa 50.1 37.0 87.1 turkey 37.7 57.0 94.7 source: megan greene, us border adjustment tax: the path to stagflation, debt and deflation?, manulife asset mgmt.: market views and insights (jan. 26, 2017), http://www.manulifeam.com/us/research-and-insights/market-views-and-insights/usborder-adjustment-tax-the-path-to-stagflation-debt-and-deflation/. 130 columbia journal of tax law [vol.8:117 15 the impact of a potential 25 percent rise in the value of the dollar • some of these magnitudes follow: country govt (%) nfc (%) govt + nfc (%) increase in debt (%) brazil 70.2 58.6 128.8 12.5 china 43.9 198.0 241.9 34.4 india 69.0 63.0 132.0 12.0 indonesia 30.3 25.9 56.2 5.3 s. korea 38.6 127.5 166.0 22.1 malaysia 55.8 76.6 132.3 10.4 mexico 46.4 28.9 75.3 7.3 south africa 54.9 42.5 97.3 10.2 turkey 45.9 58.6 104.4 9.8 ratio of debt to gdp 2015, with 25% dollar appreciation source: megan greene, us border adjustment tax: the path to stagflation, debt and deflation?, manulife asset mgmt.: market views and insights (jan. 26, 2017), http://www.manulifeam.com/us/research-and-insights/market-views-and-insights/usborder-adjustment-tax-the-path-to-stagflation-debt-and-deflation/. 2017] the known unknowns of the business tax reforms proposed 131 16 • if the cost of those debts were to increase by 25 percent, as some of the proponents of the dbcft suggest, this would have a major impact on these countries’ ability to repay the debt and on their balance sheets. • many of our trading partners, such as these issuers of dollar-denominated debt, will lose while others, such as large holders of u.s. debt, will gain. • the macroeconomic effects of such a change are uncertain. some economists have speculated that these effects would be dire, perhaps creating both stagnation in the global economy and inflation. the impact of a potential 25 percent rise in the value of the dollar 132 columbia journal of tax law [vol.8:117 17 the impact of exchange rate adjustments note: shading denotes recession. source: federal reserve board; jason furman calculations. 2017] the known unknowns of the business tax reforms proposed 133 18 • even if the dollar rises by 25 percent there will be some price effects on dollar-denominated commodities. • a number of commodities, e.g., oil and wood pulp, are priced in dollars in world markets. • a key question is whether the world price of such commodities will fall by 25 percent to reflect the appreciation of the dollar. • in some cases, such as oil, this may turn on the response of an international cartel. • if world prices do not fall, domestic prices (such as for heating oil or gasoline at the pump) will rise significantly. • the domestic price of dollar-denominated commodities will be greater than the world price of those commodities even assuming that currencies adjust fully and the world price falls by 25 percent. • markets, especially in currencies and in commodities, are likely to become more volatile as the legislation moves through the legislative process, and speculators anticipate potential changes. large bets will be made and won or lost on each side of these issues. potential price effects 134 columbia journal of tax law [vol.8:117 19 • if the dollar does not appreciate by 25 percent, as some predict, prices should rise. • the effect on prices will depend on how the federal reserve responds. • these effects may be different in the immediate future than in the longer term as businesses and other nations attempt to minimize potential losses. • retailers who import many of the products they sell and oil refiners, particularly on the east coast, whose capacity allows them to use only imported oil, have been extremely concerned about the potential rise in the after-tax costs of imports and the impact of such a rise on their profit margins and prices. potential price effects 2017] the known unknowns of the business tax reforms proposed 135 20 • some economists have predicted that the enactment of a dbcft would produce an increase in wages. • the extent of such an increase, and its timing, is highly uncertain. • the wage subsidy (deduction) is to employers—not to employees. • allowing expensing of capital assets reduces their after-tax cost compared to current law. • subsidizing wage payments to employers is not necessarily identical, especially in the short-term, to subsidizing wages of employees. • consider for example two alternatives to the wage deduction: an increase in the earned income tax credit (eitc) or a reduction in the employees’ share of payroll taxes. in these cases, the subsidy goes directly into employees’ pocketbooks. if the wage benefit is given to employers, employees will benefit only to the extent that wages rise. potential effects on wages 136 columbia journal of tax law [vol.8:117 21 • under our trade agreements, value-added taxes may be adjusted at the border for imports and exports. these agreements include the wto agreements with 163 other countries. • it is quite certain that the dbcft of the blueprint would be held to be in violation of our international trade agreements by the wto. • article iii of the gatt requires no worse treatment of an imported good by a tax than that imposed on a domestic product. • a value-added tax or a retail sales tax complies with this article. • because of the deduction for domestic wages and the absence of any similar deduction for the wage component of imported products, the cash-flow tax would burden the entire value-added of imported products, but not the labor component of valueadded in domestic products. if wages were included in the tax base as they are with value added taxes, no violation of article 3 should be found. impact on trade agreements 2017] the known unknowns of the business tax reforms proposed 137 22 • annex 1 of the gatt prohibits export subsidies. • the deduction for wages in the dbcft combined with the exclusion of revenues from the sales of exported goods or services means that the dbcft advantages exports over domestic consumption in violation of trade agreements. • again, the problem is that wages are deducted from cash flow in computing the dbcft in contrast to vats where wages are included in the tax base. • because of the flow-through treatment of partnerships with taxation to individual owners and the taxation of net investment income, the dbcft may be characterized by the wto as a direct tax. border adjustments of direct taxes violate the wto. • these violations of our trade agreements are not overcome by the fact that a different combination of taxes with similar economic effects could pass wto scrutiny. • as alan auerbach and douglas holtz-eakin have demonstrated, an economic equivalent of the dbcft could be achieved by a combination of a value-added tax or retail sales tax, and a reduction in payroll taxes or a wage subsidy. • the lawyers who will resolve any dispute in the wto will regard such a potential economic equivalence as irrelevant. • including wages in the tax base and using the tax revenues from that change to reduce payroll taxes or to eliminate those taxes for many employees, for example, could solve this problem. impact on trade agreements 138 columbia journal of tax law [vol.8:117 23 impact on trade agreements • what will be the timing of a wto finding that a dbcft violates our trade agreements? • in recent years, wto determinations have taken anywhere from three to seven years. • the eu has already begun preparing a case against the u.s. in case the dbcft is enacted. • individual countries may respond more quickly than the wto. • what will be the remedy for a violation of our trade agreements? • an adverse finding by the wto will likely lead to the imposition of countervailing duties on u.s. products – estimated at $220 billion on imports from the u.s. • these countervailing duties would be imposed prospectively, but there is much discretion as to what products these duties might apply to. • individual countries may impose countervailing duties: estimates suggest more than $40 billion by china and the e.u., $25-30 billion by canada and mexico, and $13 billion by japan. • france, for example, might be inclined to impose large countervailing duties on boeing airplanes to advantage airbus. 2017] the known unknowns of the business tax reforms proposed 139 24 impact on trade agreements • how will the u.s. respond to an adverse decision by the wto? • president trump during his campaign labeled the wto a “disaster.” • the trump administration’s response might be to walk away from our trade agreements. • what impact would this have on international trade and supply chains? • negotiating or re-negotiating bilateral trade agreements with 163 countries would take considerable time, and success is hardly foreordained. • an important question is how the uncertainties of this potential disruption to international trade arrangements will affect business decisions and behavior by u.s. companies. • will they refrain from making substantial changes to international supply networks until these issues are resolved. • if so, one should be cautious about claims of large increases in jobs, investments, and economic growth in the united states. 140 columbia journal of tax law [vol.8:117 25 bilateral income tax treaties • the blueprint raises substantial questions with respect to u.s. bilateral income tax treaties. • the u.s. has treaties with 68 countries. • first, do the rules of the treaties apply to this tax? • the income tax treaties apply to “substantially similar taxes subsequently enacted.” • the dbcft is closer to a tax on consumption than to a tax on income, and depending on how congress chooses to draft legislation, the dbcft may be outside the treaties’ scope. • if on the other hand, the tax is treated as an income tax—or drafted as an income tax—there are a number of ways in which it would violate our income tax treaties. • these include the taxation of imports to sellers where there is no “permanent establishment” in the united states, potential discrimination against foreign multinational corporations; for example, in the treatment of royalties, and perhaps in the treatment of intercompany transfer prices. 2017] the known unknowns of the business tax reforms proposed 141 26 • if applicable, the most recent u.s. treaties provide for mandatory arbitration. • the u.s. is likely to lose. • the great unknown—regardless of whether the dbcft is inside or outside the scope of our bilateral income tax treaties—is how will other countries respond? • for example, if a u.s. multinational licenses its intellectual property for use abroad in exchange for payment of royalties from abroad, those royalties will not be subject to u.s. taxation under the dbcft because they will be treated as revenue from an export. • under current law, however, those royalties are deductible in computing income tax in the foreign country. • based on recent experience in the oecd and the eu, many foreign countries would likely respond by trying to grab the revenue that the u.s. is giving up. • they might, for example, deny deductions for royalties paid to the u.s. or impose withholding taxes, or even deny deductions for imported goods or services from the u.s. bilateral income tax treaties 142 columbia journal of tax law [vol.8:117 27 • the blueprint denies any deductions for imports, including imports that constitute costs of goods sold. • in the 1918 case doyle v. mitchell bros. co., the supreme court distinguished gross receipts from gross income and implied that a reduction of gross receipts by the costs of goods sold might be implicit in the definition of “income” under the 16th amendment. (see also, roswell magill, taxable income, chapter 9 (rev. ed. 1945); sullenger v. commissioner, 11 t.c. 1076 (1948). • the 1982 senate report – discussing the addition of section 280e to the internal revenue code, disallowing business expense deductions but not costs of goods sold to businesses selling drugs illegal under federal law – stated: “to preclude possible challenges on constitutional grounds, the adjustment to gross receipts with respect to effective costs of goods sold is not affected by the provision of the bill.” • the irs has made similar statements in office of chief counsel memorandum no. 201504011, january 23, 2015. • constitutional challenges to the denial of deductions for costs of goods sold relating to imports may or may not succeed, but are certain to occur because of the resemblances of the dbcft to an income tax. • this will create uncertainty about the validity of the denial of deductions for imports by the dbcft. • a retail sales tax or vat could tax all domestic purchases (or consumption) without raising any constitutional issues. a constitutional challenge to the dbcft seems inevitable 2017] the known unknowns of the business tax reforms proposed 143 28 • some proponents and opponents of the dbcft have claimed that the rate at which the dbcft is imposed does not matter. • it is true, as the proponents assert, that the rate of this border-adjusted tax will have no effect in stimulating the kinds of tax-planning activities that turn on rates of corporate income taxes. • high corporate income tax rates attract deductions, such as for interest or royalties, and low corporate income tax rates attract income. this is one reason that having the highest corporate rate in the developed world currently disadvantages the united states. • differences in corporate income tax rates stimulate transfer pricing and other tax planning gambits. • likewise, high corporate income tax rates discourage the location of corporate headquarters. • the rate of a dbcft does not affect these kinds of transactions. • but this does not mean that the dbcft rate does not matter. • the level of the tax rate might affect compliance with the tax and will affect tax planning (e.g., “compensation” to partners vs. “profits”). • the size of exchange rate adjustments and/or price effects resulting from the enactment of a dbcft turns on the rate at which the dbcft is imposed. • because the house blueprint tax would be imposed at a 20 percent (taxinclusive) rate, the combination of exchange rate adjustments and/or price adjustments would be equal to 25 percent. • if wages were included in the tax base, as they are with vats and retail sales taxes, a rate of about 6.3 percent or less could raise revenues equivalent to the house blueprint’s 20 percent dbcft. the rate of tax matters 144 columbia journal of tax law [vol.8:117 29 • the 2005 tax reform panel of president george w. bush recommended a dbcft (which they called a growth and investment tax) at a 30 percent rate because it did not count the revenue from border adjustments because of concerns that they violate the wto and therefore would not be sustainable. •at a 30 percent rate, the necessary exchange rate and / or price effects would exceed 40 percent. the higher the rate, the greater the costs reported on companies’ financial statements. the rate of tax matters 2017] the known unknowns of the business tax reforms proposed 145 30 • a principal political advantage of a border-adjusted tax is that it will produce revenue as long as our trade balance in goods and services is negative. • the excess of imports minus exports multiplied by the rate of tax would produce revenues for the treasury in any given year. • over a ten-year budget window, our trade imbalances may produce more than $1 trillion at a 20 percent tax rate. • “dynamic scoring” will push that number higher in the congressional process. • these two factors help pay for a 20 percent dbcft rate rather than our current 35 percent corporate income tax rate based on congressional budget scorekeeping conventions. • how will anticipated exchange rate adjustments that lower would lower the prices of imports affect the revenue estimates over the budget period? • it is widely agreed among economists that the revenues to the federal government will be negative in present value. alan viard describes “the border adjustment money” as a “disguised form of borrowing.” jason furman estimates a long-term increase in deficits of 0.4 to 0.7 percent of gdp. • according to cbo, a broad-base vat at a 2 ½ percent rate would raise revenues in the budget period similar to the border adjustments of the 20 percent dbcft. revenue 146 columbia journal of tax law [vol.8:117 31 • most states and many local governments in the united states already impose their own border-adjusted taxes— retail sales taxes. • most state governments also impose corporate income taxes. • these taxes typically use the federal corporate income tax as the basis (or at least the starting point) for their corporate taxes. •many states use their own depreciation schedules and might resist expensing for budget reasons. • how will state and local governments respond to the elimination of the federal corporate income tax and its replacement with a dbcft? • absent specific congressional authorization, a state-level, border-adjusted dbcft might violate the commerce clause of the constitution. how will state and local governments react? 2017] the known unknowns of the business tax reforms proposed 147 32 • major tax reforms have historically been enacted on a bipartisan basis and as a result have been stable over time. • republicans intend to enact this tax reform through the budget reconciliation process. • needing only 51 votes to pass budget reconciliation legislation, it becomes possible to enact a major tax reform with only republican votes in the house and senate. • under senate rules (“the byrd rule”) if reconciliation legislation loses revenue in years beyond the budget period, it is subject to a point of order, which can be overruled only with 60 or more votes. • if a dbcft is enacted with only republican votes, will democrats, when they reassume power, repeal and replace this tax? • replacement here is much easier than with obamacare. all one needs to do is replace expensing with depreciation rules, revise tax rates, eliminate border adjustments, and perhaps impose a minimum income tax on global income. enactment through the reconciliation process 148 columbia journal of tax law [vol.8:117 33 • because this tax is unique, its treatment for financial accounting purposes is uncertain. • the tax may be treated like a vat and reduce corporations’ revenues. • alternatively, this tax may be treated like an income tax and therefore be treated as a business expense, perhaps with permanent and timing adjustments. • who will decide this issue? • fasb (with the sec) is most likely. •congress could decide (with committees other than the house ways and means and senate finance committee). • how will this transformation of the u.s. tax system affect existing deferred tax assets and liabilities on financial statements? • how will exchange rate adjustments affect balance sheets? accounting treatment 2017] the known unknowns of the business tax reforms proposed 149 34 • in the near term, a dbcft will burden different people depending on how much exchange rates adjust or prices rise. • u.s. holders of foreign assets lose and foreign holders of u.s. assets win if the value of the dollar rises. • foreign borrowers in dollar-denominated debt lose if the value of the dollar rises. • consumers who pay more for goods and services lose if prices of those goods and services rise (unless wages rise to the same extent). • profits of companies that export may increase (and profits of companies that import may decrease) to the benefit (or detriment) of their shareholders. • generous transition rules will tend to benefit corporate equity owners. • over the longer term, the burdens of this tax will be different. burdens of the tax 150 columbia journal of tax law [vol.8:117 35 • in the most comprehensive analysis of a dbcft to date, the economists alan auerbach, michael devereux, and mick keen claim: given the equivalence between a dbcft and a vat combined with a labour tax cut, the incidence of the tax would be on domestic residents financing consumption other than from wages, including from profit subject to the dbcft. in that respect, the dbcft would be more progressive than a single rate vat, and possibly more so than existing corporate taxes. • allowing expensing of capital assets is viewed by economists as exempting from tax the “normal rate of return on capital.” • compared to a corporate income tax, which allows deductions for wages but requires recovery of capital costs over time, expensing should reduce the cost of capital. • disallowing deductions for interest expense increases the cost of capital compared to a corporate income tax. • the blueprint replaces a 35 percent corporate income tax with a 20 percent dbcft. • the border adjustment and wage deductions eliminate the burdens on domestic wages. why should a consumption tax exempt consumption financed out of very high labor income? • do changes in prices change these results? • it is not clear how the joint committee on taxation – which typically produces distributional tables showing how changes in revenue affect the distribution of the tax burden and its after-tax income – will distribute the house blueprint. burdens of the tax 2017] the known unknowns of the business tax reforms proposed 151 36 • the issues and questions raised by the preceding slides will be resolved based on a series of government, business, and international institutions’ behavior subsequent to enactment. • the issues that follow will be resolved in the process of drafting this legislation. •their economic impact, however, will turn on the subsequent behavior of businesses, governments, and international institutions. different kinds of known unknowns 152 columbia journal of tax law [vol.8:117 37 • under a value-added tax, whenever inputs exceed outputs, the tax reduction on the excess is refunded. • although economists have long urged refunds of the income tax rate on losses, income taxes are not refunded. and the income tax limits the use of losses through mergers. • because of the exclusion of export sales from income, including payments associated with intellectual property used abroad, losses will be more prevalent under a dbcft than under the existing corporate income tax. • because of the deduction for wages, losses will be greater under the dbcft than under at vat. • for businesses that are primarily exporters, losses will occur year after year, perhaps with no years of positive taxes. • providing interest on loss carry forwards may not solve their problem. • a great variety of transactions designed to enable businesses to utilize their losses seem likely to emerge. • these include the potential for transferring losses to others through leasing transactions or mergers and acquisitions designed to match income with losses. • tax planners are certain to engage in numerous, and perhaps novel, transactions to monetize losses. • it is unknown how generous the ability to use losses will be under a dbcft. losses 2017] the known unknowns of the business tax reforms proposed 153 38 • how will mergers or transfers of substantial business assets be treated? •with respect to normal business transactions, purchases and sales of real assets will be treated differently from purchase and sales of financial assets. •when a line of business is sold, will sales of assets be treated similarly to sales of stock? •will companies be able to elect stock or asset treatment to minimize taxes? • will the sale and purchase of a line of business be excluded from this tax as is usually the case in value-added taxes? if so, how will such sales be defined? mergers 154 columbia journal of tax law [vol.8:117 39 • the house blueprint provides for different rates of tax on corporations (20%) than on partnerships and other flow-through entities (25%). • different tax rates depending on how a business is organized do not exist in consumption taxes elsewhere, including retail sales taxes or vats. • such a rate differential will create incentives to locate deductions in flowthrough business entities and taxable receipts with corporate entities. and to locate exports in flow-through entities, imports in corporations. • how will the deduction for wages apply to partnerships and other flowthrough entities? • will a rule requiring “reasonable compensation” be included? will “special allocations” by partnerships of losses, for example, continue to be allowed? will any deduction be allowed for wages of employees abroad? • what opportunities will occur for tax planning through complex structures that include both partnerships and corporations under the same ownership? • will any tax be imposed on foreign-owned entities that do business in the united states but do not sell their products here? differences in taxation of corporations and flow-through entities 2017] the known unknowns of the business tax reforms proposed 155 40 • value added taxes are typically of the credit-invoice type and rely on invoices showing taxes paid for their enforcement. credits are allowed only for taxes previously paid. • the dbcft is an accounts-based tax and the extent to which payment of tax by sellers will be required for deductions by purchasers is uncertain. • will the allowance of a deduction under the blueprint require a document showing how the item was treated and whether tax was paid at the previous stage of production? • vats rely on customs authorities to enforce the tax on imported goods. • the role, if any, of customs under the dbcft is uncertain. • in the absence of customs enforcement, europe has experienced significant missing-trader fraud. • in the absence of customs enforcement, many of the problems of taxing services under vats will also occur in taxing goods under a dbcft. • vats typically require registration of businesses, including foreign businesses, for enforcement. will registration be required under the dbcft? • taxation of services, especially imported services, has been troublesome under vats. • will vat rules, which typically rely on the location or residence of customers, be used in the dbcft? enforcement 156 columbia journal of tax law [vol.8:117 41 • will there be any exemption or special treatment for small businesses? • value-added taxes typically have exemptions for small businesses, sometimes quite large exemptions. • similar exemptions might create substantial difficulties under a dbcft. it has already been suggested that a deduction be allowed for interest expenses of small businesses. • how will purchases and sales of tax-exempt organizations and state and local governments be treated? • this question has been difficult and controversial in designing vats. • will there be any special treatment of goods that are not produced in the united states? importers of chocolate, coffee, bananas, and spices, for example, have requested exemptions. • will there be exemptions or special rates for particular industries, e.g., agriculture, real estate, housing? • the blueprint seems to disallow immediate deduction of capital expenditures on inventories and on land. why? how will sales of these assets be treated? exemptions 2017] the known unknowns of the business tax reforms proposed 157 42 • how will industries that necessarily operate across borders be treated? • these industries include communications suppliers, e.g., telephone and internet companies. questions also arise involving international transportation companies, e.g., fedex, ups, maersk. • will border adjustments turn on the residence of the buyer? • will transportation companies (or credit card companies) be required to collect taxes on imports to consumers? • how will advertising that reaches both domestic and foreign customers be treated? • how will puerto rico – which is within u.s. customs jurisdiction – be treated? inherently mobile industries, etc. 158 columbia journal of tax law [vol.8:117 43 • the blueprint disallows deductions for interest expenses in excess of interest income. • how will interest equivalents, such as rents from net leases, be treated? • lease transactions are important in the automobile industry, the airline industry, and the real-estate industry, for example. • this question has been difficult under the income tax, even though both rent and interest expenses are deductible. • what will be the treatment of non-financial corporations who earn financial income abroad? • will the personal holding company rules of subpart f be retained? • how will interest equivalents in financial instruments, such as swaps and forward contracts, be treated? • the blueprint distinguishes transactions in real assets from transactions in financial assets. how will business hedges of inventories and other business assets be treated? financial transactions 2017] the known unknowns of the business tax reforms proposed 159 44 • the blueprint expressly put aside the treatment of financial institutions under the dbcft. • there are many different kinds of financial institutions: for example, banks, insurance companies, hedge funds, private equity. • these institutions provide many different kinds of financial services, including merger and acquisition services, insurance and re-insurance services, checking and savings accounts, etc. will each of these services be treated similarly? • will financial services provided to businesses simply be ignored? • many industrial companies provide financing of their own products. • for example, ge finances its sales of airplane engines and medical equipment; there are many others. • will these lines of businesses be taxed as financial institutions? does it matter whether they provide financing in the form of loans or leases? • value-added taxes have long struggled, without great success, in fashioning tax rules for financial institutions. • will only services provided to consumers be taxed? or will there be some tax on transactions between financial institutions and other businesses. • will financial transactions or transactions of financial institutions be borderadjusted? • how will this be accomplished? will fees for foreign mergers be ignored as exports? taxation of financial institutions 160 columbia journal of tax law [vol.8:117 45 • will the corporation (or partnership) become a tax shelter opportunity for individuals? • under the blueprint, taxes on investment income can be deferred indefinitely at the business level (or, if investment income is taxed, subject to a lower rate). • should the step-up in basis (section 1014) be repealed to limit tax avoidance? • the blueprint taxes dividends to individuals. • how will dividends be defined? • for example, will earnings and profits (e&p) be required? • if so, will the depreciation and other e&p rules of current law be retained? • if not, will all distributions, including returns of capital, be taxed to individuals as dividends? relationship to individual taxation 2017] the known unknowns of the business tax reforms proposed 161 46 • what rate of tax will be imposed on existing foreign assets held by usmncs abroad? • will there be a distinction between cash (and cash equivalents) and other assets such as plant and equipment? • will potential exchange rate adjustments be taken into account in devising the tax? • how will pre-enactment transactions be treated? • pre-enactment assets: recovery of remaining basis? • pre-enactment loans: ongoing deductions of interest? • pre-enactment net operating losses: ongoing allowances against the dbcft? • pre-enactment credits: ongoing carry-forwards? • treatment of pre-enactment contracts? • any distinction based on whether contracts are dollardenominated? • any rules for unwinding existing arrangements? • phase-in of dbcft rules and rate? transition 162 columbia journal of tax law [vol.8:117 47 • enact a low-rate corporate income tax or cash flow tax without border adjustments. • perhaps revise transfer pricing rules to allocate more income to the destination country (especially income from ip). • allocate residual profits (after allowing a fixed rate of return on manufacturing, research and development, and financing) to the countries where sales occur. • or finance a 15 percent corporate tax rate and payroll tax relief with a 5 percent retail sales tax or vat. • or eliminate the dbcft wage deduction, lower the tax rate by up to two-thirds, provide payroll tax relief to employees and employers. • or as a revenue and distributionally neutral alternative: enact a 12.9 percent (tax-exclusive) rate vat, provide payroll tax relief, provide vat offsets to low and moderate income families, exempt 150 million families from the income tax through a $100,000 family exemption and reduce the corporate income tax rate to 15 percent. some alternatives to the dbcft 2017] the known unknowns of the business tax reforms proposed 163 48 appendix a bibliography 164 columbia journal of tax law [vol.8:117 alan j. auerbach, border adjustments and the dollar, am. ent. inst. (feb. 21, 2017), https://www.aei.org/publication/border-adjustment-and-the-dollar/. alan j. auerbach, notes on the us wealth effect of border adjustment (feb. 13, 2017), http://eml.berkeley.edu/~auerbach/notesontheuswealtheffectofborderadjustment.pdf. alan j. auerbach, the future of fundamental tax reform, 87 am. econ. rev. 143 (1997). alan j. auerbach & douglas holtz-eakin, the role of border adjustments in international taxation, am. action forum (nov. 30, 2016), https://www.americanactionforum.org/research/14344/. alan auerbach, michael p. devereux, michael keen & john vella, destination-based cash flow taxation (oxford u. ctr. for bus. tax’n, working paper no. 17-01, 2017), http://eml.berkeley.edu/~auerbach/cbtwp1701.pdf. reuven s. avi-yonah, back to 1913? the ryan-brady blueprint and its problems, tax notes (dec. 12, 2016), http://repository.law.umich.edu/cgi/viewcontent.cgi?article=2820&context=articles. reuven s. avi-yonah, & kimberly clausing, problems with destination-based corporate taxes and the ryan blueprint, 8 colum. j. tax l. 229 (2017). johannes becker & joachim englisch, a european perspective on the us plans for a destination based cash flow tax (mar. 10, 2017), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2924313. tom bergin & david morgan, u.s. tax plan would break wto rules, lawyers say, as eu business frets, reuters (feb. 1, 2017), http://www.reuters.com/article/us-trump-usa-tax-tradeiduskbn15g5eh. stephen bond & michael p. devereux, cash flow taxes in an open economy (2002), http://eml.berkeley.edu//~burch/bond.pdf jason bordoff, what would the us border tax adjustment mean for energy?, petroleum economist (mar. 14, 2017), http://www.petroleum-economist.com/articles/politics-economics/northamerica/2017/what-would-the-us-border-tax-adjustment-mean-for-energy. keith bradsher, rachel abrams & bill vlasic, counting the winners and losers from an importbased tax, n.y. times (jan. 26, 2017), https://www.nytimes.com/2017/01/26/business/economy/import-tax-business-reaction.html?_r=1. cong. budget office, impose a 5 percent value-added tax (dec. 8, 2016), https://www.cbo.gov/budget-options/2016/52285. a-1 2017] the known unknowns of the business tax reforms proposed 165 a-2 willem h. buiter, exchange rate implications of border tax adjustment neutrality (ctr. for econ. pol’y res., discussion paper no. dp11885, 2017), http://voxeu.org/article/exchange-rate-implicationsborder-tax-adjustment-neutrality. jonathan curry, tax reform prospects for 2017 dimming, economists say, tax notes (mar. 13, 2017), http://www.taxanalysts.org/content/tax-reform-prospects-2017-dimming-economists-say. jonathan curry, trump comments breathe new life into border-adjustable tax, tax notes (feb. 27, 2017), http://www.taxnotes.com/tax-notes-international/tax-reform/trump-comments-breathe-newlife-border-adjustable-tax/2017/02/27/18850866. shawn donnan, barney jopson & paul mcclean, eu and others gear up for wto challenge to us border tax, fin. times (feb. 13, 2017), http://www.ft.com/content/cdaa0b76-f20d-11e6-87586876151821a6. geoff dyer, donald trump threatens to pull us out of wto, fin. times (july 24, 2016), http://www.ft.com/content/d97b97ba-51d8-11e6-9664-e0bdc13c3bef. brian faler, retailers fear massive tax increases under house republican tax plan, politico (nov. 23, 2016), http://www.politico.com/story/2016/11/retailers-fear-massive-tax-increases-under-houserepublicans-tax-plan-231817. jason j. fichtner, veronique de rugy & adam n. michel, border tax adjustments: what we know (not much) and what we don’t (all the rest), mercatus ctr. at george mason u. (feb. 2017), http://www.mercatus.org/system/files/fichtner-border-adjustment-tax-brief-v2_0.pdf. jason furman, senior fellow, peterson inst. for int’l econ., border adjustment as tax policy and as macroeconomic policy, presentation at border tax adjustment and corporate tax reforms conference (feb. 1, 2017), http://piie.com/system/files/documents/furman20170201ppt.pdf. jason furman, katheryn russ & jay shambaugh, us tariffs are an arbitrary and regressive tax, voxeu.org (jan. 12, 2017), http://voxeu.org/article/us-tariffs-are-arbitrary-and-regressive-tax. meghan gordon & john kingston, gop tax reform and what’s at stake for the oil industry, platts: s&p global (jan. 19, 2017), http://blogs.platts.com/2017/01/19/gop-tax-reform-oil-industry/. michael j. graetz, 100 million unnecessary returns: a simple, fair, and competitive tax plan for the united states (2010). michael j. graetz, the tax reform road not taken -yet, 67 nat’l tax j. 419 (2004). 166 columbia journal of tax law [vol.8:117 a-3 megan greene, us border adjustment tax: the path to stagflation, debt and deflation?, manulife asset mgmt.: market views and insights (jan. 26, 2017), http://www.manulifeam.com/us/research-and-insights/market-views-and-insights/us-borderadjustment-tax-the-path-to-stagflation-debt-and-deflation/. itai grinberg, where credit is due: advantages of the credit-invoice method for a partial replacement vat, 63 tax l. rev. 309 (2009). david p. hariton, financial transactions and the border-adjusted cash flow tax, tax notes (jan. 9, 2017), http://www.taxanalysts.org/content/financial-transactions-and-border-adjusted-cash-flow-tax. mindy herzfeld, news analysis: a better way on border adjustability, tax notes (feb. 20, 2017), http://www.taxnotes.com/tax-notes-international/tax-reform/news-analysis-better-way-borderadjustability/2017/02/20/18843196. mindy herzfeld, news analysis: tax reform -all about passthroughs, tax notes (feb. 6, 2017), http://www.taxnotes.com/tax-notes-international/tax-reform/news-analysis-tax-reform-all-aboutpassthroughs/2017/02/06/18829411. mindy herzfeld, news analysis: economics -the real appeal of the border adjustment tax, tax notes (mar. 13, 2017), http://www.taxnotes.com/tax-reform/news-analysis-economics-real-appealborder-adjustment-tax. mindy herzfeld, news analysis: reality check on a destination-based cash flow tax in 2017, tax notes (dec. 5, 2016), http://www.taxnotes.com/worldwide-tax-daily/tax-reform/news-analysisreality-check-destination-based-cash-flow-tax-2017/2016/12/05/18688971. mindy herzfeld, news analysis: who will pay for tax reform?, tax notes (feb. 13, 2017), http://www.taxnotes.com/tax-notes-today/tax-reform/news-analysis-who-will-pay-taxreform/2017/02/13/18835631. press release, house comm. on ways and means, chairman brady delivers remarks at the u.s. chamber of commerce (jan. 24, 2017), http://waysandmeans.house.gov/chairman-brady-deliversremarks-u-s-chamber-commerce/. daniel p. hui & michael feroli, border adjustment and fx, j.p. morgan (feb. 15, 2017). gary clyde hurfauer & zhiyao (lucy) lu, pb 17-3 border tax adjustments: assessing risks and rewards, peterson inst. for int’l econ. (jan. 2017), http://piie.com/system/files/documents/pb173.pdf. barney jopson & sam fleming, us will ‘leapfrog’ the world with tax reforms, says kevin brady, fin. times (feb. 1, 2017), http://www.ft.com/content/8068420e-e887-11e6-893c-082c54a7f539. 2017] the known unknowns of the business tax reforms proposed 167 a-4 kezie mckeague, viewpoint: four reasons why the u.s.-chile tax treaty is vital, americas society/council of the americas (june 20, 2016), http://www.as-coa.org/articles/viewpoint-fourreasons-why-us-chile-tax-treaty-vital. david mericle, alec phillips & daan struyven, us daily: what would the transition to destinationbased taxation look like?, goldman sachs economics research (dec. 8, 2016). gregory meyer & david sheppard, why a us border adjustment tax would matter for the oil price, fin. times (jan. 31, 2017), http://www.ft.com/content/d5283a64-e707-11e6-967b-c88452263daf. dylan f. moroses, rep. rice working on small business interest deduction carveout, tax notes (mar. 22, 2017), http://www.taxnotes.com/tax-notes-today/tax-reform/rep-rice-working-smallbusiness-interest-deduction-carveout/2017/03/23/18875556. leonard e. burman, james r. nunns, benjamin r. page, jeffrey rohaly & joseph rosenberg, an analysis of the house gop tax plan, 8 colum. j. tax l. 257 (2017). oecd, base erosion and profit shifting, http://www.oecd.org/tax/beps/. office of the speaker of the house, tax reform task force blueprint—a better way: our vision for a confident america (2016), http://abetterway.speaker.gov/_assets/pdf/abetterway-taxpolicypaper.pdf. elena patel & john mcclelland, what would a cash flow tax look like for u.s. companies? lessons from a historical panel (office of tax analysis, working paper no. 116, 2017), http://www.treasury.gov/resource-center/tax-policy/tax-analysis/documents/wp-116.pdf. kyle pomerleau, what is the distributional impact of a destination-based cash-flow tax?, tax foundation (jan. 18, 2017), http://taxfoundation.org/what-distributional-impact-destination-basedcash-flow-tax/. the president’s advisory panel on federal tax reform, simple, fair, and progrowth: proposals to fix america’s tax system (2005), http://www.treasury.gov/resource-center/taxpolicy/documents/report-fix-tax-system-2005.pdf. alan reynolds, first doubts about border adjustability, the cato inst.: cato at liberty (jan. 30, 2017), http://www.cato.org/blog/first-doubts-about-border-adjustability. alan reynolds, second doubts about a border adjustable corporate tax (bact), the cato inst.: cato at liberty (jan. 31, 2017), http://www.cato.org/blog/second-doubts-about-border-adjustablecorporate-tax-bact. 168 columbia journal of tax law [vol.8:117 a-5 richard rubin & heather haddon, fish importer casts worry over border-adjusted tax, wall street j. 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randall k. johnson* abstract this article explains who wins residential property tax appeals in cook county, illinois. it does so by collecting and combining public sector data, which has been recently released by the cook county assessor. the article then uses this data to compute three statistics. lastly, it contextualizes each statistic in order to determine if some townships, or groups of townships, win more appeals than expected. 210 columbia journal of tax law [vol.6:209 i. introduction ............................................................................................ 211 ii. applicable law ........................................................................................ 213 iii. methodology ........................................................................................... 215 iv. findings....................................................................................................... 216 a. northwest suburbs ..................................................................................... 216 b. southwest suburbs ..................................................................................... 216 c. city of chicago .......................................................................................... 217 v. discussion .................................................................................................. 217 vi. conclusion ................................................................................................ 219 appendix ........................................................................................................... 220 2015] who wins residential property tax appeals? 211 i. introduction serious budgetary shortfalls have plagued state and local governments for a number of years. 1 traditionally, budgetary shortfalls arose from government failures such as excessive spending, optimistic projections, and modest tax collections. 2 these shortfalls often were made worse by other market failures. 3 an example of a case in point was provided by the great recession. the great recession, which ―started in 2007 [and] . . . caused the largest collapse in state [tax] . . . revenues on record,‖ 4 forced many governments to set new budgetary priorities. some governments, in response, reduced spending to eliminate budgetary shortfalls. 5 other states focused their efforts on increasing public sector efficiency. 6 a third category emphasized improving tax collections. 7 improving tax collections may be the single best approach, since it is one of the few ―options available . . . outside of the . . . ‗either-or‘ framework of tax increases and spending cuts.‖ 8 this approach also works well due to a relative lack of visibility. 9 lastly, it may help to eliminate unjustified grants of relief. 10 using a newly released dataset from the second-largest county in the u.s. 11 — cook county, illinois—my article describes one way to improve local tax collections. it 1 see, e.g., phil oliff, chris mai & vincent palacios, states continue to feel recession’s impact, ctr. on budget & pol‘y priorities (jun. 27, 2012), http://www.cbpp.org/cms/index.cfm?fa=view&id=711 (―in the early 2000s, as in the early 1990s and early 1980s, state fiscal problems lasted for several years after the recession ended.‖). 2 see clifford winston, government failure vs. market failure: microeconomics policy research and government performance, brookings (sept. 2006)), http://www.brookings.edu/research/papers/2006/ 09/monetarypolicy-winston (―government failure, [which is a type of a market failure,] . . . arises when government has created inefficiencies because it should not have intervened in the first place or when it could have solved a given problem or set of problems more efficiently, that is, by generating greater net benefits.‖). 3 public production: government failure vs. market failure: hearing before the h.r. comm. on fin. serv., 110th cong. 1 (2007) (statement of clifford winston, senior fellow, economic studies, the brookings institution) (―market failure occurs when a socially desirable good or service–that is, a good or service whose social benefits exceed its social costs–is not provided because firms would find it unprofitable to do so.‖). 4 oliff, supra note 1, at 1. 5 see, e.g., iris j. lav & dylan grundman, a balanced approach to closing state deficits, ctr. on budget & pol‘y priorities 2 (feb. 25, 2011), http://www.cbpp.org/cms/?fa=view&id=3084 (―[in cases where state governments are prohibited]… from running a deficit, state policymakers‘ first impulse when confronting a revenue shortfall is usually to reduce spending.‖). 6 see id. at 3 (―[for example, public expenditure] on prisons and related areas is getting a lot of attention during this recession and its aftermath; a number of states have been looking at ways to reduce corrections budgets without compromising public safety.‖). 7 see id. at 7–8 (―after soliciting recommendations from a review panel, iowa passed a law in 2010 that places limitations on certain business-related credits, creates a tax expenditure review committee, and requires the committee to closely evaluate each tax expenditure‘s costs and benefits at least once every five years.‖). 8 id. at 1. 9 see id. at 7 (―each year states give up billions of dollars of revenue in the form of tax [exemptions–including tax assessment reductions,] credits, deductions, and exemptions spent through the tax code as opposed to through the regular appropriations process. . . . but there is an important difference . . . expenditures . . . receive far less scrutiny.‖). 10 id. (―[unjustified grants of relief, generally, arise because]… policymakers do not regularly examine tax expenditures, nor do states document their effectiveness the same way they do for on-budget expenditures.‖). 11 see office of the cook county assessor, cook county residential property tax assessment data, 1993–2012 (2013) [hereinafter assessor], which was directly provided to the author by the office of 212 columbia journal of tax law [vol.6:209 does so by critically assessing the residential property tax appeals process in cook county, which has led to about $345 million in property valuation reductions during a recent tax year. 12 as a result, this article explains why more governments should eliminate unjustified property tax appeals. in carrying out its work, this article draws on recent tax law scholarship. it is informed, for example, by cutting-edge behavioral law and economics research. 13 the article also builds on interdisciplinary studies that ask if property tax appeals impact local tax burdens. 14 a third influence is work that explores the relationship between property tax appeals and inequality. 15 within this context, the article makes three contributions to the property tax appeal literature. 16 first, it identifies the township location of every residential property that is taxed in cook county. next, this article identifies the township location of every residential property tax appeal that is filed between 2009 and 2013. finally, it combines and analyzes this data, thereby determining if some townships, or groups of townships, ―win‖ more appeals than anticipated. 17 the article proceeds in five additional parts. part ii describes the applicable law in cook county. part iii explains this article‘s methodological approach. part iv outlines its preliminary research findings. part v contains the article‘s normative recommendations. part vi is the conclusion. the cook county assessor in jan. 2013; see office of the cook county assessor, cook county residential property tax appeals data, 2009–2013 (2014) [hereinafter assessor 2], which was directly provided to the author by the office of the cook county assessor in may 2014 and in nov. 2014; see infra tables 1, 2, 3, 4 & 5. 12 see civic federation, cook county property tax appeals: a primer on the appeals process with comparative data for 2000–2008, 15 (2009) [hereinafter civic federation] (―the total amount of the reductions in assessed [property] value granted by the [cook county] . . . assessor‘s office declined by $1.3 billion, or 38.6%, between 2000 and 2008. while the value of assessment reductions granted to residential properties increased during this time from $158.4 million to $344.6 million, the value of assessment reductions granted to all other [property types] . . . declined by $1.5 billion.‖). 13 see, e.g., andrew t. hayashi, the legal salience of taxation, 81 u. chi. l. rev. 1443 (2014). 14 see, e.g., rachel n. weber & daniel p. mcmillen, ask and ye shall receive? predicting the successful appeal of property tax assessments, 38 pub. fin. rev. 74 (2010) [hereinafter weber]. 15 see, e.g., brent c. smith, intrajurisdictional segmentation of property tax burdens: neighborhood inequities across an urban sphere, 30 j. real est. res. 207 (2008). 16 see weber, supra note 14, at 77 (―unfortunately, scant research has been undertaken on the topic of property tax appeals.‖). 17 in order to determine who wins residential property tax appeals, this article uses percentage analysis. this simplified approach permits the computation of three win percentages. these win percentages are computed at the aggregate level, at the group level, and at the individual township level. within this context, any individual or group-level average that is higher than the population average indicates that there may be more wins than anticipated. in contrast, any individual or group-level average that is lower than the population average indicates that there may be less wins than expected. in cases where the averages are equal, then that individual or group wins as frequently as anticipated. this article makes no attempt to determine whether the observed differences are statistically significant, but it still may serve as a potential point of departure for future research. cf. randall k. johnson, where schools close in chicago, 7 alb. gov‘t l . rev. 508, 510–11 n.20 (2014) (―[future] research may go beyond the basic question to be answered in this article: ‗are there [any] differences between the samples or categories of the independent variable?‘ instead, it asks: ‗are the differences between the samples large enough to reject the null hypothesis and [to] justify the conclusion that the populations represented by the samples are different?‘‖) (citations omitted). 2015] who wins residential property tax appeals? 213 ii. applicable law in illinois, the property tax is the largest source of state tax revenues. 18 this tax, on average, yields $59,466,000 in annual revenues. 19 about half of these revenues are collected in cook county, 20 which is the second-largest property tax assessment area in the entire u.s. 21 these revenues have grown markedly over time, especially during the last 25 years. 22 under applicable law, cook county uses a real property classification system to make tax assessments. 23 this classification system recognizes seven property types: vacant land (class-1), residential properties (class-2), apartments (class-3), nonprofits (class-4), commercial properties (class-5a), industrial properties (class-5b), and various properties (class-incentives). 24 the tax rate is ten percent for vacant land, residential properties, apartments, and various properties, whereas it is 25 percent for nonprofit properties, commercial properties, and industrial properties. 25 these tax rates became fully effective in tax year 2011. 26 the classification system also ―establishes a requirement of uniformity of assessments [so as to assure that] . . . the assessing authority [assigns an accurate] . . . value for real property.‖ 27 this requirement does not ―call for mathematical equality . . . 18 see ares g. dalianis & scott r. metcalf, property tax litigation, ill. inst. for continuing legal educ. 12.1 (2013) [hereinafter dalianis]. 19 see state tax revenues: charts and data, governing (2012), http://www.governing.com/govdata/state-tax-revenue-data.html (displaying an interface that permits the entry of information, which identifies state property tax revenues over time, by entering: state: illinois; tax type: property tax). in recent years, illinois had state property tax revenues of $59,134,000 (2008); $63,853,000 (2009); $50,962,000 (2010); $58,273,000 (2011); and $65,106,000 (2012). the average annual revenue over this five-year period was $59,466,000. 20 see 2012 property tax statistics, illinois.gov (2012), http://tax.illinois.gov/aboutidor/ taxstats/propertytaxstats/2012/index.htm; see dalianis, supra note 18, at 12.1 (―approximately 45 percent of all [illinois] property taxes are collected in cook county.‖). 21 see weber, supra note 14, at 76. 22 see dalianis, supra note 18, at 12.1 (―the increase in [illinois] . . . property taxes from 1989 to 2010 was 192.5 percent, or an annual average rate of increase of 5.24 percent.‖). 23 see id. at 12.2–12.3 (―property tax assessment litigation is governed almost exclusively by state law. the illinois constitution and the property tax code, 35 ilcs 200/1-1, et seq., provide exceptional detail and guidance for real property taxation in illinois. . . . [it nevertheless] should be noted that property tax litigation, particularly assessment appeals, can give rise to equal protection claims under the fourteenth amendment to the united states constitution. . . . see, e.g., allegheny pittsburgh coal co. v. county commission of webster county, west virginia, 488 u.s. 336, 102 l.ed.2d 688, 109 s.ct. 633 (1989). however, the tax injunction act, 28 u.s.c. §1341, provides that ‗district courts shall not enjoin, suspend or restrain the assessment, levy or collection of any tax under state law where a plain, speedy and efficient remedy may be had in the courts of such state.‘ . . . the effect of the tax injunction act is that almost all assessment litigation is pursued under state law.‖). 24 see id. at 12.6 (―article ix, § 4, of the illinois constitution allows counties with a population of more than 200,000 to classify real property for taxation purposes. cook county . . . is the only county in illinois that classifies real property for taxation purposes.‖). 25 see id. (―the cook county board of commissioners adopted significant amendments to the cook county real property assessment classification ordinance, cook county code of ordinances §74-64, which were effective beginning in the 2009 tax year. cook county ordinance no. 08-0-51 (sept. 17, 2008).‖). 26 see id. (―for the 2011 tax year and beyond, assessments in cook county will be either 10 percent or 25 percent of the fair cash value of the property.‖). 27 ill. const. art. ix, §4(a). 214 columbia journal of tax law [vol.6:209 a practical uniformity, rather than an absolute one, is the test.‖ 28 this uniformity test has been challenged in a variety of ways. 29 a less controversial practice, as indicated by the modest amount of litigation that it generates over time, is the real property tax appeal process. 30 under this process, 31 which begins with the cook county assessor or with the cook county board of review, 32 ―property owners within a township may appeal their assessment every year . . . , as long as the appeal is filed within the period of time [that] their township is ‗open.‘‖ 33 property owners may learn about township openings opening by mail, 34 as well as through publication in a general circulation newspaper. 35 to successfully appeal an assessment, property owners must produce legallysufficient evidence. 36 this evidence may show that there is an error in the property description, a lack of uniformity, or a mistake in the property valuation. 37 all evidence must be filed as part of a property tax appeal complaint. 38 28apex motor fuel co. v. barrett, 169 n.e.2d 769 (ill. app. ct. 1960). 29 see, e.g., cook cnty. bd. of review v. prop. tax appeal bd., 791 n.e.2d 8 (ill. app. ct. 2002); see, e.g., cook cnty. bd. of review v. prop. tax appeal bd., 803 n.e.2d 55 (ill. app. ct. 2003). 30 see j. lyn entrikin, symposium: v. atypical consumer agreements as aberrant contracts: tax ferrets, tax consultants, bounty hunters, and hired guns: the property tax netherworld fueled by contingency fees and campertous agreements, 89 chi.-kent l. rev. 289, 296 (2014) (―relatively few assessment appeals reach the state appellate courts.‖). 31 see 35 ill. comp . stat. 200/14-35 (2014). 32 see robert m. sarnoff & michael f. baccash, administrative challenges to assessments and equalizations, illinois institute for continuing legal education 5.1 (2012) (―the property tax code, 35 ilcs 200/1-1, et seq., provides that assessments may be revised either by the [cook county] assessor or the [cook county] board of review, depending on when the revision is requested.‖) [hereinafter sarnoff]. 33 dalianis, supra note 18, at 12.8. 34 see id. (―the cook county assessor typically launches the general assessment process by sending notice to all property owners in the district being reassessed, advising them of the proposed assessment for their property. the notice of the change in assessment provides a date, generally 30 days from the date of the notice, before which the property owner may file an appeal.‖); see 35 ill. comp . stat. 200/14-35. 35 see sarnoff, supra note 32, at 5.3 (―the assessor is required to publish a schedule of the dates on which he or she will hear complaints concerning real property assessments from one or more townships or taxing districts after the assessment books are complete. publication of schedules must occur in a newspaper of general circulation within the county at least one week before the hearings.‖); see 35 ill. comp . stat. 200/14-35; see sarnoff, supra note 32, at 5.10 (―the board of review in a county with three million or more inhabitants must publish notice in a newspaper of general circulation within the county specifying the time and place at which taxpayers may file complaints.‖); see 32 ill. comp . stat. 200/16-110. generally speaking, real properties are re-assessed every three years in cook county. 36 see sarnoff, supra note 32, at 5.4 (―each complaint filed with the cook county assessor must contain the township, volume, permanent index number, and name and address of the complainant. the taxpayer must also provide additional information pertaining to the value of the property and the basis for the complaint in accordance with the assessor‘s rules.‖); see sarnoff, supra note 32, at 5.11 (―evidence should support a taxpayer‘s complaint [to the cook county board of review.‖). 37 see sarnoff, supra note 32, at 5.11 (―when using comparable sales as a basis for a complaint, a listing of the various comparable properties should include the permanent index numbers of each comparable, the date of sale, the sales price, the document number of the deed, and the unit value of the comparison (e.g. rental value per room of an apartment building.‖)). 38 see sarnoff, supra note 32, at 5.3 (―a taxpayer may file a complaint with the cook county assessor before the assessor completes and verifies the assessment books. after filing a valuation complaint, the taxpayer is entitled to an opportunity to be heard in support of the complaint.‖); see 35 ill. comp . stat. 200/9-85; see civic federation, supra note 12, at 16-7 (―the methods of presenting these complaints are largely the same as at the assessor‘s office . . . . after a proper complaint is filed, the board schedules a 2015] who wins residential property tax appeals? 215 once an appeal is submitted, and decided, the property owner is notified by mail. 39 this final decision may be appealed, as of right. 40 additional options for appeal, beyond a reconsideration or a re-review, also could be available. 41 these options include a review by the illinois property tax appeals board or an appeal to the circuit court of cook county. 42 iii. methodology my article introduces a new property tax appeal dataset for cook county, which counsels for the elimination of unjustified property tax appeals. it does so, initially, by collecting and combining public sector data. 43 then, these data are used to compute three statistics: the percentage of residential properties that appeal their assessments, the percentage of successful appeals, and the percentage of successful appeals with an attorney. 44 lastly, the article contextualizes these statistics: in order to determine whether some townships, or groups of townships, win more residential property tax appeals than expected. 45 this project is undertaken, in the first instance, at the aggregate-level (i.e. cook county). 46 next, it is undertaken at the group level (i.e. the 13 townships that are located in the northwest suburbs, the 17 townships that are located in the southwest suburbs, and the eight townships that are located in the city of chicago). 47 the project, finally, is undertaken at the individual level (i.e. each of the 38 townships that are used for tax purposes). 48 in the process, this article explains which townships win the most residential property tax appeals. 49 a single methodological approach is used, percentage analysis. 50 this approach ―consists of reducing a series of related amounts to a series of percentages of a given base.‖ 51 depending on the characteristics of these related amounts, the unit of analysis is a ―percentage‖ or a ―rate.‖ percentage analysis is used for at least three reasons. first, the approach is ―helpful in evaluating the relative size of items or the relative change in items.‖ 52 public hearing on the complaint.‖); see 35 ill. comp . stat. 200/16-95(1); see 35 ill. comp . stat. 200/16-120. 39 see civic federation, supra note 12, at 5 (―the [cook county] assessor‘s office notifies the property taxpayer of its decision by mail.‖); see civic federation, supra note 12 at 17 (―the taxpayer is notified by letter of the board [of review‘s] decision regarding the assessment.‖). 40 see civic federation, supra note 12, at 5 (―a property taxpayer unsatisfied with the decision may request a reconsideration of the assessment by the [cook county] assessor‘s office.‖); see civic federation, supra note 12, at 17 (―once a decision is rendered, the property taxpayer may request that the board [of review] re-review the assessment.‖). 41 see civic federation, supra note 12, at 28. (―only those parties who filed a complaint at the board of review may further appeal assessments at the illinois property tax app eal board (ptab) or the circuit court of cook county.‖); see 35 ill. comp . stat. 200/16-180. 42 id. 43 see assessor, supra note 11; see assessor 2, supra note 11. 44 see infra tables 6, 7, and 8. 45 id. 46 see infra tables 4 and 5. 47 see infra tables 6, 7, and 8. 48 see infra tables 4 and 5. 49 see infra tables 4, 5, 6, 7, and 8. 50 see financial analysis primer, introduction: basic financial statement analysis, objective five, 2014 http://www.wiley.com/college/kieso/0471363049/dt/analysttool/faprimer/fap11.htm. 51 id. 52 id. 216 columbia journal of tax law [vol.6:209 percentage analysis also provides ―a useful way of comparing fractions with different denominators.‖ 53 lastly, the approach lays ―a solid foundation for discussing . . . more complicated . . . [empirical] issues.‖ 54 this approach, however, will not be useful if the article does not account for a range of methodological issues. several methodological issues are dealt with deliberately by this article. for example, selection effects are accounted for by testing all 38 townships in cook county. omitted variables are dealt with by testing these townships at the aggregate, group, and individual levels. additional problems have been avoided by identifying who wins residential property tax appeals. iv. findings this article collects data about the 1,532,170 taxable properties in cook county. 55 it later combines the data with other information, which focuses on the 484,956 residential property tax appeals that were filed over the last 5 years. 56 finally, the article analyzes the combined data to determine if some townships, or groups of townships, win more than expected. the article‘s computations, and its research findings, are summarized in sub-parts a, b, and c. a. northwest suburbs the thirteen townships in the northwest suburbs, at least when compared to the entire population of cook county townships, win more residential property tax appeals than expected. 57 for example, 7.2 percent of all northwest suburban residences appealed their tax assessment (versus 6.3 percent of all cook county residences). 58 of this subset of class-2 properties, 3.7 percent then went on to successfully appeal (as opposed to 3 percent of the sample population). 59 finally, 1.8 percent of all northwest suburban residences successfully appealed with an attorney (versus 1.3 percent of all cook county residences). 60 b. southwest suburbs the 17 townships in the southwest suburbs, at least when compared to the entire population of cook county townships, win more residential property tax appeals than expected. 61 for example, 8 percent of all southwest suburban residences appealed their tax assessment (versus 6.3 percent of all cook county residences). 62 of this sub-set of class-2 properties, 4 percent also went on to successfully appeal (as opposed to 3 percent 53 international centre of excellence in mathematics, percentages: a guide for teachers – years 7 and 8, number and algebra: module 20, 1 (june 2011). 54 jessica polito, the language of comparisons: communicating about percentages, 7 numeracy 14 (2014). 55 see assessor, supra note 11. 56 see assessor 2, supra note 11. 57 compare infra table 6 with infra table 5. northwest suburban townships had 401,312 taxable properties in 2009, which is 26 percent of the 1,532,170 taxable properties in cook county. in contrast, this subset of townships had 144,868 residential property tax appeals between 2009 and 2014, which is 30 percent of the 484,956 residential property tax appeals in cook county. 58 id. 59 id. 60 id. 61 compare infra table 7 with infra table 5. southwest suburban townships had 423,119 taxable properties in 2009, which is 28 percent of the 1,532,170 taxable properties in cook county. in contrast, this subset of townships had 168,732 residential property tax appeals between 2009 and 2014, which is 35 percent of the 484,956 residential property tax appeals in cook county. 62 id. 2015] who wins residential property tax appeals? 217 of the sample population). 63 lastly, 1.4 percent of all southwest suburban residences successfully appealed using an attorney (versus 1.3 percent of all cook county residences). 64 c. city of chicago the eight townships within the city of chicago, at least when compared to the entire population of cook county townships, win less residential property tax appeals than expected. 65 for example, 4.8 percent of all city of chicago residences appealed their tax assessment (versus 6.3 percent of all cook county residences). 66 of this sub-set of class-2 properties, then, 2.1 percent went on to successfully appeal (as opposed to 3 percent of the sample population). 67 finally, 1 percent of all city of chicago residences successfully appealed with an attorney (versus 1.3 percent of all cook county residences). 68 v. discussion the article finds that northwest and southwest suburban townships win more tax appeals than anticipated, in absolute and relative terms. 69 the finding remains true whether wins are defined in terms of the percentage of residential properties that appeal their tax assessments, the percentage of residential properties that successfully appeal, or the percentage of residential properties that successfully appeal with an attorney. this finding, however, is expressly limited to the last five tax years. this finding carries positive and normative implications for cook county. among the positive implications is that cook county residents cannot claim, at least with respect to residential property tax appeals, that suburban townships are treated more poorly than urban townships. more research, however, is needed 70 to confirm or disprove related claims. 71 63 id. 64 id. 65 compare infra table 8 with infra table 5. city of chicago townships had 707,739 taxable properties in 2009, which is 46 percent of the 1,532,170 taxable properties in cook county. in contrast, this subset of townships had 171,356 residential property tax appeals between 2009 and 2014, which is 35 percent of the 484,956 residential property tax appeals in cook county. 66 id. 67 id. 68 id. 69 compare infra table 6 with infra table 5 (northwest suburban townships wins more than expected in absolute terms); compare infra table 7 with infra table 5 (southwest suburban townships win more than anticipated in absolute terms); compare infra table 6 with infra table 8 (northwest suburban townships win more than city of chicago townships in relative terms); compare infra table 7 with infra table 8 (southwest suburban townships win more than city of chicago townships in relative terms). the reason why suburban townships win more often is outside the scope of this article. the author plans to answer this question, among others, in a future publication. 70 cf., e.g., randall k. johnson, why we need a comprehensive recording fraud registry, 2014 n.y.u. j. legis. & pub. pol‘y quorum 88, 90 (2014); randall k. johnson, why police learn from thirdparty data, 3 wake forest l. rev. online 1, 4 (2013); randall k. johnson, do police learn from lawsuit data?, 40 rutgers l. rec. 30, 37–38 (2012–2013). 71 compare e.j. dionne, how government helps the 1 percent, wash. post (jan. 14, 2015), http://www.washingtonpost.com/opinions/ej-dionne-how-government-helps-the-1-percent/2015/01/14/ 17cf8448-9c29-11e4-a7ee-526210d665b4_story.html with greg hinz, chicago homeowners get tax break relative to burbs, crain‘s chicago business (dec. 12, 2013), http://www.chicagobusiness.com/article/ 20131212/blogs02/131219903/chicago-homeowners-get-tax-break-relative-to-burbs. 218 columbia journal of tax law [vol.6:209 the normative implications, in comparison, are somewhat less obvious. for example, cook county could point out that appeals are very costly. 72 it also may limit current public outreach efforts, at least to the 30 suburban townships, so as to discourage unjustified property tax appeals. 73 lastly, cook county could standardize its property tax appeal requirements. 74 cook county should take up each recommendation for three reasons. first, these reforms may limit moral hazard. 75 next, each recommendation could ensure that the property tax remains horizontally and vertically equitable. 76 lastly, these reforms may help to deter future litigation. 77 it must be recognized, however, that special interest groups could oppose these recommendations. 78 this potential opposition may be overcome in several ways. for example, cook county could show that most residential properties are significantly under-assessed. 79 it may also point out that ―the proportions of property owners appealing . . . assessments . . . are relatively high.‖ 80 lastly, cook county could explain the problem with unjustified property tax appeals. 81 72 see weber, supra note 14, at 75 (―[residential property tax appeal] . . . processes are . . . expensive to administer, as adjudicators must devote scarce resources and staff time to distinguish between frivolous and legitimate claims.‖). 73 id. at 81 (―since 1998, the cook county assessor and several alderman and county commissioners have made concerted efforts to solicit appeal from residential property owners—for example, staffing satellite offices at grocery stores and senior centers and investing heavily in publicity materials that made the process more accessible and transparent.‖). 74 this recommendation would have the added benefit of bringing the appeals process that is used by the office of the cook county assessor into complete alignment with the appeals process that is used by the cook county board of review. 75 see stewart e. sterk and mitchell l. engler, property tax reassessment: who needs it, 81 notre dame l. rev. 1037, 1039–40 (2006) (―[moral hazard often arises when] a taxpayer whose tax assessment is low relative to the benefits she receives from additional municipal services [consumes] . . . additional services even when the costs of those services greatly exceed their benefit.‖). 76 see weber, supra note 14, at 75 (―appeals could make property tax assessments less uniform and violate the principle of horizontal equity, which assumes that two taxpayers with identical houses receive the same assessment. if only the one who appeals receives a lowered assessment, appeals can lead to disparate tax rates despite the use of a single, nominal tax rate. appeals also could make the distribution of the property tax less vertically equitable and even ‗regressive‘ if applications and successful appeals were correlated with higher-valued properties—either because owners of higher-valued homes were more likely to appeal or because assessors were more likely to grant relief to such owners.‖). 77 cf. roxanna asgarian, new property tax bills would stymie appeals form trophy towers , houston business journal, http://www.bizjournals.com/houston/morning_call/2015/03/new-property-taxbills-would-stymie-appeals-from.html?page=all (march 10, 2015) (―three new bills in the texas legislature this year take aim at a passage in the tax code that counties are saying has sharply increased the number of lawsuits against appraisal districts in the state—and taxpayers are footing a $16.1 million bill to cover the litigation.‖). 78 entrikin, supra note 30, at 290 (―because property owners annually transfer substantial tax dollars to state and local governments, a financial incentive exists for opportunists to step in. taxpayers and local governments alike are vulnerable to largely unregulated agents whose livelihoods depend on a share of the annual cash transfer of property tax dollars from property owners to local government coffers. . . . as a result, a substantial portion of the revenue that could be generated by the property tax base to finance public services is effectively diverted to private third parties to the detriment of taxpayers and local governments alike.‖). 79 weber, supra note 14, at 81 (―in cook county, the statutory assessment ratio for residential properties is 16 percent of market value. in practice, the average assessment ratio is closer to 9 percent.‖). 80 id. at 83. 81 id. at 75 (―[for example, it could explain that when a residential property tax appeals] . . . system is systematically weighted toward certain property owners, then an adjudicator‘s willingness to grant relief 2015] who wins residential property tax appeals? 219 vi. conclusion this article finds that suburban townships win more residential property tax appeals than anticipated. 82 the finding remains true whether wins are defined in terms of residential property tax appeal percentages, successful appeal percentages or successful appeal percentages with an attorney. 83 this conclusion is based, initially, on the fact that northwest suburban townships win more than expected. 84 it is also supported by a finding that southwest suburban townships win more than anticipated. 85 finally, the conclusion is substantiated by a third result: city of chicago townships win less than expected. 86 as a result, this article explains who wins residential property tax appeals. could alter the incidence of property tax; i.e. by lowering the burden on some property owners, it raises the burden on others.‖). 82 compare infra table 6 with infra table 5; compare infra table 7 with infra table 5; compare infra table 8 with infra table 5. 83 id. 84 compare infra table 6 with infra table 5. 85 compare infra table 7 with infra table 5. 86 compare infra table 8 with infra table 5. 220 columbia journal of tax law [vol.6:209 appendix table 1: residential property tax appeals: cook county, illinois township 87 (tax code) 88 2009 89 2010 90 2011 91 2012 92 2013 93 2009-2013 average barrington* (100, 101) 521 1331 419 572 710 711 berwyn (110) 664 267 1654 684 1658 985 bloom (120, 121, 122) 938 554 2329 796 2483 1420 bremen (130, 131) 1113 466 3314 1316 3877 2017 calumet (140) 157 60 568 156 618 312 cicero (150) 684 438 1553 801 1253 946 elk grove* (160, 161, 164) 1341 2370 635 1042 1495 1377 evanston* (170) 1369 2995 838 1057 1295 1511 hanover* (180, 181) 2089 3015 1713 1196 1750 1953 lemont (190) 846 471 1645 646 1663 1054 leyden* (200, 201, 202, 204) 1999 4514 999 2374 3090 2595 lyons (210, 211, 212, 214) 2772 1306 6369 2228 6788 3893 maine* (220, 221, 222) 2357 6083 1317 1776 3048 2916 87 see dalianis, supra note 18, at 12.8 (―the county is divided into three assessment districts: (1) the city of chicago; (2) that portion of the county outside of the city of chicago and north of illinois route 64 (north avenue); and (3) that portion of the county outside of the city of chicago and south of illinois route 64 (north avenue). 35 ilcs 200/9-220.‖). 88 see office of the cook county clerk, tax code rate summary 1-158 (july 6, 2012) [hereinafter clerk]. 89 see assessor, supra note 11. 90 id. 91 id. 92 id. 93 id. 2015] who wins residential property tax appeals? 221 township 87 (tax code) 88 2009 89 2010 90 2011 91 2012 92 2013 93 2009-2013 average new trier* (230, 234) 3004 6112 1426 1605 2488 2927 niles* (240, 244) 1846 4293 2241 2031 2534 2589 northfield* (250, 251, 252) 2841 7101 1422 1588 2402 3071 norwood park* (260) 397 1188 413 619 704 664 oak park (270) 962 459 3443 1283 3981 2026 orland (280) 2048 1299 5093 1690 5002 3026 palatine* (290, 291) 2528 5776 1354 1590 2568 2763 palos (300) 1009 342 3103 890 3222 1713 proviso (310, 311, 314) 2514 1737 5592 2396 6227 3693 rich (320, 321, 324) 1347 419 3351 1320 3776 2043 river forest (330) 262 184 1320 520 1332 724 riverside (340) 229 211 1324 660 1251 735 schaumburg* (350) 2621 6130 1708 1207 1706 2674 stickney (360, 361) 667 167 1334 508 1532 842 thornton (370, 371, 372) 2322 1755 5391 1813 4898 3236 wheeling* (380, 381, 382) 2889 6299 1540 2422 2965 3223 worth (390, 391) 3784 3955 6710 4381 6582 5082 hyde park^ (700) 4876 1833 1920 5261 1939 3166 222 columbia journal of tax law [vol.6:209 township 87 (tax code) 88 2009 89 2010 90 2011 91 2012 92 2013 93 2009-2013 average jefferson^ (710, 711) 12694 4251 5023 19452 6572 9598 lake^ (720, 721) 7619 3191 1770 7948 2325 4571 lake view^ (730) 10598 1858 2276 9583 2862 5435 north chicago^ (740) 3449 1419 932 3399 885 2017 rogers park^ (750) 2393 530 635 2390 784 1346 south chicago^ (760, 765) 3376 1476 818 3071 961 1940 west chicago^ (770) 9342 4291 2984 10667 3703 6197 cook county totals 102467 90146 86476 102938 102929 96991 2015] who wins residential property tax appeals? 223 table 2: successful residential property tax appeals: cook county, illinois township 94 (tax code) 95 2009 96 2010 97 2011 98 2012 99 2013 100 2009-13 average barrington* (100, 101) 217 554 261 297 465 359 berwyn (110) 163 55 790 256 938 440 bloom (120, 121, 122) 233 320 975 367 1720 723 bremen (130, 131) 254 136 1509 553 1602 811 calumet (140) 44 28 214 55 409 150 cicero (150) 228 128 700 281 509 369 elk grove* (160, 161, 164) 431 1654 396 481 667 726 evanston* (170) 322 967 406 503 582 556 hanover* (180, 181) 146 1788 1202 628 1085 970 lemont (190) 280 269 882 281 1341 611 leyden* (200, 201, 202, 204) 561 3006 366 1026 2231 1438 lyons (210, 211, 212, 214) 863 645 3132 930 4958 2106 maine* (220, 221, 222) 766 2022 629 816 1249 1096 new trier* (230, 234) 448 4553 829 828 1555 1643 94 see dalianis, supra note 18, at 12.7; see 35 ilcs 200/9-220. 95 see clerk, supra note 88. 96 see assessor, supra note 11. 97 id. 98 id. 99 id. 100 id. 224 columbia journal of tax law [vol.6:209 township 94 (tax code) 95 2009 96 2010 97 2011 98 2012 99 2013 100 2009-13 average niles* (240, 244) 496 1228 1038 1056 1686 1101 northfield* (250, 251, 252) 350 4780 775 774 1535 1643 norwood park* (260) 132 315 228 289 270 247 oak park (270) 310 189 1967 587 2680 1147 orland (280) 587 989 2513 948 3758 1759 palatine* (290, 291) 894 3963 699 745 1829 1626 palos (300) 262 116 1513 390 2376 931 proviso (310, 311, 314) 540 1203 2262 886 4092 1797 rich (320, 321, 324) 402 158 1433 485 2605 1017 river forest (330) 82 61 758 189 622 342 riverside (340) 70 95 815 342 649 394 schaumburg* (350) 262 4182 715 596 1139 1379 stickney (360, 361) 186 69 498 194 1082 406 thornton (370, 371, 372) 459 720 2092 651 3127 1410 wheeling* (380, 381, 382) 921 4654 766 1192 2030 1913 worth (390, 391) 794 2446 2612 1907 3840 2320 hyde park^ (700) 1389 1061 1016 2267 1224 1391 jefferson^ (710, 711) 3595 2932 2474 10872 4392 4853 2015] who wins residential property tax appeals? 225 township 94 (tax code) 95 2009 96 2010 97 2011 98 2012 99 2013 100 2009-13 average lake^ (720, 721) 1801 1828 618 3019 961 1645 lake view^ (730) 2934 634 1145 4478 1005 2039 north chicago^ (740) 905 798 444 1652 452 850 rogers park^ (750) 619 173 361 1230 348 546 south chicago^ (760, 765) 823 735 301 1353 466 736 west chicago^ (770) 2810 2377 1163 4536 2176 2612 cook county totals 26579 51831 40497 47940 63655 46100 226 columbia journal of tax law [vol.6:209 table 3: successful residential property tax appeals with attorney: cook county, illinois township 101 (tax code) 102 2009 103 2010 104 2011 105 2012 106 2013 107 2009-2013 average barrington* (100, 101) 98 358 135 151 323 213 berwyn (110) 26 24 185 85 440 152 bloom (120, 121, 122) 43 79 212 125 744 241 bremen (130, 131) 48 43 382 185 626 257 calumet (140) 8 13 28 16 89 31 cicero (150) 26 81 96 37 168 82 elk grove* (160, 161, 164) 142 984 125 131 244 325 evanston* (170) 103 568 166 223 332 278 hanover* (180, 181) 18 813 280 162 422 339 lemont (190) 130 137 348 79 682 275 leyden* (200, 201, 202, 204) 161 1717 77 173 521 530 lyons (210, 211, 212, 214) 215 276 1325 376 2719 982 maine* (220, 221, 222) 357 1308 258 326 553 560 new trier* (230, 234) 193 3473 535 524 1264 1198 101 see dalianis, supra note 18, at 12.7; see 35 ilcs 200/9-220. 102 see clerk, supra note 88. 103 see assessor, supra note 11. 104 id. 105 id. 106 id. 107 id. 2015] who wins residential property tax appeals? 227 township 101 (tax code) 102 2009 103 2010 104 2011 105 2012 106 2013 107 2009-2013 average niles* (240, 244) 177 700 360 426 994 531 northfield* (250, 251, 252) 123 3045 420 391 1128 1021 norwood park* (260) 33 191 100 78 109 102 oak park (270) 56 114 688 247 1226 466 orland (280) 115 155 826 285 1960 668 palatine* (290, 291) 350 2269 233 189 788 766 palos (300) 48 39 506 188 1084 373 proviso (310, 311, 314) 131 316 583 222 1646 580 rich (320, 321, 324) 134 40 282 119 805 276 river forest (330) 33 21 402 77 372 181 riverside (340) 19 50 287 66 294 143 schaumburg* (350) 42 1409 156 133 526 453 stickney (360, 361) 37 15 108 56 383 120 thornton (370, 371, 372) 57 160 480 161 1056 383 wheeling* (380, 381, 382) 217 2286 286 381 1047 843 worth (390, 391) 215 202 686 350 1286 548 hyde park^ (700) 426 379 353 978 777 583 jefferson^ (710, 711) 1617 950 682 4147 1748 1829 228 columbia journal of tax law [vol.6:209 township 101 (tax code) 102 2009 103 2010 104 2011 105 2012 106 2013 107 2009-2013 average lake^ (720, 721) 396 385 115 1028 495 484 lake view^ (730) 1774 431 740 3195 663 1361 north chicago^ (740) 693 586 351 1272 414 663 rogers park^ (750) 295 96 176 714 190 294 south chicago^ (760, 765) 300 270 120 589 261 308 west chicago^ (770) 1350 940 525 2451 1389 1331 cook county totals 10206 24923 13617 20336 29768 19770 2015] who wins residential property tax appeals? 229 table 4: baseline years and population averages: cook county, illinois township 108 (tax code) 109 residential properties subject to taxation (baseline tax year is 2009) 110 residential properties that appeal their taxes per year (2009-2013 average) 111 successful residential property tax appeals per year (2009-2013 average) 112 successful residential property tax appeals with attorney per year (2009-2013 average) 113 barrington* (100, 101) 5540 711 359 213 berwyn (110) 13744 985 440 152 bloom (120, 121, 122) 28810 1420 723 241 bremen (130, 131) 38799 2017 811 257 calumet (140) 5124 312 150 31 cicero (150) 13996 946 369 82 elk grove* (160, 161, 164) 29276 1377 726 325 evanston* (170) 21587 1511 556 278 hanover* (180, 181) 30790 1953 970 339 lemont (190) 6991 1054 611 275 leyden* (200, 201, 202, 204) 28292 2595 1438 530 108 see dalianis, supra note 18, at 12.7; see 35 ilcs 200/9-220. 109 see clerk, supra note 88. 110 see assessor 2, supra note 11. the author used 2009 as the baseline tax year, since it was the last time that all 38 townships were re-assessed in the same tax year. 111 see assessor, supra note 11. 112 id. 113 id. 230 columbia journal of tax law [vol.6:209 township 108 (tax code) 109 residential properties subject to taxation (baseline tax year is 2009) 110 residential properties that appeal their taxes per year (2009-2013 average) 111 successful residential property tax appeals per year (2009-2013 average) 112 successful residential property tax appeals with attorney per year (2009-2013 average) 113 lyons (210, 211, 212, 214) 35921 3893 2106 982 maine* (220, 221, 222) 47264 2916 1096 560 new trier* (230, 234) 20006 2927 1643 1198 niles* (240, 244) 40046 2589 1101 531 northfield* (250, 251, 252) 31399 3071 1643 1021 norwood park* (260) 9035 664 247 102 oak park (270) 16884 2026 1147 466 orland (280) 36246 3026 1759 668 palatine* (290, 291) 39156 2763 1626 766 palos (300) 19811 1713 931 373 proviso (310, 311, 314) 45882 3693 1797 580 rich (320, 321, 324) 25769 2043 1017 276 river forest (330) 4071 724 342 181 riverside (340) 5665 735 394 143 schaumburg* (350) 43880 2674 1379 453 2015] who wins residential property tax appeals? 231 township 108 (tax code) 109 residential properties subject to taxation (baseline tax year is 2009) 110 residential properties that appeal their taxes per year (2009-2013 average) 111 successful residential property tax appeals per year (2009-2013 average) 112 successful residential property tax appeals with attorney per year (2009-2013 average) 113 stickney (360, 361) 12776 842 406 120 thornton (370, 371, 372) 56818 3236 1410 383 wheeling* (380, 381, 382) 55041 3223 1913 843 worth (390, 391) 55812 5082 2320 548 hyde park^ (700) 81202 3166 1391 583 jefferson^ (710, 711) 136660 9598 4853 1829 lake^ (720, 721) 149742 4571 1645 484 lake view^ (730) 90280 5435 2039 1361 north chicago^ (740) 68847 2017 850 663 rogers park^ (750) 20815 1346 546 294 south chicago^ (760, 765) 54108 1940 736 308 west chicago^ (770) 106085 6197 2612 1331 cook county average 40320 2552 1213 520 232 columbia journal of tax law [vol.6:209 table 5: appeal percentages and successful appeal percentages: cook county, illinois township 114 (tax code) 115 percentage of residential properties that appeal their taxes (20092013) 116 percentage of successful residential property tax appeals (20092013) 117 percentage of successful residential property tax appeals with attorney (20092013) 118 barrington* (100, 101) 0.128 0.065 0.038 berwyn (110) 0.072 0.032 0.011 bloom (120, 121, 122) 0.049 0.025 0.008 bremen (130, 131) 0.052 0.021 0.007 calumet (140) 0.061 0.029 0.006 cicero (150) 0.068 0.026 0.006 elk grove* (160, 161, 164) 0.047 0.025 0.011 evanston* (170) 0.070 0.026 0.013 hanover* (180, 181) 0.063 0.031 0.011 lemont (190) 0.151 0.087 0.039 leyden* (200, 201, 202, 204) 0.092 0.051 0.019 114 see dalianis, supra note 18, at 12.7; see 35 ilcs 200/9-220. 115 see clerk, supra note 88. 116 see assessor, supra note 11; see assessor 2, supra note 11. the author computed this percentage by dividing the number of residential properties that appealed their taxes, on average (tax years are 2009-2013), by the number of taxable properties (baseline tax year is 2009). 117 id. the author computed this percentage by dividing the number of residential properties that successfully appealed their taxes, on average (tax years are 2009-2013), by the number of taxable properties (baseline tax year is 2009). 118 id. the author computed this percentage by dividing the number of residential properties that successfully appealed their taxes using an attorney, on average (tax years are 2009-2013), by the number of taxable properties (baseline tax year is 2009). 2015] who wins residential property tax appeals? 233 township 114 (tax code) 115 percentage of residential properties that appeal their taxes (20092013) 116 percentage of successful residential property tax appeals (20092013) 117 percentage of successful residential property tax appeals with attorney (20092013) 118 lyons (210, 211, 212, 214) 0.108 0.059 0.027 maine* (220, 221, 222) 0.062 0.023 0.012 new trier* (230, 234) 0.146 0.082 0.060 niles* (240, 244) 0.065 0.027 0.013 northfield* (250, 251, 252) 0.098 0.052 0.033 norwood park* (260) 0.074 0.027 0.011 oak park (270) 0.120 0.068 0.028 orland (280) 0.083 0.049 0.018 palatine* (290, 291) 0.071 0.042 0.020 palos (300) 0.086 0.047 0.019 proviso (310, 311, 314) 0.080 0.039 0.013 rich (320, 321, 324) 0.079 0.039 0.011 river forest (330) 0.178 0.084 0.044 riverside (340) 0.130 0.070 0.025 schaumburg* (350) 0.061 0.031 0.010 stickney (360, 361) 0.066 0.032 0.009 234 columbia journal of tax law [vol.6:209 township 114 (tax code) 115 percentage of residential properties that appeal their taxes (20092013) 116 percentage of successful residential property tax appeals (20092013) 117 percentage of successful residential property tax appeals with attorney (20092013) 118 thornton (370, 371, 372) 0.057 0.025 0.007 wheeling* (380, 381, 382) 0.059 0.035 0.015 worth (390, 391) 0.091 0.042 0.010 hyde park^ (700) 0.039 0.017 0.007 jefferson^ (710, 711) 0.070 0.036 0.013 lake^ (720, 721) 0.031 0.011 0.003 lake view^ (730) 0.060 0.023 0.015 north chicago^ (740) 0.029 0.012 0.010 rogers park^ (750) 0.065 0.026 0.014 south chicago^ (760, 765) 0.036 0.014 0.006 west chicago^ (770) 0.058 0.025 0.013 cook county average 0.063 0.030 0.013 2015] who wins residential property tax appeals? 235 table 6: appeal percentages & successful appeal percentages: northwest suburbs township 119 (tax code) 120 percentage of residential properties that appeal their taxes (fy 2009-2013 average) 121 percentage of successful residential property tax appeals (fy 2009-2013 average) 122 percentage of successful residential property tax appeals with attorney (fy 2009-2013 average) 123 barrington* (100, 101) 0.128 0.065 0.038 elk grove* (160, 161, 164) 0.047 0.025 0.011 evanston* (170) 0.070 0.026 0.013 hanover* (180, 181) 0.063 0.031 0.011 leyden* (200, 201, 202, 204) 0.092 0.051 0.019 maine* (220, 221, 222) 0.062 0.023 0.012 new trier* (230, 234) 0.146 0.082 0.060 niles* (240, 244) 0.065 0.027 0.013 northfield* (250, 251, 252) 0.098 0.052 0.033 norwood park* (260) 0.074 0.027 0.011 palatine* (290, 291) 0.071 0.042 0.020 schaumburg* (350) 0.061 0.031 0.010 119 see dalianis, supra note 18, at 12.7; see 35 ilcs 200/9-220. 120 see clerk, supra note 88. 121 see assessor, supra note 11; see assessor 2, supra note 11. 122 id. 123 id. 236 columbia journal of tax law [vol.6:209 township 119 (tax code) 120 percentage of residential properties that appeal their taxes (fy 2009-2013 average) 121 percentage of successful residential property tax appeals (fy 2009-2013 average) 122 percentage of successful residential property tax appeals with attorney (fy 2009-2013 average) 123 wheeling* (380, 381, 382) 0.059 0.035 0.015 northwest suburbs* (13 townships) 0.072 0.037 0.018 cook county (38 townships) 0.063 0.030 0.013 2015] who wins residential property tax appeals? 237 table 7: appeal percentages & successful appeal percentages: southwest suburbs township 124 (tax code) 125 percentage of residential properties that appeal their taxes (fy 2009-2013 average) 126 percentage of successful residential property tax appeals (fy 2009-2013 average) 127 percentage of successful residential property tax appeals with attorney (fy 2009-2013 average) 128 berwyn (110) 0.072 0.032 0.011 bloom (120, 121, 122) 0.049 0.025 0.008 bremen (130, 131) 0.052 0.021 0.007 calumet (140) 0.061 0.029 0.006 cicero (150) 0.068 0.026 0.006 lemont (190) 0.151 0.087 0.039 lyons (210, 211, 212, 214) 0.108 0.059 0.027 oak park (270) 0.120 0.068 0.028 orland (280) 0.083 0.049 0.018 palos (300) 0.086 0.047 0.019 proviso (310, 311, 314) 0.080 0.039 0.013 rich (320, 321, 324) 0.079 0.039 0.011 124 see dalianis, supra note 18, at 12.7; see 35 ilcs 200/9-220. 125 see clerk, supra note 88. 126 see assessor, supra note 11; see assessor 2, supra note 11. 127 id. 128 id. 238 columbia journal of tax law [vol.6:209 township 124 (tax code) 125 percentage of residential properties that appeal their taxes (fy 2009-2013 average) 126 percentage of successful residential property tax appeals (fy 2009-2013 average) 127 percentage of successful residential property tax appeals with attorney (fy 2009-2013 average) 128 river forest (330) 0.178 0.084 0.044 riverside (340) 0.130 0.070 0.025 stickney (360, 361) 0.066 0.032 0.009 thornton (370, 371, 372) 0.057 0.025 0.007 worth (390, 391) 0.091 0.042 0.010 southwest suburbs (17 townships) 0.080 0.040 0.014 cook county (38 townships) 0.063 0.030 0.013 2015] who wins residential property tax appeals? 239 table 8: appeal percentages & successful appeal percentages: city of chicago township 129 (tax code) 130 percentage of residential properties that appeal their taxes (fy 2009-2013 average) 131 percentage of successful residential property tax appeals (fy 2009-2013 average) 132 percentage of successful residential property tax appeals with attorney (fy 2009-2013 average) 133 hyde park^ (700) 0.039 0.017 0.007 jefferson^ (710, 711) 0.070 0.036 0.013 lake^ (720, 721) 0.031 0.011 0.003 lake view^ (730) 0.060 0.023 0.015 north chicago^ (740) 0.029 0.012 0.010 rogers park^ (750) 0.065 0.026 0.014 south chicago^ (760, 765) 0.036 0.014 0.006 west chicago^ (770) 0.058 0.025 0.013 city of chicago^ (8 townships) 0.048 0.021 0.010 129 see dalianis, supra note 18, at 12.7; see 35 ilcs 200/9-220. 130 see clerk, supra note 88. 131 see assessor, supra note 11; see assessor 2, supra note 11. 132 id. 133 id. 240 columbia journal of tax law [vol.6:209 township 129 (tax code) 130 percentage of residential properties that appeal their taxes (fy 2009-2013 average) 131 percentage of successful residential property tax appeals (fy 2009-2013 average) 132 percentage of successful residential property tax appeals with attorney (fy 2009-2013 average) 133 cook county (38 townships) 0.063 0.030 0.013 microsoft word mazur9-1 (1).docx social impact bonds: a tax-favored investment? orly mazur* abstract social impact bonds (sibs) have recently generated a lot of excitement nationwide as an innovative way to finance social projects. a sib is a financing mechanism that uses private capital to fund social services, with the government only repaying investors their capital plus a potential return on investment if improved social outcomes are achieved. as such, it brings together the private, public, and non-profit sectors in a manner that unlocks an additional source of capital to fund social service providers, promotes innovation, encourages interagency cooperation, and creates more accountability. despite these benefits, tax law likely hinders the development of sib-funded programs in the united states by discouraging private investment in sibs. this article is the first to consider the role of u.s. tax law in promoting sib investments by examining the tax implications of a sib investment from both a doctrinal and policy perspective. it concludes that the current tax system creates unnecessary compliance risks for private sib investors and unjustifiably treats sib investments less favorably than comparable investments, thereby increasing administrative complexity, distorting investment decisions, and creating inequities among similarly situated investors. given the unintended discriminatory tax treatment towards sibs, this article argues that congress should consider enacting legislation to make a sib investment a tax-favored investment. this change could best be achieved by extending preferential tax rates to sib earnings, exempting sib earnings from taxation, or by allowing an upfront deduction for contributions to sib investments. by modifying the tax law to treat sib investments more in parity with comparable investments, sib-funded programs will likely attract additional private capital and allow sibs to potentially make a meaningful impact on some of our nation’s most challenging social problems. * assistant professor of law, smu dedman school of law. many thanks to jessica mantel, michael simkovic, and anthony colangelo for thoughtful suggestions and comments on prior drafts and to timothy gallina for his research assistance. i am also grateful for the valuable comments that i received from the participants at the texas legal scholars workshop, the smu faculty workshop, and the junior tax scholars workshop. finally, this research was supported by the generous funding from the marla and michael boone faculty research fund. 142 columbia journal of tax law [vol.9:141 i. introduction .................................................................................................... 143 ii. a new financing mechanism ..................................................................... 145 a. the concept of a sib ......................................................................................... 145 b. the current status of sibs ................................................................................ 146 c. the potential of sibs ......................................................................................... 149 iii. taxation of sibs .............................................................................................. 154 a. tax uncertainty ................................................................................................. 154 b. unavailable tax preferences ............................................................................. 156 1. preferential tax rates ................................................................................. 156 2. tax exemption ............................................................................................. 157 3. upfront deduction ....................................................................................... 159 iv. sibs as a tax-favored investment? ...................................................... 160 a. traditional equity investments .......................................................................... 161 b. tax-exempt bonds ............................................................................................ 162 v. recommendations for reform ............................................................... 163 a. preferential tax rates ........................................................................................ 164 b. tax exemption ................................................................................................... 167 c. upfront deduction ............................................................................................. 170 d. the u.k. approach ............................................................................................ 171 vi. conclusion ........................................................................................................ 174 vii. appendix a ......................................................................................................... 175 2017] social impact bonds 143 i. introduction salt lake county, utah, like many other counties throughout the nation, has struggled with finding a meaningful and effective way to address persistent homelessness and high rates of recidivism within the county. 1 current government funding for programs to address these issues is limited and their effectiveness is often unknown.2 the result is costly: 43% of persistently homeless individuals in salt lake county become chronically homeless within two years; 74% of high-risk offenders return to county jail within four years of their release; and the salt lake county jail is currently operating at full capacity.3 these issues also result in numerous other social and financial costs to society. in an attempt to address these issues, in december 2016, salt lake county launched a million dollar initiative to provide more than 500 of the county’s most vulnerable and at-risk population with innovative, evidence-based, preventative services never before available to these residents.4 unlike other social programs, the government (and taxpayers) will not have to pay anything initially.5 instead, investors will provide the upfront capital to finance the program and assume the risk of an unsuccessful program. if the program is successful in achieving pre-determined results, only then will the government repay the investors their initial capital, as well as a small return on their investment.6 the structure of the salt lake county program is just one example of a new type of financing mechanism that has recently emerged: social impact bonds (“sibs”). 7 although still in their infancy, sibs have generated a lot of excitement. they have received support from the obama administration, major financial institutions, policy experts, philanthropic organizations, and universities.8 as a result, numerous sibs have 1 see salt lake county pay for success initiative: frequently asked questions, 1 (2016), http://www.thirdsectorcap.org/wp-content/uploads/2016/12/161214_slco-pfs-faq-final.pdf [https://perma.cc/vmw7-utz7] [hereinafter slc faq]. 2 see michelle schmidt, salt lake county launches two pay for success projects (dec. 19, 2016), http://slco.org/mayor/news/pfs-projects-launch/ [https://perma.cc/8esf-49mv]. for instance, studies reveal that existing programs within salt lake county only reach approximately 19% of the persistently homeless population due to budget constraints. slc faq, supra note 1. 3 slc faq, supra note 1. 4 id. 5 id. 6 id. 7 sibs are often also referred to as pay for success contracts. although these two terms are often used interchangeably, they are not always synonyms. benjamin r. cox, financing homelessness prevention programs with social impact bonds, 31 rev. banking & fin. l. 959, 964 (2012). in a joint sib and pay for success contract arrangement, the government shifts the risk of economic loss from non-performance to the private investor, whereas in a pay-for-success contract, the risk of loss may also be shifted from the government to the service provider. id. in addition, many variations of the sib model exist. see orly mazur, taxing social impact bonds, 20 fla. tax rev. 431 (2017). in this article, i use the term sib to refer to “a relatively narrow and truly innovative concept where payment from government is tied solely to outcomes and where government places few controls on the external organization.” jitinder kohli, douglas j. besharov & kristina costa, ctr. for am. progress, what are social impact bonds: an innovative new financing tool for social programs, 2 (mar. 22, 2012), http://cdn.americanprogress.org/wpcontent/uploads/issues/2012/03/pdf/social_impact_bonds_brief.pdf [https://perma.cc/and7-wk5h]. 8 see infra notes 24–33 and accompanying text. 144 columbia journal of tax law [vol.9:141 already been launched in communities across the country and world to address issues ranging from unemployment and child welfare to education and mental illness.9 despite this initial excitement, sibs have not yet generated sufficient private capital to truly make an impact in the united states. this article is the first to argue that u.s. tax law is one factor that significantly contributes to the lack of private sib investments in the united states. to demonstrate the chilling effect that the tax law has on these potentially powerful investments, i first describe the concept of a sib, its benefits and limitations, and the likely tax implications to private sib investors. against this backdrop, i then consider from a normative perspective whether congress should modify federal income tax laws to make sibs a more tax-favored investment for private investors. my conclusion is that a tax policy change is needed. first, private investors who participate in sib investments are subject to unnecessary compliance risks. tax compliance risks arise because the federal income tax consequences to investors who participate in sib investments are unclear under current law. given this ambiguity, sib investors may find it difficult to confidently compute and assess their tax liability. modifying the tax law would provide investors with additional guidance in this area, thereby minimizing tax uncertainty, taxpayer audit risks, and any accompanying deterrent effects. second, sib investors most likely do not benefit from tax preferences that are extended to comparable investments. for instance, traditional stock investments share many economic features with sib investments, but are taxed at preferential rates and generally only subject to tax at the time at which the investment is disposed. on the other hand, sib investments are likely to give rise to lower rates of return that are subject to tax at higher non-preferential tax rates throughout the term of the investment. municipal bonds are also similar in many respects to sibs in terms of their goals and rate of return, but unlike sibs, these bonds are generally exempt from taxation. thus, sib investors face an additional tax burden relative to other investors. this high tax cost is likely to disincentivize large-scale private investment in sibs despite the potential of sibs to improve the social service system in the united states or at least move us toward a more evidence-based, collaborative delivery of social services. lastly, these tax policies, together with the currently relatively low rate of return on risky sib investments, significantly impact the availability of the private capital required for sib investments to achieve their goals. however, there is no sound policy basis for these distinctions. thus, the unfavorable tax treatment of sib investments unjustifiably increases administrative complexity, distorts investment decisions, and creates inequities among similarly situated investors. given these negative policy implications, the government should create a more favorable regulatory environment that does not deter private investments in sibs.10 in short, this article proposes several potential tax policy solutions to minimize the current tax burdens imposed on private sib investors. the tax policy options include subjecting the sib investment earnings to preferential tax treatment, exempting the earnings from taxation, or granting investors a deduction for income tax purposes at the 9 see infra notes 21–23 and accompanying text. 10 to prevent the current tax law from hindering the development of sibs in the united states, legislative or regulatory action is also needed to address the current limitations on investments by non-profit organizations and private foundations. a discussion of the necessary changes to encourage investments by these entities is beyond the scope of this article. 2017] social impact bonds 145 time they make a sib investment. each alternative would minimize some of the deterrent effects that the tax law currently imposes on sib investments by treating these investments more in parity with similar investments. as a result, these changes would mitigate some of the risk that investors assume when they invest in these speculative financial instruments and enable sibs to compete more fairly for a share of private capital. part i describes the emergence of this new social financing instrument and its potential to revolutionize how we fund social services as well as its limitations. part ii explains the current tax treatment of sib investments and illustrates how the current state of the law treats private sib investments unfavorably relative to other investments. part iii argues that changes to tax policy are needed to prevent the unintended discriminatory tax treatment towards sib investments and to promote sound tax policy. finally, part iv discusses several ways this change could be accomplished. by clarifying the tax treatment of sibs and removing unnecessary tax barriers to sib investments, private participation in this innovative financing mechanism is likely to increase and allow sibs the opportunity to live up to their potential. ii. a new financing mechanism this part describes what sibs are, their growth, and their current status. it then analyzes the benefits and shortcomings of using sibs to finance social programs and concludes that if adequately structured and regulated, sibs have the potential to provide an alternative source of financing to address some of society’s long-lasting social challenges. a. the concept of a sib a sib, also referred to as a pay-for-success contract, is a multi-stakeholder arrangement, in which private investors provide the upfront capital to fund social services, with the government repaying investors only if certain social outcomes are achieved.11 in a traditional sib model, a government agency identifies a social issue that it wants to address, such as homelessness, criminal justice, public health, or preschool education.12 it then enters into an agreement with an intermediary organization.13 the intermediary organization both raises the funds from private investors to finance a multiyear social program to address the identified social issue and selects and manages the 11 an overview of social impact bonds in the united states, soc. impact architects (oct. 6, 2015), http://socialimpactarchitects.com/wp-content/uploads/2016/12/overview-of-social-impact-bonds100615.pdf [https://perma.cc/8gzs-2w97]; mckinsey & co., from potential to action: bringing social impact bonds to the u.s., 4 (may 2012), http://mckinseyonsociety.com/downloads/reports/socialinnovation/mckinsey_social_impact_bonds_report.pdf [https://perma.cc/xk64-eph6]. a sib does not have a precise, uniform definition because there are numerous variations of the sib model. however, the features discussed above are common in most existing sib structures. see mazur, supra note 7, at 436–41. see appendix a for diagram of a traditional sib structure. 12 see mazur, supra note 7, at 437; soc. impact architects, supra note 11. 13 see mazur, supra note 7; soc. impact architects, supra note 11; emilie goodall, choosing social impact bonds: a practitioner’s guide, bridges impact+, 13 (2014), http://www.bridgesfundmanagement.com/wp-content/uploads/2017/08/bridges-choosing-social-impactbonds-a-practitioner’s-guide.pdf [https://perma.cc/fm43-y25e]. 146 columbia journal of tax law [vol.9:141 service providers that implement the program.14 after a specified period of time, if the project meets or exceeds pre-determined project outcome metrics, as verified by an independent evaluator, the government pays the investors, through the intermediary, their original investment plus a potential return on investment.15 the return on investment depends on the outcomes achieved, with the maximum return capped at a contractually agreed-to value. this amount is often calculated based on the projected government savings resulting from a successful program.16 however, if the program is unsuccessful in producing specific social outcomes, the government does not pay for the social services and the investor loses his or her entire investment.17 the creation of this new financing mechanism was prompted by the need to increase the pool of capital available to finance social programs and to do so with minimal cost to taxpayers.18 specifically, the founders sought to find a solution to “the challenge of financing social action programs, with a specific focus on prevention and early intervention.”19 sibs offer the promise of enabling proven and evidence-based programs to scale, creating cost-savings for governments, and encouraging innovation in the social sector, while shifting the political and financial risks of failure to the private sector.20 these promised benefits have sparked a lot of interest in sibs worldwide. b. the current status of sibs in 2010, the united kingdom originated and launched the first sib.21 since then, sibs have become a worldwide phenomenon. numerous sibs have been launched in the united states and across the world and many more sibs are under development.22 14 see mazur, supra note 7, at 436–37; cox, supra note 7, at 965–66; emily gustafsson-wright & sophie gardiner, policy recommendations for the applications of impact bonds, brookings inst. (nov. 2015), https://www.brookings.edu/wp-content/uploads/2016/07/sib20policy20brief201web-1.pdf [https://perma.cc/bf62-892p]; goodall, supra note 13, at 20. however, this role may also be performed by two separate parties. mazur, supra note 7, at 440. 15 see nonprofit fin. fund, financing and social impact bonds, http://www.payforsuccess.org/learn/basics/#pay-for-success-financial-and-social-impact-bonds (last visited sept. 17, 2017) [https://perma.cc/xh45-jsgt]; adriana barajas et al., social impact bonds: a new tool for social financing, princeton univ. pub. policy & int’l affairs program, 14 (2014), https://wws.princeton.edu/sites/default/files/content/social%20impact%20bonds%202014%20final%20rep ort.pdf [https://perma.cc/5mmg-3czb]. 16 see lisa barclay & tom symons, a technical guide to developing social impact bonds, social fin. (jan. 2013), http://www.socialfinance.org.uk/wp-content/uploads/2014/05/technical-guide-todeveloping-social-impact-bonds1.pdf [https://perma.cc/esb7-9kr7]; soc. impact architects, supra note 11. 17 mckinsey & co., supra note 11. 18 see david butler, dan bloom & timothy rudd, using social impact bonds to spur innovation, knowledge building, and accountability, 9 cmty. dev. inv. rev. 53 (2013); cox, supra note 7, at 965. 19 max liang, brian mansberger & andrew c. spieler, an overview of social impact bonds, 13 j. int’l bus. & l. 267, 268 (2014) (noting that the council on social action, a uk think tank, came up with the idea for a sib). 20 id. 21 this sib was launched with the aim of cutting the rate of recidivism at peterborough prison. see butler, bloom & rudd, supra note 18, at 57; cox, supra note 7, at 962. liang, mansberger & spieler, supra note 19, at 269. 22 see soc. enterprise greenhouse, social impact bonds fact sheet, http://segreenhouse.org/wpcontent/uploads/2013/09/sib-fact-sheet_final.pdf [https://perma.cc/w9gy-qcpm]; goodall, supra note 13; laura tyson & lenny mendonca, doing well by doing good, times of oman (jan. 29, 2016), 2017] social impact bonds 147 currently, the united states has more sibs under development than any other country.23 one factor that has contributed to the growth of sibs in the united states is that numerous groups have supported the development of sibs. for instance, philanthropic organizations, such as the rockefeller foundation and bloomberg philanthropies have helped launch some of the earliest sibs by guaranteeing a portion of the investors’ funds.24 philanthropic foundations have also fostered sibs by providing grants to finance pro bono assistance to help implement sibs. 25 major financial institutions, like goldman sachs, have invested capital in sib-funded programs, indicating their belief in the potential of sibs to deliver effective social services. 26 moreover, groups have formed, such as the harvard kennedy school social impact bond technical assistance lab and the sorenson impact center at the university of utah, to assist in the development of sibs and to foster social innovation through research, http://timesofoman.com/article/76393/opinion/columnist/the-united-states-is-already-the-largest-pay-forsuccess-market-in-the-world [https://perma.cc/3klz-prbg]; barajas et al., supra note 15, at 8. as of june 2016, more than 65 sib projects were at different phases of development across the united states and, as of february 2017, 15 sib projects have been launched in the united states. sindhu lakshmanan, pay for success: to invest or not to invest?, living cities (oct. 18, 2016), https://www.livingcities.org/blog/1129-pay-for-success-to-invest-or-not-to-invest [https://perma.cc/8s56ud4t]; social impact bonds 101, harv. kennedy sch. gov’t performance lab., http://govlab.hks.harvard.edu/files/siblab/files/sibs_101_hks_gpl_2017.pdf [https://perma.cc/ya63-vgvc]. sibs have also been implemented abroad in countries such as canada, the united kingdom, pakistan, india, the netherlands, germany, australia, rwanda, and mozambique, among others. esha chhabra, the ‘it girl’ of muni finance: are social impact bonds a fad or a long-term solution for underfunded public programs?, nextcity (jun. 23, 2014), https://nextcity.org/features/view/social-impactbonds-public-private-solution-social-problems-cities [https://perma.cc/8288-k2sy]; john hartley, social impact bonds are going mainstream, forbes (sep. 15, 2014), http://www.forbes.com/sites/jonhartley/2014/09/15/social-impact-bonds-are-goingmainstream/#17ad409217d5 [https://perma.cc/udh4-pce5]. 23 tyson & mendonca, supra note 22. 24 see, e.g., fact sheet – investing in what works: “pay for success” in new york state increasing employment and improving public safety (mar. 2014), http://www.payforsuccess.org/sites/default/files/resource-files/pfsfactsheet_0314_0.pdf [https://perma.cc/t8ue-v68j] [hereinafter state of ny fact sheet] (providing that rockefeller foundation has provided a first-loss guarantee of up to $1.3 million to investors in the new york state’s sib); press release, office of the mayor, city of new york, mayor bloomberg, deputy mayor gibbs and corrections commissioner schriro announce nation’s first social impact bond program (aug. 2, 2012), http://www1.nyc.gov/office-of-the-mayor/news/285-12/mayor-bloomberg-deputy-mayor-gibbs-correctionscommissioner-schriro-nation-s-first#/0 [https://perma.cc/97wt-44z8] (describing bloomberg philanthropies’ guarantee to protect up to $7.2 million of investor principal). 25 see, e.g., ashley pettus, pay for progress: social impact bonds, harv. mag. (jul. –aug. 2013), http://harvardmagazine.com/2013/07/social-impact-bonds [https://perma.cc/c6ft-z3fc] (describing how the rockefeller foundation funds the harvard social impact bond technical assistance lab, which helps provide governments with technical assistance in developing and launching a sib-funded program); gov’t performance lab., supra note 22, at 5 (noting that the government performance lab receives financial support from multiple philanthropic organizations including bloomberg philanthropies, the corporation for national and community service social innovation fund, the dunham fund, the laura and john arnold foundation, the pritzker children’s initiative, and the rockefeller foundation). 26 see, e.g., office of the mayor, city of new york, supra note 24 (listing goldman sachs as the primary investor in the sib-funded program); goldman sachs, fact sheet: the massachusetts juvenile justice pay for success initiative, http://www.goldmansachs.com/our-thinking/trends-in-ourbusiness/massachusetts-social-impact-bond/ma-juvenile-justice-pay-for-success-initiative.pdf [https://perma.cc/c3cd-u2bn] (indicating that goldman sachs provided $9 million in senior loan financing through its social impact fund); state of ny fact sheet, supra note 24 (noting that the project raised the majority of its funds from the clients of bank of america merrill lynch). 148 columbia journal of tax law [vol.9:141 advisory, and educational work in understanding and improving the sib model.27 in addition, community groups, policy experts and leading economists have also supported the development of sibs in the united states in various other ways.28 the federal government has also played a big role in promoting sibs in the united states. sibs have received bipartisan support from politicians. for instance, in june 2016, the house of representatives unanimously passed legislation to increase federal funding for the creation of sibs by state and local governments in order to encourage the creation of public-private partnerships and thereby increase the effectiveness of social programs in the united states.29 although the senate did not pass the legislation before the end of congress, a similar bill was introduced in the house of representatives on january 2017.30 additionally, financial support has come from several federal agencies including the social innovation fund,31 which is planning to provide more than $13 million in funding for promising sib projects.32 similarly, other federal agencies, such as the u.s. department of labor, have provided grants to government agencies to help finance any outcome payments to investors of a successful sib-funded program.33 several states have also supported sibs by advancing legislation to facilitate the exploration and testing of sibs.34 27 see pettus, supra note 25; gov’t performance lab., supra note 22 (describing the harvard kennedy school’s government performance lab’s participation in the majority of the sib projects launched in the united states to date); mission, univ. of utah sorenson impact center, http://sorensonimpact.com/mission/ (last visited oct. 30, 2017) [https://perma.cc/ex22-nlpk]. 28 see tyson & mendonca, supra note 22, at 1; john hartley, social impact bonds are going mainstream, forbes (sept. 15, 2014), http://www.forbes.com/sites/jonhartley/2014/09/15/social-impactbonds-are-going-mainstream/#17ad409217d5.; barajas et al., supra note 15, at 8. 29 social impact partnerships to pay for results act, h.r. 5170, 114th cong. (2016). however, because the legislation was not passed by the senate by the end of congress, the legislation was not enacted. similarly, a separate bill that involves pay for success initiatives in education was also introduced and enacted in the senate in 2015. every student succeeds act, s. 1177, 114th cong. (2015). 30 social impact partnerships to pay for results act, h.r. 576, 115th cong. (2017) (described as, a bill “[t]o encourage and support partnerships between the public and private sectors to improve our nation’s social programs, and for other purposes.”). 31 sif classic, corp. for nat’l & cmty. serv., https://www.nationalservice.gov/programs/socialinnovation-fund/our-programs/classic [perma.cc/ps9s-b3wd]. the social innovation fund was authorized by the edward m. kennedy serve america act as a federal grant-making initiative of the corporation for national and community service that is intended to support “the growth of effective programs to have greater impact, as well as the development of innovative approaches to address the most challenging social problems.” about the social innovation fund, corp. for nat’l & cmty. serv., https://www.nationalservice.gov/programs/social-innovation-fund (last visited oct. 30, 2017) [https://perma.cc/2ega-yqp3]. 32 federal agency announces $13 million in funding to support pay for success projects, corp. for nat’l & cmty. serv. (nov. 3, 2016), https://www.nationalservice.gov/newsroom/pressreleases/2016/federal-agency-announces-13-million-funding-support-pay-success (last visited oct. 30, 2017) [perma.cc/2jbk-4m2d]. 33 see, e.g., pay for success intermediary agreement between new york state department of labor, social finance, inc. and social finance ny state workforce re-entry 2013 manager, inc. (oct. 1, 2013), https://www.budget.ny.gov/contract/icpfs/pfsmainagreement_sched_0314.pdf (providing that the u.s. department of labor, employment and training administration would award the new york state government a grant of up to $12,000,000 to help pay for any outcome payments the state owes investors if the project is successful). goldman sachs, supra note 26 (describing how the u.s. department of labor awarded the commonwealth of massachusetts a grant of $11.7 million to help fund any success payments resulting from the sib-funded initiative). see alex goldmark, the most exciting 0.003% of obama’s budget: social impact bonds, fast company (feb. 16, 2011), https://www.fastcompany.com/1728321/themost-exciting-00003-of-obama-s-budget-social-impact-bonds [perma.cc/vx3p-7ef8]. in addition, the 2017] social impact bonds 149 despite the foregoing, private investors have not responded as quickly to the promise of sibs.35 however, sufficient private capital is critical for sibs to have a chance to fully succeed. as further discussed below, the current tax law may be one factor deterring these potential investors.36 c. the potential of sibs sibs have tremendous potential to help tackle some of society’s toughest social problems. at a time when most non-profits are underfunded, the sib structure brings together public and private actors in a manner that encourages an increase in funding for social service projects by private investors and a more efficient and effective use of that capital. in particular, sibs unlock an additional source of capital, promote innovation, encourage interagency cooperation and create more accountability, which together can result in a more effective and efficient service model than the traditional manner in which social services are funded and implemented in the united states.37 for instance, the sib structure incentivizes private investors to help finance social programs by promising both a social and financial return on the investor’s investment. 38 social service providers no longer have to solely rely on government funding and philanthropic donations and grants to fund programs, but rather acquire an additional source of capital to fund programs that otherwise might be too expensive to implement.39 in addition, service providers receive this capital upfront, which protects them from unpredictable government budget cuts or a decline in charitable donations.40 this, in turn, helps service providers scale successful programs and make a greater social impact.41 former administration also aimed to support the advancement and testing of sibs by allocating funds in its budget proposal specifically for this purpose. 34 see nicole truhe, state of play: pay for success and evidence-based policy, am. forward (may 2, 2016), http://www.americaforward.org/state-of-play-pay-for-success-and-evidence-based-policyaprilmay-2016/ [perma.cc/zjp8-w6q4]. 35 ron davies, european parliamentary research serv., social impact bonds: private finance that generates social returns (aug. 2014), http://www.europarl.europa.eu/eprs/538223-socialimpact-bonds-final.pdf. 36 see infra part ii. 37 see valerie dao et al., univ. of chicago harris sch. of pub. policy, social impact bonds: a feasibility analysis of the wyman teen outreach program, http://128.135.46.110/sites/default/files/practica/spring2012-report2.pdf [perma.cc/9lqu-vttu]; what is a social impact bond?, soc. fin. (jan. 22, 2015, 2:14 pm), http://www.socialfinanceus.org/print/491; cox, supra note 7, at 967. the traditional model for delivering social services focuses on inputs or outputs, rather than outcomes or results. cox, supra note 7, at 968; tyson & mendonca, supra note 22, at 1. as described by one commentator, “a traditional social program is usually judged by volume of services provided, such as the number of people trained or homeless people sheltered. by contrast, in a pay-for-success model, the returns are based on the social benefits achieved or savings reaped by government.” id. at 1–2. 38 see pettus, supra note 25; liang, mansberger & spieler, supra note 19, at 273; barajas et al., supra note 15, at 17; goodall, supra note 13, at 9; davies, supra note 35. 39 see chhabra, supra note 22, at 3. 40 see peter g. dagher, jr., note, social impact bonds and the private benefit doctrine: will participation jeopardize a nonprofit’s tax-exempt status?, 81 fordham l. rev. 3479, 3504 (2013); cox, supra note 7. 41 see cox, supra note 7, at 970; state of ny fact sheet, supra note 24. 150 columbia journal of tax law [vol.9:141 moreover, by having private investors, rather than the government, provide the upfront investment capital, the government effectively shifts the performance and financial risks of funding certain social service activities to the private sector.42 given that private investors generally have a higher risk tolerance than government agencies, this shift encourages the pursuit of new and creative methods to solve complex social problems and allows for innovation in the public sector.43 because ineffective programs cost the government and taxpayers nothing, the sib structure also provides governments with a risk-free way to implement these new interventions and de-politicizes the funding process so that governments can address issues that are politically unattractive or expensive.44 “the aim of the investor for higher returns and requirement that service providers deliver efficient and effect[ive] interventions is what drives further innovation.”45 in addition, by tying repayment to outcomes, the sib structure gives service providers flexibility to experiment with different strategies instead of requiring them to focus on specified inputs or the volume of services provided. this allows governments to purchase social results (e.g., increase in employment) rather than social services (e.g., job training) that may not achieve desired results, thus enabling more effective and efficient use of taxpayer dollars.46 this type of outcomes-focused arrangement also provides a method and incentive for multiple service providers to work together to achieve a common goal with the project intermediary overseeing and coordinating the multiple parties. 47 similarly, this structure encourages different government agencies to work together to accomplish a broader goal, because sib-financed programs often result in savings across agencies.48 thus, sibs have the potential to help overcome government silos and maximize the impact of various social programs.49 the sib structure also incentivizes service providers to invest in preventative programs, rather than more costly remedial programs.50 traditionally, governments tend to prefer remedial programs because of the timing discrepancy between cost and savings inherent in preventative programs.51 but sibs change this result because preventative programs are often more effective at achieving the desired project outcome. 52 preventative programs also have the added benefit of reducing long-term government spending because they tackle the root cause of a social problem, which creates public savings even after the duration of the sib-funded project has terminated.53 42 see liang, mansberger & spieler, supra note 19, at 274; davies, supra note 35, at 5; state of ny fact sheet, supra note 24. 43 see chhabra, supra note 22, at 2 (noting that “[i]nvestor dollars provided through sibs do [not] have the limitations of project grants or government dollars; they offer a new freedom.”); kohli, besharov & costa, supra note 7; goodall, supra note 13, at 7. 44 see barajas et al., supra note 15, at 12, 17; liang, mansberger & spieler, supra note 19, at 273; kohli, besharov & costa, supra note 7, at 1, 6. 45 liang, mansberger & spieler, supra note 19, at 272. 46 see cox, supra note 7, at 968; tyson & mendonca, supra note 22. 47 see barajas et al., supra note 15, at 17; kohli, besharov & costa, supra note 7. 48 pettus, supra note 25. 49 kohli, besharov & costa, supra note 7, at 6. 50 see soc. impact architects, supra note 11; kohli, besharov & costa, supra note 7, at 2. 51 cox, supra note 7, at 968. 52 see id. (recognizing that government authorities “have little political or financial incentive to invest in prevention [initiatives]”). 53 see goodall, supra note 13, at 8. 2017] social impact bonds 151 finally, the sib service model also creates more accountability in the social services space, which further contributes to the creation of more effective social programs. 54 specifically, by requiring outcomes to be measured, sibs expand our knowledge about what programs are effective and what programs are ineffective at addressing certain social challenges. it allows for more evidence-based decision making in the social service sector. this also improves government accountability by incentivizing governments to shift funding from ineffective programs towards those that work well.55 moreover, because the investors’ return depends on the success of the program, investors are financially incentivized to only support programs that they believe will be effective, rather than programs chosen because of the service provider’s political ties.56 to manage their risk, private investors often also contribute their financial or managerial expertise in performing due diligence and require certain quality controls to be implemented.57 the service providers also have an interest in providing an effective social intervention, because they are often rewarded with a success fee if they reach certain performance thresholds. service providers that can show that they use any money received to successfully achieve a positive social impact are more likely to attract additional capital to that organization. 58 "by implementing and using a performance management (measurement) system, organizations can measure, report, learn, improve, and demonstrate … [the] positive change they are making in the lives of the people they serve."59 thus, the sib structure brings together multiple stakeholders, who each have an interest in achieving a common goal and who each have something different to contribute. this cross-sector collaboration has the potential to make sib-funded programs operate more effectively and efficiently. d. the limitations of sibs despite these benefits, sibs are not a panacea and have limitations as well as opponents. for instance, one of the most challenging features of a sib is the requirement to define and measure social outcomes.60 although this feature is beneficial in providing the government, the public, and the non-profit sector with valuable information about which programs work and which do not, this feature makes sibs not suitable to address every social issue. accordingly, sibs should only be used to finance programs that are capable of objective measurement and assessment, such as addressing homelessness, the 54 see barajas et al., supra note 15, at 17. 55 see kohli, besharov & costa, supra note 7, at 6 (noting that without this publicly available knowledge, governments find it difficult to shift money away from current programs, even if they are ineffective at addressing the problem at hand). 56 see liang, mansberger & spieler, supra note 19, at 272. 57 see id.; davies, supra note 35, at 5 (noting that “involving investors who are knowledgeable and experienced in business brings new rigor and discipline to the supply of social services”); third sector capital partners, pay for success/social impact bonds: rfi 1, 3, 5 (june 20, 2011) (on file with author). 58 see liang, mansberger & spieler, supra note 19, at 272; third sector capital partners, supra note 57, at 3. 59 soc. impact res., root cause, improving nonprofit performance 7 (2012), http://www.rootcause.org/docs/resources/publications/sir2012-performance-management-primer.pdf [https://perma.cc/3h3g-rymx]. 60 see davies, supra note 35, at 6 (recognizing that measuring social outcomes is difficult especially ensuring a direct correlation between the intervention and the result); kohli, besharov & costa, supra note 7. 152 columbia journal of tax law [vol.9:141 rate of recidivism, childhood education, unemployment, or preventative health care.61 however, as information technology continues to evolve, it will become easier to capture administrative data with respect to certain outcomes that can provide us with thorough and reliable measures of social impact.62 moreover, as with any pay-for-success contract that ties payments to results, there is the risk of the parties manipulating results to maximize payments.63 sibs help minimize some of this risk by focusing on social outcomes rather than inputs or outputs. rewarding inputs and outputs creates the wrong incentives by encouraging service providers to pursue more cost-effective methods to increase the volume of these inputs or outputs, irrespective of its actual social impact.64 also, it is often easier to manipulate inputs, such as the number of people enrolled in a job-training course, or outputs, such as the number of job training certificates received. 65 but it may be more difficult to manipulate outcomes, such as an increase in the employment rate. 66 sibs further minimize any potential gaming of the system by requiring an independent evaluator and/or verifier to measure and determine whether the desired outcomes have been achieved as a result of the sib-financed program. nevertheless, it is important to note that sibs are not immune from these types of concerns. thus, the evaluation must be rigorously performed by independent expert evaluators, with a strong focus on counterfactuals and a power to audit. in addition, the stakeholders must be excluded from the evaluation process. government regulation is also necessary to minimize collusion between the different sib parties.67 another potential limitation is the cost of implementing a sib-financed program. due to the infancy of the sib model, the multiple parties involved, and the complexity of identifying and measuring performance outcomes, sibs are costly to set up.68 therefore, sibs are best suited for projects that can generate enough cost savings to overcome these additional expenses.69 for instance, large-scale projects may be preferable, because the increased economies of scale can help lower the costs of the program and administrative expenses.70 as sibs become a more popular form of financing social projects, it is possible that implementing these projects will become more standardized and less costly.71 61 see kohli, besharov & costa, supra note 7, at 2. 62 third sector capital partners, supra note 57, at 3. 63 this is a result of campbell’s law: “the more any quantitative social indicator is used for social decision-making, the more subject it will be to corruption pressures and the more apt it will be to distort and corrupt the social processes it is intended to monitor.” jon pratt, flaws in the social impact bond/pay for success craze, nonprofit quarterly (apr. 17, 2013, 2:01 pm), https://nonprofitquarterly.org/2013/04/17/flaws-in-the-social-impact-bond-craze/ [https://perma.cc/7cxgkycj]. 64 cox, supra note 7, at 968–69. 65 see id. at 968; barajas et al., supra note 15, at 10. 66 see cox, supra note 7, at 968; barajas et al., supra note 15, at 10. 67 see cox, supra note 7, at 977; davies, supra note 35, at 7; third sector capital partners, supra note 57, at 6. 68 see barajas et al., supra note 15, at 18; jessica toonkel, corrected-wall street not giving up on u.s. social impact bonds, reuters (jul. 29, 2015, 10:22 am), http://www.reuters.com/article/2015/07/29/usa-socialbonds-idusl1n1082s820150729 [https://perma.cc/3z7q-z6ct]. 69 see barajas et al., supra note 15, at 18. 70 liang, mansberger & spieler, supra note 19, at 274; barajas et al., supra note 15, at 18. 71 see toonkel, supra note 68. 2017] social impact bonds 153 finally, at this point, it is unclear whether or not sibs will live up to their potential. to assess their potential accurately, more evidence is necessary. as of february 2017, only three sibs launched in the united states have been operating for long enough to have their outcomes evaluated and any success payments calculated.72 of these three, one project was terminated early because the program was unsuccessful in reaching its goal of reducing the recidivism rate at rikers island.73 the second one, the utah high quality preschool program, resulted in a success payment, but the success metrics used to evaluate the results of the program, designed to help at risk kindergarteners, were questionable.74 this generated a lot of criticism of the program.75 most recently, the third project resulted in an initial success payment to private investors of a sib aimed at expanding high quality pre-school education to low-income children.76 although it is too early to evaluate the true success of chicago’s sib project, some of the evaluation design issues with the utah program have been addressed in this project. despite setbacks, these early projects do not necessarily diminish from the potential of sibs to address social challenges. on the one hand, the sib model is not structured to guarantee success, but rather to shift the risk of innovating to private investors.77 thus, the failure of the rikers island project to reach its goal of reducing the rate of recidivism has the benefit of using private funds to demonstrate a type of program that is ineffective. similarly, the controversial results of the utah program reveal the type of evaluation methodologies that do not work, and reinforce that the sib model is not suitable for all projects. as one commentator has noted, “[f]ailed efforts are not only inevitable, they are essential to finding real solutions.”78 on the other hand, regardless of 72 see gov’t performance lab., supra note 22, at 4. these projects are: (i) new york city’s sibfunded program aimed at reducing the recidivism rate among juveniles detained at rikers island, which was the first sib launched in the united states; (ii) utah’s sib-funded program targeting early childhood education; and (iii) chicago’s sib-funded program to provide access to high-quality early childhood education to at-need students. see press release, mayor’s press office, city of chicago, mayor emanuel announces expansion of pre-k to more than 2,600 chicago public school children (oct. 7, 2014), http://www.cityofchicago.org/city/en/depts/mayor/press_room/press_releases/2014/oct/mayor-emanuelannounces-expansion-of-pre-k-to-more-than-2-600-ch.html [https://perma.cc/632r-6w85] (describing the city of chicago’s sib expanding pre-kindergarten to more than 2,600 chicago public school children); fact sheet: the utah high quality preschool program, https://hceconomics.uchicago.edu/sites/default/files/file_uploads/sib-rbffact_sheetutahversion.pdf [https://perma.cc/mpk5-w93v] (describing the utah high quality preschool program); toonkel, supra note 68; vera inst. of soc. justice, social impact bond evaluation, http://www.vera.org/project/impactevaluation-adolescent-behavioral-learning-experience-program-rikers-island [https://perma.cc/3mxy-uzpl] (describing the program and results of the new york city sib targeting recidivism). 73 see john olson & andrea phillips, rikers island: the first social impact bond in the united states, 9 community dev. inv. rev. 97, 97 (2013); gov’t performance lab., supra note 22, at 4. 74 see gov’t performance lab., supra note 22, at 4; nathaniel popper, did goldman make the grade, n.y. times, nov. 3, 2015, b1. 75 see gov’t performance lab., supra note 22, at 4; popper, supra note 74. 76 see gov’t performance lab., supra note 22, at 4; melissa sanchez, investors earn max initial payment from chicago’s ‘social impact bond’, chi. rep. (may 16, 2016), http://chicagoreporter.com/investors-earn-max-initial-payment-from-chicagos-social-impact-bond/ [https://perma.cc/kmg8-erbe]. 77 see gov’t performance lab., supra note 22, at 4 (“the early u.s. pfs projects have demonstrated the model’s potential to increase resources dedicated to tackling challenging social problems, while simultaneously minimizing the risk that ineffective programs continue to receive funding year after year.”); tyson & mendonca, supra note 22. 78 tyson & mendonca, supra note 22, at 2. 154 columbia journal of tax law [vol.9:141 success, the sib model has the potential to increase funding for social programs and encourage evidence-based decision-making.79 in sum, a sib-financed program is not appropriate to address all social issues.80 but as already recognized, “where viable … they present many advantages over traditional grant and appropriation financing.” 81 thus, if appropriate precautions are taken to minimize collusion or corruptive practices, sib-financed programs could make a substantial impact on many of the challenging social issues our nation faces.82 however, a sufficient number of sibs need to be implemented and evaluated before we can conclude whether or not sibs can fulfill their goal of improving the delivery of social services. iii. taxation of sibs this part discusses the current tax treatment of sibs for u.s. federal income tax purposes. 83 section a briefly explains why the federal income tax consequences to investors who participate in a sib-funded program are unclear under existing law. section b demonstrates that the current law does not treat sibs as a tax-favored investment. in particular, it discusses why sib investments most likely do not benefit from preferential tax rates, tax-exempt treatment, or an upfront charitable contribution deduction. a. tax uncertainty because the taxation of sib investments is not specifically addressed by existing federal income tax laws, their current tax treatment must be discerned from the general rules governing financial instruments. under existing law, the tax implications of an investment in a financial instrument significantly depend on how the instrument is characterized for tax purposes.84 courts generally weigh numerous factors in determining an instrument’s characterization.85 under this facts and circumstances analysis, sibs can 79 see barajas et al., supra note 15, at 17; gov’t performance lab, supra note 22, at 4. 80 davies, supra note 35, at 6; kohli, besharov & costa, supra note 7, at 8. 81 cox, supra note 7, at 970. 82 see kohli, besharov & costa, supra note 7, at 8. 83 for a detailed discussion of the tax consequences to investors who participate in a sib-funded program, see mazur, supra note 7, at 468–486. 84 see fin hay realty co. v. united states, 398 f.2d 694 (3d cir. 1968); staff of the j. comm. on tax’n, jcs-3-13, rep. to the house comm. on ways and means on present law and suggestions for reform submitted to the tax reform working groups 58 (2013); staff of the j. comm. on tax’n, jcx-41-11, present law and background relating to tax treatment of business debt (2011); edward d. kleinbard & erika w. nijenhuis, everything i know about new financial products i learned from decs, 553 pli/tax 491 (2002); michael s. farber, equity, debt, not—the tax treatment of non-debt open transactions, 60 tax l. 635, 636 (2007); bret wells, tax consequences of participations in international trade finance, 13 tax note int’l 23 (dec. 2, 1996). 85 the characterization of a financial instrument requires the consideration of numerous factors, such as (i) the parties’ intent, (ii) the existence of an unconditional promise to pay at a fixed maturity date; (iii) the provision of fixed interest rates; (iv) participation in profits; (v) the adequacy of the interest; (vi) the source of payments (vii) participation in management; (viii) the extent of subordination to the claims of general creditors; (ix) the identity of interest between holders of the instrument and owners; (x) satisfaction of the independent creditor test; and (xi) the use of the funds. see i.r.c. § 358(a); roth steel tube co. v. comm’r, 800 f.2d 625 (6th cir. 1986), cert. denied, 481 u.s. 1014 (1987); estate of mixon, jr. v. united states, 464 f.2d 394 (5th cir. 1972); fin hay realty, supra note 84; staff of the j. comm. on tax’n, jcs2017] social impact bonds 155 plausibly be characterized in several different ways.86 this uncertainty exposes a private sib investor to tax compliance risks, as well as to an unpredictable tax liability. for instance, the tax law may treat sibs as debt instruments. sibs are referred to as “bonds” and the majority of u.s. sib arrangements indicate that the parties intend that the instrument be treated as debt.87 in addition, several other factors may also weigh in favor of debt characterization. specifically, the rate of return set forth in a typical sib arrangement is likely considered a “reasonable” rate of return, thereby supporting debt characterization. the source of repayment also suggests a sib arrangement is akin to debt because a state or local government generally guarantees the intermediary’s payments to investors upon a successful outcome.88 moreover, the payment preference, which sib investors often receive over other claimants, likely also favors debt characterization.89 finally, several other factors are inconclusive and do not preclude debt characterization, such as the provision of a fixed rate of interest whose payment is contingent on the success of the project, or weigh only slightly in favor of debt characterization, such as the limited rights of sib investors to participate in management.90 alternatively, current law may also treat sibs as equity.91 two factors potentially weigh in favor of equity characterization. first, a traditional sib arrangement does not necessarily provide an unconditional promise to pay the principal at a fixed maturity date, which is a significant factor in the debt/equity characterization analysis.92 on the one hand, the sib investment provides for a fixed maturity date. on the other hand, repayment is contingent on the program’s successful delivery of social outcomes, which undermines the requirement that payment is unconditional. thus, this factor may point towards an equity characterization.93 second, sib investors participate in the profits of the enterprise, which is another factor that favors equity characterization.94 specifically, sib investors stand to gain an additional return on their investment to the extent the sibfunded program exceeds pre-determined outcome metrics.95 generally, the amount of these “success payments” is based on the cost-savings the program accrues to the government that initiated the sib project.96 however, sibs generally also cap the profit potential of the sib investor and the profit participation is not discretionary once the 3-13, supra note 84, at 58; staff of the j. comm. on tax’n, jcx-41-11, supra note 84; i.r.s. notice 94-47, 1994-1 c.b. 357; farber, supra note 84, at 645. 86 for a detailed analysis of how sibs are likely characterized for tax purposes under current law, see mazur, supra note 7, at 446–66. 87 see, e.g., olson & phillips, supra note 73 (describing the investment structure as a multiple draw term loan to the project intermediary); pay for success contract among the commonwealth of mass., roca, inc., and youth servs. inc. (jan. 7, 2014), http://www.thirdsectorcap.org/wpcontent/uploads/2015/03/final-pay-for-success-contract-executed-1-7-2013.pdf [https://perma.cc/34klllb8] (referring to the financing of a sib launched in massachussets to target juvenile rescidivism as a loan). 88 see mazur, supra note 7, at 453. 89 see id. at 454. 90 see id. at 453. 91 if a sib arrangement is treated as creating an equity interest, it may result in the creation of a corporate equity interest or a partnership interest or joint venture. see id. at 457. 92 see id. at 449. 93 see id. 94 see william t. plumb, jr., the federal income tax significance of corporate debt: a critical analysis and a proposal, 26 tax l. rev. 369, 442 (1970); mazur, supra note 7, at 451. 95 see supra notes 10–16 and accompanying text. 96 see supra notes 10–16 and accompanying text. 156 columbia journal of tax law [vol.9:141 performance thresholds are met. thus, although this factor potentially suggests equity characterization, it does not definitively preclude debt characterization.97 it is also possible that a sib arrangement is characterized as neither debt nor equity, but rather as a derivative instrument. a sib arrangement has several important features in common with derivative instruments, in general, and more specifically with notional principal contracts. both sib arrangements and derivative instruments seek to shift financial risks to another party.98 both instruments also calculate payments based on the value of an underlying transaction. 99 in addition, like prepaid swaps, a type of notional principal contract, sibs also require one party to pay a fixed amount upfront, while the other party is contractually obligated to make variable future payments, which are calculated based on the value of the underlying transaction at a particular date.100 to summarize, a traditional sib arrangement can arguably be treated as debt, equity or a derivative instrument. there are factors that support each of these characterizations. taxpayers and the service may disagree as to the correct treatment for tax purposes, thereby affecting a sib investor’s ultimate tax liability. moreover, sibs are not structured uniformly. certain modifications may change the tax classification, and as sibs continue to evolve, the characterization analysis also may lead to different results. b. unavailable tax preferences the tax preferences that the federal government currently extends to traditional equity investments, municipal bonds, and charitable donations likely do not apply to traditional sib investments. as a result, private investors who participate in sibs do not currently enjoy tax benefits, such as preferential tax rates, tax-exempt treatment, or an upfront deduction. 1. preferential tax rates in general, qualified dividends and capital gains are subject to preferential tax treatment.101 these forms of income are subject to tax at a maximum rate of 20%,102 rather than the 39.6% tax rate imposed on other forms of income.103 even though a sib arrangement may be treated as an equity interest under certain circumstances, a traditional sib arrangement would most likely not be treated as equity for tax purposes.104 accordingly, income generated by a sib investment would not benefit from these preferential tax rates. 97 see mazur, supra note 7, at 451. 98 see boris i. bittker & lawrence lokken, federal taxation of income, estates and gifts ¶ 57.1 (2017) (quoting c.t. plambeck et al., general report, 80b cahiers de droit fiscal int’l 653, 657 (1995)) (defining a derivative instrument as a “risk-shifting financial contract … whose payment terms are determined by or derive from the value of the underlying transaction”); mazur, supra note 7, at 462. 99 see bittker & lokken, supra note 98; mazur, supra note 7, at 451. 100 see mazur, supra note 7, at 463. a sib instrument also has several features in common with a cash-settled prepaid forward contract. see id. 101 i.r.c. § 1(h)(1), (11). 102 because of the 3.8% surtax imposed on net investment income, this top federal tax rate on capital gains is effectively 23.8%. see i.r.c. § 1411. 103 see i.r.c. § 1. 104 for a thorough discussion of this conclusion, see mazur, supra note 7 (discussing why a sib arrangement may potentially be treated as creating a corporate equity interest or a partnership interest and the corresponding tax consequences of each characterization). 2017] social impact bonds 157 a traditional sib arrangement is more likely characterized as a contingent debt instrument under the existing law. 105 this characterization is especially likely in situations where the parties label the sib investment as a “loan” and/or issue a note or other evidence of indebtedness.106 moreover, as discussed above, the factors that weigh in favor of characterizing a sib investment as equity, such as the unconditional promise to pay at a fixed maturity date and the sib investor’s participation in profits do not preclude debt characterization in all cases.107 as a debt instrument, the sib investment would likely be subject to the noncontingent bond method.108 pursuant to this method, the sib investment will give rise to interest income, which will be calculated and taxable on an annual basis, even prior to any payments being made.109 if the actual amounts of the contingent payments differ from the projected amounts, either because the sib-funded project is unsuccessful or the project satisfies a different level of outcome metrics, adjustments are made to reflect the difference at the time the actual payment amounts are first determinable.110 moreover, this interest income will be subject to tax at a marginal rate of up to 39.6%, instead of the lower tax rates imposed on capital gains and dividend income.111 2. tax exemption current law provides a federal tax exemption for interest on bonds issued by a state or local government. 112 for the reasons discussed below, it is possible that a traditional sib arrangement would not qualify for this tax-exempt status.113 105 mazur, supra note 7, at 486. 106 the majority of the sibs implemented in the united states to date structure the sib arrangement as a loan from investors to the project intermediary. see id. at 442. although the service is not bound by the debt label given to a sib instrument, the instrument’s issuer and all holders of the instrument are generally bound by this characterization. see notice 94-47, supra note 85. 107 see supra notes 91–97 and accompanying text. see also mazur, supra note 7, at 486 (arguing that the totality of the factors weigh in favor of characterizing a traditional sib investment as debt rather than equity). 108 see reg. § 1.1275–4(a) (applying the non-contingent bond method to certain debt instruments that provide for one or more contingent payments). even if the sib investment is characterized as a prepaid swap agreement, the tax consequences are likely to be similar. see also mazur, supra note 7, at 463. the noncontingent swap method, which applies to prepaid swap agreements, is comparable to the noncontingent bond method. see treas. reg. § 1.446–3. however, if the sib investment is ultimately characterized as a different type of derivative instrument, such as prepaid forward contract, then the tax implications of a sib investment will differ significantly. see mazur, supra note 7, at 464. 109 “under the noncontingent bond method, interest on a debt instrument must be taken into account whether or not the amount of any payment is fixed or determinable in the taxable year. the amount of interest that is taken into account for each accrual period is determined by constructing a projected payment schedule for the debt instrument and applying rules similar to those for accruing oid on a noncontingent debt instrument.” treas. reg. § 1.1275–4(b)(2). 110 see id. 111 i.r.c. § 1. this rate is effectively 43.4% for income that constitutes net investment income as a result of the 3.8% surtax imposed by section 1411. i.r.c. § 1411. similarly, capital gains and dividend income that constitute net investment income and exceed a statutory threshold are also subject to this 3.8% surtax. i.r.c. § 1411. 112 see i.r.c. § 103. 113 however, it may be also possible to structure a sib arrangement in a manner that may qualify for tax-exempt treatment. specifically, a sib may be structured so that it does not satisfy the private use test and the private security or payment test or the private loan financing test and therefore does not constitute an ineligible private activity bond. moreover, sib proceeds that are used to pay service providers may be considered working capital expenditures that can qualify for tax-exempt treatment. nevertheless, the 158 columbia journal of tax law [vol.9:141 to qualify for the exemption, the bond issuer has to comply with numerous reporting and filing requirements.114 in addition, no portion of the bond may constitute a private activity bond.115 in other words, the bond proceeds may not benefit a private business or a person that is not a governmental unit.116 one exception to this rule is if the bond constitutes a qualified 501(c)(3) bond.117 in general, a qualified 501(c)(3) bond is a bond issued by a state or local government whose proceeds are used to finance property owned by 501(c)(3) organizations, such as charities or educational organizations, or governmental units.118 even though the proceeds of a sib are also generally used to benefit charitable organizations, a traditional sib arrangement likely does not qualify as a 501(c)(3) bond. a 501(c)(3) bond is disqualified from tax-exempt status if neither a 501(c)(3) organization nor a governmental entity owns all of the property financed by the net proceeds of the bond.119 a traditional sib arrangement most likely fails to satisfy this requirement because neither a government entity nor a 501(c)(3) organization own any property as a result of the issuance of the sib.120 unlike most tax-exempt bonds that are issued to finance physical capital projects, such as schools, hospitals, airports, highways, or other types of public infrastructure or government facilities, a traditional sib is not issued to finance the acquisition or building of any property.121 instead, the sib proceeds are used to finance social services that do not typically result in the creation of any tangible property. thus, a sib most likely fails to meet the statutory requirements of the ownership test. the features of a sib also differ in several significant respects from current municipal bonds. generally, a municipal bond is issued as either a general obligation bond or a revenue bond. a sib does not appear to fall within either of these categories.122 a general revenue bond is backed by the “full faith and credit” of the issuing government uncertainty involved in determining whether sibs qualify for tax-exempt treatment may be enough to deter some potential investors from claiming the exemption for tax purposes. 114 an issuer also has to comply with requirements related to the “proper and timely use of bondfinanced property … and arbitrage yield restriction and rebate requirements.” i.r.s. pub. no. 4079, taxexempt governmental bonds, 11 (jan. 2016). 115 i.r.c. § 103. arbitrage bonds (as defined in section 141 of the code) are also ineligible for this tax-exempt status. id. although this raises interesting issues in the sib context, it is likely that a sib arrangement would not be considered an arbitrage bond. 116 see i.r.c. § 141. a private activity bond is a bond that either meets the requirements of (1) the private use test and the private security or payment test; or (2) the private loan financing test. id. 117 i.r.c. § 141(b)(9). 118 see i.r.c. § 145. 119 i.r.c. § 145(a)(1). a 501(c)(3) bond is also disqualified from tax-exempt status if the bond satisfies both the modified private business use test and the modified private payment or security test. id. the private business use test looks to whether more than 5% of the net proceeds of the 501(c)(3) bond issue are to be used for any private business use. i.r.c. §§ 145(a)(1), 141(b)(1). the private payment or security test is satisfied if more than 5% of the payment of principal or interest on the bond issue is either made or secured by payments or property used or to be used for a private business use. i.r.c. §§ 145(a)(1), 141(b)(2). 120see dao et al., supra note 37, at 15; office of inv’r educ. & advocacy, u.s. sec. & exch. comm’n, investor bulletin: municipal bonds (june 1, 2012), https://www.sec.gov/investor/alerts/municipalbonds.htm [https://perma.cc/3nsk-mqhn]. 121 see grant a. drissen, cong. research serv., rl30638, tax-exempt bonds: a description of state and local government debt (2016). 122 see dao et al., supra note 37, at 16 (concluding that “in attempting to find a home for the sib in the current municipal framework, we found that there is no existing area of natural fit and believe it is likely that legislation needs to be passed in order to complement the issuance of a sib”). 2017] social impact bonds 159 entity.123 although a government entity may guarantee the full repayment of a sib by its taxing power, this repayment is contingent on a particular social program achieving a certain level of success.124 this likely does not satisfy the criteria of a general obligation bond. a sib likely also does not constitute a revenue bond. a revenue bond is a bond that is not backed by the full faith and credit of the issuer, but instead is backed by the revenue generated from a specified income-producing project.125 a sib likely also does not fall within this bond category because projects financed by sibs generally do not generate revenue. instead, a successful sib-funded project often generates government cost savings by improving a particular social issue.126 in addition, a municipal bond is structured as a debt instrument with fixed or variable interest payments and a promise of the repayment of principal on the maturity date. unlike a typical municipal bond, a sib is a hybrid financial instrument that has both debt and equity features. although it has a fixed maturity date, it does not have fixed interest payments. instead, the return on investment depends on the success of the project. a sib also does not provide for a repayment of the principal investment upon the maturity date. instead, both the “interest” payments and the repayment of principal are contingent upon a social program exceeding certain performance thresholds. thus, considering the cumulative effect of these differences, it is likely that traditional sibs do not qualify for tax-exempt status. instead, specific legislation is likely needed to make sibs tax exempt.127 3. upfront deduction current law also provides a federal income tax deduction for donative transfers to qualified charitable organizations, which meet the requirements of a charitable contribution.128 even though a traditional sib investment generally involves the transfer of money or property to a qualified charitable organization129 and sib investments by private investors, thus far, have been made primarily for philanthropic reasons,130 an 123 u.s. sec. & exch. comm’n, investor bulletin: municipal bonds, supra note 120. 124 see, e.g., pay for success contract, supra note 87 (providing that the funds the commonwealth of massachusetts uses to enter into pay-for-success contracts are backed by the full faith and credit of the commonwealth). 125 u.s. sec. & exch. comm’n, investor bulletin: municipal bonds, supra note 120. 126 see dao et al., supra note 37, at 19. 127 see id. at 16. 128 i.r.c. § 170. a contribution or gift generally qualifies for the federal income tax deduction if it meets four requirements: (1) it is a transfer of money or property; (2) the recipient is a qualified organization as defined in section 170(c); (3) the transfer is voluntary, donative in nature and exceeds the value of any actual or expected return benefit; and (4) the contribution is in proper form. see id.; carla neeley freitag & barbara l. kirschten, charitable contributions: income tax aspects, 863-3rd tax mgmt. port. (bna), ii(a) (apr. 11, 2016). 129 to date, the organizations that have operated as project intermediaries in u.s. sibs have been qualified charitable organizations. see mazur, supra note 7. 130 see liang, mansberger & spieler, supra note 19 (observing that the primary mission of sibs is to “promote proven social benefit programs,” while any economic benefit or growth is only of secondary importance); mazur, supra note 7; robert milburn, ‘pay for success bonds’ drum up interest, barron’s: penta daily (jan. 13, 2014, 11:40 am), http://blogs.barrons.com/penta/2014/01/13/pay-for-success-bondsdrum-up-interest/ [https://perma.cc/dc5h-azg2] (noting that “[m]uch of the private investor interest, at this point, has come from philanthropic-minded individuals and their foundations.”). 160 columbia journal of tax law [vol.9:141 investment in a sib-funded program is not likely to give rise to a deductible charitable donation. the tax law provides that a payment does not qualify as a charitable contribution unless the transferor “intends to make a payment in an amount that exceeds the fair market value” of any goods or services that it receives from the charitable organization.131 however, a private investor in a sib expects a return benefit. this is evident from the terms of the traditional sib arrangement, which provide that if the sib-funded program exceeds certain performance thresholds, the investor recoups its initial capital investment and possibly also receives a return on that investment.132 in other words, in addition to any social good the investment may generate, an investor generally also expects a financial return from its investment. thus, it does not matter that the investor may potentially lose its entire investment or that the investor is willing to make this risky, lowfinancial reward investment.133 this expectation of benefits is enough to disqualify an individual investor from deducting its payment upfront as a charitable contribution deduction.134 instead, the sib investment would generate a capital loss deduction only once (and if) the sib-financed project fails to meet the pre-determined performance thresholds and the investor loses its investment. in conclusion, private investors who participate in sibs do not currently enjoy any tax benefits related to their investment. instead, these investments likely give rise to ordinary income taxable at non-preferential tax rates throughout the life of the project and only give rise to a limited capital loss deduction at the time an unsuccessful sib-funded project is terminated. iv. sibs as a tax-favored investment? despite the sibs’ potential to help tackle some of society’s toughest social problems or at least move us toward a more evidence-based, collaborative delivery of social services, the current tax law discourages private investments in sibs. this situation arises because the current tax treatment of sibs, like many novel financial instruments, is not clear, due to the difficulties in characterizing the arrangement under the traditional debt/equity analysis.135 this ambiguity creates an audit risk that may deter some private investors from investing in sib arrangements especially given the speculative nature of the investment and the below-market rate of return.136 moreover, potential sib investors have many options of where to invest their private capital. among their choices are traditional equity investments and municipal 131 treas. reg. § 1.170a–1(h)(1)(i) (emphasis added). in addition, the payment must also actually exceed the fair market value of the goods or services. treas. reg. § 1.170a–1(h)(1)(i–ii). 132 see supra notes 11–17 and accompanying text. 133 see stubbs v. u.s., 428 f.2d 885 (9th cir. 1970); singer co. v. u.s., 449 f.2d 413, 424 (ct. cl. 1971); mazur, supra note 7; freitag & kirschten, supra note 128, at ii(e)(1)(b)(2). 134 however, it is possible that certain sib arrangements that are structured as a tranche loan structure may be bifurcated so that a portion of the transaction is treated as a charitable contribution with respect to non-profit investors that transfer funds to the sib as junior lenders. see mazur, supra note 7. 135 although the ambiguity that arises in applying the debt/equity analysis to sibs is not unique to these transactions, it may nevertheless have a deterrent effect to risk-adverse investors. 136 as discussed above, although often structured as a debt instrument, the traditional sib arrangement does not necessarily constitute debt for tax purposes. see infra part ii.a. moreover, if the investment is treated as an equity interest in the project intermediary, this may be cause a non-profit intermediary to lose its tax-exempt status. see mazur, supra note 7. 2017] social impact bonds 161 bonds. this part argues that despite sharing many similar features with a traditional sib investment, each of these options receive better tax treatment than a sib investment, which may further deter private investments in sib-funded programs. because no strong justifiable basis exists for discouraging sib investments, this part concludes that extending tax benefits to sib investments would be a sound policy choice. a. traditional equity investments given the below-market rate of return on a sib investment and the potentially unfavorable tax treatment of a traditional sib investment, a rational investor may be more incentivized to invest in a traditional equity investment. even without considering taxes, a traditional equity investment with similar market risk would likely generate a higher rate of return than a comparable sib investment and provide investors with more liquidity.137 when taxes are taken into account, this disparity in return on investment is exacerbated, because a traditional equity investment generally also results in more favorable tax consequences than a sib investment. in particular, a profitable equity investment is more favorable from a tax perspective, because it can generate income taxed at preferential tax rates.138 a non-corporate investor that receives qualified dividend income from a corporation will pay tax on that income at up to a 20% rate,139 whereas a sib investor would pay tax on the same stream of income at up to a 39.6% rate.140 the traditional equity investor also benefits from a time value of money perspective. this advantage arises because the recipient of qualified dividend income generally would only be liable for taxes in the taxable year that the dividends are paid to her. a sib investor, however, would be liable for tax on any projected return on investment prior to the time of actual payment under the non-contingent bond method.141 as a result of these significant differences in tax treatment, the tax law likely distorts the capital market against sib investments. this is undesirable from a policy 137 see emily gustafsson-wright, katie smith & sophie gardiner, public-private partnerships in early childhood development: the role of publicly funded private provision, brookings inst. (2016), https://www.brookings.edu/wp-content/uploads/2016/11/global-20161129-public-private-partnerships.pdf [https://perma.cc/nxe6-6nhy]. see also erika k. stump & amy f. johnson, an examination of using social impact bonds to fund education in maine, univ. of southern me. (2016), https://usm.maine.edu/sites/default/files/cepare/examination_of_using_social_impact_bonds_to_fund_edu cation_in_maine.pdf [https://perma.cc/m84y-xqwf] (concluding that “[w]hile many venture market capital investors expect a return of up to 20%, sib investments usually offer less than a 10% return”). 138 see i.r.c. §§ 1(h)(1, 11) (providing for a preferential tax rate for qualified capital gains and qualified dividends). 139 this rate is reduced to 15% if the taxpayer is not in the 39.6% tax bracket. in addition, this income may also be subject to a 3.8% surtax if certain income thresholds are met. see i.r.c. § 1411. 140 see supra notes 108–11 and accompanying text (discussing why a sib investment is most appropriately treated under the non-contingent bond method under the current law, rather than as a corporate equity investment that gives rise to preferential tax rates). this income may also be subject to the 3.8% surtax on net investment income when certain income thresholds are met. see i.r.c. § 1411. 141 even if both an equity investment and sib-funded project are unsuccessful, the tax implications to the equity investor are generally more favorable from a timing perspective. in both cases, the investor would recognize a capital loss at the termination of the investment. however, because the non-contingent bond method likely applies to the sib investment, the sib investor nevertheless has to report any projected return on investment on an annual basis. the sib investor only accounts for any difference between the amount of income reported and the amount of the contingent return on investment that the investor receives, if any, at the time the contingent payment is made. see treas. reg. 1.1275–4. 162 columbia journal of tax law [vol.9:141 perspective for several reasons. first, there is no justifiable reason for the distinction. even though a sib shares many features with a traditional equity investment, there is a strong argument that traditional sib investments are not treated as corporate equity, but instead treated as contingent bond instruments and taxed under the less favorable noncontingent bond method.142 second, if sib investments live up to their potential, they will produce a social good that should be encouraged, or at least not discouraged. given that sib investments, unlike traditional investments, are created to generate government cost savings and produce a social benefit, this does not make sense from a policy perspective.143 also, as further discussed below, it is conceptually consistent with the policy behind the dividend and capital gains tax preference to extend similar tax treatment to income generated by sibs. b. tax-exempt bonds alternatively, a sib investor could have used its funds to invest in a municipal bond, in which case any interest generated would be exempt from taxation. 144 a municipal bond shares many features with a sib arrangement. for instance, the proceeds of a qualified 501(c)(3) bond, a specific type of municipal bond, must be used for the benefit of charities, educational organizations, or other 501(c)(3) organizations and governments.145 similarly, the proceeds generated by a sib arrangement are often used for the benefit of 501(c)(3) organizations, because qualified nonprofit organizations generally perform the social services financed by the sib. thus, sibs indirectly provide these nonprofit organizations the capital with which to operate and address a social issue that is aligned with that organization’s charitable mission. moreover, sibs are also specifically designed for the benefit of governments by funding programs and providing social services that have traditionally been provided by governments. these instruments are also intended to create savings for the government by improving social programs. despite these similarities, as discussed above, it is possible that a traditional sib arrangement does not qualify as a tax-exempt bond.146 a sib investment is disqualified primarily for technical reasons. for instance, a sib arrangement does not generate taxexempt income, because its proceeds are used to finance services, rather than physical capital projects. section 501(c)(3) bonds, which qualify for tax-exempt treatment, are generally issued to fund the acquisition, development, or improvement of facilities used for the operation of non-profit organizations. the absence of property in the sib context is likely one factor that precludes tax-exempt treatment. in addition, a sib does not take on the form of either a general obligation bond or a revenue bond. thus, despite the similarities, a sib arrangement may not qualify for the same tax-exempt treatment. 142 see supra notes 108–11 and accompanying text; mazur, supra note 7. 143 see cox, supra note 7, at 981–82 (arguing that “because the government already realizes significant savings upon successful completion of a sib-funded program, legislators should consider exempting investor sib earnings from capital gains taxation”). 144 see i.r.c. § 103. 145 see i.r.c. § 145. alternatively, to qualify for tax-exempt treatment, more than 5% of the net proceeds of the 501(c)(3) bond cannot be used for any private business use and more than 5% of the payment of principal or interest on the bond must either be made or secured by payments or property used or to be used for a private business. id. 146 however, as also discussed above, it may be possible to structure a sib arrangement in a manner so that it does not constitute a private activity bond. supra note 113. 2017] social impact bonds 163 this disparate tax treatment likely distorts investment decisions away from sibs and in favor of municipal bonds. even though both sibs and municipal bonds benefit the government or a non-profit entity and even though both offer lower rates of returns, a rational investor, who is motivated purely for financial reasons, would be more willing to accept the relatively low interest payments on municipal bonds because they are taxfree.147 in addition, municipal bonds are generally considered a less risky investment given their relatively low default rates. on the other hand, a sib investment is a high risk investment. it conditions repayment of principal on the success of a particular social program and has a novel and unique risk profile that is hard to measure. consequently, sibs, which do not offer any comparable incentives, carry a high level of risk, and function similarly to municipal bonds, are at a disadvantage relative to municipal bonds. in summary, as the above discussion demonstrates, the tax consequences to private investors who contribute funds to sibs are generally unfavorable relative to comparable investments. however, there is no sound policy basis for this distinction. as a result, the current tax law creates unjustified inefficiencies and inequities, limits a sib’s ability to attract private capital to expand in the united states, and prevents governments from effectively studying the true potential of sibs to advance solutions to challenging social issues. v. recommendations for reform by increasing compliance risks for sib investors and granting tax-favored status to comparable investments, the current tax system creates administrative issues, distorts investment decisions, and treats similarly-situated taxpayers differently. existing tax policies need to be changed to accommodate sibs and minimize the discriminatory tax treatment towards private investment in sibs. there are numerous ways that congress can minimize the current, unfavorable tax treatment towards sib investments. this article focuses solely on tax policy changes that will treat sib investments more in parity with comparable investments for tax purposes.148 thus, in answering the question of which tax benefits enjoyed by other investments should be extended to sib investments, it is helpful to understand why certain investments enjoy significant tax benefits. this part briefly summarizes the commonly cited rationales for the tax benefits extended to certain investments and suggests several possible modifications to the federal tax system that would make the sib arrangement a more tax-favored investment. 147 see scott greenberg, reexamining the tax exemption of municipal bond interest, tax found., (july 21, 2016), https://taxfoundation.org/reexamining-tax-exemption-municipal-bond-interest/ [https://perma.cc/4jqs-bcu2]. 148 for instance, instead of providing a tax incentive, the federal government can incentivize sib investments by granting money directly to state and local governments for social welfare purposes, which these governments may then use to increase the potential return to investors of sib arrangements. this method is likely to be a simpler and more effective way to increase the attractiveness of sibs. however, this article does not argue that the federal government should promote sib investments. instead, this article argues that the federal government should treat sib investments similarly to other investments for tax purposes. doing so would minimize the distortionary effects of the current law and enable the market to better determine whether sibs make a worthy investment. for these reasons, this article does not include other types of legislative solutions, such as direct expenditures, even though these legislative changes may better promote sibs in some instances. 164 columbia journal of tax law [vol.9:141 a. preferential tax rates one option is to extend preferential tax rates to the income generated by sib investments. preferential tax treatment for capital gains has been a part of our tax system for nearly 100 years.149 hence, it would not be unprecedented to subject the returns on a sib investment to the same lower rate of tax. as discussed further below, it would also be conceptually consistent with the policy behind this preference to extend similar tax treatment to income generated by sibs. the tax preference for capital gains has been justified on numerous grounds.150 one common justification, and arguably the strongest justification, for the preferential capital gains tax rate is that this benefit will help minimize the lock-in effect.151 the lockin effect refers to the theory that a tax on capital gains upon a realization event will discourage investors from liquidating assets whose value has appreciated and reinvesting those proceeds in a new investment.152 because a taxpayer is only taxed when he or she disposes of the asset, a taxpayer is therefore incentivized to hold onto his or her investments. this phenomenon creates market inefficiencies that “impedes the flow of capital to its most productive uses.”153 proponents of the capital gains preference also argue that the special tax treatment of capital gains is necessary to increase savings and to encourage risk-taking, both of which are necessary to achieve economic growth.154 this argument is based on the premise that subjecting capital gains to a lower rate of tax would induce more savings by removing some current tax disincentives on savings. 155 similarly, reducing the effective tax rates on capital gains would minimize the current tax law’s negative effects on risk taking by increasing the expected return from a risky investment.156 another popular argument in favor of the capital gains tax preference is that without such preference, a successful investment would result in the bunching of income accrued over multiple years into a single year, thereby unfairly subjecting the income to a higher marginal tax rate.157 proponents of a capital gains tax preference also argue that this lower tax rate is necessary, because the gain is not a genuine economic gain in that it does not reflect capital appreciation, but rather largely reflects inflation occurring during 149 bittker & lokken, supra note 98, at ¶ 46.1 (2017) (finding that “[s]ince 1921, with the exception of the years 1987 through 1990, capital gains were taxed more leniently than ordinary income …”). 150 for a thorough discussion of the different justifications in favor of the preferential treatment of capital gains, see walter j. blum, a handy summary of the capital gains arguments, 35 taxes 247, 252–58 (1957). 151 staff of the j. comm. on tax’n, jcs-5-05, general explanation of tax legislation enacted in the 108th congress 22–23 (2005); staff of the j. comm. on tax’n, 95th cong., general explanation of the revenue act of 1978 252 (2d sess. 1979); blum, supra note 150, at 252–58; noel b. cunningham & deborah h. schenk, the case for a capital gains preference, 48 tax l. rev. 319, 344–45 (1993); calvin h. johnson, taxing the consumption of capital gains, 28 va. tax. rev. 477, 500 (2009). 152 see blum, supra note 150, at 256–58; cunningham & schenk, supra note 151, at 344–45; johnson, supra note 151, at 499. 153 cunningham & schenk, supra note 151, at 344–45. 154 see staff of the j. comm. on tax’n, jcs-5-05, supra note 151; staff of the j. comm. on tax’n, general explanation of the revenue act of 1978, supra note 151, at 252; blum, supra note 150, at 250; cunningham & schenk, supra note 151, at 340–44; johnson, supra note 151, at 507–08. 155 staff of the j. comm. on tax’n, jcs-5-05, supra note 151, at 23–24 ; staff of the j. comm. on tax’n, general explanation of the revenue act of 1978, supra note 151, at 252; cunningham & schenk, supra note 151, at 331–37. 156 see cunningham & schenk, supra note 150, at 340–44. 157 see blum, supra note 149, at 253. 2017] social impact bonds 165 the period the taxpayer held the asset.158 moreover, another justification given is that a lower tax rate is necessary to minimize the “tax-induced distortions in the capital markets”159 caused by the double tax on corporate income160 and the tax law’s preference for corporations to use debt rather than equity financing.161 this preferential tax treatment comes in the form of a reduced rate of tax on capital gains, as well as on qualified dividend income.162 finally, many other justifications have also been given for the special tax treatment enjoyed by these types of investments including arguments that capital gains are not income, capital gains are unexpected, and that consumption, rather than income, should be taxed.163 not everyone supports the preferential tax treatment extended to capital gains and dividend income. as many commentators have already observed, this tax preference lacks a clear conceptual rationale.164 for example, there is no clear empirical evidence that supports the argument that this special tax treatment increases investments and stimulates economic growth.165 instead, an increase in savings may not necessarily be tied to a lower tax rate on capital gains since many forms of savings do not constitute capital gains and the decision to save is often not solely dependent on the potential rate of return available.166 in addition, the bunching of income rationale is unpersuasive given that the taxpayers who realize capital gains are often already subject to the highest marginal tax rate.167 furthermore, because of the realization requirement, capital gains also enables many taxpayers to benefit from the deferral of income. this deferral may potentially counteract some or all of the additional tax liability created by the bunching of income, as well as the taxation of the portion of the gain attributable to inflation.168 despite the foregoing, extending similar tax treatment to income generated by sibs would neither be unprecedented nor inconsistent with the tax policy behind this preference. regardless of whether or not one is in favor of or opposed to the capital gains tax preference, the current law provides for this tax preference. in addition, because there is no clear rationale for granting a tax preference to capital gains and dividend income, it is difficult to argue that granting a similar tax preference to sibs is contradictory to the goals of the capital gains tax rate. moreover, extending a similar tax benefit to sib investments is arguably conceptually consistent with some of these rationales. for 158 see id. at 255–56. 159 staff of the j. comm. on tax’n, jcs-5-05, supra note 151, at 23–24. 160 corporate earnings are currently subject to two levels of taxation, because the income is taxed once at the corporate level and then a second time at the shareholder level when the earnings are distributed to the shareholders. see i.r.c. §§ 11, 301. 161 staff of the j. comm. on tax’n, jcs-5-05, supra note 151, at 23–24. the tax law creates a bias against equity financing and in favor of debt financing by allowing corporations a deduction for interest payments, but not allowing a similar deduction for dividend payments. see i.r.c. § 163(a). 162 see i.r.c. §§ 1(h)(1, 11). in other words, by also extending preferential treatment to dividend income, congress intended to lower the tax burden on equity investments and thereby minimize the influence that tax considerations place on a corporation’s investment decision and incentivize corporations to make additional investments. see staff of the j. comm. on tax’n, jcs-5-05, supra note 151, at 23–24. 163 for a comprehensive summary of the various arguments in favor and against the preferential capital gains tax treatment, see blum supra note 150. 164 see, e.g., blum, supra note 150; cunningham & schenk, supra note 151; daniel halperin, a capital gains preference is not even a second-best solution, 48 tax l. rev. 381 (1993); johnson, supra note 151. 165 see blum, supra note 150, at 265; cunningham & schenk, supra note 151, at 378–79. 166 see blum, supra note 150, at 250; cunningham & schenk, supra note 151, at 377. 167 see cunningham & schenk, supra note 151, at 328. 168 see id. at 328–31. 166 columbia journal of tax law [vol.9:141 instance, the binary, speculative and novel nature of sib investments makes these investments inherently risky. by subjecting the returns on a sib investment to a lower rate of tax, the expected rate of return on a sib investment would increase, thereby making a sib investment more attractive and encouraging risk-taking. also, sib investments often require an investor to make an illiquid investment of capital for four to six years, with all or a majority of the payments made towards the end of the investment term. thus, sib investments often create a bunching of income, which may result in a higher marginal tax rate for the investor. as with capital gains, this can be minimized with a lower tax rate. finally, extending this tax preference to sib investments is also consistent with sound tax policy. a failure to grant a similar tax benefit to sib investments distorts the economics of private sector investment decisions and treats sib investors less favorably than traditional equity investments. but it is unclear why a capital gain or dividend should be singled out for better treatment than other types of capital income, such as income generated by a sib investment. given that sibs explicitly seek to provide not only financial returns, but also create a public benefit, they create a more compelling case for extension of these benefits. moreover, sib investments currently are structured so that economically they are more like equity investments than debt investments. in particular, an investment in a sib shares many features of preferred stock. by allowing investors to recognize any return on their capital at preferential capital gain rates, this treats sib investors in parity with investors of preferred stock who currently receive preferential tax treatment. thus, for the foregoing reasons, congress should consider enacting legislation that grants sib investors a preferential tax rate on any earnings from the sib investment at the time of the distribution of that income instead of treating the projected returns on a sib investment as ordinary income taxable on an annual basis. alternatively, congress should consider enacting a provision that provides successful sib investments with tax benefits that are comparable to the benefits offered to qualified small business stock. the current tax code grants special preferential tax treatment to investments in qualified small business stock.169 this tax benefit allows investors of qualified small business stock that is held for more than five years to exclude 50% of that gain from gross income. the remaining gain is subject to tax at a maximum rate of 28%.170 together, these provisions effectively tax the gain from qualified small business stock at a preferential tax rate of up to 14%.171 the policy rationale given for this tax preference is that “targeted relief for investors who risk their funds in new ventures, small businesses, and specialized small business investment companies will encourage investments in these enterprises. this should encourage the flow of capital to small businesses, many of which have difficulty attracting equity financing.”172 similarly, sib investments also require investors to take on substantial risk in funding new social program ventures, which creates difficulties in attracting sufficient financing. thus, based on the same rationale given for the qualified small business stock tax preference, the government can encourage the flow of capital to social projects by granting a similar tax benefit to sib investments. this change would enable sib investments to compete more fairly with both tax-exempt bonds and traditional equity financing for investors’ capital. 169 i.r.c. § 1202. 170 i.r.c. § 1(h)(4). 171 bittker & lokken, supra note 98, at ¶ 45.3 (2017). 172 h.r. rep. no. 111, 103d cong., 1st sess., at 600 (1993). 2017] social impact bonds 167 b. tax exemption a second option is to exempt from taxation any gain that the investor realizes from its sib investment.173 a similar tax exemption currently exists for the interest earned on state or local bonds.174 the federal income tax exemption for the interest earned on municipal bonds has been a part of the federal tax landscape since the enactment of the first federal income tax.175 for the reasons detailed below, this section concludes that expanding the list of activities that qualify as tax-exempt private activity bonds to include the types of social services supported by sibs is conceptually consistent with the rationale commonly given for this tax preference. in particular, the primary rationale currently given for the tax exemption of the interest on state and local bonds is that the tax exemption “encourages governments to provide the optimal amount of public services.”176 according to this economic theory, without this exemption, state and localities may be unwilling to undertake projects which benefit nonresidents who pay minimal tax in that jurisdiction.177 this tax exemption addresses this issue by lowering the cost of borrowing for state and local governments, which in turn incentivizes more investment in infrastructure and other local projects, regardless of who benefits.178 specifically, the tax exemption enables state and localities to offer a lower rate of return than corporate debt and still attract investors who seek to maximize their after-tax returns.179 as a result, by exempting interest on state and local bonds, the federal government encourages public projects, which also have the added benefit of creating jobs.180 this same line of reasoning applies in the sib context. state and local governments are generally responsible for funding various social services, but may be unwilling to address certain social problems because they are politically unpopular, risky, or expensive. 181 often, these types of programs target the poor and marginalized populations, involve high upfront costs, result in future, rather than immediate, cost savings, and may require the use of innovative, untested programs.182 as a result, state 173 even though the proceeds of certain sib arrangements may possibly qualify for tax-exempt treatment, the inherent uncertainties involved in determining whether the instrument qualifies for this tax benefit may deter qualified investors from claiming the exemption or potential investors from investing in sibs. thus, new legislation specifically including sibs as tax-exempt instruments would be more effective in treating sib investments in parity to municipal bond investments. 174 i.r.c. § 103. 175 greenberg, supra note 147, at 2; revenue act of 1913, 38 stat. 114, 167–68. 176 steven maguire & jeffrey stupak, cong. research serv., rl30638, tax-exempt bonds: a description of state and local government debt (dec. 23, 2016). 177 id. 178 id. in other words, the current justification for the tax exemption is that by subsidizing some borrowing by state and local governments, the federal government is able to incentivize these governments to invest in projects that the government would otherwise not invest in, because they benefit non-residents who pay minimal tax in that jurisdiction. 179 id.; greenberg, supra note 147. 180 see andrew ackerman, hundreds of local officials defend municipal-bond tax exemption, the wall street j. (march 1, 2016), https://www.wsj.com/articles/hundreds-of-local-officials-defendmunicipal-bond-tax-exemption-1456830002 [https://perma.cc/tg7a-vum9]. 181 see, e.g., slc faq, supra note 1; barajas et al., supra note 15, at 12, 17; gustafsson-wright, smith & gardiner, supra note 137; kohli, besharov & costa, supra note 7; liang, mansberger & spieler, supra note 19, at 273. 182 see, e.g., mckinsey & co., supra note 11; slc faq, supra note 1; barajas et al., supra note 15, at 12, 17; gustafsson-wright, smith & gardiner, supra note 137; kohli, besharov & costa, supra note 7; 168 columbia journal of tax law [vol.9:141 and local governments may underinvest in the optimal amount and type of social services. for instance, “despite evidence about the effectiveness of preventive services in areas such as health care, education, and homelessness, budget officials and appropriators infrequently direct resources toward them.”183 but by extending the tax exemption to sibs, the federal government could potentially encourage more private investment in sibs, which would increase the availability of funds to finance these types of social projects and do so in a manner that may more effectively address certain social issues. it would also encourage cross-collaboration, which is necessary for adequately addressing certain challenging social issues.184 in addition, a particular government entity may be unwilling to undertake certain sib-funded projects, because it provides benefits that extend outside of the state or local jurisdiction where the program is implemented. this situation creates a “diffuse benefit” or “wrong pocket” problem because the return on investment that a particular government pays to sib investors is calculated on the basis of budgetary savings and the benefits to society generated by a successful program, which may be partially realized outside that government’s jurisdiction. 185 for instance, the federal government may substantially benefit from sib-funded programs targeting health issues and homelessness, because successful programs will result in budgetary savings to medicaid and other federal programs, but a different government entity pays for these benefits.186 to address this issue, as one commentator has accurately noted, payments should ideally be funded by a combination of agencies that benefit from the outcome being achieved because benefits will accrue across multiple agencies and possibly across different levels of government.187 by having the federal government offer tax relief to encourage investors to invest in sibs, this measure may help mitigate the diffuse benefit problem with respect to the federal government and encourage state and local governments to fund these types of social services even if they are not the sole beneficiaries. moreover, extending this type of tax benefit to sib investments may be necessary to treat comparable investments equally and thereby improve the equity and efficiency of our tax system. as discussed above, a sib investment shares many features in common with a state or local bond investment. because the federal government already offers tax relief to comparable investments, a failure to offer similar tax benefits to sib investments may distort investment decisions away from sibs and disproportionately favor tax-exempt municipal bonds. for these forgoing reasons, this article argues that exempting the return on sib investments from federal income taxation is another acceptable way to grant sib liang, mansberger & spieler, supra note 19, at 273; ashley pettus, social impact bonds, harv. mag. (july/aug. 2013), http://harvardmagazine.com/2013/07/social-impact-bonds [https://perma.cc/z253-7jat]; gov’t performance lab., supra note 22. 183 kohli, besharov & costa, supra note 7. 184 see sindhu lakshmanan & tynesia boyea-robinson, pay for success: to invest or not to invest? assessing collaboration, living cities (nov. 8, 2016), https://www.livingcities.org/blog/1145-payfor-success-to-invest-or-not-to-invest-assessing-collaboration [https://perma.cc/6a3t-rpj4]; barbara ray, what to make of social impact bonds, nonprofit fin. fund (mar. 4 2016), http://www.payforsuccess.org/resource/what-make-social-impact-bonds [https://perma.cc/y3m2-z4bk]; gov’t performance lab., supra note 22. 185 see dagher, supra note 40, at 3502–03; kohli, besharov & costa, supra note 7; mckinsey & co., supra note 11 at 37. 186 see gov’t performance lab., supra note 22. 187 kohli, besharov & costa, supra note 7. 2017] social impact bonds 169 investments a tax-favored status. even though the federal income tax exemption for municipal bonds is controversial, extending this benefit to sibs is a potential policy solution to address the shortcoming of the current law, because this tax benefit currently exists for other investments and is conceptually consistent with the rationale commonly given for this tax preference.188 moreover, the sib structure minimizes some, but not all, of the negative implications of the current tax exemption granted to municipal bonds. for instance, one drawback of the current tax exemption for the interest on municipal bonds is that it may contribute to more socially wasteful investments. specifically, opponents of the municipal bond tax exemption argue that this tax exemption creates economic inefficiencies by incentivizing the overinvestment in infrastructure.189 because the tax exemption effectively lowers the cost of capital required for qualified projects, the exclusion of municipal bond interest may finance unnecessary state and local spending projects. 190 similarly, extending the municipal bond tax exemption to sib investments may also encourage governments to issue sibs for unnecessary or ineffective social projects. the difference is that in the sib context, the private market is likely to play a role in partially mitigating this risk. because an ineffective social program will result in a sib investor losing her entire capital investment, investors are unlikely to invest in unnecessary and ineffective social programs. therefore, this criticism of the tax exemption is not as strong in the sib context. another common criticism of the tax exemption for municipal bond interest is that “[tax exemption] imposes greater costs on federal taxpayers than the benefits it confers upon state and local governments.” 191 empirical evidence indicates that approximately only 80% of the federal cost of the tax exemption benefits the intended beneficiaries and thereby subsidizes state and local investment in capital projects.192 this inefficiency often arises because state and local governments have to issue municipal bonds with higher interest rates in order to economically appeal to an investor who is not in the highest marginal income tax bracket.193 as a result, instead of state and local 188 opponents of the tax exemption argue that it results in abuse and fraud, creates inequities by favoring high-income taxpayers, creates economic inefficiencies by incentivizing the overinvestment in infrastructure, represents an inefficient subsidy to state and local governments because the middleman often benefits more than the intended beneficiary, and produces a substantial cost to the federal government, among other arguments. see greenberg, supra note 147; calvin h. johnson, repeal tax exemption for municipal bonds, tax notes 1259 (dec. 24, 2007); maguire & stupak, supra note 176. as a result, there have been numerous requests to modify or repeal the tax benefit. these proposals have included recommendations to replace the tax exemption with a federal grant made directly to the state or local government, cap the tax exemption for interest earned on these types of tax-favored bonds, or, alternatively, simply repeal the tax preference. see the white house, the nat’l comm’n on fiscal responsibility and reform, the moment of truth, 2010, available at http://momentoftruthproject.org/sites/default/files/themomentoftruth12_1_2010.pdf [https://perma.cc/6nkb-zuav] maguire & stupak, supra note 176; johnson, repeal tax exemption for municipal bonds, supra note 188, at 1262. a detailed consideration of whether and how the tax exemption for municipal bonds should be reformed is beyond the scope of this article. 189 see greenberg, supra note 147; maguire & stupak, supra note 176. 190 greenberg, supra note 147, at 1261; johnson, repeal tax exemption for municipal bonds, supra note 188. 191 peter fortune, the municipal bond market, part ii: problems and policies, 1992 new england econ. rev. 47, 48 (may/june 1992). 192 greenberg, supra note 147, at 1260–61; johnson, repeal tax exemption for municipal bonds, supra note 188. 193 fortune, supra note 191; greenberg, supra note 147. 170 columbia journal of tax law [vol.9:141 governments capturing the benefits of the tax exemption in the form of lower borrowing costs, the extra savings goes to taxpayers in high-income households.194 furthermore, even to attract wealthy taxpayers, municipal bonds often have to bear premium interest rates because of inadequate market information, the illiquid nature of many municipal and the numerous alternative types of tax-advantaged investment options available to investors.195 although some of these issues may arise if a tax exemption is extended to the interest earned on sib investments, the concern that a tax exemption is likely to primarily benefit high income investors is not as detrimental in the sib context. in particular, one of the potential benefits of the sib structure is that the involvement of investors who have business knowledge and experience could be a valuable asset in improving the delivery of social services.196 if this is true, then the additional cost to attract these investors may be worthwhile. moreover, it may not be necessary for a sib to bear a premium interest rate to attract these investors, since most private sib investors are willing to accept a lower financial return, given that they already have wealth and that they are also receiving a non-financial return in the form of social benefits.197 c. upfront deduction a third option is to allow sib investors to deduct up to a certain amount of their sib investment on their federal income tax return at the time of the investment and defer the recognition of any income until the time that it is realized. this type of tax preference currently exists for federal income tax purposes for certain investments. for instance, as discussed above, federal income tax law provides a deduction for qualified charitable contributions.198 one of the main policy rationales for the existence of this tax benefit is to help fund qualified charitable organizations. as the report of the house committee on ways and means on the revenue act of 1938 states: “the exemption from taxation of money or property devoted to charitable and other purposes is based upon the theory that the government is compensated for the loss of revenue by its relief from financial burden which would otherwise have to be met by appropriations from public funds, and by the benefits resulting from the promotion of the general welfare.” 199 investing in a sib is consistent with this policy rationale. although an investment in a sib does not qualify for the charitable contribution deduction because there exists both a potential return of the contributed funds and a return on investment, a 194 fortune, supra note 191; greenberg, supra note 147, at 1261. 195 see johnson, repeal tax exemption for municipal bonds, supra note 188; greenberg, supra note 147, at 1261. 196 see supra notes 53–58 and accompanying text. 197 if the sib structure does not adequately overcome these drawbacks, then an alternative to a tax exemption may be to offer tax benefits similar to those given to build america bonds. build america bonds are taxable bonds that provide either (i) a direct federal payment subsidy for a portion of the state or local government’s borrowing costs or (ii) a tax credit for the bondholder. u.s. dep’t of the treasury, treasury analysis of build america bonds issuance and savings (may 16, 2011), https://www.treasury.gov/initiatives/recovery/documents/babs%20report.pdf [https://perma.cc/gm3kjhkh]. although the build for america bonds program has expired, this program was overall considered a success. the empirical evidence suggests that these bonds attracted additional bond investors as compared to traditional municipal bond investors, resulted in state and local governments benefitting from significant savings in borrowing costs and improved the efficiency of the delivery of the federal benefit. id. 198 i.r.c. § 170. 199 h.r. rep. no. 75-1860, at 19 (1938), as reprinted in 1939-1 cb (pt. 2) 728, 742. 2017] social impact bonds 171 sib is used more like a charitable vehicle than an investment vehicle. in particular, sib investments promote the general welfare and minimize the government’s financial burden by funding social services that generally would otherwise be funded by state and local governments. moreover, given the below-market rate of return that many sibs offer, sibs currently primarily attract philanthropically-motivated, rather than profit-seeking, investors. federal income tax law also provides an upfront federal income tax deduction to taxpayers that make qualified retirement contributions to a traditional individual retirement account (“ira”).200 pursuant to the terms of this tax preference, the amount of the contribution that is eligible for the tax deduction is subject to a contribution ceiling of $5,000, adjusted for inflation.201 any distributions of principal or investment earnings are taxed at ordinary income tax rates unless rolled over into a different ira or eligible retirement plan for the benefit of such individual within 60 days of the distribution.202 the rationale for this tax preference is to encourage individuals to save for retirement.203 similarly, offering this type of tax benefit to sib investments may also encourage taxpayers to save, but by investing in programs that potentially also produce a social good. thus, another viable tax policy option is treating sib investments similarly to qualified retirement contributions. pursuant to this type of provision, sib investors would be permitted to deduct a portion of their sib investment upfront at the time of the investment and treat the receipt of any payments from the sib investment as ordinary income subject to tax at the time of receipt. as a result, if the investment is ultimately unsuccessful, the investors are able to write off their losses as a tax deduction at the time of the investment, rather than waiting to take a deduction at the end of the project term. this upfront deduction would help mitigate some of the risk that investors bear when they invest in these speculative financial instruments that currently offer a below-market rate of return. in addition, as with qualified retirement contributions, this type of provision could also allow sib investors to defer recognition of their gains if they rollover their funds to another sib investment within a certain period of time. as one commentator has observed, “with traditional philanthropy, you pay for the program and then your money is gone; this way the money comes back and can be recycled into the system to help more people.”204 thus, extending this tax benefit to sibs would likely encourage reinvestment in sibs and provide non-profit organizations with a more stable stream of income. d. the u.k. approach another possible approach to incentivize private investors to invest in sibs is to enact legislation similar to that of the united kingdom’s social investment tax relief 200 i.r.c. § 219. similarly, an employer’s contribution to a qualified retirement plan offers the same deferral benefits. see i.r.c. § 408(c). 201 the 2016 contribution limitation for a traditional ira is $5,500 per person and is increased to $6,500, if age 50 or older. 202 i.r.c. § 408(d). this ability to rollover contributions tax free is subject to limitations, including the requirement that this benefit may only be exercised once in a one-year period. id. 203 staff of j. comm. on tax’n, 104th cong., general explanation of tax legislation enacted in the 104th congress 145 (2nd sess. 1996). 204 pettus, supra note 25, at 3. 172 columbia journal of tax law [vol.9:141 act (“the sitr”), the first of its kind in the world.205 the goal of this legislation is “to support social enterprises seeking external finance by providing incentives to private individuals who invest in them.”206 the sitr provides up to three possible types of tax relief to qualifying individuals who invest in a qualified social enterprise.207 first, it allows investors to reduce their income tax liability by an amount equal to 30% of their investment.208 second, any gain the investor realizes when it disposes of its investment in the social enterprise is exempt from capital gains tax.209 finally, an investor may defer its tax on a capital gain that it realizes from the disposal of any kind of asset if the gain is reinvested in a qualified social investment.210 under this legislation, an investment in a sib-financed program qualifies as a social enterprise eligible for tax relief if the investment is made through an accredited special purpose vehicle entity that is established solely for the purpose of entering into and carrying out a social impact contract.211 to qualify as an accredited special purpose vehicle, the entity must hold a social impact contract that satisfies the following conditions: (i) includes a government agency as a stakeholder; (ii) defines pre-determined outcomes intended to be achieved that are capable of being objectively measured; (iii) sets forth the method of measurement of these outcomes; (iv) requires periodic progress assessment; (v) makes at least 60% of the potential payments conditional on achieving the defined outcomes; and (vi) has a social or environmental purpose.212 a qualifying investment in this entity may take the form of either an equity investment or a debt investment, provided that the investment meets certain requirements, 205 social inv. scotland et al., social investment tax relief: a brief guide, http://www.socialinvestmentscotland.com/files/9413/9697/0411/sitr_guide.pdf [https://perma.cc/c873av6d] [hereinafter social investment tax relief]. 206see guidance: social investment tax relief, h.m. treasury, https://www.gov.uk/government/publications/social-investment-tax-relief-factsheet/social-investment-taxrelief (last updated nov. 23, 2016) [https://perma.cc/e5q2-8tzy]. 207 see social investment tax relief, supra note 205. 208 id. this is subject to a maximum deduction of about £250,000. id. the reason for this limitation is because these types of investments are subject to the restrictions of the european commission relating to the giving of state aid. id. however, the government has indicated that it intends to seek permission from the european commission to offer greater tax relief in the future. id. 209 id. to qualify for this tax exemption, the investment must have qualified for and received the income tax relief under sitr at the time the investment was made. id. 210 id. 211 see id.; cabinet office, social investment tax relief: guidance concerning accreditation of social impact contractors (jan. 2016), https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/492974/sitraccreditationgui danceversion2forpunlicationjan16v2.pdf [https://perma.cc/te3a-v557]. the special purpose vehicle must be organized as a company limited by shares. id. a qualified social enterprise includes more than solely investments in sib arrangements. it is defined as (i) a community interest company, (ii) a community benefit society that is not a charity, (iii) a charity, or (iv) any other entity prescribed by the treasury. social investment tax relief, supra note 205. these are entities that are currently regulated in some way. id. 212 cabinet office, supra note 211. a social or environmental purpose means: “the relief of those in need by reason of youth, age, ill-health, disability, financial hardship or other disadvantage. the relief of prevention of poverty, the promotion of employment, culture, heritage or sport, the advancement of training and education, the prevention of crime, environmental protection, social housing and the relief of homelessness, the provision of community facilities, the promotion of social inclusion and cohesion, the advancement of citizenship or community development, the improvement of physical and mental health, the provision of long-term care in relation to any infirmity, or any other areas that may reasonably be regarded as analogous to, or within the spirit of, any of the areas listed above.” id. 2017] social impact bonds 173 and must be held for at least three years.213 for instance, one requirement is that any dividend rights must be at a rate that depends on the enterprise’s financial success and which does not exceed a reasonable commercial rate.214 similarly, if the investment is structured as a loan, the rate of any interest payable must not be more than a reasonable commercial rate and the principal and any interest must not be secured by any assets and must be subordinate to other debts of the social enterprise.215 to be eligible for this tax relief, sitr also imposes additional conditions to ensure that the investor’s capital is genuinely put at risk and to ensure that the investor is not related to or in control of the entity.216 although the goals of sitr are commendable, this article argues for a more modest tax incentive that is consistent with how comparable investments are currently treated for u.s. federal income tax purposes. accordingly, this article argues for a preferential tax rate on investment returns, a tax exemption, or an upfront federal income tax deduction for the sib investment, but recommends that congress consider several aspects of the u.k. legislation when drafting legislation in support of a tax-favored status for sib investments. first, the u.k. legislation is useful for studying its effects on private investments in sibs and other social enterprises since it has already been enacted. second, the u.k. legislation provides several structural elements and requirements that are necessary to properly regulate investments in social enterprises and which congress should include when modifying the law to grant sib investments a tax-favored status. for instance, to address concerns of abuse, fraud and collusion with respect to sibs, this article recommends that congress adopt the united kingdom’s requirement that sib investments need to be made through an accredited special purpose entity established for this purpose. in addition, as required by the sitr, any legislation extending tax benefits to sibs should require that the sib investment be held for a minimum period of time as a condition for the investor to qualify for the tax relief. this condition is necessary because non-profit service providers need the benefit of capital funding for an extended period of time to effectively implement social service projects. moreover, because the purpose of this tax relief is to incentivize investors to invest in sibs, which are speculative and offer a below-market rate of return, as opposed to more lucrative investments, the tax relief should not be available to sibs that offer an 213 social investment tax relief, supra note 205. an investor can qualify for tax relief under sitr if it has invested in either: (i) shares issued by the social enterprise in exchange for full payment in cash or (ii) qualifying debt that has been wholly drawn down. id. 214 id. any dividend rights may not be of a fixed amount or at a fixed rate. id. 215 id. in addition, in the event the enterprise winds up, the amount due to the shareholders is subordinate to any debts of the enterprise and does not have a preference in relation to any other shares of the enterprise. id. similarly, the debt investment cannot have a preference in relation to any shares of the enterprise. id. 216 see id. in particular, the investment will not qualify for tax relief if there is: (i) a pre-arranged opportunity for the investor to exit the investment during the three-year period beginning at the date the investment is made; (ii) a linked loan is made to the investor (a linked loan is defined as any loan which would not have been made on the same terms if the investor had not made the investment); or (iii) a principal tax avoidance purpose for entering into the arrangement. see id.; cabinet office, supra note 211. in addition, the investor is prohibited from being: (i) a partner or trustee of the social enterprise or its subsidiary; (ii) a paid director or employee of the social enterprise, its subsidiary, partner, or partner of a subsidiary of the social enterprise; or (iii) own more than 30% of the social enterprise’s ordinary share capital, loan capital or voting rights during the period one year before the investment to the third anniversary of the investment. social investment tax relief, supra note 205. 174 columbia journal of tax law [vol.9:141 above-market rate of return or to the extent that the investor’s funds are not truly at risk. in particular, as discussed above, the sitr has a provision that requires that the return on investment may not exceed a reasonable commercial rate. a similar provision should also be adopted for purposes of u.s. sib investments. similarly, as with the sitr, if an investor’s funds are secured by assets or otherwise, the tax relief will also not be available. for instance, some sibs currently provide a guarantee that ensure that a portion of the investor’s funds will be repaid regardless of the project’s success. the risk on this type of investment is already mitigated and therefore, should not benefit from the tax relief described above. finally, regulations should be put in place to minimize collusion between the multiple stakeholders, ensure that the project’s outcomes are capable of objective measurement, and to guarantee the independence of the different parties. some of these conditions are already included in the sitr, which currently imposes specific requirements to ensure that the investor is not related to or in control of the intermediary or non-profit entity. in summary, modifying the tax law to extend tax benefits, such as preferential tax rates, tax exemption, or an upfront tax deduction, to sib investments is conceptually consistent with the availability of these tax preferences in other contexts and are possible ways to grant sibs tax-favored status. for all the reasons detailed above, this article concludes that congress should consider modifying the tax law to (i) subject the returns on a sib investment to preferential tax rates similar to that of capital gains or qualified small business stock, (ii) exempt the interest earned on a sib investment from federal income taxation, or (iii) provide an upfront federal income tax deduction for a certain amount of the private capital invested in a sib with any returns on investment subject to ordinary income tax rates. in addition, to further encourage capital to remain in a sib investment, this article also recommends that congress allow the tax-free rollover of funds from one qualified sib investment to another. together these changes, along with legislation to properly regulate these novel instruments, should help prevent the current tax law from discouraging private investors from contributing capital to fund sibfinanced projects aimed at addressing some our most pressing social problems. vi. conclusion the current tax system significantly limits the ability of a sib-funded program to attract sufficient private capital to establish a viable market in the united states. this is in large part due to the compliance risks that a sib investment creates, as well as the unfavorable tax treatment of a sib investment relative to comparable investments. given the nearly $210 trillion of unrealized potential that the private markets hold, having access to this type of private capital can be a powerful tool for helping governments test whether sibs can truly revolutionize the way we provide social services in the united states.217 in particular, if sibs work as intended, they have the potential to improve the efficiency and effectiveness of social programs, thereby providing tremendous social benefit to high-need populations. thus, this article argues that legislation is warranted to provide certainty as to the correct tax treatment to private investors who participate in sibs and to treat sib investments more equally with current tax-favored investments that share similar features and policy goals. by adopting the 217 see judith rodin, innovations in finance for social impact, the rockefeller found. (sept. 5, 2014), https://www.rockefellerfoundation.org/blog/innovations-in-finance-for-social-impact/ [https://perma.cc/pe3b-jz45]. 2017] social impact bonds 175 changes proposed in this article to make sibs a more tax-favored investment, the federal government can ensure that the current law does not unnecessarily discourage the growth of this promising financial vehicle and minimize the inequities and inefficiencies that the current law creates. with this additional private capital, the development of sibs can move forward on a larger scale and create an opportunity for social policy to evolve in a meaningful way. vii. appendix a traditional social impact bond structure218 218 diagram adapted from what is pay for success?, nonprofit fin. fund, http://www.payforsuccess.org/learn/basics/#what-is-pay-for-success [https://perma.cc/kx4u-rmme]. investor s social service providers target population intermed iary govern ment indepen dent evaluator/ validato r (2) structure, coordinate, & fund (7) repay principal & return (4) achieve outcomes (6) pay for successful programs (1) invest capital (3) deliver services (5) measure & validate formatted-lederman irs reform: politics as usual? leandra lederman* abstract the irs is still reeling from accusations that it “targeted” tea party and other non-profit organizations. although multiple government investigations found no politically motivated behavior—only mismanagement—congressional hearings were quite inflammatory. congress recently followed up those hearings with a set of irs reforms. congress’s approach is reminiscent of the late 1990s, when highly publicized congressional hearings regarding alleged abuses by the irs resulted in a major irs reform and restructuring, although the allegations subsequently were largely debunked. this article argues that the recent allegations against the irs also were overblown. it looks to the aftermath of the 1998 irs reform, which included a major downturn in enforcement, for lessons for the present day. the article concludes that congress as a whole can do a better job of keeping politics from undermining tax administration. * william w. oliver professor of tax law, indiana university maurer school of law, bloomington. the author would like to thank danshera cords, michael doran, daniel hemel, sarah lawsky, darien shanske, david walker, and george yin for valuable comments on prior drafts. for helpful discussions, the author thanks lisa bernstein, jennifer bird-pollan, bill black, june carbone, emily cauble, allison christians, nick cole, lee fennell, charlotte garden, lily kahng, jody madeira, omri marian, ruth mason, stephen mazza, shuyi oei, deborah schenk, jeri seidman, ethan yale, and participants in the following events: the minnesota law school symposium; the 2015 university of virginia invitational tax conference; faculty workshops at the law schools of the university of chicago, depaul university, indiana university-indianapolis, and seattle university; the 2015 critical tax conference at northwestern law school; the 2015 midwest law & economics association meeting at kansas law school; the legal scholarship workshop at the university of chicago law school; the third annual tax symposium at the university of washington school of law; and the 2015 southeastern association of law schools meeting. a significant portion of the work on this article was done while the author was a visiting professor at the university of chicago law school. the author would like to thank both chicago and indiana law for their support. chicago law students jordan fossee and john wilson and indiana law students joseph dugan, sean hamner, brandon king, michael tenenboym, and brent tunis provided valuable research assistance. © 2016 lederman. this is an open-access publication distributed under the terms of the creative commons attribution license, https://creativecommons.org/licenses/by/4.0/, which permits the user to copy, distribute, and transmit the work provided that the original authors and source are credited. 2016] irs reform: politics as usual? 37 i. introduction ...................................................................................................... 38 ii. the 2013 irs controversy ............................................................................. 42 a. the rise of political 501(c)(4)s ........................................................................... 45 b. the exempt organizations division’s challenges .............................................. 47 c. the targeting allegations ................................................................................... 48 1. delays ............................................................................................................ 49 2. selection criteria .......................................................................................... 50 3. the political controversy ............................................................................. 52 d. the irs’s response to the controversy .............................................................. 54 iii. the 1997/1998 collections controversy ............................................... 55 a. the story behind the irs reform act of 1998 ................................................... 55 b. hearings and horror stories ................................................................................ 58 c. alleged targeting of conservative tax-exempt organizations ......................... 60 iv. irs reform in controversy ......................................................................... 61 a. the 1998 reform ................................................................................................. 62 1. changes made by the irs reform act .......................................................... 62 2. the fallout of the 1998 reform .................................................................... 64 b. the 2015 legislative reforms ............................................................................. 67 c. political reform ................................................................................................... 70 v. conclusion .......................................................................................................... 79 38 columbia journal of tax law [vol.7:36 i. introduction the internal revenue service (irs) recently experienced a major public humiliation, stemming from allegations, beginning in 2013, that it targeted tea party and other conservative non-profit organizations. the report that prompted the controversy, issued by the treasury inspector general for tax administration (tigta), found that the irs delayed approval of tea party and other conservative groups’ applications for a determination of tax-exempt status under internal revenue code (code) section 501(c)(4).1 the federal bureau of investigation (fbi)2 and department of justice (doj) conducted criminal investigations and eventually found mismanagement but no criminal activity.3 it turns out that the irs also scrutinized and delayed the applications of some progressive groups.4 yet the message many taxpayers heard was that the irs “targeted” conservative groups.5 perhaps the worst part of the controversy for tax administration was the highly publicized hearings at least four congressional committees held.6 congress’s approach to the investigation was quite partisan.7 the house committee on oversight and government 1 a may 2013 report of the treasury inspector general for tax administration (tigta) found that “[t]he irs used inappropriate criteria that identified for review tea party and other organizations applying for tax-exempt status based upon their names or policy positions instead of indications of potential political campaign intervention.” treas. inspector gen. for tax admin., inappropriate criteria were used to identify tax-exempt applications for review i (2013), http://www.treasury.gov/tigta/auditreports /2013reports/201310053fr.pdf [https://perma.cc/s7mn-xyj9] [hereinafter 2013 tigta report]. tigta’s report did not use the word “target,” but others did, including some congress members. see sandy fitzgerald, rep. issa: conservative, tea party groups still targeted for scrutiny, newsmax (july 24, 2015), http://www.newsmax.com/newsfront/darrell-issa-tea-party-irs-lois-lerner/2015/07/24/id/658797 [https:// perma.cc/lf99-4kyp]. 2 see kevin johnson & gregory korte, fbi to investigate tea party tax affair, usa today (may 14, 2013), http://www.usatoday.com/story/news/politics/2013/05/14/irs-tea-partyinvestigation/2158899 [https://perma.cc/e72q-gtbm]. 3 see devlin barrett, criminal charges not expected in irs probe, wall st. j. (jan. 13, 2014), http://www.wsj.com/articles/sb10001424052702303819704579318983271821584 [https://perma.cc/9jqr2lmb] (noting that the fbi announced that it did not plan to file charges because it found only mismanagement, not criminal behavior); letter from u.s. dep’t of just., off. of legis. affairs to the hon. bob goodlatte, chairman, comm. on the judiciary 1 (oct. 23, 2015), http://online.wsj.com/public/resources /documents/irs1023.pdf [https://perma.cc/d9cs-zh8q] [hereinafter u.s. dep’t of just., letter to the hon. bob goodlatte]. (“we found no evidence that any irs official acted based on political, discriminatory, corrupt, or other inappropriate motives that would support a criminal prosecution.”). the senate finance committee’s bipartisan investigation found numerous instances of irs mismanagement. see s. rep. no. 114-119 (2015), http://www.finance.senate.gov/imo/media/doc/crpt-114srpt119-pt1.pdf [https://perma.cc /ypv5-9bq5]. 4 see s. rep. no. 114-119, at 255 (2015); see also infra note 132 and accompanying text. 5 see stephen dinan, tea party targeting accusations, legal issues persist for irs after justice ends probe, wash. times (oct. 25, 2015), http://www.washingtontimes.com/news/2015/oct/25/irs-tea-partytargeting-accusations-legal-issues-p/?page=all [https://perma.cc/7589-x5h5] (“‘the american people deserve better than this. despite the doj closing its investigation, the ways and means committee will continue to find answers and hold the irs accountable for its actions,’ said [rep. paul] ryan . . . .”). 6 see josh hicks, five and counting: yet another irs hearing, wash. post (june 4, 2013), http:// www.washingtonpost.com/blogs/federal-eye/wp/2013/06/04/five-and-counting-yet-another-irs-hearing [https://perma.cc/9gnv-bjfa]. the committees included “the senate finance committee, the house ways and means committee, the house committee on oversight and government reform, and the house appropriations subcommittee on financial services and general government.” lily kahng, the irs tea party controversy and administrative discretion, 99 cornell l. rev. 41a, 42a n.8 (2013). 7 see tom cohen, partisan views of irs targeting: political conspiracy or overzealous scrutiny, cnn (jun. 4, 2013), http://www.cnn.com/2013/06/04/politics/irs-targeting/ [https://perma.cc/4va8-sbf5] (“like a partisan version of the proverbial blind men touching the elephant, members of congress have 2016] irs reform: politics as usual? 39 reform hearings were particularly negative in tone8 and have been dubbed “witch hunts” by some observers.9 congress followed up the hearings with legislation. the protecting americans from tax hikes (path) act of 2015, enacted in december, included a set of provisions entitled “internal revenue service reforms.”10 the consolidated appropriations act, 2016, of which path is a part,11 contained other restrictions on the irs.12 reform following scandalizing congressional hearings is all too familiar for the irs. the last major irs reform occurred in 1998, the product of the internal revenue service restructuring and reform act of 1998 (irs reform act).13 that reform followed congressional hearings that were similar in tone to the hearings that began in 2013. the 1990s hearings accused irs collections agents of abusive behavior. 14 the general accounting office (gao) 15 ultimately found many of the witnesses’ horror stories unfounded or exaggerated.16 however, that was after congress enacted sweeping changes in the irs reform act,17 including restricting collection actions in various ways and requiring a major structural reorganization that diverted significant resources from enforcement.18 starkly differing views of the scope and magnitude of the internal revenue service targeting of conservative groups seeking tax-exempt status that dominates headlines and committee hearings.”); elijah e. cummings & sander m. levin, editorial, reform the irs, but leave politics out of it, wash. post (aug. 12, 2013), http:// www.washingtonpost.com/opinions/reform-the-irs-but-leave-politics-out-of-it/2013/08/12/64c5d36c-036211e3-9259-e2aafe5a5f84_story.html [https://perma.cc/9bwb-rxlj] (editorial in the washington post by the ranking democrats on the house committee on oversight and government reform and the house ways and means committee, stating, in part, “for nearly three months, republicans have engaged in a sustained and orchestrated campaign to accuse the white house and the obama administration of using the irs to target the president’s political enemies—without any evidence to support their claims.”). 8 at one low point, “house oversight and government reform chairman darrell issa, r-calif., cut off rep. elijah e. cummings’ microphone and adjourned [the] morning’s hearing on the irs while cummings was still speaking . . . .” steven t. dennis, issa cuts off cummings at irs hearing, roll call (mar. 5, 2014), http://blogs.rollcall.com/218/issa-cuts-off-cummings [https://perma.cc/6tgk-9t4l]. 9 see kahng, supra note 6, at 43 n.13 (“circus ringmaster darrell issa’s relentless attacks on the irs and willful ignorance of any facts that might undermine his witch hunt have been truly impressive.”); rebekah metzler, democrats accuse rep. darrell issa of mccarthyism during panel vote on lerner, u.s. news (jun. 28, 2013), http://www.usnews.com/news/articles/2013/06/28/democrats-accuse-rep-darrel-issaof-mccarthyism-during-panel-vote-on-lerner [https://perma.cc/9x4g-4cpg] (“democrats said they were sick of issa’s ‘witch hunts’ and ‘mccarthy-ite’ tactics . . . .”). 10 protecting americans from tax hikes (path) act of 2015, pub. l. no. 114-113, tit. iv, subtit. a, https://www.congress.gov/114/bills/hr2029/bills-114hr2029enr.pdf [https://perma.cc/qux5-8e7t]. 11 see pub. l. no. 114-113. 12 see infra text accompanying notes 282–283. 13 internal revenue service restructuring and reform act of 1998, pub. l. no. 105-206, 112 stat. 685. 14 see senate panel hears stories of alleged irs abuses, cnn (apr. 28, 1998), http://www.cnn .com/allpolitics/1998/04/28/irs.hearings [https://perma.cc/x3x3-2rqd]. 15 in 2004, the gao was renamed the government accountability office. our name, gov’t accountability off., http://www.gao.gov/about/namechange.html [https://perma.cc/yle5-rude]. 16 u.s. gen. acct. off., gao/ggd 99-82, gao report on allegations of irs taxpayer abuse (1999). the webster commission similarly found “there was no pattern of misuse by the cid of search warrants, grand juries, informants, or undercover operators, although there were ‘one or two isolated abuses.’” joe spellman, conference panel ponders finance hearing horror stories, 83 tax notes 1854, 1855 (1999). 17 internal revenue service restructuring and reform act of 1998, pub. l. no. 105-206, 112 stat. 685. 18 see infra notes 244–247 and accompanying text. one commentator analogized the 1998 reorganization as akin to “trying to change a jet engine on a plane as it is flying over the ocean.” 40 columbia journal of tax law [vol.7:36 unlike the 1998 irs reform, the 2015 reforms occurred after a full investigation— not only by the fbi and doj, but also a follow-up investigation by tigta.19 yet, although all three investigations reached positive conclusions for the irs, congress legislated “reforms” in the areas that were the subject of hearings. the 2015 reforms were nowhere near as sweeping as the large-scale irs restructuring congress mandated in 1998, but there could be calls for such a major irs reform, particularly if current anti-irs sentiment continues.20 the 1998 irs reform took a major toll on tax enforcement activity.21 minimal enforcement does not help narrow the “tax gap”—the gap between taxes due and taxes collected.22 the tax gap for the most recent year the irs estimated it, 2006, was $450 billion before enforcement actions and $385 billion after late payments and enforced collections.23 enforcement is needed both for direct collection of taxes—such as the enforced collections portion of the $65 billion the irs collected after the due date for 2006—but also for the indirect or “shadow” effect it has on compliance.24 moreover, reduced enforcement primarily benefits those with greater opportunity to evade taxes—not those who receive income from visible sources such as employment and interest on bank accounts25—and provides greater benefits to those who have more tax liability to evade. modernization update: new irs up and running, j. acct. (feb. 29, 2000), http://www .journalofaccountancy.com/issues/2000/mar/modernizationupdatenewirsupandrunning.html [https://perma.cc /tyq6-bd26]. 19 see treas. inspector gen. for tax admin., status of actions taken to improve the processing of tax-exempt applications involving political campaign intervention (mar. 27, 2015), https://www.treasury.gov/tigta/auditreports/2015reports/201510025fr.pdf [https://perma.cc/7upw-7t7g] [hereinafter tigta, status of actions taken]. 20 see most view the cdc favorably; va’s image slips, pew res. ctr. (jan. 22, 2015), http:// www.people-press.org/2015/01/22/most-view-the-cdc-favorably-vas-image-slips [https://perma.cc/dc6bljzm] (“the irs is the lowest rated federal agency included in the survey. overall, 45% hold a favorable view of the irs, while about as many (48%) say they have an unfavorable view of the agency. attitudes toward the irs have changed little over the past several years.”). 21 see infra text accompanying note 240 (reporting several enforcement statistics for fiscal years 1994 through 2005). 22 see joel slemrod, cheating ourselves: the economics of tax evasion, 21 j. econ. perspectives 25, 25 (2007) (“no government can . . . rely on taxpayers’ sense of duty to remit what is owed. . . . over time the ranks of the dutiful will shrink, as they see how they are being taken advantage of by the others.”). 23 see internal revenue serv., tax gap “map” tax year 2006 (dec. 2011), https://www.irs .gov/pub/irs-soi/06rastg12map.pdf [https://perma.cc/3hwd-quww]. 24 the treasury estimates a 6:1 return on investment in irs enforcement. dep’t of the treasury, departmental offices 1035, https://timedotcom.files.wordpress.com/2015/04/tre.pdf [https://perma.cc /k64g-b78u]. an econometric study by an irs employee estimated the indirect effect of a dollar spent on enforcement at over eleven times the direct effect. see alan h. plumley, the impact of the irs on voluntary tax compliance: preliminary empirical results ¶ 19 (nov. 14, 2002), lexis, 2002 tnt 224-22 (irs paper presented at the national tax association 95th annual conference on taxation) (“the average indirect effect of . . . audits started in 1991 was about 11.7 times as large as the average adjustment directly proposed by audits closed that year.”). cf. jeffrey a. dubin et al., the effect of audit rate on the federal individual income tax, 1977–1986, 43 nat’l tax j. 395, 405 (1990) (finding that that the indirect effect of audits is responsible for six out of every seven dollars of tax revenue). 25 see internal revenue serv., tax year 2001 individual income tax underreporting gap (2007), https://www.irs.gov/pub/irs-utl/tax_gap_update_070212.pdf [https://perma.cc/c33h-vu9s] (estimating 98.8% reporting of amounts subject to substantial information reporting and withholding—wages and salaries—and 95.5% reporting of amounts subject to substantial information reporting, such as interest and dividend income, compared to 46.1% estimated reporting of amounts subject to little or no information reporting, such as self-employment income). the reason for these stark differences in underreporting levels 2016] irs reform: politics as usual? 41 that is, in general, reduced tax enforcement likely is regressive.26 accordingly, we should proceed with caution before tying the hands of the irs. government agencies, such as the irs, certainly need supervision and to be held accountable for their actions.27 however, agencies can receive “too much supervision or supervision of the wrong kind,”28 which can actually be destructive.29 excessive oversight, like excessive disclosure, is not costless.30 congressional investigations into the irs are enormously costly—not just in terms of taxpayer money,31 but also in terms of both personnel time 32 at an already overextended agency 33 and irs employee morale. 34 likely is the opportunity to evade taxes on amounts not reported to the irs. leandra lederman, statutory speed bumps: the roles third parties play in tax compliance, 60 stan. l. rev. 695, 697–98 (2007). 26 see leandra lederman, the irs, politics, and income inequality, 150 tax notes 1329, 1332 (2016). 27 see gillian e. metzger, the constitutional duty to supervise, 124 yale l.j. 1836, 1840 (2015) (“the central importance of supervision should not come as a surprise.”). the irs receives constant supervision from numerous oversight bodies. see infra note 228 and accompanying text. 28 metzger, supra note 27, at 1839. 29 see id. (providing examples of “managerial and supervisory failure” and stating that “[m]ost commonly, the problem is too little supervision, but sometimes the concern is too much supervision or supervision of the wrong kind.”). 30 see omri ben-shahar & carl e. schneider, more than you wanted to know 169 (2014) (“mandated disclosure is not harmless if its costs outweigh its benefits.”); see also joshua d. blank, overcoming overdisclosure: toward tax shelter detection, 56 ucla l. rev. 1629, 1632 (2009) (“the overdisclosure response poses serious threats to tax administration. . . . [the] distraction [of disclosure of non-abusive transactions] slows the irs’s investigations of truly abusive transactions, delaying statutory responses to tax avoidance strategies.”). 31 see written testimony of irs commissioner john a. koskinen before the house oversight and government reform committee on irs operations, internal revenue serv. (mar. 26, 2014), https://www .irs.gov/uac/newsroom/written-testimony-of-commissioner-koskinen-before-the-house-oversight-andgovernment-reform-committee-on-irs-operations [https://perma.cc/rrj7-7k8t] [hereinafter koskinen march 2014 testimony] (stating that the personnel costs of complying with committee requests over the preceding eight months amounted to nearly $8 million, in addition to a comparable amount spent on supporting information-technology infrastructure); press release, new irs inspector general report finds no evidence that lerner intentionally crashed computer or concealed emails from investigators, comm. on oversight and gov’t reform (july 2, 2015), http://democrats.oversight.house.gov/news/press-releases /new-irs-inspector-general-report-finds-no-evidence-that-lerner-intentionally [https://perma.cc/4apv-v5ad] (quoting rep. elijah e. cummings as stating, “after spending more than $20 million and three years investigating, the inspector general’s conclusions remain the same: there is no evidence to substantiate republican claims of political motivation, white house involvement, or intentional destruction of evidence.”). 32 irs commissioner john koskinen testified in 2014 that “[o]ver the last 8 months, the irs has devoted significant resources to this committee's investigation and requests for information, as well as those of other congressional committees. more than 250 irs employees have spent nearly 100,000 hours working directly on complying with the investigations . . . .” koskinen march 2014 testimony, supra note 31. 33 in recent years, congress has required the irs to do more (such as administer the aca) with less. see infra note 301 and accompanying text. 34 see george guttman, news analysis—evaluating the irs: the senate finance hearings in retrospect, 77 tax notes 13, 13 (1997) (describing the three days of hearings by the senate finance committee as “both unusual and traumatic” and “deeply embarrassing to the irs”); pete kasperowicz, the next big problem at the irs: low worker morale, the blaze (july 23, 2013), http://www.theblaze.com /stories/2014/07/23/the-next-big-problem-at-the-irs-low-worker-morale [https://perma.cc/9wdk-u6x5] (noting that irs commissioner john koskinen testified that “ongoing investigations by congress into the irs targeting scandal are having the effect of lowering morale at the tax-collection agency.”). 42 columbia journal of tax law [vol.7:36 excessive oversight can make irs managers and other employees reluctant to take risks35 and lower-level employees reluctant to report problems to managers.36 the tone of congressional investigations may also affect the public’s perception of the fairness of the federal tax system.37 the federal income tax system relies in part on taxpayer self-reports, and citizens may be more likely to comply with legal authorities they view as legitimate.38 accordingly, this article turns the spotlight to congress’s treatment of the irs, comparing the recent irs hearings with the ones congress conducted leading up to the 1998 irs reform. part ii of the article analyzes the 501(c)(4) controversy that is a principal factor in the irs’s current relationship with congress. this part examines the facts behind the headlines and argues that the controversy was much more banal than it often was portrayed in the media and by some in congress. next, part iii turns to the 1998 irs reform. it explains that that the controversy that led to that reform similarly was not the scandal portrayed by congress and the media. part iv considers each of these two irs reforms as controversy-driven reforms. it first looks at the 1998 irs reform and examines the negative effects that reform had on irs collection activity. it then turns to the irs reforms congress enacted in 2015, briefly addressing how they relate to the 2013 irs controversy. finally, this part looks at the costs of politicizing the irs and argues that congress’s approach to the irs needs reform. ii. the 2013 irs controversy the most recent irs controversy focused primarily39 on whether the irs delayed granting determination letters to tea party and other conservative organizations requesting 35 barry bozeman reported that commissioner charles rossotti told him in an interview that because of oversight of the irs, “[w]e live in a fishbowl. it is difficult to make even a small mistake because it instantly gets magnified.” barry bozeman, ibm ctr. for the bus. of gov’t, government management of information mega-technology: lessons from the internal revenue service’s tax systems modernization 24 (mar. 2002), http://www.businessofgovernment.org/sites/default/files /bozemanreport.pdf [https://perma.cc/39n8-svmm] (explaining that much of the funding went into software and hardware the irs was still using in 2002, and some of the funds went into renovating buildings) [hereinafter bozeman, information mega-technology]. bozeman also notes that an employee blamed congress’s oversight of the agency for part of the employees’ fear of taking risks. barry bozeman, risk, reform and organizational culture: the case of irs tax systems modernization, 6 int’l pub. mgmt. j. 117, 131 (2003) [hereinafter bozeman, organizational culture]. 36 see bozeman, organizational culture, supra note 35, at 129; see also id. at 133 ([e]mployees “‘think they will get shot if they say their project has a problem . . . .’”) (quoting an anonymous irs employee). 37 see leandra lederman, tax compliance and the reformed irs, 51 kan. l. rev. 971, 1010 (2003). 38 tom r. tyler & john m. darley, building a law-abiding society: taking public views about morality and the legitimacy of legal authorities into account when formulating substantive law, 28 hofstra l. rev. 707, 722–24 (2000). even if negative taxpayer views of the irs do not reduce tax compliance, restrictions on the irs’s ability to enforce the laws—whether through budget cuts or otherwise—likely will have that effect. see leonard e. burman & joel slemrod, the irs scandal and tax compliance, oupblog (may 30, 2013), http://blog.oup.com/2013/05/irs-scandal-tax-compliance-nonprofit [https://perma.cc/7l2v-3wca]. 39 in the same month that it released its report on the 501(c)(4) issue, tigta found that the irs had spent too much money on conferences and on training videos that included a gilligan’s island parody, a star trek parody, and irs employees learning the “cupid shuffle.” treas. inspector gen. for tax admin., review of the august 2010 small business/self-employed division’s conference in anaheim, california (2013) [hereinafter tigta, review of sb/se conference], http://oversight.house .gov/wp-content/uploads/2013/06/201310037fr.pdf [https://perma.cc/vm79-tppa]; see also paul caron, the complete irs video collection, taxprof blog (june 10, 2013), http://taxprof.typepad.com/taxprof_blog 2016] irs reform: politics as usual? 43 a determination of tax-exempt status under code section 501(c)(4). the controversy erupted in seemingly the least likely of venues: a meeting of the tax section of the american bar association. lois lerner, then-director of the irs’s exempt organizations division, apparently acting at the direction of then-acting irs commissioner steven miller,40 planted a question that she answered after prepared remarks at the tax section’s exempt organizations committee meeting on may 10, 2013.41 irs leadership had seen tigta’s draft report on its investigation of alleged targeting of certain non-profit organizations and apparently wanted to get out ahead of it.42 of course, this approach quickly backfired.43 tigta issued its report four days later.44 the fallout was fast and furious. the same day, president obama directed the secretary of treasury to request the resignation of steven miller; miller complied the next day.45 lois lerner refused to resign and was put on paid administrative leave for several months, but announced her retirement in /2013/06/the-complete.html [https://perma.cc/sr9c-7nmj] (also linking a mad men-themed training video). this issue did not get nearly the same amount of attention as the 501(c)(4) issue. gutfield: small government is back, fox news (june 6, 2013), http://www.foxnews.com/transcript/2013/06/06/gutfeldsmall-government-back [https://perma.cc/k4wg-6alu] (“irs targeting groups. it’s a much bigger issue than some silly video.”). however, in recent appropriations bills, congress restricted the irs use of funds for videos. see infra notes 282–283 and accompanying text. 40 see staff of s. permanent subcomm. on investig., comm. on homeland security & gov’t affairs, irs & tigta management failures related to 501(c)(4) applicants engaged in campaign activity 6 (sept. 5, 2014), http://taxprof.typepad.com/.m/files/senate-democrats.pdf [https://perma.cc/7jlcjajg] [hereinafter u.s. senate, irs & tigta management failures] (stating that “[a]t the acting commissioner’s direction and in response to a planted question, ms. lerner apologized for the irs’ having used ‘tea party’ to identify 501(c)(4) applications subject to heightened review.”). the irs apparently had considered having lerner make a statement at a conference at georgetown law center in april 2013. darrell issa, chairman, lois lerner’s involvement in the irs targeting of tax-exempt organizations app. 4 at 43–44 (mar. 11, 2014), http://oversight.house.gov/wp-content/uploads/2014/03/lerner-report1.pdf [https://perma.cc/zs79-uxrr] [hereinafter darrell issa, chairman, lois lerner’s involvement]. 41 abby phillip, irs planted question about tax exempt groups, abc news (may 17, 2013), http://abcnews.go.com/blogs/politics/2013/05/irs-planted-question-about-tax-exempt-groups [https://perma.cc /2z5l-2zfh] (“celia roady, a prominent washington lawyer in private practice . . . said that she received a call from lerner the day before the may 10 conference, requesting that roady ask a question about tax exempt groups.”). 42 see u.s. senate, irs & tigta management failures, supra note 40 (“as the release date for the tigta audit report neared, acting irs commissioner steven miller decided to try to preempt news coverage of the negative audit results by having the head of the exempt organizations division, lois lerner, disclose the audit before it was released and apologize for the agency’s conduct during a conference she was scheduled to address.”). 43 see jonathan weisman & jeremy w. peters, republicans expand i.r.s. inquiry, with eye on white house, n.y. times (may 17, 2013), http://www.nytimes.com/2013/05/18/us/politics/irs-scandalcongressional-hearings.html?_r=0 [https://perma.cc/5ehh-qu4p] (noting that the “revelation [of a planted question to lois lerner] only underscored the ham-handed way the scandal has burst into view.”). the senate report states that ms. lerner’s “apology triggered a public firestorm.” u.s. senate, irs & tigta management failures, supra note 40, at 6. 44 see 2013 tigta report, supra note 1 (dated may 14, 2013). 45 bruce r. hopkins, “hot stuff” for exempt organizations geeks, cv018 ali-aba 1 (nov. 2013), http://files.ali-cle.org/thumbs/datastorage/skoobesruoc/pdf/cv018_chapter_01_thumb.pdf [https:// perma.cc/85wq-6r2y]. the previous commissioner of the irs, douglas shulman, had stepped down at the end of his term after testifying before the house that the irs had not engaged in targeting. see robert w. wood, despite lois lerner pass, judge orders irs to release key target list administration blocked, forbes (apr. 6, 2015), http://www.forbes.com/sites/robertwood/2015/04/06/despite-lois-lerner-pass-judgeorders-irs-to-release-key-target-list-administration-blocked. 44 columbia journal of tax law [vol.7:36 september of that year. 46 “joseph grant, the commissioner of the tax-exempt and government entities (te/ge) division, announced his retirement eight days after being promoted;”47 and holly paz, director of rulings and agreements in the te/ge division, was put on administrative leave48 and then removed from that position.49 at least four congressional committees conducted investigations and hearings,50 and the fbi and doj began criminal investigations. 51 tigta conducted a criminal investigation into lois lerner emails that the irs said were lost.52 “politicians were quick to denounce the irs. house speaker john boehner (r-ohio), for one, didn’t bother with niceties. ‘who is going to jail over this scandal?’ he asked.”53 the house ways and means committee opened a website entitled “the irs political discrimination investigation” to collect tax-exempt organizations’ stories.54 rep. darrell issa (r-ca), then-chair of the house oversight and government reform committee, seemed to view lois lerner as a villain of the piece,55 and he introduced a resolution56 under which the house voted to hold her in contempt of congress after she made a short statement proclaiming her innocence57 before invoking the fifth amendment.58 46 michael wyland, lois lerner “retires” from irs as scandal investigations continue, nonprofit q. (sept. 24, 2013), https://nonprofitquarterly.org/policysocial-context/22954-lois-lerner-retiresfrom-irs-as-scandal-investigations-continue.html [https://perma.cc/e6qu-yhus]. 47 richard rubin & roxana tiron, irs chief says 2010 meeting under review was unfortunate, bloomberg bus. (june 1, 2013). 48 u.s. senate, irs & tigta management failures, supra note 40, at 12. 49 associated press, irs supervisor scrutinized tea party cases, fox news (june 17, 2013), https://www.questia.com/newspaper/1p2-36649244/irs-supervisor-scrutinized-tea-party-cases [https://perma .cc/65dj-jvau] (stating that paz, “who until recently was a top deputy in the division that handles applications for tax-exempt status,” has been “replaced”). the people moved into these four positions had “acting” status and were replaced in december 2013. see u.s. senate, irs & tigta management failures, supra note 40, at 11–13 (separately discussing who was put in each of these positions). 50 see supra note 6 and accompanying text. 51 see supra text accompanying notes 2–3. 52 stephen dinan, irs watchdog reveals lois lerner missing emails now subject of criminal probe, wash. times (feb. 26, 2015), http://www.washingtontimes.com/news/2015/feb/26/irs-watchdogreveals-lois-lerner-missing-emails-no/?page=all [https://perma.cc/n33s-5bmy]; see also stephen dinan, irs finds yet another lois lerner email account, wash. times (aug. 24, 2015), http://www.washingtontimes .com/news/2015/aug/24/irs-finds-yet-another-lois-lerner-email-account [https://perma.cc/yhk7-q2dg]. 53 sam stein, irs scandal hearings put inspector general in the spotlight, huffington post (july 17, 2013), http://www.huffingtonpost.com/2013/07/17/irs-scandal_n_3611460.html [https://perma.cc /d2d6-2wms]. 54 see aaron mercer, house committee wants to hear from irs targeting victims, nat’l religious broadcasters (june 7, 2013), http://nrb.org/news_room/articles/house-committee-wants-to-hearfrom-irs-targeting-victims/?ccm_paging_p_b33272=6 [https://perma.cc/gpn6-m2f3] (the website, which has since been removed, stated, “as the committee continues to pursue this investigation, this website allows those affected by the irs scandal to share their story. your story is critical to moving the investigation forward. taking a few minutes to fill out the form below and share your story will allow the committee to identify key facts and take action to deal with the failures of the irs.”). 55 see lois lerner’s involvement, supra note 40, at 10–11 (stating that lerner “created unprecedented roadblocks for tea party organizations, worked surreptitiously to advance new obama administration regulations that curtail the activities of existing 501(c)(4) organizations—all the while attempting to maintain an appearance that her efforts did not appear, in her own words, “per se political.”). 56 h.r. res. 574, 113th cong. (2014), https://www.congress.gov/bill/113th-congress/houseresolution/574/all-actions [https://perma.cc/lcd8-q6w3]. 57 the statement is reproduced in a house committee on oversight and government reform document. see lois lerner’s involvement, supra note 40, at 10–11. 58 kelly phillips erb, house finds lerner, central figure in tax exempt scandal, in contempt of congress, forbes (may 7, 2014), http://www.forbes.com/sites/kellyphillipserb/2014/05/07/house-finds2016] irs reform: politics as usual? 45 a determination letter from the irs traditionally was not even required for tax exemption.59 so, what brought about the irs’s actions and tigta’s report? the next section describes the forces that led to the controversy. a. the rise of political 501(c)(4)s a logical first question is why tax-exempt organizations involved in political activity might claim tax exemption under code section 501(c)(4), given the existence of code section 527 (titled “political organizations”). section 501(c)(4) provides tax exemption for: civic leagues or organizations not organized for profit but operated exclusively for the promotion of social welfare, or local associations of employees, the membership of which is limited to the employees of a designated person or persons in a particular municipality, and the net earnings of which are devoted exclusively to charitable, educational, or recreational purposes.60 read literally, the statute prohibits an organization engaging in any activity that does not promote social welfare from receiving exemption under code section 501(c)(4). treasury regulations interpret campaigning and similar political activity as not promoting social welfare.61 however, the treasury department has long interpreted the statutory exclusivity requirement as requiring that a qualifying organization be “primarily engaged in promoting in some way the common good and general welfare of the people of the community.”62 because the treasury regulation requires only that a 501(c)(4) be primarily (not exclusively) engaged in the promotion of social welfare, it allows a 501(c)(4) to engage in a significant amount of political activity. treasury’s goal seems to have been to allow organizations that did not qualify under 501(c)(3) because of excessive lobbying activity to qualify under 501(c)(4)63 as long as the primary purpose of the organization was lerner-central-figure-in-tax-exempt-scandal-in-contempt-of-congress (“the vote was 231 yeas to 187 nays. of the votes, 225 of the yeas were from republicans; all of the nays were from democrats.”). u.s. attorney donald c. machen, jr., subsequently found that ms. lerner had not waived her fifth amendment rights and refused to prosecute her. see michael s. schmidt, former i.r.s. official won’t be charged for refusing to testify, n.y. times (apr. 1, 2015), http://www.nytimes.com/2015/04/02/us/lois-lerner-former-irs-officialwont-be-charged-for-refusing-to-testify.html [https://perma.cc/352x-t65w]. 59 see nat’l taxpayer advoc., internal revenue serv., special report to congress, political activity and the rights of applicants for tax-exempt status 13 (2013), http://www .taxpayeradvocate.irs.gov/userfiles/file/fullreport/special-report.pdf [https://perma.cc/4jrb-ungb] [hereinafter national taxpayer advocate, special report] (“[o]rganizations can begin operating as taxexempt under irc § 501(c)(4) before receiving a determination letter from the irs . . . .”). the path act of 2015 has since required nonprofits seeking exemption under code section 501(c)(4) to file a one-page notice of registration within 60 days after the organization is formed. see infra note 260 and accompanying text. 60 i.r.c. § 501(c)(4)(a) (emphasis added). professor lily kahng explains that social welfare is “defined to be ‘the common good and general welfare of the people of the community’ and ‘bringing about civic betterments and social improvements.’” kahng, supra note 6, at 44–45a (footnote omitted). 61 see treas. reg. § 1.501(c)(4)-1(a)(2)(ii) (“the promotion of social welfare does not include direct or indirect participation or intervention in political campaigns on behalf of or in opposition to any candidate for public office.”). 62 id. § 1.501(c)(4)-1(a)(2)(i) (emphasis added); t.d. 6391, 1959-2 c.b. 139, 145–46. 63 see i.r.s. gen. couns. mem. 33,495 (apr. 27, 1967) (“the contemplated effect of this provision of the regulations is that even though an organization fails to achieve classification under section 501(c)(3) because it engages in . . . lobbying and propagandizing, it does not necessarily follow that it would not achieve exempt status under section 501(c)(4) as well.”). section 501(c)(3) organizations can receive deductible contributions but 501(c)(4)s cannot. see i.r.c. § 170(c)(2)(d) (“‘charitable contribution’ means a contribution or gift to . . . [a] corporation, trust, or community chest, fund, or foundation—which is not 46 columbia journal of tax law [vol.7:36 not participation in political campaigns.64 section 501(c)(4) therefore encompasses both organizations that engage in no political activity at all65 and advocacy groups such as “the sierra club and the national rifle association.”66 professor lloyd mayer has explained that, in the 1960s, a corollary to the rule that political activity could not be a 501(c)(4)’s primary activity was that “organizations engaged primarily in political activity were taxable.”67 however, as he observes, that principle did not specifically address the question of whether the donations received by political organizations should be included in taxable income. to resolve this issue, congress enacted code section 527 in 1975,68 which provides tax-exemption for those organizations, as well, but only with respect to donated funds the organization sets aside for political use.69 thus, until fairly recently, political organizations generally would simply use code section 527.70 however, in 2000, the law changed in an important way: it required organizations organized under section 527 to disclose who their donors are.71 experts predicted that a wholesale shift from 527 organizations to 501(c)(4)s would result. 72 however, that shift did not occur until 2010, after the supreme court decided citizens united,73 which allowed corporations to spend unlimited amounts of funds on election activity.74 however, treasury regulations still require that an organization be primarily engaged in promoting general welfare—not politics—in order to qualify for tax exemption under code section 501(c)(4). that, in turn, calls for irs screening of 501(c)(4) determination requests. disqualified for tax exemption under section 501(c)(3) by reason of attempting to influence legislation, and which does not participate in, or intervene in (including the publishing or distributing of statements), any political campaign on behalf of (or in opposition to) any candidate for public office.”). 64 see i.r.s. gen. couns. mem. 33,495, supra note 63 (distinguishing permissible lobbying from involvement in political campaigns and stating, “it was our view that so long as activities of this [latter] type were clearly germane to a recognized social welfare purpose, and stop short of being an organization’s primary activity, then the regulation’s language would not operate to preclude exempt status for the organization.”). 65 kahng, supra note 6, at 47a (referencing “the lumberjack world championships foundation and the ballroom latin and swing dance association”). 66 lloyd h. mayer, the much maligned 527 and institutional choice, 87 b.u. l. rev. 625, 639 (2007). 67 id. 68 see pub. l. 93-625, § 10(a) (1975). 69 mayer, supra note 66, at 640. 70 id. 71 i.r.c. § 527(e)(5)(a)(ii), (iii) (“the term ‘qualified state or local political organization’ means a political organization . . . which [among other requirements] is subject to state law that requires the organization to report (and it so reports) . . . information regarding the person who makes such contribution or receives such expenditure . . . and . . . with respect to which the reports [above] . . . are . . . made public . . . .”). 72 kahng, supra note 6, at 48a. 73 citizens united v. fed. election comm’n, 558 u.s. 310 (2010) (holding that the first amendment of the u.s. constitution prohibited the government from banning political speech based on the speaker’s identity as a non-profit or for-profit corporation). 74 see robert maguire, editorial, a new low in campaign finance, n.y. times (oct. 27, 2015), http://www.nytimes.com/2015/10/27/opinion/a-new-low-in-campaign-finance.html [https://perma.cc/gzm6g9pm] (“election-related spending by groups that don’t disclose their donors has grown exponentially in the last few years . . . . the expenditures reported by these groups rose from just under $6 million in 2004 to $308 million in the last presidential election.”); see also kahng, supra note 6, at 48a (noting that “crossroads gps . . . was founded by karl rove in 2010 and spent at least $70 million in the 2012 election cycle”). 2016] irs reform: politics as usual? 47 b. the exempt organizations division’s challenges during the rise of political 501(c)(4)s, the irs’s exempt organizations (eo) division faced significant challenges. first, the eo division experienced a spike in applications for a reason unrelated to citizens united. that is because, starting in 2011, a change in the law resulted in automatic revocation of the tax-exempt status of organizations that had not filed returns in three years. 75 the result was a purge that led many organizations to reapply, resulting in a spike in requests for determination letters.76 the spike consisted of approximately 30,000 applications in addition to the normal volume of approximately 60,000.77 thus, the eo division was dealing with a significant backlog of cases. moreover, the irs’s outdated technology made it difficult for managers to observe and handle the size of that backlog.78 the management issues seem to have been exacerbated by the geographic organization of the eo division. the division centralized in cincinnati in the 1990s—far from irs headquarters—because that city had a history of being able to hire employees at low pay.79 the pay scale for those positions was such that the irs could not find qualified people to fill them in larger cities.80 thus, irs resources influenced the structure of the division. most of the employees in cincinnati screened applications to ascertain whether to grant a determination of tax-exempt status,81 while people in positions like the one lois lerner held—director of the eo division—were located at headquarters in washington.82 the result was a geographic separation of upper-level management from the employees in cincinnati actually doing the day-to-day screening of applications. in addition, during the time period in which applications for determinations of taxexempt status had increased dramatically, the irs had experienced budget cuts that decreased the number of employees working in that area.83 fewer than 200 employees 75 u.s. gen. acct. off., gao-15-164, report to the ranking member, committee on homeland security and governmental affairs, u.s. senate, tax exempt organizations: better compliance indicators and data, and more collaboration with state regulators would strengthen oversight of charitable organizations 30 (2014), http://www.gao.gov/assets/670/667595 .pdf [https://perma.cc/f5nf-tae6] [hereinafter gao, better compliance indicators]. most tax-exempt organizations are required to file form 990 annually. see 2014 instructions for form 990 return of organization exempt from tax 2, https://www.irs.gov/pub/irs-pdf/i990.pdf [https://perma.cc/3cguk3rh]. 76 see national taxpayer advocate, special report, supra note 59, at 27. 77 id. 78 id. 79 kim barker & justin elliott, how the irs’s nonprofit division got so dysfunctional, propublica (may 17, 2013), http://www.propublica.org/article/how-irs-nonprofit-division-got-sodysfunctional [https://perma.cc/6dm6-nqs4]. 80 see id. (quoting marcus owens, who ran the exempt organizations division from 1990 to 2000 as explaining that in new york city, “we had one accountant who just had gotten out of jail—that’s the sort of people who would show up for jobs.”). 81 id. 82 2013 tigta report, supra note 1, at 29 (showing an organizational chart locating in washington, d.c. management offices such as the acting commissioner of the tax exempt and government entities division (eo) and director, eo). lois lerner was the director of the eo division. see supra text accompanying note 40. 83 gao, better compliance indicators, supra note 75, at 30. 48 columbia journal of tax law [vol.7:36 worked directly on applications.84 as a result, each cincinnati employee would need to review an average of one application per day, and some of them were very time-consuming because of the need “to look through a group’s website, track down tv ads and so forth.”85 moreover, the limits on political participation are difficult to define and interpret,86 and they call for a messy facts-and-circumstances test.87 because 501(c)(4) determination denials were not subject to judicial review, there was no case law to serve as a guide.88 c. the targeting allegations in february of 2012, the house committee on oversight and government reform received complaints that “the irs was delaying the approval of conservative-oriented organizations for tax exempt status”89 and began investigating.90 rep. darrell issa, thenchair of the house oversight and government reform committee, “asked tigta to determine whether conservative groups were being targeted by the irs.”91 note that the allegation was not that the irs was denying 501(c)(4) applications of any organizations but rather focused on (1) delays and (2) negative effects on conservative groups. the tigta report found both effects: it found that organizations the irs selected for further review “experienced substantial delays. . . . some cases have been open during two election cycles (2010 and 2012),”92 and that the irs inappropriately used key-word searches “that identified for review tea party and other organizations.”93 although tigta did not accuse the irs of being biased, the language it used, such as the portions italicized above, could raise that concern. 84 internal revenue serv., questions and answers on 501(c) organizations, internal revenue serv., https://www.irs.gov/uac/newsroom/questions-and-answers-on-501(c)-organizations [https://perma .cc/h3wk-u7lw] [hereinafter internal revenue serv., questions and answers]. 85 barker & elliott, supra note 79. 86 see kahng, supra note 6, at 45–46a (courts might view that as “somewhere in the range of ten to fifteen percent of an organization’s expenditures” but “the irs seems to take a more liberal position, although it has never set out a specific percentage, and some practitioners argue that the threshold is as high as forty or even forty-nine percent.”) (citing mariam galston, vision service plan v. u.s.: implications for campaign activities of 501(c)(4)s, 53 exempt org. tax rev. 165, 167 n.20 (2006)). 87 id. at 46a. 88 national taxpayer advocate, special report, supra note 59, at 2. the path act of 2015 amended code section 7428 to extend declaratory judgment actions, including on the initial qualification for tax-exempt status, to 501(c)(4) and other tax-exempt organizations. pub. l. no. 114-113, § 406. 89 lois lerner’s involvement, supra note 40, at 6. 90 id. (“on february 17, 2012, committee staff requested a briefing from the irs about this matter. on february 24, 2012, lerner and other irs officials provided the committee staff with an informal briefing.”). 91 teresa ambord, irs scandal shifts focus to russell george, accountingweb (june 27, 2013), http://www.accountingweb.com/tax/irs/irs-scandal-shifts-focus-to-russell-george [https://perma.cc/9ak8jlfc]. see also 2013 tigta report, supra note 1, at 3 (stating that tigta “initiated this audit based on concerns expressed by members of congress.”). see also bernie becker, treasury ig: liberal groups weren’t targeted by irs like tea party, the hill (june 27, 2013), http://thehill.com/policy/finance/308131ig-liberal-groups-not-targeted-like-tea-party [https://perma.cc/tul3-h2ng] (“[a] spokesman for the inspector general said they were only tasked with looking into whether conservative groups faced tough irs scrutiny.”). a senate finance committee report explains that “[t]he greater number of tea party applications resulted in a greater number of tea party applications being scrutinized” which could lead to a belief that they were targeted or even being used to support “an unproven narrative of bias against nonprofits on the conservative side of the political spectrum.” s. rep. no. 114-119, at 249 (2015). 92 2013 tigta report, supra note 1, at 11 (emphasis added). 93 id. at i (highlights) (emphasis added). the report adds, “subsequently, the determinations unit expanded the criteria to inappropriately include organizations with other specific names (patriots and 9/12) or policy positions.” id. at 5. 2016] irs reform: politics as usual? 49 after tigta’s report, some republican lawmakers suggested that president obama used the irs to cloud the tax status of tea party organizations during the 2010 and 2012 elections.94 some commentators analogized to former president richard nixon’s infamous “enemies list.”95 however, as described below, neither tigta nor anyone else found involvement by president obama, and in fact, the explanation both tigta and the department of justice have given for the delays is much more banal than these accusations suggest.96 1. delays tigta identified the delays as beginning in april 2010, when the irs designated a “specialist”—later a team of specialists97—to process “potential political cases.”98 at that time, the determinations unit program manager, lucinda (cindy) thomas,99 who was located in cincinnati,100 requested assistance from the technical unit,101 which is part of the rulings and agreements office in washington, d.c.102 she did not receive prompt guidance.103 in september 2010, max baucus (d-mt), chair of the senate committee on finance, wrote to then-irs commissioner douglas shulman, asking him to investigate whether 501(c)(4) organizations were complying with the code, in light of media reports about politically active 501(c)(4) organizations.104 senator orrin g. hatch (r-ut) and 94 see, e.g., comm. on oversight & gov’t reform, u.s. house of representatives, how politics led the irs to target conservative tax-exempt applicants for their political beliefs (2014), http://oversight.house.gov/wp-content/uploads/2014/06/how-politics-led-to-the-irs-targetingstaff-report-6.16.14.pdf [https://perma.cc/s6mh-hd7d] (alleging that “president obama’s bully pulpit led to the internal revenue service’s targeting of conservative tax-exempt applicants”); lisa rein & juliet elperin, house gop leader’s final report on irs targeting accuses agency of ‘culture of bias,’ wash. post (dec. 23, 2014), http://www.washingtonpost.com/blogs/federal-eye/wp/2014/12/23/house-gop-leadersfinal-report-on-irs-targeting-accuses-agency-of-culture-of-bias [https://perma.cc/7jjt-8bvh] (“house republicans have alleged that the obama administration used the irs and other enforcement agencies to silence conservative critics during the 2010 and 2012 election cycles, when the targeting occurred.”). 95 see matthew vadum, a president’s enemies list?: add irs-gate to a scandal-ridden administration, frontpage mag (may 13, 2013), http://www.frontpagemag.com/fpm/189411/presidentsenemies-list-matthew-vadum (“some commentators draw parallels with president richard nixon, noting he came dangerously close to impeachment for unleashing the irs on his enemies.”). during his presidency, richard nixon “pressured the irs to initiate tax audits and otherwise harass opponents of the administration or its policies.” john a. andrew iii, power to destroy: the political uses of the irs from kennedy to nixon 201 (ivan r. dee ed. 2002). 96 tigta’s investigation is described immediately below. for the results of the department of justice’s investigation, see infra text accompanying notes 138–139. 97 2013 tigta report, supra note 1, at 5 & n.14 (stating that the team was expanded from one specialist to several specialists in december 2011). 98 id. at 13. 99 u.s. senate, irs & tigta management failures, supra note 40, at 12–13 (noting that in august 2013, ms. thomas moved out of that position, which she had held since 2005, and became a senior technical advisor to the eo director). 100 2013 tigta report, supra note 1, at 29 (showing an organizational chart with geographic locations). 101 id. at 13. 102 id. at 1. 103 see infra note 107 and accompanying text. 104 see darrell issa, chairman, lois lerner’s involvement, supra note 40, at 2–3 (letter from max baucus, chairman, senate committee on finance, to douglas h. shulman, commissioner, internal revenue service (sept. 28, 2010)). baucus’s letter mentioned a new york times article and a time magazine article. id. at app. 4 at 3. it did not mention any 501(c)(4) organizations by name, although it referred to groups 50 columbia journal of tax law [vol.7:36 then-minority whip jon kyl (r-az) soon reacted, asking “the irs to make sure any such probe does not take political considerations into account and requested that an inspector general review any investigation to make sure it is not partisan.”105 the result was pressure on the irs from both the left and the right, which may have left some employees hesitant to take action.106 in october 2010, the specialists had 40 cases but stopped working on them through november 2011 while they waited for written guidance from the technical unit. 107 compounding the problem, cindy thomas, the determinations unit program manager, was unaware that the specialists were not working on those cases for this 13-month period.108 2. selection criteria the second part of the issue republicans raised was the manner in which the irs selected applications for further review. tigta’s report found that the “be on the lookout” (bolo) list of words to watch for in 501(c)(4) applicants’ names109 originated in may 2010 as a spreadsheet compiled by determinations unit specialists in cincinnati. the cincinnati office distributed the first formal bolo listing in august of that year.110 the national taxpayer advocate describes the bolo lists as resulting from irs employee attempts to triage the tens of thousands of applications they were receiving. discussed in the time magazine article, entitled “the new gop money stampede.” darrell issa, chairman, lois lerner’s involvement, supra note 40, at app. 4 at 3. 105 steven t. dennis, battle escalates over undisclosed campaign cash, roll call (oct. 6, 2010), http://www.rollcall.com/news/76003-1.html [https://perma.cc/2xve-xdf6]. 106 tigta observed in its investigative report that “the team of specialists stopped working on potential political cases from october 2010 through november 2011, resulting in a 13-month delay, while they waited for assistance from the technical unit.” 2013 tigta report, supra note 1, at 12. 107 national taxpayer advocate, special report, supra note 59, at 12–13. some organizations waited much longer because the irs had requested further information from them and then did not act during that 13-month period. 2013 tigta report, supra note 1, at 14. 108 2013 tigta report, supra note 1, at 13. tigta reports that the director of rulings and agreements later stated “that there was a miscommunication about processing the cases.” id. that statement is ambiguous, in that it could refer to a miscommunication to tigta. however, in context, it appears to refer to a miscommunication between ms. thomas and the specialists. the director of rulings and agreements at the time was holly paz. see infra note 122. 109 see stein, supra note 53. 110 2013 tigta report, supra note 1, at 6. the bolo lists apparently distinguished between “historical” and “emerging” issues. see, e.g., letter from j. russell george, inspector gen., to rep. sander m. levin, comm. on ways and means, u.s. house of representatives (june 26, 2013), http://online.wsj.com /public/resources/documents/tigtafinalresponsetoreplevin06262013.pdf [https://perma.cc/rw4l354k] [hereinafter george letter to levin] (reporting that the term “progressives” was categorized as a “tag historical” or “potential abusive historical” term); josh hicks, irs bolos: what’s the problem?, wash. post (july 3, 2013), http://www.washingtonpost.com/blogs/federal-eye/wp/2013/07/03/irs-boloswhats-the-problem [https://perma.cc/7csv-g9r7] (“the list’s ‘emerging issues’ category included only conservative terms at the outset, raising questions about why the irs prioritized conservative groups but none from the left.”). however, the senate finance committee’s report explained in the section titled “additional views of senator wyden prepared by democratic staff”: according to irs agent ron bell, who was responsible for the bolo list, screening terms were placed on the ‘‘tag historical’’ tab after irs employees were not seeing the cases as frequently. while the organizations with the name ‘‘progressive’’ in their name were not applying for tax-exempt status as frequently as conservative or tea party organizations, the irs was still instructing its employees to screen and set aside cases because of potential political activity based on the word “progressive.” s. rep. no. 114-119, at 253 (2015) (footnote omitted). 2016] irs reform: politics as usual? 51 those applications generally fell into three categories. the easiest applications, irs screeners in the cincinnati determinations unit would approve on “first read.” 111 somewhat more complicated applications needed to be assigned to a determinations unit specialist.112 the most complicated applications, such as those in which no established precedent applied, would be sent to an eo technical unit specialist in washington, dc to work on before being returned to cincinnati and assigned to a determinations unit specialist.113 given the flood of applications and limited personnel, irs employees began using key words to try to identify groups likely to be engaging in political activity.114 as the national taxpayer advocate notes, “the employees presumably assumed that an application for tax exemption from an organization with ‘tea party’ or similar terms in its name was more likely to be focused primarily on political activity, rather than the common good and general welfare, as required by law.”115 these “potential political cases” were referred to the determinations unit specialists for further review. 116 although only approximately one-third of the cases sent for additional review contained these words,117 the optics were disastrous. tigta subsequently found that “determinations unit employees . . . did not consider the public perception of using politically sensitive criteria when identifying these cases.”118 irs management did not step in immediately to stop the cincinnati employees’ efforts to simplify their jobs. the issue was not that irs management endorsed the cincinnati employees’ development of key-word criteria but rather that they were unaware that the employees had done so.119 the 2013 tigta report found that when ms. lerner was briefed on the criteria in june 2011, she “immediately directed that the criteria be changed. in july 2011, the criteria were changed to focus on the potential ‘political, lobbying, or [general] advocacy’ activities of the organization.” 120 however, the determinations unit employees had trouble applying these fact-sensitive criteria and in january 2012, the determinations unit “changed the criteria . . . without executive approval because they believed the july 2011 criteria were too broad.” 121 it took three months for holly paz, the director of rulings and agreements122 to learn that the determinations unit had changed the criteria.123 she revised the criteria in 111 national taxpayer advocate, special report, supra note 59, at 11. 112 id. 113 id. 114 id. 115 id. at 12. 116 2013 tigta report, supra note 1, at 5. 117 id. at 8. 118 id. at 7 (also stating that “the criteria developed showed a lack of knowledge in the determinations unit of what activities are allowed by i.r.c. § 501(c)(3) and i.r.c. § 501(c)(4) organizations”). 119 id. (finding that irs management exercised insufficient oversight). 120 id. 121 id. 122 holly paz was the director of rulings and agreements from january 2011 to june 2013. u.s. senate, irs & tigta management failures, supra note 40, at 12. 123 2013 tigta report, supra note 1, at 7. 52 columbia journal of tax law [vol.7:36 may 2012 and issued a memorandum requiring all subsequent changes to the bolo lists to obtain prior executive-level approval.124 3. the political controversy the idea that the civil servants in cincinnati singled out tea party groups for further review may be surprising to some, given that the determinations unit employees are not political appointees. tigta’s report found that determinations unit employees used the term “tea party” as “shorthand” for all potentially political cases.125 moreover, recall that the charge congress gave tigta apparently was to “determine whether conservative groups were being targeted by the irs.”126 it appears that congress did not ask tigta to undertake a comparative study or to examine whether progressive groups experienced delays.127 tigta’s report thus did not address the treatment of progressive groups. it did not provide a comparative analysis of the treatment of left-leaning and right-leaning groups. in addition, it did not mention that a july 2010 irs “screening workshop” powerpoint presentation lists under “current activities” both “tea party” and “progressive” groups.128 the report also did not mention that the irs apparently denied tax-exempt status to at least one progressive organization but not to any conservative organizations.129 in addition, one of tigta’s “own investigators had concluded from a review of 5,500 emails that the targeting had not been politically motivated,” but the report did not mention that.130 the u.s. senate permanent subcommittee on investigations, committee on homeland security and governmental affairs majority staff report called out tigta for a flawed report, management failures in its audit, and failure to disclose for weeks that the irs had included progressive key words on the bolo lists, “even though it was directly 124 id. 125 id. 126 ambord, supra note 91. 127 see supra note 91 and accompanying text. 128 see stein, supra note 53 (“democrats on the house ways and means committee turned up a 2010 irs powerpoint presentation that said both ‘progressive’ groups and ‘tea party’ organizations deserved extra scrutiny when applying for tax-exempt status.”). the powerpoint (with some redactions labeled “6103”) is available at http://democrats.waysandmeans.house.gov/sites/democrats.waysandmeans.house.gov /files/irsr0000006674.pdf [https://perma.cc/57kp-3xhh]. “the notes from the meeting [at which the powerpoint was shown] state that gary muthert indicated that the ‘following names and/or titles were of interest and should be flagged for review: • ‘9/12 project, • ‘emerge [“an organization that sought to train female democratic political candidates”], • ‘progressive, • ‘we the people, • ‘rally patriots, and • ‘pink-slip program.’” s. rep. no. 114-119, at 252 (2015). 129 cummings & levin, supra note 7 (referencing a statement of then-irs acting commissioner daniel werfel). 130 sam stein, irs scandal hearings put inspector general in the spotlight, huffington post (july 17, 2013, 2:24 pm), http://www.huffingtonpost.com/2013/07/17/irs-scandal_n_3611460.html [https:// perma.cc/5tpt-av6n]. the report did state, “according to the director, rulings and agreements, the fact that the team of specialists worked applications that did not involve the tea party, patriots, or 9/12 groups demonstrated that the irs was not politically biased in its identification of applications for processing by the team of specialists.” 2013 tigta report, supra note 1, at 8. 2016] irs reform: politics as usual? 53 relevant to tigta’s audit objective and could have helped alleviate public concern about potential irs political bias.”131 the majority staff report found that: [t]he irs subjected not only conservative groups with “tea party,” “9/12,” or “patriot” in their names to heightened scrutiny, but also liberal groups with “progressive,” “progress,” “acorn,” “emerge,” or “occupy” in their names. the evidence also shows that, from 2010 to mid-2013, more conservative groups than liberal groups applied for tax exempt status, underwent irs scrutiny, and ultimately won tax exempt status.132 in june 2013, inspector general russell george stated in a letter to rep. levin: we reviewed all cases that the irs identified as potential political cases and did not limit our audit to allegations related to the tea party. . . . from our audit work, we did not find evidence that the criteria you identified, labeled ‘progressives,’ were used by the irs to select potential political cases during the 2010 to 2012 timeframe we audited.133 the letter further stated that “[t]he ‘progressives’ criteria appeared on a section of the ‘be on the look out’ (bolo) spreadsheet labeled ‘historical,’ and, unlike other bolo entries, did not include instructions on how to refer cases that met the criteria.”134 tigta’s additional research reported in the june letter found that of the applications filed during the time period of the initial audit, six applications with “progress” or “progressive” in the organization’s name were included in the irs’s “potential political cases” while fourteen were not.135 it contrasted that with 100 percent inclusion of organizations with names that included the terms tea party, 9/12, or patriot in their names, which were 96 of the 298 potentially political cases.136 accordingly, it appears that the cincinnati employees did not treat all of the liberal and conservative-sounding groups identically, leaving room for accusations of political 131 u.s. senate, irs & tigta management failures, supra note 40, at 8. 132 id. at 4. at some point, “medical marijuana” was included on the list. see hicks, supra note 110 (“irs documents released last week have complicated matters. they show that terms such as ‘progressive,’ ‘blue’ and ‘medical marijuana’ appeared on a multi-part ‘be on the lookout’ list . . . .”). 133 george letter to levin, supra note 110, at 1. 134 id. 135 id. 136 id. at 1–2. seventy-two of the ninety-six used the term “tea party” in the organization’s name, eleven used “9/12,” and thirteen used “patriots.” 2013 tigta report, supra note 1, at 8 fig. 4. it is possible that some employees treated the “tea party” label as shorthand for all potentially political cases while others took the label literally and did not apply the same procedures to other groups. cf. philip hackney, an examination of the irs tea party affair, 49 val. l. rev. 453, 479 (2015) (“some testimony indicates that some service employees viewed the term tea party cases as a generic category, like someone might refer to coke as a generic term for soft drink. other testimony seems to suggest that some employees understood in the early stage that they should be pulling and looking at only tea party-related organizations and should avoid looking at any others.”) (footnote omitted). a senate report also explains that after two tea party cases were identified and subject to further review in washington, d.c.: [i]t can be argued that it was logical to develop a method of collecting all the tea party applications that continued to surface in cincinnati. the bolo list can be seen as an efficient procedure to use to make sure personnel in cincinnati identified the right applications to set aside while washington d.c. determined the best way to deal with these applications. applications by left-leaning groups were also collected in this manner. s. rep. no. 114-119, at 251 (2015). however, this does not seem to explain why all of the organizations containing “9/12” or “patriots” were treated as potentially political while only some of those using the term “progress” were. 54 columbia journal of tax law [vol.7:36 bias.137 however, in october 2015, the doj, after a two-year investigation, found “no evidence that any irs official acted based on political, discriminatory, corrupt, or inappropriate motives that would support a criminal prosecution.”138 instead, the doj found that irs mismanagement was the culprit.139 the fbi reached the same conclusion in its investigation.140 the doj and fbi’s conclusions align with tigta’s finding of insufficient oversight by irs management.141 d. the irs’s response to the controversy the irs reacted quickly and extensively to the 501(c)(4) controversy. one day after tigta released its report, the irs stated on its website that it had made mistakes.142 the irs also changed its procedures relating to determinations of tax-exempt status. among other things, it suspended the use of watch lists, including bolo lists.143 tigta found in a follow-up audit in march 2015 that the irs was no longer using bolo lists.144 the irs also directly addressed the delays many non-profits had experienced by instituting an expedited review process for all applications for tax-exempt status in which the organization had stated that it might be engaged in political activities.145 under an irs procedure, if the application of such an organization had been pending for more than 120 days, the irs would grant the application within two weeks if an authorized official from the organization made certain declarations about the organization’s planned activities, under penalty of perjury.146 this program succeeded in expediting the grant of applications for determinations of tax-exempt status. tigta found in its march 2015 follow-up audit that the irs had “completed processing for 149 of the 160 applications for tax-exempt status that, as of december 2012, had been open for lengthy periods.”147 the irs reported that, as of july 2015, it had resolved 97 percent of the 145 organizations’ applications included in the new 137 see supra notes 133–136 and accompanying text. republican minority staff included a dissent to the senate’s report that argued, “far fewer liberal groups were investigated by the irs, and those that were received less intrusive questioning, the dissent said, adding that in some cases the liberal groups were affiliated with organizations that had behaved illegally in the past and as a result could expect extra scrutiny.” id. see also media prompted irs to target conservative groups, oversight committee finds, 2013 tax notes today 182-29 (sept. 18, 2013) (stating that “the acorn entry appears primarily on the watch list tab of the bolo spreadsheet whereas the tea party entry appears on the emerging issues tab of the spreadsheet. . . . [n]otes from the july 2010 screening group workshop state that while progressive applications should be ‘flagged,’ only tea party applicants were to be sent to a special coordinator.”). 138 u.s. dep’t of just., letter to the hon. bob goodlatte, supra note 3. 139 see id. at 1. 140 see supra note 3 and accompanying text. 141 see supra text accompanying note 119. 142 see internal revenue serv., questions and answers, supra note 84, at q&a 12 (“did mistakes occur in working the centralized cases? yes. applicants whose cases were centralized unfortunately experienced inappropriate delays and over-expansive information requests in some cases. this was caused by ineffective processes and not related to the selection criteria used for the centralization of a case.”). that document is dated may 15, 2013. tigta’s report is dated may 14, 2013. see 2013 tigta report, supra note 1. 143 see daniel werfel, charting a path forward at the irs: initial assessment and plan of action app. c (june 24, 2013), https://www.irs.gov/pup/newsroom/initial%20assessment%20and%20plan%20of %20action.pdf [https://perma.cc/2grf-bdzw]. 144 tigta, status of actions taken, supra note 19, at 3. 145 see lloyd hitoshi mayer, “the better part of valour is discretion”: should the irs change or surrender its oversight of tax-exempt organizations?, 7 colum. j. tax l. 80, 103–04 (2016). 146 id. at 27. 147 tigta, status of actions taken, supra note 19, highlights; see also id. at 16. 2016] irs reform: politics as usual? 55 process, and by november 2015, it had resolved 98 percent.148 subsequently, as discussed below, congress enacted a streamlined procedure that requires nonprofits seeking exemption under code section 501(c)(4) to file a one-page notice of registration within 60 days after the organization is formed and for the irs to acknowledge receipt of the form within 60 days.149 iii. the 1997/1998 collections controversy the recent irs hearings may strike a familiar chord for some observers: the irs experienced hearings similar in tone in 1997 and 1998. the path to the earlier hearings was somewhat different because it started with irs technology issues. however, as described below, perceived failures by the irs were an important catalyst, and the end result was “reform” of the irs.150 a. the story behind the irs reform act of 1998 one of the initial forces behind the 1998 reform was the irs’s perceived failure in implementing a multi-year computer project called “tax systems modernization (tsm),”151 which was designed to be “a complete business re-engineering of the irs over a decade.”152 in 1996, when tsm was shut down,153 representative jim lightfoot (r-ia), who chaired the house appropriations subcommittee responsible for irs budgets said, “to date this has been a $4 billion fiasco.”154 that was an exaggeration, however, both because the irs spent significantly less than that on tsm155 and because a substantial portion of the irs’s tsm expenditures went into infrastructure that continued to be useful even after tsm was cancelled.156 148 tigta recommendation #7: details and status, internal revenue serv., http://www.irs.gov /charities-&-non-profits/tigta-recommendation-7 [https://perma.cc/7ajr-dadg]. the irs subsequently expanded the expedited-review program to provide the possibility of granting later applicants the same approach. see mayer, supra note 145, at 103–04. however, that was superseded by new procedures in the path act. see infra notes 260–261 and accompanying text. 149 see infra notes 260–261 and accompanying text. 150 joseph j. thorndike, annual regulation of business focus: reorganization of the internal revenue service: reforming the internal revenue service: a comparative history, 53 admin. l. rev. 717, 765 (2001). 151 id. 152 computer sci. & telecomm. bd. nat’l res. council, continued review of the tax systems modernization of the internal revenue service: final report 13 (1996), http://www.nap.edu /read/10771/chapter/3 [https://perma.cc/72n2-5ld4] [hereinafter continued review of tsm]. 153 bozeman, organizational culture, supra note 35, at 131. the treasury department stepped in in early 1996 and halted work on tsm projects while it reviewed the program. nat’l comm’n on restructuring the internal revenue serv., report of the national commission on restructuring the internal revenue service: a vision for a new irs 73–74 (june 25, 1997), http://www.house.gov /natcommirs/final.htm [https://perma.cc/pea6-we2m] [hereinafter report of the national commission]. 154 robert d. hershey, jr., a technological overhaul of i.r.s. is called a fiasco, n.y. times (apr. 15, 1996), http://www.nytimes.com/1996/04/15/us/a-technological-overhaul-of-irs-is-called-a-fiasco.html [https://perma.cc/8mv2-r8qf]. 155 the irs responded that it had spent only $2.7 billion on tsm. id. the irs’s figure is more plausible. gao reported that the irs had spent $2.5 billion on tsm through 1995. u.s. gen. acct. off., gao/aimd-95-156, tax systems modernization: management and technical weaknesses must be corrected if modernization is to succeed (1995), http://www.gao.gov/assets/160/155115.pdf [https:// perma.cc/4kd2-dkfj] [hereinafter gao, tax systems modernization]. congress appropriated $695 million for 1996 but held $100 million of that appropriation back. see infra note 160. tsm was cancelled in 1996. see supra note 153 and accompanying text. 156 see bozeman, information mega-technology, supra note 35, at 7 (explaining that much of the funding went into software and hardware the irs was still using in 2002, and some of the funds went into renovating buildings). 56 columbia journal of tax law [vol.7:36 tsm was created because the irs had been struggling for years to maintain systems that dated from the 1950s and 1960s.157 congress had frequently ignored the irs’s requests for information-technology funding.158 in 1985, after the irs introduced new technology for processing returns that had been insufficiently tested and simply did not work, it had a very public failure: a janitor at the irs’s philadelphia service center reported finding mangled unopened returns in wastebaskets and in the bathroom, including checks made out to the irs aggregating more than $300,000.159 in response to complaints from angry constituents, in 1989, congress approved the irs’s tsm plan, which the irs told congress could cost several billion dollars over the course of a ten-year period.160 tsm was actually not a single project, but rather a group of projects that included more than 40 initiatives161 such as cyberfile, an experiment in filing over the internet;162 scrips, the service center recognition/image processing system, which was supposed to convert paper returns into digital images; and the document processing system (dps), which was supposed to produce similar digitized information.163 many of these projects failed to produce technology that worked adequately.164 barry bozeman describes the problem the irs had developing and implementing tsm as resulting from the inadequacy of state-of-the art technology at the time for many of the irs’s needs; failure of irs management to recognize that failure was inevitable;165 and an insular, distrusting agency culture that limited employees’ willingness to take risks, such as by delivering bad news.166 however, he also notes that tsm was less of a failure than generally believed, in that much of the funding went into software and hardware the irs was still using in 2002, the time of his writing.167 157 u.s. gen. acct. off., gao/imtec-90-13, tax systems modernization: irs’ challenge for the 21st century 2 (1990), http://www.gao.gov/assets/220/212210.pdf [https://perma.cc/c2rl-8jat] [hereinafter tsm: irs’ challenge]. the irs had abandoned two previous efforts, the first, in 1978, due to congressional concerns about cost and security and the second due to several factors, including frequent leadership changes at treasury and irs as well as inadequate technical expertise on the part of irs management. id. at 3. 158 bozeman, information mega-technology, supra note 35, at 46. 159 bozeman, organizational culture, supra note 35, at 125. 160 gao, tsm: irs’ challenge, supra note 157, at 3. in 1995, the gao reported that the irs had spent $2.5 billion on tsm since 1986 and requested another $1.1 billion for fiscal year 1996, with a total projected budget of $8 billion through 2001. gao, tax systems modernization, supra note 155, at 2. appropriations for tsm were annual, as part of the irs’s budget. see bozeman, organizational culture, supra note 35, at 127 (referring to this as a perceived risk of the project from the irs’s perspective). nonetheless, the irs experienced the tsm appropriation as a significant influx of resources. bozeman, information mega-technology, supra note 35. the irs requested $717 million for tsm for 1994. id. at 1. funding was cut for 1996: “of the $695 million in funding approved for tsm for this year, the conference committee restricts irs from spending $100 million until it receives a full accounting of the $8 billion tsm program.” christopher j. dorobek, tax systems modernization gets $300 million less than irs wants, gcn (dec 11, 1995), https://gcn.com/articles/1995/12/11/tax-systems-modernization-gets-300-million-lessthan-irs-wants.aspx [https://perma.cc/3yxr-vnlc]. 161 bozeman, organizational culture, supra note 35, at 126–27. 162 id. at 127. 163 id. at 131. 164 id. at 127–28, 131. 165 id. at 132. for example, technology at the time was unable to digitize documents that might be partly typed, partly handwritten, and might include notes attached to them. id. 166 see id. at 129. 167 see bozeman, information mega-technology, supra note 35, at 7, 43. 2016] irs reform: politics as usual? 57 the gao issued numerous reports criticizing the irs’s management of the tsm project.168 congressional support for tsm declined.169 in 1995, congress approved a lower budget for tsm than the irs requested170 and appointed senator bob kerrey (dne) and representative rob portman (r-oh) co-chairs of a one-year commission to examine not only tsm but also consider restructuring the irs. 171 the impetus for considering restructuring the irs went beyond the problems with tsm. taxpayers who were subject to line-by-line audits under the program the irs used for research at the time, the taxpayer compliance measurement program (tcmp), objected to the burden it imposed.172 taxpayers also complained that it was hard to reach the irs by telephone173 and that irs employees treated them rudely.174 although the restructuring commission was bipartisan, irs reform was a highly political process, and the ultimate “reform bore the distinct fingerprints of leading income tax antagonists.”175 that is because, in 1994, democrats had lost control of the house for the first time in decades,176 significantly undermining support for progressive income 168 see, e.g., gao, tax systems modernization, supra note 155; gao, tsm: irs’ challenge, supra note 157; u.s. gen. acct. off., gao/ggd/aimd-97-31, tax systems modernization: irs needs to resolve certain issues with its integrated case processing system (1997), http://www.gao.gov /assets/230/223536.pdf [https://perma.cc/m3xp-vxap] (hereinafter gao, irs needs to resolve certain issues). cf. thorndike, supra note 150, at 767 (gao issued “more than 40 . . . reports between 1991 and 1997 that were critical of irs management, procedures, and performance.”). in 1995, gao added tsm to its list of high-risk areas—projects vulnerable to delays, cost overruns, and failure to meet goals. see gao, irs needs to resolve certain issues, supra, at 7. 169 the negative reports by gao and the national research council eroded congress’s support of tsm over a period of about three years. elana varon, congress threatens tsm funds, fcw (mar. 17, 1996), https://fcw.com/articles/1996/03/17/congress-threatens-tsm-funds.aspx [https://perma.cc/u66ahll5]. 170 dorobek, supra note 160. 171 id. (“the role of the commission, proposed by sen. bob kerrey (d-neb.), will be broader than merely examining tsm, a senate staff member said. ‘we want to look at the way irs does its business,’ he said.”). see also thorndike, supra note 150, at 768 n.189. 172 cong. res. serv. crs reports on status of irs restructuring and reform (mar. 22, 2001), lexis, 2001 tax notes today 60-42 [hereinafter crs reports on status of irs restructuring]. the irs later replaced the tcmp with a less intrusive audit program, the national research program. see sarah b. lawsky, fairly random: on compensating audited taxpayers, 41 conn. l. rev. 161, 167 (2008) (“a[] tcmp was scheduled for the 1994 tax year, but the study was postponed in response to anti-irs political pressure, and then was cancelled in 1995 after congress significantly reduced the irs budget. in 2002, the irs began its national research program, or ‘nrp.’ like the tcmp, the nrp selects returns randomly, but it reviews even fewer returns and does so with less intensity than the tcmp.” (footnote omitted)). 173 crs reports on status of irs restructuring, supra note 172. through 1996, the irs’s call center technology was geographically based, so a caller would have to wait until an employee at a specific geographic location became available. treas. inspector gen. for tax admin., the internal revenue service restructuring and reform act of 1998 was substantially implemented but challenges remain 17 (2010), https://www.treasury.gov/tigta/iereports/2010reports/2010ier002fr.pdf [https://perma.cc/yz9a-bzf8]. “between october 1995 and september 1996, the irs answered 21 percent of all calls.” id. 174 crs reports on status of irs restructuring, supra note 172. 175 thorndike, supra note 150, at 766. see also ryan j. donmoyer, three days of hearings paint picture of troubled irs, 76 tax notes 1655, 1658 (1997) (“although roth took pains to say his investigation was not politically biased and that he did not intend to merely bash the irs, democrats remained suspicious. on numerous occasions they quoted from republican fund-raising letters that recommended bashing the agency.”). 176 thorndike, supra note 150, at 768. 58 columbia journal of tax law [vol.7:36 taxation.177 former irs commissioner donald alexander noted that pollster frank luntz recommended that political candidates score points by vilifying the irs, an approach some congressional leaders adopted.178 that political context ultimately hijacked the irs reform process. the bipartisan commission started its work in 1996, and, after a year of research and hearings, released its recommendations. 179 the recommendations included “restructuring congressional oversight of the irs, providing the irs with a board of directors, updating the irs’s technology, requiring the irs to develop a strategic plan for increasing electronic filing of tax returns, increasing taxpayers’ ability to recover damages in appropriate cases, and simplification of the tax law.”180 the commission also blamed the laws enacted by congress for some of the irs’s problems, and urged congress to consider the effects on tax administration before changing the laws.181 the house responded very favorably, and house ways and means chair bill archer introduced a bill in 1997 that the house quickly passed in early november.182 however, while the senate was still working on the bill,183 senator william roth (r-de), then-chair of the senate finance committee, took the reins and “sought to make the legislation his own.”184 the vivid parade of horribles in his fall hearings—a moral panic over the actions of irs collections employees—“effectively altered the tenor of the legislation.”185 b. hearings and horror stories in the fall of 1997, senator roth oversaw a hearing186 that focused primarily on horror stories of irs abuses of taxpayers.187 the house ways and means committee, not 177 id. at 766. 178 donald c. alexander, some musings about the irs, 83 tax notes 297, 297 (1999) (citing frank luntz, 1997 instructions to candidates); see also donmoyer, supra note 175, at 1658 (“pollster frank luntz . . . observed that ‘nothing guarantees more applause and more support than the call to abolish the irs.’”). 179 thorndike, supra note 150, at 768. 180 lederman, supra note 37, at 978 (footnotes omitted). 181 thorndike, supra note 150, at 772. 182 id. at 774. 183 crs reports on status of irs restructuring, supra note 172. 184 thorndike, supra note 150, at 774. 185 crs reports on status of irs restructuring, supra note 172. 186 id. then-senator david pryor (d-ar), who headed the oversight subcommittee of the senate finance committee, was also involved. see daniel l. mcclain, united states v. leach and internal revenue code section 7521(c): applying a text-based analysis to provisions of the tax code, 77 iowa l. rev. 371, 372 (1991) (describing the “horror stories” of irs abuse that were revealed during hearings conducted by senator david pryor). 187 mcclain, supra note 186, at 372 (describing the “horror stories” of irs abuse that were revealed during hearings conducted by senator david pryor); guttman, supra note 34, at 13 (“in 1987 and 1988, thensenator david pryor, who was head of the finance committee’s oversight subcommittee, held hearings on taxpayer problems in dealing with the irs.”). senator roth also co-authored a provocatively titled book. see william v. roth, jr. & william h. nixon, the power to destroy: how the irs became america’s most powerful agency, how congress is taking control, and what you can do to protect yourself under the new law (1999). the dust jacket states, in part, “in 1997 william roth . . . initiated an investigation into the irs and chaired congressional hearings that uncovered horrifying stories of abuses against taxpayers that shocked the nation.” id. (front dust jacket). 2016] irs reform: politics as usual? 59 to be left out,188 held similar hearings.189 the house actively solicited these tales. in a theatrical move, it opened a website on the symbolic date of halloween, linked to the house republican conference’s website, expressly “to collect taxpayer horror stories.”190 ryan j. donmoyer quoted rep. john boehner, then-chair of the house republican conference, as stating, “this halloween, the republican congress is unmasking the irs for what it really is: a bureaucratic monster stalking the american taxpayer.”191 the hearings received extensive media coverage, 192 with some broadcast on national television193 and featuring irs employees testifying behind screens to hide their identities, implying that they feared imminent retaliation. 194 representative michael forbes (ny)195 made that link as vivid as possible, stating, “we saw current and former irs agents who had to testify in secret because they feared for their lives.”196 congress apparently carefully selected its witnesses.197 they included “lawrence ballweg, an angry 79-year-old priest, [who] alleged that while administering his mother’s estate, the irs improperly assessed him personally more than $18,000 in taxes.”198 the owner of a virginia restaurant called “the jewish mother,” john colaprete, detailed a raid involving armed agents “pulling his manager’s [teenaged] daughter out of a shower at gunpoint.”199 some used the rhetoric of criminal law, not just to refer to how the irs allegedly treated taxpayers, but also how the irs should be treated. for example, representative forbes stated: we saw a government agency totally out of control, lacking accountability, an agency where one is guilty until proven innocent. 188 alexander, supra note 178, at 299 (stating that “[t]he ways and means committee, not to be left behind, promptly took up the restructuring commission’s bill and made it much stricter . . .”). 189 see taxpayer rights: written comment and hearing before the subcomm. on oversight of the h. comm. on ways and means, 105th cong. 12 (1997) (statement of rep. bill archer) (“[t]here are too many instances in which taxpayers are denied their fundamental rights. money is coerced from people who do not owe it. and the defenseless and the weak can become irs targets.”). 190 ryan j. donmoyer, gop opens irs horror story web site, 77 tax notes 667, 667 (1997). 191 id. 192 see lederman, supra note 37, at 1010 (discussing the media’s focus on horror stories and the need to reform the irs); see also thorndike, supra note 150, at 774 (“the hearings drew widespread media coverage.”). 193 see donmoyer, supra note 175, at 1655 (“by the end of the high-profile senate finance committee oversight hearings on alleged irs abuses of taxpayers, the agency was issuing apologies to taxpayers who related their horror stories on live television and promising to clean up its act. again.”). 194 thorndike, supra note 150, at 774. 195 mr. forbes was a member of the republican party until july 17, 1999, when he switched to the democratic party. rep. forbes loses aides over switch to democrats, l.a. times (july 20, 1999), http:// articles.latimes.com/1999/jul/20/news/mn-57768 [https://perma.cc/8e8l-3dd4]. 196 joint review of the strategic plans and budget of the internal revenue service, as required by the internal revenue service restructuring and reform act of 1998, jcs-4-99, at 9 (may 25, 1999) (opening statement of rep. forbes) (emphasis added), https://www.jct.gov/publications.html ?func=startdown&id=2912 [https://perma.cc/eq93-8msn] [hereinafter opening statement of rep. forbes]. 197 see spellman, supra note 16, at 1854 (former irs commissioner mortimer caplin said at a conference, “roth ‘brought six people up—these miserable collection cases. he had studied thousands and thousands of cases and came up with six extreme charges against the irs.’”). 198 leslie book, the new collection due process taxpayer rights, 86 tax notes 1127, 1127 (2000). 199 id. see also ryan j. donmoyer, judge may dismiss jewish mother lawsuit, 83 tax notes 1696, 1696 (1999). 60 columbia journal of tax law [vol.7:36 we saw and heard all this and we acted to put a stop to it. . . . in a sense, the internal revenue service restructuring and reform act put the irs on probation.200 the hearings effectively put the irs on trial201 but, largely because congress— perhaps intentionally—did not obtain waivers from the witnesses202 of their statutory right to confidentiality of their tax return information,203 the irs was essentially a voiceless and thus helpless defendant.204 in fact, the bona fides of many of the shocking stories told at the irs hearings are questionable. john colaprete famously “has ‘recanted all this—he happened to be out of the country’ when this was said to have occurred.”205 the gao ultimately found many of the witnesses’ horror stories unfounded or exaggerated. 206 however, that was after congress enacted sweeping changes in the irs reform act.207 during the hearings that preceded the act, many congressmen were horrified by the witnesses’ testimony.208 c. alleged targeting of conservative tax-exempt organizations in 1997, the heyday of irs horror stories and congressional hearings, the irs encountered another problem: the press accused the irs of targeting the applications for tax-exempt status of organizations perceived to be antithetical to the views of the clinton administration.209 the seven allegations included the following two: 200 opening statement of rep. forbes, supra note 196. 201 see id. (“in 1997, congress held a series of hearings where the american people saw the internal revenue service almost literally on trial. they saw a parade of witness [sic] come before congress to testify about the naked abuse of power over at the internal revenue service.”). 202 see alexander, supra note 178, at 299 (“presumably aware that the irs was powerless to respond or correct the record without waiver of the strict privacy rules under section 6103, the committee did not obtain waivers of confidentiality from the witnesses telling their lurid stories or give the irs the right to respond.”). cf. george k. yin, reforming (and saving) the irs by respecting the public’s right to know, 100 va. l. rev. 1115, 1133 (2014) (noting that “[w]ith jct [joint committee on taxation] approval, the irs has a limited ability to disclose return information in order to correct a misstatement of fact. see i.r.c. § 6103(k)(3).”). 203 see i.r.c. § 6103. 204 see, e.g., donmoyer, supra note 175, at 1659 (referring to “a squabble [with senator roth] as [irs acting commissioner michael] dolan declined to answer questions about the case because he said he did not have all of the necessary waivers required under the tax code’s confidentiality provisions.”); cf. alexander, supra note 178, at 299 (“perhaps under instructions to limit its response, the irs made little effort to rebut claims of misdeeds or to explain its actions.”). 205 spellman, supra note 16, at 1854 (quoting former irs commissioner mortimer caplin). see also mom’s, inc. v. weber, 82 f. supp. 2d 493, 524 & n.62 (e.d. va. 2000), rev’d in part sub nom. mom’s, inc. v. willman, 109 fed. app’x 629 (4th cir. 2004) (“while the restaurants were being searched, agents simultaneously searched the homes of [jewish mother manager richard] miller and colaprete as well. there was no one home at colaprete’s house at the time of the search except colaprete’s two dogs. colaprete was in jamaica at the time. . . .”). 206 u.s. gen. acct. off., gao report on allegations of irs taxpayer abuse (may 24, 1999), lexis, 2000 tax notes today 80-13. the webster commission similarly found, “there was no pattern of misuse by the cid of search warrants, grand juries, informants, or undercover operators, although there were ‘one or two isolated abuses.’” spellman, supra note 16, at 1855. 207 pub. l. no. 105-206, 112 stat. 685. 208 crs reports on status of irs restructuring, supra note 172. 209 joint comm. on taxation, report of investigation of allegations relating to internal revenue service handling of tax-exempt organization matters, jcs-3-00, at 12 (mar. 2000), http://www.jct.gov/s-3-00.pdf [https://perma.cc/l68c-3dcl] (“[a]llegations were made through certain media reports that the irs was engaged in politically targeted examinations of tax-exempt organizations.”). 2016] irs reform: politics as usual? 61 (1) [t]he irs delayed or refused to issue determination letters to certain organizations either because the organization was perceived to represent views that were opposed to the clinton administration or because individual irs employees were opposed to the views of the organization; [and] (2) [t]he irs inappropriately granted determination letters or expedited the granting of determination letters for organizations whose political views were in line with those of the clinton administration . . . .210 at the request of senator roth and others, the joint committee on taxation investigated the allegations and issued a report.211 it found no evidence to support the allegations. 212 instead, the joint committee found that, for technical reasons, some determination letter applications took longer than others for the irs to process. specifically, those that were not “approved by a technical screener on the basis of information contained in the application” and those that were forwarded to the irs’s national office in washington, d.c. took much longer.213 the report also found no evidence that the screening process was used selectively or in a manner intended to subject organizations with views contrary to the clinton administration to more scrutiny.214 according to the report, although determination-letter applications followed different paths, these differences were not politically motivated. rather, they resulted from: (1) [d]ifferences in the statements made by organizations on their determination letter applications as to the organizations’ purposes, (2) the failure of irs employees to understand the circumstances under which determination letter applications should be forwarded to the irs national office, and (3) differences in information provided to the irs relating to potential operations of the organizations in question.215 however, the report noted its concern that the different paths the applications took could create the appearance of bias.216 the joint committee determined that “the move by the irs to centralize the processing of determination letter requests in a single irs key district office may address certain of the problems identified by the joint committee staff.”217 ironically, sixteen years later, tigta found that irs employees in that office in cincinnati had created exactly the problem the joint committee thought in 2000 a centralized office would solve.218 iv. irs reform in controversy 210 id. at 12–13. 211 id. at 1. 212 id. at 14–15. 213 id. 214 id. at 15. 215 id. 216 id. at 16. 217 id. 218 see supra text accompanying notes 91–93. in fact, the 1998 reform may have contributed to the problem because “[f]ollowing reorganization, many highly trained lawyers in washington who previously handled the most sensitive nonprofit applications were reassigned to focus on special projects . . . .” barker & elliot, supra note 79 (reporting statement of paul streckfus, a former irs attorney). 62 columbia journal of tax law [vol.7:36 it is too soon to tell what the long-term effect on the irs will be from the recent congressional hearings and 2015 irs reform legislation. however, the outcome of the 1998 irs reform, which followed similarly inflammatory hearings, may provide some useful lessons. before turning to the irs reforms congress made at the end of 2015, the next section examines the effects of the 1998 irs reform. a. the 1998 reform not surprisingly, the highly publicized 1997 and 1998 hearings, with their allegations of shocking abuses perpetrated by the irs, resulted in strong public support for major changes in irs procedures and operations.219 the hearings deeply embarrassed the irs and “did little to assure respect for either the income tax or the agency assigned to collect it.” 220 the hearings also proved very profitable for republicans, “attracting attention and campaign contributions.” 221 they also resulted in the creation of a commission, headed by william webster, to investigate the criminal investigation division of the irs.222 1. changes made by the irs reform act the irs reform act itself did many things. first and foremost, it required the irs to undertake a major structural reorganization, moving from a geography-based structure to one organized into four operating divisions based on taxpayer groups.223 this aligned with the vision of the incoming irs commissioner, charles rossotti.224 the 1998 act also enacted the taxpayer bill of rights iii, which has over seventy provisions, including restrictions on certain tax collections;225 and created a statutory list of “ten deadly sins” for which an irs employee would be fired.226 the irs reform act also established two new irs oversight bodies, the irs oversight board and tigta,227 bringing the total number of non-congressional irs watch 219 albert b. crenshaw, senate passes irs overhaul, wash. post, may 8, 1998, at a01, http:// www.washingtonpost.com/wp-srv/politics/special/tax/stories/irs050898.htm [https://perma.cc/s4er-wpav]. 220 guttman, supra note 34, at 13. 221 senate panel hears stories of alleged irs abuses, all politics (apr. 28, 1998), http://www .cnn.com/allpolitics/1998/04/28/irs.hearings [https://perma.cc/z6lm-cwwj]. 222 see stephen w. mazza, taxpayer privacy and tax compliance, 51 kan. l. rev. 1065, 1144 n.144 (2003) (discussing william webster’s report, which found that “no evidence of systematic or repeated disclosure violations by the irs criminal division existed”). for the report, see william h. webster, review of the internal revenue service’s criminal investigation division (april 1999), http:// permanent.access.gpo.gov/lps19053/27623d99.pdf [https://perma.cc/m9bd-yff8]. 223 thorndike, supra note 150, at 775–76. the geography-based structure that existed prior to the 1998 reform was the result of the previous restructuring, in 1952. id. at 762. before that, the irs had been organized by type of tax. id. 224 statement of charles o. rossotti, commissioner of internal revenue, before the senate finance committee, january 28, 1998, at 12, internal revenue serv. (jan. 28, 1998), https://www.irs.gov/pub/irsnews/ir-98-3.pdf [https://perma.cc/ew6x-68vv] (“[o]ne logical way to organize the irs is into four units, each charged with end-to-end responsibility for serving a particular group of taxpayers with similar needs.”). 225 thorndike, supra note 150, at 775–76. for examples of such restrictions, see pub. l. no. 105206, 112 stat. at 758–63 §§ 3421 (“approval process for liens, levies, and seizures”), 3433 (“levy prohibited during pendency of refund proceedings”), 3441 (“prohibition of sales of seized property at less than minimum bid”), 3445 (“procedures for seizure of residences and businesses”). 226 pub. l. no. 105-206, § 1203, 112 stat. at 720–22; see also lederman, supra note 37, at 981. 227 see irs oversight bd., faq, q&a 1, dep’t of the treasury, http://www.treasury.gov/irsob /faqs/pages/default.aspx#q1 [https://perma.cc/arz2-gqwf]; tigta, home page, dep’t of the treasury, http://www.treasury.gov/tigta [https://perma.cc/wed4-ys3z] (“the treasury inspector general for tax administration (tigta) was established under the irs restructuring and reform act of 1998 to provide independent oversight of irs activities.”) [hereinafter tigta, home page]. 2016] irs reform: politics as usual? 63 dogs to nine.228 tigta’s website states that it was established, among other things, “to provide independent oversight of irs activities” and to prevent “fraud, waste, and abuse within the irs and related entities.”229 it was tigta’s 2013 report that gave rise to the 501(c)(4) controversy.230 the 1998 act also took a few steps to address the technology problems that served as the initial catalyst for reform.231 commissioner rossotti was particularly concerned about the technology issue.232 under rossotti’s leadership, the irs launched a computer modernization effort, outsourcing the project to computer sciences corp. (csc) in 1999.233 however, at a 2004 congressional hearing, testimony suggested that although the modernization project had produced some results, it had been beset with “significant delays and cost over-runs.”234 in the same year, then-commissioner rossotti admitted in an 228 the irs lists its non-congressional oversight organizations as including the following eight entities: (1) the gao; (2) the office of management and budget; (3) tigta; (4) the electronic tax administration advisory committee (etaac); (5) the information reporting program advisory committee (irpac); (6) internal revenue service advisory council (irsac); (7) the taxpayer advocacy panel (tap); and (8) the irs oversight board. internal revenue serv., irs oversight organizations, internal revenue serv., http://www.irs.gov/uac/irs-oversight-organizations [https://perma.cc/a7kf-4fvp] (last updated feb. 23, 2015) (listing etaac, irpac, irsac, tap, and the irs oversight board as “advisory/advocacy organizations”). the national taxpayer advocate also exercises an oversight function. see samuel d. brunson, watching the watchers: preventing i.r.s. abuse of the tax system, 14 fla. tax rev. 223, 245 (2013) (“the principal oversight mechanisms congress has established [for the irs] are the office of the taxpayer advocate and the internal revenue service oversight board.”). the irs oversight board is now largely defunct because the u.s. senate has not filled vacancies on the board, so it does not currently have enough members to constitute a quorum. see u.s. treasury, irs oversight board, dep’t of the treasury, http://www.treasury.gov/irsob/pages/default.aspx [https://perma.cc/ab85-g9l6]. however, other oversight bodies are quite active. for example, the gao released at least 15 reports on the irs from january to september 2015. see u.s. gov’t accountability office, search for “irs”, http://www.gao.gov/search ?rows=10&now_sort=score+desc&page_name=main&search_type=solr&o=0&path=&facets=&adv_begin_ date=&adv_end_date=&adv=0&advanced=&q=irs [https://perma.cc/ab85-g9l6]. during the same 9month period in 2015, tigta released at least 47 audit reports. tigta, audit reports: fy – 2015, dep’t of the treasury, https://www.treasury.gov/tigta/oa_auditreports_fy15.shtml [https://perma.cc/z2xu-3nky] (last updated oct. 15, 2015). 229 tigta, home page, supra note 227 (also stating that it was established to “promote[] the economy, efficiency, and effectiveness in the administration of the internal revenue laws”). 230 see supra part ii. 231 the irs reform act amended code section 7802 to provide that members of the irs oversight board would be selected on the basis of factors including their professional experience and expertise in the area of information technology. internal revenue service restructuring and reform act of 1998, pub. l. no. 105-206, 112 stat. 685, § 1101(a). it amended section 7803 to require tigta to annually evaluate the “adequacy and security” of irs technology. id. § 1102(a). it also instructed the secretary of the treasury to convene an electronic commerce advisory group to advise on the development of e-filing. id. § 2001(b)(2). in addition, it required the joint committee on taxation to report annually between 1998 and 2004 on the status of the irs technology modernization project. id. § 4002. 232 karen kaplan, bringing the irs into the 21st century, l.a. times (june 27, 1999), http:// articles.latimes.com/1999/jun/27/business/fi-50556 [https://perma.cc/p2uy-mzw8] (discussing how commissioner rossotti’s technological “vision represents a dramatic change from the hodgepodge of computer systems that store taxpayer records today”). 233 id. (stating below the headline, “computer sciences embarks on modernizing the computer systems that enable the agency to collect $1.7 trillion and deal with its millions of taxpaying ‘customers.’”). 234 irs efforts to modernize its computer systems: hearing before the s. comm. on oversight of the comm. on ways and means, 108th cong. (2004) (statement of rep. amo houghton, chairman, s. comm. on oversight), http://www.gpo.gov/fdsys/pkg/chrg-108hhrg93550/html/chrg-108hhrg93550.htm [https://perma.cc/8dwc-4a7n]. 64 columbia journal of tax law [vol.7:36 interview that irs computer modernization remained a “serious problem.”235 the irs has not made significant strides in this regard since, as discussed below.236 2. the fallout of the 1998 reform one result of the irs reform act was a sharp downturn in collection activity for several years. audit rates, tax lien filings, levy notices served on third parties, and seizures237 all dropped dramatically starting around the 1998 fiscal year, as shown in table 1.238 in addition, as professor leslie book has explained, in 1999, the irs started to defer collection activity on billions of dollars in taxes, and, by september 2002, had deferred action on approximately one in three cases.239 235 interview with charles rossotti, irs commissioner, on pbs frontline (feb. 19, 2004), http:// www.pbs.org/wgbh/pages/frontline/shows/tax/interviews/rossotti.html [https://perma.cc/4mfn-8ybr]. in 2007, the irs recognized “limitations of [its] existing computer systems and technical infrastructure,” and detailed its information-technology development plan for the next several years. internal revenue serv., it modernization vision & strategy 6 (2007), http://www.irs.gov/pub/newsroom/mvs-10-07.pdf [https:// perma.cc/aj4z-2md6]. in 2012, the irs discontinued its contract with csc. jonathon o’connell, computer sciences corp. shedding hundreds of jobs in prince george’s county, wash. post (nov. 1, 2013), http://www.washingtonpost.com/business/capitalbusiness/computer-sciences-corp-shedding-hundredsof-jobs-in-prince-georges-county/2013/10/31/c34e2de8-4175-11e3-8b74-d89d714ca4dd_story.html [https:// perma.cc/akw2-pzjn]. 236 see infra text accompanying notes 316–320. 237 “in [internal revenue] service jargon, a ‘seizure’ is what is done to something that can be sold, usually tangible realty or personalty, while a ‘levy’ is done to something that cannot be sold, generally intangible property such as payments due the taxpayer from a third party, or money.” bryan t. camp, the failure of adversarial process in the administrative state, 84 ind. l.j. 57, 67 n.45 (2008). 238 for similar statistics for fiscal years 2006 through 2014, see infra text accompanying note 249. for additional tables showing collection figures over a multi-year period spanning the enactment of the 1998 act, see lederman, supra note 37, at 984–88. 239 leslie book, the collection due process rights: a misstep or a step in the right direction?, 41 hous. l. rev. 1145, 1148 n.9 (2004). 2016] irs reform: politics as usual? 65 table 1: irs enforcement statistics for fiscal years 1994–2005240 fiscal year audit rate for individual income tax returns notices of federal tax lien (rounded) notices of levy (rounded) seizures 1994 1.07% 813,000 2,935,000 10,000 (rounded) 1995 1.67% 799,000 2,722,000 11,000 (rounded) 1996 1.67% 750,000 3,109,000 10,000 (rounded) 1997 1.28% 544,000 3,659,000 10,090 1998 0.99% 383,000 2,503,000 2,259 1999 0.90% 168,000 504,000 161 2000 0.49% 288,000 220,000 74 2001 0.58% 428,000 447,000 255 2002 0.57% 483,000 1,284,000 296 2003 0.54% 544,000 1,681,000 399 2004 0.62% 534,000 2,030,000 440 2005 0.75% 523,000 2,744,000 512 as this table reflects, the most dramatic decline was in seizures of property: the irs went from approximately 10,000 seizures per year in the mid-1990s to just seventyfour at the low point in 2000. seizures have never returned to their pre-1998 levels.241 although the drop in seizures was particularly dramatic, it is just part of a general picture of a reduction in irs enforcement activities during this time period. the perception that the irs was toothless probably contributed to the proliferation of aggressive tax shelters in 240 for the sources of the table’s statistics, see internal revenue serv., soi tax stats delinquent collection activities irs data book table 16 (2002-2010), https://www.irs.gov/uac/soitax-stats-delinquent-collection-activities-irs-data-book-table-16 [https://perma.cc/u2n5-4rlg]; internal revenue serv., soi tax stats examination coverage: recommended and average recommended additional tax after examination irs data book table 9a (2002), https://www.irs .gov/uac/soi-tax-stats-examination-coverage-recommended-and-average-recommended-additionaltax-after-examination-irs-data-book-table-9a [https://perma.cc/8369-btua]; internal revenue serv., soi tax stats archive 1863 to 1999 annual reports and irs data books table 11 (1995), https:// www.irs.gov/uac/soi-tax-stats-archive-1863-to-1999-annual-reports-and-irs-data-books [https://perma .cc/6yx7-4lt2]; internal revenue serv., soi tax stats delinquent collection activities irs data book table 16 (1994-2001), https://www.irs.gov/uac/soi-tax-stats-delinquent-collectionactivities-irs-data-book-table-16 [https://perma.cc/5g6m-96lu]; internal revenue serv., soi tax stats 2003 irs data book table 10 (revised) (2003), https://www.irs.gov/pub/irs-soi/03db10ex.xls; internal revenue serv., soi tax stats 2004 irs data book table 10 (revised) (2004), https://www .irs.gov/pub/irs-soi/04db10ex.xls; internal revenue serv., soi tax stats 2005 irs data book table 10 (revised) (2005), https://www.irs.gov/pub/irs-soi/05db10ex.xls; gov’t acct. off., report to the chairman, subcommittee on oversight, committee on ways and means, house of representatives, tax administration: audit trends and results for individual taxpayers 18 tbl. i.1 (1996), http:// www.gao.gov/archive/1996/gg96091.pdf [https://perma.cc/ub2y-c5rn]. 241 see infra text accompanying note 249 (reporting seizure statistics for fiscal years 2006 through 2014). 66 columbia journal of tax law [vol.7:36 the late 1990s.242 david cay johnston has aptly described the irs reform act as having “handcuffed the tax police.”243 there were several reasons for the decline in irs enforcement activity. first, the restructuring itself took years and significant resources.244 second, the irs needed to shift substantial resources from collection to “customer service” to comply with the requirements of the act.245 in part, it detailed employees from enforcement to service positions,246 resulting in a substantial reallocation of staff from enforcement to service for several years.247 third, some collections employees feared the strict penalty of the ten deadly sins and found it safer to do nothing than to try to collect taxes from recalcitrant taxpayers.248 subsequently, there was an uptick in enforcement during the 2009 through 2011 fiscal years, then enforcement statistics began declining again. those statistics are not only at lower levels than they were in 2006, as shown in the next table, they are below where they were in the mid-1990s, before the irs reform act.249 242 see tanina rostain & milton c. regan, jr., confidence games: lawyers, accountants, and the tax shelter industry 244 (2014) (noting that irs reform “created an environment in which any attempt to identify and challenge tax shelters would run into both resource constraints and concern about engaging in activity that could anger taxpayers and get the agency hauled before congress once again”); id. at 331 (“treasury officials were preoccupied with dealing with a hostile congress and attempting to modernize irs operations. . . . for some tax professionals involved in shelter activity, the fact that shelters were low on the government’s priority list meant that they were not going to be caught if they engaged in promoting highly questionable deals.”). 243 david cay johnston, perfectly legal: the covert campaign to rig our tax system to benefit the super rich—and cheat everybody else 150 (2003). 244 see william hoffmann, 15 years after rra ‘98: time to re-restructure the irs?, 140 tax notes 647 (2013) (describing how the process took years, as each new division and function “stood up” at different times). 245 patti mohr, compliance problems top priority, rossotti says, 91 tax notes 206, 206 (2001) (“the agency’s ability to enforce compliance fell [in 2000] because of a long-term decline in staffing and a shift toward staffing customer service positions.”). 246 see james r. white, gen. acct. off., gao-02-674, report to the chairman, subcommittee on oversight, committee on ways and means, house of representatives, tax administration: impact of compliance and collection program declines on taxpayers (may 22, 2002), lexis, 2002 tnt 126-60 (“in response to the . . . demands, and with a declining pool of staff resources, irs reallocated staff from compliance (other than returns processing) and collection programs to provide additional support to taxpayer assistance services.”). 247 dep’t of the treasury, management advisory report: analysis of trends in compliance activities through fiscal year 2001, ref. no. 2002-30-184, at 14 (sept. 2002). a staff year is 2000 hours. dep’t of the treasury, management advisory report: the internal revenue service’s response to the falling level of income tax examinations and its potential impact on voluntary compliance, ref. no. 2002-30-092, at 9 n.9 (june 2002) (reporting such reallocation of 265 staff years in 1997; 491 in 1998; 755 in 1999; and 974 in 2000). 248 see joint comm. on tax’n, no. jcx-53-03, report relating to the internal revenue service as required by the irs reform and restructuring act of 1998, at 45 (2003), http://www.jct .gov/x-53-03.pdf [https://perma.cc/444x-7ls8] (“the irs reports that since enactment of section 1203, irs employees frequently report that fear of a section 1203 allegation causes reluctance to take appropriate enforcement actions.”). see also hoffman, supra note 244 (“‘[n]ot only did you have the prohibition on using enforcement statistics to evaluate employees, but you also had these 10 deadly sins where the employees were very concerned that if they tried to do their job or they tried to take enforcement, then an allegation would be made about them and they would be fired,’ according to a senior tigta official.”). 249 see supra text accompanying note 238. 2016] irs reform: politics as usual? 67 table 2: irs enforcement statistics for fiscal years 2006–2014250 fiscal year audit rate for individual income tax returns notices of federal tax lien notices of levy seizures 2006 0.80% 629,813 3,742,276 590 2007 0.90% 683,659 3,757,190 676 2008 1.00% 768,168 2,631,038 610 2009 1.00% 965618 3,478,181 581 2010 1.11% 1,096,376 3,606,818 605 2011 1.11% 1,042,230 3,748,884 776 2012 1.03% 707,768 2,961,162 773 2013 0.96% 602,005 1,855,095 547 2014 0.86% 535,580 1,995,987 432 b. the 2015 legislative reforms congress followed up the inflammatory hearings that began in 2013 with legislation at the end of 2015. the consolidated appropriations act, 2016, contained various restrictions on the irs, including a subtitle termed “internal revenue service reforms,” part of the included path act of 2015.251 although some reforms focused on other issues,252 several of the reforms focus on issues aired in congressional hearings, including alleged “targeting” by the irs based on political views. in particular, the path reforms include an amendment to the ten deadly sins, for which the sanction is termination of employment, to add to the tenth sin a prohibition of “performing, delaying, or failing to perform (or threatening to perform, delay, or fail to perform) any official action (including any audit) with respect to a taxpayer for purpose of extracting personal gain or benefit or for a political purpose.”253 this amendment directly links the 2015 reform to a provision of the 1998 irs reform that was widely criticized as deterring irs collection employees from doing their job.254 250 internal revenue serv., soi tax stats delinquent collection activities irs data book table 16, https://www.irs.gov/uac/soi-tax-stats-delinquent-collection-activities-irs-data-booktable-16 [https://perma.cc/um7s-bhsq] (individual spreadsheets for 2011-2014 and combined spreadsheet for 2002-2010); internal revenue serv., soi tax stats examination coverage: individual income tax returns examined irs data book table 9b, https://www.irs.gov/uac/soi-tax-stats-examinationcoverage-individual-income-tax-returns-examined-irs-data-book-table-9b [https://perma.cc/7z8rqnfg] (individual spreadsheets for 2008-2014); internal revenue serv., soi tax stats 2007 irs data book table 9 (revised), https://www.irs.gov/uac/soi-tax-stats---2007-irs-data-book---table-9(revised) [https://perma.cc/m465-3dvj]; internal revenue serv., soi tax stats 2006 irs data book table 10 (revised) (2006), https://www.irs.gov/pub/irs-soi/06db10revised.xls. 251 consolidated appropriations act, 2016, pub. l. no. 114-113, div. q, tit. iv, subtit. a (2015), https://www.congress.gov/114/bills/hr2029/bills-114hr2029enr.pdf [https://perma.cc/qux5-8e7t]. 252 for example, the path act allows victims of irs wrongdoing, such as unauthorized disclosure of confidential tax information, to find out facts such as whether the case has been referred to the department of justice for criminal prosecution. id. § 403. 253 id. § 407. 254 see barton massey, uncertainty, “deadly sins” sink morale at irs, ex-official claims, 85 tax notes 1364, 1364 (1999); supra note 248 and accompanying text. 68 columbia journal of tax law [vol.7:36 the 2015 appropriations law also includes a restriction on using funds made available in the bill “to target citizens of the united states for exercising any right guaranteed under the first amendment to the constitution of the united states”255 and a similar prohibition on the use of such funds “to target groups for regulatory scrutiny based on their ideological beliefs.”256 the wording of these reforms could suggest that congress believes that the irs engaged in politically motivated targeting despite the findings of the doj, fbi, and tigta.257 the path act reforms also include several sections applicable to tax-exempt organizations. one of these is the provision mentioned above,258 which provides an expedited process for determination of exempt status under section 501(c)(4).259 it requires nonprofits seeking exemption under code section 501(c)(4) to file a one-page notice of registration within 60 days after the organization is formed.260 that provision also requires the irs to respond within 60 days acknowledging receipt of the form.261 the new process seems directed at the irs’s delays in approving the applications of potentially political groups. it adopts a different approach than the irs did to expediting applications.262 the one-page notice apparently is not intended to allow the irs to vet the organization’s qualification under code section 501(c)(4). instead, the new law requires the organization to submit with its first return such information as the irs may require to support the organization’s claim to exemption under section 501(c)(4). 263 the new procedure will thus generally delay consideration of the organization’s qualifications until after the organization files its first return. the new law also creates some rights for tax-exempt organizations. one provision requires the irs to create a procedure under which an organization facing a determination that it fails to qualify (or to continue to qualify) as tax-exempt under section 501(c) may appeal to the irs appeals office.264 this creates a procedural right in the form of an administrative appeal. another provision allows section 501(c)(4) and other exempt organizations to seek a declaratory judgment in federal court regarding their initial qualification or revocation of tax-exempt status.265 this is an extension of a provision applicable to other tax-exempt organizations, such as 501(c)(3) organizations.266 the declaratory judgment procedure requires exhaustion of administrative remedies.267 the bill also contains a moratorium during 2016 on issuing or revising “guidance not limited to a particular taxpayer relating to the standard which is used to determine whether an organization is operated exclusively for the promotion of social welfare for 255 pub. l. no. 114-113, div. e, tit. i, § 107 (2015). 256 id. § 108. 257 see supra text accompanying notes 138–141. 258 see supra text accompanying note 149. 259 pub. l. no. 114-113, div. q, tit. iv, subtit. a, § 405 (2015) (“organizations required to notify secretary of intent to operate under 501(c)(4)”). 260 id. 261 id. 262 see supra text accompanying notes 145–146. 263 pub. l. no. 114-113, div. q, tit. iv, subtit. a, § 405(b) (2015). 264 id. § 404. another reform in the path act provides that the federal gift tax does not apply to transfers to 501(c)(4), 501(c)(5), and 501(c)(6) organizations. id. div. q, tit. iv, subtit. a, § 408. 265 id. § 406. 266 see i.r.c. § 7428(a)(1)(a) (2012) (referring to “an actual controversy . . . with respect to the initial qualification or continuing qualification of an organization as an organization described in section 501(c)(3)”). 267 id. § 7428(b)(2). 2016] irs reform: politics as usual? 69 purposes of section 501(c)(4).”268 the bill further provides that the standards as in effect on january 1, 2010 are to apply.269 congress has imposed moratoria on the development of substantive law in the past.270 such restrictions may impose difficulties on the irs, such as “undermining public confidence in the fairness of the tax laws.”271 the path act also prohibits irs employees from using personal email accounts for government business. 272 lois lerner apparently had done so. 273 a report accompanying h.r. 1152 stated: “notwithstanding internal irs policy, the committee’s investigation of the agency’s targeting practices revealed that the former director of the irs exempt organizations division, lois lerner, among others, conducted official business involving taxpayer information, using a personal email account.”274 the report explained that irs policies restrict the use of personal email accounts because of concerns about irs accountability and the confidential and sensitive nature of irs information.275 nonetheless, because the committee was concerned that irs employees continued to use personal email accounts for official business in spite of irs policy, “a statutory ban on use of nongovernmental email accounts by irs employees conducting official business is necessary.”276 however, the path act fails to provide a penalty for violation of the prohibition.277 the path act reforms also include codification of the bill of rights the irs adopted in 2014, in that the path act requires the commissioner of the irs to “ensure that employees of the internal revenue service are familiar with and act in accord with taxpayer rights” that include the ten listed.278 these rights include such things as “the right to be informed” and “the right to quality service.”279 these statutory rights are different than the provisions congress included in the taxpayer bill of rights iii, which was part of the irs reform act and generally related to procedural issues. 280 the 268 pub. l. no. 114-113, div. e., tit. i, § 127. in 2013, treasury had proposed a regulation attempting to provide more definitive guidance on what constitutes political activity that does not promote social welfare. see prop. treas. reg. § 1.501(c)(4)-1(a)(2)(ii) & (iii), 78 fed. reg. 71535–42 (nov. 29, 2013), https://www.gpo.gov/fdsys/pkg/fr-2013-11-29/pdf/2013-28492.pdf [https://perma.cc/w3cmqmes]. 269 pub. l. no. 114-113, div. e., tit. i, § 127. 270 see archie parnell, congressional interference in agency enforcement: the irs experience, 89 yale l.j. 1360, 1370–72 (1980) (providing several examples). 271 id. at 1375. 272 pub. l. no. 114-113, div. q, tit. iv, subtit. a, § 402 (2015) (“no officer or employee of the internal revenue service may use a personal email account to conduct any official business of the government.”). 273 see stephen dinan, lois lerner had yet another private email!, wash. times (sept. 1, 2015), http://www.washingtontimes.com/news/2015/sep/1/irs-reveals-another-private-email-account-for-lois/?page= all [https://perma.cc/5c2z-n3zy] (“lois g. lerner used yet another private email account to do government business, the irs revealed in a court filing late monday . . . . the lawyers withheld the name and address of the new account but said it’s different than the ‘toby miles’ account they revealed in a previous court filing last week.”). 274 report to accompany h.r. 1152, irs email transparency act, 114 h. rep. 69, 2 (2015). 275 id. at 4. 276 id. 277 see pub. l. no. 114-113, div. q, tit. iv, subtit. a, § 402 (2015). 278 id. § 401; irs adopts “taxpayer bill of rights;” 10 provisions to be highlighted on irs.gov, in publication 1, ir-2014-72 (june 10, 2014), https://www.irs.gov/uac/newsroom/irs-adopts-taxpayer-billof-rights%3b-10-provisions-to-be-highlighted-on-irsgov,-in-publication-1 [https://perma.cc/w4tr-3jlf]. 279 irs adopts “taxpayer bill of rights, supra note 278. 280 pub. l. no. 105-206, 112 stat. 685, § 3000 (“this title may be cited as the ‘taxpayer bill of rights 3’”; title included such things as a new burden of proof statute, an increase in the dollar limit for u.s. 70 columbia journal of tax law [vol.7:36 codification of rights recently adopted by the irs means that congress wanted to elevate those rights to statutory law, perhaps indicating that it did not want the irs to have the power to change them. although the main focus of the irs controversy was the irs treatment of 501(c)(4) organizations, tigta had also issued a negative report regarding the irs’s spending on conferences and videos.281 recent funding bills include restrictions on spending on those activities. with respect to conferences, the funds congress appropriated for 2015 and 2016 cannot be spent on “conferences that do not adhere to the procedures, verification processes, documentation requirements, and policies issued by the chief financial officer, human capital office, and agency-wide shared services.”282 the appropriations bills for 2014 through 2016 prohibit any use of the bill’s funding for irs videos “unless the servicewide video editorial board determines in advance that making the video is appropriate, taking into account the cost, topic, tone, and purpose of the video.”283 c. political reform a well-known problem with crisis-based reform is that it is ill-suited to deliberation and moderation, so it is prone to producing an overcorrection.284 the 1998 irs reform manifested that tendency in such things as the ten deadly sins, which reportedly chilled irs employee motivation to collect taxes.285 irs reform following a perceived scandal is also likely to be focused on reining in the irs, not on looking at the whole picture, including whether the irs has sufficient funding to effectively carry out all of the duties congress has given it. as in 1998, congress followed up the sensational irs hearings of 2013 with cuts to an already declining irs’s budget.286 congress gave the irs less funding for 2015 than it requested, less funding than it had the prior year, and less funding in absolute dollars than it had in 2010.287 for 2016, congress left the irs’s base funding unchanged but added $290 million tax court cases to be heard as small tax cases, and a new statute providing relief from joint and several liability for “innocent spouses.”). 281 see supra note 39. 282 pub. l. no. 114-113, div. e, tit. i, § 109; pub. l. 113-235, 128 stat. 2130, 2338-39, div. e, tit. i, § 109. 283 pub. l. no. 114-113, div. e, § 105; pub. l. 113-235, div. e, tit. i, § 105 (2014); pub. l. 113-76, 128 stat. 5, 190 div. e, tit. i, § 105 (2014). the irs created the service-wide video editorial board in february 2013. tigta, review of sb/se conference, supra note 39, at 15 (irs management’s response to tigta recommendation 6). 284 cf. dodd-frank act and regulatory overreach: hearing before the subcomm. on oversight and investigations, 114th cong. 5 (2015) (prepared statement of paul g. mahoney) (discussing the perils of crisis-based financial reform); j.r. spencer, legislate in haste, repent at leisure, 69 cambridge l.j. 19, 19 (2010) (“in response to monday’s ‘scandal’ comes tuesday’s ministerial ‘pledge’ and on wednesday this is followed by an instant bill, rushed through parliament with inadequate debate.”). 285 see massey, supra note 254. 286 see infra note 291 for figures on the irs’s budget in absolute dollars, which show a decline after 1995 each year through 1998. 287 see irs must use resources more efficiently, inspector general says, 15 tax notes today 38–42 (feb. 25, 2015) (“in fy 2014, the irs budget was approximately $11.3 billion in appropriated resources, $850 million less than its fy 2010 level. . . . the irs’s approved budget for fy 2015 was further reduced to $10.9 billion, resulting in a cut of approximately $346 million in appropriated resources from fy 2014.”). 2016] irs reform: politics as usual? 71 directed to taxpayer services, prevention of tax refund fraud, and enhanced cybersecurity.288 this did not bring the irs’s funding even up to its 2014 level.289 in inflation-adjusted dollars, the irs’s 2015 budget was approximately eighteen percent lower than it was in 2010.290 in fact, in inflation-adjusted dollars, the irs’s budget is comparable to 1998. 291 in 2014, the internal revenue service advisory council 288 consolidated appropriations act, 2016, pub. l. no. 114-113 tit. iv, div. e, tit. i, § 113; see also house appropriations committee, fy 2016 omnibus – financial services appropriation, http:// appropriations.house.gov/uploadedfiles/12.15.15_fy_2016_omnibus_-_financial_services_-_summary.pdf [https://perma.cc/9j8m-g59c] (“the legislation includes the 2015 level of $10.9 billion for base irs activities, but provides an additional $290 million targeted solely for taxpayer services . . . . in total, this is a reduction of $1.7 billion from the president’s request for the agency.”). 289 the irs’s 2016 budget is $11.235 billion ($290 million over its 2015 budget). see consolidated appropriations act, 2016, pub. l. no. 114-113, div. e, tit. i, § 113; see also house appropriations committee, fy 2016 omnibus – financial services appropriation, http://appropriations.house.gov /uploadedfiles/12.15.15_fy_2016_omnibus_-_financial_services_-_summary.pdf [https://perma.cc/9j8mg59c]. the irs’s budget for 2014 was slightly higher, at $11.291 billion. see u.s. dep’t of treas., budget in brief fy 2015, at 1 (2014), https://www.treasury.gov/about/budget-performance/budget-in-brief /documents/treasury_fy_2015_bib.pdf [https://perma.cc/s9yn-hrzn]. its budget for 2015 was $10.945 billion. internal revenue serv., program summary by appropriations account and budget activity 1 (2015), https://www.irs.gov/pup/newsroom/irs%20budget%20in%20brief%20fy%202016 .pdf [https://perma.cc/b8xb-ktcz]. 290 chuck marr et al., irs funding cuts continue to compromise taxpayer service and weaken enforcement, ctr. on budget & policy priorities (sept. 30, 2015), http://www.cbpp.org/research/federaltax/irs-funding-cuts-continue-to-compromise-taxpayer-service-and-weaken-enforcement [https://perma.cc /gge5-3t6r]. 291 written testimony of john a. koskinen, commissioner, internal revenue service, before the senate finance committee on irs budget and current operations, internal revenue serv. (feb. 3, 2015), https://www.irs.gov/pup/newsroom/written_testimony_of_commissioner_koskinen_before_the_senate _finance_committee_on_irs_budget_and_current_operations.pdf [https://perma.cc/yr37-3vct]. the chart below shows the irs’s budget over the past 22 years in both absolute and constant (2016) dollars. 72 columbia journal of tax law [vol.7:36 fiscal year irs budget (absolute dollars, in thousands) irs budget in inflationadjusted (2016) dollars (in thousands) 1994 $7,340,000 $11,743,554 1995 $7,474,000 $11,628,396 1996 $7,348,000 $11,104,472 1997 $7,206,000 $10,645,619 1998 $7,804,829 $11,353,441 1999 $8,245,797 $11,735,709 2000 $8,256,272 $11,368,484 2001 $9,003,000 $12,060,510 2002 $9,485,000 $12,501,378 2003 $9,845,000 $12,686,727 2004 $10,185,000 $12,784,413 2005 $10,236,000 $12,427,385 2006 $10,573,706 $12,436,220 2007 $10,597,065 $12,118,532 2008 $10,892,384 $11,995,672 2009 $11,522,598 $12,735,028 2010 $12,146,123 $13,207,522 2011 $12,121,830 $12,777,772 2012 $11,816,696 $12,203,579 2013 $11,198,611 $11,398,300 2014 $11,290,612 $11,308,497 2015 $10,945,000 $10,949,341 2016 $11,235,000 $11,235,000 the irs budget figures are from the following sources: u.s. gen. acct. off., gao/ggd-94-129, analysis of irs’ budget request for fiscal year 1995, at 8 (1994), http://www.gao.gov/assets/220 /219481.pdf [https://perma.cc/sy2c-5bn6] (1994 budget, rounded); irs budget proposal for fiscal year 1996 and 1995 tax return filing season: hearing before the subcomm. on oversight of the h. comm. on ways and means, 104th cong. 2–3 (1995), https://www.gpo.gov/fdsys/pkg/chrg-104hhrg90652/pdf /chrg-104hhrg90652.pdf [https://perma.cc/99t7-yb52] (1995 budget, rounded); u.s. gen. acct. off., gao/t-ggd/aimd-97-66, irs’ fiscal year 1997 spending, 1997 filing season, and fiscal year 1998 budget request 5 (1997), http://www.gao.gov/assets/110/106787.pdf [https://perma.cc/86bb-ltm5] (1996 and 1997 budgets, rounded); u.s. gen. acct. off., gao/t-ggd/aimd-98-114, irs’ fiscal year 1999 budget request and fiscal year 1998 filing season 26 (1998), http://www.gao.gov/assets/110 /107350.pdf [https://perma.cc/a7xn-ccnr] (1998 budget); u.s. gen. acct. off., gao/t-ggd/aimd-99140, irs’ fiscal year 2000 budget request and 1999 tax filing season 28 (1999), http://www.gao.gov /assets/110/107859.pdf [https://perma.cc/gc3b-lqn5] (1999 budget); u.s. gen. acct. off., gao/tggd/aimd-00-133, irs’ 2000 tax filing season and fiscal year 2001 budget request 24 (2000), http://www.gao.gov/assets/110/108348.pdf [https://perma.cc/v9hc-bn2k] (2000 budget); u.s. dep’t of treas., the budget for fiscal year 2005, at 279, https://www.gpo.gov/fdsys/pkg/budget-2005-bud /pdf/budget-2005-bud-25.pdf [https://perma.cc/4wwg-b26u] (2001 and 2003 budgets) (amounts rounded); u.s. dep’t of treas., the budget for fiscal year 2004, at 242, https://www.gpo.gov/fdsys/pkg /budget-2004-bud/pdf/budget-2004-bud-22.pdf [https://perma.cc/36fl-xw6z] (2002 budget, rounded); u.s. dep’t of treas., the budget for fiscal year 2006, at 260, https://www.gpo.gov/fdsys/pkg /budget-2006-bud/pdf/budget-2006-bud-24.pdf [https://perma.cc/c4rp-j5uv] (2004 budget, rounded); u.s. dep’t of treas., the budget for fiscal year 2007, at 236, https://www.gpo.gov/fdsys/pkg /budget-2007-bud/pdf/budget-2007-bud-22.pdf [https://perma.cc/maz3-jz8t] (2005 budget, 2016] irs reform: politics as usual? 73 (irsac)292 said, “in irsac’s view, the irs is in the midst of an existential funding crisis.”293 the gao reported that irs budget cuts resulted in an 11 percent decline in staffing between 2010 and 2014, with most of the reduction in enforcement.294 tigta—the same organization that conducted the 2013 investigation into the irs’s treatment of tea party groups—has reported that the reduction in the irs’s budget of almost $1.2 billion (in absolute dollars) between 2010 and 2015295 resulted in a smaller work force,296 reduced tax collections, 297 reduced case closures by revenue officers, 298 and reduced service to rounded); u.s. dep’t of treas., budget in brief fy 2008, at 1, https://www.irs.gov/pub/newsroom/budgetin-brief-2008.pdf [https://perma.cc/rk77-4qbj] (2006 budget); u.s. gov’t accountability off., gao07-719t, assessment of the 2008 budget request and an update of 2007 performance 7, http://www .gao.gov/assets/120/116547.pdf [https://perma.cc/9vwb-l42f] (2007 budget); u.s. gov’t accountability off., gao-08-567, fiscal year 2009 budget request and interim performance results of irs’s 2008 tax filing season 16, http://www.gao.gov/assets/280/273727.pdf [https://perma.cc/fx9x-bsbn] (2008 budget); u.s. dep’t of treas., budget in brief fy 2011, at 65, https://www.treasury.gov/about /budget-performance/budget-in-brief/documents/irs%20fy11%20508.pdf [https://perma.cc/s4r8-3bud] (2009 and 2010 budgets); u.s. dep’t of treas., budget in brief fy 2013, at 1, https://www.treasury.gov /about/budget-performance/budget-in-brief/documents/11.%20irs_508%20-%20passed.pdf [https://perma .cc/vjb6-65l3] (2011 and 2012 budgets); internal revenue serv. oversight bd., fy 2015 irs budget recommendation special report 19 (2014), https://www.treasury.gov/irsob/reports/documents/irsob %20fy2015%20budget%20report-final.pdf [https://perma.cc/al8h-usuc] [hereinafter irs oversight board, fy 2015] (fiscal year 2013 budget after sequestration); u.s. dep’t of treas., budget in brief fy 2015, at 61 (2014), https://www.treasury.gov/about/budget-performance/budget-in-brief/documents/treasury _fy_2015_bib.pdf [https://perma.cc/s9yn-hrzn] (2014 budget); internal revenue serv., program summary by appropriations account and budget activity 1 (2015), https://www.irs.gov/pup /newsroom/irs%20budget%20in%20brief%20fy%202016.pdf [https://perma.cc/b8xb-ktcz] (2015 budget); house appropriations committee, fy 2016 omnibus – financial services appropriation, http:// appropriations.house.gov/uploadedfiles/12.15.15_fy_2016_omnibus_-_financial_services_-_summary.pdf [https://perma.cc/9j8m-g59c] (2016 budget). inflation calculations were performed using us inflation calculator, http://www.usinflationcalculator.com [https://perma.cc/t3fb-spm3] (as of february 2016). 292 irsac was “[c]hartered to convey the public’s perception of the internal revenue service and its activities to the commissioner . . . .” internal revenue serv. advisory council, 2014 irsac general report, https://www.irs.gov/tax-professionals/2014-irsac-general-report [https://perma.cc /rj8k-7u3b] (last updated oct. 6, 2015). 293 id. 294 u.s. gov’t accountability office, gao-14-732, large partnerships: with growing number of partnerships, irs needs to improve audit efficiency 11 (2014), http://www.gao.gov/assets /670/665886.pdf [https://perma.cc/v6xr-h8z5] [hereinafter gao, irs needs to improve audit efficiency]. 295 treas. inspector gen. for tax admin., reduced budgets and collection resources have resulted in declines in taxpayer service, case closures, and dollars collected 1, dep’t of the treasury (may 8, 2015), https://www.treasury.gov/tigta/auditreports/2015reports/201530035fr.pdf [https://perma.cc/4fn4-ker4] [hereinafter tigta, reduced budgets]. the $1.2 billion reduction is more than a ten-percent decline in absolute dollars. id. in inflation-adjusted dollars, the irs’s funding in fiscal year 2015 is approximately seventeen percent below 2010. see catherine rampel, as congress cripples the irs, tax rates are likely to rise, wash. post (dec. 15, 2014), http://www.washingtonpost.com/opinions /catherine-rampell-as-congress-cripples-the-irs-tax-rates-are-likely-to-rise/2014/12/15/a7a30754-8476-11e4b9b7-b8632ae73d25_story.html [https://perma.cc/tm3a-jkal] (citing data from the center on budget and policy priorities). 296 see tigta, reduced budgets, supra note 295, at 2 (noting that in fiscal year 2012, the irs offered buyouts to 7,000 employees and 1,200 accepted, and that “[t]he irs also instituted an ‘exceptiononly’ hiring freeze, leaving many vacancies unfilled.”). 297 id. at 8. 298 id. at 13, 16. 74 columbia journal of tax law [vol.7:36 taxpayers.299 moreover, the irs’s per-employee expenditure on employee training in 2014 was less than 18 percent of what it was in 2010, in constant dollars.300 the irs is thus operating with a smaller workforce that also receives less training. meanwhile, its workload has increased. it is not only that the agency is dealing with new responsibilities such as those occasioned by the affordable care act.301 the irs also has more taxpayers to deal with.302 the number of individual tax returns filed increased by 6.6 million returns (4.67 percent) between 2010 and 2014.303 over the past twenty years, the number of returns filed by partnerships has increased 142 percent.304 from 2002 through 2011, the number of s corporations increased 32 percent, the total number of partnerships grew by 47 percent—and the number of large partnerships grew 257 percent—while the number of c corporations decreased only 22 percent.305 gao reported that the irs conducts few audits of large partnerships, 306 despite their potential high risk of noncompliance.307 the irs is also combatting a troubling wave of identity theft tax refund fraud.308 for example, the agency estimated that for 2013, it prevented approximately $24.2 billion in identity theft-based fraudulent refund claims but actually paid out $5.8 billion that it later determined had been fraudulently claimed.309 in fiscal year 2014, the irs assigned 299 id. at 10. reduced service includes increased telephone wait times. id. 300 david cay johnston, the cost of the shrinking irs budget, 2015 tnt 105-11 (june 2, 2015) (“adjusted to 2014 dollars, the irs spent $1,926 on training per employee in 2010, but just $339 last year.”). 301 see bryan camp, overlooked costs of irs budget cuts will hit taxpayers hardest, the conversation (april 14, 2015), http://theconversation.com/overlooked-costs-of-irs-budget-cuts-will-hittaxpayers-hardest-39762 [https://perma.cc/3j4p-lfzf] (“fy10 was . . . the year congress really began piling on the acronymic workload: ppaca (the official acronym for obamacare) and fatca (which required the irs to start investigating taxpayer foreign bank accounts).”). 302 since 1998, “the number of additional taxpayers the agency must help and oversee grew by some 16 million.” id. 303 see internal revenue serv., 2014 annual report to congress–vol. 1, nat’l taxpayer advocate 9 (2014), http://www.taxpayeradvocate.irs.gov/media/default/documents/2014-annual-report /volume-one.pdf [https://perma.cc/ps2z-bq76] (141.2 million individual tax returns were filed in fiscal year 2010, and 147.8 million filed in fiscal year 2014). 304 johnston, supra note 300. 305 gao, irs needs to improve audit efficiency, supra note 294, at 13–14 (2002 calculation performed by the author). 306 id. at 19 & n.24 (reporting a 4 percent audit rate when including “campus audits” and 0.8 percent rate of audits that involve looking at the partnership’s books and records). 307 id. at 21. in the 2015 budget bill, congress changed the audit procedures for large partnerships, to try to facilitate these audits. see bipartisan budget act of 2015, pub. l. 114-74, tit. xi, § 1101; michael cohn, budget deal makes it easier for irs to audit large partnerships, acct. today (nov. 2, 2015), http:// www.accountingtoday.com/blogs/debits-credits/news/budget-deal-makes-it-easier-for-irs-to-audit-largepartnerships-76285-1.html. however, congress did not provide additional funds for increased audits. see generally bipartisan budget act of 2015. 308 see irs intensifies work on identity theft and refund fraud; criminal investigation enforcement actions underway across the nation, internal revenue serv. (apr. 10, 2014), https://www .irs.gov/uac/newsroom/irs-intensifies-work-on-identity-theft-and-refund-fraud%3b--criminalinvestigation-enforcement-actions-underway-across-the-nation [https://perma.cc/w74v-fam8]. 309 u.s. gov’t accountability off., gao-15-119, identity theft and tax fraud: enhanced authentication could combat refund fraud, but irs lacks an estimate of costs, benefits and risks (2015), http://www.gao.gov/assets/670/667965.pdf [https://perma.cc/53dy-9wz9] (gao highlights preceding page 1). more recently, the irs announced that from january through november of 2015, it halted processing of 4.8 million suspicious returns and rejected 1.4 million identity theft returns claiming a total of $8 billion. states and tax industry combat identity theft and refund fraud on many fronts, fs-2016-1, internal revenue serv., https://www.irs.gov/uac/newsroom/irs,-states-and-tax-industry-combatidentity-theft-and-refund-fraud-on-many-fronts [https://perma.cc/9nlg-35j2]. 2016] irs reform: politics as usual? 75 3,000 employees to work on identity theft issues.310 budget cuts have hindered the irs in modernizing its fraud-detection systems, 311 however, so this remains an ongoing problem.312 moreover, this problem not only burdens the federal fisc, it burdens the taxpayers whose identities were used to claim fraudulent refunds.313 budget insufficiencies may also exacerbate the irs’s longstanding deficiencies in technology infrastructure. much of the irs’s current technology expenditures are still used for upgrades to systems built in the 1950s and 1960s.314 a lot of its newer technology is outdated, too. “thousands of employees are still using the windows xp operating system, which microsoft no longer supports.”315 irs technology limitations pose real problems for tax administration and confidential taxpayer data. a 2014 tigta report on the irs’s information technology found weaknesses in programs relating to risk management and the protection of federal tax information, among other things. 316 it also found that while some of the irs’s technology projects are on schedule and within budget, budget cuts may be negatively affecting other critical systems.317 the irs requested $3.2 billion, about 23 percent of its 2016 budget request, for information technology. 318 in its 2016 appropriations bill, 310 irs combats identity theft and refund fraud on many fronts, fs-2014-1, internal revenue serv., https://www.irs.gov/uac/newsroom/irs-combats-identity-theft-and-refund-fraud-on-many-fronts2014 [https://perma.cc/da7a-8765]. 311 see matt hunter, tax-refund fraud to hit $21 billion, and there's little the irs can do, cnbc (feb. 11, 2015), http://www.cnbc.com/2015/02/11/tax-refund-fraud-to-hit-21-billion-and-theres-littlethe-irs-can-do.html [https://perma.cc/4hlp-avbe]. 312 the consolidated appropriations act, 2016 reflects concern about tax-related identity theft. it requires at least $5 million of the $206 million given to taxpayer advocate services be spent on identity theft casework. pub. l. no. 114-113, div. e, tit. i. it also requires the irs to “institute and enforce policies and procedures that will safeguard the confidentiality of taxpayer information and protect taxpayers against identity theft.” id. div. e, tit. i, § 103. in addition, the path act permits employers to use “identifying numbers” instead of social security numbers on w-2 forms. id. div. q, tit. iv, subtit. a, § 409. the intention seems to be to permit the use of truncated social security numbers: the heading of section 409 of the bill is “extend internal revenue service authority to require truncated social security numbers on form w–2.” id. 313 see steve weisman, what the irs isn’t telling you about identity theft, usa today (jan. 30, 2016), http://www.usatoday.com/story/money/columnist/2016/01/30/what-irs-isnt-telling-you-identity-theft /79306984 [https://perma.cc/yv9z-dk56] (pointing out that, among the issues is the fact that, “[i]f you are the victim of income tax identity theft, it still takes an average of 278 days to resolve your claim and get your refund”). 314 jeanne sahadi, irs says it’s using technology from jfk’s time, cnn money (feb. 3, 2015, 6:38 pm), http://money.cnn.com/2015/02/03/pf/taxes/irs-budget-cuts [https://perma.cc/a3ad-xk56]. 315 david sherfinksi, technology problems at irs go far beyond loss of lois lerner’s email, wash. times (july 2, 2014), http://www.washingtontimes.com/news/2014/jul/2/technology-problems-at-irsgoes-far-beyond-loss-of/?page=all [https://perma.cc/y9tm-2dcw] (also reporting that “[t]he irs has a backlog of up to $500 million in requested technology upgrades”). 316 treas. inspector gen. for tax admin., no. 2014-20-095, annual assessment of the internal revenue service information technology program i (2014) (highlights), http://www .treasury.gov/tigta/auditreports/2014reports/201420095fr.pdf [https://perma.cc/xla5-vnxs]. 317 id. at 20. tigta also expressed concern that the irs’s existing fraud detection systems may be insufficient to detect fraud before the irs issues claimed tax refunds. id. 318 see u.s. gov’t accountability off., irs is scaling back activities and using budget flexibilities to absorb funding cuts 1 (june 2015), http://www.gao.gov/assets/680/670969.pdf [https:// perma.cc/9tyq-ave9] (“irs requested $3.2 billion for information technology (it) investments. this accounted for 23 percent of irs’s budget request for fiscal year 2016.”). 76 columbia journal of tax law [vol.7:36 congress provided the irs with $290 million for business systems modernization,319 a little more than 9 percent of the $3.2 billion the irs requested.320 some in congress have stated that the irs budget cuts, which began in 2011,321 are punishment for bad behavior.322 regardless of the reason, it is very hard for any organization to run effectively when its funding drops suddenly and in unpredictable amounts.323 in 2014, the taxpayer advocate service, whose role is to “ensure that every taxpayer is treated fairly,”324 identified the inadequate funding of the irs as the number one most serious problem for taxpayers.325 it may not be surprising that a congress that has vilified the irs in public hearings has also cut its budget. in theory, irs reform could give the irs political support for a time, as seems to have happened in 1998. but, in that situation, congress portrayed the institution of the irs as the villain, with a possible savior, charles rossotti, the new irs commissioner, waiting in the wings.326 congress and the media viewed mr. rossotti as someone who could restructure the irs to behave like a private-sector business.327 the 319 financial services and general government appropriations act, 2016, pub. l. no. 114-113, div. e, tit. i. the funds will remain available until september 30, 2018. id. 320 congress also required quarterly reports to the committees on appropriations of the house of representatives and the senate and the comptroller general of the united states regarding such things as the costs and schedules for the irs’s major information technology investments. id. at 187–88. 321 see tigta, reduced budgets, supra note 295 (showing irs expenditures over a period of years that includes 2011). 322 for example, the 2015 report by the committee on ways and means stated, after discussing irs conference spending and the 501(c)(4) investigation, “as a result of the irs’s blatant misconduct, congress significantly reduced the agency’s budget.” h.r. comm. on ways & means majority staff report, doing less with less: irs’s spending decisions harm taxpayers 2 (apr. 22, 2015), http:// waysandmeans.house.gov/uploadedfiles/4.22.15_tax_filing_report.pdf [https://perma.cc/49xm-wg8s]. 323 unlike a private-sector organization, the irs cannot put aside funds for potential future lean years. 324 taxpayer advocate service, internal revenue serv., https://www.irs.gov/advocate [https:// perma.cc/sl2c-scek]. 325 internal revenue serv., annual report to congress vol. i, nat’l taxpayer advocate 3 (2014), http://www.taxpayeradvocate.irs.gov/media/default/documents/2014-annual-report/volume-one .pdf [https://perma.cc/vcw9-4hqp] [hereinafter national taxpayer advocate, 2014 annual report] (“as we begin 2015, the widening imbalance between the irs’s increasing workload and its shrinking resources leads us to designate it the #1 problem for taxpayers.”). the national taxpayer advocate identified insufficient irs funding as the number 1 most serious problem in 2011, number 3 most serious problem in 2012, and number 2 most serious problem in 2013. see national taxpayer advocate, special report, supra note 59, at xi (referring to 2011 and 2012); taxpayer advocate serv., national taxpayer advocate 2013 annual report to congress, most serious problems, http://www .taxpayeradvocate.irs.gov/2013-annual-report/most-serious-problems.html [https://perma.cc/yz6j-2uea] (listing the 10 most serious problems for 2013). 326 mr. rossotti was irs commissioner from 1997 to 2002. the carlyle group, charles o. rossotti, http://www.carlyle.com/about-carlyle/team/charles-o-rossotti [https://perma.cc/88mm-7www]. 327 see robert d. hershey, jr., nominee for i.r.s. vows to serve taxpayers, n.y. times (oct. 24, 1997), http://www.nytimes.com/1997/10/24/us/nominee-for-irs-vows-to-serve-taxpayers.html [https://perma .cc/3skz-xyr9] (quoting senator roth as calling rossotti a “successful businessman, in touch with the needs, concerns and risk-taking mindset of entrepreneurs” who made his mark as a “management consultant and expert on computer systems”); see also president william j. clinton, remarks at the signing of irs reform legislation (july 22, 1998), http://www.cnn.com/allpolitics/1998/07/22/irs.signing/transcript .html [https://perma.cc/ydb2-5xdf] (praising rossotti as a “seasoned private sector ceo” who could “reshape the agency, expanding office hours and phone hours, making it easier to file taxes over the telephone or by computer”). mr. rossotti helped design the irs’s new structure and emphasized the irs mission of providing service to taxpayers. see, e.g., hal g. rainey & james thompson, leadership and the transformation of a major institution: charles rossotti and the internal revenue service, 66 pub. admin. 2016] irs reform: politics as usual? 77 present situation is quite different. president obama replaced the previous irs commissioner with john koskinen, but congress has not portrayed him as the irs’s savior. instead, in october 2015, nineteen house republicans, led by rep. jason chaffetz (r-ut), filed a resolution seeking commissioner koskinen’s impeachment.328 the house committee on oversight and government reform alleged that mr. koskinen failed to preserve emails of lois lerner.329 ultimately, a core problem is that the irs is an easy target for politicians. opprobrium for tax collectors has a long history,330 although it is about as helpful as killing the messenger upon receiving bad news.331 most people do not like to pay taxes, so it is rare for a politician to jump to the defense of the irs.332 politicians therefore have an opportunity both to criticize the irs for simple political gain and to try to undermine the irs as a way to undermine the effectiveness of a federal tax system they oppose.333 rev. 596 (2006) (arguing that rossotti and his team implemented reforms that substantially improved taxpayer service and effective tax administration); rossotti appoints new irs team, j. acct. (nov. 1, 1998), http://www.journalofaccountancy.com/issues/1998/nov/rossottiappointsnewirsteam.html [https://perma.cc /9xv7-ymmh (describing rossotti’s “effort to place the right people in the right jobs to help move . . . toward the creation of a new, taxpayer-focused irs”). 328 m. alex johnson, republicans seek to impeach irs chief over alleged tea party targeting, msnbc (oct. 27, 2015), http://www.msnbc.com/msnbc/republicans-seek-impeach-irs-chief-over-allegedtea-party-targeting [https://perma.cc/k2z5-phge]. 329 see s.a. miller, republicans demand obama fire irs chief john koskinen, wash. times (jul. 27, 2015), http://www.washingtontimes.com/news/2015/jul/27/john-koskinen-irs-chief-must-resign-sayhouse-repu/?page=all [https://perma.cc/7m43-ldcm]. tigta stated in a june 2015 report that “the investigation did not uncover evidence that the irs and its employees purposely erased the [back-up magnetic] tapes in order to conceal responsive e-mails from the congress, the doj and tigta.” treas. inspector gen. for tax admin., report of investigation 3 (2015), http://democrats.oversight.house.gov /sites/democrats.oversight.house.gov/files/documents/tigta%20report.pdf [https://perma.cc/l5cu-u3d5]. the report further stated, “no evidence was uncovered that any irs employees had been directed to destroy or hide information from congress, the doj or tigta.” id. at 18. it found that “the irs did not put forth an effort to uncover additional responsive emails.” id. 330 “the tax-collector . . . is never esteemed a lovable man. his methods are too blunt, and his powers too obnoxious. he comes to us, not with a ‘please,’ but with a ‘must.’” woodrow wilson, congressional government: a study in american politics 100 (johns hopkins univ. press 1981) (1885); see also brunson, supra note 228, at 224–25 (“taxpayers dislike and distrust tax collectors. these feelings transcend time and culture. . . . in eighteenth-century wales, tax men attempting to collect the excise tax on spirits found themselves attacked, horsewhipped, robbed, killed, and disfigured.”). 331 the irs could, in theory, work on trying to improve its public image. however, a media campaign about taxes may backfire, as the recent airbnb advertisements—though different in context—may suggest. see airbnb issues apology after tone-deaf new ads debut in san francisco, mother jones (oct. 23, 2015), http://www.motherjones.com/mixed-media/2015/10/airbnb-ads-san-francisco [https://perma.cc /qfh4-kjrb] (also showing a photo of such an airbnb ad, which states, “dear parking enforcement, please use the $12 million in hotel taxes to feed all the expired parking meters. love, airbnb”). most important, a public relations campaign likely would not affect congress’s actions. 332 occasionally, a member of the media defends the irs when the public is hearing a largely onesided story. last week tonight host john oliver made a humorous case for increasing the irs’s budget that included an ode to the irs sung by grammy award winner michael bolton. see jacob davidson, 450 billion reasons why john oliver is right about the irs, money (apr. 13, 2015), http://time.com/money/3819382 /john-oliver-and-irs-tax-gap [https://perma.cc/5krz-9v9c]. 333 for example, during the 1997 irs hearings, rep. bob riley (r-al) stated: the irs has too much muscle, too much money, and too little oversight. the agency is out of control and it is not going to fix itself. only congress can do that. in my view, we should overhaul—if not eventually abolish—the irs. then we should scrap the tax code and replace it with one that is fairer and flatter. 78 columbia journal of tax law [vol.7:36 experience has shown that if congress finds irs enforcement or service inadequate, it need not conclude that the irs needs more resources—such as more personnel or better technology—to carry out that function. instead, congress can discipline the irs for perceived failures in service or enforcement by decreasing its funding. the reduction in resources may also pose challenges for management, increasing the likelihood of mistakes.334 in other words, congress can set a struggling irs up for further failures. there are limited checks on congress’s behavior toward the irs: “the power of congress to investigate the irs is wide-ranging and may effectively be limited only by discretion and prudence. congress’s oversight entities possess an almost unwieldy power to inquire into, prod, and make suggestions to the service.”335 thus, congress needs to exercise that power appropriately. the u.s. supreme court has stated: congress [is not] a law enforcement or trial agency. these are functions of the executive and judicial departments of government. no inquiry is an end in itself; it must be related to, and in furtherance of, a legitimate task of the congress. investigations conducted solely for the personal aggrandizement of the investigators or to “punish” those investigated are indefensible.336 ultimately, if some politicians are disinclined to restrain themselves, the best hope for overall congressional restraint may lie within the halls of congress. although the irs has few natural supporters,337 some in congress no doubt support a progressive income tax or other aspects of our current federal tax system. congressional supporters of progressive taxation could link the irs’s enforcement of the tax laws with a fight against increasing income inequality.338 that is, progressive taxation generally reduces income inequality, but if the tax system is not adequately enforced, the net effect may be to increase income 143 cong. rec. e2306-01 (daily ed. nov. 10, 1997) (remarks of rep. riley). this approach reverses the order one might expect from the perspective of administration of the laws—the size and existence of an enforcement and service agency would seem to depend on the needs of the substantive law, rather than vice versa. 334 the effectiveness of management depends in part on resources, such as adequate staff and technology, and on structural decisions such as where employees and their managers are located. congress may take those decisions away from the irs by mandating a certain organizational structure, as it did in the 1998 act, see supra text accompanying note 223, or simply by underfunding it. 335 parnell, supra note 270, at 1360. 336 watkins v. united states, 354 u.s. 178, 187 (1957) (appeal from a conviction for contempt of congress during testimony before a subcommittee of the house of representatives committee on unamerican activities for refusal to answer questions regarding whether certain other people had belonged to the communist party in the past). 337 see supra note 332 and accompanying text. the irs does have stakeholders, including business people who rely on irs guidance—both published guidance such as revenue rulings and private guidance such as advance pricing agreements and letter rulings—to get deals done. tax writer david cay johnston reports that “there is hope. while few of us are willing to stand up for the tax police, tax practitioners are starting to complain that they cannot serve their clients when the irs lacks enough staff to resolve problems.” david cay johnston, the cost of the shrinking irs budget, 2015 tnt 105-11 (june 2, 2015). he added that “on may 17 the council that sets policy for the american institute of certified public accountants passed a resolution advocating that congress provide enough money so that the irs is able to fulfill its mission . . . .” id. 338 the united states rose in 2005 to among the highest levels of income inequality in developed countries. see anthony b. atkinson et al., top incomes in the long run of history, 49 j. econ. literature 3, 45 tbl.6 (2011); leonard e. burman, taxes and inequality, 66 tax l. rev. 563, 566 fig. 2 (illustrating top income shares of various countries using the atkinson et al. data). 2016] irs reform: politics as usual? 79 inequality.339 if the irs had vocal supporters within congress, that might help temper the one-sidedness both the recent irs hearings and those of the late 1990s evidenced. v. conclusion the irs, though central to the collection of the taxes that support our federal government,340 is unfortunately no stranger to controversy. allegations of wrongdoing by the irs certainly warrant investigation. tigta’s 2013 report, which launched the latest controversy, was the result of an investigation requested by congress’s house oversight committee. tigta made recommendations and it followed up with a subsequent investigation that found that the irs was no longer delaying the applications of 501(c)(4) organizations. the fbi and doj also investigated. like tigta, they found no politically motivated actions by the irs.341 by contrast, some in congress seem to have political motivations for vilifying the irs. the nation’s experience with the 1998 irs reform suggests that a moral panic over irs employees’ behavior poses risks for tax administration, and particularly for enforcement of the tax laws. allegations of irs wrongdoing can also provide an excuse to cut the irs’s budget. irs resources are a critical issue, because, as milka casanegra de jantscher and richard bird have pointed out, in the context of their work on tax administration in developing countries, three ingredients are necessary for effective tax administration: “the political will to implement the tax system effectively; a clear strategy as to how to achieve this goal; and adequate resources for the task at hand.”342 lack of congressional support threatens at least the first and third ingredients of this formula. of course, how to keep congress from treating the irs as a political football is a very difficult problem. it may help for supporters of progressive taxation to stand up to defend our nation’s tax collector against one-sided attacks.343 regardless, reforming the irs does not address an important and fundamental problem: congress’s lack of support for enforcement of the tax laws it has legislated. 339 denvil duncan & klara sabirianova peter, unequal inequalities: do progressive taxes reduce income inequality?, iza discussion paper no. 6910 3–4, 34–35 (oct. 2012), http://ftp.iza.org/dp6910.pdf [https://perma.cc/l49c-3mbq]. 340 see johnston, supra note 300 (“the real costs of not spending enough to run the irs properly include threatening the foundation of the united states, its wealth, and its liberties. all of those are built on a foundation of taxes. without a sound tax system our economy and society will wither, not flourish. proper tax administration is as much a part of that as how congress chooses to tax us.”). 341 see supra note 3. the senate’s permanent subcommittee on investigations comm. on homeland security & gov’t affairs, majority staff report reached similar findings, but the minority dissented. see supra notes 132–137 and accompanying text. 342 richard m. bird, improving tax administration in developing countries, 1 j. tax admin. 28 (2015) (citing casanegra de jantscher & bird, the reform of tax administration, in richard m. bird & milka casanegra de jantscher, improving tax administration in developing countries (1992)). 343 see lederman, supra note 26, at 1333. microsoft word 8-3-creamer-wheeler.docx a framework for testing regulatory authority ron creamer isaac wheeler* *the authors wish to thank daniel bleiberg, ryan galisewski, ethan david ross, and erick sam for their helpful assistance. 2017] a framework for testing regulatory authority 327 i. introduction .................................................................................................... 328 ii. the limits of regulatory authority – underlying principles .................................................................................................................................. 330 a. a grant of regulatory authority needs to be read precisely in order to determine whether an interpretation of that authority is unreasonable ............................... 330 b. a regulation is not authorized if it violates another, separate, principle of law 332 c. a statute, as drafted, is the complete legislative expression on the matter ........ 333 d. a selective regulatory interpretation is not improper merely because it has an effect on other code sections, even if those other code sections are acknowledged to be unambiguous and complete .............................................. 334 e. a selective application of regulatory authority could fail for lack of germaneness, even if other laws/code sections are not affronted ............................................ 335 iii. specific provisions of the regulatory package ......................... 336 a. provision #1: treasury regulation 1.956-2t ................................................... 336 b. provision #2: treasury regulation section 1.7874-8t .................................... 339 c. provision #3: treasury regulation section 1.7701(l)-4t ................................. 343 d. provision #4: treasury regulation section 1.385-3 ......................................... 344 e. provision #5: treasury regulation section 1.385-3t(f) .................................. 355 iv. conclusion ........................................................................................................ 359 328 columbia journal of tax law [vol.8:326 i. introduction in fda v. brown & williamson tobacco corp.,1 the supreme court considered whether congress had granted the fda authority to regulate tobacco and tobacco products. the court held, in a 5-4 decision, that congress had not granted such authority. writing in dissent, justice breyer primarily relied on the text of the food, drug, and cosmetic act (fdca). the fdca granted authority to the fda to regulate “drugs” and “devices.”2 nicotine is a drug; a cigarette is a device to deliver nicotine. justice breyer wrote: “in short, i believe that the most important indicia of statutory meaning—language and purpose—along with the fdca’s legislative history . . . are sufficient to establish that the fda has authority to regulate tobacco.” 3 in an opinion written by justice o’connor and joined by, among others, justices scalia and thomas, the majority looked beyond the statutory language “in isolation” and held that, after examining the fdca as a whole, the fda’s own statements on the limits of its jurisdiction, and 35 years of tobacco-specific legislation (as well as legislative history and bills proposed but not adopted), “it is clear that congress intended to exclude tobacco products from the fda’s jurisdiction.”4 in short, notwithstanding that nicotine is a drug and a cigarette is a drug delivery device (at least in the normal sense of those words), that’s not what congress meant. when the treasury department and the irs published proposed and temporary regulations under sections 385,5 956, 7701(l) and 7874, many tax practitioners had a reaction similar to the court’s reaction in brown & williamson, particularly to the proposed section 385 regulations (the “proposed 385 regulations”), and particularly to proposed treasury regulation section 1.385-3 (the “per se rule”): whatever the statute and the legislative history of section 385 can be read to say, that’s not what congress meant.6 1 fda v. brown & williamson tobacco corp., 529 u.s. 120 (2000). 2 21 u.s.c. §§ 321(g)–(h), 393. 3 529 u.s. at 163. 4 id. at 142. 5 unless otherwise specified, all section references are to the internal revenue code of 1986, as amended. 6 see, e.g., comment letter on proposed rulemaking treatment of certain interests in corporations as stock or indebtedness, org. for int’l investment (july 7, 2016), http://ofii.org/sites/default/files/ofii%20comment%20letter%20on%20proposed%20385%20regulations.p df [perma.cc/3p9k-4cyv] (“the purpose of section 385 was to provide more general guidance outside of the acquisition context on the difference between debt and equity. there is no indication that congress believed that debt incurred to acquire stock of a related or unrelated company to which section 279 did not apply should somehow be suspect under section 385.”); comment letter on proposed rulemaking treatment of certain interests in corporations as stock or indebtedness, kpmg (july 7, 2016), http://home.kpmg.com/content/dam/kpmg/pdf/2016/07/tnf-comment-letter-jul8-2016.pdf [perma.cc/u8zbjdvr] (“we believe the proposed regulations exceed the regulatory authority granted by section 385 and go beyond congressional intent. they do not seek to delineate a general debt-equity distinction or to clarify or rationalize debt-equity analysis. instead, the proposed regulations would simply treat certain arrangements as equity in order to ensure that interest expense deductions are not available in the case of certain transactions.”); comments re: proposed treasury regulations under section 385, pricewaterhouse coopers (apr. 7, 2016), http://www.pwc.com/us/en/tax-services/publications/insights/assets/pwc-proposedsection-385-regs-would-impact-related-party-financings.pdf [perma.cc/h4g5-z3eu] (“the proposed regulations incorporate none of the traditional factors used by the courts in distinguishing debt from equity: they do not look to the terms of an instrument; they do not look to the strength of an issuer’s cash flows or balance sheet; and they do not take into account the intent of the debtor and creditor in making an advance. this is not what section 385 provides nor what congress intended in enacting section 385.”). 2017] a framework for testing regulatory authority 329 and yet, the initial reaction was that the proposed 385 regulations were clearly within the scope of authority granted to the irs under section 385.7 “the explicit language of section 385 gives the treasury secretary direct and powerful regulatory authority to reclassify debt as equity and thereby transform a deductible interest payment into a nondeductible dividend.”8 that may be the case, but to assess whether the statute authorizes these regulations one must look not just at the statute and its legislative history (and, according to the supreme court in brown & williamson, any number of other sources), but also at the regulations themselves. the reflexive conclusion that anything the irs does under section 385 is blessed is too dismissive of too important a question. yes, the authority granted under section 385 is broad, but it is certainly not limitless. in october 2016, the irs issued final regulations (the “final and temporary 385 regulations”, and together with the regulations proposed on april 4, 2016, the “regulatory package”),9 trimming some, but not all, of the excesses of the proposed 385 regulations. however, the irs did not back down from its assertion of regulatory authority.10 in this article, we consider whether certain provisions of the regulatory package (including regulations proposed and issued under section 385, section 956, section 7701(l) and section 7874) are outside the scope of the irs’s authority. we approach these questions first by formulating our own set of “underlying principles” that we believe are necessary guideposts to any question of regulatory authority. we believe using our own “underlying principles” as the lens through which to focus the question allows us to develop tax-specific examples to illustrate the limits of regulatory authority rather than rely on the facts of non-tax cases in which similar questions of regulatory authority were considered. not surprisingly, the principles we outline below are echoed in the case law involving questions of statutory interpretation and the administrative procedure act (the “apa”). even with the changes to the regulatory package, as well as potential tax reform which may further limit the impact of any section 385 regulations,11 attempting to define the limits of regulatory authority is as important a task as ever. the expansion of executive power, the seeming impossibility of bipartisan legislation, and the potential of 7 cf. jasper l. cummings, jr., rite aiding the debt-equity regulations, 152 tax notes 377 (2016) (outlining arguments that might be made in opposition to the validity of the proposed regulations, including that “[d]ebt in form is not an interest in a corporation; therefore, on its face, [section 385(a)] does not authorize regulations treating corporate debt as stock” and that because the statute states that “[t]he regulations ‘shall set forth factors’ to be ‘taken into account’ in analyzing particular factual situations and categorizing the relationship between an investor and the corporation[,] the regulations cannot state preclusive rules for broad categories of factual situations based on an extremely limited set of factors (such as an arbitrarily prescribed type of documentation or a time sequence”). 8 stephen shay, mr. secretary, take the tax juice out of corporate expatriations, 144 tax notes 473 (2014) at 473. 9 t.d. 9790, 2016-45 i.r.b. 540, 81 fr 72858-72984 (oct. 21, 2016). in january 2017, president trump issued a memorandum instituting a temporary freeze on most federal regulatory activity. reince priebus, memorandum for the heads of executive departments and agencies—regulatory freeze pending review, white house office of the press sec’y (jan. 20, 2017), http://www.whitehouse.gov/the-pressoffice/2017/01/20/memorandum-heads-executive-departments-and-agencies [perma.cc/f9bx-tmlq]. it is unclear what, if any, impact the memorandum has had on the section 385 regulations. 10 see generally t.d. 9790, 2016-45 i.r.b. 540, 81 fr 72858-72950 (oct. 21, 2016). 11 if interest were no longer deductible, the distinction between debt and equity would be considerably less important from a tax perspective. 330 columbia journal of tax law [vol.8:326 radical tax reform which would involve, inevitably, congress charging the treasury department and the irs to fill in statutory gaps mean the limits of administrative authority will continue to be tested in the near future. ii. the limits of regulatory authority – underlying principles below we lay out principles necessary for discerning the limits of regulatory authority. these principles are not intended to be comprehensive or even the most fundamental principles of the limits of regulatory authority (indeed, in proving out our propositions, we rely on more fundamental concepts of law). we chose to highlight the below because each is integral in examining whether specific provisions of the regulatory package exceed irs authority. a. a grant of regulatory authority needs to be read precisely in order to determine whether an interpretation of that authority is unreasonable. of course it does.12 yes, everyone understands that the executive has been given wide latitude to craft reasonable interpretations of the questions that have been granted to it.13 that probably also means (although it is a different question) that the executive has been given wide latitude to craft reasonable interpretations of the scope of the questions.14 and, in many cases, there will be many reasonable interpretations of the scope of those questions. however, it does not follow that there are infinitely many; some will be unreasonable. and we can only discover the answer to that question by really digging into the initial grant of authority by the legislature. let’s illustrate by a real example (which will be discussed later)—section 956(e). section 956(e) authorizes “such regulations as may be necessary to carry out the purposes of this section, including regulations to prevent the avoidance of the provisions of this section through reorganizations or otherwise.” that sounds very broad, and it is, but not infinitely so. there are many textual uncertainties, and one’s view on the scope of authority granted by section 956(e) will depend on how one interprets those uncertainties. 12 see united states v. mead corp., 533 u.s. 218, 234–35 (2001) (“this court in chevron recognized that congress not only engages in express delegation of specific interpretive authority, but that ‘[s]ometimes the legislative delegation to an agency on a particular question is implicit.’ congress, that is, may not have expressly delegated authority or responsibility to implement a particular provision or fill a particular gap. yet it can still be apparent from the agency’s generally conferred authority and other statutory circumstances that congress would expect the agency to be able to speak with the force of law when it addresses ambiguity in the statute or fills a space in the enacted law, even one about which ‘congress did not actually have an intent’ as to a particular result.”). 13 see chevron u.s.a., inc. v. natural resources defense council, inc., 467 u.s. 837, 843–44 (“we have long recognized that considerable weight should be accorded to an executive department’s construction of a statutory scheme it is entrusted to administer, and the principle of deference to administrative interpretations has been consistently followed by this court whenever decision as to the meaning or reach of a statute has involved reconciling conflicting policies, and a full understanding of the force of the statutory policy in the given situation has depended upon more than ordinary knowledge respecting the matters subjected to agency regulations.”). 14 cf. mead, 533 u.s. at 234–35 (acknowledging that even where a statute precludes chevron deference to agency interpretations thereof, “an agency’s interpretation may merit some deference whatever its form, given the ‘specialized experience and broader investigations and information’ available to the agency, and given the value of uniformity in its administrative and judicial understandings of what a national law requires”). 2017] a framework for testing regulatory authority 331 the first question is what congress means when it references the “purposes” of section 956. one possible answer could be that the purposes of section 956 are to treat as a deemed dividend the portion of the controlled foreign corporation’s (cfc’s) unrepatriated, non-previously taxed income (pti) earnings that have been invested in u.s. property. a second possible answer could be that the purposes of section 956 are to treat as a deemed dividend the portion of the cfc’s un-repatriated, non-pti earnings that have been deployed in a manner that produces an economic benefit to the u.s. shareholder that is sufficiently analogous to a dividend that it should be treated as such. the difference in effect is obvious. and although it may seem intuitively correct to say that the latter is at least a reasonable interpretation, we are not so sure that is true. the latter was certainly the impetus behind the legislative effort, and was the subject of the debate. but the outcome of the debate was a significantly narrower phraseology. doesn’t that imply a legislative rejection of the cases that fell outside of that phraseology?15 again, suppose the house advanced a broader definition of u.s. property for purposes of section 956, the senate rejected it, and the conferees supported the senate version. could the executive reinstate the house version in regulations under the auspices of a broad interpretation of the “purposes” of section 956? that seems like a stretch.16 the second question involves the use of the word “including.” in this context, does “including” mean that the second clause is a subset of the first clause, or is in addition to the first clause? it is incredible that such a basic point could be uncertain, but it seems so. the import is not as dramatic as the first question, but it is important nonetheless. if regulations do not further the purpose, does the executive still prevail if the regulations prevent avoidance? unclear. the third question involves the word “provisions.” here, the foil is obviously the prior word “purposes.” “provisions” certainly reads as a narrower term than “purposes,” more akin to “what i wrote down on the piece of paper” than “the thoughts in my head as i was writing.” does that narrowness necessitate a reinterpretation of the breadth of “purposes,” which was so important to the first question? the fourth question is what to make of the shift from the positive to the negative. the first clause empowers regulations “to carry out the purposes”; the second clause empowers regulations “to prevent the avoidance of the provisions.” perhaps that phrasing implies that one should be restrictive in interpreting the first grant but liberal in interpreting the second? 15 see john f. manning, why does congress vote on some texts but not others?, 51 tulsa l. rev. 559, 565–71 (2016) (suggesting that the fact that portions of the legislative history of a given statute were not enacted into law, despite legislators’ awareness that legislative history does not have the force of law, suggests that legislators did not believe that the contents of the legislative history could pass). 16 in fact, the irs tried to stretch section 956 in ludwig v. commissioner, 68 t.c. 979 (1977). in ludwig, the taxpayer, a u.s. person, pledged shares of stock in “oceanic”, a cfc (whose primary asset was stock in another cfc), in order to secure a loan from a third party. as part of the loan agreement, the taxpayer entered into a number of negative covenants. the irs argued that the pledge of cfc stock was an indirect pledge of its assets, and thus implicated section 956. the tax court held for the taxpayer, distinguishing between situations in which a taxpayer receives a benefit in respect of the value of a cfc’s assets and when such benefit is covered by section 956: “that petitioner realized a benefit from owning and pledging his oceanic stock to secure the bank loans does not mean that oceanic’s earnings were invested in united states property within the meaning of section 951. neither that section nor section 956(c) reaches every benefit derived from the ownership of stock in a controlled foreign corporation.” id. at 988. in 1980, the treasury department amended treasury regulations section 1.956-2(c)(2) to provide that a pledge of at least 66 and 2/3rds percent of the voting stock of a cfc is treated as an indirect pledge of the cfc’s assets. t.d. 7712 (aug. 6, 1980). 332 columbia journal of tax law [vol.8:326 the fifth question involves the last phrase, “through reorganizations or otherwise.” that sounds like the legislators had something specific in mind. if we find something specific in the legislative history (which turns out to be an invocation to prevent arbitraging section 956 against now-repealed section 956a),17 does that mean that we should reject that there is any additional content to this phrase? and, last but not least, does the invocation of reorganizations mean to lower the otherwise applicable standards, such that what might not have been found permissible in general is suddenly permissible if a reorganization is involved? these are hard questions, no doubt. we believe there are many reasonable answers, and the executive should prevail if its regulations can be supported by any of those. but some answers are unreasonable, and if the executive’s regulations can only be defended on that basis, then they have a problem. b. a regulation is not authorized if it violates another, separate, principle of law. 18 (and authority to promulgate broad regulations does not demonstrate authority to promulgate every narrower-included subset of such regulations).19 assume, for example, that it is true (which we believe it is) that sufficient authority has been delegated under section 385 to promulgate regulations that recharacterize all related-party debt as equity.20 does that mean that no further inquiry is necessary if the regulations take an even narrower approach? if the executive has the power to turn all such instruments into equity, does that not imply that it has the power to turn a subset of such instruments into equity? suppose the narrower regulations recharacterized related-party debt only in cases where the ceo of the us company was a woman? a silly example, perhaps, but an illustrative one. these regulations would be improper because their narrow enforcement violates a separate and in this case clearly superseding principle of law. 21 this conclusion holds whether the law being violated is supreme (the constitution) to the law 17 see conference committee report on p.l. 103-66 (“the conference agreement also provides regulatory authority under which the treasury is instructed to prescribe such regulations as may be necessary to carry out the purposes of section 956, and to prevent their avoidance. within this authority, the conferees anticipate that the treasury may prescribe regulations that, for example, would prevent taxpayers from taking advantage of the differences between the excess passive asset rules and the rules of section 956.”). 18 see, e.g., nat’l family planning and reproductive health ass’n, inc. v. gonzales, 468 f.3d 826, 829 (d.c. cir. 2006) (“[o]f course[,] a valid statute always prevails over a conflicting regulation.”). 19 see, e.g., judulang v. holder, 132 s. ct. 476, 485 (2011) (explaining that even though the board of immigration appeals “may well have legitimate reasons for limiting [the scope of a statute permitting discretionary relief] in deportation cases . . . it must do so in some rational way. if the bia proposed to narrow the class of deportable aliens eligible to seek . . . relief by flipping a coin—heads an alien may apply for relief, tails he may not—we would reverse the policy in an instant. that is because agency action must be based on non-arbitrary, ‘relevant factors,’ which here means that the bia’s approach must be tied, even if loosely, to the purposes of the immigration laws or the appropriate operation of the immigration system.”). 20 see infra notes 82–84 and accompanying text. 21 see davis v. passman, 442 u.s. 228, 234–35 (1979) (“to withstand scrutiny under the equal protection component of the fifth amendment’s due process clause, ‘classifications by gender must serve important governmental objectives and must be substantially related to achievement of those objectives.’” (quoting craig v. boren, 429 u.s. 190, 197 (1976))). 2017] a framework for testing regulatory authority 333 authorizing the regulations or a law passed by congress that speaks directly on the matter.22 now let us try a slightly more realistic example. in stephen shay’s 2014 article that planted the seed for the obama administration’s sense of optimism on expansive regulatory authority, shay postulated that regulations under section 385 could recharacterize related-party debt into equity so as to achieve the same amount of interest disallowance as would have been achieved if section 163(j) had been amended to reduce the 50% adjusted taxable income (ati) limitation to 25%. 23 this is quite a bold assertion, because the hypothetical regulation is not a rule about section 385 but rather a rule about section 163(j). if we assume that there is no regulatory authority to alter section 163(j)—and in fact an implicit but clear legislative demand not to do so (more about that later)—then how is this example different from the one involving female ceos? in other words, the selective enforcement of section 385 rewrites (i.e., violates, or overturns) another law. 24 if this section 163(j) change could be made, then presumably the administration could also have used section 385 to increase the tax rate under section 11 from 35% to 45%.25 a permissive approach to selective application of the section 385 regulations would (because interest deductions are nearly ubiquitous) permit revision of virtually every other code section. want to repeal the mortgage interest deduction? use section 385.26 want to double the section 4985 excise tax by imposing a mirror version on corporations? use section 385. it is true that eventually you run out of ammunition, but section 385 is a well-stocked arsenal. c. a statute, as drafted, is the complete legislative expression on the matter. let us now digress briefly to set forth a theory of legislative completeness.27 this is important in figuring out whether a violation of another, separate principle of law has occurred. the legislative process is not orderly. bills are cobbled together to please different constituencies, and theoretical clarity is often sacrificed. the house has one version; the senate has another; and the negotiated resolution is not designed to please 22 see, e.g., michigan v. e.p.a., 135 s. ct. 2699, 2707–11 (2015) (holding that the epa could not lawfully determine that regulation of hazardous air pollutants was “appropriate and necessary” without considering the costs of the regulation where a statute directed the epa to study the costs associated with the technologies available to control emissions). 23 shay, supra note 9. 24 cf. crawford fitting co. v. j.t. gibbons, inc., 482 u.s. 437, 441–42 (1987) (explaining that where a statute stated that a judge or clerk of any court “may tax as costs” certain enumerated expenses, a federal rule of civil procedure could not “grant[] courts discretion to tax whatever costs may seem appropriate,” because to do so would “render . . . specific statutory provisions entirely without meaning”). 25 in other words, section 385 could recharacterize debt into equity to arrive at an effective tax rate of 45%. 26 one might argue that section 385 is limited to corporate debt, but that has not stopped the irs from proposing regulations that would recharacterize partnership debt. see 26 cfr § 1.385-3t(f). 27 for a discussion of the evolution of the concept of statutory purpose in american jurisprudence, see generally john f. manning, the new purposivism, 2011 sup. ct. rev. 113; see also john f. manning, what divides textualists from purposivists, 106 colum. l. rev. 70 (2006) (arguing that even though “[m]odern textualists acknowledge that statutory language has meaning only in context, and that judges must consider a range of extratextual evidence to ascertain textual meaning . . . textualism nonetheless remains distinctive because it gives priority to semantic context (evidence about the way a reasonable person uses words) rather than policy context (evidence about the way a reasonable person solves problems)”). 334 columbia journal of tax law [vol.8:326 the theoretician.28 nevertheless, one must respect the outcome as the complete expression of the legislature on the topic.29 if the executive branch is empowered to go beyond merely curing ambiguities, then what is to prevent the executive from reasserting the house position, for example, replaying the legislative debate, but with a different outcome? it is true that the legislature sometimes asks the executive branch for help in drafting rules. but the general baseline is that the statute as finally drafted is complete. if a statute defines bad behavior and imposes a penalty, in general it is not appropriate for the executive to add an additional penalty.30 this is true even if the behavior is deeply offensive and is not deterred by the extant statutory penalty. this is true even if every member of congress subsequently decries the inefficacy of the statutory language; if those outcries result in an amendment to the statute, then fine, but otherwise, the prior statute remains the complete legislative expression on the matter. using a selective application of the section 385 regulations to add to a statute that is universally viewed as defective is just as problematic as using the regulations to alter a statute that is universally loved. in order to make the foregoing more concrete, let us return to section 163(j). in the prior section 163(j) example, we analyzed an attempt to change a 50% limitation to 25% through the auspices of broad section 385 regulatory authority. in that case it was clear that the statutory rule was being altered because one needed to cross out the number “50” and replace it with the number “25.” but is it any different if the new provision adds words without deleting anything? imagine, for example, that a new subsection was added to section 163(j) to provide that if a corporation has “disqualified interest” within the meaning of section 163(j)(1)(a), then in addition to the foregoing section 163(j) restrictions, the tax rate on the corporation’s net income from all sources is increased from 35% to 40%. this could be achieved, for example, by providing that, for any corporation with disqualified interest, the amount of disqualified interest is grossed up to arrive at an effective 40% tax rate on the corporation’s net income. in effect, this change would be an increase in the section 163(j) “penalty” for overleverage. if a selective application of section 385 regulatory authority were used to back into the same result— using section 385 to add additional penalties for running afoul of section 163(j)—such action should be analyzed in the same manner as if the regulations had changed 50% to 25%. d. a selective regulatory interpretation is not improper merely because it has an effect on other code sections, even if those other code sections are acknowledged to be unambiguous and complete. this sounds like the opposite of what we set out in part i.2. above, but it is obviously also true. for example, a selective interpretation of section 385 has a direct effect on section 163. this is not strange; of course, it is the precise reason that one makes a change to section 385. turning an instrument into equity is designed to invoke 28 see landgraf v. usi film prods., 511 u.s. 244, 286 (1994) (“statutes are seldom crafted to pursue a single goal, and compromises necessary to their enactment may require adopting means other than those that would most effectively pursue the main goal.”). 29 see ragsdale v. wolverine world wide, inc., 535 u.s. 81, 93–94 (2002) (“like any key term in an important piece of legislation, the [relevant] figure was the result of compromise between groups with marked but divergent interests in the contested provision… courts and agencies must respect and give effect to these sorts of compromises.”); w. va. univ. hosps., inc. v. casey, 499 u.s. 98–99 (1991) (“the best evidence of [a statute’s] purpose is the statutory text adopted by both houses of congress and submitted to the president.”). 30 see ragsdale, 535 u.s. at 93–94. 2017] a framework for testing regulatory authority 335 all of the consequences that follow therefrom. in plainer language, it doesn’t make sense to say that one is changing section 385 in order to make a sub rosa change to section 163; instead, one is changing section 385 to produce a derivative consequence under section 163.b this observation immediately makes clear that it is going to be harder to apply these principles than it originally appeared. we will need to decide when one statutory provision is derivative of another and when they are independent of each other. moreover, the effect on another code section could be a proper application of selective regulatory interpretation of section 385, not only because the other code section derives from section 385, but also because both section 385 and the other code section derive from a common higher-order principle. thus, for example, one might say that a selective transformation of related-party debt into equity has a suspicious effect on treaties. isn’t this a way to backhandedly renegotiate all treaties that have a lesser rate of withholding on interest than on dividends? we would argue that those suspicions are illfounded, because both section 385 and treaties acknowledge the higher-order principle that relatedness is relevant. relatedness is relevant to the debt-equity question because it calls into question whether the parties will act purely in accordance with their debtorcreditor status. relatedness is relevant to treaties because the portfolio interest exception obviates the need to rely on reduced treaty withholding rates on interest in most other circumstances. and, moreover still, when it comes to higher-order principles, some are more equal than others. suppose, for example, that the presumed higher-order principle is appetite for risk. from that derives both aggressive structuring to create interest deductions and the incurrence of the substantial understatement penalty under section 6662. would it then be appropriate to selectively apply the related-party debt recharacterization regulations under section 385 only to companies that had incurred the substantial understatement penalty within the last ten years? it seems unfair—a continuing cloud of potential recidivism hanging over a taxpayer that has paid full penance for its sins—and unwieldy. but is it improper? on balance we would say it is improper, on the theory that the vague correlation to a higher order principle is insufficient to overcome a more direct objection that one has used section 385 to impose an additional consequence to (i.e., re-write) section 6662. e. a selective application of regulatory authority could fail for lack of germaneness, even if other laws/code sections are not affronted.31 to illustrate here, suppose that regulations under section 385 impose equity treatment on related-party debt where the name of the u.s. company begins with the letter “a”. this is not gender discrimination; nor does it impinge on any other aspect of the code. it is a nonsensical rule. but is it improper? in other words, is there a germaneness requirement to regulatory selectivity? well, yes, there is. this is an important observation which is very different from the foregoing ones. the foregoing principles tried to discern whether the executive was pretending to apply section 385 but actually doing something else; there was a sense of trickery in the air. here the executive is doing nothing nefarious, rather simply something irrelevant. 31 see motor vehicle mfrs. ass’n of u.s. v. state farm mut. ins. co., 463 u.s. 29, 42–44 (1983) (“normally, an agency rule would be arbitrary and capricious if the agency has relied on factors which congress has not intended it to consider…or is so implausible that it could not be ascribed to a difference in view or the product of agency expertise.”). 336 columbia journal of tax law [vol.8:326 this is very much at the heart of the matter when we get to analyzing the actual provisions of the final and temporary 385 regulations. is the selectivity of applying the debt-equity rules only to debt that is created in a certain manner a relevant distinction, or an irrelevant one? is it more like prioritizing relatedness as a super factor (legitimate) or is it more like demonizing the letter “a” (illegitimate). while the executive is entitled to deference in this context, there must be limits. it will be easiest to explore this proposition further when examining the actual regulations. iii. specific provisions of the regulatory package we turn now to four specific provisions of the regulatory package. for each provision, we first briefly describe the mechanics of the regulation and the authority pursuant to which the irs claims it relied. we then look more closely at the irs’s claimed authority, and finally ask the question of whether the regulation is within or outside the limits of regulatory authority. a. provision #1: treasury regulation 1.956-2t (the “deemed u.s. property rule”) one of the potential benefits of an inversion transaction is the ability to access “trapped cash” (i.e., cash in a cfc that could not be repatriated to the united states without triggering taxable income, either as a direct dividend or under section 956). following an inversion, a cfc can lend to its foreign parent without triggering a section 956 inclusion because the loan would not be an “investment in u.s. property” within the meaning of section 956. to address this perceived “abuse,” treasury regulations section 1.956-2t(a)(4) provides that, in certain circumstances, stock or an obligation of a non-u.s. person will be treated as u.s. property (we refer to this as the “deemed u.s. property rule”). more specifically, if an “expatriated foreign subsidiary”32 holds an obligation or stock of a non-cfc related person that was acquired in relation to the inversion transaction or within the ten years following the inversion transaction, such obligation or stock will be deemed to be u.s. property for purposes of section 956. 1. irs claimed authority according to the preamble to the regulatory package, a transaction in which a cfc that is an expatriated foreign subsidiary lends directly to foreign parent, bypassing its u.s. shareholder(s), is a transaction that circumvents the purpose of section 956.33 the preamble recites section 956(e) (described above) and then states, “an inversion transaction may permit the top corporate parent in the newly inverted group, a group still principally comprised of united states shareholders and their cfcs, to avoid section 956 by accessing the untaxed earnings and profits of the cfcs without a current tax to the u.s. shareholders. this is a result that the u.s. shareholders could not achieve before the inversion. the ability of the new foreign parent to access deferred cfc earnings and profits would in many cases eliminate the need for the cfcs to pay dividends to the united states shareholders, thereby circumventing the purposes of section 956.” 32 26 cfr § 1.956-2t(a)(4). 33 the 2014 notice, which originally set forth the deemed u.s. property rule, stated that “section 956(e) directs the secretary to prescribe regulations to prevent the avoidance of the provisions of section 956 through reorganizations or otherwise; an inversion is an example of such a transaction.” notice 2014-52, 2014-42 i.r.b. 712. 2017] a framework for testing regulatory authority 337 2. a closer look as noted above, defining the purpose of section 956 is not a straightforward exercise. but before we go there, we must acknowledge this rule for what it is—an antiinversion rule. in a foreign-parented structure that includes u.s. corporations and their cfcs, and where the structure is not the consequence of an inversion, the deemed u.s. property rule does not apply.34 we can thus infer two separate but related points. first, this rule is not a rule about section 956, but a rule about section 7874. the deemed u.s. property rule creates another consequence—a penalty—for undertaking an inversion transaction. second, the “purpose” of section 956 is not abused when a non-inverted foreign-parented group with u.s. corporations and lower-tier cfcs undertakes the kind of transaction that “circumvents” the purpose of section 956 when undertaken by an inverted group. 3. is the deemed u.s. property rule within the scope of the irs’s regulatory authority? imagine section 7874 had never been enacted and an “inversion transaction” was not a technical term but just a colloquial phrase for a tax-free reorganization in which a u.s. target is merged with and into a foreign acquiring corporation. could the irs have issued regulations under section 956 applying the deemed u.s. property rule only when an “inversion transaction” has previously taken place? the answer to that question would rest solely on whether such a regulation is within the grant of the authority under section 956(e). since there is no anti-inversion statute in this hypothetical, there is no concern that the deemed u.s. property rule is invalid because it is really a rule about section 7874. section 7874 does exist, however, and so we must ask (in addition to the “purpose” question) whether the deemed u.s. property rule is doing something to section 7874 that could not be done directly—i.e., is the regulation rewriting section 7874 in an inappropriate manner? in effect, the deemed u.s. property rule treats a foreign parent as a u.s. corporation for purposes of section 956 in the context described above in order to target a perceived abuse relating to inversions. had the ownership percentage with respect to the foreign parent’s u.s. shareholders been 80% or more, the foreign parent would have been treated as a u.s. corporation for all purposes of the code pursuant to section 7874(b). thus, one way to articulate the effect of the deemed u.s. property rule is that for section 956 purposes, the regulation lowers the 80% ownership percentage threshold in section 7874(b) to 60%. should this be allowed? perhaps the answer is yes, in the context of sections 956 and 7874, insofar as one could argue that the deemed u.s. property rule does not actually cause a foreign parent to be treated as a u.s. corporation; rather, the regulation causes the stock and obligations of a foreign parent (and other non-cfc related persons) to be treated as stock or obligations of a u.s. person. but that nuance should not be sufficient 34 the deemed u.s. property rule is limited to “expatriated foreign subsidiaries.” a non-inverted foreign-parented group with u.s. corporations and lower-tier cfcs can therefore “circumvent” section 956 by having its cfcs lend directly to the foreign parent. 338 columbia journal of tax law [vol.8:326 to bless all regulatory action under one section that frustrates a congressional bright-line test set forth in another section.35 in the extreme, imagine the irs issued regulations under each code section, stating that (i) an inversion transaction presents the potential for abuse of such section, and (ii) therefore, in order to prevent such abuse, solely for purposes of such section, a foreign corporation that was involved in an inversion transaction will be treated as a u.s. corporation (or interests in such a foreign corporation will be treated as interests in a u.s. corporation). in that scenario, the irs would have overstepped its authority—the net effect of the regulations would be to lower the 80% threshold in section 7874(b) to 60%—a result at odds with the clear statutory text of section 7874. (as discussed below, regulations issued under section 7874 that reached the same result would be equally invalid.) even if the deemed u.s. property rule can survive a challenge that the rule effects an unauthorized sub rosa change to section 7874, there is still the question of whether the rule can be supported by a coherent description of the purpose of section 956. in order for the deemed u.s. property rule to prevent avoidance of the “purpose” of section 956, we must be able to articulate a purpose of section 956 that would be circumvented only in the case when the foreign-parented group is the consequence of an inversion transaction, and not an old-and-cold foreign-parented group. maybe the avoidance has to do with the fact that an inverted group is still “primarily composed of united states shareholders and their cfcs”, which is the language the preamble uses to explain the provision. but if that is relevant to the purpose of section 956, why is a recently inverted group any different than an old-and-cold foreign-parented group that consists primarily of u.s. companies and their cfcs? maybe what the irs meant in the preamble was that it is relevant to the purpose of section 956 that in an inversion transaction the shareholders of the foreign parent are primarily composed of the old shareholders of old u.s. parent. in other words, the old shareholders of old u.s. parent previously owned a company that would have been taxed under section 956 if its cfcs had made loans to the old u.s. parent; now the shareholders own a company that, absent the deemed u.s. property rule, would not be taxed if those same lower-tier companies made loans to the new foreign parent. that would explain the deemed u.s. property rule only applying to inverted groups, but that articulation of section 956’s purpose is unsupportable—section 956 was conceived to police the relationship between a cfc and its u.s. shareholders (within the meaning of section 951(b)). if a cfc makes a loan to a u.s. person that is not a u.s. shareholder (within the meaning of section 951(b)) or a person related to the u.s. shareholder, section 956 is not implicated.36 the preamble gives another suggestion of section 956’s purpose: “the ability of the new foreign parent to access deferred cfc earnings and profits would in many cases eliminate the need for the cfcs to pay dividends to the u.s. shareholders, thereby circumventing the purposes of section 956.” this suggests that cash is somehow finding its way into the u.s. shareholder through a subsequent transaction: the u.s. shareholder 35 see chevron, 467 u.s. at 842-43 (“when a court reviews an agency’s construction of the statute which it administers, it is confronted with two questions. first, always, is the question whether congress has directly spoken to the precise question at issue. if the intent of congress is clear, that is the end of the matter; for the court, as well as the agency, must give effect to the unambiguously expressed intent of congress.”). 36 see § 956(c)(2)(f), (l). 2017] a framework for testing regulatory authority 339 needs cash, but the inversion transaction eliminates the “need” to acquire the cash by declaring a dividend from the cfc. if the abuse is really a transaction that occurs after the loan from cfc to foreign parent, i.e., a subsequent transaction where the foreign parent lends or contributes the borrowed cash to a u.s. shareholder, we agree that such a transaction (or transactions) could be abusive of section 956. but that is not what is happening in the deemed u.s. property rule, which does not require that cash ever find its way to the u.s. shareholder. if the cash stays at the foreign parent, how is that different than if a cfc owned by a publicly-traded u.s. corporation lent money to the public shareholders? if that is the abuse that the deemed u.s. property rule is targeting, it is hard to understand why this is only a circumvention of section 956 in the context of inverted groups. such transactions are equally “abusive” of the purposes of section 956 in an old-and-cold foreign parented group.37 the deemed u.s. property rule is a rule about inversions. while that does not necessarily mean it cannot be authorized under section 956 (although there are strong arguments that it cannot), we are not convinced there is a reasonable articulation of the purpose of section 956 that can support the deemed u.s. property rule and its application only to inverted groups. if the rule is not in support of the purposes of section 956 and/or does not prevent the abuse of section 956, the rule is not authorized under section 956(e). b. provision #2: treasury regulation section 1.7874-8t (the “serial acquisition rule”) the serial acquisition rule in treasury regulations section 1.7874-8t provides that, for purposes of calculating the ownership percentage (i.e., total vote/value of foreign corporation stock held by former shareholders/partners of the domestic corporation/partnership divided by total vote/vale of foreign corporation stock), the value of stock attributable to a “prior domestic entity acquisition” is excluded from the denominator. a “prior domestic entity acquisition” is any domestic acquisition that occurred during the 36-month look back period beginning on the signing date of the current acquisition being tested. 1. irs claimed authority the irs cites sections 7874(c)(6) and (g) as its authority to adopt the serial acquisition regulation. the relevant section of the preamble declares serial inversion transactions as inconsistent with the purposes of section 7874 and analogizes the serial acquisition regulation to the stock exclusion rules of treasury regulations sections 1.7874-4t and 7t. 38 treasury regulations section 1.7874-4t excludes certain stock of a foreign 37 in addition, such transactions could be attached under the circular cash flow doctrine or the anticonduit theory. see rev. rul. 83-142 (ruling that where a domestic corporation contributes a sum of money to a subsidiary and then immediately receives that same sum as a dividend, the contribution is a “circular flow of cash,” which “is a transitory step that has no federal income tax consequences”); 26 cfr § 1.8813(a)(3)(ii) (permitting the irs to disregard an intermediate entity in a financing arrangement for the purpose of determining the non-effectively connected income of a foreign corporation). 38 see t.d. 9761, 2016-20 i.r.b. 743, 81 fr 20865 (“the treasury department and the irs have concluded that it is not consistent with the purposes of section 7874 to permit a foreign acquiring corporation to reduce the ownership fraction for a domestic entity acquisition by including stock issued in connection with other recent domestic entity acquisitions. moreover, the treasury department and the irs do not believe that the application of section 7874 in these circumstances should depend on whether there was a 340 columbia journal of tax law [vol.8:326 acquiring corporation issued in transactions in anticipation of an acquisition of a domestic entity from the denominator of the ownership fraction that is used to determine the extent to which the inverted corporation is domestically owned. treasury regulations section 1.7874-7t similarly excludes from that denominator stock of the foreign acquiring corporation that is attributable to certain passive assets. 2. a closer look both sections 7874(c)(6) and (g) give the irs a broad grant of regulatory authority, and as with section 956, it is necessary to parse the language closely to determine what is within the scope of that grant. section 7874(c)(6) provides: the secretary shall prescribe such regulations as may be appropriate to determine whether a corporation is a surrogate foreign corporation, including regulations to treat warrants, options, contracts to acquire stock, convertible debt interests, and other similar interests as stock, and to treat stock as not stock. according to the irs, the serial acquisition regulation is authorized because by excluding shares attributable to a prior domestic entity acquisition from the denominator, the regulation is treating “stock” as “not stock.” section 7874(g) provides a grant of authority similar to that in section 956(e): to “provide such regulations as are necessary to carry out this section, including regulations providing for such adjustments to the application of this section as are necessary to prevent the avoidance of the purposes of this section.”39 3. is the serial acquisition rule within the scope of the irs’s regulatory authority? let us start with the limits that apply to both section 7874(c)(6) and section 7874(g)—limits that apply to all regulatory authority. we know that a regulation promulgated under either section would be invalid if it violated another law, as in the gender discrimination example. the serial acquisition rule does not suffer from any defect in that respect. we also know that a regulation promulgated under either section would be invalid if it rewrote section 7874—for example, a regulation that crossed out “80” in section 7874(b) and replaced it with “60.” this is a harder question, but we believe the serial acquisition rule does not encroach on any of the statutory language of section 7874. many commentators have expressed frustration that the serial acquisition rule applies regardless of whether the previous acquisitions were done pursuant to a plan that includes the later acquisition.40 however, the “pursuant to a plan” concepts that are demonstrable plan to undertake the subsequent domestic entity acquisition at the time of the prior domestic entity acquisitions.”). 39 the full text of section 7874(g) reads: “the secretary shall provide such regulations as are necessary to carry out this section, including regulations providing for such adjustments to the application of this section as are necessary to prevent the avoidance of the purposes of this section, including the avoidance of such purposes through (1) the use of related persons, pass-through or other noncorporate entities, or other intermediaries, or (2) transactions designed to have persons cease to be (or not become) members of expanded affiliated groups or related persons.” 40 see, e.g., amanda athanasiou, chamber of commerce, irs face off in inversion rule challenge, 153 tax notes 355 (2016) (noting the u.s. chamber of commerce’s argument in litigation that the serial acquisition rule is invalid for not “depend[ing] on a scheme intended to circumvent the statute by inflating the foreign corporation’s size”). 2017] a framework for testing regulatory authority 341 expressed in the statutory language of section 7874, as well as the existing regulations, are not incompatible with the serial acquisition rule. sections 7874(a)(2)(b) and section 7874(c)(3) refer to acquisitions as part of a plan and presume an acquisition of all of the properties of a domestic corporation over a four-year period to be part of a plan, but those sections are trying to prevent “creeping acquisitions” 41 of a single entity from falling outside of section 7874. 42 treasury regulations section 1.7874-2(e) provides that if, pursuant to a plan or a series of related transactions, a foreign corporation undertakes multiple domestic entity acquisitions, the acquisitions are treated as a single acquisition and the entities are treated as a single entity. the irs did not rely on any specific authority granted under section 7874 when promulgating 1.7874-2(e); instead, the irs believes this regulation “clarified” existing law and that “the operative rule . . . is not a change from current law.”43 we read this as applying either the rule in treasury regulations section 1.368-2(h) (treating multiple corporations as a single corporation “if the context so requires”), as was cited in the preamble to the regulations, or, more accurately, acknowledging that under the step transaction doctrine the irs could aggregate multiple acquisitions made pursuant to a single plan.44 the serial acquisition rule is one step further because it applies to any acquisition done within the relevant time period regardless of whether the acquisitions were pursuant to a plan. that the serial acquisition rule was issued pursuant to sections 7874(c)(6)’s and 7874(g)’s authority implies that the irs believes the rule is not a “clarification” of current law, and we agree. it would be inappropriate to rely on section 1.368-2(h) or the step transaction doctrine where separate acquisitions are truly unrelated other than temporally. but that does not suggest that the rule is somehow inconsistent with the statute; it suggests that for the regulation to be authorized, the authorization must come from section 7874(c)(6) or section 7874(g). and so we must to turn to the language of those sections. section 7874(c)(6) grants broader discretion, but is narrower in scope, than section 7874(g). the former allows the irs to issue regulations “as may be appropriate”, whereas the latter authorizes regulations “as are necessary.” “as may be appropriate” gives the executive a lot of leeway—the regulations can be appropriate, but not necessary, and the “as may be” language suggests that the executive has quite a bit of 41 for example, a series of acquisitions, none alone which constitutes “substantially all”, but in the aggregate does. 42 see t.d. 9591, 2012-28 i.r.b. 32, 77 fr 34790 (june 12, 2012) (“[i]f, pursuant to a plan (or series of related transactions), a foreign corporation completes two or more acquisitions described in section 7874(a)(2)(b)(i) involving domestic corporations or partnerships (domestic entities) then, for purposes of section 7874(a)(2)(b)(ii), the acquisitions are treated as a single acquisition and the domestic entities are treated as a single domestic entity.”). 43 t.d. 9453, 2009-28 i.r.b 114, 74 fr 27922 (june 12, 2009); see also id. (“the preamble to the 2008 final regulations explains that any regulations issued would clarify that references in section 7874(a)(2)(b) to ‘a domestic corporation’ shall, as appropriate, mean ‘one or more domestic corporations’ where the properties of more than one domestic corporation are, directly or indirectly, acquired by a foreign corporation pursuant to the same plan.” (citing 26 cfr §1.368-2(h))). 44 see smith v. commissioner, 78 t.c. 350, 389 (1982) (“the step transaction doctrine generally applies in cases where a taxpayer seeks to get from point a to point d and does so stopping at points b and c in-between. the whole purpose of the unnecessary stops is to achieve tax consequences differing from those which a direct path from a to d would have produced. in such a situation, courts are not bound by the twisted path taken by the taxpayer and the intervening stops may be disregarded or rearranged.” (citing gregory v. helvering, 293 u.s. 465 (1935))). 342 columbia journal of tax law [vol.8:326 room to decide what is appropriate (although chevron deference likely grants the executive such power in any event).45 but section 7874(c)(6) regulations are limited to determining whether a corporation is a surrogate foreign corporation, whereas the irs can issue regulations under section 7874(g) “to carry out this section [7874].” since the regulations determine whether a corporation is a surrogate foreign corporation by treating stock attributable to a previous domestic entity acquisition as “not stock”, which is specifically authorized in section 7874(c)(6)(b), the regulations come within the narrower scope, but broader discretion of section 7874(c)(6). we begin again with an example of a hypothetical regulation that would be unauthorized under section 7874(c)(6), despite the section’s broad grant of authority. suppose the irs issued a regulation, the preamble to which stated that in addition to the specific stock exclusion rules set forth in the section 7874 regulations, the irs has determined that taxpayers are implementing many other transactions that have the effect of increasing the denominator of the ownership fraction in a manner inconsistent with the purpose of section 7874. in order to combat these transactions (which are too varied and creative to tailor specific rules in response), the irs is going to automatically discount the denominator by 25%. the preamble might further declare that this rule, while not perfectly precise, is adopted as a matter of administrative convenience in light of taxpayers’ attempts at manipulating the ownership fraction. (indeed, the irs has recently offered this justification in a number of contexts, some of which raise similar questions of authority.) the effect of this regulation, of course, would be to lower the statutory percentage thresholds in section 7874 (and increase a 60% ownership percentage to 80%). that regulation would fail because it would be a backhanded way of rewriting section 7874. does the serial acquisition rule similarly rewrite section 7874 in any manner? we believe the answer is no. congress identified a specific abuse in adding the “pursuant to a plan” language in section 7874(b)—a taxpayer should not be able to avoid section 7874 by structuring one or more related acquisitions as separate transactions. that does not mean that congress viewed multiple transactions that are not pursuant to a plan as per se not in avoidance of the purposes of section 7874. a foreign corporation could have a plan to acquire smaller u.s. companies, growing in size until the foreign corporation could acquire larger and larger u.s. companies without triggering the relevant ownership thresholds. this scheme might not fall within section 7874(b)’s “pursuant to a plan” definition because the foreign corporation’s successive targets may not have been identified at the time of previous transactions. nevertheless, one might still consider such a fact pattern as inconsistent with the purpose of section 7874. the fact that congress identifies a specific abuse and targets such abuse in the statute does not preclude an agency from regulating other situations the agency finds abusive, particularly where congress has granted broad anti-abuse rulemaking authority and congress has not directly commanded otherwise with respect to the relevant situation. serial inversions were a likely target of any irs action and there were a number of ways the irs could have attacked the issue. for example, the irs could have adjusted the numerator of the ownership fraction by declaring that all stock issued in prior 45 in case there was any doubt, the legislative history makes clear that “as may be appropriate” means, or at least should be read as meaning, as may be appropriate “to carry out the purposes of this provision.” see h.r. rep. no. 108-755, at 572 (2004) (conf. rep.) (“the treasury secretary is given authority to issue regulations appropriate to carry out the purposes of this provision and to prevent its abuse.”). 2017] a framework for testing regulatory authority 343 domestic entity acquisitions to be “by reason of” stock (essentially aggregating all domestic entity acquisitions in the last three years). that approach might have been sustained, although it would have been outside of the specific grant of authority under section 7874(c)(6) “to treat stock as not stock”. alternatively, the irs could have issued regulations deeming all domestic entity acquisitions within the last three years as having been adopted pursuant to a plan. that too might be authorized, although one might argue that a hard-and-fast rule, as opposed to a presumption, might be beyond the statutory text if a taxpayer could prove the absence of a plan. the irs instead relied on the authority in section 7874(c)(6), and we believe it was within its power to do so. it is worth noting that this approach might become impermissible if taken to extremes. if the serial acquisition rule were not limited to a three-year look-back, but a twentyor fifty-year look-back, at some point the rule would become too tangential to the activity the rule was intending to police. we do not believe that is the case here, although the question of “how long is too long” is undoubtedly a question that cannot be answered by any set of objective guidelines on limiting regulatory authority. we leave you with the unsatisfying conclusion that the serial acquisition rule does not seem like an overreach. c. provision #3: treasury regulation section 1.7701(l)-4t (the “de-cfc rule”). following an inversion transaction, a foreign parent and its affiliates may undertake transactions to dilute a u.s. shareholder’s interest in an expatriated foreign subsidiary, in some cases causing the expatriated foreign subsidiary to lose its status as a cfc. these transactions have the potential to allow a cfc’s pre-inversion earnings and profits (e&p) to be distributed to a non-cfc related person (i.e., a foreign parent or one of its foreign subsidiaries) such that the e&p permanently avoids attracting u.s. tax. in order to address this perceived abuse, treasury regulations section 1.7701(l)-4t (the “de-cfc rule” or “de-cfc regulation”)46 recharacterizes a “specified transaction” in which an expatriated foreign subsidiary issues stock to a “specified related person” during the applicable period. the base example of a specified transaction in the de-cfc regulation is set forth in treasury regulations section 1.7701(l)-4t(g) and is as follows: dt is owned by fp following an inversion transaction; dt owns cfc, and fp also owns fa. fa subscribes for stock representing 60% of the vote and value of cfc in exchange for $6x of cash. absent recharacterization, cfc would cease to be a cfc as a result of fa’s ownership. under the recharacterized transaction, fa is treated as having contributed $6x of cash to dt in exchange for dt stock. dt is deemed to contribute $6x of cash to cfc for additional stock of cfc and the terms of the deemed dt stock and deemed cfc stock mirror each other and mirror the terms of the actual cfc stock (issued to fa). 1. irs claimed authority. the preamble (and notice 2014-52) state that the irs is relying on section 7701(l) for the authority to issue the de-cfc regulation. the entirety of section 7701(l) reads: “the secretary may prescribe regulations recharacterizing any multiple-party financing transaction as a transaction directly among any 2 or more of such parties where the secretary determines that such recharacterization is appropriate to prevent avoidance of any tax imposed by this title.” 46 the de-cfc rule was originally set forth in notice 2014-52 (oct. 14, 2014). 344 columbia journal of tax law [vol.8:326 the notice claims that section 7701(l)’s legislative history authorizes the irs to issue regulations under section 7701(l) to combat abuse under “a wide variety of code sections.”47 2. a closer look. first, neither notice 2014-52 nor the preamble acknowledge the title of section 7701(l): “regulations relating to conduit arrangements.” while the legislative history of section 7701(l) does not limit the irs to “back-to-back loans,” it is clear from the title of section 7701(l), the case cited to in the legislative history, and the general discussion of section 7701(l) at the time the provision was adopted, that congress was targeting transactions (i) with more than two parties, and (ii) where certain parties (conduits) were introduced to the transaction in order to avoid u.s. tax that otherwise would have been imposed if the transaction had been undertaken without the conduit’s involvement. 3. is the de-cfc rule within the scope of the irs’s regulatory authority? in a word, no. one does not need to perform a deep dive into the legislative history or a particulate analysis of the statutory text (but we’ll get there) to conclude that the de-cfc rule should not be something the irs can adopt under the power granted by section 7701(l). the statute was intended to grant the irs regulatory authority to prescribe rules to recharacterize transactions involving more than two parties and more than two legal arrangements as more direct transactions involving fewer parties and fewer steps. the de-cfc rule creates additional steps, additional legal arrangements, and deems parties that were not party to the transaction to have been involved.48 the irs has exercised its authority under a statute designed to disregard conduit arrangements in order to create a deemed conduit arrangement. in addition to being outside the scope of congressional purpose behind the anticonduit regulations, the de-cfc rule also exceeds the explicit regulatory grant of section 7701(l). section 7701(l) authorizes the irs to recharacterize “any multiple-party financing transaction as a transaction directly among any 2 or more of such parties.” even if one reads “multiple-party” as encompassing two-party transactions, the irs is authorized to recharacterize the transaction only as a transaction among two or more of such parties—i.e., the parties to the multiple-party financing transaction. in the example above, the de-cfc rule recharacterizes a transaction between two parties (fa and cfc) as having occurred between more than two parties (fa, dt and cfc). because dt was not a party to the original financing transaction, the anti-conduit regulation cannot recharacterize the transaction as having included dt. the de-cfc rule is outside of the regulatory authority granted by section 7701(l), a conclusion supported by a common sense understanding of “conduit” and the clear text of the statute. d. provision #4: treasury regulation section 1.385-3 (the “per se rule”). 47 see h.r. rep. no. 103-213, at 655 (1993) (“it is intended that the provision apply not solely to back-to-back loan transactions, but also to other financing transactions. for example, it would be within the proper scope of the provision for the secretary to issue regulations dealing with multiple-party transactions involving debt guarantees or equity.”). 48 the irs has previously exercised its authority under section 7701(l) to adopt (1) regulations under section 881, see t.d. 8611, 1995-2 c.b. 286, conduit arrangement regulations, 60 fed. reg. 40997 (aug. 11, 1995), and (2) regulations recharacterizing “fast pay stock” arrangements under treasury regulations section 1.7701(l)-3. the fast pay stock regulations similarly create extra steps and therefore also introduce material questions of authority. see t.d. 8853, 2000-1 c.b. 377, 65 fed. reg. 1310-01 (jan. 10, 2000); see also peter m. daub, the conduit regulations revisited, 147 tax notes 409 (2015) at 409. 2017] a framework for testing regulatory authority 345 section 385 authorizes the irs to prescribe regulations to determine whether an interest in a corporation is stock or debt (or part-stock/part-debt).49 the regulations are supposed to set forth factors to be taken into account to determine “with respect to a particular factual situation whether a debtor-creditor relationship exists or a corporationshareholder relationship exists.”50 in treasury regulations section 1.385-3, the irs set forth a “per se rule” that treats debt as equity in the following circumstances where the debtor and creditor are members of the same expanded group:51 (1) the debt is distributed from a corporation to its shareholder, (2) the debt is exchanged for expanded group stock (subject to certain exceptions), or (3) the debt is exchanged for property in an asset reorganization. in addition, if a corporation borrows cash from an expanded group member (a “funding transaction”) with a principal purpose of engaging in a transaction described above, but where cash or other property is distributed or exchanged instead of debt (a “funded transaction”), the funding transaction is recharacterized as equity (the “funding rule”). the funding rule is implicated if the funding transaction and funded transaction occur within 36 months of each other, regardless of whether the funding transaction was undertaken with a principal purpose of financing the funded transaction.52 there are exceptions to the per se rule, including (1) an exception to the extent of accumulated e&p of the debtor,53 (2) a de minimis threshold of $50 million,54 (3) an exception for debt between consolidated group members, 55 (4) a limited ordinary course of business exception, 56 (5) an exception for instruments issued by certain regulated financial companies and regulated insurance companies,57 (6) an exception for debt issued by nonu.s. corporations, and (7) a rule allowing certain distributions and acquisitions by an expanded group member to be netted against the fair market value of stock issued by that member.58 if a debt instrument is recharacterized as stock, the debt instrument is treated as stock for all purposes of the code. 1. irs claimed authority. in the preamble to the proposed 385 regulations,59 the irs relied on section 385(a)’s grant of regulatory authority to adopt rules for the “particular factual situations” 49 i.r.c. § 385(a). 50 i.r.c. § 385(b). 51 see i.r.c. § 1504(a)(1) (defining “affiliated group” to mean “1 or more chains of includible corporations connected through stock ownership with a common parent corporation which is an includible corporation,” but only if the common parent owns 80% of the total voting power and value of at least one of the other includible corporations and every includible corporation within the chain is owned 80% by vote and value by another includible corporation); treas. reg. § 1.385-1(c)(4) (defining “expanded group” using concepts similar to those used to define the term “affiliated group,” such that, in general, an “expanded group” contains foreign corporations and corporations that are 80% owned by vote or value). 52 26 c.f.r. § 1.385-3(b). 53 26 c.f.r. § 1.385-3(c)(3)(c). 54 26 c.f.r. § 1.385-3(c)(4). 55 26 c.f.r. § 1.385-4t(b). 56 26 c.f.r. § 1.385-3t(b)(3)(vii)(b). 57 26 c.f.r. § 1.385-3(g)(3)(i), (iv). 58 26 c.f.r. § 1.385-3(c)(3)(ii)(a). 59 we focus our analysis on the preamble to the proposed 385 regulations because the preamble lays out the irs’s authority argument more clearly. the preamble to the final and temporary 385 regulations does respond to comments regarding the irs’s authority to issue the section 385 regulations (see “summary of comments and explanation of revisions”, ii.a.), however the response largely repeats the arguments made in the preamble to the proposed 385 regulations. 346 columbia journal of tax law [vol.8:326 that the irs believes “raise significant policy concerns.”60 the irs cited to section 385’s legislative history for the proposition that the irs need not rely on the factors listed in section 385(b): the provision also specifies certain factors which may be taken into account in these [regulatory] guidelines. it is not intended that only these factors be included in the guidelines or that, with respect to a particular situation, any of these factors must be included in the guidelines, or that any of the factors which are included by statute must necessarily be given any more weight than other factors added by regulations.61 the preamble cited debt/equity factors that were considered in cases involving related parties. 62 more specifically, in adopting the per se rule in the context of distributions of debt instruments, the irs determined that “the parent-subsidiary relationship, the fact that no new capital is introduced in connection with a distribution of debentures, and the typical lack of a substantial non-tax business purpose, support the conclusion that the issuance of a debt instrument in a distribution is a transaction that frequently has minimal or nonexistent non-tax effects.”63 the extension of the per se rule to exchanges and acquisitions involving related-party debt, as well as the funding rule, were adopted because the irs believes such transactions raise similar concerns. 2. a closer look. section 385’s grant of regulatory authority is indeed very broad. while the statute lists certain debt/equity factors, the legislative history is clear that the irs is free to issue regulations that consider other factors and/or do not consider the listed factors at all, and the irs has a wide discretion with respect to the weight given to these factors in particular factual situations.64 3. is the per se rule within the scope of the irs’s regulatory authority? before we address whether there are any limitations on the irs’s authority under section 385 (there are) and whether the irs has exceeded its authority in adopting the per se rule (we believe the irs has), it is necessary to consider what congress thought it was authorizing when it enacted section 385. outside the context of the section 385 regulations, the question of whether an instrument is debt or equity is, and has always been, a question of economic substance: is the relationship between the parties that of a debtor-creditor or that of a corporation 60 reg-108060-15 (apr. 25, 2016), https://www.irs.gov/irb/2016-17_irb/ar07.html [perma.cc/pp2a-m2wz]; 2016-17 i.r.b. 636, 641 (apr. 25, 2016), https://www.irs.gov/pub/irs-irbs/irb1617.pdf [perma.cc/z9d6-shjb]; 81 fr 20916 (apr. 8, 2016), https://www.gpo.gov/fdsys/pkg/fr-2016-0408/pdf/2016-07425.pdf [perma.cc/6g99-9tcg]. 61 s. rep. no. 91-552, at 138 (1969), https://www.finance.senate.gov/imo/media/doc/rpt91552.pdf [perma.cc/q63b-t7bq]. 62 among others, the preamble cites to kraft foods co. v. commissioner, 232 f.2d 118 (2d cir. 1956); arlington park jockey club, inc. v. sauber, 262 f.2d 902, 906 (7th cir. 1959); uneco, inc. v. united states, 532 f.2d 1204, 1207 (8th cir. 1976); talbot mills v. commissioner, 146 f.2d 809 (1st cir. 1944); and sayles finishing plants, inc. v. united states, 399 f.2d 214 (ct. cl. 1968). 63 reg-108060-15, 2016-17 i.r.b. 636, 643, 81 fr 20917 (apr. 8, 2016). 64 in fact, section 385 was adopted at the same time section 279 was added to the code. section 279 limited interest deductions attributable to debt issued in certain corporate acquisitions and the senate report, which considered sections 279 and section 385 together, made it clear that congress authorized the irs to issue general debt/equity guidelines that would cause debt to be treated as equity even if such debt were not subject to the interest deduction limitations congress set forth in section 279. 2017] a framework for testing regulatory authority 347 shareholder, and have the parties acted in a manner consistent with that relationship? the factors referenced in section 385, the debt/equity case law, and irs public and private rulings are guideposts to assist in determining the true economic relationship between the parties, which is the essence of the debt/equity question. the legislative history of section 385 (during its enactment and subsequent amendments) evidences that congress shares this view. for example, the house report accompanying the 1989 amendment to section 385 stated “the characterization of an investment in a corporation as debt or equity for federal income tax purposes generally is determined by reference to numerous factors that are deemed to reflect the economic substance of the investor’s interest in the corporation”65 (emphasis added). three years later, when congress again amended section 385, the house report discussing the amendment provided: in 1969, congress granted the secretary of the treasury the authority to prescribe such regulations as may be necessary or appropriate to determine whether an interest in a corporation is to be treated as stock or indebtedness for federal income tax purposes (sec. 385). the regulations were to prescribe factors to be taken into account in determining, with respect to particular factual situations, whether a debtor-creditor relationship or a corporation-shareholder relationship existed.66 similarly, the irs acknowledged in the preamble to the proposed 385 regulations that the debt/equity question is a question of economic substance. in fact, the entire premise of the documentation requirements set forth in treasury regulations section 1.385-2 is that (i) there are certain factors (e.g., ability to repay) that indicate whether as a matter of substance an instrument is debt or equity, (ii) in the related-party context, it is less likely that a creditor will have demanded evidence of those factors, and (iii) therefore, it is necessary to impose documentation requirements in order to ensure the irs has the necessary information in order to undertake a substantive analysis of the instrument in question to determine whether it is debt or equity.67 65 h.r. conf. rep. 101-386, at 562 (1989). 66 h.r. rep. 102-716 (1992) (emphasis added). 67 prop. treas. reg. 1.385-2. a sampling of quotations from the preamble to the proposed 385 regulations (emphasis added in all quotes): “this all-or-nothing approach is particularly problematic in cases where the facts and circumstances surrounding a purported debt instrument provide only slightly more support for characterization of the entire interest as indebtedness than for equity characterization, a situation that is increasingly common in the related-party context. the treasury department and the irs have determined that the all-or-nothing approach frequently fails to reflect the economic substance of related-party interests that are in form indebtedness and gives rise to inappropriate federal tax consequences.” reg-108060-15, 2016-17 i.r.b. 636, 639, 81 fr 20914 (apr. 8, 2016). “related-party indebtedness, like indebtedness between unrelated persons, may be respected as indebtedness for federal tax purposes, but only if there is intent to create a true debtor-creditor relationship that results in bona fide indebtedness.” reg108060-15, 2016-17 i.r.b. 636, 640, 81 fr 20915 (apr. 8, 2016). “it is increasingly problematic that there is a lack of guidance prescribing the information and documentation necessary to support the characterization of a purported debt instrument as indebtedness in the related-party context.” reg108060-15, 2016-17 i.r.b. 636, 641, 81 fr 20915 (apr. 8, 2016). “this requirement also serves to help demonstrate whether there was intent to create a true debtor-creditor relationship that results in bona fide indebtedness.” reg-108060-15, 2016-17 i.r.b. 636, 641, 81 fr 20916 (apr. 8, 2016). “these requirements are necessary to the conduct of the multi-factor analysis used in the mixon and fin hay line of cases to determine the nature of an interest as indebtedness for federal tax purposes.” reg-108060-15, 2016-17 i.r.b. 636, 641, 81 fr 20916 (apr. 8, 2016). 348 columbia journal of tax law [vol.8:326 in contrast, the per se rule is fully divorced from the question of whether an instrument is, in substance, debt or equity.68 in fact, the per se rule first requires a taxpayer go through a traditional debt/equity analysis (i.e., determine the economic substance of the instrument).69 only if such an analysis reveals the instrument as true debt does the per se rule potentially recharacterize the debt (which was just determined to be debt under the traditional debt/equity factors) as equity. we think it is fair to say that this is not what congress envisioned when it adopted and subsequently amended section 385. the question of what is authorized under section 385 is admittedly a harder question, given the expansive authority granted by the statutory language and the legislative history. lee sheppard has written that “the statute clearly empowers the government to write regulations that would effectively replace case law.”70 that may be the case in some respects, but it cannot be true in all respects. suppose the irs issued a regulation under section 385 that declared all instruments with a term of less than one year, regardless of their relationship to the issuer/holder, to be equity. yes, the term of an instrument can be relevant to the debt/equity analysis, but surely a shorter-term instrument is more debt-like, not more equity-like. would this rule be authorized? the answer must be no. in laypersons’ terms; that would be a crazy rule. in the language of a judicial challenge of administrative action; such a rule could never survive state farm.71 common sense tells us that this rule cannot be within the irs’s scope of authority, and apa jurisprudence tells us the same.72 what is the thing that makes such a rule unauthorized? the answer is that the rule bears not just zero relation, but an inverse relation, to the substance of the instrument as debt or equity. that’s what makes it a crazy rule; that’s what would make its issuance “arbitrary and capricious”73. as the supreme court recently noted, “even under chevron’s deferential framework, agencies must operate ‘within the bounds of reasonable interpretation.’”74 such reasonable interpretation “must account for both ‘the 68 “the treasury department and the irs have determined that the issuance of a related-party debt instrument to acquire stock of a related person is similar in many respects to a distribution of a debt instrument and implicates similar policy considerations.” reg-108060-15, 2016-17 i.r.b. 636, 643, 81 fr 20917 (apr. 8, 2016). “in light of these policy concerns, the proposed regulations treat a debt instrument issued in fact patterns similar to that in kraft as stock.” reg-108060-15, 2016-17 i.r.b. 636, 642, 81 fr 20916 (apr. 8, 2016). 69 26 cfr §1.385-3(g)(4); reg-108060-15, 2016-17 i.r.b. 636, 648, 81 fr 20922 (apr. 8, 2016). (“thus, the term debt instrument for purposes of proposed §§1.385-3 and 1.385-4 means an instrument that satisfies the requirements of proposed §§1.385-1 and 1.385-2 and that is indebtedness under general principles of federal income tax law.”). 70 lee a. sheppard, news analysis: tailoring the proposed debt-equity regulations, 152 tax notes 311 (2016). 71 see state farm, 463 u.s. at 43 (“normally, an agency rule would be arbitrary and capricious if the agency has relied on factors which congress has not intended it to consider, entirely failed to consider an important aspect of the problem, offered an explanation for its decision that runs counter to the evidence before the agency, or is so implausible that it could not be ascribed to a difference in view or the product of agency expertise.”). we think it is fair to say that, all other things being equal, the crazier a rule, the less likely it is to withstand such review. 72 going one step further, a regulation that completely reversed all existing case law (e.g., by determining that all factors previously considered to be indicative of debt are in fact indicative of equity) would likewise not stand. 73 state farm, 463 u.s. at 43 74 utility air regulatory group v. e.p.a., 134 s. ct. 2427, 2442 (2014) (quoting city of arlington v. f.c.c., 133 s. ct. 1863, 1868 (2013)). 2017] a framework for testing regulatory authority 349 specific context in which . . . language is used’ and ‘the broader context of the statute as a whole.’”75] the example above, however absurd, proves that we have to look at the per se rule and the relationship of the rule to the substantive question of debt vs. equity to see whether the rule is authorized. the broad authority granted to the irs in section 385 – and it is broad – has limits. and, more importantly for the analysis of the per se rule, the actual substance of an instrument as debt or equity, and the relation any proposed rule has to that substance, is one of those limits. the preamble describes or cites to a few debt/equity cases, focusing primarily on kraft v. commissioner.76 in kraft, the taxpayer was a subsidiary corporation that had issued a debt instrument to its parent and claimed deductions for interest payments made with respect to the instrument.77 the court held for the taxpayer, stating that “to strike down a genuine transaction because of the parent-subsidiary relation would violate the scheme of the statute [permitting deduction of interest payments] and depart from the rules of law heretofore governing intercompany transactions.”78 the preamble, however, states that “the factors discussed in kraft and talbot mills, including [1] the parentsubsidiary relationship, [2] the fact that no new capital is introduced in connection with a distribution, and [3] the typical lack of substantial non-tax business purpose, support the conclusion that the issuance of a debt instrument in a distribution is a transaction that frequently has minimal or nonexistent non-tax effects.” we believe the first factor is (or can be) relevant to the determination of the economic substance of an instrument. in the context of proportionately-held debt (e.g., parent-subsidiary debt), there is limited economic significance to the distinction between the debtor-creditor and corporation-shareholder relationships. moreover, the parties in such an arrangement may be less likely to act in accordance with the form of their legal arrangements. if debt and stock are held in the same proportion and there are no thirdparty creditors, why would the creditors (who are also shareholders) enforce their legal rights in an event of default? 75 id. (quoting robinson v. shell oil co., 519 u.s. 337, 341 (1997)). 76 kraft foods co. v. commissioner, 232 f.2d 118 (2d cir. 1956). 77 id. at 121–22. 78 id. at 124. 350 columbia journal of tax law [vol.8:326 in addition, this factor has universally been considered as relevant in the debt/equity case law and in irs guidance.79 it is true that section 385 and its legislative history make clear that case law does not bind the irs in considering or weighting factors in issuing regulations under section 385. but courts and the irs have not come upon this factor by accident – this factor is well-established as a relevant data point because the overlap of the creditors and shareholders of a corporation may call into question whether the purported debt instrument creates a true debtor/creditor relationship and whether the parties will act in a manner consistent with that relationship. in other words, the case law confirms the conclusion that this factor is germane to the substance of an instrument as debt or equity. this is in contrast to the “no new capital factor” discussed below, which, but for the few cases cited in the preamble to the proposed 385 regulations, is absent from the debt/equity case law. it is worth discussing further why the related party factor is germane to the debt/equity question. debt issued to a shareholder or related party does not, per se, make the debt “equity-like” in the same way other traditional equity-like features play into the analysis. convertibility into equity, for example, is an equity-like feature regardless of context (i.e., regardless of to whom and in what context the debt is issued). so too are features like subordination, the lack of a fixed maturity, the lack of interest, voting rights, and so forth. the related party factor is relevant for a different reason—because the relationship between the parties calls into question whether a true debtor/creditor relationship exists, regardless of the legal rights that the instrument creates. it is a situation that raises the antennae of the court (or the tax advisor, or the irs) because the related party context allows for a greater possibility that the parties will not act in accordance with the terms of their agreement, which is unlikely when debt is issued to a true third party.80 79 see, e.g., id. at 123 (“undoubtedly, there are elements in the present case which invite close scrutiny by the commissioner, among them the fact that the arrangement was made between a parent corporation and its wholly-owned subsidiary.”); nassau lens co. v. commissioner., 308 f.2d 39, 46 (2d cir. 1962) (“it is all very well to say that it makes little ‘economic’ difference whether the investment [of a parent in a subsidiary] was divided between debt and equity or was entirely allocated to equity. but by the same reasoning it may make little ‘economic’ difference to [the owner of the parent corporation] whether he has an unincorporated business or a corporation in which he is the sole stockholder. and if one wanted to carry the argument far enough, presumably the commissioner would be free to make ad hoc attacks on a whole variety of transactions involving closely held corporations. but this code does not so empower the commissioner, for it recognizes and treats corporations as separate entities and affords significance to the type of investment chosen in them so long as that investment has substantial economic reality in terms of the objective factors which normally surround the type chosen .”); malone & hyde, inc. v. commissioner, 49 t.c. 575, 578, (1968) (“we start from the premise that arrangements between a parent corporation and its wholly owned subsidiary ‘invite close scrutiny.’ at the same time, we think it unwarranted to apply legalistic and mechanical tests, in the area of parent-subsidiary relationships, without regard to the realities of the business world and the manner in which transactions are handled in the normal and ordinary course of doing business.”); pepsico puerto rico, inc. v. commissioner, t.c. memo 104 t.c.m. (cch) 322, 2012 w.l 4207299, at *18 (2012) (“[n]otwithstanding the greater scrutiny afforded to related-party transactions, we believe that disregarding petitioners’ international corporate structure based solely on the entities’ interrelatedness is, without more, unjustified.”). 80 see, e.g., kraft, 232 f.2d at 123 (“[t]here are elements in the present case which invite close scrutiny by the commissioner, among them the fact that the arrangement was made between a parent corporation and its wholly-owned subsidiary.”); cf. litton business systems, inc. v. commissioner, 61 t.c. 367, 377-78 (1973) (“it is quite clear that a valid debt may exist between parties even where no formal debt instrument exists. this is particularly true in the case of related parties since [f]ormal debt paraphernalia of this type in a closeknit family or corporate cousins are not as necessary to insure repayment as may be the case between unrelated entities.”). 2017] a framework for testing regulatory authority 351 when the irs issued regulations under section 385 in 1981, the preamble acknowledged that the irs considered treating all proportionately-held debt as stock, implying that the irs believed it had authority to do so.81 does the related party context so completely cloud the lens through which a debt/equity analysis is viewed that the irs is within its authority under section 385 to recharacterize all related party debt as equity? we are not sure—there are plenty of other related party contracts that give rise to questions about whether the parties will act in accordance with the contract’s terms, and absent evidence the parties plan to ignore (or have ignored) their legal rights and obligations, such contracts generally are given effect for tax purposes.82 in any event, such an approach would have been, in our opinion, more consistent with the irs’s authority than the approach the irs adopted with the per se rule.83 the “no new capital factor” is not relevant to the question of whether an instrument is in substance debt or equity. there is no logical connection between the economic substance of an instrument (and the nature of the relationship it creates) and the fact that it was issued as part of a recapitalization or as a dividend, and the vast majority of the case law and irs guidance has not considered this a relevant factor. of the three cases the irs adduced to support its position (kraft, talbot mills, and sayles fishing), the case that considers the issue most thoroughly, kraft, determined that the fact that the notes were issued in a distribution was not a relevant factor, let alone a determinative one. the court stated that the code “recognizes that indebtedness may be created by a 81 they ultimately rejected this approach because “treasury believed it would have been unsound policy in effect to deny corporations access to shareholder capital in the form of indebtedness when loans on the same terms could have been obtained from independent lenders.” 45 fr 86440 (dec. 31, 1980). these regulations were never effective and were withdrawn. t.d. 7920, 1983-2 c.b. 69. 82 see, e.g., kenco restaurants, inc. v. commissioner, 206 f.3d 588, 595 (6th cir. 2000) (noting that section 482 only justifies transfer pricing reallocations if “an arrangement between related parties differs from those reached in an uncontrolled, arm’s-length dealing”). if the irs were to adopt a rule recharacterizing all related party debt as equity, we believe it would be appropriate to adopt correlative changes to the code to account for the economics of third party borrowing in the context of a consolidated group. as debbie paul noted in her article on july 25, 2016, it is often more efficient to have a single group member be a third party borrower, the creditors of which rely on the equity of the borrower’s affiliates to support the debt. related party debt (when issued in appropriate amounts) is therefore a mechanism to allocate interest deductions with the group members that are effectively supporting the third party borrowing. if related party debt were ignored for tax purposes and no additional changes were made to the code, the result would be a non-economic allocation of the interest expense 100% to the third party borrower, even if the third party creditors are relying in part on the credit support of lower-tier subsidiaries. deborah l. paul, how to kraft (or not kraft) debt-equity regulations, 152 tax notes 525 (2016). 83 as noted (and rejected) above, one might argue that because the irs could have taken an even broader approach to recharacterizing debt as equity in the related-party context, the irs cannot be restricted from adopting a more limited approach. in other words, the irs could have declared all related-party debt to be equity and then provided specific exceptions precisely to arrive at the per se rule. but that argument cannot prevail for the reasons discussed in part i. if the broader approach is authorized because the irs considered factors germane to the question, in order for the “exclusions” to be authorized, the “exclusions” must have the same logical connection to the substantive debt/equity inquiry. 352 columbia journal of tax law [vol.8:326 distribution or by a recapitalization exchange through the issuance of securities out of capital or earnings or both, though the tax treatment may vary with the method chosen.”84 in addition, congress did not consider the “no new capital factor” to be germane to the debt/equity inquiry in 1984 when congress added section 1275(a)(4) to the code and amended section 312(a)(4), each of which provide rules that apply when a corporation distributes its own note as a distribution under section 301. neither the code sections nor the legislative history suggest any special debt/equity scrutiny is appropriate in such context. does it matter that the irs can point to three cases that mention this factor (one of which ignores it) in the more than one hundred cases that have considered the debt/equity question? if the irs is not bound by case law, the fact that the case law has or has not considered a particular factor should not bear directly on the question of authority. if no case had ever mentioned this as a factor, however, declaring such a factor as germane to the debt/equity question would be suspect. do three cases move the needle? we think not. one does not need to mine the case law to come to the conclusion the “no new capital” rule is irrelevant to the substance of an instrument as debt or equity. suppose corporation x funds its subsidiary in year 1 with $90 of equity, and $10 of debt. the “no new capital rule” is not implicated, and the question of whether that $10 of debt is true debt will depend on the outcome of an economic substance inquiry based on the traditional debt/equity factors. now suppose in year 3 the value of the subsidiary has increased to $200, and corporation x determines that its subsidiary is over-capitalized relative to corporation x’s other subsidiaries, and causes the subsidiary to distribute a second $10 note. is the relationship between corporation x and its subsidiary any more debtor/creditor-like with respect to the first note than their relationship with respect to the second note? the answer will depend on the actual relationship between the parties, the terms of the notes, and so forth. what it will not depend on is whether the note was issued under the circumstances described in year 1 or those described in year 3. another example: suppose corporation x and corporation y, unrelated, is each formed on day 1. corporation x’s shareholders hired counsel prior to formation, and on counsel’s advice, corporation x was part equityand part-debt capitalized: $100 contributed in exchange for $90 of stock and a $10 note. corporation y’s shareholders contributed $100 in exchange for $100 of stock, but on day 2, after consulting with counsel, caused corporation y to distribute a $10 note. in each case, introducing debt to the capital 84 kraft foods co. v. commissioner, 232 f.2d 118, 126 (2d cir. 1956). while the court in talbot mills did note in its analysis that “[t]he issuance of the notes brought no new capital into the corporation”, the court, in finding the instrument to be equity, also relied on the fact that the notes (1) were subordinated, (2) paid a variable rate of interest based on profits of the corporation (subject to a cap and a floor), and (3) paid interest annually, but such payment could be deferred by the directors of the corporation. the court in sayles finishing, the other case the irs cited, states: “conversion of equity interests into evidence of indebtedness does not necessarily defeat tax treatment of the resulting relationship between a stockholder or stockholders and the corporation as a bona fide indebtedness. here again, all of the facts and circumstances of the particular case must be considered. even the fact that no new money was invested in the business does not require a holding that issuance of corporate debentures was a capital transaction, but such debentures are to be allowed tax treatment as indebtedness when the other factors in the case establish a true indebtedness. [citations omitted] however, in an appropriate case, lack of new money can be a significant factor in holding a purported indebtedness to be a capital transaction, particularly when the facts otherwise show that the purported indebtedness was merely a continuation of the equity interests allegedly converted.” sayles finishing plants, inc. v. united states, 399 f.2d 214, 220 (ct. cl. 1968). 2017] a framework for testing regulatory authority 353 structure was tax motivated. any reason corporation y’s note is more equity-like that corporation x’s note? of course not.85 this brings us to the third “factor.” the third “factor” that the irs considered is that distributions of debt typically lack a substantial non-tax business purpose. this is not a factor but rather support for why the no new capital factor is relevant. framed differently, because debt distributions are generally tax motivated (a conclusion for which the irs does not provide any support), debt distributions require special scrutiny from a debt/equity perspective. this is, simply, a fundamental misunderstanding of the debt/equity question. debt is a tax-preferred form of raising capital. that is how the code works. a taxpayer may always choose to issue debt instead of equity, even if that decision is entirely tax motivated, as long as the instrument is true debt. suppose a corporation needs to raise capital and prepares to access the public capital markets. the tax director is on vacation, and no one bothers to consult with her, and the decision is made to raise equity capital. moments before the offering documents are to be filed, the tax director rushes in and asks the cfo and coo to consider issuing debt instead of equity because of the tax benefits. the cfo and coo conclude that the principal and interest payments are supportable by the corporation’s operations, and decide that the benefit of the tax deduction associated with the interest expense exceeds the burdens of the required interest and principal payments. the corporation instead issues debt securities to the public. is any of this relevant to the debt/equity question? no. an irs auditor could have been in the room while these discussions were taking place and the fact that the switch from equity to debt was 100% tax motivated does not color the debt/equity analysis one bit. if the instrument is in substance debt, and the parties behave in a manner consistent with that substance, the instrument is debt. the fact that a taxpayer’s motivation is irrelevant to the debt/equity question is not limited to the debt/equity context; it is the case for much of the code. a taxpayer is able to structure into a like-kind exchange solely to achieve a specific tax result, or change the mix of consideration in a merger solely to achieve tax-free status. national starch and granite trust transactions are both, by definition, tax motivated transactions. the fact that a debt distribution may be tax motivated is no more relevant to the debt/equity question than the fact that a corporation issuing third party debt may have been motivated by the fact that interest is deductible. debt/equity is not a context where motivation matters. the third “factor” also fails the germaneness inquiry. it is not too surprising that the per se rule is unhinged from the question of whether an instrument is in substance debt or equity, because the irs acknowledges in the preamble to the proposed 385 regulations that this rule serves a different purpose. according to the irs, the section 385 regulations are intended to “limit the benefits of 85 we do not believe that any regulation that fails to create tax symmetry between two economically similar or even identical transactions is per se invalid. nor should a regulation have to pick up every potential abuse to be upheld. however, where a specific fact pattern is being offered as evidence of something (in this case, either “equity-like” features or potential for abuse – it is not entirely clear), it is necessary to test whether such a fact pattern is actually relevant to the substantive question, and these examples demonstrate that the no new capital factor is not relevant. similarly, the irs can issue regulations in piecemeal – addressing one factual situation in a set of regulations, with more robust and broad reaching regulations to follow. that, however, cannot bless every set of “along the way” regulations. the irs cannot issue regulations targeting corporations whose name begins with a, for example, and justify the regulations by declaring that the regulations dealing with b-z are to follow. 354 columbia journal of tax law [vol.8:326 post-inversion tax avoidance transactions” (i.e., the section 385 regulations are the “earnings stripping” guidance referred to in the 2014 notice and notice 2015-79).86 the irs considers a note distribution to a foreign parent from an inverted u.s. corporation to be this type of transaction. additionally, in the preamble to the proposed 385 regulations, the irs considered the proposed 385 regulations to combat the “abuse” of a first-tier cfc’s distribution of a note in a year when it has no e&p, which allows for future untaxed e&p to be brought into the u.s. without tax as principal payments are made on the note.87 we previously discussed and analyzed an overt use of regulations under section 385 to adopt an earnings stripping policy inconsistent with the statutory text of section 163(j)—a set of regulations that recharacterize debt as equity to arrive at a different percentage for calculating “excess interest expense” (25% instead of 50%) in section 163(j). similarly, we asked whether if that approach is impermissible (and it should be), should it be permissible to use section 385 to rewrite section 163(j) in a less obvious manner? again, we concluded the answer should be no. can the policy behind section 163(j) ever justify regulations under section 385? the answer here is less straightforward. the policies of the two sections are less overlapping than they might seem, as the legislative history of section 385 (and the inclusion of the section 385(b) listed factors) suggests that the purpose of section 385 is not to police interest expense but to provide clarity to the “ambiguities and uncertainties which have long existed in our tax law in distinguishing between a debt interest and an equity interest in a corporation.”88 the policy of section 163(j) (to limit excess interest expense) and section 385 (to provide clear rules on debt/equity) might be viewed as in service of a similar higher principle, but the further the section 385 regulations drift from a substantive analysis of an instrument as debt or equity, the more suspect they become. the per se rule is completely unmoored from the substantive debt/equity question and, as the irs acknowledges, motivated entirely by policy concerns. if this is allowable, the irs could also issue a “per se rule” for debt of a u.s. corporation held by a non-u.s. person (repealing portfolio interest) because the executive branch determines that the policy of section 871(h)(3)—the limitations on portfolio interest—needs to be backstopped. using section 385 to support the policy of limiting cfc note distributions in the context described in the proposed 385 regulations is even more novel. when has congress ever espoused such a policy? it cannot be found in section 301, 316, 317, 367(b), 951, or 956. indeed, such a policy is arguably inconsistent with those sections. if the executive branch can use a grant of authority pursuant to section 385 to backstop a “policy” that is missing, not just from section 385, but the entire code, then section 385’s scope is alarmingly broad—what is to prevent a future administration that 86 reg-108060-15, 2016-17 i.r.b. 636, 642, 81 fr 20917 (apr. 8, 2016). 87 reg-108060-15, 2016-17 i.r.b. 636, 641, 81 fr 20916 (apr. 8, 2016). while this rule was not retained in the final and temporary 385 regulations because those regulations are limited to debt issued by u.s. corporations, the irs did not pare back the regulations in response to questions of authority. instead, the final and temporary 385 regulations “reserve on their application with respect to debt issued by foreign issuers due to the potential complexity and collateral consequences of applying the regulations in this context where the u.s. tax implications are less direct and of a different nature.” t.d. 9790, 2016-45 i.r.b. 540, 568, 81 fr 72882 (oct. 21, 2016). 88 s. rep. no. 91-552 (1969). 2017] a framework for testing regulatory authority 355 determines that the corporate tax is anti-competitive from issuing new regulations under section 385 that treat all corporate equity as debt?89 for any set of section 385 regulations to be valid, there must be a relationship between the factors the regulations set out and the true nature of an instrument as stock or debt. the factors listed in the preamble to the proposed 385 regulations do not satisfy this requirement and the per se rule, a rule that the irs acknowledges is a rule about earnings stripping, is therefore beyond the scope of even the broad authority granted by section 385. e. provision #5: treasury regulation section 1.385-3t(f) (the “partnership rule”). under treasury regulations section 1.385-3t(f), for purposes of applying the per se rule, a controlled partnership is treated as an aggregate of its partners. thus, if a controlled partnership borrows, the borrowing is treated as having been made by its corporate partners. if the debt of the partnership (deemed to be debt of the corporate partners) is recharacterized as equity with respect to one or more of the corporate partners, the holders of the recharacterized debt instrument is deemed to transfer the recharacterized portion of the debt instrument to the corporate partner(s) in exchange for stock of the corporate partner(s). 1. irs claimed authority. the irs breaks down its authorization for the partnership rule into three steps. first, the partnership rule treats partnership debt as debt of the corporate partners, relying on the legislative history of subchapter k that for purposes of interpreting code provisions outside of subchapter k, a partnership may be treated as either an entity separate from its partners or an aggregate of its partners, “depending on which characterization is more appropriate to carry out the purpose of the particular section under consideration”.90 second, the irs analyzes the deemed partner-level debt under the section 385 regulations. no specific authority is cited for this position, although it follows from the treatment of the partnership debt as partner-level debt under the aggregate theory. last, if the deemed partner-level debt would be recharacterized as equity, the irs relies on the anti-conduit rule of section 7701(l) to deem the recharacterized debt instrument as having been transferred to a corporate partner in exchange for its stock.91 2. a closer look. section 385 is titled “treatment of certain interests in corporations as stock or indebtedness”. there is no reference to partnerships in any of the legislative history of section 385. the previous iterations of the section 385 regulations contained no reference 89 it is too cute to declare this hypothetical regulation unauthorized because the irs is constrained by section 385(b)’s reference to factors taken into account in a “particular factual situation” and this example is not a particular situation, but all situations. that linguistic hurdle is easily cleared; we can limit the “all stock is debt” rule to u.s. corporations and non-u.s. corporations with foreign source income. the limitations of section 385 must be more fundamental than whether a clever lawyer can wordsmith a regulation so clearly at odds with congressional intent. 90 reg-108060-15, 2016-17 i.r.b. 636, 653, 81 fr 20926-20927 (apr. 8, 2016). (referencing h.r. conf. rep. no. 2543, 83rd cong. 2d. sess. 59 (1954)); see also t.d. 9790, 2016-45 i.r.b. 540, 612, 81 fr 72922 (oct. 21, 2016). 91 preamble to the final and temporary 385 regulations, t.d. 9790, 2016-45 i.r.b. 540, 613; treatment of certain interests in corporations as stock or indebtedness, 81 fed. reg. 72858, 72922, (oct. 21, 2016). 356 columbia journal of tax law [vol.8:326 to partnerships. however, partnerships are treated as aggregates of their partners in various provisions of the code. the text and the purpose behind the anti-conduit rule are discussed in detail above. 3. is the partnership rule within the scope of the irs’s regulatory authority? perhaps more interesting than the question of whether the partnership rule is authorized (which we address below) is both preambles’ discussion of the partnership rule, which informs us of what the irs believes it can—and cannot—do under section 385 and section 7701(l). the preamble to the proposed 385 stated that the irs does have the authority to recharacterize partnership debt as equity, but that the irs did not propose that approach because the partnership equity could have given taxpayers the same benefits of interest deductions.92 the relevant language in the preamble read: if a debt instrument issued by a controlled partnership were to be recharacterized as equity in the controlled partnership, the resulting equity could give rise to guaranteed payments that may be deductible or gross income allocations to partners that would reduce the taxable income of the other partners that did not receive such allocations. therefore, under the authority of section 7701(l) to recharacterize multiple-party financing transactions, proposed §1.385-3(d)(5)(ii) provides that, when a debt instrument issued by a partnership is recharacterized, in whole or in part, under proposed §1.385-3, the holder of the recharacterized debt instrument is treated as holding stock in the expanded group partner or partners rather than as holding a partnership interest in the controlled partnership. under the proposed 385 regulations, first, on the aggregate theory, partnership debt would have been treated as partner debt. then, partner debt would be analyzed under the section 385 regulations to determine whether the debt should be recharacterized. if it would be recharacterized, the debt would be recharacterized as equity of the partnership under the authority granted pursuant to section 385. then, the partnership equity would be re-recharacterized as equity of the partners pursuant to the anti-conduit rule of section 7701(l). the final and temporary 385 regulations take a slightly different approach. the first step is the same: a partnership is treated as an aggregate of its partners.93 the second step is also the same – the partner-level debt is analyzed under the section 385 regulations. the third step outlined in the proposed 385 regulations – recharacterizing partnership debt as partnership equity – is omitted: “in response to comments, the final 92 reg-108060-15, 2016-17 i.r.b. 636, 654; treatment of certain interests in corporations as stock or indebtedness, 81 fed. reg. 20912, 20926-20927 (apr. 8, 2016). in its request for comments, the irs seems to believe its power extends to recharacterizing partnership preferred equity. reg-108060-15, 2016-17 i.r.b. 636, 656; treatment of certain interests in corporations as stock or indebtedness, 81 fed. reg. 20912, 20929 (apr. 8, 2016). 93 “thus, consistent with the longstanding practice of the treasury department and the irs to apply aggregate treatment to partnerships and their partners when appropriate, and in accordance with the legislative history of subchapter k, the final and temporary regulations generally treat a controlled partnership as an aggregate of its partners in the manner described in the temporary regulations.” t.d. 9790, 2016-45 i.r.b. 540, 613; treatment of certain interests in corporations as stock or indebtedness, 81 fed. reg. 72858, 72922 (oct. 21, 2016). 2017] a framework for testing regulatory authority 357 and temporary regulations do not recharacterize debt issued by a partnership as equity under section 385.”94 instead, the final and temporary 385 regulations skip right to the final step: instead, pursuant to the authority granted under section 7701(l) to recharacterize certain multi-party financing transactions, the temporary regulations deem the holder of a debt instrument issued by a partnership that otherwise would be subject to recharacterization (based on an application of the factors in §1.385-3 to the expanded group partners under the aggregate approach) as having transferred the debt instrument to the expanded group partner or partners in exchange for stock in the expanded group partner or partners.95 the change suggests that the irs acknowledges at least some limit on their power under section 385. unfortunately, the irs believes it can simply look to the anticonduit regulations to get to the answer it desires. as we discuss below, this type of “connect-the-dots” authority—mining for whatever textual support (whether it be in legislative history, case law, or the code) can support an end result, irrespective if those authorities are being completely severed from their original context, is not appropriate. but before we get there, let us examine the partnership rule in more detail. the first question raised by the partnership rule is whether it is appropriate to consider partnership debt as debt of its partners. the treatment of a partnership as an aggregate of its partners or as an entity varies throughout the code. for purposes of the portfolio interest 10% ownership test, for example, ownership is tested at the partner level.96 the legislative history of the 1954 act, however, requires that the aggregate or entity theory be adopted based on whichever theory better carries out the purposes of the relevant code section. this question too, then, requires us to consider the purpose of section 385. if the purpose of section 385 is to prevent a situation the irs considers abusive, then the inquiry is over—whatever theory (aggregate or entity) the irs chooses will necessarily be in furtherance of its anti-abuse provision.97 if however, as we have demonstrated above, the purpose of section 385 is to set forth factors to determine the true nature of the relationship between the debtor and creditor, then the irs has again strayed from traditional debt/equity analysis in applying the aggregate theory. debt/equity authorities look to the relationship of the legal borrower and legal lender, unless there is reason to doubt that the legal borrower is truly the source of the funds on which the lender is relying to repay the debt (for example, in a plantation patterns-like fact pattern). to look through partnerships as a general matter makes no sense in the debt/equity framework,98 no more so when considering related-party debt. once the partnership debt is deemed to be partner-level debt, applying the section 385 tests to the partner-level debt, particularly as it relates to the funding rule, 94 t.d. 9790, 2016-45 i.r.b. 540, 613; treatment of certain interests in corporations as stock or indebtedness, 81 fed. reg. 72858, 72922 (oct. 21, 2016). 95 id. 96 for purposes of applying the insolvency exception to recognition of cancellation of indebtedness income to the debt of a partnership, insolvency is tested at the partner level. i.r.c. § 108(d)(6) (2015). 97 the irs acknowledges the aggregate theory is being adopted to “prevent avoidance of these rules through the use of partnerships.” reg-108060-15, 2016-17 i.r.b. 636, 653; treatment of certain interests in corporations as stock or indebtedness, 81 fed. reg. 20912, 20926-20927 (apr. 8, 2016). 98 applying the aggregate theory would cause a partnership’s debt-equity ratio to include debt owed by its partners, even if not secured by the partnership’s assets. 358 columbia journal of tax law [vol.8:326 can lead to odd results. suppose a controlled partnership (p) has two partners parent and sub1. p borrows from a member of the expanded group and uses the proceeds in p’s trade or business. p never makes a distribution or loan to either parent or sub1, but within three years of p’s borrowing sub1 makes a distribution (out of its own funds) to parent, and none of the exceptions to the per se rule are available. because p is treated as an aggregate of its partners, parent and sub1 would each be treated as having borrowed from the expanded group member and, because sub1 paid a dividend, a portion of that borrowing would be recharacterized as equity in sub1. the preamble to the proposed 385 regulations states the reason the funding rule is appropriate is “because money is fungible and because it is difficult for the irs to establish the principal purposes of internal transactions.”99 but money is not that fungible; it cannot make its way from p to sub1 without having been distributed or loaned to sub1. thus, even if one adopts the internal logic of the section 385 regulations (that the “no new capital” factor is germane to the debt/equity question and that the funding rule is necessary because cash is fungible), that logic cannot support the partnership rule. finally, the irs relies on the anti-conduit rule to complete its recharacterization of partnership debt to corporate stock, in the case of the final and temporary 385 regulations, by deeming the debt holder to have transferred a portion of the debt to the corporate partner(s) in exchange for its/their stock. we have discussed the limitations of the conduit rule above, and need not revisit them here except to say that the same analysis applies – the anti-conduit rule is not (and was not intended to be) an unlimited anti-abuse rule.100 the partnership rule requires the irs to jump through three hoops, and for each the rule relies on distinct authority. all three of the authorities are being used in a questionable manner, and we believe than none of them can justify the uses to which the partnership rule puts them. the partnership rule, perhaps more than any other questionable provision (though the de-cfc rule comes close) lays bare just how “results oriented” the rules set forth in the regulatory package are. when the irs encountered a perceived roadblock under section 385 (i.e., a potential limit to its authority), the irs simply invoked the anticonduit rule to circuitously arrive at the desired result. this, in our view, cannot be within the bounds of regulatory authority. the limits of regulatory authority should not be constrained only by whether drafters can piece together a coherent-enough story through unrelated code sections, cherry-picked case law and scraps of legislative history to support a policy-driven regulation unrelated to the policy of the code section under which the regulations are issued. if that is indeed a valid exercise of executive power, it is hard to put any limit on irs authority. 99 reg-108060-15, 2016-17 i.r.b. 636, 650; treatment of certain interests in corporations as stock or indebtedness, 81 fed. reg. 20912, 20923 (apr. 8, 2016). 100 an interesting point to note is that the irs’s regulatory authority under section 7701(l) can only be exercised “to prevent avoidance of any tax imposed by this title.” the anti-conduit financing regulation in treasury regulations section 1.881-3 is consistent this limitation. that regulation allows the director of field operations to disregard an intermediate entity only if the financing arrangement significantly reduces the tax that otherwise would have been imposed. 26 c.f.r. 1.881-3(b)(2)(i) (2012). consider whether the conduit rule can be used to recharacterize partnership equity as stock if such recharacterization does not reduce the expanded group’s u.s. tax liability. 2017] a framework for testing regulatory authority 359 iv. conclusion our system of government discourages quick action by the legislative branch, and we are experiencing a political moment of greater than normal legislative paralysis. the executive branch (and the citizens) may become justifiably frustrated by this inability of the legislature to promulgate much needed laws. it will become very tempting for the executive branch to fill this void with an expansive assertion of regulatory authority. as a political matter, we as citizens may need to confront the possibility that stasis is the appropriate outcome of the divisions in the country. our goal in this paper is more limited—to try to construct a framework to evaluate whether the assertion of regulatory authority fails as a technical matter. careful reading of the enabling statute is a necessary starting point for this inquiry, but the analysis must also encompass whether there are improper hidden goals of the regulation, and whether the regulation is sufficiently germane to its purpose. if broad agreement can be established regarding the limits of regulatory authority, then we will be closer to fulfilling the proper delineation of the functions of our branches of government. microsoft word sanjuan9-1 11-15-17.docx who pays the price of civilization? eric a. san juan* abstract at the current juncture of fiscal uncertainty and pending tax reform, this article addresses tax compliance, combining principles of tax law with methodologies of social science. a narrative on the evolution of the rule of law introduces social science methodologies for studying the operation of law in historical and cultural context. then the article sets forth an overview of federal individual income taxation. as the core data, the article presents a survey on u.s. taxpayer compliance attitudes gathered by a research team of which the author was a member. to complement the u.s. data, the article discusses field studies from other countries reported in the social science literature. in turn, the article discusses the implications of the social science research to the effect that compliance with the rule of law, represented here by a modern fiscal apparatus, may wax and wane through history as national bureaucracy siphons resources off their local origins. contrary to the theoretical story of legal evolution, actual cases haven’t culminated in an ideal civilized state. finally, the article makes suggestions for future research on tax law compliance. the article concludes that rational-legal authority may have less effect on taxpayer compliance than primordial personal motivations. * ab harv. 1987, jd ibid. 1991, ma chicago 1996; adjunct professor of law, georgetown university. chair, tax policy committee, american bar association. member, core idea group (executive committee) of meridian-180.org, the multi-lingual platform of the clarke program on east asian law & culture, cornell university. without prejudice, the author wishes to thank thomas r. beers, mba (harv.), msc (mit), for comments on the manuscript. 46 columbia journal of tax law [vol.9:45 i. introduction to tax compliance as an aspect of the rule of law ........................................................................................................................... 47 ii. theories of legal evolution .................................................................... 47 iii. social science methodologies for empirical study of law & tax compliance ................................................................................................. 52 iv. overview of federal income taxation ............................................... 54 v. u.s. survey research on small business tax compliance ........ 55 a. pertinent results of survey on taxpayer compliance ........................................ 56 b. details of survey data on attitudes toward government .................................. 57 c. further analysis of socio-geographic networks in the community survey ..... 59 vi. field studies of legal & tax compliance in the social science literature ........................................................................................................... 60 vii.implications of tax compliance research for the rule of law ........................................................................................................................... 61 viii.topics for future research on tax law compliance ................ 64 ix. conclusion on the socio-historical context of tax compliance .......................................................................................................... 65 2017] who pays the price of civilization? 47 i. introduction to tax compliance as an aspect of the rule of law current events appear to challenge preconceptions of civilization. on opposite sides of the ocean, heads of state are associated with “alternative facts,” alleged fratricide, or death squads.1 central to the received notions shaken by these developments would be the rule of law. can rational legality survive apparently aberrant administrations? to address this question, this article introduces the evolutionary context from which the rule of law arose. to balance inaccuracies of generalization, this article proceeds with case studies from both america and overseas. as a particular field of compliance (or noncompliance) with the rule of law, the article focuses on tax law. as u.s. justice oliver wendell holmes, jr. opined in a landmark trans-pacific case, “taxes are what we pay for civilized society.”2 the reasons why people do or don’t comply with taxation may offer insight into legal compliance generally. thus, a case study of tax may have implications for popular adherence to the rule of law. part ii proceeds from a heuristic narrative of legal evolution to introduce, in part iii, various social science methodologies for studying the operation of law in historical and cultural context. part iv sets forth an overview of federal individual income taxation, before part v discusses survey data on u.s. taxpayer compliance attitudes gathered by a research team of which this writer was a member.3 part vi complements the u.s. data with field studies from other countries reported in the social science literature. part vii discusses the implications of the research to the effect that compliance with the rule of law, represented here by modern fiscal apparatus, may wax and wane through history as national bureaucracy siphons resources off their local origins, rather than following a teleology toward any ideal civilized state. part viii makes suggestions for future research on tax law compliance. part ix concludes that rational-legal authority may have less effect on taxpayer compliance than primordial personal motivations. ii. theories of legal evolution this part describes the evolution of the rule of law, as narrated by successive schools of thought in jurisprudence, to set the stage for empirical study of law, especially tax law, employing social science methodologies. historically and metaphorically, civilization arose from a primordial substrate of tribal culture and religion. according to a well-known anthropologist, the 1 see nicholas fandos, white house pushes “alternative facts,” n.y. times, jan. 22, 2017, at a15; aidan foster-carter, kim jong-nam was assassinated. but was it on his brother’s orders?, the guardian, feb. 15, 2017, https://www.theguardian.com/commentisfree/2017/feb/15/kim-jong-namassassinated-kim-jong-un-north-korea [https://perma.cc/9gsj-c6fp]; duterte paid us to conduct davao death squad killings, claims cop, abs-cbn news, feb. 20, 2017, http://news.abscbn.com/news/02/20/17/duterte-paid-us-to-conduct-davao-death-squad-killings-claims-cop [https://perma.cc/pd7r-3zff]. 2 compañía general de tabacos de filipinas v. collector of internal revenue, 275 u.s. 87, 100 (1927) (holmes, j., dissenting). 3 the views in this article are solely those of this writer. the data were released in a government report as cited, but not disseminated in the academic literature. see tom beers, eric lopresti & eric san juan, factors influencing voluntary compliance by sole proprietors: preliminary survey results, paper given at the 2013 irs-tax policy center research conference (june 20, 2013), available at https://www.irs.gov/pub/irs-soi/13rescon.pdf [https://perma.cc/67l8-jrhh]. 48 columbia journal of tax law [vol.9:45 tension between primordial sentiments and civil politics … of place, tongue, blood, looks, and way-of-life … is rooted in the nonrational foundations of personality … [i]nvolvement of this unreflective sense of collective selfhood in the steadily broadening political process of the national state is certain … [w]hat the new states—or their leaders—must somehow contrive to do as far as primordial attachments are concerned is not, as they have so often tried to do, wish them out of existence by belittling them or even denying their reality, but domesticate them. they must reconcile them with the unfolding civil order by divesting them of their legitimizing force with respect to governmental authority, by neutralizing the apparatus of the state in relationship to them, and by channeling discontent arising out of their dislocation into properly political rather than parapolitical forms of expression.4 while the anthropologist refers specifically to “new states,” also known as developing countries, these observations could apply to any polity where people are motivated by their identity, as recent ballots in industrial economies have shown.5 given the anthropological foundations of civilization, how did the rule of law evolve? starting with technologically simple societies, village order would be a matter of social mores and personal charisma, rather than law per se. people might band together around the persuasive authority of a big man, but only would a more complex tribe ascribe hereditary leadership to a chief.6 ultimately, civilization would give rise to kings who would become law-givers not only to clans related by kinship but to all subjects in a kingdom.7 thus, a territorial state that monopolizes legitimate violence becomes the jurisdiction of the law of the land.8 since the coronation of the first kings, governments have extracted tribute from their subjects to fund public works, infrastructure, and wars, ultimately in the form of taxes. 9 the incidence of taxation may reveal non-trivial particularities of each civilization.10 types of authority would advance from the patrimonial absolutism of the feudal autocrat to the impersonal office of the state bureaucrat. 11 through the cold war, ideologically opposed states would become mirror images of bureaucratic apparatus on either side of the pacific ocean.12 in a country with a particular history of race relations, president obama’s strategic role may have been that of the colorless technocrat. 4 clifford geertz, the integrative revolution: primordial sentiments and politics in the new states, in old societies & new states: the quest for modernity in asia & africa 105, 128 (clifford geertz ed., 1963). 5 see, e.g., richard v. reeves, brexit: british identity politics, immigration and david cameron’s undoing, brookings inst. (june 24, 2016), available at https://www.brookings.edu/opinions/brexit-britishidentity-politics-immigration-and-david-camerons-undoing/ [https://perma.cc/u3da-fj4r]. 6 see marshall d. sahlins, rich man, poor man, big man, chief: political types in melanesia & polynesia, 5 comp. stud. in soc’y & hist. 285 (1963). 7 see generally morton h. fried, evolution of political society: an essay in political anthropology (1967). 8 see max weber, politics as a vocation, in max weber: essays in sociology 77 (h.h. gerth & c. wright mills eds., 1970). 9 see generally aaron wildavsky & carolyn webber, a history of taxation & expenditure in the western world (1986). 10 see, e.g., sally falk moore, power & property in inca peru (1958). 11 see max weber, the three pure types of authority, in economy & society 215 (guenther roth & claus wittich eds., 2013). 12 see c. r. mitchell, the structure of international conflict 113 (1989). 2017] who pays the price of civilization? 49 at the same time, charismatic personalities may continue to attract followers even in a formal nation-state. in the range of historical anthropology, there is even the case of “a theatre state in which the kings and princes were the impresarios, the priests the directors, and the peasants the supporting cast, stage crew, and audience…. power served pomp, not pomp power.”13 it would not be unprecedented for the state to enact authority, even if the performance is administratively ineffective. meanwhile, social mores and personal charisma would not wither away but persist as local reflectors of official law. local custom and the rule of law may coincide. for example, the scriptural commandment that “you shall not kill” finds itself inscribed in the criminalization of homicide.14 dissonance would arise when the rule of law diverges from local custom, which in turn informs personal psychology. such dissonance may inform tax compliance or “social noncompliance,” i.e. transgression of law while conforming to custom, as discussed below. later, a case study will describe a “blending” of traditional and modern practices to achieve practical legal results.15 the rule of law as such was celebrated in the eighteenth-century european enlightenment. classic liberal writers anticipated law with a social contract entered out of mutual consideration.16 people volunteered to observe laws to lift themselves out of the state of nature, an “original position.”17 paradoxically, law was natural because it was a logical consequence of social life. under liberal legality, natural law was to embody social mores. in the enlightenment imagination, the "noble savage” populates the state of nature logically antecedent to the social contract which forms the basis of the western republic.18 as clans of such people, tribes animate the anthropology of this state.19 through variants on whig history, the social contract became more than metaphorical. what had been heuristic became dogmatic. consider the “contract with america” of former speaker newt gingrich (r-ga.) or latter-day commentators who have suggested that the social contract is an obligation between each citizen and the government.20 they may do so by a convoluted rhetoric as follows. some tax administrators subscribe to a version of the social contract whereby governments render services to taxpayers in consideration for revenue collected from them. literally, this would constitute more of a procurement contract than a social one. according to the organisation for economic co-operation and development (oecd), the multi-lateral, non-governmental organization of developed economies: bargaining with citizens over tax makes governments more accountable, as taxpayers mobilise to resist or negotiate tax demands, monitor how tax is collected 13 clifford geertz, negara: the theatre state in nineteenth-century bali 13 (1980). 14 exodus 20:13. 15 see jane kaufman winn, relational practices and the marginalization of law: informal financial practices of small businesses in taiwan, 28 l. & soc’y rev. 193 (1994). 16 see generally jean-jacques rousseau, the social contract (1762). 17 cf. john rawls, a theory of justice (1971). 18 cf. robert a. williams jr., the american indian in western legal thought (1990). 19 cf. renato rosaldo, utter savages of scientific value, in politics & history in band societies (eleanor leacock & richard lee eds., 1982). 20 on “gingrich’s contract for america and its attacks on the irs,” see w. elliot brownlee, federal taxation in america: a short history 214 (2004). 50 columbia journal of tax law [vol.9:45 and used, and insist on having a greater say in public policy in exchange for compliance with tax demands.21 notwithstanding the merits of accountability, then the logical consequence is that the citizen as taxpayer would be entitled to reduce his or her tax liability in consideration of every policy shortcoming. in a small political sense, accountable (electoral) democracy has become both precept and telos. applied to tax compliance, a similar logic of the pre-social man, or so-called noble savage, leads to “everyday libertarianism,” the premise “that people earn their pretax incomes without any assistance from the government, with the result that there is a strong presumption that it is unfair for the government to tax away any of that pretax income.”22 as discussed below, nowadays noncompliance may be principled, if obtuse. on the contrary, the eighteenth-century text clarified that “each contracting party” was an “individual personality.”23 in any case, the government was not a party to the social contract: “a contract between the people and the rulers it sets over itself” would be “absurd and contradictory.”24 rather, “the institution of government is not a contract, but a law.”25 in other words, the social contract was not a procurement contract but a metaphor for the reciprocal agreement by which individual people united in political society. nineteenth-century disseminators of social science viewed law as a mechanism of social ideology. for instance, law could direct restitution in case of injustice;26 legal concepts could rationalize transactions in the economy; 27 or regulatory rules could prescribe ideal workings of government.28 while early social science drew on a varied tradition of political economy, generally this approach would emphasize the artifactual quality of law. in particular, positive law promulgated as statutes and regulations may be more artificial than the natural path of the common law, so conceived. by the early twentieth century, north american legal scholars would react against a natural law style, gravitating toward an empiricist approach that borrowed from social science. legal realism that emphasized experience of compliance coincided with empirical (imperial) discoveries of nomothetic order outside of nations then recognized as civilized.29 later twentieth-century u.s. jurisprudence would follow with schools of thought focusing on the institutional process or economic consequences of law-making rather than the internal logic that had been the stuff of traditional legal philosophy.30 in the late twentieth century, a revisiting of the internal logic of law would take a sharply critical 21 the organisation for economic co-operation and development, taxation, state building & aid 1 (dec. 2009), available at https://www.oecd.org/ctp/taxation-state-building-and-aid-factsheet.pdf [https://perma.cc/s34y-5d29]. 22 lawrence zelenak, tearing out the income tax by the (grass)roots, 15 fla. tax rev. 649, 657 (2014). 23 rousseau, supra note 17, book i, at 6. 24 id. book iii, at 16. 25 id. book iii, at 18. 26 see émile durkheim, the division of labor in society (george simpson trans., macmillan 1933) (1893). 27 see karl marx, grundrisse: foundations of the critique of political economy (martin nicolaus trans., penguin 1973) (1939). 28 weber, supra note 12, ch. 8. 29 see karl n. llewellyn, the common law tradition: deciding appeals (1960). 30 see henry m. hart & albert sacks, the legal process: basic problems in the making & application of law (1958); richard posner, economic analysis of law (1986). 2017] who pays the price of civilization? 51 turn.31 in sum, legal theory has grown out of intersections with social science, which may inform an otherwise artifactual legal logic. by comparison, an eastern philosophy of law proceeded from a broader nomothetic framework. in particular, a legal scholar explains chinese social order: the chinese neither saw public, positive law as the defining focus of social order nor divided law into distinct categories of civil and criminal. rather, traditional chinese thought arranged the various instruments through which the state might be administered and social harmony maintained into a hierarchy ranging downward in desirability from heavenly reason (tianli), the way (tao), morality (de), ritual propriety (li), custom (xixu), community compacts (xiang yue), and family rules (jia cheng) to the formal written law of the state. public, positive law was meant to buttress, rather than supersede, the more desirable means of guiding society and was to be resorted to only when these other means failed to elicit appropriate behavior.32 this rendition of chinese law dispenses with public, positive law, or sanctions. consequently, statutes, “formal written law,” are understood best in terms of larger principles of social, and even heavenly, order. reversing the western premise, here, custom is conceptually superior to law. north atlantic political scientists have contradistinguished the western rule of law from this asian pacific legality by reference to a religiously infused natural law that rose above any man.33 nevertheless, the extent to which the confucian heavenly order would fall short of liberal transcendence is unclear.34 within anglo-american legal history, commentators have shown how trial or appellate courts alternately bolstered and transformed the social concept of race or nationality.35 nineteenth-century courts depicted chinese immigrants as black, while in 1894 the american legal scholar john henry wigmore, who had served as a professor at keio university in tokyo, agreed that chinese were not white, although japanese were.36 perceived diversity amongst the taxpayer population may affect compliance behavior. below, a juxtaposition of case studies will pose the question of comparability between american, asian, and european tax compliance. presumably, some common principles of political science should emerge. in short, successive theorists of liberal legality hypothesized the evolution of the rule of law. their reflections on civilization arose in contrast to an imagined natural state populated by noble savages who still haunt nations today. consequently, the concept of legality developed in conjunction with social sciences that produced empirical methodologies. 31 see roberto m. unger, the critical legal studies movement (2015). 32 william p. alford, to steal a book is an elegant offense: intellectual property law in chinese civilization 10 (1995). 33 francis fukuyama, the origins of political order: from prehuman times to the french revolution 249 (2011). 34 see william p. alford, the inscrutable occidental? implications of roberto unger’s uses and abuses of the chinese past, 64 tex. l. rev. 915 (1986). 35 see, e.g., ian f. haney-lopez, white by law (1996). 36 id. at 51, 61. 52 columbia journal of tax law [vol.9:45 iii. social science methodologies for empirical study of law & tax compliance of course, the foregoing account of legal evolution is more heuristic than chronological. currently, various communities inside civilized states may experience law in more or less official uniform. still, legal anthropology can help. historically, writers may have inferred the evolution of civilization from observations of isolated tribes. by now, however, it was no longer possible to study dominated non-european ‘tribes’ in imagined isolation from the historical forces which had not only formed them, but which had transformed them into politically independent national entities resentful at the prospect of inclusion on library shelves devoted to ‘vanishing savages.’37 instead, legal anthropology can discern various experiences of law across societies. societies without states no longer serve to falsify or contrast to liberal legality. nevertheless, anthropology can still show how the rule of law is never realized, that is, functions as an ideology, even in modern societies, or those engulfed by global capitalism. a case study set forth below may exemplify this proposition. consequently, the theory of legal evolution, from natural status to social contract, leads to an empirical methodology to study the rule of law.38 if the rule of law emerged as a rational result of individual negotiation, then the question why obey the law logically follows whenever the cost outweighs the benefit. this could be a classic question of homo economicus. even assuming the neo-classical terms of public finance in which tax policy may be couched, internal inconsistencies appear. under existing federal penalty amounts, a cost-benefit analysis would not effectuate deterrence.39 nonetheless, the internal revenue service (irs) enjoys approximately 83 percent compliance, estimating a 17 percent tax gap. 40 consequently, there is an explanatory appeal to psychology and other social sciences of decision-making, now taking center stage as behavioral economics. 41 if compliance reflects values other than gross maximization, presumably enforcement strategies can build on those values.42 major contributions of behavioral economics to research on tax compliance include the following. one hope is that trust in government makes people accept the obligation to pay tax, even when it is possible to evade.43 other researchers look at taxation in terms of reciprocal relationships of giving and receiving.44 still others have elaborated 37 george w. stocking jr., race, culture & evolution: essays in the history of anthropology xii (1982). 38 see henry maine, ancient law ch. 5 (1861). 39 eric a. posner, law and social norms: the case of tax compliance, 86 va. l. rev. 1781, 1782 (2000). 40 see internal revenue serv., tax gap estimates for ty 2008-10 (apr. 2016), available at https://www.irs.gov/pub/irs-soi/p1415.pdf [https://perma.cc/4cyj-3nt9]. 41 see daniel kahneman, thinking: fast & slow (2011). 42 cf. michael s. barr, sendhil mullainathan & eldar shafir, behaviorally informed financial services regulation, new am. found. (oct. 2008), available at http://repository.law.umich.edu/cgi/viewcontent.cgi?article=1028&context=other [https://perma.cc/tgy3wwps]. 43 see valerie braithwaite, defiance in taxation and governance: resisting and dismissing authority in a democracy (2009); valerie braithwaite, responsive regulation and taxation, 29 j. law & pol’y 3 (2007). 44 see erich kirchler, the economic psychology of tax behaviour (2007). 2017] who pays the price of civilization? 53 on the concept of “tax morale.”45 the survey presented below pursues questions from the tax morale and related behavioral literature. a related psychological inquiry focuses on reasons for compliance with criminal sanctions and the law as a whole. in general, legal psychologists report that procedural fairness is a predominant reason why people obey the law.46 along with behavioral economics and legal psychology, another social science methodology that may illuminate tax compliance is fiscal sociology, the study of revenue collection and budgetary appropriation to reveal the priorities of society in peace and war, as will be mentioned below.47 early twenty-first-century anthropologists studying economics extended ethnographic fieldwork from traditional farmers’ markets to modern financial institutions. 48 the study of tax compliance may learn from both legal and business anthropology. in this vein, the second half of this article will present a case study from the anthropological literature concerning a modern tax collection agency.49 legal anthropologists have advanced the concept of the semi-autonomous social form (sasf) which may be emblematic of their methodology.50 the core of the concept is that the socio-geographic community that operationalizes state laws comprises the same people who embody and enforce customs. the implication is that law is different from custom only by degree. a weakness of the sasf would be not only the distinguishability of legal rules, but also that a mere showing of coincidence between state law and customary context is insufficient to explain the validity of law. on the other hand, a theory of the commitments one makes by engaging in nomothetic discourse would go beyond coincidence.51 perhaps the sasf means that everything about social coherence is implied in law, or that rules are a creature of culture. still, the observation that legal rules are imposed on a community does not explain how they got there, or why people took them there. these rules are not just facts devoid of moral significance to those who make, apply, and follow them, and give praise or blame according to them. to disregard this rule-guided aspect of existence would be to set aside the subjective meaning of behavior. one must therefore determine the relationship between the scientific search for factual regularities in society and the use of rules in everyday life.52 an analytic device, like the sasf, which emphasizes the coincidence of factual regularities in society and the use of rules in everyday life, would beg the question. the characteristic of legal anthropology, then, would be an emphasis on the empirical or extrinsic function of rules rather than the subjective meaning of behavior. the strengths of legal 45 see, e.g., james alm & benno torgler, culture differences & tax morale in the u.s. & europe, 27 j. econ. psych. 224 (2006); benno torgler, the importance of faith: tax morale & religiosity, 61 j. econ. behav. & org. 81 (2006). 46 see tom tyler, why people obey the law (1990). 47 see isaac william martin, rich people’s movements: grassroots campaigns to untax the one percent (2013). 48 see, e.g., annelise riles, collateral knowledge: legal reasoning in the global financial markets (2011); karen ho, liquidated: an ethnography of wall street (2009). 49 see lotta björklund larsen, moulding knowledge into a legal complex: para-ethnography at the swedish tax agency, 2 j. bus. anthro. 209 (2013). 50 see sally falk moore, law and social change: the semi-autonomous social field as an appropriate subject of study, in law as process: an anthropological approach 54 (1978). 51 cf. jurgen habermas, between facts & norms 68 (1996). 52 roberto m. unger, law in modern society 44 (1976). 54 columbia journal of tax law [vol.9:45 anthropology would be the description of “native” custom by reference to juridical concepts, or of the interaction of tribal custom with state government; or in the vein of law & society studies or criminology, the verification of the empirical effect of statutes—in short, micro-politics. to the extent that legal anthropology precisely describes native sanctions, it would not apply to the state as a whole, or to the elaboration of political ideals on a large scale. observations of law and society long have oscillated between rules and the organic mores over which they may be superimposed. in the case of compliance with tax law, it may not be hard to envision micro-economic examples in which positive prescriptions deviate from cultural norms. for example, the federal gift tax law favorably allows use of carry-over basis in determining gain upon disposition of property originally received as a gift.53 ascertaining original cost-basis would require the recipient to inquire of the donor. such an inquiry, however, would transgress a cultural norm of not “looking a gift horse in the mouth” as if to question a donor’s generosity.54 if hypotheses like these about deviation from cultural norms may be accurate (so-called social noncompliance), reduced compliance with tax rules should be empirically verifiable. despite the limits of any particular methodology, any instantiation of a system, rationale, or law is inevitably human. thus, the irreducible experience of tax compliance can ultimately be reflected empirically through sociological and anthropological methods employed below. iv. overview of federal income taxation the second half of this article begins within an overview of federal income taxation of individuals, covering the diversity of the taxpayer population, and sets forth national data from a survey of that population. for comparison, the article reviews field studies of taxpayer behavior in certain countries. finally, the article discusses the survey data in light of the theories of legal compliance introduced above. in 1913, the u.s. congress imposed the individual income tax on high-income taxpayers. at that time, the predecessor to irs was a hands-on collector of various excise and other taxes. consistent with the incidence of taxation to fund wars, the income tax raised revenue for the u.s. entry into world war i. in 1942, congress enacted the “greatest tax bill in american history” largely to fund the u.s. effort in world war ii, expanding the income tax to the middle class.55 consequently, the treasury made an historic effort to popularize the income tax, famously staging walt disney’s cartoon character donald duck as a mascot of the public fisc.56 the wartime transition from “class tax to mass tax” occasioned a “marriage of convenience that survived.” 57 in the second half of the last century, irs deployed information processing machines that in ensuing years made the agency increasingly “faceless.” in recent decades, a diverse low-income population has become a significant customer base, especially due to refundable credits. as a result, irs 53 see i.r.c. § 1015. 54 on reciprocity, see marcel mauss, the gift: forms & functions of exchange in archaic societies (1922). 55 randolph paul, taxation in the united states 294 (1954). 56 see carolyn jones, class tax to mass tax: the role of propaganda in the expansion of the income tax during world war ii, 37 buff. l. rev. 685 (1989). 57 u.s. dep’t of the treasury, irs historical fact book: a chronology, 1646–1992 135 (1993). 2017] who pays the price of civilization? 55 started as a revenue bureau but now administers social expenditures as well, through highly automated systems.58 as long as there has been an income tax, opponents have organized against it politically and ideologically. according to recent scholarship in fiscal sociology, a tax club movement convened hundreds of protest meetings in small towns throughout the south and midwest to demand repeal of the high rates that paid for world war i. at the beginning, tax protest took place in particular geographic communities. in response to the new deal, grassroots campaigns arose in several states calling for a constitutional amendment to limit the top rate of income tax. responding to tax increases that paid for world war ii and the korean war, thousands petitioned for a constitutional tax ceiling. federal tax increases in 1993 sparked a campaign to repeal taxes on the wealthy, i.e. estates and capital gain, arising in the context of the contract with america mentioned earlier. as discussed above, the evolution of any state—embodied by its fiscal apparatus—is an ongoing history, rather than a teleology.59 nowadays, individual taxpayers are a significant subset of the u.s. population. individual taxpayers filed 141.2 million returns in 2010, when there were 308.7 million people in the united states according to the census that year.60 with a tax return for about every two people, demographic trends are likely to influence the behavior of the taxpayer population, which may be characterized by ethnicity, economics, gender, age, and geography. thus, taxpayer behavior is subject to the inherent dynamics of society theorized above. each demographic group may be more or less acculturated into the nation-state. in sum, the history of u.s. income tax has been the superimposition of the federal system on a diverse mass of taxpayers. amidst diversity, achieving uniformity—the hallmark of the bureaucratic state—is the challenge of compliance here. v. u.s. survey research on small business tax compliance assuming that the probability of punishment is insufficient to deter noncompliance as discussed above, why do taxpayers voluntarily comply? this part sets forth national survey data and results on u.s. taxpayer compliance attitudes. the survey inquired into themes from the tax morale and related behavioral literature as summarized below. taxpayers in a compliant group may exert social pressure on other members to comply (e.g. shaming), and those who cheat may feel guilty when they break the norm that has become reciprocal. those who trust the government and feel that the tax laws and procedures are fair and justly enforced may be more likely to feel a moral obligation to comply, even if the outcome of those procedures is unfavorable.61 to address the foregoing hypothetical issues, a research team of which this writer was a member conducted a statistical survey of tax compliance as follows. the research team surveyed sole proprietors (i.e. those filing form 1040, u.s. individual income tax 58 see eric san juan, from tax collector to fiscal panopticon: social history of a century of federal income taxation, 15 rutgers j. of l. & pub. pol’y (forthcoming). 59 on this paragraph, see martin, supra note 48. 60 irs pub. 55-b, data book, at 4 tbl.2 (2010), available at https://www.irs.gov/pub/irssoi/10databk.pdf [https://perma.cc/6vml-ut4v]; u.s. bureau of the census, population distribution & change: 2000 to 2010 (mar. 2011), available at https://www.census.gov/prod/cen2010/briefs/c2010br01.pdf [https://perma.cc/3cz4-edmn]. 61 see beers, lopresti & san juan, supra note 4, at 66 tbl.2. 56 columbia journal of tax law [vol.9:45 return, schedule c) to better understand the factors that may affect their income tax reporting compliance. identifying how to improve compliance among this segment is particularly important because sole proprietor income is generally not subject to information reporting, is difficult for the irs to detect, and represents the largest portion of the tax gap, i.e. tax not timely and voluntarily paid.62 because actual reporting compliance is difficult to measure, the research team used irs tax compliance estimates to identify sole proprietors most likely to have high or low levels of reporting compliance. the research team surveyed a stratified random national sample of each group (the “national survey”). the sample was statistically representative of the u.s. population of schedule c filers. accordingly, questions on attitudes could reflect the demographic diversity of the population. ultimately, the national survey provides an unprecedented link between the views of the schedule c filers and their compliance level (at least according to irs scores).63 because compliance could be affected by local conditions and attitudes, the research team identified geographic communities where a disproportionate number of taxpayers were in the highor low-compliance group. the research team surveyed taxpayers at random in certain communities (the “community survey”) using the same survey questions. the questions went to the effect, if any, on reporting compliance of various factors, such as deterrence, tax morale, compliance norms, trust in the government and the tax administration process, complexity and the convenience of complying, and the influence of preparers.64 a. pertinent results of survey on taxpayer compliance pertinent results of the national survey included the following. taxpayers in the high-compliance group expressed more trust in government and the irs. taxpayers in the low-compliance group were more likely to participate in local organizations. they were also significantly more likely to report that other participants view the law and the irs negatively. both groups professed a “moral” obligation to report income accurately. the responses do not show “asocial” behavior, i.e. that economic deterrence motivates compliance decisions. those in the low-compliance group were less likely to agree that noncompliance goes unpunished.65 pertinent results of the community survey included the following: there were more low-compliance communities than high compliance communities because taxpayers characterized by high compliance were not geographically concentrated. respondents from the low-compliance communities were suspicious of the tax system and its fairness, whereas those from the high-compliance communities viewed government positively. among business classifications, the biggest cluster in low-compliance communities was under “professional, scientific, or technical services”; in high-compliance communities, the “other” service industry (e.g. repair & maintenance, personal & laundry, and private household services). the low-compliance community respondents reported more participation in civic institutions than their high-compliance counterparts. the high 62 this paragraph summarizes id. at 66. 63 this paragraph summarizes id. at 67. 64 this paragraph summarizes id. at 68. 65 this paragraph summarizes id. at 70–80. 2017] who pays the price of civilization? 57 compliance community respondents were motivated by morals and, if only due to compliant predisposition, deterrence.66 in sum, all groups and communities agreed that it is morally wrong to cheat and that they would feel embarrassed if others learned they were not reporting all of their income. surprisingly, those in the low-compliance group were also more likely than those in the high-compliance group to believe that the irs detects and penalizes noncompliance. thus, other factors appeared to overshadow these positive moral, social, and economic pressures for those in the low-compliance group and communities.67 specifically, the results of both surveys associate distrust of the national government and the irs with the low-compliance groups and communities. for example, respondents from the low-compliance group were more likely to report that the government is too big and wastes tax dollars, while tax laws and irs are unfair.68 the community survey revealed that those with low compliance levels clustered in geographic communities, while those with high compliance levels were more dispersed. perhaps those with low levels of compliance are more likely to associate with each other.69 those in the low-compliance group and communities were more likely to participate in local organizations and to report that other members of those organizations believe the law and the irs are unfair. the closer association with local organizations by members of the low-compliance group and communities could have undermined their connection with the nation and the national tax system as a whole. the negative views they attributed to other members appeared to mirror their own views. in other words, they affiliated with others who reinforced noncompliance norms locally, feeling a closer connection here than nationally.70 b. details of survey data on attitudes toward government salient survey results of particular relevance to the socio-legal theories discussed in the first half of this article are detailed below. to recapitulate, taxpayers in the highcompliance communities were more geographically dispersed than those in lowcompliance communities, who were more likely to participate in local organizations. lowcompliance communities clustered in professional occupations; high-compliance communities, the “other” service industry. nationally, the high-compliance group was more likely to trust government, while the low-compliance group was more inclined to participate in local organizations. the following encapsulates the detailed data: respondents from the high-compliance communities most frequently clustered in ‘other services’ (22 percent vs. 11 percent of low-compliance respondents), whereas those from the low-compliance communities most frequently clustered in ‘professional, scientific, or technical services’ (22 vs. 11 percent from the highcompliance communities). those from the high-compliance communities were more than twice as likely to speak a language other than english at home (22 vs. 9 percent from the low-compliance communities). the community survey may have identified a unique type of ‘social’ compliance related to a particular socio 66 this paragraph summarizes id. at 83–86. 67 this paragraph summarizes id. at 82. 68 see id. at 81. 69 see id. at 89. 70 see id. 58 columbia journal of tax law [vol.9:45 economic experience, that of a linguistic minority employed in the service industry who expressed trust in government.71 taxpayers in the [national survey] high-compliance group were more likely to trust the government than those in the low-compliance group, potentially suggesting that negative views about the government promote symbolic noncompliance … for example, those in the high-compliance group were less likely to agree that the government is involved in areas best left to the private sector (59 percent of the high-compliance group agreed vs. 66 percent of the lowcompliance group), more likely to support higher taxes in exchange for improved government services (37 vs. 30 percent), and more likely to believe that the federal government spends tax dollars wisely (80 percent of the low-compliance group disagreed vs. 70 percent of the high-compliance group). these results are generally consistent with research suggesting that trust in government has a positive effect on compliance.72 taxpayers in the [national survey] high-compliance group were less likely than those in the low-compliance group to belong to a local business organization (11 vs. 16 percent), a local trade, labor, or other occupational organization (15 vs. 18 percent), or religious congregation (61 vs. 71 percent). to the extent association with these groups transmits local compliance norms, those norms appear to have a negative effect on compliance, rather than a positive one.73 among [national survey] respondents who belong to local organizations, those in the low-compliance group were more likely to report that they usually participate. this was true for various organizations identified by the survey, including local business organizations (50 percent from the low-compliance group usually participate vs. 30 percent from the high-compliance group), local trade, labor, or occupational organizations (40 vs. 24 percent), and local civic, community, or fraternal organizations (67 vs. 47 percent). thus, active participation in these groups appears to be negatively correlated with tax compliance, possibly promoting social noncompliance … perhaps those with a closer connection to local groups feel a weaker connection to the federal government, and a weaker obligation to comply with federal tax laws. they may also choose to associate with those who hold similarly negative views about the federal government and tax compliance, which reinforced their own views.74 in short, trust in government versus local ties were better indicators of compliance behavior than deterrence, morality, or norms (inasmuch as noncompliance may be social as well as asocial). the apparent contradiction between received norms and (non)compliance level may reflect the inherent tension between commitment to the nationstate versus the local community. 71 id. at 85 (footnote omitted). 72 id. at 70 (footnotes omitted). 73 id. at 73. 74 id. at 74. 2017] who pays the price of civilization? 59 c. further analysis of socio-geographic networks in the community survey given the results above, the research team conducted further analysis of social networks that the community survey had indicated were geographically based as follows: the community survey … mapped low-compliance sites as they occurred not randomly but heavily clustered in regions where geographers have classified cultures of the south and west. at the same time, responses to a set of questions in the community survey tended to link low compliance levels with social affiliations or networks associated especially with volunteering, voting, and congregations (i.e. houses of worship of any denomination). consequently, the question arises whether low-compliance sites are located in regions where those social networks are prevalent. to answer that question, further analysis focuses on one state [of the u.s.] containing low-compliance sites among other sites not so classified. in particular, the state is composed of 23 counties, six of which contained low-compliance sites. physical geography divides the counties into areas labeled valley, hills, and shore (east & west). according to geographers, the valley and east shore fall into cultures of the north and south, respectively. the hills and adjacent west shore run between those two areas, hosting a regional metropolitan corridor classified by geographers as megalopolis. the low-compliance sites were located in megalopolis. given this geographic layout, this analysis employs a fairly transparent methodology as follows … [the research team compiled] statistics reported by the u.s. census and other published sources on relevant demographics, urban concentration, congregational membership, charities, and voter turn-out. countylevel data are averaged into the four physical areas, with the two middle areas again averaged for megalopolis, which has the highest urban concentration … the demographic and related statistics for the geographic areas identified above [in the relevant time-frame] reveal the following. megalopolis has the highest percentages of population involved in congregations, living in families, and turning out to vote (depending on which election). within megalopolis, the six counties containing low-compliance sites had high rates of urban concentration and ethnic diversity. on the other hand, the valley has the most charities per ten thousand population. the valley has the lowest rates of voter turnout and population living in families. overall, the valley’s population is the oldest, least ethnically diverse, and most masculine (i.e. has the highest male to female ratio) of the three average areas. finally, the east shore population was the youngest and least religious, but most rural. in sum, megalopolis had some expected characteristics related to social networks. however, another area turned out to be more charitable. accordingly, [the analysis] … may be inconclusive at this point while additional research could 60 columbia journal of tax law [vol.9:45 uncover further, more granular data. if further research could confirm that the least compliant area is the densest in social networks, an implication might be that those networks could be a medium for messages about tax compliance. potentially, future research could extend to field studies at a granular level … [f]uture research alternatively could survey relevant social science literature for attributes statistically linked to the prevalence or density of social networks. ***** while this [community] survey elicited direct responses from taxpayers, the ‘social’ nature of norms should be observable even beyond these responses, potentially by observing characteristics of the highand low-compliance communities or regions. future research could build upon the survey results by investigating social noncompliance and compliance in sites where they occur. further investigation would relate to tax administration vis-à-vis regional traditions.75 thus, there were some indications that tax noncompliance travels along social networks. since the foregoing geographic profile based on the community survey above suggested in part that granular field research could prove fruitful, literature reviewed below reveals a couple of examples of field studies of legal and tax compliance. vi. field studies of legal & tax compliance in the social science literature this part sets forth relevant case studies from the social science literature from the perspectives of both taxpayers and tax collectors. while the literature contains various studies, these ones ethnographically highlight tax behavior. the first concerns informal financial practices of small business in taiwan; the second, bureaucratic practices in the swedish tax agency. while north american taxpayers, east asian entrepreneurs, and northern european bureaucrats may be incomparable as informants, these case studies exemplify the kind of information available from field research that could complement the nationwide survey data above. field research can illuminate tax compliance as exemplified by a study of small business in a particular insular country. through interviews of informants in that country, this study looks at the informal financing techniques used by small businesses to clarify the interaction between the formal republic of china (roc) legal system and the network structure of taiwanese society. according to the study, the traditional structure of rural chinese society has survived on taiwan in a modified form, which selectively blends elements of the modern legal system, networks of relationships, and the “enforcement services” by organized crime.76 75 tom beers, mike nestor & eric san juan, small business compliance: further analysis of influential factors, irs pub. 2104-b, taxpayer advocate serv. annual report to congress, at 43–45 (2013) (footnotes omitted), available at http://taxpayeradvocate.irs.gov/2013-annual-report/downloads/volume-2tas-research-and-related-studies.pdf [https://perma.cc/j9l2-yrd9]. on measures of civic engagement, see, e.g., robert d. putnam, making democracy work (1994). 76 see winn, supra note 15. 2017] who pays the price of civilization? 61 when small businesses have been unable to rely on the formal legal system to support relational practices, alternatives as simple as post-dated checks (pdcs), have served a similar function. for example, when the roc enacted criminal penalties on bounced checks, creditors lending without benefit of written contracts but “interacting through networks of relationships assumed they could verify the other party’s good faith by simply asking for a pdc to document any extension of credit.”77 thus, informal business relationships leveraged legal consequences, although not as intended by the legislators. in this study, the roc represents the modernity adopted in the twentieth century from the west, especially german civil law. traditional chinese culture here represents a rural survival, rather than confucian philosophy of the legal theories discussed in the first half of this article. nevertheless, what the study glosses as a practical grounding in “relational practices,” rather than niceties like written contracts, may not be inconsistent with the historical observation that, as a nomothetic concept, customary morality took precedence over positive law throughout chinese civilization. on the other side of the tax system, ethnographic research can illuminate compliance from the perspective of the tax collector as well as the taxpayer. a study of the swedish tax agency exemplifies this. the swedish study proceeds from the proposition that the foundation of a functioning welfare state is a tax system that is widely accepted and considered to be fair and legitimate. this proposition resonates with various theoretical bases for compliance discussed above, from the social contract to procedural fairness. how and by what means a tax collection agency interprets the laws affect taxpayers’ willingness to pay. through participant observation in government offices and related sites, this study addresses the various practices, knowledge and forms of data in the swedish tax agency against a background of the agency’s ongoing endeavor for legitimacy. this study shows how the agency’s methods entail not only regulations, research, and statistical data, but also stories, hunches, and examples from the media—including the instant ethnographer—and from everyday life. for example, the ethnographer witnessed the agency’s process of deciding to execute questionnaire research through telephone interviews, not unlike the survey presented above.78 both case studies illustrate the instantiation of national systems in quotidian locales. field research on this micro-scale could complement survey research of the national dimension described above. vii. implications of tax compliance research for the rule of law after review of the tax morale literature at outset of the survey set forth above, the research team formed a hypothesis that, in general, tax law compliance would reflect conformity to social norms related to trust in government. in part, the survey results reversed those expectations. those taxpayers who conformed to social norms, to the extent measured by participation in local organizations and geographic clustering, turned out to be relatively noncompliant. additionally, low-compliance communities tended to 77 id. at 219. 78 see larsen, supra note 49, at 218. 62 columbia journal of tax law [vol.9:45 comprise professionals rather than “other” service personnel. while those who trusted government were more compliant, they were relatively dispersed. in fact, they may have been a small minority. these odd results may be reconciled as follows. as discussed in the first half of this article, legal evolution has been a history of national cooptation of local power. states, kingdoms, and chiefdoms emerged above the primordial substrate of tribal culture, which never withers away. the survey results above may be consistent with that political science model of tension between national power and local resources. in the case of so-called tax protest, litigants have attempted to avoid federal tax by assertion of citizenship in one of the fifty states rather than the u.s.79 likewise, recent scholarship in political sociology confirms that americans are willing to pay taxes for local services like roads, schools, and healthcare, but not nationwide expenses such as science or foreign aid.80 the national government, represented by irs, may hold sway over a small, relatively disenfranchised, population. these observations are consistent with legal commentary that underscores the role of legislators, at least in the u.s. congress, who may encourage low compliance in pursuit of regressive tax policy. in particular, 2016 presidential candidate gov. john kasich (r– oh.), then chair of the house budget committee, said in the context of a 1995 “flat tax” legislative proposal that “the end game here is to strip the government of the financial means for butting into the lives of americans, and thus returning power and responsibility to families and localities.”81 the commentators conclude that subsequent senate finance committee hearings that “revealed shortcomings in the irs’s operations … mainly provided a highly visible forum for antitax forces to levy sensational charges about outrageous agency behavior.”82 objections to the conduct of the federal tax collector were coupled with local resistance. local elites could have the power to resist compliance with taxation as representative of federal law more generally. if so, the expected result would be that wellestablished socio-economic communities may have low compliance, rather than high compliance with national taxation. the professional status of the low-compliance communities, which were geographically clustered, may indicate that they constitute a localized elite. even in the national survey, the low-compliance group was more likely to participate in local organizations. that’s why the further analysis above mapped the geographic communities for social networks that could transmit or reinforce low levels of compliance. local elites may be known to commentators variously as the petite bourgeoisie, characterized by a “parochial” outlook, or smallholders, responsible in large part for “the military and fiscal basis of the empire” in historic civilizations. 83 this commentary reinforces the role of local elites, who ultimately pay tax, in the acceptance or rejection of legal regimes generally. then this article drew on an ethnographic study of small business to suggest potential mechanisms for the transmission of noncompliant behavior. while the u.s. 79 see, e.g., betz v. u.s., 40 fed. cl. 286, 294–95 (1998). 80 see vanessa williamson, read my lips: why americans are proud to pay taxes (2017). 81 tanina rostain & milton c. regan, jr., the irs under siege, in confidence games: lawyers, accountants, and the tax shelter industry 12 (2014). 82 id. at 19. 83 roberto m. unger, plasticity into power: comparative-historical studies on the institutional conditions of economic & military success 5 (1987); frank bechhofer & brian elliott, persistence & change: the petite bourgeoisie in industrial society, 17 eur. j. of sociol. 74, 84 (1976). 2017] who pays the price of civilization? 63 survey and the taiwan field study reflect vastly divergent cultures, it is possible that local elites in different countries avail themselves of the same type of small business practices (or even conveniences), as simple as post-dating checks, or more generally, informal—and thereby noncompliant—economics. as expected, those who trusted government had higher compliance than those who didn’t. nationally, high-compliance taxpayers were more likely to support higher taxes in exchange for improved government services. conversely, respondents from the lowcompliance group were more likely to report that the government is too big and wastes tax dollars, while tax laws and irs are unfair. apparently, the highly-compliant feel that they receive commensurate utility from their taxes, either personally or through public goods. on the other hand, the low-compliance group either suffers from redistribution or, in principle, opposes tax policy. the survey doesn’t resolve which interpretation of the social contract may prevail. the national versus local model, encapsulated by the sasf concept set forth above, may be consistent also with the field studies summarized from the literature above. small businesses in the insular case study may have relied on informal market and legal practices where the modern state couldn’t penetrate the economy. obversely, tax collectors in the second cited ethnography represent the attempt of the state to intercede in the everyday stories of inevitably local life. as a practical matter, compliance must be embedded in local culture because it is an aspect of individual behavior. to extrapolate to popular adherence to the rule of law, a fruitful inquiry could be whether contemporary divisions also fall along national (cosmopolitan) versus local (rural) lines. moreover, high compliance was consistent with a perception of a fair process that underlies legal compliance in general. as expected, respondents from the low-compliance communities were suspicious of the tax system and its fairness. as discussed above, the psychological literature concludes that compliance arises from a perception of procedural justice. theoretically, the question why obey the law arises where people can disobey. on a small scale, this may mean schedule c, which presents opportunities for noncompliance, especially mischaracterization of personal consumption as deductible business expenses.84 on a larger scale, the discretion to disobey comes from the premise that the rule of law evolved out of the social contract as an individually reasoned artifact.85 paradoxically, the question of compliance is a function of the social contract, without which the question wouldn’t arise. without the mutual consideration of right-bearing individuals, the question presumably would be one of conquest or counterattack, or put simply, might makes right. outside of the rule of law, so conceived, the question may be that of customary conduct (or immoral behavior) rather than reasoned compliance (or civil disobedience). assuming rational actors, legal compliance becomes a cost-benefit analysis. then the exercise is to identify the costs and benefits. 84 see, e.g., peacock v. comm’r, t.c. memo. 2002–122 (2002) (denying incorrect deduction). 85 cf. mortimer & sanford kadish, discretion to disobey: a study of lawful departures from legal rules 5 (1973) (“legal systems may still fairly be called such even though they provide alternatives to unqualified obedience”). 64 columbia journal of tax law [vol.9:45 viii. topics for future research on tax law compliance where rational legal analysis prevails, the following research topics may have potential. consider a previous american proposal to mandate that businesses establish bank accounts segregated from the personal funds of their owners to reduce, presumably through tracing, incorrect tax deduction of personal consumption as business expenses.86 given the proposal’s attempt to reach beyond title 26 to manipulate business behavior for a potential tax compliance effect, it may be no wonder that the proposal failed to gain legislative traction. on the other hand, the substance of the proposal could be designed as a product for the convenience of business owners. that is, banks could offer business accounts enhanced with recordkeeping services that automatically generate income and expense tabulations useful for tax purposes, as long as the account contains the entirety of a business’ monetary transactions. thus, an attempt to control behavior may be transformed into an opportunity that recognizes the value of convenience in today’s business culture. for comparison, some brokerage houses offered certain basis reports as a customer service even before congress mandated basis reporting for tax purposes.87 to whatever extent behavioral economics has identified complexity as a reason for noncompliance, this proposal could help. similarly, policy-makers could design tax legislation in view of user friendliness, including administrability by the tax collector. to take a negative example, the home buyer credit enacted in the wake of the u.s. housing market crisis requires purchase documentation exogenous to the tax system (not to mention a housing expenditure policy as to which the tax collector could not be expected to have the requisite institutional expertise).88 in this case, tax noncompliance could be expected as a result of cumbersome design of housing policy.89 as a subset of legal compliance, tax compliance may correlate with other aspects of civil compliance, such as postal rules or traffic violations. at least since the eighteenth century, commentators have idealized small business as the backbone of america, 90 ultimately in contradistinction to big business, big government, and even big labor. no wonder that a major contributor to the tax gap is small business,91 a sector that may gloss noncompliance as “cutting red tape.” as a testable hypothesis, small business compliance may diverge from big business compliance not only in tax but in other regulatory areas, 86 see the presidential advisory panel on fed. tax reform, simple, fair, and pro-growth: proposals to fix america’s tax system, at 128 (2005), available at https://www.treasury.gov/resourcecenter/tax-policy/documents/report-fix-tax-system-2005.pdf [https://perma.cc/b436-gp8b]. 87 see joint comm. on taxation, general explanation of tax legislation enacted in the 110th congress, at 363 (mar. 2009), available at https://www.jct.gov/publications.html?func=startdown&id=1990 [https://perma.cc/zk2b-zb7h]. 88 see i.r.c. § 36 (2008). 89 the treasury inspector general for tax administration (tigta) “recommended that the irs require taxpayers to provide documentation to verify a home purchase, such as a u.s. department of housing and urban development settlement statement (hud-1) issued to homebuyers at closing. the irs disagreed … as a result of the irs’s inaction, tigta’s report found that 19,351 taxpayers claimed $139.4 million in credits for homes they had not yet purchased.” press release, tigta, tigta audits irs’s administration on first-time homebuyer credit (oct. 22, 2009), https://www.treasury.gov/tigta/press/press_10222009.htm [https://perma.cc/r463-rnwr]. 90 see, e.g., alexis de tocqueville, democracy in america (1840). 91 stacy cowley, why the irs fails to crack the small-business tax nut, n.y. times, june 15, 2016, at b4 (“most of that ‘tax gap’ is income that goes unreported, and the biggest chunk of it, by far—$125 billion—is individual business income … primarily sole proprietors,” referring to the survey presented above). 2017] who pays the price of civilization? 65 such as licensing requirements. the case study above indicates that small business may have this potential not only in the u.s. but similarly in developing economies. if tax morale is an instantiation of civic responsibility at the national level, presumably tax compliance would rise with the ascendancy of the so-called welfare state, while the tax gap would grow during periods of dissension. the post-world war ii hegemony of the so-called military-industrial complex, 92 accompanied by burgeoning programs for a great society,93 could represent a peak of legal, including tax, compliance. on the other hand, dissension over the vietnam war, segregation in violation of civil rights, and lapse of bureaucratic authority epitomized by the watergate burglary could have decreased legal and tax compliance. presumably, this hypothesis could be tested by historical data. likewise, tax morale as civic responsibility could be higher in homogeneous, organic nation-states but lower in countries whose populations are historically divisive.94 in other words, comparative data could confirm the incidence of tax morale in context. in sum, an interdisciplinary social science of law, or law & society studies, can inform hypotheses about tax compliance as a subset of legal compliance, on both worldhistorical and micro-economic scales. the latter may be most productive for applied research. in either case, actual behavior could be informed by received social ideologies or cultural norms, while intended policy may be ostensibly based on rational principles of revenue raising. an understanding of the interstices between behavior and policy may inform strategies and designs for better compliance. ix. conclusion on the socio-historical context of tax compliance as intimated at the outset, the rule of law continues to be an aspiration in industrial as well as developing economies around the world. on the bottom line, revenue collection has always been necessary to fund the operations of governments. accordingly, tax compliance has formed the nexus between the local origin of resources and supra-local civilization, or nation-states. the noncompliant communities discussed above may occupy this nexus. meanwhile, every regime arises in its particular time and place, or social context. consequently, the rule of law can be actualized only in irreducible human experience. in turn, this experience is subject to study through social science methodologies, which then may inform legal theory or jurisprudence. while a teleology of liberal legality has held heuristic and metaphorical sway, the empirical reality has been merely evolutionary or historic. observance of the rule of law may be more or less adaptive at times. even in advanced countries, the level of compliance is a perennial question for local elites, who ultimately pay tax. there is no escaping the substrate of custom and culture that informs human behavior, as in the case of so-called social noncompliance. the primordial nature of personality is a reality not only for taxpayers but also for presidents. colorless rational authority may not persuade taxpayers to remit or propel candidates into national office. on the contrary, compliance with tax law has expanded through national mobilization or even fervor, as in the case of major 92 see generally c. wright mills, the power elite (1956). 93 see generally theda skocpol, protecting soldiers & mothers: the political origins of social policy in the u.s. (1992). 94 for a typology, see hugh seton-watson, nations & states (1977). 66 columbia journal of tax law [vol.9:45 wartime efforts. further research could confirm that tax compliance, and the rule of law in general, may be more of an historic incidence than an endpoint of evolution. * j.d. 2019, columbia law school. note the partnership audit rules of 2015: the implications for misvalued private funds and new partners iryna malakhouskaya* abstract this note takes an interdisciplinary approach by analyzing new partnership audit rules’ effects on misvalued private funds from securities law and tax law perspectives. first, the funds’ valuation regulations are examined; second, the new partnership audit rules are reviewed; and finally, implications for new investors and private funds are examined. this note suggests that marketability of private funds, which are ineligible for an opt-out option, would decrease. especially serious negative effects may be anticipated for private funds with a history of misvaluation administrative proceedings. nevertheless, several protective measures are available for new partners who want to continue taking advantage of pooled investment vehicles. finally, there is a potential positive effect on the private funds’ valuation techniques and, consequently, on the number of the sec administrative proceedings relating to misvalued funds. 228 [vol. 10:2 columbia journal of tax law table of content i. introduction 229 ii. funds and misvaluation issues 229 a. funds overview 230 b. legal and regulatory framework of funds’ valuation 231 c. current instances of misvalued funds 234 iii. overview of the partnership audit rules 236 a. the partnership audit rules in a nutshell 236 b. unresolved issues: negative consequences for new partners 238 iv. the implications of the partnership audit rules for misvalued private funds and new partners 241 a. private funds’ marketability under the partnership audit rules 241 b. protections for new investors in private funds 243 c. positive effects of the new partnership audit rules on valuation techniques 246 v. conclusion 247 2019] 229 the partnership audit rules of 2015: the implications for misvalued private funds and new partners i. introduction modern investors are presented with a wide array of investment vehicles. which vehicle is the right one for a particular investor may depend on many factors. significant factors often include minimal regulatory and legal requirements as well as beneficial tax consequences. these factors played an important role in attracting wealthy individuals and institutions to private funds, which may be hedge funds, private equity funds, or liquidity funds. there are, nevertheless, some disadvantages in holding an investment in a private fund. one of them is the possibility of misvaluation of the assets. since hedge funds frequently hold hard-to-value securities, misvaluation may take place either accidentally or intentionally. some securities and exchange commission (“sec”) administrative proceedings involving misvaluation become widely publicized because of outrageous conduct by the managers. through enforcement of federal laws and issuance of various publications, the sec attempts to guide the valuators how to deal with hard-to-value securities. additionally, hedge funds are required to make disclosure statements about the valuation techniques they implement. finally, the dodd-frank act imposes advisers’ registration requirement for hedge funds advisers, which were previously exempted from registration. the possibility of misvaluation is no longer the only serious concern for potential investors in private funds. in 2015, congress amended the internal revenue code (“code”) and changed the way partnerships are being audited. generally, private funds are organized as partnerships because of the beneficial pass-through tax treatment, where all the taxes flow from the partnership to its partners, so there is no double taxation as under the corporate form of organization. starting january 1, 2018, the partnership audit rules of the bipartisan budget act of 2015 (“partnership audit rules”) have gone into effect. there are negative implications for both new partners and for private funds. the partnership audit rules would allocate former partners’ tax underpayment to the most current taxable year, in which partners’ base may have entirely changed, and therefore new partners might become liable for tax underpayments from past years unless they locate former partners. there is, however, a potential incidental effect on improvement of valuation techniques because of private funds’ possible intention to attract new partners. by improving their valuation techniques, private funds might attempt to assure new partners that they use credible valuation methods and would not expose new partners to tax overpayments. section ii of this note describes various funds, elaborates on regulatory and legal frameworks for the valuation of private funds, and references several current news-making instances of misvaluation. section iii reviews the partnership audit rules and addresses certain unresolved issues related to new partners in private funds, including misvalued funds. section iv highlights potential effects of the partnership audit rules on private funds’ marketability, elaborates on protective measures available for new partners, and suggests a potential positive effect on valuation techniques for private funds. ii. funds and misvaluation issues 230 [vol. 10:2 columbia journal of tax law this section reviews various investment vehicles available to investors, the problem of misvaluation of the funds’ assets, and the federal laws which attempt to protect investors from the funds’ managers’ intentional or unintentional errors in valuation. a. funds overview today’s investors, both individual and institutional, have many choices regarding where to invest their money. common investment vehicles include mutual funds, private funds (such as hedge funds, private equity funds, and liquidity funds), and pension funds. mutual funds “gather money from numerous investors and invest in a diversified portfolio of assets,” including “stocks, bonds, and/or other mutual funds,” through continuous public offerings and redemptions at net asset value determined by their price at the markets in which these portfolio investments trade, or at prices determined by the fund managers and directors if there is no active public market.1 hedge funds “invest the assets of high-net-worth individuals in a way that is designed to earn abovemarket returns” through incorporation of “high-risk strategies such as short selling, derivatives and leverage.”2 hedge funds often “rely on active trading, which is a practice in which investment positions are changed with high frequency – sometimes to maintain a desired risk-return profile as market prices fluctuate, and sometimes to profit from short-term changes in prices.”3 pension funds can be both private and public; however, there are not many traditional pension plans left in the private sector.4 private investment funds have certain advantages over publicly traded funds because of relatively more flexible regulatory and legal requirements.5 for example, in goldstein v. s.e.c., the court noted that “[w]hile mutual funds … must register with the commission and disclose their investment positions and financial condition, hedge funds typically remain secretive about their positions and strategies, even to their own investors.”6 nevertheless, starting from the enactment of the dodd-frank act, there are much more rigorous disclosure requirements for private funds.7 this note focuses primarily on private funds since the new partnership audit rules affect mostly private funds due to the misvaluation issues which are frequent in these funds and which potentially result in over-taxation of new funds members. 1 fund, https://www.investopedia.com/terms/f/fund.asp [https://perma.cc/9d6l-nqzp] (last visited nov. 8, 2018). 2 id. 3 david m. schizer, constructive ownership under section 1260, bna portfolio: financial instruments: special rules, chapter iv, n.1, 2002 (internal quotations omitted). 4 see how do pension funds work?, https://www.investopedia.com/articles/investingstrategy/090916/how-do-pension-funds-work.asp [https://perma.cc/764n-k3mg] (last visited nov. 8, 2018). 5 see private investment fund, https://www.investopedia.com/terms/p/privateinvestmentfund.asp [https://perma.cc/93uz-r77e] (last visited nov. 8, 2018) (a private fund must meet one of the exemptions outlined in the investment company act of 1940. the most frequent exemptions are under section 3(c)(1), “fund can have up to 100 accredited investors,” and under section 3(c)(7), “fund can have a soft limit of around 2,000 qualified investors.” an accredited investor is required to have “more than $1 million in net worth without counting their primary residence and/or $200,000 in annual income for an individual and $300,000 for a couple.” a qualified investor is required to hold assets in excess of $5 million.). 6 goldstein v. s.e.c., 451 f.3d 877, 875 (d.c. cir. 2006). 7 the dodd-frank wall street reform and consumer protection act. pub.l. 111-203, h.r. 4173 (eliminating the investor act’s section 203(b)(3) “private investment adviser” exemption and adding significant reporting requirements). https://www.investopedia.com/terms/f/fund.asp 2019] 231 the partnership audit rules of 2015: the implications for misvalued private funds and new partners b. legal and regulatory framework of funds’ valuation especially relevant legal and regulatory issue that concerns both registered and unregistered funds is valuation of the assets in their portfolios. valuation, or more precisely misvaluation, often results from the conflicts of interests between a manager’s “incentive to increase the value of portfolio assets in order to reap more handsome fees” and to promise “more attractive returns to prospective investors” and an investor’s incentive to have the fund receive maximum market returns.8 significantly, “compensation schemes for institutional investors are frequently tied to annual investment return.”9 consequently, some managers may implement questionable valuation techniques in order to increase their own compensation, which is in large part based on the percentage of net assets. generally, it is easy for a manager to discern an actual value of the investment. however, managers frequently rely on investment strategies which incorporate “thinly traded bonds, derivative instruments, and other securities that do not have transparent market price.”10 in order to prevent potential abuse in relation to funds valuation, several federal securities laws respond to these concerns. these laws include the investment company act of 1940 (“investment company act”) and the investment advisers act of 1940 (“advisers act”). additionally, investors can turn to “the courts’ interpretation of the federal securities antifraud statutes.”11 this resort, however, is generally not successful for individual investors because the provisions of anti-fraud statutes do not sufficiently address problematic valuation techniques used by the advisers.12 the investment company act applies to the registered funds. in section 2(a)(41), it defines “value: (a) as used in sections 3, 5, and 12 of this title, (i) with respect to securities owned at the end of the last preceding fiscal quarter for which market quotations are readily available, the market value at the end of such quarter; (ii) with respect to other securities and assets owned at the end of the last preceding fiscal quarter, fair value at the end of such quarter, as determined in good faith by the board of directors; and (iii) with respect to securities and other assets acquired after the end of the last preceding fiscal quarter, the cost thereof; and (b) as used elsewhere in this title, (i) with respect to securities for which market quotations are readily available, the market value of such securities; and (ii) with respect to other securities and assets, fair value as determined by the board of directors. (emphasis added).13 8 salvatore massa, outside a black box: court and regulatory review of investment valuations of hardto-value securities, 8 wm. & mary bus. l. rev. 1, 3 (2016). 9 james r. repetti, corporate governance and stockholder abdication: missing factors in tax policy analysis, 67 notre dame l. rev. 971, 996-99 (1992). 10 massa, supra note 8, at 3. 11 id. at 5. 12 see id. 13 investment company act § 2(a)(41), 15 u.s.c. § 80a-2(41) (2012). 232 [vol. 10:2 columbia journal of tax law thus, if market quotations are “readily available” for the securities, the act directs reliance on them; if there is no readily available market price, however, the act authorizes the fund’s board of directors to determine the value “in good faith.” the latter approach is generally referred to as a fair value approach. it can be utilized for foreign securities, where the market is closed for holidays, and for hard-to-value securities.14 the sec further elaborated upon the fair value approach. in accounting series release no. 113 (“asr 113”), the sec applied the “current sale” test to fair value restricted securities and stated that the board’s obligation “to determine fair values of restricted securities, in good faith, entails continuous review of propriety of valuation methodology, consideration of relevant factors and retention of information on which the board has relied.”15 additionally, the sec authorized the board to delegate “calculation of fair values pursuant to board approved methodologies.”16 in accounting series release no. 118, the sec addressed the valuation of hard-to-measure securities and stated that “value can be determined fairly in more than one way for unlisted securities traded regularly in the over-the-counter market.”17 furthermore, the sec highlighted that there is no single standard to determine the fair value of a security or other asset “because fair value depends on the facts and circumstances of each situation.”18 finally, the sec elaborated on the fair value method in the sec interpretive letter to the ici regarding valuation issues (“letter”). 19 in the letter, the sec included the list of factors that can be taken into account by funds’ boards: the value of other financial instruments, including derivative securities, traded on other markets or among dealers; trading volumes on markets, exchanges, or among dealers; values of baskets of securities traded on other markets, exchanges, or among dealers; changes in interest rates; observations from financial institutes; government (domestic or foreign) actions or pronouncements; and other news events.20 this list shows how much flexibility fund managers and valuation companies have in determining what information to rely on when determining the value of the assets. this, however, may lead to disparities in value of similar securities held by different funds. although the letter does not state that all the factors should be taken into account by the valuators, this conclusion is preferable because taking as many factors as possible into 14 see massa, supra note 8, at 9. 15 statement regarding “restricted securities,” investment company act release no. 5847, accounting series release no. 113 (oct. 21, 1969), https://www.sec.gov/divisions/investment/icvaluation.htm [https://perma.cc/g8c2-nd7j] (last visited nov. 15, 2018). 16 id. 17 accounting for investment securities by registered investment companies, investment company act release no. 6295, accounting series release no. 118 (dec. 23, 1970), https://www.sec.gov/divisions/investment/icvaluation.htm [https://perma.cc/e5fg-q7zm] (last visited nov. 15, 2018). 18 id. 19 craig s. tyle, division of investment management: december 1999 letter to the ici regarding valuation issues (dec. 8, 1999) (on file with author). 20 id. https://www.sec.gov/divisions/investment/icvaluation.htm 2019] 233 the partnership audit rules of 2015: the implications for misvalued private funds and new partners consideration would more likely lead to the determination of the fair value of hard-to-value securities. section 34(b) of the investment company act prohibits “disclosing materially misleading information in any required commission filing.”21 the sec utilizes this provision to institute administrative proceedings against registered funds which implemented inadequate or inaccurate valuation techniques or did not follow “a fund’s stated valuation procedures.”22 additionally, the sec relies on rule 22c-1(a), which is promulgated pursuant to section 22(c) of the act, to institute administrative proceedings against funds which inaccurately reflect the funds’ current net asset value.23 for example, in in the matter of jon d. hammes, the sec identified misvaluation techniques and charged the board with five types of misconduct: (1) failure to monitor the liquidity of the securities; (2) passive reliance on valuation committee valuations; (3) failure to review financial statements; (4) failure to follow up on the requests for information; and (5) improper application of “a generic haircut to securities in lieu of conducting a fair value estimation.”24 as a result, the sec found a violation of rule 22c-1(a) of the investment company act and issued an order to cease and desist.25 the problem of misvaluation is exacerbated by the fact that private funds are generally not required to register under the investment company act because they operate in accordance with one of the exemptions – sections 3(c)(1), 3(c)(7), or 7(d).26 the sec is still able to track private funds valuation techniques through disclosures under the advisers act and under the dodd-frank amendments of registration requirements.27 under section 202(a)(11) of the advisers act, an investment adviser is “any person or firm that: (1) for compensation; (2) is engaged in the business of; (3) providing advice, making recommendations, issuing reports, or furnishing analyses on securities, either directly or through publications.”28 although the definition is broad and attempts to cover as many potential advisers as possible, all three criteria must be satisfied. the advisers act’s anti-fraud rule 206 “prohibits untrue statements of material facts to investors or prospective investors in ‘pooled investment vehicles,’ omissions to state material facts and other fraudulent, deceptive or manipulative conduct.”29 the advisers act applies to both 21 massa, supra note 8, at 17-18 (citing 15 u.s.c.§ 80a-33(b) (2012)). 22 id. 23 see id. at 24. 24 id. at 25. 25 see hammes, administrative proceeding file no. 3-11351, order instituting cease-and desist proceedings, making findings, and imposing a cease-and-desist order pursuant to section 8a of the securities act of 1933 and section 9(f) of the investment company act (2003), https://www.sec.gov/litigation/admin/33-8346.htm [https://perma.cc/lnv3-lc8l] (last visited nov. 24, 2018) (finding that “heartland advisors, the investment adviser of the funds and the principal underwriter of heartland group’s securities, violated rule 22c-1(a) by selling, redeeming and repurchasing fund shares at navs calculated using bond prices that were not based on the bonds’ fair value as determined in good faith, as discussed above, which resulted in incorrect navs for the funds”). 26 see nora jordan, private fund overview, davis polk & wardwell 1, 4, 9 (nov. 17, 2015) (unpublished presentation). 27 see id. 28 who is an investment adviser?, https://www.sec.gov/divisions/investment/iaregulation/memoia.htm [https://perma.cc/b4sg-z99w] (last visited nov. 16, 2018) (the definition is broadly interpreted). 29 jordan, supra note 26, at 13; see anti-fraud provisions, https://www.sec.gov/divisions/investment/iaregulation/memoia.htm [] (last visited nov. 16, 2018) (citing s.e.c. v. 234 [vol. 10:2 columbia journal of tax law registered and unregistered advisers.30 importantly, there is no scienter requirement, but also no private right of action; only the sec can enforce this act.31 the dodd-frank act eliminated the section 203(b)(3) “private investment adviser” exemption, which used to permit the investment advisers to avoid registration if they “(i) had fewer than 15 clients during the preceding 12 months and (ii) did not hold themselves out to the public as investment advisers.” 32 there are still many exempted advisers, which include venture capital fund advisers, some private fund advisers (assets under management must be less than $150 million), foreign private advisers, cftc registered advisers that advise private funds, and family offices. 33 furthermore, all registered advisers are required to make disclosures about private funds: (i) “substantial reporting requirements” which generally include “census data, investment strategy, gross asset value, approximate number of beneficial owners”; (ii) “reporting of private fund service providers,” such as “auditors, prime brokers, custodians, administrators and marketers”; and (iii) “fair value reporting of private fund assets (including illiquid securities).”34 thus, the advisers act provides at minimum disclosure requirements of valuation techniques to deter the misvaluation of hard-to-value securities. finally, the investors can bring private actions by relying on anti-fraud provisions of the securities act of 1933 and the securities exchange act of 1934. the investors may allege that “an adviser’s inaccurate portfolio valuations may become material misstatements of fact.” 35 in virginia bankshares, inc. v. sandberg, for example, the supreme court of the united states “acknowledged that opinion statements can be misleading.”36 the decision, however, resulted in a narrow interpretation of the “misleading opinion” term because subsequent decisions by the second and seventh circuits distinguished “pure opinions from quantifiable and verifiable facts” concerning valuations.37 thus, the current regime is not advantageous for the investors’ private actions. c. current instances of misvalued funds despite the federal laws and judicial precedent, misvaluation of funds remains a significant problem especially in funds that are not subject to the investment act. misvaluation of funds is especially a big problem where general partners, for example, in hedge funds and pension funds, in order to keep up with increased pension liability, politically appointed boards and state or municipal officials seek increased yields in more risky and non-readily marketable securities. capital gains research bureau, inc., 375 u.s. 180 (1963) (holding that “under section 206, advisers have an affirmative obligation of utmost good faith and full and fair disclosure of all material facts to their clients, as well as a duty to avoid misleading them”)). 30 see jordan, supra note 26, at 13. 31 see id. 32 id. at 16. 33 see id. at 18. 34 id. at 34. 35 massa, supra note 8, at 41. 36 id. at 42-43 (citing virginia bankshares, inc. v. sandberg, 501 u.s. 1083 (1991)). 37 id. at n.293-96 (citing fait v. regions fin. corp., 655 f.3d 105 (2d cir. 2011); fulton cty. emps. ret. sys. v. mgic inv., 675 f.3d 1047 (7th cir. 2012); in re barclays bank plc sec. litig., no. 09 civ. 1989 (pac), 2011 wl 31548 (s.d.n.y. jan 5, 2011)). 2019] 235 the partnership audit rules of 2015: the implications for misvalued private funds and new partners one of the news-making examples involved a portfolio manager at a new york hedge fund, stefan lumiere, who was found guilty in 2017 of inflating bond prices in visium asset management’s (“visium”) credit fund and hid those losses from investors.38 his sentence included a $1 million fine as well as three years of supervised release.39 this case of misvaluation was considered as “one of the most notable” in the recent years because visium hedge fund attracted billions in assets, including from public pensions and endowments, and at its peak, it managed $8 billion.40 the misvaluation case did not only result in an enormous fine, but also in distancing of the wall street players.41 another recent misvaluation case involved daniel thibeault, who falsely reported fake loans as assets of gl beyond income fund, and gemini fund services (the manager), who continued to calculate net asset value on all of loans until gl beyond income fund was finally dissolved.42 the sec imposed $561,000 fine against gemini fund services and stated that “fund managers must verify that all of the fund’s assets actually exist by comparing the records of the fund’s holding to the records of other services providers.”43 the sec also advised that “[i]f the books don’t match, don’t strike another nav [net asset value] until the discrepancy is fixed.”44 this case did not result in as big fine as the visium’s case did; nevertheless, the sec expressed its expectations of high scrutiny of valuation techniques and bookkeeping by fund managers. finally, in a recent new york times article, donald trump’s father allegedly hid dozens of millions of tax dollars through misvaluation of real estate assets held under various organizational forms.45 despite these instances of misvaluation of real estate assets to hide millions of tax dollars, no internal revenue service (“irs”) action has followed. although investors in these vehicles did not suffer from the problems of investment private fund misvaluation, the motives in real estate assets misvaluation are similarly perverse because of tax evasion, and tax consequences of either private funds or real estate funds are significant for both private investors and general public. thus, misvaluation has been a recurring problem despite various federal laws and judicial precedent. in addition, it has been a problem for tax purposes since some investment vehicles may use questionable valuation techniques to evade taxes. as a result, misvaluation can harm investors 38 see united states v. lumiere, 249 f. supp. 3d 748 (s.d.n.y. 2017). 39 see a one-time portfolio manager at a top new york hedge fund has been sentenced to 18 months in prison, business insider, https://www.businessinsider.com/visiums-stefan-lumiere-sentenced-2017-5 [https://perma.cc/tjl2-3bkw], june 14, 2017. 40 id. 41 see id. 42 see gemini fund services llc, admin. proc. file no. 3-18348 (“on january 22, 2018, the commission simultaneously instituted and settled a cease and desist proceeding (the ‘order’) against gemini fund services, llc (‘gemini’)…. the trustees of the gl fund have agreed to make payments to those victim investors, provide a written report and evidence of such payments to commission staff, and return any undistributed funds to the commission.”). 43 see sec to fund admins: no proof, no nav, finops report, https://finops.co/investors/sec-to-fundadmins-no-proof-no-nav [https://perma.cc/4abw-s6ce], jan. 31, 2018. 44 id. 45 david barstow et al., trump engaged in suspect tax schemes as he reaped richies from his father, n. y. times, oct. 2, 2018 (“critical to the complex transaction was the value put on the real estate. the lower its value, the lower the gift taxes. the trumps dodged hundreds of millions in gift taxes by submitting tax returns that grossly undervalued the properties, claiming they were worth just $41.4 million. the same set of buildings would be sold off over the next decade for more than 16 times that amount.”). https://www.businessinsider.com/visiums-stefan-lumiere-sentenced-2017-5 https://finops.co/investors/sec-to-fund-admins-no-proof-no-nav https://finops.co/investors/sec-to-fund-admins-no-proof-no-nav 236 [vol. 10:2 columbia journal of tax law whose return on their investment is decreased as well as it can harm the revenue, where undervalued funds, sometimes intentionally and sometimes through clerical errors, result in collection of smaller amounts of tax. today, the code amendment in relation to the partnership audit rules may become a useful tool to discourage misvaluation occurrences, at least undervaluation. since vast majority of funds select to be taxed as a partnership, it is especially important for private funds to understand these new rules. the partnership audit rules take an entity approach46 to audit partnerships rather than individual partners, so any tax adjustment which results from past taxable years will become the responsibility of the partnership as a whole at the current taxable year. since misvaluation of funds can be one of the reasons for tax adjustments made by the irs upon the audit of specific partnership, there may be severe consequences for a partnership, former partners, current partners, and new partners. iii. overview of the partnership audit rules this section overviews newly enacted partnership audit rules and discusses private funds and misvalued assets unresolved issues, which are inherent in these rules due to a lack of finalized regulations. a. the partnership audit rules in a nutshell the partnership audit rules have been enacted as a part of the bipartisan budget act (“bba”) on november 2, 2015.47 the bba repealed previous partnership audit system – the tax equity and fiscal responsibility act of 1982 (tefra) and the electing large partnership rules enacted in 1997.48 the tefra took a mixed approach to partnership taxation because it used an entity approach “in the examination of partnerships” and an aggregate approach for collection purposes, where adjustments were made on an individual partner’s level.49 due to complicated rules under the tefra and rapid growth of number of partnerships, there was a need for an amendment of the code.50 the partnership audit rules shift significantly toward the entity theory of partnerships: “any underpayment of tax resulting from a partnership-level examination will be paid by the partnership itself,” and “the partnership’s liability will be assessed for the tax year in which the examination concludes, and not the partnership’s tax year that was examined.”51 the effectiveness and efficiency of new rules are supposed to be achieved by “(1) allowing the irs to collect from 46 see generally rachel l. partain, the new partnership audit regime: what we know, what we do not and what is next, 33 rej issue no. 04 (2017) (there are two theories how to tax partnership’s income: an aggregation theory, where each partner is taxed individually, and an entity theory, where the partnership as an overall organization is taxed. the partnership audit rules change a previously used mixed aggregate and entity taxation of the underpayment to almost pure entity taxation.). 47 see id. 48 see id. 49 id. 50 see id. (“from 2002 to 2011, the number of large partnerships in the united states almost tripled, bringing the total number to over 10,000 distinct large partnerships. of those partnerships, nearly two-thirds had more than 1,000 direct or indirect partners. the adjusting and collecting from partners in this environment was too great a burden for the irs.”). 51 id. (citing u.s.c. § 6221(a); u.s.c. § 6225(b)(1)). 2019] 237 the partnership audit rules of 2015: the implications for misvalued private funds and new partners the partnership any partnership tax adjustment; and (2) requiring the appointment of a partnership representative to act as the point-person and binding decision maker with respect to any irs audit procedures and related matters.”52 the partnership audit rules, section 6221(a) provides: “any adjustment to items of income, gain, loss, deduction, or credit of a partnership for a partnership taxable year (and any partner’s distributive share thereof) shall be determined, and any tax attributed at the partnership level.”(emphasis added).53 additionally, under section 6225, an imputed underpayment should be calculated “by netting all adjustments made in the partnership examination and taking the net adjustment at the highest applicable tax rate,” that is currently 39.6%, under section 1 or section 11.54 some authors commented on this tax rate as tending “to punish the current partners for the tax sins of the prior partners.”55 there is, however, a way to opt out of the new entity treatment. for example, under section 6221(b), eligible partnerships may elect to be out of the centralized partnership audit regime.56 partnerships must meet two conditions in order to be eligible to opt out of the centralized regime: (1) “a partnership must have 100 or fewer partners,” and (2) “a partnership must only have eligible partners,” which are “individuals, c corporations, foreign entities that would be treated as c corporations if they were domestic, s corporations, and estates of deceased partners.” 57 a partnership cannot elect to be out of the new partnership audit rules if any of its partners include another partnership, a disregarded entity, a trust, an estate of an individual other than a deceased partner, or “if an interest in the partnership is held by a person acting as a nominee on behalf of the ultimate beneficial owner.”58 if a partnership had successfully elected out, the irs would collect the resulting imputed underpayment at the partner level.59 additionally, the partners can make a “push-out” election under section 6226, where “[w]ithin 45 days of receiving a notice of final partnership adjustment, a partnership may make an election to subsequently issue its partners schedules k-1 to account for their share of the adjustments”; thus, election allows partners instead of the partnership “to pay any additional tax liability” resulting from the audit.60 as a result, a partnership that made a valid “push-out” election, will be free from imputed underpayment liability.61 there is, however, a two per cent higher rate of underpayment interest for the partners who make a “push-out” election.62 52 are you ready for the new partnership audit regime?, katten muchin rosenman llp (july 12, 2018), https://katten.com/are-you-ready-for-the-new-partnership-audit-regime [https://perma.cc/qgg5-zxhd]. 53 reg-136118016, 2017-28 i.r.b. 9, https://www.irs.gov/irb/2017-28_irb [https://perma.cc/5mnsbdpv] (last visited nov. 20, 2018). 54 partain, supra note 46 (citing 26 u.s.c. § 6225). 55 terence floyd cuff & jerald david august, 75-14 n.y.u. ann. inst. on fed. tax’n § 14.07 (2018). 56 see 2017-28 i.r.b., supra note 53. 57 id. 58 mary conway et al., expert q&a on the new partnership tax audit rules, davis polk & wardwell llp, 1, 3 (june 06, 2018). 59 see id. 60 partain, supra note 46 (citing 26 u.s.c. § 6226(a)). 61 see conway, supra note 58, at 3. 62 see partain, supra note 46 (citing 26 u.s.c. §6226(c)(2)). https://katten.com/are-you-ready-for-the-new-partnership-audit-regime 238 [vol. 10:2 columbia journal of tax law if the partnership is subject to the partnership audit rules and cannot opt out or “push out,” then it is required to designate “a partner or other person with a substantial presence in the united states as the partnership representative.”63 this person will have “the sole authority to act on behalf of the partnership.”64 the irs may also choose a partnership representative if the partnership failed to comply with the selection rules.65 it is very important for partnerships to implement the new regime in accordance with the rules. to prepare for a new regime, many authors advise review of the partnership agreements and amend them in order to comply with the new partnership audit rules.66 these changes may include: whom to appoint as the partnership representative and procedures for his, her or its replacement; indemnification provisions for the partnership representative; contractual limitations of power on the partnership representative and/or notice requirements to partners with respect to all irs (and where applicable, state income tax) communications; if it is eligible, whether the partnership should make elections to opt-out of the new regime or to push-out the assessed tax liability to the partners; how to allocate any tax liability that is imposed on the partnership; and the ability of the partnership to obtain, upon request, certain information from its partners necessary for the partnership to modify its tax liability.67 it should be noted that the partnership audit rules would require funds to take many changes into consideration in order to avoid over-taxation and investors’ dissatisfaction with their investment decisions. b. unresolved issues: negative consequences for new partners the partnership audit rules went into effect on january 1, 2018, and some treasury regulations have been issued in relation to these new rules.68 nevertheless, many unresolved issues still exist and pose complicated questions for partnerships. one of the problems which the new rules pose is the risk which new partners bear when they acquire an interest in an existing partnership. under section 6225, “adjustments for reviewed years are taken into account in the adjustment year.”69 new partners will be required to perform an increased due diligence and to consider negotiating inclusion of indemnity clauses in the partnership interest purchase agreements 70 until the treasury issues specific regulations which deal with new partners’ 63 2017-28 i.r.b., supra note 53 (citing 26 u.s.c. § 6223(a)). 64 id. 65 are your ready for the new partnership audit regime?, supra note 52. 66 see id. 67 id. 68 see, e.g., partnership representative under the centralized partnership audit regime and election to apply the centralized partnership audit regime, 26 cfr part 301, https://www.federalregister.gov/documents/2018/08/09/2018-17002/partnership-representative-under-thecentralized-partnership-audit-regime-and-election-to-apply-the [https://perma.cc/8wu3-fyuk] (last visited nov. 20, 2018). 69 partain, supra note 46 (citing 26 u.s.c § 6226(d)). 70 see id. 2019] 239 the partnership audit rules of 2015: the implications for misvalued private funds and new partners treatment. the fact that the adjustments would have an effect on current partners rather than the reviewed-year partners, including former partners, is one of the most controversial aspects of the partnership audit rules.71 the new york state bar association (“nysba”) tax section addressed some questions related to former partners in its “report on the partnership audit rules of the bipartisan budget act of 2015” (“nysba report”).72 the nysba report, however, does not deal directly with the question of how new partners should seek indemnity from former partners in the continuing partnership. rather this report provides information on how to interpret section 6241(7), that addresses partnerships that ceased to exist or deemed to cease to exist due to insufficient assets. these interpretations are still helpful in understanding how to identify former partners in situations where new partners buy interests in partnership and are audited by the irs and required to include the underpayment from the past taxable years in current taxable year. under section 6241(7), “if a partnership (i) ‘ceases to exist’ before a partnership adjustment under this subchapter takes effect, then (ii) such ‘adjustment shall be taken into account’ by (iii) the ‘former partners’ of such partnership ‘under regulations prescribed by the secretary.”73 the relevant term from this provision is “former partners.” the nysba suggests that it could refer to “(a) reviewed year partners, (b) the persons that were partners in the entity just before the partnership ceased to exist, or (c) any and all partners.”74 the nysba rules out options (b) and (c) and defends the position that “former partners” should mean “reviewed year partners and that the adjustment should be allocated among them in accordance with the partnership agreement for the reviewed year.” 75 the nysba provides its reasons for this conclusion: (1) “the imputed underpayment regime is a collection mechanism”; (2) this conclusion “prevents moving the liability or benefit from the reviewed year partners to other partners, and avoids the double taxation risk”; (3) “as a fairness matter, there is no reason to impose a direct tax liability on a partner for income that was allocated to another person”; (4) “asking dissolution year partners to bear the liability for taxes on income allocable to other partners would negate the limited liability on which partners rely when they invest in most modern partnerships.”76 there is, however, one serious consideration which goes against the nysba’s conclusion and is especially relevant for the current discussion since it relates to possible actions by current partners who did not obtain indemnity against the former year partners. the nysba concedes the weakness of their argument by stating: interpreting section 6241(7) in this way may encourage the partners in a partnership that is under audit and anticipating a material adjustment to cause that partnership to “cease to exist” to avoid having to bear section 6225 tax (particularly 71 cuff & august, supra note 55. 72 new york state bar association, tax section, report on the partnership audit rules of the bipartisan budget act of 2015 (no. 1347) (may 25, 2016). 73 id. at 92. 74 id. at 93. 75 id. at 94. 76 id. 240 [vol. 10:2 columbia journal of tax law if the partnership or the current partners do not have indemnity rights against the re reviewed year partners).77 although the nysba acknowledges the weakness of the argument, it still insists that it is very unlikely to become a common problem.78 it provides with three reasons for this suggestion: (1) the partnership would decide to “cease to exist” only in most extreme circumstances; (2) partnerships already have an ability to push out the liability to reviewed year partners under section 6226; and (3) the regulation may include examples of abusive situations, which would be precluded.79 as to the last reason, the reference to upcoming regulations, there having already been two sets of proposed regulations80 and some final regulations,81 but no final regulations which are relevant to “former partners” term. the proposed regulations of 2018 define “former partners” as “the adjustment year partners (as defined in § 301.6241-1(a)(2)) of a partnership that ceases to exist for the partnership taxable year to which the partnership adjustment relates.”82 section 391.6241-1(a)(2) defines “adjustment year partner as “any person who held an interest in a partnership at any time during the adjustment year.”83 it appears from the proposed regulations of 2018 that the treasury agreed with the nysba’s definition of “former partner” term. this, however, does not resolve the problem of new partners not having indemnity against former partners and not being able to locate former partners. also, it is unclear when and whether these proposed regulations will be finalized. thus, the partnership audit rules attempt to improve the administrability of partnership taxation, which has become a complicated enterprise due to exponentially increased number of partnerships and partners within them. these rules, however, are begging for further interpretations by the treasury. the disincentives to purchase an interest by a new partner is one of the possible negative consequence of the new rules, which do not address directly the funds’ joining and leaving partners. since the investment funds’ misvaluations are still happening, there is even higher possibility of over-taxation due to former partners’ underpayments of taxes passed on new partners. the overall effect of new partnership audit rules may be a decrease in private funds marketability because uncertain rules and the possibility of over-taxation are strong deterrents for new investors. there is, however, a possible incidental positive effect of these under-interpreted rules on valuation techniques improvement and consequent decrease in administrative proceedings under the investment company act because in order to attract new investors, funds may consider improving its valuation techniques and by this, assuring new investors that they would not be overcharged in taxes for former partners’ tax underpayments. 77 id. at 95. 78 see id. 79 see id. 80 see generally centralized partnership audit regime, 26 cfr parts 1 and 301 (published on aug. 17, 2018). 81 see generally partnership representative under the centralized partnership audit regime and election to apply the centralized partnership audit regime, 26 cfr part 301 (published on aug. 9, 2018). 82 centralized partnership audit regime, supra note 80, at 227. 83 id. at 220. 2019] 241 the partnership audit rules of 2015: the implications for misvalued private funds and new partners iv. the implications of the partnership audit rules for misvalued private funds and new partners although the instances of misvaluation which frequently result from conflicts of interests between general and limited partners in funds, investing in funds, especially private funds, is still a lucrative and therefore appealing enterprise. for this reason, it is necessary to evaluate how investors can continue taking advantage of investment opportunities and at the same time protect themselves from negative consequences of new partnership audit rules. this section addresses how the partnership audit rules may affect the investors’ incentives to continue investing in private funds and overall private funds marketability, taking into account past instances of misvaluation effects on new partners, various options which may be available for new investors in order to protect themselves from over-taxation under the new audit rules, and possible positive effects on valuation technique improvements within private funds. a. private funds’ marketability under the partnership audit rules the partnership audit rules apply to all partnerships and entities which elect to be taxed as partnerships.84 many private funds are structured as partnerships because this structure provides funds with an opportunity “to pool money from investors in a manner that preserves, to the extent practicable, tax neutrality for those investors when compared to investing directly in capital markets.”85 the investors are both tax-exempt and taxable institutional investors, which seek “the professional risk management, portfolio diversification, and other benefits provided by managers of private investment funds.”86 unlike operating partnerships, in investment fund partnerships, there is only one level of tax that is imposed on the investor, solely in respect with that investor’s investment.87 it is important to note that in private funds, the investors’ base changes all the time, where new investors come into the fund, while the earlier investors leave. 88 the taxation of the partnership as an entity creates serious negative implications for funds’ marketability since “investors would face the potential to indirectly bear tax obligations from a period prior to their investment in the fund.” 89 application of the new partnership audit rules may result in disincentive to invest into private funds because these rules create a disadvantage private funds’ investors “compared to investors in other asset management structures.”90 this would affect the entire market of private funds and might result in a decrease of new investors’ interest in investing 84 see monica gianni, new rules for audits of partnership returns, 6 tax dev. j. 50, 52 (2016). 85 donald b. susswein & miriam l. fisher, new partnership audit rules: what you need to know and do now, ali cle, sy004 ali-aba 189 (2016); see also goldstein v. s.e.c., supra note 6, at 876 (noting that “domestic hedge funds are usually structured as limited partnerships to achieve maximum separation of ownership and management”). 86 susswein & fisher, supra note 85. 87 see id. 88 see id. 89 id. 90 id. 242 [vol. 10:2 columbia journal of tax law into private funds. new investors might prefer investing into other asset management structures since partnership fund structures no longer provide with a pass-through tax benefit.91 additionally, most institutional investors owe a fiduciary duty to their investors and therefore may be precluded from investing into private funds, where high risk of over-taxation exists.92 a risk of losing the partner’s total investment might be considered too great because it is based on another partner’s failure to fully pay taxes, so the fiduciary duty would likely preclude investments in the funds which are taxed under the new partnership audit rules.93 decrease of institutional investors’ interest in investing into private funds can lead to dramatic drop in private funds’ marketability since institutional investors constitute “the largest force behind supply and demand in securities market” and therefore comprise the biggest investors at the market.94 furthermore, because many new partners would not want to be covered by the new partnership audit rules, they may start investing solely into eligible for an opt-out option private funds which consist of one hundred or less partners and comply with other requirements for electing out.95 as a result, marketability of private funds with more than one hundred people would decrease because new partners would not want to be audited under the partnership audit rules and to bear risk of over-taxation. finally, as noted in section ii, 96 despite the federal securities laws, the instances of misvaluation of private funds are still frequent in the market. this creates significant concerns for new investors into private funds. the tax on partnership’s misvalued funds would likely eventually be reassessed, and new investors would feel disincentivized taking a high risk of possible overpayment due to past valuation errors. additionally, the imputed underpayment is taxed at the highest rate, so new investors not only possibly bear the tax consequences of former partners due to misvaluation but bear these consequences at the highest possible rate.97 consequently, new partners would likely stay away from private funds which are ineligible to opt out and which have had any occurrences of misvaluation, whether due to clerical errors or malign intentions. in order to prevent negative consequences for new investors into private funds, some authors suggest that “it’s critical for treasury and the service to implement sections 6225 and 6226 in a way that imposes post-audit tax liabilities as closely as possible to partners’ tax liabilities outside of the audit context.”98 they add that “investment activity is likely to be distorted” if the new partnership audit rules “impose additional tax liabilities on investors that they do not rightfully owe to the government, impose double taxation, or shift tax liabilities from investors to other investors.”99 one of the possible distortions may include investors’ new expectation that 91 pass-through or flow-through benefit is generally achieved by the entity through electing into being taxed as a partnership. after such an election, tax will be paid by individuals after the partnership furnishes k-1 form to its partners. the partnership audit rules approach takes away part of this benefit by taxing a partnership as an entity for the previous years’ underpayments. 92 see susswein & fisher, supra note 85. 93 see id. 94 institutional investor, https://www.investopedia.com/terms/i/institutionalinvestor.asp [https://perma.cc/zn6t-yxxf] (last visited nov. 24, 2018). 95 see 26 u.s.c § 6221(b). 96 for funds and misevaluation issue, see section ii. 97 see 26 u.s.c. § 6225(b)(1)(a). 98 susswein & fisher, supra note 85. 99 id. 2019] 243 the partnership audit rules of 2015: the implications for misvalued private funds and new partners managers will provide separate account structures instead of pooled funds.100 this, however, will eliminate many purposes, including efficiency, which pooled vehicles provided before the new partnership audit rules.101 another possible distortion is investors’ new choice “to invest through passive foreign investment company structures.”102 this will permit investors “to avoid investment funds structured as entities treated as partnerships” and therefore to avoid potential over-taxation under the partnership audit rules. 103 furthermore, the partnerships would likely attempt to become eligible for an opt-out option under section 6221(b).104 this would result in another distortion because the partnerships will have to consist of one hundred or less partners and satisfy another requirement of who may be a partner to an eligible opt-out partnership.105 all these actions motivated solely by new tax regime will result in economic inefficiencies. despite the above comments, the treasury has not addressed the issues of private funds in its partnership audit rules final regulations106 or proposed regulations.107 there are rules which provide for former partners’ liability under the rule where a partnership ceases to exist, but there are no guarantees that new partners would not bear the consequences of over-taxation since some of former partners might not be located or might be illiquid. thus, there is an uncertainty about whether the partnership audit rules would provide new partners with protection against overtaxation resulting from former partners’ underpayment. the concern is especially relevant for investment private funds, where the assets are valued by using various, sometimes questionable, techniques, which may lead to misvaluation. new partners are generally aware of possibilities of misvaluation, and they would likely become more cautious after the new partnership audit rules have gone into effect because they bear higher risk to become responsible for former partners’ underpayment of taxes of previously misvalued assets. b. protections for new investors in private funds new investors have various options on how to protect themselves from over-taxation under the new partnership audit rules and to continue taking advantage of the pooled vehicles for investments, such as private funds. these options, however, generally impose additional transactional costs on new investors, which is another negative consequence of the partnership audit rules for new partners. first, the safest option for new partners, especially if it is a purchasing partner, is to negotiate with the partnership to restructure the partnership, so it could comply with the requirements to opt out. as described in a previous section,108 to opt out, the partnership should not have more than one hundred partners, and each of the partners must be an individual, a c 100 see id. 101 see id. 102 id. 103 id. 104 see 26 u.s.c § 6221(b). 105 see id. 106 see partnership representative under the centralized partnership audit regime and election to apply the centralized partnership audit regime, supra note 80. 107 see id. at 220. 108 for an overview of partnership audits rules, see section iii. 244 [vol. 10:2 columbia journal of tax law corporation, an s-corporation, or an estate of a deceased partner.109 this may be an easy decision for many hedge funds, which have less than one hundred investors and whose members are within the above list of qualified investors for the opt-out option. it is, however, a much more complicated route to take for bigger private funds which can have up to two thousand investors.110 additionally, where “the partnership agreement satisfies the conditions for opting out of the bba rules, the partnership agreement may contain provisions prohibiting the partners from taking actions that could jeopardize that status.” 111 to protect availability of an opt-out option, a partnership agreement may include prohibitions for any partner to convert “into a partnership or disregarded entity.”112 partnership agreement may also prohibit any partner from “transferring its interest to a person that is not an eligible partner or in a manner that causes the partnership to violate the 100partner rule.”113 in general, opting out should always be the first choice to make if this choice is available. second, new investors should examine a partnership interest purchase agreement to identify whether it contains indemnity provision or clawback provision. if there are none, new partners should request “an indemnity for pre-closing taxes from the seller.” 114 clawback provisions generally require “former partners who owned interests in the partnership for one or more ‘reviewed years’ be required to pay back to the partnership its pro rata share of any resulting income tax liability resulting in an imputed underpayment.”115 partnerships start implementing the bba specific indemnity clauses in response to the partnership audit rules. the indemnity clause may be drafted as follows: [t]he general partner shall reasonably determine the portion of an imputed underpayment amount attributable to each partner and/or former partner. to the extent feasible, this requirement shall be implemented through adjustments to distributions in accordance with article vi, but partners and former partners shall be obligated to indemnify and hold harmless the partnership to the extent this requirement cannot be so implemented. any portion of an imputed underpayment amount that the general partner attributes to a former partner of the partnership shall be an obligation of such former partner and any third-party transferee or assignee of such former partner. (emphasis added).116 109 see conway, supra note 58, at 3. 110 see partain, supra note 46; see also private investment fund, supra note 5. 111 conway, supra note 58, at 8. 112 id. 113 id. 114 id. at 9. 115 jerald david august & megan l. brackney, the tefra partnership audit repeal: partnership and partner impacts, vcxg0523 ali-cle 1 (2016). 116 private equity funds business structure and operations appendix d1, amended and restated agreement of limited partnership, https://advance.lexis.com/document/?pdmfid=1000516&crid=355e08e2-be49-4514-83671ab229469d36&pddocfullpath=%2fshared%2fdocument%2fanalyticalmaterials%2furn%3acontentitem%3a5tgf-7wv1-jbr1-y14m-0000000&pddocid=urn%3acontentitem%3a5tgf-7wv1-jbr1-y14m-0000000&pdcontentcomponentid=380718&pdteaserkey=sr0&pditab=allpods&ecomp=5pklk&earg=sr0&prid=9b9d5b76d47f-4b26-ab4e-a9984df22a62 (last visited 11/24/18). https://advance.lexis.com/document/?pdmfid=1000516&crid=355e08e2-be49-4514-8367-1ab229469d36&pddocfullpath=%2fshared%2fdocument%2fanalytical-materials%2furn%3acontentitem%3a5tgf-7wv1-jbr1-y14m-00000-00&pddocid=urn%3acontentitem%3a5tgf-7wv1-jbr1-y14m-00000-00&pdcontentcomponentid=380718&pdteaserkey=sr0&pditab=allpods&ecomp=5pklk&earg=sr0&prid=9b9d5b76-d47f-4b26-ab4e-a9984df22a62 https://advance.lexis.com/document/?pdmfid=1000516&crid=355e08e2-be49-4514-8367-1ab229469d36&pddocfullpath=%2fshared%2fdocument%2fanalytical-materials%2furn%3acontentitem%3a5tgf-7wv1-jbr1-y14m-00000-00&pddocid=urn%3acontentitem%3a5tgf-7wv1-jbr1-y14m-00000-00&pdcontentcomponentid=380718&pdteaserkey=sr0&pditab=allpods&ecomp=5pklk&earg=sr0&prid=9b9d5b76-d47f-4b26-ab4e-a9984df22a62 https://advance.lexis.com/document/?pdmfid=1000516&crid=355e08e2-be49-4514-8367-1ab229469d36&pddocfullpath=%2fshared%2fdocument%2fanalytical-materials%2furn%3acontentitem%3a5tgf-7wv1-jbr1-y14m-00000-00&pddocid=urn%3acontentitem%3a5tgf-7wv1-jbr1-y14m-00000-00&pdcontentcomponentid=380718&pdteaserkey=sr0&pditab=allpods&ecomp=5pklk&earg=sr0&prid=9b9d5b76-d47f-4b26-ab4e-a9984df22a62 https://advance.lexis.com/document/?pdmfid=1000516&crid=355e08e2-be49-4514-8367-1ab229469d36&pddocfullpath=%2fshared%2fdocument%2fanalytical-materials%2furn%3acontentitem%3a5tgf-7wv1-jbr1-y14m-00000-00&pddocid=urn%3acontentitem%3a5tgf-7wv1-jbr1-y14m-00000-00&pdcontentcomponentid=380718&pdteaserkey=sr0&pditab=allpods&ecomp=5pklk&earg=sr0&prid=9b9d5b76-d47f-4b26-ab4e-a9984df22a62 https://advance.lexis.com/document/?pdmfid=1000516&crid=355e08e2-be49-4514-8367-1ab229469d36&pddocfullpath=%2fshared%2fdocument%2fanalytical-materials%2furn%3acontentitem%3a5tgf-7wv1-jbr1-y14m-00000-00&pddocid=urn%3acontentitem%3a5tgf-7wv1-jbr1-y14m-00000-00&pdcontentcomponentid=380718&pdteaserkey=sr0&pditab=allpods&ecomp=5pklk&earg=sr0&prid=9b9d5b76-d47f-4b26-ab4e-a9984df22a62 https://advance.lexis.com/document/?pdmfid=1000516&crid=355e08e2-be49-4514-8367-1ab229469d36&pddocfullpath=%2fshared%2fdocument%2fanalytical-materials%2furn%3acontentitem%3a5tgf-7wv1-jbr1-y14m-00000-00&pddocid=urn%3acontentitem%3a5tgf-7wv1-jbr1-y14m-00000-00&pdcontentcomponentid=380718&pdteaserkey=sr0&pditab=allpods&ecomp=5pklk&earg=sr0&prid=9b9d5b76-d47f-4b26-ab4e-a9984df22a62 2019] 245 the partnership audit rules of 2015: the implications for misvalued private funds and new partners this clause provides new partners with an indemnification right against former partners. although new partners are provided with this legal right, it may not be the most convenient way to seek former partners’ contributions because it adds transactional costs for new partners and uncertainties about potential over-taxation in case former partners cannot be located. additionally, new partners must take into account a legal obligation which they are acquiring: where “a partner transfers all or any portion of its interest in the partnership, the transferee partner will generally be made jointly and severally liable for any taxes, interest, and penalties attributable to the transferor partner.”117 thus, despite the indemnity provisions, new partners are still exposed to risk of tax overpayments. for this reason, indemnification provision may not be the best option to use because it still exposes new partners to risk of over-taxation and additional transaction costs of including this provision and looking for former partners. third, as an alternative to the indemnity or clawback provision inclusion, the partnership agreement may include the clause requiring the partnership “to create a reserve for unpaid taxes.”118 the general partner or the manager may be in charge of setting up this reserve.119 the problem with the tax reserve or fund is that investors may become concerned if the managers use too much caution in setting up a tax reserve.120 this protective option, nevertheless, is preferable over indemnification clause because “it’s impractical for the purchaser to submit an indemnification claim to the partnership and then have the partnership chase after all the former partners.”121 the reserve, on the other hand, is a more convenient option for a new partner and for this reason, new partners frequently require the partnership “to retain a sufficient amount of cash to pay any contingent liabilities,” which may include tax underpayments.122 a reserve can be created by contributing to “a trust the amount of cash necessary to cover contingent liabilities.”123 as a result, the partners are becoming the beneficiaries of that trust and will be “entitled to receive any of the cash held by it at the end of the trust’s term.”124 creation of trust would make a general partner liable for any contingent liabilities, including tax underpayments. more importantly, a general partner would not be able to go after the former partners.125 thus, creation of the tax reserve provides with a convenient mechanism for new partners to protect themselves from tax underpayments; on the other hand, the former partners are released from liabilities, so any shortage of funds in this tax reserve would still become new partners’ responsibility. another important concern in creating a tax reserve is the way to determine the amounts to be charged from partners. one of the possible solutions is to charge audit expenses in the same 117 see conway, supra note 58, at 8. 118 august & brackney, supra note 115. 119 id. 120 id. 121 robert m. kane, partnership terminations: when does something become nothing?, ropes & gray llp (2018). 122 id. 123 id. 124 id. 125 see id. 246 [vol. 10:2 columbia journal of tax law ratio as allocations are made in the reviewed year.126 this approach represents a sensible solution since it reflects the economics of the business enterprise. nevertheless, even this allocation-ratiobased approach may lead to too much funding being allocated into the audit reserve. as a result, many investors may be discouraged from investing into the funds which try to set aside a significant amount for audit reserve. at the same time, new investors would not take a risk investing into a fund which provides too little protection. consequently, some funds, even though offering strong investment strategies, would be avoided for a fear of an audit resulting in overtaxation. fourth, new partners should consider requesting existing partners to make a “push-out” election, so they can protect themselves “against the possibility that it will bear taxes that should have been borne by prior partners.”127 where a “push out” election under section 6226 is made and implemented in a partnership agreement, there may also be an additional requirement for former partners “to keep the partnership of their current addresses.”128 this requirement seems to be easily implemented just by including the requirement in partnership agreement, so former partners would update a partnership on their current addresses. one concern here may be whether partners would agree to make a “push-out” election since it imposes an additional fee of two per cent higher rate of underpayment interest.129 finally, under the new partnership audit rules, a buyer of partnership interest should consider conducting a more rigorous due diligence, which is similar to a corporate mergers and acquisition due diligence.130 under the tefra regime, the purchasers did not have to conduct this kind of due diligence because each partner was responsible for its underpayments individually.131 because of an entity approach of the new partnership audit rules, purchasers should be much more cautious and should familiarize themselves with the partnership agreement provisions related to the partnership audit rules.132 c. positive effects of the new partnership audit rules on valuation techniques it is important to note that uncertainty existing in the new partnership audit rules potentially lead to improvements of valuation techniques and to a decrease in the number of administrative proceedings for the sec. this potential incidental positive effect may result from private funds’ decrease in marketability due to possible over-taxation of new partners instead of former partners and various transactional costs inherent in due diligence process and in negotiating partnership interest purchase agreements. because the new partnership audit rules would likely decrease marketability of at least big private funds which are ineligible for an opt-out option, especially funds with a history of misvaluation proceedings, private funds would likely attempt to improve its reputation by using more credible valuation techniques. private funds would have to find a way to assure new partners 126 see august & brackney, supra note 115. 127 see conway, supra note 58, at 9. 128 august & brackney, supra note 115. 129 see partain, supra note 46 (citing 26 u.s.c. § 6226(a)). 130 see conway, supra note 58, at 8-9. 131 see id. at 8. 132 see id. 2019] 247 the partnership audit rules of 2015: the implications for misvalued private funds and new partners investors that they would not be exposed to a risk of overpayment of taxes due to questionable techniques used in the past. new partners, in their turn, while picking funds to invest would likely conduct a more serious due diligence procedures, through which they can learn whether these funds were a part of any administrative proceedings brought by the sec and whether the funds were found to be violating the standards for more accurate valuation requirements imposed by the investment company act or anti-fraud provisions of the securities act of 1933, the exchange act of 1934, and the advisers act. as a result, private funds might pay even more serious attention to the valuation methods used. thus, the potential positive consequence of the present uncertainty under the partnership audit rules may include not only the improved valuation techniques used by private funds, but also decreasing number of administrative actions brought by the sec under the investment company act, the advisers act, the securities act, and the exchange act. v. conclusion the partnership audit rules have only been in effect since january 1, 2018, so it is still too early to evaluate the impact of these rules on private funds. nevertheless, some authors have already addressed the potential negative effects on new partners joining private funds. new partners would be discouraged from joining ineligible for an opt-out partnership because new partners would be unwilling to undertake a risk of tax overpayments for previous years. it might also become a nuisance for new partners to chase former partners to pass on a responsibility for tax adjustments. nevertheless, strict adherence to honest valuation of fund held securities is vital to the credibility of that market. plainly dishonest valuation is illegal and may also be criminal. it may also lead to over-taxation of new partners as a result of new partnership audit rules. there are many protective measures available for new partners to counter-act these negative effects. the best one is for investors to make sure that the private fund opted out of the partnership audit rules and included clauses in the partnership agreement mandating to comply with the electing out requirements. this is, however, a limited protective measure because many private funds consist of more than one hundred people. another reasonable solution would be selecting private funds which contain in their agreement a requirement for creating a reserve for unpaid taxes. this reserve would be a guarantee for new partners that they do not have to chase after former partners to obtain previous years’ tax underpayments. an indemnity clause, on the other hand, is not as effective even if included in the agreement because new partners will be required to search former partners. finally, new partners should consider conducting a more serious due diligence examination when investigating interests in a private fund and examining the agreements for various provisions, such as “push out” elections, which should protect new partners from tax overpayments, as well as records of general partners and fund managers’ activities regarding valuation of securities, offering documents, and other accounting records. overall, it is important to understand that the partnership audit rules may have serious negative consequences for private funds ineligible for an opt-out option, since new investors would likely invest in the funds which are eligible for an opt-out option in order to avoid unnecessary risk of being over-taxed. additionally, these rules require further treasury’s interpretation which should address new partners’ concerns in joining private funds. furthermore, misvalued private 248 [vol. 10:2 columbia journal of tax law funds would likely suffer the most because the misvalued assets would eventually be revalued, and tax deficiency would be reassessed against a private fund as a whole, so new partners risk even more joining a private fund with a reputation of using questionable valuation techniques. there is, however, a potential incidental positive effect on private funds’ valuation techniques. this effect may result from private funds’ competition to attract new partners by assuring them that their valuation techniques are unlikely to be questioned by the sec and the tax is unlikely to be reassessed by the irs. this may also lead to a decrease in administrative proceedings with the sec because in order to attract new investors, private funds might choose to use only credible valuation techniques. greed factor, however, may suppress any positive effects of the new partnership audit rules. thus, it is more likely that an active sec initiative to curb misvaluation of assets will be more effective than new partnership audit rules incidental positive effects. since the partnership audit rules have been in effect only one year, this topic may be further refined when more statistical evidence becomes available. the useful evidence would include changes in private fund sizes, a decrease in marketability of large funds, an increase in marketability of small funds (under one hundred investors), a decrease of marketability of funds with a misvaluation history, and a very unlikely decrease in administrative proceeding instituted by the sec in relation to misvalued funds. automobiles, tax mischaracterizations, and articles automation and the income tax jay a. soled & kathleen delaney thomas* abstract technological advancements are playing a transformative role in curtailing the need for labor. these very same forces are catapulting capital in the form of robotics, machinery, and intellectual property to the economic forefront. in virtually every sphere of human existence, labor’s decline and capital’s rise have been widely felt. in short, automation has become society’s new focal point. notwithstanding the magnitude of these changes, congress appears committed to retaining its historic pattern of taxing labor income more heavily than it taxes income derived from capital. however, as technology continues to evolve and capital gradually eclipses labor’s role in the economy, a fundamental shift in the tax system will be needed to maintain a viable revenue stream. this article explores the ways that automation has impacted the tax system in terms of efficiency, fairness, and revenue. it concludes that our twentieth-century tax system is unsustainable in the twenty-first century. it then offers proposals for how policymakers should reform the tax law to account for labor’s decline and capital’s rise. among other things, the technological era requires that all income—regardless of source—bear a similar tax burden. * jay a. soled is a professor at rutgers business school, and kathleen delaney thomas is a professor at university of north carolina school of law. the authors thank kelly mauer and seth proctor for their excellent research assistance and professors david herzig, susan c. morse, orly mazur, and the participants at the 2017 national taxation association fall meeting for their valuable feedback and insights. 2 [vol.10:1 columbia journal of tax law table of contents i. introduction ................................................................................................................. 3 ii. background .............................................................................................................. 4 a. heritage of the income tax and its favorable bias toward capital ................... 5 b. current taxation of labor and capital income under the code .......................... 7 c. tax revenue generation from labor and capital income under the code ....... 18 iii. the technological revolution and the labor-capital dynamic 20 a. technological changes that curtail or eliminate labor .................................... 20 b. consequences associated with labor income’s diminishment ......................... 25 c. tax revenue projections associated with technological transformation ........ 32 iv. tax reform in an era of rapid technological advancements .. 36 a. twenty-first-century tax reform in a changing labor market ...................... 36 b. implications associated with proposed tax reform.......................................... 42 v. conclusion ............................................................................................................... 46 2018] 3 automation and the income tax i. introduction there is a trend afoot that shows no signs of abating: technological advancements are progressing at an extraordinarily rapid pace, eliminating jobs and whole industries.1 notwithstanding the pace of these transformative changes, the income tax system has been slow to adjust, largely still rooted in taxing labor-produced income more heavily than income produced from capital.2 nevertheless, as human labor—the erstwhile driving force behind the nation’s economic growth3—wanes in importance and as capital in the form of robotics, machinery, and intellectual property emerges in its place, the tectonics of the income tax system will have to shift. while this shift will have significant economic implications that warrant careful circumspection and exploration, perhaps its greatest impact may be on how the country raises tax revenue. more specifically, because wealth generation and concentration are increasingly anchored to capital, not labor, congress must consider reforming the internal revenue code (code) in a manner that takes this dynamic into account. in broad brushstroke, as tax revenues from wages fall, taxes on business profits, investment income, and capital gains must correspondingly increase.4 this constitutes a complete reversal of past practices in which income derived from labor has historically borne the brunt of taxation; and, by contrast, income derived from capital was either exempt from tax or, alternatively, experienced much lower tax rates.5 1 see, e.g., martin ford, rise of the robots: technology and the threat of a jobless future (2015) (presenting a compelling and comprehensive case that technology is eradicating many jobs and, in some cases, has caused whole industries to vanish). see also samantha masunaga, robots could take over 38% of u.s. jobs within about 15 years, report says, l.a. times (mar. 24, 2017), https://www.latimes.com/business/la-fi-pwcrobotics-jobs-20170324-story.html [https://perma.cc/nk2f-sat7] (“more than a third of u.s. jobs could be at “high risk” of automation by the early 2030s . . . .”); john markoff, skilled work, without the worker, n.y. times (aug. 18, 2012), (“a new wave of robots, far more adept than those now commonly used by automakers and other heavy manufacturers, are replacing workers around the world in both manufacturing and distribution”); stephanie clifford, u.s. textile plants return, with floors largely empty of people, n.y. times (sept. 19, 2013), https://www.nytimes.com/2013/09/20/business/us-textile-factories-return.html?pagewanted=all&_r=0 (“and politicians’ promises that american manufacturing means an abundance of new jobs is complicated—yes, it means jobs, but on nowhere near the scale there was before, because machines have replaced humans at almost every point in the production process.”); carl benedikt frey & michael a. osborne, the future of employment: how susceptible are jobs to computerisation? (oxford martin programme on tec. and emp., 2013), https://www.oxfordmartin.ox.ac.uk/downloads/academic/the_future_of_employment.pdf[https://perma.cc/u9ree6by] (“according to our estimates, about 47 percent of total us employment is at risk [of being lost].”); james manyika et al., disruptive technologies: advances that will transform life, business, and the global economy, mckinsey global inst. (may 2013), https://www.mckinsey.com/business-functions/digital-mckinsey/ourinsights/disruptive-technologies [https://perma.cc/5m22-qkw7] (“twelve emerging technologies—including the mobile internet, autonomous vehicles, and advanced genomics—have the potential to truly reshape the world in which we live and work. leaders in both government and business must not only know what’s on the horizon but also start preparing for its impact.”). bear in mind that even over a half a century ago, technology was a perceived threat to the job market. see the automation jobless: not fired, just not hired, time (feb. 24, 1961), https://content.time.com/time/subscriber/printout/0,8816,828815,00.html [https://perma.cc/8e5k-drn6]. 2 see infra section ii. 3 see generally george langelett, human capital: a summary of the 20th century research, 28 j. educ. fin. 1 (2002). 4 see infra section iva. 5 see infra section iia. https://www.latimes.com/business/la-fi-pwc-robotics-jobs-20170324-story.html https://www.latimes.com/business/la-fi-pwc-robotics-jobs-20170324-story.html https://www.nytimes.com/2013/09/20/business/us-textile-factories-return.html?pagewanted=all&_r=0 https://www.oxfordmartin.ox.ac.uk/downloads/academic/the_future_of_employment.pdf https://www.mckinsey.com/business-functions/digital-mckinsey/our-insights/disruptive-technologies https://www.mckinsey.com/business-functions/digital-mckinsey/our-insights/disruptive-technologies 4 [vol.10:1 columbia journal of tax law there is already some evidence that technological advancements have begun to make their mark on the code. over the last two decades, as the pace of technological changes has accelerated, congress has chosen to retain relatively constant tax rates on wage income.6 indeed, even recent tax legislation passed in 2017—the most significant tax reform in decades—made only modest adjustments to individual income tax rates and no adjustments to payroll tax rates.7 in contrast, congress raised rates on investment income in 20108 and increased the maximum capital gains rate in 2013.9 while it is hard to be prescient, particularly with respect to the income tax, there is every reason to believe that this general trend will continue and that congress will no longer rely upon labor income as heavily as it once did as a revenue source. yet, for now, a significant disparity still exists between the tax treatment of labor and capital, and policy makers must do more to correct this course. this article explores how congress should reform the code to account for labor’s decline and capital’s rise, as well as the concomitant implications associated with the reform measures proposed. section ii sets forth several salient background items, including a short history of the labor-capital income dynamic; an explanation of how the code currently taxes wages, business profits, investment income, and capital gains; and a discussion of the relative revenue that each mode of taxation generates. section iii next explores how automation has transformed the economy in ways that, only a generation ago, were unimaginable and the impact that these changes have had on the tax system. section iv predicts how congress will have to reform the income tax system to better align it with technological advancements and discusses the larger economic and social implications of doing so. section v concludes. ii. background examining the impact that technological advances have had on the economy and the larger implications that such changes presage for the code requires an investigation of the past and an explication of the present. while various modes of taxation are endemic to civilized societies and extant for many millennia, income tax systems are of relatively recent vintage.10 tracing the origins of the modern income tax reveals much about why and how our tax system has evolved into one that taxes labor and capital so differently. delving into this history raises the following important questions: • why did the code come into existence and supplant prior means of tax revenue collection? • how did the code evolve into what it is today? • can the code successfully continue to raise revenue? 6 see, e.g., american taxpayer relief act of 2012, pub. l. no. 112-240, § 101 (2012) (making “permanent” the lower rates of the so-called bush tax cuts (while retaining the higher tax rate at upper-income levels)). 7 see tax cuts and jobs act of 2017, pub. l. no. 115-97, § 11001 (2017) (amending i.r.c. § 1) [hereinafter tax cuts and jobs act]. 8 see health care and education reconciliation act of 2010, pub. l. no. 111-152, § 1402 (2010) (instituting i.r.c. § 1411, which imposes a 3.8 percent medicare contribution tax on passive investment income). 9 see american taxpayer relief act of 2012, pub. l. no. 112–240, §102, 126 stat. 2313, 2318-19 (2013) (raising maximum capital gains rate from 15 percent to 20 percent). 10 see infra section ii.a. 2018] 5 automation and the income tax the next three subsections attempt to answer these questions, exploring (a) the history of the income tax, with emphasis on its treatment of income derived from labor versus that derived from capital; (b) the current tax treatment of labor-generated income versus capital-generated income; and (c) the relative revenue that labor and capital income each generate. a. heritage of the income tax and its favorable bias toward capital for millennia, dating back as far as when mesopotamia was in its vibrancy, civilized societies have implemented tax collection to fund essential governmental services such as the military, judicial systems, and garbage collection.11 there has been a host of ways that governments have levied tax burdens. for example, in ancient egypt, taxes were largely agrarian based;12 whereas during the greek and roman empires, taxes were frequently assessed on property ownership.13 shortly after the norman conquest in 1066, when feudalism came into full vogue, the socalled product tax—the predecessor of the modern-day income tax—came into existence.14 such taxes were assessed primarily based on the capitalized value of rental income derived from real estate ownership.15 at the time, this mode of tax collection made eminent sense because, under feudalism, land was essentially not saleable; that being the case, for tax-collection purposes, rents derived from such property were an accurate indicator of the property’s underlying value. this practice of taxing the capitalized rental income of real estate was periodically extended to the capitalized income of other “products,” such as business enterprises.16 as described by the renowned economist, edwin seligman, “[a] product tax is a tax upon a thing itself, irrespective of who the owner may be, or who benefits from the income.”17 in 1660, the tenures abolition act eliminated the feudal system. product taxes nevertheless left an indelible mark on the future of income tax systems worldwide. in feudalism’s absence, landowners were finally free to bequeath estates to heirs of their choosing without interference from the crown. nevertheless, great britain established a comprehensive so-called entailment system, which allowed a line of heirs to use an estate but essentially denied them 11 see, e.g., tonia sharlach, taxes in ancient mesopotamia, 48 u. pa. almanac (2002), http://www.upenn.edu/almanac/v48/n28/ancienttaxes.html [http://perma.cc/fc5b-hepb] (“since they didn’t have coined money, ancient households had to pay taxes in kind, and they paid different taxes throughout the year. poll taxes required each man to deliver a cow or sheep to the authorities. merchants transporting goods from one region to another were subject to tolls, duty fees, and other taxes.”). 12 see, e.g., aristide theodorides, the concept of law in ancient egypt, in the legacy of egypt 291-92 (j. r. harris ed., 2d ed. 1971). 13 see, e.g., taxation, in ancient greece and rome: an encyclopedia for students 437 (carroll moulton ed., 1998), https://erenow.com/ancient/ancient-greece-and-rome-an-encyclopedia-for-students-4-volumeset/437.html (“the major tax throughout roman history was the tributun, which was a tax on material wealth, including land, slaves, and goods.”). 14 stephen dowell, a history of taxation and taxes in england from the earliest times to the year 1885, at 67 (2d ed.1888). 15 edwin seligman, the income tax: a study of the history, theory, and practice of income taxation at home and abroad 41 (1914) (“the ‘capitalized value’ refers to the present value of the projected future income stream from the property.”). 16 id. at 42. 17 id. at 13. other historians believe that the products tax was essentially the equivalent of an income tax. william kennedy, english taxation, 1640–1799: an essay on policy and opinion 47–48 (1913). http://www.upenn.edu/almanac/v48/n28/ancienttaxes.html 6 [vol.10:1 columbia journal of tax law discretionary rights to sell or gift it.18 the system of entailing property created a situation in which the realization of capital appreciation of real property was virtually nonexistent. in the vast majority of cases, most, if not all, of a person’s estate consisted of entailed real property; therefore, a perception quickly emerged that capital constituted a physical object outside the scope of income. put somewhat differently, over a tenant’s lifetime, capital value might experience increases or decreases, but such fluctuations were viewed as changes in the corpus, not as unrealized income or loss.19 a british tradition thus arose of referring to a person’s worth in terms of annual income rather than making reference to the underlying property ownership itself.20 in 1799, when great britain enacted the first full-fledged income tax system, what was singularly unsurprising was that capital gains were not taxed.21 after all, for centuries, engrained in the mind-set of the general populace was the notion that income was comprised of reoccurring revenue on an annual basis; capital gains simply did not meet this definition. all other income sources, however, were taxed.22 for nearly two centuries, this tradition of taxing income but not capital gains remained a regular feature of the english income tax system—only recently revisited in 1965, when capital gains were finally made subject to income tax.23 with the passage of the sixteenth amendment, congress considered formulating an income tax system of its own. unlike england, however, there was no system of entails in the united states and thus land was regularly bought and sold, with no intrinsic reason to differentiate it from other wealth accretions. when instituting the nation’s first income tax, gains and losses associated with capital ownership were accordingly subject to taxation and treated akin to other income sources. but this tax parity did not last long. remnants of the income tax systems of great britain and other european countries—in which capital gains were either not taxed or only lightly taxed— likely became catalysts for change in the united states. soon after the nation’s income tax was instituted, secretary of the treasury andrew mellon exclaimed that high capital gains tax rates were a drag on economic growth.24 in addition, a leading corporate attorney, fredrick r. kellogg, testified several times before the senate finance committee about the need to reduce capital gains tax rates to “unlock” capital realizations.25 no doubt aware that their european counterparts already granted preferential treatment to capital gains, congressional members were receptive to 18 frederic maitland, a sketch of english legal history 139–40 (james f. colby ed.,1915); see also harvey perry, capital gains: the british point of view, 46 proc. ann. conf. on tax’n under auspices of the nat’l tax ass’n 150, 151–52 (1953); lawrence h. seltzer et al., the nature and tax treatment of capital gains and losses 26 (1951). 19 perry, supra note 18, at 152–53. 20 a bibliophile may recall that mr. darcy was worth “[a] clear ten thousand per annum.” jane austen, pride and prejudice (1813). 21 seltzer, supra note 18, at 28. 22 dowell, supra note 14, at 93–94. 23 finance act 1965, 1965, chapter 25, § 19 (eng.), http://www.legislation.gov.uk/ukpga/1965/25/pdfs/ukpga_19650025_en.pdf [https://perma.cc/j9u5-kbl8]. 24 andrew w. mellon, taxation: the people’s business 18–19, 127–38 (1st ed. 1924). 25 ajay k. mehrotra & julia c. ott, the curious beginnings of the capital gains tax preference, 84 fordham l. rev. 2517, 2525–26 (2016) (citing internal-revenue hearings before the s. comm. on finance on the proposed revenue act of 1921, 67th cong. 534–54 (1921) (statement of frederick r. kellogg)). http://www.legislation.gov.uk/ukpga/1965/25/pdfs/ukpga_19650025_en.pdf 2018] 7 automation and the income tax mellon’s and kellogg’s entreaties and passed the revenue act of 1921.26 this legislation reduced capital gains rates to a flat 12.5 percent (compared to a maximum tax rate of 58 percent applicable to ordinary income).27 ever since the revenue act of 1921 became law, except for a four-year period following the passage of the tax reform act of 1986,28 capital gains have enjoyed a significant tax rate preference relative to ordinary income. this tax rate preference constitutes a tax expenditure, which has come at a significant dollar cost to the government’s coffers.29 the unanswered question is whether, in the age of automation, the nation can continue to endure this hefty financial burden. b. current taxation of labor and capital income under the code in theory, under the code, all income should be taxed absent a compelling public policy justification for exemption: code § 61 declares that all wealth accretions “from whatever source” should be included in the tax base.30 furthermore, code § 61’s definition of income, like the haigsimons economic definition, 31 does not differentiate between and among income sources. but, for a variety of reasons, the code taxes labor income much more severely than capital income. part (1) first compares the tax burdens that befall income derived from labor versus income derived from capital. we use capital for this purpose to refer to any investment in property, regardless of form (tangible or intangible) and regardless of use (business, investment, or personal). for example, salary would constitute income derived from labor, while rents received on an investment property would constitute income derived from capital. part (2) next explores the putative reasons underpinning the incongruent tax treatment of labor versus capital. 1. tax burdens investments in capital are generally taxed more favorably than labor income. within the universe of capital investment, the tax law further distinguishes between investments taxed at ordinary income rates and those that receive even more favorable capital gains treatment. ordinary income treatment32 generally applies to both business profits and recurring investment income (e.g., interest paid on bonds); by contrast, capital gains treatment generally applies when a capital 26 revenue act of 1921, pub. l. no. 67-98, § 206(b) (1921). 27 see mehrotra & ott, supra note 25, at 2526–27; top federal income tax rates since 1913, citizens for tax justice (2011), http://www.ctj.org/pdf/regcg.pdf [http://perma.cc/ekd6-wkk5]. 28see robert mcclelland, capital gains, tax pol’y ctr. (feb. 6, 2017), https://www.taxpolicycenter.org/publications/capital-gains/full [http://perma.cc/w9dg-sm2t]. 29 see office of tax analysis, u.s. dep’t of the treasury, tax expenditures, ¶ 70, at 11 (sept. 28, 2016), https://www.treasury.gov/resource-center/tax-policy/documents/tax-expenditures-fy2018.pdf [http://perma.cc/fmx7-m6qb] (estimating that the capital gains tax rate preference reduces revenue yields by over $100 billion annually). 30 i.r.c. § 61(a). 31 the so-called “haig-simons” definition of income (named after the two economists who wrote it) provides that income equals: (1) one’s change in net worth plus (2) one’s consumption. see henry c. simons, personal income taxation 50 (1938); robert m. haig, the concept of income—economic and legal aspects, in the federal income tax 1, 7 (robert m. haig ed., 1921). see also theodore p. seto, inside zarin, 59 smu l. rev. 1761, 1795 (2006). 32 ordinary income treatment means that the income is taxed under § 1 of the code at the same marginal tax rates that apply to labor (rather than preferential capital gains rates). however, ordinary income derived from capital is still taxed more favorably than labor income because the former is not subject to payroll taxes. http://www.ctj.org/pdf/regcg.pdf https://www.taxpolicycenter.org/publications/capital-gains/full https://www.treasury.gov/resource-center/tax-policy/documents/tax-expenditures-fy2018.pdf 8 [vol.10:1 columbia journal of tax law asset (e.g., stock) is sold. in sum, there are different regimes for taxing income, which depend on whether the income is derived from (a) labor, (b) business profits, (c) investment income, or (d) capital gains. consider, in general, how the code taxes each. a. income derived from labor labor income bears the nation’s highest tax burden, which is largely attributable to the fact that it is taxed twice. first, the code imposes an income tax on labor earnings.33 more specifically, depending upon the taxpayer’s filing tax status (i.e., single, married, or head of household) and income level, labor earnings are subject to income tax rates ranging from 10 percent to 37 percent.34 second, upon the very same earned income, the code imposes employee and employer payroll taxes, which amount to an additional tax burden of roughly 15 percent.35 the employee payroll tax is levied on earnings from employment36 and consists of two components: (i) an old-age, survivors, and disability insurance tax equal to 6.2 percent of wages;37 and (ii) a hospital insurance tax equal to 1.45 percent of wages.38 the employer payroll tax contains the same two components at the same rates.39 in other words, an employee owes a combined 7.65 percent of her wages in payroll taxes, and her employer owes an additional 7.65 percent in payroll taxes on those same wages.40 in those cases where the taxpayer is instead self-employed, payroll taxes take the form of a self-employment tax with the same components41 but at rates that are double the tax rate paid by employees. in other words, the self-employed taxpayer is responsible for (i) an old-age, survivors, and disability insurance tax equal to 12.4 percent of net selfemployment income;42 and (ii) a hospital insurance tax equal to 2.9 percent of net self-employment income.43 to illustrate the tax burden that congress places on labor income,44 consider a plumber who is employed by a plumbing business and who is paid an annual salary of $100,000. assume 33 i.r.c. § 61(a). 34 i.r.c. § 1(a)–(d); see also rev. proc. 2018-18, 2018-10 i.r.b. 392 (new tax brackets for 2018). 35 i.r.c. § 3101 (payroll tax imposed on employees); i.r.c. § 3111 (payroll tax imposed on employers). 36 i.r.c. § 3121(a). 37 i.r.c. § 3101(a). 38 i.r.c. § 3101(b). 39 i.r.c. § 3111(a), (b). 40 additional hospital insurance taxes apply for employees paid more than $200,000 per year at a rate of 0.9 percent; and old age, survivors, and disability insurance taxes are not required after the first $127,200 of wages for 2017. see internal revenue serv., publication 15: (circular e), employer’s tax guide 25, 33 (2017), https://www.irs.gov/pub/irs-pdf/p15.pdf [https://perma.cc/x597-bktc]. the employer may also have to pay federal unemployment taxes on the first $7,000 of wages at a rate that varies based on the amount of state unemployment contributions made. see id. at 37. 41 i.r.c. § 1401. 42 i.r.c. § 1401(a). 43 i.r.c. § 1401(b). self-employment taxes only apply if an individual earns at least $400 during the year from self-employment. the same $127,200 ceiling applies for old age, survivors, and disability insurance taxes; and the same additional hospital insurance tax applies for net earnings over $200,000. see supra note 40, at 33; internal revenue serv., topic number 554: self-employment tax (jan. 31, 2018), https://www.irs.gov/taxtopics/tc554.html [https://perma.cc/fu7a-2bys]. 44 labor income as used in this article refers to both wages paid by employers and labor earnings from selfemployment. a self-employed taxpayer might earn both labor income and “business profits” (discussed in the next subpart). https://www.irs.gov/pub/irs-pdf/p15.pdf https://www.irs.gov/taxtopics/tc554.html 2018] 9 automation and the income tax that the employee’s effective income tax rate is 20 percent, resulting in $20,000 of income tax due on the wages. additionally, the employee’s wages would be subject to $15,300 of payroll taxes ($7,650 paid by the employer and $7,650 paid by the employee).45 the total taxes levied on the taxpayer’s labor income thus would be $35,300, or approximately 35.3 percent of income earned. had the taxpayer instead been a self-employed plumber earning $100,000 net of expenses, a similar tax fate would have befallen the plumbing income earned.46 b. income derived from business profits comparatively, business profits endure a moderate amount of tax. this lower tax burden results in part because business profits are generally taxed only once (i.e., under the income tax but not the payroll tax), applying the same progressive income tax rates as those imposed on labor income.47 moreover, because the code permits related expenses to be deducted,48 businesses are generally taxed on a net basis rather than on a gross dollar amount (as is generally the case with wages).49 as an example, consider again the employed plumber who earns $100,000 of wages. if he spends $10,000 of his own funds on tools, he will not be able to deduct that amount; he will still owe payroll taxes on all $100,000 of his wages, only able to claim personal deductions (e.g., the standard deduction) for income tax purposes.50 in contrast, consider a plumber who operates his own business through a solely owned s corporation,51 earning $100,000 in fees. this plumber will be able deduct $10,000 spent on tools as a business expense,52 resulting in net business income of $90,000. furthermore, any business profit earned by the plumber through his s corporation will be taxed at the plumber’s ordinary marginal income tax rates but generally will not be subject to payroll taxes.53 45 bear in mind that many states also levy special payroll taxes on labor income. some of these taxes are for state unemployment insurance; others are for state disability insurance. see, e.g., n.j. stat. ann. § 43:21-7 (2009). 46 two caveats are in order. first, self-employed taxpayers may deduct half of their self-employment tax liability, see i.r.c. § 164(f). second, the plumber’s income taxes may be lower because certain self-employed taxpayers will qualify for a deduction under new § 199a of the code (discussed further below), while employed taxpayers may not take advantage of this deduction. 47 i.r.c. § 1. 48 i.r.c. §§ 162, 212. 49 business expenses of employees are currently nondeductible under the code. see tax cuts and jobs act of 2017, supra note 7, § 11045 (suspending miscellaneous itemized deductions under i.r.c. § 67 until 2026). even before this recent law change, most employee business expenses could not be deducted because of the 2 percent floor on miscellaneous itemized deductions. see i.r.c. § 67. 50 see tax cuts and jobs act of 2017, supra note7, § 11045. 51 a business taxed as an s corporation is treated as a pass-through entity, meaning that the owners pay tax on the earnings of the business on their own personal tax returns and that there is no separate level of tax on the business itself. see internal revenue serv., s corporations (may 3, 2018), https://www.irs.gov/businesses/small-businesses-self-employed/s-corporations [https://perma.cc/t93w-ltbu]. 52 i.r.c. § 162. 53 however, the code requires that s corporations pay owners who perform services “reasonable compensation,” which is subject to payroll taxes. the plumber in this example would thus be required to divide the $90,000 earned by his s corporation between “salary” (subject to self-employment tax) and “profits” (not subject to self-employment tax) and would presumably allocate as much income as possible to the latter. see rev. rul. 74-44, 1974-1 c.b. 287 (reasonable compensation requirement); u.s. gov’t accountability office (gao), gao-10195, tax gap: actions needed to address noncompliance with s corporation tax rules 6 (2009). not all 10 [vol.10:1 columbia journal of tax law congress has been particularly magnanimous with respect to business expenses, generously permitting robust deductions such as accelerated depreciation54 and research and development credits.55 indeed, the 2017 tax reform bill allows businesses to deduct the entire cost of certain depreciable business property acquired through the year 2022, after which only slightly less generous bonus depreciation deductions apply.56 these deductions and credits can significantly diminish the tax burden associated with the production of business and investment profits. consider, for example, a taxpayer who owns a $1 million widget-making machine that annually generates $100,000 of gross revenue. depending upon when the widget-making machine was placed into service, the taxpayer may be entitled to deduct the entire cost of the machine in the first year or take large depreciation deductions over a fixed number of years.57 as a result of these deductions, the taxpayer may report very little or no net business income, notwithstanding the $100,000 of annual gross earnings the machine may generate, resulting in an effective tax rate as low as zero in some years. moreover, some of the dollars spent developing the widget-making machine might also generate a research and development credit,58 further offsetting whatever tax dollars would be due on the taxpayer’s net business profits. newly enacted § 199a of the code provides even more tax benefits to certain business owners—benefits that are not available to wage earners.59 section 199a allows for a deduction of up to 20 percent of the net business income of any noncorporate business, including sole proprietorships, s corporations, and partnerships.60 for example, a plumber earning $50,000 of net profit through an s corporation would be able to deduct up to $10,000,61 reducing his taxable business income to $40,000. business owners are able to avoid payroll taxes. business income earned through a sole proprietorship or partnership is generally subject to self-employment tax, although the tax applies net of business expenses. taxpayers who earn business income through a c corporation are not subject to payroll taxes on business income (other than on wages paid to employees of the corporation); however, such income is subject to income tax at both the corporate level and again at the individual level when distributed as a dividend. u.s. gov’t accountability office (gao), supra note 53, at 7 tbl.1. 54 i.r.c. § 168(a). 55 i.r.c. § 41(a). 56 i.r.c. § 168(k) (allowing for 100 percent bonus depreciation for tangible, non–real estate property until 2022). the amount of bonus depreciation reduces to 80 percent of cost in 2023 and 60 percent in 2024, and it continues to scale down by 20 percent each year until it reaches zero in 2027. tax cuts and jobs act, supra note 7, § 13201. however, when bonus depreciation is less than 100 percent, taxpayers may also be able to take advantage of generous expensing provided under § 179 of the code, which allows for an immediate deduction of up to $1 million of the cost of certain qualifying property. id. § 13101. 57 i.r.c. § 168(k). 58 i.r.c. § 41(a). 59 see i.r.c. § 199a(d)(1)(b) (excluding employees from the definition of a “qualified trade or business”). 60 tax cuts and jobs act of 2017, supra note 7, § 11011. the deduction is scheduled to sunset at the end of 2025. i.r.c. § 199a(i). 61 however, the § 199a deduction cannot exceed 20 percent of the taxpayer’s taxable income (less any net capital gain). this amount might be less than 20 percent of the taxpayer’s net business income. consider, for example, the plumber earning $50,000 of net business income. if the plumber’s taxable income were only $35,000 after taking into account his personal deductions, his § 199a deduction would be only $7,000 (20 percent of $35,000), not $10,000. see i.r.c. § 199a(a)(1). 2018] 11 automation and the income tax below certain income thresholds,62 the § 199a deduction is available to any noncorporate business owner. but above the income threshold,63 the deduction is available only to taxpayers who aren’t in a “specified service trade or business,” such as law, health, accounting, or any other business that relies primarily on “the reputation or skill” of its owner or employees.64 presumably, a self-employed plumber who is over the income threshold would not qualify for the § 199a deduction because the principal asset of his business would be his skill, whereas the income earned by a real estate investor might qualify for the deduction. in essence, by carving out specified service businesses from the application of § 199a, congress drew another line in the sand between labor and nonlabor income. those businesses owners that primarily provide services (a term crudely defined by the statute65) are not favored by the deduction, while those that derive income in other ways—real property ownership, for example—will reap its benefits.66 c. income derived from investments most investment income endures a similarly moderate amount of tax. for example, $100,000 of interest income earned on a bond portfolio would be taxed at the same rate as $100,000 of wages, but there would be no additional payroll tax levied on the bonds. in the case of so-called qualified dividends,67 investment profits enjoy an even lower tax rate of just 20 percent.68 taxpayers with investment income over a certain threshold may face an additional 3.8 percent investment income tax,69 but the total tax rate on investment income for those taxpayers will generally be far lower than that on labor income. to illustrate this difference, consider a taxpayer who earns $100,000 of additional wage income and who is in the highest marginal income tax bracket (37 percent). this taxpayer will pay income tax of $37,000—plus payroll taxes. but if that same taxpayer instead earns $100,000 in qualified dividends from a public company, she would owe at most $23,800 of tax on those dividends, a tax rate of just 23.8 percent. d. income derived from capital gains finally, compared to income from labor, business profits, or investments, capital gains 62 the taxable income thresholds are currently $157,500 for single taxpayers and $315,000 for married taxpayers filing joint returns and are annually adjusted for inflation. see i.r.c. § 199a(e)(2)(a), (b). 63 additional limitations also apply to taxpayers above the income threshold based on the amount of w-2 wages paid by the business and/or by the amount of depreciable business property held by the business. i.r.c. § 199a(b)(2)–(3). 64 i.r.c. § 199a(d)(1)–(3). 65 politics likely caused certain industries to be designated as inside or outside the scope of the specified service trade or business definition. for example, architects and engineers were in the originally proposed version of § 199a but were (mysteriously) excluded from the final version. see daniel shaviro, evaluating the new u.s. passthrough rates, 1 brit. tax rev. 49, at 60, 64 (2018). 66 id. at 51 (“the likes of real estate, oil and gas, manufacturing, and retailing are apparently ‘good’, while the likes of medicine, law, accounting, consulting, the arts, professional sports, and corporate management are apparently less good, but one cannot quite tell why.”). 67 a “qualified dividend” is one that is paid on stock in a domestic or qualified foreign company and that meets a certain minimum holding period requirement. i.r.c. § 1(h)(11)(b). 68 i.r.c. § 1(h)(11)(a). 69 see i.r.c. § 1411. 12 [vol.10:1 columbia journal of tax law often sustain the smallest tax burden. for starters, capital gains are not subject to payroll taxes and command preferential rates far lower than ordinary income tax rates.70 tax relief does not end there, however; under the code, there are a series of provisions that serve to alleviate;71 defer;72 and, in some cases, entirely eliminate73 capital gains. indeed, the whole concept of realization, a central bedrock of code § 1001, constitutes a significant departure from the conceptual purity denoted in code § 61, in which all annual wealth accretions ostensibly constitute income.74 to illustrate the favoritism that congress has historically bestowed upon capital gains, consider a taxpayer who purchased a marketable security for $10,000 that has gradually appreciated over a nine-year period to $100,000. notwithstanding the security’s annual increases in fair market value, the taxpayer does not have to bear any income tax on that appreciation. furthermore, if the taxpayer sells the security, the $90,000 of gain will be taxed—but at tax rates far lower than those that apply to labor income or business income.75 for example, a taxpayer in the highest marginal tax bracket for ordinary income (37 percent) will face a 20 percent capital gains rate under § 1 of the code, with a possible additional tax of 3.8 percent,76 for a combined rate of 23.8 percent. furthermore, if the security is acquired by or passes to another by reason of the taxpayers’ death, the $90,000 of capital gains will never be subject to income tax.77 2. rationales underpinning distinct tax treatments clearly, the categorization of income under the code has important tax consequences. but are there compelling justifications for such dissimilar treatments? dating back to when congress instituted the income tax in the early and midpart of the twentieth century, many rationales—primarily based upon administrative necessity and historical precedent from other countries—were adopted to explain how income derived from different sources was to be taxed.78 over time, however, technological advances have gradually eroded and, in some cases, obliterated these rationales, requiring that they now be revisited. below is a compendium of the historic justifications for different tax treatments under the code. a. rationale for labor income taxation when congress first instituted the income tax in 1913,79 it made no ostensible distinctions between and among the various sources of the income that taxpayers earned—plain and simple, it was all to be equivalently taxed.80 70 i.r.c. § 1(h)(1). 71 see, e.g., i.r.c. § 121. 72 see, e.g., i.r.c. § 1031. 73 i.r.c. § 1014. 74 admittedly, there are some factors that favor preferential capital gains rates, which are discussed in the next subsection. 75 i.r.c. § 1(h)(1). 76 an additional tax of 3.8 percent applies to the “net investment income” of certain high-income taxpayers; when applicable, a taxpayer’s maximum capital gains rate would be 23.8 percent. i.r.c. § 1411. 77 i.r.c. § 1014(a). 78 see supra section ii.a. 79 revenue act of 1913, pub. l. no. 63, ch. 16, 38 stat. 114, 166–81. 80 even at the inception of the income tax, congress and the treasury department, by instituting a realization requirement, laid the groundwork for the preferential tax treatment accorded to capital income. 2018] 13 automation and the income tax however, three major historical events made labor income a particularly attractive target for taxation. the first was the economic depression that struck the nation in 1929. during this time, congress sought to provide an economic safety net for those retiring from the labor force.81 consequently, it used labor income as an easily identifiable demarcation point to determine annual contributions to what became known as social security.82 second, in 1943, when world war ii was raging, the country needed a steady and more robust revenue stream. using a new wagewithholding system, congress saw labor income as a vast reservoir of wealth that could readily be tapped to underwrite its wartime-expenditure obligations.83 third, in the 1960s, president lyndon johnson launched a so-called war on poverty.84 capitalizing upon the success from taxing labor income for social security, congress introduced medicare and medicaid to provide hospital and medical insurance to the elderly and indigent.85 these historic events led to the institution of massive entitlement programs and strengthened our nation’s military might. but why did congress opt to tax labor more heavily than other income sources? a number of factors led to this outcome. one was administrative expediency. labor income is difficult to camouflage. when taxpayers perform labor in their capacity as employees, they usually incur few related expenses; as such, whatever remuneration they receive gives rise to taxable income. labor income also tends to involve the presence of third parties, in the form of employers. this is beneficial from the government’s standpoint, since third-party employers facilitate tax withholding and information reporting, both of which result in better taxpayer compliance.86 by way of contrast, the same is not always true of business profits, investment income, and capital gains. production of these latter forms of income often involves deductible expenses and basis recoveries; in addition, third-party payers have historically been absent from many of these transactions, resulting in relatively lackluster compliance.87 another factor pertains to economic theory. more specifically, a tax on labor income may cause some taxpayers to work more (this is known as the “income effect”).88 for lowand middle 81 see, e.g., h.r. 4120, 74th cong. (1935) (“to alleviate the hazards of old age, unemployment, illness, and dependency . . . .”). 82 social security act (act of august 14, 1935), ch. 531, 49 stat. 620. 83 current tax payment act of 1943, pub. l. no. 68, ch. 120, 57 stat. 126; carolyn c. jones, class tax to mass tax: the role of propaganda in the expansion of the income tax during world war ii, 37 buff. l. rev. 685 (1989). for an excellent historical overview of income tax withholding, see richard l. doernberg, the case against withholding, 61 tex. l. rev. 595, 599–604 (1982). 84 president lyndon baines johnson, first state of the union address (jan. 8, 1964), http://www.americanrhetoric.com/speeches/lbj1964stateoftheunion.htm. [https://perma.cc/nsf6-qa5r]. 85 social security amendments of 1965, pub. l. no. 89-97, 79 stat. 286. 86 see generally leandra lederman, statutory speed bumps: the roles third parties play in tax compliance, 60 stan. l. rev. 695 (2007) (stating that “structural systems that engage third parties to help facilitate compliance with the federal income tax are … highly successful”). 87 internal revenue serv., tax gap estimates for the years 2008–2010, at 2 (2016), https://www.irs.gov/pub/irs-soi/p1415.pdf [https://perma.cc/vq45-9a7q] (“misreporting of income amounts subject to substantial information reporting and withholding is 1 percent; of income amounts subject to substantial information reporting but not withholding, it is 7 percent; and of income amounts subject to little or no information reporting, such as nonfarm proprietor income, it is 63 percent.”). 88 see generally a. b. atkinson & j. e. stiglitz, lectures on public economics 27, 33–34 (1980); j. a. mirrlees, an exploration in the theory of optimum income taxation, 38 rev. econ. stud. 175 (1971). 14 [vol.10:1 columbia journal of tax law income taxpayers, their participation in the labor market is likely inelastic; they need to put the proverbial “bread on the table,” and the imposition of taxes may thus cause them to increase their work hours.89 therefore, with the exception of financially well-to-do taxpayers (who may engage in more leisure activities and less work, which is known as the “substitution effect”),90 a tax on labor income could be imposed with little or no negative effect on the labor market.91 a third factor is grounded in the notion of sufficiency. for a tax to have utility/functionality, there must be an adequate base upon which to impose a tax.92 for example, in terms of revenue generation, the institution of a universal estate tax would probably be nonsensical for one simple reason: without imposing tax rates that the general public would likely consider confiscatory, not enough taxpayers perish annually with sufficient wealth to provide a sustainable tax base.93 the same is not true of labor income. relative to other income forms, it is plentiful.94 furthermore, labor income tends to be generated in a fairly steady stream, with few opportunities to defer receipt to later tax years. a fourth factor pertains to political expediency. as the income tax system evolved in the united states, consider in whose hands power vested, namely, those who controlled the capital apparatus.95 it comes as no surprise that the powerful elite devised the nation’s income tax system in a manner that imposed a greater tax burden on others than on themselves.96 in an endeavor to make payroll taxes more politically palatable to the masses, though, congress introduced tax withholding on wages, helping to ensure compliance while simultaneously alleviating taxpayers of the difficult administrative burden of having to put aside adequate savings to meet their annual tax obligations.97 89 see martin j. mcmahon jr. & alice g. abreu, winner-take-all markets: easing the case for progressive taxation, 4 fla. tax rev. 1, 43–45 (1998) (analyzing the different substitution effects between lowand high-income taxpayers). 90 see atkinson & stiglitz, supra note 88, at 27–28. 91 see joseph bankman & thomas griffith, social welfare and the rate structure: a new look at progressive taxation, 75 cal. l. rev. 1905, 1964–65 (1987) (“looking at the whole range of econometric studies of the labor supply, the most plausible conclusion is that the elasticity of substitution between consumption and leisure lies between 0.3 and 0.8 and almost certainly is less than the elasticity of 1.0 used in the mirrlees model.”). 92 see joseph t. sneed, the criteria of federal income tax policy, 17 stan. l. rev. 567, 570 (1965) (“thus, when it is determined that a given amount of additional revenue is required, existing and possible additional taxes must be evaluated to determine their capacity to fulfill the need.”). 93 see james m. poterba, steven f. venti & david a. wise, were they prepared for retirement? financial status at advanced ages in the hrs and ahead cohorts 1 (nat’l bureau of econ. research, working paper no. 17824, 2012), http://www.nber.org/papers/w17824 [https://perma.cc/49yy-m4ec] (“we find that a substantial fraction of persons die with virtually no financial assets—46.1 percent with less than $10,000—and many of these households also have no housing wealth and rely almost entirely on social security benefits for support.”). 94 see supra notes 81-85 and accompanying text. 95 see generally charles r. morris, the tycoons: how andrew carnegie, john d. rockerfeller, jay gould, and j.p. morgan invented the american supereconomy (2005); matthew josephson, the robber barons (1932). 96 see margaret levi, the predatory theory of rule, 10 pol. & soc’y 431, 438 (1981) (arguing that “all rulers are predatory in the sense that they, as much as they can, design property rights and policies meant to maximize their own personal power and wealth”). 97 see doernberg, supra note 83, at 595 (“the irs claims that the use of withholding as a verification and collection technique is the most efficient method of obtaining the revenues necessary to provide government services.”). https://1.next.westlaw.com/link/document/fulltext?findtype=y&sernum=0112536096&pubnum=111260&originatingdoc=i0dae12da989711e08b05fdf15589d8e8&reftype=lr&fi=co_pp_sp_111260_43&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search)#co_pp_sp_111260_43 https://1.next.westlaw.com/link/document/fulltext?findtype=y&sernum=0112536096&pubnum=111260&originatingdoc=i0dae12da989711e08b05fdf15589d8e8&reftype=lr&fi=co_pp_sp_111260_43&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search)#co_pp_sp_111260_43 https://1.next.westlaw.com/link/document/fulltext?findtype=y&sernum=0101992936&pubnum=1107&originatingdoc=i0dae12da989711e08b05fdf15589d8e8&reftype=lr&fi=co_pp_sp_1107_1964&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search)#co_pp_sp_1107_1964 https://1.next.westlaw.com/link/document/fulltext?findtype=y&sernum=0101992936&pubnum=1107&originatingdoc=i0dae12da989711e08b05fdf15589d8e8&reftype=lr&fi=co_pp_sp_1107_1964&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search)#co_pp_sp_1107_1964 http://www.nber.org/papers/w17824 2018] 15 automation and the income tax a fifth, and final, factor relates to the connection that congress conveniently drew between the payment of payroll taxes and the subsequent receipt of retirement income in the form of social security. the structure of defined-benefit retirement plans provides a model for this justification. under a defined-benefit retirement plan, workers contribute a set percentage of their income to a plan; and, depending upon their “overall years/months of service,” they later become entitled to fixed dollar amounts of annual retirement benefits.98 in devising social security, the federal government, to provide financial security for the nation’s workforce, sought to replicate the defined-benefit plan structure via a mandated tax on labor income.99 in sum, administration and enforcement concerns, as well as economic efficiency, were principle rationales for taxing labor more than other sources of income in the formative years of our income tax system. additionally, the political environment at the time and congress’s desire to fund a retirement system provide further historical context for higher labor taxes. b. rationale for business profits and investment income taxation the united states has deep capitalistic roots echoed, in part, even in its constitution.100 more than a century after the nation declared its independence, when it came to devising a viable framework to raise needed revenue, capitalist tenets played a pivotal role in shaping the code.101 congress accordingly devised an income tax system designed to promote capital growth and production and prioritized private property ownership. these objectives and their accomplishment manifested themselves in several salient ways. to encourage taxpayers to acquire tools of production, the code provides many robust incentives. for example, two of the most formidable are bonus and accelerated depreciation deductions encapsulated in code §§ 168 and 179.102 the code also provides a series of incentives designed to promote private-party ownership and investment. a smattering of code section examples helps illustrate this point: to encourage real estate ownership, the code permits taxpayers to deduct their mortgage interest payments;103 to make capital investments more attractive, dividend income is accorded preferential tax treatment;104 and, finally, retirement accounts are 98 pension benefit guar. corp. v. ltv corp., 496 u.s. 633, 637 n.1 (1990) (stating that a “defined benefit plan is one that promises to pay employees, upon retirement, a fixed benefit under a formula that takes into account factors such as final salary and years of service with the employer”). 99 see, e.g., regina t. jefferson, privatization: not the answer for social security reform, 58 wash. & lee l. rev. 1287, 1303–04 (2001) (“the defined benefit plan structure is currently used by the social security program, with the government effectively guaranteeing the delivery of the promised benefits.”). 100 how capitalistic is the constitution? (robert a. goldwin & william a. schambra eds., 1982); (stating that some authors argue that capitalism is “essential for democracy as it was understood by the founders and as it was established by the constitution”); arthur selwyn miller, the supreme court and american capitalism (1968). 101 see, e.g., ajay k. mehrotra & julia c. ott, the curious beginnings of the capital gains tax preference, 84 fordham l. rev. 2517, 2521 (2016) (“[t]the theories that support the capital gains preference are the product of shifting ideas and beliefs not only about economic growth, but also about the meaning of risk, wealth, and opportunity in modern american capitalism.”); beverly i. moran, capitalism and the tax system: a search for social justice, 61 smu l. rev. 337 (2008) (describing how the “father” of capitalism, adam smith, shaped the origins of the nation’s income tax system). 102 see supra notes 56-57 and accompanying text. 103 i.r.c. § 163(h)(3). 104 i.r.c. § 1(h). https://1.next.westlaw.com/link/document/fulltext?findtype=y&sernum=1990094362&pubnum=780&originatingdoc=i1361db115acc11dbbe1cf2d29fe2afe6&reftype=rp&fi=co_pp_sp_780_637&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search)#co_pp_sp_780_637 16 [vol.10:1 columbia journal of tax law allowed to grow tax-free, sheltering vast amounts of income from taxation for years and decades to come.105 a lack of political will has also led business profits to be taxed rather moderately, particularly given that profits earned by small businesses and independent contractors have been historically difficult to monitor. traditionally, there have been no third parties to issue tax information returns, taxpayers easily concealed profits by dealing in cash, and the internal revenue service (irs) lacked the resources to adequately police compliance.106 as a result, when it comes to these sorts of trade and business enterprises, tax compliance has been abysmal.107 theoretically, congress could have invigorated enforcement efforts by augmenting irs funding and instituting other tax-compliance measures,108 but many politicians and commentators have argued that this course of action would be too intrusive.109 finally, capitalism (with its puritan religious origins 110) places an immense premium on savings in lieu of consumption.111 in light of this bias, investment income in the form of interest, 105 i.r.c. §§ 401–24. 106 see, e.g., associated press, income tax audits plummet as irs loses agents to budget cuts, fortune (mar. 5, 2017), http://fortune.com/2017/03/05/income-tax-audits-irs-agents/ [https://perma.cc/259r-u3e2] (“the number of people audited by the irs in 2016 year dropped for the sixth straight year, to just over 1 million. the last time so few people were audited was 2004. since then, the u.s. has added about 30 million people.”); gov. accountability office (gao), enforcement of tax laws remains high-risk area, 2017 tax notes today 31-26, https://www.taxnotes.com/tax-notes-today/compliance/enforcement-tax-laws-remains-high-risk-area-gaosays/2017/02/16/gdlj [https://perma.cc/ck4g-qqts] (feb. 16, 2017) (“between fiscal years 2011 and 2016, irs’s annual appropriations declined about $900 million. likewise, staffing has declined: full-time equivalent staff members funded by annual appropriations declined by 12,000 between fiscal year 2011 and fiscal year 2016, a 13 percent reduction. at the same time, irs’s enforcement performance has declined . . . . reductions in examinations can reduce revenue collected and may indirectly reduce voluntary compliance.”); bruce bartlett, slashing the irs budget— penny-wise and pound-foolish, fiscal times (jan. 17, 2014), http://www.thefiscaltimes.com/columns/2014/01/17/slashing-irs-budget-penny-wise-and-pound-foolish [https://perma.cc/2fns-yylb] (detailing how budgetary constraints restrict the irs’s ability to fulfill its taxpayercompliance mission). 107 see, e.g., stacy cowley, why the i.r.s. fails to crack the small-business tax nut, n.y. times (june 15, 2016), https://www.nytimes.com/2016/06/16/business/smallbusiness/why-the-irs-fails-to-crack-the-small-businesstax-nut.html?_r=0 (“most of that “tax gap” is income that goes unreported, and the biggest chunk of it, by far—$125 billion—is individual business income.”). 108 for example, congress has periodically made some feeble attempts to increase small-business tax compliance. see, e.g., joel slemrod et al., does credit-card information reporting improve small-business tax compliance?, 149 j. pub. econ. 1 (2017) (explaining how the form 1099-k, which provides the i.r.s. with information about electronic sales, has increased income reporting). 109 see robert e. brown & mark j. mazur, the national research program: measuring taxpayer compliance comprehensively, 51 u. kan. l. rev. 1255 (2003) (explaining how the i.r.s. instituted the so-called national research program as a successor to the taxpayer compliance measurement program in large part because the latter was deemed too intrusive and time-consuming for the average taxpayer). 110 mark valeri, heavenly merchandize: how religion shaped commerce in puritan america (2010) (exploring the interconnectedness between puritan religious doctrine and the gradual spread of capitalism in colonial america). 111 marjorie e. kornhauser, the morality of money: american attitudes toward wealth and the income tax, 70 ind. l.j. 119, 133-34 (1994) (“in america, social darwinism . . . reach[ed] its peak in 1882 and [was] endorsed by entrepreneurs such as andrew carnegie. progress resulted from the economic virtues of frugal living and industriousness—lots of saving and little leisure and consumption.”). notwithstanding the proposition that levying an income tax supposedly constitutes a disincentive to save, empirical studies have yet to substantiate this position. compare michael j. boskin, taxation, saving, and the rate of interest, 86 j. polit. econ. 15 (1978), and laurence http://fortune.com/2017/03/05/income-tax-audits-irs-agents/ https://www.nytimes.com/2016/06/16/business/smallbusiness/why-the-irs-fails-to-crack-the-small-business-tax-nut.html?_r=0 https://www.nytimes.com/2016/06/16/business/smallbusiness/why-the-irs-fails-to-crack-the-small-business-tax-nut.html?_r=0 https://1.next.westlaw.com/link/document/fulltext?findtype=y&sernum=0297604258&pubnum=0001527&originatingdoc=i5111c0ab850711e498db8b09b4f043e0&reftype=lr&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search) https://1.next.westlaw.com/link/document/fulltext?findtype=y&sernum=0297604258&pubnum=0001527&originatingdoc=i5111c0ab850711e498db8b09b4f043e0&reftype=lr&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search) 2018] 17 automation and the income tax dividends, and rents enjoys a relatively light tax burden insofar as they constitute the embodiment of savings (i.e., bank deposits, capital investment, and real estate ownership). as such, to the extent possible, the code seeks to minimize and, on occasion, even exempt such earnings from taxation.112 c. rationale for capital gains income taxation over the past century, the code has afforded preferential tax treatment to long-term capital gains relative to ordinary income.113 the historic tax rate chart found in the appendix illustrates this point. a central justification114 for the capital gains tax rate preference, which has likely played a major role in historically low capital gains rates, is the so-called lock-in effect. the lock-in effect refers to the powerful disincentive to engage in a sale or other taxable disposition of property (in other words, a realization event) because doing so triggers taxation.115 while the precise magnitude of the lock-in effect depends on many factors,116 the most prominent among them is the tax rate imposed. when that rate is low, the disincentives are still present but matter less; when that tax rate is high, the disincentive to sell is much more potent.117 an additional factor in taxing capital gains lightly or not at all pertained to administrative practicalities. in particular, the tax bases of many assets were deemed hard or impossible to know. for example, investors who held stock or securities for many years struggled to identify the tax basis that they had in their investments; poor record keeping along with dividend reinvestment s. seidman & kenneth a. lewis, the consumption tax and the saving elasticity, 52 nat’l tax j. 67 (1999), with robert e. hall, intertemporal substitution in consumption, 96 j. pol. econ. 339 (1988), and a. lans bovenberg, tax policy and national saving in the united states: a survey, 42 nat’l tax j. 123 (1989). 112 see, e.g., i.r.c. § 103 (exempting interest on state bonds from tax). 113 see supra section ii.b. 114 commentators have offered additional justifications for the capital gains preference, although it’s unclear how much those justifications have played a role in the history of capital gains rates. for example, preferential rates may compensate taxpayers for taxes on gains that are inflationary rather than true economic gains and may serve to alleviate the “double tax” on corporate profits insofar as a sale of corporate stock is concerned. but for a refutation of many of these additional justifications, see noel b. cunningham & deborah h. schenk, the case for a capital gains preference, 48 tax l. rev. 319 (1993). 115 see generally charles c. holt & john p. shelton, the lock-in effect of the capital gains tax, 15 nat’l tax j. 337 (1962). 116 for example, a taxpayer will likely be influenced by how much taxable appreciation is built into the asset. if an asset has only a negligible basis—such as a founder’s stock of a corporation—and will be taxed at a relatively high tax rate, the combined effect is daunting. a share of stock with a basis of $1 that is sold for $1,000 will produce a tax liability of $299.70 if taxed at a 30 percent rate (i.e., .3 x ($1,000 – $1)). in contrast, if the same stock was sold for $1,000 but had only appreciated by $100 (i.e., with a basis of $900), the sale would produce only $30 of tax assuming the same 30 percent rate (i.e., .3 x ($1,000 – $900)). 117 there is considerable literature on the effect of rate changes on realization rates. see, e.g., cong. budget office, how capital gains tax rates affect revenues: the historical evidence (1988), https://www.cbo.gov/sites/default/files/cbofiles/ftpdocs/84xx/doc8449/88-cbo-007.pdf [https://perma.cc/g85nmr9b]; cong. budget office, perspectives on the ownership of capital assets and the realization of capital gains (1997), https://www.cbo.gov/sites/default/files/105th-congress-1997-1998/reports/capgains.pdf [https://perma.cc/5ksu-vbj6]; george zodrow, economic analyses of capital gain taxation: realizations, revenues, efficiency and equity, 48 tax l. rev. 419 (1993); jane g. gravelle, can a capital gains tax cut pay for itself?, 48 tax notes 209 (1990); j. andrew hoerner, treasury’s capital gains estimates: mr. economist goes to washington, 44 tax notes 141 (1989). https://1.next.westlaw.com/link/document/fulltext?findtype=y&sernum=0104712549&pubnum=1247&originatingdoc=i160bf8e14b2811db99a18fc28eb0d9ae&reftype=lr&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search) https://1.next.westlaw.com/link/document/fulltext?findtype=y&sernum=0104712549&pubnum=1247&originatingdoc=i160bf8e14b2811db99a18fc28eb0d9ae&reftype=lr&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search) https://www.cbo.gov/sites/default/files/105th-congress-1997-1998/reports/capgains.pdf 18 [vol.10:1 columbia journal of tax law plans and redemptions plagued tax basis identifications and computations.118 a taxpayer’s death also clouded accurate tax basis identifications.119 the lack of third-party reporting further obfuscated accurate tax basis identifications; when it came to taxpayers reporting their gains and losses, they were essentially on the honor system, which has historically not boded well for tax compliance.120 another rationale for the preferential treatment of capital gains is historical in nature. as previously pointed out, facets of our nation’s income tax system undoubtedly originated from old english law.121 under these laws, capital gains were deemed principal, not income; this same psychology likely pervaded the mind-set of those who initially crafted the income tax and who, by providing a lower tax rate, sought to strike a compromise between those who thought that capital gains should be exempt from tax and those who thought that capital gains should be treated akin to ordinary income.122 c. tax revenue generation from labor and capital income under the code to understand the respective roles that labor and capital income play in revenue generation, it is useful first to examine the overall makeup of federal tax revenues. in recent years, the federal 118 see, e.g., joseph m. dodge & jay a. soled, debunking the basis myth under the income tax, 81 ind. l.j. 539, 542 (2006) (“that is, under the current income tax regime, (a) taxpayers often lack the acumen and requisite records and information to fulfill their tax basis reporting obligations, (b) the rules themselves are unwieldy and complicated, and (c) the irs is unable to fulfill its compliance mission insofar as basis and gain monitoring is concerned.”). 119 see, e.g., carryover basis provisions: hearing before the house comm. on ways and means, 96th cong., 1st sess. 13 (1979) at 81 (statement of american bankers association) (noting that manufacturer’s hanover trust company reported that cost basis information for marketable securities was impossible to locate in 22 percent of estates, required time and research in 44 percent, and was readily available in 34 percent); id. at 126–29 (statement of the american college of probate counsel) (offering letters from practitioners indicating the difficulty in reconstructing basis of old stock certificates, closely held stock, and stock that underwent recapitalizations or stock splits). for a detailed look at the tax bar’s critique of the carryover basis rule, see howard j. hoffman, the role of the bar in the tax legislative process, 37 tax l. rev. 411, 448–68 (1982). some of the problems in ascertaining historical basis are discussed in thomas j. mcgrath & jonathan g. blattmachr, carryover basis under the 1976 tax act 191–94, 222–28 (1977). 120 see u.s. gov’t accountability office, gao-06-603, capital gains tax gap (2006), http://www.gao.gov/new.items/d06603.pdf [https://perma.cc/cfd5-94d8] (indicating that, of all individual taxpayers who misreported securities sales, roughly two-thirds of taxpayers underreported their capital gains and one-third overreported). 121 see supra section ii.a. 122 across the globe, countries tax capital gains in a whole host of ways. see rainder niemann & caren sureth, sooner or later?—paradoxical investment effects of capital gains taxation under simultaneous investment and abandonment flexibility, 22 j. eur. acct. rev. 367, 368 (2013): other countries do not tax capital gains at all if some preconditions are met. for example, greece, latvia, poland, romania, and switzerland usually refrain from taxing capital gains on selling non-business property. according to austrian, danish, dutch, estonian, bulgarian, finnish, french, german, hungarian, spanish, and swedish tax law, gains and losses on the disposal of business property are taxable as ordinary income, whereas gains on selling non-business securities are subject to a flat capital gains tax rate. in the czech republic, great britain, lithuania, luxembourg, portugal, and slovenia, private capital gains are tax-exempt if a certain period of time is allowed to elapse between acquisition and disposal. even countries with tax systems close to theoretically ideal tax systems, such as the nordic dual income tax, have developed a variety of capital gains tax regimes. 2018] 19 automation and the income tax government has collected around $3 trillion in revenue annually from taxes, duties, and other government fees ($3.3 trillion in 2016).123 individual income taxes generally make up approximately half of the total revenue collected (47 percent for 2016), while payroll taxes comprise about one-third of total revenue (34 percent for 2016).124 the corporate income tax contributed 9 percent of total revenues for 2016, and the remaining 9 percent included estate and gift taxes; excise taxes; and other miscellaneous taxes, duties, and fees.125 individual income taxes, the largest source of federal revenue, consist of taxes on wages as well as taxes on investments, business income, and capital gains. while the above-cited data does not break down federal income tax revenues by income source, statistics are available from the irs. the agency’s studies indicate that the majority of individual income is earned from salary and wages (approximately 70 percent), as opposed to business and investments (approximately 16 percent) or capital gains (approximately 5 percent).126 the foregoing percentage outcomes signify that a substantial majority of taxable income is a product of labor. by extension, the majority of tax revenues flowing from the individual income tax are also derived from labor. when combined with payroll taxes (which are no doubt labor-centric), taxes on labor clearly represent a majority of federal tax revenue. when it comes to taxes on capital gains, the exact opposite is true. specifically, data from the treasury department indicates that tax revenues from long-term capital gains represent only a small portion of overall federal tax revenue. for example, in 2013, tax revenue from long-term capital gains was approximately $86 billion,127 which represented just 6.5 percent of total federal income taxes collected ($1.3 trillion) and just 3.1 percent of all federal revenue collected ($2.8 trillion).128 similarly, in 2014, taxes on long-term capital gains were approximately $126 billion,129 representing 9 percent of federal income taxes ($1.4 trillion) and just 4.2 percent of all federal revenue collected ($3 trillion).130 while these dollar figures and percentages are, in part, driven by the fact that most income does not derive from capital gains, preferential tax treatment applied to capital gains also plays a 123 cong. budget office, options for reducing the deficit: 2017–2026, at 119 (dec. 2016), https://www.cbo.gov/publication/52142 [https://perma.cc/6dcc-gabz]. 124 id. 125 id. 126 percentage calculations are on file with the authors and are based on data from internal revenue serv., statistics of income tax stats: individual income tax returns publication 1304 tbl.a (2014), https://www.irs.gov/statistics/soi-tax-stats-individual-income-tax-returns-publication-1304-complete-report#_tbla. [https://perma.cc/7snk-asrj]. total income from salaries and wages for 2013 was reported to be approximately $6.5 trillion, while total income from all sources was reported to be approximately $9.2 trillion. business and investment income for this purpose includes income from: (1) interest (taxable and tax-exempt); (2) dividends (qualified and ordinary); (3) business and professional activities; and (4) rents, royalties, partnerships, trusts and estates. capital gains income is comprised of net capital gains and capital gains distributions. 127 office of tax analysis, u.s. dep’t of the treasury, taxes paid on long-term capital gains, https://www.treasury.gov/resource-center/tax-policy/tax-analysis/documents/taxes-paid-on-long-term-capitalgains.pdf [https://perma.cc/v4jy-tb8j]. 128 office of mgmt. & budget, historical tables, receipts by source: 1934–2022 tbl.2.1 (june 15, 2018), https://www.whitehouse.gov/omb/budget/historicals [https://perma.cc/rp94-78y8]. 129 see taxes paid on long-term capital gains, supra note 127. 130 id. https://www.treasury.gov/resource-center/tax-policy/tax-analysis/documents/taxes-paid-on-long-term-capital-gains.pdf https://www.treasury.gov/resource-center/tax-policy/tax-analysis/documents/taxes-paid-on-long-term-capital-gains.pdf 20 [vol.10:1 columbia journal of tax law significant role in the low revenue receipts associated with such income. the joint committee on taxation estimates that the preferential tax rate on long-term capital gains and qualified dividends alone cost the government $130.9 billion in lost tax revenue in 2016. likewise, in 2016, the exclusion of capital gains at death is estimated to have cost the government lost revenue of $32.9 billion; the exclusion of capital gains from sales of personal residences, $29.2 billion; and the deferral of gains on like-kind exchanges by individuals, $5.9 billion.131 in sum, of the roughly 3 trillion of tax revenue collected each year, well over half comes from income and payroll taxes on labor; taxes levied on business and investment income make up a smaller portion of that revenue; and capital gains taxes contribute only a very small percentage of overall revenue. in an era when labor was the dominant driver of the economy, this tax paradigm made sense: the government could readily tap into a vast revenue reservoir. however, as discussed in the next section, the technological revolution may alter the prominence of labor in the economy. if that is the case, the revenue implications of such a change may be significant insofar as this vast revenue reservoir is likely to gradually (and significantly) diminish in size.132 iii. the technological revolution and the labor-capital dynamic memorable, salient designations are typically reserved for major or transformative events. in recognition that we are now in the midst of this sort of happening, the current time period has earned the moniker “technological era,”133 emblematic of the fact that monumental changes are occurring that are challenging the status quo. while physical and intellectual labor were once commonplace features of everyday society, technological advancements are now taking over both of these roles in lieu of human capital. the subsections below elaborate on how capital in the form of technological advancement is uprooting labor. subsection a details this dynamic; subsection b then examines the implications to the income tax system associated with these changes; and subsection c next sets forth the potential long-term revenue consequences that these changes may produce. a. technological changes that curtail or eliminate the need for labor technological advances affect every facet of the economy. from the mundane removal of street trash to the ultra-sophistication of laparoscopic surgery, technology has been touching the daily existence of virtually every taxpayer at a pace that is unprecedented. as evidence of the speed at which technological changes are progressing, consider moore’s law, which predicts that computer processing power will double approximately every two years.134 over half a century ago, 131 joint comm. on taxation, jcx-3-17, estimates of federal tax expenditures for fiscal years 2016–2020, at 32–33 (2017), https://www.jct.gov/publications.html?func=startdown&id=4971 [https://perma.cc/a7n7-7yws]. 132 professor orly mazur has also argued that the tax base will likely shrink if labor income declines due to automation. see orly mazur, taxing the robots, pepperdine l. rev. (forthcoming 2018) (manuscript at 17), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3231660 [https://perma.cc/mm7f-emz6]. 133 see klaus schwab, the fourth industrial revolution (2017) (describing the numerous technological advancements of the present time period). 134 gordon e. moore, cramming more components onto integrated circuits, electronics 114 (apr. 19, 1965), http://www.monolithic3d.com/uploads/6/0/5/5/6055488/gordon_moore_1965_article.pdf https://www.jct.gov/publications.html?func=startdown&id=4971 https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3231660 2018] 21 automation and the income tax this prediction was made and, to the surprise of many scientists, engineers, and commentators, it holds true even today.135 but these technological advances do not remain untapped in researchers’ labs. instead, these advances have been brought to market; in endeavors to secure workplace efficiency, their adoption has been widespread. with the assistance of technological advances, work that in yesteryear might take months or even years to complete can now be accomplished in a matter of a few hours, minutes, or even seconds.136 along the same lines, work that once required hundreds or thousands of workers to complete may now be accomplished by just a few workers or even a single worker.137 this situation has the potential to wreak havoc in the labor market. although statistics vary across the board, artificial intelligence puts jobs at risk of being lost.138 and at least for the foreseeable future, this concern is anticipated to continue.139 one response to this concern may be that we have weathered technological change in the past and the labor force has emerged relatively unscathed.140 but there is reason to believe that the present transformation is fundamentally different. the pace and scale of technological [https://perma.cc/pn3w-sn2j]; see also moore’s law, https://www.mooreslaw.org/ [https://perma.cc/23xye7db]. 135 dan hutcheson, transistor production has reached astronomical scales, ieee spectrum (apr. 2, 2015), http://spectrum.ieee.org/computing/hardware/transistor-production-has-reached-astronomical-scales [https://perma.cc/wu4b-tajg]; thomas l. friedman, opinion, moore’s law turns 50, n.y. times (may 13, 2015), http://nyti.ms/1jgip5t. 136 see, e.g., nick heath, let’s try and not have a human do it: how one facebook techie can run 20,000 servers, zdnet (2013), https://www.zdnet.com/article/lets-try-and-not-have-a-human-do-it-how-one-facebooktechie-can-run-20000-servers/ [https://perma.cc/ml6y-kayq] (“how many people does it take to run 20,000 servers? in the case of facebook just the one.”). 137 see, e.g., stephanie clifford, u.s. textile plants return, with floors largely empty of people, n.y. times ( sept. 19, 2013), https://www.nytimes.com/2013/09/20/business/us-textile-factoriesreturn.html?pagewanted=all&_r=0 (explaining how a factory that once employed 2,000 employees can easily manage now with just 140 employees); wade roush, hamburgers, coffee, guitars, and cars: a report from lemnos labs, xconomy (june 12, 2012), http://www.xconomy.com/san-francisco/2012/06/12/hamburgers-coffee-guitars-andcars-a-report-from-lemnos-labs/# [https://perma.cc/s4td-4rw6] (“‘our device isn’t meant to make employees more efficient,’ said co-founder alexandros vardakostas. ‘it’s meant to completely obviate them.’”). 138 james vincent, robots do destroy jobs and lower wages, says new study, the verge (mar. 28, 2017), https://www.theverge.com/2017/3/28/15086576/robot-jobs-automation-unemployent-us-labor-market [https://perma.cc/c3qk-2v67]. (“[the study] found that each new robot added to the workforce meant the loss of between 3 and 5.6 jobs in the local commuting area. meanwhile, for each new robot added per 1,000 workers, wages in the surrounding area would fall between 0.25 and 0.5 percent.”). 139 calum mcclelland, the impact of artificial intelligence – widespread job losses, iot for all (aug. 17, 2018), https://www.iotforall.com/impact-of-artificial-intelligence-job-losses/ [https://perma.cc/5s8k-52m4] (“a two-year study from mckinsey global institute suggests that by 2030, intelligent agents and robots could eliminate as much as 30 percent of the world’s human labor, displacing the jobs of as many as 800 million people.”). 140 see ruchir sharma, no, that robot will not steal your job, n.y. times (oct. 7, 2017), https://www.nytimes.com/2017/10/07/opinion/sunday/no-that-robot-will-not-steal-your-job.html (“if robots threatened human labor, human joblessness would be growing. but it’s not. in fact, since 2008, job growth has been strongest in countries like germany and japan, which deploy the most robots.”); katie allen, technology has created more jobs than it has destroyed, says 140 years of data, guardian (aug. 18, 2015), https://www.theguardian.com/business/2015/aug/17/technology-created-more-jobs-than-destroyed-140-years-datacensus [https://perma.cc/q8qy-j42u] (“study of census results in england and wales since 1871 finds rise of machines has been a job creator rather than making working humans obsolete.”). https://www.mooreslaw.org/ https://www.theverge.com/2017/3/28/15086576/robot-jobs-automation-unemployent-us-labor-market 22 [vol.10:1 columbia journal of tax law advancement surpasses what we have experienced in the past. computers can accomplish exponentially more than they could historically and at a cheaper cost than ever before.141 even under a more optimistic view—i.e., that new jobs will eventually emerge to replace the ones that are lost—the labor market is still likely to experience significant disruptions in the short term.142 the ubiquity of technological advances and their effects on the labor market can be categorized into two general baskets: (1) physical labor and (2) intellectual labor. below is a short exposition of each. 1. physical labor for most of human civilization, production of food, shelter, and clothing required an intense amount of physical labor: fields and domesticated animals had to be planted and tended to, respectively; wood, stones, and bricks had to be gathered and then nailed or laid and mortared; and cotton, silk, and skins had to be harvested, carded, and tanned, respectively. this physical labor was all-consuming and, in the never-ending search for more able hands, was a major factor in universally high birth rates.143 for many millennia, physical labor remained a staple in people’s lives. only after the industrial revolution began to hit its full stride did technology alleviate some of the physical drudgeries associated with daily existence. while there are many examples of technological innovations that played transformative roles during the industrial revolution, two stand out: the assembly line and the combustible engine. introduced by henry ford, the assembly line significantly increased productivity and alleviated much of the physical labor associated with consumer goods production.144 the combustible engine led to the genesis of the field tractor, which made agricultural production considerably less physically demanding.145 in terms of reducing the need for physical labor in the workplace, recent technological advances have gone far beyond those that the industrial revolution produced. for example, 141 ryan abbott & bret bogenschneider, should robots pay taxes? tax policy in the age of automation, 12 harv. l. & pol'y rev. 145, 158-59 (2018), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2932483 [https://perma.cc/e25g-63hf]. 142 id. at 159 (“during past episodes of widespread automation and technological change, it took decades to develop new worker skill sets on a significant scale and to build new job markets.”). 143 john c. caldwell & thomas schindlmayr, explanations of the fertility crisis in modern societies: a search for commonalities, 57 population stud. 241, 256 (2003) (“as industrialization spreads and incomes rise, the evidence grows that rich, highly urbanized and educated countries with few families working in agriculture may not reproduce themselves. simply, the family is no longer the production unit.”). 144 see generally ray batchelor, henry ford: mass production, modernism and design (1994). 145 see generally william j. white, economic history of tractors in the united states, eh.net, https://eh.net/encyclopedia/economic-history-of-tractors-in-the-united-states/ [https://perma.cc/8xag-9ylx]; see also erik brynjolfsson & andrew mcafee, the second machine age: work, progress, and prosperity in a time of brilliant technologies 176 (2014). 2018] 23 automation and the income tax machinery now exists that can prune an orchard,146 milk cows,147 and harvest entire fields of crops.148 other machinery can build skyscrapers that eclipse small mountains149 or construct prefabricated homes for shipment.150 finally, still other machinery is starting to be developed with the expectation that it can stitch together the finest gossamer gowns and do so continuously, from dawn to dusk every morning, afternoon, and evening.151 opportunities to engage in physical labor remain—but usually by choice, not necessity. consider the fact that before the middle of the nineteenth century, commercial gyms did not exist— and for good reason: members of the general populace apparently already endured enough on-thejob physical labor that they did not need to rely upon a third-party source to secure a physical workout. over the last several decades, the advent of commercial gyms and the success that they have enjoyed speak volumes regarding the diminishing role that physical labor plays in the twentyfirst-century economy.152 2. intellectual labor the use of technology in performing intellectual labor is pervasive. machinery can perform the same intellectual tasks as humans, often more efficiently, and not need personal, sick, or vacation days. 146 peter murray, automation reaches french vineyards with a vine-pruning robot, singularityhub (nov. 26, 2012), https://singularityhub.com/2012/11/26/automation-reaches-french-vineyards-with-a-vine-pruningrobot/ [https://perma.cc/7345-rbfv] (“now that wall-ye v.i.n. has been built we can rest assured that there are no jobs too sacred to be handed over to the automated expertise of robots. wall-ye is a robot that takes the human touch out of caring for those grape vines that make french wines among the best in the world.”). 147 see kaleigh rogers, robots are milking cows for dairy, data, motherboard (feb. 26, 2015), https://motherboard.vice.com/en_us/article/robots-are-milking-cows-for-dairy-data [https://perma.cc/2pbr-x9r2] (“milking has been semi-automated for decades now, but it still requires a human to corral the animals, clean the cows’ udders, and hook up and detach the milking machine. robotic milkers eliminate the need for human intervention: it’s just animal and machine.”). 148 see tim hornyak, strawberry-picking robot knows when they’re ripe, cnet (dec. 13, 2010), https://www.cnet.com/news/strawberry-picking-robot-knows-when-theyre-ripe/ (“strawberry fields will forever be changed by robots that can automatically identify and pick ripe berries, according to japanese researchers.”). 149 see generally adam hadhazy, these are the world’s 21 tallest buildings, popular mechanics (feb. 13, 2015), http://www.popularmechanics.com/technology/design/g1705/21-tallest-buildings-in-the-world/ [https://perma.cc/jt2q-2azy]. 150 see generally peter gössel, arnt cobbers & oliver jahn, a brief history of prefab, architecture wk. (oct. 3, 2012), http://www.architectureweek.com/2012/1003/design_1-1.html [https://perma.cc/j46j-2ayp]. 151 see, e.g., rina raphael, is this sewing robot the future of fashion, fast company (jan. 24, 2017), https://www.fastcompany.com/3067149/is-this-sewing-robot-the-future-of-fashion [https://perma.cc/fnq5-2psr] (“startup sewbo has figured out how to get a machine to sew an entire garment, and it may finally push clothing factories to fully automate.”). 152 see, e.g., eric chaline, school for naked exercise: a history of the gym, boston globe (jan. 3, 2016), https://www.bostonglobe.com/ideas/2016/01/03/school-for-naked-exercise-historygym/lahtscidhcueckb7ldrcpo/story.html [https://perma.cc/wg4r-gm8v]. (the article discusses the commercial gyms that began to appear in europe in the mid-19th century, saying: “what had happened between 1820 and 1850 to account for this exercise revolution? primarily, the rapid industrialization, democratization, and urbanization of western europe, with france and great britain at the industrial and political forefront.”). http://wall-ye.com/ https://www.bostonglobe.com/ideas/2016/01/03/school-for-naked-exercise-history-gym/lahtscidhcueckb7ldrcpo/story.html https://www.bostonglobe.com/ideas/2016/01/03/school-for-naked-exercise-history-gym/lahtscidhcueckb7ldrcpo/story.html 24 [vol.10:1 columbia journal of tax law over time, there has been no discernible difference in the intellect between us and our predecessors.153 the acclaimed intellectual works of the twentieth century, for example, do not demonstrate any greater intellectual prowess than those dating back to ancient greece. in other words, from a strict cerebral vantage point, there has not been any noticeable progression. nevertheless, our ability to store, retrieve, and process data has never been greater. computer hard drives and the “cloud” permit almost unlimited storage capacity.154 access to this information is unparalleled: in milliseconds, we can retrieve virtually any electronic information that we need.155 and in terms of data manipulation, computers open the door to processing at lightning speeds.156 therefore, while we are no smarter intellectually than our predecessors, technology now permits us to do far more with our existing ingenuity. the capacity to do far more with the same intellect has affected the labor market. in many instances, intellectually intense jobs either no longer exist or are not as time intensive, thus requiring less human intellectual labor. consider legal research. it once required attorneys to scour the library for sources; photocopy material; and, if need be, transcribe findings into legal memoranda and briefs.157 now, often with just a few keystrokes, attorneys can find governing 153 see, e.g., steve connor, human intelligence ‘peaked thousands of years ago and we’ve been on an intellectual and emotional decline ever since, independent (nov. 12, 2012), http://www.independent.co.uk/news/science/human-intelligence-peaked-thousands-of-years-ago-and-weve-been-onan-intellectual-and-emotional-8307101.html [https://perma.cc/7ues-ffwf] (“professor gerald crabtree, who heads a genetics laboratory at stanford university in california, has put forward the iconoclastic idea that rather than getting cleverer, human intelligence peaked several thousand years ago and from then on there has been a slow decline in our intellectual and emotional abilities.”). 154 martin ford, rise of the robots: technology and the threat of a jobless future 63–64 (2015) (“for example, computer memory capacity and the amount of digital information that can be carried on fiber-optic lines have been both experienced consistent exponential increases. nor is the acceleration confined to computer hardware; the efficiency of some software algorithms has soared at a rate far in excess of what moore’s law alone would predict.”); thomas l. friedman, owning your own future, n.y. times (may 10, 2017), https://www.nytimes.com/2017/05/10/opinion/owning-your-own-future.html (emphasis in original): mark bohr, intel’s senior fellow for technology, explained to me that intel’s main workhorse microprocessor today is the 14-nanometer chip it introduced in 2014. it packs 37.5 million transistors per square millimeter. by the end of 2017, thanks to moore’s law, intel will begin producing a 10-nm chip that will pack “100 million transistors per square millimeter— more than double the previous density with less heat and power usage,” said bohr. 155 see, e.g., michael p. lynch, the internet of us: knowing more and understanding less in the age of big data 6-7 (2017) (“we used to say ‘seeing is believing’; now, googling is believing. with 24/7 access to nearly all of the world’s information at our fingertips, we no longer trek to the library or the encyclopedia shelf in search of answers. we just open our browsers, type in a few keywords and wait for the information to come to us.”). 156 see, e.g., president’s council of advisors on sci. & tech., report to the president and congress: designing a digital future: federally funded research and development in networking and information technology 71 (dec. 2010), https://www.hsdl.org/?view&did=10223 [https://perma.cc/y5c5en5y] (“grötschel, an expert in optimization, observes that a benchmark production planning model solved using linear programming would have taken 82 years to solve in 1988, using the computers and the linear programming algorithms of the day. fifteen years later—in 2003—this same model could be solved in roughly 1 minute, an improvement by a factor of roughly 43 million.”). 157 see generally steven m. barkan, on describing legal research, 80 mich. l. rev. 925 (1982) (reviewing j. myrn jacobstein & roy m. mersky, fundamentals of legal research (2d ed. 1981)). 2018] 25 automation and the income tax authority (assuming it exists); send it to their printers; and, if need be, copy and paste their findings.158 the role that technology has played in terms of facilitating legal research is just the tip of the iceberg. technological advancements have also led to the elimination or diminishment of jobs such as toll collectors, telephone operators, and bank tellers. and with the widespread use of selfdriving automobiles and trucks around the corner,159 whole other industries (e.g., taxi driving and trucking) are likely soon to come to a screeching halt or disappear into complete oblivion. b. consequences associated with labor income’s diminishment the labor market’s transformation has important consequences for the way in which the government raises revenue to meet its expenditures, particularly when the first decade of the twenty-first century has resulted in the creation of no new jobs.160 given that the income tax has historically relied on labor income as a key component of its revenue base, a major upheaval is on the horizon.161 specifically, the role of labor is ebbing and that of capital is rising; furthermore, information availability via the internet is unprecedented.162 these significant developments have upended the traditional justifications proffered for the varied tax treatments of income derived from labor, business and investment profits, and capital gains. consider each income category and the transformative effects that technological advancements have had. 1. taxing labor in the technological age 158 see, e.g., john markoff, armies of expensive lawyers, replaced by cheaper software, n.y. times (mar. 4, 2011), https://www.nytimes.com/2011/03/05/science/05legal.html (“last year, clearwell software was used by the law firm dla piper to search through a half-million documents under a court-imposed deadline of one week. clearwell’s software analyzed and sorted 570,000 documents (each document can be many pages) in two days. the law firm used just one more day to identify 3,070 documents that were relevant to the court-ordered discovery motion.”); jane croft, legal firms unleash office automatons, fin. times (may 16, 2016), https://www.ft.com/content/19807d3e-1765-11e6-9d98-00386a18e39d [https://perma.cc/532d-zxqw] (demonstrating the existence of software programs that can outperform attorneys and paralegals in document review). 159 see, e.g., guilbert gates et al., the race for self-driving cars, n.y. times (june 6, 2017), https://www.nytimes.com/interactive/2016/12/14/technology/how-self-driving-cars-work.html (explaining how selfdriving cars are being perfected and will soon be mass produced). 160 neil irwin, aughts were a lost decade for u.s. economy, workers, wash. post (jan. 2, 2010), http://www.washingtonpost.com/wp-dyn/content/article/2010/01/01/ar2010010101196.html [https://perma.cc/vh4e-gtfz]. 161 cf. edward j. mccaffery, the death of the income tax (or, the rise of america’s universal wage tax 48 (usc class research paper no. class18-25, 2018),https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3242314 [https://perma.cc/fq45-3zc3]. (“history and common sense, let alone empathy, supply reasons to believe that this situation cannot endure. a shrinking labor base cannot perpetually bear an increasing tax burden, and see the benefits particular to their life situations slashed, while a growing class of the wealthy need not work or pay taxes. none of this bodes well for the future.”). 162 see stephanie pappas, how big is the internet, really?, live sci. (mar. 18, 2016, 11:40 am), http://www.livescience.com/54094-how-big-is-the-internet.html [https://perma.cc/3hzr-jn92] (“as of september 2014, there were 1 billion websites on the internet, a number that fluctuates by the minute as sites go defunct and others are born . . . . by the end of 2016, global internet traffic will reach 1.1 zettabytes per year . . . and by 2019, global traffic is expected to hit 2 zettabytes per year. one zettabyte is the equivalent of 36,000 years of high-definition video . . . .”). https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3242314 26 [vol.10:1 columbia journal of tax law it first should be noted that taxing income derived from labor remains a viable avenue for raising tax revenue, notwithstanding the transformative effects of technology. readily subject to third-party withholding and the issuance of tax information returns,163 labor income continues to be highly visible. furthermore, due to technological innovations, the labor market has become even more inelastic (i.e., with a soft market for good, high-paying jobs, there is less taxpayer proclivity to substitute leisure activities for labor).164 that being the case, taxing labor income theoretically should have a minimal effect on economic behavior.165 in other words, the efficiency case for taxing labor income remains strong. however, the justifications for taxing labor income more heavily than business and investment profits and capital gains have become increasingly suspect. as discussed above, throughout much of the twentieth century, the labor income base was robust compared to the capital income base. in the twenty-first century, a reversal is happening as technology propels capital income upward compared to that derived from labor. if this overall economic trend continues, congress can no longer rely primarily upon labor income to keep the treasury’s coffers full. for every job that is lost to technology (without replacement in another sector), the share of income attributable to labor declines and, along with it, the corresponding tax revenue. to generate sufficient revenue to meet its expenditures, congress must therefore reconsider the tax rate applicable to labor, business and investment profits, and capital gains. consider, too, that historical factors that once justified taxing labor more heavily than other types of income have waned in importance in recent years. since world war ii, the combination of tax withholding and information return reporting on labor income readily ensured a robust and steady revenue supply,166 whereas business and investment income was historically harder to monitor. however, over this same time period, the use of cash currency has declined, and electronic transfers in the form of credit and debit card payments have become much more commonplace.167 as a result of this marketplace transformation, business and investment profits 163 jay a. soled, homage to information returns, 27 va. tax rev. 371 (2007). 164 see joel slemrod, a general model of behavioral response to taxation, 8 int’l tax & pub. fin. 119 (2001) (“in the model of labor supply, as long as the marginal cost of avoidance depends on true labor income the real behavioral response to wage rates or tax rates depends on a mixture of the elasticity of substitution and the avoidance technology.”); patrick gillespie, millions in gig economy can’t find better jobs or pay, cnn money (oct. 27, 2016), http://money.cnn.com/2016/10/27/news/economy/gig-economy-workers/ [https://perma.cc/x5j9-7wua] (“most of the estimated 68 million gig workers choose the freelance lifestyle for better work-life balance. but nearly 20 million of them do it out of necessity because they can't find better work or pay, according to a report by mckinsey global institute, a consulting firm.”); ian salisbury, why it’s still hard to find the job you really want, money (dec. 5, 2014), http://time.com/money/3619921/jobs-report-unemployment/ [https://perma.cc/3cdq-cpgm] (“the problem is that the post-recession economy is still better at producing marginal jobs—think retail and food service gigs—than the comparatively well-paying construction, manufacturing, and government jobs that let middle-class people buy homes and support their families.”). 165 see generally thomas piketty & emmanuel saez, optimal labor income taxation (nat’l bureau of econ. research, working paper no. 18521, 2012) https://eml.berkeley.edu/~saez/piketty-saeznber12handbook.pdf [https://perma.cc/2ar3-9t2c]. 166 see supra note 83and accompanying text. 167 jeffrey h. kahn & gregg d. polsky, the end of cash, the income tax, and the next 100 years, 41 fla. st. u. l. rev. 159 (2013). see susan cleary morse, stewart karlinsky & joseph bankman, cash businesses and tax evasion, 20 stan. l. & pol’y rev. 37 (2009) (explaining why the use of cash facilitates tax noncompliance and the underground economy). https://eml.berkeley.edu/%7esaez/piketty-saeznber12handbook.pdf 2018] 27 automation and the income tax have become much more visible and easier to trace, making them more akin to wage income in this respect.168 this increased visibility makes nonlabor income a much more accessible and attractive target of taxation. 2. taxing business profits and investments in the technological age there is no reason to assume that the united states will seek to shed its capitalist roots anytime soon. over the past two and one-half centuries, the country has proven to be an economic powerhouse, achieving unprecedented levels of productivity.169 to date, consistent with this capitalist heritage, congress has sought to tailor the code in a manner that aggressively cultivates a business and investment environment that is friendly to economic growth.170 yet, it is unclear if these favorable tax rules are necessary and worth their cost, particularly in the modern technological era. the code has been intentionally designed to minimize the tax burden associated with business profits and investments. while there is a whole series of code sections that reflect this pro–business/investment approach, bonus and accelerated depreciation deductions stand out. these deductions sanction income deferral: they enable production costs that yield many years of annual income to be fully deducted in the year of acquisition.171 congress thus underwrites these acquisitions, forgoing taxes to the detriment of expenditures for public services (e.g., strengthening the military, providing cleaner public parks, and making infrastructure investments). yet, in light of the vast and unparalleled productivity of twenty-first-century machinery, taxpayers are already incentivized to make such purchases. they do not need congressional assistance in the form of income deferral to motivate them.172 query, too, whether congress needs to dangle tax incentives, such as the deductibility of home mortgage interest and the reduced tax rate on dividends, in front of taxpayers to foster private property ownership and investment. empirical evidence that these incentives have a significant impact on taxpayer behavior is mixed at best.173 further, the internet has made investing easier 168 james alm & jay a. soled, w(h)ither the tax gap, 92 wash. l. rev. 521, 539-543 (2017). 169 mack mclarty & nelson cunningham, north america is the strongest economy in the world. let’s keep it that way, wash. post (june 29, 2016), https://www.washingtonpost.com/opinions/global-opinions/north-americais-the-strongest-economy-in-the-world-lets-keep-it-that-way/2016/06/29/ca06952c-3e0b-11e6-84e81580c7db5275_story.html?utm_term=.da14efaf8f6f [https://perma.cc/h2m6-wjnx] (“but north america the economic powerhouse has reigned supreme for nearly a century, becoming the largest and strongest in the world, an industrial dynamo, a commodities cornucopia and a magnet for millions upon millions of immigrants seeking a better life.”). 170 see, e.g., n. gregory mankiw, how best to tax business, n.y. times (apr. 21, 2017), https://www.nytimes.com/2017/04/21/upshot/tax-code-business.html?_r=0 (discussing ways congress may reform business taxes to make the united states more competitive in the global economy). 171 i.r.c. §§ 168(a), 179(a). for an excellent overview of accelerated depreciation, see rebecca n. morrow, accelerating depreciation in recession, 19 fla. tax rev. 465, 472–89 (2016). 172 indeed, a recent paper by professor lily batchelder suggests that many firms don’t take favorable tax expensing rules into account in making investment decisions because, in part, financial accounting rules do not recognize the benefit of immediate expensing. lily l.batchelder, accounting for behavioral considerations in business tax reform: the case of expensing, 4 (jan. 24, 2017) (unpublished working paper) https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2904885. [https://perma.cc/r4d2-hfda]. 173 see, e.g., joel slemrod & jon bakija, taxing ourselves: a citizen’s guide to the debate over taxes 320–21 (mit press 5th ed. 2017) (“the historical experience in the united states and other countries casts 28 [vol.10:1 columbia journal of tax law than ever before, even by relatively unsophisticated individuals. the justification for spending billions of dollars in the form of tax expenditures that shelter business profits and investment income from taxation thus appears quite weak. next, administrative obstacles that once beset the monitoring of business profit and investment income are no longer as daunting. three major changes in the nation’s economy have led to this change. first, there is a global trend under way in which cash—which in yesteryear was easily hidden and made to disappear—is being dethroned as the preferred mode of transacting business; it is instead being replaced by credit cards, debit cards, wire transfers, and smartphone applications, all of which leave electronic traces that make business profits and investment income much harder to hide.174 second, automation has allowed congress to pass into law measures that augment third-party oversight. consider, for example, the passage of the foreign account tax compliance act.175 this law requires overseas investment institutions to collect and submit information to the irs, effectively limiting taxpayers’ ability to invest offshore in ways that camouflage their identities.176 third, technological changes and globalization have led to largescale businesses replacing many small-scale business enterprises.177 this is relevant because larger doubt on predictions of large impacts on either housing prices or the extent of homeownership [from repealing the mortgage interest deduction].”). 174 see catherine new, cash dying as credit card payments predicted to grow in volume, huffington post (june 7, 2012), https://www.huffpost.com/entry/credit-card-payments-growth_n_1575417 [https://perma.cc/z7bd-jtqh]: what was once the most secure way to pay for things—hard cash—is increasingly becoming currency non grata in wallets and checkouts across the country. airlines won’t take it for in-flight snacks and a growing number of stores and restaurants like standard market, a new neighborhood market in chicago, won’t accept it. it’s plastic or bust for consumers who want to do a transaction in these card-only places. meanwhile, plastic cards purchases comprised 66 percent of all in-person sales, with nearly half of them, or 31 percent, made with debit cards, according to [javelin strategy & research, a marketing research firm]. last year shoppers used credit cards for 29 percent of point-of-sale purchases; javelin expects that number to rise to 33 percent by 2017. shoppers deployed gift cards and prepaid cards for 6 percent of purchases made with plastic last year. a mere 7 percent of transactions involved use of a paper check, with such transactions projected to drop further in the next few years. see generally john heggestuen, cash is fading, and checks are dying as smartphones and tablets change the way we pay, bus. insider (aug. 4, 2014), https://www.businessinsider.com/cash-is-fading-and-checks-aredying-as-smartphones-and-tablets-change-the-way-we-pay-2014-8 [https://perma.cc/l66j-kxmp]; tamás briglevics & scott schuh, u.s. consumer demand for cash in the era of low interest rates and electronic payments 1 (fed. reserve bank of boston, working paper no. 13-23, 2013), http://www.bostonfed.org/economic/wp/wp2013/wp1323.pdf [https://perma.cc/c98w-cnbc]. 175 hiring incentives to restore employment act, pub. l. no. 111-147, §§ 501–62, 124 stat. 71, 97–118 (2010). 176 see dean marsan, fatca: the global financial system must now implement a new u.s. reporting and withholding system for foreign account tax compliance, which will create significant new exposures—managing this risk (part iii), taxes-the tax mag., sept. 2010, at 28 (explaining that u.s. taxpayers will find it increasingly hard to park investments offshore and fail to disclose them). 177 see anthony caruso, u.s. census bureau, g12-susb, statistics of u.s. businesses employment and payroll summary: 2012, 1 (2015), www.census.gov/content/dam/census/library/publications/2015/econ/g12-susb.pdf [https://perma.cc/hvc4-assc]; see also alm & soled, supra note 168, at 544 (“the most recent report indicates that only 17.6% of the labor force http://www.bostonfed.org/economic/econbios/schuh.htm 2018] 29 automation and the income tax business enterprises (and the employees who work for such enterprises) tend to be far more tax compliant than smaller business enterprises,178 for a whole host of reasons (such as management oversight and lack of opportunities for collusion). 3. taxing capital gains in the technological age under the code, capital gains are accorded unparalleled preferential tax treatment, emblematic of their semisacred status in the united states.179 the proffered justifications for such preferential treatment have withstood scrutiny for close to a century180—until now, when technological advancements and information availability have cast a shadow on the legitimacy of these justifications. perhaps the longest-standing justification for not taxing capital gains (or, at the most, taxing them lightly) is that they do not constitute income.181 as previously mentioned,182 this claim’s origin dates back to old english trust law in which capital gains were defined to be principal rather than income. this was an important distinction for trustees to make; after all, they had to balance their fiduciary allegiances and duties between income and remainder beneficiaries.183 but stripped of the trust context, this justification for a tax rate preference makes no sense. plain and simple, capital gains constitute an accretion to wealth, deferred until there has been a recognition event (an administrative concession designed to help enhance compliance and moot issues of liquidity). as such, capital gains fit snugly in the traditional scope of income and should be so treated under the code.184 the evolving business landscape in the twenty-first century also casts a new light on the capital gains preference. as several commentators have recently argued, the line between capital now works for ‘very small enterprises’ (defined as having fewer than twenty employees); the rest of the labor force works for small, medium, and large enterprises.”). 178 see alm & soled, supra note 168, at 543–48 (explaining the reasons large-business enterprises are apt to be more compliant than small-business enterprises); u.s. gov’t accountability office, gao-07-1014, tax gap: a strategy for reducing the gap should include options for addressing sole proprietor noncompliance 10 (2007), https://www.gao.gov/assets/270/265399.pdf [https://perma.cc/854p-z6rr] (“[a]n estimated 70 percent of schedule c filers in 2001 (about 12.9 million) made an error when reporting net business income (that is, net profit or loss on line 31 of schedule c). most of the misreporting was underreporting . . . . [a]n estimated 61 percent of schedule c filers underreported their net income and 9 percent overreported.”); kathleen delaney thomas, presumptive collection: a prospect theory approach to increasing small business compliance, 67 tax l. rev. 111, 113 (2013) (“when combined with under-reported self-employment tax ($57 billion), individual small business noncompliance accounts for approximately $179 billion, or 40% of the total tax gap.”). 179 i.r.c. § 1(h). 180 see, e.g., cunningham & schenk, supra note, at 320 (“nevertheless, a capital gains preference continues to garner much support in political circles”); constantine n. katsoris, in defense of capital gains, 42 fordham l. rev. 1, 3 (1973) (“in the forefront of many tax reform proposals is the alteration and/or elimination of the present treatment of capital gains.”); daniel halperin, commentary, a capital gains preference is not even a second-best solution, 48 tax l. rev. 381 (1993); daniel n. shaviro, commentary, uneasiness and capital gains, 48 tax l. rev. 393 (1993). 181 david f. bradford, untangling the income tax 46–51 (harvard univ. press 1999). 182 see supra notes 21–22 and accompanying text. 183 see supra notes 121-122 and accompanying text. 184 i.r.c. § 61(a). https://1.next.westlaw.com/link/document/fulltext?findtype=y&sernum=0104712550&pubnum=1247&originatingdoc=i160bf8e14b2811db99a18fc28eb0d9ae&reftype=lr&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search) https://1.next.westlaw.com/link/document/fulltext?findtype=y&sernum=0104712550&pubnum=1247&originatingdoc=i160bf8e14b2811db99a18fc28eb0d9ae&reftype=lr&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search) https://1.next.westlaw.com/link/document/fulltext?findtype=y&sernum=0104712551&pubnum=1247&originatingdoc=i160bf8e14b2811db99a18fc28eb0d9ae&reftype=lr&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search) https://1.next.westlaw.com/link/document/fulltext?findtype=y&sernum=0104712551&pubnum=1247&originatingdoc=i160bf8e14b2811db99a18fc28eb0d9ae&reftype=lr&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search) 30 [vol.10:1 columbia journal of tax law gains and ordinary income is becoming increasingly difficult to draw.185 many taxpayers earning capital gains conduct business via pass-through entities the likes of which were nonexistent at the point in time when the capital gains preference originated. whereas a century ago policy makers could easily distinguish between gains from a sale of stock held in an investment portfolio and income derived from a plumbing business, nowadays there are many gray areas. a taxpayer conducting business through an entity may derive some income from his labor and other income that represents true “profit” of the business. because of the favorable tax rules afforded to nonlabor income, there is a powerful incentive for taxpayers to characterize as much income as possible as derived from profits,186 for example, by characterizing earnings as dividends instead of wages.187 this incentive to essentially convert labor income into capital income likely causes noncompliance with the tax laws,188 encourages socially wasteful tax planning,189 and imposes increased enforcement costs on the irs.190 taxing capital and labor alike would eliminate the inefficiencies associated with separating income streams into multiple baskets. further, much of today’s capital gains income is not derived from earnings on investment portfolios. instead, as pointed out by tax professor victor fleischer, a large portion of capital gains originates from so-called carried interest—this is income earned by skilled fund managers for their 185 victor fleischer, taxing alpha: labor is the new capital (nov. 19, 2015) (unpublished manuscript), https://ostromworkshop.indiana.edu/pdf/seriespapers/2015f_c/fleischerpaper.pdf [https://perma.cc/u8mz-wv7k]; thomas piketty, emmanuel saez & gabriel zucman, rethinking capital and wealth taxation 2 (sept. 17, 2013) (unpublished manuscript), http://piketty.pse.ens.fr/files/pikettysaez2014rkt.pdf [https://perma.cc/mw8s-uede ] (“in our view, the fuzziness of the capital vs. labor frontier is the simplest—and the most compelling—rationale for a comprehensive income tax (i.e. an income tax treating labor and capital income flows alike). . . .”). 186 some commentators have advocated for a rule that would impose a fixed rate of return on capital to eliminate the need to distinguish between labor and capital. see, e.g., edward d. kleinbard, capital taxation in an age of inequality, 90 s. cal. l. rev. 593, 601 (2017) (“[a dual income tax structure] requires the development of a new tax tool, namely a ‘labor-capital income tax centrifuge,’ to tease apart labor and capital income when the two are hopelessly intermingled, as in the case of the owner-entrepreneur of a closely held business.”). 187 see, e.g., piketty, saez & zucman, supra note 185, at 2 (“typically, self-employed individuals and business owners can to a large extent decide how much they get paid in wages and how much they receive in dividends. this also applies to a large number of corporate executives . . . .”). 188 for example, while the code technically prohibits taxpayers from paying salaries that are unreasonable, see i.r.c. § 162(a)(1) (permitting a deduction for “a reasonable allowance for salaries or other compensation for personal services actually rendered”), it does nothing to prevent taxpayers from paying meager salaries to elude employment taxes. see paul sullivan, the advantages and risks of gingrich’s tax strategy, n.y. times (feb. 3, 2012), http://www.nytimes.com/2012/02/04/your-money/advantages-and-risks-of-gingrichs-scorporation.html?pagewanted=all&_r=0 [https://perma.cc/k3hu-q7hn] (explaining how newt gingrich and john edwards avoided paying a lot of taxes by categorizing their labor income as s corporation earnings). 189 see david a. weisbach, the failure of disclosure as an approach to shelter, 54 smu l. rev. 73, 80 (2001) (“most tax planning is wasteful activity and we should not be shy about restricting it severely.”). 190 see james m. poterba, tax evasion and capital gains taxation 436 (m.i.t., working paper no. 436, 1987), https://dspace.mit.edu/bitstream/handle/1721.1/64275/taxevasioncapita00pote.pdf?sequence=1 [https://perma.cc/ms7d-hqqr] (detailing capital gains taxation noncompliance). 2018] 31 automation and the income tax talents191 and the sweat equity of founder’s stock held by successful entrepreneurs.192 however, gains from carried interest and founder’s stock are largely attributable to the labor of the fund managers and entrepreneurs; and, thus, the case for taxing them at preferential rates appears weak.193 what’s more, this type of income inures almost exclusively to the very wealthiest taxpayers, who are able to ensure that most of their income is taxed at preferential rates.194 in light of both growing income inequality and the increasing ease with which taxpayers can now characterize labor income as capital gains, the upsides of the capital gains preference no longer justify its costs. perhaps the strongest justification for granting preferential tax rates to capital gains has been that lower rates reduce the lock-in effect, i.e., the inefficient incentive to hold on to capital assets to avoid taxation.195 even in recent years, some commentators continue to contend that a capital gains tax rate preference is a sine qua non for a vibrant economy.196 yet, in a technological age, the lock-in effect potentially has less currency than it once did. it has become increasingly clear that many factors color taxpayers’ investment decisions,197 the foremost being anticipated investment returns, which are far more accessible via the internet than ever before.198 in the case of entrepreneurs and fund managers, who earn the most taxable capital gains in the modern economy, there is virtually no evidence that tax rates influence the timing of income realizations.199 191 a common practice of fund managers is a so-called two and twenty fee structure: the manager earns a 2 percent management fee on the capital deployed; in addition, a 20 percent premium (i.e., carried interest) is paid once a specified return threshold is reached. the 2 percent fee is generally taxed as ordinary income, while the 20 percent “carry” is generally taxed as capital gains. see victor fleischer, how a carried interest tax could raise $180 billion, n.y. times (june 5, 2015), https://www.nytimes.com/2015/06/06/business/dealbook/how-a-carried-interest-taxcould-raise-180-billion.html [https://perma.cc/2l4n-33xw] (suggesting that earning fees in this fashion is a ubiquitous practice); see also alan d. viard, the taxation of carried interest: understanding the issues, 61 nat.’l tax j. 445, 445 (2008), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2221668 [https://perma.cc/4rhev8c3] (“carried interest is a share, allocated to fund managers, of the income generated by the fund’s holding in its portfolio companies. when that income consists of qualified dividends or long-term capital gains, the managers are taxed at the [. . .] rate applicable to those forms of income.”). 192 fleischer, supra note 185, at 18 (“carried interest alone generates about $100 billion a year of capital gains income, or about 1/8 of all reported capital gains.”). 193 see id. at 3 (“when mark zuckerberg sells shares of facebook, the capital gain he reports on his tax return represents the realized value of the hard work, ideas, and leadership that he provided to facebook. it does not represent a return on whatever small financial investment he made with after-tax savings while sitting in a harvard dorm room.”). 194 see id. at 28. 195 see supra note 116 and accompanying text. 196 william d. popkin, the deep structure of capital gains, 33 case w. res. l. rev. 153 (1983); daniel j. mitchell, the overwhelming case against capital gains taxation, forbes (nov. 7, 2014), https://www.forbes.com/sites/danielmitchell/2014/11/07/the-overwhelming-case-against-capital-gainstaxation/#1e03b1a83b0a [https://perma.cc/4ff8-dryc]. 197 see, e.g., alex davidson, a guide to sustainable investing, wall st. j., nov. 8, 2015, https://www.wsj.com/articles/a-guide-to-sustainable-investing-1447038115 [https://perma.cc/7f4l-e8zu] (listing factors that taxpayers should consider when investing). 198 see, e.g., robert powell, what investors need to understand about ‘investment return,’ wall st. j., apr. 12, 2017, https://www.wsj.com/articles/what-investors-need-to-understand-about-investment-return1491790501 [https://perma.cc/9tyr-yb8r] (explaining the different ways to calculate investment return). 199 fleischer, supra note 185, at 6, 38–39 (“entrepreneurs and fund managers often do not control the timing of income in the same way that a portfolio investor controls the timing of asset sales.”). https://perma.cc/7f4l-e8zu 32 [vol.10:1 columbia journal of tax law even conceding that capital gains taxes exacerbate the lock-in effect to some degree, the impediment to the flow of capital investment has proven to be minimal,200 as evidenced by the burgeoning capital economy.201 and since the lock-in effect is, in part, a product of the generous tax deferral afforded capital appreciation, raising tax rates on capital gains would help foster equity.202 finally, certain administrative practicalities that once favored a capital gains preference are now moot. historically, congress probably shied away from taxing capital gains too heavily as a concession to the administrative reality that taxpayers had a hard time computing their gains and, by the same token, that the i.r.s. had a difficult time monitoring taxpayer compliance.203 for example, consider the plight of taxpayers who purchased at&t stock in, say, 1980.204 after a series of spin-offs and other capital events (e.g., stock dividends and redemptions), if and when taxpayers sold their investment, they would have to compute their tax bases in the original at&t stock they owned as well as the tax bases of the spin-off companies. most taxpayers lacked the ability, time, and resources to make these computations; furthermore, the i.r.s. lacked the resources to ensure compliance.205 fast-forward to the twenty-first century, in which data storage, data mining, and data manipulation are routine.206 congress capitalized upon these technological advances and mandated that third-party brokers maintain, adjust, and report the tax basis that investors have in their marketable securities on the face of tax information returns.207 from a taxpayer-oversight perspective, this third-party tax information reporting requirement leveled the playing field between the income derived from labor and that derived from capital: each now can be readily monitored for complete accuracy. c. tax revenue projections associated with technological transformation since taxes on labor comprise a majority of federal tax revenue, a decline in labor income will inevitably diminish tax revenue if there is no meaningful reform.208 indeed, a recent report by the international monetary fund indicates that “the u.s. labor share [of income] has fallen by 3.5 200 cf. marcus ryu, why corporate tax cuts won’t create jobs, n.y. times (oct. 9, 2017), https://www.nytimes.com/2017/10/09/opinion/corporate-tax-cuts-entrepreneur.html [https://perma.cc/9qn9-hf89] (“i have never heard someone say, ‘i would have started a company, but tax rates were too high.’”). 201 thomas piketty, capital in the twenty-first century 42 (2014) (“by 2010, and despite the crisis that began in 2007–2008, capital was prospering as it had not done since 1913.”). 202 see supra notes 116-118 and accompanying text. 203 u.s. gov’t accountability office, gao-06-603, capital gains tax gap: requiring brokers to report securities cost basis would improve compliance if related challenges are addressed 12 (june 2006). 204 the national taxpayer advocate, in her 2005 report to congress, utilizes at&t stock to illustrate the nature of the problem. taxpayer advocate serv., 2005 annual report 435 https://www.irs.gov/pub/tas/section_2.pdf [https://perma.cc/5fgt-r9at]. 205 see supra note 120. 206 see supra notes 154-156. 207 see energy improvement and extension act of 2008, pub. l. no. 110-343, § 403, 122 stat. 3807, 3854– 58 (introducing i.r.c. § 6045(g), which requires that brokers track and report taxpayers’ tax basis in the covered securities in which they invest). 208 see supra section ii.c. 2018] 33 automation and the income tax percent” since 2000.209 the report attributes the fall, in part, to “higher substitutability between labor and capital arising from technological change and routinization.”210 similarly, recent empirical studies have documented a decline in the share of gross domestic product (gdp) allocated to wages in recent years, both abroad and in the united states.211 table 1, below, illustrates the composition of individual income over a recent five-year period. from 2010 until 2014 (the most recent year for which data is publicly available), salaries and wages have declined as a percentage of total income. in contrast, over this same time period, business and investment income has slightly increased, while capital gains income as a percentage of income has increased more significantly.212 table 1: income sources as a percentage of total income213 year salaries/wages as percentage of total income business/investment as percentage of total income214 capital gains as percentage of total income 2010 71.1 15.2 4.4 2011 71.3 15.3 4.4 2012 68.2 16.9 6.7 2013 70.1 15.8 5.3 2014 68.4 16.1 7.0 further, consider table 2, below, which documents the respective shares of total tax revenue for payroll taxes and income taxes from 2010 to 2018. in 2010, payroll taxes (for both social security and hospital insurance) represented 40 percent of total tax revenues. in 2011 and 209 int’l monetary fund, imf country report no. 17/239, united states: 2017 article iv consultation 17 (july 2017), http://www.imf.org/en/publications/cr/issues/2017/07/27/united-states-2017article-iv-consultation-press-release-staff-report-45142 [https://perma.cc/9gxb-bwvx]. 210 id. 211 see, e.g., david autor et al., the fall of the labor share and the rise of superstar firms (nat’l bureau of econ. research, working paper no. 23396, 2017), http://www.nber.org/papers/w23396 [https://perma.cc/nf23r8z2] (attributing the fall in the labor share of gdp in the united states to the rise of “superstar firms,” which take advantage of technology and globalization to produce high profits with relatively low labor costs); loukas karabarbounis & brent neiman, the global decline of the labor share 1 (nat’l bureau of econ. research, working paper no. 19136, 2013), http://www.nber.org/papers/w19136.pdf [https://perma.cc/yr4n-ktft] (attributing the global decline in the labor share to “[e]fficiency gains in capital producing sectors, often attributed to advances in information technology and the computer age . . . .”); see also simcha barkai, declining labor and capital shares, http://home.uchicago.edu/~barkai/doc/barkaideclininglaborcapital.pdf [https://perma.cc/prp3-xt4y] (presenting evidence that firms have reduced spending on both labor and capital in recent years, while profits have increased). 212 however, in the case of capital gains income, fluctuations may be due, in part, to changes in capital gains rates, which may cause capital gains realization rates among taxpayers to vary from year to year. 213 this table was populated using data generated by the service. this data is found at internal revenue serv., statistics of income tax stats, individual income tax returns publication 1304,tbl.a (updated apr. 11, 2018), https://www.irs.gov/uac/soi-tax-stats-individual-income-tax-returns-publication-1304-completereport#_tbla [https://perma.cc/d23a-wgwk]. 214 see supra note 126 for a description of the components of business and investment income. http://www.nber.org/papers/w23396 https://www.irs.gov/uac/soi-tax-stats-individual-income-tax-returns-publication-1304-complete-report#_tbla https://www.irs.gov/uac/soi-tax-stats-individual-income-tax-returns-publication-1304-complete-report#_tbla 34 [vol.10:1 columbia journal of tax law 2012, social security tax rates were temporarily reduced (from 12.4 percent to 10.4 percent),215 so the overall share of payroll taxes as a percentage of tax revenues fell predictably from 2010 to 2011. however, even assuming that the 2011 and 2012 shares would have been somewhat higher without the temporary rate decrease, there is an overall decline in the percentage of total tax revenues from payroll taxes over this period, from 40 percent in 2010 to an estimated 33.5 percent for 2018. at the same time, income taxes (including taxes on labor, investments, profits, and capital gains) as a percentage of total tax revenue have steadily increased, from 41.5 percent in 2010 to an estimated 50.2 percent for 2018. 215 payroll tax rates: 1937–2017, tax pol’y ctr., https://www.taxpolicycenter.org/statistics/payroll-taxrates [https://perma.cc/zrv5-9xw6]. 2018] 35 automation and the income tax table 2: taxes as a percentage of total tax revenue216 year payroll taxes as percentage of total tax revenue income taxes as percentage of total tax revenue 2010 40.0 41.5 2011 35.5* 47.4 2012 34.5* 46.2 2013 34.2 47.4 2014 33.9 46.2 2015 32.8 47.4 2016 34.1 47.3 2017 estimate 34.0 48.0 2018 estimate 33.5 50.2 *temporarily lower payroll tax rate. together, these trends suggest an overall decline in tax revenue generation from labor income in recent years.217 payroll taxes are derived only from labor; thus, without changes in payroll tax rates (except for the temporary decrease in 2011–2012), a decline in the share of payroll taxes as a percentage of overall tax revenue suggests an overall decline in labor income.218 the fact that tax revenue from income taxes has simultaneously increased suggests that taxes on nonlabor income—business income, investment income, and capital gains—now constitute a greater share of overall tax revenue than they used to. with over $3 trillion in annual tax revenue collected in recent years, a decline of even a few percentage points in the tax revenue associated with labor income would result in a substantial revenue loss for the government. thus, to sustain a viable tax base, policymakers must impose offsetting adjustments in the code. the next section lays out suggestions for meaningful tax reform that would preserve the tax base in an era of declining labor income. 216 table 2.2: percentage composition of receipts by source, in office mgmt. & budget, historical tables, https://www.whitehouse.gov/omb/budget/historicals [https://perma.cc/6ptg-u29m]. 217 there is evidence, however, that some of this shift in revenues results from taxpayers increasingly mischaracterizing labor income as business profits to avoid taxes, often through the use of s corporations. see matthew smith et al., capitalists in the twenty-first century 5 (draft), https://eml.berkeley.edu/~yagan/capitalists.pdf [https://perma.cc/m9z5-2aa3]. such tax avoidance creates deadweight loss and further supports the arguments in this article to reduce or eliminate the disparate treatment between labor income and other forms of income. 218 while payroll tax rates generally have not changed, the threshold for social security taxes is indexed for inflation and changes from year to year. thus, payroll tax revenues could also decline if the threshold adjustments for social security did not keep up with rising incomes. https://www.whitehouse.gov/omb/budget/historicals 36 [vol.10:1 columbia journal of tax law iv. tax reform in an era of rapid technological advancements in the past, technological changes have colored the direction that tax reform has taken. as the country has modernized, for example, congress introduced third-party reporting, mandated the use of magnetic tape submissions, and required electronic form filing.219 likewise, as internet use has become ubiquitous, congress has instituted changes to facilitate e-filing and encouraged the i.r.s. to use cost-effective measures to dispense important tax-related information.220 these changes and others like them signify that when it comes to tax reform, congress has not been oblivious to technological advances and their pivotal role in shaping the nation’s economic landscape. but capital’s rise and labor’s ebb have yet to make a significant mark on tax reform. in many respects, the same system of taxation that was instituted close to a century ago—i.e., income derived from labor taxed heavily, business and investment profits taxed moderately, and capital gains taxed lightly—remains entrenched. retention of a twentieth-century tax system, however, makes little or no sense in the twenty-first century. in the subsections below, we explore (a) twenty-first-century tax reform in a changing labor market and (b) the anticipated effects associated with the institution of these tax reform measures. a. twenty-first-century tax reform in a changing labor market the technological era requires that congress reconsider the nature of the tax reform that it institutes. while congress has sought to foster the use of capital, it has done little to nurture the use of labor—even unintentionally (via the current tax rate structure), yet perversely, dissuading its use. in devising tax reform, congress should not institute measures that hinder technological advancement; after all, technological advancements have significantly raised most taxpayers’ standard of living, augmented leisure time, and considerably reduced mortality rates.221 at the same time, labor remains an essential component of a vibrant economy. without a knowledgeable, energetic, and committed workforce, capital production would stall, and the nation’s economic fabric would tatter. bearing in mind tax reform’s dual objectives of simultaneously promoting both technology 219 see internal revenue service data book, tbl.14 n.2 (2010), https://www.irs.gov/pub/irssoi/09databk.pdf [https://perma.cc/ym5a-yv4b]. (“the use of magnetic tapes for delivery of information returns was discontinued on december 31, 2008. information returns previously provided on magnetic tape were provided electronically through the filing information returns electronically system beginning on january 1, 2009.”). 220 for example, the service has essentially stopped printing information booklets and has instead posted virtually every communication on the internet. internal revenue serv., more people using irs.gov in 2015 filing season, irs says, 49 tax notes today 12 (2015). taxpayers can easily and quickly view or download any i.r.s. form, publication, or instruction booklet by visiting irs.gov. if taxpayers still need printed forms or instructions, they can place their order online at irs.gov/orderforms. 221 see lindsey burke & james sherk, automation and technology increase living standards, heritage found. (july 20, 2015), http://www.heritage.org/jobs-and-labor/report/automation-and-technology-increase-livingstandards#_ftnref9 [https://perma.cc/5y5g-e4a2] (“technological progress enables employees to produce vastly more goods and services with their labor. this increases their compensation because competitive labor markets compel employers to pay employees proportionately to their productivity.”); joel mokyr, chris vickers & nicolas l. ziebarth, the history of technological anxiety and the future of economic growth: is this time different?, 29 j. econ. persp. 3, 31–50 (2015) (detailing the value and wealth that technology generates). https://www.irs.gov/pub/irs-soi/09databk.pdf https://www.irs.gov/pub/irs-soi/09databk.pdf https://perma.cc/5y5g-e4a2 2018] 37 automation and the income tax and labor, congress should institute the following three-pronged strategy: (1) institute a universal progressive tax rate structure, (2) curtail subsidization of capital relative to labor, and (3) adopt alternative social security funding and disbursement mechanisms. the institution of these tax reform measures would establish an environment in which congress places capital and labor on equal footing, recognizing that they must function synergistically. 1. universal progressive tax rate structure as discussed above, over the course of the last century, capital gains have been taxed at much more favorable tax rates than ordinary income.222 although commentators have proffered numerous justifications for the capital gains tax preference, those justifications have not gone unchallenged. tomes have been written,223 colloquia convened,224 and election platforms orchestrated225 that directly speak to the advantages and disadvantages associated with the capital gains tax preference. these debates have touched upon a wide array of topics, including capital gains tax preference’s microeconomic and macroeconomic effects,226 behavioral impact upon taxpayers’ investment decisions,227 and ability to spur economic growth.228 while these debates have provided a more thorough understanding of how the capital gains tax preference came into being and the reasons it remains intact even today, rehashing them would be of little practical utility. instead, there is a new prism—built on an economic landscape where capital now dominates and labor’s importance has ebbed—through which the capital gains tax rate preference should be viewed and evaluated. this is an important exercise, informing whether the capital gains tax rate preference has outlasted its usefulness. when the capital gains tax rate preference was first instituted, capital in the form of machinery and intellectual property (e.g., patents and know-how) was in its infancy. for example, car engines existed, but they were rudimentary in nature. the nation remained largely agriculturally based and labor oriented. to propel economic growth, congress sought to spur capital investments. what better way to do this than to lessen the financial burden associated with the use of capital?229 222 see supra section ii.b. 223 see, e.g., cunningham & schenk, supra note 114; daniel shaviro, commentary, uneasiness and capital gains, 48 tax l. rev. 393 (1993); george zodrow, economic analyses of capital gains taxation, realizations, revenues, efficiency and equity, 48 tax l. rev. 419 (1993). 224 see, e.g., deborah h. schenk, colloquium on capital gains, 48 tax l. rev. 315 (1993). 225 see, e.g., ryan ellis, clinton and sanders propose highest capital gains tax rate in history, forbes (jan. 26, 2016) https://www.forbes.com/sites/ryanellis/2016/01/26/clinton-and-sanders-propose-highest-capitalgains-tax-rate-in-history/#43a5e98a1127 [https://perma.cc/4rm4-uspy]. 226 see, e.g., joint econ. comm., the economic effects of capital gains taxation (june 1997), https://www.jec.senate.gov/public/_cache/files/b3116098-c577-4e64-8b3f-b95263d38c0e/the-economic-effects-ofcapital-gains-taxation-june-1997.pdf [https://perma.cc/v5cr-mwt4]. 227 see, e.g., edward a. dyl, capital gains taxation and year-end stock market behavior, 32 j. fin. 165 (1977). 228 see, e.g., len burman, capital gains tax rates and economic growth (or not), forbes (mar. 15, 2012), https://www.forbes.com/sites/leonardburman/2012/03/15/capital-gains-tax-rates-and-economic-growth-ornot/#6998ca7a1e2e [https://perma.cc/an9d-wble]. 229 an example of this approach is embraced in i.r.c. § 1231. this code section permits taxpayers the best of two worlds: on the dispositions of their trade and business assets, if taxpayers experience overall gains, they secure a capital gains tax rate preference; conversely, on the dispositions of their trade and business assets, if they experience https://1.next.westlaw.com/link/document/fulltext?findtype=y&sernum=0104712551&pubnum=1247&originatingdoc=i6ccc9850652311dbbe1cf2d29fe2afe6&reftype=lr&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search) https://1.next.westlaw.com/link/document/fulltext?findtype=y&sernum=0104712551&pubnum=1247&originatingdoc=i6ccc9850652311dbbe1cf2d29fe2afe6&reftype=lr&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search) https://1.next.westlaw.com/link/document/fulltext?findtype=y&sernum=0104712552&pubnum=1247&originatingdoc=i6ccc9850652311dbbe1cf2d29fe2afe6&reftype=lr&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search) https://1.next.westlaw.com/link/document/fulltext?findtype=y&sernum=0104712552&pubnum=1247&originatingdoc=i6ccc9850652311dbbe1cf2d29fe2afe6&reftype=lr&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search) https://www.forbes.com/sites/ryanellis/2016/01/26/clinton-and-sanders-propose-highest-capital-gains-tax-rate-in-history/#43a5e98a1127 https://www.forbes.com/sites/ryanellis/2016/01/26/clinton-and-sanders-propose-highest-capital-gains-tax-rate-in-history/#43a5e98a1127 https://www.jec.senate.gov/public/_cache/files/b3116098-c577-4e64-8b3f-b95263d38c0e/the-economic-effects-of-capital-gains-taxation-june-1997.pdf https://www.jec.senate.gov/public/_cache/files/b3116098-c577-4e64-8b3f-b95263d38c0e/the-economic-effects-of-capital-gains-taxation-june-1997.pdf https://www.forbes.com/sites/leonardburman/2012/03/15/capital-gains-tax-rates-and-economic-growth-or-not/#6998ca7a1e2e https://www.forbes.com/sites/leonardburman/2012/03/15/capital-gains-tax-rates-and-economic-growth-or-not/#6998ca7a1e2e 38 [vol.10:1 columbia journal of tax law but, as previously pointed out, technological advances have eclipsed the traditional economic forces of yesteryear embodied in labor. while the equivalent of trillions of dollars has been spent promoting the use of capital in the form of various tax expenditures, the same level of resources has not been devoted to spurring the use of labor (see part 2, below). this annual spending cycle dedicated to capital must end; instead, to propel a nimble and capable workforce that harmoniously and symbiotically functions with capital, congress needs to make significant investments in labor. a starting point to treating capital and labor equally is via tax rates. in the twenty-first century, there is no compelling reason for income generated by capital to be treated any more favorably than income from labor. both should be subject to the same tax rates. by leveling the playing field in this fashion and eliminating its procapital bias, congress would send a loud and unambiguous message to the economic community: both capital and labor need to be vibrant. as technology advances, capital needs to evolve in a manner that can maximize labor’s potential; simultaneously, the workforce needs to evolve in a manner that can likewise maximize capital’s potential. until capital production can exist on its own and is wholly automated, labor remains an essential component of the economy. congress should therefore seek to cultivate it. having universal tax rates applicable to income (whether derived from labor or capital) is an important step forward in realizing this goal. 2. subsidization of capital relative to labor next, congress should curtail its spending on subsidies to promote capital and invest more in the promotion of labor. the tax law provides subsidies through tax expenditures—those deductions, credits, and exemptions in the code that are designed to achieve various social and economic goals.230 the current list of tax expenditures in the code is long and extensive.231 consider the largest of such expenditures: the code presently excludes the provision of employer-provided health-care insurance from the tax base.232 while there are presumably legitimate public policy objectives associated with this tax expenditure’s institution and retention, it significantly distorts the tax base and costs the treasury an estimated quarter of a trillion dollars annually in forgone revenue.233 overall losses, they are allowed ordinary loss treatment (and the avoidance of the capital loss limitation rules). under the code, no other types of assets are afforded such favorable tax treatment. 230 stanley s. surrey, federal income tax reform: the varied approaches necessary to replace tax expenditures with direct governmental assistance, 84 harv. l. rev. 352, 354 (1970). as defined under the congressional budget and impoundment control act of 1974 (budget act), tax expenditures are “revenue losses attributable to provisions of the federal tax laws which allow a special exclusion, exemption, or deduction from gross income or which provide a special credit, a preferential rate of tax, or a deferral of tax liability.” congressional budget and impoundment control act of 1974, pub. l. no. 93-344, § 3(3). 231 every year, the joint committee on taxation publishes a list of tax expenditures. the most recent, spanning 55 pages, is found in following report: joint comm. on tax’n, jcx-34-18, estimates of federal expenditures for fiscal years 2017–2021 (2018), https://www.jct.gov/publications.html?func=startdown&id=5095. 232 i.r.c. § 106. 233 see sean lowry, cong. research serv., health-related tax expenditures: overview and analysis 5 (jan. 8, 2016), https://fas.org/sgp/crs/misc/r44333.pdf [https://perma.cc/z5m2-3zmv] (“in fy2016, https://www.jct.gov/publications.html?func=startdown&id=5095 2018] 39 automation and the income tax while there are a number of tax expenditures in the code that subsidize capital and a number that subsidize labor, the subsidies to capital far outweigh those to labor. the five largest capital-related tax expenditures estimated for 2018 are as follows: (i) the reduced tax rate on dividends and capital gains, (ii) bonus depreciation, (iii) the deduction for mortgage interest, (iv) the exclusion of capital gains on the sale of a residence, and (v) the exclusion of capital gains at death.234 in contrast, the five largest labor-related tax expenditures estimated for 2018 are as follows: (i) the exclusion of benefits provided under cafeteria plans, (ii) credits for college tuition, (iii) the deduction for charitable contributions to educational institutions, (iv) the exclusion of miscellaneous fringe benefits, and (v) the exclusion of interest on state and local bonds for nonprofit and public educational facilities. 235 tables 3 and 4, below, detail the revenue loss associated with these expenditures projected for 2018. table 3: capital-related tax expenditures236 expenditure dollar amount (in billions) reduced tax rate on dividends and capital gains $128.7 bonus depreciation $62.6 deduction for mortgage interest $40.7 exclusion of capital gains on sale of residence $34.4 exclusion of capital gains at death $32.6 total $299.0 health tax expenditures are estimated to amount to $234.0 billion.”). 234 joint comm. on tax’n, supra note 231, at 36–38. 235 in selecting the largest expenditures related to labor, we relied on the joint committee report’s classifications of expenses relating to either “education and training” or “employment.” other expenditures that bear some relationship to labor were omitted because of their classification. for example, the earned income tax credit and various retirement benefits are classified as “income security” expenditures, and the exclusion of employer contributions for health care is classified as a “health” expenditure. see id. at 40–43. 236 id. at 36–38 (combining expenditures for corporations and individuals in dollar amounts). we omitted the 20 percent deduction under section 199a for this purpose, estimated to cost $34.8 billion for 2018, because serviceoriented businesses under the income threshold will be able to claim it, so it is unclear how much of the expenditure can be attributed to capital as opposed to labor. 40 [vol.10:1 columbia journal of tax law table 4: labor-related tax expenditures237 expenditure dollar amount (in billions) exclusion of benefits provided under cafeteria plans $34.3 credits for tuition for postsecondary education $19.3 deductions for charitable contributions to educational institutions $10.1 exclusion of miscellaneous fringe benefits $7.8 exclusion of bond interest for educational facilities $3.1 total $74.6 these numbers are revealing. in terms of the largest tax expenditures, congress currently spends four times more annually promoting the use of capital compared to labor. this disproportionate spending is anachronistic in nature, however, harkening back to a time period during which the economy was laborcentric as opposed to capitalcentric; in all likelihood, congress instituted these tax expenditures to invigorate capital use. for a whole host of reasons, including favorable tax policies, this congressional policy has proven wildly successful: capital, rather than labor, is now the dominant productive force in the nation’s economy.238 a top priority of the nation’s tax reform agenda should be to rethink and reform the current capital/labor dynamic. in today’s economic environment, there is no reason that congress should generously spend far more revenue promoting capital than labor. instead, congress should reverse the dollar amounts dedicated to these tax expenditures or, at the very least, handle them with parity. by eliminating (i) expensing and accelerated depreciation deductions, (ii) the tax rate preference for qualified dividends and capital gains, and (iii) section 1014 (which allows capital gains to escape tax at death), congress could curtail subsidization of capital purchases to the tune of billions of dollars.239 on the other side of the ledger sheet, congress should offer more robust credits, deductions, and exclusions related to educational expenditures;240 these sorts of measures would strengthen labor’s intellectual agility, making it a much more attractive commodity.241 3. alternative means to fund social security and dispense its benefits as discussed above in section iii.c., as labor income has gradually dwindled in recent 237 id. at 40–41 (combining expenditures for corporations and individuals in dollar amounts). we omitted the expenditure for “special tax provisions for employee stock-ownership plans,” estimated to cost $3.8 billion for 2018, because stock ownership is more closely related to capital despite this expenditure’s classification under “employment.” 238 piketty, supra note 201. 239 see, e.g., yoram margalioth, not a panacea for economic growth: the case of accelerated depreciation, 26 va. tax rev. 493 (2007) (advocating depreciation methods that match economic depreciation). 240 richard goode, educational expenditures and the income tax, in economics of higher education 281 (selma j. mushkin ed., 1962); david s. davenport, education and human capital: pursuing an ideal income tax and a sensible tax policy, 42 case w. res. l. rev. 793 (1992); brian e. lebowitz, on the mistaxation of human capital, 52 tax notes 825 (aug. 12, 1991). 241 for a discussion of potential expenditures congress could make to promote labor, see mazur, supra note 132, at 42-44. https://1.next.westlaw.com/link/document/fulltext?findtype=y&sernum=0101997626&pubnum=101217&originatingdoc=if20f368123ce11dbbab99dfb880c57ae&reftype=lr&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search) https://1.next.westlaw.com/link/document/fulltext?findtype=y&sernum=0101997626&pubnum=101217&originatingdoc=if20f368123ce11dbbab99dfb880c57ae&reftype=lr&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search) 2018] 41 automation and the income tax years, the share of payroll taxes as a percentage of overall tax revenues has correspondingly declined. if this downward trend in payroll tax revenue continues, it will place added pressure on the nation’s primary source of funding for retirement, social security, which studies indicate is already in financial jeopardy.242 thus, as a practical matter, as the role of labor becomes less important in the current economy, it makes less sense to rely solely on payroll taxes to fund retirement expenditures going forward.243 further, in the modern era, it is unclear why labor income and the subsequent receipt of social security benefits should continue to correspond. while congressional members commonly link payroll tax payments to funding of a defined-benefit retirement plan in the form of social security,244 this is not what happens in practice. congress does not set aside taxpayers’ payroll tax payments in a reserve and utilize this investment pool to satisfy the nation’s social security obligations. instead, payroll tax receipts are commingled with general tax receipts; and, together, this amalgamated whole is used to meet the government’s expenditure obligations.245 and unlike traditional retirement plans, payroll tax payments lack neutrality: those taxpayers whose life spans are shorter generally bear a larger tax burden than those taxpayers whose life spans are longer— and history has taught us that those with the shorter life spans tend to be poorer and people of color, while those with longer lifespans are likely to be financially well off and caucasian.246 studies also continually indicate that, due to taxpayers’ overall increasing longevity, there is a mismatch between payroll payments in and anticipated social security payments out.247 stripped down to its essentials, payroll taxes constitute an extra tax on labor masquerading as a retirementfunding mechanism. one alternative to social security is to replace it with a guaranteed, or “universal basic 242 see infra note 247and accompanying text. 243 see mazur, supra note 132, at 27-28 (discussing funding retirement insurance with less “labor-focused” taxes). 244 floyd norris, is it really a pension? it’s a problem, n.y. times (nov. 4, 2010), http://www.nytimes.com/2010/11/05/business/05norris.html (“if you look at social security as a pension plan, that result seems not only fair, but required. if you contribute more to a normal pension plan, you expect to get higher benefits. why else would you contribute? and social security taxes are often called contributions.”); alan l. gustman, thomas steinmeier & nahid tabatabai, the growth in social security benefits among the retirement age population from increases in the cap on covered earnings 1 (nat’l bureau of econ. research, working paper no. 16501, 2010), http://www.nber.org/papers/w16501.pdf [https://perma.cc/64sx-plxa] (“in addition, as opposed to an increase in the payroll tax rate, raising the tax ceiling creates a leak in the (future) finances of the system in the form of an increase in future benefit obligations to be paid to those at the top of the earnings distribution.”). 245 david john, misleading the public: how the social security trust fund really works, heritage found. (sept. 2, 2004), http://www.heritage.org/social-security/report/misleading-the-public-how-the-social-security-trustfund-really-works [https://perma.cc/8sk8-5fzn] (“there is no cash in the social security trust fund, and there never has been any. the social security trust fund is merely an accounting device . . . .”). 246 see, e.g., c. eugene steuerle, karen e. smith & caleb quakenbush, has social security redistributed to whites from people of color, urban inst. 1 (2012), http://www.urban.org/sites/default/files/alfresco/publicationpdfs/412943-has-social-security-redistributed-to-whites-from-people-of-color-.pdf [https://perma.cc/u7yr3g3y] (“when considered across many decades—historically, currently, and in the near future—social security redistributes from people of color to whites.”). 247 see, e.g., robert pear, social security’s financial health worsens, n.y. times (april 23, 2012), http://www.nytimes.com/2012/04/24/us/politics/financial-outlook-dims-for-social-security.html (“the social security trust fund will be exhausted in 2033, three years sooner than projected last year, the administration said. and medicare’s hospital insurance trust fund will be depleted in 2024, the same as last year’s estimate, it said.”). http://www.heritage.org/social-security/report/misleading-the-public-how-the-social-security-trust-fund-really-works http://www.heritage.org/social-security/report/misleading-the-public-how-the-social-security-trust-fund-really-works http://www.urban.org/sites/default/files/alfresco/publication-pdfs/412943-has-social-security-redistributed-to-whites-from-people-of-color-.pdf http://www.urban.org/sites/default/files/alfresco/publication-pdfs/412943-has-social-security-redistributed-to-whites-from-people-of-color-.pdf http://www.nytimes.com/2012/04/24/us/politics/financial-outlook-dims-for-social-security.html 42 [vol.10:1 columbia journal of tax law income” (ubi), payment.248 the central premise of the ubi proposal is to replace all government transfer payments—social security, medicaid, earned income tax credits, food stamps, etc.—with one lump sum payment for each individual.249 charles murray, for example, proposes an annual payment of $10,000 (paid in monthly installments), with an additional $3,000 that must be used to purchase health insurance.250 regardless of the amount, a key aspect of a ubi or other guaranteed income payment is that it would not be tied to work: every taxpayer would automatically be entitled to some minimum transfer payment regardless of employment status or earnings. that payment, however, would be the government’s sole contribution toward funding of retirement and other social needs.251 while the idea is not new, the ubi has been gaining more traction in recent years, with several cities implementing pilot programs both in the united states and abroad.252 it is beyond the scope of this article to fully explore the intricacies of current proposals for a ubi, but it is clear that policy makers should consider a radical restructuring of our current mechanism for funding retirement, health care, and basic needs for the poor.253 projections of the future funding of social security and medicare are already grim,254 and declining payroll tax revenues associated with diminishing labor income will only exacerbate this problem. a ubi, paired with enhanced tax revenue from higher taxes on capital, would provide a steady welfare safety net to withstand radical shifts in employment brought about by automation. b. implications associated with proposed tax reform tax reform measures touch upon many aspects of the economy. and while their macroeffects and micro-effects are often difficult to predict, there are some repercussions that can be readily anticipated.255 this subsection explores the anticipated consequences associated with the 248 see, e.g., charles murray, in our hands: a plan to replace the welfare state (2016). 249 as professors miranda perry fleischer and daniel hemel point out, the idea of a guaranteed income payment can be traced back at least as far as the late eighteenth century and more recently to economist milton friedman in his proposal for a “negative income tax.” see generally miranda perry fleischer & daniel jacob hemel, atlas nods: the libertarian case for a basic income, wis. l. rev. 1189 (2017). 250 charles murray, a guaranteed income for every american, wall st. j., june 3, 2016, at c1. murray’s proposal would guarantee $10,000 for adults earning up to $30,000, but the amount would gradually phase down (through a surtax) to $6,500 for those earning $60,000 of earned income or more. 251 there are advantages and disadvantages associated with the ubi proposal. on the one hand, it would (ideally) ensure that every taxpayer could afford basic living expenses, and it would vastly reduce the enforcement costs associated with the current welfare regime because eligibility requirements would not need to be policed. on the other hand, critics have noted a number of potential drawbacks, the biggest of which is that a ubi would likely require an increase in tax rates (even accounting for the elimination of other entitlement programs). see fleischer & hemel, supra note 249 (estimating that a $10,000 ubi would require a tax rate increase of 10–11 percent, after accounting for the elimination of existing entitlement programs). 252 see fleischer & hemel, supra note 249 (describing trial programs involving cash transfers in finland; kenya; the netherlands; and oakland, california). 253 another option would be increasing payroll taxes on capital income. see mazur, supra note 132, at 3033. 254 see supra note 247. 255 by way of example, consider the exclusion from income of interest on state and local bonds. i.r.c. § 103. as a result of this exemption, states and local governments can much more readily borrow funds secured by lower carrying costs. see, e.g., grant a. driessen, cong. res. serv., tax-exempt bonds: a description of state and local government debt, at summary (2016), https://fas.org/sgp/crs/misc/rl30638.pdf [https://perma.cc/l37c-t6ks] (noting that due to the exclusion from income of interest on state and local bonds, 2018] 43 automation and the income tax tax reforms proposed. although congress understandably wants to promote capital use and technological innovations, it does not want to weaken or undermine the vibrancy of the nation’s labor force. thus, it should institute one or more of the tax reform measures enumerated above: institute a universal progressive tax rate structure, curtail subsidization of capital relative to labor, and adopt alternative social security funding and disbursement mechanisms. the likely effects of such tax reform would be threefold: (1) labor’s use would be buoyed or, at the very least, stabilized; (2) administrative efficiencies would be gained; and (3) wealth equity would be enhanced. 1. labor’s use would be buoyed or stabilized elementary economics teaches that if something costs less, demand is greater.256 assuming this axiom’s validity, if congress were to repeal the payroll tax, labor would cost less, making its use more economically attractive. consider the implications for both employers and employees. for starters, payroll tax elimination would enable employers to have greater financial latitude to hire more employees. for every $100 of wages, an employer could secure $7.65 of savings in the absence of a payroll tax. these tax savings could be used for a variety of purposes, including the retention of a larger labor force. the math is simple: for every thirteen employees that a business currently hires (assuming the same wage), the elimination of the 7.65 percent payroll tax would essentially enable it to hire a fourteenth employee for no additional out-of-pocket cost (i.e., 13 x 7.65 percent = 99.45 percent). for employees, the anticipated effect of eliminating the payroll tax is somewhat more indeterminate. on the one hand, payroll tax elimination should reduce the cost of labor, increasing its demand; this increased demand should result in higher wages being paid. on the other hand, assuming revenue neutrality, payroll tax revenue would have to come from an alternative source, such as higher marginal income tax rates and/or the introduction of a new revenue source (e.g., carbon tax). until congress identifies this alternative source, the overall net economic effect on employees remains uncertain.257 states and local governments can much more readily borrow funds secured by lower carrying costs, “this tax exemption of interest income is granted because it is believed that state and local capital facilities will be underprovided if state and local taxpayers have to pay the full cost.”). not all effects of tax reform are easy to predict. consider the deduction for home interest. i.r.c. § 163(h)(3). while the real estate lobby claims that this deduction entices people to purchase homes, there is scant empirical evidence that this is actually the case. for excellent pieces that present this point of view, see dennis j. ventry jr., the accidental deduction: a history and critique of the tax subsidy for mortgage interest, 73 l. & contemp. probs. 233 (2009); bruce barlett, the sacrosanct mortgage interest deduction, n.y. times (aug. 6, 2013), https://economix.blogs.nytimes.com/2013/08/06/the-sacrosanctmortgage-interest-deduction/ [https://perma.cc/7rmn-ljc2] 256 see, e.g., catherine rampell, why is turkey cheaper when demand is higher?, n.y. times (nov. 19, 2013), http://www.nytimes.com/2013/11/24/magazine/why-is-turkey-cheaper-when-demand-is-higher.html (“consumers might get more price-sensitive during periods of peak demand and do more comparison-shopping, so stores have to drop their prices if they want to capture sales.”). 257 the effect of higher marginal tax rates remains unsettled: on the one hand, there are many economists who contend that higher marginal tax rates drive taxpayers to pursue more leisure-oriented activities (i.e., the substitution effect); on the other hand, there are other economists who argue that higher marginal tax rates lead taxpayers to work more to secure the same net take-home pay (i.e., the income effect). orley ashenfelter & james heckman, the estimation of income and substitution effects in a model of family labor supply, 42 econometrica 73 (1974). https://economix.blogs.nytimes.com/2013/08/06/the-sacrosanct-mortgage-interest-deduction/ https://economix.blogs.nytimes.com/2013/08/06/the-sacrosanct-mortgage-interest-deduction/ 44 [vol.10:1 columbia journal of tax law on balance, a reduction or elimination of the payroll tax should have a positive bearing on the economy and, in particular, provide vibrancy to the labor market. as employers ramped up hiring, the nation’s workforce would benefit; meanwhile, higher wages combined with a larger tax burden (be it in the form of income tax, carbon tax, or other tax) would essentially leave employees in the same position that they were in prior to the institution of this proposed tax reform measure. ultimately, an economic equilibrium point would be reached in which labor’s use would be either buoyed or, at the very least, stabilized. further, congress could use the projected revenue savings from no longer subsidizing business and investment profits to augment educational opportunities. study after study reports that the united states is lagging in training the next generation of engineers and scientists.258 congress therefore needs to send a signal that this is where the future lies and that, to this end, it is willing to invest in the human capital of its youth. how exactly this objective is achieved is the fodder of a vast array of analysis in the educational arena. suffice it to say that congress should be creative in its approaches and utilize the code as a tool to promote investments in human capital. a myriad of opportunities exists; none of which is the unequivocal answer. 2. administrative efficiencies would be gained a major contributing factor to the code’s girth and complexity is the preferential tax rate treatment of capital gains. the code is replete with sections, subsections, clauses, and subclauses that elaborate when and if something is a capital asset and the appropriate tax treatment associated with this label.259 these are not easy-to-understand provisions; to the contrary, some of the code’s most challenging attributes relate to capital gains treatment and the concomitant computations that these determinations engender.260 if congress eliminated the capital gains tax rate preference, administrative efficiencies would result. if all income was subject to the same tax rates, taxpayers would have an easier time comprehending their tax burden. with a few keystrokes on their computer or numeric entries on their smartphone, taxpayers could quickly secure a good idea of their anticipated annual tax burden. furthermore, they would no longer have to dwell on whether they should hold onto their capital investments for a particular period of time (e.g., more than one year) 261 or how deductions for certain charitable contributions might be limited.262 to be sure, even if congress eliminated 258 see drew desilver, u.s. students’ academic achievement still lags that of their peers in many other countries, pew res. center.: facttank, feb. 15, 2017, http://www.pewresearch.org/fact-tank/2017/02/15/u-sstudents-internationally-math-science/ [https://perma.cc/gs5k-vs4v] (“recently released data from international math and science assessments indicate that u.s. students continue to rank around the middle of the pack, and behind many other advanced industrial nations.”); katherine beard, behind america’s decline in math, science and technology, u.s. news (nov. 13, 2013), https://www.usnews.com/news/articles/2013/11/13/behind-americasdecline-in-math-science-and-technology [https://perma.cc/8cwm-bssk] (“america has fallen far from its place as a leader in math and science, experts said during a science, technology, engineering and math (stem) diversity symposium on capitol hill . . . .”). 259 see e.g., i.r.c. §§ 1211, 1212, 1221, 1222, 1231, 1234, 1239, 1245, 1248, and 1250. 260 see generally samuel a. donaldson, the easy case against tax simplification, 22 va. tax rev. 645, 713–22 (2003); john w. lee, critique of current congressional capital gains contentions, 15 va. tax rev. 1 (1995). 261 i.r.c. § 1222(3). 262 i.r.c. § 170(e). 2018] 45 automation and the income tax the capital gains tax rate preference for some taxpayers, the code would remain shrouded in mystery—however, for far more taxpayers, its enigmatic veil would be lifted. repealing the capital gains tax preference would also eliminate socially wasteful tax planning resulting from taxpayers and their advisers seeking out strategies to recharacterize labor income as capital gains.263 furthermore, the i.r.s. would be a benefactor of a unified tax rate structure. a by-product of eliminating the distinction between capital gains and ordinary income tax treatment is that fewer resources would need to be dedicated not only to training i.r.s. personnel to identify capital assets but also to uncovering taxpayer-exploitation strategies. in addition, the i.r.s. could redirect resources away from monitoring whether taxpayers were being compliant in this sphere of tax practice and toward other pressing needs (e.g., identity theft and privacy concerns) that are currently besieging the agency and the general public.264 3. wealth equity would be enhanced over the last several decades, there has been compelling evidence that the vast majority of the nation’s income has inured disproportionately to the wealthy.265 furthermore, it is likewise clear that the code has played a contributory role in perpetuating wealth inequity.266 indeed, for the wealthiest americans, only a small portion of income stems from salaries—the majority of income is passive, taxed at preferential rates.267 while there is no single panacea for reducing wealth inequality, reforming the code 263 see, e.g., supra notes 185-194 and accompanying text. 264 see dennis j. ventry jr., why steven mnuchin wants a stronger i.r.s., n.y. times (mar. 27, 2017), https://www.nytimes.com/2017/03/27/opinion/why-steven-mnuchin-wants-a-stronger-irs.html: unfortunately, the seemingly endless cuts have compromised the agency’s ability to collect taxes, combat identity theft, prosecute tax criminals and deliver taxpayer services. the size of the audit staff has fallen by 30 percent, resulting in a decades-low audit rate of 0.7 percent for individual taxpayers. for large corporations, the number of returns audited in 2016 fell by nearly half compared to 2006, to 9.5 percent from 17 percent. meanwhile, the enforcement unit lost 7,000 employees. the criminal investigations unit has also suffered staff reductions, resulting in fewer cases, prosecutions and convictions. 265 see emmanuel saez & gabriel zucman, wealth inequality in the united states since 1913: evidence from capitalized income tax data (nat’l bureau of econ. research, working paper no. 20625, 2014), https://gabrielzucman.eu/files/saezzucman2014.pdf [https://perma.cc/495j-52kv] (“the rise of wealth inequality is almost entirely due to the rise of the top 0.1% wealth share, from 7% in 1979 to 22% in 2012—a level almost as high as in 1929. the bottom 90% wealth share first increased up to the mid-1980s and then steadily declined. the increase in wealth concentration is due to the surge of top incomes combined with an increase in saving rate inequality.”); emmanuel saez, striking it richer: the evolution of top incomes in the united states, at 1st page. (unnumbered) (2013), http://eml.berkeley.edu//~saez/saez-ustopincomes-2012.pdf [https://perma.cc/p5ss-gzx9] (“top 1% incomes grew by 31.4% while bottom 99% incomes grew only by 0.4% from 2009 to 2012.”). 266 wojciech kopczuk, recent evolution of income and wealth inequity, comments on piketty’s capital in the twenty-first century, 68 tax l. rev. 545 (2015); beverly moran, wealth redistribution and the income tax, 53 how. l.j. 319 (2010). 267 see, e.g., sanjay sanghoee, fantasy cliff: debunking the biggest myths about the bush tax cuts and the rich, huffpost (jan. 30, 2012, 10:45 am), https://www.huffingtonpost.com/sanjay-sanghoee/bush-taxcuts_b_2207472.html [https://perma.cc/cvl7-32tw] (“unlike most low or middle income americans, the rich make a substantial portion of their money from passive income (on average, the top 400 earners in the us make 59 percent of their income from capital gains or dividends versus only 9 percent from salaries), which is taxed at a preferential rate of 15 percent.”). https://www.nytimes.com/2017/03/27/opinion/why-steven-mnuchin-wants-a-stronger-irs.html http://topics.nytimes.com/your-money/credit/identity-theft/index.html?inline=nyt-classifier https://gabriel-zucman.eu/files/saezzucman2014.pdf https://gabriel-zucman.eu/files/saezzucman2014.pdf https://perma.cc/p5ss-gzx9 https://1.next.westlaw.com/link/document/fulltext?findtype=y&sernum=0353597605&pubnum=0001531&originatingdoc=if157dac1076711e498db8b09b4f043e0&reftype=lr&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search) https://1.next.westlaw.com/link/document/fulltext?findtype=y&sernum=0353597605&pubnum=0001531&originatingdoc=if157dac1076711e498db8b09b4f043e0&reftype=lr&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search) https://www.huffingtonpost.com/sanjay-sanghoee/bush-tax-cuts_b_2207472.html https://www.huffingtonpost.com/sanjay-sanghoee/bush-tax-cuts_b_2207472.html 46 [vol.10:1 columbia journal of tax law constitutes a viable starting point. consider that tax expenditures inure disproportionately to upperincome taxpayers268 and, furthermore, that the vast majority of business and investment income plus capital gains is earned by higher-income earners.269 axiomatically, the converse must be true as well: the less-well-to-do enjoy fewer tax expenditures, and, furthermore, they derive their income primarily through labor. left untouched, the code thus appears poised to worsen the existing wealth gap. to close or, at the very least, reduce the wealth gap, congress must recognize that technological advances are fundamentally changing the economic landscape. relative to labor, capital has become the dominant force. in this environment, the use of capital no longer needs to be subsidized; instead, labor in the form of human capital needs to be cultivated. two ways that this can be achieved are as follows: first, congress must overhaul the nation’s tax expenditures and dedicate a larger proportion to strengthening human capital; second, taxing income at similar rates—no matter how derived—would help narrow existing wealth disparities. v. conclusion when it comes to fundamental tax reform, congress can no longer afford to ignore the transformation of the nation’s economic landscape. relative to labor, capital has catapulted economic productivity to new heights—a trend that will undoubtedly continue and likely accelerate. and while the interplay between capital and labor has many important public policy implications, perhaps none is as important as the direction that tax reform should take. for close to a century, congress has harbored what amounts to a fixation on taxing the income that labor produces. it has proven to be a plentiful “crop” that historically was easy to harvest. but as labor’s yields dwindle and, in some cases, entirely dry up, bountiful new crops are emerging in the form of business profits, investment income, and capital gains. congress must therefore revisit how it tends to these crops and shares in taxpayers’ harvest of them. to state the obvious, in the nation’s economic field, capital has overtaken labor. the only unanswered question is whether congress will strategically tend this field and cultivate it to the nation’s advantage. to preserve the code’s sanctity, the conclusion is elementary. instead of taxing income from labor heavily, business profits and investment income moderately, and capital gains lightly 268 see cong. budget office, the distribution of major tax expenditures in the individual income tax system 2 (2013), http://cbo.gov/sites/default/files/cbofiles/attachments/43768_distributiontaxexpenditures.pdf [https://perma.cc/caz2-85qt] (“in calendar year 2013, more than half of the combined benefits of those tax expenditures will accrue to households with income in the highest quintile (or one-fifth) of the population (with 17 percent going to households in the top 1 percent of the population), cbo estimates. in contrast, 13 percent of those tax expenditures will accrue to households in the middle quintile, and only 8 percent will accrue to households in the lowest quintile . . . .”). 269 see internal revenue serv., cumulative 2015 filing season information for tax returns processed by the irs through may 28, 2015, https://www.irs.gov/pub/irs-soi/15inweek21.xls [https://perma.cc/by8x-w3hx] (of those taxpayers who have adjusted gross incomes in excess of $10 million, showing that 39.6 percent of their income was comprised of capital gains). see also tony nitti, why republicans should embrace a 28% tax on capital gains, forbes (jan. 20, 2015) (“these preferential rates are expected to save taxpayers $540 billion over the next four years. and of that $540 billion in savings, approximately 85% of it will inure to the wealthiest 2%.”). https://perma.cc/caz2-85qt https://www.irs.gov/pub/irs-soi/15inweek21.xls 2018] 47 automation and the income tax (or not at all), all income—regardless of source—must bear a similar tax burden.270 adhering to this straightforward approach would, for purposes of the code, be in line with restoring the concept of income to its theoretical roots. this would have several virtues, including resurrecting labor’s economic role in the economy, simplifying tax administration, and fostering equity. transforming the code into a more efficient revenue-raising tool will strengthen the nation’s fiscal solvency and, thus, ensure the country’s enduring vitality. 270 see richard goode, the individual income tax 11 (1964) (calling for a system of uniform taxation); walter j. blum, federal income tax reform—twenty questions, 41 taxes 672, 680–82 (1963) (same). there are commentators who instead advocate for “optimal tax.” see, e.g., eric m. zolt, the uneasy case for uniform taxation, 16 va. tax rev. 39, 41 (1996): there are at least three reasons [that optimal taxation is better than uniform taxation]. first, advances in economic and political theory throw new light on the design of tax systems and the usefulness of nonuniform taxation. second, low compliance rates for certain types of income undermine the fairness and efficiency of tax systems where nonuniform tax treatment could significantly improve the ability of the taxing authorities to collect and enforce taxes. third, the increasing international flows of capital severely undermine the validity of a uniform tax system, particularly in small countries with open economies. 48 [vol.10:1 columbia journal of tax law appendix271 271 this chart was prepared with data from cch, a historical look at capital gains rates, https://wolterskluwer.com/binaries/content/assets/wk/pdf/news/ta/historicalcapitalgainsrates.pdf [https://perma.cc/56nh-3gu4], and the tax foundation, federal individual income tax rates history, https://files.taxfoundation.org/legacy/docs/fed_individual_rate_history_nominal.pdf [https://perma.cc/px24-n92v]. 0 10 20 30 40 50 60 70 80 90 100 19 13 19 16 19 19 19 22 19 25 19 28 19 31 19 34 19 37 19 40 19 43 19 46 19 49 19 52 19 55 19 58 19 61 19 64 19 67 19 70 19 73 19 76 19 79 19 82 19 85 19 88 19 91 19 94 19 97 20 00 20 03 20 06 20 09 20 12 20 15 20 18 historical tax rates top individual rate long-term capital gains rate https://wolterskluwer.com/binaries/content/assets/wk/pdf/news/ta/historicalcapitalgainsrates.pdf https://perma.cc/56nh-3gu4 https://files.taxfoundation.org/legacy/docs/fed_individual_rate_history_nominal.pdf articles automation and the income tax jay a. soled & kathleen delaney thomas0f* formatted-mehrotra “from contested concept to cornerstone of administrative practice”: social learning and the early history of u.s. tax withholding ajay k. mehrotra* * executive director and research professor, american bar foundation, chicago, il. earlier versions of this essay were presented at the university of minnesota law school’s symposium on “reforming the irs,” and the ucla law school’s tax policy colloquium. thanks to the participants at those venues, especially steve bank, kristin hickman, steve johnson, leandra lederman, jason oh, and joe thorndike for their insightful comments. and thanks to my indiana university maurer school of law research assistants, rian dawson, jayce born, and jessica laurin, as well as the editors and staff of the columbia journal of tax law. © 2016 mehrotra. this is an open-access publication distributed under the terms of the creative commons attribution license, https://creativecommons.org/licenses/by/4.0/, which permits the user to copy, distribute, and transmit the work provided that the original authors and source are credited. 2016] social learning and the early history of u.s. tax withholding 145 i. introduction .................................................................................................... 146 ii. the existing literature and the significance of the early history of withholding ............................................................................. 149 iii. the civil war income tax and the origins of american withholding ..................................................................................................... 151 a. learning from the british .................................................................................. 153 b. the war context ................................................................................................ 155 c. the supreme court’s support for withholding ................................................ 156 iv. the 1913 income tax and the beginnings of u.s. “stoppage at the source” ........................................................................................................ 157 a. the 1913 comprehensive system of collection ............................................... 158 b. echoes of resistance ......................................................................................... 160 c. the legal significance of withholding ............................................................. 161 v. the dominance of information reporting ...................................... 162 a. growing opposition to withholding ................................................................. 162 b. reforms to rescue information reporting ........................................................ 164 c. social security and the return of withholding ................................................. 166 vi. conclusion ........................................................................................................ 167 146 columbia journal of tax law [vol.7:144 i. introduction the process of establishing a stable and effective system of taxation is a hallmark of nearly all modern states. indeed, securing the ability to tax is a sine qua non of the historical process of state-building.1 from ancient athens to the modern united states, nearly all societies have been concerned with the process of successfully collecting tax revenues.2 one critical concern that all taxing authorities face is limiting the “tax gap”— the difference between what should be paid voluntarily and on time and the amount that is actually paid.3 among the many modern administrative innovations adopted to facilitate effective tax compliance, arguably none has been more significant than the use of thirdparty reporting and tax withholding. since at least the early nineteenth century, when great britain first adopted a crude form of withholding as part of its national income tax,4 governments have increasingly relied on harnessing the knowledge and power of third parties to increase income tax compliance. as a result, employers, financial institutions, and business corporations have become instrumental remittance vehicles and reporting agents for nearly all modern taxing agencies. in most developed nation-states today, some form of withholding has become a socially accepted part of the tax system. although tax protests of one sort or another have been an endemic part of u.s. history,5 today most ordinary americans seem to accept our current system of income tax collections. national lawmakers, for their part, have gone further in praising the present day system. one described withholding as “the cornerstone of the administration of our individual income tax.”6 tax scholars, likewise, have documented how vital withholding and information reporting have been to generating tax revenue.7 yet, like most administrative achievements, the effective implementation of information reporting and tax withholding did not occur quickly or easily. when the united states originally adopted withholding as part of the civil war income tax—the nation’s first federal income tax—this novel process of tax collection was highly contested and contingent. not only was there tremendous political and social opposition, legal challenges to the process reached the u.s. supreme court. in a significant—yet 1 phillip t. hoffman, what do states do? politics and economic history, 75 j. econ. hist. 303 (2015). for an introduction to the vast literature on taxation and state-building, see generally john l. campbell, the state and fiscal sociology, ann. rev. soc., 1993, at 163–85. 2 carolyn webber & aaron b. wildavsky, a history of taxation and expenditure in the western world 107 (1986). 3 u.s. gov’t accountability office, gao-10-968, tax gap: irs can improve efforts to address tax evasion by networks of businesses and related entities 7 (2010). 4 an exposition of the act for a contribution on property, professions, trades, and offices; in which the principles and provisions of the act are fully considered, with a view to facilitate its execution, both with respect to persons chargeable, and persons liable to the tax by way of deduction, and the officers chosen to carry it into effect (london, i. gold 1803); see also piroska soos, the origins of taxation at source in england (1997). 5 see generally romain d. huret, american tax resisters (2014). 6 tax compliance act of 1982 and related legislation: hearing on h.r. 6300 before the h. comm. on ways & means, 97th cong. 162 (1982) [hereinafter hearing]. 7 see, e.g., leandra lederman, statutory speed bumps: the role that third parties play in tax compliance, 60 stan. l. rev. 695 (2007); joel slemrod, does it matter who writes the check to the government? the economics of tax remittance, 61 nat’l tax j. 251 (2008); piroska soos, self-employed evasion and tax withholding: a comparative study and analysis of the issues, 24 u.c. davis l. rev. 107, 121 (1990). 2016] social learning and the early history of u.s. tax withholding 147 understudied—legal decision, the court upheld the constitutionality of withholding. 8 still, social resistance to the policy persisted.9 the issue became moot when the civil war income tax was eventually repealed after the war, but opposition to the growing administrative powers of tax collection remained.10 in subsequent decades, tensions over the use of information reporting and tax withholding waxed and waned in parallel with the development of the modern u.s. income tax. in 1913, when the federal income tax became a permanent part of the u.s. tax system—on the heels of the ratification of the sixteenth amendment—congress initially enacted a crude form of tax withholding and information reporting.11 it was soon eliminated, however, due to vociferous opposition from business interests and limited federal administrative capacity.12 between the two world wars, when tax rates remained relatively low and the income tax affected mainly the wealthy elite, ersatz types of thirdparty reporting aroused little opposition.13 it was not until the current tax payment act of 1943 helped institutionalize a mass income tax and the process of withholding that strong objections once again rose to the fore.14 although today some individuals and businesses may object to tax withholding and third-party reporting, these administrative methods have generally become a socially accepted and politically entrenched part of our tax system.15 not only have lawmakers celebrated withholding as an administrative “cornerstone,” 16 but most everyday americans appear to believe that employers, financial institutions, and business corporations should be able to collect and remit tax dollars and convey important tax information to the government. thus, while tax withholding and information reporting have had a contested and contingent past, they both appear to be stable and accepted parts of the present-day u.s. tax system.17 the evolution of withholding and third-party reporting raises a series of important historical questions: how did a contested administrative concept become an accepted and celebrated method of tax collection? what were the pivotal periods of administrative reform during this seemingly path-dependent process? why were activists, commentators, and lawmakers opposed to the growth of this administrative 8 united states v. balt. & ohio r.r., 84 u.s. 322 (1872). 9 see sheldon d. pollack, the first national income tax, 67 tax law., winter 2014, at 16. 10 ajay k. mehrotra, making the modern american fiscal state: law, politics, and the rise of progressive taxation 1877-1929 (2013); robert stanley, law and the dimensions of order: origins of the federal income tax (1991). 11 act of oct. 3, 1913, ch. 16, 38 stat. 114, 169 (1913). 12 war revenue act of 1917, ch. 63, § 1204(2), 40 stat. 300, 332 (1917); see roy g. blakey, the new revenue act, 6 am. econ rev. 837, 842 (1916) (“perhaps no feature of the income tax has caused more unfavorable criticism than the stoppage-at-the-source provision, which throws much of the burden of collecting the government’s revenues upon banks, trust companies, corporations, and other agents.”). 13 anuj c. desai, what a history of withholding tells us about the relationship between statutes and constitutional law, 108 nw. u. l. rev. 859, 896–99 (2014). 14 id. at 899-900; current tax payment act of 1943, pub. l. 68, ch. 120, 57 stat. 126 (june 9, 1943). 15 see, e.g., desai, supra note 13. but see richard l. doernberg, the case against withholding, 61 tex. l. rev. 595 (1982) (scholar acknowledges that withholding has become entrenched, but argues that it should be replaced). 16 hearing, supra note 6. 17 as tax expert bruce bartlett has noted, “it is highly unlikely that withholding will ever be abolished.” bruce bartlett, tax withholding still controversial after 70 years, n.y. times economix blog, http://economix.blogs.nytimes.com/2013/10/22/tax-withholding-still-controversial-after-70-years/?_r=0 [https://perma.cc/wb52-93sn]. 148 columbia journal of tax law [vol.7:144 practice? and, how did reformers and government officials overcome this hostility during critical junctures in the development of this important administrative achievement? these questions frame the historical analysis in this article. these questions are not merely about narrow, academic interests. examining the early history of u.s. income tax withholding and third-party reporting may provide some traction on broader questions about the social, political, and economic conditions that are necessary for effective administrative tax reform. if one of the central aims of this law review symposium on “reforming the irs” is to imagine what tax administrative reform might look like, it may be instructive to look back and understand empirically how the united states was able to adopt and maintain one of its most successful administrative reforms—the adoption and permanent establishment of income tax reporting and withholding. one of the principal aims of this article is to attend to the early u.s. history of income tax withholding and third-party information reporting. building upon earlier studies, this article contends that examining the pre-1943 adoption of income tax withholding is critical not only to a deeper historical understanding of how information reporting and withholding were transformed from a contested concept to an administrative cornerstone, but also to our future expectations of administrative and bureaucratic reform. more specifically, this article contends that significant administrative reform has occurred historically through a process of incremental institutional change and what political scientist hugh heclo calls “social learning.” 18 rarely in american administrative history do we see a dramatic or radical alteration of bureaucratic processes or procedures. instead, what the history of information reporting and withholding illustrates is that reformers and policymakers developed key administrative advancements gradually by puzzling over policy options based on past ideas and experiences as well as new information.19 although wars and national emergencies have often been triggers for dramatic changes to governance and administration, these events have also brought with them great uncertainty and complex problems and puzzles. 20 faced with such grave uncertainty, policy analysts and lawmakers have turned to past practices and ideas to solve pressing problems. they have engaged in social learning. leading tax experts and government officials have relied on the legacy of past policies and the previous social and political responses to pressing problems to understand how best to build an effective tax collection system. this historical story unfolds in five acts. the first briefly summarizes the existing literature on tax withholding. in the process, it explains why a pre-1943 history of withholding is particularly pertinent. each of the article’s subsequent four parts investigates one of the critical junctures in the early development of modern administrative practices. part iii examines the beginnings of the ephemeral system of 18 hugh heclo, modern social politics in britain and sweden (1974); see also peter a. hall, policy paradigms, social learning, and the state: the case of economic policymaking in britain, 25 comp. pol. 275 (1993). 19 hall, supra note 18. peter hall defines “social learning” more precisely as “a deliberative attempt to adjust the goals or techniques of policy in response to past experience and new information. learning is indicated when policy changes as the result of such a process.” id. at 278. 20 see generally w. elliot brownlee, federal taxation in america: a short history (2004). 2016] social learning and the early history of u.s. tax withholding 149 income tax withholding during the u.s. civil war. it explains how congress, the courts, and the bureau of internal revenue (bir)—the forerunner to the internal revenue service—all helped to initiate the process of “social learning” that would come to inform subsequent generations of administrators and reformers. part iv turns to the 1913 income tax and shows how the civil war legacy shaped the adoption of the first system of withholding and information reporting. during this critical period, reformers and state-builders were able to elaborate upon the early success of the civil war income tax and the supreme court’s previous support for withholding to quell opposition to the new “stoppage at the source” system. not only did the concept of using third parties as quasi-treasury officials have the formal support of the courts, but the material achievements of this process taught subsequent policymakers an important lesson about successful administrative innovation. part v explores the interregnum between the use of information reporting as part of the 1913 income tax and the institutional establishment of mandatory withholding in 1943. this period is critical for what it can tell us about the rising opposition to income tax withholding. this period was also when the advent of social security in 1935 contributed to a learning process that eventually paved the way for our permanent system of income tax withholding. thus, between the two world wars, the administrative process of withholding went through an episodic era when its future fortunes were highly uncertain. this section seeks to make sense of the rise, fall, and return of income tax withholding and information reporting. this article concludes with an assessment of how, during the post-wwii era, withholding and information reporting became an entrenched part not only of our tax system, but also of american political and legal culture. the conclusion also reflects on how the historical evolution of withholding and information reporting may help us better understand the current and future possibilities for administrative reforms. ii. the existing literature and the significance of the early history of withholding other scholars have duly noted the importance of third-party reporting and income tax withholding. public finance economists, for example, have empirically documented how more stringent forms of withholding and information reporting generally increase tax compliance.21 tax law scholars have similarly documented how third-party reporting provides a structural mechanism to reduce tax evasion and facilitate compliance.22 some scholars have even theorized that the american combination of inexact withholding and tax filing reconciliation may have ancillary political and social benefits beyond increasing compliance.23 nearly all of these accounts are premised on the notion that the u.s. tax system operates under what political scientist margaret levi has dubbed “quasi-voluntary compliance,” a system of compliance that combines individual voluntariness with potential compulsion by the state.24 21 see, e.g., ann d. witte & diane f. woodbury, the effect of tax laws and tax administration on tax compliance: the case of the u.s. individual income tax, 38 nat’l tax j. 1 (1985); slemrod, supra note 7. 22 lederman, supra note 7. 23 lawrence zelenak, learning to love form 1040 (2013). zelenak contends that the present u.s. system of inexact withholding and tax filing reconciliation has the potential to increase a sense of civic engagement and fiscal citizenship. id. at 111–125. 24 see generally margaret levi, of rule and revenue (1997). 150 columbia journal of tax law [vol.7:144 indeed, withholding and third-party reporting are both crucial catalysts in supporting a quasi-voluntary system of tax compliance. as most students of u.s. taxation know, the use of withholding and third-party reporting curtail, and in some cases almost eliminate, the underreporting of taxable individual income. according to irs tax gap studies, only one percent of wages and salaries, which are remitted through withholding, are underreported. similarly, only four percent of taxable interest and dividends, which are governed by third-party information reporting requirements, are misreported.25 moreover, tax withholding and third-party reporting are responsible for a significant portion of annual public revenues. scholarly estimates suggest that withholding alone accounts for roughly 70% of all annual tax income tax receipts.26 these figures and the existing literature illustrate the critical role that withholding and information reporting play in our existing tax system. table 1: compliance estimates for selected types of personal income, 200127 type of personal income reported net income as a percentage of true net income from this source percentage of total individual income tax underreporting contributed by this item wages and salaries 99 5 pensions and annuities 96 2 interest and dividends 96 2 capital gains 88 6 partnerships and s corporations 82 11 nonfarm proprietor income 43 35 farm net income 28 3 despite the acknowledged importance of information reporting and withholding, few scholars have examined the historical origins and development of these concepts. those that have generally use the adoption of mandatory withholding in 1943 as a case study to test empirically some larger socio-legal or political theory. for example, professor anuj c. desai has recently explored whether the current tax payment act of 1943 and the establishment of withholding can be depicted as a “superstatute” within existing legal and constitutional theories. 28 likewise, economic historian charlotte twight has investigated the evolution of federal income tax withholding to study how public choice theory, or what twight refers to as a “transaction-cost” framework, can 25 see infra table 1. internal revenue serv., tax gap update, individual income tax underreporting gap estimates, tax year 2001 (2007), https://www.irs.gov/pub/irs-utl/tax_gap_update _070212.pdf [https://perma.cc/x57n-lp65]. 26 robert higgs, wartime origins of modern income-tax withholding, independent institute (dec. 24, 2007), http://www.independent.org/newsroom/article.asp?id=2092 [https://perma.cc/973p-gt4x]. 27 internal revenue serv., supra note 25. 28 desai, supra note 13 (determining that the current tax payment act of 1943 is in some ways a “superstatute,” but not in the way that the term is conventionally defined). for more on the conventional definition of a “superstatute,” see generally william n. eskridge, jr. & john ferejohn, a republic of statutes: the new american constitution (2010). 2016] social learning and the early history of u.s. tax withholding 151 explain institutional and ideological change. 29 although these types of empiricallygrounded, historical analyses are insightful, their theory-driven investigations frequently occlude or overlook the nuances of historical context and sequence. even those historians and historically-minded social scientists who have attended to the importance of historical conditions and chronology have generally overlooked the pre-history of withholding and information reporting. 30 they have typically been preoccupied with the world war ii period, when a unique political compromise, known as the ruml plan, was brokered to ensure the permanent adoption of income tax withholding for most individual taxpayers. in fact, nearly all fiscal historians of the united states tend to agree that the major pivot points in the development of the modern american income tax regime and its attendant administrative procedures occurred during the mid-1940s and afterwards.31 yet, like the theory-driven case studies, these rich historical narratives often elide the significance of the long duration of institutional and administrative reforms. they overlook how state actors gradually learned from pre-1943 practices to improve administrative techniques that helped maximize tax collection well beyond the 1940s.32 without taking the developments of the1940s for granted, this article focuses mainly on the pre-history of u.s. tax withholding and third-party reporting. it contends that from the civil war era through the 1930s, american policymakers looked to the past and to the experiences of other countries to determine how best to facilitate tax compliance. through this process of learning from the successes and failures of past policies and the social and political responses to them, american tax administrators were able to transform a contested concept into a cornerstone of administrative practice. iii. the civil war income tax and the origins of american withholding the american experience with income tax withholding began with the civil war income taxes. at first, northern lawmakers attempted to pay for the unprecedented costs of the war by simply raising rates on the existing tax regime, namely the protective tariff and excise taxes on alcohol and tobacco.33 but they soon realized that while the tariff may have been a useful tool of international trade policy, it was rather ineffective in raising large amounts of revenue in a short period of time. likewise, hiking excise taxes during a national crisis, when consumption of luxury goods was declining, proved equally futile.34 29 charlotte twight, evolution of federal income tax withholding: the machinery of institutional change, 14 cato j. 359 (1995); see also charlotte twight, dependent on d.c.: the rise of federal control over the lives of ordinary americans (2003). 30 see, e.g., brownlee, supra note 20; sidney ratner, taxation and democracy in america (1980); joseph j. thorndike, their fair share: taxing the rich in the age of fdr (2012). 31 see brownlee, supra note 20; ratner, supra note 30; thorndike, supra note 30; carolyn c. jones, class tax to mass tax: the role of propaganda in the expansion of the income tax during world war ii, 37 buff. l. rev. 685 (1989). 32 one scholar has stated that “[w]ithholding did not play a major role in the collection and enforcement of the income tax in the united states until 1943, when congress introduced withholding on wages and salaries.” soos, supra note 7, at 124. such an interpretation, of course, overlooks the gradual process of social learning, whereby lawmakers became educated by government officials about the successes and failures of past tax administrative practices. 33 steven a. bank et al., war and taxes (2008). 34 sheldon d. pollack, war, revenue and state building: financing the development of the american state 217–19 (2009). 152 columbia journal of tax law [vol.7:144 as lawmakers began looking for alternative sources of revenue, some suggested a national property tax. u.s. treasury secretary salmon chase explored the idea of adopting an emergency national property tax based on a levy adopted during the war of 1812. yet given the constitutional requirements of apportionment for a federal direct tax on property, this idea was quickly dashed.35 nevertheless, chase’s reference to past practices not only illustrates the treasury department’s early instinct to turn to historical precedents to learn from the past, it also shows a contingent path not taken. if the union had attempted a property tax, the future fate of the income tax and the system of withholding and third-party reporting may have been dramatically different. the failure of existing taxes to meet the increasing fiscal demands of the war forced the union to turn to bold, new sources of public revenue, including an innovative income tax. levied on both individual and business income, the new tax quickly became an important source of wartime revenue. the first effective federal income tax was adopted in 1862, when congress imposed a “normal” three percent tax on “annual gains, profits, or incomes” above eight hundred dollars, “whether derived from any kinds of property, rents, interests, dividends, salaries or from any profession, trade, employment or vocation carried on in the united states or elsewhere, or from any source whatever.”36 in 1864, as the war dragged on and the demand for public revenue continued to increase, congress raised income tax rates and lowered certain exemption levels, leading to even greater tax revenue. by the following year, approximately 10% of union households were paying an income tax, and the levy was generating roughly $61 million or about one fifth of total annual federal revenue.37 in sum, the first american experiment with an income tax became a vital part of civil war financing.38 one of the primary reasons for the relative success of the civil war income tax was the use of withholding. in 1865 alone, the federal government collected nearly 40% of income tax receipts through the crude and nascent process of income tax withholding.39 the specific withholding provisions began with the 1862 law and required certain institutions to withhold the “normal” tax rate of 3% on the payment of dividends and interest to stockholders and bondholders, respectively. 40 at the same time, the federal government was required to withhold the “normal” rate on salary income. when congress increased the “normal” rate to 5% in 1864, it also increased the withholding rate to 5% and broadened the number of institutions required to withhold income taxes on interest and dividends to include other transportation companies besides railroads.41 throughout its evolution, the civil war income tax benefited from a process of social learning. key tax experts working in the treasury department and the bureau of internal revenue collectively puzzled over the problem of tax collection. despite strong resistance from business interests and the wealthy elite who were the targets of the income tax, administrative reformers forged the bureaucratic autonomy necessary to 35 tax history project: the civil war, tax analysts, http://www.taxhistory.org/www/website.nsf /web/thm1861?opendocument [https://perma.cc/34vw-wl5p]. 36 revenue act of 1862, ch. 119, § 90, 12 stat. 432, 473 (1862). 37 see bank et al., supra note 33; brownlee, supra note 20; hugh rockoff, until it’s over, over there: the u.s. economy in world war i, in the economics of world war i 310, 316 (stephen broadberry & mark harrison eds., 2005). 38 bank et al., supra note 33. 39 frederick c. howe, the federal revenues and the income tax, 4 annals am. acad. pol. & soc. sci. 557, 568 (1894). 40 12 stat. at 469. 41 revenue act of 1864, ch. 173, §§ 120, 122, 123, 13 stat. 223, 283-85 (1864). 2016] social learning and the early history of u.s. tax withholding 153 overcome such defiance. they looked abroad to the british experience with “taxation at the source” to construct their own crude yet effective form of income tax withholding. a. learning from the british the united kingdom first adopted its own form of income tax withholding in 1803. known at the time as “taxation at source,” this early form of withholding was seen as a “peculiar distinction” of the british income tax that was designed mainly as a bulwark against tax evasion.42 levied during the napoleonic wars, the income tax and the use of withholding were critical components of wartime fiscal policies. some historians have maintained that british prime minister henry addington introduced “taxation at source” in 1803 because of his wide knowledge of english fiscal history and the use of withholding for other direct taxes, many of which had been in operation since the sixteenth century. addington, it is frequently maintained, deployed his own form of incremental social learning.43 regardless of the precise origins of british withholding, there is little doubt that the mechanism proved to be highly durable. the u.k. experience with taxation at the source endured throughout the napoleonic wars and beyond. while the 1803 income tax was amended several times, taxation at the source remained an integral part of the tax laws throughout the war and well beyond. ultimately, when the british income tax was reinstated on a permanent basis in 1842, taxation at the source returned as a core element.44 one reason for the early success of british withholding was because a flat income tax rate, as opposed to a graduated one, allowed taxation at source to operate easily and efficiently.45 with a flat rate, remittance agents did not need to speculate about the taxpayer’s total tax liability. they could easily withhold and remit the “normal” rate due on taxable income. u.s. policymakers picked up on this subtle, yet effective, observation. this was one reason why congress matched the normal rate of tax with the withholding rate during the civil war. when the normal rate was increased during the war, so too was the rate for withholding.46 british policy makers praised the administrative significance of withholding, just as their american counterparts would do much later. the u.k. royal commission on the income tax hailed taxation at source as of “paramount importance” and as “the only sure safeguard against evasion of duty.”47 likewise, u.k. inland revenue has celebrated taxation at source as “a principle which has been of incalculable benefit to the revenue of this country, and which . . . remains the great buttress of income tax stability and efficiency.”48 early twentieth-century american tax experts, looking back at the british 42 royal commission on the income tax: first instalment of the minutes of evidence with appendices, cmd. 288-1, para. 19 (1919) (hereinafter minutes of evidence) (testimony of a commissioner of inland revenue); see also piroska e. soos, the origins of taxation at source in england, in 1 taxation: critical perspectives on the world economy (simon james ed., 2002). 43 soos, supra note 42, at 50–52. 44 see generally b.e.v. sabine, a history of income tax (1966). 45 d.e. schremmer, taxation and public finance: britain, france, and germany, in the cambridge economic history of europe 335 (peter mathias & sidney pollard eds. 1989). 46 see supra text accompanying notes 33-41. 47 report of the royal commission on the income tax, cmd. 615, para. 154, 156 (1920). 48 see minutes of evidence, supra note 42, at app. 1 para. 3. 154 columbia journal of tax law [vol.7:144 experience, also acknowledged that this early form of withholding was “perhaps the chief cause of the great success of the english income tax.”49 during the civil war, american tax officials were well aware of britain’s income tax and its peculiar distinction. indeed, union policymakers frequently looked overseas to the british experience to learn how to enact and administer a new income tax despite growing resistance.50 treasury secretary salmon p. chase may not have been well-versed in economic policy and european precedents, but the first commissioner of the bureau of internal revenue, george s. boutwell, was keenly aware of british fiscal policies.51 although boutwell was only bir commissioner for a short period before he was elected to congress, his deep knowledge of british history and politics informed his short yet pivotal duration at the bir.52 even before the treasury department began looking abroad for assistance, congressional leaders were explicitly pointing to the british income tax as a model worth replicating. north carolina senator f.h. simmons, a key proponent of the income tax, understood that there were other industrialized nations in the world that had successfully administered such a levy. “i think it is a pretty safe rule to follow the practice of older nations who have had this tax for fifty years,” he announced to his fellow lawmakers. “they have tried this; and i noticed in the last revision of the income tax of england, that they have kept the feature of taxing government securities one half,”53 as a proxy for withholding. american tax experts, reflecting back on the efficacy of the civil war income tax, echoed what the british had learned about the importance of withholding. they stressed how withholding eased administrative burdens and limited the possibility of evasion. “a large portion of the tax was paid,” wrote tax reformer fredric c. howe, “without the income passing through the hands of the eventual payor of the duty while fraudulent returns were rendered impossible and the necessity of supervision was reduced to a minimum.”54 others acknowledged the pivotal role that business corporations and financial institutions played in remitting income taxes. “[i]t was much easier and simpler to collect [tax] from the corporations than from the individual stockholders and bondholders,” noted political economist joseph hill.55 the british experience with the income tax also presaged some of the objections that americans would level against the new levy and its system of collection. english citizens protested that an income tax was unfair because it taxed all income equally, regardless of its source. other critics maintained that the new levy would blunt economic 49 edwin r.a. seligman, the income tax 216 (2d ed. 1914). 50 jerold waltman, origins of the federal income tax, 62 mid-am. hist. rev. 147 (1980); see also cong. globe, 37th cong., 1st sess. 252 (1861) (statement of frederick a. pike). 51 joseph j. thorndike, an army of officials: the civil war bureau of internal revenue, tax analysts (dec. 21, 2001), http://www.taxhistory.org/thp/readings.nsf/artweb /ff949517831b181685256e22007840e8?opendocument [https://perma.cc/vzc7-z2za]. 52 for examples of boutwell’s knowledge of british and european history, see generally 1 george s. boutwell, reminiscences of sixty years in public affairs (1902). boutwell boasted that he “had neither the time nor opportunity to study the excise system of great britain,” and that the organization of the u.s. system grew out of the “requirements of the law.” id. at 313. yet his detailed description of the withholding process was remarkably similar to the one used by england. see george s. boutwell, a manual of the direct and excise tax system of the united states 226 (1963). 53 cong. globe, 37th cong., 1st sess. at 315. 54 howe, supra note 39, at 568. 55 joseph a. hill, the civil war income tax, 8 q.j. econ. 416, 427 (1894). 2016] social learning and the early history of u.s. tax withholding 155 incentives and therefore lead to lower future tax revenue. and perhaps most importantly, many complained that an income tax was inherently intrusive and “inquisitorial.” as one commentator at the time explained, the income tax “proposes to establish an inquisitorial power unknown in this country—inconsistent with the principles of the british constitution—and repugnant to the feelings of englishmen.”56 the loss of privacy that would come with greater tax assessment also troubled many british taxpayers. “is a true briton to have no privacy?” asked one opponent. “are the fruits of his labour and toil to be picked over, farthing by farthing, by the pimply minions of bureaucracy?”57 americans echoed these complaints. as the civil war income tax was winding its way through congress, lawmakers stressed how the collection of a direct tax on income would require a vast bureaucracy of tax collectors. new york congressman roscoe conkling argued that “one of the most obnoxious—perhaps the most obnoxious—of all it features is that which creates an army of officers whose business it is to collect the tax.”58 the new law would create “an army of office-holders,” conkling continued. “it provides cumbrous and unnecessarily expensive. it provides oppressive modes of assessment and collection.” ultimately, it would create “a system more unendurable than the tax itself.”59 political leaders were not alone in voicing their fears over the administrative machinery that would accompany an income tax; they were simply conveying the concerns of their constituents. petitions and protest letters poured into congressional offices. some like those from pike county, ohio warned that the new army of tax collectors would be prohibitively costly, eating “up at least half of the money that is collected.”60 business interests similarly complained about the “unlimited power” of the bir.61 b. the war context to be sure, the war context muffled the extent of protests and complaints. early military victories by the confederacy and the increasing evidence of wartime profiteering convinced many citizens and lawmakers that a vast new bureaucracy of tax collectors was a necessary evil if the union was to survive. in fact, some political leaders inverted the fear of a new “army of officials.” the powerful chair of the house ways & means committee, thaddeus stevens, deployed conkling’s military metaphor against him. “i know that the army of collectors are odious everywhere,” declared stevens, “but i know, also, that they are not quite so dangerous to my constituents . . . as the army of rebels that renders this other army necessary; for the one must be raised or the other will be triumphant.”62 still, there were some lawmakers who insisted that adequate revenues could be raised to fight the war without resorting to a vast new federal bureaucracy. one alternative was to leverage the already existing state-level system of tax collection. rep. conkling and others contended that “so far as the state machinery can be used for the 56 william frend, principles of taxation 16 (1799), quoted in seligman, supra note 49, at 76. 57 man midwife: the further experiences of john knyveton, m.d., late surgeon in the british fleet during the years 1763-1809, quoted in sabine, supra note 44, at 31. 58 cong. globe, 37th cong., 1st sess. 247 (1861). 59 id. at 272; see also thorndike, supra note 51. 60 huret, supra note 5, at 15. 61 cong. globe, 77th cong., 1st sess. 23 (1941). 62 id. at 807. 156 columbia journal of tax law [vol.7:144 purpose . . . the expense to the federal government [will] be saved, and this obnoxious provision to the people be avoided.”63 there was, of course, a great irony to the idea of relying on state governments to help collect federal taxes in the midst of the civil war—an irony that was not lost on most lawmakers. indeed, for some, the times required a strong showing of federal force. after all, one of the central contentions of the war was the battle between state and federal authority. what better way to demonstrate federal supremacy than through the creation of a powerful taxing authority. congress, declared virginia unionist charles horace, “should make the people feel the arm of the national government, and know that we are in earnest in this manner.”64 it was against this political backdrop that congress instituted not only an army of tax collectors but also an early form of withholding that would help smooth tensions. borrowing from the british, american lawmakers understood that they needed to assuage taxpayer concerns. like their british counterparts, us policymakers were operating during a wartime emergency with a great deal of uncertainty. just as english leaders exploited past practices of tax collection, american leaders turned to the british model for guidance. facing a similar set of complaints and protests, american used their inchoate form of withholding to address administrative challenges. “the inclusion of withholding techniques in the 1862 legislation was an important innovation in american taxation,” historian joseph thorndike has aptly noted. “it reflected an understanding among lawmakers of the inherent difficulty of collecting taxes on income.”65 the new american system of “stoppage at the source” did not completely eliminate the inherent difficulties, but it did provide future lawmakers with a model worth replicating. c. the supreme court’s support for withholding before the civil war income tax and system of withholding could become a model for subsequent policymakers, it had to first withstand a constitutional challenge. well after the war had ended and as the wartime income tax was about to expire, taxpayers challenged the withholding provisions of the income tax.66 section 122(d) of the 1864 revenue act, as amended by the 1866 act, required corporations to “deduct and withhold from all payments on account of any interest or coupon, and dividends, due and payable . . . the tax of 5 per centum.”67 this was the language similar to that used in the 1862 law which first adopted withholding. in this case, the party challenging the provision was the city of baltimore. in 1854, the maryland legislature approved baltimore’s issuance of bonds, the proceeds of which were subsequently lent to the baltimore & ohio railroad company. as a result of these transactions, the railroad became a debtor, and the city of baltimore was one if its creditors. after the civil war income taxes were enacted, the u.s. government claimed that the railroad company, under section 122(d), was obligated to withhold and remit to 63 cong. globe, 37th cong., 1st sess. 247 (1861). 64 id. at 300. 65 thorndike, supra note 51. 66 united states v. balt. & ohio r.r., 84 u.s. 322, 324-25 (1872). this case has received scant attention from scholars. see generally seligman, supra note 49, at 430–76; marjorie e. kornhauser, corporate regulation and the origins of the corporate income tax, 66 ind. l.j. 53 (1990); george k. yin, the future taxation of private business firms, 4 fla. tax. rev. 141 (1999). 67 13 stat. 223 (1864). recall that five percent was also the rate for the normal tax at this time. 2016] social learning and the early history of u.s. tax withholding 157 the u.s. treasury a 5% tax on interest paid to its creditors, including the city of baltimore.68 the railroad refused, contending that because its creditor (baltimore) was a municipality not subject to taxation by congress, it was not obligated to withhold and remit taxes on behalf of the municipality. the court acknowledged that the purpose of section 122(d) was to use railroad companies and other corporations as remittance vehicles, with the goal of taxing the ultimate creditor/taxpayer. “this is a clear, distinct, unqualified adjudication, by the unanimous judgment of this court, that the tax imposed by the 122(d) section is a tax imposed upon the creditor or stockholder therein named; that the tax is not upon the corporation,” wrote the court, “and that the corporation is made use of as a convenient and effective instrument for collecting the same.” 69 ultimately, the court agreed that because the final taxpayer/creditor was a municipality, section 122(d) could not be enforced against the railroad company. yet, in finding for the city, the court also affirmed the process of income tax withholding. the court noted that if a private individual made the city of baltimore its agent and trustee to receive interest payments from the railroad, such interest income would be subject to income tax withholding because the city would not be receiving municipal revenues, but would rather be assuming the position of a private trustee. in such a hypothetical case, the receipt of non-public revenues “would be subject to taxation.”70 in the end, the court focused mainly on the economic substance of the transaction—correctly so. but in the process it approved and implicitly upheld the law’s use of withholding. as we shall see, this tacit approval would soon become a valuable tool for income tax supporters. iv. the 1913 income tax and the beginnings of u.s. “stoppage at the source” between 1872 and 1894, there was no federal income tax. the civil war levy had expired by 1872. it was initially intended as a temporary wartime measure, and thus when civil war debt levels receded, congress allowed the measure to expire without renewal.71 there were, however, numerous attempts to revive the income tax in the last decades of the nineteenth century. as the fortunes of america’s leading industrialists began to swell, concerns about the growing concentration of wealth and income and the massive inequalities of the first gilded age began to press upon policy agendas. in response, the populist movement made several attempts to attack inequality through numerous devices, including using progressive taxation.72 it was not until 1894 that income tax advocates were able to prevail with the first peacetime national income tax. their victory, however, was short-lived, as the u.s. supreme court struck down the 1894 income tax in the following year.73 for our purposes, the 1894 income tax is significant because it attempted to continue the tradition of using a limited form of withholding. although the tax was never enforced because of the supreme court’s invalidation of the law, the 1894 revenue act 68 balt. & ohio r.r., 84 u.s. at 322-23. 69 id. at 326. 70 id. 71 bank et al., supra note 33. 72 see generally elizabeth sanders, roots of reform: farmers, workers, and the american state, 1877-1917 (1999). 73 pollock v. farmers’ loan & tr. co., 157 u.s. 429 (1895). 158 columbia journal of tax law [vol.7:144 did contain a provision requiring the federal government to withhold income taxes on salaries over $4,000.74 because there was only a flat rate of 2% levied on all income, the notion of collecting government employee income through withholding was relatively straightforward. the law did not contain a similar provision, as its civil war predecessor had, to withhold taxes on interest or dividend income. the 1894 income tax did, however, respond to some of the critiques leveled against the civil war income tax and its “inquisitorial” collection system. instead of requiring railroads and other transportation companies to withhold income taxes on dividends and interest, the 1894 law developed the innovation of requiring a system of third-party information reporting. under the invalidated law, business corporations were required to report to the bir the name, address, and salary of each employee who was paid more than the statutory exemption level of $4,000.75 the initial house version of the 1894 law mirrored the civil war income tax collection system,76 but the final version of the law demonstrated that lawmakers were learning from the past, as they attempted to create more of a hybrid system of tax collection. as we shall see, the 1894 law’s innovative mix of using withholding for government employees and information reporting for private companies would soon be a model for future collection mechanisms. a. the 1913 comprehensive system of collection the supreme court’s invalidation of the 1894 income tax put a halt on the progressive income tax movement. but it was hardly the last word. over the next decade, as the united states began building an international empire, especially after the spanish-american war, the calls for a more robust national tax system became more strident. in 1909, a movement for a constitutional amendment to overturn the pollock decision began to take shape.77 within four years, two-thirds of the states had ratified the new constitutional amendment, which granted the federal government the power to tax incomes without apportionment. president woodrow wilson and his congressional allies wasted no time in leveraging the popular support for the sixteenth amendment and the income tax. in 1913, the same year the amendment was ratified, the federal government adopted the first permanent, peacetime income tax.78 like its civil war predecessor, the 1913 income tax had graduated rates and contained a “stoppage at the source” provision of withholding. under the new law, all individual incomes above the exemption level of $3,000 were taxed at a “normal” rate of 1%, and incomes above that level were taxed at progressive “surtax” rates, ranging from an additional 1% on income above $20,000 to 6% on incomes above $500,000.79 with its high exemption level, the new income tax reached only about 2% of american households.80 it was clearly a “class tax” aimed at the wealthy. buoyed by the wide-spread and popular support for the sixteenth amendment, lawmakers enacted a new income tax that was much more progressive than the civil war income tax. 74 revenue act of 1894, ch. 349, § 33, 28 stat. 509, 559 (1894). 75 id. § 35. 76 richard joseph, the origins of the american income tax: the revenue act of 1894 and its aftermath 69 (2004). 77 see john d. buenker, the income tax and the progressive era (1982). 78 act of oct. 3, 1913, ch. 16, 38 stat. at 166-70. 79 id. at 168. 80 john f. witte, the politics and development of the federal income tax 78 (1985). 2016] social learning and the early history of u.s. tax withholding 159 a similar sense of optimism also informed congress’s creation of a more comprehensive withholding system. the new law required any person or organization making payments of more than $3,000 in salary, interest, or other fixed income to withhold and remit tax payments on behalf of the individual taxpayer.81 unlike the more narrowly-tailored civil war income tax system, the 1913 version was an ambitious attempt to capture nearly all of the “normal” tax through the process of withholding. whereas the civil war system was limited to government salaries and interest and dividends from transportation companies, the 1913 regime was much more comprehensive. as one historian has noted, the goal was “to secure the maximum revenue and to prevent evasion by the dishonest taxpayer.”82 in the process of drafting the new law, congressional leaders fully acknowledged that they were borrowing from past u.s. experiences and building upon the british model of withholding. in this sense, even the failure of the 1894 law provided lawmakers and treasury officials with a useful model worth examining. at the same time, influential legislators were also highlighting the unique character of the american economy at the time. alabama congressman oscar underwood, one of the primary sponsors of the 1913 law and an early advocate of withholding, pointed to the work of academic experts to show that there was ample comparative evidence that “stoppage at the source” could be especially effective in the united states. underwood explained that the accelerating rise of american corporate capitalism had made “stoppage at the source” particularly appealing: in the united states the arguments in favor of this method are far stronger than in europe, because of the peculiar conditions of american life. in the first place, nowhere is corporate activity so developed and in no country of the world does the ordinary business of the community assume to so overwhelming an extent the corporate form. not only is a large part of the intangible wealth of individuals composed of corporate securities, but a very appreciable part of business profits consists of corporate profits.83 accordingly, underwood predicted that withholding would be particularly effective in the united states. “the arguments that speak in favor of a stoppage at the source income tax abroad hence apply with redoubled force here,” concluded underwood.84 one reason for underwood’s confidence was his view that withholding could facilitate the collection process. “the stoppage at the source scheme lessens to an enormous extent the strain on the administration; it works, so far as it is applicable, almost automatically; and where enforced it secures to the last penny the income that is rightfully due,” noted underwood.85 since the civil war income tax and its narrow and limited version of withholding seemed to be successful, lawmakers appeared willing in 1913 to push the envelope of taxpayer tolerance by using a much more comprehensive 81 act of oct. 3, 1913, ch. 16, 38 stat. at 169. 82 ratner, supra note 30, at 336. 83 48 cong. rec. 3587 (1912) (statement of rep. underwood). underwood was quoting from the work of edwin r.a. seligman. see seligman, supra note 49, at 661–62. 84 id. 85 id. 160 columbia journal of tax law [vol.7:144 withholding system. this did not mean, of course, that taxpayers were happy about the new law and its comprehensive system of taxation. b. echoes of resistance in fact, there was a great deal of resistance to the 1913 income tax, notwithstanding the success of the sixteenth amendment. whereas income tax supporters hailed the new measure as an example of the united states joining other civilized, democratic nations, opponents chided that the tax was “un-american.” new york senator david b. hill, a longtime opponent of the income tax, warned against the “european professors” who were promoting a “new political economy for universal application.” hill was not modest in his critique. “from the midst of their armed camps between the danube and the rhine, the professors with their books, the socialists with their schemes, the archaists with their bombs,” he declared, “all are instructing the people of the united states in the organization of society, the doctrines of democracy, and the principles of taxation.”86 meanwhile, other income tax opponents criticized the collection system, reviving the civil war claims about an inquisitorial “army of officials.” 87 philadelphia representative robert adams jr. warned that the process of withholding and selfassessment would “corrupt” the people, and bring an unwanted army of “spies” and “informants.” 88 other lawmakers claimed the income tax and the comprehensive withholding system would put “a premium upon dishonesty and evasion of the law.”89 to guard against any potential dishonesty and evasion, the 1913 law empowered the u.s. treasury department to develop the necessary bureaucratic details and machinery to enforce the new system of withholding. reflecting back on the civil war experience, wilson’s treasury secretary william mcadoo was well aware of the need to create a robust tax enforcement system.90 unlike the civil war emergency, the 1913 income tax was adopted at a time of relative calm. in puzzling over the new administrative machinery, policymakers in the treasury could think carefully about how to improve upon past experiences with withholding. one attempted improvement was to combine information reporting with withholding. less than a month after the enactment of the 1913 law, the treasury department issued two detailed regulations outlining the specific requirements of the new withholding system.91 these regulations provided precise guidance on which financial institutions in the chain of fiduciary agents had the legal duty to collect and remit taxes. they also emphasized the importance of ascertaining accurate tax information and using institutions like large-scale, industrial corporations as deputized tax-collecting agents.92 in short, the treasury department appeared to agree with underwood’s theory that the development of corporate capitalism in the united states provided a unique opportunity for tax authorities. 86 huret, supra note 5, at 85 (quoting david b. hill). 87 see supra text accompanying notes 61–64. 88 huret, supra note 5, at 86. 89 id. (quoting new jersey senator james smith jr.). 90 william g. mcadoo, crowded years: the reminiscences of william g. mcadoo 202-03, 207-18 (1931). 91 treas. reg. of oct. 25, 1913; treas. reg. of oct. 31, 1913; see also roger foster, a treatise on the federal income tax under the act of 1913 (1913). 92 mehrotra, supra note 10, at 283. 2016] social learning and the early history of u.s. tax withholding 161 c. the legal significance of withholding the significance of these administrative reforms did not escape the notice of legal experts. garrard glenn, a new york commercial lawyer and occasional columbia law school lecturer, identified “collection at the source” as “the new law’s most salient, if not its most popular feature.” what caught glenn’s attention was how the new regulations authorized a form of private, third-party reporting and remittance that appeared revolutionary. in the case of interest payments, for instance, the regulations required debtor corporations and financial institutions to remit withheld taxes along with certificates of ownership identifying the taxpayer/creditor. similar rules were established for other forms of fixed income payments. “thus in every case of deduction at the source,” wrote glenn, “the government ends by not only getting the tax, but by knowing whom it is taxing.”93 citing to the supreme court case upholding the civil war use of withholding,94 glenn explained that the courts had long upheld the use of a business corporation as “an agent of the government for the collection of the tax.” the new regulations, however, went further. they “laid upon this citizen turned tax gatherer the additional duty of collecting from the creditor a statement identifying himself as such.”95 the gathering and disclosure of this type of personal information was precisely what income tax detractors feared when they claimed that the new law would be inquisitorial. with the new law and regulations, some of the country’s leading business corporations had become deputized tax collectors. yet, rather than retreat from this criticism, glenn frankly acknowledged that an income tax inherently required such intrusions. “we might as well face the fact,” glenn conceded, “that the government cannot go very far with taxation of incomes without being forced to adopt an inquisitorial system for discovering objects of taxation.”96 what was far more important for glenn and state-builders in the treasury department, who were trying to create a wellfunctioning tax system, was the desire to provide the income tax with greater social legitimacy and credibility. indeed, if there is one thing that government officials learned over time, it was that administrative reforms had to be supported and accepted by the people. the use of withholding complemented by information reporting was one way of developing that acceptance and legitimacy. the process of collecting taxpayer information not only facilitated greater social control and surveillance by making national taxpayers more visible or legible to state actors, 97 it also assured other americans that the federal government was serious about enforcing a tax aimed primarily at the country’s wealthiest citizens. because the 1913 income tax was a class tax created by political elites aimed at economic elites, the withholding and information gathering aspects of the new law may have bolstered faith and confidence in the new fiscal system. by securing the tax at the source and verifying the accurate taxpayer, the new law demonstrated that the income tax was much more than mere political rhetoric. if quotidian workers and farmers, who paid their share of taxes to the national government through excise taxes and import duties, could be assured that national tax authorities were monitoring and collecting income 93 garrard glenn, the income tax law and deductions at the source, 13 colum. l. rev 714, 714– 26 (1913). 94 united states v. balt. & ohio r.r., 84 u.s. 322, 322 (1872). 95 glenn, supra note 93, at 725. 96 id. at 723. 97 see generally james c. scott, seeing like a state: how certain schemes to improve the human condition have failed (1998). 162 columbia journal of tax law [vol.7:144 taxes from the wealthier classes, these ordinary working-class americans were more likely to support the new tax system.98 v. the dominance of information reporting while the new system of withholding and reporting may have provided greater political credence and social credibility, the ultimate effectiveness of the collection mechanisms was soon called into question. in fact, within three years, the process of income tax withholding was eliminated in favor of a simpler method of third-party reporting, which was referred to as “information at source.”99 this subtle yet significant shift occurred for at least two reasons. first, there was growing political and social pressure from business organizations that had been compelled to become deputized tax collectors. second, government administrators came to recognize that they needed to solve the problem of social resistance by gradually acclimating taxpayers to the new levy and its exacting system of collection, while at the same time building up their administrative capacity. the income tax, simply put, was still an innovation for many taxpayers and withholding agents—an innovation that required a certain amount of social learning and popular acceptance. a. growing opposition to withholding indeed, even before the 1913 law was enacted, some lawmakers were warning that the novelty of the income tax warranted greater patience. “like any new tax law,” tennessee congressman cordell hull, one of the chief architects of the income tax noted, “it will be necessary for the people to become acquainted with the proposed law and for it to become adjusted to the country before extending its classifications, abatements, deductions, exemptions and so forth.”100 to be sure, state-level income taxes had been in existence for some time, including a modern version adopted in wisconsin in 1911 complete with information reporting. still, the complexities of the collection process were still a novelty for the nation as a whole. in this sense, contemporaries like congressman underwood and garrard glenn may have been overly optimistic about the social acceptance of withholding and its ability to generate revenue. given the paucity of empirical data from the time period, it is difficult to determine precisely how effective the new system of withholding actually was. initially, some lawmakers estimated that the new collection system would yield two-thirds of income tax revenue. 101 economic experts reflecting back on the tax indicated that the withholding system probably raised “less than one-fourth” of total income tax revenues.102 others have suggested that it might have been even less.103 although the exact effectiveness of withholding may be uncertain, there was little doubt that many tax experts feared that the regulations requiring third-party reporting may have been overly onerous, especially given the novelty of the new system. “perhaps no feature of the income tax law,” noted political economist roy g. blakey, “has caused more unfavorable criticism than the stoppage-at-the-source provision, which throws much of the burden of collecting the government’s revenue upon banks, trust 98 mehrotra, supra note 10, at 285. 99 war revenue act of 1917, ch. 63, § 1211, 40 stat. at 336–37. 100 50 cong. rec. 508 (1913) (statement of rep. hull). 101 see h.r. rep. no. 63-5, at 38 (1913). 102 roy g. blakey & gladys c. blakey, the federal income tax 143 (1940). 103 desai, supra note 13, at 887. 2016] social learning and the early history of u.s. tax withholding 163 companies, corporations, and other agents.” 104 of course, most corporations and financial institutions by this time already had the managerial skills and information to comply with withholding and the regulations regarding information reporting, but the novelty and intricacies of the process provided an opportunity for many to question the use of corporations as withholding agents. the new york banker mortimer schiff was among those who voiced strong opposition to the new collection system. schiff conceded that he was no enemy of the income tax. “i am inclined to favor this form of raising revenue for the government,” wrote schiff referring to the new income tax, “if the tax is equitably levied and administered.”105 yet he was deeply ambivalent about the new collection methods. for him, the combination of withholding and information reporting gave “rise to the greatest cause of complaint.” part of the reason was the uniqueness of the system for americans who valued their privacy. indeed, for schiff and others, the borrowing of british ideas about tax collection was viewed as wholly foreign. “we are not used to the parental form of many european governments and, therefore,” wrote schiff, “an income tax, with its resultant inquisitorial methods and prying into the affairs of individuals is, from its nature, bound to cause dissatisfaction, a large part of which is possibly unwarranted.”106 with this observation, schiff singled out how the united states was different from other countries that adopted an income tax and a system of withholding. for him, america was exceptional. “this method of collection is an importation from europe and is copied, to a great extent, from the provisions of the english income tax law,” he admitted. “it has, however, apparently been overlooked that in england substantially everybody, except the person dependent upon daily wages, is taxed and that practically no one in receipt of any other form of income is exempt.”107 he continued that there were many other factors that set the united states apart from england and other european countries, including the size of the united states, the way it conducted business, and especially the way that american banks and corporations distributed interest to their bond holders.108 ultimately, schiff was deeply ambivalent about the new collection methods. on the one hand, he believed that the treasury regulations were gradually becoming more rational and routinized, and consequently collections were “considerably simplified.”109 yet, on the other hand, he insisted that it was unfair for the government to deputize private citizens as tax collectors without any remuneration. “it does not seem fair that the government should force corporations and individuals to bear this expense and do work, which probably belongs to the government, without compensation,” he wrote. 110 according to schiff’s anecdotal accounts, some railway companies had to double the size of their clerical departments to keep up with demands of collection at the source, and they did so at their own costs. 104 roy g. blakey, the new revenue act, 6 am. econ. rev. 837, 842 (1916). 105 mortimer l. schiff, some aspects of the income tax, 58.1 ann. am. acad. pol. & soc. sci. 15 (1915). 106 id. at 15. 107 id. at 20. 108 id. 109 id. at 21. 110 id. at 23–24. 164 columbia journal of tax law [vol.7:144 schiff concluded his analysis of the income tax with three recommendations. first, he called for a lowering of exemptions levels so that more taxpayers could be included in the tax system. second, he argued that “the law should be so clarified as to make it comprehensible to the average person.” third, and perhaps most important for our purposes, he contended that “the system of collection at the source should be abandoned and a system of collection from the recipient substituted, with information at the source and severe penalties for false statements.”111 b. reforms to rescue information reporting it was not only business leaders like schiff who were weary of withholding. treasury officials seemed to agree. but rather than abolish the entire collection system, they sought to find a middle ground. by 1916, treasury secretary mcadoo and his staff began to reconsider the costs and benefits of their dual system of income tax withholding and rigorous information reporting. in his annual report, mcadoo recommended that congress “do away with the withholding of the income tax at the source, and in place thereof . . . require information at the source.”112 although mcadoo did not directly address the onerous administrative burden that the new collection system placed on the treasury department, his comments were interpreted by many as a plea for assistance. the existing law, as we’ve seen, required both withholding and reporting, but mcadoo’s point was to draw attention to the particular demand of verifying the process of withholding. yet, for most treasury officials, some form of third-party assistance was considered absolutely essential. after three years of experience with the new income tax, they realized that if they were to sustain a new and effective tax and collection system, they needed to find a way to placate business interests. thus, mcadoo and the treasury department settled on eliminating the direct withholding of income taxes to maintain the reporting of tax information. in framing this reform for lawmakers, the treasury department stressed both the financial and political benefits. this new system, mcadoo contended, “will mean the collection of a larger amount of revenue and eliminate a great deal of criticism which has been directed against the law.”113 although mcadoo may have been overly optimistic about his revenue estimates, his aim was to consolidate some remnant of the new collection system rather than have the entire process eliminated. despite the treasury department’s recommendations and the growing social antagonism towards withholding, congress did not immediately repeal the provision in 1916. in fact, it wasn’t until the united states officially entered world war i the following year that the withholding system and the entire income tax regime were changed dramatically.114 with the onset of a global war, lawmakers quickly realized that they needed to turn to the nascent income tax as a major source of wartime revenue. once the united states officially entered the war in april 1917, the economic demands of waging an international war became obvious. over the next three years, the federal government enacted a series of revenue laws that transformed the modern 111 id. at 31. 112 u.s. treasury dep’t., annual report of the secretary of the treasury of the state of finances for the fiscal year ended june 30, 1915, at 19 (1916). 113 id.; see also w. elliot brownlee, wilson and financing the modern state: the revenue act of 1916, 129 proc. am. phil. soc’y 173, 197 (1985). 114 as historian david m. kennedy has noted, wwi “occasioned a fiscal revolution in the united states.” david m. kennedy, over here: the first world war and american society 112 (1980). 2016] social learning and the early history of u.s. tax withholding 165 american income tax. by the height of the war, the top marginal tax rate on individual income had skyrocketed from a pre-war figure of 7% to 77%. at the same time, exemption levels dropped dramatically and nearly 20% of the american labor force was paying income taxes.115 although the united states did not introduce a mass income tax at this time, the experience with steeply progressive individual income taxes and innovative war profits and excess profits taxes on business paved the way for future reforms. perhaps most importantly, the 1917 revenue act repealed the requirement of direct income tax withholding while maintaining a reporting system of “information at the source.”116 the growing business opposition to withholding and the treasury department’s pre-war ambivalence surely played a part in the abolition of direct withholding. but an equally important factor was the astonishing complexity of the new wartime tax regime. the dramatic rise in rates, the enactment of complex and uncertain business taxes, and the drop in exemption levels—not to mention the numerous bond drives—all placed tremendous administrative stress on the treasury department as well as deputized private sector tax collectors. one obvious way to relieve that stress without overly comprising revenue was to eliminate withholding while maintaining information reporting. for present day commentators, the abolition of withholding in 1917 has been interpreted as a sign of the pre-world war ii failures of withholding. “[i]t is the revenue act of 1917,” writes anuj desai, “that so clearly tells us that withholding was not entrenched in any sense of that word: an income tax without any withholding was not only possible, it had now become law.”117 desai elides, however, how information reporting remained a crucial part of the tax collection system from 1913 throughout world war i. private, third-party organizations, namely large businesses and financial institutions, were still required to provide “information at the source.” they did so not only because the law required it, at least since 1913, but also because they had the modern managerial and accounting systems in place to comply with these information reporting requirements.118 to focus only on withholding while ignoring information reporting misses how these two provisions worked to bolster the burgeoning income tax regime. indeed, the income tax and the system of third-party reporting flourished during world war i, and their success helped ensure their post-war consolidation. “without the intervention of the united states in world war i,” historian w. elliot brownlee has noted, “the development of federal taxation would have proceeded far more incrementally. it most certainly would have relied much more heavily on the taxation of consumption.”119 the fundamental rejection of a mass consumption tax, such as a retail sales tax, during the war and afterwards demonstrated that while lawmakers and business interests may have had their doubts about the income tax and withholding, they were not 115 cambridge university press, historical statistics of the united states, series ea758-772, http:// hsus.cambridge.org/hsusweb/toc/showtable.do?id=ea731-826 [https://perma.cc/j9u3-k34z]; blakey & blakey, supra note 102, at 512; mehrotra, supra note 10, at 299–300. 116 war revenue act of 1917, § 1211, 40 stat. at 336–37. 117 desai, supra note 13, at 888. 118 for more on the relationship between modern managerial capitalism and u.s. income tax administration, see generally ajay k. mehrotra, american economic development, managerial corporate capitalism, and the institutional foundations of the modern income tax, 73 l. & contemp. probs. 25 (2010). 119 brownlee, supra note 20, at 47. 166 columbia journal of tax law [vol.7:144 willing to experiment with an entirely new tax order after the war. in fact, the income tax and third-party reporting would continue at the federal level unabated until the mid-1930s when the great depression and the enactment of the 1935 social security act provided a new opportunity to reconsider the return of withholding. c. social security and the return of withholding if the national emergency of world war i provided the context for saving information reporting, it was another national crisis that led to the return of a crude form of withholding. the great depression, like world war i, was a crisis that dramatically altered the fiscal landscape. the depression changed the way everyday americans thought about the role of government in the economy and society. led by president franklin d. roosevelt, the new deal order attempted to address the many social dislocations brought on by the economic crisis.120 during most of his first term, president roosevelt advanced a cautious fiscal policy. like his predecessor, herbert hoover, fdr was initially committed to balanced budgets. but, unlike hoover, roosevelt was a supporter of highly progressive income taxes that could potentially “soak the rich.”121 while the roosevelt administration and its congressional allies originally attempted to craft a fiscal policy that adhered to the two pillars of balanced budgets and soak-the-rich taxation, their enactment of the social security act in 1935, with its regressive payroll taxes, seemed to undermine the commitment to progressivity. 122 some historians have interpreted roosevelt’s turn to payroll taxes as evidence that his calls for tax justice were symbolic and hollow.123 yet, because social security was framed as a form of old-age insurance, where tax payments were earmarked for future benefits, roosevelt and his allies did not see it as a regressive component of fiscal policy. in fact, by earmarking these tax payments as insurance premiums, roosevelt had hoped to secure the long-run durability of social security. in this sense, he was driven by both economic and political motives. “with those taxes in there,” he was reported to have stated, “no damn politician can ever scrap my social security program.”124 over the decades, roosevelt’s vision has become reality. another reason for social security’s long-term survival has been its effective use of withholding, which many scholars have depicted as “the groundwork for the full-scale adoption of withholding enacted during world war ii.”125 but, as we’ve seen, social security was not the federal government’s first use of withholding. rather, the administrators who supported social security and its use of payroll deductions were building upon the consistent use of information reporting for income taxes, and returning to the pre-1917 use of income tax withholding. this was perhaps the quintessential example of social learning: government administrators relying on past policies and practices as a guide for addressing new and pressing problems. at its core, social security was designed to be a comprehensive and compulsory social insurance program funded by both employer and employee contributions. 120 see generally david m. kennedy, freedom from fear: the american people in depression and war, 1929-1945 (1999); jason scott smith, a concise history of the new deal (2014). 121 smith, supra note 120, at 69. 122 social security act, 49 stat. 620 (1935). 123 see generally mark leff, the limits of symbolic reform: the new deal and taxation, 1933-39 (1980). for a contrary view of new deal tax policy, see generally thorndike, supra note 30. 124 franklin delano roosevelt, quoted in brownlee, supra note 20, at 76. 125 desai, supra note 13, at 889. 2016] social learning and the early history of u.s. tax withholding 167 according to the statute, the tax on employees was to “be collected by the employer of the taxpayer, by deducting the amount of the tax from the wages as and when paid.” in sum, the law requires employers both to pay their portion of the contribution and withhold and remit the employee’s contribution at its source.126 implementing social security was a colossal administrative task. the bureau of internal revenue had to assist roughly 3.5 million employers who had to make contributions on behalf of more than 30 million employees. one of the earliest administrators referred to the accounting challenges as “the largest bookkeeping job in the world.”127 yet, as treasury officials noted, employers were already collecting and remitting information about high-income taxpayers. extending that reporting requirement to a broader swath of workers was simply an elaboration of an existing system. as frank mires of the treasury department explained, “little more would be required of the employer than he already does.”128 thus, the social security system’s adoption of withholding was less of an innovation than it was an elaboration of existing practices and a return to an earlier tax collection regime.129 vi. conclusion while the adoption of social security and its system of withholding was certainly a key moment in the expansion and incremental process of administrative reform, a second salient moment occurred during world war ii. for that was when the establishment of a mass income tax facilitated the full-fledged return of income tax withholding. other scholars have already adequately explained the importance of the victory tax of 1942, the current tax payment act of 1943, and the ruml plan that helped expedite the transition to a withholding regime of tax collection.130 what is important for our purpose is to see how the mid-1940s was part of a larger and broader trajectory of tax administrative reform. world war ii, in this sense, was not solely a watershed moment in tax administrative reform; it provided, instead, an important emergency context for the culmination of administrative reforms that had begun as early as the civil war. the history of income tax withholding and information reporting from the civil war to world war ii thus provides an illustration of the usefulness and limits of theories about social learning and policy change. first, this history shows the primacy of ideas for institutional reform, just as social learning advocates would suggest. like all institutions, withholding and information reporting did not just randomly appear on the american administrative stage. rather, the adoption of this tax collection institution occurred through a historical process, whereby influential individuals promoted particular ideas and concepts at specific moments, with the use of unique resources and power. second, the incremental development of withholding and information reporting did not occur simply because of the bureaucratic autonomy of state actors, as the theory of social learning would suggest. treasury officials, to be sure, played a key role in this 126 social security act, title vii, § 801-811, 49 stat. 636-30 (1935). 127 arthur j. altmeyer, the formative years of social security 71, 87 (1966). 128 charles mckinley & robert w. frase, launching social security: a capture-andrecord account, 1935–1937, at 317 (1970) (quoting frank mires, u.s treasury department coordinator with the social security board). 129 as anuj desai has accurately noted, “the 1917 abandonment of stoppage at source in favor of information at source actually laid the groundwork for the choice of administrative method when withholding was next introduced into the law.” desai, supra note 13, at 894. 130 see, e.g., thorndike, supra note 30, at 247–58; brownlee, supra note 20, at 114-16. 168 columbia journal of tax law [vol.7:144 historical process, but while these state actors were puzzling over solutions, powerful private political and social actors were also exercising their authority over the shape of future reforms. administrative reforms were thus produced by a combination of semiautonomous public figures responding to social and political pressures. finally, withholding and information reporting arrived, above all else, through a gradual process of evolution. although there were salient events and key historical contexts—frequently national emergencies—that acted as catalysts or accelerants, the deep-seated causes of administrative reform were more subaltern and less sudden. in fact, our current process of tax collection went through several periods of episodic reform, from the original implementation of a crude and limited form of withholding during the civil war to the comprehensive use of tax collection in 1913 to abolition of withholding during wwi, and then finally to the return of withholding and information reporting during the 1930s and ‘40s. what can this historical story of incremental administrative reform teach us about other types of policy changes? can this historically specific tale be generalized across other policy arenas? perhaps not. but if there is a lesson to be drawn, it is that current failures may turn out to provide the foundation for future success. the elimination of withholding in 1917, for example, may have seemed like a step back for some tax administrators and fiscal reformers, but ultimately, this “failure” permitted the maintenance of information reporting, which became a crucial foundation for future tax administrative reforms. if scholars of american healthcare are correct, the recent success of healthcare reforms may be the result of a similarly long process of episodic attempts at political change.131 there may be an art to losing that allows current setbacks to tee up or prompt future reforms. in the end, this historical narrative about the origins and early development of u.s. income tax withholding and third party reporting is not simply an antiquarian tale about forgotten moments in american legal and administrative history. rather, this story is meant to provide a usable past. it is intended to shed some light, albeit cautiously, on the general conditions and processes that can facilitate possible bureaucratic reform. thus, for a law review symposium on “reforming the irs,” this historical tale is more than mere prologue; it is meant to provide a broader perspective on the seminal events, key actors, and structural processes that have shaped past attempts at institutional change. ultimately, the goal of this history is to provide a better understanding of current administrative practices and the promise of future reforms. 131 see generally david blumenthal & james a. morone, the heart of power: health and politics in the oval office (2009). microsoft word santos8-1.docx property tax exemptions for hospitals: a blunt instrument where a scalpel is needed eric j. santos* * columbia law school j.d. 2016. i would like to thank my faculty advisor, professor michael j. graetz for, for his help and guidance. i would also like to thank my parents, dr. rene e. santos and dr. jody w. zylke, exemplary members of the medical field and the inspiration for this note. 114 columbia journal of tax law [vol.8:113 i. introduction .................................................................................................... 115 ii. background ...................................................................................................... 116 a. hospitals in the united states ............................................................................ 116 b. federal tax exemption for hospitals ................................................................ 117 1. history of federal tax exemption for hospitals ........................................ 117 2. modern federal tax exemption for hospitals: the community benefit standard ...................................................................................................... 118 c. state property tax exemption for hospitals ..................................................... 119 1. overview of the history of state property tax exemptions for hospitals .. 119 2. overview of modern standards of state property tax exemptions for hospitals ...................................................................................................... 120 iii. the problem ...................................................................................................... 121 a. challenges facing modern nonprofit hospitals ............................................... 121 1. hospitals face thin profit margins and struggle to continue operations 121 2. hospitals’ tenuous hold on property tax exemptions .............................. 123 3. coerced pilots add to some hospitals’ financial burdens .................... 127 b. incongruity between tax exemption standards and reality of hospital administration ................................................................................................... 129 iv. a unified regime of hospital property taxation ........................ 130 a. why subsidize hospitals at all? ....................................................................... 130 b. state property tax exemptions are the best choice for initial reform ............ 131 c. replace all-or-nothing exemption with a more flexible system ................... 132 1. identifying services that generate credits ................................................. 132 2. measuring credits ....................................................................................... 136 3. other considerations .................................................................................. 138 v. conclusion ........................................................................................................ 139 2017] property tax exemptions for hospitals 115 i. introduction the hospital industry in the united states has entered a crucible. though the financial state of nonprofit hospitals has improved recently, many are still struggling to cope with sweeping regulatory reform and a changing healthcare landscape.1 they are attempting to accommodate a wave of newly insured patients without sacrificing quality of care.2 nonprofit hospitals largely enjoy tax exemption, but are facing challenges from state governments in both courtrooms and statehouses. 3 there is widespread dissatisfaction with the status quo. from a tax perspective, the primary problem is that hospitals no longer fit the mold of traditional charitable institutions. when the tax exemption rules were written, hospitals were places where only the indigent sought care, the providers of last resort. they did not charge for their services and were staffed primarily by volunteers.4 since then, hospitals have become the nexus of the united states healthcare system. they now host the world’s best doctors and cutting-edge medical technology. and, they have become larger and more business-oriented.5 despite the increasing complexity of hospitals as institutions, the rules granting them tax exemption have remained relatively general. at the federal level, they have historically been exempt under internal revenue code (i.r.c.) § 501(c)(3), the provision exempting charitable institutions generally, since the late nineteenth century.6 the first hospital-specific rules in the i.r.c. were added in 2010 through the patient protection and affordable care act (aca).7 the current test, the “community-benefit standard,” has been criticized for awarding nonprofit hospitals de facto exemption.8 every state has rules that allow nonprofit hospitals to gain exemption from property taxes.9 some of 1 moody’s revises us not-for-profit healthcare outlook to stable from negative as cash flows increase, moody’s (aug. 26, 2015), http://www.moodys.com/research/moodys-revises-us-not-for-profithealthcare-outlook-to-stable--pr_333323 [http://perma.cc/6mse-r77x]; paul demko, as rural hospitals struggle, solutions sought to preserve healthcare access, modern healthcare (may 16, 2015), http://www.modernhealthcare.com/article/20150516/magazine/305169959 [http://perma.cc/8a3smgyt]. 2 medicaid and chip enrollment data, medicaid.gov, http://www.medicaid.gov/medicaid-chipprogram-information/program-information/medicaid-and-chip-enrollment-data/medicaid-and-chipenrollment-data.html [http://perma.cc/z85g-wdnh]; kathleen o’brien, who will treat the flood of obamacare medicaid patients?, nj.com (feb. 5, 2015), http://www.nj.com/healthfit/index.ssf/2015/02/where_will_400k_new_nj_medicaid_patients_get_care.html [http://perma.cc/566g-zgqg]. 3 see provena covenant med. ctr. v. dep’t of revenue, 925 n.e.2d 1131 (ill. 2010); ahs hosp. corp. v. town of morristown, 28 n.j. tax 456 (n.j. tax ct. 2015); stephanie strom, states move to revoke charities’ tax exemptions, n.y. times (feb. 27, 2010), http://www.nytimes.com/2010/02/28/us/28charity.html [http://perma.cc/peb2-6mnd]. 4 ahs hosp. corp., 28 n.j. tax at 478-95; barbara mann wall, history of hospitals, u. of pa. sch. of nursing, http://www.nursing.upenn.edu/nhhc/pages/history%20of%20hospitals.aspx [http://perma.cc/peb2-6mnd]; mark c. westenberger, tax-exempt hospitals and the community benefit standard: a flawed standard and a way forward, 17 fla. tax rev. 407, 418-20 (2015). 5 wall, supra note 4. 6 i.r.c. § 501(c)(3); westenberger, supra note 4. 7 patient protection and affordable care act § 9007, 42 u.s.c. § 18001 (2010); i.r.c. § 501(r). 8 m. gregg bloche, health policy below the waterline: medical care and the charitable exemption, 80 minn. l. rev. 299, 300-01 (1995). 9 martha h. somerville et al., hospital community benefits after the aca: the state law landscape, the hilltop institute (mar. 2013), http://www.hilltopinstitute.org/publications/hospitalcommunitybenefitsaftertheacastatelawlandscapeissuebrief6-march2013.pdf [http://perma.cc/r3cc-qhf2]. 116 columbia journal of tax law [vol.8:113 these systems are even older than the federal level exemption.10 nearly half of the states draw from the federal standard and require hospitals to demonstrate some form of community benefit to receive exemption.11 in this note, i argue that the state level property tax rules governing tax exemption for hospitals are in dire need of reform. other commentators have suggested changing the metrics used to determine eligibility for tax exemption, usually focusing on federal level exemptions, but these proposals are insufficient.12 hospitals are complex institutions with viable for-profit analogues. yet, they perform socially beneficial services that are worthy of subsidy through the tax system. an effective system must acknowledge and embrace this complexity. i argue that an all-or-nothing exemption is inadequate in the hospital sector and should be replaced by a more flexible system of tax credits. credits should be provided to hospitals to offset the cost of performing traditional charity care and providing services that would otherwise be difficult for communities to access. this will allow state governments to focus their subsidies on the socially beneficial functions that hospitals offer and avoid interfering in legitimately competitive markets. while the critiques and proposed reforms i discuss could be applied to all tax exemptions for hospitals at both the state and federal levels, there are compelling reasons to begin with state property tax exemptions. in this note, i argue that the current system of property tax exemptions in every state is in need of reform. in part ii, i provide background information on the history of united states hospitals; the history of tax exemption for hospitals at the federal and state levels; and an overview of current federal and state tax exemption standards for hospitals. i discuss the federal standards because federal policy currently informs state level exemptions to a significant degree. in part iii, i discuss why reform is needed. finally, in part iv, i propose a solution that replaces traditional property tax exemptions with a series of tax credits based on the costs hospitals accrue from performing socially beneficial functions that serve the indigent or extend access to underserved populations. ii. background a. hospitals in the united states though hospitals have long been exempt from tax at both the state and federal levels, modern hospitals are far different from the institutions that existed at the turn of the twentieth century. early hospitals were truly charitable institutions. they were places where the poor could go for treatment when better options were not available. they were funded almost entirely by donations and staffed primarily by volunteers.13 10 see, e.g., ahs hosp. corp., 28 n.j. tax at 484-86 (indicates that new jersey hospitals have been exempt from tax since 1851); ky. const. § 170 (provision in kentucky constitution used by modern hospitals to secure tax exemption was originally ratified in 1891). 11 somerville et al., supra note 9. 12 e.g., nina j. crimm, evolutionary forces: changes in for-profit and not-for-profit health care delivery structures; a regeneration of tax exemption standards, 37 b. c. l. rev. 1, 101-10 (1995); john d. colombo, health care and tax exemption: the push and pull of tax exemption law on the organization and delivery of health care services: the failure of community benefit, 15 health matrix 29, 52-64 (2005); jessica berg, putting the community back into the “community benefit” standard, 44 ga. l. rev. 375, 391-95 (2010). 13 tamara r. coley, note: extreme pricing of hospital care for the uninsured: new jersey’s response and the likely results, seton hall legis. j. 275, 279 (2010). 2017] property tax exemptions for hospitals 117 the best private physicians would generally work by administering care to clients of means through direct home visits or small clinics.14 this model predominated until the end of the nineteenth century. 15 between the 1890s and 1920s, technological advancements made it possible for hospitals to offer sophisticated care to certain patients in ways that private physicians could not. hospitals became the source of the country’s best medical care and education.16 beginning in the 1930s and throughout world war ii, the advent and proliferation of hospital insurance pulled more and more paying customers into hospitals.17 this was the first period in history in which hospitals became dependent on paying patients and paid staff rather than charitable donations and volunteers.18 in 1965, the creation of medicare and medicaid accelerated this trend even further.19 today, nonprofit hospitals rely almost entirely on fees collected from patients; charitable donations constitute a negligible portion of their revenues.20 modern hospitals, for-profit and nonprofit alike, have facilities, equipment, staff, and specialists at the forefront of medical science. though no hospital is prepared to treat every possible ailment, it is generally expected that the best care of every kind will take place at some hospital. 21 modern hospitals are complex institutions; they occupy huge campuses, contain advanced medical equipment, and employ large full-time staffs of doctors, nurses, administrators, and more.22 despite these changes, however, nonprofit hospitals have generally retained their tax-exempt status at both the federal and state levels. b. federal tax exemption for hospitals 1. history of federal tax exemption for hospitals at the federal level, lawmakers have sought to exclude charities from taxation since before the advent of the modern federal income tax. the wilson-gorman tariff act of 1894 imposed a 2% tax on corporate income, but excluded “corporations, companies, or associations organized and conducted solely for charitable, religious, or educational purposes.”23 though the 1894 statute would later be found unconstitutional for other reasons, the revenue act of 1909 contained a similar provision that exempted charitable organizations, “no part of the net income of which inures to the benefit of any private stockholder or individual,” marking the first requirement that tax-exempt organizations be not for-profit. 24 the revenue act of 1913, which established the 14 id. 15 id. at 279-80; wall, supra note 4 at 2-3; m. gregg bloche, tax preferences for nonprofits: from per se exemption to pay-for-performance, 25 health affairs w304 (jun. 20, 2006), http://content.healthaffairs.org/content/25/4/w304.full [http://perma.cc/qtl7-efbl]. 16 wall, supra note 4 at 2-3; bloche, supra note 15. 17 bloche, supra note 15. 18 wall, supra note 4 at 2-3. 19 bloche, supra note 15. 20 mark a. hall & john d. colombo, the charitable status of nonprofit hospitals: toward a donative theory of tax exemption, 66 wash. l. rev. 307, 319-20 (1991). 21 wall, supra note 4 at 4-5. 22 see provena covenant med. ctr., 925 n.e.2d 1131, 1136-38 (ill. 2010); ahs hosp. corp., 28 n.j. tax. at 471, 474. 23 paul arnsberger et al., a history of the tax exempt sector: an soi perspective, internal revenue service statistics of income bulletin (winter 2008) 105, 106, http://www.irs.gov/pub/irssoi/tehistory.pdf [http://perma.cc/2twk-89yz]. 24 id. at 107. 118 columbia journal of tax law [vol.8:113 modern federal income tax system, included nearly identical language.25 at that time, hospitals were recognized as organizations that generally fit this provision, and though additional requirements have proliferated, nonprofit hospitals have been included among the entities eligible for exemption from the federal income tax ever since.26 because hospitals were initially purely charitable, their tax-exempt status was rarely challenged.27 as they evolved into more commercial entities, their de facto taxexempt status came into question. in 1956, the internal revenue service sought to clarify the application of i.r.c. § 501(c)(3) through revenue ruling 56-185.28 this created the “charity care” standard. the ruling stated that a hospital must provide care “to the extent of its financial ability” for those unable to pay to retain tax-exempt status.29 the service conceded that a tax-exempt hospital could charge certain patients for services, but that the exemption would be lost if it operated “with the expectation of full payment from all those to whom it renders service.”30 in 1965, congress created medicare and medicaid through amendments to the social security act.31 hospital administrators worried that the rapid expansion of health insurance coverage to the indigent and elderly would jeopardize their tax-exempt status simply because far fewer people would be unable to pay for their services.32 under pressure from stakeholders in the healthcare industry, the irs issued revenue ruling 69545 in 1969. this ruling created the modern “community benefit” standard.33 the standard was quickly challenged by groups representing indigent persons in need of care.34 the ruling was struck down by the district court, but was ultimately upheld by the d.c. circuit.35 the supreme court took the case and held that the plaintiffs had no standing to sue.36 this effectively upheld the revenue ruling, and it remains intact today. 2. modern federal tax exemption for hospitals: the community benefit standard understanding the federal standard is important to the analysis of state property tax exemptions because the federal standard has influenced state law. in addition to the four states that predicate property tax exemption on the maintenance of federal taxexempt status, twenty-five states utilize some form of the community benefit standard.37 formally, nonprofit hospitals are granted federal tax exemption under i.r.c. § 501(c)(3). that section provides an exemption from the federal income tax for entities 25 id. 26 see westenberger, supra note 4 at 414-23. 27 id. at 420. 28 rev. rul. 56-185, 1956-1 c.b. 202. 29 id. 30 id. 31 s.s.r. cum. ed., pub. l. no. 89-97, 79 stat. 286 (1965). 32 daniel m. fox & daniel c. schaffer, tax administration as health policy: hospitals, the internal revenue service, and the courts, 16 j. health pol’y & l. 251, 259-62 (1991). 33 rev. rul. 65-545, 1969-2 c.b. 117. 34 eastern kentucky welfare rights organization v. schultz, 370 f. supp. 325, 326-27 (d.d.c. 1973). 35 id. at 338; eastern kentucky welfare rights organization v. simon, 506 f.2d 1278 (d.c. cir. 1974). 36 simon v. eastern kentucky welfare rights organization, 426 u.s. 26 (1976). 37 somerville et al., supra note 9. 2017] property tax exemptions for hospitals 119 “organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes” that are operated on a nonprofit basis and do not intervene in or attempt to influence the political process.38 under the community benefit standard, hospitals meet these requirements because they promote the health of a significant portion of their community, not necessarily because they provide services to the indigent. rev. rul. 69-545 suggests that nonprofit hospitals should be exempt from tax by virtue of the fact that they provide medical services alone, 39 but some courts have interpreted the standard to require some proof that benefiting the public is the primary aim of the hospital.40 while certain activities listed on schedule h of form 990 – including providing charity care, conducting health education programs, and health advocacy efforts – have been accepted as indications that a hospital provides community benefits, no single activity is necessary or sufficient to meet the standard.41 the most significant change to the community benefit standard since 1969 was the addition of i.r.c. § 501(r) through the patient protection and affordable care act passed in 2010.42 section 501(r) creates two new major requirements that hospitals must meet to qualify for tax exemption under § 501(c)(3). first, hospitals must prepare a community health needs assessment (chna) every three years.43 a chna is a report based on data collected from the community served by a hospital identifying the major health challenges facing that community and laying out a plan for the hospital to better address them in the coming years.44 second, hospitals must create a financial assistance plan (fap) that delineates how the hospital will determine whether a patient is eligible for free or reduced-cost care and make the plan freely accessible for the public.45 section 501(r) also requires that individuals that qualify for assistance under the fap cannot be charged more for the services they use than an individual with insurance coverage and that hospitals take reasonable steps to determine whether a patient is covered by the fap before initiating extraordinary collections actions.46 these requirements force hospitals to more clearly demonstrate the benefits they confer on their communities.47 c. state property tax exemption for hospitals 1. overview of the history of state property tax exemptions for hospitals 38 i.r.c. § 501(c)(3). 39 rev. rul. 69-545, 1969-2 c.b. 117. 40 see, e.g. geisinger health plan v. comm’r of internal revenue, 985 f.2d 1210 (3rd cir. 1993) (holding that a health maintenance organization did not qualify for exemption because it created benefits only for its paid subscribers); ihc health plans, inc. v. comm’r of internal revenue, 325 f.3d 1188 (10th cir. 2003) (holding that “not every activity that promotes health supports tax exemption” and that hmos do not create benefits for their communities beyond their paying customers). 41 2015 form 990: schedule h, hospitals, http://www.irs.gov/pub/irs-pdf/f990sh.pdf [http://perma.cc/p76r-pnz3]. 42 patient protection and affordable care act § 9007, 42 u.s.c. § 18001 (2010). 43 i.r.c. § 501(r)(3). 44 id. 45 id. § 501(r)(4). 46 id. § 501(r)(5)-(6). 47 see susannah camic tahk, tax-exempt hospitals and their communities, 6 colum. j. tax l. 33 (2015). 120 columbia journal of tax law [vol.8:113 in many states, hospitals have been exempt from property taxes for even longer than they have been exempt from the federal income tax. in new jersey, for example, many hospitals qualified under the state’s first property tax exemption statute, passed through the laws of 1851, which exempted charitable and religious organizations generally.48 the first specific exemption for hospitals was created in 1913 and has remained essentially unchanged through the modern day.49 in 1898, kentucky added a section to its constitution exempting charitable organizations from state taxes, a provision that to this day serves as the basis by which nonprofit hospitals claim tax exemption in that state.50 currently, all fifty states contain some provision by which hospitals can claim exemption from property taxes.51 some states have altered their standards over time, either statutorily or through case law. others have continued to grant hospitals per se tax-exempt status with no significant challenges. 2. overview of modern standards of state property tax exemptions for hospitals hospitals are eligible for exemption from property taxes in all fifty states. while no two states have identical property tax rules, some commonalities do exist. no state extends full property tax exemption to for-profit hospitals; each one contains a limitation prohibiting hospitals from generating revenue that inures to private interests.52 each state also imposes some other limitation that hospitals must meet to gain tax-exempt status. hospitals can most commonly claim exemption from state property taxes through a provision of the state’s law that applies specifically to hospitals. thirty-two different states have exemptions that apply only to hospitals or health care centers, but even within this group, significant variations exist.53 some of these states, like washington, kansas, and new york, require that the property for which exemption is sought is used primarily or exclusively for hospital purposes.54 others, including indiana and colorado, require that the property be owned by a hospital and used for charitable purposes.55 in certain states, hospital-specific exemptions are constrained. for example, nevada specifically exempts the land and buildings owned by hospitals, but the provision does not cover personal property like equipment and supplies.56 this property can only be granted exemption under a statute that applies to charitable organizations generally.57 alabama 48 ahs hospital corp., 28 n.j. tax at 485. 49 id.at 491. 50 ky. const. § 170. 51 somerville et al., supra note 9. 52 id. 53 states: al, ak, az, ca, co, fl, ga, hi, id, il, in, ks, ct, md, ms, mt, nv, nj, ny, nc, nd, ok, ri, sc, sd, tx, ut, va, wa, wv, wi, wy. see a 50-state survey of state community benefit laws through the lens of the aca, the hilltop institute, http://www.hilltopinstitute.org/hcbp_cbl.cfm [http://perma.cc/28p2-zy3x] [hereinafter “a 50 state survey”]. 54 wash. rev. code § 84.36.040 (west 2010); kan. stat. ann. § 79-201b (2015); n.y. real prop. tax law § 420-a. 55 ind. code § 6-1.1-10-16 (2016); colo. rev. stat. § 39-3-108 (2016). 56 nev. rev. stat. § 361.083 (2010) (exempts real property owned by a nonprofit hospital that treats orphans or the indigent). 57 nev. rev. stat. § 361.140 (2010) (exempts all property owned by a nonprofit public charity and used for the charity’s purpose). 2017] property tax exemptions for hospitals 121 exempts all property used for hospital purposes, but only up to an amount of $75,000.58 beyond that, hospitals must rely on a more general statute.59 the other eighteen states do not have a property tax exemption that applies specifically to hospitals. in each of these states, hospitals must rely on a statute that exempts charitable institutions in general.60 usually, these provisions require that the property in question be used and the organization owning it be organized exclusively or primarily for charitable purposes.61 most of these states apply a test similar to the federal charity-care standard.62 some states in this category also impose additional restrictions. iowa, for example, only allows an exemption for a maximum of 320 acres of real property held by charitable institutions and used for tax-exempt purposes.63 a majority of states have adopted some measure of community benefit as a requirement for property tax exemption. in one way or another, twenty-nine states require hospitals to qualify as tax-exempt organizations under i.r.c. § 501(c)(3) to be eligible for exemption from property taxes.64 eighteen states impose an independent community benefit requirement on hospitals seeking exemption from property taxes.65 these often deviate significantly from the federal standard. for example, california accepts a wide variety of activities as evidence of community benefit, including educational programs, child care programs, and the sponsorship of charitable activities that promote health in some way, like food drives.66 florida, by contrast, conditions property tax exemption on qualification under i.r.c. § 501(c)(3), but also requires all nonprofit hospitals to provide a separate, state-level community benefit, which is defined solely as the provision of charity care and participation in the medicaid program.67 to summarize, state standards vary considerably. some states generally exempt hospitals from property taxes as long as the hospital operates on a nonprofit basis and works primarily to benefit the community, much like the current federal standard. others have narrower requirements and hew more closely to the old federal charity care standard. iii. the problem a. challenges facing modern nonprofit hospitals 1. hospitals face thin profit margins and struggle to continue operations many nonprofit hospitals face difficult financial situations. as a result, many hospitals choose to merge into ever-growing hospital systems or to eschew tax-exempt 58 ala. code § 40-9-1(2) (2016) (exempts property used for “hospital purposes” up to $75,000). 59 ala. code § 40-9-1(1) (1975) (exempts all property used “for purposes purely charitable”). 60 states: ar, de, ia, ky, la, me, ma, mi, mn, mo, ne, nh, nm, oh, or, pa, tn, vt. see a 50-state survey, supra note 53. 61 see a 50-state survey, supra note 53. 62 see rev. rul. 56-185, 1956-1 c.b. 202. 63 iowa code § 427.1(8)(a) (2016). 64 see a 50-state survey, supra note 53. 65 somerville et al., supra note 9 at 4. 66 cal. health & safety code § 127345(c) (west 1996). 67 fla. stat. § 617.2002 (1990). 122 columbia journal of tax law [vol.8:113 status altogether and become for-profit. 68 no two institutions are the same, and struggling hospitals can be plagued by an array of challenges, from incompetent and inefficient management to the lingering specter of malpractice lawsuits.69 however, one of the most frequently mentioned problems facing most hospitals and a main driver of the recent trend towards the consolidation of healthcare services is far more banal: low reimbursement rates. in a survey of hospital ceos regarding the greatest financial challenges hospitals faced in 2015, the second and third most common responses were medicaid reimbursement rates and bad debt from uncollectable fees.70 proponents of hospital consolidation argue that mergers are justified by economies of scale; larger hospital systems can more easily coordinate patient care and spread fixed costs, resulting in better care and lower costs for all.71 however, health economists have generally found little evidence to support this claim.72 waves of hospital mergers, most recently in the 1990s and late 2000s, have been correlated with substantial price increases and no accompanying improvement in care quality.73 finding that administrators’ stated reasons for merging are, at least to a degree, pretextual, many researchers believe that one of the main advantages sought by merging hospitals is bargaining power. in other words, a large hospital system with fewer competitors can more easily negotiate higher reimbursement rates with insurance companies.74 the bargaining power narrative is at least facially supported by the fact that both recent waves of mergers coincided with increased access to healthcare for the poor. between 1990 and 1995, the peak of the merger wave, medicaid added almost thirteen million enrollees, a significant percentage of whom were children.75 more recently, the affordable care act extended the medicaid program to cover more than thirteen million 68 see leemore dafny, hospital industry consolidation – still more to come?, 370 new eng. j. med. 198 (2014); karen e. joynt et al., association between hospital conversions to for-profit status and clinical and economic outcomes, 312 jama 1644 (2014). 69 eugene litvak, mismanaged hospital operations: a neglected threat to reform, health aff. blog (feb. 22, 2011), http://healthaffairs.org/blog/2011/02/22/mismanaged-hospital-operations-a-neglectedthreat-to-reform/ [http://perma.cc/4jtx-ykvj]; michelle m. mello et al., national costs of the medical liability system, 29 health affairs 1569, (sept. 2010), http://content.healthaffairs.org/content/29/9/1569.full.pdf+html [http://perma.cc/manage/create?url=http://content.healthaffairs.org/content/29/9/1569.full.pdf+html]. 70 top issues confronting hospitals in 2015, am. c. of healthcare executives (feb. 2016), http://www.ache.org/pubs/research/ceoissues.cfm [http://perma.cc/ngr9-fpwd]. 71 kenneth davis, hospital mergers can lower costs and improve medical care, wall st. j. (sep. 15, 2014), http://www.wsj.com/articles/kenneth-l-davis-hospital-mergers-can-lower-costs-and-improvemedical-care-1410823048 [http://perma.cc/v8fh-h5am]; james ellis & aaron razavi, 3 reasons why hospital mergers are advantageous, healthcare finance (feb. 8, 2012), http://www.healthcarefinancenews.com/blog/3-reasons-why-hospital-mergers-are-advantageous [http://perma.cc/ym5b-qv9z]. 72 see thomas c. tsai & ashish k. jha, hospital consolidation, competition, and quality: is bigger necessarily better?, 312 jama 29 (2014); leemore dafny, the good merger, 372 new eng. j. med. 2077 (2015). 73 see tsai & jha, supra note 72; dafny, supra note 72; william vogt & robert town, how has hospital consolidation affected the price & quality of hospital care?, the synthesis project (2006). 74 see vogt & town, supra note 73. 75 medical enrollment and spending, kaiser comm’n (sept. 1999), http://kaiserfamilyfoundation.files.wordpress.com/2013/01/medicaid-enrollment-and-spending-trends-factsheet-2.pdf [http://perma.cc/8ajf-8zn8]; vogt & town, supra note 73. 2017] property tax exemptions for hospitals 123 new people.76 while these expansions have improved access to care for vulnerable populations, medicaid is notorious for offering very low reimbursement rates to hospitals.77 this trend has only gotten worse, and has been exacerbated by growing losses attributable to the medicare program.78 it makes sense that hospitals would want to improve their profit margins in situations where they can bargain to offset an influx of patients covered by medicaid and growing losses from medicare. there is evidence that the factors pushing hospitals to become for-profit are similar. the recent trend towards for-profit conversion geographically mirrors the wave of consolidation; both are most frequent in the south.79 and criticisms aside, it is clear that both have beneficial effects on hospitals’ financial health.80 the hospitals of the nineteenth century were established almost exclusively to care for the poor and the elderly. the realities of modern hospital finance, however, push hospitals to run from that legacy. medicare and medicaid reimburse at much lower rates than private insurance.81 practices that have a high rate of medicare and medicaid patients, like obstetrics, tend to operate at a loss,82 but are also vital services that would be extremely difficult to access if not provided by nonprofit hospitals. 83 this is especially true in rural areas that tend to have the highest percentages of individuals covered by medicare or medicaid.84 the result is that hospitals, especially in areas that are poor and rural, have conflicting incentives. they provide services that are necessary to keep their tax exemption, but those same services cost the hospitals money and make it more difficult for them to continue operating at all. 2. hospitals’ tenuous hold on property tax exemptions 76 table 1a: medicaid and chip: june and july 2016 monthly enrollment updated september 2016, medicaid.gov, http://www.medicaid.gov/medicaid/program-information/downloads/updated-july2016-enrollment-data.pdf [http://perma.cc/6jyb-c4tq]. 77 stephen zuckerman et al., trends in medicaid physician fees, 2003-2008, 28 health affairs w510, (june 2009), http://content.healthaffairs.org/content/28/3/w510.full [http://perma.cc/5kh5-6s72]. 78 see am. hosp. ass’n, hospital payment shortfall relative to costs for medicare, medicaid, and other government, 1997-2014 (may 12, 2016), http://www.aha.org/research/reports/tw/chartbook/2016/chart4-7.pdf [http://perma.cc/6v8m-7vza]. 79 see vogt & town, supra note 73; joynt et al., supra note 68. 80 see joynt et al., supra note 68; j. kevin holloran et al., u.s. not-for-profit health care sector revised to stable from negative, though uncertainties persist, standard & poor’s global credit portal (sept. 9, 2015), http://www.globalcreditportal.com/ratingsdirect/renderarticle.do?articleid=1448167&sctartid=339491&fro m=cm&nsl_code=lime&sourceobjectid=9325791&sourcerevid=1&fee_ind=n&exp_date=2025090820:11:39 [http://perma.cc/t68m-9a9r] (indicating that improvements in hospital finances attributable to frequent mergers). 81 see am. hosp. ass’n, aggregate hospital payment-to-cost ratios for private payers, medicare and medicaid, 1994-2014 (may 12, 2016), http://www.aha.org/research/reports/tw/chartbook/2016/chart46.pdf [http://perma.cc/ms3e-mcpj]. 82 see john commins, obstetrics a money-losing challenge for rural hospitals, health leaders media (apr. 8, 2015), http://healthleadersmedia.com/page-2/com-315108/obstetrics-a-moneylosingchallenge-for-rural-hospitals [http://perma.cc/a4gl-cuj4]. 83 jill r. horwitz, why we need the independent sector: the behavior, law, and ethics of notfor-profit hospitals, 50 ucla l. rev. 1345, 1364-76 (2003) (finding that nonprofit hospitals provide undersupplied, unprofitable services at significantly higher rates than for-profits). 84 id.; commins, supra note 82. 124 columbia journal of tax law [vol.8:113 though most nonprofit hospitals have traditionally received exemption from property taxes in every state, in recent years, both courts and legislatures around the country have begun to challenge this status quo. several states’ taxing authorities have brought high-profile challenges against various hospitals’ exemptions and won. in 2010, the supreme court of illinois decided a case challenging the property tax exemption for much of the property located at the provena covenant medical center (pcmc), a nonprofit hospital owned and operated by provena hospitals.85 at the time of the case, property was exempt from taxation in illinois if it was “owned by an institution of public charity” and “actually and exclusively used for charitable or beneficent purposes, and not leased or otherwise used with a view to profit.”86 the illinois department of revenue denied provena hospitals’ application for exemption regarding the pcmc campus in 2002, finding that provena hospitals was not a charitable institution and the property was not used for charitable purposes.87 an administrative law judge reviewed the department’s decision and recommended that provena hospitals receive exemption for most of its property. 88 the department disagreed with the recommendation and denied the exemption.89 provena hospitals brought suit in the state trial court, which concurred with the administrative law judge and granted the exemption.90 the appellate court reversed. provena hospitals then appealed to the illinois supreme court, which upheld the department of revenue’s denial of provena hospitals’ application for property tax exemption for pcmc based on a finding that provena hospitals was not a charitable institution and the pcmc campus was not used in a charitable way.91 the court pointed to two major factors that swayed its decision. the first was the fact that pcmc was funded almost entirely by fees for services; of the hospital’s $118 million of total revenue, less than 4% came from sources other than fees, and less than $7,000 came from charitable donations.92 the second was the fact that neither provena hospitals nor pcmc actively promoted pcmc’s charity care program.93 the hospital would treat indigent patients but would bill them as a matter of course and force those patients to apply for free or discounted care under the terms of the financial assistance program. the court found that fees waived under this program were treated more like bad debt than charitable work and that this approach led pcmc to provide charity care at a level far below the community’s need for it. 94 of the more than 110,000 admissions at pcmc in 2002, just 302 received financial assistance.95 the court found that this number was slightly misleading; the hospital’s charity care program gave patients discounts based on the fee that they would have charged otherwise, rather than the cost of providing the care to the hospital. many of the discounts were smaller than the hospital’s profit margin, so pcmc ended up with a net gain even when treating patients that qualified for 85 provena covenant med. ctr., 925 n.e.2d at 1136. 86 id. at 1141; 35 ill. comp. stat. 200/15-65(a) (west 2002). 87 provena covenant med. ctr., 925 n.e.2d at 1141. 88 id. 89 id. at 1141-42. 90 id.at 1142. 91 id. at 1146-47. 92 id. at 1146. 93 id. at 1149. 94 id. 95 id. at 1150. 2017] property tax exemptions for hospitals 125 financial assistance.96 the court also explicitly rejected arguments about other ways that pcmc created community benefit, noting that the state standard differed from the federal one.97 in 2012, the illinois legislature responded to provena by enacting new property tax exemption rules for hospitals. rather than conforming to the federal standard, the new rules clarified the definition of “charity” in the existing rules.98 to receive a tax exemption for real and tangible personal property, an illinois hospital must provide charity care or reduced-cost services for the indigent at levels at least equivalent to what that hospital would otherwise pay in property taxes.99 additionally, the new rules allow for-profit hospitals to receive limited tax credits against their property tax burden equal to the lesser of the real property taxes on hospital facilities and the amount spent providing free and discounted care.100 while these new rules clarified the old standard, they are far from the de facto exemption offered by the federal community benefit standard, indicating that hospitals in illinois with practices similar to those employed by pcmc remain vulnerable to legal challenges. additionally, an illinois appellate court recently held that the rules requiring a quantum of charity care and other services for a hospital to receive a property tax exemption (but not those granting tax credits to for-profit hospitals) violate the illinois constitution, so the standard applicable in provena may return.101 in 2006, 2007, and 2008, the town of morristown, new jersey denied morristown medical center’s (mmc’s) application for property tax exemption. mmc is one of several nonprofit hospitals owned and operated by atlantic health system (ahs) in new jersey.102 this was the first time that a hospital’s entire property tax exemption was challenged in new jersey.103 after discussing mmc, ahs, and their structure and practices, the court traced the origin of tax exemptions for hospitals in the united states as a whole and in new jersey. the court emphasized that the rules grew out of a desire to provide tax relief to charitable institutions and that the typical practices of hospitals had changed so drastically that they no longer fit into that label.104 in new jersey, as in every other state, taxation is the rule and exemption is the exception. therefore, the court examined mmc with a critical eye and with a posture that any failure to meet the requirements contained in the statutory rules and clarifying case law would result in a loss of exemption.105 at the time of the case, new jersey exempted property “actually used in the work of associations and corporations organized exclusively for hospital purposes” and “not conducted for profit.”106 in two prior letter opinions, the state tax court concluded that mmc was organized exclusively for hospital purposes and that the vast majority of its property was used for those purposes. the question remaining in this case, therefore, was 96 id. 97 id. at 1152 98 35 ill. comp. stat. 200/15-86(a). 99 id. 15-86(c). 100 35 ill. comp. stat. 5/223(a). 101 carle foundation v. cunningham township, 45 n.e.3d, 1173, 1180 (january 2016). 102 ahs hospital corp., 28 n.j. tax at 462, 470-71. 103 id. at 464. 104 id. at 478-95. 105 id. at 496 (quoting princeton university press v. borough of princeton, 172 a.2d 420 (n.j. 1961)). 106 id. at 495; n.j. stat. ann. § 54:4-3.6. 126 columbia journal of tax law [vol.8:113 whether the property was used to generate profit.107 the court held that, except for the parking lot, fitness center, and auditorium, every portion of the mmc campus used for hospital purposes was also used to generate profit and was therefore ineligible for tax exemption.108 the court came to this conclusion through an exhaustive examination of the hospital’s practices. it found that almost every worker in the hospital, from the majority of its physicians to its food and laundry service providers, was actually a for-profit contractor. 109 though the association with for-profit service providers would not jeopardize ahs’s nonprofit status, the same for-profit companies and individuals had access to and regularly used all of the property for which the hospital was claiming exemption.110 both the identity of the taxpayer and the actual use of the property were essential components of the analysis. the court acknowledged that hospital employees had access to all of the same facilities and equipment, but noted that property used for a mix of exempt and non-exempt purposes is ineligible for exemption unless the two uses can be clearly separated. 111 in this instance, there was no distinction; for-profit physicians and staff could and did use every area of the hospital.112 in addition to the use of the property by certain for-profit entities, the court noted that ahs had direct control of various for-profit entities. the hospital group owned five separate for-profit physician practices that operated out of the mmc, an arrangement typically referred to as “captive p.c.’s.”113 the court also highlighted a cayman-based for-profit corporation that was a subsidiary of mmc. this corporation was presented as an insurance company, but the court concluded that it was functionally a reserve fund to cover unexpected liabilities. in other words, it was a way for the hospital to retain profits without formally retaining profits.114 the court also took issue with ahs’s and mmc’s extremely generous compensation of their top executives.115 all of these factors together showed that, despite its technical nonprofit status and the careful planning that sustained it, the mmc and ahs functionally operated with for-profit interests. in november of 2015, ahs reached a settlement with the town of morristown.116 months later, the new jersey legislature passed a bill that would have allowed nonprofit hospitals with some profit-generating functions to retain their exemption, but make payments to the municipalities where they were located.117 the bill was ultimately pocket-vetoed by governor christie, but its passage suggests that the 107 ahs hospital corp., 28 n.j. tax at 468. 108 id. at 536. 109 id. at 529-30. 110 id. at 501. 111 id. at 500. 112 id. at 501-02. 113 id. at 507-08. 114 id. at 510-12. 115 id. at 515-22. 116 andrew kitchenman, deal strips morristown medical center of some of its tax-exempt status, n.j. spotlight (nov. 12, 2015), http://www.njspotlight.com/stories/15/11/11/agreement-strips-morristownmedical-center-of-some-of-its-tax-exempt-status/# [http://perma.cc/xr29-7w4z]. 117 tax court rules against hospital in morristown property tax case, center for non-profits (oct. 17, 2016), http://www.njnonprofits.org/propertytax_morristownmedical.html [http://perma.cc/k9gy5kef]. 2017] property tax exemptions for hospitals 127 legislature is unwilling to continue to extend full exemption to institutions that engage in activities similar to those of mmc.118 both provena and ahs show the fragility of the property tax exemption currently held by the majority of nonprofit hospitals across the united states. in addition to the threat of litigation under current law, as recently as 2010, legislatures in states as farflung as pennsylvania, hawaii, kansas, and connecticut have introduced legislation to scale back or repeal tax exemptions for nonprofits, including hospitals.119 the problem is not simply that state and local taxing authorities have become more zealous; it is that hospitals have evolved so much since the creation of the current standards that the law has become unmoored from reality. in concluding its lengthy opinion, the new jersey tax court acknowledged,“[i]f it is true that all non-profit hospitals operate like the hospital in this case, as was the testimony here, then for purposes of the property tax exemption, modern non-profit hospitals are essentially legal fictions.”120 this has left hospitals in every state in a vulnerable, uncertain position. 3. coerced pilots add to some hospitals’ financial burdens though most nonprofit hospitals are formally tax exempt, many do pay some amount of money to their state and local governments through payments in lieu of tax (pilots).121 usually, pilots are voluntary payments made by tax-exempt entities to state and local taxing authorities. their purpose is to give municipalities some revenue stream for the services they provide to tax-exempt organizations that would otherwise pay significant amounts of tax.122 this is not always a bad thing. property taxes are hugely important for state and local governments. in 2009, it was estimated that nonprofits as a class were exempted from paying between $17 and $32 billion in property taxes across the country.123 of all of the types of nonprofits, hospitals and health care facilities would owe the largest absolute amount of property taxes absent the exemption.124 because the shortfall can be harmful to communities, in many cases, municipal taxing authorities and tax-exempt organizations can work together to facilitate the payment of pilots.125 they can be an important source of revenue for governments experiencing financial difficulties or contemplating a significant one-time expenditure that promises great social benefit.126 in these cases, pilots are not sinister; they are a way to facilitate the flow of resources to higher-valued uses in a way that is more tailored to individual situations than the 118 id. 119 strom, supra note 3; governor’s s.b. no. 945, gen. assemb., sess. year 2015 (conn. 2015); andy marso, hospitals on guard after nonprofit tax proposal surfaces, kansas health institute (jun. 1, 2015), http://www.khi.org/news/article/hospitals-on-guard-after-nonprofit-tax-proposal-surfaces [http://perma.cc/ew6r-qp32]. 120 ahs hosp. corp., 28 n.j. tax at 536. 121 daphne a. kenyon & adam h. langley, payments in lieu of taxes: balancing municipal and nonprofit interests, lincoln inst. of land pol’y 4-6 (2010), http://www.lincolninst.edu/sites/default/files/pubfiles/payments-in-lieu-of-taxes-full_0.pdf [http://perma.cc/bfn3-2jur]. 122 id. at 6. 123 id. at 19. 124 id. at 5. 125 id. at 6. 126 maria di miceli, drive your own pilot: federal and state constitutional challenges to the imposition of payments in lieu of taxes on tax-exempt entities, 66 tax law 835, 836 (2013). 128 columbia journal of tax law [vol.8:113 sweeping exemption rules and can be employed in the short run and on a temporary basis. this can allow nonprofits to bolster the communities that support them and build goodwill in areas where citizens disapprove of their exempt status.127 though pilots are technically voluntary, researchers have noted that cashstrapped state governments have used the implicit threat of judicial or legislative action against nonprofit hospitals’ vulnerable tax exemptions as leverage to extract higher payments (and have done the same to other nonprofits).128 not all states or localities pressure nonprofits into making pilots, but there is evidence that the practice has become more common in recent years, especially since the economic downturn that began in 2007. since 2000, at least 117 cities and 18 states have utilized some form of pilots, most commonly in the northeast.129 in 2010, for example, the government of baltimore, maryland agreed to forego a controversial “bed tax” in exchange for an agreement from johns hopkins and other hospitals to begin or increase pilots.130 in 2009, the city of boston, the largest collector of pilots in the united states, proposed reforms to its standing program that would assess pilots on all tax-exempt organizations above a certain size, which includes several hospitals.131 while the plan was partially crafted by and drew support from certain nonprofit institutions, it also has its share of critics who argue that the program is coercive.132 though it is not a problem everywhere, the proliferation of extractive pilots is harmful to the nonprofit hospital sector. when municipalities grant tax exemption, it is not solely humanitarian; it is a tradeoff. the government agrees to set aside its taxing authority on the theory that the organizations given preferential treatment will provide some benefit to the community that outweighs the lost revenue.133 the connection between hospitals and public benefit is clear: hospitals keep people healthy, and a generally healthy society has positive effects for everyone in it. every dollar extracted from hospitals by municipalities through pilots is a dollar diverted away from that mission and towards the general operations of the state or local government. this topdown reallocation of funds may or may not be economically sound, but whether or not that is the case is a determination that should be made by a legislature, not through closed negotiations. when pilots are coerced rather than freely given, the municipality functionally imposes tax on otherwise tax-exempt entities without the safeguards of a full legislative process.134 these functional taxes are imposed unevenly, creating horizontal equity issues. coerced pilots make it difficult for the targeted hospitals to administer charity care and other socially beneficial services and impose another costly burden on 127 kenyon & langley, supra note 121 at 6. 128 di miceli, supra note 126 at 842-43. 129 id. at 843. 130 peter sicher, hopkins and other institutions pay baltimore $20.4 million to avoid tax increases, the johns hopkins news-letter (jul. 15, 2010), http://nlonthedl.wordpress.com/2010/07/15/hopkins-and-other-institutions-pay-baltimore-20-4-million-toavoid-tax-increases/ [http://perma.cc/y66q-ufs7]. 131 kenyon & langley, supra note 121 at 21-24. 132 tim delaney, boston’s coercive pilots experiment should crash, huffington post (jun. 28, 2011), http://www.huffingtonpost.com/tim-delaney/bostons-coercive-pilots-e_b_854531.html [http://perma.cc/4ab6-g735]. 133 see rev. rul. 65-545, 1969-2 c.b. 117 (federal tax exemption is predicated on hospital’s benefit to the community); provena covenant med. ctr., 925 n.e.2d at 1145-46 (noting that reducing the burden of government is an important function of nonprofit hospitals). 134 di miceli, supra note 126 at 855 (concludes that coerced pilots are analogous to unauthorized taxes). 2017] property tax exemptions for hospitals 129 already-struggling institutions.135 this blunts the positive effects that tax-exemption promotes in the first place. b. incongruity between tax exemption standards and reality of hospital administration hospitals are huge, complicated businesses, and addressing the issues they face is made more difficult by the fact that they provide services that are essential. quality healthcare is important for both the individuals who receive it and all others who benefit from living in a generally healthy place. however, the current system grew out of a world where hospitals were simpler and less integral to our society. the fundamental problem is that tax exemption is all or nothing; a hospital either keeps exemption or loses it. losing exemption from state property taxes would be massively costly for any hospital. modern hospitals necessarily own and occupy a huge amount of property. provena covenant medical center, the hospital discussed in the illinois case above, occupied approximately nine acres of land and accrued $1.1 million in property taxes in 2002 and 2003 alone.136 morristown medical center, the hospital discussed in the new jersey case, occupied more than forty acres and is expected to owe more than $2.5 million in property taxes each year following the decision against it.137 being forced to bear such a cost with little warning could predictably force a hospital to cancel unprofitable services and become for-profit, or close its doors entirely. in other words, all-or-nothing exemption is too rigid and heavy-handed a tool; a more nuanced, flexible system is needed. currently, the status quo awards hospitals with exempt status if they provide a quantum of certain services, but offers no benefits to offset the costs of these services above or below that line. this creates strange incentives for hospitals. they have a reason to engage in the activities necessary to attain exempt status, but only to the degree that is absolutely required; beyond that point, charity care is pure cost. it logically follows that the most successful nonprofit hospitals under this regime will be the ones that provide the bare minimum amount of charity care and other socially beneficial services. there is some evidence that hospitals are acting on these incentives. several researchers have found that nonprofit and for-profit hospitals provide similar quality of care and do not differ in terms of the number of poor people, children, and seniors they treat.138 compensation packages for nonprofit executives are set specifically to mirror their for-profit competitors. 139 some commentators indicate that nonprofit hospitals contemplate making cuts to obstetrics divisions, a practice area that is notoriously unprofitable, in times of financial strain.140 if hospitals are viewed and treated like 135 id. at 843. 136 provena covenant med. ctr., 925 n.e.2d at 1138, 1140. 137 tim darragh, morristown hospital loses property tax court case; judge says facility does not meet non-profit status, nj.com (jun. 26, 2015), http://www.nj.com/morris/index.ssf/2015/06/morristown_medical_center_loses_tax_case_raising_f.html [http://perma.cc/p3s3-r8em]. 138 e.g., colombo, supra note 12 at 45-50 (reviewing studies finding little to no difference between nonprofit and for-profit hospitals in terms of quality of care and volume of charity care). 139 rachel landen, another year of pay hikes for non-profit hospital ceos, modern healthcare (aug. 9, 2014), http://www.modernhealthcare.com/article/20140809/magazine/308099987 [http://perma.cc/9fve-24z2]. 140 commins, supra note 82. 130 columbia journal of tax law [vol.8:113 businesses, these moves make sense. a hospital cannot consistently operate at a loss. this position does not conflict with the view that hospitals should create social benefits. if they cannot make ends meet, they cannot care for anyone, and it is good for people across the country to have easy access to medical services.141 therefore, a tax system that subsidizes hospitals in a way that acknowledges that they are run primarily as businesses that produce strong, positive externalities is warranted. iv. a unified regime of hospital property taxation a. why subsidize hospitals at all? many economists believe that the free market is the most effective way to provide goods and services to society.142 if the free market produces the most efficient outcome, taxes that distort behavior produce inefficiency. based on these assumptions, there is a surface-level appeal to the idea that hospitals should simply not be eligible for tax-exemption. a significant amount of evidence suggests that tax-exempt nonprofit hospitals and for-profit hospitals provide comparable levels of charity care and deliver similar quality of care. 143 administrators at nonprofit hospitals often receive high compensation and benefits.144 exemption from property taxes costs many state and local governments a huge amount of revenue that could go to other important programs.145 given that nonprofit hospitals run essentially like businesses and compete with financially-viable, for-profit companies, it makes some sense to simply eliminate property tax exemption for hospitals and allow the free market to run its course. however, these facts over-simplify reality. many economists acknowledge that markets do not produce efficient outcomes in instances where supply and demand for some product do not converge at a socially optimal point.146 these market failures can occur for a variety of reasons. one commonly-acknowledged source of market failure is the presence of significant externalities. externalities exist when a person’s actions cause some harm or benefit, but that person cannot feasibly be paid to perform or abstain from those actions by the affected party. 147 there is strong evidence that healthcare has positive externalities. that is, when a person is made healthy, society as a whole benefits, not just the healthy person and her doctor.148 therefore, subsidizing health in general is warranted. but health is a multifaceted concept, and there is reason to believe 141 see john d. colombo, the role of access in charitable tax exemption, 82 wash. u. l. q. 343 (2004) (arguing that expanding access to care for previously-underserved populations should be the main criteria for determining tax-exempt status). 142 see, e.g., milton friedman, capitalism and freedom (u. of chi. press, 40th anniv. ed. 2002). 143 e.g., colombo, supra note 12 at 45-50. 144 landen, supra note 139. 145 kenyon & langley, supra note 121 at 19. 146 tax court rules against hospital in morristown property tax case, center for non-profits (oct. 17, 2016), http://www.njnonprofits.org/propertytax_morristownmedical.html [http://perma.cc/aet7hc29]. 147 id. (“externalities are probably the argument for government intervention that economists most respect.”). 148 david e. bloom, et al., the effect of health on economic growth: theory and evidence (nat’l bureau of econ. research, working paper no. 8587, 2001), http://www.nber.org/papers/w8587 [http://perma.cc/9ztm-pbgp] [hereinafter bloom, et al., effect of health on economic growth]. 2017] property tax exemptions for hospitals 131 that nonprofit hospitals currently contribute to it in ways that for-profit hospitals do not, and that incentive structures could be created to help them do so even more effectively. nonprofit hospitals do not provide more charity care or deliver better service than their for-profit counterparts, but research shows that nonprofit hospitals do provide important but unprofitable services at far higher rates than for-profits.149 in other words, nonprofit hospitals are not the sole providers of health care to all people, but they are the only viable option for certain people to receive certain services.150 for businesses in a free market, access is not always a virtue. if a car company manufactures a bad car, they can drop it from their line; society at large will not suffer. on the other hand, if a hospital eliminates its obstetrics and psychological health divisions because they are unprofitable, pregnant women and the mentally ill will be in serious trouble. those people, their families, and the people that they interact with will suffer. by providing services that would be difficult to justify for a purely profit-oriented business, nonprofit hospitals create a social value that is difficult to quantify in terms of dollars and cents, but is nonetheless essential.151 the tax system should not ignore this reality; it should embrace it. the current all-or-nothing community benefit model does not accomplish this goal very well. a new system should push hospitals to provide the services that people need without wasting dollars subsidizing those for which there is a competitive market. hospitals are complex; a nuanced and flexible solution is needed. b. state property tax exemptions are the best choice for initial reform the general critique that antiquated, all-or-nothing tax exemption rules are not flexible enough to adequately create pro-social incentives for complex, modern hospitals can be leveled equally against state-level property tax exemptions and the federal-level exemption in i.r.c. § 501. however, it makes sense to begin reform at the state level. the first reason is practicality. the proposed reforms will likely be costly in the short term for hospitals that need to learn and conform to the new rules and for governments that need to create an administrative apparatus capable of executing the program. the relative size of these costs will likely vary from state to state. on the other side of the coin, the benefits of a more nuanced system of tax subsidy for hospitals may be larger in certain states than others. those with the most to gain can bear the costs of necessary trial and error and, if ultimately successful, can serve as a model that helps subsequent adopters avoid pitfalls. in other words, early-adopter states that fall on the favorable end of the cost-benefit spectrum can help lower economic barriers and uncertainty for those that come later. second, reforms at the state level will allow for greater variation. different states face wildly divergent health policy challenges. it is possible that certain services should generate tax credits in sparsely populated, primarily rural states in the great plains because they are universally costly to provide or difficult to access through other means and that the same services can support a legitimately competitive, net-profitable market and should not generate tax credits in more affluent, more densely-populated new england. if states can make these determinations for themselves, they can create a 149 horwitz, supra note 83, at 1364-76. 150 id. 151 id., see also colombo, supra note 142 (emphasizing the importance of nonprofits expanding access to underserved populations, particularly in the healthcare field). 132 columbia journal of tax law [vol.8:113 system that more effectively controls administrative costs. by contrast, attempting to start with a blank slate at the federal level could devolve quickly into a nightmare of costly administrative backlog. in short, it makes sense to begin hospital tax exemption reform at the state level, where experimentation is possible, before attempting to tackle the federal system. c. replace all-or-nothing exemption with a more flexible system to begin to fix the inadequacies of the current landscape of property tax exemptions for hospitals, states must acknowledge that, at their core, modern hospitals are money-driven enterprises. rather than fight or deny this reality, states should strive to craft rules that use this business-oriented mindset to encourage hospitals to operate in a way that is maximally beneficial for society. to begin, states should repeal the current all-or-nothing property tax exemptions available to hospitals and replace them with a series of tax credits. hospitals should be granted credits against their property tax burden equal to the cost of certain services. additionally, the services that are eligible to generate credits should be regularly reassessed. this system is similar to the one proposed at the federal level by professor nina j. crimm, but distinct in several important ways.152 to the extent that the two proposals overlap, there are strong reasons to revisit and revise her ideas at the state level because of the recent political push towards reform and certain provisions of the aca that will support such a complex system. the system of credits should be generally available to all hospitals except those that would continue to qualify for tax exemption even after the repeal of general exemption, like many municipal, religious, and university hospitals.153 these reforms would create better incentives for hospitals by providing subsidies for services with substantial public benefit that would not otherwise be offered and removing subsidies from activities that can be profitable and thus will be provided through a free market. they will also reduce uncertainty and allow hospital administrators to more effectively plan their operations. 1. identifying services that generate credits one fundamental problem with the all-or-nothing exemption standards currently in force in every state is that they lack the nuance required to create socially optimal incentives for the sophisticated institutions that hospitals have become. indeed, hospitals are given a reason to perform certain activities, like provide emergency room services and charity care, but only to a degree necessary to obtain exemption. and when other activities are important for the promotion of health but unprofitable and excluded from 152 crimm, supra note 12 at 101-10. crimm proposes replacing federal tax exemption for hospitals with deductions or credits that offset the costs of activities deemed to be charitable by a series of regional expert panels and scaled according to broad federal guidelines. while similar to the proposal in this note, crimm envisions a system in which a web of federal guidelines creates a general framework for tax exemption within which regional panels have a great deal of discretion. this proposal, by contrast, advocates more bright-line rules and grants more responsibility and discretion to the healthcare providers themselves. 153 it is not a foregone conclusion that all such hospitals will retain their exemptions if the rules that currently grant property tax exemptions to hospitals are removed, but it is likely that at least some will, and a system of credits should not extend to hospitals that do retain full exemption. 2017] property tax exemptions for hospitals 133 the schedule of services that can contribute to tax-exempt status, hospitals gain no financial advantage by expanding access or quality of care for their patients. to realign these incentives, hospitals should be granted credits on a hospital-byhospital basis for performing activities that meet a few general criteria of public benefit. the activities should be 1) needed by the community, 2) unprofitable for any hospital in the region, and 3) unavailable through other means. these criteria ensure that credits are only awarded for services that are medically important and cannot be provided through a competitive market. in transitioning to a credit system, states do not necessarily need to abandon all gateway requirements for hospitals to gain tax-exempt status. they could preserve the mandatory nature of certain services by treating them as preconditions for the receipt of tax credits. these elements would need to be concrete and essential for a charitable hospital. for example, states could require all hospitals that want to claim these tax credits to be licensed in the state or to participate in the medicare and medicaid programs. while precondition status will give hospitals a very strong incentive to perform a particular function, the drawback is that every item treated as such would complicate hospital administration and would create the risk that some hospitals will be cut off from all of the benefits and positive incentives that would come with access to the credits. therefore, while states may decide to require some preconditions, it is not clear that any are essential. 154 in addition, states can adopt a softer approach than pure preconditions. for example, a state could allow hospitals that do not accept medicare and medicaid patients to receive credits for charity care, but calculate them based on a lower percentage of net costs than the credits extended to hospitals that do participate in those programs. once hospitals meet the conditions necessary to receive tax credits, the state should determine which services should be eligible to generate credits. states should attempt to designate a wide range of services, like charity care and emergency room services, which generate credits for every hospital by default. they should also attempt to create some metric to pinpoint hospitals and services that should be presumed credit eligible. one way to do this would be to adapt the formula currently used to allocate disproportionate share payments under the medicare program.155 these payments award higher reimbursement rates to hospitals that treat a particularly large number of medicare and medicaid patients. 156 hospitals are designated disproportionate share hospitals (dshs) based on a formula incorporating the total number of inpatient days attributable to medicare and medicaid patients relative to the hospital’s total pool of patients.157 similar criteria could be used to identify specific services at hospitals that should generate credits per se. for example, a service that consistently operates at a loss could be granted per se credit eligibility if a sufficiently high percentage of the patients who utilize it are uninsured or covered by medicare or medicaid. distance-based metrics could also be employed; a state could extend credits to important services offered by 154 even without explicit preconditions, functionally, certain choices may make it difficult for hospitals to be eligible for any credits. for example, it would be difficult for a hospital that does not accept medicare and medicaid patients to make the case that they meaningfully extend access of necessary services to underserved members of their communities. still, it may be socially beneficial to extend credits for charity care performed by these hospitals. 155 42 c.f.r. § 412.106(b) (2015). 156 id. 157 id. 134 columbia journal of tax law [vol.8:113 hospitals that cannot be obtained from any other healthcare providers within fifty miles. this metric would be similar to the one used to identify sole community hospitals, another special classification that earns higher reimbursement rates under the medicare program.158 while different states can and should settle on a wide variety of metrics, the only important criteria is that they be objectively, unequivocally measurable. if a hospital’s services meet any of these criteria, they should be deemed to generate credits without the need for any prior administrative approval.159 ideally, the majority of hospitals would be able to calculate and claim their own credits directly on their annual returns, giving healthcare providers a greater ability to predict and control their own finances. while the metrics discussed above should serve as a safe harbor for hospitals seeking to claim credits for specific services, the new law must include a catch-all provision that allows hospitals to receive credits for services that extend needed healthcare access to underserved populations. individual hospitals should be allowed to petition the state under the catch-all provision and provide evidence showing that other services meet the three criteria that justify the provision of tax credits. to evaluate these petitions, the state should empanel a hospital tax credit evaluation board comprised of specialists in the medical field, hospital administrators, lawyers, and other experts. the board should evaluate the evidence provided by the hospital and either grant or deny credits for those services for a set period of years. to facilitate the petitioning process for both hospitals and the tax credit evaluation board, states could leverage the new chna requirement created through the aca.160 every three years, nonprofit hospitals are required to generate a detailed report on the health needs of the community they serve.161 these reports could serve as the basis for hospitals’ petitions. there would be no extra cost in obtaining the necessary data because they would have generated it anyway. the state’s board could grant or deny credits for particular services for three year periods, meaning that each hospital will need to make their next petition at the same time that they produce their next chna. such a rule has the added benefit of reinforcing the chna requirement by giving hospitals a financial incentive to use thorough, rigorous methodologies and generate a large amount of data about their communities’ health. critics may point out that tying the chna process to tax exemptions will give hospitals an incentive to tweak their findings. however, the potential problems caused by these incentives can be mitigated, if not eliminated. first, the evaluation board should implement ways to check the methodologies employed by hospitals that submit petitions for tax credits. this is why the evaluation board should contain a wide range of experts, including administrators, doctors, and public health specialists. second, the evaluation board will receive reports from many hospitals, some with overlapping communities. in this way, hospitals can be used to check one another. currently, the irs allows hospitals 158 id. at § 412.106(d)(2)(ii)(b). 159 this is a significant point of difference between this proposal and the one made by crimm – under that plan, all services would need to be approved by a regional board before a provider can claim any credits or deductions. crimm, supra note 12 at 106-09. 160 patient protection and affordable care act § 9007, 42 u.s.c. § 18001 (2010); i.r.c. § 501(r)(3) (2015). 161 i.r.c. § 501(r)(3)(a)(i) (2015). 2017] property tax exemptions for hospitals 135 with overlapping service areas to conduct joint chnas.162 to prevent collusion and to add an extra incentive for hospitals to collect and report accurate data, joint reports should not be allowed for hospitals seeking state-level tax exemption. credits should be extended to different services at different hospitals because hospitals are situated in such complex markets. the purpose of these tax credits is to subsidize needed services that would otherwise be difficult to access for people in the community served by a particular hospital. which services fit that definition will vary from region to region and institution to institution, and thus so should the credits. for example, obstetrics and psychiatric care are often costly for hospitals. 163 expectant mothers may only be able to find essential services at a single facility within convenient driving distance.164 at these hospitals, it makes sense to subsidize obstetrics. in more affluent urban areas, however, obstetrics can at least break even, and mothers can have a variety of options to choose from when deciding where to receive care.165 at these hospitals, it does not make sense to subsidize obstetrics. the determinations must also be comparative when communities have access to multiple hospitals. it would be incoherent to subsidize an unprofitable program at one hospital if the same services are available to the community and profitable at a competing institution a few miles away.166 there are several additional critiques that could be leveled against this plan. some may argue that running certain hospital tax credit determinations through a board that consists of a relatively small number of appointed individuals may raise concerns of corruption or bias. this can be addressed by insulating the evaluation board from political pressure by making it an independent organization and limiting the term that board members can serve. the composition of the board itself can also be used to mitigate concerns about bias. for example, the inclusion of individuals that have experience working in both rural and urban communities could help to ensure that the board is familiar with and sensitive to the main health issues facing different populations within a state. finally, board members should be required to disclose any financial conflicts of interest and be excluded from considerations where those conflicts could affect their decision making. critics may also contend that transitioning to this plan would be prohibitively costly in the short term. these concerns, too, can be somewhat alleviated. early adopting states will face the highest short-term administrative costs because they will need to build a new system from the ground-up. but the earliest adopters are also likely to be the states with the most to gain from transitioning to a credits-based hospital property tax system. if a state decides to implement reform, it can be assumed that it has 162 t.d. 9708, 2015-5 i.r.b. 352 (“[t]he final regulations . . .permit collaborating hospital facilities to produce joint chna reports”). 163 paul s. appelbaum, the ‘quiet’ crisis in mental health services, 22 health affairs 110, (2003), http://content.healthaffairs.org/content/22/5/110.full; commins, supra note 82. 164 health disparities in rural women, american college of obstetricians and gynecologists: committee opinion no. 586, (feb. 2014), http://www.acog.org/resources-andpublications/committee-opinions/committee-on-health-care-for-underserved-women/health-disparitiesin-rural-women. 165 id. 166 though their function should be relatively limited, the boards should have a fairly large degree of discretion over cases that come before them. for example, a hospital should not be denied credits for their obstetrics program if it treats a large number of medicaid patients even if a competitor operates a profitable obstetrics department with relatively few or no medicaid patients. 136 columbia journal of tax law [vol.8:113 at least considered the relevant costs and benefits and determined that the balance of the two is favorable. the transition will also be expensive for hospitals. though a credits-based system could theoretically bring in more money for a hospital than the loss of property tax exemption removes, in the short term, many hospitals will need to figure out how to effectively compile and present evidence to the evaluation board. these up-front costs, coupled with the existing expense of the chna process, may be difficult for struggling hospitals to bear. to remove some of this burden, the system could be announced several years before it takes effect. the state could also allow hospitals to make a “practice” round of tax credit petitions. in the first year of implementation, the evaluation board could give all hospitals who submit petitions for specific credits the choice between transitioning immediately to the credits-based system and keeping their existing exemption for a period of three years after seeing the results. this will allow hospitals to go through the petition process, see how their petitions fared, and learn about to prepare more effectively for the next cycle while maintaining their existing exempt status. ultimately, this should allow hospitals to craft reasonable predictions about what credits will be available to them once the law goes fully into effect and plan their finances accordingly. on balance, a centralized oversight board that makes determinations about services that do not fit a state’s safe harbor eligibility provisions ensures that the credit system is adequately flexible to create socially beneficial incentives for hospitals. 2. measuring credits identifying which services at which hospitals should be eligible to generate credits creates incentives for hospitals to provide more of the things that benefit their communities the most. however, this first step alone creates a new problem: how are the credits measured? to create an effective incentive for hospitals to create social benefits, the financial subsidy, the credits, must be tethered to the costs of providing the activity to be subsidized, the eligible services. however, if credits are offered based purely on costs with no other controls or oversight, hospitals would have an incentive to inflate the costs of credit-eligible services. though most hospitals may not waste time and resources to unscrupulously inflate charity care services, they would also have little reason to ensure that those cases were handled efficiently. though each state must ultimately evaluate for itself which metric is best, any workable system must contain at least some answer to this challenge. states could peg the value of the credits to the net cost of providing the eligible services and pair such a system with provisions that require sound practices on the part of hospitals. hospitals could be required to maintain an ombudsman program to evaluate procedures of credit-eligible services and ensure that they comport with industry standards. the state could also empower an administrative agency to conduct periodic, random audits of hospitals’ credit-eligible activities. the enacting legislation could also subject hospitals to criminal fraud charges for inflating costs or deviating from standard industry practice when handling a credit-eligible patient. this approach has both pros and cons. one advantage is that it closely correlates the tax credits offered to hospitals with the activities that the state wishes to promote. it also gives state legislatures the power, which could be passed on to the evaluation board, to specifically tailor the credits in a way that creates good incentives and controls costs. 2017] property tax exemptions for hospitals 137 if they worry about excessive costs, states could provide credits at lower rates for services that are nearly profitable and higher rates for care that goes completely unreimbursed. finally, the state could adjust the multiplier to offer larger or smaller credits as a percentage of the cost of providing the service in question based on how effectively the service relieves a burden that would otherwise be borne by the government. alleviating government obligations is a critical function of nonprofit organizations, is currently used to determine eligibility for property tax-exemptions in several states, and was discussed in regards to hospitals in the provena case.167 the main drawback of using actual net costs to measure the value of the credits is that directly policing the practices of doctors and other practitioners will be difficult and expensive. if the punitive measures meant to control cost and quality are too stringent, professionals will have a reason to avoid socially beneficial work, at least in difficult cases. an oversight program must necessarily be enforced, so litigation and its attendant costs will be unavoidable in at least some instances. finally, no matter the effort, ensuring best practices in the face of a financial incentive for inefficiency will be impossible, and some hospitals will simply get away with inflating the cost of some services and be rewarded with higher tax credits. alternatively, states could allocate credits with a fixed service-by-service estimate of costs rather than actual costs. periodically, the same board responsible for determining whether non-codified services are credit-eligible for each hospital could come together with accounting professionals to create average reimbursement tables for different types of services. the primary advantage of a proxy measure is that it would create an incentive for hospitals to keep their costs low; a hospital that performs a certain service at a cost point below the fixed level of the credit will be able to pocket the difference. in this way, the credits would become a vehicle to subsidize both scarce, socially beneficial services and innovation in providing them efficiently. additionally, this system would be more administratively convenient than one that valuates credits based on the true cost of individual services performed. when filing a return, hospitals would only need to list the type and quantity of credit-eligible care they provided. a measurement system based on actual costs, by contrast, would require hospitals to include a far more in-depth accounting of their operations. a fixed credit system would therefore reduce costs for both the hospitals and state governments. to avoid insufficient credits in extraordinarily expensive cases, the state could also allow hospitals to appeal for a positive adjustment to their credit amount if they can show that a particular case was atypically costly. this would at least mitigate the incentive that hospitals would have to avoid complex crediteligible patients. opposite its advantages, a system of allocating tax credits to hospitals using fixed service-by-service cost estimates has distinct drawbacks. first, while fixed credit amounts would give hospitals an incentive to provide credit-eligible services more efficiently, it would also give them an incentive to keep costs low by sacrificing quality of care. for example, if a new surgical technique in a credit-eligible practice proves both more effective and more costly than the old standard, hospitals may push against its adoption, thereby stifling, rather than promoting, innovation. while this tendency will always be bounded by industry standards and outcomes, it may decrease marginal quality of care in credit-eligible services. second, developing the credit tables would be costly. 167 provena covenant medical center v. dept. of revenue, 925 n.e.2d 1131, 1145-46. 138 columbia journal of tax law [vol.8:113 these expenses could be defrayed somewhat by spacing out the periodic recalculations of the tables, but larger gaps will also increase the risk that technological or other changes will render them inaccurate for a significant period of time. finally, using a fixed proxy for generating credits will create some discrepancy between the amount of the credit gained by the hospital and the actual cost of treating each patient or providing each service. absent careful safeguards, this could create opportunities for abuse if hospitals are able to blur the lines between services that can produce different fixed credit amounts. 3. other considerations in evaluating this proposal, it is important to consider some final pros and cons from the perspective of both hospitals and states. on balance, this system is intended to provide the most aid to the hospitals with the greatest financial difficulties that provide essential services to otherwise underserved populations. if its state crafts a fair system of refundable credits, it is likely that a hospital that provides a large amount of charity and greatly improves its community’s ability to access necessary care will benefit financially from these reforms relative to even full tax exemption. however, inequities may arise between hospitals in states where there is a high degree of variation in property values, like new york and california. a hospital situated in the heart of manhattan would likely be liable for astronomically high property taxes relative to one in a far-flung suburb of buffalo.168 the same problem may arise if the system of credits does not account for variations in property tax rates between localities. this problem is another reason that reform should begin at the state level, where it would be far easier for the states that face particular challenges to craft unique solutions than it would be on a much larger scale. for example, states could at least mitigate these disparities by pairing a system of credits with a provision that valuates hospitals for tax credits based on their use of the land that they occupy rather than fair market value. similar statutes are already employed by various states to subsidize agricultural land.169 the drawback to such a solution is administrative costs; alternative valuations will ultimately require more bureaucratic intervention in a system that, even at its most streamlined, will necessarily be highly complex.170 while these measures may be required to administer the system of tax credits more fairly in certain situations, the purpose of the proposal would be defeated, especially from the perspective of the state, if the rules were too hospital friendly. these rules are meant to subsidize the most socially beneficial behaviors of hospitals and to cease subsidies to activities that are essentially competitive. in other words, if the system is working correctly, many hospitals that currently enjoy total exemption from state property taxes will either need to greatly alter their activities to generate more tax credits 168 see andrew haughwout, et al., the price of land in the new york metropolitan area, 14 fed. res. bank of n.y. 3, 1 (2008), http://www.newyorkfed.org/medialibrary/media/research/current_issues/ci14-3.pdf [http://perma.cc/nu7gyq2m] (describes sale of unimproved land in manhattan in 2000 for over $2,300 per square foot); bellevue, nyc health & hospitals, http://www.nychealthandhospitals.org/bellevue/html/about/history.shtml [http://perma.cc/7gfc-agar] (bellevue hospital in manhattan occupies a campus of approximately 1.7 million square feet). 169 see, e.g., kan. stat. ann. § 79-1476 (west 2016); fla. stat. ann. § 193.461(6)(a) (west 2016); utah code ann. § 59-2-503 (west 1953). 170 crimm, supra note 12 at 110 (acknowledging that the proposed tax credit system is “complex, and likely to pose numerous administrative challenges”). 2017] property tax exemptions for hospitals 139 or begin paying at least some property taxes. while the devil is in the details, many states will probably create systems that are expected to increase net tax revenues, particularly from urban areas where they currently forego the greatest amount of property taxes to exempt hospitals and where municipalities are already most likely to employ pilots to temper the effects of all-or-nothing exemption. 171 when reforms are administered well, therefore, states and their citizens can expect a shift in hospital behavior towards more socially beneficial practices and an increase in general tax revenue that can fund other important programs. v. conclusion hospitals have been exempt from tax in the united states for more than a century. however, they have evolved from typical charities to complex businesses and the tax law has not kept pace. for-profit hospitals that do not differ from their nonprofit counterparts in a variety of meaningful ways have proliferated, 172 but the positive externalities of widespread, easy access to quality healthcare continue to justify subsidy.173 the system must be reformed to acknowledge this reality. new rules must continue to subsidize essential, socially beneficial hospital functions and avoid interfering in competitive markets by subsidizing activities performed by certain hospitals and failing to do so for essentially identical functions of other institutions. all-or-nothing exemptions cannot accomplish these goals because they are not equipped to differentiate between a hospital’s many functions. the reforms proposed in this note attempt to accomplish these twin aims by replacing current state-level property tax exemptions with a series of tax credits. first, states should identify objective safe harbors that hospitals can use to claim credits for services that are charitable or increase access to care. second, states should establish a catch-all rule that allows an evaluation board comprised of experts to evaluate hospital functions that do not fall into any of the safe harbors, but should be eligible to receive credits. specific hospital programs should be deemed eligible if they 1) are essential medical services, 2) are not provided for a profit by any hospital easily accessible to the community, and 3) are not accessible through any other means. finally, the credits must be valuated according to a hospital’s net cost of providing the eligible services. this can be accomplished either by measuring actual costs or through the periodic establishment of a schedule of fixed credit amounts for specific services. if implemented, these reforms would allow nonprofit and for-profit hospitals to compete fairly in markets for services that are readily available and maintain subsidies for activities that extend unprofitable, socially beneficial services to those for whom access would otherwise be difficult. especially in light of the recent expansion of the low-reimbursement medicaid program, this new system will help hospitals provide services that are not strictly charitable but are nonetheless important without jeopardizing their financial position. finally, reform will allow states and localities to generate needed revenue in areas with robust, competitive health services markets. 171 kenyon & langley, supra note 122 at 6, 19. 172 e.g., colombo, supra note 12 at 45-50. 173 bloom, et al., effect of health on economic growth. microsoft word cooper9-1 (1).docx soldiers with fortunes? rethinking the tax treatment of fallen combatants jeffrey a. cooper* abstract section 2201 of the internal revenue code provides a partial estate tax exemption for members of the armed forces who die in, or as a result of, combat operations. in this article, i explore the origins of this exemption and assess the extent to which it serves three important policy goals: (1) reducing financial and administrative burdens on military families, (2) incentivizing military service, and (3) avoiding the moral hazard of the government being able to “profit” (through increased tax revenues) as a result of combat deaths. through this analysis, i conclude that this arguably well-intentioned provision does little to serve these three policy ends. i urge congress to abandon the provision and replace it with expanded, simplified, income tax relief for the families of those lost in combat. this income tax relief will better serve the enumerated policy goals than does the current combat exemption, offering more meaningful relief to more typical military families. * carmen tortora professor of law and associate dean for research and faculty development, quinnipiac university school of law. my thanks to michael rapiejko (class of 2018) for his able research assistance and to my faculty colleagues for helpful comments on preliminary versions of this article. thanks also to the student participants in the fall 2017 legal research symposium for their thoughtful feedback on this article. i. introduction .................................................................................................... 115 ii. a brief overview of estate taxation and the combat exemption ........................................................................................................... 115 a. modern federal estate tax: overview .............................................................. 115 b. modern federal estate tax: the combat exemption of section 2201 ............. 116 1. world war i ................................................................................................. 117 2. subsequent legislation ................................................................................ 118 iii. evaluating the policy success of the combat exemption .... 121 a. reduce burdens on soldiers’ families .............................................................. 121 1. reduce financial burdens .......................................................................... 122 2. reduce administrative burdens .................................................................. 123 b. incentivize service in armed forces ................................................................. 124 1. congress ...................................................................................................... 124 2. army recruiting .......................................................................................... 128 c. avoiding the government “profiting” from deaths in combat ........................ 129 1. no draft ....................................................................................................... 129 2. normalized estate tax rates ...................................................................... 130 iv. a better idea? ................................................................................................... 132 a. structuring a better income tax exemption ..................................................... 133 1. the current regime .................................................................................... 133 2. a proposal for reform ................................................................................ 134 b. assessing the proposal ....................................................................................... 135 1. reducing burdens on surviving family members ...................................... 135 2. incentivize service ....................................................................................... 136 3. avoiding the government profiting from death ......................................... 138 v. conclusion ........................................................................................................ 139 2017] soldiers with fortunes? 115 i. introduction from the revolutionary war to the battle against international terrorism, american history has been shaped by military conflict.1 that national history also reflects an ongoing effort to thank those who have served in our nation’s armed forces and to honor those who have fallen in combat.2 like much in our national consciousness, such as our desires to incentivize energy efficiency,3 higher education,4 and home ownership,5 our quest to honor our fallen heroes has shaped modern tax policy. the tax code contains a litany of tax relief provisions targeted toward members of the nation’s military, including statutes providing relief from income and estate taxes for those who die in combat operations.6 in this article, i explore the origins, justification and operation of the estate tax relief offered to those who fall in combat (hereinafter the “combat exemption” or “the estate tax exemption”), currently codified in section 2201 of the internal revenue code (hereinafter “the code”).7 i contend that while well-intentioned, the combat exemption is a poorly-targeted provision that does little to address the plight of those left behind by our fallen heroes. i urge congress to abandon the provision and instead to offer greater, simplified, income tax relief to the families of those lost in combat. ii. a brief overview of estate taxation and the combat exemption in this section, i provide a brief overview of the federal estate tax and the combat exemption, including relevant legislative history. a. modern federal estate tax: overview the federal estate tax has a long history as a wartime revenue measure, with its 1 see generally terence t. finn, america at war: concise histories of u.s. military conflicts from lexington to afghanistan (2014). 2 see generally jason r. harris, the protection of sunken warships as gravesites at sea, 7 ocean & coastal l.j. 75, 114–16 (2001) (discussing public holidays and military traditions that honor soldiers’ sacrifices). 3 richard a. westin, energy and environmental tax changes in the flood of recent federal revenue laws and what they imply, 15 penn st. envtl. l. rev. 171, 176–82 (2007) (discussing a variety of tax provisions designed to incentivize energy conservation by consumers). 4 see generally sean m. stegmaier, tax incentives for higher education in the internal revenue code: education tax expenditure reform and the inclusion of refundable tax credits, 37 sw. u. l. rev. 135 (2008). 5 anthony b. kuklin, impetus to an industry – the effect of taxation of real estate and real estate derived income on real property development in the united states, 17 real prop. prob. & tr. j. 458 (1982) (“the united states is certainly a leader, if not preeminent, among the nations of the world in the use of taxation as a policy tool to foster real estate development and ownership.”). for a defense of using the tax code in this manner, see joseph w. trefzger, why homeownership deserves special tax treatment, 26 real est. l.j. 340 (1998). for a contrary viewpoint, see rebecca n. morrow, billions of tax dollars spent inflating the housing bubble: how and why the mortgage interest deduction failed, 17 fordham j. corp. & fin. l. 751 (2012) (contending that the major tax code provision designed to incentivize home ownership, the deductibility of home mortgage interest, is misguided and ineffective). see also sagit leviner, affordable housing and the role of the low income housing tax credit program: a contemporary assessment, 57 tax law. 869 (2004) (discussing tax incentives for the construction of low income housing). 6 the first of these, codified in i.r.c. § 692, provides income tax relief to a soldier who dies in a combat zone. the second, codified in i.r.c. § 2201, provides estate tax relief. 7 i.r.c. § 2201. 116 columbia journal of tax law [vol.9:113 antecedents being used to finance the buildup of the u.s. navy in the late 18th century,8 the civil war,9 and the spanish-american war.10 in 1916, congress again turned to this source of revenue amid the growing crisis that would eventually become world war i.11 unlike its short-lived 18th and 19th century ancestors, the estate tax enacted in 1916 has remained in place for over a century. on its face, the federal estate tax seems to cast a wide net, applying to “every decedent who is a citizen or resident of the united states”12 as well as “all property, real or personal, tangible or intangible, wherever situated.”13 however, despite this broad verbiage, relatively few estates actually pay any tax.14 two main features of the code account for this result. first, each taxpayer is given a generous exemption from the estate tax, $5,490,000 per taxpayer for deaths in 2017 with additional inflation adjustments thereafter.15 taxpayers with wealth below this level are effectively exempt from the tax.16 second, the code exempts from tax transfers to, or to certain types of trusts for the benefit of, a decedent’s surviving spouse. 17 taken together, these two provisions effectively exempt well over 99% of estates from the estate tax.18 b. modern federal estate tax: the combat exemption of section 2201 in addition to the exemptions and credits available to all taxpayers, the code contains a special exemption for soldiers19 who die in combat. the relevant code section, 8 an act laying duties on stamped vellum, parchment, and paper, ch. 11, 1 stat. 527 (1797). for a brief discussion of this act and other early federal estate taxes, see jeffrey a. cooper, interstate competition and state death taxes: a modern crisis in historical perspective, 33 pepp. l. rev. 835, 844 (2006). for a more detailed analysis, see staff of j. comm. on tax’n, 107th cong., description and analysis of present law and proposals relating to federal estate and gift taxation, 10–18 (comm. print 2001) (analyzing the legislative history of federal death taxes enacted between 1797 and 2001). 9 an act to provide internal revenue to support the government and to pay interest on the public debt, and for other purposes, § 110, 13 stat. 223, 277 (1864); an act to provide ways and means for the support of the government, and for other purposes, § 1, 13 stat. 218, 218 (1864). 10 an act to provide ways and means to meet war expenditures, and for other purposes, § 29, 30 stat. 448, 464–65 (1898). 11 revenue act of 1916, pub. l. no. 64–271, 39 stat. 756 (1916). 12 i.r.c. § 2001. 13 i.r.c. § 2031. 14 in recent years, the tax has impacted just 0.1% to 0.2% of decedents, a “historically low number.” see paul l. caron, the one-hundredth anniversary of the federal estate tax: it’s time to renew our vows, 57 b.c. l. rev. 823, 826 (2016). see also philip bump, here’s how many people have to pay the estate tax that trump wants to dump, wash. post (apr. 26, 2017), https://www.washingtonpost.com/news/politics/wp/2017/04/26/heres-how-many-people-have-to-pay-theestate-tax-that-trump-wants-to-dump [https://perma.cc/mss5-afca] (citing statistics and including both illustrative graphics and an interactive tax simulator). 15 i.r.c. § 2010(c)(3). 16 per i.r.c. § 2010(a), the “unified credit” is a single credit applicable to inter vivos transfers subject to the federal gift tax and testamentary transfers subject to the estate tax. taxpayers with wealth below the level of the credit thus can transmit all of their wealth tax free during life or at death. per i.r.c. §§ 2010(c)(2)(b) and (c)(4), a taxpayer has additional unified credit if the taxpayer was predeceased by a spouse who did not fully utilize his or her own unified credit. for a discussion of this “deceased spousal unused exclusion” (dsue), see john a. miller & jeffrey a. maine, wealth transfer tax planning for 2013 and beyond, 2013 b.y.u. l. rev. 879, 913 (2013). 17 i.r.c. § 2056. 18 see caron, supra note 14. 19 in this article, i use the term “soldier” to refer generically to all members of all u.s. military branches. i have made this choice solely in the interests of readability of an article written for a predominantly civilian audience. it is not my intent to exclude or offend members of the military who 2017] soldiers with fortunes? 117 recently expanded to include astronauts and victims of domestic terrorism, provides a partial estate tax exemption, as follows: (a) in general. unless the executor elects not to have this section apply, in applying sections 2001 and 2101 to the estate of a qualified decedent, the rate schedule set forth in subsection (c) shall be deemed to be the rate schedule set forth in section 2001 (c). (b) qualified decedent. for purposes of this section, the term “qualified decedent” means— (1) any citizen or resident of the united states dying while in active service of the armed forces of the united states, if such decedent— (a) was killed in action while serving in a combat zone, as determined under section 112 (c), or (b) died as a result of wounds, disease, or injury suffered while serving in a combat zone (as determined under section112 (c)), and while in the line of duty, by reason of a hazard to which such decedent was subjected as an incident of such service, (2) any specified terrorist victim (as defined in section 692 (d)(4)), and (3) any astronaut whose death occurs in the line of duty.20 in its practical effect, the combat exemption does two things. first, it increases the effective amount of the unified credit from approximately $5.5 million to over $10 million.21 second, it halves the applicable tax rate paid thereafter to 20% from the current 40%.22 c. legislative history of section 2201 1. world war i when the modern federal estate tax was first enacted in 1916, it contained no special provisions relating to members of the armed forces.23 that changed the following year when congress enacted a supplemental war tax to finance the nation’s entry into world war i.24 during legislative consideration of the proposed supplemental tax bill, some members of congress saw a significant policy concern—the likelihood that fallen members of the armed forces would represent a disproportionate percentage of those dying during a time of war and thus would bear a disproportionate burden of the wartime associate that term solely with the u.s. army rather than members of their branch of the armed forces. see paul brians, common errors in english usage 297 (3d ed. 2013) (“marines, air force personnel, and navy soldiers all object to being called ‘soldiers’ but there is no other traditional generic term.”). 20 i.r.c. § 2201. 21 rev. proc. 2016-14, 2016–9 i.r.b. 365. for an example of the calculations required to compute these figures, see rev. rul. 2002–86, 2002–2 c.b. 993. 22 i.r.c. § 2201(c). 23 an act to increase the revenue, and for other purposes, pub. l. no. 64–271, § 1, 39 stat. 756, 756–57 (1916). 24 an act to provide revenue to defray war expenses, and for other purposes, pub. l. no. 65–50, 40 stat. 300 (1917) [hereinafter 1917 tax act]. 118 columbia journal of tax law [vol.9:113 estate tax. those congressmen actively opposed such a tax that would “put a special penalty upon the estates of men who may sacrifice their lives for their country.”25 initially, those pleas did not inspire the broader house of representatives, which rejected an amendment that would have exempted estates of soldiers from the proposed wartime estate tax.26 but a defeat on the house floor did not end the matter. rather, when deliberations reached the senate, that chamber voted to strike out the supplemental estate tax in its entirety. 27 this set the stage for a compromise brokered in a conference committee: the supplemental estate tax was returned to the bill but with the caveat that it would not apply to any members of the armed forces who died during the war.28 those dying on the battlefields of world war i would pay estate tax at the 1916 rates rather than the higher 1917 ones. the combat exemption was born. in the revenue act of 1918, congress enacted another supplemental war estate tax, further increasing the applicable rates.29 when doing so, congress again considered the plight of soldiers and retroactively augmented the combat exemption to provide a full, rather than partial, estate tax exemption, for soldiers who died during the war.30 by their terms, these 1917 and 1918 variants of the combat exemption were to be in effect only during world war i. the end of the war thus brought the end of the exemption. 2. subsequent legislation in the decades that followed the end of world war i, the united states remained at peace and congress had no reason to revisit the combat exemption. this is not to say that those decades were uneventful ones for the federal estate tax. to the contrary, congress in this era paid considerable attention to the tax, making numerous revisions to the tax rate and applicable exemption, 31 as well as engaging in extensive debates regarding the interplay between federal and state death taxes.32 these debates ultimately led to a major structural change—congress bifurcated the estate tax into two different taxes, a basic estate tax (calculated at the rates in effect during 1926 and shared with the 25 55 cong. rec. h2,726 (daily ed. may 22, 1917) (statement of rep. platt). 26 on may 22, 1917, the house rejected representative good’s amendment to add a soldiers’ exemption to the proposed wartime estate tax. see id. at h2,727. 27 55 cong. rec. s6,133 (daily ed. aug. 17, 1917). 28 1917 tax act, § 901 (“the tax imposed by this title shall not apply to the transfer of the net estate of any decedent dying while serving in the military or naval forces of the united states, during the continuance of the war in which the united states is now engaged …”). this provision was added in conference committee as a result of a compromise between members of the house who favored increased estate taxation and senate conferees who wanted to delete the estate tax in its entirety. see 55 cong. rec. s7,620 (daily ed. oct. 2, 1917) (statement of sen. simmons) (discussing the compromise). see also amendment 274 in the conferee’s report, available at 55 cong. rec. 7,571 (1917). 29 revenue act of 1918, pub. l. no. 65–254, § 401, 40 stat. 1057, 1096 (1919). 30 id. at 1097 (“the taxes imposed by this title or by title ii of the revenue act of 1916 (as amended …) or by title ix of the revenue act of 1917, shall not apply to the transfer of the net estate of any decedent who has died or may die while serving in the military or naval forces of the united states in the present war or from injuries received or disease contracted while in such service.”). it is worth noting that the revenue act of 1918 was not enacted until february 1919, months after the war had ended. the expanded combat exemption provided by 401 was thus retroactive in effect. for a more detailed discussion of congress’ pattern of retroactively modifying the combat exemption, see infra part ii, section (b)(1)(b). 31 see jeffrey a. cooper, ghosts of 1932: the lost history of estate and gift taxation, 9 fla. tax rev. 875, 883 (2010) (discussing subsequent legislative developments). 32 for a detailed history of these debates, see cooper, supra note 8, at 848–60. 2017] soldiers with fortunes? 119 states via a mechanism known as the state death tax credit) and an additional estate tax (the revenue from which was reserved entirely to the federal government).33 initially this bifurcation was designed as a mechanism to alter the balance between federal and state estate tax revenues and had nothing to do with the soldier’s exemption.34 it soon became crucial to that issue. during world war ii, congress again offered relief to soldiers dying in combat.35 the resulting variant of the combat exemption was modeled after that in place during 1917, offering soldiers a partial relief from taxation. mechanically, congress achieved this end by providing that only the basic estate tax, and not the additional estate tax, would apply to combatants dying in world war ii. 36 much like its world war i counterpart, this world war ii combat exemption was added without any significant debate.37 in the decades that followed, the combat exemption became a permanent fixture of the code. an analogous provision applied to those killed in action in a combat zone between june 25, 1950, and december 31, 1953.38 this relief was later extended and expanded to apply to those killed in action in a combat zone during any induction period between 1954 and june 30, 1973.39 the induction period requirement was dropped during 1975, extending partial estate tax relief to all soldiers killed in action in a combat zone on 33 congress enacted the first version of a state death tax credit in 1924. revenue act of 1924, pub. l. no. 68–176, § 300, 43 stat. 253, 304. (“the tax imposed by this section shall be credited with the amount of any estate, inheritance, legacy, or succession taxes actually paid to any state or territory or the district of columbia, in respect of any property included in the gross estate. the credit allowed by this subdivision shall not exceed 25 per centum of the tax imposed by this section.”). in 1926, congress increased the maximum credit from 25% to 80%. revenue act of 1926, pub. l. no. 69–21, §301(b), 44 stat. 9, 70 (“the tax imposed by this section shall be credited with the amount of any estate, inheritance, legacy, or succession taxes actually paid to any state or territory or the district of columbia, in respect of any property included in the gross estate. the credit allowed by this subdivision shall not exceed 80 per centum of the tax imposed by this section …”). in 1932, congress amended the estate tax regime by keeping the 1926 rates in place but supplementing them with an “additional estate tax” which was not subject to the state death tax credit. see revenue act of 1932, pub. l. 72–154, §§ 401, 402, 47 stat. 169, 245 (adding the “additional estate tax” and providing that “the credit provided in section 301(c) of the revenue act of 1926, as amended (80 per centum credit), shall not be allowed in respect of such additional tax.”) 34 under the state death tax credit in effect beginning from 1926, an estate could claim a dollar-fordollar federal credit for state estate taxes paid up to 80% of the basic estate tax. originally, congress enacted this regime to facilitate state estate tax collections and most states took advantage of this mechanism by enacting state estate taxes exactly equal to the available credit. see cooper, supra note 8, at 852–70 (discussing congress’s motivation in enacting the state death tax credit and state legislative responses). the additional estate tax enacted in 1932 was not included in this revenue-sharing regime, thus allowing congress to increase estate tax rates without sharing the resulting revenue with the states. see cooper, supra note 31, at 905–09 (discussing congress’s motivation in restructuring the estate tax and illustrating the resulting effect on tax rates). 35 congress offered this relief retroactively to those dying during world war ii. see pub. l. no. 81–378, § 10, 63 stat. 891, 896 (1949) (providing that additional estate tax shall not apply to estates of decedents killed in action between december 7, 1941 (the attack on pearl harbor) and december 31, 1946 (the date president truman proclaimed to be the end of the war). see proclamation no. 2714, 3 c.f.r. 19431948 comp. (dec. 31, 1946). 36 pub. l. no. 81–378, § 10, 63 stat. 891, 896 (1949). 37 95 cong. rec. 12,997 (1949) (amendment was approved by voice vote without any debate). 38 pub. l. no. 82–183, §606, 65 stat. 452, 567 (1951) (extending partial estate tax exemption to those killed in action while serving in a combat zone after june 24, 1950 and before january 1, 1954). 39 i.r.c. § 2201 (1954). 120 columbia journal of tax law [vol.9:113 or after july 1, 1973.40 the exemption, by then codified in i.r.c. § 2201, was later expanded41 to extend partial estate tax relief to all citizens (whether military personnel or civilians) dying as a result of the terrorist attacks of april 19, 1995,42 and september 11, 2001,43 or by anthrax poisoning.44 a final expansion provided relief to the estate of any astronaut whose death occurs in the line of duty after 2002.45 as congress expanded the scope of the combat exemption it also added, and expanded, numerous other provisions offering tax relief to those serving in combat zones. foremost among these is the income tax analogue to the combat exemption, codified at i.r.c. § 692(a), which provides for a soldier dying in a combat zone to receive a refund of all income taxes paid while in that combat zone (hereinafter the “income tax exemption”). 46 in addition the code now offers a series of other tax benefits for combatants.47 as examples, i.r.c. § 112 excludes compensation received in a combat zone,48 i.r.c. § 104(a)(4) excludes combat-related disability payments,49 i.r.c. § 4253(d) 40 pub. l. no. 93–597, § 6(b), 88 stat. 1950, 1953 (1975). that act contained a typographical error that was corrected by title xix, pub. l. no. 94–455, § 1902(a)(7)(a), 90 stat. 1805, 1805 (1976) (correcting erroneous cross-reference that had been to section “2210” rather than the intended section “2201”). 41 victims of terrorism tax relief act of 2001 § 103; pub. l. no. 107–134, 115 stat. 2427, 2430 (2002). this major expansion of the combat exemption included adoption of a separate estate tax rate table applicable only to those entitled to relief under section 2201. this restructuring was necessitated by the economic growth and tax relief reconciliation act of 2001 (egtrra), pub. l. no. 107–16, 115 stat. 38, which combined the prior basic estate tax and additional estate tax into a single rate structure, thereby inadvertently eliminating the basis for computing the soldier’s exemption. as a result of all of these legislative machinations, i.r.c. § 2201, which began in 1917 as a single sentence, now contains some 500 words. 42 on this date, 168 people were killed when a truck filled with explosives was detonated in front of the alfred p. murrah federal building in oklahoma city, oklahoma. see cnn library, oklahoma city bombing facts, cnn, http://www.cnn.com/2013/09/18/us/oklahoma-city-bombing-fast-facts/index.html [https://perma.cc/8dzq-7vky] (last updated mar. 29, 2017, 4:10 pm) (providing a summary of the day’s events and the subsequent prosecution of the perpetrators). 43 on this date, 2,977 people were killed when terrorists simultaneously hijacked four airliners. the hijackers crashed two of the aircraft into the towers of the world trade center in new york city and one into the pentagon in washington, d.c. passengers are believed to have prevented the hijackers of the fourth airliner from reaching its intended target and it crashed into a field in shanksville, pennsylvania. see cnn library, september 11th terror attacks fast facts, cnn, http://www.cnn.com/2013/07/27/us/september-11anniversary-fast-facts/index.html [https://perma.cc/82mm-emrb] (last updated aug. 24, 2017, 6:04 pm) (providing detailed information on the day’s events and aftermath). 44 between september and november 2001, an unknown perpetrator mailed numerous letters containing anthrax spores. five people died from anthrax as a result. see timeline: how the anthrax terror unfolded, npr (feb. 15, 2011, 11:00 am), http://www.npr.org/2011/02/15/93170200/timeline-how-theanthrax-terror-unfolded [https://perma.cc/26g6-58xa] (providing a detailed timeline of the anthrax poisoning and subsequent law enforcement investigation). 45 military family tax relief act of 2003, pub. l. no. 108–121, 117 stat. 1335. as reflected in the text of the legislation itself, this expansion of the combat exemption was inspired by the february 1, 2003 explosion of the space shuttle columbia, which killed all seven astronauts onboard. see id. at § 110 (entitled “tax relief and assistance for families of space shuttle columbia heroes”). for a history and analysis of the columbia flight, see nasa mission archives, sts-107, nasa, https://www.nasa.gov/mission_pages/shuttle/shuttlemissions/archives/sts-107.html [https://perma.cc/49zstxku]. 46 i.r.c. § 692(a). like the estate tax combat exemption, this income tax exemption traces its roots to 1917. 47 for a comprehensive, albeit slightly dated, overview of many of these provisions, see theodore paul manno, federal income taxation of soldiers, sailors, airmen and marines, 50 s.d. l. rev. 293 (2005). 48 i.r.c. § 112. 2017] soldiers with fortunes? 121 provides exemption from excise taxes on phone calls originating in a combat zone,50 and i.r.c. § 7508(a) offers those deployed to combat zones an automatic 180-day extension of time to file and pay their income taxes.51 iii. evaluating the policy success of the combat exemption having considered the history and current operation of the combat exemption, i now turn to the major normative question: does that exemption serve any important policy goals? this analysis is somewhat complicated by the fact that the legislative history of section 2201 and its predecessors is extremely thin, revealing little about congress’ original policy justification for the provision beyond the overarching desire to reduce the burdens on soldiers killed in combat and their loved ones left behind. there was almost no recorded legislative debate concerning the first enactment of the combat exemption during world war i.52 when the provision returned in world war ii, the legislative history is similarly thin, with the house ways and means committee reporting only that the provision would be “similar to the relief congress granted to persons killed in action during world war i.” 53 modern legislative history is similarly devoid of any detailed analysis of the ongoing rationale for retaining the combat exemption.54 given the dearth of legislative history, determining the rationale for the exemption requires piecing together remarks made by various individual legislators throughout the past century. combining these snippets of legislative history with some general principles of tax policy yields three potential justification for the combat exemption. in the balance of this section, i present these potential policy justifications and evaluate whether, after a century has passed, the exemption still serves these policy goals. a. reduce burdens on soldiers’ families a first potential justification for the combat exemption is that it would reduce the burdens on those left behind by deceased members of the armed forces. congressman good, one of the initial proponents of the exemption, argued this point in 1917. he contended that estate tax “ought to stop at the open grave of our heroic dead who give their lives for the defense of the flag, and not reach into the pockets of the widow and children for the savings of such a man … the soldier has given enough when he has 49 i.r.c. § 104(a)(4). 50 i.r.c. § 4253(d). 51 i.r.c. § 7508(a). 52 see supra notes 26 and 28 and accompanying text (discussing how the 1917 predecessor of i.r.c. § 2201 was added in a legislative committee without any substantive floor debate). 53 94 cong. rec. 9,204 (1948) (statement of rep. knutson). like its predecessor in effect during world war i, the estate tax combat exemption applicable during world war ii was added via amendment without any material debate. see 95 cong. rec. 12,997 (1949). 54 research reveals far greater legislative history relating to the subsequent expansion of the combat exemption to civilians killed in terrorist attacks in 1995 and 2001 and to astronauts dying in the line of duty. for purposes of this article, that legislative history is largely unhelpful. my inquiry is limited to the question of the combat exemption as applied to soldiers rather than these other groups. as a general rule, modern soldiers differ from civilian terrorism victims and astronauts on key demographic and socioeconomic metrics and also, typically voluntarily, expose themselves to different kinds of peril. accordingly, the policy implications of the estate tax exemption offered to soldiers that is the focus of this paper materially differ from those applicable to the other individuals covered by these later expansions of section 2201. 122 columbia journal of tax law [vol.9:113 given his life for the defense of the flag.”55 in a line generating applause from his fellow members of congress, congressman platt agreed with good’s rationale for a military exemption, contending that tax code should not “penalize the families of those who lose their lives for their country.”56 the potential “penalty” of estate taxation takes two forms. first is the financial burden of paying the tax itself, the “reach into the pockets” that congressman good found so distasteful. but, taxes impose a second type of “penalty” as well—the compliance burden of calculating the tax due and preparing the appropriate returns. as detailed below, the modern combat exemption does little to redress either burden faced by families of our fallen soldiers. 1. reduce financial burdens unfortunately, as a practical matter, the modern section 2201 typically fails to achieve its stated purpose of providing economic relief to loved ones left behind by those who die in combat. taking into account the other available estate tax exemptions and the demographics of the modern armed forces, section 2201 can be expected to achieve the goal of minimizing financial burdens only in an exceedingly small number of cases. one reason for this result is that under the complex modern estate tax the military exemption is far from the only way to reduce, or completely eliminate, estate taxation. as a starting proposition, as noted above, each individual has a $5.49 million exemption from the federal estate tax as well as an unlimited marital deduction which exempts from estate taxation any property left to, or to certain types of trusts for the benefit of, a surviving spouse.57 the combined effect of the exemption and the marital deduction is to eliminate all estate taxes for well over 99% of decedents. 58 accordingly, if soldiers represented a random socio-economic cross section of the population, we would expect a mere fraction of 1% to benefit from the combat exemption. in reality, due to the demographics of the modern military, the percentage of soldiers’ estates benefitting from the exemption is likely even smaller. members of the u.s. armed forces are not a random socio-economic cross-section of the population but rather are skewed toward lower socio-economic strata. indeed, as professors aprill and schmalbeck have noted, “soldiers are often among the least affluent groups in our society,”59 a conclusion supported by both anecdotal evidence60 and detailed empirical studies.61 as one senator observed in a modern debate regarding the expansion of section 55 55 cong. rec. 2,726 (1917) (statement of rep. good), in support of his amendment to add a soldiers’ exemption. the amendment was rejected. see 55 cong. rec. 2,727 (1917). 56 55 cong. rec. 2,726 (1917) (statement of rep. platt). 57 see supra notes 15–17 and accompanying text. 58 see supra note 18 and accompanying text. 59 ellen p. aprill & richard schmalbeck, post-disaster tax legislation: a series of unfortunate events, 56 duke l.j. 51, 72 (2006). 60 see, e.g., small towns absorb the toll of war, npr (feb. 20, 2017, 6:00 am) http://www.npr.org/templates/story/story.php?storyid=7492231 [https://perma.cc/xs7p-r5la] (observing that “nearly three quarters of those killed in iraq came from towns where per capita income is below the national average” and discussing the war’s impact on these towns). 61 a recent analysis by douglas l. kriner & francis x. shen illustrates that soldiers disproportionately come from lower-class and middle-class backgrounds, a demographic trend which has increased since world war ii. douglas l. kriner & francis x. shen, invisible inequality: the two americas of military sacrifice, 46 u. memphis l. rev. 545, 547 (2016) (“through a series of empirical investigations—including analysis of over 500,000 american combat casualties from world war ii through 2017] soldiers with fortunes? 123 2201, an army specialist earning the average base pay of $24,000 per year “won’t be worrying, nor (sic) his family be worrying about the estate tax.”62 further demographic headwind for the combat exemption comes from the fact that more than half of the members of the modern military are married.63 accordingly, the unlimited marital deduction already provides those soldiers with a sufficient means to exempt their estates from taxation, making section 2201 superfluous as a means of blunting the impact of the estate tax. in sum, the combat exemption offers meaningful financial relief only to unmarried, multi-millionaire, members of the military. demographic evidence suggest those soldiers are few and far between.64 thus, to the extent the combat exemption was designed to reduce the financial burden on fallen soldiers’ estates, it will fail in this mission more than 99% of the time.65 the inefficiency of using section 2201 to offer financial relief is further shown by comparison with two other programs the military currently uses to offer much more direct financial relief to the families of fallen soldiers. the most direct of these is the oddly-named “death gratuity” whereby the families of soldiers who die in a combat zone receive a cash payment of $100,000.66 in addition, the government provides for $400,000 in life insurance coverage for all soldiers in combat, making for a total of $500,000 in direct, cash payments to the estate of each fallen soldier.67 while some might contend that the combat exemption appropriately provides an additional benefit for the families of the most affluent soldiers, whose financial loss perhaps is not adequately compensated by $500,000 in payments, i contend that the exemption has become an extraneous, poorlytargeted subsidy to a demographically narrow population. 2. reduce administrative burdens what of the related justification for the combat exemption: namely that it will reduce administrative burdens on soldiers’ estates? while this is a desirable result, and a afghanistan, combined with seven unique surveys of american public opinion—we reveal that, even more than previous wars, iraq and afghanistan have been working class wars”). 62 152 cong. rec. s5,543 (daily ed. june 7, 2006) (statement of sen. reed). 63 149 cong. rec. 7,718 (2003) (statement of sen. baucus). 64 the demographics of soldiers in world war i were very different than those of the modern military. part of this result is attributable to the design of the draft in effect during that war, which gave a higher priority to unmarried soldiers and those with additional sources of family income. see selective service act, pub. l. no. 65–12, 40 stat. 76 (1917). see also selective service regulations prescribed by the president, § 73 (1917) (providing that the first class of draftees would be unmarried or otherwise without dependents). 65 since my focus here is on the effects of section 2201, i intentionally do not consider the normative question of whether it is good tax policy to target these soldiers for financial relief. i consider this question in part error! reference source not found. infra of this article. 66 i.r.c. § 1475 et seq. the congress of 1917 similarly provided for direct compensation to families of fallen soldiers. act of oct. 6, 1917, ch. 105, §§ 300–14, 40 stat. 398, 405–08 (providing in relevant part for monthly compensation to specified family members of those killed in military service.). 67 the coverage, known as servicemembers’ group life insurance (sgli) is available to several categories of individuals engaged in military service. those eligible are automatically insured for the maximum $400,000 death benefit unless they opt out. for a description of the program, see veterans benefits admin. managing agency, service members’ group life insurance, https://www.benefits.gov/benefits/benefit-details/585 [https://perma.cc/7lw5-cnve]. 124 columbia journal of tax law [vol.9:113 bedrock principle of good tax policy,68 the combat exemption simply doesn’t achieve it. as an initial matter, the partial reduction afforded by modern section 2201 doesn’t eliminate any paperwork. an estate relying on the relief provision of the code section must still complete a federal estate tax return in its entirety.69 in fact, an enhanced administrative burden is placed upon an estate claiming relief under section 2201 insofar as claiming the combat exemption requires including additional calculations on the deceased soldier’s return, about which the applicable instructions provide no clear guidance.70 from a strictly administrative standpoint, section 2201 serves to increase, rather than reduce, administrative and paperwork burdens.71 putting this issue in a larger context, the code imposes a massive administrative burden on the estate of a fallen soldier. as discussed in greater detail below, the income tax exemption is particularly cumbersome to navigate.72 refund of income taxes due can be collected only by filing amended returns for all years in which the decedent served in a combat zone.73 in the case of married soldiers, these returns must distinguish the decedent soldier’s income from that of his or her surviving spouse.74 rather than eliminating even a single tax return, the overarching scheme of tax relief designed by congress has added additional, complicated, administrative burdens for the families of fallen soldiers. b. incentivize service in armed forces a second potential justification for the combat exemption is that it might incentivize service in the armed forces. professors aprill and schmalbeck have attributed this motive to congress, arguing that “longstanding special tax provisions for members of the armed forces, including the special … estate tax provisions for those killed in combat, are part of a package designed ex ante to attract and reward soldiers for a decision to serve voluntarily in the armed forces.”75 while seemingly a logical rationale, available evidence suggests that neither members of congress nor the leaders of the modern military view the exemption as a significant tool for incentivizing military service. 1. congress three factors suggest that congress has never considered the combat exemption as a means of incentivizing volunteering for military service. first, the legislative history itself suggests that congress envisioned the combat exemption as applying to conscripted soldiers rather than volunteers. second, congress often implemented or expanded estate tax relief through retroactive legislation, thus all but eliminating the legislation’s incentive effects. third, congress has declined to expand the combat exemption to 68 michael j. graetz, the u.s. income tax: what it is, how it got that way, and where we go from here 10 (1999) (indicating that “most everyone agrees” that a good tax or tax system is one that is “easy to comply with and administer”). 69 cch tax law editors, u.s. master estate and gift tax guide ¶ 1565 (2017). 70 id. 71 in contrast, the complete exemption provided by the revenue act of 1918 did reduce the compliance burden. rather than filing a complete estate tax return, the soldier’s representative filed a shorter form detailing the soldier’s military history and his cause and manner of death. if that form was accepted as filed, a complete estate tax return was not required. 72 see infra part iii, section error! reference source not found.. 73 see infra note 134 and accompanying text. 74 see infra notes 135 and 136 and accompanying text. 75 aprill & schmalbeck, supra note 59, at 71–72. 2017] soldiers with fortunes? 125 civilian military contractors and private military, groups which tend to be wealthier than military combatants and thus more likely to be incentivized by the prospect of estate tax relief. a discussion of these factors follows. a. focus on draftees the earliest formulations of the combat exemption were enacted in times when there was a wartime draft.76 the limited legislative debate regarding the initial 1917 exemption reflects a congress far more concerned with mitigating the plight of those forced into military service than inducing volunteers to enlist. while one proponent of the combat exemption did argue that the exemption would “encourage the millionaire to go [to war] and take a chance on getting killed,”77 most were far more motivated by the plight of the conscripted soldier than the volunteer.78 this same concern for those forced into military service, rather than volunteers, was reflected in the language of the combat exemption in effect from 1954 through june 30, 1973, which applied only in times of a military draft.79 both the content of congressional debates and the language of the statute itself thus undercut the notion that congress intended the combat exemption to incentivize military and combat service. b. retroactivity further undercutting the notion of the combat exemption as an incentive for wartime service is the fact that congress often enacted the exemption retroactively. for example, the major expansion of the exemption in 1918 was enacted after world war i had ended.80 similarly, relief for those dying between 1941 and 1947 in world war ii was included as part of the revenue act of 1948, enacted in 1949, long after the cessation of combat.81 a congress seeking to use the combat exemption to incentivize wartime military service presumably would have enacted the exemption as wars began, not after they had ended.82 76 for a brief history of the military draft in the u.s., see andrew m. pauwels, mandatory national service: creating generations of civic minded citizens, 88 notre dame l. rev. 2597, 2601–02 (2013) (surveying the subject from the civil war to the modern era). 77 55 cong. rec. 2,726 (1917) (statement of rep. little). 78 i explore this in more detail in the following section of this article. see infra part ii, section c. 79 see supra notes 39 and 40 and accompanying text. 80 see generally supra note 30 and accompanying text. in 1924, congress provided another retroactive benefit to the soldiers of world war i in the form of an additional “bonus” for their wartime service. world war adjusted compensation act, pub. l. no. 68–120, §§ 401–501, 43 stat. 121, 125 (1924). for a discussion of that bonus legislation, see generally james d. ridgway, recovering an institutional memory: the origins of the modern veterans’ benefits system from 1914 to 1958, 5 veterans l. rev. 1, 11 (2013) (discussing the origins and mechanics of the bonus). see also anne l. alstott & ben novick, war, taxes, and income redistribution in the twenties: the 1924 veterans’ bonus and the defeat of the mellon plan, 59 tax l. rev. 373 (2006) (providing a detailed history of the legislation and considering its implications for tax policy). 81 see supra notes 35 and 36 and accompanying text. 82 congress has taken a similar retroactive approach to the expansion of section 2201 to victims of domestic terrorism, expanding the statute to cover victims of specified terrorist incidents after they had taken place. see supra notes 42 to 44 and accompanying text. for a discussion of this phenomenon, see generally aprill & schmalbeck, supra note 59. similarly, the expansion of the section to include astronauts was motivated by the space shuttle challenger disaster. military family tax relief act of, pub. l. no. 108–121, § 110, 117 stat. 1342, 1342 (“tax relief and assistance for families of space shuttle columbia”). in this last 126 columbia journal of tax law [vol.9:113 c. exclusion of contractors and support personnel finally, the incentive effects of the combat exemption are further muted by the fact that it is narrowly tailored to exclude government employees and civilians operating in combat zones, individuals who typically earn more than their military equivalents83 and thus presumably would be far more likely to be incentivized by the prospect for estate tax relief. an obvious example on point is that of richard dupont, a wealthy civilian who died during world war ii.84 at the time of his death, dupont was serving as special assistant to general h. h. arnold, commanding general of the united states army air forces. 85 dupont died during a test flight of an experimental transport glider being developed for the army.86 when his estate sought to avail itself of the combat exemption, the tax court denied the exemption, holding that its application was “strictly limited” to those who were “formally members of the armed forces” at the time of death.87 the relevance of the dupont case to this article lies in the history of dupont’s affiliation with general arnold. the army desperately needed dupont, a skilled glider pilot, to train other pilots.88 given the urgency with which his skills were needed, dupont volunteered to serve in a civilian, as opposed to a military role.89 this decision was made solely in the name of efficiency—he could begin service earlier and have more direct reporting lines in this capacity.90 his motivation to aid his country’s military efforts and the nature of his service, including time spent in active combat zones, 91 was indistinguishable from many who formally enlisted in the war. indeed, as general arnold himself stated, “[dupont being in civilian clothes was truly a military expedient. factually, he was as much a member of our military establishment as though he held a commission. he gave his life in military service as actually as any officer in uniform, in actual military combat.”92 yet the tax court was unmoved: “while to [general arnold’s] military mind, decedent may have been considered factually as much a member of the military establishment as any military personnel, it does not necessarily follow that decedent may be legally so considered…”93 the court thus denied the exemption. as a matter of law, the tax court may have correctly applied the statute as written.94 but as a matter of policy, one must ask why congress failed to respond. if the case, unlike in the case of terrorism victims, congress did include future astronauts within the protection of section 2201. 83 christopher d. belen, reining in rambo: prosecuting crimes committed by american military contractors in iraq, 27 penn st. int’l l. rev. 169, 204 n.276 (2008) (citing authority for the proposition that “private contractors often complete similar or identical operations as active duty service members but for exponentially more pay.”). accord robert bejesky, mercenaries, myrmidons, and missionaries, 37 u. ark. little rock l. rev. 45, 61 (2014) (citing data from the iraq war). 84 estate of du pont v. comm’r, 18 t.c. 1134 (1952), aff'd sub nom. du pont’s estate v. comm’r, 233 f.2d 210 (3d cir. 1956). 85 id. at 1138. 86 id. 87 id. at 1142. 88 id. at 1137. 89 id. at 1136. 90 id. at 1137. 91 id. at 1138. 92 id. at 1137. 93 id. at 1142. 94 under the same facts, a district court judge found that dupont was a member of the military at the time of his death, a result which triggered an exclusion on his personal life insurance policy. wilmington 2017] soldiers with fortunes? 127 goal of the combat exemption really was to incentivize military service, then dupont seemed like the perfect person to come within its protection. yet the statute facially fails to cover him or others like him. notably, congress did later expand the income tax exemption to offer a more limited form of relief to civilian employees of the government working in combat zones, 95 a provision which would offer income tax relief to modern day duponts.96 despite revising the applicable estate tax statutes numerous times since dupont’s death, however, congress has not seen fit to similarly expand the estate tax combat exemption.97 the failure of congress to include individuals such as dupont within the protection of section 2201 is a tacit approval of the tax court’s restrictive reading of the applicable statutes 98 and further undercuts the ability of the combat exemption to incentivize wealthy americans to serve their nation in combat zones.99 in an era when increasing numbers of those exposing themselves to the dangers of combat are in civilian contractor roles,100 a congress seeking to encourage wealthy americans to assume those roles would have included them within the scope of section 2201. absent such extension, the combat exemption is narrowly targeted to a portion of the population that is extremely unlikely to ever benefit from it, dramatically weakening its incentive effects. trust co v. mut. life ins. co. of n.y., 76 f. supp. 560, 564 (d. del. 1948), aff’d sub nom. wilmington trust co. v. mut. life ins. co., 177 f.2d 404 (3d cir. 1949) (“[dupont] was under orders from a commanding general during war time and i think it unreal to say that he had a degree of volition anywhere comparable to a civilian employee in peacetime … his status, it would appear, at the time of his death was clearly military and again it is unreal to argue that he was not performing a military function at the time of death.”). 95 section 692(c) of the code provides a refund of taxes paid “in the case of any individual who dies while a military or civilian employee of the united states, if such death occurs as a result of wounds or injury which was incurred while the individual was a military or civilian employee of the united states and which was incurred in a terroristic or military action.” i.r.c. § 692(c). the refund period includes both the year of death and “the last taxable year ending before the taxable year in which the wounds or injury were incurred.” this relief is more limited temporally than the relief offered to soldiers. 96 while the general point is valid, this may be a bit of a factual oversimplification as dupont was killed in a training mission rather than during a combat flight. in addition, the world war ii version of the combat exemption, unlike modern law, applied to all those dying in military service, whether or not in an active combat zone. pub. l. no. 81–378, § 10, 63 stat. 891, 896 (1949). 97 as noted, congress has revisited the combat exemption several times since the dupont case and has expanded its scope to cover astronauts and victims of terrorism. 98 lorillard v. pons, 434 u.s. 575, 580–81 (1978) (“congress is presumed to be aware of an administrative or judicial interpretation of a statute and to adopt that interpretation when it re-enacts a statute without change.”) (citing albemarle paper co. v. moody, 422 u.s. 405, 414 n.8 (1975)); nlrb v. gullett gin co., 340 u.s. 361, 366 (1951); nat’l lead co. v. united states, 252 u.s. 140, 147 (1920). 99 the courts have been similarly strict in applying section 2201 to the estates of “specified terrorist victims” under section 2201(b)(2). see estate of kalahasthi v. united states, 630 f. supp. 2d 1120 (c.d. cal. 2008) (holding that grieving widow who committed suicide shortly after the death of her husband in the 9/11 terrorist attacks was not herself a “specified terrorist victim.”). for a discussion of the case, see howard m. zaritsky, district court limits estate tax relief for terrorist victims, 35 est. plan. 48, 48 (2008) (summarizing the case and defending the result). 100 jeffrey f. addicott, contractors on the “battlefield:” providing adequate protection, antiterrorism training, and personnel recovery for civilian contractors accompanying the military in combat and contingency operations, 28 hous. j. int’l l. 323, 325 (2006) (“although many americans still visualize the u.s. military as a monolithic force of uniformed personnel only, the reality is far different … [h]undreds of activities once performed by the military are now privatized and outsourced to thousands of civilian contractors.”). for a discussion of the various types of civilian roles in the modern military, see lisa l. turner & lynn g. norton, civilians at the tip of the spear, 51 air force l. rev. 1, 4–16 (2001) (discussing multiple categories of civilians who may be deployed to combat zones alongside military personnel). 128 columbia journal of tax law [vol.9:113 2. army recruiting as is the case with congress, the military establishment has done nothing to suggest that the combat exemption will incentivize voluntary military service and does not actively exploit the combat exemption in recruiting efforts. consider, for example, the content of the military recruiting websites, all of which are silent on the issue of estate tax relief for combat deaths. specifically, internet searches on the army’s website for the terms “estate tax” and “death gratuity” generate no results, while search terms such as “uniform allowance,” “tax-free,” and “education benefits” do link the searcher to information about various fringe benefits that are exempt from income taxation.101 this same pattern is reflected in the army’s pocket recruiter guide, billed “as a ready reference for recruiters and other members of u.s. army recruiting command,” but which contains no reference to “estate,” “estate tax,” or “death.”102 similarly, on the navy’s recruiting website, a search for “tax” or “benefits” sends the searcher to a comprehensive listing of compensation and other benefits while searches for “estate,” “estate tax,” and “death” all yield no results.103 the recruiting websites for the coast guard,104 air force,105 and marines106 are all similarly silent about the estate tax consequences of combat deaths.107 101 searches on www.goarmy.com performed on july 1, 2017. in addition, the army has another area in the recruiting website where a virtual “sargent star” will answer recruiting questions. when asked about “death in combat” the virtual recruiter links to information about death benefits and life insurance but makes no reference to the combat exemptions (“sgt star: the army's risk management system ensures the best possible outcome to all army missions. unfortunately, some soldiers do die during combat. the possibility of death exists in every profession. in the event that a soldier dies, the army provides compensation for the family.” the website then provides links to information on va death benefits and life insurance.). 102 2015-16 pocket recruiter guide, u. s. army recruiting command, http://www.usarec.army.mil/hq/apa/download/prg15-16.pdf. 103 searches on www.navy.com performed on july 1, 2017. 104 an internet search for “estate tax” generates no result on the coast guard’s official recruiting website (www.gocoastguard.com) while “income tax” generates 3 results. the area of the website addressing frequently asked questions includes life insurance and income tax exclusions in response to the question “what are some benefits of joining?” what are some benefits of joining?, go coast guard, http://www.gocoastguard.com/faq/what-are-some-benefits-of-joining. no mention is made of either the estate tax or the combat exemption. 105 internet searches for “income tax” and “estate tax” generate no results on the air force’s official website (www.airforce.com). the area of the website addressing pay and benefits includes a mention of life insurance and tax-free housing allowance but no reference to either the estate tax or the combat exemption. pay and benefits, u.s. air force, https://www.airforce.com/careers/pay-and-benefits. 106 internet searches for “income tax” and “estate tax” generate no results on the marines’ official website (www.marines.com). the area of the website addressing pay and benefits includes a generic reference to “insurance” but does not reference to the income tax, estate tax or combat exemption. benefits, u.s. marine corps, http://www.marines.com/being-a-marine/benefits/salary. 107 one piece of legislative history reinforces this conclusion that military leadership does not view estate tax relief as a major recruitment tool. during the limited debate concerning the world war ii combat exemption, one congressman reported that military leaders had pressed congress for income tax benefits they could use as recruitment tools but characterized the estate tax exemption as a matter of basic fairness rather than as having any incentive effect. cf. 91 cong. rec. h9,204 (daily ed. june 19, 1948) (statement of rep. knutson) (“the armed forces have particularly requested us to make this [income tax] extension effective in order to assist them in attracting high-caliber personnel.”) with 91 cong. rec. h9,204 (daily ed. 2017] soldiers with fortunes? 129 media coverage of military recruiting reflects a similar silence about the combat exemption. a recent discussion of the army’s intensified recruiting effort in 2017 summarized the army’s general approach as “beefier bonuses, more advertising and shorter enlistment periods for some.”108 the reporter’s interview with maj. gen. jeffrey snow, the commanding general of us army recruiting command, did not include any discussion of estate tax relief.109 c. avoiding the government “profiting” from deaths in combat a third potential rationale for the combat exemption is that the death of a soldier in battle is simply an inappropriate time to assess a tax. professor fennel has aptly described this policy concern as the “incongruity of the government profiting from certain categories of untimely deaths.”110 borrowing a term from the insurance literature, professor jones has called it a “moral hazard.”111 as discussed above, the legislative history from the world war i era confirms that many legislators were concerned with this issue.112 yet, it is crucial to remember that the relief offered by section 2201 is only partial relief. the government still does “profit” from the death of multi-millionaire soldiers, just not as much as it would without the exemption in place. there is no doubt that on one level it is unseemly for the government to collect tax, and thus to benefit financially from, the death of a fallen soldier. given the relative youth of members of the armed forces and the nature of combat, those deaths can be expected to be both tragic and untimely. as a matter of politics and public policy, it may well remain appropriate for the government to offer a tax reduction in such circumstances. having said that, for two reasons, this rationale for the combat exemption is weaker currently than it was when the combat exemption was created a century ago. first, today’s military is an all-volunteer force, the military draft having ended forty years ago. second, the estate tax which was in its infancy in 1917 has gone on to become a permanent feature of the tax code. these two factors undercut the argument that it would be inappropriate for congress to fully tax the estate of a soldier who falls in combat. in the balance of this section, i explore those two significant changes. 1. no draft it is indisputable that the congressmen who advocated for the initial combat exemption in 1917 saw it as incongruous to draft a man into military service and then impose a heightened wartime estate tax if he died during that service. one congressman reasoned as follows: “under the new conscript law the soldier serves whether he will or not. you compel him to stand up on the firing line. is it fair to take tax from the property june 19, 1948) (statement of rep. knutson) (“a person who gave his or her life while serving in the armed forces during world war ii should not be made to bear the additional penalty of an estate tax.”). 108 tom vanden brook, army to spend $300 million on bonuses and ads to get 6,000 more recruits, usa today, feb. 13, 2017, at a1. 109 id. 110 lee anne fennell, death, taxes, and cognition, 81 n.c. l. rev. 567, 652 (2003). 111 carolyn c. jones, the moral hazard of the estate tax, 48 clev. st. l. rev. 729, 734 (2000) (analyzing the potential for the government to profit from soldiers’ deaths as a “moral hazard.”). 112 in the end, these predictions failed to foresee a major intervening force: the influenza pandemic of 1918. eighty percent of soldiers dying during the war died of influenza, a disease which killed ten civilians for every soldier who died during the war. id. at 734–35. 130 columbia journal of tax law [vol.9:113 of the man whom you compel to serve?”113 another congressman put it even more bluntly: “it is not right to kill a man and make him pay for it.”114 however, similar logic does not apply today, insofar as our military is an entirely volunteer one, not a conscripted one.115 while the fact that modern soldiers volunteer for military service certainly does not make combat deaths less tragic or lessen the impact on the affected soldiers’ survivors, it does on one level reduce the government’s culpability in those deaths. 116 while the fact that a soldier has volunteered, rather than being conscripted, may not eliminate the policy concerns about the government profiting from that soldier’s death, it largely eliminates the argument that the government has caused the very death it is now seeking to tax.117 2. normalized estate tax rates the second way in which the landscape surrounding the combat exemption has materially changed is that the estate tax has become a permanent feature of our taxing system.118 113 55 cong. rec. h2,726 (daily ed. may 22, 1917) (statement of rep. mondell). 114 55 cong. rec. h2,726 (daily ed. may 22, 1917) (statement of rep. little). see also 55 cong. rec. h2,726 (daily ed. may 22, 1917) (statement of rep. platt) (“we are going to conscript men in the army, rich and poor.”). 115 while technically correct, this may be an overstatement due to the government’s unilateral ability to extend the tour of duty of a service member. see 10 u.s.c. § 12305(a) (“the president may suspend any provision of law relating to promotion, retirement, or separation applicable to any member of the armed forces who the president determines is essential to the national security of the united states.”). it can be argued that volunteer soldiers that are ordered to remain in combat duty through stop-loss orders are effectively being conscripted into military service. for a discussion of stop-loss orders, see hannah dyer, keeping faith: the united states military enlistment contract and the implementation of stop-loss measures, 34 pepp. l. rev. 791, 795 (2007). for a criticism of the policy, see cheryce m. cryer, stop loss and the back-door draft: an illumination of government contract violations and potential allegations of modern-day slavery, 49 how. l.j. 843 (2006). for a defense of the practice, see matthew ivey, the broken promises of an all-volunteer military, 86 temp. l. rev. 525 (2014). for a judicial decision upholding the practice, see santiago v. rumsfeld, 425 f.3d 549 (9th cir. 2005) (stop-loss order did not violate either enlistment contract or due process). 116 professor jones similarly seems to associate a military draft with the immorality of taxing soldiers’ estates. jones, supra note 111, at 735. (“the government, in drafting men, required a sacrifice of time and, in some cases, of life itself … [t]he government could be seen as a moral hazard, profiting from death it had compelled.”). 117 going further, the elimination of the draft has eliminated a bright line related to the combat exemption and replaced it with a slippery slope. section 2201 now exempts astronauts dying on missions from estate tax because proponents of that change successfully analogized astronauts to modern soldiers, both groups volunteering to expose themselves to great danger in the name of our national interest. but what about those who secure our domestic borders or devote their lives to service in law enforcement, or protecting us from fire? the distinction between soldiers in combat and law enforcement involved, for example, in the “war on drugs” or the “war on terror” seems increasingly arbitrary. consider specifically the example of police officer sean a. collier, who was killed in the aftermath of the 2013 boston marathon bombing but does not come within the protection of section 2201. see supra notes 42 to 44 and accompanying text. for a discussion of officer collier’s death, see wendy ruderman, serge f. kovaleski & michael cooper, officer’s killing spurred pursuit in boston attack, n.y. times, april 25, 2013, at a1 (discussing officer collier’s death and connecting it to the bombing). 118 admittedly there may be no such thing as a “permanent” feature of our ever-changing tax system as evidenced by the one-year repeal of the estate tax in 2010. see beth shapiro kaufman, 2010: the anatomy of a train wreck, 37 est. plan. 42 (2010) (discussing the estate tax applicable to 2010 deaths). revision of the code is even more likely in the coming year given the results of the 2016 election which left republicans in control of both congress and the white house. howard m. wagner and david a. lifson, the 2017] soldiers with fortunes? 131 the congress of 1917 was operating under the assumption that the heightened wartime estate tax would be repealed after the war. proponents of the tax had promised their fellow legislators that “as soon as the war ends, this tax will likewise end.”119 for this reason, the wartime estate tax could be assailed as arbitrary in its application—those who died during the war would pay tax at a higher rate than those who died at other times. as one congressman argued, “i do not see … why a tax should be higher which occurs once in a lifetime, on a death that occurs during war, than at any other time.”120 others agreed that such a tax would be capricious and “unjust.”121 the senate in particular seemed swayed by these arguments. the finance committee proposed deletion of the wartime estate tax from the revenue bill, contending that it would unjustly punish those who died during wartime while leaving unaffected those “who had the good fortune to outlive the period of the war.”122 the broader senate agreed, voting to strike the tax.123 when the compromise committee restored the tax, they also added the combat exemption. by so doing, they addressed the most obvious source of potential injustice resulting from a wartime estate tax: the soldier whose life was cut short by the war, thus exposing him to the double penalty of a shortened life and heightened estate taxation. at the same time, however, congress understood that soldiers, like all other humans, must ultimately die and rightly should pay tax by virtue of those deaths. this logic explains why the initial combat exemption provided for soldiers to pay estate tax at the standard (pre-war) tax rates, the ones congress expected to remain in effect after the war’s end.124 put another way, soldiers were exempted from the estate tax consequences of wartime death. they were not exempted from the tax consequences of death itself.125 taxes they are a changin’, 98 prac. tax strategies 38, 38 (2017) (“with the republican party in control of congress and the presidency, tax reform certainly will be a focus in 2017 and potentially beyond …”). my point is solely that the modern 1916 estate tax has proven to be much more long-lived than its antecedents. since the last two u.s. world war i veterans died in 2009 and 2011, the estate tax ended up being in force at death of every american who served in world war i. see paul courson, last living u.s. world war i veteran dies, cnn (feb. 28, 2011, 9:33 pm), http://www.cnn.com/2011/us/02/27/wwi.veteran.death/ [https://perma.cc/l93r-lg8h] (reporting the 2011 death of the last u.s. world war i veteran, frank buckles); wikipedia, robley rex, https://en.wikipedia.org/wiki/robley_rex [https://perma.cc/gys9zqb4] (reporting the 2009 death of the second-to-last u.s. world war i veteran, robley rex) (as of oct. 16, 2017, 11:17 est). 119 55 cong. rec. h2,726 (daily ed. may 22, 1917) (statement of rep. miller). senator penrose, one of the senate conferees, agreed: “this bill is only for the duration of the war.” 55 cong. rec. s7,628 (daily ed. oct. 2, 1917) (statement of sen. penrose). 120 55 cong. rec. h2,726 (daily ed. may 22, 1917). 121 55 cong. rec. h2,228 (daily ed. may 12, 1917) (report of the committee on financing war to the u.s. chamber of commerce) (“inheritances are, in our opinion, not proper subjects for war taxes, as such a tax would place an unjust burden upon the estates of those dying during the progress of the war.”). 122 senator lodge explained the conference committee’s rationale: “[t]he provisions of this bill are temporary in their nature. this is headed a war estate tax. the assumption is, and the provision of the bill is, that it will expire on the conclusion of the war. as we have a permanent inheritance tax, the result of that would be that the estates of those persons, comparatively few in number, who died during the war period would … have to bear an additional tax, whereas the estates of those persons who had the good fortune to outlive the period of the war would escape it entirely. it therefore seemed to the committee that it was unjust.” 55 cong. rec. s6,130 (daily ed. aug. 17, 1917) (statement of sen. lodge). 123 55 cong. rec. s6,133 (daily ed. aug. 17, 1917) (amendment passes on floor). 124 see supra note 122. 125 with the exception of the 1918 revenue act, which retroactively offered full estate tax exemption for those dying during world war i, the estate tax exemption for soldiers has always been a partial exemption. the modern codification, based upon the traditional 1926 estate tax rates, carries forward this 132 columbia journal of tax law [vol.9:113 placed in that historical context, the ex ante logic of the combat exemption was unassailable. it was a skillfully crafted, well-targeted, provision to avoid one particular injustice—a soldier paying tax at the “wrong” rate by virtue of a premature death. but in the current era, with the benefit of a century of hindsight, that justification for the provision no longer applies. today, there is no heightened, temporary, wartime estate tax rate in effect. rates may always change by act of congress, but in theory may go up just as easily as they may go down. accordingly, it cannot be said in 2017, as it could in 1917, that a soldier’s premature death would expose her estate to higher estate tax rates than if that soldier had lived to her full life expectancy.126 an untimely death might just as likely expose a soldier to a lower, rather than a higher, estate tax than if she had lived out a full life expectancy. it all depends on what future congresses might do. iv. a better idea? as demonstrated by the above analysis, the combat exemption was a wellintentioned effort to avoid a potential tax injustice. but a century after its inception, it no longer serves important policy goals. it adds massive verbiage and complexity to the tax code, yet serves only a poorly-targeted slice of those who serve in the nation’s armed forces. for these reasons, it should be repealed. if congress repeals the exemption, the obvious question is whether it should enact something in its place. two potential answers come to mind. the first would be to expand any of the myriad of programs designed to provide services to living veterans. in modern warfare, soldiers are increasingly likely to suffer disabling wounds rather than death. 127 yet, veterans programs are woefully underfunded. 128 healthcare is often historical ideal that there is a baseline, permanent, element of the estate tax that all taxpayers should expect to confront regardless of the timing or nature of their deaths. but soldiers should be rightly exempted from estate taxes viewed as temporary—taxes which they could expect to see repealed prior to their deaths had they been given the opportunity to live full life expectancies. during the latter half of the 20th century, there was another reason to structure the estate tax in this manner; since the basic estate tax was the computational basis for the state death tax credit, congress seemingly didn’t wish to interfere with that mechanism. see 94 cong. rec. h9,204, (daily ed. june 19, 1948) (statement of rep. martin) (“the exemption … is restricted to the additional estate tax and does not apply to the basic estate tax. this provision is made to avoid interference with the inheritanceand estate-tax laws of the individual states.”). if this concern about the combat exemption interfering with state estate taxes were ever valid, and it is not clear to me that it is, the issue is now moot since the state death tax credit has since been replaced with a deduction for state death taxes. see generally jeffrey a. cooper, time for permanent estate tax reform, 81 univ. of mo. kan. city l. rev. 277, 283–86 (2012) (discussing this legislative change). 126 an ex post analysis shows that the congress of 1917 incorrectly predicted the course of the federal estate tax. rates over the ensuing century increased over time, such that a soldier dying in 1917 most likely would have paid estate tax at a higher rate had he lived to his full life expectancy. see darien b. jacobson, brian g. raub & barry w. johnson, the estate tax: ninety years and counting, 27 stat. income bull. 118, 122 fig.d (2007), http://www.irs.gov/pub/irs-soi/ninetyestate.pdf [https://perma.cc/fu7l-ht4c] (chart of estate tax rates from 1917 through 2007). 127 rajiv chandrasekaren, a legacy of pride and pain, wash. post (mar. 29, 2014), http://www.washingtonpost.com/sf/national/2014/03/29/a-legacy-of-pride-and-pain/ [https://perma.cc/rc9vvffs] (“although more than 6,800 u.s. service members were killed in iraq and afghanistan, advancements in body armor, transportation and battlefield medicine gave troops a better chance of coming home than any other generation of war fighters.”). kriner & shen, supra note 61, at 569–70 (2016) (“[w]hen compared with vietnam and korea, the ratio of wounded to killed soldiers in iraq/afghanistan is more than two and a half times larger. when compared to world war ii, the ratio in iraq/afghanistan is more than four times as large.”). 128 michael waterstone, returning veterans and disability law, 85 notre dame l. rev. 1081, 1084 (2010) (“veterans programs and commitments are chronically underfunded …”). 2017] soldiers with fortunes? 133 substandard.129 returning soldiers, particularly enlisted men and women, face significant economic challenges.130 depression, marital discord, and suicide are massive issues to confront.131 while a wealthy soldier’s combat death is tragic, it is arguably no less tragic than the plight faced by thousands of returning combat veterans struggling with the physical and psychological wounds of battle. although the potential details of any such solution go far beyond the scope of this article, providing estate tax benefits for deceased soldiers seems less important than providing quality health care and education benefits for living veterans. a second potential alternative lies within the tax code itself. as noted above, the code already contains an income tax exemption for soldiers dying in combat. 132 however, as explored below, the provision as drafted is poorly-targeted and creates unnecessary administrative complexity. in the balance of this article, i propose an alternative version of the income tax exemption and assess the extent to which this alternative addresses the policy failures that plague the combat exemption. i conclude that my proposed income tax relief would more effectively address key goals than does the current estate tax exemption. a. structuring a better income tax exemption 1. the current regime in addition to the estate tax combat exemption discussed above, congress has provided income tax relief to those dying in combat. specifically, when a soldier dies in combat, her estate is entitled to a full refund of all taxes on the soldier’s income from the time the soldier entered a combat zone until the date of death. the governing provision is i.r.c. § 692(a), which provides in relevant part as follows: § 692. income taxes of members of armed forces, astronauts, and victims of certain terrorist attacks on death (a) general rule. —in the case of any individual who dies while in active service as a member of the armed forces of the united states, if such death occurred while serving in a combat zone (as determined under section 112) or as a result of wounds, disease, or injury incurred while so serving— (1) any tax imposed by this subtitle shall not apply with respect to the taxable year in which falls the date of his death, or with respect to any prior taxable year ending 129 nema milaninia, the crisis at home following the crisis abroad: health care deficiencies for us veterans of the iraq and afghanistan wars, 11 depaul j. health care l. 327, 328 (2008) (contending that the va health system is incapable of delivering the health care services needed by returning combat veterans, specifically mental care assistance). 130 chandrasekaren, supra note 127 (“enlisted vets also report more severe economic challenges. forty-three percent of them have taken an extra job or worked additional hours because they need the money, compared with just 16 percent of officers. a quarter of enlisted members have had trouble paying their rent or mortgage; only 11 percent of officers say the same.”). 131 see generally rand ctr. for military health policy research, invisible wounds of war: psychological and cognitive injuries, their consequences, and services to assist recovery (terri tanielian & lisa h. jaycox eds., 2008), https://www.rand.org/pubs/monographs/mg720.html [https://perma.cc/q4n6-hd47]. 132 see supra note 46 and accompanying text. 134 columbia journal of tax law [vol.9:113 on or after the first day he so served in a combat zone.133 in its application, this income tax exemption provision is complex, requiring a soldier’s estate to file amended income tax returns for each year in which the soldier served in a combat zone.134 the complexity is compounded in the case of a married soldiers who filed joint income tax returns while on combat duty. since the income tax exemption forgives taxes attributed to the soldier’s income but not the spouse’s, income must be divided between those two sources when preparing this series of complex amended returns.135 the resulting administrative burden can be substantial.136 2. a proposal for reform as shown above, the estate tax combat exemption fails to achieve important policy goals and the income tax exemption introduces significant complexity, particularly in the case of a married soldier. i contend that rather than relying on these two very imperfect tax exemptions, congress should implement a single better one. to do so, congress should abandon the estate tax combat exemption in its entirety and modify the income tax exemption of section 692(a) to apply to both a soldier and that soldier’s surviving spouse, entitling both of them to a refund of all taxes imposed on them during the soldier’s combat service.137 as explored more fully below, this expanded income tax exemption would better serve important policy goals than does the current regime. 133 i.r.c. § 692 (2012). 134 u.s. dep’t of the treasury internal revenue service, armed forces’ tax guide, i.r.s. pub. no. 3, cat. no. 46072m, 25 (dec. 22, 2016). 135 treas. reg. § 1.692–1 (1978) (“if such an individual and his spouse have for any such year filed a joint return, the tax abated, credited, or refunded pursuant to the provisions of section 692 for such year shall be an amount equal to that portion of the joint tax liability which is the same percentage of such joint tax liability as a tax computed upon the separate income of such individual is of the sum of the taxes computed upon the separate income of such individual and his spouse.”). 136 i.r.s. pub. no. 3, supra note 134, at 25 outlines the multi-step process required to compute the tax forgiveness for each year of service in a combat zone: computation when the decedent filed joint returns. only the decedent's part of the joint income tax liability is eligible for the refund or tax forgiveness. to determine the decedent's part, the person filing the claim must: 1. figure the income tax for which the decedent would have been liable if a separate return had been filed, 2. figure the income tax for which the spouse would have been liable if a separate return had been filed, and 3. multiply the joint tax liability by a fraction. the top number of the fraction is the amount in (1) above. the bottom number of the fraction is the total of (1) and (2). 137 it is worth noting that i leave (at least) two questions for a future date. first, for purposes of analysis, i make the simplistic assumption that a “married soldier” is married to the same spouse for his or her entire combat service and at the time of death. by so doing, i avoid the complex administrative questions of how to treat soldiers and their spouses who marry during the years of the soldier’s combat service and/or get divorced prior to that soldier’s death. second, as i have throughout this paper, i consider the income tax exemption solely as it applies to soldiers dying in combat and do not offer any proposal for how the tax code should treat other groups offered tax relief under section 692, including civilian military employees, victims of terrorism, and astronauts. 2017] soldiers with fortunes? 135 b. assessing the proposal 1. reducing burdens on surviving family members a. financial burdens as discussed above, one of the major justifications for the combat exemption was that it would offer financial relief to the family members left behind by soldiers killed in combat.138 but the current estate tax relief is a blunt tool in this effort.139 in contrast, the proposed income tax relief would be a more precise policy tool that offers more targeted financial relief to those left behind by a soldier lost to combat. there are three major reasons why income tax relief would be superior to estate tax reduction. first, the proposed income tax exemption would offer greater financial benefits to married soldiers than does the combat exemption. as noted above, in the case of a married soldier, the unlimited marital deduction already provides a sufficient means to avoid all estate taxes, rendering the combat exemption largely superfluous in the case of a married soldier.140 the existing provision thus oddly targets the unmarried soldier for relief. in contrast, the proposed expansion of the income tax exemption, which would offer a full refund of taxes paid on both spouses’ income, offers greater relief to the married soldier than to his or her unmarried counterparts. given the goal of minimizing the financial burden on soldiers’ surviving loved ones, it would seem preferable to target those leaving behind a surviving spouse. second, expanded income tax relief would more effectively target the soldier whose death means the loss of income, either directly (for example, the death of a highpaid career officer) or indirectly (due to the possible disruption of the surviving spouse’s own career in the aftermath of the soldier’s combat service and eventual death).141 third, given that the top marginal rate on earned income is double that imposed upon dividends and capital gains,142 income tax forgiveness will afford more relief to families whose income is attributed to the wages of the soldier or her spouse (and thus more likely to be disrupted by the soldier’s death) rather than mere portfolio investors. in sum, the proposed income tax relief would more directly advance the goal of 138 see supra part ii, section a. 139 in addition to the factors discussed below, it is also important to realize that the fact that a soldier leaves behind a sizable estate tells us nothing about the source of that wealth. the soldier may have earned it, in which case, the soldier’s death will end the stream of income. alternatively, the soldier may have inherited it, in which case the soldier’s death eliminates a consumer of that wealth rather than its source. estate tax relief does not distinguish between these two very different scenarios. 140 see supra note 17 and accompanying text. 141 for a discussion of some of the hardships faced by a soldier’s surviving spouse, see adam ashton, washington-based army widows group takes care of their own, army times (mar. 16, 2015), https://www.armytimes.com/story/military/2015/03/16/washington-based-army-widows-group-takes-care-oftheir-own/24842391/ [https://perma.cc/uua9-k543]. for a discussion of the role of a soldier’s spouse in his or her career, see generally matthew a. ward, the military must lead in advocating for marriage equality, 37 n.y.u. rev. l. & soc. change 457, 476–87 (2013). 142 under current law, the top nominal marginal tax rate for earned income is 39.6% whereas longterm capital gains and qualified dividends are taxed at a maximum nominal rate of 20%. see tax policy center, briefing book: key elements of the u.s. tax system, http://www.taxpolicycenter.org/briefingbook/how-are-capital-gains-taxed [http://perma.cc/3gtf-els3] (last visited oct. 18, 2017). the actual rates of tax may vary slightly from these numbers if a taxpayer reported itemized deductions and/or is subject to the 3.8% tax on net investment income. id. 136 columbia journal of tax law [vol.9:113 offering appropriate financial benefits to the family members of soldiers lost in combat. b. administrative burdens a second shortcoming of the estate tax combat exemption is that it fails to adequately reduce the administrative burdens on soldiers’ surviving family members. the proposed expansion of the income tax exemption for deceased soldiers would far better serve this policy goal. as discussed above, under current law, a soldier’s estate wishing to claim income tax relief under section 692 must file amended returns for every year from the year that soldier first entered a combat zone until the year of his or her death.143 in the case of a married taxpayer, these returns must retroactively separate the decedent’s income from the spouse’s. 144 disentangling a married couple’s income in this manner requires extensive, complicated, computations and imposes a massive compliance burden.145 the proposed expansion of section 692 would all but eliminate this cumbersome regime. in order to obtain relief under the provision as modified, the soldier’s survivors would simply need to show how much income tax liability was reported on the soldier’s and/or spouse’s applicable income tax returns for the years deployed in combat service. that amount could then be refunded. there would be no complex calculations, and no lengthy amended returns. particularly in the case of married soldiers, this approach would dramatically reduce administrative burdens. 2. incentivize service to the extent the estate tax combat exemption incentivizes anyone to volunteer for combat service, a possibility i discount above,146 it narrowly targets its incentivizing effects to unmarried soldiers with considerable net worth. rather than target this group, the proposed income tax exemption would offer additional incentives to all married soldiers. like the current version codified in section 692(a), expanded income tax relief would offer greater benefits to those serving in combat zones for longer durations, and for those earning higher salaries for such service. since the benefits offered would increase the more a soldier earned and the longer he or she remained in a combat zone, the proposal maintains current incentives for all soldiers to extend their tours of duty and seek promotions.147 but the proposed expanded income tax exemption would offer a 143 see supra part iii, section (a)(error! reference source not found.). 144 id. 145 id. for an example of the arcane computations required to amend a joint return, see theodore paul manno, supra note 47, at 307–08 (2005). the irs publication setting out the process of making these computations seems to acknowledge that they create a compliance burden many surviving spouses will be unable to meet. see i.r.s. pub. no. 3, supra note 134 (“if you are unable to complete this process, you should attach a statement of all income and deductions, indicating the part that belongs to each spouse. the irs will determine the amount eligible for forgiveness.”). while this offer may seem to reduce the potential administrative burdens on the surviving spouse, it does nothing to eliminate the most cumbersome step in the filing process, namely locating and/or recreating the records necessary to divide sources of income between the spouses. 146 see supra part ii, section b. 147 in this regard, income tax exemptions offer superior incentives to the current estate tax combat exemption. an estate tax exemption does not offer incentives for extended tours of duty (the benefits offered are the same regardless of deployment length) and only indirectly incentivizes a solider to seek promotions or 2017] soldiers with fortunes? 137 heightened incentive for military service for married soldiers, a group the military has been striving to attract and maintain. 148 in addition, due to documented correlations between educational attainment and income level, 149 the proposal would incentivize military service by those who already possess good educations and/or valuable marketable skills, providing a cohort of recruits the modern military often lacks. 150 accordingly, the proposed exemption more directly targets a cohort of families that the military wishes to attract and retain and for whom military service, and a subsequent pay raises (to the extent some of the increased compensation is saved rather than consumed and thus ultimately would be subjected to estate tax). 148 see generally david crary, latest military maneuvers target tarnished family ties, l.a. times (may 28, 2000), http://articles.latimes.com/2000/may/28/local/me-35065 [https://perma.cc/keh5vpl8] (discussing the army’s effort to become more “family friendly” to compete with civilian employers). in addition to incentivizing married individuals to enter and stay in military service, the proposal could have an unintended effect of encouraging some existing soldiers to marry in order to obtain this potential tax benefit. see benjamin r. karney & john s. crown, families under stress: an assessment of data, theory, and research on marriage and divorce in the military xxxiii (2007), https://www.rand.org/content/dam/rand/pubs/monographs/2007/rand_mg599.pdf [https://perma.cc/7s6drrfa] (“[t]o the extent that valuable benefits are reserved for married couples only, the existence of those benefits may induce couples to marry who might otherwise have postponed marriage or never married at all.”). undercover reporting by the today television show reinforces this concern. jeff rossen & jovanna billington, hidden cameras reveal how us soldiers 'shop' for wives to get more pay, benefits, today (oct. 2, 2014, 7:42 am), http://www.today.com/news/us-soldiers-shop-wives-get-more-pay-benefits-2d80186882 [http://perma.cc/7rpd-vc2k] (reporting how some soldiers enter into sham marriages just to obtain additional military benefits). 149 given the relatively modest salaries earned by most soldiers in combat zones, particularly in comparison to civilian salaries, my conjecture that income tax relief would attract higher-skilled and highereducated soldiers requires some justification. i offer three arguments in support. first, there is an established correlation between one spouse’s educational level and the other’s earnings. see chong huang, hongbin li, pak wai liu & junsen zhang, why does spousal education matter for earnings? assortative mating and cross-productivity source, 27 j. labor econ. 633, 634 (2009) (“economists have long noticed the positive relationship between spousal education and a person’s own earnings …”). accordingly, military recruits married to higher earners are more likely to be well educated than those married to lower earners. a tax provision which offers greater benefits to soldiers with higher-earning spouses, as would my proposed income tax relief, thus indirectly attracts more highly-educated soldiers. second, some soldiers, particularly members of the national guard and reserves called away from private-sector employment to serve in combat zones may continue to receive salaries from their private employers during the time of their combat service. see alex fryer, while on military duty, some jobs pay, some don’t, seattle times (aug. 15, 2005), http://www.seattletimes.com/seattle-news/while-on-military-duty-some-jobs-pay-some-dont [http://perma.cc/z7s6-qpvc]. third, the income tax exemption extends retroactively to the beginning of the year a soldier entered a combat zone. accordingly, the exemption may extend to a small portion of the soldier’s civilian income if that soldier dies early in his or her deployment. congress could enhance this effect and further bolster efforts to lure civilians away from lucrative employment and into military service by extending tax relief backwards one or more years, to income earned prior to the soldier’s entering the combat zone. the code already includes a similar provision providing one additional year of income tax relief to the other categories of taxpayers covered by section 692: military and civilian employees, victims of domestic terrorism, and astronauts. i.r.c. §§ 692 (c)(1)(b), (d)(1)(b), (d)(5). 150 put another way, the current mix of salary, benefits, and training offered by military service is often more attractive to those with fewer employment opportunities and limited family incomes. as congressman charles rangle has observed, “the people that we ask to fight our wars are people who join the military because of economic conditions, because they have fewer options.” david m. halbfinger & steven a. holmes, a nation at war: the troops; military mirrors a working-class america, n.y.times (mar. 30, 2003), http://www.nytimes.com/2003/03/30/us/a-nation-at-war-the-troops-military-mirrors-a-working-classamerica.html [https://perma.cc/g5dk-uehk]. while rangle has supported a military draft as a way of restoring social-economic balance to the military, the proposed income tax reform would serve this same end by providing an incentive targeted to those who do have economic options other than military service, as evidenced by their higher family incomes. 138 columbia journal of tax law [vol.9:113 combat death, would represent a meaningful economic burden.151 3. avoiding the government profiting from death the final policy concern underlying the current combat exemption is the distasteful thought of the government collecting money from a dead soldier’s estate. on this final policy point, my proposed income tax relief will be inferior to the current regime in the extremely limited number of cases in which a soldier dies in combat who is both (a) wealthy enough to be subject to estate taxation and (b) unmarried and thus ineligible for the estate tax marital deduction. in this case, the government will assess a “full” estate tax and thus arguably will “profit” from that death more than under the current regime. i offer two responses to this concern. first, this hypothetical is the rare exception rather than the rule. as discussed in detail above, for the most part, our armed services are populated by those from poor or middle-class families.152 accordingly, the vast majority of soldiers would be financially better off under the proposed regime which trades a meaningless estate tax exemption for more meaningful income tax relief. the second reply to the policy concerns about the government profiting from death is an indirect one, but one which justifies the estate tax as a general matter; that death is an appropriate time for the wealthy to be subject to taxation to enable the government to serve the living.153 the original proponents of the combat exemption did not dispute this overarching theme that death was universal and death taxation appropriate. their concern was not the estate tax itself but rather the morality of imposing a heightened estate tax on drafted soldiers; the fear, as framed by congressman little, that the government would “kill a man and make him pay for it.”154 but a century later the analysis is very different. given the estate tax’s longevity, one cannot say that a soldier’s death in 2017 would expose him to a heightened wartime estate tax, as the congress of 1917 feared over a century ago. similarly, the government’s “culpability” in that soldier’s death is very different in this era of an all-volunteer military than it was in past times of military conscription, weakening the “government as moral hazard” objection.155 in enacting the combat exemption, congress merely provided a partial exemption designed to insulate combat casualties from heighted wartime estate taxes and not from a normalized estate tax that would have applied had their lives not 151 like the current exemption, my proposed revision offers greater benefits to those from higher socio-economic classes, by merely shifting the focus to those with higher incomes rather than higher net worth. given that the death gratuity and life insurance are flat amounts, equal for all soldiers, see supra notes 66, 67 and accompanying text, an income tax benefit offering greater protection to married, high-earning soldiers would seem to achieve the proper balance of incentives. 152 see supra notes 59–61 and accompanying text. 153 see generally mark l. ascher, curtailing inherited wealth, 89 mich. l. rev. 69, 151 n.14 (1990) (collecting authority in defense of estate taxation). 154 see supra note 114. 155 one other issue implicated by the discussion of the government’s “culpability” is whether a fallen soldier should be able to sue the government in tort, a question the supreme court answered in the negative. see, e.g., feres v. united states, 340 u.s. 135 (1950) (holding that the government cannot be held liable under the federal tort claims act for injuries or death incident to military service). for a discussion of this case, see paul figley, in defense of feres: an unfairly maligned opinion, 60 am. u. l. rev. 393 (2010) (discussing the case, surveying the literature criticizing the result, and offering the author’s defense of the court’s holding). 2017] soldiers with fortunes? 139 been cut short by war.156 in the modern world, that standard would be met by imposing the then-current estate tax, whatever it may be, on the handful of combat fatalities wealthy enough to pay it. v. conclusion for over a century, congress has wrestled with the proper tax treatment for those soldiers who make the ultimate national sacrifice by dying in combat. the current regime offers tax reduction to those dying in combat in the form of an estate tax combat exemption, which provides partial estate tax relief to the wealthiest soldiers, coupled with an income tax exemption applicable to all soldiers but not their spouses. as illustrated above, this current combination of partial estate tax relief and partial income tax relief fails to achieve crucial policy goals attributed to the combat exemption. accordingly, i contend that congress should consider abandoning the estate tax combat exemption in its entirety and replacing it with a more robust income tax exemption applicable to both a fallen soldier and the spouse he or she leaves behind. by making this change, congress could offer more meaningful financial and administrative relief to more typical military families. 156 the only exception to this general rule was the revenue act of 1918. see supra note 29. schrodinger's currency_v5_formatted schrödinger’s currency how virtual currencies complicate the ric and reit qualification requirements laura d. pond* abstract bitcoin and other virtual currencies have created new opportunities for individuals to invest in a rapidly appreciating new asset class, but the internal revenue code has been unable to keep pace with this new technology. because the code does not suitably define what a virtual currency is in the contexts of regulated investment companies (rics) or real estate investment trusts (reits), the concepts of “good” income and “good” assets in i.r.c. §§ 851 (rics) and 856 (reits) are inapplicable to virtual currency. under the current regime, a ric or a reit may not be able to invest directly in virtual currency without compromising the investment entity’s qualification as a tax-favorable pass-through entity. the legislative purposes behind sections 851 and 856 suggest that digital currency possesses the characteristics of “good” income and “good” assets. accordingly, rics and reits should be able to invest in this potentially lucrative new technology without risking disqualification as a tax-favored entity because virtual currency could constitute a “security” for the purposes of sections 851 and 856. yet the code’s ric and reit rules require that any qualifying security be registered under the investment company act of 1940. virtual currency is not yet regulated under the 1940 act, and thus cannot qualify as a security for the purposes of the ric and reit “good” income and “good” asset tests. the inability of the code and the ’40 act to adapt to new technology makes virtual currency a nonviable investment for rics and reits, but even more so, renders the unyielding nexus between the ‘40 act and code sections 851 and 856 nonsensical. the i.r.c. must somehow provide for the possibility of ric or reit investment in a non1940 act security, while avoiding the significant non-tax consequences attendant with a sweeping classification of all virtual currency as securities. the investment company act of 1940 should supplement—not comprise—the tax rules that define the kinds of income and assets that allow an entity to qualify as a ric or a reit. *columbia law school, j.d. candidate 2018. many thanks to professor willard taylor for his advice and expertise, as well as aaron josephson, jisoo han, zhiyuan zuo, and the editorial staff of the columbia journal of tax law. 230 columbia journal of tax law [vol.9:229 i. introduction ............................................................................................... 231 ii. background ................................................................................................. 232 a. virtual currency ............................................................................................ 232 1. virtual currency user considerations ..................................................... 233 2. bitcoin transactions................................................................................ 235 3. the value of bitcoin ................................................................................ 237 4. how bitcoin is used ................................................................................ 237 5. tax treatment ......................................................................................... 238 6. regulators’ characterization of virtual currency ................................... 240 b. ric and reit qualification rules ................................................................. 241 1. “good” income....................................................................................... 241 2. “good” assets ........................................................................................ 242 iii. virtual currency & the ‘40 act........................................................... 243 a. what is virtual currency under the current ric and reit rules?................ 244 b. rics, reits, and the ‘40 act ........................................................................ 247 iv. conclusion ................................................................................................... 249 2018] schrödinger’s currency 231 i. introduction internal revenue code (hereinafter “i.r.c.” or “the code”) provisions governing regulated investment companies (rics) or “mutual funds” predate the internet by nearly half a century.1 the investment company act of 1940 (hereinafter “the ‘40 act”) followed four years thereafter.2 twenty years later, i.r.c. § 856 was added;3 it contains very similar qualification requirements to section 851 but is only applicable to investments in real estate investment trusts (reits). computers were in their infancy when rics and reits changed the way individuals invested. at that time, no one could have predicted the impact the internet would have on the world. even more recently, virtual currency has emerged as a lucrative new way for individuals to invest their real-world cash, but tax policy has not caught up. in 2014, the internal revenue service (hereinafter “the service” or “the irs”) declared that virtual currency will be treated as property—not currency—for federal income tax purposes.4 other administrative agencies have taken a markedly different stance, classifying virtual currency as a commodity, 5 or a security, 6 although the securities and exchange commission (sec) has not yet taken a public position on the regulation of virtual currency.7 none of these characterizations adequately define virtual currency for the ric or reit context. the code does not yet allow a security which is not regulated by the ‘40 act to constitute a security for the purposes of the ric or reit qualification requirements. to qualify as a tax-favored ric or reit, (1) the entity must derive a high percentage of its income from certain enumerated sources (hereinafter “good” income),8 and (2) a certain percentage of its assets must be represented by cash, securities, and, in the case of reits, real estate (hereinafter “good” assets).9 this paper explores the origin and justification of the “good” income and “good” asset qualification requirements or “tests.” the tests’ complete dependence on the ‘40 act to classify qualifying securities can hinder the service’s ability to adjust the tax rules to technological advancements. the paradigm should be driven by the service’s classification of securities and other income and assets, wherein the ‘40 act supplements the code’s ric and reit qualification requirements but does not dictate them. as new technologies manifest, the service will be able to address them quickly, thereby fostering investment in new technologies without the confusion or abuse attendant when technological advancements and the tax code collide.10 1 revenue act of 1936, pub. l. no. 74–740, 49 stat. 1648, 1669 (1936). oliver burkeman, forty years of the internet: how the world changed for ever, the guardian (oct. 23, 2009), https://www.theguardian.com/technology/2009/oct/23/internet-40-history-arpanet [https://perma.cc/h94wk4nh]. 2 internal revenue code of 1954, pub. l. no. 83–591, § 851, 68a stat. 3, 268 (1954). 3 act of sept. 14, 1960, pub. l. no. 86–779, § 10(a), 74 stat. 998, 1004 (1960). 4 i.r.s. notice 2014-21, 2014-16 c.b. 938, 938. 5 in re coinflip, inc., cftc no. 15-29, 2015 wl 5535736 (sept. 17, 2015). 6 sec v. shavers, no. 13-416, 2013 u.s. dist. lexis 110018, at *5 (e.d. tex. aug. 6, 2013) (finding that “bitcoin is a currency or form of money.”). 7 jeffrey e. alberts & bertrand fry, is bitcoin a security?, 21 b.u. j. sci. & tech. l. 1, 2 (2015). 8 i.r.c. §§ 851(b)(2), 856(c)(2) and (3). 9 i.r.c. §§ 851(b)(3), 856(c)(4). 10 see, e.g., harvey j. shulman, our low-tech tax code, the wall street j., feb. 21, 2010, at wk8; news release, information technology industry council, after e.u. tax proposal, tech industry calls for modernization of u.s. tax code (sept. 21, 2017), https://www.itic.org/news-events/news 232 columbia journal of tax law [vol.9:229 ii. background this section describes what virtual currency is and how investors use it. it also provides a brief overview of the ric and reit qualification requirements. a. virtual currency virtual currency (also called digital currency or cryptocurrency) is an online token designed to function as a unit of value or vehicle for exchange. although digital currency has been discussed in anti-regulation circles since the inception of the internet,11 digital currencies emerged in the mid-2000s as a closed-flow trading mechanism in the context of online, virtual world, role-playing games.12 the money was not real, but the exchanges had real-world value to serious players in these virtual worlds. sales of virtual currency for cash emerged as a lucrative (albeit illicit) way for players to gain an in-game advantage, while others seized the opportunity to line their pockets with real currency, tax-free.13 as virtual currency and real-world currency mixed, businesses seized the opportunity to accept this highly popular yet unregulated currency. 14 before long, reality’s first standalone, open-flow virtual currency—bitcoin15—became available to the public.16 shortly thereafter, multiple new digital currencies emerged. currently, there are seven different virtual currencies of prominence, including bitcoin, litecoin, ethereum, zcash, dash, ripple, and monero.17 as of april 2018, there were over 1,500 virtual currencies available to the public, doubling the number of currencies available one year releases/after-e-u-tax-proposal-tech-industry-calls-for-modernization-of-u-s-tax-code [https://perma.cc/223qzpln]. 11 nicolas wenker, online currencies, real-world chaos: the struggle to regulate the rise of bitcoin, 19 tex. rev. l. & pol. 145, 147-49 (2016). 12 see, e.g., geforce, description, https://www.geforce.com/games-applications/pc-games/worldof-warcraft/description (last visited feb. 9, 2018) [https://perma.cc/p8j2-npkm] (“world of warcraft® is an online role-playing experience set in the award-winning warcraft universe.”); linden labs, about linden lab, https://www.lindenlab.com/about (last visited feb. 9, 2018) [https://perma.cc/s3wp-ysng] (second life is “the pioneering virtual world that’s been enjoyed by millions of people and seen billions of dollars transacted among users in its economy.”). for a description of how players interact with these games, see byron m. huang, walking the thirteenth floor: the taxation of virtual economies, 17 yale j.l. & tech. 224 (2015). 13 adam chodorow, rethinking basis in the age of virtual currencies, 36 va. tax rev. 371, 376 (2017). for a description of how “virtual worlds” work, see leandra lederman, “stranger than fiction”: taxing virtual worlds, 82 n.y.u. l. rev. 1620, 1621-23 (2007). 14 lederman, supra note 13, at 1667 n.235; stephen totilo, finally, you can buy something real with play money, mtv (jan. 19, 2006), http://www.mtv.com/news/1521239/finally-you-can-buy-somethingreal-with-play-money/ [https://perma.cc/dt6d-vv5s]; joshua davis, the crypto-currency, the new yorker (oct. 10, 2011), at 68 (the author was the first person to pay in bitcoins at a howard johnson hotel in fullerton, california). 15 bitcoin (with a capital “b”) denotes the bitcoin network that generates bitcoins (the currency, denoted by a lower-case “b”) and facilitates transactions. see alyson, drawing the distinction between the uppercase “b” and lowercase “b” in bitcoin, blockchain blog (dec. 29, 2014), https://blog.blockchain.com/2014/12/29/drawing-the-distinction-between-the-uppercase-b-and-lowercase-bin-bitcoin/ [https://perma.cc/hnk3-mvdj]. 16 wenker, supra note 11, at 146, 149. 17 prableen bajpai, the 6 most important cryptocurrencies other than bitcoin, investopedia (dec. 7, 2017), http://www.investopedia.com/tech/6-most-important-cryptocurrencies-other-bitcoin/ [https://perma.cc/9x46-798h]. 2018] schrödinger’s currency 233 prior.18 as of the time of publication in april 2018, bitcoin holds the lion’s share of the market at around 42.2% followed by ethereum with 15.7%.19 1. virtual currency user considerations a functional open-flow digital currency must (1) tightly regulate the supply available to the public, and (2) ensure that the same coin is not double-spent.20 accordingly, all virtual currency consists of proprietary systems that simultaneously verify coin ownership and monitor transactions while retaining complete anonymity of ownership.21 beyond their operations, there are features universal to virtual currencies that may make them appealing to individuals: • transacting with virtual currency is simple, fast, and free. it takes minutes to create an account. in most cases, there are no transaction fees because there is no intermediary in the transactions.22 • international transactions take only a few minutes, whereas banks may take several weeks.23 • transactions are simultaneously secret and public. anonymized transactions are meticulously recorded in a publicly available ledger.24 but there are also very real risks of investing in or using virtual currency. because bitcoin is the oldest and most widely used of the virtual currencies, its fraught history best illustrates these risks. first, virtual currency has been unstable since its inception.25 for much of 2010, bitcoins were valued around 6¢ each.26 three years later, bitcoins were trading at $1,200. three years after that, in 2016, the value decreased to around $600. on december 7, 2017, the value skyrocketed to $17,000 before dropping 18 elena eyber, the rise and regulation of virtual currency, wolters kluwer: tax & accounting blog (jan. 23, 2017), http://news.cchgroup.com/2017/01/23/rise-regulation-virtual-currency/ [https://perma.cc/r6ux-x9zh]; cryptocurrency market capitalizations, https://coinmarketcap.com/all/views/all/ [https://perma.cc/9awa-vznb] (last visited apr. 13, 2018). 19 cryptocurrency market capitalizations, supra note 18 (last visited apr. 13, 2018). 20 chodorow, supra note 13, at 376; alberts & fry, supra note 7, at 3. 21 chodorow, supra note 13, at 376. r. joseph cook, bitcoins: technological innovation or emerging threat?, 30 j. marshall j. info. tech. & privacy l. 535, 538 (2014) (“[a]lthough other types of dvcs [decentralized virtual currencies] exist, bitcoin was the pioneer for decentralized currency, and many other dvcs are modeled on the same or similar principles.”). 22 at a 2014 hearing before the house committee on small business, jerry brito, a senior research fellow with the mercatus center at george mason university, testified that the “decentralized nature [of bitcoin] results in lower transaction costs…because there is no central intermediary in bitcoin transactions, fees associated with those transactions are relatively small” as compared with credit card fees. jerry brito, benefits and risks of bitcoin for small business, house of rep. small bus. comm., 1-2 (apr. 2, 2014), https://smallbusiness.house.gov/uploadedfiles/4-2-2014_brito_total_final_testimony.pdf [https://perma.cc/v7fa-eqx2]. 23 eyber, supra note 18. 24 chodorow, supra note 13, at 377. 25 see, e.g., sec. & exch. comm’n (sec), office of investor educ. & advocacy (sec), investor alert: bitcoin and other virtual currency-related investments (may 7, 2014), https://www.sec.gov/oiea/investor-alerts-bulletins/investoralertsia_bitcoin.html [https://perma.cc/574z7mrg]; fin. indus. regulatory auth. (finra), investor alerts – bitcoin: more than a bit risky, http://www.finra.org/investors/alerts/bitcoin-more-bit-risky [https://perma.cc/l7jv-fsd9]. 26 damian davila, if you had purchased $100 of bitcoin in 2011, investopedia, https://www.investopedia.com/articles/investing/123015/if-you-had-purchased-100-bitcoins-2011.asp [http://perma.cc/6ed7-4cm7] (last updated may 2, 2017, 9:25 am). 234 columbia journal of tax law [vol.9:229 below $14,000 48 hours later.27 some think that the value is volatile because the technology is new and still exchanged in low volumes. as more businesses and individuals adopt it and the technology becomes more ubiquitous, the instability is expected to subside.28 still, some prominent financial experts believe that bitcoin is currently experiencing a bubble, and its value will plummet.29 in addition, the anonymity that makes virtual currency appealing to some can also support its use for illegal activity.30 for example, patrons of the silk road, a nowshuttered secret online marketplace for drugs, illegal services, and forged documents, could only conduct their illegal transactions using bitcoin.31 virtual currency is also associated with tax evasion.32 libertarian bitcoin user roger ver (a.k.a. “bitcoin jesus”) purchased st. kitts citizenship, transferred his fortune to the tax haven via bitcoin (thereby evading the foreign account tax compliance act) and then renounced his american citizenship.33 he and others have succeeded in this scheme because the regulations that limit money transfers to foreign jurisdictions do not yet apply to virtual currency.34 if the government decides to regulate virtual currency transactions more closely in the future, such transactions may be subject to greater scrutiny than standard cash or securities transactions.35 27 renae merle, bitcoin soars above $17,000, boosting worries and a worldwide frenzy, wash. post (dec. 7, 2017), http://wapo.st/2ieuh7q?tid=ss_mail&utm_term=.eecdc3bb4605 [http://perma.cc/k7wjwlvd]; will martin, bitcoin is getting pounded after a wild week of gains, bus. insider (dec. 8, 2017), http://www.businessinsider.com/bitcoin-is-finally-falling-friday-december-8-2017-12 [https://perma.cc/5jv7m4eb]. 28 e.g. brito, supra note 22, at 3 (“[t]here is nothing inherent in bitcoin’s design that makes it naturally volatile. its volatility is likely attributable to the fact that it is a new currency, still in the process of discovering its stable price.”). 29 see, e.g., john wasik, why buffett sees bitcoin bubble, forbes (nov. 6, 2017), https://www.forbes.com/sites/johnwasik/2017/11/06/why-buffett-sees-bitcoin-bubble/#25f0bcc662a8 [http://perma.cc/upj8-sxhj]; jeremy g. philips, what jamie dimon is missing about bitcoin, n.y. times dealbook (sept. 18, 2017), https://nyti.ms/2y8mkru; kevin roose, such currency. much risk., n.y. times, sept. 16, 2017, at b1. 30 finra, supra note 25. see also omri marian, a conceptual framework for the regulation of cryptocurrencies, 82 u. chi. l. rev. 53 (2017); reuben grinberg, bitcoin: an innovative alternative digital currency, 4 hastings sci. & tech. l.j. 159, 206 (2011). 31 see united states v. ulbricht, 31 f. supp. 3d 540, 547 (s.d.n.y. 2013) (no. 13–6919); joseph goldstein, arrest in u.s. shuts down a black market for narcotics, n.y. times, oct. 3, 2013, at a3; cook, supra note 21, at 557. 32 craig w. smalley, cryptocurrency and taxes, the tax adviser (apr. 20, 2017), https://www.thetaxadviser.com/newsletters/2017/apr/cryptocurrency-taxes.html [http://perma.cc/lu5d8swg] (“[i]n response to the possibility that cryptocurrency users could be using their accounts for illicit activities or to evade tax, the irs issued a john doe summons to coinbase [a bitcoin exchange] asking for information about all of its customers from jan. 1, 2013, to dec. 31, 2015. according to the irs, in a filing in support of the summons request, an irs agent attested to the fact that he had uncovered two taxpayers who admitted that they disguised the amounts they spent purchasing bitcoins as deductible technology expenses.”); kelly phillips erb, irs wants court authority to identify bitcoin users & transactions at coinbase, forbes (nov. 21, 2016), https://www.forbes.com/sites/kellyphillipserb/2016/11/21/irs-wantscourt-authority-to-identify-bitcoin-users-transactions-at-coinbase/#4830db7d5979 [http://perma.cc/fr47xgwc]; richard holden & anup malani, why the i.r.s. fears bitcoin, n.y. times, jan. 23, 2018, at a25. 33 jason clenfield & pavel alpeyev, ‘bitcoin jesus’ promises a virtual paradise, wash. post (june 20, 2014), http://wapo.st/1lgo6wf?tid=ss_mail&utm_term=.87df80bf493e [http://perma.cc/39pj-glgl]; eyber, supra note 18. 34 eyber, supra note 18. 35 the sec monitors “for potential securities law violations related to virtual currencies.” id. 2018] schrödinger’s currency 235 finally, investments in bitcoin are risky because the system can be hacked.36 in 2014, mt. gox, a japanese bitcoin exchange, collapsed when hackers absconded with $460 million of bitcoin.37 because there was no financial institution backing the currency, users were unable to recover those losses.38 such hacks cause the trading value of bitcoin to plummet, which impacts users who were not direct victims of the hack.39 despite these risks, financial mavericks have used virtual currency to create new investment opportunities. for example, in 2014, twin entrepreneurs cameron and tyler winklevoss sought sec approval to create a bitcoin exchange-traded fund (etf).40 in 2017, however, the sec thwarted two new attempts to create bitcoin etfs, citing the threat to investors inherent in the unregulated currency.41 hedge funds that primarily operate in bitcoin have also embraced the volatility of virtual currency.42 2. bitcoin transactions a bitcoin is a virtual token with a fair market cash value that can be transmitted from one user to another via the internet. bitcoins were first made publicly available in 2009 as an “alternative currency” that needs neither a bank nor governmental regulation to operate.43 in fact, former chair of the federal reserve system janet yellen called digital currency “entirely outside the banking industry” in a 2014 senate banking committee hearing.44 according to yellen, the federal reserve cannot and will not regulate virtual currency.45 there are three ways for an individual to get bitcoins. first, they can be purchased for cash, either directly from bitcoin or through a company that sells bitcoins to users through a specialized account (similar to a traditional bank account).46 bitcoin also has atms throughout the united states and abroad, where a user can exchange cash for bitcoins. as of april 13, 2018, there are 2,743 bitcoin atms globally, including 36 finra, supra note 25. 37 eyber, supra note 18; sec, supra note 25. 38 anthony volastro, cnbc explains: how to mine bitcoins on your own, cnbc (jan. 23, 2014), https://www.cnbc.com/2014/01/23/cnbc-explains-how-to-mine-bitcoins-on-your-own.html [http://perma.cc/2app-rh7n]. 39 e.g. “a major bitcoin exchange, bitfinex, was hacked and nearly 120,000 bitcoins, worth $65 million, were stolen in august 2016. bitcoin value crashed, and bitfinex was forced to temporarily suspend its trading.” eyber, supra note 18. 40 wenker, supra note 11, at 180. 41 allan eberhart, sec rejects bitcoin etfs: should you reject bitcoin investments?, forbes (apr. 6, 2017), https://www.forbes.com/sites/allaneberhart/2017/04/06/sec-rejects-bitcoin-etfs-should-youreject-bitcoin-investments/#e5eacab79bd4 [http://perma.cc/wa5d-b9rh]; paul vigna & alexander osipovich, etfs: sec gives second bitcoin fund a thumbs-down, the wall street j., mar. 29, 2017, at b15. 42 wenker, supra note 11, at 180; andrew osterland, as bitcoin soars and icos spread, advisors urge caution, cnbc (nov. 13, 2017), https://www.cnbc.com/2017/11/13/as-bitcoin-soars-and-icos-spreadadvisors-urge-caution.html [http://perma.cc/m5ln-ery6]. 43 grinberg, supra note 30, at 206; chodorow, supra note 13, at 378. 44 eyber, supra note 18; paul davidson, yellen: fed can’t regulate bitcoin, usa today (feb. 27, 2014), http://usat.ly/1fusexe [http://perma.cc/29fk-dcj7]. 45 eyber, supra note 18. 46 nathaniel popper, bitcoin basics: why hackers demand it and how it works, n.y. times, may 16, 2017, at a8. 236 columbia journal of tax law [vol.9:229 1,760 in the united states.47 second, like cash, bitcoins can be exchanged for goods and services. third, a user can generate new bitcoins via a “mining” process—akin to striking virtual gold. a bitcoin transaction has three components: (1) “the input”—the bitcoin address that originally transmitted the bitcoins to the transferor; (2) the number of bitcoins being transferred in the transaction at-issue; and (3) “the output”—the transferee’s individual bitcoin address.48 because bitcoins are solely “entries on [the bitcoin ledger] and do not exist outside of it,” each bitcoin transfer depends on the transfer that preceded it, the one that resulted in the transferor’s ownership of the bitcoin that it now seeks to transfer.49 when a user undertakes a bitcoin transaction, the network must verify that the transferor actually owns the transferred bitcoins, and that the same coin is not “double-spent” by being transferred to multiple transferees. 50 accordingly, bitcoin has developed a proprietary transaction verification system called “the block chain.” multiple transactions are grouped into “blocks.” when grouped together, these blocks create the block chain, a decentralized,51 permanent public ledger.52 this block chain records the details of every transfer that has ever been completed on the bitcoin network. users on the bitcoin network run software to solve complex algorithms associated with a block of transactions to verify new bitcoin transactions that enter the network. this verification process ensures that the transferor has enough bitcoins in his or her wallet to complete the transaction, and that none of those coins are double-spent. the first miner to solve the algorithm receives a reward in bitcoins, which are generated specifically to reward that user for verifying the transaction. once the transaction has been verified and consummated, the transferee owns the received bitcoins, and the miners receive their bitcoin reward. the new bitcoins are affiliated with the user who solved the algorithm, the verified transactions are recorded on the block chain, and the process repeats as new transactions enter the network. by verifying and recording bitcoin transfers on the block chain, members of the public generate more bitcoins. at the same time, public maintenance of the block chain protects it from fraud and corruption, and “obviates the need for third party intermediaries, such as banks.”53 despite this very public verification, monitoring, and recording system, bitcoin transfers are completely anonymous. each bitcoin user has a file called a digital wallet, which contains public keys and private keys. a public key is 47 coin atm radar, bitcoin atm industry statistics / charts, https://coinatmradar.com/charts [https://perma.cc/l3ex-pt2d] (last visited apr. 13, 2018); coin atm radar, bitcoin atms in the united states, https://coinatmradar.com/country/226/bitcoin-atm-united-states [https://perma.cc/2eql-njs4] (last visited apr. 13, 2018). 48 eyber, supra note 18. 49 id. 50 wenker, supra note 11, at 149 (“[b]ecause any digital currency is essentially just computer code, it is easy to reproduce via mechanisms such as copying and pasting”) (citing morgen e. peck, bitcoin: the cryptoanarchists’ answer to cash, ieee spectrum (may 30, 2012), http://spectrtm.ieee.org/computing/sofware/bitcoin-the-cryptoanarchissanswer-to-cash [https://perma.cc/l2at-52ap]). 51 “it is decentralized because it is powered by its users rather than any central authority.” alberts & fry, supra note 7, at 2-3. 52 kevin petrasic & matthew bornfreund, beyond bitcoin: the blockchain revolution in financial services, white & case llp (mar. 7, 2016), https://www.whitecase.com/publications/insight/beyondbitcoin-blockchain-revolution-financial-services [http://perma.cc/fgt9-tvfq]. 53 chodorow, supra note 13, at 377. 2018] schrödinger’s currency 237 recorded on the block chain whenever the user associated with that public key receives a bitcoin transfer, although it does not identify the owner of the wallet. the private key is used to make transfers from the digital wallet. each bitcoin user has both a public and a private key to control the transfer of bitcoins in and out of the digital wallet.54 each transaction associates a certain number of bitcoins with at least one public key. to the recipient, those bitcoins are bundled in the amounts in which they came into the wallet. in other words, unlike in a regular wallet where all the cash is assembled in one pocket, transactions in a bitcoin wallet remain separate transactions and are assembled in the wallet in the bundles in which they were received. for example, when someone receives a $10 bill in one transaction, and $1 in another transaction, and puts both bills in their wallet, they have $11 dollars. if someone receives 10 bitcoins in one transaction and 1 bitcoin in another transaction, they do not have 11 bitcoins, they have one bundle of 10 bitcoins in their wallet, and another bundle of 1 bitcoin. when the owner wants to send bitcoins, the wallet will recruit those bundles of bitcoins in the wallet that add up to or exceed the amount being transferred. if the transaction bundles in the wallet do not add up exactly to the amount being sent, the sender must send more bitcoins than necessary and collect the difference as change.55 these bundled bitcoins which are recruited to fulfill a new transfer are collectively called the “bitcoin address.” 3. the value of bitcoin although it takes nearly two million attempts to solve the algorithm and unlock new bitcoins, a reward of 12.5 bitcoins is issued approximately every ten minutes.56 to control bitcoin production, the reward is halved every four years, and the algorithm to create them becomes increasingly complex. this process was created “to mimic the production rate of a commodity such as gold.”57 as of april 2018, there are nearly 17 million bitcoins in circulation.58 bitcoin will stop issuing new currency when it has issued exactly 21 million bitcoins. it is estimated that the final bitcoin will be generated around the year 2140.59 as of the time of publication in april 2018, bitcoins were valued at around $8,117 each, for a total valuation of nearly $138 billion.60 4. how bitcoin is used as major retailers begin to accept bitcoin, some users treat bitcoin like cash to purchase goods and services. businesses typically “convert the bitcoins to u.s. dollars upon receipt.”61 other users purchase bitcoins as an investment. bitcoin has been publicly 54 eyber, supra note 18. 55 id. 56 volastro, supra note 38. 57 eyber, supra note 18. 58 bitcoin price index chart, coindesk, http://www.coindesk.com/price/ [https://perma.cc/7nn6nnpv] (last visited apr. 13, 2018). 59 volastro, supra note 38. 60 for the current bitcoin valuation, see bitcoin price index chart, supra note 58. 61 chodorow, supra note 13, at 378. 238 columbia journal of tax law [vol.9:229 traded since the first bitcoin exchange opened in canada in 2015.62 other countries, including the united states’ new york stock exchange, quickly followed suit.63 beyond currency, other institutions have considered using bitcoin’s underlying blockchain technology in different ways. the online retailer overstock.com plans to use blockchain technology to record and track company stock ownership.64 goldman sachs is developing a “virtual transfer system” based on the block chain which “could be used to record all kinds of transfers of financial assets.”65 other financial institutions are exploring alternative uses for a block chain to cheaply, efficiently, accurately, and securely “document the transfer of any digital asset, record the ownership of physical and intellectual property, and establish rights through smart contracts, among other applications.”66 5. tax treatment although virtual currency is becoming increasingly popular, whether it ultimately ends up as a favored currency may depend on the extent to which the government regulates its uses and scrutinizes transactions, as well as how the internal revenue service decides to treat it for tax purposes. based on the way digital currency is used, and the way the american tax system taxes accessions to wealth, those who receive virtual currency in exchange for goods or services should pay income tax on the value of the currency received. similarly, those who invest in virtual currency like securities should be taxed on any gains in the value of that currency when it is sold and converted to cash. the service has been grappling with virtual currency since as early as 2007 when its electronic business and emerging issues group made efforts to understand possible compliance issues inherent in the use of virtual currency.67 it concluded that digital currency may enable malicious users to underreport their income from virtual transactions. it developed “a potential compliance strategy” and a plan of action, both of which necessitated further study of the industry and compliance trends.68 the resourcestrapped service ultimately dropped the action plan in favor of “other higher priority needs,” but continued to study compliance trends.69 it concluded that the risk of tax 62 diana ngo, quadrigacx to become world’s first publicly traded bitcoin exchange, cointelegraph (mar. 4, 2015), https://cointelegraph.com/news/quadrigacx-to-become-worlds-first-publiclytraded-bitcoin-exchange [http://perma.cc/4t5e-vkg9]. 63 michael j. casey, bitcoin swaps exchange gets public listing via reverse merger, the wall street j. (feb. 27, 2015, 7:18 pm), https://blogs.wsj.com/moneybeat/2015/02/27/bitcoin-swaps-exchangegets-public-listing-via-reverse-merger/; yessi bello perez, new york stock exchange launches bitcoin price index, coindesk (may 19, 2015), https://www.coindesk.com/new-york-stock-exchange-launches-bitcoinprice-index/ [http://perma.cc/se33-rk8f]. 64 cade metz, overstock files to offer stock that works like bitcoin, wired (apr. 27, 2015), https://www.wired.com/2015/04/overstock-files-offer-stock-works-like-bitcoin/ [http://perma.cc/c3ww6fdw]. 65 chodorow, supra note 13, at 379 (citing ian kar, goldman sachs wants to create its own version of bitcoin, quartz (dec. 2, 2015), https://qz.com/563967/goldman-sachs-wants-to-create-its-own-version-ofbitcoin/ [http://perma.cc/8hm9-798k]); petrasic & bornfreund, supra note 52. 66 petrasic & bornfreund, supra note 52. 67 u.s. gov’t accountability office, gao-13-516, virtual economies and currencies – additional irs guidance could reduce tax compliance risks 15 (2013) [hereinafter gao report]. 68 id. 69 id. 2018] schrödinger’s currency 239 evasion or non-compliance was minimal given the very few u.s. taxpayers using virtual currency at that time.70 in 2009—the year that bitcoin became publicly available—the service first published taxpayer guidance concerning the tax consequences of transactions in virtual currency.71 the guidance maintains that taxpayers may be required to report gains from transactions in virtual currency as taxable income. it equated such transactions with “bartering, gambling, business, and hobby income,” and provided information about prior irs guidance on those issues.72 as bitcoin gained popularity, the service’s regime became unworkable and the government accountability office (gao) weighed in. in 2013, it issued a report discussing the tax compliance risks attendant with virtual currencies, including: taxpayer ignorance that accessions to wealth are taxable, the ambiguous character of income or basis for gains from digital currency, third-party reporting requirements, and outright evasion.73 it called on the service to issue new, informal guidance to address the risks it identified. the irs satisfied the gao’s recommendation the following year. in notice 2014-21 the irs issued its public position on the taxation of any kind of virtual currency that can be converted into cash. it noted that virtual currency “does not have legal tender status in any jurisdiction” in spite of its similarities to “‘real’ currency,” which it defines as “the coin and paper money of the united states or of any other country that is designated as legal tender.”74 accordingly, the service declined to treat virtual currency as a foreign currency for tax purposes.75 instead, it would be treated as property.76 upon sale or exchange of virtual currency, the “character of the gain or loss generally depends on whether the virtual currency is a capital asset in the hands of the taxpayer.”77 this definition prevents whipsaw wherein taxpayers would treat virtual currency like an asset when it appreciates by claiming a capital gain, but claiming an ordinary loss when it depreciates.78 pro-virtual currency commentators balked at the service’s stance. they believed that taxing the currency based on its fair market value on the date of receipt destroyed the fungibility that made it an appealing alternative to cash.79 in addition, suddenly virtual 70 id. 71 id.; internal revenue service, tax consequences of virtual world transactions, https://www.irs.gov/businesses/small-businesses-self-employed/tax-consequences-of-virtual-worldtransactions [https://perma.cc/7fcc-x453] (last updated mar. 21, 2018). 72 gao report, supra note 67, at 15. 73 id. at 12-15. 74 i.r.s. notice 2014-21, supra note 4, at 938. 75 but see u.s. dep’t of treasury fin. crimes enforcement network, fin-2013-g001, application of fincen’s regulations to persons administering, exchanging, or using virtual currencies (mar. 18, 2013), https://www.fincen.gov/sites/default/files/shared/fin-2013-g001.pdf [http://perma.cc/jnz9-zr77] (classifying virtual currency as a currency); cook, supra note 21, at 545. 76 i.r.s. notice 2014-21, supra note 4, at 938. 77 id. at 939. 78 victor fleischer, taxes won’t kill bitcoin, but tax reporting might, n.y. times dealbook (mar. 26, 2014), https://nyti.ms/2kpf8uf [https://perma.cc/eaq8-dfms]. 79 chodorow, supra note 13, at 380. under a capital gains tax, users must record when different coins were acquired in order to determine whether its basis made the new transaction tax-efficient. if the fair market value of the goods, services, or face value of cash exchanged for virtual currency exceeds the coin’s basis in the transferor’s hands, the transferor has taxable gain. if the basis exceeds the fair market value, the transferor has a loss. under the service’s rule, a transferor would be incentivized to exchange high basis coins in order to minimize the taxable gain or maximize the deductible loss, thereby reducing their taxable 240 columbia journal of tax law [vol.9:229 currency users could be subject to tax every time they conducted a transaction. because of the potential tax consequences of inattentive virtual currency usage, virtual currency would lose its appeal to taxpayers.80 more optimistic commentators view this preference as a business opportunity: “developers may provide ‘instant conversion’ tools, which would enable a person to buy bitcoins at the moment needed for a transaction; thus effectively eliminating taxable gain or loss.”81 6. regulators’ characterization of virtual currency the service’s position that virtual currency is treated as property is inconsistent with the stance taken by other regulators or judicial authorities, which have characterized virtual currency as cash,82 a commodity,83 or a security.84 its fragmented regulatory state stems from agencies’ eagerness to regulate this complex, dynamic, and unfamiliar creature “through the prism of what they understand,” according to edmund moy, former director of the u.s. mint.85 moy explains that: every agency has to look at bitcoin from the perspective of what their agency does. so the commodities futures trading commission looks at bitcoin as a commodity, because it complies with all the issues that commodities applies with. the federal trade commission looks at this as a bartering issue, as a trading issue; the fec looks at it from an investment perspective; the irs looks at it as a taxable event.86 income. this is starkly different from cash, where every bill has an unchanging value that is equal to the value of bills in the same denomination. a purchaser need not decide which bill to use in a transaction because the basis of cash always equals its unchanging face value; there is no tax benefit to using different bills to purchase a good. in the context of virtual currency, like cash, the basis of each coin would be the same if the coins all had the same value, regardless of its fair market value on the date of receipt. transferors would not have a preference for certain high basis coins if they all had the same value. eyber, supra note 18. 80 chodorow, supra note 13, at 381. 81 eyber, supra note 18. 82 sec v. shavers, no. 13-416, 2013 u.s. dist. lexis 110018, at *5 (e.d. tex. aug. 6, 2013) (“bitcoin is a currency or form of money.”). 83 in re coinflip, inc., cftc no. 15-29, 2015 wl 5535736 (sept. 17, 2015). 84 shavers, 2013 u.s. dist. lexis 110018, at *6 (finding with the sec, “[t]he court finds that [investments in a bitcoin hedge fund] meet the definition of investment contract, and as such, are securities.”). some commentators believe that this holding means that bitcoins themselves are securities. see dan stroh, secure currency or security? the sec and bitcoin regulation, u. cin. l. rev. blog (nov. 18, 2014), https://uclawreview.org/2014/11/18/secure-currency-or-security-the-sec-and-bitcoin-regulation/ [https://perma.cc/mm4h-ljwr]. but cf. alberts & fry, supra note 7, at 14 (“this is incorrect. the court limited its holding to whether shares of the hedge fund were investment contracts and did not consider whether bitcoin itself is an investment contract.”). 85 wenker, supra note 11, at 184 (citing stan higgins, former us mint director: how to save bitcoin from the regulators, coindesk (july 9, 2014), https://www.coindesk.com/former-us-mint-directorsave-bitcoin-regulators/ [http://perma.cc/eap4-zvlf]). for a discussion of possible regulatory coordination among agencies, see generally viktor mayer-schönberger, virtual heisenberg: the limits of virtual world regulability, 66 wash. & lee l. rev. 1245 (2009). 86 wenker, supra note 11, at 184-85 (citing higgins, supra note 85). 2018] schrödinger’s currency 241 the tax uncertainty that continues to surround bitcoin most recently manifested in a 2016 report from the treasury inspector general for tax administration.87 echoing the gao report from 2013, the service acknowledged that it had taken steps to understand the unique tax character of virtual currency by creating a virtual currency issue team, but that it had not developed guidelines for taxpayer compliance. while the report was full of optimism and recommendations for further action, including “developing a coordinated virtual currency strategy, providing updated guidance for requirements and tax treatments, and revising third-party reporting requirements,” it is not clear that such steps have yet been taken.88 for now, the increasingly popular system of currency is left with no clear classification or regulation. b. ric and reit qualification rules rics and reits are pass-through entities through which individuals might make tax-efficient investments. rics are the longest standing statutory pass-through entity in the american tax system. they were originally enacted as a legislative response to the morrissey case, which classified managed investment trusts as c corporations and subjected them to a corporate-level tax. interest groups successfully lobbied for taxfavorable treatment for those investment entities. a ric allows small investors to invest in the stocks and securities of operating companies by pooling their funds to buy shares in investment companies without subjecting those funds to corporate-level taxes. those investment companies then invest those aggregated funds in the stocks and securities of operating companies. a reit uses a similar pooling mechanism, but primarily invests in interests in real property, broadly defined, and interests in the mortgages attached to real property. 89 to stimulate investments in real estate, congress afforded reits “substantially the same” favorable tax treatment “since in both cases the methods of investment constitute pooling arrangements.”90 as pass-through entities, rics and reits are not required to pay tax at the corporate level on distributed earnings as long as they meet the stringent qualification requirements imposed by the code. two such requirements include the “good” income and “good” asset tests. 1. “good” income a. rics under i.r.c. § 851(b)(2), a ric must derive at least 90% of its yearly gross income from dividends; interest; payments with respect to securities loans; gains from the sale of stock, securities, or foreign currencies; income from publicly traded partnerships; or other income derived from its business of investing in stocks and securities. this rule is intended to distinguish between income from passive investments and income resulting from conducting an active business. when a ric’s (or a reit’s, as discussed below) 87 treasury inspector gen. for tax admin., as the use of virtual currencies in taxable transactions becomes more common, additional actions are needed to ensure taxpayer compliance (sept. 21, 2016), https://www.treasury.gov/tigta/auditreports/2016reports/201630083fr.pdf [http://perma.cc/azf9-8x3g]. 88 smalley, supra note 32. 89 see treas. reg. § 1.856-10. 90 h.r. rep. no. 86-2020, 1960-2 c.b. 819, 820 (1960). 242 columbia journal of tax law [vol.9:229 income is derived from passive investments, the entity can qualify for favorable tax treatment if it so elects.91 b. reits under i.r.c. § 856(c)(2), at least 95% of a reit’s gross income at the end of a taxable year must be derived from dividends; interest; rents from real property; gains from the sale of stock, securities, and real property; or certain other income. under i.r.c. § 856(c)(3), at least 75% of a reit’s gross income must come from rents from real property, interest on mortgages secured by real property, gain from sale or other disposition of real property, dividends from the sale of transferable shares in other reits, and certain other real estate income. in other words, three-quarters of the reit’s income must be derived from real property. up to an additional 15% of the reit’s income can come from sources from which a ric would derive the vast majority of its income.92 thus, while the same passive investment rule applies to both rics and reits, the additional 75% rule on reit income is designed to ensure that the majority of the passive investments made by a reit are in real property or in mortgages on real property.93 2. “good” assets a. rics the ric “good” asset test is intended to mirror the asset diversification requirement in the ‘40 act for certain investment companies. the “good” asset test, when satisfied, may afford tax-favored treatment to certain diversified investment companies. under i.r.c. § 851(b)(3)(a), at the end of each quarter, 50% or more in value of the total assets of the ric must be cash or cash items (including receivables), government securities (e.g. treasury securities), securities of other rics, and certain other types of securities. this tax requirement parrots the definition of “diversified management company” in section 5(b)(1) of the ‘40 act. section 5(b) provides that a diversified company is a management company,94 at least 75% of the total assets of which are invested in cash, government securities, securities of other investment companies, and certain other securities. section 5(b) also provides that no more than 5% of the value of the total assets invested by the diversified company may be invested in the securities of any one issuer, and no more than 10% (by vote or value) of the outstanding voting securities of one issuer.95 in the internal revenue code, that 75% threshold from the ‘40 91 id. at 821 (congress “has…taken care to draw a sharp line between passive investments and the active operation of business…”). 92 id. at 822. 93 id. at 819, 822. 94 “‘management company’ means any investment company other than a face-amount certificate company or a unit investment trust.” investment company act of 1940, pub. l. no. 76–768, § 4(3), 54 stat. 789, 799 (1940). 95 “‘diversified company’ means a management company which meets the following requirements: at least 75 per centum of the value of its total assets is represented by cash and cash items (including receivables), government securities, securities of other investment companies, and other securities for the purposes of this calculation limited in respect of any one issuer to an amount not greater in value than 5 per 2018] schrödinger’s currency 243 act is decreased to 50% for ric tax qualification purposes. the legislative purpose for the ric “good” asset test and its nexus with section 5(b) of the ‘40 act are somewhat of a mystery. one commentator hypothesizes that diversified investment companies must satisfy the asset diversification requirement under the ‘40 act “to inform stockholders of the character of the portfolio of the company in which they have invested,” thereby enabling the small investors that tend to invest in rics to make sound investment decisions and to be insulated from the risks of a non-diversified investment.96 b. reits under i.r.c. § 856(c)(4), at the close of each quarter at least 75% of a reit’s total assets must be invested in real estate, cash, and government securities. no more than 25% of those assets may consist of securities other than government securities or reit debt instruments. this requirement echoes the ric “good” asset requirement because congress, in crafting a tax regime for reits, wanted to assure investors that (1) the majority of the reit’s investments are in real property, and (2) the trust’s assets are sufficiently diversified in investments other than real estate (or cash, or government securities).97 thus, the rationale behind the “good” asset test for both rics and reits is the same: diversification of investments. according to the service, “[b]oth sets of rules are intended to protect the investor from the risks of loss and of illiquidity inherent in the concentration of assets in the securities of a single or a small number of issuers.”98 iii. virtual currency & the ‘40 act given that investor interest in virtual currency has skyrocketed in recent years,99 it is likely that rics and reits will invest in virtual currency in the future. however, any substantial investment in virtual currency may jeopardize an entity’s ability to qualify as a ric or reit, even though the characteristics of virtual currency are consistent with the legislative intent of those qualification requirements. this section discusses how virtual currency should be classified under i.r.c. subchapter m and proposes a workable regulatory solution in light of that definition. centum of the value of the total assets of such management company and to not more than 10 per centum of the outstanding voting securities of such issuer.” id. at § 5(b)(1). 96 alfred jaretzki jr., the investment company act of 1940, 26 wash. u. l. q. 303, 314 n.34 (1941); h.r. rep. no. 86-2020, supra note 90, at 820 (“your committee believes that the equality of tax treatment between the beneficiaries of real estate investment trusts and the shareholders of regulated investment companies is desirable since in both cases the methods of investment constitute pooling arrangements whereby small investors can secure advantages normally available only to those with larger resources. these advantages include the spreading of the risk of loss by the greater diversification of investment which can be secured through the pooling arrangements; the opportunity to secure the benefits of expert investment counsel; and the means of collectively financing projects which the investors could not undertake singly.”). 97 h.r. rep. no. 86-2020, supra note 90, at 822. 98 p.l.r. 2005-26-011; note, the investment company act of 1940, 41 colum. l. rev. 269 (1941). 99 michael j. casey & paul vigna, bitcoin and the digital-currency revolution, the wall street j. (jan. 23, 2015), https://www.wsj.com/articles/the-revolutionary-power-of-digital-currency-1422035061 [https://perma.cc/9wky-j428]. 244 columbia journal of tax law [vol.9:229 a. what is virtual currency under the current ric and reit rules? the service has spoken only once on the classification of virtual currency, in its 2014 notice.100 under this ruling, any substantial investment in virtual currency may jeopardize an entity’s ability to qualify as a ric or reit because “property” is not enumerated in either the “good” income or “good” asset tests. but an analysis of the legislative history of these qualification requirements reveals that the liquidity that diversification provides and income that is passively-earned are the key features of “good” assets and “good” income, respectively. virtual currency possesses those key features; as to assets, virtual currency resembles already-approved “good” assets like cash and securities. in some regards, virtual currency is cash-like; users are able to use it to purchase goods and services from accepting retailers. some investors also treat an investment in virtual currency like an investment in securities. it might qualify as a “security” under the broad “investment contract” definition in the securities act of 1933,101 although it does not strictly fit the definition and is unlikely to be regulated by the sec as a security.102 in addition, virtual currency should qualify as a “good” asset because it satisfies the legislative intent that rics and reits invest in liquid assets; as it becomes more widely adopted, virtual currency becomes increasingly liquid.103 if congress intended the ric and reit “good” asset tests to encourage portfolio diversification, the rules are likely not intended to foreclose entire classes of investments, particularly when those investments closely resemble already-approved “good” assets like cash and securities. as to “good” income, rics and reits could—and perhaps should, given its trajectory over the past year—invest in virtual currency like a security, receiving gains from its sale as “good” income. in addition, if a tenant in a building owned by a reit pays his rent in virtual currency,104 and the reit held that virtual currency and ultimately sold it at a gain, the difference between the value of the currency when it was used to pay the rent and the value for which the currency was ultimately sold should also qualify as “good” income because it is income received as rent as well as a gain from the sale of a security. other regulators might disagree that virtual currency should be treated like a security. some argue that virtual currency is more similar to a commodity than a security. such a definition may work in other contexts, but it is unworkable for rics. if virtual 100 see i.r.s. notice 2014-21, supra note 4. 101 see infra notes 110-20. see also the argument in grinberg, supra note 30, at 195-98. after much deliberation, the author concluded that bitcoin is not an investment contract because users are not engaged in a common money-making enterprise. see also alberts & fry, supra note 7, at 20-21. for an analysis of how certain characteristics of a digital token map onto the legal definition of a security, see lee schneider et al., a securities law framework for blockchain tokens (dec. 7, 2012), https://www.coinbase.com/legal/securitieslaw-framework.pdf [https://perma.cc/v8vj-mqra]. 102 but cf. kerry lynn macintosh, the new money, 14 berkeley tech. l. j. 659, 672 n.78 (1999) (“an argument can be made that ‘obligation’ was never intended to include electronic money…”). 103 laura shin, 4 reasons why bitcoin represents a new asset class, forbes (june 2, 2016), https://www.forbes.com/sites/laurashin/2016/06/02/4-reasons-why-bitcoin-represents-a-new-assetclass/#49cf8b5f3426 [https://perma.cc/w5j3-faxf]. 104 this hypothetical is not divorced from reality. for example, a condominium in washington, d.c. recently listed for 59 bitcoin. see michele lerner, four condos in northwest washington list for $569,000 to $949,000 – and bitcoin, wash. post (feb. 7, 2018), http://wapo.st/2dyk9g9?tid=ss_mail&utm_term=.66d38cd0cd24 [https://perma.cc/t5xn-qcdw]. 2018] schrödinger’s currency 245 currency is considered a commodity, it would satisfy the “good” asset test only for reits; rics and commodities have a fraught relationship.105 however defined, virtual currency should mean the same thing for both rics and reits for the sake of regulatory simplicity and administrability.106 others have wondered if virtual currency should be treated as a foreign currency for tax purposes, rather than property. such a classification brings up some issues in the ric and reit contexts. the ric rules allow gains from the sale of foreign currency to qualify as “good” income; the reit rules do not.107 the reit rules also do not allow a reit to hold foreign currency as a “good” asset (cash) unless that currency is the reit’s “functional currency.”108 the regulations do not provide guidance on tax treatment when a virtual currency is a reit’s functional currency. at the same time, to define virtual currency as any kind of cash would oppose the service’s current position that such currency is an asset. such a stark inconsistency will inevitably lead only to further tension in other code provisions. thus, assuming that both rics and reits should be able to invest in virtual currency, as argued in part iii(a) above, it is easy to say what virtual currency is not for the purpose of the ric and reit qualification rules. but it is not nearly as simple to say exactly what it is. based on the way it is used,109 it might fall somewhere between a foreign currency and a security. the securities act of 1933 defines a “security” as a number of instruments, including “any note, stock, … transferable share, investment contract, … or group or index of securities (including any interest therein or based on the value thereof)…”110 although users make investments in virtual currency like a stock, virtual currency lacks the essential characteristics of a stock, including voting rights and the right to receive dividends.111 virtual currency could constitute a note if a court were to find that it represents a “written promise by one party to pay money to another party” that bears a “family resemblance” to other kinds of notes.112 although the definition of “note” has been broadly construed, it is likely inapplicable to most types of virtual currency.113 a note represents a continuing obligation between two parties: the notemaker, and the note-holder. when a holder “cashes in” his virtual currency, it is not the note-maker that pays the obligation, it is the third party to whom the holder transfers or sells his currency. 105 see rev. rul. 2006-1, 2006-1 c.b. 261; rev. rul. 2006-31, 2006-1 c.b. 1133 (the service ruled that a derivative contract on commodities was not a security under i.r.c. § 851(b)(2); a ric’s income from such a contract is not “good” income). 106 see generally willard b. taylor & diana wollman, why can’t we all just get along: finding consistent solutions to the treatment of derivatives and other problems, 53 tax law. 95 (1999). 107 i.r.c. § 851(b)(2)(a); i.r.c. § 856(n). 108 i.r.c. § 856(c)(5)(k). 109 see part ii supra. 110 securities act of 1933, 15 u.s.c. § 77b(a)(1). 111 see grinberg, supra note 30, at 195-96 (“a bitcoin is not ‘stock’…because it lacks important characteristics of stock, such as conferring the right to receive dividends contingent upon an apportionment of profits.”). cf. report of investigation pursuant to section 21(a) of the securities exchange act of 1934: the dao, exchange act release no. 81,207 at 1, 4 (july 25, 2017) (finding that tokens available for purchase in a “virtual” organization are securities because they “permit the participant to vote and entitle the participant to ‘rewards.’”). 112 note, black’s law dictionary (10th ed. 2014); reves v. ernst & young, 494 u.s. 56, 62-63 (1990). 113 reves, 494 u.s. at 62-63. 246 columbia journal of tax law [vol.9:229 some virtual currencies might meet the broad definition of an investment contract: “a contract, transaction, or scheme whereby a person (1) invests his money in (2) a common enterprise and is led to expect profits (3) solely from the efforts of the promoter or a third party…”114 given that most virtual currency investors purchase their currency from exchanges, it satisfies the first element of the definition. at least one federal court has concluded that a bitcoin purchase is an investment under this element.115 as to the second element, all bitcoin investors are involved in the common enterprise of maintaining the block chain system and ensuring that the currency’s value is maximized, because “each individual investor’s fortunes [are tied] to the fortunes of the other investors…”116 others have argued that because bitcoin is so decentralized, “there is no one money-making business that seeks to raise money through investments,” and thus, there is no common enterprise.117 but in rics and reits, investors rely on investment advisors to manage the portfolio. the court in shavers found that such reliance qualifies such entities as a common enterprise.118 the third element, which requires that the “essential managerial efforts which affect the failure or success of the enterprise” “are made by those other than the investor,” is the trickiest.119 on one hand, investors passively rely on the virtual currency’s network administration to manage their investment vehicle. but those “essential managerial efforts” come from other investors, who guard the network to ensure the value of the currency. still, bitcoin has value because of the increasing number of people who use it; like other technological advances, the value of the technology grows as the network grows.120 on balance, it is difficult to predict what a court would decide based on sec precedent, so it is unlikely that virtual currency will qualify as a security under existing securities laws in the near future. regardless of what the sec decides to call virtual currency, however, the service affords it the same treatment as a security: much like a stock or a bond, the gains and losses from the sale of virtual currency are treated as capital gains and losses.121 the characterization of virtual currency as a security thus most closely aligns with the existing irs guidance; when virtual currency is treated like property, investors are treated like those who invest in stocks.122 but the fact remains that the code does not currently describe how non-’40 act securities are treated for the purpose of the ric and reit “good” income or “good” asset qualification requirements. this regulatory no-man’s land may prevent rics and reits from investing in virtual currency when legislative history indicates that it should be able to do so. 114 sec v. w. j. howey co., 328 u.s. 293, 298-99 (1946). for a thorough discussion of how the various qualities of bitcoin satisfy (or do not satisfy) this definition, see grinberg, supra note 30, at 196-99. 115 sec v. shavers, no. 13-416, 2013 u.s. dist. lexis 110018, at *6 (e.d. tex. aug. 6, 2013). 116 revak v. sec realty corp., 18 f.3d 81, 87 (2d cir. 1994); schneider et al., supra note 101at 14-15. for an alternative analysis of “common enterprise” and bitcoin, see alberts & fry, supra note 7, at 15-20. 117 grinberg, supra note 30, at 197; alberts & fry, supra note 7, at 16. 118 shavers, 2013 u.s. dist. lexis 110018, at *5. 119 sec v. glenn w. turner enters., inc., 474 f.2d 476, 482 (9th cir. 1973). 120 joe weisenthal, here’s the answer to paul krugman’s difficult questions about bitcoin, bus. insider. (dec. 30, 2013), http://www.businessinsider.com/why-bitcoin-has-value-2013-12 [perma.cc/3mznwacx] (the author cites the late-90s file-sharing phenomenon napster as one such example). 121 tara siegel bernard, when trading in bitcoin, keep the tax man in mind, n.y. times, jan. 20, 2018, at b2. 122 wenker, supra note 11, at 186. 2018] schrödinger’s currency 247 b. rics, reits, and the ‘40 act the liquidity and passivity of virtual currency, regardless of whether or not it can properly be classified as a security, suggest that it is a “good” asset. under the current statutory scheme, it most closely qualifies as a “security” for the ric and reit rules, although that characterization is admittedly not without controversy. yet because the ‘40 act does not recognize virtual currency as a security, and because the ric and reit rules do not contain any provisions that would otherwise capture virtual currency, it cannot qualify as a “good” asset under the status quo.123 there is no contingency in the code for a non-’40 act security. this structural limitation at best complicates, and at worst forecloses completely ric or reit investment in virtual currencies. while other pass-through entities are able to invest in virtual currency,124 rics and reits are liable to lose their tax-favored status simply by investing in these lucrative technologies. but defining virtual currency as securities has major non-tax consequences; thus, the tether between the ‘40 act and the ric and reit “good” income and “good” asset tests serves an important purpose.125 perhaps instead the ric and reit rules too rigidly define “good” income and “good” assets. but this limitation is not just a byproduct of the internet age. a similar tension between the ric qualification requirements and physical commodities has led some experts to believe that rics cannot invest directly in commodities.126 when different regulatory agencies define something in a variety of different ways, the regulatory scheme breaks down where those regulators overlap, like the sec and the irs do in the ric and reit qualification rules. by effectively deferring to the sec’s definition of a security, the service connects an otherwise fragmented system. problems arise, however, when the regulator on which another agency relies is slow to take a position on a unit that tests the bounds of the existing shared regulatory regime. virtual currency has been the thorn in regulators’ sides since it emerged in 2009 and the irs has only recently begun to regulate virtual currency. but its current solution is not ideal; the classification of virtual currency as property creates problems in other areas of the code where such a definition is unsuitable. a tether to the ’40 act places the onus on the sec to understand the new currency and regulate it accordingly, thereby preventing such a stopgap regulatory scheme from creating problems. in the cryptocurrency context, however, the sec has not acted quickly enough, even though the securities act of 1933 was designed to “create a legal construct that would not be 123 in order to constitute a security in the ric and reit code provisions, it must be recognized by the ‘40 act. rev. proc. 2016-50, 2016-43 i.r.b. 522. 124 fixed investment trusts and publicly traded partnerships are two such entities. see vaneck vectors bitcoin strategy etf, registration statement (form n-1a) (aug. 11, 2017); rex bitcoin strategy etf, registration statement (form n-1a) (aug. 23, 2017). 125 see alberts & fry, supra note 7, at part ii. 126 see rev. rul. 2006-1, supra note 105; rev. rul. 2006-31, supra note 105 (holding that income from derivative contracts with respect to a commodities index is not “good” income because such contracts do not constitute a security under the ric qualification rules). see also rev. proc. 2016-50, supra note 123; regulated investment company modernization act of 2010, pub. l. no. 111–325, 124 stat. 3537; ronald e. creamer, jr., willard b. taylor & ari m. zak, ric modernization act of 2010, sullivan & cromwell llp 6 (dec. 23, 2010), https://www.sullcrom.com/sitefiles/publications/sc_publication_ric_modernization_act_of_2010.pdf [https://perma.cc/c663-tp7x]. 248 columbia journal of tax law [vol.9:229 outpaced by financial innovations.”127 although formal problems in the subchapter m context have not yet come before the irs, they quite possibly could in due time. for now, however, based on the sec’s posture towards investments in virtual currencies, ric and reit investments in virtual currency are unlikely to gain much popularity any time soon.128 thus, it is either nonsensical that rics are registered under the ’40 act, or that there is no contingency in the ric and reit qualification rules for technological advances that create appealing investment opportunities in non-’40 act securities. as shown in the legislative history behind the rules, congress wants to enable small investors to minimize their investment risk by investing in pooling arrangements. it should not allow the service’s intransigence to prevent such investors from investing in lucrative technologies. a statutory or regulatory scheme that explicitly determines that virtual currency qualifies as a “good” asset, and that income from the sale of virtual currency can count as “good” income when it is earned from passive investments should solve this problem. accordingly, something resembling the following language should be added to sections 851 and 856 or their regulations: securities not otherwise defined in the investment act of 1940. securities that are not otherwise defined in the investment act of 1940 shall be defined by reference to service determination, taking into account the purposes for which those terms are being applied in the context of sections 851 and 856 of the internal revenue code. this language requires the service to reverse its current position that it will not rule on whether or not an instrument is a “security” under the ’40 act for ric qualification purposes.129 upon a ruling request, the service will assess the security for liquidity and its connection with passive investment, as opposed to active business. it may also look to decisions by the sec or other regulatory agencies to inform its decision, if such decisions or rulings have already been made. it will also look for a sinister intention to flout the tax rules.130 without such language, rics and reits will be precluded from investing in new technologies until the tether between the ‘40 act and the code is severed. such a severance is more easily fathomed in the reit context, where the code’s reliance on ’40 act definitions is a bastion of its origin as a mutual fund for real estate. in fact, extending the ric qualification rules to entities not registered under the ’40 act may facilitate simpler tax structures. for example, if hedge funds could organize as rics, the complex tiered partnership structures under which they now operate would be eliminated. but completely separating the code’s and the ’40 act’s definitions of securities may be inadvisable in the long-run. as agencies’ regulatory expertise is unable to keep pace with new technologies that fall within the purview of multiple agencies which either cannot or 127 alberts & fry, supra note 7, at 8 (citing reves v. ernst & young, 494 u.s. 56, 61 (1990)). 128 eberhart, supra note 41. 129 rev. proc. 2016-50, supra note 123. 130 cf. owen davis, in the world of cryptocurrencies, the ‘wolf of wall street’ guy is a paragon of probity and reason, above the law (oct. 23, 2017, 7:30 pm), https://abovethelaw.com/2017/10/in-theworld-of-cryptocurrencies-the-wolf-of-wall-street-guy-is-a-paragon-of-probity-and-reason/ [http://perma.cc/2hgs-7ed2]. 2018] schrödinger’s currency 249 will not coordinate, the service may need to defer to the expertise and relative alacrity with which the sec operates to characterize new technologies, which should be regulable—if not taxable—instruments. iv. conclusion consistent with its libertarian origins, cryptocurrency has created chaos among regulatory agencies. the sec has been slow to regulate virtual currencies, which may create problems for small investors who wish to invest in virtual currency through a ric or a reit. the congressional intent behind the ric and reit qualification requirements indicates that virtual currency should qualify as a “good” asset, and gain from the sale thereof should constitute “good” income. but the service has classified virtual currency as “property,” which cannot qualify for either under the current regime. instead, virtual currency may be classifiable as a “security.” yet that sweeping generalization is a dangerous proposition; such a classification would have great non-tax consequences. for the specific tax purposes of the ric and reit qualification requirements, and any other requirements in the code where such a definition fits, however, it may be practicable to call some digital currencies “securities.” it is up to the service to generate such a definition; it has not yet and may never come from the sec. the service must acknowledge that it serves a purpose distinct from that of the sec, and that sometimes the code’s reliance on sec action may be unworkable. microsoft word ozai-12-3.docx inter-nation equity revisited ivan ozai* abstract states are on the verge of a new form of global competition. some have taken unilateral measures to tax multinational profits that they would typically not be able to tax, at least not according to conventional international tax concepts and rules. others have threatened to retaliate with economic countermeasures to protect their tax base and corporate residents. the recent attempt of the oecd to build consensus for a global tax compact has so far proven unsuccessful due to broad disagreement about how taxing rights should be equitably distributed between countries. as policymakers and tax scholars increasingly call into question long-standing theories of international taxation, the concept of inter-nation equity plays a pivotal role as a guiding principle in determining how to divide the international tax base among states. inter-nation equity is one of the most ubiquitous concepts appearing in international tax policy discussions and yet one of the most understudied in tax scholarship. this article introduces a comprehensive normative analysis of inter-nation equity by discussing how the concept should reconcile the two primary goals of international allocation of taxing rights: on the one hand, the concern of states to preserve their tax sovereignty and, on the other hand, the need to promote some degree of redistribution to address the challenges of global poverty and inequality. this article further explains how a similar notion of inter-nation equity has developed in other areas of international law and discusses some practical implications for tax policy design. i. introduction ...................................................................................................... 59 ii. the concept of inter-nation equity ...................................................... 60 a. significance in the literature ............................................................................... 60 b. competing conceptions of an uncontested concept .......................................... 62 c. the musgraves’ original formulation ................................................................ 64 iii. inter-nation equity as a two-fold concept ..................................... 67 a. two normative components ............................................................................... 67 b. normative compromise ....................................................................................... 70 c. the concept of differentiation ............................................................................ 71 iv. allocating rights according to inter-nation equity ............... 74 a. reconciling entitlement and differentiation ....................................................... 74 * richard h. tomlinson doctoral fellow at mcgill university faculty of law. for thoughtful comments and suggestions on earlier drafts, special thanks go to professors allison christians, laurens van apeldoorn, catherine walsh, tarcísio magalhães, diane ring, steven dean, miranda stewart, kim brooks, wei cui, as well as participants of seminars at dalhousie university’s schulich school of law, york university’s osgoode hall law school, and ryerson university’s faculty of law, where versions of this work were presented. the core of this paper was written during a four-month research fellowship in 2019 at the centre d’études et de recherches internationales de l’université de montréal (cérium), and i am grateful to magdalena dembinska, frédéric mérand, and their team for their hospitality and support. finally, thank you to the editors of the columbia journal of tax law for their insightful comments. 2020] inter-nation equity revisited 59 b. requirements for differentiation ......................................................................... 78 c. practical implications .......................................................................................... 80 1. tax sparing agreements ............................................................................... 80 2. unitary taxation with formulary apportionment ........................................ 81 3. the oecd’s “unified approach” ................................................................ 84 v. conclusion .......................................................................................................... 85 i. introduction in 1963, economist peggy musgrave (née brewer, formerly richman) developed the concept of inter-nation equity as a metric to determine how rights to tax should be distributed among states.1 her work diverged from the more familiar tax policy analysis which focused on the distribution of tax burdens within closed societies.2 a decade later, peggy musgrave teamed up with her husband richard musgrave to revise her 1963 work and made a compelling argument for allocating the international tax base in a way that acknowledges the entitlement of countries to tax income arising in their territories while making allowance for some degree of international redistribution.3 the concept of internation equity gained nearly universal embrace in tax scholarship and became the go-to normative principle in tax policy discussions regarding the distribution of taxes across jurisdictions. yet, much of the purpose behind its original formulation has been lost over the years. inter-nation equity has become a vague enough term that it is used to justify virtually any possible stance on how to distribute the international tax base while giving the impression that such a stance, because it is purportedly aligned with the concept of inter-nation equity, is grounded in some sense of fairness between nations. some have argued that the musgraves’ formulation of inter-nation equity is too narrow to lead to any practical guidance or recommendations.4 a more charitable view of their scholarship, however, suggests that the musgraves provided an important starting point for a broader discussion about international distributive justice.5 this article explores the rationale behind the original conception of inter-nation equity and demonstrates that it is more than a mere rhetorical device. the musgraves’ ingenious work on the notion of inter-nation equity was foundational and is still the leading contribution to the field. 6 yet, it has two significant limitations from a normative standpoint. first, despite their meaningful concern with international justice, their focus 1 peggy brewer richman, taxation of foreign investment income: an economic analysis (1963). 2 previous discussions about distributive justice in the tax literature were mostly limited to the concept of inter-individual equity, which refers to how tax burdens should be distributed among fellow nationals. see id. 3 richard a. musgrave & peggy b. musgrave, inter-nation equity, in modern fiscal issues: essays in honor of carl s. shoup 63, 85 (richard m. bird & john g. head eds.,1972) (“on the whole, it would seem desirable to implement redistributional objectives through rate differentiation while attempting to divide the source in line with ‘true’ economic imputation.”). 4 alex easson, taxation of foreign direct investment: an introduction 39 (1999); reuven s. avi-yonah, globalization, tax competition, and the fiscal crisis of the welfare state, 113 harv. l. rev. 1573, 1648 (2000); tim edgar, corporate income tax coordination as a response to international tax competition and international tax arbitrage, 51 can. tax j. 1079, 1154 (2003). 5 kim brooks, inter-nation equity: the development of an important but underappreciated international tax policy objective, in tax reform in the 21st century: a volume in memory of richard musgrave 471, 493 (john g. head & richard krever eds., 2009). 6 see id. at 472. 60 columbia journal of tax law [vol. 12:58 unsurprisingly leans more toward the economic implications of different tax policies than to the normative underpinnings of inter-nation equity. second, they wrote their 1972 seminal essay at a time when sophisticated discussions about global justice had yet to unfold in the political philosophy literature. this article’s first goal is to present a comprehensive normative analysis of internation equity. building on contemporary developments in global justice, this article evaluates how the concept of inter-nation equity can reconcile two major goals of international allocation of taxing rights: the concern of states to preserve their tax sovereignty and tax entitlement and the need to promote some degree of redistribution to take up the challenges of addressing global poverty and inequality. this analysis puts forth a two-pronged principle for how to allocate taxing rights among jurisdictions. it considers that whenever a normative approach based on tax sovereignty (entitlement approach) does not provide satisfactory guidance for how to divide the international tax base, taxing rights should be allocated to the benefit of less affluent countries so as to address global poverty and inequality (differential approach). this article’s second contribution is to establish general but concrete normative requirements for differential mechanisms. the global recognition of the urgency of tackling global inequality has led some developed nations, both independently and collectively, to adopt tax measures that aim to reduce such inequality. some of those initiatives, however, are problematic because they fail to address global inequality in a meaningful way. the normative requirements put forth in this article indicate that redistribution through tax policy should be comprehensive and consistent so as not to produce further inequalities. the remainder of this article proceeds as follows. part ii introduces the concept of inter-nation equity. it demonstrates the significance of the concept in the tax literature, considers some of the varied and frequently conflicting interpretations the term has received over the years, and identifies the main assumptions and purposes behind its original formulation. part iii turns to the two normative components (entitlement and differentiation) comprising the original conception of inter-nation equity. it demonstrates that a dual conception of inter-nation equity finds some precedent in other areas of international law. part iv puts forth normative requirements deriving from inter-nation equity and explores the practical implications of those requirements for tax policy design. part v concludes by discussing potential constraints and objections to a dual conception of inter-nation equity. ii. the concept of inter-nation equity a. significance in the literature peggy musgrave is generally regarded as having coined the phrase “inter-nation equity” so as to make a conceptual distinction from the more common notion of interindividual equity.7 the conceptual development of inter-nation equity was made known more broadly in a 1972 essay co-authored with richard musgrave,8 but peggy musgrave 7 richman, supra note 1; see also klaus vogel, worldwide vs. source taxation of income a review and re-evaluation of arguments (part iii), 11 intertax 393, 394 (1988) (stating that peggy musgrave deserves tribute for being the first to distinguish inter-individual equity considerations from those based on inter-nation equity); michael j. graetz, taxing international income: inadequate principles, outdated concepts, and unsatisfactory policies, 26 brook. j. int’l. l. 1357, 1395 (2001); nancy h. kaufman, fairness and the taxation of international income, 29 l. & pol’y int’l bus. 145, 153 (1998). 8 musgrave & musgrave, supra note 3. 2020] inter-nation equity revisited 61 continued to develop the practical implications of inter-nation equity in her later work.9 a great part of the originality of her contribution to the tax literature was establishing the possible underlying principles of inter-nation equity and evaluating the consequences of incorporating those principles in concrete tax policy design.10 the concept of inter-nation equity is now ubiquitous in the tax literature. commentators have applied the concept to a wide array of subjects, frequently beyond the scenarios envisaged by the musgraves themselves. for instance, the concept has been used to argue for the replacement of the arm’s length principles with a formulary apportionment approach,11 for a digital services tax,12 a global e-commerce tax,13 for the allocation of taxing rights to the country where economic activities occur and where value is created,14 against the restrictions on source-based taxation in the oecd and the un model tax treaties,15 for the regulation of tax competition,16 for the expansion of the existing concept of permanent establishment to include sales jurisdictions,17 for the harmonization of the legal treatment of inheritance tax rules in european countries,18 for the assessment of treaty 9 see, e.g., peggy b. musgrave, the oecd model tax treaty: problems and prospects, 10 colum. j. world bus. 29 (1975); peggy b. musgrave, interjurisdictional equity in company taxation: principles and applications to the european union, in taxing capital income in the european union: issues and options for reform 46 (sijbren cnossen ed., 2000) [hereinafter musgrave, interjurisdictional equity]; peggy b. musgrave, consumption tax proposals in an international setting, 54 tax l. rev. 77 (2000); peggy b. musgrave, sovereignty, entitlement, and cooperation in international taxation, 26 brook. j. int’l l. 1335 (2001) [hereinafter musgrave, sovereignty]; peggy b. musgrave, taxing international income: further thoughts, 26 brook. j. int’l l. 1477 (2001) [hereinafter musgrave, taxing]; peggy b. musgrave, combining fiscal sovereignty and coordination: national taxation in a globalizing world, in the new public finance: responding to global challenges 167 (inge kaul & pedro conceiçāo eds., 2006) [hereinafter musgrave, combining]. although the term “inter-nation equity” remains popular in the tax literature, musgrave shifted to “interjurisdictional equity” in her later work. because “jurisdiction” and “nation” are not precise substitutes, and the international allocation of taxing rights takes jurisdictions as the relevant political unit, “interjurisdictional equity” seems conceptually more accurate. 10 brooks, supra note 5, at 477. for a review of the relevance of peggy musgrave’s work in current tax policy discussions, see allison christians, digital services taxes and internation equity: a tribute to peggy musgrave, 95 tax notes int’l 589 (aug. 12, 2019). 11 otto h. jacobs, christoph spendgel & anne schäfer, ict and profit allocation within multinational groups, 32 intertax 268 (2004). 12 wei cui & nigar hashimzade, the digital services tax as a tax on location-specific rent (cesifo, working paper no. 7737, 2019). but see daniel shaviro, digital services taxes and the broader shift from determining the source of income to taxing location-specific rents (nyu law and economics, working paper no. 19-36, 2019) (although supporting a digital services tax, arguing that inter-nation equity does not have much relevance to the discussion). 13 rifat azam, global taxation of cross-border e-commerce income, 31 va. tax rev. 639 (2012). 14 oecd/g20 base erosion and profit shifting project, oecd, addressing the tax challenges of the digital economy, action 1 2015 final report (2015). 15 oladiwura ayeyemi eyitayo-oyesode, source-based taxing rights from the oecd to the un model conventions: unavailing efforts and an argument for reform, 13 l. & dev. rev. 193 (2020). 16 joel p. trachtman, international regulatory competition, externalization, and jurisdiction, 34 harv. int’l l.j. 47, 73 (1993). 17 justus eisenbeiss, beps action 7: evaluation of the agency permanent establishment, 44 intertax 481, 496 (2016). 18 jan szczepański, personal genuine links under domestic inheritance tax rules in the light of international and european standards, 43 intertax 595, 604 (2015). 62 columbia journal of tax law [vol. 12:58 obligations to proportionally allocate personal tax benefits among eu member states,19 and for the discussion of tax information exchange standards.20 perhaps the most remarkable feature of inter-nation equity is that regardless of the disparities in how the concept is understood,21 there does not seem to be any disagreement about its primacy as a normative directive for how to allocate rights between jurisdictions.22 considering the nearly universal acceptance of inter-nation equity in the realm of international tax policy, the lack of a robust effort in the literature to provide a comprehensive examination of its conceptual content and normative underpinnings is somewhat surprising.23 the following section will discuss a few conceptions of internation equity put forth in the literature and then propose a more comprehensive understanding based on peggy musgrave’s own development of the concept. b. competing conceptions of an uncontested concept the absence of extended analyses of inter-nation equity did not bar commentators from employing it in ways that denote different and sometimes contradictory conceptions of the idea. probably the most common approach to understanding inter-nation equity is to view it as a substitute for a general notion of fairness in how tax revenues are shared among states. in this sense, inter-nation equity is employed to provide certain normative legitimacy to the author’s main claim but with no further elaboration on what it might mean as a normative guide.24 19 ruth mason, tax expenditures and global labor mobility, 84 n.y.u. l. rev. 1540, 1593-99 (2009). 20 christopher rose, exchange of tax information: neutrality and inter-nation equity (2007) (unpublished ph.d. thesis, university of oxford) (on file with author). 21 for additional examples of how inter-nation equity has been used (and misused) in the literature besides the ones listed above, see brooks, supra note 5, at 489–90. 22 some may argue that inter-nation equity is insufficient as the sole guide for allocating taxing rights but still do not disagree that it deserves consideration as a factor. see musgrave & musgrave, supra note 3 and accompanying text. 23 see kaufman, supra note 7, at 203 (arguing that a conception of inter-nation equity deserves greater attention than it has received); diane ring, democracy, sovereignty and tax competition: the role of tax sovereignty in shaping tax cooperation, 9 fla. tax rev. 555, 583 (2009) (“[f]irm foundations for a generally accepted vision of inter-nation equity have yet to be established . . .”); miranda stewart & yariv brauner, introduction: tax, law and development, in tax law and development 3, 18 (miranda stewart & yariv brauner eds., 2013) (“[a]lthough some have engaged with the concept of internation equity, it has remained rather thin and has not been particularly tractable to substantive analysis.”). besides the work of the musgraves, rare exceptions include kaufman, supra note 7; brooks, supra note 5; jinyan li, improving inter-nation equity through territorial taxation and tax sparing, in globalization and its tax discontents tax policy and international investments 117 (arthur j. cockfield ed., 2010); anthony c. infanti, internation equity and human development, in tax law and development 209 (miranda stewart & yariv brauner eds., 2013). 24 some of the recent literature includes, carlo garbarino, inter-country equity and intra-group transactions at eu level: an analysis of the ccctb proposal and ecj tax cases, 21 e.c. tax rev. 248 (2012); reinout de boer & otto marres, beps action 2: neutralizing the effects on hybrid mismatch arrangements, 43 intertax 14 (2015); jan szczepański, personal genuine links under domestic inheritance tax rules in the light of international and european standards, 43 intertax 595 (2015); bastiaan starink, source versus residence state taxation of cross-border pension payments: trouble shared is trouble halved, 44 intertax 6 (2016); bruno peeters & herwig verschueren, the impact of european union law on the interaction of members states’ sovereign powers in the policy fields of social protection and personal income tax benefits, 25 e.c. tax rev. 262 (2016); wolfgang schön, one answer to why and how to tax the digitalized economy, 47 intertax 1003 (2019); johannes becker & joachim englisch, taxing where value is created: what’s ‘user involvement’ got to do with it?, 47 intertax 161 (2019). 2020] inter-nation equity revisited 63 a second recurring conception of inter-nation equity is to understand it as the normative basis for taxation at source.25 however, views differ on the extent to which source-based taxation is supported by inter-nation equity. some argue that it requires greater taxing rights to source countries.26 others take it to provide a much more limited support for taxation at source and suggest restricting its application to earnings with abovenormal rates of return.27 and some even take an absolutely opposite view by arguing that inter-nation equity leads to exclusive residence-based taxation.28 inter-nation equity is also thought to provide normative grounds for how to allocate multinationals’ profits among jurisdictions. however, whereas some argue that it supports a balanced consideration between the supply and demand sides of economic activity in allocating profits (that is, a supply-demand approach),29 others argue, conversely, that inter-nation equity requires a supply-only approach to profit allocation.30 a less prevalent view of inter-nation equity focuses on its appeal for international redistribution aimed at addressing the revenue concerns of lower-income countries.31 in this sense, some point out that inter-nation equity captures the belief that the global tax revenue pie is distributed unfairly with respect to developing nations and consequently supports a claim for global distributive justice.32 similarly, some argue that inter-nation 25 see, e.g., alex easson, fiscal degradation and the inter-nation allocation of tax jurisdiction, 3 e.c. tax rev. 112, 112–13 (1996) (arguing that inter-nation equity favors source-based taxation because capital-importing countries are usually poorer than capital-exporting countries); michael p. devereux & peter birch sørensen, the corporate income tax: international trends and options for fundamental reform 17 (european commission, working paper no. 264, 2006) (arguing that a source-based corporation tax is legitimate on the grounds of inter-nation equity since source countries provide costly infrastructure and protection of property rights that allow for profitable use of capital by foreign investors); sijbren cnossen, company taxes in the european union: criteria and options for reform, 17 fiscal studies 67, 79 n.22 (1996); veronika daurer, tax treaties and developing countries, 42 intertax 695 (2014). see also avi-yonah, supra note 4, at 1648 (noting that inter-nation equity relates primarily to the question of entitlement and favors the prevalent practice of source-based taxation against the preference for residence-based taxation). 26 see, e.g., eyitayo-oyesode, supra note 15 (arguing that inter-nation equity should prevent the current restrictions on source-based taxation in the oecd and the un model tax treaties). 27 see, e.g., peter birch sörensen, issues in the theory of international tax coordination 14–15 (bank of finland, working paper no. 4/1990, 1990); vincent c. avagliano, the second wave: it outsourcing, globalization, and worker rights, 23 penn st. int’l. l. rev. 663, 684 (2005). 28 william b. barker, optimal international taxation and tax competition: overcoming the contradictions, 22 nw. j. int’l l. & bus. 161, 205 (2002) (arguing that inter-nation equity requires the assignment of the tax base exclusively to the residence state because that state provides the environment for the production and suffers a large loss in income and jobs due to the export of its capital and labor whereas the source state enjoys disproportionately greater benefits compared to what it provides). 29 see, e.g., erika dayle siu, milly i. nalukwago & marcos aurélio pereira valadão, lessons from existing subnational unitary and formulary apportionment approaches for a regional transition to unitary taxation, in taxing multinational enterprises as unitary firms 150, 169 (sol picciotto ed., 2017). 30 see, e.g., otto jacobs, christoph spengel & anne schäfer, ict and international corporate taxation: tax attributes and scope of taxation, 31 intertax 214, 231 (2003). 31 see, e.g., avi-yonah, supra note 4, at 1650 (noting that inter-nation equity can be interpreted as embodying explicit redistributive goals so that “when a choice is presented between two otherwise comparable alternative rules, one of which has progressive and the other regressive implications for the division of the international tax base between poorer and richer countries, the progressive rule should be explicitly preferred to the regressive one.”). 32 ring, supra note 23, at 585. ring shows some skepticism towards this claim. as part iii.b will demonstrate, one of the reasons is that global justice claims at the time were mostly grounded on early cosmopolitanism. recent discussions on global justice have gradually shifted toward a more refined, balanced view. see also miranda stewart, redistribution between rich and poor countries, 72 bull. int’l taxation 297 (2018) (taking inter-nation equity to mean that redistribution is warranted when international tax system leads to an unfair allocation of the international tax base). 64 columbia journal of tax law [vol. 12:58 equity implies consideration for less affluent countries’ interests.33 others take inter-nation equity outside the context of tax jurisdiction allocation and understand it as a normative requirement for countries’ commitment to aid low-income countries.34 conversely, some have suggested that inter-nation equity equates to the principle of non-discrimination, thus translating to a notion of treating countries equally rather than benefiting lower-income states.35 inter-nation equity has become the go-to concept when one needs to provide normative basis to a given stance on an international tax issue.36 yet, when it comes to understanding what the concept entails, one finds that there are a significant number of competing conceptions. these conceptions capture only parts of what is a much more nuanced concept. such a limited view of inter-nation equity hinders its potential as a normative guide for international tax policy and many times contradicts the main normative goal behind its original formulation. the following section will go over a few aspects of the musgraves’ original formulation and then offer one possible interpretation of the concept. c. the musgraves’ original formulation peggy musgrave articulated her conception of inter-nation equity throughout dozens of papers, in which she translated the concept into practical policy recommendations. 37 she repeatedly noted that inter-nation equity does not apply exclusively to the distribution of tax jurisdictions. rather, she argued that it more broadly relates to the overall economic gains and losses of the involved jurisdictions and that therefore consideration of any factors that impact a country’s overall earnings, such as labor and capital, is warranted. however, acknowledging the complexity in analyzing these additional aspects, she frequently limited her analysis to what an equitable allocation of tax bases should be.38 despite her extensive analyses and applications of the concept, inter-nation equity is most systematically articulated in the 1972 essay inter-nation equity,39 co-authored with richard musgrave. in that paper, the musgraves introduced inter-nation equity as a set of principles aimed to answer two fundamental questions: (1) which countries should tax income internationally and (2) how to distribute tax jurisdiction between them.40 33 see, e.g., s.a. stevens, the duty of countries and enterprises to pay their fair share, 42 intertax 702, 705–06 (2014); martin hearson, the challenges for developing countries in international tax justice, 54 j. develop. stud. 1932 (2018). 34 see, e.g., neil brooks & thaddeus hwong, the social benefits and economic costs of taxation: a comparison of highand low-tax countries 24–25 (2006). 35 see, e.g., maarten f. de wilde, some thoughts on a fair allocation of corporate tax in a globalizing economy, 38 intertax 281, 287 (2010). 36 see brooks, supra note 5, at 491 (noting that musgrave and musgrave’s 1972 essay continues to be cited regularly decades after publication and the concept of inter-nation equity continues to be relevant as a widely accepted criterion for assessing the international tax regime). 37 see sources cited supra note 9. 38 see, e.g., musgrave, interjurisdictional equity, supra note 9, at 54 (“in fact, the significance of these tax arrangements for [interjurisdictional equity] goes beyond the mere revenue share. as capital moves from one jurisdiction to another, this not only affects tax bases but also has its impact on factor earnings in both host and home jurisdictions. . . at the same time, allowance for these secondary effects in determining an equitable distribution of tax bases would be administratively unmanageable, so, for practical purposes, [interjurisdictional equity] has to be confined to revenue shares.”). 39 musgrave & musgrave, supra note 3. 40 musgrave’s analysis is sophisticated in many respects and is not limited to these two normative principles. this article will not go into these details because the main goal is to understand the normative 2020] inter-nation equity revisited 65 the first aspect of the musgrave’s conception of inter-nation equity, regarding the allocation of taxing rights, concerns the question of how to divide the international tax base among countries when a business residing in one country earns income in another country. entitlement to tax is typically determined by the source principle, which allows a jurisdiction to tax foreign income generated within its territory, and the residence principle, which recognizes the right of a jurisdiction to tax all income of its residents regardless of where the income was earned. the musgraves argue that the source principle should take precedence in determining entitlement to tax. in their view, there are two main reasons for this choice. first, because low-income countries are typically source jurisdictions, it would be inequitable to favor residence-based taxation.41 second, because the place of corporate residence involves a fairly arbitrary decision by the corporation itself and can be easily manipulated.42 once it is determined that the source country has the primary entitlement to tax, the next question is how much the source country is entitled to tax.43 two assumptions made by the musgraves are relevant here. the first assumption is that any income earned by an investor arising from international trade and investment is part of the residence country’s earnings. this means that any taxes imposed at source will result in inter-nation redistribution (transfer of international gains from the residence to the source country), whereas any taxes imposed by the residence country will not (because it only transfers earnings from a resident to the treasury of the residence country).44 the rationale behind this assumption is not clear. one reason might be that until 1991, the united states used as its overall economic indicator the gross national product (gnp), which includes income earned by residents overseas and excludes income earned by non-residents in the country. in 1991, the united states shifted to gross domestic product (gdp), which computes exclusively income produced in the country, either by residents or non-residents. 45 another reason might be that the musgraves adopted the typical assumption that income is owned by who produces it, regardless of its place of origin. 46 but the practical grounds for the principles they articulate and how these principles are situated in the current global justice debate. 41 musgrave & musgrave, supra note 3, at 78. 42 id. 43 the musgraves highlight that inter-nation equity is relevant in determining the distributional claims not only between source and resident countries, but also among the different possible source countries and the different possible residence countries. as for the latter, they argue that a residence country should be entitled to tax only if it is either the country of source or the country of primary tax allegiance (residence or citizenship) for individual shareholders owning a substantial proportion of the equity. see musgrave & musgrave, supra note 3, at 78–79. 44 this assumption is later relaxed, when they consider that whenever the incidence of corporation tax falls on consumers rather than solely on profits, taxation by the residence country on its foreign investment results in a national loss to the source country (and a gain to the residence country). in such a case, they argue that residence-based taxation would be inappropriate for redistributive reasons because the capital exporting country will hardly be the low-income country. see id. at 80–81. 45 see united states bureau of economic analysis, gross domestic product as a measure of u.s. production 8 (1991). 46 klaus vogel criticized this assumption by arguing that it ignores the fact that when income is produced it consists of values integrated into the economy of the source country and thus is subject to that state’s sovereignty. see vogel, supra note 7, at 400–01. kaufman also questions whether the musgraves’ assumption is still valid because of the universality of source-based taxation in today’s international tax system. see kaufman, supra note 7, at 194. kaufman’s criticism, however, seems to conflate entitlement to overall earnings (which is what musgrave’s assumption refers to) with entitlement to tax (which is what the source principles relates to). the main question here is about which country has the legal or moral right over gains arising from international trade and investment. the main problem with the musgraves’ assumption that the 66 columbia journal of tax law [vol. 12:58 consequences of this assumption are significantly attenuated by their preference for the source principle for allocating tax jurisdiction, thus giving the source country the primary entitlement to tax. the second assumption made by the musgraves is a corollary to the first. taxation by the residence country affects inter-individual equity in that country but does not interfere with inter-nation equity. therefore, in their view, inter-nation equity is exclusively determined by how much tax jurisdiction is allocated to the source country. the tax rate applied at the source will determine how much international gain is transferred from the residence country to the source country and thus determine how taxing rights are divided between the residence country and the source country. therefore, determination of the appropriate tax rate applicable at the source is an important factor for inter-nation equity. the musgraves propose three alternative principles for making such a determination: the principle of non-discrimination, the principle of national rental, and the distributional approach. the first possible criterion for determining the tax rate at source is the principle of non-discrimination, which follows what they take to be “the general principle of equality under the law” and requires that “all economic activity within a country’s border be treated alike.”47 the practical implication is that source countries’ withholding tax rates should vary according to their own rate structure so that the same combined tax rate is imposed on domestic and foreign taxpayers. the principle of national rental considers the total national gains of each country (residence and source) accruing from international investment48 and suggests that there should be some form of equal net benefit to both sides. according to this principle, if the source country is resource-rich but capital-poor, it should be allowed to charge a national rental charge for the use of its investment environment and natural resources.49 the distributional approach builds on the national rental principle, but unlike that principle, the rates adopted by each source country vary according to “distributional considerations.”50 under this approach, rather than a reciprocal or equal rate schedule, tax rates at source should be differentiated so that they would relate inversely to per capita income in the source country and directly to per capita income in the residence country, so as to improve the relative position of low-income countries.51 for instance, if the source country has a low gdp per capita in relation to the residence country’s gdp per capita, the allowable tax rate at source will be significantly high. if the source country’s gdp per capita is low relatively to the residence country’s gdp per capita, the allowable tax rate will be proportionately lower.52 the main underpinning for the distributional approach is residence country holds primary entitlement over gains from international investment is that the issue might require a more in-depth discussion over international property rights that are not explicitly addressed. 47 id. at 72. 48 this includes the net gain to the residence country due to increased capital income and the net gain to the source country due to increased labor income. 49 id. at 72–74. 50 the musgraves describe it as rental rates tempered by distributional considerations. 51 id. at 74. 52 the musgraves provide the following table as an example of what the distributional approach would look like. id. 2020] inter-nation equity revisited 67 the normative demand to promote international redistribution in a world with a “highly unequal distribution of resource endowments and per capita income among countries and in the absence of an adequate method for dealing with the problem”.53 the musgraves note that these principles are incompatible with each other, so that a choice must be made as to which principle applies in each case.54 the choice, in their view, depends fundamentally on whether the residence and the source countries are at the same or different levels of development. when both are high-income countries, either the non-discrimination or the national rental principle could apply. however, in treaty arrangements between low-income and high-income countries, the distributional approach takes priority.55 this two-pronged standard for allocating taxing rights among jurisdictions points to a dual notion of inter-nation equity. part iii will explore a few normative implications of this view. iii. inter-nation equity as a two-fold concept a. two normative components as shown above, most conceptions of inter-nation equity tend to incorporate only some aspects of the concept originally formulated by the musgraves. these conceptions usually fail to recognize the importance of the musgraves’ assertion of a two-pronged approach to allocating rights that considers, on the one hand, economic imputation and, on the other hand, international redistribution.56 for this discussion, it is helpful to consider two alternative normative approaches for allocating tax jurisdiction at an international level. entitlement approaches consider a jurisdiction entitled to tax by virtue of a specific political or economic relationship with the person or income being taxed. from a moral perspective, this approach relies on the notion of tax sovereignty and builds on a statist view of international relations.57 discussions around source and residence are fundamentally informed by entitlement approaches.58 differential approaches tend to disregard direct economic and political connections 53 id. 54 id. at 80. 55 the musgraves explicitly reject the principle of reciprocity, which requires that countries adopt equal tax rates on income accruing to non-resident corporations. they point out that the principle has little economic justification and is incompatible with the more sensible principles they propose, namely the principle of non-discrimination, the national rental principle, and the distributional approach. see id. 56 id. at 85 (“on the whole, it would seem desirable to implement redistributional objectives through rate differentiation while attempting to divide the source in line with ‘true’ economic imputation.”). 57 laurens van apeldoorn, who calls this view an internationalist position, has accurately described it as the “model [that] conceives of states as independent and autonomous, entitled to shape their social, political and economic institutions as they see fit . . . [s]tates are presumed to have an unqualified right to the resources they control and the wealth they create in their territory.” laurens van apeldoorn, exploitation, international taxation, and global justice, 77 rev. soc. econ. 163, 167 (2019). 58 for a broader analysis of this view, see ivan ozai, origin and differentiation in international income allocation, 44 dalhousie l.j. (forthcoming 2021) (using the term origin-based approaches to refer to normative theories that build on the entitlement view). 68 columbia journal of tax law [vol. 12:58 between a taxpayer and a state as morally relevant criteria to divide the tax base among countries. according to this view, tax jurisdiction should be distributed so as to carry out a universal moral objective, usually one that aligns with a concern about global justice.59 differential approaches take the allocation of taxing rights as a significant tool for addressing global inequality and propose a distribution among countries according to characteristics such as per capita income or number of inhabitants. proposals for global taxes typically endorse this view. one prominent example is thomas pogge’s global resources dividend (grd). grd is effectively a tax on the use of natural resources. the revenue collected would be distributed to less affluent countries.60 a recent proposal by a group of european tax professors to transfer to the european union the power to levy specific taxes embraces both concepts simultaneously.61 such a proposal does not entirely abandon the entitlement approach and possibly creates a regionally differential system. the musgraves seem to embrace neither of these approaches completely. they rather advance an allocation of tax jurisdiction based on “economic imputation” that is “tempered . . . by distributional considerations,”62 which indicates a two-fold view that combines an entitlement component—based on the notions of economic allegiance, 63 benefit terms,64 and tax sovereignty65—with a differential one.66 the entitlement component of inter-nation equity is grounded in the idea of sovereignty and is conveyed through the general alignment with the benefit principle, which requires an entitlement to tax according to the benefits derived from each country’s provision of public goods and services. the musgraves embrace source-based taxation by arguing that “a sovereign country is entitled to tax all activity which occurs within its borders.”67 they also embrace residence-based taxation, but only as a normatively residual right over the entitlement of the source country.68 the principles of non-discrimination and of national rental are two corollaries of this normative component. as part ii.b has 59 alexander cappelen calls this the assignment approach. see alexander w. cappelen, the moral rationale for international fiscal law, 15 ethics & int’l aff. 97, 108 (2001) (“a characteristic feature of international fiscal law is that considerations of international income distribution do not have any role in the distribution of tax rights. the assignment approach would challenge this feature of international fiscal law based on what we could call the distributional objection. in its general version this objection points out that benefits arising from special relationships might work to the disadvantage of those who are most in need.”). 60 thomas w. pogge, eradicating systemic poverty: brief for a global resources dividend, 2 j. hum. dev. 59, 67-68 (2007) (“proceeds from the grd are to be used toward ensuring that all human beings will be able to meet their own basic needs with dignity.”). 61 frans vanistendael et al., european solidarity requires eu taxes, 98 tax notes int’l 577 (may 4, 2020). 62 musgrave & musgrave, supra note 3, at 78. 63 musgrave, combining, supra note 9, at 168. 64 id. at 172–73. 65 musgrave & musgrave, supra note 3, at 71–72. 66 id. at 74–75, 80, 89. 67 id. at 71–72. 68 in later work, peggy musgrave takes a more nuanced view of the residence country’s entitlement to tax. she provides a basis for residence entitlement as a matter of tax sovereignty (because residents owe tax allegiance to their country of residence in return for rights and privileges they receive), as a requirement of inter-individual equity (by ensuring equitable tax treatment of resident taxpayers by taxing all their income wherever earned), and as corollary of the benefit principle (since the residence country provide productivityenhancing benefits to residents’ factors of production prior to foreign investment as well as rights and privileges resulting from registration). see musgrave, combining, supra note 9, at 168–69. but she still regards the residence country as a residual taxing authority vis-à-vis the source country. id. 2020] inter-nation equity revisited 69 shown, this is markedly the most prevalent interpretation of inter-nation equity in the tax literature. the differential component is an equally important but significantly overlooked aspect of the musgraves’ conception of inter-nation equity.69 the idea that international taxation should be informed by a moral requirement of redistribution from highto lowincome countries run through many of the policy recommendations offered in their 1972 essay. along with the case they made for a differentiated tax rate schedule based on each country’s different level of per capita income,70 the musgraves also took distributional considerations into account when they argued for an internationally agreed-upon framework to replace the existing bilateral treaty network,71 against taxation at residence whenever the corporation tax incidence falls on consumers,72 for primary source-based taxation,73 and when considering an apportionment formula for allocating the international tax base among multiple source countries.74 in later work, peggy musgrave also referred to distributional considerations when calling for investment in low-income countries,75 condemning tax competition,76 and arguing against the unilateral substitution of consumption taxes for the income tax by the united states77 and compensatory revenue transfers in case of global substitution of consumption taxation.78 despite the ubiquitous concern with distributional considerations in the musgraves’ (notably in peggy musgrave’s) scholarship,79 it would be misleading to take their case for international redistribution as a call for cosmopolitan global justice. 80 global cosmopolitanism typically disregards the significance of states and treats each individual as a member of a universal society and thus deserving of an equal share of entitlements.81 although the differential component is an important part of the musgraves’ conception of inter-nation equity, they still consider the entitlement component to be a fundamental component of the concept. as the following section will discuss, this normative position aligns with what could be regarded in today’s global justice debate as a middle course between cosmopolitanism and statism.82 that the musgraves took such an unorthodox 69 see kaufman, supra note 7, at 203 (pointing out that it would be a mistake to disregard the differential aspect of the musgraves’ scholarship and think of inter-nation equity only in terms of entitlement theory). 70 supra note 50. the idea for a tax rate schedule inversely related to per capita income was reiterated in musgrave, interjurisdictional equity, supra note 9, at 59. 71 musgrave & musgrave, supra note 3, at 79–80. 72 id. at 80. 73 id. at 78. 74 id. at 85. 75 musgrave, combining, supra note 9, at 170. 76 musgrave, sovereignty, supra note 9, at 1343–44; musgrave, taxing, supra note 9, at 1478. 77 musgrave, sovereignty, supra note 9, at 1353–54. 78 id. at 1355. 79 but see infanti, supra note 23, at 214 (noting that although peggy musgrave often revisited her articulation of inter-nation equity in later work, she never returned to its differential aspect in a similarly sustained way). 80 this seems to be the position taken, for example, by avi-yonah, supra note 4, at 1648–49. 81 cosmopolitanism and other views on the global justice debate will be further discussed in part iii.b. 82 see laura valentini, justice in a globalized world: a normative framework 3–4 (2011). peggy musgrave’s adoption of a moderate view on global justice is also indicated by the fact that her scholarship is significantly informed by the concept of inter-individual equity (within a state) as a normative requirement that is separate from inter-nation equity. 70 columbia journal of tax law [vol. 12:58 position in their 1972 essay at a time when discussions about global justice were still incipient is but one facet of the ingenuity of their scholarship. b. normative compromise one of the questions regarding what constitutes global justice asks whether principles of distributive justice should be constrained to the domestic realm or whether they should extend to the international domain as well. on one end of the spectrum of answers to this question stands global cosmopolitanism, which argues that normative requirements of distributive justice should apply at the global level.83 global cosmopolitan theories are rich and nuanced, and they increasingly vary in content, scope, and justification.84 but all cosmopolitan theorists share the belief that human beings—and not families, cultures, or nations—are the ultimate units of moral concern and thereby should be treated equally regardless of nationality or citizenship.85 on the other end stands statism, which typically claims that no duty of egalitarian distributive justice exists outside of the state.86 statists usually accept that we have universal duties to provide humanitarian assistance to those in desperate need, but these duties are limited and not grounded on principles of distributive justice.87 between these two normative accounts of global justice, several recent theories have positioned themselves somewhere in the middle of the spectrum. some have called this a “third wave” of the debate on global justice.88 this middle course position generally rejects theories that accept no principles of justice at the global level as well as theories 83 early works embracing global cosmopolitanism are charles beitz, political theory and international relations (1973) and thomas w pogge, realizing rawls (1989). for more recent theories of global cosmopolitanism, see darrel moellendorf, cosmopolitan justice (2002); kok-chor tan, justice without borders: cosmopolitanism, nationalism and patriotism (2004); simon caney, justice beyond borders: a global political theory (2005). 84 one fundamental distinction is offered by andrea sangiovanni. see andrea sangiovanni, global justice, reciprocity, and the state, 35 phil. & pub. aff. 3 (2007). he divides cosmopolitan theories into relational and non-relation conceptions of distributive justice. in non-relational cosmopolitanism, duties of justice should extend beyond national borders because they rest on a conception of person rather than of the existence of particular types of social relations or institutions. conversely, relational cosmopolitanism conditions the extension of principles of distributive justice to the international realm to the existence of shared political, social or cultural shared values or institutions. relational cosmopolitanism theorists typically argue that there exists a global basic structure which requires that liberties, opportunities and wealth be equally distributed across the world. 85 kok-chor tan, the demands of global justice, 3-4 oeconomia 665 (2013). see also sangiovanni, supra note 84, at 3. 86 one important representative of this view is thomas nagel, the problem of global justice, 33 phil. & pub. aff. 113 (2005). frequently deemed representatives of a moderate statist view include michael blake, distributive justice, state coercion, and autonomy, 30 phil. & pub. aff. 257 (2001); samuel freeman, the law of peoples, social cooperation, human rights, and distributive justice, 23 soc. phil. & pol’y 29 (2006). for a discussion about the statist view applied to international tax policy, see laurens van apeldoorn, a sceptic’s guide to justice in international tax policy, 32 can. j.l. & juris. 499 (2019). 87 this normative concession was taken by many critics as inadequate to addressing global economic injustice. see, e.g., thomas pogge, ‘assisting’ the global poor, in the ethics of assistance: morality and the distant needy 260 (deen k chatterjee ed., 2004). pogge differentiates duties of assistance from duties of distributive justice mainly because the former has an absolute target whereas the latter has a relative target that constrains international inequalities. id. at 261. 88 in laura valentini’s reading, this “third wave” provides “a sustained critical discussion of cosmopolitanism and statism, and a fresh perspective helping us to steer a middle course between them.” valentini, supra note 82, at 3. according to valentini, two representatives of this position are gillian brock, global justice: a cosmopolitan account (2009) and david miller, national responsibility and global justice (2007). yet, as she notes, these authors explicitly place themselves in the cosmopolitan and statist traditions, respectively. 2020] inter-nation equity revisited 71 that claim that the same principles apply both domestically and globally. intermediary positions on global justice generally agree with cosmopolitans that duties of justice exist in the realm of global distribution, while agreeing with statists that the state has a special place in accounts of justice, so that duties of justice applied internationally differ in content and scope to those applied domestically.89 this middle course position is sometimes referred to as “internationalism.” the term is fitting, as it conveys the idea that the scope of principles of distributive justice extends not only outside but also between (“inter”) states.90 because there is currently no substitute for the state as a political mechanism for realizing people’s democratic preferences, global distributive justice is to be achieved through states rather than beyond them. a normative compromise that includes both an entitlement component (that recognizes state sovereignty) and a differential one (that allows for the demands of global distributive justice) should require that international regimes and institutions allocate both political and economic rights to jurisdictions in a way that do not worsen global inequality and, to some degree, promote global justice. how and to what extent the differential component applies will be further explored in part iv. c. the concept of differentiation the dual conception of inter-nation equity introduced in part iii.a prominently aligns with the internationalist stance of global justice advanced in part iii.b. it demands the integration of two apparently opposing normative requirements: that states are entitled to the wealth generated in their territories or arising from the resources they control and that the distribution of rights over that wealth should allow for a differential regime that favors less affluent economies.91 although the differential approach is still quite unorthodox in the international tax law context, it has been applied to some degree to foster substantive equality among states with varying levels of capacity in areas of international labor law,92 law of the sea,93 international trade law,94 international climate law,95 and international patent law.96 one of the fundamental tenets of international law is the principle of sovereign equality, which conveys the notion of equal rights and strict reciprocity between states.97 sovereign equality is limited to recognizing states’ sovereignty and implies formal equality 89 see, e.g., jon mandle, global justice (2006); sebatiano maffettone, global justice: between leviathan and cosmopolis, 3 global pol’y 443 (2012); mathias risse, on global justice (2012). 90 risse, supra note 89, at 10. 91 laurens van apeldoorn, although adopting different normative assumptions and a different scope, has recently made a similar case for restricting the entitlement approach to promote some degree of international redistribution. see laurens van apeldoorn, international tax co-operation in an unjust world: do states have an entitlement to tax income arising in their territory?, 4 brit. tax rev. 557, 558 (2019) (“[r]elatively affluent states have an exclusive (or primary) entitlement to tax income arising in their territory only in the absence of subsistence rights deficits abroad (in so far as such deficits can be prevented by curtailing that entitlement).”). 92 constitution of the international labour organization (ilo) art. 19(3). 93 united nations convention on the law of the sea art. 61-62, dec. 10, 1982, 1833 u.n.t.s. 397. 94 general agreement on tariffs and trade art. xviii, oct. 30, 1947, 61 stat. pt. 5, 55 u.n.t.s 194 95 united nations framework convention on climate change art 3, may 9 1992 s. treaty doc no. 102-38, 1771 u.n.t.s. 107 [hereinafter unfcc]. 96 agreement on trade-related aspects of intellectual property rights art. 65(2), 65(4), 66(2), and 67, jan. 1, 1995, 1869 u.n.t.s. 299. 97 brad r. roth, sovereign equality and moral disagreement 55 (2011). sovereign equality is codified in u.n. charter art. 2(1): “the organization is based on the principle of the sovereign equality of all its members.” 72 columbia journal of tax law [vol. 12:58 between states, despite economic, political, and military inequalities. 98 differential treatment is a deviation from the principle of sovereign equality.99 it typically consists of non-reciprocal arrangements aimed at promoting substantive equality between countries.100 the rationale for differentiation in international law lies in the recognition that formally equal treatment can secure equality only among parties at an identical or similar level of economic and political power, and that differentiated treatment is necessary to correct inequalities among parties without similar economic or political attributes. 101 differentiation is also seen as a way to foster international cooperation and facilitate the effective implementation of international norms.102 one prominent example of differential treatment is the principle of common but differentiated responsibilities and respective capabilities, formalized in the united nations framework convention on climate change. 103 this principle distinguishes between countries according to their level of responsibility for greenhouse gas emissions and their varying capacities to act in response. it not only guides differentiated obligations under the un’s climate change convention, but also has specific applications in particular areas of activity, such as adaptation, technology transfer, finance and capacity building, and allows for other tailored interpretations by negotiating groups.104 the principle of common but differentiated responsibilities and respective capabilities allocates greater environmental burdens and costs to affluent countries than to poor ones. the rationale derives from both distributive justice and a form of restorative justice. the former holds that distribution of burdens should be made according to countries’ ability to pay to avoid delaying poverty eradication in less developed 98 lora anne viola, duncan snidal & michael zürn, sovereign (in)equality in the evolution of the international system, in the oxford handbook of transformations of the state 221, 223–24 (stephan leibfried et al. eds., 2015) (“traditional theorizing on international relations takes state relations to be characterized by resource inequality on the one hand, and sovereign equality on the other hand. . . . as a principle of the international system, sovereign equality emphasizes the equality of states in spite of obvious resource inequalities.”). 99 philippe cullet, differential treatment in international law: towards a new paradigm of interstate relations, 10 e.j.i.l. 549, 551 (1999). 100 differential treatment recognizes the limits of a system based on the fiction of legal equality between states that imposes reciprocity of commitments by all state parties to any treaty. see daniel barstow magraw, legal treatment of developing countries: differential, contextual, and absolute norms, 1 colo. j. int’l envtl. l. & pol’y 69 (1990). for a discussion about rules that are nominally reciprocal but substantively asymmetrical in international taxation, see steven a. dean, more cooperation, less uniformity: tax deharmonization and the future of the international tax regime, 84 tul. l. rev. 125 (2009). 101 see oscar schachter, the evolving law of international development, 15 colum. j. transnat’l l. 1 (1976) (grounding differential treatment on a consideration of need as basis for entitlement); cullet, supra note 99, at 550; frank j. garcia, trade, inequality, and justice: toward a liberal theory of just trade (2003) (taking differentiation as a mechanism to achieve wealth redistribution in the face of substantial inequalities); eduardo tempone, special and differential treatment, max planck encyclopedia of public international law (dec. 10, 2020), https://opil.ouplaw.com/view/10.1093/law:epil/9780199231690/law9780199231690-e2159?rskey=ra4rso&result=2&prd=mpil [https://perma.cc/k63s-87g3]. 102 cullet, supra note 99; tempone, supra note 101. 103 unfcc, supra note 95, art. 3(1). 104 sébastien jodoin & sarah mason-case, what difference does cbdr make? a socio-legal analysis of the role of differentiation in the transnational legal process for redd+, 5 transnat’l environ. l. 255, 257 (2016). 2020] inter-nation equity revisited 73 countries.105 the latter holds that the distribution of burdens should consider countries’ historical contribution to climate change as a measure of their responsibility.106 when it comes to the international tax system, similar normative grounds call for differentiation.107 from a historical point of view, some of the fundamental problems of the international tax regime affecting the current distribution of taxing rights such as tax competition and tax avoidance significantly result from how the present rules were designed in the 1920s, when the league of nations commissioned a group of experts to evaluate how to avoid the problem of double taxation in cross-border transactions.108 the decisions made then by today’s most powerful economies resulted in the current web of inconsistent rules that are increasingly exploited by multinationals to avoid taxes.109 lowincome economies have often times been encouraged by wealthier countries and by international organizations such as the imf or the world bank to pursue policies that include low taxation of capital.110 moreover, policy choices made by developed countries in the last few decades have intensified tax competition. the adoption of specific domestic policies of developed countries has created international conditions that favored tax competition over cooperation, constraining policy alternatives of less developed countries, as multinationals put pressure on them to reduce their taxes.111 105 darrel moellendorf, the moral challenge of dangerous climate. change: values, poverty, and policy 173–77 (2014). 106 henry shue, global environment and international inequality, 75 int’l aff. 531 (1999); simon caney, climate change and the duties of the advantaged, 13 crit. rev. int’l soc. & pol. phil. 203 (2010). 107 for an exploration of how a similar principle could apply to reform proposals aimed at addressing tax competition, see ivan ozai, tax competition and the ethics of burden sharing, 42 fordham int’l l.j. 61 (2018). 108 see allison christians, beps and the power to tax, in tax sovereignty in the beps era § 1 (sérgio andré rocha & allison christians eds., 2016). 109 policymakers at the time did foresee that this tax regime would allow taxpayers to more easily engage in tax avoidance and evasion, but they were more concerned that an alternative solution would harm efforts to liberalize trade and investment, the primary objective at the time. see thomas rixen, from double tax avoidance to tax competition: explaining the institutional trajectory of international tax governance, 18 rev. int’l pol. econ. 197, 212 (2011). 110 philipp genschel & laura seelkopf, winners and losers of tax competition, in global tax governance: what is wrong with it and how to fix it 55, 69 (peter dietsch & thomas rixen eds., 2016) (pointing out that international organizations such as the united nations conference on trade and development (unctad) often encourage small, resource-poor countries to embrace tax-haven strategies as a means for accelerating development). an important point to make is that the current tax regimes of many tax havens is not the expression of their political will as they are “often holdovers from the colonial era.” steven a. dean, philosopher kings and international tax: a new approach to tax havens, tax flight, and international tax cooperation, 58 hastings l.j. 911, 936 (2007). 111 see allison christians, global trends and constraints on tax policy in the least developed countries, 42 u.b.c. l. rev. 239, 265–66 (2010) (pointing to the united states’ international tax rules as an example of policies that increase the sensitivity of taxpayers to foreign tax rates); karen b. brown, introduction, in taxation and development: a comparative study xv, xv (karen b. brown ed., 2017) (“[p]olicies instituted by the leaders of the more industrialized, higher-income nations in their quest to produce and prosper helped to create the environmental degradation plaguing everyone, particularly nations which are geographically and economically vulnerable.”). see also peter dietsch, catching capital: the ethics of tax competition 44-46 (2015). some have noted that given the need for tax revenues, developing countries would generally prefer not to engage in tax competition, but they are compelled to grant tax incentives in response to the existing competitive scene. see, e.g., reuven avi-yonah, globalization and tax competition: implications for developing countries, 44 l. quadrangle notes 60, 63 (2001). 74 columbia journal of tax law [vol. 12:58 from a broader perspective, economic globalization is at least a partial factor that contributes to global poverty.112 this causal relationship implies that some degree of correction is warranted to reduce or eliminate inequalities stemming from global factors.113 while globalization of markets has allowed rapid growth for some economies, it has left many others lagging behind in living standards.114 from a distributive justice standpoint, the international tax regime increasingly constitutes a strong and largely non-voluntary economic association between countries. this raises special associative duties—duties owed to parties with whom one stands in a robust relationship or interaction115—one of which is the duty of international institutions not to become sources of privileges to wealthier, more powerful participants.116 more broadly, the current level of economic integration of nations has made the global economy a substantial presence in the lives of all states, and economic regulation and policy decisions today take place in a global setting that is inescapably interdependent. the fact that rules made by a state (or by supranational rule-making bodies) are consequential to other states raises the need for some degree of coordination and equity beyond the national level.117 iv. allocating rights according to inter-nation equity a. reconciling entitlement and differentiation part iii introduced the dual conception of inter-nation equity by showing that, from a normative perspective, it builds on an internationalist view of global justice and, from a legal perspective, it can operate through the mechanism of interjurisdictional differentiation. once the dual conception of inter-nation equity is established as a normative guide for allocating taxing rights, the question that follows is how to reconcile inter-nation equity’s two normative components. when should the allocation of taxing rights be guided by an entitlement approach, thus preserving allocation on the basis of sovereignty and economic allegiance, and when should it give way to a differential approach, thereby tackling global inequality)? 112 this view is sometimes called “explanatory pluralism” and rejects that global poverty can be wholly explained as either a product of domestic factors (explanatory nationalism) or a result of global factors (explanatory globalism). see chris armstrong, defending the duty of assistance?, 35 soc. theory & prac. 461, 468–69 (2009). 113 building on luck egalitarianism, cappelen argues for what he calls a principle of equalization at the international level, according to which the opportunities different countries have to pursue their goals be equalized, so that differences stemming from global factors be eliminated. see alexander cappelen, responsibility and international distributive justice, in real world justice: grounds, principles, human rights, and social institutions 215 (andreas follesdal & thomas pogge eds., 2005). see also mandle, supra note 87, at 102 (arguing that this duty of justice is stronger among wealthy states and those that played a historical role in making the social order unjust such as through colonialism). 114 ilan benshalom, how to redistribute: a critical examination of mechanisms to promote global wealth redistribution, 64 u. toronto l.j. 317, 322 (2014). see generally joseph e. stiglitz, making globalization work 100 (2006). 115 these duties are sometimes called relational duties. see andrea sangiovanni, on the relation between moral and distributive equality, in cosmopolitanism versus non-cosmopolitanism: critiques, defenses, reconceptualizations 55 (gillian brock ed., 2013). 116 darrel moellendorf, cosmopolitanism and compatriot duties, 94 monist 535 (2011). see also darrel moellendorf, human dignity, associative duties, and egalitarian global justice, in cosmopolitanism versus non-cosmopolitanism: critiques, defenses, reconceptualizations 222 (gillian brock ed., 2013). 117 joshua cohen & charles sabel, extra rempublicam nulla justitia?, 34 phil. & pub. aff. 147, 165 (2006). 2020] inter-nation equity revisited 75 a solution to reconcile entitlement and differentiation might arise from the limitations of an entitlement approach as a sole normative guide to the allocation of taxing rights. a largely uncontested feature of the current tax rules for determining entitlement to tax is its significant arbitrariness. the concept of residence, for instance, particularly when applied to corporations, is significantly problematic.118 in contrast to an individual’s residence, which is in part determined by the physical presence of that individual in a country, the place of a corporation’s residence is subject to a high degree of legal discretion and is significantly inconsistent throughout different tax systems. 119 despite being a foundational legal construct in international taxation, 120 the concept of corporate tax residence is commonly regarded as “outdated and unstable,”121 incoherent,122 completely artificial,123 a “crude, if not naive, criterion,”124 lacking economic substance,125 and not very meaningful.126 some have gone farther and called for the abandonment of the concept altogether.127 as a result of this arbitrariness, multinational enterprises are able to easily adopt foreign statehood while governments cannot do much more than complain about the abuse of corporate residence for tax-avoidance purposes.128 establishing a coherent concept of source appears to be an even more challenging task. countries establish different sets of criteria to define the concept of source. 129 moreover, somewhat arbitrary thresholds, such as the permanent establishment requirement, are used to limit the taxation of non-residents at the source.130 the allocation 118 see tsilly dagan, the future of corporate residency (sep. 29, 2017) (unpublished manuscript), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3045134 [https://perma.cc/8yew-ehyx]. 119 see, e.g., brian j. arnold, a tax policy perspective on corporate residence, 51 can. tax j. 1559, 1559–60 (2003). for an extended analysis of the varying criteria employed by different jurisdictions to determine corporate residence, see robert couzin, corporate residence and international taxation (2002). assigning tax residence to individuals, however, is without problems. for a comparative overview, see reuven s. avi-yonah, nicola sartori & omri marian, global perspectives on income taxation law 152–53 (2011). 120 omri marian, jurisdiction to tax corporations, 54 b.c. l. rev. 1613 (2013). 121 see, e.g., graetz, supra note 7, at 1422. 122 see, e.g., michael j. mcintyre, determining the residence of members of a corporate group, 51 can. tax j. 1567, 1568 (2003). 123 see, e.g., edward d. kleinbard, the lessons of stateless income, 65 tax l. rev. 99, 159 (2011). 124 see, e.g., david r. tillinghast, a matter of definition: ‘foreign’ and ‘domestic’ taxpayers, 2 int’l tax & bus. l 239, 260 (1984). 125 see, e.g., michael s. kirsch, taxing citizens in a global economy, 82 n.y.u. l. rev. 443, 465– 67 (2007). 126 see, e.g., reuven s. avi-yonah, tax competition and the trend toward territoriality (university of michigan public law, working paper no. 297, 2012). 127 see, e.g., david elkins, the myth of corporate tax residence, 9 colum. j. tax l. 5 (2017). 128 geoffrey loomer, the disjunction between corporate residence and corporate taxation: is improvement possible, 63 can. tax j. 91 (2015). 129 see hugh j. ault & brian j. arnold, comparative income taxation: a structural analysis 495–526 (3rd ed. 2010); john prebble, ectopia, tax law and international taxation, 5 brit. tax rev. 383, 386 (1997); alex easson, common law approaches to the determination of the source of income: pragmatism over principle, 60 bull. int’l taxation 495 (2006). 130 the permanent establishment model imposes two constraints on taxation at source. first, source states may only tax non-resident corporations if the corporation has a permanent establishment in the country and, second, source-based taxation is limited to the income attributable to that permanent establishment. see oecd, model tax convention on income and on capital 116–69, 173–218 (2017); arthur cockfield, reforming the permanent establishment principle through a quantitative economic presence test, 38 can. bus. l.j. 400 (2003) (providing historical evolution of the concept of permanent establishment and noting its arbitrariness despite practical usefulness). for a critical view of permanent establishment from the perspective 76 columbia journal of tax law [vol. 12:58 of profits among jurisdictions also builds on concepts such as transfer pricing and arm’s length standards that require a significant degree of stipulation and are subject to varying accounting methods that lead to significantly different distributional outcomes.131 the digitalization of the economy in recent decades further compounds the problem.132 recent difficulties in aligning tax jurisdictions with the location of economic activity and recent attempts by the oecd to update rules for nexus and profit attribution for the digitalized economy also point to a significant arbitrariness in how entitlement to tax is assigned.133 all of these difficulties demonstrate that the effectiveness of existing tax concepts in asserting tax entitlement is limited. they have been historically useful in determining international tax rules, but the increasing complexity—and, more importantly, arbitrariness—involved in redefining and adapting them to the present reality reveals the limitations of entitlement approaches as normatively justified tools to determine allocation.134 these limitations make it difficult to justify an allocation of the international tax base solely on the basis of sovereignty or economic allegiance. when these entitlement approaches fail to accurately determine how rights should be normatively distributed, some other normative criterion is required to address their shortcomings.135 of developing countries, see sergio andré rocha, should developing countries include article 7 in their tax treaties?, 71 bull. int’l taxation 354 (2017). 131 see michael mazerov, why arm’s length falls short, 5 int’l tax rev. 28 (1994); reuven s. avi-yonah, the rise and fall of arm’s length: a study in the evolution of u.s. international taxation, 15 va. tax rev. 89 (1995); see also yariv brauner, between arm’s length and formulary apportionment, in the allocation of multinational business income: reassessing the formulary apportionment option §8.01 (rick krever & françois vaillancourt eds., 2020) (pointing out the complexity and costliness of arm’s length standard-based transfer pricing for developing countries). 132 see, e.g., alessandro turina, which ‘source taxation’ for the digital economy?, 46 intertax 495 (2018); yariv brauner, taxing the digital economy post-beps, seriously, 46 intertax 462 (2018). 133 see, e.g., michael p. devereux & john vella, are we heading towards a corporate tax system fit for the 21st century?, 35 fiscal stud. 449 (2014); allison christians, taxing according to value creation, 90 tax notes int’l 1379 (jun. 18, 2018); allison christians & laurens van apeldoorn, taxing income where value is created, 22 fla. tax rev. 1 (2018); j. scott wilkie, the way we were? the way we must be? the ‘arm’s length principle’ sees itself (for what it is) in the ‘digital’ mirror, 47 intertax 1087 (2019); ruth mason, the transformation of international tax, 114 am. j. int’l l. 353 (2020). for the oecd’s work on addressing the digitalization of the economy, see oecd, programme of work to develop a consensus solution to the tax challenges arising from the digitalisation of the economy: inclusive framework on beps (2019), https://www.oecd.org/tax/beps/programme-of-work-to-develop-a-consensussolution-to-the-tax-challenges-arising-from-the-digitalisation-of-the-economy.pdf [https://perma.cc/7hextm3n] [hereinafter, oecd, programme of work]; oecd, secretariat proposal for a “unified approach” under pillar one: public consultation document ( 2019), https://www.oecd.org/tax/beps/public-consultation-document-secretariat-proposal-unified-approach-pillarone.pdf [https://perma.cc/cv3g-b6rf] [hereinafter, oecd, secretariat proposal]; oecd, statement by the oecd/g20 inclusive framework on beps on the two pillar approach to address the tax challenges arising from the digitalisation of the economy (2020), https://www.oecd.org/tax/beps/statement-by-the-oecd-g20-inclusive-framework-on-beps.htm [https://perma.cc/a2vf-jls9]. 134 for analyses pointing to the problematic normative underpinnings of entitlement approaches for assigning tax jurisdiction, see hugh j. ault & david p. bradford, taxing international income: an analysis of the us system and its economic premises, in taxation in the global economy 11, 30 (assaf razin & joel slemrod, eds., 1990) (arguing that “[t]he idea that income has a locatable source seems to be taken for granted, but the source of income is not a well-defined economic idea”); wei cui, minimalism about residence and source, 38 mich. j. int’l l. 245 (2017) (pointing to the insufficiency of the concepts of source and residence and arguing they require additional considerations such as tax enforceability and normative objectives). 135 see stewart, supra note 32, at 307–09 (noting that the increasing reconfiguration of the concepts of source and residence should lead to a differential approach to international taxation). 2020] inter-nation equity revisited 77 taking the insufficiency of entitlement approaches as an uncontested feature of the current international tax system, a dual conception of inter-nation equity entails what might be called the differential principle,136 according to which: 1. states are entitled to tax income generated in their territories or arising from the resources they control—the entitlement component; and 2. whenever allocation according entitlement cannot be asserted unambiguously, taxing rights should be assigned on the basis of differentiation so as to promote international distributive justice—the differential component. whenever an entitlement approach is unable to accurately determine where income should be allocated or how much of it should be allocated to different jurisdictions, a decision about allocation requires additional moral judgment to be regarded as normatively legitimate. in the absence of clear moral criteria, such a decision will be made by either some form of dispute resolution or political negotiation. if the former is adopted, a purportedly technical solution will eventually conceal a political or moral judgment,137 since a straightforward answer based on entitlement is, in this case, unavailable. if the latter is adopted, the final decision will inevitably be made on the basis of influence and power, and the resulting allocation of rights will ultimately favor more powerful countries, compounding the problem of global inequality. 138 both alternatives are problematic because they lack a sound normative basis. in the absence of a justifiable normative criterion for allocating taxing rights, priority should be given to a solution that promotes, rather than departs from, distributive justice. a controversial aspect of the differential principle might be determining the meaning of “unambiguously” (in proposition 2) since the term establishes the threshold from which the differential component departs. this determination requires settling the degree of failure of the entitlement approach with which we can come to terms. on one end of the spectrum, one could tolerate an absolute degree of failure and take the existing proxies for entitlement as acceptable from a normative standpoint. this is the view implicitly adopted, for example, by those who consider that the current allocation of taxing rights is normatively justified. the main problem with taking this stance is that the more complex it is to determine the underlying factors that contribute to the generation of income, the more inaccurate entitlement approaches are in establishing proxies. it follows that these proxies become increasingly arbitrary. on the opposite end, one could be as strict as to 136 despite the lexical similarity, the differential principle proposed in this article should not be confused with rawls’s difference principle, which is significantly distinct in scope and content. 137 for a discussion of the relevance of political and moral biases in legal interpretation, see, for example, gillian k. hadfield, bias in the evolution of legal rules, 80 geo. l.j. 583 (1992); eric a. posner, does political bias in the judiciary matter?: implications of judicial bias studies for legal and constitutional reform, 75 u. chi. l. rev. 853 (2008); jill anderson, misreading like a lawyer: cognitive bias in statutory interpretation, 127 harv. l. rev. 1521 (2014). 138 for a discussion about how influence and power affect matters of distributive justice in international tax policy, see ivan ozai, two accounts of international tax justice, 33 can. j.l. & jur. 317 (2020). hugh ault identifies two distinct strands of tax competition. besides the more commonly observed competition for investment, the recent disagreements about how to allocate taxing rights to deal with the challenges posed by the digitalization of the economy has unveiled the concurrent competition for revenues, which despite being largely unnoted, goes back to the work of the league of nations in the 1920s. see hugh j. ault, tax competition and tax cooperation: a survey and reassessment, in international taxation in a changing landscape: liber amicorum in honour of bertil wiman 1 (jérôme monsenego & jan bjuvberg eds., 2019). 78 columbia journal of tax law [vol. 12:58 conclude that any entitlement approach will be arbitrary to some degree and that therefore any entitlement approach must be replaced by some other normatively justified approach. 139 the main problem with this stance is that it fails to acknowledge the normative validity of origin-based theories and the importance of state sovereignty in today’s state of affairs. if one is to stand, however, somewhere in the middle of these two extremes, it is difficult to draw a bright-line test for when to shift from an origin-based to a differential approach. a pragmatic solution is to begin by applying the differential approach in cases where the failure of origin-based criteria is most evident. part iv.c will consider a few cases where entitlement approaches are ineffective to a sufficient degree and should therefore trigger a differential approach. this section offered a solution for reconciling the entitlement and the differential components of inter-nation equity by addressing the question of when a differential approach should apply to the allocation of taxing rights. the remaining question is how a differential approach should operate, which is the focus of the following section. b. requirements for differentiation differentiation has been used in different areas of international law. yet, both the literature and the real-world applications of differential treatment do not provide straightforward normative requirements that could apply to interjurisdictional differentiation to ensure that it promotes international distributive justice. nonetheless, based on the normative objectives and underpinnings of differentiation, this section will put forward three core requirements of a legitimate use of this mechanism in international tax policy design. universality. the first requirement is a version of horizontal equity, but applied to the international domain.140 since the primary goal of differentiation is to promote international equity, a differential regime that includes some but excludes other states that are equally in need of resources is normatively problematic. one example is a policy that aims at improving the position of low-income countries by using a differentiating factor that favors some of them but excludes others that do not qualify according to that factor. as part iv.b will discuss, some recent proposals to reform the international tax regime draw on economic impact assessments to argue that a given policy is likely to favor low-income countries which have a specific attribute (such as being rich in natural resources or in labor supply). the main problem with this approach is that it fails to include other countries that are equally poor but do not possess the attribute chosen for differentiation. it might improve vertical equity (by reducing overall inequality between more and less affluent countries), but such improvement comes at the detriment of horizontal equity (by creating further inequalities between equally low-income countries). 139 this case is made, for example, in adam kern, illusions of justice in international taxation, 48 phil. & pub. aff. 151 (2020). 140 the terms horizontal and vertical equity appear frequently in the economics literature to refer to the moral requirement of treating equals equally and unequals unequally, respectively. for a discussion about the relationship between these two notions, see paul r. mcdaniel & james r. repetti, horizontal and vertical equity: the musgrave/kaplow exchange, 1 fla. tax rev. 607 (1993). these concepts, used as measures of equity between individuals in a domestic context, are rarely used to describe equity between nations. even when used to describe equity between nations, commentators employ the terminology without much elaboration on the concept. see, e.g., yoram margalioth, tax competition, foreign direct investments and growth: using the tax system to promote developing countries, 23 va. tax rev. 157, 202 (2003); adam h. rosenzweig, harnessing the costs of international tax arbitrage, 26 va. tax rev. 555 (2007); reuven s. avi-yonah & yoram margolioth, taxation in developing countries: some recent support and challenges to the conventional view, 27 va. tax rev. 1 (2007). 2020] inter-nation equity revisited 79 universality also favors a multilateral approach in place of the bilateralism that is prevalent in the current international tax system. besides for the other problems with bilateral tax treaties, largely documented in the tax literature, 141 bilateralism is also problematic for leaving weaker states susceptible to power imbalances142 and resulting in a non-universal regime.143 part iv.b will show that differential approaches taken through bilateralism, such as tax sparing provisions, are problematic among other reasons for their non-universal nature. granularity. this requirement builds on the notion of vertical equity. 144 differential mechanisms should provide countries in unequal positions with distinct treatment. this requirement disapproves of differential regimes that fit low-income countries into generalizing categories such as developing countries, least developed economies, transition economies, newly industrialized countries, and small island developing states. this approach is normatively problematic not only because of the practical hurdles, such as disputes regarding which category a particular country should be placed in, particularly in borderline cases, 145 but also because it disregards relevant inequalities within the group and thereby limits the ability of the differential regime to efficiently achieve its normative goal.146 taxing rights are rivalrous goods, and so their availability for allocation to developing countries through differentiation is limited.147 a differential mechanism that allocates the same share of rights to countries with significantly different levels of development reduces the share that would be available to the ones in the 141 see, e.g., michael rigby, a critique of double tax treaties as a jurisdictional coordination mechanism, 8 austl. tax f. 303 (1991); john f. avery jones, are tax treaties necessary, 53 tax l. rev. 1 (2000); victor thuronyi, international tax cooperation and a multilateral treaty, 26 brook. j. int’l l. 1641 (2000); ricardo garcía antón, the 21st century multilateralism in international taxation: the emperor’s new clothes?, 8 world tax j. 147 (2016); vincent arel-bundock, the unintended consequences of bilateralism: treaty shopping and international tax policy, 71 int’l org. 349 (2017). 142 see ivan ozai, institutional and structural legitimacy deficits in the international tax regime, 12 world tax j. 53 (2020); tsilly dagan, the tax treaties myth, 32 n.y.u. j. int’l l. pol’y. 939 (2000); kim brooks & richard krever, the troubling role of tax treaties, in tax design issues worldwide 159 (geerten m.m. michielse & victor thuronyi eds., 2015); yariv brauner, the true nature of tax treaties, 74 bull. int’l taxation 28 (2020). 143 see musgrave & musgrave, supra note 3, at 79–80 (arguing that international tax policy should not be left to purely bilateral agreements but should be based on an internationally agreed-upon framework). a similar case made by philippe cullet regards the use of equity in international law. one pitfall of differentiation made by judicial equity, such as adopted by the international court of justice—the same as any solution limited to individual cases—is its incapacity to consider structural inequalities in the medium and long term, in contrast to structural reform that moves away from the idea of strict reciprocity. see philippe cullet, differential treatment in environmental law: addressing critiques and conceptualizing the next steps, 5 transnat’l environ. l. 305, 308 (2016). 144 this granularity requirement, however, is less demanding than vertical equity. vertical equity, as applied to the distribution of tax burdens between nationals, is frequently deemed to warrant progressivity. the granularity requirement discussed here does not go that far. for a discussion of the relationship between vertical equity and progressivity in domestic settings, see c. eugene steuerle, and equal (tax) justice for all?, in tax justice: the ongoing debate 253 (joseph j. thorndike & dennis j. ventry eds., 2002). 145 see kristin bartenstein, de stockholm à copenhague : genèse et évolution des responsabilités communes mais différenciées dans le droit international de l’environnement, 56 mcgill l.j. 177, 212 (2010). 146 see patrícia galvão ferreira, differentiation in international environmental law: has pragmatism displaced considerations of justice?, in global environmental change and innovation in international law 21 (neil craik et al. eds., 2018) (noting the need to consider the growing south-south differences in interests and values in future differential policy design). 147 the discussion on the allocation of resources (in this case, taxing rights) presupposes scarcity. for a historical analysis of the role of the concept of scarcity in political economy, see raphael sassower, scarcity and setting the boundaries of political economy, 4 soc. epistemology 75 (1990). 80 columbia journal of tax law [vol. 12:58 lowest position had a more granular approach (where each country is differentiated individually rather than as part of a group) been applied.148 a less practical but normatively superior approach would be to differentiate each country individually rather than as part of a group. consistency. the third normative requirement is in part a logical corollary of the previous one. since differentiation aims to address a certain type of inequality, whether economic, political, geographical, any mechanism used for differentiation should conform to (1) its targeted inequality and (2) its regulatory context. regarding (1), if differentiation is used to reduce economic inequality between countries, a mechanism that differentiates countries based on a factor that is disproportionate to their actual levels of economic development is problematic. part iv.c will show that a few reform proposals purportedly aimed at improving taxing rights allocation to low-income countries fail to meet this normative requirement. regarding (2), if the context in which the differential norm is designed has specific normative goals, the differentiating factor should take those goals into consideration. one prominent example comes from climate change. besides economic considerations, differential treatment in climate law might additionally require social and environmental considerations to identify the vulnerability of states and their resilience to environmental problems.149 c. practical implications differentiation seems to have been implicitly embraced in the international tax system to some degree. despite the absence of clear normative underpinnings for its application in tax policy, some mechanisms adopted in international tax law clearly take a differential approach by specifically targeting the improvement of the position of less affluent countries. this section will submit that, despite their laudable intent, some of these initiatives are normatively problematic because they fail to meet the basic normative requirements for differentiation. 1. tax sparing agreements although in disuse in today’s treaty negotiations, tax sparing provides one of the most visible forms of differentiation in international taxation, notably when applied to an asymmetrical agreement between developed and developing countries. 150 developing countries often offer tax incentives as a way to attract foreign investors. such incentives involve either reduced tax rates or exemptions. however, the main goal of these incentives is defeated whenever the developed country where the investor resides taxes the low-taxed or untaxed income earned by its resident. through a tax sparing agreement, a developed country commits to “spare” the tax that it would otherwise impose, thus preserving the economic benefits of tax incentives provided by the developing country to foreign investors. some have voiced a firm defense of tax sparing mechanisms from a normative point of view, praising it as a meaningful and necessary mechanism for international redistribution.151 however, the adoption of tax sparing provisions has largely decreased since 1999, in part as result of a negative view of the mechanism by the oecd in its 1998 148 yet, the differential regimes in place today rarely fulfill this requirement. see cullet, supra note 143, at 317–19 (noting that most of the existing differential treatment provisions in international law are still based on classification systems that essentially divide the world in north and south). 149 id.; see also ferreira, supra note 146. 150 tax sparing has also been used as a reciprocal mechanism between countries with similar trade and investment volumes or close political connections. see na li, the tax sparing mechanism and foreign direct investment 44–46 (2019). 151 see, e.g., li, supra note 23, at 128-29. 2020] inter-nation equity revisited 81 tax sparing report.152 other explanations for its decline are a widespread recognition that tax sparing provisions allow for abuses by multinational corporations through tax avoidance strategies, 153 the lack of evidence that tax sparing increases foreign investment,154 and the fact that tax sparing clauses often require low-income countries to make relevant concessions in exchange.155 the normative framework put forth in part iv.b for differentiation suggests that tax sparing is problematic as a differential mechanism. because only developing countries that are able to secure a tax sparing agreement benefit from the mechanism, tax sparing does not meet the universality requirement for differentiation. non-universality results in part from the bilateral context from which it arises. at the same time, it is an underlying condition for tax sparing to work, since a comprehensive application of the mechanism would in great part defeat its effectiveness.156 tax sparing also fails to meet the consistency requirement. since negotiation of tax treaty clauses significantly depends on political negotiation and other contextual factors, the global redistribution effected by tax sparing is strikingly arbitrary from a normative point of view. 157 additionally, tax sparing agreements encourage a competitive environment that generally leads to the erosion of tax bases and might make low-income countries that do not have similar agreements even worse-off as a result. again, this points to the need for universality in differential mechanisms.158 2. unitary taxation with formulary apportionment one proposal prominently advanced in tax policy circles to tackle the differential component of inter-nation equity is to shift how profits earned by multinational corporations are allocated among jurisdictions. many scholars have called for a departure from separate accounting under the arm’s length principle toward a unitary taxation system with formulary apportionment. a unitary taxation system would apportion multinationals’ 152 oecd, tax sparing: a reconsideration (1998). 153 deborah toaze, tax sparing: good intentions, unintended results, 49 can. tax j. 879 (2001). 154 see, e.g., allison christians, tax treaties for investment and aid to sub-saharan africa: a case study, 71 brook. l. rev. 639, 693–94 (2005); william b. barker, an international tax system for emerging economies, tax sparing, and development: it is all about source, 29 u. pa. j. int’l l. 349, 388 (2007) (describing one reason as being due to the fact that tax sparing decreases investment in low-income countries by encouraging repatriation); kim brooks, tax sparing: a needed incentive for foreign investment in lowincome countries or an unnecessary revenue sacrifice, 34 queen’s l.j. 505, 555–56 (2009); but see james r. hines jr, tax sparing and direct investment, in developing countries international taxation and multinational activity 39 (james r. hines jr. ed., 2000) (demonstrating some positive correlation between tax sparing and foreign direct investment increase); céline azémar, rodolphe desbordes & jean-louis mucchielli, do tax sparing agreements contribute to the attraction of fdi in developing countries?, 14 int’l tax & pub. fin. 543 (2006). 155 developing countries might have to accept, for example, lower withholding tax rates or stricter permanent establishment rules in exchange for tax sparing. see richard d. kuhn, united states tax policy with respect to less developed countries, 32 geo. wash. l. rev. 261, 263–64 (1963) (pointing out that tax sparing is negotiated in a quid pro quo context); hope ashiabor, tax sparing: a timeworn mechanism in australia's bilateral treaties with its trading partners in southeast asia, 24 int’l tax j. 67, 75 (1998). 156 because tax sparing aims to favor a given country in its efforts to attract foreign investment through tax holidays, it presupposes that other competing countries do not have a similar advantage. the effectiveness of tax sparing provisions relies in great part precisely on the fact that it is exclusive. 157 see brooks, supra note 154, at 557 (“granting one low-income country a tax sparing arrangement will undoubtedly encourage other such countries to seek similar arrangements with their treaty partners, thereby reducing the advantage any one country has. this inevitably discriminates against low-income countries that have neither the political nor the economic clout to press for tax treaties in the first place, even though they are likely the ones that most need to encourage investment in some fashion.”). 158 see christians, supra note 154, at 694. 82 columbia journal of tax law [vol. 12:58 profits based, partially or entirely, on a multi-factor formula that considers the location of economic factors such as assets, sales, and employees or payroll. the shift toward unitary taxation would eliminate the complexity of transfer pricing rules and associated administrative and compliance costs that currently take a toll on lower-income countries.159 one important and challenging aspect of adopting unitary taxation is settling on the formula according to which profits would be allocated among jurisdictions. since the rights of countries to tax are determined based on how income is allocated, formulary apportionment would significantly change the current distribution of taxing rights. proposals for formulary apportionment mostly suggest a formula based on a combination of economic factors, such as the location of sales, payroll expenses, and physical assets. different proposals assign varying weights to each of these economic factors. 160 considering the relative arbitrariness according to which such a formula is to be eventually decided (that is, considering the insufficiency of an entitlement approach as normative guidance), 161 the differential principle stated in part iii.a implies that a differential approach should take priority in determining allocation.162 the relevance of a differential approach in formulary apportionment seems to have been recognized in tax policy circles. in a policy paper released in 2014, the international monetary fund (imf) aimed to assess “spillover effects on developing countries of major tax reforms proposed.”163 one of the major concerns presented in the paper is how 159 michael c. durst, the tax policy outlook for developing countries: reflections on international formulary apportionment (international centre for tax and development, working paper no. 32, 2015). 160 for a brief analysis of the distributive outcome of different formulas, see heinz-klaus kroppen, roman dawid & richard schmidtke, profit split, the future of transfer pricing? arm’s length principle and formulary apportionment revisited from a theoretical and a practical perspective, in fundamentals of international transfer pricing in law and economics 267, 273–76 (wolfgang schön & kai a konrad eds., 2012). 161 see edgar, supra note 4, at 1154 (“[f]ormulary allocation approaches cannot be justified as realizing some correct allocation defined in any precise normative sense.”); reuven s. avi-yonah, kimberly a. clausing & michael c. durst, allocating business profits for tax purposes: a proposal to adopt a formulary profit split, 9 fla. tax rev. 497, 516–17 (2009) (acknowledging that any formula can produce arbitrary results in a given industry but arguing that the present separate accounting system is equally or more arbitrary); james r. hines jr, income misattribution under formula apportionment, 54 eur. econ. rev. 108 (2010) (showing that formulas included in proposals for formulary apportionment are not strongly correlated with determinants of business incomes). the normative arbitrariness is also clear when noted that in countries where a formulary apportionment was adopted to allocate tax base among states, the choice of formula significantly relies on pragmatism rather than on an entitlement approach. in the u.s., states gradually shifted to sales as the main allocating factor, not because of its normative appeal, but because it is less vulnerable to corporations’ arbitrage. see michael mazerov, center on budget and policy priorities, the singlesales-factor formula: a boon to economic development or a costly giveawav? (2001) (noting the weak economic rationale behind the shift toward a single-sales-factor formula); jack mintz, europe slowly lurches to a common consolidated corporate tax base: issues at stake, in a common consolidated corporate tax base for europe 128 (wolfgang schön, ulrich schreiber & christoph spengel eds., 2008). for some legal implications of a sales-based formula at the international level, see charles e. mclure jr. & walter hellerstein, does sales-only apportionment of corporate income violate international trade rules?, 27 tax notes int’l 1315 (sep. 9, 2002). 162 for a similar observation, see tommaso faccio & valpy fitzgerald, sharing the corporate tax base: equitable taxing of multinationals and the choice of formulary apportionment, 25 transnat’l corp. 67, 85 (2018) (pointing out that the existing formula proposals lack a clear economic rationale and pay insufficient attention to the equitable treatment of developing countries). 163 international monetary fund, spillover in international corporate taxation 24 (2014), https://www.imf.org/external/np/pp/eng/2014/050914.pdf [https://perma.cc/ch6f-8qb4]. for a 2020] inter-nation equity revisited 83 different formulas would significantly impact the distribution of tax base to developing countries. based on an economic impact assessment of how different formulas would impact different groups of countries (divided into advanced, developing, and conduit countries), the paper emphasizes criteria that would favor poorer economies, namely a formula that places heavy weight on employment factors (based on headcount, not wages).164 the initiative deserves praise for taking the interests of developing countries into consideration. however, there are some problems with this approach. the first is methodological, since it relies on data with only limited availability.165 the second is that, in the absence of a clear economic rationale behind any choice of formula, the distributive consequences of the final decision on the weight of each economic factor in the formula will be concealed under a purportedly technical discussion.166 third, and most importantly from an inter-nation equity perspective, choosing a formula based on the economic impacts on groups of countries violates the normative requirements for differentiation put forth in part iii.b. by analyzing the economic impacts of formulas on three generalized groups of countries (advanced, developing, and conduit countries), the imf study disregards the fact that the level of development varies within each of these groups. although some lowincome countries would potentially benefit from a formula based on employment, others might not. a final allocation of multinationals’ profits largely based on employment might reduce overall global inequality but would potentially leave many low-income countries unattended, thereby failing to meet the granularity requirement. additionally, even countries that would benefit from such an approach would likely not benefit in proportion to their development needs because development needs and employment by multinational corporations are not directly correlated. therefore, such an allocation fails to meet the consistency requirement. the problem, of course, is not with the imf’s study but rather the idea that the allocation of profits based on one or a set of production factors would offer a fair division of taxing rights. taking again into consideration the reasonable degree of arbitrariness that a choice of formula involves—in which case the differential principle requires the application of a differential approach—some economic or human development indicator is called for as a contributory factor to the apportionment formula. including a direct measure of international inequality in the formula is perhaps the only possible way to achieve a universal, granular, and consistent approach.167 it would not only be more suitable to similar conclusion, see faccio & fitzgerald, supra note 162, at 72–73 (noting that developing countries gain from employment factors but lose from payroll factors because wages are much higher in developed countries). 164 international monetary fund, supra note 163, at 39–40. 165 id., at 40 (stating that data limitations prevent precise calculations); sol picciotto, unitary alternatives and formulary appointment, in taxing multinational enterprises as unitary firms 27, 3637 (sol picciotto ed., 2017) (emphasizing the lack of data, especially relating to developing countries, for this type of quantification). 166 for example, it has been noted that capital-importing countries might argue for factors based on destination sales, while capital-exporting states might argue for apportionment focused primarily on aspects relating to residence. see arthur j. cockfield, formulary taxation versus the arm’s-length principle: the battle among doubting thomases, purists, and pragmatists, 52 can. tax j. 114, 120 (2004). 167 although the most common approach would be to use per capita income as a reference, other indexes may be more appropriate to measure and compare international inequality. see infanti, supra note 23 (arguing for expanding the focus of inter-nation equity beyond economic growth to incorporate other noneconomic considerations, such as feminist, social or strategic ones, and proposing the use of other indexes that include non-economic dimensions as the criteria for a differential approach, such as the human development index (hdi), the inequality-adjusted hdi (ihdi), gender inequality index (gii), and the uk department for 84 columbia journal of tax law [vol. 12:58 accomplishing inter-nation equity, but would also bring greater transparency regarding normative rationales and distributional outcomes and be less reliant on estimations that frequently suffer from data limitations.168 3. the oecd’s “unified approach” in a project aimed to address the tax challenges arising from the digitalization of the economy, the oecd has put forward, among other measures, a proposal to allocate a portion of multinationals’ residual profits to the jurisdictions where customers and users are located, also referred to as “market jurisdictions.”169 the proposal is part of what the oecd has called the “unified approach” and comes as a response to demands from countries with substantial consumer markets to update the current allocation of profits generated by digitalized businesses. 170 the phrase “unified approach” indicates the oecd’s stated goal to achieve a compromise solution that satisfies all conflicting proposals on the table, namely the european union’s focus on user participation, the united states’ preference for considering marketing intangibles, and the group of twenty-four’s proposal for allocating income based on multinationals’ significant economic presence.171 the unified approach proposal allocates a share of multinationals’ residual profits to market jurisdictions using a formulaic approach.172 the distributional impacts of this proposal are, however, unclear. in february 2020, the oecd suggested that it would significantly favor lowand middle-income economies,173 but commentators are skeptical about that assertion.174 considering that the oecd’s proposal aims to favor countries with international development (dfid)). see also kim brooks, global distributive justice: the potential for a feminist analysis of international tax revenue allocation, 21 can. j. women & l. 267 (2009) (arguing that one of the implications of a feminist analysis of international tax policy is the requirement to allocate greater taxing rights to lower-income countries). 168 due to the absolute immobility of development indexes to corporate decisions, this approach could also potentially limit tax-avoidance opportunities resulting from formulas that rely on mobile factors. 169 oecd, programme of work, supra note 133, at 11. 170 oecd, secretariat proposal, supra note 133. 171 for a detailed discussion on the political struggles and distributive implications involving these proposals, see allison christians & tarcisio diniz magalhaes, a new global tax deal for the digital age, 67 can. tax j. 1153 (2019). 172 in addition to this formulaic approach (which the oecd calls amount a), the unified approach includes a fixed baseline return for routine market-facing activities (amount b) and incremental return attributable to a jurisdiction when amount b falls short of the market-based routine return assumed under the application of the arm’s-length principle (amount c). for an overview, see kartikeya singh, w joe murphy & gregory j ossi, the oecd’s unified approach — an analysis of the revised regime for taxing rights and income allocation, 97 tax notes int’l 549 (feb. 3, 2020). 173 see webcast: update on economic analysis and impact assessment, oecd.org/tax/beps/webcasteconomic-analysis-impact-assessment-february-2020.htm [https://perma.cc/2b4e-te7r]; oecd, tax challenges arising from the digitalisation of the economy update on the economic analysis & impact assessment, http://www.oecd.org/tax/beps/presentation-economic-analysis-impact-assessment-webcastfebruary-2020.pdf [https://perma.cc/kx97-zale]. 174 see, e.g., alex cobham, tommaso faccio & valpy fitzgerald, global inequalities in taxing rights: an early evaluation of the oecd tax reform proposals (2019), https://osf.io/preprints/socarxiv/j3p48 [https://perma.cc/9kqr-wazb] (concluding that the reallocation of taxing rights derived from oecd’s proposal is likely to reduce revenues for several low-income countries). see also allison christians, oecd digital economy designers: share your work!, 97 tax notes int’l 1251 (mar. 23, 2020) (noting that the information provided in february 2020 by the oecd was only partial—a webcast and a few slides outlining its findings—and the underlying data that led to these results was not made publicly available, raising questions about transparency and inclusivity). 2020] inter-nation equity revisited 85 larger consumer markets, low-income countries with small consumer markets will hardly benefit from this approach.175 more importantly, the same criticisms made above regarding the imf’s approach to unitary taxation apply here. considering the relative normative arbitrariness according to which the oecd’s unified approach was established, the differential principle warrants that a differential approach should take priority in determining allocation. although the oecd suggests that the new approach would significantly favor lowand middle-income economies, its argument suffers from methodological problems due to limitations in data availability, the absence of clear normative or economic rationale behind the chosen formulary approach, and the lack of transparency that conceals disputes about rights allocation under an apparent technical discussion. but more importantly, the oecd’s unified approach fails to meet the normative requirements for a differential approach. in a context where the transfer pricing regime is maintained, apportioning residual profits on a formulaic basis seems promising.176 however, considering that residual profits, by definition, are not directly attributable to any specific jurisdiction, any formula established on the basis of an entitlement approach will largely lack economic rationale and thus be significantly arbitrary. 177 the lack of normative guidance for allocating residual profits among jurisdictions calls for the application of the differential principle advocated in this article, which warrants a differential approach in such cases. similar to the case of unitary taxation discussed above, an appropriate approach to the allocation of residual profits should include some development indicator, such as gdp per capita, as a factor in the apportionment formula.178 v. conclusion normative discussions on how to distribute tax jurisdictions are frequently met with skepticism. the realist view of international relations, where any agreements on normative principles are based on self-interest and bargaining power, still predominates in tax policy analysis. yet, there is evidence that governments are, at least to some extent, motivated by a concern with international justice. initiatives such as the united nations’ sustainable development goals (sdgs), 179 the oecd’s task force on tax and 175 see christians & magalhaes, supra note 171, at 1173–76 (showing that the shift of profits allocation toward location of consumers will mostly benefit countries with larger consumer markets, such as the eu countries, the u.s., and middle-income countries, rather than the lower-income ones). see also faccio & fitzgerald, supra note 162, at 85; independent commission for the reform of international corporate taxation, a roadmap to improve rules for taxing multinationals: a fairer future for global taxation 10 (2018). 176 see reuven s. avi-yonah & ilan benshalom, formulary apportionment – myths and prospects: promoting better international tax policies by utilizing the misunderstood and under-theorized formulary alternative, 3 world tax j. 371 (2011). 177 see reuven s. avi-yonah, the rise and fall of arm’s length: a study in the evolution of u.s. international taxation, 15 va. tax rev. 89, 148–49 (1995) (noting that residual profit, by definition, is the return resulting from the interaction of the constituent parts of a multinational entity and thereby cannot be assigned to respective components without a significant degree of arbitrariness). 178 for the idea of including a differential approach to the allocation of multinationals’ profits, see musgrave & musgrave, supra note 3, at 85 (“[t]he only satisfactory solution . . . would be the taxation of such [multinational] income on an international basis with subsequent allocation of proceeds on an apportionment basis among the participating countries, making allowance for distributional considerations.”). 179 g.a. res. 70/1, ¶ 43 (oct. 21, 2015) (stating that, among other goals, it aims to “mobilize public resources domestically, especially in the poorest and most vulnerable countries with limited domestic resources”). 86 columbia journal of tax law [vol. 12:58 development, 180 and the inter-agency platform for collaboration on tax 181 seem to demonstrate a substantial effort to improve economic development in less affluent countries. additionally, a meaningful concern with international redistribution may encourage cooperation of lower-income countries in undertaking obligations required for a coordinated effort to address the current international tax challenges. insofar that this is the case, more extended discussions about inter-nation equity should provide normative guidance for an allocation of the international tax base that allows for meaningful redistribution while preserving nations’ entitlements. there is also reason to argue that redistribution through allocation of taxing rights is a viable option compared to alternative policies. for instance, there are doubts as to the effectiveness of development aid, especially considering its potential to exacerbate corruption and reduce incentives to develop sustainable policies.182 foreign aid also often limits recipient countries’ fiscal autonomy because donor countries frequently impose direct control over expenditure of aid toward specific projects.183 moreover, redistribution through foreign aid lacks uniformity since the selection of recipients depends on reasons that are fairly arbitrary from a normative perspective, such as close economic ties or geographic proximity.184 compared to differential treatments adopted in other areas of law, differentiation in international tax law also seems to offer a more promising and direct form of redistribution because it entails less distortionary effects.185 improving taxing rights of lower-income countries also contributes to their ability to mobilize revenue, which is a fundamental requirement to finance achievement of sustainable development goals.186 180 oecd, oecd work on tax and development 32 (2019), http://www.oecd.org/ctp/brochureoecd-work-on-tax-and-development.pdf [https://perma.cc/w8ee-4x6u] (stating that it was established to “build an environment in developing countries that will enable them to collect appropriate and adequate tax revenues and build effective states”). 181 the platform for collaboration on tax, strengthening tax capacity in developing countries: inter-agency platform for collaboration on tax (2018), https://www.un.org/esa/ffd/wpcontent/uploads/2018/05/2018-ecosoc-ictm-sm_platform_consolidated.pdf [https://perma.cc/we2geqcp] (stating that it is a joint collaboration between the imf, the oecd, the un, and the world bank group established to “facilitate the participation of developing countries in the global dialogue on tax matters” and “strengthen domestic revenue mobilization in developing countries”). 182 see stephen knack, does foreign aid promote democracy?, 48 int’l stud. q. 251 (2004) (suggesting that when aid dependence increases as a proportion of government consumption, recipient states will become less accountable for their own actions, and conflicts over aid funds increase); see also stephen knack & aminur rahman, donor fragmentation and bureaucratic quality in aid recipients, 83 j. dev. econ. 176 (2007). 183 stewart, supra note 32, at 304–05. 184 but see ilan benshalom, the new poor at our gates: global justice implications for international trade and tax law, 85 n.y.u. l. rev. 1, 29 (2010) (arguing that arbitrary geographic proximity may be a factor sufficiently relevant to trigger or intensify duties of justice). 185 differential approaches included in specific regulatory frameworks, such as the principle of common but differentiated responsibilities and respective capabilities adopted in the unfcc (see supra text accompanying notes 102-03), can potentially cause inefficiencies that impact its main goal. the problem does not exist in international taxation, whose fundamental goal is to allocate taxing rights among jurisdictions. see benshalom, supra note 114, at 338 (“in the international tax context, the distribution of the right to tax is the main objective, and there is no external, common good objective that can be distorted. because the policy objective of the international tax regime is to achieve sustainable distribution of profits derived from international commerce, there may be less of a dichotomy between redistributive equity and efficiency.”). 186 see u.n. comm. of experts on int’l cooperation in tax matters, the role of taxation and domestic resource mobilization in the implementation of the sustainable development goals, u.n. doc. e/c.18/2018/crp.19 (2018); see also apeldoorn, supra note 91 (arguing that allocating taxing rights in a way that favors low-income states is fundamental to increasing their capacity to mobilize revenue while preventing double taxation that could disturb international investment). 2020] inter-nation equity revisited 87 recent developments in international tax policy seem to offer an unparalleled opportunity to reconsider the normative justification of long-standing criteria used in the international allocation of taxing rights.187 the relevance of multinational corporations and the global changes arising from digitalization have recently impelled a revision of the present distribution of taxing rights,188 thus motivating a re-examination of the normative underpinnings for the division of the international tax base.189 claims from countries with large consumer markets—mostly highand middle-income countries—that a revised global compact should give them a greater share of tax revenues seems to hold valid, but the lack of clear entitlement for a significant portion of the international tax base calls for more sustained normative criteria. a dual conception of inter-nation equity entails the accommodation of the two normative components of international justice (entitlement and differentiation) in a way that the limitations of the entitlement approach are offset by the differential approach. the differential principle put forward in this article requires that whenever entitlement to tax cannot be clearly established based on an entitlement approach, determining the allocation of taxing rights should be primarily guided by redistributive goals. differentiation must meet three main normative requirements: (1) universality, so that it does not shut out countries equally in need; (2) granularity, so that differentiation considers countries individually rather than generalizing them into groups that disregard relevant intra-group inequalities (e.g., developing countries); and (3) consistency, so that rights be assigned in a way that adequately address the targeted inequality that gave rise to a differential approach in the first place. these seemingly evident normative requirements have robust practical implications and proscribe some initiatives that are commonly regarded as favoring lower-income countries. one may view the normative requirements put forth in this article as excessively demanding. at the end of the day, it could be argued, any change in the current international tax system that contributes to tilting the scale in favor of lower-income countries should deserve praise and encouragement. although this may hold some truth— pointing to an important difference between duty of assistance and claims of distributive justice—satisfying international justice is not simply about improving the situation of worse-off countries, but also about doing it in a way that is consistent with their needs. the fundamental problem with accepting any differential mechanism as normatively satisfying is that, regardless of normative demands, the agreement of more powerful, affluent countries to redistribution faces political limitations. without clear normative guidelines 187 see steven a. dean, a constitutional moment for cross-border taxation (aug. 25, 2020) (unpublished manuscript), https://www.law.nyu.edu/sites/default/files/a%20constitutional%20moment %20in%20cross-border%20taxation-%20dean_0.pdf [https://perma.cc/w9qq-y2lu] (pointing out that for the first time in decades, international tax policy has entered a fluid phase in which fundamental reform becomes possible, and warning for the urgency in recognizing the opportunity for critical improvements before the moment passes); mason, supra note 133, at 401. 188 see oecd, addressing the tax challenges of the digitalisation of the economy (2019), https://www.oecd.org/tax/beps/public-consultation-document-addressing-the-tax-challenges-of-thedigitalisation-of-the-economy.pdf [https://perma.cc/rqw5-z6q8]. for an overview of the context and political motivations of the oecd’s efforts to address this issue, see allison christians & magalhaes, supra note 171. 189 see, e.g., christians & apeldoorn, supra note 133; michael p. devereux & john vella, value creation as the fundamental principle of the international corporate tax system (european tax policy forum, working paper, 2018); wolfgang schön, one answer to why and how to tax the digitalized economy, 47 intertax 1003 (2019); wilkie, supra note 133; svitlana buriak, a new taxing right for the market jurisdiction: where are the limits?, 48 intertax 301 (2020). 88 columbia journal of tax law [vol. 12:58 for meaningful redistribution, promotion of suboptimal initiatives might prevent the consideration of normatively superior ones. or, as a more cynical view may suggest, the absence of criteria for appropriate redistribution may lead to the opportunistic use of modest or unsatisfactory concessions to excuse the lack of more significant initiatives. at a time when governments struggle with the more immediate domestic concern of fighting a global pandemic and an upcoming economic crisis, it might seem futile to argue for placing attention on normative demands to address international inequality in the international tax system. yet, if there are valid reasons for embracing aspirations for justice in times of stability, this becomes even more pressing during a recession, when the global poor will inevitably bear a greater burden. articles and you may ask yourself, what is that beautiful house:1 how tax laws distort behavior through the lens of architecture meredith r. conway* * professor of law, suffolk university law school. thanks to hilary allen, megan carpenter, allison christians, rebecca curtin, sara dillon, joseph glannon, janice griffith, renee landers, camille nelson, diane ring, adam rosenzweig, kerry ryan, sarah schendel, patrick shin, and maria toyoda for comments and suggestions. this paper also benefited from feedback received during presentations at the cuny school of law’s faculty workshop and suffolk university school of law faculty works in progress, and to my aunt violet vietoris, whose travel, interest in the guinness factory and the windows and thoughtfulness of me inspired this piece. 1 talking heads, once in a lifetime, remain in light (feb. 2, 1981) (downloaded using itunes). 166 [vol. 10:2 columbia journal of tax law table of content i. introduction 168 ii. justifications for taxing real estate and architecture 170 iii. the hearth/chimney tax 172 a. byzantine empire 172 b. french hearth tax 172 c. the netherlands 173 d. british hearth tax 173 e. ireland 174 f. new orleans chimney tax 175 iv. the window tax 175 a. the window tax of great britain 175 b. the british window tax and separate buildings 179 c. window tax in the united states 180 d. the window tax in ireland 181 e. the windows and doors tax of france 181 f. the window and door tax in the netherlands 182 v. tax laws that affect the construction of buildings 182 a. the mansard roof of france 182 b. the brick tax 183 c. the british wallpaper tax 185 d. japanese hidden stairs 186 vi. taxes and skinny houses 187 a. the netherlands frontage tax 187 b. the frontage tax in charleston, south carolina 188 c. japan’s property and inheritance taxes 188 d. vietnamese tube houses 190 e. new orleans 190 vii. the direct tax of 1798 and its impacts on american architecture 191 a. the direct tax of 1798 191 b. dutch colonial architecture 193 c. the saltbox houses 194 2019] 167 and you may ask yourself, what is that beautiful house: how tax laws distort behavior through the lens of architecture viii. architectural changes from land taxes versus building taxes 194 a. tax laws that discourage new improvements and buildings 194 b. russian tax on plowed land 195 ix. tax and eco-friendly building 195 a. inaccurate proxy for “eco-friendly”: the leed standard 196 b. competing interests: the solar projects 196 x. conclusion 197 168 [vol. 10:2 columbia journal of tax law i. introduction “most taxes distort economic decision-making.”2 taxes have long been used to influence the decision making of taxpayers. using taxes to induce taxpayer actions may be effective; however, it also, regrettably, often results in distorting taxpayer behavior that subverts the original intention of the law. whether the tax law should be used as a tool to provoke taxpayer behavior, if such use is effective or wise due to the inadvertent results is often debated. as one commentator noted regarding the tax incentives for historic tax provisions and the unintended consequences: discussion of the role of tax policy in the preservation movement should be approached from the viewpoint that u.s. tax laws are fundamentally a mechanism for raising the revenue needed by the government and that this process should be carried out in a fair, rational and straightforward manner. before complicating the system through the use of tax laws for other purposes – whether to regulate conduct or to achieve societal or economic objectives – one should first test the availability of alternative methods for achieving those non-revenue goals.3 scholarship has explored these unintended distortions, which sometimes conflict directly with congressional intent, particularly with respect to corporate transactions. 4 the beauty of studying how tax law has resulted in distortions to architecture is that the study presents a visual representation of these distortions and makes such unintended consequences noticeable or even obvious to taxpayers. adam smith said it was clear a tax provision was bad if it encouraged evasion by taxpayers.5 he also said a tax was bad if it put taxpayers through “odious examinations of the taxgatherers, and expose[s] them to much unnecessary trouble, vexation and oppression.”6 2 j. anthony coughlan, land value taxation and constitutional uniformity, 7 geo. mason l. rev. 261 (1999). 3 mortimer caplin, federal tax policy as an incentive for enhancement of the built environment, in tax incentives for historic preservation 7 (g. andrews ed. 1981). 4 my previous scholarship focuses on unintended distortions caused by tax code provisions in the corporate tax context. see, e.g., meredith conway, money, money, money; it’s a rich man’s world: making the corporate tax fair, 17 u. penn. j. bus. l. 1181 (2015) (discussing how high corporate tax rates and lower tax rates on partnership income unintendedly result in horizontal inequity); see also meredith conway, stealth inequity: using corporate integration to ease unfairness in the tax code, 2 wm. & mary pol’y rev. 53 (2010) (describing how the accredited investor standard combined with the high corporate income tax rate compared to lower tax rates on partnership income unintendedly results in a higher tax burden on investments by lower income taxpayers); meredith conway, with or without you: debt, equity and the continuity of interest, 15 stan. j. l. bus. & fin. 261 (2010) (discussing that the tax distinctions between equity and debt unintentionally encourage taxpayers to design instruments to maximize efficient tax treatment in spite of corporate features of the instrument); meredith conway, money for nothing and the stocks for free: taxing executive compensation, 17 cornell j. l. & pub. pol'y 383 (2008) (describing that the taxation of excess executive compensation results in executive stock options; resulting in aggressive and imprudent decisions aimed to maximize stock prices); meredith conway, clowns to the left of me, jokers to the right, here i am, stuck in the middle with you: the inconsistent tax treatment of security holders in tax-free reorganizations, 56 cath. u.l. rev. 99 (2006) (arguing that the tax treatment of security holders results in inefficient superior tax benefits to holders of equities or debt and discourages long term investment through debt). 5 5 adam smith, the wealth of nations 561–564 (1776). 6 id; 2 adam smith, the wealth of nations 309 (1776). 2019] 169 and you may ask yourself, what is that beautiful house: how tax laws distort behavior through the lens of architecture this article presents a number of tax provisions that were enacted to raise revenue or influence taxpayer behavior, and resulted in modifying and warping architecture in terms of unexpected architectural design changes. not only did these architectural design permutations spread within the taxing jurisdiction, but also caused enduring changes to architecture that dispersed into other countries as well as changes to longstanding architectural design principles. as mentioned earlier, architecture serves as a perfect visual illustration of these distortions, making these unintended effects and their influence accessible even to those not well-versed in tax law. often, taxes that are enacted to encourage or discourage a certain behavior result in distorting taxpayer behavior in unanticipated ways. legislatures enacting tax laws to induce actions or even raise revenue will often inadvertently distort taxpayer behavior as taxpayers seek to minimize their tax burden.7 tax avoidance, which involves taxpayers seeking to lower or avoid taxes, is legal, as opposed to tax evasion which is illegal.8 a popular statement of their distinction is as follows: “the man who deliberately adopts one of several possible courses, because that one will save him the most tax, must be distinguished from the man who does the same but for entirely different reasons. a tax avoidance transaction is one which would not be adopted if the tax-saving element had not been present.”9 a legislature enacting taxes must balance the burden imposed by the tax against possible actions taxpayers might take to avoid the increased tax burden, the taxpayer’s cost and inconvenience of avoiding the tax, and finally the possibility of any unintended distortion to taxpayer behaviors. 10 taxpayers’ attempts to avoid taxes result in not just behavioral (or, in the context of this article, architectural) distortions, but also in outright brutality historically. in the seventeenth century, french objectors killed a teenage clerk who merely kept the books for a collector of taxes, nailing his flesh to doors to caution revenue officials of the dangers that awaited them.11 one of the reasons tax authorities deliberately taxed certain items was an attempt to reach a specific demographic. legislatures often advocated for taxes that would reach the wealthy and impose a lesser burden on the poor. to achieve this, rather than just tax the wealth, legislatures 7 see g.s.a. wheatcroft, the attitude of the legislature and the courts to tax avoidance, 18 mod. l. rev. 209, 209–210 (1955) (citing examples such as alcohol taxes to reduce drunkenness, additional profits tax to avoid dividends, and in particular the strategy of purchasing insolvent companies to absorb future profits and reflecting that the bidding prices increased while the owner of the company emphasizes how significantly insolvent the company is to raise prices). 8 see id. (the author defines tax avoidance as “a transaction that (a) avoids tax, (b) is entered into for the purpose of avoiding tax, (c) is carried out lawfully, and (d) is not a transaction with the legislature has intended to encourage”). 9 id. 10 see id. at 210. 11 see charles adams, for good and evil: the impact of taxes on the course of civilization 229 (2001) (describing how the french would not accept taxes and would routinely respond with murder, mayhem and violence). 170 [vol. 10:2 columbia journal of tax law would tax items they thought served as a proxy for wealth – items reflecting “opulent living.”12 for example, tax authorities have targeted wallpaper, windows, pocket watches, bricks and more.13 as this article will demonstrate, with respect to the architectural aspects, each resulted in paradoxical results, changing the face of architecture rather than serving as a tax on the items. as this article will demonstrate, the unintended effects that taxes can have on architecture become part of the architectural landscape as the underlying tax avoidance strategies are identified and utilized by others, and as the designs gain independent popularity.14 the legislative intent may have been well-meaning; however, targeting specific architectural aspects for taxation often results in both arbitrary taxation and unintended consequences such as altered architecture style. using arbitrary measures such as rooflines or materials as a proxy for wealth may not effectively target wealth. further, “architecture-based” taxation also interferes often with a taxpayer’s ability to pay. these issues violate the first two canons of adam smith: first, taxing individuals on their ability to pay; and second, ensuring the taxes are not arbitrary.15 this article proceeds in ten parts: part i is an introduction of architectural changes due to tax policy; part ii explains the basic framework of taxing real estate and architecture; part iii discusses the hearth/chimney tax; part iv discusses the window tax; part v discusses various tax laws that have led to distinctive architecture styles; part vi focuses on tax laws that have created a particular architecture style: drastically narrow houses; part vii focuses on tax laws in a particular period, colonial america, and their influence on architecture styles of the period; part viii gives a brief introduction to the distinction between land and building taxes and examples of architecture styles that result from tax policies targeting buildings instead of land; part ix describes unintended architectural changes created by tax policy that intends to subsidize environmental conservation and protection efforts; and part x concludes that architecture provides a meaningful and tangible illustration of the way tax laws can distort taxpayer behavior in unintended and significant ways. ii. justifications for taxing real estate and architecture in addition to influencing taxpayer behaviors, property tax is one of several tools to raise revenue for local governments.16 because real property is clearly visible and can often be assessed from the street, a property tax is often seen as a less intrusive, more objective and transparent tax. adam smith noted that “[i]t is easy to lay a tax upon land, because it is evident what quantity everyone possesses, but it is very difficult to lay a tax upon stock or money without very arbitrary proceedings [and] a hardship upon a man in trade to oblige him to show his books.”17 land taxes were in use long before income taxes, principally because taxpayers objected to the intrusion in their privacy associated with income taxes. as mentioned earlier, a significant advantage of land 12 see isaac william martin, the permanent tax revolt: how the property tax transformed american politics 151 (2008). 13 see id. 14 see wheatcroft, supra note 7, at 213. 15 see 2 adam smith, the wealth of nations 307–308 (1776). 16 see joan m. youngman & jane h. malme, an international survey of taxes on land and buildings, lincoln land institute and oecd 2 (1994). 17 see smith, supra note 5, at 442. 2019] 171 and you may ask yourself, what is that beautiful house: how tax laws distort behavior through the lens of architecture taxes was that accessors could avoid interacting with the owners of the property, for example, by determining the value of such land as a base for tax from observations made while standing on the sidewalk. this was particularly helpful at times of great hostility toward taxes and tax accessors. because of its frequent use, property taxes influenced how taxpayers held their properties at least as far back to as the roman times. during the time of diocletian’s new order, emperor diocletian enacted a tax based on the number of acres a farmer owned in syria.18 in response, “[f]armers started to abandon their farms if they did not like their classification. the new system was endangered by the fundamental right of all roman citizens to move about the empire as they pleased.”19 farmers were also reluctant to stay because their tax burden was unpredictable as it was determined year to year every september.20 in addition to unintended consequences, taxes on buildings and land were also used intentionally to influence taxpayer behaviors by creating incentives or disincentives for desired outcomes.21 modern examples, which are discussed in greater details later, include tax credits for environmentally friendly buildings and for preservation of historic sites.22 a criticism of real property taxes is that a taxpayer’s wealth in land or buildings does not necessarily coincide with his or her ability to pay since it does not reflect the taxpayer’s asset liquidity.23 consequently, a real property tax could force sales or foreclosures of the property. historically, the property tax was also attacked for lack of horizontal equity, i.e., taxing wealth in the form of real property but omit wealth such as cash, stock, and bonds.24 another criticism is that assessors could be motivated to value their assessments in a way to serve their own advantages.25 the valuation standards employed by assessors could be highly subjective, leading to unequal and inconsistent applications. these inconsistencies were particularly concerning when motivated by political favors or outright bribes.26 in addition, the difference between the respective abilities of personal and real property owners to circumvent taxes imposed on their properties led to further inequity. for example, colonial farmers would drive their livestock into the forest when assessors came to conceal their wealth and avoid taxes.27 18 see adams, supra note 11, at 114–115. 19 id. (traditionally, roman farmers enjoyed the freedom of movement within the empire, but the land tax introduced by emperor diocletian forced them to remain in one place, altering the long-established precedent). 20 see id. at 116–17 (delinquency was also not an option—the farmer faced the possibility that soldiers would plunder her land and torture or sell her children into slavery if she did not pay the tax). 21 see comment, municipal real estate taxation as an incentive for community planning, 57 yale l.j. 219, 220 (1947) (describing how property taxes can be “an instrument to facilitate the realization of such desirable objectives such as the minimization of land speculation, the abolition of slums, the encouragement of new residential and business construction”) 22 see part ix, infra. 23 see youngman & halman, supra note 16, at 2; see also martin, supra note 12, at 6667. 24 see youngman & halman, supra note 16, at 3. 25 see martin, supra note 16, at 6667. 26 see id. 27 see robert a. becker, revolution, reform and the politics of american taxation, 1763–1783 8 (1980). 172 [vol. 10:2 columbia journal of tax law the real property, however, was much more difficult to hide..28 as professor isaac william martin notes, the “system was unfair to property owners who lived in the wrong neighborhood.”29 iii. the hearth/chimney tax a. byzantine empire the first known hearth (i.e., fireplace) tax was imposed by the byzantine empire in the seventh century, although few details are known about the tax. 30 it was called the kapikon (translated into the “smoke tax”).31 it was imposed on each household, as a proxy for families, based on the number of fireplaces in a municipality.32 orphanages, hospitals, as well as monastic and religious institutions were exempt from the tax, but there was no exemption for the poor or indigent.33 as a result of the exemption for monasteries, families created monasteries to avoid paying the tax and the amount of monasteries grew dramatically, as many private individuals began monasteries to deliberately avoid paying the tax.34 the byzantine hearth tax replaced the roman head tax.35 it appears there was also a land tax at the time, but separate inspectors were used for the land tax and for the hearth tax.36 b. french hearth tax the french also had a hearth tax (also referred to as the fourage). it played a more significant role in france although there were similar versions of the tax in nearby countries like england.37 historically, the french population had significantly less active role and participation in the enactment and imposition of taxes than the citizens in england.38 the french hearth tax was first imposed in 1146.39 it was used for the first time successfully as a source of revenue by phillip the fair in 1294.40 while the tax did not generate enough revenue to become part of the general tax structure until much later in history, it was the most direct tax france had until the late 14th century. although the tax was briefly abolished by charles v on his deathbed in 1380, it continued to play a role at various times during french history.41 28 see id. 29 see martin, supra note 12. 30 see john f. haldon, byzantium in the seventh century: the transformation of a culture 149 (1997); see also charles m. brand, two byzantine treatises on taxation, 25 traditio 35, 41 (1969); w. ashburner, a byzantine treatise on taxation, 35 j. hellenic stud. 121–123 (1915). 31 see haldon, supra note 30. 32 see id. 33 see id. at 112–113. 34 see id. at 293. 35 see brand, supra note 30, at 41. 36 see ashburner, supra note 30, at 76–78, 121–123. 37 see james collins, the state in early modern france 16, 111 (1995); see also 14(4) yoram barzel & edgar kiser, taxation and voting rights in medieval england and france, rationality and society copyright 8, 494 (2002). 38 see barzel supra note 37, at 494. 39 see id. 40 see id. 41 see collins, supra note 37, at 111. 2019] 173 and you may ask yourself, what is that beautiful house: how tax laws distort behavior through the lens of architecture after napoleon rose to power, the popular view among french citizens was that many taxes should be overthrown.42 to raise revenue, napoleon chose to impose the hearth tax rather than a more intrusive poll tax or income tax.43 as napoleon conquered countries, such as italy and netherlands, he removed local tax exemptions, including those for the poor, and imposed significant taxes, including a hearth tax, in order to fund his military operations.44 commentators state that he essentially destroyed the kingdom of westphalia with a heavy tax burden.45 the hearth tax caused significant resentment among the french population during the time of napoleon.46 but as french taxpayers gained more and more voting rights on the enactment of new taxes,47 the hearth tax was confirmed several times by national voting assemblies.48 c. the netherlands in denmark, the government decreed that all hearths had to have chimneys.49 an important purpose of this rule is to allow tax collectors to count the number of hearths without entering the home and instead by counting the number of chimneys.50 to avoid this new chimney law, many denmark farmers would gather all of the hearths together in one black kitchen.51 this would allow them to use a single chimney for all of the hearths, frustrating the tax collectors’ attempts to count the correct number of hearths.52 d. british hearth tax the hearth tax was introduced in england from 1662 to1666 and then again from 1669 to 1674 after charles ii was put on the throne.53 the hearth tax was intended to be a tax on wealth, using the number of fireplaces and chimneys that a household has as a proxy for the household’s 42 see 3 stephen dowell, a history of taxation and taxes in england from the earliest of times to the year 1885 153 (1888). 43 see adams, supra note 11, at 351. 44 see mosheh tsuḳerman, ethnizität, moderne und enttraditionalisierung 400 (2002) (explaining that napoleon essentially destroyed the kingdom of westphalia by imposing a tax of 26 million francs to be paid over 18 months), https://books.google.com/books?id=shmeirm84scc&pg=pa400&dq=napoleon+french+hearth+tax&hl=en&sa=x &ved=0ahukewiu1s25ythahwp11kkhyxdcc84chdoaqgvmae#v=onepage&q=hearth&f=false [https://perma.cc/d5g9-9pxa]; see also holger nehring & flrian schui, global debates about taxation 6263 (2007). 45 see nehring & schui, supra note 44, at 62-63 (2007). 46 see philip g. dwyer, napoleon and europe 173 (2014). 47 see brazel, supra note 37, at 494. 48 see id. at 495. 49 see allen noble, traditional buildings: a global survey of structural forms and cultural functions 31 (2009). 50 see id. 51 see id. 52 see id. 53 see hearth money act (1663), 15 car. 2, c. 13, § 1. a subsequent act was passed, see hearth money act (1664), 16 car. 2, c. 3, §1, to enable official collection of the tax. it was later abolished, in hearth money act (1688), 1 w. & m., c. 10. see also dowell, supra note 42, at 258. https://books.google.com/books?id=shmeirm84scc&pg=pa400&dq=napoleon+french+hearth+tax&hl=en&sa=x&ved=0ahukewiu1s25ythahwp11kkhyxdcc84chdoaqgvmae#v=onepage&q=hearth&f=false https://books.google.com/books?id=shmeirm84scc&pg=pa400&dq=napoleon+french+hearth+tax&hl=en&sa=x&ved=0ahukewiu1s25ythahwp11kkhyxdcc84chdoaqgvmae#v=onepage&q=hearth&f=false 174 [vol. 10:2 columbia journal of tax law wealth.54 each fireplace was taxed at two shillings.55 unlike other property taxes in england, the tax on hearths required tax accessors to actually enter the home to determine the number of fireplaces since a visual inspection of chimneys from the outside would not accurately reflect the number of working fireplaces in a dwelling.56 the tax assessors who examined the homes were called “chimney men.”57 the hearth tax was very unpopular and many taxpayers took measures to avoid paying the tax. one common method to avoid the tax was boarding up or blocking their chimneys which prevented the chimneys from being counted as working hearths. 58 occasionally, devastating consequences resulted from blocking up a chimney. for example, in churchill oxfordshire, on july 3, 1684, a fire was caused by a baker who blocked her chimney to avoid the hearth tax.59 she knocked a hole through the wall from her oven to her neighbor’s chimney to use her neighbor’s chimney.60 the fire destroyed 20 houses and other buildings, and killed four people.61 the village was rebuilt higher up the hill, with stone houses instead of the old timber-framed and thatched cottages.62 the hearth tax was abolished after the 1688 glorious revolution when a report referred to the tax as “ a badge of slavery upon whole people, exposing every man’s house to be entered and searched at the pleasure of persons unknown to him.”63 on a lighter note, rebecca rogers, who died august 22, 1668, had her tombstone inscribed “a house she hath, its made of such good fashion, the tenant ne’er shall pay for reparation nor will her landlord ever raise her rent or turn her out of doors for non-payment from chimney money too this cell is free of such a house who would not tenant be.”64 e. ireland the irish also were subject to the hearth tax imposed by great britain after 1793.65 the tax applied to households having only one hearth, which are typically poorer taxpayers. to make the tax more like a wealth-based tax, the rates applicable to households with multiple hearths were later raised above those applicable to single hearth household.66 eventually, in 1795, an exemption 54 see inst.of historical research, university of london, london and middlesex hearth tax (1666): an analysis of the status and wealth of neighborhoods and households on the eve of the great fire, https://www.history.ac.uk/projects/research/hearth-tax. 55 see dowell, supra note 42, at 153; see also adams, supra note 11, at 351. 56 see adams, supra note 11, at 258. 57 see id. (“there is not one old dame in ten, and search the nation through. but, if you talk of chimney-men will spare them a curse or two.”); see also dowell, supra note 42, at 39. 58 see dowell, supra note 42, at 169; see also paul sullivan, the little book of oxfordshire 38 (2012). 59 see sullivan, supra note 58, at 38. 60 see id. 61 see id. 62 see id. 63 dowell, supra note 42, at 40. 64 mike hanagan & pat cox, legends of kent 72 (2012). 65 see d. dickson, taxation and disaffection in late eighteenth-century ireland, in samuel clark & james donnelly, irish peasants: violence and political unrest, 1780-1914, 45 (1983). 66 see id. at 45. https://www.revolvy.com/page/chimney-money https://www.history.ac.uk/projects/research/hearth-tax 2019] 175 and you may ask yourself, what is that beautiful house: how tax laws distort behavior through the lens of architecture for all one hearth households was enacted to lessen the burden on the poor.67 it was observed that some homes in ireland were built entirely without chimneys to avoid the tax68 due to the unpopular nature of the hearth tax, many immigrants to the united states, especially those from france and germany, strongly opposed any hearth tax.69 the distrust for hearth tax also led to a distrust for general property taxes later in the united states.70 f. new orleans chimney tax new orleans has had an intriguing discourse over property and architectural taxes. some have speculated that at one time, there was a door tax, incentivizing citizens to create floor to ceiling windows that would not be counted as doors.71 others have speculated that the “shotgun house” which became a standard in new orleans architecture is a tax-avoidance strategy against a tax on the frontage of buildings.72 the spanish chimney tax of 1794 imposed a version of the historical hearth tax to raise fund for street lights.73 the tax was so unpopular that it only lasted for six months and was replaced with a tax on bread.74 in addition to raising revenue, the chimney tax was also an attempt to reduce fire risks (by taxing chimneys as a proxy to fireplaces which tend to impose such risks), in response to the great fires in 1788 and 1794, which destroyed 856 buildings out of approximately 1100.75 as a typical tax avoidance strategy against such tax, households in the city of new orleans started to share chimneys without necessarily reducing the number of fireplaces.76 iv. the window tax a. the window tax of great britain a tax on windows (the “windows tax”) was imposed in england on inhabited dwellings based on the number of windows in the house.77 it was initially introduced in england 67 see id. at 46. 68 see a business man on taxes, in tax facts published in the interests of sound economics and american ideals 29, 31 (dec. 1992 ed.) (noting taxes that deliberately targets an industry may cripple an industry). 69 see adam, supra note 11 at 326 (german citizens in particular despised hearth taxes that had been imposed in their former homeland and were unwilling to be subjected to them again); see also paul newman, fries’s rebellion: the enduring struggle for the american revolution 20, 20-21 (2004). 70 see centre for hearth tax research, university of roehampton, https://gams.uni-graz.at/context:htx; see also newman, supra note 69, at 20. 71 see robert cangelosi, why do older new orleans houses have so few closets, 46:2 preservation in print, 36 (mar. 2019). 72 see robert ross & deanne ross, walking to new orleans: ethics and the concept of participatory design, in postdisaster reconstruction 408 (2008); richard campanella, cityscapes of new orleans 90 (2017). 73 see lawrence powell, the new orleans of george washington cable: the 1887 census office report 58 (2008). 74 see id. 75 see id. 76 see id. 77 see window duties act (1747), 21 geo. 2, c.10 [hereinafter the british window tax act]; see also adams, supra note 11, at 259; dowell, supra note 42, at 154; wallace e. oates & robert m. schwab, the window tax: a transparent case of excess burden, in land lines, lincoln institute of land policy 11 (apr. 2014). https://gams.uni-graz.at/context:htx 176 [vol. 10:2 columbia journal of tax law and wales in 1696 and was eventually repealed in 1851.78 in addition to taxing windows on the dwelling itself, the window tax also taxed windows on certain side buildings that served living purposes, like laundry houses.79 there were exemptions for those in poverty, certain outbuildings including dairies, cheese rooms and millhouses provided that they were labeled as such.80 many of these labels still remain in some rooms carved on the lintel.81 there were many unintended architectural changes as a result of the tax on windows, including bricked over windows, fewer windows, and false painted windows. the goal of the window tax was to tax the wealthy, under the assumption that the wealthier someone is, the more windows in his or her house.82 the window tax also led to profound architectural changes evidenced in contemporary designs and extended beyond great britain to influence other countries including the united states.83 prior to the imposition of the window tax, wealthier citizens in england often had many windows to display and flaunt their prosperity.84 the most prestigious households in england had entire porches or alcoves surrounded by windows, creating a glass wall.85 the initial window tax in great britain imposed a flat-rate house tax of 2 shillings per window, with an additional tax for homes with more than ten windows and up to 20 windows of an extra 4 shillings.86 a significant benefit to the window tax was that it was relatively easy to assess and collect because windows are clearly visible from the street.87 assessment was generally unobtrusive since there was no need to interact with taxpayers or go inside homes.88 adam smith suggested that a window tax was better than a hearth tax because “windows are visible markers of wealth and would thus not require the tax collector to enter the taxpayer’s home.”89 it was suggested that the tax could discourage “wealth imposters” (social climbers) from purchasing excess windows to create the false impression that they were wealthy by taxing such behaviors.90 the window tax could serve to “restore the honours and distinctions of this sort, due to our nobility, gentry, merchants and others of real ability . . . .”91 “the laws would, in some 78 the bank of england act (1696), 8 & 9 will 3, c. 20. 79 see m. humberston, the absurdity and injustice of the window tax, considered with especial reference to the new survey 8 (1841). 80 see dowell, supra note 42, at 173-174. 81 see id; see also asshof likhovski, chasing ghosts: on writing cultural histories of tax law, 1 uc irvine l. rev. 843, 878 (2011). 82 see m. humberston, supra note 79, at 6. see also likhovski, supra note 81, at 875; the british window tax act, supra note 77; see also adams, supra note 11, at 259. 83 see andrew e. glantz, a tax on light and air: impact on the window duty on tax administration and architecture, 1696-1851, 15(2) penn hist. rev. 18, 28 (2008). 84 see stephen eskilson, the age of glass: a cultural history of glass in modern and contemporary architecture 4 (2018); see also chantal stebbings, the victorian taxpayer and the law, a study in constitutional conflict 5, 29 (2012) (noting that “wealth was perceived as an indication of moral worth”). 85 see eskilson, supra note 84, at 4; see also oates, supra note 77, at 13-14. 86 the british window tax act, supra note 77; see also oates, supra note 77, at 13. 87 see dowell, supra note 42, at 153-154; see also adams, supra note 11, at 259. 88 see newman, supra note 69, at 20-21; the british window tax act, supra note 77; eskilson, supra note 84, at 3. 89 likhovski, supra note 81, at 879; see also smith, supra note 5, at 239-240, 845-46. 90 id. at 885-895. 91 id. at 886. 2019] 177 and you may ask yourself, what is that beautiful house: how tax laws distort behavior through the lens of architecture measure, confine people to the practice of frugality, and take it out of their power to spend their substance in vainly mimicking their superiors.”92 the irony, however, is that even the wealthy began to brick over their windows to avoid the tax, thus making the (false) appearance of wealth even easier.93 one aspect of the window tax that made it significantly more palatable to the british citizens was that, unlike an income tax, the window tax was imposed on “visible objects.”94 the assessment of a window tax, like that of a general property tax, typically would not involve an invasive inquisition into the taxpayer’s financial affairs or privacy.95 in addition, the window tax was viewed as an objective tax, not subject to favoritism or judgment calls.96 the number of windows each building has is not affected by the subjective judgment of the tax collector.97 further, the tax on windows was in some respects viewed as a voluntary tax because a taxpayer could choose to avoid the tax by eschewing windows.98 however, it was not easy or in many cases possible for the poor to avoid the tax by moving to homes with less windows, and therefore the tax could unfairly burden less wealthy taxpayers.99 despite the possible advantages of the window tax as compared to an income tax, the tax was still unpopular. it became known as a tax on "light and air."100 since the number of windows in a dwelling was not an accurate measurement of the wealth of its occupants, for example, old, low-value houses inhabited by the poor but nonetheless having many windows, using windows as a proxy for wealth could capture taxpayers who were not actually wealthy, for example, those who inhabited old houses with many windows or those who installed more windows because they liked natural light and air.101 one commentator noted that, at the time of its enactment, the window tax “can no more be depended on [as a proxy for wealth] than the buttons of a coat can be said to denote its value.”102 as a previous example indicates, large houses with many windows may be owned in earlier times by the wealthy, but now often served as homes for the poor as the wealthy moved on to newer and grander houses.103 some also argued that the window tax was a regressive tax, imposing a greater burden on the middle and lower classes.104 92 see id. 93 see id. at 878. 94 see id. 95 id. 96 see martin, supra note 12, at 6-7 (arguing that fractional property taxes are subjective and cause unrest in many states within the unites states because of the perception that they are not impartial and involve favoritism). 97 see id. 98 see id.; see also stebbings, supra note 84, at 12 (noting that when england enacted an income tax it reflected “ideological adherence to voluntarism.”); see also adams, supra note 11, at 397. 99 see humberston, supra note 79, at 14; see also chantal stebbings, the impact of tax on the landscape: social expectations and the built environment in nineteenth-century england, in challenges to authority and the recognition of rights: from magna carta to modernity 183 (catherine macmillan & charlotte smith eds., 2018). 100 see humberston, supra note 79, at 23. 101 see id. at 8. 102 id. 103 see id. at 9; see also oates, supra note 77, at 12-13. 104 see humberston, supra note 79, at 23. 178 [vol. 10:2 columbia journal of tax law unsurprisingly, after the window tax was imposed, entire blocks of houses were built without windows.105 such tax-avoidance strategy reduced revenue collected by the government and dramatically affected the window industry.106 in 1718 it was noted that there was a decline in revenue raised by the window tax because english citizens were blocking their windows to avoid the tax.107 one manufacturer stated that the window tax was far more injurious to his business than the glass excise tax because of the significant reduction in the demand for windows from consumers.108 furthermore, taxpayers would build separate structures on the property in order to exempt those portions used for commercial purposes (thus not counted as part of the dwelling) from the window tax.109 the government response to this new trend was to extend the window tax to all buildings, commercial or not, thus extending its impact to industries in addition to the window industry.110 as evidence of the impact of the tax, glass production in england remained stagnant from 1810 to 1850 despite significant population growth and many more houses being built.111 since glass manufacturers played an important role in great britain’s market economy, some called the window tax a “grievous tax on the industry.”112 another response of the government was to expand the definition of “window” for window tax purposes, such as treating any hole in a wall as a “window” subject to the tax.113 one critic noted that under this tax even “the air holes and wire gratings in our cellars and larders” might be taxed as windows.114 the reduced number of windows on buildings were also potentially harmful to the health of its occupants.115 the window tax also resulted in several distinct architectural changes which spread throughout england and beyond as the changes became fashionable.116 bricked over windows and fake windows became so stylish that new construction included them for stylistic purposes.117 such “ghost windows” or “blind windows” can still be found in buildings today. 118 the architectural design of new buildings was further modified because bay windows often became prohibitively expensive, leading to flat fronted buildings; making the architecture of many areas 105 see stebbings, supra note 84, at 183. 106 see id.; see also oates, supra note 77, at 11-12. 107 see dowell, supra note 42, at 171; see also eskilson, supra note 84, at 4. 108 t.c barker & j.r. harris, a merseyside town in the industrial revolution: st helens 17501900 215 (2012). 109 see glantz, supra note 83, at 30. 110 see id. 111 id. 112 robert montgomery martin, taxation of the british empire 68, 91 (1833); see also eskilson, supra note 84, at 4 (noting that combined with the glass excise tax, taxes on glass had essentially more than doubled); 182 hansard’s: the parliamentary debates from year 1803 to the present time 170 (1851) (including a parliamentary debate where a member was unwilling to vote for the tax because of its burdens on many industries). 113 see dowell, supra note 42, at 176. 114 see m. humberston, supra note 79, at 10 (noting that a lack of windows leads to health risks such as typhus). 115 id. 116 see glantz, supra note 83, at 28. 117 see stebbings, supra note 99, at 191; see also glantz, supra note 83, at 31. 118 see glantz, supra note 83, at 28. 2019] 179 and you may ask yourself, what is that beautiful house: how tax laws distort behavior through the lens of architecture lacking character.119 architects struggled to a great extent to design palatable buildings with the window size and number restrictions imposed by the british government.120 many observers objected to the perceived damage that the window tax was causing to the architectural landscape of great britain, claiming that “the visual impact of the legislation . . . and that the lack of engagement by the architectural associations was striking.”121 the window tax was incorporated into a larger tax bill in 1798 under the triple assessment, which imposes taxes on windows, servants, carriages, lights, clocks, watches and luxury goods.122 unsurprisingly, the triple assessment tax was very unpopular and failed to raise the revenue required to fund the war with france, which eventually led to great britain enacting its first income tax.123 coincidence or not, the all glass crystal palace opened in 1851, the same year that the window tax was repealed.124 today, bricked up windows can still be seen frequently in great britain and are often used in countries including the united states to convey a historical look on new buildings.125 b. the british window tax and separate buildings the british window tax altered architecture further than less windows being used in architectural design; it also resulted in the use of separate buildings on a homestead, for example, as work facilities, in addition to the primary dwelling. since the tax was initially imposed only on primary dwellings, those separate buildings not used as primary dwelling were not subject to tax.126 this architectural innovation successfully reduced the taxpayers’ tax burden on the work facilities they separated from the dwelling portion of the house.127 in response, the british parliament revised the window tax in 1747 to specifically cover windows on buildings separate from the primary dwelling, including any “[k]itchen, [s]cullery, [b]uttery, [p]antry, [l]arder, [w]ash-house, [l]aundry, [b]ake house, [b]rewhouse, and [l]odging[r]oom, whether contiguous to, or disjoined from the [d]welling [h]ouse.”128 119 see stebbings, supra note 99, at 193. 120 id. 121 id. at 189. 122 an act for granting to his majesty an aid and contribution for the prosecution of the war (1798), 38 geo. 3, c. 16, §§ 1, 10 [hereinafter the triple assessment]; see also dowell, supra note 42, at 87; stebbings, supra note 84, at 5, 25; likhovski, supra note 81, at 879. 123 the triple assessment, supra note 122; see also likhovski, supra note 81, at 875; adams, supra note 11, at 351. 124 see charles macfarlane, the comprehensive history of england: civil and military, religious, intellectual, and social, from the earliest period to the suppression of the sepoy revolt 653 (1861). 125 see noble, supra note 49, at 31, 51; see also andrew burman, blurring the lines with blind windows, in greenwich village for historic preservation (dec. 23, 2011), https://gvshp.org/blog/2011/12/23/blurringthe-lines-with-blind-windows/ [https://perma.cc/77yb-xndl] (the 1845 campbell house in virginia, which has 4 fake windows despite no window tax existing in virginia at the time, implies that they were added merely for stylistic purposes). 126 the british window tax act, supra note 77; see also dowell, supra note 42, at 177. 127 see dowell, supra note 42, at 173. 128 the duty on inhabited houses, 1778, 18 geo 3 c. 26 (eng.); the british window tax act, supra note 77; houses and windows duties amendment act, 1748, 21 geo. 2 c. 10 §26 (eng.). see dowell, supra note 42, at 94 https://gvshp.org/blog/2011/12/23/blurring-the-lines-with-blind-windows/ https://gvshp.org/blog/2011/12/23/blurring-the-lines-with-blind-windows/ 180 [vol. 10:2 columbia journal of tax law the use of separate buildings also served as a strategy to reduce taxes under the property tax enacted following the window tax.129 the property tax was imposed on occupied houses but did not include warehouses, shops, unoccupied servants’ quarters or other buildings used for trade or businesses.130 the tax was imposed on any shops or warehouses if they were physically attached to the dwelling house.131 as a result, taxpayers moved work spaces into separate buildings in order to reduce tax.132 c. window tax in the united states there is no known evidence that a tax specifically on windows was ever enacted in the united states. however, similar taxes were imposed historically. the revenue act of 1767, one of the townshend acts, imposed taxes on glass, lead and paint.133 as a result of the act, imported glass became so expensive that using it for windows was a luxury that few colonists could afford.134 more impactful than the prohibitive price was the boycott of the importation of the taxed items in rebellion against the english imposition of taxes.135 for example, the 1767 boston nonimportation agreement was a covenant signed by hundreds of boston merchants to boycott british imports in the wake of the townshend acts.136 the lack of imported glass to make windows made winters even more brutal, and colonists sometimes used oiled paper or mica as replacement for glass windows.137 many colonists also started to experiment on ways to manufacture high-quality glass locally in order to be less dependent on imported glass. glass-manufacturing factories began to spring up in massachusetts, new york, virginia and pennsylvania.138 in pittsburgh, green window glass, known as flint glass, was produced and still used by older homes today.139 the earliest glass windows produced in the colonies were small, often diamond shaped panes and leaded together in a pattern and then into the casement, known today as leaded windows.140 because the colonists struggled to create larger (noting the law originally provided a 10% limit repairs for unoccupied houses and buildings while farm buildings were permitted 8%); income and property taxes act, 1806, 46 geo. 3 c. 65 (eng.) [hereinafter the 1806 property tax act]. 129 see id. at 178. 130 the 1806 property tax act, supra note 128. 131 see dowell, supra note 42, at 180. 132 an act for tax management, 1803, 43 geo. 3, c. 50 (eng.); see also dowell, supra note 42, at 182. 133 see revenue act of 1767, 7 geo. 3 c. 46. the act was one of the five townshend acts that impose tax on the colonies. the second of the townshend acts led to the boston tea party, while another led to the boston massacre. see kevin schultz, hist 85 (2010) (discussing the townshend acts and other historical events leading to the boston massacre). 134 see harold donaldson eberlein, the architecture of colonial america 248 (1915). 135 see glantz, supra note 83, at 28; see also john ridpath, the constitution and washington’s presidency 312 (1912); george upham, pre-revolutionary life and thought in a western new hampshire town, in 54(5) the granite monthly: a mag. of lit., hist. and state progress 199, 200 (1922). 136 see t.h. breen, "baubles of britain": the american and consumer revolutions of the eighteenth century, in 119 past and present 73, 77, 91 (1988); see also arthur m. schlesinger, politics, propaganda, and the philadelphia press, 1767-1770, in 60(4) the penn. mag. of hist. and biography 309, 318 (1936). 137 see allen noble, vernacular buildings: a global survey 180 (2013); see also upham, supra note 135, at 202. 138 see ridpath, supra note 135, at 312. 139 see id. 140 eberlein, supra note 134, at 249. 2019] 181 and you may ask yourself, what is that beautiful house: how tax laws distort behavior through the lens of architecture single panes of glass, the dimensions for window openings in that period were also smaller. it was not until late eighteenth century that residents began to desire larger windows for their houses.141 d. the window tax in ireland the british imposed the window tax on ireland in 1799 to help raise revenue for the napoleonic wars.142 it was only imposed on households with seven or more windows.143 the taxes were oppressive for the irish and were repealed for small farmhouses in 1823.144 irish taxpayers used similar tax avoidance strategy or simply refused to pay.145 of particular concern was that irish windows were used not only for indoor lighting, but also for venting, due to the lack of chimneys which can be further traced back to the chimney tax.146 as a response to the window tax, members of the irish parliament and the chancellor of ireland argued that the taxes were too heavy and the irish taxpayers could not afford them; they also expressed a concern over the potential harmful impact on health.147 the tax was eventually repealed after the war because of objections of the irish parliament.148 e. the windows and doors tax of france the france enacted a tax on both windows and doors in 1798 and repealed the tax in 1926.149 one distinction between the british and the french window taxes was that the french tax rate was based on both the number and the size of the windows or doors, while the british tax rate was solely based on the number of windows150 similar tax avoidance behaviors were observed in france as those observed in england. for example, a missionary in the french colony of akaroa described how he would climb in and out of his “home” on his hands and knees in an attempt to minimize the size of windows and doors.151 perhaps in response to the wide use of tax avoidance strategy, exemptions were enacted later for large tenement housing as well as for families with 141 see id. 142 see dickson, supra note 65, at 58. 143 see id. 144 see stephen dowell, direct taxes and stamp duties 193 (1884). 145 see 4 henry grattan, the speeches of the right honorable henry grattan: in the irish, and in the imperial parliament 407, 409 (longman, hurst, rees, orme and brown 1822). 146 see oates, supra note 77, at 11. 147 see grattan, supra note 145, at 407; see also oates, supra note 77, at 11. 148 see the repeal of the window and hearth tax in ireland (1851), 3 geo. 4 c. 82 & 54; see also motion for the repeal of the window tax in ireland, 40 hcd cc. 126-148 (may 5, 1819); oates, supra note 77, at 11; grattan, supra note 145, at 407. 149 see chantal stebbings, consent and constitutionality in nineteenth-century taxation, in 3 studies in the history of tax law 302 (john tiley ed. 2009); see also oates, supra note 77, at 11. 150 reports from his majesty's representatives abroad respecting graduated income taxes in foreign states: presented to both houses of parliament by command of his majesty august 1905, france no. 16, 143 ¶4 (great britain. parliament sessional papers, 1905. cd. 2587.); see also noble, supra note 49, at 31. 151 see t. lindsay buck, the french at akaroa: an adventure in colonization 151-152 (2011). 182 [vol. 10:2 columbia journal of tax law more than 7 children. 152 further, to avoid disproportionate tax burden, the tax would be apportioned in a collective amount by region, arrondissement, commune, and so forth.153 similar to the british, the french resented any imposition of tax that intruded into their privacy and therefore preferred taxes that were assessed by an objective standard and without the need to collect sensitive personal information.154 a tax on windows and doors arguably satisfies such a standard. however, similar to what was observed in england, french architects with an eye to taxation started to design buildings with smaller and fewer windows.155 the tax is often cited to explain the very small gable windows french settlers in quebec used in their homes. 156 additionally, residences for the poor were designed to have as few openings as possible.157 in extreme cases, entire houses in france were built without windows.158 f. the window and door tax in the netherlands the tax on windows and doors was introduced to netherlands by napoleon. according to alexander gogel, the minister of finance appointed for the netherlands, architectural changes were almost immediately observed after the tax was first imposed in 1810.159 gogel himself sought a 25% reduction of the tax in an attempt to stop the changes he observed, stating the taxes were “irregular, indiscriminate taxes without guidelines [or] standards . . . and cause problems with determining everyone’s share in the level of taxation.” 160 according to him, windows were blocked up immediately to avoid the tax and palaces were built with few windows. jean-baptiste say, a prominent contemporary french economist, recalled that as a teenager, he watched men hired by the owner of the building where he lived bricked over windows to avoid the tax.161 “even today, in old dutch cities and villages, houses with bricked up windows can still be found. moreover, on the canals of amsterdam there are city palaces from this period that have relatively few windows….”162 v. tax laws that affect the construction of buildings a. the mansard roof of france 152 see edwin robert anderson seligman, the income tax: a study of the history, theory, and practice of income taxation at home and abroad 276 (1914). 153 see thomas piketty, top incomes in france in the 20th century: inequality and redistribution 1901-1998 (2018); see also j. bouvier, le système fiscal français. ètude critique d'un immobilisme, in deux siècles de fiscalité française, xixe–xxe siècle 231-32 (j. bouvier and j. wolff eds., paris and la haye: mouton 1973). 154 see stebbings, supra note 149, at 302; see also onno ydema & henk vording, dutch tax reforms in the napoleonic era, in 6 studies in the history of tax law 489 (john tiley ed. 2013). 155 see michael moïssey postan & h. j. habakkuk, the cambridge economic history of europe: the industrial economies: the development of economic and social policies 385 (1966). 156 see noble, supra note 49, at 81. 157 see james c. scott, seeing like a state: how certain schemes to improve the human condition have failed 47 (1999). 158 see a business man on taxes, supra note 68. 159 see ydema, supra note 154, at 513. 160 id. 161 see id. at 514. 162 see id. at 513. 2019] 183 and you may ask yourself, what is that beautiful house: how tax laws distort behavior through the lens of architecture during the reign of napoleon, french property taxes were partially based on the number of floors a property has.163 the number of floors is counted based on all floors below the roofline (hence the name “roof tax”).164 in 1783, the city of paris implemented a 20-meter (roughly 65 feet) maximum height on architectural structures, with a crucial caveat: the height of a building is measured up to the cornice line, leaving the roof zone above (the attic) unaffected by the limit.165 the mansard roof was initially designed by francois mansart, a french architect, in the seventeenth century, but did not become popular until napoleon’s roof tax was enacted.166 the mansard roof is a flat roof, with hip sides that slope upwards on an angle. the top floor has enough roof space to be a living space.167 because under the roof tax law, the top floor (above the roofline) was an attic and not counted as part of the tax base, taxpayers sought to maximize the habitable space in a dwelling while minimizing the roof tax through the use of mansard roofs.168 eventually, the mansard roof became recognized as a distinctive architectural style, independent of its previous use as a tax avoidance strategy.169 the mansard roof was called the “second empire” style in the united states and was especially popular from 1865 to 1895 for both private and public buildings.170 architects in the united states found the mansard roof reflective of european style artistically and used it both to create an urban atmosphere and to maximize living space through the top floor.171 as people moved west in the united states, the mansard roof design spread west, resulting it its presence throughout the country.172 b. the brick tax 163 see national association of tax administrators, revenue administration: 1987. proceedings of the fiftyfifth annual conference of national association of tax administrators, 55, 152 (1987) [hereinafter nta 1987]; see also richard f. dye & richard w. england, assessing the theory and practice of land value taxation, in lincoln institute of land policy 6, 59 (2010); steve carlson, your low-tax dream house: a new approach to slashing the cost of home ownership (1989). 164 see dye & england, supra note 163, at 59; see also richard v. francaviglia, main street revisited: time, space, and image building in small-town america 28 (1996). 165 see karen e. powell, a historical perspective on montanan property tax: 25 years of statewide appraisal and appeal practice, 70 mont. l. rev. 21, 23 (2009); see also carlson, supra note 163; 12 old house journal no. 7, 152 (aug. sept. 1984). 166 see dye & england, supra note 163, at 59; see also francaviglia, supra note 164, at 28. 167 see marvin trachtenberg & isabelle hyman, architecture from pre-history to postmodernism: the western tradition 361 (1986). 168 see powell, supra note 165, at 23; see also carlson, supra note 163; 12 old house journal no. 7, 152 (aug. sept. 1984). 169 see francaviglia, supra note 164, at 28. 170 see nta 1987, supra note 163. 171 see id. 172 see francaviglia, supra note 164, at 28; see also 12 old house journal no. 7, 152 (aug. sept. 1984). 184 [vol. 10:2 columbia journal of tax law the british brick tax was a tax based on the number of bricks in a building, which was introduced by king george iii in 1784 to help pay for the war against colonial america.173 bricks were initially taxed at 4 shillings per a thousand bricks, with almost no exemptions.174 the brick tax had several unintended effects on popular architecture.175 first, bricks were essentially eliminated as a building material in rural areas following the enactment of the brick tax.176 second, brick manufacturers increased the size of bricks manufactured, often doubling their size, so that less bricks were needed for the same building.177 the british government responded by limiting a maximum size of a brick to that of a typical brick before the enactment of the brick tax.178 tax rate was increased if a brick exceeded the maximum size limit.179 also, alternative materials, such as wood or weatherboards, received more popularity in home construction, despite being considered as inferior to bricks.180 some builders turned to stone despite it being more expensive.181 houses built with larger bricks or with alternative materials to bricks today are reminiscent of the brick tax that has long been repealed. one observer noted that “[t]he taxes on building materials and windows were perceived as materially damaging to architectural style and beauty.” 182 joseph wilkes of measham, leicestershire became well-known for his “jumb” or “gob” bricks.183 his bricks, almost double in size of a normal brick, has become an icon of his time.184 the tax was devastating to the brick industry and was detrimental to industrial development. numerous small brick producers went out of business, after being forced to sell their inventory to pay the tax.185 the tax was abolished in 1850.186 despite repealing the tax, the british government did not take any corrective actions to remedy the damage caused by the tax.187 the tax was intended to raise revenue and instead damaged an industry and distorted the architectural design and aesthetics of buildings. 173 duties on bricks and tiles (1784), 24 geo. 3, c. 24, §1 (eng.); see r.w. brunskill, houses and cottages of britain: origins and development of traditional buildings 184-186 (2000). 174 see barry bridgwood & lindsay lennie, history, performance and conservation 27 (2013). 175 see id. 176 see id. at 51. 177 see dowell, supra note 42, at 390-391. 178 the excise act (1805), 45 geo. iii c. 30 (eng.). 179 see stebbings, supra note 99, at 181. 180 see id. at 183, 191. 181 brick making act (1725), 12 geo. 1, c. 85 (eng.); see also horace wallpole, 2 memoirs of the reign of king george ii 178 (1846) (claiming he tried to convince the king to tax stone instead, but was rebuffed); see also stebbings, supra note 99, at 181. 182 id. at 189. 183 see robin lucas, the tax on bricks and tiles, 1784-1850: its application to the country at large and, in particular, to the county of norfolk, 13 constr. hist. 850, 850 n. 80 (1997); see also j.m. mccomish, york arch. trust for excavation and research, a guide to ceramic building materials: an insight report 43 (2015). 184 mccomish, supra note 183, at 43. 185 see lucas, supra note 183, at 869-70. 186 the repeal of brick duties, 1850, 13 & 14 vict c. 9 (eng.). 187 see caplin, supra note 3, at 1; see also stebbings, supra note 99, at 182. 2019] 185 and you may ask yourself, what is that beautiful house: how tax laws distort behavior through the lens of architecture c. the british wallpaper tax188 in the early 1700’s, wallpaper became more popular in england as its advantages over tapestries became clear. queen anne enacted a tax on wallpaper in great britain in 1712 as a tax on luxury items.189 wallpaper was taxed if it had patterns or was printed or painted. until the mid1800’s, wallpaper in england was almost exclusively hand painted, hand stenciled or embossed by talented workers.190 the tax was finally repealed in 1836.191 there were four major issues with the english wallpaper tax. first, although the tax was imposed on locally manufactured wallpaper, no equivalent tax was imposed on imported wallpaper until much later. this disparate tax treatment significantly disadvantaged england’s otherwise booming wallpaper industry.192 second, the government’s attempt to maximize revenue under the tax led to inefficiency and waste, such as preventing the use of machinery in wallpaper production or requiring wallpaper to be cut into smaller pieces so that more pieces were subject to tax.193 consumers, however, generally preferred larger or whole pieces of wallpaper to smaller ones.194 third, foreign consumers of exported wallpaper from england were not subject to the tax, while domestic consumers were subject to the tax.195 fourth, various tax avoidance strategies, such as hiring artisans to directly paint on plain paper already attached to the wall, or just painting on the plain plaster, became widely used.196 to deter the use of such tax avoidance strategies, british government imposed a tax on the use of plain paper as wallpaper to be painted later on.197 regardless, such “half self-made” wallpaper still cost less than commercially manufactured wallpaper. ireland also enacted a wallpaper tax at the same time, but it adopted a more aggressive anti-avoidance rule by making it illegal to hang plain paper to be painted and used as wallpaper. the law also permitted aggressive and potentially disruptive enforcement, such as government inspection of the interior of private houses without notice.198 interior architectural decoration grew in popularity as a trade as wallpaper design became an art form, either imported or stenciled after hanging.199 ideally, “[w]all papers should be printed 188 see owen w. davis, friends in council, wall papers, in the british architecture 291 (1882) (describing the importance of wall decoration including wallpaper in the history of british architecture). 189 taxation act (1711), 10 ann., c. 18, § 44 [hereinafter the wallpaper tax]. 190 see e.a. entwisle, wallpaper and its history, 109 j. royal soc’y arts 450, 451, 455 (may 1961). 191 stamps and taxes act (1735), 5 & 6 will c. 20; see also richard leslie hills, papermaking in britain 1488-1988: a short history 85 (2015). 192 see hills supra note 191, at 84-85. 193 see id. at 90. 194 see davis, supra note 188, at 291. 195 see joanne kosuda-warner, landscape wallcoverings 17 (2001); see also hills supra note 191, at 85. 196 see jim postell & nancy gesimondo, materiality and interior construction 212 (2011). 197 duties and drawbacks made to cease as to customs as to excise act (1792), 27 geo. 3, c. 13, §8; see also act for more effectually securing the duties upon foreign printed, painted or pained paper imported into great britain (1792), 32 geo. 3, c. 54, § 4. 198 see id. 199 id. 186 [vol. 10:2 columbia journal of tax law in lengths . . . from 6 to 12 feet.”200 a wallpaper machine was invented to accommodate this length and facilitate production201 despite these innovations, however, british wallpaper was cut into smaller sizes to accommodate the higher tax burden on larger sheets.202 regrettably, the tax on domestically created wallpaper stifled development of the industry in great britain.203 the tax was repealed in 1836, coinciding with the development of steam making machinery that mass-produced wallpaper at a significantly lower cost.204 the tax on wallpaper failed to raise the anticipated revenue, and instead disrupted the english wallpaper industry, and simultaneously distorted the behavior of buyers, encouraging alternative architecture designs such as hand painting and stenciling to avoid taxes.205 d. japanese hidden stairs in the eighth century, japan imposed a tax on multi-story buildings. 206 the central government, the bakufu, had power over the local governments and charged each village with collecting and paying the tax through leaders.207 the bakufu did not impose consistent tax rates or regulations, delegating it to the village leaders, unless the tax rates were expressly in conflict with rules of the bakufu.208 komononari taxes were broad and included taxes on features that indicated wealth, such a second story of a houses.209 further, during this time period, the tax burden fell mainly on farmers, who, with the village leaders, became resentful of wealthy merchants and would “[extort] taxes and loans from merchants” motivating some to disguise the square footage of a house.210 japanese artisans created stair chests called kaidan-tansu which many speculate was in response to these taxes, disguising two story homes as one story.211 they were intricate chests used as armoires or general storage as well as stairs that could be rolled in place for use as a staircase, or rolled out of sight if a tax accessor visited.212 some kaidantansu could be disassembled to 200 davis, supra note 188, at 291. 201 see hills supra note 191,at 90. 202 see id. 203 see harriet bridgeman & elizabeth drury, the encyclopedia of victoriana 301 (1975). 204 see james a. schmiechen, reconsidering the factory, art-labor, and the schools of design in nineteenth-century britain, 6 design issues 58, 61 (1990). 205 see entwisle, supra note 190, at 457. 206 see kazuko koizumi, traditional japanese furniture: a definitive guide 24 (1986). 207 dan fenno henderson, “contracts" in tokugawa villages, j. japanese stud. 51, 56 (1974). 208 gary r. saxonhouse, the stability of megaorganizations, in 151(4) the tokugawa state j. instit. and theoretical econ. 741, 784-785 (1995); see also thomas c. smith, the land tax in the tokugawa period, 18 j. asian stud.3, 9 (1995). 209 see smith, supra note 208, at 12. 210 see eijiro honjo, changes of social classes during the tokugawa period, 3 kyoto univ. econ. rev. 56, 62 (1928). 211 see id; there is debate about whether these staircases were designed to avoid taxes or merely for design. see, e.g., david jackson, the kaidan dansu, a stairway in historic shadow, japan found. 8 (2007) http://www.tansuconservation.com/wp-content/uploads/2014/03/djackson_kaidan.pdf [https://perma.cc/3v9x3abh]. 212 see kazuko koizumi, traditional japanese furniture: a definitive guide 24 (1986); see also nicholas bornoff, things japanese: everyday objects of exceptional beauty and significance 7 (2014). http://www.tansuconservation.com/wp-content/uploads/2014/03/djackson_kaidan.pdf 2019] 187 and you may ask yourself, what is that beautiful house: how tax laws distort behavior through the lens of architecture further disguise it from the tax collector while other versions would be moved elsewhere in the home and appear as a bookcase or closet.213 vi. taxes and skinny houses a. the netherlands frontage tax among the unique characteristics of amsterdam’s architecture are the extremely narrow buildings,214 particularly those along the dutch canal.215 in the early 17th century, amsterdam was in its golden age, and the city was experiencing great expansion. within 75 years, the population increased from 54,000 to 200,000. due to the lack of space, particularly along the canal, the city of amsterdam enacted a tax on houses based on the width of their frontage. 216 to reduce liability under the new tax, canal houses were built strikingly narrow, tall but deep so that it could provide more living space behind the frontage.217 those houses also had large windows to improve indoor lighting and to transport items in and out of the house through the pulley system, which were necessary given the unique physical structure of those houses. ironically, when napoleon came to power and imposed the french tax structure, taxes were imposed based on the size of the windows on the front of the houses. the singel 166 building in amsterdam is perhaps the narrowest building in the city: it is less than six feet wide, only slightly wider than the front door. 218 interestingly, since the tax made wider houses significantly more expensive, building a house with wide frontage became a new symbol of power and wealth. for example, wealthy merchants would sometimes buy two adjacent plots of land to build “city palaces” along the canal. the “golden bend” (gouden bocht) of the herengracht, one of the major canals in amsterdam, was known as the wealthiest section of the city, with wide houses built on several adjacent lots.219 the so-called “dutch staircase” is another architectural change that accommodated houses with extremely narrow frontage.220 such staircases were designed to be extremely steep and spiral to fit within the narrow space.221 they were so steep that they were unfit for carrying items up and down the building, necessitating more architectural innovations.222 the crane and pulley system was the answer. such system featured a large hook permanently attached to the roof of the building. to bring items to the upper floors, a rope was put through the hook, creating the pulley that allowed lifting of heavy items. once the items were lifted to the target level, they could be brought in 213 see the home office, toronto star, jan. 15, 2004, at ho 3; see also christine brun, east and west share trend of elegance in room design, the san diego union-tribune (apr. 2, 2006). 214 see adriaan jacob barnouw & raymond a. wohlrabe, the land and people of holland 21 (1972). 215 see id. at 134. 216 see j. wessels, history of the roman-dutch law 292 (1908); burton malkiel & charles ellis, the elements of investing 10 (2009); see also carlson, supra note 163. 217 steen eiler rasmussen, experiencing architecture 198 (1964). 218 derek blyth, amsterdam, rotterdam & the hauge 118 (1992). 219 see id. 220 see barnouw, supra note 214, at 134. 221 see id. 222 see carlson, supra note 163. https://www.google.com/search?tbo=p&tbm=bks&q=inauthor:%22raymond+a.+wohlrabe%22 188 [vol. 10:2 columbia journal of tax law through the large windows, another architectural feature mentioned earlier that specifically accommodated the narrow frontage design. 223 b. the frontage tax in charleston, south carolina because of a tax on frontage, many houses in charleston, sc feature narrow frontage, producing a distinctive architectural building design representative of the city, known as a charleston single.224these characteristic residences are often several floors high and are built deep into the lot.225 the houses usually also have two substantial, upper and lower side porches called piazzas, which are often used as outside rooms.226 such houses remained popular throughout the 18th century and for most of the 19th century, but abruptly disappeared after the 1890s.227 at its peak, the so-called charleston single house dominated the city with around 4,000 in existence.228 today that figure is estimated to be 2,700.229 this unique architectural style coincided with a tax based on the frontage of buildings in the 18th and 19th century.230 only the frontage facing the street was subject to the tax, which did not include the side porches. 231 to reduce liability under the tax, homeowners tried to minimize the building frontage while increasing its height and depth.232 c. japan’s property and inheritance taxes in japan, three separate taxes: the frontage tax, the property tax on farmland and the inheritance tax, have historically led to uniquely small houses. the frontage tax was enacted to raise revenue and shift some of the tax burden from farmers to merchants and artisans.233 rather than producing revenue, the tax resulted in very narrow, deep buildings with a width of rarely 223 see barnouw, supra note 214, at 134. 224 see sam davis, the architecture of affordable housing 152 (1997); walter edgar, south carolina: a history 152 (1998); michael crosbie, gentle infill in a genteel society, in 45 architecture (july 1985); see also jefferson kolle, charleston single house: built to last, in this old house (2018), https://www.thisoldhouse.com/ideas/charleston-single-house-built-to-last [https://perma.cc/87ss-vgs8]. 225 see edgar, supra note 224, at 197; see also kolle, supra note 224. 226 see kolle, supra note 224. 227 see kristin walker, so what exactly is the charleston single house? charleston inside and out (june 11, 2009), https://charlestoninsideout.net/2009/06/11/so-what-exactly-is-the-charleston-single-house/ [https://perma.cc/56xq-hde3]. 228 see id. 229 id. 230 see crosbie, supra note 224; kolle, supra note 224. 231 see burdett a. rich, annotation, mauldin v. greenville (s.c.), in 27 the lawyers’ reports annotated 284, 289 (1895) (discussing state v. charleston where the court stated that the city of charleston taxed its residents based on the frontage of their houses on the road, but that the tax did not cover improvements to the sidewalk in front of their houses). 232 davis, supra note 188, at 152. 233 yosaburo takekoshi, the economic aspects of japan 314 (2004); japanese capitals in historical perspective: place, power and memory in kyoto, edo and tokyo 106 (fieve & waley eds., 2003); see karin lofgren, machiya: history and architecture of the kyoto town house 238 (2003). https://www.thisoldhouse.com/ideas/charleston-single-house-built-to-last https://charlestoninsideout.net/2009/06/11/so-what-exactly-is-the-charleston-single-house/ 2019] 189 and you may ask yourself, what is that beautiful house: how tax laws distort behavior through the lens of architecture exceeding six meters.234 the front, first floor was commonly used as a shop or marketplace while the back and upper floors were used as living quarters.235 the property tax on farms was almost negligible, motivated by a policy to encourage agriculture and reduce the financial burden on working farmers.236 however, because of the low property tax, there was little incentive to sell or improve the land because the cost of holding the land unused was minimal whereas there were immediate tax consequences if the land was sold.237 as a result, many farm owners would leave the land idle, rather than finding a more productive or efficient use for it.238 as a response to the consolidation and unproductive use of farm land, the inheritance tax on the same property was set extremely high to encourage sale and reduce the deadhand control of large real estates. 239 however, the inheritance tax was reduced as the number of heirs increased, since a larger number of heirs served to break up the estate and more efficient use of the property.240 as a result, land inherited in japan was progressively divided into smaller pieces.241 because the tax was based on both the size of the estate and the number of statutory heirs under the civil code,242 it was beneficial to have as many heirs as possible, even if they were not named in the will.243 for example, testators sought to adopt grandchildren, nephews and nieces to make them statutory heirs. 244 234 see chapter l, the revenue and expenditures of the shogunate, annual revenue under ordinary heading, (5)house land tax and the household tax. it taxed the frontage of houses, and exempted three areas, suburban kyoto, sakai and nara (not the cities themselves), which was enacted in 1696. a second tax was imposed called the public service tax in 1721 which applied to the frontage of houses primarily in edo. see takekoshi, the economic aspects of japan 314 (1930); japanese capitals in historical perspective: place, power and memory in kyoto, edo and tokyo 106 (fieve & waley eds., 2003); karin lofgren, machiya: history and architecture of the kyoto town house 238 (2003). 235 see james king, under foreign eyes: western cinematic adaptations of postwar japan 216 (2012); kinoshita ryoici, preservation and revitalization of machiya in kyoto, in japanese capitals in history perspective: place, power and memory in kyoto, edo and tokyo 370 (fieve & waley eds., 2003); see also yuko nakamura & aina maeguchi, what is machiya and its history, the kyoto project (may 27, 2013), http://thekyotoproject.org/english/kyoto-machiya/ [https://perma.cc/s28f-cm9w]. regarding the japanese preference for new architecture, it “has no culture of house restoration.” see lucy alexander, why foreign buyers are seeking ‘worthless’ wooden homes in kyoto, fin. times, https://www.ft.com/content/a03d15b6-2b08-11e5-acfbcbd2e1c81cca (last visited july 24, 2015); anthony j. fielding, class and space: social segregation in japanese cities, 29 trans. inst. bri. geo. 64, 69 (2004) (“as incomes go up . . . the family will often knock down the old house and build a new one on the same site.”). 236 see hiromitsu ishi, the japanese tax system 230 (2001); rice and trade-one example, 133 cong. rec. e127 (daily ed. jan. 8, 1987) (statement of rep. lehman). 237 see bernie shelton, learning from the japanese city: looing east in urban design 39 (2012); see ishi, supra note 236, at 223. 238 see shelton, supra note 237, at 39; see ishi, supra note 236, at 223. 239 see carl s. shoup, tax reform in japan, 7 austl. tax f. 411, 439 (1990). 240 see id. 241 id. 242 id. 243 ishi, supra note 236, at 230. 244 see id. http://thekyotoproject.org/english/kyoto-machiya/ 190 [vol. 10:2 columbia journal of tax law the joint effect of the property and the inheritance taxes often resulted in destroying family farms, as farmers decided whether to sell their farms during their lifetime or to leave the farms to their heirs, breaking it into smaller pieces in the process. either way, the family farm was lost. d. vietnamese tube houses vietnamese “tube houses” are very narrow houses typically built up to five floors. the typical tube house was originally a building with shops on the first floor and living spaces above. as generations of the family grew, floors would be added.245 the architectural design coincided with a tax based on the frontage of the buildings.246 these houses could be as narrow as two meters and as long as 70 meters.247 tube houses were first built in the “old city” (hanoi) during the le dynasty, from 1428 to 1788.248 to receive more natural light, despite the narrowness, such houses often had multiple courtyards along the longer side. the traditional tube house construction continued until the end of the 19th century.249 despite the fact that tube houses were designed to reduce the tax burden, these houses have become a fundamental part of vietnam’s architecture.250 they are often very colorful, as well as architectural feats, with staircases, balconies, and roof decks despite their narrowness. 251 recognizing its independent architectural value, unesco-funded organizations have restored some tube houses as representatives of the 19th century houses in the old city. e. new orleans the traditional new orleans “shotgun houses” were very narrow, often only one room wide, but long and deep into the lot.252 the houses received their names because it would be easy to fire a shotgun from the front door straight into the back since the house was so long and 245 id.; see also ta van tai, vietnam's code of the lê dynasty (1428-1788), 30 (3) amer. j. comp. law 523, 538-539 (1982). law on agricultural land use tax (1993) and decree on land and houses tax (1994); 246 the code was quốc triều hình luật, later translated into french by r. deloustal and cl.-e. m., la justice dans l'ancien annam, 8 bulletin de l'école française d'extrême-orient 13,19, 22 (1908-22). the real estate taxation sections were §§ 342-373; deloustal, at 10: 461 et. seq.; see also thi nhu dao, urbanization and urban architectural heritage preservation in hanoi: the community’s participation? in soc. université panthéonsorbonne, paris i (2017). 247 see peter boothroyd & pham xuan nam, socioeconomic renovation in vietnam: the origin, evolution, and impact of doi moi 90 (2000). 248 see richard sterling, dk eyewitness travel guide: vietnam and angkor wat 27 (2013). the law of the le dynasty was known as “hong duc law” (translated as imperial criminal law or le dynasty criminal law, despite the fact that it also included tax provisions), which was the most prominent and vital law in feudaljurisdictional vietnam. 249 see to kein, tube house and neo tube house in hanoi: a comparative study on identity and typology, 262 j. asian arch. and buil. engineering 255 (2008). 250 see alexandra sauvegrain, dialogues of architectural preservation in modern vietnam: the 36 streets commercial quarters, 13 tdsr 23, 25 (2001); see also m. askew & w.s. logan, cultural identity and urban change in southeast asia: interpretive essays 50 (1994). 251 see sauvegrain, supra note 250, at 25; marc askew, cultural identity and urban change in southeast asia: interpretive essays 50 (marc askew & william stewart logan eds., 1994). 252 see, e.g., jay d. edwards, shotgun: the most contested house in america, j. vernacular architecture forum 62 (2009) (discussing various non-tax explanations for the architectural design of shotgun houses). 2019] 191 and you may ask yourself, what is that beautiful house: how tax laws distort behavior through the lens of architecture narrow.253 despite the possibility that non-tax factors such as lot size or the need for cooling might have motivated the design,254 the new orleans bar association has taken the position that the shotgun houses were probably used to avoid taxes.255 some evidence also indicated that the city of new orleans countered the use of shotgun houses with a tax calculated based on the number of hallways or closets in the building.256 there is also evidence that taxpayers responded to the new tax by minimizing the number of hallways and closets.257 however, the actual reason for such architectural design remains uncertain and debatable. vii. the direct tax of 1798 and its impacts on american architecture in the early days of the united states, despite the rarity of federal taxes, the main source of revenue for the federal government was real property taxes.258 the federal government usually apportioned the burden of such taxes among the states and allowed each state to administer its own tax system. this could lead to different enforcement regime in each state. for example, in new jersey, although the land itself has independent economic value, taxes generally applied only to land with buildings or other improvements.259 consequently, property owners reduced their tax liabilities by separating improved from unimproved parcels, in order to reduce the value of the parcels with improvements and thus subject to tax. 260 as another example, new hampshire enacted a law that made each individual property holder in a community jointly and severally liable for the entire property tax liability of that community.261 this eased the burden of accounting on the state before it could sue and seize properties of an individual for tax delinquency. the unlucky individual whose properties were seized could then sue their neighbors for contribution.262 a. the direct tax of 1798 253 see campanella, supra note 72. 254 see id. 255 see ned hemard, new orleans nostalgia: remember new orleans history, culture and traditions, new orleans bar assoc. (2018), http://www.neworleansbar.org/uploads/files/they%20all%20taxed%20for%20you_3-18.pdf [https://perma.cc/mr73-f5u5]. 256 see christian antenhofer et al., cities as multiple landscapes: investigating the sister cities innsbruck and new orleans 152-53 (2016) 257 see id. 258 see glenn w fisher, the worst tax? a history of the property tax in america 15 (1996). 259 see id. 260 id. 261 id. 262 id. http://www.neworleansbar.org/uploads/files/they%20all%20taxed%20for%20you_3-18.pdf 192 [vol. 10:2 columbia journal of tax law the direct tax of 1798 was imposed on land, residential houses and slaves.263 the federal government sought to raise $2 million in anticipation of an upcoming war with france.264 congress divided the $2 million total among the states and required that each state assess the tax. alexander hamilton, the former secretary of the treasury, favored a tax on houses over land, believing houses could be valued more accurately and were a better measurement of taxpayer wealth, using indicators like the number of rooms, wallpaper and other signs of lavishness. a tax on houses also ensured that citizens residing in urban and rural areas shared the tax burden rather than for the tax to disproportionately affect taxpayers such as farmers.265 oliver wolcott, then secretary of the treasury, was against enacting any tax at all, but if one was enacted, he preferred a land tax, believing that residences were merely a cost of living whereas farm land was a source of income and the tax would be merely a cost of producing that income. alternatively, he proposed a house tax that would initially exempt the houses of farmers and their laborers.266 ultimately, the tax was a combination of both. 267 sixty-five percent of the tax was to be on dwellings, with the remainder of the tax imposed on land and slaves.268 the tax assessed on the dwellings was based on such factors as the number of windows, the building materials used, the number of floors, and the dimension of any outhouse.269 the tax was progressive, intended to tax the wealthy at a higher rate, but the progressivity only applied to dwellings; land and slaves were taxed at fixed rates.270 it had harsh results for farmers because they often did not have liquid asset such as cash and were at risk of foreclosure if they were unable to pay the tax.271 the direct tax of 1798 was criticized by many and was unpopular with the public, triggering memories of the despised hearth taxes and window taxes imposed on many citizens in their former countries.272 for example, john williams from new york remarked before the house of representatives that a land tax would penalize owners of large tracts of land such as farmers in 263 an act authorizing the president of the united states to raise a provisional army, may 28, 1798 558-61 [hereinafter the provisional army act]; an act to provide for the valuation of lands and dwelling houses and the enumeration of slaves within the united states, july 9, 1798, 1: 580-91; an act to lay and collect a direct tax within the united states, july 14, 1798, 1: 597-604 [hereinafter the valuation act]; an act respecting alien enemies, july 6, 1798, 1: 596-97 [hereinafter the direct tax]; an act for the punishment of certain crimes against the united states, july 14, 1798, 1: 596-97; see also newman, supra note 69, at iv. 264 see james r. campbell, dispelling the fog about direct taxation, 1 brit. j. am. stud. 109, 142, 144 (2012); see also harry c. adams, the direct tax of 1798 234 (1994) (explaining that the direct tax was unpopular because the war with france was mere speculation); the provisional army act, supra note 263; the valuation act, supra note 263. 265 see campbell, supra note 264, at 142, 144 (2012); adams, supra note 264, at 234. 266 see newman, supra note 42, at 5, 31, 77; see also adams, supra note 11, at 351; dowell, supra note 42, at 390-91. 267 see campbell, supra note 264, at 142. 268 see newman, supra note 69, at 76. 269 the direct tax, the valuation act, §9; see also campbell, supra note 264, at 143 (2012). 270 see newman, supra note 70, at iv, 77; see also cynthia g. falk, architecture and artifacts of the pennsylvania germans, constructing identity in early america 101 (2008). 271 see newman, supra note 70, at 13. 272see campbell, supra note 264, at 142-43; see also adams, supra note 264, at 234; newman, supra note 69, at 20-21. 2019] 193 and you may ask yourself, what is that beautiful house: how tax laws distort behavior through the lens of architecture favor of urban residents.273 some argued that the tax burdened homeowners and farmers who improved or cultivated their land but benefited land speculators.274 one of the strongest objections to the direct tax of 1798 was that it directed accessors to count the number of windows in a dwelling.275it alarmed citizens that a window tax similar to the taxes imposed in europe had followed them to their new country.276 in truth however, there was not a tax on windows and they were not part of the assessment. rather, accessors were asked to count the windows should a window tax be enacted in the future.277 residents in pennsylvania had strong objections to the tax in part because of the large german population who were still resentful of the hearth tax imposed in germany.278 there was an active resistance to the tax resulting in the “fries rebellion.”279 the community prevented accessors from doing their jobs by blocking accessors from completing their assessments and throwing scalding hot water on any accessors who came close to their homes.280 residents in pennsylvania would also prevent foreclosures for non-payment of the tax by blocking roads.281 b. dutch colonial architecture the dutch colonial house is a famous example of architecture developed to avoid taxes imposed by the direct tax of 1798.282 a dutch colonial house typically has a gambrel roof, sometimes with flared eaves, and frequently has dormers.283 the amount of taxes under the direct tax of 1798 was partially determined by the number of floors, and, according to the federal direct tax records of 1798, gambrel-roofed houses were treated as having only one floor because the upper floor under the gambrel roof was considered an attic.284 a dutch colonial house helped to minimize taxes and at the same time had a living space equivalent to that of a two-floor building 273 see falk, supra note 270, at 101. 274 see oracle of dauphin, and harrisburg advertiser, jan. 23, 1799; see also newman, supra note 70, at 16. 275 see oracle of dauphin, and harrisburg advertiser, jan. 23, 1799; see also newman, supra note 70, at 16. 276 see newman, supra note 69, at 5, 31, 77; see also adams, supra note 11, at 351; dowell, supra note 42, at 390-91. 277 see newman, supra note 69, at 77. 278 see adams, supra note 11, at 326 (german citizens in particular despised hearth taxes that had been imposed in their former homeland and were unwilling to be subjected to them again); see also newman, supra note 69, at 20-21. 279 see adams, supra note 264, at 234; see also falk, supra note 270, at 102. 280 see gladys bucher sowers, lebanon county pennsylvania united state direct tax of 1798 2 (2006) (noting that the direct tax also was known as the hot water tax because of the hot water thrown at accessors); see also newman, supra note 69, at 13; adams, supra note 264, at 234. 281 see newman, supra note 69, at 5. 282 see noble, supra note 49, at 61. this record was discovered in returns of the united states direct tax of 1798, the new england historical and genealogical register 45, 82–83 (jan. 1891). in addition, the “board of commissioners record book, 1798," at the connecticut historical society museum in hartford contains relevant information. 283 see noble, supra note 49, at 61; eberlein, supra note 134, at 26. 284 this record was discovered in returns of the united states direct tax of 1798, the new england historical and genealogical register 45, 82–83 (jan. 1891). in addition, the “board of commissioners record book, 1798," at the connecticut historical society museum in hartford contains relevant information. 194 [vol. 10:2 columbia journal of tax law since gambrel roofs allowed the top floor to be used as a living space.285 commentators stated that “[o]f all of the types of domestic architecture . . . modified during the colonial period, none more generally commends itself to the favourable consideration of the modern home builder than the dutch colonial.”286 c. the saltbox houses “saltbox houses” are traditional new england style houses, characterized by a wooden frame house with a clapboard exterior.287 the front of the house appears to be a two-story house, while the back roofline slopes steeply down allowing for smaller space in the back.288 houses with this slanted shape date back to the colonial new england in 1650 when they were classified as a single-story house for tax purposes under a tax imposed by queen anne despite allowing for larger living space.289 the saltbox house continued in popularity as it was classified as a single story house under the direct tax of 1798 as well historically, one of the most famous saltbox houses was the birthplace of john adams, the second president of the united states. the place now belongs to a national historic park in massachusetts. viii. architectural changes from land taxes versus building taxes a. tax laws that discourage new improvements and buildings property taxes based on the value of land improvements or buildings can discourage new improvements and buildings.290 property owners, particularly speculators, might be incentivized to allow their properties to fall into disrepair or to underutilize their properties in order to lower the tax liabilities.291 further, such taxes may encourage speculators to subdivide their land into smaller, developed or undeveloped parcels, in order to minimize the value of undeveloped parcels.292 as evidence of the depressing effect on land improvement efforts, pennsylvania enacted a law in 1913, requiring the cities of pittsburgh and scranton to assess buildings at a lower rate than land.293 it was an experiment to see if the change in taxes affected the development and use of land.294 not surprisingly, following the law’s enactment, the volume of building construction increased, estimated by the number of new building permits issued. this in turn caused the market 285 see noble, supra note 49, at 61. 286 see id.at 37. 287 id.at 48. 288 jane de-forest shelton, the salt-box house: eighteenth century life in a new england town 23 (1902). 289 see id 290 see coughlan, supra note 2, at 261 (arguing that taxes on buildings may result in owners failing to maintain existing structures). 291 see del. valley reg’l planning comm’n, chasing ratables: the impact of property taxes on local planning (2005) (encouraging townships and the states to implement land value taxation to reduce speculation and bring attention to neighborhood decline); see also municipal real estate taxation, supra note 21, at 229-30. 292 see municipal real estate taxation, supra note 21, at 221-22. 293 pa. laws 1913, no. 147; see also martin, supra note 12, at 111-12. 294 see martin, supra note 12, at 111. 2019] 195 and you may ask yourself, what is that beautiful house: how tax laws distort behavior through the lens of architecture price of undeveloped land to fall and made land speculation less economically attractive.295 obviously, the new law also reduced the tax burden on homeowners.296 following the experiment, the city of pittsburgh imposed an increased tax on the value of land itself, which further encouraged residential and commercial building construction.297 australia and canada also historically modified their land tax policies to try to encourage the development of architecture and construction.298 australia in 1906 and western canada in 1892 both imposed taxes either on the value of land itself, or on the value of land plus the value of improvements and buildings with the latter at a reduced rate.299 in both cases, the result was an increase in the volume of new building construction.300 australia in particular, after the revision of the law, there was evidence that areas in economic disrepair were revitalized with new construction projects.301 b. russian tax on plowed land as another example, there was evidence that a tax on plowed farm land in russia during the seventeenth century led to underdeveloped land.302 since the tax was imposed on plowed land only, taxpayers were incentivized to leave their land uncared. land was used unproductively and families gave up farming.303 in addition, since the tax was also imposed on a one-dwelling-one-tax basis, many people chose to live together and share a common dwelling to minimize tax. this contributed to the growth of duplexes and triplexes.304 in response, tax collectors began to consider each door that gave access to the outside as a separate household.305 families using shared dwelling in turn began to board up additional doors.306 eventually, peter the great revised the tax system, eliminating the tax on plowed land, and instating a poll tax on males instead.307 ix. tax and eco-friendly building 295 see nathan farris, what to do when main street is legal again: regional land value taxation as a new urbanist tool, 164 u. pa. l. rev. 755, 766 (2016). 296 see municipal real estate taxation, supra note 21, at 233. 297 see generally nicolaus tideman & cathleen johnson, a statistical analysis of graded property taxes in pennsylvania, in 3 lincoln inst. land policy (1995); farris, supra note 295, at 775. 298 see municipal real estate taxation, supra note 21, at 238-239. 299 see id. 300 id. 301 see martin, supra note 12, at 116-17; see also coughlan, supra note 2, at 261. 302 see john wilkinson, real estate tax shelters handbook 176-77 (1980); see also adams, supra note 11, at 177 (noting previous taxes created a culture of idleness which peter the great had to overcome to incentivize citizens to work). 303 see wilkinson, supra note 302, at 177; see also adams, supra note 11, at 177. 304 see wilkinson, supra note 302, at 177; see also adams, supra note 11, at 177. 305 see wilkinson, supra note 302, at 177; see also adams, supra note 11, at 177. 306 see adam, supra note 11, at 177 (noting previous taxes created a culture of idleness which peter the great had to overcome to incentivize citizens to work). 307 see burton malkiel & charles ellis, the elements of investing 10 (2009); see also adam, supra note 11, at 177. 196 [vol. 10:2 columbia journal of tax law taxes are frequently used as inducement for decisions regarding development and conservation. 308 however, tax laws intended to change behaviors concerning environmental protection might lead to unintended architectural changes, sometimes even to the detriment of the environment.309 a. inaccurate proxy for “eco-friendly”: the leed standard many jurisdictions use the leed standard as a standard for certain favorable tax treatments in order to incentivize private research and development of eco-friendly buildings. 310 the leadership in energy and environmental design (leed) program was developed by the u.s. green building council, a non-profit organization.311 the leed standard evaluates a building for environmental sustainability in six areas: (1) location and sitting, (2) water efficiency, (3) energy and atmosphere, (4) materials and resources, (5) indoor environmental quality, and (6) innovation and design.312 earning points under the standard awards certificates of different levels which are used by many jurisdictions to determine the amount of tax credits a taxpayer is entitled to for ecofriendly initiatives. however, the leed standard itself is often exploited. for example, critics of leed standard argue that the average certified building increases the need for automobiles by 137%.313 since leed projects are usually located far from city centers,314 they sometimes necessitate additional automobile use, but automobile use associated with the project is not factored into the leed standard.315 in addition, developers often choose the cheapest ways to accumulate points, like using bamboo flooring or including bike racks, but these measures might not contribute a lot to environmental sustainability.316 it is contended that one quarter of leed certified buildings do not meet the energy saving goals.317 b. competing interests: the solar projects despite the wide use of tax incentives for the use and development of solar technology,318 solar panels and solar farms are often deemed aesthetically unappealing and undesirable (like 308 see james mcelfish, taxation effects on land development and conservation, 22 temp. envtl. l. & tech. j. 139 (2004) (noting that there has been a long relationship between tax policy and land use, but it is rarely made explicit in public policy documents). 309 see mcelfish, supra note 308, at 139 (noting that taxes can change the economic behavior regarding the transactions it targets). 310 see n.y. tax law §19 (2018); see also nancy j. king & brian j. king, creating incentives for sustainable buildings: a comparative law approach featuring the united states and the european union, 23 va. envtl. l.j. 397, 421-22 (2005). 311 the leadership in energy and environmental design, u.s. green building council, https://new.usgbc.org/ [https://perma.cc/6duk-vywy]. 312 see id. 313 see james a. kushner, affordable housing as infrastructure in the time of global warming, 42/43 urb. law. 179, 213 (2011). 314 see id. 315 id. 316 id. 317 id. at 213-14. 318 id. at 268. https://new.usgbc.org/ 2019] 197 and you may ask yourself, what is that beautiful house: how tax laws distort behavior through the lens of architecture nuisance).319 as an example, california enacted a law preventing local governments from denying permits for solar technology based exclusively on aesthetic concern and allowing denials only for safety or public health reasons.320 x. conclusion although the primary goal of a tax is to raise revenue, there are times when it is used to induce certain behaviors or actions. there are also times when tax laws are enacted solely to induce certain behaviors. often, a tax distorts taxpayer behaviors beyond their expectations, sometimes in direct contravention of what the law was enacted to incentivize. much of my previous scholarship has explored the same phenomenon with a focus on corporate tax. this article serves as an illustration and proof of the distortion that results when tax laws are designed to target a class of people or action as a proxy for something else. architecture is the perfect example though which such distortion can be viewed directly and intuitively: it is right in front of us. 319 id. at 251. 320 cal. gov’t code sec. 65850.5(b) (west 2018). automobiles, tax mischaracterizations, and determining an asset’s tax basis in the absence of a meaningful transfer tax regime jay a. soled & richard l. schmalbeck* abstract until recently, in those circumstances where there was a valuation range with respect to a particular asset, executors faced a choice: among estates subject to the estate tax, declaring a high value would increase the estate tax liability; however, due to the internal revenue code’s “basis equal to fair market value” rule applicable at death, declaring a low value would expose heirs to a greater capital gains tax on subsequent asset disposition. because the estate tax rates were higher and that tax was immediate (as opposed to deferred until a later sale by the heir), executors typically minimized asset values, with the corresponding effect of tax basis diminishment. this commonplace strategy thus negated the possibility that taxpayers might exploit the basis equal to fair market rule. but this is often no longer the case. through a series of exemption level increases, tax rate reductions, and other reforms, congress has gutted the nation’s transfer tax system. what remains is a teetering transfer tax system that applies only to a handful of the wealthiest taxpayers. for the rest, the transfer tax system provides no disincentive to executors from assigning the highest defensible valuations to a decedent’s assets, opening the opportunity to capitalize upon the basis equal to fair market value rule. unfortunately, the i.r.s. lacks the tools and resources to combat this practice. to preserve the integrity of the capital gains tax and the revenue that it produces, congress must therefore intercede. * jay a. soled is a professor at rutgers business school and directs its masters of taxation program and richard l. schmalbeck is the simpson thacher & bartlett professor of law at duke law school. 50 [vol.10:1 columbia journal of tax law table of contents i. introduction ............................................................................................................... 51 ii. the prior tax paradigm .................................................................................... 52 a. the nation’s formerly robust transfer tax regime ........................................ 53 b. disappearing asset value ................................................................................... 54 c. the basis equal to fair market value rule ....................................................... 57 d. the estate planning bar’s role .......................................................................... 59 iii. the new tax paradigm ....................................................................................... 60 a. the gutting of the transfer tax system ............................................................ 61 b. tax burden levied on capital income ............................................................... 62 iv. the aftermath: tax basis maximization ................................................. 64 a. taxpayer objective: exploitation of the basis equal to fair market value rule 65 b. asset basis maximization methodologies.......................................................... 66 c. i.r.s. challenges in policing the tax basis problem ......................................... 70 d. need for congressional reform ......................................................................... 71 v. conclusion ............................................................................................................... 74 2018] 51 determining an asset’s tax basis in the absence of a meaningful transfer tax regime i. introduction for close to a century, when the federal transfer tax system (comprised of the gift, estate, and generation-skipping transfer taxes) broadly applied to estates of decedents with any significant wealth, an important goal of estate planners was to minimize value of a decedent’s assets reported for estate tax purposes.1 and for good reason: from 1941-1976, the top marginal estate tax rate was 77% (applying to taxable estates in excess of $10,000,000), and, as recently as 2001, the top rate was 55% (applying to taxable estates in excess of $3,000,000).2 but over the course of the last two decades, congress has gutted the nation’s transfer tax system. beginning with the passage of the economic growth and tax relief reconciliation act of 20013 and ending in 2017 with the tax cuts and jobs act,4 the amount that taxpayers can transfer free of transfer tax has risen approximately twenty-fold, from $675,000 to $11,180,000.5 in addition, over the course of the same time period, the top transfer tax rate has been reduced from 55% to 40%.6 the combination of a huge transfer tax exemption and a lower top tax rate, together with the fact that the vast majority of state legislatures have repealed their estate taxes,7 has left the estate tax essentially a shell of its former self – applicable to less than .01% of all 1 see, e.g., james r. repetti, minority discounts: the alchemy in estate and gift taxation, 50 tax l. rev. 415, 416 (1995) (“a common tool of estate planning involves the purposeful diminution in value of family property in order to reduce estate and gift taxes.”); william s. blatt, minority discounts, fair market value, and the culture of estate taxation, 52 tax l. rev. 225, 225 (1997) (“the allowance of minority discounts encourages transactions designed to reduce transfer taxes.”); joseph m. dodge, redoing the estate and gift taxes along easy-to-value lines, 43 tax l. rev. 241, 244 (1988) (“[v]irtually all of the transfer tax loopholes involve undervaluation of gratuitous transfers with the blessing of existing law.”); mary louise fellows & william h. painter, valuing close corporations for federal wealth transfer taxes: a statutory solution to the disappearing wealth syndrome, 30 stan. l. rev. 895 (1978) (“disappearing wealth occurs in two situations. first, if a controlling shareholder makes one or more inter vivos gifts of minority blocks so that he divests himself of control . . . . [s]econd, the value incident to de facto control over a corporation is not subject to the transfer taxes . . . .”). 2 darien b. jacobson, brian g. raub & barry w. johnson, the estate tax: ninety years and counting, i.r.s. statistics of income bulletin, summer 2007, at 122. 3 economic growth and tax relief reconciliation act of 2001, pub. l. no. 107-16, 115 stat. 38 (2001). 4 tax cuts and jobs act, pub. l. no. 115-97, 131 stat. 2054 (2017). 5 id. at § 11061(a). in 2001, the federal estate tax exemption was $675,000; in 2018, this same dollar figure would have a purchasing power equivalent to about $955,000. see federal reserve bank of minneapolis, consumer price index, 1913-2018, https://www.minneapolisfed.org/community/financial-and-economic-education/cpicalculator-information/consumer-price-index-and-inflation-rates-1913 [https://perma.cc/4mhu-4csn]. that being the case, under inflation-adjusted dollar figures, the increase in the exemption amount is approximately twelve-fold. 6 i.r.c. § 2001(c). 7 see, e.g., ashlea ebeling, where not to die in 2018, forbes (dec. 21, 2017, 3:00 pm) https://www.forbes.com/sites/ashleaebeling/2017/12/21/where-not-to-die-in-2018/#16c43bd85b1b [https://perma.cc/n8fv-yzpl]. see generally jeffrey a. cooper, interstate competition and state death taxes: a modern crisis in historical perspective, 33 pepp. l. rev. 835, 881 (2006); jeffrey a. cooper, john r. ivimey & donna d. vincenti, state taxes after egtrra: a long day’s journey, 17 quinnipiac prob. l.j. 90, 92 (2003) (“in an effort to reduce the fiscal impact of federal tax cuts, the federal government effectively repealed the entire death tax system of over 30 states. ending nearly 80 years of revenue sharing, congress and the president effectively told the states to fend for themselves on the issue of estate taxation, and fend for themselves they have [by eliminating their estate taxes].”). https://1.next.westlaw.com/link/document/fulltext?findtype=y&sernum=0102901249&pubnum=1247&originatingdoc=i69c3e3014a8611db99a18fc28eb0d9ae&reftype=lr&fi=co_pp_sp_1247_254&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search)#co_pp_sp_1247_254 https://1.next.westlaw.com/link/document/fulltext?findtype=y&sernum=0102901249&pubnum=1247&originatingdoc=i69c3e3014a8611db99a18fc28eb0d9ae&reftype=lr&fi=co_pp_sp_1247_254&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search)#co_pp_sp_1247_254 https://1.next.westlaw.com/link/document/fulltext?findtype=y&sernum=0306383483&pubnum=1239&originatingdoc=i69c3e3014a8611db99a18fc28eb0d9ae&reftype=lr&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search) https://1.next.westlaw.com/link/document/fulltext?findtype=y&sernum=0306383483&pubnum=1239&originatingdoc=i69c3e3014a8611db99a18fc28eb0d9ae&reftype=lr&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search) https://1.next.westlaw.com/link/document/fulltext?findtype=y&sernum=0306383483&pubnum=1239&originatingdoc=i69c3e3014a8611db99a18fc28eb0d9ae&reftype=lr&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search) 52 [vol.10:1 columbia journal of tax law decedent taxpayers (or one in every 10,000 decedents).8 the foregoing transfer tax reforms have been a true valuation game-changer. because in most instances the internal revenue code (“code”) no longer imposes an estate tax, the incentive to minimize estate asset values no longer exists. due to the basis equal to fair market value rule applicable at death,9 it is now common to maximize asset values to defeat or lighten capital gain tax burdens.10 put somewhat differently, executors, personal representatives, and administrators are apt to use the highest justifiable date of death asset values in order to minimize or eliminate the future income tax burdens of a decedent’s heirs.11 furthermore, except in extreme cases, this new tactic of augmenting a decedent’s tax basis in the assets owned at death will likely be accomplished without significant interference from the i.r.s., which lacks the resources to monitor inflated valuation determinations.12 this analysis tracks how congressional actions have unraveled the dynamic between the transfer and income tax systems that historically kept the date of death valuation process in check. section ii overviews the prior tax paradigm and how taxpayers then conducted their testamentary affairs. section iii describes the new tax paradigm and taxpayers’ and the estate planning bar’s predominant concerns. next, section iv summarizes taxpayers’ newly-minted tax-minimization strategies and what, if anything, the i.r.s. and congress can do to combat these ploys. finally, section v concludes. ii. the prior tax paradigm over the course of the past century, the income tax and transfer tax regimes have coexisted. 8 sasha a. klein & mark r. parthemer, the new tax law: it’s déjà vu all over again, 32 prob. prop. 40, 43 (2018) (“[raising the basic transfer tax exclusion amount from $5 million to $10 million] will result in a substantial further reduction in taxable estates, estimated to decline from .02% to .01% of taxpayers (or one in every 10,000 decedents).”). for a small number of decedents, the transfer-tax system thus continues to apply, and the old choice between reducing the estate tax at the cost of increasing the capital gains taxes faced by heirs will operate in much the same way as it always has. admittedly, this small number of decedents holds considerable wealth. for the most recent year for which data are available (decedents dying in 2013), while the nationwide number of estates having assets of more than $20 million numbered only 1,228, the aggregate value of the assets owned by these estates were in excess of $82 billion, constituting a bit more than half of all assets reported on estate tax returns for that year. i.r.s. statistics of income division, soi tax stats estate tax statistics year of death table 1, i.r.s. (2017), https://www.irs.gov/statistics/soi-tax-stats-estate-tax-statistics-year-of-death-table-1 [https://perma.cc/a9uh-xusj]. 9 i.r.c. § 1014(a). 10 i.r.c. § 1(h). see also health care and education reconciliation act of 2010, pub. l. no. 111-152, §1402, 124 stat. 1029, 1060-61 (taxpayers whose incomes exceed specified thresholds incur an additional 3.8% tax on capital income, including capital gains). 11 see section iv.b, infra. 12 see nat’l taxpayer advocate, annual report to congress vii (2017) (“funding cuts have rendered the irs unable to provide acceptable levels of taxpayer service, unable to upgrade its technology to improve its efficiency and effectiveness, and unable to maintain compliance programs that both promote compliance and protect taxpayer rights.”); chuck marr & cecile murray, ctr. on budget and policy priorities, irs funding cuts compromise taxpayer service and weaken enforcement 1 (2016) (“the internal revenue service (irs) budget has been cut by 17 percent since 2010, after adjusting for inflation, forcing the irs to reduce its workforce, severely scale back employee training, and delay much-needed upgrades to information technology systems.”). https://www.irs.gov/statistics/soi-tax-stats-estate-tax-statistics-year-of-death-table-1 2018] 53 determining an asset’s tax basis in the absence of a meaningful transfer tax regime while the two tax systems were not intertwined,13 congress instituted several measures designed to ensure that each was in sync with the other.14 this symbiotic relationship extended to the area of asset valuations: the “bite” of the estate tax regime was somewhat lessened by the application of the basis equal to fair market rule applicable upon death to a decedent’s assets. the next four subsections explore the depth of this interrelationship, examining (a) the nation’s formerly robust transfer tax regime, (b) taxpayers’ valuation minimization strategies, (c) the basis equal to fair market value rule, and (d) the estate bar’s role in this process. a. the nation’s formerly robust transfer tax regime the exact catalyst for creation of the nation’s transfer tax system is unclear. certainly, it was a means of meeting the country’s need for revenue;15 another important function it served was to curtail inherited wealth and the power associated therewith.16 whatever the reasons, congress enacted the nation’s modern estate tax in 191617 and it has been an almost continuous feature of the code ever since.18 at inception, the estate tax regime was simple. with a relatively high exemption (i.e., $50,000),19 and a top rate of 10%, it applied to very few decedent taxpayers’ estates and did not burden those estates tremendously. furthermore, since there was initially no tax on inter vivos gifts, estate taxes could be easily avoided to the extent that living taxpayers were willing to part with all or some of their estates prior to their deaths. recognizing that the inter vivos gift option threatened the integrity of the estate tax, congress, in 1924, enacted a gift tax to complement the estate tax.20 a few years later, it lowered the transfer tax exemption amount to $40,000 and subsequently raised the highest estate tax rate 13 see, e.g., farid-es-sultaneh v. comm'r, 160 f.2d 812, 814-15 (2d cir. 1947) (“[t]he income tax provisions are not to be construed as though they were in pari materia with either the estate tax law or the gift tax statutes.”). 14 see, e.g., i.r.c. § 691(c) (permitting an income tax deduction for any estate taxes paid in connection with income with respect to decedent items included in the taxpayer’s estate (e.g., retirement plan proceeds)); i.r.c. § 2053(a) (permitting an estate tax deduction for state income taxes a decedent taxpayer may owe at the time of death). 15 see, e.g., joel c. dobris, a brief for the abolition of all transfer taxes, 35 syracuse l. rev. 1215, 121617 (1984) (stating that the first federal estate tax was enacted in 1916 as a war tax); louis eisenstein, the rise and decline of the estate tax, 11 tax l. rev. 223, 230 (1956) (reciting the ways and means committee's view that death taxation would be a large source of revenue). 16 see, e.g., paul l. caron & james r. repetti, occupy the tax code: using the estate tax to reduce inequality and spur economic growth, 40 pepp. l. rev. 1255, 1277 (2013) (explaining how the federal wealth transfer tax reduces wealth transfers from the largest estates to their heirs). 17 revenue act of 1916, pub. l. no. 64-271, 39 stat. 756 (1916). 18 in 2010, the estate tax was made optional. see tax relief, unemployment insurance reauthorizations, and job creation act of 2010, pub. l. no. 111-312, 124 stat. 3301 (2010). as a result, in that year, few estates paid such a tax. see, e.g., robert gordon, david joulfaian & james poterba, revenue and incentive effects of basis step-up at death: lessons from the 2010 "voluntary" estate tax regime, 106 am. econ. rev. 662, 663 (2016). 19 revenue act of 1916, supra note 17, at § 201. the $50,000 exemption in 1916 would have a current, inflation-adjusted value of about $1,150,000. see federal reserve bank of minneapolis, consumer price index, 19132018, https://www.minneapolisfed.org/community/financial-and-economic-education/cpi-calculatorinformation/consumer-price-index-and-inflation-rates-1913 [https://perma.cc/4mhu-4csn]. 20 revenue act of 1924, pub. l. no. 68-176, §§ 319-324, 43 stat. 253, 313-16. https://1.next.westlaw.com/link/document/fulltext?findtype=y&sernum=1947115031&pubnum=350&originatingdoc=ieba6491596d811e08b05fdf15589d8e8&reftype=rp&fi=co_pp_sp_350_814&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search)#co_pp_sp_350_814 54 [vol.10:1 columbia journal of tax law to 77%.21 admittedly, the road to a robust transfer tax system had a few bumps, including a puzzling repeal of the new gift tax in 1926,22 followed by its restoration in 1932.23 indeed, by the end of world war ii, the nation’s transfer tax had matured to the point of reaching most estates that contained significant wealth, rendering it a serious source of federal revenues.24 during the decades following world war ii, the nation’s transfer tax system continued to mature and stabilize.25 in part, its success was propelled by the fact that, during the approximately six decades that followed (1940-2000), the exemption amount and transfer tax rates remained relatively constant.26 furthermore, in 1976, to further augment the integrity of the nation’s estate and gift taxes, congress introduced the generation-skipping transfer tax.27 this tax was designed to curtail taxpayers (commonly, grandparents) from gifting or bequeathing their assets and estates to others (commonly, grandchildren or great-grandchildren) who were two or more generations younger than themselves, thereby eliminating one generational level of transfer tax exposure.28 while imperfect, the nation’s three-pronged transfer tax system, composed of the estate, gift, and generation-skipping transfer taxes, has not only richly contributed to the nation’s revenue base,29 but has also somewhat reduced the flow of inherited wealth and inhibited the creation and perpetuation of dynasties. by way of example, in 1976, the transfer tax regime was hitting its full stride. that year, it produced nearly 2.6% of overall federal revenue, and reached nearly eight percent of all decedents’ estates.30 for several more decades, at least in terms of revenue collection, until 2001, this state of affairs regarding the status of the transfer tax regime was to remain largely intact.31 b. disappearing asset values how the transfer tax system shapes taxpayers’ testamentary affairs is evident in the sphere of asset valuation. for the past century, taxpayers have gone to great lengths to minimize their transfer tax burdens, chiefly by reporting the lowest defensible values associated with a decedent’s assets.32 21 jacobson, supra note 2. 22 revenue act of 1926, pub. l. no. 69-20, § 324, 44 stat. 9, 86. 23 revenue act of 1932, pub. l. no. 72-154, §§ 501-532, 47 stat. 169, 245-59. 24 jacobson, supra note 2, at 125. 25 see, e.g., eddie metrejean & cheryl metrejean, death taxes in the united states: a brief history, 7 j. bus. & econ. res. 33, 36 (2009) (“the estate tax enacted in 1916 set the standard for what the estate tax would be for the next 50 years. other than rate and exemption changes and several other minor changes, the estate tax remained largely unchanged until 1976.”). 26 jacobson, supra note 2. the 77% top rate consistently applied from 1941 until 1976. 27 tax reform act of 1976, pub. l. no. 94-455, § 2006(a), 90 stat. 1520, 1879. the tax reform act of 1986 retroactively repealed the 1976 generation-skipping transfer tax and replaced it with chapter 13 of the code. tax reform act of 1986, §§ 1431-1433, pub. l. no. 99-514, 100 stat. 2712, 2717. 28 see, e.g., howard e. abrams, rethinking generation-skipping transfers, 40 sw. l.j. 1145, 1145 (1987) (“the very wealthy, though, use cascading life estates and special powers of appointment to approximate outright transfers while avoiding the periodic imposition of transfer tax.”). 29 jacobson, supra note 2, at 125. 30 id. 31 id. 32 see generally james r. repetti, minority discounts: the alchemy in estate and gift taxation, 50 tax l. rev. 415 (1995) (describing the techniques taxpayers employ to temporarily diminish asset values); george cooper, https://1.next.westlaw.com/link/document/fulltext?findtype=l&pubnum=1077005&cite=uuid(i1b025698b7-c649ce94a44-d3854ef6d0a)&originatingdoc=ia4f722214a4511db99a18fc28eb0d9ae&reftype=sl&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search) https://1.next.westlaw.com/link/document/fulltext?findtype=l&pubnum=1000546&cite=26uscas90&originatingdoc=ia4f722214a4511db99a18fc28eb0d9ae&reftype=lq&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search) https://1.next.westlaw.com/link/document/fulltext?findtype=l&pubnum=1077005&cite=uuid(i4b69eee9a1-e642eca21e4-01f8d0a45cf)&originatingdoc=i43ebb8c14b2011db99a18fc28eb0d9ae&reftype=sl&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search) https://1.next.westlaw.com/link/document/fulltext?findtype=y&sernum=0101588712&pubnum=1243&originatingdoc=ia4f722214a4511db99a18fc28eb0d9ae&reftype=lr&fi=co_pp_sp_1243_1145&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search)#co_pp_sp_1243_1145 https://1.next.westlaw.com/link/document/fulltext?findtype=y&sernum=0106697207&pubnum=1247&originatingdoc=id93d1571472611db876784559e94f880&reftype=lr&fi=co_pp_sp_1247_424&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search)#co_pp_sp_1247_424 https://1.next.westlaw.com/link/document/fulltext?findtype=y&sernum=0106697207&pubnum=1247&originatingdoc=id93d1571472611db876784559e94f880&reftype=lr&fi=co_pp_sp_1247_424&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search)#co_pp_sp_1247_424 2018] 55 determining an asset’s tax basis in the absence of a meaningful transfer tax regime in the transfer tax system, asset valuations have thus always been contentious, sparking much litigation involving recurring taxpayer valuation ploys.33 ultimately, congress choose to respond by enacting chapter 14 of the code, which is entitled “special valuation rules.”34 despite its brevity, this chapter sought to deter a broad range of taxpayer valuation minimization schemes.35 a voluntary tax? new perspectives on sophisticated estate tax avoidance, 77 colum. l. rev. 161, 195 (1977) (“[a]n extraordinarily productive technique for reducing taxes on these transfers is to exploit valuation uncertainties. aggressive tax lawyers have developed a package of valuation stratagems which cuts deeply into the estate and gift tax base.”). 33 in particular, the following four ploys were widely used: • recapitalizing family-owned businesses with two-tiered capital structures. older family members would receive preferred stock with rich dividend and liquidation rights, while younger members would get, by gift, common stock with little current value, but substantial growth potential. see, e.g., h.r. rep. no. 391, pt. 2, reprinted in 1987 u.s.c.c.a.n. 2313-378, 657-60 (detailing how corporate and partnership arrangements were enabling taxpayers to defeat their transfer tax obligations); h.r. rep. no. 795, at 422 (1988) (explaining how taxpayers orchestrated their business affairs to minimize their transfer tax exposure). see generally byrle m. abbin, taking the temperature of asset value freeze approaches: what’s hot, what’s not, 66 taxes 3 (1988); • utilizing a grantor retained income trust (or grit) that was designed to bloat the value of a retained interest in the transferor’s hands in order to diminish the value of the transferred trust remainder interest passing to transferees. see, e.g., john r. price, contemporary estate planning § 9.43 (1992); boris i. bittker & lawrence lokken, 5 federal taxation of income, estates and gifts ¶136.4.1; stephens et al., federal estate and gift taxation ¶ 4.08 [9] [e] (6th ed. 1991); see also staff of joint comm. on tax'n, 101st cong., federal transfer tax consequences of estate freezes 12 (comm. print 1990); richard a. oshins, grits, splits and tidbits, 126 tr. & est. 28, 28 (1987); • adding certain rights and restrictions to business agreements involving familyowned businesses with the intent of constraining asset value of those family members in the older generation. see, e.g., brent b. nicholson, holman v. commissioner: a death knell for the tax value of transfer restrictions in family limited partnerships?, 2 wm. & mary bus. l. rev. 291 (2011) (explaining how taxpayers, to minimize the value of business assets, sought to exploit transfer restrictions)); and • instituting voting or liquidation rights in the hands of senior family member’s hands that were purposefully designed to lapse upon death (or other event), augmenting thereby the value of the interests held by junior family members. see, e.g., jerald david august, planning for lapsing rights and restrictions – the impact of section 2704 on valuation, 82 j. tax’n 342 (1995) (explaining how taxpayers manipulated voting and liquidation rights); estate of harrison v. comm’r., 52 t.c.m. 1306 (1987) (holding that when the taxpayer’s right of partnership liquidation lapsed at death, the taxpayer’s representatives could, in valuing the partnership interest, rightfully ignore the value associated with this liquidation right). 34 chapter 14 of the internal revenue code, entitled “special valuation rules,” was enacted under the omnibus budget reconciliation act of 1990, pub. l. no. 101-508, § 11602, 104 stat. 1388. see h.r. 5835, 101st cong. § 11602 (1990). 35 the four code sections that comprise the entirety of chapter 14 and their objectives are listed seriatim. i.r.c. § 2701: with respect to transfers made to family members of controlled business enterprises, the code requires that a retained senior equity interest (e.g., preferred stock) be valued at zero unless it includes a right to a “qualified payment” (i.e., a cumulative right to periodic dividends or other distributions at a fixed rate). i.r.c. § 2702: modeled after split-interest charitable trusts, this code section essentially requires a retained term interest held in trust to be expressed as an annuity or unitrust interest; any other retained interest is deemed to be of zero value, making the entirety of the trust contribution fully taxable. https://1.next.westlaw.com/link/document/fulltext?findtype=y&sernum=0341428720&pubnum=0003050&originatingdoc=i3d34c73e39de11e698dc8b09b4f043e0&reftype=lr&fi=co_pp_sp_3050_195&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search)#co_pp_sp_3050_195 https://1.next.westlaw.com/link/document/fulltext?findtype=l&pubnum=1077005&cite=uuid(i0b2d0c6475-e74e4f8d9ad-773c5f92731)&originatingdoc=iedfa6321227111dbbab99dfb880c57ae&reftype=sl&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search) 56 [vol.10:1 columbia journal of tax law but congressional loophole-closing action was met with stiff taxpayer opposition. to mitigate their transfer tax burdens, taxpayers quickly turned to two transfer-tax avoidance tactics, namely, (a) valuation discounts and (b) the use of grantor retained annuity trusts. consider each. (a) valuation discounts. after congress enacted chapter 14, taxpayers began an ambitious campaign to “wrap” their assets in closely-held business arrangements (i.e., partnerships, limited liability companies, and corporations) and then transfer their asset ownerships in ways that, for transfer tax reporting purposes, allow reporting of significant minority and marketability valuation discounts, ranging as high as 70%.36 a simple example illustrates how taxpayers (with the assistance of their advisors) chose to orchestrate their personal affairs. assume taxpayer j owns $10 million of apple stock. she forms a limited liability company, funding it with all of her apple stock. a week later she transfers a 49% minority interest in the limited liability company to her daughter. rather than report the value of the gifted interest to be $4.9 million (i.e., $10 million x .49), after taking a 30% marketability and minority interest discounts, she may report the value of the gifted interest to be $3.43 million ($4.9 million – ($4.9 million x .3)). over the course of the last two decades, taxpayer j and many similarly-situated taxpayers have utilized valuation discounts to diminish the value of the assets they gift and bequeath, meeting with significant judicial success.37 indeed, a few years after the passage of chapter 14, even the i.r.s. conceded that some valuation discounts are appropriate in certain circumstances.38 and despite many academics and politicians decrying the use of this valuation strategy,39 taxpayers have continued to take aggressive valuation discounts for gift, estate, and generation-skipping transfer tax reporting purposes. (b) grantor retained annuity trusts (grats). with chapter 14’s enactment, congressional members thought they had eliminated the ability of taxpayers to make transfers into i.r.c. § 2703: unless an enumerated exception applies, this code section declares that all property valuation computations should be conducted by disregarding “(1) any option, agreement, or other right to acquire or use the property at a price less than the fair market value of the property (without regard to such option, agreement, or right), or (2) any restriction on the right to sell or use such property.” i.r.c. § 2704: in the context of a family-owned business, this code section states that the lapse of a voting or liquidation right can give rise to a taxable gift or inclusion in the holder’s estate, whichever is applicable. 36 martin v. comm’r, 149 t.c. 12 (1985). the practice of valuation discounts has been widespread. see, e.g., ronald h. jensen, the magic of disappearing wealth revisited: using family limited partnerships to reduce estate and gift tax, 1 pitt. tax rev. 155 (2004); justin p. ransome & vinu santchit, valuation discounts for estate and gift taxes, j. of accountancy (2009), https://www.journalofaccountancy.com/issues/2009/jul/20091463.html [https://perma.cc/jrv7-4b96]. 37 see, e.g., wendy c. gerzog, kelley: a green light for flps, 109 tax notes 1467 (2005); wendy c. gerzog, return to senda: order determinative for flp discounts, 110 tax notes 791 (2006); espen robak, recent cases suggest how to maximize the marketability discount, 31 est. plan. 605 (2004). 38 see rev. rul. 93-12, 1993-1 c.b. 202 (“[m]inority discount will not be disallowed solely because a transferred interest, when aggregated with the interests held by family members, would be a part of a controlling interest.”). 39 see, e.g., treasury dep't, tax reform for fairness, simplicity, and economic growth 386-87 (1984) (expounding a proposal to curtail minority discounts); george cooper, a voluntary tax? new perspectives on sophisticated estate tax avoidance, 77 colum. l. rev. 161, 195-204 (1977) (pointing out how taxpayers make wealth artificially disappear). https://1.next.westlaw.com/link/document/fulltext?findtype=y&sernum=0341428720&pubnum=3050&originatingdoc=i69c3e3014a8611db99a18fc28eb0d9ae&reftype=lr&fi=co_pp_sp_3050_201&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search)#co_pp_sp_3050_201 https://1.next.westlaw.com/link/document/fulltext?findtype=y&sernum=0341428720&pubnum=3050&originatingdoc=i69c3e3014a8611db99a18fc28eb0d9ae&reftype=lr&fi=co_pp_sp_3050_201&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search)#co_pp_sp_3050_201 2018] 57 determining an asset’s tax basis in the absence of a meaningful transfer tax regime trust that would enable them to circumvent their transfer tax obligations. they were wrong. creative tax advisors devised a transfer tax strategy that turned newly enacted code section 2702 upside down: taxpayers would transfer assets into trust, retain a large annuity amount, and report the fair market value of the gifted remainder interest to be zero.40 if the contributed trust assets produced yields or appreciated in value in excess of the applicable federal interest rate, wealth would inure free of transfer tax to the trust remainder beneficiaries; if the contributed trust assets failed to produce yields or appreciate value in excess of the applicable federal rate, there was no downside risk to the taxpayer (who, in making the trust contribution and reporting a $0 gift, had not used any portion of his lifetime exemption amount). to illustrate, suppose taxpayer k is the sole owner of stock in a closely-held business, worth $10 million. suppose further that taxpayer k establishes a grat with a three-year term in a month when the applicable federal interest rate is 4.6%, and transfers her stock to the grat. assuming taxpayer k retains a 36.45% annuity interest (i.e., each year, for the next three years, the trust must pay a $3,645,000 annuity to taxpayer k), then the fair market value of the remainder interest would be zero. however, at the end of the trust term, assuming the business was able to produce income or increase in value in excess of the applicable federal rate, any trust assets remaining at the end of the three-year term would pass tax free to the trust’s designated beneficiaries. as long as the transfer tax regime has remained vibrant, taxpayers have employed both predictable and ingenious methods to diminish the value of those assets they intend to gift and bequeath. and their efforts have generally met with judicial success and begrudging administrative acquiescence by the i.r.s.41 c. the basis equal to fair market value rule in the income tax sphere, the code instructs that, at death, the tax bases of a decedent’s 40 jerome j. caulfield, the quest for the zeroed-out grat: walton says it can be done, 28 est. plan. 251 (2001); carlyn s. mccaffrey, lloyd leva plaine & pam h. schneider, the aftermath of walton: the rehabilitation of the fixed-term, zeroed-out grat, 95 j. tax’n 325 (2001). 41 two concessions should be noted. first, absent a ready marketplace, such as a stock exchange, there is usually a range of possible values that can be assigned to any asset. the valuation standard is “the price at which such property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell, and both having reasonable knowledge of the relevant facts.” treas. reg. § 25.2512-1(a). particularly in the case of real estate or the stock in a closely-held business, the range of possible valuations may be great indeed. the second concession is that not all assets, such as publicly-traded stock, are difficult to value. however, remember that even the easy-to-value assets may be wrapped in entity structures, which entitle their owners to exploit valuation discounts. see, e.g., mccord v. comm’r, 120 t.c. 358 (2003) (stating that valuation are discounts permitted for ownership interest in family limited partnership which owned stock, bonds, real estate, oil and gas investments, and other closely-held business interests); lappo v. comm’r, 86 t.c.m. (cch) 333 (2003) (applying the valuation discount to a family limited partnership that owned marketable securities and real property); peracchio v. comm’r, 86 t.c.m. (cch) 412 (2003) (applying the valuation discount to a family limited partnership that owned cash and marketable securities). 58 [vol.10:1 columbia journal of tax law assets should equal their fair market value.42 although this rule’s origins are not entirely clear,43 it has been one of the code’s cornerstones for nearly a century. while there are several reasons congress has chosen to retain this rule, the one most commonly cited is that of administrative convenience. that is, it is sometimes difficult or impossible to identify the tax basis that decedents may have in some of their assets acquired years or decades earlier.44 the basis equal to fair market value rule at death obviates the need for taxpayers’ heirs to ascertain this information. in light of the administrative convenience associated with the basis equal to fair market value rule, efforts to repeal it have been met with stiff resistance. congress has tried twice. the first time was in 1976,45 but the public outcry against repeal was so loud that congress quickly suspended it, 46 and ultimately rescinded it. 47 the second time was in 2001 when congress instituted a one-year carryover tax basis rule;48 again, congress lacked the will to make this stick, opting instead to make its application elective.49 the basis equal to fair market rule thus remains unscathed, despite significant misgivings regarding its inequity and the fact that technological advances that have made tremendous strides towards facilitating the tax basis identification of a decedent’s assets.50 and while the debate on whether congress should retain the basis equal to fair market value rule continues to rage, the revenue losses associated this rule’s retention grow. each year, the treasury department provides cost estimates associated with those code provisions that deviate from the haig-simons definition of income.51 these estimates are known as the tax expenditure budget.52 in 2018 alone, the estimated cost associated with maintaining the basis equal to fair market value rule was a staggering $54 billion.53 but this tax expenditure is about to climb significantly. for nearly a century, the 42 i.r.c. § 1014(a). 43 see lawrence zelenak, figuring out the tax: congress, treasury, and the design of the early modern income tax 83-109 (2018) (explaining code section 1014’s obscure origins). 44 see id. at 110-32 (explaining why, for the past century, congress has chosen to retain code section 1014). 45 tax reform act of 1976, pub. l. no. 94-455, § 2005, 90 stat. 1520, 1872. 46 revenue act of 1978, pub. l. no. 95-600, § 515, 92 stat. 2763, 2884. 47 crude oil windfall profit tax act of 1980, pub. l. no. 96-223, § 401(a), 94 stat. 229, 299. 48 economic growth and tax relief reconciliation act of 2001, pub. l. no. 107-16, § 501, 115 stat. 38, 6869 (though enacted in 2001, according to its terms, this rule was not to go into effect until 2010). 49 tax relief, unemployment insurance reauthorization, and job creation act of 2010, pub. l. no. 111312, § 301(c), 124 stat. 3296. 50 see richard schmalbeck, jay a. soled & kathleen delaney thomas, advocating a carryover tax basis regime, 93 notre dame l. rev. 109, 128-32 (2017) (detailing technological advances that facilitate tax basis identification). 51 see u.s. dep’t of the treasury, tax expenditures (2017) 2, https://www.treasury.gov/resourcecenter/tax-policy/documents/tax-expenditures-fy2019.pdf [https://perma.cc/39xp-y9wh] (“the normal tax baseline is patterned on a practical variant of a comprehensive income tax, which defines income as the sum of consumption and the change in net wealth in a given period of time.”). 52 see steven a. dean, the tax expenditure budget is a zombie accountant, 46 u.c. davis l. rev. 265, 267 (2012) (“[t]he tax expenditure budget computes the dollar cost of a wide range of tax breaks.”). 53 office of mgmt. & budget, fiscal year 2018: analytical perspectives of the u.s. government, 131 tbl.13-1, item 72, https://www.whitehouse.gov/sites/whitehouse.gov/files/omb/budget/fy2018/spec.pdf [https://perma.cc/bj96-jt4k]. https://1.next.westlaw.com/link/document/fulltext?findtype=l&pubnum=1077005&cite=uuid(i1b025698b7-c649ce94a44-d3854ef6d0a)&originatingdoc=id2e2e808e13d11e79bf099c0ee06c731&reftype=sl&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search) https://1.next.westlaw.com/link/document/fulltext?findtype=l&pubnum=1077005&cite=uuid(i061eb5f62c-f6451ea7d29-9ba5053cc9b)&originatingdoc=id2e2e808e13d11e79bf099c0ee06c731&reftype=sl&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search) https://1.next.westlaw.com/link/document/fulltext?findtype=l&pubnum=1077005&cite=uuid(icb7a82d214-7744e58ab82-aebf5fcd9df)&originatingdoc=id2e2e808e13d11e79bf099c0ee06c731&reftype=sl&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search) https://1.next.westlaw.com/link/document/fulltext?findtype=l&pubnum=1077005&cite=uuid(ia4b2566fe2-9240e98ea8e-fb5311ac482)&originatingdoc=id2e2e808e13d11e79bf099c0ee06c731&reftype=sl&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search) https://1.next.westlaw.com/link/document/fulltext?findtype=l&pubnum=1077005&cite=uuid(ia4b2566fe2-9240e98ea8e-fb5311ac482)&originatingdoc=id2e2e808e13d11e79bf099c0ee06c731&reftype=sl&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search) https://1.next.westlaw.com/link/document/fulltext?findtype=l&pubnum=1077005&cite=uuid(ia4b2566fe2-9240e98ea8e-fb5311ac482)&originatingdoc=id2e2e808e13d11e79bf099c0ee06c731&reftype=sl&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search) 2018] 59 determining an asset’s tax basis in the absence of a meaningful transfer tax regime exploitation of the basis equal to fair market value rule has always been kept in check by the nation’s modest transfer tax regime, a key feature of which led taxpayers to prize lower asset valuations. in the absence of even a modest transfer tax regime, however, taxpayers can capitalize upon the basis equal to fair market value rule with intense vigor. d. the estate planning bar’s role while many factors motivate taxpayers to hire estate planning professionals, chief among them has historically been transfer tax minimization.54 estate planners would routinely pitch their services, claiming that a few billable hours of their time could produce remarkable transfer tax savings. to illustrate this point, consider a hypothetical example based on the rules and rates applicable in the early and mid-1990s, when the lifetime exemption amount was $600,000 and the lifetime exemption amount was not portable – i.e., automatically transferable – between spouses as is the case today.55 suppose a married couple had a combined net worth of $1.2 million, with $600,000 of assets separately titled in each spouse’s name. they retain the services of an estateplanning attorney, who recommends that each spouse execute a last will and testament directing the $600,000 of assets owned each spouse to pass into a testamentary trust for the lifetime benefit of the surviving spouse. this testamentary trust served a dual purpose: it absorbed the use of the first decedent spouse’s lifetime exemption amount and, in addition, the assets owned by this trust would not subsequently be included in the surviving spouse’s gross estate. (in the vernacular of the estate-planning bar, testamentary trusts of this sort were commonly referred to as “by-pass trusts”).56 in this example, the use of such a trust would reduce the potential estate tax faced by the couple from $192,500 to zero.57 the estate planning bar can hardly be faulted for the swiss-cheese structure of the wealthtransfer tax system that created such easy opportunities for professionals to reduce potential tax bills. but regardless of fault, estate planners over the years developed an impressive arsenal of transfer-tax saving techniques, generating acronyms the likes of which are unparalleled in virtually any other area of the law. a small such sampling include the following commonly used estate planning techniques: grits, grats, gruts, crats, cruts, clats, cluts, qtips, and 54 see howard m. zaritsky, say goodbye to the estate tax – for at least a decade, 44 est. plan. 47, 48 (2017) (“the repeal of the estate tax will dramatically alter present estate planning, which for large estates tends to focus on the minimization of estate and gst taxes.”). 55 i.r.c. § 2010(c)(4). 56 see, e.g., stewart j. beyerle, bypass trusts can maximize unified credit, 18 est. plan. 212, 212 (1991) (“a bypass trust shelters assets from the estate tax assessed on the death of both spouses, while still permitting the surviving spouse to have access to these assets. this is why it is often called a ‘credit shelter’ trust.”). 57 absent legal advice, the hypothetical couple would probably have bequeathed their respective estates to each other, with testamentary bequests to the children if there was no surviving spouse. but this would mean that the surviving spouse would eventually leave an estate of $1.2 million (more or less, depending on subsequent fluctuations in asset values) to their children. at the time, such a disposition would have subjected the surviving spouse’s estate to an estate tax liability of $192,500. 60 [vol.10:1 columbia journal of tax law qprts.58 the government bears the revenue loss associated with this creativity. but instead of fixing the transfer tax rules to reduce avoidance opportunities, congress has instead chosen to largely take the transfer tax off the table for all but the very wealthiest of estates. even this, however, did not extinguish the creativity of the estate planning bar; instead, as explained below, its members have developed a whole set of new techniques to capitalize on the basis equal to fair market value rule. iii. the new tax paradigm the last two decades have witnessed a concerted effort to repeal the wealth-transfer taxes. this has been a particular point of emphasis among republicans,59 but they have not been entirely alone. 60 while efforts to repeal the transfer tax system completely have thus far proven unsuccessful, congress has made significant strides to ensure that families could maintain sizable amounts of wealth free of transfer tax levies. many state legislatures have also joined the wealth preservation bandwagon, perhaps best exemplified by their near-universal elimination of the rule against perpetuities.61 the passage of the tax cut and jobs act reflects the deep disdain which the 2017 congress harbored towards the nation’s transfer tax system. now, only those families that need a ten-figure 58 see, e.g., wendy c. gerzog, the times they are not a-changin’: reforming the charitable split-interest rules (again), 85 chi.-kent l. rev. 849, 853 (2010) (“a crt must be created either as a charitable remainder annuity trust (crat) or a charitable remainder unitrust (crut). a clt must be in the form of either a charitable lead annuity trust (clat) or a charitable lead unitrust (clut).”); david w. olsen, so…what’s for breakfast: grits, grats, or gruts?, 7 j. suffolk acad. l. 49 (1990/1991) (“grits, grats and gruts, in one form or another, have been tools used by estate planners for years.”); bruce l. stout, a qtip election can lend flexibility to an estate plan, 52 tax’n for acct. 294 (1994), westlaw (“the use of a qtip election is very much the best of both worlds-the testator has the ability to determine and control the ultimate disposition of his estate while retaining the opportunity to benefit from the unlimited marital deduction.”); jeremy t. ware, using qprts to maximum advantage for wealthy clients, 32 est. plan. 34, 34 (2005) (“the qualified personal residence trust, or ‘qprt,’ is one of the tried-and-true workhorses of estate planning. it provides a tax-favored and irs-blessed means of transferring a personal residence to the objects of a donor's bounty.”). 59 see zaritsky, supra note 54, at 47 (“repeal of the estate tax has been part of every republican tax reform plan in recent years.”); grayson m.p. mccouch, the empty promise of estate tax repeal, 28 va. tax rev. 369, 373 (2008) (“estate tax repeal figured as a prominent issue in the 2000 presidential campaign, especially after candidate george w. bush endorsed repeal as part of his tax-cutting agenda, along with income tax rate cuts, an expanded child credit, and reduction of the marriage tax penalty.”). 60 while the republicans have repeatedly voted for estate tax repeal, see generally edward j. mccaffery & linda r. cohen, shakedown at gucci gulch: the new logic of collective action, 84 n.c. l. rev. 1159, 1165 (2006), in 2012 former president obama approved increasing the applicable exclusion amount from $3.5 million to $5 million. terence s. nunan, basis harvesting, 25 prob. & prop. 54, 55 (2011) (“the tax act, with its $5 million estate tax exclusion, was a compromise between the obama administration and republican legislators, the latter favoring total repeal of the estate tax.”). 61 robert h. sitkoff & max m. schanzenbach, jurisdictional competition for trust funds: an empirical analysis of perpetuities and taxes, 115 yale l.j. 356 (2005); stewart e. sterk, jurisdictional competition to abolish the rule against perpetuities: r.i.p. for the rap, 24 cardozo l. rev. 2097 (2003); joel c. dobris, the death of the rule against perpetuities, or the rap has no friends—an essay, 35 real prop. prob. & tr. j. 601, 603-04 (2002). traditionally, under this rule, property rights generally had to vest within a life in being plus twenty-one years. see generally frederick r. schneider, a rule against perpetuities for the twenty-first century, 41 real prop. & tr. j. 743 (2007). without the application of this rule, property can theoretically remain in trust indefinitely. https://1.next.westlaw.com/link/document/fulltext?findtype=y&sernum=0343908911&pubnum=0001508&originatingdoc=id2e2e808e13d11e79bf099c0ee06c731&reftype=lr&fi=co_pp_sp_1508_373&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search)#co_pp_sp_1508_373 https://1.next.westlaw.com/link/document/fulltext?findtype=y&sernum=0343908911&pubnum=0001508&originatingdoc=id2e2e808e13d11e79bf099c0ee06c731&reftype=lr&fi=co_pp_sp_1508_373&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search)#co_pp_sp_1508_373 https://1.next.westlaw.com/link/document/fulltext?findtype=y&sernum=0306371681&pubnum=0001292&originatingdoc=i13c67fc580fb11e498db8b09b4f043e0&reftype=lr&fi=co_pp_sp_1292_410&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search)#co_pp_sp_1292_410 https://1.next.westlaw.com/link/document/fulltext?findtype=y&sernum=0306371681&pubnum=0001292&originatingdoc=i13c67fc580fb11e498db8b09b4f043e0&reftype=lr&fi=co_pp_sp_1292_410&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search)#co_pp_sp_1292_410 https://1.next.westlaw.com/link/document/fulltext?findtype=y&sernum=0294737706&pubnum=1441&originatingdoc=i10f57d910e8711dc8c64a372964bef5d&reftype=lr&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search) https://1.next.westlaw.com/link/document/fulltext?findtype=y&sernum=0294737706&pubnum=1441&originatingdoc=i10f57d910e8711dc8c64a372964bef5d&reftype=lr&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search) https://1.next.westlaw.com/link/document/fulltext?findtype=y&sernum=0283585583&pubnum=1224&originatingdoc=i10f57d910e8711dc8c64a372964bef5d&reftype=lr&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search) https://1.next.westlaw.com/link/document/fulltext?findtype=y&sernum=0283585583&pubnum=1224&originatingdoc=i10f57d910e8711dc8c64a372964bef5d&reftype=lr&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search) 2018] 61 determining an asset’s tax basis in the absence of a meaningful transfer tax regime calculator to compute their net worth fall within its clutches.62 a. the gutting of the transfer tax system as previously pointed out, over the course of the last two decades, the transfer tax system has been a repeated target of political attacks.63 these attacks have resulted in the passage of multiple legislative initiatives that, at the federal level, have gutted the transfer tax system;64 furthermore, in the wake of these federal initiatives, many state legislatures have followed suit, repealing or, at the very least, mitigating the estate tax burdens of those domiciled within their borders.65 consider first the legislative trend at the federal level. three key pieces of legislation tell the majority of the transfer tax saga. each either significantly raised the lifetime exemption amount or lowered the top marginal tax rate (and, in one instance, it did both). the chart immediately below spells this out: exemption amount tax rate before after before after 1. economic growth and tax relief reconciliation act of 200166 $675,000 $3,500,000 55% 35% 2. american tax relief, unemployment insurance reauthorization, and job creation act of 201067 $3,500,000 $5,000,000 35% 35% 3. tax cut and jobs act68 $5,490,000 $11,180,000 40% 40% next, consider the legislative trend at the state level. by way of background, to attract citizens to establish domicile within their borders, many state legislatures have long eschewed estate tax imposition.69 to help states augment their coffers, in 1926 congress enacted legislation 62 see supra note 5. 63 see supra notes 59-62. 64 see supra notes 3-4 and accompanying text. 65 see supra note 7. 66 see supra note 3. note that the $3,500,000 exemption did not take effect immediately upon passage of this bill, but rather was deferred until 2009. 67 pub. l. 111-132, 124 stat. 3296. this act was also the first to incorporate an indexing provision into the exemption amount, so that it thereafter is adjusted annually to reflect inflation. 68 see supra note 4. 69 claire arritola, repealing the federal credit for state estate taxes was bad policy, state tax notes (2014), http://www.taxanalysts.org/content/repealing-federal-credit-state-estate-taxes-was-bad-policy [https://perma.cc/wv59-nyfc]. (“some states already had wealth transfer taxes in place, but other states, such as florida, did not. states looking to attract the wealthy took steps such as placing prohibitions on estate taxes in their state constitution.”). 62 [vol.10:1 columbia journal of tax law to the effect that the federal estate tax would, within limits, offer a credit for state estate taxes paid.70 with no additional financial cost to their citizens, every state enacted an estate tax to absorb the federal government’s largesse. this revenue sharing arrangement persisted for over six decades; however, it came to a quick end when congress enacted the economic growth tax relief act of 2001 that repealed the state estate tax credit,71 replacing it instead with a deduction.72 the repeal of the state estate tax credit launched a wave: to safeguard against taxpayer flight, the majority of state legislatures repealed their estate taxes.73 some states still impose an estate tax, but their numbers continue to dwindle. indeed, in 2017 only 17 states remain that still impose an estate and/or inheritance tax.74 the implications associated with the federal and state trends are dire for the transfer tax system. the federal transfer tax system now exempts $11,180,000 from transfer tax. (married couples can transfer twice this amount or $22,360,000.) this dollar amount is adjusted annually for inflation.75 according to the i.r.s. statistics of income, the number of taxable estates that equaled or exceeded $10 million in 2016 totaled 2,204.76 given the fact that the u.s. census bureau reports that 2,744,248 u.s. residents died in 2016,77 less than a paltry .01% of the entire u.s. population would have any federal transfer tax exposure. at the state level, if the current transfer-tax repeal trend continues,78 there is every reason to believe that state estate tax imposition will soon become a relic of the past.79 b. tax burden levied on capital income while the federal and state estate tax regimes have been largely phased out or, in many cases, eliminated, the tax on capital income remains intact. at the risk of oversimplification, earned income generally falls into one of the following three baskets: (i) labor and service income; (ii) business profits; and (iii) capital gains. the first income basket – labor and service income – generally bears the greatest financial burden, subject to both income and payroll taxes.80 next, the second basket – business profits – generally bears a moderate financial burden, subject to the income tax.81 finally, the third basket – capital gains – generally bears a relatively light financial 70 see revenue act of 1926, pub. l. no. 69-20, § 301(b), 44 stat. 9, 70. 71 economic growth and tax relief reconciliation act of 2001, pub. l. no. 107-16, 115 stat. 38 (2001). 72 i.r.c. § 2058(a). 73 see supra note 7. 74 ebeling, supra note 7. 75 i.r.c. § 2010(c)(3)(b). 76 see soi tax stats – estate tax statistics filing year table 1 (2016), https://www.irs.gov/statistics/soitax-stats-estate-tax-statistics-filing-year-table-1 [https://perma.cc/3pth-n736]. 77 kenneth d. kochanek, sherry l. murphy, jiaquan xu & elizabeth arias, mortality in the united states in 2016 (2017), https://www.cdc.gov/nchs/data/databriefs/db293.pdf [https://perma.cc/9pt9-48gz]. 78 see supra note 7. 79 no state except connecticut imposes a gift tax (conn. chapter 228c § 12-640). that being the case, in those states that still impose estate taxes, it is possible for taxpayers to reduce their transfer tax obligations. 80 linda sugin, payroll taxes, mythology, and fairness, 51 harv. j. on legis. 113, 115-16 (2014). 81 i.r.c. § 61(a). note that several features of the tax cuts and jobs act of 2017 will further lighten this load by reducing the corporate income tax rate (i.r.c. § 11) and allowing a generous business income deduction for noncorporate businesses (i.r.c. § 199a). 2018] 63 determining an asset’s tax basis in the absence of a meaningful transfer tax regime burden, subject to preferential tax rates,82 deferral opportunities,83 and exemptions.84 many taxpayers nonetheless contend that the putative “light” tax burden capital gains endure is still too heavy. they believe that congress should not tax capital gains at all or, alternatively, tax such gains with even more restraint. advocates for this position point out that capital gains often constitute nominal rather than economic gains and, as such, should not be taxed;85 likewise, capital appreciation is frequently related to income that has already been taxed at the corporate level and, that being the case, such wealth should not be taxed a second time in the hands of its shareholders.86 putting aside the question of whether capital gains should be taxed, consider how such gains are actually taxed. at the federal level, the capital gain tax burden is composed of two components. the first is the imposition of income tax with a series of graduated tax rates that range as high as 20%.87 the second is the imposition of the net investment income tax that the code imposes on the income of those taxpayers whose adjusted gross incomes exceed certain thresholds.88 the current net investment income tax rate is a flat 3.8%.89 aside from federal income tax imposition, those states that impose income taxes also tax capital gains. but unlike their federal counterpart, no state offers a preferential tax rate for capital gains. with state income tax rates that currently range as high as 13.3%,90 this is another potential tax burden to which capital gains are exposed. state taxes paid are theoretically deductible on taxpayers’ federal tax returns,91 which would mitigate their burden. however, due to threshold 82 i.r.c. § 1(h). 83 i.r.c. § 1031(a). 84 i.r.c. § 1202(a). 85 see, e.g., charles j. cooper, michael a. carvin & vincent j. colatriano, the legal authority of the department of the treasury to promulgate a regulation providing for indexation of capital gains, 12 va. tax rev. 631, 638 (1993): one of the express congressional justifications for the preferential treatment of capital gains has been the adverse effect of inflation on the calculation of capital gains. during periods of high or even moderate inflation, nominal gains realized upon the sale of property may not reflect a true increase in the value of the property at all. thus, the taxpayer is taxed on the sale even though, in real terms, he has not received any income in the sense of an increase in wealth or purchasing power. 86 noel b. cunningham & deborah h. schenk, the case for a capital gains preference, 48 tax l. rev. 319, 331 (1993): under our current income tax system, corporate income is taxed twice, once at the corporate level when earned, and again at the shareholder level when distributed. this “classical system” of taxation is inconsistent with an ideal haig-simons income tax and has been the subject of much criticism. for decades, reformers have called for its elimination by integrating the corporate and individual income taxes. 87 i.r.c. § 1(h). 88 i.r.c. § 1411(b). 89 i.r.c. § 1411(a). 90 see, e.g., cal. rev. & tax. code §§ 17041, 17043 (west 2014) (declaring that the highest marginal income tax rate in the state of california is currently 13.3%). 91 i.r.c. § 164(a). 64 [vol.10:1 columbia journal of tax law limitations,92 the imposition of the alternative minimum tax,93 and the option of utilizing robust (and recently augmented) standard deductions,94 the availability of this deduction often proves illusory. in light of the fact that capital gains are subject to income tax, the net investment tax, and state tax, many taxpayers consider the aggregate tax burden consequential. they therefore are apt to take one or more measures to minimize their capital gains tax exposure. among other strategies, they purposefully harvest losses,95 avail themselves of exemptions,96 and strategically move to states that do not impose income taxes.97 to date, there has been one capital gain tax-saving strategy that has largely remained in abeyance, namely, capitalizing upon the basis equal to fair market value rule. the reason for that has been explained above: because the estate tax rates have historically been higher than the capital gains rates, taxpayers did not seek refuge in the basis equal to fair market value rule to inflate the values of assets owned by decedents.98 iv. the aftermath: tax basis maximization now that congress has diminished the impact of the transfer tax regime, taxpayers will likely turn to income tax planning. as part of their strategy, they are devising creative and innovative approaches to secure high tax bases for their assets. in this section, subsection a details taxpayers’ objectives. subsection b discusses methodologies to maximize asset tax bases. subsection c analyzes the challenges that the i.r.s. faces in identifying misreported tax bases and the meager enforcement weapons at its disposal even when it does identify problems. finally, subsection d posits congressional options that could address the tax basis maximization syndrome. 92 see i.r.c. § 164(b)(6) (providing that taxpayers may only deduct up to a maximum of $10,000 of state or local taxes (or $5,000 for a married taxpayer filing a separate return)). 93 i.r.c. § 55 et. seq. 94 i.r.c. § 63(c) (providing that in 2018, the standard deduction is $12,000 for a single taxpayer and $24,000 for a married couple filing a joint return). 95 richard b. toolson, higher tax rates increase importance of choosing tax efficient investments, 92 prac. tax strategies 108, 113 (2014) (“[s]omeone who invests directly in stocks has the opportunity to directly harvest capital losses. these capital losses may be used to offset, without limit, the investor's capital gains from all sources and up to $3,000 of an individual's noncapital gain income.”). 96 see, e.g., i.r.c. § 1202(a) (exempting capital gain, subject to limitations, recognized on the sale or disposition of so-called small business stock); i.r.c. § 1400z-2 (if certain conditions are met, exempting from taxation a portion of capital gain proceeds if they are reinvested in so-called “opportunity zones”). 97 see, e.g., robert w. wood, california’s 13.3% tax on capital gains inspires move then sell tactics, forbes (aug. 31, 2017), https://www.forbes.com/sites/robertwood/2017/08/31/californias-13-3-tax-on-capital-gainsinspires-move-then-sell-tactics/#5c3bc9502097 [https://perma.cc/e2vn-2hf9] (“it should be no surprise that former californians often become residents of no-tax states like texas. the irs reports that between 2013 and 2014, over 250,000 california residents moved away.”). 98 once in a while, aggressive taxpayers apparently sought to “park” their assets on a temporary basis with those who were dying to exploit the basis equal to fair market value rule. however, after congress learned of this strategy, it took measures to make its use less attractive. see economic recovery tax act of 1981, pub. l. no. 9734, § 425(a), 95 stat. 172. now, when taxpayers transfer assets to those dying, in anticipation of receiving a bequest returning the gifted assets, the basis equal to fair market value rule will not apply if the transferee dies within a year of the initial transfer. i.r.c. § 1014(e). see footnote 114 infra and accompanying text. https://www.irs.gov/uac/soi-tax-stats-migration-data-2013-2014 2018] 65 determining an asset’s tax basis in the absence of a meaningful transfer tax regime a. taxpayer objective: exploitation of the basis equal to fair market value rule taxpayers have no duty to pay more taxes than they owe, 99 and accordingly tend to structure their affairs to minimize their tax burdens. when congress institutes laws that deviate from the haig-simon definition of income, taxpayers will predictably avail themselves of taxsaving opportunities. sometimes, these deviations are purposefully encouraged by congress to incentivize particular taxpayer behavior. for example, it appears that congress has intentionally favored home ownership,100 the acquisition of automobiles that are powered by electricity rather than fossil fuels;101 and investment in entrepreneurial enterprises.102 before delving into how the current code entices taxpayers to maximize the tax basis of the assets that they own, the role of basis in the income tax regime must be clearly understood. tax basis is one of the central concepts in the taxation of income from capital. when a taxpayer acquires an asset, its purchase price constitutes the asset’s cost basis.103 if the taxpayer improves the asset or takes depreciation deductions, the asset’s basis is increased or decreased accordingly.104 as time passes, an asset’s tax basis and its fair market value are apt to diverge. sometimes an asset’s tax basis may exceed its fair market value (e.g., if a share of stock falls in value); more commonly, due to either market appreciation or to depreciation deductions that exceed natural erosion, an asset’s tax basis will be less than its fair market value. because tax basis is the measuring stick from which gain and loss are computed, taxpayers cherish it. a higher basis is better than a lower basis, and taxpayers will quite reasonably go to great lengths to secure higher bases in their assets when opportunities arise. for example, in an endeavor to secure higher future depreciation deductions, taxpayers often find it advantageous to purchase corporate assets rather than acquire corporate stock.105 similarly, if taxpayers purchase partnership interests, rather than the partnership assets themselves, they may cause the partnership to make a section 754 election, which enables partners to command a higher tax basis in their proportionate share of partnership assets that they are deemed to own. 106 these tax basis augmentation strategies and others like them are routine in income tax planning. 99 see helvering v. gregory, 69 f.2d 809, 811 (2d cir. 1934), aff’d, 293 u.s. 465 (1935) (“[t]here is not even a patriotic duty to increase one's taxes.”). 100 see i.r.c. § 163(h)(3) (permitting an interest deduction for liabilities associated with the purchase of a qualified residence). 101 see i.r.c. § 30d (providing a credit to taxpayers who place into service a new qualified plug-in electric drive motor vehicle). 102 see i.r.c. § 1202(a) (exempting gains on the disposition of small business stock from taxation). 103 i.r.c. § 1012(a). 104 i.r.c. § 1016(a)(1) & (2). 105 see, e.g., michael l. schler, basic tax issues in acquisition transactions, 116 penn. st. l. rev. 879, 887-88 (2012) (“a stock purchase would result in target continuing to amortize its existing tax basis over the remainder of the statutory lives of its assets. however, an asset purchase would result in all of acquiring's tax basis being amortized over a new statutory life beginning on the acquisition date.”). 106 see, e.g., walter d. schwidetzky, integrating subchapters k and s – just do it, 62 tax law 749, 764 (2009) (“among the times a section 754 election can be useful is when a partnership interest is purchased or inherited. if an election is made, the “inside basis” of the purchasing or inheriting partner's share of partnership assets is increased or decreased to equal the outside basis of that partner's partnership interest.”). 66 [vol.10:1 columbia journal of tax law one of the most common sources of basis augmentation is the rule, applicable at death, which re-sets an asset’s tax basis to equal fair market value.107 while this rule appears neutral (i.e., tax basis could be upwardly or downwardly adjusted), in the vast majority of cases, application of this rule works to the advantage of taxpayers. this is true for several reasons. first, due to inflation and economic growth, the vast majority of capital assets appreciate in value.108 second, the code permits generous “write-offs” in the form of depreciation and amortization deductions for those assets used in trades and businesses,109 which usually exceed the actual economic loss in value.110 finally, taxpayers who are elderly or in poor health can manage their portfolios to harvest losses before death, while retaining assets in which they have accumulated gains. b. asset basis maximization methodologies because most taxpayers have been relieved of the impediment of transfer taxes, they are now free to pursue several strategies that exploit the fair market value at death rule. such techniques include, but are not limited to: (1) high-value appraisals, (2) asset retention, (3) asset gift-giving, (4) trust ploys, and (5) domicile changes. 1. high-value appraisals. when taxpayers need to ascertain asset values, they often rely upon specially-trained appraisers. theoretically, the appraiser might not know whether an estate desired an appraisal at the high or low end of the defensible range because he or she would not necessarily know whether the estate would be large enough to attract a tax liability. now, in the absence of a meaningful transfer tax regime, high asset appraisals will undoubtedly become the norm.111 consider if a decedent owned a piece of real estate at the time of death that was originally purchased many years ago for $100,000 and was now worth somewhere between $800,000 and $1 million. suppose that the decedent’s executor retained the services of an appraiser to assess the property’s fair market value. adhering to executor’s instructions to maximize the appraisal dollar amount, the appraiser would likely issue an appraisal report listing the property’s fair market value to be $1 million. 107 i.r.c. § 1014(a). 108 see, e.g., henry ong, how does inflation affect the stock market, inquirer.net (sept. 17, 2014), http://business.inquirer.net/178899/how-does-inflation-affect-the-stock-market [https://perma.cc/tev5-v4bv] (explaining how equities are a worthwhile economic investment and hedge during inflationary periods); but cf. lawrence h. summers, inflation and the value of corporate equities (nat’l bureau of econ. res., working paper no. 824, 1982) (arguing that inflation can diminish equity value). 109 see i.r.c. § 168(k) (permitting, aside from real estate, the vast majority of purchased assets used in a trade or business to be immediately expensed). 110 see, e.g., charles t. terry, normative capital cost recovery for a realization-based income tax, 5 fla. tax rev. 467, 480 (2002) (“[t]he present value of the series of recovery deductions available to u.s. income taxpayers with respect to many assets exceeds the present value of economic depreciation….”). 111 see, e.g., james john jurinski, estate plans with real estate may need major revisions, 42 real est. tax’n 44, 46 (2014) (“in some situations, the planning focus will be on maximizing asset values to take advantage of the step-up rather than minimizing the value of property to minimize estate tax. the irs may also reverse roles and urge low asset valuations and even valuation discounts.”); john j. scroggin, income tax planning now that estate taxes are less significant, 32 est. plan. 33, 35 (2005) (“instead of lowering the value of assets to reduce transfer taxes, clients may actually want to increase the value of assets to obtain a higher basis step-up. the higher basis will reduce the income taxes paid by heirs on the sale of inherited assets and will create new depreciable values for depreciable assets.”). 2018] 67 determining an asset’s tax basis in the absence of a meaningful transfer tax regime going forward, the decedent’s heir would presumably use this high value appraisal report for tax basis computational purposes (i.e., determining future depreciation deductions and computing gain/loss upon subsequent property sale, exchange, or disposition). thus, by reporting a $1 million date of death fair market value, the decedent’s executor is able to save the decedent’s heirs tax on $200,000 (i.e., $1 million (reported value) $800,000 (theoretical value)). 2. asset retention. taxpayers are at liberty to make lifetime gifts or testamentary bequests of the assets that they own. there is a pro and a con associated with gift-giving: the pro is that, for transfer tax purposes, taxpayers can effectively fix the asset’s value for transfer tax purposes as of the time of the gift, thereby safeguarding all future asset appreciation from additional transfer tax exposure.112 the con is that, for income tax purposes, the property’s recipient must take the transferor’s basis in the transferred asset.113 in the absence of a transfer tax, basis considerations will drive many taxpayers to retain their assets rather than gift them. the reason is simple: taxpayers prefer not to saddle their intended recipients with assets that have the transferor’s basis; instead, they want to accord their intended beneficiaries with assets that have tax bases equal to fair market value. with highlyappreciating assets, retention in the taxpayer’s hands will become the norm, not the exception. to illustrate, consider again the example of the real estate that the taxpayer acquired for $100,000 and is now worth between $800,000 to $1 million. if the taxpayer gifts such property, its recipient will have a $100,000 tax basis in the property;114 however, if the taxpayer retains the property and later bequeaths it, its recipient will have a $1 million tax basis in the real estate.115 asset retention thus saved the asset recipient taxes on $900,000 (i.e., $1 million $100,000), epitomizing why, going forward, large-scaled asset retention will likely become standard practice. 3. asset gift-giving. the previous part demonstrates why older taxpayers are clearly motivated to retain their appreciated assets, and let the fair market value basis rule eliminate taxable gains in the hands of beneficiaries. but in other circumstances, the opposite strategy may still have some uses. more specifically, younger, well-heeled, taxpayers may now have a greater incentive to give their appreciated assets to older relatives, with the expectation that the gifted assets will be returned to them in the form of subsequent bequests.116 currently, if the gift recipient lives for more than one year,117 the strategy works and achieves the goal of tax elimination.118 112 this is commonly known as a “freeze” strategy; even though the asset may well appreciate after the gift, its value for transfer tax purposes will always be the “frozen” amount. see, e.g., douglas p. long & timothy j. riffle, family partnerships for estate freezes: the role of business purpose, 3 j. partnership tax’n 46 (1986); a. kel long, iii, statutory freeze partnerships: a useful estate planning technique, 28 est. plan. 59 (2001); gregory j. naples, recapitalizations can still “freeze” an estate despite recent changes, 41 tax’n for acct. 70 (1988). 113 i.r.c. § 1015(a). 114 id. 115 i.r.c. § 1014(a). 116 see, e.g., james s. judd, the evolution of estate planning, 28 utah b.j. 14 (2015) (“with federal income tax avoidance becoming paramount to estate planning, an estate planner's client may insist on implementing an estate plan that uses the imminent death of a terminally ill parent in order to get a basis step-up in the client's assets.”). 117 i.r.c. § 1014(e). 118 this is not a new strategy, and it is not without risks. the elderly recipient of the assets may turn out to need them for his or her own support. or, he or she may misunderstand or forget the plan and fail to transfer the 68 [vol.10:1 columbia journal of tax law consider the situation of a forty-year old real estate developer who owns appreciated real estate with a $100,000 tax basis with a $1 million fair market value. she can gift title to this property to her elderly grandmother. assuming the real estate developer’s grandmother lives for more than one year and then bequeaths this property back to her granddaughter, her granddaughter is able to save taxes on $900,000 (i.e., $1 million $100,000). while this strategy is old, the stakes have now changed. the strategy involves two transfers—into and out of the portfolio of the elderly relative—that would potentially be subject to a wealth-transfer tax. while this may have discouraged taxpayers in the past, as the wealthtransfer tax system fades in relevance, this strategy, even with its risks, will presumably be more appealing to a larger number of taxpayers. 4. trust strategies. in the trust arena, three options are available to capitalize upon the basis equal to fair market value rule. the first is to eliminate those trusts that no longer serve a transfer-tax savings purpose and impede utilization of the basis equal to fair market value rule. there are hundreds of thousands of trusts currently in existence that taxpayers have established to help circumvent transfer tax imposition. now that congress has relieved nearly all estates of any transfer tax liabilities, their purpose has disappeared. furthermore, these trusts generally hold highly appreciated assets that will not be in a position to benefit from the basis equal to fair market value rule because they are not included in the gross estate of the trust beneficiary. these trusts, in other words, are now doing more harm than good. under these circumstances, taxpayers will want to undertake measures to terminate these trusts by having the trustee make discretionary trust distributions,119 resulting in the trust assets falling into the hands of trust beneficiaries who are then able to give their heirs the benefit of the fair market value bases in their assets. the second trust related tactic is to have taxpayers execute trust instruments that contain an asset substitution power.120 this provision transforms a trust into a grantor trust that is ignored as a separate tax-paying entity for income tax purposes,121 yet, for transfer tax purposes, this power’s presence does not cause asset inclusion.122 ever since congress compressed the tax rates property back to the original transferee in his or her will. or the two parties may have a falling out, with the result that the elderly relative intentionally disregards the original understanding. while some of these possibilities could be controlled by creating contractual obligations to return the assets in question at death, those very contractual obligations, if known to the i.r.s. or a court, would require recharacterization of the transaction as something other than a gift. 119 see judy b. shepura, design trusts that shine in clients’ twilight years, est. plan. (2015) (detailing the ways that settlors can draft inter vivos and testamentary trusts that can be readily terminated if doing so makes sense from a transfer or income tax perspective). 120 see jonathan g. blattmachr & madeline j. rivlin, searching for basis in estate planning: less tax for heirs, 41 est. plan. 3, 4 (2014): a common method by which a trust is made a grantor trust is for it to either contain a substitution power under section 675(4)(c) … and is otherwise structured to avoid inclusion under section 2036 or 2038…under current law, however, in order to accomplish the strategy of giving low-basis assets to a trust and later reacquiring them to achieve a basis step up at death, the grantor must have sufficient high-basis assets or cash on hand to exchange for the appreciated trust assets. 121 i.r.c. § 671. 122 see generally jay a. soled, reforming the grantor trust rules, 76 notre dame l. rev. 375 (2001). https://1.next.westlaw.com/link/document/fulltext?findtype=l&pubnum=1000546&cite=26uscas675&originatingdoc=ia463ab79225411e498db8b09b4f043e0&reftype=rb&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search)#co_pp_0bd500007a412 https://1.next.westlaw.com/link/document/fulltext?findtype=l&pubnum=1000546&cite=26uscas2036&originatingdoc=ia463ab79225411e498db8b09b4f043e0&reftype=lq&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search) https://1.next.westlaw.com/link/document/fulltext?findtype=l&pubnum=1000546&cite=26uscas2038&originatingdoc=ia463ab79225411e498db8b09b4f043e0&reftype=lq&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search) 2018] 69 determining an asset’s tax basis in the absence of a meaningful transfer tax regime applicable to income earned by trusts and estates, an asset substitution power has gained popularity, because it allows trust income to be subject to the grantor’s lower income tax rates. but now this asset substitution power can serve another purpose: it can provide a bridge to remove highly appreciated assets from an irrevocable trust and replace such assets with cash or nonappreciated assets.123 by gaining title to the appreciated trust assets, a taxpayer is positioned to take advantage the basis equal to fair market value rule. the third tactic involving trusts taxpayers are gravitating towards is the use of so-called joint exempt step-up trusts (or jests).124 the details of these trusts have been described elsewhere;125 but the gist is that married taxpayers can establish a jest to hold title to their assets. the terms of a jest grant each spouse a general power of appointment over the trust assets; due to the presence of this power, taxpayers contend that a decedent spouse should include the entirety of the trust assets in his or her gross estate, commanding application of the basis equal to fair market rule to all, not just one-half, of the trust assets. 5. domicile changes. some taxpayers are extraordinarily tax sensitive, and make even the most important of life decisions based upon tax considerations.126 it is therefore not surprising that some taxpayers might make tax-driven domicile decisions. literature on this issue abounds and states regularly compete to make their tax environments as attractive as possible to individual taxpayers and business enterprises.127 taxpayers can manipulate their domicile to maximize the benefit of the fair market value basis rule in two ways. first, they may seek to establish domicile in those states that do not levy an estate tax,128 enabling them to embrace aggressive valuation positions without the “friction” of a having to pay a state transfer tax toll charge. second, due to a quirk in the code applicable only 123 see supra note 118. 124 there are other trusts that estate planners are devising with the same tax basis maximization agenda in mind. austin w. bramwell, brad dillon & leah socash, the new estate planning lexicon: sugrits and other grantor-retained interest step-up trusts, 123 j. tax’n 196 (2015). 125 see turney p. berry & paul s. lee, retaining, obtaining, and sustaining basis, 7 est. plan. & community prop. l.j. 1, 28 (2014) (“following in the line of a number of rulings, a planning technique referred to as the “joint exempt step-up trust” (jest) has arisen that seeks to give married couples residing in noncommunity property states some of the same step-up in basis enjoyed by couples who pass away with community property under section 1014(b)(6).”). see also alan s. gassman, christopher j. denicolo & kacie hohnadell, jest offers serious estate planning plus for spouses (pts. 1 & 2), 40 est. plan. 3, 3 (oct. 2013), 40 est. plan. 14 (nov. 2013). 126 see, e.g., james alm & leslie a. whittington, income taxes and the timing of marital decisions, 64 j. of pub. econ. 219 (1997) (discussing the bearing timing has in when couples decide to marry). 127 see karen smith conway & jonathan c. rork, state “death” taxes and elderly migration--the chicken or the egg?, 59 nat’l tax j. 97, 123 (2006) (finding “some evidence” that “states that experience high elderly inmigration may be more likely to subsequently eliminate or reduce their incremental [estate, inheritance and gift] taxes”); jeffrey a. cooper, interstate competition and state death taxes: a modern crisis in historical perspective, 33 pepp. l. rev. 835, 842 (2006) (“interstate competition has impacted state death taxes since their inception.”); cristobal young, charles varner, ithai lurie & richard prisinzano, millionaire migration and taxation of the elite: evidence from administrative data, 81 am. soc. rev. 421 (2016); cf. jon bakija & joel slemrod, do the rich flee from high state taxes? evidence from federal estate tax returns 36 (nat'l bureau of econ. research, working paper no. 10645, 2004) (finding evidence “consistent with the idea that some rich individuals flee states that tax them relatively heavily, although it may reflect other modes of tax avoidance as well.”). 128 see generally cooper, supra note 127. https://1.next.westlaw.com/link/document/fulltext?findtype=y&sernum=0393271986&pubnum=0100771&originatingdoc=i7c65c891bccd11e498db8b09b4f043e0&reftype=lr&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search) https://1.next.westlaw.com/link/document/fulltext?findtype=y&sernum=0393271986&pubnum=0100771&originatingdoc=i7c65c891bccd11e498db8b09b4f043e0&reftype=lr&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search) https://inequality.stanford.edu/about/people/charles-varner https://inequality.stanford.edu/about/people/charles-varner http://www.law.georgetown.edu/faculty/symposia-lectures/tax-law-public-finance/upload/millionaire-migration-and-taxation-of-the-elite.pdf http://www.law.georgetown.edu/faculty/symposia-lectures/tax-law-public-finance/upload/millionaire-migration-and-taxation-of-the-elite.pdf 70 [vol.10:1 columbia journal of tax law in community property states, the basis equal to fair market value rule applies to all the property a couple owns, not just that property titled in the decedent’s name;129 taxpayers may thus gravitate towards establishing domicile in such states.130 suppose, for example, that a couple residing in new york owns investment real estate in california with a tax basis of $1,000,000 and a fair market value of $10,000,000. they might consider retiring in california. unlike new york, california does not levy an estate tax and, furthermore, it is a community property state. thus, if the husband dies domiciled in california, his estate will owe no federal or state estate tax and, furthermore, his wife will receive title to the real estate with a $10 million tax basis, which can be sold at that point with no taxable gain. c. i.r.s. challenges in policing the tax basis problem the i.r.s. has not fared well in the last two decades. enveloped in controversy,131 the agency has watched its funding dwindle and its staffing cut.132 at the same time, congress has expanded the agency’s scope of responsibilities and weakened its enforcement arm.133 with audit rates hovering at historic lows,134 in all but the most egregious cases, taxpayer aggressiveness will often go undetected. when it comes to policing tax basis reporting, the i.r.s. faces unique challenges. unlike other reporting distortions that computer algorithms can pinpoint, such as excessive charitable 129 i.r.c. § 1014(b)(6). 130 see generally paul caron & jay a. soled, the new prominence of tax basis and estate planning, 150 tax notes 1569 (2016). 131 see, e.g., alan rappeport, in targeting political groups, i.r.s. crossed party lines, n.y. times (oct. 5, 2017), https://www.nytimes.com/2017/10/05/us/politics/irs-targeting-tea-party-liberals-democrats.html. a federal watchdog investigating whether the internal revenue service unfairly targeted conservative political groups seeking tax-exempt status said that the agency also scrutinized organizations associated with liberal causes from 2004 to 2013. the findings by the treasury department’s inspector general mark the end of a political firestorm that embroiled the i.r.s. in controversy, led to the ouster of its commissioner and prompted accusations the tax collection agency was being used as a political weapon by the obama administration. 132 see supra note 12. 133 see, e.g., u.s. gov't accountability office (gao), enforcement of tax laws, in gao-17-317, highrisk series: progress on many high risk areas, while substantial efforts needed on others 500, 506 (1998) (“between fiscal years 2011 and 2016, irs's annual appropriations declined about $ 900 million. likewise, staffing has declined: full-time equivalent staff members funded by annual appropriations declined by 12,000 between fiscal year 2011 and fiscal year 2016, a 13 percent reduction. at the same time, irs's enforcement performance has declined …. [r]eductions in examinations can reduce revenue collected and may indirectly reduce voluntary compliance.”); kristin e. hickman, administering the tax system we have, 63 duke l.j. 1717, 1730 (2014) (“anecdotally, treasury and irs officials bemoan the amount of time they spend implementing the patient protection and affordable care act (aca).”); bruce bartlett, slashing the irs budget--penny-wise and pound-foolish, fiscal times (jan. 17, 2014), http://www.thefiscaltimes.com/columns/2014/01/17/slashing-irs-budget-penny-wise-andpound-foolish [https://perma.cc/xwc9-lnja] (in light of budgetary constraints, the irs lacks the ability to fulfill its taxpayer compliance mission); associated press, income tax audits plummet as irs loses agents to budget cuts, fortune (mar. 5, 2017), http://fortune.com/2017/03/05/income-tax-audits-irs-agents/ [https://perma.cc/9tmlaube] (“the number of people audited by the irs in 2016 year dropped for the sixth straight year, to just over 1 million. the last time so few people were audited was 2004. since then, the u.s. has added about 30 million people.”). 134 internal revenue serv., pub 55b, data book 2017, at 21 (2018), https://www.irs.gov/pub/irssoi/17databk.pdf [https://perma.cc/wsn4-4axg] (noting in calendar year 2016, 0.5% of all filed tax returns were audited). https://www.nytimes.com/2017/10/05/us/politics/irs-targeting-tea-party-liberals-democrats.html https://www.treasury.gov/tigta/auditreports/2017reports/201710054fr.pdf https://www.treasury.gov/tigta/auditreports/2017reports/201710054fr.pdf https://www.irs.gov/pub/irs-soi/17databk.pdf https://www.irs.gov/pub/irs-soi/17databk.pdf 2018] 71 determining an asset’s tax basis in the absence of a meaningful transfer tax regime deductions and business entertainment expenses, overstated tax basis can be elusive.135 more specifically, regardless of the sale price, a particular asset can have any tax basis or no basis at all.136 time lag is another problem that plagues accurate tax basis identification. when a taxpayer dies and the recipient receives property, it may be years or decades before the issue of tax basis is relevant (i.e., when there is a sale, exchange, or other disposition). ascertaining the fair market value of assets is never easy; when this exercise relates back years or several decades, it compounds the tax basis accuracy problem. finally, insofar as application of the basis equal to fair market value rule is concerned, even if a taxpayer takes an aggressive valuation position, it usually engenders little financial risk. this is because valuation is an art, not a science. this, combined with the fact a taxpayer always has recourse to a reasonable cause defense,137 means as long the taxpayer’s reporting position is (i) not negligent or reckless and (ii) backed by a reputable appraiser, an accuracy-related penalty will likely not apply.138 thus, in most cases, if the i.r.s. successfully challenges the reported tax basis, the taxpayer would simply owe additional tax on the understatement plus interest. d. need for congressional reform aside from the revenue losses associated with the tax basis issues described here a concomitant problem is that of equity. the financial benefits associated with tax basis maximization inure largely to the wealthy and, as such, further tilt a tax system towards inequity, which already faces serious criticism on those grounds.139 support for this proposition is readily found in numerous studies that report the majority of appreciated assets are in the hands of the affluent.140 the tax basis maximization methodologies just enumerated enable potential income to 135 joseph m. dodge & jay a. soled, debunking the basis myth under the income tax, 81 ind. l. j. 539, 563 (2006) (“a basis figure entered on schedule d can neither be incorrect on its face nor … can it fail to match an information return submitted to the irs.”). 136 admittedly, due to the advent of third-party tax basis reporting, see emergency economic stabilization act of 2008, pub. l. no. 110-343, § 403, 122 stat. 3765, 3854-60, some taxpayer derelictions will be easy to detect. more specifically, the code now requires third-party brokers to retain tax basis records on behalf of their clients related to marketable securities. see i.r.c. § 6045(g). therefore, in those instances when taxpayers report a basis that does not accord with the third-party information return, the i.r.s. will be on notice to challenge the taxpayer’s reporting position; however, in all other cases, the i.r.s. can detect overstated basis only through costly and time-consuming audits. 137 i.r.c. § 6664(c). 138 i.r.c. § 6662(a). 139 see james m. poterba & scott weisbenner, the distributional burden of taxing estates and unrealized capital gains at death, in rethinking estate tax and gift taxation 422, 422-49 (william g. gale, james r. hines jr. & joel slemrod eds., 2001) (observing that large portions of wealthy taxpayers’ estates are comprised of unrealized capital gains); david m. herszenhorn, consensus on need to revise tax code, but partisan split on specifics, n.y. times (feb. 21, 2016), https://www.nytimes.com/2016/02/21/business/yourtaxes/consensus-on-needto-revise-tax-code-but-partisan-split-on-specifics.html (quoting vice president biden saying stepped-up tax basis benefits “two-tenths of 1 percent of the population that is already very wealthy [and] does not need it….”). 140 see generally edward n. wolff, a century of wealth in america (2017). see also christopher ingraham, the richest 1 percent now owns more of the country’s wealth than at any time in the past 50 years, 72 [vol.10:1 columbia journal of tax law escape taxation, further exacerbating wealth concentrations. congress should respond by taking one or more measures to curtail taxpayer methodologies designed to maximize the tax basis of their assets. three such counter measures – (1) reinvigorating the transfer tax regime, (2) instituting a universal carryover tax basis rule, and (3) stiffening penalty exposure – should be considered. these proposed reforms are not mutually exclusive. 1. reinvigorating the transfer tax regime. for well over a century the nation’s transfer tax regime has performed an admirable job in retarding undue wealth concentrations. indeed, some commentators argue that it hasn’t gone far enough.141 that is to some degree a matter of taste, but it appears to be true that most taxpayers are concerned about growing income and wealth inequality, and our wealth transfer tax was at least one effective element in controlling that. in light of the wealth inequality concern, congress could strengthen the transfer tax regime in a number of ways.142 perhaps the most critical element of this effort would be to lower the exemption amount. although it would be more difficult technically, closing a myriad of loopholes would also be highly desirable.143 the tools to rekindle the transfer tax regime thus exist; what has thus far been lacking is the necessary political will to effectuate change. 2. instituting a universal carryover tax basis rule. the basis equal to fair market value rule appears to have been incorporated into the code as a result of administrative error, approximately a century ago.144 since then, the administrative convenience associated with this rule has been viewed as sufficient to justify its retention.145 yet, as the information technology age advances, where books and records are easily stored and readily retrieved, tax basis identifications have never been easier. the ease of tax basis identification subverts the administrative convenience argument embraced by proponents of the basis equal to fair market value rule, making it appear anachronistic in nature. wash. post (dec. 6, 2017), https://www.washingtonpost.com/news/wonk/wp/2017/12/06/the-richest-1-percentnow-owns-more-of-the-countrys-wealth-than-at-any-time-in-the-past-50years/?noredirect=on&utm_term=.a738e5b9dcae [https://perma.cc/s62b-rbrp] (“the top 20 percent of households actually own a whopping 90 percent of the stuff in america….”). 141 see, e.g., mark l. ascher, curtailing inherited wealth, 89 mich. l. rev. 69, 73 (1990) (“my proposal views inheritance as something we should tolerate only when necessary -not something we should always protect.”). 142 the following are just a small smattering of available articles on this topic: dennis l. belcher & mary louise fellows, report on reform of federal wealth transfer taxes: task force on federal wealth transfer taxes, 58 tax law. 93 (2004); john e. donaldson, the future of transfer taxation: repeal, restructuring and refinement, or replacement, 50 wash. & lee l. rev. 539 (1993); harry l. gutman, reforming federal wealth transfer taxes after erta, 69 va. l. rev. 1183 (1983); paul b. stephan, iii, a comment on transfer tax reform, 72 va. l. rev. 1471 (1986). 143 see gutman, supra note 142. 144 see supra note 43. 145 see s. rep. no. 96-394, at 122 (1979) (“administrators of estates have testified that compliance with the carryover basis provisions has caused a significant increase in the time required to administer an estate and has resulted in raising the overall cost of administration. the committee believes that the carryover basis provisions are unduly complicated. the committee therefore believes that the carryover basis provisions should be repealed.”). 2018] 73 determining an asset’s tax basis in the absence of a meaningful transfer tax regime the adoption of a universal carryover tax basis rule would be an attractive alternative to the basis equal to fair market value rule.146 just as in the gift context, anytime a taxpayer transferred an asset – whether during life or upon death – the recipient of such property would have the transferor’s tax basis in the asset. if, for whatever reason, the recipient could not identify the asset’s tax basis, he or she could make a good faith estimate (or perhaps be compelled to report a basis of zero).147 for nearly a century, the carryover tax basis world has worked in the gift-giving context; there is no reason why its extension to the realm of testamentary bequests would not fare just as well. the virtues of congress instituting a carryover tax basis at death are twofold. first, it preserves an asset’s taxable gains/losses, contributing to the integrity of an income tax system; and, because asset dispositions generally result in more gains than losses,148 congress can hope to collect more revenue without raising tax rates. in addition, through this rule’s institution, congress would be restoring a modicum of equity to the code, as recipient heirs paid tax on the appreciation of the inherited assets they received. 3. stiffening the penalty regime. taxpayers who know there is little or no downside risk, are more apt to take aggressive tax reporting positions. study after study confirms this simple proposition.149 as previously noted,150 from the i.r.s.’s vantage point, the problem of tax basis misreporting is particularly nettlesome: the agency cannot use traditional methods, such as a computerized dif score, to identify possible taxpayer defalcations. instead, oversight requires that the agency conduct an actual labor-intensive audit.151 however, the i.r.s.’s limited resources rarely permit the agency recourse to this option. to ensure better taxpayer compliance, congress should consider adjusting two existing code provisions. first, congress should narrow the acceptable range of value overstatements. to 146 see supra note 50. 147 see generally jay a. soled, exploring and (re)defining the boundaries of the cohan rule, 79 temp. l. rev. 939 (2006). 148 see supra notes 107-109 and accompanying text. 149 susan b. long, commentary, the influence of tax audits on reporting behavior, in why people pay taxes: tax compliance and enforcement 115 (joel slemrod ed., 1992); henrik jacobsen kleven, martin knudsen, claus thustrup kreiner, soren pedersen & emmanuel saez, unwilling or unable to cheat?, 79 econometrica 651 (2011); niels johannesen, patrick langetieg, daniel reck, max risch & joel slemrod, taxing hidden wealth: the consequences of u.s. enforcement initiatives on evasive foreign accounts, (nat’l bureau of econ. res., working paper no. 24366, 2018), https://www.nber.org/papers/w24366 [https://perma.cc/ykj4-gcs2]; joel slemrod, tax compliance and enforcement (nat’l bureau of econ. res., working paper no. 24799, 2018), https://www.nber.org/papers/w24799 [https://perma.cc/7p9w-59hh]. 150 see supra note 134 and accompanying text. 151 id. 74 [vol.10:1 columbia journal of tax law achieve this objective, it should penalize third-party appraisers who supply taxpayers with dateof-death appraisals that are 120% or greater than the asset’s actual fair market value. (the current threshold for penalty imposition pertains to property valuations that are 150% or more of actual fair market value.)152 second, taxpayers can currently sustain a reasonable cause defense if they reasonably relied on the expertise of a professional. 153 congress, however, could repeal the reasonable cause defense anytime an asset’s appraised value exceeded actual fair market value by 120% or more. the effects of repealing the reasonable cause defense might prove particularly interesting. presumably, taxpayers themselves would have an incentive to exercise more care in the selection of skilled and honest appraisers, and exercise more restraint in the signaling they give regarding their preferences for the highest possible appraised values. in addition, appraisers would have increased malpractice exposure, if their careless or dishonest appraisals led to penalty imposition on their clients, inducing greater care on their part. finally, as appraisers face greater liability exposure, they would likely bear enhanced insurance premiums, potentially diminishing their incentive to overstate the basis of inherited assets. v. conclusion in the income tax realm, tax basis has always been of central importance. it functions as a metric that enables taxpayers to calculate their asset gains and losses. for close to a century, to lessen their transfer tax exposure, taxpayers have placed a premium on minimizing asset values; in the income tax realm, this kept application of the basis equal to fair market rule applicable at death largely in check. but this de facto check-and-balance system between the transfer and income tax regimes is no longer in place. now that congress has emasculated the transfer tax regime, taxpayers are subscribing to new strategies such as inflating date of death asset values, retaining rather than gifting their assets (in the case of older-generation taxpayers), gifting rather than retaining their assets (in the case of younger-generation taxpayers), establishing specialized trusts, and changing their domiciles, all in an effort to maximize the tax basis of the assets they own. 152 i.r.c. § 6662(e). insofar as charitable gifts are concerned that require a qualified appraisal (defined as “an appraisal document that is prepared by a qualified appraiser … in accordance with generally accepted appraisal standards….” treas. reg. § 1.170a-17(a)(1)), treas. reg. § 1.170a-17(a)(3)(vi) requires that every appraiser make the following declaration: i understand that my appraisal will be used in connection with a return or claim for refund. i also understand that, if a substantial or gross valuation misstatement of the value of the property claimed on the return or claim for refund results from my appraisal, i may be subject to a penalty under code sec. 6695a, as well as other applicable penalties. i affirm that i have not been barred from presenting evidence or testimony before the department of the treasury or the internal revenue service pursuant to 31 u.s.c. section 330(c). consideration should be given to whether appraisals prepared by qualified appraisers for tax basis reporting purposes should be required to make the same or similar declaration. 153 i.r.c. § 6664(c). 2018] 75 determining an asset’s tax basis in the absence of a meaningful transfer tax regime to preserve the nation’s tax base, something must be done. however, in view of the budget and workforce constraints, addressing the tax basis issue administratively by more i.r.s. tax audits is unrealistic. the only meaningful solution lies in the legislative branch of government: congress must institute reforms lest the nation’s tax base be put in grave jeopardy. possible reforms include reinvigorating the transfer tax regime, eliminating the basis equal to fair market value rule, and/or instituting a stiffer penalty regime related to taxpayers artificially inflating the tax basis of their inherited assets. when it comes to tax basis reporting, the stakes are high. tax basis determinations are pivotal in terms of accurately determining taxpayer gains and losses. more must therefore be done to insure that this key component of the nation’s income tax system be respected. 76 [vol.10:1 columbia journal of tax law [this page is intentionally left blank] formatted-hickman pursuing a single mission (or something closer to it) for the irs kristin e. hickman* abstract it is often said that taxes are the lifeblood of government. as the nation’s tax collector, the irs serves a critical function without which the federal government would cease to function. yet the irs is an agency in crisis—mired in scandal, chronically underfunded, overreliant on automation, and failing to provide taxpayers with the support they need to comply with the tax laws and pay their taxes. this essay argues that a major contributor to the irs’s woes is congress’s penchant in recent decades for utilizing the irs to administer social welfare and regulatory programs that are only tangentially related to the irs’s traditional revenue raising mission. this essay examines the consequences of that choice and calls for reforming the irs’s organizational structure to segregate the revenue collection function from the biggest and most politically fraught social welfare and regulatory programs that currently fall within the irs’s jurisdiction. to that end, this essay suggests giving serious consideration either to spinning off several non-revenue raising programs from irs oversight or to splitting up the irs altogether and distributing its many functions among other new or existing agencies. * harlan albert rogers professor of law, university of minnesota law school. i am thankful for comments and suggestions from participants at the reforming the irs symposium held at the university of minnesota law school on march 27, 2015, for which this essay was written, as well as from participants in the squaretable presentation series, also at the university of minnesota law school, and at the third annual tax symposium at the university of washington school of law. thanks also go to stuart benjamin, amy monahan, and steve shay for helpful conversations and to nick bednar for research assistance. © 2016 hickman. this is an open-access publication distributed under the terms of the creative commons attribution license, https://creativecommons.org/licenses/by/4.0/, which permits the user to copy, distribute, and transmit the work provided that the original authors and source are credited. 170 columbia journal of tax law [vol.7:169 i. introduction .................................................................................................... 171 ii. the modern, multi-mission irs ................................................................ 174 iii. the problems and pitfalls of the multi-mission irs .................. 179 iv. returning to a single mission (or close to it) .............................. 186 a. learning from other agency experiences ........................................................ 186 1. the interstate commerce commission ....................................................... 187 2. the immigration and naturalization service .............................................. 189 b. contemplating the irs’s future ........................................................................ 192 v. conclusion ........................................................................................................ 193 2016] pursuing a single mission (or something closer to it) 171 the code of the organization may be supposed governed most strongly by its primary functions. but an organization has in general many functions, auxiliary indeed to its primary ones but important to its welfare. alternatively, it may be thought desirable to add some secondary functions to the organization because their accomplishment appears to be complementary to the primary ones. but if the code appropriate to the primary functions is inappropriate to the auxiliary or secondary functions, the organization may function badly.1 i. introduction the internal revenue service (irs) serves an incredibly important function as an agency of the federal government—that of collecting taxes and enforcing the tax laws. the irs has been described as “the federal government’s accounts receivable department.”2 without the tax revenues the irs collects, the federal government would quickly cease to function. yet the irs is struggling. in her 2013 annual report to congress, national taxpayer advocate nina olson described an irs in crisis—mired in scandal, chronically underfunded, overreliant on automation, and “entrenched in unproductive methods that do not promote voluntary compliance.” 3 in her 2014 annual report, olson again emphasized the irs’s difficulties, this time highlighting the “declining quality” of taxpayer services provided by the irs as “the most serious problem” faced by taxpayers, and expressing concerns about the potential impact on taxpayer compliance.4 the irs’s revenue collection function is no easy task, and the irs takes that mission seriously and generally handles it well. in its fiscal year 2014, the irs collected more than $3 trillion in taxes.5 in collecting that revenue, the irs processed more than 240 million tax returns and supplemental documents—and even that large number does not include all of the forms and returns the irs handles, like w-2s and 1099s.6 irs revenue raising efforts depend heavily on voluntary compliance by taxpayers.7 again, historically, the irs has fared pretty well in this regard. more than 98% of the taxes that the irs actually collects are paid voluntarily and on time.8 of course, taxes collected are not synonymous with taxes owed. in 2012, using data from earlier years, the irs estimated a pre-enforcement (i.e., voluntary) compliance rate of 1 kenneth j. arrow, the limits of organization 57 (1974). 2 nat’l taxpayer advoc., 2013 ann. rep. to cong. vol. 1, at xiii–xx (2013), http://www .taxpayeradvocate.irs.gov/2013-annual-report/downloads/volume-1.pdf [http://perma.cc/6733-qx98]. 3 id. 4 nat’l taxpayer advoc., 2014 ann. rep. to cong. vol. 1, at 3–25 (2014), http://www .taxpayeradvocate.irs.gov/media/default/documents/2014-annual-report/volume-one.pdf [https://perma.cc /a53m-a3gc] [hereinafter nta 2014 ann. rep.]. 5 internal revenue serv., internal revenue serv. data book, 2014, at 3 (2015), http://www .irs.gov/pub/irs-soi/14databk.pdf [http://perma.cc/u7n6-vdux]. 6 id. at 4–5. 7 see, e.g., george o’hanlon, the role of the internal revenue agent then and now, fed. bar ass’n. sec. on tax’n rep., winter 1993, at 1 (describing voluntary compliance as “the cornerstone of the tax system”). but see bryan t. camp, tax administration as inquisitorial process and the partial paradigm shift in the irs restructuring and reform act of 1998, 56 fla. l. rev. 1 (2004) (suggesting that the description of the u.s. tax system as “voluntary” is not entirely accurate). 8 nina olson, nat’l taxpayer advoc., fiscal year 2016 objectives rep. to cong. vol. 1, at 2 (2015), http://www.taxpayeradvocate.irs.gov/media/default/documents/2016-jrc/volume_1.pdf [http:// perma.cc/ts7y-ppsp]. 172 columbia journal of tax law [vol.7:169 83.1%, yielding a gross tax gap of $450 billion.9 irs enforcement efforts increased that compliance rate only slightly, to 85.5%.10 nevertheless, these statistics demonstrate that, whether motivated by a citizen’s desire to contribute or by fear of the tax man, most people in the united states file their tax returns and pay their taxes. not every country is so fortunate; the specter of greece—with a shadow economy representing approximately 27% of gdp and collections of assessed taxes running less than 12%11—looms in the background as an example to avoid. the internal revenue code is increasingly complicated. to help taxpayers in their efforts to prepare their tax returns and comply with the tax laws, the irs in fiscal year 2014 answered more than 100 million phone calls and assisted more than 5 million taxpayers at more than 300 taxpayer assistance centers across the country. 12 and, concerned about even a roughly 15% tax gap, the irs in the past has tried various strategies to increase voluntary compliance, including improving its computer systems, hiring a higher quality and more diverse workforce, and providing better training for its agents.13 yet, as olson and others have documented, budget cuts have reduced irs employee training and diminished taxpayer service,14 as well as curtailing funds and the number of irs employees available for enforcement efforts.15 to olson’s litany of the irs’s woes, i would add the following: the irs is stretched too thinly across multiple missions that are in tension with one another. as i have documented in prior work, as the administrator of an increasingly-complex internal revenue code, the irs has moved far beyond its original and primary mission as the nation’s tax collector to become a multi-mission or omnibus agency, serving a variety of congressional programs and goals that are arguably in tension with one another.16 to that observation, i will add that many if not most of the political controversies that have battered the irs’s reputation in recent years have concerned social welfare or regulatory 9 irs releases new tax gap estimates; compliance rates remain statistically unchanged from previous study, ir-2012-4, internal revenue serv. (jan. 6, 2012), http://www.irs.gov/uac/irs-releasesnew-tax-gap-estimates;-compliance-rates-remain-statistically-unchanged-from-previous-study [http:// perma.cc/xzn4-vsxq]. 10 id. 11 int’l monetary fund, imf country rep. no. 13/155, greece: selected issues 18–27 (2013) (documenting greece’s abysmal rate of tax compliance). 12 see nta 2014 ann. rep., supra note 4, at xvii. 13 o’hanlon, supra note 7. 14 nat’l taxpayer advoc., 2013 ann. rep. to cong. executive summary: preface and highlights, at 23–24 (2013), http://www.taxpayeradvocate.irs.gov/2013-annual-report/downloads/2013annual-report-to-congress-executive-summary.pdf [http://perma.cc/wdw2-pbs9]; u.s. gov’t accountability off., gao-14-534r, internal revenue service: absorbing budget cuts has resulted in significant staffing declines and uneven performance 8–9 (2014), http://www.gao.gov /assets/670/662681.pdf [http://perma.cc/h9er-49re] [hereinafter gao irs budget cuts rep.] (showing budget cuts both generally and as allocated among enforcement functions, taxpayer services, and operations support and business system modernization). 15 gao irs budget cuts rep., supra note 14, at 8–9, (documenting that budget cuts have fallen mostly on irs enforcement functions and that the number of irs full-time employees has declined as well, both generally and with respect to enforcement functions). while many government agencies have reduced their workforces through outsourcing, the irs is not among them. see, e.g., letter from nina olson, national taxpayer advocate, to cong., at 4–5 (may 13, 2014), http://www.taxpayeradvocate.irs.gov /userfiles/file/nta_pdc_letter.pdf [http://perma.cc/7ea4-5geq] (documenting past failed efforts to privatize certain collection functions). 16 kristin e. hickman, administering the tax system we have, 63 duke l.j. 1717 (2014). 2016] pursuing a single mission (or something closer to it) 173 programs and functions with only a tangential relationship to taxation, rather than traditional revenue raising.17 congress may be willing to trade some reduction in the irs’s revenue raising efforts to accomplish other goals efficiently. congress also may be willing to trade some reduction in the efficacy of social welfare or regulatory programs for the convenience of utilizing the irs’s existing administrative structure. my argument in this essay, however, is that congress’s repeated utilization of the irs to serve functions beyond its traditional revenue raising mission has reached a tipping point that threatens to undermine substantially the viability of the irs’s primary mission as the nation’s tax collector. tax scholars and policy makers sometimes talk about simplifying the tax code, both in general18 and as a key element of solving the irs’s problems.19 but, as a general matter, congress is not likely to stop using the tax code to achieve policy goals other than revenue raising—and, indeed, often has very good reasons for doing so. nor is congress likely to fully restore the irs’s budget anytime soon (let alone provide appropriations beyond said restoration). beyond those obvious but unlikely solutions to the irs’s woes, existing reform proposals often seem like so much tinkering around the edges, akin to rearranging the deck chairs on the titanic. my objective with this essay is not to offer a detailed blueprint for irs reform. instead, as a potential solution to at least some of the irs’s present difficulties, this essay takes seriously a suggestion that, when advanced by certain politicians or pundits,20 strikes many tax experts as hopelessly naïve and unworkable if not simply crazy: abolish the irs—perhaps not precisely as the politicians or pundits intend, but closely enough, either by spinning off certain programs from direct irs oversight or, though less likely, by splitting up the irs and distributing its many functions among other new or existing agencies. the key notion behind this sort of fundamental restructuring is to segregate the revenue collection function from the biggest and most politically fraught social welfare and regulatory programs that currently fall within the irs’s jurisdiction. the most obvious candidates for separate administration are exempt organization status determinations and monitoring, health care and pension matters that fall within the scope 17 see discussion infra part iii. 18 tax simplification has been a topic of academic discussion for decades. for just a few examples of that vast literature, see generally joseph m. dodge, some income tax simplification proposals, 41 fla. st. u. l. rev. 71 (2013) (outlining goals and proposals for simplification); edward j. mccaffery, the holy grail of tax simplification, 1990 wis. l. rev. 1267 (analyzing different goals and definitions of tax simplicity). for an example of policymaker proposals for tax simplification, see perab tax reform tax force releases final report, 2010 tax notes today 167-50 (aug. 30, 2010) (identifying tax simplification as a goal and documenting proposals of president’s economic recovery advisory board to simplify the tax system). 19 see, e.g., jonathan barry forman & roberta f. mann, making the internal revenue service work, 17 fla. tax rev. 725, 772–79, 782–88 (2015) (identifying tax system complexity as one of the irs’s problems and proposing simplification as the first of several solutions); koskinen speaks in favor of tax simplification, irs transparency, 2013 tax notes today 241-83 (dec. 16, 2013) (documenting irs commissioner’s support for tax simplification). 20 see, e.g., jerry moran, editorial, overhaul tax code, abolish irs, usa today (apr. 14, 2016) http://www.usatoday.com/story/opinion/2016/04/14/sen-moran-overhaul-tax-code-abolish-irs/83050708/ [https://perma.cc/d7fy-fbrq](“instead of spending millions in an attempt to fix the irs, we should abolish the agency through comprehensive tax reform.”); the simple flat tax plan, tedcruz.org www.tedcruz.org /tax_plan/ [https://perma.cc/m9ua-yc72] (describing presidential candidate ted cruz’s tax reform proposal as including “abolish[ing] the irs”). 174 columbia journal of tax law [vol.7:169 of erisa and the affordable care act, and eligibility for social welfare payments such as the earned income tax credit and the child tax credit. obviously, the devil is in the details, which i cannot offer here. nevertheless, although lacking that precise blueprint, this essay offers preliminary thoughts as to why proposals to break up the irs ought to be given serious consideration. ii. the modern, multi-mission irs the internal revenue code has always reflected goals beyond revenue raising, and irs administration of the tax laws has necessarily followed suit. historical evidence suggests that congress enacted the corporate income tax not only to raise revenue but also to provide a mechanism by which the government could regulate corporate activity and constrain corporate political power.21 the progressive structure of the individual income tax is frequently justified at least partly as a remedy for societal inequality.22 combating inequality is also a justification for maintaining the estate tax. 23 the government has subsidized home ownership through mortgage interest deductions and charitable organizations through exemption from the corporate income tax since 1913, although both the details and our thinking about these provisions have changed substantially over the decades. whereas both items were once considered definitional, policymakers now acknowledge them as tax expenditures, and tax expenditures as government spending.24 nevertheless, the legislative trend for several decades now has been to fold a variety of other governmental programs into the tax system, and thus to put the irs in charge of administering them. the growth of tax expenditures is one part of this trend. although the precise definition of what constitutes a tax expenditure is elusive, generally speaking, tax expenditures represent government spending that just happens to be structured in the form of exclusions, exemptions, or deductions that reduce taxable income or as credits that reduce the amount of taxes owed and that, in some instances, are refundable. 25 regardless of how one chooses to define what is or is not a tax expenditure, there is no question that congress has expanded their use. not long after stanley surrey coined the tax expenditures term in the 1960s, 26 the federal tax expenditure budget listed sixty items totaling somewhere between $60 billion and $65 21 steven a. bank, from sword to shield: the transformation of the corporate income tax, 1861 to present 43–44 (2010); reuven s. avi-yonah, corporations, society, and the state: a defense of the corporate tax, 90 va. l. rev. 1193, 1217–20 (2004); marjorie e. kornhauser, corporate regulation and the origins of the corporate income tax, 66 ind. l.j. 53 (1990). 22 henry c. simons, personal income taxation: the definition of income as a problem in fiscal policy 15–19 (1938); meredith r. conway, money, it’s a crime. share it fairly, but don’t take a slice of my pie!: the legislative case for the progressive income tax, 39 j. legis. 119, 130–32 (2013). 23 see generally paul l. caron & james r. repetti, occupy the tax code: using the estate tax to reduce inequality and spur economic growth, 40 pepp. l. rev. 1255 (2013) (invoking societal inequality as a rationale for retaining the estate tax); jeffrey a. cooper, ghosts of 1932: the lost history of estate and gift taxation, 9 fla. tax rev. 875, 882 (2010) (recognizing societal inequality as one justification for adopting the estate tax). 24 see hickman, supra note 16, at 1727–28, 1733–35 (summarizing home mortgage interest deduction and charitable exemption history). 25 see staff of j. comm. on tax’n, 113th cong., estimates of fed. tax expenditures for fiscal years 2014–2018 2–3 (2014), http://www.jct.gov/publications.html?func=startdown&id=4663 [http://perma.cc/3k7l-8mr9] (describing tax expenditures and analogizing them to direct spending programs). 26 see stanley s. surrey, pathways to tax reform vii (1973). 2016] pursuing a single mission (or something closer to it) 175 billion. 27 by comparison, a compendium of tax expenditures prepared by the congressional research service in 2012 lists two hundred and fifty such items totaling well over $1 trillion, 28 and even that extensive list does not purport to be comprehensive.29 former joint committee on taxation chief of staff edward kleinbard has called tax expenditures “the dominant instruments for implementing new discretionary spending policies.”30 former assistant secretary of the treasury for tax policy pamela olson has elaborated further that the continual enactment of targeted tax provisions leaves the irs with responsibility for the administration of policies aimed at the environment, conservation, green energy, manufacturing, innovation, education, saving, retirement, health care, child care, welfare, corporate governance, export promotion, charitable giving, governance of tax exempt organizations, and economic development, to name a few.31 administering government spending through the tax code is really the tip of the iceberg of irs involvement in programs and goals that are only tangentially associated with revenue raising.32 for example, congress increasingly utilizes refundable tax credits rather than direct subsidies to alleviate poverty and support working families.33 amounts expended by the government on the earned income tax credit (eitc) and the child tax credit each surpassed those for temporary assistance for needy families and its predecessor, aid to families with dependent children, years ago.34 in other words, the irs is now one of the government’s principal welfare agencies, on par with the department of health and human services (hhs) and the social security administration. some academics tout tax credits and irs administration thereof as a particularly efficient means of accomplishing congressional social welfare goals.35 other 27 id. at 7–11. 28 s. comm. on the budget, 112th cong., tax expenditures: compendium of background material on individual provisions 1, 11 (comm. print. 2012) (cong. research serv.) [hereinafter 2012 crs compendium]. 29 the crs compendium draws its data from tax expenditure estimates compiled by the joint committee on taxation (jct). id. at 1. the jct, in turn, acknowledges that it does not include de minimis items that fall below $50 million or items for which quantification is unavailable. staff of j. comm. on tax’n, 112th cong., estimates of fed. tax expenditures for fiscal years 2011–2015 27–30 (2012), http://www.jct.gov/publications.html?func=startdown&id=4386 [http://perma.cc/spc7-mpx4]. 30 edward d. kleinbard, woodworth memorial lecture: the congress within the congress: how tax expenditures distort our budget and our political processes, 36 ohio n.u. l. rev. 1, 3 (2010). 31 pamela f. olson, woodworth memorial lecture: and then cnut told reagan . . . lessons from the tax reform act of 1986, 38 ohio n.u. l. rev. 1, 12–13 (2011) (citations omitted). 32 see susannah camic tahk, everything is tax: evaluating the structural transformation of u.s. policymaking, 50 harv. j. on legis. 67, 67 (2013) (“for the past twenty-five years, congress has been relying increasingly on the tax code to accomplish goals beyond raising revenue.”). 33 see francine j. lipman, access to tax injustice, 40 pepp. l. rev. 1173, 1180–84 (2013) (describing the history of the eitc as a mechanism for alleviating poverty); michelle lyon drumbl, those who know, those who don’t, and those who know better: balancing complexity, sophistication, and accuracy on tax returns, 11 pitt. tax rev. 113, 120–23 (2013) (discussing the history of refundable credits with examples); see also eitc & other refundable credits, internal revenue serv., http://www.eitc.irs .gov [http://perma.cc/uk5u-94q6] (highlighting and facilitating claims to the eitc and other refundable tax credits). 34 nat’l taxpayer advoc., internal revenue serv., 2009 ann. rep. to cong. vol. 2, at 78 (2009), http://www.irs.gov/pub/tas/09_tas_arc_vol_2.pdf [http://perma.cc/t737-qyp6]. 35 see, e.g., david a. weisbach & jacob nussim, the integration of tax and spending programs, 113 yale l.j. 955 (2004); lawrence zelenak, tax or welfare? the administration of the earned income tax credit, 52 ucla l. rev. 1867 (2005). 176 columbia journal of tax law [vol.7:169 scholars have documented administrative challenges posed by this arrangement, given the complexity of the statutory requirements as well as the irs’s lack of affinity for or expertise regarding anti-poverty policies and objectives.36 it is no secret among tax experts that tax returns claiming such benefits are among the most likely to be audited, largely due to irs studies documenting high error rates (or high rates of fraud, depending on one’s perspective) in claiming such benefits. 37 in past years, the irs has been criticized extensively for allegedly over-auditing the tax returns of benefits claimants.38 the newest big refundable tax credit is the subsidy for health insurance premiums adopted as part of the patient protection and affordable care act (aca).39 enacted in 2010, 40 the aca is a complicated and lengthy piece of legislation that endeavors to expand health insurance coverage and control health care costs through various mandates, regulations, and subsidies administered by a combination of federal and state agencies.41 the aca contains several excise taxes that the irs must collect.42 individual income tax returns serve as the mechanism by which taxpayers also report their compliance with the aca’s requirement that they purchase health insurance, and the irs correspondingly relies upon those returns to determine and assess “shared responsibility payments” (i.e., the penalties for failing to acquire health insurance).43 but the legislation’s core aims are health care access and cost control, and the irs’s role in aca implementation extends far beyond revenue collection. working with the department of health and human services (hhs) and the department of labor (labor), irs personnel have drafted regulations that, among other things, accommodate religious organizations that object to mandatory contraceptive coverage;44 elaborate the extent to which group health plans are precluded from denying coverage to individuals with preexisting health conditions;45 and identify ways in which health insurance providers 36 see drumbl, supra note 33, at 132-39 (2013) (describing at length the mismatch between the irs’s usual approach to tax enforcement and the needs and challenges of credit recipients). 37 see, e.g., stephen d. holt, keeping it in context: earned income tax credit compliance and treatment of the working poor, 6 conn. pub. int. l.j. 183, 185–96 (2007) (documenting eitc error and audit rates, and irs and public perceptions regarding error versus fraud in that area). 38 see, e.g., u.s. gov’t accountability off., gao-12-98, adoption tax credit: irs can reduce audits and refund delays 10 (2011), http://www.gao.gov/assets/590/586423.html [https://perma .cc/j6hy-2tre](noting that the irs had audited 68% of returns claiming the adoption tax credit but found no fraud and only disallowed all or part of the credit for 17% of the returns audited); david cay johnston, i.r.s. audits of working poor increase, n.y. times (feb. 28, 2002) http://www.nytimes.com/2002/03/01 /business/irs-audits-of-working-poor-increase.html [https://perma.cc/k6pl-x3cy] (criticizing irs for increasing audits of taxpayers claiming the eitc). 39 i.r.c. § 36b (2012); king v. burwell, 135 s. ct. 2480 (2015). 40 patient protection and affordable care act, pub. l. no. 111-148, 124 stat. 119 (2010) (codified as amended in scattered sections of 21, 25, 26, 29 and 42 u.s.c.). 41 see nat’l fed’n of indep. bus. v. sebelius, 132 s. ct. 2566, 2580 (2012) (noting the aca’s goals and size). 42 examples include excise taxes on indoor tanning services (i.r.c. § 5000b) and medical devices (i.r.c. § 4191). see also affordable care act tax provisions, internal revenue serv., http://www.irs.gov /affordable-care-act/affordable-care-act-tax-provisions [http://perma.cc/3ewp-uf8m] (listing and describing aca tax provisions, including but not limited to several excise taxes). 43 i.r.c. § 5000a (2012). 44 see, e.g., t.d. 9578, group health plans and insurance issuers relating to coverage of preventive services under the patient protection and affordable care act, 77 fed. reg. 8725 (feb. 15, 2012). 45 see, e.g., t.d. 9491, patient protection and affordable care act: preexisting condition exclusions, lifetime and annual limits, rescissions, and patient protections, 75 fed. reg. 37,188 (june 28, 2010), 2010-32 i.r.b. 186, 188–89. 2016] pursuing a single mission (or something closer to it) 177 may or may not offer incentives for participating in wellness programs.46 most recently, in king v. burwell, the irs had to defend its determination that taxpayers retained eligibility for the premium tax credit when they purchased health insurance on “exchanges” established by the federal government rather than state governments. 47 although the irs won the case, the supreme court noted that the irs “has no expertise in crafting health insurance policy” and, consequently, declined to give its interpretation the usual deference extended to agency interpretations of statutes they administer.48 beyond the aca, the irs plays a leading role in administering pension benefits as well as health care under the employee retirement income security act of 1974 (erisa).49 congress enacted erisa to protect participants in certain employee pension and welfare plans, including health coverage plans, by imposing various participation, vesting, funding, reporting, and disclosure requirements on the employers and unions that sponsor them.50 the role of the irs in administering the pension aspects of erisa largely corresponds to provisions in the internal revenue code that exclude qualifying pension contributions and earnings from taxable income 51 —acknowledged tax expenditure items.52 by contrast, irs responsibilities for administering erisa health coverage requirements (as opposed to aca health coverage requirements) relate most closely to a financial penalty, styled as an excise tax, imposed by the internal revenue code on nonconforming group health plans.53 in administering erisa, the irs has worked in recent years, again with hhs and labor, to adopt regulations concerning the length of hospital stays for new mothers and their newborn infants54 and ensuring that the mental health and substance abuse disorder benefits provided by group health plans enjoy 46 see, e.g., notice of proposed rulemaking, incentives for nondiscriminatory wellness programs in group health plans, 77 fed. reg. 70,620 (nov. 26, 2012). 47 see king v. burwell, 135 s. ct. 2480, 2488 (2015). 48 id. at 2489. 49 employee retirement income security act of 1974, pub. l. no. 93-406, 88 stat. 829 (1974) (codified as amended in scattered sections of 26 and 29 u.s.c.). 50 see steven j. sacher, james i. singer & terese m. connerton, employee benefits law 22–35 (2d ed. 2000); anne tucker, retirement revolution: unmitigated risks in the defined contribution society, 51 hous. l. rev. 153, 163–66 (2013). although historical accounts of erisa focus primarily on pension reform, congress drafted erisa to cover a broader array of employee welfare plans, including employer-sponsored health insurance plans. see sacher et al., supra, at 28. 51 see, e.g., i.r.c. §§ 401–407, 410–418e, 457 (2012). many of these provisions have parallel provisions in erisa, and treasury claims interpretive jurisdiction over both. see colleen e. medill, introduction to employee benefits law 95–96 (3d ed. 2011); see also t.d. 9419, mortality tables for determining present value, 73 fed. reg. 44,632 (july 31, 2008), 2008-40 i.r.b. 790, 791 n.1 (asserting jurisdiction to adopt mortality tables for determining present value and making other computations for purposes of applying pension funding requirements under i.r.c. §§ 412 and 430 as well as erisa § 302); t.d. 9484, diversification requirements for certain defined contribution plans, 75 fed. reg. 27,927 (may 19, 2010); 2010-24 i.r.b. 748, 748–49 (adopting regulations concerning diversification requirements for defined contribution plans holding publicly traded employer securities under both i.r.c. § 401(a)(35) and parallel provision 29 u.s.c. § 204(j)). 52 2012 crs compendium, supra note 28, at 963. 53 specifically, for any group health plan that fails to meet the requirements of i.r.c. ch. 100, i.r.c. § 4980d imposes an excise tax upon a sponsoring employer of $100 per day, per individual affected. i.r.c. § 4980d (2012). chapter 100, in turn, imposes an array of portability, access, and renewability requirements, as well as benefit requirements for mothers and newborns and for mental health, among other things. i.r.c. §§ 9801–9802, 9811–9812 (2012) (imposing group health plan requirements); see also medill, supra note 51, at 354–55 (discussing the “excise tax penalty” adopted to enforce group health plan requirements). 54 t.d. 9427, final rules for group health plans and health insurance issuers under the newborns’ and mothers’ health protection act, 73 fed. reg. 62410 (oct. 20, 2008). 178 columbia journal of tax law [vol.7:169 parity with those plans’ medical and surgical benefits55—also subjects that fall outside the irs’s primary expertise. one need not be anti-irs to question whether irs personnel are desirable arbiters of such matters. the irs also plays a key role in regulating the activities of the exempt organization sector.56 current irs administration efforts in this one area now involve an entire irs division (out of only four) monitoring more than 1.6 million tax exempt organizations 57 across a few dozen separate statutory classifications that encompass universities with billion-dollar endowments and tiny religious schools teaching a few dozen students; large hospitals and small, free health clinics; labor unions; chambers of commerce; churches, big and small; the metropolitan opera and tiny, rural theater companies; the local elks lodge; and your aunt sadie’s garden club.58 defining which organizations are eligible for exempt status and, separately, which may receive tax deductible contributions is complicated.59 evaluating applications for exempt status and monitoring existing organizations for continued compliance with eligibility requirements are even more difficult and often require the irs to venture outside its primary expertise. tax administrators in this sector routinely make decisions implicating issues as varied as free speech, politics, and religion;60 election law and campaign finance;61 and, again, health policy and hospital governance.62 for example, public charities are not allowed to participate in election campaigns, but the irs’s efforts to curb political speech by church 55 t.d. 9479, interim final rules under the paul wellstone and pete domenici mental health parity and addiction equity act of 2008, 75 fed. reg. 5410 (feb. 2, 2010). 56 but see lloyd hitoshi mayer & brendan m. wilson, regulating charities in the twenty-first century: an institutional choice analysis, 85 chi.-kent l. rev. 479, 498 (2010) (“despite the irs’s recent attempts to regulate charity governance, it is generally recognized that congress, in granting tax exemption to charitable organizations, did not intend for the irs to become a national regulator of the charitable sector.”). 57 see at-a-glance: irs divisions and principal offices, internal revenue serv., http://www.irs .gov/uac/at-a-glance:-irs-divisions-and-principal-offices [http://perma.cc/hs29-eqa6] (listing four primary irs divisions: wage and investment; large business and international; small business/selfemployed; and tax-exempt and government entities); tax exempt & government entities division at a glance, internal revenue serv., http://www.irs.gov/government-entities/tax-exempt-&-governmententities-division-at-a-glance [http://perma.cc/wp25-3r6l] (describing the work of the te/ge division and noting “this sector is not designed to generate revenue, but rather to ensure that the entities fulfill the policy goals that their tax exemption was designed to achieve”). 58 i.r.c. § 501(c)(1)–(29), (d)–(f) (2012); see also charles a. borek, decoupling tax exemption for charitable organizations, 31 wm. mitchell l. rev. 183, 201–07 (2004); james j. fishman, the nonprofit sector: myths and realities, 9 n.y. city l. rev. 303, 303–05 (2006). 59 only some exempt organizations can receive tax deductible contributions. compare i.r.c. § 501 (listing types of exempt organizations), with i.r.c. § 170(c) (listing organizations eligible to receive deductible contributions). 60 see generally johnny rex buckles, does the constitutional norm of separation of church and state justify the denial of tax exemption to churches that engage in partisan political speech?, 84 ind. l.j. 447 (2009); richard w. garnett, a quiet faith? taxes, politics, and the privatization of religion, 42 b.c. l. rev. 771 (2001); steffen n. johnson, of politics and pulpits: a first amendment analysis of irs restrictions on the political activities of religious organizations, 42 b.c. l. rev. 875 (2001). 61 demonstrating the issues that the irs faces in this area, in 2011, the election law journal published an entire volume on this topic. for just a few of the contributions to that volume, see, for example, richard briffault, nonprofits and disclosure in the wake of citizens united, 10 election l.j. 337 (2011); lloyd hitoshi mayer, charities and lobbying: institutional rights in the wake of citizens united, 10 election l.j. 407 (2011); donald b. tobin, campaign disclosure and tax-exempt entities: a quick repair to the regulatory plumbing, 10 election l.j. 427 (2011). 62 see, e.g., jessica berg, putting the community back into the “community benefit” standard, 44 ga. l. rev. 375, 377 (2010) (discussing irs-developed “community benefit” criteria that nonprofit hospitals must satisfy to maintain exempt status). 2016] pursuing a single mission (or something closer to it) 179 leaders implicate first amendment issues that the irs has proven ill-equipped to handle, damaging the irs’s credibility.63 for another prime example of the difficulties the irs faces in regulating nonprofits, one need look no further than the recent irs-tea party kerfuffle, concerning the irs’s efforts to evaluate the involvement of internal revenue code § 501(c)(4) social welfare organizations in candidate-related political activities. no matter whom or what one blames for that brouhaha, the fact remains that the irs failed to appreciate the landmine onto which it was stepping, and then handled the aftermath ineptly, resulting in lasting damage to the irs’s public image.64 the irs’s subsequent attempt to promulgate regulations to clarify exactly which activities are candidate-related political activities was almost as fraught. the irs received more than 150,000 comments—many critical—from a broad array of interested parties and members of the public, prompting the irs to delay the implementation of those regulations.65 these and other programs, purposes, and functions that are at best tangentially related to the irs’s revenue raising mission take up a much greater proportion of tax administration efforts and resources than is generally realized. in other work, i documented the extent to which treasury and irs focus their regulatory efforts on tax expenditures and other social welfare and regulatory programs as opposed to revenue raising.66 according to that study, from 2008 through 2012, treasury and the irs spent almost as much time and effort drafting regulations addressing tax expenditures and other social welfare and regulatory matters like the affordable care act, erisa, and exempt organizations as they did drafting regulations addressing the individual, payroll, and corporate income tax matters that actually raise revenue. 67 in short, the irs has transitioned over time from a mission-driven agency that collects taxes to an omnibus agency that does many things. iii. the problems and pitfalls of the multi-mission irs tax policy experts have debated for some time whether and under what circumstances congress ought to assign nontax responsibilities to the irs. for example, a sizable literature exists considering whether and under what circumstances tax expenditures are adequate substitutes for, or perhaps even more effective than, direct spending programs. comparing the eitc and food stamp programs as illustrative, david weissbach and jacob nussim argue that the irs’s special expertise in measuring income makes it especially suited to administer means-tested welfare programs. 68 also comparing the eitc and food stamps, larry zelenak touts the benefits of allowing people to self-declare their eligibility for government benefits, rather than requiring precertification of eligibility.69 ann alstott counters that, because beneficiaries claim the 63 see, e.g., donald b. tobin, political campaigning by churches and charities: hazardous for 501(c)(3)s, dangerous for democracy, 95 geo. l.j. 1313, 1315–17 (2007) (describing the controversy). 64 see, e.g., lily kahng, the irs tea party controversy and administrative discretion, 99 cornell l. rev. online 41 (2013) (detailing the controversy, describing the irs’s “ineptitude” and “[b]ureaucratic bungling,” and concluding that the incident “inflicted needless damage on the irs”). 65 e.g., irs update on the proposed new regulation on 501(c)(4) organizations, internal revenue serv. (may 22, 2014), http://www.irs.gov/uac/newsroom/irs-update-on-the-proposed-newregulation-on-501%28c%29%284%29-organizations [http://perma.cc/796f-8fqd]; irs to rewrite nonprofit rules amid criticism, politico (may 23, 2014), http://www.politico.com/story/2014/05/irsrewrite-nonprofit-rules-amid-criticism-107015.html [http://perma.cc/342c-jjpy]. 66 hickman, supra note 16. 67 id. at 1746–53. 68 weisbach & nussim, supra note 35, at 1001–02. 69 zelenak, supra note 35, at 1915. 180 columbia journal of tax law [vol.7:169 eitc by filing an annual tax return, that program is less able than more traditional welfare programs to respond timely to changes in personal circumstances.70 eric laity complains that tax expenditures shift administrative costs from the government to the private sector—which others might find a feature rather than a bug. 71 eric toder suggests that both tax expenditures and direct spending possess potential attributes and difficulties, and he counsels careful case-by-case consideration of programmatic design.72 relatively little scholarly consideration has been paid, however, to whether administering such programs might cause problems for the irs. and, of course, the irs’s capacity to administer any one social welfare or regulatory program effectively (or at least effectively enough) does not automatically equate with a capacity to administer many such programs simultaneously. having a government agency serve multiple missions is not always problematic. cabinet-level departments serve multiple missions, with a single leadership that oversees a variety of subordinate offices, bureaus, administrations, and agencies—although those subordinate agencies within agencies are more typically oriented toward a single mission. for example, the department of the treasury includes not only the irs but also the u.s. mint, the financial crimes enforcement network, the bureau of engraving and printing, and the alcohol and tobacco tax and trade bureau, as well as several policy offices, on its organization chart.73 and the department of health and human services includes the centers for disease control and prevention, the centers for medicare and medicaid services, the indian health service, and the food and drug administration among its many offices and operating divisions.74 just as cabinet-level departments coordinate and manage the many functions of their subordinate agencies, so too a single agency ought to be able to organize its personnel to administer multiple programs. moreover, using an existing agency like the irs to administer new programs or functions is not unusual in american government. congress often has very good reasons to assign a new program or function to an existing administrative agency, even when that new program or function is not entirely germane to the agency’s original or core mission. the case for utilizing an existing agency for a new program or function often focuses on a combination of efficiency and resource constraints.75 setting up a new agency takes time, so assigning a new program or function to an existing bureaucracy may allow for faster implementation. such assignments are not entirely random; congress generally tasks an existing agency with a new program or function based on its perception that the 70 ann alstott, the earned income tax credit and the limitations of tax-based welfare reform, 108 harv. l. rev. 533, 579–84 (1995). 71 eric laity, the corporation as administrative agency: tax expenditures and institutional design, 48 va. tax rev. 411, 425, 442–43 (2008). 72 eric j. toder, tax cuts or spending—does it make a difference?, 53 nat’l tax j. 361, 365– 370. 73 see organizational structure, u.s. dep’t of the treasury, http://www.treasury.gov/about /organizational-structure/pages/default.aspx [http://perma.cc/y9tc-ez3f]; bureaus, u.s. dep’t of the treasury, http://www.treasury.gov/about/organizational-structure/bureaus/pages/default.aspx [http://perma .cc/2vkg-zcpb]. 74 hhs organizational chart, u.s. dep’t of health and human services, http://www.hhs.gov /about/agencies/orgchart/index.html [http://perma.cc/t38e-hfxy]. 75 rachel barkow, prosecutorial administration: prosecutor bias and the department of justice, 99 va. l. rev. 271, 307–08 (2013) (noting these considerations in the context of assigning tangential functions to the department of justice). 2016] pursuing a single mission (or something closer to it) 181 agency may have some specialized expertise relevant to the task. 76 when a new program’s goals overlap or are at least compatible with an existing agency’s core mission or expertise, then the agency’s ability to coordinate among those complimentary programs may create synergies that achieve superior outcomes while conserving government resources. even when programmatic goals are not so closely aligned, for smaller or more experimental programs, creating a new agency may make little sense when an existing agency’s expertise is at least close enough for congress to believe it can handle the additional responsibility appropriately. just because congress can assign multiple missions to an agency does not mean, however, that congress always should. the more missions an agency has, the greater the strain on the agency. in measuring agency priorities, scholars who study agency design often describe agencies as having primary and secondary missions. they recognize that an agency often, or even typically, will pursue its primary mission, perhaps to the detriment of secondary missions, for a variety of reasons.77 which goals an agency prioritizes can depend on a number of factors including political pressure, measurability, agency culture, and personnel.78 for example, political and economic pressure from congress, lobbyists, and executive oversight typically will push an agency toward its primary mission. 79 the more an agency’s primary and secondary missions conflict—yielding opposing pressures, the more likely the agency will shirk its secondary responsibilities. j.r. deshazo’s and jody freeman’s study of hydropower relicensing decisions by the federal energy regulatory commission (ferc) is illustrative. 80 as its name suggests, ferc’s responsibilities and expertise center around energy, yet ferc also has secondary environmental obligations under the national environmental policy act, the clean water act, and the endangered species act. deshazo and freeman posit that, at least from 1982 to 1998, ferc resisted pursuit of its environmental responsibilities because congress and the executive branch prioritized propower policies in light of the 1970s energy crisis, even as they continued to support environmental protection.81 agencies also tend to favor missions, goals, or functions that are easily measured and monitored—focusing on short-term, tangible results rather than abstract policy ideals.82 from a practical standpoint, and in light of political pressures, this preferencing makes sense. congress and the executive branch reward agencies they regard as successful, and nothing demonstrates success so much as tangible, quantifiable results. agencies may thus allocate fewer resources to secondary missions that pursue more 76 see, e.g., weisbach & nussim, supra note 35, at 987–90 (discussing the role of expertise in organizational design). 77 see, e.g., eric biber, too many things to do: how to deal with the dysfunctions of multiplegoal agencies, 33 harv. envtl. l. rev. 1, 4 (2009) (concluding that “agencies are most likely to underperform on ‘secondary goals’ that both interfere with the completion of what are perceived to be the agency’s primary goals”); j.r. deshazo & jody freeman, public agencies as lobbyists, 105 colum. l. rev. 2217, 2221 (2005) (noting that political pressure from congress and lobbyists both will push an agency toward one primary mission); barkow, supra note 75, at 306–07 (suggesting that the prosecutorial functions of the department of justice have won out against the secondary interests of corrections, clemency, and forensic science). 78 barkow, supra note 75, at 307–12 (drawing these factors from the agency design literature). 79 id. at 309; deshazo & freeman, supra note 77, at 2221. 80 deshazo & freeman, supra note 77, at 2221–22 (describing the study). 81 id. at 2230–45. 82 barkow, supra note 75, at 310. 182 columbia journal of tax law [vol.7:169 abstract goals, such as promoting societal equality, welfare, or environmental sustainability.83 agency culture additionally plays a prominent role in how an agency approaches its various missions. internal cultural conflicts are pervasive throughout the administrative state. political scientist james q. wilson generalized about the effects of culture on agencies: first, tasks that are not part of the culture will not be attended to with the same energy and resources as are devoted to tasks that are part of it. second, organizations in which two or more cultures struggle for supremacy will experience serious conflict as defenders of one seek to dominate representatives of others. third, organizations will resist taking on new tasks that seem incompatible with its dominant culture. the stronger and more uniform the culture—that is, the more the culture approximates a sense of mission—the more obvious these consequences.84 wilson offered as an example the former immigration and naturalization service (ins), discussed at greater length in part iv below, as an agency torn between competing goals: “keep out illegal immigrants, but let in necessary agricultural workers”; “find and expel illegal aliens, but do not break up families, impose hardships, violate civil rights, or deprive employers of low-paid workers.” 85 rachel barkow’s examination of the department of justice’s administration of corrections, clemency, and forensic science matters further illustrates wilson’s point. barkow observed that the department of justice has a culture that is oriented toward its prosecutorial function, and that culture has resulted in fewer pardons, undermined reform efforts by the bureau of prisons, and encouraged botched scientific investigations that favor the prosecution. 86 in sum, agencies struggle with or even ignore outright secondary goals that conflict with their dominant culture, and too much tension between competing functions can undermine agency efforts across the board. an agency’s culture is intertwined with its personnel and leadership. agencies recruit like-minded individuals to preserve their culture and further their primary missions.87 for example, the national aeronautics and space administration (nasa) hires engineers who demonstrate a “‘can-do’ attitude based on the diligent and systematic application of hard work and engineering principles,” rejecting subjective orientations that emphasize “i feel” or “i think” in favor of a “complete, fully documented, verifiable set of data.”88 personnel also shape how primary missions are defined and measured. for example, the forest service employs biologists, economists, engineers, and foresters, all of whom define the forest service’s mission of attaining “sustainable yields” differently.89 83 cf. chris bonastia, why did affirmative action in housing fail during the nixon era? exploring the “institutional homes” of societal politics, 47 soc. probs. 523 (2000) (suggesting the department of housing and urban development ignored its secondary mission of combating racial segregation because measuring progress was difficult). 84 james q. wilson, bureaucracy 101 (1989). 85 id. at 158. 86 barkow, supra note 75, at 341–42. 87 wilson, supra note 84, at 96–99. 88 id. at 104. 89 id. at 107. 2016] pursuing a single mission (or something closer to it) 183 in summary, when congress assigns a new program or function to an existing agency, the general understanding is that the new program or function may “take a backseat” to the agency’s primary or core mission.90 agencies tend to focus on the tasks likely to garner the most attention from congress and gravitate toward goals that are most easily measured and achieved.91 in such circumstances, an agency is likely to hire new employees whose skills and interests align with such efforts, solidifying an agency culture that emphasizes some programs or functions, even to the detriment of others.92 consequently, the efficacy of the new program or function may suffer somewhat as a consequence of congress’s decision to assign it to an existing agency. one can imagine such is especially the case when an agency is established originally to accomplish one mission and only subsequently had other, conflicting missions grafted onto its brief. when an agency’s multiple missions are in tension with one another, the agency may be particularly hard pressed to accomplish all of them well. no agency or government program design is perfect, and life and government both often require such tradeoffs. to a great extent, therefore, the question really is whether and when the costs of the tradeoff outweigh the benefits. the irs’s administration of nontax programs—even if well-intentioned and dutiful—suffers from many of these same issues. the irs’s traditional mission as the nation’s tax collector dominates everything it is and does. the irs’s mission statement emphasizes compliance, helping taxpayers “understand and meet their tax responsibilities,” and ensuring that taxpayers “pay their fair share.”93 the irs’s website home page is loaded with information about preparing and filing tax returns and paying taxes,94 with only a few nods toward other matters within the irs’s jurisdiction: a “credits & deductions” tab linked to lists of prominent tax benefits available through filing an annual tax return;95 a “hot topics” reference to the affordable care act linked to a page that in turn refers to “important changes” to “how individuals and families file their taxes;”96 and a “news” item linked to an acknowledgment of “the 10th anniversary of eitc awareness day,”97 for example. the irs publishes dozens of reports annually documenting the numbers of tax returns filed and audits conducted, and the amounts of taxes received and refunds paid—all of which are readily quantifiable.98 speeches by the irs commissioner regarding the agency’s challenges and priorities emphasize answering taxpayer questions, improving tax enforcement, and collecting more revenue: “for every dollar invested [in the irs budget], there can be returns ranging from 6-to-1 and even up 90 barkow, supra note 75, at 307–12; david b. spence & frank cross, a public choice case for the administrative state, 89 geo. l.j. 97, 119 (2000) (“that agencies are systematically more loyal to their basic mission seems persuasive, even obvious.”). 91 barkow, supra note 75, at 308–10. 92 id. 93 the agency, its mission and statutory authority, internal revenue serv., https://www.irs.gov /uac/the-agency,-its-mission-and-statutory-authority [https://perma.cc/xlz4-2zw4]. 94 see internal revenue serv., https://www.irs.gov/ [https://perma.cc/t8sl-xvhg]. 95 id. (linking to https://www.irs.gov/credits-&-deductions [https://perma.cc/zhm4-6yq3]). 96 id. (linking to https://www.irs.gov/affordable-care-act [https://perma.cc/guf8-wq2n]). 97 id. (linking to https://www.irs.gov/uac/newsroom/on-the-10th-anniversary-of-eitcawareness-day-irs-alerts-workers-of-significant-tax-benefit [https://perma.cc/3k9n-767n]). 98 see, e.g., https://www.irs.gov/uac/tax-stats-2 [https://perma.cc/4yvx-ulwf] (linking to dozens of irs reports). 184 columbia journal of tax law [vol.7:169 to 20-to-1 in some initiatives.”99 the irs does not, by comparison, provide reports documenting its impact or otherwise touting its efforts in achieving other congressional goals like alleviating poverty, protecting the environment, or improving access to health care. consider one representative example that illustrates the irs’s focus: the annual irs data book, most recently issued for 2014. the 2014 irs data book includes table after table documenting tax collections and refunds, tax returns and other forms filed, and audits and other enforcement actions pursued.100 “taxpayer assistance” is denominated principally in terms of the various ways in which irs personnel answer taxpayer questions—e.g., through telephone calls answered, walk-in assistance contacts made, or website visits made101—and also the number of appeals of proposed liability assessments the irs handled,102 although the irs additionally tracks by type the various matters addressed by the taxpayer advocate service.103 the data book further contains sections concerning tax-exempt organizations and the affordable care act. but rather than discussing how the irs’s efforts accomplish congressional goals in those sectors, the data book denominates filings processed, guidance issued, and taxes collected.104 consistent with its primary mission and the emphasis of its leadership, the irs’s workforce is culturally oriented toward raising revenue, maximizing collections, and protecting the fisc. most of the irs bureaucracy is focused on the practical, accountingoriented functions of processing and evaluating hundreds of millions of taxpayer filings with the end goal of evaluating who has paid and who still owes, taxpayer by taxpayer, entity by entity. the webpage advertising careers that prospective employees might pursue with the irs lists administrative and clerical positions; accounting, budget, and finance positions; business and tax enforcement positions; research and analysis positions; tax law specialist positions; mail and file, financial, and cash processing clerk positions; and tax examiner positions, among others—but does not list positions suggesting training or aptitude in social work, health policy, environmental policy, or any of the myriad nontax functions congress has assigned to the agency.105 anecdotally, casual conversations with irs managers reveal a perception that their responsibility visa-vis tax expenditures is to hold the line on spending through interpretation and enforcement, not to achieve the congressional goals that inspired the tax expenditures in the first place. the quantitative skills and fiscal orientation of irs personnel are well suited for the agency’s primary function of collecting government revenue; processing and evaluating hundreds of millions of taxpayer filings and collecting trillions of dollars in 99 statement of irs commissioner john koskinen on the fiscal year 2016 budget (feb. 2, 2015), https://www.irs.gov/uac/newsroom/statement-of-irs-commissioner-john-koskinen-on-the-fiscal-year2016-budget [https://perma.cc/swr5-svre]; see also, e.g., written testimony of commissioner koskinen before the house ways and means committee’s subcommittee on oversight on the 2015 tax filing season (apr. 22, 2015), https://www.irs.gov/uac/written-testimony-of-irs-commissioner-koskinen-before-thehouse-ways-and-means-committee [https://perma.cc/ar64-jtxf] (reflecting similar emphases). 100 internal revenue serv., internal revenue service data book, 2014, supra note 5, at 1– 46. 101 id. at 48–49. 102 id. at 51. 103 id. at 50. 104 id. at 53–58, 71–72. 105 see our careers, internal revenue serv., https://jobs.irs.gov/careers.html [https://perma.cc /fvw8-2x5h]. 2016] pursuing a single mission (or something closer to it) 185 taxes is no small task. those same employees may be of less utility but cause little real harm in the administration of some tax expenditures, like a research and development credit adopted to encourage corporate investment in such activities,106 an exclusion of municipal bond interest maintained to subsidize local government activities and investments,107 or a home mortgage interest deduction intended to promote middle-class home ownership. 108 but the irs’s green-eyeshade culture may make the irs spectacularly ill equipped for some of the tasks congress has assigned it. irs personnel are not automatons or drones, but nor are they social workers, environmental scientists, health policy experts, or first amendment scholars.109 they are not trained, and thus may often fail to recognize when their efforts will implicate nontax values, sensitivities, or needs. as mary heen has observed with respect to anti-poverty programs in particular, “[a] revenue-raising system, overseen by accountants, tax lawyers, and tax administrators, has serious shortcomings as a mechanism for administering social benefit programs, such as distributing income security funds to low-income workers and development funds to low-income housing programs.”110 it would be lamentable enough if the irs’s focus, culture, and expertise limitations were merely obstacles to accomplishing congressional goals of alleviating poverty, improving access to health care, or encouraging the pursuits of the nonprofit sector. but the disconnect between the irs’s traditional revenue raising function and some of its contemporary social welfare and regulatory responsibilities poses a more fundamental problem for the irs itself. some of these social welfare and regulatory programs have drawn the irs into controversial political waters. last year’s king v. burwell decision saw the irs dragged into a highly politicized controversy over taxpayer eligibility for affordable care act subsidies,111 a subject the supreme court recognized as outside the irs’s expertise.112 even if one is inclined to give the irs the benefit of the doubt when it comes to its past handling of 501(c)(4) exemption applications, only the most partisan ideologues think the irs handled that controversy adeptly and escaped undamaged in the eyes of average taxpayers.113 other examples already noted include whether in the nonprofit area with the first amendment rights of churches and 501(c)(4) social welfare organizations, 114 under the affordable care act in requiring health 106 i.r.c. § 41 (2015). 107 i.r.c. § 103 (2015). 108 i.r.c. § 163(h) (2015). 109 cf. jane aiken & stephen wizner, law as social work, 11 wash. u. j.l. & pol’y 63, 64–67 (2003) (comparing mindsets of lawyers versus social workers). 110 mary l. heen, reinventing tax expenditure reform: improving program oversight under the government performance and results act, 35 wake forest l. rev. 751, 792–93 (2000). 111 135 s. ct. 2480, 2486–87 (2015). 112 id. at 2489 (declining to apply the chevron review standard to the irs’s interpretation of the affordable care act because the irs “has no expertise in crafting health insurance policy”). 113 see, e.g., kahng, supra note 64, at 41 (2013) (detailing the controversy, describing the irs’s “ineptitude” and “[b]ureaucratic bungling,” and concluding that the incident “inflicted needless damage on the irs”). 114 see discussion supra notes 63–65 and accompanying text (describing these issues). 186 columbia journal of tax law [vol.7:169 insurance plans to include contraceptive coverage,115 or through irs efforts to combat eitc fraud using traditional tax enforcement tools like tax return audits and penalties.116 moreover, the integration of social welfare programs into the internal revenue code has a substantial impact on the profile of the persons most likely to have to engage in a meaningful way with irs personnel. historically, a simple wage earner with two children who did not itemize her deductions would have interacted rather minimally with irs personnel—filing a relatively uncomplicated annual tax return, perhaps receiving a refund or at least not owing much tax. now, that same individual grapples with pages and pages of forms and instructions to avail herself of social welfare benefits like the eitc or the child tax credit. she might enjoy the check she receives from the irs at the outset. but if she makes a mistake, the irs will not seem so friendly as it seeks to recoup the distributed funds and she additionally faces the prospect of penalties for underpayment of taxes.117 whether or not one believes that the irs has done anything wrong in any of these situations, the irs’s frequently flat-footed and tone-deaf reactions—both before and after controversy erupted—have undermined taxpayer perceptions of the agency’s competence as well as its fairness. agencies like the environmental protection agency or the national labor relations board may be expected to pursue partisan priorities. the irs, by contrast, relies heavily on its reputation for fairness and impartiality, and cannot afford to be perceived otherwise. unfortunately, as noted, congress’s response has been to cut the irs’s budget, even as politicians from both parties call for adding to the irs’s burden by adopting even more programs for the irs to administer.118 the irs just cannot succeed under these conditions. iv. returning to a single mission (or close to it) the purpose of this essay is not to offer a precise blueprint for removing programs and functions from the irs’s jurisdiction. accomplishing such a task would be substantially more complicated and require far more expertise than any one symposium essay or person can offer. instead, having argued that making the irs a multi-mission agency has harmed the irs’s ability to perform its critical role as the federal government’s tax collector, this essay merely suggests that tax policymakers and administrators ought to contemplate either spinning off certain programs and functions from the irs or splitting up the irs altogether to segregate revenue raising from other government activities. of course, the devil is in the details, and trying to segregate the revenue collection function altogether from other congressional goals is a fool’s errand. but the irs is not unique in seeing its responsibilities grow and change over time, and past restructurings of other, nontax agencies may offer significant guidance in this regard. a. learning from other agency experiences the irs is hardly alone in finding itself overburdened with multiple missions and in need of a substantial overhaul. from the century plus of the modern administrative state, examples abound. the past decade alone has seen at least two such examples. 115 see discussion supra notes 44–48 and accompanying text (listing this and other examples of controversial irs actions implementing the affordable care act). 116 see discussion supra note 36–38 and accompanying text (noting criticism of irs administration of the eitc program). 117 see drumbl, supra note 33, at 140–41 (describing how this happens). 118 see discussion supra notes 14–16 and accompanying text. 2016] pursuing a single mission (or something closer to it) 187 after the 2008 financial crisis, congress discerned that consumer finance regulation was spread among several agencies, none of which viewed consumer protection as their primary mission.119 perceiving a greater need to protect consumers within the financial sphere, in the dodd-frank wall street reform and consumer protection act of 2010, congress created the consumer financial protection board and reassigned functions from several other agencies to it.120 also, in the wake of the massive deepwater horizon oil spill in 2010, government officials realized that the agency responsible for regulating offshore oil development, the minerals management service (mms), had subordinated its safety and environmental regulatory functions to its other missions of facilitating offshore drilling and production and collecting government royalties therefrom. 121 consequently, the secretary of the interior ordered that the mms and its responsibilities be divided into three new successor agencies—the bureau of ocean energy management, the office of natural resources revenue, and the bureau of safety and environmental enforcement—segregating the agency’s permitting and revenuecollection tasks from its enforcement functions, and thereby removing the conflict among those missions.122 just as each agency is at least somewhat unique, the story behind each reorganization of a government agency is a little different. nevertheless, commonalities exist. the experiences of other agencies in the past may offer useful insights into the irs’s present problems. the following discussion describes in greater depth two such reorganizations as especially instructive: the spinoff of telephone regulation from the interstate commerce commission (icc) to the federal communication commission (fcc) in 1934, and the division of the immigration and naturalization service (ins) into three successor agencies in 2003. 1. the interstate commerce commission the icc was originally established in 1887 to regulate railroads as common carriers.123 throughout its existence, the icc’s primary expertise lay in the area of transportation services.124 over time, the icc’s authority was expanded to encompass other transportation industries, such as trucking and interstate bus lines.125 the icc was 119 dylan j. castellino, a spotlight on shadow banking: the cfpb finalizes procedures to supervise risky nonbanks, 18 n.c. banking inst. 333, 334–37 (2014); michael s. barr, the financial crisis and the path of reform, 29 yale j. on reg. 91, 107–08 (2012). 120 dodd-frank wall street reform and consumer protection act, pub. l. no. 111-203, 124 stat. 1376 (2010). 121 rebecca m. bratspies, a regulatory wake-up call: lessons from bp’s deepwater horizon disaster, 5 golden gate u. envtl. l.j. 7, 52–53 (2011); see also henry b. hogue, cong. research serv., r41485, reorganization of the minerals management service in the aftermath of the deepwater oil spill 1–3 (2010) (hereinafter reorganization of the minerals management service). 122 bratspies, supra note 121, at 64 n.7 (documenting two executive orders reorganizing the mms); see also reorganization of the minerals management service, supra note 121, at 3 (“the perceived conflicts between the missions of energy development, safety and environmental regulation enforcement, and royalty collection and disbursement for the use of state and federal governments provided the rationale for post-oil-spill administrative and legislative initiatives to reorganize mms.”). 123 interstate commerce act, ch. 104, § 11, 24 stat. 379, 383 (1887) (repealed 1995); see also john j. esch, the interstate commerce commission and congress—its influence on legislation, 5 geo. wash. l. rev. 462, 462–63 (1937) (describing icc origins). 124 s. rep. no. 73-781, at 2 (1934), reprinted in a legislative history of the communications act of 1934 712 (max d. paglin ed., 1989) (observing that the primary focus of the interstate commerce act, and thus the icc, was railroads). 125 motor carrier act of 1935, ch. 498, 49 stat. 543 (1935). 188 columbia journal of tax law [vol.7:169 eventually abolished and its functions were transferred to the surface transportation board.126 in 1910, the mann-elkins act gave the icc authority to regulate telephone and telegraph services as well.127 obviously, the mechanics of railroads and telephones are very different. so why give the icc authority over telephones in the first place? the courts had decided that telephone companies were at least strongly akin to common carriers, prompting state governments to regulate their intrastate activities.128 but in the late 1800s and early 1900s, the economic significance of interstate communications was negligible.129 the icc, as the regulator of railroads, had significant experience and expertise in issues associated with common carrier regulation, including but not limited to setting rates and enforcing nondiscrimination requirements.130 with the communications act of 1934, congress transferred responsibility for telephone service regulation from the icc to the newly-created federal communications commission.131 the icc supported that transfer.132 no crisis prompted congress to move telephone regulation from the icc to the fcc. according to jim speta, “[i]n 1934, there were no burning issues forcing new regulation of telephone companies.”133 but the icc had not asked congress to give it jurisdiction over telephones,134 and its personnel were focused primarily on regulating railroads and less interested in telephones. 135 meanwhile, the telephone industry was growing. 136 with that growth came new 126 icc termination act of 1995, pub. l. no. 104-88, 109 stat. 803. 127 mann-elkins act of 1910, ch. 309, § 7, 36 stat. 539, 544–45 (1910). 128 see, e.g., delaware & a. tel. & tel. co. v. delaware, 50 f. 677, 678 (3d cir. 1892) (“it is no longer open to question that telephone and telegraph companies are subject to the rules governing common carriers and others engaged in like public employment.”); chesapeake & p. tel. co. v. balt. & ohio tel. co., 7 a. 809, 811 (md. 1887) (“[telegraphs and telephones] are public vehicles of intelligence, and they who own or control them can no more refuse to perform impartially the functions that they have assumed to discharge than a railway company, as a common carrier, can rightfully refuse to perform its duty to the public.”); cf. w. union tel. co. v. texas, 105 u.s. 460, 461 (1881) (“a telegraph company occupies the same relation to commerce as a carrier of messages, that a railroad company does as a carrier of goods.”). 129 kenneth a. cox & william j. byrnes, the common carrier provisions—a product of evolutionary development, in a legislative history of the communications act of 1934, supra note 124, at 25. 130 see id. at 25–30 (comparing and contrasting congressional and icc regulation of railroads and telephones). 131 47 u.s.c. § 151 (1934). 132 hearing on h.r. 8301 before the h. comm. on interstate and foreign com., 73d cong. 83 (1934) (statement of frank mcmanamy, chairman, legis. comm. of the interstate com. comm’n.), reprinted in a legislative history of the communications act of 1934, supra note 124, at 429 (describing the jurisdictional transfer as “sound public policy and in the interest of effective and economical regulation”). 133 james b. speta, a common carrier approach to internet interconnection, 54 fed. comm. l.j. 225, 263 (2003). 134 esch, supra note 123, at 480 (noting that the mann-elkins act gave the icc authority over telephones “without even any suggestion from” the agency). 135 see h. rep. no. 73-1850, at 3 (1934) (noting that the icc “ha[d] never set up any bureau within its organization designed to concentrate on this field”); see also peter w. huber et al., federal telecommunications law § 3.2.2 (2d ed. 1999) (noting that the icc “was preoccupied with railroad regulation” and “never formulated any national plan for the [telephone] industry”). 136 cox & byrnes, supra note 129, at 30 (“by 1934, interstate communications had risen to a level of importance requiring greater public attention than the icc, still very busy with regulating railroads, was able to give it.”). 2016] pursuing a single mission (or something closer to it) 189 complexities. key aspects of the industries’ structures were different.137 methods that had been successful in regulating railroads proved inadequate in the context of telephones.138 contemporary documents reflect perceptions that the task of regulating telephone service had simply grown too great to leave as a secondary function of the icc. 139 according to the new york times, the chief sponsor of the 1934 communications act, senator clarence dill, maintained that an icc focused primarily on railroad issues simply could not “deal adequately with the communications problem.”140 in summary, congress initially assigned what it perceived to be a relatively minor secondary function to an existing agency that seemed to have relevant expertise. as the secondary function grew in size and complexity, the limitations of that assignment became apparent. the agency’s emphasis on its primary mission meant that the secondary function received less attention, blunting the advantages of the agency’s expertise. and the agency’s lack of knowledge about other important aspects of the secondary function correspondingly hampered its ability to accomplish congressional goals. hence, congress decided to spin off the secondary function to an agency created specifically to serve those goals. of course, spinning off communications matters from the icc to the fcc created its own issues. in particular, assigning the responsibility for regulating an industry to a single government agency with no other agenda is a perfect recipe for regulatory capture—whereby the agency comes to identify so closely to the industry it regulates that it ultimately serves the interests of industry participants as much as or more than the public interest. both critics and more neutral observers of the fcc’s history level precisely that complaint.141 2. the immigration and naturalization service the story of the ins is a little different. in 1933, president roosevelt issued an executive order establishing the ins as a combination of the bureau of immigration and the bureau of naturalization, both of which were housed in the department of labor.142 137 speta, supra note 133, at 262–63; see also s. rep. no. 73-781, at 2 (1934) (“no government organization can provide such regulation without a full knowledge of the contractual relations between the parent, subsidiary, and affiliated corporations engaged in the telephone, telegraph, and cable business.”). 138 carl i. wheat, the regulation of interstate telephone rates, 51 harv. l. rev. 846, 846–47 (1938). 139 see s. rep. no. 73-781, at 2 (1934) (“this vast monopoly which so immediately serves the needs of the people in their daily and social life must be effectively regulated”); h.r. rep. no. 73-1850, at 3 (1934) (acknowledging the need for greater regulatory attention); see also committee urges wire-radio bill, n.y. times, apr. 20, 1934, at 6. 140 committee urges wire-radio bill, supra note 139, at 6. 141 see, e.g., thomas w. hazlett, explaining the telecommunications act of 1996: comment on thomas g. krattenmaker, 29 conn. l. rev. 217, 220–21 (1996) (“indeed, the [fcc] became a cartelenforcement agency, one which could reliably be called on by incumbents to formulate rules which would make competitive entry economically impossible.”); john f. duffy, the fcc and the patent system: progressive ideals, jacksonian realism, and the technology of regulation, 71 u. colo. l. rev. 1071, 1120– 21 (2000) (describing the fcc’s history as a prototypical example of agency capture). but see louis l. jaffe, the illusion of the ideal administration, 86 harv. l. rev. 1183, 1187–88 (1973) (suggesting that capture theory “grossly exaggerat[es] the germ of truth which it does indeed embody”). 142 president’s comm. on immigr. and naturalization, whom we shall welcome: rep. of the president’s comm. on immigr. and naturalization 128 (1953). 190 columbia journal of tax law [vol.7:169 in 1940, congress moved the ins to the department of justice, where it operated for several decades.143 as part of the department of justice, the ins served two sets of functions that, arguably, were in tension with one another. first, the ins was an “enforcement agency,” charged with preventing immigrants from entering the country illegally, finding and deporting illegal immigrants, and sanctioning employers of undocumented workers.144 additionally, however, the ins was a “service agency,” charged with processing millions of applications annually from u.s. companies, citizens, permanent residents, and others applying for “immigration benefits” such as visas for foreign workers, family members, or asylum seekers, or certificates of naturalization.145 by the 1990s, the ins was an agency in crisis. chronic budget shortfalls were one problem, although this was due more to financial mismanagement than to congressional budget cuts.146 service fees were a significant source of funds for the ins, representing roughly one third of its budget.147 every year, the ins overestimated the fees it would collect and failed to collect fees that it was owed.148 due to poor internal financial controls, the ins also endured a bribery scandal.149 the ins’s primary difficulty, however, was its inability to balance effectively its enforcement functions with its more service-oriented benefit functions. culturally, the ins prioritized its enforcement functions, cultivating an “enforcement mentality” in training its employees, and emphasizing enforcement experience in filling management positions. 150 the agency’s emphasis on its enforcement functions often resulted in apathy, suspicion, and hostility toward applicants for immigration benefits, prompting even agency employees to describe their organization as “cold, rude, [and] insensitive.”151 yet, the ins’s service functions—resolving millions of individual applications for immigration benefits each year—were, quite literally, the ins’s “bread and butter,” given the agency’s reliance on service fees. 152 meanwhile, even as the ins regarded its enforcement functions as primary, the ins was criticized for failing to deport convicted felons, and when they did, for failing to stop those same felons from reentering the country. 153 yet, even successful border control efforts prompted criticism from 143 id. 144 daniel w. sutherland, the federal immigration bureaucracy: the achilles heel of immigration reform, 10 geo. immigr. l.j. 109, 113 (1996); bennett j. lee, note, the immigration and naturalization service: in search of the necessary efficiency, 6 geo. immigr. l.j. 519, 521–22 (1992). 145 sutherland, supra note 144, at 113; lee, supra note 144, at 521–22. 146 acct. and fin. mgmt. div., u.s. gov’t accountability off., gao/afmd-91-20, financial management: ins lacks accountability and controls over its resources 2 (1991), http://www.gao.gov/products/afmd-91-20 [http://perma.cc/lbn5-d59f](“ins does not have fiscal accountability over its resources.”); sutherland, supra note 144, at 110 (noting substantial increases in congressional appropriations to the ins). 147 sutherland, supra note 144, at 127; joel brinkley, at immigration, disarray and defeat, n.y. times, sept. 11, 1994, at a1. 148 sutherland, supra note 144, at 127–28; brinkley, supra note 147, at a1. 149 stephen engelberg, in immigration labyrinth, corruption comes easily, n.y. times, sept. 12, 1994, at a1. 150 sutherland, supra note 144, at 127–28; deborah sontag & stephen engelberg, insider’s view of the i.n.s.: ‘cold, rude and insensitive’, n.y. times, sept. 15, 1994, at a1. 151 sontag & engelberg, supra note 150, at a1 (describing ins employee training as “inculcat[ing] an intrinsic suspicion of immigrants” that “often translates into rudeness and even vindictiveness”). 152 sutherland, supra note 144, at 116. 153 deborah sontag, porous deportation system gives criminals little to fear, n.y. times, sept. 13, 1994, at a1. 2016] pursuing a single mission (or something closer to it) 191 congressional and executive branch officials, essentially for complicating the service side of the equation.154 a series of articles by the new york times summed up the ins’s difficulties. “hobbled by understaffing, underfinancing, conflicting mandates from congress and widespread mismanagement failures, it is an agency in disarray. it lurches from one immigration emergency to the next, its employees demoralized, its mission unrealized.”155 subsequently, the bipartisan u.s. commission on immigration reform, created by the immigration act of 1990 to evaluate the immigration system,156 concluded, while some argue that enforcement and benefits are complimentary functions, . . . placing incompatible services and enforcement functions within one agency creates problems: competition for resources; lack of coordination and cooperation; and personnel practices that both encourage transfer between enforcement and service positions and create confusion regarding mission and responsibilities. combining responsibility for enforcement and benefits also blurs the distinction between illegal migration and legal admissions. as a matter of public policy, it is important to maintain a bright line between those two forms of entry.157 the commission counseled assigning the immigration enforcement and immigration service functions to different agencies. 158 in 2002, congress did just that. in the homeland security act, congress disbanded the ins and divided its functions among three new agencies—u.s. citizenship and immigration services (cis), u.s. immigration and customs enforcement (ice), and u.s. customs and border protection (cbp)—all within the newly-created department of homeland security.159 splitting the ins has created its own problems, most obviously with respect to interagency coordination between the newly-created agencies within the department of homeland security,160 and also between the department of homeland security and the department of justice. for example, under the new structure, both cis and the executive office of immigration review (eoir), which is housed in the department of justice, adjudicate asylum proceedings.161 eoir and cis do not readily share information and 154 joel brinkley, a rare success at the border brought scant official praise, n.y. times, sept. 14, 1994, at a1. 155 brinkley, supra note 147, at a1. 156 immigration act of 1990, pub. l. no. 101-649, § 141, 104 stat. 4978 (1990). 157 u.s. comm’n on immigr. reform, becoming an american: immigration and immigrant policy 147 (1997), https://www.utexas.edu/lbj/uscir/becoming/full-report.pdf [http://perma.cc/mn4u6hqm]. 158 id. at 228. 159 homeland security act, pub. l. no. 107-296, 116 stat. 2135 (2002); see also deepa iyer & jayesh m. rathod, 9/11 and the transformation of u.s. immigration law and policy, 38 hum. rts., no. 1, winter 2011, at 10 (describing the homeland security act’s division of the ins). 160 u.s. gov’t accountability off., gao-05-081, homeland security: management challenges remain in transforming immigration programs 12 (2004), www.gao.gov/assets/250 /244485.pdf [https://perma.cc/m9kd-x6rr] (finding that cbp, cis, and ice required “a clearer understanding of the roles and responsibilities of each program”). 161 accord 8 c.f.r. § 1208.2(b) (2015) (“immigration judges shall have exclusive jurisdiction over asylum applications filed by an alien who has been served a form i-221.”); 8 c.f.r. § 208.2(a) (2015) (“[refugee, asylum and international operations] shall have initial jurisdiction over an asylum application filed by an alien physically present in the united states . . . .”); see also bijal shah, uncovering coordinated interagency adjudication, 128 harv. l. rev. 805, 814–20 (2015). 192 columbia journal of tax law [vol.7:169 have not adopted standard procedures, to the detriment of asylum applicants seeking legal benefits. along these lines, the failure of eoir and cis to collaboratively manage applicants’ asylum clocks162 resulted in a class action lawsuit against the agencies.163 and eoir and cis are not the only agencies that clash in the immigration context.164 nevertheless, these coordination difficulties pale in comparison to the problems associated with the former ins’s clashing missions and cultures. b. contemplating the irs’s future the parallels between these stories and the irs’s current situation should be obvious. for example, making exempt status determinations and monitoring exempt organizations was once a relatively small and straightforward endeavor. over the decades, as the nonprofit sector has expanded and as congress has recognized new categories of exempt organizations, the task has grown and become substantially more complicated, giving rise to a host of issues the irs is ill equipped to handle. similarly, an initially modest eitc has been expanded several times, and has correspondingly increased in complexity, again placing the irs in its present, more challenging position as that program’s administrator. the irs is being torn apart by conflicts that, for the most part, are not of its making. the question is how to resolve that problem. the most straightforward approach to dealing with the irs’s issues would be to spin off the largest and most politically damaging irs programs and functions to other new or existing agencies. for example, even if congress wants to continue using tax credits and deductions rather direct subsidies to accomplish social welfare goals, another agency could determine and monitor eligibility, handle enforcement of eligibility requirements, and then coordinate with and rely on the irs to administer the mechanics of processing the credits or deductions through tax returns. social workers with expertise in the issues faced by socioeconomically disadvantaged persons, rather than tax experts, could determine and monitor eligibility for the eitc and like refundable tax credits, and handle claims of ineligibility and fraud as well, removing those responsibilities from the irs’s jurisdiction. perhaps congress could spin off exempt organization determinations and monitoring wholesale, and have the responsible agency just provide the irs with a list of approved entities. if the irs suspects a problem with a particular entity, it could refer the matter back to the responsible agency. by comparison, abolishing the irs outright seems extreme. certainly, the federal government cannot function without a revenue agency of some sort. whatever the irs’s problems, abolishing the irs and discarding an otherwise effective tax 162 the “asylum clock” measures when an asylum claim starts and stops. an individual with a pending asylum application is permitted to obtain an employment authorization document once the clock reaches 150 days. see jesús saucedo & david rodríguez, up against the asylum clock: fixing the broken employment authorization asylum clock 3 (2010). 163 see a.b.t. v. u.s. citizenship & immigration servs., no. c11-2108, 2013 wl 5913323 (w.d. wash. nov. 4, 2013); shah, supra note 161, at 816 (2015) (“exacerbating the problem was the extent to which the doj and the dhs were often unable to effectively communicate regarding when one agency was tolling the clock, both because they were not keeping sufficient track of it themselves (due to bureaucratic ineptitude) and because they rarely shared this information with one another (due to inefficiencies and firewalls set up by the division of the asylum process between the two agencies.”)). 164 see generally julia braker, navigating the relationship between the dhs and the dol: the need for federal legislation to protect immigrant workers’ rights, 46 colum. j.l. & soc. probs. 329 (2013); stephen lee, monitoring immigration enforcement, 53 ariz. l. rev. 1089 (2011) (surveying enforcement conflicts between ice and the department of labor); daphna renan, pooling powers, 115 colum. l. rev. 211 (2015) (discussing ice and the fbi’s pooling of resources). 2016] pursuing a single mission (or something closer to it) 193 administration infrastructure developed over more than 100 years, only to start over with a new revenue agency, seems wasteful and counterproductive. nevertheless, although abolishing the irs seems drastic as a sound bite, dividing the irs into two or three new agencies—one of which would focus on revenue raising under a new name—has its merits. arguably, the “internal revenue service” brand has been substantially compromised in the eyes of at least a plurality of the taxpaying public. at the risk of giving bragging rights to demagogues, dividing the irs into two or three new agencies might give the revenue collection arm a fresh start. with that fresh start, perhaps congress might be persuaded to “restore” funding to those new agencies. whether cast as spinning off certain programs and functions or dividing the irs outright, either approach to restructuring the irs would likely give rise to interagency coordination problems. jody freeman and jim rossi stress the importance of interagency coordination in an age where “so many domains of social and economic regulation now seen populated by numerous agencies, which—to satisfy their missions—must work together cooperatively or live side by side compatibly.” 165 nevertheless, potential interagency coordination issues are not without remedy. whatever combination of agencies emerges from reorganizing the irs can deliberately pursue both formal interagency agreements and informal interagency consultations, can coordinate policymaking (much as the irs, the department of labor, and the department of health and human services do presently in the erisa and affordable care act contexts), and can seek the assistance of the office of information and regulatory affairs to prevent coordination problems.166 where there’s a will, there’s a way to minimize interagency coordination challenges. v. conclusion the irs is in perilous shape at the moment, and its condition is largely congress’s fault. congress has burdened the irs with too many secondary social welfare and regulatory programs, most of which have little to no relation to the irs’s primary mission: collecting taxes. the irs has made its own share of errors, but so do we all when given responsibilities for which we are unprepared and ill-suited. the secondary functions assigned by congress to the irs divert too many resources from the irs’s core mission. the irs and its personnel lack the expertise to assess the political consequences of many of the administrative decisions the irs must make on a day-to-day basis. politically-controversial decisions upset taxpayers, give rise to skepticism regarding the fairness and legitimacy of the tax system, and thus imperil tax compliance. finding a way to separate some of the largest and most politically fraught nonrevenue raising functions from the irs, such as exempt status determinations or health policy administration, would allow the irs to avoid such political turmoil and return its focus to its core expertise. at the very least, the idea is worth considering. 165 see jody freeman & jim rossi, agency coordination in shared regulatory space, 125 harv. l. rev. 1131, 1137–38 (2012). 166 see id. at 1138–1178. microsoft word sheffrin12-1 final formatted.docx articles a minimal role for minimum taxes steven m. sheffrin* abstract the 2017 tax cuts and jobs act eliminated the alternative minimum tax for corporations and sharply eviscerated the alternative minimum tax for individuals. yet recently there has been a resurgence of interest in minimum taxes both for the international tax systems and in certain domestic contexts. this article argues that there should be a role, but a very minimal one, for minimum taxes in our tax system. while reasonable arguments have been put forward for minimum taxes, on closer examination, many of these arguments are found wanting. this article, however, does make a second-best case for one type of minimum tax, namely as a backstop for a potentially flawed or deficient tax. that is the “minimal role for a minimum tax.” to develop this argument, i explore three distinct theoretical rationales for minimum taxes that have been put forward. first, i discuss the distinction between unilateral and multilateral minimum taxes and the potential role that multilateral minimum taxes can play in alleviating concerns that arise from tax competition and the presence of tax havens. while unilateral minimum taxes may have a strong rationale, the rationale for multilateral minimum taxes is not compelling. second, i show how considerations of fairness, public perception, and alternative views of the corporation create a demand for minimum taxes. this demand, however, can be satisfied in other ways. finally, i discuss how the imperfect targeting of tax preferences and practical limitations in the design and effectiveness of the most common taxes can provide a potential, but limited, efficiency rationale for the use of minimum taxes. i lastly provide an example of the use of minimum taxes for reforming state corporate taxation. i. introduction ........................................................................................................ 2 ii. three rationales for minimum taxes .................................................... 4 a. multilateral minimum taxes ................................................................................. 4 b. the problem of zero tax payments .................................................................... 10 c. efficiency arguments for minimum taxes ......................................................... 14 iii. tax design issues .............................................................................................. 17 * professor of economics and affiliated professor of law, tulane university. i would like to thank mary penn and spencer landry for research assistance on this project. daniel groft, formerly of the louisiana department of revenue, kindly provided data for this article. janet schwartz, michele hanlon, and drew lyon all pointed me to interesting research on this topic. james alm and katie weaver provided valuable comments on earlier drafts. 2 columbia journal of tax law [vol. 12:1 a. policy drift and the individual and corporate alternative minimum taxes ...... 17 b. accounting bases for alternative taxes ............................................................. 19 iv. one example of an efficiency based amt ........................................... 21 v. conclusion .......................................................................................................... 25 i. introduction in 1969, in the wake of publicity about a very small number of very high-income individuals not paying any income tax, congress created two new minimum taxes—one for individuals and one for corporations. these taxes were enacted to avoid having taxpayers employ a variety of tax preferences, including deductions and exclusions, to pay zero or very limited amounts of tax. although such methods were legal, their outcomes were perceived by the general public as both unfair and politically unacceptable. over time, the two minimum taxes evolved to become the alternative minimum tax (amt) for individuals and the corporate amt. nearly fifty years later, the tax cuts and jobs act of 2017 (tcja) eliminated the corporate amt and sharply decreased the amt that applied to individuals, trusts, and estates. for 2018, the tax policy center estimated that only 200,000 taxpayers would be subject to the amt compared to approximately 5 million before the tcja was enacted.1 what happened over those fifty years to cause this change? do the changes in the tcja mean that the concerns that prompted the creation of the alternative minimum taxes have disappeared? should minimum taxes still play an important role in our tax system? these are the issues i address in this article. over a fifty-year period, as the alternative minimum taxes evolved and adapted to other major tax legislation, they became increasingly complex and created unintended consequences. the corporate alternative minimum tax was particularly complex, requiring, for example, that corporations use three different accounting systems to determine income subject to the tax. scholars also demonstrated that the provisions of the tax could easily create inefficient investment incentives.2 the individual amt became very complex in an era before tax preparation software was ubiquitous. moreover, the tax lost its focus on preventing very high-income individuals from paying little tax. instead, it transformed into a tax that primarily affected the upper-middle class, effectively taking away relatively uncontroversial deductions, such as those for state and local taxes. because of these problems, reformers had long targeted the amts for either repeal or restructuring. although they have largely disappeared from the tax landscape for the time being, many individual provisions in the tcja are scheduled to expire in 2025, which will effectively bring the individual amt back in full force. beyond this uncertainty, other minimum taxes are still present in both state and federal tax codes and new ones have been contemplated. the tcja created a new tax on * professor of economics and affiliated professor of law, tulane university. i would like to thank mary penn and spencer landry for research assistance on this project. daniel groft, formerly of the louisiana department of revenue, kindly provided data for this article. janet schwartz, michele hanlon, and drew lyon all pointed me to interesting research on this topic. james alm and katie weaver provided valuable comments on earlier drafts. 1 see tax policy center, how did the tcja change the amt? (may 2020), https://www.taxpolicycenter.org/briefing-book/how-did-tcja-change-amt-0 [https://perma.cc/a6lk-sdvl]. 2 for an extensive analysis of the inefficiencies deriving from the corporate alternative minimum tax, see andrew b. lyon, cracking the code: making sense of the corporate alternative minimum tax 62-128 (1997). 2020] a minimal role for minimum taxes 3 global intangible low tax income (gilti) which, while very complex, effectively operates as a minimum tax on foreign-sourced income.3 it also eliminated carrybacks of tax losses, preventing current tax payments from falling below zero.4 the oecd has proposed a global minimum tax (globe) as part of the continuation of the base erosion and profit shifting (beps) project which resembles the united states’ gilti as well as its base erosion and anti-abuse tax (beat), which was also enacted by the tcja.5 the european union (eu) already imposes minimum rates for the value added tax (vat) on its member countries. at the level of state government in the united states, a few states have franchise taxes which serve as minimum taxes for their state corporate income taxes. what role should minimum taxes play in a tax system? should those who make tax policy aim to eliminate these taxes, or do they have a lasting role to play in complex tax systems? this article argues that there should be a role, but a very minimal one, for minimum taxes in our tax system. our prior experience with minimum taxes has shown that they drift from their original purposes and become an unstable part of the tax system. while reasonable arguments have been put forward for minimum taxes, on closer examination, many of those arguments are found wanting. this article, however, does make a second-best case for one type of minimum tax, namely as a backstop for a potentially flawed or deficient tax. that is my “minimal role for a minimum tax.”6 to develop this argument, i explore three distinct theoretical rationales for minimum taxes that have been put forward. first, i discuss the distinction between unilateral and multilateral minimum taxes and the potential role that multilateral minimum taxes can play in alleviating concerns that arise from tax competition and the presence of tax havens. while there are reasonable arguments for unilateral minimum taxes, the case for multilateral minimum taxes, however, is not compelling. second, i show how considerations of fairness, public perceptions, and alternative views of the corporation create a demand for minimum taxes. this demand could, in principle, be satisfied in other ways. finally, i discuss how the imperfect targeting of tax preferences and practical limitations in the design and effectiveness of our most common taxes can both provide a potential, but limited, efficiency rationale for the use of minimum taxes. in discussing each of these three rationales i provide a critical assessment of the arguments that have been put forward in favor of minimum taxes. i then turn to some of the implementation issues that have arisen in the design and implementation of minimum taxes, focusing on the issue of the relationship between the 3 for a general discussion of gilti, see susan morse, gilti: the co-operative potential of a unilateral minimum tax, 4 brit. tax rev. 512 (2019). 4 the coronavirus aid, relief, and economic security cares act, 15 u.s.c. ch. 116 (2020), which was signed into law on march 27, 2020, temporarily reinstates the ability to carry back losses to past tax years. for a discussion of these provisions, see i.r.s., irs provides guidance under the cares act to taxpayers with net operating losses (apr. 9, 2020), https://www.irs.gov/newsroom/irs-provides-guidance-under-thecares-act-to-taxpayers-with-net-operating-losses [https://perma.cc/mxw6-l4uy]. 5 the globe is discussed in the oecd public consultation document: organisation for economic co-operation and development [oecd], global anti-base erosion proposal (“globe”)—pillar two (nov. 8, 2019), http://www.oecd.org/tax/beps/public-consultation-document-global-anti-base-erosion-proposalpillar-two.pdf.pdf [https://perma.cc/sr7h-3fak]. 6 after completing this article, i came across the work of daniel shaviro. shaviro’s focus in his paper is primarily on the taxonomy of minimum taxes and the potential for arbitrage and the possibility of discontinuous marginal tax rates. my focus is more on the empirical and psychological arguments in favor of minimum taxes and our historical experience with them. see daniel shaviro, what are minimum taxes and why might one favor or disfavor them? (n.y.u., law and econ. paper series, working paper no. 20-38, 2020). 4 columbia journal of tax law [vol. 12:1 tax bases for the regular tax and the alternative minimum tax and the problems that arise from these interactions. i draw on the historical u.s. experience with respect to the evolution of the individual and corporate amts to demonstrate these points. i also discuss the range of issues that would arise from using book income as a base for an alternative minimum tax. finally, i illustrate the use of minimum taxes in the state corporate tax context for a potential reform. i conclude that both fairness and efficiency considerations may warrant minimum taxes in some carefully circumscribed and second-best circumstances. for the reasons i discuss in this article, these taxes will not go away. they should therefore be structured as carefully as possible to do minimal harm. they should be “boutique taxes” and not “mass taxes” to avoid the historical problems we have witnessed with our minimum taxes. ii. three rationales for minimum taxes before discussing the theoretical rationales for minimum taxes, a few definitions will be helpful. i will define minimum taxes as any taxes that are designed to place a floor—which typically, but not necessarily, will be taxpayer-specific—on the taxes paid by any entity. alternative minimum taxes are those taxes that use an alternative base to compute the minimum tax. so, for example, a rule that specified a minimum ten percent rate on foreign-sourced income—regardless of what rate was levied by a foreign country— would clearly be a minimum tax, whereas a state using a franchise tax calculation to place a floor on a corporation’s state income tax would be deemed an alternative minimum tax. alternative minimum taxes are thus a subset of minimum taxes in our terminology. in this section, i discuss and evaluate three different rationales for minimum taxes. the first perspective is based on the role that minimum taxes could play in ameliorating concerns arising from tax competition and the use of tax havens. here, the minimum taxes would arise from a multilateral agreement. as i discuss below, these ideas have been put forward in the international tax context. the second rationale traces back to the original motivations for the amt in the united states. even when individuals or corporations are complying with the rules and regulations of the tax system and employing legitimate deductions, exclusions, credits, and other tax preferences, an outcome that results in zero tax payments or limited payments for taxpayers may appear unfair and unacceptable to many in the public. an important issue is how corporations are conceived—are they just conduits for shareholders or viewed as entities in themselves? if the public holds the latter view, then corporations that do not pay taxes will draw the public ire and create perceptions of unfairness in the tax system. the third and perhaps most important rationale is the role that minimum taxes can play in promoting economic efficiency. the insight here is that minimum taxes can serve as a safeguard or backstop against overly broad tax incentives and provisions of the tax code that are difficult for tax administrators to monitor and that can be too easily manipulated by taxpayers. in these cases, minimum taxes serve as tools to prevent problems that emerge in the tax system because other components of the system are imperfect. a. multilateral minimum taxes a jurisdiction may levy its own minimum tax regardless of the taxes levied by other countries or jurisdictions. these are unilateral minimum taxes. on the other hand, a jurisdiction may levy a minimum tax as a part of a coalition of other jurisdictions. these are multilateral minimum taxes. 2020] a minimal role for minimum taxes 5 as an example of a multilateral minimum tax, consider the vat within the eu. according to eu rules, member countries must impose a vat no lower than 15%. this is the minimum rate. there are exceptions for up to two reduced rates (the lowest not being less than 5%) for a specific set of goods and services listed in annex iii to the eu vat directive. these goods include food for home consumption, drugs, and a variety of other items. there are also “super-reduced” rates that were in place prior to 1991, which were grandfathered in.7 why does the eu require a minimum basic tax rate for the vat? the essential reason is that this minimum rate is designed to limit competition between countries on taxes within the eu. the implicit belief is that without this minimum rate there would be “excessive” tax competition, driving down tax rates and causing a drain on financing for public services. the eu countries thus agreed to the minimum rate as a political disciplining device to avoid competition between member states and to provide a floor to their public budgets. while minimum tax rates can set a floor, whether minimum tax rates in fact lead to overall higher tax rates is not conclusive from the standpoint of economic theory. states that were considering setting rates above a proposed minimum might lower their rates to the minimum, reducing the variance of tax rates. in the eu this has not been the case, with the largest economies having rates around 20%.8 if anything, there is a “race to the middle” rather than a race to the bottom. france, germany, belgium, the united kingdom, spain, and the netherlands all have rates between 19 and 21%.9 luxembourg at one time had a rate of 15% but its current rate is 17%. the rationale for a minimum vat rate may be more political than purely economic. the vat is a consumption tax and falls primarily on domestic consumers—it is imposed on imports and removed on exports. as a consumption tax, the vat is levied on the destination so that a high rate in france affects french consumers, not german consumers. in principle, then, the french could choose a high rate for their country and not adversely affect the flow of goods or capital between france and germany.10 one technical argument in favor of synchronization or harmonization of rates is that a major discrepancy in vat rates could lead to some unreported cross-border shopping. however, this is probably not as important as a country feeling that it is a “political outlier” with a higher rate of tax. imposing a high minimum tax therefore provides a safeguard for domestic politicians. on the corporate side, tax avoidance and tax competition are much less straightforward. countries are concerned with profit shifting to tax havens as well as with competition among more traditional economic rivals. as has been well-documented, an important component of tax competition has often involved the use of tax havens in complex arrangements that exploited uncoordinated features in corporate law as well as 7 for a concise discussion of the european union vat rules, see ian crawford, michael keen & stephen smith, value added taxes and excises, in dimensions of tax design: the mirrlees review 275, 297-99 (inst. for fiscal stud. ed., 2010). 8 for a listing of current vat rates, see 2020 european union vat rates, avalara (2020) https://www.avalara.com/vatlive/en/vat-rates/european-vat-rates.html [https://perma.cc/r773-zqke]. 9 the united kingdom is no longer in the european union but has not yet adjusted its vat rate. 10 similar arguments were made that a consumption tax rate did not affect international tax competition during the discussion of the potential adoption of the border adjusted cash flow tax in the united states for a discussion of the border adjusted cash flow tax in terms of a consumption tax, see alan auerbach, demystifying the destination-based cash-flow tax, brookings papers on econ. activity 409 (2017). 6 columbia journal of tax law [vol. 12:1 the inherent difficulties of using transfer pricing methods for intangible assets.11 there are also successful examples of tax competition providing substantial economic benefits to countries that offer lower rates, apart from offering access to tax havens to the corporations taking advantage of those rates. ireland is an example of a country that has benefited from lower rates in attracting foreign investment.12 in february 2019, the oecd discussed a proposal for a minimum tax on the profits of multinational firms, dubbed the globe “global anti-base erosion proposal.” 13 in november 2019, the oecd issued a public consultation document for the globe proposal, the second in a series of proposals for reforms of international taxation, spelling out the proposal in more detail.14 resolving design issues and obtaining international agreement is a much more difficult task for corporate minimum taxes than it is for the vat. not only are corporate taxes fundamentally different from personal consumption taxes, but the corporate taxes would need to cover a much wider range of countries than those encompassed by the eu. one challenge is that the united states, in 2017, adopted some elements of the minimum tax philosophy in the enactment of the gilti and the beat, but did so on a unilateral, not multilateral, basis. proponents of minimum taxes on the profits of multinationals have offered several rationales. as englisch and becker discussed, a minimum rate can move countries closer to the goal of capital export neutrality (each country taxing income of its resident firms and individuals at the same rate regardless of the source of the income), thereby promoting economic efficiency by ensuring that the pretax rate of return of capital is the same in all jurisdictions. in addition, minimum rates can prevent the diversion of reported profits to tax havens, ensuring that multinationals do not use these havens to escape taxation. if most major countries impose similar minimum taxes on foreign income, the benefits of zero or low taxes in tax havens can be limited. in their recent book, emmanuel saez and gabriel zucman make a similar argument.15 the argument here is that multilateral minimum taxes can in principle provide benefits to a group of countries. since capital is mobile, there is pressure for countries to reduce their tax rates to attract foreign investment. access to tax havens only exacerbates this pressure. minimum taxes, according to this view, can prevent a race to the bottom which might threaten the public finances of countries. they can also be a tool to deal with 11 the literature on this topic is vast. for a recent estimate of profits in tax havens, see jennifer blouin & leslie robinson, double counting accounting: how much profit of multinational enterprises is really in tax havens? (may 20, 2020) (unpublished manuscript) (on file with author) (https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3491451). an early statement of the complex methods used to avoid global taxation can be found in edward d. kleinbard, stateless income, 11 fla. tax rev. 699 (2011). 12 while ireland has attracted foreign investment and grew rapidly over the last 30 years, exact measurements are difficult as some profits may be simply shifted to ireland. for a popular account of some of these difficulties, see understanding ireland’s ‘unreal’ economic growth, eolas magazine (sept. 2016), https://www.eolasmagazine.ie/understanding-irelands-unreal-economic-growth/ [https://perma.cc/y68ew5lk]. 13 for an analysis of the proposal, see joachim englisch & johannes becker, international effective minimum taxation – the globe proposal, 11 world tax. j. (2019). 14 organisation for economic co-operation and development, supra note 5. 15 emmanuel saez & gabriel zucman, the triumph of injustice: how the rich dodge taxes and how to make them pay, 67-87 (2019). 2020] a minimal role for minimum taxes 7 diversion of profits of multinationals to tax havens. finally, they are consistent with traditional notions of economic efficiency in terms of capital export neutrality. there are two traditional counterarguments against curtailing tax competition. first, arguments against curtailing tax competition rely on the notion of broadly wellintentioned governments. yet if one takes the position that governments are largely rentseeking leviathans, then minimum taxes become presumably successful oligopoly strategies for a collection of leviathan states.16 second, a case can also be made for legitimate tax competition in the presence of differential social benefits from investment, taking into account the external effects of investment.17 for example, a country may believe that the spillover effects from foreign investment create a divergence between private and social rates of return. in turn, the country would want to provide subsidies in some manner to foreign investors to attract new investment. this would be an example of socially beneficial tax competition. resolving whether these arguments in favor of tax competition outweigh the conventional wisdom against tax competition, though, would take us beyond the scope of this article. aside from this issue, there is an important limitation to the necessity of multilateral minimum taxes. to best understand this limitation, consider an alternative international tax system—a worldwide tax system with foreign tax credits. until 2018, the united states taxed worldwide income of corporations but provided a foreign tax credit. while the united states allowed for deferral for income earned from foreign corporations and, aside from subpart f income, generally only taxed dividends when they were repatriated, one could imagine a system without deferral so that all income would be taxed as it was earned.18 with a full foreign tax credit, capital export neutrality would be preserved. moreover, if countries agreed to implement a similar worldwide system and limit the range of their tax rates, this would also prevent income from escaping tax by being shifted to tax havens. the proposals in the oecd pillar two proposal aim to create a worldwide tax system with coordinated minimum tax rates, not unlike our hypothetical system. we can then ask the question: why is the oecd pillar two system a more realistic scenario than a worldwide credit system with coordinated rates? it is not clear that it would be, absent other important differences. now, of course, the united states did allow deferral, and other major economic powers had more of a territorially based system than a worldwide system of taxation. these divergent policies allowed for economic competition in the face of countries having different tax rates and placed extensive pressure on the u.s. corporate tax system with its higher statutory tax rates. with the tcja, the united states sought to alleviate some of this pressure by partly moving to a territorial system by allowing a dividend exemption. however, it did not go all the way by allowing a full exemption on active foreign source income and instead enacted gilti to provide some basic level of minimum taxes. although the acronym gilti contains the term “intangible,” it applies to all income to corporate shareholders of controlled foreign corporations on a global basis in 16 for a summary of the argument, see deepak lal, restraining leviathan, bus. standard (jan. 19, 2013), https://www.business-standard.com/article/opinion/deepak-lal-restraining-leviathan-1130119000691 .html [https://perma.cc/8lqq-dmds]. 17 see david elkins, the merits of tax competition in a globalized economy, 91 ind. l.j. 905 (2016). 18 subpart f income is a category of income defined in § 952 of the internal revenue code for controlled foreign corporations that is included immediately in shareholders’ income and not allowed deferral. it generally refers to income that is passive or easily mobile. 8 columbia journal of tax law [vol. 12:1 excess of ten percent on invested foreign assets. that income could be profits from intangible assets or simply measured returns from other investments exceeding ten percent. this income is included in the current tax year in a shareholder’s income. there is a 50% deduction for gilti income, which brings the effective tax rate on foreign income below domestic rates. a foreign tax credit of 80% is allowed, although technical limitations on the scope of the credit, including expense allocations rules, may effectively disallow some portion of the tax credit.19 key to making these new provisions work for the united states in terms of foreign tax competition was the overall new lower u.s. corporate tax rate of 21% (and even a lower rate for foreign source income due to the deduction for gilti). with u.s. rates on foreign source income now near or even below the rates of our primary competitors, the u.s. could end deferral (with its inefficient overhang of unrepatriated profits due to the benefits of deferral) and implement immediate taxation of gilti income. however, without the new lower rates (and the gilti deduction), the new u.s. minimum tax on foreign source income would not have been feasible. the upshot here is that minimum taxes are not enough—countries also must coordinate, or at least avoid sharp divergence of tax rates, as well as other aspects of corporate taxation. susan morse provides an extensive discussion of the coordination needed for minimum taxes.20 from this perspective, the u.s. prior to 2017 had a worldwide system that putatively aspired to a minimum tax (the full u.s. tax rate) but was deficient in many regards, particularly because of allowing deferral. this complex arrangement represented our political compromise, forged over the years, between a tax system based on capital export neutrality—which would tax domestic and foreign income at the same rate—and one with lower taxes on foreign source income in light of international tax competition from countries with lower tax rates. with the passage of the tcja and the new international tax provisions, we tilted the playing field a bit more towards lower rates on foreign source income, conceding to the demand to match lower rates abroad and conform to international practice with a (partial) exemption of dividends from subsidiaries. in order to preserve revenue and offset concerns about capital flight, as part of the new compromise system, we put in place a new unilateral minimum tax, although one not without controversial and complex provisions.21 our new minimum tax was thus part of the complex tradeoffs necessary for the u.s. to meet foreign competition but not leave foreign income untaxed. it had its own domestic rationale, and the policy was not tied to a vision of multilateral tax coordination. and while it had minimum tax aspects, gilti may also have simply constituted an effort to balance the taxation of domestic and foreign source income, tilting, as ever, toward lowering tax rates on foreign source income. if other major countries stumbled to their own form of a unilateral gilti or minimum tax there could be some international benefits. it would help clamp down on the diversion of profits to tax havens, as profits would eventually be taxed somewhere. indeed, the u.s. could be a model or at least a starting place for other systems. 19 for a discussion of gilti, see supra note 3. for a succinct non-technical overview of the expense allocation issue, see kyle pomerlau, what’s up with being gilti?, tax found. (mar. 14, 2019), https://taxfoundation.org/gilti-2019/ [https://perma.cc/69vz-gtc2]. 20 see morse, supra note 3. 21 see martin a. sullivan, a new gilti spreadsheet for policy and planning, tax notes (july 29, 2019), https://www.taxnotes.com/featured-analysis/economic-analysis-new-gilti-spreadsheet-policy-andplanning/2019/07/26/29s4v [https://perma.cc/3kkv-uyn5]. 2020] a minimal role for minimum taxes 9 but it is not clear what a full multilateral agreement, with all its constraints on individual country tax policies, would additionally accomplish. a full international tax agreement would either require the unlikely full synchronization of tax bases across countries, including for example agreement over the extent of accelerated depreciation, or an agreed upon non-tax global financial accounting standard—an issue i address later in this article. of course, the process of international dialogue itself might pressure some countries who would not otherwise have the will or interest to change their tax systems. but that same type of international pressure could be applied to direct measures to curb profit shifting to tax havens, as the original beps project intended, without the heavyhanded apparatus of a global minimum tax that would impinge on tax sovereignty. 22 martin sullivan suggests that we can accomplish most of our domestic goals through a second round of international tax simplification that would avoid the need to define gilti as the excess over the 10% return on invested assets (called qualified business asset investment or “qbai”) and simply impose a low tax rate on foreign source income. sullivan opines: would it be such a terribly uncompetitive outcome for u.s. multinationals if the second round of international tax reform adopted a modest minimum tax on all foreign profits? the rate could be in the neighborhood of 10% . . . yes, this would be a floor on the overall rate of foreign tax to limit the incentive to move investment offshore. it could do that with no diminution of its role as an anti-abuse measure.23 sullivan’s suggestion mirrors the argument being made here that actions taken unilaterally to protect the tax base and avoid capital flight can also assist in curbing excessive profit shifting, without the recourse to a new global system of minimum taxes. again, we should see this as a balancing of conflicting u.s. objectives of raising revenue, avoiding capital flight, and preserving a competitive framework for u.s.-based multinationals. one solution has the form of a convenient, low minimum tax on foreign source income, but this is far from justifying a multilateral system of minimum taxes. indeed, this rationale for a unilateral minimum tax is silent on the perceived need to coordinate tax rates among countries to avoid what some might deem excessive tax competition. unilateral minimum taxes can be seen in this context as combating a defect in our tax system—the well-known and inherent difficulties in using arms-length pricing methods to police the income of intangible assets. this is not the only source of profits shifted to tax havens, but it is one that is conceptually intractable.24 as such, it provides a rough and ready method to deal with a persistent and largely unresolvable tax problem. using unilateral minimum taxes in this manner would qualify as a minimal use of a minimum tax. 22 for details on the oecd beps project, see organisation for economic co-operation and development [oecd], international collaboration to end tax avoidance, https://www.oecd.org/tax/beps/ [https://perma.cc/6vqg-4sd9]. 23 sullivan, supra note 21. 24 see jane gravelle, cong. rsch. serv., r40623, tax havens: international tax avoidance (2015) for a discussion of mechanisms to shift reported income to tax havens and intangible assets. for a contrary perspective, see lorraine eden, the arm's length standard is not the problem, 48 tax mgmt. int'l j. 10 (2019). 10 columbia journal of tax law [vol. 12:1 b. the problem of zero tax payments behavioral economists have documented that individuals are extremely sensitive to “zeros” in economic transactions.25 consumer behavior appears discontinuous with respect to very low prices for goods versus “free” goods. goods which are advertised as free experience much higher demand than do goods with a price, even if the price is only nominal. zeros in taxation also appear to have great resonance in the public. the birth of the original amt in the united states arose from the january 1969 testimony of treasury secretary joseph w. barr. barr served at the very end of president johnson’s administration for just 28 days, but his testimony three days before president nixon’s inauguration had great political impact. “mr. chairman and members of the joint economic committee, i will hazard a guess that there is going to be a taxpayer revolt over the income taxes in this country unless we move in this area. now, the revolt is not going to come from the poor. they do not pay very much in taxes. the revolt is going to come from the middle class. it is going to come from those people with incomes from $7,000 to $20,000 who pay every nickel of taxes at the going rate. they do not have the loopholes and the gimmicks to resort to, mr. chairman. however, when these people see, as i see, that in the year 1967, there were 155 tax returns in this country with incomes of over $200,000 a year and 21 returns with incomes of over a million dollars for the year on which the "taxpayers" paid the u.s. government not 1 cent of income taxes, i think those people are going to say it is time to do something about it and i concur.”26 this testimony created great political controversy and had a large impact. according to len burman, “in 1969, members of congress received more constituent letters about the 155 taxpayers than about the vietnam war.” 27 as i discuss below, congress adopted the first minimum tax provisions in that year. there is also strong evidence that zero tax payments for corporate entities matter. think tanks, such as the institute on taxation and economic policy, regularly publish studies based on accounting data that demonstrate that many corporations do not report paying any u.s. federal taxes.28 these studies are then regularly and widely picked up by the press, which sometimes even try to explain why particular companies paid zero taxes.29 this has been a perennial feature of american political discourse. birnbaum and murray describe the public outcry following a citizens for tax justice study by robert mcintyre 25 see dan ariely, predictably irrational 55-74 (2008). 26 the 1969 econ. rep. of the president, hearing before the joint econ. comm. of the cong., 91st cong. 5-6 (1969) (statement of joseph w. barr, treasury secretary). 27 leonard e. burman, william g. gale & jeffrey rohaly, the expanding reach of the alternative minimum tax, 17 j. econ. persp. 173 (2003). 28 see e.g. matthew gardner & steve wamhoff, corporate tax avoidance remains rampant under new tax law, inst. on tax’n and econ. pol’y (apr. 11, 2019), https://itep.org/notadime/ [https://perma.cc/dl5k-43rq]. 29 for an informative popular discussion, see matthew yglesias, amazon’s $0 corporate tax bill last year explained, vox (feb. 20, 2019), https://www.vox.com/2019/2/20/18231742/amazon-federal-taxeszero-corporate-income [https://perma.cc/5k76-8jc8]. 2020] a minimal role for minimum taxes 11 in 1984, which found that 128 out of the 250 largest corporations paid no federal income taxes for at least one year between 1981 and 1983.30 experimental evidence also shows a deep sensitivity to corporations not paying taxes. one study compared public reaction to two investment programs—one with direct subsidies to corporations for investment and one using tax credits.31 if corporations paid positive amounts in taxes, the reaction of respondents in the survey was to treat the two programs (direct subsidy and investment credit) as roughly equivalent. but when the tax credits netted corporate tax liability to zero, then the subsidy program was greatly preferred. this experimental result is an illustration of the “entity” phenomenon, which suggests that the public perception is that entities that are subject to taxes have a normative obligation to pay taxes. this applies especially to corporations, even though, as economists stress, corporations themselves do not “pay” taxes in terms of bearing an economic burden. shareholders, workers, consumers, or other owners of capital bear the economic burden of taxes levied on corporations. but the ultimate incidence of corporate taxes does matter for public reaction. the public does seem to hold an alternative view of corporate taxation that emphasizes the idea that the corporation itself should be paying tax aside from any payments of its shareholders. this is known as the “entity view” of corporate taxation as opposed to the “aggregative view” that sees the corporation as purely a conduit for shareholders. the entity view was initially developed in the late 19th and 20th centuries as large corporations became dominant forces in the economy. as marjorie kornhauser emphasized, one of the rationales for the original 1909 corporate income tax was to regulate the corporation while, in a related vein, reuven avi-yonah suggested that the corporate tax was a method to contain corporate power by explicitly reducing corporate profits.32 related to these discussions are the deeper issues of whether corporations are really “persons” and, if so, whether they are “artificial” or “natural” persons. despite some resistance to this notion in casual opinion, it has been long established in united states law that corporations are “persons” in the sense that they can write and execute contracts and be held responsible for their actions.33 as adam winkler documents, u.s. courts have at times used both aggregative and entity views as they developed evolving doctrines of corporate rights.34 in the philosophical literature, the reality of group agency is also well established—groups can be seen to have their own goals and purposes, which can be encouraged or thwarted by public policies.35 psychologists have also explored the contours of perceptions of agency and moral responsibility for corporations versus individuals.36 30 see jeffery birnbaum & alan murray, showdown at gucci gulch 38-39 (1987). 31 see steven sheffrin, perceptions of fairness in the crucible of tax policy, in tax progressivity and income inequality 325-327 (joel slemrod ed., 1993). 32 see marjorie e. kornhauser, corporate regulation and the origins of the corporate income tax, 66 ind. l.j. 53 (1990); reuven s. avi-yonah, corporations, society, and the state: a defense of the corporate tax, 90 va. l. rev. 1193 (2004). 33 see morton j. horwitz, santa clara revisited: the development of corporate theory, w. va. l. rev. 173 (1986). 34 see adam winkler, we the corporations: how american businesses won their civil rights (2018). 35 see christian list & philip pettit, group agency: the possibility, design, and status of corporate agents (2011). 36 see mark plitt, ricky r. savjani, & david m. eagleman, are corporations people too? the neural correlates of moral judgments about companies and individuals, 10 soc. neuroscience at 113 12 columbia journal of tax law [vol. 12:1 with the entity view, corporations paying zero tax can be seen as broadly similar to nonpayment of taxes by individuals or as a moral failing. granted that there is visible public angst in the presence of zero tax payments for taxpayers who presumably have positive economic income, are explicit minimum taxes required in order to ease this political tension? there are at least two reasons to suggest that there may be political alternatives to minimum taxes: alternative presentations of taxpayer data and alternative tax strategies to directly attack the problems causing the zero taxes. in late december 2019, royal dutch shell made public its revenue, profit, and taxes paid in 98 countries around the globe.37 as of 2017, this data is now required to be reported for tax authorities for major companies based on policies agreed upon at the oecd.38 royal dutch shell now voluntarily made these public. as the wall street journal noted, it did attract adverse publicity in the uk (its tax home) because it paid no taxes due to loss carryforwards. nonetheless, it could point to the substantial amount of taxes paid around the globe. this public reporting strategy can potentially turn the debate about corporate taxation in a new direction. instead of asking whether royal dutch shell “pays taxes,” the debate turns to whom the taxes are paid. this may prompt debates about transfer pricing or related tax strategies, but these are practical rather than moral arguments. royal dutch shell may be paying too much in singapore and the united states and not enough in the uk, but it is difficult to say that as a worldwide company it is not paying taxes at all. when the original studies of non-tax paying corporations were first published in the 1980s, the focus of most americans was on domestic matters. but with the advent of rapid globalization and the emergence of non-oil corporations into world leaders, the political focus and landscape has changed. apple, google, and starbucks may be criticized in europe for minimal tax payments to eu countries, but they paid u.s. tax. amazon is an exception, paying no u.s. federal taxes in 2018 due to loss carryforwards, research and development tax credits, expensing of investment, and stock-based employee compensation. however, even they reported $2.6 billion in corporate taxes worldwide.39 reporting this information in its totality may raise questions about the structure of the u.s. tax system and provisions in the tax code, but again it is hard to claim that amazon is an immoral entity not paying taxes at all. whether the public will be satisfied if a corporation pays taxes somewhere is a subject that has not really been studied, but it clearly changes the terms of the debate. alternative tax strategies other than minimum taxes can also deal with the problem of zero tax payments. the best way to see this is to consider the changes to the alternative minimum tax after the passage of the tcja. as i noted above, the tcja vastly reduced the number of taxpayers subject to the amt, so that the number now totals approximately (2015); adam waytz & liane young, the group-member mind trade-off: attributing mind to group versus group members, 23 psychol. sci. at 77 (2012). 37 rochelle toplensky, the beginning of the end of tax secrecy, wall st. j. (dec. 20, 2019), https://www.wsj.com/articles/the-beginning-of-the-end-of-tax-secrecy-11576837708 [https://perma.cc/gq9q-xtvd]. 38 see martin sullivan, are country-by-country reports worthless?, 166 tax notes fed. 198 (jan. 13, 2020) (explaining the weaknesses in these required reports). 39 see andrew davis, why amazon paid no 2018 us federal income tax, cnbc (apr. 4, 2019), https://www.cnbc.com/2019/04/03/why-amazon-paid-no-federal-income-tax.html [https://perma.cc/r2hv32rs]. 2020] a minimal role for minimum taxes 13 only 200,000, down from approximately 5 million. yet, the explanation of the joint committee of taxation for the changes to the amt seem on the surface rather modest.40 according to this explanation, the threshold amount was increased, the phaseout level was increased, and the amounts are now indexed for inflation. but there were other more important reasons why the number of amt taxpayers has fallen. specifically, the tcja eliminated the personal exemption and placed a limit of $10,000 on total state and local tax deductions. the combination of these deductions had previously pushed many taxpayers in high-tax states into the amt. the taxpayers remaining under the amt are still subject to a number of provisions, including limits on depreciation and amortization and, perhaps most significantly, inclusion of the “spread” on incentive stock options when they are exercised.41 individual taxpayers are also subject to limitations on the use of net operating losses (nols) and are not allowed to carry back losses.42 although detailed data on the nature of current amt taxpayers is not yet available, there were some reports that many the taxpayers falling under the new amt are there due to the incentive stock option rules.43 if taxpayers now fall under the amt for only a selected number of tax preferences, there is an argument for either tackling these preferences directly by strictly limiting them or partially limiting them using an “add-on” minimum tax. an add-on minimum tax— which was the original design for the current amt—simply adds back some fraction of tax preferences, subjects them to a specified tax rate and then adds the results to regular tax liability. they can be designed in various ways to apply strictly to taxpayers with higher economic income by providing exemption levels, but they are all specific to a certain list of tax preferences. these could be structured in several different ways: under one model, each tax preference could have its own exemption level and under a second model, there could be an exemption level for all tax preferences taken together. for an example of the former, the spread on incentive tax options could be included at a specified rate (or according to a rate schedule based on some expanded measure of economic income) above a given exemption level. what would be the advantages and disadvantages of this approach? one immediate advantage it that it would finally dismantle the amt, which is scheduled to return in 2026. depending on the other tax changes that are legislated at that time, we could be in a situation where upper-middle class taxpayers are drawn back into paying the amt. more directly, this approach would focus attention on the specific tax provisions that may or may not need reform. of course, this could be a political disadvantage as it does require politicians to single out certain tax preferences for reduction. but if the number of tax preferences is relatively small, this may not be a major political economy concern.44 40 staff of joint comm. on tax’n, 115th congress, gen. explanation of pub. law 115-97, 9798 (joint comm. print 2018) 41 the spread is the difference between the market price of the stock and the price at which the option allowed one to buy the stock. 42 as noted above, the cares act temporarily suspended some limitations on nols and the use of carrybacks. 43 see matthew frankel, your 2020 guide to the alternative minimum tax, the motley fool (dec. 17, 2019), https://www.fool.com/taxes/2019/12/17/your-2020-guide-to-the-alternative-minimum-tax.aspx [https://perma.cc/f4kn-pk89]. 44 see, e.g., daniel shaviro, perception, reality, and strategy: the new alternative minimum tax, 66 taxes 91 (1988) (discussing some political economy issues). 14 columbia journal of tax law [vol. 12:1 it is important to keep in mind that the nol limitations generally prevent taxpayers from totally zeroing out their tax liabilities.45 coupled with other tax code provisions such as the passive loss rules, we no longer have the broad spectrum of taxpayers with large economic income paying no taxes. for the few exceptions that might occur—such as someone subsisting totally on interest on private tax-exempt bonds (where even then they pay an implicit tax)—we could design specific provisions to deal with these cases without creating an entirely new parallel tax system. again, we can treat tax preferences separately or as a group. if there were separate exemption levels for each tax preference, one could imagine a few situations where taxpayers employ a full range of tax preference strategies, manage to fall under the exemption levels for all of them, and in total reduce their taxable income close to zero. that would be a prima facie case where a limitation on total tax preferences might be more effective in preventing this situation from occurring. but whether it is worth the extra complication would depend on how frequently this pattern would occur. once we move away from taxpayers with zero tax payments, we also must ask whether provisions such as the amt which try to limit differences in effective tax rates for taxpayers (based on economic income) are worth the effort. there are clearly more glaring holes in the tax system than taxpayers who enjoy tax-exempt interest on private activity bonds. wealthy individuals who only minimally realize income from sales of stock and can live off lines of credit—without direct tax consequences—are a much more serious failure of our tax system.46 this is not to say that we may not want some add-on tax provisions for tax-exempt interest or incentive stock options, but we need to keep in mind the relative benefits of complicating our tax system for marginal gains in taxpayer equity. c. efficiency arguments for minimum taxes at first glance, making efficiency arguments in favor of minimum taxes appears to be a daunting task, at least in the domestic context. typically, minimum taxes have had the following structure: first, legislatures decide that taxpayers should be entitled to take certain deductions to aid legitimate social goals, for example, for state and local taxes or accelerated depreciation. second, minimum taxes then take these deductions away if the taxpayer’s income is reduced “too much” by the allowed deductions. the operation of minimum taxes in this manner raises immediate questions. if policymakers believe it is beneficial to subsidize state and local governments through deductions on individual income taxes, why should it be arbitrarily limited if a taxpayer either takes too many of these deductions or if their cumulative deductions from other items are too high? the issue with respect to investment income is even more stark. suppose a legislature believed that there was a strong efficiency case for subsidizing investment through accelerated deprecations. if we bar a firm or individual from taking full advantage of these subsidies because their resulting income would be too low, we are then removing what was deemed to be a beneficial subsidy in the first place. moreover, we create economic inefficiencies (as well as horizontal inequities) as two taxpayers with identical investment opportunities will face different after-tax benefits to their investments if one is subject to the minimum tax and the other is not.47 45 nol deductions after 2017 are limited to 80 percent of taxable income (before the nols are included) for that year. however, this provision has been temporarily suspended by the cares act. 46 see edward j. mccaffery, the death of the income tax (or, the rise of america's universal wage tax), 95 ind. l.j. 1233, 1264 (2020) (reporting that larry ellison has a $10 billion line of credit). 47 this can also create clientele effects where taxpayers purchase assets based on their own tax status. 2020] a minimal role for minimum taxes 15 what then could be the efficiency rationales for minimum taxes? there are two types of efficiency arguments that can be put forward. first, policymakers cannot target their subsidies with full accuracy and a minimum tax can serve as a partial antidote to this failure in targeting. second, there are inherent flaws in the operation of our traditional tax instruments relative to ideal taxes. for example, if we tax capital gains only when they are realized as opposed to when they accrue, we set the stage for complex tax shelters based on borrowing against appreciated assets. if we cannot avoid the realization requirement, then alternative tax instruments may be necessary to achieve our tax policy goals. with respect to targeting, consider the following example. the government wishes to subsidize productive firms with investment credits for investment. however, there are two types of firms—productive firms and unproductive firms. unproductive firms will show perennial losses. most productive firms will have positive ongoing taxable income but some, for example start-up firms, will not. even productive firms can have some bad luck and resulting losses for some period. if all firms were productive, we would want the investment credits to be fully refundable and not require the credit to be taken against positive taxable income. refundable credits, of course, would mean that some firms would effectively have negative taxes. what can policy makers do in this case? enforcing a minimum tax at zero (no refundability or allowance for carrybacks) creates a trade-off. if they permit refundable credits, they will subsidize unprofitable firms. but if they do not, they will miss the opportunity to subsidize efficient firms who are temporarily unprofitable. one solution would be to impose a minimum tax of zero by requiring the investment credits to be taken against taxable income, but to allow the credits to be carried forward, with interest. if productive firms based their decisions on present values—and were not liquidityconstrained by cash flow—this would solve the design problem for policy makers in this simple setting. alan auerbach analyzed a dynamic framework without interest on carryforwards and found that the ability to design a system to encourage only productive firms was limited.48 minimum taxes could also in principle be used to offset flaws in our tax instruments. david gamage makes a strong case that when individual taxes do not fully measure the tax base, there may be a case for using multiple instruments to achieve tax policy goals.49 for example, faced with the practical limits of a realization requirement, combing a consumption tax with an income tax can ensure that even those taxpayers who are taking advantage of realization requirements to shelter income will at least pay some tax when they consume. david schizer makes a related point with respect to whether to tax capital income at the corporate or shareholder level.50 as taxes on either shareholders or corporations rise, so do the incentives for tax avoidance. according to schizer, we should avoid relying too much on a single tax instrument as that will give rise to avoidance costs for the economy; it would be better to use a combination of taxes to minimize avoidance costs, even if that creates some additional inefficiencies. minimum taxes can also be a potential remedy when a tax avoidance strategy becomes all too evident but the normal tools to tackle the strategy are not effective. the 48 see alan auerbach, the dynamic effects of tax law asymmetries, 53 rev. econ. stud. 205 (1986). 49 see david gamage, the case for taxing (all of) labor income, consumption, capital income and wealth, 68 tax l.r. 355 (2005). 50 see david m. schizer, between scylla and charybdis: taxing corporations, shareholders (or both), 16 colum. l.r. 1850 (2016). 16 columbia journal of tax law [vol. 12:1 entire beps program of the oecd was predicated on the inability of countries to use their normal tax tools—transfer pricing, controlled foreign corporation (cfc) rules and others— to address the tax base erosion problem. while the beps project also made other recommendations to improve the operation of tax systems, for example, avoiding mismatches of business structures that permit tax avoidance, the oecd was led, as discussed above, to at least consider minimum taxes as a solution to their collective problem. as i have argued, however, a global minimum tax is itself problematic – but the origins of such an idea are understandable because of other deficiencies in the international tax system. the state corporation income tax provides another example. states are required to apportion income of businesses that operate in multiple states. however, they approach the apportionment process in several different ways, including through the use of different apportionment formulas. aside from any differences in apportionment formulas, states also differ in the business entities that they apportion. twenty-two states tax corporations on an entity-by-entity basis, while the others (plus the district of columbia) base their apportionment on a combined return, which apportions the income of a unitary group.51 while precisely defining a unitary group is challenging, it typically requires ownership thresholds above 50% and that the combined corporations (and partnerships) are generally in similar lines of business. in a combined report, payments from one member of the group to another are netted out, so that the income of the combined group does not depend, for example, on a payment from one subsidiary to another for the use of intangible property. in an entity-by-entity or single entity system, such payments do matter, particularly if the payor and payee subsidiaries reside in different states. for these reasons, most tax experts believe that single entity states face more potential problems with corporate tax avoidance than do combined reporting states. now, the states with corporate taxes that have not adopted combined reporting (mostly in the southern united states) all have their unique reasons for not doing so. perhaps there is a coordination problem in that being a first mover would make them stand out from their neighbors. there are strong political pressures from the business community not to adopt combined reporting and the states may see this as an economic development matter on which they cannot afford to stand out. finally, they may believe that entity-byentity taxation is better on the merits.52 whatever the precise reason, these states do subject themselves to the additional risks of profit-shifting to other states. one potential response to this risk would be to impose another tax on corporations that cannot be as easily shifted. in fact, many of the single entity states in addition to their state corporate income tax also have a corporate franchise or net worth tax. of the sixteen states that have franchise taxes, nine of them are single entity states. the franchise tax in these states could be a vehicle to ensure that they receive some revenue from multistate corporations in the face of potential profit shifting. later in this article, i discuss a more concrete proposal to have the franchise tax serve as an alternative minimum tax for corporations. 51 see e.g., center on budget and policy priorities, 28 states plus d.c require combined reporting for the state corporate income tax (2018), https://www.cbpp.org/27-states-plus-dc-require-combinedreporting-for-the-state-corporate-income-tax [https://perma.cc/9fjf-fmlp]. 52 see la. tax inst., report to the legislature on corporate income tax combined reporting, 2019-001 (2019), http://revenue.louisiana.gov/miscellaneous/txi%202019-001%20mucr %20report.pdf [https://perma.cc/2ljc-m76w]. 2020] a minimal role for minimum taxes 17 iii. tax design issues in this section i address some issues that have arisen with the individual and corporate alternative minimum taxes. i highlight two themes. first, both taxes evolved over time away from their original goals, which eventually led to either their effective or actual demise. i try to understand the features of the taxes which led to this evolution. second, i explore the idea that has been recently resurrected of using non-tax bases—for example, financial accounting measures—to serve as the basis for alternative taxes. a. policy drift and the individual and corporate alternative minimum taxes during the first part of the decade of the 2000s, the number of taxpayers subject to the alternative minimum tax rose from approximately 1 million in 1999 to over 4 million by 2005.53 projections made by tax experts in 2003 and 2005 predicted that without changes to the amt rules, over 30 million taxpayers would be subject to the amt by 2010.54 in fact, though, the number of amt taxpayers stabilized in the 4-5 million range until the sharp curtailment of the amt in 2018. the initial increase in the projected rise in the number of amt taxpayers can be attributed to the intricate interactions between the regular tax system and the amt. taxpayers first calculate their regular tax liability, then make an alternative calculation under the amt disallowing certain tax preferences and calculating their amt amount under the exemption levels, rules for phaseouts of the exemptions, and the tax rates under the amt. if the calculated amt amount is higher than their regular tax liability, taxpayers pay the difference as an additional amt. aside from the amt tax preferences, the base and rates of the regular tax and the exemption level, phaseout and rates of the amt are primary determinants of total tax liability and the number of taxpayers subject to the amt. when significant changes were made to the regular tax system in 2001, 2003, and 2004, all of which lowered tax liabilities, there necessarily would have been an increase in amt liability unless the key tax parameters of the amt were changed as well. while there were some minor changes to amt exemption levels that accompanied these tax bills, they were not enough to prevent the number of amt taxpayers from increasing by a factor of four over this period. the additional revenue from the amt would have been incorporated into the revenue projections for the tax bills so that the tax committees and presumably some members of congress would have been aware of these changes. while tax brackets under the regular income tax were indexed for inflation, the brackets under the amt were not. this was one of the factors leading to the projection of further sharp increases in the number of amt taxpayers. the other reason was the cumulative effect of the tax reductions from the 2001, 2003, and 2004 acts, which were themselves phased in. the projected increase to over 30 million taxpayers subject to the intricacies of the amt by 2010 was deemed an “amt crisis.”55 rather than tackle this issue directly with a reform that more closely tied the base of the regular income tax to the base of the amt, congress instead enacted a yearly set of 53 see tax policy center, what is the amt? (may 2020), https://www.taxpolicycenter.org/briefingbook/what-amt [https://perma.cc/aey8-r85v]. 54 see burman et al., supra note 27, at 173; patrick fleenor & andrew chamberlin, backgrounder on the individual alternative minimum tax (amt), tax found. (may 24, 2005), https://taxfoundation.org/backgrounder-individual-alternative-minimum-tax-amt/ [https://perma.cc/et29x99z]. 55 fleenor & chamberlin, supra note 54. 18 columbia journal of tax law [vol. 12:1 what came to be known as “patches” that increased the exemption levels to keep the number of amt taxpayers approximately constant. 56 it was not until the american taxpayer relief act of 2012 that the exemption levels and phaseouts were indexed for inflation. this bill also raised taxes on higher income individuals, and the joint effect of these changes was to stabilize the number of amt taxpayers until they dropped sharply in 2018 with the tcja changes. the type of instability we witnessed in the amt in the first decade of the 2000s is to be expected when an alternative minimum tax starts from the same base as the regular income tax. when congress enacts tax legislation, there is often an overriding vision. the 2001 and 2003 tax bills were explicitly focused on promoting economic growth (the economic growth and tax relief reconciliation act of 2001 and the jobs and growth tax relief reconciliation act of 2003), while the 2004 tax legislation suggested relief for families (the working families tax relief act of 2004). legislators, as well as the media and constituents, will naturally focus their attention on the explicit provisions in the legislation. it would be unnatural for them to focus as much attention on the amt. the one exception might be if there were a desirable tax provision in the new legislation that would become ineffective because of the amt rules. aside from that case, legislators would typically ignore the amt or at best make minor adjustments to it. and indeed, if the new tax bill lowers tax liabilities, there is an incentive to ignore increases under the amt, as making offsetting changes to the amt would increase revenue loss from the proposed legislation. it would be more politically advantageous to use the extra revenue gained under the amt to provide more visible tax benefits to constituents. moreover, to the extent that the amt would increase the tax liabilities of upper-middle class individuals, it would improve the appearance of the tax distribution tables. it took more than a decade of instability and ad hoc changes to enact inflation indexing for the amt. the corporate amt followed a different path in the 2000s, but also exhibited tensions from being closely tied to the regular corporate income tax. the corporate alternative minimum tax operated on similar principles to the individual amt but was considerably more complicated. in calculating an alternative tax liability, there were two principal adjustments that constituted roughly all of the difference between the regular and corporate tax base.57 the first was limits on deductions for depreciation that corporations could utilize in the current year and the second (after 1990) was an adjusted current earnings provision based on the “earnings and profits” provisions of the tax code, which are used in calculating dividend distributions. because these were effectively timing adjustments—limiting, for example, accelerated deprecations but eventually allowing for assets to be fully depreciated—the corporate amt allowed credits for prior tax payments so that there would be full basis recovery. thus, the corporate amt effectively accelerated tax payments, thereby typically imposing a higher cost of capital for firms subject to it. lyon discusses several economic distortions arising from the timing provisions of the amt and the loss of tax credits.58 56 cong. budget office, the individual alternative minimum tax (2010) https://www.cbo.gov/sites/default/files/111th-congress-2009-2010/reports/01-15-amtbrief.pdf [perma.cc/cb8l-9nag]. 57 lyon, supra note 2, at 15-47. 58 id. at 77-81. 2020] a minimal role for minimum taxes 19 the tax legislation in the early 2000s, however, was designed to stimulate investment and provide “bonus depreciation” or a form of accelerated depreciation. it would defeat the purposes of the legislation to award bonus depreciation but then remove it through the corporate amt. large corporate taxpayers, who were the ones primarily subject to the corporate amt, and their representatives made these concerns known in the legislative process. unlike the individual amt provisions, the adverse consequences from the corporate amt could not easily hide in the background away from the light of interested taxpayers. consequently, bonus depreciation was allowed under the corporate amt and not counted as a preference item. the result of removing bonus depreciation as an amt preference significantly reduced the revenues from the corporate amt. based on statistics of income data on amt tax payments net of amt credits, the ratio of corporate amt payments to regular corporate income tax liability decreased from about 1.7% in 1996 and 1997 to 0.8% in 2006.59 it remained roughly at this level through 2013, when it was at 0.9%. by the time of the passage of tcja, the joint committee on taxation estimated that eliminating the corporate amt would lead only to a $40 billion revenue loss over a 10-year period.60 although the senate did try to maintain the corporate amt for revenue purposes, the relatively small amount of revenue involved and the prospect that some firms would not be able to take research and development credits led ultimately to the corporate amt being eliminated in the conference.61 our experience with the corporate amt in the 2000s is another example of how tying a minimum tax closely to an existing tax base can cause complexity and thwart legislative purposes. while sophisticated corporate taxpayers in the early 2000s were able to ensure that some benefits of investment incentives were still provided to them, it took fifteen years before an eviscerated corporate amt was removed from the law. while i have argued that minimum taxes that rely on the same underlying tax base tend to thwart legislative purposes, as we saw with the bonus depreciation example, it is possible to synchronize changes between the regular tax and the amt. but in less salient settings, it is certainly possible that adjustments to the regular tax could be offset by increased liability under the amt. b. accounting bases for alternative taxes if tying an alternative tax too closely to the regular tax causes problems, what about using an alternative non-tax base for a minimum tax? about fifteen years ago, there was a flurry of interest in using income as reported on financial statements to revamp the corporate tax.62 more recently, in the oecd’s pillar 1 proposal designed to reallocate taxing rights, there was a suggestion that the starting place should be the consolidated 59 calculations based on irs statistics of income data. see i.r.s., soi tax stats table 18 returns of active corporations (jan. 30, 2020), https://www.irs.gov/statistics/soi-tax-stats-table-18-returns-of-activecorporations [https://perma.cc/t9c5-e6sc]. 60 see joint comm. on tax’n, 115th cong. jcx-67-17, estimated budget effects of the conference agreement for h.r.1, the "tax cuts and jobs act" (dec. 18, 2017). 61 see neil barr et al., davis polk, tax reform and transition (dec. 3, 2017), https://www.taxreformandtransition.com/2017/12/last-minute-retention-of-corporate-amt-in-senate-tax-billhas-unintended-consequences/ [https://perma.cc/8yx2-4wgn] (showing the opposition to retaining the amt). 62 see generally michele hanlon & terry shevlin, book tax conformity for corporate income: an introduction to the issues, 19 tax pol’y econ. (2005); john mcclelland & lillian mills, weighing benefits and risks of taxing book income, 32 ins. tax rev. 721 (2007). 20 columbia journal of tax law [vol. 12:1 financial accounts based on the headquarters of large multinational firms. there was also a proposal from a 2020 presidential candidate for a supplemental tax based on financial accounting income.63 the response of tax and accounting experts to the original proposals was largely negative. while relying on financial accounting measures as a basis for corporate taxation had some advantages in terms of reducing compliance costs and possibly reducing profitshifting, the risks were a degradation of the financial information provided to shareholders and the public, and a keen recognition of the differing purposes of financial and accounting measures. as hanlon and shevlin wrote: “financial accounting income is intended to provide outside stakeholders (e.g., investors, creditors, regulators, etc.) with information about firm performance.” in contrast, the objectives of the irc are to provide a framework for efficient and equitable determination of tax liabilities and the subsequent collection of revenue, and to provide incentives for firms to engage in, or not engage in, particular activities, and to reward particular constituencies.”64 hanlon and shevlin also provided evidence that countries that moved to more closely align book and tax income saw less influence of financial reports on financial markets, suggesting that this linkage led to less informative financial accounting. they also emphasized that the differences between book and accounting measures—for example, in terms of depreciation deductions and bad debt expenses—were profound and inconsistent with the needs of the taxing authorities to maintain a robust tax base.65 in terms of minimum taxes, from 1987 to 1989, the alternative corporate minimum tax was partly calculated using financial measures, but that system was abandoned in 1990 and replaced with adjusted current earnings as one of the bases to calculate tax preferences.66 ultimately, principles derived from the existing tax code were utilized to calculate tax preferences. more generally, the issues i raised above about the need to synchronize the regular and alternative minimum taxes still apply and with more force. as i discussed with the alternative minimum taxes, if congress wishes to provide incentives with accelerated depreciation or expensing as under the tcja, the base for the alternative minimum tax will need to be adjusted to ensure that the incentives congress wishes to apply have their intended impact. while congress historically only made limited adjustments to the individual alternative minimum tax, in the corporate arena they were more sensitive to the need to synchronize the tax bases, for example, by allowing bonus depreciation under the corporate alternative minimum tax. 63 see mindy herzfeld, warren, the oecd, and book-tax conformity, 165 tax notes fed. 393 (oct. 21, 2019). the oecd pillar one proposal is primarily concerned with reallocating the tax base and suggest financial accounting as a starting point. see organisation for economic co-operation and development [oecd], secretariat proposal for a “unified approach” (oct. 9, 2019), https://www.oecd.org/tax/beps/public-consultation-document-secretariat-proposal-unified-approach-pillarone.pdf [perma.cc/z242-d9cc]. 64 hanlon & shevlin, supra note 62, 104-05. 65 tax law often allows accelerated depreciation, but this is not recognized for book purposes. financial accounting is more lenient than tax accounting with respect to when bad debt deductions are recognized. in the united states, large corporations are currently required to file schedule m-3 to reconcile book and tax income, which may be useful to the irs for auditing purposes. 66 for an early discussion of the issues with this initial experiment, see shaviro, supra note 44. 2020] a minimal role for minimum taxes 21 having both bases under congressional control, therefore, is necessary to be consistent with its legislative intent. delegating the content of an alternative base to a nongovernmental third party would defeat this purpose. as a practical matter, it would also be highly unlikely to survive any normal legislative process. even if this delegation were initially to take place, based on experience it is likely that congress would try to intervene in the accounting standards setting process.67 herzfeld also highlights several different reasons why national governments, through their tax policy, may have different goals than financial accountants, which would inevitably lead to sharp tensions between measures of financial and taxable income.68 governments may be interested in promoting growth (through accelerated depreciation), managing downturns (through increasing the usage of nols and carrybacks), encouraging innovation by not limiting credits such as those for research and development, and providing investment incentives in locales where firms might initially report losses. the national and international demand for these goals may rise and fall over time, but they are unlikely to disappear. since the mid-2000s, there have been more radical tax base changes both proposed and enacted by congress. the destination cash flow tax was initially proposed by house republicans, while the tcja enacted expensing along with limits of interest deductibility. if anything, the conceptual distance between book and tax measures has increased as congress has increasingly adopted more consumption tax principles in their actual or contemplated legislation. book accounting measures would only be potentially comparable if the tax system were based on income tax principles. once consumption tax principles take root, the conceptual distance between tax and book accounting measures becomes insurmountable. iv. one example of an efficiency based amt in this section, i provide an example of how restructuring a tax as a minimum tax can lead to an improvement in the tax structure of a state, moving in the direction of reform in a manner that may be politically feasible. the example is restructuring the franchise tax as an alternative minimum tax for the state corporate income tax in louisiana. first, some necessary background. the state of louisiana imposes both a corporate income tax and a franchise tax. corporations file a single return that includes both income and franchise taxes, and allowable credits can be taken against both taxes. the corporate income tax is based on the separate entity principle, where each corporation files a separate return and its income is apportioned separately. as i discussed above, twenty-two states use this method and it is heavily concentrated in the southern states. louisiana is also one of the sixteen states that levy a general franchise tax or a tax levied on a base of a corporation’s equity or sometimes capital.69 in determining the sixteen states, i exclude those that only levy franchise taxes on financial corporations (michigan and vermont), impose very minimal franchise fees (new mexico), or use the term to refer to their corporate income tax (california). nine of the sixteen states that have a franchise tax are in the south—all those states also have single entity filing for corporate taxation. some states, including mississippi in 67 see hanlon & shevlin, supra note 62, at 113 (discussing controversies over stock options and other more recent examples). 68see herzfeld, supra note 63. 69 see janelle cammenga, does your state levy a capital stock tax? tax found. (aug. 21, 2019) https://taxfoundation.org/state-capital-stock-tax-2019/ [perma.cc/bcj9-ns36]. 22 columbia journal of tax law [vol. 12:1 the south, are in the process of phasing out their franchise tax. nonetheless, the combination of single entity filing for corporation taxes and franchise taxes appear to be a robust combination in the southern states. louisiana imposes its franchise tax on a taxable base that includes issued and outstanding capital stock, surplus, and undivided profits.70 all of these terms are defined by louisiana statutes, but the tax base can be construed as the amount paid for shares plus retained earnings. debt was removed from the tax base in prior years, so effectively the franchise tax is a tax on equity capital. the top rates applied to the capital base are $1.50 per $1,000 up to $300,000 and then $3.00 per $1,000 of taxable base above $300,000. there is no cap on the total tax (as in seven other states) and it is levied separately and added to any corporate tax liability. although the tax originally only applied to corporations, the law was changed in 2016 to include corporations that own property in the state either directly or indirectly through partnerships or joint ventures and to other entities that checked the box as corporations. the franchise tax is apportioned based on property and sales. as a tax on equity capital that is paid regardless of profitability, it is naturally an unpopular tax. tax reform groups have recommended repeal if alternative revenue sources can be found. the 2017 report of the task force for structural change in budget and tax policy, a group appointed by the governor and legislature, was clear on its assessment of the franchise tax: “the franchise tax is a tax on wealth and investment that represents the equity of a corporation. investment supported by long-term debt is not subject to the corporate franchise tax. it is widely recognized as a complex and antiquated type of taxation that discourages investment, inhibits economic development, provides a disincentive to corporate headquarters operations and causes costly compliance and auditing problems.”71 however, because of the potential loss in revenues, the task force recommended seeking strategies to eliminate or phase out the tax with other changes made to the tax system to preserve revenue neutrality. to understand the revenue impact, staff at the louisiana department of revenue provided data showing the effects of a repeal of the franchise tax on the total of corporate tax and franchise tax revenues, arrayed by the taxable base of the franchise tax. table 1 below shows the impact of the repeal after all allowable credits that could be taken against the total tax liability under both taxes for tax year 2017. 70 for background, see james richardson, steven sheffrin & james alm, exploring longterm solutions for louisiana’s tax system (2018). 71 see task force on structural changes in budget and tax pol’y, louisiana’s opportunity: comprehensive solutions for a sustainable tax and spending structure, la. dep’t of revenue 36 (2017), https://www.revenue.louisiana.gov/lawsandpolicies/taskforceonstructuralchanges budgettaxpolicy [perma.cc/utu5-a65r]. 2020] a minimal role for minimum taxes 23 table 1: repeal of franchise tax taxable base range number of returns total after credits new total after credits difference average difference less than 0 17,759 11,317,022 10,693,134 -623,888 -35 0 77,248 21,331,846 21,215,175 -116,672 -2 1 25,000 19,647 3,010,333 2,782,549 -227,784 -12 25,001 100,000 13,796 3,972,061 2,940,232 -1,031,828 -75 100,001 500,000 15,073 12,019,278 6,844,953 -5,174,325 -343 500,001 1,000,000 4,339 77,703,477 71,541,321 -6,162,155 -1,420 1,000,001 10,000,000 6,645 74,945,614 29,284,395 -45,661,219 -6,872 10,000,001 50,000,000 1,327 110,744,136 42,520,269 -68,223,867 -51,412 50,000,001 100,000,000 243 59,382,074 20,776,308 -38,605,766 -158,871 100,000,001 500,000,000 193 145,410,704 44,008,697 -101,402,007 -525,399 500,000,001 1,000,000,000 32 68,653,352 14,233,062 -54,420,290 -1,700,634 > 1,000,000,000 19 82,694,996 9,176,247 -73,518,749 -3,869,408 total 156,321 671,184,893 276,016,343 -395,168,551 -2,528 source: louisiana department of revenue, data for tax year 2017.72 the table shows that in 2017 the total of corporation and franchise taxes was $671 million. repealing the franchise tax would reduce total revenue by $395 million, or by 59%. moreover, the benefits to taxpayers would be heavily weighted to the largest corporations, with those with franchise taxable values over $1 billion reducing their tax payments by approximately $4 million and 85% of the net reduction accruing to corporations with a taxable base over $10 million. one reform possibility that has been discussed at the louisiana tax institute is structuring the franchise tax as a minimum tax on corporate income.73 corporations would pay the corporate income tax if their liability was greater than their franchise tax but would otherwise pay the franchise tax so that the franchise tax would serve as an alternative minimum tax.74 while that policy would also lose revenue, the revenue losses would only come from those corporations whose corporate income tax payments were lower than their 72 la. dep’t of revenue, tabulations for tax year 2017 (2018) (on file with author). 73 see la. tax inst., franchise tax scenario handout, la. dep’t of revenue, https://revenue.louisiana.gov/lti/louisianataxinstitutematerials [https://perma.cc/j6ae-qq95]. 74 it is an alternative minimum tax because it uses an alternative tax base for the corporate income tax calculation. 24 columbia journal of tax law [vol. 12:1 franchise tax. new york and connecticut currently structure their franchise taxes as minimum taxes. if one believed that the single-entity corporate tax had the capacity for allowing significant profit-shifting, redeploying the franchise tax as a minimum tax could be a reasonable, though imperfect, backstop to the corporate tax. a recent study by the louisiana tax institute discussed the potential benefits of combined reporting for curbing profit-shifting, but also raised the concern that moving away from single-entity taxation would make louisiana an outlier in the south.75 restructuring the franchise tax as a minimum tax would ensure that some corporate-level revenues would be derived from taxpayers with significant economic presence, in this case measured by the taxable base of the franchise tax. in a state where the populist tradition dating back to huey long still resonates, this is certainly a political plus. the louisiana department of revenue provided estimates of the effects of employing the franchise tax as a minimum tax. table 2 below, in the same format as table 1, provides the revenue estimates and impact by taxable base for taxable year 2017. the data presented are after all allowable credits can be taken against both the corporate and franchise tax. table 2: franchise tax as a minimum tax taxable base range number of returns total after credits new total after credits difference average difference less than 0 17,759 11,317,022 11,200,501 -116,521 -7 0 77,248 21,331,846 21,330,190 -1,656 0 1 25,000 19,647 3,010,333 2,951,253 -59,080 -3 25,001 100,000 13,796 3,972,061 3,710,171 -261,890 -19 100,001 500,000 15,073 12,019,278 10,646,403 -1,372,875 -91 500,001 1,000,000 4,339 77,703,477 75,945,020 -1,758,457 -405 1,000,001 10,000,000 6,645 74,945,614 58,595,403 -16,350,210 -2,461 10,000,001 50,000,000 1,327 110,744,136 86,221,259 -24,522,877 -18,480 50,000,001 100,000,000 243 59,382,074 47,190,540 -12,191,534 -50,171 100,000,001 500,000,000 193 145,410,704 111,616,857 -33,793,847 -175,098 500,000,001 1,000,000,000 32 68,653,352 48,003,800 -20,649,552 -645,298 > 1,000,000,000 19 82,694,996 60,526,883 -22,168,113 -1,166,743 total 156,321 671,184,893 537,938,280 -133,246,613 -852 75 see la. tax inst., report to the legislature on corporate income tax combined reporting 2019-001 (2019), http://revenue.louisiana.gov/miscellaneous/txi%202019-001%20mucr %20report.pdf [perma.cc/7v6y-83fn]. 2020] a minimal role for minimum taxes 25 source: louisiana department of revenue, data for tax year 2017.76 the revenue loss drops to $133 million from $395 million compared to straight repeal. this amount fits much more easily into the usual budget arithmetic facing the governor and legislature (at one point, louisiana was spending nearly $200 million per year in film credits). under this proposal, the largest corporations do receive some benefits—the top 19 corporations by taxable base save about $1.2 million in taxes. the differences from table 1 arise because some of these corporations paid very little in state corporation income taxes after credits. results for tax year 2016 were quite similar, suggesting that at least for a few years, low state corporate income tax payments for firms with high franchise taxable value were systemic. whether the low corporate income tax payments reflect avoidance activities, divergences between economic and taxable income, or simply convey information about real economic profitability is beyond the scope of this analysis. this proposed policy has several positive design features. first, it continues to allow credits to be taken against corporate level taxes. one of the largest credits is for property taxes paid to local government on inventory; while the state legislature did not wish to have firms pay property taxes on inventories, they were not willing to prevent local governments from levying property taxes on inventories. as a result, they provided tax credits at the corporate or individual level for inventory taxes paid. structuring the franchise tax as a minimum tax does not change that. moreover, other credits (such as employment credits for the quality jobs program) can also be taken against the combined corporate payments. second, the rules for the franchise tax are enshrined in louisiana law. if there were changes that were desired, they could still be instituted through the normal legislative process. the base for the alternative minimum tax would not be outsourced to a third party. of course, there are other reforms that could be made to the franchise tax. it would not be difficult to remove many taxpayers from the tax entirely without much loss in revenue by only requiring corporations with taxable bases above a certain threshold to be subject to the tax. it would also be possible to reduce the rate, which is one of the highest in the country. the minimum tax proposal could be integrated with these changes. it does have the virtue of serving as a true backstop against a tax that potentially can be manipulated. v. conclusion one way to summarize the arguments in this article is to distinguish between a “mass tax” and a “boutique tax.” a mass tax applies to a large number of taxpayers and is an intrinsic part of the overall tax base and tax system. a boutique tax is much more limited in scope and applies either to a small number of taxpayers or a smaller part of the tax base. the united states has had extensive experience with the alternative minimum tax as a mass tax, both at the individual level and corporate level. at the individual level, it drifted from its original intention of ensuring some high-income taxpayers did not escape all tax to a system in which large numbers of the upper-middle class were subject to the tax and were an important source of overall tax revenue. it also increased tax complexity and most likely decreased knowledge about the operation of the actual tax system. for example, many of the complaints from taxpayers in high-tax states about the $10,000 limit on state and local tax deductions were from those who had effectively already lost the 76 la. dep’t of revenue, supra note 72. 26 columbia journal of tax law [vol. 12:1 deduction because of the alternative minimum tax. large corporations who paid the bulk of the corporate alternative minimum tax were certainly aware of its provisions but had to plan around times when they would be subject to the tax and when they would not be in order to calculate the true cost of investment and their eligibility for tax credits. for both systems, the links between the regular and minimum taxes were problematic. for the individual amt, congress only partially adjusted the amt in response to changes in the regular tax and had an incentive not to make further adjustments in order to preserve revenue for more visible tax changes. at the corporate level, taxpayers were at times successful at forcing integration, but nonetheless there was always the risk that the credits provided in the regular tax system would not be available under the corporate amt. as a mass tax, the amts operated at cross purposes from the regular tax law and had unpredictable and often inefficient consequences. it was not a positive experience, and the repeal of the corporate amt and the temporary evisceration of the individual amt do seem to be overall improvements in our tax structure. to deal with the perception issue, i suggested that for individuals the tax provisions could be tackled directly—such as for incentive tax options—with limitations on nols (allowing for carryforwards) being a valuable component of the system. at low interest rates, the present value of deductions arising from nol carryforwards will not be substantially less than the value to the taxpayer of immediate deductions. therefore, the use of nols will not cause economic inefficiencies. for dealing with perceptions about corporate taxpayers, i suggested that corporations reframe their tax presentations, emphasizing global as well as state and local tax payments. the stigma of an amoral, nontaxpaying corporation could be eased if it were clearly demonstrated that taxes were being paid in a variety of jurisdictions. this does leave room for boutique minimum taxes. in this article, i suggested that a minimum tax on foreign earnings might be a reasonable compromise in the balance of taxing foreign versus domestic activity but that a full-fledged multilateral minimum tax was much less feasible and desirable. at the state level, i made a case for using the franchise tax only as an alternative minimum tax for state corporate income tax structures that were not robust to combat profit-shifting. minimum taxes should be used like surgical tools in select situations, rather than as broad-based components of an overall tax system. * professor, university of baltimore school of law. the author would like to thank lily kahng, mildred robinson, nancy shurtz, and all of the participants at the 18th annual critical tax theory conference, held at the northwestern school of law, apr. 3-4, 2015, for their very helpful comments. the author would also like to thank the university of baltimore for its generous support for this project. a simpler verifiable gift tax wendy c. gerzog* abstract the author proposes reforms to simplify the current federal gift tax system, foster uncomplicated outright transfers, eliminate valuation distortions, and increase taxpayer return compliance. in order to obtain those results, the author’s simpler verifiab le gift tax would incorporate hard-to-complete rules of transfer taxation, harmonize the gift and estate tax regimes, and grant gift tax preference inducements to encourage the filing of timely gift tax returns. 2015] a simpler verifiable gift tax 183 i. introduction ............................................................................................ 184 ii. valuation distortions ......................................................................... 192 iii. gift completion rules .......................................................................... 195 iv. tax preferences for current lifetime gifts ............................... 201 v. compliance ................................................................................................ 206 vi. conclusion ................................................................................................ 207 184 columbia journal of tax law [vol. 6:182 i. introduction the purpose of this article is to create a simpler and more accountable federal gift tax. 1 in order to do that, this author proposes to address the issues of (1) valuation distortions; (2) gift completion rules; (3) current preferences for lifetime gifts; and (4) compliance. present law provides the opportunity for attorneys and their clients to benefit by infusing complexity into the gift tax system 2 and has penalized those taxpayers who have opted not to adopt convoluted, empty contrivances. it is time to adopt a rule of law that encourages and rewards simplic ity. 3 when the taxpayer complicates valuation, the value of his or her property interest should be interpreted in a way adverse to that taxpayer‘s interest. 4 this position is justified by: (1) the element of taxpayer volition unaccompanied by any reasonable rationalization (apart from slashing transfer tax liability) for the taxpayer‘s employing the convolution; (2) the lack of a business-world counterpart to using entities to reduce the value of a company‘s assets without a businessmotivated rationale; and (3) the unwarranted revenue loss from the resulting discounted valuation and from the increased revenue costs (auditing, appraisals, and litigation) that accompany these tortuous transactions. essentially, the law should be reformed so that 1 while similar abuses are found in other areas of taxation, even in other transfer tax areas like in the estate tax, this article is focused on a discussion of the federal gift tax system. also, while the gift, income, and estate tax charitable deduction rules need to be changed to curtail abuses, and the gift and estate marital deduction provisions should be reformed to reflect an equal partnership and power between the spouses, they are beyond the purview of this article. this author has written about some of those charitable and marital deduction issues in other articles. see, e.g., wendy c. gerzog, alms to the rich: the façade easement deduction, 34 va. tax rev. 229 (2014); wendy c. gerzog, the new super-charged pat (power of appointment trust), 48 hous. l. rev. 507 (2011); wendy c. gerzog, from the greedy to the needy, 87 or. l. rev. 1133 (2009); wendy c. gerzog, the marital deduction qtip provisions: illogical and degrading to women, 5 ucla women's l.j. 301 (1995). this article will also not cover the capital gains and gift and bequest basis issues, although this author‘s opinions on these issues are much in line with professor dodge‘s proposal for deemed realization. see generally joseph m. dodge, a deemed realization approach is superior to carryover basis (and avoids most of the problems of the estate and gift tax), 54 tax l. rev. 421 (2001). while capital gains rates, basis rules, and transfer tax rates clearly overlap with each other, affecting realizations and the timing of transfers, that analysis is also beyond the scope of this article. on that issue, see, staff of joint comm. on tax‘n, 112th cong., m odeling the federal revenue effects of changes in estate and gift taxation 21 (joint comm. print 2012). 2 see, e.g., jeffrey n. pennell, wealth transfer taxation: ‘transfer’ defined, 128 tax notes 615 (aug. 9, 2010) (―valuation is the most controversial and pervasive topic in estate planning today. much valuation controversy reflects ‗value‘ used as a verb: how value is determined and how it is altered for wealth transfer tax purposes. . . . there is little more than general bromides that are principled, concrete, or reliable that can be gleaned from one situation and transported to another.‖). 3 one of the fundamental goals of a tax system is simplicity. see dept. of the treas., blueprints for basic tax reform (treas. report jan. 17, 1977) (―the first part of this report is devoted to clarifying the goals of the tax system, attempting to give specific content to the universally recognized objectives of equity, efficiency, and simplicity.‖); dept. of treas., 1 tax reform for fairness simplicity and economic growth 15 (treas. report nov. 27, 1984) (―an important goal of the treasury department study of fundamental tax reform is simplification.‖). in addition, the goal of simplicity in the transfer tax area is reflected in the supreme court‘s holding in robinette v. helvering, 318 u.s. 184 (1943). see lockard v. comm’r, 166 f.2d 409 (1st cir. 1948); steinberg v. comm‘r, 141 t.c. 258 (2013); infra text accompanying notes 7–10. 4 see robert n. macris, open valuation and the completed transfer: a problem area in federal gift taxation, 34 tax l. rev. 273, 304 (1978) (―[t]he real point [of robinette] was that the donor, despite the retention of an interest, would be taxed on the amount of the entire transfer when the value of the retained interest was not of certain value.‖). 2015] a simpler verifiable gift tax 185 ―tax minimization‖ is not equated with an artifice that undermines the integrity of the tax system itself. 5 in robinette v. helvering, the donor created a reversionary interest that depended not only on survivorship but also on her daughter‘s death without issue surviving to age 21. 6 the supreme court stated: it may be true . . . that trust instruments . . . frequently create ‗a complex aggregate of rights, privileges, powers and immunities . . . .‘ but before one . . . is entitled to deduction from his gift tax on the basis that he had retained some of these complex strands it is necessary that he at least establish the possibility of approximating what value he holds. 7 a broadened corollary to this holding that seems appropriate and more than timely in the context of family entity discounts is that when a taxpayer creates such an entity and transfers liquid assets to it in order to obtain valuation discounts for estate planning purposes, he or she is no longer a seller under the fair market value definition 8 and is outside the real business world where such interests are generally traded. indeed, the government‘s valuation expert in holman v. commissioner shined a light on the reality of these contrivances when he stated that it was unlikely that a third party would accept the sale or use restrictions of the family limited partnership (flp) agreement; clarifying on cross-examination, he said: ―what i mean is . . . the issue [of transfer restrictions] wouldn‘t arise, because nobody at arm’s length would get into this deal.‖ 9 thus, the first rule in a simpler verifiable gift tax is a valuation rule intended to strip interests in such taxpayer-created non-business family entities of any illiquidity (non-transferability) and minority discounts 10 under the theory that when one creates a family estate planning contrivance, no tax benefits should be available to reduce the value of the entity‘s underlying assets. by disallowing those tax benefits, in addition to the cost of creating and maintaining such family entities, 11 despite claims to the contrary, 12 no one would create these devices. 5see, e.g., erhard seminars training v. comm’r, 52 t.c.m. (cch) 890 (1986) (―while a taxpayer has the right to minimize his taxes by whatever means the law permits, this right does not bestow upon the taxpayer the right to structure paper arrangements that do not stand on the solid foundation of economic reality.‖). 6 robinette, 318 u.s. at 188. 7 id. 8 see wendy c. gerzog, valuation discounting techniques: terms gone awry, 61 tax law. 775 (2008) (explaining that the fair market value definition in treas. reg. § 20.2031-1(b) implicitly requires a seller (the asset holder) to want to maximize the value of an asset in order to supply the proper tension with the buyer who wants to minimize cost. a seller who wants to minimize the value of his property is not, by any reasonable definition, a seller.). 9 holman v. comm‘r, 130 t.c. 170, 198 (2008) (emphasis added) (internal quotation marks omitted). 10 as suggested in the text, there would be one exemption from the simple valuation rule: a family business exemption, which would require an ongoing, active family business and not one created or maintained primarily for the management or holding of investments. 11 see, e.g., kiara ashanti, what is a family limited partnership (flp) – pros & cons, m oney crashers: your guide to financial fitness, available at http://www.moneycrashers.com/family-limitedpartnership-flp/ (―setting up an flp can cost anywhere between $5,000 to $10,000 dollars [sic] with ongoing costs after setup.‖); frequently asked questions about family limited partnerships, the texas probate website, available at http://www.texasprobate.net/faqs/flpfaq.htm (―because the organizational costs can be substantial, families with business assets of less than $2 million rarely find it advantageous to establish an flp.‖). 186 columbia journal of tax law [vol. 6:182 the second rule in a simpler gift tax would be to adopt a hard-to-complete rule of transfer taxation. 13 that change from the current system would eliminate much of the confusion generated by the gift completion regulations 14 and would eliminate the tax abuses that have sprung from section 2702, including the ability to create ladders of short-term grats. 15 under the simpler gift tax proposal, for a gift to be complete, the donor must relinquish all interests in, and control over, the transferred property. instead of drawing unsatisfying lines among different divestments of control and of relying on actuarial techniques that may be manipulated to avoid transfer tax, a simple gift tax would apply only to transfers with the donor‘s complete renunciation of all interests and control in the property. retained interests or powers would constitute incomplete gratuitous transfers that would be taxed in the donor‘s estate. 16 that simple rule would coordinate well with the estate tax provisions and would eliminate instances where a transfer could under current law be subject to both transfer taxes, 17 albeit with present law offsets in the calculations of the estate tax to prevent double taxation. 18 that rule would deny the donor of complex transfers the benefit of value freezing and any additional benefits available for lifetime transfers. 19 that rule would also encourage outright transfers of property. 12 see, e.g., owen g. fiore, flps are good business, not a party or game, 99 tax notes 289 (2003). 13 this article does not analyze the effects of carryover gift tax basis rules. 14 see treas. reg. § 25.2511-2. 15grat is an acronym for a grantor retained annuity trust. because of valuation abuses in the area of grantor retained interest gifts, wherein the retained interest was overvalued in order to undervalue the grantor‘s gift, most grantor retained interests are given a zero value under the provisions of i.r.c. § 2702. see i.r.c. § 2702 (2012). grats, wherein the transferor retains an annuity interest in a trust, are specifically allowed under that code section to permit the value of the transferred property to be reduced by the actuarially determined value of the annuity interest because that type of fixed retained interest was deemed to be a more reliable measure of the grantor‘s retained interest than the more easily manipulated retained variable income interest. however, if the value of the annuity is fixed at a very high amount, the transferred interest may be valued at or near zero. in walton v. commissioner, 115 t.c. 589 (2000), acq., 2003-2 c.b. 964, the tax court invalidated then example 5 of treas. reg. § 25.2702-3(e), but also implicitly validated the donor‘s use of short-term two-year zeroed-out grats that can effectuate tax-free transfers. see joseph m. dodge, wendy c. gerzog & bridget j. crawford, federal taxes on gratuitous transfers: law and planning 451-53 (2011) [hereinafter dodge, gerzog, & crawford]. 16 other scholars have proposed rules to deal with valuation problems and gift completion. see, e.g., mitchell m. gans, gift tax: valuation difficulties and gift completion, 58 notre dame l. rev. 493, 536 (1983) (―thus, the valuation-difficulty rule should be applied to all gifts not immediately capable of valuation if: (1) an interest charge is imposed to neutralize the deferral; (2) only those post -severance events of a revelation character are permitted to enter the tax base; and (3) the death-completion rule is adopted to prevent tax avoidance.‖). 17 for example, under treas. reg. § 25.2511-2(d) and 25.2511-2(e), respectively, gifts with donor retained control over the timing or manner of the gift and joint gifts that are made together with someone holding a substantial adverse interest to the exercise of a donor retained power are completed gifts; however, they are nonetheless subject to the estate tax under i.r.c. § 2036 or § 2038 if the donor has retained those powers at his death (or, under i.r.c. § 2035(a)(2) or § 2038, if he has released them within three years of his death). see i.r.c. §§ 2035(a)(2), 2036, 2038 (2012); treas. reg. § 25.2511-2(d)–(e); see also lober v. u.s., 346 u.s. 335 (1953); smith v. shaughnessy, 318 u.s. 176 (1943). 18 see i.r.c. § 2001(b)(2) (2012). for further explication, see dodge, gerzog & crawford, supra note 15, at 449-50. 19 see infra part iv. 2015] a simpler verifiable gift tax 187 this article will review the present preferences allotted to gifts 20 and the policy considerations to justify them. arguably, except for a small annual exclusion, there is no cogent argument to retain any of the other gift tax benefits. while this author thus acknowledges that she has not found convincing data that requires the preservation of most gift tax benefits, she nevertheless proposes that the simpler gift tax retain at least some of those preferences in order to encourage easily valued and reported lifetime transfers and to compensate for the revenue loss attached to the adoption of a hard-tocomplete rule for gift tax gift completion. inevitably, the gift tax simplification rules would reduce the gift tax revenue now generated by complex transactions. although the gift tax was created to generate current revenue, 21 in addition to serving as a backstop for both the estate tax 22 and the income tax, 23 this article suggests that by limiting or denying preferences for lifetime gifts under certain circumstances, the simplification and verification rules may serve to underline the tax saving accorded simple and reported taxable gifts that, in turn, may increase those preferred lifetime transfers, ultimately resulting in additional revenue. 24 in other words, while wealthy people may be all right with complex, attorney-involved strategies, they may actually prefer to make simple, tax-favored gifts. however, the simpler gift tax proposal would make some changes to the exclusions currently provided under section 2503. specifically, the annual exclusion would be reduced to $2,000 per donee per year in outright gifts in order to cover de minimis holiday or occasion gifts and to eliminate both tax-free wealth transfers of 20 the benefits include the exclusions under i.r.c. § 2503, a tax exclusive base, gift splitting, valuation freezing, and either passing the post-gift income to a lower bracket donee or creating an intentionally defective grantor trust (―idgt‖). see infra part iv. creating an idgt is a way of freezing the value of the asset by making a taxable gift. as the owner of income under the grantor trust rules, the grantor can further reduce his taxable estate by paying the income taxes on the income without incurring an additional gift tax for those income tax payments, which legally are the grantor‘s own income tax liabilities. see staff of joint comm. on tax‘n, 112th cong., m odeling the federal revenue effects of changes in estate and gift taxation 24 (joint comm. print 2012). 21 see stanley s. surrey et al., federal wealth transfer taxation: cases and m aterials 5 (3d ed. 1987) (―by 1932 the country had entered into the years of depression. reduced tax yields from the falling national income and increasing expenditures brought about deficits. congress, in trying to overcome the deficits, not only adopted the gift tax and increased the income tax rates but also strengthened the estate tax. . . . thus in 1932 congress decided that the transfer taxes should be an important source of revenue to the federal government.‖); jeffrey a. cooper, ghosts of 1932: the lost history of estate and gift taxation, 9 fla. tax rev. 875, 913 (2010) (explaining that the gift tax was enacted to provide incentives for making current taxable gifts in order to produce much needed revenue during the depression; ―in effect congress told wealthy taxpayers, you can pay us now or you can pay us later. but, they added one key proviso: if you pay us now, you'll pay far less. the gift tax thus wasn't designed to prevent estate tax avoidance. rather, it was carefully designed to encourage such avoidance.‖). 22 h.r. rep . no. 72-708, at 8 (1932); s. rep . no. 72-665, at 11 (1932); see united states v. irvine, 511 u.s. 224, 234 (1994); smith v. shaughnessy, 318 u.s. 176, 179 (―[t]he gift tax serves to supplement the estate tax.‖); sanford’s estate v. comm’r, 308 u.s. 39, 44 (1939). 23h.r. rep . no. 72-708, at 8 (1932); s. rep . no. 72-665, at 11 (1932); see smith v. shaughnessy, 318 u.s. at 179 n. 1 (―the gift tax was passed not only to prevent estate tax avoidance, but also to prevent income tax avoidance through reducing yearly income and thereby escaping the effect of progressive surtax rates.‖); sanford’s estate, 308 u.s. at 47 (―one purpose of the gift tax was to prevent or compensate for the loss of surtax upon income where large estates are split up by gifts to numerous donees.‖). 24 to boost current revenue, the government may also want to consider touting the benefits of making these simple tax-favored gifts. the simpler verifiable gift tax will make marketing lifetime gifts more accessible and hence much easier to promote. 188 columbia journal of tax law [vol. 6:182 greater amounts and crummey 25 trusts. while limiting the annual exclusion, which was intended to obviate the record-keeping difficulties involved in small gifts, this article proposes to amend trusts to minors under section 2503(c) 26 to allow ―minor‖ trusts to extend the 2503(b) exclusion to cover donees until age 30. at that time, however, the trust would need to terminate and its assets be distributed. 27 the payout requirement of section 2503(c) at age 21 has always been a concern for donors 28 and most estate planners use techniques to discourage the termination of these trusts. 29 the new rule would alleviate that unease and shorten the actual term of minor trusts. in addition, the simpler verifiable gift tax would expand the exclusion under section 2503(e) to other consumption type transfers. the amended statute would state that these exclusions, which are additional to the annual exclusion, are intended to cover consumption items and, therefore, do not apply to any transfer that, in fact, is primarily an unconsumed gratuitous property wealth transfer. currently, section 2503(e) excludes certain tuition and medical payments from the gift tax. 30 this article proposes three additions to this part of the exclusion statute: (1) 25 see crummey v. comm’r, 397 f.2d 82 (9th cir. 1968). in a crummey trust, ―[e]ach beneficiary is given the power, exercisable annually, to withdraw from the trust an amount equal to the lesser of (a) the amount (if any) transferred to the trust by the grantor during that year or (b) an amount equal to the maximum annual exclusion. if the power is not exercised, the gift amounts become part of the trust corpus and cease to be subject to the demand power.‖ dodge, gerzog & crawford, supra note 15, at 131. for a discussion of the case and an expanded discussion of a crummey trust, see dodge, gerzog & crawford, supra note 15 at 131-41. 26 i.r.c. § 2503(c) provides: no part of a gift to an individual who has not attained the age of 21 years on the date of such transfer shall be considered a gift of a future interest in property for purposes of subsection (b) if the property and the income therefrom--(1) may be expended by, or for the benefit of, the donee before his attaining the age of 21 years, and (2) will to the extent not so expended-(a) pass to the donee on his attaining the age of 21 years, and (b) in the event the donee dies before attaining the age of 21 years, be payable to the estate of the donee or as he may appoint under a general power of appointment as defined in section 2514(c). 27 although commonly referred to as covering gifts to minors, ―minors‖ is already a misnomer as the age of majority is now 18 and not 21 when the statute provides for termination and payment to the donee. yet, even trust termination and payout at age 21 does not comport with the contemporary medical findings that young adults‘ brains are not completely formed until their mid-to-late twenties. see, e.g., tony cox, brain maturity extends well beyond teen years, npr (oct. 10, 2011), available at http://www.npr.org/ templates/story/story.php?storyid=141164708 (interviewing sandra aamodt, neuroscientist and co-author of welcome to your child's brain: how the mind grows from conception to college); a. rae simpson, brain changes, mit young adult dev. project (2008), available at http://hrweb.mit.edu/worklife/youngadult/ brain.html#beyond (arguing that the brain is not fully developed until at least age 25). thus, it is not surprising for donors today to be wary of creating these trusts and, consequently, this explains t he employment of techniques to minimize the actual termination and payout at age 21. see dodge, gerzog, and crawford, supra note 15, at 129–31. 28 see james casner, american law institute federal estate and gift tax project, 22 tax l. rev. 515, 530 (1967) (―the most troublesome aspect of the requirements has been that the beneficiary be entitled to the principal and any accumulated income when he reaches 21 if the gift of principal is to qualify for the exclusion.‖). 29 see bridget j. crawford, reform the gift tax annual exclusion to raise revenue, 132 tax notes 443 (july 25, 2011) (citing rev. rul. 74-43, 1974 c.b. 285) (―if the beneficiary has the right to withdraw all the trust property at age 21 but the trust continues if the beneficiary does not do so, the trust will still qualify for the annual exclusion.‖). 30 i.r.c. § 2503(e) provides: (1) any qualified transfer shall not be treated as a transfer of property by gift for purposes of this chapter. (2) for purposes of this subsection, the term ―qualified transfer‖ means 2015] a simpler verifiable gift tax 189 an expanded section 2503(e) education exclusion that would cover ―qualified higher education expenses‖ (as defined in section 529) while the donee is attending postsecondary school as, at least, a half-time student; 31 (2) an exclusion that would cover reasonable living expenses (food, clothing, and lodging) of any donee living in the same residence as the donor, regardless of age; 32 and (3) an exclusion that would apply to cash payments to any individual who provides care for a disabled person, including the donor, living in the donor‘s home as long as the payments bear a reasonable relationship to the services provided to the disabled person and all associated required state and federal employment and income taxes are timely paid. while payments to non-relatives generally fall outside of the gift tax under the ―ordinary-course-of-business‖ exception in the gift tax regulations, 33 payments to relatives who perform care for their disabled relatives have at times been construed as taxable gifts. 34 the purpose of this added exclusion is to clarify under what circumstances payments to family and friend caregivers would be exempt from gift tax. the author understands that the consumption exclusions indirectly add to the transferee‘s wealth, either by adding to her human capital (the ability to make more money because of an advanced education) or by allowing her to preserve her financial capital instead of having to use her investments to pay for the value of her living costs. 35 however, comparable to the exclusion for services, 36 consumption costs outlined in the proposed exclusion may be too elusive for most donors to consider their wealth transfer effect and, as such, produce administrative reasons not to subject those items to tax. any amount paid on behalf of an individual-(a) as tuition to an educational organization described in section 170(b)(1)(a)(ii) for the education or training of such individual, or (b) to any person who provides medical care (as defined in section 213(d)) with respect to such individual as payment for such medical care. 31 see i.r.c. § 25a(b)(3). 32 this proposal is similar to but less restrictive than the one proposed by the american law institute (―ali‖) in the 1960s. see casner, supra note 28, at 538 (explaining an exclusion for transfers for current consumption cannot be one that results in the acquisition of property ―if it is an expenditure for: (1) the benefit of a minor child of the transferor; or (2) educational costs or medical or dental costs of an individual; or (3) food, clothing, and maintenance of living accommodations of an individual and persons dependent on such individual that does not exceed $3000 annually.‖). 33 see treas. reg. § 25.2512-8 (stating, in part: ―however, a sale, exchange, or other transfer of property made in the ordinary course of business (a transaction which is bona fide, at arm‘s length, and free from any donative intent), will be considered as made for a full and adequate consideration in money or money‘s worth.‖). 34 many cases involving the issue of whether a transfer is a bequest or a valid claim against the estate under i.r.c. § 2053 rest on presumptions under state law, which, when facts of an employment agreement are ambiguous, often presume services provided to family members to be gratuitous. having a clear exclusion may obviate the need for such litigation. see e.g., olivo v. comm‘r, t.c.m. 2011-16 (applying new jersey law presumption); estate of wilson v. comm‘r, t.c.m. 98-309 (finding payments by the executor to two brothers, distant relatives of the decedent‘s predeceased husband, who consecutively performed services for the decedent, elderly and suffering from severe diabetes and its consequences (blindness and leg amputation), were held to be for adequate consideration in money or money‘s worth). in wilson, the court upheld an oral compensation agreement because it found that the agreement was between nonrelatives who were not the natural objects of the decedent‘s bounty and, like unrelated third parties, were both service providers engaged the estate in litigation and settlement. 35 see surrey, supra note 21, at 696 (―. . . [t]he payment of certain educational and medical expenses where the donor has no legal obligation to support the donee constitute transfers properly subject to tax.‖); paul l. caron, taxing opportunity, 14 va. tax rev. 347, 423 (1994) (advocating the limitation of the gift tax exemption for services to those that ―the parents do not provide to third parties.‖). 36 see comm’r v. hogle, 165 f.2d 352 (10th cir. 1947). 190 columbia journal of tax law [vol. 6:182 additionally, there are non-tax reasons 37 to allow some of these new exemptions: encouraging education 38 and the care of disabled family members by family members, 39 especially with the dearth of caregivers nationwide. 40 finally, a verifiable gift tax means better taxpayer compliance with the gift tax filing and payment requirements, which are increasingly ignored rather than timely satisfied. 41 in their recent article, 42 professors gans and soled have noted the dismal compliance rate for gift tax returns due to the lack of consequences and enforcement tools in this area 43 and have suggested the imposition of filing of mandatory donee information returns in order to confirm the information on the donor‘s required return 44 and of new penalties on delinquent donors. 45 while their arguments are convincing, this article proposes an alternative solution to what this author also sees as very real problems. as stated, there are benefits to making lifetime gifts. among those benefits are the unified credit (currently exempting $5.43 million when combined with the estate tax credit), 46 the annual exclusion (both the current one and as modified under this proposal), 47 and the gift tax tax-exclusive tax base. 48 adopting something like the 37 surrey, supra note 21, at 696. 38 see, e.g., 529 report (coll. sav. plans network, lexington, ky.), sep. 2014, tax analysts‘ document service, doc. 2014-21949 (―education is the key to unlocking the door to opportunity. throughout the past several years, new research continues to provide supportive evidence that a college degree not only increases the economic earning power of both individuals and our national economy, but it is also proven to contribute to improved health, homeownership, voting rates, community volunteerism and other social benefits.‖). 39 see national family caregiver support act, pub. l. no. 106-501, 114 stat. 2253 (2000) (codified as amended at 42 u.s.c. §§ 3030s to 3030s-2 (2012)). for information about sponsored programs, see administration on aging (aoa): national family caregiver support program (oaa title iiie), admin. for cmty. living, u.s. dep‘t of health and human servs. available at http://www.aoa.gov/ aoa_programs/hcltc/caregiver/index.aspx. under the income tax system, payments to relatives, as defined under i.r.c. § 152(d)(2)(a)–(g), for long term care for the ―chronically ill‖ are denied medical care deductions. see i.r.c. §§ 213(d)(11), 7702b(c). these are income tax issues and thus not within the scope of this article; however, this author would welcome a change in those provisions as well. abuse in this area can better be dealt with by requiring proper and timely income and work-related filing and tax payments in order to receive a deduction or other income tax benefit. 40 see, e.g., walt zywiak, global inst. for emerging healthcare practices, u.s. healthcare workforce shortages: caregivers, computer sciences corp . (may 2013), available at http:// assets1.csc.com/health_services/downloads/csc_us_healthcare_workforce_shortages_caregivers.pdf. 41 mitchell m. gans & jay a. soled, reforming the gift tax and making it enforceable, 78 b.u. l. rev. 759, 775 (2007) (noting that ―compliance with the gift tax appears to be ebbing.‖). 42 mitchell m. gans & jay a. soled, reforming the gift tax and making it enforceable, 78 b.u. l. rev. 759 (2007). 43 id. at 776 (―when it comes to gift tax enforcement, however, the issuance of any third-party information returns is noticeably absent, and there is no self-policing mechanism in place.‖). 44 id. at 793–95 (suggesting a requirement of information returns and aggregated multiple gifts from individual information returns, aggregating multiple gifts, from individual donees for outright gifts and from trustees for transfers in trust). 45 id. at 795–96. none of the penalties would be determined with reference to the taxpayer‘s actual gift tax liability because they would be computed without taking into account the credit exemption amount. id. the authors ask congress ―to institute reporting mechanisms that facilitate irs oversight and a penalty system that taxpayers will think twice about before violating.‖ id. at 799. 46 see i.r.c. § 2010. beginning with 2012, the $5 million exemption equivalent is indexed for inflation. i.r.c. § 2010 (c)(3)(b). in 2015, that indexed exemption equivalent is $5.43 million. see rev. proc. 2014-61, 2014-47 i.r.b. 860 § 3.33 (―for an estate of any decedent dying during calendar year 2015, the basic exclusion amount is $5,430,000 for determining the amount of the unified credit against estate tax under § 2010.‖). 47 see infra part iv. 2015] a simpler verifiable gift tax 191 portability 49 filing requirement, 50 in which the surviving spouse only receives the deceased spouse‘s unused exemption amount if a timely return is filed, this article proposes to deny one, two, or all of the gift tax benefits to a donor who is required to, but does not, file a gift tax return. 48 the estate tax differs from the gift tax in that the estate tax, like the income tax, is a tax-inclusive tax. see dodge, gerzog & crawford, supra note 15, at 8, 46, 349 n.46. that is, assets used to pay the estate tax liability are themselves subject to estate tax. id. a benefit of the gift tax is that the money used to pay gift tax liability is not itself subject to gift or estate tax and yet it diminishes the donor‘s estate. id. 49 the tax relief, unemployment insurance reauthorization, and job creation act of 2010 §§ 302(a)(1) & 303(a), pub. l. no. 111-312, 124 stat. 3296, 3302–04, amended i.r.c. § 2010(c) by enacting a temporary ―portability‖ provision, applicable to decedents dying in 2011 and 2012, which allowed the deceased spousal unused exclusion amount to be applied to both the surviving spouse‘s gift and estate tax liabilities in addition to her own exemption amount. see dodge, gerzog & crawford, supra note 15, at 290. the american taxpayer relief act of 2012 § 101(a), pub. l. no. 112-240, 126 stat. 2313 (2013), made those portability provisions a permanent feature of estate taxation. with the enactment of the portability provisions, § 2010(c)(2) defines the ―applicable exclusion amount‖ as aggregating the surviving spouse‘s ―basic exclusion amount‖ with her ―deceased spousal unused exclusion amount.‖ the surviving spouse‘s additional exclusion amount is defined as ―the lesser of (a) the basic exclusion amount, or (b) the excess of– (i) the basic exclusion amount of the last such deceased spouse of such surviving spouse, over (ii) the amount with respect to which the tentative tax is determined under section 2001(b)(1) on the estate of such deceased spouse.‖ i.r.c. § 2010(c)(4). on the topic of portability, see outside the box on estate tax reform: reviewing ideas to simplify planning: hearings before the s. fin. comm., 110th cong. 2 (2008) (testimony of shirley m. kovar, chair, transfer tax study committee, american college of trust and estate counsel); staff of joint comm. on tax‘n, 110th cong., taxation of wealth transfers within a family: a discussion of selected areas for possible reform, (joint. comm. print 2008); bridget j. crawford and jonathan g. blattmachr, planning with portability do-overs (but only for a limited time), 143 tax notes 117 (2014) (outlining the temporary relief in rev. proc. 2014-18, 2014-07 i.r.b. 513); bridget j. crawford & wendy c. gerzog, portability, marital wealth transfers and the taxable unit, in controversies in tax law: a m atter of perspective (anthony c. infanti, ed., forthcoming apr. 2015); wendy c. gerzog, portability of exemptions, 119 tax notes 509 (2008) (discussing background material on portability); david cay johnston, patches, portability, and punting versus an estate tax kiss, 125 tax notes 249 (2009); fred stokeld, senators, witnesses ponder estate tax reform options, 119 tax notes 15 (2008). 50 under i.r.c. § 2010(c)(5)(a), a portability election is effective only if made on a form 706 that is filed within the time prescribed by law (including extensions) for filing such return. see temp. treas. reg. § 20.2010–2t(a)(1) (2012), which provides: to allow a decedent's surviving spouse to take into account that decedent's deceased spousal unused exclusion (―dsue‖) amount, the executor of the decedent's estate must elect portability of the dsue amount on a timely -filed form 706, ―. . . estate (and generation-skipping transfer) tax return‖. . . . accordingly, the due date of an estate tax return required to elect portability is nine months after the decedent's date of death or the last day of the period covered by an extension (if an extension of time for filing has been obtained). see §§20.6075-1 and 20.6081-1 for additional rules relating to the time for filing estate tax returns. likewise, temp. treas. reg. § 20.2010–2t(a)(3)(ii) provides: ―the executor of the estate of a decedent (survived by a spouse) will not make or be considered to make the portability election if . . . [t]he executor does not timely file an estate tax return in accordance with paragraph (a)(1) of this section.‖ these temporary regulations were added by t.d. 9593, 2012-28 i.r.b. 17, were published in 77 fed. reg. 36150, 36157–60 on june 18, 2012, and are retroactively effective june 15, 2012. the applicability of the temporary regulations expires on or before june 15, 2015. temp. treas. reg. § 20.2010-2t(f). the american institute of certified public accountants (―aicpa‖) has recently proposed easing the filing requirements for portability for those not required to file an estate tax return because the decedent‘s estate is below the filing dollar threshold, allowing those estates to file a 706-ez form and allowing the surviving spouse to make the portability election. aicpa letter to irs on portability relief, am. inst. of cpas (mar. 19, 2015), available at http://www.aicpa.org/advocacy/tax/downloadabledocuments/ aicpa_comments_on_portability_relief_extend_request-3-19%2015-submitted-es.pdf. 192 columbia journal of tax law [vol. 6:182 to comply with the portability rules for estate tax purposes, in order to allow the surviving spouse to benefit from the first-spouse-to-die‘s unused ―unified credit‖ (by aggregating the decedent‘s unused credit amount with the surviving spouse‘s own credit exemption), 51 even if the decedent is not subject to estate tax, the executor is required to file an estate tax return for the purpose of computing, and permitting the porting of, the deceased spouse‘s unused spousal exemption. 52 in sum, without timely and proper filing of an estate tax return for portability purposes, the surviving spouse loses a potentially hefty tax benefit. mirroring the portability requirement, denying sought-after gift tax preferences to non-filers should provide a sufficient and simple incentive for donor compliance. ii. valuation distortions wealthy parents and grandparents create non-business entities, primarily flps and limited liability companies (―llcs‖), in order to devalue the almost entirely liquid (and therefore undiscounted) assets they transfer to those entities. because the entity or state law imposes restrictions on the transferability of such entity interests, gifts of those interests are entitled to lack-of-marketability discounts. the values of those gifts are also generally entitled to a minority (lack of control) discount because holders of those interests cannot freely control the entity‘s assets. 53 together, those discounts reduce the values of the transferred underlying assets to between 30-to-60 percent of their fair market value. 54 in bongard 55 , the tax court merely required a showing of ―the existence of a legitimate and significant nontax reason for creating the family limited partnership, and [that] the transferors received partnership interests proportionate to the value of the property transferred.‖ 56 although urged by judges halpern and laro in their separate opinions 57 to focus, respectively, on the ordinary-course-of-business exception under the regulations 58 and 51 see i.r.c. § 2010(c). 52 see supra note 49. 53 see dodge, gerzog & crawford, supra note 15, at 484–99. in addition, because the wealthy entity creators generally make gifts of minority interests in the entity and because, subsequent to that gift giving, the parents or grandparents hold a minority share in the entity at their deaths, minority interest discounts also apply to further decrease the value of any gifts or bequests. id. 54 see martha britton eller, which estates are affected by the estate tax?: an examination of the filing population for year-of-death 2001, stats. of income bull., summer 2005, at 185, 197, rev. ed. available at http://www.irs.gov/pub/irs-soi/01esyod.pdf (―according to irs estate and gift tax attorneys, who review and audit federal estate tax returns, and various private-sector studies of valuation discounting, recent discounts of flp interests fall between 30 percent and 60 percent.‖). 55 estate of bongard v. comm‘r, 124 t.c. 95 (2005). see wendy c. gerzog, bongard’s nontax motive test: not open and schutt, 107 tax notes 1711 (june 27, 2005). the bongard test is used to determine whether or not the ―bona fide sale for adequate and full consideration‖ exception under § 2036 applies. while § 2036 is an estate tax provision, the bona fide sale exception refers to the decedent‘s lifetime transfer. 56 bongard, 124 t.c. at 118. according to the tax court, the nontax reason must be ―a significant factor that motivated the partnership‘s creation‖ and it ―must be an actual motivation, not a theoretical justification.‖ id. the family entity must also comply with the formal requirements of establishing a limited partnership or limited liability company and adhere to a proper sequence of events. see hurford v. comm‘r, 96 t.c.m. (cch) 422 (2008); senda v. comm‘r, 433 f.3d 1044 (8th cir. 2006), aff’g t.c.m. (ria) 2004-160. 57 judge laro concurred in the result in bongard. 124 t.c. at 133. judge halpern concurred in part and dissented in part. 124 t.c. at 141. 2015] a simpler verifiable gift tax 193 similar case law, 59 the court rejected that analysis and diverged from gift tax basics and the primarily non-motive focus of the gift definition statute, which effectively inhibits abuse. 60 the court crafted its own two-prong approach, which unfortunately introduced motive as determinative 61 and has improperly equated proportionality with the fundamental gift tax tenet that to avoid the transfer tax, there must be an equivalent exchange in money or money‘s worth. 62 as a result, application of the court‘s bongard test requires a fact-intensive inquiry with inconsistent and unpredictable results. 63 the court in bongard listed factors that demonstrated the lack of a nontax purpose: (1) the taxpayer stands on both sides of the transaction; (2) the taxpayer needs partnership distributions for his maintenance and support; (3) the partners commingle partnership assets with their own; and (4) the taxpayer does not transfer the property to the flp. 64 with such minimal requirements, some taxpayers have prevailed in asserting the following purported ―nontax motives‖: gift giving and estate planning 65 (including providing funds to pay the donor‘s gift tax or the decedent‘s estate tax liabilities), 66 creditor or asset protection, 67 protection from property division in the event of a divorce, 68 centralized asset management, 69 maintaining and retaining family assets, 70 encouraging family harmony and reducing litigation expenses from family 58 treas. reg. § 25.2512-8 (―however, a sale, exchange, or other transfer of property made in the ordinary course of business (a transaction which is bona fide, at arm‘s length, and free from any donative intent), will be considered as made for an adequate and full consideration in money or money‘s worth.‖); treas. reg. § 25.2511-1(g)(1) (―the gift tax is not applicable to a transfer for a full and adequate consideration in money or money‘s worth, or to ordinary business transactions . . . .‖). judge halpern criticized the majority‘s deviation from the regulations by imposing a motive test: ―by the explicit terms of section 25.2512-8, gift tax regs., the resulting inquiry is limited to an economic calculus, and there is no room for any inquiry as to the transferor‘s (decedent‘s) state of mind.‖ bongard, 124 t.c. at 144 (concurring in part and dissenting in part). 59 judge laro maintained that the court should continue to apply the gregory v. helvering, 293 u.s. 465 (1935), business purpose test, cited by the third circuit in estate of thompson v. commissioner, 382 f.3d 367, 383 (3d cir. 2004). bongard, 124 t.c. at 139 (concurring in result). 60 under i.r.c § 2512(b), a gift for gift tax purposes is defined as an unequal exchange in money or money‘s worth. see comm‘r v. wemyss, 324 u.s. 303 (1945) (holding that transfers out of love and affection are not consideration in money or money‘s worth). because the gift tax is concerned with transfers that result in a diminution of the donor‘s estate without imposing a gift tax, its focus differs from the test for a gift for income tax purposes, which, under commissioner v. duberstein, 363 u.s. 278 (1960), requires donative intent. indeed, the role of donative intent is minimal in gift tax law. see treas. reg. § 25.2511-1(g)(1) (―donative intent on the part of the transferor is not an essential element in the application of the gift tax to the transfer.‖). 61 as judge halpern stated in bongard, ―by the explicit terms of section 25.2512-8, gift tax regs., the resulting inquiry is limited to an economic calculus, and there is no room for any inquiry as to the transferor‘s (decedent‘s) state of mind.‖ 124 t.c. at 144 (concurring in part and dissenting in part). 62 id. at 145 (―while an inquiry as to proportionality may have some bearing on whether the transfer was in the ordinary course of business, within the meaning of section 25.2512-8, gift tax regs. (e.g., was at arm‘s length), i fail to see how proportionality aids the inquiry as to whether the value of the property transferred exceeded the cash value of the consideration received in exchange.‖) (footnote omitted). 63 see wendy c. gerzog, tax court flp confusion: mirowski, 120 tax notes 263 (july 21, 2008). 64 124 t.c. at 118–19. 65 see estate of schutt v. comm‘r, 89 t.c.m. (cch) 1353 (2005). 66 estate of mirowski v. comm‘r, 95 t.c.m. (cch) 1277 (2008). 67 see kimbell v. united states, 371 f.3d 257, 268 (5th cir. 2004), vacating 244 f. supp. 2d 700 (n.d. tex. 2003); mirowski, 95 t.c.m. (cch) 1277. 68 see kimbell, 371 f.3d 257. 69 see id.; mirowski, t.c.m. (cch) 1277; schutt, t.c.m. (cch) 1353. 70 see schutt, t.c.m. (cch) 1353. 194 columbia journal of tax law [vol. 6:182 disagreements, 71 investment education for the family and the family‘s children and grandchildren, 72 providing for children equally, 73 reducing family members‘ probate costs, 74 and consolidating fractional interests in family assets. 75 the obama administration has proposed measures to eliminate family entity nonmarketability 76 discounts, but thus far none has been enacted into law. the focus of the budget proposals is to diminish the use of marketability discounts in family entities by creating ―a more robust version of section 2704(b).‖ 77 however, these proposals do not address the elimination of minority discounts. 78 also, by leaving many of the specific 71 see kimbell, 371 f.3d 257; stone v. comm‘r, t.c.m. 2003-309. 72 see kimbell, 371 f.3d 257. 73 see mirowski, t.c.m. (cch) 2008-74. 74 see kimbell, 371 f.3d 257. 75 id. 76 the obama administration‘s budget proposals from 2010 through 2013 included the following proposed change to §2704(b), although those proposals have not yet been enacted into law: the proposal modifies section 2704(b) to create a category of ‗disregarded restrictions‘ that would be ignored when valuing an interest in a family -controlled entity transferred to a member of the family if, after the transfer, the restriction will lapse or may be removed by the transferor and/or the transferor‘s family. . . . the proposal provides that disregarded restrictions would include limitations on a holder‘s right to liquidate that holder‘s interest in the family -controlled entity that are more restrictive than a standard to be specified in regulations. a disregarded restriction also would include a limitation on a transferee‘s ability to be admitted as a full partner or holder of an equity interest in the entity. . . . such interests are to be identified in regulations. under the proposal, regulatory authority is granted, including the ability to create safe harbors under which the governing documents of a family-controlled entity could be drafted so as to avoid the application of section 2704 if certain standards are met. see staff on joint comm. on tax‘n, 111th cong., description of revenue provisions contained in the president‘s fiscal year 2010 budget proposal—part one: individual income tax and estate and gift tax provisions, at 140-42 (joint comm. print 2009), available at https://www.jct.gov/ publications.html?func=startdown&id=3573 [hereinafter 2010 budget proposal]. the budget proposal indicates that the administration wants to reduce non-marketability discounts in family entities, but it leaves to the treasury the specific areas of abuse that need to be remedied. however, the proposal indicates that whatever restrictions are to be disregarded would apply retroactively to october 8, 1990 (the effective date of section 2704). dept. of the treas., general explanations of the administration‘s fiscal year 2010 revenue proposals, at 121 (may 2009); dept. of the treas., general explanations of the administrations fiscal year 2011 revenue proposals, at 124 (feb. 2010), available at http://www.treasury.gov/resource-center/taxpolicy/documents/general-explanations-fy2011.pdf; dept. of the treas., general explanations of the administrations fiscal year 2012 revenue proposals 127 (feb. 2011), available at http://www.treasury.gov/ resource-center/tax-policy/documents/general-explanations-fy2012.pdf; dept. of the treas., general explanations of the administrations fiscal year 2013 revenue proposals 260, at 268 (feb. 2012), available at http://www.treasury.gov/resource-center/tax-policy/documents/general-explanations-fy2013.pdf (―the proposal was contained in the president‘s budget proposals for fiscal years 2010, 2011, and 2012.‖). see ronald d. aucutt, the obama administration‘s revenue proposals, capital letter no. 17 (sep. 30, 2009), available at http://www.actec.org/public/capitalletter17.asp (―the proposal is estimated to raise revenue by $19.038 billion over the ten fiscal years from 2010 through 2019. the estimate of $667 million of additional revenue for fiscal 2010, which ends september 30, 2010, necessarily assumes that enactment will occur early enough to catch a substantial number of transfers in calendar 2009.‖). 77 2010 budget proposal, supra note 76, at 142. 78 2010 budget proposal, supra note 76, at 144 (―although the administration‘s budget proposal considers family relationships in determining whether a restriction on liquidation could be removed for purposes of section 2704(b), it does not include a family attribution rule that addresses the inappropriate use of minority discounts where family members control an entity. some may argue, however, that such a family attribution rule would be inappropriate, because it is not correct to assume that individuals always will cooperate with one another merely because they are related.‖); see paul l. caron & james r. repetti, revitalizing the estate tax: 5 easy pieces, 142 tax notes 1231, 1232-34 (mar. 17, 2014) available at http:// 2015] a simpler verifiable gift tax 195 ―disregarded restrictions‖ to the treasury to define in regulations, the proposals are inherently vague. however, the administration‘s revenue estimates, in the context of transfer taxation, 79 are significant. 80 the simpler gift tax would streamline the transfer tax valuation of most family entities by ignoring the family entity and valuing the underlying assets transferred to those entities. with traditional gift tax precepts, however, the simpler gift tax would exempt family entities that operate businesses as long as the transferred assets are customary in kind and extent to similar non-family operating business entities. 81 there would be no motive inquiry, 82 just the economic equivalence test in, and the ordinarycourse-of-business exception of, current gift tax law. with the goal of simplifying the transfer tax system, these changes may be more politically palatable. iii. gift completion rules under current law, the rules for gift completion are found in regulation § 25.2511-2. they begin with a clear focus: the central tenet of gift completion is the donor‘s relinquishment of the transferred property, regardless of whether the donee‘s identity is known. 83 a donor makes a completed gift when he ―has so parted with dominion and control as to leave in him no power to change its disposition, whether for his own benefit or for the benefit of another . . . .‖ 84 the regulation should have stopped papers.ssrn.com/sol3/papers.cfm?abstract_id=2410985 [hereinafter carson & repetti] (proposing to eliminate minority discounts when the transferred entity or asset continues to be controlled by the transferor or certain family members). 79 revenue collected from federal transfer taxes, particularly from gift taxes, is very low as compared to revenue derived from the federal income tax. see joseph a. pechman, federal tax policy 222 (3d ed. 1977) (―despite the appeal of estate and gift taxes on social, moral, and economic grounds, taxes on property transfers have never provided significant revenues in this country.‖). even with the preferences for gifts, taxpayers generally do not fully take advantage of them. see id. at 231-32 (―the figures . . . show clearly that wealthy people prefer to retain the bulk of their property until death and fail to use gifts to maximum tax-saving advantage. there are a number of reasons for the small proportion of gifts. first, most people are reluctant to contemplate death. uncertainty regarding time of death encourages delay in making estate plans even by those with considerable wealth. second, many wish to retain control over their businesses. disposal of stock or real estate frequently means loss of control over substantial enterprises. third, donors may wish to delay transfers of property until their children have had an opportunity to make their own careers. fourth, many people—even those who are wealthy—do not know the law and often do not take the advice of their tax lawyers on such personal matters.‖). 80 from the elimination of minority discounts, the administration‘s estimate is $18.1 billion over the next ten years. see jane g. gravelle, cong. research serv., r42959, the estate and gift tax provisions of the american taxpayer relief act of 2012, at 6 (2013) (discussing the administration‘s flp proposal within the minority discounts section), available at https://www.fas.org/sgp/crs/misc/ r42959.pdf. 81 see caron & repetti, supra note 78, at 1234 (rejecting a family business exception to their proposal). 82 that is, there would be no motive inquiry except to the extent that the regulations define the ordinary course of business exception as being ―free from any donative intent.‖ see treas. reg. §25.2512-8. 83 treas. reg. § 25.2511-2(a). 84 treas. reg. § 25.2511-2(b). a purely administrative power subject to fiduciary restraints is not considered a retained power either under current transfer tax rules or under the proposed simpler gift tax. see casner, supra note 28, at 547 (―[a] problem is presented as to whether certain administrative powers are to be regarded as powers to determine who takes under the transfer. even if broadly stated, basically administrative powers should not be so regarded, if under the controlling local law the trustee is subject to fiduciary standards in their exercise.‖). 196 columbia journal of tax law [vol. 6:182 there. the rest of the regulation contains double negatives, 85 convoluted syntax, 86 and is generally confusing. 87 more significantly, the remainder of the regulation parses unsatisfying distinctions and creates inconsistency with the estate tax provisions covering identical types of transfers. for example, it makes sense that if the donor retains the power to name new beneficiaries, the gift is not complete; however, it is unclear why the regulation does not view the donor‘s retained power over the timing of the donee‘s receipt of the gift in the same light. 88 why is the retained control over timing insufficient to negate the transfer of the donor‘s control? if, as donee, i may have to wait fifty years or more to receive the property (although i may receive it earlier at the donor‘s whim), how has the donor relinquished sufficient control over the property to indicate she has surrendered ownership of the property? under the estate tax provisions, if one retains control over the timing of beneficial enjoyment of transferred property, the property is thereby in the donor‘s estate. 89 thus, the conflict with the estate tax rules indicates she has not transferred such ownership. likewise, the gift tax rule for joint retained control under the regulation 90 effectuates a completed gift that, under the estate tax rules, is subject to estate tax inclusion. 91 the gift tax rule concerning the donor‘s retention of a power jointly with another requires that the other power holder be someone who has a ―substantial adverse interest‖ 92 to the donor‘s exercise of her power in order for the gift to be complete. the rationale is that self-interest will make the joint power holder reluctant to allow the donor to exercise her power, 93 but the estate tax rule requires estate tax inclusion if the donor retains at her death a power jointly with anyone. while the gift tax motivation-based principle may or may not be appropriate (since the wealthy donor likely has more power 85 see, e.g., treas. reg. § 25.2511-2(d) (―a gift is not considered incomplete. . . .‖ (emphasis added)). 86 see, e.g., treas. reg. § 25.2511-2(c) (―thus, if an estate for life is transferred but, by an exercise of a power, the estate may be terminated or cut down by the donor to one of less value, and without restriction upon the extent to which the estate may be so cut down, the transfer constitutes an incomplete gift.‖). 87 treas. reg. § 25.2511-2(b) (―for example, if a donor transfers property to another in trust to pay the income to the donor or accumulate it in the discretion of the trustee, and the donor retains a testamentary power to appoint the remainder among his descendants, no portion of the transfer is a completed gift. on the other hand, if the donor had not retained the testamentary power of appointment, but instead provided that the remainder should go to x or his heirs, the entire transfer would be a completed gift. however, if the exercise of the trustee‘s power in favor of the grantor is limited by a fixed or ascertainable standard . . . , enforceable by or on behalf of the grantor, then the gift is incomplete to the extent of the ascertainable value of any rights thus retained by the grantor.‖). 88 see treas. reg. § 25.2511-2(c) (retained power to add a new beneficiary); treas. reg. § 25.2511-2(d) (retained power to affect timing of beneficial enjoyment). 89 see lober v. united states, 346 u.s. 335 (1953). 90 treas. reg. § 25.2511-2(e) provides that ―[a] donor is considered as himself having a power if it is exercisable by him in conjunction with any person not having a substantial adverse interest in the disposition of the transferred property or the income therefrom.‖ 91 see camp v. comm’r, 195 f.2d 999 (1st cir. 1952). 92 as defined in the income tax grantor provisions, a ―substantial adverse interest‖ refers to a beneficiary‘s economic interest in the trust that would make him unlikely to join in on a decis ion to diminish his own financial interest. treas. reg. § 1.672(a)-1(a) (1960); see e.g., treas. reg. § 1.672(a)-1(b) (―thus, if a, b, c, and d are equal income beneficiaries of a trust and the grantor can revoke with a's consent, the grantor is treated as the owner of a portion which represents three-fourths of the trust; and items of income, deduction, and credit attributable to that portion are included in determining the tax of the grantor.‖). 93 see camp, 195 f.2d at 1004-05. 2015] a simpler verifiable gift tax 197 to control lifetime decisions over the exercise of a joint power), the estate tax rule is a much simpler rule. therefore, the simpler gift tax would allow the gift tax rule to conform to estate tax law. under the current gift tax rules, a gift of a contingent interest to third parties is a completed gift, 94 valued to reflect the risk of loss, 95 and not subject to estate tax. however, if § 2702 96 applies to a transfer with a contingent reversionary interest, that interest will have zero value and the undiscounted value of the property is subject to gift tax. by contrast, under the simpler gift tax, if the donor retains any interest in the property, even a contingent interest, it is an incomplete gift of the donor‘s whole ownership interest. 97 the simpler gift tax is more comprehensible than the present rules 94 see smith v. shaughnessy, 318 u.s. 176, 180 (1943) (holding that the gift tax reaches gifts of ―property, however conceptual or contingent‖); see also dickman v. comm’r, 465 u.s. 330 (1984). where gifts are subject to the condition that they will not be subject to gift tax, the condition subsequent is void as contrary to public policy. see comm’r v. proctor, 142 f.2d 824 (4th cir. 1944). gifts subject to the donee‘s payment of gift tax are net gifts computed by subtracting the gift tax as partial consideration for the gift. see diedrich v. comm’r, 457 u.s. 191 (1982) (holding that in terms of a net gift, the donor realizes gain where the amount of the gift tax paid exceeds the donor‘s basis in the property). 95 see, e.g., jewett v. comm’r, 455 u.s. 305, 310 n.11 (―as the tax court noted in this case: ‗the value of petitioner‘s remainder interest was not, of course, equal to 50 percent of the value of the trust corpus. rather, it depended upon actuarial factors reflecting the various contingencies.‘‖ (quoting jewett v. comm‘r, 70 t.c. 430, 435 n.3)). 96 i.r.c. § 2702 was enacted as part of the revenue reconciliation act of 1990 (―the 1990 tax act‖). pub. l. no. 101-508, §§ 11601-02(a), 104 stat. 1388-400, 1490-91 (1990). (the 1990 tax act added §§ 2701–04 (chapter 14) to the internal revenue code. i.r.c. § 2702 applies to transfers to ―a member of the transferor‘s family‖ (i.e., the donor‘s spouse, his (or his spouse‘s) ancestor or lineal descendant (or their spouses), or his sibling (or his sibling‘s spouse) where the transferor or ―applicable family member‖ (i.e., the transferor‘s spouse, his ancestor, or his ancestor‘s spouse) retains an interest in a trust or in property treated as if held in a trust.). i.r.c. §§ 2702(e)), 2704(c)(2), 2701(e)(2), 2702(c)(1), 2702(a)(3)(ii) (2012); treas. reg. § 25.2702-5. for current transfers with retained contingent reversions, the completed gift is generally valued at its full value without any reduction for the possibility that the property could revert to the donor. see i.r.c. § 2702 (2012) (providing that unless the retained interest is a ―qualified interest,‖ the donor‘s retained interest will be valued at zero); treas. reg. § 25.27023(f)(iii) (―[a]n interest is non-contingent only if it is payable to the beneficiary or the beneficiary‘s estate in all events.‖). where a donor transfers property subject to alternate contingencies that cover all logical possible events or conditions, although she retains a reversionary interest at law, even without the application of i.r.c. § 2702, the donor‘s retained interest in such a case would be valueless under current gift tax rules. 97 let us examine the difference between the following two transfers in terms of donor-retained control: (1) a donor who retains the power to change the relative income interests of two third-party beneficiaries, which under the regulation is not a completed gift because of too much donor-retained control; and (2) a donor who sets different percentage ownership interests in trust income as between two third-party beneficiaries depending on calculations derived by multiple contingencies provided by the donor when the trust was established. we can assume the multiple contingencies are the typical reasons a donor might want to change the percentage ownership between the two third-parties (e.g., marriage, divorce, employment, school, support needs, other assets, illegal activities, etc.). in the first situation, the donor can change interests capriciously, for any reason, or for no reason at all. in the second situation, the donor may only change the parties‘ percentage ownership for the reasons stated at the time of the transfer. otherwise, the two transfers are virtually identical. the current gift tax rules treat the two transfers differently and so would the simpler gift tax. these comparisons parallel the questionable differences between a general power of appointment and a special power of appointment. as professor griswold stated, ―any power can very easily be made a special power without materially limiting the [holder‘s] freedom of choice.‖ erwin n. griswold, powers of appointment and the federal estate tax, 52 harv. l. rev. 929, 957 (1939). see also joseph m. dodge, redoing the estate and gift taxes along easy-to-value lines, 43 tax l. rev. 241, 325 (1988) (―the definition of general power under current law is unsatisfactory insofar as it exempts a power to withdraw corpus limited by standards relating to ‗support,‘ ‗maintenance,‘ ‗health,‘ and ‗education.‘ in practice, the ‗standards‘ exception has the effect of making the incidence of 2041 elective among the cognoscenti.‖ (citations omitted)). 198 columbia journal of tax law [vol. 6:182 for gift completion: a donor makes a completed gift when he has so parted with dominion and control as to leave in him no power or interest in the transferred property. the new rule is blunt, uncomplicated, and is consistent with the estate tax rules. therefore, gift completion only occurs during lifetime with respect to donor retained control or interests if the donor relinquishes all of those powers or interests more than three years before his death. 98 while adopting a hard-to-complete rule may reduce the number of gifts, 2009 data shows that reduction would be limited. in 2009, almost two-thirds of reported gifts were outright transfers, 99 and approximately half of taxable and nontaxable gifts consisted of cash, which when added to gifts of real estate and stock, totaled more than eighty percent of reported gifts for the year. 100 any revenue loss, may also be counteracted by the greater understanding of the advantages of gift giving brought about by enacting and publicizing the benefits of the simpler gift tax. because § 2702 would be repealed as unnecessary under the simpler gift tax, strategies such as short-term zeroed-out grats 101 (and their concomitant revenue loss) would disappear. 102 for a zeroed-out grat, the retained annuity is calculated to be valued at the same value or close to the same value, if intending to effect a small gift 103 — as the remainder interest passing to third parties. generally, only one asset is placed in the grat in order to avoid tainting a highly appreciating asset. finally, the term is short, like the two-year term in walton, in order to reduce the chance that the donor might die during the term. should death occur, the estate tax provisions would tax the full dateof-death value of the trust, and the donor would lose all of the tax benefits associated with the grat strategy; therefore, a short period of risk is desirable. by employing this planning device, if the trust asset appreciates more than the calculated actuarial value, any excess value passes to the third parties free of transfer tax (i.e., the extra value would not be reached by either the gift or the estate tax — the latter effect occurring because of the benefit of the easy-to-complete gift tax rule of § 2702). many scholars have decried the tax avoidance from the use of grats. 104 in addition, president obama‘s revenue proposals have included grat reform. 105 98 for relinquishments within three years of the donor‘s death, i.r.c. § 2035 would apply to include those transfers in decedent‘s estate. id. § 2035 (2012). 99 melissa j. belvedere, 2009 gifts, statistics of income bull. 143 (spring 2012) (―most [2009] gifts (67.3 percent, or $25.5 billion) were given directly, meaning that recipients immediately had full use and enjoyment of the gifts. gifts through trust, where the donee‘s use of the gift is controlled by a trustee, accounted for the remaining 32.7 percent ($12.4 billion) of the gifts.‖ (internal reference omitted)). 100 id. (―most gifts were in the form of cash which represented 47.5 percent ($18 billion) of total gifts. cash represented the largest share of gift amounts reported on both taxable and nontaxable returns. gifts of real estate and stock made up the second and third largest shares of total gifts, 18.4 percent and 16.2 percent of the total, respectively.‖ (internal reference omitted)). 101 this technique was at least tacitly approved by the tax court in walton v. commissioner, 115 t.c. 589 (2000), and acquiesced to by the government in notice 2003-72, 2003-2 c.b. 964. see discussion, supra note 15. 102 qualified personal residence trusts (―qprts‖) would likewise be useless under the simpler gift tax. and, even though this article does not discuss the transfer tax or income tax charitable deduction, clats, niocruts, and nimcruts could also be eliminated if rules similar to the simpler gift tax applied with equal force to charitable gifts. 103 some estate planners recommend creating a small taxable gift so that the statute of limitations period would begin to run on the transfer. see dodge, gerzog & crawford, supra note 15, at 452 n.83. 104 see, e.g., caron & repetti, supra note 78, at 1240 (proposing a lifetime limit on grats); gans & soled, supra note 41 at 789–90 (proposing to treat grats and qprts as incomplete gifts until the 2015] a simpler verifiable gift tax 199 specifically, the administration‘s proposal mandates a minimum ten-year term for a grat. that would increase the risk of § 2036 exposure, which, if the donor died within the lengthened trust term, would subject the trust property to estate tax. 106 this measure would eliminate the walton short-term (two-year) zeroed-out grat and would increase the chance of that device creating an estate tax transfer rather than a preferred gift tax transfer—effectively imposing a hard-to-complete rule. the president‘s grat proposal was estimated to increase revenue by $3.6 billion over a ten-year period. 107 finally, the simpler gift tax would eliminate the current freebie known as the five or five power rule under § 2514(e). 108 section 2514(e) exempts from gift tax 109 a lapse (as distinct from an exercise or release) of the power 110 in stating that a lapse will not be considered a release, which would cause the property to be subject to gift tax 111 to the extent that the value of the property subject to the donee holder‘s general power to withdraw funds from the trust does not exceed the greater of $5,000 or five percent of the aggregate value of the property subject to the power. that is, in each year the donee power holder allows his power over the statutorily de minimis amount of property to lapse, he would not be making a gift of future interest to the remainder beneficiary of the trust. 112 although he is a donee because he did not create the trust for his benefit, he is grantor‘s interest terminates or, at the taxpayer‘s option, to tax the full value of the property paid to the trust (instead of only the remainder value)). 105 the joint committee on taxation proposed imposing a minimum ten-year term requirement for a grat. staff of joint comm. on tax‘n, 111th cong., description of revenue provisions contained in the president‘s fiscal year 2010 budget proposal—part one: individual income tax and estate and gift tax provisions 149 (joint comm. print 2009). 106 i.r.c. § 2036(a) provides as follows: the value of the gross estate shall include the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer (except in case of a bona fide sale for an adequate and full consideration in money or money's worth), by trust or otherwise, under which he has retained for his life or for any period not ascertainable without reference to his death or for any period which does not in fact end before his death -(1) the possession or enjoyment of, or the right to the income from, the property, or (2) the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom. 107 see gravelle, supra note 80, at 6. 108 i.r.c. § 2514(e) was enacted in 1951. see powers of appointment act of 1951, pub. l. no. 82-58, 65 stat. 91 (1951), reprinted in 1951-2 c.b. 343. this code section provides as follows: the lapse of a power of appointment created after october 21, 1942, during the life of the individual possessing the power shall be considered a release of such power. the rule of the preceding sentence shall apply with respect to the lapse of powers during any calendar year only to the extent that the property which could have been appointed by exercise of such lapsed powers exceeds in value the greater of the following amounts: (1) $5,000, or (2) 5 percent of the aggregate value of the assets out of which, or the proceeds of which, the exercise of the lapsed powers could be satisfied. 109 i.r.c. § 2041(b)(2) provides the same exemption from estate taxation. i.r.c. § 2041(b)(2) (2012). 110 essentially, a lapse requires inaction. for an explanation of the interplay between a five or five power and the annual exclusion, including a discussion of a ―hanging power,‖ see dodge, gerzog & crawford, supra note 15, at 135–36. 111 additionally, the estate tax equivalent provision prevents inclusion in the donee power holder‘s estate. see i.r.c. § 2041(a)(2). 112 moreover, the donee power holder could continue to receive the income from that amount and not have any property included in his estate under i.r.c. § 2041(a)(2), which parallels §§ 2035–38 for general power of appointment holders. see i.r.c. §§ 2035–2038, 2041(a)(2). without a lapse instead of an exercise or release, inclusion in decedent‘s gross estate is determined under treas. reg. § 20.2041-3(d)(3)-(5). see treas. reg. § 20.2041-3(d)(3)–(5). 200 columbia journal of tax law [vol. 6:182 also rendered a donor by not taking money out of the trust as he is able to do by exercising his withdrawal power; by leaving the money in the trust, he becomes a donor to the remainder beneficiary who receives those additional amounts. estate planners typically restrict the time for exercising the five or five power to ensure that it is likely to ―lapse.‖ as is readily apparent, this code provision and related computations are complex. although use of this de minimis exclusion is very common today in estate planning, 113 it does not serve any valid purpose 114 and is inconsistent with fundamental transfer tax rules. in enacting this gift and estate tax exemption, congress codified the then common practice of allowing a beneficiary to withdraw small sums so long as he did not make such a withdrawal on the rationale that other income beneficiaries were ―unsophisticated‖ and needed such a fallback provision. 115 however, as a representative from the american bar association (―aba‖) countered: [d]onees in small communities or with general powers over small funds, who did not have access to competent legal advice, either might not learn of the existence or nature of their powers or might not be properly advised of steps which could be taken to reduce their estate tax liability. 116 in 1988, the aba urged repeal of this exemption. 117 essentially, because of its complexity and lack of a defensible policy rationale, the power of appointment five or five exception would not be included in the simpler gift tax. 113 the popularity of the combination of providing for both a five or five power and a crummey annual exclusion withdrawal power is clear. see, e.g., aba sec. of tax‘n task force on transfer tax restructuring, report on transfer tax restructuring, 41 tax law. 395, 412 (1988) [hereinafter aba sec. of tax‘n task force] (―this ‗five-and-five‘ exception and the resulting crummey problem discussed above may be routinely exploited by some sophisticated taxpayers.‖). 114 see george craven, powers of appointment act of 1951, 65 harv. l. rev. 55, 78 (1951). it appears that the provision was merely enacted to reflect current trust provision practice: ―prior to the 1942 act it was quite common for a testator in his will to give a noncumulative power of invasion of principal in a small amount each year to his widow or children, and it is quite likely that this practice will be revived.‖ id. at the time of this rule‘s enactment, it was unclear how popular this devise would become: ―it is too early to know just what use will be made of the provisions which exempt the first $5,000 or 5% of a trust fund over which a power lapses during the lifetime of the donee.‖ id. 115 see s. comm. on fin., s. rep . no. 82-382, at 5 (1951), reprinted in u.s.c.c.a.n. (1951 stat.) 1530, 1535–36 (―since the problem of the termination or lapse of powers of appointment during life arises primarily in the case of dispositions of moderate-sized properties where the donor is afraid the income will be insufficient for the income beneficiary and therefore gives the income beneficiary a noncumulative invasion power, it is believed that the exemption provided in the committee amendment ($5,000 or 5 percent of the principal) will be adequate to cover the usual cases without being subject to possible abuse.‖). see also craven, supra note 114, at 77. in fact, however, this provision has been of greater service to sophisticated taxpayers who do hire attorneys to avoid wealth transfer taxes. see aba sec. of tax‘n task force, supra note 113. 116 craven, supra note 114, at 63. 117 see aba sec. of tax‘n task force, supra note 113, at 412 (―there is no conceptual justification for that exception.‖); amy morris hess, the federal taxation of nongeneral powers of appointment, 52 tenn. l. rev. 395, 429 (1985) (arguing that the five or five power exception is ―simply an obvious example of the propensity of congress to draft transfer tax statutes that exclude from taxation the most common forms of wealth transmission and tax only the unusual ones.‖). 2015] a simpler verifiable gift tax 201 iv. tax preferences for current lifetime gifts subsequent to unification by the 1976 tax act, 118 there remain six benefits to making gifts: (1) the de minimis and consumption exclusions under section 2503; 119 (2) the non-taxation of the funds used to pay the gift tax (its ―tax-exclusive‖ base); 120 (3) giftsplitting; 121 (4) the ability to freeze the value of a gift early in the taxpayer‘s lifetime so that post-gift excess appreciation (increased future value that outpaces inflation) is not taxed; 122 (5) the ability to transfer post-gift income to a lower bracket donee, often rendering the gift partly or wholly exempt from gift tax; 123 and (6) the ability to make non-taxable additional gifts by creating an intentionally defective grantor trust (―idgt‖), 124 through which the grantor can make a completed gift of the trust property, but continue to pay the income tax liability on the donee‘s post-gift income, without incurring any additional gift tax. rationales for gift tax preferences include: (1) the ability to generate current revenue; 125 (2) the creation of discounts to equalize gratuitous transfers made at different times in the taxpayer‘s life; 126 (3) gifts, more than bequests, contribute to a decline in wealth concentration; 127 (4) pragmatic reasons; 128 and (5) gifts place property in the hands 118 tax reform act of 1976, pub. l. no. 94-455, 90 stat. 1520 (1976). 119 i.r.c. § 2503(b), (e). 120 see discussion, supra note 48. 121 i.r.c. § 2513. 122 george cooper, a voluntary tax? new perspectives on sophisticated estate tax avoidance, 77 colum. l. rev. 161, 243 (1977) [hereinafter cooper] (―the ali report does not grapple with these questions because it proceeds from the convenient assumption that they are not really very important once the estate and gift tax is unified with a single rate scale. . . . more significantly, [the ali report] brushes aside estate freezing as if it were not even an issue. . . . [t]he easy -to-complete-gift approach is disturbingly inadequate.‖). however, from an income tax perspective, see dodge deemed realization, supra note 1 at 463-64 (―the government‘s interest under either a carryover-basis or a deemed-realization system would favor an easy-to-complete rule, so as to reduce the pool of property qualifying for upward basis adjustments.‖). 123 a gift would not be subject to gift tax, for example, if the value of the gift fell below the credit equivalent amount or the annual exclusion amount. otherwise, any income tax advantage would be diminished or supplanted by the gift tax disadvantage. that is, the gift tax is generally viewed as preventing wide-scale income shifting. see william c. brown, judicial expansion of the future interest exception to the gift tax annual exclusion—examination of the legislative history and policy basis for the future interest exception, 65 tax law. 477, 481 (2012) [hereinafter brown] (the gift tax ―also serves to discourage income shifting from high bracket taxpayers to low bracket taxpayers under the progressive rate structure of the federal income tax.‖). 124 an idgt avoids additional gifts where the donor makes a gift in trust that is a completed gift for gift tax purposes, but under the grantor trust rules (i.r.c. §§ 671-77) she is still liable for paying income taxes on the trust income. see daniel l. ricks, i dig it, but congress shouldn’t let me: closing the idgt loophole, 36 actec l. j. 641 (2010). 125 see cooper, ghosts of 1932, supra note 21; david joulfaian, gift taxes and lifetime transfers: time series evidence, 88 j. pub. econ. 1917, 1919 (2004) [hereinafter joulfaian]. 126 see joulfaian, supra note 125, at 1919 (―the benefit to the wealthy from such acceleration is that paying the gift tax would be equivalent to prepaying the estate tax, but at a significant discount.‖); see jerome kurtz & stanley s. surrey, reform of death and gift taxes: the 1969 treasury proposal, the criticisms, and a rebuttal, 70 colum. l. rev. 1365, 1390-391 (1970) [hereinafter kurtz & surrey] (―the only way to provide for an equitable encouragement of gifts is to adopt a unified transfer tax system with gross-up for lifetime transfers and then allow some percentage discount in the rate applicable to gifts as compared to death transfers.‖). 127 pechman, supra note 79, at 233 (―it is argued, in fact, that gifts tend to reduce the concentration of wealth by dispersing property among a relatively large number of donees.‖). 128 see 1 dept. of treasury, tax reform for fairness simplicity and economic growth, 376 (nov. 1984) [hereinafter tax reform for fairness simplicity] (―notwithstanding the policies supporting full 202 columbia journal of tax law [vol. 6:182 of the young who invest in riskier holdings. 129 reasons to eliminate these preferences include: (1) the further unification of gift and estate taxes; 130 (2) gift tax preferences unfairly favor the richest donors who are less likely to require all of their property to satisfy their future needs; 131 (3) the government should not interfere with the timing of family wealth transfers, 132 and (4) the argument that transfers to younger generations encourage more diversified investments is unsupported and inaccurate, particularly for gifts made in trust. 133 the treasury‘s 1984 tax reform proposals included a proposal to further unify the gift and estate taxes: the gift tax, like the estate tax, would be a tax inclusive tax; that is, funds that are used to pay the gift tax would, as with estate tax and income tax, unification of the estate and gift taxes, significant tax incentives remain for individuals to make lifetime gifts. arguably, some of these tax advantages are justifiable because of practical considerations. for example, the $10,000 annual exclusion from gift tax is often justified as a threshold for application of the tax because of the compliance and administrative problems that otherwise would be created. the application of the same progressive rate schedule to all transfers, without adjustment for post -transfer appreciation in the value of the property, may also be justified because of simplicity and because a lifetime transfer deprives the donor of the use of the property and the use of any money used to pay gift tax on the transfer.‖). 129 see kurtz & surrey, note 126 supra, at 1390 (―the argument usually advanced to support tax incentives for lifetime gifts is that it is to the advantage of the government to have property moved into younger hands, for the young will tend to be more venturesome with such capital and thus improve the economic climate by increasing the mobility and risk-taking capacity of that capital.‖); see also note 133, infra. 130 see tax reform for fairness simplicity, supra note 128, at 145 (nov. 1984) (―perhaps the most significant of these proposals is to complete the unification of the estate and gift tax systems by conforming the computation of the gift tax base to that of the estate tax. . . . together, these changes will assure that the form of ownership and transfer of assets within a family will play a greatly reduced role in determining the transfer taxes paid by that family.‖). the 1976 tax act unified the gift and estate tax rates and exemptions and made gifts and bequests part of the same cumulative rate structure for estate tax purposes. see dodge, gerzog & crawford, supra note 15, at 42-43, 449; surrey, supra note 21, at 56. but, some preferences for gifts remain. pechman, supra note 79, at 231 (citing the gift tax annual exclusion and the tax exclusive tax base). 131 see tax reform for fairness simplicity, supra note 129, at 374 (―in addition, since wealthier individuals are more likely to be financially able to make substantial lifetime gifts, taxing lifetime transfers and transfers made at death in the same manner helps to ensure fairness and progressivity in the overall transfer tax system.‖); kurtz & surrey, supra note 126, at 1371 (―but even assuming that some favoritism [for lifetime gifts] should be shown, the existing system provides this favoritism in an irrational and inequitable manner. . . .the larger the estate, the more advantageous transfer by gift becomes.‖); pechman, supra note 79, at 232 (―and among those who do make gifts, the law discriminates in favor of wealthier donors by rewarding them with larger tax savings than less wealthy donors obtain on gifts of the same value. this feature stems from the exclusion of the gift tax from the base of the tax.‖). 132 see tax reform for fairness simplicity, supra note 129, at 374 (―unification of the gift and estate taxes is designed to ensure that taxes are a relatively neutral factor in an individual's decision whether to make a lifetime gift.‖); kurtz & surrey, supra note 126, at 1390 (―[t]he government is not appropriately concerned with the rate of transfer of wealth from parents to children and should leave such matters to family decision, or at least it is not so concerned as to provide tax incentives to affect whatever may be a family‘s natural inclinations in such matters.‖). 133 see surrey, supra note 21, at 273 (―if the purpose is to move property into younger and presumably more venturesome hands, in a desire to produce economic benefits by supposedly increasing the mobility and risk-taking capacity of capital, analysis is then required as to whether this result in fact occurs. if the gifts are in trust then the economic effect is not likely to differ from continued ownership by the donor.‖); kurtz & surrey, supra 126, at 1391 (―most lifetime gifts are of marketable securities placed in trust, and they are made at a time when the donor is quite elderly. a gift to a trust extending for a long period of time seems little different in terms of economic mobility and risk-taking than continued ownership by the donor.‖). 2015] a simpler verifiable gift tax 203 themselves be subject to tax. 134 as with estate tax and income tax, the additional grossed-up tax would be built into the gift tax tables, which the taxpayer could easily access. 135 according to the treasury department, with this additional unity between the transfer taxes, certain tax provisions could be repealed 136 and gift completion rules could be simplified. 137 under the proposed 1984 rules, retained powers would be ignored to allow for an easy-to-complete rule of gift completion; 138 retained interests would be ignored for valuation purposes, but a retained interest gift would be considered complete at the expiration of the retained interest. 139 the retained interest rule would decrease dependence on actuarial tables and would produce more accurate valuation. 140 however, the 1984 proposal also presents serious problems by ignoring retained powers and using easy-to-complete rules. complex retained power transfers would proliferate (contrary to the proposal‘s stated goal of simplification) because the wealthy generally care more about retaining power over transferred assets as compared to retaining an interest in the transferred property. 141 moreover, under the proposal, posttransfer growth, which may be substantial, would pass to third parties without being subject to transfer taxes. some of the most significant anti-abuse provisions, such as sections 2036(a)(2) and 2038, which require date of death value estate tax inclusion for lifetime transfers with retained powers, would be eliminated. though the 1984 proposal states that an adjustment of the gift for post-transfer appreciation is unwarranted ―because a lifetime transfer deprives the donor of the use of the property and the use of any money used to pay gift tax on the transfer,‖ 142 that rationale falls short when one considers that 134 see tax reform for fairness simplicity, supra note 129, at 377-78 (―application of the gift tax on a tax-inclusive basis would eliminate the major disparity between the transfer tax treatment of lifetime gifts and transfers at death.‖). 135 see tax reform for fairness simplicity, supra note 129, at 377. 136 primarily, i.r.c. § 2035(a), the section that deals with gifts of life insurance and transfers of ―taxable strings‖ within three years of decedent‘s death, would be repealed. the same is true for i.r.c. § 2035(b), which ―grosses up‖ the decedent‘s estate by adding the gift tax paid as an estate tax inclusion. repealing i.r.c. § 2035(b) makes sense as that provision is duplicative of the main 1984 unification proposal. inter vivos charitable lead trusts (―clts‖), which, under current law, are subject to abuse, would be reformed under the 1984 proposal. ―the creator of such a trust would be treated as owning the property for transfer tax purposes until the vesting of the non-charitable interest or his or her death, if sooner.‖: that would mean that the donor‘s third party remainder gift would be accurately valued at the time that interest vests. id. at 379. 137 see tax reform for fairness simplicity, supra note 129, at 378-83 (―finally, by removing the major incentive for disguising testamentary transfers as lifetime gifts, the proposal would permit the simplification of the rules governing when a transfer is complete for estate and gift tax purposes.‖). 138 id. at 379. 139 id. at 380. 140 id. at 382 (―by delaying the imposition of transfer tax liability until the donor's interest terminates, the proposed rules would reduce the number of instances in which it is necessary to consult an actuarial table to value the transfer of a partial interest in property and would provide greater accuracy in the valuation of the transferred interest.‖). 141 see richard schmalbeck, avoiding federal wealth transfer taxes, rethinking estate and gift taxation, 121-22 (william g. gale, james r. hines, jr. & joel slemrod eds., 2001) (concluding that even with the great tax benefit of the annual exclusion, few wealthy taxpayers currently are influenced to make those lifetime transfers because ―the real barrier to full use of the annual exclusion is the strong preference of potential donors for the retention of economic power.‖). 142 see text note 128, supra. 204 columbia journal of tax law [vol. 6:182 abusive transfer tax freeze strategies would likely become even more popular estate planning devices. 143 the stated policy of the 1932 annual exclusion was two fold: on one hand, ―to obviate the necessity of keeping an account of and reporting numerous small gifts and on the other, to fix the amount sufficiently large to cover in most cases wedding and christmas gifts and occasional gifts of relatively small amounts.‖ 144 that stated policy, which highlights the exclusion‘s administrative goal, 145 was intertwined with the overriding purpose of the gift tax, to raise immediate revenue during the depression years. 146 otherwise, the 1932 $5,000 exclusion would not have been such a large one, allowing relatively large gifts to go untaxed. 147 in fact, together with the other gift tax preferences 148 enacted with the 1932 act, 149 the large annual exclusion successfully encouraged taxable gifts. according to economists, 1935 produced the second largest revenue from gift taxes when indexed for inflation. 150 scholars have criticized the annual exclusion, particularly the ―present interest‖ requirement, and many have urged the elimination of crummey powers, 151 but this author proposes to have the annual exclusion return to its original stated purpose of eliminating the need to keep track of minor gifts, which do not substantially add to the donee‘s wealth. the simpler gift tax, therefore, includes an annual exclusion for small outright gifts (capped at $2,000, with inflation adjustments, aggregated yearly per donee). 152 143 see cooper, supra note 122, at 247 (―for the time being, there are a number of steps which have been described above that can reasonably be taken to improve the estate and gift tax. those measures, in particular the modifications in valuation procedures to stop the absurd abuses now occurring, will do much to protect the tax base and improve the fairness and effectiveness of the tax in reaching existing accumulated wealth. as for estate freezing, some improvements in sections 2036 and 2038 can raise the ante substantially for taxpayers who want to transfer future growth to their prospective heirs, and thereby limit the greatest abuses in this area.‖). 144 see s. rep . no. 665, 72d cong., 1st sess. 41, reprinted in (1939-1 c. b. (pt. 2) 525-526; h.r. rep . no. 708, 72d cong., 1st sess. 29-30, reprinted in 1939-1 c. b. (pt. 2) 478). 145 see brown, supra note 123, at 483 (―the legislative history to the 1932 act clearly indicates that the principal policy behind the gift tax annual exclusion is administrative in nature--to avoid the necessity of tracking small gifts which do not materially avoid the federal transfer tax system.‖). 146 see cooper, ghosts of 1932, supra note 21. 147 as brown points out: ―. . . the $5,000 annual exclusion enacted as part of the 1932 act was a very significant exclusion amount relative to the size of the specific exemption amount of $50,000 in the gift tax and hence would be expected to generate gifts designed to reduce future estate tax liability.‖ brown, supra note 123, at 486. in addition, he notes that if you analogize those amounts to 2012 numbers, as a ten percent portion of the exemption or to account for inflation, the 1932 $5,000 annual exclusion would amount, respectively, to $500,000 or to approximately $77,000. brown, supra note 123, at 486. 148 the 1932 act included lower rates, a separate cumulate rate structure, and a separate exemption amount for gifts than the ones imposed by the estate tax. in addition, as today‘s gift tax, the 1932 gift tax was computed on a tax exclusive basis. 149 revenue act of 1932, c. 209, 47 stat. 169. 150 see joulfaian, supra note 125, at 1924-1925. 151 see, e.g., brown, supra note 123; crawford, supra note 29, at 446 (―[congress] should eliminate the present interest requirement and in lieu thereof, allow to qualify for the annual exclusion only outright transfers and transfers in trust that meet the requirements of section 2642(c).‖); jeffrey g. sherman, 'tis a gift to be simple: the need for a new definition of "future interest" for gift tax purposes , 55 u. cin. l. rev. 585, 666 (1987) [hereinafter sherman] (proposing that a demand right, like in crummey, not constitute a present interest for annual exclusion purposes); surrey, supra note 21, at 695. 152 see crawford, supra note 29, at 444-45 (―crummey trusts are complex instruments that require substantial professional advice; provisions like those above are entirely tax-driven.‖); sherman, supra note 151, at 590 (―one seldom makes a gift of a future interest without the advice and intervention of an attorney or other professional.‖). 2015] a simpler verifiable gift tax 205 while the current $10,000 (with inflation adjustments, making the 2015 exclusion cap at $14,000) annual exclusion may seem more palatable to most people, it is clear that most of the annual exclusion is not used for the statute‘s original stated purpose, but is instead used to transfer tax-free a goodly sum to third parties. 153 while generally disallowing transfers in trust to qualify for the annual exclusion, the simpler gift tax allows a slightly different version of what is currently referred to as a minor trust under section 2503(c): it would extend until the donee turned thirty years of age. at the donee‘s thirtieth birthday, the trust would terminate and pay out whatever was held in the trust (corpus and accumulated income) to the donee. in addition to the annual exclusion, the simplified gift tax embraces and extends some consumption transfers from the gift tax. each of these new provisions will amend section 2503(e) and all of the section 2503(e) exclusions will be prefaced by a statement that these exemptions are intended to cover consumption items and do not apply to any transfer that is in fact an unconsumed gratuitous property transfer. while accepting that these exclusions indirectly aid the recipient by not requiring him to expend his own wealth for expenses and that education creates human capital, the reality is that most of the following consumption exclusions added in the simpler gift tax provisions are not thought of as gifts. the simpler gift tax would add the following exclusions: (1) an expanded education exclusion; (2) a new exclusion for reasonable living expenses of any donee living in the donor‘s residence; and (3) a new exclusion for certain payments to caretakers, including family members. these exclusions do not directly increase the donee‘s accumulation of assets and, like a parent‘s managerial services, they cannot from a pragmatic position be verified; in addition, they may not rise to the level of property transfers that are subject to the gift tax. 154 the current section 2503(e) exclusion for medical costs paid directly to the provider is geared to the section 213(d) definition of ―medical care.‖ 155 thus, besides doctors‘ and hospital costs, other medical expenses that are currently excluded under section 2503(e) include: medical insurance, 156 prescription drugs and insulin, 157 transportation, 158 lodging, 159 and some capital expenses. 160 the simpler gift tax exclusion for education costs would be expanded and tied to the definitions of ―qualified higher education expenses‖ in section 529. as such, the exclusion would not only cover tuition, but would also cover required fees, books, supplies, and equipment while attending an 153 see, e.g. crawford, supra note 29, at 444 (―well-drafted crummey trusts typically limit the withdrawal right to the annual exclusion amount (less $1,000 or so to allow for de minimis outright gifts during the year).‖); david joulfaian & kathleen mcgarry, estate and gift tax incentives and inter vivos giving, 57 nat‘l tax j. 429, 430 (2004) [hereinafter joulfaian & m cgarry] (―this [annual exclusion] allowance permits a substantial sum to be transferred to heirs free of tax. while yearly amounts may be small, consistent use of this annual exemption can lead to the tax–free transfer of large amounts of wealth.‖). 154 they may be less than the annual exclusion amount or they may be either revocable transfers or licenses. see joseph m. dodge, are gift demand loans of tangible property subject to gift tax, 30 va. l. rev. 181 (2010). 155 see i.r.c. § 2503(e)(2)(b). 156 i.r.c. § 213(d)(1)(d). 157 i.r.c. § 213(b) (limitations on deductible medications). 158 i.r.c. § 213(d)(1)(b). 159 meals and lodging expenses are excluded for a required hospital confinement. in addition, i.r.c. § 213(d)(2) covers $50 per person per night of lodging exp enses, not lavish or extravagant, while receiving medical care. 160 treas. reg. § 1.213-1(c)(1)(iii) (excluding, among other expenses, the costs of eye glasses, crutches, and certain medically necessary home alterations). 206 columbia journal of tax law [vol. 6:182 eligible educational institution, and expenses for special needs services for a special needs student. 161 they would also include room and board for students enrolled at least half-time at an eligible educational institution. 162 similar to a 1960‘s ali exclusion proposal that ignored food, clothing, and living expenses ―for any person dependent upon the transferor,‖ 163 (capped at $3,000 annually), 164 the simpler gift tax would add exclusions for the reasonable living expenses of any donee, 165 regardless of age, living in the same residence as the donor. most families either ignore the living expense transfers to adult dependents or non-dependents or, without actually calculating their value, view those expenses as not exceeding the annual exclusion. because they may not be transfers of property interests or are too difficult to monitor, if they are reasonable in amount and not a subterfuge for property wealth transfers, these consumption costs should be excluded under section 2503(e). the second new consumption exclusion would cover certain payments made to family-member caregivers. the exclusion would allow cash amounts to be transferred to a family or non-family member in exchange for caregiver services provided either to the transferor, the transferor‘s spouse, or to a dependent living in the household of the transferor. in order to qualify for this exclusion, the taxpayer would be required timely to file the necessary employment forms and to pay applicable income and employment taxes on those payments in a timely manner. the reason for this exclusion is to state simply the circumstances under which a payment to a family or non-family member, reasonable in amount and in consideration for caretaking services, will be presumed conclusively to be exempt from gift taxes regardless of any local law presumptions to the contrary. v. compliance few donors report gifts in a timely manner and the scholars who write about the gift tax compliance failure believe that the causes of this problem are a lackadaisical reporting and penalty system. 166 taxpayers do not worry about filing gift tax returns ―because (1) they know their chances of being caught are infinitesimally small and (2) even if they are caught, they are not likely to be penalized.‖ 167 161 i.r.c. § 529(e)(3)(a). 162 i.r.c. § 529(e)(3)(b); i.r.c. § 25a(b)(3) (defining eligible student). 163 see surrey, supra note 21, at 190. 164 see casner, supra note 28, at 538-539 (―the exclusion of transfers for consumption will eliminate many transfers from gift taxation that are now technically subject to such taxation. it is believed, however, that many of these eliminated transfers are rather widely ignored today in the gift tax area.‖). 165 see ali federal estate and gift tax project: m ajor problems in federal estate and gift taxation and recommendations in reference thereto (1968). one of the purposes of the ali consumption exclusion was ―that there be excluded from gift taxation various so-called transfers for consumption, without regard to whether they in fact involved a discharge of a legal obligation to support another and cause the transfer tax law to be applied in the same way in all geographical areas .‖ id. 166 see jay a. soled, paul l. caron, charles davenport, and richard schmalbeck, rethinking the penalty for the failure to file gift tax returns, 141 tax notes 757 (2013); gans & soled, supra note 41, at 760-61. 167 gans & soled, supra note 41, at 774. as the basis of the poor compliance rate, professors gans and soled cite the lack of third party information returns, the politically untenable use of random audits that would unlikely produce additional revenue, and, historically, the lack of enforcement of gift tax filing requirements. as solutions, they propose third party (donee or trustee) information return filings, which would be especially productive if a transfer is made in trust; establishing a ―meaningful penalty system,‖ similar to the current penalty system, but where the penalty computations would not take into account the gift tax exemption (at the time of the article, the gift tax $1 million lifetime amount), delinquent returns would be 2015] a simpler verifiable gift tax 207 given that there is no imperative to have preferences for lifetime transfers, apart from a limited annual exclusion, this article proposes to retain other gift tax benefits but only for donors who adhere to the filing and payment requirements. compliance rules in a verifiable gift tax should replicate the portability rules: 168 if you don‘t properly file a gift tax return and pay your gift tax, you don‘t obtain the tax benefits that compliant filers receive. depending on which benefits are denied delinquent donors, donors should be motivated to comply. denying the benefit of a tax exclusive transfer tax should increase self-reporting. for greater incentives, new benefits could be added to gifts, such as limiting the unified credit exemption to the 2009 level $3.5 million unified credit, 169 but for the first $1.5 million in taxable gifts, provide a lower rate or an additional run-through regime similar to a pre-1977 gift tax model. 170 additional gift tax benefits for compliant donors should produce more revenue in line with the goal of the 1932 gift tax. 171 historically, instead of utilizing even simple tax minimization techniques to the maximum extent allowable, 172 wealthy taxpayers have reacted to changes in tax rates by accelerating inter vivos transfers. 173 that was particularly true in 1976 in anticipation of the new law‘s elimination of lower gift tax rates and the separate exemption run-through scheme. 174 according to joulfaian, 1976 was a banner year for gifts before the 1976 tax act took effect in 1977, mainly due to the enormous sensitivity to rate changes between those two years. 175 while the revenue effect of a simpler verifiable gift tax is uncertain, the evidence from 1976 suggests a positive revenue effect from changes that would be policy improvements to the current gift tax. vi. conclusion the purpose of this article is to propose a simplified verifiable gift tax, to reassert the basic principles of transfer taxes, to encourage simple, outright gifts, and to eliminate some major abuses in the current gift tax regime. to accomplish these goals, the subject to a hefty twenty-five percent maximum penalty if they are five or more months late, with interest accruing from the required filing date. id. at 777-78. 168 see supra notes 49-52 and accompanying text. 169 recent legislation has returned the unified credit exemption equivalent to 2009 levels. see, e.g., s. 2899, 113th cong., 2d sess. § 2(b)(1) (amending i.r.c.§ 2010(c)(3) by reducing the ―basic exclusion amount‖ exemption to $3.5 million for transfers after december 31, 2014) (proposed by sen. bernard sanders.). 170 see supra notes 130, 148 and accompanying text. 171 see cooper, ghosts of 1932, supra note 21. 172 see joulfaian & mcgarry , supra note 153, at 419 (―overall, we conclude that while taxes are an important consideration in transfer behavior of the rich, their behavior is not universally consistent with a tax minimization strategy.‖) (―[i]ndividuals fail to exploit fully available avenues of tax avoidance.‖). id. at 430. 173 see joulfaian, supra note 125, at 1927 (―using data for gifts made in the years 1933 through 1988, the findings suggest that the wealthy are quite responsive to taxes in the timing of their gifts, particularly in the short run.‖); staff of joint comm. on tax‘n, 112th cong., m odeling the federal revenue effects of changes in estate and gift taxation 26 (joint comm. print 2012). 174 see supra notes 130, 148 and accompanying text. 175 see joulfaian, supra note 125, at 1924 (―[g]ifts made in 1976, in anticipation of the higher tax rates in 1977, surpass those made in any other year since the enactment of the tax.‖). one other factor that probably contributed to the number of gifts in that year was that, under the 1976 act, carryover basis would be extended to bequests with the repeal of i.r.c. § 1014 (date of death (generally ―stepped up‖) basis rule for transfers at death). while later, the repeal of i.r.c. § 1014 was itself retroactively repealed, in 1976 that post-enactment event could not be anticipated. therefore, some of the increase in gifts in 1976 could be attributed to the fact that the wealthy anticipated the estate tax inclusion benefit was about to disappear, equalizing the capital gains effect between gifts and bequests. 208 columbia journal of tax law [vol. 6:182 proposed tax would simplify gift completion rules, adopt a hard-to-complete rule of transfer taxation, reduce the annual exclusion while expanding the consumption exclusion, and employ loss of preference inducements to increase gift tax compliance. formatted-mayer “the better part of valour is discretion”: should the irs change or surrender its oversight of taxexempt organizations? lloyd hitoshi mayer* abstract recent events have highlighted the difficulties the internal revenue service faces when attempting to ensure that purportedly tax-exempt organizations in fact qualify for that status. the problems in this area go much deeper than a group of irs employees subjecting certain organizations to greater scrutiny based on their political leanings, however. for decades members of the public, the media, the academy, and congress have criticized the limited ability of the irs to ensure that organizations claiming exemption from federal income tax in fact deserve that categorization. yet examples of irs failings in this area continue to arise with depressing frequency. this is not surprising given that oversight of exempt organizations is but one of many areas that suffers from major difficulties faced by the irs as a whole, including shrinking resources, growing responsibilities, and increasing responsibility for determinations that go beyond those necessary for revenue collection. this article draws on tax compliance literature to explore how the current level and methods of oversight for exempt organizations could be modified to improve compliance even given the existing resource constraints. it concludes that while marginal improvements in oversight are possible, there is no silver bullet to counter the irs’s growing inability to oversee this area. part iv of this article therefore turns to more radical proposals that would move the locus of oversight for exempt and particularly charitable organizations out of the irs. the proposal that shows the most promise, but also is the most risky, would shift much of this role to a private, self-regulatory body overseen by the irs. given the current state of irs oversight, this proposal deserves serious consideration. * professor, notre dame law school. i am very grateful to kristin hickman for organizing the university of minnesota law school tax policy symposium of which this article is a part, to paul caron, chris walker, the other symposium participants, and philip hackney for helpful comments, and to erik adams and kyle chen for research assistance. © 2016 mayer. this is an open-access publication distributed under the terms of the creative commons attribution license, https://creativecommons.org/licenses/by/4.0/, which permits the user to copy, distribute, and transmit the work provided that the original authors and source are credited. 2016] “the better part of valour is discretion” 81 i. introduction ...................................................................................................... 82 ii. a brief history of irs oversight ............................................................. 82 a. exempt organizations and the irs exempt organizations division .................. 83 b. applications for recognition of exemption ........................................................ 88 c. annual information returns and examinations .................................................. 90 d. guidance, rulings, technical advice and other activities ................................ 93 e. current compliance ............................................................................................. 94 iii. modifying oversight ..................................................................................... 96 a. concerns and proposals ....................................................................................... 97 b. methods unlikely to significantly improve oversight ....................................... 99 c. methods with the potential to significantly improve oversight ....................... 102 1. streamlined application procedures .......................................................... 102 a. expedited process for certain i.r.c. § 501(c)(4) applications ........... 102 b. new form 1023-ez & streamlined procedures ................................... 103 c. criticisms and evaluation ..................................................................... 104 2. more efficient examination techniques ..................................................... 107 3. increased disclosure ................................................................................... 110 4. increased electronic filing ......................................................................... 111 iv. rethinking the locus of oversight ..................................................... 113 a. proposals for national alternatives to the irs .................................................. 113 1. new federal regulatory agency ................................................................. 113 2. new federal advisory group ..................................................................... 114 3. new national self-regulatory organization .............................................. 114 b. considering the proposals ................................................................................. 115 1. leaving the irs ........................................................................................... 115 2. leaving the federal government ................................................................ 117 v. conclusion ........................................................................................................ 121 82 columbia journal of tax law [vol.7:80 i. introduction recent events have highlighted the difficulties the internal revenue service (irs) faces when attempting to ensure that purportedly tax-exempt organizations do in fact qualify for that status.1 these problems go much deeper than a group of irs employees subjecting certain organizations to greater scrutiny based on their political leanings. for decades, members of the public, the media, the academy, and congress have criticized the limited ability of the irs to ensure that organizations claiming exemption from federal income tax in fact deserve that categorization.2 yet examples of irs failings in this area continue to arise with depressing frequency despite numerous suggestions for improvement and various congressional and agency initiatives. 3 this is consistent with the major difficulties faced by the irs as a whole and discussed by other presenters at this symposium.4 as detailed in part ii of this article, these difficulties have rendered the irs unable to keep pace with the growth of the exempt organizations sector over the past 40 years. one of the latest such initiatives suggests a new approach, however. in 2014, the irs introduced the much shorter and simpler form 1023-ez application for nonprofit organizations that claim exempt charitable status and expect to have only modest financial resources, accompanied by faster procedures for handling all applications for recognition of exemption.5 these innovations represent the first significant, permanent reduction in the level of oversight the irs provides in this area since the introduction of the form 990ez, a shorter version of the annual information return required for most exempt organizations.6 it is arguable, however, whether a reduction of oversight is in fact prudent and whether other reductions might also be advisable. part iii of this article draws on tax compliance literature to explore how the current level and methods of oversight for exempt organizations could be modified to improve compliance given existing resource constraints. it concludes that while marginal improvements in oversight are possible, there is no silver bullet to counter the irs’s growing inability to oversee this area. part iv of this article therefore turns to more radical proposals that would move the locus of oversight for exempt and particularly charitable organizations out of the irs. the proposal that shows the most promise, but also is the most risky, would shift much of this role to a private, self-regulatory body overseen by the irs. the current crisis, however, highlights the need to pursue this proposal now. ii. a brief history of irs oversight in theory, oversight of exempt organizations by the irs and its predecessors is as old as the internal revenue code itself.7 in practice, there appears to have been little actual oversight until congress began requiring an annual information return for some exempt 1 see s. rep. no. 114-119, at 60 (2015); lily kahng, the irs tea party controversy and administrative discretion, 42 cornell l. rev. online 41, 42-44, 49-51 (2013); paul caron, the irs scandal, taxprof blog, http://taxprof.typepad.com/taxprof_blog/irs-scandal [http://perma.cc/fs8w-7t8h]. 2 see infra part iii.a. 3 id. 4 see memorandum from j. russell george, inspector general, dep’t of the treasury, to jacob lew, sec’y of the treasury 1-2 (oct. 15, 2014), https://www.treasury.gov/tigta/management/management _fy2015.pdf [https://perma.cc/wmp4-gxhg]. 5 see form 1023-ez, streamlined application for recognition of exemption under section 501(c)(3) of the internal revenue code, http://www.irs.gov/uac/about-form-1023ez [http://perma.cc /23vw-qgjr]. 6 see irs announcement 89-34, 1989-10 i.r.b. 30. 7 see act of oct. 3, 1913, pub. l. no. 63-16, § 2(g)(a), 38 stat. 114, 172 (1913). 2016] “the better part of valour is discretion” 83 organizations effective as of 1943. 8 furthermore, congress did not require that any organizations apply to the irs for recognition of their exempt status until it imposed this requirement on many charitable organizations in 1969.9 this part describes these two main channels for irs oversight of exempt organizations: consideration of applications for recognition of exemption and examinations of annual information returns. it also reviews the other significant exempt organization related activities engaged in by the irs, such as providing various forms of guidance, rulings, and technical advice, and the limited evidence regarding the current level of compliance by exempt organizations with the applicable federal tax laws. first, it is useful to consider both the extent to which the size of the regulated community has grown over time and the resources the irs directs to overseeing this community, which have not kept pace. a. exempt organizations and the irs exempt organizations division the following two tables show the irs-reported numbers and aggregate assets and revenues for exempt organizations, both generally and specifically for charitable (i.r.c. § 501(c)(3)) organizations and the most numerous non-charitable organizations (i.r.c. § 501(c)(4) social welfare organizations; i.r.c. § 501(c)(5) labor, agricultural, and horticultural organizations; i.r.c. § 501(c)(6) business leagues, chambers of commerce, and similar entities; i.r.c. § 501(c)(7) social and recreational clubs; and i.r.c. § 501(c)(8) fraternal beneficiary organizations). 8 see revenue act of 1943, pub. l. no. 78-285, § 117, 58 stat. 21, 36-37 (1944); h.r. rep. no. 78871, at 24-25 (1943); s. rep. no. 78-627, at 21 (1943). the treasury department imposed an annual information return requirement in 1942 on certain exempt organizations, effective for tax year 1941, although it was not clear it had the authority to do so. see t.d. 5125, 1942-1 c.b. 101 (codified at treas. reg. 103, § 19.101-1), as modified by t.d. 5177, 1942-2 c.b. 123; marion r. fremont-smith, governing nonprofit organizations: federal and state law and regulation 65 (2004). 9 see tax reform act of 1969, pub. l. no. 91-172, § 101(a), 83 stat. 487, 494-96 (1969) (codified at i.r.c. § 508); h.r. rep. no. 91-431, pt. 1, at 37 (1969); s. rep. no. 91-552, at 53 (1969). treasury by regulation provided an application process before 1969, but it is not clear if treasury sought to make this process mandatory. see, e.g., t.d. 2693, 20 treas. dec. int. rev. 293 (1918); t.d. 5125, 1942-1 c.b. 101 (codified at treas. reg. 103, § 19.101-1); philip hackney, should the irs never “target” taxpayers? an examination of the irs tea party affair, 49 val. u. l. rev. 453, 460-61 (2015). 84 columbia journal of tax law [vol.7:80 table 1: exempt organizations: numbers10 fiscal year all 501(c)s 501(c)(3)s 501(c)(4)-(8)s other 501(c)s 1980 846,433 319,842 453,415 73,176 1985 854,806 366,071 412,877 75,858 1990 1,022,214 489,882 443,066 89,266 1995 1,162,810 626,226 439,424 97,160 2000 1,354,395 819,008 431,965 103,422 2005 1,570,023 1,045,979 421,410 102,634 2010 1,821,824 1,280,739 437,581 103,504 2011 1,494,882 1,080,130 330,336 84,416 2012 1,484,818 1,081,891 320,029 82,898 2013 1,442,197 1,052,495 310,126 79,576 2014 1,568,454 1,117,941 369,41611 81,097 10 see irs 1980 ann. rep. 76; irs 1986 ann. rep. 60; irs ann. rep. 1990, at 38; irs data book 1995, at 25; irs data book 2000, at 24; irs data book 2005, at 40; irs data book 2010, at 56; irs data book 2011, at 56; irs data book 2012, at 56; irs data book 2013, at 56; irs data book 2014, at 58. 11 the sharp increase from fiscal year 2013 to fiscal year 2014 for i.r.c. § 501(c)(4)-(8) organizations is almost entirely attributable to a dramatic increase in the number of reported i.r.c. § 501(c)(4) organizations. compare irs data book 2013, at 56 (91,056 such organizations), with irs data book 2014, at 58 (148,585 such organizations). in response to an inquiry, the irs stated its preliminary conclusion is that this increase represents “entities that have applied for an [employer identification number] as an exempt organization (eo) but have not yet filed a form 1023 or 1024 and obtained an eo determination” (and so are not necessarily claiming exemption under i.r.c. § 501(c)(4)). email from emily gross, irs statistics of income division (aug. 31, 2015, 3:22 p.m. edt) (on file with author). 2016] “the better part of valour is discretion” 85 table 2: exempt organizations: finances12 (millions of dollars) fiscal year 501(c)(3) assets 501(c)(4)-(8) assets 501(c)(3) revenues 501(c)(4)-(8) revenues 1995 1,143,079 159,344 663,371 81,415 2000 1,562,536 217,068 866,208 109,350 2005 2,241,887 282,862 1,252,889 153,688 2010 2,946,521 342,898 1,593,011 176,623 2011 3,030,133 359,926 1,647,905 179,300 the numbers reproduced in the first table above appear to exclude i.r.c. § 501(c) organizations that are not required to apply for irs recognition of their exempt status and have not chosen to voluntarily do so.13 organizations not required to apply include churches, certain church-related entities, very small organizations (less than $5,000 in annual gross receipts), and all non-501(c)(3) entities.14 a study by the urban institute estimates that churches currently number approximately 300,000 and very small organizations number approximately 400,000.15 these figures also do not include several other, relatively small in terms of numbers and financial resources, types of exempt organizations that fell within the jurisdiction of the irs exempt organizations division during some or all of this period, nor do they include a small subset of taxable entities (primarily non-exempt trusts) that also fell within that division’s jurisdiction during this period.16 similarly, the financial figures do not include organizations that are not required to file annual information returns, including churches, certain church-related entities, and organizations with annual gross receipts below certain thresholds (which thresholds have varied over time).17 the financial figures for i.r.c. § 501(c)(3) organizations also do not include financial information for private foundations, which the irs reports separately. those figures also reflect a growth in numbers and financial resources over the same time 12 cecelia hilgert & melissa whitten, charities and other tax-exempt organizations, 1995, stat. inc. bull. 105, 123-25 (winter 1998-1999); paul arnsberger, charities and other tax-exempt organizations, 2000, stat. inc. bull. 122, 134-36 (fall 2003); paul arnsberger, charities, labor and agricultural, and other tax-exempt organizations, 2005, stat. inc. bull. 271, 281-82 (fall 2008); paul arnsberger, nonprofit charitable organizations, 2010, stat. inc. bull. 74, 85, 87 (winter 2014); paul arnsberger, nonprofit charitable organizations, 2011, stat. inc. bull. 1, 10, 12 (spring 2015) [hereinafter charitable organizations 2011]. these sources rely on a sample of annual information returns for each fiscal year. see, e.g., charitable organizations 2011, at 4. 13 see irs data book 2014, at 58 n.1. 14 see i.r.c. § 6033(c)(1) (2014). 15 see katie l. roeger et al., the nonprofit almanac 2012, at 2 n.1 (2012). 16 for example, as of fiscal year 2014 there were 222 i.r.c. § 501(d) religious and apostolic associations, 29,462 i.r.c. § 527 political organizations, and 125,177 non-exempt trusts also within the division’s jurisdiction. irs data book 2014, at 56-58. 17 u.s. gov’t accountability off., gao-05-561t, tax-exempt sector: governance, transparency, and oversight are critical to maintaining public trust 7 (2005) [hereinafter gao 2005 report]. 86 columbia journal of tax law [vol.7:80 period, although revenues and to a lesser extent assets have varied more.18 in 2012, the latest year reported by the irs, private foundations had assets worth approximately $633 billion and total annual revenue of approximately $95 billion.19 the growth in the number and financial resources of exempt organizations follows a trend that dates back to at least 1975 and likely earlier.20 the decline in the number of organizations (but not the reported financial resources) after fiscal year 2010 is primarily the result of congress automatically revoking the exempt status of organizations that failed to file three consecutive required annual information returns after 2006.21 while some of those organizations were active, most of them likely had ceased operations and so did not represent a significant amount of activities, assets, or revenues.22 as for irs resources dedicated to overseeing exempt organizations, the irs does not release separate budget figures for its exempt organizations division.23 in recent years, however, the government accountability office (gao) has provided information about the number of employees within this division. 18 see cynthia belmonte, domestic private foundations and related excise taxes, tax year 2009, stat. inc. bull. 114, 115 (winter 2013); melissa ludlum, domestic private foundations, tax years 19932002, stat. inc. bull. 162, 163 (fall 2005). 19 irs, soi tax stats – domestic private foundation and charitable trust statistics, http://www.irs.gov/uac/soi-tax-stats-domestic-private-foundation-and-charitable-trust-statistics [http:// perma.cc/mc8f-yqdg] (see statistical tables, domestic private foundations: number and selected financial data, tax year 2012, cells x11 & d11). 20 see alicia meckstroth & paul arnsberger, a 20-year review of the nonprofit sector, 1975-1995, stat. inc. bull. 149, 151, 153 (fall 1998). 21 u.s. gov’t accountability off., gao-15-164, tax-exempt organizations: better compliance indicators and data, and more collaboration with state regulators would strengthen oversight of charitable organizations 11 (2014) [hereinafter gao 2014 eo rep.]. 22 see amy s. blackwood & katie l. roeger, revoked: a snapshot of organizations that lost their tax-exempt status, urban institute, at 2 (aug. 2011), http://www.urban.org/sites/default/files /alfresco/publication-pdfs/412386-revoked-a-snapshot-of-organizations-that-lost-their-tax-exempt-status .pdf [http://perma.cc/c5s4-kc72]; linda m. lampkin, automatic revocation of nonprofits’ tax-exempt status: what nonprofits, grantmakers, and donors need to know 3 (july 27, 2010), https://www.guidestar .org/viewcmsfile.aspx?contentid=2947 [https://perma.cc/q9n6-8jyx]. 23 the staff of the joint committee on taxation has on occasion obtained these figures, however. see, e.g., staff of the joint comm. on taxation, jcs-3-00, report of investigation of allegations relating to internal revenue service handling of tax-exempt organization matters 120 (2000) [hereinafter jct 2000 report]. 2016] “the better part of valour is discretion” 87 table 3: irs exempt organizations division employees24 (full-time equivalents) fiscal year total examinations determinations/rulings & agreements25 education outreach & other 2000 798 424 342 32 2005 856 467 347 42 2010 889 529 341 19 2011 886 534 328 24 2012 858 516 319 23 2013 842 493 326 23 looking further into the past, for fiscal year 1975 the irs reported devoting an average of 495 field professional positions to the examination of exempt organization returns.26 while this earlier figure is not directly comparable to the figures from recent years, it suggests that the number of employees dedicated to examinations in fiscal year 2013 is about the same as almost 40 years earlier.27 for fiscal year 1975 the irs reported 658 average positions, with 666 employees at the end of the year, indicating that the exempt organization division in fiscal year 2013 had about 20 percent more employees total than 38 years earlier.28 the reliability of this figure is unclear, however, as a 1977 report stated that “[a]bout 1,000 irs employees administer the exempt organization provisions of the internal revenue code,” or about 160 more employees than do so today.29 regardless of the exact figures, however, during approximately the same time period the number of organizations exempt under i.r.c. § 501(c) has almost doubled and the financial resources controlled by the most common organizations has increased by 50 percent or more over just the fourteen years from 1995 to 2011 (adjusting for inflation).30 and both the applicable law and the main forms filed by exempt organizations have increased in complexity and length, as detailed later in this part.31 the irs employees dedicated to exempt organization matters do not operate in a vacuum. rather, they enjoy significant support from other parts of the irs and the federal government. these other parts include: service center, technology, other support, and appeals staff within the irs; chief counsel staff and other treasury employees who help 24 gao 2014 eo rep., supra note 21, at 20; gao 2005 report, supra note 17, at 41; see also jct 2000 report, supra note 23, at 60 (862 and 946 total eo staff in fiscal years 1990 and 1995, respectively). 25 the figures for 2000 and 2005 are for “determinations” while the figures for later years are for “rulings & agreements,” a broader function that included determinations. 26 comm’r of internal revenue, ann. rep. 1975, at 41. 27 see also u.s. general accounting off., gao-02-526, tax-exempt organizations: improvements possible in public, irs, and state oversight of charities 23 (2002) [hereinafter gao 2002 report] (irs tax exempt and government entities staffing remained essentially flat from 1974 to 1997). 28 see comm’r of internal revenue, supra note 26, at 147. 29 david ginsburg et al., federal oversight of private philanthropy, in 5 commission on private philanthropy and public needs, research papers 2578, 2581 (1977). 30 see bureau of labor statistics, cpi inflation calculator, http://www.bls.gov/data/inflation _calculator.htm [http://perma.cc/r9wb-asnc] (used to adjust 1995 figures to 2011 dollars); supra notes 10, 12 and accompanying text. 31 see infra notes 48-50, 60-62 and accompanying text. 88 columbia journal of tax law [vol.7:80 with exempt organizations matters; and attorneys within the department of justice’s tax division who litigate certain disputes with exempt organizations.32 information regarding how the availability of these other supports has varied over time is not readily available, however. b. applications for recognition of exemption for fiscal year 1970, the irs reported receiving 23,349 applications and issuing 17,367 determination letters, representing a steady increase in both applications and determination letters from the comparable figures four years earlier (17,361 and 14,394, respectively). 33 for fiscal year 1980 the irs reported having processed 49,534 applications, with 36,980 approved, 1,914 denied, and 10,640 withdrawn or otherwise disposed of without a determination. 34 the following table shows more detailed information that the irs has made available in recent years regarding the applications that it closed. table 4: applications closed35 fiscal year charitable (501(c)(3)) other 501(c) total approved denied other total approved denied other 1995 56,408 42,324 377 13,707 10,866 8,289 242 2,355 2000 74,534 61,005 456 13,073 8,120 6,229 26 1,865 2005 77,539 63,402 765 13,372 6,029 4,801 16 1,212 2010 59,945 48,934 500 10,511 5,600 4,726 13 628 2011 55,319 49,677 205 5,437 5,656 5,016 10 609 2012 51,748 45,029 123 6,596 9,027 7,547 20 1,127 2013 45,289 37,946 79 7,264 7,750 6,162 9 1,116 2014 100,032 94,365 67 5,600 17,493 16,289 22 1,182 other resolutions include applications withdrawn by the organization, applications that did not provide required information or were otherwise incomplete, or applications on 32 see irs, today’s irs organization, http://www.irs.gov/uac/today’s-irs-organization [http:// perma.cc/4vmw-pg5m]; u.s. department of the treasury, tax policy, http://www.treasury.gov/about /organizational-structure/offices/pages/tax-policy.aspx [http://perma.cc/7kd4-3vnm]; u.s. department of justice, tax division, http://www.justice.gov/tax [http://perma.cc/x699-hn6v]. 33 comm’r of internal revenue, 1970 ann. rep. 26. 34 irs 1980 annual report 76. 35 see irs data book 1995, at 25; irs data book 2000, at 23; irs data book 2005, at 39; irs data book 2010, at 55; irs data book 2011, at 55; irs data book 2012, at 55; irs data book 2013, at 55; irs data book 2014, at 57. 2016] “the better part of valour is discretion” 89 which the irs refused to rule.36 data from the 1990s indicates that during the decade more than two-thirds of other resolutions were for failure to establish exemption.37 the irs does not generally release the number of applications it receives each fiscal year. in 2012 congressional testimony, however, a senior irs official reported that the irs receives approximately 60,000 applications annually, of which more than 50,000 are for exemption under i.r.c. § 501(c)(3).38 this latter figure is similar to an urban institute estimate of i.r.c. § 501(c)(3) applications for the period from 2001 through 2011 of between approximately 45,000 to slightly over 50,000 per year.39 the reason why the number of closed i.r.c. § 501(c)(3) applications is so much higher than that figure in 2000 and 2005 is apparently because before 2009 the irs included in the closed applications figure private foundation status rulings that many applicants routinely received five years after their initial application; these closed “foundation follow-up cases” averaged over 19,000 annually from 2001 to 2008.40 closed cases also reflect some other types of determinations, but based on the apparent number of applications those other determinations are probably relatively rare.41 in recent years, however, the irs has seen a sharp increase in applications due to organizations seeking reinstatement after automatic revocations began in 2011.42 when the department of the treasury submitted the new form 1023-ez and revised form 1023 to the office of management and budget for review in 2014, it stated that annually there are approximately 80,000 applications for recognition under i.r.c. § 501(c)(3) alone, which presumably included requests for reinstatement.43 therefore, the decline in the number of applications processed from 2010 to 2013 reflects not a reduction in the number of applications submitted but rather an increased backlog of pending applications, including requests for reinstatement.44 this backlog reached more than 60,000, which at the then current processing pace would have taken the irs more than a year to clear.45 using the streamlined procedures and application form 36 see, e.g., irs data book 2014, at 57 n.2. 37 see staff of the joint comm. on taxation, description of present law relating to charitable and other exempt organizations and statistical information regarding growth and oversight of the tax-exempt sector 41 (2004). 38 public charity organizational issues, unrelated business income tax, and the revised form 990: hearing before the subcomm. on oversight of the h. comm. on ways and means, 112th cong. 5, 8 (2012) [hereinafter 2012 hearings] (statement of steven t. miller, deputy commissioner of services and enforcement, internal revenue service). 39 amy s. blackwood & katie l. roeger, applications for 501(c)(3) tax-exempt status declining: recession or rule change?, urban institute, at 2 (2013), http://www.urban.org/research/publication /applications-501c3-tax-exempt-status-declining-recession-or-rule-change [http://perma.cc/2pth-ldqj]. 40 id. at 1-2. 41 see, e.g., irs data book 2014, at 57 n.1. 42 see eric b. carriker et al., exempt organizations: leveraging limited irs resources in the tax administration of small tax-exempt organizations, in advisory committee on tax exempt and gov’t entities, 2013 report of recommendations 10; 1 nat’l taxpayer advoc., 2012 ann. rep. to congress 194, 196. 43 see submission for omb review: comment request, 79 fed. reg. 18124, 18125 (mar. 31, 2014). 44 see nat’l taxpayer advoc., special report to congress: political activity and the rights of applicants for tax-exempt status 27 (2013); supra note 42. 45 see press release, irs, new 1023-ez form makes applying for 501(c)(3) tax-exempt status easier; most charities qualify (july 1, 2014), http://www.irs.gov/uac/newsroom/new-1023-ez-formmakes-applying-for-501c3tax-exempt-status-easier-most-charities-qualify [http://perma.cc/rb29q8gv]. 90 columbia journal of tax law [vol.7:80 described in part iii.c.1 below, in fiscal year 2014 the irs more than doubled the number of applications closed.46 at the same time, however, the proportion of applications denied or resolved by means other than approval or denial dropped significantly (from 0.17% to 0.08% and from 15.8% to 5.8%, respectively).47 over time, the application forms have become lengthier and more complex. for example, the form 1023 for organizations seeking recognition of exemption under i.r.c. § 501(c)(3) has grown from four pages when it was first introduced in the early 1950s to twelve pages, plus fourteen pages of schedules that apply to certain types of organizations.48 the counterpart form for organizations seeking recognition of exemption under other provisions of i.r.c. § 501(c) has grown from two pages in the early 1960s to six pages, plus thirteen pages of schedules that apply to certain types of organizations.49 at least part of this growth is attributable to the increasing complexity of the statutes and other federal tax rules governing exemption.50 c. annual information returns and examinations as noted above, congress did not generally require exempt organizations to file annual information returns until 1944.51 even then, there were apparently no examinations of such returns before 1954 unless the irs received a complaint.52 the irs examined the returns of 13,000 exempt organizations in 1966 but only the returns of 8,500 organizations in 1970. 53 this decline was part of the impetus for irs to create the exempt organization examination branch in 1970 and to implement other structural changes to increase its capacity for overseeing exempt organizations. examinations appear to have peaked in fiscal year 1973, when the irs examined the returns of almost 19,000 organizations; close to 15,000 of these organizations were private foundations, as required to fulfill a commitment by the then irs commissioner to examine all private foundations within five years of the new rules imposed on them by congress in 1969.54 the following table shows the examination information reported by the irs for more recent years. 46 see supra note 35 and accompanying text. 47 see id. 48 karen a. gries et al., exempt organizations: form 1023 – updating it for the future, in advisory committee on tax exempt and gov’t entities, report of recommendations 6 (2012); see also irs form 1023 (revised dec. 2013). 49 see irs form 1024 (revised sept. 1998); irs form 1024 (revised june 1962), http://texashistory .unt.edu/ark:/67531/metapth250819/m1/1/ [http://perma.cc/e8th-mgar]. 50 see nicole s. dandridge, choking out local community service organizations: rising federal tax regulation and its impact on small nonprofit entities, 99 ky. l.j. 695, 708 (2011). 51 supra note 8 and accompanying text. 52 ginsburg et al., supra note 29, at 2584. 53 id. at 2584-85; see also comm’r of internal revenue 1970 ann. rep. 24-26. 54 id. at 2610. 2016] “the better part of valour is discretion” 91 table 5: exempt organization returns examined55 fiscal year all annual returns filed form 990/990-ezs examined other annual returns examined percent annual returns examined other returns examined 1995 523,191 3,852 380 0.8% 6,265 2000 719,928 3,630 200 0.5% 3,605 2005 849,342 2,402 362 0.3% 2,189 2010 776,300 3,596 329 0.5% 7,524 2011 858,865 2,962 240 0.4% 8,849 2012 798,903 2,918 125 0.4% 7,700 2013 771,675 2,774 138 0.4% 7,693 2014 765,395 2,579 246 0.4% 5,259 annual returns include form 990, form 990-ez, form 990-pf (for private foundations), form 1041-a (relating to certain trusts), form 1120-pol (relating to certain political organizations), and form 5227 (also relating to certain trusts).56 in contrast, other returns are returns that exempt organizations normally file in addition to its annual information return, such as form 990-t (unrelated business income tax).57 the number of annual returns examined does not necessarily equal the number of organizations that had their annual returns examined, as the irs might choose to examine returns from multiple years for a single organization. 58 also, while the percentage provided is based on the number of annual returns examined in a given fiscal year compared to the number of annual returns filed during the calendar year ending in that fiscal year, it only provides a rough estimate of examination coverage because the returns examined in a given fiscal year were usually filed in earlier years.59 as with the application form, the annual information returns have also generally grown longer and more complex over time, where the number of pages acts as a rough measure of their length and complexity. occurring in 2007, the most recent major revision of the form 990 resulted in a form with eleven pages that all filers must complete and sixteen schedules that certain organizations may also need to complete (and since then the 55 see irs data book 1995, at 14, 33; irs data book 2000, at 20; irs data book 2005, at 3233; irs data book 2010, at 33; irs data book 2011, at 33; irs data book 2012, at 33; irs data book 2013, at 33; irs data book 2014, at 34. 56 see, e.g., irs data book 2014, at 34 n.1. 57 see, e.g., id. at 34. 58 see gao 2002 report, supra note 27, at 22; marcus s. owens, charity oversight: an alternative approach 2 n.2 (2013), http://academiccommons.columbia.edu/download/fedora_content /download/ac:168629/content/owens_-_charity_oversight_an_alternative_approach.pdf [http://perma .cc/6r9m-ze2x]. 59 owens, supra note 58, at 2 n.2. 92 columbia journal of tax law [vol.7:80 main form has grown to twelve pages).60 by comparison, the form was only a single page long in 1968, and before the 2007 revision, it was only nine pages long with two possible schedules (including a seven-page schedule applicable to most i.r.c. § 501(c)(3) organizations).61 a significant part of the most recent growth in the length of the form appears to have been driven by the irs’s addition of numerous inquiries relating to governance issues.62 there are several important additional caveats to this return and examination information. first, churches (of all faiths) and certain church-related entities are exempt from the annual return requirements.63 while the irs can still examine a church, the existence of special statutory protections for churches and, in recent years, questions about the proper implementation of those protections have made examinations of churches very rare.64 second, there are financial filing thresholds for the form 990 and, after it was introduced in 1989, the form 990-ez.65 the threshold for most exempt organizations having to file the form 990-ez is having annual gross receipts of more than $50,000.66 while the financial filing thresholds have varied over time, their existence means that many smaller exempt organizations had not been required to file annual information returns before congress imposed that requirement on all exempt organizations (except churches and certain church-related entities) in 2006.67 for these smaller organizations, the irs now requires the online form 990-n, which only asks for eight items of information.68 in fiscal year 2014, the irs received 470,895 of these forms 990-n.69 the irs does not appear to release any information regarding the number of examinations involving the form 990-n, but it has procedures in place for such examinations and has recently stated that it instituted 60 see irs, overview of form 990 redesign for tax year 2008 (2007), http://www.irs.gov/pub/irstege/overview__form__990__redesign.pdf [http://perma.cc/9hkv-ubma]; irs, form 990 (2014), https:// www.irs.gov/pub/irs-pdf/f990.pdf [https://perma.cc/ghd2-hjlm]. 61 see irs form 990 (1968), http://www.irs.gov/pub/irs-prior/f990shf--1968.pdf [http://perma.cc /ku5w-8fal] (for exempt organizations other than those exempt under i.r.c. § 501(c)(3)); irs, form 990a (1968), http://www.irs.gov/pub/irs-prior/f990asf--1968.pdf [http://perma.cc/cst5-5u9r] (for organizations exempt under i.r.c. § 501(c)(3)); irs, form 990 (2007), http://www.irs.gov/pub/irs-prior /f990--2007.pdf [http://perma.cc/22w5-eshl]; irs, 2007, instructions for form 990 and form 990-ez, at 5 (2007), http://www.irs.gov/pub/irs-prior/i990-ez--2007.pdf [http://perma.cc/2eef-9gga]; irs, schedule a, form 990 (2007), http://www.irs.gov/pub/irs-prior/f990sa--2007.pdf [http://perma.cc/v48k-h2xx]. 62 see rummana alam, note, not what the doctors ordered: nonprofit hospitals and the new corporate governance requirements of the form 990, 2011 u. ill. l. rev. 229, 240. 63 supra note 17 and accompanying text. 64 see i.r.c. § 7611 (2014); prop. treas. reg. § 301.7611-1, 74 fed. reg. 39003 (aug 5, 2009); u.s. gov’t accountability off., gao-15-514, irs examination selection: internal controls for exempt organization selection should be strengthened 25-26 (2015) [hereinafter gao 2015 rep.]. 65 see service considering improvements to collection of ubit information, 42 tax notes 1053 (1989). 66 irs, 2014 instructions for form 990-ez, at 4 (2014), https://www.irs.gov/pub/irs-pdf/i990ez.pdf [https://perma.cc/ex7h-vg3w]. 67 see pension protection act of 2006, pub. l. no. 109-280 § 1223, 120 stat. 780, 1090 (2006) (codified at i.r.c. § 6033(i)); irs, annual electronic filing requirement for small exempt organizations – form 990-n (e-postcard), http://www.irs.gov/charities-&-non-profits/annualelectronic-filing-requirement-for-small-exempt-organizations-form-990-n-%28e-postcard%29 [http:// perma.cc/bw6d-vtvk] [hereinafter irs form 990-n website] (last updated april 21, 2015). 68 irs form 990-n website, supra note 67. 69 irs data book, 2014, at 34 n.1. 2016] “the better part of valour is discretion” 93 compliance checks on hundreds of organizations that had filed the form since they appeared to be ineligible to do so.70 d. guidance, rulings, technical advice and other activities the irs also provides precedential guidance in a variety of forms, responds to taxpayers’ formal requests for rulings, issues technical advice in response to requests made either by irs employees or by organizations during the course of examinations, and responds to other correspondence both from the public and from members of congress. table 6: other activities71 fiscal year guidance technical advice and assistance closed ruling requests from taxpayers correspondence 2000 10 26 2,182 595 2005 7 22 1,664 501 2010 7 33 400 525 2011 18 27 390 607 2012 15 37 357 702 2013 8 24 566 810 2014 16 33 724 735 guidance is defined as regulations, revenue rulings, revenue procedures, notices, announcements, and information/news releases.72 annual irs reports from earlier years show a significantly higher number of regulations, revenue rulings, and revenue procedures issued through the early 1980s, peaking at 84 in fiscal year 1977 (the annual reports did not consistently provide figures for other types of guidance).73 the sharp decline in such guidance, particularly revenue rulings and procedures, coincided with the controversy that erupted over the irs’s handling of private schools with racial discriminatory policies, which culminated in the bob jones university supreme court case.74 one critical part of the controversy was a revenue procedure that congress so disfavored that it passed legislation preventing the irs from spending any funds to enforce it. this may have led the treasury and the irs to shy away from issuing guidance more generally with respect 70 see id. at 34; irm 4.75.15.6(2), http://www.irs.gov/irm/part4/irm_04-075-015.html [http://perma .cc/9mnw-eq3h]; irs exempt org., fy 2012 ann. rep. & fy 2013 workplan 20 (2012), http://www.irs .gov/pub/irs-tege/fy2012_eo_annualrpt_2013_work_plan.pdf [http://perma.cc/za7r-astk] [hereinafter eo 2012 ann. rep.]. 71 see irs data book, 2000, at 22; irs data book, 2005, at 37; irs data book, 2010, at 53; irs data book, 2011, at 53; irs data book, 2012, at 53; irs data book, 2013, at 53; irs data book, 2014, at 55. 72 see, e.g., irs data book, 2014, at 55 n.1. 73 see 1975 irs. ann. rep. 45; 1976 irs ann. rep. 45; 1977 irs ann. rep. 37; 1978 irs ann. rep. 33; 1979 irs ann. rep. 25; 1980 irs ann. rep. 33; 1981 irs ann. rep. 20; 1982 irs ann. rep. 17; 1983 irs ann. rep. 17; 1984 irs ann. rep. 20. 74 see bob jones university v. united states, 461 u.s. 574 (1983). 94 columbia journal of tax law [vol.7:80 to exempt organizations.75 beginning at that time, there was also a general decline in revenue rulings, possibly driven by an increasing irs priority on resolving open cases more swiftly.76 technical advice and assistance refers to written responses to internal requests for legal guidance from irs employers.77 such technical advice and assistance similarly peaked in the mid-1980s at slightly over 400 annually, and closed ruling requests from taxpayers peaked at close to 6,000 at the same time.78 the reason for the sharp decline in later years is not clear, although again there was a general decline in such guidance that began in the 1980s, possibly driven by the increasing irs priority on resolving open cases more swiftly and without having to issue publicly available (even in redacted form) documents.79 the irs had also begun to take steps that discouraged requests for private letter rulings, including imposing (and then significantly increasing) a fee for such rulings, making more areas off limits for such rulings, and adopting streamlined procedures for some common rulings. 80 the fact that the amount of both precedential and nonprecedential guidance declined generally over the past several decades makes it unlikely that the recent shift in responsibility for guidance relating to exempt organizations from the irs to the office of chief counsel will cause a resurgence.81 finally, the irs also engages in public education in a variety of ways, including maintaining an extensive website of exempt organization information, drafting and revising publications as needed, hosting various workshops for the public and practitioners, and communicating with the regulated community in numerous ways.82 however, the service has discontinued some forms of public education in recent years, most notably the internal but publicly available articles published as part of the exempt organizations continuing professional education technical instruction program.83 e. current compliance despite these trends, it is not clear to what extent this reduced irs oversight has led to increased violations of the applicable federal tax laws by exempt organizations. information regarding such violations, and related violations of applicable state and local 75 see olatunde c. johnson, the story of bob jones university v. united states: race, religion, and congress’ extraordinary acquiescence, in statutory interpretation stories 126, 137-38 (william eskridge & elizabeth garrett eds., 2010). 76 see marion marshall et al., the changing landscape of irs guidance: a downward slope, 90 tax notes 673, 673 (2001). 77 irm 7.1.2.3.1, 7.1.2.3.2, http://www.irs.gov/irm/part7/irm_07-001-002.html [http://perma.cc /25v6-yspl]. 78 see 1982 irs ann. rep. 59; 1983 irs ann. rep. 63; 1984 irs ann. rep. 63; irs, highlights of 1985, at 7; 1986 irs ann. rep. 59; 1987 irs ann. rep. 58; 1988 irs ann. rep. 56. 79 see marshall et al., supra note 76, at 673-74. 80 see id. at 674; rev. proc. 2015-1, 2015-1 i.r.b. 1, 80 (setting user fees); irs, form 8940 miscellaneous determination requests, https://www.irs.gov/charities-&-non-profits/new-form-8940-formiscellaneous-determination-requests [https://perma.cc/svg5-ejjj] (last updated aug. 28, 2015). 81 irs announcement 2014-34, 2014-51 i.r.b. 949; see also matthew r. madara, realignment of eo rulings will bring new work rules, 146 tax notes 1215 (2015). 82 see irs tax information for charities and other non-profits, http://www.irs.gov /charities-&-non-profits [http://perma.cc/m3rf-wn3t] (last updated oct. 16, 2015); carriker, supra note 42, at 9-10. 83 see irs, exempt organizations-continuing professional education articles, http://www .irs.gov/charities-&-non-profits/exempt-organizations-continuing-professional-education-technicalinstruction-program [http://perma.cc/vgc3-xn8n] (last updated may 1, 2015); kim barker & justin elliott, how the irs’s nonprofit division got so dysfunctional, propublica (may 17, 2013). 2016] “the better part of valour is discretion” 95 laws, is almost completely anecdotal. 84 the irs estimated a voluntary payment compliance rate for all tax-exempt and government entities in tax year 2001 of 99.87%, the highest rate among the four irs operating divisions.85 it is not clear how reliable or how reflective of actual compliance that figure is, given that violations of the requirements for exemption rarely result in revocation. 86 at the same time, some instances of noncompliance may not be related to the federal tax law requirements for exemption, such as failures to comply with employment tax rules.87 the irs has attempted to gather more data specifically about compliance with the requirements for exemption within certain subsets of i.r.c. § 501(c)(3) organizations through various projects. most of those projects have found a relatively limited and minor incidence of noncompliance. for example, the colleges and universities compliance project resulted in less than 10 percent of colleges and universities surveyed being selected for examination, with examinations uncovering various unrelated business income tax, compensation-setting procedure, and employment tax issues, but no issues that apparently rose to the level that would justify revocation of exempt status.88 similarly, the hospital compliance project did not report any significant compliance issues based on questionnaires received from almost 500 hospitals and led to compensation-focused examinations of only 20 of those hospitals.89 while the political activities compliance initiative led to examinations of over 250 i.r.c. § 501(c)(3) organizations for alleged prohibited political activity, which was substantiated in over half the examinations, the irs apparently found most violations minor or inadvertent enough that it resolved almost all with only a warning.90 the one notable exception is the credit counseling compliance project, which resulted in revocation of exempt status, completed or proposed, for all 41 completed examinations.91 but even before this project, credit-counseling organizations only represented a tiny proportion of i.r.c. § 501(c)(3) organizations.92 there are nevertheless some indications that at least minor noncompliance may be relatively widespread in the larger exempt organizations universe. for example, a recent project focusing on large private foundations resulted in additional taxes or penalties in 84 see, e.g., roger colinvaux, charity in the 21st century: trending toward decay, 11 fla. tax rev. 1, 19-20 (2011); marion fremont-smith & andras kosaras, wrongdoing by officers and directors of charities: a survey of press reports 1995-2002, 42 exempt org. tax rev. 25 (2003); mark sidel, the guardians guarding themselves: a comparative perspective on nonprofit self-regulation, 80 chi.-kent l. rev. 803, 804-07 (2005). 85 irs, reducing the federal tax gap: a report on improving voluntary compliance 16 (2007). 86 see evelyn brody, sunshine and shadows on charity governance: public disclosure as a regulatory tool, 12 fla. tax rev. 183, 219 & n.139 (2012). 87 see memorandum from j. russell george to jacob lew, supra note 4, at 7-8. 88 irs colleges and universities compliance project final rep. 2-6 (2013), http://www.irs .gov/pub/irs-tege/cucp_finalrpt_042513.pdf [http://perma.cc/6sk7-q3wq] [hereinafter universities rep.]. 89 irs exempt org., hospital compliance project final rep. 1-5 (2014), http://www.irs.gov /pub/irs-tege/frepthospproj.pdf [http://perma.cc/2qzh-6ams] [hereinafter hospital rep.]. 90 irs exempt org., 2011 work plan 19-21 (2011), http://www.irs.gov/pub/irs-tege/fy2011_eo _workplan.pdf [http://perma.cc/4v3a-tq8b]. the limited information available on a related sub-project involving political contributions also indicates the irs resolved almost all confirmed violations with a written warning. see irs, 2006 political activities compliance initiative 6-7 (2007), http://www.irs.gov/pub /irs-tege/2006paci_report_5-30-07.pdf [http://perma.cc/2r3d-btas]. 91 irs, credit counseling compliance project 3 (2006), http://www.irs.gov/pub/irs-tege/cc _report.pdf [http://perma.cc/czf4-upzy]. 92 id. at 1. 96 columbia journal of tax law [vol.7:80 almost half of the closed examinations, although apparently no revocations as of the last report from the irs.93 and an irs review of several thousand organizations in the middle of the last decade resulted in 22 percent being referred for examination, including 15 percent of recently established organizations.94 scholars also have identified significant accuracy problems with the annual information returns (the form 990 series) filed by exempt organizations.95 however, many of the inaccuracies appear to stem from arithmetic and other inadvertent errors or from efforts to present the organization in a better light to donors and other potential supporters, rather than representing efforts to hide violations of the federal tax laws.96 this limited information has left scholars and other commentators to extrapolate (i.e., guess) the extent to which known violations are reflected in the wider exempt organization sector and, for obvious reasons, these extrapolations vary widely.97 it appears, however, that the vast majority of exempt organizations seek to comply with the applicable federal tax laws, with only a small subset of organizations and their leaders being engaged in intentional and significant violations (as apparently frequently occurred in the credit counseling area). but even inadvertent violations are still a concern, especially since exempt organizations, particularly charities, risk a significant loss in public confidence and support from even a relatively low level of noncompliance.98 the challenge for the irs is therefore to help the apparently vast majority of exempt organizations that desire to comply with the applicable tax laws to do so, while at the same time identifying and addressing the relatively small pockets of intentional and significant noncompliance, even as the service’s resources fail to keep pace with the size and complexity of both the exempt organizations community and the applicable law. iii. modifying oversight this part first briefly reviews the concerns raised by commentators regarding irs oversight of exempt organizations and related proposals for improving that oversight. it then considers whether there are currently promising candidates for improving oversight in light of the resource constraints the irs faces, drawing on the extensive literature addressing tax law compliance more generally. this consideration includes describing the 93 eo 2012 ann. rep., supra note 70, at 19. 94 treasury inspector general for tax admin., performance measures and improved case tracking would help the exempt organizations function better allocate resources 4 (2008) [hereinafter tigta 2008 rep.]. 95 see carolyn cordery, light-handed charity regulation: its effect on reporting practice in new zealand 6-7 (working paper no. 83, 2011), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2028666 [http://perma.cc/58ep-mqz7] (summarizing this research). 96 see gao 2002 report, supra note 27, at 9-13; elizabeth k. keating & peter frumkin, reengineering nonprofit financial accountability: toward a more reliable foundation for regulation, 63 pub. admin. rev. 7 (2003); see also jeffrey j. burks, accounting errors in nonprofit organizations, 29 accounting horizons 341, 350, 360-61 (2015) (finding a relatively high rate of accounting errors among public charities as compared to u.s. publicly traded companies but no evidence of intentional manipulations, and also finding indications that financial audits of public charities are relatively rigorous and independent). 97 see, e.g., colinvaux, supra note 84, at 19-20; fremont-smith & kosaras, supra note 84, at 25; terri lynn helge, policing the good guys: regulation of the charitable sector through a federal charity oversight board, 19 cornell j. law & pub. pol’y 1, 3-5 (2009); peter swords, the form 990 as an accountability tool for 501(c)(3) nonprofits, 51 tax law. 571, 573-74 (1998). 98 see panel on the nonprofit sector, strengthening transparency, governance, accountability of charitable organizations: a final report to congress and the nonprofit sector 21 (2005) [hereinafter panel final rep.]; paul c. light, how americans view charities: a report on charitable confidence, 2008, http://www.brookings.edu/research/papers/2008/04/nonprofitslight [http://perma.cc/b2er-cdvg]; swords, supra note 97, at 573-74. 2016] “the better part of valour is discretion” 97 recent irs initiatives to reduce oversight at the application stage and discussing how best to evaluate the effects of such changes. a. concerns and proposals concerns about the effectiveness of irs oversight for exempt organizations are not new, as illustrated by the following passage from a 1977 report prepared under the auspices of the blue-ribbon commission on private philanthropy and public needs: recently the service has acknowledged that in the exempt organizations area it fulfills a regulator rather than tax-collecting role. while troubled by the breadth of its responsibility in this area, in which the service admits that “the tax collector has never been entirely comfortable,” those within the service who specialize in exempt organizations . . . take this responsibility seriously and attempt to meet it fairly. in doing so, these officials are somewhat handicapped by (a) cumbersome procedures which were designed generally to meet the needs of the tax-collecting branches of the service; (b) inadequate authority in relation to other officials near the top of the service’s hierarchy; (c) the understandable emphasis of the service on its role as tax collector rather than as overseer of a non-revenue-producing activity; and (d) the generally weaker qualifications and training of the service’s field staff as compared with the national office staff.99 more recently, the panel on the nonprofit sector—organized in response to concerns raised by congress with respect to irs oversight of charities—stated that “[f]unding for federal and state oversight of tax-exempt organizations has become increasingly inadequate as the size and complexity of the exempt sector has grown.”100 the national taxpayer advocate’s 2014 annual report to congress noted that taxpayer advocate services cases involving applications for recognition of exempt status have been increasing dramatically in recent years, demonstrating “that the irs’s processes are creating significant hardship for both new organizations and those whose exempt status was automatically revoked.”101 these concerns were in addition to the more specific concerns regarding the handling of certain applications relating to political activity.102 finally, gao issued a critical report at the end of 2014 highlighting how shrinking resources have made the irs’s oversight of charitable organizations less extensive and more complicated.103 gao also noted the need for the irs to develop compliance goals and additional performance measures to assess the impact of its enforcement activities, while at the same time acknowledging the technical difficulty of doing so.104 proposals to address these concerns tend to fall into three categories: reorganizing the irs to enhance the prominence of the exempt organizations function, increasing and improving procedures for gathering and analyzing information relating to exempt organizations, and increasing the financial and personnel resources devoted to the exempt organizations function. for the most part, the irs and congress have already implemented 99 ginsburg et al., supra note 29, at 2583 (citations omitted). 100 panel final rep., supra note 98, at 24. 101 1 nat’l taxpayer advocate 2014, ann. rep. to congress 540 [hereinafter 1 nta 2014 ann. rep]. 102 nat’l taxpayer advocate, special rep. to congress: political activity and the rights of applicants for tax-exempt status (2013); see also supra note 1. 103 gao 2014 eo rep., supra note 21, at 19-23. 104 id. at 24-29. 98 columbia journal of tax law [vol.7:80 the first category of proposals. in 1969, the irs doubled the number of revenue agents and tax auditors assigned to exempt organization managers, provided them with special training, and centralized the consideration of such matters in key districts.105 in 1974, congress created a new office of employee plans and exempt organizations headed by an assistant commissioner within the irs national office, and the irs in turn created a separate exempt organizations division within that office as well as employee plans and exempt organizations offices within its regional and key district field offices.106 the next 25 or so years saw some slippage with respect to the prominence and particularly the resources allocated to the exempt organizations function within the irs.107 nevertheless, when congress reorganized the irs in the late 1990s to shift from a geographic to a functional structure, it retained the prominence of the exempt organizations function within the irs by making the new tax exempt and government entities (te/ge) division one of the four primary operating divisions, albeit the smallest in terms of budget and personnel.108 within that division there is a separate exempt organizations (eo) office, headed by an eo director who reports directly to the te/ge commissioner.109 given the relatively small size of the exempt organization sector numerically and financially compared to individuals and businesses, any further increase in prominence within the irs is both unlikely and difficult to justify.110 the second category of proposals is illustrated by the increased obligations imposed on exempt organizations with respect to both the initial application and the annual information return detailed above.111 it is also illustrated by irs efforts to concentrate examinations on certain potential problem areas, such as colleges and universities, credit counseling, hospitals, and political activity, as well as more recent proposals to improve data collection and analysis.112 the third category of proposals, relating to increased resources, is perhaps the most common although also the least fruitful. 113 as detailed previously, the number of employees and the financial resources dedicated to the irs’s exempt organizations function appears to have been relatively stagnant, even as the number, financial assets, and federal tax law applicable to such organizations has grown significantly.114 at the same time, there appears to be little congressional interest in increasing irs funding.115 105 ginsburg et al., supra note 29, at 2585. 106 id. at 2520, 2622, 2627. 107 see robert a. boisture et al., how the irs plans to restructure its exempt organization operations, 10 j. tax. of exempt orgs. 195, 197-98 (1999); owens, supra note 58, at 3-4. 108 see boisture, supra note 107, at 201-02. 109 see irm 1.1.23.2(1), 1.1.23.5(2), http://www.irs.gov/irm/part1/irm_01-001-023.html [http:// perma.cc/ws55-lqal]; irs, tax exempt & government entities division at-a-glance, http://www .irs.gov/government-entities/tax-exempt-&-government-entities-division-at-a-glance [http://perma.cc /9g7m-weha]; irs, today’s irs organization, http://www.irs.gov/uac/today’s-irs-organization [http://perma.cc/j7h7-mzre]. 110 see, e.g., irs data book, 2014, at 3; irs, supra note 85, at 11. 111 see supra notes 48-49, 60 and accompanying text. 112 see, e.g., gao 2014 eo rep., supra note 21, at 26; supra notes 88-91 and accompanying text. 113 see, e.g., fremont-smith, supra note 8, at 471; panel final rep., supra note 98, at 24. 114 see supra notes 10, 12, 50, 62 and accompanying text. 115 see, e.g., u.s. gov’t accountability off., gao-15-624, irs 2016 budget: irs is scaling back activities and using budget flexibilities to absorb funding cuts 31 (2015); 1 nta 2014 ann. rep., supra note 101, at 22-23; jonathan barry forman & roberta f. mann, making the internal revenue service work, 17 fla. tax. rev. 725 (2015), at 758-65; memorandum from j. russell george to jacob lew, supra note 4, at 1-2. 2016] “the better part of valour is discretion” 99 realistically, not much more can be done with respect to increasing the prominence of the exempt organizations function within the irs.116 nor is a significant increase in resources for the exempt organizations function likely in the foreseeable future, given both the financial state of the federal government and the political unpopularity of the irs.117 so while securing additional resources for this function will be revisited in part iv as part of considering possibly moving this function out of the irs, this part will assume this function remains within the resource-constrained irs as currently structured and focuses instead on the possibilities for improving the efficiency of irs procedures. there is a rich academic literature discussing how to increase compliance with the tax laws, although it rarely reaches the relative backwater of exempt organizations.118 this literature discusses a variety of process-oriented methods that may be effective with respect to such organizations.119 this part will first briefly explain why some methods that may be effective with respect to taxpayers generally have little potential with respect to exempt organizations before turning to those methods that have more promise. this part also focuses on methods that do not require changes in the substantive standards for exempt status. the reason for this limitation is that recent attempts to enact such changes have only resulted in limited legislative enactments addressing specific, identified concerns as opposed to more comprehensive changes that could significantly impact compliance across all or most exempt organizations.120 recent congressional tax reform proposals have also generally not reached the substantive laws governing exemption.121 in contrast, congress has recently been willing to enact significant procedural changes relating to reporting and disclosure.122 b. methods unlikely to significantly improve oversight some of the methods proposed to aid compliance with the federal tax laws are generally a poor fit for exempt organizations. for example, increasing the regulation of or penalties on gatekeepers such as lawyers and accountants is unlikely to be particularly helpful.123 this is both because many exempt organizations do not use such gatekeepers 116 see supra notes 105-110 and accompanying text. 117 see cong. budget off., the budget and economic outlook: 2015 to 2025 1 (2015); supra note 115 and accompanying text. 118 see, e.g., leandra lederman, the interplay between norms and enforcement in tax compliance, 64 ohio st. l.j. 1453 (2003); susan cleary morse, using salience and influence to narrow the tax gap, 40 loy. u. chi. l.j. 483 (2009); alex raskolnikov, revealing choices: using taxpayer choice to target tax enforcement, 109 colum. l. rev. 689 (2009). 119 see, e.g., u.s. dep’t of the treasury, a comprehensive strategy for reducing the tax gap (2006); w. edward afield, dining with tax collectors: reducing the tax gap through churchgovernment partnerships, 7 rutgers bus. l.j. 53, 57-58 (2010); dave rifkin, a primer on the “tax gap” and methodologies for reducing it, 27 quinnipiac l. rev. 375, 408-420 (2009). 120 see, e.g., colinvaux, supra note 84, at 44-53. 121 see, e.g., staff of the joint comm. on taxation, technical explanation of the tax reform act of 2014, discussion draft of the chairman of the house committee on ways and means to reform the internal revenue code: title v – tax exempt entities (jcx-16-14) 38-45 (2014); press release, senate finance committee, hatch, wyden launch bipartisan finance committee tax reform working groups (jan. 15, 2015) (none of the five working groups focus on exempt organizations) (on file with author). 122 see, e.g., patient protection and affordable care act, pub. l. no. 111-148, § 9007, 124 stat. 119, 855-59 (2010); pension protection act, pub. l. no. 109-280, §§ 1224-1225, 120 stat. 780, 1091-93 (2006). 123 see generally w. edward afield, a market for tax compliance, 62 clev. st. l. rev. 315 (2014); leslie book, the need to increase preparer responsibility, visibility and competence, in 2 nat’l 100 columbia journal of tax law [vol.7:80 and because there is evidence that the exempt organizations most likely to have the resources to engage such gatekeepers, such as colleges, universities, and hospitals, generally have a high level of compliance with the applicable federal tax laws. 124 similarly, increasing the penalties for noncompliance imposed on the organizations or their managers would only enhance compliance if the organizations and their leaders are aware of those costs and believe there is a significant risk of discovery of non-compliance.125 none of these facts appear to exist with respect to most exempt organizations; most such organizations lack expert advisors to inform them about potential penalties, usually because of resource constraints,126 and the current examination rate, and thus the risk of discovery is—and is known to be—very low.127 rewarding whistleblowers and encouraging private enforcement actions through enabling qui tam lawsuits are alternative methods for enhancing compliance with the federal tax laws without requiring increased governmental resources, since they enlist private parties to improve compliance. 128 the success of the existing federal tax whistleblowing program has been relatively limited, however, and has not generated much interest with respect to exempt organizations.129 furthermore, rewards for whistleblowers (and qui tam suit filers) are usually a portion of the tax revenue collected as a result, which would not be particularly effective with respect to exempt organizations. insiders at charities and other exempt organizations may also be less inclined to engage in whistleblowing than employees of for-profit companies because of the potential harm to their organization’s mission and those who benefit from its activities. finally, the exempt organizations area may be particularly vulnerable to damaging harassment if such methods are available, given the controversial nature of some exempt organizations and their usually limited financial resources to defend themselves against false accusations. two other methods that have improved compliance significantly, with respect to federal tax laws, are generally also a poor fit for the exempt organizations area. the first taxpayer advocate, 2008 ann. rep. to congress 74 (2009); reinier h. kraakman, gatekeepers: the anatomy of third-party enforcement strategy, 2 j.l. econ. & org. 53 (1986). 124 see public charity organizational issues, unrelated business income tax, and the revised form 990: hearing before the subcomm. on oversight of the h. comm. on ways and means, 112th cong. 46 (2012) (statement of eve borenstein) [hereinafter borenstein statement]; supra notes 88-90 and accompanying text. the one possible significant exception is private foundations. see francie ostrower, the role of advisors to the wealthy, in america’s wealthy and the future of foundations 247, 26364 (teresa odendahl ed., 1987); supra note 93 and accompanying text. 125 see generally michael g. allingham & agnar sandmo, income tax evasion: a theoretical analysis, 1 j. pub. econ. 323 (1972); kyle d. logue & gustavo g. vettori, narrowing the tax gap through presumptive taxation, 2 colum. j. tax l. 100, 120 (2011); j. manhire, toward a perspective-dependent theory of audit probability for tax compliance models, 33 va. tax rev. 629 (2014); alex raskolnikov, crime and punishment in taxation: deceit, deterrence, and the self-adjusting penalty, 106 colum. l. rev. 569 (2006). 126 see borenstein statement, supra note 124, at 46; gries et al., supra note 48, at 3-4. 127 see karen a. froelich & terry w. knoepfle, internal revenue service 990 data: fact or fiction?, 25 nonprofit & voluntary sector q. 40, 49 (1996); supra note 55 and accompanying text. 128 dennis j. ventry, jr., whistleblowers and qui tam for tax, 61 tax law. 357, 377-79 (2008); franziska hertel, note, qui tam for tax?: lessons from the states, 113 colum. l. rev. 1897, 1922-23 (2013). see generally kneave riggall, should tax informants be paid? the law and economics of a government monopsony, 28 va. tax rev. 237 (2008). 129 see irs, whistleblower program (internal revenue code section 7623) fiscal year 2014 rep. to congress 13-14 (2015), http://www.irs.gov/pub/whistleblower/wb_annual_report_fy_14 _final_signature_june_11-signed%20corrected.pdf [http://perma.cc/4649-z8p2]; karie davis-nozemack & sarah webber, paying the irs whistleblower: a critical analysis of collected proceeds, 32 va. tax rev. 77, 89 (2012). 2016] “the better part of valour is discretion” 101 is the highly successful introduction of third-party information reporting (e.g., the wellknown form w-2).130 in the exempt organizations area, there is no obvious third party to provide information relating to compliance, nor is it clear what information could be reported that would be particularly useful to the irs.131 the other such method is the withholding of taxes owed by the source of the taxable income.132 however, for exempt organizations, there (usually) is no tax to withhold in the first place. beyond these specific process-oriented methods, a significant portion of recent compliance literature discusses methods for shifting the attitudes of taxpayers from the apparently dominant norm of noncompliance with the applicable tax laws, generally through a “responsive regulation” approach. 133 this approach includes cooperative compliance efforts that seek to resolve potential irs-taxpayer disputes in a more cooperative and efficient manner.134 existing, albeit limited, evidence indicates that most exempt organizations and particularly the largest grouping of them (charities) already have a strong pro-compliance bias, however.135 there is therefore probably little room to strengthen pro-compliance norms among such organizations generally, and probably not much to be gained from cooperative compliance programs or similar techniques.136 finally, some of the other common methods proposed for improving compliance with the federal tax laws would require the irs to have significantly more resources, which is not a realistic possibility in the foreseeable future for the reasons already discussed.137 for example, more resources would be required to significantly increase guidance and other educational materials given the irs-wide decline in guidance over the past several decades. 138 the same obstacle would apply to simply increasing the number of examinations (as opposed to changing examination methods to do more with less, discussed below). finally, significantly improving the technology used by the irs would also require substantial additional resources. indeed, the treasury department has identified all three of these areas as priorities for the irs, but the irs has made little progress with respect to them precisely because of its shrinking budget.139 130 see forman & mann, supra note 115, at 22-23; leandra lederman, statutory speed bumps: the roles third parties play in tax compliance, 60 stanford l. rev. 695, 698 (2007). 131 see leandra lederman, reducing information gaps to reduce the tax gap: when is information reporting warranted?, 78 fordham l. rev. 1733, 1739-41 (2010). 132 see lederman, supra note 130, at 698. see generally ajay mehrotra, “from contested concept to cornerstone of administrative practice”: social learning and the early history of u.s. tax withholding, 7 colum. j. tax l. 144 (2016). 133 see generally valerie braithwaite, responsive regulation and taxation: introduction, 29 law & pol’y 3 (2007); marjorie e. kornhauser, a tax morale approach to compliance: recommendations for the irs, 8 fla. tax rev. 599 (2007); lederman, supra note 118; eric a. posner, law and social norms: the case of tax compliance, 86 va. l. rev. 1781 (2000). 134 see, e.g., w. edward afield, agency activism as a new way of life: administrative modification of the internal revenue code through limited issue focused examinations, 7 fla. tax rev. 455, 461-72 (2006); leigh osofsky, some realism about responsive tax administration, 66 tax l. rev. 121, 132-37 (2012); diane m. ring, on the frontier of procedural innovation: advance pricing agreements and the struggle to allocate income for cross border taxation, 21 mich. j. int’l l. 143, 159-69 (2000). 135 see supra part ii.e. 136 but see betsy buchalter adler et al., proposal for an exempt organizations voluntary compliance program, in advisory committee on tax exempt and gov’t entities, report of recommendations 61 (2007). 137 see supra notes 114-115 and accompanying text. 138 see carriker, supra note 42, at 2-3, 28-34; supra part ii.d. 139 see treasury inspector general for tax admin., annual assessment of the internal revenue service information technology program 20 (2014); u.s. dep’t of the treasury, supra 102 columbia journal of tax law [vol.7:80 c. methods with the potential to significantly improve oversight several methods show more promise, however. the irs has already implemented one set of such methods by introducing procedures and a new form to streamline the application process for organizations seeking recognition of exempt status as described below. another set of such methods is greater reliance on resource-intensive examination techniques, such as correspondence audits, no-contact review of operations procedures, and the use of compliance data to better target examinations. a third set of such methods is designed to improve disclosure and transparency to enhance media and public input with respect to exempt organizations, including during both the application and examination processes. a final promising method would be requiring increased electronic filing. 1. streamlined application procedures the irs recently made two significant decisions to streamline the application for recognition of exemption process. the first of these decisions was the introduction of an expedited review process for applications submitted by organizations seeking exemption under i.r.c. § 501(c)(4), primarily to clear the backlog of such applications in the wake of the controversy over the handling of them. the second was the introduction of the new form 1023-ez, a streamlined application form for certain organizations seeking exemption under i.r.c. § 501(c)(3), along with streamlined procedures for all applications. a. expedited process for certain i.r.c. § 501(c)(4) applications less than two months after the i.r.c. § 501(c)(4) application controversy exploded in may 2013, newly appointed acting irs commissioner daniel werfel issued an initial assessment and plan of action to address the crisis.140 a major component of the plan was the creation of a voluntary process for expediting i.r.c. § 501(c)(4) applications that had been pending for more than 120 days as of may 28, 2013 and in which the organizations had indicated that they may be involved in political campaign intervention or issue advocacy.141 for eligible applicants that chose to take advantage of this process, the irs promised to grant their pending application within two weeks if an authorized official of the organization declared, under penalties of perjury, that the organization (1) had spent in each past year and would spend in the current year and each future year 60 percent or more in terms of both expenditures and time (employee and volunteer) on activities promoting social welfare and (2) for each such year had spent or would spend less than 40 percent on participation or intervention in any political campaign on behalf of (or in opposition to) any candidate for public office.142 the irs later expanded this program to give itself the option of inviting later filing organizations to make these declarations, and receive a favorable determination in return, if the irs determined that the note 119, at 2-3 (three of seven reducing tax gap components are improvements in information technology, improving compliance activities, and enhancing taxpayer service); memorandum from j. russell george to jacob lew, supra note 4, at 6, 13-14. 140 daniel werfel, charting a path forward at the irs: initial assessment and plan of action (june 24, 2013) http://www.irs.gov/pup/newsroom/initial%20assessment%20and%20plan%20of %20action.pdf [http://perma.cc/zjj5-wbpl]. 141 id., app. e. 142 id. 2016] “the better part of valour is discretion” 103 only potential issues raised by the organization’s application were possible involvement in political campaign intervention or providing private benefit to a political party.143 the program has achieved its short-term goal of clearing the backlog of applications raising political campaign intervention issues. the irs reported that as of august 2015 141 (97 percent) of the 145 organizations that were eligible for the expedited process had had their cases resolved, including 43 organizations that chose the optional expedited process, with the irs issuing 108 favorable determination letters.144 separately, the treasury inspector general for tax administration (tigta) reported that of the 160 applications for recognition of exemption under i.r.c. § 501(c)(4) that involved possible political activity and were open as of december 17, 2012, 149 applications had been closed as of march 2015 and the 11 remaining applications were either in litigation, in appeals, or had received a proposed adverse determination.145 b. new form 1023-ez & streamlined procedures in mid-2014, the irs announced a new “streamlined application for recognition of exemption under section 501(c)(3)”—the form 1023-ez. 146 only organizations anticipating relatively low annual gross receipts ($50,000 or less), owning total assets not exceeding $250,000, lacking a variety of other characteristics (such as being a church, school, or hospital), and not planning to engage in certain activities (such as credit counseling or maintaining donor advised funds) are eligible to use this new form.147 for the organizations that are eligible to use the new form, however, relatively minimal information is required and, most importantly, certain key requirements are deemed satisfied as long as an appropriate official of the organization attests that they have been met. these requirements include whether the group’s organizing document contains required provisions (thereby avoiding the need to provide the irs with an actual copy of that document), whether the group is organized and will be operated exclusively for permitted purposes (thereby avoiding the need to provide a narrative description of the group’s current and planned activities), and whether the group has not and will not conduct prohibited activities such as supporting candidates or providing a substantial private benefit. 148 the application also asks whether the organization will engage in certain permitted but limited or regulated activities, such as attempting to influence legislation, paying compensation to officers, directors, or trustees, and operating overseas.149 the form 1023-ez grew out of streamlined procedures for processing applications for recognition of exemption under any i.r.c. § 501(c) paragraph. the irs first adopted these procedures for applications that had been pending for more than a year, but then extended these procedures to all pending applications, and finally to new applications as 143 irs, optional expedited processing expanded to all eligible 501(c)(4) applicants beginning in december 2013, http://www.irs.gov/charities-&-non-profits/other-non-profits/expandedoptional-expedited-approval-process-for-501c4s [http://perma.cc/2tx3-klrn]. 144 irs, tigta recommendation #7: details and status, http://www.irs.gov/charities-&-nonprofits/tigta-recommendation-7 [http://perma.cc/hvg7-mkxl]. 145 treasury inspector general for tax admin., status of actions taken to improve the processing of tax-exempt applications involving political campaign intervention 16-19 (2015), http://www.treasury.gov/tigta/auditreports/2015reports/201510025fr.pdf [http://perma.cc/f6v6-nyqn]. 146 see supra note 5. 147 irs, instructions for form 1023-ez, at 11-17 (revised aug. 2015), https://www.irs.gov/pub /irs-pdf/i1023ez.pdf [http://perma.cc/by6y-6m4g]. 148 irs form 1023-ez (june 2014). 149 id. 104 columbia journal of tax law [vol.7:80 well.150 similar to the form 1023-ez, these procedures generally require attestations, as opposed to copies of organizing documents or narrative descriptions to resolve open issues if certain conditions are satisfied.151 as with the optional expedited process for i.r.c. § 501(c)(4) applications, these changes appear to have achieved their short-term goal of clearing the backlog of i.r.c. § 501(c)(3) applications. gao recently found that the irs had reduced the inventory of all applications (the vast majority of which were presumably for recognition of i.r.c. § 501(c)(3) status) from 65,718 at the end of fiscal year 2013 to 22,759 at the end of fiscal year 2014, and had closed 117,000 cases in fiscal year 2014 (or more than double the number of cases closed in the previous fiscal year).152 the irs also separately reported that the streamlined procedures adopted for all applications had reduced the inventory of cases that were more than 270 days old from 54,564 in april 2014 to 4,791 in september 2014.153 the irs further noted that by december 26, 2014 it had received 20,103 forms 1023-ez, representing approximately half of the applications under i.r.c. § 501(c)(3) filed during the period the form 1023-ez had been available, and that, on average, the irs processed forms 1023-ez in less than 30 days.154 c. criticisms and evaluation the limited streamlined application process for certain i.r.c. § 501(c)(4) applicants, as well as the form 1023-ez and the broader streamlined process for all i.r.c. § 501(c) applicants, have attracted their share of criticisms. for the former, some commentators viewed it as “giveaway” by the irs and questioned whether the irs would have any appetite to later examine the returns of organizations that had taken advantage of this expedited process.155 others criticized the irs for not further clarifying the legal standards regarding what qualifies as political campaign intervention and for requiring at least 60 percent social welfare activity in order to take advantage of the process even though there was no clear legal authority imposing such a requirement.156 as for the new form 1023-ez, even before its introduction the irs advisory committee on tax exempt and government entities (act) recommended against developing it because of the important educational purpose that the form 1023 served by forcing applying organizations both to consider deeply their activities, finances, and management and to recognize that they would be subject to a comprehensive regulatory regime.157 act was also concerned that such an abbreviated form would not supply 150 see 1 nat’l taxpayer advocate, fiscal year 2015 objectives rep. to congress 53-54 [hereinafter 1 nta 2015 objectives report]. 151 see memorandum for all exempt organizations rulings and agreements employees from stephen a. martin, acting director, exempt organizations, rulings and agreements (mar. 12, 2015), http:// www.irs.gov/pub/foia/ig/spder/ig-tege-07-0315-0006%2003-12-2015%5b1%5d.pdf [http://perma.cc /r6z9-gefg]. 152 gao 2014 eo rep., supra note 21, at 30; see supra note 35 and accompanying text. 153 irs, progress update on form 1023-ez, http://www.irs.gov/portal/site/irspup/menuitem .143f806b5568dcd501db6ba54251a0a0/?vgnextoid=44beb23f06ffb410vgnvcm1000003b4d0a0arcrd [http://perma.cc/8gzl-v5ns]. 154 id. 155 see, e.g., deirdre shesgreen, critics question irs’ new “fast-track” path to tax-exempt status, cincinnati enquirer, july 10, 2013, at 3. 156 see, e.g., id.; press release, aclj, aclj rejects obama administration’s “expedited review” for conservative groups unlawfully targeted by irs (july 1, 2013), http://aclj.org/free-speech-2/acljrejects-obama-administration-expedited-review-for-conservative-groups-unlawfully-targeted-by-irs [http:// perma.cc/k2rx-vft2]. 157 gries et al., supra note 48, at 31-32. 2016] “the better part of valour is discretion” 105 information needed by the irs both to make an accurate determination regarding whether the applying organization qualified for exempt status and to spot potential abuse risks.158 the national association of state charity officials (nasco) reiterated these concerns in april 2014, highlighting in particular the increased opportunity for fraud and the resulting heightened burden on federal and state regulators in the long-term. 159 the national taxpayer advocate (nta) also criticized the irs for introducing the form 1023-ez in its current form, and particularly for that form’s use of attestations in place of copies of organizing documents and a narrative statement of current and planned activities.160 while nta had previously proposed the development of a form 1023-ez for use by certain small organizations, the form 1023-ez actually introduced by the irs was developed without consulting the taxpayer advocate service and went much further in reducing the information required than nta had anticipated.161 finally, a number of practitioners and other commentators also raised concerns about the form 1023-ez not providing sufficient information to the irs, the applicant, or the public (if the irs approves the application, which causes it to become public).162 while the focus of most critics has been on the form 1023-ez, some of the same criticisms would also apply to the more general streamlined application procedures to the extent they rely on attestations. at this point there is no information on whether any of the groups that are seeking i.r.c. § 501(c)(4) exempt status and that took advantage of the new expedited process have acted contrary to their declarations, nor has the irs announced any specific plans for follow-up examinations of such organizations. there is some preliminary information regarding whether groups benefitting from the broader changes are in fact living up to their attestations, however. according to nta, when the irs reviewed a representative sample of forms 1023-ez the approval rate for such applications was less than 80 percent, or well below the overall approval rate for such applications of 95 percent through december 26, 2014.163 this approval rate is actually less than the overall approval rate prior to the introduction of the form 1023-ez and the streamlined procedures, which from 2010 through 2013 ranged from 81.6 percent to 89.8 percent for applications filed under i.r.c. § 501(c)(3). 164 this relatively low approval rate may indicate that the smaller organizations may actually be less likely to make it through the approval process, for whatever reasons (including not responding to irs inquiries), than larger ones.165 nta also reported that a non-representative check of organizational documents for a handful of form 1023-ez filers found that most had documents that did not meet the organizational 158 id. 159 letter from alissa hecht gardenswartz, president, nasco, to office of information and regulatory affairs (apr. 30, 2014), http://www.nasconet.org/wp-content/uploads/2014/05/final-nascocomments-re-form-1023-ez1.pdf [http://perma.cc/x6wr-pbzp]. 160 1 nta 2015 objectives report, supra note 150, at 55. 161 see 1 nat’l taxpayer advocate fiscal year, 2016 objectives rep. to congress 70 [hereinafter 1 nta 2016 objectives report]; 1 nat’l taxpayer advocate, 2011 ann. rep. to congress 448 n.44, 562-64 [hereinafter 1 nta 2011 ann. rep.]. 162 see patricia cohen, irs shortcut to tax-exempt status is under fire, n.y. times, apr. 8, 2015; fred stokeld, streamlined exemption application could pose compliance problems, 143 tax notes 439 (2014); david van den berg, new irs form may fuel nonprofit political activity, 144 tax notes 671 (2014); george k. yin, the irs’s misuse of scarce eo compliance resources, 146 tax notes 267 (2015). but see manoj viswanathan, form 1023-ez and the streamlined process for the federal income tax exemption: is the irs slashing red tape or opening pandora’s box?, 163 u. pa. l. rev. online 89 (2014). 163 1 nta 2016 objectives report, supra note 161, at 72-73. 164 see supra note 35 and accompanying text. 165 see 1 nta 2016 objectives report, supra note 161, at 75. 106 columbia journal of tax law [vol.7:80 test under i.r.c. § 501(c)(3) even though the applicants had attested they satisfied that test. 166 the irs plans to select another sample of form 1023-ez filers for a postdetermination compliance program involving correspondence examinations in early fiscal year 2016.167 while preliminary (and with respect to the organizational documents, anecdotal), these data are troubling. two other, related sets of data also raise concerns about the accuracy of self-reported information. as noted previously, there are data indicating that exempt organizations’ annual returns often contain inaccurate information, even if usually unintentionally.168 there are also data indicating that a significant number of donors to i.r.c. § 501(c)(3) organizations who claim deductions for noncash contributions fail to properly substantiate those contributions and so may be claiming undeserved tax benefits.169 while such donors of course have a strong financial incentive to exaggerate the value of their contributions, exempt organizations also have incentives both to mask any possible noncompliance and to provide favorable but inaccurate financial information.170 the irs is facing a crisis in the form of a growing backlog of applications, driven in large part by reinstatement requests arising out of the congressionally mandated automatic revocation process, and lacks additional resources to devote to processing those applications. furthermore, if the vast majority of applicants are seeking exempt status in good faith and desire to comply with the applicable laws, as is likely the case, then it is overly burdensome to require all applicants to go through an overly lengthy process to identify a relatively small number of bad actors (contrary to the concerns raised by act and nasco). this is particularly true given that the application is ill-suited to ferreting out bad actors because much of the information provided is aspirational (what the organization plans to do, as opposed to what it has done or is doing) and the irs is generally limited to considering the information provided by the organization itself, making deception relatively easy.171 that said, even organizations that desire to comply with the applicable laws need their leaders to have both an understanding of those laws and incentives to make compliance a sufficiently high priority amongst the many competing demands for time and resources for new organizations. early indications are that new form 1023-ez has a significant failure rate in this regard, which does not bode well for the adoption of streamlined procedures that also rely on attestations. this information suggests several areas where further evaluation is needed and, if that further evaluation confirms these concerns, the irs should make improvements to both the form 1023-ez and the streamlined procedures. with respect to further evaluation, the irs needs to complete its planned postdetermination evaluation of a statistically valid sample of form 1023-ez filers to determine whether in fact their attestations were accurate, including with respect to required organizational document provisions. as important, the irs, or an oversight group 166 id. at 75. 167 irs, supra note 153. 168 see supra notes 95-96 and accompanying text. 169 see treasury inspector general for tax admin., many taxpayers are still not complying with noncash charitable contribution reporting requirements 5-6 (2012). 170 see supra note 96 and accompanying text. 171 see found. of human understanding v. united states, 88 fed. cl. 203, 213-14 (2009); church of the visible intelligence that governs the universe v. united states, 4 cl. ct. 55, 62 (1983). 2016] “the better part of valour is discretion” 107 such as the government accountability office, nta, or tigta needs also to do a similar evaluation of form 1023 filers that used attestations to resolve outstanding issues with respect to their applications (which the irs does not appear to currently be planning). while the irs should also do an evaluation, with respect to politically active organizations seeking i.r.c. § 501(c)(4) status that successfully used the optional streamlined procedure, it is almost certainly not worth the effort from a tax compliance perspective, given the political sensitivity of asking such groups for additional information, the relatively small number of them, and the relatively small amount of tax at issue with respect to them (especially since they only receive exemption, not the ability to receive tax deductible contributions). if such evaluations reveal a significant level of noncompliance, as early indications imply they will, then both the form 1023-ez and the streamlined procedures need to be modified to sufficiently educate organizational leaders about the applicable laws and to reduce opportunities for noncompliance. possible methods for improving education include requiring applicants to review critical definitions and requirements before providing related attestations on the electronically filed form (as opposed to simply urging them to review the lengthy instructions for that form), providing faqs for the form (which have not been released even though the form has now been available for over a year), and requiring applicants to complete the eligibility form electronically (with critical definitions and requirements readily available or required to be reviewed) as opposed to simply attesting that they have done so.172 while in theory it would be helpful if more applicants consulted experienced advisors during the application process, small organizations eligible to complete the form 1023-ez are unlikely to have been able to obtain such assistance even if they were still required to complete the form 1023.173 absent resources to aid such organizations in obtaining professional help, which the irs is certainly not in a position to provide, it is necessary to better educate the organizational leaders who are almost certainly going to be primarily, if not exclusively, responsible for completing the forms. possible methods for reducing noncompliance opportunities include requiring additional information to verify compliance (such as copies of organizational documents, if noncompliance in that area is found to be a significant issue) and selecting a substantial number of applications for close review within a certain time period after a favorable determination.174 for reasons already discussed, increasing the penalties on individuals who complete the form is less likely to be helpful. 175 the exact educational and compliance-enhancing methods chosen will ultimately depend, however, on the areas of significant noncompliance identified by the further evaluations. 2. more efficient examination techniques because low examination rates are an issue for all types of taxpayers, commentators have suggested various techniques for more efficiently conducting examinations. such suggestions are particularly important for the exempt-organizations function, given the new streamlined application processes that reduce the level of initial oversight. these techniques include a greater reliance on correspondence audits, better 172 see irs, supra note 147, at 3; supra note 5. 173 see gries et al., supra note 48, at 3. 174 see brad bedingfield, blame it on the roo: from 1023-ez and decline of eo determinations, 144 tax notes 184 (2014). 175 see supra notes 123-127 and accompanying text. 108 columbia journal of tax law [vol.7:80 targeting of examinations, and the expanded use of operations reviews that do not require direct contact with the organization at issue. correspondence audits are conducted by mail and are in theory less burdensome for the irs (and taxpayers) because they eliminate in-person meetings with, and on-site visits by, irs employees.176 they also often are more focused than in-person examinations because they are limited to specific issues identified by irs review of the taxpayer’s relevant return(s).177 the savings can be significant—the gao recently estimated that the cost per case for an individual income tax correspondence audit is $274, compared to $2,278 for a field examination—in terms of irs resources.178 correspondence audits could potentially provide these benefits in the exempt organizations area as well. in fact, approximately a quarter of the examinations that the exempt organizations division completed in fiscal year 2012 were correspondence audits. 179 this proportion is significantly less than the three-quarters for individual audit.180 better targeting of examinations is usually accomplished by first examining a statistically valid sample of similar organizations to determine both overall levels of compliance and likely indicators or areas of significant noncompliance.181 given the diversity of the exempt organizations area in terms of purposes, types of activities, financial size, and complexity, and therefore the likely variance with respect to levels and types of noncompliance, such targeting has the potential to increase the efficiency of irs oversight of such organizations. the irs has in fact attempted to use these techniques in this area through the compliance projects cited previously, as well as other “market segment” efforts.182 the current exempt organizations director recently announced plans to move instead to an issue-based approach. 183 the gao has also reported that the irs is considering additional areas for special focus with respect to form 1023-ez filers, including “legislative or overseas activities, compensation issues, and unrelated business activity.”184 the review of operations (roo) program involves irs review of an exempt organization’s annual returns and of publicly available information, with limited or no contact with the organization at issue unless the organization is referred for an 176 see u.s. gov’t accountability off., gao-14-479, irs correspondence audits: better management could improve tax compliance and reduce taxpayer burden 1-2 (2014) [hereinafter gao 2014 audit rep.]. they include “limited scope” or “soft contact” examinations and compliance checks that may focus only a single issue. see karl emerson et al., the “ripple” project: reviewing irs policies and procedures to leverage enforcement: recommendations to enhance exempt organization’s (eo) enforcement and compliance efforts, in advisory committee on tax exempt and gov’t entities, report of recommendations v-1, v-14 (2004); gao 2015 rep., supra note 64, at 13-14. 177 see gao 2014 audit rep., supra note 176, at 7. 178 u.s. gov’t accountability off., gao-13-151, tax gap: irs could significantly increase revenues by better targeting enforcement resources 6 (2012). 179 eo 2012 ann. rep., supra note 70, at 5. 180 see gao 2014 audit rep., supra note 176, at 42. 181 see generally carolyn cordery et al., differentiated regulation: the case of charities, acc. & fin. (forthcoming 2015); leigh osofsky, concentrated enforcement, 16 fla. tax rev. 325 (2014). 182 see gao 2002 report, supra note 27, at 23-24; bruce r. hopkins, irs audits of taxexempt organizations: policies, practices, and procedures 137-39 (2008); supra notes 88-91 and accompanying text. 183 diane freda, irs exempt chief: sharper, faster tool available in data-driven exams, 54 daily tax rep. (bna) no. 54, at g-9 (mar. 20, 2015); see also gao 2015 rep., supra note 64, at 10-11; irs, te/ge priorities for fy 2016, at 7 (2015), http://www.irs.gov/pub/irs-tege/tege_priorities_for _fy2016.pdf [http://perma.cc/4lmv-xc2m]. 184 gao 2014 eo rep., supra note 21, at 33. 2016] “the better part of valour is discretion” 109 examination.185 the irs initiated this program in response to requests for a process to review all organizations several years after they successfully complete the application process, but as established, it also affects older organizations.186 commentators have recently renewed calls for such a review in light of the streamlined application processes discussed above.187 the primary advantage of correspondence audits and the roo program is that by limiting or even eliminating irs interactions with exempt organizations, the employee time and other resources devoted to each case are significantly reduced. recent studies of correspondence audits, conducted outside the exempt organizations area, indicate that this limitation results in at least two significant disadvantages, however. first, communication with the targeted taxpayer is impaired, including through mail delivery failures,188 low taxpayer responsiveness,189 and a lack of taxpayer understanding regarding the process and any identified issues.190 this leads to significant taxpayer dissatisfaction191 and even, possibly, to violations of taxpayers’ rights.192 second, such audits, at least in the individual income context, tend to be more superficial and less accurate than the field examinations that they displace.193 the latter concern also likely applies to the roo program, given that it relies on irs filings and publicly available information to identify possible noncompliance as opposed to documents and information requested from the exempt organization, as is the case for examinations. greater selectivity with respect to examination targets would in theory permit the irs to better detect significant pockets of noncompliance (particularly intentional noncompliance), and focus its limited examination resources on those areas. in practice, however, successfully implementing such selectivity is difficult. for example, nta recently found that the irs tends not to use the already available information to inform its examination process.194 in the exempt organizations area, the compliance projects noted earlier either have not been designed to incorporate a statistically valid sample of organizations of a particular type or engaged in a particular activity, or have ultimately failed to do so at the examination stage (rendering the examination results not representative and so of limited utility).195 the irs, therefore, needs to evaluate its existing exempt organization correspondence audit, roo, and its selective examination programs to determine if the 185 see tigta 2008 rep., supra note 94. 186 see id. at 1-2, 4. 187 e.g., bedingfield, supra note 174; see also evelyn brody, time for an eo-ez status for small charities, 147 tax notes 815 (2015) (recommending provisional approval for form 1023-ez filers). 188 see 2 nat’l taxpayer advocate, 2011 ann. rep. to congress 82 [hereinafter 2 nta 2011 ann. rep.]. 189 id. at 86. 190 see id. at 82-83; leslie book, the irs’s eitc compliance regime: taxpayers caught in the net, 81 or. l. rev. 351, 397-401 (2002). 191 see ann marie maloney, correspondence audits need some work, tax community tells irs, j. acct. (feb. 28, 2012), http://www.journalofaccountancy.com/news/2012/feb/20125227.html [http://perma.cc /v6r3-a5y6]; national taxpayer advocate, are irs correspondence audits really less burdensome for taxpayers? (feb. 6, 2012), http://www.taxpayeradvocate.irs.gov/news/are-irscorrespondence-audits-really-less-burdensome-for-taxpayers [http://perma.cc/y4uu-wf2z]. 192 2 nta 2011 ann. rep., supra note 188, at 81. 193 see id. at 71; treasury inspector gen. for tax admin., 2013-30-099, actions are needed to strengthen the national quality review system for correspondence audits 2, 5-7 (2013). 194 see 1 nta 2014 ann. rep., supra note 101, at 115-17. 195 see, e.g., hospital rep., supra note 89, at 2-3; universities rep., supra note 88. at 2. 110 columbia journal of tax law [vol.7:80 criticisms have merit and, if so, can be resolved favorably. if the same problems apply in the context of exempt organizations targeted for correspondence examinations, it appears most of the highlighted problems could be resolved by providing more accurate information to the targeted organizations regarding the examination process and timeframe and, most importantly, by providing the organizations with the ability to interact, at least by telephone, with the examining agent.196 while the latter change would be more costly, it appears that the irs has given resource conservation too high a priority, resulting in unfair treatment of examination targets and in high levels of taxpayer dissatisfaction. with respect to accuracy and depth issues, if they exist in the exempt organization correspondence audit and roo programs, they may represent an unavoidable trade-off for the resource savings those programs represent. that trade-off puts even greater importance on gathering and applying data that can be used to selectively target examinations better, both to focus the issues addressed in those programs and to determine what issues or organizations require relatively resource-intensive field examinations as opposed to these less costly, but less thorough, reviews. here, the irs needs to do a better job, even at an increased initial investment cost, at conducting statistically valid sampling of major exempt organization categories and activities, so that its limited resources can be better targeted in the future. 3. increased disclosure commentators have cited increased disclosure of information to the public as having the potential to enhance compliance with the federal tax laws both generally and specifically with respect to exempt organizations.197 this specific application is in large part because the normal presumption of confidentiality of taxpayer information does not generally apply for exempt organizations.198 both the irs and exempt organizations are required to make publicly available applications for recognition of exemption (after the application is granted) and annual information returns, with only relatively limited redactions permitted (e.g., donor information, trade secrets, etc.).199 such disclosure has been enhanced both through the increasing amount of information required on these forms200 and through the efforts of private parties, particularly guidestar, which makes all recent annual returns of exempt organizations available on the internet.201 even given this high level of existing disclosure, commentators have identified several areas where greater disclosure could enhance compliance with little additional burden on the irs. one such area is that of pending applications, which are currently not subject to disclosure until the application is approved. 202 another area is that of examinations, which are not subject to disclosure except that if the examination results in revocation of exempt status, that result is made public when it is finalized or litigated; but 196 see gao 2014 audit rep., supra note 176, at 35-36. 197 see, e.g., emerson et al., supra note 176, at v-15; helge, supra note 97, at 75; george k. yin, reforming (and saving) the irs by respecting the public’s right to know, 100 va. l. rev. 1115, 1118 (2014). 198 see generally 2 staff of the joint comm. on tax’n, jcs-1-00, study of present-law taxpayer confidentiality and disclosure provisions relating to tax-exempt organizations 5-6 (2000) [hereinafter jct disclosure rep.]; brody, supra note 86, at 203-07; lloyd hitoshi mayer, nonprofits, politics, and privacy, 62 case w. res. l. rev. 801, 808-12 (2012). 199 see i.r.c. § 6104 (2014); jct disclosure rep., supra note 198, at 34-38. 200 see supra notes 48-49, 60-61 and accompanying text. 201 see guidestar, http://www.guidestar.org [http://perma.cc/d66s-gpbb]. 202 see, e.g., jct disclosure rep., supra note 198, at 86-87; yin, supra note 197, at 1152-57. 2016] “the better part of valour is discretion” 111 even still, such a result is not widely disseminated.203 other suggestions include enhancing information-sharing with state regulators, even if that information is not made available to the public.204 common advantages cited for increased disclosure with respect to taxpayers generally include shaming them into compliance;205 improving public perceptions of the level of compliance; the risk of noncompliance; 206 and, particularly for exempt organizations, vindicating the public’s right to know about entities that enjoy significant tax benefits.207 increased disclosure also has the potential to provide enhanced oversight at little cost to the irs by essentially enlisting the media and public in reviewing the disclosed information.208 even commentators who are supportive of increased disclosure acknowledge various risks, however. these risks include potential privacy harms, the risk of harassment for more controversial exempt organizations and their leaders, the risk of disclosing irs examination selection criteria, the burden on the irs of managing and enforcing disclosure rules, the burden on the exempt organizations themselves, and the risk of imposing extra-legal requirements.209 furthermore, disclosure by itself does not necessarily lead to increased oversight— the media and public may choose not to use the revealed information or even to take the time to review it, and state regulators may have other enforcement priorities.210 at the same time, the irs would have to manage any such disclosure system and deal with requests for exceptions based on claims of potential harassment or other legitimate grounds. so while disclosure may improve the public accountability of the irs, its actual effect on compliance is less certain and may not be worth even its modest burden on the irs and exempt organizations.211 at a minimum, the irs should take steps to evaluate whether, and to what extent, disclosure could enhance the detection of noncompliance. 4. increased electronic filing a related and widely shared recommendation is to increase the extent of required electronic filing by exempt organizations (“e-filing”). indeed, strong support for expanded, mandatory e-filing for exempt organizations is found not only throughout the federal government but also in the exempt sector itself.212 currently, e-filing is required only for 203 see, e.g., jct disclosure rep., supra note 198, at 84-86; helge, supra note 97, at 75; yin, supra note 197, at 1158-62. 204 see, e.g., gao 2002 report, supra note 27, at 34; carriker, supra note 42, at 34-38. 205 see jay a. soled & dennis j. ventry jr., a little shame might just deter tax cheaters, usa today, apr. 10, 2008, at a11. 206 see joshua d. blank & daniel z. levin, when is tax enforcement publicized?, 30 va. tax rev. 1, 37 (2010). 207 see jct disclosure rep., supra note 198, at 80; mayer, supra note 198, at 828-29; yin, supra note 197, at 1149-50. 208 see yin, supra note 197, at 1148-49. 209 see jct disclosure rep., supra note 198, at 81-82; brody, supra note 86, at 204; antonia m. grumbach, whither regulation?, patterson belknap webb & tyler llp, at 17-18 (aug. 2008), https:// www.pbwt.com/content/uploads/2015/07/a-_grumbach-paper_oct-2007-conference.pdf [https://perma.cc /5gvn-82s5]; gregory korte, irs assailed from all sides for lack of transparency, usa today (aug. 19, 2013, 10:40 am), http://www.usatoday.com/story/news/politics/2013/08/18/irs-transparency-tea-party /2668193/ [http://perma.cc/lu6x-cu2b]. 210 see dana brakman reiser, there ought to be a law: the disclosure focus of recent legislative proposals for nonprofit reform, 80 chi.-kent l. rev. 559, 607 (2005). 211 see robert a. britton, note, making disclosure regulation work in the nonprofit sector, 2008 u. ill. l. rev. 437, 452-54. but see brody, supra note 86, at 232. 212 see, e.g., gao 2014 eo rep., supra note 21, at 41; u.s. dep’t of the treasury, general explanations of the administration’s fiscal year 2015 revenue proposals 231 (2014) [hereinafter 112 columbia journal of tax law [vol.7:80 the annual information returns filed by the largest organizations and for the form 1023-ez and form 990-n, which only certain, relatively small exempt organizations may use.213 increased e-filing would enhance both public and irs access to filed information.214 increased e-filing may also have at least two other significant benefits. first, e-filing may prevent some common errors on both applications and annual returns, as well as help educate applicants about the applicable legal requirements, thereby aiding organizations that desire to file accurate forms but through inadvertent errors fail to do so.215 second, expanded mandatory e-filing could enhance the ability of the irs to target examination efforts as discussed above. currently, the irs is limited in its use of information from electronically filed returns because it can only incorporate in computer analyses information that it also enters from non-electronically filed returns (in order to not disadvantage organizations that electronically file).216 if congress required all exempt organizations to file their annual returns electronically, the irs could instead analyze all of the submitted information. a survey by the act found that few exempt organizations believe e-filing would be burdensome, so the only significant downside to increased mandatory e-filing would be the need for an initial investment by the irs.217 as with the other methods discussed above, however, the irs would still need to evaluate the results of electronic filing to determine if in fact it leads to the expected compliance benefits. * * * the above discussion demonstrates that there are a number of ways to improve compliance by exempt organizations with the applicable federal tax laws through more efficient oversight by the irs. in addition, enacting these various methods in tandem could create helpful synergies. for example, e-filing could both make disclosure easier and enhance the ability of the irs to target examinations. none of these methods is without its disadvantages; however, there may be ways to offset or even eliminate them, such as by prioritizing organizations that take advantage of the streamlined application process for examination several years after irs recognition of exemption. at the same time, there is no obvious solution. even if congress, the treasury, and the irs were willing and able to enact, evaluate, and recalibrate all of these methods, as is necessary, it is far from clear that they would be able to significantly enhance compliance by exempt organizations with the applicable federal tax laws, given the current resource limitations faced by the irs and the unlikelihood of significant changes to the substantive legal standards for exemption. in a climate of pervasive concern regarding treasury 2015 proposals]; u.s. senate comm. on finance, the business income tax bipartisan tax working group rep. 55-56 (2015); panel final rep., supra note 98, at 26; gries et al., supra note 48, at 41; virginia c. gross et al., exempt organizations: the redesigned form 990: recommendations for improving its effectiveness as a reporting tool and source of data for the exempt organization community, in advisory committee on tax exempt and gov’t entities, 2015 report of recommendations 85, 141-43. 213 see treasury 2015 proposals, supra note 212, at 231; irs, instructions for form 1023-ez, at 2, http://www.irs.gov/pub/irs-pdf/i1023ez.pdf [http://perma.cc/8s4y-hvhc]. 214 see gao 2014 eo rep., supra note 21, at 35-36; u.s. dep’t of the treasury, general explanations of the administration’s fiscal year 2016 revenue proposals 248 (2015); gries et al., supra note 48, at 21-22; gross et al., supra note 212, at 104-05. 215 see gries et al., supra note 48, at 20-21; gross et al., supra note 212, at 107. 216 see gross et al., supra note 212, at 105. 217 see id. at 118. the initial investment by the irs may be difficult to obtain, however, if the apparent failure of the form 1023 cyber assistant program is any indication. see 1 nta 2011 ann. rep., supra note 161, at 441 & n.23. 2016] “the better part of valour is discretion” 113 possible bias in the irs oversight of exempt organizations, more radical change is ripe for consideration—moving the oversight function out of the irs completely. iv. rethinking the locus of oversight it is an unavoidable reality that the irs is hobbled both by the awkwardness of adapting its revenue-collection culture and practices to the regulation of exempt organizations and by congressional hostility toward increasing the agency’s funding.218 as these cultural and resource concerns are far from new, commentators have proposed numerous alternatives to the irs for housing the oversight role.219 since at least the 1970s, none of these proposals has attracted much attention, acceptance or implementation. the extremity of current circumstances both justifies and renders more realistic the pursuit of an alternative to the irs, however. this part briefly summarizes the proposals for an alternate, national overseer for exempt organizations. a national body, as opposed to state or local bodies, is key because the oversight role flows from federal tax law. this part then considers the advantages and disadvantages that would likely arise from moving the exempt organization function out of the irs into either a new federal agency or a new private, self-regulatory body (albeit one closely overseen by the federal government). a. proposals for national alternatives to the irs commentators have developed essentially three national alternatives to the irs.220 one proposal is the creation of a new federal regulatory agency. a second is the creation of a federal advisory group. the third is the creation of a national self-regulatory organization. 1. new federal regulatory agency even as congress reorganized the irs in the 1970s to increase the prominence and resources available for the exempt organizations function, several commentators testified before congress in support of a bolder move with respect to charitable (i.r.c. § 501(c)(3)) organizations: creating a new national entity.221 as later elaborated by others, the proposed agency would be structured along the same lines as the securities and exchange commission (sec), with commissioners appointed by the president and confirmed by the senate for set terms.222 the agency would take over the application, examination, and guidance functions conducted by the irs (except in instances where such organizations owed unrelated business income tax); would compile and publish data relating to philanthropic organizations and activities; and would advise both congress and the executive branch on charitable matters.223 others writing at the same time were not supportive of this proposal, however, preferring to put their faith in the then ongoing changes at the irs.224 joel fleishman revisited this proposal in 1999 but only as a strategy 218 see supra notes 99-104 and accompanying text. 219 see fremont-smith, supra note 8, 461-66; lloyd hitoshi mayer & brendan m. wilson, regulating charities in the twenty-first century: an institutional choice analysis, 85 chi.-kent l. rev. 479, 495-504 (2010). 220 see fremont-smith, supra note 8, at 461-63. 221 see donald r. spuehler, the system for regulation and assistance of charity in england and wales, with recommendations on the establishment of a national commission on philanthropy in the united states, in 5 commission on private philanthropy and public needs, research papers 3045 (1977). 222 id. at 3080. 223 id. at 3080-81. 224 see ginsburg et al., supra note 29, at 2642-44. 114 columbia journal of tax law [vol.7:80 of last resort if other, self-regulatory strategies had failed; he has since shifted his support to a national self-regulatory organization.225 2. new federal advisory group in the 1970s, two different commissions proposed a new federal advisory group.226 such a group would serve an information gathering and sharing role, and would craft recommended best practices and proposals for legislative and regulatory changes, but would not exercise any regulatory authority itself, leaving that role to the irs and the states.227 these proposals also failed to gather sufficient support to advance, either then or since.228 several private, national organizations have since arisen that serve in essentially this role, however, albeit without a government imprimatur. the most prominent is independent sector, which organized the panel on the nonprofit sector.229 other such organizations include the council on foundations, the evangelical council for financial accountability (which organized the commission on accountability and policy for religious organizations), and the national council of nonprofits.230 3. new national self-regulatory organization in 1999 fleishman also put forward the idea of a private self-regulatory organization (“sro”) that would investigate and report malfeasance by unscrupulous individuals or groups and propose best practices that go beyond legal requirements for well-meaning but perhaps unwise or careless groups and their leaders, either as an alternative or in addition to a joint private/public effort. 231 former irs exempt organizations division director marcus owens modified and further developed this idea, suggesting the creation of a quasi-public sro that would work with the irs in a similar manner to how the financial industry regulatory authority (finra) currently works with the sec.232 his proposal would create an entity for which membership for organizations seeking to attain or maintain i.r.c. § 501(c)(3) status (or possibly any category of i.r.c. § 501(c) tax-exempt status) would be mandatory and over which representatives of the regulated community would have influence but not control through a board divided equally 225 see joel l. fleishman, the foundation: a great american secret 257-58 (2007); joel l. fleishman, public trust in not-for-profit organizations and the need for regulatory reform, in philanthropy and the nonprofit sector in a changing america 172, 187-91 (charles t. clotfelter & thomas ehrlich eds. 1999); see also nina j. crimm, a case study of a private foundation’s governance and self-interested fiduciaries calls for further regulation, 50 emory l.j. 1093, 1192 & n.494 (2001) (endorsing fleishman’s 1999 proposal). 226 see eleanor l. brilliant, private charity and public inquiry: a history of the filer and peterson commissions 94, 130-31 (2000); commission on foundations and private philanthropy, foundations, private giving, and public policy 181-88 (1970) [hereinafter peterson comm’n rep.]; adam yarmolinsky & marion r. fremont-smith, preserving the private voluntary sector: a proposal for a public advisory commission on philanthropy, in 5 commission on private philanthropy and public needs, research papers 2857, 2857-58 (1977). 227 peterson comm’n rep., supra note 226, at 181-88; yarmolinsky & fremont-smith, supra note 226, at 2858. 228 see brilliant, supra note 226, at 95, 142-43. 229 see fremont-smith, supra note 8, at 462; panel final rep., supra note 98, at 110-112. 230 see grumbach, supra note 209, at 15-16; council on foundations, http://www.cof.org [http:// perma.cc/wp6d-ecev]; press release, ecfa to lead independent commission on major accountability and policy issues for churches and other religious organizations (jan. 7, 2011); national council of nonprofits, https://www.councilofnonprofits.org [http://perma.cc/b3z8-2jzh]. 231 fleishman, supra note 225, at 186-87; see also staff of the senate finance comm., discussion draft 14-15 (2004), http://www.finance.senate.gov/imo/media/doc/062204stfdis.pdf [http:// perma.cc/qx3c-8rn6] (proposing an irs-supported, privately administered accreditation system). 232 owens, supra note 58, at 1. 2016] “the better part of valour is discretion” 115 between sector representatives, governmental representatives, and independent “public directors.”233 the sro’s focus would be on enforcing and interpreting the federal tax laws, but subject to the ability of the irs to reject or amend proposed rules.234 as noted above, fleishman has now endorsed owens’s proposal.235 b. considering the proposals before considering the various proposals, it is necessary to determine what characteristics would be optimal for an oversight body charged with ensuring compliance by exempt organizations with the applicable federal tax rules. as noted previously, the body should be national in scope. other desirable characteristics can be easily gleaned from both the critics of the irs in this regard and the proponents of the various alternatives: an exclusive focus on overseeing exempt organizations; a realistic possibility of increased funding; a staff capable of impartial, accurate, and professional application of the pertinent federal tax laws; and systems and procedures that reflect a regulatory as opposed to a revenue-collecting focus.236 the second option—a federal advisory body—is clearly inferior to the other possibilities for at least two reasons. first, it would be duplicative of various private, advisory bodies that have arisen or grown in prominence since the 1970s.237 second, because it is advisory in nature, its positions would not be binding on the regulated community and so it would be significantly limited in its ability to promote compliance.238 the remaining possibilities raise two sets of advantages and disadvantages. one set relates to moving the oversight function out of the irs, even if it were to remain within the federal government. the second set relates to moving that function out of the federal government to a private sro, albeit one still tied to the federal government in various ways. 1. leaving the irs the spin off of a regulatory function from an existing agency into a separate federal agency is unusual but not unprecedented. for example, congress spun the federal communications commission off from the interstate commerce commission (icc) because the task of regulating telephone service had simply grown too great to leave as a secondary function of the icc.239 in a similar way, it appears the exempt organization function has grown from a relatively small role for the irs to a much larger one both because of the growth in the number and complexity of such organizations and because of increased oversight expectations on the part of congress and the public.240 moving some or most of exempt organization oversight to a new federal agency would increase accountability for that oversight, since it would be the sole function of the new agency as opposed to only one function among many at the irs.241 such a move 233 id. at 18-19. 234 id. at 20. 235 fleishman, supra note 225, at 257-58; see also helge, supra note 97, at 70 (also endorsing this approach, but with significant modifications). 236 see helge, supra note 97, at 20-33; owens, supra note 58, at 4-7; supra notes 1, 99-104 and accompanying text. 237 see supra notes 229-230 and accompanying text. 238 see owens, supra note 58, at 7-8. 239 see kristin e. hickman, pursuing a single mission (or something closer to it) for the irs, 7 colum. j. tax l. 169 (2016). 240 see supra part ii.a. 241 see fleishman, supra note 225, at 256. 116 columbia journal of tax law [vol.7:80 would also permit the development of procedures and rules designed for the regulatory nature of this oversight, as opposed to the revenue-collection procedures and rules of the irs, which include a presumption of taxpayer confidentiality and procedures that delay examinations until after the filing of an annual return.242 furthermore, it would allow a reboot of the regulator’s relationship with the exempt organizations community, providing an opportunity to put the recent i.r.c. § 501(c)(4) application controversy firmly in the rearview mirror (and free the irs from the risk of similar controversies in the future).243 finally, a stand-alone budget would highlight the relatively paltry amount of resources allocated to the exempt organization function and disassociate that function from the unpopular irs and could lead to greater congressional appropriations.244 funding can, however, be a double-edged sword. if the funding is done with appropriations of general treasury funds, that may both invite political interference by congress and lead to instability.245 common alternatives for independent agencies are dedicated funding from the regulated industry in one of two ways, either assessments of the regulated industry—for example, dedicating the private foundation investment income excise collections for the agency—or fees for services (such as the existing application fee).246 the latter approaches can both create stability and protect the agency from political interference, but are only available if congress is willing to authorize them and thereby surrender this means of influencing the agency. self-funding also may increase presidential influence, particularly as exercised through the appointment process, as compared to congressional influence.247 at the same time, such a departure may leave certain advantages behind. even with its battered reputation, a letter from the irs has an in terrorem effect that a new agency would be hard-pressed to duplicate. as part of the irs, the exempt organization function also receives support in numerous ways from other parts of the federal government that would have to either remain available to the new agency or be transferred to it.248 at first glance, neither of these disadvantages appears particularly strong, however, especially since maintaining existing support (e.g., irs service center processing of forms, the department of justice tax division’s litigation support) or assuming it (e.g., hiring inhouse attorneys to provide legal support in place of irs chief counsel) appears to be achievable. certain restrictions would continue to apply, however, including civil service rules and compensation levels that may inhibit the ability of the new agency to hire and retain qualified personnel.249 similarly, procurement rules may limit the ability of the new 242 see helge, supra note 97, at 25; kristin e. hickman, administering the tax system we have, 63 duke l.j. 1717, 1733-35 (2014); owens, supra note 58, at 5-7. 243 see supra note 1. 244 see jct 2000 report, supra note 23, at 120 (eo division budget of $61.7 million in fiscal year 1999). 245 see ashley c. brown, the funding of independent regulatory agencies: a special report to the public utilities commission of anguilla 7 (2008), http://www.hks.harvard.edu/hepg /papers/anguillapuc.pdf [http://perma.cc/hm8p-r4zq]; joel seligman, self-funding for the securities and exchange commission, 28 nova l. rev. 233, 253-54 (2004); note, independence, congressional weakness, and the importance of appointment: the impact of combining budgetary autonomy with removal protection, 125 harv. l. rev. 1822, 1825-29 (2012). 246 see brown, supra note 245, at 4, 8; seligman, supra note 245, at 254-55. 247 see note, supra note 245, at 1839. 248 see supra note 32 and accompanying text. 249 see fremont-smith, supra note 8, at 392; brown, supra note 245, at 13-14; owens, supra note 58, at 5. 2016] “the better part of valour is discretion” 117 agency to obtain needed technology and outside expertise in the form of consultants.250 perhaps most importantly, it is not clear to what extent congress would fund any new agency, particularly in these budget-conscious times.251 finally, careful consideration would also have to be given regarding what portions of the internal revenue code would become subject to the interpretation and enforcement of the new agency and what portions would remain with the irs to minimize overlap and the resulting need for coordination.252 2. leaving the federal government the type of sro proposed by owens is one that would have mandatory (as opposed to voluntary) membership for all exempt (or at least charitable) organizations and would wield implementation and enforcement authority (including the ability to impose direct sanctions, unlike most private accrediting bodies). 253 the academic literature relating to sros indicates there are four threshold requirements for successful execution of this type of sro’s regulatory role. first, the regulated community must support both the creation of the sro and regulation by that sro in the public interest, including through needed enforcement. 254 second, the sro must be able to apply legally enforceable sanctions to members of the regulated community who violate the applicable rules.255 third, the sro must be able to secure sufficient resources, both in terms of funding and staff expertise, to fulfill its assigned role.256 fourth, the government agency overseeing the sro must have sufficient resources, including expertise, and incentives to be effective as an overseer.257 the exempt organizations area appears to satisfy all four of these threshold requirements. as already noted, exempt organizations, and particularly charities, generally have a strong interest in regulation that promotes the public’s interest in ensuring such entities satisfy the legal requirements for the tax benefits they receive.258 by conditioning tax exemption and, for charities, the ability to receive tax deductible contributions on being a member in good standing of the sro and giving the sro authority to enforce in court 250 see brown, supra note 245, at 13-14. 251 see jct 2000 report, supra note 23, at 120 (eo division budget of $61.7 million in fiscal year 1999); joseph bankman & paul l. caron, california dreamin’: tax scholarship in a time of fiscal crisis, 48 u.c. davis l. rev. 405, 406-08 (2014). 252 see generally alejandro e. camacho & robert l. glicksman, functional government in 3-d, a framework for evaluating allocations of government authority, 51 harv. j. on legis. 19 (2014). 253 see jody freeman, private parties, public functions and the new administrative law, 52 admin. l. rev. 813, 831-38 (2000); douglas c. michael, federal agency use of audited self-regulation as a regulatory technique, 47 admin. l. rev. 171, 174-81 (1995); saule t. omarova, wall street as community of fate: toward financial industry self-regulation, 159 u. pa. l. rev. 411, 424 (2011); supra notes 233-234 and accompanying text. 254 see, e.g., onnig h. dombalagian, self and self-regulation: resolving the sro identity crisis, 1 brook. j. corp. fin. & com. l. 317, 323 (2007); neil gunningham & joseph rees, industry selfregulation: an institutional perspective, 19 l. & pol’y 363, 391 (1997); michael, supra note 253, at 192-93, 243-44; omarova, supra note 253, at 446-47. 255 see, e.g., the nat’l ctr. on philanthropy & the l., study on models of self-regulation in the nonprofit sector 11 (2005), http://www1.law.nyu.edu/ncpl/pdfs/self%20regulation%20final %20report-040307updates.pdf [http://perma.cc/xnx2-63tg] [hereinafter ncpl rep.]; omarova, supra note 253, at 445-46; mark sidel, the guardians guarding themselves: a comparative perspective on nonprofit self-regulation, 80 chi.-kent l. rev. 803, 812-13 (2005). 256 see, e.g., ncpl rep., supra note 255, at 12; michael, supra note 253, at 243. 257 see, e.g., michael, supra note 253, at 195; derek fischer, note, dodd-frank’s failure to address cftc oversight of self-regulatory organizations rulemaking, 115 colum. l. rev. 69, 89-95 (2015). 258 see supra note 98 and accompanying text. 118 columbia journal of tax law [vol.7:80 any sanctions imposed for violations of the applicable rules, congress can satisfy the second requirement. 259 through the same mechanism, congress can ensure that all organizations enjoying these federal tax benefits provide financial support to the sro, which the sro could use in turn to hire staff with the necessary expertise.260 the federal government currently collects from private foundations an amount that is two or more times the irs exempt organizations division budget through a very modest (no more than two percent) excise tax on investment income, so it should be an easy matter to construct a sliding scale dues structure that provides sufficient financial resources without unduly burdening the regulated community.261 finally, the irs has spent decades developing expertise in this area that could be deployed to provide the necessary government oversight. its still-healing scars from the latest exempt organizations oversight failure should also provide sufficient incentive to provide adequate supervision of the sro.262 that said, moving the exempt organization function entirely out of the federal government to a self-regulatory body raises additional advantages and disadvantages, while sharing some but not all of the advantages and disadvantages of a new federal agency. the most important new advantage is the ability to generate financial support outside of the federal budget process.263 while some of the funding options discussed previously for a new agency could make that agency’s funding less vulnerable to political interference, an sro would have greater separation from the political branches. 264 another new advantage is freedom from civil service rules, which would permit the sro to pay higher levels of compensation and more easily hire (and fire) employees than either the irs or a new federal agency.265 unlike a federal agency, a sufficiently private body would not be subject to constitutional restrictions on its activities or the administrative procedure act, giving it more flexibility.266 at the same time, however, it is necessary to both limit constitutional challenges and bolster the legitimacy of the sro by providing some level of due process and transparency. 267 finally, a self-regulatory body with significant involvement by nonprofit organization leaders may result in greater cooperation between the regulator and the regulated community as well as greater regulated community buy-in, participation, and compliance.268 the reduced government involvement may also attract more political support for strong oversight.269 259 see helge, supra note 97, at 76; owens, supra note 58, at 21; see also jonathan macey & caroline novogrod, enforcing self-regulatory organization’s penalties and the nature of self-regulation, 40 hofstra l. rev. 963, 998-1000 (2012) (mere expulsion from membership is only an effective sanction if the sro has sufficient market power). 260 see helge, supra note 97, at 73; owens, supra note 58, at 23. 261 see helge, supra note 97, at 73-74; owens, supra note 58, at 2-3. 262 see supra note 1. 263 see supra notes 260-261 and accompanying text. 264 see supra note 246 and accompanying text. 265 see helge, supra note 97, at 26-27; owens, supra note 58, at 24; see also center for the study of democratic institutions, survey on the future of government service executive summary 2 (2015), http://www.vanderbilt.edu/csdi/research/sfgs.php [http://perma.cc/77jl-c5y2] (rigid civil service rules and low salaries contribute to difficulties in recruiting the best employees). 266 see dombalagian, supra note 254, at 340 & n.102; owens, supra note 58, at 14-15. see generally kristin e. hickman, unpacking the force of law, 66 vand. l. rev. 465 (2013) (administrative law limits on tax administration). 267 see omarova, supra note 253, at 485-86; owens, supra note 58, at 21. 268 see helge, supra note 97, at 80-81; michael, supra note 253, at 183-84. 269 see michael, supra note 253, at 184-88. 2016] “the better part of valour is discretion” 119 with respect to disadvantages, an sro would not be able to directly impose criminal sanctions, but such sanctions are rarely used in the exempt organizations area and could still be accessible indirectly through referrals to the irs criminal investigation division.270 sros also usually have a significant risk of inadequate oversight because of capture by the regulated community (or dominant players within that community), a risk that also exists with a separate federal agency but may be magnified with a private body that has closer formal and informal ties to the regulated industry. 271 in this context, however, the regulated industry leaders (and particularly prominent charities) likely are more amenable to having a strong and effective regulator than normally is the case for regulated communities because of their interest in the reputation of the exempt organization sector.272 in fact, one potential risk of an sro is that if it is dominated by the largest and wealthiest tax-exempt organizations with a strong interest in preventing noncompliance, it could create a risk of over regulation that would unduly burden smaller, poorer, and less sophisticated organizations. 273 for example, the move of the irs toward regulating governance, criticized in part because of the potential for ill-fitting one-size-fits-all rules, could be accelerated in an sro dominated by leaders of the largest and wealthiest organizations (and encouraged by sro officials seeking to increase their sphere of authority).274 such a risk could be mitigated by sufficient involvement of representatives from smaller and less well-resourced exempt organizations and, as suggested by owens, by not giving the sro the ability to impose rules that went beyond those necessary to ensure compliance with the applicable federal tax laws.275 another potential disadvantage is the reduced influence of the federal government and the public on the interpretation of statutory provisions, possibly leading those interpretations to be less responsive to political pressures than may be desirable.276 the irs’ role likely could be adjusted to address this concern if it arose, however (as has happened with the sec and the sros it oversees). it is also unclear as to what extent a private body, even one with close ties to the federal government, could continue to benefit from various government support functions, but it may be possible to still take advantage of at least some of that support, especially to the degree it is essentially ministerial (e.g., processing filings). finally, a new sro might also face a constitutional challenge to its authority. 277 that said, the constitutional questions generally relate either to a lack of clear legislative approval, a lack of sufficient 270 see treasury inspector general for tax admin., ie-09-013, review of the internal revenue service criminal investigation division’s nonprofit fraud referral process 6-8 (2010), https://www.treasury.gov/tigta/iereports/2010reports/2010ier006fr.pdf [https://perma.cc/ny3y-cnaa]. 271 see michael, supra note 253, at 189-90; owens, supra note 58, at 11-12. 272 see supra note 98 and accompanying text. 273 see gabriel s. mairzadeh, self-regulation of investment companies and advisers: a proven solution to a contemporary problem, 16 ann. rev. banking l. 451, 507-08 (1997) (highlighting this issue with respect to securities law sros). 274 see bonnie s. brier et al., the appropriate role of the internal revenue service with respect to tax-exempt organization good governance issues, in advisory committee on tax exempt and gov’t entities, report of recommendations 43-44 (2008). 275 see owens, supra note 58, at 19-20; see also mayer & wilson, supra note 219, at 534-39 (recommending an enhanced state role in overseeing charity governance as opposed to a federal or selfregulatory approach). 276 see michael, supra note 253, at 190-91. 277 see generally harold i. abramson, a fifth branch of government: the private regulators and their constitutionality, 16 hastings const. l.q. 165 (1989); alexander volokh, the new privateregulation skepticism: due process, non-delegation, and antitrust challenges, 37 harv. j.l. & pub. pol’y 931 (2014). 120 columbia journal of tax law [vol.7:80 due process, or a lack of sufficient government oversight.278 it therefore should be possible to properly construct an sro and its processes such that it should survive any such constitutional scrutiny. an sro therefore appears to be a viable option and most of the disadvantages of leaving the federal government appear relatively minor in the context of the exempt organization function. furthermore, the advantages of leaving the federal government appear significant, particularly with respect to the ability to access greater resources and escape ill-fitting civil service and revenue-collection related rules. there is, however, one important caveat. most examples of national sros wielding substantial authority in cooperation with a federal agency occurred in situations where the federal government was taking on a new regulatory responsibility and choose from the beginning to house that responsibility primarily in one or more sros.279 in contrast, the regulation of exempt organizations through the federal tax laws is a longstanding and relatively mature regulatory role. moving that role to an sro now could therefore raise certain additional concerns. for example, the irs has almost 900 employees currently dedicated to exempt organization matters, and some of the support functions such as chief counsel also have a significant number of dedicated exempt organization employees.280 if the exempt organization function moved to a new federal agency, it might reasonably be expected that many of those employees, and particularly the ones with the greatest experience and expertise, could also be persuaded (or possibly required if they wanted to remain employed by the government) to move to that agency. such an expectation seems less reasonable, however, if that function were to move to a private body that does not offer the same level of job security or benefits (including union representation) as a federal government position.281 particularly, given this concern, it is far from clear how quickly a new sro could staff up even with the aid of existing, voluntary self-regulatory bodies such as independent sector, which in turn could lead to it falling behind in the processing of the close to 90,000 applications and the hundreds of thousands of returns filed annually, not to mention the dozens of current guidance projects and other less formal education initiatives.282 while there are some existing organizations that develop and promulgate best practices and in some instances even provide certifications, none of them has developed to anywhere near the scale required to oversee all exempt organizations (or even all charities).283 it would also take a major educational effort to familiarize the over a million existing exempt organizations, the millions of individuals who serve in leadership roles with such groups, and the numerous professionals that advise those organizations with the new regulatory structure. for example, despite years of effort to communicate with smaller exempt organizations about the looming risk of automatic revocation, tens of thousands of such organizations apparently missed the message.284 and because such a shift appears to 278 see volokh, supra note 277, at 950, 960. 279 see michael, supra note 253, at 203-240. 280 see jct 2000 report, supra note 23, at 117-19; supra note 24 and accompanying text. 281 see nat’l treasury employees union, about nteu, http://www.nteu.org/nteu [http:// perma.cc/d4r9-yc8b]. 282 see supra parts ii.b. to ii.d.; supra notes 229-230 and accompanying text. 283 see, e.g., bbb wise giving alliance, http://www.give.org [http://perma.cc/j7mw-4y9u]; charity navigator, http://www.charitynavigator.org [http://perma.cc/xn9f-qpxq]; supra notes 229-230 and accompanying text. 284 see treasury inspector general for tax admin., 2012-10-027, appropriate actions were taken to identify thousands of organizations whose tax-exempt status had been 2016] “the better part of valour is discretion” 121 be unprecedented, there are almost certainly other transition issues that would not be identified until after the transition was ongoing. these identified and unknown risks are not necessarily fatal to the proposal to shift the exempt organization function to a private, self-regulatory body, but they strongly suggest further thought and research needs to be devoted to developing and planning for them before moving in this direction, as attractive as it may otherwise appear. there also are numerous implementation issues, some of which owens addresses in his proposal.285 they include what functions would shift to the sro with respect to application processing, examinations and other compliance initiatives, rulemaking and other guidance, and policy setting. they also include whether the functions should be transferred over a period of time, both in order to better address the challenges of moving a mature regulatory role out of the federal government and to permit systematic evaluation of whether the transfer of each function has had positive results, and, if so, on what timetable. relatedly, congress would need to determine the continuing role of the irs and the treasury department with respect to the transferred functions. also, the above discussion assumed there would be a single sro (with a broadly representative board), but it might make sense to instead have multiple sros, each covering distinct types of exempt organizations (e.g., schools, hospitals). congress would also need to determine the extent of the sro’s immunity from liability, both generally and with respect to antitrust laws specifically.286 again, none of these questions necessarily raise fatal issues. they do, however, indicate how complicated and difficult shifting regulation of exempt organizations from the irs to a non-governmental body likely would be. nevertheless, the increasing failure of irs oversight detailed in part ii of this article, the limited ability to improve that oversight given likely available resources described in part iii, and the potential benefits of moving the locus of exempt organization oversight to an sro formed along the above lines all support pursuing development of such an entity. v. conclusion the irs oversight of exempt organizations with respect to their compliance with applicable federal tax laws has reached a breaking point. absent significant changes, the public’s confidence both in the ability of the irs to provide such oversight and in the good behavior of exempt organizations themselves will almost certainly continue to decline. and that decline may soon reach a point, if it has not already, that threatens both the irs’s ability to fulfill its primary, revenue-collecting responsibilities and the public support on which most exempt organizations rely. even with its current resources and with no changes in the applicable substantive law, there are several ways in which the irs could improve its oversight of exempt organizations. these ways include continuing to use streamlined application procedures, increasing the efficiency of the examination process, ensuring greater disclosure of relevant information, and expanding electronic filing requirements. particularly if enacted together and carefully evaluated and recalibrated as necessary to maximize their impact on compliance, these methods have the potential to help the irs do more with less. automatically revoked, but improvements are needed (2012), https://www.treasury.gov/tigta /auditreports/2012reports/201210027fr.html [https://perma.cc/r8hp-5vea]; supra note 42 and accompanying text. 285 owens, supra note 58, at 18-24; see also helge, supra note 97, at 70-79. 286 see michael, supra note 253, at 198-203. 122 columbia journal of tax law [vol.7:80 but given the resource constraints faced by the irs and the continuing growth of the exempt organization sector, it is unlikely that these methods will be sufficient to attain an acceptable level of oversight for exempt organizations. the time is therefore ripe to consider bolder but riskier proposals to shift the oversight of exempt organizations outside of the irs. while a new federal agency has certain advantages, a new self-regulatory body that operates under the close supervision of the irs appears to be a significantly better candidate for obtaining funding and freedom needed to substantially increase this oversight and therefore compliance with the federal tax laws applicable to exempt organizations. while the risks of moving this mature regulatory role out of the federal government are substantial and not completely known, such that any such move would require careful consideration of what functions would move out of the irs, how such a transition would be sequenced, and how it would be evaluated, it is time to pursue this option. microsoft word choike9-1 (final).docx gallery-supported art exhibitions: critiquing “crayola” anne m. choike* abstract for-profit art galleries are making news for the donations they are providing to nonprofit art organizations to support exhibitions by artists these galleries represent (part of a broader practice i term “crayola,” in reference to payola, the word invented to describe a similar practice of paying for airtime on radio and television). yet nonprofit art organizations are committed to advancing art for the public interest, not for private profit. this article examines whether there are any meaningful limits on crayola gallery donations that support art exhibitions at nonprofit arts organizations, focusing on the legal framework governing federal tax-exempt status, as well as the self-regulatory rules and informal norms of the art industry. does the existing regime allow gallery-supported art exhibitions or do these activities contravene nonprofit art organizations’ missions? what short-term and long-term solutions are available and appropriate in light of the causes and context of gallery-supported art exhibitions? these questions are animated by the broader dialogue about equitable access to publicly funded resources, with the answers having important implications for what it means to promote art that is representative of american society. *assistant professor (clinical), wayne state university law school (2017 – present); fellow, the university of michigan law school (2014 – 2017). i am very appreciative for the feedback and encouragement of colleagues in writing this article, including gabriel rauterberg, alicia alvarez, keith fogg, kim thomas, paul tremblay, manoj viswanathan, dustin marlan, liz porter, zahr said, shannon weeks mccormack, and the participants of the new york university clinical law review writers’ workshop. i also express my gratitude to the participants of presentations at northern illinois university college of law and the university of washington school of law. i also thank the columbia journal of tax law, especially editors-in-chief arisa manawapat and laura pond, articles editor rebecca kim, and staff members moshe jacob, simon kwong, janice lee, arash mahboubi, george najjar, bohao zhou, corey rogoff, charles roper, cassandre saint-preux, and matt schroth. for insight into the art world, i thank nolan simon. i am also grateful to amy albanese, university of michigan law school j.d. 2017, nancy welsh, university of michigan law school and taubman college of architecture and urban planning candidate 2018, and the university of michigan law library, especially virginia neisler, for their research assistance and for the university of michigan clinical fellows program for its support. 68 columbia journal of tax law [vol.9:67 i. introduction ...................................................................................................... 69 ii. institutional framework ........................................................................... 73 a. commercial and noncommercial art exhibitions .............................................. 73 b. strategies for financing art exhibitions at museums ......................................... 75 c. genesis of gallery-sponsored art exhibitions ................................................... 77 d. impacts of gallery-sponsored art exhibitions ................................................... 78 e. alternatives to gallery-sponsored art exhibitions ............................................. 80 iii. regulatory framework .............................................................................. 82 a. federal tax exemption under the internal revenue code’s operational and other tests ........................................................................................................... 82 b. self-regulatory industry associations and museum guidance .......................... 86 c. informal art market norms ................................................................................. 88 iv. critiquing gallery-supported art exhibitions ............................. 90 a. exempt purpose and its exclusive pursuit in question ....................................... 91 1. private inurement .......................................................................................... 91 2. private benefit ............................................................................................... 94 3. a special case of private benefit: joint ventures ........................................ 99 4. commerciality and unrelated business income tax .................................. 102 b. lack of self-discipline ...................................................................................... 107 c. cooperation is currently the only option ......................................................... 107 v. recommendations and conclusion ..................................................... 108 a. structural changes to the institutional and regulatory framework .................. 109 b. eliminating and expanding gallery-supported art exhibitions ....................... 110 c. increased disclosure about gallery-sponsored art exhibitions ....................... 111 2017] gallery-supported art exhibitions 69 i. introduction in 2007, “©murakami”, a large-scale retrospective exhibition for japanese artist takashi murakami, opened at the museum of contemporary art in los angeles (moca). murakami’s art is acclaimed for its direct engagement with commerciality, and ©murakami did not disappoint. in addition to a number of his other artworks and exhibition-related merchandise that were for sale, the retrospective debuted “oval buddha”, a twenty-foot tall, platinum leaf-covered sculpture created after murakami’s own likeness.1 following the exhibition, oval buddha ultimately sold at an art fair— where a majority of galleries’ art sales takes place today2—for $8 million.3 more notable than the price was the way that ©murakami was funded and produced. the murakami retrospective at moca largely owed its existence to the financial backing of private galleries that had represented murakami for many years. blum & poe, a los angeles-based gallery that had shown murakami’s work for decades, not only chartered a private jet to fly out oval buddha from tokyo, but also donated $100,000 dollars toward the exhibition, bought $50,000 worth of tickets to the opening night gala, and paid for the exhibition’s advertising. gagosian gallery, which represents murakami in new york, emmanuel perrotin, who represents him in paris, and a third gallery who formerly represented murakami each matched blum & poe’s six-figure donation.4 the ©murakami exhibit is one high profile example of a trend in which forprofit galleries fund exhibitions of the artists they represent at nonprofit art museums, art organizations and alternative arts spaces – spaces committed to advancing art for the public interest, not for profit. gallery-supported exhibitions at museums, in particular, occur when a commercial gallery provides money to a nonprofit museum to support an exhibition, which may or may not be a pre-planned part of the nonprofit museum’s programming. bruce altshuler, director of the museum studies program at new york university and former director of the isamu noguchi garden museum, a nonprofit art museum in new york city, compared the practice to “accepting money from a corporation to display its merchandise.”5 galleries’ donations vary in size, with estimates ranging from $5,000 to $200,000 per gallery. museums claim to tailor contributions to a gallery’s capacity to pay.6 even so, the figure is substantial, given that even expensive 1 don thompson, the $12 million stuffed shark: the curious economics of contemporary art 222 (2010). ©murakami included an entire room in the exhibition devoted to exhibition-related merchandise, as well as a louis vuitton boutique that sold the luxury fashion label’s limited edition handbags designed by murakami, reportedly averaging sales of ten bags per day. id. see also carol vogel, many old names but few showstoppers at art basel, n. y. times (june 5, 2008), http://www.nytimes.com/2008/06/05/arts/design/05fair.html [perma.cc/2vsf-fbz9]. 2 isabelle graw, high price: art between the market and celebrity culture 68 (2010) (“the majority of a gallery’s business has been made at a growing number of art fairs”); but see robin pogrebin, how a dealer prepares for the “most important” art fair of the year, n. y. times (june 8, 2016), http://www.nytimes.com/2016/06/09/arts/design/how-a-dealer-prepares-for-the-most-important-art-fair-ofthe-year.html [perma.cc/t87a-jxkh] (“fairs account for about 40 percent of gallery sales by value, according to the tefaf art market report”). 3 vogel, supra note 2. 4 jori finkel, museums solicit dealers’ largess, n. y. times (nov. 18, 2007), http://www.nytimes.com/2007/11/18/arts/design/18fink.html [perma.cc/6crw-fzup]. 5 id. (commenting on the ©murakami exhibition specifically and expressing concern about moca’s fund-raising from galleries as more problematic than its hosting of the louis vuitton boutique, which seemed to him “perfectly in the spirit of murakami’s work”). 6 pogrebin, supra note 2. 70 columbia journal of tax law [vol.9:67 exhibitions at nonprofit art museums are likely to incur direct expenses between $13 to $200 per square foot, in addition to high indirect costs of conservation, packing, artifact loans, shipping and exhibition advertising.7 for example, using such data from a recent smithsonian study to estimate the cost of the 35,000 square foot ©murakami exhibition,8 the donations made by the galleries representing murakami alone would have accounted for fifty percent of direct exhibition costs – and this estimate excludes indirect costs covered by the gallery such as advertising and oval buddha’s transpacific private jet transportation.9 alternatively, if the total direct expenses of ©murakami ran on the high end of industry averages for direct exhibition costs, calculations using such industry data suggest that ©murakami could have cost $7 million. figures so large in the absolute suggest that even a donation comprising a small fraction of the total cost may be determinative in bringing an exhibition to the public, given the extreme cost of the entire exhibition.10 today’s tight budgets and limited funding availability mean that such margins may make the difference in choosing which exhibitions to present. while galleries have always provided scholarly support to museums exhibiting their artists’ work, it is becoming common for galleries to pay the nonprofit institutions to present shows featuring work by the artists represented by such galleries.11 i term this practice “crayola” in reference to payola, the word invented to describe a similar practice of paying for airtime on radio and television. for those galleries that can afford it, they feel they compelled to pay given the reciprocal benefit.12 for those that cannot, the practice raises concerns of a pay-to-play system that distorts art programming at the expense of the independence, curatorial integrity and especially the tax-exempt status of museums and other nonprofit art institutions.13 specifically, the practice of galleries providing financial backing for nonprofit art exhibitions raises legal questions about whether galleries’ financing of exhibitions advances the public purpose of a nonprofit art institution. artist bill powhida prominently critiqued questionable curating practices in 7 sarah bartlett & christopher lee, measuring the rule of thumb: how much do exhibitions cost?, exhibitionist (2012), http://nameaam.org/uploads/downloadables/exh.fall_12/8.%20exh%20fall_12_measuring%20the%20rule%20of%20 thumb_bartlett_lee.pdf [perma.cc/z92l-bpyw] (citing indirect costs of art exhibitions); mark walhimer, how much do museum exhibitions cost?, museum planner (june 23, 2011), http://museumplanner.org/how-much-do-exhibits-cost/ [perma.cc/f9q6-548x] (indicating per square foot cost of art museum exhibitions between $75 and $200); smithsonian institution office of policy and analysis, the costs of funding exhibitions (2002), http://www.si.edu/content/opanda/docs/rpts2002/02.08.costsfundingexhibitions.final.pdf [perma.cc/29pug9ep] (indicating art museums’ median per square foot exhibition costs at $13 to $27 per square foot). 8 sarah thornton, seven days in the art world 100 (2008) (stating location of ©murakami as moca’s 35,000 geffen contemporary building). 9 this estimate was calculated by dividing the $300,000 donation from blum & poe, gagosian and perrotin galleries by the total estimated cost of the exhibition ($17 per square foot in direct costs multiplied by the 35,000 square foot geffen exhibition space, for a total cost of $595,000 to $7 million). 10 see infra note 30. 11 id. (citing examples including the partial funding of the whitney museum of american art’s 2015 frank stella retrospective by the marianne boesky and dominique lévy galleries, which jointly represent mr. stella; the museum of fine arts, houston’s vera lutter exhibition by the gagosian gallery, which represents ms. lutter; and the los angeles county museum of art’s pierre huyghe show by the marian goodman gallery, which represents mr. huyghe). 12 id. 13 id. 2017] gallery-supported art exhibitions 71 his work how the new museum committed suicide with banality (2009). his cartoon, which he bluntly subtitled, “how to use a non-profit museum to elevate your social status and raise market values,” likened the subject art institution to a showroom.14 powhida’s analogy underscores the important legal question as to whether exemption from federal income tax is appropriately granted to nonprofit art institutions, whose marquee programming seems to be increasingly in furtherance of select commercial, nonexempt galleries’ interest. this inquiry echoes similar questions raised with respect to the for-profit activities of nonprofit museums and art organizations15 and in other areas of the fine arts,16 as well as in other industries.17 however, the practice of galleries funding art exhibitions at nonprofit art organizations has not been previously examined in legal scholarship. this article examines galleries’ practice of financially supporting art exhibitions presented by nonprofit art institutions, in light of the requirement imposed upon charitable organizations by the united states internal revenue code to “exclusively” conduct activities that advance a public interest. 18 board members of nonprofit art organizations have fiduciary duties that require fidelity to the organizational mission, but courts’ deferential position results in tax rules being more restrictive in practice. 19 14 william powhida, how the new museum committed suicide with banality, brooklyn rail (nov. 2009), http://www.brooklynrail.org/2009/11/ [perma.cc/er7a-s6l7]. 15 see, e.g., leila john, museums and the tax collector: the tax treatment of museums at the federal, state, and local level, 15 u. pa. j. bus. l. 877 (2013); elizabeth bildner, conflicting ethics: a case study of new museum’s exhibit “skin fruit: selections from the dakis joannou collection,” 21 nysba entertainment, arts & sports l. j. 100 (2010); andras kosaras, note: federal income and state property tax exemption of commercialized nonprofits: should profit-seeking art museums be tax exempt?, 35 new eng. l. rev. 115 (fall 2000); carolyn c. clark and john sare, income-producing activities of us museums: where does charity stop and commerce begin?, 21 int’l legal prac. 82 (1996); peter a. levitan, serving god and mammon: financing alternatives for nonprofit cultural enterprises, 8 colum. j.l. & arts 403 (1983-1984). 16 see, e.g., miranda perry fleischer, how is the opera like a soup kitchen?, in the philosophical foundations of tax law (monica bhandari ed., 2016); leia lefay, one singular sensation: the rise of enhancement deals between nonprofit theatres and commercial producers, 21 nysba entertainment, arts and sports l. j. 88 (2010); carolyn casselman, waltzing with the muse or dancing with the devil: enhancement deals between nonprofit theaters and commercial producers, 27 colum. j.l. & arts 323 (2004). 17 see, e.g., lloyd hitoshi mayer and joseph r. ganahl, taxing social enterprise, 66 stan. l. rev. 387 (2014); peter molk, reforming nonprofit exemption requirements, 27 fordham j. corp. & fin. l. 475 (2012); lloyd hitoshi mayer, the “independent” sector: fee-for-service charity and the limits of autonomy, 65 vand. l. rev. 51 (2012); john d. colombo, article: the ncaa, tax exemption, and college athletics, 2010 u ill. l. rev. 109 (2010). 18 see part iii.a, infra. 19 state agency and nonprofit corporation laws impose certain duties, fiduciary and otherwise, upon both galleries and art museums that may affect museums’ ability to accept funding to present an exhibition. to the extent that an artist entrusts work to the gallery through a consignment or more comprehensive artistdealer agreement, the gallery becomes an agent of the artist. whether an art organization is organized as a nonprofit corporation or a trust, the directors and employees of such art organizations are also fiduciaries to their organization, and can be sued for their role in activities that deviate from the art organization’s mission. see generally sue chen, art deaccessions and the limits of fiduciary duty, 14 art antiquity and law 103 (analyzing fiduciary duties of art museum board member duties with respect to artwork deaccessioning activities at museums). museums and other nonprofit art organizations, as charitable organizations, have obligations to the public as their beneficiaries, and the state has the power to enforce such obligations. leonard duboff, christy o. king & sally holt caplan, the museum organization, 2 in the deskbook of art law, t-21 (1997). in each case, state agency law governs the fiduciary relationship between the fiduciary and principal. agency law in general requires the fiduciary to act only in the interest of the 72 columbia journal of tax law [vol.9:67 nonprofit art organizations receive federal income tax exemption conditional upon their pursuit of a charitable purpose that serves a public, rather than a private, interest.20 organizations do not have a charitable, exemption-eligible purpose if they conduct their activities in a commercial manner.21 in addition, 501(c)(3) organizations operate subject to the condition that their assets do not benefit of any individual who exercises control over them. 22 a further restriction on 501(c)(3) organizations, the “private benefit doctrine,” prohibits third parties to the organization from benefiting from a relationship with the nonprofit more than incidentally.23 it is the broader public, rather than any individual insider(s) or external private entity(s), who should benefit from the organization’s mission and activities in furtherance thereof.24 these rules have fairly strictly prohibited nonprofit art galleries from selling art. it is unclear whether the same rules can and do extend to the practice of gallery-supported art exhibitions, which seem to effectively enable for-profit galleries to conduct—for the price of a “donation” fee— some of their commercial activities in connection with nonprofit art exhibitions. this article concludes that the relevant legal and nonlegal framework suggests limits upon nonprofit art institutions display of gallery-supported exhibitions in at least some circumstances. yet, it also acknowledges the complex nature of art and its relationship to the commercial sphere, as well as the structural, budget-constrained conditions that compel nonprofit art institutions to seek such assistance in the first place. therefore, this article’s broader argument is for policy that is more sensitive to the complicated context of the art market, as well as supportive of all artists and the art they create. ultimately, this article seeks to raise awareness of the legal issues and implications presented by gallery-supported museum exhibitions among gallerists, curators, board members of nonprofit art museums, and the taxpaying public. only with such awareness can such actors effectively dialogue about the appropriate limits on nonprofit art museums’ relationship with galleries and place in our public cultural life more broadly. this article’s principal contribution is to the tax law literature addressing principal and forgo all personal advantage aside from reasonable compensation. for a commercial gallery that represents an artist, this means maximizing sales. meanwhile, in order for any exhibition to be presented in accordance with the museum’s duties, it must further the charitable mission of the museum. curatorial integrity is central to achieving the museum’s mission, so museums must avoid any financial or other influences that compromise it or give the appearance of doing so. therefore, in considering whether to accept sponsorship of art exhibitions, a museum or other nonprofit art institution “should consider the public’s view of such sponsorship and question whether it compromises the purpose and goals of the cultural institution or the particular exhibit receiving the support.” id. at t-40. in evaluating fiduciary duty compliance, courts are generally hesitant to replace directors’ judgment with their own. chen, supra note 19, at 119. fuller discussion of fiduciary duties’ finer contours and their applicability to gallery-supported art exhibitions is outside the scope of this article. 20 a charitable purpose is any which fits within the broad language of i.r.c. § 501(c)(3), namely the promotion of "religious, charitable, scientific, testing for public safety, literary, or educational purposes, or to foster national or international amateur sports competition…, or for the prevention of cruelty to children or animals…” i.r.c. § 501(c)(3). 21 see part iv.b.4, infra. 22 henry b. hansmann, the role of nonprofit enterprise, 89 yale l.j. 835, 838 (1980). 23 redlands surgical servs. v. comm’r, 113 t.c. 47, 74 (1999). occasional economic benefits flowing to persons as an incidental consequence of an organization pursuing exempt charitable purposes will not generally constitute prohibited private benefits. am. campaign acad. v. comm’r, 92 t.c. 1053, 1065–66 (1989). 24 treas. reg. 1.501(c)(3) –1(d)ii (1982) (“an organization is not organized or operated exclusively for one or more of the purposes specified in [subdivision (d)(i)] unless it serves a public rather than a private interest.”). 2017] gallery-supported art exhibitions 73 exempt organizations’ primary purpose requirement and the appropriate treatment of transactions between for-profit and nonprofit institutions in the art world. beyond its primary focus, this article also has broader implications for theory and policy in other areas of law, including sponsorship law, nonprofit governance, and the public/private distinction. though gallery-supported art exhibitions take place at nonprofit art institutions across the spectrum, including art museums and alternative arts spaces such as redcat in los angeles,25 this article will focus primarily upon museums as one example in a wider trend of nonprofit art organizations that accept galleries’ financial support in presenting art exhibitions. specifically, this article examines whether gallery-supported art exhibitions comply with nonprofit art institutions’ requirement to exclusively conduct exempt activities and whether such institutions comply with industry regulations and norms. part ii discusses the art market and its actors, with an emphasis on art museums, galleries and other relevant art exhibition spaces, and each of their respective roles in exhibiting art. this section also offers a more detailed description of gallery-supported art exhibitions. part iii presents the federal tax law governing cooperation between nonprofit and for-profit entities, focusing on determination of exempt purpose, excess benefit and taxation on non-exempt activities conducted by nonprofit organizations. this section also examines select applicable self-regulatory industry association guidance, and industry norms applicable to gallery-supported art exhibitions. part iv analyzes gallerysupported art exhibitions under this guidance, finding that they may even endanger nonprofit art museums’ exempt status entirely. ii. institutional framework in order to accurately analyze gallery-supported museum exhibitions, it is necessary first to precisely contextualize art museums, galleries and the art market. of course, the nature of the art market and its actors is a source of timeless debate. therefore, this section does not seek to settle such questions, but rather provides a rough overview based on industry, media, academic and legal sources. a. commercial and noncommercial art exhibitions in the united states, nonprofit art organizations and for-profit galleries have traditionally occupied distinct roles in the production of art, even while both entities engage in the exhibition of art. a for-profit art gallery, such as a commercial, cooperative or vanity gallery, exhibits and offers art for sale on behalf of artists, with whom the gallery has a formal relationship as the artists’ agent or dealer. meanwhile, nonprofit art museums engage and educate the public about art outside of the market. historically, the primary purpose of for-profit galleries has been to sell or re-sell art on the primary market, while the art market’s noncommercial actors—not only museums, but also alternative spaces and nonprofit galleries—exist both as a part of the discourse setting infrastructure of the art industry and as contextualizing institutions that provide the public with an opportunity to see artworks in context. accordingly, when for-profit art galleries sell works, the gallery owner and artist take home the income. the income, if any, derived from works produced in the noncommercial context primarily benefits the wider public and is reinvested in future programming or operational costs. thus, galleries represent the commercial, private interest in the art market; art museums 25 finkel, supra note 4. 74 columbia journal of tax law [vol.9:67 represent the noncommercial, public interest; and alternative spaces and nonprofit galleries both exist somewhere at the intersection of for-profit galleries and art museums. these commercial and noncommercial entities comprise part of the growing multi-dimensional art market composed of different sectors that function together to produce and legitimize art. these sectors include (1) the commercial art market, which is split into a primary market of artists, galleries, and collectors, and a secondary market of dealers and auction houses; (2) the knowledge market, including conferences, art academies, and publications; (3) the market of institutions, dominated by museums and art societies; and (4) the market of major exhibitions such as the bienniales, manifestas, and documentas. 26 these individual markets exist side by side and also overlap.27 within this web, the role of art museum exhibitions, and art museums generally, functions as one institution that contributes to the generation of art’s symbolic value28 that in turn drives art’s commercial value.29 commercial exhibitions of art in a for-profit gallery are created by the artist for the primary market and produced by a gallerist that coordinates and markets all aspects of the exhibition. a single individual or corporate patron may commission art works and cover costs, or the production cost may be funded by the artist and recouped upon sale. a commercial gallery may also advance or subsidize an artwork’s production costs especially in the case of capital-intensive projects.30 the costs of unprofitable artworks are borne by the artist, and in some cases a gallery, to the extent it advances funds to the artist. if an artwork sells, artists usually see half of the profit from sales of their work, with galleries retaining a 50% commission to compensate for efforts in marketing and placing the art with buyers on the primary market. furthermore, if a repurchase and/or resale right is negotiated, the gallerist and artist may receive additional income on subsequent sales of the same artwork. otherwise, neither the gallerist nor artist receives further income from future sales made by art dealers or auction houses on the secondary market. another feature of commercial exhibitions is that traditionally they have not been presented in an art historical or otherwise critical manner, beyond any artist statement or marketing materials the gallery may provide in connection with the exhibition. exhibitions of art in noncommercial settings date back to the establishment of the first art museums in the united states in the late nineteenth century. a desire to provide classical education of the american public, as well as an intent to shape a popular culture 26 according to sarah thornton, “a biennial is not just a show that takes place every two years; it is a goliath exhibition that is meant to capture the global artistic moment . . . a true biennial is international in outlook and hosted by a city rather than a museum . . . unlike an art fair, where the displays are organized by participating galleries, the underlying structures of biennials are determined by national identity and other curatorial themes.” thornton, supra note 8, at 100. the venice biennial is among the largest and most noteworthy. id. others include manifesta, a biennial hosted by a different european city every other year, and documenta, hosted in kassel, germany every five years. about the biennial, manifesta, [http://manifesta.org/biennials/about-the-biennials [perma.cc/9pja-z958]; thornton, supra note 8, at 100. 27 graw, supra note 2, at 65. 28 see part iii.d, infra, for a more detailed discussion on the meaning of symbolic value of art. 29 graw, supra note 2, at 21. see generally olav velthuis, talking prices: symbolic meanings of prices on the market for contemporary art (2007). 30 w.a.g.e. (working artists and the greater economy), certification background, “production costs,” http://www.wageforwork.com/certification/5/certification-background [perma.cc/udm8-lbdq] (last visited nov. 10, 2017). 2017] gallery-supported art exhibitions 75 in which art was prominent, drove wealthy businessmen, industrialists and heirs to establish art museums. traditionally, noncommercial exhibitions presented art belonging to a museum’s collection that, except in rare cases, was not commissioned or otherwise directly acquired from an artist. rather, art museums’ collections comprised of art either purchased on the secondary market from a dealer or through an auction house, or donated by a collector. today, more than ninety percent of the art collections held in public trust by america’s art museums have been donated by private individuals.31 b. strategies for financing art exhibitions at museums a museum’s costs entail a budget for purchasing, preserving and interpreting art, in addition to operational costs associated with overhead and the administration of the museum by its curator and staff. to cover such costs, neither direct government funding 32 nor the sale of works from art museums’ collections (also known as deaccessioning)33 are available as primary sources of support. rather, art museums have historically depended upon direct funding from the private sector to cover costs,34 in seeming contradiction to art museums’ noncommercial purpose and anti-market stance. a decrease in direct private funding, combined with growing operating and programmatic 31 association of art museum directors, association of art museum directors standards & practices: art museums, private collectors and public benefit (2007), http://aamd.org/sites/default/files/document/privatecollectors3.pdf [perma.cc/y672-7lne]. 32 ford w. bell, you asked: how are museums supported financially in the united states?, u. s. dept. of state bureau of int’l info. programs (mar. 14, 2012), http://iipdigital.usembassy.gov/st/english/pamphlet/2012/05/201205155699.html#axzz4esszbybt [perma.cc/p7wu-ktje] (stating that direct government support comprises only 24 percent of art museum funding). although the government provides relatively little in the way of direct federal, state and local funding support of the arts, it otherwise acts as a “facilitator” to create the conditions that allow cultural production to happen through a highly decentralized arts infrastructure. see generally harry hillman chartrand & claire mccaughey, the arm’s length principle and the arts: an international perspective past, present and future, in who’s to pay? for the arts: the international search for models of support (m.c. cummings jr. & j. mark davidson schuster eds., 1989), http://www.compilerpress.ca/cultural%20economics/works/arm%201%201989.htm [perma.cc/7t6f5drv]. cultural organizations and cultural production are therefore subsidized by taxes, since contributions to cultural organizations are made tax-deductible for the philanthropists and corporations who support them; in this way, the government encourages cultural patronage by its citizens and private organizations. id. 33 originally bequests circumscribed museums’ ability to sell, or deaccession, art in order to make sure that museum directors did not engage in self-dealing in their own interest at the expense of the art and its purpose. peter temin, an economic history of museums, in the economics of art museums 179–94, 182 (martin feldstein ed., 1991). these restrictions were increased and institutionalized in the 1970s after the metropolitan museum of art received major scrutiny for selling art to fund the acquisition of other art. id. at 183–84. 34 the civic groups active in creating the early museums included figures from the arts as well as from business. jennifer a. donnelly, the ceo art museum director: business as usual?, transatlantica rev. détudes américaines am. stud. j. (2010), http://transatlantica.revues.org/5044 [perma.cc/fg6bpd9d]. see generally temin, supra note 33, at 181–83. this is because american society lacked an aristocratic class to seed art museums (as was the case in european counterparts), and government provided only token, in-kind support for the arts. id. at 181. private support remained critical in the period following the first museums’ establishment, as the institutions expanded and more were built. id. at 182. the federal government became a significant patron of the arts as a result of the depression and the new deal and has remained a source of funding with the 1965 establishment of the national endowment for the arts. donnelly, supra note 34. nonetheless, the private sector has historically been the largest source of the noncommercial art museum’s support, and remains so today. bell, supra note 32. 76 columbia journal of tax law [vol.9:67 costs, 35 has driven a shift away from traditional, collection-focused noncommercial art exhibitions. the stated mission of today’s art museums remains educational; due to museums’ perpetual search for more and more private support, however, their activities and programming have significantly expanded in scope. among the most prominent techniques to raise funds and broaden audiences attending art museums is the temporary “blockbuster” exhibition. 36 although some museums were organizing temporary exhibitions in the 1940s, “blockbuster” temporary traveling exhibitions were new in their large scale and scope of funding. the blockbuster strategy boosted attendance at the same time that it raised the standard for exhibitions to attract wide audiences and revenue. this expectation persists today, despite the budget cuts driven by the faltering global economy in the early twenty-first century, as well as criticisms that “blockbusters” detract resources and distract attention from museums’ missions.37 beyond the “blockbuster” exhibition, museums are continually looking for new ways to fund the programming that drives their donations. other techniques to attract donations included shifting the focus of art museums’ fundraising campaigns to financing the construction of new buildings; buildings were then built cheaply enough to support operational expenses with the remaining funds after construction completed.38 museum membership drives became another successful strategy, as well as unrestricted gifts.39 art museums now seek donors not only among wealthy individuals, but among corporations as well, despite the numerous concerns such commercial support raises.40 in the wake of the 2008 financial crisis, however, already waning corporate funding for the arts has decreased even more.41 it is in this climate that art museums have again gone looking for the next untapped well of private sector support, and gallery-supported museum exhibitions seem to represent the latest result of that search. while the first gallery-supported museum exhibitions predated the financial crisis,42 they became more prevalent thereafter43 — and therefore more problematic. 35 donations dropped after the 1986 tax code reforms increased marginal tax rates and the regulation of art museums’ operations and management – leaving museums with a deficit created by fewer donations and more administrative burdens that cost money. temin, supra note 33, at 185. in addition, growing inflation in the 1970s took its toll on museums. donnelly, supra note 34. 36 donnelly, supra note 34. the first such show in the united states is usually said to be “treasures of tutankhamen,” shown at six museums (including the metropolitan museum of art in new york city) between 1976 and 1978 following its spectacular success at the british museum in 1972. id. 37 specifically, “blockbusters” have been criticized for siphoning resources and attention from permanent collections and from worthy but possibly less sensational subjects; distracting from the museum’s core missions of acquisition, preservation, and interpretation; and placing the focus on attendance numbers, attention in the press, and growth for the museum. id. 38 temin, supra note 33, at 186. 39 id. 40 donnelly, supra note 34. 41 robin pogrebin, corporate support for the arts, n. y. times (feb. 21, 2007), http://www.nytimes.com/2007/02/21/arts/21fund.html [perma.cc/wc7d-2hpp] (describing pre-financial crisis dip in corporate support for arts). 42 see infra, part c. 43 powhida, supra note 14 (drawing attention to and criticizing gallery-supported art exhibitions as they became more common). 2017] gallery-supported art exhibitions 77 c. genesis of gallery-sponsored art exhibitions one of the first exhibitions to draw the nation’s attention to this practice was “sensation” at new york city’s brooklyn museum of art in 1999. 44 wealthy art dealers, galleries and collectors who had financial interests in the artworks shown in sensation funded the estimated $2 million exhibition in significant part: among other examples, the museum’s director and his assistants solicited donations of at least $10,000 from dealers who represented many of the artists whose works were on display, and even asked one well known collector, charles saatchi, to underwrite the entire show.45 thenmayor rudolph giuliani ordered city lawyers to “follow the money trail,” but the litigation ultimately settled out of court. 46 since sensation, the trend of galleries providing financial backing for nonprofit art exhibitions has only increased in prevalence and magnitude. the practice most recently garnered press again in early 2016, after the new york times reported the role of galleries in funding the new whitney museum of american art’s opening exhibition, as well as a number of other recent exhibitions at major art museums around the united states.47 despite the recurring headlines spreading awareness about galleries’ role in supporting art over the past fifteen years, however, no change has resulted to date. such inaction stands in curious contrast to the art industry’s self-regulating response to corporate sponsorships of art museum exhibitions, which many museums addressed when they adopted revised codes of ethics addressing corporate sponsorship. in spite of this, crayola donations that fund gallery-supported art exhibitions have persisted unfettered. how a gallery-sponsored art exhibition comes to fruition at a museum varies. some curators visit galleries to gather ideas for potential exhibitions. 48 among the nonprofit art museums that have presented gallery-sponsored exhibitions (because some categorically do not),49 some curators say that they exclusively approach galleries for 44 david barstow, brooklyn museum recruited donors who stood to gain, n. y. times (oct. 31, 1999), http://www.nytimes.com/1999/10/31/nyregion/brooklyn-museum-recruited-donors-who-stood-togain.html [perma.cc/8hbl-694d]. better known for featuring provocative artworks like the holy virgin mary (1996), a canvas depicting the religious icon of the same name adorned with elephant dung, the sensation exhibition led then-mayor rudolph guliani to cut the brooklyn museum of art’s funding and fire its board, actions ultimately reversed as unconstitutional curtailment of free speech. challenging that censorship motivated his actions, however, giuliani said: “this is all about dollar signs . . . it’s actually a desecration of the first amendment, as much as it is a desecration of religion, to use the first amendment as a shield in order to take money out of the taxpayers’ pockets in order to put that money into the pockets of multimillionaires.” 45 id. 46 alan feuer, giuliani dropping his bitter battle with art museum, n. y. times (mar. 28, 2000), http://www.nytimes.com/2000/03/28/nyregion/giuliani-dropping-his-bitter-battle-with-art-museum.html [perma.cc/lf4k-rwnl]. 47 robin pogrebin, art galleries face pressure to fund museum shows, n. y. times (mar. 7, 2016), http://www.nytimes.com/2016/03/07/arts/design/art-galleries-face-pressure-to-fund-museumshows.html [perma.cc/dg8u-6ckl]. 48 lawrence alloway, when artists start their own galleries, n. y. times (apr. 3, 1983), http://www.nytimes.com/1983/04/03/arts/when-artists-start-their-own-galleries.html [perma.cc/c4vfnkwf] ("museum curators accept the idea that it is the function of the galleries to filter the masses of new artists, and indeed welcome the tidying hand.”). see generally renaud proch & mari spirito, mavericks: the shape of things to come (2015). see also interview with anonymous guggenheim museum of art representative (oct. 26, 2013). 49 pogrebin, supra note 47. 78 columbia journal of tax law [vol.9:67 help realizing an exhibition and reject the suggestion that they respond to offers by galleries. some galleries report that museums have approached them to express interest in exhibiting the work of an artist represented by a gallery, conditional upon financial support from the gallery for the exhibition. if a gallery does not have the means to provide monetary support, museums may tailor the contribution to the budget of the gallery. other museums have offered to match a gallery with a wealthy donor interested in the work of an artist represented by the gallery, who will loan money to the gallery to fund the museum show, in exchange for a work by the artist. in such arrangements, the sum loaned by the donor may be below the going market price of the artist’s work. in addition to outright financial support, museums may also ask artists to make an in-kind donation of their artwork that it will sell or auction at a fundraising reception associated with the exhibition or otherwise. other nonmonetary support may include framing of artwork, organizing of the opening reception, coordination of loans from collectors, and production of exhibition catalogs. galleries may directly pay for indirect costs associated with an artist’s creating new work for a show, such as advertising, shipping costs for any loaned artworks appearing in the show, art installation and even fabrication costs of the art itself. one gallery indicated that “the only thing [it has] not been asked for is postage.”50 some museums may commission artworks appearing in the exhibition; to the extent the new piece is not destined for the museum’s permanent collection, some museums will enter into agreements with dealers for the artwork’s ultimate sale, and some may not as a matter of museum policy.51 artists may also create art specifically for the exhibition even if it is not commissioned by the museum, and the exhibition may feature previously produced art that is or will soon be for sale on either the primary or the secondary market. beyond rights regarding the individual artworks, other rights over the exhibition – namely control over its content and execution, and rights in the exhibition catalogue, images and merchandise, sponsorship credit and reciprocal sponsorship – vary as well. the gallery support arrangements addressing these issues may be structured as a straightforward sponsorship or similar to a traditional licensing agreement. in some cases, the nonprofit museum controls all rights in the exhibition, including its content, and is responsible for its genesis and production. the gallery is but a silent, albeit credited, sponsor in the exhibition’s opening as well as in any other exhibitions at museums to which it travels, often for a fee. in other cases, the artist and gallery retain greater rights and exert more control. for example, the activities of the entire ©murakami exhibit were controlled by the artist himself, pursuant to four contracts: (1) a co-publishing agreement for the exhibition catalogue, (2) an image licensing agreement for the publicity, (3) a data treatment memorandum related to the use of superhigh resolution files to make things like merchandise, and (4) a seven-page letter of agreement outlining, among other details, murakami’s “final right of approval on all aspects of everything.”52 d. impacts of gallery-sponsored art exhibitions in practice, some recent gallery-museum collaborations resemble actual joint ventures carried out to generate revenue, permitting the gallery and museum to each have 50 id. 51 finkel, supra note 4. 52 id.; thornton, supra note 8, at 181–218. 2017] gallery-supported art exhibitions 79 some control in the project. 53 although the revenue generated from the exhibition ultimately may not appear to offset the costs of the exhibition, the audiences attracted by the exhibition are critical to the success of future grant awards and donations. in addition, the exhibition may travel, generating a continuing income stream from fees paid by host museums. meanwhile, benefits for the gallery include, in the words of jeffrey deitch, longtime dealer and former director of the museum of contemporary art, los angeles, “the best platform in the art world for free, where they can sell work to their clients on the walls of the greatest museums.”54 another dealer, james cohan, echoes this sentiment: “the competition to get one’s artist seen in a noncommercial context like a museum or international survey is quite intense but ultimately hugely gratifying. it’s part of our job to step up to support our artists.”55 a gallery’s other artists may indirectly benefit as well from the raised profile and increased legitimacy brought by a prominent exhibition sponsorship. to be sure, galleries’ financial support helps bring big budget art exhibitions to the public that might not otherwise occur in an era of falling arts funding. however, in the art industry, bigger is not necessarily better, and the market’s limited ability to determine art’s significance compounds the worry that such nonprofit art institutions – and the public they serve – are missing out on the work of talented and culturally important artists who are not represented by galleries with the means to sponsor art exhibitions.56 in addition, galleries’ role in sponsoring art exhibitions has significant nonlegal implications that may threaten the integrity of art institutions, as value-legitimators central to an already opaque art-financial industry,57 and as cultural establishments that are inclusive and representative of society at large. there remains a scarcity of artists who are not of culturally dominant demographic groups (including nonmale, nonwhite, nonheterosexual, noncisgender and/or non-eurocentric artists) from the rosters of galleries that have resources to finance museum exhibitions. galleries financed approximately one third of the major solo exhibitions at american art museums between 2007 and 2013.58 of the 121 artists currently represented by such galleries, nineteen (15.7%) are women and ten (8.3%) are nonwhite artists.59 gender disparity is especially pronounced; only around thirty percent 53 joint venture, black’s law dictionary (10th. ed. 2014) (defining a joint venture as “[a] business undertaking by two or more persons engaged in a single defined project. the necessary elements are (1) an express or implied agreement; (2) a common purpose that the group intends to carry out; (3) shared profits and losses; and (4) each member’s equal voice in controlling the project.”). 54 pogrebin, supra note 2. 55 id. 56 for example, one potential consequence of art exhibitions relying upon galleries for financial support is that there may be fewer exhibitions of noncommercial art that are difficult to own or sell in any conventional way, such as performance art and social practice art. 57 stuart plattner, a most ingenious paradox: the market for contemporary fine art, 100 am. anthro. 482, 8, http://www.stuartplattner.com/aa-art-paradox.pdf [perma.cc/ff3p-cklx] (examining the lack of clear guidance supporting the valuation of art). 58 julia halperin, almost one third of solo shows in us museums go to artists represented by just five galleries, the art newspaper (apr. 2, 2015), http://old.theartnewspaper.com/articles/almost-one-thirdof-solo-shows-in-us-museums-go-to-artists-represented-by-just-five-galleries/37402 [perma.cc/q3eutkz3]. 59 see generally gagosian gallery, artists, http://www.gagosian.com/artists [perma.cc/9hheq7rs]; pace gallery, artists, http://www.pacegallery.com/ [perma.cc/chx8-98qv]; marian goodman gallery, artists, http://www.mariangoodman.com/artists [perma.cc/fn3g-nesm]; hauser & wirth, artists, http://www.hauserwirth.com/artists/ [perma.cc/t36s-8bhe]. 80 columbia journal of tax law [vol.9:67 of the artists represented by commercial galleries in the united states are women.60 this is in stark contrast to recent figures that show women represent more than sixty percent of the students in art programs in the united states.61 this discrepancy may thus affect the representativeness of the supposedly critically acclaimed art presented by art museums, providing yet another reason to be troubled by galleries’ financing of museums exhibitions. indeed, the percentage of solo exhibitions by female artists at five major contemporary art museums in the united states – the museum of modern art, the whitney museum of american art, the guggenheim museum, the museum of contemporary art los angeles and the los angeles county museum of art – hovers around only twenty percent.62 black artists have recently seen greater success in major art museums but “[i]t’s not happening everywhere, and there’s still a long way to go.”63 as more galleries and art museums cooperate to bring in audiences at gallerysupported museum exhibitions, there are increasingly fewer truly independently produced exhibitions of art in the united states today. the art exhibited at museums is determined by popular pressures, market demand and the galleries that can pay for them. in turn, galleries, increasingly corporate 64 and characterized by temporary, transactional partnerships with artists, have lost their loyalty to artists and the fixed-profile, programmatic vision of art that they formerly championed.65 instead, galleries are driven by the art market – and in the huge contemporary art market, with total global sales of $63.8 billion in 2015 of which the united states has a market share of 43%, 66 the effect of such demand is enormous. since the 1990s at the latest, collectors and their buying habits, alongside gallerists, influence the process of art’s value creation much more than critics do.67 e. alternatives to gallery-sponsored art exhibitions the collaboration between commercial galleries and art museums in producing gallery-supported museum exhibitions is especially troubling in light of the decline of other producers of “noncommercial” art exhibitions. in theory, nonprofit galleries and alternative art spaces crowd the contemporary noncommercial art exhibition scene and 60 maura reilly, taking the measure of sexism: facts, figures, and fixes, artnews (may 26, 2015), http://www.artnews.com/2015/05/26/taking-the-measure-of-sexism-facts-figures-and-fixes/ [perma.cc/fe3b-hajl]. 61 id. 62 id. 63 randy kennedy, black artists and the march into the museum, n. y. times (nov. 28, 2015), http://www.nytimes.com/2015/11/29/arts/design/black-artists-and-the-march-into-the-museum.html [perma.cc/c3wh-qu6p]. 64 graw, supra note 2, at 18; legacy russell, beauty & the beast: collectivity and the corporation, guernica (2012), http://www.guernicamag.com/daily/legacy-russell-beauty-the-beastcollectivity-and-the-corporation/ [perma.cc/pat8-q8xz] (last visited jul 20, 2016). 65 see graw, supra note 2, at 118; robin pogrebin, it’s an art gallery. no, a living room. o.k., both., n. y. times (july 3, 2016), http://www.nytimes.com/2016/07/04/arts/design/its-an-art-gallery-no-aliving-room-ok-both.html [perma.cc/txp4-lkm6] (describing the art world as one “in which dealer representation is increasingly hard to come by”). 66 tefaf 2016 art market report, artnet news (2016), http://news.artnet.com/market/tefaf2016-art-market-report-443615 [perma.cc/585v-vdru]. 67 graw, supra note 2, at 121; id. at 59 (stating that artists, galleries and art collectors are business partners who live in a single economic sphere); id. at 99 (discussing the “now-pervasive figure of the ‘collector-dealer’ who tends to claim the additional functions of a curator or publicist. he collects and deals in art, speculating on the appreciation of his purchases, which he buys at attractive prices, possibly splitting resale profits with the gallerist.”). 2017] gallery-supported art exhibitions 81 complicate art museums’ role in the art market. nonprofit galleries operate as the commercial-lite, lower commission, educational version of a for-profit gallery, assuming the nonprofit gallery even sells the work at all. alternative arts spaces are anticommercial, independent venues that put on shows and workshops which defy traditional standards of art display and categorization. emerging and experimental artists may exhibit, show or workshop their art at nonprofit galleries or alternative art spaces. their art may be unsaleable or not commercially viable for any reason, and therefore unsuitable to a for-profit gallery; it may also be outside the scope of a museum’s mission, or not yet recognized as a work of stature warranting inclusion in a museum’s collection.68 like art museums, noncommercial nonprofit galleries and anti-commercial alternative arts spaces lack a financial mandate to maximize profits. furthermore, both nonprofit arts galleries and alternative arts spaces may be tax-exempt organizations like art museums, and can seek tax-deductible donations from individuals, foundations and corporations, as well as government funding from municipal, regional, state and national programs. art museums of an earlier era nonetheless would have been clearly distinct from the other noncommercial actors based on their purpose and elitism alone. today, however, the boundary may be blurred, especially among contemporary art museums that deepen their community engagement and broaden their range to include experimental and ephemeral art. whatever the similarities among the noncommercial actors in today’s art market, market presence remains a significant difference between art museums on the one hand and the remaining nonprofit galleries and alternative art spaces on the other. more importantly, while nonprofit galleries and alternative art spaces still operate, they do so in significantly smaller numbers69 than during their height in the 1970s. the reduction of public funding for artists and for the arts generally, restructuring of federal supports upon which some artists relied,70 and even proscription of alternative art and the galleries that featured them71 contributed to the decline of alternative spaces and nonprofit galleries by the 1990s. therefore, nonprofit art museums and commercial art galleries remain the primary actors in the art market presenting art exhibitions today, at the same time that an increasing number of gallery-supported museum exhibitions and museum quality gallery shows drive their programmatic profiles to converge. despite the decline of nonprofit galleries and alternative arts spaces, nonprofit public arts museums have not cornered the market for noncommercial art exhibition. galleries are also beginning to stage exhibitions on par with both public and private museums. for example, “piero manzoni: a retrospective” was what is known as a 68 alloway, supra note 48. 69 brian wallis, public funding and alternative spaces, in alternative art, new york, 19651985 164, 164 (julie ault ed., 2002). 70 joseph mclellan, nea: the first 20 years; looking back on the up-and-down union of government and art, wash. post (sept. 26, 1985), http://www.washingtonpost.com/archive/lifestyle/1985/09/26/nea-the-first-20-years/5e31fcb3-f712-48f88a16-8b50915bb9c1/?utm_term=.f5996c3760c0 [perma.cc/s68k-b6wp]. 71 see, e.g., national endowment for the arts v. finley, 524 u.s. 569 (1998); jackie demaline, mapplethorpe battle changed art world, the cincinnati enquirer, may 21, 2001, http://www.enquirer.com/editions/2000/05/21/loc_mapplethorpe_battle.html [perma.cc/zu86-eslk]. 82 columbia journal of tax law [vol.9:67 “museum quality gallery show” put on by the gagosian gallery in new york. 72 germano celant, a well-known italian art historian, curated the exhibit, and used the works of manzoni’s contemporaries in the show to help illustrate the art historical and political context of the artist. while the exhibition ostensibly was meant to be didactic, like that of any museum show, the exhibition ultimately was about the sale of art – even if only one or two lone pieces were for sale among the many exhibited. this wide sweeping and well researched “museum quality gallery show” is not unique, and increasingly galleries stage similar exhibitions. 73 a more recent example is yayoi kusama’s museum quality gallery show “i who have arrived in heaven” at david zwirner gallery in new york city, which was compared to both fireflies on the water (2002), an artwork that she exhibited at the whitney american museum of art, as well as rain room (2012), an artwork created by art collective random international that appeared at moma around the same time.74 in addition, a new crop of nonprofit private art museums that have been established by private collectors have also recently entered the art exhibition scene.75 facing increased competition for art audiences from galleries, private art museums and other forms of cultural entertainment, attendance and revenues at nonprofit public art museums are down, even as their admission fees remain some of the lowest among all kinds of museums. iii. regulatory framework all of the foregoing art market factors contribute to museums’ identity crisis76 and precarious financial position, and their acceptance of crayola gallery sponsorship is therefore predictable. the question is whether such reliance is or should be permissible in light of current rules on the commercial and noncommercial exhibition of art. a. federal tax exemption under the internal revenue code’s operational and other tests the internal revenue code exempts organizations from federal income tax under section 501(a) if they meet the requirements of section 501(c) or (d). section 501(c)(3) includes, among others, entities the conduct of which is charitable or educational purposes. federal tax law recognizes “promotion of the arts” as an exempt charitable or educational purpose, but any organization that exhibits art must still apply to the internal revenue service (irs) for exemption from taxation. if successful, the irs will 72 howard halle, piero manzoni, “a retrospective” | art | reviews, guides, things to do, film time out new york (2009), http://www.timeout.com/newyork/art/piero-manzoni-a-retrospective [perma.cc/5cpz-392t]. 73 hilarie m. sheets, female artists are (finally) getting their turn, n. y. times (mar. 29, 2016), http://www.nytimes.com/2016/04/03/arts/design/the-resurgence-of-women-only-art-shows.html [perma.cc/ycb3-kcfq]. 74 william grimes, yayoi kusama’s “mirrored room” at david zwirner gallery, n. y. times (dec. 1, 2013), http://www.nytimes.com/2013/12/02/arts/design/yayoi-kusamas-mirrored-room-at-davidzwirner-gallery.html [perma.cc/9q8j-46m2]. 75 nizan cohen art collectors gain tax benefits from private museums, n. y. times (jan. 10, 2015), http://www.nytimes.com/2015/01/11/business/art-collectors-gain-tax-benefits-from-privatemuseums.html [perma.cc/kne9-6ghd]; nizan shaked, something out of nothing: marcia tucker, jeffrey deitch and the deregulation of the contemporarymuseum model, art & educ., http://www.artandeducation.net/paper/somethingoutofnothingmarciatuckerjeffreydeitchandthederegulationoft hecontemporarymuseummodel/ [perma.cc/qp53-87nr] (describing trend of private individuals establishing museums). 76 proch & spirito, supra note 48. 2017] gallery-supported art exhibitions 83 recognize the art organization’s exemption pursuant to a determination letter, and thereafter it may pursue, tax-free, activities that are in furtherance of its exempt purpose. in order to receive and maintain tax-exempt treatment under section 501(c)(3) of the internal revenue code, an organization must be organized and operated “exclusively” 77 for one or more exempt purposes.78 with respect to exempt purpose, activities conducted for cultural and artistic purposes can qualify as exempt. 79 specifically, exhibition of art,80 and promotion of the arts generally, has consistently been recognized by courts as both charitable and educational,81 two categories of exempt purpose under section 501(c)(3).82 museums are expressly identified by the treasury regulations as educational organizations under section 501(c)(3), and recent irs decisions confirm the exempt status of museums.83 the organizational test likewise does not present a significant obstacle to organizations that exhibit art. in relevant part,84 the organizational test requires that the organizational documents pursuant to which an exempt organization is established limit its purpose to only exempt activities. such documents must not expressly empower it to engage in activities that further non-exempt purposes, unless those activities are an insubstantial part of the organization’s overall activities.85 notwithstanding a recognized exempt purpose and formation documents that comply with the organizational test, the presence of substantial nonexempt activities mean that the organization is not operated exclusively for an exempt purpose, as required by the operational test.86 whether an activity is substantial is a fact-determination for which there is no formal definition; it has been measured by both importance to the 77 better business bureau of washington, d.c., inc. v. united states, 326 u.s. 279 100 (1945) (“the presence of a single [nonexempt] purpose, if substantial in nature, will destroy exemption regardless of the number or importance of truly [exempt] purposes.”); universal church of jesus christ, inc. v. comm’r, 55 t.c.m. (cch) 143 (1988). in addition, a “primary purpose” test looks at an organization’s purposes, and asks whether the organization’s activities accomplish one or more tax-exempt purposes. 78 treas. reg. § 1.501(c)(3)–1(a)-(d). 79 treas. reg. § 1.501(c)(3)–1(d)(2) and (3)(ii); rev. rul. 65-271, 1965-2 c.b. 161. 80 rev. rul. 66-178, 1966-1 c.b. 138. see also, e.g., bob jones univ. museum & gallery v. comm’r, 71 t.c.m. (cch) 3120 (1996). 81 see goldsboro art league, inc. v. comm’r, 75 t.c. 337 (1980). see also plumstead theatre soc., inc. v. comm’r, 74 t.c. 1324 (1980). 82 treas. reg. § 1.501(c)(3)–1(d)(1). 83 p.l.r. 2007–34–024 (may 30, 2007). 84 in addition to the requirements of the organizational test specified here, the organizational documents of an organization seeking tax exemption must specify that the organization will dedicate its assets to an exempt purpose in the case of its dissolution. treas. reg. § 1.501(c)(3)–1(b)(4). the organization’s documents also may not give the organization characteristics of an action organization. an organization is an action organization if it has at least one of the three following characteristics: a substantial part of the organization’s activities is attempting to influence legislation, by propaganda or otherwise; the organization participates or intervenes, directly or indirectly, in any political campaign on behalf of or in opposition to any candidate for public office; or the organization’s main or primary objective(s) may be attained only by legislation or defeat of proposed legislation and the organization advocates or campaigns for the attainment of such main or primary objective(s). see treas. reg. § 1.501(c)(3)–1(c)(3). however, these requirements are not applicable to museum organizations, and therefore this article omits further discussion of them. 85 treas. reg. § 1.501(c)(3)–1(b)(2). 86 treas. reg. § 1.501(c)(3)–1(c)(1). 84 columbia journal of tax law [vol.9:67 organization87 as well as size (e.g., the amount of revenues and/or expenditures vs. other revenues/expenditures of the organization, the number of employees involved and so forth).88 one court found that less than 10% of nonexempt activity did not jeopardize exempt status,89 while more than 30% seemed too much to another.90 the operational test focuses on the actual purposes the organization advances by means of its activities, 91 and is a question of fact to be determined under the facts and circumstances of each case.92 the operational test under section 501(c)(3) generally focuses on the purpose accomplished by, rather than the nature of, any activity.93 the organization bears the burden of demonstrating that it meets and continues to operate in compliance with the requirements under section 501(c)(3), the treasury regulations, irs interpretations and judicially constructed doctrines.94 among other reasons,95 an organization may fail the operational test if any of its net earnings are “private inurement” and benefit any person having a personal and private interest in the activities of the organization.96 in addition, courts have imposed another test, now baked into the statutory framework of section 501(c)(3), known as the “private benefit doctrine.” this test applies not only to an organization‘s insiders captured in the private inurement test, but also prohibits an organization from operating to benefit disinterested private interests to more than an insubstantial extent.97 such benefits may include advantage, profit, privilege, gain, or interest.98 a separate, non-statutory test known as the “commerciality doctrine” further considers the nature of an organization’s 87 see, e.g., christian echoes nat’l ministry, inc. v. united states, 470 f.2d 849, 855-56 (10th cir. 1972) (opining that the “no substantial part” test for the lobbying limitation is not purely a mathematical assessment but rather a balancing test that measures how important lobbying is to the underlying objectives of the organization). 88 treas. reg. § 1.501(c)(3)-1(e) (2008) (stating that whether the operation of an unrelated business is a primary purpose of an organization is measured in part by “the size and extent of the trade or business and the size and extent of the activities which are in furtherance of one or more exempt purposes.”). see, e.g., goldsboro art league, inc. v. comm’r, 75 t.c. 337, 341-342 (1980) (rejecting the irs’s argument that exemption should be denied to goldsboro because it operated two art galleries at which it sold art to the public in part because of the minor amount of money involved (gross receipts never exceeded $6,500 per year, and profits were negligible). 89 world family corp. v. comm’r, 81 t.c. 958, 100 (1983). 90 orange county agric. soc’y, inc. v. comm’r, 55 t.c.m. 1602, 1604 (1988), aff’d, 893 f.2d 647 (2nd cir. 1990). 91 treas. reg. § 1.501(c)(3)–1(c)(1); see living faith, inc. v. comm’r, 950 f. 2d 365, 371 (7th cir. 1991). 92 see treas. reg. § 1.501(c)(3)–1(f)(1). 93 federation pharmacy services v. comm’r, 72 t.c. 687 (t.c. 1979), aff’d, 625 f. 2d 804 (8th cir. 1980). 94 see treas. reg. § 1.501(c)(3)–1(f)(1). 95 an organization will also fail the operational test if it is an action organization. see supra note 84, infra. 96 treas. reg. § 1.501(a)–1(c); treas. reg. § 1.501(c)(3)–1(c)(2). united cancer council, inc. v. comm’r, 165 f. 3d 1173, 1176 (7th cir. 1999) (interpreting the term “private shareholders or individuals” to mean insiders of the organization – the founder, members of the board, their families, or anyone else equivalent to an owner or manager of the organization). 97 see am. campaign academy v. comm’r, 92 t.c. 1053 (t.c. 1989); treas. reg. § 1.501(c)(3)1(d)(1)(ii). it is sometimes impossible for organizations to serve exempt public purposes without providing benefits to private individuals. accordingly, substantial private benefit that is incidental to the primary public benefit provided by an organization’s operations does not jeopardize the organization’s tax-exempt status. see rev. rul. 70-186, 1970-1 c.b. 128 (jan. 1970). 98 see retired teachers legal def. fund v. comm’r, 78 t.c. 280, 286 (t.c. 1982). 2017] gallery-supported art exhibitions 85 activities and if the manner of its conduct transforms its stated exempt purpose into a nonexempt, commercial purpose.99 increasingly, the internal revenue service is relying on the commerciality doctrine’s “smell test” as the lines between for-profit and non-profit activities become messier. partnership with a for-profit organization may cause nonprofit organizations to run afoul of any of these limitations under certain circumstances. private inurement, private benefit and the commerciality doctrine have presented challenges to art museums and other nonprofit art organizations that display art. the application of these operational test rules and limitations to nonprofit organizations that exhibit art, independently or jointly in cooperation with a for-profit entity, is discussed in more detail in part iv below. even when a nonprofit organization possesses an exempt purpose and passes the organizational and operational tests, it may still be subject to tax upon certain activities that are unrelated to its exempt purpose. specifically, activities unrelated to an organization’s purpose, but that do not rise to the level of being conducted for a commercial purpose, may be subject to tax for generating unrelated business income (ubit).100 in order to qualify as taxable unrelated business income, income must come from a trade or business, such trade or business must be regularly carried on by the organization, and the conduct of such trade or business must not be substantially related, other than through production of funds, to the organization’s performance of its exempt functions.101 the “fragmentation” rule permits the irs to apply the ubit to separate revenue streams, even if those revenue streams are part of a single business.102 for example, the fragmentation rule allows the irs to apply the ubit to the sale of souvenir pens at a museum gift shop, but not to sales of postcards with art reproductions.103 the primary objective of ubit is to eliminate a source of unfair competition by taxing the income from unrelated business activities of exempt organizations the same as the income earned by nonexempt businesses with which the exempt organizations’ business activities compete.104 by imposing this tax, regulators can sanction exempt organizations engaging in unrelated business activities without revoking exemption entirely.105 generally, unrelated business activities must be a less than substantial part of an exempt organization’s overall activities or the organization will lose its exemption.106 substantiality is often determined by looking the ratio of unrelated business income to total income107 – with this method, a ratio of about one-third has found to be “substantial” 99 living faith, inc. v. comm’r, 950 f 2d 365, 371 (1991). see also bruce r. hopkins, the law of tax-exempt organizations (10th ed. 2011). 100 treas. reg. § 1.513–1(a). 101 id. 102 i.r.c. § 513(c) (stating that “an activity does not lose identity as trade or business merely because it is carried on within a larger aggregate of similar activities or within a larger complex of other endeavors which may, or may not, be related to the exempt purpose of the organization”); treas. reg. §1.513-1(b). 103 rev. rul. 73-105, 1973-1 c.b. 264 (1973) (sales of art reproductions are substantially related, but sales of science books and general souvenir items relating to city in which art museum was located were not substantially related to museum’s exempt purpose of promoting public understanding of art.). see also rev. rul. 73-104, 1973-1 c.b. 263 (1973) (sales of postcards with art reproductions are not subject to ubit). 104 treas. reg. § 1.513–1(b). 105 hopkins, supra note 99, at 634. 106 see treas. reg. § 1.501(c)(3)–1(c)(1); rev. rul. 66-221, 1966-1 c.b. 220 (1966). 107 rev. rul. 64-182, 1964–1 c.b. 186 (1964); see also hopkins, supra note 99, at 635. 86 columbia journal of tax law [vol.9:67 and thus disqualified an organization from exemption.108 however, the irs occasionally applies a “commensurate test,” under which it will permit substantial unrelated business income where the exempt organization also spends a significant amount of time or funds on exempt functions.109 profitable activities have recently gained greater relevance to art museums and nonprofit organizations that display art, as exhibitions and other revenue-generating activities become a critical source of funding. many kinds of activities undertaken by museums have not been considered impermissibly commercial in nature, including the operation of retail and gift shops, restaurants, event space rental, and even direct sale and lending of original artworks by the art museum. in some cases, these activities also are considered to take place in furtherance of a museum’s purpose and remain untaxed.110 the application of the ubit rules as applied specifically in the context of art exhibition activities by nonprofit organizations is discussed in more detail in part iv, below. b. self-regulatory industry associations and museum guidance many professional self-regulatory associations, such as the american alliance of museums (aam), the association of art museum directors (aadm), the association of art museum curators (aamc) and the college art association (caa), exist as a means of promoting communication as well as uniform policies and ethical guidelines among museums, arts organizations and arts professionals.111 the organizations are based on voluntary memberships, but joining creates certain responsibilities, in addition to benefits, for the museum. the aam is the most prestigious museum organization in the united states and offers an accreditation process for arts institutions. aam accreditation gives both credibility to the institution among the arts community and broader funding opportunities, since many arts grants will only be given to aam accredited museums.112 108 orange county agric. soc'y., inc. v. comm’r, 893 f 2d 529 (1990). 109 hopkins, supra note 99, at 636. 110 whether gallery-supported art exhibitions constitute an activity in furtherance of an art museum’s exempt purpose may depend on the meaning of “in furtherance of,” a concept which remains unsettled under federal tax law. the key issue is whether “in furtherance of” means that the activity must functionally advance exempt purpose, or simply that profits therefrom are used in commensurate proportion to exempt activities. in general, court cases and irs rulings provide support for both interpretations. assuming that art exhibitions funded by galleries are commercial and therefore not an activity that advances a museum’s exempt purpose for all the reasons provided above, the distinction in interpretations may have consequences for a museum’s exempt status. if “in furtherance of” means that the profits from gallerysupported art exhibitions support a commensurate amount of other charitable activities, they are likely to withstand the challenge in light of the other activities art museums undertake to promote art. according to the 2015 aamd annual report, museums spend approximately 51 to 67 percent of their annual budget on programs or program-related expenses. ass’n of art musuem directors, art museums by the numbers 2015, ass’n of art musuem directors (2016), http://aamd.org/our-members/from-the-field/art-museumsby-the-numbers-2015 [perma.cc/5kgq-ct67]. however, if “in furtherance of” means functional relation, commercial – and therefore functionally unrelated – gallery-supported museum exhibitions could endanger museum’s exempt status to the extent they are substantial in relation to the museum’s overall activities. 111 am. alliance of museums, about us, am. alliance museums, http://www.aamus.org/about-us [perma.cc/3895-afev]; ass’n of art museum directors, mission, ass’n of art musuem directors, https://www.aamd.org/about/mission [perma.cc/u67e-zef3]; ass’n of art museum curators, mission & vision, ass’n of art museum curators, http://www.artcurators.org/?page=missionvision [perma.cc/943z-3cee]; college art ass’n, about caa, college art ass’n, http://www.collegeart.org/about/ [perma.cc/73ag-acsx]. 112 am. alliance museums, benefits of accreditation, am. alliance museums, http://www.aamus.org/resources/assessment-programs/accreditation/benefits [perma.cc/9ydp-mqub]. 2017] gallery-supported art exhibitions 87 more specialized organizations, such as the aadm, offer a forum for museum staff to share information with each other and stay current with various practices. in addition, the organizations often put forward guidelines or best practices in their respective fields regarding professional ethics.113 consequences of violating the guidelines may result in discipline by reprimand, suspension, expulsion from the association and even sanctions, such as suspension of loans and shared exhibitions with members. while a minimum effort to follow the organizations’ guidelines is necessary on the part of museums or specific staff members to maintain their membership, 114 the professional organizations have no power of enforcement over museum activities. similarly, an association’s power to enforce sanctions is also limited.115 no museum association requires a policy be in place for museums working with corporations or other for-profit entities. the aamd provides a series of questions that museums are encouraged to consider when working with either a for-profit, a donor, or a corporation. the aam provides guidelines that are meant to be employed by individual museums to create their own specific policy for working with corporations. however, there is no specific warning against working with corporations or other for-profit institutions. the aam simply cautions museums to be aware of the risk and the potential consequences of working with these entities and to avoid practices that provide an individual or business with benefits at the expense of the museum’s mission, reputation, or the community it serves. the aamc addresses employment of curators by dealers. it also addresses curators’ acceptance of compensation from dealers in their personal capacity, but seems directed at compensation in curators’ personal capacity and not on behalf of the museum.116 significant variation exists in what guidelines, if any, have been adopted by individual museums regarding gallery financing of museum exhibitions. infrequently, museums’ written guidelines may explicitly prohibit acceptance of financial 113 ass’n of art museum directors, code of ethics, ass’n of art museum directors, http://www.aamd.org/about/code-of-ethics [perma.cc/j7yb-8wlg]; am. alliance museums, ethics, standards, and best practices, am. alliance museums, http://www.aam-us.org/resources/ethics-standardsand-best-practices [perma.cc/zmr2-64au]; college art ass’n., standards and guidelines, college art ass’n, http://www.collegeart.org/guidelines/ [perma.cc/xrm4-us3c]; ass’n of art musuem directors, supra note 113; ass’n of art museum curators, professional practices for art museum curators (2007), http://www.collegeart.org/pdf/aamc_professional_practices.pdf [perma.cc/u5cq-btga]. 114 margie fishman, delaware art museum loses accreditation, delaware online (june 19, 2014), http://www.delawareonline.com/story/life/2014/06/18/museum-directors-sanction-delaware-artmuseum/10757111/ [perma.cc/672m-kgym] (describing loss of aam accreditation by the delaware art museum after it sold one of their paintings in order to pay museum operating costs, which is against the ethical guidelines of the aam). 115 see ass’n of art museum directors, ass'n of art museum directors sanctions delaware art museum, ass’n of art museum directors (june 18, 2014), http://aamd.org/for-the-media/pressrelease/association-of-art-museum-directors-sanctions-delaware-art-museum [perma.cc/n3n6-6emy]; ass’n of art museum directors, ass'n of art museum directors statement on randolph college and maier museum of art, ass’n of art museum directors (mar. 12, 2014), http://aamd.org/for-themedia/press-release/association-of-art-museum-directors-statement-on-randolph-college-and [perma.cc/6fvd-hczv]. 116 ass’n of art musuem curators, supra note 113. 88 columbia journal of tax law [vol.9:67 compensation (including donations) from dealers for any reason,117 whether or not related to an exhibition, or more narrowly prohibit compensation for certain types of exhibitionrelated expenses. 118 other written museum policies may address certain aspects of gallery relationships with museums, such as artwork loans to galleries, but do not specifically address gallery sponsorship of a museum’s art exhibitions. 119 some museums may have general conflict of interest policies that allow donations for any general or special purpose of the museum, provided that they do not undermine the museum’s best interest or the public’s confidence in the museum’s integrity.120 in other cases, policies are either publicly unavailable 121 or available upon request, 122 and it therefore unclear whether there exist any written policies on gallery donations for exhibitions or otherwise. c. informal art market norms social norms are one of four modalities by which behavior may be regulated or constrained, as lawrence lessig observes in setting forth his “new chicago school” regulatory theory.123 therefore, no discussion of the rules applicable to the funding by galleries of art museum exhibitions can be complete without acknowledging the art industry’s “relatively heteronomous”124 norms and overarching informal nature. a brief summary of relevant art market dynamics recently examined by an art industry expert, professor isabelle graw, follows. experts including professor graw describe the art market as an “informal economy” thriving on personal agreements, unwritten laws, casual conversations, and a distinctive language, logic and set of laws.125 this leads to “practices capable of plunging 117 moma, code of conduct for staff of the museum of modern art (2001), http://moma.org/momaorg/shared/pdfs/docs/about/code_of_conduct_staff_4.2014.pdf [perma.cc/98lfl6c3]. 118 finkel, supra note 4 (citing walker museum of art’s written guidelines). 119 see, e.g., moma, collections management policy (2010), http://www.moma.org/momaorg/shared/pdfs/docs/explore/collectionsmgmtpolicymoma_oct10.pdf [perma.cc/n996-dbpf]; whitney museum, collections management policy (2013) http://whitney.org/file_columns/0004/5939/cmp_december_2013.pdf [perma.cc/9cgt-2laa]. 120 lacma, lacma audit committee of the board of trustees, policy and procedures for review of conflict of interest transactions (2009), http://www.lacma.org/sites/default/files/conflict-of-interest-policy.pdf [perma.cc/y5zh-nkmk]; lacma, amended and restated bylaws of museum associates as of january 13, 2016 (jan 13, 2016), http://www.lacma.org/sites/default/files/lacma_amended_and_restated_bylaws_1_13_16.pdf [perma.cc/r4q4-w776] (last visited jul 20, 2016). 121 id. 122 see christopher knight, moca’s questionable painting loan to a culver city art gallery, l.a. times, (june 11, 2014), http://www.latimes.com/entertainment/arts/culture/la-et-cm-moca-loan-frank-stellahonor-fraser-gallery-20140610-column.html [perma.cc/mm5b-cnng] (referring to a written museum policy obtained by email request). 123 lawrence lessig, the new chicago school, 27 j. legal stud. 661, 662 (1998). 124 graw, supra note 2, at 142 (defining relative heteronomy in contrast to relative autonomy, to mean that external constraints – primarily the economy and the market – prevail, but only in a relative fashion due to the specific rules and conditions of the art world). 125 id. at 62 (“anyone entering the art market as a novice will inevitably be confronted with business practices that would be quite unthinkable in conventional business relationships. as if it were the most natural thing in the world, collectors cancel orders payments are delayed, and invoices simply ignored. not to mention the large amounts of ‘dirty’ money that circulate in this field on account of the many transactions ‘off the books.’”). see judith b. prowda, visual arts and the law: a handbook for professionals 182 (ed. 2013) (“the art world is one where relationships play an inestimable role between 2017] gallery-supported art exhibitions 89 any accountant into disrepair,” as well as price manipulation and insider trading. 126 rather than brazen disregard for rule of law and moral deficiency, however, professor graw believes that the “the reason why this market has developed its own, unorthodox practices . . . lies in its product – the work of art – which itself eludes economic categories.” 127 the value of art is determined, and uniquely characterized, by both symbolic and market value. in turn, this dualistic nature of art’s value has implications on the professional profiles of and interactions between museums and galleries. the symbolic and market values of art remain conceptually distinct and in conflict with one another; at the same time, they are dependent upon each other and inextricably fused.128 art’s market value derives necessarily from its existence within a capitalist system, with its price determined by buyers and sellers who agree upon an amount for which to exchange it.129 in turn, this value and its expression as a price is driven by art’s symbolic value, which goes beyond what economic terms can measure. symbolic value is about cultural relevance, and is an expression of the manner in which art is loaded with idealistic concepts, such as an “artist’s reputation, promise of originality, prospect of duration, claim to autonomy and intellectual acumen” as well as the artwork’s singularity and “arthistorical verdict.” 130 these concepts (and thus symbolic value) are negotiated by a broad range of contributors, including the art historians, critics, curators – and also more recently, the art market itself.131 in contrast to art’s prior tolerance of its market value during the 1970s and 1980s as a “necessary means for making sadly inevitable financial transactions,” the nature of art’s market value as relative and conditional is now obscured as an end in itself.132 transacting parties…buyers and sellers alike must rely on the personal relationships and integrity of such intermediaries. this system of reliance often leads to artworks of great value changing hands in an informal manner…”). 126 graw, supra note 2, at 45 (describing collusion between buyers at auctions and the minimum auction price guarantees that auction houses grant to sellers); id. at 61 (describing the art market to know only unwritten laws and be rife with murky goings-on). see also john gapper & peter aspden, davos 2015: nouriel roubini says art market needs regulation, fin. times (jan. 22, 2015), http://www.ft.com/intl/cms/s/0/992dcf86-a250-11e4-aba2-00144feab7de.html#axzz4b9dt8w1u [perma.cc/q8ns-lacc]. 127 graw, supra note 2, at 147. but see andrew m. goldstein, would the art market benefit from more regulation?, artspace (jan. 28, 2013), http://www.artspace.com/magazine/news_events/1_28_13 [perma.cc/2ad9-enad] (stating that the key reason that art market regulation has been difficult to achieve is that galleries do not comply with the law requiring listing of prices). 128 graw, supra note 2, at 7 (describing art as a “dialectical unity of opposites, an opposition whose poles effectively form a single unit.”). see generally martha buskirk, creative enterprise: contemporary art between museum and marketplace (3rd ed. 2012) (describing inseparable dynamics of art and business of art). 129 graw, supra note 2, at 29; diedrich diederichsen, on (surplus) value in art (2008); thornton, supra note 8, at 100 (“on one level, the art market is understood as the supply and demand of art, but on another, it is an economy of belief.”). 130 graw, supra note 2, at 26–27. see thornton, supra note 8, at 100 (describing the art market as a “symbolic economy” in which artwork is made by artists, dealers, curators, critics and collectors); see also graw, supra note 2, at 20–21 (stating that art’s symbolic value is the “surplus and an assumption of meaning and worth that goes beyond the concrete object used to refer to it”). 131 graw, supra note 2, at 21. 132 id. at 55. see thornton, supra note 8, at 100 (“many worry that the validation of a market price has come to overshadow other forms of reaction, like positive criticism, art prizes and museum shows.”). 90 columbia journal of tax law [vol.9:67 today, art’s symbolic value remains its driving force, but “[d]uring the art boom of the first years of the new millennium, market success became the measure of all things, while at the same time remaining curiously dependent on the consecrating authorities that vouch for symbolic importance (criticism, art history, the museum).”133 the result is that the market significantly influences the process of value creation more than critics do,134 even while market value alone is no guarantee for long-term symbolic importance.135 the convergence of art’s driving values has compelled previously distinct professional spheres to similarly merge within the art industry.136 art industry actors have embraced broader professional profiles that span both market and non-market roles, such as the collector-dealer who also functions as a curator or publicist, or auction houses’ acquisition of ownership stakes in galleries.137 increasingly, each hybrid art industry actor acts in cooperation with other hybrid art industry actors.138 accordingly, “few figures in the art world are entirely free of conflicting roles, although these conflicts are hardly experienced as such” in light of the prevailing demand for transdisciplinarity across all art industry actors,139 with art criticism in particular undergoing a change in function.140 the blurring of the “commercial” and “institutional” spheres is a bid for symbolic legitimacy on the part of market actors as much as it is a general tendency toward market imperialism.141 yet professor graw acknowledges that the problem is not the lack of a rigid division of labor. she nonetheless emphasizes that it “makes a difference whether [an art industry actor] cultivates an awareness of [conflicts] in order to consciously set limits on them, or whether one simply neglects the problem, considering oneself separate from the conditions of market.”142 iv. critiquing gallery-supported art exhibitions as the analysis in this part iv demonstrates, examining gallery-supported art exhibitions results in the following conclusions. gallery-supported art exhibitions are unlikely to confer private inurement, but may bestow private benefit upon galleries and artists in limited circumstances – especially when nonprofit art organizations do not fully control the exhibitions, when gallery donations preference artists for consideration in an art exhibition, and when the sponsorship rights granted to a gallery in exchange for making a donation facilitate galleries’ ability to sell art outside of the art exhibition. gallery-supported art exhibitions may be impermissibly commercial when sponsored by commercial galleries; however, only if gallery-supported art exhibitions are also found to comprise a substantial part of a museum’s activities do they threaten museum’s exempt 133 graw, supra note 2, at 54. see plattner, supra note 55, at 8 (describing the increase in the market’s weight in determining short-term artistic relevance). 134 id. at 121. see thornton, supra note 8, at 100 (describing how auctions “market-test” artwork). 135 id. at 26;. see thornton, supra note 8, at 100 (describing the test for artistic authenticity as “the perceived depth and longevity of [artists’] ‘intervention’ in art history”). 136 id. at 99. 137 id. at 99–100. 138 see generally id. at 103–06. 139 id. at 102-03. 140 id. at 229. 141 russell, supra note 64 (discussing the relationship between symbolic and financial capital); graw, supra note 2, at 44. 142 graw, supra note 2, at 102. 2017] gallery-supported art exhibitions 91 status. meaningful, enforced self-regulation and internal norms against gallery-supported museum exhibitions are all but absent, even as the industry itself recognizes the troublingly close nature of gallery-museum relationships. this state of affairs is, at least in part, a result of the current structure of the art market, with galleries at its center. a. exempt purpose and its exclusive pursuit in question 1. private inurement private inurement has the potential to present issues for museums that conduct gallery-supported art exhibitions.143 private inurement is well defined by the irs and the courts as siphoning off the assets of an exempt organization to an insider. this may occur when the charity charges too little for property or services it provides to an insider (some examples in the museum context might be free event space rental or curatorial services). alternatively, private inurement may also occur when a charity overpays for property or services provided by an insider (for example, an unreasonable salary or other compensation in excess of market value). even de minimis private inurement violates the operational test and threatens an organization’s exempt status as a whole. however, in lieu of revoking exemption, the penalty for inurement transactions in most cases is not revocation of exempt status, but the imposition of excise taxes under section 4958. the irs has issued guidance to clarify the factors it will consider in determining whether to revoke the exempt status of a tax-exempt organization that engages in excess benefit transactions such as private inurement. 144 in providing such guidance, now officially reflected in the treasury regulations, the irs specifically addressed the situation in which a museum and art dealers have too cozy of a relationship. the first such example provided in the treasury regulations interpreting section 4958 describes an art museum created for the purpose of exhibiting art to the general public, and governed by a board comprised of art dealers.145 the museum directly purchases art solely from the dealers at prices exceeding fair market value, and the museum exhibits and offers for sale all of the art it purchases.146 the irs states that the purchase of art from the dealers constitutes private inurement.147 furthermore, the irs compares the museum’s activities to “dealing in such art in a manner similar to a commercial art gallery”.148 notably, the irs states that such transactions are so significant in size and scope in relation to the museum’s exempt purpose that, unless remedied,149 they would 143 although arts administrators’ salaries have significantly risen in recent years, this article sets aside the private inurement issue of unreasonable compensation to administrators in art museums as a general and tangential issue, despite whatever contribution to higher salaries is facilitated by the operational budget savings made possible in part by galleries’ donations. see rm vaughn, point of view: who makes up the 1%? in the arts, it’s the bureaucrats, cbc (july 8, 2016), http://www.cbc.ca/beta/arts/point-of-view-whomakes-up-the-1-in-the-arts-it-s-the-bureaucrats-1.3607715 [perma.cc/2tyg-ters]. 144 t.d. 9390, 2008-18 i.r.b. 852, 855 (2008), http://www.irs.gov/pub/irs-irbs/irb08-18.pdf [perma.cc/z3wu-wvlg]. 145 treas. reg. § 1-501(c)(3)-1(f)(2)(iv) examples 1-3. 146 treas. reg. § 1-501(c)(3)-1(f)(2)(iv) example 1(i). 147 treas. reg. § 1-501(c)(3)-1(f)(2)(iv) example 1(ii). 148 treas. reg. § 1-501(c)(3)-1(f)(2)(iv) example 1(iii). 149 the irs indicates elsewhere in the treasury regulation that a museum’s exempt status would not be in question if it addresses the conflicts presented by museum-dealer transactions. specifically, if the museum replaces its board with “members of the community who are not in the business of buying or selling art and who have skills and experience running charitable and educational programs and institutions”; no longer buys art from current or former board members; and adopts written conflict of interest and art 92 columbia journal of tax law [vol.9:67 cause the museum to lose its exempt status.150 this is an extreme example, and it does not explicitly address the situation in which a third-party gallery funds a museum show; nonetheless, at a more general level the example highlights the concern of the irs with dealers who financially benefit from, and are involved in the decision-making that takes place at, an art museum. significantly, the mere exhibition of art – even in the absence of a sale – also results in excess benefit to someone who has a financial interest in that art, due to the “nature of art” and the impact display has on its value.151 the irs directly acknowledged this in its 1992 private letter ruling 9408006, stating: there is no requirement that an [art] exhibition be of a commercial nature or that a sale must accompany an exhibition for the exhibition to result in private benefit. the nature of art is such that every exhibition increases the value of each piece on display and the value of all other works of that artist, including those pieces presently in existence and those that the artist will create in the future.152 the irs made this sweeping pronouncement in the course of examining the exempt status of a 501(c)(3) organization formed to further the promotion of textile art. the board governing the organization consisted of the organization’s former attorney, as well as a well-known textile artist, her husband and her brother-in-law; in addition, the artist and her husband were the sole contributors to the organization. although the organization stated in its application for exemption that it planned to develop textile artists, sponsor educational public art events, publish materials for cultural and educational activities and display textile art of the highest quality, the organization’s actual activities told a different story. in fact, the irs found that the organization in private letter ruling 9408006 almost exclusively exhibited the work of a single artist: namely, the well-known textile artist who was a board member and one of the organization’s contributors. the case again demonstrates the influence that an interested art industry actor – this time the artist herself, unaided by an intermediary gallery – can wield over a nonprofit art organization’s dealings. the organization had formal selection criteria in place, as well as a sizable collection, that presented it with options in choosing among the art it wanted to promote. nonetheless, in most instances, the organization showed only the contributor-artist’s art.153 even when the organization combined financial resources valuation policies, the museum would retain its exempt status. treas. reg. § 1-501(c)(3)–1(f)(2)(iv) example 2 (2008). 150 treas. reg. § 1-501(c)(3) –1(f)(2)(iv) example 1(iii) (“the size and scope of the excess benefit transactions collectively are significant in relation to the size and scope of any of o’s ongoing activities that further exempt purposes . . . [the museum] has not implemented safeguards…to prevent such transactions in the future. the excess benefit transactions have not been corrected, nor has [the museum] made good faith efforts to seek correction from the disqualified persons who benefited from the excess benefit transactions (the trustees). the trustees continue to control [the museum]’s board. based on the application of the factors to these facts, [the museum] is no longer described in section 501(c)(3)…”). 151 p.l.r 94–08–006 (dec. 4, 1992) (“the nature of art is such that every exhibition increases the value of each piece on display and the value of all other works of that artist, including those pieces presently in existence and those that the artist will create in the future.”). 152 id. 153 id. the organization sent only the contributor-artist’s work to several exhibitions in which it participated. it also staged a solo exhibition of only the contributor-artist’s art that displayed pieces from her 2017] gallery-supported art exhibitions 93 to fund a group show of multiple artists, it showed only the contributor-artist’s work among the others from its collection. the organization also solicited european museums and others to host traveling exhibitions of the contributor-artist’s art, and printed catalogs containing her biography and a listing of the art from her personal collection. although the organization received all proceeds from the sale of the catalog, it incurred significant other direct and indirect expenses of showing the contributor-artist’s work. the irs ultimately revoked the organization’s exemption, rejecting the argument that because the contributor-artist was already well known, any benefit that she received was incidental and tenuous. instead, the irs concluded that the contributor-artist received substantial “private benefit”154 from the organization’s aforementioned existence and activities. this determination is consistent with a long line of irs interpretive guidance and tax court decisions that prohibits insiders of an art organization from selling their art through such organizations. the irs recently confirmed its position in 2014 with private letter ruling 201210043, when it revoked the exemption of a nonprofit cooperative art gallery that not only exhibited, but also sold its members’ art.155 the exhibiting artists were exclusively members of the organization; therefore, they were also insiders. they also set prices and selected works for exhibition; significantly, the irs determined that the members’ financial and in-kind donation, required by the organization from its member artists in order to exhibit their work, constituted a sales commission. the artists received all proceeds from the sale of their art less such commission, thereby constituting forbidden inurement.156 even after this recent decision, private letter ruling 9408006 remains relevant. specifically, the irs acknowledged in that case that “[t]here is no reason why [the contributor-artist] could not realize the appreciation resulting from the display of her art in a private sale of the art or donate the appreciated art for higher charitable deductions.”157 in other words, the irs embraces the fluid reality of the contemporary art market with its recognition that there is little meaningful difference between exhibits by commercial art gallery or an art museum. both create interest in and esteem for an artist’s work, and both may lead to sales. accordingly, in light of private letter ruling 9408006, the rules against private inurement apply not only to the traditional notion of insiders who have significant control and a current financial interest in the art; it also captures insiders with significant control and only a latent or prospective financial interest in art. the critical effect of private letter ruling 9407006 expands the scope of private inurement in a way that could encompass not only artists, but also their galleries as the agents who act on their behalf. however, despite this expansion, the effect of private letter ruling 9408006 is likely to have a greater impact on gallery sponsorship of personal collection and one of her collector’s collections. at other times, the organization exhibited her art together with some art from its own collection. 154 id. 155 p.l.r. 2012–10–043 (2011). while this decision did not deal directly with museums, it explicitly stated that the gallery was “like the [museum] described in example 2 of section 1.501(c)(3)1(d)(1)(iii) of the regulations.” 156 id. (“providing a display and retail space for member artists and allowing each member artist to set the sales price, select the works for sale, and receive a commission promotes the private interests of the artist members. . . since the individuals who will be selling and retaining any proceeds are members they are also insiders. as insiders, any direct benefit derived through your operations is inurement.”). 157 p.l.r. 2012–10–043, supra note 155. 94 columbia journal of tax law [vol.9:67 museum exhibitions from the perspective of private benefit, rather than private inurement. for example, even if takashi murakami delegated his “final right of approval on all aspects of everything” over ©murakami to his gallery, this would be insufficient to subject the gallery to the prohibition on private inurement. arrangements that grant gallerists ultimate control over exhibitions on behalf of the artists they represent – in addition to their inherent financial interest – do not necessarily make gallerists into museum insiders. for that to be the case, gallerists and artists would need to possess “significant formal voice in [an exempt organization’s] activities generally and . . . substantial formal and practical control over most of [the organization’s] income” like the contributor-artist in private letter ruling 9408006 or the member artists in private letter ruling 201210043.158 while some art museums do indeed have artists or gallery owners in positions of power within their organization, the majority of gallery relationships with museums are temporary and transactional, formed for the purpose of producing a single exhibition. gallery support of museum exhibitions tend to look more like licensing contracts or sponsorship agreements between the gallery and museum. they may also take the form of a three-way arrangement among a donor, museum and gallery. in such multi-party arrangements, a museum identifies a donor to advance money to a gallery; the gallery in turn contributes such funds to the museum’s exhibition of the artist; and the artist provides an artwork to the donor, often for less than the value of the donor’s advance to the gallery. in any case, a contractual relationship alone has been ruled insufficient to make a third party an insider, even when the contract considerably favors such third party. 159 therefore, most crayola gallery sponsorships of museum exhibitions are unlikely to support a finding of private inurement, and this article’s analysis thus excludes further discussion of private inurement, excess benefit transactions and intermediate sanctions.160 however, even a short-term relationship nonetheless may still present a basis for challenging gallery sponsorship of museum exhibitions, from the perspective of a private benefit or joint venture analysis. 2. private benefit a commercial gallery that works with a nonprofit art museum to present an exhibition of its artists’ work could stand to reap prohibited substantial private benefit. in addition to any benefits inherent to exhibiting art in a museum (such as elevated prestige and greater name recognition), the private benefits associated with gallery-supported museums may include legal rights for the gallery or others included in negotiating the donation. these benefits may be specified in the sponsorship or licensing agreement, and include: signage, program and advertising credits, hospitality, tie-in promotions, access to star personnel, merchandising, and in some cases, even ultimate control over the 158 see variety club tent no. 6 charities, inc. v. comm’r, 74 t.c.m. 1485, 1493 (1997). 159 see united cancer council, inc. v. comm’r, 165 f.3d 1173 (7th cir. 1999) (reversing the tax court’s finding of private inurement and remanding for consideration of private benefit present in a contract that gave 90% of the contributions received by the charity to the fundraising company it hired). 160 it would be necessary to examine the individual provisions in licensing and sponsorship agreements to determine with greater certainty whether a commercial gallery’s relationship with a nonprofit museum justifies disqualified person status and thus makes the intermediate sanctions and excess benefit provisions applicable. 2017] gallery-supported art exhibitions 95 exhibition.161 whether any of these benefits are permissible is determined by the rules on private benefit. private benefit is a judicially-constructed doctrine that can cause an organization to lose its exemption if, as a result of serving its charitable class, it confers an excessive benefit (often, but not necessarily, a financial benefit) on parties outside of the charitable class. unlike private inurement transactions, the private benefit doctrine extends to independent, disinterested third parties to the organization, 162 even if when transactions are fairly and objectively priced at market value.163 as with private inurement, the treasury regulations specifically address the example of an art museum that, in pursuing its mission of exhibiting art to the public, provide indirect, secondary benefits to specific individuals outside the intended charitable class. in this example, the irs describes an art museum that displays the work of unknown but promising artists; unlike the example provided in the case of private inurement, the board governing the art museum is unrelated to these artists. nonetheless, because the art exhibited is for sale pursuant to a consignment arrangement that gives the artist 90% of the proceeds, the primary activity of the art museum serves the artists’ interest, and the art museum is not exempt.164 while the irs recently confirmed this position in denying exempt status to an art gallery that it deemed to be like the museum described in the treasury regulations,165 the private benefit doctrine is even broader than the treasury regulation suggests. the key case establishing the doctrine, american campaign academy v. commissioner, 166 disallowed exemption of an educational institution whose graduates nearly all worked for a single political party, and whose curriculum and faculty mostly originated from programs previously conducted by that party. there was no evidence that the political party exerted insider influence or funneled off funds, yet the court still found that the political party benefitted to an impermissibly substantial degree.167 therefore, while the treasury regulation again does not explicitly address the situation in which a third-party gallery funds a museum show, american campaign academy establishes that a gallery that neither exerts influence over an art exhibition nor improperly takes funds from the presenting art organization could nonetheless be the recipient of forbidden private benefit. 161 mark walhimer, the museum toolbox: sample museum exhibit sponsorship agreement, museums 101, 190 (2015). see also mary hutchins reed, sponsorship and the arts: a brief overview of legal issues for not-for-profits, 13 ent. sports law 13 (1995) (describing common benefits provided in sponsorship agreements); barstow, supra note 44 (detailing hospitality benefits provided in exchange for christie's sponsorship of an exhibition at the brooklyn museum); thornton, supra note 8, at 100 (describing contracts between artist and exhibiting museum that grant artist ultimate control). 162 american campaign academy v. comm’r, 92 t.c. 1053 (1989). 163 united cancer council, inc. v. comm’r, 165 f.3d at 1176 (suggesting that a one-sided contract may effectively support a finding of private benefit.). 164 treas. reg. § 1-501(c)(3) –1(d)(1)(iii) example 2. 165 p.l.r. 2015–16–066 (2015). 166 american campaign academy, supra note 162. 167 id. 96 columbia journal of tax law [vol.9:67 when taken to an extreme, the implications of american campaign academy are that exhibitions of art, gallery-supported or not, would confer private benefit to the artist and gallery, and call into question the exempt status of all nonprofit art institutions. indeed, the exact doctrinal scope of the potentially all-encompassing private benefit prohibition is unclear. it derives from irs and court interpretations of treasury regulation §1.501(c)(3)1(d)(1)(ii), which provides: an organization is not . . . [qualified for exemption] . . . unless it serves a public rather than private interest. thus . . . it is necessary for an organization to establish that it is not organized or operated for the benefit of private interests such as designated individuals, the creator or his family, shareholders of the organization, or persons controlled directly or indirectly, by such private interests.168 the doctrine itself does not appear anywhere in the statute supposedly interpreted by such regulations, however. an irs general counsel’s memorandum issued in 1987 provides the most exhaustive explanation of the doctrine available: an organization is not described in section 501(c)(3) if it serves a private interest more than incidentally…if, however, the private benefit is only incidental to the exempt purposes served, and not substantial, it will not result in a loss of exempt status … a private benefit is considered incidental only if it is incidental in both a qualitative and a quantitative sense. in order to be incidental in a qualitative sense, the benefit must be a necessary concomitant of the activity which benefits the public at large, i.e., the activity can be accomplished only by benefiting certain private individuals … to be incidental in a quantitative sense, the private benefit must not be substantial after considering the overall public benefit conferred by the activity.169 thus, a balancing test determines the presence of private benefit by assessing the benefits to private individuals or organizations of an organization’s activity, against those received by the charitable class. if the former is substantial, the organization is not exempt – even if the activity also serves the latter. substantial benefits may include a direct financial stake in an organization’s profits from its otherwise exempt activities.170 in the context of organizations that exhibit art, several possessed solely a profit motive to sell the work of artists they exhibited and thus lost their exemptions for such reason.171 on the other hand, if the incentives created by the private benefit also benefit the community – for example, to encourage participation or the expansion of resources in an underserved area – the very same incentives might be justified as necessary, and thus 168 treas. reg. § 1.501(c)(3)-1(d)(2)(ii). 169 i.r.s. gen. couns. mem. 39,598 (1987). 170 i.r.s. gen. couns. mem. 39,862, 36 (1991) (determining that financial incentives for doctors to promote the competitive position of a hospital do not necessarily constitute a public benefit). 171 see, e.g., rev. rul. 71-395, 1971–2 c.b. 228 (revoking exemption of an organization that had a stated purpose of selling its members’ art); rev. rul. 76-152, 1976–1 c.b. 152 (revoking exemption of an organization that had a stated purpose to sell local artists’ art); p.l.r. 80–34–018 (1980) (revoking exemption of organization whose stated purpose was not to sell art, but whose sales activities grew to comprise 75% of its operations). 2017] gallery-supported art exhibitions 97 permissible private benefit.172 for example, the irs has granted exempt status to galleries that promote art by providing such incentives for high schoolers, 173 economically disadvantaged artisans174 and artists with disabilities,175 and for artists in areas distant from other organizations that exhibit or sell art.176 considering the audiences that art exhibitions at major art museums already draw, it is difficult to say that an incentive encouraging galleries’ display of artwork by artists they represent is necessary to get good art into museums. in addition, there is already a concentration of art museums in the major markets in which gallery-supported museum exhibitions take place. thus, further private benefit, beyond the benefit inherent to exhibition, seems unnecessary in order to promote art, and there should be no exception for gallery-supported art exhibitions to the general rule that private benefit be incidental.177 private benefit must be both quantitatively and qualitatively incidental. to be quantitatively incidental, the private benefit must be insubstantial, measured in the context of the overall exempt benefit conferred by the activity.178 applying this part of the test, the tax court in several decisions scrutinized everything from an organization’s frequency of its art-related newsletters to the total number of hours engaged in educational activities compared against some measured financial benefit to artists.179 the irs has likewise assessed quantitative incidental benefit with vigor.180 most frequently, its comparisons evaluate the number and regularity of educational activities compared against the hours spent, or dollars earned, in the undertaking of sales activity.181 if the requirement that private benefit be quantitatively incidental was applied to a situation in which a gallery funded an art museum’s exhibition of art, the test would utilize similar 172 i.r.s. gen. couns. mem. 39,862, supra note 170, at 76 (“we recognize that there may well be legitimate purposes for joint ventures, whether analyzed under the anti-kickback statute or the tax code. these may include raising needed capital; bringing new services or a new provider to a hospital’s community; sharing the risk inherent in a new activity, or pooling diverse areas of expertise.”). 173 rev. rul. 78-131, 1978–1 c.b. 157. 174 aid to artisans v. comm’r, 71 t.c. 202 (1978); p.l.r. 8849072 (sept. 10, 1988). 175 p.l.r. 9141053 (1991). 176 goldsboro art league, inc. v. comm’r, 75 t.c. 337, 341-42 (1980); cleveland creative arts guild v. comm’r, t.c.m. 1985–316; p.l.r. 8634001 (1986); p.l.r. 201441017 (july 18, 2014) (denying exemption to gallery located in an area with other galleries and organizations that exhibit art). 177 for the purpose of this article, the author does not challenge the fiction in which irs and courts engage: that the labor to produce art is free. this assumption is implicit in the irs and tax court interpretations, which find that full compensation for artists work constitutes private benefit. the average rate for reasonable compensation of artists is a 50% commission, though the power imbalance of artistgallerist relationship undermines the validity of this market-based profit allocation. therefore, it is actually impossible to provide art without necessarily benefitting the private interests of artists in doing so, and one would never suggest such an arrangement in other industries; for example, that doctors are not paid for medical services they deliver in the realm of health care. in any event, the irs is hardly alone in making this problematic assumption, and therefore the scope of the issue and its associated implications are best left for other forums. 178 e.g., ginsburg v. comm’r, 46 t.c. 47 (1966); rev. rul. 75-286, 1975-2 c.b. 210; rev. rul. 6814, 1968-1 c.b. 243. 179 aid to artisans v. comm’r, 71 t.c. 202 (1978); goldsboro art league, inc. v. comm’r, 75 t.c. 337, 341-342 (1980); cleveland creative arts guild v. comm’r, t.c.m. 1985–316 (1985). 180 see, e.g., p.l.r. 88–49–072 (sept. 10, 1988) and p.l.r. 86–34–001 (aug. 13, 1986) (each approving exemption after lengthy analysis). see also p.l.r. 80–34–018 (may 14, 1980); p.l.r. 2008–29– 046 (apr. 17, 2008); p.l.r. 2011–25–044 (mar. 30, 2011); and p.l.r. 2014–41–017 (jul. 18, 2014) (each disapproving exemption after lengthy analysis). 181 id. 98 columbia journal of tax law [vol.9:67 arithmetic. provided a nonprofit art organization engages in no direct art sales activity (that is, it does not sell art off its walls), the quantitative test would seem to easily result in a public benefit that outweighs private benefit to galleries or the artists they represent. yet, private letter ruling 9407006’s statement that the commercial and noncommercial spheres of the art market are not so easily distinguished casts doubt upon this outcome.182 in stating that “[t]here is no requirement that an [art] exhibition be of a commercial nature or that a sale must accompany an exhibition for the exhibition to result in private benefit,” the ruling provides support for finding private benefit even in the absence of a specific sum of revenue directly obtained by the artist or gallery through a particular exhibition. this result is consistent with the approach of the irs and tax court to date, which relies only upon rough approximations of public and private benefit and does not utilize available models for measuring museum impact or artwork value. as importantly, any other result is difficult to reconcile consistently with private letter ruling 9407006’s determination that nonprofit art exhibitions at which no sales take place can confer private benefit. private letter ruling 9407006’s unsettling expansion of quantifiable private benefit can be narrowed when considered together with the limitation that private benefit be qualitatively incidental. to be qualitatively incidental, private benefit must be a necessary concomitant of the exempt activity, in that the exempt objectives cannot be achieved without necessarily benefiting certain individuals privately.183 depending on how broadly or narrowly the phase “exempt objectives” is interpreted, the qualitative incidental requirement places some limit upon the otherwise boundless implications of private letter ruling 9407006. as the irs recognized in that ruling, all exhibitions of art, commercial and noncommercial alike, benefit anyone with an interest in the exhibited art. to state that a museum would be unable to achieve its purpose without engaging in private benefit and therefore the benefit of all exhibitions are incidental, however, eviscerates the limitation of its meaning. more carefully confined, however, the requirement that private benefit be qualitatively incidental is useful in separating gallery-supported art exhibitions that confer private benefit from exhibitions, gallery-supported or otherwise, that do not. specifically, it compels the question of what art an organization must display in order for the public to benefit from its exhibition, and whether certain conditions under which the art is displayed vary the extent of private benefit. thus, the contributor-artist’s argument from private letter ruling 9407006 has merit in the context of private benefit, as an exhibition likely confers less benefit for an artist who is already well-known than one who is unknown; likewise, some exhibitions confer greater benefit to galleries and artists than others,184 such as those that take place at major art museums. a particular exhibition of art might also confer greater benefit if the artist’s work is currently or will soon be on 182 p.l.r. 94–08–006 (dec. 4, 1992) (“there is no requirement that an [art] exhibition be of a commercial nature or that a sale must accompany an exhibition for the exhibition to result in private benefit. the nature of art is such that every exhibition increases the value of each piece on display and the value of all other works of that artist, including those pieces presently in existence and those that the artist will create in the future.”). 183 see rev. rul. 70-186, 1970-1 c.b. 128. 184 thornton, supra note 8, at 100. 2017] gallery-supported art exhibitions 99 the market,185 or if the price for the exhibited art is already higher to begin with than unexhibited art.186 however, these private benefits exist whether or not a gallery makes a donation to a nonprofit art organization. on the other hand, a gallery-supported art exhibition might specifically confer greater private benefit to galleries when their donations preference the artists they represent for consideration in an art exhibition, and when the sponsorship rights granted to a gallery in exchange for making a donation facilitate galleries’ ability to sell art outside of the art exhibition. under such circumstances, it is likely that gallery-supported art exhibitions confer more than a quantitatively and qualitatively incidental private benefit to galleries and the artists they represent. 3. a special case of private benefit: joint ventures the characteristics of the short-term relationship between a museum and gallery may be impermissible as a joint venture.187 while the law overall is clear that exempt organizations may partner with for-profits without affecting the former’s exempt status or tax liability, this rule is not absolute – especially when collaborations between for-profit and tax-exempt organizations present the potential for substantial benefits to for-profit participants. accordingly, joint ventures are a special case of private benefit, and the irs has challenged many transactions in which a charity enters into a joint venture with private investors, even in circumstances where transactions did not involve insiders or siphoning off of the exempt organization’s assets. while the majority of such decisions have taken place in the health care industry, 188 the irs has taken issue with exempt arts organizations that work with for-profit partners to produce their programming.189 it is therefore conceivable that the irs could challenge art exhibitions put on by museums with the assistance of galleries as joint ventures. in general, galleries’ financing of museum exhibitions does not take the form of joint venture entities or explicit joint venture agreements. substance matters more than form under federal tax law, however; therefore, when galleries fund art museum exhibitions, the irs and courts may characterize their cooperation as a joint venture. the classic joint venture recognized under federal tax law involves an exempt organization and a discrete legal entity, such as a partnership, limited liability company or other unincorporated association, through or by means of which any business, financial operation or venture is carried on. the joint venture rules also apply to a wide variety of other legal forms, including potentially the types of agreements made between galleries and museums. joint ventures may exist between or among discrete legal entities, when they combine their resources to carry out a single business venture for joint profit, but do not create a formal incorporated or unincorporated association to do so. for example, a tax-exempt organization and the for-profit entity might enter into an agreement to conduct an activity together, such as the exhibition of art. in determining whether an 185 barstow, supra note 44. this situation occurred in connection with the sensation exhibition. christie’s auction house explicitly said it wanted to make the most of its $50,000 donation to the exhibition, its largest ever such contribution to a museum. 186 even if the gain in value from exhibition is proportionate, 10% of $10 million ($1 million) is objectively larger than 10% of $100,000 ($10,000). 187 supra, part ii.a.1. 188 see, e.g., i.r.s. gen. couns. mem. 39,862, supra note 170, at 39–47 (nov. 22, 1991) (holding that “revenue stream” joint venture arrangements between doctors and a hospital for outpatient services violated the private benefit doctrine). 189 plumstead theatre soc., inc. v. comm’r, 74 t.c. 1324 (1980). 100 columbia journal of tax law [vol.9:67 arrangement constitutes a joint venture, some courts find the parties’ intention to be the most important factor. others disregard “nomenclature” and consider all facts and circumstances, emphasizing especially the elements of control and risk of loss. therefore, even when tax-exempt and for-profit entities do not explicitly intend to create a joint venture, a court or the irs may find that the parties’ relationship and behavior warrants characterization as a “law imposed joint venture” anyway.190 furthermore, federal tax law recognizes variation in the level of joint venture involvement. members in the joint ventures may actively participate in the joint venture through management, decision-making and execution, or they may be passive investors who supply funds and exercise limited agency but nonetheless profit from the joint venture’s activities. in addition, the scope of the joint venture may encompass all or some of a tax-exempt entity’s activities. at one extreme, the entirety of the exempt organization is in the venture; these joint ventures are called “whole entity” joint ventures. in the middle, the primary operations of the exempt organization are in the venture. in “ancillary joint ventures,” less than the primary operations of the exempt organization are in the venture. depending on the degree of a museum’s collaboration with a gallery to produce an exhibition, the cooperation between a tax-exempt museum and a for-profit gallery to produce an exhibition could be subject to scrutiny as a law-imposed joint venture. pursuant to the terms of the sponsorship agreement, galleries provide monetary or in-kind donations to fund the exhibition; the irs has found that an art organization’s voluntary donations are provided in exchange for a benefit to artists.191 in addition, galleries exercise some (sometimes even ultimate) control over the exhibition. in light of galleries’ fiduciary duties to the artists they represent, such activities are conducted in their best interest with a profit motive, not a public interest.192 meanwhile, museums provide resources ranging from exhibition space, curatorial expertise and administrative coordination. a gallery-supported museum exhibition thus could constitute a joint venture, and whether it is an ancillary joint venture or something more depends on whether its activities are substantial. a gallery-supported art exhibition remains an ancillary joint venture if it constitutes an insubstantial portion of the museum’s overall activities. even so, any ancillary joint venture activities that do not further an exempt purpose generate unrelated business income subject to the ubit thereupon.193 formal guidance issued by the irs states that an exempt organization would not be subject to the ubit if it retains control over the joint venture and its operations that constitute one or more related businesses. an exempt organization may retain control in ways other than by means of composition of a governing board of the joint venture, such as agreements that grant the exempt organization decision-making power. conversely, if such agreements grant control to the 190 p.l.r. 2006–22–055 (mar. 7, 2006); p.l.r. 2012–35–021 (june 4, 2012); p.l.r. 2013–09–016 (dec. 5, 2012). 191 p.l.r. 2012–10–043 (dec. 13, 2011). 192 see supra note 20. 193 in ancillary joint ventures, the operational test is not at issue because the joint venture constitutes an insubstantial part of an exempt organization’s total operations (provided the exempt organization otherwise operates primarily for exempt purposes). 2017] gallery-supported art exhibitions 101 for-profit in the joint venture or are unrelated to an exempt purpose, its activities may be subject to the ubit.194 gallery-supported museum exhibitions that comprise a substantial portion of a museum’s programmatic budget could even rise to the level of a joint venture that conducts the primary operations of the exempt museum. such joint venture’s activities may endanger the exempt organization’s exempt status entirely. this risk derives from the conflict that arises when an exempt organization serves in a managing capacity as a general partner of the joint venture. this is because the joint venture’s general partner has fiduciary duties to the other partners that conflict with an exempt organization’s obligation to pursue an exempt purpose exclusively. therefore, unless the principal purpose of the joint venture is to advance exempt purposes, an exempt organization that serves as general partner of a joint venture will lose or be denied exemption. furthermore, the for-profit partners must not receive an undue economic return or other more than incidental private benefit, and the exempt organization must be insulated from the day-to-day management of the joint venture. at the same time, however, the exempt organization cannot cede full control to a for-profit partner in a joint venture, either. the irs has suggested that a for-profit partner’s control of joint venture activities that constitute an exempt organization’s primary purpose raises private benefit issues. in addition, even where the activities of the joint venture are related to the exempt purpose of the tax-exempt organization, control of such related activities by a for-profit convert the otherwise exempt activities into an unrelated business, and will lead to the loss of exempt status.195 whether a joint venture is ancillary or constitutes an exempt organization’s primary purpose, control is the crucial indicator in both cases that determines whether the joint venture’s activities advance an exempt purpose – even if such activities are inherently related to the exempt organization’s stated exempt purpose. accordingly, exhibition of art – one of the exempt purposes of art museums – effectively may not constitute an exempt purpose in a joint venture, if a for-profit such as a gallery or artist has control over such exhibition. therefore, gallery-supported museum exhibitions like ©murakami, which granted final say to the artist and his gallery, would all but certainly mean that the exhibition furthered a nonexempt purpose. such finding would be consistent with the position of the irs in revenue ruling 2004-51, 2004-1 c.b. 974, in which it found that ancillary joint ventures did not endanger the exempt organization’s status when the exempt organization maintained exclusive control over all major decisions, and at least equal control over all other, non-administrative issues. 196 in subsequent decisions considering such issue, the for-profit partners in other joint ventures have similarly not possessed control over the joint venture, and the exempt organization was able to maintain its status.197 conversely, even when exempt organizations ceded only constructive,198 substantial199, majority200 or shared control201 the irs denied their applications for exempt status. 194 mary hutchins reed, sponsorship and the arts: a brief overview of legal issues for not-forprofits, 13 ent. sports law 13 (1995); gilbert, corporate sponsorship: the ubit analysis, c786 aliaba 21 (1992). 195 hopkins, supra note 99. 196 rev. rul. 2004-51, 2004-1 c.b. 974. 197 p.l.r. 2005–28–029 (apr. 20, 2005); p.l.r. 2014–19–015 (feb. 14, 2014). 198 p.l.r. 2008–51–033 (sept. 25, 2008). 102 columbia journal of tax law [vol.9:67 such decisions strongly suggest that revenue ruling 2004-51’s standard – full control over major decisions and equal control over all other non-administrative decisions – is the minimum level of control that an exempt organization must possess over a joint venture’s activities in order for such activities to further an exempt purpose. if a museum has anything less than full control over a gallery-supported museum exhibition, revenue from such exhibition may be taxable as unrelated business income or even cause the museum to lose its tax exemption if it constitutes a substantial portion of the museum’s activities. 4. commerciality and unrelated business income tax beyond benefit to private interests (disinterested or otherwise), cooperation between for-profit galleries and nonprofit museums in producing exhibitions also poses the question of whether such activity is commercial in nature. outside of tax law, at least one court has determined that certain activities undertaken by museums in connection with art exhibitions, such as advertising a collection and publishing a guidebook for sale, constitute commercial activity.202 in addition, under federal tax law, nonprofit galleries’ ability to conduct art sales remains very restricted as nonexempt commercial activity.203 however, the irs and the courts have not explicitly extended this rule to noncommercial, but commercial gallery-supported, art exhibitions. and while private letter ruling 9407006 significantly blurred the distinction between the commercial and noncommercial exhibition of art, it did not erase them entirely. in stating that “[t]here is no requirement that an [art] exhibition be of a commercial nature or that a sale must accompany an exhibition for the exhibition to result in private benefit,” it implicitly acknowledged that some—but not all—art exhibitions are commercial. therefore, even though a nonprofit art organization may not directly engage in art sales at a gallerysupported art exhibition, the commercial nature of such exhibition remains an important determination relevant to exempt status, especially in light of the role that for-profit gallery sponsors play. generally, an exempt organization may engage in profit-seeking activities in furtherance of its exempt purpose, as long as the organization’s mission itself is not commercial, and its primary objective is not the production of profits. under the commerciality doctrine, however, an organization that conducts substantial activities in a commercial manner may be found to be engaged in nonexempt activity that risks its exempt status entirely. furthermore, although commercial activity will not endanger exemption if it is insubstantial, it may still be subject to the ubit. a clear, definitive test 199 p.l.r. 2013–14–047 (jan. 10, 2013) (denying exemption to an organization where one of its four directors owned a for-profit and such director made significant decisions about the operations of the organization). 200 p.l.r. 2014–36–050 (june 12, 2014). 201 p.l.r. 2010–07–072 (sept. 24, 2009). 202 altmann v. republic of austria, 142 f. supp. 2d 1187, 1205 (c.d. cal. 2011). 203 see supra notes 162–67. but see aid to artisans, inc. v. comm’r, 71 t.c. 202 (t.c. 1978) (finding that an organization that engaged in activities similar to those of a commercial import firm – the purchase, import, and sale of handicrafts – was nonetheless operated exclusively for exempt purposes because those activities were carried out exclusively to accomplish the exempt purpose of helping disadvantaged artisans); p.l.r. 9141053 (jul. 19, 1991) (finding that the sale of consigned art by disabled artists as well as the sale of donated art by nondisabled artists is in furtherance of an exempt purpose and not subject to ubit, where all proceeds supported operations); p.l.r. 8634001 (aug. 13, 1986) (finding rental and sale of art in furtherance of an exempt purpose and not subject to ubit). 2017] gallery-supported art exhibitions 103 for determining the commercial nature of an activity has not developed under the commerciality doctrine.204 an activity may be commercial in nature if it is conducted in the same manner as is the case in the realm of for-profit organizations.205 competition, profitability, and an otherwise “commercial hue” are all evidence that an activities’ manner of conduct are too for-profit like. with respect to profitability, gallery donations primarily cover exhibition costs, and a straightforward summation of a museum’s ticket sales revenue from a gallerysupported art exhibition would likely show minimal net earned income, if any. 206 however, considering the gain that galleries expect to obtain for their artists in exchange for their donations, it seems that gallery donations are payment for a services and therefore would be most appropriately categorized as earned income, like ticket sales. this classification of gallery contributions as profit seems especially appropriate when an art organization professes that it would still be conducting the same exhibition in the absence of gallery donations; if the organization conducts the same activities and brings in the same revenue only at a lower cost due to galleries’ donations, the difference results in a greater profit. 207 this fact significantly distinguishes gallery-supported art exhibitions from other exhibitions at nonprofit art organizations, such that the former results in greater profitability than the latter. commercial hue is the extent to which a nonprofit organization’s activities are largely animated by a commercial purpose and directed fundamentally to ends other than exempt purposes.208 a definite meaning of commercial hue is missing from the tax framework, inviting subjective assessment of art exhibitions and whether their quality renders them commercial.209 in addition, application of the commercial hue factor to art is further complicated by the dual nature of art as both a commodity and something more than a market good, such that art is simultaneously both commercial and anti-commercial in character.210 while these conceptual challenges are valid in broad strokes, it may nonetheless be possible to discern meaningful marginal variation in the commercial hue of gallery-supported art exhibitions when compared against non-gallery-supported art 204 indeed, the commerciality doctrine suffers same definitional problems as private benefit, and has a potentially limitless application as the bounds of what is commercial and noncommercial blur in today’s economy of social enterprise, triple bottom lines, and the creative industry. 205 living faith, inc. v. comm’r, 950 f.2d 371 (1991) (finding that competition with commercial firms is a strong suggestion that a substantial nonexempt purpose exists; evidence of such competition may include setting market (rather than below-cost) prices, locating near similar for-profit enterprises, investing in promotional advertising, and reaping profits). 206 mike boehm, report shows art museums rely mainly on kindness, not commerce, l.a. times, jan. 9, 2015, http://www.latimes.com/entertainment/arts/culture/la-et-cm-art-museums-financial-surveygetty-lacma-eli-broad-hammer-aamd-20150108-story.html (reporting that art museums’ earned income from ticket sales and concessions cover only 15% of average art museum expenses) [perma.cc/vw66-at7m]. 207 john d. colombo, in search of private benefit, 58 fla. l. rev. 1063, 1087 (2006) (arguing that the private benefit doctrine does not apply to a tax-exempt organization’s day-to-day services but may apply to its “core services” central to its mission). see also brian frye, arts funding & “private benefit,” nonprofit law prof blog (2016), http://lawprofessors.typepad.com/nonprofit/2016/05/arts-fundingprivate-benefit.html. 208 better business bureau of washington, d.c., inc. v. united states, 279 u.s. 279, 326 (1945). 209 jessica pena & alexander l.t. reid, a call for reform of the operational test for unrelated commercial activity in charities, 76 n.y.u. l. rev. 1855, 1877 (dec. 2001). 210 an exception is nearly unsellable work, like the land art of christo and jeanne-claude or robert smithson; however, even unsellable art may be sold in the form of derivative works, such as the artist’s study sketches or photographs of the work. 104 columbia journal of tax law [vol.9:67 exhibitions. reports of gallery-supported art exhibitions locate them at large, corporatized art organizations. while commercial hue does not mean that art organizations must not professionally operate or provide their goods and services free of charge, 211 such institutions are often the same institutions with greatest power to legitimize–and therefore increase the commercial value of–art.212 gallery-supported art exhibitions are not taking place at smaller, unknown nonprofit art organizations, even though these institutions seem as if they would be most in need of sponsorship in light of their commensurately smaller budgets and collections. this distribution of gallerysupported art exhibitions seems indicative of their commercial hue, with the function of such nonprofit art organizations and galleries thus converging as commercial. the final factor indicative of commerciality considers the existence of competition among for-profit counterparts to the exempt organization’s activity. an activity is commercial in nature if it has a direct counterpart in for-profit organizations. evidence of competition with such counterparts may include setting market (rather than below-cost) prices, locating near similar for-profit enterprises, investing in promotional advertising, or otherwise conducting operations in a manner similar to that of analogous commercial entities. reaping profits is also evidence of competitive commercial operations.213 art exhibitions’ below market prices to view art (for the price of only an admission ticket) generally undermines a finding of competitiveness that is indicative of commerciality. whether they are collecting or non-collecting institutions, museums and other nonprofit art organizations are contextualizing institutions in theory that are a part of the discourse setting infrastructure of the art industry. the value they deliver to the public is the opportunity to see artworks in context, an activity that would be prohibitively expensive for most people if only for the curating and art shipping costs, let alone the cost of, and access to, the artworks themselves. indeed, in the commercial market, generally there may be no way to view an artwork after it is sold into a collection, in light of the strong norm disfavoring resale and the lack of public information about the location and owners of artworks. in effect, but for nonprofit art organizations’ efforts in curating and coordinating exhibitions, art would be largely inaccessible and unaffordable to the public. a museum admission ticket enables viewing of many artworks for a fraction of what it would cost to own artworks as a private collector. the for-profit private collector counterpart analogy breaks down, however, if the artworks are for sale.214 even when nonprofit art organizations are not directly selling a work, simply hosting an exhibition can lead to sales. every artwork loan is potentially a sale and can lead to establishing a consignment relationship with the lending collector. also, exhibitions help galleries cultivate relationships with artists or estates that galleries 211 plumstead theatre soc., inc. v. comm’r, 74 t.c. 1324 (1980), aff'd 675 f.2d 244 (9th cir. 1982). 212 graw, supra note 2, at 92 (stating that the greater the success in “preserving art’s reputation as . . . more than objects of speculation – which they really are—the greater the positive impact on [the] business” of selling art”). 213 living faith, inc., 950 f.2d at 373; b.s.w. group, inc. v. comm’r, 70 t.c. 352, 359 (1978). 214 museums are generally prevented from selling their collections on account of strict deaccessioning policies and norms. however, artworks that are loaned to a museum by a gallery or a collector are not bound by such museum policies. 2017] gallery-supported art exhibitions 105 hope to ultimately represent.215 while this is the case in any exhibition facilitated, even if not financially supported, by a gallery, it is even truer when the gallery sponsoring the exhibition has negotiated for advertising credits and other sponsorship rights that help them make sales. in this sense, gallery-supported art exhibitions that take place at art museums are the functional equivalents of temporary, for-profit pop-up galleries, with the gallery’s donation to the art museum best understood as rent for the period of the pop-up rather than a gratuitous gift. in this case, the applicable counterpart to a nonprofit art organization is not a private collector but rather a gallery,216 which exhibits works at no cost to the viewing public to solicit sales. as an increasing number of galleries are hosting “museum quality gallery shows,” this alternative analogy becomes even more appropriate. the remaining factors used in evaluating the presence of competition, and thus commerciality, weigh against the exempt status of nonprofit art organizations. nonprofit art organizations undertake significant advertising of gallery-supported museum exhibitions–typically paid for by the gallery itself as a condition of its sponsorship. many of the museums hosting gallery-supported art exhibitions are also located near forprofit galleries; even if the exhibitions travel, they often go to museums in cities with significant numbers of commercial galleries and not remote locations lacking in the availability of commercially or non-commercially exhibited artwork. for example, the ©murakami exhibition traveled from moca to the brooklyn museum of art in new york; the museum für moderne kunst in frankfurt; and lastly the guggenheim museum bilbao, spain. each such city is a significant art center with some of the highest concentrations of galleries in their respective markets. all three aspects that assess competition plausibly support that nonprofit art organizations hosting gallery-supported art exhibitions do so in a commercial manner that competes with other for-profit galleries–specifically, other for-profit galleries that do not have the benefit of the hosting tax-exempt exhibitions. in addition, the factors evaluating a gallery-supported art exhibition’s profitability and commercial hue are also indicative of commerciality. while no precedent directly supports a definitive finding that forprofit gallery sponsorship of nonprofit art museum exhibitions is commercial, it is not a question that the irs or courts have precisely considered to date. in a relevant decision, however, the irs has concluded that sales and exhibition activity conducted by a volunteer committee of a nonprofit art museum is unrelated to an art museum’s exempt purpose.217 215 sheets, supra note 73. 216 that private collections are ultimately donated to the collections of existing public museums or to the collections of newly established private operating foundation museums is of no consequence to the analogy. 217 in private letter ruling 80–40–014, the irs considered whether insubstantial art sales and rental activities conducted at a nonprofit art museum jeopardized the museum’s exempt status. the women’s committee of the museum operated a gallery, which presented four shows each year, generating gross income constituting less than four percent of the museum’s gross income for the year in question. all such income from the operation of the gallery was used exclusively for the benefit of the museum. the irs found that the gallery’s activities served the private interest of artists, rejecting the museum’s contention that the gallery’s operation substantially related to the museum’s exempt purpose. because the gallery’s activities were insubstantial in comparison to the museum’s primary activities, however, the irs concluded the museum was still operated exclusively for exempt purposes. p.l.r. 80–40–014 (july 9, 1980). 106 columbia journal of tax law [vol.9:67 even if gallery-supported art exhibitions are commercial, they may not necessarily undermine exempt status entirely, provided that they are insubstantial in nature. instead, insubstantial commercial activities are subject to the ubit as previously discussed. one irs decision suggested that insubstantial gallery sales and rental activities conducted at a nonprofit art museum did not jeopardize the museum’s exempt status, but potentially could be subject to the ubit as a separate revenue stream under the fragmentation rule.218 alternatively, it is conceivable that gallery donations provided to a museum in support of an exhibition of its artists might be considered unrelated business income as a “substantial return benefit,” if a gallery’s sponsorship was not considered to be a “qualified sponsorship payment,” which does not generate unrelated business income.219 “qualified sponsorship payments” are excluded from the unrelated business income of exempt organizations when there is no arrangement or expectation that the payor of the sponsorship will receive a “substantial return benefit” for the payment, other than the use or acknowledgement of the name or logo (or product lines) of the payor’s trade or business in connection with the tax-exempt organization’s activities.220 the benefits enumerated by the irs in its interpretive guidance that might constitute a “substantial return benefit” are comprehensive in scope: among others, advertising, intellectual property rights, goods, services and “other privileges.”221 while the irs has applied these rules to art museums and other arts organizations in illustrative examples included in its binding interpretive guidance,222 these enumerated benefits have not been interpreted to capture the significant benefits that galleries receive from an exhibition it sponsors at an art museum. specifically, the irs has overlooked benefits to galleries from exhibitions they sponsor at museums including: the space in which the exhibition takes place; the costs of installing the exhibition; the curatorial services of the staff in arranging the exhibition; the connections to potential purchasers of an artist’s works that would otherwise be facilitated by art consultants in private art transactions; and the most valuable benefit of all, the appreciation in value of an artist’s works, both those shown in the exhibition or others in the artist’s oeuvre. especially when gallery-sponsored exhibitions take place at major art museums, such appreciation can be significant, resulting from an artwork’s more varied provenance as a result of appearing in the show, and the increased esteem of the artist due to his or her appearance of the exhibition and its inclusion an additional line on the artists’ curriculum vitae. establishing the exhibition as the cause of such appreciation could be accomplished by using the expertise of art valuation experts before and after an exhibition. to date, however, this appreciation has not been measured or otherwise considered to constitute an “other privilege” to the sponsoring gallery under the 218 id. 219 i.r.c. § 513(i)(1). a “substantial return payment” is any benefit other than (a) goods, services or other benefits of insubstantial benefits that are disregarded under treas. reg. § 1.1513–4(c)(2)(ii) or (b) a use or acknowledgement described in treas. reg. § 1.1513–4(c)(2)(iv). treas. reg. § 1.513–4(c)(2)(i). 220 i.r.c. § 513(i)(2)(a). 221 benefits may include advertising, an exclusive provider arrangement, certain goods, facilities, services or other privileges, and an exclusive or nonexclusive right to use an intangible asset (e.g., trademark, patent, logo, or designation) of the exempt organization. treas. reg. § 1.1513-4(c)(2)(iii). 222 treas. reg. 1.513-4(c)(2)(iii), illustration n (describing how a dinner provided to sponsors of an art exhibition would be considered a substantial return benefit); treas. reg. § 1.1513-4(f), illustration t (describing how a symphony orchestra’s promotion of a sponsor’s business in the symphony’s program guide and complimentary tickets to a symphony show are substantial benefits). 2017] gallery-supported art exhibitions 107 “substantial return benefit” rules. because appreciation, if any, benefitting a sponsoring gallery is not considered to be a “substantial return benefit,” the result is that the amount of the gallery donation that is taxable to the art museum as unrelated business income is reduced or entirely eliminated. in any case, whether gallery-supported art exhibitions generate unrelated business income or not is unlikely to have a significant deterrence effect upon their continuation. even if profit were defined expansively to include not only gallery donations but also admission ticket revenues and even grants received because of successful attendance numbers at gallery-supported exhibitions, there likely would be little or no “profit” subject to the ubit. museums could deduct all business expenses and proportionate overhead directly attributable to the gallery-supported exhibition, leaving little revenue to tax. a review of recent museum unrelated business tax reporting on form 990-t confirms this outcome, 223 and there is little reason to think that characterizing gallery donations as additional unrelated business income would change the current practice. b. lack of self-discipline the art industry demonstrates a near total lack of industry self-discipline with respect to the permissibility of gallery-supported museum exhibitions. among the publicly available written guidelines reviewed, no self-regulatory museum association and, with rare exception, no individual museum specifically prohibits donations made by galleries, as a general matter or specifically with respect to underwriting the direct costs of an exhibition. gallery-supported art exhibitions are thus largely permissible under individual museum and other industry association guidelines. even if museums or the art industry adopted such guidelines, the absence of meaningful enforcement mechanisms fail to provide confidence that museums would observe them. for example, following the aamd’s 2014 sanction of the delaware art museum for its deaccession of several artworks, the delaware art museum nonetheless collaborated with an aamd-member – the director of the smithsonian american art museum no less. 224 even if aamd members honor sanctions, they may not be sufficiently severe to deter violations, such as in the case of the two-year sanction for the national academy museum.225 c. cooperation is currently the only option the art industry demonstrates self-awareness of the potential for conflict that gallery-supported museum exhibitions present. for example, the whitney museum of american art did not allow robert morris to arbitrage art with the museum’s funds and his insider knowledge–even for the museum’s benefit and not his own–as proposed for 223 see, e.g., art institute of chicago, form 990-t, exempt organization business income tax return (2015). 224 our america: the latino presence in american art, del. art museum, http://www.delart.org/exhibits/our-america-the-latino-presence-in-american-art/ [perma.cc/vjq4-gldw] (last visited jul 23, 2016); members, ass’n of art musuem directors, https://aamd.org/ourmembers/members [perma.cc/yre2-r9gb] (last visited july 23, 2016). 225 national academy museum, national academy on the suspension of sanctions by aamd (oct. 18, 2010), http://www.nationalacademy.org/wp-content/uploads/2012/08/national-academyon-suspension-of-sanctions-by-aamd.pdf [perma.cc/s87p-snh2] (last visited july 23, 2016); carolina miranda, museums behaving badly: are sanctions too little, too late?, l.a. times (june 21, 2014), http://www.latimes.com/entertainment/arts/miranda/la-et-cam-museums-behaving-20140619-column.html [perma.cc/mu43-hmhs]. 108 columbia journal of tax law [vol.9:67 his piece money (1969).226 just two years later, however, the art world demonstrated that the “market casts a long shadow reaching into the economy-free zone of the public museum” with hans haacke’s shapolsky et al. manhattan real estate holdings, a real time social system, as of may 1, 1971 (1971).227 the artwork was 142 photographs of the properties owned by a well-known new york slumlord, and was to be presented at the guggenheim until its exhibition was cancelled in light of the show’s political and economic overtones. more recently, the subject of several artworks has critically addressed hybrid, conflicting roles within the art industry. andrea fraser’s performance art pieces official welcome (2001) and untitled (2003) have juxtaposed the characters of critic, artist, curator, and collector, and bill powhida’s aforementioned work how the new museum committed suicide with banality (2009) directly addressed one museumrelated dealer’s relationship to new museum-exhibited artists. however, norms have not yet evolved to set limits on gallery-supported art exhibitions. this persistence is at least partially attributable to the art industry norms discussed in part iii that do not frown upon, and even encourage, cooperation of the sort that would be considered questionable in other contexts. in addition, no other option exists in the art market’s current configuration but close cooperation. museums have always had to work with galleries to present complete exhibitions that entailed borrowing works from private collector’s collections. art transactions are not public knowledge, and therefore museums must rely upon galleries in order to identify collectors and coordinate artwork loans. closer cooperation has occurred as nonprofit art organizations have turned to galleries for financial support as well, in light of the declines in government grants, private donations from individuals, and corporate sponsors. not presenting high profile exhibitions that require significant artwork loans and financial resources has not seemed to be a viable option either, as these productions maintain the cultural legitimacy that give museums the power to execute their function in the first place. existing legal standards have not yet been applied to current market practices to directly confront for-profit galleries’ funding of exhibitions presented by nonprofit art museums. industry self-regulation also has not evolved to address gallery-supported art exhibitions. the result further exacerbates an already limited number of genuinely noncommercial art exhibition spaces that can show art free from market pressures.228 accordingly, any attempt to restrict gallery-supported art exhibitions must address the ultimate causes of the practice itself as well as industry norms. regulation that is insensitive to context is likely to be ill-suited and distorting in the best case and ignored and ineffective in the worst case. v. recommendations and conclusion analysis of the laws, self-regulatory guidance, and industry norms reveals that there are a number of possible responses to address the problem of gallery-supported museum exhibitions. 226 graw, supra note 2, at 211. 227 id. at 202. 228 but see pogrebin, supra note 65 (describing the proliferation of temporary noncommercial artist spaces in artists’ homes). 2017] gallery-supported art exhibitions 109 a. structural changes to the institutional and regulatory framework at one end of the spectrum is structural overhaul of the existing regime to address the causes that lead museums to seek galleries’ financial support. at its most extreme, such response might entail direct public funding for the arts—a highly improbable proposal in light of a recent proposal to eliminate the national endowment for the arts. 229 alternatively, structural change within the facilitation model for supporting the arts that the united states currently uses might look like relaxation of rules that would permit greater indirect funding to artists. for example, the irs could reverse its current position that nonprofit galleries’ compensation of artists for their artworks do not constitute private benefit but rather reasonable compensation. this reversal would be consistent with the position of the irs that other contexts, such as nonprofit health care or higher education, do not require service providers (in each example, physicians and professors) to work for free. the narrowest structural response would target the art industry with special rules within tax law–for example, establishing better, objective standards for the irs to evaluate the process by which nonprofit art organizations select programming. unless such standards were carefully crafted to focus solely on curatorial methods, one drawback of this approach might be that it all but compels the irs to judge the merits of artwork, which has proven problematic in other areas of law, such as copyright. 230 this response also might create further doctrinal chaos in the already muddled areas of private benefit and commerciality, so modifying or augmenting the law in this way may be undesirable. effective structural reform addressing gallery-sponsored art exhibitions should also comprehensively contemplate the panoply of problematic practices–in the art world and beyond–that raise the same or similar issues in order to foster a cohesive regulatory scheme. these practices include sponsorship of museum programming by artists or private collectors of artworks, such as when kakai kiki, the artist collective-slash-gallery started by murakami, sponsored an exhibit of one of its own artists,231 or when the private collectors who owned alexander calder’s famous flying fish mobile sponsored its exhibition only a few years before its record-shattering auction at christie’s for nearly $26 million.232 examination of the role of for-profit sponsorship at nonprofits may even extend to programming outside of art museums, like a hypothetical “finding nemo day” sponsored by disney at a nonprofit public aquarium or paid product placement in television programs and movies. similar to the fact-driven approach taken in this article, each of these context demands careful scrutiny before blanket curtailment. as professor 229 eileen kinsella, donald trump’s newly released 2018 budget calls for eliminating the nea, artnet news (may 23, 2017), https://news.artnet.com/art-world/trump-budget-proposes-steep-cuts-to-artsfunding-969641 [https://perma.cc/cxt9-mku2]. 230 see bleistein v. donaldson lithographing company, 188 u.s. 239 (1903); see generally christopher j. robinson, the "recognized stature" standard in the visual artists rights act, 68 fordham l. rev. 1935 (2000). 231 seattle art museum, past exhibitions, http://www.seattleartmuseum.org/exhibitions/liveon [https://perma.cc/dh3a-eldq] (last visited nov. 10, 2017); kaikai kiki co., ltd., artists: mr., http://english.kaikaikiki.co.jp/artists/list/c7/ [https://perma.cc/3yra-bjgg] (last visited nov. 10, 2017). 232 juan perez, jr., art collection by chicago couple fetches millions at auction, chi. tribune (may 14, 2014), http://articles.chicagotribune.com/2014-05-14/news/chi-art-collection-by-chicago-couple-fetchesmillions-at-auction-20140514_1_art-collection-art-institute-wayne-thiebaud [https://perma.cc/u7qr-lff9]; museum of contemporary art chicago, past exhibitions: alexander calder and contemporary art: form, balance, joy, https://mcachicago.org/exhibitions/2010/alexander-calder-and-contemporary-artform-balance-joy [https://perma.cc/pm8k-3r7m] (last visited nov. 10, 2017). 110 columbia journal of tax law [vol.9:67 zahr said points out in her article, embedded advertising and the venture consumer, this is because sponsorship can have positive effects in certain circumstances, such as when consumers are educated, empowered, and discerning; when product placement improves allocation of costs and risks; and when the additional cash flow provided by “embedded advertising” improves programming quality.233 these circumstances ultimately do not translate, however, to the realm of gallery-sponsored art exhibitions at museums; at the very least, programming quality is highly subjective and promoting art is an educational activity, and therefore the target “consumer” museum patron is by definition uneducated. however needed structural reform addressing gallery-sponsored art exhibitions at museums may be, any structural change requires proactive policy introductions that are unlikely to take place in the current stalemate political climate. b. eliminating and expanding gallery-supported art exhibitions within the existing framework, the challenges most likely to be successful in curbing certain gallery-supported art exhibitions are that they constitute a joint venture in which galleries possess too great of control, therefore obtaining impermissible private benefit; that the preferential consideration for exhibitions, the sponsorship rights they grant to galleries, or both are also impermissible private benefit; or that the gallerysupported art exhibitions are substantial commercial activities that do not further an exempt purpose. the effect of these determinations would likely put an end to museum demand for galleries’ generosity, as it is unlikely that a museum would throw away its valuable exempt status in exchange for any gallery’s financial support. eliminating gallery-supported art exhibitions at some nonprofit art organizations would not necessarily eliminate such exhibitions entirely. similar forms of such exhibitions might continue to take place at galleries, while the profile of some nonprofit art organizations would diverge therefrom–making space for truly non-and anticommercial exhibitions of art to take place. for the cities that do not have galleries that host museum-quality gallery shows or the smaller-scale museums that do not currently attract gallery-sponsored art exhibitions, there still may be a case for galleries to work with museums to present these shows. in fact, perhaps somewhat counterintuitively, the charitable purpose of promoting art may be better served by encouraging more gallerysponsored exhibitions to take place in such locations. doing so could channel more funding for higher quality exhibitions to venues that currently suffer from lower quality programming from lack of financial support. another possible outcome is that curbing gallery-sponsored art exhibitions in certain circumstances might drive demand for alternative art spaces. to the extent such spaces don’t exist yet, they may crop up to the delight of cities that are currently vying to establish and attract art venues. for example, dealers interested in displaying their artists’ work but that are unable to do so at a museum might invest in infrastructure to do so. these outcomes are consistent with the incentives of federal tax law that seek to promote art through wide dissemination to markets that are otherwise without access. while ending gallery-supported exhibitions at nonprofit art organizations would represent short-term progress toward the conscious boundary setting for which professor isabelle graw advocates, this solution ultimately does nothing to address the trifold structural causes ultimately driving the need for a boundary. museums’ lack of funding compels them to seek donations from galleries in the first place. secondly, museums lack 233 see zahr said, embedded advertising and the venture consumer, 89 n.c. l. rev. 99 (2010). 2017] gallery-supported art exhibitions 111 independent access to the critical information exclusively possessed by galleries about culturally important artworks. even the most extensive permanent museum collections do not contain all the necessary artworks to present a complete thematic exhibition, and therefore museums are unable to produce complete exhibitions without borrowing works from collectors. galleries fiercely protect this private and proprietary information about their clients, so it is not public information that museums can obtain without a dealer’s assistance. third, the incredibly high prices and market imperialism as of late across all art world institutions compel museums to engage with the market in order to maintain their industry relevance. museums need to resolve their identity crisis and establish their place in relation to the art market in order to curtail their dependence upon it. c. increased disclosure about gallery-sponsored art exhibitions currently form 990 annual informational returns filed by museums do not disclose the identities of donors. also, there does not seem to be self-regulatory organization guidance requiring that museums post disclosures about the sponsors of exhibits. increased disclosure could put museum patrons on notice that the artworks they are viewing may be on display for reasons including those unrelated to their merit. nonetheless, such disclosures are unlikely to be effective in addressing the issues raised by gallery-supported art exhibitions. the issue is not so much disclosure as it is the very fact that sponsored exhibitions are occurring and potentially crowding out others of equal or greater merit but with fewer financial resources to pay-to-play. therefore, more disclosure is not a responsive reform. even if disclosure was nonetheless part of a solution for addressing gallerysponsored museum exhibitions, its efficacy depends upon its location and audience. the form 990 informational return is not an effective place to disclose sponsorship; museum patrons are unlikely to dig up nonprofit art museums’ tax returns to identify sponsored exhibits a year after they visit a museum when the museum’s tax returns are filed and become public. disclosures juxtaposed with artworks at a gallery-sponsored art exhibition may present yet other limitations. absent is a “shareholder” base to scrutinize informational returns in the same way that securities disclosures are analyzed by public capital markets, and enforcement of nonprofit laws is lax in light of primary responsibility falling upon state attorney generals and an underfunded federal agency. further disclosure drawbacks may be the same as those identified in professor zahr said’s embedded advertising and the venture consumer, including burdening the museum patron’s “immersion interest” and whether or not the consumer even cares.234 (however, beyond the ways in which embedded advertising in television and movies was distinguished from gallery-supported art exhibitions in the foregoing section, what is at stake in museums–cultural production and preservation–may be greater than television and movies. among other distinctions, even if the artistic endeavors embodied in television and movies also contribute to culture, television and movies may not share the same cultural function as museums beyond their entertainment function.) counterintuitively, mandating disclosure might even increase the benefit to sponsors as free advertising, at the same time that it decreases crayola donations to museums, who often use billing credit as a negotiation chip to increase gift size. there is research demonstrating that sponsors already desire credit for their “altruism” and treat donations as advertising (for example, professor vikramaditya khanna’s research 234 id. 112 columbia journal of tax law [vol.9:67 suggests that corporate social responsibility expenditure mandates may decrease advertising spending).235 * * * the art industry ultimately must reckon with the structural causes of gallerysupported art exhibitions in order to sustain the existence and integrity of art museums in the long-term. appropriate redress will necessarily be as complex as the cause, and there are no easy solutions. direct public funding for the arts is likely to take a back seat to other budget priorities in light of fiscal conservativism, a privatization imperative, and other reasons. promoting market transparency and efficient pricing for a more wellfunctioning art market are goals that already have significant support and therefore may resonate more broadly. however, the devil is in the details with respect to developing and implementing an appropriate art market regulatory apparatus. the effort required to do so would be worthwhile in light of the importance of museums, and art and culture more broadly, to our society. our society as a whole should care about museums, because they are where we express, understand, and negotiate our cultural identities and relevance to one another. we want institutions responsible for something as important as cultural preservation to be inclusive and protected from self-serving elitism that perpetuates cultural dominance. finally, addressing these structural issues provides an opportunity to reflect upon what it means to promote art responsibly, especially in an age of burgeoning cultural production, shrinking art organization budgets and programming, and increasingly inequitable access to art. how can we restructure the provision of resources and power to museums in light of financial stress upon art organizations more broadly, as well as wealth and social inequality in general? this is part of a broader conversation about access to publicly funded resources, and how to negotiate growing demands upon them from an increasingly diverse general public with varying needs, at the same time that such resources become more limited. what is public? what is private? what level of habitability do we want of our public cultural life, and how low can diversity in the arts go before promotion of arts instead becomes the reproduction of power and privilege?236 in light of the importance of art to culture and community cohesion, we want to answer this question proactively, and not let the market decide for us. 235 dhammika dharmapala & vikramaditya khanna, the impact of mandated corporate social responsibility: evidence from india’s companies act of 2013 4 (univ. of chicago pub. law & legal theory working papers, paper no. 601, 2017), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2862714 [https://perma.cc/93xm-3qzp] (analyzing findings of recently mandated corporate responsibility in india to suggest substitution between corporate social responsibility spending and advertising). 236 see holland cotter, making museums moral again, n. y. times (mar. 17, 2016), http://www.nytimes.com/2016/03/17/arts/design/making-museums-moral-again.html?_r=0 [perma.cc/r4v7ctmu] (arguing that museums should show more socially just art). microsoft word innovation or stagnation_print.docx enhancing efficiency at nonprofits with analysis and disclosure by david m. schizer1 abstract the u.s. nonprofit sector spends $2.54 trillion each year. if the sector were a country, it would have the eighth largest economy in the world, ahead of brazil, italy, canada, and russia. the government provides nonprofits with billions in tax subsidies, but instead of evaluating the quality of their work, it leaves this responsibility to nonprofit managers, boards, and donors. the best nonprofits are laboratories of innovation, but unfortunately some are stagnant backwaters, which waste money on out-of-date missions and inefficient programs. to promote more innovation and less stagnation, this article makes two contributions to the literature. first, this article breaks new ground in identifying sources of inefficiency at nonprofits. the literature focuses on incentives, arguing that managers and board members are less motivated to run a nonprofit efficiently because they cannot keep its profits. in response, this article emphasizes that the problem is not just motivation, but also information. measuring success is harder at nonprofits. instead of tracking profitability, they use metrics that are less reliable and harder to measure. these measurement challenges complicate the efforts even of dedicated and competent managers to operate efficiently. while this information problem is familiar, another has been largely overlooked in the literature: when success is hard to measure, incompetence and self-interested practices are less visible, and thus are harder to stop. for example, if managers regularly overpay vendors, the consequence at a for-profit firm (lower profits) is easier to observe than at a nonprofit (less effective service for beneficiaries). second, this article recommends a response to this underappreciated source of inefficiency: better analysis and disclosure as a strategy for organizational change. in principle, nonprofits are supposed to maximize social return, but how can they operationalize this abstract principle? to help them do so, this article recommends three questions that nonprofits should answer every year: first, how important are the challenges the nonprofit is trying to address?; second, how effective are the nonprofit’s responses to these challenges?; and third, is the nonprofit the right organization to respond to these challenges? these questions press nonprofit managers and boards to be more explicit about priorities, monitor progress, improve and expand high-value programs, and fix or shut down ineffective ones. this article also recommends that nonprofits should disclose this analysis to the public, even though current law does not require them to do so. this disclosure would empower donors and rating agencies to be more effective monitors. it also would help donors make better informed philanthropic choices and would enable charities to borrow innovative ideas from each other more easily. 1 dean emeritus & harvey r. miller professor of law, columbia law school. copyright 2020. david m. schizer. all rights reserved. from january 1, 2017 to december, 31, 2019, the author served as ceo of the american jewish joint distribution committee, an international humanitarian organization that cares for needy people in seventy countries across the globe. helpful comments on this article were received from akhil amar, tom brennan, jack coffee, elizabeth emens, alan feld, brian galle, zohar goshen, henry hansmann, louis kaplow, hyunkyu kim, michael knoll, kate judge, david pozen, alex raskolnikov, diane ring, chris sanchirico, meredith wolf schizer, steve shay, reed shuldiner, ted sims, andrew steinerman, colin stretch, eric talley, david walker, tim wu, and workshop participants at boston university law school, columbia law school, the tax economists forum, and the university of pennsylvania law school. 2020] enhancing efficiency at nonprofits with analysis and disclosure 77 table of contents introduction .................................................................................................................... 78 i. sources of inefficiency at nonprofits: incentives and information ...................................................................................................................... 81 a. flawed incentives as a source of inefficiency: the nondistribution constraint ............. 81 b. flawed information as a source of inefficiency: social return is hard to measure ....... 83 c. flawed information as a source of inefficiency: mismanagement is harder to detect ... 87 ii. which nonprofit stakeholders can monitor impact and costeffectiveness? .................................................................................................................. 92 a. the three i’s: incentives, influence, and information .................................................... 92 b. government regulators ................................................................................................. 92 c. beneficiaries ................................................................................................................. 97 d. boards of directors ....................................................................................................... 98 e. donors ........................................................................................................................ 101 f. rating agencies .......................................................................................................... 107 iii. countering inefficiency with a rigorous planning process .......... 110 a. three questions .......................................................................................................... 110 b. benefits of preparing a program analysis.................................................................... 118 c. costs of preparing a program analysis ........................................................................ 120 iv. countering inefficiency with better disclosure ................................ 121 a. three benefits from disclosing a program analysis ................................................... 121 b. costs of disclosing a program analysis ...................................................................... 124 c. program analyses for for-profit firms ........................................................................ 127 v. should disclosure of a program analysis be voluntary or mandatory?..................................................................................................................... 128 a. reports shared privately with specific donors ............................................................ 128 b. public disclosure shared voluntarily .......................................................................... 129 c. rationales for mandatory disclosure ........................................................................... 130 d. concerns about mandatory disclosure ....................................................................... 131 vi. conclusion ............................................................................................................... 134 [vol. 11.2 columbia journal of tax law 78 introduction the u.s. nonprofit sector spends $2.54 trillion each year.2 if the sector were a country, it would have the eighth largest economy in the world, ahead of brazil, italy, canada, and russia.3 the government provides nonprofits with billions in tax subsidies,4 but instead of evaluating the quality of their work, it leaves this responsibility to nonprofit managers, boards, and donors.5 the best nonprofits are laboratories of innovation, which develop new ways to aid vulnerable populations, strengthen communities, advance frontiers of knowledge, and much more. but unfortunately, some nonprofits are stagnant backwaters, which waste money on out-of-date missions and inefficient programs. to promote more innovation and less stagnation, this article makes two contributions to the literature.6 first, this article breaks new ground in identifying sources of inefficiency at nonprofits. the literature focuses on incentives, arguing that managers and board members are less motivated to run a nonprofit efficiently because they cannot keep its profits.7 in response, this article emphasizes that the problem is not just motivation, but also information. measuring 2 brice mckeever, the nonprofit sector in brief 2018, https://nccs.urban.org/publication/nonprofit-sector-brief2018#the-nonprofit-sector-in-brief-2018-public-charites-giving-and-volunteering [https://perma.cc/utf6-vskv] (nonprofits filing form 990 reported $2.54 trillion of revenue in 2015). 3 see gdp by country, https://www.worldometers.info/gdp/gdp-by-country/ [https://perma.cc/9kcq-6rdm]. 4 the two relevant tax rules are the deduction for charitable contributions, see i.r.c. §170, and the exemption of a nonprofit’s income from tax, see i.r.c. §501(a). all references to sections are to the internal revenue code of 1986, as amended. according to the treasury department’s 2020 estimate, the charitable deduction cost the treasury $57.69 billion in 2020. u.s. dep’t of treasury, office of tax analysis, tax expenditures 24, 25, 31 (feb. 26, 2020), https://home.treasury.gov/system/files/131/tax-expenditures-2021.pdf [https://perma.cc/b8wc-wfze] ($4.45 billion from charitable contributions to education from individuals and $600 million from corporations; $8.08 billion to hospitals from individuals and $3.81 billion from corporations; $39.54 billion to other charities from individuals and $1.21 billion from corporations). the treasury does not estimate the revenue loss from the exemption. when a tax rule is called a “subsidy,” the tax burden differs from what it otherwise would be under a “regular” regime. this article assumes that the baseline is an income tax and that taxpayers otherwise would pay tax on resources they give away. see david m. schizer, charitable subsidies and nonprofit governance: comparing the charitable deduction with the exemption for endowment income, 71 tax l. rev. 665, 668 n.5 (2018) [hereinafter “comparing the deduction with the exemption”]. 5 see schizer, comparing the deduction with the exemption, supra note 4, at 677-82 (noting that exclusion and deduction delegate monitoring to board, donors, and other private parties). 6 this article focuses on charitable organizations under i.r.c. §501(c)(3), rather than on other nonprofits, such as advocacy groups, trade associations, and social clubs. the article focuses on public charities, but also discusses private foundations. the main difference is that public charities have many more donors. see i.r.c. §509(a) (defining private foundation). public charities “are the organizations people usually think of when they hear the word charity,” while private foundations are usually “established with funds from a single source . . ., such as family or corporate money.” suzanne coffman, just what are public charities and private foundations, anyway?, sept. 1, 2001, https://trust.guidestar.org/just-what-are-public-charities-and-private-foundations-anyway [https://perma.cc/e27u-p96w]. 7 henry hansmann, the role of nonprofit enterprise, 89 yale l. j. 835,844 (1980) (“of course, one would expect that when the profit motive is eliminated a price is paid in terms of incentives.”) [hereinafter “nonprofit enterprise”]; burton a. weisbrod, the nonprofit economy 23 (1988) (“nonprofit managers may also have less incentive to be efficient, since efficiency cannot lawfully be rewarded.”) [hereinafter “nonprofit economy”]; dennis r. young, if not for profit, for what? 130 (1983) (“a commonly held view is that nonprofits maintain quality but produce services in a relatively wasteful fashion”); id. at 129 (attributing this “sluggishness” to lack of profit motive and capital constraints). 2020] enhancing efficiency at nonprofits with analysis and disclosure 79 success is more difficult at nonprofits. instead of tracking profitability, nonprofits depend on metrics that are harder to measure and less reliable.8 these measurement challenges complicate the efforts of even dedicated and competent managers to operate efficiently.9 while this information problem is familiar,10 another has been largely overlooked in the literature: when success is hard to measure, incompetence and self-interested practices are less visible, and thus are harder to stop. for example, if managers regularly overpay vendors, the consequence at a forprofit firm (lower profits) is easier to observe than at a nonprofit (less effective service for beneficiaries).11 second, this article recommends a response to this underappreciated source of inefficiency: better analysis and disclosure as a strategy for organizational change. in principle, 8 see, e.g., mary kay gugerty & dean karlan, the goldilocks challenge viii (2018) (“the trend to measure impact has brought with it a proliferation of poor methods of doing so, resulting in organizations wasting huge amounts of money on ‘bad impact evaluations’”); burton a. weisbrod, an agenda for quantitative evaluation of the nonprofit sector, in measuring the impact of the nonprofit sector (patrick flynn & virginia a. hodgkinson ed.) 274 (2001) [hereinafter “measuring impact”] (“if measuring the nonprofit sector’s benefits and costs, advantages and disadvantages is not done well, it will likely lead to erroneous decisions. done well, it will likely be expensive and time consuming.”) [hereinafter “quantitative evaluation”]. 9 see, e.g., raj kumar, the business of changing the world 59-60 (2019) (calling “a set of standard universal metrics that would allow us to make true apples to apples comparisons between different kinds of organizations” the “holy grail” because [w]e’re not going to find it”); michael m. weinstein & ralph m. bradburd, the robin hood rules for smart giving 14 (2013) (evidence of a program’s impact “can be incomplete, imprecise, and sometimes downright atrocious.”). 10 in the literature, information problems are invoked not only to show the difficulties faced by even the best nonprofits in measuring impact, see supra note 8 & 9, but also in justifying the use of the nonprofit form. see, e.g., hansmann, nonprofit enterprise, supra note 7, at 843-44 (“yet occasionally . . . consumers may be incapable of accurately evaluating the goods promised or delivered. . . . in situations of this type, consumers might be considerably better off if they deal with nonprofit producers” since nonprofits “lac[k] the incentive to [raise prices or cut quality] because those in charge are barred from taking home any resulting profits”). 11 a few commentators have considered how information problems complicate efforts to monitor nonprofit managers, but have deemed these problems to be either less important than the incentive problems emphasized in the literature or a consequence of them. see geoffrey a. manne, agency costs and the oversight of charitable organizations, 1999 wisc. l. rev. 227, 227, 268 (1999) (noting that “charitable goals are ambiguous, or, at least, difficult to quantify” and “there is no easy mechanism by which to monitor the efficacy of the nonprofit’s activities,” but still referring to “the absence of residual claimants” as “the primary problem inherent in the nonprofit form”); aseem prakash & mary kay gugerty, trust but verify? voluntary regulation programs in the nonprofit sector, 4 regulation & governance 22, 25-26 (2010) (observing that information asymmetries are “particularly acute” at nonprofits and offering incentive-based explanations, including the lack of “residual claimants with private incentives to monitor,” as well as “the absence of a merger and acquisitions market in the nonprofit sector [which] further reduces incentives”). george triantis has also observed that information asymmetry can exacerbate nonprofit agency costs, but in a somewhat different context. in analyzing when for-profit and nonprofit firms should segregate assets (e.g., with separate entities, security interests, or restricted donations), triantis argues that asset segregation can limit agency costs, but at the cost of keeping managers from responding to new information. triantis considers this tradeoff to be especially stark at nonprofits: on the one hand, managers have a greater need to reallocate resources, since they face greater challenges in demonstrating the value of charitable opportunities to outsiders; on the other hand, these same challenges exacerbate agency costs. george g. triantis, organizations as internal capital markets: the legal boundaries of firms, collateral, and trusts in commercial and charitable enterprises, 117 harv. l. rev. 1102, 1147 (2004) (“information asymmetry is a greater obstacle to external finance in the charitable sector than it is in the commercial sector,” but information asymmetry “also makes agency costs less tractable”). [vol. 11.2 columbia journal of tax law 80 nonprofits are supposed to maximize social return, but how can they operationalize this abstract principle? to help them do so, this article recommends three questions that nonprofits should answer every year: first, how important are the challenges the nonprofit is trying to address?; second, how effective are the nonprofit’s responses to these challenges?; and third, is the nonprofit the right organization to respond to these challenges? these questions press nonprofit managers and boards to be more explicit about priorities, monitor progress, improve and expand high-value programs, and fix or shut down ineffective ones. this article also recommends that nonprofits should disclose this analysis to the public, even though current law does not require them to do so. this disclosure empowers donors and rating agencies to be more effective monitors. it also helps donors make better informed philanthropic choices and enables charities to borrow innovative ideas from each other more easily. admittedly, these benefits come at a cost: the time and effort invested in preparing the analysis and in policing the accuracy of disclosure. to balance these competing considerations, this article recommends that this analysis and disclosure should be mandatory for large public charities and voluntary for other nonprofits. this recommendation is somewhat out of step with recent work criticizing mandatory disclosure. for example, professors ben-shahar and schneider warn that “disclosees often do not read disclosed information” and “do not understand it when they read it.”12 yet these concerns loom larger with unsophisticated consumers (e.g., of health care or credit cards).13 the goal here is not to protect an unsophisticated audience from being duped, but to recruit a sophisticated audience of donors and rating agencies as monitors.14 although the focus here is on nonprofits, this article also has implications for for-profit firms and, in particular, for the debate on stakeholder capitalism. proponents urge for-profit firms to pursue goals other than profitability, such as enhancing the wellbeing of employees and their communities.15 yet in taking on these responsibilities, for-profit firms face the same challenges 12 omri ben-shahar & carl e. schneider, the failure of mandated disclosure, 159 u. pa. l. rev. 647, 651, 665 (2011); see also omri ben-shahar & carl e. schneider, more than you wanted to know: the failure of mandated disclosure (2014); david e. pozen, transparency’s ideological drift, 128 yale l. j. 100 (2018) (measures to promote transparency used to pursue pro-regulatory agenda, but now often advance deregulatory agenda); joshua mitts, how much mandatory disclosure is effective? (october 4, 2014), http://dx.doi.org/10.2139/ssrn.2404526 (arguing that question is not whether to require disclosure, but how much of it to require). 13 these are two of their “paradigmatic cases.” ben-shahar & schneider, supra note 12, at 665-72. 14 professors ben-shahar and schneider acknowledge the value of disclosure “aimed directly at sophisticated intermediaries . . . where the presence of such intermediaries produces a desirable effect for the nonreading populous.” id. at 732. one of their examples of this is disclosure to investors. id. 15 see, e.g., business roundtable, statement on the purpose of a corporation, aug. 19, 2019, https://opportunity.businessroundtable.org/wp-content/uploads/2019/08/brt-statement-on-the-purpose-of-acorporation-with-signatures.pdf (“we share a fundamental commitment to all of our stakeholders”); elizabeth warren, companies shouldn’t be accountable only to shareholders, wall st. j., aug. 14, 2018 (advocating legislation requiring “corporate directors to consider the interests of all major corporate stakeholders — not only shareholders”); addisu lashitew, stakeholder capitalism arrives at davos, brookings, jan. 21, 2020 (noting “an emerging shift away from the paradigm of ‘shareholder capitalism’ that has guided the world economy since the 1970s”), https://www.brookings.edu/blog/future-development/2020/01/21/stakeholder-capitalism-arrives-at-davos/ [https://perma.cc/4t7x-mpus]. 2020] enhancing efficiency at nonprofits with analysis and disclosure 81 that this article identifies at nonprofits: success becomes harder to measure, so mismanagement is harder to stop. this risk complicates the case for stakeholder capitalism, and creates a need for something like the analysis and disclosure proposed here in any effort to operationalize it. part i investigates the unique sources of inefficiency at nonprofits. part ii considers which stakeholders are best positioned to press for efficiency, and chooses boards, donors, and rating agencies to play this role. to help nonprofits run more efficiently, part iii proposes a rigorous planning process, in which managers and boards analyze the impact and costeffectiveness of programs by answering three questions. part iv urges nonprofits to share their answers with the public. part v recommends mandating this disclosure for public charities with annual budgets over $10 million. part vi is the conclusion. i. sources of inefficiency at nonprofits: incentives and information this part considers the unique challenges nonprofits face in striving to operate efficiently. while the literature focuses on flawed incentives,16 this article emphasizes information problems. a. flawed incentives as a source of inefficiency: the nondistribution constraint the defining feature of nonprofits is their bar on distributing profits. the literature regards this “nondistribution constraint” as both a governance blessing and a curse. since managers and board members cannot share in profits, they are less motivated to cheat beneficiaries and donors, but they also have less incentive to operate efficiently. 1. nondistribution constraint builds trust in path-breaking work, henry hansmann has shown how the nonprofit form overcomes information asymmetry. since managers and board members do not have a financial incentive to take advantage of beneficiaries and donors,17 beneficiaries trust them not to overcharge or skimp 16 henry hansmann, economic theories of the nonprofit sector, in the nonprofit sector 29 (walter powell ed. 1987) [hereinafter “economic theories”] (nonprofits have less incentive to cut costs); evelyn brody, agents without principals: the economic convergence of the nonprofit and for-profit organizational forms, 40 n.y.l. sch. l. rev. 457, 465 (1996) (as a legal matter, donors are not owners) [hereinafter “agents without principals”]. 17 hansmann, nonprofit enterprise, supra note 7, at 844 (“the nonprofit producer . . . lacks the incentive to [raise prices and cut quality] . . . because those in charge are barred from taking home any resulting profits. “). [vol. 11.2 columbia journal of tax law 82 on quality.18 likewise, funders buy goods and services for third parties without confirming receipt19 or knowing the incremental impact of their contributions.20 admittedly, nonprofit managers and boards can still behave in self-interested ways, which are well understood. managers can claim overly-generous pay, engage in nepotistic hiring, pursue “pet” projects, and set a relaxed pace, while board members can claim a range of private benefits.21 yet the nonprofit form still provides some reassurance to beneficiaries and donors. 2. nondistribution constraint breeds inefficiency even so, the literature also emphasizes a downside to the nondistribution constraint: since managers and board members do not benefit financially from increasing revenue or cutting costs, they have less reason to make hard choices.22 after all, saying “no” to colleagues, grantees, and vendors is harder than saying “yes.” pushing them to perform better can be unpleasant, as is severing ties with those who don’t measure up. in addition to sapping their motivation, the nondistribution constraint also insulates managers and boards from external scrutiny. since there are no owners to demand a distribution, managers and boards retain control of any resources they do not spend.23 they can use these 18 henry hansmann, the ownership of enterprise 228 (1996) [hereinafter “ownership”] (“nonprofit firms commonly arise where customers are in a particularly poor position to determine, with reasonable cost or effort, the quality or the quantity of the services they receive from a firm.”). admittedly, beneficiaries are reassured by the nondistribution constraint only when they understand its significance. see prakash & gugerty, supra note 11, at 27 (noting evidence that consumers “have limited understanding of what the nonprofit form entails”). 19 hansmann, nonprofit enterprise, supra note 7, at 847 (funding disaster relief thousands of miles away). 20 ira ellman, another theory of nonprofit corporations, 80 mich l. rev. 999, 1010 (1982) (donors do not know if their personal contribution enhanced either quality or quantity); hansmann, economic theories, supra note 16, at 30 (nonprofits are used when “collective consumption goods produced in such aggregate magnitude that the increment purchased by a single individual cannot be easily ascertained”); hansmann, nonprofit enterprise, supra note 7, at 851. 21 brody, agents without principals, supra note 16, at 493; hansmann, economic theories, supra note 16, at 38 (there is evidence that nonprofit managers seek nonpecuniary perquisites); hansmann, nonprofit enterprise, supra note 7, at 875 (noting various ways nonprofits managers can indirectly share in profits). 22 henry hansmann, the economics of nonprofit organizations, in comparative corporate governance of nonprofit institutions 60, 64 (klaus j. hopt ed.) (2010) [hereinafter “economics”} (“the principal forms that managerialism might be expected to take in nonprofit organizations are a general failure to minimize costs and a bias toward excessive quality and/or quantity.”); hansmann, nonprofit enterprise, supra note 7, at 878 (“nonprofits might therefore be expected to be less vigilant in eliminating unnecessary expense than are their for-profit counterparts.”); anup malani, tomas philipson & guy david, theories of firm behavior in the nonprofit sector in the governance of not for profit organizations (edward l. glaeser, ed.) 192 ( 2003) (“nfp [not-for-profit] firms invest less effort in cost-cutting effort because the returns to such investment are lower.”). 23 hansmann, economics, supra note 22, at 64 (“the absence of owners . . . means that managers are largely free of outside discipline.”). to an extent, the tax law limits this discretion in private foundations by requiring minimum distributions. i.r.c. §4942 (private foundations must make grants equal to at least 5% of their endowment each year). this requirement does not apply to public charities. 2020] enhancing efficiency at nonprofits with analysis and disclosure 83 funds to run inefficiently — sometimes for years — until the money is all gone.24 the market for corporate control is unlikely to stop them.25 yet although the literature emphasizes flawed incentives as a key source of inefficiency at nonprofits, this incentive problem should not be overstated for two reasons. first, although managers and board members cannot share in profits, they still have familiar reasons to be efficient, including their professional reputations, as well as their commitment to the nonprofit’s mission.26 second, they usually also face an important external pressure to perform: they need to raise money. b. flawed information as a source of inefficiency: social return is hard to measure although the literature attributes inefficiency at nonprofits to imperfect motivation, this article emphasizes that it derives also from imperfect information. in other words, information problems are not only a justification for nonprofits, as the literature emphasizes, but also a key source of their inefficiency for two reasons. first, unlike for-profit firms, which measure success with financial return, nonprofits have to track social return, which is more difficult. this measurement challenge, which is well understood, complicates the efforts of even the best management teams and boards to allocate resources efficiently.27 second, this measurement challenge has another effect that the literature has largely overlooked: when managers and board members are less capable and committed, the flaws in their choices are harder to detect. 24 hansmann, ownership, supra note 18, at 241 (“in short, capital tends to get locked into nonprofit firms.”). restrictions on the endowment can be a further source of inefficiency, to the extent that they keep the board and managers from moving in a more productive direction. 25 henry hansmann, a reform agenda for the law of nonprofit organizations, in klaus hopt & dieter reuter, eds., stiftungsrecht in europa 241, 256 (carl heymanns verlag, 2001) [hereinafter “reform agenda”] (“[h]ostile takeovers of nonprofit firms are today essentially impossible.”). in principle, a hostile takeover might be feasible at “mutual” nonprofits, whose boards are not self-perpetuating, and instead are elected (and removed) by members. cf. ellis carter, nonprofit jargon buster -voting members versus self perpetuating boards, charity lawyer blog, april 26, 2011, https://charitylawyerblog.com/2011/04/26/nonprofit-law-jargon-buster-voting-members-vs-selfperpetuating-boards/ [https://perma.cc/y4gy-7fxv] (donors and beneficiaries do not choose directors, except at “mutual” nonprofits). 26 hansmann, economic theories, supra note 16, at 29 n. 5 (“the nondistribution constraint . . . screen[s] for managers who place an unusually low value on pecuniary compensation and an unusually high value on having the organization they run produce large quantities of services or services that are of especially high quality”); weisbrod, nonprofit economy, supra note 7, at 23 (“if managers of nonprofits derive relatively greater personal satisfaction than their proprietary counterparts do from providing a particular service, then there would be an incentive for nonprofit managers to be efficient even though they cannot benefit financially”). 27 see, e.g.,gugerty & karlan, supra note 8, at 5 (noting that “the struggle to find the right fit in monitoring and evaluation systems resembles the predicament golidlocks faces” in that some organizations collect too much data and do not use it, while other organizations do not collect enough data); weinstein & bradburd, supra note 9, at 14 (evidence of a program’s impact is often incomplete or flawed); kumar, supra note 9, at 42, 49 (noting “increasing demand for results” and that “good results are hard to find,” while observing that “[o]rganizations are beginning to showcase their cost-effectiveness at a granular level by using independent, serious research”); acumen fund metrics team, best available charitable option, january 2007, at 2 https://acumen.org/wpcontent/uploads/2013/03/baco-concept-paper-final.pdf (“finding a standard metric to measure the success of a social investment has been a vexing challenge”). [vol. 11.2 columbia journal of tax law 84 1. measuring success at for-profit firms is relatively straightforward measuring success at for-profit firms is much easier than at nonprofits. in general, forprofit firms seek to maximize profits and share prices. there are well understood and widely accepted conventions for computing earnings. at public companies, share prices also are easy to access. both metrics can be used to compare the success of different firms, and earnings can be used to compare initiatives within the same firm. compensation contracts can draw on these metrics to align the incentives of managers, board members, and shareholders. this is not to say that earnings and share prices are a bullet-proof solution to every governance challenge at for-profit firms. stakeholders sometimes disagree about the reliability of these metrics in particular circumstances and about how to compute them. in measuring profitability and share prices, is the right time horizon the current quarter or a longer period? causation also can be an issue. was the quarter’s profit low because managers pursued a flawed strategy, or because of unusual market conditions. to answer this question, stakeholders want to know how comparable firms performed, but they may differ on which firms are comparable. moreover, even if they agree about the past, they may offer different predictions about the future. there also is a debate about whether for-profit firms should pursue goals other than profitability. proponents of “shareholder primacy,” such as milton friedman, the late nobel prize-winning economist, urge businesses to focus on profitability. for-profit managers and boards should not “spend other people’s money” on “general social interests,” since they lack the expertise to do so, as well as criteria to mediate among competing goals; instead, this responsibility should be left to the government and nonprofits.28 in contrast, advocates of “stakeholder capitalism,” such as larry fink, the ceo of blackrock, want for-profit firms not only “to deliver financial performance,” but also to “benefit all of their stakeholders, including shareholders, employees, customers, and the communities in which they operate.”29 but as important as these disagreements can be, they are bounded. at the end of the day, everyone agrees that profitability and market value are key measures of performance at a forprofit firm (even if some do not consider them the only measures). likewise, everyone agrees on the broad outlines of how to compute these metrics. debates in for-profit firms typically reduce to the same question: which alternative maximizes the firm’s profitability and market value? 2. measuring success at nonprofits is more challenging in contrast, nonprofits cannot use profitability or share prices to measure success, since the main role of nonprofits is to address market failures. they step in when there is no costeffective way to charge for valuable goods and services — as is the case with parks, basic research, and other public goods. nonprofits also serve needy beneficiaries who lack the means to pay. since the whole purpose of a nonprofit is to run initiatives that the market does not fund adequately, operating revenue is a flawed measure of a nonprofit’s social value. 28 milton friedman, the social responsibility of business is to increase its profits, n.y. times magazine, sept. 13, 1970. 29 https://www.blackrock.com/hk/en/insights/larry-fink-ceo-letter (jan. 2018 letter to shareholders) [https://perma.cc/7zmj-xz3n]. 2020] enhancing efficiency at nonprofits with analysis and disclosure 85 likewise, a nonprofit’s fundraising totals are not always a reliable measure of its social value. sometimes the willingness of donors to contribute reflects the value of a nonprofit’s work, but sometimes it merely shows that the nonprofit invests heavily in fundraising. attracting donations is a more dependable measure of quality when donors are well informed about the nonprofit’s work. in principle, the right measure of a nonprofit’s success is its social return. how much good does it do in the world?30 even so, measuring social return is less precise — and, frankly, much messier — than measuring financial return. how do we calculate it for a church, soup kitchen, or university? there is no uniform and consensually accepted way to do so. as albert einstein supposedly said, “not everything that counts can be counted, and not everything that can be counted counts.”31 to be clear, the argument here is not that inefficiency at nonprofits is inevitable; on the contrary, this article suggests ways for them to run more efficiently. rather, the point is that nonprofits face unique challenges in pursuing this goal, which are rooted in difficulties in measuring progress. these measurement challenges complicate the management of nonprofits in five important ways, which arise even when an organization’s managers and board are committed and competent, so there is no risk of mismanagement. first, unlike for-profit firms, nonprofits cannot easily compare the value of different missions. at for-profit firms, profitability tells us whether to invest in real estate, energy, bio-tech, or software. at nonprofits, by contrast, there is no common metric to compare student financial aid, medical research, soup kitchens, art museums, and public interest litigation.32 unlike at for-profit firms, data alone cannot determine their relative value; instead, any ranking turns in part on subjective values and preferences. as a result, evaluating the importance of the mission becomes much more difficult. second, like comparing two missions, comparing two ways to advance the same mission poses analogous challenges. which goals should be prioritized? for instance, if the mission is poverty relief, should the nonprofit help vulnerable populations in u.s. inner cities or in venezuela? should the focus be on children or on elderly? once the nonprofit chooses the population it wishes to help, what programs should it run? for example, should it provide food or medicine? fortunately, comparing options to advance the same mission (e.g., poverty relief in the u.s. or venezuela) is somewhat easier than comparing different missions (e.g., poverty relief versus medical research), since data becomes more useful. in this example, the nonprofit can compare the standard of living of various populations, as well as the impact and cost of different 30 see gugerty & karlan, supra note 8, at 6 (“unlike for profit companies with no stated social impact goal, nonprofits and social enterprises claim to make a positive impact on the world.”). 31 https://quoteinvestigator.com/2010/05/26/everything-counts-einstein/ [https://perma.cc/8dal-5xeh] (attributing quote to william cameron). 32 weinstein & bradburd, supra note 9, at 3 (“a basic problem that plagues philanthropic decisions is that there is no natural yardstick by which to measure, and thus compare, different philanthropic outcomes.”); kumar, supra note 9, at 60 (noting that a universal metric for nonprofits is impossible); young, supra note 7, at 127 (“within present limits of social science knowledge, application of a single global criterion of social welfare is untenable.”). [vol. 11.2 columbia journal of tax law 86 interventions. yet the relevant findings are not always definitive (e.g., in comparing the relative value of food versus medicine), and decisions are still likely to turn on contestable value judgments. for instance, should the focus be on children because they represent the future? or on elderly because this is the last opportunity to help them? these moral dilemmas do not arise when for-profit firms decide whether to provide consumer products to children or elderly. rather, a for-profit firm simply asks which market is more lucrative.33 third, the inability to measure success with profitability is a challenge not only in picking a mission and in setting program priorities, but also in evaluating specific programs.34 how can nonprofits tell whether their programs are working? unlike for-profit firms, which can use profitability to answer this question, nonprofits need other metrics that are reliable and easy to track.35 yet as the following example shows, there is often a tradeoff between reliability and cost: to strengthen civil society in a disadvantaged community, a nonprofit launches a new leadership training program. the goal is to train community members to develop and lead promising new grassroots initiatives. how do the nonprofit’s stakeholders know whether this initiative is successful? a relatively easy way to evaluate this program is to ask participants to rate different aspects of it and suggest improvements. yet although a survey is inexpensive, it offers only limited information. the real test is not what participants thought of the program, but what they actually did after completing it. to shed light on this issue, the nonprofit can compare the communal contributions of program participants and a control group over time.36 this alternative is a better measure of the program’s long-term impact, but it is much costlier and slower.37 fourth, since nonprofits cannot rely on profitability to define success, and must use other metrics instead, there is a risk that they will choose flawed metrics which induce them to misallocate resources.38 after all, in the words of peter drucker, a prominent expert on management, “what gets measured gets done.”39 in the example above, participant surveys might 33 weinstein & bradburd, supra note 9, at 4 (“capitalists don’t care if they earn a dollar’s worth of profits by selling potato chips or computer chips”). 34 see kumar, supra note 9, at 43 (stressing importance of evaluating programs and recommending “results-oriented approach” in which a nonprofit uses a pilot study to test results and then rolls out initiative iteratively, updating each phase with lessons from the prior phase). 35 see gugerty & karlan, supra note 8, at 8 (showing how challenging it is to evaluate programs by highlighting “three traps in . . . monitoring and evaluation efforts”: collecting too little data, collecting more data than the organization has the capacity to use, and collecting the wrong data, which “does not allow them to know if the organization caused the changes” the relevant program is seeking). 36 see id. at 5 (“without [a comparison group], it is quite challenging to know whether the program caused the observed changes to occur.”). 37 see kumar, supra note 9, at 51 (“drawbacks [of randomized control trials] include cost and lost time, and the inability to translate lessons from one context to another.”). 38 weisbrod, quantitative evaluation, supra note 8, at 275 (“the danger is that easily measured outputs or outcomes will be measured while others remain unmeasured and, in effect, valued at zero. resources will then be misallocated.”). 39 weinstein & bradburd, supra note 9, at 15 (quoting drucker). 2020] enhancing efficiency at nonprofits with analysis and disclosure 87 motivate nonprofits to overemphasize program features, such as extravagant venues, which inspire positive evaluations but do not contribute much to social return. finally, since nonprofits cannot measure success with profitability, analyzing opportunity cost is more difficult for them. in the example above, even if a training program yields positive results, another alternative might have been better still. to make this judgment in for-profit firms, managers can require new projects to exceed a “hurdle rate,” such as the average return from other projects. at nonprofits, by contrast, operationalizing a hurdle rate is difficult. instead, the best a nonprofit can do is develop various options for pursuing a goal, and try to choose the best one.40 c. flawed information as a source of inefficiency: mismanagement is harder to detect the last section showed that allocating resources efficiently can be challenging even for the best nonprofit managers and board members, since they cannot use profitability to measure success. this section shows that if these stakeholders are self-interested or incompetent, this information problem imposes still another cost, which the literature has largely overlooked: when success is hard to measure, mismanagement is less visible, and thus is harder to stop. in other words, challenges in measuring success breed inefficiency not only in obliging faithful agents to do their best with imperfect information, but also in giving disloyal or inept agents license to misuse their authority. to make this case, this section surveys four challenges: agency costs, incompetence, conflict, and inertia. while these problems also arise at for-profit firms, they are likely to be more acute at nonprofits because success is harder to measure. 1. agency costs needless to say, the interests of employees and board members sometimes diverge from those of the organization. blocking a self-interested choice is not easy at for-profit firms, but it can be even harder at nonprofits. at both types of firms, managers and board members seldom admit that their decision is motivated by self-interest, perhaps even to themselves. instead, they defend it as good for the organization. the right response is to expose their choice as bad for the organization and good only for them personally. this showing is harder when success at the organization is more difficult to measure. for example, assume an organization has to eliminate one of two lines of business for budgetary reasons. looking for a slower pace and less stress, managers want to cut the one that is harder to run, even though it adds more value. to justify this self-interested choice, they try to mischaracterize the high-value (and difficult) line of business as low-value. how easy is it to expose this decision as self-interested? if a firm’s success is measured in profits, the relative value of the two businesses is transparent: the one that is harder to run generates more profit. invoking this information, which is relatively easy to access, board 40 see, e.g., acumen fund metrics team, supra note 27, at 3 (“rather than seek an absolute standard . . ., acumen fund . . . quantif[ies] an investment’s social impact and compare it to . . . existing charitable options”). [vol. 11.2 columbia journal of tax law 88 members and shareholders can challenge this choice, questioning why management wants to close the more profitable business. however, if success is measured in social return, instead of profitability, assessing the relative value of the two initiatives is much more difficult. granular information is needed about the impact and cost-effectiveness of these programs, and board members, donors, and other nonprofit stakeholders usually depend on management for this information. as a result, these stakeholders are less able to discern – and, for that matter, to make the case – that management’s choice is self-interested. in this less transparent environment, managers have more latitude to prioritize their own interests. the opacity of social return can provide “cover” for any number of other self-interested choices as well.41 when performance is hard to measure, basing personnel decisions on friendship (or animosity) is more feasible. likewise, questionable travel, overstaffing, expensive offices, and other wasteful expenditures are easier to justify when the asserted benefits are hard to quantify.42 in theory, incentive compensation could discourage self-interested choices, but the most common versions at for-profit firms — stock options, equity grants, and bonuses based on earnings — are unavailable. indeed, a bonus for generating a surplus could jeopardize a nonprofit’s tax-free status. instead, a bonus must be based on other benchmarks, such as program-related targets. yet these benchmarks can align incentives only if they are reliable measures of success. as a result, challenges in measuring success undercut the effectiveness of incentive compensation at nonprofits.43 admittedly, incentive compensation is less necessary with employees who are committed to the mission. indeed, some nonprofit managers are so dedicated that they forgo more lucrative jobs at for-profit firms. self-motivated employees arguably need less monitoring; even when they have latitude to pursue their self-interest, they might still prioritize the mission.44 yet unfortunately, this commendable impulse is not universal. as a counter example, some employees could become embittered about lucrative paths not taken, rendering them all the more motivated to take advantage. agency costs surely are a problem with at least some nonprofit employees, and monitoring them is harder because of difficulties in measuring success. 41 cf. young, supra note 7, at 118 (“nonprofit ventures often operate under vague performance criteria and loose control” that “leave substantial room for discretionary behavior . . . to indulge in self-defined motives and goals”). young does not focus on the risk of abusing this autonomy, calling managers’ goals “self-defined,” not “selfinterested.” 42 of course, some self-interested practices are not harder to monitor at nonprofits (e.g., embezzlement and selfdealing) and require the same responses (e.g., internal controls and conflict-of-interest policies). 43 see kumar, supra note 9, at 40 (“good evidence is hard to find”). 44 hansmann, nonprofit enterprise, supra note 7, at 876 (“the nondistribution constraint . . . screen[s] selectively for . . . employees who are more interested in providing high-quality service and less interested in financial rewards”). 2020] enhancing efficiency at nonprofits with analysis and disclosure 89 2. incompetence even when managers and board members want to put the organization’s interests first, they do so ineffectively if they have poor judgment, weak analytical abilities, flawed interpersonal skills, low energy levels, or other deficiencies. nonprofits are no different from forprofit firms in rooting out incompetence that is easy to observe, such as missed deadlines, perennial tardiness, rudeness, and personal calls at work. yet nonprofits face greater challenges in evaluating employees in a deeper way. after all, for-profit firms can evaluate most managers based on the profits they generate. admittedly, this calculation can be challenging, since causation is sometimes unclear. market conditions beyond a manager’s control may inflate or erode profitability, and the relative contribution of different managers can be debated. but these challenges arise equally at nonprofits, along with a more fundamental one, which is unique to charities: since the organization’s success is hard to measure, an individual’s contribution to that success is all the more difficult to assess. notably, while a manager or board member’s commitment to the cause can prevent her from making self-interested choices, she can still make unwise ones. even idealists can be inept. in the above example, when managers and board members must shut down one of two lines of business, they may choose the wrong one — not because they are angling for the easier path — but because they misjudge which offers a better social return. unfortunately, intense philosophical commitments can breed overconfidence, inducing some nonprofit managers to resist empirical evaluations of their work, as well as changes in priorities and programs.45 clear and measurable goals are needed not only to monitor employees, but also to motivate them. “when people have conflicting priorities or unclear, meaningless, or arbitrarily shifting goals,” a prominent venture capitalist has observed, “they become frustrated, cynical, and demotivated.”46 again, nonprofits need to work harder to articulate and track these goals. 3. conflict another challenge at both for-profit and nonprofit firms is conflict. at well-run organizations, key stakeholders resolve disagreements amicably, basing decisions on information and analysis, not on politics and personalities. lines of authority are clear, and the losing side accepts the decision and helps to implement it. the two sides do not become warring factions. at first blush, conflict may seem less likely at nonprofits, since key stakeholders all believe in the mission. but in fact, this shared commitment can make conflict more corrosive, since fights about principle are often more heated and harder to settle than fights about profit. bitter clashes can arise about how to interpret the mission.47 for example, some environmental organizations oppose nuclear power as a source of radioactive waste, while others support it as 45 i thank louis kaplow for this point. 46 john doerr, measure what matters 5 (2018). 47 young, supra note 7, at 114 (“board members, clients, and resource providers may all have their own ideas and preferences with respect to the purposes of the organization and programs”). [vol. 11.2 columbia journal of tax law 90 carbon-free energy. donors who favor one interpretation (“no nukes!”) can become quite disillusioned in inadvertently supporting the other (“no carbon!”). this sort of misunderstanding is much less likely at for-profit firms, since the mission — maximizing profits — is clear to all. even when nonprofit stakeholders agree on the mission, they still might disagree on how to advance it. these disputes can be hard to resolve, especially if the relevant evidence is not definitive enough to change someone’s mind. 4. inertia finally, another challenge at both for-profit and nonprofit firms is resistance to change. ironically, the same factors that initially help an organization succeed can breed inertia. according to michael hannan and john freeman, organizations need standard operating procedures to succeed, but these routines later become hard to change, even when a new approach is urgently needed.48 change involves effort and risk. managers have to design new approaches, develop different skills, replace personnel, and acquire new assets.49 if a new initiative fails, reputations suffer. obviously, the status quo is also risky, but stakeholders may still prefer “the devil they know.” after all, they are less likely to be blamed – by the media, rivals within the organization, the board, funders, and potential future employers — for sticking with a strategy that used to work. at for-profit firms, when managers and board members have outdated confidence in the status quo, declining profits and stock prices can force them to face reality. yet at nonprofits, there are no comparably clear “wakeup calls.” in some cases, beneficiaries respond by defecting to other nonprofits, but only if the market is competitive enough to support alternatives. in other cases, donors respond by reducing their donations, but only if they are motivated and knowledgeable enough to realize that the nonprofit is ineffective. in combating inertia, the commitment of nonprofit stakeholders to the mission is a mixed blessing. on the one hand, this idealism can steel them to make painful choices. on the other hand, they may find it upsetting to admit, either to themselves or to others, that past efforts and donations – once the source of great pride and satisfaction — actually were wasted. even after better alternatives have emerged, they may remain irrationally wedded to their mission or the minutiae of how they have pursued it.50 for example, their passion for helping needy people may evolve into passion for helping them in a particular way, which is no longer cutting edge.51 in 48 michael t hannan & john freeman, structural inertia and organizational change, 49 am soc. rev. 149, 154 (1984) (“the very factors that make a system reproducible make it resistant to change.”). 49 id. at 154 (“it is easier to continue existing routines than to create new ones or borrow old ones.”) 50 cf. young, supra note 7, at 108 (“nonprofit agencies . . . may be substantially affected by both the sentimental loyalties of longstanding board members and by the conservative interests of staff”). 51 cf. hannan & freeman, supra note 48, at 149 (discussing “the tendency of precedents to become normative standards”). 2020] enhancing efficiency at nonprofits with analysis and disclosure 91 contrast, managers and board members motivated by profit are less likely to imbue the status quo with moral significance. at nonprofits, inertia can draw further strength from legal constraints. the nondistribution constraint traps capital,52 as do restrictions on endowments. “once nonprofit institutions have been created,” henry hansmann observed, “they are difficult to control and particularly difficult to get rid of.”53 to sum up, although the tendency of nonprofits to operate inefficiently is familiar, the literature offers an incomplete explanation. stakeholders lack not only the incentive, but also the information, to demand better performance. because nonprofits generate social returns, instead of financial returns, their success is harder to measure. this lack of a clear and widely accepted metric complicates efforts to expose self-interested behavior, root out incompetence, resolve conflict, and overcome inertia. 5. stakeholder capitalism makes it harder to measure success at for-profit firms in showing that information problems make mismanagement harder to stop, this part obviously has focused on nonprofits. yet the same dysfunctions can arise at a for-profit firm, as long as it faces challenges in measuring success. although profitability is relatively easy to compute, as noted above, proponents of stakeholder capitalism want for-profit firms also to pursue other goals that are harder to track, such as helping employees and their communities. unfortunately, when a for-profit firm’s goals become more varied and less quantifiable, it faces the same challenges as nonprofits in rooting out mismanagement. pursuing goals other than profitability can exacerbate conflict (by introducing competing goals) and inertia (by authorizing more rationalizations for the status quo). the need to balance multiple goals gives managers and boards more discretion, which they might abuse with self-interested or incompetent decisions. for example, when for-profit managers need to shut down one of two businesses, as in the example above, a self-interested choice is easier if they are not obliged to keep the more profitable one.54 obviously, a comprehensive analysis of stakeholder capitalism is beyond this article’s scope. yet one of its downsides is that for-profit firms face greater challenges in measuring success. as a result, they lose their edge over nonprofits in rooting out mismanagement. 52 hansmann, economics, supra note 22, at 66 (“nonprofit institutions also seem to be inefficiently slow in contracting their scale of operations, or in exiting an industry entirely, when demand for their services contracts.”). nonprofits cannot return capital to donors when its mission fades in importance, but they can contribute to another nonprofit. id. at 66. 53 id. at 68. 54 see supra part i.c.1 & 2. [vol. 11.2 columbia journal of tax law 92 ii. which nonprofit stakeholders can monitor impact and costeffectiveness? the last part showed that challenges in measuring success afford nonprofit managers discretion to make unwise and self-interested choices.55 to block these choices, effective monitoring is needed. but who has the necessary motivation and capacity to play this role? which nonprofit stakeholders have the potential to be the most effective monitors? after analyzing different possibilities, this part recommends board members, major donors, and rating agencies, while showing that these stakeholders need better information to discharge this responsibility more successfully. a. the three i’s: incentives, influence, and information to block self-interested choices and incompetence, monitors must be willing to invest time and effort. they need to learn the details of a nonprofit’s work and its managers’ choices. to be effective, monitors also must be independent. someone seeking the good will of managers — for instance, so they will admit a family member to a competitive program — is not wellpositioned to question their decisions. along with the right incentives, monitors also must have sufficient influence. even if they invest time and effort to identify where a nonprofit falls short, they can improve the situation only by persuading, pressuring, or replacing the relevant managers. a board member or major donor obviously is more likely to have this sway than a modest donor. to be effective monitors, stakeholders also require fine-grained information. they have to explore whether programs are accomplishing the relevant goals, and whether lower-cost alternatives would have comparable impact. to sum up, nonprofit stakeholders can be effective monitors only if they have “the three i’s”: incentives, influence, and information. this part considers the potential of four groups to satisfy these criteria: regulators; beneficiaries; board members; donors; and rating agencies. b. government regulators for a range of reasons, government regulators are not well-positioned to monitor nonprofit managers. when nonprofits need the government to endorse their work, they are less free to test novel ideas and adjust to changing circumstances. moreover, government officials usually lack the information and authority to provide this sort of substantive oversight when they act as regulators, at least under current law. in making grants, however, government agencies can (and should) wield the same sort of influence as other major donors. 55 see young, supra note 7, at 115 (“in nonprofit sectors especially, there tends to be a large margin for discretionary behavior [by managers]. . . . the relatively indirect and part-time control exerted by constituent groups, the imprecise criteria that such groups can apply, and the separation of resource acquisition from resource allocation are the main reasons for this discretion.”). 2020] enhancing efficiency at nonprofits with analysis and disclosure 93 1. incentives when they make grants, government officials have reason to dig into the details of a nonprofit’s work. but otherwise, government officials do not have the same incentives as other stakeholders to scrutinize a nonprofit’s mission and programs. unlike beneficiaries, regulators obviously do not use the nonprofit’s goods and services. unlike board members, they do not make a choice to volunteer time and associate their reputation with a specific nonprofit. unlike donors, they do not commit their own money. without this sort of personal stake, government regulators will not necessarily invest the time and effort needed to dig into the details. just as government regulators are too “hands off” in some cases, they are too “hands on” in others. because regulators usually represent the preferences of median voters and powerful interest groups, they sometimes have political reasons to block a nonprofit from incubating an innovative but controversial idea. indeed, this used to be a serious concern. years ago, in deciding whether to approve new nonprofits, state regulators and judges discriminated against “foreigners, cultural diversity, controversial causes, persons of low income and labor unions, and persons of color,”56 as professors fishman, schwartz, and mayer have observed. fortunately, regulatory review has become more ministerial than substantive under current law,57 allowing nonprofits to engage in bold experiments. “unlike government, an independent sector group need not ascertain that its idea or philosophy is supported by some large constituency . . . ,” john gardner has observed. “if a handful of people want to back a new idea, they need seek no larger consensus.”58 this immunity from political constraints is the reason why civil rights, women’s rights, environmentalism, and other transformative social movements in the u.s. began in nonprofits; the government did not embrace them until much later, when they enjoyed broader support.59 in addition to undercutting a nonprofit’s ability to experiment with unconventional ideas, substantive regulatory oversight has other costs as well. if nonprofits need the government to “sign off,” political and bureaucratic barriers become more formidable in launching and shutting down initiatives, as well as in making course corrections.60 56 james j. fishman, stephen schwarz & lloyd hitoshi mayer, nonprofit organizations cases and materials 55-56 (5th ed. 2015). 57 id. 58 john w. gardner, the independent sector in american voluntary spirit xiii (brian o’connell ed. 1983); see also burton a. weisbrod, toward a theory of the voluntary nonprofit sector in a three sector economy, in the economics of nonprofit institutions 21, 30-31 (susan rose-ackerman ed., 1986) (defending charitable deduction as empowering minorities to pursue public goals that majoritarian political processes would not endorse). 59 david m. schizer, subsidizing charitable contributions: incentives, information, and the private pursuit of public goals, 62 tax l. rev. 221, 244 (2008-2009) (“[a] number of important social movements-from civil rights and women's rights to environmentalism-were pursued first through nonprofits (for example, the naacp, the aclu women's rights project, the nrdc) before they ultimately became the subject of government action.”). 60 see hansmann economic theories, supra note 16, at 35 (nonprofits are less bureaucratic than government); john tyler, transparency in philanthropy 33 (2013) (”there is inherent value in the sector being independent of government and having the flexibility to respond quickly to unexpected needs and opportunities”). [vol. 11.2 columbia journal of tax law 94 in some contexts, substantive oversight from the government — whether in the form of regulation or grant-making – compromises important values. for instance, government officials should not make substantive judgments about the social value of religious institutions. the same is true of newspapers, since the press is supposed to monitor (and criticize) the government.61 another key function of nonprofits — competing with the government62 — can also become more difficult. 2. information even if preserving nonprofit independence were not an issue, government regulators would not be well positioned to oversee the missions and programs of nonprofits for another reason: they lack the relevant expertise and information, at least in the office of the state attorney general (“ag”) and the irs, which currently are the agencies most involved in regulating nonprofits. the scope of the u.s. nonprofit sector’s work is panoramic — from medicine to art, religion, education, social services, disaster relief, human rights, and more. state ags and the irs are unlikely to have “in-house” expertise on even a fraction of this work. in principle, other regulators could step in. indeed, some nonprofits are already subject to licensing requirements, periodic recertification, or other substantive oversight by a range of government agencies. yet extending this sort of oversight to more nonprofits would pose a range of challenges. for example, coordination among different potential regulators could be daunting. in addition, although government experts might well be knowledgeable about social problems — and thus could assess whether a nonprofit is targeting an important issue — they are unlikely to know about a specific nonprofit’s strategy or programs. for example, civil servants at the u.s. department of health and human services presumably know a great deal about poverty and homelessness, but very little about the work of specific soup kitchens. to monitor the impact and cost-effectiveness of these facilities, they would need access to detailed information about their operations. even if regulators receive this information, they might not use it effectively; after all, some government agencies do not conduct adequate evaluations of their own work. they are unlikely to do better in assessing nonprofits.63 3. influence in addition to lacking the necessary incentives and information to monitor nonprofit managers, government officials also lack the influence to play this role under current law (except in making grants). the main regulators of nonprofits — the state ag, courts, and the i.r.s. — 61 see generally david m. schizer, subsidizing the press, 3 j. legal anal. 1 (2011). 62 brian galle, the role of charity in a federal system, 53 wm. & mary l. rev. 777 (2012) (arguing that charities compete with the government, and are especially useful when state and local governments cannot take on the job). 63 i thank louis kaplow for this point. 2020] enhancing efficiency at nonprofits with analysis and disclosure 95 generally do not make judgments about the social value of nonprofit initiatives. any effort to task these (or other) regulators with this function would require changes in the law.64 a. state attorneys general and courts the main regulators of nonprofits are state ags.65 in principle, they have significant power, but in practice their resources are limited.66 they focus on misconduct, as well as on abusive fundraising practices, but not on the impact and cost-effectiveness of programs. they lack the expertise, information, and objectivity to provide substantive oversight.67 courts face similar limitations. while they know how to police misconduct and enforce duties of loyalty — for instance, by deciding cases about undisclosed conflicts and embezzled funds — courts lack the expertise and information to evaluate a nonprofit’s work.68 issues of impact and cost-effectiveness are seldom litigated, if only because standing rules do not permit donors and beneficiaries to bring derivative lawsuits.69 therefore, courts and state attorneys general do not provide meaningful substantive oversight of charities. b. tax subsidies that preserve nonprofit independence likewise, the i.r.s. is quite “hands off” in administering the tax system’s two main charitable subsidies: the deduction for donations70 and the tax exemption for a charity’s income.71 these subsidies do not depend on the i.r.s. to make judgments about which charities 64 see tyler, supra note 60, at 38 (“ neither charity officials nor the irs have the legal authority or legitimate right to substitute their personal opinions, preferences, or judgment for that of the donor or of foundation personnel, if such judgment is exercised reasonably and in good faith and otherwise satisfies donor intent and complies with the law”). 65 manne, supra note 11, at 228 (“nonprofits are loosely overseen by . . . the attorneys general of the fifty states”). 66 mary grace blasko et al., standing to sue in the charitable sector, 28 u.s.f.l. rev. 37, 39 (1993) (“lack of money, coupled with the obligation to discharge the other important duties of the attorney general's office, contributes to inadequate staffing for the purpose of supervising charities. this often results in a necessarily selective prosecution of only the most egregious of abuses.”). 67 manne, supra note 11, at 227 (“the attorney general's office is often understaffed and underfunded. . . . it is also a highly political office, and the government's agenda with respect to enforcement of charitable obligations is unlikely to include detached matters of efficiency, and may reflect a political ideology inimical to the aims of certain nonprofits.”). 68 cf. zohar goshen & gideon parchomovsky, the essential role of securities regulation, 55 duke l. rev. 711, 750 (2006) (“courts are ill-suited to handle breaches of the duty of care, as identifying mismanagement requires second guessing managements’ business decisions”). 69 hansmann, economic theories, supra note 16, at 32; manne, supra note 11, at 238 (“to the detriment of nonprofits, standing rules have essentially undermined the effectiveness of default fiduciary rules as they apply to the nonprofit sector.”). 70 the charitable deduction generally allows donors to avoid paying tax on amounts they give to charity. see i.r.c. § 170. for example, if a taxpayer earns $1 million of salary and contributes $100,000 to charity, she pays tax on only $900,000. if her marginal tax rate is 37%, this contribution of $100,000 reduces her tax by $37,000. 71 the exclusion spares charities from paying tax on their income from operations and from passive investments. see i.r.c. §501(a) (excluding the income of i.r.c. §501(c)(3) organizations from tax). for example, a charity that [vol. 11.2 columbia journal of tax law 96 to subsidize; instead, they provide billions of dollars automatically, as long as charities satisfy very general criteria.72 each subsidy is available to charities qualifying under i.r.c. § 501(c)(3) as “organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes.”73 to confirm their eligibility, charities can seek a letter from the i.r.s. by sharing their bylaws and articles of incorporation, and also describing their mission, projected budget, and sources of funding. although some applications are denied, the government is not supposed to assess the merits of the cause or the charity’s competence to advance it. once charities satisfy these very general requirements, the deduction and exemption are automatically available, as long as private individuals take the relevant steps. for the deduction, this step is a contribution to charity.74 for the exemption, by contrast, the subsidy is triggered when a charity earns income.75 in each of these subsidies, government officials have no discretion to adjust the size of the subsidy, regardless of their view of a charity’s work.76 c. government agencies as donors in contrast, the government has considerable discretion in making grants, which are quite sizable in some fields. like other donors, government agencies evaluate the merits of specific nonprofit programs, and often seek detailed reports, set benchmarks, and impose conditions. government grants are a significant source of income for some nonprofits,77 and a government grant also can be a positive signal, which induces others to contribute. as a result, government donors can have significant influence, as well as the incentive and expertise to monitor earns $100,000 of interest on bonds does not pay tax, thereby avoiding the 21% corporate tax that otherwise would apply. 72 as noted above, in describing the exemption as a subsidy, this article assumes that the baseline regime is an income tax, and that taxpayers otherwise would be taxed on resources they give away. compare william d. andrews, personal deductions and the ideal. income tax. 86 harv. l. rev. 309 (1972) (money a taxpayer gives away should not be considered her income) with mark kelman, personal deductions revisited: why they fit poorly in an “ideal” income tax and why they fit worse in a far from ideal world, 31 stan. l. rev. 831 (1979) (giving money away is something a taxpayer chooses to do, so this money should be considered her income). 73 i.r.c. §501(c)(3). i.r.c. §501(c)(3) lists a few other permissible purposes as well, and also requires nonprofits to use the right kind of legal entity, avoid certain types of political activity, and ensure that their net earnings do not “inur[e] to the benefit of any private shareholder or individual.” id. in general, the deduction is available only for contributions to organizations that qualify under i.r.c. §501(c)(3), but the exemption is available also to social welfare organizations that engage in lobbying, labor unions, and trade associations. see i.r.c. §501(c)(4) & (5). 74 i.r.c. §170. 75 charities pay no tax on revenue from their mission or from passive investments. for a discussion of which aspects of this tax exemption should be considered a subsidy, see boris i. bittker & george k. rahdert, the exemption of nonprofit organizations from federal income taxation,85 yale l. j. 299, 311, 315 (1976). 76 since charitable contributions reduce a donor’s taxable income, and thus her tax bill, the subsidy rate is based on the donor’s marginal tax rate. since a nonprofit’s revenue is not taxed, the subsidy is the marginal rate that otherwise would apply to the charity (the 21% corporate tax rate). 77 government grants represented 8% of public charities’ revenue in 2013, and government fees represented another 24.5%. brice s. mckeever, the nonprofit sector in brief 2015 (2015), http://www.urban.org/sites/default/files/alfresco/publication-pdfs/2000497-the-nonprofit-sector-in-brief-2015public-charities-giving-and-volunteering.pdf [https://perma.cc/yez8-2ndd]. 2020] enhancing efficiency at nonprofits with analysis and disclosure 97 management. yet in making grants, the government obviously is functioning as a donor, rather than as a regulator; the critical role of donors in monitoring nonprofits is discussed below.78 c. beneficiaries in general, beneficiaries of a charity have the right incentives to push for impact and costeffectiveness, and often have the right information as well. but they do not have enough influence unless they fund a meaningful share of a nonprofit’s budget. as a result, beneficiaries can monitor management more effectively at “commercial” nonprofits, which are largely funded by beneficiaries, than at “donative” nonprofits, which are mostly funded by donors.79 1. incentives by definition, a nonprofit’s mission is to serve its beneficiaries. as a result, beneficiaries want nonprofits to be efficient. when a nonprofit wastes money, beneficiaries get less value from it. but when a nonprofit figures out how to provide more (or better) goods and services for the same price, beneficiaries reap this reward. admittedly, beneficiaries do not always have the right incentives. when nonprofits serve multiple constituencies, each might try to advance its own narrow interests, distracting the nonprofit from higher value efforts to serve other (or, indeed, all) beneficiaries. for example, alumni fans might urge universities to spend on lavish stadiums instead of on research and instruction, even though the latter are more valuable to students and to society as a whole. 2. information to be effective, monitors must have not only the right incentives, but also the right information. in this regard, beneficiaries often compare favorably with other stakeholders because they use a nonprofit’s goods and services, and thus have first-hand knowledge of its impact. for example, when a disaster relief organization helps earthquake victims, they know more about the aid they receive than donors, who may be thousands of miles away. yet beneficiaries cannot always evaluate the quality of a nonprofit’s work. they may lack relevant expertise (e.g., to evaluate health care) or cognitive ability (e.g., to evaluate animal shelters).80 or they may have no contact with a nonprofit, even though they are part of a diffuse group that benefits from its work, for instance, in basic scientific research, civil rights advocacy, or environmental protection. 78 see infra part ii.e. 79 see hansmann, economic theories, supra note 16, at 28 (distinguishing donative and commercial nonprofits). 80 indeed, reassuring beneficiaries who can’t judge quality is a key reason to use nonprofits. see supra part i.a.1. but cf. prakash & gugerty, supra note 11 (to be reassured, beneficiaries need to understand that the nonprofit form limits the incentive of nonprofit leaders to overcharge or skimp on quality). [vol. 11.2 columbia journal of tax law 98 3. influence even if beneficiaries are motivated and knowledgeable, they also need influence to be effective monitors. will managers listen to them? the answer often turns on how much revenue they supply. if beneficiaries do not foot much of the bill, they have relatively little leverage. managers may still choose to listen, motivated by their own professional pride and commitment to the mission. even so, ignoring this feedback will not jeopardize their budgets or jobs, unless stakeholders with more influence, such as board members and donors, press managers to pay more attention to beneficiaries’ views. the analysis changes, though, if beneficiaries supply a meaningful share of a nonprofit’s revenue. this financial clout gives them essentially the same influence as consumers at for-profit firms. indeed, when beneficiaries have the means to fund a nonprofit’s budget, other nonprofits are likely to compete for their business. this product market competition is likely, in and of itself, to enhance impact and cost effectiveness.81 obviously, nonprofits vary significantly in the funding they receive from beneficiaries. at universities, tuition revenue is critical, so universities compete vigorously for students by offering innovative programs, better amenities, and the like. in contrast, soup kitchens and disaster relief organizations derive very little revenue from beneficiaries, so product market competition imposes less discipline on them. to sum up, beneficiaries usually have the incentive and information to monitor management. the key variable is whether they supply enough funding to have meaningful influence. in general, they have significant clout at commercial nonprofits, but not at donative nonprofits. d. boards of directors like beneficiaries, boards of directors also play a role in monitoring management. yet boards vary in their effectiveness. in general, they are better at monitoring issues that are easy to observe or measure. 1. incentives board members have two main motivations to monitor management, which resonate more with some than with others. first, they usually believe in the nonprofit’s mission, and want it to succeed. second, they have a reputational stake in avoiding problems on their watch. 81 hansmann, ownership, supra note 18, at 239 (“nonprofit firms often appear to be managed with substantial efficiency when, as is often the case, they operate in a competitive environment”); prakash & gugerty, supra note 11, at 41 (“when customers provide much of the revenue, they can vote with their feet.”). 2020] enhancing efficiency at nonprofits with analysis and disclosure 99 in principle, they also want to avoid liability, but this motive is weak at best. boards are supposed to act in the organization’s best interest, stay informed, and avoid conflicts of interest. yet enforcement of these fiduciary duties is weaker in nonprofits than in for-profit firms; the state ag can bring a lawsuit, but donors and beneficiaries generally lack standing to sue.82 as a result, if directors are like justice holmes’ “bad man” in doing only the minimum to avoid liability, they need to block egregious managerial behavior, but can settle for mediocrity. as a result, much depends on the personal commitment and abilities of board members. to keep managers from making unwise and self-interested choices, boards need to dig into the details, vetting the impact and cost-effectiveness of programs. how willing are they to do so? unfortunately, some nonprofit board members are less capable and committed than others. as volunteers, many invest only limited time.83 some are there for self-interested reasons. they value the prestige of board service and like to form social ties with influential people.84 they may also want special access to the nonprofit’s services (e.g., the best doctors at hospitals). board members with these motives are unlikely to ask hard questions. someone looking for friendships and pleasant experiences usually steers clear of uncomfortable situations. likewise, someone seeking a leadership role does not want to “rock the boat,” and someone wanting special access to a nonprofit’s services can’t afford to antagonize managers. board members sometimes pursue other personal agendas as well. if they befriend a manager, they might advocate for their friend’s career and program. conversely, if they dislike a manager, they might undercut her and her program for non-merits-based reasons. in addition, if they donate to a specific project, they might use their influence as board members to advance this initiative.85 in pursuing personal agendas, board members sometimes clash with each other. unfortunately, these conflicts can delay key decisions, consume the attention of the organization’s leaders, and interfere with fundraising. 2. information to monitor managers effectively, nonprofit boards must have not only the right incentives, but also the necessary information. as volunteers, they know less about day-to-day operations than management, but have ample authority to ask for information. 82 brody, agents without principals, supra note 16, at 466. 83 young, supra note 7, at 155. 84 melissa middleton, nonprofit boards of directors: beyond the governance function, in the nonprofit sector: a research handbook (walter w powell ed. 1987) (first edition) at 141, 149-51 (“[b]oard members are part-time volunteers who may serve as trustees for a variety of noneconomic reasons, such as the desire to become more fully integrated into the community, to develop new circles of friends, and to gain status and prestige.”); hansmann, economic theories, supra note 16, at 36 (donating to performing arts can confer membership in prestigious club). 85 triantis, supra note 11, at 1148 (since donors have different philanthropic objectives, a board member’s interests are likely to diverge from those of other donors). [vol. 11.2 columbia journal of tax law 100 in requesting information, most boards focus on their nonprofit’s solvency, internal controls, and compensation, rather than on the details of its work. boards typically review audited financials, insurance coverage, investment reports, management compensation,86 and policies to prevent misconduct.87 yet as francie ostrower has observed, “[w]e have to ask not only whether nonprofit boards have various practices and policies in place to avoid malfeasance, but whether they are . . . ensuring that the organization is accomplishing its mission.”88 based on a survey of over 5,000 nonprofits, she concludes that boards are much less likely to monitor the substance of a nonprofit’s work.89 this focus on solvency and governance, instead of on programs and grants, reflects the skill sets of most nonprofit board members. arguably, nonprofit boards should include more members with expertise in the mission. yet boards often are composed of investment bankers, lawyers, and entrepreneurs, who are chosen in part for their philanthropic capacity. these board members often have deep experience reviewing financial statements, updating governance policies, and setting pay, but not in analyzing the nuances of disaster relief, performing arts, social services, or academic research.90 at most nonprofits, boards are self-perpetuating. in choosing successors, board members often gravitate toward candidates with similar professional experience, replicating their own strengths and weaknesses. like nonprofits, for-profit firms sometimes also have directors who are not experts in the firm’s work. yet these generalists can use a short-cut to monitor management – tracking earnings – that is unavailable at nonprofits, as emphasized above. for example, if an investment banker joins the board of an energy company, and is not an expert on energy, she can focus on whether the company is profitable. if it is losing money, she knows to ask probing questions. in contrast, if the same investment banker joins the board of a humanitarian organization, she cannot look at its earnings to check whether it is succeeding; instead, she has to dig into the details of its work, as noted above. to develop this granular understanding, boards should ask managers to educate them about the nonprofit’s work. they also should seek feedback from beneficiaries. in addition, they also can consult independent experts, for instance, about which metrics to track, as well as about whether the nonprofit’s programs, fundraising, and governance are state of the art. 3. influence to monitor management, boards must have not only motivation and information, but also influence. in general, boards have three key sources of authority. first, they choose (and fire) the ceo. second, they usually sign off on the budget. since almost anything a nonprofit does must appear in its budget, boards can use their sway over budgets to influence almost any aspect of a 86 francie ostrower, nonprofit governance in the united states: findings on performance and accountability from the first national representative study 2 (2007) [hereinafter “nonprofit governance”]. 87 id. at 4. 88 id. at 1. 89 id. at 12 (“substantial percentages of nonprofits report that their boards are not actively engaged in basic stewardship responsibilities”). 90 brody, agents without principals, supra note 16, at 467-468. 2020] enhancing efficiency at nonprofits with analysis and disclosure 101 nonprofit’s work. third, as noted above, boards usually choose who serves on the board, allowing them to remain in place or to pick their successors. in principle, these formal powers give board members ample influence over managers. yet in practice, the board’s influence varies on two dimensions. first, some nonprofit boards are more active than others. some are quite “hands on” about details, while others are very deferential to management. meeting agendas, the frequency of meetings, and the time and effort invested by the board all vary dramatically. second, within each board, some members have more influence than others. for example, some chairs have effective control, while others are “first among equals.” likewise, some board members gain extra clout through especially large donations, while others do so through close personal ties with managers and other board members. to sum up, all board members have formal authority to monitor management, but they vary in their motivation and capacity to do so. in general, they focus on what they can easily observe and understand, such as ceo pay and conflict of interest policies. unfortunately, they focus less on the impact and cost-effectiveness of programs. while some board members make this effort, others shy away from difficult decisions and focus on personal agendas. in other words, some board members are a solution to agency costs, while others are part of the problem. e. donors like boards of directors, major donors often have the incentive and influence to monitor management. a key question is whether they have the right information. 1. incentives donors usually give money because they are committed to the cause,91 but this commitment can manifest itself in different ways. for some donors, good intentions are enough, and they do not need to verify that their funds are put to good use.92 at some level, they may even prefer not to know this hard truth, which would erode their feelings of satisfaction.93 these donors obviously are less motivated to police managerial agency costs and incompetence. in contrast, other donors are very focused on impact. wanting to get the most for their money, they look for evidence that their gift is making a difference. this quest for results is a familiar philanthropic trend, which is especially common among professionally managed 91 in some cases, donors have other motivations (e.g., a favor to a friend, a way to burnish their image, etc.). 92 see kumar, supra note 9, at 3-4 (“the global aid industry has long operated with an underlying assumption that the most important thing is to have good intentions. for as long as people have been giving money and help to strangers, after all, they have felt driven by the intention to do good and, often, to take credit for it.”). 93 i thank louis kaplow for this point. [vol. 11.2 columbia journal of tax law 102 foundations and younger donors.94 these donors are motivated to serve as monitors, at least when they give major gifts.95 the literature has not focused sufficiently on the motives of these donors, assuming instead that stakeholders who cannot share in surpluses do not press for efficiency.96 yet donors still benefit from efficiency in two ways. first, their gift has greater impact, and thus is more satisfying. second, instead of giving a fixed amount, some donors fund a specific need, and thus can give less when a nonprofit addresses it at a lower cost; this savings is the functional equivalent of a distribution.97 despite these reasons to press for efficiency, donors do not always do so — and, indeed, are sometimes a source of inefficiency — for a range of reasons. first, their support comes at a cost. nonprofits must invest in fundraising, just as for-profit firms spend on marketing. although these expenditures are necessary, diverting resources from the mission is never wholly satisfying. second, in deciding what to support and how to use their influence, some donors are swayed by personal relationships. like board members, they might befriend (or dislike) specific managers, and defend (or undercut) them and their programs for non-merits-based reasons. third, even when donors focus on the merits, they sometimes champion the wrong cause (just as managers sometimes do). for some, good intentions are enough, as noted above. for others, the results matter, but these donors do not take the time to make fully informed judgments, especially in making modest contributions.98 in addition, some donors have idiosyncratic preferences, and fund causes that others find unappealing or even offensive. after all, a key purpose of nonprofits, emphasized above, is to experiment with new ideas, which may well be controversial. some ideas prove themselves over time, while others do not. fourth, even when donors support worthwhile causes, they sometimes choose the wrong strategies and programs. after all, donors often lack expertise about the mission.99 they sometimes receive helpful guidance from philanthropic advisors or other experts. nonprofit managers can also be a valuable resource, at least if donors trust them. but managers are not 94 see gugerty & karlan, supra note 8, at 8 (“[p]hilanthropic culture has changed ... young and wealthy philanthropists are different from their parents and grandparents; they want to make sure their dollars are having a measurable impact.”); kumar, supra note 9, at 4 (“in the new aid industry, giving is increasingly being evaluated not by the goodness of the intentions or the amount of money given but rather by results.”). 95 triantis, supra note 11, at 1148 (“donors with small stakes are likely to exhibit the same passivity as their counterparts in commercial corporations”). 96 hansmann, nonprofit enterprise, supra note 7, at 878. 97 to illustrate these two (related) donor motivations, consider two donors who support financial aid at a school. anne gives $50,000, regardless of what the tuition is. if anne pushes the school to run more efficiently, she does not save money, but her gift helps more students and thus is more satisfying. in contrast, betty commits to pay the tuition of one student. if efficiencies reduce tuition from $40,000 to $35,000, betty saves $5,000. 98 hope consulting, money for good 27 (2015), http://www.cambercollective.com/moneyforgood [https://perma.cc/9nl9-znap] (38% of surveyed donors researched at least one donation, 33% researched performance, and 9% compared two nonprofits). 99 see prakash & gugerty, supra note 11, at 25 (noting that donors often lack expertise to monitor nonprofits). 2020] enhancing efficiency at nonprofits with analysis and disclosure 103 always willing or able to steer donors in the most productive direction (and, indeed, make the wrong choices themselves sometimes, as noted above). fifth, even when donors choose the right strategy, they do not always push hard enough for it. instead of pressing managers to improve, the easier course often is to look for a different nonprofit to support. for example, in suggesting improvements in a program, a donor sometimes encounters resistance from managers, who have self-interested reasons to favor the status quo. other donors may push back as well, not wanting to acknowledge flaws in a program they have supported for years. when facing this sort of resistance, a donor cannot invoke the warning signs that justify change at for-profit firms: declining earnings or share price. instead of continuing to press the issue, a donor may decide instead to find a different cause. sixth, pride and ego complicate some donor choices. for example, some donors want to fund only new initiatives, considering this the best way to make their mark. admittedly, a gift can seem especially impactful in helping a nonprofit do something new, but a key question is why the nonprofit is not already doing it. if the reason is that conditions have changed, and the new initiative is a necessary response, then funding it is worthwhile. but another explanation is that managers do not consider the initiative a priority. if their assessment is correct, funding it is a misallocation of resources. finally, some donors are themselves organizations, which have agency costs of their own. at private foundations, managers sometimes prioritize their own preferences over those of their principal. similar dynamics can influence federated funds, such as the united way and jewish federations. the nonprofit equivalent of mutual funds, these public charities collect donations and allocate them to other charities, which run the relevant programs. their grantmaking is supposed to focus on the merits — and, indeed, is often the product of extensive deliberations by professionals and volunteers. but sometimes their priorities shift for nonmerits-based reasons (e.g., to reflect the interests of new lay and professional leaders or to enhance fundraising by focusing on trendy needs). likewise, their allocations sometimes reflect political dynamics, for instance, in deferring to influential stakeholders. 2. information along with the right motivation, donors also need the right information. to ensure that the programs they fund are impactful and cost-effective, while also confirming that a nonprofit’s work aligns with their preferences, donors need to dig into the details. yet the relevant information can be hard to acquire. donors often do not have first-hand knowledge of a nonprofit’s work, since they usually fund goods and services for beneficiaries they never meet. admittedly, some donors are themselves beneficiaries (or former beneficiaries), for instance, in supporting their alma mater, local religious and cultural institutions, and hospitals. some donors also learn about a nonprofit’s [vol. 11.2 columbia journal of tax law 104 work as volunteers. but many donors have little personal contact with programs they fund.100 their main source of information is the nonprofit’s management, who have an obvious conflict of interest. admittedly, investors in a for-profit firm face similar challenges. but again, these investors can rely on profitability to measure success, while nonprofit donors cannot. even when donors have a clear picture of a nonprofit’s overall activities, they rarely know the marginal impact of their contribution.101 donors make decisions in isolation, without knowing what others fund.102 since money is fungible, each donor has only limited influence on a nonprofit’s budget.103 for example, a university donor might designate her gift to financial aid, hoping to increase the financial aid budget. but fundraisers can respond by steering other donors away from financial aid, so total expenditures on financial aid do not change. the broader the nonprofit’s portfolio of programs, the easier it is for managers to maintain their discretion in this way, even as donors make targeted gifts. although no donor has complete information, some have more than others. compared with modest donors, major donors have leverage to ask for details. in gift agreements, they can require reports on how their gift was spent, as well as on its impact. the agreement also can set benchmarks, such as the number of clients that must be served. this has become a common practice for private foundations, and is increasingly common for wealthy individual donors and government agencies as well. yet although this sort of report is helpful, it is still likely to have gaps. donors do not necessarily ask the right questions or suggest the right benchmarks, since they are not immersed in the nonprofit’s operations.104 in addition, a report prepared for only one donor may not convey the full picture, and may even be inconsistent with reports prepared for other donors. instead of a tailored report, modest donors usually have to rely on publicly available information, which can be uneven. a nonprofit’s website and marketing materials typically offer 100 see young, supra note 7, at 111 (“one important source of relief, and hence discretion, for nonprofit entrepreneurs is that few constituents will have direct knowledge of performance, much time for monitoring, or precise criteria for judgment.”); hansmann, economic theories, supra note 16, at 30 (“the difficulty is that the purchaser (donor), who has no contact with the intended beneficiaries, has little or no ability to determine whether the firm performs the service at all, much less whether the firm performs it well.”). 101 ellman, supra note 20, at 1010. 102 see saul levmore, taxes as ballots, 65 u. chi. l. rev. 387, 411 (1998) (“a donor's decision as to how to allocate his own funds . . . depends on other contributors' decisions”). 103 cf. young, supra note 7, at 111-12 (noting that decisions about programs are separate from resource allocation, leaving nonprofit entrepreneurs with substantial discretion). 104 cf. jennifer alexander, jeffrey l. brudney & kaifeng yang, introduction to the symposium: accountability and performance measurement: the evolving role of nonprofits in the hollow state, 39 nonprofits & vol. sect. q. 565, 566 (2010) (“funders and nonprofit executives indicated that they do not always fully understand what they are asked to measure or how to make sense of the results. practitioners and academics concurred that a great deal of data is generated for symbolic purposes and that the interpretation can be highly ambiguous”). 2020] enhancing efficiency at nonprofits with analysis and disclosure 105 general descriptions of their mission, compelling images, and inspiring anecdotes.105 but data and analysis on the mission and programs are harder to find. donors can read form 990, the nonprofit’s annual tax return, on a website called “guidestar” that shares information about thousands of nonprofits. yet form 990 is of limited value under current law. it often includes errors106 and is out-of-date.107 form 990 also offers very little information on a nonprofit’s mission and programs.108 it includes a financial statement, which classifies how much is spent on programs, as opposed to administration and fundraising. yet nonprofits are not asked to explain how they measure success, or to offer details on the impact or cost-effectiveness of their programs.109 instead, form 990 focuses on governance, solvency, and compliance with tax rules. for example, it describes the nonprofit’s internal controls and lists the names and pay of board members and senior managers, enabling the i.r.s. to confirm that the organization is not distributing profits to its leaders. form 990 also offers information about two types of activities, lobbying and for-profit businesses, which are subject to special tax rules.110 in addition to form 990, modest donors can seek information from the media. the press often covers problems targeted by nonprofits, such as natural disasters, pandemics, and failing 105 see gugerty & karlan, supra note 88, at 6 (“often, organizations trying to produce social impact have marketed their work to donors through stories about specific individuals who benefited from their programs.”). 106 evelyn brody, sunshine and shadows on charity governance: public disclosure as a regulatory tool, 12 fla. tax rev. 183, 184 (2012) (observing that many form 990s “contain errors, some materially misleading”) [hereinafter brody, “sunshine”]; karen a. froelich & terry w. knoepfle, internal revenue service 990 data: fact or fiction?, 25 nonprofit & vol. sect. q., 40, 42 (1996) (“problems with this source of data are increasingly being recognized”). 107 since the filing deadline is over ten months after the end of their tax year, information about a given year (e.g., 2020) is not available until november 15 of the following year (e.g., 2021). this assumes nonprofits are on a calendar tax year and claim an automatic six-month extension. 108 the closest form 990 comes to these issues is in part iii, a “statement of program service accomplishments,” which is supposed to describe the mission and give an overview of accomplishments and expenses in the nonprofit’s three largest program areas. the focus is supposed to be changes since the prior year. see instructions for form 990 return of organization exempt from income tax (2019), part iii, https://www.irs.gov/instructions/i990#idm140401897078624 [https://perma.cc/3yfe-uycf]. 109 peter swords, the form 990 as an accountability tool for 501(c)(3) nonprofits, 57 tax lawyer 571, 517 (1998) (noting that form 990 is potentially effective in preventing self-dealing, an effort he calls “negative accountability,” but it is not effective at determining “whether an organization is doing anything useful or whether it is doing it effectively,” which he calls “positive accountability”); brody, sunshine, supra note 106, at 188 (“regrettably, the most important information that both regulators and the public might want will continue to be unavailable. . . as a society, we would want to be able to assess whether and which charities are producing favorable outcomes, but often we cannot even measure outputs because quality can be subjective. . . . thus, beyond the scope of this paper is the ultimate disclosure question: how do we challenge an organization that says it ‘does good’?”). 110 certain types of nonprofits are required also to provide special disclosure. for example, hospitals must release a community health needs assessment every three years. see treas. reg. 1.501(r) -3(b)(1)(iv). likewise, nonprofits engaged in public interest litigation are required to disclose “a description of cases litigated and the rationale for the determination that they would benefit the public generally.” see section 3.04 of https://www.irs.gov/pub/irstege/rp1992-59.pdf. [vol. 11.2 columbia journal of tax law 106 schools. scandals at nonprofits also are likely to be covered.111 supplementing this piecemeal reporting, outlets that focus on the nonprofit sector, or on areas within it such as international development, provide more sustained coverage.112 even so, the media rarely analyzes the impact and cost-effectiveness of specific programs. donors also can investigate whether nonprofits have received a “seal of approval” from an industry association by committing to meet its standards. yet as with rating agencies, these associations usually focus more on governance practices than on the quality of programs.113 given these limits on publicly-available information, some modest donors rely on intermediaries to allocate their donations, such as the united way or jewish federations. these federated funds have the clout to ask for information but, as noted above, their allocations are sometimes skewed by their own agency costs and other internal dynamics. 3. influence even if donors have the incentive and information to press for more efficient resource allocation, they do not always have the influence to do so. the key variable is how much they give. unlike modest donors, major donors have significant sway with management.114 if the nonprofit does not meet their expectations, these donors can find other outlets for their philanthropy, and this prospect gives them leverage. some donors exert added influence by inducing others to give. for example, a gift from well-respected donors can serve as a “seal of approval” for others. current and future donations carry more influence than past donations. for example, a donor who gave an endowment last year can no longer withhold her support, and thus has less clout than one who retains discretion to stop giving.115 this is all the more true of someone who endowed a private foundation, and has since passed away; in this circumstance, foundations often implement the preferences of their professionals and board, rather than of their founder. anticipating this erosion of influence, endowment donors often require the endowment to be returned (or given to another charity) in specified circumstances. but these contractual restrictions are an imperfect source of influence, since donors cannot anticipate all the scenarios they wish to prevent. 111 see swords, supra note 109, at 573 (“good reporters -hard-news, hard-news reporters -love nothing more than exposing such abuses.”). 112 see, e.g., https://www.devex.com/news [https://perma.cc/gj3l-9u95] (covering international aid industry); https://ejewishphilanthropy.com/ [https://perma.cc/sv7x-ynu8] (covering jewish philanthropy). 113 see prakash & gugerty, supra note 11, at 34-35 (advocating “accountability clubs” as signals of quality and offering examples of club standards on board composition, hr management, fundraising practices, and transparency). 114 hansmann, economic theories, supra note 16, at 31-32. at first blush, the influence of donors as a group might seem limited, since donations on average are less than a third of u.s. nonprofits’ revenue. see brody, agents without principals, supra note 16, at 470 (“few nonprofits actually rely on donors for the bulk of their support.”) yet some (e.g., social services organizations) rely much more on donations than others (e.g., hospitals). even when donations fund only a fraction of the budget, managers still don’t want to lose them, or they will have to make painful cuts in services and employee headcounts. 115 schizer, comparing the deduction with the exemption, supra note 4, at 665. 2020] enhancing efficiency at nonprofits with analysis and disclosure 107 to sum up, many donors want their money to be used wisely, but only a subset give generously enough to exert meaningful influence. like board members, major donors have the motivation and clout to monitor management, but they do not always have this information. one way to improve the monitoring of nonprofit managers, then, is to provide major donors with the information they need. f. rating agencies in principle, a promising source of information and analysis for donors is rating agencies. the mission of these institutions is to analyze philanthropic opportunities. like major donors, they usually have the right incentives, as well as the potential to exert significant influence. yet as with major donors, a key question is whether they have the necessary information. 1. incentives the job of these rating agencies is to evaluate nonprofits. to attract readers (and revenue), rating agencies need to dig into the details of missions, budgets, and programs, identifying which nonprofits offer the most “bang for the buck.” to deploy the relevant expertise, agencies should either hire a broad range of experts or specialize in particular types of nonprofits (e.g., so one focuses on hospitals, another on social services, still another on the arts, etc.). in mobilizing this expertise, rating agencies offer economies of scale. individual donors can avoid the duplicative effort of conducting their own assessments, depending instead on a rating agency to amortize the costs of its analysis across all of its readers. needless to say, rating agencies can play this role only if they attract the necessary funding. in principle, donors should be willing to pay for this service – for instance, by subscribing to a website with restricted access – so they can find better philanthropic opportunities. but if donors can access evaluations without paying, they will be tempted to “free ride.” to offset this loss of revenue, rating agencies can organize as nonprofits and seek donations. foundations and other donors that value rigorous analysis should support this work, recognizing that better monitoring should enhance the nonprofit sector’s impact and costeffectiveness. even so, a familiar concern about all gatekeepers applies here as well: who is monitoring the monitor?116 is the rating agency going the extra mile? is it developing a nuanced understanding of a nonprofit’s impact and cost-effectiveness? competition with other rating agencies should motivate it to do so. is the rating agency even-handed? its objectivity could be compromised, for example, if it charges nonprofits for evaluations or other services. by analogy, commentators worry about conflicts of interest facing proxy advisors. these firms evaluate (for-profit) public companies, 116 see generally john c. coffee, jr., gatekeepers (2006). [vol. 11.2 columbia journal of tax law 108 advising shareholders how to vote on proxy proposals. but these firms also sell consulting services to companies they monitor, prompting commentators to worry about quid pro quos, in which companies essentially pay to receive positive evaluations.117 to avoid this sort of conflict of interest, rating agencies should not take money from nonprofits they evaluate. instead, they should rely on subscription revenue and donations, as noted above. admittedly, major donors to a rating agency might try to advocate for nonprofits they support. but rating agencies need to rebuff this lobbying – something donors should understand – to ensure that ratings are unbiased. 2. information to monitor nonprofit managers, rating agencies need not only the right incentives, but also the necessary information. yet unfortunately, most rely on form 990, which says very little about nonprofit programs, as noted above. as a result, most rating agencies do not analyze a nonprofit’s work. for example, charity navigator assesses a nonprofit’s “financial health” and “accountability and transparency,” but does not evaluate programs.118 similarly, global giving vets nonprofits every two years for “transparen[cy],” accountab[ility],” and legal compliance, but not for “effectiveness.”119 given the limited information available on form 990, rating agencies often focus on a number that is easy to compute with the information it provides: the percentage of the budget allocated to administration, as opposed to programs.120 yet these overhead ratios are “deeply flawed as a measure of implementation quality,” mary kay gugerty and dean kalman have observed. “some things simply cost more to administer than others.”121 in addition, some types of overhead actually are evidence of quality. for example, donors depend on nonprofits to 117 see timothy doyle, the conflicted role of proxy advisors, harv. law school forum on corporate governance blog, (may 22, 2018), https://corpgov.law.harvard.edu/2018/05/22/the-conflicted-role-of-proxy-advisors/ [https://perma.cc/uq33-pupw] (“proxy advisory firms are incentivized to align with the comments of those who pay them the most and to move targets and change policy to create a better market for their company-side consulting services”) 118 specifically, charity navigator awards between one and three stars based on two factors. first, “financial health” reflects access to working capital, growth in the program budget, and spending on administration and fundraising. second, “accountability and transparency” evaluates governance practices, such as whether the charity has an independent board and audited financials. see charity navigator, charity navigator's methodology, https://www.charitynavigator.org/index.cfm?bay=content.view&cpid=5593&from=short-url#rating [https://perma.cc/97z6-tvxj]. 119 https://www.globalgiving.org/aboutus/how-it-works/vetting/ [https://perma.cc/7qvx-z5c6]. (“global giving performs rigorous due diligence . . . to ensure they are performing charitable work in a transparent and accountable manner, and that they meet local requirements for registration with their local government. . . . [o]ur nonprofit partners have the opportunity to share extra information about the effectiveness of their work. organizations can share information about how they listen to their stakeholders, test out new ideas, and improve their programs and services based on what they learn from data and feedback.”) 120 diana stork & jill woodilla, nonprofit organizations: an introduction to charity rating sources and cautions in their use, 6 int’l j. applied man. & tech. 5 (2008) (rating agencies rely predominantly on financial ratios). 121 gugerty & kalman, supra note 8 at 68. 2020] enhancing efficiency at nonprofits with analysis and disclosure 109 comply with the law and have effective internal controls, and this internal oversight requires resources. in addition, overhead also includes efforts to set priorities and monitor the effectiveness of programs, and this article obviously urges nonprofits to invest more in this type of overhead. at best, a rating that focuses on information in form 990, such as “financial health” and “accountability and transparency,” is “basically a negative screen — it flags organizations that do not meet basic criteria,” raj kumar has observed, “the tougher challenge comes in evaluating an organization’s positive impact.”122 recognizing these limitations, charity navigator sometimes allows nonprofits to post impact evaluations by third parties. likewise, guidestar highlights whether organizations share impact evaluations.123 but to be clear, guidestar does not conduct or even vet these evaluations; it merely indicates whether a nonprofit shares this information, but does not comment on whether the organization’s methodology is sophisticated or, for that matter, whether the results are compelling.124 another rating agency, givewell, relies on academic studies, instead of on form 990. to advance its mission of helping poor people outside the u.s., givewell combs the academic literature for cost-effective interventions, such as distributing insecticide-treated nets and treating children for parasites.125 givewell then invites charities that offer the relevant programs to provide specific information, which it reviews.126 to its credit, givewell has found a way to go beyond the limited information in form 990, but it rates only a targeted set of programs at a small number of organizations.127 3. influence effective monitoring requires not only the right incentives and information, but also the necessary influence. on this dimension, rating agencies fare quite well. they wield significant influence through their readers. board members, major donors, and prospective donors are likely to review their analyses, and managers obviously want the good will of these influential stakeholders. so if rating agencies express doubts about the impact or cost-effectiveness of 122 see kumar, supra note 9, at 55. 123 https://learn.guidestar.org/seals [https://perma.cc/d398-3xc4] (listing criteria for various levels of seals of approval, which turn on how much information the nonprofit shares). 124 see kumar, supra note 9, at 56 (noting that guidestar “rankings are more subjective, and not based on an agreed-upon system of external reviews”). 125 see https://www.givewell.org/how-we-work/process [https://perma.cc/l4ky-dupk]. (“based on these investigations, we have concluded that: highly rigorous evidence connecting aid activities to improved life outcomes . . . is found in academic literature, and not (in any cases that we've seen) in internal self-evaluations by charities.”) 126 see id. (“we invite eligible charities to participate in our intensive evaluation process, which aims to deeply and critically question the case for the charity's impact, and lay out what we see as the strengths and weaknesses publicly.”). 127 see kumar, supra note 9, at 57. [vol. 11.2 columbia journal of tax law 110 specific initiatives, or question other aspects of a nonprofit’s operations, managers are unlikely to ignore this feedback in some cases, modest donors and beneficiaries also read a rating agency’s review. even though individual members of these groups have only limited influence, their clout in the aggregate can be quite significant so, again, managers are likely to pay attention. in a sense, rating agencies can stand in for these groups, monitoring management on their behalf. to sum up, rating agencies have strong incentives to monitor management and can wield significant influence. yet to play this role effectively, rating agencies – like major donors – need better information about the impact and cost-effectiveness of nonprofit programs. the rest of this article considers how to make this information more readily available. iii. countering inefficiency with a rigorous planning process so far, this article has identified a key source of inefficiency at nonprofits: instead of relying on profitability to measure success, they have to track their progress in other ways. as a result, even the best nonprofit leaders need to work harder to allocate resources efficiently, while less capable and committed leaders have more latitude to make self-interested and unwise choices. to discourage these flawed decisions, this article urges boards, donors, and rating agencies to monitor management. yet as the prior part showed, these monitors need the right information to play this role effectively. to address these challenges in measuring success and detecting mismanagement, this part recommends a more rigorous planning process for nonprofits. every year, they should update their mission, revisit their priorities, and search for ways to improve their programs. to guide this analysis, this part recommends a set of questions for nonprofits to answer every year. after discussing these questions, this part analyzes the benefits and costs of engaging in this analysis. a. three questions too often, nonprofits keep doing what they have done before. alarm bells that force forprofit firms to make painful changes — declining profits and share prices — do not ring at nonprofits. longstanding initiatives endure, even as new ones are layered on top of them. indeed, nonprofit programs are sometimes easier to explain with archeology than with logic. instead of assuming that existing programs should continue, nonprofits should periodically review all of their programs. the same standard should apply in deciding both whether to continue an existing initiative and whether to launch a new one: is this program the best use of the nonprofit’s scarce resources? in planning programs and setting budgets each year, nonprofits should strive to maximize social return, but how can they operationalize this somewhat abstract principle? to do so effectively, their planning process has to account for the context, since nonprofits vary widely in their missions and goals; universities, humanitarian organizations, and houses of worship need to analyze very different issues. 2020] enhancing efficiency at nonprofits with analysis and disclosure 111 the planning process should also be tailored to the skill sets of nonprofit managers, who are often social workers, educators, religious leaders, doctors, and lawyers. while they know a great deal about the nonprofit’s work, they often know less about econometrics, cost-benefit analysis, management theories, and other disciplines that could bear on choices they face. to help nonprofits evaluate their programs’ social return, this section proposes three questions, which nonprofits should answer in writing every year. the author developed these questions as the ceo of an international humanitarian organization.128 this article refers to them as “the three questions” and refers to the nonprofit’s answers as a “program analysis.” the questions are general enough to apply to any nonprofit — whether they are soup kitchens, symphonies, or grant-making foundations. the questions use jargon-free language that should resonate with nonprofit managers and boards. to be clear, the goal here is not to advocate for these specific questions, but for a rigorous written analysis – in whatever form – that assesses the relevance of a nonprofit’s mission and the impact and cost-effectiveness of its programs. while the questions recommended here are a good starting point, nonprofits can tailor them to fit their work, organizational culture, and other institutional needs. nonprofits should also fine tune other details of the planning process. for example, the recommendation here is to produce a new program analysis every year, as a way to ensure that the annual budget reflects up-to-date priorities and strategies. yet some nonprofits might prefer to conduct this analysis every other year. still others might do a bare bones analysis some years, and a deeper dive in others (e.g., every three or five years). it is essential to keep revisiting these questions, but reasonable minds can disagree about how frequently to do so. 1. first question: how important are the challenges the nonprofit is trying to address? the social value of a nonprofit’s work depends in part on its mission. what problem is it trying to solve, and why is this problem important? this question weeds out missions that become stale, such as the march of dimes’ efforts to eradicate polio.129 this first question invites a nonprofit to make the case for its mission and key goals. admittedly, there is no metric to compare the value of different goals, but a nonprofit can still 128 the author initiated a practice of answering these questions in a new report every year, which analyzes all of the nonprofit’s major activities in 70 countries across the world and explains how the $365 million budget is allocated. for the 2020 report, see https://www.jdc.org/wpcontent/uploads/2019/12/jdc_global_strategy_2020_12192019.pdf [https://perma.cc/24jv-5zen]. 129 see march of dimes, about us, https://www.marchofdimes.org/mission/about-us.aspx [https://perma.cc/a453dlh3] (“we pioneered the vaccine research leading to the eradication of polio in the u.s., and then we shifted focus to address some of the biggest health threats to moms and babies with innovations like folic acid, newborn screening and surfactant therapy.”) [vol. 11.2 columbia journal of tax law 112 show why its goals are important. instead of superlative adjectives and emotional anecdotes, its program analysis should offer data and analysis.130 to provide the right data – and, more generally, to demonstrate the urgency of the challenges it addresses – a nonprofit should define its goals clearly and specifically. for example, instead of saying it seeks “to help poor people,” a nonprofit should say that it is “providing food and medicine to elderly in ukraine” or “enhancing crop yields of ethiopian farmers with innovative agricultural technology.” once the nonprofit defines its goals clearly, it can offer objective facts to demonstrate their importance. for example, the nonprofit can report that daily government pensions for elderly in ukraine are just two dollars, compared with thirty-two dollars in france and fifty dollars in the united states.131 similarly, the nonprofit can emphasize that 85% of ethiopia’s 109 million people earn their living from agriculture, and that the country’s average income is only $2.16 per day.132 compelling facts speak for themselves. if the relevant facts are not compelling, the nonprofit needs to rethink its goals. information about the importance of a nonprofit’s goals should not be hard to provide. after all, managers are supposed to know why their mission is important. they can draw on academic research and media coverage, which often is easier than gathering and analyzing data about their own programs and grants. 2. second question: how effective are the nonprofit’s responses to these challenges? even if a challenge is important, social return is low if a nonprofit cannot address it effectively. so operating charities and funders should produce a detailed answer to a second question, which is harder to answer: how effective is their response to this problem? a. revisiting priorities and testing improvements this question presses nonprofits to keep revisiting priorities and testing potential improvements. in answering this question, nonprofits need to ensure that their approach is cutting edge and their costs are lean. 130 see gugerty & karlan, supra note 8, at 6 (“even though . . . stories [about individuals] may be compelling, they do not tell us the impact of the program on people’s lives -whether the program is actually working”). 131 see https://finance.yahoo.com/news/heres-every-states-average-social-132355610.html [https://perma.cc/bv5fmk3w] (average social security benefit in u.s. is $1,503 per month or about $50 per day); https://www.cleiss.fr/docs/regimes/regime_france/an_3.html [https://perma.cc/yvy8-ynuj]. (french solidarity allowance for elderly brings monthly income €868.20 or approximately $32 per day, assuming an exchange rate of 1.085 dollars per euro); https://www.ssa.gov/policy/docs/progdesc/ssptw/2018-2019/europe/ukraine.html (minimum pension in ukraine for those aged 65 or older is 40% of 3,723 hryvnias (the monthly minimum wage) or 1,489 hryvnias; at an exchange rate of .037 dollars per hryvnia, this is $55.10 per month). 132 https://www.worldbank.org/en/country/ethiopia/overview [https://perma.cc/85x8-xxhf]. 2020] enhancing efficiency at nonprofits with analysis and disclosure 113 if a program is ineffective, they should shut it down. for example, if deploying agricultural technology in ethiopia does not actually enhance crop yields, the effort should be discontinued. even when a program is effective, nonprofits should try to make it better. if crop yields are already increasing by 25%, what would it take to increase them by 50%? or could the nonprofit get the same result while spending 15% less? is there a less expensive technology? can management costs be reduced? innovative organizations constantly search for better approaches, and this second question invites nonprofits to engage, restlessly and relentlessly, in this sort of constant experimentation. to benefit from these experiments, nonprofits need the right planning process. along with collecting reliable information about their results, they need to incorporate this information into their decision-making process, so it contributes to organizational learning.133 the first two questions push organizations to take these steps. in encouraging constant goal-setting and analysis, these questions resemble “okr” or “objectives and key results,” a management approach used at google and other leading forprofit firms. under okr, at the beginning of the relevant period, which might be the month, quarter, or year, senior managers specify between five and ten objectives, along with “key results” that measure their progress. managers monitor these key results throughout the period, and then refine or change their objectives and key results for the following period.134 b. measuring progress in constantly reexamining their work, what results should nonprofits monitor? to assess whether their response to a problem is effective, they need to define success. since profitability is not relevant, other benchmarks are needed. perhaps the most basic metric is the quantity of goods and services a nonprofit produces, which are called “outputs.” nonprofits should track the number of people they serve, the services they provide, and the average cost per unit of these services. without this information, managers and boards have at best an abstract sense of how they are addressing the relevant issue. this information also can help them improve operations, for instance, by looking for ways to reduce the cost per unit delivered.135 while outputs are a necessary measure of progress, they are not always sufficient. for example, to determine the impact of agricultural technology on ethiopian farms, the units of technology delivered are less relevant than the increase in crop yields; the latter indicator, known 133 see gugerty & kalman, supra note 8, at 69 (“if monitoring data are to support program learning, they must be incorporated into organizational decision making processes.”). 134 see generally john doerr, supra note 46. 135 see gugerty & kalman, supra note 8, at 69 (referring to output measures and related information as “monitoring,” which helps “you understand whether you are doing what you set out to do and to improve how you do it”). [vol. 11.2 columbia journal of tax law 114 as an “outcome,” measures social benefits more directly.136 put another way, if you deliver the equipment, does it actually work?137 although outcomes are usually more informative, outputs can still be a reasonable measure of social return in some cases. for example, if desperately poor elderly clients would die without food and medicine, the quantity delivered, the number of clients, and cost per client give a meaningful sense of social return. ideally, a nonprofit also would track relevant outcomes, such as impact on life expectancy and quality of life. yet these outcomes are harder to measure, and arguably are unnecessary in this context, since the causal link between outputs and outcomes is so clear. since the work of nonprofits varies so dramatically, goals and metrics will be correspondingly diverse. yet every nonprofit has outputs, outcomes, and other metrics that shed light on their effectiveness. at first blush, this observation may seem more persuasive for social service providers and health care providers, since their work is somewhat easier to quantify.138 yet the same is true, at least to an extent, of organizations with less concrete missions. perhaps the quintessential example is religious organizations. needless to say, fundamental aspects of their value turn on faith, which cannot be quantified or even verified. yet these institutions also provide goods and services that are straightforward to evaluate, including the size of their membership, attendance at religious services, the vibrancy of their other programming, and the strengths and weaknesses of their professional leadership.139 the analysis is similar for museums and orchestras. they are supposed to promote artistic achievement, offer opportunities to be inspired and educated, and serve as stewards of our cultural heritage. yet although the value of specific performances and exhibits can debated — as, indeed, can the social significance of their missions — these institutions can still measure their success, at least in part, by the size of their audience, the number of return visitors, average operating cost per visitor, the perspective of expert critics, and the like.140 likewise, universities are supposed to prepare students to live successful and fulfilling lives, while also strengthening democracy and advancing the frontiers of knowledge. admittedly, there is no way to measure each university’s precise contribution to this effort, but a range of 136 martha taylor greenway, the emerging status of outcome measurement in the nonprofit human service sector, in measuring impact, supra note 8, at 217, 225 (“all [output measures] tell us is how much effort has been generated for how many people. they tell us nothing about whether this effort has made any difference.”). 137 see gugerty & kalman, supra note 8, at 69 (distinguishing “impact evaluation,” which analyzes whether the intervention has produced the desired social change, from “monitoring evaluation,” which analyzes whether it has been implemented reliably and cost-effectively). 138 see, e.g., greenway, supra note 136, at 217 (impact measures for social services); see also bradford gray, measuring the impact of nonprofit health care organizations, in measuring impact, supra note 8, at 185 (impact measures for health care). 139 see, e.g., robert wuthnow, the religious dimensions of giving and volunteering, in measuring impact, supra note 8, at 231 (impact measures for religious institutions). 140 see, e.g., margaret jane wyszomirski, revealing the implicit: searching for measures of the impact of the arts, in measuring impact, supra note 8, at 199 (impact measures for the arts sector). 2020] enhancing efficiency at nonprofits with analysis and disclosure 115 familiar factors shed light on its success, including the credentials of students and faculty, student-faculty ratios, citation counts, reputation surveys, and job placement records.141 since measuring impact directly can be challenging, nonprofits sometimes use indirect measures, although these have limitations. for example, reputation surveys convey whether third parties believe a nonprofit is effective,142 but their reliability depends on whether participants are well-informed and objective, and whether the right questions are asked. another indirect measure focuses on process, instead of outcomes. the theory is that good processes, which are relatively easy to observe, are likely to generate good outcomes. has a nonprofit adopted best practices, such as an annual planning process and a board with independent directors?143 yet although best practices are relevant, they tell us nothing about the importance of a nonprofit’s mission and relatively little, at least directly, about the impact and cost-effectiveness of its programs. as noted above, there are risks in relying on imperfect measures of social return. managers might overemphasize features they are measuring, while neglecting key goals their metrics don’t track. a familiar example is the emphasis of university rankings on standardized test scores and grades, which motivates some universities to undervalue applicants’ other important strengths.144 yet the right response to this challenge is to fine-tune the metric, not to abandon efforts to monitor progress. c. drawing comparisons in monitoring results, nonprofits need to make comparisons. which programs are producing the best results and which are underperforming? if a program is tweaked, does the modification make it more or less effective? the goal of these comparisons is to figure out which initiatives offer the highest social return, so nonprofits can focus on those, maximizing the impact of each dollar they spend. in 141 see generally douglas c. bennett, assessing quality in higher education, 87 liberal education (2001), https://www.aacu.org/publications-research/periodicals/assessing-quality-higher-education [https://perma.cc/jd8k3pgk] (describing various approaches to measuring quality in higher education); see also james p. connell & adena m. klem, a theory of change approach to evaluating investments in public education, in measuring impact, supra note 8, at 173 (impact measures for public education sector). 142 see daniel p. forbes, measuring the unmeasurable: empirical studies of nonprofit organization effectiveness from 1977 to 1997, 27 nonprofit & voluntary sector quarterly 183, 186 (1998) (describing “perception-based or reputational approach” to measuring organizational effectiveness of nonprofits). 143 see, e.g., kellie c. liket & karen maas, nonprofit organizational effectiveness: analysis of best practices, 44 nonprofit and voluntary sector q. 268 (2015) (evaluating nonprofits based on survey measuring utilization of best practices); forbes, supra note 142, at 190 (noting studies that seek correlation between specific processes and effective outcomes). 144 see, e.g., benjamin wermund, how u.s. news college rankings promote economic inequality on campus, politico, sept. 10, 2017 (“criteria used in the u.s. news rankings . . . create incentives for schools to favor wealthier students over less wealthy applicants”). [vol. 11.2 columbia journal of tax law 116 general, there are two ways to make these comparisons: cost-benefit analysis and costeffectiveness analysis. each has advantages and disadvantages. the robin hood foundation, a prominent nonprofit whose mission is to improve the income and health of low-income new yorkers, is an enthusiastic proponent of cost-benefit analysis. to compare the impact and cost-effectiveness of different initiatives, they assign a dollar value to a program’s social benefit (e.g., $50,000 for placing someone in a job). robin hood divides the total benefit (e.g., $1 million for a program placing 20 graduates) by the program’s cost (e.g., $200k), and uses the resulting ratio (e.g., $1 million/200k, or 5) to compare different initiatives.145 in theory, an advantage of this approach is the ability to compare dissimilar outcomes (e.g., job placement versus medical care). yet because this methodology depends on estimates that can be difficult to compute, its precision sometimes is more apparent than real. for example, to compare the value of raising incomes with the value of improving health, robin hood must assign a dollar value to the benefit of each type of program. this is easier for income initiatives (which generate dollars) than for health initiatives (which extend life). for the latter, robin hood estimated the value of extending life for one year. yet when health initiatives consistently outperformed income initiatives, robin hood responded — not by discontinuing income initiatives — but by reducing their estimate for extending life (from $100,000 to $50,00), so income initiatives would be more competitive.146 invoking this decision, a cynic might say that robin hood believes in their methodology only when it confirms what they already think, but this is unfair. when robin hood’s analysis does not align with their intuitions, they take a harder look at their assumptions. this is the right thing to do. even so, there is an important lesson here: looking at the ratios alone is not sufficient, since the assumptions underlying them are so important. rather, to compare two initiatives, it is necessary to consider the entire analysis. indeed, robin hood’s experience comparing income and health programs highlights the imprecision of cost-benefit analysis and, more fundamentally, the difficulty of determining the relative value of very different initiatives. in contrast, when programs advance similar goals, rigorous comparisons are easier. instead of estimating the dollar value of outcomes, nonprofits can simply track outcomes directly, and estimate what they spend to achieve them. this approach is known as costeffectiveness analysis. 145 see generally weinstein & bradburd, supra note 9, at 1-16 (describing robin hood’s strategy of “relentless monetization” or rm). 146 see id. at 36 (“the danger was that robin hood’s funding decisions, assuming health gains would be measured at $100,000 per qaly [quality-adjusted life year], would be biased toward health-related interventions and therefore away from income improving interventions . . . robin hood has since set the monetized value of a qaly at $50,000 and allocated grants accordingly.”) 2020] enhancing efficiency at nonprofits with analysis and disclosure 117 for example, a nonprofit that provides job training can track the number of trainees placed in jobs, while a hospital can track patients successfully treated for a disease.147 in each case, the nonprofit can compute its average cost per successful outcome and compare it with the cost of other ways to attain the same outcome. in other words, cost-effectiveness analysis compares programs with the same goal (e.g., job placement), identifying which advances it most efficiently.148 cost-effectiveness analysis poses two challenges, though. first, in drawing these comparisons, nonprofits need to assure that the outcomes actually are comparable; notably, adjustments are needed to account for differences in quality. second, this approach cannot compare programs with very different goals (e.g., jobs versus health). this is a key difference from cost-benefit analysis, which can be used (however imperfectly) to compare dissimilar outcomes.149 3. third question: is the nonprofit the right organization to respond to these challenges? even when a nonprofit targets a compelling issue with a cost-effective response — thereby offering persuasive answers to the first two questions — it still needs to address a third question: is the nonprofit the right organization to take on this challenge? in other words, does it have a comparative advantage over other nonprofits that are addressing the issue? this question is easy to answer when a nonprofit is “the only game in town.” if no one else is taking on an important problem, and the nonprofit’s response is effective, it clearly is offering unique value. admittedly, this is not the typical situation. when a problem is important, other organizations usually also try to address it, but not always. when the field is more crowded, nonprofits should push themselves — frankly, more than they usually do — to justify why they should do work that others are also doing. the third question urges a nonprofit to prioritize work that others cannot do as well. what are the nonprofit’s unique strengths? does it have special expertise? a hospital specializing in cancer research has obvious advantages in treating cancer patients. does a nonprofit’s location give it an edge? a law school based in d.c. can offer students easier access to experiential opportunities in the federal government. has the nonprofit built an infrastructure for one job which enables it to take on another? a nonprofit that already cares for holocaust 147 cf. kenneth c. land, social indicators for assessing the impact of the independent not-for-profit sector of society, in measuring impact, supra note 8, at 69-73 (giving examples of indicators for different types of nonprofits). 148 see, e.g., acumen fund metrics team, supra note 27, at 3 (“the baco calculation ultimately conveys the net cost per unit of social impact.”). 149 the world bank dime wiki ,cost-effective analysis, , https://dimewiki.worldbank.org/wiki/costeffectiveness_analysis [https://perma.cc/tq8m-7ggb] (comparing cost-effectiveness analysis to cost-benefit analysis). [vol. 11.2 columbia journal of tax law 118 survivors enjoys economies of scale in caring for other elderly. comparative advantages obviously can arise from other qualities as well, including a unique reputation, better access to clients, and close ties to key operating partners or funders. in urging nonprofits to focus on their comparative advantages, the third question echoes a key theme in good to great, a classic management text that seeks to explain how merely competent for-profit firms can become market leaders. the author, jim collins, urges companies to figure out “[w]hat you can be the best in the world at (and, equally important, what you cannot be the best in the world at).”150 at first blush, this might seem obvious, but the temptations to stray from core competencies are familiar. like their for-profit counterparts, nonprofit managers often view expanded operations as a source of prestige and even a justification for higher pay. there is also glory in addressing trendy issues, even if they are not a good fit with the nonprofit’s mission and expertise. since nonprofit managers are judged in part by their fundraising totals, they have reason to accept gifts for programs they would not otherwise prioritize and might not implement effectively. as long as the success of these programs is hard to measure, managers won’t pay a price for mediocre results. the third question, then, is a necessary antidote to these empirebuilding impulses. b. benefits of preparing a program analysis a rigorous planning process, which generates insightful and detailed answers to the three questions, can offer important advantages even if it is shared only internally (or, at least, selectively). to be clear, though, these benefits are not automatic. to generate them, the team preparing this analysis must have the right skills, motivation, and authority. ideally, they are able to ask hard questions, test assumptions, gather and analyze data, balance competing considerations, make wise judgments, and document and explain their conclusions. the planning team also must be willing to consider significant changes. their focus should be on the mission, not on their own interests. instead of trying to justify the status quo, they need to reimagine the nonprofit’s work, reset priorities, and hunt for improvements. the planning team also needs adequate authority. the nonprofit’s most senior leaders should be personally involved, and the planning process should include ways to generate feedback and “buy in” from other key stakeholders. yet even when these conditions are not satisfied, a program analysis can still add value, if only in alerting the board to management’s limitations. a planning process that satisfies all (or even some) of these requirements can yield five significant benefits. first, even if senior managers are the only ones involved, the three questions encourage them to develop a better strategy. these questions urge them to revisit priorities, monitor progress, improve high-value programs, and shut down ineffective ones. admittedly, the analysis might not turn out as thoughtful or sophisticated as it should be, but it still should push managers in the right direction. second, the three questions encourage a nonprofit not only to develop a better strategy, but also to implement it more effectively. when managers commit their goals to writing, they 150 jim collins, good to great 95 (2001). 2020] enhancing efficiency at nonprofits with analysis and disclosure 119 have greater incentive to achieve them, if only because failure becomes more visible. in addition, by sharing the program analysis with all employees, managers can promote “buy-in” and ensure that everyone knows how their work fits into the overall strategy.151 a process that revisits the three questions each year also has the potential to change a nonprofit’s culture; when senior managers become more goal oriented and data driven, others are likely to follow their example. third, sharing a program analysis with the board raises the reputational stakes for managers, so they are even more motivated to achieve their goals. in addition, the board can exert more meaningful oversight. although board members usually have less expertise than managers do about the nonprofit’s work, as noted above, a program analysis helps to redress this imbalance. it gives the board something specific to evaluate and empowers them to provide substantive input. admittedly, the board is not always motivated to detect and block selfinterested and unwise managerial choices, but when they are motivated, a program analysis can help them do so. in reviewing it, they can comb for red flags, such as declining demand, rising costs, and unpersuasive priorities. if the board is concerned about any aspect of the program analysis, they can ask for changes and then review a revised version. even after approving it, the board can still ask for updates on specific issues. in short, if board members are motivated to monitor management, a program analysis can help them discharge this responsibility a lot more effectively. fourth, a program analysis can also empower donors who are eager to serve as monitors, while also enabling nonprofits to respond more effectively to donors’ requests for information. an increasing number of donors — especially professionally run foundations — have begun requiring more sophisticated program evaluations.152 in principle, this is a promising trend, but the funders’ role is a mixed blessing. on the one hand, donors obviously have significant influence, so they can push nonprofits to be more effective, as long as they focus on the right issues. but on the other hand, donors have limited knowledge of their grantees’ work. as a result, donors sometimes ask the wrong questions, requiring managers to gather data that is not especially illuminating. indeed, managers may scramble to respond to multiple funders, whose questions are not framed well enough to test (or improve) the nonprofit’s work.153 a better approach is for the nonprofit itself to pose the right questions and offer the relevant information. this better outcome is more likely if managers already are engaging in rigorous internal reviews — as they should do in answering the three questions. they can then urge funders to accept data and analysis that they already are generating. 151 see generally doerr, supra note 46 (describing morale and other benefits of articulating organizational goals). 152 patrick flynn & virginia a. hodgkinson, measuring the contributions of the nonprofit sector, in measuring impact, supra note 8, at 4 (“in an increasingly competitive world in which nonprofits operate, there are new demands for impact analysis.”) 153 see gugerty & kalman, supra note 8, at 68 (“[w]hile reporting requirements are important for funding organizations to track their work, they often require grantee organizations to collect information that does not help improve operations.”); alexander, brudney & yang, supra note 104, at 566-67 (“nonprofit funding may derive from dozens of sources, each with its own processes and measures of performance, time lines, indicators, and tracking and reporting. . . . as a result of such daunting complexity, the practitioners felt that the potential of using performance measurement as a management tool is squandered and has not led to greater transparency or better decision making.”). [vol. 11.2 columbia journal of tax law 120 fifth, and relatedly, by producing a clear strategy and sharing it internally, a nonprofit can speak with one up-to-date voice in addressing external audiences. for example, the program analysis can help make the case to traditional funders, who focus more on good intentions than on impact. as noted above, these funders may be disappointed that programs they have supported for years need to be retooled or replaced.154 to bring these donors around, a nonprofit usually relies on its fundraisers, who are supposed to form close ties with them. yet in order to “sell” the new strategy, fundraisers need to understand it. this does not happen automatically, since fundraisers are not usually involved in program planning. fortunately, the program analysis supplies the details they need. indeed, without it, fundraisers might play a counterproductive role by continuing to “pitch” the old approach. in the same way, the program analysis also helps the marketing department update their messaging to journalists, online donors, and other key audiences. c. costs of preparing a program analysis as the last section showed, answering the three questions offers significant benefits, even if the answers are not shared widely. yet this exercise is not cost-free. this section highlights three costs, which should be manageable at most nonprofits. first, and most fundamentally, preparing rigorous and comprehensive answers requires time and effort. hours invested in this analysis cannot be devoted to other tasks, including work with beneficiaries and fundraising. some managers are reluctant to serve fewer clients or to lay off program experts or fundraisers in order to fund a more rigorous planning process. yet if this investment helps them deploy resources more efficiently, they would serve beneficiaries more effectively. rigorous planning also can inspire confidence in donors, attracting more resources for the nonprofit’s work. as a result, skimping on planning turns out to be a false economy in many cases. the value of investments in planning increases with a nonprofit’s size and complexity. for example, a nonprofit that runs only one program, which is valuable and runs efficiently, has less need to reevaluate goals and operations every year than one with multiple programs. yet even though simple nonprofits have less need for this process, they can run it more easily. since there are fewer hard questions to answer, a simple (and relatively inexpensive) process is adequate, and this “bare bones” process is likely to be cost-justified. arguably, then, every nonprofit should provide at least basic answers to the three questions – or, at least, every nonprofit with a budget or employee head count above a minimum level — while larger and more complex nonprofits should provide more comprehensive answers. a second cost of preparing a program analysis is that key stakeholders have to make difficult (and even unpleasant) choices. for example, some professionals are viscerally uncomfortable with quantifying (and ranking) the needs of different populations. they regard this approach as cold-hearted and better suited to the commercial world they escaped in working at nonprofits. likewise, board members who view nonprofits as a refuge, where they share inspiring experiences with interesting people, may not want to grapple with unpalatable choices. 154 see supra part ii.e.1. 2020] enhancing efficiency at nonprofits with analysis and disclosure 121 yet although these choices may be unpleasant, they are unavoidable. because resources are limited, nonprofits inevitably have to prioritize some beneficiaries and programs over others. the question is not whether – but how – to make these judgments. they can be made either explicitly or implicitly. the better course is to confront them head-on, instead of defaulting to an answer, for instance, by reflexively continuing the status quo or deferring to donor preferences. in preparing a program analysis, managers and boards have the opportunity to make important choices the right way. finally, there is a risk that they will not take this task seriously or approach it honestly. managers and boards who “go through the motions” of answering the three questions will not get much from this effort. they are wasting their time if they merely offer disingenuous arguments to justify self-interested choices. fortunately, attentive readers should be able to recognize this sort of empty analysis. indeed, since attentive readers can motivate managers and board members to produce a better analysis, there are advantages to sharing it more broadly. the next part considers advantages and disadvantages of disclosing a program analysis to the public. iv. countering inefficiency with better disclosure because success is hard to measure at nonprofits, efficient resource allocation is challenging even for dedicated and competent managers and board members. for the same reason, self-interested and incompetent choices are harder to detect. to address these challenges, the prior part recommended a more rigorous planning process, in which nonprofits answer three questions every year. preparing this program analysis yields a number of advantages, even if the nonprofit does not share it widely. yet disclosing this analysis to the public offers additional advantages. this part urges nonprofits to take this step, identifying both advantages and costs of doing so. a. three benefits from disclosing a program analysis this section considers three benefits of disclosing a program analysis to the public: first, donors and rating agencies can monitor agency costs and incompetence more effectively; second, donors can make more informed choices; and third, nonprofits can more easily borrow innovative ideas from each other. 1. countering agency costs and inertia one advantage of sharing a program analysis with the public is that managers and board members are likely to work harder on it. since the analysis is visible to a wider audience, they have a greater reputational stake in producing a comprehensive document and reporting strong results. [vol. 11.2 columbia journal of tax law 122 disclosing this analysis also helps a nonprofit to recruit more monitors.155 as noted above, major donors usually have significant influence with nonprofits and want to get the most for their money. but to serve as effective monitors, they need detailed information on programs, which a program analysis can provide. rating agencies also need this information. as noted above, they usually focus on topics that form 990 covers, such as governance and solvency. yet if rating agencies also can review a nonprofit’s program analysis, they can offer more insights about programs. ideally, in monitoring nonprofits, rating agencies and donors would compare the performance of different organizations. likewise, managers and board members should use their peers’ performance as benchmarks. yet these comparisons obviously require information about all the relevant nonprofits. if each nonprofit discloses a program analysis, comparisons become more feasible. even then, comparisons are not wholly reliable unless nonprofits share similar information and compute it the same way. for example, even if two charities report their average cost in providing a particular service, the comparison is not illuminating if they calculate it differently.156 as a result, disclosure conventions and methodologies become more valuable when used more widely. these network effects only arise, though, when nonprofits are similar enough to be compared. for instance, it is important for two soup kitchens to disclose the same way, but not for a soup kitchen and an orchestra to do so. for nonprofits with similar missions, disclosure practices can converge in various ways. for example, if the same major funders support the relevant nonprofits, these funders can ask for a particular format and methodology. likewise, rating agencies and media outlets that publish rankings can exert comparable influence by specifying what they evaluate. ideally, these shared conventions would develop gradually and flexibly, so different variations can be vetted, refined, and compared; premature standardization could prevent better approaches from emerging. industry organizations can help to manage this process, mediating among competing approaches and (eventually) giving some a “seal of approval.” in principle, regulators also can play this role. yet in deciding how nonprofits should measure success, regulators would inevitably influence what nonprofits prioritize, and this sort of substantive oversight has disadvantages, as discussed above.157 155 weinstein and bradburd argue that sharing goals and metrics empowers others to decide whether they agree with the analysis. their emphasis is not the need to monitor self-interested decisions or incompetence, but the value of debate in refining the relevant analysis. see weinstein & bradburd, supra note 9, at 36 (“explicit figures make it possible for interested parties -donors, employees, outside experts -to take a critical look and decide for themselves whether they like what the funder has done. critics are free to substitute their own figures. . . by making metrics explicit, funders can invite debate and revision.”); see also id. at 95 (“internal politics, favoritism, habit, difficult personalities never disappear altogether, but all matter less for making grants when conversation focuses on outcomes-based evidence.”). 156 for example, one might include overhead (e.g., the cost of senior management’s time) while the other does not. 157 see supra part ii.b. 2020] enhancing efficiency at nonprofits with analysis and disclosure 123 admittedly, a program analysis cannot turn every donor and rating agency into a perfect monitor. some will still lack the necessary incentives, expertise, or influence. yet when product market competition is limited and boards are passive or disengaged, donors and rating agencies are the best available monitors, as noted above. they need information to play this role. 2. better-informed resource allocation in the nonprofit sector disclosing a program analysis to the public empowers donors not only to serve as monitors, but also to make better-informed choices. donors often need detailed information to ensure that charities share their goals. for example, some environmental organizations support nuclear power, while others oppose it, as noted above.158 since these variations are not always obvious to outsiders, donors might mistakenly fund work they consider unappealing or even offensive. public charities can prevent these mismatches by sharing program analyses with the public.159 better-informed decisions are good not only for donors, but also for society as a whole. with better information, donors are more likely to choose the most productive philanthropic opportunities. a similar justification is commonly invoked for disclosure in capital markets, which is required under the u.s. securities laws. in providing accurate information, “the ultimate goal of securities regulation,” zohar goshen and gideon parchomovsky wrote, “is to attain efficient financial markets.”160 according to jack coffee, “the beneficiaries of increased allocative efficiency include virtually all members of society, not just investors.”161 yet disclosure arguably is even more important in nonprofits. after all, for-profit (public) firms offer another way to monitor changed circumstances: share prices. when investors trade on private information, the changes they trigger in share prices are visible, even to those who are not privy to the underlying information. yet nonprofits cannot impound undisclosed information in the same way. perhaps the closest substitute for nonprofits is a high profile donation. when a donor with private information gives generously, others with less information may follow her example. but donations — even high profile ones — are usually less visible than changes in stock prices. as a result, disclosing the underlying information becomes all the more important at nonprofits. 158 see supra part i.c.3. 159 a private foundation is permitted to accept donations only from a small group. to ensure that its donors are informed, a private foundation needs to share information only with this group, and does not also have to share it with the public. 160 goshen & parchomovsky, supra note 68, at 713. 161 john c. coffee, market failure and the economic case for a mandatory disclosure system, 70 va. l. rev. 717, 736 (1984); see also frank h easterbrook & daniel r. fischel, mandatory disclosure and the protection of investors, 70 va. l. rev. 669, 673 (1984) (“a world . . . without adequate truthful information . . . is a world with too little investment, and in the wrong things to boot.”). [vol. 11.2 columbia journal of tax law 124 3. better dissemination of innovative ideas sharing a program analysis with the public also helps nonprofits learn from each other. when they incubate a successful initiative, disclosure allows other nonprofits, government agencies, and for-profit firms to replicate it, make improvements, and help more people. failures also offer valuable lessons about what to avoid. to improve each other’s work, even as they operate independently, public charities and private foundations need to disseminate knowledge. as michael dorf and charles sabel put it, “linked systems of local and inter-local or federal pooling of information . . . enable the actors to learn from one another's successes and failures . . . .”162 yet like any effort to promote innovation, a rule directing nonprofits to disclose a program analysis requires a balancing of familiar considerations. on the one hand, sharing information spares would-be innovators from “reinventing the wheel.” on the other hand, it can reduce the private return from innovating.163 arguably, eroding this return should be less of a concern at nonprofits, since financial rewards are not supposed to motivate their stakeholders. if their goal is to advance the nonprofit’s mission, as opposed to its competitive position, they might favor disclosure as a way to enhance their impact. yet this altruistic perspective is more likely at some nonprofits (e.g., soup kitchens) than others (e.g., rival universities). obviously, there are a range of ways to balance these competing considerations. for example, sensitive information such as trade secrets and fundraising strategies can be exempt from disclosure, or this disclosure can be delayed.164 alternatively, competitors can be allowed to borrow an idea only if they negotiate a license, give credit to its creator, or comply with some other condition. an analysis of these (and other) alternatives is beyond this article’s scope. b. costs of disclosing a program analysis as the prior section emphasized, disclosing a program analysis can reduce agency costs, improve resource allocation, and disseminate ideas. yet these benefits come at a price. this section surveys the main costs of this disclosure. 162 michael c. dorf & charles f. sabel, a constitution of democratic experimentalism, 98 colum. l. rev. 267, 287 (1998). 163 cf. easterbrook & fischel, supra note 161, at 708 (“a new product might be profitable if built in secrecy, stealing a march on rivals; if the rules require advance disclosure, rivals' responses make the project less attractive.”). 164 see treas. reg. § 301.6104(a)-5 (nonprofits are exempt from disclosing a “trade secret, patent, process, style of work or apparatus” if the i.r.s. “determines that the disclosure of information would adversely affect the organization”); andrew masak, steps to protect trade secrets in the non-profit sector and balance the need for transparency, trade secrets, (aug. 19, 2014) https://www.tradesecretslaw.com/2014/08/articles/trade-secrets/notfor-profit-not-entitled-to-trade-secret-protection-no-so-fast-steps-to-protect-trade-secrets-in-the-non-profit-sectorand-balance-the-need-for-transparency/ [https://perma.cc/7rfv-dpld]. 2020] enhancing efficiency at nonprofits with analysis and disclosure 125 1. cost of preparation if a nonprofit is already producing a program analysis to use internally, the incremental cost of disclosing it is modest. documents from their internal process can be adapted for a less knowledgeable audience and trade secrets or other confidential information can be removed. this redrafting should not be costly. indeed, many nonprofits already produce reports for some donors, as noted above, and often produce multiple versions when donors request different information.165 producing a standard version (with a supplement answering donor-specific questions) could actually reduce their reporting costs. 2. cost of inaccuracy to offer the monitoring and other benefits discussed above, disclosure must be accurate. misstatements can distort behavior and cause resources to be misallocated.166 by concealing selfinterested choices or overstating the impact or cost-effectiveness of its programs, a nonprofit might attract donations that should go to more efficient competitors. similarly, disclosure that exaggerates the effectiveness of a new approach could induce other charities to adopt it in error. 3. cost of assuring accuracy to minimize these distortions, the accuracy of disclosure must be policed, and this effort requires resources. relying on individual donors to verify the accuracy of disclosure is inefficient, since they lack key information and would duplicate each other’s efforts in acquiring it. since managers and board members already have this information, the most efficient strategy is to rely on them to share it, while motivating them to be accurate.167 for example, like with financial statements, auditors can be enlisted to verify key facts in a program analysis. at many nonprofits, an auditor already helps to prepare form 990, and can be retained to review a program analysis as well. since they issue a steady stream of communications — from paid advertising and glossy brochures to emails and videos — nonprofits need to clarify which ones are meant to be strictly accurate. for example, a program analysis could include a legend saying that it has been certified by managers under penalty of perjury or verified by an auditor. in communications without this sort of legend, the audience would know to expect (and discount) emotional appeals, evocative anecdotes, and exaggerated claims, which are the grist of advertising. to reinforce the incentive of management (and auditors) to produce accurate program analyses, regulators or private plaintiffs have to scrutinize them for inaccuracies, and a 165 see prakash & gugerty, supra note 11, at 35 (added complexity when donors “vary in their information requirements”). 166 see easterbrook & fischel, supra note 161, at 678 ("the costs of . . . inaccurate enforcement are hard to see but no less real."). 167 cf. goshen & parchomovsky, supra note 68, at 779 ("managers, as insiders, can verify information more costeffectively”). [vol. 11.2 columbia journal of tax law 126 mechanism also is needed to resolve disputes. an investment of resources is needed here, as well as a choice about who should assume this responsibility. perhaps the most straightforward option is to require nonprofits to include a program analysis in form 990, and to make the i.r.s. responsible for policing its accuracy. yet the i.r.s. may not want this job, which does not advance its main mission of raising revenue.168 another alternative is for state ags to take on this responsibility or share it with the i.r.s.169 as a backstop, donors can already bring some private law suits under current law, including common law fraud.170 additional legislation or contractual provisions can also be considered to facilitate and regulate private law suits.171 each alternative would require significant resources, for instance, to fund more staff at the irs or the attorney general’s office or to cover fees for plaintiffs’ lawyers. in addition, nonprofits would incur costs in defending actions, as would courts or arbitrators in adjudicating them. to avoid underand over-enforcement, penalties and liability standards should be carefully calibrated. in principle, nonprofits have optimal incentives to be accurate when they expect (on average) to pay fines equal to the harm caused by their misstatements.172 yet estimating this harm is challenging, so penalties are likely to diverge significantly from this ideal.173 168 see swords, supra note 109, at 575 (i.r.s.’s main interest in form 990 is whether “there might be money that ought to be taxed”). 169 see id. at 576 (compared with i.r.s., state charities office has a broader interest in protecting the public’s interest in charities). 170 under common law fraud, a charity’s misrepresentation must be material and intentional, and donors must have reasonably relied on it and been harmed as a result; a charity’s intent and donor reliance are hard to prove. sean hayes, proving civil fraud in ny, n.y. l. blog, (feb. 22, 2016), https://www.thenewyorklawblog.com/2016/02/ny-fraudin-new-york.html [https://perma.cc/rbv4-qglx]. an action under state consumer protection law is easier, but yields lower damages. see id. (explaining that new york’s deceptive practices act caps damages at $1,000). some states also offer damages for “charity fraud,” which targets deceptive practices, including phony charities that do not actually serve clients. marguerite keane, charity fraud, encyclopedia britannica (oct. 11, 2019), https://www.britannica.com/topic/charity-fraud [https://perma.cc/dl43-n3k5] (“money solicited by persons or groups that are not legitimate charitable organizations constitutes charity fraud”). notably, donors generally do not have standing under current law to enforce fiduciary duties. joseph meade & michael pollack, courts, constituencies, and the enforcement of fiduciary duties in the nonprofit sector, 77 u. pitt. l. rev. 281, 299 (2016) (“donors typically do not have standing, nor do the customers or beneficiaries of the nonprofit’s programs.”) (footnotes omitted). 171 for example, one option is for nonprofits to commit to meet the standards of industry associations, and to rely on these associations to police their compliance. see prakash & gugerty, supra note 11, at 34-35. another option, recommended by geoffrey manne, is for nonprofits to contract with private monitors, authorizing them to sue “to enforce charitable obligations, fiduciary duties, and certain members’ rights . . . .” manne, supra note 11, at 253. if nonprofits issue the program analyses recommended here, manne’s proposal — which contemplates litigation about mismanagement — could be retooled to police inaccuracies in this disclosure. see id. manne’s proposal is appealing in recommending mandatory arbitration to limit costs and deter strike suits, but it involves a conflict of interest, which he acknowledges: manne expects nonprofit managers to hire these monitors, but a monitor who depends on managers for her job might hesitate to challenge them. id. at 261-62. industry associations face similar conflicts, since vigorous enforcement might deter nonprofits from committing to their standards. 172 as a result, the penalty should reflect both the harm and the likelihood of detection. for example, if a misstatement causes harm of $100,000, and every misstatement is detected, the fine should be $100,000. but if only half are detected, the fine should be doubled to $200,000, so the average fine ($100,000) still equals this harm. 173 for example, the penalty for filing an incomplete form 990 is up to $50,000. i.r.c. § 6652(c)(1)(a). since form 990 is a tax return, general penalties for misstatements also apply. see i.r.c. § 7206 (providing for a fine of up to 2020] enhancing efficiency at nonprofits with analysis and disclosure 127 4. balancing costs and benefits in choosing penalties, standards of liability, and enforcement mechanisms, policymakers need to manage tradeoffs among the costs discussed above. on the one hand, more vigorous enforcement means enforcement costs are higher (e.g., more legal fees, more regulators, etc.). but on the other hand, disclosure is more likely to be accurate, so the cost of inaccurate disclosure is reduced (e.g., less waste at nonprofits, fewer self-interested management choices, less money flowing to inefficient charities, etc.) even so, the precise effects are not easy to predict. for example, making nonprofits strictly liable for inaccuracy should strengthen their incentive to be accurate, but it also could motivate them to issue less detailed disclosure. as a result, the net impact on the supply of information is unclear. instead of offering a detailed proposal to manage these tradeoffs, this article makes a more fundamental point: the goal of the relevant rules should be to maximize the net benefit from program analyses. in choosing the scope of required disclosure, standard of liability, penalties, and enforcement mechanism, policymakers should strive to maximize the benefits of disclosure, while minimizing the costs of verifying and sharing this information, so total benefits exceed total costs by as wide a margin as possible. c. program analyses for for-profit firms while the focus here is on nonprofits, for-profit firms should also consider disclosing a program analysis if they pursue goals other than profitability. by sharing their goals and strategies, they can reap the same monitoring and other benefits as nonprofits. in fact, state law requires disclosure from a special type of for-profit corporation, the “benefit corporation,” which “looks like a standard corporation in almost all respects but one: it is legally obligated to promote the public interest.”174 as with nonprofits, rating agencies can play a useful role in evaluating their $500,000 for corporations making false statements under penalty of perjury); i.r.c. § 7207 (providing for a fine up to $50,000 for corporations filing false returns). 174 briana cummings, note, benefit corporations: how to enforce a mandate to promote the public interest, 112 colum. l. rev. 578, 580 (2012). benefit corporations are available in 36 states. b lab, state by state status of legislation, https://benefitcorp.net/policymakers/state-by-state-status. [https://perma.cc/r8kw-lk94] they are required to issue benefit reports. b lab, benefit corporation reporting requirements, https://benefitcorp.net/businesses/benefit-corporation-reporting-requirements [https://perma.cc/7eld-h6ez]. [vol. 11.2 columbia journal of tax law 128 work,175 and common metrics are needed for comparisons.176 the costs of preparing disclosure and policing its accuracy should also be comparable, though different regulators are involved.177 v. should disclosure of a program analysis be voluntary or mandatory? the last part analyzed the benefits and costs of disclosing a program analysis. should each nonprofit weigh these competing considerations and make its own decision? or should a policy be set for the entire sector? in the for-profit sector, the question of whether disclosure should be mandatory is “[p]robably the most debated issue in securities regulation.” 178 meanwhile, a different literature criticizes other types of mandatory disclosure, arguing that its intended audience does not read it or cannot understand it.179 notwithstanding these concerns, this part recommends that disclosure should be mandatory for large public charities (e.g., with budgets above ten million dollars) and voluntary for other nonprofits. after discussing a nonprofit’s incentives to disclose voluntarily, this part emphasizes gaps in these incentives that justify mandatory disclosure, and then addresses familiar concerns about disclosure requirements. a. reports shared privately with specific donors obviously, there is no need to require disclosure if nonprofits already share information voluntarily. this is true to a certain extent. for example, donors to a private foundation usually can get detailed information about its activities. likewise, major donors to a public charity usually require reports on how their money was spent and sometimes also on the impact and costeffectiveness of programs they fund, as noted above. if every major donor and rating agency negotiates to receive a program analysis — for instance, in a private report sent only to them — they all can be more effective monitors, thereby advancing a key goal of this article. admittedly, modest donors might not have the leverage to receive a program analysis, but they are unlikely to be effective monitors anyway. after all, a 175 ben & jerry’s ice cream, stonyfield organic, and over 3,000 other companies have become “certified b corps.” see b corp directory, b lab, https://bcorporation.net/directory [https://perma.cc/s5rp-ef8m]. for a discussion of the process, see how to become a benefit corporation, b lab, https://benefitcorp.net/businesses/how-becomebenefit-corporation [https://perma.cc/5fkz-vw6v] 176 see roy shapira, corporate philanthropy as signaling and co-optation, 80 fordham l. rev. 1889, 1898 (2012) (describing a “cacophony of indices” for measuring social impact); brent j. horton, how a uniform disclosure regime would empower benefit corporations, cls blue sky blog (july 24, 2018), https://clsbluesky.law.columbia.edu/2018/07/24/e [https://perma.cc/a6yr-hd2l] (advocating uniform disclosure for benefit corporations); see also toward common metrics and consistent reporting of sustainable value creation (world economic forum) (jan. 22, 2020), https://www.weforum.org/whitepapers/toward-common-metrics-andconsistent-reporting-of-sustainable-value-creation [https://perma.cc/mk3w-yv3m ] (proposing “a common, core set of metrics and recommended disclosures”). 177 the securities and exchange commission regulates disclosure of public for-profit firms, and the internal revenue service plays no role in their disclosure. 178 goshen & parchomovsky, supra note 68, at 755 (“probably the most debated issue in securities regulation is whether disclosure duties should be mandatory.”). 179 see generally ben-shahar & schneider, supra note 12; pozen, supra note 12. 2020] enhancing efficiency at nonprofits with analysis and disclosure 129 donor who lacks the clout to ask for disclosure presumably has little influence on management’s choices. even so, a report shared selectively is less useful than one shared with the public for a number of reasons. for one thing, managers are likely to take a publicly-disclosed report more seriously. it is visible to the media, potential future employers, peers at other nonprofits, and other audiences that matter personally to managers. in addition, when managers communicate separately with each donor, they have more latitude to vary the message, telling each donor what she wants to hear. for example, if a donor worries that management is favoring other donors’ priorities over her program, she learns less from a report sent only to her, since managers are freer to overstate the importance of her program when addressing her alone.180 in a report that goes to everyone, by contrast, managers are forced to deliver a consistent message. likewise, a document provided only to selected donors obviously is less effective than public disclosure in generating the two other benefits discussed above: better informed donor choices and wider dissemination of innovative ideas. in contrast, public disclosure reaches anyone who might benefit from it, including modest donors, potential donors, and managers of other nonprofits. b. public disclosure shared voluntarily all of these audiences can benefit when a program analysis is posted on a public website, even if this step is not required. one reason to do so voluntarily — at least at a public charity — is to enhance fundraising. a program analysis can make the case “on the merits” for the nonprofit’s work. sharing this information also demonstrates the nonprofit’s commitment to transparency and accountability, and its willingness to revisit priorities and hunt for new efficiencies every year. this willingness to share detailed information — and, in effect, to invite more rigorous scrutiny from external stakeholders — is a signal of quality.181 yet managers obviously are less motivated to disclose voluntarily when the news is bad. facts that cast doubt on the mission’s importance or a program’s effectiveness do not help fundraising and can tarnish reputations. needless to say, disclosing this bad news still has significant social value, for instance, in cautioning donors about a nonprofit’s ineffectiveness or in allowing other nonprofits to learn from its mistakes. but managers and board members obviously may hesitate to share this information for their own reasons.182 180 cf. triantis, supra note 11, at 1148 (“the philanthropic motives of donors differ somewhat from each other, and this heterogeneity multiplies the axes of agency conflict”). 181 admittedly, some donors are less interested in data than in emotional appeals. for them, nonprofits can rely on inspiration instead of information. yet a growing cohort of donors, who focus on impact and efficiency, want an analysis like the one recommended here. 182 indeed, one commentator warns foundations to be careful about disclosing “information about not-so-successful outcomes” because it “may give ammunition to those who want to brand the foundation as ineffective.” tyler, supra note 60, at 87. [vol. 11.2 columbia journal of tax law 130 even so, they might still volunteer bad news for two reasons. first, disclosing bad news strengthens credibility. second, a lack of disclosure is itself a negative signal. managers might worry that if they stay silent, others will assume the situation is worse than it actually is. as easterbrook and fischel have observed, a firm “must disclose the bad with the good, lest investors assume that the bad is even worse than it is.”183 c. rationales for mandatory disclosure so far, this article has offered a number of reasons to prepare and disclose a program analysis. first, preparing it presses managers to make better decisions. second, sharing it with board members can improve their oversight. third, showing it to donors empowers them to be more effective monitors. fourth, rating agencies can use it to conduct better-informed evaluations. fifth, sharing a single analysis with everyone — instead of a different report with each major donor — forces managers to be consistent. sixth, circulating this analysis widely raises the reputational stakes for managers and the board, motivating them to produce better results. seventh, sharing disclosure with the public enables donors who otherwise would not receive this information to make better-informed decisions. finally, disseminating this information helps nonprofits borrow ideas from each other. given these benefits, nonprofits might choose to share program analyses voluntarily. yet there are still two reasons to mandate this disclosure, which are considered here in turn. first, when disclosure is voluntary, nonprofits undersupply it. second, in disclosing voluntarily, nonprofits are free to use varying metrics and methodologies, rendering comparisons more difficult. 1. voluntary disclosure is undersupplied when not required to share program analyses, nonprofits are likely to undersupply them for three reasons. first, a program analysis is valuable to people who do not pay for it, including philanthropists who decide not to donate, beneficiaries, and other nonprofits that want to borrow innovative ideas. to these stakeholders, a program analysis functions as a public good, which is likely to be undersupplied unless nonprofits are required to offer it.184 second, agency costs can keep a nonprofit from disclosing bad news, even if it is in the organization’s interest to do so. for example, managers and board members might choose not to disclose so they can avoid current reputational harm and declines in funding, even if the result is greater reputational harm and declines in funding in the future. this is a rational choice when managers and board members are near the end of their service. obviously, they cannot make this self-interested choice if disclosure is mandatory. third, compared with for-profit firms, nonprofits can offer a more plausible explanation for not providing a program analysis, so their silence is less likely to be construed as a red flag. 183 easterbrook & fischel, supra note 161, at 683. 184 cf. coffee, supra note 161, at 728 (“[i]f market forces are inadequate to produce the socially optimal supply of research, then a regulatory response may be justified”); goshen & parchomovsky, supra note 68, at 756 (concluding that information is a public good and “the misalignment between the private and social value of information justifies mandatory disclosure”). 2020] enhancing efficiency at nonprofits with analysis and disclosure 131 unlike a for-profit firm, a nonprofit can plead poverty. “every dollar i spend on a program analysis,” the head of a soup kitchen might say, “is a dollar i can’t spend on feeding clients.”185 this argument often is based on a false economy, as noted above, since the analysis should help a nonprofit run more efficiently and raise more money. but frugality could still be a plausible pretext, which spares nonprofits from issuing disclosure — even when they are, in fact, seeking to conceal bad news.186 2. voluntary disclosure is less useful if disclosure is voluntary, there is a risk not only that less information will be disclosed, but also that it will be less useful. if only a subset of nonprofits provide a program analysis, it becomes more difficult to compare those that do with those that do not. even among nonprofits that do issue disclosure, comparisons are more difficult if organizations share different information or use inconsistent methodologies, as noted above. with mandatory disclosure, a format can be specified to facilitate comparisons. for example, all nonprofits can be required to answer the three questions, but soup kitchens and orchestras can answer with different types of information. regulators should be careful not to prescribe the details of what each type of nonprofit should disclose, as noted above.187 yet they can nudge the process along, relying on competing nonprofits to vet different methods of sharing information, mediated by funders, rating agencies, and industry groups. admittedly, a common approach could still emerge if disclosure is voluntary, but some nonprofits might be less willing to participate in this process without a regulatory mandate to do so. d. concerns about mandatory disclosure the prior section offered reasons to require the disclosure recommended here. this section considers offsetting reasons not to do so. the main downside is cost, at least for small nonprofits. other familiar criticisms of mandatory disclosure — the risk that no one would read it or that it would crowd out better regulatory alternatives — should not apply in this context. 185 cf. melissa m. stone & susan cutcher-gershenfeld, challenges of measuring performance in nonprofit organizations, in measuring impact, supra note 8, at 52, 54 (noting that funders and nonprofit executives interviewed “fear that money spent on evaluating performance was money that would have to be taken away from program delivery”). 186 there is empirical evidence that donors do not always “assume the worst” when nonprofits choose not to issue disclosure. putnam barber, megan farwell & brian galle, does mandatory disclosure matter? the case of nonprofit fundraising 17 (june 12, 2020), ssrn: https://ssrn.com/abstract=3625800 or http://dx.doi.org/10.2139/ssrn.3625800 [https://perma.cc/6k7g-h5ql] (when charities were required to disclose the ratio of their fundraising costs to their budget, donations declined for nonprofits with high ratios, so donors must not have assumed ratio was high before it was disclosed). 187 see supra part iv.a.1. [vol. 11.2 columbia journal of tax law 132 1. limiting mandatory disclosure to large public charities notwithstanding the advantages of preparing and disclosing a program analysis, some might consider the cost too high, especially at small nonprofits. this cost should not be overstated even at small nonprofits, since they have less to analyze and discuss, as noted above. yet there are still fixed costs, including management time, which can represent a meaningful percentage of a small nonprofit’s budget.188 to avoid this expense, some small nonprofits might reasonably decide not to prepare a program analysis. yet the calculation is different at large nonprofits. their scale and complexity make a program analysis more valuable. admittedly, this complexity may force a large nonprofit to spend more than a small nonprofit to produce a program analysis. however, this expense still is likely to represent a smaller percentage of the large nonprofit’s budget, since important components, such as management time, are fixed costs. compared with small nonprofits, then, large ones are likely to derive more benefit from a program analysis, while incurring a (proportionally) lower cost. as a result, if a large nonprofit “pleads poverty” in declining to provide a program analysis, there is a greater risk that this claim is a pretext to avoid sharing bad news, as noted above. given this difference between large and small nonprofits, this article recommends requiring large nonprofits to disclose a program analysis, while letting small nonprofits choose whether to do so.189 the cost of this disclosure should not be an issue for nonprofits with an annual budget over ten million dollars, and a lower threshold would be plausible as well. among these large nonprofits, the case for requiring public disclosure is stronger for public charities than for private foundations. foundations should certainly engage in rigorous analysis to decide how to allocate their funds, and many do. but this analysis does not need to be disclosed publicly to reach a private foundation’s donors, which (by definition) are a small group. as a result, two of this article’s main justifications for public disclosure — recruiting more donors as monitors and helping donors make better-informed choices — do not apply to private foundations.190 188 cf. easterbrook & fischel, supra note 161, at 671 (“existing rules give larger issuers an edge, because many of the costs of disclosure are the same regardless of the size of the firm or the offering.”). 189 by analogy, nonprofits do not have to file form 990 if their annual budget is below $200,000. i.r.s. publication 557, tax-exempt status for your organization 11 (feb. 6, 2020). they file form 990ez if their budget is between $50,001 and $200,000, and an e-postcard if their budget is below $50,000. id. as of 2015, approximately 34% of the nation’s 1.56 million registered nonprofits file form 990, form 990ez, or form 990pf (for private foundations). mckeever, supra note 2. 190 although public disclosure by private foundations would not reach potential donors, it could still reach rating agencies and the media. i thank henry hansmann for this observation. yet the main reason why rating agencies and the media have influence over nonprofits -their sway with donors -is absent, or at least muted, in private foundations. donors to private foundations ordinarily have ample information about their activities. as a result, rating agencies and the media are unlikely to provide a donor with new information, although they can offer a different perspective or highlight something the donor has missed. however, the analysis changes somewhat after the donor has passed away. at this point, the foundation’s board has significant autonomy (especially if the heirs are not involved) and might benefit from rigorous feedback from rating agencies and the media; indeed, in setting up a foundation, a donor might choose to require annual disclosure for this reason. but see tyler, supra note 60, at 89-91 (highlighting the downsides of disclosure by private foundations, including administrative costs and the awkwardness of explaining why grants were rejected). in principle, rating agencies and the media can also influence private foundations by mobilizing 2020] enhancing efficiency at nonprofits with analysis and disclosure 133 admittedly, disclosure from private foundations can add value in other ways. for example, they can share information about innovations, failed experiments, and best practices; again, many already do. in any event, if the disclosure requirement suggested here applies only to public charities with budgets over $10 million, it would reach only 5.3% of public charities, but would still cover 87.7% of the annual spending of all public charities, totaling $1.6 trillion.191 2. will enough donors read this disclosure? a familiar criticism of mandatory disclosure is that its intended audience often does not read it or cannot understand it. because consumers don’t have the time or cognitive bandwidth to review the barrage of disclosure they receive every day, professors ben-shahar and schneider conclude that this disclosure cannot “protect the naïve from the sophisticated.”192 yet the main goal of the disclosure proposed here is not to protect unsophisticated consumers, but to empower and recruit sophisticated monitors, including board members, donors who make large gifts, rating agencies, and the media. by improving their monitoring, and thus causing the nonprofit to run more efficiently, this disclosure can indirectly benefit stakeholders who do not read it, including donors who give modestly and the nonprofit’s beneficiaries.193 in other words, this disclosure can still add value even if only a fraction of a relatively small audience reads it. a program analysis also can inform stakeholders who lack the clout to be effective monitors. it allows modest donors to ensure that a nonprofit’s work matches their preferences, while also enabling nonprofit managers to borrow promising ideas from each other more easily. even though some of these stakeholders will not use this information, others surely will. 3. will mandatory disclosure crowd out better regulatory responses? another concern about mandatory disclosure, emphasized by professor pozen, is that it might “stave off other forms of regulation” that could be more effective.194 yet the other regulatory options are somewhat limited in this context. the i.r.s. and the state ag lack the expertise to regulators, but substantive oversight from the government poses complex tradeoffs, as discussed above. see supra part ii.b. 191 of 1.09 million public charities in 2015, only 16,556 (or 5.3 percent) had budgets of ten million dollars or more, but those with budgets in excess of ten million dollars spent $1.6 trillion, representing 87.7 percent of all spending by public charities. mckeever, supra note 2. 192 ben-shahar & schneider, supra note 12, at 649, 705-08 (using stylized example of “chris consumer” to show the impossibility of actually reading and absorbing all mandated disclosures). 193 cf. alan schwartz & louis l. wilde, intervening in markets on the basis of imperfect information: a legal and economic analysis, 127 u. pa. l. rev. 630, 638 (1979) (“the presence of at least some consumer search in a market creates the possibility of a ‘pecuniary externality’: persons who search sometimes protect nonsearchers from overreaching firms.”); ben-shahar & schneider, supra note 12, at 748 (“insofar as disclosure causes disclosers to behave better . . . , disclosees need not rely on the disclosed data but can instead (as they say) shop with confidence”). 194 pozen, supra note 12, at 162; see also ben-shahar & schneider, supra note 12, at 740 (“[l]awmakers who devised disclosure mandates may think their mission accomplished and avoid the onerous work of devising more imaginative, more effective alternatives”). [vol. 11.2 columbia journal of tax law 134 engage in substantive oversight of nonprofit programs in many cases, as noted above, and could undermine nonprofit independence in playing this role.195 if the government set aside these concerns and decided to engage in substantive oversight, regulators would need information. to assess the social value of a nonprofit’s mission and the impact and cost-effectiveness of its programs, regulators would need something like the program analysis recommended here. so if the government wants to review the substance of nonprofits’ work, disclosure would not be a distraction from this effort, but a precondition for it. vi. conclusion unfortunately, some nonprofits waste money on dated missions and inefficient programs. this article breaks new ground in attributing this inefficiency not just to imperfect incentives, but also to imperfect information. challenges in measuring success complicate the efforts of even the best managers and boards to run nonprofits efficiently. these measurement challenges also make self-interested and unwise choices less visible, and thus harder to stop. in response, this article recommends better analysis and disclosure as a strategy for organizational change. as a template for this analysis, this article recommends three questions for nonprofits to answer every year: first, how important are the challenges they address?; second, how effective are their responses?; and third, are they the right nonprofit to respond? this sort of analysis presses managers and boards to clarify priorities, monitor progress, improve even their best programs, and shut down ineffective ones. nonprofits should also share this analysis with the public. this disclosure empowers boards, donors, and rating agencies to be more effective monitors, enables donors to make better informed philanthropic choices, and allows charities to borrow innovative ideas from each other more easily. admittedly, these benefits are not free. difficult issues must be analyzed and the accuracy of disclosure must be policed. to balance these competing considerations, this article recommends that this disclosure should be mandatory for large public charities and voluntary for other nonprofits. admittedly, analysis and disclosure are not foolproof remedies. at the margin, though, this effort can press nonprofits to operate more efficiently, so they touch more lives and do more good in the world. 195 see supra part ii.b. shaping the future of transnational tax dispute settlement: the path to mediation julien chaisse & xueliang ji* abstract the underlying objective of the article is to impart an insightful comprehension of mediation and its efficacy as a viable alternative for resolving transnational tax disputes. the article posits three main arguments. firstly, mediation, as a method of conflict resolution, offers an array of benefits, and its utilization has witnessed a surge in popularity, particularly with the recent establishment of the singapore mediation convention. secondly, in the rapidly evolving global landscape, transnational tax disputes have become increasingly intricate and arduous to adjudicate. the current system of dispute resolution, though possessing certain advantages, ultimately falls short in keeping pace with the evolving demands of the industry. the final contention is that mediation can serve as a potent tool to augment the effectiveness of the mutually agreed procedure (map) system. in sum, the article posits that the use of mediation in the context of tax-related disputes embodies the characteristics of soft law, owing to its imaginative and inventive nature. additionally, as a non-binding mechanism, mediation confers increased flexibility to contending parties, particularly sovereign entities, to safeguard their respective interests. consequently, mediation can be a valuable adjunct to the map system in facilitating the resolution of taxrelated conflicts. * mr. julien chaisse is a professor at the school of law, city university of hong kong, and president of the asia pacific fdi network. he can be reached at julien.chaisse@cityu.edu.hk. mr. xueliang ji is a research associate at the asian academy of international law (aail) and a phd candidate at the faculty of law, chinese university of hong kong. he can be reached at xueliang.ji@link.cuhk.edu.hk. this work was substantially supported by the humanities and social sciences prestigious fellowship scheme (hsspfs) from the research grants council of the hong kong sar (project no. cityu 31000121). the authors would like to express their gratitude to richard bolwijn, jeffrey owens, david bradbury, michael keen, zahira quattrocchi, ruth mason, irma mosquera, tove ryding, logan wort, anita kapur, and michael lennard for their indispensable feedback and comments on this article. the authors also acknowledge the attendees at the unctad’s 7th edition of the world investment forum (wif2021) session on “the interplay between international taxation and investment – evaluating the implications of g20’s promoted changes” (october 2021) and the comments received from the wu global trade and tax advisory group (wirtschaftsuniversität wien gtpc), where a previous version of this article was first presented. 2023] the path to mediation 31 introduction ...................................................................................................... 31 i. mediation as a dispute resolution mechanism ........................................ 36 a. singapore mediation convention .............................................................. 36 b. mediation clauses in trade and investment treaties ................................ 39 c. advantages of mediation in resolving disputes ....................................... 41 d. mediation clause in tax treaties .............................................................. 43 ii. current transnational tax dispute resolution mechanism .............. 44 a. by design: map in double tax treaties .................................................. 45 b. by design: baseball arbitration ................................................................ 47 c. independent arbitration and tax matters .................................................. 49 d. by default: mandatory arbitration under bits........................................ 50 iii. mediation for transnational tax disputes ........................................... 53 a. shortcomings of map ............................................................................... 53 b. mediation can make up for it ................................................................... 54 c. what types of disputes can mediation resolve?..................................... 57 d. mediation and soft law ............................................................................. 58 iv. conclusion ................................................................................................... 60 introduction ever-increasing global interconnectivity has precipitated a surge in the number and complexity of transnational tax disputes. with all taxation areas, including direct and indirect taxes, falling within the purview of such conflicts, a plethora of multinational entities find themselves embroiled in legal tussles with sovereign states. a prime illustration of such disputes is the ongoing tax inquiry against kering, a leading luxury conglomerate, by french authorities, who have accused the company of fraud and tax evasion.1 this is not the first time that kering has come under the scrutiny of tax having previously faced a similar investigation by italian authorities, which was ultimately resolved through the payment of substantial fines. against this backdrop, the viability of traditional methods of dispute resolution, such as litigation and arbitration, has come under increasing scrutiny, paving the way for alternative mechanisms such as mediation to emerge as a potentially effective means of resolving transnational tax disputes.2 in fact, many transnational conglomerates, including apple and google, have entangled 1 coily lozada, kering confirms tax probe by french authorities, denies any wrongdoing, s&p global, dec. 18, 2020, https://www.spglobal.com/marketintelligence/en/newsinsights/latest-news-headlines/kering-confirms-tax-probe-by-french-authorities-denies-anywrongdoing-61804070, [https://perma.cc/zw3w-47ys]. 2 claudia cristoferi & emilio parodi, kering to pay 187 mln euros to settle bottega veneta tax dispute, reuters, apr. 1, 2022, https://www.reuters.com/business/retail-consumer/keringagrees-pay-187-mln-euros-bottega-veneta-tax-dispute-sources-2022-04-01/, [https://perma.cc/jm8x-j5jt]. 32 columbia journal of tax law [vol 14:1 with authorities and have made payments to regularize their fiscal positions.3 the dilemma in this matter is that the core principle of transnational corporate tax is that companies should be taxed on the territorial base of their activities. but tech companies can skirt ordinary corporate taxes because they have little or no physical presence. in transnational tax disputes, the state has sovereignty to design its taxation mechanism and decide the nature of its domestic taxation law.4 however, as the relationship between countries is growing tight, the effect of the domestic tax system inevitably exceeds a country’s borders. 5 as a logical consequence, tax disputes may arise when “these domestic tax systems are not aligned with each other”.6 moreover, the ever-increasing transnational activities of companies show that the risk of double taxation is greater than ever, which is fueling the number of disputes.7 the current scenario raises a fundamental challenge for transnational dispute settlement because when a double taxation dispute cannot be adequately resolved, the likely consequence is that the confidence of mncs and foreign investors decreases, and the free flow of investment may also be affected negatively.8 on october 5, 2015, oecd issued action 14 under base erosion and profit shifting (beps) project to improve the dispute resolution in transnational tax disputes.9 aside from securing revenues by realigning taxation with economic activities and value creation, the oecd/g20 beps project seeks to develop a single set of consensus-based transnational tax rules to address beps, and thus to protect tax bases while providing increased certainty and predictability to taxpayers. the oecd and g20 established an inclusive framework on beps in 2016 to allow interested countries and jurisdictions to collaborate with oecd and g20 members to develop standards on beps-related issues as well as review and monitor the implementation of the entire beps package.10 the action 14 report, 3 jiyoung sohn, google, apple hit by first law threatening dominance over app-store payments, wall st. j., aug. 31, 2021, https://www.wsj.com/articles/google-apple-hit-in-southkorea-by-worlds-first-law-ending-their-dominance-over-app-store-payments-11630403335/, [https://perma.cc/37en-kc2c]. 4 michelle markham, litigation, arbitration and mediation in international tax disputes: an assessment of whether this results in competitive or collaborative relations, 11 contemp. asia arb. j. 278 (2018). 5 vito tanzi, globalization, tax competition and the future of tax systems 4-11 (imf, working paper no. 1996/141, 1996). 6angel gurria, oecd, remarks on oecd tax and competition policy (feb. 11, 2014), http://www.oecd.org/competition/taxation-and-competition-policy.htm/, [https://perma.cc/75cfjsbq]. 7 roy rohatgi, basic international taxation, 2 (2d ed. 2005). 8 michelle markham, recurring resistance to tax treaty arbitration as a dispute resolution mechanism, austaxpolicy: tax & transfer pol’y inst., oct. 23, 2017, http://www.austaxpolicy.com/recurring-resistance-tax-treaty-arbitration-dispute-resolutionmechanism/, [https://perma.cc/k59w-3v2j]. 9 oecd, action 14 mutual agreement procedure, http://www.oecd.org/tax/beps/bepsactions/action14/, [https://perma.cc/348w-sdpy] (last visited may 20, 2023). 10 oecd, oecd/g20 base erosion and profit shifting project, https://www.oecdilibrary.org/taxation/oecd-g20-base-erosion-and-profit-shifting-project_23132612, [https://perma.cc/5glu-mcqx] (last visited may 20, 2023). 2023] the path to mediation 33 making dispute resolution mechanisms more effective, presents a commitment by countries to implement a so-called “minimum standard” on dispute resolution, according to the oecd. 11 mandatory arbitration is mentioned in the 14th movement of beps and oecd model convention (2008 version). 12 the negotiation of the multilateral instrument (mli)13 under action 15 of the beps action plan14 has included a mandatory binding map arbitration provision to encourage countries to adopt arbitration procedures in their tax treaties. when the states adopt beps requirements, they are required to make some changes associated with their domestic taxation system. beps aims to decrease disputes; however, disputes may arise in the short term when states are adopting new criteria for dealing with taxation.15 thereby, it becomes imperative to consider the taxrelated dispute mechanisms on which taxpayers always depend upon. pillar one and pillar two make up the two-pillar solution. pillar one aims to ensure an equitable distribution of profits and taxing rights among countries relating to the largest mnes, which have benefited from globalization. the new rules emphasize tax certainty, which includes a mandatory and binding dispute resolution process for pillar one. on the other hand, pillar two limits tax competition on corporate income tax by instituting a global minimum corporate tax of 15% that countries can use to protect their tax bases (the globe rules). pillar two does not eliminate tax competition, but rather limits it through multilateral agreements.16 the two-pillar strategy offers to remove tax competition while imposing multilaterally agreed upon limits. these new regulations will apply to multinational firms with worldwide sales of more than €20 billion and profits of more than 10%, which can be called winners of globalization, with 25% of profits over the 10% level to be redistributed to market jurisdictions. regarding the largest and most successful multinational firms, a fairer division of earnings and taxing rights across nations will be ensured by pillar one. some taxation powers over mnes will be reallocated from mnes’ home states to the host states, where mnes are conducting business and making profits. based on the multilateral convention (mlc), the parties will be required to eliminate all digital services taxes and other related equivalent measures affecting all enterprises, as well as to promise not to 11 oecd, beps actions, http://www.oecd.org/tax/beps/beps-actions.htm/, [https://perma.cc/l7cv-wdne] (last visited may 20, 2023). 12 oecd, articles of the model convention with respect to taxes on income and on capital, (july 17, 2008) http://www.oecd.org/tax/treaties/42219418.pdf, [https://perma.cc/rcu9wekj]. 13 the mli was released in 2016 and serves to amend existing treaties so that they are updated with the oecd beps measures agreed by the g20. 14 oecd, developing a multilateral instrument to modify bilateral tax treaties, action 15 – 2015 final report, oecd/g20 base erosion and profit shifting project (2015). 15 julien chaisse & xueliang ji, ‘soft law’ in international law-making: how soft international taxation law is reshaping international economic governance, 13 asian j. of wto & int’l health l. & pol’y 463 (2018). 16 oecd, statement on a two-pillar solution to address the tax challenges arising from the digitalisation of the economy, oecd/g20 base erosion and profit shifting project (oct. 8, 2021), https://www.oecd.org/tax/beps/statement-on-a-two-pillar-solution-to-address-the-taxchallenges-arising-from-the-digitalisation-of-the-economy-october-2021.htm, [https://perma.cc/4c6b-akqb]. 34 columbia journal of tax law [vol 14:1 enact such measures in the future. from october 8, 2021 till the sooner of december 31, 2023, or the effective date of the mlc, no recently legislated digital services taxes or other relevant equivalent requirements are going to be levied on any firm. the method for removing current digital services taxes, as well as other relevant equivalent actions, will be coordinated accordingly. 17 pillar two establishes a 15 percent worldwide minimum corporation tax rate. the new minimum tax rate, which is expected to raise an additional us$150 billion in worldwide tax collections each year, will be applied to companies with revenues over €750 million.18 in tax treaties, the map article permits selected representatives from contracting states' governments to interact with the goal of resolving transnational tax disputes. these examples feature both economic and legal double taxation, as well as contradictions in the interpretation and application of a convention. 19 through mediation, a neutral third party can help disputing parties resolve disputes in a voluntary and confidential way.20 some countries, like china, have already utilized mediation in resolving tax-related disputes, including transfer pricing cases.21 furthermore, the united nations has included mediation as an advance dispute resolution (adr) method to resolve transnational tax disputes in one chapter of a dispute resolution handbook.22 mediation is also mentioned in the commentary on article 25 of the 2017 un model double taxation convention between developed and developing countries. .23 consequently, mediation can be used more often in the future to complement and facilitate the mutual agreement procedure (map) in solving taxation disputes. the aim of this article is not to illustrate the defects of the current transnational tax dispute resolution mechanism; instead, the article aims to enhance the understanding of mediation and how to adopt it in resolving taxation disputes. the article makes three central claims. the first claim is that mediation has merits in resolving disputes, and with the singapore mediation convention, it has gained more attention. firstly, the oecd has suggested mediation as a dispute resolution option, but has not provided specific guidance. thus, mediation is not considered a serious option by the oecd. the oecd has expressed interest in mediation, so this article focuses on the singapore mediation convention as a potential solution. instead of 17 see id. 18 reuven s. avi-yonah, the international tax regime at 100: reflections on the oecd's beps project (law & economics working paper no. 209, 2021). 19 oecd, centre for tax policy and administration, manual on effective mutual agreement procedures (memap), (ctr. for tax pol’y and adm’ ed. 2007). 20 alternative dispute resolution in state and local governments: analysis and case studies (otto j. hetzel & steven gonzales eds., 2015). 21 svitlana buriak, alexandra miladinovic, & jean-philippe van west, european union/oecd/international conference report: tax treaty arbitration, 73 bull. for int’l tax’n 3 (2019). 22 see id. 23 united nations, united nations model double taxation convention between developed and developing countries 2017 update 199 (2018). 2023] the path to mediation 35 creating a new treaty, it would be better to determine whether and how the singapore mediation convention can be applied to tax disputes. in addition, even though the singapore convention is designed for commercial mediation, it can be applied to other disputes as well. the mechanism can be used, for instance, to resolve disputes between investors and states. a definition of “commercial” is not provided in the convention, but the uncitral model law on international commercial mediation and international settlement agreements resulting from mediation (2018) tends to define it broadly, so investor-state disputes are included in the definition.24 apart from that, icsid assumes that investment disputes can also benefit from the singapore convention, even though it has not provided an explanation.25 in other words, the singapore mediation convention is not purely limited to commercial disputes. the third factor is that mediation has gained new credibility since 2020 as a method of resolving transnational disputes. as an example, ceta, ect, and icsid all support mediation.26 historically, mediation was underutilized due to ineffective transnational enforcement regimes. however, this gap has been filled by the singapore mediation convention. mediation was recognized by the participating states in the singapore mediation convention as a means of handling cross-border disputes. thus, the convention has become a new benchmark for dispute resolution for the tax community. in addition, since tax law is becoming increasingly multilateral (beps, etc.), there is no need to launch a new initiative. the second claim is that the current transnational tax dispute resolution regime has its own disadvantages and is not enough to deal with growing transnational tax disputes. the final claim is that mediation can be experimented to use as a soft law in resolving taxation disputes, and with mediation, the efficiency of map can be improved. mediation does not aim to replace the current transnational tax dispute resolution regime; it just aims to make some improvements. this article provides another angle in dealing with transnational tax disputes. as the world becomes more interconnected, transnational taxation disputes have become increasingly complex and challenging to resolve. the current dispute resolution regime has its limitations and falls short in keeping pace with the evolving demands of the industry. in light of these challenges, this article proposes mediation as a complementary mechanism to augment the efficiency of the existing 24 mushegh manukyan, singapore convention series: a call for a broad interpretation of the singapore mediation convention in the context of investor-state disputes, kluwer mediation blog (june 10, 2019), http://mediationblog.kluwerarbitration.com/2019/06/10/singapore-convention-series-a-call-for-abroad-interpretation-of-the-singapore-mediation-convention-in-the-context-of-investor-statedisputes/?_ga=2.155267774.401588551.1665561051-124403074.1605057846, [https://perma.cc/8tff-bjyc]. 25 int’l ctr. for settlement of inv. disps., world bank grp., proposals for amendment of the icsid rules consolidated draft rules, 173-183, (world bank grp. ed., vol. 2 2018). 26 wolf von kumberg, investor state mediation and the singapore convention, adr perspectives (apr. 4, 2023, 7:48 pm), https://adric.ca/investor-state-mediation-and-thesingapore-convention/, [https://perma.cc/mt33-yb4v]. http://mediationblog.kluwerarbitration.com/author/mushegh-manukyan/ https://perma.cc/8tff-bjyc 36 columbia journal of tax law [vol 14:1 dispute resolution mechanisms, particularly the map. by serving as a form of soft law, mediation confers increased flexibility to contending parties, especially sovereign entities, in safeguarding their respective interests. this article is divided into four parts, beginning with a brief overview of mediation and its merits, followed by an examination of the current tax-related dispute resolution mechanisms, including map and other forms of arbitration. part iii discusses the potential for mediation to address the weaknesses of the current system and improve the efficiency of transnational tax dispute resolution. finally, part iv concludes by outlining the potential benefits of mediation and offering recommendations for its successful implementation. i. mediation as a dispute resolution mechanism mediation, an extensively employed mechanism for resolving disputes, has emerged as a potent tool in the armamentarium of contemporary legal practitioners. a quintessential feature of mediation is the involvement of an impartial third-party professional, who facilitates constructive discussions between conflicting parties to arrive at a mutually agreeable resolution. whether the setting is an informal meeting or a structured settlement conference, mediation has proven to be an effective means of addressing disputes that may either be the subject of ongoing litigation or have the potential to escalate into contentious legal entanglements. a salient characteristic of mediation is that the contending parties retain full autonomy over the decision of whether or not to settle and the terms of such a settlement. this degree of flexibility has made mediation a valuable resource for resolving complex disputes, particularly those with cross-border implications. 27 commercial mediation provides a non-public forum within which the parties will perceive each other’s positions and work along to explore choices for resolution. further, with the initiation of the singapore mediation convention in 2018, it has gained more attention. in the following parts, a brief introduction of the singapore mediation convention is introduced at part a, part b is about the introduction of mediation in trade and investment areas, and the merits of mediation in resolving disputes are analyzed in part c. this section is about general mediation, not mediation in tax matters. a. singapore mediation convention the singapore convention on mediation (singapore convention) is a multilateral treaty aimed at providing members with an effective framework for resolving transnational economic disputes. this pact bears some resemblance to the new york convention on arbitration, which was signed in the same year. like the new york convention for transnational arbitral decisions, the singapore convention provides a consistent and effective method for parties who have agreed to a negotiated settlement to apply the terms of that agreement in other 27 david foster, what is commercial mediation?, moore barlow resources (may 15, 2021), https://www.moorebarlow.com/what-is-commercial-mediation, [https://perma.cc/6ngvcjpb]. https://www.moorebarlow.com/what-is-commercial-mediation https://www.moorebarlow.com/what-is-commercial-mediation 2023] the path to mediation 37 jurisdictions.28 as a result, the singapore convention is attempting to accomplish for mediated international settlement agreements what the new york convention does for foreign arbitral awards (i.e. allow cross-border enforcement on a large scale) in a standardized manner. the new york convention has had an unparalleled impact on transnational dispute resolution.29 furthermore, a fundamental similarity between the two conventions is that they both aim to attract commercial parties to arbitration and mediation rather than other forms of dispute resolution. the new york convention permits the enforcement of arbitral awards, or written results reached after the parties “submit to arbitration all or any differences that have arisen or may arise between them in respect of a defined legal relationship, whether contractual or not, concerning a subject matter capable of settlement by arbitration.” similarly, the singapore convention “applies to a written agreement reached by parties after mediation to resolve a commercial dispute.”30 the application of the singapore convention favors mediated settlements over other business settlements reached through direct party-to-party negotiations, much like the new york convention that encourages arbitration over litigation or adjudication.31 the singapore convention follows the success of language and structure of the new york convention.32 for example, both conventions demand that “each party to the convention” or “each contracting state” enforce settlement agreements or arbitral judgements in accordance with the procedure of the territory where enforcement is sought and within the terms of the conventions respectively. 33 additionally, article v and vi of both conventions are similar in nature. these provisions are essential because they strike a compromise between the competing goals of improving the enforceability of foreign arbitral rulings and the requirement for judicial monitoring.34 finally, the singapore convention, like the new york convention, requires local implementation of the treaty.35 in mediation, parties have a greater degree of control than in litigation or arbitration, since reaching a settlement is entirely up to them. the mediator does not determine the case by himself but aims to facilitate the resolution of disputes.36 it is the parties’ opinions and not those of the mediators that matter. there has been a significant growth in mediation to settle disputes in the past few years, while the 28 united nations convention on international settlement agreements resulting from mediation, dec. 20, 2018 [hereinafter singapore convention]. 29 suraj sajnani, the singapore convention: is this the new york convention for mediation?, 50 h.k. l.j. 863 (2020). 30 singapore convention, supra note 28, at 3 31 id. 32 robert butlien, the singapore convention on mediation: a brave new world for international commercial mediation, 46 brook. j. int'l l. 183 (2020). 33 id. 34 emmanuel gaillard & benjamin siino, enforcement under the new york convention, in the guide to challenging and enforcing arb. awards 96 (j. william rowley qc et. al eds., law business research ltd., 2019). 35 singapore convention, supra note 28, at 3. 36 jeffrey owens, arno e. gildemeister, & laura turcan, proposal for a new institutional framework for mandatory dispute resolution, 82 tax notes int'l 1011 (2016). 38 columbia journal of tax law [vol 14:1 number of disputes that are submitted to commercial courts is decreasing. 37 changes within civil and commercial society are leading to this growth. after the covid-19 pandemic, arbitration and mediation will still be important dispute resolution tools in an altered legal landscape. such procedures, it is said, aid in the promotion of access to justice, particularly in legal systems that are not open to the public.38 even if virtual adr has some drawbacks, it cannot be overlooked or dismissed that covid-19 has prepared the way for parties to move towards virtual or hybrid adr for the quick resolution of disputes, with reduced travel costs, documentation, and other time-consuming procedures.39 the united nations commission on international trade law (uncitral) approved the final draft of the singapore convention on june 26, 2018.40 with the enforcing framework built by the singapore convention, “mediation will undoubtedly become a fierce competitor of arbitration.”41 according to article 1(1), the dispute settlement agreement must be “international,” which requires the parties to the dispute or the subject of the dispute to be international.42 further, as per article 2(3), mediation is a process to resolve disputes between the parties amicably with the help of a mediator.43 in order to get relief from related competent authority, article 4 prescribes (1) a settlement agreement; (2) evidence that shows “the settlement agreement resulted from mediation,” like the signatures of mediators or a document which illustrates that the mediation is applied; (3) a requirement that a settlement agreement be signed by parties; (4) that a translation may be required when the official language is not applied to conclude a settlement agreement; (5) that a competent authority may require any necessary documents to verify the requirements mentioned in the convention and (6) that the authority shall act expeditiously when a request of relief is placed before them by the parties.44 mediation is welcome, especially in asia, for dispute resolution; as per a survey conducted by the international institute for conflict prevention and resolution in 2011, more than sixty percent of respondents expressed positive attitudes towards mediation. in light of this and lack of a cross-border implementation of mediated 37 see houzhi tang, worldwide use of mediation (2013), https://www.cityu.edu.hk/slw/adr_moot/doc/worldwide_use_of_mediation_(by_prof_tang_hou zhi).pdf, [https://perma.cc/3rv9-7p92]. 38 see generally jacqueline nolan-haley, international dispute resolution and access to justice: comparative law perspectives, 2020 j. disp. resol. 391 (2020). 39 see generally donna erez-navot, reimagining access to justice: should we shift to virtual mediation programs beyond the covid-19 pandemic, especially for small claims, 15 ny disp. resol. law. 42 (2022); amy j pierce, mediation in the time of a pandemic: preparing for the ‘new normal’ of online mediations, okla. bar j., nov. 2020, at 24. 40 int’l trade law comm’n, rep. on its fifty-first session, u.n. doc. a/73/17 (2018), https://documents-ddsny.un.org/doc/undoc/gen/v18/052/21/pdf/v1805221.pdf?openelement/, [https://perma.cc/9hr9-2w9e]. 41 elisabetta silvestri, the singapore convention on mediated settlement agreements: new string to the bow of international mediation, access to justice in eastern europe sep. 2019, at 5, 11. 42 singapore convention, supra note 28, art. 1. 43 id. at art. 2(3). 44 id. at art. 1. 2023] the path to mediation 39 resolution agreements, the singapore mediation convention, which provides an effective mechanism to recognize and enforce mediated resolution agreements, is required. 45 moreover, with the singapore mediation convention, transnational mediation will have a great future.46 when comparing mediation with arbitration, mediation is possibly a successor to arbitration with the establishment of the singapore convention.47 due to transnational arbitration’s increasing cost and procedural complexity, a more collaborative approach, like mediation, can be utilized to deal with cross-border disputes. 48 mediation may be deployed simultaneously with the arbitration in solving cross-border commercial disputes, considering that the majority of countries in east asia allow mediation to be used with arbitration.49 the singapore mediation convention will promote the understanding and development of contractual interpretation.50 b. mediation clauses in trade and investment treaties mediation is accepted and incorporated in some treaties, including bilateral investment treaties (bits), free trade agreements (ftas), and multilateral treaties. according to the database of investment policy hub, 624 out of 2,572 bits have incorporated mediation or conciliation for isds. 51 for example, in the norway draft model bit 2015, mediation is stipulated as a non-binding procedure to settle disputes amicably.52 moreover, in the china model bit 2010, mediation is presented as one form of negotiation, which can be utilized to resolve investment disputes between disputing parties amicably.53 compared with the examples above, the thailand model bit provides more specific requirements for mediation 45 see generally timothy schnabel, the singapore convention on mediation: a framework for the cross-border recognition and enforcement of mediated settlements, 19 pepperdine disp. resol. l. j. 1, 3 (2019). 46 see generally lucy reed, ultima thule: prospects for international commercial mediation, (nus centre for international law working paper no. 19/03, 2019). 47 see generally veronika vanisova, current issues in international commercial mediation: short note on the nature of agreement resulting from mediation in the light of the singapore convention 8, (prague law working paper no. 2019/ii/5, 2019). 48 see generally kim m rooney, turning the rivalrous relations between arbitration and mediation into cooperative or convergent modes of a dispute settlement mechanism for commercial disputes in east asia, 12(1) contemp. asia arb. j. 109 (2019). 49 see generally id. 50 christina g hioureas, the singapore convention on international settlement agreements resulting from mediation: new way forward, 46(1) ecology l. q. 61 (2019). 51 international investment agreements navigator, investment policy hub, http://investmentpolicyhub.unctad.org/iia/mappedcontent#iialnnermenu/, [https://perma.cc/7yha-tncm]. 52 norway draft model bilateral investment treaty 2015, art. 14.2, https://www.regjeringen.no/contentassets/e47326b61f424d4c9c3d470896492623/draft-modelagreement-english.pdf, [https://perma.cc/5kew-zuvl]. 53 kun fan, mediation of investor-state disputes: a treaty survey, 2020 j. of disp. resol. 332. 40 columbia journal of tax law [vol 14:1 procedures, like the timing of initiation and termination.54 according to article 10.4, as long as the disputing parties agree, the mediation can be started or be closed at any time.55 additionally, the 2017 investment agreement between mainland china and hong kong sar provided a mediation mechanism with detailed guidance. 56 further, hong kong has also proposed to use mediation in isds during uncitral working group iii.57 in addition to bits, ftas have also provided mediation in the dispute resolution mechanism. for example, mediation has been included in a fta between the republic of korea and the republics of central america.58 the comprehensive economic and trade agreement (ceta) between the european union and canada has incorporated mediation in article 14.5. 59 in this treaty, the timing of a mediation’s initiation is not particularly regulated, and disputing parties are provided with the flexibility to resolve their disputes among different alternatives.60 under annex iii, the mediation procedure is more strictly regulated. 61 the mediators enjoy procedural freedom, like holding individual meetings whenever they think is appropriate, in order to reach a flexible resolution.62 the energy charter treaty (ect) also contains provisions for mediation, which allow disputing parties to resort to mediation for help during the cooling-off period.63 moreover, mediation provisions are also provided in the trans-pacific partnership (tpp).64 even in the comprehensive and progressive agreement for trans-pacific partnership (cptpp), mediation is mentioned, and it states that when disputes appear, the disputing parties may initially utilize mediation to resolve the 54 thailand model bit may 2012, art. 10.4, https://www.itd.or.th/wpcontent/uploads/2019/09/annex-08-2012-thailand-model-bit.pdf [https://perma.cc/6suc-4z79]. 55 see id. at art. 10.4. 56 mainland & hong kong closer economic partnership arrangement investment agreement 2018, art. 20(iv), dec. 14, 2018, https://investmentpolicy.unctad.org/internationalinvestment-agreements/treaty-files/2657/download, [https://perma.cc/dnx3-8cd5]. 57 teresa cheng, secretary for justice of hong kong, closing remarks at uncitral working group iii virtual pre-intersession meeting (nov. 9, 2020), https://www.doj.gov.hk/en/community_engagement/speeches/20201109_sj1.html/, [https://perma.cc/ly5c-abyb]. 58 free trade agreement between the republic of korea and the republics of central america 2018, art. 9.16, feb. 21, 2018, http://www.sice.oas.org/trade/cacm_kor/english/cacm_kor_preamble_e.pdf, [https://perma.cc/b72z-jsmt]. 59 comprehensive economic and trade agreement (ceta) between canada, of the one part and the european union 2014, art. 14.5, aug. 5, 2014. 60 id. at art. 14.5 61 id. 62 id. 63 energy charter treaty 1994, art. 26.2, dec. 17, 1991, https://www.energycharter.org/fileadmin/documentsmedia/legal/1994_ect.pdf [https://perma.cc/z92y-3maf]. 64 trans-pacific partnership agreement 2014, art. 28.6, feb. 4, 2016, http://www.sice.oas.org/trade/tpp_final_texts/english/chapter28.pdf, [https://perma.cc/ph8tq62c]. 2023] the path to mediation 41 related disputes. 65 specific provisions about the usage of mediation are also contained in the international institute for sustainable development (iisd) model international agreement on investment for sustainable development 2006.66 c. advantages of mediation in resolving disputes mediation is voluntary in nature, and parties are not bound by it. due to its voluntary nature, mediators are significant to facilitate the negotiation process. a fundamental feature of mediation is the impartiality of mediators.67 icc mediation rules regulate that before appointing a mediator, a declaration of acceptance, availability, fairness, and independence must be signed. if there are facts questioning the mediator’s independence or impartiality, these facts should be disclosed to the centre, and the centre shall write to the disputing parties and allow them to submit comments in a time limit set by the centre.68 mediators are not decision-makers; instead, they facilitate voluntary dispute settlement processes and aim to reach agreements that satisfy all partiess. additionally, mediation stipulates confidentiality obligations. 69 the meetings used in mediation are private and ex parte. 70 hearings and communications are conducted privately between the mediator and each disputing party separately, and different opinions can be heard during the process.71 private communications between the mediator and parties are standard in the mediation process. without permission of the party, the information exchanged is confidential and is not disclosed to other parties.72 for example, according to scc mediation rules, unless disclosure is authorized by the related disputing party, the information cannot be disclosed to other parties by the mediator.73 with the information obtained from these discussions, the mediator can identify the main disputes. 74 the information is confidential because the information may have a negative effect on a possible lawsuit in the future. 75 65 comprehensive and progressive agreement for trans-pacific partnership, art. 9.18, dec. 30, 2018, https://www.iilj.org/wp-content/uploads/2018/03/cptpp-consolidated.pdf, [https://perma.cc/8fn4-ub4s]. 66 howard mann et al., iisd model international agreement on investment for sustainable development (negotiator’s handbook 2d ed. 2005). 67 carol a. ludington, med-arb: if the parties agree, 5 y.b. on int’l arb. 317 (2017). 68 mediation rules of the international chamber of commerce 2014, art. 5 (3), https://iccwbo.org/dispute-resolution/dispute-resolution-services/adr/mediation/mediation-rules/, [https://perma.cc/wuf5-uh2u]. 69 see ludington, supra note 67, at 318. 70 kristen m. blankley, keeping a secret from yourself? confidentiality when the same neutral serves both as mediator and as arbitrator in the same case, 63 baylor l. rev. 317, 334 (2011). 71 id. 72 johnathan rickman, aba tax section meeting: confidentiality preserved in the dispute resolution process, 103 tax notes fed. 822 (2004). 73 mediation rules of the arbitration institute of the stockholm chamber of commerce 2014, art. 3(2). 74 hyung kyun kwon, med-arb adoption in securities law disputes: advantages and costs, 2 concordia law rev. 53 (2017). 75 id. 42 columbia journal of tax law [vol 14:1 compared with the trial process, mediation provides (1) a cheaper alternative ,76 (2) more flexible remedies, (3) a speedier procedure,77 (4) an informal platform for participants to describe their concerns freely,78 and (5) an agreed dispute resolution mechanism by all participants.79 parties can control both the mediation procedure and the agreement. 80 during the mediation procedure, besides the dispute itself, communications and relationships may also be discussed.81 a more creative, durable solution can be reached after the mediation procedure. 82 mediation has a principle of selfdetermination, which includes procedural self-determination and substantive selfdetermination. procedural self-determination includes the selection of mediators and conditions incorporated in the mediation agreement. 83 substantive selfdetermination indicates that the disputing parties control the dispute resolution process, and with some guidance from the mediators they can find the best solution.84 considering cost,85 speed,86 confidentiality, and satisfaction, mediation is more favorable to disputing parties. for example, mediation is attracting more businesses as an alternative to arbitration.87 although arbitration has a dominating position, mediation is gaining attention from businesspeople, lawyers, judges, and governments88 because parties seek an effective, inexpensive, and friendly dispute resolution mechanism to maintain their business relationships.89 the international chamber of commerce (icc), which is a significant arbitration supplier, prefers 76 rudolph j. gerber, recommendation on domestic relations reform, 32 ariz. l. rev. 9, 16 (1990). 77 stephen b. goldberg, the mediation of grievances under a collective bargaining contract: an alternative to arbitration, 77 nw. u l. rev. 270, 290 (1982). 78 see gerber, supra note 76. 79 karen l. henry, med-arb: an alternative to interest arbitration in the resolution of contract negotiation disputes, 3 ohio st. j. on disp. resol. 385 (1988). 80 debra l. shapiro & jeanne m. brett, comparing three processes underlying judgments of procedural justice: a field study of mediation & arbitration, 65 j. of personality and soc. psych. 1167, 1170 (1993). 81 robert a. baruch bush & joseph p. folger, the promise of mediation: the transformative approach to conflict 23-24 (john wiley & sons eds., 2004). 82 howard j. aibel, mediation works: opting for interest-based solutions to a range of business needs, 51 disp. resol. j. 24, 26 (1996). 83 diana van hout, is mediation the panacea to the profusion of tax disputes?, 10 world tax j. 59 (2018). 84 id. at 60. 85 u.s. corporate counsel litigation trends survey findings, fulbright & jawroski llp (2004), http://www.fulbright.com/mediaroom/files/fj0536-uk-v13.pdf, [https://perma.cc/rf4l-a7qw]. 86 noel rhys clift, introduction to alternative dispute resolution: a comparison between arbitration and mediation, pennington manches cooper llp, at 7-9 (feb. 1, 2006). 87 thomas j stipanowich, contract and conflict management, wis. l. rev. 831, 849-51 (2001). 88 carlos de vera, arbitrating harmony: ‘med-arb’ and the confluence of culture and rule of law in the resolution of international commercial disputes in china, 18 colum. j. asian l. 150, 154 (2004). 89 alan redfern & martin hunter, law and practice of international commercial arbitration 41 (sweet & maxwell eds., 3rd ed. 1999). 2023] the path to mediation 43 mediation.90 this is a deviation from dispute resolution requirements in contracts, in which mediation is most preferred, followed by arbitration, and litigation as a last resort. 91 in 2007, the american institute of architects (aia) maintained mediation as a precondition to litigation, and the arbitration clause was deleted from the aia contract.92 mediation has become a choice of adr for both dispute and pre-dispute contracts.93 there is a trend that lawyers have combined litigation skills with mediation.94 mediation has become a kind of "new arbitration" as it has gained some characteristics of arbitration, like the third party adjudicating and evaluating the disputes. 95 consequently, mediation can be a substitute for arbitration.96 mediation’s confidentiality level is higher than that in arbitration.97 if the information gained during the mediation process is used to reach arbitration or litigation awards, the related awards may be repealed. compared with arbitration, mediation is more straightforward and cheaper.98 for example, in mediation, there are fewer procedural rules that parties are likely to encounter. mediation is a settlement assistance procedure in nature.99 mediation can be a catalyst for parties to reach a settlement and save more money. as the parties establish the terms of the agreement, the parties’ needs will be more efficiently satisfied by the settlements reached through mediation.100 d. mediation clause in tax treaties it is important to first ask whether mediation can be adopted to settle taxation disputes before applying it to tax-related investment disputes. the oecd has already discussed the possibility of utilizing mediation to enhance the map. as an additional dispute resolution procedure to map, mediation has been used in the model tax convention commentary on article 25.101 oecd manual on effective 90 int’l chamber of commerce, arbitration and adr rules, art. 5.2 (2011). 91 robert n. dobbins, the layered dispute resolution clause: from boilerplate to business opportunity, 1 hastings bus. l.j. 159, 162-77 (2005). 92 am. inst. of architects, general conditions of the contract for construction, art. 15.3.1 (2007). 93 brian a. pappas, med-arb and the legalization of alternative dispute resolution, 20 harv. negot. l. rev. 163 (2015). 94 see am. inst. of architects, supra note 92, at art. 15.3.1. 95 jacqueline nolan-haley, mediation: the "new arbitration", 17 harv. negot. l. rev. 61 (2012). 96 robert baruch bush, substituting mediation for arbitration: the growing market for evaluative mediation, and what it means for the adr field, 3 pepp. disp. res. l.j. 125 (2002). 97 see blankley, supra note 70. 98 comparison between arbitration & mediation, fin. indus. regul. auth., https://www.finra.org/arbitration-and-mediation/comparison-between-arbitration-mediation, [https://perma.cc/z479-r4sj]. 99 see kwon, supra note 74. 100 see henry, supra note 79. 101 the potential use of other supplementary dispute resolution mechanisms is discussed in oecd model tax convention on income and on capital: commentary on article 25 paras. 86-87 (2017). no similar discussion is to be found in the 2017 update of the un model tax convention 44 columbia journal of tax law [vol 14:1 mutual agreement procedures (memap) 2007 describes how mediators can provide assistance during negotiations. 102 as part of this assistance, process hindrances can be identified, an aspect of the discussion can be provided, and a main focus can be placed on the problem-solving process.103 the european commission published the directive on tax dispute resolution mechanisms in october 2017.104 dispute resolution techniques include mediation and alternative dispute resolution (adr) commissions that are permitted by article 10 of the directive. as a dispute resolution mechanism for cross-border tax disputes within the eu, mediation can be included as a means of resolving disputes. chapter 3 of the united nations handbook on dispute avoidance and resolution, published in october 2019, discusses the application of mediation through country examples. 105 the subcommittee on dispute avoidance and resolution of the un was responsible for drafting this chapter, which was approved by the un committee of experts on international cooperation in tax matters.106 chapter 6 of this handbook has provided mediation to improve maps in specific conditions.107 the purpose of this chapter is to analyze several aspects of mediation and present mediation as an alternative dispute resolution regime that can enhance the effectiveness of map.108 ii. current transnational tax dispute resolution mechanism unresolved transnational tax disputes may impede global development because they can undermine cooperation and discourage investment. 109 on a practical level, dispute resolution is an effective mechanism that ensures justice to commentary, united nations 2017, https://www.un.org/esa/ffd/wpcontent/uploads/2018/05/mdt_2017.pdf, [https://perma.cc/h9x6-arxx]. 102 on the use of mediation in the context of the communication between competent authorities, see the memap, at § 3.5.2. http://www.oecd.org/ctp/dispute/manualoneffectivemutualagreementprocedures-index.htm; see also http://www.oecd.org/ctp/transferpricing/3howmap35interactionbetweentaxpayersandcompetentauthorities-352.htm. 103 id. 104 eu, council directive 2017/1852, oct. 10, 2017 on tax dispute resolution mechanisms in the european union. 105 un, document e/c.18/2019/crp 17, sept. 23, 2019, https://www.un.org/esa/ffd/wpcontent/uploads/2019/09/19stm_crp17_domestic-dispute-resolution-mechanisms.pdf, [https://perma.cc/4q32-tsc7]. 106 id. 107 un, document e/c.18/2019/crp 18, sept. 23, 2019, https://www.un.org/esa/ffd/wpcontent/uploads/2019/09/19stm_crp18_new-chapters-5-and-6.pdf, [https://perma.cc/v2vbm86k]. 108 id. at § 6.6.4. 109 jeffery owens, resolving international tax disputes: the role of the oecd, gale academic onefile (oecd publications and information centre, 2004), https://go.gale.com/ps/i.do?id=gale%7ca132120958&sid=googlescholar&v=2.1&it=r&linkacc ess=abs&issn=00297054&p=aone&sw=w&usergroupname=anon%7ecc17f21, [https://perma.cc/4g8r-n33q]. 2023] the path to mediation 45 the tax authorities who, because of limited resources, find it difficult to stand up to multinational conglomerates and foreign authorities. fair and effective dispute resolution mechanisms serve as a significant influence on the compliance attitudes of taxpayers. by the equivalent token, the oecd and imf focus on tax-related mandatory binding arbitration to improve taxpayer certainty.110 international double taxation has been a significant issue in which two jurisdictions seek to tax the same set of transactions or activities.111 such disputes are usually resolved by tax treaties. when adopting the treaty provision, if there is a disagreement, the map can be used to resolve the related disagreement. an efficient way to resolve tax disputes can be arbitration or mediation, as its costs are significantly less than the costs incurred in litigation.112 a. by design: map in double tax treaties taxpayers can escape the possibly unfair hearings by utilizing the map process. with map, taxpayers do not have to expose themselves to host states’ regulations.113 the map process provides taxpayers with an alternative dispute resolution regime to the host state’s judicial system. moreover, under double tax treaties, map is a prepositive stage before taxpayers reach mandatory arbitration. there has been a significant increase in the use of investor-state dispute settlement (isds) mechanisms for the settlement of tax disputes. 114 further, investment arbitral awards are easier to enforce as they will be enforced in accordance with the related arbitral institution’s corresponding regulations.115 for example, when enforcing icsid arbitration awards116, the corresponding bits and international convention on the settlement of investment disputes between states and nationals of the other states 117 will be applied. when enforcing the uncitral arbitration awards, arbitration rules and the corresponding bits should be applied.118 according to article 54 of the icsid convention, arbitration awards have binding effect on the contracting parties, and they have to enforce them 110 hans mooij, international tax disputes and developing countries, ciat (july 1, 2020), https://www.ciat.org/international-tax-disputes-and-developing-countries/?lang=en/, [https://perma.cc/8zt3-8wur]. 111 michael lang, introduction to the law of double taxation conventions 2 (ibfd 2021). 112 see generally michelle markham, litigation, arbitration and mediation in international tax disputes: an assessment of whether this results in competitive or collaborative relations, 11 contemp. asia arb. j. 277 (2018). 113 michele potestà, legitimate expectations in investment treaty law: understanding the roots and the limits of a controversial concept, 28 icsid rev. 88, 88–122 (2013). 114 august reinisch, the scope of investor-state dispute settlement in international investment agreements, 21(1) asia pac. l. rev. 3, 3-26 (2013). 115 vincent o. nmehielle, enforcing arbitration awards under the international convention for the settlement of investment disputes (icsid convention), 7 ann. surv. int’l & compar. l. 21, at 30, 36 (2001). 116 julien chaisse, international investment law and taxation: from coexistence to cooperation, e15 initiative, at 11 (2016). 117 icsid convention, regulations and rules 2006, at 27-28. 118 julien chaisse, making tax dispute resolution mechanisms more effective—the base erosion and profit shifting project and beyond, 10 contemp. asia arbit. j. 1, 27 (2017). 46 columbia journal of tax law [vol 14:1 within their territories.119 additionally, only the parties to the dispute are bound by the awards.120 when an arbitral tribunal in bits reaches an award, the contracting parties and participating members of icsid’s convention are bound by the related awards.121 furthermore, as the icsid has a close relationship with the world bank, icsid awards are enforced by the world bank’s member states voluntarily.122 therefore, the losing parties will follow the icsid awards to avoid negative consequences, such as sanctions.123 in this respect, the arbitration clause under bits is chosen by foreign investors to deal with their transnational taxation disputes. however, during the map process, taxpayers enjoy little legal standing and can only provide some written materials of evidence.124 according to the 2017 oecd model convention, before the map process, disputes should be submitted by taxpayers to the corresponding competent authority.125 if the dispute can be resolved by the competent authority unilaterally, the other methods, like map procedure, will not be needed. consequently, access to the map procedure can be decided by the competent authority.126 a lack of transparency in the competent authority’s decision-making process is a main shortcoming.127 over 100 jurisdictions signed the multilateral convention to implement tax treaty related measures to prevent base erosion and profit shifting (“multilateral instrument” or “mli”) in november 2016, which will quickly implement a series of tax treaty measures to update transnational tax rules and reduce the opportunity for multinational enterprises to avoid paying taxes. during the map procedure, the national interests of disputing parties can be vital, as map works as a diplomatic dispute resolution mechanism.128 map includes some issues such as lack of finality, double taxation, binding nature, issue of impartiality, etc.129 map, despite its flaws, is capable of serving the vital interests of the opposing parties. for taxpayers, map is an alternative to tax litigation and will be less cumbersome for them. 130 with tax litigation, taxpayers have to wait until the 119 dany khayat, enforcement of awards in icsid arbitration, mayer brown (dec. 19, 2011), https://www.mayerbrown.com/en/perspectives-events/publications/2011/12/enforcementof-awards-in-icsid-arbitration, [https://perma.cc/7n2s-l92v]. 120 id. 121 id. 122 id. 123 id. 124 oecd, model tax convention on income and on capital: condensed version 2017 (oecd publishing, 2017), https://doi.org/10.1787/mtc_cond-2017-en, [https://perma.cc/y6r9pa2t]. 125 id. 126 jasmin kollmann & laura turcan, overview of the existing mechanisms to resolve disputes and their challenges, in international arbitration in tax matters at 155 (michael lang & jeffrey owens eds., ibfd, 2016). 127 jean-pierre lieb, introduction: taking the debate forward, in international arbitration in tax matters at 61 (michael lang & jeffrey owens eds., ibfd, 2016). 128 see kollmann & turcan, supra note 126. 129 konstantinos taramountas, the mutual agreement procedure: coordinating the global tax orchestra, lse l. rev. 39, at 41-50 (2019). 130 oecd model commentary on article 25, para.7. 2023] the path to mediation 47 taxation is actually charged. however, map can be accessed as long as the disputing tax measures may result in taxation that violates the tax convention.131 for competent authorities, as map is a kind of diplomatic dispute resolution mechanism and taxpayers have little participation during the process, the national interest can be better protected. b. by design: baseball arbitration final offer arbitration (foa), also referred to as baseball arbitration, represents a potent mechanism for dispute resolution in which an arbitrator considers all the outstanding issues as a collective package and elects one party's package over the other. this arbitration format necessitates that both sides submit a proposed remedy, following which the arbitrator selects one offer, rendering it as the ultimate resolution. foa has garnered a reputation for its expeditiousness and effectiveness in arriving at a resolution, as it incentivizes both parties to provide their best offer upfront, promoting transparency and ensuring that both parties make an earnest effort to find a middle ground. the foa approach has found extensive application in diverse industries, including but not limited to, sports, healthcare, and labor disputes, owing to its pragmatic and streamlined approach to resolving complex disputes. therefore, foa serves as an excellent option for parties seeking a cost-effective and efficient mechanism for resolving disputes in a timely and impartial manner.132 no midpoint or compromise can be formulated in such a process. this is ideal for parties who are wary of the “split the difference” kind of arbitral awards. the united states spearheaded the adoption of baseball arbitration in resolving tax disputes.133 the double tax treaty between the united states and canada firstly included foa at the transnational level, and the united states also incorporated this clause in some other tax treaties, for instance, with germany, belgium, france, and switzerland. 134 it is also stipulated in a un model convention.135 in order to protect their tax sovereignty, the developed economies tend to incorporate foa in resolving tax-related disputes.136 foa is also beneficial for companies as they can enjoy quicker tax bill certainty. the idea behind this form of arbitration is that each party, conscious of the risk of rejection of an outrageous proposal, makes concessions in order to submit the most reasonable offer, thus incentivizing the parties to move towards a compromise, speeding up the resolution of disputes, and lowering costs. in order to improve efficiency, some guidance can be given on implementation of the 131 id. at para.14. 132 see lieb, supra note 127. 133 raffaele petruzzi, petra koch, & laura turcan, baseball arbitration in comparison to other types of arbitration, in international arbitration in tax matters (michael lang & jeffrey owens eds., ibfd 2016). 134 joost pauwelyn, baseball arbitration to resolve international law disputes: hit or miss, 22 fla. tax rev. 51 (2018). 135 united nations model double taxation between developed and developing countries, art. 25, p.5, (alternative b) (2017). 136 william w. park, tax and arbitration, 36 arbit. int’l. 200 (2020). 48 columbia journal of tax law [vol 14:1 arbitration clause.137 for example, although taxpayer participation is not provided in foa138,many detailed regulations are provided in the united states-canada double tax treaty. 139 in the treaty, submission deadlines and maximum page numbers of the individual submissions are stipulated clearly. furthermore, a baseball arbitral award is cheaper to obtain140, and since no reasoning is required, the whole procedure is speedier. 141 earnings are also limited. 142 instead, technological submissions including emails are preferred.143 according to the 2016 oecd model convention, if a tax dispute cannot be solved within two years, foa would be triggered when both disputing parties opt for it.144 according to article 23(1) of mli, foa is the default approach in resolving disputes. 145 one explicit merit of foa is that it limits and avoids certain sovereignty costs, as the arbitral tribunals have to pick one of the proposals provided by the disputing parties instead of developing their own proposals.146 with foa, the arbitrator’s discretion is limited, and tax sovereignty is protected.147 another advantage of foa is that it can keep and preserve the disputing parties’ relationship.148 one of the disadvantages of this process is that this model limits the arbitrator’s role. if both parties submit unreasonable proposals, the arbitrator is forced to choose one, resulting in a probably vital and unjustified loss in one of the disputing parties’ tax revenue. the limited authority has another consequence, which is that the decision has no additional information or comment from the arbitrator. another weakness is that only a limited range of cases can be resolved better by foa. if the dispute is a principled threshold question rather than a numerical one, foa cannot reach a satisfying result.149 137 convention between canada and the united states of america with respect to taxes on income and on capital (1980). 138 hans mooij, tax treaty arbitration, 35 arbit. int’l. 215 (2019). 139 id. 140 memorandum of understanding between the competent authorities of canada and the united states of america (2008), art. 13 [hereinafter canada-us memorandum]. 141 josh chetwynd, play ball? an analysis of final-offer arbitration, its use in major league baseball and its potential applicability to european football wage and transfer disputes, 20 marq. sports l. rev. 128 (2009). 142 see kollmann and turcan, supra note 126, at 130. 143 see canada-us memorandum, supra note 140, at art. 14. 144 multilateral tax convention to implement tax treaty related measures to prevent base erosion and profit sharing art. 19 (2016). 145 michelle andrea markham, arbitration and tax treaty disputes, 35 arbitration int’l 496 (2019). 146 see pauwelyn, supra note 134, at 56. 147 ehab farah, mandatory arbitration of international tax disputes: a solution in search of a problem, 9 fla. tax rev. 703, 15–17 (2009). 148 see pauwelyn, supra note 134, at 56. 149 see petruzzi et al., supra note 133. 2023] the path to mediation 49 c. independent arbitration and tax matters in the past, the only option for resolving tax disputes was independent arbitration, which is a more traditional and widely used method.150 in contrast to independent arbitration, baseball arbitration represents a compelling alternative for resolving disputes, particularly in the context of the eu directive on dispute resolution. 151 it is noteworthy that baseball arbitration has been included in the ambit of the european arbitration convention, further underscoring its significance as a dispute resolution mechanism. 152 with its unique features, such as the finality of awards and a simplified procedure, baseball arbitration has gained popularity as a method for settling disputes. the inclusion of baseball arbitration in the european arbitration convention highlights the recognition of its value and underscores the growing significance of alternative dispute resolution methods in the contemporary legal landscape. there is no interference from competent authorities in the final award of the arbitration tribunal.153 professional and less biased arbitrators can produce a more reliable final award.154 in independent arbitration, a written opinion is required, which makes it differ from baseball arbitration.155 an independent arbitration decision is reached “. . . based on a written, reasoned analysis of the facts involved and applicable legal sources.” 156 it is even highlighted in the oecd commentary, arguing that when taxpayers know how arbitrators arrived at an opinion, they will be more likely to accept it.157 an arbitrator will deal with the disputing parties’ facts and arguments during the arbitration process. supporting independent arbitration also requires consideration of due process.158 even though a written opinion has no precedential value, subsequent arbitrators can use it as a reference point.159 the “independent opinion” approach in arbitration has garnered significant criticism, with one of the main contentions being its proclivity towards a “splitting the baby” mindset. essentially, this approach often compels arbitrators to seek a 150 see oecd, commentaries on the articles of the model tax convention 2017, 387 (2017). 151 luís flávio neto, baseball arbitration: the trendiest alternative dispute resolution mechanism in international taxation, in flexible multi-tier dispute resolution in international tax disputes 279 (pasquale pistone & jan j.p. de goede eds. 2020). 152 hans mooij, map arbitration in tax treaty disputes, in flexible multi-tier dispute resolution in international tax disputes 278 (pasquale pistone & jan j.p. de goede eds., 2020). 153 see oecd, commentaries on the articles of the model tax convention 2017 387 (oecd publishing, 2017). 154 see generally michael lang & jeffrey owens, international arbitration in tax matters (michael lang & jeffrey owens eds., 2016). 155 petruzzi et al., supra note 133. 156 oecd, model tax convention on income and on capital (oecd publishing, 2017); commentary on article 25, sample mutual agreement on arbitration, clause 2, in model tax convention on income and on capital (oecd publishing, 2017). 157 see oecd, commentaries on the articles of the model tax convention 387 (oecd publishing, 2017). 158 see mooij, supra note 152, at 279. 159 see oecd, model tax convention on income and on capital: condensed version 2017 472 (oecd publishing, 2017). 50 columbia journal of tax law [vol 14:1 middle ground between the contending parties in order to reach a resolution, which can have detrimental consequences. by seeking compromise, parties may be incentivized to take extreme positions during negotiations in an attempt to shift the final outcome in their favor, thereby having a “chilling effect” on the proceedings. consequently, this aspect of independent arbitration has been a subject of considerable debate and calls for more effective approaches to address the nuances of dispute resolution.160 d. by default: mandatory arbitration under bits taxation disputes can also be resolved by arbitration under bits. furthermore, taxpayers tend to submit claims based on investment law treaties.161 mandatory arbitration within the bits has its own advantages, compared with the map usually utilized in double tax treaties.162 while competent authorities are sometimes not independent, arbitration can provide a fair hearing and award to taxpayers. 163 accordingly, taxpayers enjoy a substantial advantage under arbitration within bits.164 foreign investors can decide to pursue a claim when a breach of a treaty obligation appears.165 however, under double tax treaties, the determining power is controlled by the related competent authorities.166 the map cannot be launched without the related competent authorities’ permission. 167 according to article 25(5) of the oecd model convention, arbitration can only be initiated when unresolved disputes are available after the map process. in international investment law, the entire dispute can be submitted by foreign investors directly to the arbitral tribunal.168 for instance, a foreign investor can submit a claim based on an issue that has already been considered by a national court. deutsche bank v. sri lanka serves as a poignant illustration of the complex dynamics of transnational dispute resolution. 169 the claimant, in this instance, was compelled to take recourse to an 160 see petruzzi et al., supra note 133; i. grlica, baseball arbitration: comparison of the rules under the us-canada tax treaty with the rules under the multilateral instrument, in oecd, arbitration in tax treaty law (m. lang ed., linde 2018). 161 duke energy electroquil partners v republic of ecuador, icsid case no. arb/04/19, (aug. 18, 2008) (gives one example where the claim was made through the united states-ecuador bilateral investment treaty regarding import tax and custom duties). 162 julien chaisse, making tax dispute resolution mechanisms more effective—the base erosion and profit shifting project and beyond, 10 contemp. asia arb. j. 25 (2017). 163 carlos protto, mutual agreement procedures in tax treaties: problems and needs in developing countries and countries in transition, 42 intertax 176 (2014). 164 un conference on trade and development, world investment report (2014), https://unctad.org/system/files/official-document/wir2014_en.pdf, [https://perma.cc/c7u6-8eav]. 165 maira de melo vieira, the regulation of tax matters in bilateral investment treaties: a dispute resolution perspective, 8 disp. resol. int’l. 63 (2014). 166 michael j. mcintyre, comments on the oecd proposal for secret and mandatory arbitration of international tax disputes, 7 fla. tax rev. 622, 623–24 (2006). 167 oecd, model tax convention on income and on capital art. 25 (oecd publishing, 2014). 168 see chaisse, supra note 162. 169 deutsche bank ag v democratic socialist republic of sri lanka, icsid case no. arb/09/02, award, (oct. 31, 2012). 2023] the path to mediation 51 international tribunal due to the apparent inability of the supreme court of sri lanka to administer a just hearing. the claimant's submission centered around the violation of the fair and equitable treatment (fet) principle by the sri lankan authorities. this case highlights the challenges that litigants often face in crossborder disputes, particularly when navigating the nuances of legal systems that may differ vastly from their own. moreover, it underscores the critical role played by international tribunals in addressing the limitations of domestic courts and facilitating the resolution of conflicts between sovereign entities and private parties.170 because of the substantive clauses provided under bits, foreign investors prefer submitting their claims based on the bits.171 the substantive principles include national treatment (nt), most favored nations (mfn), fet, full protection and security (fps), and umbrella clauses.172 taxpayers often use fet standards to protect their interests under bits, because the fet standard’s scope has been expanded by arbitral tribunals.173 for instance, in roussalis v. romania, the arbitral tribunal has expanded the scope of the fet standard. 174 in the occidental exploration v. ecuador award, the tribunal stated that based on the fet standard, foreign investors should be provided with a stable and predictable environment.175 investment plans are made based on investors’ expectations.176 if the host state destroyed this predictability by utilizing the tax regulations, the fet standard would be breached. 177 based on the oecd model convention, the initiation of mandatory arbitration must wait for final taxation to be imposed.178 in contrast, as long as the taxation has breached foreign investors’ rights under bits, foreign investors can approach arbitration no matter whether the tax is imposed or not.179 however, only a limited number of claims related to taxation can be claimed under bits. for example, according to article 21 of the ect and article 13 of 170 id. at para. 108. 171 see generally katia yannaca-small, interpretation of the umbrella clause in investment agreements, in international investment law: understanding concepts and tracking innovations, 101 (oecd 2008) (describing the additional protections umbrella clauses provide to investors in bits); see also julien chaisse, the treaty shopping practice: corporate structuring and restructuring to gain access to investment treaties and arbitration, 11 hastings bus. l.j. 225, 226 (2015) (describing the impact of bit coverage on a foreign investor). 172 see rudolf dolzer & christoph schreuer, principles of international investment law, 161 (oxford university press, 2012). 173 id. at 11. 174 see spyridon roussalis v. romania, icsid case no. arb/06/1, award, 318 (dec. 7, 2011) (“beyond these general principles, the scope of the standard is not precisely defined.”). 175 see occidental exploration and production co. v. the republic of ecuador, case no. un3467, final award, 62-63 (london centre of international arbitration 2004). 176 id. at 62. 177 id. at 64. 178 see oecd, model tax convention on income and on capital 2014 art. 25(3) (oecd publishing, 2014), https://www.oecd-ilibrary.org/taxation/model-tax-convention-on-income-andon-capital-2015-full-version_9789264239081-en, [https://perma.cc/3c62-wau4]. 179 see julien chaisse, international investment law and taxation: from coexistence to cooperation, the e15 initiative 11 (2016) (comparing the oecd model tax convention with arbitration within the international investment law regime). 52 columbia journal of tax law [vol 14:1 united kingdom-colombia, the treaty can only be applied when tax measures amount to expropriation.180 the expropriation provision under bits is often used to resolve tax-related disputes.181 the definition of expropriation is seizing private profits for a public goal.182 furthermore, according to article 13(1) of the ect, expropriation is legal if it is (a) for a public purpose; (b) non-discriminatory; (c) conducted under due procedure; and (d) with quick and sufficient compensation.183 the actual effect is the key to tell the difference between direct and indirect expropriation.184 based on the burlington resources v. ecuador, a disputing act can amount to indirect expropriation when (i) the value of investment has been deprived substantially; (ii) the related measure is permanent; and (iii) the related measure is not justified.185 the arbitration clause under bits can be used to deal with disputes where taxation measures amount to indirect expropriation.186 in link-trading v. moldova, the claimant claimed that tax changes issued by the defendant constituted expropriation measures.187 the claimant used the mandatory arbitration under the united states-moldova bit.188 referring to tza yap shum v. peru, the aggressive tax changes also deprived the taxpayer’s business. 189 tax measures can be expropriatory when the related measures are arbitrary or abusive.190 however, the expropriation clause may not be violated just because of the mere changes in tax regulations. 191 if taxpayers still hold possession of the real property, sudden taxation changes cannot be treated as expropriation.192 however, in order to protect their own national sovereignty, countries prefer restricting arbitration under bits in resolving tax related disputes.193 many states have limited the utilization of the fet standard.194 for example, in nations energy corp. v republic of panama, the arbitral tribunal excluded taxation claims based on fet standards.195 additionally, tax measures are excluded if no explicit words 180 elizabeth snodgrass, tax controversies and dispute resolution under tax treaties: insights from the arbitration sphere, 19 derivatives & fin. instruments 4 (2017). 181 see kollmann & turcan, supra note 126, at 166–67. 182 see william h. reeves “expropriation,”“confiscation,” “nationalization”: what one can do about them, 24 the bus. law. 867, 867 (1969). 183 the energy charter treaty (annex 1 to the final act of the european energy charter conference), art. 13(1), energy charter treaty and related documents 2014. 184 see dolzer & schreuer, supra note 172, at 11. 185 see julien chaisse, investor-state arbitration in international tax dispute resolution: a cut above dedicated tax dispute resolution?, 35 va. tax rev. 149, 187 (2016). 186 see link-trading stock co. v. dep’t for customs control of the republic of moldova, final award, 1.4 (ita inv. treaty cases 2002). 187 id. at 10. 188 id. at 4. 189 see tza yap shum v. republic of peru icsid case no. arb/07/6, award, (july 7, 2011). 190 id. at 181. 191 id. 192 see chaisse, supra note 185. 193 see chaisse, supra note 179, at 9, 11. 194 nations energy corp. v republic of panama icsid case no.arb/06/19, award, 39, (nov. 24, 2010). 195 id. 2023] the path to mediation 53 have interpreted the fet standard in a bit.196 moreover, tax matters tend to be limited or excluded by states when signing bits.197 for instance, taxation was excluded from the scope of the 2015 indian-european union model bit.198 hong kong -new zealand bit.199 this agreement cannot be applied to tax matters.200 instead, tax matters should be considered based on both parties’ domestic laws and taxation agreements between them. due to the limitations mentioned above, the dispute resolution regimes under double tax treaties may be more suitable in resolving tax-related disputes. when using the double tax treaties to deal with disputes, the first step is to submit the dispute to the related competent authority. the related competent authority will try to resolve it unilaterally.201 if the competent authority fails to resolve the dispute unilaterally, then the map will proceed. iii. mediation for transnational tax disputes the resolution of transnational tax disputes is an intricate and formidable task, necessitating sophisticated mechanisms that can adeptly navigate the complex web of domestic and international legal regimes. the map is a widely utilized approach to resolving tax-related conflicts, yet it has been subjected to substantial criticism due to its perceived inefficiency. to enhance the efficacy of the map system, mediation can be employed in conjunction with it, taking into account the myriad benefits of the mediation process. mediation is not intended to supplant the map mechanism, but rather to augment it, presenting an innovative and complementary approach to resolving complex tax disputes in a mutually agreeable manner. a. shortcomings of map although map is popular, it is an inefficient tax-related dispute resolution regime. according to some experts, map is not an effective dispute resolution regime because it can be blocked by either disputing party unilaterally.202 as per the oecd committee on fiscal affairs (cfa), states regard map as the last choice. 203 based on the 2001 global transfer pricing survey, multinational 196 see chaisse, supra note 185. 197 model text for the indian bilateral investment treaty 2015, art. 2.6 (iv). 198 id. 199 agreement for the promotion and protection of investments hong kong-n.z., art. 8(2) (1995). 200 id. 201 see oecd, model tax convention on income and on capital: condensed version 2017 (oecd publishing, 2017), https://doi.org/10.1787/mtc_cond-2017-en, [https://perma.cc/l73s-zls3]. 202 reuven s. avi-yonah & haiyan xu, evaluating beps: a reconsideration of the benefits principle and proposal for un oversight, 6 harv. bus. l. rev. 185, 233 (2016). 203 oecd, transfer pricing and multinational enterprises: three taxation issues 18 (1984). 54 columbia journal of tax law [vol 14:1 corporations do not have trust in map.204 some reasons include that the map process is too expensive and time-consuming.205 map cases may not be resolved even after more than ten years. 206 moreover, article 25(2) of the model tax convention only requires the competent authorities to try to resolve the related disputes during map process.207 further, taxpayers criticize the map because there is little space for them to participate. 208 in other words, the competent authorities control the whole process, and there is a lack of transparency. b. mediation can make up for it mediation is a consensual and collaborative process in the transnational dispute resolution area. based on the definition provided by the united nations, in mediation, a third party is needed to reconcile the claims proposed by both disputing parties and its role is to help both disputing parties reach a compromise agreement in the end.209 mediation has the potential to resolve cross-border tax disputes. according to the oecd manual on effective map (the “memap manual”)210, mediation provides competent authorities a chance to view a case from a different angle.211 in the 2008 update to oecd model tax convention, mediation was referenced as a possibility.212 mediation can be used to resolve domestic tax disputes, and based on oecd, the application of mediation may be extended to the map cases.213 when faced with unforeseen issues that complicate the map case, a mediator can clarify key controversies and identify a middle ground between disputing parties.214 in dealing with domestic disputes, some countries have already used mediation. countries including united kingdom, united states, the netherlands, and australia 204 michelle markham, mandatory binding arbitration is this a pathway to a more efficient map?, 32 arbit. int’l 152 (2019). 205 id. 206 michelle markham, seeking new directions in dispute resolution mechanisms: do we need a revised mutual agreement procedure?, 70 bull. for int’l tax’n 82 (2016). 207 marcus desax & marc veit, arbitration of tax treaty disputes: the oecd proposal?, 23 arbit. int’l 405, 409 (2007). 208 hugh j ault, improving the resolution of international tax disputes, 7 fla. tax rev. 137, 139 (2005). 209 un office of legal affairs codification division, handbook on the peaceful settlement of disputes between states 123 (1992). 210 oecd, manual on effective mutual agreement procedures (feb. 2007), www.oecd.org/ctp/dispute/manualoneffectivemutualagreementprocedures-index.htm, [https://perma.cc/q7nd-ly95] 211 joe dalton, unlocking map disputes; is mediation the key, 24 int’l tax rev. 14 (2013). 212 oecd, model tax convention on income and on capital: commentary on article 25 paras. 86, 87 (2008). 213 michelle markham, litigation, arbitration and mediation in international tax disputes: an assessment of whether this results in competitive or collaborative relations, 11 contemp. asia arb. j. 277 (2018). 214 committee of experts on international cooperation in tax matters nineteenth session, possible improvements to map, in preliminary draft of the chapters on map arbitration and on possible improvements to map of the handbook on dispute avoidance and resolution 14 (geneva, oct. 15-18, 2019). 2023] the path to mediation 55 have already successfully utilized mediation at the internal level.215 for instance, in the united kingdom, adr is brought to facilitate negotiation processes. during a negotiation process, competent authorities maintain their sovereignty. 216 the benefits of such adr include confidentiality and the respective positions of disputing parties can be sharpened.217 in comparison to the traditional multi-day hearings, adr is more efficient.218 mediation may be helpful in resolving some critical issues in the map process, as the mediators can illuminate the case elements from a different view.219 when there is a disagreement between disputing parties in a map case, mediation is recommended, and the mediators can clarify the disputes.220 during the map process, mediators can communicate with the disputing parties and assist them in getting a better understanding of their viewpoints.221 the united nations subcommittee on the map dispute avoidance and resolution is considering including mediation as a non-binding dispute resolution form to improve the efficiency of the map procedure.222 by using mediation, the issues of disputes can be clarified, and misunderstandings can be resolved. 223 although mediation is non-binding, the mediator can bring the conflicts back to the discussions.224 mediation is advisory in nature. a mediator needs to find a solution to the dispute and reach a balance between the disputing parties (a win-win scenario). mediation can be active or passive depending on the dispute , and involves guiding discussions, exchanging information, making suggestions, and offering solutions.225 during the mediation process, “all the relevant facts can be sorted out and agreed until there is no unnecessary dispute left on those anymore and it can be examined and agreed what essentially is the scope of the dispute and where and 215 oecd, comments received on public discussion draft, beps action 14: make dispute resolution mechanisms more effective (2015), http://www.oecd.org/tax/dispute/publiccomments-action-14-make-dispute-resolution-mechanisms-more-effective.pdf, [https://perma.cc/873k-ycd7] 216 committee of experts on international cooperation in tax matters nineteenth session, supra note 211. 217 id. 218 geoff lloyd & paul dennis, q&a: how is adr working for large businesses?, tax j. (2015). 219 joe dalton, supra note 211. 220 see oecd, model tax convention on income and on capital: condensed version 2017 (oecd publishing, 2017), https://doi.org/10.1787/mtc_cond-2017-en, [https://perma.cc/k3gr-v9bq] 221 id.; katerina perrou, the ombudsman and the process of resolution of international tax disputes – protecting the ‘invisible party’ to the map, world tax j. (ibfd) 108 (2018). 222 comm. of experts on int’l coop. in tax matters, rep. on its fourteenth session, coordinator’s report on work of the subcommittee on the mutual agreement procedure dispute avoidance and resolution, at 2 , u.n. doc. e/c.18/2017/crp.4 (2017) 223 id. 224 “mediation” includes all elements of such procedures as are appropriate in the map process. 225 committee of experts on international cooperation in tax matters nineteenth session, supra note 211, at 10. 56 columbia journal of tax law [vol 14:1 why the disputing parties’ positions differ.”226 during the process, parties retain full control of the decision.227 because of its flexibility and confidentiality, mediation is frequently used to solve different kinds of disputes. mediation’s effectiveness is determined by the mediator, and the fundamental role of a mediator is to create awareness between the disputing parties about what mediation is. when there is a dispute between states with various levels of map experience, mediation can be helpful, especially for less developed countries with little experience in map processes. mediation is beneficial to protect the respective countries’ tax bases by building experience in resolving such disputes. the ordinary focus of a mediation is not to let the mediator point out the dispute. instead, the working relations between the disputing parties should be focused more on the mediation process, which is whether or not they are willing to communicate with each other and achieve mutual understanding. as mediation has already been allowed in article 25 of the oecd model and its respective commentary,228 countries can choose to adopt mediation either as a default or supplementary option.229 rather than depending on the map, tax related disputes can also be resolved with the help from a mediator. as it is normal for countries to have various interpretations on the same treaty provision, the dispute may be caused by this plurality of perspectives. the involvement of a mediator can improve the understanding of each party’s position and an agreement may be more likely to be reached. by incorporating mediation to the map, the whole procedure can be more efficient and less burdensome. taxpayers may be more likely to initiate proceedings if they have confidence that their disputes can be resolved efficiently. 230 if countries decide to incorporate mediation into map , the proceedings may be conducted without the involvement of taxpayers in line with the requirements of map. mediation can be a good method to resolve disputes at the very beginning. during the map process, the taxpayer is not a party to the process.231 map, as a government-to-government process, is conducted between competent authorities. the role of taxpayers is limited in the fact-finding procedure.232 the inclusion of taxpayers in the dispute resolution process is valuable.they not only provide basic documents and information related to the disputes, but also provide 226 hans mooij, supra note 152, at 254-55. 227 committee of experts on international cooperation in tax matters nineteenth session, supra note 211. 228 see oecd, model tax convention on income and on capital, supra note 212. 229 united nations, ecosoc committee of experts on international cooperation in tax matters, coordinator’s report on work of the subcommittee on the mutual agreement procedure – dispute avoidance and resolution 3 (2016), e/c.18/2016/crp.4, annex 3 on mediation and other forms of nbdr. 230 joe dalton, unlocking map disputes; is mediation the key, 24 int’l tax rev. 15 (2013). 231 for a more detailed analysis on the role of the taxpayer in international tax dispute resolution, see limor riza, taxpayers’ lack of standing in international tax dispute resolutions: an analysis based on the hybrid norms of international taxation, 34 pace l. rev. 1064 (2014). 232 see, oecd, manual on effective mutual agreement procedures (memap) (feb. 2007), https://www.oecd.org/ctp/38061910.pdf, [https://perma.cc/a6jb-tuut]. 2023] the path to mediation 57 their own proposal to resolve the disputes. in this way, the speed of the dispute resolution process can be improved. if mediation is a part of map, the mediator can grant the rights of taxpayers. c. what types of disputes can mediation resolve? some double tax treaties allow the application of the map.233 mediation is especially useful as a means of building confidence in resolving the related dispute when the disputing countries have different levels of experience in map.234 third parties serve as mediators during the mediation process to help disputing parties resolve certain issues.235 it is important to differentiate between fact-related and law-related disputes when analyzing why transnational tax disputes arise. 236 disputes over taxation may arise when disputing parties lack the same information. when disputing parties cannot reach an agreement on some vital facts, mediation can be useful in resolving these disputes. mediation is effective in eliminating differences and helping disputing parties reach an agreement on some crucial facts. as a result, mediation may be especially helpful in dealing with some types of tax disputes. unlike legal disputes, which may be associated with the interpretation of some legal terms, mediation is more appropriate when resolving factual disputes. cooperation and discussion cannot be of any value in resolving legal disputes unless one disputing party has outright misinterpreted some legal concepts. it is impossible to resolve these legal disputes simply by giving up one's own arguments and accepting the other's.237 the use of mediation can, therefore, be used to resolve tax-related investment disputes over factual issues. mediation can facilitate understanding between disputing parties when one party is having difficulties understanding the other party's positions. it is possible for them to make some compromises during mediation even if they cannot reach an agreement on some factual issue. however, mediation does not suffice in some cases, especially those involving complex legal issues. 233 see the commentary on the map in the dutch agreements to avoid double taxation with spain, australia and tunisia (available via: kluwer navigator, vakstudie international belastingrecht). 234 document e/c.18/2019/crp .18 of sept. 23, 2019, at para. 52, https://www.un.org/esa/ffd/wp-content/uploads/2019/09/19stm_crp18_new-chapters-5-and6.pdf, []. 235 for an analysis of the nature of tax disputes and what is different about them that affects the possible us of mediation for the resolution of tax disputes, see m.b.a. van hout, is mediation the panacea to the profusion of tax disputes?, world tax j. § 4., 10 (2018). 236 see the definition of “dispute” as proposed by f d berman, as “a disagreement on a defined issue of law or fact, or law and fact combined, which has brought the interests of two or more states into conflict and which they (or at least one amongst them) require to have solved.”; see f.d. berman, legal theories on international dispute prevention and dispute settlement: lessons for the transatlantic partnership, in transatlantic economic disputes 455 (e.-u. petersmann & m.a. pollack eds., oup 2003). 237 katerina perrou, using mediation for the resolution of cross-border tax disputes, in flexible multi-tier dispute resolution in international tax disputes 204 (pasquale pistone & jan j.p. de goede eds., ibfd 2020). 58 columbia journal of tax law [vol 14:1 d. mediation and soft law although soft law has no binding power, it still has its own practical effects.238 soft law is suitable for the states that prefer the final award without many commitments.239 there are six main merits of soft law as stated below: 1) because of the non-binding characteristic of soft law, the contracting costs can be decreased.240 2) with soft law, cooperation can be promoted, and sovereignty costs can be lowered.241 3) soft law can deal with diversity and meet different and unique conditions.242 4) greater flexibility can be provided by soft law during negotiations.243 5) ssoft law can speed up the process of reaching agreements, especially when something unforeseen occurs.244 6) more participants can join the process.245 soft law is important, and when experimentation is needed, it can be functional.246 if an agreement is not binding, it can be seen as soft to some extent.247 with soft law, the disputing parties can decide the implementation totally. 248 complex law cannot cope with the diversity and uncertainties of the changing world.249 under soft law, there will be more choices.250 states can avoid making hard-law commitments and maintain flexibility with soft law instead when their interests are uncertain.251 238 francis snyder, the effectiveness of ec law: institutions, processes, tools and techniques, 56(1) modern l. rev. (1993); francis snyder, soft law and institutional practice in the european community, in the construction of europe: essays in honour of emile noel 197, 198 (stephen martin ed., kluwer academic publishers, 1994). 239 c. m. chinkin, the challenge of soft law: development and change in international law, 38(4) int’l and compar. l.q. 850, 861 (1989). 240 kenneth w. abbott & duncan snidal, hard and soft law in international governance, 54 int’l org. 421, 434 (2000). 241 wolfgang h. reinicke & jan martin witte, interdependence, globalization, and sovereignty: the role of non-binding legal accords, in commitment and compliance: the role of non-binding norms in the international legal system 75, 94-95 (dinah shelton ed., oxford university press, 2003). 242 christine chinkin, normative development in the international legal system, in commitment and compliance: the role of non-binding norms in the international legal system 21, 26-29 (dinah shelton ed., oxford university press, 2003). 243 see abbott & snidal, supra note 240. 244 charles lipson, why are some international agreements informal?, 45 int’l org. 495, 501 (1991). 245 see chinkin, supra note 242. 246 see abbott & snidal, supra note 240; david m trubek et al. ‘soft law’, ‘hard law’ and eu integration, in law and new governance in the eu and the us 67 (gráinne de búrca & joanne scott eds., bloomsbury publishing, 2006). 247 see trubek et al., supra note 246. 248 gregory c shaffer & mark a pollack, hard vs. soft law: alternatives, complements, and antagonists in international governance, 94(3) minn. l. rev. 715 (2010). 249 trubek et al., supra note 246, at 3. 250 james d morrow, modeling the forms of international cooperation: distribution versus information, 48(3) int’l org. 387, 395 (1994). 251 see reinicke & witte, supra note 241, at 94-95. 2023] the path to mediation 59 mediation can be treated as a kind of soft law when it is adopted to resolve tax-related disputes. mediation, as soft law, can be adopted in improving the efficiency of map.252 mediation can be utilized to resolve some issues during map as the disputes can be clarified and illuminated by mediators from a different angle.253 during the whole process, the disputing parties maintain full control of the decision.254 the flexibility and confidentiality of mediation are also helpful in dealing with various disputes.255 although mediation has its own advantages, due to its disadvantages, it cannot be adopted as a kind of hard law. instead, countries can choose to adopt it as a kind of soft law after considering its merits and drawbacks. for example, it is not compulsory. a result is not guaranteed in mediation. even if a mediation agreement is reached, the enforcement of the agreement is still a concern. cooperation is required during the process: if one or both disputing parties are unwilling to cooperate with each other, mediation cannot be a success. in order to illustrate the disadvantages of mediation in detail, the practice of china can be an example. firstly, consider disputing parties that are worried about the disclosure of some important information exchanged during a mediation process. if the dispute is not resolved with mediation and the case is submitted to the trial, there is a concern that the arguments of one party may be revealed to the other party.256 some opponents to mediation hold the view that the impartiality of a mediator is hard to be ensured, so the risk of disclosing secrets during the mediation exists. although article 7 of the people’s mediation law chinese mediators from disclosing information gained during the mediation process, 257 disputing parties may still feel insecure. secondly, the mediation process may be time and money consuming. in some cases, time may be expanded and cost may be increased. for instance, an additional burden may be levied on the disputants if mediation fails, because the disputing parties may initiate another proposal to mediate the failing case. collecting evidence and hearing witnesses again will be time and money consuming.258 thirdly, the satisfaction of a mediation resolution may be diminished.259 mediators enjoy no rights to impose a duty on the disputing parties because mediation is non-binding. only when both disputing parties fully 252 comm. of experts on int’l coop. in tax matters, rep. on its fourteenth session at 2, u.n. doc e/2017/45 (2017). 253 see dalton, supra note 211 at 14; also see oecd, model tax convention on income and on capital, supra note 124. 254 pasquale pistone & jan j p de goede, the flexible multi-tier dispute resolution framework and our final conclusions and recommendations, in flexible multi-tier dispute resolution in international tax disputes 492 (pasquale pistone & jan j.p. de goede eds., 2020). 255 see id. 256 nicholas gould, recent trends in dispute resolution, fenwick elliot (nov. 2011), https://www.fenwickelliott.com/research-insight/articles-papers/recent-trends-dispute-resolution0, [https://perma.cc/tfy3-ckep]. 257 karwan a. perot, the advantages and disadvantages of mediation in the chinese commercial arbitration process, 1 china & wto rev. 125 (2018). 258 gabrielle kaufmann-kohler & kun fan, integrating mediation into arbitration: why it works in china, 25 j. of int’l arbit. 479 (2008). 259 see perot, supra note 257 at 125. 60 columbia journal of tax law [vol 14:1 accept the resolution can a satisfactory resolution be achieved through mediation. if the disputants are coerced to reach or accept a resolution by the mediator, the value of mediation is diminished. so, in this condition, the satisfaction of the mediation is diminished because of this compromised resolution, as from the disputants’ perspective it appears that the decision is imposed by the mediator.260 furthermore, parties cannot appeal a mediation decision.261 if there was a mistake in fact or law during the mediation process, the disputing parties could reject the decision. based on article 31 of the chinese mediation rules, even though if a mediation is unsuccessful, no appeal is available. 262 another problematic feature of mediation is that it may be used as a delaying tactic.for example, mediation can be used to delay the payment of debt. if disputing parties have no intention to resolve the disputes in the mediation process, mediation can take a long time and become useless . lastly, in china, mediators have minimal incentives to perform well.263 this is because most mediators in china are are retired and employed on a part-time basis with small allowances. iv. conclusion the contemporary global landscape has undergone substantial metamorphosis, characterized by significant geopolitical realignments, technological advancements, pervasive globalization, emergent business and consumer requirements, and novel lifestyle paradigms, as well as the inception of unprecedented entrepreneurial entities. historically, sovereign states engaged in persistent rivalry to proffer advantageous arrangements to corporations. this approach was rational when said entities could establish a manufacturing facility and engender gainful employment opportunities. however, the advent of the digital epoch has considerably facilitated cross-border commerce and investment for organizations. concomitantly, market actors have refined their dexterity in translocating profits from their operational jurisdictions to those with more favorable tax regimes, consequently propelling the phenomenon of base erosion and profit shifting to unparalleled heights. thus, imposing taxation within the multinational framework has become a progressively formidable task. concerted efforts are underway, exemplified by the oecd’s ambitious endeavor to establish a bifurcated architecture encompassing enhanced tax mechanisms. nevertheless, upon implementation, additional lacunae may surface, necessitating vigilant identification and rectification. for instance, it may be difficult to determine which nations will get reallocated revenue proposed in pillar one of the plan or how double taxation of reallocated income will be avoided. developing a compelling 260 see de vera, supra note 88, at 159-60. 261 see perot, supra note 257, at 126. 262 he wei & zeng ying king, extra-judicial mediation system and practice, china law insights: dispute resolution (oct. 31, 2011), https://www.chinalawinsight.com/2011/10/articles/dispute-resolution/extrajudicial-mediationsystem-and-practice-ipart-i-of-iii/, [https://perma.cc/b82x-zhfa]. 263 vai lo lo, resolution of civil disputes in china, 18 ucla pac. basin l.j. 134 (2000). 2023] the path to mediation 61 dispute resolution process to promote tax, especially in light of developing countries’ objections, may be a challenge. the current transnational tax dispute resolution mechanism is not sufficient and cannot meet the increasing trend of transnational tax disputes. as a result, mediation can be put to the test. as there is a converging trend among trade, investment and taxation, a unified mediation regime is plausible and desirable.264 however, mediation does not make amendments to existing tax treaties. as taxpayers seek an effective, efficient, and transparent dispute resolution mechanism, map is not suitable, and mediation can be a choice. because the revenue at stake is large and the issues related to treaty interpretation and transfer pricing are complex, the average duration of map is around two and a half years.265 with the help of a mediator, competent authorities can consider the map process from a different view. furthermore, some systemic issues of the map process may also be solved by mediation. adr is attracting many tax authorities’ attention, and they want to utilize adr to reduce the number of cases and compliance costs. mediation, as a flexible dispute resolution mechanism, is less burdensome for both disputing parties. with adr, taxpayers have changed their views on the competent authorities. moreover, they have a better understanding of tax administration. thereby, mediation can be put to the test to facilitate the effectiveness of tax-related dispute resolution mechanisms. in the realm of addressing tax-associated conflicts, the utilization of mediation may be regarded as an embodiment of soft law, characterized by its inventive and exploratory nature. owing to its non-binding essence, contending parties, particularly sovereign entities, are afforded enhanced latitude in safeguarding their vested interests. as a manifestation of soft law, the efficacy of the map may be augmented through the integration of mediation. the incorporation of an “opt-in” stipulation within the dispute resolution accord enables parties to elect mediation as their preferred modality. consequently, mediation may serve as a valuable adjunct to map in the resolution of tax-related disputes. 264 comm. of experts on int’l coop. in tax matters twenty-fifth session, item 3(p) of the provisional agenda, relationship of tax, trade and investment agreements, u.n. doc. e/c.18/2022/crp.18 (oct. 18-21, 2022). 265 poonam khaira sidhu, is the mutual agreement procedure past its ‘best-before date’ and does the future of tax dispute resolution lie in mediation and arbitration?, bull. for int’l tax’n 605 (2014). microsoft word state individual income tax conformity in practice.docx state individual income tax conformity in practice: evidence from the tax cuts & jobs act amy b. monahan* nearly every state incorporates the federal tax code into its individual income tax system. this widespread incorporation has many supporters and has been justified on the basis that it is necessary in order for states to have a simple and efficient tax system. this article explores the practical effects and dynamics of state tax conformity through a novel examination of how states that tightly conformed to the federal individual income tax responded to the recently enacted tax cuts and jobs act which, for these states, would have both raised state taxes and changed the distribution of state tax burdens. the study reinforces concerns raised in both the theoretical and economic literature regarding conformity’s enhancement of revenue volatility and likelihood of distorting state legislative decision-making, while adding several new observations of conformity’s impact. the study illustrates that conformity imposes significant time constraints on state legislatures, conformity causes not only revenue shocks, but tax policy shocks, and even where state revenue is kept constant following a federal change, conformity may cause relative state tax burdens to change. based on these findings, the article concludes by offering suggestions for how states can move past the idea that extensive conformity with the federal tax code is required and instead design an individual income tax system that is simple, efficient, and enhances a citizen’s relationship to the state. * melvin c. steen professor and associate dean for research & planning, university of minnesota law school. i am grateful for helpful comments and suggestions received from ruth mason, darien shanske, and the participants in the duke tax policy colloquium, and for excellent research assistance provided by rachel lochner. [vol.11:1 columbia journal of tax law 58 table of contents introduction ................................................................................................................. 59 i. state individual income tax and the advantages and disadvantages of state tax conformity....................................... 61 a. the state of state individual income tax ......................................................................61 b. advantages of conformity ...............................................................................................64 c. disadvantages of conformity ..........................................................................................66 a. the practical dynamics of conformity ....................................................................67 b. pre-tcja evidence of state responses to changes in federal tax law .............69 1. state decisions to conform or decouple .....................................................70 2. do states make revenue-neutral adjustments? .........................................72 c. a study of state responses to the tcja’s individual income tax provisions ...................................................................................................................74 1. updated cross-references............................................................................78 2. revenue retention & tax burden distribution ...........................................80 3. tight conformity outliers: colorado and north dakota ...........................86 4. discussion ......................................................................................................92 iii. state individual income tax policy for the 21st century ... 94 a. carefully weigh the costs of decoupling from specific features of the federal income tax ...................................................................................................95 b. borrow federal definitions, not federal treatment ...............................................96 c. take advantage of existing data .............................................................................97 d. give up on tax expenditures ...................................................................................98 e. design around the taxpayer experience.................................................................99 f. protect the system through institutional safeguards .......................................... 100 conclusion .................................................................................................................... 101 2019] state individual income tax conformity in practice: evidence from the tax cuts & jobs act 59 introduction state income taxes are of critical importance to ordinary citizens in the forty-one states that impose them. such taxes fund a significant portion of essential governmental services,1 directly impact take-home pay of workers, and involve one of the most significant interactions citizens have with their state government. yet, despite this central importance, most states tie their individual income tax to the widely-criticized federal income tax code, 2 a system that has been characterized by a bipartisan study as “fundamentally unfair, far too complex, and long overdue for sweeping reform.”3 while many scholars acknowledge that there are trade-offs involved in state incorporation of federal tax law, commonly referred to as state tax conformity, the practice enjoys widespread support. 4 there are many arguments made in its favor. conformity is thought to greatly simplify recordkeeping and return preparation for taxpayers, who only need to learn one set of rules. it is also thought to make enforcement of state tax laws much more efficient, since states can rely on federal tax guidance and audits when enforcing their own tax laws. another common argument is that conformity conserves state legislative resources by outsourcing tax design to the federal government. indeed, some have argued that conformity should be required,5 while others simply argue that conformity should be encouraged and increased.6 1 the individual income tax is in fact a much more important revenue source for states than the corporate income tax. state individual income taxes are nearly forty percent of all state tax collections, while state corporate income taxes account for only five percent of such collections. u.s. census bureau, state & local government finance, fiscal year 2016 (2019), https://www.census.gov/data/datasets/2016/econ/local/public-use-datasets.html [perma.cc/hvj9-5g4p] (percentages calculated by author). 2 see, e.g., richard l. doerenberg & fred s. mcchesney, doing good or doing well? congress and the tax reform act of 1986, 62 n.y.u. l. rev. 891 (1987); mary louise fellows, rocking the tax code: a case study of employment-related child-care expenditures, 10 yale j. l. & feminism 307 (1998); kristin e. hickman, pursing a single mission (or something closer to it) for the irs, 7 colum. j. tax l. 169 (2016); edward j. mccaffery & linda r. cohen, shakedown at gucci gulch: the new logic of collective action, 84 n.c. l. rev. 1159 (2006); julie roin, united they stand, divided they fall: public choice theory & the tax code, 74 cornell l. rev. 62 (1988); 3 nat’l commission on fiscal resp. & reform, the moment of truth 24 (2010). 4see, e.g., heather m. field, binding choices: tax elections & federal/state conformity, 32 va. tax rev. 527, 539 (2013); ruth mason, delegating up: state conformity with the federal tax base, 62 duke l.j. 1267, 1267–68 (2013) (noting that “the administrative and compliance advantages of federal-state tax-base conformity are so significant that states are unlikely to abandon it”); kirk j. stark, the federal role in state tax reform, 30 va. tax rev. 407, 423 (2010) (“the availability of the federal income tax base as a starting point in calculating state tax liability is an unqualified benefit”). 5 daniel shaviro, an economic and political look at federalism in taxation, 90 mich. l. rev. 895, 897 (1992) (“i urge that congress require the states to use partly or wholly uniform tax bases for business and perhaps personal income taxes”). 6see, e.g., harley duncan & leann luna, lending a helping hand: two governments can work together, 60 nat’l tax j. 663 (2007); jared walczak, toward a state of conformity: state tax codes a year after federal tax reform, tax found., fiscal fact no. 631, jan. 2019, at 42. [vol.11:1 columbia journal of tax law 60 despite relatively widespread support for conformity, prior literature has also examined the detriments of conformity. conformity increases the volatility of state income tax revenue by subjecting it to exogenous shocks triggered by federal tax changes. 7 conformity not only introduces these exogenous shocks, but it also may skew legislative decision-making in response to such shocks.8 states are about evenly split in whether they dynamically conform to federal tax law, or whether they use static conformity. in dynamic conformity states, federal tax changes automatically take effect without legislative action. static conformity states, on the other hand, remain tied to prior federal law unless the legislature votes in favor of a statutory amendment. a state legislator in a static conformity state may be unwilling to affirmatively vote to conform to federal changes where doing so would raise state taxes. but a legislator in a dynamic conformity state might be perfectly willing to do nothing and allow a stealth tax increase to take effect. in part because of these exogenous revenue effects and unique decision-making dynamics, economists and political scientists have long been interested in state tax conformity. yet nearly all such empirical studies have focused exclusively on the state corporate tax— a tax that is much more complicated and much less fiscally important to most states than the individual income tax. those studies’ findings are not terribly encouraging. they have found little rhyme or reason to what drives state legislative decisions to either conform or decouple from specific federal tax provisions.9 but they have found that, where federal tax changes increased state taxes, state legislators did not take action to fully reverse those tax increases.10 in other words, states allowed an exogenous federal change to increase the taxes its citizens pay – an irrational result if legislators had already determined their optimal mix of taxes and spending. this article uses the recently-enacted tax cuts and jobs act (the “tcja”) to explore how state tax conformity operates in the real world. it provides a novel examination of how states with the tightest conformity to federal tax law responded to the fundamental changes in the federal individual income tax structure enacted by the tcja in 2017. in each of these states, state taxes would have significantly increased if the state remained in tight conformity with federal law and made no offsetting state tax changes. in addition, the relative distribution of those tax burdens would have shifted because the federal law eliminated the previous adjustment for family size and provided a significant deduction for some forms of business income. as a result, the 2017 federal changes provide an excellent opportunity for a real world look at how conformity affects state individual income tax systems. 7 stark, supra note 4, at 424-25. 8 mason, supra note 4, at 1325-28. 9 see infra part ii.b.i. 10steven d. gold, the state government response to federal income tax reform: indications from the states that completed their work early, 40 nat’l tax j. 431, 438-442 (1987); helen f. ladd, state responses to the tra86 revenue windfalls: a new test of the flypaper effect, 12 j. pol’y analysis & mgmt. 82, 83 (1993). 2019] state individual income tax conformity in practice: evidence from the tax cuts & jobs act 61 in contrast to an earlier study, the findings show a stark difference in the response of static versus dynamic conformity states. each of the dynamic conformity states remained in tight conformity with federal law, thereby allowing federal changes to increase state taxes and change the relative distribution of state tax burdens, while each of the static conformity states made changes to their state individual income tax in order to keep state tax collections at pre-tcja levels.11 in addition, each of the static conformity states also attempted to prevent the tcja from raising taxes for families by adding back a state tax adjustment based on family size. some of these findings are troubling. if state legislators would not have affirmatively voted for a bill that increased state taxes and imposed relatively higher taxes on large families, the same result should not have occurred as a result of dynamic conformity. additionally, even in states that appeared to respond rationally to conformity by trying to preserve the status quo, they did so under significant time pressure and in many cases without robust information and analyses. while the sample presented in this article is small, it suggests that state tax conformity – or at least tight conformity that incorporates nearly all of the federal individual income tax – may work against state tax policy goals. the article begins in part i by providing an overview of state individual income tax, and a short summary of the existing theoretical literature on the advantages and disadvantages of conformity. part ii shifts from theory to practice, examining how states have responded to major changes in the federal individual income tax code. it first reviews the existing literature on state responses to prior federal changes before examining how those states that were in tightest conformity with federal tax law responded to the tcja’s individual income tax provisions. part iii concludes with some initial suggestions for a path forward for states that want to break free from conformity, yet achieve a simple and efficient individual income tax system that enhances taxpayers’ relationship with the state. i. state individual income tax and the advantages and disadvantages of state tax conformity a. the state of state individual income tax this article focuses on state individual income tax. while much more attention is given to state corporate income taxes in the existing scholarly literature, state individual income tax has a profound impact on ordinary citizens and their experience of state government, and is a much more 11 my research found only a single study examining the impact of static versus dynamic conformity. that study found no statistically significant difference between these two models of conformity with respect to decisions to either conform or decouple from federal law, despite hypotheses that dynamic conformity would lead to a greater likelihood to conform to federal changes. see michaele morrow & robert ricketts, state conformity with federal tax changes, 32 j. am. tax’n ass’n 27, 29 (2010). [vol.11:1 columbia journal of tax law 62 significant source of state revenue than its corporate counterpart. forty-one states and the district of colombia currently impose a broad-based individual income tax, 12 and the revenue from individual income taxes is, on average, 37% of all tax collections and 27% of a state’s total general revenue.13 state corporate income taxes, by contrast, account for only 5% of states’ tax collections and 3.6% of states’ general revenue.14 there is significant variation among the states with respect to top marginal individual income tax rates, from a high of 13.3% in california to a low of 2.9% in north dakota.15 while most states have some type of progressive rate structure, nine states impose income tax at a flat rate.16 nearly every state that imposes a broad-based individual income tax bases its state income tax system on the federal income tax code through a mechanism known as conformity, which incorporates federal tax law directly into state statute. there are, however, significant differences among the states in the degree to which they conform to federal tax law. at one end of the spectrum is full conformity, where a state simply imposes tax equal to a given percentage of federal income tax liability, thereby incorporating every feature of the federal system into state law other than the ultimate tax rate. the next type, which i will refer to as tight conformity, incorporates all of the basic features of the federal income tax system other than federal rates and credits. states using tight conformity begin their state income tax calculations with federal taxable income, which incorporates not only federal definitions of income, but also all federal deductions. finally, we have what i will refer to as light conformity, which explicitly incorporates only the federal definition of gross income and a small number of favored federal deductions17 by starting state income tax calculations with a taxpayer’s federal adjusted gross income.18 while these three categories can be helpful in capturing the structural differences among state income tax systems, they do not fully capture the diversity of state approaches. for example, a state that uses tight conformity may have a very long list of state-specific adjustments that result in a tax system that functions much differently than the federal system. and a state that uses light conformity might create state-specific tax provisions that closely mirror the entire federal tax structure, for example 12 katherine loughead & emma wei, state individual income tax rates and brackets for 2019, 92 st. tax notes 769, 769 (may 27, 2019). 13 u.s. census bureau, supra note 1 (percentages calculated by author). see also urban-brookings tax pol’y ctr., the state of state (and local) tax policy 9 (n.d.), https://www.taxpolicycenter.org/sites/default/files/briefing-book/the_state_of_state_and_local_taxes.pdf [perma.cc/9lf2-de7a] 14 u.s. census bureau, supra note 1 (percentages calculated by author). 15 loughead & wei, supra note 12, at 769. 16 id. 17 these deductions include, among other items, a $250 deduction for out-of-pocket expenses for teachers, a deduction for certain contributions to individual retirement accounts, as well as a deduction for certain health savings account contributions. see i.r.c. § 62. 18 one commentator has characterized the choice between tight and light conformity as one that involves state judgment about whether they value the federal itemized deductions (in which case they might elect tight conformity), or whether their goal is to provide a broad income tax base with the lowest possible marginal rates (in which case they are more likely to elect light conformity). see richard d. pomp, restructuring a state income tax in response to the tax reform act of 1986, 36 tax notes 1195, 1200 (sep. 14, 1987). 2019] state individual income tax conformity in practice: evidence from the tax cuts & jobs act 63 by adding state standard and itemized deductions, as well as personal exemptions, that mirror those that exist at the federal level even if they are not incorporated by reference to federal law. for the purposes of this article, it is the extent to which federal law is directly incorporated into state law that matters most, since it is the incorporation itself that changes how state income tax law is made and updated. there are no states that currently use full conformity, with the last three states to do so abandoning full conformity in 2001.19 at the beginning of 2018, there were six states that used tight conformity.20 as discussed in more detail in part ii, that number dropped to four by 2019. thirty-one states and the district of columbia currently use light conformity.21 the remaining six states that impose a broad-based income tax do not technically conform to federal law. 22 in addition to differences in the extent of conformity, states also differ with respect to how they update their incorporation of federal law. one method is static conformity, where state statute incorporates features of the federal income tax code as of a specific date, and any future amendments to federal law do not take effect without an affirmative act of the state legislature.23 under the second method, dynamic conformity, state statute references the federal tax code as in effect for the relevant taxable year, and therefore any changes to relevant sections of the federal tax code automatically become part of state law, with no legislative action necessary. the states that conform to the federal individual income tax are almost evenly split when it comes to static versus dynamic conformity.24 regardless of the specific details of conformity, there are a fair number of commonalities among state individual income tax systems. most states provide taxpayers with the choice between 19 see walczak, supra note 6, at 9. 20 id. 21 id. 22 richard auxier & frank sammartino, the tax debate moves to the states: the tax cuts and jobs act creates many questions for states that link to federal income tax rules, tax pol’y ctr. 2 (jan. 23, 2018) (source lists status for 2018; author modified figures to reflect 2019 changes, as well as a disagreement as to the correct classification for idaho). while alabama, arkansas, massachusetts, mississippi, new jersey, and pennsylvania do not technically conform to the federal income tax code, they still incorporate aspects of the federal system as a practical matter. for example, they all use w2 wages, and many borrow amounts from a taxpayer’s federal return for state income tax purposes (such as business income and loss from federal schedule c). the difference is that these states do not specifically incorporate the federal income tax code into state statute. 23 in some states, courts have held that static incorporation is the only permissible form of conformity, because doing otherwise is an impermissible delegation of state taxing authority. see wallace v. comm’r, 184 n.w.2d 588 (minn. 1971). see also robinson v. tax comm’r of indian hill, 61 ohio misc.2d 95 (ohio ct. comm. pleas 1989) (prohibiting dynamic incorporation of state tax law into municipal tax law on similar grounds). 24 auxier & sammartino, supra note 22, at 3 (among states that begin with agi, half use static conformity and half use dynamic, while among the taxable income states three are static and two are dynamic). [vol.11:1 columbia journal of tax law 64 itemizing their deductions or claiming a standard deduction amount.25 an even more common feature is an adjustment for family size. every state other than pennsylvania provides some form of adjustment for family size, either in the form of personal exemptions or credits.26 states differ significantly when it comes to features such as tax credits27 and the treatment of capital gains and losses.28 compared to the federal income tax, state income tax systems tend to be less progressive, but they do a better job of treating taxpayers in similar circumstances equally (a concept known as “horizontal equity” in the tax literature).29 b. advantages of conformity states incorporate federal law into their own statutes in a variety of subject areas and for a variety of reasons. 30 the literature offering arguments in favor of such incorporation is welldeveloped, and for that reason this subpart will offer only a brief overview of the principle arguments made in favor of both state incorporation of federal law generally, as well as arguments specific to the tax context. a frequently cited benefit of incorporation is that its use helps conserve state lawmaking resources, and is therefore more efficient than a state drafting its own statutes.31 uniformity and consistency are also cited as positive benefits,32 as are lower information costs for both lawmakers and citizens.33 and finally, the federal government’s relative expertise, particularly in highly complex scientific and technical areas, is also seen as a key rationale for incorporation.34 for example, the federal government’s technical expertise and analysis may significantly outweigh a state’s capabilities, such that it makes sense for states to simply follow federal law in relevant areas 25 loughead & wei, supra note 12, at 771-78 (showing thirty-one states offered a standard deduction). see also wisc. legis. fiscal bureau, individual income tax provisions in the states 4 (2003) (reporting that for the 2001 tax year, 33 states plus the district of columbia provided a standard deduction). 26 wisc. legis. fiscal bureau, supra note 25, at 5 (figures provided for 2001 tax year). see also loughead & wei, supra note 12, at 771-78 (showing that, for 2019, thirty-five states offer some type of personal exemption deduction). 27 for example, arkansas has twenty-five state tax credits, while connecticut has two. wisc. legis. fiscal bureau, supra note 25, at 15, 18. 28 see elizabeth mcnichol, state taxes on capital gains, ctr. on budget & pol’y priorities 2 (dec. 12, 2018) (finding that only nine states offer some type of state tax preference for long-term capital gains). 29 marcus c. berliant & robert p. strauss, state and federal tax equity: estimates before and after the tax reform act of 1986, 12 j. pol’y analysis & mgmt. 9, 9 (1993). the extent of progressivity, however, varies significantly by state. id. at 39. 30 see generally scott dodson, the gravitational force of federal law, 164 u. pa. l. rev. 703 (2016); michael c. dorf, dynamic incorporation of foreign law, 157 u. pa. l. rev. 103 (2008); jim rossi, dynamic incorporation of federal law, 77 ohio st. l.j. 457 (2016). 31 dodson, supra note 30, at 731; dorf, supra note 30, at 134; rossi, supra note 30, at 468. see also larry e. ribstein & bruce h. kobayashi, an economic analysis of uniform state laws, 25 j. legal studies 131 (1996) (citing such rationale in the context of uniform state laws). 32 dodson, supra note 30, at 736; rossi, supra note 30, at 504 (noting that uniformity helps simplify an individual’s understanding of rights and obligations under the law). 33 ribstein & kobayashi, supra note 31, at 138. 34 rossi, supra note 30, at 465. 2019] state individual income tax conformity in practice: evidence from the tax cuts & jobs act 65 such as environmental, health, antitrust, or controlled substances regulation.35 professor jim rossi has also argued that state incorporation of federal law can amplify the political significance of federal law, thereby enhancing political accountability for the federal law. 36 the primary arguments in favor of state incorporation of federal tax law are administrative ease and compliance advantages.37 state tax conformity is thought to ease legislative burdens, because state lawmakers can shift responsibility for a significant amount of tax legislation to the federal government. it is much simpler, after all, for a state lawmaker to simply vote in favor of adopting the existing federal tax system than to structure a state revenue system from scratch.38 state tax conformity is also thought to lessen the burden on state executive and judicial branches, which can rely on both federal rulemaking and federal judicial decisions when state tax law is substantively identical to the federal code. for example, if a state conforms to the federal code’s definition of a deductible business expense, then state tax agencies and state courts may rely on federal rulemaking and judicial decisions in the event of a dispute about whether a taxpayer can claim the deduction. the extensive tax guidance produced at the federal level is more than what any individual state could produce.39 in addition, state tax conformity is thought to significantly simplify recordkeeping and return filing for taxpayers, as well as tax planning. 40 for example, if the state individual income tax essentially includes the same items in taxable income and allows the same deductions as the federal tax system, a taxpayer only needs to keep a single set of records and only needs to make a single decision about whether to include a specific item or deduct a specific item on both returns. conformity may also therefore increase state tax compliance, since taxpayers only need knowledge of a single set of tax rules. for taxpayers who must file in multiple states, conformity (if adopted similarly in the relevant states) offers further simplification.41 35 id. 36 id. at 486. 37 see, e.g., mason, supra note 4, at 1267 (claiming that these two advantages are in fact so significant that states are unlikely to ever abandon conformity). most of the work on state tax conformity has either focused on or included state corporate tax in its analysis and, as a result, some of these arguments have much greater power in the context of sophisticated multi-state businesses than for ordinary individual taxpayers. while i am quickly summarizing the primary arguments made in favor of state conformity, mason, supra note 4, comprehensively reviews both the advantages and disadvantage of conformity in detail. 38 see, e.g., stark, supra note 4, at 423 (“the availability of the federal income tax base as a starting point in calculating state tax liability is an unqualified benefit”). 39 walczak, supra note 6, at 2. 40 see, e.g., leann luna & ann boyd watts, federal tax legislative changes and state conformity, 47 st. tax notes 619, 619 (2008). 41 mason, supra note 4, at 1281-83. [vol.11:1 columbia journal of tax law 66 conformity may also streamline state tax enforcement. state conformity allows states to “piggyback” on federal tax audits and participate in data exchange programs with the irs.42 for example, a state that conforms to federal tax deductions may have an agreement with the irs that requires the irs to inform the state where a state taxpayer is found to have improperly claimed a federal tax deduction. the state thus outsources part of its tax enforcement to the federal government. it can then engage in a targeted audit or collection process involving the affected taxpayer, without having to invest the resources to identify the taxpayer. from the states’ perspective, this may decrease the cost of administration, resulting in a more efficient tax system.43 c. disadvantages of conformity when a state incorporates federal law by reference into its own statutes, it becomes difficult for both state lawmakers and state citizens to determine the content of the law.44 for example, if a state passes a law incorporating federal environmental standards, lawmakers and citizens would need to then locate, read, and understand the content of that federal law in order to make an informed vote or hold legislators accountable for voting responsibly. the state lawmaking process is less transparent as result. because of these concerns, some state constitutions explicitly prohibit such referential legislation.45 the concerns are even greater where state law automatically incorporates any future changes to federal law. after all, under such dynamic incorporation, the federal government can have an immediate effect on state law, with no state legislative action necessary.46 scholars have argued, and several courts have held, that such dynamic incorporation of federal law is unconstitutional under state law, even when static incorporation is permitted.47 of course, even where such dynamic incorporation is legally permissible, it represents the ceding of state legislative authority to the federal government. 48 widespread state incorporation of federal law also blunts innovation.49 an oft-cited benefit of our federalist system of government is that states can serve as laboratories of democracy, experimenting to see which governmental interventions are most effective. when every state does the same thing, we lose that important source of experimentation and innovation. while each of these concerns holds true in the tax context, state tax conformity comes with the unique disadvantage of exacerbating state revenue volatility. 50 even in a perfectly designed 42 luna & watts, supra note 40, at 619. 43 david a. super, rethinking fiscal federalism, 118 harv. l. rev. 2544, 2595 (2005). 44 rossi, supra note 30, at 466-68. see also mason, supra note 4, at 1301-02 (examining this issue in the tax context). 45 approximately twenty state constitutions limit or ban the use of referential legislation. rossi, supra note 30, at 482. 46 id. at 468. 47 for a review and critique of these constitutional arguments, see generally rossi, supra note 30. 48 mason, supra note 4, at 1301 (describing state tax conformity as a “democratic loss for state residents”). 49 mason, supra note 4, at 1304-05. 50 stark, supra note 4, at 423-25. 2019] state individual income tax conformity in practice: evidence from the tax cuts & jobs act 67 system, an income tax is always a volatile source of revenue because it can change so dramatically based on economic conditions. indeed, this engrained volatility has led scholars to suggest that states should minimize their dependence on the income tax and embrace other, more stable forms of revenue.51 but states make this inherent income tax volatility worse by conforming their state income tax to federal law. conformity adds a new form of revenue volatility: the volatility that results from federal tax law changes.52 the federal government might expand the individual income tax base, and therefore generate increased revenue for a state, but it can also narrow the tax base and thereby decrease state revenue. states, of course, are uniquely dependent on their annual revenue to provide services53 and on income tax as important source of that revenue. 54 the stakes are high, and conformity makes an already imperfect system even less desirable. ii. state tax conformity in practice while the existing literature on state tax conformity explores the theoretical aspects of conformity at great depth, this article extends that literature by examining the practical aspects of conformity. this part begins by reviewing the process of conformity and then examines the existing empirical literature on tax conformity, before presenting the results of a study of state responses to the federal tax cuts and jobs act of 2017. a. the practical dynamics of conformity walking through the lifecycle of state tax conformity is helpful to understand the realworld dynamics of conformity. conformity begins when state lawmakers make the initial decision to base the state income tax system on the federal income tax system, a decision generally motivated by a desire for simplicity for taxpayers, lawmakers, and revenue agencies. to achieve this simplicity and conform to the federal tax system, lawmakers must choose which specific line of the federal tax return is transferred to the state tax return as the starting point for state income tax calculations. the specific line chosen will determine how much federal tax policy is incorporated directly into the state tax system. a state using “total tax” on the federal return will incorporate all aspects of federal tax policy, while a state beginning with “adjusted gross income” will incorporate only federal income inclusions, exclusions, and above-the-line deductions, but avoid itemized federal deductions, the federal standard deduction, and any federal credits. while state lawmakers have limited choices here given that they must pick a starting point that exists on the federal return, the decision is not terribly problematic. democratically accountable state 51 see, e.g., darien shanske, expanding state fiscal capacity, part i: a new and improved consumption tax paired with a tax on a federal windfall (the qbi deduction), fla. tax. rev. (forthcoming). 52 stark, supra note 4, at 423-25; mason, supra note 4, at 1306-09. 53 see david gamage, preventing state budget crises: managing the fiscal volatility problem, 98 cal. l. rev. 749 (2010). 54 urban-brookings tax pol’y ctr., supra note 13 [vol.11:1 columbia journal of tax law 68 lawmakers will choose a starting point that best satisfies their preferences, even if it is within a constrained set of choices. once the starting point is chosen, lawmakers must decide whether and to what extent they would like to make adjustments to the starting point to achieve their desired policy result. for example, any conforming state would automatically incorporate the federal exclusion from gross income for employer-provided health insurance. if a state disagreed with the policy of allowing employed individuals to pay for such benefits with tax-free dollars, the state could enact an addition to state taxable income for such amounts. we, in fact, want state legislatures to consider these types of adjustments, because once a state has chosen to conform to federal law these adjustments are the only mechanism by which a state can maintain control of state tax policy. 55 the downside is that these desirable adjustments may undercut the simplicity rationale used to justify conformity in the first place. starting with federal adjusted gross income and making dozens of state-specific adjustments thereto is not simpler than the state crafting its own definition of taxable income. of course, legislators might decide that simplicity is a higher priority than maintaining nuanced control over state tax policy and make very few, if any adjustments to the federal starting point. 56 anecdotal evidence suggests that very few states have made that choice.57 even where a state tax system is initially simple, legislatures tend to add to them over time to the point that one must question whether conformity actually delivers any significant simplicity benefit to the state tax system. a quick look at state individual income tax returns will help establish this point from the taxpayer’s perspective. in arizona, it takes twenty-nine entries on the individual income tax return to get from the federal adjusted gross income starting point to state adjusted gross income.58 in minnesota, after filling in the starting point from the taxpayer’s federal return the taxpayer must complete forty-one lines in order to arrive at minnesota taxable income.59 illinois similarly has a forty-item adjustment schedule.60 indiana, which has an individual income tax return form that looks remarkably clean and simple, requires two separate schedules to compute indiana add-backs (twenty-three lines) and indiana deductions (twelve lines).61 south carolina, which its revenue 55 see field, supra note 4, at 541(describing conformity as ceding sovereignty). 56 see erin adele scharff, laboratories of bureaucracy: administrative cooperation between state and federal tax authorities, 68 tax l. rev. 699, 712 (2015) (expressing doubt that such complete conformity would ever be likely to occur). 57 jane g. gravelle & jennifer gravelle, how federal policymakers account for the concerns of state and local governments in the formulation of federal tax policy, 60 nat’l tax j. 631 (2007). see also scharff, supra note 66, at 712 (expressing doubt that states would ever fully conform to the federal tax code without making state-specific adjustments). 58 ariz. dep’t revenue, form 140 (2018). 59 minn. dep’t revenue, schedule m1m (2018). 60 ill. dep’t revenue, schedule m (2018). 61 ind. dept. revenue, schedule 1 & schedule 2 (2018). 2019] state individual income tax conformity in practice: evidence from the tax cuts & jobs act 69 department described as having “one of the simplest” individual income tax systems the country, requires twenty-three state-specific adjustments.62 one factor driving increasing complexity over time is that states must respond to changes made to federal tax law after the state’s initial conformity decision. when the federal government makes changes that affect the state’s conformity point, it creates exogenous revenue and policy shocks for the state. for example, if a state elects to begin its state income tax calculations with federal taxable income and congress adds a new federal itemized deduction, that state must consider whether it wants to conform to that change or decouple from it by adding the federal deduction back to state taxable income, a decision that will impact both state revenue and the distribution of state tax burdens. these decisions are problematic not only because they potentially add complexity to the state tax system, but also because they take place in a context that is highly likely to distort decision-making. once a state has decided to peg its income tax to a particular line on the federal return, any decisions to deviate from that starting point are framed accordingly. take, for example, a state that chose to conform to federal taxable income, a starting point that incorporates all federal income inclusions and exclusions, as well as the standard and itemized deductions. if congress passed a law doubling the standard deduction after that state’s decision to conform to federal taxable income, the state would need to decide whether to conform to that decision and double the standard deduction for state tax purposes, or whether to decouple and create a state add-back to offset the newly increased federal deduction. in a dynamic conformity state, where the federal change would automatically take effect, state legislators would be voting on a bill that could be characterized as increasing taxes because, if the state continued to conform to the federal standard deduction, state taxable income would be lower than under a system where the original standard deduction amount is retained.63 in a static conformity state, the dynamics may be reversed such that updating state law to reflect current federal law could be billed as a tax decrease. the end result may be that state tax systems are shaped by distorted legislative decision-making and become complicated over time due to the need to respond to federal changes. b. pre-tcja evidence of state responses to changes in federal tax law the fact that state tax conformity allows changes in federal law to directly impact state revenue raises the issue of how states respond in practice to such revenue shocks. this subpart 62 s.c. dep’t revenue, the tax cuts and jobs act (tcja): federal tax reform and the effects on south carolina 9 (2018), https://www.scstatehouse.gov/committeeinfo/ways&meansincometaxsubcommittee/sc%20dor%20tax%20co nformity%20presentation%20to%20the%20wm%20committee.pdf; state of south carolina, department of revenue, 2018 individual income tax return. 63 see mason, supra note 4, at 1327. [vol.11:1 columbia journal of tax law 70 reviews the existing empirical literature on this issue, which is based primarily on state reactions to the tax reform act of 1986 (“tra ‘86”), the only large-scale revision of the federal income tax code to occur between world war ii and the tcja. described at the time as a “sweeping change,”64 tra ’86 broadened the federal income tax base, lowered federal rates, and enjoyed significant bi-partisan support.65 similar to our current situation, at the time tra ’86 was passed, forty states had broad-based income taxes, thirty of which formally conformed to the federal income tax. of the thirty states with formal conformity, they were evenly split between dynamic and static conformity.66 because states overwhelmingly conform only to the federal tax base, but not to its rates, states conforming to tra ’86 were expected to receive increased revenue as a result.67 1. state decisions to conform or decouple in examining how conforming states respond to federal tax changes, there tend to be two distinct but related issues: whether and to what extent the state updates its statutes to reflect the current version of federal tax law and whether the state attempts to neutralize any revenue changes that might result from a decision to conform to federal changes. this section examines pre-tcja evidence regarding the first issue. available evidence shows that states always update their statutes to reference the current version of the federal tax code, but they occasionally choose to decouple from specific, discrete provisions in the code. following passage of tra ’86, states uniformly chose to update their state tax code to incorporate the revised version of the federal tax code, irrespective of whether they were static or dynamic conformity states. thirty-nine of forty states were in conformity with tra ‘86 in the first year the federal changes were effective.68 the one outlier was merely delayed a year because of its legislative calendar.69 two states, minnesota and colorado, were prompted by tra ’86 to increase their state tax conformity and moved from light to tight conformity.70 while states have always updated their cross references to the current version of the federal tax code, they often reject (or decouple from) specific provisions in the federal code. for example, the federal tax code provides favorable tax treatment to health savings accounts, but a handful of 64 alan j. auerbach & joel slemrod, the economic effects of the tax reform act of 1986, 35 j. econ. lit. 589, 589 (1997). 65 see id. at 595. tra ’86 also made significant changes to the taxation of capital gains. 66 gold, supra note 10, at 431. 67 pomp, supra note 18, at 1195. some have argued that the resulting revenue increase should not be considered a windfall because the federal government had also transferred additional responsibilities to the states. id. at 1196. 68 auxier & sammartino, supra note 22, at 4. see also walczak, supra note 6, at 7-9 (providing an overview of states’ conformity prior to the tcja). 69 auxier & sammartino, supra note 22, at 4. 70 id. 2019] state individual income tax conformity in practice: evidence from the tax cuts & jobs act 71 states have chosen to decouple from that treatment for state tax purposes.71 yet we know little about what drives these state decisions to reject specific items in the federal tax code. the existing literature on legislative decision-making in this context is underdeveloped, and is limited to studies of state corporate tax provisions, not those affecting individual taxpayers.72 while it is perhaps understandable why studies are limited to state corporate income tax, those studies may be of limited utility in analyzing individual income tax conformity. after all, states are likely to compete for corporate taxpayers on a much different basis than they do for individual taxpayers,73 who are often less mobile and much less likely to engage in a sophisticated analysis of various states’ individual income tax provisions in deciding where to live. while the state corporate tax literature may not be directly relevant, it does not give one confidence in legislative conformity decisions, suggesting instead that legislators are inconsistent in their decision-making and ignore “potentially important factors.”74 one study found that state legislatures controlled by the same party as the federal administration that enacted a particular tax benefit are more likely to adopt that federal tax benefit at the state level, suggesting that national party affiliation may be a significant factor in determining whether a state conforms or decouples from a specific federal tax provision.75 that correlation did not hold, however, when researchers compared a median state voter’s preference compared to the political party in power at the federal level when the tax provision passed. 76 state legislators appear to follow their own party’s preferences when it comes to federal tax breaks, but not those of the citizens they represent. these studies, however, were not only limited to the corporate income tax, but they also tended to involve discrete changes to the federal tax code (such as allowing bonus depreciation for some assets), rather than sweeping reform of the type enacted by tra ’86. it is therefore unclear whether its findings have much applicability in the individual income tax context. the pre-tcja literature therefore establishes relatively little about state decision-making around conformity. we know that no state took the seemingly untenable position of basing their individual income tax on superseded federal law, but we know little about state decisions to 71 see the hsa report card, state taxation of hsas (2018) [https://perma.cc/7swb-98gq] (describing the state tax treatment of health savings accounts, and noting that california, new jersey, new hampshire, and tennessee have decoupled from federal law). 72 see, e.g., luna & watts, supra note 40 (examining factors influence state corporate tax conformity); morrow & ricketts, supra note 11, at 29 (examining factors that influence state corporate tax conformity and noting that researchers “have largely ignored the question of why some states choose to conform to changes in federal tax legislation while others choose not to do so”). 73 see e.g., luna & watts, supra note 40, at 620 (“states are…actively competing for increasingly mobile businesses”). 74 morrow & ricketts, supra note 11, at 33. see also luna & watts, supra note 40, at 624 (finding no statistically significant correlations among the variables studied other than a negative relationship between a state’s highest marginal corporate tax rate and the decision to decouple; in other words, as the corporate tax rate rises, states will decouple from fewer federal tax provisions). morrow & ricketts, supra note 11, at 33. 75 id. at 47. 76 id. [vol.11:1 columbia journal of tax law 72 decouple from specific provisions in the federal tax code. one possibility is that such decisions are driven by revenue effects, a possibility explored in more detail below. 2. do states make revenue-neutral adjustments? one side effect of state tax conformity is that federal tax changes can directly impact and suddenly change forecasted state revenues. theoretically, federal changes can either increase or decrease projected revenue, although each of the major federal tax reforms to date have been revenue-increasing for states. this dynamic raises the question of how states respond to such windfalls. if state governments were perfectly rational, we would expect that the state would always undo any revenue effects caused by federal tax changes.77 after all, if state government had already determined the optimal level of taxes and spending, any external change to that mix should be reversed. of course, from the perspective of an individual legislator, it might be perfectly rational to accept a tax increase on which he or she does not need to vote. setting aside tax conformity for a moment, there are many instances in which states have received an unexpected revenue windfall, or suffered an unanticipated deficit, and state legislative responses thereto have been of interest to both economists and political scientists. windfalls have been particularly well studied because, unlike deficits, the state’s decision is not forced. with a deficit, the state generally must eliminate it quickly through some combination of spending reductions and tax increases in order to comply with balanced budget requirements.78 with a revenue windfall, lawmakers might choose to return it to taxpayers and therefore keep the size of government constant, or they might use the windfall to increase spending. there are two types of windfalls that have been well-studied: revenue increases that result from economic growth and those that flow from intergovernmental (i.e., federal) grants. with respect to revenue increases resulting from state economic growth, evidence suggests that state governments generally reverse such increases – they make changes to the tax system, such as lowering rates, in order to keep revenue neutral. 79 in contrast, intergovernmental grants (which come from outside the state, not directly from the state’s taxpayers) produce a different result. states tend to keep the revenue and increase overall spending – a phenomenon referred to as the “flypaper effect” because the external funds “stick where it hits.”80 77 ladd, supra note 10, at 83. 78 james m. poterba, state responses to fiscal crises: the effects of budgetary institutions and politics, 102 j. pol. econ. 799, 811 (1994). states with tax limitations, however, raise taxes by less in response to unanticipated deficits than do states without such limits. id. at 815. states with single political party control raise taxes and cut spending by greater amounts than states where the governor is of a different political party than the legislative majority. id. at 816. 79 see, e.g., daniel r. feenberg & harvey s. rosen, tax structure and public sector growth, 32 j. pub. econ. 185 (1987). 80 see ladd, supra note 10, at 83 (crediting arthur okun with the original use of the term). given that federal grants are often made for specific purposes, with specific conditions attached, in order to get states to spend in a way they otherwise would not, the flypaper effect does not seem particularly surprising in this context. 2019] state individual income tax conformity in practice: evidence from the tax cuts & jobs act 73 the dynamics of windfalls and deficits that result from state individual income tax conformity are less well studied than those in other contexts, in part because there have been relatively limited opportunities to do so. there is, however, reason to suspect that the structure of state tax conformity might lead to different decision-making than that seen in non-conformity contexts. consider first the case of a state with dynamic conformity. if the federal government makes changes to its tax code, those changes are mirrored at the state level unless the state legislature passes a bill that changes that result. in other words, the default in the event of nonaction is conformity. if the federal change has the effect of raising state taxes, state legislators in a dynamic conformity state can essentially enact a stealth tax increase: do nothing and increase revenue. at a basic level, we would expect that this dynamic might lead to higher state taxes than would be the case absent conformity. where the federal change decreases state taxes, the opposite may be true. if legislators must pass legislation in order to keep revenue at its pre-federal change level, legislators may shy away from action – afraid to be labeled a supporter of higher taxes – and state taxes may be artificially suppressed. the dynamics are likely different in static conformity states, since updating the crossreference requires an affirmative legislative vote. the political pressures on that vote might be based on whether the bill can be fairly characterized as increasing or decreasing state taxes, but it may be more likely that little attention would be paid to a bill that looks like mere housekeeping rather than a change of law. despite these reasonable hypotheses about legislative decisionmaking, however, the sole empirical study of the issue found no statistically significant differences between static and dynamic states with respect to decisions to either conform or decouple from federal tax law.81 studies of tra ’86 found significant variation in how states responded to the resulting revenue windfall.82 overall, economists found some evidence of the flypaper effect.83 that is, state governments did not react to tax conformity windfalls by returning such amounts in full to state taxpayers but rather retained some of the revenue and increased spending. for example, one study found that states kept, on average, 40 cents of every windfall dollar resulting from tra ‘86.84 another study estimated that states kept, on average, only 19 cents of every windfall dollar, but with significant variation among the states.85 among thirty-four states with windfalls, thirteen 81 morrow & ricketts, supra note 11, at 49. 82 auxier & sammartino, supra note 22, at 5. 83 see ladd, supra note 10, at 100; gold, supra note 10, at 431. 84 see ladd, supra note 10, at 100. the windfall dollars were not insubstantial. as a share of income tax revenues, windfalls exceeded 10% in over half the states. id. at 87. 85 id. at 90. [vol.11:1 columbia journal of tax law 74 returned the full amount, fifteen states returned none of the windfall, with the remaining six returning a portion of the windfall.86 while studies of conformity found a flypaper effect following tra ’86, there is no evidence of a flypaper effect for other, smaller changes to federal tax law.87 one explanatory hypothesis is that major federal tax changes publicize the state windfalls and, as a result, lobbyists know the state has increased fiscal capacity and therefore “[they] have something to fight about.”88 there is much more limited evidence available about how states respond to federal tax changes that lower anticipated state revenue because such changes have been much less common. 89 perhaps our best evidence comes from the economic growth and tax relief reconciliation act of 2001 (“egtrra”).90 egtrra lowered federal individual income tax rates, a change that would have no impact on the vast majority of states that do not conform in any way to federal rates. however, at the time egtrra was passed there were three full conformity states that calculated state income taxes simply as a percentage of federal tax liability.91 with federal rates lowered, total federal tax liability was decreased, which would have resulted in decreased state revenue for those states that simply imposed a tax equal to a percentage of federal tax liability. each of those states quickly abandoned full conformity after egtrra’s passage in order to preserve state revenue.92 while this limited evidence on federally-created state revenue decreases suggests that states do not allow conformity to artificially lower state revenue, the evidence surrounding revenue increases is less comforting. existing studies of state responses to conformity-driven revenue increases present at least some evidence that the conformity mechanism itself results in some states increasing income taxes. the subpart below explores whether state responses to the tcja reinforce these conclusions or offer new insights. c. a study of state responses to the tcja’s individual income tax provisions the tax cuts and jobs act, signed into law in late december 2017, made major changes to the federal individual income tax. because of its significant effects on the structure of the federal individual income tax, and its potential impact on states that closely conform to federal provisions, it provides an excellent opportunity to study state tax conformity in practice. 86 id. one possible benign explanation for these findings is that states were hesitant to return the full windfall amount due to uncertainty of the windfall estimates, although this does not appear to fully account for the magnitude of the windfall retention. see id. at 96. 87 id. at 100. 88 id. at 101. 89 auxier & sammartino, supra note 22 at 4. see also walczak, supra note 6, at 7 (noting that while state conformity legislation is typically a “rote action”, conforming to tcja caused more robust debate). 90 pub. l. no. 107-16, 115 stat. 100 et seq. (2001). 91 auxier & sammartino, supra note 22, at 4. 92 id. 2019] state individual income tax conformity in practice: evidence from the tax cuts & jobs act 75 to understand the impact of the tcja on individual income taxes at both the federal and state level, it is helpful to review the basic income tax structure in place from 1987 until passage of the tcja. the calculation to determine federal individual income tax liability begins with all of the taxpayer’s income other than items specifically excluded by congress (this starting point is referred to as “gross income”). 93 from there, a taxpayer may deduct a small number of congressionally-favored deductions known as “above-the-line” deductions. 94 the resulting number is known as adjusted gross income (“agi”).95 once agi has been calculated, a taxpayer may deduct his or her “personal exemptions.”96 a taxpayer is entitled to a personal exemption for herself (and her spouse, if married), plus any other dependents.97 the deduction is a flat dollar amount per personal exemption, and is intended to adjust a taxpayer’s tax liability for family size. in addition, the taxpayer may deduct the larger of a standard deduction amount or his or her itemized deductions (these include many popular deductions, such as home mortgage interest, medical expenses, and charitable contributions).98 the standard deduction is intended to simplify tax recordkeeping and filing, because taxpayers who know they will not incur itemized deductions in excess of the standard deduction amount do not need to keep track of such expenses. after the personal exemptions and either standard or itemized deductions are taken, we arrive at taxable income, the amount to which federal tax rates are then applied.99 of course, there are multiple other complications such as capital gains rates, tax credits, and alternative minimum tax that may come into play, but these are not necessary to understand the basic changes made by the tcja. the tcja changed the structure of the federal individual income tax by, among other things, doubling the standard deduction amount and eliminating the deduction for personal exemptions.100 the tcja also eliminated or reduced several itemized deductions, including the deductions for state and local taxes, home mortgage interest, employee business expenses, and miscellaneous itemized deductions.101 in order to at least partially offset the loss of personal exemptions, the child tax credit was made more generous.102 finally, in a provision that straddles both individual and business income tax, the tcja added section 199a to the code, commonly 93 i.r.c. §61. for example, an employer’s contributions toward employee health insurance is excluded from the starting point of gross income. id. §106. 94 id. §62. 95 id. 96 id. §151. 97 id. §151(b) & (c). 98 id. §63. 99 id. §§1 & 63. 100 id. §§63(c)(7) & 151(d)(5). see, e.g., auxier & sammartino, supra note 22, at 6 (describing the changes to the standard deduction and personal exemption as “unprecedented”). 101 id. §§67(g), 163(h), & 164(b)(6). 102 id. §24(h). [vol.11:1 columbia journal of tax law 76 referred to as the “pass-through deduction,” which allows individuals who receive business income as sole proprietors, or through certain non-corporate entities such as partnerships or llcs, to deduct 20% of that income in arriving at their federal taxable income.103 the tcja also reduced most individual income tax rates, with the top rate falling from 39.5% to 37%.104 altogether, the tcja will cause federal taxable income to increase in the aggregate, but ultimate federal tax liability will be reduced due to the rate reductions.105 nearly all of the tcja’s changes to the individual income tax are effective only for 2018 – 2025, after which the law reverts to its pre-tcja provisions.106 while in effect, the changes to individual income tax are expected to have a profound impact on the total amount of revenue raised by the federal government, as well as on the distribution of federal tax burdens. in total, the tcja’s individual income tax provisions, including the section 199a pass-through deduction, are expected to decrease federal revenue by $1.1 trillion from 2018-27.107 the distribution of that tax cut, however, is not uniform. in general, higher income households will receive a larger tax cut than lower income households.108 the tcja is also expected to simplify tax filing for many taxpayers by reducing the number of taxpayers who itemize their deductions from 30% of all filers to 12% post-tcja.109 the tcja also impacts state revenue and the distribution of state tax burdens, although the nature and magnitude of these state changes varies in part based on the type of conformity a state uses. 110 the most significant impacts will be felt by those states that begin their state tax calculations with federal taxable income (“tight conformity states”). 111 because the tcja 103 id. §199a. 104 id. §1(j). while nearly all the seven individual tax brackets were reduced, the 10% rate and the 35% rate remained unchanged. see tax pol’y ctr., how did the tax cuts & jobs act change personal taxes, https://www.taxpolicycenter.org/briefing-book/how-did-tax-cuts-and-jobs-act-change-personal-taxes. 105 frank sammartino et al., the effect of the tcja individual income tax provisions across income groups and across the states 2 (2018), https://www.taxpolicycenter.org/publications/effect-tcja-individualincome-tax-provisions-across-income-groups-and-across-states/full. [https://perma.cc/mfz4-6uly] 106 a change to the method of indexing the tax system for inflation does not sunset, however. see i.r.c. §1(f)(3). 107joint committee on taxation, estimated budgetary effects of the conference agreement for h.r. 1, the “tax cuts and jobs act” 3 (2017). 108 sammartino et al., supra note 95, at 4. while many taxpayers will be made better off by the doubling of the prior standard deduction, that tax cut will be more than offset in the aggregate by the loss of the personal exemption and not fully offset by the increased child tax credit. the increased standard deduction and child tax credit are expected to collectively decrease taxes by $86.5 billion in 2018, that tax cut is more than offset by the $93.3 billion dollar increase in taxes that will result from the loss of personal exemptions in 2018. see jct, supra note 107, at 1. 109 see jct, supra note 107, at 1 110 see generally walczak, supra note 6. 111 auxier & sammartino, supra note 22, at 1. in contrast, states that lightly conform, and do not otherwise incorporate other federal tax features such as the standard deduction or personal exemption, are not expected to see significant revenue changes from tcja conformity. auxier & sammartino, supra note 22, at 5. but see walczak, supra note 6, at 3 (stating that “most states” were likely to see increased revenue as a result of the tcja). one of the few changes that would impact agi states is the elimination of the above-the-line deduction for moving expenses (for all individuals other than active duty military personnel). id. at 13. while twenty-eight states use agi as their starting point, many of those states still closely mirror the federal model of allowing the greater or a standardized or itemized 2019] state individual income tax conformity in practice: evidence from the tax cuts & jobs act 77 broadened the definition of federal taxable income, states that use that amount to begin their state income tax calculations will automatically be taxing more income if they conform to the federal changes. and while rate cuts at the federal level resulted in lower overall federal income taxes, states do not conform to federal rates, with the result that conformity will simply raise state taxes in tight conformity states. even if a tight conformity state lowered its rates to keep revenue constant under the tcja, the distribution of state tax burdens would change and there would be winners and losers among state taxpayers.112 for example, large families may pay more in state tax post-tcja because the loss of personal exemptions at the state level is not offset by the federal child tax credit.113 on the other hand, individual taxpayers with few itemized deductions would likely see their state taxes decreased due to the significantly increased standard deduction, as would those who receive the type of income now eligible for a section 199a deduction. examining the legislative responses of tight conformity states to the tcja’s significant changes should provide valuable insights on conformity’s real-world dynamics. the current study therefore includes each state that was identified as using federal taxable income as the starting point for their state individual income tax calculations as of december 2017: colorado, idaho, minnesota, north dakota, south carolina, and vermont.114 while each of these states would see significant changes in state revenue and state tax distribution if it fully conformed to the tcja, the default in the event of non-action differed depending on whether a given state used static or dynamic conformity. if a static conformity state did nothing, its taxpayers would be forced to deduction from income, as well as deductions for personal exemption amounts. minn. house res., a presentation to the house taxes committee on federal tax conformity 6 (jan. 22, 2019), (finding that, among the states that use agi, eighteen have smaller standard deductions than the federal standard deduction, while nine have standard deductions equal to or greater than the federal deduction) 112 auxier & sammartino, supra note 22, at 6. this would also be true of states that do not start with federal taxable income, but do incorporate the federal standard deduction and personal exemption by reference. 113 id. at 11. see also richard auxier & elaine maag, addressing the family-sized hole federal tax reform left for states, urban inst. brief, november 2018. at the federal level, the loss of personal exemptions is addressed by an increased federal child tax credit. but only two states, oklahoma and new york, offer a state child tax credit that is based on the federal credit. oklahoma’s credit is equal to 5% of the federal credit, while new york’s credit is equal to generally equal to 30% of the federal amount. okla. stat. ann. tit. 68, §2357; n.y. tax law §606(c-1). 114 vermont was not technically a federal taxable income state when the tcja became effective, having switched from federal taxable income to federal agi six months prior to the tcja’s passage. see h. 516, 2017-18 reg. sess. (vt. 2017). however, like idaho, it functionally was still a taxable income state because while it began calculations with federal agi, it then allowed federal personal exemptions and the greater of the federal standard or itemized deductions. the change was characterized as a “minor” or “administrative” change. the only functional change was that when vermont was a taxable income state “taxpayers add back deductions they are not allowed to take [for vermont tax purposes]” and switching to agi meant that taxpayers would “subtract deductions and exemptions they are allowed to take [for vermont tax purposes].” vt. legis. joint fiscal off., fiscal note, h.516 miscellaneous tax bill 1 (march 24, 2017). see also off. legis. council, summary of act no. 73 (h.516) taxation and fees 1 (noting that vermont’s individual income tax law will remain substantively unchanged, with only a difference in the mechanics of the calculation). [vol.11:1 columbia journal of tax law 78 compute their state taxes using outdated federal law. but if a static conformity state updated its cross-reference to current federal law and did nothing else, state taxes would rise significantly and the distribution of relative state tax burdens would be changed. for dynamic conformity states, the cross-references are updated automatically, so inaction by a state would trigger higher state taxes and changes in state tax burdens. the legislature in a dynamic conformity state would need to take positive legislative action to undue the effects of conformity. of the six states included in the present study, four used static conformity and two used dynamic conformity. the study first examines the baseline question of whether each of the static conformity states updated its cross-reference to the federal tax code to a date on or following the tcja’s effective date. next, it examines whether each tight conformity state kept or returned the revenue windfall that was expected to result from the decision to conform to the tcja. in examining the question of revenue retention, it looks at how states that chose to return revenue windfalls did so. did states simply lower rates, or did they make state-specific adjustments to try to respond to some of the policy choices reflected in the tcja? the study period includes any legislative sessions held in 2018 (both regular and special legislative sessions), as well as 2019 regular legislative sessions. in addition to examining enacted legislation, proposed legislation, legislative history, and media coverage of conformity in each state were also reviewed. 1. updated cross-references for the four static conformity states, a foundational issue was whether they would update their reference to the federal tax code to a post-tcja date. unsurprisingly, each did so.115 after all, if a state did not update its cross references to the current version of the federal tax code, a taxpayer filing her state return in 2018 would need to calculate her federal tax liability under pre2018 federal law because those would be the required figures for her 2018 state return. as the south carolina department of revenue warned legislators, if cross references were not updated “south carolina’s tax system will go from one of the simplest to one of the most complex in the us.”116 most press reports on the issue treated this type of state statute updating as “necessary” 115 this finding is consistent with the corporate tax conformity literature, which found no statistically significant difference in the likelihood that a state would conform or decouple from federal corporate tax changes based on whether the state used static or dynamic conformity. morrow & ricketts, supra note 11, at 41. 116 s.c. dep’t revenue, the tax cuts and jobs act (tcja): federal tax reform and the effects on south carolina 9 (2018),https://www.scstatehouse.gov/committeeinfo/ways&meansincometaxsubcommittee/sc%20dor%20tax %20conformity%20presentation%20to%20the%20wm%20committee.pdf. relevant to earlier discussions, this self-proclaimed simple tax system still required twenty-three state-specific additions and subtractions. see state of south carolina, department of revenue, 2018 individual income tax return.[https://perma.cc/nf63-tr7n]; 2019] state individual income tax conformity in practice: evidence from the tax cuts & jobs act 79 117 or “automatic,” 118 and that a failure to do so would create a “complete nightmare.”119 the one state that did not successfully avoid this nightmare was minnesota, which was unable to pass conformity legislation during the 2018 legislative session.120 it did so the following year,121 but minnesota taxpayers did indeed have to compute their federal tax liability twice once under current, 2018 federal law, and then again under the repealed 2016 rules that still governed minnesota individual income tax calculations – when they completed their tax returns for 2018. the local media widely reported and highlighted the complications for taxpayers during both legislative sessions.122 given the significant negative consequences of failing to conform, it is unsurprising that every static conformity state updated their conformity date to the current version of the federal tax code. after all, the reality of forcing one’s constituents to keep track of two versions of the federal tax code would seemingly put any state legislator’s reelection prospects in question. this finding is consistent with the studies of tra ’86 discussed earlier, which similarly found that all states quickly updated their statutes to reflect the current version of the federal tax code.123 117 see, e.g., jessie van berkel, dayton offers new state tax plan, star. trib., mar. 17, 2018 (stating that minnesota “has to update its tax code because minnesotans’ state taxes are based on their federal taxable income”); j. patrick coolican, state house passes gop tax plan, star trib., may 1, 2018 (“every year, the legislature has to bring the state tax system into alignment with federal law, an annual exercise known around the state capitol as ‘conformity’”); seanna adcox, next year’s tax filings could be a bigger headache without new sc law, charleston post & courier, sept. 26, 2018; seanna adcox, nearly half of sc residents will pay less on next year’s tax filings, charleston post & courier, oct. 4, 2018 (stating that nonconformity would have been “a complete nightmare”). 118 see, e.g., morgan scarboro, s.c. lawmakers must pass ‘tax conformity’ legislation, charleston post & courier, aug. 14, 2018; seanna adcox, next year’s tax filings could be a bigger headache without new sc law, charleston post & courier, sept. 26, 2018 (“south carolina legislators have routinely updated the state tax code to align with any new federal rules since 1985”); sean bennett, will south carolina take your federal tax cut?, charleston post & courier, june 4, 2018 (referring to annual conformity legislation as a “little-known, ordinarily benign routine”). 119 seanna adcox, nearly half of sc residents will pay less on next year’s tax filings, charleston post & courier, oct. 4, 2018. 120 while both parties agreed that conformity legislation was needed, the governor vetoed the resulting legislation due to an unrelated dispute over emergency school aid. editorial, a plea for fairness in state tax reform, star trib., may 10, 2018; judy keen, as promised, dayton vetoes tax bill over emergency school aid funding, star trib., may 18, 2018. 121 h.f. 5, 91st leg., 1st spec. sess. (minn. 2019). 122 see, e.g., mark zdechlik, tax preparers expect more extensions this season, minn. pub. radio, april 11, 2019 (quoting a tax preparer who reported that “this is the roughest tax season i’ve ever been through”); jessie van berkel, dayton offers new state tax plan, star trib., mar. 17, 2018 (stating that if minnesota does not conform, it would create “significant confusion for tax filers and businesses”); judy keen, supra note 120 (quoting a local tax attorney describing the complexity that would result from a lack of conformity as “mind-boggling,” and another attorney predicting the consequences would be “convoluted” and “felt widely”). 123 see, infra part ii.c.i [vol.11:1 columbia journal of tax law 80 2. revenue retention & tax burden distribution while updating a state’s cross-reference to the federal tax code appears to be more or less automatic, it is the revenue and tax policy consequences of conformity that impact state taxpayers most directly. as illustrated in table 1 below, each tight conformity state was expected to gain increased revenue if it simply conformed to the tcja and made no other changes to its state individual income tax system.124 table 1: projected state revenue effects of tcja conformity state projected increase in state revenue from tcja individual income tax changes time period for estimate colorado $1.4 billion125 fy2017-22 idaho $118.8 million126 2018 minnesota $1.5 billion127 fy2018-21 north dakota $15.2 million128 fy2017-21 south carolina $169 million129 fy2018-19 vermont $795 million130 not specified 124 each state uses different methodology to produce such estimates. for example, states differed in whether they categorized the section 199a pass-through deduction as an individual or business tax provision. 125 memorandum from colo. legis. council staff to interested persons 3, tbl 1 (march 5, 2018) (total calculated by author using annual figures from 2017 to 2022). 126 idaho state tax commission, federal tax reform – idaho impact 3 (2018). when all conformity effects are taken into account (including business tax provisions), idaho was expected to receive a net revenue increase of $97.4 million. id. at 6. 127 minn. dep’t of revenue, federal update: the tax cuts and jobs act of 2017 (2018), http://www.mtc.gov/getattachment/resources/legislation/tcja-(h-r-1)-analysis-and-primarydocuments/minnesota.pdf.aspx[https://perma.cc/98rv-p3f6](total calculated by author). 128 n.d. tax, federal tax cuts and jobs act (tjca) estimated fiscal impact on north dakota state income taxes, https://www.nd.gov/tax/data/upfiles/media/tcja-on-nd-may-2018.pdf?20190604123625 [https://perma.cc/drzm-2n5f]; (total calculated by author). 129 s.c. revenue & fiscal affairs off., estimated south carolina impact of federal “tax cuts and jobs act” of 2017 & “bipartisan budget act” of 2018 9 (2018), a.cc/ http://rfa.sc.gov/files/final%20estimated%20impact%20of%20federal%20tax%20law%20changes%20report%2 05-4-2018.pdf [https://perma.cc/h557-6q82]; (estimating that individual income to increase by $246 million in fiscal year 2018-19, but that figure is reduced by a $77 million tax decrease attributable solely to the section 199a passthrough deduction). 130 graham campbell, joint fiscal office & peter griffin, office of legislative council, tax workshop: income taxes and federal reform, https://ljfo.vermont.gov/assets/subjects/friday-tax-workshops-2019session/596453acb1/2019-friday-tax-sessions-income-taxes-and-federal-reform.pdf. [https://perma.cc/47hswzkc]; 2019] state individual income tax conformity in practice: evidence from the tax cuts & jobs act 81 for most states there were two separate, but related, issues. the first was whether the revenue windfall resulting from conformity would be retained, or whether the legislature would adjust the tax system to keep overall revenue at pre-tcja levels. the second major issue for states to address was whether they wanted to adjust or attempt to offset any of the tcja’s distributional effects – a distinct tax policy issue rather than a simple revenue issue. the two issues are related, of course, because while revenue neutrality can be achieved through a simple reduction in state tax rates, revenue neutrality can also be accomplished through distributional changes. for example, adding a state personal exemption would both reduce the amount of revenue raised by the government, and also address one of the distributional changes caused by tcja conformity. table 2 below sets forth a summary of each state’s response to these issues. table 2: state responses to tcja conformity131 state political control revenue windfall retained? conformity type notes colorado divided in 2018 (democratic governor and house, republican senate); democratic in 2019 yes dynamic • little public debate around conformity issues; • did not decouple from any tcja provisions idaho republican no static • significant debate about loss of personal exemption; enacted state child tax credit to at least partially offset the tax increase that would otherwise affect families; • did not decouple from §199a; • tax rates reduced by .475% across the board minnesota divided (democratic governor and house; republican senate) no static • moved to light conformity (based on federal agi) and therefore decoupled from §199a, but largely mirrored the tcja changes with the exception of adding back a personal exemption for state tax purposes; • second lowest tax bracket reduced by .25% 131 underlying sources for this table can be found throughout part ii.c. in the relevant discussion of each of the states. [vol.11:1 columbia journal of tax law 82 north dakota republican yes dynamic • no real public debate or discussion of conformity; • did not decouple from any tcja provisions south carolina republican no static • enacted two additional state child tax credits to offset distributional effects of the tcja; • decoupled from §199a vermont divided (republican governor, democratic legislature) no static • moved to light conformity (based on federal agi) and therefore decoupled from §199a, but enacted statespecific standard deduction and personal exemption that mirror federal rules pre-tcja; • eliminated top tax bracket and reduced remaining rates by .2% with respect to the revenue windfall from individual income tax changes, four of the six states enacted revenue-neutral conformity legislation meaning that – on paper at least – the state kept overall tax burdens at pre-tcja levels.132 for the four states that did so, this suggests that the dynamics of state tax conformity did not distort decisions about the ideal mix of state revenue and spending, and that legislators did not use conformity decisions as cover for stealth tax increases. but two states – notably the states that automatically incorporate federal tax changes – kept the increased revenue. because of the potentially troubling implications of such a decision, those two states and their responses to the tcja are explored in more detail at the end of this subpart. while overall revenue neutrality suggests that the state did not allow federal changes to affect the desired mix of state revenue and spending, it does not tell us whether the state allowed the tcja to alter the pre-tcja distribution of state tax burdens, an issue that should be just as important to state lawmakers and citizens although perhaps harder to address. as a result, this study also examined the methods by which each state achieved revenue neutrality and whether, in doing so, they sought to undo some of the distributional impacts of the tcja. it finds that every state that enacted revenue-neutral conformity made some attempt to adjust the distributional impacts caused by the tcja. the two most significant distributional impacts from the tcja for state taxpayers were caused by the tcja’s elimination of the personal exemption and the new deduction under section 199a for certain types of pass-through income. each of the four states that passed revenue-neutral conformity legislation attempted to respond to the elimination of the personal exemption by adding 132 vt. dep’t taxes, 2018 vermont income tax reform plan. 2019] state individual income tax conformity in practice: evidence from the tax cuts & jobs act 83 some type of adjustment for family size to the state income tax,133 while three of the four decoupled from the section 199a deduction.134 three of the four states also used modest rate cuts to help achieve revenue neutrality.135 one state, vermont, essentially created a state income tax system that mirrored federal law prior to the tcja in order to preserve the status quo.136 while these findings are positive, in that they suggest that state lawmakers remained actively engaged in tax policy decision-making and did not allow federal changes to dictate state results, it is worth looking at each change in more detail to better determine the effects of conformity on state legislative decision-making. one clear finding from the study is that state legislators often did not have the type of detailed information one would hope would guide tax policy decisions. despite the clear distributional impacts of the tcja, few states had robust estimates of those impacts in the legislative record, nor did the distributional impacts receive much media attention. in minnesota, for example, the department of revenue and the house research department provided good overviews of the issues involved in conformity,137 but there were no official estimates of the distributional effects of either fully conforming to the tcja or for the ultimately passed legislation that decoupled from various provisions in the tcja. the most significant estimate of distributional impact from an official source was a simple statement by the minnesota department of revenue that “[o]ver 200,000 returns would receive tax relief in 2019” under the proposed conformity legislation.138 the statement did not, however, specify which returns would receive such relief.139 133 h.b. 675, 64th leg., 2d reg. sess. (idaho 2018); h.f. 5, 91st leg., 1st spec. sess. (minn. 2019); h. 5341, 122nd gen. assemb., 2nd reg. sess. (s.c. 2018); h. 16, 1st spec. sess. (vt. 2018). 134 h.f. 5, 91st leg., 1st spec. sess. (minn. 2019); h. 5341, 122nd gen. assemb., 2nd reg. sess. (s.c. 2018); h. 16, 1st spec. sess. (vt. 2018). 135 h.b. 675, 64th leg., 2d reg. sess. (idaho 2018); h.f. 5, 91st leg., 1st spec. sess. (minn. 2019); h. 16, 1st spec. sess. (vt. 2018). 136 vermont enacted a state-specific personal exemption and standard deduction in dollar amounts similar to pre-tcja federal levels. h. 16, 1st spec. sess. (vt. 2018). the bill became law without the governor’s signature, apparently due to objections to other parts of the tax bill. see, e.g., april mccollum, vt budget fight ends as scott allows tax increase to become law, burlington free press (jun. 26, 2018), https://www.burlingtonfreepress.com/story/news/politics/government/2018/06/26/phil-scott-allows-budgettax-become-law-ending-vermont-budget-standoff/733879002/. 137 see, e.g., minn. dep’t revenue, budget for one minnesota, march 11, 2019 presentation to house taxes committee 12 (march 11, 2019) (explaining that moving to agi “gives minnesota the ability to determine how itemized and standard deductions meet minnesota’s needs”); minn. house res., a presentation to the house taxes committee on federal tax conformity 18 (jan. 22, 2019) (providing, among other things, a detailed chart of the pros and cons of retaining federal taxable income as the starting point for minnesota income tax liability); minn. house res., background briefing on minnesota taxes 15-17 (jan. 2019) (outlining the many choices legislators must make with respect to tax conformity). 138 minn. dep’t revenue, supra note 180, at 14. see also minn. dep’t revenue, federal update: the tax cuts and jobs act of 2017 generally effective beginning tax year 2019 retroactive for select provisions (dec. 18, 2018) (showing revenue effects of conformity, but not distribution of effects). 139 see id. [vol.11:1 columbia journal of tax law 84 south carolina had perhaps the most robust analysis of conformity’s distributional effects. the south carolina revenue and fiscal affairs office provided a detailed analysis of exactly how conformity would affect south carolina taxpayers.140 overall, the office found that conforming to the tcja would increase south carolina individual income taxes by $246 million for the 201819 fiscal year, but that the section 199a pass-through deduction would decrease state taxes by $77 million, for a net increase of $169 million.141 the office also presented estimates of how taxpayers at varying income levels would fare.142 for example, conformity would reduce state taxes for those with more than $1 million of income, while those with income between $50,000 and $125,000 would see significant state tax increases.143 even this best-of-the-bunch analysis did not tell the full story on distribution impact. it did not, for example, break down how families of different sizes at different income levels would be affected, nor how the benefits of the section 199a pass-through deduction would be distributed, both key impacts of tcja conformity that would be highly relevant for state lawmakers. in examining the specific methods by which states sought to undo the impacts of the tcja on state taxpayers we see how the relative lack of information affected decision-making. for example, the issue of the tcja’s impact on families with three or more children received significant attention in idaho.144 the result was that the legislature passed a law providing a $130 140 s.c. revenue & fiscal affairs off., estimated south carolina impact of federal “tax cuts and jobs act” of 2017 & “bipartisan budget act” of 2018 (2018), http://rfa.sc.gov/files/final%20estimated%20impact%20of%20federal%20tax%20law%20changes%20report%2 05-4-2018.pdf. [https://perma.cc/h557-6q82] 141 id. at 9. 142 id. news coverage also reported on income-specific effects. see, e.g., seanna adcox, next year’s tax filings could be a bigger headache without new sc law, charleston post & courier, sept. 26, 2018 (“there are still winners and losers across all income levels, depending on the household”); seanna adcox, nearly half of sc residents will pay less on next year’s tax filings, charleston post & courier, oct. 4, 2018 (detailing that filers with over $200,000 of income are most likely to see a state tax increase under the conformity legislation, while those earning $30,000 or less are likely to see no change in state tax liability). 143 s.c. revenue & fiscal affairs off., supra note 183, at 19. the report also included information on the impact of the tcja on south carolina taxpayers’ federal tax liability, so that legislators could get a sense of the overall tax burden for its citizens. id. at 27 (showing an overall decrease of $1.621 billion in federal tax liability for south carolinians, with the largest decrease for taxpayers with income between $100,000 and $200,000). 144 see, e.g., kyle pfannenstiel, house unanimously passes child-tax credit bill, coeur d’alene press, march 14, 2018 (quoting representative john gannon, d-boise as objecting to conformity on the basis that it eliminates the personal exemption for dependent children); cynthia sewell, 5 things to watch as idaho lawmakers return to boise for 2018 session, idaho statesman, jan. 6, 2018 (noting the possibility that debates over conformity could turn the legislative session “from low-key to high-key”); cynthia sewell, gov. otter finds tax relief ‘on the backs of families and children,’ democrats say, idaho statesman, jan. 8, 2018 (noting democratic opposition to conformity proposal on the basis of its impact on families and children); james dawson, senate vote means tax cuts ahead for many idahoans, idaho statesman, march 1, 2018; income tax bill misses final element: fairness for low-income families, idaho statesman (march 4, 2018.), https://www.idahostatesman.com/opinion/editorials/article203478109.html there were intra-party disputes concerning the correct response to the impact on families. see, e.g., betsy z. russell, big tax cut bill clears senate panel despite concern it raises taxes on families, idaho statesman (feb. 21, 2018), https://www.idahostatesman.com/news/politics-government/state-politics/article201469704.html (noting disagreements among republican state senators about conformity’s impact on families with children). 2019] state individual income tax conformity in practice: evidence from the tax cuts & jobs act 85 nonrefundable state child tax credit. 145 following the tax change, an analysis by an independent nonprofit showed that many idahoan families would still see a significant state tax increase as a result of tcja conformity.146 the legislature then passed a second bill in the same session increasing the credit amount to $205147 – still short of the $280 amount that was estimated to be necessary to prevent the loss of the personal exemption from increasing taxes for idaho families. in other states, there was simply no attempt to model whether or to what extent the proposed family size adjustments would offset the tcja’s impact on those families.148 state responses to the section 199a deduction were simpler than other tcja adjustments in that states could simply deny the deduction and fully avoid the distributional impacts it would otherwise create. it was also a potentially easier tax policy decision for the states, given that it was a highly controversial provision at the federal level,149 and – unlike the purely individual tax provisions would result in revenue loss for states if they were to adopt it.150 given each of these conditions, it seems reasonable to expect that states would decouple from section 199a.151 yet only three of the six states did so.152 idaho passed legislation specifically adopting the section 199a deduction, 153 while the two dynamic conformity states simply left the section 199a deduction in place through inaction. the rationale for idaho’s decision is not readily ascertainable. a review of the legislative record reveals that written testimony from a nonpartisan, nonprofit tax research was received urging idaho to decouple from the deduction on tax policy grounds.154 there 145 h.b. 463, 64th leg., 2d reg. sess. (idaho 2018). 146 idaho ctr. fiscal pol’y, analysis of house bill 463, feb. 6, 2018, http://idahocfp.org/new/wpcontent/uploads/2018/02/analysis-of-hb463-2-6-2018.pdf. [https://perma.cc/rh6s-7v9a] see also kyle pfannenstiel, house unanimously passes child-tax credit bill, coeur d’alene press (march 14, 2018) , supra note 146 147 h.b. 675, 64th leg., 2d reg. sess. (idaho 2018). 148 this statement is based on the review of publicly-available legislative materials. it is possible that such modeling was performed, but was not publicly disclosed. 149 see, e.g., daniel shaviro, evaluating the new us pass-through rules, 2018 british tax rev. 1, 49 (stating that the §199a deduction “achieved a rare and unenviable trifecta, by making the tax system less efficient, less fair, and more complicated. it lacked any coherent (or even clearly articulated) underlying principle, was shoddily executed, and ought to be promptly repealed”); david kamin et al., the games they will play: tax games, roadblocks, and glitches under the 2017 tax legislation, 103 minn. l. rev. 1439, 1459 (2019) (devoting an entire section of the article to “the faulty pass-through deduction”). 150 the federal government estimated that it would lose $414.5 billion in revenue over the ten years following enactment. joint committee on taxation, supra note 107, at 1. while there are no readily available estimates of the amount of revenue states would lose were they to conform, it is clear that state tax receipts would be lower if they conformed to the section 199a deduction, as it would reduce otherwise taxable income. for the status of state conformity to section 199a, see walczak, supra note 6, at 19. 151 for a detailed discussion of why states should decouple from section 199a, see shanske, supra note 51. 152 see h.f. 5, 91st leg., 1st spec. sess. (minn. 2019); h. 5341, 122nd gen. assemb., 2nd reg. sess. (s.c. 2018); h. 16, 1st spec. sess. (vt. 2018). 153 idaho code ann. §§63-3022 & 63-3021(b)(5) (2019). 154 idaho should consider decoupling from the pass-through deduction, hearing before the h. comm. on rev. & tax’n, 64th leg., 2nd sess. (idaho 2018) (written testimony of nicole kaeding, director of special projects at the tax foundation) [vol.11:1 columbia journal of tax law 86 was also an explicit acknowledgement in the legislative record that idaho would be the first state to conform to the section 199a deduction,155 but no further information is provided. the state’s decision to add the section 199a deduction was not covered by any of the news sources reviewed.156 in three of the four states, the revenue windfall was not returned solely through a family size adjustment or decoupling from section 199a, but also through modest rate cuts ranging from .2 to .475%.157 rate cuts are the simplest method to arrive at a revenue target if the desire is to return any tcja windfall to taxpayers. rate cuts are also highly practical response when federal law makes many small adjustments that would be tedious for a state to attempt to directly offset. for example, the tcja eliminated the ability of employers to reimburse employees for a small amount of their qualifying bicycle commuting expenses on a tax-free basis.158 such a change may well have distributional effects that a state disagrees with from a policy perspective, but the effects are so minor that it is impractical for a state to attempt to directly offset it. while blunt, state rate reductions can broadly put taxpayers at various income levels in close to the same position they would have been in absent federal changes. finally, one of the six states using tight conformity pre-tcja switched to light conformity post-tcja. by doing so, minnesota switched from beginning state income tax calculations with federal taxable income to beginning such calculations with federal adjusted gross income, with the result that the state now directly incorporates much less of the federal income tax code.159 interestingly, while minnesota lessened its direct incorporation of federal tax law, it still chose to largely mirror federal tax law by adopting state standard and itemized deductions that largely mirrored those adopted by the tcja.160 presumably the switch to light conformity was an effort to limit the state’s future vulnerability to federal changes, a particular concern given the tcja’s sunset. 3. tight conformity outliers: colorado and north dakota as noted above, only two tight conformity states allowed the changes made by the tcja to increase state taxes. this effect is perhaps the most basic concern with conformity — that it will distort legislative decision-making on the ideal mix of taxes and spending, and allow legislators to gain revenue that they could not politically achieve if they proposed a stand-alone bill raising taxes 155 minutes, house revenue & taxation committee, idaho legislature, feb. 19, 2018. 156 i reviewed all idaho news sources available through westlaw for any mention of the section 199a deduction. while some articles informed taxpayers of the availability of the deduction after it was passed, none examined the legislative decision to make it available at the state level. 157 idaho reduced each of its tax brackets by .475%. minnesota reduced the second of its four tax brackets by .25%. vermont eliminated its top tax bracket and reduced the remaining rates by .2% each. 158 i.r.c. §132(f)(8). 159 h.f. 5, 91st leg., 1st spec. sess. (minn. 2019). 160 see id. 2019] state individual income tax conformity in practice: evidence from the tax cuts & jobs act 87 (let alone a bill that effectively raised taxes on large, middle-class families). as a result, the legislative processes and related media coverage in these two states are examined in more detail. colorado is generally considered a “purple state.”161 during the first legislative session following tcja passage, colorado had a democratic governor and a split legislature, with the house controlled by democrats and the senate controlled by republicans.162 the election in 2018 resulted in full democratic control of both the executive and legislative branches.163 colorado has a somewhat unusual state tax system given its strong “taxpayer bill of rights” (commonly referred to in colorado by the acronym “tabor”)164 as well as a flat individual income tax rate.165 colorado’s tabor limits the state’s year to year revenue growth based on a formula that takes into account inflation and population growth.166 if the state takes in more revenue than is allowed under that formula, the excess gets refunded to taxpayers unless voters approve a spending increase.167 the result is that tax increases can be particularly hard to enact in colorado.168 but colorado is also a dynamic conformity state, meaning that federal tax changes are automatically effective unless the legislature takes affirmative action to decouple. following the passage of the tcja, colorado would gain significant revenue if its legislature simply did nothing.169 while it was clear that political leaders were aware of the windfall ahead of the 2018 legislative session,170 a review of legislative records and news coverage shows an apparent lack of any serious effort to make the federal changes revenue neutral.171 additionally, there was not much discussion in the popular press about the basic dynamics involved – that federal law changes 161 see, e.g., nick coltrain, colorado democrats seize state trifecta: ascendant party faces electorate that rejected tax increases, fort collins coloradan, nov. 6, 2018. 162 see id. 163 see id. 164 see, e.g., anna staver, colorado taxpayers possibly headed for both tabor refund and tax cut, denver post, june 19, 2019. 165 colo. rev. stat. ann. §39-22-104 (2018). 166 colo. const. art. 10, §20. 167 id. 168 there have, however, been successful efforts to have certain amounts collected by the state by characterized as “fees” and not taxes subject to tabor’s limits. see kieran nicholson, colorado hospital fees do not violate tabor, denver district court rules, denver post, march 6, 2019. https://www.denverpost.com/2019/03/06/colorado-hospital-fees-tabor-denver-district-court/ [https://perma.cc/ 359pe6gs] 169 memorandum from colorado legislative council staff to interested persons, 71st reg. legis. sess., 3, tbl. 1 (colo. march 5, 2018) (estimating a $1.4 billion revenue increase from 2017-22; total calculated by author). 170 auxier & sammartino, supra note 22, at 10 (noting news article reporting that colorado’s political leaders discussed keeping at least part of the tcja windfall and spending it on infrastructure). 171 see, e.g., john frank & brian eason, a look at the top 8 issues for the 2018 legislative session, denver post, jan. 9, 2018 (discussing debates over how to spend the windfall, but not any discussion of returning the windfall). [vol.11:1 columbia journal of tax law 88 automatically increased state taxes.172 democrats did propose and ultimately pass an increased child care tax credit, which presumably would help offset at least part of the tax increase on families.173 however, the bill was not pitched or discussed as an offset to tcja conformity. instead, it appeared to be a stand-alone bill with an entirely separate motivation. 174 senate republicans proposed an income tax rate cut in that same legislative session, but that bill was characterized as having “no chance.”175 the 2019 legislative session was similarly unresponsive to the state impact of the tcja. while both the outgoing and incoming governors made various tax proposals that would have returned some of the windfall, no proposal made it out of legislative committee. 176 there were in fact no significant individual income tax bills during the 2019 session, leaving colorado in tight conformity with federal law and with significantly increased revenue. this result is surprising, given that the state 2018 election results seem to indicate that colorado had significantly different policy preferences than the federal government that enacted the tcja. there are, however, a few possible explanations. the first is an inherently practical one: colorado’s legislature may have desired increased revenue and was happy to take advantage of 172 but see gop tax bill lines up a potential $300m bump for colorado’s budget (colorado public radio broadcast dec. 18, 2017;) https://www.cpr.org/2017/12/18/gop-tax-bill-lines-up-a-potential-300m-bump-for-colorados-budget/ [https://perma.cc/r999-pbmm]; jon caldara, the republican grand betrayal just keeps getting worse, denver post, feb. 4, 2018. https://www.denverpost.com/2018/02/02/the-republican-grand-betrayal-that-just-keeps-gettingworse/ [https://perma.cc/b39p-pbgb]; nick coltrain, federal tax reform might boost state budget, fort collins coloradoan, feb. 28, 2018. https://www.coloradoan.com/ story/news/2018/02/24/federal-tax-cuts-could-boostcolorados-budget-though-who-knows-how-much/ 370294002/ [https://perma.cc/jpe6-cw7n]; jon caldara, colorado stole your trump tax cut, denver post, april 14, 2019. https://www.denverpost.com/2019/04/12/caldara-colorado-stole-your-trump-tax-cut/ [https://perma.cc/4jpc-d9bc] (each acknowledging the state tax effects of the tcja). 173 brian eason, expanded child care tax credit may benefits 40,000 families, denver post, feb. 6, 2018. https://www.denverpost.com/2018/02/05/proposed-colorado-tax-credit-children-40000-families-14-million/ [https://perma.cc/qpb2-snhp]. the child tax credit was increased for families with agi of $60,000 or less, in an amount equal to 50% of the federal credit. 174 see, e.g. id.; crisanta duran et al., helping coloradoans pay for quality child care, denver post, june 1, 2018. https://www.denverpost.com/2018/06/01/helping-coloradans-pay-for-quality-child-care/ [https://perma. cc/lj9e2b4k] (neither of which mention the impact of the tcja on colorado taxes). it is likely that the increased revenue from tcja did in fact help pay for the increased credit. see colo. legis. council staff, final fiscal note hb 18-1208, 71st reg. legis. sess., at 4 (colo. 2018) at 4 (indicating that the full cost of the credit for the first two fiscal years following enactment would be paid for out of the anticipated tabor refund for those years). 175 brian eason, dozens of bills offered yearly have no chance, denver post, feb. 15, 2018. https://www.denverpost.com/2018/02/14/colorado-legislature-rejected-bills/ [https://perma.cc/lcm9-q9g7] 176 anna staver, governor hickenlooper’s final colorado budget includes new tax credits for child care, education, denver post, nov. 2, 2018. https://www.denverpost.com/2018/11/01/hickenlooper-tax-credits-finalcolorado-budget/ [https://perma.cc/z5dj-sqjr] (describing outgoing governor’s tax proposal); nic garcia, jared polis sworn in as colorado governor: “this is a moment in history,” denver post, jan. 8, 2019. https://www.denverpost.com/2019/01/08/jared-polis-inauguration-gay-governor-colorado/ [https:// perma.cc/5bzrbk59] (describing incoming governor’s tax proposal); nic garcia, six things we learned about colorado governor jared polis: his first months in office, denver post, may 19, 2019. https://www.denverpost.com/2019/05/19/jaredpolis-colorado-governor-first-5-months/ [https://perma.cc/6yq9-cfjq] (noting that incoming governor’s proposal did not make it out of legislative committee). 2019] state individual income tax conformity in practice: evidence from the tax cuts & jobs act 89 dynamic conformity to hide a tax increase. 177 another possibility is that the legislature was unconcerned about the tax increase based on the belief that any significant tax increases would be undone by tabor. while the colorado legislative council’s office recently predicted that tabor refunds would be triggered in 2019 and 2020,178 i could find no indication in the legislative record or media coverage that it motivated legislative inaction on tcja conformity. it is therefore difficult to determine to what extent tabor may explain the seeming disconnect between colorado’s political preferences and its response to the tcja. even if we assume that colorado’s legislature had sound motivation for allowing the tcja to increase state taxes, we would still expect the legislature to take into account the distributional changes caused by conformity. my research, however, found almost nothing in the legislative record or in news accounts thereof that any real consideration was given to these issues. colorado’s legislative staff did not provide estimates of relative state tax burdens post-tcja, although they did note that families with large numbers of children “may incur a higher state tax liability” as a result of tcja conformity.179 there was no significant legislative response to that finding, nor any significant media attention paid to it.180 similarly, i did not see any indication that the legislature considered the distributional impacts or the policy choices inherent in the section 199a deduction. as with the overall revenue increase, one might be tempted to think that the reason the colorado legislature paid so little attention to the distributional effects of tcja conformity is that they believed tabor would ultimately return the tax increase, thereby solving the distributional impacts. but tabor is not designed to reverse tax increases only for specific demographic groups. instead, tabor returns excess revenue through property tax relief a temporary income tax rate reduction. 181 while such relief would reduce overall taxes owed, it would not change the fact that certain families would pay more than others. in terms of analyzing the effects of conformity on state tax systems, one must wonder if colorado legislators would ever have voted for a tax bill that specifically increased taxes on large families while lowering taxes on certain 177 there was evidence in colorado of significant interest in raising revenue in order to better fund public education in the state. while a ballot measure proposing a tax increase specifically to fund such needs failed to pass, legislators might have been happy to have the increased tcja revenue available for this and other spending priorities. 178 colo. legis. council staff, june 2019 economic & revenue forecast 15-16 (2019), http://leg.colorado.gov/sites/default/files/images/juneforecast.pdf (estimating that tabor will drop the state’s tax rate in 2019 and 2020 from 4.63% to 4.5%). see also anna staver, colorado’s taxpayers possibly headed for both tabor refund & tax cut, denver post, june 19, 2019. 179 colo. legis. council staff, supra note 125 at 8. 180 based on author’s review of state legislative records and major state news sources. 181 the current tabor mechanism provides that the first $150 million in refunds goes to local governments to fund property tax relief. additional refund amounts can be used to temporarily reduce the income tax rate from 4.63% to 4.5%, or to refund sales taxes based on six income-based tiers. see colo. legis. council staff, memorandum to interested persons re: history of tabor refund mechanisms, march 25, 2019, https://leg.colorado.gov/sites/default/files/history_of_tabor_refund_mechanisms.pdf. [https://perma.cc/58ulnx2r]. [vol.11:1 columbia journal of tax law 90 types of business income. if the answer is negative – as i suspect it is it would be very damning evidence against at least this type of dynamic state tax conformity.182 the second state to keep the windfall, north dakota, is a very different state politically than colorado. while colorado shifted from a divided state government to a democraticallycontrolled state in the november 2018 elections, north dakota did the opposite. it went from an already heavily republican state to one in which all state-wide offices were held by republicans. 183 but like colorado, north dakota dynamically conforms to federal tax law changes. its legislature convenes only in odd-numbered years, and so it had only a single legislative session to respond to the significant changes of the tcja. during that session, however, there was no attempt to alter the state tax system in response to the tcja.184 the official state estimates clearly found that the tcja would impact the distribution of income tax burdens within north dakota, while lowering overall revenue collected. 185 specifically, the tcja would increase state individual income taxes, but that increase would be outweighed by a reduction in state business tax collections.186 in the previous biennium, the legislature had to cut spending from previous levels due to decreased tax revenues, which would suggest the legislature might be interested in decoupling from those federal changes that pushed revenues even lower.187 there was, however, no apparent legislative interest in decoupling from those tcja provisions that lowered state taxes, and nearly no discussion of the change in relative 182 of course, one might be untroubled by this result if one believes that state taxes are suboptimally low due to political pressures faced by legislators. 183 only a single state-wide office was held by a democrat, senator heidi heitkamp, who was defeated by a republican challenger, kevin cramer, in the november 2018 elections. jack dura, republicans reign: cramer claims north dakota’s second u.s. senate seat in crown jewel of statewide races, bismarck trib., nov. 7, 2018. https://bismarcktribune.com/news/election/republicans-reign-cramer-claims-north-dakota-s-second-us/article_d7fc4b65-d524-5010-a0ca-f9972a4a573a.html [https://perma.cc/jlu8-2hze] 184 see, e.g., highlights from this legislative session, williston daily herald, april 29, 2019) (noting no individual income tax proposals among the major bills of the 2019 legislative session); https://www.willistonherald.com/news/state/highlights-from-this-legislative-session/article_8306330e-6aa8-11e9ba7f-231b151700ed.html [https://perma.cc/s2uh-tn9a]; jack dura, ‘heavy lifts,’ collaboration highlight 2019 north dakota legislative session, bismarck tribune, april 28, 2019)(noting same). https://bismarcktribune.com/news/local/govt-and-politics/heavy-lifts-collaboration-highlight-north-dakotalegislative-session/article_d9975fde-5450-5979-8aa9-20505d49c9c9.html [https://perma.cc/6xfr-v9bu] 185 n.d. tax, supra note 128. 186 see id. (estimating $15.2 million state tax increase for individuals and a $42.977 million state tax decrease for businesses). see also amy dalrymple, tax reform projected to decrease n.d. revenue, bismarck trib., aug. 22, 2018. https://bismarcktribune.com/news/local/govt-and-politics/tax-reform-projected-to-decrease-north-dakotarevenue/article_2a07fdcd-216e-57bf-a47c-dd5c4c48ff0d.html [https://perma.cc/9bp4-mlv4] 187 see, e.g., jack dura, forecasting remains conservative but hopeful as new north dakota budget cycle begins, bismarck trib., july 1, 2019 (noting use of state’s rainy day fund in 2017-19 biennium to cover revenue shortfalls) https://bismarcktribune.com/news/local/govt-and-politics/forecasting-remains-conservative-but-hopeful-as-newnorth-dakota-budget/article_fe76b2e0-3a6a-50c1-8b09-c894b7207b0b.html [https://perma.cc/5mky-t8bp]; sam easter, n.d. leaders anxiously await revenue reversal, bismarck trib., june 3, 2018 (noting tax rate decreases from 2009-16 that reduced revenue and the resulting need to cut spending). https://bismarcktribune.com/news/stateand-regional/north-dakota-leaders-anxiously-await-revenue-reversal/article_066d8583-1909-5dcb-9551cd9ab856b337.html [https://perma.cc/x99j-gxsd] 2019] state individual income tax conformity in practice: evidence from the tax cuts & jobs act 91 tax burdens.188 instead, newspapers covered the fact that nearly all north dakotans would receive a federal tax cut,189 and the tax commissioner and several legislators touted the fact that tax revenues would be decreased in the state – which they characterized as a tax cut without specifying that it was only a tax cut for businesses. in fact, the only significant legislative proposal during the 2019 session related to income taxes was a bill to repeal the income tax entirely.190 yet, the same legislature allowed the federal government to increase state individual income taxes. of course, in the state with the lowest individual income tax rates in the country, and a strong republican majority that is likely to agree with tax policy changes enacted at the federal level, it may make sense that north dakota continued to fully conform. but it is important to remember that the tcja had different effects at the state level, because north dakota does not mirror the federal child tax credits. and not even the democratic legislators appeared to point this out or attempt to respond to it. as with colorado, one is left to wonder whether north dakota lawmakers would ever have voted in favor of legislation that increased taxes on large families, while simultaneously cutting taxes for businesses. regardless of the various factors at play in these two states, perhaps the most troubling finding of this study is that neither legislature appeared to engage in any serious debate or consideration of decoupling from any of the federal changes, nor of dropping state tax rates in order to make the change revenue neutral.191 and while it is understandable that states would be 188 see, e.g., jack dura, governor lays out north dakota budget proposal with increased spending, raises for public employees, bismarck trib., dec. 5, 2018 (governor’s budget proposal did not include any proposed income tax changes) https://bismarcktribune.com/news/local/govt-and-politics/governor-lays-out-north-dakota-budget-proposalwith-increased-spending/article_751aed47-4a38-58e6-9387-7779b55e5728.html [https://perma.cc/2mwp-f438]; legislature facing some major issues, bismarck trib., jan. 2, 2019 (income tax changes not listed among legislative priorities) https://bismarcktribune.com/opinion/editorial/ legislature-facing-some-major-issues/article_9b27f2b7ca8c-5ab6-a28c-f7b9fd4c036e.html [https://perma.cc/ p8cb-uewy]; dem-npl leaders outline priorities, bismarck trib., feb. 25, 2019 (democratic legislators criticized the lowering of corporate taxes, but did not mention or propose any response to the tcja changes). https://bismarcktribune.com/opinion/columnists/dem-npl-leadersoutline-priorities/article_b2836dcf-ca67-55d2-a6a0-9c84847ce19a.html [https://perma.cc/pb6s-lled] 189 see, e.g., tom campbell, letter to the editor: the proof is in people’s paychecks, bismarck trib., oct. 19, 2018 (touting federal tax cut for north dakotans). https://www.inforum.com/opinion/letters/4515287-letter-proof-paycheck [https://perma.cc/5g6m-warv] 190 see john hageman, chairman eyes income tax elimination, bismarck trib., jan. 8, 2019 (describing proposal). https://bismarcktribune.com/news/state-and-regional/chairman-of-north-dakota-tax-committee-eyes-income-taxelimination/article_3c1a18f0-d336-5bed-b64c-5f93785a3da2.html [https://perma.cc/kzm7-2tz3].). while the bill passed the house, the governor did not support the proposal. john hageman, house approves bill labeled ‘bad policy,’ bismarck trib., feb. 15, 2019, https://www.inforum.com/ news/government-and-politics/970279-northdakota-house-approves-plan-to-tap-legacy-fund-for-income-tax-reductions [https://perma.cc/3nel-aw62]. the bill failed to pass the senate. john hageman, income tax bill fails, bismarck trib., mar. 21, 2019., https://www.prairiebusinessmagazine.com/news/government-and-politics/4587473-bill-tapping-legacy-fundearnings-replace-income-taxes-fails [https://perma.cc/44pq-srml] 191 based on author’s review of bills introduced during the 2018 and 2019 legislative sessions in colorado, and the 2019 legislative session in north dakota. [vol.11:1 columbia journal of tax law 92 happy to have the increased revenue (and not have to take any political fallout from raising tax rates), these states essentially ceded their tax policy to the federal government. while it is possible this is because colorado and north dakota happened to have perfectly aligned preferences with the federal government, that seems unlikely. it is particularly unlikely given that the tcja changes result in significant shifts in the distribution of tax burdens, and that the shift in burdens at the state level differs significantly from that at the federal level given that neither of these states conforms to the federal child tax credit.192 4. discussion with respect to the four static conformity states, the study presents relatively good news in the sense that these states at least attempted to prevent federal changes from increasing state taxes and changing the distribution of state tax burdens. even though these four states responded in a manner that suggests conformity did not distort state decision-making, the study illustrates three underappreciated detriments of conformity – the complexity that is added by the dynamic nature of conformity, the significant time constraints conformity imposes on state legislatures, and the fact that revenue neutrality does not mean relative state tax burdens remain unchanged. the current study reminds us that federal tax law is dynamic, and illustrates that the exogenous revenue and policy shocks created by conformity can significantly complicate the state lawmaking process. 193 when federal tax law changes, states that disagree with either the policy choices or revenue effects thereof are forced to decouple from those changes. while this can sometimes be easily accomplished in the case of individual, discrete changes, this study shows that large, complex reforms can be difficult to respond to for tightly conforming states. with respect to the tcja, states that conformed to federal taxable income had to interpret and respond to the combined effects of the elimination of personal exemptions, the doubling of the standard deduction, the limitation of itemized deductions, and a new deduction for specific types of business income. it would be difficult (and inaccurate) for a state to simply look at each of these items individually, rather than as a combined whole. for example, if a state disagreed with the elimination of the personal exemption, simply adding it back for state tax purposes would not necessarily be a viable solution. after all, doing so would lower state taxable income, and the 192 as the institute on taxation & economic policy noted, while automatic conformity helped raise additional revenue for state needs, “this is not an improvement in tax fairness as much of that revenue will come from middle-income families, and many of the wealthiest residents will see unnecessary state tax cuts on top of their federal tax cuts.” dylan grundman, an update on state responses to the federal tax bill, inst. taxation & econ. pol’y, just taxes blog (july 3, 2018), https://itep.org/an-update-on-state-responses-to-the-federal-tax-bill/ [https://perma.cc/zey3zskg]. 193 minnesota in fact switched to tight conformity as a result of tra ’86 and then switched to light conformity in response to tcja. . pat dalton et al., overview of income, corporate franchise, sales and other state taxes: background information for members of the house committee on taxes 17 (2019), https://www.house.leg.state.mn.us/comm/docs/057b0e45-0cc3-4377-b7fc-b01392c18f8c.pdf; h.f. 5, 91st leg., 1st spec. sess. (minn. 2019). 2019] state individual income tax conformity in practice: evidence from the tax cuts & jobs act 93 standard deduction had just doubled, also lowering state taxable income. if a state wanted to retain the personal exemption but keep revenue neutral, it might consider reducing the standard deduction amount – but it would have to determine by how much and whether any other changes were warranted. once a state starts adjusting multiple aspects of the tcja, it is questionable whether tight conformity delivers much of a simplicity benefit. another consequence of conformity illustrated by this study is that it not only forces a state to respond to exogenous revenue and tax policy shocks caused by federal changes, but it requires them to do so under tremendous time pressure. the tcja was signed into law in late december 2017, effective for 2018. for states, this meant they had less than one year to (1) evaluate the impact of the federal changes on their state tax system; (2) develop and pass any necessary legislative changes in response thereto, and (3) update all necessary tax forms, instructions, and software. given that state legislatures are typically only in session for approximately the first half of the calendar year, and in some states only every-other year, it is not surprising that the study found in most states less analysis and information in the legislative record than would be considered ideal. indeed, one would expect that this time pressure would create an incentive to simply conform to federal changes, and it is impressive that these four states resisted this easy path. in the case of the tcja, what makes the entire conformity process even worse is that all the work states put into their response is potentially temporary given that the individual income tax provisions are scheduled to sunset in 2026.194 the third key observation from this study is that examining revenue neutrality does not provide the full picture of conformity’s impact on state taxes. previous studies examining conformity’s impact on states have examined the extent to which states returned any anticipated revenue windfall through rate cuts and other state tax changes. while studying the overall revenue impact of conformity is a helpful big-picture measure, it does not capture the full tax policy impact of conformity. in observing state reactions to the tcja we can see that, while states might keep overall tax levels constant, doing so does not mean that the distribution of state tax burdens is kept constant. instead, even revenue-neutral federal changes can result in some taxpayers shouldering a greater part of the state tax burden, while others shoulder less. the study also illustrates that it can be very difficult for states to try to undo those changes in relative tax burden, and that they often do not have the type of modeling or analyses that should be available to guide such actions.195 for the dynamic conformity states in the study, the conclusions to be drawn are less favorable. these two states remained in tight conformity, and essentially ceded state individual income tax authority to the federal government, even though it (1) increased overall individual 194 for a discussion of the dynamics involved in tax sunsets, see rebecca m. kysar, the sun also rises: the political economy of sunset provisions in the tax code, 40 ga. l. rev. 335 (2006). 195 see supra text accompanying notes 137-148. [vol.11:1 columbia journal of tax law 94 state taxes and (2) changed the relative distribution of state tax burdens. there are two likely explanations. the first possibility is that the revenue and policy effects of the tcja aligned with state preferences. this rationale seems unlikely for a number of reasons. the two states had very different political preferences (suggesting that it would be odd that they would each find the tcja’s impact to be perfectly aligned with state political preferences) and the tcja had the effect of raising state taxes on large families (an outcome it is hard to imagine any state legislator endorsing). the more likely explanation is that these states desired increased revenue, and were happy to receive it through the combination of federal legislative action and state legislative inaction. while this position is certainly understandable, it seems desirable only if one assumes that the state political process is fundamentally flawed in a manner that artificially suppresses state tax levels and that the situation is so dire any increased revenue, irrespective of relative tax burdens, should be embraced. the study, while small and qualitative, is in many ways consistent with the existing empirical and theoretical literature. every state updated its cross-references to the current version of the federal tax code, but not all states returned the resulting revenue windfall, suggesting that conformity may indeed distort state legislative decision-making. however, unlike earlier empirical studies, this study suggests that dynamic conformity may involve greater risk of state policy distortion and raises new concerns regarding conformity’s impact on states. the results suggest a particular need for further empirical study of dynamic conformity and conformity’s impact on the distribution of state tax burdens. iii. state individual income tax policy for the 21st century while state income tax conformity has no shortage of proponents,196 this article has illustrated some of its real world disadvantages. this part addresses the positive implications of this evidence. if a state desires to impose an individual income tax,197 how can it create an efficient, administrable system that is consistent with its values without suffering the negative consequences of conformity? as with the rest of this article, the focus is on the individual income tax system. while some individuals have highly complicated tax lives, due to pass-through entities or other complicated business or investment arrangements, my primary concern is with the average taxpayer. in general, the bulk of a state’s revenue comes from these ordinary citizens, not the 1%, and my premise is that the individual income tax system should be designed with this in mind. this part attempts to provide an initial exploration of how a state could minimize the impact of 196 see, e.g., auxier & sammartino, supra note 22, at 11. 197 there are, certainly, arguments in favor of moving away from a state individual income tax, but i will assume for purposes of this article that the state individual income tax is sufficiently entrenched that it is unlikely to disappear entirely anytime soon. 2019] state individual income tax conformity in practice: evidence from the tax cuts & jobs act 95 conformity and end up with an individual income tax system that is simple, efficient, and carefully constructed to reflect state values. a. carefully weigh the costs of decoupling from specific features of the federal income tax in structuring its individual income tax system, a state should take into consideration that certain provisions in the federal income tax code are very difficult to decouple from, provisions that professor ruth mason refers to as “practically nonseverable.”198 these are items where the inconvenience and complexity that would result from decoupling would outweigh any potential benefits. for example, the federal tax system has rules that govern when a taxpayer realizes gain or loss for tax purposes, which generally trigger reporting such item as income or loss unless a specific nonrecognition rule applies. similarly, the federal tax code incorporates two different methods of accounting – cash and accrual – and has significant guidance around each of these that affects the timing of when income is reported and when deductions may be claimed. both the realization standard and accounting rules are likely practically nonseverable a state would substantially complicate its tax administration by adopting its own, different system for determining when gain or loss and income and deductions are reported.199 states would be ceding very little control of tax policy by going along with these basic standards, as their primary work is to simply put in place a set of consistent rules around timing. another large category i would add to mason’s list of “practically nonseverable” provisions is the tax allocations from a business entity taxed as a partnership under federal law. as anyone familiar with partnership tax knows, the rules and regulations governing how a non-corporate entity allocates its income, gain, loss, and deduction are extraordinarily complex. layering additional state rules on top of those rules seems untenable. this does not, of course, mean that a state must tax those allocations in the same way as the federal government. it simply means that they must accept the allocation amounts. for example, if a partner is allocated $10,000 of income under federal partnership rules, the state can decide how to tax that $10,000 of income, but it cannot decide that the partner should actually have been allocated $7,000 of income. there may, of course, be reasonable disagreements as to the precise list of items that should be considered practically nonseverable. but the importance of this concept does not depend on uniform agreement on what is or is not nonseverable. rather, the key argument is that states should 198 mason, supra note 4, at 1329 199 the centrality or non-negotiability of the federal realization rule has been recognized by many scholars. see, e.g., mason, supra note 4, at 1290; scharff, supra note 66, at 703. mason also identifies annual filing without income averaging and the exclusion of imputed income as practically nonseverable. mason, supra note 4, at 1289-91. [vol.11:1 columbia journal of tax law 96 carefully consider the relevant costs and benefits of its decisions to conform or decouple from specific features of the federal income tax system.200 b. borrow federal definitions, not federal treatment one frequently cited justification for conformity is that it would be impossible or impracticable for a state to develop the kind of detailed tax guidance that the federal government produces. to be clear, this is a legitimate concern, particularly for small states. it would also likely be tremendously inefficient. do we really need fifty state governments to develop their own guidance on what qualifies as deductible home mortgage interest? but a state can take advantage of that federal guidance without signing on to the federal tax treatment of the underlying item. for example, a state could choose to begin its individual income tax calculations from federal gross income – now referred to as “total income” on the form 1040. one might refer this as “super light” conformity as it only includes federal income and does not incorporate any federal deductions. to the extent that a state decides to sign on to any of the federal deductions, it could do so by adding them to state statute using the relevant federal definition, but not incorporating the deduction wholesale from the federal code. this allows a state to benefit from federal guidance while lessening the state’s vulnerability to federal changes to the deduction itself. take the example of the current federal deduction for home mortgage interest. many states conform to the federal deduction, which includes not only definitions of several terms (qualified residence, principal residence, acquisition indebtedness, home equity indebtedness), but also several quantitative limits on the deduction (the amount of principal on which interest can be deducted, how many homes can count as a qualified residence, etc.). if a state wanted to allow a deduction for home mortgage interest, it could (after careful analysis!) decide which features of the federal deduction it wanted to borrow. for example, it might make sense for a state to rely on the federal tax code definition and guidance establishing a taxpayer’s “principal residence” and “acquisition indebtedness,” but otherwise craft state-specific features. a state might decide to allow a deduction for home mortgage interest on only a single home, rather than two as the federal rules allow. or it might adopt different quantitative limits on the principal on which mortgage interest may be deducted. the federal limit of $750,000 of acquisition debt might be appropriate for a state with high housing prices, but it might be undesirably high for a state with modest housing prices. a state could easily make these choices, and they could be easily administered, by borrowing a few key definitions and not simply incorporating the federal deduction wholesale. while congress might change various aspects of the deduction from time to time, it would be unlikely to change a basic definition like principal residence very often. and even if congress 200 see, e.g., shanske, supra note 51, (manuscript at 8-9, on file at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3324557, [perma.cc/hl99-seq7) (noting that states might be better off deviating from federal depreciation rules). 2019] state individual income tax conformity in practice: evidence from the tax cuts & jobs act 97 ended up repealing the home mortgage interest deduction entirely, a state could still take advantage of the existing federally-defined terms. the only impact would be a lack of future federal changes or guidance. using this type of approach would allow a state to more finely tune its tax policy while insulating the state from future federal changes. c. take advantage of existing data a state tax system should generally minimize the burden of recordkeeping and return filing to the extent possible, as such costs represent deadweight losses. 201 the good news for states is that many of the items that are either included in income or would potentially be allowed as deductions are already reported by third parties. states should be cognizant of these available data sources in designing their tax systems, and take advantage of easily available data whenever possible. doing so simplifies return preparation for taxpayers and enhances compliance and enforcement. in contrast, and related to earlier points made, the state should be careful about requiring taxpayers to keep track of information that is not otherwise available or required for federal tax filing. to the extent a state does require such information, it should clearly communicate with taxpayers on an annual basis about those state-specific items so that accurate records can be kept.202 the state should also consider this additional recordkeeping burden in deciding whether the provision’s benefits outweigh its costs. in addition to third party reporting, another available data source is the irs. the irs and state tax authorities typically enter into data sharing agreements in order to enhance compliance and enforcement.203 for example, if the irs determines that a taxpayer underreported his wage income, that information would typically be shared with the relevant state and therefore allow the state to take enforcement action based on the federal finding rather than an independent state audit. a common misconception is that these data sharing agreements are only available and relevant where a state conforms to the federal tax code. but, as professor erin scharff documents, these data sharing agreements are in fact very flexible and do not depend in any way on state conformity.204 in designing its own revenue system, a state should consider this availability of federal return data and rely on it where appropriate. 201 amy finkelstein, ez-tax: tax salience and tax rates, 124 q. j. econ. 969, 969 (2009). some argue that the burdens are desirable, because they increase the political salience of taxes. id. see also david gamage & darien shanske, three essays on tax salience: market salience and political salience, 65 tax l. rev. 19, 38-40 (2011). 202 for example, minnesota allows taxpayers to deduct the cost of a child’s music lessons and instrument rental, a benefit unavailable at the federal level. under my proposal, minnesota should annually notify taxpayers of this and any other minnesota-specific recordkeeping in order to facilitate the return preparation process. 203 see scharff, supra note 56, at 712-13. 204 id. at 733-735. [vol.11:1 columbia journal of tax law 98 d. give up on tax expenditures states desiring a simple tax system either without conformity or with minimal conformity should give serious consideration to eliminating or very substantially reducing tax expenditures,205 a common feature of both federal and state income tax systems. tax expenditures, which have few fans at the federal level, 206 are typically intended to produce some combination of behavior change or economic subsidy, but their design often seems ill-suited to these purposes and are subject to numerous critiques.207 the federal government, with its comparatively vast resources and tax expertise, has a hard time getting tax expenditures right, in part because it can be difficult to effectively target a tax-based subsidy so that it reaches all and only the intended recipients in the desired amount. even where the only goal of a tax expenditure is to provide a subsidy and the expenditure is structured so that it successfully reduces the taxes of the intended recipients, its benefits can be captured by third parties through the price mechanism.208 for states, the situation is likely even worse. as an initial matter, a state should only mirror a federal tax expenditure if it agrees with the underlying policy rationale and believes that the expenditure is an effective method of achieving the stated goal. even when state and federal policy preferences are perfectly aligned and the federal tax expenditure is appropriately designed, it is not 205 the concept of tax expenditures was pioneered by stanley surrey. see stanley s. surrey, pathways to tax reform: the concept of tax expenditures (1973); stanley s. surrey & paul r. mcdaniel, tax expenditures (1985). the term “tax expenditure” is meant to capture the idea that a government forgoing revenue through a tax break is the functional equivalent of government spending and should be considered as such during the legislative process. see, e.g., stanley s. surrey, federal income tax reform: the varied approaches necessary to replace tax expenditures with direct governmental assistance, 84 harv. l. rev. 352, 360-61 (1970) (providing sample analyses of tax expenditures as direct spending programs). see also mason, supra note 4, at 1340-41 (discussing federal tax expenditures in the context of state tax conformity). 206 see, e.g., lily l. batchelder et al., efficiency and tax incentives: the case for refundable credits, 59 stan. l. rev. 23 (2006); hickman, supra note 2; jason s. oh, the social cost of tax expenditure reform, 66 tax l. rev. 63 (2012); edward d. kleinbard, the congress within the congress: how tax expenditures distort our budget and political process, 36 ohio n.u. l. rev. 1 (2010); david m. schizer, limiting tax expenditures, 68 tax l. rev. 275 (2015); phyllis c. smith, the elusive cap and gown: the impact of tax policy on access to higher education, 10 berkeley j. afr.-am. l. & pol’y 181 (2008); david a. weisbach, tax expenditures, principal-agent problems, and redundancy, 84 wash. u. l. rev. 1823 (2006). 207 see, e.g., gregory s. burge, do tenants capture the benefits from the low-income housing tax credit program?, 39 real estate econ. 71 (2011); bridget terry long, the impact of federal tax credits for higher education expenses, in college choices: the economics of where to go, when to go, and how to pay for it (caroline hoxby, ed., 2004). but see edward a. zelinsky, james madison and public choice at gucci gulch: a procedural defense of tax expenditures and tax institutions, 102 yale l. j. 1165 (1993). 208 for example, when the federal government offered widely available tax credits of $1,500 to offset the cost of the first two years of post-secondary education, evidence suggests that community colleges raised their prices, thereby capturing the credit for themselves. long, supra note 262, at 155-58. similarly, there is evidence that the economic benefit of the home mortgage interest deduction has been captured by home sellers through increased prices rather than improving affordability for buyers. see, e.g. steven c. bourassa & ming yin, tax deductions, tax credits and the home ownership rate of young urban adults in the u.s., 45 urban studies 1141 (2008). see also will fischer & chye-ching huang, mortgage interest deduction is ripe for reform, ctr. budget & pol’y priorities, june 2013, https://www.cbpp.org/sites/default/files/atoms/files/4-4-13hous.pdf (noting that the deduction primarily benefits high-income, not middleor low-income taxpayers, and that three major bipartisan tax reform panels have recommended it be substantially changed or eliminated). 2019] state individual income tax conformity in practice: evidence from the tax cuts & jobs act 99 obvious that mirroring the expenditure at the state level would deliver the same results. if the goal is behavior change, state tax expenditures have less power than their federal counterparts due to comparatively lower tax rates. and if the goal is to provide a subsidy to certain activity, the state would have to decide that a state subsidy on top of the federal subsidy provides the correct level of support for the given transaction. a state could avoid these interaction effects by designing its own state tax expenditures that reflect state policy priorities, but doing so requires the more limited resources of a state government to produce sophisticated economic modeling and legislative analysis to get it right. it seems unlikely that many state-created tax expenditures would be worth the costs involved both in terms of expenditure design and added complexity to the tax system. given both the criticisms and complications of tax expenditures, states should strongly consider erring on the side of simplicity209 and either eliminate or severely limit their use of tax expenditures within their individual income tax system. e. design around the taxpayer experience a key feature of state individual income tax systems is the ability of a tax system to profoundly shape the relationship between citizens and the state. taxes play a significant role in forming civic identity.210 they determine, in some measure, both what an individual owes society and the reach of a state’s power.211 individual income tax policy therefore gives states a unique ability not only to raise the appropriate amount of revenue for their state, but to shape how citizens perceive the state and its services, and to distribute burdens in a manner that reflects state values. taxation “establishes one of the most widely and persistently experienced relationships that individuals have with their government.”212 given the importance of the individual income tax to a state’s relationship with its citizens, its design is worthy of careful consideration, not a simple duplication of a federal system few are happy with. a final piece of the individual income tax design puzzle is therefore to give careful consideration to the taxpayer experience. states should consider fundamental issues such as what filing returns should look like, or whether returns should be required at all, and if so, for which 209 as richard pomp has observed, it is generally easier, at the state level, to “strike the balance on the side of simplicity.” pomp, supra note 18, at 1199. 210 isaac william martin, ajay k. mehrotra, & monica prasad, the thunder of history: the origins and development of the new fiscal sociology 1, in the new fiscal sociology: taxation in comparative and historical perspective (isaac william martin, ajay k. mehrotra & monica prasad, eds. 2009). for discussions of the role of tax in civic identity and political and social community, see lawrence zelenak, learning to love form 1040: two cheers for the return-based mass income tax (2013); ajay k. mehrotra, reviving fiscal citizenship, 113 mich. l. rev. 943 (2015)(reviewing zelenak’s learning to love form 1040); morton keller, regulating a new economy: public policy and economic change in america, 1900-1933 209 (1996). 211 martin et al., supra note 210, at 1. 212 id. at 3. [vol.11:1 columbia journal of tax law 100 taxpayers.213 a state might decide to make return filing broadly required, but as simple as possible through mechanisms such as pre-filled returns 214 or even a mobile application that allows taxpayers to file their return on their phone simply by agreeing to the accuracy of third-party reported data.215 states could eliminate tax returns altogether,216 or go in the opposite direction and make everyone fill out their tax returns using paper and pen. states could eliminate withholding so that a single (highly salient) payment must be made at tax filing, so that citizens feel their taxes “good and hard.”217 states can make similar decisions about optimal enforcement of whatever tax system they adopt.218 indeed, one could argue that state government has an obligation to consider these weighty issues, and to come to independent conclusions on them.219 there is no one prescription that will be perfect for each state, but it is critical that each state thoughtfully consider their citizens’ taxpaying experience. to the extent that states are able to develop systems that simplify tax administration, they could help their residents save some of the extraordinary sums that are currently spent on tax preparation costs.220 and to the extent they thoughtfully design the return process to be consistent with state values, they will be able to harness the tax return’s civic potential.221 f. protect the system through institutional safeguards one might have read the above suggestions with a bit of skepticism. after all, even if lawmakers initially construct a simple, efficient income tax system, political economy would suggest that those same lawmakers may be highly tempted to use that tax system in future years to curry political favor, such that the end result is a system that is just as complicated as the one that existed under conformity. to quote one commentator, over time, state income tax systems 213 for example, professor michael graetz has proposed limiting return filing to a wealthy minority of taxpayers. michael j. graetz, 100 million unnecessary returns: a simple, fair, and competitive tax plan for the united states (2008). 214 see joseph bankman et al., using the “smart return” to reduce evasion and simplify tax filing, 69 tax l. rev. 459 (2016). 215 the netherlands has such a mobile app and, in sweden, taxes can be completed for some taxpayers by responding “yes” to a text message. derek thompson, the 10-second tax return, the atlantic, march 20, 2016. 216 william g. gale & janet holtzblatt, on the possibility of a no-return tax system, 50 nat’l tax j. 475 (1997). 217 chris edwards, options for tax reform, 106 tax notes 1529, 1538 (2005). 218 for a discussion of tax enforcement and optimal deterrence, see joel slemrod, tax compliance and enforcement: new research and its policy implications, university of michigan ross school of business working paper no. 1302 (jan. 2016). 219 see mehrotra, supra note 210, at 968-69 (discussing that citizens not only have a responsibility to pay their taxes, but that “governmental officials have a reciprocal social obligation and democratic duty to their citizens” when it comes to raising revenue and distributing the burden thereof). of course, it may not always be clear to policymakers which approach is most desirable. for a discussion of some of the difficulties in tax system design, see gamage & shanske, supra note 201. 220 while there is no readily available public data on the specific costs of state return preparation, the total figure for return preparation costs in the united states are estimated at around $15 billion per year. zelenak, supra note 210, at 2. 221 id. at 5. 2019] state individual income tax conformity in practice: evidence from the tax cuts & jobs act 101 “degenerate and deteriorate into a state of disorder, chaos, and inconsistency,” like “a garbage pail that is never emptied.”222 to combat such tendencies, states should consider enacting institutional safeguards to make it more difficult to complicate the state tax code. one can imagine many different mechanisms that might be used. for example, state statute might require a super majority to pass any tax expenditure legislation. if there is concern that such a requirement might be too big a hurdle (and therefore might needlessly paralyze tax policy decision-making ), softer restraints might be put in place, such as requiring specific, detailed modeling and analysis of any tax code amendments before they can be considered by the legislature. similarly, any tax bill affecting individual taxpayers might require an analysis of the bookkeeping requirements and recordkeeping burden prior to bill consideration. a slightly tougher approach might be to not only require such analysis before initial bill consideration, but also require a follow-up study after a specific number of years in order to ensure that the change is having its desired effect. restrictions could also be based on the return itself. a state could cap the number of lines of information on a tax return, such that the legislature would have to remove one adjustment if it wanted to add a new one. another approach is to require all tax laws to automatically sunset after a certain number of years, requiring a future legislature to authorize the continuation of the provision in an attempt to encourage continuing attention to how the particular provision is working.223 other innovative design features should be considered as well, such as dynamic legislation that might automatically repeal tax provisions if certain targets are not met, or outcomes not achieved.224 the possibilities are limitless, and state lawmakers would serve their citizens well by considering simplicitypreserving protections. conclusion while conforming to the federal income tax code is the norm for states that impose a broadbased income tax and is a practice that enjoys relatively widespread support in the literature, theorists have expressed concern that doing so comes at a price. they explain that while conformity might be supported on the basis that it simplifies state tax systems, it also increases revenue volatility and may distort state legislative decision-making. prior empirical studies, however, have failed to reach strong conclusions about what guides state behavior where federal tax changes create revenue and policy shocks for conforming states. 222 pomp, supra note 18, at 1196. 223 of course, it can be hard as a political matter to take away a perceived tax benefit, even if temporarily enacted. see manoj viswanathan, sunset provisions in the tax code: a critical evaluation and prescriptions for the future, 82 n.y.u. l. rev. 656 (2007) (noting that, “[e]ven if a tax cut is intended to be in effect for only a short period of time, it is politically challenging to allow the cut to expire”). 224 rebecca m. kysar, dynamic legislation, 167 u. pa. l. rev. 809 (2018). [vol.11:1 columbia journal of tax law 102 this article has presented the findings of a study of state responses to recently enacted federal individual income tax changes in an attempt to illustrate some of the real-world dynamics of conformity. in the six states that tightly conformed to federal tax law, the tcja was expected to significantly increase state individual income taxes, and also change the relative tax burdens among state taxpayers. in four of those states, lawmakers took action to prevent the federal changes from increasing state taxes and attempted to counteract the change in relative tax burdens by using state-specific adjustments. the remaining two states fully accepted the federal changes, despite the resulting increase in state taxes. in neither case were the outcomes ideal. states either allowed the federal government to increase taxes and change state tax burdens, or they struggled under significant time pressures to attempt to undo federal policy based on imperfect data and analyses. the good news is that it is possible for states to regain control of their individual income tax policy, and do so in a way that embraces simplicity and efficiency. while states will never be able to wholly free themselves from the impact of federal tax policy,225 they can and should minimize the impact federal tax changes have on the state tax system and embrace their power and responsibility to structure a state tax system that is responsive to their citizens. 225 for example, the federal deductibility of state and local taxes will create various pressures and incentives at the state level even if a state tax system is completely decoupled from federal tax. see, e.g., paul n. courant & daniel l. rubinfeld, tax reform: implications for the state-local public sector, 1 econ. persp. 87, 88 (1987) (discussing how the tax reform act of 1986’s elimination of the deduction for state sales taxes would probably result in states shifting away from sales taxes in favor of still-deductible income taxes and noting the federal tax code’s impact on state revenue-raising through the taxation of state and local bonds); gilbert e. metcalf, tax exporting, federal deductibility, and state tax structure 12 j. pol’y analysis & mgmt. 109 (1993) (examining the effect of the tax reform act of 1986’s impact on state tax structure). secrets of the panama papers: how tax havens exacerbate income inequality arthur cockfield abstract data leaks like the panama papers show how tax havens provide a secret offshore financial system that privileges three main actors: malefactors, millionaires, and multinational corporations. such leaks have provided millions of documents detailing how certain taxpayers benefit from tax haven services. wealthy criminals use the offshore world to anonymize their financial misdeeds and, in low-income countries, drain governments of valuable resources while citizens remain in dire circumstances. high-income taxpayers exploit the offshore world to legally reduce their tax bills, deploying techniques that are not available to ordinary-income taxpayers. the leaks also show how the wealthiest members of society—the top 0.01%—are more likely to engage in the criminal offense of offshore tax evasion by hiding their fortunes in tax havens. finally, multinational corporations set up related corporations in tax havens to reduce global tax liabilities legally, providing higher returns for wealthier shareholders. by privileging the interests of criminals, millionaires, and corporations, the offshore world is exacerbating the growing income inequality found in much of the world. this article considers legal and policy reforms to address this challenge. i. introduction .......................................................................................................... 46 ii. privileging malefactors, millionaires, and multinationals... 48 a. a primer on the offshore world and income inequality ............................................. 49 b. gangster paradise ......................................................................................................... 51 c. millionaire paradise ..................................................................................................... 54 d. multinational firm paradise ......................................................................................... 59 e. summary ....................................................................................................................... 63 iii. legal and policy reforms .............................................................................. 63 a. tax transparency initiatives to counter multinational firm tax avoidance ............. 64 b. other global tax agreements to counter firm tax avoidance ................................. 65 c. tax transparency measures against offshore tax evasion ........................................ 67 d. summary ...................................................................................................................... 69 iv. the way forward................................................................................................. 69 a. creating a framework to withhold taxes on tax haven investments ....................... 69 b. global financial registry ............................................................................................. 70  professor and associate dean (academic policy), queen’s university faculty of law, canada. an earlier draft of this article was presented on may 30, 2021, via zoom at the annual law and society conference held in chicago. the author is grateful for the helpful comments received. in addition, the author is grateful for the research assistance provided by juakatha karunakaran, sunny brar, and caine chapman, jd candidates at queen’s law. any errors remain with the author. columbia journal of tax law [vol: 13:45 46 c. addressing the problem of onshoring ......................................................................... 71 d. fighting back through technology ............................................................................ 73 e. other policy recommendations ................................................................................... 74 v. conclusion .............................................................................................................. 75 subreddit latestagecapitalism repost from january 30, 2021: hey remember when the panama papers came out and revealed that all the rich people in the world are part of enormous [sic] criminal conspiracy to dodge taxes and hoard stolen wealth in offshore accounts and literally nothing happened colin taylor @colsbols1 i. introduction tax haven data leaks like the panama papers show how tax havens provide a secret offshore financial system that privileges three main actors: malefactors, millionaires, and multinational corporations.2 the leaks have provided millions of documents detailing how taxpayers use tax haven services. wealthy criminals use the offshore world to anonymize their financial misdeeds and, in low-income countries and failed states, drain governments of valuable resources while most citizens live in desperate poverty.3 high-income taxpayers use the offshore world to reduce their tax bills legally, deploying techniques that are not available to ordinaryincome taxpayers.4 the leaks also show how the wealthiest members of society—the top 0.01%— 1 u/coloppy, the panama papers, reddit (jan 30, 2021), https://www.reddit.com/r/ latestagecapitalism/comments/l8utb8/the_panama_papers/ [https://perma.cc/zfa9-hchj]. 2 see gerard ryle et al., secret files expose offshore’s global impact, int’l consortium investigative journalists (apr. 2, 2013), https://www.icij.org/investigations/offshore/secret-files-expose-offshores-globalimpact/ [https://perma.cc/5tcg-5m6z] [hereinafter international consortium of investigative journalists (icij), offshore leaks]. for discussion of revelations from the leaks, see arthur j. cockfield, big data and tax haven secrecy, 18 fla. tax rev. 483 (2016) (discussing revelations from tax haven data leaks) [hereinafter cockfield, big data]; shu-yi oei & diane m. ring, leak-driven law, 65 ucla l. rev. 532 (2018) (claiming leaks may distort legal and policy responses); carmen franchesca s. del mundo, how countries seek to strengthen anti-money laundering laws in response to the panama papers, and the ethical implications of incentivizing whistleblowers, 40 nw. j. int’l l. & bus. 87 (2019) (describing global responses to panama papers); will fitzgibbon & michael hudson, five years later, panama papers still having a big impact, int’l consortium investigative journalists (apr. 3, 2021), https://www.icij.org/investigations/panama-papers/five-years-later-panama-papers-still-having-a-bigimpact/ [https://perma.cc/x4e9-c76e] (“beyond individual countries, the panama papers has become a global touchstone of the debate around corruption, financial crime and inequality.”). the title of this article refers to the panama papers, revealed to the public in 2016, because this leak gained the most media attention. but it also discusses a number of other tax haven data leaks such as the offshore leaks of 2013, the paradise papers of 2017, and the pandora papers of 2021. 3 see nicholas shaxson, tackling tax havens, 56 fin. & dev., sept. 2019, at 7 (highlighting how tax havens promote inequality). 4 see deborah hardoon, sophia ayele & ricardo fuentes-nieva, an economy for the 1%, oxfam (jan. 18, 2016), https://www-cdn.oxfam.org/s3fs-public/file_attachments/bp210-economy-one-percent-tax-havens-180116en_0.pdf [https://perma.cc/9uk2-57xa] (describing increasing rates of income and wealth inequality, particularly with respect to top 1%, and how wealthy class benefits from tax havens). see also the discussion in the text relating to notes 21 to 34. 2021] secrets of the panama papers 47 are more likely to engage in the criminal offense of offshore tax evasion by hiding their fortunes in tax havens.5 finally, multinational firms form related corporations in tax havens to reduce their global tax liabilities legally, providing higher returns for (normally) high-income investors. by privileging the interests of criminals, millionaires, and corporations, the offshore world exacerbates growing income inequality.6 over the last quarter-century, middle-class incomes have stagnated, growing at low rates throughout much of the western world while high incomes have soared.7 in the united states, incomes in the top 5% rose while the share of american adults who live in middle-income households decreased from 61% in 1971 to 51% in 2019.8 growing income inequality, in turn, is encouraging increased nationalism, nativism, anti-immigrant sentiment, and unhealthy forms of populism, along with the view that the system is rigged in favor of the wealthy and powerful.9 income inequality is fueled by complex factors, including technological change, increased foreign competition, and the global pandemic.10 this article focuses on the offshore world’s role in enhancing the incomes of the very rich and/or the very corrupt at the expense of average-income citizens around the world.11 part ii of the article begins with a primer on tax havens and income inequality. it then describes how the offshore world, which normally shrouds financial transactions with secrecy, serves the interests of criminals, wealthy individual taxpayers, and multinational corporations. part iii reviews the main legal and policy responses that strive via international tax transparency 5 see matthew collin, what lies beneath: evidence from leaked account data on how elites use offshore banking, (brookings inst., global working paper no. 156, 2021), https://www.brookings.edu/wpcontent/uploads/2021/05/what-lies-beneath_collin.pdf [https://perma.cc/5asx-ngqe] (reviewing data leaked from isle of man bank). 6 for earlier studies of tax havens and the ways they assist criminals and high-net-worth individuals, see u.s. s. permanent subcomm. on investigations, comm. on homeland sec. and gov’t aff., minority & majority staff rep., tax haven abuses: the enablers, the tools and secrecy (2006) [hereinafter subcomm. on investigations, tax haven abuses]; dmitry gololobov, the yukos money laundering case: a never-ending story, 28 mich. j. int’l l. 711 (2007); jeffery simser, tax evasion and avoidance typologies, 11 j. money laundering control 123 (2008); douglas j. workman, the use of offshore tax havens for the purpose of criminally evading income taxes, 73 j. crim. l. & criminology 675 (1982). 7 the basic concern is that, over the last forty years, the incomes of the top 10% of taxpayers have increased while middle-class incomes have stagnated. piketty maintains that the returns on capital enjoyed by the wealthier investor class exceed returns on labor, at least in the long run, which leads to ever-growing income inequality within liberal democracies. see thomas piketty, capital in the twenty-first century (arthur goldhammer, trans., 2014); chrystia freeland, plutocrats: the rise of the new global super-rich and the fall of everyone else (2012); see also the discussion in the text accompanying notes 28 to 34. 8 see, e.g., juliana menasce horowitz et al., pew rsch. cent., trends in income and wealth inequality (2020), https://www.pewresearch.org/social-trends/2020/01/09/trends-in-income-and-wealth-inequality/ [https://perma.cc/s7up-wzj4] (“[u.s.] inequality, whether measured through the gaps in income or wealth between richer and poorer households, continues to widen.”). 9 see arthur j. cockfield, shaping international tax law and policy in challenging times, 54 stan. j. int’l l. 223, 236-38 (2018) [hereinafter cockfield, shaping international tax] (discussing how tax leaks showed public that global financial system is “rigged” against average-income taxpayers). 10 see credit suisse rsch. inst., global wealth report 2021 (2021), at 23 (“the repercussions of the covid-19 pandemic led to widespread rises in wealth inequality in 2020.”). 11 see reuven s. avi-yonah, globalization, tax competition, and the fiscal crisis of the welfare state, 113 harv. l. rev. 1573 (2000) (warning tax havens encourage wealth and income inequality, which could lead to antiglobalization reforms); miranda stewart, global trajectories of tax reform: the discourse of tax reform in developing and transition countries, 44 harv. int’l l. j. 139 (2003) (describing how international tax discourse confronts challenges surrounding income inequality); tsilly dagan, international tax and global justice, 18 theoretical inquiries l. 1 (2017) (claiming global tax cooperation is necessary to legitimize democratic governance to preserve a country’s ability to redistribute wealth to low-income taxpayers). https://www7.tau.ac.il/ojs/index.php/til/article/view/1474 columbia journal of tax law [vol: 13:45 48 measures to shed light on some of the more shadowy regions of the offshore world.12 these measures, along with global minimum taxes, may reduce some of the tax haven services that exacerbate income inequality. part iv discusses optimal laws and policies to address challenges presented by tax havens, including a framework to carve off a portion of the offshore world and impose gross withholding taxes on cross-border payments. part iv also addresses how “onshoring” (the use of domestic law to provide tax haven-like benefits to taxpayers) and technology change represent additional challenges to reducing illicit flows within the global financial system. part v concludes by noting how tax haven data leaks improve our theoretical, empirical, and methodological understanding of tax havens and the role they play within the global financial system. ii. privileging malefactors, millionaires, and multinationals governments generally tax their “tax residents” on their worldwide income; hence, residents who do not report the existence of offshore accounts along with any related investment income may be guilty of the crime of offshore tax evasion.13 in the late 2000s, u.s. tax authorities gained access to limited offshore account information about their residents. the u.s. senate held hearings in 2008 with a focus on u.s. citizens engaged in offshore tax evasion via ubs bank in geneva, switzerland.14 unlike earlier leaks, beginning in 2012, a series of mega-leaks were ultimately obtained by the international consortium of investigative journalists (“icij”), a washington, d.c.-based organization coordinating global reporting investigations. instead of mere account information,15 the leaks contained millions of documents that provided highly detailed profiles of transactions by individuals and business entities (e.g., an offshore corporation) engaged in global financial crimes. 12 the analysis focuses on recent global tax agreements while recognizing that some governments are considering unilateral action against tax havens. see stop tax haven abuse act, h.r. 1712, 116th cong. (2019) (proposing measures to inhibit use of tax havens by u.s.-based multinational corporations). 13 in the case of the united states, u.s. citizens are also taxed on their worldwide income. see i.r.c. § 61(a) (“gross income means all income from whatever source derived”); see also i.r.c. §§ 1 (individuals), 11 (corporations). with respect to tax evasion, see i.r.c. § 7201 (“any person who willfully attempts in any manner to evade or defeat any tax imposed by this title or the payment thereof shall, in addition to other penalties provided by law, be guilty of a felony and, upon conviction thereof, shall be fined not more than $100,000 ($500,000 in the case of a corporation), or imprisoned not more than 5 years, or both, together with the costs of prosecution.”). the penalties under the currency and foreign transactions reporting act of 1970, 31 u.s.c. § 5311 (2018) (commonly referred to as the “bank secrecy act”), for failure to file a foreign bank account report (“fbar”) are more severe than the ones imposed by the internal revenue code in some circumstances. for instance, a u.s. person who lives outside of the united states and fails to file an fbar for one year can attract a penalty of up to 50% of the value of any undisclosed taxpayer assets. two years of non-compliance with fbar requirements can result in a penalty equalling 100% of the taxpayer’s undisclosed assets. see 31 u.s.c. § 5321 (2018). 14 for background, see, e.g., lynnley browning, tentative resolution set in ubs tax evasion case, n.y. times, july 31, 2009, at b2; subcomm. on investigations, tax haven abuses, supra note 6, at 1 (reviewing evidence that suggests americans “illegally evade between $40 and $70 billion in u.s. taxes each year”); u.s. gov’t accountability office, gao-13-318, offshore tax evasion: irs has collected billions of dollars, but may be missing continued evasion 1 (2013); tax haven banks and u.s. tax compliance: hearing before the s. permanent subcomm. on investigations of the comm. on homeland sec. and gov’t affairs, 110th cong. (2008) (estimating $100 billion annual loss from both individual tax evasion and corporate tax planning “abuses”). 15 for instance, a 2007 leak from a bank in liechtenstein only contained account information. see mark landler, liechtenstein seeks man suspected of selling information that led to tax scandal, n.y. times, mar. 13, 2008, at c3. 2021] secrets of the panama papers 49 in terms of data size, the first leak obtained by the icij, labeled “offshore leaks,” was revealed to the public in april 2013 and contained 2.5 million documents involving 70,000 taxpayers.16 measured at 260 gigabytes, the total size of the leaked files obtained by the icij was more than 160 times larger than the leak of u.s. state department documents by wikileaks in 2010.17 after the icij received this initial leak, i served as a legal consultant to explain to journalists what the leaked data meant. in the first media announcement of the leak, i said the documents reminded me of the scene in the movie classic the wizard of oz in which “they pull back the curtain and you see the wizard operating this secret machine.”18 for the first time, researchers and journalists were presented with tax haven documents that had previously been shrouded in secrecy.19 over 600 icij journalists working in 117 countries have now published hundreds of articles concerning the many leaks, for which they have been awarded the pulitzer prize.20 a. a primer on the offshore world and income inequality before proceeding with an account of how the offshore world fuels inequality, i will briefly set the stage by defining the boundaries of the research topic under examination. the offshore world is comprised of over thirty countries generally categorized as “tax havens.”21 while the definition of tax havens remains academically contentious, these countries normally provide: attractive tax and other benefits to non-resident investors; laws to mask the real human ownership of assets that are indirectly owned by business and legal entities (such as nonresident corporations or trusts); and the ability to reduce global tax liabilities by forming these entities within their jurisdictions.22 in essence, tax haven governments develop tax and legal 16 see icij, offshore leaks, supra note 2. 17 see id. 18 id. 19 most tax haven countries pass financial secrecy laws that make it a criminal offense to disclose personal financial information to a third party. the tax haven data leaks, including the offshore leaks, were derived from individuals within the tax haven who violated these criminal laws by seizing the data and disclosing it to journalist organizations. the anonymous leaker of the offshore leaks, as well as subsequent leakers of the panama papers, the paradise papers, and the pandora papers, have never been revealed. 20 see michael hudson, panama papers wins pulitzer prize, int’l consortium investigative journalists (2017), https://www.icij.org/investigations/panama-papers/panama-papers-wins-pulitzer-prize/ [https://perma.cc/bf7s-esy5]. the number of reporters working on the more recent file of the pandora papers now exceeds 600. see debbie cenziper et al., post reporters answer your questions about the pandora papers, wash. post (oct. 4, 2021), https://www. washingtonpost.com/world/2021/10/03/questions-answers-pandora-papers/ [https://perma.cc/fkk2-8b9r]. 21 the modern attempt to classify some countries as tax havens emerged from the oecd’s project on harmful tax competition (later renamed the “harmful tax practices” project). see org. for econ. co-op. and dev. (oecd), harmful tax competition: an emerging global issue 26–30 (1998), https://www.oecd.org/ctp/harmful/1904176.pdf [https://perma.cc/a2dw-w7kd] [hereinafter oecd, harmful tax competition]; see also oecd, global forum on transparency and exchange of information, moving forward on the global standards of transparency and exchange of information for tax purposes (2009), http://www.oecd.org/ctp/harmful/43775637.pdf [https://perma.cc/2j27-9sth]. 22 in a series of communiqués, the g20 endorsed the oecd’s definition of tax havens. see, e.g., g20 summit int’l org. comm. ass’n (g20), the global plan for recovery and reform (2009), http://www.g20ys.org/upload/auto/9c0ee8439921b1032fba1b8ca960ba8be8ca4e0d.pdf [https://perma.cc/9ldy columbia journal of tax law [vol: 13:45 50 systems that provide services to foreign businesses and individuals with both legal and illegal income. the offshore world is a legal construct that is linked to a nation’s domestic laws as well as, increasingly, forms of international law. governments enact laws that encourage companies to “go global” by basing a related corporation in a tax haven and reducing taxes owed vis à vis its competitors. for instance, u.s. tax laws effectively reduce taxes by half when a u.s. firm sets up a subsidiary corporation in a tax haven for foreign exports.23 in terms of international law efforts, global organizations such as the organization for economic cooperation and development (“oecd”) and the financial action task force (“fatf”) promote the adoption of globally negotiated rules that nations are supposed to implement via domestic law.24 for example, fatf-recommended “know your customer” rules, which force banks to ask questions to customers to discern whether deposited funds come from legal or non-legal means, are implemented by the united states through revisions to federal antimoney laundering and terrorist financing laws.25 tax havens are also connected to international law through recent global agreements that try to inhibit tax haven usage (see part iii.b). the offshore world itself is managed by a professional class of lawyers, accountants, financial advisors, clerks, bookkeepers, and others who work within tax haven law firms or offshore service providers. these offshore service providers are companies that provide financial and corporate services like forming a trust under the laws of the tax haven.26 in my experience working in tax havens, the majority of citizens within these countries normally do not work within the financial industry. sometimes, research centers, such as the university of luxembourg and the university of west indies, are situated within tax havens and, at times, train workers for jobs within the tax haven’s financial industry.27 with respect to inequality, the primary concern for many countries is that middleclass incomes have stagnated or grown very little over the last generation, whereas incomes mcjx]; g20, declaration on strengthening the financial system (2009), https://www.treasury.gov/resource-center/international/g7g20/documents/london%20 april%202009%20fin_deps_fin_reg_annex_020409_-_1615_final.pdf [https://perma.cc/cvp8-cvnz]. 23 see chris william sanchirico, the u.s.’s hidden export subsidy, the hill (jan. 22, 2020), https://thehill.com/opinion/finance/479293-the-uss-hidden-export-subsidy [https://perma.cc/t6u8-c33n] (discussing how u.s. minimum taxes allow u.s. exporters to reduce foreign tax liabilities). another example would be canadian tax laws that permit a “double-dip” loan whereby one loan can generate two interest deductions when a company places a related corporation in a tax haven. see income tax act r.s.c. 1985, c. 1, s. 95(1)(a) (can.). 24 see fin. action task force, international standards on combating money laundering and the financing of terrorism & proliferation (2012), https://www.fatfgafi.org/media/fatf/documents/recommendations/pdfs/fatf%20recommendations%202012.pdf [https://perma.cc/f87l-resy]. 25 see 31 c.f.r. §§ 1010, 1020, 1023, 1024, 1026 (2021). for discussion, see richard gordon & andrew p. morriss, moving money: international financial flows, taxes and money laundering, 37 hastings int’l & comp. l. rev. 1 (2014). 26 see nicholas shaxson, treasure islands: tax havens and the men who stole the world (2011) (providing interviews with workers who toil in offshore world); cockfield, big data, supra note 2, at 519-522 (discussing revelations from leaks concerning offshore workers and customer communications). 27 the main campus for the university of west indies is located in cave hill, barbados and educates students in law, accounting, and finance. many graduates work within the offshore financial industry. for a discussion concerning how developed countries appear to focus sanctions on more vulnerable black-majority tax havens while not sanctioning more mature european tax havens like switzerland, see steven dean & attiva waris, ten truths about tax havens: inclusion and the ‘liberia’ problem, 70 emory l.j. 1657 (2021) (claiming international tax policy reforms must become more inclusive of needs of traditionally downplayed interests of certain tax havens). 2021] secrets of the panama papers 51 within the top 10% have increased.28 in turn, income inequality encourages unhealthy forms of populism, nationalism, nativism, and anti-immigrant sentiment.29 over the past fifty years, and particularly since 2000, u.s. incomes in the top 10%—and especially the top 1%—have increased significantly while middle-class incomes have enjoyed less growth.30 why is income inequality growing? piketty suggests that, within liberal democracies, over time the investor class enjoys higher returns on their investments compared to the return enjoyed by workers through their wages, resulting in widening income inequality.31 for instance, while the shock of world war ii flattened u.s. incomes and reduced income inequality, inequality has risen significantly since the 1970s.32 piketty’s theory is bolstered with respect to studies that measure wealth inequality. wealth inequality measures the differences between total assets owned by different individuals. the netherlands, for instance, has the highest wealth inequality in the world, which may be attributable to the fact that it is one of the oldest liberal capitalist societies that has enabled the investor class to grow relatively larger than individuals who derive their returns mainly through wages.33 the dutch example, however, also demonstrates how tax policy can effectively address inequality in at least some circumstances: after accounting for tax subsidies and other government transfers, the netherlands significantly reduces income inequality to the point that it is more equal than a majority of other oecd countries.34 the following sections review how the offshore world contributes to income inequality by enhancing the wealth of criminals, high-income individuals, and multinational corporations. indeed, various leaks such as the paradise papers of 2017 revealed that tax havens provide a veritable paradise for these three actors. b. gangster paradise income inequality discussions by academics and policymakers normally focus on legitimate sources of income to show that, in real terms, top incomes have grown significantly while middle-class incomes have either stagnated or grown slowly. yet, illegal income and its illegal transfer to tax haven bank accounts exacerbate inequality outcomes in many low-income 28 see piketty, supra note 7. 29 see cockfield, shaping international tax, supra note 9. 30 see horowitz et al., supra note 8. 31 see piketty, supra note 7. 32 see thomas piketty & emmanuel saez, income inequality in the united states, 1913–1998, 118 q. j. econ. 1 (2003). see also christopher kollmeyer, trade union decline, deindustrialization, and rising income inequality in the united states, 1947-2015, 57 rsch. soc. stratification & mobility 1 (2018), https://aura.abdn.ac.uk/bitstream/handle/2164/12582/final_submission_ for_aberdeen_27s_library_.pdf;jsessionid=86ab207c826b4c4c8f1a44fb6dc81fbe?sequence=1 [https://perma.cc/95r5-xds7]. 33 see wikipedia, list of countries by wealth inequality, https://en.wikipedia.org/wiki/list_of_countries_by_wealth_inequality [https://perma.cc/6xmm-ykj9] (describing how the netherlands has highest gini co-efficient and thus highest level of wealth inequality in world); james b. davies, the level and distribution of global household wealth, 121 the econ. j. 223 (apr. 2008). 34 see wikipedia, list of countries by income equality, https://en.wikipedia.org/wiki/list_of_countries_by_income_equality [https://perma.cc/t32n-t5lk]. see also ruud muffels, didier fouarge & ronald dekker, longitudinal poverty and income inequality a comparative panel study for the netherlands, germany and the uk (tilburg univ. osa, working paper no. 2000-6, 2012). columbia journal of tax law [vol: 13:45 52 countries (the impact of such flight on middleand high-income countries is discussed in part iii.c).35 in some countries, political and business elites drain the fiscal coffers of their nations by hiding their booty in tax havens while citizens remain in dire circumstances, now with fewer resources. although the matter is often discussed in terms of its human rights implications, capital outflows by high-level politicians or other well-connected individuals have a severely deleterious impact on both income and wealth inequality.36 in terms of crimes taking place within tax havens, the literature on the economics of money laundering estimates that up to $3 trillion flows through the money laundering market every year, with much of these financial flows taking place within tax havens.37 according to vernier:38 this money [in tax havens] comes from the worst forms of trafficking, in non-trivial proportions: drugs (over $1 trillion), organs (10 percent of the transplants carried out in the world), child sex tourism (involving more and more countries, particularly in africa, asia and south america), the trafficking in women, crimes against the environment, counterfeiting of medical products (15 percent of medications), etc. while these crimes wreak havoc throughout the world, the phenomenon of “capital flight,” whereby criminals transfer their stolen monies to tax havens, is the main contributor to income inequality. capital flight is a global phenomenon whereby wealthy individuals in europe, the americas, asia, and elsewhere move legally earned and crooked money offshore.39 certain countries in africa, however, are suspected to be the most vulnerable to such activities. in a 2008 study on capital flight from sub-saharan african countries, the authors concluded that a “narrow, relatively wealthy stratum” of the populations of the countries under study maintained assets in foreign countries that exceeded the national public debts of their own countries.40 for a number of african countries, wealthy elites shift more monies to offshore tax havens than the total foreign 35 for sources that discuss how tax policy can provoke poverty and income inequality, see allison christians, fair taxation as a basic human right, 9 int’l rev. const. 211 (2009) (suggesting tax policy should be evaluated against impact on human rights); maria magdalena sepúlveda, report of the special rapporteur on extreme poverty and human rights, u.n. doc. a/hrc/26/28 (may 22, 2014); see also int’l bar assoc., tax abuses, poverty and human rights: a report of the international bar association’s human rights institute task force on illicit financial flows, poverty and human rights (2013); philip alston & nikki reisch, eds., tax, inequality, and human rights (2019) (discussing relevance of human rights to tax law and policy). 36 see john guyton et al., tax evasion at the top of the income distribution: theory and evidence 3-4, (nber, working paper no. 28542, 2021) (“the result that accounting for tax evasion increases inequality is robust to a [wide range of tests].”). 37 for a summary of estimates of the scale of the money laundering industry, see killian j. mccarthy, why do some states tolerate money laundering? on the competition for illegal money, in research handbook on money laundering 127, 128–29 (brigitte unger & dean van der linde eds., 2013). 38 alain deneault, legalization theft: a short guide to tax havens 24 (2016) (quoting eric vernier, french expert on money laundering). 39 see nathan sheets, capital flight from the countries in transition: some theory and empirical evidence (bd. of governors of the fed. reserve sys., int’l fin. discussion paper no. 514, 1995) (discussing capital flight from different parts of world). 40 james k. boyce & léone ndikumana, new estimates of capital flight from sub-saharan african countries: linkages with external borrowing and policy options (univ. mass. at amherst pol. econ. rsch. inst., working paper no. 166, 2008). see also john christensen, africa’s bane: tax havens, capital flight and the corruption interface 1-2 (madrid real instituto elcano, working paper no. 1, 2009) (describing how certain african countries vulnerable to capital flight adopt preferential tax policies to compete with tax havens). 2021] secrets of the panama papers 53 aid poured into the continent. in many cases, the situation resembles a revolving door: foreign countries provide aid, then the monies are seized by corrupt elites and hidden offshore.41 south sudan, the world’s youngest country, provides a distressing example of the costs associated with corruption facilitated by the offshore world.42 two years after the country was founded in 2011, it became embroiled in a civil war.43 the violence and conflict have taken a terrible toll on the south sudanese, with an estimated 400,000 people killed and more than four million people displaced. since 2017, approximately seven million of the country’s ten million citizens are at risk of starvation, according to the united nations.44 a report by the sentry, a journalist organization, revealed that the country’s elites were stealing foreign aid pouring into the country and hiding it offshore.45 the report quoted south sudan’s president as saying: “an estimated $4 billion are unaccounted for or, simply put, stolen by former and current officials, as well as corrupt individuals with close ties to government officials.”46 the sentry investigation also revealed that the president’s family members as well as those of other government officials owned or lived in mansions in kenya and uganda.47 corrupt officials sometimes hide the ownership of these homes through a tax haven corporation although the sentry’s reporting did not dig up evidence this was taking place. a 2020 tax haven data leak known as the luanda leaks also showed how isabel dos santos, africa’s wealthiest woman, stole billions and transferred the ill-gotten monies to tax havens, draining oiland diamond-rich angola of valuable resources and leaving its citizens among the poorest in the world.48 documents connect ms. dos santos or her husband, sindika dokolo, to a network of more than 400 companies and subsidiaries in 41 countries, including 94 companies set up in tax havens such as malta, mauritius, and hong kong. once the authorities began an investigation, ms. dos santos absconded to dubai, another tax haven. this outcome provides another example of illicit cross-border financial flows to tax haven-based entities (where the funds are normally in turn invested in financially stable oecd countries through, for instance, the purchase of condominiums in miami or vancouver).49 the pandora papers revealed the king of jordan shifted over $100 million to tax haven companies that in turn own properties around the world, including three homes in malibu worth 41 see jorgen j. anderson, niels johannesen & bob rijkers, elite capture of foreign aid: evidence from offshore bank accounts (world bank, working paper no. 9150, 2020). 42 see arthur j. cockfield, how countries should share tax information, in tax, inequality & human rights 303 (philip alston & nikki reisch, eds., 2019) [hereinafter cockfield, share tax information]. 43 in neighboring sudan, the panama papers revealed in 2016 that former sudanese president ahmad al mirghani was the owner of a british virgin islands company called orange star corporation, created in 1995, that in turn purchased a long-term lease on a london apartment. see ahmad ali al-mirghani, int’l consortium investigative journalists, https://offshoreleaks.icij.org/stories/ahmad-ali-al-mirghani [https://perma.cc/p8gplgzy]. 44 see united nations, south sudanese ‘one step away from famine', as un launches humanitarian response plan, https://news.un.org/en/story/2021/03/1087492 [https://perma.cc/ny5z-rzuq] (noting that roughly 7.2 million citizens suffer from severe food insecurity). 45 see the sentry, war crimes shouldn’t pay: stopping the looting and destruction in south sudan (sept. 2016). 46 id. at 11. 47 see id. at 5-6. 48 see sydney p. freedberg et al., how africa’s richest woman exploited family ties, shell companies and inside deals to build an empire, int’l consortium investigative journalists (jan. 19, 2020), https://www.icij.org/investigations/luanda-leaks/how-africas-richest-woman-exploited-family-ties-shell-companiesand-inside-deals-to-build-an-empire/ [https://perma.cc/8426-aqvv]. 49 for discussion, see mccarthy, supra note 37, at 128-31. columbia journal of tax law [vol: 13:45 54 roughly $70 million—at the same time as his country was receiving foreign aid.50 with respect to other middle eastern countries, the panama papers also uncovered how former heads of state, including from kuwait, palestine, saudi arabia, and qatar, use tax haven entities like corporations to move money offshore.51 after surveying the wealth held by these individuals, the german journalists who first received the panama papers noted: “they enjoy unimaginable luxury while at least part of the population is living a hand-to-mouth existence.”52 where do the looters go after they have impoverished their countries? there is always a friendly port in the storm. dubai, in particular, serves as the last-stop destination for many of the world’s biggest financial crooks in part due to its unwillingness to extradite criminals back to their home countries to face charges. al khanani, the world’s biggest money launderer and a terrorist financier suspected of laundering billions of dollars, was based in dubai.53 after looting south africa for decades, the gupta brothers fled to dubai.54 as mentioned, after the luanda leak revealed africa’s richest woman stole billions of dollars from her own country, she also absconded to dubai.55 dubai is filled with so many foreign gangsters and demimonde characters it resembles rick's café américain in the movie casablanca or perhaps the mos eisley cantina in star wars episode iv. c. millionaire paradise the offshore world is also a paradise for millionaires, including a group of individuals who are referred to, in tax industry jargon, as “ultra-high-net-worth individuals”—those who own $50 50 see will fitzgibbon, while foreign aid poured in, jordan’s king abdullah funnelled $100m through secret companies to buy luxury homes, int’l consortium investigative journalists (oct. 3, 2021), https://www.icij.org/investigations/pandora-papers/jordan-king-abdullah-luxury-property/ [https://perma.cc/sc3vhck4]; greg miller, while his country struggles, jordan’s king abdullah secretly splurges, wash. post (oct. 3, 2021), https://www.washingtonpost.com/world/interactive/2021/jordan-abdullah-shell-companies-luxury-homes/ [https://perma.cc/6xss-xrdz]. 51 see bastian obermayer & frederik obermaier, the panama papers: breaking the story of how the rich and powerful hide their money 117-118 (2016) (two german journalists, bastian obermayer and frederik obermaier, first gained access to panama papers tax haven data leak from panamanian law firm mosseck fonseca and then provided leaks to icij). see also secret dealings of middle east leaders exposed by panama papers leak, middle east eye (april 4, 2016), https://www.middleeasteye.net/fr/news/huge-tax-leak-exposes-leaderssaudi-pakistan-1560802862 [https://perma.cc/3u4y-tskj]. 52 id. at 117-18. 53 u.s. authorities, with global partners from australia to canada, managed to lure khanani from dubai to panama where he was promptly arrested. see khurram husain, khanani pleads guilty to money laundering in us court, dawn (nov. 7, 2016), https://www.dawn.com/news/1294812 [https://perma.cc/xq72-mf7q]. 54 the gupta brothers are suspected of draining south africa of $7 billion in lost tax revenues. in one case, the south african revenue service (sars) illegally gave certain gupta companies rand 420 million (roughly $27 million) in tax refunds between 2016 and 2018. the sars commissioner tom moyane, a known zuma crony, was suspended in 2018 for his suspected complicity in the corruption. see press trust of india, south african court freezes assets of gupta family and associate, bus. standard (june 5, 2021), https://www.businessstandard.com/article/international/south-african-court-freezes-assets-of-gupta-family-and-associate121060500014_1.html [https://perma.cc/l6va-pyvw]. 55 see freedberg et al., supra note 48; see also anisha kohli, facing global pressure, the united arab emirates to begin fining violators of new corporate transparency rules, int’l consortium investigative journalists (june 21, 2021), https://www.icij.org/investigations/fincen-files/facing-global-pressure-the-unitedarab-emirates-to-begin-fining-violators-of-new-corporate-transparency-rules/ [https://perma.cc/3nha-azrx] (discussing how united arab emirates has begun to cooperate with global financial laws targeting beneficial owners with glaring loophole that its two largest cities, dubai and abu dhabi, are exempt from these laws). https://www.middleeasteye.net/fr/news/huge-tax-leak-exposes-leaders-saudi-pakistan-1560802862 https://www.middleeasteye.net/fr/news/huge-tax-leak-exposes-leaders-saudi-pakistan-1560802862 https://www.dawn.com/news/1294812/khanani-pleads-guilty-to-money-laundering-in-us-court https://www.dawn.com/news/1294812/khanani-pleads-guilty-to-money-laundering-in-us-court https://www.icij.org/investigations/fincen-files/facing-global-pressure-the-united-arab-emirates-to-begin-fining-violators-of-new-corporate-transparency-rules/ https://www.icij.org/investigations/fincen-files/facing-global-pressure-the-united-arab-emirates-to-begin-fining-violators-of-new-corporate-transparency-rules/ 2021] secrets of the panama papers 55 million or more in assets. even during the pandemic, this wealthy group grew by over 24% in one year.56 the rise of these extraordinary well-to-doers was facilitated by the offshore world.57 this group takes advantage of the laws within tax havens that allow them to hide their wealth from the scrutiny of governments. in fact, the offshore world is awash in their hidden cash—an estimated $5 to $33 trillion in private financial wealth is stashed away in tax havens.58 this section begins by describing how wealthy chinese investors move money out of their country and invest via tax haven entities like corporations in countries such as the united states. next, the section sets out how wealthy individuals within liberal democracies also embrace the offshore world through legal and illegal means. consider the situation of china where the greatest amount of money has fled a country via capital flight. in a one-and-a-half-year period from 2016 to 2017, an estimated $1 trillion was transferred offshore.59 the first mega-tax haven leak also revealed family members connected to high-level officials maintained offshore corporations and assets.60 individuals in middle-income countries like china engage in capital flight via tax havens for three main reasons.61 first, they often wish to diversify their investments, including retirement savings, by putting their money in “safe” parts of the world where returns are stable. under conventional financial theory, diversifying investment portfolios allows chinese investors to earn higher returns with less risk.62 second, they fear their government could one day take their money back—and they will not have recourse to a reliable dispute resolution system (due to a weak rule of law and/or government corruption). third, in some cases chinese investors also take out a second citizenship in a tax haven in case they have to flee their country.63 56 see credit suisse rsch. inst., supra note 10, at 22. 57 see id. 58 see james henry, the price of offshore revisited, tax justice network 36 (2012); see also the missing $20 trillion, economist (feb. 16, 2013), https://www.economist.com/leaders/2013/02/16/the-missing-20trillion [https://perma.cc/4rmq-lfmk]; alain deneault, offshore: tax havens and the role of global crime 42-50 (2011) (reviewing estimates). 59 see keith bradsher, chinese start to lose confidence in their currency, n.y. times (feb. 13, 2016); marina walker guevara et al., leaked records reveal offshore holdings of china’s elite, int’l consortium investigative journalists (jan. 2014), http://www.icij.org/offshore/leaked-records-reveal-offshoreholdings-chinas-elite [https://perma.cc/88tn-sbpx] (“every corner of china’s economy, from oil to green energy and from mining to arms trading, appears in the icij data.”). 60 many of the individuals identified within the leaks were family members of the rulers of the communist party, including the politburo standing committee. see mar cabra & marina walker guevara, unlocking china’s secrets, int’l consortium investigative journalists (jan. 23, 2014), http://www.icij.org/offshore/unlockingchinas-secrets [https://perma.cc/8gct-yjp7]; guevara et al., supra note 59. 61 in the case of china, much of money transferred offshore comes from legitimate sources of income earned through work or business. nevertheless, the transferors are often breaking domestic chinese laws that prohibit crossborder transfers in excess of $50,000. see, e.g., michael hudson et al., hidden in plain sight: new york just another island haven, int’l consortium investigative journalists (april 8, 2014), http://www.icij.org/offshore/hiddenplain-sight-new-york-just-another-island-haven [https://perma.cc/wn24-qtbj] [hereinafter hudson, new york] (“high-end new york real estate is an alluring destination for corrupt politicians, tax dodgers and money launderers around the globe.”). 62 see frank j. fabozzi et al., the legacy of modern portfolio theory, 11(3) j. investing 7 (2002), https://doi.org/10.3905/joi.2002.319510 [https://perma.cc/3yua-vqah]. 63 wealthy individuals have opportunities to purchase citizenship in a number of countries, including tax havens, at times to avoid taxation by their home countries. for instance, st. kitts and nevis in the caribbean can grant citizenship within 60 days upon payment of a specified amount. in addition to tax avoidance, individuals may wish to hold a second citizenship as a backup plan in the event of political instability in their home countries. see andy https://www.economist.com/leaders/2013/02/16/the-missing-20-trillion https://www.economist.com/leaders/2013/02/16/the-missing-20-trillion columbia journal of tax law [vol: 13:45 56 chinese capital flight leads to lower economic growth as resources are hidden and invested overseas instead of domestically, leading to lower employment and lost tax revenues. wealthy chinese individuals use tax haven to enhance their after-tax income by diversifying their investment portfolios and, at times, by escaping chinese taxation on their income, which encourages income inequality because the bulk of chinese people do not get such benefits. this process is taking place at a time of great inequality. for instance, one study estimates that china exceeded u.s. income inequality levels by 2012.64 while average incomes have been steadily rising for the past thirty years, the growing chinese economy has contributed to income and wealth inequality. in liberal democracies, such as the united states, tax laws allow wealthy individuals to take advantage of offshore tax privileges that are not available to lowand middle-income taxpayers. for example, in 2005, the accounting firm kpmg admitted to marketing large-scale offshore tax shelters to wealthy clients. the firm’s so-called offshore portfolio investment strategy cost the u.s. government hundreds of millions of dollars in lost revenue.65 the u.s. government alleged the scheme violated tax law in part because it lacked economic substance—it amounted to nothing more than paper-shuffling investor funds to generate tax savings. under a deferred prosecution agreement with the u.s., kpmg admitted criminal wrongdoing and agreed to a $456 million fine, in addition to ongoing review of its tax practice.66 moreover, nine senior kpmg officers were criminally indicted for tax fraud and suspended from practicing accounting. subsequent litigation resulted in both acquittals and convictions.67 the pandora papers of 2021 revealed that cherie blair, wife of former u.k. prime minister tony blair, used a tax haven corporation to purchase a london building that was partially owned by the family of a bahraini minister.68 by purchasing the shares of the tax haven corporation, instead of buying the asset directly, ms. blair reportedly saved $422,000 in taxes on the sale. semotiuk, st kitts and nevis possibly an investor immigrant’s best 2nd passport, forbes (aug. 17, 2020), https://www.forbes.com/sites/andyjsemotiuk/2020/08/17/st-kitts-and-nevis-possibly-an-investor-immigrants-best2nd-passport/?sh=70deeedd3a61 [https://perma.cc/9gf7-mzm4] (indicating citizenship can be purchased for usd$200,000). see allison christians, buying in: citizenship and residence by investment, 62 st. louis u. l.j. 51 (2018). 64 see yu xie & xiang zhou, income inequality in today’s china, 111 pnas, 6928, 6930 (apr. 28, 2014), https://doi.org/10.1073/pnas.1403158111 [https://perma.cc/6na8-7p2l] (estimating a gini coefficient of 0.55 for china in 2012 compared to 0.45 for the united states). see also branko milanovic, china’s income inequality will lead it to a stark choice, foreign aff. (feb. 11, 2021), https://www.foreignaffairs.com/articles/china/2021-0211/chinas-inequality-will-lead-it-stark-choice [https://perma.cc/rv7b-sn2m]. 65 the offshore portfolio investment strategy is sometimes referred to as a “basis-shift cloned” tax shelter for high-net-worth individuals. the deal is “cloned” in that the same tax shelter is pitched to numerous potential clients. for discussion, see u.s. permanent subcomm. on investigations, comm. on homeland sec. and gov’t affairs, s. rep. no. 109-54, the role of professional firms in the u.s. tax shelter industry (2005). 66 for discussion, see lynnley browning, 3 convicted in kpmg tax shelter case, n.y. times (dec. 17, 2008), https://www.nytimes.com/2008/12/18/business/18kpmg.html?mcubz=0 [https://perma.cc/t2nt-ptbq]; press release, department of justice, kpmg to pay $456 million for criminal violations in relation to largest-ever tax shelter fraud case (aug. 29, 2005), https://www.justice.gov/archive/opa/pr/2005/august/05_ag_433.html [https://perma.cc/2fcr-lcgj]. 67 see id. 68 see bbc panorama, pandora papers: blairs saved £312,000 stamp duty in property deal, bbc news (oct. 3, 2021), https://www.bbc.com/news/uk-58780559 [https://perma.cc/sd77-7rcj]. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3043325 https://www.bbc.com/news/uk-58780559 2021] secrets of the panama papers 57 consider also one of the exposés from the 2017 paradise papers, which revealed a tax perk available to the very wealthy.69 lewis hamilton, a british formula one racing star, purchased a jet for $27 million—a “candy-apple-red bombardier challenger 605 with armani curtains.”70 he owed $5.2 million in sales taxes (called value-added taxes in europe and elsewhere). unlike common consumer purchases, the wealthy can avoid paying these sales taxes on their jets entirely. mr. hamilton’s jet was briefly parked in the isle of man, a tax haven, and registered there. as a result, his $5.2 million tax liability was reduced to $0. finally, the canadian government has held hearings to investigate a controversy whereby wealthy canadians paid no income taxes on their wealth that they had “gifted” to a corporation based in the isle of man.71 the tax plan, which was supported by legal opinions from a canadian and isle of man tax lawyer, involved transferring canadian income to the offshore corporation. because the monies were allegedly gifted, they were subject to the isle of man’s zero tax rules. at the time of this writing, audits and litigation remain underway.72 tax havens contribute to significant revenue losses in many countries. according to a recent working paper that was supported by internal revenue service (i.r.s.) data, the united states loses an estimated $175 billion in revenue per year due to its inability to track the top 1% of earners who engage in tax avoidance.73 this revenue loss forces the i.r.s. to audit more low and middle-income taxpayers, further reducing their after-tax income and amplifying income inequality.74 notably, an i.r.s. data leak revealed that many of the wealthiest individuals in the united states pay little to no taxes on their multi-billion dollar fortunes, largely because capital gains are not taxed until the stocks are sold.75 in addition to the legal use of tax havens by the rich, data leaks reveal that illegal offshore tax evasion may be more extensive than previously thought. as will be discussed, there is some social science evidence—whereby leaked materials were matched with real taxpayers—that suggests many wealthy individuals and families in western democracies engage in illegal offshore tax evasion. 69 see ryan chittum & juliette garside, offshore gurus help rich avoid taxes on jets and yacht, int’l consortium investigative journalists (nov. 6, 2017), https://www.icij.org/investigations/paradisepapers/offshore-gurus-help-rich-avoid-taxes-jets-yachts/ [https://perma.cc/78ah-3ngb]. 70 id. 71 see house of commons, the canada revenue agency, tax avoidance and tax evasion: recommended actions, rep. of the standing comm. on fin., 42d parl. (1st sess., oct. 2016). 72 see harvey cashore, mps braced for battle with global accounting firm over naming wealthy canadians behind offshore tax shelters, can. broad. corp. (may 19, 2021), https://www.cbc.ca/news/politics/kpmg-isle-ofman-tax-dodge-shelter-1.6031057 [https://perma.cc/9gfs-24m9]. 73 see guyton et al., supra note 36, at 4. 74 the i.r.s. is four times more likely to audit an individual who has applied for the earned income tax credit, a refundable tax credit that supports very low incomes, than taxpayers who earn $400,000 or more per year. see id. at 3. see also joel slemrod, cheating ourselves: the economics of tax evasion, 21 j. econ. persp. 25 (2007) (discussing how decline in i.r.s. enforcement likely increases tax evasion and how “the rich avoid, and the poor evade taxes” because wealthy individuals have resources to engage in tax planning). 75 see jesse eisinger et al., the secret irs files: trove of never-before-seen records reveal how the wealthiest avoid income tax, propublica (june 8, 2021), https://www.propublica.org/article/the-secret-irs-filestrove-of-never-before-seen-records-reveal-how-the-wealthiest-avoid-income-tax [https://perma.cc/6tsg-rgbv] (noting that jeff bezos and elon musk paid no u.s. federal taxes in some years despite adding billions to their fortunes from stock appreciation). under u.s. tax law, assets that appreciate in value are not taxed unless there is a “realization event,” such as a sale of the stock. see i.r.c. § 1001. wealthy individuals who need money to spend typically take out a loan secured against the collateral of their stock holdings; this avoids a stock sale and taxable capital gains. https://www.propublica.org/article/the-secret-irs-files-trove-of-never-before-seen-records-reveal-how-the-wealthiest-avoid-income-tax https://www.propublica.org/article/the-secret-irs-files-trove-of-never-before-seen-records-reveal-how-the-wealthiest-avoid-income-tax columbia journal of tax law [vol: 13:45 58 prior to the data leaks, the offshore world was shrouded in secrecy. researchers traditionally estimated offshore tax evasion indirectly by analyzing matters like cross-border financial flows and relying on data from sources such as the bank of international settlements.76 now equipped with real-world data from the tax haven data leaks, researchers analyzed scandinavian taxpayers with a new methodology that suggests the traditional approach may be flawed.77 the new approach estimates much higher revenue losses from offshore tax evasion.78 the authors devised a novel way to test under-reporting of income and wealth by ultrahigh-net-worth individuals and concluded that the top 0.01% of the wealthiest households in scandinavia illegally evade taxes on roughly 25% of their wealth.79 prior studies have shown that the “regular rich” in the top 1% evade 5% of their income taxes. the general population, in contrast, is thought to evade only 0.6% of their taxes via offshore investments.80 the paper’s data drew on two key tax haven data leaks. the first set of data was taken from hsbc switzerland in 2007 and contained the names and bank records of 30,000 taxpayers. it is known as the falciani list—after hervé falciani, the bank employee who initially obtained the list—or, alternatively, the lagarde list—after christine lagarde, the french minister of finance who later received the list.81 the french government shared it with governments around the world, including the united states and various scandinavian countries. unusually, this list did not just specify the owners of bank accounts; it also set out the beneficial owners of business entities, like corporations, that in turn owned the bank accounts. the second set of data was obtained from the panama papers, which also revealed undisclosed offshore accounts maintained by ultra-wealthy scandinavians. working with the study’s authors, tax authorities from denmark, sweden, and norway matched the secret bank accounts to actual taxpayers in their countries. after a lengthy investigation, the danish and norwegian tax authorities concluded that 90-95% of taxpayers on the lagarde list had not reported, or paid taxes on their income.82 the governments took the position that this non-reporting was a crime. the study also found that, in many cases, the wealthiest members of society were the real problem: the top 0.01% (in this case, individuals with $45 million and over in wealth) was thirteen times more likely to hide assets in hsbc switzerland than the bottom half of the top 1% (individuals with $2–3 million in wealth).83 in other words, 76 see collin, supra note 5 (noting that bis data on offshore accounts that has been provided by banks is not reliable because banks only report the “immediate counterparty” that includes corporations based outside of tax havens). 77 see jannick damgaard et al., what is real and what is not in the global fdi network? (int’l monetary fund, working paper no. 19/274, 2019); gabriel zucman, the missing wealth of nations: are europe and the u.s. net debtors or net creditors?, 128 q. j. econ. 1321 (2013); lukas menkhoff & jakob miethe, tax evasion in new disguise? examining tax havens’ international bank deposits, 176 j. pub. econ. 53 (2019). 78 see annette alstadsæter et al., tax evasion and inequality, 109 am. econ. rev. 2073, 2074–75 (2019). 79 id. 80 see id. at 2093. 81 see patrick radden keefe, the bank robber, new yorker (may 23, 2016), https://www.newyorker.com/magazine/2016/05/30/herve-falcianis-great-swiss-bank-heist [https://perma.cc/hha9t3l5]. 82 see alstadsæter et al., supra note 78, at 2078. 83 see id. at 2083. the authors also mention that 14% of the top 0.01% of the wealthiest households disclosed assets in a tax amnesty program offered by scandinavian governments between 2009 and 2015. these tax dodgers, on average, hid almost one-third of their wealth, which is consistent with the study’s finding that they avoided taxes on 40% of their wealth. 2021] secrets of the panama papers 59 ultra-high-net-worth taxpayers committed criminal tax evasion at a much higher rate than the merely rich. the study is surprising because prior research has shown scandinavian countries have some of the highest taxpayer compliance rates in the world.84 if criminal tax evasion is so prevalent among ultra-high-net-worth scandinavian individuals, it could be even worse in most other countries. in fact, this is what the study’s authors concluded in an earlier analysis of data on bank account deposits from the bank for international settlements (the data did not cover securities, like shares, in which most tax haven wealth is found).85 this data is probably less reliable than tax haven data leaks, but nevertheless, it is helpful in estimating the frequency of illegal activity. through this earlier analysis, the authors estimate that tax havens hold hidden wealth equal to about 10% of global gross domestic product.86 in the united states, great britain, france, and spain, the ultra-high-net-worth households (that is, the wealthiest 0.01%) hide approximately 3040% of their wealth in tax havens.87 as mentioned, a study suggests that taxing the top 1% of u.s. income earners would increase tax revenue by $175 billion per year.88 these findings are consistent with a 2018 study that reviewed taxpayer behavior in colombia and found that the wealthiest 0.01% are twenty-four times more likely to be named in the panama papers than the wealthiest 5%.89 two-fifths of the top 0.01% of income earners disclosed illegal offshore assets after a voluntary disclosure program was announced, with a 900% increase in such disclosures after the release of the panama papers.90 again, the richest of the rich were far more likely to stash their monies offshore than other well-off taxpayers. some social science analysis to date suggests that many of the wealthiest members of society have hidden a portion of their fortunes offshore illegally where it grew tax-free, potentially for generations. the existence of two de facto financial systems—a domestic system for average taxpayers and a global, offshore system for wealthy taxpayers—exacerbates income inequality. d. multinational firm paradise in addition to criminals and millionaires, the offshore world is a paradise for multinational firms legally to avoid an estimated $240 billion in taxes per year.91 this section discusses how governments exacerbate income inequality by allowing companies to take advantage of tax 84 see henrik jacobsen kleven, how can scandinavians tax so much?, 28 j. econ. persp. 77, 92–95 (2014) (discussing cultural and political factors that encourage high taxpayer morale and compliance). 85 see annette alstadsæter et al., who owns the wealth in tax havens? macro evidence and implications for global inequality, 162 j. pub. econ. 89 (2018). 86 see id.; see also gabriel zucman, the hidden wealth of nations 34-42 (2015). 87 the study also revealed that many of the wealthiest individuals in russia, venezuela, saudi arabia, and the united arab emirates stash much greater amounts offshore. see alstadsæter et al., supra note 85, at 95. 88 see guyton et al., supra note 36, at 4. the authors suggest that increasing i.r.s. resources would support tax administration at the top of the income distribution. see id. at 5. 89 see juliana londoño-vélez & javier ávila-mahecha, can wealth taxation work in developing countries? quasi-experimental evidence from colombia 4 (working paper no. 482, 2018). 90 see id. at 5. 91 see oecd, addressing base erosion and profit shifting 38 (2013). see also javier garcia-bernardo & petr janský, profit shifting of multinational corporations worldwide (int’l ctr. for tax and dev., working paper no. 119, 2021) (relying on oecd data, estimating multinational corporations shifted roughly $1 trillion in profits to avoid between $200 and $300 billion in taxes). columbia journal of tax law [vol: 13:45 60 havens.92 these governments pursue national interest objectives ostensibly to support companies in their efforts to compete in a global market-place.93 particularly since the 1980s, governments have been engaged in a “race to the bottom” as they have generally reduced corporate income tax rates and given other tax breaks to multinational firms.94 international tax rules for corporations encourage three main income inequality outcomes.95 first, the race to the bottom redistributes government tax burdens away from mobile capital to be focused exponentially more on immobile workers, leading to overall less after-tax income for laborers. second, the reduced taxation on multinational firms enhances their after-tax profits, leading to a greater return for shareholders (that is, investors or capital owners).96 because capital owners tend to have higher incomes, the use of tax havens enhances the income and wealth of these high incomes while lowand middle-income taxpayers generally cannot avail themselves of such benefits.97 third, the inability to tax multinational firms effectively leads to revenue losses and a corresponding reduction in government services which harms middleand low-income earners the most because they lose out on government services they would otherwise enjoy. governments were generally content to let this course of events continue until the global financial crisis of 2008 that left many governments in greater need for tax revenues from any possible sources. in 2013, the oecd and the g-20 began the most ambitious international tax reform effort in history called base erosion and profit shifting (“beps”).98 apart from some important administrative agreements like country-by-country reporting (“cbcr”) (discussed in part iii.a) and a global agreement on minimum corporate income tax rates (discussed in part iii.b), the beps reforms have resulted in modest changes to the system while leaving most of its elements untouched.99 92 while this article focuses on income inequality, international tax can promote other forms of inequality, such as gendered outcomes. see, e.g., kathleen lahey, missing women: gender-impact analysis and international taxation, in globalization and its tax discontents: tax policy and international investments 153, 163 (arthur cockfield ed., 2010) (discussing how tax-haven based tax incentives for multinational corporations lead to revenue losses that disproportionately harm females). 93 critics of this view maintain that the use of the “competitiveness” concept is not grounded in any substantive tax policy and should not therefore be used as a guiding principle to develop international tax policy. paul r. mcdaniel, territorial vs worldwide international tax systems: which is better for the u.s.?, 8 fla. tax rev. 283, 301 (2007) 94 see r. altshuler and h. grubert, the three parties in the race to the bottom: host governments, home governments and multinational companies, 7 fla. tax rev. 153 (2005). 95 see arthur j. cockfield, purism and contextualism with international tax law analysis: how traditional analysis fails developing countries, ejournal tax rsch. 199, 206-13 (2007). 96 see peter diestch, catching capital: the ethics of tax competition (2015) (discussing how tax competition worsens income and wealth inequality and undermines a country’s fiscal autonomy). who should bear the burden of corporate tax remains academically contentious as the tax burden may be imposed on shareholders, workers, or other stakeholders of the firm. see li liu and rosanne altshuler, measuring the burden of the corporate income tax under imperfect competition, 66(1) nat’l tax j. 215 (2013). 97 see thomas r tørsløv, ludvig s wier & gabriel zucman, the missing profits of nations (nat’l bur. of econ. rsch. working paper no. 24701, 2020) (discussing how multinational firms use tax havens to shift profits out of high tax countries to benefit the investor class). 98 see oecd, beps project (2013); see also rifat azam, ruling the world: generating international tax norms in the era of globalization and beps, 50 suffolk u. l. rev. 517 (2017). 99 see arthur j. cockfield, the limits of the international tax regime as a commitment projector, 33 va. tax rev. 59-113 (2013); see also arthur j. cockfield, tax wars: how to end the conflict over taxing global digital commerce, 17 berkeley bus. l.j. 353, 358-63 (2020) [hereinafter cockfield, tax wars]. https://scholar.google.com/scholar?oi=bibs&cluster=16056914285672605488&btni=1&hl=en https://scholar.google.com/scholar?oi=bibs&cluster=16056914285672605488&btni=1&hl=en 2021] secrets of the panama papers 61 in particular, the paradise papers of 2017 contained data that revealed tax planning efforts by corporate taxpayers.100 the documents came from the internal files of an offshore law firm called appleby, mainly based in bermuda, and an offshore service provider named estera.101 offshore service providers, also called offshore financial centers, provide financial and other services to foreign investors. these services include forming offshore corporations and other entities and drafting contracts between these entities and the investor. in this case, the files demonstrated how appleby’s lawyers as well as staff members at estera helped corporate taxpayers use tax havens to reduce their global tax liabilities. the leak showed how, four years after the beps process was initiated, the offshore world continued to offer tax perks to apple, nike, uber, and other multinational corporations. in some cases, these corporations used tax haven services to engage in aggressive tax avoidance techniques, including assisting these taxpayers in legally exploiting gaps between different tax laws around the world (a phenomenon referred to as “international tax arbitrage”).102 the paradise papers showed how the ownership of all-important intangible assets—such as the rights to nike’s swoosh trademark, uber’s taxi-hailing app, and medical patents covering such treatment options as botox—could all be traced to a five-story office block in bermuda occupied by appleby and estera.103 similarly, the ownership of facebook’s user database and rights to use its platform technology was held by companies in a small office building, used by appleby and estera, on grand cayman, a caribbean tax haven.104 in other words, the legal ownership of the database was traced to shell corporations that had registered addresses at this location. multinational firms like facebook create tax plans that base or transfer intangible assets such as databases, copyrights, or patents within an offshore corporation so that cross-border royalties will be paid to the tax-haven-based company and taxed at the tax haven’s income tax rate, which is normally zero.105 these intangible assets are mobile in the sense their ownership can be shifted “on paper” to tax havens while still complying with all tax laws.106 100 see icij, about the paradise papers investigation, int’l consortium investigative journalists (nov. 5, 2017), https://www.icij.org/investigations/paradise-papers/about/ [https://perma.cc/v8f2-slpr]. 101 the two businesses operated together under the appleby name until estera became independent in 2016. like the panama papers, the german newspaper süddeutsche zeitung first obtained the records then shared them with the international consortium of investigative journalists and its media partners, including the new york times, bbc in the united kingdom, le monde in france, and cbc in canada. see id. 102 see simon bowers, nike shifted billions in profits from europe to tax-free bermuda, paradise papers leak shows, int’l consortium investigative journalists (nov. 4, 2017) [hereinafter bowers, nike]; simon bowers, leaked documents expose secret tale of apple’s offshore island hop, int’l consortium investigative journalists (nov. 6, 2017), https://www.icij.org/investigations/paradise-papers/apples-secret-offshore-island-hoprevealed-by-paradise-papers-leak-icij/ [https://perma.cc/h4bb-m7l2] [hereinafter bowers, leaked documents]. 103 see id. 104 see id; see also matthew gardner, amazon in its prime: doubles profits, pays $0 in federal income taxes, inst. tax’n econ. pol’y (feb. 13, 2019) (describing amazon’s avoidance of u.s. federal income taxes). 105 see arthur cockfield & david kerzner, international taxation core concepts 58-62, 141-47 (2d ed., 2017). 106 see subpart f 951-965 i.r.c § 2017 (providing for current (accrual) taxation of foreign source passive income). co-ownership or co-development of intellectual property by entities or individuals within tax havens allows taxpayers to avoid the application of subpart f in some contexts. see id. columbia journal of tax law [vol: 13:45 62 the paradise papers revealed how apple, the world’s largest multinational firm measured by market capitalization,107 aggressively sought out new offshore tax savings after suffering bad media about prior tax plans. at an earlier point, apple deployed a form of international tax planning with the memorable name “double irish with a dutch sandwich.” the plan involved setting up two corporations in ireland (a tax haven) so that neither corporation was a resident anywhere in the world under irish tax law, and then siphoning off the untaxed income to another corporation residing in the netherlands, another tax haven.108 through its double irish with a dutch sandwich tax plan, apple reduced its rate on profits outside of the united states to 5% in most years, dipping to 0.005% in others.109 the paradise papers revealed that, in light of the bad media surrounding the double irish with a dutch sandwich, apple restructured its global tax plan.110 the documents showed how apple shifted the two irish corporations to jersey, a tax haven located off the coast of great britain.111 one of these corporations was apple sales international and had been apple’s biggest profit-maker, generating $120 billion in revenue or almost 60% of apple’s global earnings.112 as a result of these moves, apple managed once again to reduce its global tax liability greatly. similarly, a data leak known as luxleaks revealed how luxembourg, a land-locked european tax haven, engages in predatory tax competition by offering private rulings to multinational corporations to reduce their global tax liabilities legally.113 luxleaks was derived from a database taken from pricewaterhousecoopers and included the accounting firm’s application for private rulings that were granted to its corporate clients by luxembourgian tax officials, although these rulings were never provided to any foreign tax authorities. these rulings 107 see statistica, the 100 largest companies in the world by market capitalization in 2021 (2021), https://www.statista.com/statistics/263264/top-companies-in-the-world-by-market-capitalization/ [https://perma.cc/f84p-9tal]. 108 see jeremy kahn, google’s ‘dutch sandwich’ shielded 16 billion euros from tax, bloomberg (jan. 2, 2018), https://www.independent.co.uk/news/business/news/google-alphabet-tax-netherlands-dutch-sandwichbermuda-ireland-a8138466.html [https://perma.cc/elh8-b3nq]. 109 the tax plan was also (unsuccessfully) attacked by european commission (ec) regulators. the ec alleged apple’s plan was an illegal subsidy (more technically, illegal state aid) that improperly reduced irish tax revenues by around $16 billion. the european commission calculated the tax rate for one of apple’s irish companies for one year to be 0.005%. while a court initially supported the ec, the european general court overturned the decision and ruled in favor of apple. see case t-778/16, ireland v. comm’n, ecli:eu:t:2020:338 (july 15, 2020); case t-892/16, apple sales int’l v. comm’n, ecli:eu:t:2020:338 (july 15, 2020). 110 see id. 111 the leaked documents allowed journalists to trace apple’s money trail to a building used by appleby and estera in jersey, a tax haven and u.k. crown dependency with zero corporate taxes for foreign companies. see jessie drucker & simon bowers, after a tax crackdown, apple found a new shelter for its profits, n.y. times (nov. 6, 2017), https://www.nytimes.com/2017/11/06/world/apple-taxes-jersey.html [https://perma.cc/j5w8-w2lq]; bowers, nike, supra note 102. 112 see bowers, leaked documents, supra note 102. 113 see matthew caruana galizia et al., explore the documents: luxembourg leaks database, int’l consortium investigative journalists (dec. 9, 2014), http://www.icij.org/project/luxembourg-leaks/exploredocuments -luxembourg-leaks-database [https://perma.cc/u7eh-6e85]. see also omri y. marian, the state administration of international tax avoidance, 7 harv. bus. l. rev. 1, 6–8 (2017) (discussing revelations from luxleaks, which revealed luxembourg was undermining international tax system by providing significant tax breaks to multinational firms); b. huesecken et al., effects of disclosing tax avoidance: capital market reaction to luxleaks (university of cologne working paper, 2018), http://doi.org/10.2139/ssrn.2848757 [https://perma.cc/g38a-u96d] (providing big data analysis to show how firms had positive abnormal returns after being identified in luxleaks). 2021] secrets of the panama papers 63 offered tax breaks that allowed the companies legally to reduce global tax liabilities in ways that were not transparent to other tax authorities. luxleaks spurred international tax transparency reforms to encourage governments to exchange tax rulings with each other (see part iii.a). e. summary over the course of the last century, tax benefits offered by the offshore world increasingly privileged the interests of three main groups: criminals, wealthy taxpayers, and multinational corporations. criminals benefit from the opacity of the offshore world where offshore entities are deployed to launder dirty money and mask the identity of beneficial owners (that is, the human being who actually owns assets held by the entities). trillions of dirty dollars flow through the offshore system each year, primarily as a result of drug trafficking and government corruption. for some lowand middle-income countries, corrupt elites and politicians steal foreign aid and hide the funds within secret tax haven bank accounts, exacerbating existing inequalities and, at times, leaving citizens with insufficient resources like food. from a more global perspective, wealthy taxpayers, especially the new gilded class of ultrahigh-net-worth individuals with $50 million or more, increasingly take advantage of tax havens to engage in tax planning. if the taxpayers have global income, then a portion of this income is diverted to tax havens where it remains untaxed. there is also some social science evidence based on the tax haven leaks that shows ultra-high-net-worth individuals are far more likely to use tax havens to engage in the criminal offense of offshore tax evasion. by allowing taxpayers to stash a significant portion of their fortunes offshore, potentially for generations, tax havens may have fueled the rise of ultra-high-net-worth families by allowing the returns on the hidden monies to escape taxation altogether. finally, multinational corporations have long benefited from the rules that allow them legally to allocate global profits to tax havens where these profits are normally taxed at a rate of zero, reducing overall global tax liabilities and enhancing returns for shareholders. these shareholders—who tend to have higher incomes than average taxpayers—benefit from higher after-tax returns when they receive more dividends (that is, the multinational corporation distributes its enhanced after-tax profits to its shareholders) or when their share price appreciates (which occurs when firms retain earnings, instead of, for example, distributing them via dividends). in addition, the race to the bottom—whereby corporate income tax burdens have gradually been reduced for mobile capital over the past half-century—leads to revenue losses, a reduction in government services, and a greater focus on taxing immobile labor, thus reducing the after-tax return for workers. over time, such tax breaks have enhanced income inequality between wealthier shareholders (capital owners) and workers. iii. legal and policy reforms this part examines some of the main legal and policy responses to address challenges created by the offshore world, including the fact that it encourages income and wealth inequality. columbia journal of tax law [vol: 13:45 64 a. tax transparency initiatives to counter multinational firm tax avoidance while there are many different proposed solutions, this section briefly touches on tax transparency measures used to inhibit aggressive tax avoidance.114 there is normally an information imbalance between taxpayers and tax authorities. while taxpayers know exactly how they calculate their tax liabilities, tax authorities often know little to nothing, at least with respect to business or illegal income. as a result, it can be hard for these tax authorities to detect taxpayers’ financial activities that do not comply with tax laws. the solution: pass laws or policies to force the taxpayer or some third party to provide more and better information to tax authorities, so they can accurately assess a taxpayer’s tax liability.115 as mentioned, the 2008 global financial crisis and the subsequent financial distress felt by many governments made them take a closer look at tax revenue losses associated with noncompliant aggressive international tax planning. in 2013, the oecd and g-20 launched the beps reforms to counter this planning.116 one of the main innovations to come out of the beps project was a proposal to force multinational firms to disclose tax and other payments in every country where they operate: the new country-by-country reporting (cbcr) system. before this reform took place, most countries, such as the united states, did not force their multinational firms to disclose tax dealings with other countries (although securities laws sometimes prompt public companies to disclose geographic earnings, which can provide some information to tax authorities concerning foreign operations). under cbcr, participating governments, including the united states, are supposed to pass domestic tax laws that force multinational firm taxpayers to disclose tax payments in every country where they operate, which should assist with transfer pricing audits.117 under cbcr, large multinational firms with over eur750 million (or $850 million) in annual global income must disclose all tax and similar payments they have made to every country where they operate.118 now, these large firms provide detailed information on all tax payments to the parent company’s jurisdiction, and this information will be shared with tax authorities in all countries where the firm operates. as mentioned, luxleaks revealed that a government was giving private tax rulings to corporate taxpayers that allowed them to reduce global tax liabilities.119 in response to luxleaks, governments have, under beps action 5, additionally promised they will exchange tax rulings to make this system more transparent. under this reform, governments have agreed to provide tax rulings, or summaries of tax rulings, to their exchange partners.120 in this way, governments will 114 see arthur j. cockfield, international tax transparency, 1 persp. tax l. & pol’y 1 (2020). 115 see leandra lederman & joseph dugan, information matters in tax enforcement, 2020 byu l. rev. 145 (2020) (describing how third-party information flows continue to play critical role in tax enforcement); petr jansky et al., the corporate tax haven index: a new geography of profit shifting (ies, working paper, 2019) (discussing need for better information concerning corporate foreign profits). 116 see oecd, supra note 91. 117 see arthur j. cockfield & carl macarthur, country-by-country reporting and commercial confidentiality, 63 can. tax j. 627 (2015). for a discussion of how cbcr works, see generally oecd, countryby-country reporting: handbook on effective tax risk assessment (2017); oecd, handbook on effective implementation (2017). 118 see cockfield & macarthur, supra note 117, at 636-637. in the u.s., cbcr is implemented through section 6038 of the internal revenue code as well as accompanying regulations. 119 see the discussion accompanying note 113. 120 see oecd, countering harmful tax practices more effectively, taking into account transparency and substance (action 5 2015 final report, 2015). 2021] secrets of the panama papers 65 have more information concerning how their multinational firms use tax havens such as luxembourg to reduce taxes owed. b. other global tax agreements to counter firm tax avoidance in addition to transparency measures, the beps reforms led to other initiatives to inhibit the ability of multinational firms to avoid taxes.121 in particular, in 2021 over 130 countries, including the united states, agreed to a framework to implement two important measures.122 first, new tax rules will apply to large corporations with over eur750 million in annual global income that have cross-border sales of digital goods and services.123 under the proposed approach, firms such as facebook and google will have to pay taxes to countries where their customers are located.124 this is an entirely new approach to taxing global income because traditional rules and principles emphasize the need to tax cross-border profits where value is added to a cross-border transaction, which was normally where the head office of the firm was based.125 the rule change was motivated by the view that, under the older rules, governments were unable to tax significant profits despite the fact that millions of their consumers contributed to this profit-making.126 the united states, which serves as a base for many of the world’s largest technology firms, is likely disadvantaged by the proposed new rules (since its firms could pay more tax in foreign countries) but nonetheless signed the global agreement, mainly to end a brewing “tax war” as countries developed new uncoordinated taxes like france’s digital services tax to tax the technology firms.127 if the new approach is ultimately implemented, it would likely reduce the ability of these firms to shift cross-border profits to tax havens because consumer countries would now be able to tax the profits. 121 see ruth mason, the transformation of international tax, 114 am. j. int’l l. 353 (july 2020) (claiming, in contrast to critics of oecd beps project, that international tax law and reform has been fundamentally changed); eduardo a. baistrocchi, the international tax regime and global power shifts, 40 va. tax rev. 219, 271 (2021) (describing how global political developments are fundamentally changing international tax reform processes). 122 see paul hannon & kate davidson, u.s. wins backing for a global minimum tax, wall st. j. (july 1, 2021); daniel shaviro, what are minimum taxes, and why might one favor or disfavor them? 40 va. tax rev. 395 (2021) (supporting minimum taxes while cautioning against apparent weaknesses); yariv brauner, thinking like a source state in a digital economy, 18 pitt. tax rev. 225 (2021) (advocating reforms to u.s. taxation to strengthen source and residence-based taxation through measures akin to minimum tax proposals). 123 see oecd, statement on a two pillar solution to address the tax challenges arising from digitalisation of the economy (july 1, 2021). 124 a formula will be used with factors such as the amount of sales taking place within a consumer to determine global tax liabilities instead of using the traditional arm’s-length transfer pricing approach. for discussion, see michael p. devereux et al., residual profit allocation by income (oxford univ. ctr. for business taxation working paper 19/01, 2019). for support, see cockfield, tax wars, supra note 99, at 389-94. 125 see arvid a. skaar, permanent establishment: dilution of a tax treaty principle 24-38 (1991). 126 see oecd, addressing the tax challenges of the digital economy, action 1: final report 3 (2015); see also klaus vogel, worldwide vs. source taxation of income – a review and re-evaluation of arguments, 11 intertax 393, 400 (1988). vogel credits georg von schanz with focusing on the need to support taxation by the country where consumers reside. von schanz proposed that the source state should levy its tax at three-quarters of the normal rate and proposed that the residence state should levy its tax at one-quarter the normal rate. see george von schanz, zur frage der steuerpflicht, 9 finanzarchiv 356 (1892). 127 the united states threatened trade sanctions against france due to its digital services tax until the countries reached a tentative settlement. see luke baker, france, u.s. agree on method for global digital-tax reform, globe & mail (jan. 24, 2020), at b3. for a comprehensive discussion, see cockfield, tax wars, supra note 99, at 358-79. columbia journal of tax law [vol: 13:45 66 second, governments agreed to accept a minimum corporate income tax rate of 15% for cross-border profits.128 this move followed the enactment of minimum taxes by the united states and other governments in recent years. under the u.s. approach, minimum taxes are applied both to inbound foreign direct investment (via the base erosion and anti-abuse tax (“beat”)) and outbound foreign direct investment (via the global intangible low taxed income (“gilti”)).129 in a typical global structure, a related party within a multinational firm is situated in a low or nil tax jurisdiction, so the income inclusion will be subject to low or nil tax rates.130 beat denies expense deductions for payments to tax-haven-based entities such as corporations that are not subject to a minimum tax.131 gilti seeks to ensure that u.s. multinational corporations are taxed at a minimum rate on their outbound transactions with other countries.132 the purpose of gilti is to make sure that the united states can continue to tax its multinational firms’ foreign profits even if a taxpayer tries to shift these profits to a tax haven (e.g., a taxpayer may try to shift ownership of intellectual property such as a patent to a tax haven corporation so that future crossborder royalty payments will be taxed by the tax haven government, which normally does not have an income tax). under the new global tax agreement, if participating countries adopt minimum taxes like beat or gilti then the other signatories must accept the minimum tax rate.133 for the first time, these governments agreed in principle to give up political control over aspects of their income tax systems such as corporate tax rates.134 overall, minimum taxes are intended to thwart the ability of multinational firms to divert profits to tax havens and away from countries like the united states 128 see arthur cockfield, globalization is alive and well and made healthier by the worldwide minimum tax agreement, toronto star (july 30, 2021), https://www.thestar.com/business/opinion/2021/07/31/globalizationis-alive-and-well-and-made-healthier-by-the-worldwide-minimum-tax-agreement.html [https://perma.cc/396glgvv]. but see wei cui, will new global tax co-operation benefit the world?, globe & mail (july 11, 2021) (claiming global agreement does not really create minimum corporate tax). 129 for discussion, see cockfield, tax wars, supra note 99, at 370-71. 130 see id. 131 the united states adopted beat, which became effective on january 1, 2018, as part of the tax law known as the tax cuts and jobs act. beat applies to u.s. resident corporations and permanent establishments of non-residents that are members of a multinational group with over $500 million in annual sales (over a three-year period). if a tax liability arises as a result of beat, then it is payable in addition to any liabilities for regular corporate income. if applicable, beat applies at a rate of 10% of the taxpayer’s ‘modified taxable income’ (5% for 2018 and 12.5% after 2025), less a portion of certain tax credits. see id. 132 it applies corporate tax on the excess of a shareholder’s net cfc income over an ordinary return (that is, a deemed tangible income return). under this approach, an excess return beyond the deemed tangible income return is normally considered gilti, regardless of the actual character of the earnings. this gilti is then subjected to a 10.5% tax rate—as long as no tax is paid abroad. to the extent gilti has been taxed at a rate of that exceeds 13.125%, then no u.s. tax will be applied. the innovation here arises from the rule’s initial focus on returns generated by tangible assets to arrive at a measure of ostensible returns generated by intangible assets. unlike traditional cfc rules, gilti seeks to impose a minimum tax on foreign-source profits—regardless of the characterization of such income as being active or passive. see id. gilti has been criticized on the basis that it only ensures roughly half the tax burden on exports, compared to tax rates imposed on domestic activities. see sanchirico, supra note 23. 133 see oecd, supra note 120. 134 after world war i, countries began to negotiate bilateral tax treaties to smooth over the problems caused by the interaction of their different national tax systems—without ever mandating the same income tax rates for treaty partners. and despite over two decades of reform efforts, european union countries have never agreed on adopting the same corporate income tax base or rates. see michael devereux & clemens fuest, corporate income tax coordination in the european union, 16(1) transfer: eur. rev. lab. & rsch. 23 (2010), https://doi.org/10.1177/1024258909357699 [https://perma.cc/mes4-b3uw]. https://doi.org/10.1177/1024258909357699 2021] secrets of the panama papers 67 that impose corporate income taxes: cross-border profits should be subject to at least a 15% tax rate, which should enable governments to raise more tax revenues. if these initiatives are implemented and work as planned, they would inhibit the race to the bottom that occurs when governments compete for cross-border capital by continually lowering their corporate income tax rates. such rate-lowering reduces global tax burdens on multinational firms, which benefits mainly the firm’s shareholders who tend to have higher incomes. to the extent the minimum taxes increase firm tax liabilities, this will have a redistributive effect by increasing tax burdens on these shareholders. in turn, this could also relieve the pressure to focus taxation on immobile factors of production like labor. moreover, if minimum tax measures raise more revenues, governments will be in a better position to support more vulnerable citizens. c. tax transparency measures against offshore tax evasion assume joe criminal lives in brooklyn and makes $100 million, held in cryptocurrencies, by selling illicit drugs on the dark web. he converts his cryptocurrencies to u.s. dollars and deposits them in an offshore corporation based in a tax haven. joe has engaged in the criminal offense of offshore tax evasion by not disclosing these transfers or any resulting investment income to the u.s. government.135 the u.s. government will probably never be able to find out about joe’s criminal activities unless they can gain access to information concerning joe’s tax haven dealings. one way to obtain this information is to force the tax haven government to provide crossborder tax information concerning u.s. citizens or residents to the u.s. government. while governments have negotiated tax treaties to exchange limited cross-border tax information with each other since after world war i, modern measures date back to the late 1990s when the oecd tried to inhibit “harmful tax competition” and created a blacklist of tax haven countries.136 the oecd identified a lack of effective tax information sharing from these tax havens to oecd countries as the main culprit. in 2002, the oecd created a model tax information exchange agreement (tiea), which envisioned agreements between oecd countries and tax haven countries.137 but the “information on request” basis of this model was soon found deficient:138 the resident country usually does not have sufficient information to make the request in the first place.139 beginning around 2007 the revelation of tax information leaks from liechtenstein and swiss banks turned the world’s attention to revenue losses associated with offshore tax evasion. the u.s. senate held hearings that influenced the passing of a law that came to be known as the foreign account tax compliance act (fatca), which seeks to force foreign banks to divulge 135 see supra note 13 and accompanying text. 136 oecd, harmful tax competition, supra note 21. for discussion, see joann m. weiner & hugh j. ault, the oecd’s report on harmful tax competition, 51 nat’l tax j. 601, 608 (1998) (concluding that project is important first step in inhibiting race to bottom where countries keep lowering income tax rates on corporations and focus heavier taxation on workers). 137 see oecd, model agreement on exchange of information for tax matters (paris, 2002). 138 for discussion, see david kerzner & david w. chodikoff, international tax evasion in the global information age 316 (2016). 139 the oecd model protocol to the tiea, published in 2015, contemplates the addition of automatic and spontaneous tax exchanges. the protocol is available at https://www.oecd.org/ctp/exchange-of-taxinformation/model-protocol-tiea.pdf [https://perma.cc/2dth-bbjd]. columbia journal of tax law [vol: 13:45 68 information concerning the deposits of “u.s. persons,” which includes tax residents in addition to u.s. citizens.140 from 2013 onward, the oecd and the g-20 emphasized that the automatic exchange of tax information needed to be the new global standard, and this standard is being implemented through the common reporting standard (crs).141 the crs mandates an “internationally agreed standard” by which countries require their financial institutions to obtain information on accounts held by non-residents and—under applicable tieas or bilateral treaties—to automatically report that information to the account holders’ local authorities.142 in turn, these tax authorities share this information with their counterparts based in countries where the investors reside.143 armed with this information, tax authorities could check to see if their resident taxpayers had disclosed any income connected to their offshore holdings.144 most developed countries participate in the crs, with the exception of the united states.145 a payee agent or trust agent can therefore operate in the united states without the need to comply with the crs’s mandate to identify beneficial owners of criminal assets that may be derived via money laundering. this is one of the loopholes that undermines the crs.146 140 see foreign account tax compliance act of 2009 (facta), h.r. 3933, 111th cong. (1st sess. 2009). fatca initially failed to be enacted. the legislation was subsequently passed within a large omnibus legislative package that was mainly directed at job creation. see hiring incentives to restore employment act, h.r. 2847, 111th cong. § 501 (2d sess. 2010). the provisions to implement fatca are now contained in sections 1471 to 1474 of the internal revenue code. 141 the main current focus of the oecd is a common standard for participating governments to exchange cross-border tax information to identify whether resident taxpayers are not disclosing offshore accounts to their domestic tax authorities. see oecd, standard for automatic exchange of financial information in tax matters (2014), http://dx.doi.org/10.1787/9789264216525-en [https://perma.cc/99hm-t8mk] [hereinafter oecd, standard for automatic exchange]. 142 id. 143 the proposal had to overcome significant concerns about taxpayer privacy. see, e.g., cynthia blum, sharing bank deposit information with other countries: should tax compliance or privacy claims prevail?, 6 fla. tax rev. 579 (2004). 144 these exchanges are governed by the provisions, including taxpayer privacy protections, within the crs multilateral competent authority agreement, the oecd multilateral convention on mutual administrative assistance in tax matters, and the relevant tiea or bilateral tax treaty (that typically includes an exchange of information provision based on article 26 of the oecd model tax treaty). despite these measures, the increase in the collection and cross-border sharing of taxpayers’ big data raises concerns, including concerns that transferred information (1) will not be protected to the extent provided by the law of the transferring country; (2) may be misused for political purposes, such as helping domestic companies compete against foreign competitors; (3) may be misused to sanction taxpayers for political reasons, which could lead to human rights violations; (4) may be illegally accessed or altered by third parties; and (5) may be inaccurate, which could lead to foreign investigations that target innocent taxpayers. for discussion, see arthur j. cockfield, cross-border big data flows and taxpayer privacy, in ethics & tax’n 379 (robert f. van brederode, ed., 2020). 145 see oecd, signatories of the multilateral competent authority agreement on automatic exchange of financial account information and intended first information exchange date (aug. 12, 2021) (noting that 112 countries, with the exception of the united states, have agreed to implement the crs). 146 another apparent loophole involves setting up structures so that non-residents can use foreign trusts as long as these trusts hold assets outside of the country where the trust is formed; domestic legal implementation of crs normally does not require beneficial owner disclosure in this circumstance. see andres knobel, trusts: weapons of mass injustice? (2017); see also chris jones, tax haven networks and the role of the big 4 accountancy firms, 53 j. world bus. 177 (2018) (describing how tax havens develop illegitimate forms of trust laws to attract investment and system benefits only those who can afford tax planning). https://www.sciencedirect.com/science/article/pii/s1090951617303553 2021] secrets of the panama papers 69 despite this obvious problem, there is evidence that these global transparency initiatives directed at tax havens have reduced investment flows to some parts of the offshore world.147 on the other hand, investors may simply be shifting their monies to tax havens that are not cooperating with the transparency measures.148 d. summary governments have been long aware that tax havens are used to facilitate offshore tax evasion and aggressive international tax avoidance. oecd and g-20 governments have most recently emphasized the need to promote tax transparency so that they can better assess the global licit and illicit earnings by individual taxpayers as well as multinational firms. with respect to international tax avoidance, governments have begun limited efforts to force multinational companies to disclose revenues and profits in every country where they operate, which should give tax authorities more ammunition to audit how these firms shift profits to tax havens. so far, the new cbcr measures apply only to large corporations (that is, those with over $850 million in global revenues). in addition, governments have agreed in principle to adopt a minimum corporate tax rate for these large corporations to inhibit profit shifting to tax havens. with respect to offshore tax evasion, the main global response is the common reporting standard, which contemplates the exchange of taxpayer account information across borders to help tax authorities identify and audit their resident tax cheats. the united states, so far, prefers to rely on its own domestic measures under fatca, instead of engaging in multilateral negotiations via the crs. this has left a glaring loophole in the system because taxpayers can set up cross-border structures with u.s. entities to dodge crs compliance requirements. while the jury is still out, these reforms ought to inhibit the use of tax havens to hide wealth and/or significantly reduce global tax liabilities. accordingly, the reforms should also inhibit the ability of tax havens to encourage income inequality. iv. the way forward this part considers additional legal and policy reforms to inhibit tax haven abuses that lead to income inequality. a. creating a framework to withhold taxes on tax haven investments a cross-border withholding tax on global investments could assist tax authorities in enforcing their tax laws.149 the idea here is to create a modified version of gross withholding taxes 147 see s. beer & coelho s. leduc, hidden treasure: the impact of automatic exchange of information on cross-border tax evasion (2019); see also niels johannesen et al., taxing hidden wealth: the consequences of us enforcement initiatives on evasive foreign accounts, 12 am. econ. j. econ. pol’y 312 (2020); elisa casi et al., cross-border tax evasion after the common reporting standard: game over?, 190 j. pub. econ. 1042 (2020). 148 see niels johannesen & gabriel zucman, the end of bank secrecy?: an evaluation of the g20 tax haven crackdown, 6 am. econ. j. 65 (2014) (describing how, in light of new bank regulations, investors shifted deposits to tax havens that do not comply with international regulations against bank secrecy laws). as subsequently touched on, investors are also increasingly transferring their deposits to domestic bank accounts protected by “onshore” rules within the united states and elsewhere. see part iv.c. 149 see cockfield, supra note 144. columbia journal of tax law [vol: 13:45 70 that are imposed on cross-border payments for global investments within uncooperative tax havens or rogue onshore governments. investments in countries with proper tracking mechanisms for taxing foreign investments will not be subject to the tax. as the new international reforms like the common reporting standard gain steam, a challenge is that certain countries either refuse to participate or agree to the tax exchange initiatives but will not meaningfully implement them. as reuven avi-yonah has discussed, provided that there is one non-participating country, undisclosed investment monies can flow to this outlier.150 his proposed solution calls for the automatic exchange information of bank account information from a tax authority to the home country of the investor. if no automatic exchange takes place, then a tax can be assessed against the transferred assets and/or any subsequent investment income. hypothetically, if joe, a u.s. citizen, deposits $1 million into a bank account based in haven, a non-cooperative tax haven, haven will not share any information with foreign tax authorities, and therefore, there is no automatic reporting of joe’s initial transfer of the money or any subsequent investment income. law and policies could be developed to impose, for example, a 30% gross withholding tax collected by payors (e.g., banks) based in participating jurisdictions. accordingly, any bank in the united states that assisted joe with the transfer would have a legal obligation to withhold and remit $300,000 to the i.r.s. because the money is being sent to haven. this measure ensures tax payment via withholding and provides the government with another source of information to contrast against the taxpayer’s tax filings. building on these views, i previously outlined how tax authorities could administrate such a withholding tax through online technologies such as an extranet.151 b. global financial registry a major challenge is that governments often cannot identify the ultimate (or beneficial) human owners of cross-border investments because corporate laws provide ownership anonymity by permitting business entities to own investments without disclosing the true human owners of these entities. the previously discussed common reporting standard is one effort in this direction as participating countries have agreed to pass laws that mandate the identification of beneficial owners. in recent years, academics and governments have discussed the need for financial registries that mandate the disclosure of beneficial owners of business entities like corporations and legal entities such as trusts and foundations.152 if governments knew who owned what, then they could pursue offshore tax cheats and other global financial criminals. this would also help to stop kleptocrats and others from hiding their ill-gotten gains in an offshore tax haven. as discussed in part iii.b, powerful individuals within low-income countries or failed states manage to pilfer government resources and hide their ownership of any assets by setting up secret offshore bank accounts—then using these accounts to purchase assets such as swiss villas. as revealed by the tax haven data leaks, offshore corporations and trusts were used 150 see avi-yonah, supra note 11, at 1583. 151 see arthur j. cockfield, transforming the internet into a taxable forum: a case study in e-commerce taxation, 85 minn. l. rev. 1171, 1237-44 (2001) [hereinafter transforming the internet]. 152 see, e.g., gabriel zucman, taxing across borders: tracking personal wealth and corporate profits, 28 j. econ. persp. 121, 136-37 (2014) (advocating a “world financial registry” to respond to ongoing increases in offshore tax evasion and aggressive international tax avoidance). 2021] secrets of the panama papers 71 to obscure the real identity of the owners of the underlying assets. this problem contributes to income and wealth inequality. even if one supports the notion of a global financial registry, a contentious issue has arisen surrounding whether governments alone should gain access to this personal financial information or whether members of the public should also be able to do so. observers claim that public access is necessary for individuals to be able to identify problem areas and then hold their governments accountable to pursue the alleged financial criminals.153 a fully searchable public financial registry, however, would be highly problematic because it would overly intrude on taxpayer privacy rights and potentially inhibit global capital flows, reducing overall economic growth. even wealthy taxpayers need to be afforded privacy protections. otherwise, they may not invest in foreign economies even when they could earn a higher return. allowing investors to diversify their investments to achieve the highest returns contributes to global capital productivity (that is, the investment dollars have the biggest impact on returns) and enhances global wealth. nevertheless, a global financial registry accessible only by government tax authorities might be politically feasible. such a registry would help government investigators by addressing the information disadvantage facing governments, namely their inability to identify the human beneficial owners of cross-border investments. additionally, the registry could help governments determine if their resident firms had paid tax on worldwide income. governments might consider inter-government exchange of entity and ownership information if they were provided with sufficient privacy safeguards, including a multilateral taxpayer bill of rights.154 the european union has similarly decided to start with a non-public centralized registry with plans to transition to public registries.155 under this “tiered access” approach, law enforcement is being provided with full access to the registry while members of the public will only have access to limited personal information such as the beneficial owner’s name and country of residence. the goal is to provide law enforcement with accurate and verifiable information concerning investment ownership, which would improve tax enforcement as well as anti-money laundering and anti-terrorist financing efforts. c. addressing the problem of onshoring problematically, powerful governments such as the united states and japan maintain “onshore” laws that offer tax-haven-like benefits via domestic law. for instance, domestic corporate laws can mask beneficial owner identities (that is, the laws hide the ultimate human owner of the asset). according to the 2020 global financial secrecy index published by tax justice network, u.s. laws provide the second-most financial secrecy in the world, whereas japan ranks number seven (the number one secrecy zone is the cayman islands, and the rest of the top ten are all tax havens.)156 153 see maya forstater, beneficial openness? weighing the costs and benefits of financial transparency (cmi working paper no. 3, 2017) (reviewing pros and cons of public disclosures). 154 see arthur j. cockfield, protecting taxpayer privacy rights under enhanced cross-border tax information exchange: toward a multilateral taxpayer bill of rights, 42 u. b.c. l. rev. 420 (2010). 155 see european commission, report from the commission to the european parliament on the council on the interconnection of national centralised automated mechanisms (central registries or central electronic data retrieval systems) of the member states on bank accounts (brussels, july 24, 2019 com 372 final 2019). 156 see tax justice network, financial secrecy index 2020 (2020). columbia journal of tax law [vol: 13:45 72 other countries that are ostensibly “good players” maintain laws that make it hard or impossible to identify who owns what: the united kingdom is ranked the twelfth most financial secret jurisdiction in the work; germany is ranked fourteenth, and canada is ranked nineteenth. by comparison, the bahamas, a caribbean tax haven, ranks twenty-two, and russia ranks fortyfour: both of these countries have laws that provide more fiscal transparency than their higherranked counterparts.157 wealthy democracies have enacted laws that allow foreign investors to conceal their identities because these countries came to depend on illicit financial flows, trillions of dollars over the decades, from these investors to buoy their economies.158 consider one example from luanda leaks, which revealed how africa’s wealthiest woman stole from her home country of angola and hid her loot within tax havens.159 the leaks disclosed that she set up a corporation in delaware to hold title to a $1.8 million home in lisbon, portugal.160 her advisors presumably chose delaware because the state’s corporate laws permit investors to hide the real human owner of assets. the more recent pandora papers revealed that south dakota has become a “go-to destination” for individuals trying to reduce taxes and/or hide their ownership of assets. in 2020, south dakota’s growing trust industry held an estimated $367 billion in assets, which were mainly owned by non-residents who may be using trusts to mask ownership so that their home governments never find out.161 any anti-tax haven initiative needs to take into account and overcome the incentives that promote global fiscal opacity when monies are transferred to, and often hidden within, tax havens.162 tax havens themselves wish to maintain financial secrecy as it brings in more business.163 non-democratic countries tolerate (or promote the use of) tax havens because they allow wealthy elites to hide and invest monies offshore, hence incentivizing them to create new wealth. oecd countries often benefit from financial secrecy because it has allowed trillions of dollars from global investors to be invested in their economies, generating new wealth and employment. as governments around the world crack down on tax havens, some may be tempted to create new onshore rules that provide tax-haven-like benefits under domestic law. increasing global cooperation is required so that countries agree to prohibit or restrict their onshoring laws. 157 see dave seglins, ‘tax haven’ canada being used by offshore cheats, panama papers show, cbcnews (jan. 24, 2017), http://www.cbc.ca/news/investigates/panama-papers-canada-tax-haven-1.3950552 [https://perma.cc/kz77-x72l] (discussing how canadian federal and provincial corporate laws permit anonymous foreign investments). 158 see michelle hanlon et al., taking the long way home: u.s. tax evasion and offshore investments in u.s. equity and debt markets, 70 j. fin. 257 (2015) (discussing how u.s. taxpayers engage in “round-tripping” tax evasion by hiding funds in entities within tax havens and then using the capital to invest in u.s. public securities). 159 see supra note 48. 160 see will fitzgibbon et al., the world’s biggest tax haven lurked behind a dos santos penthouse, int’l consortium investigative journalists (feb. 24, 2020), https://www.icij.org/investigations/luanda-leaks/theworlds-biggest-tax-haven-lurked-behind-a-dos-santos-penthouse/ [https://perma.cc/p5r8-jppz] (discussing how delaware does not publish information about owners or shareholders of delaware corporations). 161 david pegg & dominique rushe, pandora papers reveal south dakota’s role as $367bn tax haven, the guardian (oct. 4, 2021), https://www.theguardian.com/news/2021/oct/04/pandora-papers-reveal-south-dakotas-roleas-367bn-tax-haven [https://perma.cc/xd4u-47nd]. 162 see cockfield, big data, supra note 2, at 535. 163 see id. at 536. https://www.icij.org/journalists/will-fitzgibbon/ 2021] secrets of the panama papers 73 d. fighting back through technology governments are increasingly embracing new technologies such as big data and data analytics to reduce fraud and other forms of financial crime. for instance, some u.s. state tax authorities are analyzing large amounts of data to determine if taxpayers have filed fraudulent tax refund applications. state tax authorities cross-reference a taxpayer’s refund request against billions of records from public and commercial databases to catch the tax avoiders. in 2010, the new york department of taxation and finance, for instance, decreased revenue losses by $1.2 billion through this approach.164 in 2017, the australian financial intelligence unit formed the financial intelligence alliance, a partnership between government and the financial sector to fight money laundering and terrorism financing.165 collaboration is promoted by having government and bank staff physically located in the same place to solve problems together, including by investigating innovative technological approaches. in a recent report, we set out in detail how governments can make better use of data analytics to provide better and more timely information to tax authorities and other government regulators.166 many conventional approaches to detecting crimes or regulatory violations rely on analysts querying data, looking for patterns of activity that are known or thought to associate with these crimes and violations. in contrast, data analytics reviews large data sets and computes patterns of activity that are consistent with the data and presents these to analysts. in other words, data analytics can recognize patterns of activity that would otherwise evade human detection.167 privacy challenges surrounding this approach are addressed below. much as governments can embrace new technologies, so too can criminals. cryptocurrencies, for instance, can be used for criminal purposes because the use of these 164 see joanne bourquard & cassandra kirsch, big data = big benefits, nat’l conf. of st. legislatures (sep. 1, 2014), https://www.ncsl.org/research/telecommunications-and-information-technology/big-data-bigbenefits.aspx [https://perma.cc/7786-54zg]. 165 austrac, fintel alliance, https://www.austrac.gov.au/about-us/fintel-alliance [https://perma.cc/atn8-c9zx]. 166 in canada, the british columbian provincial government has an ongoing investigation (known as the cullen commission) into money laundering and other financial crimes due to the view that vancouver is the global base for such crime. our report for the commission proposes new laws and policies to inhibit financial crime. see christian lepreucht et al., detect, disrupt and deter: domestic and global financial crime – a roadmap for british columbia (commission of inquiry into money laundering in british columbia) (mar. 2021). we also testified before the commission on april 9, 2021. for the recording and transcript, see proceedings at hearing (commission on inquiry into money laundering in british columbia) (apr. 9, 2021), https://cullencommission.ca/data/transcripts/transcript%20april%209,%202021.pdf [https://perma.cc/tk9n-j2jd]. 167 see christian lepreucht et al., supra note 166, at 10. it has three main roles in detecting violations of laws for crimes such as money laundering or tax evasion. first, criminal activities normally contain particular patterns of activity because they have proven to be effective. these are often called typologies. when these patterns of activity are already known, they can be found by querying the data, but novel and unexpected patterns can be found automatically by data analytic algorithms. second, data analytics can search for anomalies. in large financial datasets, activities associated with money laundering or regulatory violation are typically rare. these can be detected using techniques tuned to look for data and patterns that are sharply different from the remainder of the data. third, data analytics can help to understand (social) networks. relationships among individuals and organizations naturally form networks, and so do financial flows. social network techniques can be used to analyze such network data, for example, by looking for network anomalies or unusual pathways and discovering a rogue bank is helping terrorist financiers. for discussion of this latter approach, see christian leuprecht et al., tracking transnational terrorist resourcing nodes, 36 fla. st. l. rev. 289 (2019). https://cullencommission.ca/data/transcripts/transcript%20april%209,%202021.pdf columbia journal of tax law [vol: 13:45 74 currencies is quasi-anonymous.168 the dark web, which is accessible only by specially configured internet browsers, also allows criminals to engage in illegal activities such as the purchase of weapons or illegal narcotics. the tax haven data leaks so far have not revealed the widespread usage of these technologies for criminal purposes. global financial criminals may have yet to embrace these new technologies fully simply because they are so new.169 in addition, crooks might be nervous to move, for example, hundreds of millions of dollars through cryptocurrencies or some other form of digital cash because the currencies can be quite volatile, raising the risk that the dirty money will be devalued if the currency crashes. as the technologies mature, it seems likely that criminals will increasingly embrace them to transfer, hide, and legitimize dirty money. this changing technological landscape will no doubt pose increasingly difficult enforcement challenges for governments. governmental suppression of traditional tax havens may encourage the rise of what could be called “digital tax havens.” these digital tax havens will not exist or be affiliated with any one country. rather, the digital tax haven will be spread over a cloud of thousands of computer servers based in a variety of different countries. using cryptocurrencies and the dark web, the digital tax haven will avoid detection and regulation by any central government. if a physical base is needed, criminals can set up servers on unregulated offshore bases like sealand, a world war ii anti-aircraft platform off the coast of england and outside of the territorial jurisdiction of the united kingdom.170 at one point, sealand operated a series of secure servers that downloaded and uploaded data to satellites. crooks used these servers to exchange and clean illicit financial flows.171 in summary, while governments can deploy policy solutions that use technologies to help investigate, arrest, and prosecute offshore tax cheats, criminals are embracing other digital technologies to better mask money trails so that they remain undetected. e. other policy recommendations the ongoing fight against global financial crimes like international money laundering and offshore tax evasion is complex and optimal laws and policies will vary according to countryspecific factors such as the political or bureaucratic environment, and culture of tax compliance.172 nevertheless, at the more granular level there exists some unity among experts in terms of recurring policy recommendations, including the need for whistleblower protections for any 168 for discussion on the use of cryptocurrencies and global financial crimes, see sarah gruber, note, trust, identity, and disclosure: are bitcoin exchanges the next virtual havens for money laundering and tax evasion?, 32 quinnipiac l. rev. 135 (2013); thomas slattery, taking a bit out of crime: bitcoin and cross-border tax evasion, 39 brook. j. int’l l. 829 (2014). 169 i never came across any references to cryptocurrencies or the dark web in the tax haven data leak materials i reviewed. nor are there any reports by icij journalists about such high-tech usage. this might be explained by the time lag between the tax haven data and the growing usage of the new technologies. for instance, offshore leaks, which was revealed to the public in april 2013, contained data that ended in 2010. bitcoin was only released as opensource software in 2009. 170 see johannesen & zucman, supra note 148, at 1194-98; james grimmelmann, sealand, havenco, and the rule of law, 2012 u. ill. l. rev. 405, 405-06 (2012). 171 see id. 172 for instance, the laws of some countries require the separation of government agencies into an information collection and investigation agency and a prosecution agency to ensure evidence disclosure rules are followed. see lepreucht et al., supra note 166. 2021] secrets of the panama papers 75 individual who provides information leading to tax and financial crime prosecutions; the need to embed lawyers within tax authority audit teams to ensure proper evidence is provided to prosecutors; the need for prosecutorial incentives to pursue significant penalties against “white collar” criminals who have often attracted lenient sentences; better information sharing among government agencies when each agency sees only one part of the overall criminal financial scheme; and bureaucratic incentives to retain police, tax officials, and prosecutors in the long run, so they can gain a necessary understanding of the complexities.173 many of these proposals necessarily implicate financial privacy. for instance, a greater sharing of information among government agencies may violate existing prohibitions against such sharing (e.g., u.s. federal laws that prohibit federal agencies from sharing tax and other information with other agencies) under the view they unduly inhibit privacy interests. these privacy interests in turn must necessarily be protected within a free and democratic society for reasons that include the need to protect freedom of expression and freedom to engage in political dissent. moreover, in an age of big data, government use of opaque algorithms to scrutinize taxpayers, and increasing data collection, taxpayer privacy rights arguably need stronger protection.174 nevertheless, and as explored elsewhere, from a distributional justice perspective, the granting of strong privacy protections to corporations or offshore bank accounts protects the interests of wealthy individuals and criminals at the expense of ordinary citizens who cannot take advantage of the benefits offered by the offshore world.175 in other words, the current system of strong financial privacy protection harms the public interest and contributes to income inequality. v. conclusion the offshore world was designed to favor the interests of the wealthiest members of society. offshore havens provide wealthy individual taxpayers with a safe place to hoard wealth and avoid taxes. in the last quarter-century, the offshore world has facilitated the rise of a new gilded class of ultra-high-net-worth individuals. they live a life of private banks, high-priced tax lawyers and financial advisors, and multiple homes around the world, including residences within tax havens. in middle-income countries, like china and russia, this class is responsible for significant capital outflows that exacerbate already-distressing income inequality levels. tax planners for the very rich within liberal democracies often deploy entities like corporations and trusts based in tax havens to reduce global tax liabilities legally—here too, the rich get richer while average-income taxpayers are never provided with similar tax benefits. the offshore world was also expressly designed, at least in most cases, to favor the interests of multinational corporations and their (normally) wealthy owners/investors. tax planning and offshore havens enhance the return that capital owners enjoy by providing special corporate tax breaks tied to the use of entities based within tax havens. in other words, individuals with higher incomes and corresponding investments based in tax havens grow wealthier while most middleincome taxpayers do not similarly benefit. again, permitting this situation to persist is an express 173 my prior parliamentary testimony, as well as views from others concerning needed reforms, have been summarized in two different federal government reports. see canada, house of commons, 41st parl.-report no. 17, 2013; canada, house of commons, 42d parl.-report no. 6, 2016. 174 see adam b. thimmesch, tax privacy?, 90 temp. l. rev. 375 (2017-2018) (claiming technological and political developments call for stronger taxpayer privacy protections) 175 see cockfield, share tax information, supra note 42, at 314-15 (discussing distributive justice concerns raised by existing privacy laws and policies). columbia journal of tax law [vol: 13:45 76 choice that, at least in theory, could be addressed via legal reforms. an example of a cooperative approach is the recent oecd agreement in principle for a global minimum corporate tax rate. in other cases, the offshore world provides secrecy and tax benefits that were likely never intended. for low-income countries, tax havens allow war profiteers and corrupt politicians and businesspeople to loot their countries and hide the stolen monies offshore, leaving citizens behind in often-dire circumstances. these outcomes—which contribute to drained treasuries of poor and middle-income countries, narco-states, and human rights violations—are all enabled by the offshore world and drive deep inequality within many countries around the world. in wealthy democracies, there is emerging evidence, based on the leaks, that ultra-high-net-worth individuals have been criminally hiding portions of their fortunes offshore, potentially for generations. the fact that there are two parallel financial worlds—one for the haves and one for the have nots—threatens the legitimacy of the democratic world, which is premised on the ideal of meritocracy and equal opportunity. accordingly, governments must pursue policies to reduce offshore tax benefits for the wealthy to reduce income inequality and to legitimize democratic state governance. governments can revisit lavish tax haven tax breaks bestowed on their corporate champions that have contributed to forty years of ongoing reductions of corporate income tax burdens and boost the after-tax income of shareholders. additionally, governments can continue bolstering efforts to make the global financial system more transparent so that tax and law authorities can better understand what is taking place in the offshore world. to promote transparency, governments can also negotiate a global registry that shows ownership along with a withholding tax imposed on cross-border investment transfers to nonparticipating countries. in the fight against global financial crimes, there are a host of additional factors to consider that are tailored to the unique legal, political, and cultural aspects of each nation. these measures would help to inhibit the use of tax havens by malefactors, millionaires, and multinational corporations. they would work against the status quo whereby the interests of the wealthy and powerful are privileged over those of the less well off. this article also demonstrates that large tax haven data leaks like the panama papers have improved our theoretical, empirical, and methodological understanding of tax havens and their ties to the global financial system. from a theoretical perspective, the leaks provide a more holistic perspective on global financial crimes, such as offshore tax evasion and international money laundering, that are traditionally examined as separate legal spheres (when in fact, they are significantly intertwined). from an empirical perspective, the data is so rich and detailed that it has provided the foundation for a series of “big data” empirical studies, mainly by economists, to understand how legal and illegal money flows around the world. finally, the leaks provide methodological advances because they allow researchers to match real-world taxpayers with tax haven dealings, instead of the traditional reliance on indirectly observing data such as the amount of foreign investor deposits compiled by the bank of international settlements. thus, the growing number of recent data leaks has contributed to a burgeoning mosaic of knowledge that has succeeded in piercing the secrecy that traditionally cloaked tax havens. such leaks have shed new light on previously obscure, abusive tax practices, provoked media and governmental outcry, and inspired new efforts to remedy the inequitable effects of tax havens on countries around the world. i. introduction ii. privileging malefactors, millionaires, and multinationals a. a primer on the offshore world and income inequality b. gangster paradise c. millionaire paradise d. multinational firm paradise e. summary iii. legal and policy reforms a. tax transparency initiatives to counter multinational firm tax avoidance b. other global tax agreements to counter firm tax avoidance c. tax transparency measures against offshore tax evasion d. summary iv. the way forward a. creating a framework to withhold taxes on tax haven investments b. global financial registry c. addressing the problem of onshoring d. fighting back through technology e. other policy recommendations v. conclusion microsoft word 8-2-miller.docx tax planning under the destination based cash flow tax: a guide for policymakers and practitioners david s. miller 296 columbia journal of tax law [vol.8:295 i. introduction .................................................................... 297 ii. tax planning under the dbcft ............................... 297 a. generating deductions ........................................................ 297 b. excluding income from exports ......................................... 298 c. transforming an onshore brick and mortar importing business into an online direct-order business conducted by a foreign subsidiary ........................................................... 298 d. earnings and profits under the dbcft ............................. 299 e. using corporate inversions ................................................ 300 f. using transfer pricing to import at a low cost ................. 301 g. generating and using export losses .................................. 301 h. converting carry from foreign investors into tax-exempt export income ..................................................................... 302 i. the preference of capital assets over financial assets .... 303 j. using affiliate sales to achieve a tax-free step-up ........ 303 k. using partnerships to sell export losses to importers ...... 303 l. tax-exempt entities ........................................................... 304 m. using u.s. corporations as tax shelters ............................ 305 n. preserving interest deductions ........................................... 306 o. foreign companies could move to the united states to receive a subsidy ............................................................... 307 p. low-cost insurance in the event of repeal ....................... 307 iii. conclusion ......................................................................... 308 2017] tax planning 297 i. introduction this essay describes some basic tax-planning strategies under the destination based cash flow tax (dbcft) proposed as part of the “blueprint” published by the committee on ways & means of the house of representatives. 1 this article is designed first for policymakers so that they can either correct or confirm the strategies i describe, and second for the practitioners and taxpayers that will navigate the dbcft if it is enacted. a central theme of the discussion that follows is that the dbcft contained in the blueprint is not the “pure” dbcft proposed by economists.2 instead, it is a hybrid that incorporates aspects of the pure dbcft, but also elements of our current income tax. many of the planning opportunities under the dbcft arise because of its hybrid nature. ii. tax planning under the dbcft a. generating deductions tax planning under an income tax system is based upon maximizing deductions and avoiding or deferring income. to illustrate, assume a u.s. pharmaceutical company (currently subject to a nominal u.s. corporate tax rate of 35%) has an irish subsidiary (currently subject to a nominal rate of 12.5%). under current income tax law, the u.s. parent would seek to transfer intellectual property to its irish subsidiary at a low transfer price, develop the intellectual property substantially using personnel located in ireland, and have the irish subsidiary receive royalty payments from unrelated parties that would not be subpart f income.3 the u.s. parent would report any gain on the initial sale, but could defer the subsequent profits of the irish subsidiary indefinitely. 1 a better way: our vision for a confident america, gop tax reform task force (june 24, 2016), http://abetterway.speaker.gov/_assets/pdf/abetterway-tax-policypaper.pdf [perma.cc/g6b3-ymt3] [hereinafter blueprint]. 2 see auerbach, et al., destination based cash-flow taxation 17 (oxford u. ctr. for bus. tax’n, working paper no. 17/01, 2017). when i refer to the dbcft, i mean the one in the blueprint. i refer to the one proposed by economists as the “pure” dbcft. 3 see temp. treas. reg. § 1.954-2t(c)(3)(i) (exempting royalty income earned with respect to property to which the foreign subsidiary has “added substantial value” if “regularly engaged in the development, creation, or production of … property of such kind”). all references to section numbers are to the internal revenue code or its regulations. 298 columbia journal of tax law [vol.8:295 under a dbcft, generating deductions onshore would remain an important tax planning strategy, but the tools to accomplish this strategy would change. for example, interest could no longer be used to strip earnings, but deductions could be generated by making capital investments that may be immediately expensed. for example, a taxpaying company operating under a dbcft could generate deductions by buying business assets and leasing them (especially to companies (like exporters) that could not use the deductions that would be generated from purchasing the equipment). likewise, a taxpaying company could buy a building, and lease it back to the seller. the purchase of the building would generate a deduction, which could shelter other income. returning to the example above, if the dbcft is enacted, the u.s. pharmaceutical company’s strategy would be reversed. the u.s. parent would fully develop the intellectual property in the united states with its own employees. their salaries would be deductible. b. excluding income from exports under a dbcft, exporting products, services, and intangibles abroad is even more important than deferring income because the proceeds would be exempt under the tax’s border adjustment feature. exporting may be accomplished by providing products, services, and intangibles to a foreign customer, but also to a foreign affiliate. the blueprint appears to respect the residence of entities, and because the corporate residence of a client or affiliate is effectively elective, there are plenty of tax planning opportunities to create exports.4 c. transforming an onshore brick and mortar importing business into an online direct-order business conducted by a foreign subsidiary next, consider a u.s. corporation that is in the domestic retail sales business. it buys all of its products domestically at wholesale prices and sells them at retail prices to u.s. customers. now assume that this u.s. corporation organizes a wholly-owned irish subsidiary that qualifies for the benefits of the u.s.-irish tax treaty. the irish subsidiary could buy the products from its u.s. parent, and then sell the products directly to the customers of its parent, with the assistance of an independent agent located in the united states. under the 4 the oecd’s international vat/gst [goods and services tax] guidelines would also respect the sales of services and intangibles to the immediate buyer without looking through to subsequent users. see chapter 3 of the international vat/gst guidelines, oecd (nov. 2015), http://www.oecd.org/tax/consumption/international-vat-gst-guidelines.pdf [perma.cc/k53k-yzk3]. 2017] tax planning 299 blueprint, the u.s. corporation could exclude the gross proceeds from the export to its irish subsidiary. the irish subsidiary would avoid u.s. federal income tax because it would not have a permanent establishment in the united states by reason of all activities being conducted through an independent agent. 5 in fact, because the blueprint would repeal the foreign base company sales rules,6 the irish subsidiary's profits would not be subpart f income and could be repatriated tax-free to its u.s. parent. thus, under the blueprint, the u.s. parent could avoid all u.s. federal income tax. to prevent this outcome, the united states would first have to dramatically expand its extra-territorial taxing powers to impose a 20% excise tax on the price of goods, services and intangibles sold by any foreign entity directly to a u.s. consumer, regardless of whether that entity has a physical presence in the united states. additionally, the united states would have to modify tax treaties to permit the united states to impose tax on a resident of a treaty jurisdiction that sells into the united states, even if the resident does not have a permanent establishment in the united states.7 enforcing these powers would be very difficult. convincing our treaty partners to agree to these changes will be equally difficult.8 d. earnings and profits under the dbcft assume that a u.s. corporation, in its first year of operation, receives $100 from exports, and has total costs of $85 (but no imports). it earns economic income of $15, but has a tax loss of $85 (because it is able to exclude the $100 of export revenue). now assume the corporation distributes all of its revenue. under our current income 5 see convention for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income and capital gains, u.s.-ir., art. 5, july 28, 1997, s. treaty doc. no. 105-31 (1997); id. at art 6 (an enterprise does not have a permanent establishment merely by carrying on business through a broker or agent of independent status); id. at art. 7 (profits of an enterprise are taxable by the other contracting state only if carrying on business through a permanent establishment situated in that state). best buy argues that china’s alibaba would be able to avoid the tax by making sales online and shipping to u.s. consumers directly. ginger gibson & david shepardson, how toyota, target, best buy are fighting back against republican border tax push, reuters (jan. 31, 2017), http://www.reuters.com/article/us-usa-trump-companiestax-insight-iduskbn15f0fk [perma.cc/7qdx-ac4g]. 6 supra note 1 at 29. 7 reuven s. avi-yonah, & kimberly clausing, problems with destination-based corporate taxes and the ryan blueprint, 8 colum. j. tax l. 229 (2017). 8 see david p. hariton, planning for border adjustments: a practical analysis, 154 tax notes 965 (2017). 300 columbia journal of tax law [vol.8:295 tax system, if a corporation has a tax loss in its first year of operation and makes a distribution, the distribution is treated as a return of capital (because generally a tax loss also means a deficit in earnings and profits). what result under the dbcft? the blueprint is silent but my guess is that distributions, to the extent of earnings and profits (determined under current rules), would be treated as dividends. if the dollar appreciates to neutralize the effect of a dbcft, and exporters can fully use their losses, then importers, exporters, and wholly domestic businesses should have the same amount of after-tax income after a border adjustment as they did before the enactment. in that case, the shareholders who receive equal distributions from equally profitable start-up companies should be taxable the same, regardless of whether the companies are importers, exporters, or wholly domestic. shareholders would be taxable on an income tax basis with respect to their investment income under the dbcft, and so dividends should be determined under the same rules as today. however, to achieve this result under the dbcft, corporations would have to keep two tax books. one set of books would be kept on a cash flow basis to determine corporate-level tax. the second would be on an income tax basis to determine earnings and profits.9 as explained in the next part, the retention of the earnings and profits concept permits tax planning opportunities that do not exist under a “pure” dbcft. e. using corporate inversions corporate inversions will still have benefits under the blueprint. for example, an irish parent could raise debt financing (and deduct the interest) to fund its u.s. subsidiary’s deductible capital investments. the u.s. subsidiary could develop intellectual property and sell the foreign rights to the irish parent on a tax-free basis, and the irish parent would amortize the purchase price and deduct the interest to reduce its earnings and profits. for example, assume that the irish parent borrows $1,000 to buy its u.s. subsidiary’s intellectual property. assume the u.s. subsidiary has more than $100 of earnings and profits. in a taxable year, the irish parent has $100 of original issue discount and the u.s. subsidiary pays a dividend of $100 to its irish parent which, in turn, pays the amount to its u.s. shareholders. had the irish parent not existed, the dividend would have been taxable 9 of course, this begs the questions about how earnings and profits would be determined under a dbcft. would today’s rules be used, would the rules measure earnings and profits based on an economic income basis, or would investments be expensed and interests denied? 2017] tax planning 301 to the u.s. subsidiary’s u.s. shareholders, or subject to u.s. withholding tax on payment to its foreign shareholders. however, in the year of the dividend, the irish parent has no current or accumulated earnings and profits (the $100 dividend received is offset by the $100 of original issue discount expense) and so the dividend it pays its shareholders would be a nontaxable return of capital. in fact, this strategy is equally available to a nonconsolidated u.s. parent company that receives a dividend from its u.s. subsidiary. the u.s. parent would have no net income by reasons of the dividendsreceived deduction, and the original issue discount deduction would offset its dividend income for earnings and profits purposes. the u.s. parent could distribute the dividend it receives to its u.s. shareholders without income tax or to its foreign shareholders without u.s. withholding tax.10 f. using transfer pricing to import at a low cost one of the principal benefits of a dbcft would be to remove the incentive for u.s. multinationals to sell intellectual property at low-transfer pricing rates to affiliated irish (or other low-taxed treatyeligible) companies. however, for those u.s. multinationals that had previously transferred u.s. intellectual property to their offshore subsidiaries and would need to license it back, under the dbcft, the royalty payments would be nondeductible import expense and, to add insult to injury, the income of the subsidiary would be subpart f income. these u.s. multinationals would seek to pay a low transferpricing royalty rate. therefore, the dbcft does not avoid transfer pricing; it merely changes the situations where transfer pricing matters. g. generating and using export losses under the dbcft, exporters would generate losses that they will be unable to use. exporters will therefore become acquisition targets for importers that are denied deductions for their imports (and vice versa).11 these would be acquisitions principally for tax reasons – the dbcft’s version of an inversion. also, the dbcft would encourage exporters to buy importers’ goods directly from abroad, and 10 i thank michael schler for this example. 11 elena patel & john mcclelland, what would a cash flow tax look like for u.s. companies? lessons from a historical panel (office of tax analysis, working paper no. 116, 2017), http://www.treasury.gov/resourcecenter/tax-policy/tax-analysis/documents/wp-116.pdf [perma.cc/t47d-6mrs] at 15-16 (“given the magnitude of the border adjustment, we expect that in the absence of a means of using these losses these larger firms would have an outsized incentive for behavioral adjustments such restructuring through mergers and acquisitions to minimize taxes.”). 302 columbia journal of tax law [vol.8:295 sell them to the importer.12 because the exporter would not receive a deduction (or basis) for the imported goods, this strategy would allow the exporter to use its tax losses and effectively sell those losses to the importer. h. converting carry from foreign investors into taxexempt export income a dbcft would also provide a windfall for managers of cayman island funds. currently, fund managers receive a relatively small fixed management fee (say 2%) of assets under management and a larger carried interest (say 20% of gains) that potentially benefit from long-term capital gains rates. under a dbcft, a u.s. hedge fund manager would seek to restructure its compensation entirely as contingent fees for services provided to foreign investors.13 all of these fees would be excludible exports (and not at all at taxed).14 additionally, unlike consumer goods, this exported service would not reflect any dollar appreciation because both parties would be transacting in dollars. the question then arises whether the blueprint will treat services provided to a cayman islands fund that is entirely owned by u.s. pension plans as provided to a foreigner (so entirely exempt) or to the beneficial u.s. owners (so fully taxable). 15 compensation received from taxable domestic investors would remain structured as carried interests (unless the income would be exempt if restructured as fees received from a cayman islands corporation owned by these investors). all expenses from salaries and overhead (used to generate both excludable and taxable amounts) could be used to offset taxable amounts. in addition, under the dbcft, lawyers who set up funds for u.s. money managers would no longer be paid by the managers but instead would be paid by the foreign funds to avoid tax on their fees (or at least the portion attributable to the foreign investors). likewise, 12 michael schler originally suggested this strategy. 13 if the dbcft does not look through entities, then this strategy would be equally effective for tax-exempt or taxable investors that invest through a cayman corporation. 14 max ehrenfreund, trump said they were ‘getting away with murder.’ now they might be getting a tax break, wash. post (feb. 8, 2017), http://www.washingtonpost.com/news/wonk/wp/2017/02/08/the-gop-tax-plancould-mean-a-big-break-for-some-of-donald-trumps-least-favoritepeople/?utm_term=.f457837564d0 [perma.cc/6lxg-9z3t]. 15 for more examples, see hariton, supra note 8. 2017] tax planning 303 if a foreign parent purchases a u.s. corporation, the law firm will prefer to be paid by the foreign parent, rather than the target. i. the preference of capital assets over financial assets because the dbcft applies a cash-flow tax to physical and intangible assets but an income tax to financial assets, taxpayers would be able to expense their purchase of capital assets (like equipment) but not financial assets. therefore, a financial investor might be expected to shift his investments from financial assets to physical and intangible assets (at least until the difference in potential return offsets the tax savings). likewise, a u.s. corporation considering the purchase of a domestic target will have an even greater incentive than under current law to structure the acquisition as an asset purchase rather than a stock purchase because of the immediate deduction for equipment and improvements. j. using affiliate sales to achieve a tax-free step-up the entirety of the u.s. international income tax system is based on taxing outbound transactions and exempting inbound ones. that system would be upended by the blueprint. if a dbcft is enacted, most outbound transactions would become exempt (as exports), but the rules would have to be changed to tax what are now tax-free inbound contributions (as imports). otherwise, a u.s. subsidiary could sell inventory to its foreign parent, and the foreign parent could contribute the inventory to another u.s. subsidiary in a section 351 transaction. if the second u.s. subsidiary received the parent’s fair market value basis in the inventory, the second subsidiary could then sell the inventory in the united states and pay no tax. a similar opportunity may exist for land, which is not subject to the dbcft. conversely, an inbound section 351 transaction would have to be treated as an import for which the subsidiary could not receive basis or claim a deduction. under a pure dbcft, these changes would not be necessary because basis does not exist under a pure dbcft. but the blueprint’s dbcft does retain the lifo method of accounting for inventory, and excludes land. k. using partnerships to sell export losses to importers assume that a domestic partnership has two businesses: a domestic sales business and an exporting business. each business earns revenues of $100, pays wages of $20, and purchases domestic inventory of $30. 304 columbia journal of tax law [vol.8:295 each business has pre-tax profits of $50. however, the export business generates a tax loss of $50, which is worth $10 based on a 20% tax rate. the domestic business has taxable income of $50 and pays tax of $10. on a combined basis, the partnership earns after-tax profit of $100. however, the domestic business pays tax of $10 and the exports business generates a loss of $50 (worth $10), so the combined business pays no tax. revenues wages inventory pre-tax profit tax aftertax profit domestic 100 -20 -30 50 10 40 foreign 100 -20 -30 50 -10 60 let’s assume that one partner is allocated all of the pre-tax economic income from the domestic business and the other is allocated all of the pre-tax economic income from the export business, and they agree to share the tax in accordance with relative profits. since each business had the same pretax profit and, as a whole, the business paid no tax, they distribute 50 to each partner. although this allocation would appear to have substantial economic effect under current law, i suspect that it wouldn’t be allowable under the blueprint. this partnership is a “splitter”. the tax benefit (exclusion of export income) is intended for exporters. exporters are not entitled to refunds of their tax losses, and they must have income under the dbcft in future years to use then. presumably, the drafters of the blueprint didn’t intend for exporters to be able to sell their losses.16 in this case, only the partner who is allocated the economic income from exporting should be entitled to the tax benefits from that activity. the domestic partner should be distributed $40 and the exporting partner $60. it also becomes clear from this example that tax does not follow book under the dbcft. capital accounts are an economic income concept; the dbcft is not. likewise, the allocation of an exporting tax loss to a partner should not reduce that partner’s basis. otherwise the exclusion would become a mere deferral. l. tax-exempt entities under our current income tax system, tax-exempt entities avoid tax on income from the activities that are related to their taxexempt status. however, under the dbcft, exporters would pay no 16 this is another example where a “pure” dbcft varies from the blueprint’s version. a pure dbcft would allow exporters a refund or, at the very least, allow the loss to offset payroll taxes. 2017] tax planning 305 tax and would receive deductions for their costs. for tax-exempt organizations that are also exporters, under a dbcft, it would be better to be taxable than tax-exempt. assume that a u.s. university develops a video-based degree for which it receives tuition and fees from foreign students. because under current law the tuition and fees are exempt from tax,17 it makes more sense for the university to operate the video-based degree business as tax-exempt and neither pay tax nor generate deductions. under the dbcft, the university would have an incentive to contribute the business to a taxable subsidiary. the taxable subsidiary would not pay any tax and would generate tax losses from the export business, even if the business were profitable. the university could also contribute to the taxable subsidiary assets that generate unrelated business taxable income and the subsidiary’s losses could be used to help to shelter what would otherwise be taxable to the university.18 m. using u.s. corporations as tax shelters under a dbcft, u.s. corporations would become a tax shelter for wealthy shareholders. first, under the rates proposed by the blueprint, there would be an increase in the disparity between the corporate rate and the top individual rate (13 percentage points as compared to under 9 percentage points today).19 second, exporters would be in perennial loss positions. shareholders could contribute their investment assets to their export companies and use the export losses to reduce the tax rate on their investment earnings to zero. the personal holding company rules and accumulated earnings tax attempted to prevent this practice, but were notoriously unsuccessful.20 17 see i.r.c. § 512 (2015) (excluding royalties from definition of “unrelated business taxable income” on which an otherwise exempt organization may be subject to tax). 18 i thank richard upton for his comments on this section. 19 the top marginal rates under the blueprint for individuals and corporations, respectively, are 33% and 20%. see supra note 1, at 17, 25. 20 see edward d. kleinbard, the sorry state of capital income taxation, n.y.u. school of law colloquium on tax pol’y & pub. fin. (mar. 6, 2012), http://www.law.nyu.edu/sites/default/files/ecm_pro_071841.pdf [perma.cc/q339-r5ty] (personal holding company and accumulated earnings tax are inadequate to protect the fisc from capital stuffing); see also david a. weisbach, a guide to the gop tax plan – the way to a better way, 8 colum. j. tax l. 171 (2017) (same problem existed in the bush tax commission’s growth and investment tax plan). 306 columbia journal of tax law [vol.8:295 n. preserving interest deductions under the dbcft, net interest deductions are denied. however, if the dbcft were simply incorporated into our existing income tax system, taxpayers would be able to achieve the functional equivalent of a deduction for interest. assume that an individual investor holds an interest in a domestic feeder fund that is treated as a partnership for u.s. federal tax purposes. the domestic feeder fund, in turn, invests in a leveraged hedge fund that is also treated as a partnership. under the dbcft, interest deductions would be denied for the hedge fund’s interest expense. however, if the taxpayer were instead to invest in a foreign feeder fund that is a controlled foreign corporation (“cfc”) or a passive foreign investment corporation (“pfic”) that has made a qualified electing fund (“qef”) election, and the foreign feeder fund invests in the hedge fund partnership, then the interest expense of the hedge fund partnership would reduce the earnings and profits of the foreign feeder fund, which could include interest, dividend income, and capital gains. through this mechanism, interest expense, which is only supposed to offset interest income, could offset other income as well. alternatively, the taxpayer could use any of a number of financial instruments that are not characterized as indebtedness (and therefore do not generate interest expense) but contain time value components. for example, a contract that provides an up-front payment for the obligation to deliver commodities or publicly-traded security in the future contains a significant time value component, which would offset income on the delivery but would not be treated as interest. if interest deductions are denied, these and similar arrangements could be used to achieve the effect of an interest deduction.21 on the other hand, for a taxpayer that does incur interest expense, interest income would be desirable because interest expense could be deducted only against interest income. under current income 21 it is possible that the blueprint intends to deny interest expense only for borrowings that are used to buy property that is expensed. this would be consistent with the purpose behind the denial – to treat the marginal effective rate of new investment to be zero. the blueprint retains an income tax for financial assets, and so it would be consistent to allow interest deductions for debt used to purchase financial assets. then interest would be entirely disallowed on debt used to purchase expensed property (and not allowable to the extent of interest income), and entirely allowable with respect to other debt (and not limited to the extent of interest income). however, because money is fungible, tracing rules would be easy to avoid. 2017] tax planning 307 tax law, taxpayers have quite a lot of flexibility to combine various financial instruments with debt, and create a single debt instrument that generates only interest income. for example, assume that a taxpayer has excess interest expense. the taxpayer wishes to purchase both a $1,000 bond from a financial institution and a $100 at-the-money option with respect to the stock of a publicly-traded company. the taxpayer could combine the two instruments into a single contingent payment debt instrument (“cpdi”): the taxpayer would advance $1,100 to the financial institution and receive back at maturity $1,000 plus the increase in the value of the publicly-traded company. although the taxpayer’s economics would have not changed, the taxpayer’s entire return on its combined investment would be interest income, which could be offset by the taxpayer’s excess interest expense. had the taxpayer instead kept the two investments separate, gain on the option would not be treated as interest income. o. foreign companies could move to the united states to receive a subsidy foreign companies that make goods and sell them abroad and whose employees are in the 15% tax bracket could receive a u.s. subsidy by moving their operations to the united states, claiming a deduction for wages taxable at a 20% rate, and paying workers taxable at 15%. p. low-cost insurance in the event of repeal proponents of the dbcft argue that under the dbcft, there would be no reason for a u.s. parent to transfer intellectual property to its offshore subsidiary because foreign royalties received directly by the u.s. parent would be exempt. however, the drafters of the dbcft assume that the dbcft will remain in effect forever. they are correct that if that were the case, there would be no reason for u.s. multinationals to transfer intellectual property to treaty-eligible, lowertaxed affiliates. however, if a dbcft is enacted, there would remain a meaningful risk that it will be repealed or modified the next time that democrats control the government, or when the united states has a trade surplus. 22 even if there would be no immediate benefit to transferring intellectual property to low-taxed foreign affiliates under a dbcft, doing so would provide low-cost insurance against a future reversal of u.s. tax policy. therefore, it is no stretch to predict that 22 this would be more likely if the dbcft sunsets after ten years in order to pass through reconciliation. 308 columbia journal of tax law [vol.8:295 enactment of a dbcft will lead to the largest tax-free exodus of u.s. intellectual property ever. because a sale by a u.s. multinational to its irish subsidiary would be exempt from u.s. tax, the u.s. multinational would seek to maximize the transfer sales price. this would allow the irish subsidiary to amortize a high purchase price and use the amortization to generate deductions for irish tax purposes. (ireland does not have a dbcft, so the irish subsidiary could amortize the “import”.) the u.s. multinational might also have the irish subsidiary borrow to finance the initial purchase of the ip to generate interest deduction. this would also generate deductions for irish tax purposes. although the blueprint would deny a u.s. parent net interest expense deductions, it does not appear to prevent the u.s. parent’s irish subsidiary from using interest deductions to reduce its own earnings and profits and shelter any subpart f income. iii. conclusion the blueprint promises a simpler tax code.23 this will be a broken promise. a dbcft won’t be simpler than our income tax, but the complexity will change. the new tax planning strategies will include (i) generating deductions by making capital investments, (ii) exporting goods, services and intangibles to related parties, (iii) selling excess losses, (iv) using the earnings and profits rules to effectively deduct interest expense, (v) using aggressive transfer prices to minimize imports, (vi) converting carry to tax-exempt foreign services income, (vii) using partnerships to sell losses, (viii) using the for-profit the subsidiaries of tax-exempt entities to generate losses, (ix) using a u.s. corporation as a tax shelter, and (x) transferring intangibles abroad in anticipation of the eventual repeal of the dbcft. 23 blueprint, supra note 1, at 6, 15, 16, 26, 30, 31, 32, 34. microsoft word 8-2-burman.docx an analysis of the house gop tax plan leonard e. burman, james r. nunns, benjamin r. page, jeffrey rohaly, and joseph rosenberg* abstract this paper analyzes the house gop tax reform blueprint, which would significantly reduce marginal tax rates, increase standard deduction amounts, repeal personal exemptions and most itemized deductions, and convert business taxation into a destinationbased cash flow consumption tax. taxes would drop at all income levels in 2017, but the highest-income households would gain the most. federal revenues would fall by $3.1 trillion over the first decade (static) and $3.0 trillion after accounting for macroeconomic feedback effects. including added interest costs, the federal debt would rise by at least $3.6 trillion over the first decade and by as much as $9.2 trillion by the end of the second ten years. *we are grateful to lily batchelder, howard gleckman, robert greenstein, eric toder, and roberton williams for helpful comments on earlier drafts. yifan zhang prepared the draft for publication and devlan o’connor edited it. the authors are solely responsible for any errors. the views expressed do not reflect the views of the house gop or those who kindly reviewed drafts. this is an expanded and updated version of a paper posted on the tax policy center website on september 16, 2016. the findings and conclusions contained within are those of the authors and do not necessarily reflect positions or policies of the tax policy center or its funders. 258 columbia journal of tax law [vol.8:257 i. introduction ...............................................................................259 ii. major elements of the proposal .....................................261 a. individual income tax ..................................................................261 b. estate and gift taxes ....................................................................264 c. business taxes ..............................................................................264 d. aca taxes ...................................................................................268 iii. impact on revenue and distribution .............................268 a. impact on revenue .......................................................................268 b. impact on distribution ..................................................................272 iv. dynamic effects on the economy ...................................276 a. impact on aggregate demand ......................................................276 b. impact on potential output ...........................................................277 c. impact on saving and investment .................................................277 d. impact on labor supply ...............................................................280 e. long-run impact on output and revenues .................................281 f. sensitivity of macro estimates to assumptions ...........................281 v. appendix a. unclear details and tpc’s assumptions about the house gop tax plan ..........................................282 a. clarifying questions and tpc’s working assumptions about broad provisions of the plan (sent to the speaker’s staff on june 30, 2016) .......................................................................................283 1. “special-interest” tax provisions .........................................283 2. transition rules .....................................................................284 3. border adjustments ................................................................284 4. estate and gift taxes .............................................................285 b. tpc assumptions (absent clarifications) about other provisions ......................................................................................285 1. individual income tax ............................................................285 2. business tax provisions .........................................................286 3. effective date .........................................................................286 c. provisions that tpc will assume are unchanged .......................286 d. health-related tax provisions .....................................................287 e. “special-interest” tax provisions .................................................287 1. corporate income tax ...........................................................287 2. individual income tax (including pass-through businesses) .289 3. payroll tax .............................................................................291 f. additional clarifying questions and tpc assumptions about the plan (sent to the speaker’s staff july 7, 2016) ............................292 1. “special interest” tax provisions .........................................292 2. rate cap on active business income .....................................292 3. child tax credit and new credit for other dependents .......292 4. standard deduction for dependents ......................................292 5. base year for indexing ...........................................................293 vi. appendix b. measuring distributional effects of tax changes .................................................................................293 2017] an analysis of the house gop tax plan 259 i. introduction house speaker paul ryan announced on june 24, 2016 the house gop blueprint for broad income tax reform. the proposal would reduce tax rates, simplify many provisions, and convert the taxation of business income into a destination-based cash-flow consumption tax.1 many important details are not specified in the blueprint. we needed to make assumptions about these unspecified details for our analysis (see appendix a). in addition, speaker ryan’s staff says the plan will be adjusted if necessary to offset any net revenue loss attributable to the tax provisions including macroeconomic feedback effects and excluding the effect of repealing the taxes enacted as part of the affordable care act.2 the tax policy center (tpc) has estimated the revenue cost and the distributional effects of a plan consistent with the house gop blueprint. we estimate that a plan such as this would reduce federal revenue by $3.1 trillion over the first decade of implementation and by an additional $2.2 trillion in the second decade, before accounting for added interest costs or considering macroeconomic feedback effects.3 most of the revenue loss arises from business tax cuts. tpc, in collaboration with the penn-wharton budget model (pwbm), also prepared two sets of estimates of the house gop plan 1 paul ryan, a better way: our vision for a confident america, gop tax reform task force (june 24, 2016), http://abetterway.speaker.gov/_assets/pdf/abetterway-tax-policypaper.pdf [perma.cc/g6b3-ymt3]. 2 that is, the net revenue loss estimated by dynamic scoring could be as great as $0.8 trillion over the first decade and $1.4 trillion over the second. ryan argues that the revenue loss from the aca taxes should be offset “by repealing the massive new entitlement program created by obamacare.” supra note 1 at 16. it is unclear what the replacement for aca would be and we did not consider changes in health care outlays—including the refundable premium tax credit—in our analysis. 3 these estimates account for many microeconomic behavioral responses, such as reduced use of tax preferences and increased capital gains realizations when marginal tax rates on income and capital gains decline. the methodology we follow in preparing these estimates follows the conventional approach used by the joint committee on taxation and the u.s. department of the treasury to estimate revenue effects before considering the macroeconomic effects. as noted in the text, we do not model certain potentially large tax avoidance responses because of uncertainty about exactly how the proposal would be implemented. 260 columbia journal of tax law [vol.8:257 that take into account macroeconomic feedback effects.4 both sets of estimates indicate that the plan would boost gdp in the short run, reducing the revenue cost of the plan. however, longer-run estimates indicate that over time the effect on output would become negative, increasing the revenue cost of the plan. including macroeconomic feedbacks, the revenue loss falls to $3.0 trillion over the first decade, but rises to $3.4 trillion over the second decade. including interest costs, the federal debt would increase by $3.6 trillion by 2026 and by $9.2 trillion by 2036. eventually, rising debt pushes up interest rates, which crowds out private investment and slows growth. by 2036, the pwbm estimates that gdp would be 2.6 percent lower than if the tax cuts had not been enacted. these estimates are sensitive to parameter assumptions and the effects on gdp could be larger or smaller in both the shortand the long-run. the plan would cut taxes at every income level in 2017, but high-income taxpayers would receive the biggest cuts, both in dollar terms and as a percentage of income. overall, the plan would cut the average tax bill in 2017 by $1,810, increasing after-tax income by 2.5 percent. three-quarters of the tax cuts would benefit the top 1 percent of households. the average tax cut for the highest-income 0.1 percent (incomes over $3.7 million in 2015 dollars) would be about $1.3 million, 16.9 percent of after-tax income. households in the middle fifth of the income distribution would receive an average tax cut of almost $260, or 0.5 percent of after-tax income, while the poorest fifth of households would see their taxes go down an average of about $50, or 0.4 percent of their after-tax income. by 2025, households in some upper-middle income groups would have tax increases (although staff report that the plan will be adjusted so that no income group would experience an overall tax increase). the average tax cut at other income levels would be smaller in 2025, relative to after-tax income, than in 2017. the plan would reduce the top individual income tax rate to 33 percent from the current 39.6 percent, reduce the corporate rate from 35 to 20 percent, and cap at 25 percent the tax rate on profits of passthrough businesses (such as sole proprietorships and partnerships), which are taxed under the individual income tax. individuals could 4 see benjamin r. page & kent smetters, dynamic scoring of tax plans, tax policy ctr., urban inst. & brookings inst. (sept. 16, 2016), http://www.taxpolicycenter.org/sites/default/files/alfresco/publicationpdfs/2000921-dynamic-scoring-of-tax-plans.pdf [perma.cc/3zg2-plxt] for a description of the macroeconomic models used in tpc’s analysis. 2017] an analysis of the house gop tax plan 261 deduct half of their capital gains, dividends, and interest, reducing the top effective rate on such income to 16.5 percent. the plan would increase the standard deduction and child tax credit. it would repeal personal exemptions and all itemized deductions except those for charitable contributions and home mortgage interest. the plan would also eliminate the alternative minimum tax (amt), estate and gift taxes, and all taxes associated with the affordable care act (aca). the corporate income tax would be replaced by a cash-flow consumption tax that would apply to all businesses: investments would be immediately deducted (i.e., expensed) and interest would no longer be deductible. the cash flow tax would be border adjustable, meaning receipts from exports would be excluded and purchases of imports would not be deductible. the plan would move the u.s. tax system to a destination-based system in which all sales to u.s. consumers would be taxable, regardless of their source, and all sales to foreign consumers would be exempt from u.s. tax. the marginal tax rate cuts would boost incentives to work, save, and invest if interest rates do not change. the plan would reduce the marginal effective tax rate on most new investments, which would increase the incentive for investment in the u.s. and reduce tax distortions in the allocation of capital. in the short run, increased investment would raise labor productivity and u.s. wages by increasing capital per worker. however, increased government borrowing would push up interest rates and crowd out private investment, eventually offsetting the plan’s positive effects on private investment unless federal spending was sharply reduced to offset the effect of the tax cuts on the deficit. if the plan is modified to reduce the overall revenue loss, the adverse effects of rising interest rates could moderate or be eliminated. those unspecified modifications could also, of course, modify economic incentives. ii. major elements of the proposal a. individual income tax the house gop tax plan would consolidate the regular standard deduction, additional standard deductions for age or blindness, and the personal exemption for tax filers into new standard deduction amounts of $12,000 for single filers, $18,000 for head of household filers, and $24,000 for joint filers. the plan would reduce the number of individual income tax brackets from the current seven brackets to three—12, 25, and 33 262 columbia journal of tax law [vol.8:257 percent—cutting the top 39.6 percent rate by 6.6 percentage points (table 1). the plan would replace the special rates on capital gains and dividends with a 50 percent deduction, which would also apply to interest income. the top rate on capital gains and dividends would be reduced from 23.8 percent (including the 3.8 percent surtax on net investment income) to 16.5 percent, a decrease of over 30 percent. the top rate on interest income would be reduced from 43.4 percent to 16.5 percent, a decrease of over 60 percent. the plan would repeal the deduction for personal exemptions for children and other dependents, which in 2016 is $4,050 and indexed for inflation. in its place, the plan would increase the child tax credit from $1,000 to $1,500 and create a new nonrefundable credit of $500 for other dependents. the child tax credit would phase out beginning at $75,000 of adjusted gross income for single filers (as 2017] an analysis of the house gop tax plan 263 under current law) and $150,000 for joint filers (an increase from $110,000 under current law).5 the plan would eliminate all itemized deductions except the deductions for mortgage interest and charitable contributions. the plan would, nonetheless, reduce or eliminate tax savings from the remaining deductions for many taxpayers for three reasons. first, eliminating most itemized deductions and increasing the standard deduction would significantly reduce the number of taxpayers who itemize.6 we estimate that 38 million (84 percent) of the 45 million filers who would otherwise itemize in 2017 would opt for the standard deduction. nonitemizers obviously do not benefit from itemized deductions. second, for many who continue itemizing, the fraction of their mortgage interest or charitable contributions that exceeded the standard deduction (that is, reduces taxable income) would decline.7 third, many would face lower marginal tax rates, which would reduce the value of any deduction. 5 the plan does not specify whether these credits would be indexed for inflation (the current child tax credit is not), whether the phase-out ranges for the child tax credit would be indexed for inflation (they are not indexed under current law), or whether the new $500 credit for other dependents would be subject to an income phase out (personal exemptions are phased out at higher income levels under current law). speaker ryan’s staff did not respond to our request for clarification on these issues. for our analysis we have assumed that neither credit is indexed for inflation, that the new credit for other dependents phases out in the same manner as the child tax credit, and that the phase-out ranges are not indexed for inflation. 6 for our analysis we have assumed that the plan repeals the limitation on itemized deductions for high-income taxpayers, although speaker ryan’s staff did not provide clarification on this issue. 7 the effective subsidy rate for an itemized deduction is the marginal tax rate multiplied by the fraction of the deduction in excess of the standard deduction. thus, for example, if a taxpayer in the 25 percent tax bracket has $10,000 of mortgage interest, but total itemized deductions exceed the standard deduction by $5,000, the effective subsidy rate is 12.5 percent (5,000/10,000*25 percent). since the plan eliminates some large itemized deductions, such as the deduction for state and local taxes, and raises the standard deduction, the fraction of itemized deductions in excess of the standard deduction will decline. 264 columbia journal of tax law [vol.8:257 the plan would repeal the individual amt and a number of “special interest” tax provisions, only some of which were explicitly identified and included in our estimates.8 b. estate and gift taxes the house gop tax plan would eliminate the federal estate, gift and generation-skipping transfer taxes.9 eliminating the estate tax would remove several economic distortions (such as the incentive it creates to spend down asset balances to below the threshold for taxation). however, eliminating the estate tax would also remove the incentive it provides the wealthy to make charitable contributions.10 c. business taxes the house gop tax plan would cut the top corporate tax rate from 35 percent to 20 percent. a top rate of 25 percent would apply to pass-through entities such as sole proprietorships, partnerships and s corporations, which are taxed at individual rates of up to 39.6 percent under current law.11 the 8 percentage point differential between the top rate on pass-through business income and wages could create a strong incentive for many wage earners to form a pass-through entity that provides labor services to their current employer instead of taking 8 because speaker ryan’s staff did not respond to our request for clarification on the specific provisions that would be repealed under the plan, our revenue and distributional estimates only include repeal of the “special interest” provisions explicitly identified in the plan description. however, we do show as an addendum to our revenue estimates (table 2) the revenue effect of repealing the other “special interest” provisions listed in appendix a. 9 the plan does not specify whether the basis of inter vivos gifts would continue to carry over from the transferor (carryover basis), or whether the basis of assets transferred at death would continue to be stepped up (stepped-up basis), as under current law, or whether limits would apply to the amount of stepped-up basis with carryover basis applying to the remainder, as under the law in effect in 2010 (when the estate tax was temporarily repealed). for our analysis, we have assumed that carryover basis would continue to apply to inter vivos gifts, and that the 2010 limitation on stepped-up basis would apply. 10 repealing the estate tax would also reduce an individual’s incentive to make donations during his or her lifetime. under current law, such donations produce an income tax deduction and reduce the size of the taxable estate, thereby saving both income and estate taxes. overall, for wealthy individuals the plan would substantially increase the tax price of donating, which would tend to reduce charitable giving. however, the large tax cuts for high-income households discussed later would produce a partially offsetting income or wealth effect because giving tends to rise with income, all else being equal. 11 certain income of pass-through entities is also subject to the 3.8 percent rate on net investment income, making the top rate 43.4 percent. 2017] an analysis of the house gop tax plan 265 compensation in the form of wages. to stem such tax avoidance, the plan would require pass-through businesses to pay “reasonable compensation” for tax purposes, so that the preferential 25 percent rate would not apply to all income of pass-through owner-operators. the plan does not specify how reasonable compensation would be defined or the rule enforced. current-law rules are very difficult to enforce, leading to significant tax avoidance; with the much larger rate differential under the house gop plan avoidance would be much more prevalent. 12 nevertheless, for purposes of our analysis we have assumed that reasonable compensation would be defined in an enforceable manner and would not permit a shift from reported wages to business income. with imperfect enforcement, the plan would lose substantially more revenue than we estimate. both corporations and pass-through businesses would be permitted to expense (i.e., immediately deduct) all investments in equipment, structures, and inventories, rather than having to capitalize and depreciate these purchases over time as current law generally requires. in addition, businesses’ net interest expense would no longer be deductible, but any unused net interest expense could be carried forward indefinitely. these rules would transform the corporate income tax and the individual income taxation of the profits of passthrough businesses into a cash-flow tax, treating business income as it would be treated under a consumption tax that allows deductibility of wages. if all business income were taxed at the same rate, the tax would be equivalent to a subtraction method value-added tax with an offsetting credit—at the same rate—for wages. if the tax rate were set at the top individual income tax rate (33 percent in the proposal) and individual taxes on capital income were eliminated, the proposal would be equivalent to bradford’s x-tax, a progressive variant of a consumption tax.13 the fact that there are two business tax rates, both 12 under current law, for high earners any income earned through a passthrough entity that is not subject to payroll tax can reduce the rate on that income by as much as 3.8 percent. under the house gop tax plan, any portion of current wages that could avoid payroll tax would save 2.9 percent, and if not part of “reasonable compensation” another 8 percent (the difference between the 33 percent top ordinary income tax rate and the 25 percent pass-through tax rate), for a total of 10.9 percent. shifted earnings below the social security maximum ($127,200 in 2017) would also avoid the 12.4 percent oasdi tax. 13 robert carroll, alan d. viard & scott ganz, the x tax: the progressive consumption tax america needs? aei (dec. 2008), http://www.aei.org/wp-content/uploads/2011/10/20081217_no423752tpog.pdf [perma.cc/dh32-vchf]. 266 columbia journal of tax law [vol.8:257 below the top individual income tax rate, create numerous complications, including the incentive for income shifting already discussed. the proposal includes a “border adjustment,” which is intended to make the business income tax apply only to domestically consumed goods and services, regardless of where they are produced. businesses would be permitted to exclude receipts from exports, and imports would not be deductible. to make the border adjustment completely neutral, taxpayers with negative taxable cash flow—which would include many or most exporters—would receive any negative tax liability as a refund. the refunds could be large. the dual business rate system also would mean that exporters would have a strong incentive to be structured as pass-throughs rather than corporations (since the refunds would be larger at a 25 percent rate than at 20 percent).14 importers would be more likely to incorporate than under current law, although the proposal could still penalize corporations relative to pass-throughs because dividends and capital gains would continue to be taxed at the individual level.15 if there is no change in the balance of trade, the border adjustment would increase revenues because u.s. imports (which would become taxable) exceed u.s. exports (which would become taxexempt). although it appears unlikely that such a border adjustment would be permissible under current international trade law, we have nevertheless included the revenue and distributional effects of them in 14 provisions would need to be made to limit the value of deductions for purchases from corporations (which are taxed at 20 percent) by pass-through entities that export their products. this could be extremely complicated. other countries with border-adjustable tax systems use a credit-invoice vat, which makes rebating taxes paid much simpler. exporters simply receive a credit for taxes remitted by their suppliers, which are tracked via tax invoices. 15 imports direct to consumers would presumably be taxable, although it is unclear whether they would be taxed at the 20 percent corporate tax rate or the 25 percent pass-through rate. 2017] an analysis of the house gop tax plan 267 our estimates.16 many analysts have noted that this short-run revenue source—$1.2 trillion over 10 years by our estimate—is effectively a form of borrowing since current trade deficits must eventually be offset by trade surpluses. moreover, setser argues that the trade surplus may be artificially inflated due to businesses shifting profits overseas to avoid u.s. tax and that border adjustments might raise substantially less revenue than estimated.17 under the plan, the u.s. would no longer tax repatriated profits from foreign-source income generated from overseas sales. the plan would make up part of this loss of future revenue by imposing a transition tax on the existing unrepatriated earnings of u.s. firms’ foreign subsidiaries. earnings held in cash would be taxed at 8.75 percent and other earnings at 3.5 percent, with the liability for this onetime tax payable over eight years. adopting a destination-based tax system and eliminating deductibility of net interest expense would eliminate u.s. corporations’ incentives to move their tax residences overseas (i.e., “corporate inversions”) and to recharacterize domestic corporate income as foreign-source income. border adjustability would remove these incentives, because the amount of u.s. income tax a corporation paid would not depend on where it was incorporated, where its product or service was produced, or where its shareholders resided. however, 16 it appears unlikely that a business cash flow tax could be border adjusted under world trade organization law. see wei cui, destination-based taxation in the house republican blueprint, 173 tax notes today 7 (2016); wolfgang schön, destination-based income taxation and wto law: a note (max planck inst. for tax l. & pub. fin., working paper no. 03, 2016). note also the conclusion of the 2005 president’s advisory panel on federal tax reform: “given the uncertainty over whether border adjustments would be allowable under current trade rules, and the possibility of challenge from our trading partners, the panel chose not to include any revenue that would be raised through border adjustments”. simple, fair, and pro-growth: proposals to fix america’s tax system, report of the president’s advisory panel on federal tax reform (nov. 2005), http://www.treasury.gov/resource-center/tax-policy/documents/report-fix-taxsystem-2005.pdf [perma.cc/v6hp-nxpw] at 172. 17 for example, under current law, u.s. multinationals have an incentive to shift profits to low-taxed foreign subsidiaries by transferring ownership of intangible assets to them at low price, so the subsidiaries earn artificially high profits. those transfers (which are counted as u.s. exports) would become nontaxable in the u.s. with the border adjustment, so u.s. multinationals could reduce their worldwide tax payments by increasing the value they place on the transfers. u.s. exports would increase, with a corresponding diminution of our balance of trade deficit. brad setser, dark matter. soon to be revealed?, council on foreign relations (feb. 2, 2017), http://blogs.cfr.org/setser/2017/02/02/darkmatter-soon-to-be-revealed [perma.cc/vxs3-2wcq]. 268 columbia journal of tax law [vol.8:257 as noted above, border adjustments are unlikely to be legal under existing trade law. if the plan were adopted without border adjustability and with exemption of sales from foreign production, it would be a territorial tax and would retain incentives for u.s. corporations to shift their profits to low-tax foreign subsidiaries. the plan would repeal the corporate amt and a number of “special interest” business tax provisions, only some of which were explicitly identified and included in our estimates.18 d. aca taxes the house gop health plan repeals all aca taxes, including the 3.8 percent surtax on net investment income, the 0.9 percent additional medicare rate on high-income workers, excise taxes (for example, the excises on medical devices and high-premium health insurance), premium credits, and related fees. we include the repeal of aca taxes in our analysis of the house gop tax plan. note that the house gop health plan also proposes a new limit on the tax exclusion for employer-provided health insurance and a new credit for non-group health insurance. we assume that the limit on the tax exclusion has the same revenue and distributional effects as the current excise tax on high-premium health insurance. 19 in addition, we exclude replacement of the aca premium credit with the proposed non-group health insurance credit because we do not include the aca premium credit in our current-law tax baseline.20 iii. impact on revenue and distribution a. impact on revenue 18 see supra note 8 for a discussion of special interest provisions. 19 while an exclusion cap is a more direct and potentially more progressive way to reduce the incentive for provision of overly generous health insurance, the cadillac plan tax is so onerous that most employers would reduce their spending to below the cap and (eventually) pass on the savings to employees. as a result, blumberg, holahan, and mermin (2015) conclude that “the incidence of the aca’s excise tax is identical in most circumstances to a cap on the employer exclusion that would raise the same revenue.” linda j. blumberg, john holahan & gordon mermin, the aca’s ‘cadillac’ tax versus a cap on the tax exclusion of employer-based health benefits: is this a battle worth fighting? urban inst. (oct. 22, 2015), http://www.urban.org/sites/default/files/publication/72391/2000482-the-acascadillac-tax-versus-a-cap-on-the-tax-exclusion-of-employer-based-healthbenefits.pdf [perma.cc/x3ns-yb8k]. 20 the aca premium credit is advanceable and refundable, making it more like a spending program than a tax provision. it is unclear what the replacement credit would look like. 2017] an analysis of the house gop tax plan 269 we estimate that the house gop tax plan would reduce federal receipts by $3.1 trillion between 2016 and 2026 before accounting for macroeconomic feedback effects (table 2).21 nearly two-thirds of the revenue loss would come from business tax provisions. corporations would pay less due because their top rate would be reduced to 20 percent and the corporate amt would be repealed. pass-through businesses taxed under the individual income tax would pay less because they would face a 25 percent top rate. all businesses would benefit from expensing of investment, which would be partially offset by the disallowance of interest deductibility, repeal of some tax expenditures, and, for corporations, the border adjustments and transition tax on unrepatriated foreign income.22 the remainder of the revenue loss would result primarily from net cuts in nonbusiness individual income taxes. reductions in income tax rates, the 50 percent exclusion for capital income, and repeal of the aca taxes and the individual amt would all reduce revenue. the increased standard deduction amounts, the higher child tax credit, and the new credit for other dependents would also reduce revenue, but these losses would be more than offset by the repeal of personal exemptions and itemized deductions other than those for mortgage interest and charitable contributions. repealing the estate and gift taxes and requiring the basis of inherited assets to be carried over (as was done in 2010, when the estate tax was temporarily repealed), would reduce revenues by $187 billion over the budget period. we also estimate the effect of the tax changes in the second decade (2027–2036) and find the revenue loss ($2.2 trillion) is smaller in nominal terms than that in the first 10 years, and also represents a smaller share of cumulative gross domestic product (gdp)—0.6 percent versus 1.3 percent in 2017–2026. the house gop blueprint indicates the plan would repeal “special interest” tax provisions, but explicitly identifies only employee fringe benefits (other than for health and retirement), the domestic production activity deduction, and credits (with several 21 although we assume an effective date of january 1, 2017, we estimate a slight revenue loss in 2016 because taxpayers would postpone realizing capital gains in anticipation of the 2017 reduction in capital gains rates. 22 we report all revenues from the border adjustments as corporate, although some portion would be from pass-through entities. 270 columbia journal of tax law [vol.8:257 exceptions).23 we included only those explicitly identified provisions. however, the addendum to table 2 shows our estimates of other tax provisions the plan might repeal. aside from the unspecified and uncertain provisions, there are a number of uncertainties associated with the revenue projection. as noted, house gop staff argue that repealing the aca taxes should not be considered a revenue loss attributable to tax reform since those will be dealt with in health reform legislation. subtracting those provisions would reduce the revenue loss by $0.8 trillion in the first decade and $1.4 trillion in the second. on the other side, the border adjustments will eventually lose revenue, and our estimate of the revenue raised by the border adjustments could be too high if the current reported trade deficit is artificially inflated by tax-motivated transfer pricing strategies. finally, conversion of wages and salaries into pass-through business income to take advantage of the lower tax rates could result in substantial revenue losses. we have not estimated the revenue loss from such shifting in the house gop plan, but our analysis of the trump plan, which would have taxed pass-through income at 15 percent (10 percentage points lower than the house plan), estimated that income shifting could ultimately cost more revenue than the direct effect of cutting pass-through tax rates. the direct revenue losses understate the effect on the national debt because they exclude the additional interest that would accrue if debt were to increase. including interest, the proposal would add $3.7 trillion to the national debt by 2026 and $8.0 trillion by 2036 (table 3). if the tax cuts were not offset by spending cuts, we estimate the national debt would rise by 13.5 percent of gdp by 2026 and 19.3 percent of gdp by 2036. taking macroeconomic feedback effects into account, the ratio of additional debt to gdp would be lower after ten years and larger after 20 years, rising to at least 13.2 percent by 2026 and to 22.7 percent by 2036. the pwbm model estimates that after 2036, revenues and gdp fall below the levels estimated without macro feedback by increasing amounts, so the ratio of debt to gdp would climb more rapidly in later years. 23 the credits identified (directly or by implication) in the house gop blueprint document as retained are the child tax credit, the eitc, education credits, the savers’ credit, the research and experimentation credit, and the foreign tax credit; all other credits would presumably be repealed. 2017] an analysis of the house gop tax plan 271 272 columbia journal of tax law [vol.8:257 b. impact on distribution24 the house gop tax plan would reduce taxes throughout the income distribution in 2017.25 24 this distributional analysis is based on the urban-brookings tax policy center microsimulation model. for a brief description of the model, see brief description of the tax model, tax policy ctr. (dec. 21, 2015), http://www.taxpolicycenter.org/taxtopics/brief-description-of-the-model2015.cfm. [perma.cc/4abr-e74q]. 25 appendix b discusses alternative distribution measures and illustrates several alternatives for the house gop tax plan. 2017] an analysis of the house gop tax plan 273 taxes would decrease by an average of $1,810, or 2.5 percent of after-tax income (table 4). on average, households at all income levels would receive tax cuts, but the highest-income households would receive the largest cuts, both in dollars and as a percentage of income. the top quintile—or top fifth of the distribution—would receive an average tax cut of about $11,800 (4.6 percent of after-tax income). three-quarters of total tax cuts would go to the top 1 percent, who would receive an average cut of nearly $213,000, or 13.4 percent of after-tax income. the top 0.1 percent would receive an average tax cut of about $1.3 million (16.9 percent of after-tax income). in contrast, the average tax cut for the lowest-income households would be just $50, 0.4 percent of after-tax income. middle-income households would receive an average tax cut of $260, about the same relative to after-tax income—0.5 percent—as for the lowest-income households. 274 columbia journal of tax law [vol.8:257 as with the revenue estimates, there are several sources of uncertainty associated with the distributional estimates. in the shortrun, the burden of the net revenue raised by the border adjustments depends on how prices adjust. if exchange rates fully adjust to offset the border adjustments, then domestic prices would remain unchanged and the net revenue should be distributed similar to a cash flow tax that does not burden wage income. however, if exchange rates do not fully adjust, then domestic prices would rise, resulting in a burden more similar to that of a broad-based consumption tax.26 an alternative approach would attribute zero burden to the border adjustments under the view that current trade deficits are temporary and will eventually be offset (with interest) by trade surpluses in the future. additionally, the plan is unclear on many details of the business tax changes, and our methodologies differ for distributing changes in existing income taxes and consumption-based taxes. our analysis distributes the changes in business taxes as incremental changes to the income tax according to our established methodology,27 but this approach does not yield the same result as if the cash flow tax was distributed as a replacement for the current income tax on business income.28 in order to illustrate the uncertainty concerning the short-run effects of the plan across the income distribution, we report the percent change in after-tax income in 2017 under alternative assumptions about the size of the changes in tax burdens due to the business tax provisions and the border adjustments, and how those burdens are distributed (table 5). overall, under the alternative assumptions the 26 eric toder, jim nunns & joseph rosenberg, methodology for distributing a vat, tax policy ctr. (apr. 2011), http://www.taxpolicycenter.org/sites/default/files/alfresco/publicationpdfs/1001533-methodology-for-distributing-a-vat.pdf [perma.cc/89gu-jk3d] 27 jim nunns, how tpc distributes the corporate income, tax policy ctr., urban inst. & brookings inst. (sept. 13, 2012), http://www.taxpolicycenter.org/publications/how-tpc-distributes-corporate-incometax/full [perma.cc/v2xx-vd8d] 28 further, by convention, tpc’s distributional analyses do not include short-run wealth effects. in particular, if exchange rates adjust to offset the effect of the border adjustments on international trade, the appreciation of the dollar would reduce the value of americans’ foreign asset holdings. this reduction in the value of existing (foreign) assets, which would primarily affect high-income households, is not included in the distribution tables. in addition, replacing the corporate income tax with a cash flow consumption tax could reduce the value of old capital—another transitory effect; however, we assume that transition rules (allowing existing asset holders to continue to deduct unused depreciation and interest on outstanding loans) would largely offset this wealth effect. we are reexamining our distributional assumptions and may revise our analysis in a future report. 2017] an analysis of the house gop tax plan 275 plan would increase after-tax income in 2017 by between 1.7 and 3.4 percent. households in the bottom four quintiles would see their aftertax income rise by as much as 1.4 percent. households in the 80th to 95th percentiles would fare the worst. higher-income households would receive the largest tax cuts. the top 1 percent would see aftertax incomes rise by between 8.0 and 14.1 percent, while the richest top 0.1 percent would receive tax cuts equal to between 10.0 and 17.4 percent of after-tax income. in the longer-run, the burden of the border adjustments would not depend on which prices adjust and the distribution of tax changes would be similar to the full exchange rate adjustment scenario. although, by 2025, the average tax cut would be smaller and households in the 80th to 95th percentiles on average would have tax increases rather than cuts. (speaker ryan’s staff have told us that the 276 columbia journal of tax law [vol.8:257 ultimate proposal will not raise taxes on any income group so presumably the plan will be revised to meet this objective.) iv. dynamic effects on the economy in addition to conventional estimates, which are based on fixed macroeconomic assumptions, tpc also prepared, in collaboration with the penn wharton budget model (pwbm), a set of estimates of the house gop plan that take into account macroeconomic feedback effects. estimates of the impacts of tax changes on the economy are subject to considerable uncertainty and can vary widely depending on the models and assumptions chosen. we present “dynamic” estimates from two models to illustrate different ways that tax policy can influence the economy. estimates using the tpc keynesian model illustrate how the plan’s impact on aggregate demand would influence the economy in the short run—that is, over the next few years. estimates using the pwbm illustrate the longer-run impact of the plan on potential output through its effects on incentives to work, save, and invest, and on the budget deficit. tpc also plans to build a neoclassical model of potential output whose results could be integrated with those of the keynesian model, but that work is still in process. a. impact on aggregate demand the house gop tax plan would increase aggregate demand, and therefore output, in two main ways. first, by reducing average tax rates for most households, the plan would increase after-tax incomes. households would spend some of that additional income, increasing demand. this effect would be attenuated to some degree because most tax reductions would accrue to high-income households, which are likely to increase spending proportionately less than would lowerincome households in response to increased after-tax income. second, the provision allowing businesses to expense investment would create 2017] an analysis of the house gop tax plan 277 an incentive for businesses to raise investment spending, further increasing demand. these effects on aggregate demand would raise output relative to its potential level for the next few years, until actions by the federal reserve and equilibrating forces in the economy returned output to its long-run potential level. using the tpc keynesian model, we estimate that these factors would boost output by about 1.0 percent in 2017, by 0.7 percent in 2018, and by smaller amounts in later years (table 6). using a range of assumptions about the response of household spending to changes in income, the response of investment to the expensing provision, and the impact of increased demand on output, tpc estimates that the impact on output could be between 0.2 and 2.3 percent in 2017, 0.1 and 1.5 percent in 2018, and smaller amounts in later years. those increases in output would boost incomes, which in turn would raise tax revenue, offsetting some of the revenue losses from the tax plan. tpc estimates that the plan’s effects on demand would, in themselves, boost revenues by $43 billion in 2017 (or between $12 billion and $129 billion in calendar year 2017 using tpcs full range of estimates), by $29 billion (or between $4 and $42 billion) in 2018, and by smaller amounts in later years. the revenue effect of the house gop plan, taking into account the dynamic revenue gains based on the tpc keynesian model using standard parameters, is shown in table 2. b. impact on potential output in addition to short-run effects on aggregate demand, the house gop tax plan would have a lasting effect on potential output— altering incentives to work, save, and invest—as well as on the budget deficit. those lasting effects, described below, were estimated using the pwbm. c. impact on saving and investment the house gop tax plan would alter incentives to save and invest in the united states. large reductions in the tax rates on corporate and pass-through business income, lower effective marginal tax rates on long-term capital gains and qualified dividends for most taxpayers with such income, and much lower rates on interest income throughout the income distribution would all increase the after-tax return to savers (table 7). assuming that interest rates do not change and that the tax cuts are not eventually financed in ways that reduce 278 columbia journal of tax law [vol.8:257 incentives to save and invest, these effects, in themselves, would tend to increase saving and investment in the u.s. economy. the overall effect of taxes on incentives to save and invest can be summarized in the proposal’s effect on marginal effective tax rates (metrs) on new investments.29 metr is a forward-looking measure of the tax system’s effect on the rate of return of a hypothetical marginal investment project (i.e., one that just breaks even). we compare the metr on different investments under the house gop tax plan with the metr under current law. because the plan would allow expensing (i.e., immediate deduction) of all investment and would reduce average individual-level taxes on interest, capital gains, and dividends, metrs for most new business investment would decrease significantly (table 8). investments in intellectual property would face higher metrs than under current law because business interest deductions would be disallowed, but intellectual property would still face the lowest metrs of any form of investment because the plan 29 joseph rosenberg & donald marron, tax policy and investment by startups and innovative firms, tax policy ctr. (feb. 9, 2015), http://www.taxpolicycenter.org/uploadedpdf/2000103-tax-policy-andinvestments-by-startups-and-innovative-firms.pdf [perma.cc/umk4-9fwa]. 2017] an analysis of the house gop tax plan 279 would retain the research and experimentation credit. business investments financed by debt would face higher effective tax rates than under current law, because the loss of interest deductibility would exceed the benefit of expensing. overall, the plan would lower metrs, making investment more attractive, and would eliminate the tax advantage for debtover equity-financed investments, which could reduce corporate leverage. although the house gop tax plan would improve incentives to save and invest, it would also substantially increase budget deficits unless offset by spending cuts, resulting in higher interest rates that would crowd out investment. while the plan would initially increase investment, rising interest rates would eventually decrease investment below baseline levels in later years. 280 columbia journal of tax law [vol.8:257 d. impact on labor supply the house gop tax plan would reduce effective tax rates on labor income (i.e., wages and salaries for employees and selfemployment income for others). effective marginal tax rates on labor income would be reduced by an average of about 2 percentage points and by over 7 percentage points for the top 0.1 percent (table 9). in combination with increased investment, which raises worker productivity and wages, these effects would initially raise labor supply. over time, however, because the plan would eventually reduce investment and the capital stock, it would also ultimately depress pretax wages and reduce labor supply. 2017] an analysis of the house gop tax plan 281 e. long-run impact on output and revenues the pwbm estimates that the house gop tax plan’s effects on investment and labor supply would boost gdp by 0.9 percent in 2017, but would reduce gdp by 0.5 percent in 2026 and by 2.6 percent in 2036 (table 6). those economic effects would in turn alter revenues, increasing them by $49.6 billion in 2017 and by $64.0 billion between 2017 and 2026, but reducing them by $1.1 trillion between 2027 and 2036 (table 2). taking into account the dynamic effects on gdp and revenues from the pwbm, the plan would increase debt by 13.2 percent of gdp by 2026 and by 22.7 percent of gdp by 2036 (table 3). the impact on the ratio of debt to gdp is lower in 2026, but higher in 2036, than projected in tpc’s conventional estimates. f. sensitivity of macro estimates to assumptions macroeconomic models are sensitive to assumptions about how individuals respond to incentives, the operation of world capital markets, and other government policies. different types of models also can produce very different estimates. the pwbm allows users to see how different assumptions change the model’s estimates.30 for example, compared with the baseline before incorporating 30 a user interface to the pwbm is available here: http://www.budgetmodel.wharton.upenn.edu/tax-policy-2/ [perma.cc/ccn45m4j]. users may alter assumptions and see effects on gdp, employment, capital stock, etc. 282 columbia journal of tax law [vol.8:257 macroeconomic response (labeled “pre-policy baseline” in figure 1), the pwbm’s baseline estimates (labeled “dynamic”) show gdp rising in the short run before eventually returning to the pre-policy level and then falling below the pre-policy baseline. the best case scenario for a large and sustained supply-side response is one in which capital markets are open and u.s. deficits do not affect the interest rates facing investors, which are solely determined on world markets.31 for the “optimistic” scenario in figure 1, we assume 100 percent openness and that labor supply and savings are very responsive to wages and interest rates (represented by elasticities of 1, compared with 0.5 in the baseline). gdp under this set of assumptions rises very quickly to about 1 percent above the prepolicy level. the effect is roughly stable over time in percentage terms. the pessimistic scenario makes the opposite assumptions. it assumes capital markets are closed—i.e., no borrowing abroad—and that workers and savers are relatively unresponsive to wages and interest rates. in this scenario, gdp falls below the static level starting in 2019. by 2040, it falls by about 9 percent compared with the level in the pre-policy baseline because the government’s borrowing creates a shortage of capital and pushes up interest rates. v. appendix a. unclear details and tpc’s assumptions about the house gop tax plan although speaker ryan released a “blueprint” that describes many details about the house gop tax plan, that document lacks some important details necessary to score the plan accurately. tpc sent the speaker’s staff two sets of clarifying questions along with tpc’s working assumptions, one set on june 30, 2016, and a second on july 7, 2016. these are listed below. we based our assumptions on the tax document released by the speaker. the speaker’s staff was not able to provide the clarifications we requested, indicating these represented issues that members had not yet resolved. however, they did point out that the blueprint intends that the ultimate plan be revenue neutral (after including macroeconomic feedback effects) and not raise average taxes on any income group. some key parameters, therefore, will have to change (assuming the joint committee on taxation’s analysis is similar to ours), but we cannot anticipate exactly how 31 this is typically referred to as a “small open economy” model, where a nation’s capital market activity is inconsequential to world markets. it is probably not appropriate for the u.s. given how large we are relative to the world economy, but is shown as a point of comparison. 2017] an analysis of the house gop tax plan 283 without further guidance. if we receive clarifications in the future, we will update our analysis. a. clarifying questions and tpc’s working assumptions about broad provisions of the plan (sent to the speaker’s staff on june 30, 2016) 1. “special-interest” tax provisions q1. the tax document indicates that the plan would repeal a number of “special-interest” exemptions, deductions and credits for individuals and deductions and credits for businesses, but only identifies one of those provisions (the section 199 domestic production deduction). what, specifically, are these provisions? a1. tpc will assume the repealed provisions would include all of the tax expenditures listed at the end of this document. note: we included in our revenue and distributional estimates only the repeal of those tax expenditures that were clearly identified in the blueprint released by the speaker: the section 199 domestic production deduction, employee fringe benefits (except those related to health and retirement), and all individual and business tax credits (except the child tax credit, the eitc, education credits, the saver’s credit, the research and experimentation tax credit, and the foreign tax credit, all of which the blueprint identifies as retained). revenue estimates for the other provisions listed below are included as an addendum item in table 2. 284 columbia journal of tax law [vol.8:257 2. transition rules the document indicates that the committee on ways and means will develop transition rules for the plan. because these rules could have a significant impact on scoring of the plan, key transition rules must be specified. q2. could unused depreciation and amortization on existing assets be used after the plan goes into effect, and if so what rules would apply? a2. tpc will assume that unused depreciation and amortization could be used under current law rules. q3. would the plan’s rules for disallowance of businesses’ net interest expense, with an indefinite carryforward (with interest), apply to debt outstanding when the rules go into effect? a3. tpc will assume that the plan’s rules would not apply, so that interest on existing debt would remain deductible without limit. q4. could unused credits repealed by the plan, including unused amt credits, be used once the plan goes into effect, and if so what rules would apply? a4. tpc will assume that unused credits could be used, generally under current law rules. q5. would existing nols [net operating losses] be subject to the new rules under the plan? a5. tpc will assume that existing nols would be subject to the new rules. 3. border adjustments the document indicates that the plan would move to a destination-basis tax system “by providing border adjustments exempting imports and taxing imports… within the context of the transformed business tax system”.32 q6. how would these border adjustments be made, and would any adjustment apply to direct imports by final consumers (households and governments)? 32 supra note 1 at 27. 2017] an analysis of the house gop tax plan 285 a6. tpc will assume that businesses would simply exclude receipts from exports and not deduct imported purchases, and that an excise tax of 20 percent (the corporate rate) would apply to direct imports by final consumers. 4. estate and gift taxes the plan would repeal the estate and generation-skipping transfer taxes. the plan does not indicate whether the gift tax would also be repealed, or how the basis of gifts and inheritances received would be determined. q7. would the plan also repeal the gift tax? a7. tpc will assume that the gift tax is repealed. q8. would the basis of gifts and inheritances received a) be carried over from the donor, b) stepped up to their current market value, or c) treated differently? if basis is stepped up, would there be any limits on the amount stepped up? a8. tpc will assume that inter vivos gifts will continue to have carryover basis and that inheritances will receive stepped-up basis, but with the limits in effect in 2010 ($1.3 million plus an additional $3 million for surviving spouses, with any additional unrealized gains carried over) but indexed for inflation from 2010. b. tpc assumptions (absent clarifications) about other provisions 1. individual income tax 1. all current law filing statuses would be retained. 2. individual income tax brackets would match current law (e.g., the plan’s 12 percent bracket ends at the same level as the current law 15 percent bracket for each filing status). 3. the 50 percent deduction for dividends would apply only to “qualified dividends” as defined under current law. 4. interest received from a pass-through would be reduced by interest paid by the pass-through (but not below zero) before applying the 50 percent deduction. 5. the limit on current deductibility of capital losses would be retained, but reduced from $3,000 to $1,500. 6. the limitation on itemized deductions (pease) would be repealed. 286 columbia journal of tax law [vol.8:257 7. the new credit for non-child dependents would phase out under the same (revised) rules used to phase out the child tax credit. 2. business tax provisions 8. adequate definitions and safeguards would be included in the plan to guide (and enforce) the “reasonable compensation” requirement for sole proprietors and pass-through businesses. 9. the 25 percent rate cap on the active business income of sole proprietors and pass-through businesses would be computed much like the current rate cap on capital gains and dividends (i.e., with active business income treated as otherwise taxable at the highest rate(s) applicable to the taxpayer). 10. the interest rate that applies to carryforwards of unused nols would be the 10-year treasury rate. 11. the foreign tax credit allowed against the deemed repatriation of accumulated untaxed earnings and profits of foreign subsidiaries (as of the effective date of the plan) would be scaled down by the same ratio as the applicable rate (8.75 percent or 3.5 percent) to 35 percent. 3. effective date 12. all provisions would become effective january 1, 2017. c. provisions that tpc will assume are unchanged the tax document identifies a number of current law provisions that the plan leaves to the committee on ways and means to examine with the goal of reforming them. because the document proposes no specific reforms of the following provisions, tpc must assume for its analysis that the current law specification of the following provisions would remain unchanged. however, we’d be happy to model the specific reforms if you can provide details. • earned income tax credit (eitc) • education incentives • employer-provided health insurance benefits, including fsas and hsas [flexible spending accounts and health savings accounts] • employer-provided retirement benefits • other saving incentives (including both retirement-related and other saving incentives) • mortgage interest deduction • charitable contribution deduction 2017] an analysis of the house gop tax plan 287 • foreign earned income exclusion and other special rules for individuals living abroad • deductibility of interest paid by financial services businesses • research and experimentation (r&e) credit d. health-related tax provisions the document only partially addresses reform of health-related tax provisions. the plan would repeal all itemized deductions other than those for mortgage interest and charitable contributions, but does not specifically list the deduction for medical and dental expenses. the plan also assumes that all of the taxes enacted as part of the aca would be repealed and not replaced with other taxes. however, repeal of these taxes is not considered part of the plan, but rather part of a separate proposal of the health care task force. the plan description includes no other health-related tax provisions. the report of the health care task force33 indicates other health-related tax changes that would be made (e.g., a cap on the exclusion for employer-provided health benefits), but does not provide specifications that would allow scoring them. in order to make its analysis consistent with the health-related tax changes that are specified in the plan and related plans, tpc will assume that the itemized deduction for medical and dental expenses would be repealed, along with all of the aca taxes including the 3.8 percent net investment income tax, the 0.9 percent additional medicare rate, excise taxes (e.g., on medical devices and high premium health insurance), and related fees. note that the premium credit is treated as an outlay, rather than a tax, by cbo, so we do not include it among the repealed aca taxes. e. “special-interest” tax provisions the following is the list of tax expenditures (including related payroll tax expenditures) that tpc assumes are repealed by the plan. please let us know if any of these items would be retained under the proposal. 1. corporate income tax energy credit (section 48): solar energy credit (section 48): geothermal coal production credit: refined coal coal production credit: indian coal excess of percentage over cost depletion, fuels: oil and gas 33 supra note 1. 288 columbia journal of tax law [vol.8:257 excess of percentage over cost depletion, fuels: other fuels excess of percentage over cost depletion, nonfuel minerals special rules for mining reclamation reserves special tax rate for nuclear decommissioning reserve funds exclusion of contributions in aid of construction for water and sewer utilities exclusion of earnings of certain environmental settlement funds exclusion of cost-sharing payments credit for low-income housing credit for rehabilitation of historic structures credit for rehabilitation of structures, other than historic structures deferral of gain on non-dealer installment sales deferral of gain on like-kind exchanges exemptions from imputed interest rules completed contract rules credit for employer-paid fica taxes on tips deduction for income attributable to domestic production activities credit for the cost of carrying tax-paid distilled spirits in wholesale inventories exclusion of gain or loss on sale or exchange of brownfield property income recognition rule for gain or loss from section 1256 contracts exemption of credit union income small life insurance company taxable income adjustment special treatment of life insurance company reserves special deduction for blue cross and blue shield companies tax-exempt status and election to be taxed only on investment income for certain small property and casualty insurance companies interest rate and discounting period assumptions for reserves of property and casualty insurance companies proration for property and casualty insurance companies deferral of tax on capital construction funds of shipping companies special tax provisions for employee stock ownership plans (esops) deferral of taxation on spread on acquisition of stock under incentive stock option plans deferral of taxation on spread on employee stock purchase plans disallowance of deduction for excess parachute payments 2017] an analysis of the house gop tax plan 289 limits on deductible compensation credit for employer-provided dependent care credit for disabled access expenditures credit for orphan drug research tax credit for small businesses purchasing employer insurance exclusion of disaster mitigation payments tax expenditures permanently extended by hr 2029: modification of tax treatment of certain payments under existing arrangements to controlling exempt organizations made permanent permanently extend and modify employer wage credit for activated military reservists minimum lihtc rate for non-federally subsidized new buildings (9%) made permanent 2. individual income tax (including pass-through businesses) exclusion of benefits and allowances to armed forces personnel exclusion of military disability benefits deduction for overnight-travel expenses of national guard and reserve members exclusion of energy conservation subsidies provided by public utilities energy credit (section 48): solar energy credit (section 48): geothermal excess of percentage over cost depletion, fuels: oil and gas excess of percentage over cost depletion, fuels: other fuels exceptions for publicly traded partnership with qualified income derived from certain energy-related activities excess of percentage over cost depletion, nonfuel minerals special rules for mining reclamation reserves special tax rate for qualified timber gain (including coal and iron ore) treatment of income from exploration and mining of natural resources as qualifying income under the publicly-traded partnership rules exclusion of cost-sharing payments exclusion of cancellation of indebtedness income of farmers income averaging for farmers and fishermen exclusion of capital gains on sales of principal residences credit for low-income housing 290 columbia journal of tax law [vol.8:257 credit for rehabilitation of historic structures credit for rehabilitation of structures, other than historic structures deferral of gain on non-dealer installment sales deferral of gain on like-kind exchanges exemptions from imputed interest rules completed contract rules credit for employer-paid fica taxes on tips deduction for income attributable to domestic production activities exclusion for gain from certain small business stock income recognition rule for gain or loss from section 1256 contracts exclusion of employer-paid transportation benefits (parking, van pools, and transit passes) exclusion of employee meals and lodging (other than military) exclusion of housing allowances for ministers exclusion of miscellaneous fringe benefits exclusion of employee awards exclusion of income earned by voluntary employees' beneficiary associations special tax provisions for employee stock ownership plans (esops) deferral of taxation on spread on acquisition of stock under incentive stock option plans deferral of taxation on spread on employee stock purchase plans credit for employer-provided dependent care exclusion of certain foster care payments adoption credit and employee adoption benefits exclusion credit for disabled access expenditures credit for orphan drug research tax credit for small businesses purchasing employer insurance exclusion of workers' compensation benefits (disability and survivors payments) exclusion of damages on account of personal physical injuries or physical sickness exclusion of special benefits for disabled coal miners premiums on group term life insurance premiums on accident and disability insurance 2017] an analysis of the house gop tax plan 291 exclusion of survivor annuities paid to families of public safety officers killed in the line of duty exclusion of disaster mitigation payments exclusion of veterans' readjustment benefits deferral of interest on savings bonds tax expenditures permanently extended by hr 2029: parity for exclusion from income for employer-provided mass transit and parking benefits made permanent permanently extend and modify employer wage credit for activated military reservists treatment of certain dividends of rics made permanent exclusion of 100 percent of gain on certain small business stock made permanent reduction in s corporation recognition period for built-in gains tax made permanent minimum lihtc rate for non-federally subsidized new buildings (9%) made permanent military housing allowance exclusion for determining lihtc eligibility made permanent treatment of rics as "qualified investment entities" under section 897 (firpta) made permanent deductibility of excise tax on high cost employer-sponsored health coverage 3. payroll tax exclusion of employer-paid transportation benefits (parking, van pools, and transit passes) exclusion of employee meals and lodging (other than military) exclusion of housing allowances for ministers exclusion of other employee benefits: premiums on group term life insurance (excludes payroll taxes) exclusion of other employee benefits: premiums on accident and disability insurance tax expenditure permanently extended by hr 2029: parity for exclusion from income for employer-provided mass transit and parking benefits made permanent 292 columbia journal of tax law [vol.8:257 f. additional clarifying questions and tpc assumptions about the plan (sent to the speaker’s staff july 7, 2016) 1. “special interest” tax provisions in addition to the list of tax expenditures listed in our prior document, we will also assume repeal of all private purpose tax exempt bonds; repeal of above-the-line deductions for expenses of educators and reservists, etc., moving expenses and alimony paid; and repeal of all personal credits (except the child tax credit, education credits, saver’s credit, and the foreign tax credit; so, for example, we will assume the child and dependent care tax credit is repealed). note: we included in our revenue and distributional estimates only the repeal of those tax expenditures that were clearly identified in the blueprint released by the speaker: the section 199 domestic production deduction, employee fringe benefits (except those related to health and retirement), and all individual and business tax credits (except the child tax credit, the eitc, education credits, the saver’s credit, the research and experimentation tax credit, and the foreign tax credit, all of which the blueprint identifies as retained). revenue estimates for the other provisions listed above are included as an addendum item in table 2. 2. rate cap on active business income we will assume that income currently subject to seca, or taxed as wages of worker/owners of subchapter s corporations, is “reasonable compensation”. for the remaining income of sole proprietors and pass-through businesses, we will assume that only income that is currently not considered “passive” will qualify for the rate cap. current active business losses will be allowed, rather than being carried forward with interest (which will shift the timing of income tax receipts somewhat, but generally not the present value of these receipts). 3. child tax credit and new credit for other dependents we will assume these are not indexed for inflation. 4. standard deduction for dependents we will assume that the standard deduction for dependents (in 2016 dollars) is the smaller of: (i) the greater of (a) earned income plus $350 and (b) $1,050, and (ii) the regular standard deduction for the dependent’s filing status (as modified by the proposal). we will assume all amounts are indexed for inflation. 2017] an analysis of the house gop tax plan 293 5. base year for indexing we will assume that all indexed parameters are stated at 2016 levels, so are indexed beginning in 2017 (our assumed effective date for the plan). vi. appendix b. measuring distributional effects of tax changes analysts use a variety of measures to assess the distributional effects of tax changes. there is no perfect measure—often a combination of measures is more informative than any single measure. the tax policy center generally focuses on the percentage change in after-tax income because it measures the gain or loss of income available to households to buy goods and services, relative to the amount available before the tax change. a tax change that raises or lowers after-tax income by the same percentage for all households leaves the progressivity of the tax unchanged. other measures used to assess a tax change’s effects include shares of the tax cut going to different parts of the income distribution, the size of each group’s cut measured in dollars, and the percentage change in tax liability. the first two measures poorly indicate the effects of a tax change because they ignore the initial distribution of taxes and thus do not assess changes in a tax’s progressivity. the percentage change in tax liability can be particularly misleading because it relies too much on the initial distribution of taxes. cutting the tax on a person making $1,000 from $50 to $10 is an 80 percent cut, whereas reducing taxes on a person making $1 million from $250,000 to $150,000 is just a 40 percent cut. but the tax savings boosts after-tax income by only about 4 percent for the poorer person, compared with a more than 13 percent increase for the higher-income person. 294 columbia journal of tax law [vol.8:257 table b1 shows several different measures of the effects of the house gop tax plan on households at different income levels in 2017. the tax cut is most significant as a share of after-tax income (column 1) for those with high incomes, as discussed above. it’s also true that for this plan, high-income people get the bulk of the tax cuts (column 2), that the average tax change is highest at high income levels (column 3), and that the tax cut is a larger share of tax liability for high-income households (column 4). finally, the share of federal tax burdens increases at most income levels, falling only for the top 1 percent (column 5). microsoft word zuo_a gain must lie where it falls .docx a gain must lie where it falls: matching tax with economics in subchapter k zhiyuan zuo* abstract society suffers efficiency costs when tax and economics are mismatched. this principle is illustrated by the tax neutrality doctrines that are the cornerstone of the u.s. international tax system and by the beps’s efforts to combat arbitrary income shifting. while society has an interest in maximizing pre-tax income from all economic activities, self-interested taxpayers seek only to maximize their aftertax income. a sound, non-arbitrary tax policy must thus incentivize taxpayers to maximize both their pre-tax and after-tax income. this note provides a novel efficiency analysis of the rules under subchapter k and reveals the efficiency costs that arise when arbitrary tax liabilities sever the positive connection between pretax and after-tax income. it applies the insight gained from the efficiency analysis to the treasury’s various flawed efforts under subchapter k to match tax with economics, including the substantial economic effect (see) safe harbor and doctrines under section 704(c). the article then explores alternatives to the treasury’s “one-size-fits-all” solution, focusing on a detailed analysis of the economic effect equivalence (eee) test and so-called target allocations. after revealing the tension between target allocations and some of the fundamental principles of section 704 regulations, the article presents a solution to the longdebated capital shift problem inherent in target allocations. * j.d. 2019, columbia law school. i would like to thank stuart l. rosow, sonia katharani-khan and ivy xiaotian yao for their helpful comments and encouragement. [vol. 11:1 columbia journal of tax law 104 table of contents i. introduction: arbitrary tax liabilities .................................................... 105 ii. efficiency costs due to tax-economics mismatches in subchapter k 106 a. the flexibility of subchapter k ................................................................................. 106 b. the problem of unintended government subsidies ................................................. 107 c. the orrisch case and the problem of capital market failure ............................. 110 d. allocation of nonrecourse deductions and the treasury’s solution ................ 112 iii. the substantial economic effect safe harbor: one size fits all? . 114 a. economic effect ........................................................................................................... 114 b. mismatch between tax and economic under the treasury’s capital account approach .............................................................................................................................. 115 1. the “ceiling rule” issue ............................................................................................... 115 2. the book-tax disparity and section 704(c)............................................................... 116 3. the abuse of dro and bottom dollar payment obligations................................. 118 c. economic effect equivalence: solution to one size fits all?............................... 121 1. the four-part analysis for economic effect equivalence .................................... 121 2. “regardless of the economic performance of the partnership” — what does it mean? .................................................................................................................................... 123 3. dro requirement and the eee test ........................................................................... 126 4. nonrecourse deductions and the eee test .............................................................. 129 5. when “reasonable” expectation fails ...................................................................... 130 iv. target allocation: a better alternative? ............................................... 132 a. capital shifting and tax avoidance motive ............................................................ 133 b. guaranteed payment as an alternative to capital shifting................................. 135 1. allocation of guaranteed payment: answer to the first question ..................... 137 2. limitation on using guaranteed payment to satisfy the see safe harbor: answer to the second question....................................................................................................... 138 3. a summary of the capital shift discussion so far .................................................. 139 4. book-equal-to-value assumption: revisited ........................................................... 139 v. conclusion ................................................................................................................. 140 2019] a gain must lie where it falls: matching tax with economics in subchapter k 105 i. introduction: arbitrary tax liabilities a famous principle of tort liability is that a loss must lie where it falls. it reflects a longstanding view that the law should not arbitrarily reallocate economic risks that parties have assumed ex ante.1the rationale behind this principle is that the risk of arbitrary tort liabilities may lead to inefficient ex ante allocations of realized social risks.2 similarly, the risk of tax liabilities that distort after-tax payoffs of transactions may incentivize transactions that fail to maximize pre-tax payoffs.3 individuals generally have an incentive to engage in transactions that maximize personal wealth. the transactions that maximize personal wealth also maximize societal wealth. therefore, in the absence of taxes, individuals pursue socially beneficial transactions in a selfish attempt to maximize their own welfare. under a sound tax policy, the transactions that maximize pre-tax personal wealth and societal wealth will also have the highest after-tax payoff. by contrast, a tax liability or policy that mismatches the pre-tax and after-tax payoffs of a transaction (an “arbitrary” tax policy) undermines private parties’ incentives to engage in socially beneficial transactions. under an arbitrary tax policy, a taxpayer no longer has the incentive to maximize social (pre-tax) payoffs in a selfish attempt to maximize his or her own (after-tax) payoffs. for example, a 100% tax credit for all net operating losses (nols) is arbitrary because it subsidizes inefficient businesses and socially insures opportunistic taxpayers against pre-tax losses. to illustrate, assume a taxpayer can invest $50x in a project today and has a 50% chance of receiving $90x in a year and 50% chance of receiving nothing. before taxes, the expected value of the transaction, ignoring time value of money, would be a social loss of $5x (50%*$90x-$50x). however, under a tax policy that provides 100% tax credit for all nols, and assuming that the taxpayer is in 40% tax bracket, the expected aftertax result of the transaction would be a private gain of $12x (50%*($90x-$50x)*60%). as a result, the taxpayer is incentivized to pursue a transaction that leads to a societal loss, but enables a private gain due to an arbitrary tax policy. similarly, a 100% tax on gross income is arbitrary because most taxpayers are unwilling to earn pre-tax income that they retain 0% of after taxes. as a final example, an100% deduction for personal consumption is also arbitrary because it incentivizes taxpayers to generate lower pre-tax returns than they would in the absence of such a shelter. if john, a taxpayer in the 40% bracket, needs only $6x after-tax for self-sustenance, he can choose either to earn $10x taxed at 40% or $6x that he can fully shelter from tax via personal consumption. though the decision to earn $10x is the socially beneficial alternative, john will choose the latter because it requires less effort for the same after-tax return. 1 see generally oliver wendell holmes, jr., the common law 95 (boston, little, brown & co. 1881) (“all the cases concede that an injury arising from inevitable accident, or…from an act that ordinary human care and foresight are unable to guard against, is but the misfortune of the sufferer…”). 2 see, e.g., adams v. bullock, 227 n.y. 208, 210 (n.y. 1919) (holding that the defendant, a trolley line company, should not be held liable for an “extraordinary casualty” that is “not fairly within the area of ordinary prevision”); united states v. carroll towing co., 159 f.2d 169 (2nd cir. 1947). 3 almost all tax liabilities have efficiency costs due to the market dampening effect, which is generally referred to by economists as “deadweight loss.” see, e.g., julia kagan, deadweight loss of taxation, investopedia (dec.30, 2019) https://www.investopedia.com/terms/d/deadweight-loss-of-taxation.asp [https://perma.cc/4lzvd5n3]. [vol. 11:1 columbia journal of tax law 106 in reality, all tax liabilities incur some efficiency costs, measured by the chilling effect on the market and the shrinking volume of socially beneficial activities.4 however, arbitrary tax liabilities can incur disproportionately large efficiency costs. in the case of the 100% tax on gross income and the 100% tax credit for nols, the efficiency cost is incurred because the link between pre-tax and after-tax payoffs is severed. in the case of the 100% deduction for personal consumption, the cost is incurred because the socially beneficial incentive to earn higher pre-tax returns (i.e. to achieve higher after-tax returns) is eliminated. the legal flexibility of subchapter k increases the likelihood that such arbitrary tax liabilities and efficiency costs are imposed on taxpayers. unlike tax policies that are clearly arbitrary, such as a 100% tax on gross income, subchapter k’s potential for arbitrariness is hidden in its complicated statutory scheme. the risk of arbitrariness is evidenced by treasury’s painstaking efforts to match tax consequences with economic arrangements in subchapter k.5 this note provides fresh insight into the design and application of complex rules in subchapter k, which are intended to match partnership tax consequences with their corresponding economic arrangements. it examines the relationship between the regulatory anti-abuse rules, the substantial economic effect (“see”) safe harbor, and the section 704(c) doctrine, while revealing their imperfections. specifically, part ii analyzes the efficiency costs that arise when arbitrary tax liabilities imposed by subchapter k give rise to mismatches between tax and economics. part iii provides a detailed analysis of how the economic effect equivalence test under treas. reg. § 1.704-1(b)(2)(ii)(i), part of the see safe harbor, has been applied to justify partnership allocations. it then assesses how the test should be applied in light of prolonged regulatory uncertainties, given its importance. part iv uses insights from parts ii and iii to address the long-debated but unresolved issue of partnership “target allocations,” with a focus on the capital shifting problem inherent in preferred return allocations. ii. efficiency costs due to tax-economics mismatches in subchapter k a. the flexibility of subchapter k congress intended for subchapter k to facilitate joint business and investment activities by permitting flexible economic arrangements without triggering entity-level taxes.6 thus, subchapter k provides significant flexibility for partners to allocate among themselves the benefits, burdens and risks of partnership activities. a partnership is not subject to entity-level tax.7 instead, each partner must separately take into account his distributive share of partnership items.8 section 704 and related regulations permit a partner’s distributive share to be determined by the partnership agreement. if such allocations lack substantial economic effect, the relevant partnership items will be reallocated, solely for tax purposes, in accordance with the partner’s interest in the partnership determined under all 4 id. 5 see part ii.a, infra. the reader may develop a sense of treasury’s “painstaking efforts” by looking at the length and complexity of section 704 regulations. see generally treas. reg. §1.704-1. 6 treas. reg. §1.701-2(a). 7 i.r.c. § 701. 8 id. see also i.r.c. § 702(a). 2019] a gain must lie where it falls: matching tax with economics in subchapter k 107 facts and circumstances.9 the partnership agreement need not provide that partnership items be allocated in proportion to each partner’s capital contribution to the partnership.10 to provide even more flexibility, subchapter k permits partners to modify the partnership agreement and make special allocations of partnership items for the taxable year up to the time prescribed by law (excluding extensions) for filing the partnership’s tax return.11 such flexibility is also in line with congress’ intent to establish partnerships as vehicles for pooling resources for productive uses without triggering gain or loss.12 it is easy to see how the significant flexibility of subchapter k, in the absence of antiabuse rules, may lead to disproportionately large efficiency costs. as with the taxpayers incurring arbitrary tax liabilities discussed in part i, partners seeking to maximize their aftertax payoffs may from time to time be incentivized to go against the socially beneficial goal of maximizing pre-tax payoffs. for example, the partners may be incentivized to shift the tax consequences of economic activities, whether related or unrelated to the partnership’s business, among themselves without shifting the underlying economic activities.13 if this is the case, the government will unintentionally subsidize inefficient businesses (as in the case with a 100% tax credit for nols) and will hinder the proper functioning of capital markets due to the use of tax shelters (as in the case with a 100% deduction for personal consumption). b. the problem of unintended government subsidies to understand the efficiency cost of subchapter k in terms of unintended government subsidies, assume that the partners initially have unlimited flexibility in allocating partnership items for tax purposes without regard to how they share those items economically. suppose an individual, a, is operating a profitable business with $100x capital at an annual pre-tax return of 10%. to expand his business, a is considering attracting capital owned by b and c. each would contribute $100x each, and both lack expertise in a’s business. a is uncertain as to whether b and c will hold a debt or equity interest in the business. for simplicity, assume that a is in the 40% tax bracket, while b and c pay no tax because of favorable tax attributes such as nol carryovers. debt form of transaction: if b and c come in as creditors for a 5% annual pre-tax return on their investment, a will now have $300x capital and retain exclusive control over the 9 i.r.c. § 704(a) & (b); treas. reg. § 1.704-1(b)(1)(i). see also s. comm. on finance, 98th cong., 2d sess., rep. on deficit reduction act of 1984, 213. 10 see staff of the joint comm. on internal revenue taxation, 94th cong., 2d sess., general explanation of the tax reform act of 1976, at 94. as a comparison to s corporation rules, see i.r.c. §1366(a) (requiring pro rata allocation of an s corporation’s items of income, loss, deduction, or credit to its shareholders). 11 see staff of the joint comm. on internal revenue taxation, supra note 10; see also section 761(c). 12 see s. comm. on finance, 98th cong., 2d sess., rep. on deficit reduction act of 1984, 214. see also supra note 6. 13 for a recent example, see tifd iii-e inc. v. united states, 342 f. supp. 2d 94 (d. conn. 2004), rev’d, 459 f.3d 220 (2d cir. 2006), also known as the castle harbour case. in that case, the taxpayers attempted to shift taxable gain to a foreign tax-neutral partner while the gain would have been taxable to the u.s. partner. though the allocations were upheld by the district court, the decision was ultimately reversed by the second circuit. [vol. 11:1 columbia journal of tax law 108 business. because of his specialized knowledge in the business and unhindered control over its operations, the business will continue to generate a 10% annual pre-tax return. assuming interest expense is fully deductible, the after-tax return on investment for the parties is as follows: party payoff a $12x b $5x c $5x total for private parties $22x u.s. government $8x total for all parties $30x a: ($300x * 10% 5% * $200x) * (1-40%) b: ($100x * 5%) c: ($100x * 5%) u.s. government: ($300x * 10% 5% * $200x) * 40% equity form of transaction: if b and c have management rights and come in as general partners, assume that their lack of business expertise and the resulting management inefficiencies means that the business (now partnership abc) can only generate a 9% annual pre-tax return on the same $300x capital. despite the lower pre-tax return, a will take advantage of the partnership’s unlimited flexibility to make special allocations and allocate all pre-tax profit to b and c solely for tax purposes, while their actual economic entitlement remains unchanged. because b and c pay no tax, and a now has no taxable income from the business, the after-tax payoff for the parties is as follows: party payoff a $17x b $5x c $5x total for private parties $27x u.s. government 0 total for all parties $27x a: ($300x * 9% 5% * $200) b: ($100x * 5%) c: ($100x * 5%) u.s. government: 0 b and c will generally be indifferent to the debt and equity forms of the transaction because they expect a 5% after-tax return in both cases. however, a will strongly prefer the equity form of the transaction due to the tax savings, and may provide b and c with management rights and a higher than 5% return as “sweetener” for participation in the income shifting scheme. although a knows that b and c are not familiar with the business and that their involvement in the business leads to an efficiency cost, a will not act as a “gatekeeper” because he is able to transfer such costs to the u.s. government. in other words, although the 2019] a gain must lie where it falls: matching tax with economics in subchapter k 109 debt form of the transaction is more socially beneficial, the unlimited flexibility in allocating partnership items incentivizes a to choose the equity form. in this example, the u.s. government provides an $8 unintended subsidy (in terms of an implied tax credit) for the private parties to operate an inefficient business: a subsidy of $3 to fully absorb the efficiency cost, and an additional $5 subsidy as a “sweetener” to continue operating the business inefficiently. the tax policy in this case thus permits an increase in the after-tax payoff for the private parties (from $22 to $27) even when the pre-tax payoff for all parties decreases from $30 to $27. in other words, since the parties can pursue a higher aftertax payoff simply by changing the form of the investment, there is no incentive to also maximize the pre-tax payoff. this is an example of an arbitrary tax liability as defined in part i of this note:14one that severs the connection between pre-tax and after-tax payoffs, subsidizes inefficient businesses, and potentially squeezes out efficient businesses.15 subchapter k’s attempts to eliminate such arbitrary tax liabilities by matching taxes with economics. 16 to illustrate with the same example, under subchapter k, the u.s. government can instead require that whoever is allocated partnership income for tax purposes must actually be entitled to such income. as a result, a will be taxed at a 40% rate on $17 of partnership income because he is actually entitled to it. the parties’ payoffs will be as follows: party payoff debt form equity form a $12x $10.20x b 5x 5x c 5 x 5x total for private parties $22x $20.20x u.s. government $8x $6.80x total for all parties $30x $27x the table above shows three things. first, the u.s. government and private parties now share the $3x efficiency cost under the equity form of transaction in proportion to a’s tax rate, or 40/60 (u.s. government: $1.2x, a: $1.8x). in other words, the u.s. government now only provides an implied deduction of $3x for the efficiency cost, by not taxing the $3x as imputed income. as a result, the $8x unintended subsidy in terms of an implied tax credit is fully eliminated. second, the new tax policy is non-arbitrary because it’s no longer possible for private parties to pursue a higher after-tax payoff given the same or even lower pre-tax payoff. at the partnership level, the $3x efficiency cost can only generate $1.2x in tax savings. thus, the partnership is better off avoiding the efficiency cost. at the partner level, for each dollar shifted from a to b or c, a loses a dollar but only receives $0.4x in tax savings., and therefore 14 another way to describe this tax policy of allowing unlimited allocations of partnership items solely for tax purposes is that it is not “neutral.” a neutral tax policy should stay in the background and allow non-tax market forces to govern a transaction. see richard l. doernberg, international taxation in a nutshell§ 1.04(9th ed. 2012) (stating that the goal of a tax system in general is “the implementation of a tax-neutral set of rules that neither discourage nor encourage particular activities.”). 15 see part ii.c, infra. 16 see supra note5. [vol. 11:1 columbia journal of tax law 110 a too is better off without shifting the income. third, a will now have an incentive to maximize the pre-tax payoff from the business, which leads to a socially beneficial result. c. the orrisch case and the problem of capital market failure to visualize how an arbitrary tax liability may squeeze out efficient businesses by disturbing normal market forces in capital markets and how it exacerbates the tax shelter effect of accelerated depreciation, consider an early case on the see safe harbor, orrisch v. commissioner.17 the orrischs and the crisafises formed a partnership to purchase and operate two apartment houses. to better utilize the accelerated 150% of straight-line depreciation, the parties agreed to allocate all depreciation to the orrischs (for both tax and book purposes) to shelter their substantial income from unrelated sources. the parties combined this with a special allocation (for both tax and book purposes) of gain on sale of the depreciated properties in the future to the orrischs to the extent of their previously allocated depreciation. they shared all other partnership items 50/50. on the surface, it was not possible for the orrischs to increase their after-tax payoff without increasing their pre-tax payoff since they would lose their entitlement in liquidation as they deduct additional depreciation. however, as the court correctly observed, the orrischs would eventually be compensated for such loss by the special allocation of gain on the sale of the depreciated properties. assuming that such properties preserve their value, the orrischs would be fully restored to their original economic position as if no special allocation had ever been made. of course, the orrischs assumed the risk that the partnership properties may lose value. but the facts and circumstances indicated that they would not have agreed to the special allocation unless they believed that the present value of expected net tax savings outweighed the present value of loss from any expected decline in property value. arrangements like this interfere with the goal of a properly functioning capital market, i.e. to allocate capital to the party that can use it to generate the greatest value. for example, if another party expects a smaller decline in property value because of its greater ability to preserve property value, but is unable to generate enough net tax saving from the investment, the property will end up in the hands of inefficient investors such as the orrischs. as a variation on the facts of the case, assume that the partnership formed by the orrischs and the crisafises (partnership oc) is in a bidding contest against another partnership (partnership ab) for an item of depreciable property. partnership oc can sell the property for $100,000 after fully depreciating it (with no salvage value). however, partnership ab, which can better utilize, maintain and improve the property, can sell it for $130,000 after full depreciation. assume a five-year investment horizon, five-year useful life, an annual discount rate of 10%, a tax bracket of 40% for all the partners, and a perpetuities valuation model to calculate the present value of future payoffs for both parties. assume further that the orrischs have substantial personal income to fully utilize any excess depreciation, while the crisafises and the partners in partnership ab have no other income to utilize against any excess 17 see orrisch v. commissioner, 55 tc 395 (1970). the orrisch case may come out differently under current section 704 regulations, under which a partnership property’s fair market value is presumed to be its adjusted tax basis for purposes of determining whether several partnership allocations are “transitory” and thus without substantial economic effect. see treas. reg. § 1.704-1(b)(2)(iii)(c). see also treas. reg. 1.701-2(d), ex. 6(i). however, the insight provided by the orrisch court is still helpful in understanding subchapter k’s logic of matching taxes with economics. 2019] a gain must lie where it falls: matching tax with economics in subchapter k 111 depreciation. the maximum bidding price that partnership ab is willing to pay, pmax(ab), is approximately $143,000 (ignoring time value of money).18 similarly, as explained in footnote 18, partnership oc’s annual income from the property is assumed to be $10,000, or $100,000 * 10% under the perpetuities model. if a court permits the special allocation, since the orrischs are in the 40% tax bracket, the maximum bidding price by partnership oc will be pmax(oc), which is equal to the sum of the expected income from the property and the net tax savings from the special allocation scheme.19solving for pmax(oc) gives $150,000. consequently, since pmax(oc) is greater than pmax(ab), partnership oc will outbid partnership ab to receive the property. however, this capital allocation is economically inefficient because partnership ab is better at utilizing, maintaining and improving the property. the efficiency cost of $45,000 (ignoring time value of money)20 stems from the tax shelter effect of depreciation provided by a tax policy that permits the special allocation proposed by the orrischs. to exacerbate the issue, partnership oc may have borrowed on a nonrecourse basis to acquire the property, and the property may be entitled to immediate expensing of its acquisition cost.21assume, in this extreme case, that partnership oc incurred $145,000 of nonrecourse debt to outbid partnership ab and acquire the property. the property has a useful life of five years and will be worth $100,000 at the end of its useful life, but the orrischs are entitled to an immediate 100% cost recovery deduction. assume that income from the property is just enough to cover interest payments, that all interest payments are deductible and that the creditor does not anticipate any decline in property value due to information asymmetries. the debt will mature after five years and will have a principal balance of $145,000 at maturity. since the property will be worth only $100,000 at maturity, partnership oc will abandon the property to the creditor in full satisfaction of the debt, and the orrischs will be allocated the $145,000 partnership minimum gain.22 the pre-tax payoff for partnership oc is zero, because it has no equity in the property and all income before interest and tax (ebit) derived from the property is paid to the creditor as interest. however, the after-tax payoff for partnership oc is 18 under the perpetuities model, a $130,000 property value and 10% annual discount rate implies a perpetual annual cash flow of $13,000, or $130,000*10%. assuming that partnership ab also generates $13,000 annual income from this property during the five-year investment period, the maximum payoff from the investment for partnership ab is (5*$13000 + 60%*$130,000), or $143,000. for an introduction to perpetuities valuation, see richard a. brealey, stewart c. myers & franklin allen, principles of corporate finance 27-28 (12th ed. 2017). 19 mathematically, pmax(oc) =100,000 * 0.6 + 0.4 * pmax(oc) – 0.4*5*$10,000 + 5*$10,000 20 this is calculated as follows: 5*($13,000 $10,000) + $130,000 $100,000. 21 for immediate expensing of certain capital expenditures, see i.r.c. § 179. see also i.r.c. § 168(k) (bonus first year depreciation). both rules potentially lead to a mismatch between tax deductions and economic income, and the result can be an increase in expected after-tax yield from the property given the same expected pre-tax yield. see michael j. graetz, implementing a progressive consumption tax, 92 harv. l. rev. 1575, 1598 (1979) (explaining the immediate-deduction/yield-exemption equivalence); michael j. graetz, deborah h. schenk, anne l. alstott, federal income taxation, principles and policies 314-318 (8th ed. 2018). 22 for the rules governing the allocation of nonrecourse deductions and minimum gain chargeback, see treas. reg. §1.704-2(a) to (g). see also crane v. comm’r., 331 u.s. 1 (1947); comm’r. v. tufts, 461 u.s. 300 (1983) (minimum gain for the difference between the amount of nonrecourse debt secured by a property and the adjusted basis must be recognized in a sale or exchange, regardless of fair market value); boris i. bittker, tax shelters, nonrecourse debt, and the crane case, 33 tax l. rev. 277, 283 (1978) (“[c]rane laid the foundation stone of most tax shelters . . . .”). [vol. 11:1 columbia journal of tax law 112 positive in present value terms. the orrischs are entitled to a depreciation deduction of $145,000 in the year of acquisition, and assuming that the property is fully deductible,23they will have a cash inflow of $58,000; after five years, the orrischs will have a cash outflow of the same amount (assuming the same tax rate) because of the realization of minimum gain. this is equivalent to taking out an interest-free loan from the treasury for five years. assuming an annual discount rate of 10%, the orrischs’ after-tax payoff is $21,987.24 even worse, since the orrischs have incurred zero after-tax cost in the property (entirely financed by non-recourse debt), the after-tax return on investment is positive infinity.25 alternatively, if a court rejects the special allocation and reallocates the excess depreciation 50/50 between the orrischs and the crisafis, as the court here correctly did, the following relation holds: pmax(oc) – (100,000 * 0.6 + 0.6*5*$10,000 + 0.4 * 0.5* pmax(oc)) = 0. solving for pmax(oc)gives $112,500. since pmax(oc) is now smaller than pmax(ab), partnership ab will outbid partnership oc, and the property will go to the party that can use it more efficiently. as the two examples show, a tax policy that allows unconstrained partnership allocations solely for tax purposes severs the connection between pre-tax and after-tax payoffs. therefore, such a policy undermines the socially beneficial incentives to maximize after-tax payoffs through the maximization of pre-tax payoffs. such a tax policy is thus arbitrary as defined in part i. if a taxpayer can consistently and predictably increase expected after-tax payoffs given the same or even lower expected pre-tax payoffs, the consequence is an unintended subsidy to inefficient businesses, as well as increased inefficiency in capital markets. d. allocation of nonrecourse deductions and the treasury’s solution the orrisch and tufts doctrines suggest that any allocation of partnership nonrecourse deductions should not be respected for tax purposes since by definition it mismatches tax and economics.26 a nonrecourse deduction is generally a deduction attributable to nonrecourse financing, such as a depreciation deduction from basis obtained through nonrecourse acquisition mortgage debt.27 the creditors, not the taxpayer, assume the economic burden of a nonrecourse deduction. 28 similarly, an allocation of gain attributable to a decrease in partnership minimum gain (or tufts minimum gain at the partnership level) for tax purposes is 23 the deduction may be limited by the “at-risk” rule. see i.r.c. § 465. 24 the number is calculated as the cash inflow today less the present value of the cash outflow in five years: $58,000 – $58,000/(1+0.1)^5. 25 see, e.g.,graetz, schenk &alstott, supra note 21, at 310-311, 364 (discussing tax arbitrage opportunities where the code allows immediate expensing of the cost of assets). as an example of such tax arbitrage, assuming a taxpayer in the 40% bracket borrows at 5% annually (economically equivalent to short-selling a 5% bond) and buys an asset of the same risk which generates a 5% annual return. if the interest expense is fully deductible and no immediate expensing is allowed on the asset, both the pre-tax return and after-tax return are zero. however, if immediate expensing is allowed, the taxpayer’s cost of borrowing would be 4% but the after-tax yield on the asset would be 5% due to the immediate-deduction/yield-exemption equivalence. see graetz, schenk & alstott, supra note 21. therefore, the taxpayer can arbitrage the 1% difference by engaging in the transaction. 26 this observation is also supported by current regulations. see treas. reg. § 1.704-2(b)(1) (“allocations of . . . (“nonrecourse deductions”) cannot have economic effect because the creditor alone bears any economic burden that corresponds to those allocations.”). 27 for the definition of nonrecourse deductions, see treas. reg. § 1.704-2(c). 28 see treas. reg. § 1.704-2(b)(1). 2019] a gain must lie where it falls: matching tax with economics in subchapter k 113 always mismatched with economics since the partners are relieved from an economic burden that doesn’t exist in the first place (e.g. when the encumbered property is surrendered to the creditor or transferred to a third party).29 since a partner who is allocated a nonrecourse deduction will be allocated partnership minimum gain in the same amount when it is realized, 30 an allocation of a nonrecourse deduction is exactly what the orrisch court described as “a trade of tax consequences.”31 without restrictions, a partnership tax shelter involving nonrecourse financing, like the one mentioned in part ii.c, will give a taxpayer zero pre-tax return but an after-tax return of positive infinity.32 the treasury’s strategy is a two-part solution. first, by explicitly stating that an allocation of nonrecourse deduction and partnership minimum gain can never match the economics, 33 the treasury can prescribe less “safeharbored” and more rigid rules to govern such allocation, and a taxpayer cannot justify her own allocation on the ground that it matches the economics. second, to reduce the possibility that a nonrecourse deduction will offset economically unrelated income for tax purposes, which is the essence of a tax shelter,34 the treasury requires nonrecourse deductions to be allocated in a way that are “reasonably consistent” with other allocations related to the same encumbered property that do match the economics. 35 by combining nonrecourse deductions with related partnership items in an allocation, partners who want to allocate nonrecourse deductions in a certain way may need to alter another allocation, which eventually alters the economic entitlement of each partner. in addition, since the allocation of net income from operation of the encumbered property, before considering nonrecourse deductions, usually matches each partner’s economic entitlement,36 an allocation of nonrecourse deductions that is tied to the allocation of such income reduces the availability of tax shelters. this is because it is now harder to create an artificial net loss for a partner through a special allocation of nonrecourse deductions.37 treasury’s position on the allocation of partnership nonrecourse deductions appears to be a compromise between complying with the tufts doctrine and reducing its harmful impact during partnership allocations. nevertheless, it often fails to take a similar position on other allocations when the same harmful impact is present. part iii of this note will perform a detailed analysis of the treasury’s efforts to match tax results with economics in partnership allocation context, discuss the inherent uncertainty, inefficiency, and inconsistency, and suggest an improvement. part iv of this note will apply the insight from this analysis to the so-called “target allocations” and propose a solution to the long-debated capital shift problem in target allocations with preferred returns. 29 see treas. reg. § 1.704-2(b)(2). 30 treas. reg. § 1.704-2(f), (g). 31 orrisch v. comm’r., 55 t.c. 395, 403 (1970). 32 see part ii.c., supra. 33 treas. reg. § 1.704-2(b)(1)–(2). 34 for a brief introduction to tax shelters, see julia kagan, tax shelter, investopedia (12/30/2019), https://www.investopedia.com/terms/t/taxshelter.asp [https://perma.cc/4lzv-d5n3]. 35 treas. reg. § 1.704-2(e)(2). 36 see treas. reg. § 1.704-2(e)(1), (4). 37 in the nonrecourse financing example in part ii.c,, if the orrischs and the crisafis agree to allocate net income before nonrecourse deduction 50/50, the nonrecourse deduction from the immediate expensing must also be allocated 50/50. this reduces the possibility that the orrischs can obtain a net loss from the nonrecourse deduction and use it to offset income unrelated to the partnership’s business. [vol. 11:1 columbia journal of tax law 114 iii. the substantial economic effect safe harbor: one size fits all? to provide a statutory link between the after-tax payoff and the expected pre-tax payoff in the partnership context, subchapter k requires all partnership allocations to either be made “in accordance with the partner’s interest in the partnership,” or have “substantial economic effect” (“see”).38 the former, known as “partner’s interest in the partnership test” (“the pip test”), is a facts and circumstances test in determining the economic substance of an allocation, and its outcome can be highly uncertain.39to reduce the uncertainty, the treasury promulgates three alternatives to provide a safe-harbor enabling most partnership allocations to qualify under the see test — the primary test, the alternate test for economic effect, and the economic effect equivalence test.40 an allocation satisfying either one of these alternatives is deemed to have an “economic effect.” if such economic effect is also “substantial” under the regulations, the allocation will be respected for tax purposes for matching the economics.41 on the other hand, if an allocation fails to satisfy any of the alternatives or if the economic effect is insubstantial, the relevant partnership item will be reallocated solely for tax purposes to reflect the parties’ real economic arrangement, i.e., “in accordance with the partner’s interest in the partnership.”42 a. economic effect not surprisingly, the regulation defines an allocation as having “economic effect” if there is a matching of actual economic benefit or burden with the allocation for tax purposes of partnership items that generate such benefit or burden.43 that is, an allocation for tax purposes will be respected only if the relevant partners are better-off or worse-off in terms of expected pre-tax payoff from partnership activities. using the problem of the unintended subsidy in part ii.c. as an example, in order for the allocation of all $27x pre-tax income to b and c to have economic effect, they must be actually entitled to the $27x in a liquidation.44as a result, a is worse-off by $27x pre-tax but can only generate tax savings equal to a fraction (a’s marginal tax rate, or 40%) of $27x. thus, under the economic effect requirement, if a desires higher after-tax income for himself from partnership activities, he must cause the partnership to earn higher pre-tax income using his knowledge and expertise. this aligns a’s personal interest with the interest of society and eliminates the $3x efficiency cost. under the primary test, an allocation is treated as having economic effect if: (1) the partners’ capital accounts are maintained to reflect any changes in economic entitlement to 38 see i.r.c. § 704(b); treas. reg. § 1.704-1(b)(1)(i). 39 to satisfy the pip test, an allocation must be made “in accordance with the partner’s interest in the partnership.” see i.r.c. § 704(b). the regulations specify four factors to be considered in determining a partner’s interest in the partnership, including relative contributions, share of economic profit or loss, cash flow rights and other nonliquidating distributions, right, and entitlement to liquidating distributions, but otherwise provides little guidance on how those factors should be weighted and applied. treas. reg. § 1.704-1(b)(3)(ii). see also william g. cavanagh, targeted allocations hit the spot, 129 tax notes 89, 96(oct. 4, 2010) (stating that the lack of guidance on the pip test indicates the drafters’ desire to encourage taxpayers’ reliance on the see safe harbor). 40 treas. reg. § 1.704-1(b)(2)(ii)(b), (d),(i). 41treas. reg. § 1.704-1(b)(1)(i), (b)(2)(i). 42 treas. reg. § 1.704-1(b)(1)(i). 43 treas. reg. § 1.704-1(b)(2)(ii)(a). 44 see, e.g.,treas. reg. § 1.704-1(b)(5),ex.(1)(i)–(ii). 2019] a gain must lie where it falls: matching tax with economics in subchapter k 115 partnership net assets as a result of partnership allocations; (2) each partner will receive her economic entitlement in liquidation; and (3) a deficit in a partner’s capital account balance, representing the amount owed to the partnership because of events such as distribution, allocation of partnership expense, or loss or assumption of partnership liabilities,45 triggers an unlimited obligation (known as “deficit restoration obligation,” or “dro”) for the partner to reimburse the partnership in liquidation.46 thus, the see safe harbor uses the capital account balance to measure the partner’s economic entitlement to the partnership’s net assets or the partner’s obligation to make additional contributions to the partnership.47 under the alternate test for economic effect, if the partnership agreement otherwise satisfies the primary test but for the fact that some or all partners do not have an unlimited dro, which can be common for limited partnerships or limited liability corporations, an allocation still has economic effect upon the satisfaction of two conditions. first, the allocation cannot create or increase a deficit in capital account balances in excess of any limited dro. second, the partnership agreement must have a provision (known as “qualified income offset,” or “qio”) that requires offsetting allocations to be made as quickly as possible to eliminate any capital account deficit caused by certain events such as an unexpected partnership distribution.48 this may require an allocation of partnership gross income or gain, given that the qio regulation specifically refers to gross income in the treasury regulations.49 interestingly, to prevent partnerships from manipulating the timing of distributions to fit an allocation of deduction into the alternate test (for example, by deferring a distribution to the beginning of the next year so that a partner has a greater capital account balance to absorb a deduction in the current year), the regulation requires that a partner’s capital account balance be reduced by the excess of expected future distributions over the reasonably expected future offsetting increases in the partners’ capital account balances.50 b. mismatch between tax and economic under the treasury’s capital account approach 1. the “ceiling rule” issue a partner’s capital account balance can only be adjusted when certain economic activities promulgated by the treasury occur. it is thus possible that an economic arrangement cannot be translated into a capital account balance because it is not included in scope of the 45 see treas. reg. § 1.704–1(b)(2)(iv)(b) (providing rules for decreasing partners’ capital accounts). 46 treas. reg. § 1.704–1(b)(2)(ii)(b)(3). see also treas. reg. § 1.704–1(b)(2)(ii)(c) (describing a partner’s deemed obligation to restore deficit even in absence of express obligation to do so). 47 see treas. reg. § 1.704–1(b)(2)(ii) (requiring maintenance of partners’ capital accounts according to treas. reg. § 1.704–1(b)(2)(iv)). see also treas. reg. § 1.704–1(b)(2)(iv) (requiring capital account balances to be increased or decreased by allocations or events which change the partner’s economic entitlement to the partnership’s net assets). 48 treas. reg. §1.704–1(b)(2)(ii)(d)(1) to (3). see “flush language” included in treas. reg. § 1.704–1(b)(2)(ii)(d) for explanation of qualified income offset, or qio. 49 see “flush language” in treas. reg. § 1.704–1(b)(2)(ii)(d) (providing that a partnership agreement contains a qio only if a partner receives allocations of income and gain, including gross income, to cure certain unexpected adjustments, allocations or distributions that lead to a deficit balance in the partner’s capital account). 50 treas. reg. §1.704–1(b)(2)(ii)(d)(6). [vol. 11:1 columbia journal of tax law 116 treasury’s listed activities.51 in other words, except under the listed situations, the regulation prohibits partners from voluntarily adjusting their respective capital account balances by any “hypothetical” gain or loss allocated.52 this can be understood as an inherent “ceiling rule” in the treasury’s capital account approach.53 the “ceiling rule ” applies even if doing so would lead to capital account balances that better reflect the partners’ entitlements on liquidation. a mismatch between tax and economics results when, for example, the liquidating distributions must deviate from capital account balances in order to reflect the partners’ economic agreement, but no corresponding tax gain or loss can be allocated at the time of liquidation to match tax with economics due to the “ceiling rule.”54 for example, suppose a partnership agreement between a and b initially provides for a 70/30 allocation of all partnership items, but requires an 80/20 allocation of liquidating distributions if a completes at least 2,000 hours of professional service to the partnership by the time of liquidation.55 a and b cannot readjust the capital account balances at liquidation to reflect the 10% difference if there is no gain or loss. moreover, they cannot allocate a fictitious partnership-level gain to a and a corresponding loss to b due to the “ceiling rule.” therefore, the capital account balances will fail to reflect the economics of transaction when liquidation distributions are shared according to the 80/20 allocation. another example of this type of mismatch is the capital shift problem in an economic arrangement involving preferred return on capital, to be discussed in part iv.b. 2. the book-tax disparity and section 704(c) certain revaluation events, such as admission of new partners or distribution of property, will also trigger a mismatch that creates a book-tax disparity in tracked basis.56 consider the following example.57 example one the balance sheet of partnership abc as of 12/31/20x1 is as follows: 51 for the rules governing capital account adjustments, see treas. reg. §1.704–1(b)(2)(iv), permitting or mandating adjustment to a partner’s capital account balance under situations like contribution of capital, certain assumptions of partnership liabilities, and allocation of partnership income or loss, including gain or loss from revaluation of property and distribution. see treas. reg. §1.704–1(b)(2)(iv)(b), (c), (f), (g). 52 see, e.g., treas. reg. § 1.704–1(b)(2)(iv)(f) (suggesting that capital account balances may be adjusted for revaluations of property that are in the form of unrealized or “fictitious” gains or losses only under limited circumstances). 53 see discussion part iv. a., infra. 54 see, e.g., daniel s. goldberg, the target method for partnership special allocations and why it should be safe-harbored, 69 tax law. 663, 702-706 (2016). 55 for a similar example, see id. at 702-703. 56 for revaluation of partnership properties, see treas. reg. § 1.704–1(b)(2)(iv)(e)(1) regarding mandatory revaluation when partnership property is distributed. see treas. reg. § 1.704–1(b)(2)(iv)(f) for the provision of optional revaluation under limited circumstances. see treas. reg. § 1.704–1(b)(4)(i) for the requirement that section 704(c) doctrine govern the allocation of tax items after revaluation. 57 for the purposes of this example, assume that none of the partnership properties are covered by section 751 or related regulations. thus, there is no “mixing-bowl” issue. see i.r.c. § 751(b). 2019] a gain must lie where it falls: matching tax with economics in subchapter k 117 tax basis book value fair market value blackacre $100x $100x $800x whiteacre 200x 200x 400x blueacre 300x 300x 1,200x a’s capital 300x 300x 1,200x b’s capital 150x 300x 600x c’s capital 150x 300x 600x suppose that on december 31, 20x1, the partnership distributes whiteacre to b. prior to distribution, the partners shared all partnership items with a 50/25/25 allocation. after the distribution, b’s share is reduced to 10%. whiteacre is revalued at the fair market value of $400x, and the resulting revaluation gain of $200x is allocated according to the partnership agreement (i.e. $100x to a, $50x to b, and $50x to c).58 suppose a section 754 election is made and an upward basis adjustment of $50x is available for blackacre and blueacre.59 if partnership abc is liquidated immediately by selling all remaining properties at fair market value, the tax consequences will not reflect the parties’ economic arrangement, resulting in a mismatch. after the sale, the partnership has total cash of $2,000x and a gain of $1,550x.60 since a, b, and c now share partnership items based on a 60/30/10 split, the $1,550x gain must be allocated accordingly to a, b, and c for both book and tax purposes. as a result, a’s economic gain from partnership activities is $900x, 61 but a’s gain for tax purposes is $930x,62creating a mismatch of $30x that is not cured by the section 754 election. similarly, b has an economic gain of $450x compared to a tax gain of $465x, and c has an economic gain of $450x compared to a tax gain of $405x. the above example shows an inherent problem in the treasury’s capital account method: in a complex transaction, the capital account adjustment rules may be totally inadequate for matching the tax consequences at the time of allocation with the economic consequences at liquidation.63 in example one, because the partners do not elect to revalue blackacre and blueacre when whiteacre is distributed to b,64section 704(c), which generally matches tax consequences after certain partnership-level changes to related economic activities 58 see treas. reg. § 1.704–1(b)(2)(iv)(e)(1) (providing that upon a distribution of property, capital accounts must be adjusted to reflect gain or loss inherent in the property as if there were a taxable disposition of the property at fair market value on the date of distribution). 59 this upward basis adjustment is due to $50x basis reduction of whiteacre owned by b. see i.r.c. § 732(a)(2). without the adjustment, the same $50x will be taxed twice when b sells whiteacre and when the partnership sells the remaining asset. for an election under section 754 to adjust basis,seei.r.c. § 734(b); i.r.c. § 754; treas. reg. § 1.734–1(a), (b); treas. reg. § 1.754–1. 60 the sum of the difference between the tax basis and fair market value of both blackacre and blueacre, minus the $50x upward basis adjustment. 61 the fair market value of a’s partnership interest, $1,200x, minus a’s tax basis in such interest, $300x. 62 the partnership’s $1,550x tax gain multiplied by a’s 60% interest. 63 see, e.g., goldberg, supra note 54, at 706 (arguing that sometimes the economic deal of the partners is too complicated for the treasury’s capital account method). 64 such revaluation is optional rather than mandatory. see supra note 52; treas. reg. § 1.704–1(b)(2)(iv)(e)(1) (requiring revaluation of the distributed property only). [vol. 11:1 columbia journal of tax law 118 prior to such changes, does not apply.65when blackacre and blueacre are sold, the treasury’s method fails to properly account for economic activities prior to the distribution from which the gain has accrued. this problem can be solved by making a revaluation of all partnership properties mandatory whenever a property distribution happens. however, such a solution may significantly increase the administrative cost of operating a partnership. professor daniel s. goldberg identified factors such as accountant errors in allocation calculations that result in mismatches between tax and economics under the treasury’s method.66 his suggested solution is to safe-harbor an alternative method, commonly known as the target method of allocations (hereinafter “target allocations”).67 as will be discussed in part iv.a., implementing this method is more complicated than it may seem, and doing so may cause new problems as it solves the old ones. 3. the abuse of dro and bottom dollar payment obligations a different type of tax-economics mismatch under the treasury’s capital account method occurs through the abuse of the deficit restoration requirement, or dro.68 a dro is an obligation of a partner to restore her negative capital account balance by making an additional contribution to the partnership, triggered by the liquidation of her partnership interest.69 because capital account deficits need to be restored only at liquidation and the associated tax deduction may be claimed immediately against unrelated income, the partnership can be structured in a way that actual liquidation will never occur.70this creates a risk that the tax mismatches the economics in present value terms. 71 this problem is exacerbated by the current regulations in three ways. first, the regulations do not consider whether a partner actually has the financial resources to honor a dro. additionally, the regulations presume that the value of partnership property is equal to its adjusted basis when determining substantiality of an allocation’s economic effect. finally, the regulations allow 65 alternatively, if the partnership elects to revaluate all properties immediately before the distribution, the $1,550x will be revaluation gain and section 704(c) doctrine can potentially ensure that in the subsequent liquidation, a, b and c will be allocated a tax gain of $900x, $450x and $250x, respectively. see i.r.c. § 704(c); treas. reg. § 1.704-1(b)(2)(iv)(f)(4) (providing that adjustments to partners’ capital accounts for gains, losses and cost recovery deductions on revalued property must be made as required by section 704(c)); treas. reg. § 1.704-1(b)(4)(i) (providing that cost recovery deductions, gain and loss on revalued property must be allocated among the partners to take into account the difference between book and tax basis as would be required under section 704(c)). 66 goldberg, supra note 54, at 705 (“[c]apital accounts can get out of alignment if the partnership’s accountants havemade allocations erroneously . . . so that even reversal allocations . . . fail to bring the partner’s capital accounts into alignment with the economic deal. under the treasury method, those errors can affect the economic arrangement of the partners.”). 67 see goldberg, supra note 54 at 728. 68 for the deficit restoration obligation, see treas. reg. § 1.704–1(b)(2)(ii)(b)(3). 69 id.; see also treas. reg. § 1.704–1(b)(2)(ii)(h) (providing that dro may be implied by the totality of the parties’ economic arrangements, such as by an indemnification agreement, even if not explicitly stated). 70 reg–122855–15, 2016-52 i.r.b. 926 (dec. 27, 2016) (“[s]ome partnerships are intended to have perpetual life and other partnerships can effectively cease operations but not actually liquidate; therefore, a partner’s dro may never be required to be satisfied.”). 71 see, e.g., treas. reg. § 1.701–2(d), ex. (6) (dro is part of a regulatory scheme that enables the taxpayers to realize “significant timing benefits through the special allocation” without being challenged based on the underlying economics of the proposed transaction). 2019] a gain must lie where it falls: matching tax with economics in subchapter k 119 partners to personally guarantee a partnership debt that entails little economic risk, such as the so-called bottom dollar guarantee.72 under the current regulations, a dro must be legally enforceable and there cannot be a plan to avoid or circumvent such an obligation.73 in the 2016 proposed regulations, the treasury added several factors to help test for whether an obligation is legally enforceable and whether there is a plan to avoid.74 these factors included commercially reasonable provisions for enforcement and collection, commercially reasonable documentation regarding the partner’s financial condition, whether the purported dro can be terminated before being triggered, and whether its terms are provided to all partners in a timely manner.75 the treasury also expressed concern that a purported dro may never be triggered and requested comments on this issue.76 this indicates that the treasury is starting to question the economic significance of many purported dros and suggests that it may enforce the restriction in treasury regulation section 1.704-1(b)(2)(ii)(c) more robustly in the future. even if a dro is legally enforceable and there is no plan to avoid, its economic significance may still be questionable if the capital account deficit caused by an initial allocation is likely to be restored by subsequent allocations.77 as a general rule, the economic effect of an allocation is not “substantial” and thus not respected for tax purposes if the partners’ capital account balances would be the same without the allocation (because of anticipated offsetting allocations) but their overall tax liability is significantly reduced in present value terms.78 however, since under current regulations a partnership property’s value is presumed to be its adjusted basis when determining substantiality of economic effect (the so-called “value-equals-basis assumption”), an offsetting allocation based on the gain on sale of such property can never be anticipated.79 as a result, a partner may be allocated a large depreciation deduction that results in a deep capital account deficit as long as she promises to restore it at liquidation, even if it is obvious that the property will likely preserve value (for example, if the property were the empire state building) and there is no real economic risk of loss. the orrisch case may also have a different result under the value-equals-basis assumption. administrative convenience may be one reason behind the value-equals-basis assumption.80 72 see treas. reg. § 1.704–1(b)(2)(iii)(c)(2) (“[t]here cannot be a strong likelihood that the economic effect of an allocation (or allocations) will be largely offset by an allocation (or allocations) of gain or loss from the disposition of partnership property.”); treas. reg. § 1.701–2(a)(3) (suggesting that the value-equals-basis assumption may have been adopted for administrative convenience or policy objectives other than matching tax with economics). see also temp. treas. reg. § 1.752–2t (2016) (representing the treasury’s recent efforts to combat abuses such as bottom dollar guarantees). 73 see treas. reg. § 1.704–1(b)(2)(ii)(c)(2). 74 prop. treas. reg. § 1.752-2(j)(3)(ii), reg-122855-15, 2016-52 i.r.b. 925-26 (dec. 27, 2016). 75 reg–122855–15, 2016-52 i.r.b. 925 (dec. 27, 2016); see also prop. treas. reg. § 1.704–1(b)(2)(ii)(c)(4)(b), 81 fed. reg. 69, 301, 69, 307 (2016). 76 reg–122855–15, 2016-52 i.r.b. 926 (dec. 27, 2016). 77 see treas. reg. § 1.701–2(d), ex. (6)(i) to (ii) (noting that the value-equals-basis assumption enables the partners to “anticipate significant timing benefits through the special allocation.”). assume, for example, a special allocation of depreciation deductions attributable to a building causes a capital account deficit. such a deficit will have little ex-ante economic significance because the partners anticipate that the building will preserve value and the allocation is thus motivated solely by tax incentives, a problematic result explained further in part ii.c. 78 see treas. reg. § 1.704–1(b)(2)(iii)(a)-(c). 79 see treas. reg. § 1.704–1(b)(2)(iii)(c) (describing transitory allocations). 80 see treas. reg. § 1.701–2(a)(3). [vol. 11:1 columbia journal of tax law 120 another rationale, although not directly mentioned in the regulations, may be to encourage taxpayers to rely on the see safe harbor rather than the pip test,81 as the assumption is available only under the see safe harbor.82 an abuse similar to the dro abuse explained above is possible through the personal assumption of partnership debt where such an assumption lacks real economic risk. although the amount of tax deductions from partnership activities that a partner can take is limited to her outside basis,83 a partner can personally guarantee partnership debt to increase the outside basis.84 in 2014, the treasury started to worry about the level of economic significance in some of these guarantees, as evidenced by its 2014 proposed regulations to ban abuses such as the use of bottom dollar guarantees where only “theoretical” risk is present.85 the 2014 proposed regulations imposed a heavy compliance burden on partners who claimed to have personally assumed a partnership debt, including maintenance of a commercially reasonable net worth and contractual restrictions on asset transfers.86 the treasury eventually withdrew from such a broad and potentially expensive anti-abuse rule and currently only limits the scope of the ban to bottom dollar payment obligations.87 to illustrate, a bottom dollar payment obligation would occur when a partner guarantees only the decline in value of the collateral in the bottom range, e.g., from $1m to zero for a $10m property.88 however, practitioners have suggested that the new rule creates further inequality between economically identical transactions.89 similar to the proposed changes to dro regulations, the treasury also proposed factors in 2016 that would help to determine when a plan seeks to circumvent or avoid an obligation through the personal assumption of partnership debt.90 although the 2014 proposed regulations have been withdrawn, the lesson is that the treasury will pay more attention to the economic significance of payment obligations to a partnership, even though, as some practitioners suggest, the result may be a mere switch from one artificiality to another.91 on one extreme, the tufts case permits taxpayers to take nonrecourse deductions even if there is zero economic risk of loss and balance it with an artificial minimum gain.92 this seems to be in tension with treasury’s more unfavorable treatment of the bottom dollar guarantee, which has significantly reduced economic risk (but not zero economic risk) as in the case of nonrecourse debt. 81 for pip test, see supra note 39. 82 see, e.g., cavanagh, supra note 39 at 96 (stating that the regulations do not incorporate the value-equals-basis assumption in the pip test). 83 see i.r.c. § 705(a)(2) (providing that partnership losses cannot reduce a partner’s outside basis below zero). 84 see i.r.c. § 752(a) (providing that an increase in a partner’s share of liabilities is treated as a contribution of money); treas. reg. § 1.752–2 (providing the rules governing a partner’s share of recourse liabilities). 85see, e.g., richard m. lipton, proposed regulations on debt allocations: controversial, and deservedly so, 120j. tax’n 156, 165-67 (2014) (“the proposed 752 regulations appear to be the product of obsessive concern about the fact that bottom-dollar guarantees can be used to allocate liabilities.”); see also prop. treas. reg. § 1.752–2(b)(3)(ii), 79 fed. reg. 4826, 4829-30 (2014). 86 see prop. treas. reg. § 1.752–2(b)(3)(ii)(a), 79 fed. reg. 4826, 4836 (2014). 87 see reg–122855–15, 2016-52 i.r.b. 892-93 (dec. 27, 2016); temp. treas. reg. § 1.752–2t(a)(3)(ii). 88 for a definition of bottom dollar payment obligation, see temp. treas. reg. § 1.752–2t(a)(3)(ii)(c). 89 see lipton, supra note 85 at 167 (noting that the bottom dollar payment obligation ban can be circumvented by tranching debt). 90 see treas. reg. § 1.752–2(j) (describing instances where payment obligations may be disregarded).; prop. treas. reg. § 1.752–2(j)(3)(ii), 81 fed. reg. 69,301, 69,308 (2016). 91 see lipton, supra note 85 at 157 (suggesting that the 2014 proposed regulations under section 752 are just another set of artificial rules to deal with the artificiality in the crane doctrine). 92 see commissioner v. tufts, 461 u.s. 300, 307-310 (1983). 2019] a gain must lie where it falls: matching tax with economics in subchapter k 121 c. economic effect equivalence: solution to one size fits all? as discussed in part iii.b., the treasury’s capital account approach and anti-abuse efforts under subchapter k may not fully eliminate the mismatch between tax and economics and may lead to artificial results. however, an allocation may be deemed to have economic effect under the economic effect equivalence test (the “eee test”), a less used alternative available under the see safe harbor. the eee test supplies flexibility but also adds uncertainty to the see safe harbor. it determines economic effect based not on actual use of capital accounts, but rather on whether the hypothetical liquidation results under the partners’ own arrangement match the results that would have been reached had capital accounts been properly maintained and used. the eee test thus seems to focus on achieving a good end-result rather than on the means to achieve such result. since the treasury has included very little guidance on how to apply the test, there are arguments both for reading it broadly and narrowly.93 this part iii.c. will examine the current interpretations of the eee test and argue that it should be interpreted in a way that is sufficient to safe harbor the most non-abusive allocations that do not follow the treasury’s capital account method. 1. the four-part analysis for economic effect equivalence the eee test will be satisfied if a liquidation of the partnership at the end of the current or any future year would produce the same economic results as would occur if the primary test is satisfied, “regardless of the economic performance of the partnership.” 94 under the regulations, the eee test seems to be a four-part analysis. first, one must determine each partner’s economic entitlement to the partnership’s net assets under the partnership agreement in a current or future liquidation, i.e., how partners intend to share the benefit or burden of whatever remains after all partnership assets are sold and the proceeds are used to pay the partnership’s creditors. second, one must determine the partners’ explicit or implied allocation of partnership income, gain, loss, deduction, or credit under the partnership agreement. third, based on such explicit or implied allocation, one must determine or re-calculate the capital account balances as if capital accounts had been properly maintained under the primary test. fourth, assuming that a liquidating distribution will be made according to such capital account balances and that each partner has an unlimited dro, one must determine whether each partner’s economic entitlement in a current or future liquidation would be the same as that under the partnership agreement, “regardless of the economic performance of the partnership.” 93 see, e.g., goldberg, supra note 54 at 728-29 (suggesting that the eee test should be clarified or expanded to explicitly safe harbor allocations not based on capital accounts such as the target method of allocation); i.r.s., market segment specialization program guideline, partnerships, 2002 wl 32770029 117 (2002) (noting that the eee test is a “dumb-but-lucky” rule intended to protect allocations based on “unsophisticated but unabusive partnership agreements”). 94 the regulations define economic effect equivalence as follows: allocations made to a partner that do not otherwise have economic effect under this paragraph (b)(2)(ii) shall nevertheless be deemed to have economic effect, provided that as of the end of each partnership taxable year a liquidation of the partnership at the end of such year or at the end of any future year would produce the same economic results to the partners as would occur if requirements (1), (2), and (3) of paragraph (b)(2)(ii)(b) of this section had been satisfied, regardless of the economic performance of the partnership. treas. reg.§1.704–1(b)(2)(ii)(i). [vol. 11:1 columbia journal of tax law 122 consider the following two examples provided in the regulations on the eee test, which seem to support the four-part analysis mentioned above.95 example two g and h contribute $75,000 and $25,000, respectively, to form a general partnership. the partnership maintains no capital accounts (thus does not satisfy the primary test) and the partnership agreement provides that all income, gain, loss, deduction, and credit will be allocated 75 percent to g and 25 percent to h. in addition, g and h are ultimately liable (under a state law right of contribution) for 75 percent and 25 percent, respectively, of any debts of the partnership. in other words, the state law right of contribution has the same effect as an unlimited dro. neither partner has any dro. the regulations state that, under these circumstances, the allocation of all partnership items in 75/25 ratio has economic effect equivalence.96 the rationale is an implied four-part analysis. first, the partnership agreement, combined with the state law right of contribution, essentially provides that g and h will share partnership net assets 75/25 in a liquidation, equal to the ratio of their original capital contributions. second, the partnership agreement explicitly provides for an allocation of all partnership items 75/25 to g and h, respectively. third and fourth, at the time of a current or future liquidation, g’s and h’s economic entitlements would be the same as if they started with capital account balances of $75,000 and $25,000, respectively, and such balances are increased by partnership income or gain and decreased by partnership loss, deduction, or credit in a 75/25 ratio of such items, respectively.97 if such balances are positive at liquidation and, assuming liquidating distributions are made according to capital account balances, g and h will certainly receive partnership net assets in a 75/25 ratio, the same result as under the partnership agreement.98 if such balances are negative at such time and, since the state law right of contribution has the same effect as an unlimited dro, each partner has satisfied partnership liabilities to the extent of partnership assets in a 75/25 ratio, using their respective shares of partnership assets, and is obligated to satisfy the remaining liabilities in a 75/25 ratio under the unlimited dro. this result is the same as that under the partnership agreement. thus, regardless of the partnership’s economic performance, i.e., regardless of how well that partnership’s business goes, the allocation of all partnership items in a 75/25 ratio produces the same economic result as if the primary test has always been satisfied, and it must have economic effect equivalence under the regulations. example three g and h contribute $75,000 and $25,000, respectively, to form a general partnership. the partnership agreement provides that all partnership items will be allocated equally between the partners, and that capital accounts will be maintained as required by the primary test, but that all partnership distributions will be made 75 percent to g and 25 percent to h regardless of capital account balances. however, all partners have an unlimited dro.99 the regulations state that the allocation of all partnership items equally to g and h has economic 95 see treas. reg. § 1.704–1(b)(5), ex. (4)(i) (iii). 96 treas. reg. § 1.704–1(b)(5), ex. (4)(ii). 97 for rules governing the maintenance of capital accounts, see generally treas. reg. § 1.704–1(b)(2)(iv). 98 this is based on the simple mathematical truth that (75,000 + 0.75 * x)/(25,000 + 0.25x), where x is any rational number, except the value of negative 100,000 to prevent division by zero, is always equal to 75/25. 99 see treas. reg. § 1.704-1(b)(5), ex. (4)(iii). 2019] a gain must lie where it falls: matching tax with economics in subchapter k 123 effect equivalence, even if the partnership agreement doesn’t require a liquidating distribution to be made according to capital account balances. the rationale, similar to that in example two, is an implied four-part analysis. first, g and h’s economic arrangement under the partnership agreement is to recover invested capital (if possible) and to share any change in partnership net assets equally in liquidation.100 second, the partnership agreement explicitly provides equal sharing of all partnership items. third, let x be the change in partnership net assets (without regard to any withdrawal or distribution) from the time of partnership formation to the time of liquidation. the capital account balances calculated in accordance with the regulations are (75,000 + 0.5x) for g and (25,000 + 0.5x) for h. fourth, assuming liquidating distributions are made according to capital account balances and there is an unlimited dro for each partner, g will receive (or is obligated to contribute) (75,000 + 0.5x), while h will receive (or is obligated to contribute) (25,000 + 0.5x), which is the same as the result under the partnership agreement,101 regardless of the partnership’s economic performance, i.e., regardless of the value of x. thus, the allocation of all partnership items equally between g and h must have economic effect equivalence. 2. “regardless of the economic performance of the partnership” — what does it mean? a threshold question in the application of the eee test is how broadly to interpret the phrase “regardless of the economic performance of the partnership.”102 there are three possible interpretations, varying based on which economic activities and which outcomes of economic activities are considered when determining the results of a hypothetical liquidation. first, a strict interpretation would interpret the words “economic performance” in the broadest sense and assume that it covers all logically possible economic results of the partnership. this interpretation would require the liquidation result under the partnership agreement to match the result under the primary test regardless of the economic activities that the partnership can possibly engage in and the outcome of such activities. for example, assume a and b each contribute $50x cash to form partnership ab and agree that all partnership items will be allocated 50/50. there is no unlimited dro. under the strict interpretation, the eee test is not satisfied because, among other reasons, it is possible that the partnership leverages 100 if this is not obvious, let x be the change in partnership net assets (without regard to any withdrawal or distribution) from the time of partnership formation to the time of liquidation. the capital account balances under the partnership agreement are (75,000 + 0.5x) for g and (25,000 + 0.5x) for h. however, since distribution will be made to g and h in a 75/25 ratio, respectively, g will receive (75,000 + 0.75x) from the partnership distribution, while h will receive (25,000 + 0.25x). since capital account balances are properly maintained as required by the primary test, g will end up with a deficit of 0.25x, while h will have an unpaid balance of 0.25x, after liquidation. since each partner has an unlimited dro, g is obligated to make an additional contribution of 0.25x to the partnership, which will be distributed to h. when the dust has settled, g’s liquidation entitlement is (75,000 + 0.5x) and h’s entitlement is (25,000 + 0.5x). 101 id. 102 see, e.g., nysba tax section, report on partnership target allocations3, 27-28 (report no. 1219, 2010) (noting that it is uncertain whether the phrase “regardless of economic performance” is intended to encompass all facts and circumstances, and advocating that it be clarified to encompass only facts and circumstances reasonably likely to occur). [vol. 11:1 columbia journal of tax law 124 up in the future. if the partnership later borrows $900x to acquire a property worth $1,000x and the property loses all its value, a and b will each have a capital account deficit of $450x, but there is no obligation to restore the deficit. under the strict interpretation, the fact that the partnership does not currently have any debt and does not expect to incur any in the future is irrelevant. second, an intermediate interpretation would require the two results to match regardless of the outcomes of the economic activities the partnership is currently undertaking or reasonably expects to undertake in the future, but all possible outcomes of each such activity must be considered unless the partnership agreement itself contains certain provisions that tend to eliminate some of those outcomes. the intermediate interpretation seems to be in line with the nysba’s position in its 2010 report. 103 under the intermediate interpretation, the expectation not to incur any debt is taken into account if reasonable, but the expectation that capital account deficits will not be an issue because the business will be profitable is not taken into account. third, a liberal interpretation would require the two results to match regardless of the reasonably expected outcomes of current or reasonably expected future economic activities. in other words, unlike the strict interpretation, this interpretation would not require the results to match under all economic activities that the partnership may engage in, but only those that they reasonably expect to have. additionally, unlike the intermediate interpretation, this interpretation gives deference to the partners’ reasonable expectations of the outcomes in comparing hypothetical liquidation results. for example, the expectation that capital account deficits will not be an issue because the business will be profitable can be respected under the liberal interpretation but is always rejected under the intermediate interpretation. since the two examples in the regulations seem to satisfy the eee test even under the strict interpretation, those examples provide little guidance on how the treasury intends to interpret the eee test.104 as a result, it is uncertain how the service will react to an allocation that satisfies the eee test only under the intermediate or the liberal interpretation. for example, if an allocation satisfies the eee test only under the assumption that the partnership is not reasonably expected to have leveraged transactions or to acquire depreciable properties in the future, or that its properties are reasonably expected to preserve value, it’s uncertain whether the eee test can give economic effect to such allocation under the current law.105 from a policy perspective, the strict interpretation should be rejected for two reasons. first, the purpose of the see safe harbor is to prevent partnership-related activities done solely or primarily for tax purposes, in which the partners expect an increase in after-tax payoff without simultaneously expecting an increase in pre-tax payoff.106 such transactions have the same efficiency problems as explained in part ii.107 in an ideal world where a person’s actual 103 id at 3(4) (suggesting that the eee test should require reaching the result under the primary test only in all fact patterns reasonably likely to occur). 104 see discussions in part iii.c.1., supra. in example two, even if the partners end up with a capital account deficit due to leveraged transactions, the state law right of contribution ensures the same liquidation result as that would occur if the partners had an unlimited dro and the primary test had been satisfied. in example three, the unlimited dro ensures the same liquidation result as would occur under the primary test, even if the partnership engages in leveraged transactions or acquires depreciable properties. 105 see nysba tax section, supra note 102, at 27-28. 106 see treas. reg. § 1.704–1(b)(2)(ii)(a) (stating the “fundamental principle” that an allocation must comport with the economic deal among the partners in order to have economic effect). 107 part ii, supra. 2019] a gain must lie where it falls: matching tax with economics in subchapter k 125 expectations can be ascertained precisely at the regulatory level, the parties’ ex ante expectations, rather than the ex post outcome, should govern a transaction from an efficiency perspective. therefore, to maximize efficiency, if the partners do not reasonably expect to undertake certain economic activities that may cause an allocation to fail the eee test, the allocation should not be disregarded merely because a technical failure of the eee test may be a logical ex post outcome. second, since in theory all partnerships may engage in unlimited recourse borrowing or other transactions which may cause a capital account deficit under certain conditions, such as in a “doomsday” scenario, the strict interpretation essentially requires all partners to have an unlimited dro under a partnership agreement or under state law in order to satisfy the eee test.108 this may bring the eee test too close to the primary test and reduces its usefulness in giving economic effect to allocations that do not follow the treasury’s capital account approach but are nonetheless harmless.109 the liberal interpretation should also be rejected because it requires too much factfinding and causes too much uncertainty and therefore diminishes the utility of the eee as a safe harbor. consider the following example. example four a and b each contribute $500x to form a general partnership, and the partnership acquires a depreciable building for $1,000x to be rented out. the partnership agreement provides that all partnership items are shared equally except that all depreciation will be allocated to a, but there is no dro requirement and no provisions that tend to restrict capital account deficits in the agreement. the partners claim that they reasonably expect a’s share of future rent to fully offset his share of partnership expenses including depreciation, and leasing the building will be the only partnership activity. based on this, they argue that a capital account deficit is unlikely and thus the allocation satisfies the eee test. in this case, the liberal interpretation will not only welcome ex post justifications, but also require determination on difficult factual questions such as the fair rental value of the building and the likelihood of a future property tax increase. it would also unduly enlarge the scope and uncertainty of the eee test, which was originally intended only as a limited exception for unsophisticated taxpayers.110 if the partners are sophisticated enough to predict the success of their business, they should have no problem complying with the primary test or including provisions that tend to prevent capital account deficits. thus, the best interpretation of the phrase “regardless of the economic performance of the partnership” in the eee test seems to be the intermediate interpretation. specifically, the eee test should be applied only based on the type of current and reasonably expected future 108 for the so-called “doomsday” test, see treas. reg. § 1.752-2(b). 109 note that the alternate test does not require an unlimited dro, but only that an allocation does not create or increase a deficit in excess of any dro and a qio provision in a partnership agreement. treas. reg. §1.704– 1(b)(2)(ii)(d). however, the so-called “safe harbor result” that the eee test requires is the result under the primary test. see treas. reg. §1.704–1(b)(2)(ii)(i). see also nysba tax section, supra note 102, at 31 (“if an agreement contains a dro, target allocations will necessarily take account of the dro and will necessarily produce the safe harbor result required under the eee test…”); see also cavanagh, supra note 39,at 95-96 (believing that reading the eee test as having an implied unlimited dro requirement is too narrow; in addition, unlimited dro in state law partnerships is rare today). 110 see i.r.s., supra note 93. [vol. 11:1 columbia journal of tax law 126 activities of the partnership, but for each such activity, one should consider all possible economic outcomes unless certain provisions in the partnership agreement tend to eliminate some of those outcomes. the intermediate interpretation also best reflects the policy behind the eee test, which seems to be balancing the goal of matching tax consequences with economic realities with the need to avoid disturbing an efficient business arrangement for failure to comply with the treasury’s technical rules. 3. dro requirement and the eee test a rejection of the strict interpretation leads to an interesting inquiry: when, if ever, an unlimited dro under a partnership agreement or state law is required for an allocation to satisfy the eee test. one may argue that an unlimited dro throughout the term of the partnership is always required to satisfy the eee test, on the ground that without such unlimited dro, there is always a possibility that the partners can modify their agreement in the year of actual liquidation to provide for a liquidating distribution that fails to reflect their prior share of partnership items.111 consider the following example. example five assume the same facts in example two, except that the partnership, a calendar year taxpayer, acquires depreciable equipment with a 10-year useful life (assuming that straightline method is used) and no salvage value for $100,000x on 01/01/20x1. the partnership breaks even each year from the operation of the equipment, which is its sole activity, without considering depreciation, which is its only noncash expense. after 5 years, the partnership’s balance sheet may look as follows: partnership’s book safe harbor capital account asset asset equipment $50,000x equipment $50,000x capital capital g’s capital 37,500x g’s capital 37,500x h’s capital 12,500x h’s capital 12,500x on 12/31/20x5, the partners modify their agreement to provide that all liquidating distributions will be made to g. the partnership then sells the equipment for $50,000x (its presumed fair market value), distributes all $50,000x cash to g, and liquidates. immediately after liquidation, the partnership’s balance sheet is as follows: partnership’s book safe harbor capital account capital capital g’s capital ($12,500)x g’s capital ($12,500)x h’s capital 12,500x h’s capital 12,500x here, the liquidation result under the partnership agreement and that under the safe harbor capital account will differ. under the partnership agreement, because there is no dro, 111 for modification of a partnership agreement, see i.r.c. § 761(c). 2019] a gain must lie where it falls: matching tax with economics in subchapter k 127 g has been allocated a net loss of $37,500x for tax purposes but only economically assumes $25,000x of such loss, with the additional $12,500x loss assumed by h. under the safe harbor capital account, because each partner is assumed to have an unlimited dro, g is obligated to contribute $12,500x to the partnership to be distributed to h. thus, the 75/25 allocation as described in example two will technically fail the eee test from the very beginning because of the possibility that the scenario above may occur (call it a “liquidation surprise”). note that logically, the possibility of a liquidation surprise cannot be explained away by a “reasonable expectation” of not to have a liquidation surprise. since the decision is almost purely subjective, such an expectation cannot be “reasonable.” the problem of a liquidation surprise can theoretically happen under the eee test because the eee test requires an allocation to generate the same liquidation result as that under the primary test in a hypothetical liquidation, and justifies an allocation based on a matching of hypothetical liquidation results. consequently, unless an allocation is deemed to fail the eee test from the very beginning because of the possibility of a liquidation surprise, the eee test cannot stop the abuse. by the time the liquidation surprise occurs in an actual liquidation, allocation of partnership items is no longer an issue and all prior allocations have already satisfied the eee test through a matching of hypothetical liquidation results.112 this problem is also connected to the “ceiling rule” issue (discussed in part iii.b.1 and will be further discussed in part iv), as the section 704 regulations usually disallow the creation and allocation of fictitious partnership-level gain or loss to adjust capital account balances and cause them to match the actual liquidation result;113 otherwise, maintenance of a capital account will be reduced to little more than an accounting routine. of course, the liquidation surprise is more of a theoretical possibility than an actual abuse. theoretically, without an unlimited dro “throughout the full term of the partnership,”114 an allocation that satisfies the eee test can never be economically equivalent ex ante to an allocation that satisfies the primary test, regardless of whether a capital account deficit can be “reasonably expected,” because the possibility of a liquidation surprise cannot be explained away (as is the case in example five). a practical question to ask, therefore, is whether and to what extent a dro should be required in order to satisfy the eee test. a corollary question is, without an unlimited dro, what the irs should do in the case of an unexpected capital account deficit if a prior allocation has been treated as satisfying the eee test. practitioners’ views on the dro requirement in the eee test diverge. some, like cuff, believe that a partnership agreement may need an explicit unlimited dro provision or an implied unlimited dro under state law in order to satisfy the eee test, but also think that “this matter is not unambiguously clear from the allocation regulations.”115 he also believes that broad application of the eee test to llcs, for which an unlimited dro is rare, should be 112 by contrast, a liquidation surprise cannot happen under the primary test because, to be able to invoke the primary test of the see safe harbor at all, the partnership agreement must provide liquidating distributions in accordance with capital account balances and unlimited dros “throughout the full term of the partnership.” see treas. reg. §. 1.704-1(b)(2)(ii)(b). 113 see supra note 52. see also infra part iv.a. 114 see supra note 112. 115 see terence floyd cuff, several thoughts on drafting target allocation provisions, 87 taxes 171, 188 (mar. 2009). [vol. 11:1 columbia journal of tax law 128 rejected.116 given the precision with which the dro requirement is written in the regulations and its arguable importance, he believes that the treasury did not intend it to be easily circumvented through the eee test, which is only a limited exception to the extensive and precise economic effect of safe harbors.117 however, cuff suggests that the eee test should be applied more flexibly to accommodate the prevalence of llcs, especially when the lack of dro is not abusive.118 others, like cavanagh and the nysba tax section in its 2010 report, propose a more liberal interpretation of the eee test and believe that, although the current law in this area is unclear, an unlimited dro should not always be required for an allocation to satisfy the eee test, especially when the partnership agreement explicitly prohibits transactions that may cause a capital account deficit or contains a qio provision.119 to reduce regulatory uncertainty, cavanagh recommends that the service describe circumstances under which the eee test applies to a partnership without an unlimited dro in a notice or revenue ruling; this includes circumstances under which “the partners do not or cannot have a capital account deficit.”120 in addition, cavanagh believes that it “would not be a wise use of irs resources” to require an unlimited dro for the eee test at all times, which is supposed to serve as “a safety net for unsophisticated taxpayers and their advisers.” 121 an opposite rule would deprive many taxpayers (such as members of an llc) of the benefit of the safe harbor and would force them to rely on the pip test,122 which is more burdensome because of the lack of taxpayer-favored assumptions such as value-equals-basis assumption.123 the lack of the value-equals-basis assumption in the pip test may put the burden on the partners to show both the current and future value of partnership properties, which can be expensive and burdensome. the nysba tax section makes a similar suggestion in its 2010 report: a partnership agreement without an unlimited dro should satisfy the eee test if a capital account deficit is only a “remote possibility” under the agreement.124 this potentially includes an agreement that prohibits aggregate negative adjustments to a partner’s capital account to exceed aggregate positive adjustments.125 in addition, the report suggests that the possibility that an allocation may cause a capital account deficit, but not in excess of a partner’s share of partnership minimum gain, should be disregarded for purposes of the eee test, just as such amount is treated as a limited dro for purposes of the alternate test,126 because such deficit will be reversed when partnership minimum gain is realized.127 116 id. at 191. 117 id. 118 id. at 189. 119 see nysba tax section, supra note 102, at 28-31; cavanagh, supra note 39, at 89 (advocating that the irs confirm that the eee test applies to a partnership agreement that has a qio provision). 120 cavanagh, supra note 39, at 96. currently, the only guidance provided in the regulations on the dro requirement in the eee test is that a partnership without an unlimited dro may satisfy the eee test if, under the respective state law right of contribution, each partner must “contribute any debts of the partnership in proportion to their shares of partnership profits.” see treas. reg.§1.704-1(b)(5), ex. (4)(ii); nysba tax section, supra note 102, at 28 n.60. 121 cavanagh, supra note 36, at 95-96. 122 id. at 96. 123 see supra note 82. 124 nysba tax section, supra note 102, at 28. 125 id. at 29. 126 id. see also treas. reg. § 1.704-2(h)(4), (i)(5) (for purposes of the alternate test, a partner’s share of minimum gain is treated as a limited dro). 127 see treas. reg. § 1.704-2(f). 2019] a gain must lie where it falls: matching tax with economics in subchapter k 129 similar to the rationale of rejecting the strict interpretation of the “regardless of the economic performance of the partnership” language in the eee test, an unlimited dro should not be a mandatory element of the test. specifically, the service should take a position that if a capital account deficit is only a remote possibility after taking into account (1) the type (but not the expected outcomes) of economic activities that the partners currently undertake or reasonably expect to undertake in the future, (2) the tax attributes of the partnership (such as partnership minimum gain) as well as (3) the partners’ agreement such as liquidation entitlement and any arrangement that tends to prevent a capital account deficit, while ignoring the theoretical possibility of a liquidation surprise, unlimited dro should not be required for an allocation to satisfy the eee test.128 the eee test, as a “dumb-but-lucky” rule intended to protect “unsophisticated but unabusive partnership agreements,”129 should not be so inflexible as to require unlimited dro even when its absence is totally “unabusive.” 4. nonrecourse deductions and the eee test it is noteworthy that under current regulations, the pip test (including its safe harbor version) is the only test available for the partnership nonrecourse deductions (such as depreciation on properties financed by allocation of nonrecourse debt), which are correctly treated by the regulations as never having economic effect, unless a safe harbor test applies.130 since the pip test is less technical and more fact-driven, whether the service will respect an allocation of nonrecourse deductions under the pip test is hard to know.131 for example, the service may logically require an allocation of nonrecourse deductions to be made strictly in accordance with the partners’ relative contributions when the realization of partnership minimum gain through taxable disposition of partnership properties is remote. the pip version of safe harbor test for allocation of nonrecourse deductions is also stricter than the see safe harbor: the allocation must either satisfy the primary test, or, if it fails the primary test because an unlimited dro is lacking, the partnership agreement must have a qio provision.132 the test also requires nonrecourse deductions to be allocated “in a manner that is reasonably consistent with allocations that have substantial economic effect of some other significant partnership item attributable to the property securing the nonrecourse liabilities.” 133 for example, if income and expense attributable to the property securing the nonrecourse liability 128 for example, if the only reasonably expected activity of a partnership is to hold equity securities, the partnership will incur no debt, and a liquidating distribution will be made strictly in proportion to capital contributions, an allocation of all partnership items in proportion to capital contributions is very unlikely to cause a capital account deficit, based on the type of economic activities and the partners’ liquidation arrangement. thus, an unlimited dro should not be required for applying the eee test. by contrast, if the same partnership takes out recourse debt and invests the proceeds in equity securities, an unlimited dro may be required for applying the eee test regardless of how small the downside risk of the equity securities is perceived to be, because the speculative outcome of an economic activity should not justify a lack of an unlimited dro for purposes of the eee test. 129 i.r.s., supra note 93. 130 see treas. reg. § 1.704-2(b)(1). 131 see treas. reg. § 1.704-2(e) for when allocations of non-recourse deductions will satisfy the pip test. 132 treas. reg. § 1.704-2(e)(1). 133 treas. reg. § 1.704-2(e)(2). an example would be income generated by the property securing the nonrecourse liability. see also discussion in part ii.d., supra. [vol. 11:1 columbia journal of tax law 130 will be allocated 50/50 between the partners and, assuming that the allocation satisfies the see safe harbor, allocations of nonrecourse deduction ranging from 50/50 to 90/10 may be considered reasonable, but there is no bright-line rule on this issue.134 an implication of the wording of the nonrecourse deduction regulations is that, if the partnership agreement does not include provisions that satisfy either the primary or the alternate test, it is not entitled to a safe harbor for allocation of nonrecourse deductions, and satisfying the eee test cannot save the day. this is because instead of referring to the see safe harbor generally, the nonrecourse deduction regulations specifically require certain elements in the primary test and the alternate test to be satisfied in order for the safe harbor to apply.135 one may argue that as a matter of tax policy, if allocations under a partnership agreement satisfy the eee test overall, the nonrecourse deduction safe harbor should apply to allocations of nonrecourse deductions under the partnership agreement.136 there are two rationales behind this argument. first, an allocation of nonrecourse deductions by itself always has economic effect equivalence due to the artificial rule of minimum gain chargebacks. regardless of how remote the chargeback is, an allocation of nonrecourse deduction will almost never cause a deviation of the outcome in a current or future hypothetical liquidation from that mandated by the primary test since its net effect on capital account balances is zero, and thus will always satisfy the eee test. second, if all other material allocations under the partnership agreement also have economic effect equivalence, the substance of the partnership agreement would be as if it contains provisions that satisfy the primary test, and the form of the deal, i.e., the specific wording of the partnership agreement, should not make a substantive difference. consider the following example. example six assume the same facts as in example two, except that g and h also take out a $100,000 nonrecourse debt, acquire depreciable property for $100,000 and use the property to secure the debt. g and h allocate depreciation deductions from the property in a ratio of 75/25. the allocation does not affect the analysis under the eee test and is obviously non-abusive. however, under current law, the allocation is not safe harbored since the partnership agreement does not directly satisfy the primary or the alternate test. 5. when “reasonable” expectation fails whether the meaning of the words “regardless of the economic performance of the partnership” should be required and whether unlimited dro should be required both depends, to some extent, on the partners’ reasonable expectations.137 two questions therefore arise: first, what kind of deference the service should give to the partners’ statement of their own business 134 see, e.g., treas. reg § 1.704-2(m), ex. 1(ii). 135 treas. reg. § 1.704-2(e). 136 see cuff, supra note 115, at 180 (arguing that a target allocation provision may satisfy the nonrecourse deduction safe harbor if allocations thereunder have economic effect under the eee test, but indicating that “whether this argument works is a matter of conjecture”); todd d. golub, target allocations: the swiss army knife of drafting (good for most situations—but don’t bet your life on it), 87 taxes 157, 163-64 (mar. 2009) (arguing that if allocations satisfy the eee test, such as in a target allocation scenario, strict compliance with this aspect of the nonrecourse deduction safe harbor really shouldn’t be necessary as the allocations would be deemed to have economic effect). 137 see discussions in part iii.c.2 and part iii.c.3, supra. 2019] a gain must lie where it falls: matching tax with economics in subchapter k 131 plan and expectations; second, what the service should do if an expectation determined to be “reasonable” ex ante deviates from the ex post outcome. this note argues that to reduce administrative cost and to initially respect the parties’ self-claimed business arrangement, the service should first defer to the partners’ articulated expectations on the partnership business, unless the partners’ position is obviously unreasonable. this initial deference can help avoid disturbing an otherwise efficient business plan by the service’s own judgment, especially when a purported allocation is likely to be unabusive. however, under a “wait-and-see” rule, if it is later determined that the original expectation did not materialize and the this is reasonably expected to continue in the future, the service may determine that the original expectation becomes unreasonable starting from the time of the determination, until the non-conformity discontinues and future conformity is reasonably expected again.138 under a “tit-for-tat” rule, the service may determine that, in hindsight, the original expectation is not reasonable from the beginning, and may require a recalculation of the partners’ taxes in all prior years to which the allocation is relevant. consider the following example. example seven a and b each contributes $50x to form partnership ab. the partnership borrows $900x on a recourse basis to buy depreciable equipment with a 20-year useful life for $1,000x. the partnership agreement provides that all partnership items will be allocated 50/50 except that depreciation will be allocated 70/30 to a and b. in addition, capital accounts will be maintained according to the relevant regulations and liquidating distributions will be made according to positive capital account balances, but the partners do not have unlimited dros and the partnership agreement does not have a qio provision. however, the partnership agreement requires reallocation of partnership items whenever possible to prevent aggregate negative adjustments to a partner’s capital account from exceeding aggregate positive adjustments. the partnership breaks even in the first three years except for the depreciation, and no payment of principle is made. the balance sheet is as follows. partnership ab’s book year 1 year 2 year 3 asset asset asset equipment $950x equipment $900x equipment $850x liability liability liability recourse debt 900x recourse debt 900x recourse debt $900x capital capital capital a’s capital 15x a’s capital 0 a’s capital (35x) b’s capital 35x b’s capital 0 b’s capital (15x) in this case, the service should initially assume that the partners’ arrangement will be given effect throughout the term of the partnership and that the partnership business is reasonably expected to be profitable eventually. based on these assumptions, it may conclude that a capital account deficit is a remote possibility. thus, the allocation of depreciation 138 see nysba tax section, supra note102, at 28. [vol. 11:1 columbia journal of tax law 132 between a and b should be respected at least for the first year and the second year under the eee test. indeed, a reallocation of the $50x depreciation 50/50 between a and b for the first year is meaningless because the 70/30 allocation is unabusive: a liquidation at book value at the end of year 1 under the partnership agreement will cause a and b to assume the total economic burden of depreciation 70/30. similarly, the allocation of depreciation in year 2 is unabusive because liquidating distributions at the end of year 2 will match each partner’s economic entitlement. however, in year 3, the original expectation that a capital account deficit is a “remote possibility” no longer seems to comply with what actually happens, because all partners will have capital account deficits, and the deficit-prevention rule in the partnership agreement can no longer prevent capital account deficits in year 3 as it does in year 2. thus, the 70/30 allocation of depreciation in year 3 can be abusive: in a liquidation at book value, suppose partnership ab’s creditors seek satisfaction of the remaining debt ($50x) entirely from b, and a, having no dro under the partnership agreement, is not obligated to compensate b for personally assuming the partnership debt. consequently, a is allocated $35x depreciation for tax purposes but does not assume an economic burden. however, under a “wait-and-see” rule, the service may impose an additional burden on the partners to show that the business will eventually become profitable and may re-allocate the year 3 depreciation under the pip test. in addition, under a “tit-for-tat” rule, if the service determines that the partners never reasonably expected to operate a profitable business through partnership ab, it can determine in year 3 that the original expectation that a capital account deficit is a remote possibility and was unreasonable from the beginning of year 1 and make retroactive adjustments on the partners’ tax liabilities in year 1 and 2. iv. target allocation: a better alternative? there has been considerable discussion on whether the target method of allocation, where only the economic target at liquidation is specified and allocations of partnership items for tax purposes simply follow the economic target,139 is superior to the treasury’s capital account method and thus should be adopted.140 this note argues that on one hand, the target allocation method can solve some of the mismatches between tax and economics as mentioned in part iii.b; but on the other hand, target allocation is in tension with the implied “ceiling rule” under section 704 regulations and can be used abusively. consider the following example. example eight assuming the same facts in example one, except that, instead of complying with the treasury’s capital account method, the partnership agreement simply provides that a, b and c will be entitled to partnership net assets 50/25/25 in a liquidation, and any partnership item must be allocated in line with the economic target at liquidation. as a result, all gain from the sale of the remaining partnership properties immediately after distribution of whiteacre to b will be allocated 50/25/25 to a, b and c, which will cause tax consequences to match the parties’ economic arrangement. under the treasury’s capital account method, however, as 139 for general discussions of target allocations, see, e.g., goldberg, supra note 54 at 668-87; golub, supra note 136 at 161-70. 140 see, e.g., goldberg, supra note 54at 700-714. 2019] a gain must lie where it falls: matching tax with economics in subchapter k 133 explained in part iii.b.2., the tax will mismatch the economics without a revaluation of all partnership properties at the time of distribution. the use of target allocation in example eight is non-abusive and better reflects the parties’ economic arrangement. however, it can in theory be used abusively as a means to circumvent the implied “ceiling rule” under section 704 regulations, which will be explained further in part iv.a. and part iv.b. consider the example below. example nine a and b each contribute $50x to form partnership ab. they intend from the very beginning to share partnership net assets 50/50 at liquidation. however, because they want to allocate more income to a for tax purposes due to a’s favorable tax attributes (such as an expiring nol), they specify that liquidation will be made 90/10 between a and b and partnership items will be allocated accordingly. after several years, when the value of partnership net asset is $200x and equal to the book value,141 a and b modify their agreement to specify a liquidating distribution of 50/50 and immediately liquidate the partnership thereafter. in this situation, the target method essentially requires an allocation of $40x fictitious loss to a and a $40x fictitious gain to b in order for tax to comply with the liquidation target. this, however, is a violation of the implied “ceiling rule” and the target method is being used abusively for income shifting purposes. although the abuse in example nine is unlikely to happen between parties in arm’s length positions, it does reveal a tension between the target method and some of the fundamental principles under the section 704 regulations. a. capital shifting and tax avoidance motive an important implication of the primary test under the see safe harbor is that capital shifting among partners, which is a mere re-allocation of capital account balances among partners without recognition of actual gain or loss at the partnership level and allocation of such gain or loss among partners, is prohibited. first, as mentioned earlier, the capital account maintenance rules under treas. reg.§1.704-1(b)(2)(iv) contain an implied “ceiling rule”: the rules do not permit recognition of fictitious gain or loss at the partnership level solely for purposes of readjusting the partners’ capital account balances.142 second, the unlimited dro requirement under the primary test prohibits capital shifting through liquidating distributions. for example, if a and b each contributes $100x to form partnership ab and the partnership is immediately liquidated, under the primary test, each partner must receive $100x. it’s not possible for a to shift her $100x contributed capital to b by having the partnership recognize a fictitious gain of $100x entirely allocated to b and a fictitious loss of the same amount entirely allocated to a. also, a cannot shift her contributed capital to b through a liquidating distribution of $200x entirely to b, because b will have a deficit of $100x and must pay a $100x due to the unlimited dro. 141 to achieve this, a and b can sell all partnership properties for cash before modifying the partnership agreement. 142 from a policy perspective, the “ceiling rule” is necessary to prevent tax abuses where a partner is allocated partnership deductions or losses (actual or fictitious) leading to a capital account deficit and is later allocated a fictitious gain for the sole purpose of restoring such deficit. the absence of such rule would permit allocation of partnership items solely for tax purposes as well as creation of fictitious items solely for such allocation, which renders the unlimited dro requirement practically meaningless. [vol. 11:1 columbia journal of tax law 134 the prohibition against capital shifting and the “ceiling rule” can theoretically cause an allocation that has economic substance but doesn’t satisfy the primary test to also fail the eee test. consider the following example. example ten a contributes $100x and b contributes $10x to form partnership ab. a is a limited partner and b is a general partner having no dro. the partnership agreement provides that, in a liquidation, (1) b is first allocated an amount that permits her to recover all invested capital and to earn a 10% return on capital; (2) a is next entitled to recover her invested capital; (3) any remaining partnership net assets are allocated 50/50 between a and b; (4) all partnership items must be allocated in accordance with the allocation of net assets in a liquidation. since liquidating distributions are not made according to positive capital account balances, and there is no unlimited dro for b, the allocation doesn’t satisfy the primary test. an important question here is whether the allocation satisfies the eee test as an alternative. one argument that the eee test is not satisfied here is that the purported allocation permits capital shifting from b to a while the primary test prohibits it. suppose the partnership has $5x income and $5x of expenses in the first year of operation and is liquidated at year end. a will receive $110x in the liquidation and b will receive nothing, essentially shifting $5x contributed capital from b to a. under the primary test, the maximum capital account balance of a at the time of liquidation is $105x since the partnership only has $5x actual income in the first year, and simultaneous creations of a $5x fictitious gain and a $5 fictitious loss are prohibited. however, from an economic perspective, the $5x income and $5x loss are not entirely “fictitious” because they reflect the parties’ ex ante assumption of actual business risks, and the consequence is not merely capital shifting. specifically, the parties agree that b will assume the risk that the partnership will generate a net income of less than $10x, and b’s concession on this issue may be necessary to induce a, a limited partner, to invest in the partnership’s business. in other words, assuming arm’s length negotiations, a’s $10x total gain on her invested capital consists of an actual income of $5x and an “imputed” income of $5x which reflects the parties’ ex ante expectations about the amount a would earn by investing in an alternative business with comparable risks. accordingly, b’s $10x total loss on her invested capital consists of a $5x actual loss and a $5x “opportunity cost” that a has incurred by investing in the partnership’s business which b has agreed to assume. there is also unlikely to be a tax avoidance motive here. first, the partnership agreement specifies an economic target in liquidation first and then simply requires an allocation of partnership items to reflect that liquidation target. second, the guaranteed 10% return on invested capital seems to be a reasonable amount and consistent with a’s role as a limited partner with no management rights. thus, the allocation should be respected for tax purposes; otherwise, an efficient business arrangement may be disturbed because of an arbitrarily created disparity between pre-tax and after-tax consequences. to fully reflect the parties’ economic arrangement in tax, the service should consider disregarding the “ceiling rule” under section 1.704-1(b)(2)(iv) in this case and treating the $5x fictitious gain and loss as if they are actually realized and recognized by the partnership. as a result, the allocation would have economic effect under the eee test. by disregarding the “ceiling” rule in an allocation that permits capital shifting but has a bona fide business purpose and no tax avoidance motive, the service would correctly treat a fictitious gain implied ex post 2019] a gain must lie where it falls: matching tax with economics in subchapter k 135 as an actual economic gain expected ex ante, and a fictitious loss implied ex post as an actual cost incurred by a party to assume a business risk ex ante. on the other hand, capital shifting can theoretically be used as a tax avoidance device to allocate partnership items solely for tax purposes. consider the following example. example eleven at the beginning of year 1, a and b each contributes $200x to form partnership ab. a has a net operating loss (nol) carryover that is about to expire. the partnership agreement provides that (1) in a liquidation before the end of year 2, a is entitled to recovery of capital plus a 100% return on invested capital before b recovers capital, and any remaining net assets are shared equally between a and b; (2) in a liquidation after the end of year 2, b is entitled to recovery of capital before a recovers her capital, and any remaining net assets are shared equally between a and b; (3) voluntary liquidation of the partnership requires mutual consent of both a and b; (4) all partnership items must be allocated in accordance with the allocation of net assets in a liquidation. the allocation obviously doesn’t satisfy the primary test. in this extreme example, there is arguably a tax avoidance motive, because a 100% return on invested capital in the first year of operation is not supported by any market reality, the partners never expect to voluntarily liquidate the partnership within the first two years of operation, and a’s tax attribute (an expiring nol carryover) unrelated to the partnership works too well with the arrangement. the sole purpose of the parties’ arrangement is to create a fictitious loss for a in year 1 and to reverse the amount in year 2. assuming that the partnership breaks even in both year 1 and year 2 with $100x income and $100x expense. at the end of year 1, a is deemed to have received $100x actual loss and $100x fictitious loss, while b received $100x actual gain and $100x fictitious gain. at the end of year 2, if the partnership is not liquidated, a is deemed to have received $100x actual gain and $100x fictitious gain, while b received $100x actual loss and $100x fictitious loss. in this case, because the fictitious gain and loss are not supported by business purposes and a tax avoidance motive is obviously present, the service should not waive the “ceiling rule” under reg. sec. 1.704-1(b)(2)(iv).143 thus, the allocation should fail the eee test, and all partnership items must be allocated “in accordance with the partners’ interest in the partnership.” in this case, the service may re-allocate the $100x income and $100x expense equally between a and b. b. guaranteed payment as an alternative to capital shifting treat the “ceiling rule” as waivable dependent on the underlying tax avoidance motive of partnership arrangement is one way to cure the problem of target allocation. alternatively, a preferred return to a limited partner through a target allocation similar to the one in example ten can be viewed as a guaranteed payment, defined as payment for the use of capital without regard to partnership profitability.144 consequently, in example ten, if the preferred return is 143 admittedly, in this extreme case, the allocation will fail the substantiality prong of the see test for being “transitory” even if it’s treated as having economic effect under the eee test. see treas. reg. § 1.7041(b)(2)(iii)(c). see also example seven, part iii.c.5, supra. 144 see i.r.c. § 707(c); treas. reg. § 1.707-1(c); treas. reg. § 1.707-4. [vol. 11:1 columbia journal of tax law 136 a guaranteed payment, it is includible in a’s gross income regardless of a’s tax accounting method and deductible to partnership ab subject to the capitalization requirement in section 263 of the code, as if it’s made to a non-partner.145 ignoring section 263 issues, the capital shifting problem is seemingly eliminated because partnership ab now has a non-fictitious, legitimate $10x loss that can be allocated to b,146 and the allocation overall satisfies the eee test and is also in line with the partners’ interest in partnership. one may argue that the guaranteed payment should exclude the amount that represents allocation of gross income or expense such that in example ten, the amount of guaranteed payment is $5x rather than $10x. assessing the validity of this argument requires one to make an assumption regarding whether the words “without regard to the income of the partnership” in section 707 of the code is intended to have an ex ante or an ex post meaning. the service’s current position on this issue is unclear, if not contradictory. on one hand, the service seems to adopt an ex post view in example (2) of treas. reg. § 1.707-1(c), suggesting that to the extent a partner’s distributive share of partnership income before taking into account any guaranteed payment is below an ex ante guaranteed minimum amount that a partner will receive, that amount is not treated as a guaranteed payment.147 on the other hand, example (1) of treas. reg. § 1.707-4(a)(4) treats a 10% preferred return on the fair market value of contributed capital as a guaranteed payment without considering the partner’s ex post distributive share of partnership income, suggesting an ex ante view.148 yet another uncertainty lies in whether the word “income” in section 707(c) of the code is intended to refer to partnership taxable income only.149 given that treas. reg. § 1.707-4 became effective in 2016, much latter than treas. reg. § 1.707-1’s effective year of 1976, and that the latter has not been amended to reflect subsequent changes, one should be aware of the possibility that the service has implicitly shifted its view from ex post to ex ante in its interpretation of section 707(c). however, viewing preferred return on contributed capital as a guaranteed payment for the purpose of keeping an allocation (like a target allocation) in line with the see safe harbor requirements has received mixed attitudes from practitioners, and the law in this area is not well-developed. 150 two questions are particularly relevant here. first, how should the 145 treas. reg. § 1.707-1(c). 146 assuming $5x income and $5x expense in year 1 without considering guaranteed payment. 147see also pratt v. commissioner, 550 f.2d 1023 (5th cir. 1977) (holding that the payment of interest on a bona fide loan by the taxpayer-partner to the partnership is not treated as guaranteed payment). 148 one may argue that, if a partner is entitled to a x% distributive share of pre-guaranteed payment partnership income with a guaranteed minimum amount of $y, he/she may or may not be allocated any deduction taken by the partnership for such guaranteed payment, and the partnership needs to have income higher than ($y/x%) in order for the partner to have true equity exposure. see, e.g., treas. reg. § 1.707-1(c), ex. (2). thus, his/her situation is distinguished from another partner who receives a straightforward guaranteed payment of $y plus a x% distributive share of post-guaranteed payment partnership income, in which case the partner is certainly allocated a portion of the deduction from the guaranteed payment, and equity exposure begins earlier (at $y). see, e.g., treas. reg. § 1.707-1(c), ex. 1; treas. reg. § 1.707-4(a)(4), ex. 1. these two distinctions, however, are not significant enough to override the fact that in both cases, the partner is entitled to $10,000 regardless of the partnership’s economic performance. 149 although the treasury regulation is also unclear on this issue, allocation of partnership gross income and expense is permitted, if not required, at least in some circumstances. see, e.g., treas. reg. § 1.704-1(b)(3)(i) (suggesting that allocation in accordance with partner’s interest in the partnership may sometimes require a specific allocation of partnership gross income, e.g., to reverse an unexpected capital account deficit). the qualified income offset rule is another example of a required allocation of partnership gross items. 150 see terence floyd cuff, drafting and understanding partnership and llc allocation and distribution provisions § 9:5 (“the law on guaranteed payments and capital shifts…is not well developed”), guaranteed 2019] a gain must lie where it falls: matching tax with economics in subchapter k 137 partnership allocate deductions that result from guaranteed payments? in example ten, if partnership ab allocates the $10x loss to a rather than b, the result of the hypothetical liquidation at the end of year 1 will obviously mismatch the result under the primary test, and the eee test is not satisfied. second, what is the limitation (if any) on creating partnershiplevel gain or loss using guaranteed payments to fit an allocation into the see safe harbor? for example, can a partnership allocation with an obvious tax avoidance motive as in example eleven also be justified under the eee test through the use of guaranteed payments? the analysis below answers each question in turn. 1. allocation of guaranteed payment: answer to the first question since a guaranteed payment is treated as a transaction between a partnership and a nonpartner solely for purposes of section 61(a) and 162(a), 151 it is a partnership-level deduction that can be allocated under the partnership agreement with the same flexibility and subject to section 704 regulations.152 thus, a partnership may allocate some or all of the deduction from guaranteed payments to the partner receiving such payment; no special rules seem to limit this partnership-level maneuver.153 however, in example ten, in order to fit the target allocation into the eee test, the partners must provide in the partnership agreement that any deduction from preferred returns treated as a guaranteed payment must be allocated to b, i.e., the general partner.154 policy wise, the same flexibility should be afforded to an allocation of deductions from guaranteed payments as that afforded to partnership allocations in general. that is, the allocation should be respected as long as the requirements under the section 704 regulations are satisfied. for example, an allocation of the entire deduction from the guaranteed payment to the partner who receives such guaranteed payment is similar to that partner receiving a distribution. as long as a guaranteed payment is not part of a disguised transaction of something else, such as a simple capital shift or a purchase money debt,155 section 704 regulations should be enough to constrain the potential abuse.156 payments as salaries, returns on capital and minimum distributions (2018 ed.). see also goldberg, supra note 54 at 663, 715-16 (stating that distributions resulting from allocations made to reflect the partners’ economic deal should arguably be treated as guaranteed payments, but that it is unclear what the guaranteed payment is for). 151 treas. reg. § 1.707-1(c). 152 by contrast, a distributive share of partnership income or gain to one partner, by definition, must reduce the distributive share of the same income or gain to other partners. 153 allocating a distributive share of post-guaranteed payment partnership income to the partner receiving the guaranteed payment is certainly permissible. see, e.g., treas. reg. § 1.707-1(c), ex. 1, 3. there is no rule that limits a special allocation of guaranteed payments except for rules that limit partnership allocation overall, such as the section 704 regulations. 154 otherwise, the target liquidation result will mismatch that under the primary test of the see safe harbor. for example, if the $10x deduction from the guaranteed payment is allocated entirely to a, a’s capital account balance under the primary test would be $90x while a is entitled to $100x in a liquidation without considering the guaranteed payment. note that guaranteed payment income doesn’t increase the capital account balance of its recipient-partner. see, e.g., treas. reg. § 1.707-4(a)(4), ex. (2)(iv). 155 for an example of disguised purchase money debt, see treas. reg. § 1.707-4(a)(4), ex. 2. 156 see discussion below for transactions disguised as guaranteed payments. [vol. 11:1 columbia journal of tax law 138 2. limitation on using guaranteed payment to satisfy the see safe harbor: answer to the second question as discussed in part iv.b.1, although a deduction from a guaranteed payment should be permitted to be allocated like a regular partnership-level deduction, there should not be unlimited ability to designate any payment by a partnership to a partner that is not based on partnership income as a guaranteed payment.157 as the extreme cases in example eleven and example twelve (below) show, such unlimited ability is equivalent to a repeal of the implied “ceiling rule” under the section 704 regulations and significantly undermines the goal that the see safe harbor is intended to achieve. example twelve a and b each contributes $100x cash to form partnership ab. the partnership purchases equipment for $100x and keeps $100x cash. a and b’s partnership agreement provides that (1) capital accounts are maintained according to the section 704 regulations; (2) liquidating distributions are made according to positive capital account balances; (3) each partner has an unlimited dro; (4) all partnership items are allocated equally except that all depreciation from the equipment is allocated to a; (5) in the year of liquidation, a is entitled to a 50% preferred return on initially invested capital that is designated as a guaranteed payment, and the partnership-level deduction from such guaranteed payment is specifically allocated to b. assuming that the partnership breaks even each year except for depreciation, the equipment’s value at liquidation is equal to its adjusted book value, and partnership ab is liquidated after the equipment is fully depreciated. as the reader might have already noticed, the partners in example twelve intend to achieve a goal similar to what the orrischs in orrisch v. commissioner tried to achieve, but through a different route.158 to be sure, a and b’s partnership agreement satisfies the primary test of the see safe harbor perfectly, but nonetheless contains the same abuse that the see safe harbor is intended to address. the “last-minute” guaranteed payment ensures that the partners will share the partnership net assets equally at liquidation, but all depreciation from the equipment is allocated to a for tax purposes. the net effect is what the orrisch court described as a “trade of tax consequences.”159 like example eleven, the tax avoidance motive here is obvious, as a 50% preferred return on capital is devoid of any business reality and works too well with the special allocation of depreciation to reduce the parties’ tax liability in present value terms. consequently, the guaranteed payment is being used here to disguise a simple capital shift from b to a which is otherwise prohibited under the section 704 regulations. one possible response to this problem that the reader might have is that the economic effect of allocation of the depreciation deduction is not “substantial” for being “transitory” 157 see cuff, supra note 150. according to cuff, “there is substantial doubt that a partnership can provide economic effect to its allocations simply by providing for guaranteed payments on liquidation equal to the excess of the amount that a partner receives on liquidation over the amount in his “book” capital account.” 158 see supra note 17 and accompanying text. 159 see supra note17. admittedly, the partnership agreement may fail the substantiality prong of the see safe harbor if the special allocations of depreciation and deductions from guaranteed payments are viewed as “transitory”. however, if there is a “strong likelihood” that liquidation will not occur within five years, the allocations will not be deemed “transitory.” see treas. reg. § 1.704-1(b)(2)(iii)(c); treas. reg. § 1.704-1(b)(5), ex. 2. 2019] a gain must lie where it falls: matching tax with economics in subchapter k 139 since it is exactly offset by the guaranteed payment.160 there are two potential issues related to this response. first, it can be hard to argue that the guaranteed payment is an “offsetting allocation” especially since the regulations specifically require a to include the guaranteed payment as ordinary income and the partnership may be able to deduct it, and this is exactly what happens here.161 second, even if the guaranteed payment is technically an “offsetting allocation,” a and b can avoid the substantiality problem by utilizing the “five-year” safe harbor provided in the regulations.162 and unlike a “charge-back” of potential future profit,163 satisfying the “five-year” rule does not make the over arrangement significantly less abusive, as a guaranteed payment is, as the words indicate, “guaranteed.” 3. a summary of the capital shift discussion so far as a summary of the above discussion on capital shifting, the section 704 regulations contain an implied “ceiling rule” that prohibits simple capital shifting among partners through the partnership agreement. thus, a partnership allocation that permits simple capital shifting cannot satisfy the eee test. however, the service should distinguish between a bona fide preferred return (example ten) from a simple capital shift (examples eleven and twelve) by looking into factors such as the presence of a tax avoidance motive as well as business reality. a bona fide preferred return should be treated as a guaranteed payment, which is equivalent to an exemption from the “ceiling rule,” while a simple capital shift disguised as guaranteed payment must be viewed for tax purposes based on its substance rather than form. 4. book-equal-to-value assumption: revisited another uncertainty in the application of the eee test is whether book value or fair market value should be used in determining the deemed liquidation amount in a current or future hypothetical liquidation. the eee test does not explicitly contain a value-equals-basis assumption, and the current law on this issue is not clear. it might be argued that since a liquidation under the treasury’s capital account approach is based on fair market value,164 the eee test permits or even requires a comparison of liquidation results on a revalued basis.165 such argument seems to be misconceived in two ways. first, if the partnership does not in fact revalue its properties during the taxable year such that the allocation of revaluation, gain or loss is not an issue, since the eee test requires a matching of liquidation results in a current or future liquidation “regardless of the economic performance of the partnership,”166 and a valueequals-basis assumption does not seem to change the result. since book value itself should cover all possible economic performances in the future, a revaluation solely for purposes of the eee test is unnecessary. second, if the partnership in fact revalues its properties, in order to determine whether the allocation of revaluation items satisfies the eee test, one only needs 160 see treas. reg. §1.704–1(b)(2)(iii)(c). 161 treas. reg. §1.707-1(c). 162 treas. reg. §1.704–1(b)(2)(iii)(c) (flush language). 163 see treas. reg. §1.704–1(b)(5), ex. 8. 164 see treas. reg. §1.704–1(b)(2)(iv)(f)(5)(ii) (a liquidation is a revaluation event). 165 see, e.g., nysba tax section, supra note 102 at 32-33. 166 treas. reg. §1.704–1(b)(2)(ii)(i). [vol. 11:1 columbia journal of tax law 140 to compare the liquidation result under the partnership agreement, taking into account the new book basis and the new capital account balances after adjustments for revaluation in accordance with the regulations, with the result under the primary test. v. conclusion unlike many other facets of federal tax law, efficiency considerations do not seem to have played an important role in the analysis of subchapter k. however, an arbitrary tax policy under subchapter k has the same potential of imposing efficiency costs on society. while the treasury has elected to use capital accounts as a measurement of the partners’ economic arrangement, its “one-size-fits-all” approach may not work well in complex partnership deals. to improve the efficiency of subchapter k, the treasury should attempt to clear up the current regulatory uncertainty under section 704 regulations and should consider establishing a safe harbor approach for non-abusive partnership allocations that do not follow the treasury’s capital account approach. microsoft word hasen article formatted.docx debt and taxes david hasen* abstract the federal income tax conceptualizes the standard loan transaction as an exchange of cash for promises to pay interest and to repay the amount borrowed by the end of the term. this formulation is subtly incorrect in ways that have led to a weaker foundation for existing tax rules than they merit. conceptualizing loans instead as closely akin to leases places most of the tax rules for debt on sounder footing because it clarifies that interest is the consideration paid for the use of the loan proceeds. if interest is the cost of the use of money, then simple borrowing is a fully-paid-for transaction, full basis credit in the loan proceeds for the period for which interest is paid is appropriate, and cancellation of debt is a straightforward accession to wealth in the period in which it occurs. these conclusions hold whether the interest is deductible or not and are consistent with current law, which has come under fire from some quarters. although the proposed reconceptualization of loan as lease supports a number of longstanding income tax rules, one area in which it counsels significant reform is the taxation of partnerships. if loans are like cash leases made in exchange for interest qualifying as rent, treasury should provide for the allocation of basis credit among partners for the partnership’s debt based on who bears the economic burden of the interest expense. the rule should apply regardless of whether the debt is recourse or nonrecourse and regardless of who would have discharge of indebtedness income on default. such an approach differs markedly from the existing rules for recourse obligations but is closer to the rules for certain nonrecourse obligations. a modification of the rules applicable to partnership debt consistent with the loan-as-lease theory, therefore, would remove a significant discontinuity in the current tax treatment of partnership debt. i. introduction ...................................................................................................... 90 ii. the loan transaction: the standard view ....................................... 93 a. tax law characterization of loans ..................................................................... 93 b. proposition 1: the extension of the loan has no tax consequences ................. 94 1. treatment of borrower .................................................................................. 95 2. treatment of lender ...................................................................................... 99 c. proposition 2: both parties receive basis credit ................................................ 99 d. proposition 3: borrower default triggers an inclusion ..................................... 102 iii. loan as lease ................................................................................................... 105 a. what is a loan? ................................................................................................. 106 b. what tax consequences follow from lal? ................................................... 108 c. lal when the lender assumes risk ............................................................... 109 1. considering the risk of loss as a partial receipt of the fee ..................... 110 2. provision of security and covenants .......................................................... 111 * professor, university of florida levin college of law. thanks to pat cain, charlene luke, gregg polsky, pierre schlag, participants at conferences and the editors of the columbia journal of tax law. i remain solely responsible for all errors. 90 columbia journal of tax law [vol. 12:89 3. taxation of doi .......................................................................................... 113 d. irrelevance of interest deductibility .................................................................. 114 iv. the tax treatment of partnership borrowing ............................ 117 a. recourse liabilities ........................................................................................... 118 b. nonrecourse liabilities ...................................................................................... 120 c. partnership borrowing under lal ................................................................... 122 v. note on the haig-simons definition of income .............................. 123 vi. conclusion ........................................................................................................ 125 i. introduction most of the tax rules that apply to loans are settled, but the proper tax treatment of loans has long been in dispute.1 this article argues that the dispute is in large part traceable to an inaccurate account of the loan transaction itself. under a better account, most of the existing tax rules turn out to be correct. others require substantial revision. a loan is commonly understood as the lender’s transfer of funds to the borrower on condition that the funds be repaid, with interest due in the interim.2 that is, the transaction is framed as a swap of loan proceeds on one hand for promises to pay interest and the amount borrowed back on the other. this formulation in turn serves as the factual substrate to which the income tax analysis of loans applies. that analysis has resulted in the following settled rules:3 the transfer of loan proceeds is nontaxable to the borrower and non-deductible to the lender;4 the borrower has full basis credit in the loan proceeds,5 meaning that no tax arises on the use of the proceeds to purchase property and the borrower has a cost basis in the purchased property; and there is no deduction to the borrower and no inclusion to the lender on repayment.6 if, however, the debt is canceled, the borrower 1 many articles have been written about whether the income tax rules for the treatment of the extension of a loan and of interest payments are correct. among the more well-known are charlotte crane, liabilities and the need to keep the tax base closed, 25 va. tax rev. 31 (2005); joseph m. dodge, exploring the income tax treatment of borrowing and liabilities, or why the accrual method should be eliminated, 26 va. tax rev. 245 (2006); deborah a. geier, tufts and the evolution of discharge theory, 1 fla. tax rev. 115 (1992); martin j. mcmahon, jr. & daniel l. simmons, a field guide to cancellation of debt income, 63 tax l. 415 (2010); daniel n. shaviro, risk and accrual; the tax treatment of nonrecourse debt, 44 tax l. rev. 401 (1989); patricia d. white, realization, recognition, reconciliation, rationality and the structure of the federal income tax system, 88 mich. l. rev. 2034 (1990). as will become clear from the discussion, most of the controversy is resolved under the proposal developed here, which focuses less on the tax rules than on the economics of the basic borrowing transaction. 2 one well-known casebook describes the basic loan transaction as follows: “[i]n a classic debt instrument, the lender transfers money to (or on behalf of) the borrower at the start of the associated loan transaction. the borrower is expected to repay the amount borrowed (i.e., the loan principal) at the end of the transaction.” joseph bankman et al., federal income taxation 317 (18th ed. 2019). 3 for a general discussion of the income tax treatment of borrowing, see, e.g., boris i. bittker & lawrence lokken, federal taxation of income, estates, and gifts, ¶ 7.1. 4 non-inclusion of loan proceeds in gross income is not specifically provided for in the internal revenue code, but loans have always been so treated. see, e.g., mcmahon & simmons, supra note 1, at 417 (“as a fundamental principle of tax, borrowed funds are excluded from gross income because the obligation to repay borrowed funds offsets the economic increment even though borrowed funds increase a taxpayer's assets and can be used as the taxpayer sees fit.”). 5 see, e.g., comm’r v. tufts, 461 u.s. 300 (1983), for a statement of the rule. 6 id. at 307. 2021] debt and taxes 91 has income from the discharge of indebtedness,7 or in some instances, gain or loss from the sale or exchange of property,8 while the lender has either a worthless security deduction or a bad debt deduction.9 although these rules are settled, they are controversial. the common justification for the treatment of the borrower is that the repayment obligation precisely offsets the value of the funds received.10 the return obligation in turn is said to imply that the arrangement has a net zero value, so that the extension of the loan does not enrich the borrower. in the language of income tax policy, the borrower is not taxed because there has been no “accession to wealth.”11 in corresponding fashion, the repayment of the loan reduces the obligation dollar for dollar so that no deduction is appropriate when the loan is repaid.12 on the lender side, the receipt of the borrower’s note in exchange for the proceeds is a simple cash purchase so that the lender likewise realizes no gain or loss. 13 and, analogously to the borrower, amounts that the lender receives as principal repayments reduce the lender’s right to further payments dollar for dollar so that no income arises on repayment either. in response, critics have noted that the income tax is normally triggered without a requirement of receipt of value; rather, tax is due when untaxed value is exchanged for property,14 and sometimes even before the exchange takes place.15 moreover, when exchanges are not taxed, a special basis regime normally applies to ensure that tax is merely deferred rather than eliminated.16 no such basis regime exists for loans. similarly, it is not obvious that the lender suffers no loss on transfer of the loan proceeds since the lender has lost use of the funds during the loan term and has placed the funds at risk. this article argues that the tax rules described above are nearly correct but the justifications for them are not because they rest on a faulty understanding of the economic substance of the loan transaction. a loan is not a swap of the loan proceeds for the obligation to return them plus interest. this description mistakes the physical events that occur in consequence of the loan agreement for the legal relations that the loan agreement 7 i.r.c. § 61(a)(12). section 108 goes on to provide circumstances in which the income is excluded based on various policy grounds generally unrelated to whether the taxpayer has economic income by reason of the discharge. 8 this is the rule when the borrower satisfies nonrecourse debt by transferring to the lender the property used as security for the loan. crane v. comm’r, 331 u.s. 1 (1940). 9 i.r.c. § 165(g) (capital loss deduction on worthless securities); i.r.c. § 166(a) (bad debt deduction on other debt instruments, the character of which depends on whether the debt is business or non-business in nature). 10 see generally the authorities cited supra note 1. see infra part ii.a for a discussion of debates in the income tax literature on the proper tax treatment of the loan so conceived. 11 the authorities and commentary are numerous. among the notable ones are comm’r v. tufts, 461 u.s. 300, 307 (1983) (“when a taxpayer receives a loan, he incurs an obligation to repay that loan at some future date. because of this obligation, the loan proceeds do not qualify as income to the taxpayer. when he fulfills the obligation, the repayment of the loan likewise has no effect on his tax liability.”); bittker & lokken, supra note 3, ¶ 7.1 (“borrowed funds are excluded from gross income, even though they increase the taxpayer's assets and can be used as the taxpayer sees fit, because the obligation to repay increases the taxpayer's liabilities by the same amount and the loan therefore produces no gain.”) (citing commentary). 12 see infra part ii.a. for further discussion of this topic. 13 i.r.c. § 1001(a). 14 see infra part ii.b. for further discussion of this topic. 15 am. auto. ass’n v. u.s., 367 u.s. 687 (1961). 16 e.g., i.r.c. § 358(a) (exchanged basis in certain corporate formations and reorganizations); i.r.c. § 722 (exchanged basis in partnership formations); i.r.c. § 1031(d) (exchanged basis in like-kind exchanges). 92 columbia journal of tax law [vol. 12:89 establishes.17 rather, a loan is simply the purchase of the use of funds during the loan term, together, in most cases, with further legal incidents that relate to the risk assumed by the lender. so conceived, a loan is analogous, though not identical, to a lease. under a lease, the physical transfer of the subject property does not signify a change in ownership of the fee interest; instead, the physical transfer of the subject property is incidental to the legal entitlement purchased (as is its retransfer at the end of the lease), which is the use of the subject property during the lease term. similarly, the physical transfer of funds pursuant to a loan agreement does not signify that the funds themselves have legally changed hands. instead, the lender has sold a time-slice of the funds to the borrower. thus, disregarding for the moment the risk of loss that attends most loan transactions, it follows that the borrower obtains no right to or interest in the proceeds beyond the loan term. in consequence, the “remainder” is not transferred to the borrower in the first place, nor transferred back in the second. it follows further that the consideration for the loan is interest, not interest plus an obligation to return. the remainder is along for the ride, but just as the remainder in a lease arrangement is not part of the parties’ bargain, the remainder of the funds lent—their use for all periods following the loan term—is not bargained-for consideration. the value-for-value exchange for the use of the funds—the “rent”—is, correspondingly, not an obligation to return but instead what is denominated “interest.” because the payment of interest is an ongoing obligation that reflects an arm’s-length cash purchase, the tax consequences of borrowing are straightforward: no income on receipt of the loan proceeds, no deduction on repayment, and full basis credit in the funds borrowed as long as interest payments remain current. things become somewhat more complicated once one incorporates risk of default into the equation, but the basic analysis does not change. the presence of default risk means that what is called “interest” pays for more than the right to use the funds during the loan term. it also covers the possibility that the incidental transfer of the remainder will not be reversed. in this respect, the deal is more than payment in exchange for use. it is payment for use plus payment for a form of insurance against a certain kind of risk of loss. nevertheless, the borrower continues to pay for that risk on the same ongoing basis that the borrower pays for the use, not through an additional promise to retransfer the loan proceeds at the term. instead, the nominal interest payment is larger to reflect the insurance purchased; it includes what is commonly termed a risk premium.18 in addition, there may be other forms of “payment” from the borrower, such as restrictions on borrower activity, the right of the lender to monitor the borrower, the provision of security, or some combination of these. like an interest payment or a risk premium, however, these payments are made contemporaneously and generally do not trigger gain or loss to either party. misconceptions about the nature of borrowing create casualties beyond their threat to destabilize the current regime. they include obscuring the proper understanding of the 17 as will become clear, the analysis is sympathetic to hohfeld’s critique of the analysis of “rights.” among hohfeld’s criticisms was that analysts often confuse the physical events attendant to the legal relations with the relations themselves. wesley newcomb hohfeld, some fundamental legal conceptions as applied in judicial reasoning, 23 yale l.j. 16, 24 (1913). 18 for a standard statement of the principle, see default risk premium, https:// corporatefinanceinstitute.com/resources/knowledge/finance/default-risk-premium/ [https://perma.cc/b7wxkmga] (last visited mar. 21, 2021) (“a default risk premium is effectively the difference between a debt instrument’s interest rate and the risk-free rate. the default risk premium exists to compensate investors for an entity’s likelihood of defaulting on their [sic] debt.”). 2021] debt and taxes 93 nature of income from the discharge of indebtedness (doi), of the differences between recourse and nonrecourse debt, and even of the relative merits of income and consumption as tax bases. stated more positively, a better theory of debt would be of significant value in the effort to tax it properly and, conversely, in any effort to implement consumption tax principles to a greater extent than the law currently does, should congress move in that direction. perhaps most significantly as a doctrinal matter, the argument counsels a wholesale revision of the tax rules for partnerships’ allocation of basis credit among the partners when the partnership borrows.19 part ii of this article describes the received view of the loan transaction and reviews both its tax treatment and the conceptual problems that commentators have identified with that treatment. part iii develops the case for understanding loans as analogous to lease transactions and, consequently, for understanding interest or interest plus insurance as the exclusive consideration that the borrower pays in a standard loan. it then shows that the loan-as-lease view (lal) solves the problems raised in part ii. a final subpart rebuts the argument that the tax treatment of loan proceeds ought to hinge on whether interest is deductible; it shows that the deductibility of interest has no bearing on the tax treatment of loan proceeds under lal. part iv discusses the tax treatment of loans in the partnership setting, which is one area in which adoption of lal would have significant ramifications for current law. part v briefly discusses some of the implications of lal for understanding the nature of and differences between income and consumption as tax bases. ii. the loan transaction: the standard view in the simplest loan transaction, the borrower receives cash from the lender in exchange for promises to pay interest periodically at a fixed rate during the loan term, and to pay the same amount of cash back to the lender at the end of the term.20 the tax law generally follows this characterization,21 which will be referred to as the “standard view.” the central feature of the standard view is its conceptualization of the loan transaction as the exchange of a fee interest in cash on one hand for promises to pay interest and a return of the fee on the other. a. tax law characterization of loans the standard view underlies the analysis of the tax treatment of the loan transaction, which has yielded the following rules:22 1. the borrower has no income on receipt of the loan proceeds and no deduction on their repayment. correlatively, the lender has no deduction and no inclusion.23 19 these rules are provided in section 752 and the regulations thereunder. partnership loan accounting is discussed in some detail in infra part iv. 20 for a definition of “loan,” see, e.g., technicorp int’l ii, inc., and statek corp. v. johnston, et al. 1997 wl 538671, *21 (del. chancery ct. 1997) (“by definition a loan is ‘something lent or furnished on condition of being returned, esp[ecially] a sum of money lent at interest.’” (citing random house college dictionary (1975) (emphases and brackets in court opinion)). proposed regulations under section 7872 define a loan to include “any transaction under which the owner of money permits another person to use the money for a period of time after which the money is to be transferred to the owner or applied according to an express or implied agreement with the owner.” prop. reg. § 1.7872–2(a)(1) (1985). 21 bittker & lokken, supra note 3, ¶ 7.1. 22 id. 23 the rule applies only to the loan proceeds themselves, not to interest or other costs incurred in connection with the borrowing, which may be deductible in full or part by the borrower and are almost always 94 columbia journal of tax law [vol. 12:89 2. the borrower has full basis credit in the loan proceeds (and the lender has full basis in the note purchased with the loan proceeds), meaning in the case of the borrower that the use of loan proceeds provides the borrower with a cost basis in purchased property even though no tax is due on that purchase. the lender similarly applies basis to offset the amount received if she disposes of the note. 3. cancellation of the loan because it is uncollectible is a taxable event to the borrower and (typically) generates a bad debt deduction to the lender equal in amount to the debt forgiven.24 the treatment of the taxable event depends on whether or not the debt was recourse or nonrecourse: a. in the case of “recourse” debt, the borrower’s inclusion is treated as ordinary income resulting from doi.25 b. in the case of “nonrecourse” debt, any inclusion or deduction for the borrower is treated as resulting from the sale or exchange of property if the debtor uses the property to satisfy the loan. 26 otherwise, the cancellation is treated the same as a cancellation of recourse debt.27 nearly all commentators agree with the standard view, but many disagree that the resulting three propositions are correct as a matter of income taxation—at least in its ideal form. as it happens, the propositions are mostly right, but they are understood as right for reasons that are vulnerable to criticism (and confusion) because the conceptualization of the debt transaction to which they apply—that is, the standard view—is wrong. the voluminous commentary on how debt “should” be taxed under a normative income tax attests to the vulnerability. the rest of this part illustrates the point through an exploration of some of the controversies that have arisen regarding the tax treatment of loan transactions under the standard view, as well as the basic arguments for and against that treatment that commentators have raised. as will become evident, the standard view does not unambiguously support the tax rules that have long been in effect. b. proposition 1: the extension of the loan has no tax consequences the starting point for an analysis of the proper treatment of the transfer of loan proceeds under an ideal, or normative, income tax is the definition of income. a normative income tax is generally understood to impose a burden on “accessions to wealth” during the taxable period. the canonical formulation is the so-called haig-simons (h-s) definition: “personal income may be defined as the algebraic sum of (1) the market value of rights exercised in consumption and (2) the change in the value of the store of property rights between the beginning and end of the period in question.”28 includible by the lender. see i.r.c. § 163 (deduction for interest expense, subject to limitations); i.r.c. § 61(a)(4) (interest is an item of gross income). 24 on the borrower side, the applicable provisions are section 61(a)(12) (inclusion of income from doi in gross income in the case of recourse debts) or sections 1001(a) and 7701(g) (gain (or potentially loss) from sale of property, treating amount realized as not less than outstanding principal amount under section 7701(g)). on the lender side, the applicable provisions are section 165(g) (deduction for loss on worthless securities) or section 166(a) (deduction for bad debts). very generally, the lender’s loss is deductible under section 165(g) if the debt is publicly traded but deductible under section 166 in most other cases. 25 treas. reg. § 1.1001–2. 26 comm’r v. tufts, 461 u.s. 300 (1983). 27 rev. rul. 91–31, 1991–1 c.b. 19; gershkowitz v. comm’r, 88 t.c. 984 (1987). 28 henry simons, personal income taxation 50 (1938). countless commentaries use this definition, the so-called “haig-simons” or “schanz-haig-simons” definition, for the purpose of defining income under a normative or ideal income tax. see william d. andrews, personal deductions in an ideal 2021] debt and taxes 95 1. treatment of borrower under the h-s definition, proposition 1 is said to follow on the borrower side because the obligation to repay, when coupled with the obligation to pay interest on the outstanding principal, precisely offsets the value of cash received.29 similarly, as amounts are repaid, the concomitant reduction in the repayment obligation implies that no deduction for the payments is appropriate—the borrower does not experience a loss on the payments because she receives an equally valuable reduction in her obligation to repay. assume borrower borrows $1,000 from lender, promising to pay a market rate of interest on the full $1,000 semiannually for 10 years and to repay the $1,000 at the end of the term. on the standard view, borrower has received $1,000 in exchange for promises. ordinarily the receipt of cash constitutes income to the extent that it exceeds the taxpayer’s basis in whatever is surrendered for the cash. 30 here, borrower surrenders nothing except promises in which she has no basis because she has paid no after-tax amount to make them. nevertheless, the tax law has long taken the view that the obligation to repay the $1,000 offsets the receipt so that borrower has no inclusion. lender has received a note of value equal to what she transfers to borrower and, likewise, has no income. on repayment, borrower’s offsetting obligation is lifted, while lender’s note is exchanged for cash of equal value. the commonly offered rationale for the rule is that because the net market value of the rights received is zero, borrower in effect has received nothing.31 although she has received value for promises in which she has no basis, the obligation to repay, which will be satisfied with already-taxed dollars, must be netted with the value received to determine how much income she has in the first place. because the netting yields zero, she has neither income nor loss. the result is to be contrasted with, for example, the sale of property for cash. suppose that seller exchanges a painting for which she had paid $700 for $1,000 cash from buyer, neither party incurring any further obligation with respect to the other. here, seller has received $1,000 of value and experienced a net increase in after-tax wealth of $300 (equal to the difference in her cost, or basis, in the painting and its fair market value). she has taxable income of $300. the offsetting liability theory has won wide but not universal acceptance in the literature.32 one group of commentators has observed that the rules differ markedly in other conceptually similar areas for reasons that are not obvious. for example, subject to limited statutory33 and administrative exceptions,34 payments received for property or income tax, 86 harv. l. rev. 309, 320 (1972) (referring to this definition as “the most widely accepted definition of personal income for tax purposes . . .”). 29 some commentators cite merely the requirement to repay the principal as the basis for the rule; others include the requirement to pay interest to account for the time-value of money as the basis for the rule. see, e.g., bittker & lokken, supra note 3, ¶ 7.1 (no inclusion because of obligation to repay); shaviro, supra note 1, at 406 (obligation to repay plus interest justifies non-inclusion); white, supra note 1, at 2072 (“the familiar justification for the rule that loan proceeds are not included in taxable income is that the borrower’s obligation to repay offsets the amount borrowed and leaves her net worth unaffected.”). it is possible that some commentators view the interest obligation as implicit, treating the statement that the principal must be repaid as shorthand for the additional obligation to pay interest. 30 i.r.c. § 1001(a). 31 bittker & lokken, supra note 3, ¶ 7.1. 32 proponents include, in addition to authors cited in preceding notes, deborah geier and ethan yale. see e.g., geier, supra note 1, at 145-146; ethan yale, anti-basis, 94 n.c. l. rev. 485, 493 (2016). 33 i.r.c. § 451(c). 34 rev. proc. 2004–34, 2004–1 c.b. 911, modified, rev. proc. 2011–18, 2011–5 c.b. 441. 96 columbia journal of tax law [vol. 12:89 services to be delivered in the future are subject to inclusion on receipt, even when the taxpayer uses an accrual method of accounting.35 under an accrual method, items are normally includible in the period during which the right to the payment is fixed and the amount of the receipt can be determined with reasonable accuracy.36 in many advance payment situations, the right to retain the payment is contingent on the provision of future services and therefore not fixed, yet the taxpayer must include on receipt nonetheless.37 another more basic criticism focuses on the fact that taxability generally hinges not on the receipt of net value but on the extent to which the taxpayer has realized value for which she lacks the requisite after-tax investment. in economic terms, arm’s-length exchanges involve no income to either party because parties acting at arm’s length do not voluntarily part with value; they exchange items (including possibly services) of equal market value, typically because there is private surplus associated with doing so.38 rather, exchanges are taxable if, and to the extent, that a transferor receives value in excess of her already-taxed investment in whatever she has surrendered for that value (and, correspondingly, a deduction if after-tax investment exceeds value received, subject to exceptions).39 in the buyer/seller example, seller does not have $300 of economic income; that $300 of value accrued during her ownership of the asset, before its disposition, a fact that explains why buyer is willing to part with $1,000 for it. instead, she has zero economic income but $300 of taxable income, and this is because of the confluence of two features of the income tax. first, she had only been taxed on $700 of the painting’s $1,000 value before the exchange; and second, under a realization-based tax system, accrued gains are generally taxed on disposition. the sale, as a realization event, sufficed to trigger a tax on the previously untaxed gain in the absence of any special rule that would defer or possibly exempt the gain.40 it is hard to see how the loan case differs from a taxable exchange if the standard view is correct. borrower exchanges promises concededly worth the value of what she receives from lender; otherwise, lender would not engage in the transaction. but borrower has made no after-tax investment in her promises. if what she receives has any value at all, it seems she should be taxed on the receipt (again, under the standard view). other critics of the current rules take a softer view, generally on the basis that policy goals other than taxing realized income may justify deferral of tax on receipt of loan proceeds even though the borrower may have income strictly speaking. there are numerous transactions for which congress has explicitly provided nonrecognition 35 see, e.g., schlude v. comm’r, 372 u.s. 128 (1963) (advance payments for future dance lessons includible on receipt even though the taxpayer used an accrual method). sections 451(b) and (c) have codified the schlude rule to some extent. 36 treas. reg. § 1.451–1(a). 37 am. auto. ass’n v. u.s., 367 u.s. 687 (1961). 38 the principle is subject to some exceptions not pertinent to the analysis here. for example, a distressed seller may settle for less than fair market value on an exchange, or a thin market may result in a price different from the price that would result if the subject property were of a kind widely traded. 39 i.r.c. § 165. note that most losses on personal property are disallowed. see i.r.c. § 165(c). the general theory of the disallowance is that in most cases the taxpayer has consumed the difference between basis and value through use. 40 i.r.c. § 1001(a). various nonrecognition provisions apply to defer gain in some cases. these provisions generally reflect non-income tax policy goals. see, e.g., i.r.c. § 102(a) (donee not taxed on receipt of gift); i.r.c. § 1031(a) (gain or loss realized in a like-kind exchange is not recognized). less commonly, gain may permanently escape tax. see, e.g., i.r.c. §§ 1014(a), 102(a) (basis in property received from a decedent is its fair market value at time of death even though no tax arises on death or transfer). 2021] debt and taxes 97 treatment on policy grounds, and one can argue that loans are just another such case. for example, anthony polito argues that under an income tax that is triggered on realization events, there is no a priori reason not to tax the receipt of loan proceeds, inasmuch as the borrower faces no cost in gaining the use of them and their receipt qualifies as a realization event—an exchange of the promises for the cash.41 in polito’s view, the tax law could equally treat the receipt as partly taxable or fully taxable, noting that each of these methods applies in different settings as a way to account for the return of capital.42 for example, amounts received as returns on corporate stock are treated first as taxable distributions of corporate earnings and only after earnings are exhausted as a return of capital.43 a similar rule applies to interest earned on debt instruments.44 amounts paid under installment obligations received in exchange for appreciated property, by contrast, are generally allocated ratably between gain and return of capital.45 in the rare cases in which the open transaction doctrine applies, amounts received may be treated as return of capital before any gain is recognized.46 polito considers that any of these regimes could conceivably apply to loans under a realization-based income tax, inasmuch as what motivates the realization rule are considerations of practicality, not the income concept.47 as another example, dan shaviro notes that borrowing that is secured by property resembles a sale in that the lender may look to the security to satisfy the loan on nonpayment. if the amount of the loan exceeds the borrower’s basis in the security, one could argue for a rule that requires gain recognition to the extent of the excess, or perhaps to the extent of some ratable portion of the excess. this argument works because, as a practical matter, the receipt of the loan proceeds ensures that the borrower has liquidated the gain.48 shaviro observes that the rule would seem more appropriate for nonrecourse debt. in a nonrecourse debt arrangement, the lender takes a security interest in one or more of the borrower’s assets but has no right to proceed against the borrower in the case of default.49 thus, the borrower incurs literally no obligation to make any payment in excess of the value of the security pledged. if the loan proceeds exceed the borrower’s basis in the security (or come to exceed it when basis declines over time, typically because of cost recovery), the borrower has locked in the excess, and the transaction appears to be closely similar to a taxable sale to that extent.50 to illustrate, suppose in our earlier example that borrower’s loan was nonrecourse and that borrower pledged as security for the loan an asset having a basis to borrower of $200. the asset is worth $1,500. if the value of the 41 anthony p. polito, borrowing, return of capital conventions, and the structure of the income tax: an essay in statutory interpretation, 17 va. tax rev. 467, 478 (1998). 42 id. at 479. see also bittker & lokken, supra note 3, ¶ 7.1 (grounding the non-inclusion, nondeduction rule in considerations of practicality rather than the nature of income). 43 i.r.c. § 301(c). 44 i.r.c. § 61(a)(4). 45 i.r.c. § 453(a). 46 as examples, this rule can apply to a shareholder who receives proceeds from a taxable liquidation of a corporation over more than one taxable year. i.r.c. § 331(a); rev. rul. 85–48, 1985–1 c.b. 126. it also applies to the writer of an option on receipt of the option premium. see rev. rul. 78–182, 1978–1 c.b. 265. 47 see helvering v. horst, 311 u.s. 112, 116 (1940). 48 see shaviro, supra note 1, at 408. shaviro concludes that even in this setting, nonrecourse borrowing generally should not trigger gain. id. at 447-48. 49 see frederick h. robinson, nonrecourse indebtedness, 11 va. tax rev. 1, 3 (1991) (“[n]onrecourse debt is an indebtedness with respect to which the person who has the use of the borrowed funds has no personal liability.”). 50 id. 98 columbia journal of tax law [vol. 12:89 asset falls below $1,000 (the face amount of the loan) at any point during the loan term, it is rational for borrower to tender the asset to lender in satisfaction of the loan. it follows that borrower has “locked in” $800 of gain by entering into the loan arrangement and, one could argue, should be taxed on that gain upon execution of the loan as though the property were deemed sold and repurchased for $1,000.51 as a final example, joseph dodge has argued that the non-inclusion rule is incorrect in the context of an income tax based on the realization rule.52 as previously noted, under a realization-based income tax, gains and losses with respect to property are not acknowledged prior to the period in which a realization—typically a disposition—of the property takes place.53 according to dodge, in the case of a loan, the receipt of the proceeds is a realization event, but the repayment obligation, which is what offsets or cancels the inclusion, is not. this is because the obligation does not cause the taxpayer to experience a diminution in control over spendable wealth during the tax period (except to the extent the repayment obligation arises in the same tax period). therefore, in dodge’s view, borrower should have a $1,000 inclusion in year 1 on the facts above and a $1,000 deduction in the year of repayment. dodge contrasts this analysis with that under an accrual income tax, under which, he argues, the obligation to repay is recognized immediately because it is fixed and determinable, there being no requirement of actual payment to acknowledge the liability.54 there are significant problems with dodge’s view, but what is relevant for present purposes is that the controversy between dodge and those who disagree with him likely cannot be finally settled under the standard view. in an extended reply to his article, charlotte crane notes, among other problems, that it is hard to square his analysis with the idea that the recipient of loan proceeds does not appear to have experienced the same increase in wealth that someone who receives a windfall in the same dollar amount does.55 we are inclined to say that two otherwise identically situated individuals who each receive $100,000 in cash are not equally wealthy if one of them must pay it back in two years while the other has it free and clear.56 for dodge, however, this criticism is presumably beside the point. we can address the problem by eliminating realization as a requirement for tax accounting. then it becomes possible to account for future obligations.57 if one considers periodicity to be essential to an income tax—a debatable proposition, as i argue below58—one might conclude that the difference between crane’s and dodge’s positions boils down to a semantic disagreement over the meaning of “realization.” for dodge it does not include events that occur in future periods even if the occurrence of the event is legally required on the basis of commitments entered into in the current period; for crane (and most others, it seems) it does.59 for them, the realization 51 the contrary rule that the borrower recognizes no gain on the execution of a nonrecourse loan is settled. see woodsam assoc., inc. v. comm’r, 198 f.2d 357 (2nd cir. 1952). 52 see dodge, supra note 1, at 256-65. 53 see i.r.c. § 1001(a). 54 see treas. reg. § 1.451–1(a). 55 see charlotte crane, loan proceeds as income: a reply to professor dodge, 27 va. tax rev. 563, 566-68 (2008). 56 see id. 57 see dodge, supra note 1, at 258. 58 see infra part v. 59 see, e.g., deborah schenk, a positive account of the realization rule, 53 tax l. rev. 354, 357 (2004) (characterizing the realization rule as disregarding “‘mere’ increases or decreases in value” between 2021] debt and taxes 99 rule prevents taking account of fluctuations in an asset’s value that arise during the taxpayer’s holding period but does not require disregarding known future rights and obligations. the question of who is right, however, does not seem capable of a definitive answer if the standard view is correct.60 as developed below, under lal it is clear that no inclusion arises for the borrower regardless of whether the realization rule is a feature of the tax. 2. treatment of lender the treatment of the lender is somewhat less controversial. if the loan is not includible to the borrower, it should not generate a deduction to the lender, for at least two reasons. first, providing a deduction when there is no inclusion would cause the loan proceeds to drop out of the tax base while the loan was extended. second, from the lender’s perspective, the transaction can be seen as a straightforward purchase of an asset: the borrower’s note. this note has a fair market value equal to that of the loan proceeds (assuming it provides for adequate interest) so that the lender has not lost anything in the exchange. similarly, if one considers that a better rule would treat the borrower as having income on receipt of the loan proceeds, it appears that the lender should have a deduction.61 generally speaking, the theory would be that the loan represents a transfer of wealth from the lender to the borrower; it does not itself create value out of thin air. correlatively, repayment is income to the lender if and only if the lender has deducted (and therefore the borrower has included) the loan proceeds on extension of the loan. c. proposition 2: both parties receive basis credit whether and to what extent the parties to the loan have basis in what they receive is technically a further question. on the borrower side, a number of authorities and commentaries consider basis credit as self-evident under the assumption that the borrower has not received any net value;62 others, however, accept nontaxation (in whole or part) on acquisition and disposition of a position); david m. schizer, realization as subsidy, 73 n.y.u. l. rev. 1549, 1555 (1998) (“when stock appreciates from $100 to $400, a taxpayer is $300 wealthier; she is not taxed, though, until she disposes of the property.”); white, supra note 1, at 2046 (discussing realization as described by the supreme court as involving separation or disposition, without reference to the period in which the disposition occurs). a legally binding repayment obligation does not qualify as a value fluctuation, or “market swing.” in the loan setting, the realization rule as understood by schenk (and others) merely prevents the parties from taking account of the effect of interest rate fluctuations on the value of the repayment obligation while the loan is outstanding. for example, if the loan is extended at five percent and interest rates rise, the present value of the repayment obligation drops, resulting in a benefit to the borrower and a detriment to the lender compared with what could be achieved under a newly negotiated loan. under the realization rule, neither the borrower’s relief nor the lender’s loss is taken into account unless the loan is settled (or disposed of) during the period. 60 although not decisive, it is worth noting that the length of the taxable period is obviously a matter of convention that, in dodge’s view, has particularly significant consequences. if the period is one year, loan proceeds scheduled for repayment in two years would be taxable, but if it’s ten years, they would not. 61 dodge is an exception. in his view, what requires inclusion for the borrower is the realization rule, which in his view precludes recognition of the obligation to repay until the period in which the repayment occurs. on the lender side, the realization of the benefit of extending the loan—namely, receipt of the borrower’s note—occurs when the loan is made so that the borrower should continue to be treated as under current law: no deduction on extension and no inclusion on repayment. see dodge, supra note 1, at 258-59. 62 e.g., comm’r v. tufts, 461 u.s. 300, 307-08 (1983) (“because of the obligation to repay, the taxpayer is entitled to include the amount of the loan in computing his basis in the property; the loan, under § 1012, is part of the taxpayer's cost of the property.”); mcmahon & simmons, supra note 1, at 418 (“if borrowed money is used to acquire property, the taxpayer's basis in the property under section 1012 is the full purchase price, including the borrowed funds applied to the purchase price. the repayment of the borrowed funds is a 100 columbia journal of tax law [vol. 12:89 receipt of loan proceeds on the basis of policy reasons (rather than whether the proceeds are income in a pure sense) but remain unconvinced that full basis credit to the proceeds should also attach. they believe that if the receipt of loan proceeds is not taxable, the basis in the proceeds should be zero or, perhaps, at least not equal to their face amount, because the nontaxation of the received loan proceeds represents an override to income tax principles under which basis credit requires a taxable outlay. the general rule for basis provides that it is equal to “cost.”63 cost, in turn, is understood to reflect the amount of after-tax investment that the purchaser makes in the property.64 in an ordinary taxable transaction, after-tax investment will usually be fair market value regardless of whether the purchaser finances the acquisition with cash or property.65 suppose purchaser pays $1,000 cash for asset, which is worth $1,000 (if asset is worth a different amount, the parties are not dealing at arm’s length or there is some other feature of the transaction besides a property sale). except in unusual cases,66 the cash will have been taxed already so that purchaser’s basis in asset is the purchase price or its $1,000 cost (in those few cases in which the cash has not been taxed, basis in the purchased assets is generally disallowed).67 similarly, if purchaser instead exchanges appreciated property for asset in a taxable transaction, purchaser will recognize gain realized on the exchange and consequently have the same basis as in a cash purchase. suppose purchaser acquires asset with x co. stock, worth $1,000 and in which purchaser’s basis is $700. purchaser recognizes $300 of gain on the exchange68 and again takes a $1,000 basis in asset under section 1012, reflecting the $700 of already-taxed investment in x co. stock and the $300 of gain that is taxed on the exchange. by contrast, in those settings in which a purchaser’s realized gain or loss is not recognized, basis ordinarily will not be cost but typically the basis that the purchaser had in the property used to acquire the asset in question. 69 the basis rules for such nonrecognition transactions reflect the idea that because unrecognized gain or loss realized in the exchange is, for policy reasons, deferred rather than excluded, the pre-transaction basis must carry over after the transaction to ensure gain or loss recognition in the future. prerequisite to full enjoyment of ownership and therefore represents a cost of the property.”) (citing tufts, 461 u.s. at 307-08) (footnote omitted). 63 i.r.c. § 1012. 64 see bittker & lokken, supra note 3, at ¶ 42.1. 65 see i.r.c. § 61(a)(3). 66 two cases include a corporation’s basis in certain assets purchased with nontaxable contributions to capital, see i.r.c. § 362(c)(2), and, subject to an election, the acquisition of property that replaces similar or related property destroyed in a casualty, see. i.r.c. § 1033(a)(2). 67 see, e.g., i.r.c.§ 362(c)(2) (contributions of money to the capital of a corporation by nonshareholders do not generate basis in property purchased by the corporation with the contribution); i.r.c § 1033(b)(2) (basis in property purchased that is similar to and replaces involuntarily converted property is reduced by nontaxed portion of recovery on the conversion). 68 see i.r.c. § 1001(a). 69 see, e.g., i.r.c. § 358(a) (transferor’s basis in property received from corporation in a section 351(a) or section 354 exchange); i.r.c § 722 (transferor’s basis in partnership interest received in exchange for property contributed to the partnership). as an alternative, it also can be the basis of the transferor, but this rule generally applies where the transferee is the successor to the transferor and is in some sense the transferor’s proxy, such as the corporation or partnership that receives the property. see, e.g., i.r.c. § 362(a) (transferee corporation’s basis in property received in a section 351(a) exchange is transferor’s); i.r.c § 723 (transferee partnership’s basis in property received in a section 721 exchange is generally transferor’s). because the lender and borrower do not stand in this type of relationship, the only deferred-tax basis candidate for the borrower would be the exchanged basis rule described in the text. 2021] debt and taxes 101 suppose that transferor’s exchange of blackacre for whiteacre qualifies for nonrecognition as a “like-kind” exchange under section 1031. transferor’s basis in whiteacre will be her basis in blackacre, not the cost of whiteacre.70 if she later disposes of whiteacre in a taxable transaction, the built-in gain or loss in blackacre that went unrecognized in the nontaxable exchange will be recognized at that time. suppose one accepts that the receipt of the loan proceeds is not taxable on the basis of some policy reason besides the goal of taxing true economic income. because of its likeness to other nonrecognition transactions, the rule of nontaxation may give rise to the intuition that the borrower’s basis in the loan proceeds should be either zero or at least not the face amount of the debt.71 borrower has no after-tax cost in her promises to pay interest or to return the loan amount. if we are not going to tax her on the receipt, so the argument runs, we should also not give her basis credit since what justifies that credit is the presence of an after-tax investment, which is precisely what is missing under the nontaxation rule. moreover, the fact that she is expected to repay the loan with taxed dollars does not justify basis credit on receipt of the loan proceeds. in the ordinary course, basis arises when payment is made (or liability accrues in the case of an accrual method taxpayer) because that is when tax is due. basis credit would arise on the occasion of a taxable receipt of the funds used to repay the loan. these considerations at least suggest that if one believes that the offsetting obligation theory justifies nontaxation of the loan exchange, one still might conclude that borrower’s zero basis in the promises should carry over to the cash received in exchange for them as it would in a typical nonrecognition transaction.72 that conclusion, in turn, could support either of two rules that are inconsistent with the actual rule. one rule would require borrower to recognize gain on use of the loan proceeds to acquire property or services, effectively rendering the borrowing transaction taxable. the other possibility would be to require borrower to take a zero basis in assets or services purchased with the loan proceeds, thereby denying cost recovery to borrower and, in effect, taxing the loan proceeds over the useful life of the asset or service purchased with them (at least in the business and investment settings).73 for these reasons, some commentators have argued for at least limited basis credit in loan proceeds in certain circumstances even if the tax regime otherwise would not support it.74 charlene luke argues, for example, that providing full basis credit for loan 70 see i.r.c. § 1031(d). 71 see, e.g., charlene luke, of more than usual interest: the taxing problem of debt principal, 39 seattle u. l. rev. 33, 49-53 (2015) (arguing that borrowing of loan proceeds is conceptually distinct from “basis borrowing”); polito, supra note 42, at 506-09 (arguing that any of a number of conventions could apply to treat loan proceeds as having basis to some extent); white, supra note 1, at 2072-73 (arguing that supplying basis credit is inconsistent with nontaxation of the receipt of loan proceeds). 72 see, e.g., i.r.c. § 358(a) (exchanged basis in nontaxable reorganization and incorporation transactions); i.r.c. § 723 (same in partner-partnership transactions); i.r.c. § 1031(d) (same in like-kind exchange transactions). 73 as a general matter, there is no cost recovery for the ordinary use of personal-use property so that taking a zero basis in such property would not be significant except upon later disposition of the asset in a taxable transaction. see i.r.c. § 165 (permitting a deduction for losses sustained on business assets, assets used in the production of income, and certain casualty losses); i.r.c. § 167 (permitting cost recovery for assets used in a trade or business or for the production of income). 74 see, e.g., william d. andrews, a consumption-type or cash flow personal income tax, 87 harv. l. rev. 1113, 1154-55 (1974); j. clifton fleming, jr., the deceptively disparate treatment of business and investment interest expense under a cash-flow consumption tax and a schanz-haig-simons income tax, 3 fla. tax rev. 544, 561 (1997). 102 columbia journal of tax law [vol. 12:89 proceeds may be more appropriate when there is assurance that the tax benefits that the borrowing finances are not inconsistent with income tax principles;75 in situations in which borrowing furnishes a tax timing or other tax advantage, basis rationing may be appropriate.76 polito argues that basis credit may be more appropriate when the borrowing transaction involves an actual cash transfer than when it does not.77 shaviro has suggested that denying basis credit for nonrecourse debt may be appropriate because of the contingency of the repayment obligation or because the justifications for not taxing unrealized gains are particularly weak when the borrower uses appreciated property as a security.78 d. proposition 3: borrower default triggers an inclusion discharge of indebtedness gives rise to gross income, 79 though discharged indebtedness may be excluded in some circumstances.80 there is wide agreement that the discharge of debt ought to be taxable (as long as no exclusion applies) assuming that receipt of the loan proceeds is not, although it took some time to settle on the rationale.81 in the early years of the income tax, authorities tended to focus on the question of whether the debt discharge “freed up” assets of the borrower, thereby resulting in an increase in net worth.82 thus, when the debt was discharged by reason of insolvency, the courts would find no income from doi on the basis that the discharge did not improve the borrower’s balance sheet. another rationale that was sometimes offered was that the question of income from doi hinged on the overall success of the borrowing-plus-finance transaction: if the overall arrangement was a bust, courts might find that the discharge did not create income to the borrower even if the borrower was solvent.83 in the last several decades, a consensus has coalesced around a different theory for inclusion of income from doi, sometimes termed the “tax benefit” theory, in analogy to the tax benefit rule (tbr).84 the tbr requires the taxpayer to include an item of gross income in the current period if an event occurs in that period that is “fundamentally 75 luke, supra note 72, at 40-50. 76 id. at 66-77. 77 polito, supra note 42, at 626-32. i find polito’s distinctions unconvincing. if the borrower receives value from the lender, the absence of an intervening cash transaction seems beside the point. in support of his argument, polito cites to cases involving promissory notes in which the putative borrower received no value for the note. see id. at 629 n.45. in those cases, there was a substantial question of whether the debt was genuine. 78 shaviro, supra note 1, at 407. 79 see i.r.c. § 61(a)(12). 80 see i.r.c. § 108. 81 see bittker & lokken, supra note 3, at ¶ 7.1. for a history of the tax treatment of doi income, see mcmahon & simmons, supra note 1, at 417-25. 82 see u.s v. kirby lumber, co., 284 u.s. 1, 3 (1931). 83 see, e.g., bowers v. kerbaugh-empire co., 271 u.s. 170 (1926) (no doi income when overall transaction of which borrowing was a part generated a loss to the taxpayer). 84 the leading cases are crane v. commissioner, 331 u.s. 1 (1940), and commissioner v. tufts, 461 u.s. 300, 309-10 (1983) (“[the tax benefit] treatment balances the fact that the mortgagor originally received the proceeds of the nonrecourse loan tax-free on the same assumption. unless the outstanding amount of the mortgage is deemed to be realized, the mortgagor effectively will have received untaxed income at the time the loan was extended and will have received an unwarranted increase in the basis of his property.”). see also vukasovich, inc. v. comm’r, 790 f.2d 1409, 1415 (9th cir. 1986) (“we have no doubt that an increase in wealth from the cancellation of indebtedness is taxable where the taxpayer received something of value in exchange for the indebtedness.”); boris i. bittker & barton h. thompson, jr., income from the discharge of indebtedness: the progeny of united states v. kirby lumber co., 66 cal. l. rev. 1159 (1978). 2021] debt and taxes 103 inconsistent” with the basis upon which the taxpayer claimed a tax benefit in an earlier period.85 for example, a taxpayer might deduct the cost of business supplies in year 1, only to go out of business unexpectedly in year 2 before the supplies were exhausted. the tbr would generally require inclusion of the cost of the unused supplies in year 2,86 subject to a limited statutory exception.87 the tbr analogy to the loan proceeds case runs as follows.88 non-inclusion of loan proceeds when the loan is extended constitutes a tax benefit to the borrower that rests on the assumption that the borrower will repay the loan. if on the loan date that obligation had not existed, so the argument runs, then receipt of the loan proceeds would have been taxable as a simple accession to wealth. in the doi case, the repayment assumption is in fact false, but that is not known until a later period, when the borrower defaults. since the only difference (again, as the argument runs) between a taxable transfer in the year the putative loan is made and the actual doi case is that the obligation is canceled in a later period, inclusion of loan proceeds in that period is said to be necessary as a means to correct the earlier mistake—that is, to reverse the untoward tax benefit.89 put otherwise, the fact that the assumption of repayment turns out to be incorrect after the loan is extended rather than contemporaneously with it seems to be an arbitrary basis to treat the two cases differently. in both, the taxpayer accedes to wealth. “[t]ransactional parity” therefore demands an inclusion in the discharge year.90 the loan discharge case bears obvious similarities to the tbr. as in the usual tbr case, an event happens in an earlier year (the borrowing transaction) that appears to provide a tax benefit (non-inclusion of loan proceeds), and that benefit is predicated on a genuine but ultimately mistaken assumption about what the taxpayer will do at a future date (repayment) at the time the benefit is claimed. in further analogy to the tbr, in the later period, when the assumption turns out to be incorrect, the taxpayer turns out to have obtained a benefit in the earlier period to which she was not entitled. consequently, a corrective inclusion is appropriate. one virtue of the tbr rationale is that it does not tie the treatment of the debt discharge to the fate of the loan proceeds.91 as one prominent commentary has noted: 85 hillsboro nat’l bank v. comm’r, 460 u.s. 370, 372 (1983). 86 see id. at 381-82. 87 section 111(a) permits the taxpayer to avoid an inclusion under the tbr to the extent that the prior year’s benefit provided no actual tax benefit. 88 see, e.g., bittker & lokken, supra note 3, at ¶ 7.1 (discussing the tbr analogy). 89 see hillsboro, 460 u.s. at 383 (“the basic purpose of the tax benefit rule is to achieve rough transactional parity in tax, see n 12, supra, and to protect the government and the taxpayer from the adverse effects of reporting a transaction on the basis of assumptions that an event in a subsequent year proves to have been erroneous.”). see also mcmahon & simmons, supra note 1, at 426 (“[w]hen the debt is discharged, in whole or in part, without payment, inclusion in gross income of cancellation of debt income is required to offset the original favorable tax treatment.”). 90 hillsboro, 460 u.s. at 383. 91 see, e.g., bittker & lokken, supra note 3, at ¶ 7.6 (“income from discharge of indebtedness should depend not on the type of debt, but only on the spread between the amount received by the debtor and the amount paid to satisfy the obligation.”); geier, supra note 1, at 145 (“exclusion from gross income on receipt of the loan proceeds . . . is premised on the obligation to repay with after-tax dollars. when that obligation disappears, so does the justification for the initial exclusion.”); and 163 (“[t]he justification for taxing both cod income and the gain arising under the collapsed approach [i.e., satisfaction of nonrecourse debt by delivering security to the lender] is the same: the release from the obligation to repay previously received untaxed loan proceeds with after-tax dollars.”) (emphasis omitted). 104 columbia journal of tax law [vol. 12:89 since borrowed funds are obviously worth their face amount and assets acquired on credit in an arm's length transaction are also worth what the buyer agrees to pay, a debtor who ultimately pays back less than was received enjoys a financial benefit whether the funds were invested successfully, lost in a business venture, spent for food and clothing, or given to charity.92 this analysis seems to be correct given the additional welfare that the discharged borrower enjoys when compared to a non-borrower, regardless of the success or failure of the loan-financed transaction or of the solvency of the borrower. consider, for example, two individuals, a and b, who each have 0 wealth. a does nothing, while b borrows $100 from lender to bet on a sporting event, loses the bet, and defaults on the loan. b has done better than a because b enjoyed the gambling opportunity that the borrowing made possible. parity requires an inclusion for b regardless of the fact that the debt-financed transaction was unsuccessful. although it may make sense to provide an exclusion or other tax relief to a borrower that defaults because of insolvency (or for other reasons), the fact of insolvency does not eliminate the economic benefit that the loan provided to the borrower. nevertheless, and despite the virtues of applying the tbr analogy to loan proceeds, the reasons for doing so are obscure. ultimately, the argument assumes its conclusion. the main difficulty arises in trying to make sense of the counterfactual that would have denied the tax benefit ab initio. in the basic tbr scenario, what turns out to be incorrect is not the assumption that the earlier transaction occurred but that the set of circumstances that would justify the claimed tax benefit obtained. 93 in the business supplies case, what turned out to be incorrect was the assumption that the taxpayer would use the purchased supplies in her business, not that she purchased them at all. the “fundamentally inconsistent” later development was what turned out to be the case with respect to justifying the tax benefit, namely that she went out of business. consistent with this approach, operation of the tbr does not amount to applying the tax law to what would have happened as a factual matter had the tax benefit been unavailable, but instead applying the tax law to what did occur in light of developments that made claiming the tax benefit erroneous. the difficulty of extending this analysis to the loan case is that it is not even possible that the loan transaction would have occurred had all facts been known when the loan was made. rather, the analogy supposes that what appeared to be a loan was not a loan. consider the odd nature of the doi formulation, as described by the same commentary: were we blessed with perfect foresight, it would be possible to exclude borrowed funds from gross income only to the extent of the ultimate repayment and to tax at the outset the amount that will not be repaid. however, in the absence of perfect provision, a second best solution is required. one alternative would be to tax the entire amount borrowed and to allow deductions only when, as, and if the debt is repaid. since most 92 bittker & lokken, supra note 3, at ¶7.1. 93 see hillsboro, 460 u.s.at 383 (“the basic purpose of the tax benefit rule is to achieve rough transactional parity in tax . . . and to protect the government and the taxpayer from the adverse effects of reporting a transaction on the basis of assumptions that an event in a subsequent year proves to have been erroneous.”). 2021] debt and taxes 105 loans are paid in full and taxing the receipt would impose a heavy frontend burden on debt financing, a better alternative is the existing system of excluding borrowed funds from gross income and requiring the taxpayer to account for any gain if the debt is later settled for less than the amount due.94 the main difficulty can be simply stated: in the doi case, the counterfactual does not assume that the event, namely, the loan, occurred but its tax attributes differed; rather it assumes that the event did not occur at all. instead, a different event occurred: the uncompensated transfer of value to the borrower in the year the loan was extended. by contrast, in the tbr case, the event occurred, but the circumstances thought to obtain that would justify a tax benefit did not in fact obtain. indeed, the fact that the original transaction could have happened without the tax benefit is a predicate to applying the tbr, since that is exactly what it does: apply the correct tax law to what actually happened. in the supplies case, no one asserts that the taxpayer did not purchase the supplies, but in the loan case, to characterize the forgiveness as akin to an uncompensated transfer when the loan originated is simply question-begging. of course such a transfer would generate income, but such a transfer is not a loan. to treat the cancellation of the loan as such a transfer is simply to conclude that the forgiveness should be income to the borrower, not to argue for it. there is a further related difficulty with application of the tbr to loans: how to account for the interest that was paid on amounts discharged in a later year. had the parties known from the start that the borrower would not repay the loan, the borrower would not have paid interest on that amount thereafter. if one wanted to apply the tbr analogy consistently, one would have to account for the erroneous payment of interest on amounts that were not “in fact” borrowed. it is hardly a point of transactional consistency to require an inclusion in the later period of the discharged amount but not to account for the interest that had been paid to that point. one might object that interest payment was appropriate given that the loan was outstanding before default, but this observation simply highlights that the tbr analogy is misplaced, not that the interest should be retroactively canceled if the tbr analogy is to be applied consistently to all aspects of the transaction. under the tbr analogy, the loan did not occur to the extent of the discharge, and therefore interest should not have accrued. iii. loan as lease if nothing else, the criticisms reviewed above of the existing tax treatment of loans indicate that the treatment rests on shaky conceptual ground. even if one agrees with the current regime (in whole or part), the regime seems hard to defend in its entirety given the standard view of the nature of the loan transaction. this part develops the point that there are substantial reasons to treat the criticisms as evidence of the failure of the standard view rather than as cogent challenges to (most of) the existing tax rules. the basic difficulty with the standard view is that it mistakes the physical events that occur in the loan transaction for the legal relations that the loan creates between the parties.95 a focus on the legal relations demonstrates that a loan is closely 94 bittker & lokken, supra, note3, at ¶ 7.1 (footnote omitted). 95 in this respect, the criticism developed here represents an instance of what hohfeld characterized as a general problem of jurisprudence. see hohfeld, supra note 17, at 22-25. see also pierre schlag, how to do things with hohfeld, 78 l. & contemp. prob. 185, 193 (2015) (“the second kind of mistake [that hohfeld 106 columbia journal of tax law [vol. 12:89 akin to an ordinary lease arrangement. as indicated earlier, lal does not result in tax rules that differ materially from those just described. it does, however, have two important virtues. first, it places the existing rules on firmer foundations, eliminating significant confusion about the conceptual basis for the current regime and, one hopes, tamping down calls for reform that purport to rest on the nature of an income tax. second, lal has important ramifications for the existing rules in the partnership tax area because of the mechanism that the partnership tax regulations adopt to allocate basis credit among the partners when the partnership borrows.96 as contrasted with the three propositions that have been the focus to this point, lal would counsel significant changes to the partnership tax rules. the discussion in this part proceeds as follows. subpart a develops the analysis of lal. subpart b analyzes the tax consequences of a simple loan in which the loan creates no risk of loss to the lender. the objective is to characterize the legal relations that arise purely from a purchase of liquidity. risk of loss is present, however, in most loan arrangements, and its presence signifies that the borrower purchases more than liquidity in the loan. when risk is present, the arrangement includes a risk-shifting provision that requires separate analysis. that analysis, however, does not change the basic conclusion that ongoing payments from the borrower to the lender reflect the full cost of what is purchased under the loan. the addition of risk-shifting is the subject of subpart c. finally, subpart d addresses the question of whether the tax treatment of loan proceeds ought to depend on whether the interest is deductible. a. what is a loan? the standard view characterizes a loan as a swap of cash for promises to pay interest and to return the cash by the end of the term. lal views the consideration in a loan transaction by analogy to the rent that a lessee pays to the lessor, the analog of which is interest paid for use. if the consideration for the loan is simply the obligation to pay interest, essentially all of the tax problems asserted to exist under the standard view disappear. begin with a basic lease. in a simple lease arrangement, the lessee enjoys use of the underlying property for a specified term in exchange for periodic rental payments.97 the parties do not contemplate their bargain to consist of a transfer of the fee interest in exchange for the promise to return it together with rent, and the law does not so treat it. (if it did, nonpayment of rent would not necessarily be a basis to terminate the lease98). rather, the leasehold is its own interest in the land that the lessee purchases; the transfer and retransfer of (mere) possession, which physically resemble transfers of a fee interest, identified] . . . lies in confusing and conflating legal ‘concepts’ with the nonlegal ‘objects’ to which they ostensibly apply.”). 96 see in particular treas. reg. §§ 1.752–1, –2 & –3. 97 for typical definitions, see, e.g., u.c.c. § 2a–103(1)(j) (am. l. inst. & unif. l. comm’n 1977) (“‘lease’ means a transfer of the right to possession and use of goods for a term in return for consideration . . .”); 15 west’s texas forms § 16.1 (“a ‘lease’ is a contract by which a property owner grants the right to possess property for specified period of time in exchange for a periodic payment of a stipulated price, or ‘rent.’”) (citation omitted). the restatement of property defines a lease to involve a transfer of possession, as contrasted with a transfer of ownership. see restatement (second) of prop., landlord & tenant, § 1.2 (am. l. inst. 1977). the restatement also characterizes as “the most crucial point” of the parties’ covenants “the landlord's right to terminate the lease and regain possession for non-payment of rent.” id. at part i. 98 see, e.g., restatement (second) of prop. § 13.1 (am. l. inst. 1977) (tenant’s nonperformance of promises under the lease entitles landlord to terminate lease). 2021] debt and taxes 107 are incidental to the purchase of the leasehold. if it were possible (and perhaps it someday will be possible) to effectuate the transfer of a time-slice such as a leasehold by literally separating the parts of the assets temporally, there would be no physical transfer of the remainder interest in the subject property—at least in the case of a riskless lease. rather the leasehold would simply disappear at the end of the rental term (or earlier on default) and the fee would reappear to the holder of the remainder. indeed, a similar type of arrangement is already common in certain licensing transactions involving computer software.99 the owner of the software licenses the right to use the software for a period and also controls the software itself such that the licensee is literally unable to use the software on expiration of the license. one might consider the difference between lal and the standard view to be a matter of arbitrary choice, much as the ptolemaic and copernican theories of the solar system are in some sense merely alternative descriptions of the same basic reality.100 in that case, viewing a loan as a rental of money would not be superior to the standard view, except perhaps in its having the aesthetically pleasing property of greater simplicity. the differences, however, run deeper than aesthetics. remaining for the moment with a riskless loan, the rationale for treating the lessee as purchasing a time-limited interest in the property and not as receiving the fee subject to a return obligation is that the lessee by definition acquires literally no rights in or power over the remainder. that is equivalent to saying that the remainder is not transferred as part of the bargain, a real difference from a transaction in which rights are transferred, including the loan transaction as conceived in the standard view. the fact that rights in the remainder are not transferred implies in turn that the factual transfer of the remainder is incidental to the parties’ deal, as described above. because there is no exchange of the remainder or any part of it for consideration, the deal between the parties consists of the payment of rent for use during the term. no return obligation arises because there is nothing to “return.” additional economic facts of the standard rental arrangement corroborate the point. nonpayment of rent ordinarily results in default and a transfer back of possession, not in an action for damages lying with the lessor coupled with an ongoing right of the lessee to occupy the property throughout the lease term. if the deal were understood to include a transfer of the fee interest in exchange for the obligation to return it, nonpayment of rent would not necessarily result in termination of the leasehold. consider, for example, a one-year lease of blackacre, with rent payable monthly. the rental value of blackacre represents a small proportion of the value of blackacre, such that nonpayment of rent in most circumstances would not constitute a material breach of the parties’ agreement. 99 for a typical example, see michael wozniak, two ways to control subscription software licenses, software key sys., https://www.softwarekey.com/blog/licensing-tips/two-ways-controlsubscription-software-licenses/ [https://perma.cc/nus4-nk7u]. a difference is that the license is rarely exclusive in this case, so that the licensor retains a right to use the property. in the case of an exclusive license, the licensor’s non-use of the licensed property during the term would take the form of a contractual promise and not a physical deprivation of the capacity to use it. 100 this appears to be the perspective adopted by reed shuldiner in one of only two other commentaries i have been able to locate that analogize loans to rent. reed shuldiner, indexing the tax code, 48 tax l. rev. 537, 592 (1993) (describing discrepancies between the tax treatment of rental arrangements and loans as due to “fundamental accounting differences”). the other commentary advocates for a position opposed to the one here that rental arrangements should be treated as loans. george mundstock, taxation of business rent, 11 va. tax rev. 683, 700-03 (1992). on the relationship of ptolemy to copernicus, see for example thomas s. kuhn, the copernican revolution 186 (1957) (noting that at one level copernicus’s work could be taken as simply a more tractable description of the ptolemaic geocentric view). 108 columbia journal of tax law [vol. 12:89 rather, the bulk of the lessee’s obligation would consist in the obligation to return the fee at the term and therefore nonpayment of rent would merely entitle the lessor to damages but not to repossession. in fact, rental arrangements commonly provide for cancellation of the lease on uncured nonpayment of rent.101 a similar set of rules commonly operates in loan arrangements. the borrower agrees to pay interest, and nonpayment typically entitles the lender to accelerate the loan if the borrower does not timely cure.102 even where there is a possibility of curing a default, the norm is that the borrower will accrue additional interest that must be paid by reason of commandeering extra liquidity.103 in all events, loan arrangements do not permit indefinite nonpayment of interest; even those loans that simply penalize a default on initial nonpayment of interest or principal will accelerate the loan if the borrower does not cure the default in a reasonable time, typically well short of the actual term of the loan.104 b. what tax consequences follow from lal? application of lal clarifies why the basic tax rules for debt are mostly correct. it also indicates why other rules need revision. the balance of this part addresses the first of these topics, focusing again on propositions 1, 2 and 3 but from the lal perspective. this subpart considers a riskless loan, while subpart c extends the analysis to include the riskshifting that occurs in most loans. because a riskless loan by definition cannot go into default, the discussion of doi income is deferred to subpart c. considered economically, in a loan the borrower purchases a time-slice of the subject property—the cash borrowed—in exchange for interest payments. in the typical loan, payment of interest is an ongoing obligation. failure to pay interest accelerates the loan or, if it does not accelerate it, generates an obligation to pay interest on the interest such that the same overall result obtains as long as the interest is actually paid;105 moreover, once it becomes clear that interest will not be paid, the loan becomes immediately due. these facts indicate that in economic substance, each interest payment purchases use for a given period. this is a simple value-for-value exchange. consequently, setting aside for the moment the possible effect of deductibility on the payment of interest, the borrower has full basis in the use of the proceeds (not in the remainder) for the period for which interest is paid for the simple reason that the interest payment represents a purchase at the cost of the time-slice with after-tax dollars. hence there is no question of inclusion on 101 see, e.g., revised unif. landlord and tenant act § 601(a)(1) (unif. l. comm’n 1972) (providing that a landlord may terminate a lease for nonpayment of rent due by giving the tenant notice in a record stating that if the rent remains unpaid 14 days after the notice is given the lease terminates). 102 see, e.g., ross p. buckley, why are developing nations so slow to play the default card in renegotiating their sovereign indebtedness, 6 chi. j. int’l l. 345, 346 n.3 (“under most loan agreements and bonds, nonpayment of interest or principal is a ground upon which a creditor can declare a debtor in default, but default is not an automatic event.”). 103 see, e.g., prompt payment, bureau of the fiscal serv., https://www.fiscal.treasury.gov /prompt-payment/interest.html [https://perma.cc/8tb3-63rg] (last visited mar. 21, 2021) (explaining that interest accrues on a late loan payment by applying the interest rate to the late amount under usual compounding principles). 104 loan agreement: overview, prac. l. fin., https://www.westlaw.com/8-3810296?transitiontype=default&contextdata=(sc.default)&vr=3.0&rs=cblt1.0 (last visited feb. 16, 2021), (“[defaults] are events (such as non-payment of interest or principal . . .) which allow lenders to exercise their remedies. these remedies allow the lenders to accelerate the repayment of outstanding debt . . .”). 105 original issue discount bonds are debt instruments on which interest due is simply added to the outstanding principal amount rather than paid to the bondholder so that more interest accrues as time passes. see i.r.c. §§ 1271-73 (so treating bonds for tax purposes whose stated redemption price at maturity exceeds their issue price by more than a de minimis amount). 2021] debt and taxes 109 receipt of the time-slice because there is nothing to include, apart, possibly, from the value of the first interest period. but just as a lessee does not include the value of a leasehold or even of the first rental period on taking possession, it seems administratively much simpler to disregard this relatively minor benefit.106 on the lender side, the sale of the use is an exchange that generates gain only as use arises, which gain is simply interest. because the transfer of the loan proceeds is itself incidental, there is no deduction on transfer because from a legal perspective the loan proceeds have not changed hands. one might imagine more nuanced fact patterns, but the basic analysis remains. consider, for example, early repayments. in many self-amortizing loans, early payments apply against principal so that interest that accrues going forward is reduced.107 but the parties may agree that prepayments can be considered simply as they are labeled. in that case, a designated prepayment of interest results in the borrower’s having paid for use in upcoming periods and, consequently, having no income during those periods either. conversely, for a cash-method taxpayer, delayed payment of interest could, based on the general rules for inclusion of income, generate income to the borrower if payment occurs after the close of the taxable year.108 consistent with the idea that the income received is the rental value of the money, the amount of the inclusion is simply the interest that goes unpaid until the later period. finally, lal explains the difference between prepaid income items and loan proceeds. the issue in the prepaid income setting is whether an accrual-method service provider—the seller—should include a payment in income even though services are to be provided in a later tax period.109 lal clarifies that in the loan setting it is the lender who is the service provider, not the borrower. the use of the loan proceeds is not analogous to a payment but to what is purchased; interest is the payment. the borrower is the service recipient. as a service provider, the lender does not have prepaid income under a standard lease because interest is paid as use occurs. c. lal when the lender assumes risk the analysis in subpart b assumed that the lender bears no risk of borrower default. ordinarily, only short-term treasury bonds are considered riskless instruments, and even that assumption is somewhat stylized since it is theoretically possible for the u.s. government to default.110 in the more realistic case in which the lender assumes risk, the 106 to illustrate, suppose a loan is extended on the 15th day of the month with interest payments due monthly on the 15th of each subsequent month that principal is outstanding. technically a calendar-year borrower has 16 days of income in respect of the liquidity purchased for the period from dec. 16 through dec. 31, because payment therefore is not made until jan. 15 of the next tax period. just as the tax law disregards the analogous income in the case of a lease with a rent payment due on the 15th, it makes sense to disregard this timing benefit because it is de minimis. 107 for a typical statement, see, e.g., how does prepaying your mortgage actually work?, sensible fin. plan. (apr. 25, 2017), https://www.sensiblefinancial.com/prepaying-mortgage-works/ [https://perma.cc /qbp8-pww2] (“when you make an extra payment on your mortgage, that money goes directly toward reducing the balance on your loan. because of how the loan is structured, the extra payment triggers a cascade effect that speeds up the repayment of the loan.”). 108 treas. reg. § 1.451–1(a). an accrual-method taxpayer generally would treat payment as accruing in the year of receipt of the loan proceeds under the all-events test. treas. reg. § 1.461–1(a)(2). 109 i.r.c. § 451(b). 110 see, e.g., joseph bankman & thomas griffith, is the debate between an income tax and a consumption tax a debate about risk? does it matter?, 47 tax l. rev. 377, 387 n.29 (1992); alvin c. 110 columbia journal of tax law [vol. 12:89 analysis changes somewhat because the borrower’s power to dissipate the lender’s fund implies that something beyond mere liquidity is transferred in the transaction. risky loans grant the borrower a limited power to dissipate the fund because the loan is obtained for the purpose of spending the funds and there can be no guarantee that the borrower’s assets will suffice to repay at the term. the extent of the grant differs, however, depending on the circumstances of the loan. loans are commonly extended only for particular purposes, thereby providing some comfort that the loan is unlikely to be spent on risks unacceptable to the lender. the lender may reserve rights to monitor the borrower, such as to observe and even affect the borrower’s decision making. a further circumstance that provides some protection to the lender is that under a recourse arrangement all of the borrower’s assets are available to satisfy the debt (subject to claims of equal and superior creditors), and under many loan arrangements, the lender takes a security interest in the borrower’s property. of course, the most significant factor is the overall financial health of the borrower. there are two ways in which these circumstances might be enlisted to support the idea that part of the bargain consists of a taxable exchange: viewing risk of loss as evidence of a fee transfer coupled with a promise to repay; and viewing the possibility that consideration provided to the lender in exchange for its assumption of risk might generate taxable gain or loss to the borrower. for reasons developed below, neither of these theories is correct. 1. considering the risk of loss as a partial receipt of the fee it may appear that the borrower’s power to dissipate the loan proceeds represents a transfer of more than mere use during the loan term, consistent with the idea that there is a transfer of at least part of the fee interest in the cash when the loan is extended and a transfer of it back if and when the borrower repays. if the borrower is capable of dissipating the loan, doesn’t that mean that she received the proceeds in fee? two features of the arrangement explain why this conclusion is incorrect. the first is that the legal relation that the loan establishes with respect to the remainder falls far short of a right to the loan proceeds beyond the term and, therefore of an obligation to return them at the end of the term. rather, the borrower might be considered, to use the language of hohfeld, to have acquired a “privilege” vis-à-vis the lender during the loan term, who correspondingly has a hohfeldian “no right.”111 the privilege is the capacity to spend the funds (as well as other assets that the borrower owns) in ways that may make the borrower unable to repay at the term, matched by the lender’s lack of a right to prevent the spending. possession of the privilege, of course, does not discharge the borrower of the obligation to repay—the lender still has a right to be repaid—but it does have the capacity to alter the lender’s legal claims with respect to the funds after the earlier of the term or when interest that is due goes unpaid. generally speaking, if the borrower is unable to repay, the usual remedy is discharge in bankruptcy, which effectively defeats the lender’s repayment right in whole or part.112 remaining with the language of hohfeld, a bankruptcy discharge warren, jr., how much capital income taxed under an income tax is exempt under a cash flow tax?, 52 tax l. rev. 1, 14 (1996). 111 for hohfeld, a’s privilege to x is a’s capacity to do x without interference from b, who correspondingly enjoys a “no right.” hohfeld, supra note 17, at 16. 112 see, e.g., discharge in bankruptcy – bankruptcy basics, u.s. courts, https:// www.uscourts.gov/services-forms/bankruptcy/bankruptcy-basics/discharge-bankruptcy-bankruptcy-basics [https://perma.cc/v8ut-w846] (last visited mar. 21, 2021) (“a bankruptcy discharge releases the debtor from 2021] debt and taxes 111 reflects the exercise of a power in the borrower, corresponding to a liability in the lender. generally speaking, a party has a power when she can alter another party’s legal entitlement with respect to some thing, and a party that is under a liability is powerless to control that alteration whether she approves or not.113 although the borrower has no right to refrain from repayment, as a practical matter she can end up creating that right in herself by failing to maintain the ability to repay—whether or not through any fault of her own. the just-described privilege and power that the borrower has in relation to the lender has a value, but that value generally is small. we know its value because we know that borrowers other than the federal government pay a risk premium to borrow, and the risk premium is simply the price of the privilege and the power that the borrower receives under the loan. over the last 35 years, the risk premium for large borrowers has averaged about three percent in excess of the rate on 12-month treasury obligations—considerably less than a right to the loan proceeds beyond the term.114 of course, rates are higher for riskier debt, but even non-investment grade borrowing typically bears a rate not higher than about 15 percent before subtracting the risk-free rate.115 thus, even if one wanted, under the standard view, to treat the promises made by the borrower to go beyond the obligation to pay for the time value of money, those promises reflect a small proportion of the face amount. secondly, and more to the point, because the borrower pays a risk premium on an ongoing basis in exchange for the privilege and the power, the essential character of the transaction as a fully paid-for taxable exchange remains unchanged. in each period, the borrower pays the pure cost of liquidity and a risk premium that reflects the parties’ judgment of the fair market value of the privilege and power discussed above. consequently, for the same reasons as previously noted, the borrower does not have income on receipt of the loan proceeds, the lender has no deduction from the transfer, and both parties have full basis in their respective legal entitlements.116 these entitlements simply include the privilege and the power described previously. 2. provision of security and covenants a separate basis on which to conclude that the extension of the loan may be taxable to the borrower relates to the consideration that the borrower provides the lender for the lender’s willingness to assume risk of loss. here one might accept lal as the theory of the loan transaction but point to the fact that a cash risk premium is not the only form of consideration paid to the lender. for example, the borrower may provide collateral to the lender that consists of appreciated property or may agree to provide zero-basis services to personal liability for certain specified types of debts. in other words, the debtor is no longer legally required to pay any debts that are discharged.”); u.s.c. §1328(a)-(c). 113 id. see also curtis nyquist, teaching wesley hohfeld’s theory of legal relations, 52 j. leg. ed. 238, 240 (2002) (“a person with a power is able to change a legal relation of another (who is under a liability).”). 114 historical interest rates: january 1986 to august 2020, first republic bank, https://www.firstrepublic.com/finmkts/historical-interest-rates [https://perma.cc/ddu4-8m5f] (last visited mar. 21, 2021). 115 ice bofa us high yield index effective yield, fed. rsrv. bank of st. louis (1997-2020) https://fred.stlouisfed.org/series/bamlh0a0hym2ey [https://perma.cc/7ac5-p52k] (last visited mar. 21, 2021). the only time during this period that rates exceeded 15 percent was in the immediate aftermath of the 2008-09 great recession. id. 116 some have suggested that the features of nonrecourse debt are enough like a sale to make the transaction taxable, since the borrower can lock in gain by pledging appreciated property. see supra text accompanying notes 49-51. 112 columbia journal of tax law [vol. 12:89 the lender (such as furnishing financials).117 in either case, if the transferred interest is substantial enough, the transaction might be considered taxable. assume borrower pledges whiteacre as security for a $1 million loan from lender. borrower’s basis in whiteacre is $700,000 and its fair market value is $1.2 million. by pledging whiteacre, borrower has transferred some of the incidents of ownership to lender, such as limitations on use or perhaps reporting obligations with respect to the security or, more generally, with respect to borrower’s activities. do these transfers count as taxable events? with respect to collateral, it is clear that the transaction would not qualify as a taxable event under well-developed realization doctrine principles. in general, realization occurs when there is a “disposition” of property.118 a disposition for tax purposes requires substantially more than placing an encumbrance on property. for example, the sale of a call option for property held by the taxpayer does not qualify as a disposition of the property unless the option is so favorable that its exercise is all but assured.119 nor do loans of property—that is, standard leases—qualify as realization events.120 if an option sale or a loan of property does not qualify as a disposition, then a transfer to the lender of rights significantly less extensive than these does not either. with respect to zero-basis services, the question is closer, though of less practical importance. the lender receives the full benefit of the services, which means there is no reservation of rights with respect to them and the transfer is complete. on the other hand, in nearly all cases, the value of the services will be either de minimis (in the case of personal loans) or deductible as an ordinary business expense (in the case of business loans).121 for example, a homeowner’s agreement with the mortgagee to maintain the property in good condition is unlikely to result in any conduct different from what she would have done without the mortgage. in the case of a business borrower, compliance with covenants may be both more substantial than in the personal loan setting and involve conduct that would not otherwise occur, but because undertaken as part of the regular conduct of the business, generally deductible under section 162.122 on the lender side, the fact that the benefit of the services provided is entirely business in nature justifies disregarding it for tax purposes. it is analogous to the benefit that a business owner receives for deductible services.123 in general, the owner has no inclusion on receipt of the services even though the payment was deductible. instead, the inclusion happens on a later disposition of goods or services thereby financed, the cost of which does not include the amount paid for the deductible services. in the case of a borrower’s execution of loan covenants or the provision of security, the lender obtains assurances that advance its business purposes but provide no personal benefit. instead, the 117 borrower covenants are common features of lending transactions. nada mora, lender exposure and effort in the syndicated loan market, 82 j. risk & ins. 205, 208 (2015). 118 i.r.c. § 1001(a). 119 rev. rul. 78–182, 1978–1 c.b. 265 (describing option rules). for deep-in-the-money options, see, e.g., progressive corp. & subsidiaries. v. u.s., 970 f.2d 188 (6th cir. 1992). 120 see, e.g., rev. rul. 55-540, 1955-2 c.b. 39, § 3.01 (discussing differences between leases and conditional sales and noting that in a genuine lease, incidents of ownership do not pass to the lessee). 121 i.r.c. § 162(a). 122 an exception would apply where the loan finances the production of identifiable property. see, e.g., i.r.c. § 263a(a)(1) (requiring capitalization of certain otherwise deductible expenditures into basis or the cost of goods sold). in these cases, an inclusion on performance would occur but the cost typically would be recovered on later disposition of the property thereby financed. see i.r.c. § 1016(a)(1) (providing for adjustment to basis for, among other things, outlays “properly chargeable to capital account.” 123 see infra part iii.d for a discussion of the tax treatment of the receipt of deductible services. 2021] debt and taxes 113 benefits show up in the greater profits the lender earns by reason of conducting its business properly. these profits are, of course, taxable.124 3. taxation of doi given that the borrower acquires no interest in the remainder when the loan is extended, the release of the borrower from repayment because it is uncollectible is a simple and straightforward accession to wealth: the borrower in effect appropriates the portion of the remainder that is canceled at the time of cancellation. no special theory, be it analogy to the tbr, the freeing of assets rationale, or the overall balance sheet rationale is necessary to explain why the debtor has income on cancellation. assume borrower borrowed $1,000 from lender in year 1 on a recourse basis. under the loan terms, interest only is due until year 5, at which point the full principal is due. borrower makes all interest payments as due until the first day of year 3, at which point she defaults and lender discharges the loan as uncollectible. the “remainder” here is simply the face amount of the principal, which at that point is economically transferred to borrower. lender has a corresponding loss equal to the face amount of the debt. there is no need to relate back to the date the loan was extended because the loan proceeds were not transferred to borrower on that date. rather, current use was transferred and it is the default that effectuates the transfer of the fee interest. that transfer is a simple accession to wealth for the borrower and a loss for the lender at the time of default. note that the treatment of the inclusion as a transfer in the year of default, rather than as a “relation back” to the year the loan was extended, avoids the difficulty under the standard view of accounting for interest payments on the forgiven amount. recall that the standard view equates the default with a “hindsight” understanding of the original transfer as an accession to wealth when the loan was extended that must be accounted for in the year of discharge under the principle of transactional consistency. but such a theory cannot explain why the borrower paid interest before the default on the forgiven portion of the loan. it also violates the principle of transactional consistency because the tax benefit theory requires treating the forgiven amount as having been extended without a repayment obligation. note also that under the tax benefit rationale there is no discount on the amount of the inclusion for the payment of interest; the inclusion is equal to the principal amount forgiven.125 it is worth noting that although lal provides a straightforward account of doi, it does not decisively resolve whether doi should result in a taxable inclusion. viewing the risk premium as a form of insurance highlights that either of two general regimes might apply to doi income: a regime in which, on average, there is one inclusion, or a regime in which there may be two. in some settings, such as death benefits paid under life insurance contracts, the tax law excludes insurance payouts from gross income.126 in most such cases, the premiums must not have been deductible.127 in theory, the overall treatment of the insurance arrangement in these cases is a “nothing.” assuming a fair insurance scheme, in the case of term life insurance, premiums paid by all policyholders in the aggregate will 124 i.r.c. § 61(a)(2). 125 treas. reg. § 1.61–12(a). 126 i.r.c. § 101(a). see also i.r.c. § 104(a)(3) (exclusion for health insurance benefits as long as premiums are paid with after-tax dollars). 127 i.r.c. § 264(a). an exception is employer-provided health insurance. subject to certain premium limitations, premiums are deductible by the employer, i.r.c. § 162(a)(1), and excluded from the employee’s gross income, i.rc. § 106(a), while the amounts expended on medical care are excluded. i.r.c. § 105(b). 114 columbia journal of tax law [vol. 12:89 equal payouts, less the cost of administering the scheme. therefore, apart from the effect of graduated rates, it is a matter of indifference from a revenue perspective whether premiums are deductible and death benefits are includible, or premiums are nondeductible and death benefits are excluded. under either approach, the death benefit is taxed once, either when the income to pay the premium is earned or when the death benefit is paid. in other settings, such as payouts under property casualty insurance policies, the internal revenue code treats recoveries as taxable to the extent of gain realized even if premiums are not deductible.128 suppose taxpayer insures her personal residence for its $300k fair market value, which exceeds her basis by $200k. if the property is destroyed by a covered peril, $200k of the $300k recovery is taxable (though the gain may be deferred and even excluded under the special rules for gains realized on personal residences).129 this is so even though the premiums are not deductible. in this type of regime, both the premiums and what they pay for are subject to tax. it is an open question as a policy matter which of these two regimes should apply. if one views the benefit of personal insurance as consisting solely of the payout, then the tax regime should be symmetrical: premiums should be deductible if and only if recoveries are taxable. the argument for symmetry would be that the exclusive income benefit of the policy derives from the payout, while any peace of mind associated with having adequate insurance is akin to normally nontaxable surplus. in that case, the choice amounts to whether we tax insurance on an ex ante basis or an ex post basis. a deduction/inclusion regime taxes ex post; it treats the benefit of the insurance as speculative while the cost represents a reduction in consumable resources. a non-deduction/exclusion regime taxes ex ante; it treats the value of the right to proceeds as purchased up-front in the same way that life insurance is taxed. whether ex ante or ex post, insurance payments are effectively taxed once. if, however, one considers the privilege a risky borrower enjoys of using borrowed funds on analogy to the peace of mind associated with personal insurance to be a “purchased” income item separate from the benefit of any payout, then no deduction, or at best a partial deduction, should be available for the risk premium, and therefore income from doi should be includible as well, subject to the exclusions and limitations available under section 108. lal does not settle the question of which regime should apply because the answer turns on how expansively one views the income concept. if one considers income a proxy for utility—here, the utility of knowing the lender rather than the borrower experiences the loss—then a dual tax regime should apply. under a more restrictive definition that sees income as consisting of a flow of material satisfactions, a single regime should likely apply.130 d. irrelevance of interest deductibility one might be persuaded of the validity of lal but be tempted to conclude that the tax treatment of loans should turn on the deductibility of interest payments. the reasoning would be that lal identifies the payment of interest as the basis for both non-inclusion and basis credit in the loan proceeds, and that conclusion rests, in turn, on the idea that 128 see, e.g., i.r.c. § 1033(a)(2) (treating amounts realized on involuntary conversions of property, which includes insurance proceeds, as taxable income unless invested in similar or related property). 129 id. 130 david hasen, how should gifts be treated under the federal income tax?, 2018 mich. state l. rev. 81, 83-84 (2018). 2021] debt and taxes 115 interest payments represent a taxable purchase of liquidity. 131 but if the interest is deductible, it appears the purchase is not made with after-tax dollars and the arguments for non-inclusion of loan proceeds and basis credit for them become weaker. nevertheless, although plausible, the idea that treatment of the loan proceeds under lal depends on whether the interest paid is deductible is incorrect for two related reasons. it mistakes the tax treatment of a deductible outlay with tax consequences that flow from a deductible outlay. more basically, it rests on a mistaken understanding of the reasons for business deductions and their effects on the taxpayer. as a preliminary matter, it is helpful to clarify the stakes of the question. recall that all that is purchased in any given period is the use of funds for that period. periodic interest payments under a simple loan entitle the borrower to the use of the funds for those periods but not beyond them. therefore, the question becomes whether there ought to be an inclusion or a denial of basis credit in the loan proceeds for that period if the associated interest payment is deductible. further, if one concluded that an inclusion was appropriate, the amount would be equal to the value of the use of the loan proceeds for that period, which by definition is the interest paid, not the face amount of the loan. this amounts to arguing that no deduction should be available for interest. stated otherwise, the argument for inclusion turns out to be that interest should never be deductible. begin with the consequences of the deductible payment itself. the receipt of goods or services in exchange for a deductible payment does not trigger income to the taxpayer.132 if it did, then the deduction itself would be pointless. for example, most salary is immediately deductible.133 it would defeat the deduction if the receipt of the service provider’s services thereby purchased were taxable. instead, the service recipient has no inclusion, but the cost of the services is not included in the cost of the goods or services thereby produced so that the deduction is recouped when they are sold. this observation might in turn suggest that a taxpayer who deducts interest payments has a zero basis in the loan proceeds or in what is purchased with them, much as some have argued should be the case for loan proceeds generally. 134 this analysis, however, rests on a mistaken view about the reason a deduction (or cost recovery more generally) for non-personal outlays is permitted in the first place. as discussed in part ii, a normative income tax reaches the individual’s net change in wealth during the taxable period.135 net change in wealth under the widely-accepted h-s income definition equals the sum of the change in explicit on-hand resources plus amounts spent on personal consumption. the inclusion of the latter in turn reflects the idea that personal consumption is merely the transformation of the thing consumed into some personal benefit to the consumer, or what is the same, that the voluntary aspect of the conversion of wealth into a consumption experience signals that the consumer is no worse off by reason of the expenditure.136 if two individuals each earn $100k of salary income during the taxable period but one of them spends $30k on consumption and the other $60k, it is not 131 see supra part iii.b. 132 the general rule for deductibility is set forth in section 162(a), which permits a deduction for ordinary and necessary business expenses. 133 i.r.c. § 162(a)(1). business expenditures that create an identifiable asset of the taxpayer generally are not deductible; instead, the outlay is capitalized—added to the basis of the asset so created. i.r.c. §§ 263(a), 263a(a). 134 see supra part ii.c. 135 see supra part ii. 136 andrews, supra note 75, at 1114. 116 columbia journal of tax law [vol. 12:89 appropriate to treat them differently under an income tax. one has chosen to defer more consumption than the other, but that is not a reason to tax that person more heavily.137 within this framework, outlays incurred to produce income enjoy separate treatment. amounts expended on supplies, utilities, and related items to generate net positive incomes in the current taxable period are subtracted from income to avoid overstating, perhaps dramatically, the individual’s true income during the period.138 an obvious reason is that the outlay does not reflect the transformation of wealth into something of equal personal value but rather is motivated by business exigency as a means to create wealth that at some future point will be converted into consumption (whether by the individual or by someone else of her choice). as contrasted with a home utility bill, amounts paid for electricity to run the factory do not confer a contemporaneous personal benefit on the taxpayer, and they also are not available as a store of wealth that can be readily converted into a consumption experience. thus, the assumption that a cash receipt is equivalent to the receipt of a personal benefit is defeated. the absence of a personal benefit to business outlays does not mean that business outlays represent losses.139 business expenses do not represent true losses; if they did, business owners would not voluntarily incur them. instead, the deduction for business expenses implements a timing principle that is justified on the basis that, at best, the outlays represent an immediate reduction of consumable value but are expected in a future period to represent a gain. in this respect, deductions for business expenses (as contrasted with losses) simply reflect a presumption shift that is justified by the fact that the personal benefit they provide is speculative and mediated. the certainty of the lack of benefit now coupled with the speculative status of the benefit later (if the taxpayer is profitable) justifies allowing a provisional deduction now that is made good later by disallowing in the cost of goods sold basis resulting from deductible outlays. as contrasted with a personal outlay, the realization of a benefit requires the successful conversion of the outlay into an income item, and that conversion may never occur. consider that implementing the principle that an income tax reaches net changes in wealth in no way requires a deduction for business expenses. the same result, apart from timing differences, could be reached (and would more obviously and directly be reached) by denying a deduction and simply adding business outlays to the cost of goods sold. indeed, this principle already applies to certain cases in which congress views the availability of an immediate deduction as inappropriate on timing grounds, largely because the outlay results in the production of tangible goods that can be readily sold.140 apart from a possible timing mismatch (since the goods thereby produced may be sold in a later period), the capitalization of costs method directly implements the idea that an income tax reaches the taxpayer’s change in wealth during the period. when already-taxed dollars are 137 the point applies to the $100k earned in the period, not to returns that the saver may receive on amounts invested. 138 the main provision in the internal revenue code that ensures a deduction is section 162(a). 139 see 7 jacob mertens, mertens law of fed. inc. tax. ¶ 28:52 (2020) (discussing differences between and relationship of business expenses and business losses). 140 section 263a requires certain taxpayers to capitalize inventory and other costs in lieu of an otherwise available business deduction. congress enacted section 263a in the tax reform act of 1986. the senate finance committee report explains in relevant part: “[t]he existing rules may allow costs that are in reality costs of producing, acquiring, or carrying property to be deducted currently, rather than capitalized into the basis of the property and recovered when the property is sold or as it is used by the taxpayer. this produces a mismatching of expenses and the related income and an unwarranted deferral of taxes.” s. rep. no. 99-313, at 92 (1986). 2021] debt and taxes 117 spent in an arm’s-length market transaction, no taxable income arises. thus, a rule that capitalizes all costs, business and personal, but allows a loss deduction only for the sale of non-personal property would yield the same basic system that a business expense regime implements. the lesson from all of this is that a true and final deduction is allowed only when the taxpayer sustains a loss.141 deductions for business outlays are nothing more than a timing rule that reflects a presumption shift: a deduction is available now because the outlay itself categorically removes resources available to provide a personal benefit and only contingently makes resources available to make the current outlay good. because amounts deducted as business expenses are not added to the cost of goods sold, the net effect is to recoup the loss (in whole or part) on sale of the associated business item. these considerations indicate that full basis credit in the liquidity purchased should be available to the taxpayer regardless of whether interest is deductible as a business expense. basis credit is appropriate in the business setting because the liquidity does not produce a personal benefit. consider that if the interest were not deductible, it is clear both that (1) under lal, basis credit in the liquidity would be available, and (2) interest expense would be added to the cost of goods sold in order to arrive at a true measure of income.142 as demonstrated in this subpart, the difference between a regime that implements these two principles and one that permits a deduction for interest and denies any further cost recovery for interest expense represents an improvement in timing because of the absence of a personal benefit from the outlay itself. iv. the tax treatment of partnership borrowing one might consider the argument to this point largely academic since the three propositions discussed in part ii are mostly consistent with lal anyway. although i am not sanguine on the point given the potential that policy discourse has for upending settled rules, the consequences of adopting lal go beyond academic debate because there are areas in which lal has ramifications for existing law. this part focuses on one such area, partnership tax accounting. when a partnership borrows, the partnership receives basis credit in the loan proceeds just as any other borrower does, but the question arises of how to allocate the basis credit among the partners.143 suppose that ab’s two partners, a and b, share all items of partnership income, gain, loss, and deduction (igld) in a 60:40 ratio. each partner has a basis in her interest in ab that reflects her after-tax investment in it.144 if ab borrows cash from a third-party lender and uses the proceeds to purchase business property, ab will 141 i.r.c. § 165. section 165 implements the deduction for losses. although the 2017 tax reform act temporarily disallows deductions for most personal losses, see § 165(h)(5), the provision is controversial in that it appears to be a departure from a normative income tax. see, e.g., jeffrey h. kahn, the misconstruction of the deductions for business and personal casualty losses, 21 fla. tax rev. 621, 630 (2018). 142 see, e.g., § 263a(f), which permits capitalization of interest payments for interest, the deduction for which is denied under section 263a(a). 143 i.r.c. § 752. the question does not arise for “c” corporations because, as contrasted with partnerships, c corporations are taxpayers. i.r.c. § 11. accordingly, the corporation functions analogously to an individual for this purpose. partnerships are subject to a pass-through regime under which the partnership’s items of igld are taxable to the partners only. i.r.c. § 701. the problem for borrowing also would arise, in theory, for s corporations, which like partnerships are pass-through entities, except that s corporation shareholders do not receive basis credit in the corporation’s debt unless the shareholder is the lender. i.r.c. § 1367(b)(2)(a). 144 i.r.c. § 722. 118 columbia journal of tax law [vol. 12:89 have basis in the property in the same way that any other borrower would,145 but it is not obvious how the basis credit will be shared between a and b in their partnership interests. does it go to them equally, or on the basis of their interests in ab, or according to some other principle? basis allocation is important for a number of reasons, including the availability to the partners of deductions allocable to them from the partnership’s activity146 and the partners’ ability to avoid inclusions on cash distributions from the partnership to them.147 as a general matter, deductions are available, and income inclusion avoided, only to the extent of the partner’s basis in her partnership interest, with deductions and cash distributions reducing basis dollar for dollar (not below 0).148 allocable deductions that exceed available outside basis are suspended and carried forward, 149 while cash distributions in excess of available outside basis are taxable.150 under current regulations, the method of allocating basis credit for partnership borrowing among the partners depends on the nature of the borrowing. if the loan is recourse to one or more partners, basis is allocated by “economic risk of loss” (erl).151 if it is nonrecourse, a more complicated regime applies, but for present purposes it will suffice to treat the basic rule as allocation by profit shares.152 as developed below, lal is flatly inconsistent with making allocations according to erl and is in some tension with making allocations by profit shares. if the rules were reformed to reflect the principle that interest is the consideration paid for the use of loan proceeds, the rules for partnership liabilities would not be bifurcated based on the nature of the debt as recourse or nonrecourse. instead, the rules would be uniform and would in some measure parallel the existing rules for what are termed “excess nonrecourse liabilities.”153 this is an especially attractive result given the functional similarity between most (genuine) nonrecourse and recourse debt. by contrast, under current law, partners can effectively choose basis allocations to a large extent by structuring a loan as recourse or nonrecourse, depending on which best suits their tax preferences, even though the facts on the ground may differ only slightly between the two arrangements. a. recourse liabilities applicable regulations define recourse liabilities of a partnership as liabilities for which one or more partners or related parties would be personally liable on default.154 the 145 i.r.c. § 752(a) (provides that a partner’s assumption of a partnership’s liability is treated for all purposes as a cash contribution by the partner to the partnership). i.r.c. § 723 (provides that the partnership’s basis in property includes that of the contributing partner, meaning that the partner gets basis credit in the cash deemed contributed under section 752). section 752 does not specify, however, how to determine the size of the deemed cash contribution of any individual partner in respect of the partnership’s third-party borrowing. instead, regulations under section 752 provide rules as discussed in this subpart. see treas. reg. §§ 1.752–1 (treatment of partnership liabilities in general), –2 (treatment of partnership recourse liabilities), –3 (treatment of partnership nonrecourse liabilities). 146 i.r.c. § 704(d)(1). 147 i.r.c. § 731(a)(1). 148 i.r.c. § 705(a)(2), (3). 149 i.r.c. § 704(d)(2). 150 id. section 705(a) provides that distributions reduce basis before deductions do. 151 treas. reg. § 1.752–2(a). 152 treas. reg. § 1.752–3(a)(3). special rules apply to “partnership minimum gain” and gain that would be allocable under the principles of section 704(c) to a partner that contributes property subject to a nonrecourse obligation in excess of basis. treas. reg. §§ 1.752–3(a)(1), (2). 153 treas. reg. § 1.752–3(a)(3). 154 treas. reg. § 1.752–1(a)(1). 2021] debt and taxes 119 erl principle assigns basis credit for the partnership’s recourse borrowing by determining which partner(s) would be personally liable to repay the loan if it immediately became due in full and essentially all of the partnership’s assets, including cash, simultaneously became worthless.155 (this is sometimes referred to as the “catastrophe theory.”) the erl procedure operationalizes the idea that the main liability that is incurred in a loan transaction is the obligation to repay principal.156 assume that prs, a general partnership, borrows $3,000 from bank. prs has three partners, a, b, and c. pursuant to state law, the partners are equally liable for the partnership’s debts, but under prs’s operating agreement, c promises to reimburse a and b for two-thirds of what they might be called upon to pay under state law to satisfy the loan. under the erl regulations, basis in the loan proceeds would be allocated $333 to each of a and b and $2,333 to c as long as the allocation was not made for an illicit tax avoidance purpose.157 apart from any such purpose, the allocation takes no cognizance of who bears the real economic cost of the loan. imagine, for example, that c contributes capital to the partnership and a and b contribute their services, with the parties’ dividing their interests in profits and losses 40 percent to each of a and b and 20 percent to c. beyond that division of income and loss, assume that prs makes no special allocations of its items of igld.158 under the erl analysis, the 20 percent partner receives more than three-quarters of the basis credit in the loan, even though she economically bears just 20 percent of its cost assuming it is paid according to its terms (as will ordinarily be the case under a genuine loan). two features of the erl regulations tacitly acknowledge the unreality of the erl test. first, the regulations assume that as long as there is no illicit tax avoidance to the allocation of liability in the catastrophe scenario, all partners are assumed able to satisfy the liabilities to which they would be subject if the catastrophe actually happened, regardless of whether it would be realistic to assume so in light of their actual financial positions.159 this rule makes perfect sense given that no one typically expects the burden of the loan to be shared in this way (that is, no one expects the catastrophe that the regulations posit is likely to happen), but that expectation in turn simply highlights that erl is unmoored to economic reality. in effect, the rule says that even though commercially reasonable parties would not expect the obligation to be satisfied in the manner prescribed by the erl analysis, they are to assume counterfactually that it would be for the purpose of assigning basis credit. 155 treas. reg. § 1.752–2(b). an exception applies to existing nonrecourse debt of the partnership, which is treated as satisfied at face amount. treas. reg. §§ 1.752–2(b)(1)(ii), –2(b)(2)(i). 156 see, e.g., william s. mckee, william f. nelson & robert l. whitmire, federal taxation of partnerships and partners ¶ 8.02[2] (2021) (“the only time a partner will be called upon to come out of pocket with respect to a partnership liability is when the partnership is unable to pay all or a portion of that liability. thus, any examination of the partners’ obligations at a time when the partnership's assets have value would necessarily produce an artificial and potentially skewed analysis as to how the partners bear the economic risk of loss. by crediting partners with outside basis attributable to a liability to the extent the partners would be obligated to make payments in the event of a total loss of value in the partnership's assets, the § 752 regulations duplicate the consequences of the worst-case hypothetical situation.”). 157 treas. reg. § 1.752–2(b)(6). that is, under the erl procedure, each partner pays $1,000, but c then reimburses a and b $667 each. 158 treas. reg. § 1.704–1(b)(2). assume further that the allocation qualifies as having “substantial economic effect” under the applicable regulations so that it is respected for tax purposes. 159 treas. reg. § 1.752–2(b)(6). 120 columbia journal of tax law [vol. 12:89 secondly, the erl regulations adopt special treatment for “bottom-dollar payment obligations” (bdpos). 160 very generally, a partner’s obligation with respect to a partnership’s liability is a bdpo if the partner is required to make good on default only to the extent in excess of one or more other partners’ obligations. suppose that in the prs example, the partners had agreed that a and b each would be equally and exclusively liable on the first $400 of partnership debt in the event of default, while c would be liable only to the extent that bank otherwise recovers less than $600. c’s obligation is a bdpo. under the bdpo rules, c’s nominal obligation is disregarded for the purpose of determining erl. instead, the basis that would have been allocated to c is reallocated among the partners under the rules that apply to the allocation of basis for nonrecourse liabilities of the partnership.161 like the erl rules, the bdpo exception to erl reflects an acknowledgment that allocation of basis credit by liability under the catastrophe theory is in many ways unrealistic. in fact, its realism depends on an assumed proportionality of what would happen under the catastrophe and what would happen under more realistic scenarios. for example, if each partner is liable for one-third of the debt, loss is allocated the same way for a default of ten percent and a catastrophic loss. but to the extent that the regulations effectively depend on this approach, the catastrophe rule is neither needed nor appropriate. the bdpo rules address one potential abuse available under the erl procedure, but not all of them. consider that the partners may well be willing to make special allocations of risk of loss that do not qualify as bdpos but that dramatically alter their obligations in the case of default. the partners may be willing to do this because they know that the risk of default is slim (and may even be insurable by a partner through an arrangement with an outside party) so that a minor economic cost yields a substantial tax benefit. the result is tax-motivated basis shifts that have little nontax significance. suppose the three partners of equal xyz are largely indifferent on a pretax basis between an allocation of erl with respect to a loan equally among themselves, or 10 percent to each of x and y and 80 percent to z. they may be willing to allocate erl in this manner because they know that default requiring the partners to make a payment is very unlikely. possible reasons could be that the security xyz provides for the debt may have a value well in excess of the loan amount, or the partnership may have a sufficiently stable income stream to make default unlikely in the first place. by adjusting the formal risk of loss to z, she secures additional basis credit at little or no economic cost.162 b. nonrecourse liabilities the unreality of the erl analysis emerges most pointedly when compared to the rules for allocation of basis in partnership nonrecourse debt. suppose instead that the loan in our prs example is nonrecourse. because the partnership has no obligation to repay the debt, erl is said to remain with the lender.163 allocation of basis according to erl is therefore impossible if nonrecourse debt is going to be treated the same as recourse debt 160 treas. reg. § 1.752–2(b)(3)(ii). 161 see treas. reg. § 1.752–2(f), ex. 10. 162 treas. reg. § 1.752–2(b)(1). 163 see, e.g., comm’r v. tufts, 461 u.s. 300, 312-13 (1983) (stating that mortgagee remains at risk with respect to the security for the loan). 2021] debt and taxes 121 for tax purposes. a long line of authority has consistently treated nrd the same as recourse debt, 164 and the partnership rules sensibly adopt the same treatment.165 to maintain parity with the treatment of debt outside the partnership setting, the partnership nonrecourse debt regulations generally allocate basis among the partners under a complicated three-tiered waterfall provision that in some respects tracks the principles for recourse debt but in others departs from those principles materially.166 because the first two tiers to some extent embody the principles for recourse debt, they also embody the problems identified above. rather than enter into an extended discussion of the nuances of these technical provisions, suffice it to say that the basic problems with them are similar to those for recourse debt. the third tier, by contrast, sets forth a principle in some ways closely aligned to lal. it applies to “excess nonrecourse liabilities,” defined as nonrecourse liabilities not covered under the first or second tier.167 excess nonrecourse liabilities are allocated among the partners in proportion to the partners’ shares of partnership profits (the “partnership profits rule” or ppr).168 notably, the ppr will often end up allocating basis credit in accordance with who bears the economic burden of the interest payments. the basic ppr provides that a partner’s interest in profits depends on all the facts and circumstances,169 but in a simple partnership, in which all items of igld are allocated ratably based on capital invested, profits and interest expense will mirror each other so that a profits rule is a perfect substitute for allocation by who economically bears interest expense. even in a more complicated arrangement or one that expressly allocates interest deductions differently from the allocation of profits, a basis rule tied to profits will often yield a reasonable result under lal because profit shares tend to reflect the partners’ real expense burden, including interest expense. as an illustration, suppose xyz’s three partners each contribute $100x in exchange for an interest in the partnership, and xyz then borrows $200x from bank on a nonrecourse basis, using the property purchased with the loan as security for it. suppose further that the xyz partnership agreement validly assigns all interest deductions to z and otherwise complies with the rules for substantial economic effect. 170 if the partners are dealing with each other at arm’s length, the overall computation of profits should nevertheless account for the net costs of each partner, so that in substance, the partners share interest expense in proportion to profit shares, even though as a matter of partnership accounting the interest is “paid” by z. beyond a general rule of assigning basis credit by profit shares under all of the facts and circumstances, the ppr contains three safe harbors that deem an assignment to be in accordance with the rule. assignments under the first safe harbor may tend to result in allocations that are the same as, or reasonably close to, an explicit allocation of basis in accordance with lal, but allocations under the second and third will not.171 under the 164 see, e.g., crane v. comm’r, 331 u.s. 1 (1947). (nonrecourse debt provides basis to borrower); tufts, 461 u.s. 300 (1983) (same under the tbr rationale); woodsam assoc., inc. v. comm’r, 198 f.2d 357 (2nd cir. 1952) (extension of nonrecourse debt not treated as a sale); treas. reg. § 1.1012–1(g)(1) (cost of property includes issue price of debt instrument exchanged therefor). 165 treas. reg. § 1.752–3. 166 treas. reg. § 1.752–3(a). 167 id. 168 id. 169 id. 170 treas. reg. § 1.704–1(b)(2). 171 treas. reg. § 1.752–3(a)(3). 122 columbia journal of tax law [vol. 12:89 first, nonrecourse debt basis allocations that track allocations of partnership income or gain that themselves have substantial economic effect will be respected. suppose that the prs operating agreement validly allocates all items of prs’s igld in respect of asset 1 to p. suppose further that prs initially financed asset 1 with partnership capital but later pledged asset 1 as security for nonrecourse debt. prs’s operating agreement could validly allocate the basis credit for the loan solely to p. this allocation would comport with lal because p would bear the burden of the interest expense as an item of deduction already allocated to p. the remaining safe harbors under the ppr are less consistent with lal. a detailed analysis of them would involve an excursion into the arcana of partnership tax, but it suffices to note that the second and third safe harbors tend to produce allocations that mimic the erl rules to some extent and therefore are problematic for the same reasons.172 c. partnership borrowing under lal for the reasons developed in part iii, the identity of the bearer of risk of loss under the loan should not be relevant to the question of who gets basis credit. because a loan is fundamentally an exchange of interest for the use of funds and, in most cases, an additional payment for insurance, the person who economically bears the interest and insurance cost should get basis credit, regardless of whose liability is discharged on nonpayment. by contrast, the existing partnership tax rules depend critically on the threshold determination of whether the loan is recourse or not to the partnership. the fact that the parties to a loan agreement often need do very little to adjust its terms between recourse and nonrecourse corroborates the point that the existing rules are incorrect. a shift from recourse to nonrecourse may require a slightly higher interest rate, a slightly better security, somewhat greater monitoring of the borrower’s use of the security, or other relatively minor adjustments to the loan terms. because the tax difference between the two types of loans when a partnership is the borrower is substantial, the rules provide untoward tax planning opportunities. consider the difference in tax treatment between two alternative $500x loans that equal abc might take, using whiteacre as security. whiteacre’s fair market value is $1000x and its basis in abc’s hands is $200x. assume that abc runs a successful business and its annual income does not fluctuate greatly; it also has no other nonrecourse debt outstanding. the loans are identical except that in one scenario it is recourse and in the other it is nonrecourse. if the loan is recourse, the partners might agree to allocate the erl largely to one of the partners, even though that partner otherwise shares equally in the partnership’s items of igld.173 if, however, the loan were nonrecourse, then the entire nonrecourse liability would qualify as an excess nonrecourse liability and, assuming the basic facts and circumstances test applied, divided equally.174 a rule for all partnership debt that mirrored the basic rule for excess nonrecourse liabilities and the first safe harbor (but not the remaining safe harbors) would be a reasonably effective means of allocating basis credit among the partners, regardless of 172 id. the second ppr safe harbor permits an allocation of basis credit for excess nonrecourse liabilities in accordance with a valid allocation of “nonrecourse deductions,” while the third safe harbor permits an allocation of basis credit in accordance with how gain would be charged to a partner on the disposition of the property in satisfaction of the debt. id. both of these methods adopt a principle that links basis credit to income on debt discharge rather than to who pays for liquidity. 173 treas. reg. § 1.752–2(b)(1). 174 treas. reg. § 1.752–3(a). 2021] debt and taxes 123 whether the debt is recourse or not. it also would provide partners the flexibility that is a hallmark of the partnership tax rules more generally.175 as a general matter, that flexibility extends to most allocations of partnership items of igld as long as they have substantial economic effect.176 the basic “facts and circumstances” rule for determining a partner’s share of partnership profits looks to the economic substance of the partners’ deal, which, as noted, would generally allocate basis credit in accordance with the economic burden of interest deductions regardless of how they are formally allocated. although the facts and circumstances test would not itself provide flexibility, the first safe harbor, known as the “significant item method,” would, and it would do so in a way that ties the allocation to profits or gains associated with the borrowing. v. note on the haig-simons definition of income at the outset i noted that lal has implications for larger policy questions as well.177 this part briefly discusses one of them, the nature of the relationship between income and consumption taxation, an area that has received sustained attention in the tax policy literature.178 to review, the h-s definition provides that income during the period equals the sum of the taxpayer’s change in wealth (positive or negative) and the market value of amounts consumed: i = w + c.179 as noted previously, the inclusion of the dollar value of amounts consumed ensures that the tax base reaches net changes in wealth, regardless of whether the wealth is retained or converted into a consumption of value equal to the income that purchased it.180 a taxpayer who during the period earns $100,000 of salary and spends $30,000 of it on consumption, saving the balance, has the same income as one who earns the same salary but spends $40,000. it is sometimes said that the practical difference between the two bases boils down to the deductibility of amounts invested, an observation that is suggested by the h-s definition itself. 181 if income equals change in wealth plus amounts consumed, consumption equals income less a deduction for amounts saved. in fact, william andrews famously argued for a simpler and, in his view, fairer cash-flow consumption tax on this basis.182 andrews observed that, given the capacity of the tax system to compute i, one 175 mckee, nelson & whitmire, supra note 156, ¶ 1.03 (“one of the principal legislative objectives of subchapter k was to afford partners ‘flexibility’ in allocating the tax burden of partnership transactions among themselves.” (citation omitted)). 176 treas. reg. § 1.704–1(b)(2). 177 see supra text accompanying notes 19-20. 178 see daniel n. shaviro, special report: replacing the income tax with a progressive consumption tax, tax notes 91, 92 (april 5, 2004) (“the literature on income versus consumption taxation could fill many rows of library shelves . . .”). 179 see simons, supra note 28, at 50. 180 see stanley a. koppelman, personal deductions under an ideal income tax, 43 tax l. rev. 679, 684-85 (1988). 181 joseph bankman & david a. weisbach, the superiority of a consumption tax over an income tax, 58 stan. l rev. 1413, 1417 (2006) (“as is well known, the difference between an income tax and a consumption tax is the taxation of the return to savings or capital income. in a consumption tax, the risk-free return to investing is exempt, while in an income tax, the return is taxed.”); edward j. mccaffery, the uneasy case for capital taxation, 23 soc. phil. & pol’y. 166 (summer 2006). 182 andrews, supra note 75. 124 columbia journal of tax law [vol. 12:89 simply needed to solve for c to adopt a cash-flow tax. in the example above, the two taxpayers would not have identical taxable amounts under a cash-flow consumption tax. the first would be taxed on $30,000 of consumption, while the second on $40,000.183 the position developed in this article, that a normative income tax does not include loan proceeds in the base, highlights an equivocation in the treatment of debt under andrews’s cash-flow model, albeit one that he recognized.184 suppose taxpayer t earns $100,000 during the period and, separately, borrows $300,000 for an extravagant roundthe-world trip for herself and her family, all of which is spent in the same year. a true cash-flow tax puts t’s consumption at $400,000 (disregarding the treatment of interest on the loan), whereas an income tax disregards the loan proceeds. two points follow. first, the inclusion of consumption in the h-s income definition should be understood as a kind of backstop; it is not so much part of the definition of income as a concession to the periodic nature of the tax. in calculating income, one cannot simply compare wealth on hand at the end of the taxable period to wealth at the end of the previous period because some, perhaps much, of the wealth received during the period may have been transformed into psychological satisfactions that would otherwise disappear from the base if consumption were disregarded. but if the tax were calculated on a continuous rather than a periodic basis, the inclusion of consumption would be unnecessary because the income that funded it would have been included on receipt.185 in other words, an income tax is really an accessions tax, where accession is understood as the receipt of value in excess of alreadytaxed amounts against which there is no claim. consumption, therefore, is not a proxy for income, because consumption can be financed with amounts against which others do have a claim, such as when consumption is debt-financed. secondly, and more importantly, the denial of an inclusion for amounts spent on debt-financed consumption does not extend to the algebraic derivation of a cash-flow consumption tax from the h-s income definition. that is, the (technically) proper definition of a cash-flow tax as c = i w applies only if i includes loan proceeds. if i does not include loan proceeds, then the tax is no longer a cash-flow tax. but if i includes loan proceeds, it is not a genuine income tax, for the reasons developed at length in this article. these observations do not defeat the general result that in their pure forms, a cashflow consumption tax and an income tax differ only in their treatment of the tax on the return to waiting.186 an income tax burdens that return while a cash-flow tax does not. but they do highlight the substantial differences between the bases in their operational forms, which of necessity are periodic. consumption is not a proxy for income (or wealth), which means that large taxes may be due under a consumption tax from a taxpayer who has little (or even negative) wealth during the period, and vice-versa. a cash-flow consumption tax is really a tax on a flow of satisfactions to the taxpayer, regardless of 183 id. at 1120. 184 see id. at 1154-55. andrews recognizes that a true cash-flow tax would include loan proceeds in income with a deduction if spent on investment but none if spent on consumption. at the back end, all loan repayments would be deductible. to avoid the problem of a large inclusion on receipt of consumer debt, he proposes instead simply disregarding the loan, which in most cases would result in a decent approximation of a consumption tax since most large consumption outlays finance consumption through a number of periods, unlike the example in the text. 185 for the operation of such a tax, see jeff strnad, taxing new financial products: a conceptual framework, 46 stan. l. rev. 569 (1994). 186 bankman & weisbach, supra note 181, at 1417. 2021] debt and taxes 125 whether the taxpayer has a final economic right to them. an income tax reaches only amounts “cleared” of others’ economic claims, regardless of whether the amounts are directed to a flow of satisfactions to the taxpayer in the period earned or in a later period. vi. conclusion debt is, in many ways, a less complicated arrangement than income tax scholarship has made it out to be. it is a simple value-for-value exchange, in most cases nontaxable to the parties involved for reasons that follow in a straightforward way from the definition of income as an accession to wealth and the nature of what is exchanged in the transaction. further, cancellation of debt triggers income to the borrower (and a deduction to the lender) for reasons having nothing to do with a retroactive tax benefit rationale but simply because an item formerly not part of the borrower’s income—the “remainder” in the cash lent— becomes part of the income in the period of cancellation. viewing loans in this way, as an exchange of interest for liquidity, does have consequences for existing law beyond shoring up the rules that apply in most settings. because the tax law treats a partnership’s borrowing as borrowing by the individual partners, it becomes necessary to allocate basis credit among them in some manner. under lal, it is clear that basis should be allocated to each partner based on the extent to which the partner bears the economic burden of paying for the liquidity. existing rules for recourse debt do not follow that principle, while some of the rules for nonrecourse debt come close. a modification to the tax rules that treats all partnership debt—recourse or nonrecourse—under lal would both allocate basis credit properly and remove a significant discontinuity in the tax law. articles cartelizing taxes: understanding the oecd’s campaign against “harmful tax competition” andrew p. morriss* lotta moberg** abstract formed in 1961 to promote global economic and social well-being, the organisation for economic co-operation and development (oecd) has become the collective voice of rich countries on international tax issues. after an initial focus on improving commerce through addressing double taxation issues, the organization shifted to a focus on restricting tax competition and increasing automatic exchanges of tax information. in this paper we analyze the reasons for this shift in policy focus. after describing the history of the oecd’s work on taxation, we examine the oecd’s project against “harmful tax competition” as it has played out since its launch in the 1990s. we analyze the mechanisms behind the project from a public choice perspective. while typical economic models portray tax competition as a prisoner’s dilemma between governments, a more powerful perspective is of the incentives of politicians and bureaucrats. we conclude that the project against tax competition is an example of the interplay between the interests of politicians and international bureaucrats. the oecd project illustrates the role that international organizations play in competition among interest groups. *d. paul jones, jr. & charlene a. jones chairholder in law and professor of business, university of alabama; research scholar, regulatory studies center, george washington university; senior scholar at the mercatus center at george mason university, and senior fellow, property & environment research center, bozeman, montana. a.b. princeton university; j.d., m.pub.aff., university of texas; ph.d. (economics) massachusetts institute of technology. we thank james bryce, charlotte ku, richard rahn, and timothy ridley for helpful comments. **b.a. (economics), lund university; ph.d. student (economics), george mason university. 2 columbia journal of tax law [vol.4:1 i. introduction ........................................................................................................ 3 ii. jurisdictional competition as a framework for tax competition ........................................................................................................... 5 iii. the evolution of the international tax cooperation .............. 15 a. the era of technical expertise ............................................................................ 15 b. the growth of tax competition .......................................................................... 23 iv. the international fight agasint tax competition ...................... 33 a. changing the agenda ........................................................................................... 33 b. policy entrepreneurship and cartelization .......................................................... 39 c. the impact of cartelization ................................................................................. 48 v. cartelization and competition ............................................................... 56 a. the public interest explanation ........................................................................... 56 b. the cartel explanation ........................................................................................ 56 c. the bureaucratic explanation ............................................................................. 57 d. conclusion ........................................................................................................... 58 appendix ....................................................................................................................... 64 2012] cartelizing taxes 3 i. introduction the organisation for economic co-operation and development (oecd) was formed in 1961 “to promote policies that will improve the economic and social well-being of people around the world.”1 since then, the oecd has become one of the world’s most respected and influential organizations. anne-marie slaughter describes the oecd as “the quintessential host of transgovernmental regulatory networks, as well as a catalyst for their creation.”2 in particular, the oecd became the main multilateral forum on tax issues through its work on solving double taxation problems caused by the impact of differences across tax systems on entities and individuals operating in more than one jurisdiction.3 the oecd serves as a means for the united states and europe “to dominate a virtually impervious institutional architecture of tax policymaking . . .”4 this mission expanded significantly over time as a focus on preventing double taxation shifted to an effort to restrict “harmful” tax competition on rates among jurisdictions. the oecd began to seek to restrain both member and non-member countries from lowering taxes and to encourage lower tax jurisdictions to raise their rates. this represented a substantial departure from its earlier focus on finding solutions to the problems caused by differences in national tax systems.5 the change in focus is important because if the oecd is successful in its efforts, jurisdictions will have ceded an important aspect of policy autonomy and sovereignty to an international forum dominated by a small group of industrialized economies with relatively high tax rates. domestic policy decisions constrained by competition among jurisdictions to attract capital will be transformed into international decisions dominated by a cartel of wealthy nations. in this paper, we explore the evolution of developed countries’ international cooperation on tax issues from the initial focus on finding solutions to problems that impeded international economic activity to a focus on protecting a few states’ abilities to collect revenues at the expense of other states.6 we ask why the oecd evolved from a 1 about the oecd, oecd, http://www.oecd.org/about (last visited oct. 2, 2011). see also organisation for european economic co-operation, oecd, http://www.oecd.org/general/ organisationforeuropeaneconomicco-operation.htm (last visited oct. 2, 2011). its predecessor, the organisation for european economic co-operation was formed in 1948 to coordinate the economic recovery from world war ii. 2 anne-marie slaughter, a new world order 46 (2004). 3 thomas rixen, the political economy of international tax governance 99 (2008). 4 allison christians, taxation in a time of crisis: policy leadership from the oecd to the g20, 5 nw. j. l. & soc. pol’y 19 (2010). 5 allison christians, sovereignty, taxation and social contract, 18 minn. j. int’l l. 99, 100 (2009) (describing oecd’s implicit articulation of “a version of sovereignty that prioritizes responsibility to the international community over the individual autonomy of nations” that enshrines the oecd’s “vision of what constitutes appropriate tax competition” as the norm). it also conflicts with other oecd advice about taxes and economic growth. for example, in its economic surveys, the oecd often recommends lowering taxes. nordic countries are frequently advised to reform their labor markets based on the notion of the benefits of lower taxes and broader tax bases. see generally andreas bergh & margareta dackehag, oecd recommends: a consensus for or against welfare states? evidence from a new database (ratio, working paper no. 159, 2010). 6 in general, we use the term “states” to refer to jurisdictions without regard to whether they are independent states under principles of international law. many low-tax jurisdictions are dependent territories or crown possessions connected to britain (e.g., bermuda, the cayman islands, the isle of man, guernsey, jersey, and the turks and caicos islands). writing “jurisdiction” to cover both independent states and dependent jurisdictions is both inelegant and tedious. note also that “international taxation” generally refers to the international interaction of different national tax systems and the way that possible problems stemming 4 columbia journal of tax law [vol.4:1 forum focused on lowering transactions costs to increase private sector competition across borders into a cartel aimed at restricting competition among states. we conclude that this transition was in part the result of entrepreneurship by a group of oecd staff who spotted an opportunity to expand their mission, yielding a concomitant increase in resources and prestige. they accomplished this by providing a framework for interests within a group of high tax states to create a cartel that would channel competition in tax policy away from areas where those states had a competitive disadvantage and toward areas in which they had a competitive advantage. how an organization formed to promote economic development began devoting resources to restricting competition to benefit some states at the expense of others illustrates an important problem for international cooperation more generally. the dynamics at work in the oecd tax competition case are present elsewhere and suggest that the creation of forums to enhance international cooperation is not always a benign development for the states and interests that are excluded from those forums. the transformation was also in part the result of the less competitive position of developed economies with respect to the rest of the world. until relatively recently, larger developed economies have been sheltered from some of the competition to attract economic activity by the combination of the costs of conducting international transactions and the barriers to such transactions—for example, those provided by the mix of capital controls, trade barriers, and other restrictions on financial transactions. as these barriers declined and investors grew more sophisticated at using international financial structures to reduce tax burdens on international transactions, states whose economies’ size had previously been sufficient to make them attractive locations for investment found themselves struggling to capture revenue from increasingly internationalized transactions.7 these states then sought to restrict tax competition. this in turn required them to create a means of delegitimizing such competition and preventing each other from defecting from the cartel by lowering tax rates unilaterally. regardless of one’s position on the merits of any particular tax regime, the evolution of the oecd from a facilitator of economic competition to a cartel enforcer represents something new in international organization behavior. since world war ii, the world economy has moved in fits and starts toward a more open financial architecture, one that has altered the relative positions of states in the competition for resources.8 the cartelization of tax policy is an important effort to hold off the impact of from this are dealt with. since there is no international statutory law, the term can be a bit misleading. see alexander jr. townsend, global schoolyard bully: the organisation for economic co-operation and development's coercive efforts to control tax competition, 25 fordham int’l l. j. 215, 224 (2001-2002). 7 more broadly, this competition is reshaping societies. see phillip brown, hugh lauder & david ashton, the global auction: the broken promises of education, jobs, and incomes (2010) (explaining that competition for jobs requiring education is now worldwide). 8 see robert z. aliber, the international money game 14 (5th ed. 1987) (“during the last hundred years, changes in technology have widened the marketplace for goods, services, and securities. for generations the market was smaller than the nation-state. the expansion of the boundaries of the market beyond the fixed boundaries of the state has threatened the viability of national economic independence and the future of many national industries.”); dilip k. ghosh & edgar ortiz, introduction in the global structure of financial markets: an overview 1, 2 (dilip k. ghosh & edgar ortiz eds., 1997) (“exchange rate convertibility and hedging instruments have created climates of covered arbitrage and, as a result, most markets irrespective of their locations have become truly global.”); mira wilkins, an overview of foreign companies in the united states, 1945-2000, in foreign multinationals in the united states: management and performance 18, 22 (geoffrey jones & lina galvez-munoz eds., 2002) (“from 1945 to the early 1960s, this common market [the u.s.] was a highly protected one, separated from the rest of the 2012] cartelizing taxes 5 the forces unleashed by competition on a more level playing field, but it is certainly not the only one. there has recently been a spate of aggressive efforts by large developed countries to demand an end to financial privacy through tax information exchange agreements (tieas), threats of blacklisting, and direct payments to individuals for stealing data from financial institutions in other jurisdictions. these efforts have the same goals as the irs’s mail intercepts of americans receiving letters from swiss banks in 1967 and 1971,9 australia’s severing of communications links to the new hebrides in the early 1970s,10 and the irs’s 1973 luring of a bahamian banker to a romantic dinner date in miami to allow it to break into his briefcase in search of documents that might incriminate american taxpayers.11 the difference is that they are now undertaken on a larger scale. the data available from foreign bankers the irs can lure to miami on dates is much less than that from the people about whom a tiea can produce automated information flows or which a bank employee can steal using a usb memory stick. if we are going to continue to reap the benefits of financial openness and relatively free capital flows, an international consensus on the shape of a level playing field for the competition for resources that takes into account the interests of more than a small group of developed economies will be necessary. part ii sets out a framework for evaluating debates over tax competition. part iii provides a brief history of efforts to address the problems caused by differences in tax regimes across states and of the emergence of tax competition. part iv lays out the qualitative change in international tax cooperation since the 1980s and examines the evolution of the oecd’s role against tax competition in the context of the framework set out in part ii. part v concludes with observations on the parameters of state competition for wealth-creating activities. ii. jurisdictional competition as a framework for tax competition states compete for economic activity in multiple ways, including offering different mixes of security of ownership, access to resources, regulatory climates, and demands on investors to share resources. tax competition is but one aspect of this competition.12 thus a dictatorship with few checks on the arbitrary behavior of the dictator, like zaire under its former dictator mobutu sese seko, offered privileged access to economic resources in exchange for granting a share of the gains to the dictator. meanwhile, oecd countries have typically offered guarantees of security of title through independent courts and other features of the rule of law in exchange for compliance with world by long-standing tariffs, and also from europe and asia by the wide atlantic and pacific oceans. from 1962 onwards, us federal governmental-imposed barriers to trade fell rapidly.”). 9 tax evasion through the netherlands antilles and other tax haven countries: hearing before the commerce, consumer, and monetary affairs subcomm. of the h. comm. on government operations, 98th cong. 31-32 (1983) (statement of william j. anderson, director, general government division, general accounting office). 10 see infra note 156. 11 see infra note 146. 12 see generally erin a. o’hara & larry e. ribstein, the law market (2009). states share an interest in maximizing the global economic pie. they disagree over how to divide the pie. allison christians, how nations share, 87 ind. l. j. 1407, 1407 (2012) (“every nation has an interest in sharing the gains they help create by participating in globalization.”). 6 columbia journal of tax law [vol.4:1 regulatory regimes and payment of taxes.13 this competition provides a lens with which to examine the issue of tax competition. we begin with the uncontroversial proposition that states do not themselves act. rather, individuals in positions of authority take actions, which together constitute the actions of the state. a state may thus act inconsistently in different forums, as different interest groups obtain the upper hand in determining a particular position or where different actors have greater influence in one arena relative to another.14 in discussing tax issues, it is important to remember that even those interest groups that share a broad agenda and operate in coalition within a particular government may have divergent interests. we will use the shorthand of referring to “states” because the more accurate phrase “the coalition of interest groups governing states” is too awkward for general use. states want economic activity for three reasons, with different political actors putting different weights on each. first, states need revenues to pay for their activities. one major source of revenue is taxation of economic activity and the wealth that such activity creates. states with natural resources may raise revenue by selling access to those resources,15 but most states are dependent on taxing economic activity in one form or another. the state activities that are funded may be the provision of public goods or genocide of disfavored ethnic groups. the crucial point is that, whether providing education or mass slaughter, governments need funds to pay their employees and buy supplies. second, states may desire economic activity for its own sake, since it brings with it the generation of wealth. a benevolent ruler or coalition of interests will prefer a richer population to a poorer one, since the richer population will have higher standards of living, better health, more education, and other things that enhance the quality of life. indeed, even a despotic regime bent on keeping power by maintaining a climate of fear may be interested in maintaining at least some minimum level of economic activity as a cheap means of quelling unrest. third, corrupt interest groups seek economic activity 13 see andrew p. morriss, the role of offshore financial centers in regulatory competition, in offshore financial centers and regulatory competition 102, 110–12 (andrew p. morriss ed., aei press 2010). one recent statement of the regulatory bargain was by harvard law professor (and u.s. senator-elect at the time of publication) elizabeth warren, who argued in favor of higher taxes that:“there is nobody in this country who got rich on his own. nobody. you built a factory out there—good for you! but i want to be clear. you moved your goods to market on the roads the rest of us paid for. you hired workers the rest of us paid to educate. you were safe in your factory because of police forces and fire forces that the rest of us paid for. you didn’t have to worry that marauding bands would come and seize everything at your factory, and hire someone to protect against this, because of the work the rest of us did. now look, you built a factory and it turned into something terrific, or a great idea—god bless. keep a big hunk of it . . . but part of the underlying social contract is you take a hunk of that and pay forward for the next kid who comes along.” elizabeth warren, the elizabeth warren quote every american needs to see, moveon.org (sept. 21, 2011), http://front.moveon.org/the-elizabeth-warren-quote-every-american-needs-to-see. governments tolerate illegal economic activities to reduce the political costs of other policies. see aliber, supra note 8, at 62–63 (“[m]ost governments tolerate black markets in foreign exchange . . . in many cases the black market permits the government to delay the political costs of formally devaluing the parity, while minimizing the economic costs of maintaining an overvalued currency.”). 14 see, e.g., tax treaties: hearing before the s. comm. on foreign relations, 97th cong. 54 (1981) (statement of rep. dan rostenkowski) [hereinafter tax treaties] (“i am not satisfied with the process that has evolved for negotiating and ratifying tax treaties . . . [t]he treasury department has determined, with little or no input from the legislative branch, those countries with which to negotiate tax treaties and has proceeded to negotiate with those countries with virtually no oversight by congress.”). 15 see, e.g., thad dunning, crude democracy: natural resource wealth and political regimes 1–2 (2008). 2012] cartelizing taxes 7 because it offers opportunities for graft. from chicago to indonesia, corruption is a perennial problem for the provision of goods by the public sector.16 if we consider the total package of non-tax regulations, taxation, and property rights protection as a specific “regulatory bargain,” we see that a state may offer different regulatory bargains depending on the goals of the interest groups that control it; particular circumstances such as its desirability as a location for particular economic activities; natural resource endowments; and the level of competition from other states seeking the same economic activities, capital or entrepreneurs. 17 this is readily apparent in the competition between london and new york for financial industry business.18 it is also present with respect to a variety of regulatory areas, as with the debate over labor and environmental standards in trade. 19 similarly, a jurisdiction with enormous natural advantages can offer a higher cost bargain than a state with less desirable climate and location: california can offer many businesses a regulatory bargain to businesses with a higher price tag than north dakota. this is not how the literature on tax competition traditionally considers these issues. instead, the literature largely presupposes a benevolent government seeking to solve the problem of efficiently providing public goods. for example, in their influential 1986 article, zodrow and mieszkowski showed that mobile capital leads to a less-than-optimal provision of a public good by the government using a model that treated all public expenditures as beneficial.20 the same year, wilson published his article laying out the equilibrium conditions under tax competition. he showed that with decentralized political decision-making, the equilibrium utility level is reduced, but he again treated all government expenditures as producing public goods. 21 numerous articles published since then have examined how different tax structures and different assumptions about the mobility of capital, firms and people change the conclusions about the effects of tax competition,22 but virtually all articles model government expenditures 16 see fighting corruption in the public sector, oecd, http://www.oecd.org/gov/ fightingcorruptioninthepublicsector. while there is evidence to suggest that moderate levels of corruption do not interfere unduly with economic growth (operating as an informal tax), more egregious corruption may reduce the beneficial impacts of economic activity but still promote the welfare of those receiving the corruption. some of the anti-offshore literature contends that corruption is part of a scheme intended to “control” developing countries and that it “diverts attention from the real springs of power.” see steven hiatt, global empire: the web of control, in a game as old as empire: the secret web of economic hit men and the web of global corruption 13, 24 (steven hiatt ed. 2007). 17 aliber, supra note 8, at 181 (“london dollar deposits differ from new york dollar deposits in terms of political risk: they are subject to the whims of a different set of government authorities.”); margaret ackrill & leslie hannah, barclays: the business of banking 1690–1996, at 215 (2001) (“london’s distinctively open and flexible wholesale money markets offered newcomers an incomparably low-risk entry strategy, with immediate access to a sterling deposit base or lending market and to eurocurrency.”). 18 see, e.g., john gapper, are we no longer the world’s financial capital?, n.y. mag., mar. 18, 2007, available at http://nymag.com/guides/london/29440 (discussing competition between new york and london). 19 see daniel drezner, bottom feeders, foreign policy, nov. 1, 2000, at 64, 66 (describing debate over existence of the race to the bottom). 20 see generally george r. zodrow & peter mieszkowski, pigou, tiebout, property taxation, and the underprovision of local public goods, 19 j. urb. econ. 356 (1986). 21 see generally john d. wilson, a theory of interregional tax competition, 19 j. urb. econ. 296 (1986). 22 see john d. wilson, theories of tax competition, 52 nat’l tax j. 269 (1999), for a review of some of the theoretical literature on tax competition. for a thorough review of the empirical research on tax 8 columbia journal of tax law [vol.4:1 as uniformly beneficial.23 this exclusive focus on public goods plays a role in the conflation of taxation with sovereignty.24 if we limit our consideration to the special case of government as benevolent provider of public goods,25 the analysis can be summarized as the following: in a world without tax competition, the benevolent government sets its tax rates at a level sufficient to fund its welfare-enhancing activities. firms and individuals pay their taxes, and public goods are provided. governments with large economies raise substantial revenue with modest taxes, while governments with resource-poor or small economies are unable to do so because the levels of economic activity within their resource-poor/small economies are too low to generate sufficient tax revenue to enable their governments to purchase the public goods their populations’ desire. 26 the introduction of tax competition offers these competition, see generally philipp genschel & peter schwarz, tax competition: a literature review, 9 socio-economic rev. 339 (2011). 23 the state is traditionally treated as a goal-directed organization that aims to solve market failures by taxing and spending and is therefore per definition benevolent. see richard e. wagner, fiscal sociology and the theory of public finance: an exploratory essay 3 (2007); alain deneault, offshore: tax havens and the rule of global crime 31 (2011) (arguing that states are “powerless” to “tax capital to finance programs in the public interest that were its responsibility.”). in that context, an important concept in the economics of taxation is the level of “optimal taxation,” which is determined by a relative weighing of efficiency and equity chosen to maximize social welfare. see simon james, taxation research as economic research, in taxation: an interdisciplinary approach research 34, 39-40 (margaret lamb, andrew lymer, judith freedman & simon james eds., 2005). following this tradition in the context of tax competition, a restriction on a government’s ability to pursue its preferred fiscal policy is by assumption undesirable. see, e.g., william h. hoyt, property taxation, nash equilibrium, and market power, 30 j. urb. econ. 123 (1991) (model of tax competition showing that the nash equilibrium level of public goods provision is determined by the number of jurisdictions); hans-werner sinn, how much europe? subsidiary, centralization and fiscal competition, 41 scot. j. pol. econ. 85, 99 (1994) (discussing future european tax competition and concluding that “tax rates have to be harmonized across all countries or chosen by a centralized agency” to avoid tax rates to be driven down by competition, as governments incur cost for supplying the mobile factors with public goods). assuming that inefficiency therefore is an inevitable outcome of non-cooperative behavior, other literature focus on how this cooperation can come about. see generally ravi kanbur & michael keen, jeux sans frontières, tax competition and tax coordination when countries differ in size, 83 am. econ. rev. 877 (1993) (discussing use of minimum tax rates to stem tax competition). a discussion about the benefits of global tax governance combined with an international social contract is provided in thomas rixen, tax competition and inequality: the case for global tax governance, 17 global governance: a rev. multilateralism & int’l institutions 447 (2011), available at http://ssrn.com/abstract=1488066. also assuming that governments provide public goods only, he argues that based on the “social-contract justification for taxation,” citizens of developing countries especially are hurt by an inadequate and suboptimal distribution of benefits as a result of tax competition. 24 christians, supra note 5, at 104 (discussing how sovereignty and taxation are conflated). 25 see, e.g., christian aid, false profits: robbing the poor to keep the rich tax-free 3 (2009), available at http://www.christianaid.org.uk/images/false-profits.pdf (describing the impact of “tax dodging” as “[p]oor countries in particular are deprived of badly needed tax revenues . . .”). 26 paradoxically, the anti-tax-haven literature often identifies tax havens with the concealment of money stolen by tyrants. for example, raymond w. baker lists kleptocrats profiting from corruption as a part of describing the global system of dirty money. raymond w. baker, capitalism’s achilles heel: dirty money and how to renew the free-market system 52 (1977). tax havens offering secrecy is a part of the “modern dirty-money system that significantly obscures global capitalism . . .” id. at 192. saddam hussein placed money from oil corruption in tax havens. id. at 128. terrorists use tax havens “in the same way as criminal syndicates.” id. at 119. yet when the money remains controlled by a government controlled by the same tyrant, this same literature assumes it is spent on public goods. see briefing paper, oxfam, tax havens: releasing the hidden billions for poverty eradication 1, 11 (2000) (“[t]ax havens have contributed to revenue losses for developing countries of at least us$50 billion a year. to put this figure in context, it is roughly equivalent to annual aid flows to developing countries . . . [m]any developing countries 2012] cartelizing taxes 9 governments an opportunity to lure economic activity away from other, richer economies by cutting tax rates. the lower rates lead the revenue for the poor governments to rise and the revenue for the rich governments to fall. importantly, the models generally assume that the rich countries lose more than the poor countries gain, because the need to compete requires such low rates that the total tax collection summed across both jurisdictions falls. tax competition thus reduces total government revenues across all jurisdictions even if it increases the revenue for the poor jurisdictions. because it is implicitly assumed that the governments are buying only public goods, tax competition reduces total welfare by reducing the total revenues available for their purchase.27 if we examine tax competition as a subspecies of the larger competition for economic activity, the incompleteness of this analysis is apparent. governments do not buy only public goods. there is also waste, fraud, and corruption, as well as considerable purchase of public “bads” such as genocide or attacks on peaceful neighbors. tax revenues may buy textbooks for schools or shoes for the closet of a dictator’s wife. they may pay for lavish ceremonies and palaces or foster development and build roads.28 whether reducing a government’s ability to charge a higher tax rate is welfare-increasing or welfare-decreasing will depend on the impact of specific governmental spending patterns.29 this ought to be obvious: in other contexts, governments, including oecd members, routinely assume that not all government revenues are devoted to enhancing public welfare. at the extreme, with pariah states, western governments frequently resort to financial sanctions and other measures designed to starve the pariah of revenue to help reduce its ability to oppress its population or to bring about its overthrow. the financial sanctions on the gaddafi regime in libya and the assad regime in syria are examples where such pressures have been enthusiastically backed by oecd member states without have low tax revenues as well as resource constraints in form of large debt burdens, declining taxes from trade, and reduced aid flows. these constraints result in poor provision of public goods in the countries that have the greatest need.”). another class of literature on tax competition describes the state as a leviathan. see generally frode brevik & manfred gärtner, can tax evasion tame leviathan governments?, 136 pub. choice 103 (2008). this view of the government, contrasting that of a benevolent social planner, follows the tradition of james m. buchanan and geoffrey brennan, picturing the government as a tax-maximizing leviathan. see generally geoffrey brennan & james m. buchanan, the power to tax: analytical foundations of a fiscal constitution (1980); see also james m. buchanan & richard abel musgrave, public finance and public choice: two contrasting visions of the state 24 (mit press 2001). 27 see, for example, rixen, supra note 3, at 32–54, for a model of tax competition and coordination as a prisoner’s dilemma. christians points out that the total amount lost to tax evasion is likely relatively small compared to states’ revenue shortfalls. see christians, supra note 4, at 24–25 (collecting estimates of $40–100 billion lost and shortfalls of $1.4 trillion in 2009 in the united states). 28 for example, the central african republic’s dictator, jean-bedel bokassa, crowned himself emperor in 1977 after a twelve-year rule as president that had “established a reputation for megalomania and incompetence that rivals that of uganda's idi amin dada.” mounting a golden throne, time, dec. 17, 1977, available at http://www.time.com/time/magazine/article/0,9171,945849,00.html#ixzz1zgot13nf. his coronation cost $20 million, an astounding sum considering the country’s gdp, was only $250 million. id. the country’s only paved road was an eighty kilometer route between his imperial capital, berengo, and the former colonial capital of bangui. brian titley, dark age: the political odyssey of emperor bokassa 99 (1997). 29 interestingly, the oecd and other anti-tax-competition groups appear to have different views of at least some limits on governments’ abilities to regulate or confiscate property. the oecd, for example, often recommends the removal of capital regulations in its economic surveys. see bergh & dackehag, supra note 5, at 4. 10 columbia journal of tax law [vol.4:1 much concern for whether the sanctions would result in a lack of textbooks for schools.30 some pariahs, such as saddam hussein’s regime in iraq, sought to undermine international support for sanctions by arguing that the sanctions result in reduced public goods expenditures.31 but we need not look solely to pariah states for examples of corruption, waste, fraud, and the purchase of public bads with tax revenues. developed economies have their own pathologies of expenditures—ranging from former governor rod blagojevich in illinois32 to the parliamentary spending scandals in britain33 and the common agricultural policy in the european union. 34 the restricted view of tax competition thus incompletely captures important aspects of the competition among jurisdictions by failing to consider the full range of behaviors by the regimes it models. the benefit of more completely specifying the objectives of the interest group coalitions controlling governments is that doing so removes the artificial restriction of assuming that the sole objective of increasing government revenues is to fund public goods. we can also expand the analysis by removing a second artificial restriction at times imposed in the tax competition literature: that tax levels have no impact on levels of economic activity. a more nuanced view is that at least some taxes and some levels of taxes impede economic growth.35 precisely where the line is drawn is a matter of heated debate, and not a question we can resolve here. the important point is that if it is possible for particular taxes or levels of taxes to impede economic growth, a welfare analysis of the impact of tax competition is no longer simply a matter of maximizing the production of public goods by maximizing total tax revenue. in at least some circumstances, reducing tax levels is likely to increase economic activity and may even increase total tax revenue. thus the levels of income taxation imposed in britain in the 30 see raf casert, officials: eu moving toward more syria sanctions, boston globe, oct. 6, 2011, available at http://www.boston.com/news/world/europe/articles/2011/10/06/ officials_eu_moving_toward_more_syria_sanctions/ (enthusiasm among eu members for more sanctions on syrian government); brooke masters & david dombey, gaddafi sanctions pose test for banks, financial times, mar. 9, 2011, available at http://www.ft.com/cms/s/0/7fb969ce-4a80-11e0-82ab00144feab49a.html#axzz1a46qlsog (describing the 2011 financial sanctions on libyan government and government officials). 31 see saddam’s parades of dead babies are exposed as a cynical charade, the telegraph, may 25, 2003, available at http://www.telegraph.co.uk/news/worldnews/middleeast/iraq/1431114/saddamsparades-of-dead-babies-are-exposed-as-a-cynical-charade.html. for a critical look at the impact of sanctions in iraq on the civilian population, see joy gordon, invisible war: the united states and the iraq sanctions (2010) (arguing that sanctions had a disastrous impact on population generally). 32 see elizabeth brackett, pay to play: how rod blagojevich turned political corruption into a national sideshow (2009) (summarizing the corruption scandals in illinois). 33 see john f. burns, in britain, scandal flows from modest request, n.y. times, may 19, 2009, available at http://www.nytimes.com/2009/05/20/world/europe/20britain.html (describing the scandal over mps’ expenses). 34 the cap consumed two-thirds of the community budget in the 1970s and 1980s, with one estimate that it cost each eu citizen about £250 per year in the 1990s. see david r. stead, common agricultural policy, eh.net, http://eh.net/encyclopedia/article/stead.cap (last accessed oct. 25, 2011). 35 this is recognized in oecd research on taxation outside the context of tax competition. see oecd, tax policy study no. 21: taxation and employment 10 (2011) (“these tax burdens discourage employers from hiring. they also reduce the incentives for the unemployed to look for a job, and for those in employment to work longer or harder.”); herwig immervoll, average and marginal effective tax rates facing workers in the eu: a micro-level analysis of levels, distributions and driving factors 6 (oecd soc., emp’t and migration working papers, paper no. 19, 2004), available at http://www.oecd.org/ tax/34035472.pdf (recognizing the linkage between tax burdens and economic development, they study the impact of taxation on the microeconomic level). more generally, see richard teather, the benefits of tax competition (2005). 2012] cartelizing taxes 11 1960s and early 1970s, when marginal rates approached one hundred percent on some forms of investment income, had impacts beyond inspiring the beatles’ taxman. 36 further, there is at least some evidence that at some point on the tax scale, reducing rates increases government revenue by both boosting economic activity and reducing the value of investments in tax avoidance and tax evasion. thus, even if one focuses entirely on maximizing government revenues, the simple model is inadequate.37 within an interest group framework, the coalition of interest groups in power will at times have different goals with respect to tax policy. for example, within the federal bureaucracy in the united states, the internal revenue service (irs) is likely to favor increased enforcement powers for the irs, deficit hawks will worry about ensuring revenues are sufficient, and the department of commerce may favor increasing tax incentives for business investment.38 during internal british government debates over the establishment of tax havens in britain’s overseas territories, the british treasury worried about revenue losses, the foreign and colonial office about the fiscal sustainability of the territories and their budgetary impact on britain, and the bank of england about the implications for exchange control.39 internationally, offshore financial centers may be favored for providing competition in one sphere even as they are denounced for providing it in another.40 to evaluate the tax competition debate as a debate among interest groups within and across nations, we must therefore consider how different types of competition affect different interests in different nations. helleiner’s account of how u.s. financial industry interests fended off aggressive measures sought by continental european governments to control capital flight after world war ii provides a clear example of how one set of u.s. interests were able to influence the overall u.s. position to promote regulatory competition when it was to their advantage.41 the cancellation of the u.s.–netherlands antilles tax treaty in 1987 provides an example of how a different set of u.s. interests—revenue authorities and law enforcement—were able to influence u.s. policy to close off a potent channel for regulatory competition when the costs to those interests became too high.42 36 see martin daunton, just taxes: the politics of taxation in britain 1914–1979 (2007). taxation was also high in the united states, where marginal rates for high-income earners rose to ninety-one percent during the 1960s. thomas piketty & emmanuel saez, how progressive is the u.s. federal income tax system? a historical and international perspective, 21 j. econ. persp. 3, 13 (2007). 37 whether cutting current u.s. or french income tax rates would increase welfare is a hotly debated question beyond the scope of this paper. 38 this can be seen in the debate over tax amnesties to encourage repatriation of overseas profits. see craig m. boise, breaking open offshore piggybanks: deferral and the utility of amnesty, 14 geo. mason l. rev. 667 (2007) (discussing debate over encouraging repatriation of overseas profits). 39 see, e.g., tax havens and tax concessions, note of a meeting held in the foreign and commonwealth office (march 25, 1969) (on file at the british national archives, file fco 59/533) (discussing concerns of various british government offices over the rise of tax havens in dependent territories). 40 see andrew p. morriss, changing the rules of the game: offshore financial centers, regulatory competition & financial crises, 15 nexus 15, 17–18 (2010) (describing competition in insurance); craig m. boise & andrew p. morriss, change, dependency, and regime plasticity in offshore financial intermediation: the saga of the netherlands antilles, 45 tex. int’l l. j. 377, 409–414 (2009) (describing official encouragement of firms’ use of offshore vehicles to access the eurodollar market); id. at 419–426 (describing attacks on offshore sector in 1970s over tax competition). 41 eric helleiner, states and the reemergence of global finance: from bretton woods to the 1990s, at 56–58 (1994). 42 boise & morriss, supra note 40, at 419–26. 12 columbia journal of tax law [vol.4:1 further, discussions of “tax competition” are often framed as if the issue were about settling the rules governing a sporting event. in essence, these discussions proceed as if the problem were akin to deciding how to handle the differences between the two u.s. baseball leagues, the national league and american league, over the designated hitter rule in scheduling inter-league play.43 (the american league has the rule; the national league does not.) playing a game is impossible without knowing whether the rule applies or not. some mechanism must be chosen to resolve the particular question, but there is broad agreement on the rules of baseball with a small number of differences in rules to be resolved. regulatory competition among nations is much more complex. a better analogy for tax issues than the problem of resolving the baseball leagues’ differences over the designated hitter rule would be imagining negotiations between spain’s europa soccer league and the u.s.–canadian national hockey league over how to play a “fair” contest between the two league champions. both leagues run organized sporting events but they are not playing the same game, differing on how to measure success, the type of playing field, the legitimate methods of play, and so on. similarly, nations play quite different “games” in their tax policies. some are attempting to attract investment to locations lacking resources; others seek to capitalize on the value of their national advantages. even within the confines of public finance theory, technically optimal tax regimes will differ across nations. moreover, cultural variables often influence tax policy.44 add the new zealand all-blacks rugby team, indian cricket teams, and japanese sumo wrestlers to the negotiations in our europa–nhl hypothetical and our sports analogy becomes closer to capturing the real spread of differences in national tax policies’ goals and methods.45 thus, the competition between ireland and france is taking place across more dimensions than just tax rates. as noted earlier, tax systems differ in their definitions of income, levels of exemptions, and a host of other criteria. these differences mean that tax competition cannot be reduced to a simplistic analysis of rates alone. not only must any analysis take into account specific details of the tax system, such as the effective rather than nominal rates after accounting for tax credits and deductions. differences in definitions can form yet another species of tax competition. for example, “dividends” are defined differently by tax laws in different countries and this can result in either over-taxation or under-taxation of a particular payment.46 thus, if countries were to 43 the american league allows a player (the “designated hitter”) to hit in place of the pitcher; the national league does not. see generally g. richard mckelvey, all bat, no glove: a history of the designated hitter (2004). 44 see, e.g., jasmine malone, greek tax evasion: ‘there is just such little incentive to be honest,’ the telegraph, sept. 18, 2011, available at http://www.telegraph.co.uk/finance/financialcrisis/8770940/ greek-tax-evasion-there-is-just-such-little-incentive-to-be-honest.html (quoting a greek businessman that “i don't feel comfortable with playing the game, but i feel justified in the sense that i am already taxed at a grossly unfair rate in my business. everything is made difficult. i almost dread having a good year because i can never be sure that i won't be taken for a fool by the taxman after.”). the cayman islands has a deeply rooted cultural tradition of no direct taxation (combined with substantial indirect taxation via customs duties). see, e.g., cayman islands, economic development plan 1986–1990, at 2 (describing legend of the wreck of the ten sails that allegedly produced grant by british crown of freedom from direct taxation and its impact on island culture). 45 it is widely accepted that nations have the right to determine their own tax system. christians, supra note 5, at 107. this may also include the right not to tax. id. at 111. 46 university of helsinki prof. marjaana helminen’s study of dividends in international tax law makes this point: “over-taxation or under-taxation may be caused, among other reasons, by different 2012] cartelizing taxes 13 cooperate to abolish just the tax competition between them, there are many more issues than a common tax rate to be agreed upon to obtain complete neutrality in taxation. the problem is even more complex than this, however. accomplishing perfect global neutrality in taxation would require an unfeasibly extensive level of tax coordination. deep coordination on rates, deductions, and definitions would be required, as well as on the structure of tax regimes themselves.47 only with complete coordination on taxation could countries see to it that all cross-border differences that create “distortions” were removed.48 this can be seen by examining the ongoing debates over relative importance of capital import neutrality49 and capital export neutrality,50 whose conflicting requirements mean that no country can ensure that taxation is internationally neutral in both cases.51 as long as tax rates differ between countries and investors are treated equally within a country while being exempt from taxation at home, lower tax rates abroad cannot make investors neutral to investing at home or in a foreign country.52 countries will be forced to choose which goal is more important.53 they will make different choices depending on their own circumstances, and differences in tax regimes definitions of the term “dividend” under two different states’ domestic tax law, and under different states’ domestic tax law and under tax treaties. the problem is obvious in a non-treaty situation, but it is also a problem in tax treaty situations because the definitions of the terms used in tax treaties may themselves be unclear and may leave room for interpretation. the problem also exists because the area of legal cases covered by the term used in other domestic legislation. therefore, there is a lot of room for conflicts and interpretation. it is also possible that taxpayers purposely avoid tax by taking advantage of the differences in definitions. alternatively, taxing authorities may intentionally seek to reach interpretations that bring tax returns to the state in question.” marjaana helminen, the dividend concept in international tax law 10 (1999). 47 tsilly dagan, the costs of international tax cooperation 4–7 (university of michigan john m. olin center for law & economics, research paper no. 02-07, 2002), available at http://ssrn.com/ abstract=315373 (last visited oct. 2, 2011). the article points out that global neutrality is possible in theory but that the political hurdles would render it impossible. in the unlikely scenario that an agreement on global neutrality would be stricken and implemented, any country would have an incentive to shirk on the agreement, and the monitoring costs needed to prevent this would make the scheme too costly to be welfare improving. 48 rixen, supra note 3, at 62 (explaining the prerequisite for “global” neutrality). 49 capital import neutrality requires that investment returns do not depend on the residence of the investor. this requires that foreign and domestic investors be treated alike in the source country, while the residence country exempts those investing abroad from any taxation on these returns. 50 capital export neutrality implies that an investor faces the same taxation no matter whether he invests at home or in another country, making his investment decision based on economic fundamentals alone. if country b has higher taxes than country a, country a will need to offer its taxpayers a tax credit to remove tax considerations from its taxpayers’ choices between investments in country a and country b. but if country c has a lower rate than country a, a taxpayer in the latter will need to make up the difference between country c’s lower tax rate and country a’s higher rate when profits are brought back to country a. 51 see rixen, supra note 3, at 61–63 (explaining how, since the different tax systems’ requirements are conflicting, total export and import neutrality cannot be obtained simultaneously within a single jurisdiction). 52 dagan, supra note 47, at 10 (pointing out that since tax treaties, including the oecd model convention, rely primarily on the residence principle of taxation, capital export neutrality seems to be the main focus when tax competition is discussed). 53 the aim of tax neutrality is to avoid causing inefficient investments because of tax laws. tax competition can be avoided if investments cannot be made at lower tax rates. complete elimination of competition is impossible so long as black markets exist. investors are never completely neutral between paying taxes and paying the price for doing deals under the table. moreover, distortions exist both because tax rates are low and high. where rates are high, investors may decide not to invest at all. this causes an inefficiency that is much harder to measure than that which occurs when capital moves from one country to the other as a result of changes in taxation but which is nonetheless potentially significant. 14 columbia journal of tax law [vol.4:1 will therefore persist regardless of specific efforts to harmonize portions of the tax rules. moreover, tax policy is just one of many dimensions on which nations compete for economic activities. an educated workforce, widespread use of languages common in international trade, the size of a particular market, a common law legal system, being in the “right” time zone, and the presence of a “creative class” are all regularly linked to economic success.54 taxation is no different in principle from these other characteristics. in a world in which differences in tax rules are inevitable, how should we evaluate the differences we observe? we argue that the appropriate lens is of the interest groups within countries that use their influence to shape tax laws domestically to their advantage. 55 we propose the following as the appropriate analytical framework for examining international tax and regulatory competition:  states enter the competition with different endowments that affect their competitive abilities to attract investment. large economies such as the united states are attractive destinations for investment and so have the opportunity to charge a relatively high price through the combination of taxes and regulatory costs in exchange for access to investment opportunities. smaller economies that lack these advantages, such as ireland, must compete on price. treating taxation issues as different in kind from other international differences disadvantages smaller, less wealthy states relative to larger, wealthier states.  states differ in the degree to which their public finances depend on encouraging economic activity. for example, natural-resource-rich states can act as rentiers while natural-resource-poor states cannot. thus a resourcerich state like venezuela can better “afford” a regime hostile to investors than a resource-poor state like costa rica. the degree to which particular states are subject to competition has differed as transportation and communications costs change, as international trade regimes change, and as the types of goods and services traded change.  within states, coalitions of interest groups determine policy positions. some interest groups seek to maximize the state’s resources to fund their priorities, while other interest groups seek to maximize the resources focused on their particular priority. others focus on expanding their power. for example, the french president would favor maximizing the resources at his disposal, french farmers want to maximize the resources available for subsidies, and the french tax authorities want to ensure that they have access to information on french taxpayers. all three groups might favor a particularly high tax regime, but for different reasons.  interest groups may seek to influence their governments’ policies by forming 54 see, e.g., n. gregory mankiw, david romer and david n. weil, a contribution to the empirics of economic growth, 107 q. j. econ. 407 (1992) (discussing the importance of education for economic growth); michael kremer, population growth and technological change: one million b.c. to 1990, 108 q. j. econ, 681 (1993) (population size); james c. bennett, the anglosphere challenge: why the english-speaking nations will lead the way in the twenty-first century (2004) (advantages of english-speaking countries); rafael la porta, florencio lopez de silanes & andrei shleifer, the economic consequences of legal origins, 46 j. econ. lit. 285 (2008) (common law); richard florida, the rise of the creative class (2002) (creative class). 55 randall g. holcombe, tax policy from a public choice perspective, 51(2) nat’l tax j. 359, 368 (1998) (“no analysis of tax policy is complete unless it includes an explicit recognition of the public choice environment within which tax policy is made.”). 2012] cartelizing taxes 15 alliances across national boundaries through international organizations and treaties. different forums offer different opportunities for different interest groups. diplomats have more influence over deliberations at the united nations while central bankers dominate discussions at the bank for international settlements (bis). interest groups therefore seek to channel policy discussions into the forum in which their influence is greatest. the organizations’ staffs also have interests, particularly in enhancing their authority, budget, and prestige. in this framework, international organizations can play four different roles. first, they provide opportunities for cross-country interest groups to coordinate.56 second, they influence the domestic debates by changing the cost-benefit calculation for domestic groups through the creation of international “soft law” standards and best practices.57 third, they offer domestic interest groups opportunities to shift a debate to a forum where their relative strengths may be greater. finally, they offer a means to enforce agreements and prevent cheating from undermining agreements to refrain from competitive steps.58 to see how the oecd fits into this framework, we now turn to the evolution of its role in international tax cooperation. iii. the evolution of the international tax cooperation the role played by international organizations in tax issues has changed substantially over time. until quite recently, these efforts focused on finding resolutions of problems caused by differences in tax regimes. the explicit goal of such efforts was to attempt to increase international economic competition by eliminating differential burdens on entities operating across borders through the elimination of double taxation. this focus began to shift as the growth of tax competition became evident. in this section, we set this history in the context of the larger trends in the world economy over the twentieth century towards freer trade and freer movements of capital. not only is this history critical to understanding the subsequent policy shifts, it also illustrates an alternative conception of the role of international organizations to the oecd’s current cartel-like focus in taxation. a. the era of technical expertise tax laws differ across states in a wide variety of details, including in definitions of taxable events, rates of taxation, allowable deductions, and allocation of costs and earnings to particular jurisdictions. as an example, consider an individual owning real estate in a foreign country. and indeed, that would be the case for a national of britain, france, netherlands, or germany who owned real estate in the united states (or vice 56 the commonwealth may be the best example of a “transnational” organization, which includes both governmental and nongovernmental networks. see slaughter, supra note 2, at 138. an example of a governmental international organization that engages non-governmental actors is the asia-pacific economic cooperation (apec), which makes deliberate efforts to reach out to non-governmental actors, primarily from the business community. id. at 142. it may be in the interest of the decision makers of international organizations to give their otherwise technocratic decisions more legitimacy by engaging nongovernmental organizations in their decision-making. id. at 220–221. 57 see slaughter, supra note 2, at 178. when government agents converge in networks, establishing codes or best practices for instance, this constitutes what can be called “soft law.” slaughter points out that “traditional international law-making had traditionally been hard law, but established by treaties, while soft law can be in the form of ‘international guidance.’” she points out, however, that the latter is emerging as a possibly more powerful form of law. 58 besides binding agreements, the personal relationships of the networks they encapsulate help strengthen the compliance with international laws and regulations. see slaughter, supra note 2, at 183. 16 columbia journal of tax law [vol.4:1 versa); she would be covered by both countries’ estate taxes on this property at her death.59 compared to the estate of a taxpayer who owned real estate only within his home jurisdiction, the estate of the cross-national property owner would be taxed twice as much. one of the most important problems that differences in tax laws pose for individuals and firms operating across jurisdictional boundaries is their creation of the possibility that the same event or revenue will be taxed by more than one jurisdiction, disadvantaging the individual or entity relative to an individual or entity not operating across boundaries. a “strong consensus” developed that “overlapping jurisdictional tax claims can significantly impede economic growth.”60 to avoid this double taxation with respect to estate taxes and real estate, the tax treaties between the united states and the four jurisdictions listed above provide a tax credit in the non-domiciliary country for the amount of tax paid in the domiciliary country.61 addressing these problems is not simple, and, for most of the twentieth century, international organizations working on international tax issues focused almost entirely on finding solutions to problems created by differences in tax laws across states, similar to this estate tax example. differences can create opportunities for those individuals and entities, as well as problems, since differences create the possibility of arbitraging across jurisdictions to reduce total tax burdens. prior to the widespread adoption of individual and business income taxation, these differences created relatively few problems or opportunities as most taxable events occurred within jurisdictional boundaries. when governments depended primarily on tariffs and real property taxes as a means of raising revenues-as they did until the early twentieth century62—reducing an individual’s tax burden required relocation to a state with a lower tariff63 or selling real estate in a high tax jurisdiction and 59 offshore tax expert marshall langer cited the problem of estate tax as a key reason for the use of corporate entities by non-u.s. taxpayers who own u.s. real estate in testimony to a congressional hearing in 1983: “in fact, under existing law, i would consider it malpractice if i allowed a legitimate foreign investor to make large u.s. investments without using a foreign corporation. the reason for that is a very silly rule that has been part of the internal revenue code for as many years as i can remember. it says that if the washington hilton hotel is owned by someone who is a nonresident alien in his own name, and he dies owning that property, it is subject to estate tax in the united states. if he puts it into a domestic u.s. corporation and dies owning the shares of that domestic corporation, it is still subject to estate tax in the united states. but if he puts it into a foreign corporation, any foreign corporation, a netherlands antilles corporation, a chinese corporation, or a russian corporation, under the estate tax situs rules, he is deemed to own foreign property which is not subject to estate tax in the united states.” tax evasion through the netherlands antilles and other tax haven countries: hearing before the h. subcomm. of the h. comm. on gov’t operations, 98th cong. 179 (1983) (statement of marshall j. langer). 60 christians, supra note 12, at 1412–14. 61 this example is taken (in a simplified form) from michael w. galligan, making sense of four transatlantic tax treaties: u.s.–netherlands, u.s.–germany, u.s.–france and u.s.–uk, 17 spg int’l practicum 47, 48 (2004). 62 see rixen, supra note 3, at 86 (pointing out that the most common revenue sources of governments, aside from tariffs, were primarily taxes on land and real estate). britain had already imposed a peacetime income tax in the mid-nineteenth century, with other nations following from the early 1890s. see carolyn webber & aaron wildavsky, a history of taxation and expenditure in the western world, 309–10 (1986). the size of western governments was however still small. id. at 310. in the united states, government revenues were raised after the election of woodrow wilson as president with the sixteenth amendment in 1913, which allowed for a graduated income tax. id. at 413. 63 for example, retired british military officers moved to the crown dependencies jersey and guernsey after the napoleonic wars in part because lower tariffs on whiskey and tea lowered the cost of living. an estimated three thousand british residents moved to the islands by 1834, three-quarters of whom were military retirees and their families. see raoul lemprière, history of the channel islands 156 (1974). the first double-tax agreement was that between prussia and austria-hungary in 1899. see rixen, supra note 3, at 87. 2012] cartelizing taxes 17 buying it in a low tax one (and, possibly, creating a taxable event through the sale). as a result, in a world dominated by indirect taxation, all individuals and businesses operating within any particular state generally faced equivalent tax environments within that jurisdiction;64 the existence of differences in national tax regimes had relatively little impact on the cost of doing business internationally.65 before the introduction of the income tax, international tax issues were few and far between. agreements on taxation between nations were mostly limited to dealing with the taxation of railway companies, inheritances, and international salesmen.66 not until governments began to impose direct taxes on larger numbers of individuals and businesses during the twentieth century did the problems posed by differences begin to become more widespread.67 by 1919, the international chamber of commerce (icc) had formed a committee on double taxation, which called for a multilateral solution to the problem and urged the newly formed league of nations to eradicate the “evils of double taxation.”68 the topic was important enough to be discussed at the 1922 international economic conference in genoa, which unsuccessfully wrestled with post-world war i international economic issues.69 even under the relatively simple systems of direct taxation in use during the twentieth century prior to world war ii, the problems posed by differences among tax systems were substantial enough that the league formed a committee to examine the problem. it is a testament to the complexity of the problems posed by even these relatively simple tax systems that the league committee abandoned its efforts in 1927. they found that “[i]n the matter of double taxation in particular, the fiscal systems of various countries are so fundamentally different that it seems at present practically impossible to draft a collective convention, unless it were worded in such general terms as to be of no practical value.”70 a 1928 league conference did provide three versions of a model convention on double taxation, although these still left many details for bilateral negotiations. the conference also created a permanent fiscal committee to address tax 64 a firm importing material from its operations elsewhere would, of course, be charged duties on the imports, while a firm making the same materials locally would not. but the international and national firms faced equivalent tax situations with respect to the decision of whether to source domestically or internationally. 65 tax rates, however varied, could not have skewed choices of business location much. corporate income tax in the united states was introduced in 1909, and then at only one percent. see webber & wildavsky, supra note 62, at 523. in both england and the united states, however, the income tax was as high as ten percent in some areas and in certain years. id. at 344. 66 rixen, supra note 3, at 87. 67 governments may have been motivated to address the problem because among the first to complain about double income taxation were diplomats taxed by both their home countries and their countries of residence. see claudio m. radaelli & ulrike s. kraemer, the rise and fall of governance's legitimacy: the case of international direct taxation (jan. 28, 2005) (unpublished manuscript), available at https://eric.exeter.ac.uk/repository/bitstream/handle/10036/23834/radaelliinformalgovernance.pdf (last visited nov. 4, 2012). deneault argues that the league entered into drafting double taxation agreements formally designed to avoid taxing the same sum twice to—in practice—allow companies “to avoid paying taxes.” deneault, supra note 23, at 29. 68 see rixen, supra note 3, at 88. 69 a.m. endres & grant a. fleming, international organizations and the analysis of economic policy, 1919–1950, at 58 (1998); comm. of technical experts on double taxation and tax evasion, double taxation and tax evasion 5 (1927) (referring to the international economic conference in genoa in april 1922, which “recommended that the league of nations should also examine the problem of the flight of capital”). 70 comm. of technical experts on double taxation and tax evasion, supra note 69, at 8. 18 columbia journal of tax law [vol.4:1 issues.71 despite the great depression and world war ii, the league continued to focus attention on the issue and to involve highly regarded tax experts in crafting technical solutions to double taxation problems. 72 as with the 1928 models, the general frameworks designed by the experts left many details to further negotiations between states for inclusion in bilateral agreements.73 by 1946, the league’s fiscal committee had agreed on two different models on how to divide the tax base, recognizing the problem that each of the approaches favored a different set of countries.74 the transition of discussions to the newly formed united nations made solving double taxation issues even more complex, since the u.n. membership included both soviet bloc and developing countries, whose tax systems differed from western developed economies’ tax laws in additional ways.75 these complications soon brought the discussions within the u.n. to an end.76 the problems remained, however, and the icc turned to the newly formed organisation for european economic co-operation (oeec), the predecessor to the oecd, for a forum within which to craft solutions to double taxation problems. 77 originally created in 1948 to coordinate american and canadian marshall plan aid to europe, the oeec’s objectives expanded in the late 1950s to “economic matters in a broad sense of the term.”78 in 1956, it organized its own fiscal committee to address double taxation issues.79 the oeec’s expanded mission also led to a broadening of its membership beyond europe, and the organization was recreated as the oecd in 1961 with the 71 double taxation can be handled unilaterally through tax exemptions, credits, and deductions. see rixen, supra note 3, at 32–54 (discussing the choice between these approaches). however, treaties may be preferred to unilateral measures, as being in a ”treaty club” with rich countries may offer other opportunities and advantages for developing nations. see dagan, supra note 47, at 21–22. 72 see rixen, supra note 3, at 88–92; allison christians, networks, norms, and national tax policy, 9 wash.u. global stud. l. rev. 1, 10 (2010). christians terms the “primary role” of tax treaties “to create, from the valid and competing jurisdictional claims of the united states and these respective treaty partners, both the legal ground for international tax disputes and the obligation of governments to resolve them.” christians, how nations share, supra note 12, at 1419. the oecd’s efforts thus play a key role in legalizing tax issues, which is one reason its mission shift is so important. 73 christians, networks, supra note 72, at 13. 74 see rixen, supra note 3, at 96. 75 in the soviet union, premier joseph stalin had in 1928 abandoned the new economic policy, which had allowed for some free trade and taxation. the system in place was instead of the completely totalitarian kind. see peter j. boettke, calculation and coordination: essays on socialism and transitional political economy 162 (2001). latin american countries that became members in 1945, such as argentina, brazil, and chile had customs as a share of government revenue of 24.7%, 50.3%, and 41.1%, respectively, compared to 5.8% in the united states. taxes of income and wealth, meanwhile, provided 17.9%, 10.2%, and 23.7%, respectively, compared to 43.0% in the united states. see kenneth l. sokoloff & eric m. zolt, inequality and the evolution of institutions of taxation evidence from the economic history of the americas in the decline of latin american economies: growth, institutions, and crises 83, 103 (sebastian edwards, gerardo esquivel & graciela márquez eds., 2007.). 76 see rixen, supra note 3, at 91–97, for an account of this process. 77 the oeec’s more homogeneous membership made it possible to avoid some of the issues the more heterogeneous u.n. membership caused. as rixen points out, the fiscal committee's delegates were government officials, who would come to agree on an approach leaving them with much flexibility in their bilateral agreements. see rixen, supra note 3, at 98–99. 78 hugo j. hahn, continuity in the law of international organization, 4 duke l. j. 522, 523 (1962). 79 see rixen, supra note 3, at 97. 2012] cartelizing taxes 19 addition of the united states and canada as members.80 the new organization described its goals in the 1960 convention on the organisation for economic co-operation and development as promoting policies that are designed: (a) to achieve the highest sustainable economic growth and employment and a rising standard of living in member countries, while maintaining financial stability, and thus contribute to the development of the world economy; (b) to contribute to sound economic expansion in member as well as non-member countries in the process of economic development; and (c) to contribute to the expansion of world trade on a multilateral non-discriminatory basis in accordance with international obligations.81 in addition to these substantive goals, individual members sought to accomplish their own goals with respect to the organization82 and the organization’s impact on them.83 the oecd’s initial role in tax measures were an effort to minimize the transaction costs of doing business across different tax systems by creating a framework that could help solve double taxation issues, an approach consistent with its formal goals of expanding economic development. this expressed itself in the 1963 draft model convention on income and capital,84 which established the oecd as the primary multilateral forum in international tax policy.85 the 1963 model convention provided nations with a framework upon which to negotiate, but it did not attempt to suggest how specific tax policy questions be answered. resolving double tax issues to spur development was also a goal of the united states’ 80 the 20 members in 1963 were austria, belgium, canada, denmark, france, germany, greece, iceland, ireland, italy, luxembourg, netherlands, norway, portugal, spain, sweden, switzerland, turkey, the united kingdom, and the united states. japan joined in 1964, finland in 1969, australia in 1971, and new zealand in 1973. later members are mexico in 1994; the czech republic in 1995; hungary, korea, and poland in 1996; the slovak republic in 2000; and chile, estonia, israel, and slovenia in 2010. currently, there are thirty-four oecd member states. by limiting membership, the oecd may have created an incentive for states to seek membership, a model that has been followed by other international organizations. see bruno s. frey, the public choice view of international political economy, in the political economy of international organizations 7, 13–14 (ronald vaubel & thomas d. willett eds., 1991). the organization also grew substantially. its budget was 159 million francs by 1971, us$164 million in today’s value. by 2011, the oecd had a budget of us$491 million. member states contribute proportionately to the size of their economy; the u.s. contributes almost twenty-two percent (us$123 million). see oecd, about, budget (http://www.oecd.org/about/budget) (last visited nov. 5, 2012). 81 convention on the organisation for economic co-operation and development art. 1, dec. 14, 1960. 82 for example, the creation of the oecd involved negotiations over which countries would supply the deputy directors. italy insisted that it be given a deputy directorship as a condition of membership, necessitating expansion of the number of deputy directors to five. similarly, britain expended considerable effort in retaining the chairmanship of the economic affairs committee in the mid-1960s, despite pressure from the oecd director to allow a country with fewer economic problems to hold the chair. 83 for example, during britain’s economic difficulties in the 1960s, british officials carefully negotiated changes in language to oecd documents discussing britain’s economy. 84 oecd, draft double taxation convention on income and capital (1963), available at http://faculty.law.wayne.edu/tad/documents/tax_treaties/oecd_1963.pdf (last visited nov. 5, 2012). oecd model convention provisions evolved into “industry standard[s]” in many cases. see, e.g., christians, supra note 12, at 1433 (“the tax treaty map [mutual agreement procedure] came into being in the early days of tax treaty history and has become the industry standard through the model tax convention promulgated by the oecd.”). 85 see rixen, supra note 3, at 99; christians, supra note 5, at 99 (noting that oecd was “long prominent as a central global institution for technical tax policy design”). 20 columbia journal of tax law [vol.4:1 broad extensions of its tax treaties with european nations to those nations’ overseas territories and newly independent former colonies during the 1950s.86 even though the oecd’s more homogenous membership eliminated some of the conceptual conflicts that had prevented the u.n. from effectively addressing the double taxation problems, even the narrower set of tax issues that the oecd addressed remained complex. unlike the league of nations, the oecd brought government officials (at least from a small group of governments) to the table as well as technical experts. and the oecd’s focus on the problems its members had with the interactions of their tax systems narrowed the range of issues to be resolved. as a result, the draft model convention was perceived as more politically feasible than its league-drafted predecessors.87 even after the 1963 model convention was published, efforts continued to refine the solution and to address additional issues. a revised convention was published in 1977 by what was now called the committee on fiscal affairs (cfa).88 both the 1963 draft and the 1977 convention were flexible frameworks for resolving tax issues between developed country national systems.89 in neither form did the oecd propose substantive policies on tax questions. by the end of the 1970s, the oecd model was “practically the infrastructure of the current bilateral treaty-based system”90 and the oecd was the most important arena for international tax negotiations, 86 see tax evasion through the netherlands antilles and other tax haven countries: hearings before a subcomm. of the h. comm. on gov’t operations, 98th cong., 51 (1983) (statement of william j. anderson, dir., gen. gov’t div., gen. accounting office) (“most u.s. tax treaties with tax haven countries are in effect because previous u.s. treaties with developed nations were extended to present and former colonies of those nations.”). the preamble stated that the purpose of the treaty was to avoid double taxation. see elisabeth e. owens, united states income tax treaties: their role in relieving double taxation, 17 rutgers l. rev. 428, 429 (1962). since u.s. nationals were shielded from double taxation by tax credits of the u.s. government, the treaties did little for american nationals, except for those living abroad. id. at 432– 33, 445. since several countries with which the united states had signed treaties in the beginning of the 1960s did not offer tax credits to their citizens to the same extent, they were also relieved from double taxation more significantly by signing the treaty. id. at 445. the treaties also may have been aimed at encouraging u.s. investments in western europe. id. at 446. the u.s. signed its first treaty with france in 1932, but had increased its number of treaties to thirty by 1973. see rixen, supra note 3, at 109–111. 87 see rixen, supra note 3, at 99–100. for example, the draft convention was to be revised according to how bilateral double tax agreements diverged from it, but as they all conformed to it, this became unnecessary. 88 c. miller, alternatives to the oecd model, in taxation and international capital flows: a symp. of oecd and non–oecd countries 83, 83 (1990). the predecessor of the cfa was named the fiscal committee. 89 rixen describes the commentary section of the convention as “the most flexible instrument available to governments trying to induce changes to a series of bilateral treaties that cannot easily and quickly be renegotiated.” rixen supra note 3, at 100. as a framework for addressing tax issues between developed economies, the oecd model proved unacceptable to developing countries, and in 1967 they turned to the u.n. to create an alternative model. this work was done through its ”ad hoc group of experts” containing mostly government appointed officials responsible for negotiating treaties for their countries. id. at 102. the u.n. published its own model convention in 1980, adapted from the oecd model convention but modified to address the unique tax issues that arise between developed and developing countries. id. at 102–104. on the dominance of the oecd model treaty, see diane ring, who is making international tax policy?: international organizations as power players in a high stakes world, 33 fordham int’l l. j. 649, 700 n.242 (2010) (noting that the u.n. is not a competitor to the oecd in international taxation issues). brauner notes that the u.n. model convention has practically vanished from influence. yariv brauner, international tax regime in crystallization, 56 tax l. rev. 259 (2002–2003). 90 brauner, supra note 89, at 310. 2012] cartelizing taxes 21 a status that the organization continues to hold today.91 the complexities of resolving double taxation issues were still seen as something largely requiring individual negotiations between countries to handle substantive matters, as evidenced by a u.s. treasury official’s 1983 congressional testimony that because of the “wide range of international economic relationships and the diversity of foreign tax systems, we must approach each treaty relationship separately” in designing treaty terms.92 even the broad solutions created by the double taxation treaties within these frameworks still left significant issues to be resolved on a case-by-case basis through a variety of hard-to-access decisions.93 significantly, the oecd provides important “soft law” that guides international tax law “by issuing commentary, guidelines, best practices, and the like.”94 thus the first way governments conceived of international tax issues was as a technical problem that required careful negotiations to ensure that international business activity was not unduly burdened by double taxation.95 the conceptualization of the problem as a technical one made it a natural issue to shift into a multilateral forum. when the difficulties of reconciling all of the world’s divergent tax systems overwhelmed the experts, the major trading countries shifted their efforts to the oeec/oecd, where they could address the most critical problems affecting the largest volume of international business (which occurred between their members). how the oecd handled tax issues evolved with the organization during this time as well. by the 1970s, three bodies within the organization were particularly important. first, the committee on fiscal affairs (cfa), which meets twice a year, officially does 91 the oecd secretary general describes the organization as being “at the forefront of setting tax standards for the global economy.” christians, supra note 72, at 14–15. 92 tax evasion through the netherlands antilles and other tax haven countries: hearings before a subcomm. of the h. comm. on gov’t operations, 98th cong. 261 (1983) (statement of john e. chapoton, asst. sec. for tax policy, dep’t of treasury). see also john stopford & louis turner, britain and the multinationals 202 (1985) (describing dispute between united kingdom and united states over u.s. states’ application of unitary taxation). 93 christians, supra note 12, at 1409 (“[t]ax agreements provide only a design for allocating international income among nation states. it is the application of these agreements that determines how revenues are allocated in practice. this application has taken place over the years through hundreds of thousands of interpretative decisions, the vast majority of which are not accessible to the public.”); tax treaties, supra note 14, at 8 (describing need to adapt model treaties “to reflect the particular policy needs of each country, the economic and commercial relations between the two countries, the need to mesh the provisions of two different tax systems and, finally, the levels of economic development of the two treaty partners.”). christians also notes that international tax law “features little international formal guidance such as regulations, administrative determinations, or cases.” christians, supra note 12, at 1409. indeed, even on the core function of blocking “treaty shopping” by non-residents attempting to take advantage of a jurisdiction’s treaty with the united states, the assistant secretary for tax policy in 1983 stated in congressional testimony that there was “no model limitation of benefits provision” and that a “single model” would not be “appropriate” because of the “wide range of international economic relationships and the diversity of foreign tax systems” that required “approach[ing] each treaty relationship separately.” tax evasion through the netherlands antilles and other tax haven countries: hearings before a subcomm. of the h. comm. on gov’t operations, 98th cong. 261 (1983). 94 christians, supra note 12, at 1411. she also notes that “[m]ost soft international tax law emerges from the oecd in its self-described role as ‘market leader in developing [tax] standards and guidelines.’” id. at 1447. 95 this conceptualization continues to be important. in 1981, john chapton, assistant secretary of the treasury, tax policy, described tax treaties’ role as “an important element in the international economic policy of the united states, one of the fundamental objectives of which is to minimize impediments to international flows of capital and technology. among these impediments are the inconsistent rules of national tax systems and their interaction.” tax treaties, supra note 14, at 3. 22 columbia journal of tax law [vol.4:1 the bulk of the oecd work on taxation.96 countries are represented in the cfa by senior tax officials and tax administrators. second, the oecd staff that works on taxation belongs to the centre for tax policy and administration (ctpa). in contrast to the delegates to the cfa, who represent their respective countries, businesses, and organizations, the staff of the ctpa consists of international bureaucrats.97 the work is divided between working parties, whose meeting agendas are usually prepared by a division of the ctpa connected to their field.98 the agendas for cfa meetings are often prepared by the cfa bureau, an executive committee appointed by the cfa.99 which countries are appointed to the bureau can therefore be significant in determining the direction of its work. 100 the various incentives, ideas, and connections of these representatives will eventually form the basis for the consensus-based statements of the oecd.101 finally, the oecd council is the body with formal decision-making power to speak for the organization; its decisions are made by consensus. the council consists of purely national representatives, who are high-level diplomats. 102 the council does, however, deal with all kinds of policy issues, and taxation is but one of them. it is more of a venue for channeling projects and decisions further down in the organization than an arena where tax policies are formed.103 96 the ctpa is a part of the 2,500-member oecd secretariat that constitutes the organization’s staff. oecd, about, available at: http://www.oecd.org/about (last visited sept. 20, 2012). its members are experts in their fields; many are tax economists with experience and knowledge of the latest developments in international taxation politics. michael webb, defining the boundaries of legitimate state practice: norms, transnational actors and the oecd's project on harmful tax competition, 11 rev. of int’l pol. econ. 787, 792 (2004). the current staff is around one hundred people from twenty-five different countries. owens looks back on his time in office, int’l tax rev. (feb. 12, 2012), http://www.internationaltaxreview.com/ article/2967120/owens-looks-back-on-his-time-in-office.html. as “international bureaucrats,” they are detached from the politics of their home country. christians, supra note 72, at 19. they may previously have served as senior tax officials in their home country or represented their country in an oecd committee. more rarely, staff members have been recruited as young professionals. oecd, staff categories (http://www.oecd.org/document/62/0,3746,en_21571361_45609340_40833406_1_1_1_1,00.html#agrades) (last accessed sept. 15, 2012) (“[r]ecruitment of young professionals (grade a1) is extremely limited.”). 97 christians, supra note 72, at 19. 98 hugh j. ault, reflections on the role of the oecd in developing international tax norms, 34 brook. j. int'l l. 757, 762 (2009). 99 id. at 760. 100 interview 4 with oecd personnel (2011) (we conducted five interviews with current and former oecd personnel in late spring and summer 2011. we agreed not to identify the individuals interviewed, which encouraged frank discussion of the agency and which shields our sources from retaliation). france, japan, and ireland were for instance elected to the new cfa bureau that was set up for the work preparing the 1998 report discussed below. choosing ireland to participate might have served to give legitimacy to the work. interview 5 with oecd personnel. 101 christians, supra note 72, at 22 (“these tax policy groups form an intertwined epistemic community that holds an important and influential position in the law-making order.”). since the oecd is not a law-making body, it does not entail the same official records and public scrutiny to which national lawmaking bodies are subjected. it is therefore inherently difficult to identify at which point decisions are made and who makes them. even if one could attend one of the high-level meetings at which the issues may be openly discussed, policy is often formed outside of the big venues, making it impossible for any student of decision to capture the process. see id., at 26–27. 102 christians , supra note 72, at 17. 103 oecd, who does what, (http://www.oecd.org/about/whodoeswhat) (last visited sept. 20, 2012). these council ambassadors have many issues on their table, and what they may focus their discussions on varies. for instance, as the expansion of the oecd was high on the agenda with the entrance of mexico in 1994, tax policy was not the main priority, and the council would therefore endorse documents on taxation without discussing the topic much at its meetings. interview 1 with oecd personnel, supra note 100. the council directs projects to subcommittees of government officials at a lower level. its statements 2012] cartelizing taxes 23 b. the growth of tax competition tax competition has been an issue for governments for as long as they have taxed income. in 1934, canadian mining millionaire harry oakes moved to the bahamas to escape canada’s high tax rates, complaining that eighty-five percent of his income was being taxed away. a canadian newspaper headlined the story of oakes’ departure with: “multimillionaire champ tax dodger: santa claus to bahamas. but heart like a frigidaire to the land that gave him wealth.”104 moves like oakes’ were relatively rare, both because of their high cost and because before world war ii relatively few people regularly paid taxes at rates like those oakes found excessive. nonetheless, the transformation of corporate income taxes from taxes on shareholders into a separate tax on corporate entities (a post-world war i development in the united states and later in britain),105 the sharp rise in tax rates on both individual and corporate income used to fund world war i,106 and the efforts to control businesses through taxation that began in the 1920s all educated a generation of tax lawyers and accountants in the need for innovation in financial structuring to reduce tax burdens.107 even before world war ii, a growing industry of lawyers and other professionals were actively engaged in finding ways to use complex and often vague statutory and regulatory language to reduce individuals’ and firms’ tax bills. after world war ii—just as the oeec/oecd was being organized and taking on tax issues—three important changes in the world economy further increased the importance of differences in tax regimes. first, as the european economies recovered from the devastation of world war ii during the 1950s and technological developments continued to reduce the cost of doing business internationally,108 cross-border transactions are important, but at least in the area of tax policy, they are usually drafted by oecd staff members. christians, supra note 72, at 17–18. thus, this is not where policy is formed, but rather where national policy is channeled into projects, where policy is mobilized by mandates to the oecd secretariat, which may delegate further to subcommittees. 104 michael craton, a history of the bahamas 254-255 (3rd ed. 1986). oakes was later elected to the bahamian assembly in the last pre-secret-ballot election. michael craton, pindling: the life and times of the first prime minister of the bahamas 1930–2000, at 13 (2002). 105 steven a. bank, from sword to shield: the transformation of the corporate income tax, 1861 to present 109–110 (2010) (noting that after world war i, “congress transformed the corporate income tax from its original pass-through vision to a separate, and at least partially additional, tax at the entity level”); daunton, supra note 36, at 94 (noting that separate corporate taxation did not develop in britain until after world war ii). 106 bank, supra note 105, at 89 (stating that top surtax rate on individuals went from six percent in 1913 to fifty percent in 1917); daunton, supra note 36, at 74 (“at the end of [world war i in britain], the proportion of people paying income tax was higher than ever before, and the rate was at an unprecedented level.”). 107 see, e.g., bank, supra note 105, at 142 (describing 1920s tax structuring to take advantage of exemptions). 108 for example, during the 1920s, transatlantic telephone calls were expensive and difficult, and travel between europe and north america required ocean liner voyages lasting four days or more. see bob dickinson & andy vladimir, selling the sea: an inside look at the cruise industry 19 (2nd ed. 2007). these transactions costs limited opportunities for transcontinental investments by raising their costs. after world war ii, these costs fell dramatically. for example, the cost of a three-minute phone call between new york and london dropped from $250 in 1930 to a few cents today. see martin wolf, why globalization works 119–20 (2004). see also paul einzig, the history of foreign exchange 239 (2nd ed., 1970) (noting that it was not until the 1950s that international telecommunications worked smoothly). similarly, transatlantic air travel became both possible and more affordable, cutting travel times from days to a matter of hours, and prices by a factor of ten from 1949 to 2009. see andrew evans, super colossal transatlantic travel, circa 1949, national geographic intelligent travel (aug. 20, 2009), 24 columbia journal of tax law [vol.4:1 expanded. the combination of the great depression and the war had dramatically reduced private trade, but once europe began to recover from the devastation of the war, cross-border transactions assumed increasing new importance. trade barriers among developed economies fell as the result of increasing european economic integration and, more broadly, through the general agreement on tariffs and trade (gatt).109 between 1950 and 1970, the world’s high-income countries saw growth rates of an average 4.9%.110 this resulted in a rapid increase in global trade, which between 1948 and 1960 grew by just over 6%;111 and 8% from 1960 to 1973.112 trade broadened as well as expanded. thus, while britain and the united states accounted for over half of world exports in 1950, by the 1970s they lost some of this dominance to other european countries and japan.113 (the oecd members’ share also increased as the organization expanded from 60% of merchandise exports in 1960 to 70% in 1973.) 114 just as importantly, international financial transactions expanded beyond the trade in government bonds that had dominated early twentieth century international finance to include private financial transactions. 115 between 1961 and 1985, bank deposits denominated in external currencies (e.g., currencies other than the home currency of the bank where the money was deposited) grew from about $1 billion to $2,000 billion.116 taxable foreign transactions involving american taxpayers grew substantially during the 1970s.117 the post-world war ii dissolution of the colonial empires also made some previously internal transactions “international” and subjected them to potentially inconsistent tax regimes. all these developments made solving double taxation problems a growing priority for businesses, financial services professionals, and financial institutions. second, the combination of the gradual weakening of capital controls and the rise of floating exchange rates expanded opportunities for cross-border economic activity available at http://blogs.nationalgeographic.com/blogs/intelligenttravel/2009/08/super-colossal-transatlantict.html. 109 the gatt was founded as an inter-governmental treaty in 1947, negotiated between twentythree countries. see bernard h. hoekman & michel m. kostecki, the political economy of the world trade system: the wto and beyond 38 (2001). although the gatt was not a very strong institution until the 1960s, it has been “the major focal point for industrialized country governments seeking to lower trade barriers.” id. at 9, 38. see also greg buckman, global trade: past mistakes, future choices 23, 31 (2005) (explaining that rapid economic growth was an important factor behind the trade increase. integration was further boosted by technological advances in transportation, as jet airplanes began flying non-stop between london and new york in 1957.). see id. at 37 (explaining that although there were trade negotiations also before the world war ii, they were few and far between). christians notes that the evolution away from tariffs represents the development of a principle against directly taxing the flow of international trade in goods through tariffs. christians, supra note 12, at 1412–13. 110 buckman, supra note 109, at 23. 111 id. 112 id. 113 id. 114 world trade organization, world trade report 2008: trade in a globalizing world 16 (2008). japan’s membership was particularly important in increasing the oecd members’ total share. 115 r.c. michie, the global securities market: a history 153 (2006) (describing the preworld war i market as “a pool of securities shared by the main markets and capable of moving easily, quickly, and cheaply between the different financial centers in response to minute variation in price”); boise & morriss, supra note 40, at 409–11 (discussing eurobond market development). 116 aliber, supra note 8, at 177. 117 internal revenue service, review of service programs relating to international transactions (aug. 25, 1981), excerpted and reprinted in improper use of foreign addresses to evade u.s. taxes: hearing before a subcomm. of the h. comm. on gov’t operations, 97th cong. 53 (1982). 2012] cartelizing taxes 25 while increasing the financial sophistication necessary to conduct it. although many countries initially maintained their wartime capital controls after the end of world war ii, these controls were progressively relaxed over the next thirty years and had almost completely vanished among developed economies by the 1980s.118 the sophistication necessary to operate internationally increased as well with the collapse of the post-world war ii bretton woods system of fixed exchange rates, which produced a world of largely floating exchange rates,119 creating both risks and opportunities for businesses operating internationally. this internationalization of capital markets was no accident. it partly developed as a result of policy choices led largely by the developed countries and driven by western europeans and u.s.-trained economists working at the international monetary fund.120 the dismantling of capital controls reflected a strong commitment by western european economies to a global financial system.121 but financial liberalization was also due at least in part to the unique dynamics of finance. unlike trade in physical goods, where agreement between both parties to liberalization is necessary, financial liberalization can be driven by unilateral efforts, and both britain and the united states pushed forward with liberalizing finance in pursuit of gaining market share in financial transactions for london and new york, respectively.122 thus important constituencies in both britain and the united states were able to mobilize their governments at appropriate times to take liberalizing steps that benefited their financial industries.123 third, the rise of the eurocurrency market offered businesses opportunities to obtain financing internationally at lower costs than available domestically. for example, during the late 1960s and early 1970s, the cost of borrowing in the eurodollar market (i.e., in dollars outside the united states) was significantly lower than borrowing in dollars within the united states. 124 as a result of federal government policies 118 barry eichengreen, globalizing capital: a history of the international monetary system 1 (2d ed. 2008) (“the three decades following world war ii were then marked by the progressive relaxation of controls and the gradual recovery of international capital flows. the fourth quarter of the twentieth century was again one of significant capital mobility. and the period since the turn of the century has been one of very high capital mobility—in some sense even greater than that which prevailed before 1913.”); manuel guitián, capital account liberalization: bringing policy in line with reality, in capital controls, exchange rates, and monetary policy in the world economy 71, 74 (sebastian edwards ed., 1997) (“perhaps the most critical feature of the recent evolution of capital movements has been the relaxation of capital controls, the bulk of which took place in the context of a broad liberalization and deregulation of domestic financial markets in industrial countries.”). 119 eichengreen, supra note 118, at 91–92 (summarizing bretton woods system); id. at 134–36 (describing movement to floating exchange rates). 120 rawi abdelal, capital rules: the construction of global finance 3 (2007) (“european policymakers conceived and promoted the liberal rules that compose the international financial architecture.”). abdelal sees the role of the united states in liberalization as “ad hoc” rather than the result of a uniform policy, and he emphasizes that the eu and oecd rules both developed without significant u.s. influence. id. 121 abdelal, supra note 120, at 105 (noting that by the late 1980s “capital account liberalization was becoming the usual behavior of oecd members,” and that this was driven by europeans). 122 helleiner, supra note 41, at 196 (“[f]or an open financial order to emerge, it was not necessary for states collectively to obey liberal rules, as is assumed to be the case in the trade sector. an open order could be created if a single state or group of states unilaterally provided resourceful financial markets operators with a degree of freedom.”). 123 helleiner, supra note 41, at 6, 83. 124 see heather d. gibson, the eurocurrency markets, domestic financial policy, and international financial instability 10–14 (1989) (describing the growth of the eurodollar market); stopford & turner, supra note 92, at 34 (“some of the early american moves to europe [by banks] were in response to restrictive us regulations primarily aimed at keeping dollars at home.”); dilip k. ghosh, 26 columbia journal of tax law [vol.4:1 discouraging u.s. multinationals from borrowing in the united states to fund their international operations, those companies began to borrow outside the united states.125 as domestic interest rates rose during the 1960s and 1970s, those same companies made extensive use of eurodollar financing through the netherlands antilles, taking advantage of a quirk in the u.s.–netherlands antilles tax treaty that eliminated the u.s. withholding tax on payments made to antilles entities.126 at the time, the irs acquiesced to and approved of this financing business, although the use of conduit entities in this fashion later became known as “treaty abuse.”127 use of international business structures to reduce regulatory and tax costs expanded as entrepreneurs in various jurisdictions had learned how to lower their costs through a wide variety of international business structures. for example the roosevelt administration’s acquiesced to the rise of flags of convenience as a means of allowing war supplies to be shipped to britain prior to u.s. entry into world war ii to evade america’s pre-war neutrality legislation’s prohibitions on u.s.-flagged ships’ sailing to belligerents. this changed the face of shipping after the war as liberian and panamanian flagged ships appeared in greater numbers.128 shipping firms and their customers learned both the scope of the benefits and the practical methods of international arbitrage from this experience. as we noted earlier, a dutch entrepreneur’s realization that the u.s.– netherlands tax treaty’s extension to dutch caribbean possessions allowed u.s. companies to access the eurodollar market without the costs of the u.s. withholding tax produced a multi-million dollar business on the island of curaçao in the 1960s.129 the eurocurrency markets themselves led american banks to open european branches.130 the demands of the oil and entrepôt businesses, in kuwait and hong kong respectively, resulted in their exemption from british currency controls for a time and created opportunities for currency transactions unavailable within the sterling area.131 offshore markets and capital flows: a theoretical analysis, in the global structure of financial markets: an overview, supra note 8, at 422 (“entrepôt centers and eurocurrency came into existence to satisfy the regulation-choked investors, transnational enterprises, and communist countries such as the soviet union and its satellite countries which wanted to keep dollars but not under the jurisdiction of the united states.”). this was broadly true of currencies, such that the eurocurrency market included trading in more than dollars. id. 125 gibson, supra note 124, at 10–14. 126 see boise & morriss, supra note 40, at 406–10. 127 see richard l. reinhold, what is tax treaty abuse (is treaty shopping an outdated concept)? 53 tax law. 663 (2000) (discussing development of concept). 128 see boleslaw adam boczek, flags of convenience: an international legal study (1962); rodney p. carlisle, sovereignty for sale: the origins and evolution of the panamanian and liberian flags of convenience (1981). 129 boise & morriss, supra note 40, at 406–10. 130 aliber, supra note 8, at 175–76 (“participation in the eurodollar market is the primary activity of most of the fifty branches of u.s. banks in london. in the absence of the ability to sell dollar deposits in london, most of these banks would not have established london branches. similarly, participation in the eurodollar market is the primary activity of the german banks in luxembourg.”). 131 catherine r. schenk, britain and the sterling area: from devaluation to convertibility in the 1950s 10 (1994) (“due to hong kong’s entrepôt trade and kuwait’s oil production, these two members of the sterling area operated free markets in sterling against dollars which were tolerated by the british authorities.”). this practice was ended in 1957. id. see also catherine r. schenk, the rise of hong kong and tokyo as international financial centres after 1950, in centres and peripheries in banking: the historical development of financial markets 81, 86 (philip l. cottrell, et al. eds., 2007) (“in the post-war period, the importance of hong kong as an international banking centre shifted to a new level. the absence of exchange control in the colony contrasted with a global environment of tight controls on capital-account convertibility and fixed exchange rates . . . [t]he ‘window’ of opportunity that hong kong http://en.wikipedia.org/wiki/%c3%94 2012] cartelizing taxes 27 as entrepreneurs learned the advantages of innovating business structures, those structures grew increasingly complex. for example, by the early 1960s the anglo-dutch multinational royal dutch/shell had 500 entities operating in more than ninety jurisdictions.132 even more than any specific arbitrage strategy, the development of london and new york as rival financial centers after world war ii drove down the cost of international business structures. 133 banks, lawyers, accountants, and other professionals in both cities aggressively competed for business both by pushing their national governments to lower regulatory costs and through innovation.134 during this period the oecd largely played the role of a pool of technicians able to provide the expertise and the contacts to help countries agree on the rules for taxation of activities that crossed borders. through the 1970s, the oecd model convention served (and continues to serve today) as a framework on which countries could base bilateral treaties. although the oecd sought agreement on the convention from government representatives rather than just technical experts, the model convention itself was not a policy product but a framework within which participating countries would settle politically the substantive issues necessary to complete a tax treaty. this approach left to the individual treaty talks the crucial questions necessary to set the boundaries for taxation between countries: who has the right to tax which transactions? where is the line drawn between what is mine and what is yours? once those boundaries were agreed, the model convention also left each jurisdiction free to tax at whichever rates they pleased, while using whatever other provisions that they deemed to be in their individual interests. this approach worked well for some transactions. if an american firm bought a british firm and operated it as a subsidiary, the framework created by the model convention plus the anglo-american tax treaty could handle dividend or interest payments from the subsidiary to the parent and similar transactions. the problem from the tax authorities’ point of view was that entrepreneurial lawyers’ and other professionals’ creation of international business structures quickly outstripped national tax authorities’ abilities to keep up with the varieties of transactions and their impacts on tax liabilities. once the rules were set in a treaty, lawyers and others set to work to find structures that minimized the total tax bill. for example, the sale of goods and services between related parties, an issue since at least the 1930s and generally labeled “transfer pricing,” posed serious problems as multinational enterprises expanded the scope of their operations since it could be used to shift profits from one jurisdiction to another.135 as offered as a gap in sterling-area exchange control attracted substantial financial flows from north america and europe as well as asia.”). 132 profit is raised for royal dutch, n.y. times, march 3, 1962, at l25. 133 helleiner, supra note 41. 134 one incident that illustrates the role of entrepreneurs in spreading policy ideas was the effort by merrill lynch to form an exclusive arrangement with guam in 1982 to offer tax structures through the jurisdiction. see merrill pioneering a new tax-free route to europe, as old haven sinks, securities week 2 (dec. 6, 1982), reprinted in tax evasion through the netherlands antilles and other tax haven countries: hearing before the commerce, consumer, and monetary affairs subcomm. of the h. comm. on government operations, 98th cong. 742 (1983). more generally, law firms played major roles in developing captive insurance offshore. see andrew p. morriss, industry insider … tom jones and lj fallon, cayman financial review, october 5, 2011, available at http://www.compasscayman.com/cfr/2011/10/05/industryinsider----tom-jones-and-lj-fallon (describing origins of offshore captive industry). 135 when assets are moved within a multinational enterprise (“mne”) across state borders, there is no reason to believe that the enterprise would report the value of that transaction according to market principles. an mne can also use a low-tax jurisdiction as the base of a part of the mne that is on the receiving end, even if 28 columbia journal of tax law [vol.4:1 intangible property grew in importance, firms discovered that they could use royalty payments to transfer profits to lower tax jurisdictions—and jurisdictions began to offer lower taxes on royalties to capture transactions. the spread of the ring-fenced tax regimes that reduced or eliminated taxes on entities not doing business within the jurisdiction as pioneered by the netherlands antilles in the 1950s also complicated the picture.136 moreover, national tax authorities often lacked the information they needed to evaluate whether tax evasion was occurring. for example, an irs review found that dividends of $16 million were reported to have been paid to east german residents in 1978 and a fifteen-percent withholding tax deducted, when the actual rate applicable to east germany was thirty percent. the reported concluded, “this condition was not identified or corrected during processing.”137 even where one nation’s tax authorities persuaded another’s to share information, making use of the information often turned out to be impossible because the recipient lacked the capacity to process it. in the united states, the irs simply warehoused foreign tax authorities’ reports of payments to u.s. taxpayers for much of the 1970s because it was unable to match the foreign tax records to u.s. records as the foreign records did not include the taxpayers’ u.s. social security numbers, the agency lacked the foreign language capacity to read the reports when they were not in english, and it was unable to determine how to make use of data reported in the company is not conducting any business activity there. rather, there is an incentive to set prices to allocate profits depending on the different tax rates in its two locations. thus the aim of an agreement is for each country to get its “fair share” of the tax. by pricing below market value, the tax authority in the receiving end gains, as it taxes according to profits, while the government from which the asset is transferred loses out. in the case of inaccurate pricing furthermore: “an mne could suffer double taxation on the same profits without proper transfer pricing.” two administrative bodies are then involved in assessing the value of the transfer. while the revenue authority in the state to which the assets are transferred want to see to it that the value is not over-estimated for the sake of tax deductibles, the customs authority in the same country is keen to make sure that the value of the transaction is not underestimated. there is a tension between these bureaucracies, both trying to value the transaction in a way that benefits them. transfer pricing is in of itself only a natural part of an mne. a price must be set on goods and services changing hands of the different parts of the enterprise. inaccurate transfer pricing however, brings with it two types of worries. on the one hand, there may be double taxation. in the case that an asset is priced too high, the tax base falls completely to the originating government. when the government in the other end discovers that lower profits are being reported than what is actually the case, they may want to levy a tax, which would lead to double taxation. on the other hand, a firm may be practicing income shifting by having its income under-reporting the income in the high-tax country, while over-reporting in the low-tax country, by claiming higher than market prices for the international shipping within the enterprise to the high-tax jurisdiction and lower than market prices in the other case. see eric j. bartelsman & roel, m. w. j. beetsma, why pay more? corporate tax avoidance through transfer pricing in oecd countries (ctr. econ. policy research, working paper no. 2543, 2000). although transfer pricing has been an issue for many decades, it is only with the proliferation of mnes that it has become a serious concern. see john neighbour, transfer pricing: keeping it at arm’s length, the oecd observer (jan. 2002), available at http://www.oecdobserver.org/news/printpage.php/aid/670/ transfer_pricing: _keeping_it_at_arms_length.html (last accessed oct. 2, 2011). the oecd issued a report in 1979 that set up guidelines for transfer pricing. margaret lamb, andrew lymer & judith freedman, taxation: an interdisciplinary approach to research 187–88 (2005). to obtain a fair allocation of tax revenues, the oecd adopted the “arm's length principle,” by which it is meant that a firm market value is to be set on the asset being transferred. see liu ping & caroline silberztein, transfer pricing, customs duties and vat rules: can we bridge the gap?, 1 world com. rev. 36, 36 (2007). this principle was originally practiced by the united states and copied by the league of nations in 1935 in their allocation convention. rixen, supra note 3, at 95. as christians summarizes, “the effect of transfer pricing rules is to divide revenues between countries in a generally acceptable way.” christians, supra note 12, at 1421. 136 boise & morriss, supra note 40, at 408–09. 137 internal revenue service, supra note 117, at 60. 2012] cartelizing taxes 29 foreign currencies where exchange rates varied over time.138 in one instance, after irs field agents discovered that they could not access the forms the canadian tax authorities sent to the irs because the forms “were not processed by the service and therefore were not retrievable,” the field agents worked out an arrangement with the canadian tax authorities to obtain their own copies of the forms being sent to the irs main office from the canadians whenever the canadians believed the forms “could be of significance” for the united states.139 that “front line” american tax personnel were forced to rely on foreigners’ judgment of what was important by the inadequacies of their own agency to process english language paperwork from the united states’ closest neighbor is an indication of the magnitude of the problems that less well-funded tax authorities around the world faced. in addition, legal arbitrage efforts swiftly expanded beyond tax issues. the availability of bearer share corporations in the netherlands antilles attracted investors in u.s. real estate (possibly including some americans) who valued both the anonymity that the bearer shares provided and, perhaps, that the shares could be transferred without u.s. tax authorities knowing that the property had changed hands.140 individuals in civil law jurisdictions established trusts in common law jurisdictions to avoid forced heirship laws.141 captive insurers located in offshore jurisdictions offered firms a combination of deductible premiums, flexible coverage, and access to the global reinsurance market.142 as the volume and size of international transactions grew, the scope of the problems they 138 oversight hearings into the operations of the irs (income information document matching program): hearing before the subcomm. on commerce, consumer and monetary affairs of the h. comm. on gov’t operations, 94th cong. 17 (1976) (statement of jacob kaufman & dean scott, subcommittee staff investigators, on detail from gao) (“irs agents had very little or no knowledge relating to the existence or use of the foreign income information documents. this is not surprising since all these documents simply arrive at the philadelphia service center and then are shipped off without examination to a federal records center.”); id. at 50 (“to begin with, finding someone who knew anything about the forms was a big problem but after that the reasons provided, as quoted in our statement, were that they were in a foreign language, and there were no identifying numbers on them. therefore, because of this, irs said it could not use them in the matching program or for any other purpose for that matter.”); id. at 83 (statement of donald c. alexander, commissioner, irs) (stating that irs needs information in dollars at time paid, but does not get it). it is easy to chuckle at the irs’s problems, but it would have been virtually impossible to know what was meant in u.s. dollar terms when a form reported a 1976 payment in lira, when that currency fluctuated against the dollar from 681.20 to 917.43, a difference of over thirty percent, unless the day of the payment was also specified. federal reserve statistical release h.10, foreign exchange rates, italy historical rates, federal reserve, available at http://www.federalreserve.gov/releases/h10/hist/dat89_it.htm (dec. 29, 1989). 139 oversight hearings into the operations of the irs (income information document matching program): hearing before the subcomm. on commerce, consumer and monetary affairs of the h. comm. on gov’t operations, 94th cong. 4 (1976) (statement of john j. olszewski, former director, intelligence division, irs). 140 boise & morriss, supra note 40, at 411–12. somewhat ironically, u.s. jurisdictions like nevada market themselves as providing secrecy. see brian grow & kelly carr, special report: nevada’s big bet on secrecy, reuters, sept. 26, 2011, available at http://www.reuters.com/article/2011/09/26/us-shell-gamesnevada-idustre78p1y020110926 (describing the state’s marketing of privacy in beneficial ownership). the use of foreign entities to hold real estate to avoid or evade transfer taxes is once again in the news, this time in britain. see james charles, beware stamp duty schemes, the sunday times (london), january 29, 2012. 141 see, e.g., firm memo, walkers global legal and management solutions, the uses and advantages of jersey trusts 1–2, available at http://www.walkersglobal.com/lists/news/attachments/ 168/(jersey)%20uses%20and%20advantages%20of%20jersey%20trusts%20(2).pdf (last accessed october 25, 2011) (discussing use of jersey trusts to avoid forced heirship laws). 142 see morriss, supra note 13. 30 columbia journal of tax law [vol.4:1 posed for national tax authorities increased as well.143 other law enforcement interests, particularly within the united states, began to pay attention to the use of international business structures and to openly speculate that they were being used to launder criminal proceeds or to conceal criminal activities.144 states adopted a variety of counter-measures to thwart taxpayers’ efforts to lower their tax obligations through international transactions. in the united states, the adoption of subpart f in 1962 escalated a long-running irs campaign to restrict u.s. taxpayers’ abilities to use foreign entities to reduce or evade their u.s. taxes.145 law enforcement operations involving intercepting mail to u.s. taxpayers from swiss addresses and arranging a miami dinner date for a bahamian banker to allow tax authorities access to the banker’s briefcase while he was pursuing romance were among the more colorful ones discussed publicly.146 in the united kingdom, the continuation of capital controls into the 1970s provided british authorities with important measures with which to prevent money from leaving the jurisdiction and so escaping taxes.147 more generally among eu governments in the 1960s and 1970s, only germany had somewhat liberal capital-account policies despite the commitment in the 1957 treaty of rome to move towards free movement of capital.148 this restricted most european taxpayers’ ability to shift funds out of a jurisdiction to avoid or evade taxes. liberalizations did come underway gradually, as even france moved away from its policy of dirigisme and state-guaranteed finance in the 1980s.149 as restrictions on capital flows declined, the impact of tax competition became more keenly felt.150 several factors restricted national tax authorities’ abilities to control international businesses’ and individuals’ use of both legal arbitrage methods and illegal tax evasion. 143 see, e.g., tax evasion through the netherlands antilles and other tax haven countries: hearing before the commerce, consumer, and monetary affairs subcomm. of the h. comm. on gov’t operations, 98th cong. 1 (1983) (statement of douglas barnard, subcommittee chair) (“offshore tax evasion schemes—which appear to have reached epidemic proportions—result in the loss to our treasury of hundreds of millions and very likely billions of dollars annually.”). 144 see illegal narcotics profits: hearings before the permanent subcomm. on investigations of the s. comm. on governmental affairs, 96th cong. (1979) (testimony of irvin b. nathan, deputy assistant attorney general, criminal division, us doj) (discussing law enforcement concerns about offshore transactions). 145 see office of tax policy, dep’t of the treasury, the deferral of income earned through u.s. controlled foreign corporations: a policy study 101–63 (2000) (describing measures). almost from the start of the modern income tax, the irs had spent considerable effort attempting to prevent “personal holding companies” from being used to lower tax bills and subpart f represented an international extension of that campaign. 146 tax evasion through the netherlands antilles and other tax haven countries: hearings before a subcomm. of the comm. on gov’t operations, h.r., 98th cong. 3 (1983) (statement of william j. anderson, director, general government division, general accounting office, describing mail watch); united states v. payner, 447 u.s. 727, 730–31 (1980) (describing briefcase incident). 147 stopford & turner, supra note 92, at 198 (“the 1947 exchange control act put the treasury firmly in the driving seat as far as control of outward investment was concerned.”). 148paola bongini, the eu experience in financial service liberalization: a model for gats negotiations?, vienna suerf – the european money and finance forum 18 (2003), available at www.suerf.org/download/studies/study20032.pdf (last accessed oct. 2, 2011). 149 vivien a. schmidt, the untold story: the impact of european integration on france in the mitterrand era (1981–1997), 3 (1997) (unpublished manuscript prepared for delivery at the european community studies association fifth biennial international conference, 1997), available at http://aei.pitt.edu/2720 (last accessed oct. 2, 2011). 150 see christians, supra note 12, at 22 (“governments might view the costs and benefits of their treaty obligations differently for different countries, over time.”). 2012] cartelizing taxes 31 tax efforts sometimes conflicted with other economic interests.151 important financial industry interests in both the united states and the united kingdom sought to improve the competitive positions of the new york and london financial centers.152 in the united states, the widespread use of antillean finance subsidiaries by american businesses during the 1960s both cut borrowing costs for the u.s. companies and served american interests by easing the capital shortages produced by lyndon johnson’s spending programs in support of his domestic agenda and the escalation of the viet nam war.153 in addition, serious missteps by the irs in the course of tax evasion investigations and the politicization of tax investigations by the nixon administration in the united states led to legal restrictions on the irs that reduced its ability to investigate international financial affairs and reduced its credibility.154 in britain, decolonization raised concerns that british taxpayers were going to be saddled with financial responsibilities for overseas territories, bringing the foreign and colonial office into policy debates on the side of encouraging, rather than restricting, british dependent territories to develop low tax and zero tax regimes to attract business.155 so powerful were these pressures that the foreign and colonial office (fco) was able to insist that british labour party prime minister harold wilson complain to australian liberal party prime minister geogh whitlam in a 1974 exchange of letters about australia’s restrictions of communications with the new hebrides as part of australia’s efforts to combat the use of new hebridean entities to reduce australian taxpayers’ tax bills.156 moreover, the lack of “natural recourse for 151 see, e.g., stopford & turner, supra note 92, at 242 (describing how balance of payments concerns limited the uk’s ability to “get tough” with london-based greek shipping interests over taxes). 152 helleiner, supra note 41. 153 see stuart w. robinson, jr., multinational banking: a study of certain legal and financial aspects of the post-war operating of the united states branch banks in western europe 278 (1972). 154 illegal narcotics profits: hearings before the permanent subcomm. on investigations of the comm. on governmental affairs, s., 96th cong. 23 (1979) (testimony of irvin b. nathan, deputy assistant att’y gen., criminal div., u.s. doj) (stating that the tax reform act of 1976 “minimized, if not eliminated, [the irs’s] role in nontax law enforcement and devotes itself almost exclusively to the voluntary tax collection system”). not surprisingly, some members of congress denied knowing about the provisions in the law that restricted the irs’s collection efforts. id. at 84 (senator cohen noting that “i suspect everyone on this committee, most of the senate and surely most of the house of representatives, voted for the tax reform act of 1976, most of whom, myself included, being unaware of the provision dealing with this particular measure [cooperation across agencies] because of the nature in which tax reform bills are enacted on capitol hill.”). 155 for example, in the debate over the australian response to the new hebrides’ tax haven activities, the fco noted in an internal memorandum that: “whatever the merits of mr whitlam’s argument that most of the benefits of the tax haven activities go to people escaping tax and those assisting them to do so, and not the new hebrides or its residents, it must be borne in mind that the trust companies established in the new hebrides have contributed well over $a1 million to british national service revenue in four years. there have been other tangible but unquantifiable benefits, e.g. activities by investment companies in the development of meat production. a territory’s resort to an offshore finance industry reflects the lack of any alternative scope for economic development to improve its own prosperity. experience has shown that in the absence of natural resources a well-managed finance industry can work a dramatic and very beneficial change on the economy of a small and undeveloped territory.” new hebrides “tax haven” 4, correspondence between australian and british officials (aug. 21, 1974) (on file with the british national archives, file prem 16/8). 156 letter from harold wilson to gough whitlam (aug. 30, 1974) (on file at the british national archives, file prem 16/8). in a memo a few days earlier, pacific dependent territories department of the foreign and colonial office noted: “on the one hand neither this nor any previous united kingdom government has actively encouraged the growth of an offshore finance centre in a british dependent territory, and the initiative for the relevant legislation comes from the territories themselves. on the other hand, no uk government has ever taken direct action against an established finance industry in a dependent territory, and 32 columbia journal of tax law [vol.4:1 governments . . . against arbitrage” meant that there were no simple barriers to tax competition available.157 thus from the mid-1960s to the late 1970s, in both britain and the united states the interests which would have sought to restrict legal arbitrage and rewrite tax policies to reduce taxpayers’ abilities to use international structures to lower their taxes legally or illegally were operating at a disadvantage.158 by the end of the 1970s, however, u.s. tax authorities were beginning to regain policy ground on international transactions, as we describe below. although the role of the oecd in international tax issues during the 1970s was primarily as a respected source of technical competence able to aid in the resolution of difficult problems caused by differences in national tax regimes, interest in using the organization to address tax competition began to appear. for example, in the internal debate over britain’s response to australia’s measures against the new hebrides financial center, one summary fco memo noted that there were “legitimate grounds for concern” by australia, and it suggested that britain tell the australians to focus their efforts on the oecd working party on tax to create a means to address the problem that avoided the limitations of the british constitutional structure and britain’s obligation to promote its territories’ economic development. 159 in general, however, by offering frameworks for resolving disputes over the details of taxation, the oecd avoided infringing on national sovereignty while reducing the transactions costs of states reaching agreements on how to handle differences in taxation. however, it did build such a presence in international tax law that “it has created debate about whether its guidance should be considered effectively binding on states, even if it is not technically law.”160 the oecd thus evolved over time into a resource with considerably higher value than it had simply as a reservoir of technical expertise. it would certainly be inequitable for hmg now to discriminate by insisting on the scrapping of one territory’s advantageous legislation while continuing to tolerate similar legislation in other territories.” see new hebrides “tax haven”, supra note 155, at 3.. that a socialist british prime minister was defending a low tax jurisdiction against a (at least nominally) market-oriented australian prime minister indicates the degree to which the british establishment saw the importance of encouraging development in the overseas territories even at the expense of tax collections by allies. britain was similarly unconcerned about the impact of its caribbean possessions’ tax policies on american tax collections. 157 christians, supra note 12, at 10. 158 see, e.g., improper use of foreign addresses to evade u.s. taxes: hearing before a subcomm. of the comm. on gov’t operations, h.r., 97th cong. (1982) (statement of alan w. granwell, international tax counsel) (describing “real purpose” of tax treaties as “to reduce the foreign taxes which u.s. businesses pay abroad”). 159 letter from p.j. weston (aug. 23, 1974) (on file with the british national archives, file prem 16/8). the letter noted: “the uk is represented on working parties in both the eec and the oecd which have been set up to combat the growing tax avoidance industry and the use of tax havens. australia is in fact also a member of the oecd working party. (the problem of tax havens also arises in connection with the examination of the impact of multi-national companies which is being carried out under the auspices of the united nations ecosoc.) we are, moreover, often under pressure from other countries to do what we can to put down the tax havens which have grown up in our dependencies and ex-dependencies in the caribbean and in the channel islands and the isle of man. while we are obliged to explain that our powers to intervene are limited either by the constitutional independence of the territories concerned or the practical difficulty of acting against what seem to the inhabitants of such territories to be their interests, we are also bound to do what we can by way of international cooperation to find ways of minimizing the damage they do.” id. at 2. it further noted that this response “has the concurrence at official level of the treasury and the board of inland revenue.” id. at 3. 160 christians, supra note 12, at 48. 2012] cartelizing taxes 33 iv. the international fight agasint tax competition the international political climate grew increasingly hostile towards the facilitators of tax avoidance and evasion. the oecd has been working on containing tax competition from “tax havens” since at least the early 1970s.161 in the early 1980s, the oecd embarked on an effort to influence national tax policies, including the policies of non-member states, on substantive matters including tax rates and the exchange of information in an effort to protect member states from competitive pressures. a. changing the agenda by the early 1980s, a number of important financial and political changes altered the competitive picture for the developed economies. private entities and individuals were using increasingly sophisticated financial transactions to challenge states’ ability to continue to extract revenue from economic activities as it became increasingly clear that a result of tax treaties was to facilitate “double non-taxation.”162 in particular, by the late 1970s and early 1980s the world’s growing numbers of “tax havens” were evolving from places where shady characters delivered suitcases of cash for concealment into jurisdictions offering increasingly sophisticated financial, accounting, and legal services. for example, the cayman islands’ initial success was in attracting banking business from the bahamas after the post-independence pindling government demanded “bahamianization” of the financial services sector workforce.163 by the early 1980s, the islands had expanded into offering a location for captive insurance companies, including the harvard medical entities’ first offshore captive.164 law firms in the cayman islands were staffed by counsel with oxbridge degrees and significant experience in london’s financial industry.165 just a short flight from new york, with no capital controls, and with excellent communications infrastructure (built deliberately to foster the finance industry),166 the growth of a sophisticated financial industry in the cayman islands and elsewhere in the caribbean and bermuda made offshore transactions available to a much broader swath of american businesses and individuals. similarly, the growth of european offshore financial centers in switzerland, liechtenstein, the channel islands, and the isle of man also brought sophisticated financial transactions within the reach of more european businesses and individuals. even countries like the netherlands—not normally referred to as an “offshore jurisdiction”—began to expand the opportunities 161 see, e.g., letter from p.j. weston (aug. 23, 1974) (on file with the british national archives, file prem 16/8) (noting that “[t]he uk is represented on working parties in both the eec and the oecd which have been set up to combat the growing tax avoidance industry and the use of tax havens”). 162 see rixen, supra note 3, at 13. as the right to tax is divided between the residence and source country of income, the residence country is no longer allowing merely for a tax credit or deduction. the tax imposed on its residence business or individual does no longer depend on the tax imposed by the source country. to attract capital and economic activity, countries therefore have an incentive to lower the tax rate to attract more investments. if, according to a tax treaty, a certain stream of income is to be only taxed at source, a zero tax rate in the source country means that no tax is paid to any jurisdiction. id. 163 letter from t. russel to d.f.s. le breton 1–2, commissioner in anguilla (may 21, 1975) (on file with the british national archives, file fco 44/1181) (recounting that after threats to offshore sector, bahamas “rapidly lost a great deal of off-shore business and the big bank operations normally have branches in several tax havens so that at the least whiff of trouble in the wind they can transfer business to another haven that seems more settled”); craton, pindling, supra note 104, at 161 (“many companies transferred all or part of their operations to what were seen as more favorable locations, bringing the first surge of prosperity to the cayman islands and reinforcing the longer-established financial industry of bermuda.”). 164 see morriss, supra note 134. 165 morriss, supra note 40. 166 id. 34 columbia journal of tax law [vol.4:1 they offered outsiders to reduce taxes and “dutch sandwich” entered the tax-planning lexicon.167 as a result, the large developed economies found themselves in a position similar to that of the rest of the world’s economies: having to compete for investment. behaving as monopolists traditionally do when forced into a more competitive marketplace, these states sought to erect barriers to such competition. in the united states, concern over the impact of international financial structuring on tax laws came to the fore in the early 1980s. in 1981, the irs issued a report by its general counsel, richard a. gordon,168 entitled tax havens and their use by u.s. taxpayers (which became known as the “gordon report”), focusing official attention on revenue losses while conceding that another state’s choice of tax rates (including zero rates for specific transactions) was “a legitimate policy decision.”169 the gordon report explicitly called for coordinated action against tax havens. 170 demonstrating that the issue had caught official attention, the united states canceled the relatively unimportant tax treaty with the british virgin islands in 1982171 and the much more significant tax treaty with the netherlands antilles in 1987.172 in 1982, congress granted the irs the power to order a taxpayer or the holder of the taxpayer's records to produce any books and records that are relevant to the taxpayer's return,173 and u.s. corporations were required to have books and records of their foreign corporations ready for irs examination.174 in 1983, the reagan administration launched its caribbean basin initiative, which subsidized american business conventions in caribbean jurisdictions agreeing to information exchanges with the united states to aid in u.s. tax enforcement.175 the deficit reduction act of 1984 also abolished the withholding tax on interest paid to foreign corporations and nonresident aliens, marking the end of the 167 see jesse drucker, google has made $11.1 billion overseas since 2007. it paid just 2.4% in taxes. and that’s legal., bloomberg bus. week, oct. 25, 2010, at 43. 168 richard a. gordon must be distinguished from richard k. gordon, an american law professor and former imf staff member, who writes on offshore issues as well. 169 richard a. gordon, tax havens and their use by united states taxpayers: an overview. report to the commissioner of internal revenue, the assistant attorney general (tax division) and the assistant secretary of the treasury (tax policy) 4 (1981). 170 id. at 10. (“the united states alone cannot deal with tax havens. the policy must be an international one by the countries that are not tax havens to isolate the abusive tax havens. the united states should take the lead in encouraging tax havens to provide information to enable other countries to enforce their laws.”). 171 see boise & morriss, supra note 40, at 419–20. one reason for the cancellation was that the growth in payments from the united states to the british virgin islands was increasing beyond the size expected for a jurisdiction with british virgin islands’ population. according to the gordon report, the total payments from the british virgin islands to people who officially were residents, for instance, had increased from one million to eight million between 1975 and 1978. meanwhile the number of british virgin islands firms in which united states citizens had interest increased between 1970 and 1979 from 53 to 678. gordon supra note 169, at 149–50. 172 see boise & morriss, supra note 40, at 423–25. during a congressional hearing discussing the antilles tax treaty, rep. benjamin rosenthal (d.-n.y.), chair of the subcommittee holding the hearing, asked a government witness, “but you will not lose sight of the fact that you work for the u.s. government rather than the dutch government?” after the witness enumerated reasons why changing the treaty would be difficult. improper use of foreign addresses to evade u.s. taxes: hearing before a subcomm. of the comm. on gov’t operations h.r., 97th cong. 42 (1982). 173 gregory p. crinion, information gathering on tax evasion in tax havens countries, 20 int’l law. 1209, 1215 (1986). 174 the exception was for third parties with interest in the record that would object to the disclosure. crinion, supra note 173, at 1219. 175 barbados, costa rica and the dominican republic entered that agreement with the united states in 1984. crinion, supra note 173, at 1236. 2012] cartelizing taxes 35 “antilles window” through which a reduced withholding tax treatment could be obtained through the use of netherlands antilles entities.176 that same year saw an amendment to the bank secrecy act of 1970177 requiring that banks and other financial institutions report to the irs any deposit or withdrawal of currency in excess of $10,000 and requiring that anyone traveling into the united states carrying over $5,000 report it to the customs service.178 the penalty for failing to report these transactions was raised from $1,000 to $50,000, and the maximum jail sentence was raised from one to five years.179 subsequently, the 1985 money laundering act amended the post-nixon 1978 right to financial privacy act to expand extraterritorial application of american laws in pursuit of drug money.180 despite all these measures, the irs continued to estimate losses due to tax evasion to offshore jurisdictions in 1985 to be several billion dollars,181 and in 1985, the senate permanent subcommittee on investigations concluded an investigation of money laundering and came out with recommendations to congress and the administration to impose sanctions on non-cooperative tax havens.182 several key european states were also forced to confront the constraints of the more globalized financial economy during the early 1980s. in france, the election of socialist president francois mitterrand brought an initial sharp left turn in economic policy. 183 soon after taking office, mitterrand nationalized twelve major industrial groups and forty-one financial institutions.184 the economic pressures created by these actions together with the remainder of the government’s “social growth” agenda slowed economic growth and increased unemployment.185 exchange rate pressures forced two devaluations of the franc within the european monetary system (ems) of pegged 176 see s. cass weiland, congress and the transnational crime problem, 20 int’l law. 1025, 1037 (1986); deficit reduction act of 1984, pub. l. no. 98–369 § 127(a), 98 stat. 494, 648–50 (“repeal of the 30 percent tax on interest received by foreigners on certain portfolio investments”). 177see the financial recordkeeping and reporting of currency and foreign transactions act of 1970, 31 u.s.c. 5311 et. seq, available at http://www.fdic.gov/regulations/safety/manual/section8-1.pdf. see also weiland, supra note 176, at 1039. 178 see , h.r.j. res. 648, 98th cong. 2d sess., § 901(g) (1984). 179 weiland, supra note 176, at 1039–40. 180 money laundering control act of 1986, pub. l. no. 99-570, 100 stat. 3207-18. 181 crinion, supra note 173, at 1211. 182 the report focused on the offshore banks problem, and was released the day after a record fine of $2.25 million had been announced for crocker national bank of san francisco for unreported currency transactions. chairman sen. william v. roth jr. (d.-del.) stated, “it's time to get though with the tax havens that insist on playing pontius pilate while the drug pushers and other criminals exploit their banking systems to the detriment of our citizens.” see jerry estill, senate panel urges crackdown on bank reporting, the miami news, august 28, 1985, at 9a, available at http:// news.google.com/ newspapers?id=ukamaaaaibaj&pg=4502,3372564 (last accessed oct. 11, 2012); cheryl arvidson, fed called lax in fight on money laundering, the miami news, august 28, 1985, at 3a; douglas jehl, panel urges tough sanctions against foreign tax havens, los angeles times, available at http://articles.latimes.com/1985-08-29/news/mn-23687_1_tax-havens (last accessed oct. 11, 2012). there is some irony in roth’s position, given that he later co-wrote a book attacking the irs. see william v. roth, jr. & william h. nixon, the power to destroy: how the irs became america’s most powerful agency, how congress is taking control, and what you can do to protect yourself under the new law (1999). 183 david r. cameron, exchange rate politics in france 1981–1983: the regime-defining choices of the mitterrand presidency, in the mitterrand era: policy alternatives and political mobilization in france 56, 56 (anthony daley & melanie nolan eds., 1996). 184 henrik uterwedde, mitterrand’s economic and social policy in perspective, in the mitterrand years 133, 134–35 (maclean ed., 1998); serge halimi, less exceptionalism than meets the eye, in the mitterrand era, supra note 183, at 83. 185 see uterwedde, supra note 184, at 135. 36 columbia journal of tax law [vol.4:1 exchange rates through 1982.186 amid speculation that france would be forced out of the ems entirely,187 mitterrand devalued the franc a third time in 1983 and then initiated his “u-turn” in macroeconomic policies. by 1986, mitterrand was arguing that “[o]ur great priority is inflation” and was seeking to reduce the public deficit despite high unemployment, a startling change for a french socialist.188 the u-turn also affected banking, and france’s 1984 banking act produced a revolution in french banking.189 credit controls were first relaxed in 1985 and then completely eliminated in 1987.190 the right-wing rally for the republic government that took office in 1986 continued these monetary and macroeconomic policies, accentuating deregulation, and initiated a massive privatization program. 191 the french left drew an important lesson relevant to our analysis from experience of the u-turn: they realized that single-country financial controls were unworkable within a global financial system.192 this pushed them toward multilateral solutions to financial problems.193 at the same time, germany was struggling with an outflow of capital to the united states, where the combination of pro-growth policies under the reagan administration and the abolition of the u.s. withholding tax on securities in 1984 had boosted demand for capital.194 germany was one of the toughest adversaries for tax havens in continental europe in the 1980s, when it passed laws to quell the flight of capital from germany; much of this capital was flowing into european offshore centers, switzerland, and luxembourg.195 the germans were also seeking to go beyond single country measures and were focused on finding multilateral solutions.196 moreover, the deregulation of financial markets in europe created opportunities for countries to attract capital using business-friendly tax and other laws. in the 1980s and 1990s, there was a surge in so-called preferential tax regimes (“ptr”) in the old eu countries, as a form of targeted tax competition.197 by the beginning of the 1990s, surging global economic integration had economists arguing that the future of capital 186 soon after his inauguration, despite heavy speculation about a devaluation of the franc and rapid capital flight in may, president mitterrand chose to defend the value of the franc and not to devalue it at that point, but went through with it later that year nevertheless. cameron, supra note 183, at 59–61. the adjustments negotiated with the erm were smaller than what the french politicians wanted and were attached to contractionary fiscal and monetary policy. id. at 58–59. 187 vivien a. schmidt, an end of french exceptionalism? the transformation of business under mitterrand, in the mitterrand era, supra note 183, at 117, 134–35; cameron, supra note 183, at 57. 188 halimi, supra note 184, at 90. the reforms also came about partly because the government wanted to see paris as a financial center to compete with london. see jonathan story & ingo walter, political economy of financial integration in europe 200 (1997). 189 story & walter, supra note 188, at 197. 190 michel boutillier & jean cordier, a look at the way the french financial system has adapted to the new monetary policy regime, in economic modelling at the banque de france: financial deregulation and economic performance in france 178, 180 (michel boutillier & jean cordier eds., 1996). 191 uterwedde, supra note 184, at 136. 192 rawi abdelali, capital rules: the construction of global finance 57–65 (2007). 193 id. at 71. 194 story & walter, supra note 188, at 177. 195 see ronen palan, richard murphy & christian chavagneux, tax havens: how globalization really works 200 (2010). 196 ironically, having abolished their withholding tax in 1984 to compete with the united states, germany reintroduced the tax in 1989 as part of negotiations with the eu to harmonize tax on capital. the result was an increase in capital outflow from germany. story & walter, supra note 188, at 178. 197achim kammerling & eric seils, the regulation of redistribution: managing conflict in corporate tax competition, 32 w. eur. pol. 756, 761 (2009). 2012] cartelizing taxes 37 taxation was bleak:198 globalization and the mobility of capital would cause investments to flow to wherever taxation was the lowest,199 distorting investment decisions.200 a decline in revenues from corporate income taxes as a share of gdp in the oecd countries as a result of the worldwide economic downturn in the beginning of the 1990s gave support to these fears. as the economies recovered towards the middle of the decade, the trend reversed and corporate tax revenues rose to record levels.201 the asian crisis in 1997 may have further triggered the demand for more transparency in the belief that tax havens were causing financial instability.202 other changes in the international economic climate, such as the end of the cold war, european integration and surging e-commerce also contributed to the demand by policy makers for more control over capital flows.203 in europe, countries were struggling with these issues within the broader context of the european union’s general moves towards greater financial integration in the 1980s and 1990s.204 while willing to free financial markets from a degree of national controls in pursuit of the wider single market,205 the eu’s goal was a broader market, not a less regulated or less taxed one. as a result, many eu members sought to create substitute regulatory and tax measures at the eu level or coordinated national measures to replace those reduced at the national level.206 similarly, to safeguard domestic tax collections, france and italy insisted that the eu combine liberalization with measures to align fiscal regimes and increase information transmission between the eu members’ financial 198 webb, supra note 96, at 795. 199 see generally oecd, taxing profits in a global economy: domestic and international issues (1991) (expressing the oecd's view that taxing corporations without distorting investments was becoming increasingly harder). 200 see vito tanzi, taxation in an integrated world 119 (1995) (stressing that greater inefficiencies will result from investments conducted as a result of taxation, and predicting that efforts towards tax harmonization will not be politically successful). 201kenneth g. stewart & michael c. webb, capital taxation, globalization, and international tax competition (univ. of victoria dep't of econ., working paper no. ewp0301, 2003). figure 2 in the appendix illustrates corporate income tax revenue as a share of gpd in the oecd and in europe respectively. rather than comparing countries by their statutory income tax rates or marginal effective tax rates, webb and stewart focus on the corporate income taxes actually paid. id. at 6. 202 robert t. kudrle & lorraine eden, the campaign against tax havens: will it last? will it work?, 37 stan. j. l. bus. & fin. 37, 50–51 (2003). 203 id. at 51. 204 see, e.g., ray barrell & nigel pain, foreign direct investment, technological change, and economic growth within europe, 107 econ. j. 1770, 1771 (1997). the european commission had issued a communiqué in 1974 addressing the problem with tax avoidance and evasion. it was followed in 1975 by a council resolution recommending member states to exchange information in the cases where money is channeled through a third country for tax purposes. see craig m. boise, regulating tax competition in offshore financial centers in offshore financial centers and regulatory competition 50, 56 (andrew p. morriss ed., 2010). a european commission may 1986 proposal for a european financial area sought a gradual end to capital controls as a step toward establishing the internal market. story & walter, supra note 188, at 254. 205 the eu directive of 1988 confirmed the principles of “complete, unconditional and free movement of capital” and non-discrimination by nationality. story & walter, supra note 188, at 256. 206 id. at 254–255. for example, the mutual funds directive of 1985 promoted the liberalization of capital movements in the eu. luxembourg now became attractive for fund management. france and the commission reacted by promoting a fifteen percent withholding tax across the eu, while germany imposed its own such tax of ten percent. this resulted in deutsche marks flooding into luxemburg until the policy was repealed in 1989. id. at 258. 38 columbia journal of tax law [vol.4:1 institutions and tax authorities.207 in particular, despite resistance from some members and only weak backing from others, france persuaded the european commission to propose in 1989 that withholding and corporate taxes be aligned.208 by the mid-1980s, it was thus apparent that there had been a significant shift in the domestic views within a number of developed economies on the utility of offshore financial centers. in both europe and the united states, liberalization of finance had exposed governments to competition that they did not like from offshore jurisdictions and from each other. increasingly, tax authorities saw the offshore jurisdictions as facilitating both tax avoidance and tax evasion despite the general lack of information about the transactions using offshore jurisdictions.209 law enforcement authorities worried that the impenetrability of offshore entities would conceal criminal activities.210 as both european governments and the united states were committed to further financial liberalization internationally, both were beginning to search for ways to insulate themselves from this competition. in particular, the gordon report helped push the oecd to work on the matter by making clear the inability of a single jurisdiction to address the problem effectively.211 in response, the oecd produced two 1987 reports on the issues, tax havens: measures to prevent abuse by taxpayers and taxation and the abuse of bank secrecy.212 in the former, the oecd spelled out a contorted definition of tax havens that excluded its own members, even while acknowledging the reality that “any country might be a tax haven to a certain extent.”213 in addition to discussing possible remedies that may be adopted by state authorities against tax evasion and avoidance, measures to prevent abuse by taxpayers also argued that model convention article 26 was insufficient to force jurisdictions to share the information necessary to prevent tax evasion. noting that there were few multilateral agreements, measures to prevent abuse suggested that “[p]ooling and sharing of relevant information at an international level . . . could constitute a new form of co-operation . . .”214 these initial steps staked out a position for the oecd that aligned with its member states’ interests. it 207 see id. at 255. also in 1989, the issue of tax neutrality was brought up again as the thencommissioner christiane scrivener proposed policies aimed to achieve neutrality in direct taxation as a “natural” part of the single market. see claudio m. radaelli, harmful tax competition in the eu: policy narratives and advocacy coalitions, 37 j. common mkt. stud. 661, 667 (1999). 208 story & walter, supra note 188, at 255-56. 209 see, e.g., tax evasion through the netherlands antilles and other tax haven countries: hearings before a subcomm. of the comm. on gov't operations, h.r., 98 cong. 1 (1983) (opening statement of subcommittee chairman douglas barnard) (“offshore tax evasion schemes—which appear to have reached epidemic proportions—result in the loss to our treasury of hundreds of millions and very likely billions of dollars annually. they also threaten the integrity of our tax system, increase the tax burden on the vast majority of hard-pressed americans who are honest taxpayers, and even undermine the nation’s efforts to get at the profits of organized crimes, drug trafficking, and other criminal activities.”). 210 see, e.g., tax evasion through the netherlands antilles and other tax haven countries: hearings before a subcomm. of the comm. on gov't operations, h.r., 98 cong. 97 (1983) (statement of robert edwards, deputy comm’r, florida dep’t of law enforcement) (claiming “widespread” money laundering in netherlands antilles). 211 interview 5 with oecd personnel, supra note 100. 212 oecd, tax havens: measures to prevent abuse by taxpayers, in international tax avoidance and evasion: four related studies 19 (1987); oecd, taxation and the abuse of bank secrecy in international tax avoidance and evasion: four related studies 107 (1987). 213 oecd, tax havens: measures to prevent abuse by taxpayers, supra note 212, at 21. 214 see oecd, tax havens: measures to prevent abuse by taxpayers, supra note 212, at 48. the report concludes with suggestions to tax authorities in matters of information sharing, but with no suggestion for any multilateral cooperation for information exchange. id. at 47–48. 2012] cartelizing taxes 39 had articulated an intellectual argument, albeit a weak one, that its members’ competition for assets through tax competition was conceptually different from the behavior of its members’ competitors. further, it had set forth an agenda for reforms, focusing on enhancing information sharing. b. policy entrepreneurship and cartelization with staff within the oecd having identified tax competition as an issue that the organization could address, the next step was building support for oecd work within member governments. 215 aside from switzerland, luxembourg, and liechtenstein, continental european governments were already sympathetic to the need to reign in tax competition; the stumbling blocks were the united states and united kingdom. with the arrival of the clinton administration in january 1993 and the blair government in may 1997, tax authorities gained powerful allies in seeking to restrict offshore activities.216 with the u.s. and u.k. changing sides during the decade, a more favorable climate for promoting substantive tax coordination was developing. under the leadership of jeffrey owens, the oecd project on fiscal degradation was launched in 1994, with a mandate217 to scrutinize the economies of europe for signs of “degradation.”218 the 215 interview 5 with oecd personnel, supra note 100. 216 in his first state of the union address, president clinton proclaimed: “our plan attacks tax subsidies that reward companies that ship jobs overseas. and we will ensure that, through effective tax enforcement, foreign corporations who make money in america pay the taxes they owe to america.” president william clinton, state of the union address (feb. 17, 1993) (transcript available at http://www.washingtonpost.com/wp-srv/politics/special/states/docs/sou93.htm). regulations by the clinton administration concerning the disclosure of transfer pricing saw a reduction of the $10 million threshold for misstatement subject to a 20% penalty to $5 million. richard g. minor, tax conferences: euromoney conference focuses on ec tax policy, eastern europe, and transfer pricing developments, 6 tax notes int’l magazine 1548, 1550 (1993). lawrence summers, appointed deputy secretary of the treasury in 1995 and secretary of the treasury in 1999, also was a strong supporter of the oecd’s project against “harmful tax competition.” see, e.g., lawrence summers, tax administration in a global era, remarks to the 34th general assembly of the inter-american center of tax administrators (washington, d.c., july 10, 2000). summers argued in the speech that the first steps in ensuring that the administration can realize their policy objectives without risking eroding the tax base are the oecd’s work and the administration’s own unilateral initiatives. see also j. c. sharman, havens in a storm: the struggle for global tax regulation 36 (2006) (providing interview material that it was under summers as secretary that the u.s. treasury was the most supportive for the oecd project against harmful tax competition). similarly, in the uk, the labour government elected in 1997 made clear in their election manifesto that they would take a hard stance towards tax avoidance “since we owe it to the tax payer,” announcing this under the headline “fraud.” the labour party manifesto 1997, new labour because britain deserves better: britain will be better with new labour, available at http://www.labour-party.org.uk/manifestos/1997/1997-labourmanifesto.shtml (last visited oct. 11, 2012). the tories did not mention cracking down on evasion or avoidance in their manifesto in 1997. instead they acknowledged, “[p]rosperity cannot be taken for granted. we have to compete to win. that means a constant fight to keep tight control over public spending and enable britain to remain the lowest taxed major economy in europe. it means a continuing fight to keep burdens off business.” the conservative party general election manifesto 1997, you can only be sure with the conservatives, available at http://www.conservative-party.net/manifestos/1997/1997-conservativemanifesto.shtml (last visited oct. 11, 2012). after a landslide victory in may 1997, labour party leader tony blair became prime minister and gordon brown chancellor of the exchequer. labour’s win was largely seen as inevitable as the conservative government staggered on during the mid-1990s. tim bale, the conservative party: from thatcher to cameron 65–66 (2010). anyone anticipating future british policy would have foreseen the shift well before 1997. 217 see working party no. 8 on tax avoidance and evasion, oecd, future work programme and proposed mandate 3 (1995) [hereinafter oecd, future work programme and proposed mandate]; working party no. 8 on tax avoidance and evasion, oecd, report on fiscal degradation 41 (feb. 6, 1996) [hereinafter oecd, report on fiscal degradation]. these reports give a mandate to working party no. 8 in 1993 to broaden its responsibilities to include fiscal degradation, whereas 40 columbia journal of tax law [vol.4:1 working group on fiscal degradation was created and met for the first time in september 1994 with the aim of establishing a “code of good conduct” that would discourage countries from continuing or creating ptrs.219 the group set up criteria for “acceptable” tax regimes, with proposals to policy makers on how these could be designed.220 ultimately, the project was ignored by many oecd members, and in the end, the oecd ministerial council did not endorse the report.221 the cfa decided that the report would be given wide distribution but would not be officially published, suggesting that the report could serve as useful input in its work.222 this project thus did not become the great leap forward in international tax cooperation that the ctpa staff sought. apparently, launching such a project at the committee level did not give it enough status as a project has that is approved on a higher level. owens would not repeat this mistake. the next time he would seek support for the project at the ministerial level.223 after the code of good conduct fizzled out, owens and his supporters crafted two measures to restore the initiative to life: a ministerial communiqué by the oecd council and an endorsement from the group of 7 (g7). at its ministerial level meeting of finance ministers and others in 1996, the oecd secretariat224 delivered the ministerial communiqué, asking the oecd to “analyse and develop measures to counter the distorting effects of ‘harmful tax competition’ on investment and financing decisions, and the consequences for national tax bases, and report back in 1998.”225 as with many documents issued at this level, the wording was prepared in advance as a draft that the gathering would sign at the meeting. the meeting at which the text was prepared, which included top officials of national tax authorities, has been described as “chaotic” with the delegates screaming at each other, suggesting the absence of a consensus. 226 those opposed called the proposed text “[a] fire that needs to be put out” and claimed that it contradicted the basic principles of the oecd.227 a month later, the g7 endorsed the the mandate for the project on fiscal degradation was issued in 1994. the working party’s mandate had previously been updated and broadened in 1984 and 1989 respectively. 218 interview 5 with oecd personnel, supra note 100. 219 see oecd, report on fiscal degradation, supra note 217, at 42. the aim of the project is described as to “avoid unfair tax competition for commercial and financial activities and to avoid the spread of tax regimes which undermine the revenue base and open up new avenues for tax avoidance and evasion.” id. at 7. a note from jeffrey owens describes the aim of the project as to “establish code of good conduct which would discourage countries from maintaining and adopting preferential tax regimes which undermine the tax base of their treaty partners.” id. at 42. 220 see oecd, report on fiscal degradation, supra note 217, at 9. 221 see sharman, supra note 216, at 41. 222 see oecd, future work programme and proposed mandate, supra note 217, at 3–5. 223 interview 5 with oecd personnel, supra note 100. 224 present at the oecd meeting were ministers and other representatives from germany, australia, austria, belgium, canada, denmark, spain, the united states, finland, france, greece, hungary, iceland, ireland, italy, japan, luxembourg, mexico, norway, new zealand, the netherlands, portugal, the czech republic, the united kingdom, sweden, switzerland and turkey. also at the meeting were representatives of the european commission, world bank, european free trade association (efta), bank for international settlements (bis), international monetary fund (imf), international labour organization (ilo), and world trade organization (wto). ministerial council, oecd, list of countries’ representatives and observers (1996). 225 ministerial council, oecd, draft communiqué (1996) (emphasis added). 226 interview 5 with oecd personnel, supra note 100. 227 interview 5 with oecd personnel, supra note 100. 2012] cartelizing taxes 41 communiqué, arguing that “harmful tax competition” distorted trade and investment.228 the g7 further “strongly urge[d] the oecd to vigorously pursue its work in this field, aimed at establishing a multilateral approach under which countries could operate individually and collectively to limit the extent of these practices.”229 this endorsement was a result of skillful diplomacy by owens and his supporters230 and enhanced the project’s political clout.231 the g7 has a history of influencing the oecd’s direction through the communiqués that the group issues after its yearly summits.232 the g7 was particularly sympathetic to the cause of regulating capital flows. primarily, it was active in controlling money laundering through its founding of the financial action task force (fatf).233 in addition, the eu regulators were increasingly critical of ireland for its low 228 oecd, harmful tax competition: an emerging global issue 7 (1998), available at http://www.oecd.org/dataoecd/33/0/1904176.pdf (last accessed oct. 11, 2012). 229 id. 230 interview 5 with oecd personnel, supra note 100. 231 it is important to put the role of the g7 into context to understand the dynamics of the debate. after gaining inadequate support from oecd to win an endorsement in the ministerial council, owens wanted to ensure that he had solid support from the onset of the project from another powerful body. he secured support from the g7, an organization with an almost identical membership but whose agenda and actions were set by a quite different group of people from the member states: prime ministers and presidents rather than finance, foreign, and other ministers who were present at the meeting of the oecd council at ministerial level. the g7 consists of france, germany, italy, japan, the united kingdom, the united states, and canada. it was created as the group of six in 1975 before adding canada to its list in 1976. it would later form the group of eight in 1997 as russia joined, while still also meeting as the g7. meetings are at the level of executive heads of member countries. (the president of the european commission is present, although the eu is not formally a member.) they are thus not the same people as those of the oecd meeting on a ministerial level, but the same countries and the european commission that attended the 1996 g7 meeting were represented also at the oecd meeting of the secretariat. it may then come as no surprise that they would be supporters of the oecd secretariat agenda. initially, the relationship between the oecd secretariat and the newly formed g7 was stained with rivalry. the oecd secretary general later wrote, “the harm done to the oecd by the increasing institutionalization of the seven has proved even more serious than i feared at the time. the oecd secretariat is not present at the g7 meetings and is not even informed about them: the best way to undermine the power of an international organization.” richard eccleston, peter carroll & aynsle kellow, handmaiden to the g20? the oecd's evolving role in global economic governance 4, 5, presentation at the 2010 australian political studies association conference, available at http://apsa2010.com.au/full-papers/pdf/apsa2010_0228.pdf. although securing an endorsement from the g7 may not have been necessary to pull the project through once it had a mandate from the ministerial council, it did certainly give more clout to the project. interview 5 with oecd personnel, supra note 100. 232 for example, in 1979, they addressed the oecd in connection to the work on oil and energy consumption following the rise in oil prices. eccleston, carroll & kellow, supra note 231, at 4. 233 fatf is described on its homepage as “an inter-governmental body whose purpose is the development and promotion of national and international policies to combat money laundering and terrorist financing. the fatf is therefore a ‘policy-making body’ that works to generate the necessary political will to bring about legislative and regulatory reforms in these areas.” see financial action task force, http://www.fatf-gafi.org/pages/aboutus. in 1989, with the united states as the driving party, the g7 established fatf at its paris summit. as money laundering was discussed referring to the “war on drugs” of the united states, the g7 decided to convene “a financial action task force from summit participants and other countries interested in these problems. its mandate is to assess the results of cooperation already undertaken in order to prevent the utilization of the banking system and financial institutions for the purpose of money laundering, and to consider additional preventive efforts in this field, including the adaptation of the legal and regulatory systems so as to enhance multilateral judicial assistance.” see generally amandine scherrer, explaining compliance with international commitments to combat financial crime fatf and the g7, presentation at the 2006 convention of the international studies association in san diego, california. housed at the oecd headquarters in paris and concerning its scope of responsibility, it is not hard to confuse 42 columbia journal of tax law [vol.4:1 tax policies.234 eu efforts to force ireland to abandon its ring-fenced ten percent rate for international financial operations backfired when ireland cut its corporate rate generally to 12.5% in 2004. 235 moreover, ireland’s aggressive marketing of dublin as an international financial center threatened further competition within the eu on tax and regulatory matters.236 france was particularly concerned about the kind of low, acrossthe-board corporate taxes that ireland was now offering, and in 1997 it began to actively call for harmonizing corporate tax rates, but consensus within the eu was blocked by belgium, ireland, and luxembourg.237 shifting the discussion to the g7 cut out the disharmonious voices of lower tax european jurisdictions. with this fresh mandate, owens and his colleagues resumed their work on tax competition issues. over the next two years, they worked rapidly to prepare a thorough indictment of low tax jurisdictions, 238 culminating in the 1998 report harmful tax competition: an emerging global issue.239 the report was a product of skillful political fatf with an oecd department. as will be seen, they have also adopted similar methods in their pursuit. on its homepage, fatf does see the need to point out that “[t]he fatf and the oecd are separate organizations.” according to sharman, fatf also uses oecd business cards and oecd stationary, hardly alleviating the confusion. see sharman, supra note 216, at 32. 234 see mark c. white, assessing the role of the international financial services in irish regional development, 13 eur. plan. stud. 387, 392 (2005). ireland cut taxes dramatically in 1989 in a bid to alleviate its persistent unemployment. see paul sweeney, the celtic tiger: ireland’s economic miracle explained 173 (1998) (top tax rates cut from 50% in 1988 to 36% in 1996 on companies, and 65% to 48% on individual income). one of the initiatives was the 1987 creation of the international financial service center, where firms enjoyed a corporate tax of 10%. see white, supra, at 391. initially tolerated by the other eu members because of ireland’s moribund economy, as irish unemployment rates fell in the 1990s the ifsc came under increased eu scrutiny. id., at 392. having cut its corporate tax rate from 50% in 1988 to 12.5% over time, ireland’s economy was drawing considerable outside investment during the 1990s as non-european firms looking to expand in europe established operations there. sweeney, supra, at 173 (tax rates). 235 see financial centre of activity, bus. & fin., july 15, 2004, available at http://www. businessandfinance.ie/index.jsp?p=450&n=466&a=1765 (discussing the end of the 10% ring-fenced regime); john deacon, global securitization and cdos 312–14 (2004) (discussing role of irish tax rates in luring financial industry to ireland). see also government confident on tax rate, irish times, oct. 4, 2011, available at http://www.irishtimes.com/newspaper/breaking/2011/0916/breaking34.html (discussing efforts to preserve the 12.5% regime). 236the hostility towards ireland’s success has dampened however, as the irish economy crashed in the midst of the global financial crisis. after a period of great expansions in the housing sector between 2003 and 2007, the housing bubble burst in 2008, leaving the country in a dire fiscal situation, and with an unemployment rate of above fourteen percent. see constantin gurdgiv, brian m lucey, ciaran macanbhaird & lorcan roche-kelly, the irish economy: three strikes and you’re out? (march 2, 2011) (unpublished manuscript), available at http://ssrn.com/abstract=1776190 (last visited oct. 5, 2011); output, prices and jobs, the economist, oct. 22, 2011, available at http://www.economist.com/node/21533447 (last visited oct. 25, 2011). 237 the eu had formed a tax policy group, composed of eu ministers of finance and their representatives, where much attention was paid to issues of “unfair” tax practices. see comm’n of the european communities, taxation in the european union: report on the development of tax systems (1996), for the recommendation of the commission of the european communities of the formation of the policy group. its work illustrated the diversity of opinion among member states, with ireland and belgium offering lower corporate taxation, and luxembourg attracting savings. claudio m. radaelli, harmful tax competition in the eu: policy narratives and advocacy coalitions, 37 j. common market stud. 661, 672–73 (1999). the european council on economic policy called for enhanced policy coordination in the eurozone, including “the discouragement of harmful tax competition.” id. at 675. germany, which had much to gain from tax coordination, put a lot of political capital into the eu policy group. id. at 673. 238 interview 5 with oecd personnel, supra note 100. 239 see generally oecd, supra note 228. 2012] cartelizing taxes 43 maneuvering. 240 one strategy was to keep the business and industry advisory committee to the oecd (biac) out of the discussion, to eliminate an anti-harmonization voice in the debates.241 the report again attempted to define the “problem of harmful tax competition” so as not to limit the major industrialized economies while promoting an international consensus around its definition. 242 in general, the 1998 report marked a distinct shift away from the past practice of articulating problems and recommending general solutions to pursuing a coordinated and active effort to counteract tax avoidance and evasion, to reduce financial privacy, and to influence states to end “unfair” tax competition. the report changed the debate over tax competition. the anti-tax competition argument had a serious problem since the low-tax states could make a legitimate claim to autonomy in designing their tax regimes that was at least as strong as the developed countries’ claim to set their own rates. as kaemer points out, identifying tax competition as ”harmful” was politically creative, as there is no such economic definition of tax competition. 243 it was therefore necessary to delegitimize the low-tax jurisdictions’ policy choices through the creation of a “standard” that they failed to meet.244 the oecd 240 interview 5 with oecd personnel, supra note 100. see christians, supra note 5, at 119–22 (discussing careful choice of language in oecd tax competition discussions). 241 the biac had been continuously involved in much of the earlier oecd work on taxation but had no role in the 1998 report. see webb, supra note 96, at 811–12; sharman, supra note 216, at 41. 242 oecd, supra note 228, at 23, 27. “tax havens” are identified by the criteria: (a) “no or only nominal taxes”; (b) “lack of effective exchange of information”; (c) “lack of transparency”; and (d) “no substantial activities,” where “[t]he absence of a requirement that the activity be substantial is important since it would suggest that a jurisdiction may be attempting to attract investment or transactions that are purely tax driven.” “harmful tax regimes” are defined by the criteria: (a) “no or low effective tax rates”; (b) “‘ring fencing’ of regimes,” which “may take a number of forms, including a regime may explicitly or implicitly exclude resident taxpayers from taking advantage of its benefits, [or] enterprises which benefit from the regime may be explicitly or implicitly prohibited from operating in the domestic market”; (c) “lack of transparency”; and (d) “lack of effective exchange of information.” to estimate a regime’s “potential harmfulness,” three questions are laid out in the report: (1) “does the tax regime shift activity from one country to the country providing the preferential tax regime, rather than generate significant new activity?”; (2) “is the presence and level of activities in the host country commensurate with the amount of investment or income?”; and (3) “is the preferential tax regime the primary motivation for the location of an activity?” the difference between a tax haven and a harmful preferential tax regime is thus that the latter has the “ring-fencing” criterion, while tax havens have a “no substantial activities” criterion. a jurisdiction was assessed as a preferential tax regime if it fulfilled the “ring-fencing” criterion in combination with either having low tax rates or a lack of transparency. see ault, supra note 98, at 769. these definitions thus include both those jurisdictions that offer lower tax rates for foreigners, who may not be in the business of financial services, and those jurisdictions without any special treatment that attract corporations in the financial business. as webb points out, part of the tactics in forming the needed consensus around these definitions was to keep the critical voice of the biac away from the discussion, for them not to encourage national lobbies to raise objection against the oecd approach on the national arena. see webb, supra note 96, at 812. 243 radaelli & kraemer, supra note 67, at 16. 244 the anti-offshore campaign generally seeks to delegitimize jurisdictions that do not follow the rich country model in taxation. for example, deneault asserts that “the bahamas, andorra, bahrain, barbados, the cayman islands, china, the cook islands, guernsey, hong kong, ireland, monaco, panama, singapore, switzerland, and taiwan” are states which “have no geopolitical relevance; they are names on lists that make it possible, through accounting manipulations and legal acrobatics, to evade the rules governing legitimate states.” deneault, supra note 23, at 45–46 (emphasis added). this remarkable list of states without “geopolitical relevance” is extraordinary not only for mixing china with andorra, but for its 44 columbia journal of tax law [vol.4:1 offered a perfect forum within which to do so. as the oecd’s 1998 report noted, while it was true that “[c]ountries should remain free to design their own tax systems,” this was true only “as long as they abide by internationally accepted standards in doing so.”245 while no one country could unilaterally create “internationally accepted standards” in tax, the oecd with its long history of leadership on double taxation was in the position to do so. the introduction of the idea of international standards defined by a small group of countries with a particular set of interests was a brilliant effort to redefine the debate. moreover, the oecd faced the problem that its own members were engaged in the same behaviors it criticized in others. for example, an american assistant secretary of the treasury was quoted by euromoney magazine in the 1970s that “[w]e are not in the business of enforcing the tax laws of other countries, just our own.”246 and the united states had encouraged the use of netherlands antilles entities to allow u.s. companies access to the eurodollar market in the 1960s and 1970s through what an irs commissioner described as “almost routine” revenue rulings approving transactions no different from those the united states would later criticize as “treaty abuse.”247 indeed, the united states itself has been described as a tax haven, with special tax breaks for foreign investments.248 manhattan may be seen as the most important tax haven in this regard. foreign persons pay no tax in the united states on their interest earnings,249 and states such as delaware, nevada, and wyoming offer secrecy services such as minimal information requirements and limited oversight for companies registering there.250 the standard was therefore carefully written to avoid delegitimizing measures being used by oecd members, as they were unlikely to welcome suggestions that they give up competitions they were winning. the report began by explaining that globalization not only had induced tax reforms and promoted economic development and a more efficient allocation of explicit claim that the listed states are not “legitimate” because they allow “accounting manipulations” and “legal acrobatics.” 245 oecd, supra note 228, at 15. 246 improper use of foreign addresses to evade u.s. taxes: hearing before a subcomm. of the h. comm. on gov’t operations, 98th cong. 2nd sess., 334 (1980) (statement of public citizen, quoting donald lubick). a ford foundation report in 1980 noted that “‘offshore’ or ‘haven’ facilities also include the u.s. and england, where favorable statutes protect foreign investors and externally-originating funds flows.” offshore banking: issues with respect to criminal use (1979), reprinted in illegal narcotics profits, hearings before the permanent subcomm. on investigations of the s.comm. on governmental affairs, 96th cong. 473, 474 (1979). 247 improper use of foreign addresses to evade u.s. taxes: hearing before a subcomm. of the h. comm. on gov’t operations, 98th cong. 2nd sess., 236 (1980) (statement of roscoe l. egger, jr., commissioner internal revenue service). 248 see, e.g., vincent p. belotsky, jr., the prevention of tax havens via income tax treaties, 17 cal. w. int’l l.j. 59 (1987). 249 marshall j. langer, harmful tax competition: who are the real tax havens?, 21 tax notes int’l 2831, 2832 (2000). in a published speech, langer further argued, “the united states, the united kingdom, and many other oecd countries have local laws and practices that are at least as abusive as those of the so-called tax havens . . . u.s. banks have paid tax-free interest rates to foreign persons for nearly 80 years. hundreds of billions of dollars of u.s. bank deposits are held in the united states by nonresident aliens and foreign corporations. if the u.s. congress ever seriously tried to tax the interest paid on these deposits, that money would immediately disappear from u.s. banks and probably move to other oecd countries.” id.; see also deneault, supra note 23, at 112–13 (discussing london as a banking and secrecy haven). 250 deneault, supra note 23, at 86–94 (discussing delaware); u.s. treasury department, u.s. money laundering threat assessment 47-48 (2005), available at http://www.treasury.gov/resourcecenter/terrorist-illicit-finance/documents/mlta.pdf (last accessed oct. 3, 2011). 2012] cartelizing taxes 45 resources (all things the oecd traditionally promoted) but also opened up doors to tax avoidance by multinational enterprises (“mnes”). the pressure to attract employment led countries into changing their tax structures, as policies in one country have repercussions in others. the report labeled a practice as “harmful” when a country was “poaching” by using tax policies to attract capital from another country, as such practices “do not reflect different judgments about the appropriate level of taxes and public outlays or the appropriate mix of taxes in a particular economy.”251 thus central to the oecd critique of tax competition was the claim that attracting investment was an illegitimate criterion for evaluating tax policy, 252 even though creating an attractive investment climate was often treated as a legitimate goal in other policy areas by the oecd.253 moreover, what was needed was a way to both ensure that oecd members toed the line and restrained their competition against one another and to control the independent exercise of sovereignty by non-members. the problem was that exhortation was insufficient to expand the oecd’s 1998 report beyond the oecd’s membership. the organization could make a policy case against tax competition but such a statement would lack teeth, as the oecd would just be issuing voluntary guidelines that non-members could ignore.254 the innovation that transformed harmful tax competition from merely a meaningless international report gathering dust on library shelves into an effective policy tool was its creation of an international cartel. first, to solve the internal coordination problem the report called for an explicit deadline for regimes to “remove, before the end of 5 years starting from the date on which the guidelines are approved by the oecd council, the harmful features of their preferential tax regimes identified in the list . . .”255 second, to induce non-members to comply, the new forum on harmful tax practices was established, with the mandate to intensify the dialogue with non-member countries but with a “priority task” of issuing a list of tax havens.256 jurisdictions on the 251 oecd, supra note 228, at 16. 252 judging by the tone at some places in the report, the response to this harm would also be firm. the chapter on measures against harmful tax competition begins: “governments cannot stand back while their tax bases are eroded through the actions of countries which offer taxpayers ways to exploit tax havens and preferential regimes to reduce the tax that would otherwise be payable to them.” oecd, supra note 228, at 37. 253 for a comprehensive and updated work on different policy area’s impact in the investment climate, see generally oecd, policy framework for investment (2006), available at http://www.oecd.org/dataoecd/1/31/36671400.pdf (last visited oct. 7, 2011). the report states, “countries’ continuous efforts to strengthen national policies and public institutions, and international co-operation, to create sound investment environments matter most.” id. at 7. competition is emphasized in the report: “[e]ffective competition and tax policies are important to ensure that investment, in particular in small businesses, is not deterred by unnecessary barriers to entry, dissuasive taxation, and poor legal compliance.” id. at 11. for discussions on related issues, see also oecd, global forum on international investment, enhancing the investment climate: the case of infrastructure (2006), available at http:// www.oecd.org/dataoecd/50/7/37785076.pdf (last accessed oct.07, 2011). 254 see webb, supra note 96, at 803, 809. 255 see oecd, supra note 228, at 56. the initial strategy for filling this list was a self-review process that the member countries agreed to carry out. they were to make an evaluation of whether they hosted any ptr, as defined by the report. at the end of that reporting period, not a single country would admit to it. no jurisdiction apparently wanted to come out first as the “bad guy.” the next step was to initiate a system of informing, asking countries to report their observations of ptrs in other member countries. in three months’ time, this resulted in over one hundred such reports. interview 5 with oecd personnel, supra note 100. see also ault, supra note 98, at 767 (describing the self-review process as a “classic prisoner’s dilemma”). 256 oecd, supra note 228, at 51–52. 46 columbia journal of tax law [vol.4:1 list would face coordinated sanctions from oecd members.257 the list would be ready within two years, giving tax havens an additional three years to comply with the guidelines in the 1998 report.258 even an oecd blacklist might not have carried enough weight to establish international standards, since the organization’s members’ self-interest in preventing competition was obvious. but the oecd members had more than one hat they could wear in issuing blacklists, and soon both the eu and the fatf were at work on blacklists of their own.259 the fatf published its first list of “non-co-operative counties and territories” (ncct) in june 2000, the same month as the oecd.260 the financial stability forum (fsf), founded in 1999 by the g7 finance ministers and central bank governors to study methods of reducing global financial volatility,261 issued a report on non-cooperative financial centers in may 2000, with material based on a survey that the organization had sent to ofcs.262 the eu launched a code of conduct for business taxation with a list of 66 “harmful” tax regimes in 13 eu-member countries and their offshore affiliation.263 both the eu and the oecd were extending the informal boundaries of tax governance into the formal sphere.264 by november 1999, the oecd had identified and evaluated numerous ptrs.265 reports were sent to the states for comments, and after some initial panic among non-oecd states, the offshore jurisdictions organized themselves and began meeting with the oecd both collectively and individually.266 in 1998 and 1999, it seemed to the forum on harmful tax practices that there was a great willingness among the offshore regimes to cooperate to avoid being listed on the forthcoming blacklist.267 before the 257 id. at 66–67. 258 id. at 56. 259 issuing blacklists proved so attractive that some governments simply copied existing blacklists and reissued them as their own. where they lacked institutions to update the blacklists, this created problems as countries were removed from the source blacklist but not the copies. see jason sharman, the bark is the bite: international organizations and blacklisting, 16 rev. int’l pol. econ. 573, 581–82 (2009). he also points out the costs incurred as ofcs are listed on private anti-money laundering software, generating red flags and hence raising costs of transactions, after once being blacklisted by an international organization. see also richard k. gordon, the international monetary fund and the regulation of offshore centers, in offshore financial centers and regulatory competition (andrew p. morriss ed., 2010). 260 see fatf, review to identify non-cooperative countries or territories: increasing the worldwide anti-money laundering measures (2000), available at http://www.fatfgafi.org/media/fatf/documents/reports/2000%202001%20ncct%20eng.pdf (last visited sept. 18, 2012). 261 see financial stability board, history, http://www.financialstabilityboard.org/ about/history.htm (last visited oct. 3, 2011). 262 see press release, financial stability forum, financial stability forum releases grouping of offshore financial centres (ofcs) to assist in setting priorities for assessment (may 25, 2000). they divided them into three groups according to their “perceived quality of supervision and perceived degree of co-operation.” in the least cooperative group were the jurisdictions of anguilla, antigua and barbuda, aruba, belize, british virgin islands, cayman islands, cook islands, costa rica, cyprus, lebanon, liechtenstein, marshall islands, mauritius, nauru, netherlands antilles, niue, panama, st. kitts and nevis, st. lucia, st. vincent and the grenadines, samoa, seychelles, the bahamas, turks and caicos, and vanuatu. 263 press release, primarolo group, code of conduct (business taxation) (feb. 29, 2000). 264 radaelli & kraemer, supra note 67, at 16. 265 oecd, towards global tax co-operation. progress in identifying and eliminating harmful tax practices (2000), available at http://www.oecd.org/dataoecd/9/61/2090192.pdf (last visited sept. 18, 2012). 266 id. at 10; interview 5 with oecd personnel, supra note 100. 267 interview 5 with oecd personnel, supra note 100. 2012] cartelizing taxes 47 final report came out in june 2000, six jurisdictions (bermuda, the cayman islands, cyprus, malta, mauritius and san marino) made commitments that saved them from being blacklisted,268 pledging to eliminate the tax practices that were deemed harmful in the harmful tax competition report.269 in the list released in june 2000, 35 jurisdictions were labeled as tax havens, and 47 as “potentially harmful tax regimes.”270 in addition, agreements progressed with the seychelles and the netherlands antilles in the spring of 2001.271 these agreements with offshore jurisdictions were a visible sign of the project’s success and its growing significance within the oecd. this created the opportunity for jeffrey owens, its director, to upgrade the status of his office by forming the directorate ctpa in 2001, shifting the tax competition work out of the daf.272 upgrading the division to a directorate was an important accomplishment, giving greater clout to the unit’s work, enhancing its future importance, and boosting funding. 273 it was also beneficial for owens personally.274 one puzzle remains—the oecd is built on decision-making by consensus, and two members in particular, namely switzerland and luxembourg, would be disadvantaged by the anti-tax competition efforts. these two countries built their reputations around confidentiality, something that would be threatened if they committed to the oecd project. in its statement on the report harmful tax competition, the swiss delegates stressed that they objected to the oecd’s view that information exchange was the only remedy to the tax competition problem,275 pointing out that switzerland was currently pursuing a withholding system, which they asserted was a less costly and fully viable alternative. the swiss stressed that they found it necessary to protect personal data and so could not support the oecd approach. luxembourg expressed similar views as a basis for not supporting the report.276 the new efforts had real costs for both countries, since, under the oecd convention, mutual agreements can lead to binding requirements for the members.277 268 oecd, supra note 265, at 29. 269 richard m. hammer & jeffrey owens, promoting tax competition (2001), available at http://www.oecd.org/dataoecd/63/11/1915964.pdf (last visited oct. 3, 2011). 270 oecd, supra note 265, at 12–14, 17. 271 interview 5 with oecd personnel, supra note 100. 272 interviews 3 and 5 with oecd personnel, supra note 100. daf is now called the “directorate for financial and enterprise affairs” and deals with issues regarding competition, corporate affairs,, bribery in international business, financial markets, insurance, pensions, international investment and private sector development. see oecd, directorate for financial and enterprise affairs, http://www.oecd.org/daf (last accessed nov. 19, 2012). 273 interviews 3 and 5 with oecd personnel, supra note 100. 274 owens benefited in terms of his influence within the organization. a division head reports to the director of the directorate. a director on the other hand, reports directly to the deputy secretary-general of the oecd secretariat. the informal link to the secretary-general is potentially strong as well. in addition, owens gained direct access to opportunities to lobby the members of the g7/8 and g20. interview 5 with oecd personnel, supra note 100. a division head, moreover, currently has a salary of €8,725 per month, while a director earns €11,287. this implies a pay rise of almost thirty percent for someone advancing from heading a division to a directorate. see oecd, salaries and benefits, http://www.oecd.org/careers/salariesandbenefits.htm (last visited sept. 18, 2012). 275 oecd, supra note 228, at 77. 276 oecd, supra note 228, at 77–78. 277 convention on the organisation for economic co-operation and development art. 6, dec. 14, 1960, available at http://www.oecd.org/general/conventionontheorganisationforeconomiccooperationanddevelopment.htm (last visited oct. 3, 2011). usually however, the oecd council instead issues recommendations, which represent a “strong political commitment” of a country. these would still be costly for non-compliant members. 48 columbia journal of tax law [vol.4:1 since members have the right to veto actions the council proposes, 278 why did switzerland and luxembourg abstain from harmful tax competition rather than vetoing it? had either done so, the report would have been much less effective. there are two possible explanations. first, oecd members interact on many issues and compromise is often necessary. setting oneself against other nations’ projects may cost a country future influence. 279 since both countries were successful in operating within the existing constraints, they may have believed that the report would ultimately do them little harm while impeding their competition outside the oecd. second, they may have made a mistake and not appreciated the full extent to which harmful tax competition would succeed in changing the terms of debate over tax competition. c. the impact of cartelization soon after the success of harmful tax competition, the effort to restrict tax competition suffered a significant setback with the diminution of u.s. support after the election of george w. bush.280 indeed, even prior to the election, barbados used the possibility of a coming shift in u.s. policy to seek concessions at a fall 2000 meeting with the oecd and was sufficiently emboldened by the results to walk out of a meeting with the oecd in january 2001.281 while bush’s stance on tax competition was initially unclear282—and the anti-tax-competition interests may have consoled themselves over the election results with the thought that it was the conservative reagan administration that had cancelled the bvi and netherlands antilles tax treaties—in may 2001, secretary of the treasury paul o’neill made it clear that the new u.s. administration would not support efforts to restrict tax competition, stating that: i am troubled by the underlying premise that low tax rates are somehow suspect and by the notion that any country, or group of countries, should interfere in any other country’s decision about how to structure its own tax system. i also am concerned about the potentially unfair treatment of some non-oecd countries. the united states does not support efforts to dictate to any country what its own tax rates or tax system should be, and will not participate in any initiative to harmonize world tax systems . . . in its current form, the project is too broad and it is not in line with this administration’s tax and economic priorities.283 prior to 1998, a similar change in u.s. priorities would likely have derailed efforts at restricting tax competition. the difference was that there was now at least the 278 ault, supra note 98, at 758. 279 interview 4 with oecd personnel, supra note 100. 280 the ofcs recognized that the u.s. was a weak link in the oecd campaign and lobbied the u.s. congress to undermine support for the oecd project. see also sharman, supra note 216, at 17. another problem concerned the british overseas territory of gibraltar, the status of which has since long been a dispute between the uk and spain. in july 2001, spain refused to endorse the report unless the uk took action over gibraltar’s fiscal policies. allowing it instead to negotiate for itself, the argument went, would allow the territory too much international recognition. this quarrel would halt the release of the 2001 progress report, with an updated version of the blacklist, which was initially due to be published in july 2001. gavin hinks, gibraltar row halts oecd tax purge, accountancy age, available at http://www.accountancyage.com/aa/news/1753426/gibraltar-row-halts-oecd-tax-purge (last visited oct. 7, 2011). 281 interview 5 with oecd personnel, supra note 100. 282 an indication of this was that the usually influential american delegation, present at the january 2001 meeting, did not speak much. interview 5 with oecd personnel, supra note 100. 283 paul o’neill, commentary, confronting oecd’s ‘harmful’ tax approach, the washington times, may 11, 2001, at a17. 2012] cartelizing taxes 49 beginning of international commitments to address the issue. thus, the change in u.s. position had a reduced impact since the tax competition efforts were more established within the oecd than they had been before 1998.284 rather than abandoning the effort, the oecd tax group shifted its focus to promoting information exchange and bank transparency, a topic on which o’neill had signaled a willingness to move ahead, noting that while the u.s. would “guard against overbroad information exchanges in which foreign governments seek information for improper purposes or without proper safeguards[,] [w]e cannot tolerate those who cheat on their u.s. taxes by hiding behind a cloak of secrecy.”285 the terrorist attacks on the united states on september 11, 2001, changed the political dynamic once again. after 9/11, the united states increased its focus on terrorism finance, which yielded increased backing for efforts to increase financial transparency.286 although the oecd’s tax competition initiative had slowed as a result of the shift marked by o’neill’s op-ed, after 9/11 the pace of work again increased, and the delayed 2001 progress report could be released in november 2001.287 this time, tax rates took a back seat to transparency and reporting issues. in particular, the oecd softened several important components of the original proposals. furthermore, as the commitments that they were now seeking from tax havens concerned transparency and exchange of information rather than tax rates, issues such as ring-fencing and “no substantial practices” were removed from the analysis, and the oecd changed the expressions “harmful tax competition” and “unfair tax competition” to “harmful tax practices.”288 many offshore jurisdictions were more willing to comply with demands for transparency than with ones that they adopt higher tax rates. especially under the condition that switzerland and luxemburg would first need to agree to information exchange, the promise of future openness in the seemingly unlikely case that those two did the same became less of a commitment.289 as a result, the oecd reported in 2004 284 ctpa senior advisor hugh ault has argued that the o’neill announcement did not have much impact on the project. the “no substantial activities” criteria had been of little significance, he argues, and the promise to deal with member countries first did no harm, as they had already announced to make the required changes. see ault, supra note 98, at 770. others point out that the oecd had already seen a victory with so many regimes making concessions, that concentrating on transparency was in any case the next natural step. interviews 3 and 4 with oecd personnel, supra note 100. 285 o’neill, supra note 283. 286 interview 5 with oecd personnel, supra note 100. 287 project on harmful tax practices, oecd, the 2001 progress report (2001), available at http://www.oecd.org/dataoecd/60/28/2664438.pdf (last accessed oct. 8, 2011); interview 5 with oecd personnel, supra note 100. 288 see generally oecd, supra note 287. 289 sharman, supra note 216, at 153; oecd, supra note 287, at 10. only seven jurisdictions (andorra, liberia, liechtenstein, the marshall islands, monaco, the republic of nauru, and vanuatu) remained on the blacklist in its updated version in april 2002. see oecd, list of uncooperative tax havens (2000), available at http://www.oecd.org/document/57/0,3746,en_2649_33745_30578809_1_1_1_1,00.html (last visited oct. 12, 2011). the republic of naura and vanuatu were removed by the oecd in 2003. project on harmful tax practices, oecd, the 2004 progress report 11 (2004), available at http://www.oecd.org/dataoecd/60/33/30901115.pdf (last visited oct. 8, 2011). the 2004 progress report announced that twenty-two offshore jurisdictions had complied with the oecd transparency standards and exchange of information since 2001. id. at 11. 50 columbia journal of tax law [vol.4:1 that “an overwhelming majority of countries and jurisdictions identified in 2000 have agreed to work toward transparency and effective exchange of information.”290 the loss of u.s. support weakened the anti-tax-competition efforts. this weakness can be seen in the oecd’s abandonment of its aggressive efforts to coerce the ofcs to conform to its substantive tax standards through the blacklist.291 negotiations between the oecd and ofcs began to be held on a multilateral basis, described as “a co-operative process”292 rather than in the context of ofcs individually attempting to clear blacklisting. to prevent sanctions breaching the level-playing-field objective, the oecd agreed that no non-member would be targeted with the “co-ordinated defensive measures” until oecd members themselves were in compliance with the standards.293 since this never happened, the commitments made after these adjustments cannot be interpreted as the same kind of surrender that the cayman islands engaged in after the release of harmful tax competition in 1998.294 the application of a slightly softer approach seems mainly to have been a response to overwhelming criticism by ofcs and their backers of harmful tax competition and the published blacklist in 2000.295 in particular, part of the failure of harmful tax competition stemmed from the ofcs’ effort to push back on the intellectual front through the 2006 report tax cooperation: towards a level playing field,296 issued with the support of the commonwealth secretariat.297 much as owens had used the g7 when his initial push at the oecd had failed, the ofcs successfully brought the commonwealth into the debate, using a forum in which a number of small ofcs were members and in which britain would find it harder to obstruct their efforts since it would not have its european allies to support it. they poked 290 oecd, tax co-operation: towards a level playing field (2006), available at http://www.oecd.org/tax/transparency/44430286.pdf (last visited oct. 25, 2011). 291 see boise, supra note 204, at 68. 292 oecd, supra note 287, at 9. 293 oecd, supra note 287, at 10. in light of this, the july 2001 deadline for commitments was postponed until february 2002. id. 294 see sharman, supra note 216, at 153. 295 the oecd was accused of a double standard when two of its members (switzerland and lichtenstein) could abstain from the recommendations about transparency and non-“harmful” tax practices, while non-members were being targeted. see sharman, supra note 216, at 90. this was indeed in contradiction to the organization’s claim to be promoting a “level playing-field.” id. the targeted jurisdictions themselves expressed discontent with the report and the business community at large was critical. for example, the prime minister of st. vincent and the grenadines pointed out that “[t]he international financial community urges competition and open markets but when we succeed they declare it unfair.” id. the oecd’s own business industry advisory committee (biac) launched harsh criticism in 1999 at the oecd project as a whole. id. at 72. among many critical voices, miami-based international relations expert anthony bryan commented that, “caribbean countries with offshore jurisdictions fear that, as earnings from traditional industries such as banana and sugar exports fall, the crackdown on tax havens will hinder their efforts to develop new businesses.” akiko hishikawa, the death of tax havens?, 25 b.c. int’l & comp. l. rev. 389, 402 (2002). 296 see generally oecd, supra note 290. 297 the commonwealth consists of fifty-four member countries, and has currently as its main pillars to work for peace, democracy, anti-poverty and sustainable development. the commonwealth secretariat, what we do, http://www.thecommonwealth.org/internal/190957/what_we_do (last visited oct. 25, 2011). it is financed by government contributions to separate budget funds; for the commonwealth fund for technical co-operation, which is one area that the commonwealth works on, the largest shares came from australia, botswana, brunei darussalam, canada, india, new zealand, nigeria and the united kingdom. the commonwealth secretariat, funding, http://www.thecommonwealth.org/ internal/190945/34492/funding/ (last visited oct. 25, 2011). 2012] cartelizing taxes 51 significant holes in the oecd’s arguments on substantive tax issues and undercut the effort to build an international consensus around the oecd’s proposed standards. at a meeting in 2004, the global forum decided to conduct a review of over eighty countries to survey whether they lived up to the oecd standards of transparency and information exchange. 298 meanwhile, bilateral efforts were undermining the multilateral project, as the united states and eu signed individual accords with other nations.299 by 2005, the project against harmful tax competition was barely alive.300 the oecd even stopped referring to jurisdictions as “tax havens,” instead terming them “participating partners.”301 whereas previous meetings have been described as somewhat “chaotic,”302 a meeting in 2005 has been described as “polite.”303 the outcome of the review project was published in tax cooperation: towards a level playing field304 in 2006, and would be updated on a yearly basis in reports with the same name. the reports do not list countries as black or gray, but instead describe thorough examinations of the countries, concerning a variety of issues of transparency and financial services.305 the black and gray list of 2000 is mentioned in the reports only in a way that diminishes its importance: the “2000 oecd list should be seen in its historical context . . . more than five years have passed since the publication of the oecd list and positive changes have occurred in individual countries’ transparency and exchange of information laws and practices since that time.”306 moreover, the ofcs successfully made the case that they constituted a well-regulated set of jurisdictions, undercutting the oecd’s arguments.307 outside events once again changed the debate, however. the tax competition efforts revived after the global financial crisis—which some attempted to blame on ofcs308—and the 2008 election of barack obama. although the financial crisis had no 298 see oecd, supra note 296, at 14, for a description of the standards. the standards of transparency and information exchange are summarized as follows: (a) existence of mechanisms for exchange of information upon request, (b) exchange of information for purposes of domestic tax law in both criminal and civil matters, (c) no restrictions of information exchange caused by application of dual criminality principle or domestic tax interest requirement, (d) respect for safeguards and limitations, (e) strict confidentiality rules for information exchanged, (f) availability of reliable information (in particular bank, ownership, identity and accounting information) and powers to obtain and provide such information in response to a specific request. id. 299 interview 5 with oecd personnel, supra note 100; sharman, supra note 216, at 74. the parties that entered into an agreement with the u.s. were the bahamas, the netherlands antilles, the cayman islands, and panama. their agreement on tax information exchange included a clause that information would not be passed further, in effect shielding them from the oecd project. id. also in 2005, the eu allowed for austria, luxembourg, and belgium to be exempted from the requirement that all member countries exchange information with other relevant national authorities, in exchange for imposing a withholding tax on earnings from deposits. see palan, murphy & chavagneux, supra note 195, at 223. 300 interview 5 with oecd personnel, supra note 100. 301 sharman, supra note 216, at 151. 302 interview 5 with oecd personnel, supra note 100. 303 see sharman, supra note 216, at 149. however, no deadline was set this time, but “all countries are strongly encouraged to take the necessary steps towards a level playing field.” see oecd, supra note 296, at 49. 304 see generally oecd, supra note 296. 305 id. 306 oecd, supra note 296, at 53. 307 see andrew p. morriss & clifford c. henson, regulatory effectiveness in onshore & offshore financial centers (march 2, 2012) (unpublished manuscript), available at http://ssrn.com/abstract=2016310. 308 jean eaglesham and alex barker, uk premier calls for crackdown on tax havens, fin. times, feb. 19, 2009; alex barker, brown warns tax havens to comply, fin. times, apr. 10, 2009; robert m. morgenthau, too much money is beyond legal reach, wall st. j., sept. 30, 2008, available at 52 columbia journal of tax law [vol.4:1 connection to either ofcs or tax rates, political leaders were quick to use it to assert a need for restrictions on financial competition.309 obama was an ally of sen. carl levin (d.-mich.), the main force behind the proposed stop tax haven abuse act (a version of which obama co-sponsored while he was in the senate). 310 in addition, obama’s ambitious agenda needed revenue, and cracking down on ofcs promised revenue (or, at least, promised the revenue that could be spent if projected under u.s. budget rules even if it was never collected).311 further bolstering the attractiveness of attacks on ofcs, aggressive tax planning efforts by liechtenstein and swiss banks came to light, with the swiss bank ubs revealed as having violated u.s. law312 and several eu governments having purchased stolen account data from a rogue lichtenstein banker that revealed widespread tax evasion by their citizens.313 with four billion euros allegedly channeled through lichtenstein by hundreds of german business people to evade (rather than avoid) taxes,314 onshore government interest in limiting access to such opportunities increased and made the arguments in favor of controls more compelling.315 domestic politics in several eu nations also increased interest in demonstrating that governments were http://online.wsj.com/article/sb122273062657688131.html; grant mccool, more offshore tax probes in the works: ny’s morgenthau, reuters, apr. 24, 2009. 309 see, e.g., morgenthau, supra note 308. the new york city district attorney lamented that “vast sums of money . . . lie outside the jurisdiction of u.s. regulators and other supervisory authorities.” nigel morris, brown leads global drive to close down tax havens, the sunday indep., feb. 19, 2009, available at http://www.independent.co.uk/news/uk/politics/brown-leads-global-drive-to-close-down-taxhavens-1625959.html (quoting the british prime minister gordon brown as calling on “the whole of the world to take action. that will mean action against regulatory and tax havens in parts of the world which have escaped the regulatory attention they need.”); sarkozy on tax havens, and more, tax justice network (aug. 28, 2008), available at http://taxjustice.blogspot.com/2008/08/sarkozy-on-tax-havens.html (quoting the french president denouncing “the excesses of financial capitalism which has experienced serious abuses: concealment of risks, uncontrolled sophistication of financial instruments, gaps in regulation and persistence of tax havens capturing a part of global savings that would be more justly employed financing investment and growth”); lucia kubosova, eu states crack down on tax evasion, eu observer, oct. 22, 2008, available at http://euobserver.com/9/26976 (last visited oct. 8, 2011). in a meeting in paris in october 2008, calls were made on the oecd to curb european tax havens. the articles point out the increased urgency of european capitals to clamp down on tax havens globally, in light of the recent financial crisis. 310 gordon, supra note 13, at 99. 311 see ctr. on budget and pol’y priorities, policy basics: congress’s ‘pay-as-you-go’ budget rule (2009), available at http://www.cbpp.org/files/policybasics-paygo.pdf (last visited oct. 25, 2011). 312 see press release, u.s. dept. of justice, united states asks court to enforce summons for ubs swiss bank account records (feb. 19, 2009) available at http://www.justice.gov/tax/txdv09139.htm (last visited oct. 22, 2011) (describing the lawsuit). 313 the liechtenstein connection, spiegel online (feb. 16, 2008), available at http://www.spiegel.de/international/business/massive-tax-evasion-scandal-in-germany-the-liechtensteinconnection-a-535768.html, (last visited oct. 25, 2011). 314 not so fine in liechtenstein, the economist, feb. 22, 2008, available at http://www.economist.com/node/10750259?story_id=10750259 (last visited oct. 12, 2012). 315 the g7 expanded to the g20 in 2007, and at their april 2009 summit, tax havens were high on the agenda. see dries lesage, the g20 and tax havens: maintaining the momentum? 3 (june 18, 2010) (unpublished manuscript), available at www.g20.utoronto.ca/biblio/lesage-tax-havens.pdf. a press conference in connection to the meeting focused much concern on regulations to prevent a future financial crisis. see, e.g., ben hall, stage set for tax havens battle, fin. times, apr. 1, 2009, available at http://www.ft.com/home/us#7720645761771122463 (last visited oct. 12, 2012). france and germany were actively pushing for a tougher stance on the issue. lichtenstein, andorra, switzerland, austria, and luxembourg all announced that they would relax their bank secrecy laws. see andrew willis, switzerland, austria and luxembourg relax banking secrecy, eu observer, mar. 13, 2009, available at http:// euobserver.com/?aid=27775 (last visited oct. 10, 2011). 2012] cartelizing taxes 53 “tough” on tax evasion. 316 for example, france’s newly elected president nicholas sarkozy had campaigned as an unusually free-market politician for france.317 after his proposed reforms of the french university and health systems were met with widespread protests,318 the campaign against tax havens may have served as a counterweight, to demonstrate firmness against the wealthy. 319 in britain, gordon brown needed to mobilize the left in preparation for an upcoming difficult election campaign.320 one important development slowed the anti-ofc campaign’s progress. the g7’s expansion to the g20 meant that china now had an important voice there.321 its relatively strong economy also made china an important player in world financial affairs, and its need for vehicles both for inward and outward investment gave it an interest in ofcs. 322 the oecd had previously threatened to place the chinese special administrative regions of hong kong and macau on the blacklist.323 not being an oecd-member, china did not want discussions conducted in a forum where it had no influence and so it sought to ensure that any multilateral transparency deal be pursued at the united nations, where it would be able to influence the process. a compromise was reached that eased china’s fears. hong kong and macau would not be blacklisted. moreover, the new global forum on transparency and exchange of information for tax purposes would be outside the oecd structure, be funded independently of the oecd, and allow membership by non-oecd countries.324 this left china with influence over the work both by means of its presence and its budget contributions.325 it also seems to have relieved the burden from the g20 of the political implications of confronting china 316 see kubosova, supra note 309. in the october meeting, convened by france and germany, the delegates lamented the slow pace of the oecd’s efforts, and called for a new list from the organization, which they claimed that switzerland should be included in. the oecd promised to deliver one by mid2009. 317 see, e.g., anna willard, france’s sarkozy turns to forming govt, next polls, reuters, may 7, 2007, available at http://www.reuters.com/assets/print?aid=usl0663346820070507 (last accessed oct. 12, 2012). 318 see, e.g., james joyner, sarkozy delays university reforms, feared greek-style riots december, new atlanticist policy and analysis blog (oct. 16, 2008), http://www.acus.org/ new_atlanticist/sarkozy-delays-university-reforms-feared-greek-style-riots (last accessed oct 21, 2012); anna willard, french workers strike against sarkozy’s reforms, reuters, nov. 14, 2007, available at http://uk.reuters.com/article/2007/11/14/uk-france-strike-idukl126064620071114 (last accessed oct. 21, 2012). 319 interview 5 with oecd personnel, supra note 100. 320 see, e.g., editorial, gordon brown: labour's dilemma, the guardian, jun. 2, 2009, available at http://www.guardian.co.uk/commentisfree/2009/jun/02/editorial-gordon-brown-labour (last accessed oct. 8, 2011). 321 john kirton, from g7 to g20: capacity, leadership and normative diffusion in global financial governance (feb. 20, 2005) (unpublished manuscript), available at http://www.g8.utoronto.ca/ scholar/kirton2005/kirton_isa2005.pdf; see generally geoffrey garrett, g2 in g20: china, the united states and the world after the global financial crisis, 1 global pol’y 29 (2010) (discussing china’s entrance in the g20 and its place among world leaders). 322 richard woodward, from boom to doom to boom: offshore financial centres and development in small states 23–24 (july 5, 2011) (unpublished manuscript), available at http://ssrn.com/abstract=1879298 (last visited oct. 12, 2012). 323 interview 5 with oecd personnel, supra note 100. 324 the oecd claims that hong kong and macau do not meet the definitions of a tax haven. oecd, countering offshore tax evasion: some questions and answers on the project 12 (2009), available at http://www.oecd.org/ctp/exchangeofinformation/42469606.pdf (last visited oct. 12, 2012). 325 interview 5 with oecd personnel, supra note 100. as christians notes, the “g20 membership may appear broad and inclusive relative to the oecd, but its membership appears to be both overrepresentative of and tightly controlled by the ‘old’ powers that created it.” christians, supra note 4, at 31. 54 columbia journal of tax law [vol.4:1 when endorsing continued efforts for transparency and sanctions on tax havens. 326 however, allison christians persuasively argues that the g20’s role is primarily to “syndicate oecd policy positions under the new, more inclusive and representative label of g20-endorsed ‘internationally agreed tax standards.’”327 she notes in particular that the only formal commitment the g20 made was “‘to maintain the momentum in dealing with tax havens, money laundering,’ and other ‘non-cooperative jurisdictions.’”328 thus the role played by china in this instance may be the exception rather than the norm. the global forum set to work on new “transparency standards” for participating states, prohibiting secrecy and demanding information exchange “where it is ‘foreseeably relevant’ to the administration of domestic laws” of the treaty partner.329 the group published a new list of non-cooperative jurisdictions in 2009. while only costa rica, malaysia, the philippines, and uruguay were listed as not having made any commitments, 38 other jurisdictions that had committed to fulfilling the standard, but had not yet fully implemented it were listed in an intermediate “gray list.”330 by the fourth meeting of the global forum in october 2011, the organization could announce a membership of over 105 jurisdictions.331 even switzerland had declared in february 2011 that it would comply with all the global forum’s standards on full exchange of information.332 non-members are also to be reviewed, a process that began in june 2011 with an assessment of botswana and trinidad and tobago.333 by the g20 summit in november 2011, almost sixty peer-review reports on the transparency of different jurisdictions were to be published.334 in addition, the 1988 oecd convention on mutual administrative assistance in tax matters was amended with a new protocol in may 326 the g20 officially declared from the 2009 summit: “we stand ready to take agreed action against those jurisdictions which do not meet international standards in relation to tax transparency.” in its communiqué from the meeting on april 2, 2009, “the global plan for recovery and reform,” they announced that “we agree . . . to take action against non-cooperative jurisdictions, including tax havens. we stand ready to deploy sanctions to protect our public finances and financial systems. the era of banking secrecy is over.” their full support and readiness to take measures against tax havens have been echoed in later meetings since. oecd, the global forum on transparency and exchange of information for tax purposes 37 (2011), available at http://www.taxjustice.net/cms/upload/pdf/ oecd_global_forum_sep_12_peer_reviews.pdf (last accessed oct. 2, 2012). 327 christians, supra note 4, at 20. 328 id. at 22. she also notes the advantages the oecd’s structure gives it relative to the g20, including the permanent staff. id. at 31. 329 oecd, supra note 326, at 21. see also deneault, supra note 23, at 33 (“tax havens became opportune blind spots where different funds could be mingled and any representative of the public who ventured to investigate their origin could be confounded.”). 330see oecd, a progress report on the jurisdictions surveyed by the oecd global forum in implementing the internationally agreed tax standard (2009), available at http://www.oecd.org/tax/harmfultaxpractices/42497950.pdf (last visited oct. 12, 2012). 331 see oecd, the global forum on transparency and exchange of information for tax purpose: statement of outcomes 1 (2011), available at http://www.oecd.org/dataoecd/11/21/ 48929580.pdf (last accessed oct. 12, 2012). 332 see oecd, supra note 329, at 3. 333 id. at 15. 334 see id. at 16. in these, jurisdictions are assessed in two phases: “phase 1 reviews will include a determination of whether each element is ‘in place’, ‘in place, but certain aspects of the legal implementation of the element need improvement’, or ‘not in place’. phase 2 and combined reviews will include a rating as to whether the jurisdiction is ‘compliant’, ‘largely compliant’, ‘partially compliant’, or ‘not compliant’ with each of these elements in practice.” id. at 14. 2012] cartelizing taxes 55 2010335 to control the use of tax information exchange agreements. fifty countries have so far either signed the conventions or stated an intention to do so.336 the level of exchange is described as “full exchange of information on request in all tax matters without regard to a domestic tax interest requirement or bank secrecy for tax purposes.”337 under the 2009 criteria of the global forum, a jurisdiction had to have signed twelve bilateral agreements on information exchange (called tax information exchange agreements, or tieas) to be whitelisted,338 a somewhat meaningless numerical quota that encouraged agreements between some odd couple jurisdictions.339 although the oecd counted over six hundred such agreements signed since 2009,340 the new convention provided a new framework that goes further than simply encouraging tieas. because it is multilateral, jurisdictions do not negotiate over adapting the provisions to the particulars of their circumstances but can only alter their obligations by making reservations, which can be withdrawn later.341 moreover, as a country enters the convention, it enters an agreement with all prior signatories.342 the question that the economists of the league of nations struggled with in the 1920s may be approaching an answer: can a multilateral agreement on taxation be created? as we previously discussed, differences in tax codes make it inherently difficult to impose general rules for many countries that would serve as a tax treaty for all countries. the updated convention may be limited to issues of disclosure and transparency, but it is a large step towards reaching the goal of a tax agreement including all countries of the world. moreover, the oecd is in the process of creating new soft law standards that influence the discussion of tax issues by changing the legal framework within which those issues are discussed.343 335 see oecd & council of eur., protocol amending the convention on mutual administrative assistance in tax matters (2011), available at http://www.oecd.org/ctp/exchangeofinformation/48980598.pdf (last visited oct. 12, 2012). 336 oecd, global forum on tax transparency welcomes new members and reviews 12 countries (2012), available at http://www.oecd.org/tax/globalforumontaxtransparencywelcomes newmembersandreviews12countries.htm (last visited nov. 19, 2012) (“the convention was amended to open it to all countries, at the request of the g20, which is now encouraging jurisdictions to join . . . we look forward to wide-ranging accession to the convention, which will turn it into a truly global instrument for international co-operation in tax matters.”); see also oecd, ireland signs multilateral convention on mutual administrative assistance in tax matters (2011), available at http://www.taxmann.com/news.aspx?nid=6005 (last visited nov. 19, 2012). 337 oecd, the convention on mutual administrative assistance in tax matters – background (2010) available at http://www.oecd.org/tax/exchangeofinformation/ theconventiononmutualadministrativeassistanceintaxmatters-background.htm (last accessed oct. 12, 2012). 338 see oecd, supra note 329, at 25–26, 31. 339 the cayman islands’ agreement with the faroe islands seems an unlikely policy goal for enhancing international tax cooperation. see cayman islands fin. servs., cayman continues to demonstrate transparency (2010), available at http://www.caymanfinance.gov.ky/portal/page?_pageid=4081,7094057&_dad=portal&_schema=portal (last visited oct. 25, 2011). 340 see oecd, supra note 329, at 3. 341 see oecd & council of eur., the multilateral convention on mutual administrative assistance in tax matters 3 (2010), available at http://www.keepeek.com/digital-assetmanagement/oecd/taxation/the-multilateral-convention-on-mutual-administrative-assistance-in-taxmatters_9789264115606-en (last visited oct. 12, 2012). 342 see generally oecd, the convention on mutual administrative assistance in tax matters, a brief overview (2012), available at http://www.oecd.org/dataoecd/58/51/47690147.pdf (last visited sept. 18, 2012). 343 christians, supra note 5, at 114–16. 56 columbia journal of tax law [vol.4:1 five things stand out in this account. first, the oecd’s (and jeffrey owens’) entrepreneurial behavior in creating a role for the organization in a new area is an impressive example of how institutions can develop a life of their own. second, for the interests within the industrialized nations threatened by the increased competition for economic activity brought on by globalization, harmful tax competition offered a mechanism through which to enforce their preferences on jurisdictions unable to participate directly in the policymaking. third, ideas matter. the naked self-interest in harmful tax competition, as revealed by its clever definition of “harmful tax competition” that excluded the behavior of oecd members, were undercut by the ofc’s successful invocation of more coherent ideas in towards a level playing field. fourth, the forum matters. just as owens was able to use the g7 to outmaneuver opponents within the oecd, the ofcs were able to use the commonwealth secretariat and g20 to fight back. finally, china’s role will be critical in the future, in ways that might surprise those accustomed to think china only in the context of international debates over human rights, since china’s interests in international finance differ significantly from oecd members’ interests. v. cartelization and competition in this section we offer three alternative explanations for the oecd’s shift in its tax policy activities. we explore the history of this shift in the oecd’s role and sketch the institutional setting between the oecd and governments as well as within the oecd itself, to compare the alternative explanations. we call these (1) the public interest explanation; (2) the cartel explanation; and (3) the bureaucratic incentive explanation. a. the public interest explanation: the oecd is a benevolent organization dedicated to improving the world, staffed by publicly spirited individuals without personal stakes in the outcomes of its efforts, and funded and organized by governments that desire nothing more than to promote global economic cooperation and development. the shift of the oecd from promoting competition in the international economy to helping large economies limit competition in finance from smaller jurisdictions is an expression of its effort to develop “rules of the game” that ensure that financial competition promotes overall economic welfare. this is in line with the classical public finance models reviewed briefly in part ii. the oecd solves a prisoner’s dilemma between states by allowing them to sign a contract not to poach on each other’s mobile tax bases by lowering tax rates or favoring foreign businesses. without the oecd, all countries know that global welfare would be higher if only tax rates would be set at the optimal level, which would maximize the welfare of all people on earth. however, since every country will gain much for its own sake by lowering tax rates, a race to the bottom is inevitable without an international auditor, judge, and policy-maker. governments know that they should not cheat on others by lowering taxes. realizing that cooperation through the oecd creates more welfare for all, they are therefore happy to be “tied to the mast” and restrict competition. to some extent this is exactly the role the oecd played with respect to economic policies, using its country reports to hold member governments to their commitments to economic liberalization. b. the cartel explanation: the people in the governments that act on behalf of the oecd have their own incentives, and are at times well placed to pursue them. the oecd provides a forum in 2012] cartelizing taxes 57 which member governments can help establish “best practices,” which in many cases are a means to win political battles at home and influence domestic policies. thus, the oecd becomes a new arena for the political process and the struggle to win votes by gaining support for policies that interests favor. aware of the organization’s importance in this respect, interest groups do their best to influence politicians to act in the oecd arena and may also seek allies for international cooperation through the oecd. increasing tax competition poses many threats. tax bases are eroded, depriving domestic interests of the opportunities that large state coffers provide, while their status may be tarnished if they are forced to adjust domestic policies to the actions of small jurisdictions that should be their inferiors. politicians that fear losing control of their own tax base are faced with a choice. the new competition can be met by policies designed to meet the competition, offering a more welcoming environment for businesses and foreign investments and promoting the economic strength of their countries, whether it be a secure and stable environment or good legal institutions. alternatively, they can seek to limit the competition. the former is not only hard work but may expose a politician both as a weak global actor and as inconsistent ideologically. if the opportunity is provided, it may be better from a politician’s point of view to form a cartel on taxation as a protection. with a cartel, there are fewer constraints on domestic policy, improving the politicians’ welfare by increasing the degrees of freedom available to satisfy domestic constituents and win re-election. c. the bureaucratic explanation: focusing on the inner workings of organizations allows us to consider the incentives of the staff to expand their mission.344 this may be an expansion of the magnitude of the organization’s responsibilities in their area of expertise as well as the range of areas over which it has jurisdiction and the size of the bureaucracy in general.345 the incentive for the staff of such an organization is to explore opportunities to further broaden their roles by expanding the scope and scale of their unit, while maximizing the opportunities for their future careers. entrepreneurial minds within the staff will be active in this pursuit. they have the wits and opportunities to expand the resources at their disposal in search of prestige, power, and compensation. it may be hard for a bureaucracy itself to push for new policies to expand their mission. the best strategy is to offer policy-makers their services when it is most likely that their suggestions may gain hearing. the bureaucrats of the oecd would therefore not be immune from changes in the global economy and opinion climate towards tax harmonization. the bureaucratic explanation thus does not imply that the oecd bureaucrats are particularly vocal proponents of global strategies. with few exceptions, like jeffrey owens as the director of the oecd tax unit, bureaucrats are not in a position to personally engage in the debate. rather, they will address policy-makers when they see signs that their interests align, thus capturing the opportunities when they present themselves. 344 see william a. niskanen, bureaucracy and representative government (1971) (demonstrating how a bureaucracy can expand its services thanks to its special place in the economy); see also gordon tullock, the politics of bureaucracy (1965) (analyzing the incentive structures within a bureaucracy and the managerial dilemmas of a politician). 345 see, e.g., gordon tullock, supra note 344 (explaining the desire of a politician to have as many subordinates as possible). 58 columbia journal of tax law [vol.4:1 d. conclusion how well does each of these models fit the oecd’s behavior? any account of an organization’s actions that does not include the interests of the governments that fund the organization or the people who act within the organization would not be credible. we are therefore skeptical that the public interest explanation can stand alone. however, there is one key element from this model that is important to acknowledge. the oecd as an organization has, over time, promoted economic liberalization. in their economic surveys, the organization provides policy recommendations to countries, which traditionally have focused on increasing competition, work incentives and fiscal discipline. other recommendations include monetary reforms and promoting labor market flexibility.346 as the organization has generally been supportive of the opening of markets and the expansion of competition as a means for economic development, the oecd might be seen as a “tie me to the mast” effort by member states to assist them in resisting domestic political pressures to restrict the growth of markets. the tax-harmonization efforts appear on the surface to be similar—as with competition-expanding measures, there is an element of self-imposed restrictions being used to prevent defections. the similarity is only on the surface, however, as the tax harmonization efforts are primarily aimed at non-members—thus rather than “tie me to the mast,” they appear to be more “tie you to the mast.” the oecd developed from its founding as an arena for international agreements on taxation and the prominent body of experts on tax treaties. it gained prominence as its model tax convention came to serve as a blueprint for bilateral tax treaties, as countries tried their best to avoid double taxation between countries to prevent reductions in international business and economic growth. the project that the organization launched as part of its work on taxation and against harmful tax competition in the 1990s broke with the tradition of enhancing the global business climate to influence the national tax policies of non-compliant countries. those sympathizing with the oecd project against harmful tax competition hold that the oecd consists of self-sacrificing souls pursuing the global good; meanwhile, tax avoiders and tax planners are sinister misers draining the common resources by enjoying public goods while not contributing to them. critics of the oecd project may describe governments as evil socialists trying to quash small island jurisdiction, remorselessly draining them of their own income and forming the international tax cartel that they need to tax their own citizens as much as possible. we take the view that bureaucrats and politicians are neither more nor less sinister than anyone else, a view that allows us to analyze the incentives of the actors as rational. how did this mission creep come about? considering the bureaucratic and cartel explanations helps us understand the development of the oecd’s tax efforts. given the organization’s focus, the original mandate was to coordinate the north american funding of efforts to rebuild europe’s economies after the devastation of world war ii. as that goal was accomplished, the organization turned to expanding markets and reducing the transactions costs of doing business across members’ borders. this served as a winning strategy in national politics, while benefitting growth in a world that was becoming increasingly tied together. politicians could show that they were promoting trade and therefore prosperity by unilateral or bilateral commitments and treaties. others could use the oecd to make shared commitments. since the interest in reaping the benefits from 346 see bergh & dackehag, supra note 5, at 4. 2012] cartelizing taxes 59 global integration and trade was shared among most countries, interests groups seeking to further economic liberalization were able to coordinate with similar interests elsewhere. as people within leading european governments grew worried about the impact of unbridled “anglo-saxon capitalism” on their social systems, 347 they became more interested in seeking cooperation on issues of taxation and financial regulation. as international financial competition grew, these interests sought to use the existing structure that the oecd provided to coordinate measures to advance their agendas. the politically costlier and less attractive option, to alter domestic policies and institutions, were set aside in favor of inducing others to change by invoking international agreements and standards to restrain competition. national government delegates to the cfa are expected to pursue their nation’s interests. on the other hand, they are also driven by the incentives of prestige, salary, and a relatively conflict-free life.348 they are most likely to sympathize with the aim of limiting tax competition, as it disrupts existing arrangements. 349 further, for many delegates, the oecd is a possible future employer, offering rewarding and stimulating jobs in the secretariat for people who are familiar with the organization and have proven to be competent and on board with the project. these bodies may therefore be a channel for governments in which to pursue policies, but only if those policies are not too strongly in contradiction to the organization’s agenda over all, as their delegates are likely reluctant to confront the general agenda too sharply.350 national government delegates to the cfa are expected to pursue their nation’s interests. on the other hand, they are also driven by the incentives of prestige, salary, and a relatively conflict-free life.351 they are most likely to sympathize with the aim of limiting tax competition, as it disrupts existing arrangements. 352 further, for many delegates, the oecd is a possible future employer, offering rewarding and stimulating jobs in the secretariat for people who are familiar with the organization and have proven to be competent and on board with the project. these bodies may therefore be a channel for governments in which to pursue policies, but only if those policies are not too strongly in contradiction to the organization’s agenda over all, as their delegates are likely reluctant to confront the general agenda too sharply.353 347 see john thornhill, france reforms its anglo-saxon attitudes, financial times, sept. 22, 2008, available at http://www.ft.com/intl/cms/s/0/9e839a34-88c5-11dd-a179-0000779fd18c.html (“for many years french politicians poured scorn on ‘anglo-saxon’ capitalism.”). 348 even those delegates who are initially skeptical may find the work most rewarding and in line with their governments interest if they can justify the project to themselves. 349 see j.r. hicks, annual survey of economic theory: the theory of monopoly, 3 econometrica 1, 8 (1935) (“the best of all monopoly profits is a quiet life.”). 350 the delegates are somewhat constrained by politics of their home country. they would not like to be seen as giving up too much sovereignty or working to a large extent against the political program of the politicians that may be appointing them. bruno s. frey & beat gygi, international organizations from the constitutional pint of view, in the political economy of international organizations: a public choice approach 58, 66 (ronald vaubel & thomas d. willett eds., 1991). 351 even those delegates who are initially skeptical may find the work most rewarding and in line with their governments interest if they can justify the project to themselves. 352 see j.r. hicks, annual survey of economic theory: the theory of monopoly, 3 econometrica 1, 8 (1935) (“the best of all monopoly profits is a quiet life.”). 353 the delegates are somewhat constrained by politics of their home country. they would not like to be seen as giving up too much sovereignty or working to a large extent against the political program of the politicians that may be appointing them. bruno s. frey & beat gygi, international organizations from the 60 columbia journal of tax law [vol.4:1 disentangling the complex social networks that are in the background of forming tax policy within the oecd is, if possible at all, not a goal of this paper.354 rather the question we set out to ask was why the oecd made its shift toward establishing substantive standards and coercing non-member states. in other words, the question is why politicians trying to promote certain policies pursue cooperation through the oecd. it is rational for them to tie themselves to the mast and lose some freedom of action as long as they gain on other fronts. an international relations explanation of the willingness of political leaders to cooperate is that they gain more national sovereignty than they lose through such cooperation.355 in a world of mobile capital and people, where territorial borders become porous under the pressure of globalization and falling transactions costs, de jure sovereignty means less in terms of de facto sovereign power than it did fifty years ago.356 taxation policy is one such power. where international organizations offer them a better position to obtain their goals, promoting certain policies through these organizations may in the end yield the results that interest groups desire more effectively than doing so through domestic means. here it becomes important to ask to which international organization they turn, for all such bodies are not equal in terms of serving an interest group’s agenda. our account supports an important role for the bureaucratic explanation as well. while tax experts within the oecd were well established to claim global prominence in technical tax issues, expanding into broader issues on taxation such as tax competition allowed for more responsibilities and funding. the oecd staff enjoys excellent jobs for academics, with high salaries and benefits. the organization offers enjoyable work, opportunities to participate in important international venues while obtaining the merit of having held a prestigious appointment at one of the world’s top organizations. international bureaucrats are generally portrayed as impartial concerning the policies of their home country government. if those bureaucrats have a background of serving their country on tax matters, they may have a bias in favor of their home country that will reflect on their work. if they in addition perceive a possibility for future employment for their home governments, this would further increase their incentive not to work against the policies of their home country and risk losing out on future appointments at home.357 constitutional pint of view, in the political economy of international organizations: a public choice approach 58, 66 (ronald vaubel & thomas d. willett eds., 1991). 354 id. at 20–22 (describing in detail the connections between oecd entities and stressing that disentangling them and understanding how tax policy is formed is virtually impossible for an outside observer). 355 christians, supra note 5; ronen palan, tax havens and the commercialization of state sovereignty, 56 int’l org. 151 (2002) (discussing the issue of sovereignty in the context of taxation); diane m. ring, what's at stake in the sovereignty debate?: international tax and the nation-state (boston college law school faculty papers, paper. no. 219, 2008) (sovereignty and taxation). 356 see christians, networks, supra note 72, at 104–14. 357 a former ctpa official pointed out that one does not sit secure on the job at the oecd, especially not when involved in such volatile and insecure projects as those on harmful tax competition. interview 5 with oecd personnel, supra note 100. the work of the cfa is supported by the centre for tax policy and administration (ctpa), which since 2001 has been a separate directorate within the oecd secretariat. the oecd council is formally the body with decision-making power, where decisions are made by consensus. oecd, who does what, http://www.oecd.org/pages/ 0,3417,en_36734052_36761791_1_1_1_1_1,00.html (last visited oct. 3, 2011). it consists of high-level diplomats, representing their own countries. 2012] cartelizing taxes 61 the ctpa provides a possible explanation of the oecd project from the bureaucratic point of view. both the director and the ctpa staff can be entrepreneurial by looking for new possibilities to expand the ctpa’s mandate. the political discussion in any member country can open such windows of opportunity. thus if a politician shows interest in fighting tax evasion, the oecd may step in and offer its services.358 if a country finds national regulations to fight tax evasion and avoidance inadequate, the oecd staff has arguments for why dealing with the issue through the oecd is a good idea. whatever the problem may be, international cooperation, they can argue, is needed to deal with it constructively. before taking any steps on the issue, the proper measures must be carefully considered. this requires expertise and experience, and this is precisely what the oecd has to offer, along with trips to paris.359 if a politician has already suggested a willingness to pursue a goal and oecd representatives announce themselves ready to work on the issue, a natural alliance emerges. the person with the biggest incentive to expand and drive a project forward is its leader. the founding ctpa director jeffrey owens is arguably the person who has been the driving force behind the project on harmful tax competition. beside professional expertise and experience,360 owens is a highly skilled negotiator and lobbyist and a brilliant policy entrepreneur. without him, the ctpa would have been unlikely to become its own directorate in 2001. not only did he have the personal motivation based on salary, prestige, and position, but he has also proven keen on stepping into the spotlight to take credit for these successes.361 the ctpa staff also has incentives to help expand their portion of the organization. with more tasks and more people needed in the office, there may be better chances for promotion. moving up from an “economist” to a “senior economist,” for instance, means a rise in pay from €5,254 to €7,534 per month (not including allowances for family, children and other allowances).362 staff also has an incentive to accomplish changes, to be an active part in various projects and to develop new ones. if members of the ctpa staff are not counting on, or even pursuing, longer term oecd employment, they may rather seek projects which they can lead or in other ways make a mark while working on them while at the oecd, than to merely do what is required from them to stay at the office. 358 interview 3 with oecd personnel, supra note 100. 359 interview 3 with oecd personnel, supra note 100. 360 owens earned his doctorate from cambridge in 1973 and has 30 years of experience as an international civil servant. oecd, jeffrey owens, director centre for tax policy and administration, http://www.oecd.org/document/10/0,3746,en_2649_34897_39363018_1_1_1_1,00.html (last visited oct. 3, 2011). 361 interview 5 with oecd personnel, supra note 100. owens also had some experienced tax experts working with the project. as it became clear to his colleagues that owens would not let his staff take the credit for the work that they believed that they deserved, some of them would end up leaving the project. id. 362 see oecd, salaries and benefits, http://www.oecd.org/document/30/0,3746,en_21571361_45609340_40803550_1_1_1_1,00.html (last visited oct. 3, 2011). salaries and allowances are tax-free for all except for oecd officials who are liable to pay income tax in the united states. id. a large share of the secretariat are seconded, and as many as seventy to eighty percent have time-limited employments in the oecd. trondal, marcussen & veggeland, supra note error! bookmark not defined., at 12. there are some bureaucrats within the oecd who stay there for decades but these are not representative of the majority of the secretariat’s bureaucracy. even short-timers have a motive to support innovations, however. 62 columbia journal of tax law [vol.4:1 this is not to say that all arguments for and against tax competition are solely tools for obtaining personal wealth, status, and fame. politicians and bureaucrats maintain ideas of what rules and principles make the world a better place and may act based on those beliefs regardless of their personal incentives. the ctpa staff would more likely than not believe that tax competition actually is harmful as they define it.363 it would remain more pleasant to pursue goals one approved of if that pursuit also resulted in personal benefits, however. the bureaucratic explanation of the changes in oecd tax policy thus adds value as well. what larger lessons might we draw from the oecd’s mission creep from technical expertise used to reduce friction in trade among its members to efforts to coerce substantive changes in non-members’ tax laws? first, the force behind this change in oecd policy seems to be that of political national agendas and international bureaucrats in tandem. the project against harmful tax competition had its ups and downs. it has been pursued and opposed at different times by some of the world’s most influential governments. the director and staff of the ctpa innovated and met a previously unmet demand by actively seeking new opportunities to expand and pursue their project. a resource grew in value and, unsurprisingly in retrospect, interests sought to capture that value by directing the resource toward their own goals. the oecd cannot act without support from its members, but the organization makes it easier for interests within the membership to form an effective cartel. reducing the autonomy of an organization’s staff and requiring unanimous votes to approve new initiatives are ways to limit mission creep. second, the choice of forum makes a difference. shifting the debate to the oecd and g7 made it easier for the high tax interests to shape the debate; invoking the commonwealth secretariat and g20 made it harder for them to do so. engaging in “fundamental restructuring” of international tax policymaking to ensure “developing countries [have] meaningful input in the crucial idea and agenda stages of tax policy development”364 is critical. paying attention to how and where issues are debated is thus important. finally, and somewhat ironically, what the oecd’s expansion of its mission on tax issues primarily suggests is that developing international law standards for evaluating when an organization is experiencing mission creep may be necessary. the most objectionable feature of the oecd’s expansion of its mission was its effort to impose its standards on jurisdictions that had no voice in the creation of those standards through the blacklist. to the extent that the oecd is “assert[ing] its legitimacy in guiding both taxpayers and tax administrations on grounds that its guidance represents international consensus,”365 it should be pressured to cede that claim to an organization with a more representative membership. moreover, the radical nature of the shift in conceptualizations of sovereignty implicit within the oecd’s formulation of tax law standards366 deserves full and open debate. among other things, the approach to tax treaties favored by the united states disadvantages developing countries by placing the heaviest burden of foregone revenue on source countries while refusing to make 363 it would be difficult for any person to perform a task contrary to one’s belief, so those believing in tax competition are likely to seek alternative employment either with the oecd or elsewhere. 364 christians, supra note 4, at 39. 365 christians, how nations share, supra note 12, at 1448. 366 christians, supra note 5, at 127-129. 2012] cartelizing taxes 63 compensating concessions through a tax credit.367 this seems to us to be an area in which real international standards could play a role. as christians notes, the oecd’s position seems designed to avoid “more difficult conversations about fundamental tax reform, especially in the context of countries with vastly different resources.”368 moreover, the opaque nature of much of the substantive content of international tax law rulings makes the “obscuring [of] public observation of international tax law as it develops” particularly inappropriate.369 the oecd has evolved into a convenient vehicle for many policies. the organization offers an arena for networking and informal opportunities for changing sentiments without media scrutiny. it is also convenient for having developed an image as a benign organization of technocrats not under the political influences that many of their peers in other organizations are. the oecd is clean and rich. as long as politicians show a willingness to pursue policies through the oecd, the people of the organization will seek to expand the mission of the organization and form it to an even more attractive arena for making policies. there is thus little to suggest that there will not be more efforts to harmonize previously national policies on a global scale, through recommendations, blacklists, and sanctions. furthermore, there is every reason to believe that the proliferation of new international networking opportunities will be developed. the continuing fight against harmful tax competition serves as a good example of how politicians’ pursuit of their interests can be enhanced by the willingness of an international organization to take on more tasks. considering issues now exploding into public consciousness like public pensions, healthcare funding, and the environment, there are more potential areas in which politicians will find useful the role of international organizations. perhaps the oecd itself will be there to help. 367 tax treaties, supra note 14, at 66 (describing how the u.s. approach to tax treaties harms developing countries). 368 christians, supra note 4, at 28. 369 christians, how nations share, supra note 12, at 1412. christians made the point in the context of debates over wealth distribution but we think it applies more broadly. elsewhere she also notes that tax authorities have chosen to keep the process by which international tax soft law evolves “obscure, not wellunderstood, unaccountable to those other than the competent authorities themselves, and rife with administrative and procedural issues.” id. at 1435. 64 columbia journal of tax law [vol.4:1 appendix i list of acronyms biac business and industry advisory committee to the oecd bvi british virgin islands cfa committee on fiscal affairs ctpa centre for tax policy and administration ems european monetary system fatf financial action task force fco foreign and colonial office g7/8/20 group of 7/8/20 oecd organisation for economic co-operation and development oeec organisation for european economic co-operation ofc offshore financial center ptr preferential tax regime u.s. united states un united nations microsoft word oeiring8-1.docx the tax lives of uber drivers: evidence from internet discussion forums shu-yi oei* & diane m. ring† abstract in this article, we investigate the tax issues and challenges facing uber and lyft drivers by studying their online interactions in three internet discussion forums: reddit.com, uberpeople.net, and intuit turbotax answerxchange. using descriptive statistics and content analysis, we examine (1) the substantive tax concerns facing forum participants, (2) how taxes affect their driving and profitability decisions, and (3) the degree of user sophistication, accuracy of legal advising, and other cultural features of the forums. we find that while forum participants displayed generally accurate understandings of tax filing and income inclusion obligations, their approaches to expenses and deductions were less accurate and more varied in sophistication and willingness to comply with tax law. forum participants also frequently discussed whether driving was profitable and exhibited a range of awareness concerning how taxes affected profitability. finally, while the forums contained a surprising degree of sophisticated and accurate tax and legal advice, they also contained many examples of inaccurate or confusing information. it is thus uncertain whether forum readers were able to successfully distinguish between accurate and inaccurate advice dispensed in the forums. based on our findings, we make tentative recommendations for effective tax administration in the ridesharing and related sectors, including use of industry-specific guidance, clarification of how existing tax rules apply to ridesharing, and guidance on form 1099-k interpretation. we analyze the implications of our findings regarding taxes and profitability for uber’s business model and its potential regulation. finally, we discuss the possible impacts of targeted tax compliance initiatives on internet communities. * hoffman f. fuller professor of law, tulane law school. † professor of law & the dr. thomas f. carney distinguished scholar, boston college law school. we are grateful to the participants of the university of virginia invitational tax conference, the duke law school tax policy workshop, the indiana university maurer school of law tax policy colloquium, the georgetown university law center tax law and public finance workshop, the brooklyn law school faculty workshop, the pepperdine school of law tax policy workshop, the uc irvine school of law tax policy colloquium, the southwestern law school faculty colloquium, the tulane tax roundtable, and the 2015 national tax association annual conference for helpful comments on this article. our particular thanks to james alm, jake brooks, paul caron, allison christians, steven dean, michael doran, lilian faulhaber, adam feibelman, pamela foohey, brian galle, david gamage, sara greene, itai grinberg, andrew hayashi, kimberly krawiec, rebecca kysar, sarah lawsky, leandra lederman, ann lipton, omri marian, ruth mason, jacob nussim, leigh osofsky, mildred robinson, adam rosenzweig, emily satterthwaite, darien shanske, stephen shay, david walker, ethan yale, george yin, and lawrence zelenak for their feedback on drafts. the authors would like to thank alice huang and kyle liftin for excellent research assistance, and would also like to thank the dr. thomas f. carney ’47 gift fund at boston college law school for its generous support. i. introduction ...................................................................................................... 58 ii. understanding the ridesharing sector: background and research questions ........................................................................................ 61 a. background: on-demand ridesharing services ................................................. 61 1. business model .............................................................................................. 61 2. tax and related issues .................................................................................. 64 b. research questions .............................................................................................. 65 iii. the study of internet forums: research methodology ........... 66 a. the study of internet discussion forums: possibilities and limitations ............ 66 b. selection of internet forums for study: reddit, uberpeople, and turbotax ..... 68 1. reddit ............................................................................................................ 68 2. uberpeople .................................................................................................... 69 3. turbotax ....................................................................................................... 70 c. selection of tax-related discussion threads for analysis ................................ 70 1. reddit ............................................................................................................ 70 2. uberpeople .................................................................................................... 71 3. turbotax intuit ............................................................................................... 71 d. coding of discussion threads ............................................................................. 71 iv. the tax lives of uber drivers: describing the data .................... 72 a. reddit ................................................................................................................... 72 b. uberpeople ........................................................................................................... 74 c. turbotax intuit .................................................................................................... 76 v. the tax lives of uber drivers: content analysis of data ....... 76 a. tax issues confronting ridesharing drivers ....................................................... 77 1. determining business mileage and deductibility of expenses ..................... 78 2. choice of method: standard mileage vs. actual expenses .......................... 84 3. documentation .............................................................................................. 85 4. issues surrounding form 1099-k receipt .................................................... 86 5. worker classification issues ......................................................................... 87 6. tax preparation issues .................................................................................. 88 b. role of taxes in decision making ...................................................................... 90 1. the decision to drive ................................................................................... 90 2. decisions on how to drive ........................................................................... 96 3. summary ........................................................................................................ 98 c. tax sophistication and tax compliance culture ................................................ 98 1. overall level of sophistication ..................................................................... 98 2. process of error correction and disapproval ............................................. 99 3. accuracy of tax advising and commentary on the forums ....................... 101 4. “marketed” tax advice in the discussion forums .................................... 103 vi. analysis and recommendations: compliance, money, and community in the internet forums ..................................................... 105 a. compliance ........................................................................................................ 105 b. money and profit ............................................................................................... 107 c. community ........................................................................................................ 108 vii. conclusion .................................................................................................... 110 58 columbia journal of tax law [vol.8:56 i. introduction the past few years have seen the meteoric rise of uber technologies inc. (uber), a company that allows consumers to request rides from registered peer drivers using the uber app. from its beginnings in san francisco in 2009, uber has grown to become one of the most highly valued startups in the world.1 according to one study, more than 460,000 drivers were “actively partnering” with uber in the united states as of the end of 2015.2 as of june 18, 2016, uber had provided two billion rides worldwide.3 uber, of course, is simply the most prominent example of a new model of production and consumption of goods and services often referred to as “sharing,” “collaborative consumption,” or “peer-to-peer consumption.” by employing internet and mobile phone platforms that reduce transaction costs, this model enables individuals to easily offer and enjoy goods and services—anything from homes and rides to bathrooms, wi-fi, and even kittens.4 as peer-to-peer consumption has proliferated, academics and policymakers have begun to tackle the legal and regulatory questions that it raises.5 an issue of increasing importance is the impact of the peer-to-peer economy on the lives of those providing goods and services via these platforms. there is some evidence that this new economy has affected the nature of work and has resulted in the 1 uber’s founding, uber, http://newsroom.uber.com/ubers-founding/ [http://perma.cc/l38cv3en]. 2 jonathan v. hall & alan b. krueger, an analysis of the labor market for uber’s driverpartners in the united states (nber working paper no. 22843), http://www.nber.org/papers/w22843 [http://perma.cc/3pu6-jc62]. “actively partnering” is defined as the provision of at least four trips via uberx or uberblack to passengers in a given month. id. at 2, 6 n.7. according to the study, the rate of growth in drivers signing up to drive is rising exponentially. id. at 2. 3 heather somerville, uber reaches 2 billion rides six months after hitting its first billion, reuters (july 18, 2016, 11:06 am), http://www.reuters.com/article/us-uber-rides-iduskcn0zy1t8 [http://perma.cc/mve3-6peb]. 4 see, e.g., airpnp, facebook, http://www.facebook.com/weallpee/ [http://perma.cc/mf3f-qxq7] (last visited sept. 24, 2016) (toilet sharing); airbnb, http://www.airbnb.com/ [http://perma.cc/33dp-yhf7] (last visited sept. 24, 2016) (home sharing); fon, http://corp.fon.com/en [http://perma.cc/bs63-mjde] (last visited sept. 24, 2016) (wi-fi sharing); sarah haydu, clear your calendars—#uberkittens are back, uber, http://newsroom.uber.com/uberkittens-are-back/ [http://perma.cc/4uky-zks3] (last visited sept. 24, 2016) (kittens). 5 see, e.g., jordan m. barry & paul l. caron, tax regulation, transportation innovation, and the sharing economy, 81 chi. l. rev. dialogue 69 (2015); christopher koopman et al, the sharing economy and consumer protection regulation: the case for policy change, 8 j. bus., entrepreneurship & l. 529 (2015); stephen miller, first principles for regulating the sharing economy (feb. 20, 2015), 53 harv. j. of legis. (forthcoming 2016); stephen miller, transferable sharing rights: a theoretical model for regulating airbnb and the short-term rental market (oct. 24, 2014) (unpublished manuscript), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2514178 [http://perma.cc/c9h4-x6n2]; shu-yi oei & diane m. ring, can sharing be taxed?, 93 wash. u. l. rev. 989 (2016); sofia ranchordas, does sharing mean caring? regulating innovation in the sharing economy, 16 minn. j.l. sci. & tech. 413 (2015); sofia ranchordas, innovation-friendly regulation: the sunset of regulation, the sunrise of innovation, 55 jurimetrics 201 (2015); daniel e. rauch & david schleicher, like uber, but for local government policy: the future of local regulation of the ‘sharing economy,’ 76 ohio st. l.j. 901 (2015); kellen zale, sharing property, 87 u. colo. l. rev. 501 (2016); brishen rogers, the social costs of uber, 82 u. chi. l. rev. dialogue 85 (2015); abbey steimer, betwix and between: regulating the sharing economy (ind. univ. kelley sch. of bus. research paper no. 15-6, 2014), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2535656 [http://perma.cc/2uyh-nhmh]. 2017] the tax lives of uber drivers 59 expansion of independent contractor jobs. 6 commentators refer to the rise of work through these platforms as the “1099 economy,” “independent contractor economy,” or “gig economy.”7 academics, courts, regulators, and commentators are just now focusing on the legal issues confronting 1099 economy workers. 8 for example, courts and tribunals are struggling with the question of whether ridesharing drivers should be classified as employees or independent contractors for purposes of labor and tax law.9 in this article, we contribute to the growing legal literature on 1099 or gig economy workers by studying the ways in which uber and lyft, inc. (lyft) drivers navigate the tax system.10 we investigate the tax issues and challenges faced by these drivers by examining the discussions and interactions that take place among drivers and other participants in three internet discussion forums: uberpeople.net, the uberdrivers subreddit on reddit.com, and the intuit turbotax answerxchange forum. internet discussion forums can provide a timely picture of the tax and related issues that concern ridesharing drivers, particularly in an environment where drivers are learning how to navigate an emerging sector and where there may be a lag in obtaining tax return and other data.11 the anonymous nature of these forums may cause forum participants to be more forthright than they might be in surveys or in-person interviews. substantive tax issues aside, online discussion forums are also interesting as a socio-legal phenomenon themselves. 12 for example, they can serve as primary source evidence of how the 6 see, e.g., eli dourado & christopher koopman, evaluating the growth of the 1099 workforce mercantus ctr., george mason u. (2015), http://www.mercatus.org/system/files/evaluating-growth1099_dourado_mop_v2.pdf [http://perma.cc/5v3z-w35r]; ian hathaway, the gig economy is real if you know where to look, harv. bus. rev. (2015), http://hbr.org/2015/08/the-gig-economy-is-real-if-you-knowwhere-to-look [http://perma.cc/gnf4-wyzp]; justin fox, the mystery of the multiple jobholder, bloomberg view (june 26, 2015), http://www.bloombergview.com/articles/2015-06-26/the-mystery-of-themultiple-jobholder [http://perma.cc/qq6d-dr7s]. 7 “sharing economy” is the term most commonly used, but does not capture the commercial nature of the exchange. the same applies to the term “collaborative consumption.” alternative terms such as “1099 economy” or “gig economy” have been urged as replacements, but no single usage has prevailed. this article generally uses the terms “1099 economy” and “gig economy” to describe the sector. 8 see, e.g., brishen rogers, employment as a legal concept (temple univ. leg. stud. research paper no. 2015-33), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2641305 [http://perma.cc/nbu3-9ffr]; see also the 2015 1099 economy workforce report (may 20, 2015). 9 cotter v. lyft, inc., 176 f. supp. 3d 930 (n.d. cal. 2016) (for full docket see docket no. 3:13cv-04065); o’connor v. uber technologies, inc., 58 f. supp. 3d 989 (n.d. cal. 2014) (for full docket see docket no. 3:13-cv-03826); berwick v. uber technologies, inc., cal. superior ct. no. 15-546378 (nov. 22, 2016) (order of dismissal with prejudice following parties’ settlement) available at http://query.sftc.org/minds_asp_pdf/viewer/downloaddocument.asp?pgcnt=0; alatraqchi v. uber technologies, inc., case no. a142059 (cal. ct. app. 2014) (dismissed plaintiff appeal on june 27, 2014; for full docket see http://appellatecases.courtinfo.ca.gov/search/case/dockets.cfm?dist=1&doc_id=2079405&doc_no=a142059 [http://perma.cc/j794-rtfv]). for fedex and taxicab litigations, see slayman v. fedex, inc., 765 f.3d 1033, 1042-1046 (9th cir. 2014); sebago v. boston cab dispatch, inc., 471 mass. 321, 327-328 (mass. 2015). 10 for an interview and survey-based study, see caroline bruckner, shortchanged: the tax compliance challenges of small business operators driving the on-demand platform economy (kogod tax pol’y ctr., american univ. 2016) available at http://www.american.edu/kogod/news/upload/shortchanged-caroline-bruckner-kogod-au.pdf [http://perma.cc/q6m3-es8b]. 11 see generally tom perez, innovation and the contingent workforce, u.s. dep’t of labor blog (jan. 25, 2016), http://blog.dol.gov/2016/01/25/innovation-and-the-contingent-workforce/ [http://perma.cc/pr6w-dfqc] (bureau of labor statistics and census bureau plans to study contingent workforce as part of may 2017 current population survey). 12 see sources cited infra note 53. 60 columbia journal of tax law [vol.8:56 process of seeking and giving tax advice functions on an internet discussion board. we selected all tax-related discussions from each of these internet forums using a search methodology tailored to each forum. we then studied this self-assembled dataset using a combination of descriptive statistics and qualitative content analysis, focusing on three key research questions: (1) the main substantive tax issues and questions discussed by forum participants, (2) the ways taxes factor into forum participants’ analyses of profitability and their decisions to drive for ridesharing platforms, and (3) the dominant cultural attitudes displayed by forum participants, including their levels of sophistication, attitudes towards compliance and risk taking, and how they expressed disagreement and corrected each other’s errors. we find that forum participants displayed generally accurate understandings regarding tax filing and income inclusion obligations. however, their approaches to expenses and deductions (particularly mileage calculations, expenses on the businesspersonal borderline, and documentation) were less accurate and more varied in sophistication and willingness to comply with tax law. forum participants also engaged in frequent discussions about whether driving was ultimately profitable and exhibited a range of awareness of how taxes affected their bottom-line profitability. they used metrics developed by tax law (in particular, the irs standard mileage rate) as rough proxies in estimating other expenses of driving. tax burdens also played a role in shaping the broad online consensus that it was preferable to drive part time rather than full time. finally, while the forums contained a surprising degree of sophisticated and accurate tax advice (including tax advice marketed by forum users claiming to be experts and professionals), they also contained many examples of inaccurate, confusing, or misleading statements about tax law. it is thus uncertain whether forum readers and participants are able to successfully distinguish between accurate and inaccurate advice dispensed on the discussion boards. based on our findings, we make three sets of recommendations and observations. first, we make suggestions for effective tax administration in the on-demand ridesharing and related sectors.13 the conversations we observed suggest that industry-specific irs guidance, irs guidance regarding which technologies and applications may be used to document mileage and other expense deductions, and irs clarification with respect to form 1099-k issuance and interpretation are fairly simple and uncontroversial steps that might help alleviate confusion and tax compliance burdens for drivers and other 1099 economy workers. the irs recently took steps in this direction through the launch of an online “sharing economy tax center,” and more could be done in a similar vein.14 second, we analyze the implications of our findings regarding how forum participants assess driver profitability (and the role played by taxes in making this determination) for uber’s business model and for potential regulation of ridesharing.15 finally, we discuss the role played by internet forums in facilitating learning about tax law and in disseminating legal information. we evaluate the promise and perils of intervening in or using internet forums to advance tax administration goals.16 for example, we consider how interventions in internet communities may have unintended impacts on the culture of such communities. while our insights and recommendations largely focus on the on 13 see discussion infra part vi.a. 14sharing economy tax center, internal revenue service, http://www.irs.gov/businesses/smallbusinesses-self-employed/sharing-economy-tax-center [http://perma.cc/ngu7-dbsf]. 15 see discussion infra part vi.b. 16 see discussion infra part vi.c. 2017] the tax lives of uber drivers 61 demand ridesharing sector, many of these observations may be extrapolated to other parts of the sharing economy as well. this article is the first in the legal literature to systematically mine internet discussion forums for detailed insights into how individuals learn about, interact with, and shape legal systems through online channels.17 it is also the first qualitative content analysis of online interactions among sharing economy workers as they grapple with questions of tax law in an emerging sector. by thickly describing how tax law plays out “in action” on internet discussion boards, our study opens a window into how ridesharing drivers and other 1099 workers interact and cope with complex tax and related regulatory regimes.18 this is particularly valuable because key decisions are being made about the legal and regulatory fate of such workers based on assumptions about worker preferences and their experiences with gig work, but these assumptions for the most part remain uninvestigated. by illuminating the ways in which these small-scale gig workers talk about, engage with, and confront the tax system, this article contributes significantly to our understanding of the realities of 1099 economy work. in part ii, we describe on-demand ridesharing and state our research questions. in part iii, we detail our research methodology, including how we chose the internet forums for analysis, how we selected discussion threads, and how we coded and analyzed the data. in parts iv and v, we present and analyze our findings. in part vi, we discuss the implications of our findings for tax administration, uber’s business model, and regulation of ridesharing. we also examine the potential impacts of targeted tax compliance initiatives on internet communities and other design considerations. ii. understanding the ridesharing sector: background and research questions in this part, we describe the basic characteristics of the ridesharing sector and the major tax questions that impact this sector. we then describe our research questions. a. background: on-demand ridesharing services 1. business model the on-demand ridesharing sector involves the hailing of a vehicle for hire using a smartphone mobile app that relies on gps technology to facilitate the pickup and ride. uber is widely acknowledged as the market leader in this sector. 19 the service is 17 for a non-legal, sociological study of sharing economy labor that investigates online forums, see alex rosenblat & luke stark, uber’s drivers: information asymmetries and control in dynamic work (oct. 15, 2015) (unpublished manuscript), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2686227 [http://perma.cc/q6d6-grvk]. for an example of tax scholarship citing internet discussions for anecdotal evidence of tax compliance behaviors, see bridget crawford, taxing surrogacy, in challenging gender inequality in fiscal policy making: comparative research on taxation, at 95-108 (asa gunnarson et al., eds. 2011); see also jeffrey hoopes et al., taxpayer search for information: implications for rational attention, 7 am. econ. j. 177 (2015). for examples of scholarship in other fields, see sources cited infra note 53. 18 see generally roscoe pound, law in books and law in action, 44 am. l. rev. 12 (1910). 19 uber, http://www.uber.com/ [http://perma.cc/9w8z-593g] (last visited nov. 20, 2016); erin griffith, uber v. lyft: the credit cards don’t lie, fortune (sept. 11, 2014, 9:00 am), http://fortune.com/2014/09/11/uber-vs-lyft-the-credit-cards-dont-lie/ [http://perma.cc/ruz7-wy93]. 62 columbia journal of tax law [vol.8:56 currently available in almost 200 u.s. cities and over 70 foreign countries.20 uber’s basic business model involves partnering with local owners of licensed private car companies and with individuals driving their own personal vehicles.21 uber does not own the cars, and the drivers themselves decide whether and when to open the mobile application and accept ride requests from customers.22 drivers are responsible for their own expenses including gas, equipment maintenance, and repairs.23 uber does, however, set fares, based in part on the level of service provided. uberx is uber’s best-known service and allows drivers to use their personal vehicles to offer rides to customers at fares often significantly lower than taxi fares for comparable trips.24 to apply to become an uberx driver all that is required is a driver’s license, a car that satisfies uber’s requirements, proper insurance, and clearing a dmv and background check.25 uber also offers other ride services in certain markets: uberblack is a traditional “black car” service that resembles limousine services. in many u.s. cities, uber riders also have the option of uberlux, a luxury car service; ubersuv, a full-sized luxury suv; ubertaxi, a licensed taxicab; uberxl, a non-luxury suv; and uberpool, a reduced-fare pooled ride service.26 a distinctive characteristic of uber’s fare structure is its use of variable pricing levels, depending on demand.27 under such dynamic or “surge” pricing, changes in fare price are determined algorithmically when wait times increase and unfulfilled requests start to rise. these fare increases may occur because of a demand surge during high traffic times or because of special conditions such as a holiday or inclement weather.28 at the time of our study, uber told customers that its fares included an automatic 20% tip and that there is no need for an additional tip; but it now states that the bill does not include a tip and that tipping is voluntary.29 in exchange for creating and providing the app-based marketplace for rides, uber 20 see uberestimator, cities, http://uberestimator.com/cities [http://perma.cc/qj5f-f5uk] (last visited nov. 20, 2016); uber, supra note 19. 21 how does uber work?, uber, http://help.uber.com/h/738d1ff7-5fe0-4383-b34c-4a2480efd71e [http://perma.cc/u7dl-d46l] (last visited sept. 24, 2016). 22 id. 23 id. 24 see alex wilhem, in another strike against the competition, uber lowers uberx prices in san diego, la, and dc, tech crunch (oct. 3, 2013), http://techcrunch.com/2013/10/03/in-another-strikeagainst-the-competition-uber-lowers-uberx-prices-in-san-diego-la-and-dc/ [http://perma.cc/c4kb-t7dc]. 25 uber, http://newsroom.uber.com/drive-with-uber-earn-cash-with-your-car-6/ [http://perma.cc/k35w-mlws] (last visited nov. 20, 2016). 26 see generally uber, supra note 19. 27 what is surge?, uber, http://help.uber.com/h/e9375d5e-917b-4bc5-8142-23b89a440eec [http://perma.cc/6wfq-uzey] (last visited dec. 22, 2016). 28 see nicholas diakopoulos, how uber surge pricing really works, wash. post (apr. 17, 2015), http://www.washingtonpost.com/news/wonkblog/wp/2015/04/17/how-uber-surge-pricing-really-works/ [http://perma.cc/f7df-w554]. 29 uber, http://help.uber.com/h/f7385bf5-1748-4fd0-a57f-3d9b62facc45 [http://perma.cc/5ef2m6g8]; jay barmann, now uber drivers want you to tip, sfist (feb. 2. 2015), http://sfist.com/2015/02/17/now_uber_drivers_want_you_to_tip.php [http://perma.cc/w8r6-7rfl]. this tip policy has created some dissatisfaction among drivers, leading to litigation. see cotter v. lyft, inc., 176 f. supp. 3d 930 (n.d. cal. 2013) (for full docket, see docket no. 3:13-cv-04065); o’connor v. uber technologies, inc., 58 f. supp. 3d 989 (n.d. cal. 2014) (for full docket, see docket no. 3:13-cv-03826); maya kosoff, uber's drivers say they don't get any tip money from all-inclusive fares — and they're furious, bus. insider (sept. 7, 2014 at 3:09pm), http://www.businessinsider.com/ubers-drivers-say-theydont-get-any-tip-money-from-all-inclusive-fares-2014-9 [http://perma.cc/ld33-upw9]. 2017] the tax lives of uber drivers 63 takes a portion of the gross fares (typically 20%, though this varies by city) generated by drivers and also deducts a “safe rides” fee.30 in a recently settled case, some uber customers alleged that uber also withheld part of the 20% tip that it had claimed was included in its fares, rather than paying all tips over to drivers.31 during our study’s timeframe, drivers could rent an uber-ready smartphone from uber but could also use their own phone and download the uber smart phone application.32 lyft is uber’s foremost competitor in the ridesharing market.33 uber and lyft are similar services 34 and have nearly identical business models. 35 like uber, lyft connects passengers and drivers through lyft’s smartphone application.36 like uber, lyft offers a basic service (lyft), a shared ride service (lyft line) and a six-passenger premium ride service (lyft plus).37 like uber, lyft also elevates fares during periods when demand is high,38 and like uber, lyft provides a liability insurance policy for periods when a lyft driver is ferrying a customer, as well as contingent liability for the period the lyft application is on but the driver has not yet accepted a ride.39 there are some differences, however. for example, lyft customers are prompted to pay within the lyft application after the ride, and are able to tip the driver using the app, though a tip is not required.40 the uber application currently does not allow for tipping.41 lyft, like 30 douglas macmillan, uber tests 30% fee, its highest yet, wall st. j. (may 15, 2015), http://www.wsj.com/articles/uber-tests-30-fee-its-highest-yet-1431989126 [http://perma.cc/dg3y-zt82]. see also uber, http://uberestimator.com/booking-fee [http://perma.cc/4c44-tx97] (explaining safe rides fee). the safe rides fee has been the subject of litigation. philliben et al v. uber technologies, inc., case no. 3:14-cv-05615, 2016 wl 6840229 (n.d. cal. 2016). see also ellen huet, uber faces class-action lawsuit over $1 ‘safe rides fee’, forbes (dec. 27, 2014), http://www.forbes.com/sites/ellenhuet/2014/12/27/uberclass-action-lawsuit-safe-rides-fee/ [http://perma.cc/9z7g-lxr3]. 31 caren ehret et al. v. uber technologies inc., 68 f. supp. 3d 1121(n.d.cal. 2014) (customer/plaintiff claimed that uber misled customers by charging 20% tip that does not go exclusively to the driver); see also joel rosenblatt, uber wins approval of settlement with customers over tips, 21 eclr vol. 37 (bloomberg bna, sept. 21, 2016). 32 see uber, http://help.uber.com/h/ba14dbf4-0e34-452b-ab0c-22f7d65b8d61 [http://perma.cc/vbe5-vffk] (last visited dec. 6, 2016); luz lazo, uber gives its drivers a choice to avoid $10 weekly fee for app use, wash. post (sept. 9, 2014), http://www.washingtonpost.com/blogs/drgridlock/wp/2014/09/09/uber-gives-its-drivers-choice-to-avoid-10-weekly-fee-for-app-use [http://perma.cc/f7x8-lcwb]. 33 see jon kelly, the uber vs. lyft war has been won in silicon valley, vanity fair (sept. 3, 2015), http://www.vanityfair.com/news/2015/09/uber-vs-lyft-war-has-been-won [http://perma.cc/cv38r7gp]. 34 farhad manjoo, uber and lyft have become indistinguishable commodities, n.y. times bits (aug. 28, 2014 at 2:27 pm), http://bits.blogs.nytimes.com/2014/08/28/uber-and-lyft-have-becomeindistinguishable-commodities/?_php=true&_type=blogs&_r=1 [http://perma.cc/xv7q-a7ck]. 35 vivek saxena, lyft v. uber: what’s the difference between these two dueling apps, inquisitr (aug. 14, 2014), http://www.inquisitr.com/1409677/lyft-vs-uber-whats-the-difference-between-thesedueling-apps/ [http://perma.cc/u4mb-yk4p]. 36 see, e.g., lyft, http://help.lyft.com/hc/en-us/articles/214219657-how-to-give-a-lyft-ride [http://perma.cc/5kkv-ydld] (last visited dec. 22, 2016). 37 lyft, http://www.lyft.com/ [http://perma.cc/z6b7-6s49] (last visited nov. 20, 2016). lyft has also started offering a “premier” service, which allows customers to request a high-end vehicle. lyft, http://help.lyft.com/hc/en-us/articles/222360127-lyft-premier-for-passengers [http://perma.cc/574t-en75] (last visited dec. 6, 2016). 38 lyft, http://help.lyft.com/hc/en-us/articles/214586017-prime-time-for-drivers [http://perma.cc/v3bu-5x6u] (last visited nov. 20, 2016). 39 lyft, http://help.lyft.com/hc/en-us/articles/213584308-insurance-policy [http://perma.cc/hz6fx7xa] (last visited dec. 6, 2016). 40 lyft, http://help.lyft.com/hc/en-us/articles/213583978-how-to-tip-your-driver [http://perma.cc/b5wu-uglf] (last visited nov. 20, 2016). 64 columbia journal of tax law [vol.8:56 uber, takes a 20% cut of the base fare; however, lyft drivers keep 100% of all tips.42 a third on-demand ridesharing service was sidecar technologies, inc. (sidecar), a ridesharing service that operated on a much smaller scale and was ultimately unable to compete.43 during 2015, sidecar modified its business model to focus on delivery of goods rather than passenger rides but ultimately ceased operations in december 2015.44 sidecar’s closure illustrates the changing landscape of the ridesharing sector, and leaves uber and lyft as the two main ridesharing services. 2. tax and related issues as a matter of formal tax law, the clear rule is that uber drivers, like any other income earners, are required to include rideshare earnings in gross income but may deduct allowable expenses from their gross income.45 however, as we have argued elsewhere, tax compliance may raise certain challenges.46 for one thing, uber classifies its drivers as independent contractors for tax and other purposes.47 as such, uber does not withhold taxes on amounts paid to drivers and does not issue forms w-2, but instead 41 dana kerr, to tip or not to tip drivers, that is uber’s question, cnet mag (feb. 16, 2015), http://www.cnet.com/news/to-tip-or-not-to-tip-drivers-that-is-ubers-question/ [http://perma.cc/mmq8rgku]. 42 lyft, http://help.lyft.com/hc/en-us/articles/214212387-how-driver-pay-is-calculated [http://perma.cc/x3ls-hmjz ] (last visited nov. 20, 2016). 43 see douglas macmillan, sidecar technologies shuts ride-sharing and delivery service, wall st. j. (dec. 29, 2015, 11:39 pm), http://www.wsj.com/articles/sidecar-technologies-shuts-ride-sharing-anddelivery-service-1451450372 [http://perma.cc/8euw-lv29]. 44 see, e.g., carolyn said, ride-sharing pioneer sidecar to shut down ride, delivery service, sfgate (dec. 29, 2015, 3:02 pm), http://www.sfgate.com/business/article/ride-sharing-pioneer-sidecar-toshut-down-ride-6726144.php [http://perma.cc/7656-4ars]; douglas macmillan, sidecar succumbs to uber and lyft in car-hailing wars, wall st. j. (dec. 29, 2015, 5:35pm), http://blogs.wsj.com/digits/2015/12/29/sidecar-shuts-down-succumbing-to-uber-and-lyft/ [http://perma.cc/w6jy-aez4]. 45 i.r.c. §§ 61, 162. 46 oei & ring, supra note 5. 47 uber, http://get.uber.com/drive/ [http://perma.cc/6ld5-ywv5]; uber, http://www.uber.com/legal/usa/terms [http://perma.cc/56k8-pvtc]. the position taken by uber and lyft that drivers are independent contractors has not gone uncontested. developments in class action court cases against these platforms, and rulings by state labor and employment tribunals that drivers are properly classified as employees, have brought a new degree of uncertainty to this determination. see sources cited supra note 9. in 2016, uber and plaintiffs sought to settle two class actions (one from massachusetts but transferred to the northern district of california and one from california). however, on august 18, 2016, the u.s. district court for the northern district of california rejected the settlement. order denying plaintiffs’ motion for preliminary approval of settlement, u.s. district court for the northern district of california, august 18, 2016, o’connor v. uber technologies, inc. et al. (case no. 13-cv-03826-emc, case no. 15-cv00262-emc), available at http://www.cand.uscourts.gov/emc/oconnorvubertechnologies [http://perma.cc/938e-52b9]. that case has been stayed, pending the outcome of various appeals. the irs test for independent contractor status in the tax context is drawn from the general common law test. see, e.g., independent contractor (self-employed) or employee?, internal revenue service, http://www.irs.gov/businesses/small-businesses-&-self-employed/independent-contractor-self-employedor-employee [http://perma.cc/2d67-rmwc]. see also i.r.c. § 3121(d)(2) (defining employee for employment tax as “any individual who, under the usual common law rules applicable in determining the employer-employee relationship, has the status of an employee”). although the tax law generally determines worker classification based on the common law analysis, in some circumstances a common law independent contractor will nonetheless be treated as a “statutory” employee for specific provisions of tax law. see, e.g., i.r.c. § 3121(d)(3). classification of drivers for tax purposes will likely be affected by the outcomes of these court cases and other rulings beyond the tax arena. 2017] the tax lives of uber drivers 65 reports gross amounts earned by drivers to both the irs and to drivers on forms 1099misc and 1099-k. 48 such “information reporting” helps the irs identify and corroborate income earned and reported by taxpayers on their tax returns, and studies suggest that in sectors where information reporting and withholding are difficult to impose (e.g., cash businesses), tax compliance declines.49 another wrinkle that may generate tax compliance consequences is that uber and lyft currently take different form 1099-k reporting positions due to a perceived ambiguity in the law. both platforms report gross driving payments earned by drivers (which are the bulk of driver payments) on forms 1099-k but take different positions on reporting thresholds.50 the relevant statute requires that banks and other “merchant acquiring entities” report all payments made to payees, no matter how small, while “third party settlement organizations” must only report payments if they exceed $20,000 and if there are more than 200 transactions with the participating payee. 51 against this backdrop, lyft has taken the position that it is a “third party settlement organization” only required to report payments above the $200,000/200 transactions threshold. uber took this position until early 2015, but then began issuing form 1099-k to drivers for all driving payments, no matter how small. the impact of uber’s changed position and the resulting divergence between uber and lyft in their form 1099-k information reporting can be observed in discussions on the internet boards.52 b. research questions given the content of formal law, what tax issues do uber and lyft drivers actually discuss and debate on the internet? in this article, we undertake this inquiry by examining three main questions: 1. major tax concerns of forum participants first, we investigate the major substantive tax questions actually discussed by forum participants. we identify the tax issues that are most relevant to forum participants and examine the ways in which they manage gaps, ambiguities, and compliance challenges that may arise. we also study the extent to which forum participants consult tax advisors, use tax preparation software, or employ other methods and resources in meeting their tax obligations. 2. effect of taxes in decision-making 48 see turbotax, http://turbotax.intuit.com/tax-tools/tax-tips/self-employment-taxes/tax-tipsfor-uber--lyft--sidecar-and-other-car-sharing-drivers/inf28820.html [http://perma.cc/8vpj-8ayw](last visited dec. 6, 2016). 49 see, e.g., leandra lederman, reducing information gaps to reduce the tax gap: when is information reporting warranted?, 78 fordham l. rev. 1733 (2010) [hereinafter lederman, reducing information gaps]; joel slemrod et al., does credit-card information reporting improve small-business tax compliance? (nat’l bureau of econ. research, working paper no. 21412); see generally leandra lederman, statutory speed bumps: the roles third parties play in tax compliance, 60 stan. l. rev. 695 (2007); james alm, et al, do individuals comply on income not reported by their employer? 37(2) pub. fin. rev. 120 (2009). 50 uber and lyft currently report driver referral bonuses and other special direct payments exceeding $600 on form 1099-misc. i.r.c. § 6041. 51 i.r.c. § 6050w(e). 52 see discussion infra part v.a.4. 66 columbia journal of tax law [vol.8:56 second, we investigate how forum participants make decisions regarding whether to drive at all and whether to drive part or full time, and we look at how taxes factor into those decisions. this second research question arose somewhat organically, because the data we collected contained many discussions of profitability and the role taxes play in its calculation. in addition to examining how forum participants talk about profitability overall, we specifically investigate when they begin to consider tax rates and administrative burdens (i.e., at outset, when deciding whether to drive, or later), whether they change their behaviors once tax and tax compliance burdens become salient, and whether their estimations and understandings of tax and compliance burdens are accurate. 3. tax sophistication, tax conduct, and tax compliance culture finally, we analyze the dominant cultural characteristics of the discussion forums, examining features such as forum participants’ levels of sophistication in understanding tax law, their attitudes towards tax compliance and risk taking, the accuracy of tax information and advice exchanged in the forums, and the ways in which forum participants express disagreement and correct each other’s errors. we also describe the activities of non-driver forum posters on the discussion boards. iii. the study of internet forums: research methodology in designing our study, we made a series of methodological choices. in this part, we discuss the key features of our research methodology: (1) the decision to study internet forums, (2) selection of the forums and discussion threads for analysis, and (3) the quantitative and qualitative analytical methods employed. a. the study of internet discussion forums: possibilities and limitations the use of discussion boards, chat rooms, blogs, and other internet forums to create community and exchange information is a well-established feature of contemporary life, and academics have increasingly realized that these internet forums are rich data sources that can be studied and analyzed. a growing body of literature in fields such as sociology and public health examines how posters in internet communities interact with each other and how information is conveyed through these online channels.53 however, detailed content analysis of how legal advice and information are transmitted through internet discussion forums has not, to our knowledge, been pursued. more specifically, in-depth analysis of how online communities of 1099 workers confront the tax system has never been performed. analysis of internet discussion forums is an appropriate method for studying ridesharing drivers and other sharing economy workers, particularly where other sources 53 see, e.g., aditya pal et al., early detection of potential experts in question answering communities, lecture notes in computer science, 6787, 231-242 (2011); rosenblat & stark, supra note 17; reijo savolainen, requesting and providing information in blogs and internet discussion forums, 67 j. documentation 863 (2011); winnie shum & cynthia lee, (im)politeness and disagreement in two hong kong internet discussion forums, 50 j. pragmatics, 52-83 (2013); l. jean harrison-walker, ecomplaining: a content analysis of an internet complaint forum, 15 j. marketing services (5) 397 (2001); wolfgang himmel et al., information needs and visitors’ experience of an internet expert forum on infertility, 7(2) j. med. internet res. e20 (2005); jyh-shen chiou & jasi lee, what do they say about “friends”? a cross-cultural study on internet discussion forum, 24 computers in human behavior 1179 (2008). 2017] the tax lives of uber drivers 67 of data may not be immediately available. first, ridesharing drivers and other sharing economy workers make intensive use of internet and mobile technologies and are generally comfortable with online interaction and communication.54 second, ridesharing drivers operate in comparative physical isolation and may have little in-person contact with other drivers. thus, drivers have turned to the internet, converging in a number of online forums to share ideas and information. one news article accurately described uberpeople.net, one of the forums we studied, as a “public water cooler” for atomized uber drivers.55 third, the format and layout of internet discussion forums makes them an effective way to share technical information such as tax advice, original sources (e.g., links to other websites), spreadsheets, and legal material. studying online forums therefore lets us observe the types of detailed technical information that are actually shared, stored, and possibly relied upon by forum participants and observers. fourth, studying the online forums allows a real-time examination, based on a written transcript consisting of questions and comments, of what ridesharing drivers are contemplating and discussing. this has a clear benefit over methods such as surveys and interviews, which rely on driver recollections of past events. fifth, the relative anonymity of online forums may encourage honesty regarding tax conduct and compliance behaviors. finally, thick description of online interactions can add nuance and texture to our understanding of the research subject that other methodologies—such as quantitative data analysis—may fail to capture. yet, study of online discussion forums, while it might yield interesting insights, is subject to a number of limitations. most obviously, only a subset of ridesharing drivers post on the discussion boards. we have limited information about how forum participants skew in terms of demographics, attitudes towards driving, or attitudes towards tax compliance. thus, it is important not to take the views expressed on the forums as representative of the views of all drivers. second, it is also difficult to know the impact of the discussion boards beyond the community of active forum participants. all of the boards we studied can be accessed and read by the public without logging in, so there are likely a significant number of “lurkers.” we did not obtain information about the number and frequency of lurkers or about site traffic, so the impact of information and opinions shared on the boards on such lurkers is unknown. third, there may be a gap between what forum participants say anonymously on the internet and what they actually do in terms of tax compliance and other behaviors. we have no way to quantify that gap, if it exists. thus, one must be careful in drawing conclusions about the actual behaviors of rideshare drivers based on what is said on the boards. there are also necessary limitations in terms of study design and methodology. as with any qualitative study, certain aspects of how we categorized the discussion threads and coded the data might be subject to debate in close cases. in addition, our study is bounded by the dates on which we conducted the search, by our search terms, and by the search engines of the respective websites. notwithstanding these limitations, study of online discussion forums can yield 54 a driver’s financial success may depend, in part, on her ability to manipulate and interpret online data (for example, the ability to identify potential price surges and locations of other drivers). 55 nellie bowles, the uber-loneliness of the sharing economy driver, the guardian (feb. 4, 2016), http://www.theguardian.com/technology/2016/feb/04/uber-protest-app-zello-sharing-economy [http://perma.cc/3nww-fwsm]. 68 columbia journal of tax law [vol.8:56 valuable information and data, particularly when supplemented by other research methods. b. selection of internet forums for study: reddit, uberpeople, and turbotax we analyzed three internet discussion forums: the uberdrivers subreddit on reddit.com, the uber drivers’ forum uberpeople.net, and the intuit turbotax answerxchange forum.56 the uberdrivers subreddit is an important internet venue where drivers interact, with over 5,000 subscribed readers, while uberpeople is a leading online forum for ridesharing drivers. while reddit and uberpeople are general interest sites, discussions on turbotax pertain only to tax. we found, somewhat surprisingly, that the most substantive and sophisticated tax discussions were contained on reddit and uberpeople, not on turbotax. all three websites are in discussion board format, which means that individuals can post content in the forum by logging in under a username and writing an entry. posted content often takes the form of questions or commentary. other users, who may be members of the public, forum employees, or moderators, may respond to or comment on posted content by logging in under a username, thereby generating a discussion. in this article, we refer to each discussion, which consists of the original post and subsequent comments and responses, as a “discussion thread.” we refer to the initial poster for each discussion thread as the “thread originator” or “original poster” and to subsequent posters on a thread as “commenters.” in all three cases, the websites were viewable by the general public without a username or a subscription; an account was required only to post content. 1. reddit reddit, which describes itself as “the front page of the internet,” is a widely used social networking and news website in which community members can post content by registering under a username and password.57 reddit can be broadly characterized as a “bulletin board” upon which users post text-based entries, links, videos, photos, and other content.58 content on reddit is organized by communities of affinity or interest, known as “subreddits,” and subreddits range widely in tone, content, and topic. we observed a number of subreddits relating to the sharing economy. the uberdrivers subreddit was by far the most significant and active subreddit for ridesharing drivers.59 reddit users may post content, comment on submitted content, and comment on those comments, thus generating a conversation within each discussion thread. reddit operates a voting system, by which users (redditors) can vote up or down (“upvote” or 56 we refer to these discussion forums as uberpeople, reddit, and turbotax. 57 see matt silverman, reddit: a beginner’s guide, mashable (june 6, 2012), http://mashable.com/2012/06/06/reddit-for-beginners/ [http://perma.cc/l5bp-6qul]. see happy 10th birthday to us! celebrating the best of 10 years of reddit, reddit blog (june 23, 2015), http://www.redditblog.com/2015/06/happy-10th-birthday-to-us-celebrating.html [http://perma.cc/7r6bgyns] (as of june 23, 2015, reddit boasted 1,715,454,785 comments, 334,626,161 monthly page views, 190,227,552 posts, and 36,136,190 user accounts). 58 silverman, supra note 57. 59 uberdrivers, reddit, http://www.reddit.com/r/uberdrivers/ [http://perma.cc/8xcf-gp4q]. 2017] the tax lives of uber drivers 69 “downvote”) on submitted content and comments.60 these upvotes and downvotes affect the ranking of items in each subreddit. during the study’s time frame, the content within a subreddit could be sorted based on the following categories: “relevance,” “new,” “hot,” “top,” and “comments.” a pew research survey conducted in april and may 2013 found that 6% of internet users surveyed use reddit, and that men were twice as likely to be reddit users (8%) as women (4%).61 young people were more likely to use reddit than older people: 11% of internet users ages 18-29 reported using reddit while 7% of internet users ages 30-49 reported reddit use. younger men were significantly more likely to be reddit users than older men.62 urban and suburban dwellers were more likely to use reddit than those living in rural areas.63 by comparison, a 2016 study of uber drivers commissioned by uber concluded that 19.1 percent of drivers are under age 30, and only 21.8 percent are age 50 or older.64 in contrast, taxi drivers and chauffeurs are substantially older.65 around 14 percent of uber drivers are women. 66 although there is not a direct overlap between the demographic profile of reddit users and uber drivers, both seem to be predominantly male and young.67 combined with the observation that uber drivers are likely to be technologically savvy enough to use internet forums, it is reasonable to conclude that reddit might provide useful, though by no means perfect, data on ridesharing drivers. 2. uberpeople uberpeople.net is an internet discussion forum that identifies itself as “an independent community of rideshare drivers.” 68 it is perhaps the leading internet discussion forum for ridesharing drivers and has been in operation since april 2014.69 the volume of discussion and the scope of ridesharing topics covered are extensive.70 60 maeve duggan & aaron smith, 6% of online adults are reddit users, pew res. ctr. (july 3, 2013), http://www.pewinternet.org/2013/07/03/6-of-online-adults-are-reddit-users/ [http://perma.cc/25zeyf8z]. 61 id.; see also maeve duggan, it’s a woman’s (social media) world, pew res. ctr. (sept. 12, 2013), http://www.pewresearch.org/fact-tank/2013/09/12/its-a-womans-social-media-world/ [http://perma.cc/7eea-u2fw] (“reddit is the only site we’ve measured in which men are significantly more likely than women to be users.”). 62 duggan & smith, supra note 60. 63 id. 64 hall & krueger, supra note 2, at 7. the data in the 2016 study was based on a 2014 web survey completed by 601 drivers (a response rate of about 11%). id. 65 id. at 7. 66 id. at 8. 67 note that the reddit statistics are calculated as a percentage of internet users, that is, the survey asked internet users questions about their demographic information and their reddit use. a conclusion that 8% of male and 4% of female internet users report using reddit does not mean that two thirds of reddit users are men. in contrast, the uber study was a study of uber drivers themselves and about their demographic information. 68 uberpeople.net, http://uberpeople.net/ [http://perma.cc/5e3y-quax]. according to its facebook page, uberpeople was founded in april 2014. uber driver forum – uberpeople.net, facebook, http://www.facebook.com/uber-driver-forum-uberpeoplenet-1505553926331482/ [http://perma.cc/t7r3ygv2]. 69 as of october 2015, uberpeople had over 26,000 members, over 33,000 discussions and over 486,000 posted messages. 70 see bowles, supra note 55 (calling the site “a sort of public water cooler” and noting that uberpeople users have made over 750,000 posts to date). 70 columbia journal of tax law [vol.8:56 the site’s ownership is unclear and has been the subject of some debate.71 like reddit, uberpeople consists of discussion threads generated by a thread originator and commented upon by subsequent posters. because of the forum layout, however, the uberpeople discussion threads seem to have a slightly less conversational style than reddit. it is generally accepted that some forum participants are self-identified uber employees, and it is assumed that others may be unidentified uber employees.72 3. turbotax intuit turbotax answerxchange is an online question and answer forum created by intuit, a leading tax preparation software developer that offers the turbotax software.73 users who have created an account can log into the forum and post questions about how to prepare their taxes.74 turbotax employees, representatives, and other users provide publicly available responses to these questions. in contrast to uberpeople and reddit, all of the discussion threads on turbotax concerned taxation, so we did not observe non-tax conversations morphing into discussions of tax issues (and vice versa). c. selection of tax-related discussion threads for analysis because of differences among the three forums, we tailored the discussion thread selection process for each forum to ensure that all relevant threads were identified. both uberpeople and reddit contain a large number of non-tax-related discussions, so our goal was to isolate the tax-specific threads. the discussions on turbotax all concerned taxation, so the goal there was to identify the threads relevant to ridesharing. across all three forums, our objective was to create a database of tax conversations that could then be analyzed. we sought to explore the kinds of tax issues significant to posters, to understand how taxes fit into posters’ assessments of profitability, and to generate a picture of forum culture and sophistication and of how legal knowledge was transmitted on the discussion boards. we did not seek to make comparative claims about the dominance of tax discussions as compared to other types of discussions (for example, discussions about insurance). therefore, our method of thread selection does not create a selection bias. 1. reddit we searched for and downloaded tax-related threads in the uberdrivers subreddit using the following words and phrases: taxes, tax, 1099-k, 1099k, 1099-misc, 1099misc, 1099, deduct and expense, deduct* and expense*, deduction*, taxation, deduct* and mile*, deduct* and cost*, mileage, irs, “independent contractor,” and “independent 71 see uberpeople.net, who owns uberpeople-net?, http://uberpeople.net/threads/who-ownsuberpeople-net.18569/ [http://perma.cc/a2gv-hk5x]. 72 see http://uberpeople.net/threads/this-needs-to-be-said-this-forum-is-run-by-and-worked-byuber-employees.3643/ [http://perma.cc/r8kz-dvk8] (thread titled “this needs to be said! this forum is run by and worked by uber employees”). 73 tubrotax, http://ttlc.intuit.com/ [http://perma.cc/n895-v8vy] (last visited dec. 22, 2016). 74 id. 2017] the tax lives of uber drivers 71 contractors.”75 our search methodology yielded 260 discussion threads. 2. uberpeople we searched for tax-related threads on uberpeople by combining a search term method and an individualized review of threads. the most pertinent section of the website was the “forums” section, which contains the bulk of the discussion threads.76 “forums” was itself divided into five categories: community, garage, information, options, and geographical. during the study’s time period, these headings were further subdivided into subheadings. we applied the following search procedure: (1) the “garage” category in the “forums” section contained a subcategory “pay” which itself contained two subcategories: “taxes” and “tips.”77 we included all the discussion threads under “taxes” in our study. (2) we performed a global search for the word “taxes” across the entire “forums” section and included all hits in our study.78 (3) we reviewed individually each remaining thread title in the “forums” section and included all threads relevant to taxation in our study.79 our search methodology yielded 261 discussion threads. 3. turbotax intuit we performed searches in the intuit turbotax live community forum, using the terms “uber” and “lyft.” the search for “uber” generated 85 threads, and the search for “lyft” generated 22 threads, for a total of 107 threads. d. coding of discussion threads we then subjected the selected discussion threads from the reddit, uberpeople, and turbotax forums (n=260, n=261, and n=107, respectively) to quantitative analysis using descriptive statistics as well as qualitative content analysis. we sorted the threads in each forum into broad topical categories to get a general sense of the dominant topics of interest in the forums. we then analyzed the discussion threads under a system of 71 substantive codes and a number of other structural and in vivo codes using the data 75 reddit allows wildcard searching using an asterisk after a word. but sometimes wildcard searching was ineffective. for example, a search for tax* yielded threads about “taxis,” and a search for deduct* yielded threads about insurance “deductibles.” in those instances, we did not use wildcards due to over-inclusiveness. 76 other sections included resources, members, blogs, and cities. 77 during this study’s time period, some threads under “pay” were in neither the “tips” nor the “taxes” sub-subheading. 78 all threads that contained the word “taxes” somewhere in the discussion were captured. once the thread was captured, all pages of that thread were saved for study. the word “tax” is not searchable on uberpeople because it is too short. 79 we did not review threads in the “geographical” category because that category was city specific and did not pertain to taxes at all. 72 columbia journal of tax law [vol.8:56 analysis software atlas.ti.80 the full list of codes is in the appendix. coding the data helped us identify the most frequently discussed tax issues on the boards. substantive codes. our 71 substantive codes can be grouped into five broad families (total number of codes in each family in parentheses): substantive tax issues (30), tax policy issues (6), attitudes towards tax compliance (7), tax-related strategies and rationales (14), and feelings and emotions about taxes (14). structural codes. to obtain a more nuanced understanding of forum dynamics and composition, we employed a number of codes (between 7 and 11 depending on which forum) designed to illuminate the structure and layout of the forum. thus, for example, we coded for thread-originating posts, posts by tax professionals and other marketing posts, possible “plants” by uber and lyft or by taxicab competitors, and possible web bots. the structural codes enabled us to tease out various features of the forums, such as number of questions asked, most commonly asked questions, and most frequent posters. thread originators and respondents. we coded the names of all forum participants. this allowed us to understand the number, frequency, and composition of forum users. other in vivo codes. finally, where there were distinctive comments or interactions, we employed in vivo coding to capture precise language. iv. the tax lives of uber drivers: describing the data we first summarize our findings using descriptive statistics. we do so in order to give the reader a broad sense of the key topics discussed, the level of activity, and the composition of forum users in these internet discussion forums, before delving into our detailed content analysis. a. reddit the 260 discussion threads yielded by our search methodology were submitted between 27 november 2013 and 1 may 2015, with 109 of the 260 threads posted in 2015.81 each thread (and each comment within a thread) is given a points score on reddit, which is the number of “upvotes” minus the number of “downvotes” received.82 each discussion thread also contains information about the thread’s “percentage upvoted,” which is the percentage of votes received that are upvotes. although all threads were selected based on some connection to tax (as described in part iii.c), the primary topics of the threads were not exclusively substantive tax issues. we therefore classified each thread into one of seven basic categories based on its 80 atlas.ti, http://atlasti.com/ [http://perma.cc/5jd6-skec] (last visited dec. 22, 2016). in this article, citations are either to an anonymized list of 177 user handles denoted “user1, user2, etc.” or to pdfs of the discussion threads that we analyzed (referred to as “primary documents” or “pdocs”). some discussion threads spanned more than one pdoc. thus, there were a total of 487 uberpeople pdocs, 291 reddit pdocs, 85 pdocs for turbotax threads with keyword “uber,” and 31 pdocs for turbotax threads with keyword “lyft.” for example, “reddit p1” denotes the first pdoc in reddit dataset. usernames and which forum a post came from have been anonymized where appropriate to protect poster identities. the suffix “_to” denotes a forum user’s thread-originating post. 81 each thread contains the date the comment was posted and the date of the original post. 82 reddit help, http://reddit.zendesk.com/hc/en-us/articles/204511559-how-is-a-post-s-orcomment-s-score-determined[http://perma.cc/y8gk-98gf]. 2017] the tax lives of uber drivers 73 primary focus. we then gathered data on (1) the date the thread was posted, (2) the number of comments on each thread, (3) the thread’s point score, (4) the percentage of upvotes received, and (4) the general composition of the forum users. general thread topics. based on our classification scheme, we found the following numerical distribution of topics: 83 table 1 thread topic number of threads substantive tax issues 103 profitability 70 uber’s business model 25 driving strategy 21 interactions with uber 15 independent contractor vs. employee issues 14 marketing 12 total 260 this suggests that the dominant topic in the discussion forum threads pertained to tax-specific issues. this is unsurprising given our search terms. it also shows that a significant number of threads dealt with questions of whether rideshare driving was profitable and the role taxes played in such profitability determinations. number of comments. the discussion threads contained an average of 13.45 comments per thread, with a median of 9.5 comments. there were a relatively small number of discussion threads that drew a large number of comments. focusing on the 50 discussion threads that drew more than 20 comments per thread, the main topics of those threads were as follows: table 2 topic number of threads profitability 27 substantive tax issues 6 uber’s business model 5 driving strategy 5 83 “substantive tax issues” refers to threads addressing issues of substantive tax law. “profitability” refers to threads dealing with whether driving for uber was profitable. “driving strategy” refers to threads addressing methods, strategies, and decisions for most effective rideshare driving. “independent contractor vs. employee” refers to threads that deal with issues surrounding worker classification, such as labor law issues or whether drivers should unionize. (tax issues relating to independent contractor status (such as form 1099 issues) were grouped in the “substantive tax issues” category.) “uber’s business model” refers to threads pertaining to how uber conducts its business. “interactions with uber” refers to discussions of interactions between drivers and the platform. “marketing” refers to posts by posters trying to market their software or services. where thread topics spanned more than one category, we assigned that thread to the category that most accurately reflected its dominant theme. 74 columbia journal of tax law [vol.8:56 independent contractor vs. employee issues 3 interactions with uber 2 marketing 2 total 50 this broadly suggests that even though there were more substantive tax threads than threads concerning profitability, the thread topics that drew the most commentary from redditors predominantly concerned whether rideshare driving is profitable, while substantive tax questions drew less interest. points score and percentage upvotes. the scores of the discussion threads ranged from 118 to 0, with an average of 4.73 points and a median of 2 points. the percentage of upvotes received by each thread ranged from 100% to 18%, with an average of 73.75% upvoted and a median of 75%. we analyzed point scores and percentage of upvotes to figure out roughly which threads drew strong reactions and might have had a wider readership or impact. compositions of forum posters. reddit forum posters were a combination of frequent, repeat posters and episodic or casual posters. the most frequent thread originator originated 11 threads. the handle84 user176, which belongs to a marketer marketing the tryzen99.com website, was second with six threads originated. there was significant but imperfect overlap between the frequency of thread origination and the frequency with which each user commented or responded on the boards. for example, the most frequent thread originator in our dataset was the second most frequent thread commenter (81 occurrences). on the other hand, the most frequent thread commenter (86 occurrences) only originated one thread in our dataset. the handle user176, who was the second most frequent thread originator, was the fifth most frequent respondent (63 occurrences). thus, repeat commenters had a strong presence on the discussion board. in addition, user176’s presence and frequent posts and comments supports our impression that the reddit discussion board is a shared space between actual drivers and other parties, such as marketers, journalists, and suspected “plants” by ridesharing platforms and taxicab competitors. episodic or casual commenters were also present in large numbers. we recorded a total of 734 thread respondents (i.e., handles who actually responded to threads, rather than originating threads) in the forum. out of these 734 respondents, 596 had posted comments on threads 5 times or fewer, 665 had posted comments on threads 10 times or fewer, and 710 had posted comments on threads 20 times or fewer. thus, over 80% of respondents had posted comments 5 times or fewer. only six respondents posted comments on threads more than 50 times, and only 24 respondents posed comments on threads more than 20 times. this suggests that the vast majority of commenters were casual, infrequent commenters, with a relatively small number of regulars. b. uberpeople the 261 discussion threads generated by our search methodology were initially submitted in a 12 month period, between 10 april 201485 and 24 april 2015. of the 261 84 we use the terms “handle” and “user” interchangeably. 85 this reflects the fact that uberpeople.net appears to have been started in april 2014. 2017] the tax lives of uber drivers 75 threads, 179 were posted in 2015 and 82 were posted in 2014. the uberpeople forum includes a function that allows commenters to “like” a given post or comment, but this feature played a minor role compared to the reddit upvote, downvote, and points system. as with reddit, we gathered data on (1) the date of the original post, (2) the number of comments on each thread, and (3) the general composition of forum users. we then classified each thread into the same seven basic categories used with respect to reddit, but added an eighth “miscellaneous” category because our search in uberpeople.net yielded a few threads unrelated to any relevant category. (as with reddit, the uberpeople threads were selected for their relation to tax, but their dominant topics were not always substantive tax issues.) general thread topics. based on these eight categories, the 261 threads yielded by our search methodology were distributed as follows: table 3 thread topic number of threads substantive tax issues 121 profitability 57 uber’s business model 25 interactions with uber 19 driving strategy 14 marketing 10 miscellaneous 8 independent contractor vs. employee issues 7 total 261 thus, as with reddit, the dominant topic of discussion in the threads captured by our search criteria related to tax-specific issues, followed by discussions about profitability determinations. discussions of uber’s business model and driver interactions with the company were a small but notable component, but discussions of driving strategy featured slightly less prominently than on reddit. there were slightly fewer marketing posts than on reddit. number of comments. the uberpeople discussion threads contained an average of 23.64 comments and a median of 11 comments. thus, the mean number of comments was significantly higher for uberpeople than for reddit, while the median was less dramatically different. looking at the 77 discussion threads that drew more than 20 comments per thread, the main topics of those threads (based on our eight category classification scheme) were as follows: table 4 topic number of threads profitability 24 76 columbia journal of tax law [vol.8:56 substantive tax issues 18 uber’s business model 9 driving strategy 7 interactions with uber 7 independent contractor vs. employee issues 5 miscellaneous 5 marketing 2 total 77 thus, as was the case for reddit, even though tax-specific threads were the largest category in the data (121 threads), they composed fewer of the frequently commented upon threads than profitability discussions. composition of forum users. uberpeople forum users, like reddit users, were a combination of repeat posters and casual or episodic ones. of 261 discussion threads analyzed, the most frequent thread originator originated seven threads, and the second most frequent originated five. there was imperfect overlap between frequency of thread origination and frequency of comments: out of the top 5 thread commenters in our dataset (number of comments: 196, 154, 154, 98, 97), one of these commenters was the most frequent thread originator (154 comments; originating 7 threads), but of the remaining four top commenters, three originated only one thread while the fourth did not originate any. the handle user153 (owner of the tryzen99 website) originated three threads and made 67 comments. while there were a fair number of repeat commenters (71 users made more than 20 comments in our dataset), the majority of forum participants were casual users. out of 816 commenters, 581 commented 5 times or fewer, 673 commented 10 times or fewer, and 745 commented 20 times or fewer. like reddit, uberpeople users appeared to consist of ridesharing drivers, marketers, journalists, tax professionals, taxi drivers, and others. c. turbotax intuit the search methodology outlined above yielded a total of 107 discussion threads. each discussion thread consisted of a question asked by a thread originator, answers to the question, and comments. some threads contained no answers and/or no comments. unlike the uberdrivers subreddit, there were almost no repeat posters. out of a total of 99 thread originators, only eight of those thread originators posted more than one question, and all of those eight posted twice each. ultimately, this forum proved less relevant to our analysis than reddit and uberpeople because of the limited number of answers and comments and because the dominant issues were return preparation logistics86 and software-specific questions. v. the tax lives of uber drivers: content analysis of data content analysis of the data reveals more detailed information about how forum 86 this refers to questions about how to prepare the tax return (e.g., where to enter income or deduct fees). 2017] the tax lives of uber drivers 77 posters navigate the tax system, make determinations about profitability and driving, and interact with each other on the discussion boards.87 a. tax issues confronting ridesharing drivers forum participants discussed a number of substantive tax issues, with varying degrees of depth and accuracy. the frequency with which codes occurred provides a rough sense of the issues that were most discussed. in reddit, some of the most commonly occurring substantive tax codes concerned business expense deductions: “expenses and deductibility” (437 occurrences), “mileage” (388), “documentation” (264), and “method: standard mileage vs. other” (248). issues surrounding drivers’ status as 1099 workers also emerged as an important topic: “employee or independent contractor” (182), “form 1099: content and accuracy” (69), “form 1099: different reporting positions” (18), “form 1099: receipt” (80), “form 1099: residual” (52), “employment taxes” (41), “estimated taxes” (43), “withholding” (57), and “schedules” (39).88 the frequency of codes was similar in uberpeople. codes related to business expenses included: “mileage” (678), “expenses and deductibility” (649), “documentation” (280), and “method: standard mileage vs. other” (271). codes related to driver classification included: “employee or independent contractor” (295), “form 1099: content and accuracy” (142), and “form 1099: receipt” (126). at a broad level, the incidence of codes suggests that when forum posters talk about tax they are generally focused on questions and problems pertaining to business deductions and to the implications of their status as small business operators or form 1099 recipients. to be sure, there were some discussions regarding the need to include income and some instances of failure or unwillingness to report income.89 for example, there were a few cases where posters filed their tax returns for the 2014 tax year in january 2015, “forgot” to include ridesharing income, subsequently received forms 1099-k from uber, and asked how to amend their returns.90 however, these income inclusions questions were relatively few compared to questions about expense taking.91 most forum participants seemed to understand the basic requirement that they pay taxes on rideshare income.92 the observation that most forum participants view rideshare 87 our discussion reflects our broad sense of thread impact, based on the metrics (such as number of comments and points scores) discussed in part iv. 88 additional substantive topics that appeared in reddit but with less frequency included “entities and structuring” (28), “interest and penalties” (13), and “state tax” (39). 89 user6_to (“so i don’t have to pay taxes if i gross less than $20k?”); user103_to (“i only made $[xxxx] for the year. . . . do i really need to waste time and file taxes over this bullshit? i heard something like if you make less than $10,000 you don't have to file taxes but i made way more than that at my ‘real’ job.”); user66 (“if they are not reporting it to the irs then i’m not going to report it”); user63 (“do you have to report your earnings from uber to the irs, and is there anyway around this?”); user98 (“do you think since lyft didn't give me form 1099 i should not bother declaring the income from their gig on my 2014 tax returns?”); see also infra note 134. 90 user16; user84. 91 we coded 211 instances of the code “income inclusion” in uberpeople and 99 instances in reddit. interestingly, the code “income inclusion” appeared comparatively frequently in turbotax (102 occurrences, compared with 126 occurrences for “expenses and deductibility”), perhaps reflecting the fact that posters were actually filling out tax forms when they posted in this forum. 92 see, e.g., user60 (“are you implying that lyft drivers who don't get a 1099-k don't owe taxes on their earnings? because that's not how it works.”). 78 columbia journal of tax law [vol.8:56 income as reportable seems broadly consistent with findings from existing tax compliance literature that third party information reporting (such as reporting on form 1099-k) can improve taxpayer reporting of income.93 drivers’ receipt of forms 1099-k from uber, combined with their knowledge that the entire business is conducted via credit card, might explain the widespread acceptance of the obligation to include driving income on the tax return.94 on the other hand, examination of the discussion threads reveals that forum posters struggled with how to handle their business expenses. many posters were new to filing taxes as independent contractors. accordingly, issues surrounding schedule c filing and expense taking and documentation were often matters of first impression. specifically, drivers focused on the following core concerns: (a) determination of business miles and deductibility of expenses, (b) the implications of the choice between the standard mileage rate and the actual expenses method, (c) documentation, (d) understanding their forms 1099-k, and (e) tax preparation issues and logistics. 1. determining business mileage and deductibility of expenses most forum posters in the uberpeople and reddit forums seemed to understand that certain types of expenses could potentially be deducted, readily identifying gas, bottled water for customers, and tolls as deductible. 95 however, posters displayed uncertainty regarding: (a) line drawing between business and personal outlays, and (b) the timing of deductions and whether expenditures had to be capitalized instead. a. the business-personal borderline: mileage and other expenses mileage with respect to the business-personal borderline, a frequent issue was whether miles spent driving without a passenger in the car counted as miles driven for ridesharing. some background information is in order: first, the tax law gives drivers a choice between taking the standard mileage deduction (i.e., an irs-specified deduction equal to $0.56 per mile driven on business for 2014) or deducting actual expenses incurred in business driving.96 however, if there is any personal use of the vehicle, then the question 93 see discussion supra part ii.a.2; see also oei & ring, supra note 5; lederman, reducing information gaps, supra note 49, at 1752 (noting that form 1099-k reporting effectiveness may be harmed by high reporting thresholds, which exclude many taxpayers from reporting); see also i.r.c. § 6050w(e). 94 susan cleary morse, stuart karlinsky, & joseph bankman, cash businesses and tax evasion, 20 stan.l.& pol’y rev. 37 (2009) (finding, based on field interviews of 275 cash business owners, that most interviewees regarded credit card receipts as taxable and reportable revenue). while it addresses a different group of taxpayers, the study raises the possibility that the electronic nature of amounts earned in ridesharing may incentivize drivers to report such income, regardless of form 1099-k reporting. 95 see, e.g., user112 (“the water provided for customers is probably ok, but keep the receipts for that, along with any tolls or parking fees”); user65 (“car chargers, water and mints for pax…[are deductible]”); but see user52 (“gas yes. water, i don’t think so.”) other expenses identified by forum participants included business cards, cell phone mounts for the car, and water and mints for passengers. see, e.g., user135. drivers discussed the best cars for ridesharing, often with a focus on the vehicle’s expected miles per gallon. hybrids were frequently cited as a promising choice, at least on cost grounds, if not aesthetic appeal. 96 i.r.c. § 274(d); treas. reg. § 1.274-5(j)(2); i.r.s. notice 2014-79 (sec.3), 2014-2 c.b. 1001; i.r.s. news release ir-2014-114 (dec. 10, 2014). rev. proc. 2010-51, 2010-2 c.b. 883; internal revenue service publication 463, “travel, entertainment, gift, and car expenses” (2013), 17. 2017] the tax lives of uber drivers 79 of which miles “count” is material no matter which method the taxpayer chooses, and she would have to track and document miles driven for ridesharing as opposed to personal use. 97 second, the rules for determining deductibility of business mileage are complicated. generally, only costs associated with miles driven for business are deductible. miles driven from “home” to work and vice versa, referred to as “commuting” miles, are generally not treated as business miles.98 however, once “at work” costs attributable to miles driven for work, for example, traveling between business locations, would be deductible.99 as the discussion below illustrates, a number of interpretative issues arise in applying these rules to ridesharing. uninformed forum posters expressed surprise that they needed to keep track of mileage information at all and frustration at having to do so.100 interestingly, however, not many drivers appeared completely uninformed. a few drivers, who seemed to sense that miles were important but had not given the matter much thought, anticipated relying on uber-provided statements regarding miles driven.101 however, uber’s statements only include miles driven with a passenger.102 more sophisticated drivers realized that the uber statement numbers were likely under-inclusive of legitimate business miles.103 in that case, drivers would need to make their own determinations of business miles. many posters assumed that all miles driving 97 for example, if the driver uses the actual expenses method and the vehicle were used only 40% of the time (based on mileage) for ridesharing (with the remainder constituting personal use), only 40% of the vehicle expenses would be deductible. 98 rev. rul. 99-7, 1999-1 c.b. 361. there are three exceptions: (1) if the taxpayer has at least one regular work location away from her home, then commuting expenses between her home and a temporary work location in the same trade or business can be deducted. (2) transportation expenses for going from home to a temporary work location outside the metropolitan area where the taxpayer lives and works are deductible. (3) if the taxpayer’s residence is her principal place of business, then she may deduct transportation expenses for going between home and another work location in the same trade or business. id. 99 id. 100 user98 (“unfortunately, i didn't keep log. i didn't know the rules when i started and uber doesn't tell you shit.”); user102 (“i started fares already without documenting this past week,”). see also the following exchange: user10: “just spoke with a cpa, he said you can count the distance between your drop off point to your next ride. you'll need to use the uber trip history, trip by trip and find the mileage in google maps.” user 23: “oh god what a pain in the ass that would be.” user10: “it's going to take me weeks” 101 user40 (“we all have proof on the uber dashboard.”); user43 (“what can i do if i have not been keeping up with miles and gas?”); user39. 102 uber’s 2014 tax summary itself states that “additional mileage may be deductible.” http://ridesharedashboard.com/2015/01/30/uber-taxes-2015-tax-summary-deducting-fees/ [http://perma.cc/863x-egf2]. 103 see, e.g., user51 (“uber will only record on your 1099 the number of miles you drove after the pax gets in the car but you can absolutely deduct all business related miles like driving around to a spot and driving to the pickup point.”); user132 (“i just thought i could use the miles logged in the waybill, summary, etc statements, but i realize these don’t track your miles spent on picking people up before the ride starts.”). 80 columbia journal of tax law [vol.8:56 around with the uber app on would “count.”104 some forum posters contended that if the driver turned on the uber app upon leaving home, then the driver had effectively started working and could count the mileage as business related.105 even more aggressively, at least one commenter suggested that a driver is “working” whenever the app is on, regardless of whether the driver was really planning to work.106 these opinions might not be correct, however, because the irs might take the position that miles driven from home to the usual place of passenger pickup constitute nondeductible commuting miles. the most sophisticated discussions of mileage did not presume that simply turning on the uber app was sufficient to render the miles driven deductible. instead, these discussions focused on whether there was a notable personal component to the miles driven. for example, some posters wondered whether miles driven from home to either the first passenger pickup or the general pickup zone107 were really business miles, or whether those constituted nondeductible commuting miles. 108 but even in these discussions there was confusion among some drivers as to the potential distinction between commuting miles (e.g., driving from home to “work”) and “dead miles” (i.e., driving around between passengers without a passenger in the car).109 the latter are 104 user121_to (“if you’re not keeping track of every mile you drive, you are screwed because this is where your tax savings will come from”); user161 (“it’s extremely important to track all of your mileage, as it is all deductible.”); user172 (“once you get behind the wheel go on line in your driveway you are on the job.”); user92 (“turn the app on when you leave your house…, now they are deductible.”); user61 (“your place of business is your house, there are no commuting miles.”); user85 (“i turn the app on before i start the engine. all miles are ‘work’.”); user147 (“you’re not listening. yes you should deduct all those miles. your home is your base when you’re an independent contractor. when you leave it, you are travelling for work and should deduct it.”); user22 (“when you leave your house..... the app is on. period.... say nothing else to the tax man. when the app is on.... you’re officially working. period. the only ‘commuting miles’ that you should have as an uber/lyft driver.... are on the soles of your shoes when you walk from your back door to your car.”). 105 see supra note 104; see also user85 (“there is no commute. i am working if the car is moving. there is no set location to commute to. uber rides begin and end everywhere.”) 106 user32 (this poster notes that they have “made it a point to turn on [the] uber [app] every time [he] get[s] in the car,” which makes all miles deductible. they also note that “[y]ou can always accept rides then cancel if you really have somewhere to be urgently” and that “[t]ime on the clock is time on the clock.”). 107 this distinction was most relevant for drivers who, for example, lived outside an active urban area and drove from home to that area to find passengers. for example, consider the following exchange: user129: “i’m wondering if you live outside of the uber coverage area, can you deduct the miles driven from your home to the coverage area? or, should you consider that ‘commuter’ miles. any thoughts?” user172: “there are people that work in one place regularly and then sometimes have to go to a farther office. they minus out their normal commute from the total trip to the outlying office. with livery you do not have to do that. once you get behind the wheel go on line in your driveway you are on the job. with the increased insurance coverage you get while you are on duty i would drive to the hot zone being on duty from your home.” 108 user105 (“i’ve heard from my dad’s tax guy, and also read that: the commute is the first leg, and last leg of your work period. when you first leave to get to where you hang out, and when you are on your way back home are concidered [sic] your commute. between fares is still working.”); user98 (“h&r block tax pros specifically answered this question contrary to what you are saying. no, you cannot deduct commute miles. this is verbatim what they said: ‘you, an ic, or self-employed driver are no different from a w-2 employee commutting [sic] from san jose daily to san francisco to work in his office. he (the w-2 employee) cannot use his travel, or commute expenses from home to work, neither can you.’.”); user162 (“well... be careful on that one. commuting miles are never deductible. if its from first job to second job, then yes. there is a fancy chart in the irs about it.”). 109 the following exchange reflects this confusion: 2017] the tax lives of uber drivers 81 likely equivalent to miles driven between clients, which are deductible under current law, but this was not obvious to all forum participants. in some cases, the forum debates took on a style familiar to legal reasoning– analogizing the current case to established, more familiar ones. 110 one commenter offered a broader vision of the underlying tax principle at stake: the question the irs will want you to answer is whether those miles were driven primarily for business purposes. practically speaking you can do whatever you want and just count on not being audited. but if you are audited and you've been fudging your mileage the irs will not be amused. if you want to do your taxes honestly, consider the following examples: 1. driving to do an errand with the uber app on. your primary purpose is running on [sic] errand. this mileage should not be deducted. 2. driving to a busy part of town with the intent to pick up uber passengers (even if you get no fares). deduct this.111 interestingly, the debate over which miles count never seemed fully resolved (regardless of the legal accuracy of any such resolution) on the discussion boards.112 moreover, it also did not appear resolved among advisors and self-identified experts: among posters who had sought professional tax advice, there seemed to be variation in the tax advice given (or at least variation in how the drivers understood that advice).113 we note also user152: “dead miles don’t count. that’s fraud. find me where you can legally claim dead miles.” user125: “if you drive around looking for fares that’s a valid business purpose. show me where it’s not. user152: “show me where it is. you are not actively engaging in commerce unloaded.” user100: “no. dead miles is called cost of doing business and /or commuting to work. . . .” see also user9 (“you also you [sic] can only deduct mileage en route to a pick up, on a run, or returning to the start of a run. you cannot deduct mileage driving around while on line.”). 110 for example, some participants engaged in such reasoning by analogy on one thread: user135: “if you drive your car to meet with a client for sales or to go to a business meeting your miles are deductible. so what’s the difference in driving to pick up a rider?” user152: “in the case you described the business owner has a home office that is ‘brick & mortar.’ you don’t. it’s the same as if you had a paper route. you can count your miles on your route and that’s it. if you have questions like this, you should consult the irs publications. the only way you can claim dead miles is if you have a commercial reason to count them. the reason why you can’t count the miles to pick up a rider is because you don’t start the meter until they get in the vehicle….” user135: “i don’t see the difference between driving around hunting down fares and a salesman driving around looking for sales. if i am on the clock, burning gas in the process of my job, it’s a business expense. plain and simple….” 111 user78. 112 see, for example, the following exchange: user25: “the only mileage you can keep track of is the mileage where you're making money. you can't use mileage unless you're actually in the middle of a fare…. i was shocked when my tax lady explained this.” user78: you need a new tax lady. this is absolutely false. you can deduct all the miles between when you leave to start uber driving until you return home. if you make personal stops during that time, those should not be deducted, however.” see also supra note 109. 113 see, for example, the following exchange: 82 columbia journal of tax law [vol.8:56 that the handle user176, a former cpa who was offering tax advice to drivers on the forums and through his website and startup, at one point took the position that commuting miles could be deducted, 114 though he appeared to back off from this position slightly in posts on uberpeople.115 finally, forum discussions revealed that some drivers adopted a strategy of driving home to wait between passenger rides.116 regardless of whether miles driven between home and the city center to begin or end the driving workday, or miles driven from home to the first passenger pickup, are deductible, the analysis might be more complicated for drivers who repeatedly head home within the period of their selfdesignated driving shift. other expenses another less significant topic of discussion was the deductibility of clothing and related costs. several posters mentioned deducting clothing and dry-cleaning costs, particularly for uberblack, a limousine-like service.117 however, other posters would usually reply to inform them that clothing was not deductible.118 the same dynamic occurred with respect to meals. for example, one driver inquired whether meals would be deductible if the taxpayer opted to use the standard mileage method (essentially a question of whether meal expenses were subsumed under the standard mileage safe harbor deduction or could be additionally deducted).119 the first reply stated: meals do not seem like they would qualify: according to the irs, “travel expenses are the ordinary and necessary expenses of traveling away from home for your business, profession, or job.” however, for these expenses to be deductible, you must be away from your tax home (the town where user10: “i just spoke to a accountant, you need to be able to prove you started at your house. he said i can count point a to b to a and so on, everything but you milage before you [sic] first and after your last ride.” user156: “yeah that is what i thought. ill have a hard time documenting that, so ill ask my guy to see what the [sic] thinks. in years past we have just come to an agreement with the auditor on things like this, so ill keep logging all my miles.” following this exchange, another driver chimes in. user9: “not according to my tax man. any time you are not attached to a run (the point you accept the ping), or returning to the starting point of a run, it is considered commuting time and is not deductible.” see also generally exchange between user98 and user8 regarding conflicting advice given by their respective accountants. 114 see, e.g., user176 (“former cpa here – fyi, you can write off any business mileage, which includes driving from home to your area of work, as well as driving around looking for passengers. uber will only tell you mileage while you have passengers, which is often a lot less than the mileage you can write off.”). 115 see discussion infra note 252 and accompanying text. 116 see, e.g., user167_to (“my strategy…was to stay online at my house until pings came in. i live very close to two popular bars in town, as well as relatively affluent residential area. after completing trips, i would look to return home and if i got a ping on the way from either of the bars or houses around i would take it. . . . i drove friday and saturday night, and was online on the driver app for about a total of 8.5 hours. my total time where i was earning money during trips was about 3:25 minutes. i would say the rest of the time was spent between driving get pickups or watching tv at my house waiting.”). 117 see, e.g., user87; user3; user151 (stating that they deducted “driver ‘uniform’”); user138 (stating that they would deduct haircuts and clothes “to ‘keep me professional’”); user40 (writing off clothes and internet). 118 see, e.g., user71 (“haircuts and clothing are generally not deductible. clothing can be if it is required specifically for the job – think welding helmet or fire retardant jacket.”). 119 user146; see also user168 (deducted meals). 2017] the tax lives of uber drivers 83 your business is located) for a period longer than one day’s work, and you must be away overnight . . .120 the process by which forum posters corrected each other’s errors and misunderstandings is discussed further below.121 notably, most of the discussion of mileage and other expense deductions was found in the uberpeople and reddit forums. with few exceptions, turbotax contained a more limited discussion of expenses and less extensive debate regarding which miles counted. 122 the questions posted were generally quite basic, and there were fewer nuanced questions about expenses and mileage.123 some of the answers were more sophisticated, but many were vague or contained standard or form language that did not adequately tailor the advice to ridesharing.124 in one case, for example, in response to a question about what can be deducted, the answer provided offered a good overview of the law, but did not address the law’s specific application to ridesharing.125 in another, a “turbotax taxpro” simply stated that drivers could rely on the statement provided by uber but noted that “your mileage may actually be more as you drove around waiting for a hit.”126 elsewhere, that poster recommended a method of estimating miles driven whereby the driver “keep[s] track of your mileage for one month starting from when you go available to when you go offline.”127 the fact that forum posters struggled with expenses and deductions—but were relatively compliant regarding income inclusions—may dovetail with the predictions of the economics literature on tax compliance. that literature suggests that even if form 1099-k reporting prompts taxpayers to accurately state income on their tax returns, such compliance may be partially eroded by inaccurate or excessive expense taking by the same taxpayers.128 we discuss the possible implications in greater detail in part vi.129 b. timing issues mileage and other expenses aside, some forum participants also displayed a limited understanding of timing issues and cost recovery. specifically, to the extent that the financial expenditure involved something other than a classic recurring outlay (e.g., gas, tolls, etc.), some comments suggested that posters did not appreciate the difference 120 user172; see also the following exchange: user90 asks, “can i claim my daily coffee as a deduction”; user70 and user44 say yes; user65 says no. 121 see discussion infra part v.c. 122 but see the following exchange: user149 states: “my understanding is that all mileage while ‘on the clock’ can be deducted, not just that while driving a passenger.” user143 responds: “the first pickup, last drop-off, and being at a ‘busy area’ are definitely a ‘business location’. it’s a big ‘gray area’ if you can count miles before your first pickup/arrival at a ‘busy area’.” 123 see, e.g., user83 (“i’m not claiming to have the answer, but from what i’ve read, we . . . are supposed to use a schedule c to report this income. this apparently is also where we report our expenses (ex: mileage)”; user82_to (“i drove for lyft for a couple of months last year. i was wondering what if anything i was allowed to write off. gas, service on my car, miles.”). 124 see, e.g., answer by user155; answer by user154. we counted 29 instances of formulaic language in turbotax. 125 user26. 126 user76. 127 id. 128 slemrod et al., supra note 49. that same study observed that form 1099-k might incentivize taxpayers who had not previously filed schedule c (profit or loss from business) to file that schedule. id. 129 see infra part vi.a. 84 columbia journal of tax law [vol.8:56 between current deductibility of the entire outlay and depreciation or capitalization over time. for example, some posters erroneously raised the possibility of deducting the purchase price of the vehicle.130 overall, this was not a dominant problem, perhaps because most drivers were using a preexisting personal vehicle for ridesharing. however, in cases in which drivers were contemplating the purchase or lease of a car to use for ridesharing, misunderstandings regarding deductions versus capitalization of outlays may present a bigger problem. 2. choice of method: standard mileage vs. actual expenses another common topic of discussion concerned the choice, provided by tax law, of the standard mileage method as opposed to the “actual expenses” method of recovering the costs of using a vehicle for business.131 as described above, the standard mileage method allows a set per mile deduction ($0.56/mile for 2014) for the costs of automobile operation while the actual expenses method requires tallying up allowable actual costs allocable to business use. 132 if the driver takes the standard mileage deduction, certain non-automobile business costs may also be deductible if the requirements of the relevant statutes are satisfied. once again the questions and answers reflected a significant range in awareness and sophistication. most posters on reddit and uberpeople appeared familiar with at least the basic idea of the standard mileage option.133 those new to driving and the forum were quickly informed of the method and the need, regardless of method, to maintain mileage logs. 134 in a few cases, the description of the method was sufficiently sophisticated so as to include a discussion of limitations on the driver’s subsequent ability to switch methods. 135 posters in both reddit and uberpeople generally agreed that 130 see, e.g., user48 (“you can write off a work vehicle purchase in full the year you buy it, or you can deduct a partial amount each year via depreciation.”); user6 (“but what if i were to deduct out of my income the cost of a vehicle? say i make $15,000 this year and buy the car i'm driving for $15,000. is that any different than buying gas and bottled water? it’s done for business purposes.”); user120 (“i'm not a tax expert either, but i think it depends on how much you use the car for business versus personal use. if you use the car half and half, say, i imagine at best you could deduct half the cost as a business expense, not the full cost.”). 131 see supra note 96 and accompanying text. 132 id. 133 see, e.g., user20 (explaining standard mileage rate); but see user165 (stating that standard mileage rate is unavailable to rideshare drivers); user64 (“can you explain the ‘standard mileage reduction method’? and how much of it is a tax write off? i’m so new to this, it’s scary what i don’t know. thanks in advance for explaining like i’m 5.”). 134 see, e.g., user173_to (“how do you guys handle your 1099 tax status? totally new to this. no idea how it works, never been an independent contractor. i don’t really have a ‘tax guy,’ im just a ‘go to liberty taxes and get em done every year.’ im in la, if that makes any difference. any stories/ideas/tips? anyone ever just not even file?”); response by user78 (“not filing is a terrible idea. it’s pretty easy. liberty, h&r block, turbotax, will all be able to handle the taxes without batting an eye. make sure you track your expenses and take all the deductions you’re entitled to. obviously consult a qualified professional, but generally the following are deductible: *irs mileage rate for all the miles you drove related to uber, including mileage between passengers.”). 135 see, e.g., user77 (“if you choose to use itemized expenses in order to deduct those costs, you have to use it every year for the duration of the lease. you could also forgo all of that and just use the standard mileage rate. but with a leased car, you have to use the smr every year for the duration of your lease. you can’t switch to itemized in a later year like you can with a car you own.”); user99 (“…if you start by itemizing you cannot switch to the standard $0.56 deduction the next year…”). 2017] the tax lives of uber drivers 85 drivers were better off using the standard mileage method as opposed to deducting actual expenses. a more nuanced question concerned which deductions a driver could additionally deduct if they selected the standard mileage method. forum posters generally agreed (correctly) that some other expenses could be deducted. there was even general agreement regarding the ability to deduct outlays such as tolls, fees to uber, uber phone rental, and water and mints for passengers. beyond that, however, posters argued over whether a wide variety of additional expenditures could be deducted in addition to the standard mileage deduction, including car washes, driver meals, driver clothing, and car detailing. for example, in response to one poster’s question as to whether the decision to deduct car washes was appropriate, another observed: “i’m fairly sure it as [sic]. as i understand it anything not directly mileage related can be deducted in addition to the standard deduction. so no oil change deductions because it’s mileage related but washes and water for example are ok.”136 in contrast, another poster observed: “i like to have an idea of how much i’m actually making. the 56 cents per mile is a reasonable estimate of my expenses in terms of fuel, vehicle depreciation, and wear-and-tear, washes, etc.”137 still other posters appeared divided on whether car washes could be deducted.138 3. documentation perhaps one of the most dominant refrains through the reddit and uberpeople forums concerned the need to keep track of and retain documentation for expenses taken, most importantly mileage. as noted above, most forum posters understood that mileage numbers were important in preparing their tax returns, and many realized that the mileage numbers provided by uber and lyft would understate permissible business miles and limit their tax deductions. as a result, posters devoted a substantial amount of time to discussing documentation, best practices, and technology that might facilitate good documentation. although a few outliers indicated that they would “estimate” the needed numbers, 139 most posters were concerned with determining the best way to contemporaneously document mileage and other expenses. this suggested a relatively compliant ethos in the forums. the risk of irs audit was a palpable concern in forum discussions,140 though one that posters might have overestimated. forum participants actively considered what would constitute adequate documentation if one were audited.141 136 user51. 137 user15. although the comment suggests that the poster is using the standard mileage rate as a benchmark for calculating profitability (which several posters seem to do), it also implies that the poster does not anticipate additional deductions for cash washes, and that such outlays are included in the $.56/mile. 138 see, e.g., user5 (“i would think that you could argue car washes are not part of standard mileage and therefore deductible.”); user121_to (deducted car washes and took standard mileage). 139 user23 (noting that if one gets audited, one can “create [one’s] own documentation”; stating that drivers should “estimate” and that “[t]he chance of being audited…is very slim.”). 140 we counted 83 instances of the code “audit risk” in reddit, and 160 instances in uberpeople. 141 see, e.g., user128 (“just as a side note, make sure your logs include: -starting odometer reading for each trip -ending odometer reading for each trip -start and end addresses of each trip if applicable -total mileage driven for the trip -purpose of trip 86 columbia journal of tax law [vol.8:56 forum participants liberally shared information and suggestions regarding the use of various apps and spreadsheets to help track, store, and document mileage and expenditures. the reddit and uberpeople datasets each included over 100 coded references to third party apps including expensify, mileiq, metromile, google sheets, gasbuddy, sherpashare, dash, and triplog. the discussions about using these apps reflected worries about audit risk. thus, for example, thread participants discussed evidence that, upon audit, the irs might prefer paper records for mileage documentation.142 as noted, what is not discernable from the forum discussions is the profile of and effects of these discussions on the lurking reader who does not post. for example, it is uncertain whether such readers comply with documentation requirements at the level described by forum posters. we also cannot tell whether posters themselves actually comply in the manner they publicly describe. nonetheless, at least the public conversation viewable by members of the ridesharing community (both posters and lurkers) devotes a notable amount of time and attention to issues of tax compliance and documentation. 4. issues surrounding form 1099-k receipt drivers also showed varying levels of understanding of how income was reported on the forms 1099-k received from uber in early 2015. as discussed above, this was the year in which uber changed its reporting position on form 1099-k to report all driving payments regardless of size.143 this change generated confusion across all three forums. less information than that, and your logs might not be usable in an audit, i believe. ianal [i am not a lawyer]”); user162 (“technically you could recreate a written mileage log. the uber app shows your first trip of the day. you can calculate the start location and determine the distance from when you first click ‘on’ which is probably at your home or office (if you have a regular job). you could reconstruct your mileage that way. but the better plan is to have a mileage-in, mileage-out log, with the beginning/ending odometer readings. i typically use one of these in excel, and have multiple columns in the middle to allocate the mileage between various categories (uber, work-reimbursable, work-non-reimbursable, commuting, charitable, etc).”) 142 for example, consider the following exchange: user176: one other note the irs doesn’t accept mileage that is tracked in a spreadsheet, so the spreadsheet wouldn’t hold up as proof if you were ever audited (meaning potential back taxes and penalties). user166: “how does the irc accept mileage then???” user176: “their preferred method is actually a paper log (yes, very outdated). we have basically made an electronic version of this that tracks your odometer over time. they haven’t explicitly commented on if mileage tracking apps are sufficient proof or not.” user77: “thats exactly why my excel document contains a printable weekly log to be kept in your car and filled out daily....you would then transfer that data into the mileage & expense log on a weekly basis, so the other worksheets in the document can pull the data needed for other calculations (so you dont have to do it yourself). you would also keep the handwritten log as backup in a safe place. however, the irs directly states that “you must generally prepare a written record for it to be considered adequate. this is because written evidence is more reliable than oral evidence alone. however, if you prepare a record on a computer, it is considered an adequate record.” see also user139 (“at the end of the year you only need the business miles. if you need to defend the return, the daily log is priceless. you can also use my tracks or whatever google calls it, this will log an entire route and default to saving it by date and time. but i think writing it down is still the best way, so far.”). 143 see discussion supra part ii.a.2. 2017] the tax lives of uber drivers 87 a few posters were puzzled that they received form 1099-k from uber in 2015 at all, because this was a departure from uber’s prior reporting position.144 additionally, some posters had questions about the numbers reported on form 1099-k. some correctly understood that the forms 1099-k listed gross amounts, including the safe rides fees, tolls, uber fees, and split fare fees, and that such fees should be deducted on schedule c, line 10 of the tax return to generate the appropriate net number.145 others were confused about why form 1099-k included gross amounts and thought that the forms contained errors. 146 in all three forums, a number of posts debated the accuracy of amounts reported on form 1099-k and how to adjust for fees and commissions.147 eventually, more knowledgeable forum participants (including marketers like user176/user153) intervened to explain correctly how to interpret the forms 1099-k.148 however, the impact of such interventions is not certain. as we discuss in part vi, these data raise the possibility, not previously explored in the information reporting literature, that some form 1099-k recipients may actually have over-reported earnings by failing to understand that amounts earned from uber were gross amounts.149 relatedly, some posters who drove for lyft seemed unsure of how to report income, in cases where they did not receive forms 1099 from lyft.150 others were also confused as to why they received form 1099-k from uber but not from lyft.151 some of these posters raised questions of how and whether to include income from driving for lyft.152 5. worker classification issues while not predominantly related to taxation, driver opinions regarding worker classification warranted attention due to their tax implications.153 as discussed, the threshold decision by the ridesharing platforms to classify workers as independent contractors rather than employees gave rise to the issuance of forms 1099-k and 1099misc and to accompanying issues such as expense taking and schedule c filing. despite this causal connection between independent contractor classification and the 144 see, e.g., thread entitled “basically...does uber screw us?”; user17; user114. 145 see, e.g., user78. 146 see, e.g., user77. user78 and user77 get into an argument about whether the fact that the form 1099-k lists gross amounts matters in the end. user78 gets it. user77 does not. 147 see, e.g., posts entitled “anyone else received a screwed up tax summary?”; “check your 1099s”; “1099-k and 1099-misc wtf???”; “1099-k has incorrect numbers”; “check your 1099-k **carefully** – they screwed mine up”; “you will get 2 forms! 1099-misc and 1099-k”; “here, from the irs, is the link detailing what a 1099-k is, and what to do with it”; “text post about my 1099 form and irs”; “1099-k and taxes.” 148 see, e.g., user153 (“how to read your uber 1099”); user176 (“we wrote a blog post on how to read your uber 1099 check it out here! http://tryzen99.com/blog_posts/read-uber-1099”); user176: post entitled “how to read your uber 1099” and link to blog post). there are numerous instances of commenters explaining that drivers have to report the gross form 1099-k amounts and then deduct fees. see, e.g., user78 (“uber now reports all your earnings except for referral bonuses and a few random things on the 1099-k. you have to report that income and then deduct the various uber fees from that.”) 149 the literature on form 1099-k reporting focuses on how increased expense taking may offset revenue gains but has not discussed the possibility of overreporting. slemrod et al., supra note 49. 150 turbotax lyft p5, turbotax lyft p6, turbotax lyft p11, turbotax lyft p12, turbotax lyft p16, turbotax lyft p17, turbotax lyft p18, turbotax lyft p19, turbotax lyft p21, turbotax lyft p23, turbotax lyft p25, turbotax lyft p27, turbotax lyft p30, 151 see, e.g., posts entitled “1099-ks uber vs. lyft” and “basically…does uber screw us?” 152 user7; user57. 153 we discuss our findings regarding worker classification issues in other work. 88 columbia journal of tax law [vol.8:56 receipt of forms 1099 and related tax compliance and reporting issues, forum posters did not typically associate their opinions about worker classification with these tax compliance matters. there were one or two notable exceptions, which we discuss below.154 some forum participants were enthusiastic about the prospect of being classified as independent contractors rather than employees while others were not. but in both cases, tax reporting and compliance issues were not the dominant reasons for their expressed preferences; rather, their opinions were based on non-tax reasons. for example, on one discussion thread dealing primarily with the employee-independent contractor debate, out of 37 posts, we saw 13 comments by 7 different posters expressing a preference for independent contractor rather than employee classification.155 reasons for preferring independent contractor classification ranged from no stated reason156 to concerns about being liable for back taxes, to preferences for “not having a boss,” to flexibility and independence and not having to report to a superior.157 other than the thread originator, there was only one poster who expressed enthusiasm for classification as an employee. the thread originator cited ability to make claims for back taxes and other benefits (including overtime and unemployment benefits) as upsides of employee classification.158 these data suggest that there is heterogeneity in classification preference but also a range of underlying rationales for those classification preferences.159 notably, however, conversations about the potential tax compliance and reporting implications of independent contractor vs. employee classification were generally absent. the meaning of the posters’ references to back taxes was unclear, but such concerns about back taxes were raised by posters on both sides of the debate. we speculate that some forum posters were worried that authorities would pursue them for self-employment taxes that had not been paid. other than the back taxes reference, however, forum posters did not causally associate worker classification with the tax compliance and reporting issues they were facing, but rather based their preference on other non-tax factors. 6. tax preparation issues forum participants discussed and debated how to prepare and file taxes and what modalities and instruments to use in doing so. several forum posters consulted, thought 154 see sources cited infra notes 187-190 and accompanying text. 155 of the 13 comments, the handle user164 was responsible for 7. 156 user126 (“but…i don’t want to be an uber employee”). 157 user164 (“…you can also be held liable for back taxes”; “[t]he best part of this uber thing is not having a boss!”); user50 (“…employers will always pay as little as they can legally get away with. the difference is they can now dictate your work schedule and behavior on the clock”); user31 (“there are no managers we dont’ report to anyone”). 158 user130. the other poster pointed out the ability to unionize as an upside. user109. 159 see sources cited infra notes 187-190 and accompanying text. 2017] the tax lives of uber drivers 89 about consulting, or encouraged others to consult a tax preparer or advisor. 160 we counted 115 coded references to tax preparers or advisors on reddit and 196 on uberpeople. one poster hilariously summarized the types of concerns that might have motivated some drivers to seek professional tax help: . . . get yourself a good accountant, that's what i did. cost me $300 a year but saves my butt. remember, the irs is the only agency where you are guilty and must prove yourself innocent! no other government agency has that power, it's the one agency that i won't screw with. nsa, cia, fbi, atf. go jump off a cliff. irs, yes sir, how can i help you sir, yes sir i'll do that sir, you bet sir . . . 161 other posters expressed frustration regarding the costs of such tax preparation help or were otherwise sensitive to the costs of hiring an adviser or preparer.162 among forum participants who used a tax preparer or advisor, there was some appreciation of variation in the quality and skill of such preparers or advisors.163 other forum posters stated that they prepared their own taxes using tax preparation software.164 we counted 44 references to tax preparation software on reddit and 104 on uberpeople. one issue that was evident from turbotax was the question of what version of turbotax software was appropriate. 14 out of 107 discussion threads in turbotax dealt with the question of which version of the software to use and whether rideshare drivers needed to upgrade to the turbotax home and business version to prepare their tax return.165 some posters appeared surprised that they needed to upgrade from turbotax deluxe to home and business to file schedule c. interestingly, a factor in their surprise or confusion seemed to be the “soft” sense held by some forum posters that they were not “running a business” and so should not be using the home and 160 see, e.g., user51 (“your best strategy is to consult with a tax accountant a few months before your taxes are due and track and keep all your receipts until that time.”); user41 (“i would, highly, and i mean highly suggest you go with a real tax professional while working for uber.”); user170 (“get a reputable tax person and do exactly what they tell you.”); user46 (“i have an accountant that will be reviewing my taxes before filing….”); user5 (“…i would advise getting a tax professional….”); user158 (“…talk to your tax person,…”); user77 (“consult a professional.”); user86 (“get a cpa. use reddit advice for asking your cpa questions, but don't take tax advice from people so bad at math they drive for uber.”); user140 (“it is very much worth your time and money to speak to a certified public accountant.”). 161 user115. 162 user148 (“…absolute bullshit how much they charge for someone to input numbers.”); user62 (“hr block and other similar 3rd party tax preparers are getting the best $ from this paid $200 for a $111 return”); user136 (“how much does h&r block charge to do your taxes?”); user47_to (“ok so i am looking for what name, address, and ein that appears on the 1099's uber sends out. i know that you don't need it to file but you do if you don't want your account/tax software to charge you a higher price.”). 163 see user53 (“ill contact my accountant and see his thoughts. i work in a business with many types of write downs and have to go to a special accountant because of it. a few years back i switched accountants and my current guy told me he could have saved me an extra $3000 if i had written this and that off. saving thousands is as simple as being with a guy who has the knowhow versus being at the wrong guy. maybe this works the same.”); user117 (“of course im not tax person and even the tax person i went to didn't seem that bright”). 164 user51, user59, user121, user78, user79_to; user144; user134. 165 turbotax uber p20, turbotax uber p42, turbotax uber p43, turbotax uber p44, turbotax uber p45, turbotax uber p47, turbotax uber p53, turbotax uber p60, turbotax uber p61, turbotax uber p65, turbotax uber p67, turbotax uber p76. 90 columbia journal of tax law [vol.8:56 business version.166 the discussions about software versions and upgrades tracked the well-known turbotax product controversy of january 2015, in which turbotax customers were displeased at having to pay to upgrade to turbotax home and business desktop software to file certain schedules (including schedule c). 167 turbotax reportedly backtracked and offered deluxe customers who had to upgrade a $25 rebate.168 however, the fact of the rebate was not reflected in the turbotax forum. b. role of taxes in decision making another important theme was how taxes factored into forum posters’ assessments regarding profitability of rideshare driving and decisions whether or not to drive. taxes factored into driving decisions and profitability in two ways: (a) decisions whether to drive at all, and (b) decisions about possible driving strategies. 1. the decision to drive as discussed in part iv, profitability was among the most frequent discussion topics in the threads we examined, and threads discussing profitability drew some of the largest numbers of comments. some participants posed the profitability question prior to deciding to drive. others, having driven, sought advice on how to assess their own profitability. still others shared detailed calculations of their profitability computations. forum posters considered several different elements in their computations of profitability, including expenses, fees, tolls, taxes, and wear and tear on the vehicle.169 the debates regarding how to evaluate profitability were never fully resolved, in part because different participants appeared to use different assumptions, facts, and terminology. taxes fit into these conversations in three ways: (1) as taxes per se, (2) as a proxy for the costs of rideshare driving, and (3) as an indirect framing device that affected whether drivers viewed profitability on a per mile or a per hour basis. a. taxes as taxes although most posters understood at least at a broad level that taxes would reduce their year-end take-home cash, a few did not appreciate the full potential impact 166 user69 (“i just worked for uber as an independent contractor so i don't consider this running a business...,”); user96 (“i work for uber…. so i dont have my own business so i dont need the upgrade to business but it is making me i dont know why”). see also turbotax uber p6, turbotax uber p42, turbotax lyft p4, turbotax lyft p9, turbotax lyft p18. 167 see generally laura northrup, changes to turbotax lead to consumer revolt, opportunity for competitors, consumerist (jan. 23, 2015), http://consumerist.com/2015/01/23/changes-to-turbotax-lead-toconsumer-revolt-opportunity-for-competitors/ [http://perma.cc/c4fw-p7jk]; janet novack, intuit cries uncle, will reverse turbotax deluxe changes, forbes (jan. 29, 2015), http://www.forbes.com/sites/janetnovack/2015/01/22/intuit-offers-25-refund-to-turbotax-deluxe-users-hurtby-software-changes/ [http://perma.cc/t9nv-gajf] (deluxe users could fill out schedule c as a form, but the home and business upgrade was required to file it as part of the turbotax package). 168 novack, supra note 167. 169 see, e.g., user106 (“i once made a spreadsheet to figure in depreciation, insurance, gas, oil changes, tires, etc...and it costs me like $.20 a mile to drive.”); user118 (considering price of car, gas, tires, insurance, brakes); user110 (“you know that uber never considers driver expenses such as fuel, maintenance or depreciation”); user58 (considering gas, wear and tear, and taxes). 2017] the tax lives of uber drivers 91 of taxes on profitability.170 some, for example, did not fully understand their obligation to “withhold” taxes for themselves (both income tax and employment taxes) and the possible need to file estimated taxes on a quarterly basis during the year.171 one poster summed up the point succinctly: “i wonder how many people will stop driving for uber once they get their 1099 and do their taxes? i'm guessing quite a few will once they realize how much money they're actually making. thoughts?”172 other forum posters seemed to appreciate the need to set aside taxes.173 still others opined (sarcastically) that given the low uber rates and expense deductions, they would not have to worry about owing taxes.174 thus, there was a range in forum poster awareness of the impact of tax burdens. the fact that some posters did not appreciate the full impact of taxes on their profitability may reflect an instance of what the literature on tax salience calls taxpayer 170 see, e.g., user27 (“this is emberassing, but i've never really had a job, hence income. what does it mean to ‘write off taxes’? can someone eli5 [explain like i’m five]? i've no experiences in taxes either. considering becoming a driver.”); user116_to (“i just recently became a driver and didn't read over the 1099 tax form because i needed to make money quickly. how do i know if i have to pay into taxes or not?”); user21_to (“…when does uber pay the driver? are taxes are taken out of the payment to the driver?”); user104_to (“do you drivers usually owe (pay taxes) to the irs, or do you get money back? (tax refund).”). 171 see, for example, the following exchange: user175_to: “so i'm trying to figure out how this 1099 thing works with uber. to my understanding, if i were to make $20,000 and had more than 200 transactions, then i would be sent a 1099-k. if uber paid me $600 or more directly, then i would get sent a 1099-misc. does this sound correct? does this mean if i make less than $20,000 then i don't need to file? also, what direct uber payments count towards the 1099-misc? does anyone in ca have experience dealing with 1099's from uber?” user40: “of course you have to file taxes if you make less than $20k!! lol talk to a tax account in your area.. dont believe what you read on reddit about taxes.. seek a professional.. i do know you should mail 20% of your gross every 3 months using the 1040ez form and in nj 5% to the state but thats it..” user161: “correction especially for part-timer uber drivers, you only have to pay the estimated quarterly tax if you believe that you will owe more than $1000 in taxes at the end of the year. with all of the mileage deductions, car washes, and rate cuts, unless you are ubering full-time you might not owe more than $1000. remember it's not $1000 in taxable income, it's owing $1000 or more at the end of the year.” user40: “yea but most of us are gonna owe more than $1000.” see also user101_to (“i just got approved to drive a week ago, so i have yet to figure out the tax implications of my shiny, new part-time employment as an uber driver....i know that full-time uber drivers are typically classified as independent contractors and are required to pay quarterly estimated taxes once they pass a certain profit threshold however, is that still the case for someone who has a full-time, 40+ hour job and is just doing uber on the side for extra cash?...i'm currently planning to set aside 30% from every uber paycheck in a separate account so i can settle up at tax time, but as for whether i should be paying quarterly estimated taxes or whether i should just be reporting this as additional income and paying what i owe come april 15th i'm at a loss. i also have no idea how it will affect my filing for my regular full-time job. (why must the tax code be so stupidly complicated?)”); user94 (“guessing a majority of uber drivers are going to have an extremely unhappy tax season. guys driving a new prius through uber finance and driving uber full time, they've likely been living off of money that should have been withheld for taxes. i bet we'll see a large wave of driver defections in the next few months because of this.”). 172 user136_to. 173 user74 (“my thought is to just toss 20% in a savings account until i file taxes next year, but will this be enough?”); user77 (“i am currently preparing to put away about 30% of my total uber income for taxes.”); user92 (“i saved 25% of my uber payouts anticipating taxes.”). 174 see, e.g., user55 (“you only need to pay taxes if you make a profit. with uber's wonderful rates i don't need to worry about that one”); user159 (“if you are paying taxes on uber income, you're doing it wrong.”). 92 columbia journal of tax law [vol.8:56 “spotlighting” on gross prices. that literature broadly suggests that how a tax is presented or perceived will affect taxpayer behavior in ways different from what one might expect in a perfectly rational world.175 the spotlighting176 hypothesis suggests that taxpayers may underestimate the full tax burden and simply focus on the immediate price schedule in front of them.177 spotlighting can arise when the imposition of the tax is separate from the market decision,178 for example, where the decision to drive occurs before receiving the tax bill.179 scholars hypothesize that spotlighting might also affect job choices and work decisions.180 the question of how taxpayers respond to perceived tax burdens may be particularly important for the sharing economy because of the presence of new entrants and because labor supply in this sector may be relatively 175 see david gamage & darien shanske, three essays on tax salience: market salience and political salience, 65 tax l. rev. 19 (2011); david gamage, on the future of tax salience scholarship: operative mechanisms and limiting factors, 41 fla. st. u. l. rev. 173 (2013); brian galle, hidden taxes, 87 wash. u. l. rev. 59 (2009); deborah h. schenk, exploring the salience bias in designing taxes, 28 yale j. on reg. 253 (2011); jacob goldin, sales tax not included: designing commodity taxes for inattentive consumers, 122 yale l.j. 258 (2012); lilian v. faulhaber, the hidden limits of the charitable deduction: an introduction to hypersalience, 92 b.u. l. rev. 1307 (2012); andrew t. hayashi, the legal salience of taxation, 81 u. chi. l. rev. 1443 (2014); susie cleary morse, using salience and influence to narrow the tax gap, 40 loy. u. chi. l.j. 483 (2009). 176 this terminology comes from liebman and zechkauser. jeffrey b. liebman & richard j. zeckhauser, schmeduling (2004) (unpublished manuscript) available at http://www.hks.harvard.edu/jeffreyliebman/schmeduling.pdf [http://perma.cc/4nvj-3ht2]. 177 id. (“spotlighting occurs when consumers identify and respond to immediate or local prices, and ignore the full schedule, even though future prices will be affected by current consumption.”); gamage & shanske, supra note 175. 178 gamage & shanske, supra note 175, at 27. 179 spotlighting behavior has been empirically demonstrated primarily in the sales tax, excise tax, personal property tax, toll charge, and tax incentive contexts, raj chetty, adam looney & kory kroft, salience and taxation: theory and evidence, 99 am. econ. rev. 1145, 1165 (2009) (showing grocery shoppers were less likely to purchase when tax information was posted than when only pre-tax prices were posted, despite having accurate knowledge of sales taxes. also demonstrating that tax increases included in posted prices reduce alcohol sales more than taxes applied at the checkout); richard ott & david andrus, the effect of personal property taxes on consumer vehicle-purchasing decisions: a partitioned price/mental accounting theory analysis, 28 pub. fin. rev. 134 (2000) (“although respondents opined that [vehicle personal property taxes] were too high, they had little effect on their decision to purchase a vehicle.”); kelly sims gallagher & erich muehlegger, giving green to get green? incentives and consumer adoption of hybrid vehicle technology, 61 j. envtl. econ. & mgmt. 1, 9 (2011) (finding that “[c]onsumer response is greater to a sales tax exemption, which is immediate and automatic at the time of purchase, than to an income tax credit, for which a consumer must understand, apply for, and eventually collect as part of their tax return”); amy finkelstein, ez-tax: tax salience and tax rates, 124 q.j. econ. 969, 970 (2009) (finding that when using electronic rather than hand toll collection, “driving becomes less elastic with respect to the toll and toll setting becomes less sensitive to the electoral calendar”). see also tomer blumkin, bradley j. ruffle & yosef ganun, are income and consumption taxes ever really equivalent? evidence from a real-effort experiment with real goods, 56 eur. econ. rev. 56 (2012) (finding that “the temporal separation between an individual’s labor market allocation and subsequent consumption decisions leads individuals to work longer when faced with a consumption tax than with an equivalent wage tax”); david gamage, andrew t. hayashi & brent k. nakamura, experimental evidence of tax salience and the laborleisure decision: anchoring, tax aversion, or complexity?, 41 pub. fin. rev. 203 (2012) (finding that “[s]ubjects are most willing to work when their net wage is transparent. any additional complexity in the wage description in the form of either a low base wage plus a surcharge or a high base wage less a tax, decreases work participation”). 180 gamage & shanske, supra note 175, at 29 (“if workers make job choices based primarily on posted pretax salary information, rather than on their aggregate post-tax salaries, then even the income tax may have low-market-salience”); jacob nussim, to confuse and protect: taxes and consumer protection, 1 colum. j. tax l. 218, 253 (2010) (noting workers may be misled by gross salaries and may choose to oversupply labor, but arguing that this may be an optimal outcome). 2017] the tax lives of uber drivers 93 elastic.181 relatedly, we observed estimating/guesstimating of the overall federal and state tax burdens, with little analysis of marginal rates. several forum participants seemed to pick a feasible sounding average number in “guesstimating” how much to put away over the course of the year to pay the eventual federal and state tax bills.182 when used in this manner, an estimated average tax rate can be a useful financial planning heuristic. however, to the extent drivers are relying on calculations of after-tax returns in making labor supply decisions, their decision-making process may be broadly consistent with another prediction of the salience literature, the “ironing” hypothesis.183 ironing predicts that when faced with a progressive income tax or complex rate schedules, taxpayers may focus on average rather than marginal tax rates when assessing the profitability of an economic activity (such as consumption or supplying labor). it is difficult to distinguish between rough financial planning uses of average rates and actual ironing behavior based on the internet board discussions. however, it is worth noting that most posters did not demonstrate awareness of the concept of a marginal tax rate at all and did not appear to rely on marginal rates in making driving decisions. in addition to the role of actual tax burdens in determining profitability, tax compliance costs were not lost on forum participants.184 one participant posted the following detailed analysis regarding compliance costs in the ridesharing sector: there are costs associated with doing all this tax compliance correctly andd [sic] they are a deductible expense, but an expense and tax filing obligation that does not scale well for a one car fleet. uber has turned the game upsidedown. when i owned and managed businesses, i had an accountant on retainer and a fulltime book keeper. i had assets, tow trucks and rental cars at risk. uber has put its independent contractor drivers in the situations of assets at risk and tax compliance obligations and expenses while it keeps the reward potential that went hand in hand with assets at risk and compliance expenses, mostly in the lap of its drivers, without considering the disincentives for drivers to invest and put the assets invested in at risk. uber sets the pricing. the driver cannot work harder to increase income because his costs mostly rise proportionately with extra miles driven to gross higher income. drivers are attracted by a near instant direct deposit and avoid considering all of the risks and costs vs. the reward potential. it is an unsustainable business model, great for uber and uberx riders as long as the service is available anywhere near current pricing.185 thus, at least a few drivers thought about the costs of tax preparation and compliance for independent contractors as a factor in determining whether rideshare driving was profitable.186 one final point bears noting: as discussed above, most posters did not directly connect worker classification issues with tax filing and compliance obligations.187 but 181 oei & ring, supra note 5; barry & caron, supra note 5. 182 see, e.g., sources cited supra note 173. 183 see generally sources cited supra notes 175 and 179 for a discussion of ironing. 184 see supra note 162. 185 user165. 186 see generally supra part v.a. 187 see discussion supra part v.a.5. 94 columbia journal of tax law [vol.8:56 some did indirectly raise a connection between the status of drivers as employees or independent contractors and the potential impact on the ridesharing business model and its ultimately profitability (with taxes being a component of such profitability). mixed feelings and opinions about worker classification were evident in various discussion threads and often seemed tied to uncertainty about the actual economic implications of one classification over another. 188 for example, some posters questioned whether litigation would force uber to treat drivers as “true” independent contractors by shifting more costs to drivers, while others maintained that even a finding that drivers were employees would have an indeterminate economic effect on actual driver costs.189 some posters expressed doubt that employee status would improve their situation because the costs would ultimately be borne by drivers anyway.190 thus, even though the posters’ worker classification comments did not pertain directly to tax law, the indirect economic implications (which encompasses tax burdens) did not escape forum posters. b. tax numbers as proxies tax numbers also played a role as proxies in how forum posters estimated other expenses of driving. a major source of difficulty for forum posters was how to calculate and evaluate the costs of using personal property for business, including costs associated with vehicle wear and tear. 191 in this context, many drivers used the tax system’s standard mileage allowance ($.56/mile for 2014) as a proxy for calculating economic 188 see, e.g., user127 (“so now what? uber and lyft are going to be hit with a shitload more expenses, and it’s coming straight out of your fares, because they’re certainly not going to raise the rates.”); user12 (“personally am not a fan of unions, would not join or pay dues, i am an independent contractor.”); user45 (“we’re independent contractors running our own businesses. we’re management, not labor.”); user88 (“personally, i have no interest in being an uber employee”); user117, user169 (discussion of possible effects on uber business model if drivers are held to be employees). one commenter noted, “i hate that we have a distinction, which is what’s driving my disdain in the first place.” user127. 189 user55 (“i am not sure "siding with us" is the right term. yes the government want's a bigger chunk, i am not sure that will mean a bigger chunk for us as well. you can not force an evil corporation to treat you better.”); see also user13, user177, user109, and user159. 190 user150 (“uber is exploiting a one sided coercive contract that favors uber over the drivers”); user80 (“…freelance workers would end up taking the biggest hit”). 191 as an example of a poster not appreciating the impact of vehicle wear and tear, see user35_to (“i just got my 1099k and for the 4 months i was driving i made $3200. i haven't added up my receipts for gas yet but i'm figuring around 500 or so spent. when i first started driving my car appraised for $18000. i later sold my car for $16000. because of the mileage. they wouldn't give me the same amount as the original offer. so all said and done after taxes i'll actually end up loosing money driving for uber.”). in response to comments from other posters who questioned why this forum participant was surprised that driving would likely decrease the value of the car, user35 clarified: “i knew it would but i didn't expect a depreciation of $2000. once i get my taxes in line i'll have a final number. i'd be happy coming out even. i needed the money when i was driving. it helped out a lot when i needed it but not worth it to me anymore. i got a new job making significantly more money.”); see also user54 (“there's no doubt that drivers have higher costs than your typical salaried 9-5'er, but that is the price we pay for having much greater freedom than the other guy. . .. on top of that, it's not exactly equal because i didn't take into account the much more frequent oil changes that i perform than your average 9-5'er, and car maintenance in general, but all of this goes back to the original question that i posed is the flexibility important enough for you to take on these expenses?”). 2017] the tax lives of uber drivers 95 costs of driving the vehicle, especially in accounting for the impact of depreciation.192 several posters appeared not to understand that the standard mileage allowance was a tax number and not necessarily a reflection of economic reality.193 others criticized the use of the standard mileage allowance as irrelevant for purposes of determining economic profitability, arguing that it actually costs nobody $.56/mile to operate their vehicle.194 more generally, forum participants displayed confusion and disagreement regarding the relationship between tax losses and economic losses. some posters expressed satisfaction at incurring a tax loss, not seeming to realize that the tax loss might reflect a true economic loss. conversely, others failed to appreciate that tax losses might be generated through aggressive tax reporting by drivers experiencing actual economic profits. consider the following contrasting responses to a forum poster who outlined how, after taking the standard mileage deduction and other deductions, there was no taxable income from uber driving: user124: “the milage [sic] deduction to me was a huge item. i used turbo tax and quickbooks to enter all items and as far as i'm concerned i made money just by not having to pay a large tax bill like i did last year before i started driving uber.” user56: “if this goes through, for you and for others, this will represent one of the greatest scams on american tax payers, in years.” user94: “only uber drivers are dumb enough to be excited about pulling a loss on their operations.”195 this exchange illustrates how the first two posters regard tax losses as an economic positive for uber drivers, believing that those tax losses are disguising economic gains, but the third presumes that those tax losses reflect actual economic losses. of course, there is no way of knowing who is right without additional information. c. taxes as a framing device for profitability computations tax concepts also influenced whether forum participants measured and discussed profitability on a per-mile or a per-hour basis. forum participants frequently made profitability calculations on a per mile basis. 196 the per-mile framing was likely prompted by how two key costs of driving are measured: (1) tax law’s standard mileage 192 see, e.g., user1 (“that's $160 after commission. so assuming that's 200 miles and operating cost is .57/mile as irs deduction states, that's $114 operating cost, and you'd be taxed on $46 (difference in revenue operating costs) which is $11.5. so net after commission, operating costs, and tax your take home is $34.5 for 10 hours of work.”); user18_to (“the irs deduction rate of $0.575/mile for 2015 is pretty accurate in terms of the actual cost per mile to drive a vehicle after depreciation, gas, oil, maintenance, and other expenses.”); user93 (“the standard mileage deduction (which i used all of the mileage that i clocked when the app was on and ready for ride requests) worked in my favor. it showed that driving for uber was a money loser for me.”). 193 see sources cited supra note 192. 194 see, e.g., user42 (“the irs mileage deduction isn't ‘operating costs.’ it's solely for the depreciation of the value of the vehicle due to mileage driven, and it's only relevant at tax time for purposes of ‘reducing’ your tax bill. it certainly doesn't cost me (or anyone else) $114 to operate a car for 200 miles.”); user157 (“be careful. many people in here will say they made $10 for a 10 mile ride, then subtract gas, then subtract 57.5 cents per mile, and tell you they made $2 an hour. they think the 57.5 cents is their ‘cost to operate their car’ because the ‘irs says so.’”); user85 (“i run my vehicle for way less than .56.”). 195 user124, user56, user94. 196 in both reddit and uberpeople, the code “profitability: per-mile vs. per hour” was among the most common (361 occurrences in reddit; 359 in uberpeople). 96 columbia journal of tax law [vol.8:56 deduction, which is frequently used as a proxy for assessing profitability, and (2) gas and vehicle mileage, which is computed on a mpg basis.197 however, sometimes drivers also described their profitability in dollars per hour, reflecting their frequent comparisons of the decision to drive with alternative low wage employment, e.g., walmart, which pays on a per-hour basis.198 there were fewer references to per-week or per-month computations. 2. decisions on how to drive a. the role of taxes in deciding “how” to drive beyond the binary decision of whether to drive at all, drivers face a secondary decision of “how” to drive, that is, whether to drive on a part-time or full-time basis.199 here, again, taxes played a role in decision making both in their own right and as proxies for other important measurements. there seemed to be a general consensus that it is more likely to make sense to drive for uber part time than full time.200 this consensus was supported by a number of non-tax factors including: (1) driving part time enables the driver to select the most profitable times of day to drive201 whereas full-time drivers need to drive at suboptimal times and are more likely to experience burnout,202 (2) forum participants perceive vehicle wear and tear as less significant and feel more justified in ignoring these costs when driving part time, 203 and (3) the instability of uber’s 197 the fact that vehicle wear and tear may ultimately be a bigger cost in ridesharing may be less salient to drivers because gas purchases constitute a daily or weekly purchase. 198 see, e.g., user142 (“since uberx decided to drop prices by 70% last year drivers are making less than minimum wage. when you work for walmart you are guaranteed you will make 9 dollars for every hour you showed up. with uberx sometimes you can come back home empty handed.”); user99 (“…uber is now the walmart of rideshare/transportation, they do not care if the drivers make livable wages, if you want a better job, look somewhere else.”); user67 (“a walmart checker may gross $2,000 an hour at their register, but what do they get to take home each hour?”). of course, such comments do not reflect the greater flexibility in setting hours for uber drivers than for substitute low-wage employment. see, e.g., user133 (“i am not obligated to work uber which is the bonus. doing this and my full time job i work 6 days a week. it's tiring and fortunately i can drop one whenever i feel like it.”); user99 (“i would rather drive uber than work behind the counter of a mcdonalds”). 199 another choice discussed was whether to drive for uberx or uberblack, or to do both. 200 see, e.g., user23 (“uber's meant to be a part-time, supplemental income gig. making it a full time, main hustle is where i see people get bitter about it.”). 201 see, e.g., user11 (“i like being able to pick and choose the times i drive. i only drive during surges now. i work like 8 hours a week usually making 200-250. i tried driving 8 hours straight one day and i was do [sic] bored out of my mind. i like to think that i can just stop after one or 2 good rides.”); user163 (“there's just not enough weekday daytime business in richmond to make uber a viable full-time gig.”). 202 see, e.g., user68 (“my advice: you work full time at this, you burn out. everyone who does this part time enjoys it. those who don't...”); user169 (“also, in order to really make it work full time, you'd need to work a crazy schedule. it just doesn't make sense to drive between 9 and 5 when everyone else is at work so you'd have to do a few hours in the morning, go home, come back out, do several more hours in the evening, then work every weekend. i don't know about you but that's not something i'd be willing to do.”) 203 see sources cited supra note 191; see also user73 (“i suppose i question as to whether or not you are really accounting for the wear and tear on your car driving uber full time.”); user174 (“it is very easy to become resentful of uber and the pax when its a f/t gig…. you will drive your vehicle into the ground, basically stealing its value to put in your bank…”). 2017] the tax lives of uber drivers 97 pricing/rate structure and the risk of relying on uber to make a living.204 tax factors also played a role. forum participants judged obligations for quarterly filing and payment of estimated taxes to be less onerous for part-time drivers with other full-time employment because such drivers could avoid estimated tax obligations by simply increasing wage withholding from their w-2 jobs. 205 forum participants also seemed to appreciate, implicitly, the value of untaxed benefits (e.g., paid vacation) received from alternative wage employment.206 although part-time driving was viewed as preferable to full-time driving, some forum participants noted that even part-time driving might not be profitable. one poster wrote: . . . i see people as being in 2 categories either: a) you are trying to make uber a full time job b) you have a job and use uber to supplement your income . . . if you are in category (b), you will probably make around $12 an hour if you live in a decent city, or more if you time your hours so you only work during the most profitable times (full timers don't have this luxury obviously). but if you live anywhere else you will be making below minimum wage. at that point it would only make sense to continue driving if you literally can't make ends meet and you can't find another job to do on the weekends. uber knows this and exploits the fact that its part-time drivers are either desperate for money or say "it's for beer money" and don't bother to do the calculations to realize they are making below minimum wage. and if that's the case, you would be better off working at mcdonalds. at least that job is here to stay, you know exactly how much you are making, and you aren't putting miles on your car.207 the sentiment here is that part-time drivers may not have the incentive to pay attention to taxes and other expenses in determining whether driving is profitable. b. the labor-leisure trade-off in part-time driving discussions among forum posters regarding their decisions to drive part time reveal interesting insights into the labor-leisure trade-off, a frequent subject of economic analysis.208 forum posters generally did not explicitly discuss leisure as something that they traded off against driving. however, they seemed to weigh leisure time implicitly, 204 see, e.g., user169 (“imo, uber isn't reliable enough to turn it into a career. it's great for cash on the side or to help you out if you're in between things but, as we've seen in most parts of the country, rates can drop at a moment's notice whenever uber feels like it.”); uberpeople p470-476 (thread containing various posts about rate cuts). 205 see, e.g., user42 (“i agree, and the fact that i have regular work/don't need to worry about setting aside 35% for taxes is why it still pays for me.”); user 68 (notes that you can adjust job withholding to avoid paying quarterly taxes on uber income); user36 (“if you are part-time, i assume you have a w-2 job. instead of doing estimated tax payments, you can adjust the w-2 tax withholding to cover both jobs.”). 206 although forum participants did not explicitly state that these benefits were untaxed compensation, the point was implicit. see, e.g., user169 (“it really depends on what your current job is. if you're making a living wage, have job security, benefits, time off, vacations, etc... then stick with it even if you think you could make a little more in the short term with uber.”); user137 (“because of the fact that just about any entry level, full-time job pays better than uber and has actual benefits, no person who is qualified for and able to acquire such a job would drive for uber full time.”). 207 user137. 208 see generally george borjas, labor economics (7th ed. 2016). 98 columbia journal of tax law [vol.8:56 as reflected by: (1) discussions about the flexibility of driving for uber, (2) descriptions of driving as having both business and pleasure components for a subset of forum participants,209 and (3) descriptions of the incentive to drive as the opportunity to earn some money for “extras” or “beer money.”210 these descriptions are suggestive of driving being a choice, to be weighed against other alternatives, such as “free time” on the weekend. as discussed above, it is possible that forum posters made these choices while mismeasuring the true costs of their earnings (through the failure to fully account for expenses, taxes, and wear and tear).211 3. summary these observations about forum posters’ profitability assessments, driving decisions, and labor-leisure trade-offs help illuminate how cognitive limitations and market considerations (including tax considerations) combine to shape their labor supply decisions. for example, to the extent that mismeasurement of driving costs affects driver decisions, it is unclear whether having a full year’s experience driving is enough to completely mitigate the mismeasurement. some costs might become visible during the tax return preparation process and allow drivers to revise their profitability assessments or implement new strategies (e.g., setting aside money to pay taxes) the following year. but other costs may remain hidden longer or may never be fully appreciated. for example, vehicle wear and tear may accelerate the need for repairs and replacement, but these costs may not be visible for several years, and drivers might not associate them with their ridesharing activities when they occur. c. tax sophistication and tax compliance culture finally, we examined broader questions of how sophisticated forum participants are in their understanding of tax law, how they conduct themselves (or, at least, talk about conducting themselves) in terms of tax compliance, and how other cultural characteristics of the discussion boards may shape the transmission of tax knowledge online. 1. overall level of sophistication 209 see, e.g., user24 (“as a result i have taken a view to only drive for pure sport and entertainment…and as a loan until i have to file for taxes.”); user81 (“…the hourly rate isn't bad for a part time job. i also get to know my city better and i can meet and talk with all kinds of interesting people while on uber time.”); user2 (“uber is like gambling. some people do it for a full time job but most just do it for fun.”); user37 (“…regardless i'm not doing it entirely for the cash. i don't get to drive as part of my daily routine, so 5-8 hours a week behind the wheel is kind of fun. plus i'm going to enjoy getting to know other parts of the city. and finally, i hope to meet some interesting people. i think it's a win/win.”); user160 (“same. i do it for ‘fun’. i enjoy the people i have given rides to, the stories i have and the rush of picking up a fare. it gives me a few extra bucks some weeks with the flexibility to do a ton of driving or zero. would i ever do uber for a full time job? heck no.”); user169 (“i enjoy driving and meeting people and the social aspect of uber as well, but based on what i've seen around this sub, i suspect i'd feel differently if i put 40+ hours in every week instead of ~10.”). 210 the term “beer money” occurred frequently as shorthand for driving for extra cash. see, e.g., user108 (“because most uberx drivers are like myself. people who just do this part time while family is asleep to make some extra beer money.”); user137 (“ . . .uber knows this and exploits the fact that its part-time drivers are either desperate for money or say ‘it's for beer money’ and don't bother to do the calculations to realize they are making below minimum wage.”); see also uber42 (“for me, it's exactly what it was supposed to be when uberx first came out extra pocket money, not a career.”) 211 see discussion supra part v.b.1.a. 2017] the tax lives of uber drivers 99 as discussed, we observed a range of sophistication in how well forum participants understood taxes. discussions on reddit and uberpeople seemed more sophisticated than those on turbotax in several respects. discussions on reddit and uberpeople often used tax terms and concepts more accurately. participants in the turbotax forums asked more basic questions about where and how to enter income, whether they had to file taxes, what software to use, and what to do with form 1099. there were a number of questions that seemed relatively inchoate on turbotax. 212 admittedly, however, it was difficult to get a robust sense of poster sophistication on turbotax because there was much less back-and-forth conversation: participants tended to pose a question, and then a turbotax employee, professional, or “superuser” would answer that question. 2. process of error correction and disapproval another interesting feature was the process by which disagreement was expressed and errors corrected on reddit and uberpeople. when a poster said something wrong (e.g., took a wrong tax reporting position or gave an inaccurate answer to some else’s question), the error was often, and often quickly, corrected by other posters. for example, in one of the forums, where several posters said they would deduct uniforms and haircuts, others chimed in to say that these items are not generally deductible.213 when one poster expressed an intent to deduct meals, another immediately countered that meals are not generally deductible.214 where one poster opined that taxes would not be owed if grossing less than $20,000, other forum participants were swift to correct the error.215 we observed error correction in the other forum as well. when some forum participants suggested that they might not report income because they did not receive a lyft form 1099-k, others (including some marketers of tax services) pointed out the audit risk and the obligation to include income.216 on one discussion thread, the thread originator posted an image of his tax return and the expenses he wrote off, which showed a net loss.217 the poster reported filing that tax return with the help of a “reputable tax agent.” other posters were quick to point out problems with his return, making statement such as: • “$[xxx] for waters and snacks? on just $[xxxx] in gross 212 see, e.g., user29 (“how do i add mileage to my return? i am an uber driver and need to add mileage to my return”); user33 (“does uber count as public transportation for tax purposes?”). 213 user151 (attempts to deduct uniform); user138 (will deduct haircuts and clothes); user28 and user71 correct user151 and user138, saying that these items are not deductible; user40 (says he will deduct clothes, internet, and other items); user107 (sarcastically questions these deductions by user40). 214 user168 says they are going to deduct meals; user78 says “you can’t generally deduct meals”; user4 says “you must be a really shitty uber driver if youre deducting meals from your tax. fraud”. see also the following exchange: user3 claims that he deducts one meal a day; user78 informs him that “meals in this circumstance are absolutely not deductible.” user86 also says meals are not deductible. 215 user6 (thinks he does not have to pay taxes, other forum participants correct him). 216 user7 (asks whether income not reported on form 1099 needs to be “claim[ed]” and user66 suggests that “[i]f [lyft is] not reporting it to the irs then i’m not going to report it”; user153 (tryzen99 founder) alerts them to compliance obligation and audit risk). 217 user30. 100 columbia journal of tax law [vol.8:56 fares? gotta say that is some creative accounting.”218 • “how did you take into account what were personal expenses vs. business expenses? in other words was all that gas used for uber only? how could you differentiate it? irs may want to know in an audit.”219 • “i agree with other posters...think you will be in big trouble if audit. at $[x] gal (not sure what you pay) you used [xxx] gallons of gas for only [xxx] trips??? no wonder you drank so much water! i will bet you did not keep track of actual miles, right? share them if you did. i drove [xxxxx] miles in [x] months!! about [xxxx] was trip miles.”220 • “i would be worried about this tax person, and would not recommend him. (i'm a former cpa, by the way.) i would also immediately ask him about a few very obvious issues…”221 • “i can tell you that the numbers you have seem way out there to me and i agree completely with the poster who is a cpa that there are some very questionable things going on with your return.”222 these comments represent an instance of robust and unequivocal error correction.223 disapproval by upvoting and downvoting. a notable feature of reddit was that even if an error was not explicitly corrected or contradicted, disapproval or disagreement sometimes occurred by upvoting and downvoting. for example, where one poster stated, with respect to whether “dead miles” count as business mileage, “if you drive around looking for fares that's a valid business purpose. show me where it's not,” that statement received 8 points (upvotes minus downvotes).224 when someone else responded “show me where it is. you are not actively engaging in commerce unloaded,” that comment received –6 points (i.e., six more downvotes than upvotes).225 when another poster wrote “i think we should simply not pay the irs anything. fuck them. fuck the united states. 218 user123. 219 user171. 220 user14. 221 user153. 222 user65. 223 see also the following exchange: user113; “if you have another vehicle in the family available for personal use (i.e. for me my wife has a truck) then you can claim every mile you drive your user vehicle as business whether it's actually for business or not. you may want to fabricate a mileage log to back that up though just in case” user162: “um…false.” user113: “yes you can claim 100% business usage on a vehicle if is not your only vehicle ...why would that be false?” user162: “that is true but you said: you can claim every mile you drive your user vehicle as business whether it's actually for business or not. the ‘or not’ makes it false.” user162: “...and fabricating a mileage log is fraud. play by the rules. you would be surprised what information comes out when irs ci investigates a tp. crazy the stuff people will say on an open forum.” 224 user78. 225 user152. 2017] the tax lives of uber drivers 101 this country can seriously choke on a gay cock,” that statement received –4 points.226 (in the latter instance, it is unclear whether the downvotes were triggered by the tax noncompliance or the phrasing.) thus, on reddit, there was arguably more than one mode of error correction, and we speculate that, among some reddit users, upvoting and downvoting might be another powerful signal of community sentiment, in addition to outright disagreement. but upvoting and downvoting is not a perfect signal of accuracy. we observed instances where reddit users sometimes upvoted popular but not totally accurate advice. for example, where someone wrote, “they only track your miles while on a fare. it's extremely important to track all of your mileage, as it is all deductible,” that comment, while not necessarily completely accurate, received 5 points.227 in sum, we observed that error correction was surprisingly robust and frequent. this created an overall impression of a compliant culture on the threads, at least in the case of correcting egregious errors. error correction, however, might be less a matter of compliance and more a matter of asserting and maintaining status and respect in an online community. error correction was, of course, an imperfect process. it did not always happen, and even when it did happen was not always effective. we observed instances in which errors, misstatements or misunderstandings of the law, or expressed intent not to comply went uncorrected. 228 we also observed instances where, even if corrected, corrections were subsequently undermined by recalcitrant commenters who perpetuated the error.229 for example, on one thread, accurate commenter statements of which miles are deductible were drowned out by repeated restatements of more aggressive/wrong tax positions by other commenters, such that by the end of the thread, it may have been impossible for the lay reader to tell which was the correct rule.230 finally, in all of this, it is unclear whether posters were compliant or accurate in their actual tax behaviors, notwithstanding the existence of error correction on the boards. however, to the extent forum readers may be influenced by their perceptions of the conduct and norms of their peers, the tenor of the forums would likely be influential. 3. accuracy of tax advising and commentary on the forums related to the question of how errors get corrected in the forums is the question of how tax advice is given and received. as our discussion above shows, there was a notable amount of accurate tax advice and commentary given on the discussion boards. in many instances, forum participants on reddit and uberpeople stated the tax law accurately, correctly characterizing, for example, the rules with respect to which miles count, whether certain items can be deducted, whether income had to be reported, and where on the tax return to report it.231 forum participants also often referred directly to irs websites and publications in formulating advice.232 several forum participants also 226 user19. 227 user161. 228 see, e.g., uberpeople p11-p13 (several misstatements about whether coffee, car washes, and meals are deductible go uncorrected, or, even if corrected, are overridden by other erroneous posts). 229 id. 230 on one thread, for example, user153 and user98 warn about commute miles not being deductible, but user85, user61, user92, user8, and others persist in claiming that all miles driven with the uber app on are deductible and that there is no commute. 231 see, e.g., user162; user105; user51; user145. 232 see, e.g., user145; user91; user60; user78, user38. 102 columbia journal of tax law [vol.8:56 shared spreadsheet and third party applications that they used in filing taxes, documenting mileage, etc.233 however, instances of accurate tax advising were interspersed with inaccurate, vague, or misleading statements about the tax law. as a consequence, while we were able to identify good advice when it occurred, we also took note of many instances of oversimplified, confusing, or just wrong tax advice. to take just a few examples: • “be careful, if you lose money 3 out of 5 years, you become notfor-profit and cannot count those losses against other income.”234 • “if you don't make a[ny] taxable income, then your business is considered a hobby by the irs and every penny is taxable.”235 • “if the time comes when you get audited, you can create your own documentation at any time.”236 • “you cannot deduct .56 cents per mile if your vehicle generates income from even an ‘informal’ taxi service. you must deduct actual expenses and depreciaton [sic] incurred, unless you are leasing your vehicle.”237 • “i deduct one meal a day, it’s been awhile since i looked it up. just don’t eat at a fancy restaurant.”238 • “this is what i do and i don't know if it's going to work. i know my average mpg is almost exactly 30, so i just take that and look at my receipts and find the total gallons i bought. 30x11 gallons for example = 330 miles. boom done.”239 • “once a month my bride and i go out for a decent meal out to discuss such topics as uber, our rental properties, and how i'm running my consulting business. we also talk about our kids, what's happening on veep, and where we want to vacation next summer. i've been expensing these outings for better than 10 years. never been a problem. just make sure you hold onto receipts and don't abuse the privilege.”240 given that good advice was intermingled with vague, misleading, or inaccurate statements, it is difficult to know whether readers of the discussion boards were able to appreciate and understand the good advice, or the extent to which they were misled by bad advice drowning out the good. 233 see, e.g., user77_to; user89; user97; user72; user49; user34. 234 user161. this statement and the next are oversimplifications of the hobby loss rule. i.r.c. § 183. 235 user119_to. 236 user23. this comment does not comply with the substantiation requirements. 237 user165. this statement is wrong. rideshare drivers can use standard mileage. 238 user3. meals are not deductible. 239 user19. this is obviously not the correct way to track mileage. see, e.g., car and truck expense deduction reminders, internal revenue service, http://www.irs.gov/uac/car-and-truck-expensededuction-reminders [http://perma.cc/3tnv-xg6f] (last visited dec. 8, 2016) (taxpayer should maintain a daily mileage log). 240 user44. meals are not deductible. see, e.g., i.r.s. publication 463, travel, entertainment, gifts, and car expenses (2015) at 5 (meals are deductible if taxpayer travels overnight for work, or if the travel is long enough to require “sleep or rest”). 2017] the tax lives of uber drivers 103 we also observed a fair amount of cautioning or disclaiming that accompanied the tax advice dispensed on the discussion boards. for example, forum participants urged each other to consult with professional tax advisors, and told each other not to rely on the tax advice they themselves gave on the boards.241 posters frequently referred each other to irs websites and publications (either by linking to them or by excerpting and quoting text) in supporting statements they were making.242 we wondered whether this might either reflect some sense of responsibility for the dispensing of tax advice, a perception that there was some risk or consequence to themselves (either legal or social) from dispensing inaccurate advice to other forum readers, or some other community norm in the forums. we have no idea whether such disclaimers were effective in terms of encouraging readers to seek professional tax help. 4. “marketed” tax advice in the discussion forums in addition to ad hoc comments and advice by various posters, we also observed instances of cpas, former cpas, and other self-identified experts answering or volunteering to answer questions. some of these posters used the forums as a platform to market their businesses or web and mobile applications they had developed.243 others just seemed to be offering free advice and sharing their experience, expertise, and spreadsheets, though perhaps with the anticipation of future profit.244 the most prominent example of “marketed” tax advice in both the reddit and uberpeople forums was the poster user176/ user153.245 this poster was the owner of the now-defunct tryzen99.com website. he originated 7 separate threads on reddit and commented 63 times, making him the sixth most frequent commenter. on uberpeople, he originated three threads and commented 67 times. the threads he originated pertained to receipt of forms 1099 from uber and lyft, how to read the forms, other issues confronting ridesharing drivers, and general issues relevant to independent contractors (such as best cities for independent contractors, and health insurance). this poster’s comments spanned several issues, including which miles “count” as deductible business miles, how to understand the forms 1099-k received from uber, deductibility of items such as meals, choice of method (standard mileage vs. actual costs), and other issues facing independent contractors. he also posted a number of links to his website, blog, and ridesharing tax guides he had published. 246 he would sometimes interject in 241 see, e.g., user120 (“i’m not a tax expert either …. but if you get audited don’t look at me. you’re better off googling stuff or asking a tax adviser.”); user68 (“as i said, this is what i’ve gleaned, but i’m not a tax professional. feel free to correct me if i’m wrong”); user86 (“pro tip: don’t take advice from this sub”); user141 (“i start [tracking miles] from the time i go online to accept calls. if i get no action, and need to move closer to a busy area, i include those miles too. however, i’m not a tax professional.”). see also the signature block of user75, a well-known forum member. (“i am a geologist; not a cpa, attorney, or anything else that means my work should be taken as the gospel. i provide information/advice to the best of my knowledge from my personal experience driving for uberx & lyft and business knowledge”); user107 (“asking for tax advise on this (or any) forum is a recipe for disaster and an unpleasant audit. plenty of bad advice will be given. it is best to ask a tax professional (hint: they'll just say to take the irs standard $0.56 per mile)”). 242 see sources cited supra note 232. 243 see, e.g., user153; user131; user95; user122; user176. 244 see, e.g., user77; user105; user51; user111. 245 this poster used two separate usernames, one in each forum. 246 as of august 2015, tryzen99.com shut down its business. biz carson, there's a big shift going on in startups, and this company just got caught in the middle, bus. insider (aug. 12, 2015, 6:06 pm) http://www.businessinsider.com/why-zen99-closed-its-doors-2015-8 [http://perma.cc/5wn8-s2gk]. 104 columbia journal of tax law [vol.8:56 discussion threads posted by other marketers to steer the conversation in different directions. overall, we found that user176/user153’s advice was in the ballpark of accurate, but there were some problem areas. for example, at one point he claimed that drivers could only deduct 50% of water or snacks provided to passengers. but that advice was subsequently recanted in the ridesharing guide published on tryzen99’s website.247 in addition, prior to january 2015, he advised readers that they would not receive forms 1099-k unless they met the 200 rides/$20,000 threshold. this turned out not to be the case, as uber decided to issue forms 1099-k to all drivers. perhaps most importantly, user176/user153 consistently took the position in one of the forums that all miles driven on uber business, including miles driven from home to one’s area of work, counted as deductible business miles.248 as we have noted, this is a fairly aggressive position and it is possible that the commute miles (i.e., miles driven from home to area of work) may not be written off, unless driving to a different metropolitan area.249 other forum posters challenged him on this point but he persisted in taking this position. 250 interestingly, user176/user153 is far less specific in his description of what miles count as business miles in his guide published on the tryzen99 website.251 in addition, his posts in the other forum were much more equivocal and less aggressive about whether commute miles can be deducted; here, he cautioned against deducting miles from home to area of work, and acknowledged that this is an open issue.252 finally, we noted that even where the advice given by user176/user153 was not outright wrong, the nature of posting in an internet forum meant that his advice was sometimes given in overly general terms and could appear ambiguous or confusing. for example, in one case, he gave advice about deducting mileage but did not adequately distinguish between the standard mileage and actual costs methods. we know that he was correctly advising forum readers of the difference between the two methods in other posts, but taken out of context, his statements in this instance could be interpreted as inaccurate. ultimately, we have no way of knowing how the incidence of error and the quality of tax advice on the boards compares to in-person peer advising or tax preparer advising. apart from user176/user153, we also counted numerous other instances on both reddit and uberpeople of marketed tax advice and promotion of applications and 247zen99, http://web.archive.org/web/20151022200742/http://tryzen99.com/1099-taxguides/ridesharing [http://perma.cc/7z8e-sr3u] (last visited dec. 8, 2016) (“you can ... write off any snacks or amenities purchased for clients (e.g., water). 248 “[y]ou can write off any business mileage, which includes driving from home to your area of work, as well as driving around looking for passengers.”; “since you are an independent contractor, you can write off any business related mileage. this includes driving from your home to area of work, or driving around waiting for passengers.”. 249 see supra note 98 and accompanying text. 250 this user said in response to critiques of prior posts, “most of those commuting rules are for employees who travel to the same office. if they travel to a client office, they can write that off as business mileage. technically, since you don't have an office, every time you drive to the area is for ‘client’ business. the irs hasn't specifically commented on ridesharing, so some accountants will say ‘yes it's fine’ and some will say ‘no it's not’. most ridesharers write it off though.”. 251 zen99, http://web.archive.org/web/20151022200742/http://tryzen99.com/1099-taxguides/ridesharing [http://perma.cc/rfr8-uag4] (last visited dec. 8, 2016). 252 it is possible that this position might have evolved over time, but we cannot tell the exact dates of some of the reddit posts. 2017] the tax lives of uber drivers 105 websites designed to help with tax compliance.253 forum participants posted tax and ridesharing guides, links to advising websites, and mobile applications that they were building to help with tasks like expense or mileage tracking. these posters sometimes requested that other participants test or fund such applications.254 on one thread, a poster professing to be a tax attorney offered to answer general questions, and even provided a circular 230 disclosure.255 vi. analysis and recommendations: compliance, money, and community in the internet forums the internet forums that we studied contained a treasure trove of information about how ridesharing drivers encountered the tax system and interacted with each other online, yielding a rich set of insights. three notable motifs were apparent from the data: (1) forum posters’ struggles with tax compliance issues; (2) ongoing questions about whether driving was profitable or made economic sense (and how this analysis changed over time); and (3) the unique nature of communication, culture, and community in the internet forums. as this part discusses, each of these motifs suggests a particular set of normative insights, which may be in tension with each other. a. compliance one of the most dominant themes we observed running through the forums was that of expense taking and its attendant difficulties. from calculating mileage to determining which miles are deductible business miles to deciding which expenses are deductible, the question of how and whether to properly recover expenses was a recurring refrain. 256 relatedly, the question of how to properly document and keep track of expenses was a key challenge for forum participants, as was the question of how to understand and interpret numbers on form 1099-k when filling out the tax return. in these questions, we saw a good deal of confusion and disagreement regarding the proper application of tax law to ridesharing. for example, forum participants disagreed about whether “dead miles” could be deducted, which apps suffice for documentation purposes, and which expenses could be deducted. the debates we observed suggest that inaccurate expense taking may be occurring in the ridesharing sector, a result roughly consistent with findings in existing tax compliance literature.257 thus, irs clarification in this area could be a helpful and realistic option. as a first step, it would be relatively simple for the irs to clarify how the existing rules for deductibility of commuting and other miles apply by extension to ridesharing and to clarify which internet and mobile applications are acceptable for 253 we coded 90 instances on reddit and 86 instances on uberpeople of “marketing posts.” 254 see, e.g., reddit p14 (hurdlr rideshare guide); p62 (app for freelancers), p72 (expense tracking excel file), p73 (feedback on whether to write ridesharing guide), p76 (sherpashare tax guide), p79 (feedback on starting tax firm focused on ridesharing), p83 (marketing for shared economy cpa), p94 (kickstarter project for automated trip logs app), p157 (seeking feedback on mobile expense tracking, etc. app for drivers); p255 (advertising app to combine fuel with mileage); p265 (sherpashare time/mileage/fare comparison feature between uber, lyft, sidecar). 255 user162. irs circular 230, 31 c.f.r. subtit. a. part 10, http://www.irs.gov/pub/irspdf/pcir230.pdf [http://perma.cc/3nmy-d346]. 256 see generally part v.a. 257 slemrod, supra note 49; see also discussion supra part v.a. 106 columbia journal of tax law [vol.8:56 documentation purposes.258 it would also be easy to issue guidance on how the form 1099-k rules apply to the ridesharing (and other sharing economy) platforms by clarifying, for example, whether the form 1099-k reporting positions taken by uber and lyft are correct, both with respect to choice of form and also choice of reporting threshold.259 guidance targeted at sharing economy workers has already been issued or is being considered by other jurisdictions.260 as this article was going to press, the irs began to take initial steps in this direction by creating a webpage261 for workers in the sharing economy with links to generalized guidance on topics such as business expenses and employments taxes. this is a useful first step. however, the more targeted efforts detailed above would be invaluable in achieving clarity in the tax law and accuracy in ridesharing drivers’ compliance. assuming that uber’s form 1099-k reporting position is correct, the irs might also perform driver education—or require the platforms to educate drivers—regarding the need to deduct on their tax return uber’s commission and other expenses from the gross income number reported on form 1099-k. 262 as discussed, conversations on the discussion boards raise the possibility that some first-time form 1099-k recipients may actually have over-reported earnings on their tax returns because uber reported gross earnings on that form, including tolls, fees, and the uber commission.263 the correct approach, as noted by various posters, is for drivers to report the gross income amounts from form 1099-k on schedule c of their tax return and then total up tolls and fees (including the split rides fee, the safe rides fee, the uber commission, and any device subscription fee) and deduct them on schedule c line 10 (commissions and fees).264 but this exercise is complicated. the tolls and fees that must be subtracted are not listed on form 1099-k itself but must be looked up separately on the year-end tax summary 258 app providers such as mileiq have claimed that their gps tracking application will be acceptable upon audit. stephen fishman, mileage log template: 4 irs requirements for business miles, mileiq: iq blog, http://www.mileiq.com/blog/mileage-log/ [http://perma.cc/4m9l-y2lk]; see also james alm & jay a. soled, the internal revenue code and automobiles a study of taxpayer noncompliance, 14 fla. tax rev. 419 (2013) (arguing that gps technology could be used effectively in ensuring accuracy of automobile deductions in general). 259 see discussion infra part ii.a.2; see also oei & ring, supra note 5 (proposing some of the same suggestions). 260 see, e.g., australian taxation office, the sharing economy and tax, http://www.ato.gov.au/business/gst/in-detail/managing-gst-in-your-business/general-guides/thesharing-economy-and-tax/ [http://perma.cc/87pz-cbt5]; see also hm government response to independent review of the sharing economy (mar. 2015), 7-8 http://www.gov.uk/government/uploads/system/uploads/attachment_data/file/414111/bis-15-172government-response-to-the-independent-review-of-the-sharing-economy.pdf [http://perma.cc/wu9nx55k] (expressing uk hmrc’s intent to “mak[e] it easier for people participating in the sharing economy to understand their tax obligations and report their income to hmrc”); see also hm revenue & customs, tackling the hidden economy: extension of data-gathering powers (july 22, 2015), http://www.gov.uk/government/uploads/system/uploads/attachment_data/file/447718/tackling_the_hidden_e conomy_-_extension_of_data-gathering_powers.pdf [http://perma.cc/w4qn-ekxs]. denmark’s taxing authority is also looking into how to more effectively tax the sharing economy. see philip tees, skat looking into tax changes for airbnb, uber and other sharing economy services, cph post (jan. 24, 2016), http://cphpost.dk/news/business/skat-looking-into-tax-changes-for-airbnb-uber-and-other-sharing-economyservices.html [http://perma.cc/2wzb-nm3x]. 261 internal revenue service, supra note 14. 262 this assumes that the form 1099-k position taken by the ridesharing businesses is correct. 263 see supra note 146 and accompanying text. 264 see sources cited supra note 148. 2017] the tax lives of uber drivers 107 sent by uber to each driver.265 to even discover the gross nature of the form 1099-k numbers, drivers would have to compare two documents—form 1099-k and the uber tax summary. while savvier posters seemed to eventually get it right, we do not know whether less savvy ones did. comparable gross-basis (i.e., fee and commission inclusive) reporting positions may have been or may be taken in the future by other sharing economy platforms, with similar consequences. part of the unstated problem is that rideshare drivers may conceptualize themselves as receiving “$100 dollars less 20%” at the outset from uber, rather than perceiving themselves as independent business owners receiving a gross payment ($100) and then having to pay an expense (the uber commission and fee) to earn that amount. thus, in part because ridesharing drivers may not see themselves as operating a small business, gross-basis information reporting may be particularly dissonant in this sector and may give rise to tax reporting mistakes. clarification or driver education—whether done by the irs or by the platforms—may help alleviate confusion.266 content aside, there are also different methods by which the irs might intervene, advise, or clarify. a less invasive approach would be to issue regular publications or statements on the irs website. a more invasive approach might be to directly intervene on the discussion boards by having a representative post content in the forums. a possible middle ground would be to use social media channels, such as the irs’s existing twitter, tumblr, and facebook pages, to do driver outreach.267 as further discussed in part vi.c, each of these methods may reverberate through internet communities in different ways.268 moreover, it is worth noting that the success of some of these methods will depend in part on the sophistication of tax conversations in the forums. for example, the efficacy of irs social media postings will depend in part on whether forum posters raise relevant questions and share such postings with other forum participants. b. money and profit another important theme was the question of whether driving was profitable and how to evaluate profitability. even though we had initially focused on tax-specific themes, we saw many discussions of how various non-tax expenses—including gas, water, car washes, costs of cleaning up vomit, and vehicle wear and tear—affected profitability. forum posters also discussed how trends in profitability (as affected by 265 for an example of the 2014 uber tax summary, see http://ridesharedashboard.com/2015/01/30/uber-taxes-2015-tax-summary-deducting-fees/ [http://perma.cc/uh4x-e3np]. on the tax summary, the uber fee and device subscription fee are not set out in the same column as the gross form 1099-k amount. uber merely states in parentheses and in a footnote in its tax summary that the uber fee was included in the gross amount. 266 a related literature, considering how compliance with the law can be a function of imitation and how that imitation can be an inaccurate rendition of the original actor’s compliance, could provide additional insight into crafting taxpayer guidance and education. see generally bert i. huang, shallow signals, 126 harv. l. rev. 2227 (2013). 267 see generally irs social media, irs (aug. 25, 2016), http://www.irs.gov/uac/irs-new-media1 [http://perma.cc/e822-6uuq]; internal revenue service, tumblr, http://internalrevenueservice.tumblr.com/ [http://perma.cc/xa2h-8ehf]; irs (@irstaxpros), twitter, http://twitter.com/irstaxpros [http://perma.cc/sgw9-5adf]; irs (@irs), facebook, http://twitter.com/irsnews [http://perma.cc/kag3-bq96]; http://www.facebook.com/irs/timeline [http://perma.cc/r5yw-mu5g]. social media interventions have been suggested in other jurisdictions as well. see sources cited supra note 260. 268 see infra part vi.c. 108 columbia journal of tax law [vol.8:56 surges, guarantees, and changes in base rates) affected their driving decisions and expressed significant anger and frustration at declines in profitability. they often compared the money they would make driving with the likely hourly rate they would earn at low-wage jobs such as walmart. taxes entered these discussions as a component of driving expenses, which would reduce gross fares earned. the irs standard mileage rate also served as a proxy for what posters thought the expenses of driving might be, though there was disagreement about the accuracy of this proxy. in these discussions, we saw confusion, guesstimation, and disagreement over how to evaluate profitability and how to estimate the ultimate tax burden. there were significant differences in how various posters estimated driving expenses, anticipated federal and state tax burdens, and made provisions for payment of taxes (e.g., by setting aside money to pay taxes or increasing withholding on w-2 income). as noted, some of these behaviors could be consistent with the spotlighting and ironing hypotheses of the salience literature.269 thus, although we had not explicitly sought to investigate the topic of money and profit, this was a resoundingly pervasive theme in the forums that suggests several normative insights. first, there is the question of whether there should be outreach or driver education with respect to questions of profitability. the rideshare industry is one in which many of the operating costs, and the burdens of estimating such costs, are borne by drivers. the online conversation suggests that some of these costs (including tax costs) may not be particularly salient to drivers at the time of their labor supply decision. if this is so, then driver outreach might be advisable in the face of a new business model that shifts hidden costs to drivers. any such driver awareness or education initiatives could take different forms. for example, the platforms might be required to disclose estimated costs of driving to drivers. alternatively, outreach might be conducted by government agencies to help drivers understand the true costs of driving. incidence and magnitude of driver costs should also be carefully considered in the current debates over worker classification: legislators, courts, and regulators might consider how employee classification—which would mean wage withholding and other non-tax benefits but also more limited ability to deduct certain business expenses for tax purposes—might play out in an industry where the bulk of costs would likely remain on drivers.270 more broadly, if driver sophistication in assessing profitability were to increase over time, this could affect uber’s business model going forward. uber’s model is predicated on attracting a large base of drivers and passengers to the platform. if drivers change their driving behaviors as they become more aware of expenses and tax burdens, this realization may affect the viability of the core business model. if, however, drivers do not change their labor supply choices over time, their continued willingness to drive may suggest that the business model is actually profitable for them. but it may also suggest that drivers’ ability to accurately assess profitability remains limited and that more robust driver protections are necessary. c. community a third theme that ran through the data was the nature of communication and culture in the online communities we studied. the tax talk contained on the discussion 269 see discussion supra part v.b.1.a. 270 this result may vary by state. see, e.g., cal. lab. code § 2802 (west 2016) (requiring an employer to indemnify employee job expenses). 2017] the tax lives of uber drivers 109 boards was a messy conversation that went back and forth and was sometimes rude, pointed, and angry but was at other times supportive and communal. forum users corrected each other’s errors (sometimes imperfectly); gave each other advice (much accurate, some inaccurate); expressed approval or disapproval in various ways (explicitly, as well as by upvoting and downvoting on reddit); argued with each other; and liberally shared information about their tax return preparation, documentation, fudging, and other practices. forum posters marketing commercial interests, suspected plants, members of the press, researchers, taxi drivers, and other interlopers interjected in these conversations, and a few (like user176/user153) became recognized and familiar contributors on the boards. at the same time, reddit and uberpeople are communities with porous boundaries. while there were some repeat posters, there were many infrequent users and likely an even larger number of lurkers. forum posters seemed aware that there was a possibility that others (including uber employees, non-drivers, and the irs) were reading the forums and, in fact, constantly discussed and referred to the presence of these outsiders, but worries about information being read by outsiders did not seem immensely salient. while we saw a few subsequently deleted posts, they were a minority. the existence of active online communities of uber drivers who discuss and debate tax and other issues surrounding rideshare driving is unsurprising in a world with widely available technology, a free speech ethos, and challenging tax obligations. thus, the issue is not whether such communities and conversations should exist, but rather whether and in what ways we might imagine influencing or harnessing them. in considering such interventions, the distinctive characteristics of the forums (including the variety of participants, accuracy of advice, and methods of error correction) raise questions and suggest that there are tensions that need to be managed: first, there clearly is a process of learning about tax law that is taking place in the forums through conversations and advising among peers and through correction of each other’s errors. this peer-to-peer learning and advising process may fill a need that is currently unmet by the tax authority or by professional tax advisors. second, however, this learning process occurs in fits and starts and may be muddied and interrupted by error propagation due to advice that is confusing, poorly stated, or just wrong. third, self-proclaimed professionals or experts, who may be trying to grow their businesses or may be seeking status due to claimed expertise, also give advice in these forums. fourth, this whole messy conversation can be read by anyone with internet access. and finally, with the exception of a few marketers operating under their real identities, there is little likelihood of imposing ex post consequences on posters through lawsuits or other non-legal means because of poster anonymity. while we did observe “soft” peer sanctions in the form of error correction or telling each other off, it is unclear whether these were a sufficient consequence to effectively discipline or regulate the conversation in terms of accuracy. any attempts to intervene in or regulate peer legal advising on the internet boards would need to consider and manage these tensions. with respect to regulation of peer advising, for example, it is possible that such regulation is not advisable because the gains from peer learning on the forums outweigh the downside of confusion or error propagation. of course, it is difficult to know if this is actually the case, especially once positive and negative externalities on lurkers are considered. another possibility is that marketers and other professionals ought to be subject to regulation while peer advisors should not. however, such an approach would create obvious line-drawing issues. outright regulation aside, other interventions or monitoring of the discussion 110 columbia journal of tax law [vol.8:56 forums by a taxing authority would also likely have impacts that should be carefully considered. as we suggested in part vi.a, for example, the irs might issue guidance with respect to tax issues concerning rideshare drivers and might disseminate such information in online forums where drivers assemble. the irs could also monitor the forums to obtain information about emerging tax compliance issues, or it could intervene directly in internet forums to correct error propagation and stake out agency positions. each of these approaches raises questions about what the impacts of such interventions might be on internet communities. for example, if it became apparent that the irs was monitoring discussion boards to keep apprised of likely major tax compliance issues, this knowledge might have a chilling effect on discussions and might compromise the openness of information sharing on the boards, disrupting the peer learning process. if, instead, the irs was actively engaging and answering questions on internet forums (e.g., “q&a hour with the irs!”), this may encourage more open discussion, but it could also expose the irs to risk if advice is misinterpreted or misperceived. development of a full theory of regulatory intervention on internet discussion boards is a project for another day. we note, for now, that there are promising ways for taxing authorities to use information discussed online, and to intervene and do taxpayer outreach on internet forums and via social media.271 the use of social media for tax administration in the sharing economy is also being considered in other countries as well.272 in designing such outreach, a variety of formats might be explored, with some approaches more interactive than others. for example, running a website that allows users to pose questions and then selecting which questions to answer is an example of a less interactive approach that might nonetheless be effective.273 ultimately, the issue is one of design choice, in which potential costs, benefits, and tradeoffs would need to be balanced. vii. conclusion in this article, we investigated the tax issues and challenges faced by ridesharing drivers by analyzing their interactions in three internet discussion forums. our detailed study of user interactions in these internet forums is the first of its kind in the legal literature. it offers a timely and nuanced picture of how the nascent encounter between ridesharing workers and the tax regime has played out “in action” on internet discussion boards. we presented a series of findings about the tax compliance challenges encountered by ridesharing workers, examined the ways taxes factor into their profitability determinations, and discussed cultural aspects of how tax advising and information exchange operate in these internet discussion forums. based on these findings, we made normative recommendations for more effective tax administration, spelled out the implications of our study for uber’s business model and for potential regulation of ridesharing, and discussed the potential impacts of various tax compliance initiatives on online communities of drivers and other 1099 workers. these recommendations may be in tension. for example, the need for taxpayer education, which may be accomplished through online forums, raises the risk that irs intervention 271 see sources cited supra note 267. 272 see sources cited supra note 260. 273 the consumer financial protection bureau runs this type of questions and answer service. askcfpb, consumer financial protection bureau, http://www.consumerfinance.gov/askcfpb/. 2017] the tax lives of uber drivers 111 in the forums may change the nature of community and communication currently present in such forums. therefore, any such interventions would need to be carefully considered in order to arrive at the optimal policy choice. in addition to yielding specific insights concerning ridesharing drivers, our study also has potentially broader application to other gig economy workers. careful analysis of internet forum discussions can provide much needed texture to our understanding of how 1099 workers deal with taxes and interact with the tax system and how taxes factor into their decision making. thus, our analysis provides a roadmap for identifying issues that may be important in the broader 1099 economy and may merit more in-depth research. 112 columbia journal of tax law [vol.8:56 appendix: list of codes attitudes towards tax compliance aggressive carefree careless compliant indifferent noncompliant uninformed substantive tax issues audit risk tax advice bad advice good advice depreciation documentation employee or independent contractor employment taxes entities and structuring estimated taxes expenses and deductibility fees filing obligation form 1099: content and accuracy form 1099: different reporting positions form 1099: receipt form 1099: residual income inclusion interest and penalties irs website and publications method: standard mileage or other mileage schedules state tax tax prep software tax preparer or advisor tax rates third party apps water and snacks withholding strategies and rationales “beer money” vs livelihood driving techniques insurance new year’s eve profitability: before and after tax profitability: decision to drive profitability: expenses profitability: per mile vs. per hour profitability: tips profitability: trends regulars leasing tesla uber financing tax policy issues administrative burden distortion fairness and equity risk preference salience tax morale emotions ` anger anxiety confusion frustration happiness hopelessness irritation relief resignation sarcasm/disdain/insulting/ rude satisfaction surprise sympathy or commiseration trepidation thread structure reddit external website link to external website marketing post plants question web bots uberpeople disclaimers external website link to external website marketing post plants question web bots turbotax duplicate posts external website link to external website form language instructions marketing post plants question unanswered detail request unanswered question web bots microsoft word 5.9.20 tmr stranded assets (clean).docx stranded assets and efficient pricing for regulated utilities: a federal tax solution tracey m. roberts* abstract most businesses recoup their investments in property, plant, and equipment from the income they earn from using those assets. when changes in markets, technology, or regulations reduce income from those assets or increase operating costs, businesses may not recover their full investments in those “stranded assets.” unregulated firms generally contain these risks by diversifying assets and income streams, procuring insurance, or engaging in hedging transactions. public utilities, however, must obtain a regulator’s permission both to manage these risks and to pass the costs of those assets forward to consumers. globally, over $20 trillion in global fossil fuel assets may be stranded as countries pass climate change legislation. to date, investor and consumer concerns about stranded costs have delayed the adoption of carbon pricing schemes, spurred the rejection of greenhouse gas regulation altogether, and formed the basis for bankruptcy filings, takings litigation, and demands for relief. this article makes four contributions. first, it clarifies that under the existing tax and regulatory rules, the economic benefits of substantial tax subsidies are currently being passed forward to consumers, artificially reducing fossil fuel electricity rates, encouraging waste, and increasing emissions. second, it quantifies the extent of stranded assets held by public utilities in the united states, pulling data on unrecovered capital from the securities filings of the fifteen largest firms in the country. third, it argues that u.s. tax measures have left fewer assets to be stranded, identifying $110 billion in “accumulated deferred income taxes” or “adit,” the tax savings from deferral, as a source of recovery. finally, the article proposes a change in tax and regulatory policy that will enhance efficiency, remove one of the supports for carbon lock-in, and help manage the threat of stranded assets, smoothing the transition to a carbon-neutral economy. * tracey m. roberts, associate professor, samford university, cumberland school of law, a.b. harvard college, j.d. vanderbilt law school, ll.m. new york university school of law. the author wishes to thank michael vandenbergh for organizing the renewable energy in the southeast conference at vanderbilt university law school, the george mason university antonin scalia law school’s law and economics center for their workshop on empirical methods, the participants of the 10th annual meeting of the society for environmental law & economics, the 16th annual meeting of the midwest law and economics association, the 2019 law and society association annual meeting, and the 20th global conference on environmental taxation for their thoughtful feedback, and adam chodorow, mirit eyal-cohen, daniel cole, mike floyd, jonathan foreman, josh galperin, michael gerrard, mitchell kane, ben leff, and larry zelenak for their valuable comments and suggestions. columbia journal of tax law [vol. 11:1 2 table of contents i. introduction: tax subsidies, stranded assets, carbon lock-in, and why they matter ................................................................................................... 3 ii. tax and regulatory rules drive discounts in consumer rates for fossil fuel-based energy .................................................................................. 8 a. a brief economic history of public utility regulation ........................................................... 9 b. accounting for fixed costs ..................................................................................................... 10 1. regulatory accounting: ferc rules and rate of return regulation ........................................... 11 2. financial accounting ....................................................................................................................... 14 3. tax accounting in the u.s. .............................................................................................................. 15 c. reconciling tax/book/regulatory disparities: the normalization rules and their effects…………………………………………………………………..................................................22 d. environmental impacts of passing tax subsidies through to consumers ........................... 30 iii. stranded assets ................................................................................................. 32 a. historical treatment of stranded assets................................................................................ 33 b. how extensive are the risks of stranded assets for public utilities in the united states? . 38 c. modifying the tax and regulatory rules to apply adit and its returns to offset stranded assets ............................................................................................................................... 42 d. handling excess adit from corporate tax rate changes .................................................. 45 e. potential application abroad ................................................................................................. 47 v. conclusion ............................................................................................................... 48 2019] stranded assets and efficient pricing for regulated utilities: a federal tax solution 3 i. introduction: tax subsidies, stranded assets, carbon lock-in, and why they matter stranded assets are fixed assets, property, plant, and equipment, that are rendered noncompetitive or nonoperational as a result of a change in the market. new government regulations, changes in the interpretation and application of existing law, technological breakthroughs that alter access to existing resources or provide an alternative product that competes with the asset, changes in social norms and consumer choices, and environmental changes may all render existing assets less valuable. 1 consequently, assets may suffer from unexpected early write-offs, negative revaluations, or conversion from assets to liabilities.2 firms transacting in unregulated markets generally undertake a variety of measures to manage these kinds of risks, such as investing in a more diversified set of assets, generating new income streams, engaging in hedging transactions, or procuring insurance. regulated industries, however, have traditionally been constrained in taking these measures. public utilities are actually privately owned by investors.3 the utilities receive a return based on rates set by regulators; they are permitted to pass the costs of assets through to customers incrementally over the “service life” of those assets, the period the assets are anticipated to be used.4 for regulated utilities to recover their investments in assets that have been impaired or prematurely retired, regulators must authorize the utility to pass the costs of those stranded assets through to consumers.5 ratepayers are naturally averse to paying for assets that may no longer be operational, generating electricity, or providing heating services, and public service commissions have the primary goal of protecting the interests of ratepayers. consequently, when sharp changes in energy or environmental policies occur, investors in regulated utilities bear greater risk than investors in an unregulated or deregulated market. 1 see atif ansar, ben caldicott & james tilbury, smith school of enterprise and the environment, university of oxford, stranded assets and the fossil fuel divestment campaign: what does divestment mean for the valuation of fossil fuel assets? 2 (2013). see also james saft, the age of stranded assets isn’t just about climate change, reuters (july 13, 2017, 4:16 pm), https://www.reuters.com/article/usmarkets-saft/the-age-of-stranded-assets-isnt-just-about-climate-change-james-saft-iduskbn19y2sv [https://perma.cc/n39q-7tl5]. 2 see ansar, supra note 1, at 9. 3 see lincoln davies, alexandra klass, hari m. osofsky, joseph p. tomain, & elizabeth wilson, energy law and policy 264 (2d ed. 2018). the law designates these investor-owned utilities as “public utilities” because they have a legal obligation to serve the public. id. when investor-owned utilities first developed they were vertically integrated, owning and operating all of the components necessary to generate electricity and to distribute it to consumers. id. under the regulatory compact, investor-owned utilities were granted a monopoly— the exclusive right to serve a designated geographic area in exchange for government regulation of its prices or utility rates and an obligation to serve every customer within that area. id. at 265-66. the country designed its national energy infrastructure, including its regulatory system, to serve these large central power stations id. at 259. this model of electricity production and regulation remains largely the same today as it was over 100 years ago. id. currently there are over 200 investor-operated utilities; they generate approximately 70% of the electricity in the united states. id. at 264. 4 see infra parts ii.a. and ii.b.1. 5 with the consent of regulators, however, the utility may pass through to its rate-paying customers any remaining unrecovered capital costs of decommissioned or prematurely retired assets. see parts iii.a. and c. infra. columbia journal of tax law [vol. 11:1 4 today, the power sector is recognized as a primary contributor to climate change and air pollution, responsible for nearly one-third of greenhouse gas emissions.6 there is widespread public acknowledgement that climate change is occurring7 and that the federal government should act to address it. 8 nevertheless, despite the clear economic gains, health benefits, and environmental advantages to employing alternative energy resources and other carbon-saving technologies, the transition to a carbon-neutral economy has been incremental at best.9 unfortunately, the united states, along with many other industrial economies, has been locked into a carbon-based economy by legal and financial systems that evolved to serve fossil 6 see greenhouse gas emissions, sources of greenhouse gas emissions, u.s. environmental protection agency, https://www.epa.gov/ghgemissions/sources-greenhouse-gas-emissions [https://perma.cc/v49x-e6jx] (last updated sept. 13, 2019) (statistics showing electricity was responsible for 27.5% of 2017 greenhouse gas emissions; “electricity production generates the second largest share of greenhouse gas emissions. approximately 62.9% of our electricity comes from burning fossil fuels, mostly coal and natural gas.”). mercury and air toxics standards, cleaner power plants, u.s. environmental protection agency, https://www.epa.gov/mats/cleaner-power-plants [https://perma.cc/j55u-t6ct] (last updated mar. 4, 2019) (the power sector is also responsible for 50% of mercury emissions, 75% of acid gas emissions, and 20 to 60% of toxic metals emissions in the united states, providing additional reasons for regulation) . 7 see yale program on climate change commc’n, climate change in the american mind 5 (dec. 2018), https://climatecommunication.yale.edu/wp-content/uploads/2019/01/climate-change-american-mind-december2018.pdf [https://perma.cc/4u46-d8ct] (reporting that 73% agree that climate change is occurring) ; brian kennedy, most americans say climate change affects their local community, including two-thirds living near coast, pew research ctr. (may 16, 2018), https://www.pewresearch.org/fact-tank/2018/05/16/most-americans-say-climatechange-affects-their-local-community-including-two-thirds-living-near-coast/ [https://perma.cc/xe5k-tx89]. 8 see, e.g., is the public willing to pay to help fix climate change?, assoc. press norc ctr. for pub. affairs research, http://www.apnorc.org/projects/pages/is-the-public-willing-to-pay-to-help-fix-climate-change-.aspx [https://perma.cc/85dd-mrx3] (november 2018 poll results indicating that 71% of americans agree that climate change is occurring); where americans stand on energy & climate, energy policy inst. at the university of chicago, http://www.apnorc.org/projects/documents/epic_infographic.pdf [https://perma.cc/7lbe-lygv] (infographic developed from november 2018 poll indicating that 83% of those agreeing that climate change is occurring are in favor of government action to address the problem); cary funk, et al., majorities see government efforts to protect the environment as insufficient, pew research ctr. 2, 5 (may 14, 2018) https://www.pewresearch.org/science/wpcontent/uploads/sites/16/2018/05/ps_2018.05.14_energyclimate_final.pdf [https://perma.cc/rr5t-xqnt] (reporting that 67% see government action on climate change as inadequate). 9 after decades of governmental delays in addressing the known causes of global warming, the u.s. supreme court issued a directive requiring the environmental protection agency to address the issue. see massachusetts v. envtl. prot. agency, 549 u.s. 497 (2007). in 2014, the obama administration proposed regulations under the clean air act to govern carbon emissions. see carbon pollution emission guidelines for existing stationary sources: electric utility generating units, 79 fed. reg. 34830 (proposed june 18, 2014) (to be codified at 40 c.f.r. pt. 60). however, the trump administration reversed course, issuing an executive order rescinding obama-era presidential and regulatory actions to address carbon emissions and ordering the environmental protection agency to withdraw the clean power plan regulations under the clean air act. see exec. order no. 13783, 82 fed. reg. 16093 (march 28, 2017). on october 10, 2017 the u.s. environmental protection agency proposed to repeal the clean power plan. see 82 fed. reg. 48035 (oct. 16, 2017). the trump administration then announced a new plan to “save coal,” proposing modifications to numerous environmental statutes in support of coal-fired energy production. see brad plumer, trump orders a lifeline for struggling coal and nuclear plants n.y. times (june 1, 2018), https://www.nytimes.com/2018/06/01/climate/trump-coal-nuclear-power.html [https://perma.cc/e3ph-emyt]. on july 8, 2019, the final rule was published, repealing the clean power plan and substituting the affordable clean energy rule (ace), which provides emission guidelines for greenhouse gas emissions from existing electric utility generating units. see repeal of the clean power plan; emission guidelines for greenhouse gas emissions from existing electric utility generating units; revisions to emission guidelines implementing regulations, 84 fed. reg. 32520 (july 8, 2019) (to be codified at 40 c.f.r. pt. 60). 2019] stranded assets and efficient pricing for regulated utilities: a federal tax solution 5 fuel-based energy and distribution systems.10 existing economic arrangements hold the current allocation of property rights and interests in place and incentivize resistance to change. tax and regulatory systems governing public utilities encourage waste, increase emissions, and exacerbate negative environmental externalities.11 they also foster the development of fiscal barriers, such as stranded assets, that make change costly and harmful to consumers.12 historically, public utilities and their investors have responded to the prospect of regulatory changes by arguing for (1) federal reimbursement for stranded assets,13 (2) the right to pass the costs of stranded assets through to their consumers, (3) the termination of plans to alter existing energy and environmental policy,14 and delay in implementing policy changes. 15 economic incentives baked into the regulatory structure stall the adoption of new energy technologies and other climate change mitigation strategies, delaying the transition to a carbon-neutral economy.16 this dynamic is known as “carbon lock-in.” recently, environmental advocates have begun a push to retire the country’s aging fleet of coal-fired power plants17 and to terminate plans to extract known oil, gas, and coal reserves so as 10 see gregory c. unruh, understanding carbon lock-in, 28 energy pol’y 817 (2000). 11 see part ii, infra. see also tracey m. roberts, picking winners and losers: a structural examination of tax subsidies to the energy industry, 41 colum. j. envtl l. 63 (2016) (describing one hundred years of tax subsidies to the fossil fuel industry, their structures, and effects). 12 see part iii, infra. 13 see part iii.a., infra. 14 fossil fuel companies have pointed to increased consumer costs from stranded assets to justify delays in implementation of climate change regulations. for example, in their comments to the obama administration’s proposed clean power plan regulations to the clean air act, the southern company argued that the epa’s cost benefit analysis should include the increased costs to ratepayers from stranded capital investments the clean power plan would force into retirement. see larry monroe comment letter on proposed rule: carbon pollution emission guidelines for existing stationary sources: electric utility generating units (dec. 1, 2014), https://www.regulations.gov/document?d=epa-hq-oar-2013-0602-22907 [perma.cc/c7ck-cy7d]. 15 concerns about harm to consumers stymies the use of some of the best tools for carbon regulation even among politicians committed to action. for example, green new deal did not include a proposal for carbon taxes because of perceived concerns about the economic harm to middleand lower-income households. see, e.g., editorial board, want a green new deal? here’s a better one., wash. post (feb. 24, 2019), https://www.washingtonpost.com/opinions/want-a-green-new-deal-heres-a-better-one/2019/02/24/2d7e491c-36d211e9-af5b-b51b7ff322e9_story.html [perma.cc/jez6-uxh6]; adam wernick, the green new deal doesn’t include carbon pricing. some say that’s a big mistake., public radio international (apr. 11, 2019), https://www.pri.org/stories/2019-04-11/green-new-deal-doesnt-include-carbon-pricing-some-say-thats-big-mistake [perma.cc/hv63-5k8u]; marianne lavelle, green new deal vs. carbon tax: a clash of 2 worldviews, both seeking climate action, inside climate news (march 4, 2019), https://insideclimatenews.org/news/04032019/green-newdeal-carbon-tax-compromise-climate-policy-congress-ocasio-cortez-sunrise-ccl-economists [perma.cc/z2vaxdxw]; zach coleman & eric wolff, why greens are turning away from a carbon tax, politico (dec. 9, 2018), https://www.politico.com/story/2018/12/09/carbon-tax-climate-change-environmentalists-1052210 [perma.cc/vb9b-cqdv]. 16 see marilyn a. brown, et al., oak ridge nat’l lab., carbon lock-in: barriers to deploying climate change mitigation technologies (2008) doi:10.2172/1424507, https://www.osti.gov/servlets/purl/1424507 [perma.cc/9kna-gjum] (classifying financial/legal institutions as one of the three major barriers that foster carbon lock-in). 17 see, e.g., about us page of the beyond coal campaign, sierra club, https://content.sierraclub.org/coal/aboutthe-campaign [https://perma.cc/76a7-t9wg] (last visited dec. 30, 2019) (“the beyond coal campaign’s main objective is to replace dirty coal with clean energy by mobilizing grassroots activists in local communities to advocate for the retirement of old and outdated coal plants and to prevent new coal plants from being built.”). columbia journal of tax law [vol. 11:1 6 to prevent a rise in global temperatures above two degrees celsius. 18 nongovernmental organizations, such as the carbon tracker initiative, have called for investors to divest by appealing to their financial self-interest, claiming that fossil fuel firms have failed to disclose the risk of loss associated with stranded assets should economic or regulatory conditions change.19 mainstream media,20 governmental entities,21 academic institutions,22 and firms in the energy,23 investment,24 banking,25 rating agencies,26 accounting,27 and insurance28 industries have estimated 18 see bill mckibben, why we need to keep 80 percent of fossil fuels in the ground, yes! magazine (feb. 2016), https://www.yesmagazine.org/issue/life-after-oil/2016/02/15/why-we-need-to-keep-80-percent-of-fossil-fuels-inthe-ground/ [https://perma.cc/pe7j-tdpd]. 19 see carbon tracker initiative, no country for coal gen – below 2°c and regulatory risk for us coal power owners (sept. 13, 2017), https://www.carbontracker.org/reports/no-country-for-coal-gen-below-2cand-regulatory-risk-for-us-coal-power-owners/ [https://perma.cc/bvc8-cuu7]; carbon tracker initiative, unburnable carbon 2013: wasted capital and stranded assets (apr. 19, 2013), https://www.carbontracker.org/reports/unburnable-carbon-wasted-capital-and-stranded-assets/ [https://perma.cc/a7eh-zyym]. 20 see, e.g., how to deal with worries about stranded assets, economist (nov 24, 2016), https://www.economist.com/special-report/2016/11/24/how-to-deal-with-worries-about-stranded-assets [perma.cc/ky8s-8ccn]; ambrose evans-pritchard, oil industry risks trillions of “stranded assets on us-china climate deal, telegraph (nov. 19, 2014), https://www.telegraph.co.uk/finance/newsbysector/energy/oilandgas/11242193/oil-industry-risks-trillions-ofstranded-assets-on-us-china-climate-deal.html [https://perma.cc/b6tt-75t8]; alex morales, “stranded assets”: will efforts to counter warming render energy reserves worthless?, wash. post (dec. 5, 2014), https://www.washingtonpost.com/business/stranded-assets-will-efforts-to-counter-warming-render-energy-reservesworthless/2014/12/05/ecbc73a6-7a45-11e4-9a27-6fdbc612bff8_story.html [https://perma.cc/pl38-x54a]. 21 see, e.g., organization for economic co-operation and development and food and agriculture organization of the united nations, agriculture outlook (2012); united nations environment programme, geo-5 environment for the future we want (2012). 22 see, e.g., oxford sustainable finance programme, smith school of enterprise and the environment, oxford university (april 6-7, 2017), https://www.smithschool.ox.ac.uk/research/sustainable-finance/forums.html [perma.cc/bmg2-529v] (“6th stranded assets forum: from disclosure to data towards a new consensus for the future of measuring environmental risk and opportunity”). 23 see, e.g., dmitry zhdannikov, shell sees no risk of ‘stranded assets’ as reserves life shrinks, reuters (apr. 12, 2018), https://www.reuters.com/article/us-shell-emissions-iduskbn1hj1fp [perma.cc/v9qh-cdnd]. 24 see, e.g., peter cripps, blackrock warns on stranded assets, envtl. fin. (nov. 4, 2015), https://www.environmental-finance.com/content/news/blackrock-warns-on-stranded-assets.html [https://perma.cc/9rmm-zget]; blackrock, global insights, adapting portfolios to climate change implications and strategies for all investors (sept. 2016), https://www.blackrock.com/us/individual/literature/whitepaper/bii-climate-change-2016-us.pdf [perma.cc/h8ang84s]. 25 see, e.g., hsbc, oil and carbon revisited (2013), https://www.longfinance.net/documents/1133/hsbc_oilcarbon_2013.pdf [perma.cc/s8ax-7m4n]; megan bowman, the role of the banking industry in facilitating climate change mitigation and the transition to a low-carbon global economy, 27 env't & planning l.j. 448 (2010). 26 see, e.g., ratings direct, standard & poor’s financial services, what a carbon-constrained future could mean for oil companies’ creditworthiness (2013), https://www.carbontracker.org/reports/bonds-2014/ [perma.cc/2naz-c8f5]. 27 see, e.g., ernst & young, australia, stranded assets, from fact to fiction, let’s talk sustainability, issue 4 (2015), https://www.slideshare.net/turloughguerin/ey-lets-talk-sustainability-issue-4 [https://perma.cc/26gxbeez]. 28 see, e.g., lloyd’s of london, stranded assets: the transition to a low carbon economy, overview for the insurance industry, emerging risk report (2017), https://www.lloyds.com/~/media/files/news-andinsight/risk-insight/2017/stranded-assets.pdf [perma.cc/c8hr-dk86]; matthew e. kahn, et al., how the insurance 2019] stranded assets and efficient pricing for regulated utilities: a federal tax solution 7 that $20 trillion in fossil fuel assets will be stranded if greenhouse gas emissions are regulated and they have begun to discuss what might be an appropriate response. regulating greenhouse gas emissions will generate a variety of distributional impacts. in 1989, academics florentin krause, wilfrid bach, and jon koomey recognized that climate stabilization would require limits on fossil fuel combustion, and that this would render fossil fuelbased infrastructure obsolete and impact the financial markets.29 they were among the first to argue that financial incentives would likely be necessary to make these risks acceptable to investors.30 given that energy incumbents have used stranded asset claims to stall the transition to cleaner, more efficient systems, the decision to allow investors to recover their stranded costs may be a rational step toward effective climate change policy. this article provides a low-cost solution to one segment of the technological-industrial complex maintaining carbon lock-in. 31 by modifying the regulatory and tax rules to change the existing incentive structures, we can dismantle the hold that fossil fuels continue to exert on the u.s. economy. the article is organized as follows. part ii first describes the economic context that gave rise to regulation of public utilities. it then describes the ways the tax and regulatory rules combine to subsidize fossil-fuel electricity generation and to deliver discounts to consumers that encourage waste and increase emissions, locking the economy into a fossil fuel-based future. part iii briefly describes the history of past efforts to recover stranded costs. it takes a first cut at quantifying the extent of unrecovered capital for the fifteen largest public utilities in the united states and quantifies the tax savings the utilities enjoy from accelerated tax depreciation. it identifies those tax savings as an insurance pool from which investors may recover their stranded costs. it then proposes a small change to the tax and regulatory rules that will alter incentive structures and address the risk of stranded assets at little additional cost to consumers or to the u.s. taxpayer. part iv concludes the discussion. industry can push us to prepare for climate change, harv. bus. rev. (aug. 28, 2017), https://hbr.org/2017/08/how-the-insurance-industry-can-push-us-to-prepare-for-climate-change [perma.cc/m4srchdf]; evan mills, et al., insurance in a climate of change, 309 science 1040 (aug. 12, 2005), doi:10.1126/science.1112121, https://science.sciencemag.org/content/309/5737/1040/tab-pdf [perma.cc/n5uva6sc]. 29 florentin krause, wilfrid bach, & jon koomey, energy policy in the greenhouse (1989). 30 id. more recently, energy executives, businessmen, and celebrities have called for the federal government to fund a “cash-for-coal clunkers” program to pay for the retirement of one eighth of the coal-fired power plants in the united states and accelerate the transition away from coal and toward natural gas and renewable energy. david crane, nrg chief executive, t. boone pickens, an oil and gas magnate, and ted turner, a celebrity businessman, have promoted “a cash for oil clunkers program. steven mufson, vintage u.s. coal-fired power plants now an ‘aging fleet of clunkers,’ wash. post (june 13, 2014), https://www.washingtonpost.com/business/economy/a-dilemma-with-agingcoal-plants-retire-them-or-restore-them/2014/06/13/8914780a-f00a-11e3-914c-1fbd0614e2d4_story.html [https://perma.cc/aa5b-hq8x]. the idea takes its name from the “cash for clunkers program” developed by the obama administration to support the american auto industry and to reduce vehicular emissions. the federal government granted cash subsidies to consumers who traded their old vehicles for new fuel-efficient models. see supplemental appropriations act, 2009, title xiii, pub. l. 111–32, 123 stat. 1859. 31 see unruh, supra note 10, at 818. columbia journal of tax law [vol. 11:1 8 ii. tax and regulatory rules drive discounts in consumer rates for fossil fuel-based energy in general, when private firms invest in their physical plant, equipment, and other fixed assets (“capital”), they recover those expenses over the period those assets are used. investorowned public utilities for natural gas and electricity are regulated at the state level by public utility commissions or public service commissions. 32 the federal energy regulatory commission (ferc) governs the transmission and sales of energy in interstate commerce.33 the state regulatory commissions and ferc set the rules by which public utilities may pass the costs of these assets through to their customers.34 these rules, therefore, determine the rate at which utility investors may recover the costs of constructing those assets and placing them in service. for decades, the depreciation rules under the federal income tax matched those for financial and regulatory depreciation in terms of timing. however, in 1954 congress began to allow firms to recover their investments in capital more quickly under the tax depreciation rules. this mechanism, known as “accelerated depreciation,” defers tax liability into the future. the tax savings from deferral are commonly described as the economic equivalent to a federally funded interest-free loan. in the regulated utilities setting, the disparity between the regulatory and financial accounting rules that utilities use to pass operating costs (including taxes) and capital costs through to consumers and the tax accounting rules the utilities follow for determining their own tax liability (“tax/book disparity”) generates a pool of tax savings.35 the aggregate value of these tax savings is tracked in the utility firms’ financial statements as “accumulated deferred income taxes” or “adit.”36 as of 2016, the fifteen largest public utilities reported over $110 billion in their adit accounts. 37 normalization rules, developed to reconcile the tax / book disparity, require that utilities pass through the benefits of these tax savings to consumers at a gradual rate. 38 normalization rules, by delivering tax subsidies to consumers, have reduced electricity rates. 32 lowell e. alt, jr., energy utility rate setting 19 (2006). states vary in ways they regulate utilities owned by municipalities and cooperatives. id. 33 specifically, ferc governs the interstate transmission of electricity, natural gas, and oil and the wholesale sales of electricity and oil. ferc regulates natural gas storage facilities, liquefied natural gas terminals and interstate natural gas pipelines. ferc rules also cover hydroelectric projects. id. at 17. 34 id. at 22-23. 35 id. at 38-39. 36 id. tax/book disparities also arise with respect to tax credits and normalization rules also apply to tax credits. see donald w. kiefer, accelerated depreciation, the investment tax credit, and their required ratemaking treatment in the public utility industry: a background report, congressional research service, rep. no. 87-312 s, 17-21 (apr. 10, 1987). the analysis applied to the accelerated depreciation applies also to the earning, application, and passthrough of tax credits, though the calculations will differ. id. at 23. while accelerated depreciation functions as an interest-free loan from the government, tax credits function as a grant to the utility. id. at 25. tax credits distort the rate-making process to provide a higher rate of return to investors on capital the government has provided. id. at 27. for the sake of brevity and simplicity, the article omits detailed discussion of tax credits. nevertheless, they are subject to a similar critique as set forth in part iii, and should be included as part of any recovery pool for stranded assets discussed in part iii. 37 see infra, part ii.b., table 4. the article uses figures from 2016 because utilities, responding to rate changes and other tax rule modifications in the tax cuts and jobs act of 2017, re-categorized a portion of the funds in their adit accounts in a variety of ways under the uniform system of accounts. 38 see infra, part ii.c. 2019] stranded assets and efficient pricing for regulated utilities: a federal tax solution 9 this part briefly outlines the history of public utility regulation, describes how the tax accounting rules began to diverge from the rules for financial and regulatory accounting, and then examines the economic effects of this divergence under the normalization rules. finally, it critiques the regulatory rules that reconcile these differences as magnifying environmental harms. a. a brief economic history of public utility regulation before discussing how tax and regulatory rules governing public utilities contribute to carbon lock-in, it may be helpful to explain why public utilities are regulated. the energy markets in the united states developed initially as natural monopolies: the benefits, and the possibility, of competition were limited.39 in the early years, the development of an energy utility required a high threshold investment and an established industry enjoyed declining long-term costs and increasing returns to scale.40 an existing utility, seeking to maximize its profit, would want to extend service to reduce its average costs.41 it might also limit competition, and undercut a competing startup investment in an adjacent area, by extending service to that new area.42 the first party to enter the market would thereby succeed in dominating it. 43 a vertically integrated firm, providing generation, transmission, and distribution facilities as the sole provider of electricity in a community, could charge excessively high rates, fail to provide reliable service, and discriminate in granting access to service.44 in markets where competition exists between two or more firms, the duplication of network services, such as a utility grid, would be wasteful, since the cost of each grid would be spread over a smaller number of customers.45 furthermore, by the time it would take either firm to recover its investment, competition could drive one or both firms into insolvency.46 to protect consumers against adverse exercises of market power, states passed progressive regulation.47 firms sought sufficient protection to recover their initial large investments in plant, 39 see davies, supra note 3, at 283-84 (quoting judge richard posner in omega satellite products co. v. city of indianapolis, 694 f.2d 119 (7th cir. 1982)). 40 id. at 283; see also amy abel, cong. research serv., 98-419 enr, electricity restructuring background: the public utility regulatory policies act of 1978 and the energy policy act of 1992 2 (1998). the costs to construct electricity generation and transmission facilities have historically been high. see joseph p. tomain, ending dirty energy policy 44 (2011). 41 see davies, supra note 3, at 284 (quoting judge richard posner in omega satellite products co. v. city of indianapolis, 694 f.2d 119 (7th cir. 1982)). 42 id. at 3 (“at the end of the 19th century, gas and electricity companies began as small, local businesses that, due to technological limitations, served relatively small geographical areas. these businesses were local, competitive, and were unregulated. with technological improvements, those companies grew to serve more customers and, to achieve economies of scale, consolidated. that consolidation revealed two things. first, these local, growing utilities could exercise market power over their customers. second, the firms that were already in the gas or electricity business would also exercise market power to set barriers to competition.”) 43 id. at 3, 282-285. but see peter z. grossman, is anything a natural monopoly, the end of a natural monopoly: deregulation and competition in the electric power industry, 34 (peter z. grossman &daniel h. cole, eds. 2014). 44 see davies, supra note 3, at 282-83. 45 id. at 284-85. 46 id. at 285, 290. 47 see alt, supra note 32, at 17. the characteristics of a natural monopoly— high initial capital costs, increasing returns to scale, and distribution networks, the duplication of which would be wasteful—are market imperfections that justify regulation as an economic matter. see davies, supra note 3, at 289 columbia journal of tax law [vol. 11:1 10 equipment, and distribution facilities.48 states granted firms monopolies to induce them to incur those investments and to eliminate the risk of financial loss from competition.49 in return, states protected consumers against monopoly practices by regulating the rates firms could charge consumers and assured quality service through nondiscrimination provisions and other service obligations.50 this arrangement is known as the “regulatory compact.”51 later, when firms began to expand their electric grids and extend service across state lines, congress passed a series of regulatory statutes to address anticompetitive behavior and other market failures occurring in interstate commerce.52 eventually congress delegated regulatory authority to the federal power commission, the predecessor to the federal energy regulatory commission (“ferc”) to regulate hydropower and interstate electricity sales.53 today, in most states, public service commissions set retail intrastate gas and electricity rates54 and, to the extent utilities provide service across state lines, they must do so in conformity with the ferc rules.55 b. accounting for fixed costs in general, when a business acquires an asset that will last several years and will earn income over time, it will account for that value of that asset over the period that the asset produces 90. in addition, regulation may also be justified as affected with the public interest, since access to electricity is essential to a functioning economy. id. 48 see grossman, supra note 43, at 41-43. 49 see alt, supra note 32 at 18; see also davies, supra note 3, at 264, 289-90. 50 id. 51 see davies, supra note 3, at 264, 289. 52 first, congress passed anti-trust laws to limit the exercise of monopoly power. see sherman antitrust act of 1890, pub. l. __, 26 stat. 209 (july 2, 1890) (codified as amended at 15 u.s.c. §§ 1–7), and clayton antitrust act of 1914, pub. l. 63–212, 38 stat. 730 (oct. 15, 1914) (codified as amended at 15 u.s.c. §§ 12–27, 29 u.s.c. §§ 52–53). congress then began regulating natural monopolies. see the interstate commerce act of 1887; the public utility holding company act of 1935, 15 usc 79a et seq. (repealed), federal power act, natural gas act of 1938, priceanderson act of 1957, atomic energy act of 1964, the national energy act of 1978, public utilities regulatory policies act, the natural gas policy act, the energy security act of 1980. from the mid-1980s congress and administrative agencies began taking actions to pull back on regulation and enhance competition for segments of the energy production, distribution, and sales process. however, many states have since slowed or reversed this process following price spikes for electricity and gas in 2000 and 2001. see alt, supra note 32, at 17. 53 federal water power act of 1920 (codified as amended at 16 u.s.c. § 12 (2018)). 54 twenty-one states regulate both electricity and gas markets: alabama, alaska, arizona, arkansas, hawaii, idaho, kansas, louisiana, minnesota, mississippi, missouri, nevada, north carolina, north dakota, oklahoma south carolina, tennessee, utah, vermont, washington, and wisconsin. twelve states regulate electricity, but have deregulated gas at least partially: colorado, florida, georgia, indiana, iowa, kentucky, montana, nebraska, new mexico, south dakota, west virginia, and wyoming. two states regulate gas but not electricity: delaware and oregon. fifteen states have deregulated both electricity and gas markets (though for some states the deregulation of gas markets is limited or offered only to certain consumer classes): california, connecticut, illinois, maine, maryland, massachusetts, michigan, new hampshire, new jersey, new york, ohio, pennsylvania, rhode island, texas, and virginia. map of deregulated energy states & markets (updated 2018), https://www.electricchoice.com/mapderegulated-energy-markets/ [perma.cc/k97d-j9ey]. 55 see alt, supra note 32, at 17. by statute, public service commissions set rates through a rate case, which is a formal, adversarial, and adjudicatory hearing. see davies, supra note 3, at 291, 304. after discovery and audits are complete, and written testimony and briefs are submitted, the public service commission schedules formal hearings and comes to a decision. see alt, supra note 32, at 19. the parties participating in the case will include the public service commission regulatory staff, representatives of the public utility firm, commercial and industrial customers, state consumer advocates, and parties representing low-income consumers. id. 2019] stranded assets and efficient pricing for regulated utilities: a federal tax solution 11 income. first, the asset is “capitalized,” with the full cost of the asset recorded on a ledger when the asset is first used.56 then, a portion of the cost of the asset will be deducted each year, a “depreciation deduction,” to reflect the asset’s decline in value from wear and tear as it is used.57 under economic depreciation, the business would appraise the asset each year to determine the extent to which the asset had declined in value.58 at the beginning of the next year, the value of the asset would be “marked to market” to reflect its new value. 59 the difference, reflecting the asset’s decline in value, would be the depreciation deduction.60 the concepts of capitalization and depreciation are used in annual accounting practices, in financial reporting, and in calculating taxes on business income. because economic depreciation requires an annual valuation and a case by case assessment, it would be expensive and time-consuming for a business to administer and difficult for tax authorities and financial regulators to monitor. 61 consequently, businesses, financial institutions, regulators, and taxing authorities use stylized and standardized systems to account for fixed assets.62 in 1912, the u.s. supreme court affirmed the authority of public service commissions to prescribe accounting practices.63 today, most states require public utilities to use the uniform systems of accounts developed by the national association of railroad and utilities commissions, the federal energy regulatory commission, or the securities and exchange commission. 64 as the tax system has evolved to serve new economic goals, congress has recognized that the accounting rules for public utilities were at cross-purposes to the goals of their tax legislation.65 in successive tax bills, congress has conditioned public utilities’ use of certain tax benefits on following normalization rules. 66 the following subsections outline those developments and their economic impacts on utilities, investors, and consumers. 1. regulatory accounting: ferc rules and rate of return regulation traditional utility regulation is designed to balance the interests of consumers in having reliable access to abundant, relatively inexpensive energy with the interests of investors in earning a profit from their significant investment in capital.67 under “rate of return” regulation, a public 56 see staff of joint comm. on tax’n, jcx-54-01, federal tax provisions affecting the electric power industry 18 (2001) (capitalization refers to the process of accounting for the costs of an asset over time rather than deducting the cost of the asset in full during the accounting period the asset was purchased). 57 id. 58 id. 59 id. 60 id. 61 id. 62 id. 63 see charles f. phillips, jr., regulation of public utilities: theory and practice, 2005 wl 998368 (1988). 64 id. 65 see richard e. matheny, taxation of public utilities, §4.01 – 4.23 (2019). 66 id. 67 see davies, supra note 3, at 281. see also smyth v. ames, 169 u.s. 466 (1898) (holding that a reasonable rate is one that provides the utility with a fair return on the fair value of the property that is used to provide service); bluefield water works v. pub. serv. comm’n of w. va., 262 u.s. 695 (1923) (holding that a utility is entitled to a return on the assets it is using to provide service that is equal to the return earned by businesses facing comparable risks); sw. bell tel. co. v. missouri pub. serv. comm’n, 262 u.s. 276 (1923) (holding that reasonable capital charges would take into consideration the risk incurred and also provide enough to attract new capital); fed. power comm’n v. hope nat. gas co., 320 u.s. 591 (1944) (granting deference to the public service commission and holding that a utility may earn columbia journal of tax law [vol. 11:1 12 service commission determines the amount of revenue a firm must collect to both recover the operating costs it prudently incurs to provide service and to earn a fair return on the capital investments it has made in its facilities.68 this sum is known as the “revenue requirement.”69 the two components, cost of service and return on capital, are expressed more specifically in the following formula: r = o + (v − d)r.70 in the equation, r refers to the utility’s total revenue requirement.71 o refers to the utility’s operating expenses.72 operating expenses normally include: (1) labor and material to operate and maintain the facilities that are used to provide service, (2) a portion of the cost of these facilities, known as “depreciation” of tangible assets and “amortization” of intangible assets under the regulatory and financial accounting rules, (3)“tax expense,” an allocation of the taxes charged to the utility over time that regulators agree may be passed through to consumers, (4) the costs of the customer accounts systems and customer service personnel, administrative and general costs, and (5) uncollectible bills. 73 operating expenses comprise the largest portion of the revenue requirement.74 as long as the utility was prudent in incurring these expenses at the time they were made, they will be reimbursed through the rate-setting process.75 v is the gross value of the utility’s tangible and intangible property.76 v is determined by reference to the original cost of the assets when they were first placed in service and dedicated to use.77 d refers to the utility’s accumulated depreciation — the aggregate of the costs of the assets that have been passed through to customers as part of the operating expenses.78 d, the aggregated regulatory depreciation, is subtracted from revenues sufficient to cover operating expenses and a return on capital costs commensurate with businesses facing comparable risk). 68 see alt, supra note 32, at 18. public service commissions may employ other methods for regulating utility rates. see james ming chen, price-level regulation and its reform, 99 marq. l. rev. 931 (2016) (contrasting cost-ofservice regulation and ramsey pricing with price-level regulation and offering a reform alternative). 69 see davies, supra note 3, at 300. 70 id. 71 id. 72 id. 73 id. see also, alt, supra note 32, at 50-54 and ferc, 18 c.f.r., pt. 101, subpts. d, and k, 74 see davies, supra note 3, at 300. 75 id. considerations in reviewing utility expenses and investments include whether the costs were incurred to meet customer needs, whether they were necessary to provide adequate service, whether the customers would benefit, whether the costs were reasonable, whether the utility’s physical plant and facilities were used and useful and whether they were consistent with an integrated resource plan that the public service commission may have mandated. see alt, supra note 32, at 29. 76 see davies, supra note 3, at 300. 77 ferc determines the depreciation amount by reference to the “service value” of the asset. the service value is defined as the difference between the original cost and the net salvage value of electric plant. these definitions reconcile what would otherwise appear to be differences in the regulatory and financial accounting rules. see ferc 18 c.f.r., pt. 101, definitions 19, 23, 35, 36, and 37 (2002). 78 the ferc uniform system of accounts provides that “[d]epreciation, as applied to depreciable electric plant, means the loss in service value not restored by current maintenance, incurred in connection with the consumption or prospective retirement of electric plant in the course of service from causes which are known to be in current operation and against which the utility is not protected by insurance. among the causes to be given consideration are wear and tear, decay, action of the elements, inadequacy, obsolescence, changes in the art, changes in demand and requirements of public authorities.” ferc 18 c.f.r. pt. 101, definition 12 (2002). 2019] stranded assets and efficient pricing for regulated utilities: a federal tax solution 13 v, the original value of those assets.79 each year, v – d reflects the utility’s unrecovered capital investment — the portion of the facilities for which the customers have not yet paid.80 utilities are allowed to earn a fair return only on the unrecovered portion of their capital investments.81 this portion, calculated as v – d, is the “rate base.”82 the value “r” stands for the rate of return the utility is allowed to earn on the rate base.83 ferc and state public service commissions set the rules by which regulated public utilities may pass the costs of capital through to their customers.84 these rules therefore determine the rate at which utility investors may recover their investment in those assets. under traditional rate of return regulation, consumers pay for an asset over the entire period the utility uses the asset (the asset’s “service life”).85 under these regulatory rules, the portion of the total cost that consumers pay each year is referred to as “depreciation.”86 however, for clarity in distinguishing the meaning of that term under the regulatory, financial, and tax accounting rules, this will be referred to as “regulatory depreciation.” calculating annual regulatory depreciation for public utilities involves four steps: (1) identifying the total cost of the asset,87 (2) estimating the service life of the depreciable asset,88 (3) estimating the net salvage value of the asset,89 and (4) identifying a depreciation system that will 79 see davies, supra note 3, at 300. 80 see edison electric institute, introduction to depreciation for public utilities and other industries 8 (2013) [hereinafter, eei]. 81 see davies, supra note 3, at 300. 82 id. 83 id. the firm’s weighted average cost of capital, the amount it must pay to lenders and investors to acquire the funds it uses to provide utility services, provides the basis for “r”. id. at 302 (“the rate of return, then, reflects the interest on debt and a return to shareholders for all of the capital that they have invested. thus, the final variable (r) represents a weighted average of the different types of investments made by the utility, calculated to attract investors.”); see also alt, supra note 32, at 40. 84 see davies, supra note 3, at 284. 85 ferc 18 c.f.r. pt. 101, definition 36 (2002) (“service life means the time between the date electric plant is includible in electric plant in service, or electric plant leased to others, and the date of its retirement. if depreciation is accounted for on a production basis rather than on a time basis, then service life should be measured in terms of the appropriate unit of production.”) 86 the u.s. supreme court affirmed cost-based depreciation for public utilities in lindheimer v. illinois bell telephone company, 292 u.s. 151 (1934), and federal power commission v. hope natural gas company, 320 u.s. 591 (1944). 87 ferc rules provide that “[o]riginal cost, as applied to electric plant, means the cost of such property to the person first devoting it to public service.” ferc 18 c.f.r. pt. 101, definition 23 (2002). firms may capitalize (include as part of the original cost of the asset) any expenses the firm incurs to make the asset ready for its intended use, including interest on debt service, labor, and other costs incurred during the construction or installation process. pricewaterhousecoopers, utilities and power companies, 12-2 – 12-13 (march 31, 2016) [hereinafter, pwc]. 88 a firm estimates the service life based on actuarial studies and past experience with like assets, taking into consideration the effects of wear and tear, operational changes, regulatory requirements and anticipated future use of the assets. see eei, supra note 80, at 3-4. 89 id. equipment and other assets used in a trade or business often continue to have value after they are removed from service by their original owner. when third parties acquire these assets, the price at which the asset is sold is its “salvage value.” for example, a firm may purchase an asset from salvage and either refurbish the asset to use for its original purpose, dismantle the asset and sell it for parts, or sell the asset for scrap. the residual value at that point, the price at which the asset is likely to sell at the end of its service life, is its salvage value. ferc defines salvage value as “the amount received for property retired, less any expenses incurred in connection with the sale or in preparing the property for sale; or, if retained, the amount at which the material recoverable is chargeable to materials and supplies, or other appropriate account.” ferc 18 c.f.r. pt. 101, definition 35 (2002). ferc defines “net salvage columbia journal of tax law [vol. 11:1 14 allocate the cost of the asset in a rational manner over the asset’s service life.90 while several types of methods for calculating depreciation exist, including deferred and accelerated methods based on the age and life of an asset, utilities use the straight-line method nearly universally.91 under straight-line depreciation, the net salvage value is subtracted from the total cost of the asset placed in service, and then that number is divided by the asset’s service life.92 2. financial accounting financial accounting rules are used to calculate firm income and to comply with financial reporting requirements. a firm’s value is measured by the regularity at which revenues exceed expenses, yielding net income, or profit. the financial accounting rules provide that in calculating annual net income, a firm may deduct a portion of the total cost of the asset each year the asset is in use, reflecting that decline in value.93 while the financial accounting rules refer to this amount as a “depreciation allowance,” this article refers to the deduction as “financial depreciation” to distinguish the amount from regulatory depreciation, described above, and tax depreciation, described below. to calculate financial depreciation using the straight-line method, a firm subtracts the salvage value of the asset from the original cost of the asset and divides that difference value” as “the salvage value of property retired less the cost of removal.” ferc 18 c.f.r. pt. 101, definition 19 (2002). cost of removal is defined as “the cost of demolishing, dismantling, tearing down or otherwise removing electric plant, including the cost of transportation and handling incidental thereto. it does not include the cost of removal activities associated with asset retirement obligations that are capitalized as part of the tangible long-lived assets that give rise to the obligation.” ferc 18 c.f.r. pt. 101, definition 10 (2002). 90 see eei, supra note 80, at 3. 91 id. at 4. utilities may also use certain accelerated depreciation methods, such as “sum-of-the-years-digits,” declining-balance methods, and units-of-production methods. see also pwc, supra note 87, 12-13. utilities may also use “group methods” or “composite methods” for multiple assets or asset groups. id. at 12.3.1. firms apply the group method to homogeneous assets with service lives of approximately the same length, such as utility poles and other largely identical units of a transmission or distribution system. id. under the group method, firms depreciate the carrying amount over the average life of the assets in the group. id. firms generally use the composite method for assets that are components of a larger asset, such as a power plant. id. the composite method depreciates heterogeneous assets with different useful lives based on a weighted average depreciation rate. id. when assets are retired, regardless of whether an asset has reached the average service life of the assets in the group, a firm will sell the asset and take the gain or loss on that sale into account as accumulated depreciation. id. earnings are not affected. id. see also eei, supra note 80, at 35-48. 92 id. at 4. 93 more specifically, the financial accounting standards board defines depreciation as follows: “the cost of a productive facility is one of the costs of services it renders during its useful economic life. generally accepted accounting principles (gaap) require that this cost be spread over the expected useful life of the facility in such a way as to allocate it as quotably as possible to the periods during which services are obtained from the use of the facility. this procedure is known as depreciation accounting, a system of accounting which aims to distribute the cost of other basic value of tangible capital assets, less salvage (if any), over the estimated useful life of the unit (which may be a group of assets) in a systematic and rational manner. it is a process of allocation, not of valuation.” eei, supra note 80, at 2 (quoting fasb accounting standards codification, asc 360-10-35-4, property, plant and equipment — overall subsequent measurement depreciation). see also pwc, supra note 91, at 12.3.1. 2019] stranded assets and efficient pricing for regulated utilities: a federal tax solution 15 by the asset’s service life.94 the regulatory rules modify the financial accounting rules for regulated utilities, to account for capitalization, and calculate depreciation for fixed assets.95 as the firm claims financial depreciation allowances each year, it deducts those depreciation allowances from the remaining undepreciated cost of the firm’s fixed assets.96 under this system, the “net plant” or “carrying amount” continues to reflect the firm’s unrecovered investment in the asset.97 utilities’ financial statements report their aggregate investments in fixed assets as “property, plant and equipment” or “plant in service”98 and include a line item for aggregate “depreciation” for those assets.99 the balance is identified as “plant in service net of depreciation” or “net plant.”100 3. tax accounting in the u.s. in the united states, accounting for recovery of capitalized investments under the tax rules has diverged significantly from financial accounting practices and regulatory depreciation rules. since the 1950s, congress has reduced by half the time frames for a firm to recover its investments in capitalized assets, standardized recovery periods for asset groups, and introduced depreciation methods that allow most of the capitalized costs to be recovered in the first few years after an asset is placed in service.101 congress has also, through “bonus depreciation” rules, allowed firms to deduct a significant portion of the purchase price of an asset in the first year an asset is placed in service. 102 after applying bonus depreciation, firms recover the remaining investment at accelerated rates under the modified accelerated cost recovery system.103 in 2010 and 2011, congress allowed firms, including public utilities, to expense their capital costs in full under the bonus depreciation rules.104 94 see eei, supra note 80, at 2. financial depreciation is usually calculated on a monthly basis and applied to reduce the monthly balance of the asset’s depreciable cost. id. at 133. assets placed in service earlier in the year receive more depreciation in the first year than those placed in service later. id. public service commissions may modify the financial depreciation rates for utilities during a general rate case proceeding. id. 95 id. at 9. 96 id. at 15-16, 148-49. 97 id. 98 id. at 14. 99 id. at 15 (“the terms ‘accumulated provision for depreciation,’ ‘accumulated depreciation,’ ‘accumulated depreciation reserve,’ ‘depreciation reserve,’ or simply the word ‘reserve’ are all used interchangeably to denote the accounts designated in the ferc uniform systems of accounts for electric and gas utilities as the ‘accumulated provision for depreciation of plant in service.”). 100 id. at 16. the cost of the plant less the accumulated depreciation, or “net plant,” is the main component in setting utility rates. id. 101 all of these reforms have added to the complexity of the tax system and increased the costs of compliance. 102 see i.r.c. § 168(k). 103 see i.r.c. § 168(k). 104 see i.r.c. §§ 168(k), 179. columbia journal of tax law [vol. 11:1 16 a. section 167: useful life and salvage value as with financial depreciation, the u.s. income tax system has historically allowed businesses to deduct only a portion of the cost of capitalized business assets each year.105 when the tax system was first designed, depreciation deductions, or “allowances” for property used in a trade or business, generally tracked the gradual decline in the value of the property from wear and tear that occurred as those assets were used to generate income.106 initially, the tax rules matched the rules for financial depreciation, permitting a firm to recover its investment in property, plant and equipment less any salvage value107 the property was likely to have on sale at the end of the service life or “useful life,” 108 a difference known as the “depreciable basis.” after the business began to use the property or the asset was “placed in service,” the firm could begin taking depreciation deductions until the business retired the asset.109 under the “straight-line method” of depreciation, the business could deduct an equal portion of the depreciable basis each year.110 while at first taxpayers had broad discretion in selecting the useful life of the asset, in 1962 congress and the department of treasury standardized the recovery periods for groups of assets.111 in general, congress designed the tax rules to match depreciation deductions with the income generated from using that asset. 105 see internal revenue service, how to depreciate property, pub. 946 (2018), https://www.irs.gov/pub/irspdf/p946.pdf [https://perma.cc/s8dg-lanh] (“depreciation is an annual income tax deduction that allows you to recover the cost or other basis of certain property over the time you use the property.”). 106 section 167(a) provides that “there shall be allowed as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear (including a reasonable allowance for obsolescence)— (1) of property used in the trade or business, or (2) of property held for the production of income.” i.r.c. § 167(a) neither financial depreciation nor tax depreciation match economic depreciation perfectly, however. 107 see treas. reg. § 1.167(b)-0 (2019). 108 see treas. reg. § 1.167(b)-0 (2019). 109 see treas. reg. § 1.167(a)-10(b) (2019). 110 see i.r.c. § 167; treas. reg. § 1.167(b)-1. other methods, such as the declining balance method were also available. see treas. reg. § 1.167(b)-2. today, property not otherwise covered under the modified accelerated depreciation system under § 168 or under the amortization provisions of § 197 continues to be governed by the depreciation rules under § 167. 111 in 1934, the department of treasury began requiring taxpayers to demonstrate that their depreciation allowances were based on useful life periods appropriate for the assets being depreciated. the 1962 revenue act authorized the department of treasury to develop special guidelines for examining depreciation deductions to reduce taxpayer–irs disagreements over recovery periods. the depreciation rate table was based on classes of assets in industry. see staff of joint comm. on tax’n, jcx-54-01, supra note 56, at 18. the 1971 revenue act authorized the department of treasury to develop the class life asset depreciation range system (adr) for machinery and equipment. class lives were based on broad classes of assets with a range of applicable periods for depreciation. treasury later expanded adr to include buildings and improvements to land. id. adr shortened class lives by 20%. kiefer, supra note 36, at 13. 2019] stranded assets and efficient pricing for regulated utilities: a federal tax solution 17 b. section 168: accelerated cost recovery the federal income tax rules now provide for accelerated recovery of capital investments.112 the modified accelerated cost recovery system (“macrs”), established under the tax reform act of 1986, modified the rules for depreciation allowances significantly. first, it eliminated the requirement that taxpayers deduct salvage value in determining the depreciable basis of property; this allowed the entire purchase price or cost of construction of the property placed in service to be recovered in full.113 second, the system established recovery periods that were significantly shorter than the useful life of the property prescribed under section 167.114 macrs generally cut by 50% the periods for recovering the costs of utility plants, including transmission and distribution facilities. for example, under the financial accounting rules, the typical life span for a nuclear power plant is 40-60 years;115 the recovery period under macrs is 15 years.116 the actual service life of a coalfired steam generation power plant is 55 years and the service life of a natural gas plant is 35 years.117 transmission equipment has an estimated service life of approximately 40 years118 and distribution poles119 have a service life of 50 years. under macrs, the recovery periods for these plants, as well as electric utility transmission and distribution and gas utility distribution facilities, is 20 years.120 while natural gas pipelines have a service life of 50 years, 121 firms may recover their 112 in 1954 congress first authorized accelerated depreciation methods, including the 200% declining balance method and the sum of the years-digits. accelerated depreciation was expanded in 1981, with the economic recovery tax act, which introduced the accelerated cost recovery system (“acrs”). this system standardized recovery periods for assets, allowing taxpayers to recover investments in tangible business assets over a shorter period— three, five, ten, or 15 years on an accelerated basis. id. the recovery period for real property was shortened to 15 years. under acrs, “public utility property” had a depreciation period of ten or 15 years. id. at 19. depreciation deductions continued to be calculated primarily using the straight-line basis with a half-year convention. when this accelerated rate of depreciation was proved too expensive, congress modified the system in 1986 to lengthen the recovery period for certain assets, creating the system known as modified accelerated cost recovery, or macrs. id. 113 i.r.c. § 168(b)(4). a robust market for fully depreciated assets exists because the recovery periods are significantly shorter than the useful lives for the asset classes. any gains on sale of zero basis property are included in income. to the extent the gains are associated with accelerated depreciation previously taken, those gains are taxed at ordinary income rates. see i.r.c. §§ 1245, 1250 (2019). 114 see i.r.c. § 168. the periods are longer, however, than those in place under the accelerated cost recovery system in place from 1981 to 1986. see economic recovery tax act of 1981, pub. l. 97-34, 95 stat. 172, §201; i.r.c. § 168(c)(2)(c) and (e) (1981) (providing a 10 year recovery period for public utility property with a class life between 18 and 25 years and a 15 year recovery period for public utility property with a class life greater than 25 years). for most types of public utility property, the tax reform act of 1986 lengthened the recovery periods prescribed by the economic recovery tax act of 1981, but the depreciation methods for public utility property remained the same. kiefer, supra note 36, at 15. 115 mark pomykacz & chris olmsted, the appraisal of power plants, appraisal j. 216, 217, tbl. 1 (summer 2014). 116 rev. proc. 87-56, 1987-2 c.b. 674. 117 pomykacz, supra note 115, at 217, tbl. 1. 118 see edison electric institute, transmission projects: at a glance ix (dec. 2016); advisian, worley parsons group, review of standard and remaining lives of assets, networks nsw 36-38 (jan. 12, 2015). 119 harris williams & co., transmission and distribution infrastructure, 5 (summer 2014), https://www.harriswilliams.com/sites/default/files/industry_reports/final%20td.pdf [https://perma.cc/qhy4fwvg]. 120 rev. proc. 87-56, supra note 116. 121 garance burke and jason dearen, aging gas pipe at risk of explosion nationwide, associated press (sep. 14, 2010). columbia journal of tax law [vol. 11:1 18 capital costs in only 15 years.122 the following chart compares the “service life” or “useful life” of utility assets for financial accounting and ferc rules to the “recovery period” in which a firm may deduct the costs of its investments in these assets under the tax rules. figure 1. comparison of recovery periods under modified accelerated (tax) depreciation (pursuant to i.r.c. section 168) and depreciation for coal fired steam generation plants, natural gas facilities and nuclear power plants under financial accounting (book) and ferc rules. third, macrs provides for property, such as equipment, to be depreciated using not only the straight-line method, but also the 200% declining balance method or the 150% declining balance method, which provides higher deductions for depreciation in the early years the asset is in service.123 these accelerated cost recovery methods allow taxpayers to recover the bulk of their investment in the first few years of use.124 consequently, capital-intensive industries, including utilities, may recover their investments in durable assets more quickly for tax purposes by “frontloading” the depreciation, deducting a higher percentage of the value of the asset in the early years of its service. electric utility steam production plants, combustion turbine production plants, and transmission and distribution plants may apply the 150% declining balance depreciation method.125 c. section 168(k): bonus depreciation recently congress has enacted tax provisions that allow taxpayers to recover their investments even more quickly than with macrs. section 168(k) provides for “bonus 122 rev. proc. 87-56, supra note 116. 123 see i.r.c. § 168(b). these methods switch to straight-line when that method would produce greater depreciation deductions. 124 see id. while the straight-line depreciation divides the total amount of the expenditure by the recovery period to give an aliquot portion of depreciation per year, the double declining balance method allows taxpayers to deduct two times the depreciation allowed under the straight-line method in the first few years of the recovery period. the 150% declining balance provides a deduction equal to one and a half times the deduction allowed under the straight-line method. see id. 125 see staff of joint comm. on tax’n, jcx-54-01, supra note 56, at 20-21. 0 10 20 30 40 50 60 transmission and distribution facilities nuclear power plant natural gas power plant coal fired steam generation plant recovery period (tax) service life (book) 2019] stranded assets and efficient pricing for regulated utilities: a federal tax solution 19 depreciation.”126 congress’s original intention was to spur growth by allowing businesses to deduct immediately, or “expense,” a portion of the cost of assets in the year they are placed in service.127 theoretically, a business that recovers its business investments more quickly may replace them sooner, leading to the acquisition of more business assets. by stimulating manufacturing and retail job growth, congress sought to improve productivity and enhance economic performance.128 congress initially employed bonus depreciation to spur the economy following the september 11, 2001 terrorist attacks. the job creation and worker assistance act of 2002129 authorized taxpayers to deduct 30% of their cost basis in qualified depreciable property with a recovery period of 20 years or less, if they acquired the property and placed it in service between september 10, 2001, and may 5, 2003. after deducting this sum, the taxpayer could also take normal depreciation deductions on their remaining basis in the property under macrs for the year the property was placed in service and subsequent years. congress has since extended bonus depreciation,130 allowed it to lapse,131 restored it,132 and increased the bonus to cover as much as 100% of the cost of the asset, with phase-downs of the percentage in later years.133 126 i.r.c. § 168(k). 127 another provision dating from 1958, section 179, permits smaller businesses to “expense,” deduct in full, the cost of equipment placed in service in a given year. i.r.c. § 179. congress has used the provision to stimulate the economy and simplify tax accounting for small businesses, though recent dramatic changes in the provision’s parameters have made the deduction available for larger businesses. see jane g. gravelle, cong. research serv., bonus depreciation: economic and budgetary issues 3, n. 6 (2014), https://fas.org/sgp/crs/misc/r43432.pdf [https://perma.cc/2zdq-93vf]. in the short term, expensing provisions reduce the cost of capital for businesses to acquire qualified assets and increase the cash flow of firms investing in those businesses. id.; see also gary guenther, cong. research serv., section 179 and bonus depreciation expensing allowances: current law and issues for the 114th congress 10 (2015). currently, businesses acquiring new or used property that is depreciable under the macrs system may take an immediate deduction of up to $1,000,000 with an investment maximum of $2,500,000, above which the deduction is reduced dollar-for-dollar. i.r.c. § 179(b) and (d). see an act to provide for reconciliation pursuant to titles ii and v of the concurrent resolution on the budget for fiscal year 2018, pub. l. 115–97, 131 stat. 2054 (2017) (colloquially known as the tax cuts and jobs act of 2017) [hereinafter, the tcja of 2017]. when combined with other depreciation provisions under section 168, section 179 is applied to the first $1,000,000 of basis, and then section 168(k) bonus depreciation is applied, and then macrs is applied, all of which happen during the first year the property is placed in service. subsequent macrs allowances are calculated from the tax basis remaining after the first year. 128 while the original goal of bonus depreciation and expensing provisions was to spur a flagging economy, empirical studies have shown that they are not effective as stimuli. see guenther, supra note 127, at 10-14. 129 see job creation and worker assistance act of 2002, pub. l. no. 107-147, 116 stat. 21. 130 the jobs growth tax relief and reconciliation act of 2003 expanded the bonus depreciation regime. see generally jobs and growth tax relief reconciliation act of 2003, pub. l. no. 108-27, 117 stat. 752. property acquired after may 5, 2003 and placed in service by december 31, 2004 was eligible for bonus depreciation of 50%. the provision expired at the end of 2004. 131 id. the provision expired at the end of 2004. 132 in 2008, responding again to an economic recession, congress enacted the economic stimulus act, restoring the temporary 50% first-year bonus depreciation break from january 1, 2008 through september 8, 2010. pub. l. 110185, 122 stat. 613 (2008). the tax relief, unemployment insurance reauthorization, and job creation act of 2010, increased the bonus depreciation allowance to 100% and extended the allowance through 2011 for property acquired after september 8, 2010 and placed in service by december 31, 2011. pub. l. 111–312, 124 stat. 3296 (2010). for 2012, bonus depreciation was reduced again to 50% for qualified property placed in service during this period. id. 133 the american taxpayer relief act of 2012 extended the 50% bonus depreciation through january 1, 2014. pub. l. 112–240, 126 stat. 2313, (2013). the provision expired in 2014, but was reinstated at the end of 2015. see economic stimulus act of 2008, pub. l. no. 110-185, 122 stat. 613; american recovery and reinvestment act of columbia journal of tax law [vol. 11:1 20 the following table identifies the percentage of an asset that may be deducted immediately (expensed) the first year that the asset is placed in service under the section 168(k) bonus depreciation provisions for any portion of the year from 2001 to 2027. the table contrasts the availability of bonus depreciation for qualifying property generally and for qualifying property held by regulated utilities. figure 2. comparison for the years from 2001 through 2027 of the percentage of asset value that may be expensed the year the asset is placed in service pursuant to section 168(k) “bonus depreciation” available for qualifying property.134 under the tax cuts and jobs act of 2017, congress limited the ability of regulated utilities to take bonus depreciation under section 168(k).135 from 2018 to 2027, utilities may not take bonus depreciation in new assets, but they may deduct the interest they pay in full.136 in contrast, nonutility firms may take bonus depreciation, but if they do, their ability to deduct interest is limited.137 the rationale for this choice is economic. historically, interest paid in connection with business loans has been deductible in full.138 when debt is used to finance the acquisition of depreciable business assets, a significant portion of the cost of those assets may be deducted immediately. by 2009, pub. l. no. 111-5, 123 stat. 115; small business jobs act of 2010, pub. l. no. 111-240, 124 stat. 2504; tax relief, unemployment compensation reauthorization, and job creation act of 2010, pub. l. 111-312, 124 stat. 3296; american taxpayer relief act of 2012, pub. l. 112-240, 126 stat. 2313. at that point, congress extended bonus depreciation to apply to property placed in service from 2015 through 2020. consolidated appropriations act, 2016, pub. l. no. 114-113, § 143, 129 stat. 2242, 3056-65 (2015). the act also applies retroactively to permit taxpayers to take bonus depreciation on qualified property placed in service in 2015. the protecting americans from tax hikes act of 2015, part of the consolidated appropriations act of 2016, sets bonus depreciation at 50% for 2015 through 2017. pub. l. no. 114-113,129 stat. 2242, 2244 (2015). the most recent change to the bonus depreciation rules occurred in december 2017. 134 note that when congress passed the bonus depreciation provisions, they were available for assets placed in service as of a particular date that did not always correspond to the beginning of the calendar year. this graph indicates where bonus depreciation was available for the majority of a particular calendar year. 135 see tcja of 2017. see part iii.b. infra. 136 i.r.c. § 163(j). 137 id. 138 i.r.c. § 163(a), (h). 0 20 40 60 80 100 120 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 20 09 20 10 20 11 20 12 20 13 20 14 20 15 20 16 20 17 20 18 20 19 20 20 20 21 20 22 20 23 20 24 20 25 20 26 20 27 bonus depreciation bonus depreciation generally regulated utilities 2019] stranded assets and efficient pricing for regulated utilities: a federal tax solution 21 combining debt financing with bonus depreciation, a taxpayer may enjoy a subsidy in excess of the value of the asset, resulting in a negative income tax rate.139 that is, congress would effectively be paying firms to buy assets. the goals of the regulatory, financial, and tax accounting systems differ. the purpose of rate regulation is to function as a substitute for competition in a monopoly setting. regulatory accounting permits the costs of operations, including a portion of the cost of the utility facilities, to be passed through to consumers over time, while allowing investors to earn a return on their investment proportionate to their remaining unrecovered investment in those facilities. financial accounting helps a firm determine its net income and provides investors with an accurate assessment of the firm’s financial status and profitability. the central function of the tax system is to generate revenue for the federal government. while the system initially followed financial accounting rules in measuring net income, in recent years, the income tax has been employed as an economic tool. tax accounting for fixed assets has been modified to accelerate cost recovery and spur economic growth. despite these differences in goals and processes, the three accounting systems use much of the same language with different meanings. the following table summarizes the parameters and clarifies the differences in the systems. what is depreciated? regulatory service value: the total cost of the asset plus any additional costs in acquiring, constructing the assets, and placing it in service. salvage value (the price at which the asset will likely sell at the end of the service life of the asset) is subtracted to determine the amount that may be depreciated. financial net plant or carrying amount: the total cost of the asset plus any additional costs in acquiring, constructing the assets, and placing it in service less salvage value (the price at which the asset will likely sell at the end of the service life of the asset). tax depreciable basis: the total cost of the asset plus any additional costs in acquiring, constructing the asset, and placing it in service. no salvage value is deducted. does the system account for salvage? regulatory yes financial yes tax no what is the period over which the asset is depreciated? regulatory service life: the period for which the asset is likely to be in use. financial useful life: the period for which the asset is likely to be in use. tax recovery period: the accounting period during which the tax system will allow the taxpayer to recover their investment in the asset, usually 50% or less of the period for which the asset is likely to be in use. what is the annual measure of depreciation and how is it used? regulatory depreciation: this is the portion of the service value of the asset the utility may pass through to customers as part of the operating cost (o) of the utility. the aggregate of each year’s depreciation (d) is subtracted from the service value to determine the rate base. the utility also earns a return on the rate base. financial depreciation allowance: each year the firm will deduct a portion of the total cost of an asset from the firm’s income to determine net income, the amount of profit. this sum is also subtracted from the remaining carrying amount to track the remaining unrecovered investment in the asset. tax cost recovery allowance: each year the firm will deduct the cost recovery allowance from gross income to assess the amount of taxable income. this sum is also subtracted from the remaining depreciable basis to track the remaining unrecovered investment in the asset for tax purposes. table 1. definition of terms and comparison of the parameters in calculating depreciation under the regulatory, financial, and tax accounting rules. 139 see gravelle, supra note 127, at 9-10 (“under the average 26% effective tax rate for equipment under current [2014] law without bonus depreciation, the effective tax rate on debt financed investment is [negative nineteen percent] -19%. with bonus depreciation, it is [negative thirty-seven percent] 37%.”). columbia journal of tax law [vol. 11:1 22 c. reconciling tax/book/regulatory disparities: the normalization rules and their effects capitalized investments feature in the ratemaking process in three places. first, regulatory depreciation is included as part of the operating expense (o) that is passed forward to customers. second, the utility and its investors are entitled to earn a return on the capital investments in the utility’s facilities to the extent that customers have not yet paid for them (v-d). third, a normalized “tax expense” is also included as part of operating expense. utilities are not permitted to pass the immediate tax savings from accelerated depreciation through to consumers or to use tax depreciation to calculate the tax expense charged to consumers as part of the ratemaking process.140 instead, both the ferc and the internal revenue service (“irs”) require regulated utilities to follow “normalization rules” when computing tax expense and establishing cost of service during the ratemaking process.141 the normalization rules reconcile the differences between tax accounting and accounting for ratemaking and financial reporting purposes.142 to enforce the normalization rules, congress provided that public utilities failing to normalize will be denied permission to use accelerated depreciation for assets currently in service and for property, plant, and equipment acquired in the future.143 penalties for failure to normalize accelerated deductions include the loss of those deductions and the recapture of tax credits.144 normalization affects the rate-setting formula in two ways. first, tax expense is calculated by deducting depreciation allowances based on the financial and regulatory accounting rules rather than deducting cost recovery allowances under the income tax rules.145 the normalization rules require that the operating expense include the taxes that consumers would pay if macrs the accelerated cost recovery system had never been enacted.146 140 see pwc, supra note 91, at 19-10. see also i.r.c. § 168(i)(9). 141 i.r.c. § 168(i)(9), (10). in the tax reform act of 1969, congress discouraged public utility commissions from allowing the tax benefits from accelerated depreciation to be passed through to current consumers by imposing normalization on new investments where the utilities used accelerated depreciation. u.s. gov’t accountability off., gao/ggd–91–51, public utilities; disposition of excess deferred taxes 30 (sept. 1991), https://www.gao.gov/assets/220/215102.pdf [https://perma.cc/29pp-5rey]. the economic recovery act of 1981 required utilities to normalize the tax and book depreciation timing differences in order to take advantage of acrs depreciation. see kiefer, supra note 36, at 13. before that, many utilities did not use normalization; they allowed the tax benefits of accelerated depreciation to flow-through to customers immediately. id. at 11. consequently, the customers paid lower rates (because lower tax expense was included in their electricity bills) in the early years. id. later customers paid a higher electricity or gas rate when the property had been fully depreciated and there was no more tax depreciation remained to offset income and reduce their tax expense. see eei, supra note 80, at 135. 142 normalization rules apply not only to accelerated depreciation, but also to other tax/book disparities, such as treatment of the “allowance of funds during use during construction” (afudc), “contributions in aid of construction” (ciac), capitalized interest, investment tax credits, and overhead. pwc, supra note 91, at 19-11 19-13. software may either be capitalized or expensed. investment tax credits (idc) are handled differently as well. see eei, supra note 80, at 134. 143 i.r.c. § 168(f)(2). 144 i.r.c. § 168(f)(2). note that in 2017, however, the internal revenue service issued a guidance providing a safe harbor for public utilities that have failed to follow the normalization rules and indicated that it would not pursue enforcement proceedings for past failures. see rev. proc. 2017-47; see also jeffrey davis, david burton and isaac maron, an irs lifeline to public utilities on normalization, law360 (sept. 14, 2017), https://www.law360.com/articles/964097 [https://perma.cc/xrn4-87kx]. 145 see pwc, supra note 91, at 19-10. 146 normalized calculation of tax expense follows the older tax depreciation rules under i.r.c.§ 167. see i.r.c. § 168(i)(9)(a)(ii). 2019] stranded assets and efficient pricing for regulated utilities: a federal tax solution 23 as a result of the timing differences in the tax and financial accounting rules, the utility enjoys tax savings from accelerated tax depreciation.147 however, under the normalization rules, the utility continues to collect tax payments from consumers as though accelerated tax depreciation did not exist. under the normalization rules the utility collects more revenue from customers than it needs to cover the actual taxes the utility pays in the early years of the asset’s service life. 148 consequently, the utility enjoys a pool of tax savings consisting of its customers’ “overpayments” of tax. the utility collects less revenue than it needs from customers later in the service life of the asset.149 the tax savings are then applied to offset actual tax liability at that time, later in the asset’s service life, after tax depreciation is complete.150 the regulatory and financial accounting rules require utilities to track the pool of tax savings in their financial statements as “accumulated deferred income taxes” or “adit.”151 adit may be calculated by subtracting the amount of financial depreciation from the tax depreciation and then multiplying that amount by the firm’s marginal tax rate. during the service life of an asset, the adit account for that asset will increase until financial depreciation exceeds tax depreciation, which will occur at the end of the tax recovery period for the asset. at that point, the tax savings will be passed forward to consumers to reduce the tax expense. the adit account increases during the period of cost recovery under the tax accounting rules and then declines at the end of the cost recovery period when there is no more tax depreciation to offset income. when the utility has recovered the full cost of the asset under the financial accounting rules at the end of the asset’s service life, the adit account for that asset will decline to a sum equal to the salvage value multiplied by the firm’s marginal tax rate. this sum is sufficient to cover the taxes on the sale of the asset for salvage, assuming that it sells for its previously estimated salvage value.152 to provide an illustration of how the tax savings accrue and are disbursed over time consider the following two examples. the first describes the accrual of tax savings as adit based on tax depreciation under macrs. the second is based on 100% bonus depreciation. in the first example, assume that a regulated public utility invests $1.2 million in a coalfired power plant with a 55-year service life. the equipment has a $100,000 salvage value at the end of the service life. to determine the amount of regulatory depreciation, the salvage value is subtracted from the total cost. ($1,200,000 total cost $100,000 salvage value = $1,100,000). second, that sum is then divided by the service life of the asset ($1,100,000 / 55 years = $20,000 per year). the utility would pass through $20,000 per year of the asset’s cost to the consumers under the rate of return rules. likewise, under normalization, the tax expense would be calculated based on the financial depreciation and regulatory depreciation rules. to determine the amount of financial depreciation, the salvage value is subtracted from the total cost ($1,200,000 total cost $100,000 salvage value = $1,100,000). second, that sum is then divided by the service life of the asset ($1,100,000 / 55 years = $20,000 per year). 147 see alt, supra note 32, at 39. 148 id. 149 id. 150 id. 151 adit is included in the firm’s financial statements as a liability account, since utility firms must gradually pass the tax savings forward to consumers over the full service life of the asset. 152 see eei, supra note 80, at 134; pwc, supra note 91, at 4-19. note that the sale for salvage at the end of the service life of the equipment will generate income. since macrs does not account for salvage value, there may be a modest amount of tax savings to apply toward the tax on that income from salvage. columbia journal of tax law [vol. 11:1 24 next, assuming a marginal tax rate of 35%, to determine the dollar value of the tax expense associated with that asset, one multiplies the amount of the depreciation deduction under the financial accounting rules by the tax rate. a depreciation allowance of $20,000 x 35% corporate tax rate = $7,000. under the normalization rules, depreciation of this asset would offset $7,000 of income taxes per year over the asset’s entire service life. under the macrs rules, however, the utility is allowed to recover the entire cost of the property placed in service over a recovery period of only 20 years. in addition, macrs does not deduct salvage value. therefore, the tax deduction the utility may take for depreciation associated with this asset is much larger. under macrs, the calculation would be as follows: $1,200,000 depreciable basis / 20 years of cost recovery = $60,000 tax depreciation per year. again, assuming a marginal tax rate of 35%, to determine the dollar value of the tax depreciation associated with that asset, one multiplies the amount of the cost recovery allowance under the tax accounting rules by the tax rate ($60,000 x 35% corporate tax rate = $21,000 per year). under the tax accounting rules, depreciation of this asset would offset $21,000 of income taxes per year over the asset’s 20-year cost recovery period (the first 20 years after the asset is placed in service). after that, the utility would have no cost recovery deductions for the remaining 35 years of the 55-year service life. the tax savings that the utility accrues each year are equal to the tax savings from applying macrs minus the tax savings that the normalization rules require the utility to use in calculating tax expense. $14,000 tax savings = $21,000 tax savings under macrs $7,000 tax savings used to calculate tax expense. another way to calculate these tax savings is to subtract depreciation deductions under the financial accounting rules from the actual tax depreciation the utility enjoys under macrs, and then multiply that sum by the marginal tax rate: $60,000 macrs depreciation $20,000 depreciation permitted to calculate tax expense under the normalization rules = $40,000. $40,000 excess depreciation x 35% corporate tax rate = $14,000 in tax savings. because of the difference in the taxes the utility actually pays to the federal government and the taxes they collect from their customers under the normalization rules, a pool of tax savings would accrue. the tax savings pool (tracked as adit under the financial accounting rules) would increase each year by $14,000 per year for each of the first 20 years. at the end of the 20-year period, the adit account will have reached $280,000. at that point the utility has no more actual tax depreciation to reduce the taxes on revenue from operating the asset. during the last 35 years the asset remains in service, the pool of tax savings would be drawn down at a rate of $7,000 per year to apply to the tax expense that is passed through to consumers. at the end of the 55-year service life of the property, the asset has been fully depreciated and the remaining $35,000 in adit may be applied to the taxes on the income from sale of the equipment for salvage ($100,000). the calculations on which figure 3 is based are included in appendix a. 2019] stranded assets and efficient pricing for regulated utilities: a federal tax solution 25 figure 3. this chart the tax savings (adit) that accrue under the normalization rules because of the timing differences under macrs. the chart shows the tax savings that accrue and are disbursed for a $1,200,000 asset, with a 55-year service life, and a 20-year cost recovery period. the vertical figures are in the $1000s. in the second example, we assume the same parameters, except that the utility is taking advantage of 100% bonus depreciation. bonus depreciation allows an immediate deduction of a certain percentage of an asset’s value before applying the usual macrs rules. bonus depreciation has ranged from 20% to 100%. bonus depreciation vastly increases the pool of tax savings in the early years of the asset’s service life. a utility will achieve the highest level of tax savings if it employs expensing, or 100% bonus depreciation, which was in effect in 2010 and 2011 for public utilities. under 100% bonus depreciation, all of the tax savings are accrued the first year the asset is placed in service. the figure below depicts the accrual and draw down of the tax savings for a $1,200,000 coal-fired power plant with a 55-year service life with 100% bonus depreciation. as above, under the rate of return rules, the utility would pass through to consumers $20,000 of regulatory depreciation each year for 55 years. under the normalization rules, the tax depreciation of the asset would offset $7,000 of income taxes per year over the asset’s entire service life. under 100% bonus depreciation, however, the utility is allowed to recover the entire cost of the property in the first year the asset is placed in service. the tax deduction for depreciation that the utility would take would be as follows: $1,200,000 depreciable basis x 100% = $1,200,000 cost recovery in the first year. the dollar value of that cost recovery deduction would be $420,000; $1,200,000 tax depreciation x 35% corporate tax rate = $420,000. after the first tax year, the utility will have no additional cost recovery allowances. applying the tax accounting rules to this asset, the utility will enjoy $420,000 in tax savings the year the asset is placed in service. however, only $7,000 of those savings will be applied to calculate tax expense for consumers. therefore, customer rates will result in tax savings of 0 50 100 150 200 250 300 350 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49 51 53 55 $ tax savings (adit) $ value of actual tax depreciation $ value tax expense depreciation allowance columbia journal of tax law [vol. 11:1 26 $413,000. these tax savings are tracked as adit under the financial accounting rules. during the remaining 54 years the asset remains in service, that pool of tax savings, the adit account, will be drawn down to offset the utility’s actual tax liabilities, and applied to reduce the tax expense passed through to consumers. figure 4. this chart depicts the tax savings (adit) that accrue under the normalization rules because of timing differences from the application of 100% bonus depreciation (expensing) under § 168(k). the chart shows the tax savings that accrue and are disbursed for a $1,200,000 asset, with a 55-year service life and a 1-year cost recovery period, applying a 35% corporate tax rate. the vertical figures are in the $1000s. at the end of the 55-year service life, the asset has been fully depreciated. again, the last $35,000 in adit would be used to offset income tax liability on the $100,000 salvage value estimated when the asset was first placed in service. the calculations on which figure 4 is based are included in appendix b. the normalization rules require the utilities to refrain from passing the immediate tax benefits of accelerated tax depreciation through to consumers. there are several justifications for this decision. first, an immediate pass-through of accelerated tax depreciation would generate less taxable income for utilities and less revenue for the government.153 if public service commissions had authorized utilities to use accelerated tax depreciation to calculate tax expense in the ratesetting process,154 the utilities would pass through to consumers the actual taxes they paid. under macrs, over the asset’s service life, the tax expense charged to consumers would be much lower in the early years of the asset’s service life, when accelerated tax deprecation provided larger tax deductions, and much higher in later years, when no tax depreciation was available to offset income.155 in recent years, many public utilities have paid no federal income taxes, because accelerated depreciation and, particularly bonus depreciation, have offset the utility’s income in 153 see eei, supra note 80, at 134. 154 id. 155 see gao, supra note 141, at 4. 0 50 100 150 200 250 300 350 400 450 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49 51 53 55 $ tax savings (adit) $ value actual tax depreciation $ value tax expense depreciation allowance 2019] stranded assets and efficient pricing for regulated utilities: a federal tax solution 27 its entirety.156 calculation of tax expense using the actual taxes paid by the utility would result in the consumers paying zero tax expense during those years, and enjoying lower utility rates. if the benefits of accelerated tax depreciation were passed through to customers during the early years, the tax expense passed through to consumers in later years (when tax depreciation was complete) would be higher and the utility would charge higher rates for the same level of service.157 lower income households might not be able to afford to cover these increased costs and the distributional impacts might include loss of service. by employing the normalization rules, congress was able to maintain the rate base and operating expense at even levels over the life of the asset.158 the normalization rules stabilize the rates consumers pay for energy and the revenues the utilities earn as they provide electric service. under the normalization rules, the utility over-collects revenue from consumers to cover tax expense.159 the tax savings that accrue from this process are treated as zero-cost capital because the customers have contributed these sums through their overpayment of tax expense. the sums in the adit account substitute for capital from investors and lenders, reducing the need to pay dividends or interest.160 to the extent the funds in the adit account have been provided by the customers, the investors should not earn a return on these funds. 161 utilities may use either of two different approaches to ensure that the returns to the tax savings in the adit account accrue to consumers rather than to investors.162 the first provides that, in calculating the rate base, both the adit and all accrued depreciation (d) are deducted from the gross value of the utility’s fixed assets.163 the rate formula used to calculate a utility’s revenue requirement is modified as follows to take into account the deduction of adit: r = o + r (v – d – adit).164 subtracting adit from the rate base ensures that the investors are not permitted to earn a return on customer-funded capital.165 conceptually, this arrangement allows consumers to enjoy 156 see sarah anderson, et al., utilities pay up, how ending tax dodging by america’s utilities can help fund a job creating, clean energy transition, institute for policy studies (july 2016), https://ipsdc.org/utilities-pay-up/ [https://perma.cc/cbl3-2lfg]. 157 see gao, supra note 141, at 6. 158 id. 159 id. at 4. 160 id. at 8; see kiefer, supra note 36, at 23. 161 see gao, supra note 141, at 4. another conceptualization of the financial effects of normalization treats the tax savings as an interest-free loan from the u.s. treasury to the utility company. see kiefer, supra note 36, at 23. the utility keeps the principal of the loan and, until repayment, earns interest itself, which it passes forward to consumers. id. the interest rate is equal to the utility’s allowed rate of return and the consumers enjoy that interest as lower utility rates. id. 162 see alt, supra note 32, at 39. 163 id. 164 again, r refers to the utility’s total revenue requirement. o refers to the utility’s operating expenses, including depreciation charges and tax expense. v is the gross value of the utility’s tangible and intangible property placed in service. d refers to the utility’s accrued financial depreciation. adit is the tax savings in the accumulated deferred income tax liability account. the rate base is reduced by the adit as well as the depreciation that has been passed through to consumers (v). the rate base (vd adit) is multiplied by r, the rate of return that regulators allow investors to earn on the rate base (the investors’ remaining capital investment). 165 see alt, supra note 32, at 39. columbia journal of tax law [vol. 11:1 28 free energy from the assets they are assumed to have acquired with their excess tax expense payments under the normalization rules. the second option is to treat adit as a zero-cost source of capital in calculating the cost of capital.166 the rate of return (r) that is applied to the rate base is essentially the weighted average cost of capital (“wacc”) for the utility.167 wacc is calculated by averaging the cost of each source of capital and then weighting each source based on the percentage that source contributes to the total.168 the percentage of capital that is funded by debt is multiplied by the interest rate paid to lenders and bondholders, the percentage of capital funded by preferred stocks is multiplied by the return that must be paid to preferred shareholders, and the percentage of capital funded by common stocks is multiplied by the return that must be paid to common stock shareholders. then those sums are added together to determine the total cost of capital. the following chart depicts the process for calculating the wacc. source of capital (no adit) percentage cost weighted cost debt 50% 5% 2.50% preferred stock 5% 7% 0.35% common stock 45% 10% 4.5% total 100% 7.35% table 2. calculation of the weighted cost of capital (with no adit to be treated as zero-cost capital). under the second option, adit is not subtracted from the rate base. adit is instead treated as consumer-funded capital with the percentage of capital funded by consumers equal to adit/value.169 the return that must be paid on this source of capital is zero. the following chart depicts the calculation of wacc where the pool of tax savings tracked as adit provides 15% of the capital needed for the utility’s facilities. source of capital (adit treated as zero cost capital) percentage cost weighted cost debt 40% 5% 2.00% preferred stock 5% 7% 0.35% common stock 40% 10% 4.00% adit 15% 0% 0% total 100% 6.35% table 3. calculation of the weighted cost of capital (with adit to be treated as zero-cost capital). in the formula above, “r” stands for the rate the regulatory authorities will allow a utility to charge on the rate base as a return on its capital investment. r, the revenue requirement, is the 166 id. 167 id. at 41; see davies, supra note 3, at 302. this is essentially the same as the rate of return— (r) applied to the rate base to calculate the revenue requirement in the rate-setting process. see alt, supra note 32, at 39. 168 see alt, supra note 32, at 39. 169 id. 2019] stranded assets and efficient pricing for regulated utilities: a federal tax solution 29 total return permitted to investors. a public service commission will set consumer utility rates at the level that will allow the utility to generate the total return needed to cover operating expenses and to provide the necessary return to investors to cover the costs of capital. if “r,” the rate of return on the rate base, is lower, the utility rates will be lower. note that the normalization rules require that the amount of adit excluded from the rate base (or treated as cost-free capital) cannot exceed the amount that the customers have paid in tax expense for a particular period during the rate-making process.170 congress wanted to ensure that the consumers gain the benefit of zero-cost capital (or have adit excluded from the rate base) only to the extent they contributed that zero-cost capital through their payment of tax expense.171 otherwise, they would be receiving an additional subsidy.172 when accelerated cost recovery was introduced and depreciation periods were cut to 50% or less of the service life of the assets, the accrual of tax savings was gradual. ratepayers would pay tax expense that was somewhat in excess of what was paid by the utility for that year. in such situations, the overpayment of tax would likely cover most, if not all, of the tax savings enjoyed by the utility under the tax depreciation rules. the normalization rules would have then required the full amount of tax savings tracked in the adit account to be deducted from the rate base. bonus depreciation, however, creates enormous tax savings. in the years in which bonus depreciation, and in particular 100% expensing, has been available, the ratepayers are unlikely to have fully funded the tax savings in the adit account. some of those tax savings would more properly be characterized as an interest-free loan from the federal government.173 since 2001, many utilities have incurred net operating losses when their deductions from bonus depreciation exceeded their income,174 raising questions about normalization and the extent to which those losses should be deducted from the rate base.175 if the tax savings from deferral exceed the amount the ratepayers have paid in tax expense, the excess is not deducted from the rate base or treated as zero cost capital. instead, those tax savings are treated as investor-contributed capital and investors are allowed to earn a return on those tax savings. in sum, the investors have earned a subsidized 170 the treasury regulations explain that a taxpayer has failed to comply with the normalization requirements if the amount of adit excluded from the rate base (or treated as cost-free capital) exceeds the amount that the customers have paid for in their tax expense for the period during the rate-making process. treas. reg. § 1.167(l)-1(h)(6)(i). the regulations include a formula which provides that a utility may deduct from the rate base (or treat as zero-cost capital) only the amount of adit that has accrued historically (that the ratepayers have previously paid for with their tax expense), plus a pro rata amount reflecting the portion that the ratepayers will pay as tax expense in the future during that period. treas. reg. § 1.167(l)-1(h)(6)(ii). 171 p.l.r. 2015-41-010 (oct. 9, 2015). accelerated cost recovery system—normalization method of accounting— accumulated deferred income tax. 172 rev. proc. 2017-47, 2017 38 i.r.b. 233 (sept. 7, 2017) (“congress enacted the itc and accelerated depreciation to stimulate investment. these incentives were not intended to subsidize the consumption of any products or services, including utility products or services. recognizing that public utility rates are set based on the utility’s costs incurred to provide the utility service, including federal income tax expense, congress enacted a set of rules to assure that some or all of the value of the incentives it provided for utility capital investment would not be diverted from investment by utilities to lower prices for consumption by customers of utilities.”) 173 see gao, supra, note 141, at 3. 174 for example, in 2015, 23 of the 40 profitable u.s. publicly held utility companies paid no federal income taxes and 16 paid no state taxes, largely as a result of bonus depreciation. see anderson, supra note 157, at 4. 175 see determining whether a utility’s ratemaking treatment of an nol carryforward complies with the normalization requirements, deloitte (2014), https://www2.deloitte.com/content/dam/deloitte/us/documents/tax/us-tax-utility-nol-102314.pdf [https://perma.cc/u9dd-9zcx]. columbia journal of tax law [vol. 11:1 30 return from bonus depreciation. therefore, these excess returns to investors from bonus depreciation should be accounted for in assessing the scope of stranded assets. d. environmental impacts of passing tax subsidies through to consumers in general, when corporate entities receive a subsidy through the tax system, the incidence of that subsidy is not clear; the economic benefit of that subsidy may accrue to consumers, to labor, to the owners of capital, or to other material inputs of the corporation’s operations.176 however, the current normalization rules specifically direct the economic benefits of the tax subsidies from accelerated tax depreciation to consumers to the extent of their excess tax expense paid to the utility.177 to clarify how the rate-setting rules pass tax subsidies forward to consumers, consider the following example, based on data pulled from the 2017 financial statements of consolidated edison of new york for the 2016 fiscal year.178 the first example calculates the revenue requirement without taking the tax savings from accelerated depreciation into account in determining the rate base. 1. without adit: r = o + r (v – d) o = $9,604,000 v = $40,411,000 d = $8,541,000 r = 7.34% source of capital amount percentage cost weighted cost debt 14,735,000 50.75% 5.09 2.58% common stock 14,298,000 49.25% 9.66% 4.76% total 29,033,000 100% 7.34% r = $9,604,000 + .0734 ($40,411,000 $8,541,000) r = $11,943,000 the second example considers the revenue requirement after deducting adit from the rate base. this assumes that ratepayers have paid sufficient tax expense that the pool of tax savings from their payments is equal to the tax savings that result from accelerated depreciation.179 2. with adit: r = o + r (v – d – adit) 176 see arnold c. harberger, the incidence of the corporate income tax, 70 j. of pol. econ. 215 (june, 1962); staff of joint comm. on tax’n, jcx-14-13, modeling the distribution of taxes on business income, (2013); jim nunns, urban institute and urban-brookings tax policy center, how tpc distributes the corporate income tax (2012), https://www.taxpolicycenter.org/sites/default/files/alfresco/publication-pdfs/412651-how-tpcdistributes-the-corporate-income-tax.pdf [https://perma.cc/u2zw-g2ch]. 177 see gao, supra note 141, at 5. 178 see appendix c, infra. 179 see supra notes 173-176, and accompanying text. 2019] stranded assets and efficient pricing for regulated utilities: a federal tax solution 31 r = $9604,000 + .0734 ($40,411,000 $8,541,000 $9,450,000) r = $11,250,000 third, the electricity rate discount that results from tax subsidies may be determined. the difference between the two revenue requirement calculations divided by the original revenue requirement (ignoring adit) will provide the percentage discount. 3. percentage difference in revenue requirement ($11,943,000 $111,250,000) / $11,943,000 = 5.81% discount while consumers may enjoy the discount in their utility rates, adverse consequences result from artificially depressing the prices for electricity and natural gas. first, there is a relationship between price and the quantity demanded for most goods in the economy.180 the law of demand provides that, all else being equal, when the price of a good rises, demand is lower; when the price of a good falls, demand is higher.181 assuming a robust market, the law of supply and demand clarifies that the price of a good will adjust to bring the quantity supplied and the quantity demanded into equilibrium.182 the equilibrium price, or market-clearing price, is the price at which buyers (who are willing and able to purchase) demand and sellers (who are willing and able to sell) supply.183 consequently, when a government introduces subsidies that artificially reduce prices for consumers, consumer demand for gas and electricity will be higher.184 lower prices may also encourage wasteful use of these resources. fossil fuels also have numerous negative externalities associated with their extraction, production, and use, including the health and environmental harms associated with air and water pollution and the growing threats associated with climate change.185 subsidizing use of fossil fuels only exacerbates these problems. furthermore, these tax subsidies may generate deadweight loss at the macroeconomic level. the loss in revenue to the federal government from the tax preference is likely to be substantial. the joint committee on taxation reports that the revenue losses associated with the shorter depreciation periods for electric transmission lines alone are between $40 and $100 million per year.186 revenue losses from accelerated depreciation of natural gas lines are between $80 and $200 million per year.187 the tax expenditure budget does not track the revenue losses specifically associated with accelerated cost recovery for other energy plant, property and equipment. 180 see n. gregory mankiw, principles of economics, 67(5th ed. 2008). 181 id. 182 id. at 77. 183 id. 184 id. at 43-44. note, however, that consumers generally have an inelastic response to energy price changes. raising prices may not immediately result in a reduction in use. 185 see supra note 1. 186 see staff of joint comm. on tax’n jcx-81-18, estimates of federal tax expenditures for fiscal years 2018-2022 22 (2018); staff of comm. on tax’n, 115th cong., estimates of federal tax expenditures for fiscal years 2016-2020, jcx-3-17, 30 (2017). 187 id. compare one year (as opposed to five year) expenditures for 15-year macrs for certain electric transmission property in staff of joint comm. on tax’n jcx-81-18, estimates of federal tax expenditures for fiscal years 2018-2022 22 (2018) with staff of comm. on tax’n, 115th cong., estimates of federal tax expenditures for fiscal years 2016-2020, jcx-3-17, 30 (2017). columbia journal of tax law [vol. 11:1 32 nevertheless, when combined with the social costs of harm to health and the environment, the total costs to the society may exceed the economic benefits of cheaper electricity. while there appear to be no studies specifically modeling the social cost of fossil fuel energy subsidies, 188 researchers have modeled the benefits of carbon pricing schemes which increase electricity rates and drive a reduction in electricity use. in 2019 resources for the future simulated the effects of a carbon dioxide prices on new york power plants.189 imposing a cost of $51 (in 2013 dollars) per ton of carbon dioxide emissions by 2025, the research team estimated that the cost of the carbon pricing scheme would raise electricity prices to consumers between 0.1% and 1.1%.190 they estimated that the increase in rates would reduce emissions between 6% and 25% and would provide a net benefit of between $108 million to $651 million per year.191 assuming that the model is non-stochastic and price increases procure emissions reductions at a linear rate, eliminating the pass through of tax subsidies to consumers could potentially multiply these social benefits by several-fold. by deflating the price of energy produced from fossil fuels, these subsidies encourage the continued acquisition, development, and use of carbon-based energy. the subsidies also undercut the market for renewable energy. terminating this passthrough would help to relieve lock-in and accelerate the shift to renewable energy resources. iii. stranded assets the risk of stranded assets also contributes to carbon lock-in. greenhouse gas regulation would increase the costs of operating coal-fired and natural gas-fired power plants, rendering these fossil-fuel based assets less profitable and potentially forcing their premature retirement. this part describes the historical treatment of stranded assets claims before the courts and by regulators. it clarifies the economic incentives that encourage consumers of fossil-fuel based energy systems to vote to keep those systems in place. it then estimates the extent of the risk of stranded costs faced by the fifteen largest public utilities based on data extracted from their financial statements. it also quantifies the tax savings to these public utilities that arise from the timing differences in tax, financial, and regulatory accounting rules based on the adit reported in their financial statements. finally, it argues that these tax savings may serve as a partial recovery pool for stranded costs. 188 in 2010, a federal interagency working group created an estimate for the social cost of carbon based on global impacts. in 2015, they estimated that the social cost of carbon was $36 per metric ton of co2 at a three percent discount rate. the group did not estimate the additional costs contributed solely by the u.s. subsidies to the fossil fuel industry. see interagency working group on social cost of greenhouse gases, technical support document: technical update of the social cost of carbon for regulatory impact analysis under executive order 12866 (aug. 2016). see also the cost of carbon pollution, inst. pol. integrity (last visited dec. 31, 2019), https://costofcarbon.org/faq/what-is-the-scc [https://perma.cc/gp8l-bzwc]. use of estimates of the social cost of carbon to evaluate taxes and subsidies is not universally supported, however. see noah kaufman, the social cost of carbon in taxes and subsidies, columbia sipa ctr. on global energy pol. (mar. 2018), https://energypolicy.columbia.edu/sites/default/files/pictures/cgepsocialcostofcarbonestimatesintaxessubsidies0 318_0.pdf [https://perma.cc/da24-lfr9]. 189 see daniel shawhan, paul picciano, & karen palmer, resources for the future, benefits and costs of power plant carbon emissions pricing in new york: overview and summary (2019), https://www.rff.org/documents/2136/ny_c_adders_intro__summary_19-08_2.pdf [https://perma.cc/wnh3my4h]. 190 id. 191 id. 2019] stranded assets and efficient pricing for regulated utilities: a federal tax solution 33 a. historical treatment of stranded assets traditional utility regulation dominates the electricity industry.192 however, in the last four decades, the industry and the regulatory models have begun to change.193 today, while a number of regulated industries continue to function as natural monopolies, some divisions of these industries are now governed by competitive markets. in the 1980s, the federal government began to disaggregate the various functions involved in a variety of regulated industries to permit some of the non-monopoly functions to operate through market competition.194 the nuclear, natural gas, and electric power industries all underwent significant transitions.195 this led management and investors in these industries either to seek compensation or to shift the costs of stranded assets to other market participants, such as consumers.196 litigants and scholars have argued that deregulation197 and changes in regulation198 violate the regulatory compact and give rise to takings claims under the fifth and fourteenth amendments of the constitution. the general argument proceeds as follows. when firms enter into implied regulatory contracts with the government, they are entitled to be compensated for costs they incur in reliance on that contract. investors in regulated utilities incur enormous costs in constructing power generation and distribution facilities. the regulatory compact protects an investor owned utility from competition by granting the utility a monopoly. by shielding the utility from competition, the utility and its investors have assurance that it may recover their investment in those facilities. in exchange, regulators control the utility’s prices and monitor its services to consumers. the utility is permitted to recover its reasonable and prudentially incurred costs, plus an agreed upon return on investment. when the government exposes the utility to competition, it breaches the regulatory compact. therefore, litigants and scholars argue that the investors are entitled to compensation for breach of that compact. furthermore, they argue the regulatory modification works a taking of private property requiring the payment of just compensation. 192 see davies, supra note 3, at 260. 193 id. at 259. 194 see tomain, supra note 40, at 33-37. 195 id. 196 see reed w. cearley and daniel h. cole, stranded benefits versus stranded costs in utility regulation, the end of a natural monopoly: deregulation and competition in the electric power industry, 169 (peter z. grossman & daniel h. cole, eds. 2003). 197 see j. gregory sidek & danliel f. spulber, deregulatory takings and breach of the regulatory contract, 71 n.y.u. l. rev. 851(1996). 198 see, e.g., west virginia et al. vs. epa, et al. (no. 15-1363). in this case, following the publication of the proposed regulations for regulating carbon emissions under section 112 of the clean air act, known as the clean power plan, west virginia filed a petition for review. west virginia was joined by 21 other states (alabama, arkansas, colorado, florida, georgia, indiana, kansas, kentucky, louisiana, michigan, missouri, montana, nebraska, new jersey, ohio, south carolina, south dakota, texas, utah, wisconsin, and wyoming) and numerous other private litigants and trade associations, challenging the clean power plan on several fronts, including a claim that the regulations would work as regulatory taking in violation of the fifth amendment, by rendering coal-fired power plants unprofitable and by upsetting “settled investment expectations.” columbia journal of tax law [vol. 11:1 34 other scholars have dismantled these arguments.199 first, while the government has held that a firm is entitled to compensation when the government violates an express provision in a formal contract, courts have not found the government owes compensation for regulatory changes when there is no formal contract in place.200 furthermore, such contracts are construed against the grantee and in accordance with the narrowest rational reading.201 second, courts elucidating the terms of the regulatory compact have concluded that a regulatory agency may decline to permit utilities to recover investments in assets that were imprudently incurred or assets that are no longer “used and useful.”202 while, as a theoretical matter, utilities may operate at least cost, a more realistic assumption is that utilities may have incurred unwarranted or excessive costs and that their managers may have made investment mistakes.203 unless the excess costs or the faulty investments were previously challenged in a rate case, the regulators are unlikely to catch those mistakes during the regulatory process.204 third, regulators may be subject to capture, leading them to exercise lax regulatory control and allow the utility to overinvest in plant, property and equipment, resulting in excess costs.205 consequently, refusing to reimburse stranded assets may be consistent with existing terms of the implied regulatory contract. requiring that utilities act reasonably and prudently when they make investments functions as a deterrent to waste and improvident spending.206 fourth, if market factors other than a governmental change to the regulatory environment are causing the assets to become obsolete, then there is no responsibility on the part of government to authorize compensation.207 the retirement of coal-fired power plants has not been caused exclusively by a change in the regulatory environment. during the past six years, hundreds of fossil fuel-based power generation plants have been retired or converted to natural gas plants.208 in 2015, plants with a total capacity of 19 gigawatts were closed or converted;209 in 2016, the number 199 see oliver e. williamson, deregulatory takings and the breach of the regulatory contract: some precautions, 71 n.y.u l. rev. 1007 (1996); stephen f. williams, deregulatory takings and breach of the regulatory contract: a comment, 71 n.y.u l. rev. 1000 (1996); jim rossi, the irony of deregulatory takings, 77 tex. l. rev. 297 (1998); herbert hovencamp, the takings clause and improvident regulatory bargains, 108 yale l. j. 801 (1999). 200 hovencamp, supra note 199, at 807-818. see united states v. winstar, 518 u.s. 839 (1996); munn v. illinois, 94 u.s. 113 (1876); proprietors of charles river bridge v. proprietors of warren bridge, 36 u.s. 420 (1837). 201 hovencamp, supra note 199, at 807, 817. 202 when utilities file a case for a rate increase to include additional costs in the operating expense or capital expenditures in the rate base, regulators review those costs to determine whether they were prudent expenditures at the time they were incurred. see alt, supra note 32, at 29. costs that are not judged prudent are disallowed and must be paid for by the utility’s shareholders. id. 203 id. 204 see williamson, supra note 199, at 1003; hovencamp, supra note 199, at 823-825. 205 see williamson, supra note 199, at 1013-14. 206 id. at 1016-18 (clarifying that making compensation contingent on the requirement of prudent investment in the regulatory compact deters excess investments ex ante and that guaranteeing full reimbursement would have the opposite effect, which is likely the reason that there is no express guarantee in the compact). 207 hovencamp, supra note 199, at 828-830. 208 see benjamin storrow, big, young power plants are closing. is it a new trend? e&e news, (apr. 27, 2017, 1:14 pm), https://www.eenews.net/stories/1060053677 [https://perma.cc/4hn3-aczb]. 209 see factbox: u.s. coal-fired power plants scheduled to shut, reuters (october 29, 2019, 1:15 pm), https://www.reuters.com/article/us-usa-coal-retirement-factbox/factbox-u-s-coal-fired-power-plants-scheduled-toshut-iduskbn1x8298 [ https://perma.cc/m2kk-9zcq]. 2019] stranded assets and efficient pricing for regulated utilities: a federal tax solution 35 was 13 gigawatts.210 in 2017, generators announced the early closure or conversion of 27 coal-fired plants with 22 gigawatts of productive capacity.211 while regulatory changes relating to mercury212 and carbon emissions213 have been cited as the cause for the plant closures, those regulations were reversed in 2017. despite the official 180 degree pivot in u.s. policy away from clean energy and in support of coal,214 coal-fired power plant closures have continued throughout 2018 and 2019.215 in 2018, generators closed or converted coal-fired plants with the total capacity of over 13,300 210 see factbox: u.s. coal-fired power plants scheduled to shut, reuters (may 16, 2017), https://www.reuters.com/article/us-usa-coal-retirement-factbox/factbox-u-s-coal-fired-power-plants-scheduled-toshut-iduskcn18c2c5 [ https://perma.cc/km3m-ml6h]. 211 see silvio marcacci, utilities closed dozens of coal plants in 2017. here are the 6 most important. forbes (dec. 18, 2017) https://www.forbes.com/sites/energyinnovation/2017/12/18/utilities-closed-dozens-of-coal-plants-in2017-here-are-the-6-most-important/ [perma.cc/upw6-lzah]. 212 during the obama administration, the environmental protection agency issued new rules under the mercury and air toxic standards (mats). these requirements would have been more expensive for older plants to meet. see national emission standards for hazardous air pollutants from coaland oil-fired electric utility steam generating units and standards of performance for fossil-fuel-fired electric utility, industrial-commercial institutional, and small industrial-commercial-institutional steam generating units, 77 fed. reg. 9304 (feb. 16, 2012) (codified at 40 c.f.r. pts. 60 and 63). however, the trump administration rolled back these rules in 2018. see michael biesecker and matthew brown, trump epa moves to roll back more clean air and water rules, wash. post (mar. 1, 2018), https://www.washingtonpost.com/business/trump-epa-moves-to-roll-back-more-clean-air-and-waterrules/2018/03/01/6ac314d8-1dbf-11e8-98f5-ceecfa8741b6_story.html [https://perma.cc/j85l-zefg]. 213 on march 28, 2017 president trump issued an executive order rescinding obama-era presidential and regulatory actions that address carbon emissions and instructing the environmental protection agency to withdraw the clean power plan regulations under the clean air act. see exec. order no. 13783, 82 fed. reg. 16093 (mar. 28, 2017). the epa proposed to repeal the clean power plan on october 10, 2017. see 82 fed. reg. 48035 (oct. 16, 2017). on august 21, 2018, the epa issued an alternative proposal, the affordable clean energy rule, to establish emission guidelines for states to regulate greenhouse gas emissions from existing coal-fired power plants. see 83 fed. reg. 45588 (sept., 10, 2018). the change would relax the rules on greenhouse gas emissions. see juliet eilperin, trump administration proposes rule to relax carbon limits on power plants, wash. post (aug. 21, 2018), https://www.washingtonpost.com/national/health-science/trump-administration-proposes-rule-to-relax-carbonlimits-on-power-plants/2018/08/21/b46b0a8a-a543-11e8-a656-943eefab5daf_story.html [perma.cc/abn8-rrld]. that rule was finalized on july 8, 2019. see repeal of the clean power plan; emission guidelines for greenhouse gas emissions from existing electric utility generating units; revisions to emission guidelines implementing regulations, 84 fed. reg. 32520 (july 8, 2019) (to be codified at 40 c.f.r. pt. 60). 214 the trump administration has also proposed modifications to numerous environmental statutes in support of coal-fired energy production. see brad plumer, trump orders a lifeline for struggling coal and nuclear plants n.y times (june 1, 2018), https://www.nytimes.com/2018/06/01/climate/trump-coal-nuclear-power.html [perma.cc/j2xr-2u6n]. these efforts have been viewed as part of a broader roll-back of environmental regulations affecting many industries and communities throughout the u.s. see nadia popovich, et al, 78 environmental rules on the way out under trump n.y. times (oct 5, 2017, updated dec. 28, 2018), https://www.nytimes.com/interactive/2017/10/05/climate/trump-environment-rules-reversed.html [perma.cc/scs6y3br]; eric lipton, et al, this is our reality now, n.y. times (dec. 27, 2018) https://www.nytimes.com/interactive/2018/12/26/us/politics/donald-trump-environmental-regulation.html [perma.cc/wy4z-j9bu]. 215 see slade johnson & kien chau, energy information administration, today in energy, more u.s. coal-fired power plants are decommissioning as retirements continue (july 26, 2019) (“between 2010 and the first quarter of 2019, u.s. power companies announced the retirement of more than 546 coal-fired power units, totaling about 102 gigawatts (gw) of generating capacity. plant owners intend to retire another 17 gw of coal-fired capacity by 2025, according to the u.s. energy information administration’s (eia) preliminary monthly electric generator inventory.”), https://www.eia.gov/todayinenergy/detail.php?id=40212 [https://perma.cc/nv84-2z8h]; us coal plant retirements to continue, economist (sept 7th 2018), http://www.eiu.com/industry/article/1277120111/us-coal-plant-retirements-tocontinue/2018-09-07 [https://perma.cc/4fxa-rxxl]. columbia journal of tax law [vol. 11:1 36 megawatts and in 2019 that number was expected to reach 13,800 megawatts.216 the age of the existing facilities,217 new technologies that directly compete with coal as an energy resource,218 and enhanced access to previously unrecoverable resources 219 have all rendered these plants less competitive in delivering power to consumers. this continued trend toward closure and conversion clarifies that the downturn in the market for coal is not tied strictly to a regulatory change. finally, to the extent that regulatory changes have caused any decline in the value of fossilfuel based assets, that regulatory change should not come as a surprise. recent research verifies that fossil fuel companies were among the first to ascertain that climbing co2 emissions would cause global warming.220 the energy industry has been aware of the negative climate externalities associated with fossil-fuel combustion for decades.221 consequently, the risk of climate change regulation is likely to have been built into both firm and individual investment strategies. this knowledge should also be considered part of any review of expenditures under the prudential standard. while the courts have resisted government reimbursement of utilities’ stranded assets under takings clause claims, regulators have been receptive when energy policy has shifted sharply.222 in the 1960s and 70s, the federal government encouraged significant investments in 216 see reuters, supra note 208; factbox: u.s. coal-fired power plants scheduled to shut, reuters (oct. 29, 2019), https://www.reuters.com/article/us-usa-coal-retirement-factbox/factbox-u-s-coal-fired-power-plants-scheduled-toshut-iduskbn1x8298 217 see most coal plants in the united states were built before 1990, u.s. energy information administration (apr. 17, 2017), https://www.eia.gov/todayinenergy/detail.php?id=30812 [https://perma.cc/87fb-9zgp] (“coal-fired electricity generators accounted for 25% of operating electricity generating capacity in the united states and generated about 30% of u.s. electricity in 2016. most coal-fired capacity (88%) was built between 1950 and 1990, and the capacity-weighted average age of operating coal facilities is 39 years.”) 218 renewable energy has grown as a source of power and the prices are reduced. however, to date, energy from renewables is available on an episodic basis. it cannot ramp up during peak demand. while combined-cycle natural gas plants can ramp up and down relatively cheaply to meet demand as a complement to renewable energy, coal plants have high fixed operating costs and lack that flexibility. see benjamin storrow, big, young power plants are closing. is it a new trend? e&e news (apr. 27, 2017), https://www.eenews.net/stories/1060053677 [https://perma.cc/mld6vepp]. 219 competition from record shale gas production reduced revenues to coal plants. see shale gas, not epa rules, has pushed decline in coal-generated electricity, study confirms, sciencedaily (october 7, 2016), https://www.sciencedaily.com/releases/2016/10/161007105548.htm [ https://perma.cc/d5lx-7ub4]; marin katusa, shale gas takes on coal to power america’s electrical plants, forbes (may 30, 2012, 01:43pm), https://www.forbes.com/sites/energysource/2012/05/30/shale-gas-takes-on-coal-to-power-americas-electricalplants/#51e2b4f18b01 [https://perma.cc/wur8-ferd]. 220 see shannon hall, exxon knew about climate change almost 40 years ago, scientific american (oct. 26, 2015), https://www.scientificamerican.com/article/exxon-knew-about-climate-change-almost-40-years-ago/ [https://perma.cc/s5ws-6jeb] (“exxon was aware of climate change, as early as 1977, 11 years before it became a public issue, according to a recent investigation ... this knowledge did not prevent the company (now exxonmobil and the world’s largest oil and gas company) from spending decades refusing to publicly acknowledge climate change and even promoting climate misinformation …”); élan young, coal knew, too, huffpost (nov. 22, 2019, updated dec. 16, 2019), https://www.huffpost.com/entry/coal-industry-climate-change_n_5dd6bbebe4b0e29d7280984f [https://perma.cc/6esa-xwnd]; cherry discovers early evidence coal knew, university of tennessee, knoxville (dec. 2, 2019), https://cee.utk.edu/cherry-discovers-early-evidence-coal-knew/ [https://perma.cc/6fkn-eefk]. 221 see id. 222 see richard j pierce, jr., the regulatory treatment of mistakes in retrospect: canceled plants and excess capacity, 132 u. pa. l. rev. 497 (1984) (coal and nuclear); john brett macarthur, cost responsibility or regulatory indulgence for electricity stranded costs, 47 amer. u. l. rev. 775, 779-80 (1998); donald f. santa, jr. & clifford 2019] stranded assets and efficient pricing for regulated utilities: a federal tax solution 37 nuclear energy.223 in the context of rising oil prices and geopolitical changes in the middle east, nuclear power allowed the united states to reduce reliance on foreign oil.224 however, in 1979, the three mile island nuclear disaster raised questions regarding the safety of nuclear energy facilities; at the same time, the stabilized oil and natural gas prices of the 1980s provided an alternative, cheaper source of power.225 with the sudden change in relative fuel costs, the federal government canceled over 120 contracts for nuclear plants, many of which were still under construction.226 the nuclear power plant owners were allowed to recover part or all of their construction and development costs for these plants: while appeals to the courts were unavailing,227 state utility commissions allowed firms to recover at least a portion of their costs, including costs associated with excess capacity, canceled plants, and construction works-in-progress228 by passing these costs through to consumers in the rate setting process.229 similarly, in the 1980s, congress restructured the natural gas industry by disaggregating gas sales from distribution and by providing open access to pipelines, allowing producers to ship gas to the market.230 previously pipeline owner-suppliers had entered into long-term “take-or-pay contracts” with buyers to ensure their recovery of the costs associated with pipeline construction.231 the contracts required purchasers to either take the product from the supplier or to pay the supplier a penalty. 232 while take-or-pay contracts reduced risk to the suppliers, they also created a significant barrier to entry for new suppliers.233 in the 1990s, when the pipelines were converted to open access resources, investors sought compensation for the loss in value from increased competition in the open market. initially, the ferc refused to grant relief to investors for the takeor-pay contracts, but after a protracted legal battle,234 ferc relented and allowed utilities to split the costs between consumers and investors.235 later, ferc allowed pipelines to pass the remaining costs through to customers in their utility rates.236 likewise, in the 1990s the federal government restructured the electric power industry from a regulated natural monopoly to a competitive wholesale market.237 while courts again spurned s sikora, open access and transition costs: will the electric industry transition track the natural gas industry restructuring?, 25 energy l. j. 113, 139-43 (2004). 223 see emily hammond & jim rossi, stranded costs and grid decarbonization, 82 brook. l. rev. 645, 653 (winter 2017). 224 id. at 652-53. 225 id. at 653. 226 id. at 654-55. 227 duquesne light co. v. barasch, 480 u.s. 299 (1989). 228 see hammond, supra note 221, at 653. 229 id. 230 id. at 655. 231 id. 232 id. 233 id. 234 associated gas distribs. v. fed. energy regulatory comm’n, 824 f.2d 981, 993 (d.c. cir. 1987). 235 regulation of natural gas pipelines after partial wellhead decontrol (order 500), 52 fed. reg. 30,334 (aug. 7, 1987) (codified at 18 c.f.r. pts. 2 and 284). 236 pipeline service obligations and revisions to regulations governing self implementing transportation under part 284 and regulation of natural gas pipelines after partial wellhead control (order 636), 57 fed. reg. 13,267 (apr. 8, 1992) (codified at 18 c.f.r. pt. 284). 237 see hammond, supra note 221, at 658. some states have also moved to competitive retail markets, creating stranded asset issues at the state level as well as the federal level, managed by state public utility commissions rather than ferc. columbia journal of tax law [vol. 11:1 38 investors’ constitutional takings clause claims for compensation for lost revenue, 238 ferc ultimately allowed utility shareholders to recover all of the stranded costs resulting from the transition.239 historically, several states have authorized utilities to securitize their stranded costs.240 under securitization, utilities issue bonds, the revenues of which will be used to repay investors for their remaining unrecovered capital expenditures in plant, property, and equipment (“ppe”).241 the bonds will be repaid by consumers over time through higher utility rates.242 recently, a number of states have introduced legislation to permit investor-owned utilities and regulators to pursue this option to cover the costs associated with closed and converted coal plants.243 state regulators have also allowed utilities to pass the costs of ppe through to consumers more quickly than previously permitted by changing the financial and regulatory depreciation rules.244 in both cases, consumer utility rates must rise to cover the costs of both working and non-working assets. because consumers desire to maintain their low utility rates, their short term interests are generally in opposition to legislation that will accelerate this process, including climate change regulation. consumer concerns about stranded assets therefore form one more impediment to effective carbon controls and a shift to renewable energy systems, contributing to carbon lock-in. b. how extensive are the risks of stranded assets for public utilities in the united states? this part examines the extent to which investors in public utilities bear the risk of stranded costs based on information set forth in their financial reports. the financial statements and balance sheets of investor-owned public utilities clarify the extent of their unrecovered capital. for example, consider the consolidated balance sheets of consolidated edison of new york for 2016, the operating revenues of which were primarily derived from regulated utilities.245 238 see fed. power comm’n v. hope nat. gas company, 320 us 591 (1944) (takings challenge for computing cost recovery). 239 order 888, 61 fed. reg. 21,540 (apr. 24, 1996) (codified at 18 c.f.r. pts. 35 and 385). some states allowed full recovery of these stranded costs; others did not. see hammond, supra note 221, at 659. 240 see j. paul forrester, unstranding stranded costs, 14 j. structured fin. 33 (2008). 241 id. 242 id. 243 see herman k. trabish, securitization fever: renewables advocates seize wall street’s innovative way to end coal, utilitydive (may 28, 2019), https://www.utilitydive.com/news/securitization-fever-renewables-advocatesseize-wall-streets-innovative-w/555089/ [https://perma.cc/f9y4-k8wt]. 244 id. for an in-depth discussion of changes made to financial depreciation and accelerate cost recovery for potentially stranded assets, see christopher serkin and michael p. vandenbergh, prospective grandfathering: anticipating the energy transition problem, 102 minn. l. rev. 1019 (2018). for examples of states and nations in which accelerated financial depreciation has been applied, see annie benn, et al., managing the coal capital transition, rocky mountain institute (2018), https://rmi.org/wpcontent/uploads/2018/09/rmi_managing_the_coal_capital_transition_2018.pdf [https://perma.cc/4j26-5lrr]. 245 see appendix c. 2019] stranded assets and efficient pricing for regulated utilities: a federal tax solution 39 consolidated edison of new york property plant and equipment (in millions) $40,411 placed in service 8,541 _______ depreciation taken (recovered from ratepayers as part of operating expense)_______________ 31,870 plant in service net of depreciation -10,205 accumulated deferred income taxes__________ $21,665 remaining unrecovered capital exposed to regulatory risk based on these calculations, consolidated edison of new york has recovered from its customers approximately 21% of the $40,411,000 of fixed assets the company has placed in service.246 as explained above, these costs were passed through to consumers as part of the utilities’ operating expense under the financial accounting and regulatory rules. the adit account reflects the tax savings the company currently enjoys as a result of accelerated depreciation. the utility will pass these tax savings through to consumers over the remaining service life of the assets. if, however, climate change regulation forced the utility to retire those assets, the adit account could serve as a recovery pool for investors. upon approval by regulators, those funds would offset an additional 23% of the ppe placed in service, significantly reducing investors’ exposure to regulatory risk. 247 the unrecovered capital remaining at risk would be 55.5% of the company’s total assets placed in service. 248 historic information relating to ppe placed in service, financial depreciation taken, and the growth of the adit account may provide a longer-term perspective. figure 5 tracks consolidated edison’s (1) total investment in depreciable ppe, (2) portions of those investments that have been recovered via the book depreciation rules permitted in the ratemaking process, and (3) the advance recovery of these investments in the form of tax savings (adit). the data has been taken from the company’s financial statements from 2009 to 2018, listed in appendix c. 246 $8,451 million of depreciation recovered from ratepayers divided by $40,411 million ppe placed in service = 20.9% of capital invested that has already been recovered by investors from ratepayers. 247 adit of $9,450 million divided by $40,411 million ppe placed in service equals 23.4% of total capital that could be recovered through a distribution of adit to investors. 248 $40,411 ppe placed in service $8,541 depreciation (recovered from ratepayers as part of operating expense) less $9,450 million accumulated deferred income taxes equals $22,420 million in remaining unrecovered capital exposed to regulatory risk; $22,420 million in remaining unrecovered capital divided by $40,411 million ppe placed in service equals 55.5% remaining unrecovered capital at risk for becoming stranded. columbia journal of tax law [vol. 11:1 40 figure 5. consolidated edison of new york, unrecovered capital at risk after deducting depreciation and adit, based on data from consolidated edison financial statements 2009 – 2018. vertical axis shows sums in the millions. to examine the broader risk of stranded assets among the 15 largest publicly regulated utilities in the united states, the following chart identifies the total capital cost of the ppe in service, the aggregate depreciation under the financial accounting rules (the portion of the capital investments that have been recovered from consumers), and the remaining unrecovered capital. the figures, from 2016, are taken from the utilities’ financial statements set forth in their 2017 annual reports listed in appendix c. each of the utilities appears to have been observing the normalization rules. the firm financial statements also include information about the tax savings from accelerated tax depreciation, tracked as adit and published in each firm’s annual report. company ppe in service deprec -iation unrecov’d capital (uc) % uc adit capital at risk % at risk 1 ameren ameren missouri 18959 7880 11079 58.4 3013 8066 42.5 ameren illinois 10208 2850 7358 72.1 1631 5727 56.1 2 american electric power appalachian power company 13073 3637 9436 72.2 2673 6763 51.7 ohio power company 7220 2116 5104 70.1 1346 3758 52 public service company of oklahoma 4948 1273 3675 74.3 1059 2616 52.9 southwestern power company 8883 2567 6316 71.1 1607 4709 53 3 cms energy consumers energy company 20838 5944 14844 71.2 3042 11802 56.6 4 consolidated edison consolidated edison of new york 40411 8541 31870 78.8 9450 22420 55.5 5 dominion resources virginia power and electric company 40030 12436 27594 68.9 5103 22491 56.2 0 5,000 10,000 15,000 20,000 25,000 30,000 35,000 40,000 45,000 50,000 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 capital at risk depreciation adit 2019] stranded assets and efficient pricing for regulated utilities: a federal tax solution 41 company ppe in service deprec -iation unrecov’d capital (uc) % uc adit capital at risk % at risk 6 dte energy dte electric company 22094 7721 14373 65.1 3793 10580 47.9 7 duke energy duke energy carolinas 41127 14365 26762 65.1 6544 20218 49.2 duke energy progress 28419 10561 17858 62.8 3323 14535 51.1 duke energy florida 16434 4644 11790 71.7 2694 9096 56.6 duke energy indiana 14241 4317 9924 69.7 1900 8024 56.3 duke energy ohio 8126 2579 5547 68.3 1443 4104 50.5 8 edison international southern california edison company 42890 9000 33890 79.0 9798 24092 56.6 9 first energy 43767 15731 28036 64.1 3765 24271 55.5 10 nextera energy florida power and light 44966 12304 32622 72.5 8541 24121 53.6 11 pg&e pacific gas and electric company 69409 22012 47397 68.3 10510 36887 53.1 12 ppl corp ppl electric utilities corporation 9654 2714 6940 71.9 1899 5041 52.2 louisville gas & electric and ku energy llc 12746 1465 11281 88.5 1735 9546 74.9 13 sempra san diego gas & electric 17844 4594 13250 74.3 2829 10421 58.4 southern california gas 15344 5092 10252 66.8 1709 8543 55.7 14 southern company 98416 29852 68564 60.7 14092 54472 55.3 15 xcel energy 45427 14381 31046 68.3 6784 24262 53.4 totals 695,474 208,576 486,898 110,283 376,615 average 67.5 52.1 table 4. this chart clarifies the extent of unrecovered capital (in millions) for the largest 15 investor-owned utilities after deducting accrued depreciation (in millions) under the financial and regulatory accounting rules based on the companies’ 2016 financial statements. if the tax savings from accelerated tax depreciation (adit) are used as a pool for capital recovery, the utilities’ capital at risk is reduced on average by 16%. as of 2016, in the aggregate these publicly regulated utilities had recovered, on average, about 33% of their investments in ppe placed in service from their customers. as a result, approximately 67% of their capital expenditures, or $486,898,000,000 of the $695,474,000,000 remained outstanding and at risk. however, these utilities also held an aggregate of $110,283,000,000 in tax savings, per the adit line in their financial records. if applied to offset existing unrecovered capital, the remaining capital at risk would be reduced by 15% to $376,615,000,000, leaving an average of approximately 52% of the utilities’ ppe placed in service at risk of being stranded. columbia journal of tax law [vol. 11:1 42 c. modifying the tax and regulatory rules to apply adit and its returns to offset stranded assets the policy of passing the returns of tax deferral forward to consumers is inefficient. the tax and energy regulations should be revised to eliminate this transfer. consider the following charts, which suggest an alternative use for the returns to adit. the charts depict the recovery of capital for a $1.2 million asset with a service life equal to that of a coal-fired power plant. for any year in the recovery period for that asset, one can identify the extent of the asset that remains at risk for stranding. the chart reflects a tax and regulatory policy change, however, that provides that the returns to adit are not passed forward to consumers, but accrued and available to offset unrecovered capital at a compounded rate of interest. the following charts depict the return of capital for an asset purchased for $1,200,000 with a 55-year service life. the graph indicates the amount of unrecovered capital after subtracting (1) depreciation allowed under the rate-setting rules — the aggregate capital costs that have been passed through to ratepayers each year, (2) the tax savings from accelerated tax depreciation (treating adit as though it were available to offset stranded assets in any year), and (3) the returns to those tax savings that have accrued up to that year based on 5% interest compounded annually. the first chart depicts capital recovery under a 20-year macrs recovery period. the second chart depicts the same parameters applying 100% bonus depreciation. figure 6. negative figures depict the unrecovered capital investment in the asset that would be stranded if the asset ceases operations that year, assuming a $1,200,000 asset with a 55-year service life, taking into consideration annual recovery of costs from consumers as operating expense, tax savings (adit) from macrs, and returns to adit invested at 5% interest compounded annually. the horizontal axis identifies the number of years in service and the vertical axis depicts recovery of capital investment in the asset (in the 1,000s). positive figures depict returns in excess of original investment. for an asset acquired or constructed and placed in service at a cost of $1,200,000, the firm will have achieved full cost recovery in year 35, not year 55. all returns to adit and the deferred tax credits generate additional profit for the final 20 years of the asset’s service life equal to $372,000, all of which could be used to cover the costs of other stranded assets. the calculations on which figure 6 is based are included in appendix a. -1,400 -1,200 -1,000 -800 -600 -400 -200 0 200 400 600 1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 46 49 52 55 capital recovery with 20-year macrs, 5% compound interest 2019] stranded assets and efficient pricing for regulated utilities: a federal tax solution 43 in 2010 and 2011, utilities, as well as other businesses, enjoyed 100% bonus depreciation for tangible assets placed in service during these years. a $1,200,000 facility costing $1.2 million to construct and place in service during those years, with a useful life of 55 years (for book depreciation purposes), would receive an immediate deduction for the full $1.2 million investment. at a 35% corporate tax rate, the actual tax depreciation would offset $420,000 in taxes, but only $7,000 would be passed through to consumers to offset tax expense for that year. as a result, the first year the disparity between the firm’s financial accounting and tax accounting rules for depreciation would yield $413,000 in adit. if, instead of passing through the return to adit to the utility’s ratepayers, the firm invested adit funds to earn a modest five percent rate of return, the adit funds would accrue $20,650 in interest in year 1. the balance of adit would gradually decline each year as the adit was applied to offset the tax expense, but that declining sum would continue to earn compound interest. the amount of unrecovered capital may be calculated by subtracting the aggregate of book depreciation, adit, and the returns to adit from the original investment in the asset. this accelerates the date by which the firm (and the investors) will have recovered the full value of the asset. the following chart depicts cost recovery for an asset purchased for $1,200,000 with a 55year service life, subject to 100% bonus depreciation in year 1. if the tax savings are invested at a modest five percent interest, compounded annually, the firm will have recovered the entire value of the asset as of year 27. figure 7. negative figures depict the unrecovered capital investment in the asset that would be stranded if the asset ceases operations that year, assuming a $1,200,000 asset with a 55-year service life, taking into consideration annual recovery of costs from consumers as operating expense, tax savings (adit) from 100% bonus depreciation, and returns to adit invested at 5% interest compounded annually. the horizontal axis identifies the number of years in service and the vertical axis depicts recovery of capital investment in the asset. positive figures depict returns in excess of original investment. -1000 -800 -600 -400 -200 0 200 400 600 800 1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 46 49 52 55 capital recovery with 100% bonus depreciation, 5% compound interest columbia journal of tax law [vol. 11:1 44 with 100% bonus depreciation, an asset costing $1.2 million to construct and place in service, with a 55-year service life, will achieve complete cost recovery (taking into consideration book depreciation, adit and returns to adit invested at 5% interest, compounded annually) at approximately the mid-point of the asset’s useful life, 26 years. earnings resulting from adit from that point forward exceed the purchase price of the asset. if the asset is employed for its fullservice life, the compounded returns to adit at this interest rate will produce an additional $582,000 in earnings after full cost recovery. the calculations on which figure 7 is based are included in appendix b. for example, if the returns to the adit account are maintained in a retirement reserve, the utility will earn interest on the adit over time. the adit and the earnings on adit from compound interest allows a full recovery of stranded assets well before the end of the service life of the asset. after that point, the compound interest earned on adit will exceed the remaining unrecovered cost of the asset. in such cases, those additional earnings may be used to offset other stranded costs at the time of the regulatory change. note that a change in regulatory and tax policy (without other modifications) could have adverse consequences. for example, changing the tax and regulatory rules to ignore adit in the ratemaking process would likely result in utilities and their investors enjoying the returns to those tax savings as either lower rates or higher returns, respectively. the tax benefits from deferral would likely be capitalized into the value of the stock, drawing additional investors to fund fossil fuel-based utilities. in other words, if these tax savings provide higher returns to investors, the price of the utility stock may rise. without regulatory limits, utilities could disburse the returns to tax savings as dividends, attracting increased investment in fossil-fuel based energy. furthermore, tax subsidies distort investment decision-making process and are likely to result in the utilities allocating capital inefficiently. without regulatory limits, utilities could also use the returns to tax savings to purchase additional fossil fuel infrastructure; this would ensure that the utility, its investors, and its ratepayers would be carbon-dependent well into the future. therefore, changes to the regulatory and tax rules should take into account these potentially adverse incentives. first, if the tax and regulatory rules require adit to be included in the rate base, consumers would no longer receive the discount from accelerated depreciation. to prevent those tax benefits from being passed forward to investors, the regulatory rules could impute a return to adit and account for it in a retirement reserve. the release of those funds for use by the utility or disbursement to investors should be conditioned upon the passage and implementation of climate change legislation and the decommissioning of fossil-fuel assets. in addition, to undercut any incentive to invest to reap the benefits of stranded assets relief, the retirement reserve could be directed to past investors based on capital ownership during the periods the assets were constructed and placed in service. the sums in the adit account, and an assumed return to those funds, would be charged against stranded assets based on ownership of stocks over the periods those assets were acquired and placed into service.249 249 utilities must maintain records relating to depreciated property based on the vintage of the asset, tax class, tax method, and recovery period; record-keeping may entail the maintenance of as many as four sets of books. see eei, supra note 80, at 133. ferc also keeps track of a utility’s book records by account, subaccount, location, and vintage based on the utility and the jurisdiction. id. by matching the records for stranded assets with the stock ownership records, the specific parties who provided capital for their construction could be reimbursed. 2019] stranded assets and efficient pricing for regulated utilities: a federal tax solution 45 d. handling excess adit from corporate tax rate changes when congress reduces corporate tax rates, accrued adit may exceed the actual tax liabilities that will be due from the utilities in the future.250 the accrued tax savings that exceed the tax liabilities that will accrue in the future under the lower tax rates are referred to “excess deferrals” 251 or “excess adit.” in 1986, when corporate tax rates were dropped from 46% to 34%, congress had the option of passing through the excess adit to ratepayers immediately or at an accelerated rate.252 congress elected to do neither and instead elected to require the excess adit to be passed to consumers on the same schedule as before the rate change occurred.253 likewise, the tax cuts and jobs act of 2017 reduced the top marginal corporate tax rate from 35% to a flat rate of 21%.254 regulators are faced with a similar quandary with the excess adit that results from that recent change. sixteen states have since called upon ferc to modify the tax and regulatory rules to permit a reduction in utility rates.255 they have requested that ferc and state public service commissions authorize the disbursement of the excess adit to consumers at an accelerated rate to reduce their tax expense, and consequently, their utility rates. ferc has declined to do so and has required that excess adit be amortized over the same period as applied before the change in the corporate tax rates.256 ferc’s rationale was that amortization would be consistent with their past practice.257 there are also other justifications for maintaining the current policy. first, current and future rate payers are not necessarily the same parties that have overpaid the tax expense which has created the excess adit. the assets that give rise to adit have service lives of over 55 years and the tax/book disparities that have given rise to the adit have been in place for over 35 years. 250 see kiefer, supra note 36, at 23. 251 see gao, supra note 142, at 18-20. 252 see gao, supra note 142, at 18. for a comparison of tax savings flow-through treatment with the normalization treatment, see max swiren, accelerated depreciation tax benefits in utility rate making, 28 chicago l. rev. 629 (1961). 253 see tax reform act of 1986, pub. l. 99-514, § 203(e), 100 stat. 2085, 2146. 254 most of the investor-owned utilities have recharacterized the funds that were previously included in adit attributing to the change in tax rates, but they have not been consistent in their recharacterization, with some reclassifying the excess adit as regulatory liabilities and others in other ways. for this reason, reviewing the financial statements before the end of 2016 provides a clearer picture of the tax savings that will continue to be available over the life of the assets for use as an insurance pool for stranded assets. 255 see paige jones, states call for lower utility rates in light of lower corporate tax rate, tax notes (jan. 15, 2018). https://www.taxnotes.com/tax-notes-today-state/utility-tax/states-call-lower-utility-rates-light-lowercorporate-tax-rate/2018/01/12/26sbv [https://perma.cc/mp5m-qbfg]. the sixteen states include california, connecticut, florida, illinois, kentucky, maine, maryland, massachusetts, nevada, new hampshire, new york, north carolina, rhode island, texas, vermont, and virginia. 256 see 83 fed. reg. 59,295 (nov. 23, 2018) (codified at 18 cfr pts. 35, 101, 154, 201, 35, and 352). with respect to ratemaking, ferc provided that the excess or deficient adit would be refunded to ratepayers based on the schedule that was initially established and not at an accelerated rate. they also held that for both accounting purposes and ratemaking purposes, public utilities and natural gas companies would be required to record the excess adit in account 254 (other regulatory liabilities) and deduct offsetting entries to account 410.1 (provision for deferred income taxes, utility operating income) under the uniform system of accounts. the commission also concluded that amortizing the excess and/or deficient adit recorded in account 254 to account 410.1 was appropriate since it was supported by their existing regulations, it was consistent with the manner the sums were reflected in rates, and those accounts provided more transparency than recording the amounts in account 407.3 because the specific source of the regulatory asset or regulatory liability would be known. 257 id. columbia journal of tax law [vol. 11:1 46 reducing tax expense to current taxpayers would not grant relief to the parties who overpaid tax expense in the past. second, given the mounting budget deficits258 and the dramatic increase in the federal debt,259 congress may soon increase the corporate tax rate again. in that case, if the current ratepayers enjoy the immediate reduction in their rates from the application of excess adit against their tax and other liabilities, future ratepayers will face rate increases when congress raises corporate tax rates. when climate change legislation is passed, future ratepayers will not only have to cover the full costs of stranded assets at that time, but also face rate hikes to cover the additional cost of a carbon price. instead, by retaining excess adit to apply to stranded assets, the ratepayers who enjoyed the benefits of overpaying tax expense (in the form of discounted electricity) are also the parties who remain burdened by the assets that produced the discounted electricity. the ratepayers shouldering the burdens are more likely to be the same persons who reaped the benefits of those tax savings. third, allowing excess adit to be allocated to current ratepayers has adverse environmental consequences. current ratepayers will enjoy artificially induced low utility rates, which encourages overuse and waste, deters actions such as weatherization that will reduce energy use, and increases emissions. these adverse incentive effects may be avoided by paying out the excess adit in one lump sum. however, this would provide current rate payers with a huge benefit that is not proportionate to their years of ratepaying. fourth, passing excess adit through to ratepayers at the same rate as planned leaves more tax savings to serve as a pool for recovery of stranded assets.260 ferc noted that when assets are sold or retired, the balance of the adit account is applied to the taxes due on that sale or retirement and extinguished.261 however, ferc held that the excess adit associated with the sold or retired asset would continue to be amortized over the full period originally planned. 262 this position currently leaves those sums available for stranded asset retirement. public service commissions have recently approved the application of excess adit to similar costs.263 in 2018, the florida public service commission approved the application of excess adit toward restoration costs incurred by duke energy florida llc following hurricane michael and toward replenishing a 258 see damian paletta & erica werner, the government set a record with a $234 billion deficit in february, wash. post. (march 22, 2019), https://wapo.st/2hnywlf?tid=ss_mail&utm_term=.ba647173ae73 [https://perma.cc/43nkjlnm]; niv elis, federal deficit jumps to $747b, likely to exceed $1t by september, the hill (july 11, 2019) https://thehill.com/policy/finance/452675-treasury-federal-deficit-jumps-to-747b-likely-to-exceed-1t-by-september [https://perma.cc/q2ap-jdut]. 259 see bill chappell, u.s. national debt hits record $22 trillion, npr (feb. 13, 2019), https://www.npr.org/2019/02/13/694199256/u-s-national-debt-hits-22-trillion-a-new-record-thats-predicted-to-fall [https://perma.cc/vl67-7lrw]. 260 see 83 fed. reg. 59295 (ferc nov. 23, 2018) (codified at 18 cfr pts. 35, 101, 154, 201, 35, and 352). the commission, consistent with their prior rulings, also determined that because the sale or retirement of an asset with an adit balance is usually deemed a taxable event under irs rules, the adit balance would be extinguished as the deferred taxes and would then become payable to the appropriate government authorities. as a result, there would no longer be an adit balance to return to customers. for a public utility or a natural gas pipeline that continued to have an income tax allowance, the commission held that any excess adit associated with the asset must continue to be amortized in rates even after the sale or retirement of that asset. 261 id. 262 id. 263 see matheny, supra note 65, at § 4.23. 2019] stranded assets and efficient pricing for regulated utilities: a federal tax solution 47 storm reserve that was depleted following hurricanes irma and nate.264 the application of excess adit toward stranded costs resulting from climate change regulation would be consistent with these practices. e. potential application abroad while federal courts and energy regulators in the united states have been dealing with claims for stranded assets since the deregulatory efforts of the 1980s, the more recent discourse has come from europe. nongovernmental organizations there have sought to force the fossil fuel industry to recognize in their financial statements that their assets may be overvalued considering the threat of climate change and the potential difficulty of recovering stranded costs. their push for disclosure is designed to encourage divestment by institutional investors and other firms seeking long-term value. these cautions may be the most effective approach to managing the risks of stranded assets in countries in which tax accounting tracks financial accounting, as is the case with most members of the european union. when the tax and regulatory regimes of a nation mirror those in the united states, with significant disparities in tax and financial accounting for fixed assets, the tax and regulatory rule modification proposed above may have a broader audience. the following table identifies the countries in which depreciation for tax and financial accounting purposes deviate. countries where tax follows financial accounting depreciation countries where tax does not follow financial accounting depreciation argentina (for moveable property) australia brazil canada france china germany india italy japan korea kuwait netherlands (in principle, with adjustments) malaysia portugal mexico spain (but subject to limits under corporate income tax rules) nigeria sweden russia turkey saudi arabia singapore south africa united kingdom (for tangible assets only) united states table 5. comparison of countries in which tax depreciation follows book / statutory accounting depreciation to countries in which tax and financial depreciation diverge.265 further research is needed to determine the extent to which tax and regulatory accounting practices differ, to quantify any tax savings that may result, and to clarify whether returns to those 264 id. (citing in re: application for limited proceeding to approve 2017 revised and restated agreement, including certain rate adjustments by duke energy florida, llc, order no. psc – 2017 – 0451-as-eu, issued nov. 20, 2017, in docket no. 20170183-e1 and 20170272-e2.) 265 see ernst & young, worldwide capital and fixed assets guide 2018 (2018), https://www.ey.com/publication/vwluassets/ey-2018-worldwide-capital-and-fixed-assets-guide/$file/ey-2018worldwide-capital-and-fixed-assets-guide.pdf [ https://perma.cc/j9u2-vage]. columbia journal of tax law [vol. 11:1 48 tax savings have been passed forward to consumers or back to investors. nevertheless, this may present a promising avenue in addressing stranded assets abroad. v. conclusion despite key economic gains and health and environmental advantages, the diffusion of alternative energy and other carbon-saving technologies has been remarkably slow. legal and financial institutions have evolved to serve existing fossil-fuel-based technologies for energy development and distribution. together, these systems enjoy returns to scale that create a significant barrier to entry for other energy systems. consequently, industrial economies have been, by institutional co-evolution and path-dependent economies of scale, “locked into” fossil fuel-based energy systems. carbon lock-in stalls the adoption of new energy technology and slows the transition to a carbon-neutral economy. by making a relatively small modification to the tax and regulatory rules for public utilities, policy-makers may begin to dismantle one of the key structures supporting carbon lock-in. for coal, natural gas, and other energy facilities, accelerated tax depreciation generates a pool of tax savings for public utilities. these tax savings accrue primarily to fossil-fuel based energy systems, resulting in discounts on electricity and gas service rates. this policy is inefficient and wasteful. first, consumers that receive these discounts are encouraged to use more energy than they would without the subsidies. second, these subsidies, by reducing prices for fossil fuels, undercut sales of electricity from renewable energy resources, and deter the deployment of these systems. third, higher energy use increases emissions, accelerating and exacerbating the effects of climate change. if, instead, tax and ferc policies are modified to bar utilities from passing the returns to these tax subsidies forward to consumers, these wasteful discounts would cease, enhancing efficiency. discussions about stranded assets have generally focused on whether the owners of fossil fuel-based infrastructure and assets should be entitled to recovery. certainly, any claims for full reimbursement of stranded costs should be discounted to the extent they arise not from regulatory action, but from the normal market responses to technological changes or from the vicissitudes of consumer demand. stranded benefits should also be included in the analysis. existing discussions about stranded assets have failed, however, to take into consideration the significant economic value that the federal income tax delivers through accelerated cost recovery. the tax savings from accelerated cost recovery are tracked and reported on a firm’s consolidated balance sheets as adit. financial statements for the 15 largest regulated public utilities firms show that these firms have aggregated a pool of tax savings in excess of $110 billion. those tax savings should be converted into an insurance pool from which investors in regulated utilities would recover an additional tranche of their stranded costs in the event of a sharp regulatory change. as of 2016, on average, the 15 largest regulated public utilities had recovered approximately 338% of their investments in ppe through regulatory depreciation, leaving approximately 672% in unrecovered capital. if the tax savings from accelerated depreciation were applied against stranded assets, the amount of their assets subject to regulatory risk would decline to approximately 52% of total capital in service. to the extent the economic returns to adit have not been passed forward to consumers, they have accrued to investors. if the tax savings accrued to date exceed customers’ overpayments from normalized tax expense, the excess has not been deducted from the rate base or treated as zero-cost capital in determining the consumers’ utility rates. instead, the returns to those tax savings in the adit account have subsidized investor returns. consequently, these subsidized 2019] stranded assets and efficient pricing for regulated utilities: a federal tax solution 49 returns to investors should also be treated as an offset in calculating stranded costs. given that many utilities have accrued net operating losses in recent years, it is likely that investors, rather than consumers, have enjoyed most of the economic benefit from bonus depreciation allowances. finally, both the tax savings currently in the adit account and the returns to the adit account could serve as a stranded asset recovery pool. the funds could be released to past investors after climate change legislation or regulations are passed and fossil fuel assets are decommissioned. to affect this change, the normalization rules would need to be revised to require that utilities (1) keep track of adit, allowing it to accrue as a retirement reserve, (2) account for (and assume) a return to those savings at a market rate of interest, (3) charge both the adit and the returns to adit against any stranded assets, and (4) trigger the release of funds at the implementation of effective climate change regulation and the termination of operations and decommissioning of the fossil fuel assets and systems. changing the tax and regulatory rules has a number of attractive features. first, the change in policy could be explicitly characterized as a payoff to investors in utilities to reimburse stranded asset claims. second, the policy is flexible. the completion of cost recovery could be designed to track the phase-out and termination of fossil fuel-based technology operations. if the phase-in of regulation or the phase-out of old technologies were delayed, any additional returns to adit during that prolonged period could be charged against other stranded assets with longer remaining service lives. third, this change in the rules reallocates existing subsidies to address transition costs; it does not create new subsidies, the costs of which increase budgetary deficits and, in the current tax environment, the federal debt.266 finally, this policy enhances equity. customers have been receiving a discount in their energy rates based on a tax subsidy. terminating that subsidy will increase prices, but reduce pollution and improve health outcomes. consumer utility rates will be no higher from this policy change than if accelerated tax depreciation had not been enacted. in addition, u.s. taxpayers rather than consumers will have paid for any tax benefits accruing to investors. if the tax savings remaining in the adit account are transferred to investors, the consumers’ share of the burden of stranded costs will be lessened, since the broader taxpaying public will have shouldered some of those costs. spreading that economic burden may soften the blow and reduce resistance to climate change policy in some of the most fossil fuel-dependent areas of the country. in the united states and abroad, comprehensive climate change policies should include a significant tax component. by changing these tax and regulatory accounting rules, policymakers may eliminate waste, manage stranded costs, and smooth the transition to a carbon-neutral economy at lower consumer cost. 266 prior to the enactment of the tax cuts and jobs act of 2017, the change would have had no additional budgetary cost. this policy change would have appealed not only to economists, but also to deficit hawks and politicians concerned about rising budget deficits, since it would only have shifted the incidence of the tax subsidies currently available. the amount of tax subsidies would not increase or otherwise affect the federal budget. columbia journal of tax law [vol. 11:1 50 appendix a: stranded asset recovery under macrs with adit and compound interest accruing to a retirement reserve total cost to be recovered = 1,200,000 v = 1,200,000 -100,000 = 1,100,000 service life: 55 years regulatory depreciation (for calculating operating expense) = 1,100,000 / 55 years = 20,000 / year dollar value of regulatory depreciation (for calculating tax expense passthrough) = $20,000 x .35 corporate tax rate = $7,000 cost recovery period 20 years cost recovery under tax accounting rules = 1,200,000 / 20 years = $60,000 dollar value of cost recovery allowance under macrs for years 1 – 20 = $60,000 x .35 = $21,000 dollar value of cost recovery allowance under macrs for years 20 – 55 = $0 adit = dollar value of cost recovery allowance under macrs – regulatory depreciation (for tax expense) = $21,000 $7,000 = $14,000 increase each year for years 1 – 20, <$7,000> for years 21 55 assume that the returns to adit are not passed through to ratepayers, but instead that adit accrues five percent interest per year, compounded annually and that at the end of the year the sum is treated as a retirement reserve for stranded costs. unrecovered investment = total asset cost – aggregate regulatory depreciation retirement reserve = adit – interest on adit – interest on interest remaining capital at risk for stranding = unrecovered investment – retirement reserve year total asset cost aggregate regulatory depreciation (passed as part of operating expense) unrecovered investment $ aggregate reg. depreciation (passed as part of tax expense) $ aggregate cost recovery macrs adit interest rate interest on adit interest to be compounded interest on interest retirement reserve remaining capital at risk for stranding 1 1,200 20 1,180 21 7 14 0.05 0.7 0 0.00 14.70 1,165 2 1,200 40 1,160 42 14 28 0.05 1.4 0.7 0.04 30.14 1,130 3 1,200 60 1,140 63 21 42 0.05 2.1 2.1 0.11 46.31 1,094 4 1,200 80 1,120 84 28 56 0.05 2.8 4.2 0.21 63.21 1,057 5 1,200 100 1,100 105 35 70 0.05 3.5 7 0.35 80.85 1,019 6 1,200 120 1,080 126 42 84 0.05 4.2 10.5 0.53 99.23 981 7 1,200 140 1,060 147 49 98 0.05 4.9 14.7 0.74 118.34 942 8 1,200 160 1,040 168 56 112 0.05 5.6 19.6 0.98 138.18 902 9 1,200 180 1,020 189 63 126 0.05 6.3 25.2 1.26 158.76 861 2019] stranded assets and efficient pricing for regulated utilities: a federal tax solution 51 year total asset cost aggregate regulatory depreciation (passed as part of operating expense) unrecovered investment $ aggregate reg. depreciation (passed as part of tax expense) $ aggregate cost recovery macrs adit interest rate interest on adit interest to be compounded interest on interest retirement reserve remaining capital at risk for stranding 10 1,200 200 1,000 210 70 140 0.05 7 31.5 1.58 180.08 820 11 1,200 220 980 231 77 154 0.05 7.7 38.5 1.93 202.13 778 12 1,200 240 960 252 84 168 0.05 8.4 46.2 2.31 224.91 735 13 1,200 260 940 273 91 182 0.05 9.1 54.6 2.73 248.43 692 14 1,200 280 920 294 98 196 0.05 9.8 63.7 3.19 272.69 647 15 1,200 300 900 315 105 210 0.05 10.5 73.5 3.68 297.68 602 16 1,200 320 880 336 112 224 0.05 11.2 84 4.20 323.40 557 17 1,200 340 860 357 119 238 0.05 11.9 95.2 4.76 349.86 510 18 1,200 360 840 378 126 252 0.05 12.6 107.1 5.36 377.06 463 19 1,200 380 820 399 133 266 0.05 13.3 119.7 5.99 404.99 415 20 1,200 400 800 420 140 280 0.05 14 133 6.65 433.65 366 21 1,200 420 780 0 147 273 0.05 13.65 147 7.35 441.00 339 22 1,200 440 760 0 154 266 0.05 13.3 160.65 8.03 447.98 312 23 1,200 460 740 0 161 259 0.05 12.95 173.95 8.70 454.60 285 24 1,200 480 720 0 168 252 0.05 12.6 186.9 9.35 460.85 259 25 1,200 500 700 0 175 245 0.05 12.25 199.5 9.98 466.73 233 26 1,200 520 680 0 182 238 0.05 11.9 211.75 10.59 472.24 208 27 1,200 540 660 0 259 231 0.05 11.55 223.65 11.18 477.38 183 28 1,200 560 640 0 196 224 0.05 11.2 235.2 11.76 482.16 158 29 1,200 580 620 0 203 217 0.05 10.85 246.4 12.32 486.57 133 30 1,200 600 600 0 210 210 0.05 10.5 257.25 12.86 490.61 109 31 1,200 620 580 0 217 203 0.05 10.15 267.75 13.39 494.29 86 32 1,200 640 560 0 224 196 0.05 9.8 277.9 13.90 497.60 62 columbia journal of tax law [vol. 11:1 52 year total asset cost aggregate regulatory depreciation (passed as part of operating expense) unrecovered investment $ aggregate reg. depreciation (passed as part of tax expense) $ aggregate cost recovery macrs adit interest rate interest on adit interest to be compounded interest on interest retirement reserve remaining capital at risk for stranding 33 1,200 660 540 0 231 189 0.05 9.45 287.7 14.39 500.54 39 34 1,200 680 520 0 238 182 0.05 9.1 297.15 14.86 503.11 17 35 1,200 700 500 0 245 175 0.05 8.75 306.25 15.31 505.31 -5 36 1,200 720 480 0 252 168 0.05 8.4 315 15.75 507.15 -27 37 1,200 740 460 0 259 161 0.05 8.05 323.4 16.17 508.62 -49 38 1,200 760 440 0 266 154 0.05 7.7 331.45 16.57 509.72 -70 39 1,200 780 420 0 273 147 0.05 7.35 339.15 16.96 510.46 -90 40 1,200 800 400 0 280 140 0.05 7 346.5 17.33 510.83 -111 41 1,200 820 380 0 287 133 0.05 6.65 353.5 17.68 510.83 -131 42 1,200 840 360 0 294 126 0.05 6.3 360.15 18.01 510.46 -150 43 1,200 860 340 0 301 119 0.05 5.95 366.45 18.32 509.72 -170 44 1,200 880 320 0 308 112 0.05 5.6 372.4 18.62 508.62 -189 45 1,200 900 300 0 315 105 0.05 5.25 378 18.90 507.15 -207 46 1,200 920 280 0 322 98 0.05 4.9 383.25 19.16 505.31 -225 47 1,200 940 260 0 329 91 0.05 4.55 388.15 19.41 503.11 -243 48 1,200 960 240 0 336 84 0.05 4.2 392.7 19.64 500.54 -261 49 1,200 980 220 0 343 77 0.05 3.85 396.9 19.85 497.60 -278 50 1,200 1000 200 0 350 70 0.05 3.5 400.75 20.04 494.29 -294 51 1,200 1020 180 0 357 63 0.05 3.15 404.25 20.21 490.61 -311 52 1,200 1040 160 0 364 56 0.05 2.8 407.4 20.37 486.57 -327 53 1,200 1060 140 0 371 49 0.05 2.45 410.2 20.51 482.16 -342 54 1,200 1080 120 0 378 42 0.05 2.1 412.65 20.63 477.38 -357 55 1,200 1100 100 0 385 35 0.05 1.75 414.75 20.74 472.24 -372 2019] stranded assets and efficient pricing for regulated utilities: a federal tax solution 53 appendix b: stranded asset recovery under 100% bonus depreciation with adit and compound interest accruing to a retirement reserve total cost to be recovered = 1,200,000 v = 1,200,000 -100,000 = 1,100,000 service life: 55 years regulatory depreciation (for calculating operating expense) = 1,100,000 / 55 years = 20,000 / year dollar value of regulatory depreciation (for calculating tax expense) = $20,000 x .35 corporate tax rate = $7,000 cost recovery period: 1 year cost recovery under tax accounting rules (100% bonus depreciation): $1,200,000 x 100% = $1,200,000 for year 1 dollar value of cost recovery allowance under bonus depreciation = $1,200,000 x 0.35 = $420,000 year 1 dollar value of cost recovery allowance under bonus depreciation for years 2 – 55 = $0 adit = dollar value of cost recovery allowance under bonus depreciation – regulatory depreciation (for tax expense passthrough) = $420,000 $7,000 = $413,000 for year 1 assume that the returns to adit are not passed through to ratepayers, but instead that adit accrues five percent interest per year, compounded annually and that at the end of the year the sum is treated as a retirement reserve for stranded costs. unrecovered investment = total asset cost – aggregate regulatory depreciation retirement reserve = adit – interest on adit – interest on interest remaining capital at risk for stranding = unrecovered investment – retirement reserve year total asset cost aggregate regulatory depreciation (passed as part of operating expense) unrecovered investment $ aggregate reg. depreciation (passed as part of tax expense) $ cost recovery 100% bonus depreciation (each year) adit interest rate interest on adit interest to be compounded interest on interest retirement reserve remaining capital at risk for stranding 1 1,200 20 1,180 7 420 413 0.05 20.65 0 0 434 746 2 1,200 40 1,160 14 0 406 0.05 20.3 20.65 2 449 711 3 1,200 60 1,140 21 0 399 0.05 19.95 40.95 3 463 677 4 1,200 80 1,120 28 0 392 0.05 19.6 60.9 4 477 643 5 1,200 100 1,100 35 0 385 0.05 19.25 80.5 5 490 610 6 1,200 120 1,080 42 0 378 0.05 18.9 99.75 6 503 577 7 1,200 140 1,060 49 0 371 0.05 18.55 118.65 7 515 545 8 1,200 160 1,040 56 0 364 0.05 18.2 137.2 8 527 513 9 1,200 180 1,020 63 0 357 0.05 17.85 155.4 9 539 481 columbia journal of tax law [vol. 11:1 54 year total asset cost aggregate regulatory depreciation (passed as part of operating expense) unrecovered investment $ aggregate reg. depreciation (passed as part of tax expense) $ cost recovery 100% bonus depreciation (each year) adit interest rate interest on adit interest to be compounded interest on interest retirement reserve remaining capital at risk for stranding 10 1,200 200 1,000 70 0 350 0.05 17.5 173.25 10 550 450 11 1,200 220 980 77 0 343 0.05 17.15 190.75 10 561 419 12 1,200 240 960 84 0 336 0.05 16.8 207.9 11 572 388 13 1,200 260 940 91 0 329 0.05 16.45 224.7 12 582 358 14 1,200 280 920 98 0 322 0.05 16.1 241.15 13 592 328 15 1,200 300 900 105 0 315 0.05 15.75 257.25 14 602 298 16 1,200 320 880 112 0 308 0.05 15.4 273 14 611 269 17 1,200 340 860 119 0 301 0.05 15.05 288.4 15 620 240 18 1,200 360 840 126 0 294 0.05 14.7 303.45 16 628 212 19 1,200 380 820 133 0 287 0.05 14.35 318.15 17 636 184 20 1,200 400 800 140 0 280 0.05 14 332.5 17 644 156 21 1,200 420 780 147 0 273 0.05 13.65 346.5 18 651 129 22 1,200 440 760 154 0 266 0.05 13.3 360.15 19 658 102 23 1,200 460 740 161 0 259 0.05 12.95 373.45 19 665 75 24 1,200 480 720 168 0 252 0.05 12.6 386.4 20 671 49 25 1,200 500 700 177 0 245 0.05 12.25 399 21 677 23 26 1,200 520 680 182 0 238 0.05 11.9 411.25 21 682 -2 27 1,200 540 660 189 0 231 0.05 11.55 423.15 22 687 -27 28 1,200 560 640 196 0 224 0.05 11.2 434.7 22 692 -52 29 1,200 580 620 203 0 217 0.05 10.85 445.9 23 697 -77 30 1,200 600 600 210 0 210 0.05 10.5 456.75 23 701 -101 31 1,200 620 580 217 0 203 0.05 10.15 467.25 24 704 -124 32 1,200 640 560 224 0 196 0.05 9.8 477.4 24 708 -148 2019] stranded assets and efficient pricing for regulated utilities: a federal tax solution 55 year total asset cost aggregate regulatory depreciation (passed as part of operating expense) unrecovered investment $ aggregate reg. depreciation (passed as part of tax expense) $ cost recovery 100% bonus depreciation (each year) adit interest rate interest on adit interest to be compounded interest on interest retirement reserve remaining capital at risk for stranding 33 1,200 660 540 231 0 189 0.05 9.45 487.2 25 710 -170 34 1,200 680 520 238 0 182 0.05 9.1 496.65 25 713 -193 35 1,200 700 500 245 0 175 0.05 8.75 505.75 26 715 -215 36 1,200 720 480 252 0 168 0.05 8.4 514.5 26 717 -237 37 1,200 740 460 259 0 161 0.05 8.05 522.9 27 718 -258 38 1,200 760 440 266 0 154 0.05 7.7 530.95 27 720 -280 39 1,200 780 420 273 0 147 0.05 7.35 538.65 27 720 -300 40 1,200 800 400 280 0 140 0.05 7 546 28 721 -321 41 1,200 820 380 287 0 133 0.05 6.65 553 28 721 -341 42 1,200 840 360 294 0 126 0.05 6.3 559.65 28 720 -360 43 1,200 860 340 301 0 119 0.05 5.95 565.95 29 719 -379 44 1,200 880 320 308 0 112 0.05 5.6 571.9 29 718 -398 45 1,200 900 300 315 0 105 0.05 5.25 577.5 29 717 -417 46 1,200 920 280 322 0 98 0.05 4.9 582.75 29 715 -435 47 1,200 940 260 329 0 91 0.05 4.55 587.65 30 713 -453 48 1,200 960 240 336 0 84 0.05 4.2 592.2 30 710 -470 49 1,200 980 220 343 0 77 0.05 3.85 596.4 30 707 -487 50 1,200 1000 200 350 0 70 0.05 3.5 600.25 30 704 -504 51 1,200 1020 180 357 0 63 0.05 3.15 603.75 30 700 -520 52 1,200 1040 160 364 0 56 0.05 2.8 606.9 30 696 -536 53 1,200 1060 140 371 0 49 0.05 2.45 609.7 31 692 -552 54 1,200 1080 120 378 0 42 0.05 2.1 612.15 31 687 -567 55 1,200 1100 100 385 0 35 0.05 1.75 614.25 31 682 -582 columbia journal of tax law [vol. 11:1 56 appendix c: annual reports for firms with investor owned publicly regulated utilities ameren, 2017 annual report (form 10-k), at 104 (feb. 28, 2018). american electric power, 2017 annual report (form 10-k), at 113-114, 141-142, 155-156, 169170 (feb. 23, 2018). cms energy, 2017 annual report (form 10-k), at 100-101 (feb. 14, 2018). consolidated edison, 2010 annual report (form 10-k), at 82-83 (feb. 22, 2011). consolidated edison, 2011 annual report (form 10-k), at 71-72 (feb. 21, 2012). consolidated edison, 2012 annual report (form 10-k), at 72-73 (feb. 21, 2013). consolidated edison, 2013 annual report (form 10-k), at 72-73 (feb. 21, 2014). consolidated edison, 2014 annual report (form 10-k), at 84-85 (feb. 19, 2015). consolidated edison, 2015 annual report (form 10-k), at 78-79 (feb. 18, 2016). consolidated edison, 2016 annual report (form 10-k), at 82-83 (feb. 16, 2017). consolidated edison, 2017 annual report (form 10-k), at 89-90, 114-115 (feb. 15, 2018). consolidated edison, 2018 annual report (form 10-k), at 93-94 (feb. 21, 2019). dominion resources, 2017 annual report (form 10-k), at 78-79 (feb. 27, 2018). dte energy, annual report (form 10-k), at 69-70 (feb. 16, 2018). duke energy, 2017 annual report (form 10-k, amend no. 1), at 77-78, 89-90, 94, 99, 104 (feb. 23, 2018). edison international, 2017 annual report (form 10-k), at 64, 76 (feb. 22, 2018). first energy, 2017 annual report (form 10-k), at 72 (feb. 20, 2018). nextera energy, 2017 annual report (form 10-k), at 66-67 (feb. 16, 2018). pg&e, 2017 annual report (form 10-k), at 95-96 (feb. 9, 2018). ppl corp, 2017 annual report (form 10-k), at 115-116, 121-122 (feb. 22, 2018). sempra, 2017 annual report (form 10-k), at f-14-f15, f-20-f21 (feb. 27, 2018). southern company, 2017 annual report (form 10-k), at 92-93 (feb.21, 2018). xcel energy, 2017 annual report (form 10-k), at 82 (feb. 23, 2018). donor-advised funds in the wake of the tax cuts and jobs act david i. walker* abstract donor-advised funds (dafs) are conduits for charitable giving that support immediate tax deductions while creating a reservoir of assets for subsequent disposition to end-use charities. the number of new daf accounts has skyrocketed in the wake of the 2017 tax cuts and jobs act (tcja). this article presents evidence suggesting that bunching charitable contributions to more fully exploit the tcja-enhanced standard deduction likely motivates much of the onslaught of new daf accounts established since 2016 and argues that the typical buncher is likely to differ from other daf account holders in ways that matter from a policy perspective. thus, while daf critics have generally focused on the unproductive accumulation of assets in daf accounts and have advanced reforms aimed at speeding up daf payouts, this article argues that in the context of bunchers, unproductive accumulation of assets in daf accounts is unlikely to be a major problem. the more significant problem with daf-facilitated bunching is that the cost to the public fisc is unlikely to be justified by incremental charitable giving. thus, while this article concludes that regulation targeting daf payouts is unobjectionable, it argues that a wholly different set of reforms targeting the deductibility of charitable giving generally would be needed to address the cost of daf-facilitated bunching under current law and under thoughtfully reformed laws involving universal charitable deductions above a floor. * professor of law and maurice poch faculty research scholar, boston university school of law. the author thanks john brooks, steven dean, alan feld, gregg polsky, and ted sims for their valuable comments and suggestions and stephen fleury for excellent research assistance. 2 columbia journal of tax law [vol: 14:1 introduction ........................................................................................................ 2 i. background ...................................................................................................... 6 a. dafs ............................................................................................................. 6 1. are dafs tax advantaged? .......................................................................7 2. why else do donors create dafs? ..........................................................9 b. the tcja and subsidies for charitable giving .......................................... 10 c. bunching philanthropy post-tcja ............................................................. 11 ii. trends in daf accounts ............................................................................. 14 iii. daf policy issues and responses – the impact of bunching ............... 17 a. asset accumulation inside dafs ............................................................... 17 b. the cost of bunching to the public fisc .................................................... 19 c. incentive effects of dafs ........................................................................... 20 d. expanding the reach of the deduction for individual philanthropy .......... 21 e. facilitation of donation of appreciated assets ........................................... 22 iv. proposals for daf and more general philanthropic reform .......... 24 a. reforms targeting daf asset accumulation ............................................ 24 b. limiting the deduction for contributions of appreciated property to basis .......................................................................................................................... 25 c. fundamental reform of philanthropic subsidies ....................................... 26 v. conclusion ..................................................................................................... 29 introduction donor-advised funds (dafs) are conduits for charitable giving. taxpayers create a daf account, most commonly with a commercial daf sponsor such as fidelity charitable.1 they contribute cash or other assets to their daf account, direct the investment of their daf account balances, and then make grants out of their daf accounts to public charities such as the red cross, bu, or the united way. under current law, taxpayers are entitled to a deduction at the time assets are contributed to daf accounts despite the fact that the funds may rest in a daf account indefinitely.2 also, as with other contributions of appreciated assets, in many cases daf donors are never taxed on unrealized gains on these assets despite being entitled to a full fair market value deduction.3 the tax and other rules governing dafs have long been controversial. in particular, critics bemoan the lack of any requirement or even incentive for taxpayers to move funds out of their dafs to end-use charities, sometimes resulting in significant gaps between daf contribution and distributions to end 1 as discussed infra, daf accounts are divided between community foundations, single issue charities, and commercially sponsored funds. the latter held 86% of daf accounts in 2020. see nat’l philanthropic tr., 2021 donor-advised fund report 22-30 (2021). 2 daf sponsoring entities are considered public charities for federal tax purposes. thus, contributions to daf accounts are deductible in the year of contribution. throughout this article, i will generally refer to daf accounts simply as “dafs.” 3 infra note 22. 2023] donor advised funds 3 use charities.4 moreover, dafs facilitate the contribution of appreciated assets, including illiquid assets, often leading to large tax subsidies and raising valuation concerns.5 while dafs have been growing in popularity over the last decade, the 2017 tax cuts and jobs act (tcja) spurred growth to unprecedented heights with the number of daf accounts more than doubling in just two years.6 the data suggest, but do not prove, that much of this growth in daf activity resulted from taxpayers seeking to “bunch” several years of philanthropy into a single year in order to increase their total deductions over time given the tcja’s massive increase in the standard deduction and adoption of a $10,000 cap on deductions for state and local taxes. while dafs are not essential for deduction bunching, as discussed below, they facilitate bunching.7 assuming that deduction bunching is driving much of the recent growth in dafs, this article asks how, as a tax policy matter, we should feel about dafs and about various proposals to increase daf regulation. the article makes several observations. first, indefinite warehousing of assets in daf accounts may be less of a problem to the extent that the creation of these accounts is motivated by bunching charitable contributions to take advantage of the tcja enhanced standard deduction. these are not cases, for example, in which taxpayers seek to accumulate enough assets in their daf accounts to make transformative gifts. of course, having received their tax deduction for their bunched contribution, bunchers, like other daf account holders, might inadvertently fail to distribute assets out of the account for some time.8 the presence of bunchers should also affect how we conceptualize daf account balances. daf critics generally assume that assets going into dafs and remaining in dafs would go directly to end-use charities in the absence of dafs.9 under that assumption, any lag between a taxpayer’s contribution to a daf and grant from the daf to an end user is a loss to the real charitable sector. to be sure, not all commentators view this lag as a negative. after all, funds held by dafs are invested and earn returns, and future generations may be as deserving of charitable support as the current generation.10 but many commentators do view the lag as a loss. this article argues, however, that for bunchers this view of end-use charities missing out on assets stockpiled in dafs may be inapposite. absent dafs, bunchers might decide to accumulate assets in taxable accounts for a number of years before making bunched donations in a single year to one or more charities. to the extent that this is an accurate picture, daf account balances do not represent an opportunity cost for end-use charities. 4 infra note 17. 5 infra note 14. 6 nat’l philanthropic tr., 2021 donor-advised fund report 16 (2021). contributions to dafs accounted for 10% of total u.s. charitable giving in 2020. nat’l philanthropic tr., 2021 donor-advised fund report, at 10 (2021). 7 infra note 65. 8 infra note 17. 9 infra note 79. 10 infra note 83. 4 columbia journal of tax law [vol: 14:1 the more significant policy concern raised by contribution bunching is likely to be the cost to the public fisc. this article argues that the cost could approach or exceed a billion dollars a year.11 to be sure, in some cases bunching charitable contribution deductions restores a marginal incentive for philanthropy that was eliminated by the tcja’s changes. the tcja slashed the number of itemizers from about 30% to about 11% of u.s. taxpayers and the number taking the itemized deduction for charitable contributions from about 25% to about 9% of u.s. taxpayers.12 some of the taxpayers who lost the deduction and incentive for philanthropy have restored it through bunching. for those who find value in broadly available subsidies for charitable giving, dafs make a very small dent in the loss engineered by the tcja. in a likely majority of cases, however, taxpayers who would itemize posttcja with or without contribution bunching, and who already experience an incentive for marginal charitable giving, bunch philanthropy solely in order to reduce their overall tax bill in light of the increased standard deduction. in short, bunching is costly for the public fisc and only creates useful incentives in what is likely to be a small subset of cases.13 a final policy issue is daf facilitation of the donation of liquid and illiquid appreciated assets. certainly, bunchers, like other daf users, may contribute such assets to dafs, but the tax treatment of contributions of appreciated assets is unlikely to drive daf formation by bunchers. put another way, suppose that congress were to (sensibly, in my view) limit the deduction for appreciated asset contributions to the taxpayer’s basis, a move that would generally result in liquidation prior to daf contribution.14 i would expect such a rule to have very little impact on the use of dafs by bunchers.15 critics have targeted dafs with several proposed reforms, principally to discourage accumulation of assets in dafs, but perhaps also to discourage daf use more generally. one proposed reform is to place a cap on the number of years assets can be held in a daf without disbursement before the donor loses any say as to disposition. in 2021 senators king and grassley proposed a fifteen-year maximum.16 professor edward zelinsky has proposed subjecting individual daf accounts to the payout rules applicable to private foundations, i.e., requiring dafs to pay out a minimum of five percent of assets each year.17 a more drastic 11 infra. 12 see u.s. dep’t of treasury, i.r.s., statistics of income – 2018 individual income tax returns, publication 1304 (rev. 09-2020), 23 (2018). 13 infra. 14 see daniel halperin, a charitable contribution of appreciated property and the realization of built-in gains, 56 tax l. rev. 1, 29 (2002). 15 infra. 16 accelerating charitable efforts act, s. 1981, 117th cong. (2021). (introduced by senators angus king of maine and charles grassley of iowa) [hereinafter “ace act”]. 17 edward a. zelinsky, a response to the initiative to accelerate charitable giving, 170 tax notes 755, 761-62 (2021). private foundations are irc § 501(c)(3) organizations that do not qualify as public charities. i.r.c. § 509. private foundations are generally funded by a small number of individuals, controlled by their funders, and make grants to public charities rather than providing philanthropic services directly. samuel d. brunson, "i'd gladly pay you tuesday for a 2023] donor advised funds 5 reform proposal would defer the deduction for charitable contributions made through dafs to the point of disbursement to the end-use charity.18 i would not expect daf payout requirements to have a significant impact on bunchers. although the tax savings from bunching increase with the number of years between bunched contributions, asset limitations (the amount available to bunch) and other concerns (e.g., potential changes in tax rates or rules) are likely to result in bunching cycles and payouts of daf assets that are much shorter than fifteen years. by contrast, deferring deductions for daf contributions until payout would essentially end the use of dafs by bunchers, resolving the accumulation issue and perhaps reducing, but probably not precluding, bunching to exploit the tcja’s expanded standard deduction.19 while the focus of this article is on the tcja amendments and their impact on daf use, the analysis has implications for one long-standing and important proposal for the reform of the tax treatment of individual philanthropy more broadly. given that, this article concludes with a brief look ahead. recognizing the costs and benefits of federal subsidies for philanthropy, some commentators have proposed a universal deduction (i.e., an “above-the-line” deduction available to all taxpayers irrespective of itemizing) but only above a floor amount set as a percentage of income.20 the idea is that most taxpayers will give a certain amount to charity with or without a subsidy. this base amount does not need to be subsidized. the payoff from subsidization is encouraging philanthropy that goes above and beyond this base amount. but, of course, for taxpayers giving near the floor, bunching (with or without dafs, but facilitated by dafs), would be an obvious strategy to effectively avoid or minimize the impact of the floor. some rule would be needed to block this end run, but again, to be clear, this would be true in a world with or without dafs.21 ultimately, this article concludes that bunching-motivated daf use, which apparently is increasing in the wake of the tcja, raises a different set of policy issues. concerns about assets accumulating unproductively in dafs and daf facilitation of illiquid asset contribution are probably mitigated for bunchers. on the other hand, many bunchers are likely using dafs simply to exploit the tcja expanded standard deduction, at great cumulative cost to the public fisc and with little benefit in the form of incentive creation. reformers should likely shift their focus given these realities. the remainder of this article is organized as follows. part i provides background on dafs and the tcja and explains how taxpayers can bunch charitable contributions, with or without dafs, to take full advantage of the tcja-expanded standard deduction. part ii provides data revealing explosive [tax deduction] today": donor-advised funds and the deferral of charity, 55 wake forest l. rev. 245, 254 (2020). 18 roger colinvaux & ray d. madoff, charitable tax reform for the 21st century, 164 tax notes 1867, 1867 (2019). 19 it is important to keep in mind that dafs facilitate bunching but are not a prerequisite for bunching. see infra. 20 infra. 21 infra. 6 columbia journal of tax law [vol: 14:1 growth in daf accounts beginning in 2017 and suggesting a new, somewhat lower income class of account holder. this data suggests that bunching charitable contributions likely drives much of the growth in accounts post-tcja. part iii reconsiders daf policy issues in light of the shifting motivation of account holders, arguing that the cost of contribution bunching to the public fisc is a more serious issue with respect to this group than unproductive asset accumulation in dafs or contribution of appreciated assets. part iv considers an eclectic set of daf and broader charitable reforms arguing principally that reforms aimed at daf asset accumulation will have no effect on bunchers. a different set of reforms is required to address the costs imposed by bunching today and going forward in a post-post-tcja tax world. i. background a. dafs donor-advised funds have been with us for decades. the first funds were associated with geographically focused community foundations or trusts. several commentators credit the new york community trust with creating the first daf accounts in the 1930s.22 other mission-specific daf funds were created by socalled “single issue” sponsors, such as universities or religious organizations.23 later, investment giants, such as fidelity, vanguard, and schwab, innovated by introducing commercial daf funds that essentially serve as a neutral conduit, allowing account holders wide latitude to support the charities of their choice.24 today, these commercial funds are the largest players in the daf landscape,25 and my focus henceforth will be on commercial daf sponsors unless otherwise noted. the process, in brief, works like this. a donor creates a daf account with a sponsor, say fidelity charitable. the donor contributes cash, publicly traded securities, or “complex” illiquid assets.26 in the latter two cases, the daf sponsor liquidates the assets creating a cash reserve for donations.27 the donor directs the investment of her daf account balance much like 401(k) participants direct the investment of those accounts.28 because the daf sponsor is a public charity, investment gains within the daf are not taxed.29 finally, the donor makes 22 john r. brooks, the missing tax benefit of donor-advised funds, 150 tax notes 1013, 1014 (2016); brunson, supra note 17, at 259; roger colinvaux, donor advised funds: charitable spending vehicles for 21st century philanthropy, 92 wash. l. rev. 39, 44 (2017). 23 colinvaux (2017), supra note 22, at 46. 24 colinvaux (2017), supra note 22, at 45 (noting that the fidelity charitable gift fund was established as a public charity in 1991). 25 commercial sponsors held 86% of accounts and 63% of total daf assets in 2020. nat’l philanthropic tr., 2021 donor-advised fund report, at 2-30 (2021).. 26 fidelity charitable, giving report 2022 6 (2022) [hereinafter fidelity 2022 report]. 27 fidelity 2022 report at 19. 28 fidelity 2022 report at 6. 29 fidelity 2022 report at 6. 2023] donor advised funds 7 disbursements (known as grants) to end-use charities.30 technically, the donor plays only an advisory role in directing disbursements, but in practice donors control disbursements.31 the reason for the artifice regarding donor advice is tax. under current law, donors receive a tax deduction for their contributions to a daf fund, which is a public charity, in the year in which those contributions are made.32 the deduction at that point is justified based on the argument that the donor has given up control; that the gift is complete.33 certainly, the funds cannot be regained by the donor, but in reality donors retain control regarding disposition.34 1. are dafs tax advantaged? one might infer that the receipt of a tax deduction at the time assets are contributed to a daf – versus at a later point when the assets are distributed to end-use charities – results in a tax advantage for daf donors.35 but this isn’t necessarily the case. indeed, as professor john brooks has shown, “for most donors most of the time, there is no substantial tax benefit to donating to a daf, and there may even be a tax cost.”36 brooks compares 1) donating to a daf today followed by distribution from the daf to a charity in one year to 2) retaining the asset for a year and then donating to charity.37 suppose first that the asset is cash, that the cash can be invested at a 10% rate, and that the donor faces a marginal tax rate of 40%. first, assume that the donor has $100 that she contributes to a daf. her immediate tax deduction provides a tax savings of $40. a year later, the daf can distribute $110 to charity, since returns within a daf are not taxed.38 and the donor’s tax savings grows to $42.40 after tax, assuming her 10% return is taxable as ordinary income. 30 fidelity 2022 report at 6. 31 as numerous commentators have pointed out, the daf sponsor market is competitive. if a sponsor failed to follow the disposition advice of account holders, those holders would likely move their accounts to another sponsor. brunson, supra note 17, at 259; colinvaux (2017), supra note 22, at 52; roger colinvaux, speeding up benefits to charity: donor advised fund and foundation reform, 63 b.c. l. rev. 2621, at 30 (2022); colinvaux & madoff (2019), supra note 18, at 1871; zelinsky, supra note 17, at 759; daniel j. hemel, joseph bankman & paul brest, are donor-advised funds good for the nonprofit sector?, 87 exempt org. tax rev. 287, at 288 (2021); brian galle, pay it forward? law and the problem of restricted spending philanthropy, 93 wash. u. l. rev. 1143, at 1150 (2016). 32 i.r.c. § 170. 33 colinvaux & madoff (2019), supra note 18, at 1870; colinvaux (2017), supra note 22, at 44. 34 colinvaux & madoff (2019), supra note 18, at 1870; colinvaux (2017), supra note 22, at 44. 35 the issue here is whether dafs produce better after-tax results than the alternative, a situation that i will refer to as a tax advantage in a conventional sense. daf accounts may also be treated more favorably than alternatives under various limitations on deductibility. these tax advantages are discussed infra. 36 brooks, supra note 22, at 1022. 37 brooks, supra note 22, at 1016. i have adjusted brooks’ hypotheticals slightly but not, i think, in any meaningful way. 38 i.r.c. § 501(c)(3). recall that the daf is a public charity. 8 columbia journal of tax law [vol: 14:1 if instead the donor holds the $100 cash for a year in an interest earning taxable account, the amount grows to $106 after tax. donation of $106 yields the donor tax savings of $42.40. so, in this hypothetical, the donor’s tax savings is unaffected by the use of a daf, but the charity receives $4 more (3.8%) if a daf is employed. the reason, of course, is that the investment earnings within the daf are not taxed. assuming that the donor cares about the net amount distributed to charity as well as her own tax position, the use of a daf in this hypothetical is tax advantaged. suppose, however, that the $100 asset consists of shares of a mutual fund that also grows at a 10% rate. immediate contribution to a daf produces the same result as above: $110 to charity in a year and $42.40 tax savings to the donor in a year assuming the earnings on her tax savings are taxed as ordinary income. but in this scenario, if the donor forgoes the daf, holds the shares for a year, and then contributes to charity, the unrealized appreciation of $10 on the shares will not be taxed.39 in a year, the charity will receive $110, and the donor will enjoy a tax savings of $44. in this scenario, there is a tax disadvantage to use of a daf.40 because the bulk of contributions to dafs consist of non-cash assets, brooks concludes that any daf tax advantage is likely to be minimal at best.41 brooks was writing in 2016. as depicted in figure 1 below, if fidelity charitable’s experience is typical, the daf contribution mix has continued to shift away from cash in favor of liquid securities over the past decade.42 the enactment of the tcja in 2017 had no visible impact on these trends, which are more likely to be driven by the extended bull market which resulted in more and more taxpayers holding appreciated securities, at least through 2021. in any event, brooks’ conclusion that dafs are not tax advantaged in this conventional sense seems likely to be even more true today. 39 as discussed infra section iii.e, the donor of market traded securities held for more than a year receives a full fair market value deduction and is not taxed on unrealized appreciation. 40 brooks, supra note 22, at 1016. 41 id. at 1014. 42 fidelity charitable, giving report 2022, at 5 (2022); fidelity charitable, giving report 2021, at 5 (2021); fidelity charitable, giving report 2020, at 5 (2020); fidelity charitable, giving report 2019, at 14 (2019); fidelity charitable, giving report 2018, at 12 (2018); fidelity charitable, giving report 2017, at 12 (2017); fidelity charitable, giving report 2016, at 12 (2016); fidelity charitable, giving report 2015, at 11 (2015); fidelity charitable, giving report 2014, at 9 (2014); fidelity charitable, giving report 2013, at 7 (2013). fidelity charitable is the largest daf sponsor accounting for about 15% of daf accounts. fidelity charitable, giving report 2020, at 8 (2021); nat’l philanthropic tr., 2020 donor-advised fund report 2020, at 16 (2020). 2023] donor advised funds 9 2. why else do donors create dafs? although dafs are not tax advantaged in terms of maximizing after-tax results, dafs do provide donors with tax and other benefits. from a tax perspective, dafs allow donors to accumulate assets leading towards a transformative contribution while avoiding annual limitations on deductions for charitable contributions.43 moving beyond tax, dafs facilitate the liquidation of complex assets that might be difficult for an end-use charity to manage if donated directly.44 dafs also facilitate the division of contributions of non-cash assets 43 generally, contributions by individuals to public charities within a tax year are not deductible beyond 60% of agi. i.r.c. § 170(b)(1)(g). suppose a taxpayer earning $1 million per year wished to make a $1 million gift to her alma mater. if made directly to the school in a single year, only $600,000 would be deductible. however, the taxpayer could donate to a daf, and fully deduct $500,000 for each of two years. at that point she could make the $1 million grant. the tax rules applied to dafs are much less onerous than those applied to private foundations. see, e.g., colinvaux , donor advised funds, supra note 21, at 52–53. for the middle to upper-middle income taxpayers who are the focus of this article, however, the most relevant comparison is likely to be between contributions to public charities with or without a daf intermediary. see brunson, supra note 18, at 258 (noting that given the administrative complexity of running a private foundation, these vehicles will only make sense for certain wealthy individuals who intend to contribute substantial sums to charity). 44 see, e.g., fidelity charitable, giving report 2022, at 19 (2022) (noting that fidelity charitable “facilitates contributions of … complex assets [that] can be complicated for individuals to give and for some nonprofits to accept”); schwab charitable, benefits of contributing non-cash assets (oct. 28, 2022), https://www.schwabcharitable.org/resource/benefits-contributing-non-cash-assets, 10 columbia journal of tax law [vol: 14:1 between multiple end-use charities.45 and dafs facilitate shifting philanthropy across time.46 the bunching motivation for daf creation that is discussed below is not entirely new. for example, prior to the tcja, donors nearing retirement and expecting to face a lower marginal tax rate in their retirement years might have pre-funded a daf with expected contributions for several years in order to take advantage of the larger tax subsidy associated with the higher marginal rate.47 of course, all of these benefits come at a cost. fidelity, vanguard, and schwab each charge daf account holders annual administrative fees that run as high as 0.6% of assets under management in addition to investment fees.48 b. the tcja and subsidies for charitable giving the tcja had a dramatic impact on tax subsidies for charitable giving. with a small exception for tax years 2020 and 2021, the deduction for charitable contributions is an itemized deduction.49 in 2016 and 2017, prior to the advent of the tcja, 30% of u.s. taxpayers itemized deductions, and 25% of taxpayers claimed the itemized deduction for charitable contributions.50 in 2018 and 2019, following the tcja, those numbers were reduced to 11% and 9%, respectively.51 in other words, the fraction of u.s. taxpayers claiming the deduction for charitable contributions declined by about two-thirds. three tcja changes primarily drove this result. first, the tcja increased the standard deduction for married couples filing jointly from $12,700 in 2017 to $24,000 in 2018.52 (with inflation adjustments, the figure for 2021 was $25,100.53) second, the aggregate deduction for state and local taxes, including income, sales, and real estate taxes (often referred to as the “salt” deduction), was capped at a non-inflation [https://perma.cc/ju6c-dek6] (noting that “not all charities have the capabilities to accept” appreciated non-cash assets). 45 hemel, bankman & brest, supra note 31, at 3-4. 46id. at 3. 47 james andreoni, the benefits and costs of donor-advised funds, 32 tax pol’y & econ. 1, 13 (2018). 48 fidelity charitable, what it costs, https://www.fidelitycharitable.org/givingaccount/what-itcosts.html#:~:text=each%20individual%20giving%20account%c2%ae,of%20any%20donor%2 dadvised%20fund, [https://perma.cc/9jth-gpr5] (last visited mar. 9, 2023); vanguard charitable, fees & minimums, https://www.vanguardcharitable.org/giving-with-vc/fees-andminimums#:~:text=standard%20account%20status%20applies%20to,those%20assets%20over%2 0%24500k, [https://perma.cc/bhl4-ma5g] (last visited mar. 9, 2023); schwab charitable, account fees and minimums, https://www.schwabcharitable.org/features/fees-and-minimums, [https://perma.cc/h88d-4smk] (last visited mar. 9, 2023). 49 i.r.c. § 170(p) (allowing nonitemizers a maximum deduction for cash contributions of $300 for single taxpayers or $600 for married couples filing jointly). 50 u.s. dep’t of treasury, i.r.s., statistics of income – 2019 individual income tax returns, publication 1304 (rev. 09-2020), at 23 (2019). these figures represent averages for the two years. 51 id. 52 rev. proc. 2016-55, 2016-45 i.r.b. 707 (2016); rev. proc. 2018-18, 2018-10 i.r.b. 392 (2018). 53 rev. proc. 2020-45, 2020-46 i.r.b. 1016 (2020). 2023] donor advised funds 11 adjusted $10,000.54 third, the tcja suspended miscellaneous itemized deductions.55 historically, the four most economically significant itemized deductions have been the deductions for state and local taxes, interest paid (chiefly home mortgage and home equity interest), charitable contributions, and miscellaneous itemized deductions.56 given the tcja’s disallowance of miscellaneous itemized deductions, a taxpayer without less commonly claimed itemized deductions, for example, medical expenses or casualty losses arising from federally declared disasters,57 would need deductible interest expense and charitable contributions in excess of about $15,000 to itemize post-tcja. apparently, two-thirds of those itemizing prior to the tcja did not. a second subsidy for charitable giving was unaffected by the tcja. as noted above, donors of appreciated property are entitled to a deduction equal to fair market value but in many cases are not taxed on the unrealized appreciation.58 this rule applies to all contributions of market quoted securities held for more than a year and many gifts of other property held for more than a year.59 the subsidy is a function of the tax rate on long term capital gains, which was not adjusted by the tcja.60 c. bunching philanthropy post-tcja given these changes, some taxpayers can reduce their post-tcja tax bills substantially by bunching their charitable contributions, with or without a daf account. bunching will most often be attractive to married taxpayers of moderate to moderately high income, but less likely attractive for singles, lower income married taxpayers, or the very affluent. consider the following examples: 1. alex and blair are married taxpayers filing jointly with agi of $150,000. they are entitled to the maximum salt deduction of $10,000, pay 54 i.r.c. § 164(b). as with most other tcja adjustments, this limitation is scheduled to disappear at the end of 2025. 55 i.r.c. § 67(g). this limitation is scheduled to disappear at the end of 2025. 56 scott greenberg, the most popular itemized deductions, tax found., (feb. 29, 2016), https://taxfoundation.org/most-popular-itemizeddeductions/#:~:text=the%20most%20popular%20itemized%20deduction,to%20state%20and%20 local%20governments, [https://perma.cc/pq3t-llfc]. 57 these deductions are less economically significant because the code places floors on otherwise deductible expenses in these two categories. medical and dental expenses are deductible in excess of 7.5% of agi. i.r.c. § 213(a). casualty losses arising from federally declared disasters are deductible in excess of 10% of agi. i.r.c. § 165(h). 58 i.r.c. § 170(e). 59 i.r.c. § 170(e)(1). the rules are complex but, inter alia, the deduction for contributions of long term gain property is limited to basis for contributions to private foundations that do not consist of marketable securities, for contributions of tangible personal property if the use by the donee is unrelated to the donee’s charitable purpose or, in some cases, the property is not retained by the donee, for certain ip contributions, and for most contributions of taxidermy property. 60 the top tax rate on long term capital gains and qualified dividends is currently 23.8% consisting of a 20% rate under i.r.c. § 1(h) and an additional 3.8% rate on the net investment income of higher income taxpayers under § 1411. the additional tax on net investment income was enacted as part of the affordable care act. 12 columbia journal of tax law [vol: 14:1 home mortgage interest of $5,000, and give $5000 each year to public charities, yielding total itemized deductions of $20,000.61 for 2021, their standard deduction is $25,100, which, of course, they take, and the upshot is that alex and blair receive no tax benefit for their charitable contributions (or any of their other itemized deductions). but suppose that alex and blair have sufficient resources to bunch their charitable contributions. suppose they contribute $15,000 to a daf in year one and make no other charitable contributions for the next two years, instead drawing down their daf account to distribute funds to various charities. absent this plan (and rounding the standard deduction to $25,000 for marrieds filing jointly), alex and blair would have total below-the-line deductions of $75,000 for three years. with bunching they will take itemized deductions of $30,000 in year one ($10,000 salt, $5,000 interest, and $15,000 charity), and the $25,000 standard deduction in years two and three, for a threeyear total below-the-line deduction of $80,000, an increase of $5,000. 2. colby and dana are married taxpayers filing jointly with agi of $750,000. they are entitled to deduct $10,000 of their $15,000 salt expenses, but having paid off their mortgage, their only other itemized deduction is for charitable contributions. they typically give $20,000 to charities each year.62 absent bunching, colby and dana would take total itemized deductions of $30,000 each year, or $90,000 for three years. if instead they have the resources to bunch three years of charity into a year one daf contribution of $60,000, their three-year total below-the-line deduction will be $120,000 ($70,000 in year one; $25,000 in years two and three). 3. elaine is a single taxpayer entitled to the maximum salt deduction of $10,000 who pays $5000 annually in mortgage interest. because the total of these two deductions exceeds her 2021 standard deduction of $12,550, bunching charitable contributions will not reduce her tax bill. note that for the married couples in these examples the bunching opportunity is the direct result of the tcja. in 2017, the year prior to the tcja’s changes, the standard deduction for married couples filing jointly was $12,700 and there was no cap on salt deductions. under the assumptions described above, bunching charitable contributions would not have affected either couple’s total aggregate below-the-line deductions prior to the tcja because each couple would have itemized deductions each year, with or without bunching. as these examples suggest, taxpayers need not be in the upper 1% of the income distribution to take advantage of bunching, and bunching can be attractive even if taxpayers are already itemizing post-tcja without bunching. the real advantage to bunching is shifting deductions so as to maximize them in some 61 for 2016, the average deduction for charitable contributions for itemizing taxpayers with agi between $100,000 $200,000 was about $4,300. u.s. dep’t of treasury, i.r.s. statistics of income – 2016 individual income tax returns, publication 1304, table 2.1 (2016). 62 for 2016, the average deduction for charitable contributions for itemizing taxpayers with agi between $500,000 $1,000,000 was about $19,000. u.s. dep’t of treasury, i.r.s., statistics of income – 2016 individual income tax returns, publication 1304, table 2.1, (2016). 2023] donor advised funds 13 years and minimize them in other years when the taxpayers can take advantage of the tcja enhanced standard deduction. and this explains why singles are less likely to be in a position to take advantage of bunching than married couples. because the standard deduction for singles is one-half that for marrieds but singles face the same $10,000 cap on salt deduction under the tcja, it is more likely that the total of salt and interest deductions for singles will exceed the standard deduction, eliminating the advantage to bunching charitable contributions.63 similarly, for very affluent married couples, it is more likely that their interest deduction alone will fill the gap between the standard deduction and the $10,000 salt limitation, again leaving no scope for advantageously bunching contributions.64 and, of course, for very affluent taxpayers, the opportunity to bunch contributions and increase deductions by $10,000 to $15,000 per year would be relatively insignificant. it is important to emphasize that taxpayers do not need a daf in order to achieve the tax savings from bunching philanthropy. taxpayers could simply make larger charitable gifts every third year, for example. what a daf achieves for bunchers is the ability to garner the tax advantages of bunching while maintaining ratable contributions to end-use charities, which is often important for donors who want to provide sustained annual support.65 63 as a result of these differences in tax treatment, for tax year 2019, 45% of single taxpayers with agi between $100,000 and $200,000 itemized deductions, while only 19% of married couples in this income range did so. u.s. dep’t of treasury, i.r.s., statistics of income – 2019 individual income tax returns, publication 1304, table 1.2, (2019). 64 to provide some context, the average itemizing taxpayer in the $500,000 to $1,000,000 agi range deducted $21,000 in interest expense in 2019. u.s. dep’t of treasury, i.r.s., statistics of income – 2019 individual income tax returns, publication 1304, table 2.1, (2019). 65 see fidelity charitable, tax strategies for charitable giving, “bunching” contributions to reach tax savings, https://www.fidelitycharitable.org/content/dam/fcpublic/docs/advisors/bunching-contributions-to-reach-tax-savings.pdf, [https://perma.cc/ag3wuvqw] (noting that “[m]any taxpayers want to continue supporting their favorite charities with regular contributions, and a donor-advised fund makes that possible for taxpayers who use the ‘bunching’ strategy to maximize their tax savings”); [perma.cc/7cru-ve28]; jeff zysik, the bunching strategy for charitable giving, donorstrust, (mar. 17, 2022), https://www.donorstrust.org/donor-advised-funds/the-bunching-strategy-for-charitable-giving/, [https://perma.cc/58dc-7mkn] (“if your bunched contribution is to a [daf] account… you can continue to provide the same dollar level of support to your favorite organizations on an annual basis so the use of the bunching strategy won’t impact your giving pattern.”). given a large pool of donors, it is not obvious from a financing perspective why ratable annual contributions to a charity would be superior to a series of lumpy gifts. however, charities generally act as if ratable giving matters, focusing on participation targets and providing recognition of donors participating within the annual cycle. see, e.g., james m. greenfield, fundraising fundamentals: a guide to annual giving for professionals and volunteers 17, (2nd ed. 2002) (observing that “annual giving is … a means to expand the involvement and participation of current donors” and “offers opportunities for donors to become active as volunteers and to exercise leadership”). regular recognition is likely to be an important factor in donor and donee preferences for ratable giving. see anya savikhin samek & roman m. sheremeta, visibility of contributors and cost of information: an experiment on public goods 2, (may 6, 2013) (working paper) (noting that “it has been generally acknowledged that recognizing contributors by revealing their identity increases contributions”). 14 columbia journal of tax law [vol: 14:1 ii. trends in daf accounts the national philanthropic trust has been collecting data on donoradvised funds since 2007.66 the number of accounts climbed fairly steadily through the first half of the previous decade, but, as portrayed in figure 2 below, the growth rate of accounts hit an inflection point (in the colloquial sense) starting in 2017, with the number of accounts more than doubling in two years and more than tripling in four years.67 although the tcja’s changes to the standard deduction and the salt deduction did not take effect until 2018, and the legislation was not signed by trump until late december 2017, it defies logic to think that the spike in daf accounts starting in 2017 was not related to the tcja. work on the legislation began in july 2017, and presumably taxpayers paying attention would have seen these changes coming. moreover, this pattern of taxpayer response kicking in prior to the year in which new tax rules take effect is consistent with a somewhat similar earlier episode. the affordable care act, signed in 2010, included an increase in the top tax rate on long term capital gains from 15% to 23.8% beginning in 2013.68 since dafs can help taxpayers avoid tax on the unrealized 66 nat’l philanthropic tr., 2021 donor-advised fund report, at 6 (2021). 67 id. at 22-30 (2021); nat’l philanthropic tr., 2016 donor-advised fund report, at 6 (2016); nat’l philanthropic tr., 2014 donor-advised fund report, at 5 (2014). 68 andreoni, supra note 47, at 34. 2023] donor advised funds 15 appreciation on gifted property, this means that dafs should have become more attractive beginning in 2013. but as professor james andreoni demonstrates, the rate of growth of daf accounts rose sharply beginning in 2012, the year before the tax rate increases took effect.69 unlike that earlier episode, however, the tcja did not impact the rate of tax on long term capital gains, so the surge in daf accounts cannot be explained on the basis of a greater incentive post-tcja to avoid tax on gifts of appreciated property.70 another possible explanation for the surge in daf accounts might be a surge in capital gains realizations, but a glance at the s&p 500 index across this period does not support that supposition.71 the year 2017 fell in the middle of a sustained bull run; there was nothing special going on in the market. all of this leads me to conclude that the likely explanation for the surge in daf accounts beginning in 2017 was the tcja’s introduction of a significant incentive to bunch charitable contributions.72 although critics have decried the recent growth in assets tied up in dafs,73 the growth in total daf assets only ticked up slightly in the wake of the tcja despite the massive surge in accounts, or, put another way, the size of the average daf account plummeted following enactment of the tcja. these patterns are exhibited in the following figures.74 69 andreoni, supra note 47, at 35. the earlier inflection point is obscured in the figure given the magnitude of the later one, but the number of accounts grew by about 7% between 2011 and 2012 after 2% to 4% annual growth over the three prior years. 2014 donor-advised fund report, supra note 67, at 5. 70 the top effective rate on long term capital gains was 23.8% before and after the enactment of the tcja. supra note 60. 71 macrotrends, s&p 500 10 year daily chart, https://www.macrotrends.net/2488/sp500-10-year-daily-chart, [perma.cc/h42a-gybg]. 72 the surge was undoubtedly assisted by the marketing efforts of daf sponsors, such as fidelity charitable, that explained the tax benefits of bunching post-tcja. see, e.g., fidelity charitable, tax strategies for charitable giving, “bunching” contributions to reach tax savings, supra note 65 (explaining how daf-facilitated bunching can restore tax deductions for charitable contributions post-tcja); donorstrust, the bunching strategy for charitable giving, supra note 65; see also slate, the disrupter, how fidelity and its donor-advised fund are shaking up charitable giving for the better; https://slate.com/business/2018/05/fidelitysdonor-advised-fund-is-shaking-up-charitable-giving.html, [perma.cc/h42a-gybg] (discussing fidelity’s creation of its fidelity charitable university to educate financial advisors on the benefits of dafs, presumably as a way of attracting new accounts). 73 see, e.g., colinvaux (2022), supra note 31, at 22, 58. 74 2021 donor-advised fund report, supra note 1, at 16.; 2016 donor-advised fund report, supra note 67, at 5.; 2014 donor-advised fund report, supra note 67, at 6. https://perma.cc/h42a-gybg 16 columbia journal of tax law [vol: 14:1 these trends are, i believe, consistent with the idea that well off, but not super-rich taxpayers have opened daf accounts following the tcja to bunch 2023] donor advised funds 17 their contributions and take advantage of the tcja’s expanded standard deduction. evaluating data for the period prior to the tcja, andreoni estimated (roughly) that the average daf holder had income of $1.4 to $2.2 million, and perhaps much more.75 the post-tcja data suggests that the taxpayers opening daf accounts in the wake of the tcja are in a different league financially than those who preceded them.76 certainly, their accounts are of a different magnitude. this supposition is buttressed by data from the national philanthropic trust indicating that the average daf account at “national charities,” e.g., fidelity, vanguard, etc., dropped from $269,206 in 2016 to $115,901 in 2020.77 and even these averages are skewed upwards by a few very large accounts. for example, fidelity reports that the median daf account balance at that institution was only $24,000 in 2021.78 iii. daf policy issues and responses – the impact of bunching assuming that a sizable portion of recent daf activity is principally motivated by bunching, how does that circumstance affect the way we should view dafs from a policy perspective? this part considers this question along a number of dimensions, but its principal argument is that, with respect to bunching-motivated daf account holders, concerns regarding unproductive asset accumulation within daf accounts are likely overblown and perhaps inapposite. the larger policy concern for this population of account holders should be the cost imposed on the public fisc by taxpayers exploiting the expanded standard deduction, a cost that is unlikely to be justified by the minimal increase in incentives for charitable giving that some dafs create. a. asset accumulation inside dafs perhaps the most common concerns about dafs are that they accumulate assets that otherwise would go to end-use charities and that this accumulation is growing.79 critics have proposed several reforms that would encourage speedier 75 andreoni, supra note 47, at 7. 76 see also ruth mccambridge & patrick m. rooney, did the tax overhaul create a spike in donor-advised funds? well, it’s complicated…, nonprofit quarterly (feb. 7, 2018), https://nonprofitquarterly.org/tax-overhaul-donor-advised-funds-spike-daf/ (citing daf sponsors who observed a shift in the market for dafs post-tcja driven by middle income taxpayers who see the benefit of bunching contributions). 77 nat’l philanthropic tr., 2021 donor-advised fund report, at 23 (2021). 78 fidelity, 2022 report at 8 (2022). 79 roger colinvaux, fixing philanthropy: a vision for charitable giving and reform, 162 tax notes 1007, 1010 (2019) (arguing that “there is reason to be concerned that the institutional default of the daf industry is toward accumulating, not spending” and that “there is a social cost to the delay because that money cannot be put to active use”); andreoni, supra note 47, at 39 (arguing unspent balances in daf accounts represent lost tax revenues that are not offset by “gains to society through charitable giving”). https://nonprofitquarterly.org/tax-overhaul-donor-advised-funds-spike-daf/ 18 columbia journal of tax law [vol: 14:1 disbursement.80 this section reconsiders the accumulation issue in the context of bunching motivated daf account holders, arguing that the idea that end-use charities are missing out on assets accumulated in dafs may be inapposite in this context. professor roger colinvaux has stressed the problem of growing accumulation of assets in daf accounts, noting that “dafs controlled $32 billion in 2007, $70 billion in 2014, $142 billion in 2019, and $160 billion in 2020.”81 as colinvaux argues, “viewed as public charity substitutes, contributions to [dafs] represent a delay to charity, pure and simple.”82 but is it so simple? even setting aside arguments about the merits of philanthropy directed towards future versus current generations, investment gains on daf balances, etc., it is not so clear that these accumulations are problematic for bunching motivated daf holders.83 first, return to figures 2 to 4 above. daf assets are growing primarily because so many more taxpayers are taking advantage of the opportunity. in fact, average account levels are falling, not rising, despite the existence of a sustained bull market in the 2010s that boosted most investment portfolios. the fact that 13% of charitable dollars are funneled through dafs today,84 or perhaps 33% tomorrow, should not be terribly worrying in steady state, if dafs are otherwise acceptable as a policy matter. in other words, it is not the size of the conduit or the number of taxpayers taking advantage of it that should matter. the question is whether dafs advance or retard our tax policy goals. second, it seems probable that tcja-motivated bunchers are less likely than some other daf holders to allow assets to rest in dafs indefinitely. the whole idea here is that bunchers actively manage their daf contributions and disbursements over the years to minimize tax given the tcja’s enhanced standard deduction and limit on salt deductions. this is an ongoing process, a repeat game. as discussed below, tax savings are maximized by increasing the number of years between bunched contributions to a daf, but doing so is limited 80 these reforms are discussed infra. 81 colinvaux (2022), supra note 31, at 22. 82 colinvaux (2017), supra note 22, at 58. 83 as professor brunson explains, if we should take future generations into account in our current decision-making-and especially if they count equally to current generations-the idea of preferring current charitable distributions may lose some of its power. that is especially the case if the private foundation or donor-advised fund that holds charitable dollars instead of distributing them earns a high enough return on those assets. provided that the discount rate applied to the future charitable donation is equal to the market rate of return a foundation or donor-advised fund can earn on the money, society should be indifferent as to whether charitable expenditures occur today or in the future (citations omitted). see brunson, supra note 17, at 264. but see galle, supra note 31, at 1159 (arguing that “shortterm spending can have long-lasting impact, that future charitable spending is likely to be less valuable because the growing philanthropic sector will have to turn to lower priority projects, and that spreading spending out over time introduces several different forms of agency and information costs”). 84 colinvaux (2022), supra note 31, at 7 (citing nat’l philanthropic tr., 2020 donoradvised fund report (2020)). 2023] donor advised funds 19 by a taxpayer’s liquid resources available to bunch and perhaps by concerns that the rules of the game may change at any time.85 compare a recent retiree who pre-funded her daf account with all the assets she plans to disburse during retirement. this individual is also tax motivated, but for her it is not a repeat game, and not knowing how long her retirement may last, she might be tempted to hang on to these daf dollars indefinitely. or consider the wealthy taxpayer who has decided to contribute a complex asset – say a piece of real estate or a partnership interest – to a daf. that individual might be motivated by the convenience of letting the daf sponsor handle the liquidation, or perhaps the prospect of a favorable valuation. once the asset is liquidated, however, this individual might or might not want to speedily disburse the funds. third and finally, it is not clear that we should even think of contributions to dafs as delays of charity, at least for bunchers. absent dafs, bunchers would have two options.86 they could make ratable contributions to end-use charities and leave tax dollars on the table, or they could accumulate assets in a taxable account at a financial institution and make bunched contributions to various charities every three or four years, for example. to the extent that bunchers would follow the second path in order to minimize their taxes, amounts accumulating in dafs are not dollars that would be in the hands of end-use charities but for daf contributions.87 b. the cost of bunching to the public fisc the larger public policy concern raised by bunching-motivated daf account holders should be the cost to the public fisc of taxpayers exploiting the tcja enhanced standard deduction; a cost that may or may not be offset in part by the creation of greater incentives to contribute to charity.88 consider again the case of colby and dana, a married couple filing jointly who take the maximum $10,000 salt deduction and give $20,000 to charity each year, on average.89 as shown above, bunching three years of charity into a single year $60,000 daf contribution increases their three-year total below-the-line deductions from $90,000 to about $120,000, or by about $10,000 a year.90 at a 37% marginal tax 85 infra. 86 setting aside the private foundation option, which does not seem realistic for the merely affluent bunching population. supra. 87 bunching donations outside of dafs might be inconvenient for the reasons discussed in part i.c., but the tax dollars at stake are considerable and would likely offset that inconvenience for some taxpayers. 88 another offset to the cost to the public fisc of bunching-motivated dafs that i will not explore in this article might be the fact that dafs commit donors to part with assets in favor of charitable institutions, which could lead to greater total contributions. compared with holding assets for later contribution to an operating charity, the contribution of assets to a daf eliminates the option to change one’s mind and deploy those assets in a different direction, e.g., consumption. i thank gregg polsky for this observation. 89 in the hypothetical, these are colby and dana’s only itemized deductions. 90 for comparison, the average taxpayer in colby and dana’s agi range ($500,000 $1,000,000) reported total itemized deductions of about $60,000 in 2019. see internal revenue service, individual complete report (publication 1304), tbl 2.1, (2019) [hereinafter irs soi]. 20 columbia journal of tax law [vol: 14:1 rate, they save $3,700 per year in federal income tax. assuming that congress did not intend or foresee high income taxpayers like colby and dana taking advantage of the tcja-expanded standard deduction, it seems reasonable to treat colby and dana’s tax savings as a cost to the fisc. more generally, in cases in which taxpayers would itemize each year with ratable charitable contributions and without a daf, the annualized cost of bunching is equal to the difference between the standard deduction and other itemized deductions, multiplied by the number of years in the bunching cycle minus one, divided by the number of years in the bunching cycle, multiplied by the marginal tax rate.91 the benefit of bunching and the cost to the fisc increases with the number of years between bunched contributions and decreases with the amount of a taxpayer’s itemized deductions other than charitable contributions. the cost of bunching to the fisc is less in cases like that of alex and blair who would not itemize absent bunching and is zero in a case like that of elaine, the single taxpayer who receives no benefit from bunching. presumably, the universe of bunching-motivated daf account holders is made up largely of taxpayers in colby and dana’s situation, who see the greatest bunching benefit. other taxpayers may open dafs, but likely for reasons unrelated or less related to bunching. bunching likely represents a significant cost to the public fisc. suppose, for example, that half of all daf account holders are married couples filing jointly who engage in bunching and, like colby and dana, would itemize each year with or without bunching. suppose that, on average, their non-charity itemized deductions are $15,000 per year, they bunch every three years, and they face a marginal tax rate of 35%. this yields a ballpark estimate of a $1.2 billion annual cost to the public fisc. c. incentive effects of dafs if the cost to the fisc of bunching-motivated dafs is offset by increased charitable giving, we might feel more charitably, so to speak, about the trade-off. unfortunately, the incentive effects are likely to be modest. for taxpayers in the position of alex and blair, bunching, facilitated by a daf, creates a tax subsidy for charitable giving that would not exist absent bunching. this is a benefit that i believe is unique to daf accounts that are created to facilitate bunching. compare, for example, a daf account that serves primarily to liquidate complex assets held by a high-income taxpayer who itemizes every year with or without bunching contributions. this taxpayer’s marginal incentive to contribute is unaffected by the creation of a daf. however, while only bunching-motivated dafs generate a tax incentive; not all bunching motivated accounts do so. recall the case of colby and dana. with the maximum salt deduction of $10,000 and charitable contributions of $20,000 per year, colby and dana itemize with or without bunching. daf 91 for colby and dana (and rounding the standard deduction) this equation is (25,000 – 10,000) x 2/3 x .37 = $3700. 2023] donor advised funds 21 facilitated bunching allows the couple to reduce their tax bill, but the subsidy on their marginal contribution dollar is unaffected by bunching. in their hypothetical, the cost of daf-facilitated bunching to the public fisc $30,000 less taxable income reported over three years – is not offset by enhanced philanthropic incentives. for colby and dana, dafs likely do nothing to spur greater charitable giving.92 for alex and blair, there is a follow-up question: to what extent do taxpayers respond to tax subsidies for giving? the literature on this question is inconclusive. we know that the average individual responds to tax subsidies for charitable giving, but it is very uncertain how strong that response is.93 some studies indicate that higher income individuals are more responsive to tax subsidies for charitable giving than are lower income individuals.94 to the extent that daf-facilitated bunching extends tax subsidies for charitable giving to middle or upper-middle income taxpayers, it is possible that the response is modest. given the likelihood that many bunching-motivated daf holders will be in the position of colby and dana whose after-tax cost of giving is unaffected by the daf and others in the position of alex and blair whose after-tax cost is affected but perhaps with little response, it is hard to be sanguine about the cost/benefit tradeoff of bunching-motivated dafs. d. expanding the reach of the deduction for individual philanthropy there is a related but equally modest benefit of bunching-motivated dafs. by facilitating bunching, donor-advised funds slightly expand the effective reach of the deduction and the tax incentive for individual philanthropy beyond the population that would itemize in the absence of dafs, and perhaps in a slightly more progressive manner. 92 to be more precise, in this situation bunching does not affect the after-tax cost of the marginal contribution. but there could be an income effect. it is possible that colby and dana might contribute part of their tax savings to charity. some daf sponsors highlight this possibility. see, e.g., fidelity charitable, tax strategies for charitable giving, “bunching” contributions to reach tax savings, supra note 65, at 2 (explaining the tax advantages of bunching charitable contributions with a daf and stating that the use of this strategy “maximize[s] your charitable giving – both for yourself and the charities you love”). 93 nicolas j. duquette, do tax incentives affect charitable contributions? evidence from public charities’ reported revenues, 137 j. public econ. 51 (2016) (noting that “a consensus has emerged that the elasticity of charitable giving with respect to its tax cost is about – 1” but that “there is wide disagreement around this consensus” and citing an earlier meta-analysis of 70 studies estimating the elasticity from zero to -7); c. eugene steuerle et al, tax pol’y ctr., urban inst. and brookings inst., designing an effective and more universal charitable deduction 4, (2021) (noting that earlier studies tended to find greater elasticities than later studies that have focused on long-run effects). 94 jon bakija, tax policy and philanthropy: a primer on the empirical evidence for the united states and its implications, 80 social res. 557, 558 (2013) (noting that “several types of evidence … suggest that the donation behavior of high-income people in particular is probably responsive to tax incentives); steuerle et al (2021), supra note 93, at 4 (noting that “some studies … found that high-income taxpayers are more responsive to the [tax] incentive’). 22 columbia journal of tax law [vol: 14:1 as noted above, in the wake of the tcja, the fraction of households taking itemized deductions for philanthropy fell from about 25% to about 9%. several commentators have recognized and criticized this change. in testimony before the senate finance committee, economist eugene steuerle urged congress to think about designing tax subsidies for philanthropy in terms of, inter alia, value promotion, arguing that “a deduction for only a few taxpayers weakly promotes and markets the value our society places on charitable giving.”95 similarly, professors roger colinvaux and ray madoff argue that a “goal of charitable tax incentives is to foster a strong culture of giving in america” and that “if only a few voices are encouraged to support the charitable sector, charities will have to cater to a narrow set of interests and lose a main source of strength and legitimacy – widespread public support.”96 in this light, reconsider the hypothetical case of alex and blair above. daf-facilitated bunching provides them with an effective deduction for charitable giving and an incentive that would not exist without bunching. and as this example also illustrates, taxpayers do not have to have very high incomes or hold a large amount of assets in order to generate an effective deduction and subsidy through bunching charitable contributions. as noted above, fidelity reports that the median daf account balance in 2021 was only $24,000. it seems likely that daf-facilitated bunching not only broadens the reach of philanthropic subsidies but does so in a somewhat more progressive fashion. however, while the potential for dafs to expand the reach of philanthropic subsidies may be significant, current use is relatively modest. even if every new daf account opened since 2016 created an effective deduction and incentive for charitable giving, which is certainly not the case, these roughly 700,000 accounts would represent less than one-half of a percentage point bump in the fraction of taxpayers receiving such subsidies.97 e. facilitation of donation of appreciated assets critics complain that dafs facilitate the contribution of appreciated assets, and, in particular, illiquid, complex assets lacking transparent valuation. indeed, daf sponsors fidelity charitable, vanguard charitable, and schwab charitable market their ability to liquidate complex assets and highlight the tax advantage of contributing appreciated assets.98 there are a number of issues here, 95 options for improving the lives of charitable beneficiaries through reform of the charitable deduction: hearing before the s. comm. on fin., 117th cong. 3 (2022) (testimony of c. eugene steuerle, cofounder, urban brookings tax policy center). 96 colinvaux & madoff (2019), supra note 18, at 1868. 97 based on 158 million taxpayers in 2019. irs soi, supra note 90, at 6 tbl.a. since the stakes are greater for higher income taxpayers who already itemize, like colby and dana, and because these taxpayers would tend to have greater assets to bunch, it seems likely that these cases would dominate among bunching-motivated daf creators. 98 see, e.g., schwab charitable, benefits of donating appreciated non-cash assets to charity, supra note 44, (noting that “while appreciated non-cash assets are the most tax-smart charitable gifts [dafs] have the resources and expertise for evaluating, processing, and liquidating the assets”). see also, vanguard charitable, complex assets, 2023] donor advised funds 23 but little that is particular to bunchers. since illiquid assets are likely to be lumpy to begin with, one would expect that bunching-motivated donors would be somewhat less likely to contribute such assets, but this supposition is not borne out by the data. this subsection briefly explores these issues. the contribution of appreciated assets to public charities under current law is problematic for two reasons. first, as professor daniel halperin has argued, whatever one thinks of the merits of the basic subsidy for charitable contributions – the tax deduction – the additional subsidy arising from the failure to tax unrealized gains on contributed property is extremely hard to justify. it is certainly inequitable, and it is unlikely to be the most efficient way of subsidizing charitable giving.99 second, contributions of illiquid assets – real estate, ownership interests in private companies, etc. – raise valuation problems.100 generally, the deduction for such contributions is based on fair market value at the time of the contribution, in many cases derived from an appraisal, not the value ultimately enjoyed by the charity.101 these problems exist, of course, with or without dafs, but dafs clearly facilitate the contribution of such assets and in that way contribute to these problems. but do tcja-motivated bunchers contribute to these problems equally with other daf account holders? my intuition was that bunchers would be equally likely to contribute liquid appreciated assets but less likely to contribute complex assets, but the data thus far fails to bear this out. the reasoning regarding complex, illiquid assets is as follows. these assets are typically “lumpy” to begin with; they are pre-bunched. the advantage of running such assets through a daf has to do with valuation and convenience, not with bunching. in other words, the tcja’s expansion of the standard deduction and limit on salt deductions seem unlikely to change the calculus of the holder of complex assets who contemplates their donation with or without a daf. a buncher, on the other hand, has discovered the opportunity created by the tcja-enhanced standard deduction and is looking for assets to bunch. of course, in some cases a complex asset might be at hand, but this would seem to be rare and serendipitous. absent this, a buncher would look at her portfolio and, like any other charitably minded donor, lean towards contributing appreciated securities, if she holds any. as noted, however, the data on sources of daf contributions from fidelity charitable does not bear this out. if my suppositions were right, one would expect the fraction of illiquid asset contributions to dip with the influx of bunchers post-tcja, but this has not happened. https://www.vanguardcharitable.org/index.php/giving-with-vc/how-itworks/contributions/complex-assets, [https://perma.cc/l2rm-t8ht]; fidelity 2022 report. 99 see halperin, supra note 14, at 36. 100 to be sure, given the limitations of irc § 170(e), the universe of non-cash property contributed to dafs is generally limited to real estate and intangibles such as securities. supra note 60. 101 vehicle donations represent a notable exception to this rule. per irc § 170(f)(12), the deduction for contributions of a vehicle generally is limited to the proceeds received by the donee on disposition of the vehicle. 24 columbia journal of tax law [vol: 14:1 iv. proposals for daf and more general philanthropic reform this part examines a selective set of reform proposals targeting dafs and individual philanthropy more generally, focusing on their impact on bunching motivated use of dafs and considering the impact of such dafs on the efficacy of these proposed reforms. i argue that 1) most reform proposals aimed at daf asset accumulation are unlikely to impact bunchers and certainly would not mitigate the cost that bunchers impose on the public fisc, 2) limiting the deduction for contributions of appreciated assets to basis would not vitiate daf use by bunchers, and 3) bunching of charitable contributions, via dafs or otherwise, would undermine the adoption of a universal above-the-line deduction for charitable contributions above a floor, absent additional restrictions. a. reforms targeting daf asset accumulation i have argued above that bunching-motivated daf account holders are less likely to accumulate assets in dafs indefinitely and that it may be inappropriate to think of their daf accumulated assets as representing a loss or opportunity cost to the real charitable sector. all that said, one must concede that current law provides no incentives for daf holders to disburse account funds at any time and that some carrot or stick would lead to speedier disbursement by some account holders, including some bunchers, which could at least potentially advance the public good. at least three reforms have been proposed. in 2021 senators king and grassley introduced the accelerating charitable efforts (ace) act.102 if enacted, the ace act would require disbursement of daf contributions and the earnings on those contributions within fifteen years for account holders who receive deductions at the time of contribution.103 the fifteen-year limit would be imposed by requiring the daf sponsor to revoke an account holder’s advisory privilege with respect to assets held beyond the fifteen year maximum.104 daf creators who were willing to forgo the tax deduction at the time of contribution would have 50 years to disburse funds before facing a confiscatory tax.105 another approach has been proposed by professor edward zelinsky. zelinsky would prefer to see daf accounts regulated like private foundations and subjected to the rule requiring private foundations to distribute a minimum of five percent of their assets to charity each year.106 finally, in 2019 colinvaux and madoff proposed deferring the income tax deduction for daf contributions until the funds are disbursed to an end-use charity.107 this approach not only creates a 102 ace act; see also, colinvaux (2022), supra note 31, at 3. 103 ace act, § 2(a). 104 id.. the act would also apply a tax on daf sponsors equal to 50% of any contributions that have not been disbursed at the end of the fifteen-year period. 105 ace act, § 3(a) (applying a tax equal to 50% of “nonqualified” daf contributions that have not been distributed at the end of the fifty-year period). 106 zelinsky (2021), supra note 17. 107 colinvaux & madoff (2019), supra note 18, at 1869. colinvaux and madoff were leaders of the coalition that designed and advanced the ace act, which offers a less aggressive 2023] donor advised funds 25 carrot for speedy disposition but also resolves the problem of valuing complex assets contributed to dafs. the deduction for such assets would be based on the cash that is ultimately distributed, not the fair value of the asset when donated to a daf. the first two proposals should have minimal impact on bunchers. although the tax savings from bunching increases with the number of years between bunched contributions, asset limitations (the liquid or illiquid assets available to bunch) and other concerns (possible changes in tax rates or rules) are likely to result in bunching cycles and payouts of daf assets that are far less than fifteen years. it is almost inconceivable that anyone motivated to create a daf account in order to take advantage of the tcja’s enhanced standard deduction would plan to bunch charitable gifts less frequently than this. and it follows that these proposals would not materially mitigate the cost that bunchers impose on the public fisc. in my hypotheticals, alex, blair, colby, and dana bunched their contributions every three years. if taxpayers were willing to bunch for fourteen years, just satisfying the king/grassley cut off, the cost to the fisc would be larger. on the other hand, deferring the tax deduction for daf dollars until disbursed, as colinvaux and madoff proposed in 2019, would completely defeat the goals of the bunchers and end the use of dafs for this purpose. under this proposal, daf holders could only achieve tax savings by bunching disbursements, and that they can easily do without a daf. there would be very little reason to pay fidelity, vanguard, or schwab 0.6% of assets each year for such a product. if one wants to kill dafs for bunchers, this is the way to do it. it is important to recall, however, that dafs only facilitate bunching. taxpayers could still take advantage of the tcja enhanced standard deduction by bunching charitable contributions to end-use charities without a daf conduit. b. limiting the deduction for contributions of appreciated property to basis charitable contributions of appreciated property can result in over-sized tax subsidies and, in some cases, questionable valuations. suppose that congress were to attack the problems associated with contributions (to dafs or otherwise) of appreciated property by adopting professor halperin’s proposal to limit the tax deduction for appreciated asset donations to the taxpayer’s basis.108 although such a reform would reduce the attractiveness of contributing appreciated property in some cases, it would by no means vitiate the use of dafs by bunchers. approach to regulating dafs. see about us, initiative to accelerate charitable giving, (it is not clear whether they continue to support their 2019 proposal, but either way, it remains a credible regulatory approach that bears consideration.). 108 as halperin suggests limiting the deduction to basis would generally result in taxpayers liquidating appreciated assets prior to donation in order to take advantage of the fact that long term capital gains are taxed at a lower rate than ordinary income. halperin, supra note 14, at 29. 26 columbia journal of tax law [vol: 14:1 obviously, such a reform would have no impact on taxpayers in the position of alex and blair or colby and dana if they hold no appreciated assets and simply bunch their cash donations. suppose, instead, that alex and blair have held appreciated stock for more than a year. hewing as close as possible to the example in part i.c, suppose that the stock’s fair market value is $15,000 and that their basis is zero (for simplicity). under current law, alex and blair could donate the entire $15,000 in year one giving them total itemized deductions of $30,000 in that year (given assumptions of a $10,000 salt deduction and a $5000 interest deduction) followed by two years taking a roughly $25,000 standard deduction.109 the result is three year below-the-line deductions totaling $80,000, which is $5000 better than contributing the stock ratably over three years (and taking the standard deduction each year). with the reform, however, alex and blair would be well advised to sell the stock, generating a $15,000 long term capital gain and a tax bill of $3,000 (at a simplified 20% rate), leaving them with $12,000 after tax. alex and blair are still better off from a tax perspective contributing the $12,000 in year one to a daf and nothing in years two and three than contributing $4,000 each year to a daf or to end-use charities.110 in other words, they are still better off bunching. the stakes are somewhat lower, but still significant. in the case of colby and dana, however, taxation of their investment gains does not reduce their incentive to bunch at all. suppose again that colby and dana have held appreciated stock for more than a year. suppose the stock’s fair market value is $60,000 and that their basis is zero. under current law, colby and dana could donate the entire $60,000 in year one, giving them total itemized deductions with their $10,000 salt deduction of $70,000 in that year followed by two years of taking a roughly $25,000 standard deduction. the result is a three year below-the-line total deduction of $120,000, which is $30,000 better than contributing the stock ratably over three years. with the reform, however, colby and dana will likely sell the stock, generating a $60,000 long term capital gain and a tax bill of $12,000 (at a simplified 20% rate), leaving them with $48,000 after tax. contributing a bunched $48,000 in year one to a daf and nothing in years two and three generates total three-year below-the-line deductions of $108,000. contributing a ratable $16,000 each year to a daf or to end-use charities yields three-year total btl deductions of $78,000. in this scenario, taxing investment gains on appreciated property contributions does not undermine the incentives to bunch donations. c. fundamental reform of philanthropic subsidies current tax subsidies for individual charitable giving are inequitable and inefficient. the below-the-line deduction for charitable contributions is currently 109 the earlier example assumed $10,000 salt and $5000 mortgage interest. 110bunching yields total three-year below-the-line deductions of $77,000; ratable contributions yield three year below-the-line deductions of $75,000. 2023] donor advised funds 27 available to only about 11% of taxpayers who itemize.111 while the recently adopted short-term deduction for charitable contributions by non-itemizers had much greater reach, the design – no floor; modest $300 or $600 cap – virtually ensured the deduction would spur little incremental giving but would be very costly to the fisc.112 this is not the place to undertake an exhaustive review of potential reforms of the tax treatment of individual philanthropy, but dafs would be problematic in the case of one long-standing and important reform proposal, which i highlight here. for over fifty years various commentators have proposed placing a floor on the deduction for charitable contributions that would be similar to the floor placed on deductions for medical expenses and casualty losses.113 some commentators would combine this reform with moving the deduction for charitable contributions above the line, making the deduction available to all taxpayers irrespective of itemization.114 one recent proponent of this idea is economist eugene steuerle. steuerle has argued that a universal (above-the-line) deduction for charitable contributions beyond a floor of, say, 1% to 2% of agi would be more equitable than current law and provide a greater incentive bang for our tax subsidy buck.115 the idea behind a floor is that most taxpayers give a certain amount to charity and would continue to do so irrespective of a tax incentive. allowing a deduction for the first dollar contributed is wasteful. it’s expensive and generates little or no behavioral change. applying the subsidy only to contributions in excess of, say, 1% or 2% of agi is much less expensive and encourages taxpayers to give more to charity than they might absent the incentive. steuerle and his co-authors show that the tradeoff between the costs and benefits of charitable subsidies are significantly improved by the introduction of such a floor.116 so where do dafs come in? suppose congress were to follow steuerle’s advice and adopt an above-the-line deduction for charitable contributions in excess of, say, 2% of agi. suppose a taxpayer with agi of $100,000 contributes $5000 to charity each year. with the floor, the taxpayer can deduct $3000 of charitable giving each year. but with a daf this taxpayer can do much better. 111 u.s. dep’t of treasury (2019), supra note 51. as colinvaux and madoff argue, “[i]f only a few voices are encouraged to support the charitable sector, charities will have to cater to a narrow set of interests and lose a main source of strength and legitimacy – widespread public support.” colinvaux & madoff (2019), supra note 18, at 1868. 112 steuerle (2022), supra note 95 at 5 (estimating that the “$300 per tax unit nonitemizer charitable deduction in 2020 provided charitable recipients with as little as $100 million at a cost of $1.5 billion in forgone federal revenue” because the deduction “created an incentive for almost no one”). the lack of a floor on the long standing below-the-line deduction is also a source of inefficiency. colinvaux & madoff (2019), supra note 18 at 1870. 113 see, e.g., stanley s. weithorn, “tax simplification” —grave threat to the charitable contribution deduction: the problem and a proposed solution, 1967 duke l.j. 943, 954 (1967); boris i. bittker, charitable contributions: tax deductions or matching grants?, 28 tax l. rev. 37, 63 (1972). 114 weithorn, supra note 113, at 954. 115 steuerle et al. (2021), supra note 93, at 1; steuerle (2022), supra note 95. see also colinvaux & madoff (2019), supra note 18, at 1869, 1870. 116 steuerle et al. (2021), supra note 93, at 10. 28 columbia journal of tax law [vol: 14:1 suppose she bunches three years of contribution into a year one daf contribution of $15,000 followed by no further daf contributions in years two and three. in year one, she can deduct $13,000, which is $4000 better than the aggregate threeyear deduction without bunching. clearly, under current rules dafs would provide an obvious way of avoiding much of the impact of a floor on the charitable contribution deduction. some reform would be needed to block the work-around. one possibility would be to follow colinvaux and madoff’s 2019 proposal and defer the charitable deduction until amounts are distributed from dafs.117 but this would not plug the loophole if taxpayers are willing to bunch disbursements to end-use charities.118 a more foolproof approach would be to maintain the floor but base the charitable deduction on average contributions (to dafs and other public charities) over a short period of years. the point here is that bunching would have to be addressed head on to fully achieve the aims of reforms along these lines. readers traveling this far will have no doubt realized that the tcja reforms that have been the focus of this article bear a resemblance to steuerle’s proposed floor on charitable contribution deductions. by increasing the standard deduction to about $25,000, capping salt deductions at $10,000, and disallowing miscellaneous itemized deductions, the tcja places a floor on the deduction for charitable contributions for most taxpayers at $15,000 less home mortgage interest and any other deductible personal interest expense.119 dafs allow taxpayers to avoid much of the impact of this floor, and this is exactly what colby and dana have done in the hypothetical discussed in part i.c above and why daf-facilitated bunching is costly to the public fisc. of course, there is a difference between the tcja charitable deduction floor and steuerle’s proposal. the latter is an intelligently designed policy intervention while the former is not. the tcja floor is inequitable – the floor is the same for taxpayers earning $100,000, $1,000,000, or $100,000,000 – and likely inefficient given that no thought was put into the tradeoff between the cost and efficacy of the subsidy. thus, one could rationally conclude that the use of dafs to facilitate bunching in the face of an unintentional tcja deduction floor is less objectionable than employing the same strategy to minimize the impact of a thoughtfully designed floor, but at one level they are the same. exploiting an agi-based floor on universal charitable deductions or the tcja enhanced standard deduction imposes costs on the public fisc – costs that are unlikely to be recouped through increased contributions. additional restrictions on deductions of contributions should be considered. 117 colinvaux & madoff (2019), supra note 18, at 1871. 118 it has long been recognized that the possibility of bunching charitable contributions undermines floors placed on their deduction. see, e.g., martin feldstein & amy taylor, the income tax and charitable contributions, 44 econometrica 1201, 1219-1220 (1976) (noting that comparison of placing a floor on the charitable contribution deduction to existing floors on deductions for medical expenses are “inappropriate because of the much greater ease with which charitable gifts can be postponed and ‘bunched’ to obtain the deduction”). 119 this assumes that most itemizers are entitled to the maximum $10,000 salt deduction. 2023] donor advised funds 29 v. conclusion the evidence suggests that bunching charitable contributions to more fully exploit the tcja-enhanced standard deduction motivates much of the onslaught of new daf accounts established since 2016. the article has argued that the typical buncher is likely to differ from other daf holders in ways that matter from a policy perspective. chiefly, in the context of bunchers, unproductive accumulation of assets in daf accounts is unlikely to be a major problem. the problem with daf-facilitated bunching is that the cost to the public fisc is unlikely to be justified by incremental charitable giving. thus, while i find the ace act’s regulation of daf payouts to be unobjectionable, this article argues that a wholly different set of reforms targeting the deductibility of charitable giving generally would be needed to address the cost of bunching under current law and under thoughtfully reformed laws involving universal charitable deductions above a floor. vat_v7_formatted on the threshold: smallness and the value-added tax emily ann satterthwaite* abstract three-quarters of the world’s population live in a country in which a valueadded tax (vat) is collected on sales of goods and services. the registration threshold determines which businesses—typically as measured by their annual revenues—remain exempt from the obligation to register for and collect vat on their sales. among vat economists, there is broad consensus that setting thresholds higher rather than lower (such that more rather than fewer businesses are exempt) increases the economic efficiency of a vat. despite these high stakes and the longstanding expert consensus in favor of high thresholds, real-world thresholds vary widely and skew low, even within oecd and european countries. this article leverages the insights of the economic model to address an issue that lies outside of it but is central to lawyers and policymakers: fairness. numerous studies show that smaller businesses’ costs of complying with the vat are disproportionately higher than those of larger businesses. to the extent that lower-income entrepreneurs internalize those costs or pass them on to lower-income consumers, there is a vertical equity rationale for raising thresholds. moreover, in the (typical) context in which small firms are more common than large firms, setting thresholds higher rather than lower—while also offering small suppliers an election to voluntarily register—can reduce the competitive unfairness of drawing an arbitrary line among similarly-situated firms. under such conditions, higher registration thresholds can improve both the fairness and the efficiency of a vat. *assistant professor, university of toronto faculty of law. the author gratefully acknowledges generous research funding from the connaught new researcher fund and the foundation for legal research. thank you to richard bird, david duff, mirit eyal-cohen, pierre-pascal gendron, andrew green, anthony infanti, karen knop, rebecca millar, jacob nussim, lisa philipps, miranda stewart, michael trebilcock, arnold weinrib and an anonymous referee for helpful comments, and to sooin kim, sufei xi and the university of toronto faculty of law’s bora laskin law library for indispensable research support. the author is also grateful to the editorial board and board of advisors of the columbia journal of tax law for their support for and improvements to this paper. annika wang provided outstanding research assistance. the author is solely responsible for all errors. 178 columbia journal of tax law [vol.9:177 i. introduction ............................................................................................... 179 ii. part i: vat, demystified ........................................................................... 185 a. what is a vat?............................................................................................. 186 1. a vat taxes sales................................................................................... 186 2. a vat is a multi-stage tax ..................................................................... 187 3. a vat requires registration ................................................................... 190 b. what makes a vat work? ............................................................................ 190 1. production efficiency .............................................................................. 191 2. fractionalism .......................................................................................... 191 3. deterring evasion ................................................................................... 192 iii. part ii: the registration threshold in theory: keen and mintz’s model .............................................................................................. 194 a. model set-up ................................................................................................ 196 1. a simple model ....................................................................................... 196 2. model with firm-size effects ................................................................... 198 b. results and policy implications ..................................................................... 200 iv. part iii: registration thresholds in practice............................. 202 a. firm bunching below registration thresholds .............................................. 202 b. current registration thresholds .................................................................... 205 c. possible explanations for the persistence of low thresholds ......................... 210 v. part iv: assessing fairness to close the gap between registration threshold theory and practice ........................... 211 a. equity in the context of vat thresholds ...................................................... 212 b. vertical equity .............................................................................................. 214 1. empirical studies of vat compliance costs ............................................ 215 2. economic incidence of vat compliance costs ........................................ 218 3. ability to pay .......................................................................................... 220 c. competitive fairness ..................................................................................... 221 1. higher thresholds minimize bunching .................................................... 223 2. optional registration .............................................................................. 223 v. conclusion ................................................................................................... 226 2018] on the threshold: smallness and the value-added tax 179 i. introduction value-added taxation (“vat”) has taken the world by storm.1 it has been adopted by over 150 countries that comprise about three-quarters of the world’s population, and accounts for more than twenty percent of worldwide tax revenue raised.2 in some regards, the vat can be seen as a more modern cousin of the retail sales taxes used by many u.s. states.3 the u.s. stands out as the only jurisdiction among oecd countries without a vat, despite recurring calls for adding it as an overdue complement to the income tax.4 in contrast, in many developing and transitional economies, the adoption of vat systems as part of austerity measures and fiscal reforms reflects the inexorable pressures of globalization.5 1see richard bird & pierre-pascal gendron, the vat in developing and transitional countries 17 (2007) (noting that “[o]ver the last few decades, vat has swept the world. with the notable exception of the united states most countries around the world now have a vat…vat has been an enormous success. it has swept away other contending general sales taxes in most of the world. only five countries have ever repealed a vat, and all either have since reintroduced one or reportedly plan to do so soon. in many countries vat has come to rival and even dominate the income tax as the mainstay of national finances. no fiscal innovation has ever spread so widely so rapidly or been so successfully adopted in such a wide variety of countries”). indeed, 140 countries had a vat of some sort as of 2006. id. at 15 (“[vat] is now the single most important source of tax revenue in some countries and one of the most important sources in many more”). see also sukumar mukhopadhyay, value added tax: how implementation is going wrong, 37 econ. & pol. wkly. 3700, 3700 (2002) (noting that, as of 2001, nearly three-quarters of the earth’s population lives in a jurisdiction that has a vat). 2 see kathryn james, the rise of the value-added tax 1-3 (2015). 3see alan schenk, victor thuronyi, & wei cui, value added tax: a comparative approach 22-23 (2015) (contrasting a single-stage tax such as retail sales taxes in many us states to a vat, describing it as “[t]he modern sales tax imposed at all levels of production and distribution”). see also walter hellerstein, hitchhiker’s guide to the oecd’s international vat/gst guidelines, 18 fla. tax rev. 590, 591 (2015) (“…even if one takes the liberty of describing the american subnational retail sales tax (rst) as a consumption tax, there are significant structural differences between the american single-stage rst and the multiple-stage collection process that defines the vat”). 4 see reuven avi-yonah, the rise and fall of the consumption tax (univ. of mich., law & econ. research paper no. 14-0245, 2014), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2523941 [perma.cc/q69z-xvlq]. see also william gale, no, value-added taxes are not bad for small business, tax pol’y center: taxvox blog (apr. 27, 2016), http://www.taxpolicycenter.org/taxvox/no-value-addedtaxes-are-not-bad-small-business [perma.cc/m2ut-vbta] (discussing renewed interest in a us vat and noting that ted cruz’s vat proposal stands in good company with other recent proposals, many claims of which are supported by nonpartisan academic research). others disagree that the prospect of a us vat is realistic. the current debate on the house republicans’ plan for replacing the corporate income tax with a destination-based cash flow tax is motivated by concerns about how us companies fare in a world where all its major trading partners have a vat. see richard ainsworth, trump & vat: nafta, trade barriers & retaliatory tariffs (boston univ. sch. of law, law & econ. working paper no. 17-16, 2016), https://papers.ssrn.com/sol3/papers2.cfm?abstract_id=2919058 [perma.cc/a64s-7tkm]. 5 as a matter of political ideology, the vat is associated with globalization, and neoliberalism’s normative emphasis on free-market small-government policies. see miranda stewart, global trajectories of tax reform: the discourse of tax reform in developing and transition countries, 44 harv. int’l l.j. 139, 177 (2003) (“[i]n many respects, economic globalization can be understood as involving an attack on the taxing powers of the state, leading to the restriction of the state’s ability to raise tax revenues, and hence a limit on its existence and capacity to act”). in the context of debt crises in developing countries in the 1980s, implementation of a vat was often a condition of receiving aid and loans from international institutions such as the imf and the world bank. id. at 169 (describing centrality of vat to structural adjustment programs and the contemporary tax reform “‘package[s]’…which includes a single-rate, broad-based vat to replace older-style sales taxes; a low-rate, broad-based corporate and personal income tax; the goal of tax “neutrality” with respect to different investments and activities; and the gradual reduction and eventual elimination of import and export tariffs. this reform package is now espoused by international institutions 180 columbia journal of tax law [vol.9:177 notwithstanding the huge range of country-level experiences with the vat, its importance is far from waning.6 the six member states of the gulf cooperation council (bahrain, kuwait, oman, qatar, saudi arabia, and the united arab emirates) are in the process of adopting a community-wide vat scheduled to take effect in 2018.7 in early august of 2016, india accomplished what had long been thought to be politically impossible and passed legislation authorizing a national vat.8 new zealand and australia have recently undertaken a series of vat reforms to improve their existing vat systems.9 canada’s vat recently celebrated its twenty-fifth birthday.10 at the same time that the vat has gained global traction, policymakers have shown increased enthusiasm for measures to support small businesses and entrepreneurship. one of the current channels for such support stands in contrast to traditional proposals for tax rate reductions and targeted subsidies, focusing instead on reducing the level of tax complexity facing small businesses.11 small business tax simplification seeks to spur the growth of emerging firms and microenterprises and increase tax compliance.12 in light of the global ascendance of the vat alongside and most tax experts”) (notes omitted). see also wilson prichard, taxation, responsiveness and accountability in sub-saharan africa: the dynamics of tax bargaining 2, 91-92 (2015) (discussing vat generally and the specific case of ghana). 6 as a general matter, vat scholars and commentators have observed that vat regimes often need to be updated after a sufficient amount of time has passed since their adoption. see bird & gendron, supra note 1, at 17, 26 (“not all is sunshine in ‘vatland,’ however. increasingly, clouds of varying sizes and shapes seem to be looming on the horizon—some in all vat countries, but some more particularly in the developing and transitional economies that have become particularly dependent on vat and are hence most vulnerable to looming or emerging problems with vat… even in the eu, vat is showing signs of age and may need rejuvenation if it is to continue to serve as well as it has in the past” (citation omitted)). 7 see richard t. ainsworth & musaad alwohaibi, gcc vat: the intra-gulf trade problem (boston univ. sch. of law, law & econ. working paper no. 17-03, 2016), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2916252 [perma.cc/gtsu-r2f2]. 8 see gaurav choudhury, gst bill passed in parliament: what happens next? hindustan times (aug. 4, 2016), https://www.hindustantimes.com/india-news/gst-what-happens-after-the-bill-passes-inparliament/story-rvsqkf41hrf0icd7qwordn.html [perma.cc/6rcj-493a]. see also goods and services tax (gst) bill, explained, express news service (aug. 5, 2016), http://indianexpress.com/article/explained/gst-bill-parliament-what-is-goods-services-tax-economyexplained-2950335/ [perma.cc/t65n-zk7w]. 9 see jessica irvin, what australia can learn from new zealand’s gst reform, gaa acct.: j. global acct. alliance (nov. 6, 2015), http://www.gaaaccounting.com/what-australia-can-learn-fromnew-zealands-gst-reform/ [perma.cc/6ras-euks]. both australia and new zealand have been in the process of reforming their vat treatment of online purchases of goods from abroad. see holly ryan, online gst jump looms for nz shoppers, n. z. herald (july 31, 2015) http://www.nzherald.co.nz/business/news/article.cfm?c_id=3&objectid=11490026 [perma.cc/j5dy-vw7d]. 10 see richard m. bird & pierre-pascal gendron, sales taxes in canada: the gst-hst-qst-rst ‘system’, 63 tax l. rev. 518, 520-22 (2010), (discussing the strengths of the 1991 federal goods and services tax in light of various commentators’ initial misgivings). 11 see kathleen delaney thomas, taxing the gig economy, 166 u. pa. l. rev. (forthcoming 2018) (offering a number of variants on a business standard deduction for independent contractors as one of two measures to address high tax compliance costs facing gig economy workers). this idea also arose in the context of the 2016 presidential campaign. hillary clinton proposed a “standard deduction” for small business to make their tax filing obligations simpler. see amanda becker, clinton details plans to boost small businesses, reuters (aug. 23, 2016), http://www.reuters.com/article/us-usa-election-clintoniduskcn10y08x [perma.cc/28lb-eb8b]. 12 the persistently low levels of tax compliance in the small business/self-employed sector are well-documented. in the us context, see susan cleary morse, stewart karlinsky & joseph bankman, cash businesses and tax evasion, 20 stan. l. & pol’y rev. 37 (2009). because many small business and self 2018] on the threshold: smallness and the value-added tax 181 lawmakers’ growing appreciation of small businesses’ tax compliance challenges, the specific question of how vat design affects the small is ripe for consideration by tax law scholars. this article builds on a large literature in public finance and law on vat design to give detailed consideration13 to a structurally vital component of most national vats that has enormous relevance for small firms: an exemption for businesses that meet the definition of a “small supplier.”14 such exemptions stipulate that enterprises (in whatever legal form, including sole proprietor and own-account work15) under a designated size are not required to register for and charge vat at the point of sale.16 although small suppliers are not legally required to register,17 many vat statutes allow for optional registration. 18 the small supplier rules, which are typically operationalized by a employed taxpayers receive income that is not subject to third-party reporting, it is challenging for tax authorities to effectively enforce compliance among this population. see internal revenue service, tax gap estimates for tax years 2008–2010 (apr. 2016), https://www.irs.gov/pub/newsroom/tax%20gap%20estimates%20for%202008%20through%202010.pdf [perma.cc/a6ps-c4fx] (discussing role of non-information-reported income in constituting the us’s net tax gap of $406 billion). 13 the academic tax law literature lacks a dedicated discussion of the registration threshold and the corresponding scope of the small supplier definition in a vat. however, two older articles, both by professor william turnier, ably address many of the issues that intersect with an assessment of the threshold’s level, but they do not focus on the threshold per se. see william turnier, accommodating to the small business problem under a vat, 47 tax law. 963, 978 (1993) [hereinafter turnier, accommodating] (stating that with respect to a prospective us vat, “[i]f congress decides to exempt small businesses, it should consider several issues. most significant would be the amount of the exemption. presumably a decision to exempt small businesses would be based on the modest contribution by small businesses to vat revenue and their large contribution to compliance and administration costs. evaluation of these factors and their relationship to the exemption ceiling is best left to the treasury and the joint committee on taxation” (citations omitted)). see also william turnier, designing an efficient value-added tax, 39 tax l. rev. 435 (1983) [hereinafter turnier, designing] (introducing the rules for the introductory uk vat threshold; concluding on the basis of a qualitative interview study that the registration threshold could be raised without significant loss of revenue and with substantial compliance and administration cost savings; parlaying these observations into a recommendation that the number of taxpayers in a vat should be minimized and offering suggestions about how to minimize compliance costs for the smallest traders through an exemption or other approaches). 14 see liam ebrill, michael keen, jean-paul bodin & victoria summers, the modern vat 113 (2001) (noting at the outset of their chapter on vat thresholds that “[e]xperience has taught, sometimes harshly, that a critical decision in designing a vat is the threshold level of firm size above which registration for the tax is compulsory”). 15 see schenk et al., supra note 3, at 59-60. 16 see id. at 60 (“[m]ost vat systems require persons engaged in regular business activity to register if their taxable sales in a given period (usually a year) exceed a threshold level”). 17 this is generally true, but there are some jurisdictions, such as israel, that require registration for all firms but exempt the small from collecting and remitting tax. see vat navigator: israel, bloomberg bna (july 2014), http://www.shekeltax.co.il/he/images/stories/site/vatn0714_israel_corrected_04.09.14.pdf [perma.cc/2jh9-dawg]. 18 see sharon smulders & chris evans, mitigating vat compliance costs – a developing country perspective, 32 austl. tax f. 283, 295 (2017) (“virtually all countries with thresholds allow small businesses to register for the vat if they so choose”). see also turnier, accommodating, supra note 13, at 978-80 (noting that “denial of the option to be taxable is probably not politically viable”). some vats do deny voluntary registration to suppliers with revenues below a certain threshold (which is sometimes different from—and lower than—the mandatory registration threshold that is the focus of this paper). for example, south african vat requires registration for suppliers with annual revenues over r1 million; however, voluntary registration is limited to those with revenues in excess of zar 50,000. see s. afr. revenue serv., small business and vat: what you need to know, 182 columbia journal of tax law [vol.9:177 “registration threshold” designating the annual revenue floor, help determine the base of taxation for the vat. in the public economics literature, registration thresholds have gained a firm foundation.19 in 2004, michael keen and jack mintz published a model for setting an “optimal” (efficiency-maximizing) vat registration threshold. they generated predictions by simulating the model using a set of parameters drawn from canadian economic data, and arrived at a counter-intuitive conclusion: the optimal vat registration threshold should generally be higher rather than lower. more rather than fewer firms should be classified as small suppliers and freed from the requirement to register for vat. 20 why were the conclusions of the model counter-intuitive (at least to non-vat specialists)? in the particular context of a vat, there are good reasons to be skeptical that exempting a larger rather than a smaller swath of firms is wise.21 first, small supplier exemptions create an incentive for firms to “bunch” just below the registration threshold. this can occur when a firm curtails its sales to stay artificially small, splits one business into two, or keeps some revenues out of sight of the tax authorities, all of which are costly from an efficiency perspective.22 second, a two-tiered system of vat, in which sales by certain firms are exempt from tax, can affect the prices of goods and services. such “breaks in the vat chain” can cause taxes paid on inputs by exempt firms to “cascade” onto the price of outputs, resulting in misallocations of resources for both producers and consumers.23 keen and mintz’s economic model addresses the downsides of exempting small firms while also taking seriously the problem that plagues nearly every real-world vat:24 compliance and administration costs are stubbornly and disproportionately high for smaller firms.25 indeed, thinking of the threshold as a “small business exemption” http://www.sars.gov.za/clientsegments/businesses/smallbusinesses/pages/small-businesses-and-vat.aspx [perma.cc/7l4s-ly6m]. 19 see bird & gendron, supra note 1, at 116 (discussing the keen & mintz model). 20 see michael keen & jack mintz, the optimal threshold for a value-added tax, 88 j. pub. econ. 559 (2004). 21 see ian crawford, michael keen & stephen smith, value added tax and excises, in dimensions of tax design: the mirrlees review 275, 305 (j. mirrlees et al. eds., 2010) (“[a]ny exemption is anathema to the logic of the vat, since it inherently breaks the chain of credit and refund, leading to an element of production taxation”). 22 see kazuki onji, the response of firms to eligibility thresholds: evidence from the japanese value-added tax, 93 j. of pub. econ. 766, 767 (2009) (describing “bunching” as relating to the densities of firms around the vat registration threshold). 23 see james, supra note 2, at 28 (“the reasons for the latter measure [minimizing economic distortions relative to other taxes—e.g., efficiency] derive from the good vat’s neutrality, as discussed above. the conventional view is that a good vat that falls only on final consumption and not intermediate business transactions is attractive for its neutrality regarding production decisions, which in turn facilitates greater production efficiency”). 24 the model’s task is to analyze how various configurations of these two cost parameters (compliance and administration) interact with the other incentives embedded in firms’ vat registration decisions. 25 see james, supra note 2, at 81 (in this draft i have adopted a version of james’s language of “real” vats as adopted in the political rough-and-tumble; part of her project is to document the ways in which real vats bear sometimes little resemblance to a theoretically pure or “good” vat). the wide variation in country-level registration thresholds as distinguished from the expert recommendation is in keeping with her account). 2018] on the threshold: smallness and the value-added tax 183 obscures its core policy purpose: rather than give a “break” to small businesses, it seeks to eliminate small businesses from the universe of registrants by acknowledging that the additional revenues they generate net of enforcement costs do not justify the compliance costs they would be forced to bear.26 simulations of the model suggest that, under a set of plausible economic conditions, registration thresholds in the range of about $110,000 to $265,000 (in 2017 u.s. dollars) can maximize the efficiency of the vat by minimizing tax compliance costs and distortions of firm and consumer behavior in response to the discontinuity.27 the intuition behind keen and mintz’s high-threshold result is threefold. first, the distribution of businesses by size (where size is measured by annual revenues) is typically skewed towards small businesses as compared to large ones,28 so higher thresholds can quickly reduce aggregate taxpayer compliance and government administration costs. 29 the simulations by keen and mintz of their model placed approximately 50 percent of firms below the optimal threshold.30 second, because the largest firms typically are responsible for the vast majority of sales and thus the lions’ share of vat revenues, the revenue consequences of high thresholds are likely to be modest to negligible. 31 third, firm bunching below the threshold compromises production efficiency, a result which has been confirmed by subsequent empirical studies.32 26 see id. at 31 (“[s]implicity is not considered to be the good vat’s greatest virtue. the vat’s complexity has caused some to question its appropriateness for developing countries with limited administrative and compliance capacity”). numerous studies in a variety of country settings have shown that these taxpayer compliance and government administration costs are sizable on average, with a significant “fixed” component (e.g., that is independent of the size of the business). see infra section iv.b.2 and accompanying notes. 27 see keen & mintz, supra note 20, at 572. 28 id. at 572 (discussing the “non-uniform” distribution of productivities case “that captures the greater frequency of small firms…”). 29 id. at 573 (because the non-uniform case “implies a denser lower tail of small firms from which relatively little revenue can be gained”). 30 id. at 573-74 (“[i]t is also striking that the threshold is in all cases so high as to exclude a very large number of firms from charging the vat: rather less than half in the uniform case, more than half in the non-uniform case”). 31 see ebrill et al., supra note 14, at 115, 117-18 (“[i]n most countries, a surprisingly small number of vat registrants, sometimes less than a few dozen, account for 80% or 90% of vat collections…[d]espite significant variation, a useful rule of thumb is that the largest 10 percent of all firms commonly account for 90 percent or more of all turnover…this seemingly universal feature has important implications for the relationship between the threshold and the tax base: starting from a low level, a $1 increase in the threshold is initially very cheap in terms of revenue foregone, but becomes much more expensive at higher levels of turnover;” noting, however, that there is “significant variation” across jurisdictions in the concentration of revenue across the distribution of firms…[but] at least 88 percent of turnover occurs in the largest 10 percent of firms”). see also bird & gendron, supra note 1, at 115 (“[i]n most [developing and transitional] countries, a surprisingly small number of vat registrants, sometimes less than a few dozen, account for 80% of 90% of vat collections”); keen & mintz, supra note 20, at 573-74 (noting that “in practice, the concentration of activity amongst a relatively few enterprises is such that it is indeed often the case that even a relatively high threshold catches an extremely large proportion of the potential base”). 32 see onji, supra note 22, at 771-73 (finding bunching of firms below the eligibility threshold in japan in a manner consistent with large firms “masquerading” as smaller firms through changes in organizational structures); see also li liu & ben lockwood, vat notches (cesifo working paper no. 5371, sept. 1, 2016), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2615702 [https://perma.cc/rs73-welq] (documenting bunching in the context of the uk vat); jarkko harju, tuomas matikka & timo rauhanen, 184 columbia journal of tax law [vol.9:177 in the time period since the model’s publication, keen and mintz’s recommendation to “aim high” when setting registration thresholds has quietly taken its place among vat design best practices.33 despite this expert consensus, however, annual surveys of registration thresholds, particularly across developing countries, confirm that there is striking heterogeneity, with many thresholds falling far below recommended levels.34 in 2001, liam ebrillet al. characterized small supplier policy as “an area in which fad [fiscal affairs department of the international monetary fund] has clearly been at odds with practice.”35 in 2007, richard bird and pierre-pascal gendron put it more bluntly: the “conventional wisdom” that registration thresholds should be set high is “generally ignored” on the ground. 36 recent contributions suggest that, over the intervening decade, particularly in developing and transitional countries, there has been movement towards higher thresholds. according to a recent paper by sharon smulders and chris evans, “[i]t appears that the case for a higher threshold has been made and many developing countries are increasing, or considering increasing their thresholds.”37 however, gendron emphasizes that, still, “thresholds in developing countries are set too low for the capacity of their tax administrations.”38 in light of these empirical facts and the well-travelled theoretical terrain, this article makes two contributions. first, for vat novices, it walks through the necessary background for and the economic theory of vat threshold-setting in non-technical terms. second, building on this background, it engages with a dimension of thresholdsetting that the economic model expressly sidesteps: distributional equity concerns. keen and mintz are careful to note that they restrict their analysis of the optimal threshold to the effects of size-based regulation on small firms: evidence from vat threshold 1, 3 (cesifo working paper no. 6115, sept. 2016), https://www.econstor.eu/bitstream/10419/147369/1/cesifo1_wp6115.pdf [https://perma.cc/47cp-kjn44cbc-9k72] (using data on the vat in finland to show that “the vat threshold causes a large and significant overall behavioral response. we find large excess mass of firms in the sales distribution just below the threshold, implying that small firms actively avoid vat liability…surprisingly, we find that even considerable reductions in the vat rate do not affect the extent of the bunching response. we do not find any changes in the observed behavior after the drastic drop in the vat rate at the threshold in 2004, nor between similar industries that faced different changes in vat rates over time. in contrast, the excess mass below the threshold decreased sharply when compliance costs were reduced in 2010. our results strongly indicate that compliance costs are the key factor in explaining the observed behavior”). 33 see bird & gendron, supra note 1, at 115 (“the ideal vat threshold was [thought to be] zero. as time went on, however, and more experience with the difficulties of imposing general sales taxes in fragmented economies with large informal sectors was accumulated, conventional wisdom changed. it now suggests that a threshold should be set considerably higher in most countries—say, at a level of u.s. $100,000”). 34 see infra section iii.a, table 1 and accompanying text. 35 see ebrill et al., supra note 14, at 113. the volume includes a table that compares thresholds recommended by the imf with those ultimately adopted by legislatures (using 2001 figures, which have moved but not significantly) and shows that “[o]n average, those adopted are less than 80 percent of what the imf recommended.” 36 see bird & gendron, supra note 1, at 25. 37 see smulders & evans, supra note 18, at 296. 38 see pierre-pascal gendron, real vats vs. the good vat: reflections from a decade of technical assistance, 32 austl. tax f. 257, 265, 267 (2017) (emphasizing that the correct threshold for a particular country is an empirical (rather than an administrative) matter with, “[g]overnments [setting] thresholds at a level which is too low for several reasons”). 2018] on the threshold: smallness and the value-added tax 185 efficiency alone, 39 where efficiency entails minimizing the costs of tax-induced behavioral distortions.40 they recommend high thresholds entirely independently of concerns about how the vat’s compliance costs are experienced by or passed along to individuals with different available resources and abilities to comply. as well, they briefly consider issues of competitive fairness among stakeholders of larger versus smaller firms but do not draw this out. this paper takes a closer look at both dimensions and argues that norms of vertical equity and competitive fairness also point in favor of higher rather than lower thresholds. for those countries considering raising their registration thresholds but not yet sold on the proposition, this article argues that there may be room to supplement the economic efficiency rationale for higher thresholds with a pair of equity rationales. proponents of higher thresholds may benefit from publicizing the proposition that high thresholds can better match vat compliance costs with available resources to comply (vertical equity) and, at the same time, minimize the competitive inequities that necessarily arise when a cutoff is introduced. in countries in which higher thresholds have been recommended by economists but have not been implemented, reframing the conversation in terms of tax fairness has the potential to resonate with important constituencies. the paper proceeds as follows. part i provides an overview of vat mechanics aimed at a general u.s. law audience (those familiar with the vat are advised to proceed directly to part ii). part ii walks through the intuition behind keen and mintz’s model using non-technical language. part iii reviews registration thresholds currently in effect in vat jurisdictions, showing that they are often lower than the rule-of-thumb recommendation of the economic model. part iv addresses the vertical equity and competitive fairness implications of threshold-setting. the last part concludes. ii. part i: vat, demystified across much of the world, the vat registration threshold represents the crossroads at which businesses on the margins of formality meet the tax system. however, to understand the importance of registration thresholds, basic vat literacy is required. this part offers such a primer by posing the question, “[w]hat is a vat?”41 it 39 see keen & mintz, supra note 20, at 564 (asking at what level “the threshold [should] be set such that the social value of the revenue gained from each firm brought into tax by slightly lowering the threshold is exactly equal to the additional administrative and compliance costs incurred”). see also id. at 574 (“the focus here has been on efficiency aspect of the threshold choice. in practice, distributional effects are naturally a major concern. much emphasis is often given, in particular, to the regressive nature of the compliance costs associated with the vat”). 40 see james, supra note 2, at 28 (“[t]he good vat is said to raise revenue with the least cost and the least economic distortions relative to other comparable taxes”) (under heading labeled “efficiency”). 41 every vat novice must tackle this deceptively simple question, and i have benefited from numerous good answers in both the technical and layperson-oriented literature. see, e.g., bird & gendron, supra note 1, at 10. see also the value added tax: experiences and issues, in international tax dialogue 14 (alan carter ed., 2005), https://www.oecd.org/tax/tax-global/itd-publication-decade-sharingexperiences.pdf [https://perma.cc/6eea-jqju] (“a broad-based tax levied at multiple stages of production [and distribution] with—crucially—taxes on inputs credited against taxes on output. that is, while sellers are required to charge the tax on all their sales, they can also claim a credit for taxes that they have been charged on their inputs. the advantage is that revenue is secured by being collected throughout the process of production (unlike a retail sales tax) but without distorting production decisions (as a turnover tax does);” 186 columbia journal of tax law [vol.9:177 then takes a step back to briefly identify the key strengths and weaknesses of a vat, to set the stage for discussing in part ii how registration thresholds and surrounding small supplier rule details interact with these strengths and weaknesses. readers already wellversed in the input-credit structure of modern vats should skip ahead to part ii. a. what is a vat? the best way to introduce the nuts and bolts of the vat is the following simple definition: value added tax (vat) is a tax that is levied on all sales by registered businesses. the three underlined portions of the definition above highlight the distinct components fundamental to most modern vats.42 1. a vat taxes sales colloquially speaking,43 a vat is levied on sales, and it is collected from consumers at the point of sale. this feature highlights that the vat is a member of the larger family of “indirect taxes.”44 indirect taxes include a wide variety of commodity taxes, excise taxes, and other consumption taxes levied on sales. the vat’s closest relatives in the indirect tax family are “general sales taxes” and “retail sales taxes.” the former appears most commonly as a “turnover” or “gross receipts” tax under which are all sales at every stage of production (manufacturer, wholesale, intermediate, retail) are taxed. by contrast, the latter is a “single-stage” tax that is collected only by retailers at the stage of the final sale to consumers. as will be discussed further below, each of these has significant drawbacks as compared to a vat. what makes a tax “direct” versus “indirect”? direct taxes generally refer to income taxes on earnings from various sources, like wages, active business income, investment income, or gains on dispositions of capital property.45 direct taxes are direct noting however that this definition is not the last word: “[i]t should be noted that the list of ‘vat countries’ found in annex table a.1 differs in some respects from the similar information contained in other recent sources… which also differ from one another. such differences are inevitable, given the fast-changing nature of the vat universe and some fuzziness around its definitional edges…[some differences arose] because bird (1970) considered a tax that used the invoice-credit method as a vat even when it was applied only at one stage of production, whereas according to itd (2005) the tax must be applied at multiple stages to be a vat. since to some extent the answers to such questions lie in the eyes (and purpose) of the beholder, lists may differ” (full citations omitted)). 42 this is true of canada’s goods and services tax, on which i frequently draw for illustration. canada’s excise tax act was amended in 1990 to add part ix, entitled “goods and services tax,” see also amending act 1993, ch. 27 § 23; 1997, ch. 10 § 9 [hereinafter gst].. note, however, that input credit-style vats are most common but not the only type of vat on offer. itai grinberg, where credit is due: advantages of the credit-invoice method for a partial replacement vat, 63 tax l. rev. 309, 358 (2010). 43 technically, vats apply to transactions using the broader concept of a “supply,” which goes beyond legal sales. 44 see schenk et al., supra note 3, at 20. 45 for those familiar with the canadian context, it is worth noting that courts have sanctioned a very wide definition of “direct taxes” for constitutional validity purposes. this definition includes taxes that would normally go in the category of “indirect” taxes, such as the canadian vat, retail sales taxes and even excise taxes. the explanation can be found in section 92 of the constitution act, which restricts provincial taxes to “direct” taxes only. however, provinces bear the lions’ share of spending responsibilities, so courts have stretched the meaning of “direct” taxes to facilitate revenue-raising. see gerald laforest, the allocation of 2018] on the threshold: smallness and the value-added tax 187 in that they accrue at the point of resource creation or realization by the taxpayer.46 indirect taxes, by contrast, accrue not at the point of resource creation but at the time at which the taxpayer (buyer) converts those resources into consumption (e.g., at the level of the transaction). 2. a vat is a multi-stage tax second, a vat applies to all sales (or, less colloquially, it is assessed on the “supply” of all goods or services). in contrast to a single-stage tax like a retail sales tax, a standard vat does not heed where a particular sale lies in the supply chain. vat is charged and collected by sellers at each and every stage. however, the vat feature of taxing all sales comes with a crucial caveat that lies at the center of the standard vat architecture: the “input credit” mechanism that distinguishes a vat from a general sales tax. this avoids the devastating “tax cascade” that would otherwise hobble a tax that is assessed at each stage of production without adjustment via input credits. what is the “tax cascade”?47 when each sale is subject to tax with no adjustment for prior sales taxes paid, such as is the case with a general sales tax, a transaction’s position in the supply chain will affect the price of the sale. put differently, where a commodity has a downstream position in the supply chain, each prior transaction causes tax to be passed downstream. it cascades at each stage of the supply chain in two ways: as a tax layered on tax and as a tax layered on value-added.48 to navigate around this tax cascade, nearly every vat in existence employs a feature called “input crediting” or “invoice-crediting.”49 input crediting allows sellers to offset the vat that they have paid on their inputs against the vat that they must charge, taxing power under the canadian constitution 96-97 (can. tax paper no. 65, may 1981) (stating that “[s]ales taxes may probably be classified as a type of excise tax, but apart from certain remarks [case citation omitted]…, the courts have not so classified them in dealing with questions of direct taxation”). 46 see schenk et al., supra note 3, at 5 (“[t]axes customarily have been classified either as direct or indirect taxes. ‘a direct tax is one that is assessed upon the property, business or income of the individual who is to pay the tax. conversely indirect taxes are taxes that are levied upon commodities before they reach the consumer who ultimately pay[s] the taxes as part of the market price of the commodity (citation omitted). this distinction, based on the incidence of the tax, has been criticized because ‘modern economic theory’ points out that income taxes (considered a direct tax) may be shifted.” (citation omitted)). 47 see alan schenk & oliver oldman, value added tax: a comparative approach in theory and practice 4-5 (2001). 48 see schenk et al., supra note 3, at 23 (“[a] vat can be described on the basis of the mechanical method used to calculate net tax liability for each tax period”). in a sense, “value-added” is concept determined not by the underlying economics of production, e.g., the value of the untaxed inputs required in creating a given good or service, but rather by the tax itself. 49 see crawford, keen & smith, supra note 21, at 291 (observing that all national vats are of the invoice-credit form except for the vat adopted by japan); bird & gendron, supra note 1, at 15 (“[i]n principle, many types of vat may exist with variations in the breadth of the tax base (gross product, net income, consumption); the treatment of foreign trade—origin, destination; and the method of collection— addition, subtraction, invoice-credit. in practice, however, almost every vat in the world today follows the eu model in several important respects: it is in principle intended to tax consumption on a destination basis (imports taxed, exports zero-rated), and it is applied on a transaction basis using the invoice-credit (output tax less input tax) method” (citations omitted); noting however that a major exception is the origin-based income-type vat that exists in various forms in italy, japan and several american states). 188 columbia journal of tax law [vol.9:177 and remit to the government, on their outputs.50 the input-credit mechanism explains where the vat gets its name, because it refers to the underlying basis on which tax is assessed. due to the input credit feature, vat taxes only the “value added” as measured by the excess of sales over inputs at each stage of production. sometimes abstract explanations of tax concepts can miss their mark, so what follows is a concrete example to illustrate how a cascading “turnover tax” on all sales (e.g., a tax that has no input-credit mechanism) contrasts with an input-credit vat. suppose robin produces cuckoo clocks. robin makes the clocks herself, but she needs a number of inputs to do so. the wooden carved cuckoo bird that pops out of the clock is a crucial input, and robin sources the birds through morgan, whose business locates remote sellers who carve birds using unusual woods. morgan sources robin’s carved birds through lee, a wood carver who carves birds from self-scavenged wood. suppose the competitive environment for cuckoo clocks is such that lee sells a particular carved bird to morgan for the (pretax) price of $100. morgan, in turn, sells the bird to robin for the (pretax) price of $200. robin, in the final stage, sells the cuckoo clock to a final consumer for the (pretax) price of $400. suppose further that a 20 percent turnover tax—without any input credits, e.g., equivalent to the general sales tax on gross receipts described above—is in effect. as a result, lee charges the 20 percent tax and morgan pays a tax-inclusive price of $120. morgan cannot claim any credits for the tax she pays, so suppose she passes along the full amount of the tax to robin. thus, instead of selling the cuckoo bird for $200, morgan sells it for a (pretax) price of $220. accounting for the 20 percent tax (on $220) of $44, the tax-inclusive price paid by robin for the bird is $264. to see how the tax has “cascaded” at each stage in the supply chain, we can first observe that the tax component of morgan’s sale to robin is $64. this is the portion of the total price of $264 that will be claimed by the government. to calculate the effective tax rate created by the cascade, the tax component is divided by the non-tax component. the effective tax rate on the carved bird at this (intermediate) stage of the cuckoo clock’s production is approximately 29 percent ($64 divided by $200). by contrast, a sale by lee directly to robin (again supposing that the seller, lee, is able to pass along the entire amount of the tax to her customer) would carry only a 20 percent tax. it gets even worse at the next stage: to earn a pre-tax profit of $200, robin would need to charge the end consumer of the cuckoo clock a pretax price of $464. with tax, the price would be $556.80. the tax paid (e.g., cascading at each stage of the supply chain) totals $156.80. relative to a good with an underlying tax-free price of $400, the effective tax rate is a whopping 39.2 percent. why is this result—a 20 percent tax on a direct sale versus a 39.2 percent tax through a middle-person—undesirable? two reasons stand out. first, the tax rate is determined not by a reasoned decision of a legislator or by voters, but by something else: a transaction’s arbitrary position in the supply chain. this arbitrariness is facially suspect: there is no obvious reason we would want robin to bear a higher effective tax rate than morgan or lee. nor is there a reason to expect that a party’s transactional position in the 50 interestingly, the cascading sales tax incentive in favor of self-supply was cited by coase as a raison d’être for the existence of a firm. see ronald h. coase, the nature of the firm, 4 economica 386, 393 (nov. 1937). 2018] on the threshold: smallness and the value-added tax 189 supply chain would be related to any commonly accepted basis for differential taxation (e.g., ability to pay, economic need, etc.). as such, the distributional impacts on different groups in society of a cascading tax are notoriously hard to assess.51 second, in terms of a tax’s behavioral impact, the differential in prices created by the tax cascade gives robin a strong incentive to “self-supply” her carved-bird input (for instance, by scavenging for wood, taking a bird-carving class, and making the birds herself) or alternatively through “vertically integrating” her business (for instance, by asking lee to become her employee rather than her arms-length supplier). by avoiding the taxable transaction at the intermediate stage, either of these strategies would allow robin to capture a portion of the 19.2 percentage point tax differential that otherwise would have been claimed by the government. the overarching objective of optimal tax design is to minimize the extent to which taxes induce people like robin and lee to change (“distort”) their behavior in response to a tax.52 the costs and effort of pursuing these tax-motivated changes (“distortions”) in decision-making and resource-allocation are unintended consequences of the turnover tax. usually, turnover taxes are intended simply to raise revenue for use by the government. what if there was a similar tax that raised the same amount of revenue but induced fewer tax-motivated changes by individuals? enter the input-credit mechanism. to see how it can remedy the tax cascade, suppose now that the same transactions take place, but the 20 percent turnover tax has been replaced by a 20 percent input-credit vat. suppose further that robin, morgan, and lee’s businesses are all vat-registered (that is, there are no small supplier exemption considerations in this example). the transactions play out as follows: 1. when morgan buys the carved bird from lee for $100 plus $20 tax, lee issues morgan an invoice that lists these amounts along with both of their vat registration numbers. depending on the technological capacity of the tax authority, invoices may or may not be remitted electronically to the government. 2. the vat outcome for lee is that she owes $20 to the government. this is because no input tax credits were available to her: her only input, aside from her own labor and creativity, was the scavenged wood. 51 see bird & gendron, supra note 1, at 30 (noting that general sales taxes, e.g., turnover taxes, are conceptually simple but have the effect of discouraging investment and exports while creating uncertain distributional and price effects because the tax burden borne by a particular exchange depends on “how many prior taxed transactions are embodied in its sales price”). assessing the distributional effects of a turnover tax would require knowing the extent to which those who are less well-off consume commodities at a “later” (more downstream) stage in the supply chain; consuming at a more downstream stage would cause the poor to face higher after-tax prices and a higher effective tax burden. similarly, one might think that better-off consumers could “negotiate around” the tax cascade in a coasian fashion (e.g., by forming a firm) whereas this would be hard for those with fewer resources. however, speculation would need to be backed up by data to accurately assess who was being hurt (or helped) by a cascading tax. 52 this is true unless behavioral change is the stated goal of the tax. in this regard, excise taxes such as alcohol or tobacco “sin taxes” or fuel taxes are fundamentally different than, and have diametrically opposed objectives from, an indirect tax on consumption designed to raise revenue (e.g., like a vat). see james a. mirrlees, an exploration in the theory of optimum income taxation, 38 rev. econ. studs. 175 (1971). 190 columbia journal of tax law [vol.9:177 3. next, morgan sells the cuckoo bird to robin for $200 plus $40 tax; morgan issues robin a receipt listing these amounts and both of their vat registration numbers. 4. the vat outcome for morgan is that the $20 input tax credit can be used to offset the $40 tax that she collected on her sale of the $200 bird to robin. morgan’s net vat liability is $20. 5. last, robin sells her finished cuckoo clock to a customer for $400 plus $80 tax, robin doesn’t issue a receipt because (by assumption) the final retail customer is not a vat-registered business. 6. the vat outcome for robin is that the $40 input tax credit can be used to offset the $80 in tax that she collected from her customer on the sale. robin’s net vat liability is $40. the vat’s solution to the tax cascade problem takes place in the third and fifth steps above. because of the availability of input tax credits, morgan does not need to pass the input tax that she paid to lee along to robin, and robin does not need to pass the input tax that she paid to morgan along to the final consumer, so tax is not layered on tax. similarly, tax on the value-added (the difference between taxed inputs and taxed outputs) at each stage of the transaction does not cascade on itself. the effective tax rate at each stage in the supply chain holds steady at the rate intended by the vat legislation: 20 percent of value-added at each stage. the government thus raises $80 of revenue on a pre-tax good with a value of $400. 3. a vat requires registration the third and final definitional element of input-credit vat systems may seem obvious on its face: notwithstanding that unregistered businesses pay (non-refunded) vat on their inputs, vat collection is required only of registered businesses. successful administration and enforcement of such vats relies fundamentally on firm-level compliance with registration rules. non-registration is one of the main channels through which vat evasion occurs.53 the centrality of the registration requirement to the basic functioning of a vat implies that the design choices surrounding which firms must register are of first-order importance. as detailed in part ii, setting the registration threshold is arguably the most fundamental vat design choice aside from the rate. b. what makes a vat work? laying out the basic elements of a vat lays the necessary foundation for understanding the centrality of vat small supplier provisions. however, the question of defining the vat’s base with respect to small-firm sales is intimately bound up with buttressing the strengths of the vat while mitigating its weaknesses. most generally, an emerging literature building on the insights of optimal tax theory provides a rationale for using a combination of multiple tax instruments from both families of taxation—direct and indirect, income and vat—to raise the politically-determined amount of 53 see crawford, keen & smith, supra note 21, at 310 (although note contrast with a subtraction method vat such as that in japan). 2018] on the threshold: smallness and the value-added tax 191 government revenue.54 the specialist vat literature can be summarized as identifying three key strengths of the vat: production efficiency, fractionalism, and deterring evasion.55 1. production efficiency production efficiency is the idea that any indirect tax should burden consumers rather than producers. this means that final consumption should be taxed, but business inputs exempted. concentrating indirect taxes on consumers may strike one as unfair. however, a key theoretical result in public economics is the production efficiency theorem of peter diamond and james mirrlees, which can be summarized as follows: taxing business inputs to address distributive concerns is shortsighted.56 such taxes distort production, which reduces aggregate output, which means there are fewer resources in the economy to tax and redistribute. put differently, taxing business inputs reduces the size of the public revenue pie even before the pie’s slices can be distributed.57 the vat accomplishes this, whereas other indirect taxes, such as the retail sales tax, do not.58 2. fractionalism the second advantage of a vat is that its input-credit structure makes it “fractional.” this sounds like a bad thing: does the vat collect only a fraction of what it should? it is just the opposite. when all businesses in the economy are registered and compliant, the vat can be viewed as collecting tax at each stage in the supply chain on just the “fraction” of the value of the transaction that is the “value-added” at that particular stage (e.g., the difference between taxed output and taxable inputs, as measured 54 see david gamage, the case for taxing (all of) labor income, consumption, capital income, and wealth, 68 tax l. rev. 355 (2015). 55 typically, these strengths are discussed in comparison to cascading turnover taxes rather than a single-stage retail sales tax because the vat is economically equivalent to the latter. see bird & gendron, supra note 1, at 31 (“firstly, vat imposes what is economically equivalent to a single-stage retail sales tax through a multistage process that in effect ‘withholds’ tax at each stage of the chain of production and distribution preceding the final sale to households. by doing so, it ultimately achieves the (presumed) goal of taxing only consumption. moreover, even if evasion occurs at the final retail stage, only that part of the potential tax base consisting of the retail margin escapes tax. secondly, by crediting taxes on inputs including capital goods, vat avoids distorting economic choices with respect to production technology. it also eliminates taxes on exports by crediting taxes paid on inputs at prior stages”). 56 see peter diamond & james a. mirrlees, optimal taxation and public production i: production efficiency, 61 am. econ. rev. 8 (1971). 57 see crawford, keen & smith, supra note 21, at 281. assuming that there are no restrictions on the government’s ability to make transfers “any distortions of production decisions reduce aggregate output, which cannot be wise so long as there is some useful purpose to which that output could be put”). 58 see bird & gendron, supra note 1, at 37 (“[t]he extent of the multifaceted distortions resulting from the rst approach to sales taxation is difficult to assess, but the vat approach should be less distorting simply because it substantially reduces the taxation of business inputs. paradoxically, precisely because most inputs pay vat, no additional tax element is included in the vat levied on the sale to the final consumer. sellers deduct vat previously paid on inputs (including purchases of capital goods) before remitting vat due on sales (assuming vat takes the conventional income-credit form). from an economic perspective, this ability of vat to ‘untax’ business is one of its most attractive features: vat is the form of consumption tax that approaches most closely taxing consumption at the explicit tax rate stated in the law”). 192 columbia journal of tax law [vol.9:177 by the tax-inclusive price paid by the buyer in the transaction). this is the mechanical result of the creditability of taxable inputs. the strength of fractionalism, however, can be seen best in the absence of full registration or compliance, particularly at the end of the supply chain.59 it allows for a “catching-up” on tax owing where the vat applies or operates imperfectly: “[t]his means that tax is recaptured at the next stage of the supply chain if there is evasion at a prior one, thus providing a check on possible evasion.”60 whereas a retail sales tax would collect zero revenue if the last supplier in the supply chain (e.g., the retailer) was not registered or was non-compliant, a vat raises revenue incrementally along the way to the retail stage. tax on value added at each stage is collected, so the loss from a break in the chain at the final stage can be mitigated. 3. deterring evasion the third advantage relates to enforcement. there are two central channels through which the vat is thought to be a particularly enforceable tax if not fully “selfenforcing” as some commentators have claimed. a. paper trail as noted by ian crawford, michael keen, and stephen smith in the landmark mirrlees report on tax design, “[t]he appropriate mix between direct and indirect taxes is one of the oldest issues in public finance.”61 this controversy is driven by a basic insight: a uniform tax on consumption—that is, a tax on all commodities at the same rate—has an identical effect as a uniform tax on wage and profit income.62 this theoretical equivalence of direct and indirect taxes raises the obvious question: why would a government desire an indirect tax like the vat if it already has an income tax? enter the practical realities of enforcement and tax administration.63 two aspects loom large under the general “paper trail” heading: vat compliance and income tax 59 see michael keen & stephen smith, vat fraud and evasion: what do we know and what can be done?, 59 nat’l tax j. 861, 865 (dec. 2006) (“if the final seller is not taxed, all revenue is lost under an rst, but the fractional nature of the vat means that tax would then be lost on the value added at that final stage (so long as vat has been properly collected throughout the preceding production chain)”). 60 see crawford, keen & smith, supra note 21, at 311 (but noting that abuse of input crediting provides one of a number of “distinctive opportunities for evasion”). 61see id. at 281. 62 id. (“[m]ore recent and formal theory has brought relatively few additional insights. the most important, perhaps, is a recognition that, in principle at least, the balance is to some degree arbitrary, there being a close similarity in terms of their impact on individuals’ budget constraints—and hence, in the absence of some form of fiscal illusion, on their behavior—between a uniform tax on consumption and a uniform tax on wage and profit income. this is immediately clear for a consumer who lives only one period and receives income only from these sources: for them, a tax of 20% on all the income they receive is equivalent to a 25% tax on everything they spend. in such a world, the balance between commodity and wage taxation would be immaterial”). to see why this last statement is true, note that the divergence in the headline rate of tax is a (somewhat confusing) result of how we speak about, and calculate, tax rates as percentages of a given base. where the government needs to collect $20 in sales taxes from a total resource base of $100 (a straightforward 20 percent income tax), the individual will be left with $80 to spend. this results in the equivalence of a 25 percent (tax-exclusive) sales tax to a 20 percent (tax-inclusive) income tax. 63 the practicalities of multi-period earning and savings decisions are also crucial, but here the focus is on compliance and government administration/enforcement. 2018] on the threshold: smallness and the value-added tax 193 compliance are more likely to be complements than substitutes.64 second, registration for and compliance with a vat has the salutary consequence of yielding a detailed record of the transactions not only of the registered business but also of the trading partners of the registered business. suppose that both parties to a transaction are vat-registered. to complete the transaction, they must agree on a price, but an evader might seek to record and invoice a price for given transaction that is different than the actual price (e.g., cooking the books for vat purposes per one of the two evasion strategies discussed below under “selfenforcement”). however, because both parties are vat-registered, the invoice can be cross-checked. invoices typically contain both buyer and seller’s registration numbers, and any inconsistency between the price on the invoice as between the buyer and the seller would be an easy tip-off for tax investigators.65 important recent research has found empirical support for the efficacy of a paper trail as a deterrent to evasion.66 and, at least theoretically, this paper trail can be used to discipline cheating across tax instruments: a vat paper trail allows auditors to gain information about an entrepreneur’s income tax liability also. however, these paper trail-based mechanisms likely work in both directions, to the detriment of the fisc in the context of the cash economy. an entrepreneur who underreports her business’s sales or over-reports her input tax credits to evade vat runs the risk of exposure if she honestly self-assesses her income on her annual tax return, so she is unlikely to do so. similarly, an entrepreneur who cheats on her income taxes is unlikely to report honestly for vat purposes. b. self-enforcement the input-credit mechanism has the potential to provide a check—through the process of what vat scholars have called “self-enforcement”—on the two primary means by which vat-registered sellers could evade vat: (1) by underreporting sales or (2) by over-reporting taxable purchases.67 separate from (but reinforced by) the paper trail channel mentioned above, this occurs because the input credit mechanism discourages collusion: the two parties have opposing economic interests. the seller’s vat liability—the amount owing on the sale—is precisely the same amount as the buyer’s input tax credit. to come back to the example of robin the cuckoo clock maker: if robin is bargaining with morgan about the price of a carved bird, robin could benefit from reporting a price for vat purposes that is higher than the actual price she paid, because 64 see discussion of robin boadway et al., towards a theory of the direct-indirect tax mix, 55 j. pub. econ. 71 (sept. 1994) in crawford, keen & smith, supra note 21, at 282 (“when some income escapes tax it may be helpful to deploy a uniform commodity tax even when there would be no other reason to do so”). 65 see bird & gendron, supra note 1, at 31 (“since the two sides of the transaction are (for interbusiness trade) in principle recorded in two sets of books, the task of the administration in detecting evasion should be easier with vat”). 66 see dina pomerantz, no taxation without information: deterrence and self-enforcement in the value added tax, 105 am. econ. rev. 2539, 2540 (2015) (“investigat[ing] the role of third-party reported paper trails for tax enforcement…through two randomized field experiments with over 445,000 firms in chile”). 67 see bird & gendron, supra note 1, at 31. 194 columbia journal of tax law [vol.9:177 she will be able to use the vat she paid on this input to offset the tax she must charge and remit on her sales of clocks to her customers. however, this ploy would work to the detriment of morgan: morgan would owe more vat because of the higher invoiced price on the sale. where neither party succeeds in manipulating the invoice price, the vat lives up to its “self-enforcing” potential, although many vat experts view the strength of this potential as being low.68 and even in a case where a firm escapes registering for vat altogether, inputs will still be taxed. * * * * * due to these advantages, in spite of its weaknesses on some dimensions with respect to evasion and fraud, the consensus in the literature is clear: “if you have a vat, keep it.”69 iii. part ii: the registration threshold in theory: keen and mintz’s model the claim that the registration threshold and accompanying small supplier provisions play a central role in a well-designed vat is neither new nor controversial.70 nearly all vats feature a positive (e.g., non-zero) registration threshold for firm registration.71 as a general matter, the cutoff typically refers to total revenues of a business in a given period. however, there are often exclusions, including any foreign sales (e.g., exports), exempt supplies, sales of capital assets, and provisions relating to 68 id. at 32 (pointing out that “it is easier to get away with this dodge when the alleged supplier [of the “input”] is in another country, as in the case of the so-called carousel frauds in the eu. but when the tax administration is as weak as it is in many developing and transitional countries, it is not hard to create and register fictitious firms domestically in order to operate such frauds”). 69 see id. (“[r]egardless of the competence of the administration and the honesty of both officials and taxpayers, both in principle and in practice it remains simpler to enforce a sales tax applied in an incremental ‘value-added’ form to a chain of transactions than to have a system in which all stands or falls on honest reporting of a single transaction (the final sale)”). they also point out that a vat has two key economic strengths unlikely to be found under a real-world rst: business inputs are not taxed (which is good because the tax is intended to burden consumption—by final consumers—not production or investment, and it avoids “cascading” taxes at each stage of production/transaction). 70 see id. at 3 (“[t]he critical issue in vat design relates not to the stage at which the tax is imposed but to the size of the registered firms…in 1991 for example, after a careful examination of egypt’s fiscal position, its existing tax structure and its administrative capacity, as well as close consideration of thenrecent experiences with adopting vat in other north african countries (morocco, algeria, tunisia), egypt introduced its first general sales tax…a vat limited to importers and manufacturers…in 2001, when egypt finally did extend its vat to include wholesale and retail trade, the immediate result was to triple the number of registrants (firms registered as vat taxpayers) with no concomitant gain in revenue. the need to deal with so many new, and mostly very small, taxpayers inevitably resulted in some loss in administrative efficiency. what had seemed a decade earlier to be a good design decision based on experience elsewhere as well as egypt’s own prior experience with manufacturer’s level consumption taxes turned out to have been mistaken...further experience has made it much clearer than it was 15 years ago that one of the most critical vat design decisions is the level of the threshold above which firms must register. for most developing and transitional countries, we now know that it is likely wiser to set that threshold too high than too low”). 71 see crawford, keen & smith, supra note 21, at 299 (showing that as of the date of publication, korea, mexico, spain, and sweden had a threshold of zero); smulders & evans, supra note 18, at 293-94 (noting that “[o]f the 34 oecd countries with a vat, 28 have set a threshold under which small businesses do not register for the tax”); alfons j. weichenrieder, survey on the taxation of small and mediumsized enterprises 13-23, oecd (sept. 25, 2007). 2018] on the threshold: smallness and the value-added tax 195 divisional registration (e.g., whether separate businesses with common ownership are required to be grouped together for vat registration purposes).72 having a registration threshold is not a forgone conclusion. some vats require each and every business to register.73 indeed, in the early days of the vat, the “usual expert advice was to set the entry point [threshold]…as low as possible.”74 however, this early advice relied on the implicit assumption that it was costless for taxpayers to comply with and for the government to administer the vat. in the absence of such costs, there are a number of reasons that the ideal registration threshold would be zero. most straightforwardly, not offering an exemption to small suppliers would avoid the inefficiencies that result from having a tax discontinuity: competition between firms of different sizes would not be affected by differential tax treatment.75 as the upcoming detailed description of the keen and mintz model illustrates, the incentives to remain small or to underreport revenues so as to report revenues below the threshold are strong and salient. third, exempting small firms “breaks the vat chain” thereby creating a tax cascade—the key bugaboo of general sales and turnover taxes that the vat was carefully designed to avoid.76 the cascade induces price distortions that can themselves exacerbate production inefficiencies. moreover, if exempted small businesses sell mostly to consumers (rather than vat-registered businesses) then the revenue effects of exemption can be negative rather than positive. fourth, the self-enforcement advantages of a vat are undercut: a registered firm supplier trading with an exempt customer does not provide an invoice for vat input tax credit purposes.77 the registered firm is therefore not “held to account” in stating accurately for vat purposes the price of the sale (because the 72 see ebrill et al., supra note 14, at 115 (“in most cases there is a single threshold, specified as a monetary amount of turnover,” but noting departures); smulders & evans, supra note 18, at 295 (“[i]n order to mitigate this [firm-splitting], developing countries such as south africa and ethiopia have introduced legislation that permits divisional registration but only under exceptional circumstances”). 73 many jurisdictions apply simplified methods of taxation to firms below the registration threshold, such as “a presumptive tax based on firm characteristics or with reduced reporting requirements.” ebrill et al., supra note 14, at 116. see also schenk et al., supra note 3, at 449 (explaining in a case study of china’s vat the rationale behind the distinction between “regular taxpayers” and “small-scale taxpayers:” “[r]egular taxpayers apply the normal vat and can both claim input credit and issue creditable vat invoices to other taxpayers. small-scale taxpayers, by contrast, pay ‘vat’ pursuant to a ‘simplified method”—method’ which currently means a turnover tax at 3%—without being able to claim input credit or issue vat invoices themselves to purchasers. (however, they may request the tax bureau to issue special vat invoices on their behalf at the 3% rate). for this reason, one may regard the boundary between ‘regular taxpayers’ and ‘small-scale taxpayers’ as the ‘vat threshold’ in china”); smulders & evans, supra note 18, at 294 (pointing out that “chile, mexico, turkey, and spain [and, formerly, sweden] have not introduced an exemption threshold—resulting in compliance costs for even the smallest businesses”). 74 bird & gendron, supra note 1, at 115 (“the idea was essentially to ensure that all potentially taxable transactions were caught in the fiscal net by having the vat base as wide as possible”). however, this approach was seen as having disastrous consequences with respect to ability to administer a vat. 75 id. at 117. having a non-zero registration threshold is thought to distort competition between registering and non-registering firms, while (potentially) depriving the government of revenue it could otherwise collect. however, the prediction is not without ambiguity. 76 see keen & smith, supra note 59, at 861, 863. 77 id. at 865-66 (noting the “self-enforcing” advantage of the vat and offering a typology of frauds that can arise under a vat, including “underreported sales;” however calling into question the strength of the self-enforcement advantage due to its lack of applicability to final sellers to private individuals and lack of incentive to make sure that even with an accurate invoice tax is actually paid and the paper trail can be followed). see also pomerantz, supra note 66, at 2540. 196 columbia journal of tax law [vol.9:177 customer does not use that amount to claim an input tax credit). therefore, underreporting of sales to intermediate exempt sellers can be expected.78 despite these reasons for requiring universal firm registration via a registration threshold of zero, the real-world experiences of adopting and administering vats in a wide range of jurisdictions have made it clear that the vat, for all its advantages, does impose significant compliance costs on registered firms as well as administrative costs for governments. the zero-threshold implications of the early vat theories thus were brought back for further scrutiny.79 a. model set-up in 2004, economists michael keen and jack mintz published a model of small firm vat compliance that sought to take into account the tradeoff between administration and compliance costs on the one hand and raising revenue on the other.80 it also modeled the distortions in prices and firm-sizes (through decisions on the part of entrepreneurs to split a firm or to keep it artificially below the threshold) that can result from exempting businesses that qualify as “small.”81 1. a simple model keen and mintz start by deriving an expression for a registration threshold that addresses the tradeoff that exists between raising revenue from a vat and its imposition of firm-level compliance costs along with government administration costs. in their initial simple model, entrepreneurs’ decisions about how big to grow their firms is made independent of the vat threshold (e.g., no firm-size distortions). here, they focus solely on how compliance and administration costs trade off with revenue in a static sense. the objective is to maximize the social value of revenue raised, net of the costs to businesses of complying with the tax and to the government of administering the tax. the simple model has five key parameters. the first two parameters are measures of average costs: first, the average perfirm cost of registering for and complying with the vat (“compliance costs”); second, the average per-firm cost to the government of administering and enforcing the vat (“administration costs”). this implies that freeing a “marginal” firm (e.g., a firm immediately below the threshold) from the obligation to register by slightly raising the 78 see prafula fernandez & lynne oats, gst and the small business 16 (curtin bus. sch., working paper no. 98.01, 1998) (“[s]ince exempt businesses do not need an invoice to claim input credit, the vendors selling to exempt businesses may not issue such an invoice, thereby creating a tendency for vat avoidance by vendors”). 79 see crawford, keen & smith, supra note 21, at 309 (“the only rationale for excluding smaller businesses from the tax is to save administration costs to the authorities and compliance costs to the taxpayer”). 80 see bird & gendron, supra note 1, at 115 (describing the keen & mintz model as “elegant,” and summarizing its argument, which simply trades off marginal benefits against marginal costs of registration, as follows: “[e]ven if some revenue is forgone by dropping many small taxpayers, in most countries any revenue loss could likely soon be recouped if the administrative effort freed from processing numerous low-return taxpayer were shifted to the medium and large taxpayers who universally account for most vat revenue”). 81 see keen & mintz, supra note 20, at 574. 2018] on the threshold: smallness and the value-added tax 197 threshold yields two fixed cost savings, one from compliance and the other from administration.82 the assumption that each firm bears a fixed compliance cost implies that these costs are regressive with respect to a firm’s size (as measured by revenues). as firm size increases, the fixed compliance cost is spread over more revenues.83 however, it is important to note that the issue of who bears costs relative to ability to pay or some other measure of resources is, by design, left outside the model.84 similarly, the “fixed cost” assumption in connection with government administration costs implies that the size of the firm makes no difference to how expensive it is for the government to administer and enforce the vat though audits, investigations, and other means. both of these fixed-cost assumptions are likely to be unrealistic when taken to the limit. the compliance costs of vat for, say, a student who sells refurbished mopeds as a side business are unlikely to be equal to those of a publicly-listed corporation. the same goes for government administration costs: potential vat noncompliance in a huge organization will be more complicated to investigate and enforce than in the case of a small proprietor. keen and mintz relax these assumptions in the more general version of the model discussed below. in addition to the parameters of average compliance cost and average administrative cost, keen and mintz’s simple model incorporates three other parameters: a measure of the marginal value of public funds (explained by keen and mintz as “the social value…of $1 in the hands of the government”), 85 the prevailing rate of vat 82 in particular, the act of registering one’s firm to get a vat number as well as setting up the necessary systems to charge, collect and remit vat each period as required imposes a cost on firms. empirical studies of this cost suggest that it is largely fixed: that ongoing compliance itself is not terribly costly but setting up the systems to facilitate compliance is the hurdle that can be daunting for a small operation. in light of these fixed costs, then, concerns about disproportionately burdening small firms become quite understandable. see, e.g., cedric sandford, minimising the compliance costs of a gst, 14 austl. tax f. 125, 128 (1997) [hereinafter sandford, minimising]. it is easy to imagine how an inability to “spread” the initial cost of registration over a sufficient base of revenues could make a crucial difference in the very delicate early stages: it could push some entrepreneurs to not form their businesses in the first place, or for those who do form, it might encourage them to operate informally so as to not comply. if the costs of vat registration at the outset are high, the returns to remaining informal at the outset are magnified. 83 for example, suppose the annual cost of registering for and complying with the vat is $500 per registrant (e.g., it is constant across all firms). for a firm with $10,000 in annual revenues, vat compliance costs as a proportion of revenues is 5 percent per year. for a firm with $1,000,000 of revenues, it is only 0.05 percent. for the small firm, it is as if a $5 bill is set on fire (or paid over to an accountant) out of every $100 that comes in, merely to address the issue of vat compliance. while this extreme situation is highly unrealistic, fixed registration costs (and fixed annual filing costs) are a persistent problem that dogs the vat. moreover, presumably keen & mintz add the variable cost component of compliance costs to make the setup of the general model less unrealistic. 84 see keen & mintz, supra note 20, at 564 (noting with respect to the simple model that despite the presence of “vertical equity concerns…in any event, we focus here on the efficiency aspect”). 85 see id. at 562. ebrill et al. provide another explanation that may be helpful: “[s]uppose that the government values an additional $1 of revenue at $δ. clearly, one expects that δ> 1, since the only rationale for raising revenue is the belief that resources are more valuable to society in the hands of the government than in those of the taxpayers. put differently, since taxation involves costs to the private sector additional to those of the resource transfer itself—because it [the tax] distorts economic activity—an additional $1 of revenue should only be raised if the uses to which it is put are valued by society at more than $1. indeed, δ-1 198 columbia journal of tax law [vol.9:177 (which is taken as fixed), and the average ratio of value-added to unit of output represented in each sale. the last parameter, the proportion of value-added that is embedded in the average sale in the economy, merits explanation. as noted above, value-added is the difference between taxed outputs and taxed inputs. what makes “value-added” a higher proportion of sales in a given economy is the average amount of labor and other untaxed inputs, plus profit, represented in the average sale. for example, suppose an individual works as an independent contractor and the only input she needs to supply is her own labor. here, the ratio of value added to the total value of the sale will be one (unity), because there are zero taxed outputs. in this case, the vat functions much like a turnover tax. a brief summary of the results of the simple model helps motivate the discussion of the more general model. first, holding other parameter values constant, an increase in either average taxpayer compliance costs or average government administration costs should imply a higher threshold. as the aggregate cost savings per firm (from both sources) associated with raising the threshold increase, it makes sense to raise the threshold. second, an increase in the need for public funds (e.g., a higher marginal value of public funds parameter) implies a lower threshold. this is because incurring compliance and administration costs makes more sense when the social payoff of each additional tax dollar increases. third, a higher rate of vat implies a lower registration threshold because more revenue will be sacrificed for each firm that falls below the threshold. fourth, a higher ratio of value-added to unit of output implies a lower optimal registration threshold.86 as noted by international tax dialogue, this result “makes a case for setting a reduced threshold for more profitable and/or labor intensive activities.”87 although vat orthodoxy dictates a single rate across a broad base with no exemptions, this last insight from keen and mintz’s model provides some support for a structure observed in a handful of vat jurisdictions such as france, ireland and malta: registration thresholds for firms providing services are lower than those applicable to firms selling goods or manufacturing products.88 2. model with firm-size effects keen and mintz then move beyond the simple model, in which firm size is static in response to the threshold, to a general-equilibrium approach. in particular, their general model accounts for a key dynamic in thinking about optimal registration thresholds: entrepreneurs’ decisions about firm size may be influenced by the registration threshold. the sharply discontinuous treatment of firms above and below the threshold can be thought of as corresponding precisely to the deadweight loss associated with the distortion of economic behavior.” see ebrill et al., supra note 14, at 118. 86 the intuition for this result is subtle and not covered in the treatment of the simple model in ebrill et al. see keen & mintz, supra note 20, at 569-70. but see ebrill et al., supra note 14, at 120 (“…[f]irms characterized by a high ratio of value-added to sales and selling to unregistered purchases— small traders providing services directly to final consumers [who will be unregistered, because only businesses are required to register] being the key group here—are likely to find it worthwhile to be exempt from vat”). 87 see the value added tax: experiences and issues, in international tax dialogue, supra note 41, at 15. 88 see infra section iii.a, table 1. 2018] on the threshold: smallness and the value-added tax 199 may influence entrepreneurs’ behavior and thus induce a misallocation of resources.89 such behavioral distortions can occur in a variety of ways: restricting growth of a firm, splitting a firm to ensure each firm’s revenue is below the threshold, or hiding revenue from the tax authorities.90 all can result in firm “bunching” below the threshold, although many real-world vats are attentive to the tax avoidance dimension of firm-splitting and have rules for “compulsory grouping” of firms with common ownership or provide leeway for the tax administrator to take into account the revenues of related parties (e.g., consolidating for threshold evaluation purposes).91 here, they add a number of parameters not present in the simple model. individuals choose between producing two goods: a taxed good and an untaxed good.92 individuals differ in their productivity with respect to the production of the taxed good,93 but not with respect to production of the untaxed good (here, it’s helpful, as keen and mintz point out, to think of the untaxed good as leisure).94 production in both sectors is modeled as occurring in the middle of a supply chain: each unit of output requires a fixed amount of a taxed input.95 finally, with respect to firms’ costs of compliance, the general model allows for both a fixed component of compliance costs, as in the simple model, and a variable component, in which compliance costs increase as firm revenues increase.96 the idea behind this new variable component of compliance cost is that as firms get larger and more complicated (e.g., more input and output transactions), vat compliance costs will—at least to some extent—increase as well. in other words, vat 89 see keen & mintz, supra note 20, at 565 (“allowing for both a fixed component to these costs and a part related to scale (each non-negative)”). 90 namely, competition between firms is affected to some degree, and incentives to remain artificially small—or even to split to avoid exceeding the threshold—are present. 91 for instance, antigua and barbuda’s vat provides that the tax administrator can take into account the sales of related parties in making the determination of whether a supplier is required to register. see sales tax act of 2006 § 9(3)(c) (ant. & barb.) available at http://laws.gov.ag/acts/2006/a2006-5.pdf [https://perma.cc/7tuy-3v28] (“the commissioner may require the person to treat the value of supplies made by that person as including the value of supplies made by a related person if he is satisfied that it is appropriate to do so due to the nature of the activities carried out by the related person, the way in which the taxable activities of the taxable person and the related person are carried on, the connections between those persons or between the activities carried on by them, or any other relevant factors”). 92 see keen & mintz, supra note 20, at 564 (“[w]e imagine a world in which individuals allocate their time between the production of the taxed good (dedicating to this an amount of labor l) and some untaxed good, (allocating to this labor of 1-l, the time endowment being unity)”. this approach allows the untaxed good to be conceptualized as either “leisure” (which is hard to measure and thus tax) or production in the exempt (unregistered, or informal) sector. although keen & mintz do not discuss optional registration at any point in their article, their general model’s micro-foundational approach seems to allow for this dynamic. 93 see id. (“output in this [the taxed] sector is f(nl) [arguments are productivity n and labor supply l], where [the function] is strictly increasing and strictly concave”; this functional form for f(nl) implies diminishing marginal productivity of labor in the taxed sector). 94 id. (here, the intuition is that there is a cap on productivity in the untaxed sector because it cannot grow to scale; or, if the untaxed sector is conceptualized as the production of leisure, the assumption implies that individuals are equally productive in this capacity. while this latter conceptualization implies an interesting philosophical point and perhaps a specific normative commitment, it is incidental to the optimal vat threshold result). 95 id. (noting however that this fixed amount of taxed intermediate input does not account for the endogeneity of input supply decisions: firms below the threshold face an incentive to “self-supply” inputs because of their inability to claim input tax credits). 96 id. at 565 (“allowing for both a fixed component to these costs and a part related to scale (each non-negative)”). 200 columbia journal of tax law [vol.9:177 compliance costs in the (arguably more realistic) general model are less regressive with respect to firm revenues than in the simple model. keen and mintz show that, once the optimal allocations of labor across the taxed and the untaxed sectors are determined,97 individuals with lower productivity will choose a firm size beneath the vat registration threshold. for individuals with higher productivity, the optimal firm size will be more than the vat registration threshold. and for the third possibility—individuals with productivities between these two amounts— production will “hover infinitely close to, but just below, the threshold.”98 this translates into one of the key takeaways of keen and mintz’s formal analysis: for entrepreneurs of intermediate productivity, bunching will occur just below the threshold and there will be a localized gap in the distribution of firms by size immediately above the threshold.99 b. results and policy implications but what about the optimal choice of threshold?100 keen and mintz summarize the intuition of their expression for the optimal threshold as follows. the expression has four components that summarize the subtle efficiency effects of a (small) increase in the threshold. first, upon such an increase, revenue may be lost from firms that now fall below the (marginally higher) threshold; noting, however, that due to bunching, there are no firms that are immediately above the threshold, so this effect is likely to be small.101 second, an increase in the threshold is not unambiguously revenue-decreasing: unregistered firms still contribute to vat revenues by paying tax on their inputs.102 third, the taxing agency saves administrative costs for each firm that now falls below the threshold.103 fourth, an increase in revenue (net of input credits) results from an increase in production by the mass of firms that formerly had bunched just below the threshold and now are free to expand.104 taking the components together, the intuition behind the general model’s optimal threshold expression is clear: relaxing the constraint that induces firms to remain small has much to recommend it, even in comparison to the simple model.105 97 id. at 568. 98 id. 99 id. 100 keen & mintz acknowledge that this step is “routine but the details…are messy.” id. at 569 (using the standard approach of specifying an indirect utility function reflecting profits of the individual entrepreneur; maximizing profits under the simplifying assumption that individuals have uniform preferences over the taxed versus untaxed goods). here, the objective of government policy is maximizing the sum of individual utilities subject to the constraint that labor is allocated optimally. id. at 568-69 (the distribution of labor across the taxed versus untaxed sectors functions as the incentive compatibility constraint subject to which the government’s objective function is maximized). 101 id. (“there are none such” firms producing exactly at the threshold). 102 id. (“[t]his mitigates the revenue loss in the previous term”). 103 id. at 571. 104 id. 105 the reference to administration and not compliance costs saved as firms drop out of the tax when the threshold is raised is intentional. keen & mintz comment on a notable feature of their expression for the optimal threshold: “the absence of any direct role for compliance costs.” id. at 570. weirdly, the parameter corresponding to the fixed component of compliance cost drops out in the optimization process. keen & mintz maintain that “the reason for this becomes clear on recalling the optimization problem being solved by those who initially just prefer to pay tax rather than stay below the threshold: balancing the 2018] on the threshold: smallness and the value-added tax 201 to bring their model to bear on real-world vat threshold decisions made by legislators, keen and mintz use data relating to canada’s vat in a simulation exercise.106 they use canadian estimates (circa 2000) for each of the model’s parameters and simulate the implied optimal threshold for a set of vat rates in two different economic settings: one in which firms are evenly distributed along a continuum of size, and another in which the distribution of firms is skewed towards the small (e.g., number of firms operating at each revenue level is decreasing as revenues rise). for this second and more realistic setting, the optimal thresholds implied by keen and mintz’s simulations are startlingly high: for a vat rate of 15 percent, the optimal threshold estimate is $101,500 (in 2002 dollars).107 at the threshold levels yielded by keen and mintz’s simulations, more than half (in the non-uniform case) of firms in the economy fall below the threshold.108 this may strike one as shocking. after all, what meaning does “small” have if half of businesses are small? however, in all but one of the simulations, the firms above the threshold account for more than 90 percent of the output (turnover as measured by revenues) in the economy. this is instructive: particularly where the firms cluster towards the small, the high-threshold implications of the model are particularly compelling. it is also worth noting that keen and mintz, in their simulations, used $100 for the fixed component of both compliance and administration costs.109 taking into account that this parameter is in nominal terms, the value is surely higher today, although one might speculate that advances in online registration and electronic systems have offset rising consumer prices. making the very conservative assumption that compliance and administration costs have stayed constant in nominal terms, one clear implication of the simulation results is that the status quo $30,000 canadian vat registration threshold is likely to be far below the efficiency-maximizing level.110 however, keen and mintz point out that the model offers the possibility of multiple equilibria, including one where the threshold is very low and the other where it is very high.111 these two equilibria have in discontinuous gain in net profit against the compliance costs incurred…the gain that such a firm reaps by now cutting its output to below the threshold, so saving itself compliance costs, is precisely offset by the loss that it sustains voluntarily through a discontinuous cut in its sales.” id. the absence of fixed compliance costs in the final expression for the optimal threshold in some sense can be seen as underscoring the complete separateness of concerns about the regressive distribution of compliance costs from concerns about efficiency. administration costs factor into the efficiency analysis, but the incentive compatibility constraint faced by entrepreneurs makes compliance costs wash out in equilibrium. 106 id. at 572 (“[c]alibrating to canadian data” (citations omitted)). 107 id. at 573. the theoretical ambiguity of the relationship between the rate of vat and the optimal threshold in the case of a non-uniform firm-size distribution is a particularly interesting implication of the general model but not particularly relevant to the discussion here. 108 id. (table 2, line 2 showing the proportion of firms above threshold in each of the cases.) 109 id. at 572 (“fixed compliance and administration costs…are both $100 per registrant”). 110 see gst, supra note 42 (the threshold was set when the federal goods and services tax was adopted in 1991 has not been changed since that time). 111 see keen & mintz, supra note 20, at 572 (“it seems quite possible that this [the optimal threshold problem] may have more than one solution. the element of increasing returns in the administration and compliance cost functions creates the possibility of one (rather trivial) kind of nonuniqueness, and others would arise with more general functional forms. a more novel possibility seems to arise, however, from the observation (here speaking very loosely) that the production inefficiency associated with a threshold can be mitigated by setting the threshold either very low or very high: in either case the bulk of taxpayers will be treated identically. this suggests that there may be cases in which two local optima arise: one has a low threshold, with high collection costs [are] offset by a relatively low level of production inefficiency and a 202 columbia journal of tax law [vol.9:177 common the feature that few firms will be “affected” by the threshold: bunching won’t be realistic for most firms where a threshold is close to zero, nor will it be within reach for most firms where a threshold is very high. in sum, keen and mintz’s expression for the optimal threshold underscores an important insight: firms’ propensities to avoid tax by manipulating their size compromise production efficiency. under economic conditions similar to those used to simulate the model, a higher threshold rather than a lower threshold is likely to maximize efficiency. this ensures that a majority or near-majority of firms are vat-exempt. moreover, keen and mintz come to this conclusion independent of any equity or other fairness considerations: exempting the small minimizes economic waste (e.g., inefficiencies), regardless of whether it is desirable to exempt the small on other normative grounds. the next part turns from theory to practice by asking how firms behave in response to realworld registration thresholds. iv. part iii: registration thresholds in practice in the years since keen and mintz’s model was published, the key conceptual contribution driving its high-threshold policy recommendation—that thresholds impose efficiency costs through distortions to firms’ production decisions—has attracted growing empirical support. concurrently, however, many countries’ vat thresholds have remained lower than is likely to be optimal. this part reviews the evidence for each of those claims. a. firm bunching below registration thresholds research on the japanese and, more recently, the uk and finnish vats has shown that vat thresholds are not neutral with respect to entrepreneurs’ decisions about the size of their firms. rather, these three studies underscore that registration thresholds can induce bunching immediately below the registration threshold. first, a 2009 study by kazuki onji documented the effects of the introduction of a preferential simplified vat filing regime for small businesses as part of japan’s 1989 overhaul of its tax system. this overhaul included a relief provision for small businesses in the form of a presumptive input percentage that could be applied by eligible firms.112 specifically, firms below the threshold (for the simplified regime) of 500 million yen ($3.3 million) were permitted to calculate tax owing with a presumptive input percentage of 80 percent, thereby converting the vat into a turnover tax.113 nearly 97 percent of all firms in 1989 were eligible.114 to the extent that an eligible firm had a taxable-input-to-sales ratio of more than 80 percent, electing into the simplified regime would reduce both the overall tax paid (relative to the non-simplified regime) and eliminate the compliance burden of calculating input credits.115 using two waves of survey data (1988 and 1990, to capture the periods before and after the reform) from all publicly traded companies and a small relatively high level of revenue; the other has a relatively high threshold, with relatively low revenues offset by relatively low collection costs and production inefficiency”). 112 see bird & gendron, supra note 1, at 531. 113 onji, supra note 22, at 767-68. 114 id. at 768 115 id. 2018] on the threshold: smallness and the value-added tax 203 number of prominent privately held companies in japan, onji found that the introduction of the simplified regime induced bunching below the eligibility threshold.116 these results provide “evidence…consistent with the hypothesis that large firms are ‘masquerading’ as many small firms” via the behavioral response of splitting.”117 second, a working paper by jarkko harju, tuomas matikka and timo rauhanen (2016) evaluates the prevalence of bunching using vat data from all firms that were operating in finland from 2000 to 2011.118 finland has a particularly low registration threshold (8,500 euros, or about $10,500 us), in contrast japan’s high threshold for the simplified system.119 as a result, harju et al.’s study seeks to disentangle the influence on firm size decisions of vat compliance costs as distinguished from the effect of the tax itself.120 to do this, the paper exploits several changes in the rules relating to small supplier registration and compliance thresholds, including a vat-relief measure in which firms could apply for a lower rate of vat that gradually increases above the threshold, as well as vat reductions targeted towards specific industries.121 harju et al. find strong evidence of bunching below the threshold but no evidence that bunching decreased with reductions in the vat rate.122 however, bunching did decrease in response to a reform designed to mitigate compliance costs associated with accessing the relief measures.123 on these bases, harju et al. conclude that high vat compliance costs at the very low end of the firm-size spectrum may be a key driver of bunching.124 third, a 2016 contribution by li liu and benjamin lockwood develops a formal model for studying the two key dimensions of behavioral responses to a vat “notch” (as the discontinuous tax treatment induced by a registration threshold is called in the public economics literature): voluntary registration and bunching.125 they show that a firm is more likely to voluntarily register and, conversely, less likely to restrict its sales to allow it to “bunch” beneath the threshold when “either (i) the cost of inputs relative to sales is high, or (ii) when the proportion of b2c sales by the firm is low.”126 the intuition for (ii) is “simply that if most customers are vat-registered, the burden of an increase in vat 116 id. at 771-72. 117 id. at 772 (applying a semiparametric density decomposition technique to net out confounding influences). 118 see harju et al., supra note 32, at 10. 119 id. at 2. 120 id. at 3. 121 id. at 3-6, 22. 122 id. at 1. 123 id. at 30 (“importantly, there is a significant increase in the take-up rate in 2011. from 2010 onwards, firms could apply for the relief with the same form they use to declare sales and purchases subject to vat. this seems to have increased the share of firms that applied for the relief. importantly, the increase in take-up is reflected in the excess bunching estimate. figure 11 above shows that excess bunching moderately decreased in 2010-2011 compared to previous years. this supports the view that the increase in transparency and the simplification of the relief system affect observed firm behavior at the threshold, at least to some extent.”). 124 id. at 36 (“we find that changing the tax system from a vat notch to a vat kink did not significantly decrease the bunching effect. this suggests that compliance costs largely explain observed responses. we find no clear traces of tax avoidance or evasion, which suggests that firms respond by reducing output.”). 125 liu & lockwood, supra note 32, at 2-3. 126 id. at 3. 204 columbia journal of tax law [vol.9:177 can easily be passed on in the form of a higher price, because the customer itself can claim back the increase…[and] for (i), [the intuition] is that when input costs are important, registration allows firm to claim back a considerable amount of input vat.”127 liu and lockwood test the predictions of their model on a massive dataset constructed by connecting “the universe of vat returns to the universe of corporation tax records in the uk” between the time periods april 1, 2004 and march 30, 2010.128 they find evidence of voluntary registration and bunching that is strongly consistent with the predictions of their model. with particular respect to bunching, they summarize their findings as being threefold: first, the vat notch creates evident bunching below the threshold. excess bunching ranges from 0.82 to 1.29 times the height of the counterfactual distribution, and is strongly significant in all years during the sample period. second, excess bunching tracks precisely the annual change in the nominal vat notch due to adjustment to inflation…third, in contrast with the large bunching below the threshold, there is a small hole in the distribution above the vat notch.129 in addition, liu and lockwood find that a firm’s propensity to bunch below the threshold is consistent with the model: firms are more likely to bunch as their share of sales made to vat-unregistered consumers rises, and less likely to bunch as their ratio of taxable inputs to sales rises.130 how do these three empirical studies of firm bunching in response to a vat connect with the keen and mintz model? importantly, none of the bunching studies provide estimates of the efficiency losses associated with bunching. onji is clear that his methodology and data do not allow him to estimate the efficiency effects that the observed level of firm bunching might imply.131 and although harju et al. note that bunching is “relatively permanent, which implies that the threshold decreases growth of small businesses,” and conclude that their bunching result “implies notable efficiency implications,” such effects were not (and could not be) estimated.132 liu and lockwood explicitly discuss the theoretical challenges of estimating the normative impact of thresholds and are clear that they take no position on the welfare effects of bunching.133 127 id. 128 id. at 20-21. 129 id. at 25. 130 id. at 26-27, 31. 131 see onji, supra note 22, at 773 (“…the present approach is not suitable for estimating revenue losses. by understanding the tax gains to firms, we learn about the extent of revenue drains caused by tax avoidance, but we can also gauge the extent of efficiency losses. the efficiency losses can occur by maintaining organizational structures that firms would not have chosen otherwise. but since a rational firm would not incur costs greater than the benefits, the amount of tax benefits provides the upper bound for the efficiency loss”) (citation omitted). 132 liu & lockwood, supra note 32, at 1. 133 see id. at 18 (“first, unlike the personal income tax case, the vat sufficient statistic t does not depend just on the tax code. in particular, [it] also depends on [some] model parameters…[that] are harder to specify. second, as shown in lockwood (2016), in the presence of a notch, the elasticity of the tax base (in 2018] on the threshold: smallness and the value-added tax 205 efficiency estimates (or lack thereof) aside, these studies conclusively show that bunching is present in a variety of vat contexts ranging from a very low threshold (finland) to high (uk), and very high (japan) thresholds. accordingly, they can be seen as validating the key tradeoff (between the threshold and production efficiency) identified by keen and mintz’s analysis. in light of the bunching evidence, it is unsurprising that keen and mintz’s highthreshold recommendation has attained the status of “conventional wisdom” among vat experts.134 setting thresholds high reduces the concentration of firms that have revenues in the vicinity of the threshold, thus limiting the prevalence (although not necessarily the magnitude) of bunching. b. current registration thresholds outside of the rarefied world of vat specialists, the wisdom of high thresholds is not a foregone conclusion. over a decade ago, a report of the international tax dialogue (2005) noted the presence of disparate thresholds and offered an observation that remains largely accurate today: “[t]here is considerable variation across countries in the level of the vat threshold, ranging from a few thousand dollars to over us$200,000. even within the european union, where there is a common legal framework governing the vats of member states, the threshold levels vary from zero to approaching us$100,000.”135 to get a sense of this variation, table 1 lists the domestic-business registration thresholds (in 2016 purchasing-power-index-adjusted united states dollars) in effect at the beginning of 2018 for each oecd country (except, of course, the united states, which does not have a vat). 136 while this list is neither representative of the average global vat threshold (it is a rich-country group) nor does it reflect important nuances in how thresholds work on the ground,137 it does facilitate blunt comparisons of the magnitude of the registration threshold across this set of countries. the case of the personal income tax, taxable income), is no longer a sufficient statistic for the marginal deadweight loss of the tax, so elasticity estimates are of less interest from a normative [efficiency] point of view. so, for these reasons, we do not attempt elasticity estimates.”). 134 see bird & gendron, supra note 1, at 115. 135 see the value added tax: experiences and issues, in international tax dialogue, supra note 41, at 5. 136 as opposed to foreign businesses doing business in the jurisdiction—sometimes these are lower, so i list the domestic thresholds to err on the side of conservatism (e.g., give higher thresholds the benefit of the doubt). 137 for instance, it does not take into account different thresholds for different kinds of sales (e.g., goods versus services). it ignores the important role that may be played by simplified schemes such as a turnover tax, a reduced rate of vat, or a presumptive input credit for all, or a subset of, small firms. see keen & mintz, supra note 20, at 562 (discussing various approaches to qualifying the threshold through specific rules through a “wide variety of measures”). see also michael smart, departures from neutrality in canada’s goods and services tax, 5 u. calgary sch. pub. pol’y res. papers 1, 20 (2012) (describing the distortions that can result from such approaches, using the example of the canadian gst’s “quick method” and the “simplified method” by which traders whose taxable sales do not exceed $200,000 and $500,000, respectively, can avail themselves of simplified reporting schemes). 206 columbia journal of tax law [vol.9:177 table 1: oecd vat threshold values138 (countries with thresholds below ppp-adjusted $50,000 us in bold) country us $, purchasing power parity-adjusted (based on gdp 2016) australia $50,336 austria $37,500 belgium $31,250 canada $24,000 chile $0 czech rep. $76,923 denmark $6,793 estonia $74,074 finland $10,989 france $101,841 germany $22,436 greece $16,667 hungary $59,259 ireland $92,593 israel $25,850 italy $41,667 japan $100,000 korea $27,429 latvia $80,00 luxembourg $33,333 mexico $0 netherlands $1,640 new zealand $40,816 norway $4,950 poland $111,732 portugal $16,949 slovak rep. $101,612 slovenia $83,333 spain $0 sweden $3,304 switzerland $81,301 turkey $0 united kingdom $121,429 average $48,841 median $32,292 138 see oecd, oecd tax database, http://www.oecd.org/tax/tax-policy/taxdatabase.htm#vattables [https://perma.cc/r386-4gjh]. 2018] on the threshold: smallness and the value-added tax 207 the heterogeneity of the threshold levels is the most immediately striking feature of table 1. the average threshold is $48,841 while the median value is approximately $32,000. on the one hand, very low or even zero thresholds are not uncommon. 60 percent of the countries listed in table 1 have a threshold value that is less than (adjusted) $50,000 us.139 on the other hand, a number of countries (france, japan, poland, slovak republic, uk) are high-threshold outliers, with thresholds in excess of $100,000. moreover, between 2016 and 2018 there have been some significant increases in thresholds that have occurred:140 estonia from 16,000 eur to 40,000 eur, hungary from 6,000 to 8,000 huf, latvia from 40,000 eur to 50,000, poland from 150,000 to 200,000 pln, and sweden from zero to about $3,000.141 as an example of increases farther back in time, in 2007, australia increased its threshold from $50,000 to $75,000 aud.142 looking outside of the oecd, a number of new vats have been adopted in recent years with low to moderate thresholds, and existing thresholds have been increased.143 tanzania and zambia increased their thresholds in the early 2000s.144 bangladesh’s vat was adopted with a threshold of about $5,000 us in 1991, but was progressively raised through amending legislation: the current statute has a threshold of approximately $29,500 for enlistment and $98,500 for registration.145 and the planned 139 see oecd, table 2.a2.3. annual turnover concessions for vat/gst registration and collection (domestic businesses), http://www.oecd.org/ctp/consumption/table-2-a2-3-vat-annual-turnoverconcessions-vat-registration-collection-2018.xlsx [https://perma.cc/e5e6-t25j] (last visited apr. 7, 2018) (showing the 20 of 33 oecd countries had a us $ppp-adjusted threshold below $50,000 as of the beginning of 2018). 140 see oecd tax database, supra note 138 (comparison of country data on 2018 tab with that of 2016 tab). 141 in 2008, the eu introduced the small business act, entitled “think small first”—a small business act for europe. commission of the european communities, “think small first”—a small business act for europe, com (2008) 394 final (june 2008). one of its main goals was to simplify the regulatory and policy environment for small and medium sized enterprises in the eu; it invited member states to reduce the administrative burden on smes by permitting them to raise their vat thresholds up to €100, 000. id. at § 2.iii (“adopt the commission proposal which would permit member states to increase the threshold for vat registration to €100 000”). 142 see a new tax system (goods and services tax) act 1999, compilation no. 68 (2016) (cth) (austl.), available at https://www.legislation.gov.au/details/c2016c00695 [https://perma.cc/l4e4-4r79]. however, australia’s black economy taskforce’s interim report asked whether lowering the gst threshold might be warranted due to “technological developments since the tax was introduced.” see black economy taskforce, interim report 47 (mar. 2017), https://consult.treasury.gov.au/tax-framework-division/blackeconomy-taskforce/supporting_documents/be_ir.pdf [https://perma.cc/7z8y-ll8j]. 143 for instance, laos adopted a vat in 2009 with a threshold of $49,000 us (4 million laotian kip). see pricewaterhousecoopers, lao pdr: value-added tax (2013), http://taxsummaries.pwc.com/id/lao-pdr-corporate-other-taxes [https://perma.cc/s6jp-9w8w] (last updated dec. 18, 2017).. see also thresholds of other recently-adopted countries: gambia (2013), saint kitts and nevis (2010), congo (2012), seychelles (2012), niue (2009), grenada (2010), sierra leone (2009), in royal malaysian customs dep’t, malaysia goods & services tax (gst), (jan. 24 2014), http://gst.customs.gov.my/en/gst/pages/gst_ci.aspx [https://perma.cc/7xw8-attf]. 144 see int’l monetary fund fiscal affairs dep’t, revenue mobilization in developing countries 63-64, 70 (2011), https://www.imf.org/external/np/pp/eng/2011/030811.pdf [https://perma.cc/b82e-ctf4]. 145 see nahida faridy et al., complexity, compliance costs and non-compliance with vat by small and medium enterprises in bangladesh: is there a relationship?, 29 austl. tax f. 281, 285 n.15 (2014) (describing trajectory of thresholds). 208 columbia journal of tax law [vol.9:177 initial (phase one) registration threshold for the gulf cooperation council vat is reported to be quite high.146 thus, higher thresholds appear to be gaining traction, albeit unevenly. from a normative (efficiency) standpoint, however, keen and mintz’s conclusions offer no direct help concerning whether any of the countries in table 1 have a registration threshold that is “too low.” to generate the high-threshold results from simulations of their model, keen and mintz used parameter values drawn from late-1990s canadian macroeconomic estimates. the recommended threshold is thus not a one-size-fits all number. reproduced below is a table from ebrill et al.’s (2001) vat handbook that makes this point, albeit in a dated fashion (some thresholds, including bangladesh’s, have been modified). table 2: vat thresholds actual and recommended (reproduced from ebrill et al.: table 11.1)147 actual threshold [circa 1999] imf recommendation albania $32,000 $50,000 bangladesh 32,609 34,900 benin 80,000 80,000 bulgaria 42,000 50,000 burkina faso 80,000 80,000 cameroon 80,000 60,000 croatia 8,000 40,000 el salvador 6,000 12,000 georgia 2,400 12,000 mauritania 46,000 55,000 mongolia 18,750 18,750 pakistan 22,700 70,000 philippines 14,000 14,000 sri lanka 33,000 30,000 uganda 50,000* 20,000 *$20,000 at introduction 146 see sarah diaa, uae outlines vat threshold for firms in phase 1, gulf news (aug. 15, 2015, 8:36 pm), http://m.gulfnews.com/business/economy/uae-outlines-vat-threshold-for-firms-in-phase-11.1847025 [https://perma.cc/lq6u-5sdc] (indicating that businesses with turnover in excess of dh 3.75 million (over us $1 million) would be required to file, with optional registration for smaller, but not the smallest, firms). 147 see ebrill et al., supra note 14, at 114 (omitting china and vietnam; these countries’ actual thresholds cases were more complicated). the data was gathered from a survey that was conducted in the late 1990s (most surveys were completed in spring/summer 1998). the goal of the survey was to get a sense of the pattern of vats implemented in developing and transitioning countries and how the actual practice in countries compared to the advice provided by fad staff. 2018] on the threshold: smallness and the value-added tax 209 here, the recommended threshold level ranges from $12,000 in el salvador and georgia to $80,000 in benin and burkina faso, underscoring the potential pitfalls of any rule of thumb. other than those reproduced in table 2, estimates of the optimal vat thresholds and accompanying policy recommendations for different jurisdictions are not publicly available.148 such recommendations may be more likely to be the subject of technical assistance rather than academic work, especially to the extent that they are seen as mere applications of the general theoretical framework established by keen and mintz.149 one exception is a stand-alone report released in april 2006 by kelly edmiston and richard bird, which examined ex post the experience of jamaica in setting its initial threshold upon adoption of a vat in 1991 and adjusting it periodically to account for high levels of inflation.150 even after reforms that substantially raised the threshold to j$300,000 in 2003, it was only a quarter (in real terms) of the threshold initially imposed in 1991, and barely half of what edmiston and bird state is “a very rough estimate of the ‘correct’ threshold…[of] about j$600,000.”151 in addition, the optimality of higher thresholds has been borne out by the vat adoption and implementation experiences of a number of different countries. 152 according to the imf survey reported in ebrill et al., low registration threshold levels were cited as significant challenges for the vats that were adopted in albania, croatia and georgia.153 the “near failure” of the vat in uganda in 1996 “is in large part attributed to a low threshold, which in the event was quickly raised from a level of $20,000 at the time of introduction to $50,000 only five months later.”154 it has also been suggested that the initial failures of the vat in malta and in ghana were the result of an inappropriately low threshold.155 148 even in the most exciting recent work on vat threshold issues that is in progress by economists, discussion of the implications for (or even speculations about) recommended thresholds seems almost conspicuously absent. see liu & lockwood, supra note 32, at 30; see also harju et al., supra note 32, at 4. 149 in part iv, i return to this issue in suggesting areas for future research that could bolster (or possibly undermine, but, in any event, inform) the case for revisiting low registration thresholds. 150 see kelly d. edmiston & richard bird, taxing consumption in jamaica, 35 pub. fin. rev. 26, 26-27 (2007). 151 in 2006 us dollar terms, this is about $9,676 (using historical currency conversion tool fxtop, currency converter [https://perma.cc/yqy2-qffr] (last visited mar. 9, 2018). see edmiston & bird, supra note 150, at 47. 152 see bird & gendron, supra note 1, at 114. 153 see ebrill et al., supra note 14, at 113. 154 id. at 114. 155 see the value added tax: experiences and issues, in international tax dialogue, supra note 41, at 16 (“[i]ndeed, in both ghana and malta an initially low threshold was one of the primary reasons for the failure of their first vat”). with respect to ghana, the failure of the 1994 vat was seen as being hastened by its high rate (17.5%, noticeably higher than the former 15% ghanaian sales tax) and low registration threshold (25 million cedi, or about $15,000 us). see miranda stewart, tax policy transfer to developing countries: politics, institutions and experts, in global debates about taxation (holger nehring & florian schui eds., 2007), 188 n.53 (citing rimmer, herbst & killick) [hereinafter stewart, transfer]. the subsequent re-introduction of the vat in 1998 featured a lower rate (ten percent) and registration threshold that was eight times the magnitude of the repealed vat (200 million cedi, or about $80,000 us). whether the connection is causal or merely circumstantial, the new ghanaian vat has met with greater success and political durability. see also prichard, supra note 5, at 91. 210 columbia journal of tax law [vol.9:177 from the other direction, the experience of countries that have adopted higher registration thresholds appears to have generally been positive. however, with the exception of edmiston and bird’s case study of the jamaica,156 research is sparse. the uk’s threshold is higher threshold than any eu member state and is the second highest (after japan) among oecd countries (£85,000 from april 1, 2017, or about $121,000 us).157 the mirrlees report, a comprehensive review of the british tax system, noted that “[t]here is good reason to suppose that the relatively high threshold should be counted as a strength of the uk vat.”158 what does all this imply about the validity of a rule-of-thumb optimal registration threshold? one appears to have emerged, albeit with caveats. with reference to developing economies, bird and gendron note that “[a]s time went on…and more experience with the difficulties of imposing general sales taxes [including vats] in fragmented economies with large informal sectors was accumulated, conventional wisdom changed…[and] now suggests that the threshold should be set considerably higher in most countries—say, at a level of u.s. $100,000 [$119,000 in 2016 dollars].”159 c. possible explanations for the persistence of low thresholds a number of commentators have cited the persistence of low vat thresholds as a puzzle.160 what factors might be responsible for this divergence? in the vat literature, two general hypotheses have emerged to explain the disconnect between vat theory and practice with respect to threshold-setting: fears about revenue losses and concerns about unfairness to large businesses.161 in 2001, ebrill et al. stated: 156 see edmiston & bird, supra note 150, at 26-27. 157 see hm revenues and customs, policy paper: vat registration threshold (mar. 8, 2017), https://www.gov.uk/government/publications/vat-registration-threshold/vat-registration-threshold [https://perma.cc/g4fp-th28] (noting however that there is a separate “deregistration threshold” that is set 2,000 pounds lower “to avoid businesses trading around the threshold level having to frequently register and deregister.”). 158 see crawford, keen & smith, supra note 21, at 311. 159 the basis for this rule of thumb comes from ebrill et al., who provide plausible parameter values that can yield a rule of thumb threshold for developed (oecd) countries. see ebrill et al., supra note 14, at 117-18. assuming administration costs per registrant on the order of $100 and compliance costs of about $500, a marginal value of one additional dollar of tax revenue of approximately $1.20, a vat rate of 15%, and a ratio of value-added to output of 40%, the simple optimal threshold rule provided in ebrill et al. (which broadly corresponds to that generated by the simple model in keen & mintz) yields a threshold value of about $52,000 in 1994 dollars. see bird & gendron, supra note 1, at 115 (explaining why relevant costs are likely to be higher; thus the difference between bird and gendron versus ebrill et al. inflation-adjusted rule-of-thumb thresholds). 160 see ebrill et al., supra note 14, at 117, 123; bird & gendron, supra note 1, at 120 (“[i]t does not make sense for most countries to apply vat as widely as their laws require [e.g., to the extent of their low threshold requirements for registration], and it is puzzling that so many developing and transitional countries persist in (nominally) attempting to do so”). see also id. at 116 (citing international tax dialogue’s 2005 report and noting that “it is a bit puzzling that most developing countries establish and maintain low thresholds for vat registration, thus encumbering their already overburdened administrations with a large amount of essentially useless work”). 161 note that these are merely the explanations that i found mentioned in the vat literature. as one vat expert suggested to me in conversation, there are a number of other compelling accounts: first, the registration threshold for a vat’s predecessor tax (e.g., a turnover tax, retail sales tax, etc.) may be a strong 2018] on the threshold: smallness and the value-added tax 211 experience indicates that setting too low a threshold can significantly compromise the political and administrative feasibility of a vat…however, authorities often appear not to have been persuaded of the wisdom of this approach. the reasons for this are not entirely clear: a belief that high thresholds may forego significant revenues, and perceptions of unfair competition, appear to be among the most prominent reasons.162 the first concern, worries about losing badly-needed revenue on which governments are depending, is the most common explanation for persistent low thresholds. it has been echoed by other leading commentators, including bird and gendron.163 as noted above, with the exception of edminston and bird’s paper, there is little empirical research assessing the revenue implications of vat threshold-raising.164 however, establishing a causal connection between threshold changes and revenues is difficult; many macroeconomic variables that can affect vat revenues are likely to be in flux as the threshold is being adjusted, especially when the impetus for the increase is price volatility. nonetheless, a cross-country compilation of the revenue trajectories before and after increases in thresholds might be helpful in allaying fears on this point. at the same time, proponents of higher thresholds would benefit from having data on the magnitude of government savings as “administrative effort [is] freed from processing numerous low-return taxpayers,” which bird and gendron refer to as “essentially useless work.”165 what about the second concern noted above—that higher thresholds as a normative goal may be at odds with fairness? the final part of the paper applies the theoretical and practical understandings of vat registration thresholds developed thus far to argue that, to the contrary, equity norms point in favor of higher thresholds. v. part iv: assessing fairness to close the gap between registration threshold theory and practice equity is often presented as the enemy of efficiency in the context of taxation: redistributive policies may reduce inequality across individuals but can introduce inefficiencies when those policies alter incentives that lead to distortions in behavior.166 focal point; second, low thresholds may be a way to ensure jobs for civil servants employed by the tax authority (an important objective for any political leader). thank you to rebecca millar for both of these suggestions. 162 see ebrill et al., supra note 14, at 117. 163 see bird & gendron, supra note 1, at 117, 123 (noting that “[t]here seems to have been a belief that a lower threshold than that advised would prove more productive of revenue”). 164 see edmiston & bird, supra note 150, at 46-47 (finding that the revenue losses following jamaica’s 2003 threshold increase were minimal). 165 see bird & gendron, supra note 1, at 120. thank you to rebecca millar for noting the countervailing political consideration that keeping revenue staff employed—at least notionally—may play an explanatory if not normatively desirable role. 166 a core premise of public economics is that typically there is a tradeoff between equity and efficiency. the more redistribution achieved or the more equal people are made on an after-tax basis, the greater the losses from behavioral distortions of economic activity. for instance, substitutions between labor 212 columbia journal of tax law [vol.9:177 vat registration thresholds could well be another arena in which this tug-of-war is present. i argue in this part that, under the right circumstances, higher registration thresholds are likely to promote efficiency and fairness simultaneously. keen and mintz emphasize at numerous points that their model focuses exclusively on the efficiency implications of registration thresholds.167 however, they note, somewhat cryptically, in their paper’s last paragraph, that the equity implications of threshold-setting are “somewhat subtle.”168 in this part, i probe that subtlety under varying assumptions.169 a. equity in the context of vat thresholds the general problem of line-drawing between tax “winners” (by virtue of exemptions or lower rates) and “losers” (by virtue of the reverse) is much broader than any particular question relating to firms’ costs of registering for vat.170 any rule that imposes differential tax treatment across firms by offering size-based exemptions will disadvantage the large, relative to the small.171 indeed, keen and mintz, following ebrill et al.,172 emphasize that the choice of threshold implicates two aspects of concerns about fairness: vertical equity at the level of individual human beings and (horizontal) competitive fairness at the level of firms.173 fairness analysis requires making comparisons across taxpayers, and is typically focused on individual human beings or family units in their capacities as taxpayers.174 and leisure in the presence of a progressive tax on labor income reduce efficiency even as the tax promotes distributional (vertical) equity. see, e.g., louis kaplow, the theory of taxation and public economics 392-401 (2008). 167 see keen & mintz, supra note 20, at 574. neoclassical economic analysis uses efficiency as its sole normative criterion, and keen & mintz emphasize in their conclusion that their model intentionally ignores questions of distributive fairness. they note: “the focus here has been on efficiency aspect[s] of the threshold choice…[i]n practice, distributional effects are naturally a major concern.” however, their model of the small firm vat compliance decision does feature a fixed component of firm-level compliance costs, and this has a profound distributional implication: smaller firms will bear a larger share of compliance costs relative to their sales. while fixed firm-level compliance costs imply regressivity, distributional equity plays no explicit role in keen & mintz’s analysis. in particular, the model specifies the objective function of government as maximizing the simple sum of individuals’ utilities. id. at 568. assumptions that might be construed as importing equity considerations into the analysis are absent, such as an assumption of decreasing marginal utility of production—whereby entrepreneurs with higher levels of sales are assumed to gain less utility from each additional dollar of sales than an entrepreneur with lower levels of sales. 168 id. 169 see int’l monetary fund fiscal affairs dep’t, supra note 144, at 26 (noting that the threshold “either confers a competitive advantage on smaller and presumably less well-off retailers and service providers, or enables their customers, likely amongst the poorer, a de facto exemption”). 170 see david weisbach, an efficiency analysis of line drawing in the tax law, 29 j. legal studs. 71, 71-97 (2000). 171 see, e.g., ravi kanbur & michael keen, thresholds, informality and partitions of compliance, 21 int’l tax & pub. fin. 536 (2014). 172 see keen & mintz, supra note 20, at 574 (noting that “much emphasis is often given, in particular, to the regressive nature of the compliance costs associated with the vat…against this, however, must be borne the competitive advantage enjoyed (at least in respect of sales to final consumers) by those who remain below the threshold”). 173 id. 174 see richard a. musgrave, the theory of public finance 160 (1959). here it is important to emphasize in the discussion that follows, where i talk about equity with respect to vat threshold-setting 2018] on the threshold: smallness and the value-added tax 213 vertical equity refers to the principle that differently-situated taxpayers should be treated differently.175 it is linked to the empirical observation that taxpayers with lower absolute levels of income (or consumption) may experience a greater increase in wellbeing from an additional increment of income (or consumption) than individuals with higher levels.176 its distributive implication is “thought to require a progressive rate structure that imposes progressively higher rates on individuals with higher incomes.”177 in contrast, or perhaps as the flip side of the same coin,178 horizontal equity refers to the principle that similarly-situated taxpayers should be treated similarly.179 it concerns itself with avoiding unwarranted discrimination across taxpayers.180 in the context of analyzing the potential discriminatory effect across firm taxpayers (rather than individual taxpayers) of requiring registration in the context of a vat, i use the term “competitive equity” for clarity. it is not clear what “differently-situated” or “similarly-situated” mean in the context of vat registration thresholds. the most frequently-discussed dimension of interest for vertical and horizontal equity analysis is an individual taxpayer’s “ability to pay” a tax.181 ability to pay, in turn, is most commonly proxied by the individual’s income or consumption: how easily can the individual marshal the necessary resources to pay the amount of tax owed (e.g., the rate times the base)?182 however, it typically does not take into account the costs that are associated with compliance, even though complying is, at least weakly, a condition precedent to paying the amount of tax that is (which affects firms rather than individuals per se), i try to be very explicit about the assumptions i am making in relating firms to individuals associated with them. see claire crawford & judith freedman, small business taxation, in dimensions of tax design: the mirrlees review 1028, 1037 (j. mirrlees et al. eds., 2010) (“it is a mistake to equate ‘small business’ with any particular economic or social characteristics when devising tax policy”). 175 see james b. bickley, cong. research serv., r41602, should the united states levy a value-added tax? 7 (2010) (discussing horizontal and vertical equity in the context of a vat in which consumption is often used as a measure of ability to pay as opposed to income). 176 see richard a. musgrave & peggy b. musgrave, public finance in theory and practice (1973); kaplow, supra note 166, at 42-44 (explaining that the degree of concavity of a utility function determines the “rate at which individuals’ marginal utility of consumption falls as consumption rises— equivalently, individuals’ degree of risk aversion…hence, ceteris paribus, a higher p [variable in utility function] also favors greater equality in the distribution of consumption;” pointing out, however, that the curvature of an individuals’ utility function is a “matter of empirical fact about individuals whereas the latter [the nature of the social welfare function that the central planner adheres to] involves a normative judgment, external to the individuals in question, that must be grounded in a theory of distributive justice”). in other words, the second derivative of a representative individual’s utility function taken with respect to consumption is typically assumed to be negative; how negative at various points is the empirical question. 177 see james repetti & diane ring, horizontal equity revisited, 13 fla. tax rev. 135, 136 (2013). 178 see id. at 137-38 (noting that “he and ve are merely both sides of the same coin, because starting an analysis by asking what the appropriate criteria are to determine which persons are not alike yields the same result as starting the analysis by asking what criteria should be used to determine whether persons are alike”). 179 see musgrave, supra note 174, at 113. 180 see id. at 160; repetti & ring, supra note 177, at 138-39 (proposing he as a concept implicating safeguards against arbitrary enforcement of tax laws). 181 see repetti & ring, supra note 177, at 140. 182 there are a number of critiques of the concept of “ability to pay” as the core criterion for evaluating horizontal and vertical equity. for one helpful discussion of some of the complexities and drawbacks, see kaplow, supra note 167, at 404-06. 214 columbia journal of tax law [vol.9:177 owed (in the case of the vat, the amount of tax collected from consumers that must be remitted by the firm). b. vertical equity assessing the vertical equity implications of vat registration threshold-setting requires distinguishing concerns about the magnitude and distribution of vat compliance costs from concerns about the magnitude and distribution of the vat itself. the issue is not whether a vat is regressive183 in requiring individuals with lower ability to pay to bear disproportionately more of the vat tax burden than individuals with higher ability to pay.184 instead, assessing vertical equity in the vat registration context requires attention to the individual-level incidence of firm-level compliance costs. are vat compliance costs shouldered by the entrepreneurs, owner-managers, or shareholders of registered firms in the form of lower earnings or profits? are they borne by employees or casual labor in the form of lower wages or piece rates? are they borne by non-labor inputs (e.g., capital providers)? are they passed along to consumers in the form of higher prices? or some combination of these? one rallying cry of businesses opposed to adopting a vat in australia (and elsewhere) was that it would require them to serve as “unpaid tax collectors for the government.”185 at least in part, this reflects the concern of owners or managers that it may be hard for firms to recoup their costs of complying with a vat from their 183 the distribution of vat liability is typically regressive when examined with reference to the income of the end consumer paying vat at the point of sale. see peter varela, brief: progressive and regressive taxes, austaxpolicy (feb. 24, 2016), http://www.austaxpolicy.com/brief-progressive-andregressive-taxes/ [https://perma.cc/k24a-qv7w] (noting that, with respect to the australian vat, or the gst, “[w]hen the gst is examined as a proportion of income, the gst is found to be a regressive tax, even though the gst is applied at a constant rate of 10 per cent. this is because people with higher incomes tend to spend less (and save more) of their income than people with lower incomes, which results in less gst being paid as a percentage of the income of higher income earners”). this means that, even though a vat looks like a proportional tax (e.g., it is levied at x percent on all goods and services—ignoring for now exemptions and zero-rating), lower-income individuals typically pay proportionally more of their income in vat than higher-income individuals. however, the regressive effect attenuates when a vat is examined with reference to expenditures, it is a dubious instrument for redistributing income. id. (continuing from above, “[h]owever, progressivity can also be measured against household expenditure rather than income. this could be justified as a proxy for lifetime income (ignoring bequests or inheritances), or as a measure of ability to pay in its own right…[the australian] gst is close to a proportional tax when compared to an expenditure benchmark”). new evidence in the canadian context suggests that the regressivity stereotype may be overblown. 184 see richard bird & michael smart, taxing consumption in canada: rates, revenues, and redistribution, 64 can. tax j. 417, 420 (2016) (presenting evidence that “the presumed regressivity of sales taxes—particularly generalized sales taxes like the gst [canada’s vat]—is far from clear”). to the extent that lower-income taxpayers pay more vat than higher-income ones (or that they don’t pay less—if progressivity is desired) this distributive deficiency can be corrected by offering low-income taxpayers a sufficiently generous means-tested credit. however, in practice such progressivity-inducing credits are the exception rather than the rule. 185 see jeff pope & nthati rametse, small business and the goods and services tax: compliance cost issues and estimates, 9 small enterprise res. 42, 52 (2001) (noting that “[i]f recurrent compliance costs appear onerous and above comparative international levels (although research on the latter remains extremely difficult) there may be further lobbying for government compensation for small business having to act as an unpaid tax collector”). 2018] on the threshold: smallness and the value-added tax 215 customers or employees. indeed, small firms are artificial legal constructs behind which there are real human beings. the question of who bears the costs of vat compliance is not straightforward, and this author is not aware of any empirical studies on point. to get a sense of what we do know, the following three questions are addressed in turn: first, how significant are the vat compliance costs imposed on firms above the registration threshold? second, what is the economic incidence of these vat compliance costs (e.g., on which individuals within the groups listed above do they fall)? third, is the incidence of vat compliance costs equitable in the sense of burdening more heavily those with greater ability to pay (or to comply, or to pay to comply) as compared to those with lesser ability? 1. empirical studies of vat compliance costs a recent study of the real-world impact of a modern vat elaborates on the tangible manifestations of compliance costs for registered firms: [t]he private costs to a taxpayer of complying with the vat law can encompass not only the direct costs of collecting documentation; accounting for vat; the fees paid to professional tax advisers; and remitting vat on products but also indirect costs…includ[ing] the value of labor time associated with the completion of vat returns; the investment costs associated with acquiring intellectual capital necessary to enable this work…and even psychological cost…[of] trying to comply with tax legislation and regulation.186 over the past 30 years, there have been numerous studies estimating the compliance costs of vats.187 these studies are part of a broader literature on measuring and assessing the distribution of compliance costs of other tax instruments including income, payroll, wealth, and excise taxes. this broader literature shows that compliance 186 see faridy et al., supra note 145, at 289. see also sandford, minimising, supra note 82, at 128 (noting that “[f]or a business, faced with a gst, they include the costs of collecting, remitting and accounting for tax together with the costs of acquiring the knowledge to enable this work to be done, including knowledge of the legal obligations and penalties. the compliance costs also include the costs of storing records as required by the tax authorities. it is also appropriate to include costs incurred by representative bodies designed to help their members to cope with the tax”). 187 see cedric sandford, michael godwin & peter hardwick, administrative and compliance costs of taxation 10-11 (1989) [hereinafter sandford et al., administrative] (“compliance costs are defined as those costs incurred by taxpayers, or third parties such as businesses, in meeting the requirements laid upon them in complying with a given tax structure. they thus include, for individuals, the costs of acquiring sufficient knowledge to meet their legal requirements; of compiling the necessary receipts and other data and of completing tax returns; payments to professional advisers for tax advice; and incidental costs of postage, telephone and travel in order to communicate with tax advisers or the tax office. for a business, the compliance costs include the cost of collecting, remitting and accounting for tax on the products or profits of the business and on the wages and salaries of its employees together with the costs of acquiring the knowledge to enable this work to be done including knowledge of their legal obligations and penalties. these costs include associated overhead costs including the costs of storing records as required by the tax authorities”). see also id. at 128 (emphasizing that “they are costs over and above the payment of tax itself and over and above any distortion costs inherent in the tax”). 216 columbia journal of tax law [vol.9:177 cost regressivity with respect to firm size is not limited to the vat.188 however, the vat stands out as unusually regressive in the following sense: smaller firms’ costs of complying with the vat are typically higher, per unit of revenues, than larger firms’ costs.189 because a number of excellent reviews of vat compliance cost research are available,190 this subpart is intended to provide a brief summary of the key contribution in this area, with attention to the newest studies and to the most recent literature reviews. the landmark first study of vat compliance costs was conducted by cedric sandford et al., and focused on the uk vat in 1977–78.191 their headline finding was that compliance costs were “exceptionally regressive in their incidence.”192 in particular, traders with gross revenues of less than £50,000 comprised 69.15 percent of all registered businesses, yet contributed only 4.48 percent of all vat receipts to the treasury.193 staggeringly, these small traders’ compliance costs constituted approximately 42.6 percent of the total compliance costs of the vat.194 this group of authors published a follow-up study of uk vat compliance in 1989 and found that compliance costs had fallen overall but were still regressive in their distribution,195 a conclusion that was confirmed by a 1994 national audit office (uk) study.196 a comparative study of the uk and german vats, conducted also in the late 1980s, concluded that compliance costs of both taxes were regressive (with the uk more so than the german); correspondingly, small firm dissatisfaction with the vat was higher in the uk than in germany.197 188 see jacqueline coolidge, findings of tax compliance cost surveys in developing countries, 10 ejournal of tax res. 250, 254-62 (2012). see also world bank group, ifc tax perception and compliance cost surveys: a tool for tax reform (2011). 189 see luca barbone, richard m. bird & jaime vazquez-caro, the costs of vat: a review of the literature 58 (int’l ctr. for pub. policy, working paper no. 12-22, apr. 2012) (reviewing literature on vat compliance with an interest in understanding link to fraud and evasion, finding that “this literature review has not uncovered rigorous testing of the hypothesis that increasing compliance burdens affects vat fraud in either direction. however…fraud appears to be directly related to the compliance burden [and]…points to the fact that it might be productive to pursue this line of research most probably through a variety of survey instruments, and with appropriate country specificity”). see also bird & gendron, supra note 1, at 120 (summarizing the findings as universally consistent with compliance cost regressivity). 190 see barbone et al., supra note 189. 191 see cedric sandford et al., costs and benefits of vat 49-57 (1981) (in 1977 the registration threshold was £18,000, or approximately £117,000 in 2017 dollars). 192 id. see also chris evans, studying the studies: an overview of recent research into taxation operating costs, 1 ejournal of tax res. 64, 84-85 (2003) [hereinafter evans, studying] (summarizing the study’s major outcomes as part of a systematic literature review of studies addressing tax compliance and administrative costs). 193 see evans, studying, supra note 192, at 57. 194 id. at 49. see also turnier, designing, supra note 13, at 458-60 (discussing the high rate of voluntary registration for the uk vat, even at a very low threshold; 200,000 out of a total of 1.25 million registered vendors, or 16%, voluntarily registered. however, these voluntary registrants generated only two tenths of one percent of all vat receipts while imposing high administrative costs on the exchequer). 195 see sandford et al., administrative, supra note 187. 196 see national audit office, hm customs and excise: cost to business of complying with vat requirements 22 (1994) (“the main message of compliance costs in relation to trader turnover is broadly consistent in all five countries: the smallest traders incur proportionately the greatest costs”). 197 see g. bannock & h. albach, the compliance costs of vat for smaller firms in britain and west germany, in governments and small business 182 (g. bannock & a. peacock eds., 1989). see also evans, studying, supra note 192, at 84-85 (summarizing the study’s major outcome as part of a systematic 2018] on the threshold: smallness and the value-added tax 217 robert e. plamondon’s 1993 study of compliance costs of the then-new canadian gst found that costs were lower than expected based on past research but were higher for smaller businesses.198 similarly, cedric sandford and john hasseldine’s survey of businesses in new zealand found that vat compliance disproportionately burdened smaller businesses.199 the united states general accounting office, in its review of the feasibility of adopting a u.s. vat, emphasized one of this study’s most shocking findings: “[b]usinesses with annual gross receipts under about us $16,000 spent 500 times as much (as a percentage of sales) to comply with the new zealand goods and services tax as a firm with annual gross receipts over about us $27 million.”200 in his review and comment on these and other circa-1990s studies, sandford concluded that “[t]he essential issue in minimizing the compliance costs of a gst/vat is that of easing the burden on small businesses.”201 more recently, john hasseldine and ann hansford collected data on the uk vat through a postal questionnaire distributed to a sample of about 6,000 businesses.202 unlike previous studies, they measured core costs (“internal staff costs and in-house and external advice…for routine vat administration, preparing for and receiving visits from hm customs & excise, learning about vat rules and communicating with hm customs & excise on routine vat matters”) separately from total costs (including “planning, oneoff vat advice and other expenses such as software and other vat overheads…total costs may have a voluntary element such as costs incurred for vat planning purposes”).203 they found both cost components were increasing in the turnover and number of employees of the business, suggesting perhaps less regressivity than prior studies; however, the rate of increase in size was not specified.204 they also found a mildly significant effect of being a new business on both measures of compliance costs.205 there have also been several studies focused on the adoption in 2000 of new goods and services tax as part of a package of wider tax reforms in australia. nthati literature review of studies addressing tax compliance and administrative costs); sijbren cnossen, administrative and compliance costs of vat – a review of the evidence, 8 tax notes int’l 1649 (1994). 198 see robert e. plamondon, gst compliance costs for small business in canada: a study for the, department of finance, ottawa (1991) (using qualitative techniques; 200 face-to-face interviews conducted by accountants). 199 see cedric sandford & john hasseldine, the compliance costs of business taxes in new zealand 112-13 (1992). 200 see u.s. gen. accounting office, gao-93-78, value-added tax: administrative costs vary with complexity and number of businesses (1993), as cited in alan schenk, administrative costs of a u.s. value-added tax: a description and analysis of the report of the united states general accounting office, 4 int’l vat monitor 4 (1993). 201 see sandford, minimising, supra note 82, at 140. 202 see john hasseldine & ann hansford, the compliance burden of the vat: further evidence from the uk, 17 austl. tax f. 369, 378-79 (2002). 203 id. at 379. 204 id. at 381-82, 384. see also ann hansford, john hasseldine & carole howorth, factors affecting the costs of uk vat compliance for small and medium-sized enterprises, 21 env’t & plan. c.: gov’t & pol’y 479, 490-91 (2003) (noting that while the general finding is that firms just above the threshold face the heaviest burden of vat compliance, there is also some evidence that due to cross-border issues “life is not necessarily easier for larger firms…[this] would support the argument that compliance costs may not be strictly regressive and that smaller firms which are able to grow may still find themselves wrapped up in red tape!”). 205 see hasseldine & hansford, supra note 202, at 381, 384. 218 columbia journal of tax law [vol.9:177 rametse and jeff pope surveyed businesses in western australia and found that gst transitional and start-up costs for businesses across the size range exceeded government estimates206 and were highly regressive.207 tran-nam and glover conducted in-depth interview and quantitative surveys of a smaller number of largely rural businesses to estimate transition costs for the gst and the wider tax reform package. 208 they found that the average transitional business compliance costs were significant but slightly less than estimated by other studies.209 most recently, in a large-scale study of vat compliance behavior of small and medium businesses in bangladesh, nahida faridy et al. used both quantitative data from government administrative tax records as well as mailed questionnaire surveys and qualitative data gathered from focus group discussions and other sources.210 they used this mixed-methods approach to attempt to estimate both the monetary compliance costs and non-monetary costs including time spent on compliance and psychological costs.211 for compliant taxpayers, total monetary and psychological costs decreased as total vat payments increased.212 to the extent that a business’s vat payments track its revenues for compliant taxpayers (which appears from the paper’s discussion to be at least roughly the case), this study’s findings provide further evidence on the firm-size regressivity of vat compliance costs.213 2. economic incidence of vat compliance costs the preceding studies conclusively establish that vat compliance is disproportionately burdensome for smaller firms. but who are the individuals who actually bear the costs of vat compliance? one might simplistically presume that because the entrepreneur or owner-manager are tasked, on the firm’s behalf, with the obligation to charge, collect and remit vat, the costs of compliance will fall exclusively on her and she will directly absorb the costs in 206 see nthati rametse & jeff pope, start-up tax compliance costs of the gst: empirical evidence from western australian small businesses, 17 austl. tax f. 407 (2002) (surveying 4,000 taxpayers, approx. 800 surveys were returned; for businesses with less than $50,000 in revenues, compliance costs of gst start-up were about 15%; for businesses in the range of $50,000 to $99,999, compliance costs were 4.5%; for the range $100,000 to $500,000, compliance costs were 1.7%; over $500,000 compliance costs were only 0.44%). see also jeff pope, estimating and alleviating the goods and services tax compliance cost burden on small businesses, 11 revenue l. j. 1, 13 [hereinafter pope, estimating] (discussing rametse & pope). 207 see pope & rametse, supra note 185, at 54. 208 see binh tran-nam & john glover, tax reform in australia: impacts of tax compliance costs on small businesses, 5 j. austl. tax’n 338, 377 (2002). 209 see binh tran-nam & john glover, estimating the transitional compliance costs of the gst in australia: a case study approach, 17 austl. tax f. 499 (2002) (using questionnaires, log-book data gathering over time and face-to-face interviews to spot-check the veracity of the quantitative data). 210 see faridy et al., supra note 145, at 292-93. 211 id. at 309 (measuring psychological costs as the “annual cost per taxpayer of sleeping pills, tobacco, consult psychologists or psychiatrists or similar medication used to relieve the symptoms of anxiety or stress connected with [vat] compliance”). 212 id. (excluding time costs). 213 id. at 310 (author’s calculations from table 7, “total monetary and psychological costs of ct” (compliant taxpayers), calculating vat payment group using means of each bin; finding that total costs are decreasing from 16 to 11% as mean payments rose by increments of 100,000 bangladeshi taka). 2018] on the threshold: smallness and the value-added tax 219 the form of lower (net) profits.214 this could happen both in the case in which costs are monetary—the entrepreneur will enjoy lower net earnings from the business because she must pay someone else to deal with vat compliance—as well as the case where costs are non-monetary, or “internal.” 215 the concept of economic incidence in the context of consumption taxation interrogates the simplistic presumption that the burdens of the tax fall exclusively on either the seller/entrepreneur or the consumer. in a recent paper examining the “supply side” incidence of cigarette taxes, kyle rozema makes the point that: [a]n ideal tax incidence analysis would characterize the effect of a tax change on the utility levels of all individuals in the economy. it would begin by identifying the individuals who ultimately bear the tax burden. for a consumption tax [like a vat] this includes all individuals affected, regardless of whether they are on the demand size [customers] or the supply side [sellers]…in practice, [however], this exercise is difficult to conduct empirically because one must be able to identify the involved parties.216 in the context of the incidence of vat compliance costs, the exercise is similarly difficult.217 depending on the competitiveness and other conditions of the market in which the firm operates, it seems plausible that an entrepreneur, owner-manager or shareholder will have more or less leeway to pass along all or some of her vat compliance costs to employees, casual labor inputs, non-labor inputs (e.g., suppliers of capital or other inputs), or customers. in their study of compliance costs of business taxes in new zealand, cedric sandford and john hasseldine’s frame the issue aptly: [b]usinesses do not pay taxes—only individuals can do that; similarly businesses do not pay compliance costs—only individuals. the question 214 see sandford & hasseldine, supra note 199, at 114 (“where we are talking of sole proprietors and partners, the compliance costs are like an additional element of personal income tax and most of the cost is likely to stay where it falls, on the proprietor or partner; shifting it will be difficult although it may be possible to shift some of it forward, as with corporate income tax”). 215 see, e.g., katherine bain, michael walpole, ann hansford & chris evans, the internal costs of vat compliance: evidence from australia and the united kingdom and suggestions for mitigation, 13 ejournal of tax res. 158, 163 (2015) (internal costs as “costs of labour/time consumed in completion of tax activities…in contrast to external costs, which are the costs of purchasing expertise, such as external advisors; summarizing surveys of internal and external tax compliance costs showing that the portion stemming from vat/gst compliance is significant (although different as between australia and the uk—in australia, 58% of internal compliance costs were attributable to the gst whereas the uk figure was 41%). in the case of internal costs, if incidence fell on the seller, they would be extracted in the form of fewer leisure hours, more stress, worse health, or other incursions to the individual entrepreneur’s subjective welfare. 216 see kyle rozema, supply side incidence of consumption taxes 1 (oct. 5, 2016), http://ssrn.com/abstract=2742254 [https://perma.cc/lnj3-amm8]. 217 much of the earlier literature on the distributive implications of the consumption tax assumed that 100 percent of the consumption of taxes are passed through to the final consumer. see glenn jenkins, hatice jenkins & chun-yan kuo, is the value-added tax naturally progressive 3 n.3 (queen’s u. dep’t of econ., working paper no. 1059, apr. 2006) (citing a number of papers published in the 1970s and 1980s). 220 columbia journal of tax law [vol.9:177 then arises, who really pays compliance costs? what is the real or effective incidence of these costs? by effective incidence we mean, essentially the difference between two situations—one with the compliance costs in existence and one without—one of which is, of course, hypothetical. the area of tax incidence—and the incidence of compliance costs is very much akin to tax incidence—is an area of considerable difficulty and on important aspects there is no agreement amongst economists.218 as suggested by the literature review above, the research relating to compliance costs (and vat compliance specifically) focuses quite narrowly on measuring the magnitude of costs rather than exploring their incidence.219 however, there is a large literature on the incidence of consumption taxes as well as a literature in industrial organization that tests for pass-through of input costs. 220 generally speaking, this literature finds varying rates of pass-through of vat via increased consumer prices, decreased wages, or decreased spending on inputs.221 3. ability to pay to understand the vertical equity implications of the compliance costs associated with high versus low registration thresholds (per the simplified assumption above), ability to pay must be analyzed with respect to each potentially-affected constituency relating to the vat registrant: entrepreneurs/owner-managers, shareholders, employees/casual labor, non-labor inputs, and consumers. for simplicity, i focus on two: entrepreneurs/owner-managers (for ease of exposition, “entrepreneurs”) and consumers. unfortunately, there is little research on how firms of varying sizes are linked with entrepreneurs and customers of varying abilities to pay. however, a few sources (including a sentence in keen and mintz’s discussion222) make the point that higher thresholds can act as an implicit subsidy to correct some of the regressive tendencies of a vat in situations, particularly where smaller firms are associated with lower-income entrepreneurs and serve lower-income consumers. is there evidence that this is the case? obviously, it would be specific to a particular setting. however, there are some hints that this is the case. 218 see sandford & hasseldine, supra note 199, at 114. 219 see part iv. b.1, infra. 220 see youssef benzarti et al., what goes up may not come down: asymmetric incidence of value-added taxes 3-4 (nat’l bureau econ. res., working paper no. 23849, 2017). see also youssef benzarti & dorian carloni, who really benefits from consumption tax cuts? evidence from a large vat reform in france 18-20 (nat’l bureau econ. res., working paper no. 23848, 2017) (finding that a vat decrease for sit-down restaurants mostly benefitted firm owners through increased profits). 221 see rozema, supra note 216, at 3-5. 222 see keen & mintz, supra note 20, at 564 (“this differential treatment [tax and compliance costs imposed above but not below the threshold] has an equity aspect, though since it tends to be the smaller and hence presumably poorer traders that are relatively advantaged there are unlikely to be significant vertical equity concerns.”). 2018] on the threshold: smallness and the value-added tax 221 glenn jenkins, hatice jenkins, and chun-yan kuo observe that: the poor tend to purchase a larger proportion of goods and services from the informal retail sector where the goods are either not taxed at all or are more lightly taxed…the higher income [sic] households purchase goods and services in retail outlets that are likely to fully comply with the tax rules. as a result, the share of consumption subject to vat for higher income households tends to be greater than that for the poor.223 similarly, a 2009 fiscal affairs department (imf) report cites jenkins et al. (2006) in support of a similar proposition: [the] regressive effect [of a proportional tax on sales, like a vat] relative to annual income…is mitigated by the common exemption of sensitive food and other items and (less noted) by the operation of the threshold: the latter either confers a competitive advantage on smaller and presumably less well-off retailers and service providers or enables their customers, likely amongst the poorer, a de facto exemption (jenkins, jenkins, and kuo, 2006). the reach of the tax is also less in poorer rural regions than in urban centers.224 none of these statements specifically address the incidence of compliance costs; their focus is the incidence of the vat burden itself. however, it stands to reason that they would apply with equal or greater force to the incidence of vat compliance costs. this is because unregistered firms are not exempt from vat due to cascading input taxes, but they are exempt from compliance costs. to the extent that compliance costs are passed along to low-income customers or borne by low-income entrepreneurs, a low vat registration threshold will have progressive distributive implications. c. competitive fairness sharp discontinuities in the taxation of otherwise-similar firms (and the individuals associated with them as entrepreneurs and customers) situated above and below the threshold can raise horizontal equity concerns.225 moreover, they have been cited as a political roadblock for advocates of higher vat thresholds. indeed, linedrawing among bigger and more politically influential firms may naturally trigger louder 223 see jenkins et al., supra note 217, at 4. 224 see int’l monetary fund fiscal affairs dep’t, supra note 144. 225 some commentators have framed these concerns as relating to horizontal equity. see crawford & freedman, supra note 174, at 1040 (“horizontal equity issues arise at each borderline and across the piece [referring to workers’ choices between employment and incorporation or employment and selfemployment]”). see also gendron, supra note 38, at 267 (“the equity argument goes along the lines that it would be unfair that large businesses must be responsible for all obligations while small businesses are not, and can thus enjoy a competitive advantage.” then offering some responses to that argument including input taxation and the availability of voluntary registration). 222 columbia journal of tax law [vol.9:177 cries of foul play than drawing similar distinctions among smaller and more politically dispersed firms.226 horizontal equity concerns itself with avoiding unwarranted discrimination across similarly-situated individual taxpayers; “competitive fairness” suggests this same concept with respect to firms. ebrill et al. suggest that the appearance of discrimination against larger firms may bear responsibility for legislators’ reluctance to adopt higher vat registration thresholds.227 firms with revenues just below the threshold can remain exempt, while an arbitrary revenue cutoff requires registration for an otherwise-identical firm with revenues at or just above the threshold. these registered firms and their associated entrepreneurs must not only bear the significant and regressive compliance burdens of the vat, but also are competitively disadvantaged as a result of having to charge vat on their sales.228 keen and mintz’s model of the optimal threshold accounts for the firm-size inefficiencies associated with a registration threshold, but it does not address the issue of discrimination against those firms (and their associated entrepreneurs and, potentially, customers) immediately above the threshold, or its political ramifications.229 there are a few reasons to suppose that the higher the proposed registration threshold, the more politically influential such firms’ competitive fairness objections will be. first, larger firms may have louder voices with which they can make their objections heard. if larger firms are suddenly threatened with competition from unregistered sellers, they are likely to have resources they can mobilize in a campaign against the proposal. second, as suggested by some reports of the first-round vat adoption experience in ghana (a low threshold was chosen but later abandoned in favor of a higher one),230 larger businesses may be more likely to form a crucial part of a given country’s domestic pro-vat coalition because of their connections with multinational firms supporting vats as part of foreign investment-friendly economic reforms. indeed, many larger suppliers want to do business with registered suppliers: this allows them to face more transparent prices and be able to claim credits for readily identifiable vat on inputs. for 226 see ebrill et al., supra note 14, at 123. 227 see id. at 117 (“there may also have been concern over the potential inefficiencies and inequities arising from the differential treatment of those above and below the threshold.”). 228 the value added tax: experiences and issues, in international tax dialogue, supra note 41, at 17 (“nevertheless, many countries—including, ironically, many with relatively weak administrative capacity—have evidently not been persuaded by the arguments for a high threshold. in addition to the revenue implications, national authorities are also often concerned that a high threshold unfairly favors small traders (by exempting them from the tax). by way of example, the european commission’s first proposal for a directive to tax “imported” electronic services advocated a threshold of €100,000 for non-eu based suppliers making supplies to consumers in the eu. however, in the ensuing negotiations the member states removed the references to thresholds. this has led to a situation where a non-eu business has, in theory at least, to account for eu vat on all sales into the eu, irrespective of the amount of sales involved. this contrasts with thresholds available in most, but not all, eu member states, thereby introducing an element of distortion.”). 229 see keen & mintz, supra note 20, at 572 (“report[ing] results for…two assumptions on the distribution of productivities: a uniform distribution, and a distribution function…that captures the greater frequency of small firms”). keen & mintz do, however, seem to gesture to competitive equity in their comments on their theoretical results. id. (“a more novel possibility seems to arise, however, from the observation (here speaking very loosely) that the production inefficiency associated with a threshold can be mitigated by setting the threshold either very low or very high: in either case the bulk of taxpayers will be treated identically.”). 230 see stewart, transfer, supra note 155, at 191-93. see also ebrill et al., supra note 14, at 117. 2018] on the threshold: smallness and the value-added tax 223 this reason, a low threshold may be “baked into the bargain” of vat adoption, rendering calls for higher thresholds politically infeasible. of course, is impossible to say without specific reference to a given jurisdiction how important, or even how fully articulated, such competitive fairness concerns may be.231 however, there are two compelling responses to competitive fairness objections to higher vat registration thresholds. 1. higher thresholds minimize bunching rather than exacerbating competitive fairness concerns, raising a low vat threshold to exempt a greater portion of the smallest firms is almost certain to reduce the number of businesses in the vicinity of, and thus at risk of being treated inequitably by, the legal discontinuity. the competitive fairness objection implies that a firm’s revenue (turnover) is the particular taxpayer attribute to which competitive fairness should refer in pursuing the objective of treating similarly-situated taxpayers similarly. taking that premise at face value, it is clear that any non-zero registration threshold will face a competitive fairness problem. unless compliance costs are so low as to make a zero-registration threshold feasible, a logical response to the objection is to select a threshold that minimizes the number of taxpayers affected by the inequity. higher thresholds accomplish this objective. as an empirical matter, most economies’ firm-size distributions are heavily skewed towards the small.232 assume that for any non-zero registration threshold, the firms in the revenue band or interval that is roughly centered around a given registration threshold (although with bunching, there is likely to be a gap immediately above the threshold) will be considered similar enough to raise the competitive fairness objection. setting the threshold lower rather than higher thus implies that a greater concentration of firms will be located in that band or interval. as the threshold is raised, the band becomes less populous. the number of affected taxpayers decreases, and the aggregate competitive fairness of the vat threshold improves. 2. optional registration almost universally, vats with non-zero registration thresholds allow small suppliers to “opt-in” to vat registration even though they are, by default, not required to register.233 keen and mintz do not incorporate elective registration into their optimal threshold analysis,234 but among vat experts an elective registration regime for small 231 see stewart, transfer, supra note 155, at 182-98. see also prichard, supra note 5, at 83-118. 232 see keen & mintz, supra note 20, at 574. 233 see james, supra note 2, at 57; crawford, keen & smith, supra note 21, at 297-98; william gale, hilary gelfond & aaron krupkin, value-added taxes and small business, brookings inst. pol’y brief (mar. 2016), https://www.urban.org/sites/default/files/publication/79206/2000713-value-added-taxes-andsmall-businesses.pdf [https://perma.cc/v9ue-3nb4]. 234 see keen & mintz, supra note 20, at 574 (“[i]mportant interaction effects arise when firms trade with one another…for then a low threshold increases the likelihood that a firm not registered for the vat— either because it is too small or because it is an outright evader—will find itself selling to registered firms, and so see a commercial advantage in registering (because they can then reclaim the tax paid on their inputs 224 columbia journal of tax law [vol.9:177 suppliers is considered “a key part of any well-designed [e.g., efficiency-maximizing] vat, albeit often with a lower limit above zero turnover and/or some discretion by the revenue commissioner.”235 the “formality chain effect” theory of voluntary registration features two separate channels through which presumptively exempt firms will find it advantageous voluntarily register.236 as the theory’s name suggests, each requires that the small supplier be part of a “formal” (vat-registered) supply chain. the first is the customer channel. suppose that a small firm sells to a vatregistered (formal) business. due to the magic of the input tax credit mechanism, the formal business customer will be indifferent to the small supplier’s decision to charge vat on her sale price (because of the input tax credit the small supplier will provide in the event of registration). further suppose that trading among registered businesses means that invoices will be issued and transactions will be documented, such that there may be managerial, accounting or contracting benefits to formality (indeed, the vat literature discusses at some length the managerial and accounting benefits of vat registration—keeping track of sales and expenses for vat purposes may provide useful information for other business decisions, and there can be cash flow benefits of claiming input credits before tax is due).237 last, suppose that the small supplier’s costs of registration (e.g., compliance costs) are not higher than those of her competitors. voluntary registration will be advantageous in this scenario: the small supplier gains the opportunity to trade with the formal customer and realizes the same after-vat revenue and net profit. for the government, voluntary registration through this no-taxable-input customer channel is revenue-neutral, but bringing these low-cost small firms into the vat net permits potential positive spillovers associated with formality (e.g., better enforcement of vat and across tax instruments, improved regulatory compliance, etc.). the second channel is the input channel.238 in this scenario, the small supplier facing the decision to voluntarily register does purchase inputs, and those inputs are without increasing the net price to their customers (since the latter, being registered, can also reclaim tax on their inputs))”). 235 see crawford, keen & smith, supra note 21, at 296. 236 see aureo de paula & jose a. scheinkman, value-added taxes chain effects and informality, 2 am. econ. j.: macroeconomics 195, 196 (2010) (testing chain effect theory using data from firms in brazil and finding that the credit system is correlated with chains whereas the effect vanishes for firms subject to estimated tax withholding system without the feature of input tax credits). the two channels mirror the hypotheses tested and validated using uk vat data in liu & lockwood, supra note 32, at 3, 21-24. 237 see pope, estimating, supra note 206, at 13. see also sandford, minimising, supra note 82, at 135. 238 the equity argument goes along the lines that it would be unfair that large businesses must be responsible for all obligations while small businesses are not, and can thus enjoy a competitive advantage…[however,] small businesses that would gain by being registered can apply for voluntary registration if such a provision exists in the vat law. a small business might want to register when it adds much of its value through purchased inputs (raw materials, machinery etc.). in that case, being registered allows for the recovery of vat on inputs. a supplier making mostly business-to-business supplies would also want to register because many of their business-to-business clients will want them to charge vat so that they can claim a credit. sometimes, larger businesses just prefer to deal with registered suppliers. finally, a supplier that is vat-registered may signal to clients that it runs a legitimate and reputable business. voluntary registration would therefore seem to do much to restore equality of treatment between small and larger businesses. see gendron, supra note 38, at 267 (presenting a similar argument regarding voluntary registration’s ability to respond to competitive fairness concerns). 2018] on the threshold: smallness and the value-added tax 225 purchased from formal vat-registered firms. voluntary registering in this case allows the small supplier to claim input tax credits. the higher a small suppliers’ taxable input expenses are relative to her sales (and especially in the case of losses, such as during start-up years), the higher the likelihood that the small supplier would consider voluntarily registering.239 however, as we know, complying with the vat is typically costly, so the small supplier must perceive her benefit from claiming input tax credits to be in excess of her compliance costs, taking into account as well any competitive disadvantage she would bear from charging vat to her customers. where this latter effect is significant, the payoff from fraudulent refund claims due to understatement of non-vat-invoiced sales is high, although such fraud potential arises with all retail sales and sales to informal businesses.240 here, it is easy to see that the presence of both the customer channel and the input channel make voluntary registration especially attractive—e.g., where the small supplier is placed in the middle of a formal supply chain. her customers typically will be indifferent to the imposition of vat because they can use an input tax credit. for the small supplier, if the input tax credit benefit exceeds the compliance cost, voluntary registration will be profitable. despite the potential for facilitating evasion, offering small suppliers an option to register is unambiguously desirable from a theoretical optimal taxation perspective.241 without voluntary registration, the vat—because of its unique “fractional” nature— would succeed in capturing revenue for the government, but at the cost of production efficiency. this is because unregistered small suppliers would pay vat on their inputs but would lack the ability to claim credit for such payments. having vat “stick” to purchases made at the business input stage rather than at the retail consumer stage violates the basic diamond-mirrlees insight that taxing consumption rather than business inputs minimizes welfare-reducing distortions.242 and, in contrast to the widespread nonadoption of the expert consensus in favor of high vat registration thresholds, the expert consensus in favor of voluntary registration has been—perhaps not surprisingly, because it’s elective so doesn’t bind anyone to pay tax against their will—to be an easier sell among legislators. the widespread presence of voluntary registration undermines competitive fairness objections to registration thresholds in general and to high thresholds in particular. voluntary registration has the effect of making the small supplier exemption better-targeted than it would be if exemption for small suppliers was mandatory. indeed, the core policy justification for having a registration threshold is to save small firms with high compliance costs but low vat revenue potential the burden of registering, while 239 see crawford, keen & smith, supra note 21, at 296 (“[t]here is a strict advantage [to registered firms] in purchasing from vat-registered businesses, since unregistered businesses will be unable to reclaim the vat they themselves have been charged on their inputs, and so may charge a higher output price. thus, traders selling to other businesses may indeed wish to register to charge the vat even if their annual turnover is below the threshold at which vat registration is mandatory…”). 240 the vat is vulnerable to evasion by sellers who under-report taxable sales while claiming (or even over-reporting) input tax credits. where the small supplier sells to non-registered customers (either informal businesses or individual consumers), the ability to understate sales is exacerbated by the lack of an input tax credit invoice trail that can be traced by the tax agency. 241 see crawford, keen & smith, supra note 21, at 283. 242 id. 226 columbia journal of tax law [vol.9:177 also relieving the government from administration costs with respect to these revenueunproductive firms. because of the high fixed component of compliance costs, using low annual revenues as a proxy for high compliance costs relative to vat revenue potential makes sense from a practical standpoint. however, revenues are merely one among a number of imperfect indicators of a firm’s relative costs of vat registration. at any given revenue cutoff, firms are likely to be heterogeneous in their compliance costs but also in their potential benefits from registration. voluntary registration can thus transform a straight bright line registration threshold—with its concomitant competitive fairness problems—into a non-linear one. two firms that are otherwise identical may indeed find themselves on either side of the registration threshold. however, the conclusion that one must register vat while the other remains exempt is inaccurate in the presence of an election to register for small suppliers. revenue is no longer the sole characteristic on which taxability turns: the election allows other signals of a firm’s compliance costs and registration benefits to be taken into account.243 by facilitating a better match between taxpayer compliance costs and vat registration, voluntary registration both promotes production efficiency and undercuts competitive fairness objections to registration thresholds. in short, a wellfunctioning voluntary registration threshold offers an elegant way to address some of the perceived inequities of having any threshold at all. but what about voluntary registration’s impact on the competitive fairness of higher vat thresholds? voluntary registration is especially advantageous in the context of higher rather than lower thresholds. this is because the higher the threshold, the higher the likelihood of voluntary registration. first, larger firms are more likely to be part of formal supply chains and thus can benefit from at least one of the customer or input channels, and often both. this benefit is likely to rise in revenues—both with respect to the customer channel (because revenues come from sales to customers) but also with respect to the input channel (because more taxable inputs will be needed to meet rising demand for sales). in contrast, as we have seen, compliance costs typically fall relative to revenues as a firm grows larger. indeed, liu and lockwood’s recent research on formality chain effects using data from the uk vat bears out this association between higher thresholds and voluntary registration. the uk vat has a high annually-indexed registration threshold (currently £85,000). at this threshold, 35 percent of uk vat registrants have revenues below the threshold.244 of those businesses, over 40 percent voluntarily register.245 in sum, voluntary registration with a high threshold allows the vat to be better tailored across firms with similar revenues but varying costs or benefits of registration. v. conclusion this article relies on the leading microeconomic model of small-firm vat compliance and subsequent literature to summarize the efficiency case for higher vat 243 see gendron, supra note 38, at 267 (noting that voluntary registration can act as a signal to clients that it runs a legitimate and reputable business). 244 see liu & lockwood, supra note 32, at 3. some of those with revenues less than the threshold may have been required to register in a prior year and simply did not de-register; for this reason, proportion of registrants with revenues less than the threshold is likely to overstate the rate of voluntary registration. 245 see bain et al., supra note 215, at 167. 2018] on the threshold: smallness and the value-added tax 227 registration thresholds. it then moves beyond the territory of economists to addresses a key consideration in threshold-setting that has received less academic attention: fairness. nearly everywhere, low thresholds are known to be regressive at the level of the firm: numerous studies show that small firms face high vat compliance burdens relative to their revenues. to the extent that smaller firms are associated with lower-income entrepreneurs or sell to lower-income customers, reducing compliance costs by raising the registration threshold has progressive equity implications. competitive fairness objections from larger and often more politically influential businesses often represent a sticking point in debates about higher thresholds: the appearance of tax discrimination among bigger businesses can risk undermining the very coalition that supported the need for a vat in the first instance. this article presents two responses to such objections. first, setting the threshold higher rather than lower minimizes the number of similar firms that are affected inequitably by the threshold. second, the presence of an election that allows small firms to voluntarily register facilitates a more equitable “matching” of registration with firms that would benefit from registration on a characteristic other than annual revenue: firms with low costs or high benefits (or both) will be most likely to voluntarily register. thus, the article’s core argument is simple: under certain circumstances, high vat thresholds can occupy the coveted policy sweet spot of promoting fairness and efficiency simultaneously. microsoft word polsky12-1 final formatted.docx the impact of the 2017 tax act on certain personal injury plaintiffs gregg polsky* abstract the 2017 tax act was the most sweeping federal tax legislation in over a generation. while many of its reforms, from dramatically lowering the corporate tax rate to altering the international tax rules, have already received significant attention, comparatively little attention has been paid to the 2017 tax act’s effects on personal injury plaintiffs. this article explores those impacts. the 2017 tax act added a new provision that indirectly affects plaintiffs who allege sexual harassment or abuse. the new provision disallows the defendants’ deductions if the parties enter into a nondisclosure agreement. while targeted at defendants, the provision likely unwittingly harms plaintiffs by reducing settlement offers. the provision also suffers from a host of ambiguities that the treasury department and internal revenue service will need to resolve. the 2017 tax act also eliminated so-called miscellaneous itemized deductions. in certain types of personal injury claims, such as defamation or emotional distress, this development causes the plaintiff to be taxed on the full settlement amount even if, as is often the case, one-third or more of the settlement is paid as a contingent fee to the plaintiff’s attorney. legislative or administrative action is required to remedy this patent unfairness. i. introduction ...................................................................................................... 28 ii. the new section 162(q): the harvey weinstein rule ...................... 29 a. the economics of section 162(q) ........................................................................ 29 1. cost-shifting to plaintiffs .............................................................................. 29 2. disincentivizing settlement ........................................................................... 31 b. ambiguities in section 162(q) ............................................................................. 32 1. the problem of multiple claims and global settlements ............................. 32 2. what constitutes a non-disclosure agreement for section 162(q) purposes? ................................................................................................................ 34 3. what are “related” attorney’s fees? .......................................................... 36 c. pleading strategies to avoid section 162(q) ....................................................... 39 iii. exacerbation of the contingent fee tax trap ............................... 40 a. claims subject to the tax trap ........................................................................... 42 b. tax policy implications ....................................................................................... 44 c. does the form of attorney fee payment matter? ............................................... 47 * francis shackelford distinguished professor in taxation law, university of georgia school of law. thanks to brant hellwig and lawrence zelenak for comments and to phillip chason for research assistance. this work was supported by a grant from the american association for justice robert l. habush endowment. 28 columbia journal of tax law [vol 12:27 d. federal comprehensive legislative solution ...................................................... 48 e. a limited state legislative solution ................................................................... 49 f. administrative solutions ..................................................................................... 51 g. taxpayer arguments ............................................................................................ 52 h. structuring to avoid non-deductibility .............................................................. 55 iv. conclusion........................................................................................................... 56 i. introduction the federal income tax legislation signed into law on december 17, 2017 (2017 tax act) was the most sweeping federal tax reform legislation in over thirty years, with an estimated cost of $1.5 trillion over the ten-year budget window.1 most significantly, the 2017 tax act reduced the corporate tax rate from 35% to 21%, added a brand new passthrough deduction for non-corporate businesses, and dramatically reformed the international tax regime. 2 while these and other headline reforms have garnered substantial attention, additional changes have remained largely unexplored, even though they may significantly affect narrow classes of taxpayers. this article addresses the impact of the 2017 tax act on one of those narrow classes: certain plaintiffs in personal injury litigation. the 2017 tax act added a new rule, officially section 162(q), but informally known as the harvey weinstein rule, that disallows tax deductions for settlements of sexual harassment or sexual abuse claims that include a nondisclosure agreement (nda).3 this appears to be the first time that the federal tax laws have been used to discourage the use of ndas. while surely instigated by good intentions, section 162(q) is a highly flawed tax rule for two reasons. first, because the provision operates as a tax on the “sale” of an nda by plaintiffs to defendants and because some portion of that tax burden will likely be shifted to plaintiffs in the form of lower settlement offers, victims of sexual harassment or abuse will bear at least some brunt of the costs imposed under section 162(q).4 second, despite its apparent simplicity, section 162(q) suffers from a host of ambiguities that will prove extremely difficult, if not impossible, for rule makers at the treasury department and the internal revenue service (irs) to resolve effectively. the new tax law also disallowed so-called “miscellaneous itemized deductions.” typically, these deductions are relatively small, so taxpayers often do not miss them much. but in some personal injury cases, such as defamation suits, the plaintiff’s contingent fee is classified as a miscellaneous itemized deduction.5 in such cases, the plaintiff will be taxed on the full settlement amount even though 40% or more may go to the plaintiff’s attorney. this article proceeds as follows: part ii explores the implications of the harvey weinstein rule and the ambiguities it prompts; part iii explores the “contingent fee tax 1 john wagner, trump signs sweeping tax bill into law, wash. post (dec. 22, 2017), https://www.washingtonpost.com/news/post-politics/wp/2017/12/22/trump-signs-sweeping-tax-bill-into-law/ [perma.cc/4g6m-f8n7]. 2 see, e.g., tax found., preliminary details and analysis of the tax cuts and jobs act 4-5 (dec. 18, 2017), https://taxfoundation.org/final-tax-cuts-and-jobs-act-details-analysis/ [perma.cc/dyj9-emnr]. 3 i.r.c. § 162(q). 4 id. 5 lawrence j. eisenberg, insight: the contingency fee tax trap and a solution, bloomberg tax: daily tax report (aug. 21, 2018), https://news.bloombergtax.com/daily-tax-report/insight-the-contingencyfee-tax-trap-and-a-solution [perma.cc/79t6-c4ll]. 2020] impact of the 2017 tax act on certain personal injury plaintffs 29 trap” in detail, recommends legislative and administrative fixes, and analyzes the efficacy of potential taxpayer attempts to avoid it; and part iv concludes. ii. the new section 162(q): the harvey weinstein rule as part of the 2017 tax act, congress enacted section 162(q): a new deduction disallowance provision responding to social concerns arising out of the allegations against harvey weinstein and the related “me too” movement.6 section 162(q)(1) denies a taxpayer’s deduction for “any settlement or payment related to sexual harassment or sexual abuse if such settlement or payment is subject to a nondisclosure agreement.”7 section 162(q)(2) goes on to deny deductions for the payor’s attorney’s fees related to such a settlement or payment.8 prior to the enactment of section 162(q), payments or settlements of legal claims by businesses and any related legal fees would generally be deductible, regardless of the nature of the underlying claim or whether the payments were subject to an nda.9 a. the economics of section 162(q) 1. cost-shifting to plaintiffs the apparent purpose of section 162(q) is to discourage ndas in sexual misconduct settlements by raising the defendant’s costs of those settlements. for example, assume that a corporation settles a harassment case for $1,000,000. if the settlement does not include an nda, the $1,000,000 would be deductible and, assuming the corporation has sufficient taxable income, would reduce the corporation’s federal income tax liability by $210,000.10 the after-tax cost of the settlement is therefore only $790,000.11 if, on the other hand, the settlement includes an nda, no deductions would be allowed and the aftertax cost would equal the pre-tax cost of $1,000,000. at first glance, it might appear that section 162(q) only burdens the defendant. in the example above, the cost of including the nda is $210,000, which is paid by the defendant in the form of additional federal income taxes. but this fails to consider bargaining dynamics, which will often result in plaintiffs being burdened as well. a typical plaintiff desires to “sell” nondisclosure to the defendant at the highest possible price.12 section 162(q) burdens that sale by denying the defendant an otherwise available tax deduction. section 162(q) is therefore a tax on the sale of nondisclosure. while the nominal burden of the tax is on the defendant who is seeking the protection of the nda, and who must pay higher taxes due to the denied deduction, the economic burden can be partially or wholly shifted through lower settlement values. this scenario is analogous to 6 i.r.c. § 162(q). 7 id. 8 id. the statutory language could be interpreted to suggest that deductions for the payee’s attorney’s fees are disallowed, however, the irs has indicated that the disallowance applies only to the payor’s attorney’s fees. see section 162(q) faq, i.r.s. (jan. 17, 2020), https://www.irs.gov/newsroom/section-162q-faq [perma.cc/nf2g-b9sq] [hereinafter irs, section 162(q) faq]. 9 cf. rev. rul. 80–211, 1980–2 c.b. 57 (ruling that punitive damages incurred in connection with a trade or business are deductible as ordinary and necessary business expenses under section 162). 10 $1,000,000 x 21% (current federal corporation income tax rate) = $210,000. 11 $1,000,000 (pre-tax settlement amount) $210,000 (tax benefit from deductions) = $790,000. 12 see jan frankel schau, where confidentiality and transparency collide, 25 disp. resol. mag. 6, 8 (2019) (“in practical terms, confidentiality is often a huge incentive, providing leverage for the plaintiff and her lawyer in early settlement negotiations . . . for most employees, payment of damages, an apology or explanation, and a commitment by the employer to make changes to ensure that the misconduct will not be repeated are sufficient compensation, and they have no need to publicize their settlement—especially if this means they will get higher damages in exchange for keeping the settlement confidential.”). 30 columbia journal of tax law [vol 12:27 a sales tax that is formally paid by the seller, but is often shifted, at least to some extent, to the buyer in the form of a higher price.13 for instance, in the example above, before section 162(q), the $1,000,000 settlement with an nda would have cost the defendant only $790,000 after tax.14 after the enactment of section 162(q), the same settlement will now cost the defendant $1,000,000 on an after-tax basis. the defendant might respond to section 162(q) in one of two ways, either of which would shift at least some of the nominal burdens of section 162(q) onto the plaintiff. first, the defendant could reduce its settlement offer to account for nondeductibility.15 if the defendant has sufficient bargaining power, it could shift the entire burden of section 162(q) onto the plaintiff by offering only $790,000 to settle the case with an nda. in that situation, the total after-tax cost of the settlement to the defendant would be the same as before the enactment of section 162(q). accordingly, section 162(q) would then burden only the plaintiff. alternatively, the burden could be shared between the plaintiff and defendant, resulting in a settlement amount between $790,000 and $1,000,000. second, the defendant could no longer insist on including an nda in the settlement. the nda would have had some value to the defendant, so its omission would correspondingly reduce defendant’s settlement offer by that value.16 if the nda had a value of $100,000 to the defendant and if the defendant would have been willing to settle the case with an nda for $1,000,000 before the enactment of section 162(q), then the defendant should now offer only $900,000. in these examples, the defendant either loses tax deductions or the benefits of an nda due to the nominal burdens of section 162(q) imposed on the defendant. however, as illustrated here, the defendant can shift some or all of the economic burden to the plaintiff by reducing its settlement offer to offset either loss. in the extreme case, the reduction could shift the entire burden to the plaintiff; in other cases, the burden would be shared by the two parties. either way, section 162(q) will unwittingly burden sexual misconduct plaintiffs by lowering the values of the settlements they receive.17 13 see mark j. cowan, nonprofits and the sales and use tax, 9 fla. tax rev. 1077, 1132 (2010). 14 $1,000,000 ($1,000,000 x 21%) = $790,000. 15 see schau, supra note 12, at 9 (“[t]hese settlements can readily reach well into six figures, and the business deduction usually realized under corporate tax codes makes that expense much more palatable to a business.”); see also trey cooper, tax cuts and jobs act limits business expense deduction for settlement of sexual harassment claims, 53 ark. law. 32, 33 (2018) (“because settlement amounts and legal costs are no longer deductible if there is a nondisclosure agreement . . . settlement amounts may be lower.”). 16 see schau, supra note 12, at 8-9 (“[an] employer may actually be trying to make things right by paying serious settlement money to the plaintiff but will not do so willingly if the employer also must suffer the negative publicity from a public disclosure that its employee, especially someone in a leadership role, failed to abide by the employer’s own policies.”). 17 previous commentators have posited that some plaintiffs will be burdened in another way. they argue that some plaintiffs desire a nondisclosure provision to prevent defendants from disclosing embarrassing or otherwise harmful information about them. if section 162(q) leads a defendant to prefer avoidance of an nda to retain its tax deductions, such plaintiffs could be harmed. see cooper, supra note 15, at 33; shane rader, the weinstein tax: congress’ attempt to curb non-disclosure agreements in sexual harassment settlements, 3 bus. entrepreneurship & tax l. rev. 329, 336 (2019). this assumes that section 162(q) applies to “unilateral” ndas that benefit only plaintiffs, an issue that is discussed further below. 2020] impact of the 2017 tax act on certain personal injury plaintffs 31 2. disincentivizing settlement section 162(q) can also harm plaintiffs in a somewhat different way by encouraging defendants to not settle cases.18 the intuition here is that damages paid pursuant to a judgment remain deductible, while settlements that include an nda are not. under prior law, all of these costs would have been equally deductible.19 to illustrate this incentive, consider a simple case with the following facts. there is a 50% chance that the plaintiff can establish liability at trial. if such liability is established, damages would be $2,000,000. if settled, the defendant would insist on an nda because it does not want to signal that the plaintiff’s allegations have merit. prior to the enactment of section 162(q), to settle the case before trial, the largest settlement offer the defendant should accept is $1,000,000. if the defendant declines the offer and ultimately prevails at trial, it would pay nothing. if the defendant ultimately loses at trial, the defendant would incur costs of $2,000,000 in damages. because the trial is assumed to be a coin flip, the defendant’s expected cost is the average of the two possible outcomes, which is $1,000,000. thus, a risk-neutral defendant should settle the case for any amount not in excess of $1,000,000. importantly, absent section 162(q), the defendant’s costs (if any) in each of the three possible outcomes (settlement, defense verdict at trial, or plaintiff victory at trial) are deductible, so there is no need to account for tax adjustments in this analysis. after the enactment of section 162(q), the defendant must consider tax adjustments in evaluating potential outcomes. a settlement involving an nda would be nondeductible. on the other hand, if the case goes to trial and the defendant loses, those damages would be deductible. the pre-tax costs if the case goes to trial are $0 or $2,000,000 if the defendant wins or loses, respectively, and the after-tax costs, assuming the defendant is a corporation, are $0 or $1,580,000.20 the average of those two amounts is $790,000. because a settlement of the case would not be deductible, this amount is the highest settlement offer that the defendant should be willing to accept. accordingly, if the plaintiff’s reservation price for settlement were to fall somewhere between $790,000 and $1,000,000, section 162(q) would impede a settlement that would have occurred prior to its enactment. while this works to the plaintiff’s benefit if the plaintiff ultimately prevails at trial, if the plaintiff loses at trial, the outcome could very well be devastating. instead of reaching a settlement where the plaintiff walks away with hundreds of thousands of dollars (even after attorney’s fees and taxes on the settlement), the plaintiff is left empty-handed.21 18 see cooper, supra note 15, at 33 (“because settlement amounts and legal costs are no longer deductible if there is a nondisclosure agreement, early settlement of claims based on sexual harassment or sexual abuse may be less common . . .”). 19 see i.r.c. § 162(a) (allowing deductions for business expenses). 20 $2,000,000 (damages paid) x (1 21% corporate tax rate) = $1,580,000. 21 this incentive for defendants to “litigate harder” could be even more pronounced depending on how the irs interprets section 162(q)(2). section 162(q)(2) denies deductions for attorney’s fees “related to” a settlement or payment in a sexual misconduct case involving an nda. a broad interpretation of “related to” would cover all attorney’s fees connected to the litigation; a narrower one would apply only to attorney’s fees specifically in connection with negotiating the settlement, the payment, and the associated nda. this issue of interpretation is discussed in depth below. if the broader interpretation prevails, it could apply to very large attorney’s fees, spanning a number of years. in that case, if the defendant views paying more attorney’s fees as increasing the likelihood of a defense verdict, the incentive to litigate harder arising out of section 162(q) would be exacerbated because the resultant substantial legal fees would be deductible only if the defendant does not settle the case. 32 columbia journal of tax law [vol 12:27 note that these burdens apply only to sexual misconduct claimants who enter into ndas. the apparent justification is that the public interest in bringing these claims to light outweighs the burdens imposed on victims. but even assuming that this is the case, the logic behind section 162(q) is not unassailable. other claims—such as racial discrimination—may have an equally strong transparency interest, yet section 162(q) does not apply to them. and even though the provision may deter the use of an nda, the absence of an nda does not ensure a full public airing of the facts. as mediator jan frankel schau has noted, in sexual harassment cases, “[i]t is often the case that neither the employer nor the employee wants the publicity and potential embarrassment that comes from a public airing of this type of very personal experience.”22 therefore, even without an nda, many settling plaintiffs will prefer to keep their allegations private. b. ambiguities in section 162(q) as there are only about forty words total in section 162(q), it is unsurprising that significant ambiguities and uncertainties exist regarding how the provision actually operates. presumably, the government will eventually issue guidance fleshing out the rule, but until then, defendants and the irs will have to work with the bare-bones statutory provision, which reads in its entirety as follows: “no deduction shall be allowed under this chapter for—(1) any settlement or payment related to sexual harassment or sexual abuse if such settlement or payment is subject to a nondisclosure agreement, or (2) attorney’s fees related to such a settlement or payment.”23 1. the problem of multiple claims and global settlements many cases involve multiple claims that are resolved with a global settlement that settles all claims in exchange for a payment by the defendant. for example, a complaint filed by an employee against an employer could include allegations of racial discrimination, gender discrimination, and breach of contract. as part of the discrimination allegations, the complaint could make specific factual allegations of harassment based on the plaintiff’s race or gender. if, as is typical, the case is settled with a payment by the defendant for a global release of all plaintiff’s claims, how does section 162(q) apply if the settlement includes an nda? the issue depends on the interpretation of “any settlement . . . related to sexual harassment.”24 at one extreme, the term could refer to any settlement that accompanies a release of potential sexual misconduct claims, even if such claims were never alleged and do not exist. under this reading, any general release of all claims, whether alleged or not, 22 schau, supra note 12, at 8. 23 i.r.c. § 162(q). robert wood has argued that it is possible that the denial of attorney’s fees in section 162(q)(2) could apply to sexual misconduct settlements that do not include an nda. see robert w. wood, tax write-offs in sexual harassment cases after harvey weinstein, 90 n.y. st. bar j. 10, 12-13 (2018). however, a careful reading of the statutory language should preclude this possibility. the term “such settlement or payment” in section 162(q)(1) refers to all sexual misconduct settlements or payments. if section 162(q)(2) also used “such settlement or payment,” then it would also apply to that entire universe. because section 162(q)(2) instead uses the term “such a settlement or payment” (emphasis added), the paragraph refers only to the settlement or payments affected by section 162(q)(1) (i.e. only sexual misconduct payments or settlements that include an nda). this technical interpretation is supported by logic as well. if one reads section 162(q) the way that wood suggests, in sexual misconduct cases that do not involve an nda, the defendant’s attorney’s fees are non-deductible even though the underlying settlement or payment remains deductible. it is difficult to divine a policy reason for that result and, in any event, there is no indication in the legislative history or context that congress was concerned about deductions for attorney’s fees but not the underlying settlement in cases not employing ndas. 24 i.r.c. § 162(q). 2020] impact of the 2017 tax act on certain personal injury plaintffs 33 would trigger the application of section 162(q), as such latent or hypothetical sexual harassment claims are thereby waived. as a result, even a garden-variety separation agreement executed to receive severance payments could be subject to section 162(q), assuming the separation agreement includes both a general release and an nda.25 while this would seem to be an unreasonable interpretation, cautious employers might specifically carve allegations of sexual misconduct out of the nda’s coverage. 26 alternatively, employers might include in the separation agreement “representations from the employee that the employee has not asserted and has no knowledge of any claims of sexual harassment or sexual abuse.”27 a somewhat less extreme interpretation would cover general releases only if an allegation of sexual harassment or abuse has been made. this would exempt gardenvariety severance deals but would also encourage strategic pleading behavior discussed in depth below. under this interpretation, if an allegation of sexual misconduct has been made, section 162(q) would apply to the entire settlement.28 on the other end of the spectrum, the provision could apply only to the portion of the settlement that is allocable to the sexual misconduct allegations, but not to the remaining portions.29 thus, in the example above, assuming a general release with an nda is executed, while the portion of the settlement allocable to the sexual misconduct claim would be non-deductible, the residual settlement amount would remain deductible.30 while at first glance this allocation approach seems straightforward, in practice it would be difficult, if not impossible, to enforce. allocations of settlements are required in other tax contexts. for example, in personal physical injury cases, because compensatory damages are generally tax-free while punitive damages are taxed, global settlements must be allocated between the compensatory portion and the punitive portion.31 in employment cases, lost wages are subject to employment taxes while other damages (such as those for emotional distress or medical distress) are not. 32 well-advised plaintiffs insist that settlement agreements aggressively allocate larger amounts to the tax-preferred damages.33 25 see cooper, supra note 15, at 33 (“it is possible the irs could take the position that a general release of employment-related claims includes claims based on sexual harassment or sexual abuse, and a separation payment is related to the release of potential sexual harassment or sexual abuse claims.”). 26 id. 27 id. 28 see wood, supra note 23, at 13-14 (considering the possibility that “any mention of [sexual harassment] claims” might implicate section 162(q) and “bar any tax deduction, even if the sexual harassment part of the case is minor”). 29 some commentators have suggested entering into multiple settlement agreements at the same time. see, e.g., cooper, supra note 15, at 33 (explaining a strategy “to settle the sexual harassment and/or sexual abuse claim in a separate agreement than the remaining claims . . .”). however, the irs would surely view the transaction as one single global settlement under substance over form principles. 30 see kelsey k. crosse, confidential sexual harassment settlements fall victim to tcja, 24 iowa emp. l. letter 5 (2018) (“can an employer maximize its tax savings if multiple claims are alleged by allocating the settlement proceeds so that a limited amount is attributed to the sexual harassment claim? time will tell.”); wood, supra note 23, at 14 (“could plaintiff and defendant expressly agree on a particular tax allocation of the settlement to head off the application of the weinstein tax?”). 31 see gregg d. polsky & dan markel, taxing punitive damages, 96 va. l. rev. 1295, 1344 (2010) (“[i]n settlements of personal physical injury claims that could have generated punitive damages, a plaintiff must make these difficult allocations.”). 32 see t.a.m. 2002–44–004 (june 19, 2002) (concluding that payments by an employer for emotional distress and reimbursement of attorney fees and costs are not subject to employment tax). 33 see polsky & markel, supra note 31, at 1329-30 (explaining the incentives for parties to allocate aggressively towards excludable damages). 34 columbia journal of tax law [vol 12:27 aggressive allocations are nearly impossible for the irs to police in pretrial settlements.34 this is because allocations are essentially a valuation exercise.35 how much is each part of the claim individually worth? this question presents a substantial challenge, as there is no market for particular types of claims, independent of other related claims.36 although there is a growing market for tort claims in general, plaintiffs rarely, if ever, sell their punitive damage claims while retaining their compensatory claims, or vice versa. in addition, the value of a claim depends on the unique facts that form the basis of the lawsuit. those facts would only be fully developed at trial, which the pretrial settlement in question itself has foreclosed. making matters worse, the counterparty to the settlement is usually indifferent to the tax-driven allocation. for defendants, both compensatory damages and punitive damages are deductible to the same extent.37 as a result, aggressive allocations away from punitive damages help plaintiffs tax-wise but have no tax impact on defendants. defendants are perfectly willing to agree to plaintiff-friendly allocations in the interest of facilitating settlement.38 of course, the irs is not technically bound to agreed-upon allocations, but in practice, the irs has great difficulty in challenging them due to the valuation difficulties previously explained.39 returning to the context of section 162(q), if allocations of settlements were required, it can be expected that parties would routinely allocate a very low amount to the sexual misconduct allegations and a significant majority of the recovery to the remaining allegations.40 if respected, these allocations would allow defendants to deduct nearly the entire settlement while still obtaining an nda. plaintiffs would be unaffected tax-wise by the aggressive allocation and therefore would likely not object so as to maximize the settlement amount. in theory, the irs could challenge the allocation, but, just as in the case of allocations between compensatory and punitive damages, it would be an uphill battle except in the most egregious of situations. 2. what constitutes a non-disclosure agreement for section 162(q) purposes? section 162(q) does not define the term “nondisclosure agreement,” raising questions about the term’s scope. one issue is whether unilateral ndas that protect only plaintiffs trigger the non-deductibility rule. as previously noted, in many sexual misconduct cases, plaintiffs are interested in ensuring that the allegations and settlement 34 see id. at 1330. however, if the case is settled after a jury verdict delineating the various amounts of damages, the irs might stand a fighting chance. see id. at 1330, 1333. 35 see id. at 1332 (“allocations depend on the relative values of the plaintiff’s compensatory and punitive claims.”). 36 see id. at 1331-32. 37 rev. rul. 80–211, 1980–2 c.b. 57. 38 see polsky & markel, supra note 31, at 1334 (“there is no benefit (tax or otherwise) to be gained by either party in making explicit allocations to punitive damages; however, there are often tax, insurance, or public relations benefits to be gained by avoiding explicit allocations to punitive damages.”). 39 see wood, supra note 23, at 15 (“of course, the irs is never bound by an allocation in a settlement agreement. but the irs does often pay attention to such allocations and (in my experience) often respects them.”); polsky & markel, supra note 31, at 1334-35 (explaining that allocations in settlements agreements away from punitive damages are very difficult for the irs to rebut). 40 see wood, supra note 23, at 15 (“i expect that we will start seeing such explicit sexual harassment allocations. we may see aggressive allocations, where the sexual harassment may have been the primary impetus of the case. we may also see such allocations, presumably with nominal dollar amounts, even in cases where the claims are primarily about something else.”). 2020] impact of the 2017 tax act on certain personal injury plaintffs 35 remain private.41 such a plaintiff might insist on a unilateral nda that prevents the defendant (but not the plaintiff) from disclosing the allegations or the settlement. however, to allow the defendant to protect itself in the court of public opinion, the unilateral nda might include a provision allowing the defendant to disclose the information if the plaintiff does so first. if so, the defendant might feel comfortable that the self-interest of the plaintiff in keeping the matter private would protect the defendant’s interest in privacy even though the plaintiff technically retains the unfettered right to disclose the information. would such a unilateral nda trigger section 162(q)? the limited statutory language offers no guidance. on the one hand, a unilateral nda is still a type of nda, and some commentators have assumed that unilateral ndas would thus implicate section 162(q).42 on the other hand, section 162(q) is clearly targeted at defendants, not at plaintiffs, and unilateral ndas directly benefit only plaintiffs (though, as explained above, they can indirectly protect defendants). the irs has already recognized in another context that the legislative target of section 162(q) was defendants not plaintiffs, notwithstanding its broad language. section 162(q)(2)’s disallowance of deductions for attorney’s fees “related to” a sexual misconduct settlement could plausibly be interpreted to apply to plaintiff-side attorney’s fees,43 but the irs has explained in informal guidance that the disallowance applies only to defense-side attorney’s fees.44 the irs could similarly take the position that ndas that explicitly protect only plaintiffs are not ndas for purposes of section 162(q). another ambiguity involves pre-existing ndas.45 employers often require new employees to execute broad ndas as a condition of their employment. what if a settlement agreement in a sexual harassment claim does not include an nda but leaves the pre-existing nda, which covers, among other things, disclosures relating to that claim, intact? while section 162(q) appears to contemplate ndas that are executed in connection with a settlement, the language is certainly broad enough to capture pre-existing ndas if the allegations in the claim are covered by the language of the nda.46 accordingly, a careful defendant that wants to ensure deductibility should explicitly carve out the settlement and its underlying allegations from the pre-existing nda’s scope in the settlement agreement. finally, there is the question of whether a provision that restricts, limits, or conditions disclosure, but does not absolutely preclude disclosure, would constitute an nda for purposes of section 162(q). on one end of the spectrum, a settlement could give the plaintiff the unfettered and unconditional right to disclose any and all information regarding the defendant; this would obviously not constitute an nda. on the other end of that spectrum, a settlement could preclude any disclosure whatsoever; this would undoubtedly be an nda. between those two extremes there exists a host of potential fact patterns, as mediator jan frankel schau has explained: 41 see schau, supra note 22 and accompanying text. 42 see rader, supra note 17, at 336-37 (arguing that a legislative change would be necessary to exempt unilateral ndas from section 162(q)’s scope). 43 see crosse, supra note 30, at 5; wood, supra note 23, at 13; cooper, supra note 15, at 33. 44 irs, section 162(q) faq, supra note 8. 45 see rader, supra note 17, at 341 (“it is unclear if [section 162(q)] would apply to ndas previously entered into between the victim and employer.”). 46 section 162(q) only requires that the settlement be “subject to” the nda. i.r.c. § 162(q)(1). 36 columbia journal of tax law [vol 12:27 [t]he parties can negotiate the terms of the confidentiality and reflect that in their agreement so that it does not rise to the level of a “non-disclosure agreement.” for example, the claims and terms of agreement may be disclosed “upon request” by subpoena or in the course of other legal processes but may not be subject to general disclosure via media or other private communication except to a spouse, attorney, or accountant. [alternatively], the parties can cooperate in drafting an approved statement that will constitute the public disclosure if either party is asked. for example, specific language could state “the parties to this lawsuit have decided it is in both side’s best interests to resolve the pending dispute in order to focus upon business and personal matters. accordingly, effective immediately, employee has dismissed her claims against the employer and any further inquiries should be directed to the human resources director.” finally, the parties can expressly expunge all preliminary non-disclosure agreements but maintain that the terms of the settlement will not be publicized without notice to the company in advance—and if the terms are made public, provide for an opportunity to craft an acceptable statement to release to current employees and to the public.47 while schau believes that the above provisions would not be treated as ndas for purposes of section 162(q),48 that conclusion is not entirely free from doubt because the statute is ambiguous regarding the definition of ndas. presumably when the treasury and the irs promulgate regulations, they will include guidance on this issue. 3. what are “related” attorney’s fees? section 162(q)(2) denies deductions for “attorney’s fees related to . . . a settlement or payment” in a sexual misconduct case where the settlement or payment is subject to an nda. 49 defendants may pay attorney’s fees over several years, beginning when allegations are first made and often ending with the negotiation of a settlement agreement. it seems clear that attorney’s fees incurred in negotiating and drafting the settlement agreement are covered by section 162(q). but what about earlier fees, such as those for initially investigating the allegations, responding to a demand letter, drafting and filing an answer and other pleadings, engaging in discovery, and attending mediation? the answer depends on the interpretation of the term “related to.” if narrowly interpreted, only attorney’s fees that specifically relate to the settlement and nda themselves would implicate section 162(q). earlier attorney’s fees would remain deductible. this interpretation seems to best comport with the specific words used by congress in that only deductions for attorney’s fees that relate to the “settlement or payment” of damages are denied. if congress intended that earlier attorney’s fees be denied, it could have denied deductions for fees related to “allegations of sexual harassment or sexual abuse” rather than merely those related to “settlement or payment” of damages. this narrow interpretation is also supported by practical tax compliance realities. litigation often spans multiple tax years—a defendant may incur attorney’s fees in years 1 through 5 with respect to a claim that is ultimately settled in year 5. it is a fundamental 47 schau, supra note 12, at 10. 48 id. at 9-10. 49 i.r.c. § 162(q)(2). 2020] impact of the 2017 tax act on certain personal injury plaintffs 37 axiom of federal income tax law that a taxpayer prepares its return based on the facts that are known as of the end of the tax year.50 the defendant therefore must decide whether to deduct its year 1 attorney’s fees as of the end of year 1 based on the facts that then exist. under a broad interpretation of section 162(q)(2), deductibility depends on whether the defendant will ultimately enter into a settlement agreement that includes an nda, a fact unknown in year 1. perhaps no settlement will ever be negotiated, and the case will proceed to trial. or perhaps the parties might negotiate a settlement that does not include an nda. alternatively, the claim could be disposed of pursuant to a motion to dismiss or a motion for summary judgment. in any of these situations, section 162(q)(2) would not bar deductions for attorney’s fees, but if the claim is ultimately resolved through a settlement that includes an nda, the attorney’s fees would be subject to disallowance under the broader interpretation, leaving the defendant in a difficult position regarding its tax compliance obligations.51 a narrow interpretation avoids this problem and appears most faithful to the words used by congress. one specific issue with a narrow interpretation, however, is when nondeductibility begins. treasury regulations in an analogous context, where a business expands by acquiring another business, may be instructive here.52 the issue in that context is whether the costs incurred in connection with the acquisition are immediately deductible. federal tax law has historically drawn a distinction between general investigatory costs, which are immediately deductible, and costs incurred thereafter to acquire a specific business, which are capitalized rather than deducted immediately.53 regulations promulgated in 2003 helpfully elaborate on this line-drawing exercise in the mergers and acquisitions context. 54 in general, under these regulations, costs incurred before the date on which a letter of intent is executed by both parties are immediately deductible, while costs incurred after that date are not.55 however, certain specified costs are not immediately deductible regardless of when they are incurred.56 these per se non-deductible costs include expenses of appraisal and those incurred in the preparation of transactional documents (e.g., merger agreements).57 a similar approach could be used in the section 162(q)(2) context, which would allow deductions for attorney’s fees incurred before the date on which the general terms of a settlement that includes an nda have been agreed upon (whether in a written document or orally), while disallowing all subsequent attorney’s fees. certain attorney’s fees, such as those incurred to draft or review a settlement agreement or language therein (including 50 erik m. jensen, the deduction of future liabilities by accrual-basis taxpayers: premature accruals, the all events test, and economic performance, 37 u. fla. l. rev. 443, 465 (1985). 51 this problem, however, is not completely intractable. defendants could make their best guesses about how claims will be resolved and then correct their errors when the case is ultimately resolved. for example, if a defendant claims deductions in earlier years for a case that ultimately settles with an nda, the defendant would “recoup” the earlier deductions in the year of settlement by including them in gross income. however, such an approach would still be fraught with difficulties. for instance, the earlier deductions could be challenged by the irs as not sufficiently probable to justify their deduction. in addition, the time-value of money and the possibility of tax rate fluctuations could cause the ex post remedy to be highly imprecise. 52 see treas. reg. § 1.263(a)–5(e). 53 lawrence lokken, capitalization: complexity in simplicity, 91 tax notes 1357, 1366 (2001); rev. rul. 99–23, 1999–1 cb 998. 54 see treas. reg. § 1.263(a)–5(e). 55 treas. reg. § 1. 1.263(a)–5(e)(1)(i). 56 treas. reg. § 1.263(a)–5(e)(2). 57 id. 38 columbia journal of tax law [vol 12:27 the terms of an nda), would be per se non-deductible, regardless of when they are incurred (assuming of course that the settlement ultimately includes an nda).58 while a narrow interpretation is the most reasonable, there are arguments in favor of a broad interpretation. although the legislative history behind section 162(q) is exceptionally sparse, it arguably supports the broad interpretation.59 the disallowance of deductions for payments related to sexual harassment settlements and associated legal fees was not included in the original house bill, but added later through a senate amendment.60 in the conference report, the senate amendment, which ultimately became section 162(q), described the provision as follows: “under the provision, no deduction is allowed for any settlement, payout, or attorney fees related to sexual harassment or sexual abuse if such payments are subject to a nondisclosure agreement.”61 this language is consistent with a broad interpretation because it conditions disallowance on the attorney’s fees relating to the underlying sexual harassment or sexual abuse. thus, the language of the conference report is suggestive of a broad interpretation. there is also a policy argument in favor of a broad interpretation. in a protracted litigation, the narrow interpretation could mean that the vast majority of attorney’s fees will remain deductible even though the ultimate settlement includes an nda. only the attorney’s fees very close to the “finish line” would be non-deductible, as would (of course) the settlement itself. this could exacerbate section 162(q)’s perverse incentive of discouraging settlement. for instance, assume that a defendant believes that for each dollar of additional attorney’s fees spent, it will reduce the eventual settlement (which will include an nda) by $0.95. absent section 162(q)(2), this state of affairs should cause the defendant to immediately settle the case, because prolonging the litigation is more costly than settlement. but with the advent of section 162(q)(2), in conjunction with a narrow interpretation of its language, this incentive is turned on its head, assuming the attorney’s fees are deductible. this is because the after-tax cost of one dollar of attorney’s fees would equal $0.79, while the after-tax cost of $0.95 of settlement will remain $0.95. 62 accordingly, the defendant should not settle. a broad interpretation would mitigate this problem because all of the defendant’s attorney’s fees would be non-deductible. this sort of policy analysis is presumably what motivated congress to deny deductions not only for settlements but for related attorney’s fees as well. a tax incentive for defendants to pay greater attorney’s fees to bid down settlement values is obviously problematic. despite the purposive and policy arguments that may be offered in support of a broader interpretation, ultimately the statutory language and practical considerations counsel in favor of a narrow interpretation. furthermore, congress did not create any mechanism to deal with the multi-year litigation issues that would necessarily arise under 58 a related issue is whether costs of in-house counsel effort would be considered attorney’s fees subject to disallowance under section 162(q)(2). if so, in-house counsel salaries would have to be allocated between the portion subject to section 162(q)(2), which would not be deductible, and the remaining portion, which would be deductible. such allocations could be difficult for defendants to make and for the irs to police because in-house counsel generally do not track their time. on the other hand, a rule that flatly exempts all inhouse salaries from section 162(q)(2) would preference in-house legal work over outside counsel. the 2003 regulations discussed above resolve this dilemma by generally allowing immediate deduction of employee compensation. see treas. reg. § 1.263(a)–5(d)(1). 59 see h.r. rep. no. 115-466, at 431 (2017) (conf. rep.). 60 id. 61 id. 62 the after-tax cost of one dollar of deductible attorney’s fees incurred by a corporate defendant would equal $0.79 because the dollar of deduction saves the corporation $0.21. 2020] impact of the 2017 tax act on certain personal injury plaintffs 39 the broad interpretation. in sum, the treasury and the irs should adopt a narrow interpretation. c. pleading strategies to avoid section 162(q) as previously discussed, section 162(q) adversely affects sexual misconduct plaintiffs who wish to maximize their financial recoveries.63 these plaintiffs therefore can benefit from avoiding section 162(q). one possible strategy would be to consider avoiding or at least delaying the inclusion of sexual harassment claims in demand letters and initial pleadings.64 for example, if a claimant has a strong discrimination case even without including sexual harassment claims, the expected value of a future settlement may counterintuitively increase by not making those additional claims. at a minimum, the potential cost due to section 162(q) must be weighed against the benefit of including those claims. the ability to amend the complaint adding in sexual harassment claims if the case does not quickly settle, would be a factor in this cost-benefit analysis. in similar contexts, plaintiffs’ lawyers have been advised to craft their complaints with an understanding of federal income tax law.65 for example, in personal physical injury cases, compensatory damages are generally tax-free, while punitive damages are taxed.66 as a result, commentators have recommended that personal injury plaintiffs avoid specifying punitive damages claims in their initial complaints.67 if a sexual harassment count has already been pleaded, plaintiffs could possibly avoid section 162(q) in certain situations by voluntarily dismissing the corresponding count with prejudice.68 for example, if the allegations of sexual harassment are extremely weak (either on the facts or on the law), and the claim is voluntarily dismissed early in the case before any serious settlement discussions occur, an eventual settlement should not be subject to section 162(q).69 63 see discussion supra part ii.a. 64 this assumes that section 162(q) could apply only in situations where sexual misconduct has been specifically alleged, even where a global release is executed. see discussion supra part ii.b.1. 65 see polsky & markel, supra note 31, at 1037 and accompanying text (describing tax-strategic pleading strategies). 66 see id. at 1311-12; i.r.c. § 104(a)(2). 67 see kevin a. palmer, recent developments in the taxation of punitive damage awards, 73 taxes 596, 600 (1995) (“if the applicable rules of pleading allow them, general demands for damages are preferable to preserve the ability to structure a future settlement on a tax-free basis.”). 68 see cooper, supra note 15, at 33 (“if the claim is not based on allegations that reasonably meet the legal standard for sexual harassment or abuse, counsel for the employer may be wise to meet and confer with counsel for the claimant in an attempt to have the claimant voluntarily abandon and/or dismiss the sexual harassment or sexual abuse claim before settling the case. if a lawsuit has been filed, a motion for the court to dismiss or grant summary judgment on a sexual assault or sexual abuse claim may pave the way for a quicker settlement. in fact, some cases (where the allegations of sexual harassment or sexual abuse are weak) may demand that the employer attempt to have the court dismiss or grant summary judgment on sexual harassment or sexual abuse claims before even attempting to settle.”). 69 note that a plaintiff, in deciding whether to plead or drop a sexual abuse claim, should consider the potential impact on the plaintiff’s own tax situation. plaintiffs may exclude from their gross income damages they received from personal physical injury claims, but not pure emotional distress recoveries. thus, for example, if a plaintiff’s sexual abuse claim is dropped, leaving only emotional distress claims, the plaintiff’s recovery will be fully taxed. on the other hand, if the sexual abuse claim is retained, it is possible that the recovery could be excluded from gross income as damages received on account of a personal physical injury. see i.r.c. § 104(a)(2). 40 columbia journal of tax law [vol 12:27 iii. exacerbation of the contingent fee tax trap the 2017 tax act significantly exacerbated an existing flaw in the code that detrimentally affects plaintiffs who pay contingent fees in certain causes of action.70 this “contingent fee tax trap” results in the plaintiff paying tax on the full amount of the settlement even though a portion of the settlement is retained by the plaintiff’s lawyer as the contingent fee. the tax trap arises where both (i) the settlement (or a portion thereof) is taxable to the plaintiff and (ii) the plaintiff’s deduction for her attorney’s fees is classified as a “miscellaneous itemized deduction.”71 prior to the 2017 tax act, miscellaneous itemized deductions could be claimed only to the extent that they (in the aggregate) exceeded 2% of the taxpayer’s adjusted gross income.72 thus, a plaintiff with $200,000 of adjusted gross income would lose the tax benefit of the first $4,000 of her miscellaneous itemized deductions.73 in addition, miscellaneous itemized deductions were disallowed entirely for purposes of the alternative minimum tax (amt).74 the amt is an alternative to the regular tax system whereby the taxpayer must pay the greater of her amt liability and her regular tax liability.75 if a plaintiff subject to the tax trap received a large settlement, it would likely put her on the amt, which has a maximum rate of 28%.76 the 2017 tax act disallowed miscellaneous itemized deductions under the regular tax system (and continued to disallow them under the amt system) between 2018 and 2025.77 this change is set to expire on january 1, 2026, returning to the former regime where miscellaneous itemized deductions were allowed for regular tax purposes only to the extent they exceed 2% of adjusted gross income (and were entirely disallowed under the amt).78 these rules can be extremely harsh. consider a plaintiff who settles a case for $1,000,000 and pays her attorney a $400,000 contingent fee, leaving her $600,000 before tax. before 2018 and after 2025, if the plaintiff were subject to the tax trap, her amt liability on the award would be approximately $280,000.79 this translates into an effective 70 plaintiffs that pay hourly fees could be affected as well, but most plaintiffs in causes of actions relevant for the purposes of this article retain their lawyers on a contingent fee basis. 71 see gregg d. polsky, taxing litigation: federal tax concerns of personal injury plaintiffs and their lawyers, 22 fla. tax rev. 120, 137-38 (2018) (describing the effect of the 2017 tax act’s disallowance of miscellaneous itemized deductions on certain personal injury plaintiffs). 72 see i.r.c. § 67(a) (allowing miscellaneous itemized deductions to the extent they exceed 2% of the taxpayer’s adjusted gross income). 73 $200,000 adjusted gross income x 2% “floor" = $4,000. note that miscellaneous itemized deductions are allowed only to taxpayers who choose to itemize their deductions rather than claim the standard deduction. i.r.c. § 63(e). 74 see i.r.c. § 56(b)(1)(a)(i) (disallowing miscellaneous itemized deductions for the purpose of the amt). 75 see generally i.r.c. § 55 (requiring taxpayers other than corporations to pay the greater of their amt liability or their regular tax liability). 76 see i.r.c. § 55(b)(1)(a) (setting the maximum rate for the amt at 28%). 77 see i.r.c. § 67(g) (suspending miscellaneous itemized deductions through 2025). 78 see i.r.c. § 67(a) (allowing miscellaneous itemized deductions to the extent they exceed 2% of adjusted gross income); i.r.c. § 56(b)(1)(a)(i) (disallowing miscellaneous itemized deductions for the purposes of the amt). 79 28% (amt rate) x $1,000,000 (gross settlement) = $280,000. depending on the plaintiff’s other income and deductions, some portion of her amt taxable income could be subject to the slightly lower rate of 26%. i.r.c. § 55(b)(1)(a). amt taxpayers also receive the benefit of an exemption amount, but this plaintiff would be phased out of the exemption amount under the amt rules that applied before 2018 and will apply again after 2025. i.r.c. § 55(d)(1)–(2), (4). 2020] impact of the 2017 tax act on certain personal injury plaintffs 41 47% federal income tax on her net $600,000 recovery,80 even though the statutory rates top out at 37%.81 if the attorney fee portion of the claim is higher (because, for example, the attorney incurred substantial costs for expert witnesses), the burden of the tax trap increases. for instance, if the plaintiff retains only $400,000 of the settlement (with the attorney receiving $600,000 as his contingent fee and recovery of costs), the effective tax rate is 70%.82 between 2018 and 2025, this plaintiff is even worse off. assuming she is unmarried, has no other income, claims the standard deduction, and pays $400,000 of a $1,000,000 settlement to her attorney, she would owe roughly $330,000 in tax.83 this translates into an effective tax rate of 55%,84 which is nearly 50% higher than the highest statutory rate of 37%.85 if an additional $200,000 went to the attorney for reimbursement of costs, her effective tax rate would be over 80%. 86 if costs surpass $200,000, the plaintiff’s effective tax rate may approach or even exceed 100%, as shown in table 1. table 1 year/tax type gross settlement attorney’s fees and costs net settlement fed. tax liability effective fed. tax rate pre2018/amt $1,000,000 $400,000 $600,000 $280,000 47% 2020/reg. tax $1,000,000 $400,000 $600,000 $330,000 55% pre2018/amt $1,000,000 $600,000 $400,000 $280,000 70% 2020/reg. tax $1,000,000 $600,000 $400,000 $330,000 83% pre2018/amt $1,000,000 $700,000 $300,000 $280,000 93% 2020/reg. tax $1,000,000 $700,000 $300,000 $330,000 110% 80 $280,000 (amt tax) / $600,000 (net settlement) = 47%. 81 see i.r.c. § 1(j)(2) (setting out maximum tax rates for taxable years 2018 through 2025). 82 $280,000 (amt tax) / $400,000 (net settlement) = 70%. 83 this is calculated using 2020 tax law. after claiming the $12,400 standard deduction, the plaintiff’s taxable income is $987,600, which, after application of the 2020 tax rates, yields federal income tax liability of $330,890. 84 $330,000 (tax liability) / $600,000 (net settlement) = 55%. 85 (55% 37%) / 37% = 49%. 86 $330,000 (tax liability) / $400,000 (net settlement) = 82.5%. 42 columbia journal of tax law [vol 12:27 a. claims subject to the tax trap many plaintiffs are unaffected by the tax trap. claims that arise out of personal physical injuries are generally exempt because the plaintiff’s recovery is often entirely taxfree.87 however, punitive damages, postand pre-judgment interest, and reimbursement of previously deducted medical expenses are taxable, even if the claim arises out of a personal physical injury.88 to the extent that a plaintiff receives these components, the tax trap will be implicated. for instance, assume that a personal physical injury plaintiff receives a settlement of $1,500,000, two-thirds of which is attributable to pain and suffering (which is received tax-free) and one-third of which is attributable to a taxable component (such as punitive damages or interest). assume further that the plaintiff pays $500,000 to her attorney pursuant to a contingent fee agreement. because $500,000 (onethird of the settlement) is taxable, before the denial of miscellaneous itemized deductions, the plaintiff would have been able to deduct $167,000 (one-third of the attorney’s fee).89 under current law, no deduction is allowed and the plaintiff is taxed on the full $500,000. claims that arise out of the taxpayer’s trade or business are also unaffected by the trap. this is because the attorney’s fees deduction in such cases is classified as an abovethe-line deduction, and above-the-line deductions cannot constitute miscellaneous itemized deductions.90 if the plaintiff’s claim arises out of the plaintiff’s self-employment, the attorney’s fees deduction is classified as an above-the-line deduction pursuant to section 62(a)(1).91 if the plaintiff’s claim arises out of the plaintiff’s employment by another person or entity, the attorney’s fees deduction is deductible as an above-the-line deduction pursuant to section 62(a)(20).92 “civil rights” claims based on federal, state, or local law (whether statutory or common law) are also exempt from the trap because section 62(a)(20) allows an abovethe-line deduction for attorney’s fees related to those claims.93 likewise, attorney’s fees 87 see i.r.c. § 104(a)(2) (excluding damages, other than punitive damages, received on account of personal physical injury or sickness). 88 see id.; see also polsky, supra note 71, at 124 (describing categories of damages received in personal physical injury lawsuits that are not excluded from gross income). 89 see johnson-waters v. comm’r, 66 t.c.m. (cch) 252, 253 (1993) (allocating attorney’s fee deduction between taxable and tax-free components on a pro rata basis); p.l.r. 2004–03–046 (jan. 16, 2004). however, before 2018 (and after 2025) the deduction was subject to the traditional limitations regarding miscellaneous itemized deductions. see i.r.c. § 67(a), (g). accordingly, the plaintiff would be able to deduct miscellaneous itemized deductions only to the extent that they (in the aggregate) exceeded 2% of the plaintiff’s adjusted gross income and these deductions would not be allowed in calculating the plaintiff’s amt liability. id. 90 i.r.c. § 63(d)(1) (defining itemized deductions as deductions other than above-the-line deductions, which are those that are taken into account in calculating adjusted gross income); i.r.c. § 67(b) (characterizing certain itemized deductions as miscellaneous itemized deductions); see also gregg d. polsky, letters to the editor: miscellaneous itemized deductions and litigation expenses, 160 tax notes 1281 (2018) (explaining the relationship between above-the-line deductions, itemized deductions, and miscellaneous itemized deductions). 91 i.r.c. § 62(a)(1) (allowing an adjustment to gross income for trade and business deductions). 92 i.r.c. § 62(a)(20) (allowing an above-the-line deduction for attorney’s fees paid in connection with claims of “unlawful discrimination”); i.r.c. § 62(e)(18)(ii) (including employment-related claims within the definition of “unlawful discrimination” for purposes of i.r.c. § 62(a)(20)). 93 i.r.c. § 62(e)(18)(i) includes civil rights claims within the definition of “unlawful discrimination” for purposes of i.r.c. § 62(a)(20). i.r.c. § 62(e)(1) through (16) provides a list of federal statutory provisions (such as specified sections of the americans with disabilities act) for which attorney’s fees deductions will be classified as above-the-line. this list and the “catch-all” provision for civil rights and employment claims appear to be entirely redundant. cf. i.r.c. § 62(e)(1)–(16) (listing federal statutes) with i.r.c. § 62(e)(18) 2020] impact of the 2017 tax act on certain personal injury plaintffs 43 paid by whistleblowers to the irs, the sec, or the cftc or by state or federal qui tam whistleblowers are classified as above-the-line deductions, exempting such whistleblowers from the tax trap.94 finally, claims arising out of the damage or destruction of property will not be affected by the tax trap because the legal fees will be added to the adjusted basis of the property.95 claims that fall outside of these descriptions are subject to the tax trap. thus, the trap will generally apply to claims for defamation or slander, 96 invasion of privacy, negligent or intentional infliction of emotional distress, private false imprisonment,97 badfaith insurance practices, and punitive damages (even if the underlying personal injury was physical in nature).98 for these claims, the plaintiff will be required to include the gross settlement in gross income and will not (under current law) receive any deduction for the contingent attorney’s fee. table 2 shows whether certain claims are subject to the trap and provides explanations for any exemptions. (catch-all provision describing civil rights and employment claims). for further discussion of this overlap, see infra text accompanying notes 178-183. 94 i.r.c. § 62(a)(20) (providing above-the-line classification for attorney’s fees in connection with a claim of “a violation of subchapter iii of chapter 37 of title 31, united states code,” commonly known as qui tam claims, and claims of “unlawful discrimination”); i.r.c. § 62(a)(21) (providing above-the-line classification for irs, sec, cftc, and state qui tam claims). 95 for example, if a plaintiff recovers $10,000 for damage to his car and pays $3,000 as a contingent attorney’s fee, the plaintiff will generally reduce his basis in the car by the $10,000 recovery and simultaneously increase his basis by the $3,000 fee, resulting in a net $7,000 reduction in basis. if the plaintiff spends the $7,000 to restore his car, basis will return to the original amount. see big four indus., inc. v. comm’r, 40 t.c. 1055, 1060 (1963), acq., 1964–2 c.b. 3, 4 (stating that, to the extent the property damages award did not exceed basis, it would be nontaxable, but any recovery in excess of basis would be taxable as capital gain); treas. reg. § 1.263(a)–3(k)(1)(iii) (requiring a taxpayer to capitalize an amount payed for restoration if that restoration is for damage to the property for which the taxpayer has claimed a casualty loss); p.l.r. 1993–08–013 (nov. 24, 1992) (“breach of contract damages relating to capitalizable items are generally treated first as a tax-free return of capital, to the extent of the taxpayer's basis in the subject-matter of the contract . . . the taxpayer must recognize income, however, to the extent such damages exceed the taxpayer’s basis in the subject-matter of the contract.”). because the attorney’s fee increases basis (i.e., it is capitalized), it is not deducted and, therefore, the miscellaneous itemized deduction rules are irrelevant. see i.r.c. § 263; f.s.a. 2002–28–005 (mar. 29, 2002) (holding that the legal fees attributable to property damage settlement should be capitalized). 96 this assumes that the defamation or slander does not relate to the taxpayer’s trade or business (other than the trade or business of being an employee). if it does, the fees will be deductible above-the-line. see i.r.c. § 62(a)(1). 97 while recoveries related to wrongful incarceration by the government are excluded (and therefore not subject to the tax trap) those related to false imprisonment are taxable. see i.r.c. § 139f(a) (excluding damages for wrongful incarceration from gross income); stadnyk v. comm’r, 96 t.c.m. (cch) 475, 478 (2008) (holding that “physical restraint and physical detention” in a false imprisonment case “are not ‘physical injuries’” under i.r.c. § 104(a)(2) and, therefore, the damages were not excluded from gross income). 98 see i.r.c. § 104(a)(2) (providing that, while compensatory damages in a personal physical injury case are excluded from gross income, punitive damages are included in gross income). section 104(c) provides a narrow exception to this rule allowing punitive damages arising out of a physical injury to be excluded in a wrongful death case where the applicable wrongful death law of a state (as in effect on september 13, 1995) provides, or has been construed by a court to provide, that only punitive damages may be awarded in such an action. see also benavides v. united states, 497 f.3d 526, 530 (5th cir. 2007) (holding that i.r.c. § 104(c) does not exclude punitive damages when the general wrongful death laws of the state do not limit recovery to punitive damages, even if some other law, such as workers’ compensation law, might have such a limit). 44 columbia journal of tax law [vol 12:27 table 2 type of claim subject to trap? if not, why not? additional comments personal physical injury generally, no recovery is often entirely tax-free under § 104(a)(2) if plaintiff receives taxable components, then tax trap will apply to those (see below) wrongful incarceration no recovery is tax-free under § 139f employment-related no § 62(a)(20) & (e)(18)(ii) allow above-the-line deduction related to selfemployment no § 62(a)(1) allows above-the-line deduction civil rights no § 62(a)(20) & (e)(18)(ii) allow above-the-line deduction the irs, the sec, the cftc, state and federal qui tam no § 62(a)(20) & (a)(21) allow abovethe-line deduction property damages no attorney’s fees added to basis, not deducted taxable components of personal physical injury recoveries yes n/a applies to allocations of punitive damages, interest, and previously deducted medical expenses other types of claims yes n/a e.g., defamation, negligent/intentional infliction of emotional distress, invasion of privacy b. tax policy implications it is an axiom of u.s. federal income taxation that costs incurred in generating gross income are deductible in arriving at taxable income.99 otherwise, a taxpayer would be taxed on her gross, rather than net, income, even though net income is the appropriate 99 see hantzis v. comm’r, 638 f.2d 248, 249 (1st cir. 1981) (explaining the deductibility of costs incurred in generating gross income). 2020] impact of the 2017 tax act on certain personal injury plaintffs 45 measure of a taxpayer’s ability to pay. accordingly, it is not surprising that congress has almost universally allowed deductions for costs incurred to generate gross income.100 in the exceptional cases where congress has disallowed deductions for these costs, either the costs or the activity itself has been deemed to violate public policy. for example, under section 280e, the costs incurred in the business of trafficking in controlled substances as prohibited by federal or state law are non-deductible. 101 likewise, subsections (c) and (f) of section 162 disallow otherwise deductible payments for illegal bribes or kickbacks and for government fines or penalties, respectively.102 while these and other similar deduction disallowance provisions are targeted narrowly to specific activities or deductions, the denial of miscellaneous itemized deductions is not targeted, as the expenses included within the definition of miscellaneous itemized deductions are varied.103 perhaps the most common types of miscellaneous itemized deductions are unreimbursed employee business expenses. the rationale for disfavoring these expenses is that employers would generally reimburse legitimate employee business expenses, so unreimbursed employee business expenses have a high risk of constituting disguised personal consumption.104 while this concern may be valid in some circumstances, some employers may simply lack the financial wherewithal to reimburse all legitimate employee expenses. other common types of miscellaneous itemized deductions are expenses related to investments of stocks, bonds, and other financial instruments, such as annual “wrap” fees paid to investment advisors.105 it is hard to discern the tax policy rationale for disfavoring these expenses. the best explanation may be that these investments generally produce at least some long-term capital gain that is not currently recognized; therefore, allowing an immediate deduction against ordinary income would be too generous. although this may be true in general, permanently disallowing any deduction is an excessive response to this concern. regardless of the merits of disfavoring these common types of miscellaneous itemized deductions, they are generally small in relation to the taxpayer’s income, and therefore denial of these deductions is merely annoying rather than devastating. for employees whose legitimate unreimbursed employee business expenses equal about 1% of their salary, they would save only about ten to forty dollars in tax per $10,000 of salary if the expenses were allowed as above-the-line deductions. likewise, an investor paying a typical wrap fee of 1% of investment assets under management would save about the same amount in tax per $10,000 of asset value. on the other hand, plaintiffs who are affected by the contingent fee tax trap often face significant adverse tax consequences because the disallowed deduction is a function 100 see, e.g., i.r.c. § 162 (allowing deductions for ordinary and necessary costs incurred in connection with carrying on a trade or business); i.r.c. § 212(1) (allowing deductions for ordinary and necessary costs incurred in connection with the production or collection of income). 101 i.r.c. § 280e. 102 i.r.c. § 162 (c), (f). 103 i.r.c. § 67(b) (defining miscellaneous itemized deductions). 104 jeffrey h. kahn, beyond the little dutch boy: an argument for structural changes in tax deduction classification, 80 wash. l. rev. 1, 31 (2005). 105 see i.r.c. § 212 (allowing deductions for expenses incurred in connection with investment activity). section 212 deductions that are not attributable to the production of rents or royalties are generally below-the-line deductions. see i.r.c. § 62(a) (listing above-the-line deductions). section 67(b) classifies these below-the-line section 212 deductions as miscellaneous itemized deductions. 46 columbia journal of tax law [vol 12:27 of the settlement amount, which can be extremely large, and because contingent fees and costs can constitute a large portion of the settlement. in table 1, the plaintiff’s disallowed fee deduction attributable to a $1,000,000 settlement ranged from $400,000 to $700,000. if instead the deduction were an above-the-line deduction, the plaintiff would have saved between $150,000 and $250,000 in tax. even before miscellaneous itemized deductions were entirely disallowed, commentators recognized the patent unfairness of the contingent fee tax trap.106 prior to 2004, attorney’s fees of employment and civil rights claimants were characterized as miscellaneous itemized deductions, subject to the then-existing 2% floor, and disallowed under the amt.107 the fees were often large enough to cause the claimant to pay tax under the amt, resulting in a very high effective rate of tax on those awards. although legislative relief came in 2004,108 before congress acted there was a chorus of criticism from courts and commentators.109 for example, in a 1995 employment case, the first circuit explained that “the outcome smacks of injustice because taxpayer is effectively robbed of any benefit of the legal fee’s below the line treatment.”110 senator chuck grassley, then chairman of the finance committee, referred to the problem as “a tax law fluke that forces plaintiffs who win settlements in civil rights cases and other lawsuits to pay income taxes on parts of the settlements they never see[—]in some cases even owing thousands of dollars more than they win.”111 he further explained: “it’s clearly a fairness issue to make sure people don’t have to pay income taxes on income that was never theirs in the first place. that’s common sense.”112 as a result of this criticism, congress legislatively addressed the tax trap in 2004, but only for a subset of the claims to which the trap applied—namely civil rights and employment claims.113 this omission—whether intentional or not—left many other types of claims in the dark. the 2017 tax act exacerbated the problem by completely disallowing miscellaneous itemized deductions for regular tax purposes.114 106 see brant j. hellwig & gregg d. polsky, litigation expenses and the alternative minimum tax, 6 fla. tax rev. 899, 931 (2004) (“courts, commentators, and even the national taxpayer advocate for years have urged congress to address the unjust and unfair tax treatment of legal fees under the amt.”) (footnotes omitted). 107 see alexander v. comm’r, 72 f.3d 938, 944-47 (1st cir. 1995) (holding that an employee’s legal fees incurred in connection with litigation arising out of his employment constitute unreimbursed employee business expenses); biehl v. comm’r, 351 f.3d 982, 986-87 (9th cir. 2003); i.r.c § 67(a) (limiting miscellaneous itemized deductions to the extent they exceed 2% of adjusted gross income); i.r.c § 56(b)(1)(a) (disallowing miscellaneous itemized deductions under the amt). 108 see i.r.c. § 62(a) (allowing deductions to gross income). 109 see biehl v. comm’r, 118 t.c. 467, 488 (2002), aff’d, 351 f.3d 982 (9th cir. 2003) (“we conclude in this case, as we have in prior cases, that it is the job of congress, if it should decide in its wisdom to do so, to cure the injustice.”); deborah a. geier, some meandering thoughts on plaintiffs and their attorneys’ fees and costs, 88 tax notes 531, 549 (2000) (“congress should act now . . . to fix the problem— and do so retroactively for all open tax years.”); nat'l taxpayer advoc., 2002 annual report to congress, 167-69, https://www.irs.gov/pub/tas/nta_2002_annual_rpt.pdf [https://perma.cc/t3my-2rkq]. 110 alexander, 72 f.3d at 946. 111 press release, sen. charles e. grassley, grassley works to end unfair taxation in civil rights cases (may 12, 2003), https://www.grassley.senate.gov/news/news-releases/grassley-works-end-unfairtaxation-civil-rights-cases [https://perma.cc/an76-pdrw]. 112 id. 113 see i.r.c § 62(a)(20), (e)(18) (classifying deductions for legal fees and costs attributable to civil rights and employment claims as above-the-line deductions). 114 see i.r.c § 67(g) (disallowing miscellaneous itemized deductions until 2026). 2020] impact of the 2017 tax act on certain personal injury plaintffs 47 c. does the form of attorney fee payment matter? in a typical situation, a settling defendant will write a check or send a wire payment to the plaintiff’s attorney’s trust fund account. the plaintiff’s attorney will then retain the portion of the settlement to which the attorney is entitled under the contingent fee agreement (i.e., reimbursement of advanced expenses plus the contingent fee amount) and remit the remaining “net settlement” amount to the client. for example, if the parties settle a case for $1,000,000, the defendant typically wires that amount to the plaintiff’s attorney’s trust fund account. if, under a contingent fee agreement, the attorney is entitled to $400,000 for attorney’s fees and advanced expenses, the attorney retains that amount and remits $600,000 through a wire payment to the plaintiff. in such a case, what are the tax consequences to the plaintiff, assuming the settlement is taxable? there are two possibilities. the plaintiff could include the full $1,000,000 gross settlement amount in her gross income and then (to the extent allowed) claim a deduction for the $400,000 attorney fee payment. alternatively, the plaintiff could include only the $600,000 net settlement amount. if the $400,000 attorney fee deduction in the first scenario is an above-the-line deduction, the end result to the plaintiff would be the same in either case. but where the attorney fee deduction is limited or eliminated; the plaintiff would prefer the $600,000 inclusion approach. this issue reached the united states supreme court in 2004 in commissioner v. banks.115 there the court held that, because the plaintiff used a portion of the settlement to satisfy her liability for attorney’s fees under the contingent fee agreement, the entire gross settlement must be included in her gross income.116 under this reasoning, the form of the attorney’s fees payment does not matter.117 even if the defendant were to write two checks—one to the attorney for $400,000 and another to the plaintiff for $600,000—the result would be the same: the plaintiff must include $1,000,000 in gross income and then may, depending on the relevant tax rules relating to deductions, claim a deduction for $400,000.118 the rules that govern the defendant’s tax reporting obligations are consistent with this approach. they provide that regardless of whether the defendant sends one check to the attorney or two checks (one to the attorney and the other to the plaintiff), the defendant must report the full settlement amount on a form 1099-misc delivered to the plaintiff.119 while banks undoubtedly resolved the main issue regarding the characterization of attorney fee payments under a contingent fee agreement, it arguably left some tangential issues unresolved. for instance, what if the defendant is required to pay the plaintiff’s reasonable attorney’s fees pursuant to a fee-shifting statute, civil procedure rule, or contractual provision?120 some commentators have argued that because the facts in the 115 comm’r v. banks, 543 u.s. 426, 430 (2005). 116 id. at 437; see also polsky, supra note 71, at 133-35 (describing the banks rule). 117 polsky, supra note 71, at 133-34. 118 id. 119 see treas. reg. § 1.6045–5(f), ex. (3). if the settlement is nontaxable because, for example, it represents compensatory damages (other than interest and previously deducted medical expenses) arising out of a personal physical injury, then no form 1099-misc reporting is required with respect to the plaintiff. see treas. reg. § 1.6045–5(f), ex. (2). 120 fee-shifting provisions would generally increase settlement amounts because the defendant would be required to pay the plaintiff’s attorney’s fees if the plaintiff were to prevail at trial. 48 columbia journal of tax law [vol 12:27 banks case (and its companion, banaitis121) did not involve any fee-shifting, the issue remains open.122 they contend therefore that a plaintiff might be able to successfully argue that an amount paid directly to the attorney should not be included in her gross income.123 however, the irs in informal guidance has indicated that it disagrees with this view.124 furthermore, a pre-banks ninth circuit case held that a plaintiff was required to include the full gross settlement in gross income even though the underlying claim was based on a federal statute that allowed for fee-shifting, relying on reasoning consistent with that subsequently used in banks.125 d. federal comprehensive legislative solution as previously discussed, in 2004 congress recognized the unfairness of the tax trap and eliminated it for many of the types of claims to which it applied.126 civil rights and employment claimants were granted above-the-line deductions for their contingent attorney fees. 127 other claims, however, slipped through the cracks, presumably inadvertently. a comprehensive legislative solution would have been to allow above-theline deductions for all otherwise deductible attorney’s fees and costs incurred in connection with a claim for damages. instead of such a global solution, congress enacted sections 62(a)(20) and 62(e), which provide above-the-line status to a laundry list of specific types of causes of actions.128 the legislative history of the 2004 reform explains how the laundry list approach came to be. a 2003 house bill had proposed to solve the tax trap by excluding from gross income all damages received on account of certain civil rights claims even though the claimant did not suffer a personal physical injury.129 while this proposal would have solved the tax trap for these claimants, it also would have gone much further by allowing the net settlement to be received tax-free.130 thus, under the 2003 bill, a plaintiff who settled a non-physical civil rights claim for $1,000,000 and paid her attorney $400,000 would pay zero tax despite receiving a net settlement of $600,000. while the 2003 house bill was never enacted, later senate bills used the 2003 house bill as a starting point for amending the code to allow specified claimants abovethe-line deductions for legal costs.131 these senate bills added garden-variety employment claims (i.e., those not based on alleged discrimination or retaliation132) to the list and 121 banaitis v. comm’r, 340 f.3d 1074 (9th cir. 2003), rev’d on other grounds sub nom. banks, 543 u.s. at 439. 122 see joanna laine, consumer protection and tax law: how the tax treatment of attorney’s fees undermines the fair debt collection practices act, 40 n.y.u. rev. l. & soc. change 721, 737 (2016). 123 id. 124 p.m.t.a. 2009-035 (oct. 22, 2008). 125 sinyard v. comm’r, 268 f.3d 756, 758-59 (9th cir. 2001). for further discussion of the feeshifting/sinyard interaction, see gregg d. polsky & stephen f. befort, employment discrimination remedies and tax gross ups, 90 iowa l. rev. 67, 88-90 (2004). 126 see supra note 113 and accompanying text. 127 i.r.c § 62(a)(20), (e)(18) (allowing deductions for civil rights and employment claims to gross income). 128 id. 129 civil rights tax relief act of 2003, h.r. 1155, 108th cong. (2003). the house bill was also simultaneously introduced in the senate. civil rights tax relief act of 2003, s. 557, 108th cong. (2003). 130 id. 131 jobs and growth tax relief reconciliation act of 2003, s. 1054, 108th cong. § 521 (2003); jumpstart our business strength (jobs) act, s. 1637, 108th cong. § 643 (2004); american jobs creation act of 2004, pub. l. no. 108-357, § 703, 118 stat. 1418, 1546-48 (2004). 132 discrimination and retaliation claims were on the original list. see h.r. 1155 § 140(b)(18). 2020] impact of the 2017 tax act on certain personal injury plaintffs 49 changed the “remedy” from full exclusion of the settlement to allowance of an above-theline deduction.133 there is no evidence that legislators were aware that some remaining claims slipped through the cracks and were therefore still subject to the contingent fee tax trap. the solution to this problem is simple. instead of the unwieldly and noncomprehensive list of claims in section 62(e), congress should enact a provision that confers above-the-line status on all allowable deductions attributable to claims for taxable damages. e. a limited state legislative solution prior to the banks decision, some states considered amending their attorney lien laws in an attempt to bolster plaintiffs’ claims that the attorney fee portion of a settlement was excluded from gross income.134 the reasoning of banks foreclosed this strategy.135 nevertheless, there remains a limited opportunity for states to pass legislation that would offer some tax relief to plaintiffs who recover punitive damages. recall that, while punitive damages are included in gross income even in personal physical injury claims, 136 the attorney’s fees allocable to those punitive damages are often characterized as miscellaneous itemized deductions and therefore are disallowed under current law.137 for instance, assume that a plaintiff with a personal physical injury claim receives a $1,000,000 settlement, half of which is allocable to pain and suffering and half of which is allocable to punitive damages. her attorney is entitled to a $400,000 contingent fee. the punitive damages of $500,000 are included in her gross income, while the $500,000 for pain and suffering is excluded. because half of the settlement is taxed, half of the contingent fee would potentially be deductible as a miscellaneous itemized deduction.138 under current law, however, miscellaneous itemized deductions are disallowed. 139 therefore, the plaintiff would end up paying tax on the entire $500,000 punitive damages portion of the settlement, unreduced by any part of the contingent attorney’s fees. 133 s. 1054 § 521; s. 1637 § 703; § 703, 118 stat. at 1546-48. 134 see stephen d. feldman, comment, exclusion of contingent attorneys’ fees from gross income, 68 u. chi. l. rev. 1309, 1317-19 (2001). prior to banks, some circuit courts had determined that state attorney lien laws had effectively transferred the attorney fee portion of the claim and, therefore, the plaintiff was required to include only the net settlement in gross income. other circuit courts had rejected that reasoning. see id. 135 comm’r v. banks, 543 u.s. 426, 437 (2005) (“th[e] rule [that plaintiffs must include the attorney fee portion of a recovery in gross income] applies whether or not the attorney-client contract or state law confers any special rights or protections on the attorney, so long as these protections do not alter the fundamental principal-agent character of the relationship . . . state laws vary with respect to the strength of an attorney’s security interest in a contingent fee and the remedies available to an attorney should the client discharge or attempt to defraud the attorney. no state laws of which we are aware, however, even those that purport to give attorneys an ‘ownership’ interest in their fees . . . convert the attorney from an agent to a partner.”). 136 see supra note 31 and accompanying text. 137 see § 67(g) (disallowing miscellaneous itemized deductions until 2026). attorney’s fees attributable to punitive damages should constitute above-line-deductions where the underlying claim arises out of the plaintiff’s trade or business. see i.r.c. § 62(a)(1). in addition, attorney’s fees attributable to punitive damages should constitute above-the-line deductions where the claim arises out of civil rights or employment claims described in section 62(e) because of the broad “in connection with” language used in section 62(a)(20). 138 the other half is flatly non-deductible because it is attributable to the tax-exempt recovery. see i.r.c. § 265(a)(1). allowing such a deduction would illogically give the taxpayer a double tax benefit: first, the $500,000 pain and suffering award would not be taxed and, second, the $200,000 attorney’s fee attributable to the award could be used to shelter gross income from other sources (such as wages). 139 see i.r.c § 67(g) (disallowing miscellaneous itemized deductions until 2026). 50 columbia journal of tax law [vol 12:27 states that have a split-recovery regime for punitive damages could amend their split-recovery statute to ameliorate this problem. in a split-recovery regime, a certain percentage of any punitive damages award is remitted directly to the state in which the claim is brought.140 in a 2002 chief counsel advice memorandum (the “2002 c.c.a.”), the irs determined that a plaintiff is not required to include the state’s portion in her gross income because the transfer to the state occurs by operation of law and therefore the plaintiff has “no command over the disposition” of that amount.141 in contrast, the transfer of the attorney’s fee portion is the result of the contingent fee agreement, which was voluntarily executed by the plaintiff. to illustrate, assume that, in the example above, 50% of the net punitive damages award (i.e., net of attorney’s fees attributable to the punitive damages award) must be remitted to the state. the $1,000,000 settlement would be distributed as follows: $450,000 to the plaintiff ($300,000 net compensatory amount plus $150,000 net punitive amount). $400,000 to the attorney (40% of $1,000,000 settlement). $150,000 to the state (50% of ($500,000 punitive damages less $200,000 attorney’s fee)). the plaintiff would be able to exclude from her gross income the $500,000 of the settlement that represents compensatory damages. in addition, under the 2002 c.c.a., the plaintiff would also exclude the $150,000 that was remitted to the state.142 only the remaining $350,000 would be included in gross income.143 the reasoning of the 2002 c.c.a. provides a potential avenue to ameliorate the contingent fee tax trap in punitive damages cases. states with split-recovery regimes could amend the existing distribution rules to provide for an automatic payment to the attorney. a recent legislative proposal in oregon is illustrative.144 under current oregon law, 70% of the gross punitive damages award is paid to the state.145 the remaining 30% is paid to the plaintiff.146 the plaintiff’s attorney’s fee is paid out of the plaintiff’s 30% award, but cannot exceed 20% of the gross award.147 thus, in the event of a $1,000,000 punitive damages award and a contingent fee percentage of 20% or greater, $700,000 would go to the state, $100,000 to the plaintiff, and $200,000 to the attorney. for federal income tax purposes, the plaintiff would include $300,000 in gross income and receive no deductions because of the disallowance of miscellaneous itemized deductions under current law. if the plaintiff’s marginal tax rate is 33%, the plaintiff would end up with no punitive damages award on an after-tax basis. 140 see, e.g., or. rev. stat. § 31.735 (2020). 141 c.c.a. 2002-46-003 4 (aug. 1, 2002). 142 id. 143 the 2002 c.c.a. also determined that the taxpayer could claim a deduction for the attorney fee portion of the award that was attributable to the state’s portion of the recovery. therefore, the plaintiff could claim a deduction for the full $200,000 attorney fee attributable to punitive damages. id. at 4-5. this deduction, however, would constitute a miscellaneous itemized deduction and would therefore, under current law, be disallowed. i.r.c. § 67(g). at the time of the c.c.a.’s publication, miscellaneous itemized deductions were deductible to the extent they exceeded 2% of adjusted gross income and were disallowed entirely for amt purposes. i.r.c. § 62(a); i.r.c. § 56(b)(1)(a)(i). 144 s. 874, 80th leg. assemb., reg. sess. (or. 2019). 145 or. rev. stat. § 31.735(1)(a). 146 id. 147 id. 2020] impact of the 2017 tax act on certain personal injury plaintffs 51 oregon senate bill 874 would substantially alter this regime.148 any punitive damages recovery would first repay costs incurred in the recovery of punitive damages, such as court costs and expert witness fees.149 the remaining amount would be divided equally (one-third each) to the plaintiff, the plaintiff’s attorney, and the state. 150 if $1,000,000 is recovered as punitive damages (assuming no costs), approximately $333,333 would go to each. for federal income tax purposes, under the reasoning in the 2002 c.c.a., the plaintiff would be required to include only her $333,333 share in gross income because the transfer of the remaining amount occurs by operation of law and therefore she has no command over its disposition.151 the following table 3 contrasts the results under current law and under oregon senate bill 874, assuming the plaintiff is subject to a marginal tax rate of 33%: table 3 approach gross settlement state’s share attorney’s share plaintiff’s share (pretax) plaintiff’s share (aftertax) current law $1,000,000 $700,000 $200,000 $100,000 $0 or. s. 874 $1,000,000 $333,333 $333,333 $333,333 $222,222 f. administrative solutions recognizing the patent unfairness of the tax trap, the federal government could provide some relief to affected plaintiffs through administrative action. as discussed below, plaintiffs can make a nonfrivolous argument that contingent fees represent capital expenditures rather than potentially deductible expenses. because capital expenditures increase a plaintiff’s tax basis in her claim, they offset the gross settlement amount in arriving at gross income. if a contingent fee of $400,000 (out of a $1,000,000 total settlement amount) is capitalized, a plaintiff would be required to include only the net $600,000 in her gross income. this is the same end result as including the full $1,000,000 in gross income but allowing an above-the-line deduction for the $400,000 contingent fee. while the banks court explicitly declined to address the capitalization approach because it was not raised in the lower courts, it has garnered the support of some prominent 148 or. s. 874. 149 id. 150 id. 151 c.c.a. 2002–46–003 4 (aug. 1, 2002). it could be argued that the mere act of hiring an attorney under the revised oregon split recovery regime provides the plaintiff with sufficient “command over the disposition” over the attorney fee portion to require inclusion in the plaintiff’s gross income. to ameliorate this concern, the state law could additionally provide that, if the plaintiff was not represented by an attorney, the portion of the proceeds that otherwise would have gone to the attorney would instead be remitted in full to the state. thus, in the example, if the plaintiff was pro se, the state’s share would be increased from $333,333 to $666,667, while the plaintiff’s share would remain $333,333. this would ensure that regardless of whether the plaintiff retained an attorney, her share would always be limited to one-third of the punitive damages. this would effectively forestall any irs argument that the plaintiff retained any “command over the disposition” of the attorney fee portion of the recovery. 52 columbia journal of tax law [vol 12:27 commentators.152 while some language in the regulations and a few cases are problematic, they would not prevent the treasury or the irs from promulgating a rule that would protect affected plaintiffs.153 for instance, the irs could issue a revenue procedure stating that the irs will not challenge a taxpayer who takes the position that a contingent fee is capitalized. the irs has used a similar approach in other situations to provide taxpayer relief and certainty.154 it would make sense to do so here as well. g. taxpayer arguments while the banks decision forecloses the most straightforward legal argument to avoid the contingent fee tax trap, other arguments are potentially still available. one set of arguments involves those that the banks case explicitly declined to consider because they were not raised in the lower courts. another set of arguments relates to an expansive interpretation of the 2004 amendment that applies to employment and civil rights claims. in the banks case, the court expressly declined to comment on three arguments that had not been advanced in earlier stages of the litigation.155 one argument was relevant only to employment-related claimants, which are no longer subject to the tax trap. 156 another argument was that the contingent fee arrangement constitutes a partnership for tax purposes.157 while the court stated that it was declining to comment on this argument, it had earlier in the opinion “reject[ed] the suggestion to treat the attorney-client relationship as a sort of business partnership or joint venture for tax purposes.”158 thus, as professor brant hellwig explained, “far from declining comment on the taxpayers’ [partnership for tax purposes] argument, it appears that the court had already expressly rejected it.”159 while these two arguments would not be helpful to affected claimants, the third and final theory is still potentially viable: under that theory, a plaintiff in a contingent fee arrangement could avoid the tax trap by capitalizing the attorney’s fees and adding it to her tax basis in the claim (which, before such adjustment, was zero). this capitalization theory was discussed above, in the recommendation that the irs issue a safe harbor for this approach (but not requiring it for all litigation fees). the theory is difficult (though 152 see comm’r v. banks, 543 u.s. 426, 437-38 (2005); joseph m. dodge, the netting of costs against income receipts (including damage recoveries) produced by such costs, without barring congress from disallowing such costs, 27 va. tax. rev. 297, 334-38 (2007); charles davenport, why tort legal fees are not deductible, 97 tax notes 703, 704 (2002); deborah a. geier, attorney’s fees: davenport has the right idea, 97 tax notes 1627, 1629 (2002). 153 see hellwig & polsky, supra note 106, at 917-21 (explaining the difficulty in reconciling the capitalization approach with treas. reg. § 1.212–1(k) and several court decisions). 154 see, e.g., rev. proc. 93–27, 1993–2 c.b. 343 (providing the circumstances in which the irs will not challenge the claimed tax-free treatment upon receipt of a partnership profits interest). 155 banks, 543 u.s. at 437-38. 156 see brief for professor stephen b. cohen as amicus curiae at 10-14, comm’r v. banks, 543 u.s. 426 (2005) (nos. 03-892 & 03-907) (arguing that contingent fees in employment-related litigation constitute reimbursed employee business expenses, which are deductible above-the-line under i.r.c. § 62(a)(2)(a)); i.r.c. § 62(a)(20), (e)(18)(ii) (allowing above-the-line deductions for employment-related legal fees). 157 banks, 543 u.s. at 435-36. 158 id. at 436-38. 159 brant j. hellwig, the supreme court’s casual use of the assignment of income doctrine, 2006 u. ill. l. rev. 751, 761 (2006). even if the partnership for tax purposes theory were viable, it is far from clear whether, due to the technicalities of partnership tax rules, the argument would have even helped the taxpayer avoid the contingent fee tax trap. for a discussion of such technical issues, see hellwig & polsky, supra note 106, at 913-15. 2020] impact of the 2017 tax act on certain personal injury plaintffs 53 arguably not impossible) to square with existing legal authorities, yet it is conceptually sound, and has the support of several esteemed commentators.160 because it is a nonfrivolous position, affected plaintiffs could legally take the capitalization position on their federal income tax returns. however, plaintiffs would need to keep in mind the potential tax penalties if the irs were to successfully challenge the position.161 yet, such a penalty could be avoided if the position is adequately disclosed on the tax return.162 taxpayers often prefer to avoid disclosure of a tax position because it is viewed as a “red flag” to the irs, beckoning them to audit the position. but, in this context, disclosure would likely not be a red flag because defendants are required to report the gross settlement amount (i.e., the settlement amount unreduced by the contingent attorney fee) to the plaintiff on a form 1099-misc, regardless of whether one or two checks are issued.163 if a plaintiff takes the capitalization tax position and includes only her net settlement in gross income, there will be a discrepancy between gross income and the form 1099-misc. accordingly, a red flag would seemingly exist regardless of whether adequate disclosure was made. another potential legal argument relates to the definition of “civil rights” in section 62(e)(18)(i). recall that in 2004 congress amended the code to allow a new above-theline deduction for legal fees paid by certain claimants.164 section 62(e) provides a lengthy list of covered claims. paragraphs (1) through (16) list claims allowed under specific federal statutes;165 paragraph (17) describes employee whistleblower claims under federal law;166 and paragraph (18) contains two subparagraphs, both of which apply to claims based on federal, state, or local law, whether statutory or common law, the first of which applies to claims based on law “providing for the enforcement of civil rights”167 and the second of which applies to claims based on law “regulating any aspect of the employment relationship, including claims for wages, compensation, or benefits.”168 paragraph (18) is a catchall category. it seems to make all of the prior 17 paragraphs redundant, as they all appear to apply to civil rights or employment-related claims. one issue is the scope of the term “civil rights” in section 62(e)(18)(i). robert wood, a prominent commentator on tax issues arising out of litigation, has argued for an extremely expansive interpretation of the term as a means of solving the contingent fee tax 160 dodge, supra note 152, at 334-38; davenport, supra note 152, at 704; geier, supra note 152, at 3. but see hellwig & polsky, supra note 106, at 915, 921. 161 in general, to avoid tax penalties for a large improper and undisclosed tax position, the position must be supported by “substantial authority.” i.r.c. § 6662(d)(2)(b)(i). if the position is adequately disclosed on the tax return, then the position need only be supported by a “reasonable basis.” i.r.c. § 6662(d)(2)(b)(ii). the substantial authority standard is “more stringent that the reasonable basis standard,” treas. reg. § 1.6662– 4(d)(2), which itself is “significantly higher than not frivolous or not patently improper,” treas. reg. § 1.6662– 3(b)(3). 162 i.r.c. § 6662(d)(2)(b)(ii)(i) (providing an exception to substantial understatement penalties for tax positions that are adequately disclosed on the tax return). in addition to adequate disclosure, this exemption from penalties requires the taxpayer’s position to be supported by a reasonable basis. i.r.c. § 6662(d)(2)(b)(ii)(ii). 163 see treas. reg. § 1.6045–5(f), ex. (1), (3). 164 see supra note 113 and accompanying text. 165 i.r.c. § 62(e)(1)–(16). 166 i.r.c. § 62(e)(17). 167 i.r.c. § 62(e)(18)(i). 168 i.r.c. § 62(e)(18)(ii). 54 columbia journal of tax law [vol 12:27 trap.169 wood notes that black’s law dictionary defines the term “civil rights” as rights guaranteed by the constitution or anti-discrimination legislation and that the irs, in informal guidance in another context, applied a similar interpretation.170 wood seems to acknowledge that this is the common definition of the term “civil rights.”171 however, he also explains that courts have used different interpretations, some consistent with the black’s law dictionary definition but others applying a much broader interpretation.172 under the broader interpretation, civil rights claims would include all civil claims for redress. if this view were to prevail, the contingent fee tax trap would be eliminated, because all claims for damages (even punitive damages claims) would constitute civil rights claims and, accordingly, the corresponding legal fees would be above-the-line deductions. the statutory interpretation inquiry which necessarily follows is whether congress intended a narrow, common interpretation or an expansive one. while neither the irs nor federal courts have considered this issue, it has arisen in a massachusetts state tax case.173 there the taxpayer was a defamation plaintiff who argued that his contingent attorney’s fee was excluded from gross income for massachusetts income tax purposes, which apparently largely depended on whether the fee was deductible on an above-the-line basis for federal income tax purposes.174 the massachusetts appellate tax board summarily concluded that a garden-variety defamation claim did not constitute a civil rights claim.175 given the absence of federal authority on the issue, the irs or a reviewing court would consider the interpretation on a clean slate. while wood makes an admirable effort in arguing for the expansive interpretation, 176 he does not adequately address two significant obstacles. first, if congress had intended to grant an above-the-line deduction for legal fees incurred in connection with all claims for damages, it could have easily and simply said so. in fact, it could have enacted the simple legislative reform recommended above.177 instead, congress drafted a very lengthy and specific eighteen-paragraph list of covered claims. why go through all this trouble if the intent was for universal application to all legal claims? giving “civil rights” its common, more narrow usage avoids this inexplicableness. wood responds to this point by noting that, even with a narrow interpretation, section 62(e) still has unnecessary surplusage.178 as a factual matter, this is true. the list of federal claims in paragraphs (1) through (16) appears redundant with statutory-based federal “civil rights” claims, as wood notes.179 but the legislative history explains how this occurred. recall that the statutory language in question arose out of an earlier bill, 169 robert w. wood, civil rights fee deduction cuts tax on settlements, 166 tax notes fed. 1481, 1482-83 (2020). 170 id. 171 id. at 1483 (noting that this interpretation “may be the more common” definition, compared with the extremely expansive interpretation described below). 172 id. at 1482-83. 173 chighisola v. comm’r, no. c319142, atb 2016-384 (mass. app. tax bd. sept. 26, 2016) https://archives.lib.state.ma.us/bitstream/handle/2452/430343/ocn960972221.pdf?sequence=1&isallowed=y [https://perma.cc/q5k9-ha87]. 174 id. at 391-92. 175 id. at 392 (“here, there was no indication in the record that the settlement at issue arose from a claim involving the enforcement of civil rights.”). 176 wood, supra note 169, at 1483. 177 see supra part iii.d. 178 wood, supra note 169, at 1487. 179 see id. 2020] impact of the 2017 tax act on certain personal injury plaintffs 55 titled the civil rights tax relief act of 2003, that would have excluded all damages from gross income, instead of merely allowing an above-the-line deduction for attorney’s fees.180 the earlier bill used the same 18-paragraph format, as well as the nearly identical relevant language: “any provision of state or local law, or common law claims permitted under federal, state, or local law, providing for the enforcement of civil rights . . .”181 the enacted language includes the term “federal” in the introductory language: “[a]ny provision of federal, state, or local law . . . .”182 in light of this overlap in language, it seems quite likely that “federal” was included just in case the listed federal statutes in paragraphs (1) through (16) were unintentionally not fully comprehensive.183 thus, while the provision is no model of elegant statutory drafting, its legislative history explains the surplusage that wood identifies. second, wood’s proffered interpretation is difficult to square with the origins of the relevant language. the civil rights tax relief act of 2003 used language identical in all relevant respects to that in the enacted section 62(e)(18)(i), expressly encompassing any provisions “providing for the enforcement of civil rights.”184 the 2003 bill would have excluded from gross income all recoveries with respect to its listed claims.185 wholesale exclusion of damages from gross income would have been a radical change to the traditional tax treatment of litigation recoveries. under existing law, recoveries that are not offset by tax basis are included in gross income except to the extent that section 104(a)(2), which carves out compensatory damages received on account of personal physical injury, applies.186 under wood’s expansive interpretation of “civil rights,” the civil rights tax relief act of 2003 would have turned this rule completely on its head. it would mean that all damage recoveries would be tax-free, thus rendering section 104(a)(2) obsolete. it is hard to imagine that any of the drafters would have conceived the language of the civil rights tax relief act of 2003 as stretching so far. h. structuring to avoid non-deductibility banks foreclosed the most intuitive options for avoiding the contingent fee tax trap. asking the defendant to cut two checks or trying to assign a portion of the claim to the attorney upon execution of the fee agreement will not work. nor, apparently, will trying to formalize the attorney-client relationship as a partnership for tax purposes. yet other less intuitive structuring solutions may still be available. one potential option takes advantage of the prospective elimination of miscellaneous itemized deductions at the end of 2025.187 assuming that congress does not statutorily extend the section 67(g) elimination, attorney’s fees that represent miscellaneous itemized deductions could be pushed out into 2026 and beyond and thereby retain, to some extent, their deductibility. the strategy would also allow more time for congress, the treasury, or the irs to act to solve the problem by amending the code or promulgating an administrative rule. such so-called “attorney fee structures” should accomplish a deferral of the fee deduction by paying out the attorney’s fees through an intermediary (a structured 180 civil rights tax relief act of 2003, h.r. 1155, 108th cong. (2003). 181 id. at § 140(b)(1)—(18). 182 i.r.c. § 62(e)(18) (emphasis added). 183 i.r.c. § 62(e)(1)—(16), (18). 184 compare h.r. 1155 § 140(b)(18) with i.r.c. § 62(e)(18)(i). 185 see h.r. 1155 § 140(a). 186 polsky, supra note 71, at 123-24. 187 see i.r.c. § 67(g). 56 columbia journal of tax law [vol 12:27 settlement company) over time, instead of in a lump sum payment upon settlement of the case. in many cases where attorney fee structures are used, the plaintiff also structures her portion of the settlement. regardless of whether the plaintiff uses a structured settlement, when attorney’s fees are structured, the plaintiff recognizes gross income under banks from the payment of the fee only at the time the fee is actually received by the attorney and, correspondingly, the plaintiff recognizes a corresponding deduction at the same time (subject to any limitations on the deduction that may apply). consider a case where a defamation plaintiff will receive $70,000 per year for five years, with the first payment due in 2026. her attorney likewise structures his fee, so he will receive $30,000 per year for five years, with the first payment due in 2026. under banks, the plaintiff should report $100,000 in annual gross income in each year beginning in 2026, as well as a $30,000 miscellaneous itemized deduction.188 if congress does not extend the disallowance of miscellaneous itemized deductions, the $30,000 deduction will be allowed for regular tax purposes (to the extent it exceeds 2% of the plaintiff’s adjusted gross income), though it will not be allowed for amt purposes. before implementing this strategy, several issues must be considered. first, as noted above, congress could change the law, for better or for worse. if congress extends the elimination of miscellaneous itemized deductions, then deferral of those deductions would be useless. if congress does not act, the elimination will expire. but the 2017 tax act has many provisions that are set to expire on december 31, 2025, and undoubtedly some will be extended. on the other hand, the attention on the contingent fee tax trap could cause congress to simply fix the problem by extending above-the-line treatment (or cause the treasury or the irs to fix the problem through rulemaking). in sum, there is no assurance that 2026 will be better for affected plaintiffs than 2020, though it likely will not be worse. second, if miscellaneous itemized deductions return to their pre-2018 status (as current law requires), they would still be subject to a 2% floor and would still be disallowed for amt purposes.189 depending on the specific tax characteristics of the plaintiff, the result might not be much better than under the current rule of complete disallowance. iv. conclusion among its wide-ranging provisions, the 2017 tax act included two provisions that significantly affect certain types of personal injury plaintiffs. section 162(q), while designed with good intentions, unwittingly burdens sexual harassment and sexual abuse victims through taxing the effective sale of an nda by plaintiffs to defendants. the incidence of the tax will likely be shifted to some extent by defendants to plaintiffs in the form of lower settlement offers. the provision is also extremely ambiguous in many significant aspects. while the treasury or the irs will likely resolve at least some of these ambiguities through rulemaking, it is not clear that all of them can be sensibly resolved. the 2017 tax act also eliminated miscellaneous itemized deductions. although most taxpayers who have these types of deductions do not suffer significant losses due to the elimination, certain personal injury plaintiffs may lose massive deductions for the 188 because no tax authorities have considered the precise issues, these tax conclusions are not entirely free from doubt. nevertheless, they logically follow from the tax court’s analysis of attorney fee structures in childs v. commissioner and an irs private letter ruling approving of so-called nonqualified structured settlements. childs v. comm’r, 103 t.c. 634, 651-53 (1994), aff’d, 89 f.3d 856 (11th cir. 1996); p.l.r. 2008–36–019 (june 2, 2008). for further discussion of this issue, see polsky, supra note 71, at 158-64. 189 see i.r.c. §§ 56(b)(1)(a)(i), 67(a). 2020] impact of the 2017 tax act on certain personal injury plaintffs 57 contingent fees they pay to their lawyers. for some plaintiffs this will cause their federal income tax liability to increase by hundreds of thousands, if not millions, of dollars. there is no tax policy justification whatsoever for this result. congress should amend the code to fix this problem. should such legislative efforts fail, however, the irs should promulgate the safe harbor rule recommended in this article, which would adequately resolve the situation. microsoft word the case for tax integration and current-base taxation_final.docx the case for tax integration and current-base taxation nir fishbien1 if you are truly serious about preparing your children for the future, don’t teach them to subtract – teach them to deduct – fran lebowitz abstract the u.s. tax system has many distortions, but two triumph them all. the first is debt-overequity. under the current corporate double taxation mechanism, c corporations are incentivized to borrow rather than issue equity, because interest is deductible, and dividends are not. the second is foreign-over-domestic investment. under the current u.s. international tax regime, u.s. multinationals are subject to a reduced tax rate, and in certain occasions are also exempt from u.s. tax on their foreign earnings, while their domestic earnings are subject to full corporate tax rate. in this article, i call for the adoption of a dividends-paid deduction form of tax integration and for current-base taxation of foreign earnings. the already reduced corporate tax rate (21%), combined with tax integration, will provide a significant relief from the relatively high burden of corporate double taxation, allowing u.s. multinationals to better compete in the global economy. it will eliminate (or substantially reduce) the debt-over-equity bias and the inefficient penalty on business activities carried through c corporations. current-base taxation will eliminate the current incentive to invest and shift income abroad, while providing a very important source of revenue. it will also obliterate the need to distinguish between domestic and foreign earnings and as such will facilitate the adoption of tax integration, because all distributions of earnings that were previously taxed will give rise to the benefits of tax integration. finally, in order to avoid a potential revenue loss as a result of this new dividends-paid deduction, a non-refundable full-rate withholding tax, or a new compensatory tax, equal to the rate of the corporate tax, should be introduced and implemented. 1 s.j.d. graduate at the university of michigan law school. i am grateful to reuven avi-yonah, jim hines and christopher hanna for their helpful comments. any errors or omissions, and the opinions expressed in this article, are my own. the author can be contacted at nirf@umich.edu. [vol. 11:2 columbia journal of tax law 2 table of contents i. introduction ....................................................................................................... 3 ii. the history of tax integration in the united states ..................... 5 a. the foundation of corporate taxation ........................................................................ 6 b. the 50s and 60s ........................................................................................................... 7 c. the 70s........................................................................................................................ 9 d. the 80s and 90s ......................................................................................................... 10 1. the 1992 treasury report ..................................................................................... 10 2. the 1993 ali report............................................................................................. 11 e. the new millennium................................................................................................. 12 1. hatch’s tax proposal and the 2017 tax reform .................................................... 13 iii. the benefits of tax integration and its main problems ............. 15 a. the main problems of tax integration ...................................................................... 17 1. corporate income not previously taxed by the united states ............................... 17 2. retained earnings .................................................................................................. 18 3. tax-exempt shareholders ...................................................................................... 18 4. regulating corporate behavior .............................................................................. 19 b. the problems of dpd with wht and territoriality ................................................... 20 1. the “trojan horse” problem of dpd and wht .................................................... 20 2. integration and territoriality .................................................................................. 21 c. imputation vs. dpd with wht ................................................................................. 22 iv. tax integration and the international tax regime .................... 22 a. the international problem of tax integration ............................................................ 23 1. active income ....................................................................................................... 23 2. passive income ...................................................................................................... 24 b. the current problems with the u.s. international tax regime .................................. 26 c. a proposal for a comprehensive tax reform ............................................................ 28 1. dpd and current-base taxation ............................................................................ 28 d. the problem of potential tax treaty violation .......................................................... 29 v. conclusions ....................................................................................................... 29 2020] the case for tax integration and current-base taxation 3 i.introduction the tax cuts and jobs act of 2017 (2017 tax reform) represents the most far reaching reform of the u.s. tax code since president reagan’s 1986 tax reform. the international provisions of the 2017 tax reform introduced a significantly new international tax regime based on the premises of participation exemption and minimum tax. the general approach is that foreign income earned by u.s. corporations will be exempt from further u.s. taxation up to a certain amount. under this approach, a u.s. corporation that owns 10% or more of a foreign corporation will be entitled to a 100% dividends-received deduction for the foreign-source portion of the dividends paid by the foreign corporation. additionally, a new 10.5%1 tax on global intangible low taxed income (gilti) was introduced and is aimed to limit the applicability of the tax benefits provided by the participation exemption mechanism. gilti is intended to capture the excess return—with the main purpose of capturing income attributable to intangibles—above a 10% return on tangible investments. nonetheless, because gilti allows a foreign tax credit (ftc) for 80% of foreign taxes attributed to gilti, foreign income that is subject to a 13.125% (or higher) foreign tax rate should generally be exempt from any additional u.s. tax. the 2017 tax reform also introduced an anti-base erosion and income shifting mechanism, the base erosion and anti-abuse tax (beat). beat imposes a minimum of 10% corporate tax, based on the taxpayer’s income before certain tax deductions and other tax benefits arising from base erosion payments. finally, the act also introduced a special regime under which foreign-derived intangible income of u.s. corporations is subject to an effective tax rate of 13.125% as well, which resembles a patent boxlike regime.2 the legislative process of the 2017 tax reform was widely covered by the media. but a certain proposal that eventually did not get into the final legislation did not get the attention it deserved. section 242 of senate’s proposed bill called for the adoption of a dividends-paid deduction (dpd).3 the dpd is a form of integration favored by senator orrin hatch, chairman of the senate finance committee. in january 2016, hatch announced that his team was working on a comprehensive proposal to adopt tax integration in the form of dpd.4 under hatch’s proposal, which was never officially published, corporations would be entitled to dpd for their distributions to both domestic and foreign shareholders. the dpd proposal was combined with a 35% (the corporate tax rate at the time) withholding tax (wht) on all distributions.5 if income is indeed distributed, dpd will effectively eliminate the current two-tier tax system, or the double taxation mechanism. generally, double taxation refers to corporate earnings that are taxed twice – first 1 this rate is half of the general corporate tax rate (which is achieved by a 50% deduction). 2 see sullivan & cromwell, u.s. tax reform: congress passes tax reform, available at https://www.sullcrom.com/sitefiles/publications/sc_publication_us_tax_reform_1 2_20_ 17.pdf [https://perma.cc/5w5t-ngdp]. 3 h.r. 1, 115th cong. section 13011 (as proposed by senate, dec. 2, 2017). 4 bernie becker, hatch to take a shot at corporate double tax, politico (jan. 21, 2016), https://www.politico.com/tipsheets/morning-tax/2016/01/hatch-to-take-a-shot-at-corporate-double-tax-brady-taxstaffer-gets-high-marks-yes-the-irs-deleted-another-key-hard-drive-212275 [https://perma.cc/mkn7-kn4d]. 5 michael j. graetz & alvin c. warren, jr., integration of corporate and shareholder taxes, 69 nat’l tax j. 677, 678 (2016) [hereinafter graetz & warren jr. integration of corporate and shareholder taxes]. [vol. 11:2 columbia journal of tax law 4 when earned by corporations (currently at a rate of 21%), and second when the earnings are distributed as dividends (currently at a rate of up to 20%). the total burden of the double taxation mechanism is up to 36.8% of the earnings.6 a dpd creates the risk of substantial revenue loss in the cross-border context. since crossborder transactions are subject to tax treaties, foreign taxpayers engaging in such transactions already receive tax benefits such as reduced wht on dividends. 7 these treaty benefits, combined with a dpd, would potentially result in minimal us taxes collected from foreign shareholders.8 clearly, one major problem that might occur when one country adopts integration and the other does not is a potential revenue loss on outgoing payments (for the first-mentioned country). for example, imagine that under the tax treaty between the united states and the united kingdom, dividends distributed by a u.s. corporation to a u.k. shareholder are not subject to u.s. wht. in such a case, if the united states adopted dpd regime, the income earned by the u.s. corporation, and later distributed to the u.k. shareholder would escape u.s. taxation entirely. this is because the u.s. corporation will be entitled to a deduction equal to the dividend distribution, effectively reducing the corporate taxable income on such distribution to zero, and the distribution itself will not be taxed by the united states because of the tax treaty. when the united kingdom tried to mitigate such effects at the time by implementing tax integration (in the form of imputation), the court of justice of the european union prevented it from doing so, on the grounds that taking preventive steps to mitigate the problem would be discriminatory and would violate e.u. law, a decision that led to the elimination of the imputation regime in the united kingdom.9 as we will see, the main advantages of tax integration primarily address the domestic problems of the u.s. tax code. but the u.s. international tax regime is also in need of a serious reform beyond the 2017 tax reform. u.s. multinational enterprises (mnes) are incentivized to shift income abroad due to the reduced rates under gilti and the foreign-derived intangible income (fdii) effectively eroding the u.s. tax base.10 to prevent this, the general premise of the u.s. tax system should be that domestic and foreign income be taxed at the same rate.11 this could be achieved by eliminating gilti and fdii and applying a current-base taxation, under which the foreign earnings of u.s. mnes are taxed in the same year they were earned and at the same rate 6 assuming an income of 100: first level of tax is of 21%, at the corporate level, for 21 of taxes. this leaves net income of 79, which is then distributed as a dividend and is subject to up to 20% of dividend tax at the shareholder level, for an additional 15.8. the total tax paid is 21+15.8=36.8. before the 2017 tax reform (and with a corporate tax rate of 35%), the total tax burden was 48%. compare these to the highest individual marginal tax rate of 39.6%. 7 see charles e. mclure, jr., must corporate income be taxed twice? 13 (1979). 8 id. 9 michael j. graetz & alvin c. warren, jr., income tax discrimination and the political and economic integration of europe, 115 yale l.j. 1186, 1208 1211 (2006) [hereinafter graetz & warren jr., income tax discrimination and the political and economic integration of europe]. 10 the gilti will also incentivize u.s. mnes to keep their earning abroad and reinvest it in foreign tangible property. see reuven avi-yonah, guilty as charged: reflections on tra 17, 157 tax notes 1134 (2017) (arguing that gilti “creates obvious discrimination between intellectual-propertyintensive domestic corporations …and other domestic c corporations” and may incentivize shifting income abroad”). 11 see reuven s. avi-yonah & nir fishbien, once more, with feeling: the ‘tax cuts and jobs’ act and the original intent of subpart f, 157 tax notes 959, 966 (nov. 13, 2017). 2020] the case for tax integration and current-base taxation 5 as domestic earnings – 21%. this, combined with tax integration, should provide a significant relief from the relatively high double taxation burden on u.s. mnes, allowing them to better compete in the global economy. furthermore, it will also eliminate (or substantially reduce) the debt-over-equity bias and the inefficient penalty on business activities carried through c corporations. current-base taxation will eliminate the current incentive to invest and shift income abroad, while providing an important source of revenue to the u.s. government. the first part of this article briefly discusses the history of tax integration in the united states, focusing specifically on dpd and imputation forms of integration. the second part discusses the current domestic and international problems of tax integration. the third part examines the main problems associated with adopting tax integration. the fourth part offers a new comprehensive tax reform proposal, under which u.s. mnes will be subject to current-base taxation, combined with dpd regime. ii. the history of tax integration in the united states the history of tax integration in the united states is important for two main reasons. first, it illuminates that the decision to tax corporate income twice has remained controversial for over a century. second, it shows that tax integration has inherent problems that have prevented it from being implemented.12 it is generally agreed that the best form of integration should comply with the following terms: it must be administratively feasible, it must comply with the realization requirement, it must further the goal of the ability-to-pay principle by imposing tax at the shareholder level, and it must tax corporate earnings only once, whether retained or distributed.13 it is common to divide the many forms of tax integration into two main groups: full and partial integration. under full integration, the income earned at the corporate level, whether distributed or not, is attributed to the shareholders, just as if they were partners in a partnership, and taxed only at the shareholder level.14 most of the proposals for integration, though, are for partial integration. partial integration offers the same treatment as full integration, but only to the extent the income earned at the corporate level is distributed, and not retained at the corporate level.15 under the current double taxation mechanism, dividends are taxed as capital gains at a preferential low rate.16 in a sense, this reduced rate (compared to the top marginal ordinary tax rate) reflects partial integration, yet it does not eliminate the current distortions of double taxation. the lower dividend tax is aimed to provide relief from the high burden of double taxation. but 12 r. glenn hubbard, economic effects of the 2003 partial integration proposal in the united states, 12 int’l tax & pub. fin. 97, 101–103 (2005). these problems are discussed in part ii, infra. 13 see david b. clement, the american law institute reporter's study of corporate tax integration: a critique 19 (feb. 14, 1994) (unpublished ll.m. thesis, georgetown university law center). 14 u.s. dep’t of the treasury, blueprints for basic tax reform 68 (1977). 15 graetz & warren jr. integration of corporate and shareholder taxes, supra note 5, at 687 (“how would integration take account of the fact that some corporate income is distributed to shareholders without bearing a full corporate tax? there are two basic approaches…[under the second approach,] instead of requiring a withholding tax on any dividends paid by the corporation, individual taxpayers would be allowed to treat dividends as taxable or nontaxable, based on a statement from each corporation regarding the amount of its dividends that had borne corporate tax.”). 16 i.r.c. §§ 1(h)(1), (11) (2012). [vol. 11:2 columbia journal of tax law 6 congress only recently (2003) agreed to extend such relief; for many years the traditional full-rate double taxation mechanism prevailed.17 a. the foundation of corporate taxation corporate income was first taxed under the revenue act of 1894 (wilson-gorman tariff of 1894), but the supreme court held the act unconstitutional.18 in 1909, a constitutional amendment was proposed to impose an excise tax on corporations.19 the corporate excise tax provided for a one percent tax on corporate income with the first $5,000 of income exempt.20 this tax was upheld by the supreme court21 and was affixed with the income tax in the revenue act of 1913, in which the exemption of $5,000 was repealed.22 it was the first time that corporations and individuals were subject to separate income taxes. at the time, the risk of double taxation of corporate earnings was addressed by generally excluding dividends from individual taxable income.23 this was the first phase of integration in the u.s. tax code.24 in 1936, congress introduced the bracket rates for corporate income tax. 25 distributed income was taxed at rates ranging from 8% to 15%. undistributed income was subject to an additional surtax with rates ranging from 7% to 27%.26 the main purpose was to eliminate any incentives to accumulate earnings in the corporation and deferring individual tax. two years later, the surtax was repealed.27 ironically, some argue that the double taxation mechanism as we know it today was the result of an intensive lobbying efforts by large corporations that preferred the double taxation mechanism over a higher tax on undistributed corporate profits so that shareholders would be inclined to keep earnings at the corporate level to avoid the additional layer of tax.28 17 see graetz & warren jr. integration of corporate and shareholder taxes., supra note 5, at 687. 18 pollock v. farmers’ loan & trust co., 158 u.s. 601 (1895). 19 steven a. bank, is double taxation a scapegoat for declining dividends? evidence from history, 56 tax l. rev. 463, 478 (2003). 20 boris bittker & james s. eustice, federal income taxation of corporations and shareholders ¶ 1.01 (7th ed. 2000). 21 flint v. stone tracy co., 220 u.s. 107, 115–16 (1911). 22 see jack taylor, corporate income tax brackets and rates, 1909–2002, irs stat. income bull. (2003), available at https://www.irs.gov/pub/irs-soi/02corate.pdf [https://perma.cc/8mw2-zrfb]. 23 see bank, supra note 19, at 489. dividends could still be subject to a surtax. 24 id. at 489-490. by excluding dividends from the “normal” individual income tax, corporate income was first taxed at corporate rates, and then at surtax rates (at progressive rates up to 6%), if applicable, when received by individuals. on the other hand, noncorporate income was subject to the “normal” individual income tax, and above a certain level, the same additional surtax was applied. corporate income and individual tax rates were tied and related. congress thus made the corporate income tax a quasi-withholding provision for individual income tax. 25 see bank, supra note 19, at 511. 26 id. 27 id. at 515. 28 steven a. bank, the story of double taxation: a clash over the control of corporate earnings, in business tax stories 159 (steven a. bank & kirk j. stark eds., 2005). the essay examines the circumstances leading up to repeal of the dividend exemption and the introduction of full double taxation and argues that the main reason behind it was a threat from another proposal—the undistributed profits tax. the main concern was that the undistributed profits tax would put pressure on managers of big corporations to distribute their profits instead of keeping them in the corporate solution and using them for potential expansion. the threat posed to managers by the undistributed profits tax led them to support the retention of the corporate income tax and eventually the repeal of the dividend exemption. this is because double taxation would aid in aligning management-shareholder attitudes toward the retention, and not distribution, of corporate earnings. double taxation, according to the essay, became a tool in the campaign against the undistributed profits tax. 2020] the case for tax integration and current-base taxation 7 b. the 50s and 60s from 1954 to 1964, individual shareholders were allowed a tax credit for a fixed percentage of dividends received.29 a partial exclusion was also available from 1954 to 1986.30 during the 70s, economists began to argue that the corporate double taxation was the main reason for the capital shortage and that integration would help relieve it. 31 in addition, policies in europe demonstrated that dividend relief proposals were driven by the goals of capital injection and increased corporate returns.32 as such, proposals to move towards integration in the form of dividend tax relief were often raised in both the united states and europe.33 the call for integration included the desire to eliminate the bias in favor of debt over equity,34 improve capital allocation, make capital markets more competitive, and reduce the difference between ordinary income rates and capital gain rates.35 some suggested a partial dpd regime, whereby corporations could deduct only half of the amount of dividends they distribute. 36 in general, under the dpd form of integration, the same rules regarding the deductibility of interest would apply to dividends, and corporations would be able to deduct the full (or partial) amount of dividends they distribute (after recognizing any section 311(b) gain for the appreciated property distributed). all of these proposals for dpd were eventually dismissed. in 1984, the proposal for a 50% dpd was raised again, this time by the treasury department, but it was not adopted mainly because of revenue concerns.37 in 1985, president reagan proposed reducing the percentage of the dpd to 10% (instead of 50%), but once again, the proposal was not adopted.38 one of the main reasons the proposal failed was the potential problem with tax treaties, under which the united states might be obliged to extend any sort of dividend tax relief also to foreign investors. such a step might result in dividends paid to foreign investors escaping u.s. taxation entirely, which would negatively impact u.s. revenue. the 60s brought about a profound change in the nature of the underlying principles of the u.s. international tax regime. the focus changed from arguments of equity and fairness to arguments 29 the president’s 1978 tax reduction and reform proposals: hearings before the h. comm. on ways and means, 95th cong. 6230 (1978). 30 id. 31 see graetz & warren jr., income tax discrimination and the political and economic integration of europe, supra note 9, at 7. 32 mclure, supra note 7, at 46-49. 33 graetz & warren jr. integration of corporate and shareholder taxes, supra note 5, at 678. 34 tax reform task force, a better way: our vision for a confident america 128 (2016), available at https://www.novoco.com/sites/default/files/atoms/files/ryan_better_way_poverty_policy_paper_060716.pdf [https://perma.cc/q9zl-mv7f]. 35 tax reform: public hearings before the h. comm. on ways and means, 94th cong. 34–35 (1975). 36 id. at 3857. 37 u.s. dep’t of the treasury, tax reform for fairness, simplicity and economic growth 124 (1984). staff of s. comm. on finance, comprehensive tax reform for 2015 and beyond, 113th cong., 131 (2014). 38 see u.s. dep’t of the treasury, supra note 37, at 127-128 (discussing the difficulties with the dpd form of integration posed by tax treaties).the president’s tax proposals to the congress for fairness, growth and simplicity 7 (may 29, 1985), available at https://www.treasury.gov/resource-center/tax-policy/documents/report-reformproposal-1985.pdf [https://perma.cc/2pdp-lbsv]. for the final bill that was eventually adopted, see tax reform act of 1986, h.r. 3838, 99th cong. (1986) (not containing a 10% dpd). [vol. 11:2 columbia journal of tax law 8 of economic efficiency and neutrality.39 it is thus useful to first briefly discuss the relevant neutralities with respect to international tax policy. capital export neutrality (cen) refers to the indifference a resident taxpayer should have upon choosing between a domestic and foreign investment.40 a global residence-based tax system, in which each country’s firms are subject to its tax regardless of where their income is earned while foreign firms’ income earned within its borders is not taxed, achieves cen.41 as such a system taxes a country’s firms at the same rate irrespective of where their investments are located, taxes will not distort the choice between domestic and foreign investment.42 if all countries adopt such a system, there would be no need for a foreign tax credit. by contrast, a worldwide tax system, which taxes a country’s nationals on their worldwide income as well as foreign nationals on income earned in the country, may violate cen. under a worldwide tax system, foreign income of a country’s nationals would be subject to tax in the home country as well as the foreign jurisdiction. this potential for double taxation would skew investors’ choices towards investing domestically.43 the common tool to mitigate the double taxation and achieve cen with a worldwide taxation system is the ftc, which generally allows taxpayers to credit their foreign tax liability paid on foreign income against any additional u.s. tax liability on that same income. an unlimited ftc equivalates the tax liability on income earned inside and outside of the united states and thus promotes cen among u.s. investors. the end result is that income, wherever earned, would ultimately be subject to u.s. tax rates.44 39 reuven s. avi-yonah, all of a piece throughout: the four ages of u.s. international taxation, 25 va. tax rev. 313, 324 (2005). 40 reuven s. avi-yonah & nicola sartori, foreword, 65 tax l. rev. 313, 317 (2012). 41 jane g. gravelle, does the concept of competitiveness have meaning in formulating corporate tax policy? 65 tax l. rev. 323, 329 (2012). 42 id. 43 see id. 44 avi-yonah & sartori, supra note 40, at 317. before the term cen came to the world, the foreign tax credit was thought to encourage the competitiveness of american firms abroad and to avoid “double taxation,” see surrey, supra note 17, at 817–18. according to surrey: the earliest differentiation between foreign and domestic income was the adoption of the foreign tax credit device. its origins are somewhat obscure. until 1918 all foreign taxes were treated as deductible expenses, in the same manner as state and local taxes. all these taxes were simply regarded as expenses of operating the business enterprise and therefore to be deducted in determining the net business income on which our federal income tax is based. in 1918 efforts were made to exempt foreign income from the united states tax. the principal grounds advanced for this relief were the alleged competitive disadvantages suffered by american corporations operating branches abroad because the united states taxes were much higher than the taxes to which competing local enterprises in foreign countries were subject. there was also talk of “double taxation,” and here the target as respects the "doubling" was the united states tax…congress thereby reaffirmed its historical decision to tax the united states citizen and corporation on worldwide income. the argument that this approach placed our corporations at a disadvantage in foreign markets because of the united states tax was rejected, but the argument based on the burden of double taxation was persuasive. the united states would retain its jurisdiction to tax on world-wide income, but it would recognize the interests of the country of source in also taxing the income arising therein. this recognition of source jurisdiction would extend as far as giving primary effect to the source jurisdiction to prevent the heavy burden that would otherwise fall on the united states taxpayer having fiscal responsibilities to two national jurisdictions. to provide this protection for 2020] the case for tax integration and current-base taxation 9 on the other hand, capital import neutrality (cin) requires that all investments in a given country are treated the same for tax purposes, regardless of the residence of the taxpayer.45 because the united states taxes worldwide income of its nationals, u.s. firms investing in a given foreign country face double taxation (the u.s. and the foreign jurisdiction) while the foreign country’s nationals are only taxed once on income earned in the foreign country.46 to prevent this additional liability that impairs the cin principle, the united states can exempt foreign income of u.s. mnes.47 exempting (and not just crediting) foreign income, is necessary because it will result in only one layer of taxation on foreign earnings—the foreign tax layer—similarly to the way foreign competitors are taxed. cen and cin usually cannot be achieved at the same time. this is because cen, to the extent that the u.s. tax rate is higher than the foreign tax rate, would require a credit method, so that the foreign source income would be subject in total to the u.s. tax rate, while in the same scenario, cin would require an exemption method, so that the foreign source income would be subject solely to the foreign tax rate, which would be the final tax liability. those neutralities can be simultaneously satisfied only if the tax rates of the united states and the source state are the same, which is not usually the case.48 c. the 70s the late 1970s saw further proposals for integration. in 1977, the treasury issued a report proposing full integration by a pass-through taxation method.49 later that year, the treasury presented a proposal for integration by imputation.50 under imputation, corporations would still pay corporate tax, but shareholders would receive a credit for that tax paid upon the distribution of dividends and the imposition of the dividend tax.51 in that sense, the corporate tax would function like wht, on behalf of the shareholders, similar to the tax withheld by an employer on behalf of its employees, and the income itself would be imputed to shareholders. when a distribution is made, the shareholders would be taxed at their marginal rate, but they would also be entitled to a credit in the amount of taxes paid by the corporation. it should be noted, of course, that shareholders would include in their taxable income the grossed-up amount of the dividend to reflect the amount of tax withheld. it is also important to note that the recommendation was to the united states taxpayer, our government would consider its own tax claims met to the extent that a tax payment had been made to the country of source. gravelle, supra note 41, at 332 (a limited ftc, which caps a firm’s ftc to the amount of tax paid to the home country either per foreign jurisdiction or in total, does not achieve cen). 45 am. law inst., integration of individual and corporate income taxes 172 (1993). 46 id. 47 id. 48 see david a. weisbach, the use of neutralities in international tax policy 4 (coase-sandor inst. for l. & econ., working paper no. 697, 2014). 49 u.s. dep’t of the treasury, supra note 14, at 68–75. 50 see the president’s 1978 tax reduction and reform proposals: hearings before the h. comm. on ways and means, 95th cong. 6250–54 (1978) (statement of donald c. lubick, acting assistant sec’y for tax policy, treasury dep’t). 51 michael j. graetz & alvin c. warren, jr., unlocking business tax reform, 145 tax notes 707, 708 (2014). [vol. 11:2 columbia journal of tax law 10 adopt a refundable credit in order to allow low bracket taxpayers to take advantage of the benefits of tax integration.52 ultimately, however, the proposal was never adopted. the joint committee on taxation also issued a report in 1977 calling for the integration of corporate and individual income taxes as part of the main goal of enhancing and injecting private capital into the financial markets.53 three methods of integration were suggested: imputation, pass-through taxation, and dpd.54 then, in 1978, the chairman of the house ways and means committee introduced a new integration proposal, calling for a shareholder tax credit equal to a graduated percentage (from 10% up to 20%) of the dividend distribution, up to a certain limitation.55 none of the proposals were ever adopted.56 d. the 80s and 90s in 1982, the american law institute (ali) called for corporate integration in the form of dpd with a statutory limit. 57 in addition, the report called for a flat-rate wht on non-dividend distributions.58 in 1989, the ali issued a supplemental study recommending that the dpd would only be available for equity acquired after the date of enactment. the main reason for this limitation was the assumption that the markets had already discounted the price of pre-enactment equity to reflect the double taxation on corporate earnings, and any deduction for that preenactment equity would result in an unjustified windfall to shareholders.59 in 1993, the ali issued another important report calling for tax integration, which was authored by harvard professor alvin c. warren jr.60 and based on a 1992 treasury report. both these reports will be discussed below. 1. the 1992 treasury report in 1992, the treasury recommended adopting corporate integration in one of four prototypes: (1) a dividend exclusion prototype; (2) a shareholder allocation prototype (pass-through), which is a form of full integration; (3) a comprehensive business income tax prototype (cbit), in which a tax would be imposed on taxable income, with no deductions for interest or dividends (while the respective holders of bonds or shares would not include interest or dividends in gross income); and, finally, (4) an imputation credit prototype.61 another method that was briefly discussed was 52 see the president’s 1978 tax reduction and reform proposals: hearings before the h. comm. on ways and means, 95th cong. 6252 (1978) 53 see staff of joint comm. on taxation, jcs-14-77, tax policy and capital formation 9 (comm. print 1977). 54 id. at 11-15. 55 staff of s. comm. on finance, comprehensive tax reform for 2015 and beyond, 113th cong., 129 (2014). 56 see id. 57 am. law inst., federal income tax project—subchapter c: proposals of the american law institute on corporate acquisitions and dispositions and reporter’s study on corporate distributions (1982). 58 id. at 442. 59 am. law inst., federal income tax project—subchapter c (supplemental study) [i], reporter’s study draft 51 (1989). 60 see am. law inst., supra note 46. 61 u.s. dep’t of the treasury, integration of the individual and corporate tax system: taxing business income once viii (1992). 2020] the case for tax integration and current-base taxation 11 dpd.62 to address the problem of retained earnings, a dividend-reinvestment plan was proposed— this proposal will be discussed separately in part iii. under cbit, a uniform tax would be levied at the business level. corporations would not be able to deduct interest (similar to the current treatment of dividends).63 on the other hand, individual shareholders would not include interest or dividends in their gross income.64 cbit would eliminate tax distortions on capital structure and related arbitrage opportunities more completely than any of the other methods of partial integration.65 in that sense, cbit offered a comprehensive solution for the bias toward debt investment.66 cbit would be applicable to almost all businesses, not just corporations. 67 to a certain extent, the cbit proposal resembled a consumption tax, similar to the flat tax of hall and rabushka.68 the main difference would be that business investment would continue to be depreciated rather than expensed.69 nevertheless, in december of 1992, the treasury recommended in a supplemental report that congress adopt a revised dividend-exclusion prototype.70 the main reasons for favoring this dividend-exclusion prototype were fewer transition and administrative costs and less disruption to financial markets.71 under the revised version, any distribution out of the corporation’s adjusted income after tax (ati) would be treated as a dividend and excludable from gross income when received by shareholders.72 distributions in excess of ati would be treated as a return of capital to the shareholders (or capital gain to the extent the distribution is in excess of basis).73 because distributions in excess of ati would be treated as a return of capital, no distribution would ever be treated as a taxable dividend. as a result, “earnings and profits (e&ps) accounts would no longer be relevant for determining the character of distributions from u.s. corporations” and “a [drd] would no longer be necessary.”74 this proposal was also never adopted. 2. the 1993 ali report in its 1993 report, the ali recommended applying an imputation form of integration. the report discussed the international problem of tax integration and suggested imposing a special 62 id. at 108. 63 id. at 121. 64 id. 65 id. at 52-53 (arguing that the cbit, by taking measures such as disallowing a deduction for interest and expanding §265 to apply to taxpayers who receive cbit interest and dividends, would reduce incentives for thin capitalization and rate arbitrage on the part of corporations). 66 reuven s. avi-yonah & amir c. chenchinski, the case for dividend deduction, 65 tax law 3, 5 (2011). 67 staff of s. comm. on finance, comprehensive tax reform for 2015 and beyond, 113th cong., 129 (2014). 68joel slemrod & jon bakija, taxing ourselves: a citizen’s guide to the debate over tax reform 272 (4th ed. 2008). 69id. 70u.s. dep’t of the treasury, a recommendation for integration of the individual and corporate tax systems (1992). 71 id. at 1. 72 id. at 2. 73 id. 74 id. [vol. 11:2 columbia journal of tax law 12 compensatory tax75 or a high-rate wht on foreign investment.76 the report justified such an additional tax on the basis that the united states, as a source state in this case, had the legitimate ties to impose tax on such inbound investments.77 according to the report, this additional tax would preserve cin and would not violate any nondiscriminatory provisions because “the u.s. would enforce an equivalent claim against domestic investment through a u.s. company owned by u.s. shareholders, by means of an income tax on those shareholders, for which the corporate tax was a withholding device.”78 yet such an additional tax might be in a direct conflict with the current tax treaty network, which provides for substantially reduced reciprocity wht rates imposed on dividends distributions sourced within the united states.79 in any case, the recommendations were presented to the senate finance committee in 201280 after another proposal for imputation was raised in 2010,81 but neither was ultimately adopted. e. the new millennium a proposal for dividend exclusion was raised again in 2003 by the bush administration.82 under that proposal, shareholders would not be taxed on dividend income. a dividend exemption is an easy, straightforward way to implement integration.83 under president bush’s proposal, a 75 see am. law inst., supra note 45, at 176. 76 id. at 176. 77 id at 174 176. 78 id. at 174. see also u.s. dep’t of the treasury, supra note 61, at 218. the report explained: the following example illustrates the problem in the context of an imputation credit system that refunds imputation credits to foreign shareholders. the issues would be the same in a dividend exclusion system that refunded corporate tax to foreign shareholders. assume, for example, that two domestic corporations each earn an annual pre-tax profit of $100. corporation a has one shareholder, a u.s. resident individual. corporation b also has one shareholder, a nonresident alien individual who resides in a country that has a tax treaty with the united states. the tax treaty limits the u.s. dividend withholding rate to 15 percent for portfolio investors (including the shareholder of corporation b) and contains a standard prohibition against discrimination based on capital ownership. assume also a 34 percent corporate tax rate, a 31 percent individual tax rate and that corporate taxes are credited to shareholders at the 31 percent individual rate. if neither corporation distributes earnings, each pays a tax of $34 on its $100 profit. no discrimination exists between the two corporations, and the withholding rules are not implicated. if, instead, each corporation distributes one-half of profits, the domestic shareholder receives a cash distribution of $33, an imputation credit of $14.83, and a grossed-up dividend, i.e., including credit of $47.83. the domestic shareholder will have a tax liability with respect to the gross distribution of $14.83, which will be exactly offset by the imputation credit. thus, for corporation a both distributed and retained earnings are taxed at a 34 percent rate. there is a significantly different result for corporation b. the foreign shareholder receives a cash dividend of $33. if he also receives an imputation credit of $14.83, his gross dividend will be $47.83. the withholding tax on this distribution will be $7.17, entitling him to a refund of $7.66. in this case, undistributed profits are taxed at 34 percent, but distributed profits are taxed at 18.7 percent ($50 of pre-tax income that bears $17-$7.66 of tax). 79 see part iv, infra. 80 tax reform: examining the taxation of business entities: hearing before the s. comm. on finance, 112th cong. (2012). 81 president’s econ. recovery advisory bd., the report on tax reform options: simplification, compliance, and corporate taxation 76 (2010). 82 staff of joint comm. on taxation, jcs-7-03, description of revenue provisions contained in the president’s fiscal year 2004 budget proposal 18 (2003). 83 see u.s. dep’t of the treasury, supra note 61, at 15. 2020] the case for tax integration and current-base taxation 13 special account, the excludable dividend account (eda), would represent the corporate e&ps that were fully taxed at the corporate level. only dividends distributed out of the eda would be excluded from the shareholder’s gross income. a dividend exemption might have a significant negative effect on u.s. tax revenue, while a reduced dividend rate, instead of an exemption, might mitigate such a problem. therefore, the original bush proposal for dividend exemption was eventually rejected in favor of the current partial integration system, under which dividends are taxed at reduced rates (up to 15% at the time it was enacted, and now 20%).84 this favorable treatment was set to expire at the end of 2008 and was extended for four additional years, until it became permanent.85 despite this, the president’s advisory panel on tax reform issued a report in 2005 recommending, once again, two other forms of integration. the first was the dividend exclusion, combined with a proposal to also exclude 75% of capital gain from the sale of corporate stock (limited to the eda, which was already taxed at the corporate level).86 the second was the application of a uniform tax on a business’s cash flow (excluding deductions for interest or dividends), combined with a flat rate tax on dividends, interest, and capital gains at the shareholder level.87 in 2011, the senate finance committee held a comprehensive debate on corporate tax integration. in support of integration, professor auerbach argued in his testimony that the current rules, including the tax deductibility of interest, encourage corporate borrowing and skew corporate investment toward risker, debt financed projects.88 though professor graetz agreed that the current tax system encouraged corporate borrowing, he argued that corporate income was not always subject to double taxation, because in some instances, income was excluded from taxation at the corporate level (e.g., deductible interest payments to taxable lenders) and sometimes it was excluded at the shareholder level (e.g., dividends to tax-exempt shareholders).89 graetz suggested flipping the current rates of the time so that the corporate rate would be significantly lower than the rate at the shareholder level.90 in addition, he suggested offering tax credits to shareholders and bondholders for a portion of the taxable income of the corporation (similar to the idea of eda).91 1. hatch’s tax proposal and the 2017 tax reform in 2014, the senate finance committee introduced a new comprehensive report calling for a reform and tax integration in the u.s.92 the document called for integration by dividend exemption or by dpd, in combination with changing the international tax regime to territoriality.93 in 2016, 84 staff of s. comm. on finance, comprehensive tax reform for 2015 and beyond, 113th cong., 134 (2014). 85 see tax reform task force, supra note 34, at 18 (“the current tax code only partially mitigates … double taxation [of savings and investment income] by providing a special rate structure for certain types of investment income… [qualified dividends are subject to] a top statutory tax rate of 20 percent.”) 86 president’s advisory panel on tax reform, simple, fair and pro-growth: proposals to fix america’s tax system xvii (2005). 87 id. at 55. 88 does the tax system support economic efficiency, job creation and broad-based economic growth?: hearing before the s. committee on finance, 112th cong. 46 (2011) (statement of professor alan j. auerbach). 89 id. at 75 (statement of professor michael j. graetz). 90 id. at 86 (statement of professor michael j. graetz). 91 id. at 12. 92 staff of s. comm. on finance, comprehensive tax reform for 2015 and beyond, 113th cong., 134 (2014). 93 id. [vol. 11:2 columbia journal of tax law 14 relying on that report, senator hatch declared that his team was working on proposal for shareholder-credit integration in the form of dpd, combined with a 35% (the corporate tax rate at the time) wht.94 under the proposal, corporations would be able to deduct dividend distributions from their income, but a special wht would be imposed on those distributions. shareholders would include the distributions in their taxable income.95 it was not clear at the time whether the credit would be refundable, yet some sources indicated that it would not.96 the main implication of non-refundability is that domestic shareholders would be able to use the credit only up to their tax liability while tax-exempt and foreign shareholders would not be able to monetize or otherwise use the credit in any way. thus, this proposal would negatively affect low bracket and tax-exempt taxpayers.97 a non-refundability feature would have reduced the potential negative effects on the u.s. tax revenue. to achieve parity between debt and equity, it was also suggested that interest payments to tax-exempt taxpayers would be subject to the same nonrefundable wht.98 business entities other than c corporations would seemingly not be affected by the proposal.99 surprisingly, the original senate version of the 2017 tax reform appeared to include a dpd mechanism of 0% (which effectively means no dpd).100 nonetheless, had the proposal been approved, congress could have easily amended the section later on by simply increasing the percentage of the dpd without raising any unwanted public attention. under the legislative language, an eligible corporation would be allowed as a deduction an amount equal to zero percent of the aggregate amount of applicable dividends paid by the corporation during the taxable year.101 to be sure, any exempt income would not give rise to an additional deduction; under the proposal 94 kyle pomerleau, senator hatch to introduce corporate integration plan, tax found. (jan. 20, 2016), available at http://taxfoundation.org/blog/senator-hatch-introduce-corporate-integration-plan [https://perma.cc/8paj-8xuk]. 95 id. 96 andrew velarde, hatch integration plan may have 35 percent interest withholding, tax notes (apr. 13, 2016), available at http://www.taxnotes.com/tax-notes-today/tax-reform/hatch-integration-plan-may-have-35-percentinterest-withholding/2016/04/13/18455691 [https://perma.cc/9vmm-j9es] (referring to the statement of one of the committee aides); see also stephen k. cooper & dylan f. moroses, corporate integration plan drafting ‘may be done,’ hatch says, tax notes (sept. 9, 2016), available at http://www.taxnotes.com/editors-pick/corporateintegration-plan-drafting-may-be-done-hatch-says [https://perma.cc/gsf3-znc6]. 97 see e.g., am. law inst., supra note 46, at 163 (explaining that the credit would be refundable). 98 see u.s. dep’t of the treasury, supra note 61, at 105. 99 see pomerleau, supra note 94. see also reuven avi-yonah, a bipartisan tax reform, 151 tax notes 505 (2016) (providing an updated debate about the 2016 presidential campaign tax proposal). 100 h.r. 1, supra note 3. 101 id. ‘eligible corporation’ means any domestic corporation other than a regulated investment company, a real estate investment trust, an s corporation, a corporation which is exempt from tax under section 501 or 521, an organization taxable under subchapter t (relating to cooperative organizations, or a domestic international sales corporations (disc) or former disc. ‘applicable dividend’ means, with respect to an eligible corporation, any distribution by the eligible corporation during a taxable year which is treated as a dividend and paid out of its ‘applicable earnings and profits’. ‘applicable earnings and profits’ means, with respect to any corporation for any taxable year, its earnings and profits for the taxable year and its earnings and profits accumulated in prior taxable years beginning after december 31, 2018. the applicable earnings and profits of a corporation shall not include any exempt earnings and profits. ‘exempt earnings and profits’ means with respect to any corporation for any taxable year, its earnings and profits for the taxable year and its earnings and profits accumulated in prior taxable years beginning after december 31, 2018, which are properly allocable to exempt amounts received or accrued by the corporation. ‘exempt amounts’ means, with respect to any corporation, among others, any dividend that was previously exempt of taxation. 2020] the case for tax integration and current-base taxation 15 and as a general rule, dividends would be treated as paid first, out of “exempt earnings and profits” and only second, out of the “applicable earnings and profits,” similarly to an ead account.102 although the proposal to adopt dpd (even at 0%) was eventually removed from the final bill, the section illustrates a possible mechanism to address one of the most prominent problems of any form of tax integration—the unwanted extension of the benefits of tax integration to exempt earnings, and particularly to foreign earnings. the main concern is clear: if a corporation is allowed to deduct a distribution out of foreign earnings that were not previously taxed by the united states, u.s. tax revenue would be significantly impacted as a result of such “double non-taxation.” the solution offered here, which follows the lines of the eda mechanism introduced in 2003 by the bush administration, was to extend the benefit of tax integration only to distributions that are not out of exempt e&ps (e&ps that were not previously taxed in the united states). the assumption here is that as long as the exempt e&ps are more than zero, any distribution will be out of that account, and thus not entitled to the benefit of tax integration. iii.the benefits of tax integration and its main problems as discussed in part i, in the early days of the u.s. corporate tax regime, congress made a conscious decision to treat corporations as separate taxable entities, resulting in a mechanism of double taxation: corporations are first taxed on their taxable income. then, once a corporation distributes a dividend out of its e&ps, an additional tax is imposed, this time at the shareholder level. this is achieved by including the distribution in the shareholder’s taxable income. at some point in history, when the maximum marginal individual tax rate reached 70% and the top corporate tax rate was 46%, this double taxation resulted in a total tax liability of more than 84%.103 many economists have argued that such a regime results in an inefficient penalty on business activities carried through corporations,104 creating a distortion of investment allocation between the business sector and the non-business sector as well as between c corporations and other forms of business entities.105 in the past, the structure of business activity was relatively simple, with c corporations earning the vast majority of business income. yet, as discussed previously, this is no longer the case. empirical research suggest that c corporations now account for less than half of 102 id. 103 stephen schwarz & daniel j. lathrope, fundamentals of corporate taxation: cases and materials 8 (8th ed. 2012). 104 see slemrod & bakija, supra note 68, at 270 105 though some argue that at times where the corporate tax rate is lower than the marginal individual tax rate, investors might prefer to conduct their business through c corporation rather than pass-through entities, like partnerships. this is because, investors were able to use the profits while still in corporate solution, so those profits would be subject only to one level of taxation – corporate tax, at the corporate level. the profits could remain in the corporate solution until the business was sold or liquidated. in the meantime, shareholders found creative ways to use the income for their own benefit, while still in corporate solution. alternatively, shareholders who were also employees of the corporation were able to use the profits of the corporation in the form of salary and fringe benefits. the salary was deductible to the corporation, resulting only in one level of taxation – at the employee level and at marginal individual tax rate. on the other hand, many of the fringe benefits were excluded from the income of the employee. shareholders could also loan funds or lease a property to the corporation and withdraw earnings in the forms of taxdeductible interest or rent. see id. at 8. [vol. 11:2 columbia journal of tax law 16 business income,106 with “pass-through” businesses (such as s corporations and partnerships) growing rapidly.107 additionally, the preference towards debt encouraged by the current double taxation regime should not be dismissed. 108 the 2008 financial crisis clearly illustrated the potential destructive consequences of corporations being over leveraged. further, to the extent one would like to avoid a second layer of taxation, double taxation still incentivizes corporations to accumulate income rather than distributing it as dividend, as doing so will effectively defer any shareholder level taxation indefinitely109 (although some mechanisms, like the accumulated earning tax, are meant to prevent exactly that).110 therefore, eliminating the double-taxation mechanism by adopting tax integration will arguably remove these distortions and consequently increase the rate of return for corporate investment, increase the capital available for corporations, and therefore increase economic growth.111 as discussed previously, senator hatch and the 2014 republican report proposed to allow a deduction for corporate distributions. to address several tax policy issues and to insure fiscal needs, a wht, at a rate similar to the corporate tax rate, should be imposed on any distributions out of corporate earnings if dpd were to be implemented. this wht will also facilitate taxation of income distributed to tax-exempt and foreign shareholders. in essence, a dpd combined with a wht has the same economic effect as an imputation form of integration.112 this is because under both forms, shareholders are entitled to a credit for the taxes remitted by the corporation. nonetheless, the characterization of wht is different from the characterization of an income tax. by allowing a deduction and imposing wht, the tax liability is “shifted” from the corporation to its shareholders, because the corporation is acting as a mere conduit and the tax is ultimately owned by the shareholders themselves. 113 although the corporation will still collect the wht, this change 106 michael cooper et al., business in the united states: who owns it, and how much tax do they pay?, 30 tax pol’y & econ. 91-92, fig. 1 (2016). 107 see matthew smith et al., capitalists in the 21st century 9 (2017). 108 the current system encourages corporations to issue debt because interest paid on debt instruments is currently deductible while dividends paid are not. see slemrod & bakija, supra note 68, at 270 (noting that the current double taxation regime can “put an inefficient penalty on business activity carried out in corporate form, and it distorts corporate financial structure toward debt finance. it also may make investment in corporate stock particularly unattractive relative to nonbusiness investments such as owner-occupied housing, causing too much high-priced housing to be built at the expense of more socially productive corporate investments”). 109 steven a. bank, from sword to shield: the transformation of the corporate income tax, 1861 to present xii (2010). 110 i.r.c. § 531 (2012). 111 it should be noted that the arguments mentioned above are mainly relevant to publicly traded corporations that do not have the choice to incorporate as pass-through entities (like s corporations). by forming a pass-through entity, an investor could avoid double taxation. recent data shows that investors do indeed choose to avoid double taxation by forming their businesses as pass-through entities. for more information, see soi tax stat – integrated business data, irs (apr. 15, 2015), available at https://www.irs.gov/uac/soi-tax-stats-integrated-business-data [https://perma.cc/92l9-q98e]. 112 edward d. kleinbard, the trojan horse of corporate integration, 152 tax notes 957, 960 (2016). 113 id. see also senator orrin hatch, keynote speech at bloomberg bna tax policy event, the politics of tax: making sense of uncertainty (feb. 24, 2016) available at https://www.finance.senate.gov/chairmans-news/hatchoffers-keynote-address-at-bloomberg-bna-tax-policy-event [https://perma.cc/x8du-9gvt]). 2020] the case for tax integration and current-base taxation 17 of characterization (from income tax to wht) presumably allows corporations to reduce their tax liability for accounting purposes, resulting in a lower effective tax rate and higher earnings per share. the main problem with this approach is that such a change is an artificial one and will affect only the financial statements of corporations.114 this issue will be discussed further below. a. the main problems of tax integration since dpd with wht and imputation are economically equivalent, both forms bear similar design issues. as will be discussed below, on the domestically side, these issues include the treatment of (1) corporate income that has not been previously taxed by the united states; (2) retained, undistributed, earnings; and (3) distributions to tax-exempt shareholders.115 all of the above have been substantially addressed in prior work related to tax integration (either in the form of dpd or imputation). in addition to the above, elimination of the double taxation regime might diminish the tax code’s ability to regulate or incentivize corporate behavior. these issues related to the current u.s. international tax regime will be discussed in the next part. 1. corporate income not previously taxed by the united states the first problem—extending integration benefits to income that was not previously taxed by the unites states—is sometimes referred to as “super-integration.”116 to illustrate, assume a corporation investing in tax-free municipal bonds and then distributing the earnings from the bonds to shareholders in the form of a dividend, without previously bearing corporate tax on those earnings. under the dpd (with no wht) form of integration, such income might escape u.s. tax completely. if a deduction is granted, not only will the distribution not bear any corporate tax (because the interest from these bonds is tax-free), but it will also reduce the total corporate tax liability because of the deduction. the result will be a negative tax liability, or a tax shield at the corporate level. the distribution, on the other hand, will be taxed at the shareholder level. taken together, the revenue will be minimal (or negative) as the saving from the tax shield will offset the tax collected from the shareholder. the general question with respect to this problem is whether tax preference should be passed through the corporation to its shareholders. in other words, the question is whether the shareholders should enjoy the tax benefit of investment in a municipal bond through a corporation.117 if the answer is in the affirmative, then we should accept the result of minimal taxation when earnings from tax-free bonds “escape” taxation. one solution to this problem might be to limit the dpd to corporate taxable income, using an eda, as discussed in part i. another possible solution would be to impose a compensatory tax on distributions out of earnings that were not previously taxed.118 a wht, applied to all distributions, could function as a compensatory tax, and would help to eliminate any pass-through of corporate preferences. in a study of eight industrialized countries that have adopted integration in the past, most did not allow corporate preferences to 114 see kleinbard, supra note 112, at 958; see also schwarz & lathrope, supra note 103, at 11. 115 see schwarz & lathrope, supra note 103, at 17. 116 see am. law inst., supra note 45, at 63. 117 id. at 61. 118 am. law inst., supra note 45, at 18. [vol. 11:2 columbia journal of tax law 18 pass-through to its shareholders.119 one potential justification for this is that the function of integration is to eliminate the existing tax on distributed corporate earnings, and not to tax shareholders as though they had interests in a pass-through entity.120 another interesting question relates to corporate equity that already benefited from tax preference under the current double taxation regime. presumably, tax integration will result in a windfall gain to current corporate equity, which was invested under the assumption of double taxation.121 in theory, there seems to be no compelling tax argument that can justify granting the benefit of tax integration to such equity. nevertheless, ad-hoc transition rules, such as designated e&p accounts, can help facilitate a mechanism that will distinguish old from new equity, as it was already invested in the market under the assumption of double taxation. 2. retained earnings the second problem relates to retained earnings. under a dpd form of integration, the elimination of double taxation is achieved only if the earnings are distributed rather than retained under corporate solution. moreover, gain from a sale of stock, part of which is the result of retained corporate earnings, will be taxed as capital gain. as corporations will want to avoid capital gains on the retained earnings component of the gain, they will be incentivized to distribute earnings to shareholders rather than using them for the benefit of the corporation.122 one solution to this problem is the use of constructive-dividend and reinvestment plans. those plans will allow corporations to extend the benefits of integration to retained earnings by treating those earnings as if they were distributed and reinvested in the corporation. this, in turn, will increase the shareholders’ basis in the corporation, reflecting the amount of the deemed dividend and ensuring that the shareholders would not be taxed on appreciation due to retained, fully taxed earnings, when the stock is later sold.123 another solution would be to convert the capital gain from the sale of a stock to dividend income (to the extent of available e&ps), which is eligible for the dpd.124 3. tax-exempt shareholders the third problem of integration relates to tax-exempt shareholders. under a dpd form of integration, the tax is imposed at the shareholder level (assuming earnings are distributed). how should tax-exempt shareholders, such as charitable organizations and pension funds, be taxed? if their tax-exempt status is respected, earnings might avoid any u.s. tax.125 again, one of the possible solutions to this problem is to impose wht or a new compensatory tax on distributions 119 reuven s. avi-yonah, the treatment of corporate preference items under an integrated tax system: a comparative analysis, 44 tax law. 196, 213 (1990). 120 alvin warren, the relation and integration of individual and corporate income taxes, 94 harv. l. rev. 719, 777–78 (1981). 121 am. law inst., supra note 45, at 10. 122 warren, supra note 120, at 750. 123 see u.s. dep’t of the treasury, supra note 61, at 87. 124 a similar mechanism applies to certain sales by a united states person of shares in a foreign corporation. i.r.c. § 1248(a)(2). 125am. law inst., integration of individual and corporate income taxes 67 (1992). 2020] the case for tax integration and current-base taxation 19 to tax-exempt shareholders and to disallow the tax withheld as credit unless the distribution is taxed at the tax-exempt shareholder level (meaning non-refundable credit).126 if a dpd form of integration is adopted, a similar nonrefundable wht or new compensatory tax should also be imposed on interest payments to tax-exempt shareholders. such an additional tax on interest would achieve parity between debt and equity because the corporation would deduct both interest and dividend payments and would impose the same tax on the distributions. since tax-exempt shareholders would exclude both dividend and interest payments from their taxable income, it is important to ensure the imposition of wht on both payments.127 such change would negatively impact the total tax liability of tax-exempt shareholders as compared to the liability under current law. today, interest payments to tax-exempt shareholders are generally deductible at the corporate level and exempt at the tax-exempt shareholder level. the new wht on interest payments can increase revenue and support a revenue neutral reform. 4. regulating corporate behavior although raising revenue and redistributing wealth are among the most well-known goals of any tax system, some argue that there is one additional goal to the corporate tax regime—a regulatory goal: [t]axation has a third goal, which has not been noticed as widely: a regulatory goal. in most developed countries governments use the tax system to change the behavior of actors in the private sector, by incentivizing (subsidizing) activities they wish to promote and by disincentivizing (penalizing) activities they wish to discourage.128 as discussed previously, and assuming any system of tax integration would not allow corporate tax preferences to pass-through to its shareholders, tax integration would hinder the ability of the tax code to regulate corporate behavior. yet there are several problems with justifying the corporate tax on the basis of its ability to regulate corporate behavior. first, history shows that in at least some areas, regulating corporate behavior through the tax code can be ineffective, temporary and perhaps even undesirable.129 this is especially true when congress has to face fierce resistance from corporations to any measures that will affect their after-tax earnings.130 second, it is not clear who actually bears the burden of the corporate tax (tax incidence). finally, there are other legal tools to regulate corporate behavior, such as security and antitrust regulations or general criminal and administrative legislation.131 126 see schwarz & lathrope, supra note 103, at 21. 127 am. law inst., supra note 125, at 69. 128 reuven avi-yonah, taxation as regulation: carbon tax, health care tax, bank tax and other regulatory taxes 2–3 (u. mich. pub. l. research paper no. 281, 2010). 129 see, e.g., kurt hartmann, the market for corporate confusion: federal attempts to regulate the market for corporate control through the federal tax code, 6 depaul bus. l.j. 159 (1993). 130 see bank, supra note 19, at 3-4. 131 hartmann, supra note 129, at 198. [vol. 11:2 columbia journal of tax law 20 b. the problems of dpd with wht and territoriality aside from the previously discussed problems of any proposal of tax integration in general, the dpd form of integration has its own unique problems. one of these problems results from the combination of dpd with wht. the other problem results from the combination of dpd with a territorial system.132 both of the problems and their solutions will be discussed in this order below. 1. the “trojan horse” problem of dpd and wht dpd combined with wht might artificially reduce the tax liability of u.s. mnes for financial accounting purposes. 133 this is because the corporate tax liability would be “shifted” to its shareholders and the corporation would function as a conduit, collecting the tax on behalf of the shareholders. some refer to this as the “trojan horse” problem, because presumably the main purpose of the proposals to implement a dpd form of integration might actually be to allow mnes to show better financial results rather than to alleviate the double taxation problem.134 it is indeed possible that dpd combined with wht would reduce, at least temporarily, the effective tax rate of u.s. corporations in their financial reports, without having any substantial economic change in the way those corporations and the earnings are taxed.135 this effect may be temporary because it is not clear how the financial accounting standards board (fasb) would treat the wht in such a case, and whether it will require u.s. mnes to consider the wht as part of their own corporate tax liability, and not as part of the shareholder’s tax liability, which would result in higher effective corporate tax rates.136 under the current fasb guidelines, the wht paid by a corporation to its shareholders should be considered as part of the corporation’s own tax liability, rather than its shareholders’. according to fasb, wht will not be a part of the tax liability of an entity paying a dividend only if both of the following conditions are met: (1) the tax is payable by the entity if and only if a dividend is distributed to shareholders—the tax does not reduce future income taxes the entity would otherwise pay; and (2) shareholders receiving the dividend are entitled to claim the withholding as tax paid by the entity, on their behalf, either as a refund or as a reduction of taxes otherwise due, regardless of the tax status of the shareholders.137 as discussed previously, one of the proposals to deal with the possible problem of tax-exempt taxpayers under a regime of integration is to disallow them the credit for tax withheld by the distributing corporation (unless the distribution will be taxed at the tax-exempt shareholder level).138 should such a rule be indeed adopted, the second condition, which requires the refundability of tax withheld regardless of the tax status of the shareholder receiving the dividend, would not be met. in addition, the first condition is not 132 martin a. sullivan, economic analysis: corporate integration would tilt investment to the u.s., 150 tax notes 739, 739 (2016). 133 see kleinbard, supra note 112, at 958. 134 id. 135 id. 136 see s. comm. on finance, the business income tax bipartisan tax working group report 60 n.32 (2015). 137 guide to accounting for income taxes 1.2, pricewaterhousecoopers (2013), available at https://www.pwc.com/us/en/cfodirect/publications/accounting-guides/income-taxes-accounting-guide.html [https://perma.cc/v3ft-h22s]. 138 see sullivan, supra note 132. 2020] the case for tax integration and current-base taxation 21 necessarily met either, because the wht is linked to the dpd, which in turn reduces the tax liability of the distributing corporation. by this analysis, the tax liability, the corporate effective tax rate, and earnings per share should be the same as under current law (because the wht will be part of the corporate’s, rather than the shareholders’, tax liability) and the “trojan horse” problem vanishes. not taking into account financial reporting considerations, “shifting” the tax liability from the corporation to its shareholders might actually be a desirable tax policy for two primary reasons. first, taxation at the individual level would allow the united states to apply graduated, more accurate individual tax rates to reflect the “ability-to-pay” principle.139 the second is that, unlike corporations, individuals are much less mobile. imposing the tax liability on individuals, instead of corporations, might also help the united states fight some of the most notorious tax avoidance techniques, such as inversions. for individuals, it is much more costly to change residence in order to escape u.s. taxation. as long as the capital is held by u.s. shareholders, taxation (at a full individual rate) would occur within the united states.140 2. integration and territoriality under a territorial system, the entire (or a certain percentage) of any dividend received by a u.s. corporation from its foreign subsidiaries, would be exempt from u.s. taxation,141 or subject to relatively low u.s. tax due to gilti (which will result in no more than half of the corporate tax rate).142 essentially, territoriality and integration are “pushing” towards opposite directions. while a territorial system provides a tax advantage to foreign over domestic investment, integration provides the opposite advantage by eliminating the benefits with respect to exempt or foreign earnings. furthermore, a dividend exemption mechanism, combined with tax integration, might result in a serious revenue loss. in the inbound case, under which a foreign shareholder invests in a u.s. corporation, dividends paid to the foreign shareholder should generally be subject to reduced u.s. wht if a tax treaty is applicable, and the u.s. corporation would be entitled to dpd. this means that full wht is needed so the united states will be able to collect tax on corporate earnings that are distributed to foreign shareholders. however, such wht might constitute a violation of the applicable tax treaty, which most probably provides for reciprocal reduced wht rates. in the outbound case, under a territorial tax system together with a dpd form of integration (and with no wht), u.s. shareholders would be exempt from dividends paid by a foreign corporation. under such a regime, distributions from a controlled foreign corporation (cfc) would not be subject to u.s. tax (or subject to reduced rates through gilti). the problem is that if and when those earnings are redistributed by the u.s. parent to its u.s. shareholders, there will be no corporate tax liability. the u.s. parent will be entitled to a deduction, while the foreign earnings were not subject to u.s. tax in the first place. this resembles the problem arising from distributions 139 avi-yonah & chenchinski, supra note 66, at 7. 140 reuven s. avi-yonah, the international tax regime: a centennial reconsideration 6-7 (u. mich. pub. l. research paper no. 462, 2015). 141 staff of s. comm. on finance, comprehensive tax reform for 2015 and beyond, 113th cong., 252 (2014). 142 sullivan & cromwell, supra note 2 at 6. [vol. 11:2 columbia journal of tax law 22 of untaxed interest from municipal bonds or super integration. as such, wht is needed in this case as well, as will be discussed in part iii. c. imputation vs. dpd with wht though dpd with wht and imputation are economically equivalent, one might be preferable over the other on administrability considerations.143 one of the main advantages of dpd over imputation is that that dpd is simpler to adopt. 144 imputation requires a set of complex computations—mainly grossing up dividends. this might be a problem when the underlying earnings are sourced from different kinds of corporate earnings, subject to different amounts of tax.145 dpd, on the other hand, is easier to administer because its implementation affects only the corporation under a fixed-rate—the corporate tax rate.146 it should be noted that tax incidence should also play a part in the determination of which form of integration is most suitable. it is still not clear who actually bears the burden of the corporate tax. while the exact incidence of the corporate tax remains disputed, it seems to be generally agreed upon that at least a portion of the tax is borne by shareholders. even so, it is not clear whether tax incidence falls equally on upper and lower income shareholders. the corporate tax is also sometimes said to be shifted to all owners of capital in general, and also to consumers, employees and so on.147 it is also possible that most of the burden of the current u.s. corporate tax is borne by holders of non-corporate capital. if so, they would benefit the most from corporate integration. although there is no consensus on who actually bears the corporate tax, different theories of tax incidence should help us choose between the several forms of tax integration.148 iv.tax integration and the international tax regime as described in part ii, the international problem of tax integration might result in a revenue loss (unless combined with full-rate wht), which in turn could result in a direct violation of tax treaties. 143 see am. law inst., supra note 4546, at 48–49 (arguing that the partnership method is more complex than than distribution related integration because the partnership method would require yearly attribution to a complex set of capital interests); see also james r. haney, integration of the corporate and individual income taxes, 30 nat’l tax j. 345, 346 (1977). 144 see avi-yonah & chenchinski, supra note 66, at 14; see also lee a. sheppard, corporate tax integration: the proper way to eliminate the corporate tax, 27 tax notes 637, 644 (1985). 145 see, e.g., am. law inst., supra note 4546, 46at 61-62 (stating that the gross-up fails when preference income is distributed). 146 adopting the imputation form of integration would result in much greater complexity. not only would imputation have the same problems associated with dpd with wht (in the form of special rules regarding foreign shareholders, tax-exempt entities, and tax preferences), but it is also not clear which tax rate the credit given to the shareholders would be based on. “[imputation] would be relatively easy to administer only if a fixed-rate credit was used. but if the credit is to be based on the effective tax rate of each separate corporation, it would be more complicated to administer.” see tax div., am. inst. of certified pub. accountants, proposed statement of tax policy 10: integration of the corporate and shareholder tax systems 5, 51, 55-56 (1993). 147 john d. mcdonald, hatch's integration plan: trojan horse or reasonable alternative?, page 6 [i can’t seem to access tax notes anymore]. 148 richard goode, the postwar corporation tax structure 55 (1947). 2020] the case for tax integration and current-base taxation 23 a. the international problem of tax integration cross-border transactions usually create problems under tax integration, because either the corporation or its shareholders are residents of the united states and subject to full u.s. tax, but not both. the question is whether the benefits of integration should be granted in cases where the income might escape u.s. taxation entirely, as will be shown below. an answer in the affirmative might result in a substantial revenue loss.149 to better understand the problem, the discussion will be divided into problems associated with active income and problems associated with passive income. 1. active income under a regime of dpd (and assuming no wht), active income is subject to tax when earned but is deducted from the corporate taxable income if and when distributed as a dividend. assume a u.s. mne operating a branch in a foreign country. the branch has income that might be taxed in the foreign country and not in the united states (due to ftc). the question is whether 149 see graetz & warren jr., income tax discrimination and the political and economic integration of europe, supra note 9, at 1209–10. in europe, the imputation form of integration was abolished mainly because limiting the benefits of integration only to domestic investors (as a step to avoid revenue loss) violated the principles of european commission treaty of freedoms and was therefore forbidden by the court. graetz and warren, jr. explain: largely as a result of the ecj tax decisions, the shareholder credit option has now been abandoned in the eu, in some cases even before the ecj had decided whether it violated the ec treaty freedoms . . . [i]nternational income also complicates imputation for both incoming and outgoing investment. the key issue regarding incoming investment is whether the shareholder credit should be available to foreign investors. a source country typically imposes only flat-rate “withholding taxes” on dividends to foreign shareholders, because it has no way of knowing the rest of the shareholder's income situation. the traditional practice has been to reduce these withholding taxes to identical low levels in bilateral tax treaties. corporate income would therefore be subject to primary taxation in the source country (due to the exemption or foreign tax credit in the residence country), while dividends then paid to the foreign investors would be subject to primary taxation in the residence country (due to reduction of withholding taxes in the source country). in this situation, imputation would achieve integration for domestic investors, while leaving for treaty negotiation the question of whether shareholder credits would be extended to foreign investors. countries have differed in their willingness to enter into treaties that extend credits to foreign shareholders. the most common decision-not to extend such credits to foreign investors -creates the possibility of sourcecountry favoritism of domestic investors, because the corporate tax on domestic income would be integrated when distributed to domestic, but not foreign, shareholders. regarding outgoing investment, the key issue is whether foreign taxes paid on corporate income earned abroad should reduce shareholder taxes when that income is distributed as a dividend. the tendency has been to ignore corporate-level foreign taxes when computing individual shareholder taxes on dividends out of foreign income. distribution of foreign income to shareholders could therefore trigger a compensatory tax, leading to the possibility of residence-country bias against investment abroad. domestic corporate income is taxed only once by the residence country when distributed to domestic shareholders under full imputation. foreign corporate income is taxed in the source country and typically benefits from either an exemption or a foreign tax credit in the residence country, but such income typically is taxed again when distributed to shareholders as a dividend. the potential for favoring domestic investors and domestic investment under imputation has long been known, and various solutions have been proposed in commission studies over the years." the unanimity requirement, however, always precluded adoption of any particular solution, and member states began to fear that their imputation systems would be found by the ecj to violate the ec treaty freedoms. id. [vol. 11:2 columbia journal of tax law 24 distributions out of those earnings should be deductible from the taxable income of the u.s. mne. this essentially turns on whether foreign taxes paid by a u.s. corporation should be treated the same as taxes paid to the united states. if so, the corporation and its shareholders should be entitled to the benefits of integration.150 if the corporation would be entitled to the ftc and a dpd would be allowed, such scenario might lead to a “negative” u.s. tax liability. this is because the earnings, if distributed, will result in a reduction of u.s. tax liability at the corporate level (due to the deduction), while the ftc would have already reduced the u.s. corporate tax liability on those earnings. in other words, the foreign source earnings will not be subject any additional u.s. tax liability, but nonetheless would generate a dpd upon distribution. a u.s. tax will be imposed only at the shareholder level, so the total u.s. tax liability (if at all) would be minimal. the 1992 treasury report discussed this question and concluded that the united states should not adopt integration unilaterally, mainly because of the potential revenue loss as discussed above. 151 imposing a wht or introducing a new compensatory tax might solve this problem because the ftc will offset the corporate level tax or the wht/compensatory tax, but not both. in the opposite scenario, consider a foreign corporation operating a branch in the united states. under current law, entities engaged in a u.s. trade or business are generally subject to the u.s. corporate tax rates on their effectively connected income. if a treaty is applicable, the foreign corporation would be subject to u.s. tax only if its business constitutes a “permanent establishment” within the united states.152 in such cases, the u.s. source income would generally be taxed similarly to income earned by a u.s. corporation. as such, it should presumably be entitled to dpd for its distributions. the dpd will reduce the u.s. tax liability of the branch to zero (to the extent earnings are later fully distributed). yet the branch is not an entity by itself. if and when a distribution is made, it would be made by the foreign entity to its shareholders, which are probably both foreign and u.s. shareholders, or only foreign shareholders. even if the foreign entity would be required to establish an account tracking the income that is earned through the permanent establishment, it might be hard to follow all distributions made to determine which shareholders received them. such determination is required since distributions to foreign shareholders should not give rise to dpd or no additional u.s. tax will be collected (assuming the foreign shareholders are not subject to u.s. tax). in this scenario as well, the earnings might escape u.s. taxation altogether. a possible solution would be to disallow the deduction entirely. yet such disallowance might violate the non-discriminatory provision of the applicable tax treaty. this provision provides that “taxation on a permanent establishment that an enterprise of a contracting state has in the other contracting state shall not be less favorably levied in that other contracting state than the taxation levied on enterprises of that other contracting state carrying on the same activities.”153 imposing wht might be problematic as well because the distributing entity is a foreign, and not a u.s., entity, and thus is not subject to u.s. tax jurisdiction. 2. passive income when a u.s. shareholder holds interest in a foreign corporation, the question would be whether the united states should grant any kind of relief to the shareholder or the foreign corporation upon 150 am. law inst., supra note 45, at 180-181. 151 see u.s. dep’t of the treasury, supra note 61, at 77. 152 u.s. model tax convention art. 7(1) (2016). 153 u.s. model tax convention art. 24(2) (2016). 2020] the case for tax integration and current-base taxation 25 distributions to the u.s. shareholders. granting a relief might result in a revenue loss.154 under dpd, the relief would be granted at the corporate level. here, the foreign corporation would not automatically be entitled to dpd. at first, this result might seem desirable, yet this might lead to burdensome taxation of foreign income held by u.s. shareholders and a potential violation of the cin principle. another possibility is to grant the u.s. shareholders a relief in the form of credit for taxes paid by the foreign corporation to the foreign country, but since the foreign entity is not subject to u.s. law, the u.s. shareholders might have difficulties obtaining the necessary documentation on the taxes the foreign corporation paid.155 in the opposite case, consider a u.s. corporation that has foreign shareholders. should the u.s. corporation be allowed a dpd on dividends that were distributed to the foreign shareholders? if so, the income might escape u.s. taxation entirely since the foreign shareholders are not subject to u.s. tax. in addition, unlike tax-exempt shareholders, foreign shareholders are entitled to the benefits of tax treaties.156 those benefits include a substantially reduced wht rate on dividends sourced within the united states; presumably, the united states cannot unilaterally impose a high wht on such distributions, but this wht would be the only tax collected by the united states.157 as discussed above, one solution could be to impose a full-rate wht, or a special new compensatory tax. this wht would be imposed on earnings distributed to foreign shareholders and would replace the low wht rate the treaty provides. to prevent revenue loss, the u.s. should disallow the tax withheld as a credit to the foreign shareholders. however, this solution still violates the tax treaties in two ways. first, it may violate the reduced wht rates provided by the applicable treaty. second, it would disallow a credit to foreign shareholders for the tax withheld, which might violate the non-discrimination provision of the applicable tax treaty.158 a potential 154 george n. carlson, international aspects of corporate-shareholder tax integration, 11 case w. res. j. int’l l. 535, 557 (1979). 155 the cin principle might be also impacted if the u.s. tax rate is higher than the foreign tax rate, but this is not related to dpd or imputation. 156 see avi-yonah & chenchinski, supra note 66 at 11. 157 see reuven avi-yonah et al., u.s. international taxation 132 (3d ed. 2010). 158 see u.s. dep’t of the treasury, supra note 61, at 79. however, note that while it is not clear whether a disallowance of a credit will constitute a violation of the applicable non-discrimination provision, many of the countries that adopted integration in the past have concluded that refusing to extend integration benefits by statute to foreign shareholders residing in other contracting countries would not violate that provision. the argument was that under imputation, all profits are taxed at the corporate level at the same rate, without regard to capital ownership and allowing or denying the imputation credit to the shareholders is an issue of how to tax shareholders, not corporations. it follows that no treaty requires foreign shareholders to receive the same tax credits as domestic shareholders. according to this analysis, there is no treaty violation. consider biddle v. commissioner, in which a u.s. taxpayer had u.s. and u.k income. under u.k. law at the time, shareholders of u.k. corporations were required to report as income, in addition to the amount of dividends actually received, amounts that reflected their respective proportions of the tax paid by the corporation on the distributions. the taxpayer argued that those amounts should be credited against their u.s. income tax. the court rejected the taxpayer’s argument, stating, at biddle v. comm’r, 302 u.s. 573, 581 (1938): our revenue laws give no recognition to that conception. although the tax burden of the corporation is passed on to its stockholders with substantially the same results to them as under the british system, our statutes take no account of that fact in establishing the rights and obligations of taxpayers… they have never treated the stockholder for any purpose as paying the tax collected from [vol. 11:2 columbia journal of tax law 26 response would be that the wht, or the compensatory tax, is not a “covered tax” and as such should not be subject to tax treaties (mainly because it is a new tax and not an income tax).159 if the united states were to entirely reform its domestic and international tax regimes, any new taxes that are similar to income taxes should not be subject to, and are not covered by, current tax treaties.160 as evident from the above examples, full-rate wht, or a new compensatory tax, is a necessary mechanism that would prevent substantial revenue loss in case a dpd form of integration were to be implemented. such a wht (or new compensatory tax) does not necessarily violate the current u.s. tax treaty network (with respect to the reduced wht rates those treaties provide or the nondiscrimination provisions). b. the current problems with the u.s. international tax regime the 2017 tax reform essentially adopts a dividend exemption system (to the extent the income is not subject to gilti), which allows u.s. mnes to repatriate future foreign earnings tax free or under a reduced rate (while past earnings were also subject to substantially reduced tax rates).161 this will presumably help achieve parity between u.s. companies and their foreign competitors and will increase the competitiveness of u.s. mnes vis-à-vis foreign competitors that are based in countries with territorial tax systems.162 a dividend exemption system is currently in place in twenty-eight out of the thirty-four oecd countries.163 territoriality, as its supporters claim, would stimulate greater economic activity and greater labor demand in the united states, would allow u.s. mnes to better compete with their foreign competitors, and would prevent u.s. mnes from accumulating earnings abroad in order to avoid tax liability resulting from repatriation.164 however, some question why the united states should permit taxpayers to borrow in the united states (and deduct their interest expenses), and then invest the proceeds abroad, effectively earning tax-exempt income under a territorial system. others answer that the added domestic investment, due to the expansion of u.s. mnes, will compensate for any u.s. revenue loss “so from the standpoint of the u.s. tax system, the borrowing does not simply generate uncompensated interest deductions, but instead a domestic tax base that is equivalent to (quite possibly greater than) the tax base that would be forthcoming if the borrowing proceeds were the corporation. nor have they treated as taxpayers those upon whom no legal duty to pay the tax is laid. measured by these standards our statutes afford no scope for saying that the stockholder of a british corporation pays the tax which is laid upon and collected from the corporation. 159 u.s. model tax convention art. 2(4) (2016). the united kingdom has taken a similar approach with its “diverted profits tax”, see reuven s. avi-yonah, three steps forward, one step back? reflections on 'google taxes', beps, and the dbct 2 (u. mich. pub. l. research paper no. 516, 2016). 160 bret wells, international tax reform by means of corporate integration, 20 fla. tax rev. 70, 107 (2016) (“a recent example of a major us trading partner taking this same position with respect to new legislation is provided by the united kingdom. in this regard, the united kingdom has taken the position that its new diverted profits regime is a new tax that is not ‘identical or substantially similar’ to any earlier uk income tax, and accordingly the uk has taken the position that its new diverted profits tax regime can be applied in preference to any treaty provision without violating its treaty obligations.”). 161 tax cuts and jobs act, 26 i.r.c. § 245a (2017). 162 see tax reform task force, supra note 30, at 28. 163 staff of s. comm. on finance, comprehensive tax reform for 2015 and beyond, 113th cong., 252 (2014). 164 id. at 241. 2020] the case for tax integration and current-base taxation 27 invested domestically by the same entity that does the borrowing.”165 however, this answer assumes that u.s. mnes will indeed stop shifting profits abroad, which may not be realistic due to the incentives to shift income abroad to attain lower tax rates.166 given the current dysfunctional transfer pricing system, this assumption might prove itself risky.167 regardless of revenue considerations, allowing u.s. mnes to exclude their foreign earnings from their taxable income would be a direct contradiction to the basic tax principle of fairness, as embedded in the principle of cen.168 assume there are two companies, both earning $100 a year. for the first company, all earnings are foreign sourced, but for the second company, all earnings are domestic sourced. on paper, those corporations should be taxed the same. this is due to basic quality considerations.169 as professor surrey wrote in 1956: our immediate concern is with united states corporations receiving income from foreign sources. here the concept of united states income taxation on worldwide income equally applies. consequently, an american corporation receiving income from a foreign source has always been subject to the united states income tax. an american corporation operating a branch in illinois and a branch in france is therefore subject to income tax on the profits of the french branch just as it is subject to tax on the profits of the illinois branch.170 surrey conceded several potential reasons for treating foreign income in a favorable manner, such as giving incentives to foreign trade and investment, enhancing the competitiveness of u.s. mnes, and furthering national security and foreign policy interests. 171 however, those justifications did not stop him from raising a somewhat obvious question: [i]f these arguments of incentive and competition and national security are regarded as pertinent to a consideration of the rate of corporate income tax to be applied to profits from foreign activities, they can be made equally persuasive as to domestic activities. able publicists could take arguments of this nature and with a 165 tax reform options: international issues: hearing before the s. comm. on finance, 112th cong. 10 (2011) (statement of professor james r. hines, jr.), available at https://www.finance.senate.gov/imo/media/doc/testimony%20of%20james%20hines.pdf [https://perma.cc/l723sknf]. 166 mcdonald, supra note 147, at 4. 167 tax reform options: international issues: before the s. comm. on finance, 112th cong. 3 (2011) (testimony of professor reuven s. avi-yonah), available at https://www.finance.senate.gov/imo/media/doc/testimony%20of%20reuven%20avi-yonah.pdf [https://perma.cc/fy6d-gv63]. 168 see slemrod & bakija, supra note 68, at 89 (defining horizontal equity as tax liability being equal for “those of equal wellbeing.”). 169 stanley s. surrey, current issues in the taxation of corporate foreign investment, 56 colum. l. rev. 815, 817818 (1956). 170 id. at 815. 171 id. at 816. [vol. 11:2 columbia journal of tax law 28 few twists here and there urge them to rationalize a lower rate of tax for one domestic industry as against another.172 furthermore, u.s. mnes might already be subject to a lower effective tax rate on their foreign earnings, compared to their foreign competitors,173 and those competitors are also usually subject to much tougher anti-deferral rules in their home countries.174 while congress might justifiably want to level the playing field and help u.s. mnes in their efforts to expand, it should also ensure these mnes are paying their “fair share” of taxes. it might just be that some of those who lobbied for territoriality care less for the u.s. economy and the competitiveness of u.s. mnes, and more for reducing their clients’ u.s. tax liability. as surrey puts so precisely, “[t]he loftier the principles involved, the less apt are the spectators to remember that the reduction achieved will in the first instance go to the marching crusaders.”175 the conclusion of all of the above is two-fold. first, a dpd form of integration should be adopted, such that the current debt-vs-equity distortion would be eliminated or substantially reduced. the dpd should be adopted in conjunction with a full rate wht to protect the u.s. revenue. second, foreign earnings should be subject to the same tax rates as domestic income to preserve horizontal equity and cen principles. a tax reform that would archive all of the above will be discussed in the next part. c. a proposal for a comprehensive tax reform 1. dpd and current-base taxation until the 2017 tax reform, tax deferral was the largest corporate expenditure.176 it accounted for 42% of corporate tax expenditures for the fiscal year of 2014.177 a territorial system, which will permanently exempt foreign earnings (and not just defer their u.s. taxation until repatriation) will cost even more. therefore, i call for a current-base taxation regime, under which foreign earnings will be taxed on a current basis, when earned, and at the full corporate tax rate. this can be achieved by including foreign earnings of a cfc, in its u.s. parent’s taxable income, when those earnings are earned, as originally intended by subpart-f.178 besides the obvious revenue considerations, this will also prevent the current incentive to shift income abroad. as discussed above, the current system results in a distortion in favor of foreign investment. subjecting foreign income to the same rate as domestic income will remove such distortion. in addition, i call for the adoption of a dpd form of tax integration. taxing all income, wherever earned, to the same tax rate, will obliterate the need to distinguish between domestic and foreign earnings and will 172 id. 173 reuven s. avi-yonah & yaron lahav, the effective tax rate of the largest us and eu multinationals 383–84 (u. mich. l. & econ, empirical legal studies ctr. working paper no. 11-015, 2011). 174 reuven s. avi-yonah & haiyan xu, global taxation after the crisis: why beps and maatm are inadequate responses, and what can be done about it 3 (u. mich. pub. l. research paper no. 494, 2016). 175 see surrey, supra note 169, at 840. 176 jane g. gravelle, cong. research serv., r44220, issues in a tax reform limited to corporations and businesses (2015). 177 id. 178 see nir fishbien, from switzerland with love: surrey’s papers and the original intent(s) of subpart-f, 38 va. tax rev. 1 (2018). 2020] the case for tax integration and current-base taxation 29 facilitate the adoption of tax integration, because all distributions of earnings that were previously taxed will give rise to the benefits of tax integration. the already reduced corporate tax rate (currently 21%), combined with tax integration, will provide a significant relief from the relatively high burden of corporate double taxation, allowing u.s. mnes to better compete in the global economy. it will eliminate (or substantially reduce) the debt-over-equity bias and the inefficient penalty on business activities carried through c corporations. the dpd form of integration is also relatively easy to administer. d. the problem of potential tax treaty violation as discussed in part iii, in order to avoid a potential revenue loss, a full-rate wht, or a new compensatory tax, equal to the rate of the corporate tax rate (currently 21%) should be introduced. this tax would also be imposed on distributions to foreign entities claiming treaty benefits. to avoid revenue loss, full-rate wht would be imposed on any distributions by a u.s. corporation to its shareholders. imposing such full-rate wht on foreign shareholders would achieve equal tax treatment and would not necessarily discriminate against foreign entities. one problem remains, however, in cases where the residence country of the foreign entity would not credit this wht. since domestic investors investing in the united states will benefit from the dpd, foreign investors will be worse-off because both the u.s. and the foreign country will deny them the benefits of tax integration. this, in turn, might discourage investment in the united states. accordingly, any adoption of tax integration will require the united states to negotiate with foreign countries that relief will be provided to foreign investors under tax integration. a new set of transition rules that will grant a temporary relief until such negotiations are concluded must also be introduced. v.conclusions the u.s. tax system has many distortions, but two are particularly prevalent. the first is that the current rules skew corporations’ preferences towards raising capital through debt rather than equity. under the current corporate double taxation mechanism, c corporations are incentivized to borrow because interest is deductible while dividends are not. the second that the rules incentivize foreign-over-domestic investment. under the current u.s. international tax regime, u.s. mnes are subject to a reduced tax rate, and in certain occasions are also exempt from u.s. tax on their foreign earnings; however, their domestic earnings are subject to the full corporate tax rate. in this article, i call for the adoption of a dpd form of tax integration and for current-base taxation of foreign earnings. the already reduced corporate tax rate (21%), combined with tax integration, will provide significant relief from the relatively high burden of corporate double taxation, allowing u.s. mnes to better compete in the global economy. it will eliminate (or substantially reduce) the debt-over-equity bias and the inefficient penalty on business activities carried through c corporations. current-base taxation will eliminate the current incentive to invest and shift income abroad, while providing a very important source of revenue. it will also obliterate the need to distinguish between domestic and foreign earnings and as such will facilitate the adoption of tax integration, because all distributions of earnings that were previously taxed will [vol. 11:2 columbia journal of tax law 30 give rise to the benefits of tax integration. finally, in order to avoid a potential revenue loss as a result of this new dpd, a full-rate wht or a new compensatory tax, equal to the rate of the corporate tax, should be introduced and implemented. the wht (or the compensatory tax) should be non-refundable, even to foreign and tax-exempt taxpayers. conglomerate spin-offs: whether u.s. tax law inhibits deconglomeration bryce maxey* abstract in this note, i examine whether the complex nature of the u.s. spin-off rules and the burdens associated with successfully navigating such rules discourage conglomerates from breaking up into smaller companies through tax-free spin-offs. first, i argue that there are numerous disadvantages of conglomeration, which generally tend to outweigh any economic benefits derived from the conglomerate form. next, i describe the statutory and nonstatutory requirements of tax-free spinoffs, evaluating particularly how each requirement may impact a conglomerate wishing to spin off one or more of its business units. because conglomerates are usually multinational corporations, i also briefly consider the tax consequences of spinning off a foreign company. in the following section, i discuss the issuance of private letter rulings in connection with conglomerate spin-offs and assess whether the i.r.s.’s recent policy changes have accelerated spin-off activity or, to the contrary, whether they have produced a chilling effect on conglomerate spin-offs. finally, i examine a recent example of a successful conglomerate spin-off— liberty’s spin-off of tripadvisor—before analyzing an example of a failed conglomerate spin-off—yahoo’s attempt to spin off alibaba. i conclude that, although tax-free spin-offs are occasionally unsuccessful, such failures are rare. even if the tax rules are byzantine and the monetary stakes are exceptionally high, conglomerates wishing to spin off business units typically manage to satisfy the requirements. therefore, although u.s. tax law does not completely hinder deconglomeration, spin-offs are nevertheless costly. fulfilling the spin-off requirements leads to economic inefficiencies because it entails expensive pre-spin-off restructuring and delays, as well as high transaction and friction costs. * j.d. 2022, columbia law school; ph.d. 2018, yale university; m.a. 2014, university of buenos aires, 2014; b.a. 2010, university of virginia. many thanks to gary mandel for his invaluable guidance and feedback in overseeing this note, to paul oosterhuis for helping me understand the tax consequences associated with conglomerate spin-offs in the cross-border context, to rick d’avino for providing me with a solid foundation in corporate tax law, and to professor jeffrey n. gordon for his help in developing this topic. 165 columbia journal of tax law [vol: 13:2 introduction .....................................................................................................166 i. the problems with conglomeration .........................................................167 ii. conglomerate spin-offs .............................................................................171 1. statutory requirements ........................................................................173 a. distribution of control ..............................................................173 b. active conduct of a trade or business .....................................173 c. nondevice..................................................................................175 2. additional statutory anti-abuse provisions .......................................176 a. section 355(d): “disqualified distributions” ............................176 b. section 355(e): anti-morris trust provision ............................177 3. nonstatutory requirements .................................................................178 a. corporate business purpose......................................................178 b. continuity of interest ................................................................180 4. two additional considerations ...........................................................180 a. section 367: international spin-offs .........................................180 b. private letter rulings................................................................182 iii. liberty’s spin-off of tripadvisor ............................................................183 iv. yahoo’s failed spin-off of alibaba ........................................................185 conclusion.........................................................................................................191 2022] conglomerate spin-offs 166 introduction following chief executive lawrence culp’s announcement in 2021 that general electric (“ge”) would split up into three smaller companies,1 ge’s stock price briefly surged, and investors and economists wondered why it had taken the company so long to take the necessary steps toward deconglomeration.2 allowing conglomerates to divest their business divisions is essential to improving corporate focus and specialization, increasing shareholder value, enhancing long-term corporate wellbeing, and enabling businesses to evolve as operational and economic circumstances change. moreover, ease and simplicity in conglomerate divestment are crucial for a well-functioning economy. nevertheless, the tax consequences of deconglomeration can be so costly that conglomerate managers may prefer to avoid divestment altogether. outright sales of business assets or corporate stock are almost always taxable events. thus, conglomerates often turn to the spin-off rules under section 355 of the internal revenue code (“i.r.c.” or “the code”) to divest their business units tax-free. satisfying the byzantine statutory and nonstatutory requirements for tax-free spinoffs,3 however, is not for the faint of heart. and failing to qualify as a tax-free spinoff can have disastrous results. the tax consequences of such a failure are draconian and—particularly in the case of conglomerates—can lead to tax liability in the billions of dollars. therefore, the stakes are incredibly high. in this note, i examine whether the complexity and severity of the spin-off rules in the united states discourage conglomerates like ge from breaking up into smaller companies through tax-free spin-offs. in part i, i discuss some of the benefits of conglomeration but then argue that the disadvantages associated with conglomeration tend to outweigh the benefits. in part ii, i review the statutory and common law requirements of spin-offs, focusing on how each requirement may impact a conglomerate wishing to spin off a business unit. i also briefly examine the difficulties that arise when a u.s. conglomerate wishes to spin off a foreign subsidiary and the issuance of private letter rulings in connection with conglomerate spin-offs—particularly, whether certain recent policy changes by the internal revenue service (“i.r.s.” or “the service”) have accelerated spin-off activity or, conversely, whether they have produced a chilling effect on conglomerate spin-offs. in part iii, i analyze a recent example of a successful conglomerate spin-off, liberty’s spin-off of tripadvisor. finally, in part iv, i 1 steve lohr & michael j. de la merced, g.e. breaks up with its storied past, n.y. times (nov. 9, 2021), https://www.nytimes.com/2021/11/09/business/general-electric-break-up.html [https://perma.cc/3m4g-3bqe]. 2 see alicia doniger, ge never made sense, says yale corporate leadership expert, cnbc (nov. 11, 2021), https://www.cnbc.com/2021/11/11/ge-never-made-sense-says-yale-corporateleadership-expert.html [https://perma.cc/y8gf-tuh6] (describing ge’s decision to split into three firms as long overdue). 3 n.y. state bar ass’n tax section, report no. 1342, report on notice 2015-59 and revenue procedure 2015-43 relating to substantial investment assets, de minimis active trades or businesses and c-to-ric spin-offs (2016), at 27 [hereinafter report no. 1342]. 167 columbia journal of tax law [vol: 13:2 examine an example of a failed conglomerate spin-off, yahoo’s attempt to spin off alibaba. i conclude that, although tax-free spin-offs are occasionally unsuccessful, such failures are rare. even if the tax rules are byzantine and the stakes are exceptionally high, conglomerates wishing to spin off business units usually manage to satisfy the requirements. therefore, although u.s. tax law does not completely hinder deconglomeration, spin-offs are costly. to satisfy the rules, companies must usually restructure in preparation for a spin-off. pre-spin-off restructuring is expensive because of the delays and friction costs that companies must endure. such costs often include consultations with outside legal and accounting experts followed by lengthy and expensive internal restructuring to comply with their advice. thus, the tax rules related to spin-offs lead to inefficiencies and economic distortions as conglomerates undergo complex restructurings in an attempt to satisfy their myriad requirements. i. the problems with conglomeration conglomerates are companies—usually corporations—comprised of multiple businesses. a conglomerate develops when a parent company begins to acquire a controlling stake in various smaller subsidiary companies.4 conglomeration can occur quickly as a result of a rapid succession of merger-andacquisition activity, or slowly through steady acquisitions over the span of many decades. although each subsidiary’s managers typically report to the senior management of the parent, each conglomerate subsidiary tends to conduct its business operations more or less independently of the parent, usually with separate boards of directors.5 the aggregation of multiple subsidiaries frequently renders conglomerates large and multinational. after world war ii, the united states experienced a boom in merger-andacquisition activity that led to the rapid creation of numerous conglomerates. many companies justified their shift toward conglomeration as a means of growth and value enhancement. proponents of conglomeration cited four main arguments in favor of such expansion. first, managers of conglomerates believed in the virtue of diversification at the firm level. this was also known as the “portfolio” effect of conglomeration.6 conglomerate managers claimed to have superior abilities vis-à-vis investors when it came to monitoring and allocating resources to promising new projects. by participating in different, often unrelated markets that offered uncorrelated revenue streams, conglomerates could dispel the risks of cyclical downturns in a single business. thus, a well-performing subsidiary’s gains could offset the losses of a subsidiary that was performing poorly. 4 james chen, conglomerate, investopedia (dec. 23, 2021), https://www.investopedia.com/terms/c/conglomerate.asp [https://perma.cc/lmt8-ynb5]. 5 id. 6 see gary t. haight, the portfolio merger: finding the company that can stabilize your earnings, 16 mergers & acquisitions 33-34 (1981) (describing the “portfolio” effect as an “acquisition benefit”). 2022] conglomerate spin-offs 168 second, conglomerates provided access to internal capital markets and internal labor markets. if external capital markets offered unfavorable rates, a conglomerate could rely on the size and breadth of its portfolio of subsidiaries to allocate capital through private internal borrowing and lending contracts at more favorable rates or on more favorable terms than could be obtained through banks or stock and bond markets.7 moreover, as an internal labor market, top conglomerate managers believed that their expertise in choosing and replacing divisional managers exceeded the expertise of a stand-alone firm’s board of directors.8 third, horizontal and vertical integration could help conglomerates take advantage of a wealth transfer from consumers to conglomerate firms. the acquisition of a greater share of market power allowed conglomerates to raise their prices at the expense of consumers. moreover, vertical integration could result in a reduction of costs through the exploitation of economies of scope—through which the average total cost of production decreases because costs are spread over a variety of products—and economies of scale—through which the increased output of goods or services yields a further cost advantage. finally, the size and interconnectedness of conglomerates could provide them with de facto immunity from takeovers, as well as a greater likelihood of obtaining governmental emergency assistance to avoid receivership or bankruptcy in the event of a major financial crisis. as a conglomerate grew larger, its number of potential acquirers tended to diminish because it became increasingly more expensive to take over. conglomeration shrinks the pool of acquirers because only very large companies likely would find themselves in a position to bid to acquire a gargantuan conglomerate. and, as the financial crisis of 2007-2009 showed, the larger and more interconnected the systemically important conglomerate—like aig or citigroup—the more concerned the regulatory authorities became in offering emergency support to prevent its downfall. failure of a systematically important financial conglomerate could unleash havoc on both the domestic and global economies.9 in recent decades, however, there has been growing consensus among economists and academics that the conglomerate form was operationally inefficient and ultimately costly for shareholders. the disastrous merger of america online and time warner in 2000 is a not-so-distant cautionary tale of the risks of conglomeration.10 there is strong evidence that many conglomerate acquisitions 7 see ronald j. gilson et al., the law and finance of corporate acquisitions 319 (3d. ed. forthcoming 2022) [hereinafter gilson et al.]; malcolm s. salter & wolf a. weinhold, diversification through acquisition 65-78 (1979). 8 gilson et al., supra note 7, at 332 (identifying internal labor markets as a “claimed advantage of the conglomerate firm”). 9 see sang yop kang, re-envisioning the controlling shareholder regime: why controlling shareholders and minority shareholders often embrace, 16 u. pa. j. bus. l. 843, 87880 (2014) (noting that conglomerates in countries like south korea are popular and successful, that development of a well-known name or brand is useful in export-oriented companies, and that government subsidies and preferential treatment come at expense of general taxpayers). 10 tim arango, how the aol-time warner merger went so wrong, n.y. times (jan. 10, 2010), https://www.nytimes.com/2010/01/11/business/media/11merger.html [https://perma.cc/2s6k-utrk] (“the trail of despair in subsequent years included countless job 169 columbia journal of tax law [vol: 13:2 decreased firm value but nevertheless occurred because of agency costs— particularly poor managerial incentives.11 first, diversification at the portfolio level has been shown to offer better returns than diversification at the firm level, which some scholars have dubbed “diworseification.”12 whereas outside investors in public companies examine stock prices that reflect other investors’ beliefs about value, the market often has trouble evaluating a conglomerate’s many business units separately.13 conglomerate managers tend to err in evaluating a single business unit’s prospects.14 rather than actually acquiring multiple subsidiaries, companies can instead acquire merely a stake in multiple subsidiaries.15 diversification at the portfolio level affords companies the benefits of diversification without the onerous burden of managing and operating multiple unrelated business units. second, there is no evidence that conglomerate managers are better than investors at allocating capital efficiently or better than the board of directors of stand-alone firms at choosing and replacing divisional managers. although access to internal capital markets may be beneficial, it is unclear whether such access contributes enough value to justify the transaction costs of a takeover. after all, an acquirer usually pays a premium for the shares of a target—particularly in a competitive bidding environment—due to the winner’s curse.16 conglomerate managers certainly have access to different information than do outside investors, losses, the decimation of retirement accounts, investigations by the securities and exchange commission and the justice department, and countless executive upheavals. today, the combined values of the companies, which have been separated, is about one-seventh of their worth on the day of the merger. to call the transaction the worst in history, as it is now taught in business schools, does not begin to tell the story of how some of the brightest minds in technology and media collaborated to produce a deal now regarded by many as a colossal mistake.”). 11 gilson et al., supra note 7, at 312. 12 louis lowenstein, sense and nonsense in corporate finance 161-66 (1991); see also haim levy & marshall sarnat, diversification, portfolio analysis and the uneasy case for conglomerate mergers, 25 j. fin. 795, 796 (1970) (“[a] conglomerate merger per se does not necessarily create opportunities for risk diversification over and beyond what was possible to individual (and institutional) investors prior to the merger.”). 13 gilson et al., supra note 7, at 330-31. 14 see id. 15 see r. hal mason & maurice goudzwaard, performance of conglomerate firms: a portfolio approach, 31 j. fin. 39, 45 (1976) (“we had expected the sample of conglomerate firms to either significantly outperform or at least perform as well as a set of randomly selected portfolios—simply because operating control should confer certain advantages to a diversified portfolio of assets. we find quite the opposite from the data at hand. the statistical tests indicate that the portfolios outperformed the conglomerates in terms of both rates of return on assets and accumulated stockholder wealth over the 1962 to 1967 period.”); gilson et al., supra note 7, at 339 (“mason & goudzwaard is representative of a large number of studies that reach the consistent conclusion that firm-level diversification reduces firm value.”); id. at 342 (“the best one can say is that there is no evidence of the value added that is needed to justify the acquirer paying a premium for the target. if anything, the evidence suggests that conglomerates turn 2 + 2 into a little bit less than 4, on average.”). 16 in m&a, the winner’s curse is the tendency for the winning acquirer to overpay for a target company in an auction-like scenario because of the competitive bidding dynamic that encourages the pool of potential acquirers to drive up target’s purchase price in excess of its intrinsic value. see gilson et al., supra note 7, at 330. 2022] conglomerate spin-offs 170 but different does not necessarily mean better.17 moreover, private companies offer outside investors detailed financial information prior to investment.18 with respect to the internal labor market argument, such intensive oversight is expensive, sophisticated private executive search firms are skilled in locating top managers, and the skills of a manager in one division of a conglomerate may not be transferable to a separate business unit.19 thus, it is unclear whether the conglomerate’s internal labor market works any better than an external market. and even if it does, it remains to be seen whether the comparative transaction costs offer the conglomerate a significant advantage that outweighs the transaction costs of an expensive acquisition.20 third, the benefits of horizontal and vertical integration may be short-lived, and the increased attention of antitrust regulatory authorities, the risk of hefty fines for engaging in antitrust violations in multiple jurisdictions, and bids from regulators to reduce market share by being broken up or reorganized may outweigh any such benefits. scholars during the wave of conglomeration in the 1960s and 1970s sounded the alarm that the ubiquitous amassing of such large concentrations of wealth and the combination of such a wide array of diverse business units were quickly creating cumbersome, bureaucratic institutions that threatened the economy and even democracy.21 fourth, companies can achieve immunity from takeovers without growing into corporate titans. through a shareholder rights agreement or “poison pill,” a board of directors without shareholder approval can force a hostile acquirer to become friendly. put differently, the threat of deploying a poison pill enables the board to compel a hostile acquirer to stop and negotiate. with respect to being too big to fail, increased size often comes at the cost of increased regulatory oversight, and such supervision can impose additional costs on the conglomerate. moreover, the empire-building hypothesis posits that conglomeration may result from corporate managers’ desire to seek growth in firm size not to maximize share price but instead “to justify better compensation and perquisites, to increase prestige, to expand opportunities for promotion, and . . . to protect themselves from the discipline of the market.”22 often, the larger the firm, the higher the salary and social standing of its managers. furthermore, the hubris hypothesis suggests that managers convince themselves that they are making good acquisitions even when they are not. and the winner’s curse hypothesis helps to explain why managers tend to overpay for acquisitions. conglomerate managers have an incentive to continue 17 see id. at 330-31. 18 see id. 19 see id. at 331. 20 see id. 21 doughtery jr. warns that private concentrations of economic power may breed antidemocratic forces that could threaten the fundamental institutions and traditions of the united states. see alfred f. dougherty jr., concentration, conglomeration, and economic democracy: a concurrent divestiture proposal, 11 antitrust l. & econ. rev. 29, 30-32 (1979) (“conglomerate mergers realize few, if any, efficiencies in specific product markets, probably confer no benefits on the economy as a whole, and may well impose substantial long-term social and political costs.”). 22 george w. dent, unprofitable mergers: toward a market-based legal response, 80 nw. u. l. rev. 777, 781 (1986). 171 columbia journal of tax law [vol: 13:2 to grow the firm through value-neutral or value-destroying acquisitions. such misguided acquisitions are one way in which cash-rich conglomerates waste excess cash.23 additionally, studies have found that conglomerates spend less on research and development than their industry peers.24 conglomerate managers may succeed in stabilizing a firm and its income stream, but such stabilization may offer no benefit to shareholders. it is estimated that one-third of all entities acquired between 1950 and 1977 were later sold off.25 conglomerates have been found to have low tobin’s q ratios—a comparison of the market value and replacement value of a company’s physical assets—which suggests high levels of managerial inefficiency in deriving value from corporate assets.26 economists believe that focus, fit, and specialization in a particular market are vital for value enhancement, whereas conglomerate diversification across multiple unrelated industries tends to drain operational efficiency and shareholder value.27 for all of these reasons, conglomeration is generally viewed as an undesirable, inefficient business structure. whatever benefits conglomerate managers touted during the wave of conglomeration that ensued after world war ii can be achieved through more efficient means. a tax-free spin-off is the best way for a conglomerate to downsize. ii. conglomerate spin-offs spin-offs are a kind of corporate division. a spin-off is a distribution of one of the businesses of a distributing corporation (“distributing” or “parent”) pro rata to its shareholders, who do not surrender any of their stock. put differently, in a spin-off, the parent separates from one of its subsidiaries by distributing all of that subsidiary’s stock to the parent’s shareholders. the result is that after the transaction, the parent and the spun-off subsidiary (“spinco”) become independent entities, although the parent’s shareholders continue to own stock in both the parent and the spinco. a key aspect in executing a spin-off is to ensure that the spin-off is structured as “tax-free” under section 355 for both the parent and the parent’s shareholders.28 at the corporate level, the advantage of the spin-off is the permanent tax benefit of truly tax-free treatment, which can save conglomerates billions of dollars. non-taxation at the entity level is the primary gift that the i.r.s. 23 see gilson et al., supra note 7, at 383. 24 see id. at 343. 25 id. at 341. 26 see id. 27 see id. at 331 (“[o]utside investors can specialize. one investor, or analyst, or bank loan officer, can focus on auto parts suppliers, another on specialty chemicals, another on computers. in contrast, the conglomerate manager probably oversees only one firm in any one industry, and must divide his attention among a number of disparate businesses. once again, the conglomerate manager lacks information available to the outside investor; in this case, the background knowledge that comes from specialization.”). 28 unless i specify otherwise, references to sections of statutory provisions refer to the i.r.c. 2022] conglomerate spin-offs 172 provides in allowing corporations to split up under section 355, and this corporatelevel non-taxation is the primary motivation for tax-free spin-offs. parent’s shareholders receive only the benefit of deferral of gain recognition. section 355 is intended to provide tax-free treatment to transactions in which each company continues with a robust business following the separation.29 through tax-free spin-offs, congress wished to provide a means of enabling corporations to divide ongoing operating business units in such a way that the different continuing businesses could persist, albeit in a modified corporate structure.30 section 355 promotes economic efficiency and the well-being of capital markets by allowing large, unwieldy conglomerates to break themselves up into smaller business units for bona fide corporate purposes.31 because congress believes that a mere readjustment of business interests within a corporation should not be impeded by gain recognition at either the corporate or the shareholder level, section 355 allows each company to avoid such gain recognition and to operate distinct business units following the separation but with a certain degree of shareholder continuity.32 the transaction at issue in gregory v. helvering embodied a perceived abuse of the tax-free spin-off rules in which the taxpayer separated and distributed principally passive non-business assets.33 here, the taxpayer attempted to use the spin-off rules to avoid paying corporate-level taxes on appreciated shares.34 the case reached the supreme court, which found that the dividend distribution was sham-like, lacked any real business purpose, and constituted a tax-avoidance device.35 gregory v. helvering is a paradigmatic example of a taxpayer’s near perfect adherence to formal statutory requirements—the letter of the law—that 29 see report no. 1342, supra note 3. 30 see id. 31 see id. 32 see id. 33 gregory v. helvering, 293 u.s. 465 (1935). 34 evelyn gregory was the sole shareholder of united mortgage corporation (“umc”) and was entitled to receive dividends from umc. umc, in turn, owned 1,000 outstanding shares of monitor securities corporation (“msc”). gregory wished to dispose of her interest in msc, but if umc sold the msc shares and distributed the proceeds to gregory as a dividend, both umc and gregory would be taxed at the high rates applicable to dividend income at that time. thus, gregory performed a corporate reorganization to avoid such tax treatment. in the reorganization, gregory had umc transfer the msc shares to a newly formed spinco. the spinco then issued its shares to gregory. after four days, gregory had the spinco liquidate and distribute the msc stock to herself. gregory then sold the msc stock to a third party for cash. gregory argued that the receipt of the spinco stock was not a recognition event because the shares were received as part of a reorganization. gregory recognized the capital gain on the receipt of the msc stock and took a stepped-up fair market value basis in the msc stock after the liquidation. thus, she recognized no gain or loss on the subsequent sale of the msc stock. the commissioner argued that the spinco should be ignored because of its sham-like, transitory nature and lack of any substantive business purpose. the government viewed the transaction as if umc had sold the msc shares for cash and distributed the proceeds to gregory in a cash dividend. the supreme court agreed with commissioner, finding that the transaction lacked any business purpose and was merely a “device which put on the form of a corporate reorganization as a disguise for concealing its real character, and the sole object and accomplishment of which was the consummation of a preconceived plan, not to reorganize a business . . . but to transfer a parcel of corporate shares to the petitioner.” id. 35 id. 173 columbia journal of tax law [vol: 13:2 nevertheless violated the spirit of the law. the case has served as an important lens through which the government and taxpayers have interpreted the spin-off rules for almost a century. to qualify for tax-free treatment under section 355, the transaction must satisfy two common law requirements: corporate business purpose and continuity of interest. moreover, three major statutory requirements must also be met: distribution of sufficient control, the active conduct of a trade or business, and nondevice. in addition, congress in recent decades has enacted additional statutory provisions in response to perceived abuses of section 355, including section 355(d) and section 355(e). finally, section 367 contains provisions that turn off nonrecognition for a u.s. corporation that spins off a foreign business with appreciated assets. 1. statutory requirements a. distribution of control spin-off transactions must result in distribution of control. the parent must distribute either all of its stock in the spinco or a sufficient amount so as to place the parent shareholders in control of the spinco.36 “control” is defined as ownership of stock that entails possession of at least both 80% of the total combined voting power of all classes of stock entitled to vote, as well as 80% of the total number of shares of each other class of stock of the corporation.37 this provision is important because if the parent does not maintain sufficient control over spinco, the spin-off begins to resemble the sale of a business unit, and sales are generally taxable transactions.38 the control requirement does not seem particularly problematic for conglomerates to satisfy and overcome because it is a mechanical test. conglomerates are often sitting on business units and holdings that they have accumulated over decades. although satisfying the control requirement may necessitate some pre-spin-off internal corporate restructuring, as long as conglomerates navigate this mechanical rule carefully, it should not stand in the way of deconglomeration through a spin-off. b. active conduct of a trade or business the active trade or business provision requires that parent and spinco be “engaged in the active conduct of a trade or business immediately after the 36 see kotran et al., spin-offs: overview, practical law practice note overview 2-5031986. 37 id. 38 moreover, any spinco stock that parent acquired in a taxable transaction during the five years before the spin-off is deemed “hot stock” and does not qualify for tax-free treatment. see spinoffs: tax overview, supra note 36. here, the government wishes to prevent parent from using excess cash to buy shares of spinco and then distribute those shares to stockholders as an in-kind but tax-free dividend. id. 2022] conglomerate spin-offs 174 distribution”39 and that the trade or business has been “actively conducted throughout the five-year period ending on the date of the distribution.”40 activities qualify as trade or business activities if they are for the purpose of earning income or profits.41 such activities include every operation that forms part of earning income, and the activities must generally include the receipt of income and payment of expenses.42 by contrast, the “holding for investment purposes of stock, securities, land, or other property, or [t]he ownership and operating (including leasing) of real or personal property used in a trade or business, unless the owner performs significant services with respect to the operation and management of the property,” does not constitute active conduct of a trade or business.43 proposed regulations from 2016 (“the 2016 proposed regulations”) imposed a threshold for the size of the active trade or business, which must be at least 5% of the total assets for each of parent and spinco.44 the 2016 proposed regulations, however, today serve only as guidance because they were never finalized and therefore expired after three years.45 but in revenue procedures over the past few decades, including revenue procedure 2021-3, the i.r.s. has expressed discomfort with spin-off transactions where the fair market value of the trade or business on which the distributing corporation relies to satisfy the active trade or business requirement is less than 5% of the fair market value of the total gross assets of the corporation.46 the active conduct of a trade or business provision helps to ensure that the spin-off is not used as a vehicle to disguise a dividend distribution or subsidiary sale. much like the device requirement discussed below, its purpose is to prevent the use of a spin-off as a mechanism for distributing excess cash as a dividend to parent shareholders. a low percentage of business assets may be evidence of an abusive transaction in which the spin-off is being used as a device to distribute earnings and profits. unlike the corporate business purpose requirement, the active trade or business requirement can be a difficult hurdle to overcome, particularly in light of the 2016 proposed regulations and revenue procedure 2021-3. although expired proposed regulations are technically not authoritative—and although revenue procedures are low-level guidance—both can still have an impact on tax practitioners’ advice and, therefore, on corporate behavior. a conglomerate wishing to spin off a subsidiary combining nonqualifying holdings for investment purposes will need to ensure that the size of the active trade or business that it spins off together with the holdings exceeds 5% of spinco. thus, this rule may preclude conglomerates from offloading large holdings of appreciated stock because the larger the stake in passive holdings, the larger the active trade or business must be 39 treas. reg. § 1.355-3(a)(i). 40 treas. reg. § 1.355-3(b)(iv)(3). 41 see treas. reg. § 1.355-3(b)(2). 42 see id. 43 treas. reg. § 1.355-3(b)(2)(iv). 44 see prop. treas. reg. § 1.355-9, 81 fed. reg. 46004 (july 15, 2016). 45 the i.r.s. may not challenge a transaction solely based on guidance issued in proposed regulations. 46 see e.g., rev. proc. 2021-3, 2021-1 i.r.b. 140; rev. proc. 2003-48, 2003-2 c.b. 86. 175 columbia journal of tax law [vol: 13:2 that accompanies the stake in the spin-off. however, through an internal corporate restructuring in anticipation of a spin-off, a conglomerate can likely customize the spinco to ensure that the transaction satisfies the 5% requirement. as i discuss in parts iii and iv, because conglomerates are by definition large and consist of numerous business units, finding an active business unit to spin off together with large passive shares is usually not overly cumbersome or prohibitive. c. nondevice tax-free treatment under section 355 is not afforded to any “transaction used principally as a device for the distribution of the earnings and profits of the distributing corporation, the controlled corporation, or both.”47 factors that constitute evidence of device include: a pro rata distribution among the shareholders of the distributing corporation,48 a subsequent sale or exchange of stock (“the greater the percentage of the stock sold or exchanged after the distribution, the stronger the evidence of device . . . the shorter the period of time between the distribution and the sale or exchange, the stronger the evidence of device”),49 and the nature, kind, amount, and use of the assets (for example, a high ratio of cash and other liquid assets not related to the reasonable needs of the business weighs in favor of device).50 on the other hand, factors weighing against a finding of device include a strong corporate business purpose,51 the extent to which the parent is a widely held, publicly traded company (where a corporation is publicly traded and has no shareholder that is “the beneficial owner of more than five percent of any class of stock is evidence of nondevice”),52 and the “fact that the stock of the controlled corporation is distributed to one or more domestic corporations that, if section 355 did not apply, would be entitled to a [dividendsreceived] deduction under section 243 . . . is evidence of nondevice.”53 moreover, if the corporation has no earnings and profits to bail out in the first place or if redemption treatment would apply to the transaction, a spin-off is ordinarily not deemed to be a device. the primary policy reason for the nondevice requirement stems from the government’s awareness that, as in gregory, “a tax-free distribution of the stock of a controlled corporation presents a potential for tax avoidance by facilitating the avoidance of the dividend provisions of the code through the subsequent sale or exchange of stock of one corporation and the retention of the stock of another corporation.”54 the government wishes to disallow the conversion of earnings and profits of what would otherwise be ordinary dividend income into capital gain through the device or vehicle of a tax-free spin-off. although dividend income may 47 treas. reg. § 1.355-2(d)(1). 48 treas. reg. § 1.355-2(d)(2)(ii). 49 treas. reg. § 1.355-2(d)(2)(iii). 50 treas. reg. § 1.355-2(d)(2)(iv). 51 treas. reg. § 1.355-2(d)(3)(ii). 52 treas. reg. § 1.355-2(d)(3)(iii). 53 treas. reg. § 1.355-2(d)(3)(iv). 54 treas. reg. § 1.355-2(d). 2022] conglomerate spin-offs 176 be taxed at the same rates as the long-term capital gain that shareholders would realize if they sold their controlled stock immediately after a section 355 distribution, there are still reasons why taxpayers may prefer capital gains over dividend income.55 the fact that conglomerates tend to be widely held and publicly traded corporations helps to constitute evidence of nondevice for conglomerate spin-offs. publicly traded conglomerates with no significant shareholder will probably be less motivated to bail out earnings and profits for the benefit of their shareholders.56 moreover, large public companies have more straightforward means of returning excess cash to shareholders.57 for example, they can engage in share tenders rather than facing the uncertainty and complex requirements of section 355.58 2. additional statutory anti-abuse provisions a. section 355(d): “disqualified distributions” section 355(d) may require that a parent recognize gain on certain distributions of stock or securities in a controlled subsidiary.59 this section considers whether a distribution is “disqualified” from corporate-level nonrecognition treatment because it is more akin to a disguised sale rather than a mere change in corporate form. stock in the distributing corporation of one of its controlled subsidiaries is considered “disqualified stock” if it was acquired by purchase within the five-year period ending on the date of the distribution.60 if so, the distribution will trigger gain to the distributing corporation as if the stock were sold to the distributee shareholders at its fair market value. section 355(d) does not, however, alter the nonrecognition treatment available to the shareholder distributees.61 section 355(d) can be a particularly burdensome hurdle for a multinational conglomerate to overcome because the conglomerate may have engaged in stock 55 see report no. 1342, supra note 3, at 24-25 (“[w]hen a taxpayer receives stock of a controlled corporation in a spin-off, it allocates a portion of its basis in its stock of distributing to the controlled stock received in the distribution. as a result, gain realized in a subsequent disposition of either distributing or controlled will generally be less than the amount of dividend income the taxpayer would have had to include in gross income if the distribution had been taxed as a dividend . . . the treasury recognized this potential for tax avoidance and, as part of the 1989 regulations, broadened the definition of device to include “a transaction that effects a recovery of basis. . . . second, in the case of individual taxpayers, capital gains are preferred to dividend income because the former may be offset by capital losses. thus, the device concern could be relevant even where a shareholder has little or no basis in the shareholder’s shares. third, foreign shareholders generally prefer capital gain over dividend income, because capital gain is not subject to withholding, while dividends are subject to 30 percent withholding, subject to reduction under treaties.”). 56 see id. at 27. 57 see id. 58 see id. 59 § 355(d)(2)(a). 60 § 355(d)(3). 61 douglas a. kahn & jeffrey h. kahn, principles of corporate taxation 243 (2d ed. 2019). 177 columbia journal of tax law [vol: 13:2 acquisitions within five years of a planned spin-off that would cause it to hold disqualified stock and therefore to engage in a “disqualified distribution.”62 if a distribution is disqualified, “no stock or securities of any of the controlled corporations will be treated as ‘qualified property,’ and any unrealized appreciation in such stock or securities will be taxed to the distributing corporation in the same manner as with other appreciated property.”63 section 355(d) is often particularly onerous for multinational conglomerates that have structured their foreign lines of business in unique ways to comply with the laws or differing economic realities of foreign jurisdictions. thus, section 355(d) can force them to engage in circuitous and costly internal tax planning to separate out their intertwined foreign companies and lines of business in preparation for a tax-free spin-off. b. section 355(e): anti-morris trust provision a spin-off transaction will not be tax-free if the distribution is “part of a plan (or series of related transactions) pursuant to which 1 or more persons acquire directly or indirectly stock representing a 50[%] or greater interest in the distributing corporation or any controlled corporation.”64 moreover, “[i]f 1 or more persons acquire directly or indirectly stock representing a 50[%] or greater interest in the distributing corporation or any controlled corporation during the 4-year period beginning on the date which is 2 years before the date of the distribution, such acquisition shall be” presumed to be pursuant to a plan unless the taxpayer can offer evidence to the contrary.65 taxpayers engaged in so-called morris trust transactions66 when they tried to circumvent the repeal of general utilities by using spin-offs to dispose of unwanted businesses in preparation for a tax-free acquisition by another 62 § 355(d)(2). 63 § 355(d); kahn, supra note 60, at 243. 64 § 355(e)(2). 65 id. § 355(e)(2)(b). 66 see herbert n. beller, section 355 revisited: time for a major overhaul?, 72 tax law. 131, 149-50 (2018) (“long before the enactment of section 355(e), in commissioner v. morris trust, prior to merging into a national bank, a state banking corporation spun-off an unwanted insurance department that the acquiring bank could not legally operate under federal law. the post-spin statutory merger separately qualified as a type ‘a’ reorganization (under section 368(a)(1)(a)), and, despite its planned occurrence immediately after the spin-off, the disappearance of distributing pursuant to the merger, and the transfer of its active business assets to the acquiring corporation, the separate section 355 qualification of the spin-off was not disturbed. consistent with the morris trust decision, similarly structured transactions subsequently flourished with the service's blessing. section 355(e) is often referred to as the ‘anti-morris trust provision.’ that label stems from certain high profile morris trust transactions during the mid-1990s that involved substantial pre-spin borrowing by distributing or controlled and an ultimate separation of the borrowing proceeds from the debt obligation (which was effectively assumed by the corporation acquiring distributing or controlled as partial consideration for the acquisition). it was the leveraging features of these transactions that initially caused ‘disguised sale’ concerns at treasury. but as ultimately enacted, section 355(e) applies as well to nonleveraged morris trust transactions where the 50% change in ownership threshold is breached and a proscribed ‘plan’ exists. for that and other reasons, the provision has been criticized by bar groups and other commentators as much broader than necessary to address the perceived abusive situations.”). 2022] conglomerate spin-offs 178 corporation.67 congress enacted section 355(e) in 1997 to stymie such transactions.68 but there are a number of safe harbors that allow conglomerate corporations to evade this requirement through careful tax planning.69 because conglomerates tend to engage in frequent mergers and acquisitions, careful navigation of section 355(e) is of particular importance for conglomerates to succeed in spinning off a business unit tax-free. 3. nonstatutory requirements a. corporate business purpose conglomerates have many valid reasons for engaging in spin-off transactions that the i.r.s. will respect. the section 355 regulations provide that the corporate business purpose requirement is independent of the statutory requirements.70 the spin-off must have a “real and substantial non federal tax purpose germane to the business of the distributing corporation, the controlled corporation, or the affiliated group.”71 valid corporate business purposes include: resolution of shareholder disputes; enabling management to focus on core businesses while allocating to non-core divisions separate resources and managerial attention to increase operating efficiencies and realize greater shareholder value; maximizing shareholder value in business units that are particularly successful and have high growth potential that the market may be undervaluing because of their 67 see azebu et al., a new role for the device test?, 150 tax notes 1427, 1430, 1432 (mar. 21, 2016) (“in general utilities, the supreme court held that corporations could distribute appreciated property to their shareholders tax free. . . . the tax reform act of 1986 added section 311(b), effectively repealing the general utilities doctrine. regarding the decision to repeal general utilities, the house committee report states: ‘the general utilities rule tends to undermine the corporate income tax. under normally applicable tax principles, nonrecognition of gain is available only if the transferee takes a carryover basis in the transferred property, thus assuring that a tax will eventually be collected on the appreciation. where the general utilities rule applies, assets generally are permitted to leave corporate solution and to take a stepped-up basis in the hands of the transferee without the imposition of a corporate-level tax. thus, the effect of the rule is to grant a permanent exemption from the corporate income tax.’ under section 311(b), if a corporation distributes appreciated property to its shareholders, the corporation must recognize gain as if that property were sold at its fmv. thus, following the repeal of general utilities, the code generally imposes two levels of tax . . . on distributions of appreciated property, including stock, outside corporate solution. to further combat the inevitable efforts of taxpayers to mitigate this double taxation, congress enacted section 337(d), which provided broad authority to treasury to issue regulations necessary to enforce the principles of general utilities repeal. section 337(d) states that treasury ‘shall prescribe such regulations as may be necessary or appropriate to carry out the purposes of’ general utilities repeal, including ‘regulations to ensure that such purposes may not be circumvented through the use of any provision of law or regulations . . . or through the use of a regulated investment company, real estate investment trust, or tax-exempt entity,’ and ‘regulations providing for appropriate coordination of the provisions of this section with the provisions of this title relating to taxation of foreign corporations and their shareholders.’”). 68 id. 69 see spin-offs: tax overview, supra note 36 (describing ten types of safe harbors under section 355(e)). 70 § 1.355-2(b)(1). 71 § 1.355-2(b)(2). 179 columbia journal of tax law [vol: 13:2 affiliation with slow-growth or declining business units; allowing the adjustment of executive and employee compensation packages in more narrow business units; separating a subsidiary in preparation for a sale to a third party; disposing of businesses that no longer fit within the business plan and that may be illiquid or lack a fair current market valuation; permitting spinco to raise capital by seeking financing separately; defending from a takeover by spinning off a valuable subsidiary, thus rendering the parent less attractive as a hostile takeover target; complying with antitrust or other regulatory decrees by changing the structure and regulatory regimes to which the parent and spinco are subject; removing conflicts among different lines of business; providing employees with an equity interest; facilitating a stock offering, borrowing or an acquisition of either the parent or spinco; generating significant cost savings; enhancing fit and focus; solving competitive concerns; and risk reduction by shielding one business from the risks of another.72 the business purpose must be a proper, corporate-level—as opposed to a purely shareholder-level—motivation. moreover, the reduction of non-federal tax may be a valid corporate business purpose only if the transaction does not result in a reduction of federal and non-federal taxes because of similarities in their respective laws or the reduction of federal tax exceeds the reduction of non-federal tax.73 in addition, a business purpose fails if the same objectives can be met through a non-taxable transaction that does not require the distribution of stock. for example, if creating a subsidiary rather than spinning off a business unit is a convenient alternative mechanism that is “neither impractical nor unduly expensive,” the transaction will fail the business purpose requirement.74 thus, the government requires that businesses wishing to take advantage of tax-free treatment articulate a business reason for the spin-off. out of concern that taxpayers like gregory will exploit the spin-off rules to avoid paying corporatelevel taxes, the government requires that companies state that the spin-off be motivated by one or more corporate business purposes. however, it would seem that even noncreative taxpayers and lawyers could fairly easily devise pretexts for a spin-off that in fact has the primary purpose of tax avoidance. one benefit of this requirement for the government, however, is that if a corporation states a qualifying business purpose—for example, in a press release or private letter ruling request— and then later changes course and fails to engage in the stated activity, the i.r.s. may be able to challenge the transaction as motivated by tax avoidance rather than by a bona fide corporate business purpose. nevertheless, most of the corporate business purposes that satisfy this requirement are rather vague. for example, the i.r.s. would have a difficult time challenging a conglomerate that stated a desire to enhance “fit and focus” as a pretext for spinning off a subsidiary for tax avoidance purposes. the i.r.s. will likely only challenge a company’s stated business purpose if it is unreasonable or frivolous, if it is a pure shareholder purpose, if it can be accomplished in a convenient alternative mechanism, or if it reduces federal tax by more than it 72 spin-offs: tax overview, supra note 36; rev. proc. 96-30, 1996-1 c.b. 696. 73 § 1.355-2(b)(2). 74 § 1.355-2(b)(3). 2022] conglomerate spin-offs 180 reduces non-federal tax. thus, the common law corporate business purpose requirement seems fairly easy to overcome and difficult to challenge in practice. business purpose is a highly factual analysis that depends on whether a disinterested party would find the business purpose reasonable. because it is generally easy to navigate, this requirement likely does little to discourage deconglomeration. b. continuity of interest the other common law requirement is continuity of interest, which encompasses both continuity of business enterprise and continuity of proprietary interest. continuity of business enterprise requires that the “businesses existing prior to the separation” be continued.75 the exact length of time required for continuing the businesses is nowhere explicitly stated, but in practice, distributing and controlled should each continue to operate at least one of their substantial historic businesses.76 continuity of proprietary interest is understood as requiring that “a substantial portion of the consideration received by parties to a reorganization consist of an ongoing equity interest in the surviving enterprise.”77 in the case of spin-offs, the current regulations require that “one or more persons who, directly or indirectly, were the owners of the enterprise prior to the distribution or exchange own, in the aggregate, an amount of stock establishing a continuity of interest in each of the modified corporate forms in which the enterprise is conducted after the separation.”78 the rationale behind the continuity of interest requirements is again to help to ensure that the spin-off resembles a mere change in form as opposed to a sale.79 as long as a conglomerate wishing to engage in a spin-off makes sure that the conglomerate and spinco continue to operate at least one substantial historic business and at least one of the shareholders who historically owned an interest in the conglomerate before the division owns an amount of stock that establishes a continuity of interest in each of the modified corporate forms following the transaction, this requirement should be met without great difficulty.80 4. two additional considerations a. section 367: international spin-offs conglomerates today are almost by definition international entities. a u.s. multinational may have strong corporate business reasons to pursue a spin-off a controlled foreign corporation (“cfc”). certain tax provisions in the code and 75 treas. reg. § 1.355-1(b). 76 kahn, supra note 61, at 224. 77 id. at 225. 78 treas. reg. § 1.355-2(c)(1). 79 treas. reg. § 1.355-1(c). 80 if at least one shareholder of distributing owns at least 50% of the equity in each of the corporations after the transaction, the continuity of proprietary interest requirement will be met. rev. proc. 77-37, 1977-2 c.b. 568; treas. reg. § 1.368-1(e)(8), ex. (1). 181 columbia journal of tax law [vol: 13:2 regulations, however, make spinning off an entirely or predominantly foreign business with appreciated assets by a u.s. conglomerate highly disadvantageous by requiring gain recognition. much as section 367(a) overrides nonrecognition in what would otherwise be a tax-free transaction under section 351—and much as treasury regulation section 1.367(b)-3 overrides nonrecognition for an inbound liquidation that would otherwise be tax-free under sections 332 and 337—so too section 367(e)(1) and treasury regulation section 1.367(b)-5 turn off nonrecognition for individual distributees in what would otherwise be a tax-free spin-off of a cfc. section 367(e)(1) states that “[i]n the case of any distribution described in section 355 . . . by a domestic corporation to a person who is not a united states person, to the extent provided in regulations, gain shall be recognized under principles similar to the principles of this section.”81 moreover, treasury regulation section 1.367(b)-5(b)(1)(ii) adds that “[i]f the distributee is an individual, then, solely for purposes of determining the gain recognized by the distributing corporation, the controlled corporation shall not be considered to be a corporation, and the distributing corporation shall recognize any gain (but not loss) realized on the distribution.”82 because these provisions override nonrecognition only for individual distributees, they may not seem too onerous at first glance. in practice, however, u.s. multinational conglomerates tend to have many—and sometimes even a majority of—foreign and individual shareholders.83 therefore, attempting to spin off a cfc with appreciated assets is often prohibitively expensive. restructuring a transaction to circumvent section 367(e)(1) and treasury regulation section 1.367(b)-5 requires navigating the complex anti-inversion provisions and related regulations under section 7874, which include numerous traps for the unwary.84 therefore, the spin-off rules in the international arena can be viewed as punishing multinational conglomerates wishing to downsize. in light of various changes in the 2017 tax cuts and jobs act including the section 245a 100% “exemptive deduction” for most dividends received from 10%-owned foreign corporations, the government may need to reconsider whether some of the inbound provisions under section 367(b) still make sense today. 81 § 367(e)(1). 82 § 1.367(b)-5(b)(1)(ii). 83 u.s. individuals and foreigners often constitute more than half of a multinational conglomerate’s shareholder base. in addition, mutual funds and tax-exempts typically own large blocks of the stock of multinational conglomerates. whether mutual funds and tax-exempts are treated as corporations or individuals for the purposes of these provisions is unclear. see devon bodoh et al., cross border spin-offs, tax webinar series, weil, gotshal & manges llp (mar. 10, 2021), https://www.weil.com/~/media/mailings/2021/q1/210310cross-border-spinoffs.pdf [https://perma.cc/v5bq-qecj]. 84 see § 7874; bodoh et al., supra note 81 (“section 7874 provides potentially detrimental u.s. tax consequences to a u.s. corporation that undergoes a transaction whereby all of its assets are acquired by a foreign corporation . . . and greater than a threshold percentage of foreign acquirer stock . . . is received by the u.s. corporation’s shareholders by reason of holding u.s. corporation stock.”). 2022] conglomerate spin-offs 182 b. private letter rulings before a conglomerate performs a high-stakes, tax-free spin-off— particularly one in which some aspect of the transaction might be considered abusive, novel, or uncertain—it may seek a private letter ruling from the i.r.s. the decision to request a private letter ruling depends on many factors, including cost, speed, certainty, and risk.85 the process is costly and slow, and there are risks associated with having a request denied.86 it may be “better not to ask than to ask and be denied.”87 regardless of whether the company requests a private letter ruling, it will undoubtedly request that its tax counsel approve the transaction. typically, corporations require “will-level”—or at a minimum “should-level”— opinions from a reputable law firm and one of the big-four accounting firms.88 the i.r.s. has changed its policies over the past couple of decades with respect to the private letter ruling procedures for spin-offs. in 2003, the i.r.s. announced that it would stop issuing rulings on whether a spin-off constitutes a device, whether the stated corporate business purpose for a spin-off is legitimate, and whether a spin-off and a related acquisition constitute a plan under section 355(e).89 these new “no-rule” areas made spin-offs slightly riskier and more uncertain. in 2005, the i.r.s. announced that it would attempt to expedite the private letter ruling process by issuing its decisions within ten weeks of receiving a request.90 and in 2009, the i.r.s. allowed taxpayers to request rulings on the discrete aspects of a spin-off within an integrated transaction without ruling on the larger transaction.91 these were taxpayer-friendly policy changes because the former policy change hastened the issuance of so-called “comfort rulings,” and the 85 robert w. wood, tax opinion or private letter ruling? a 12-point comparison, 149 tax notes 835, 835 (nov. 9, 2015). 86 id. 87 id. 88 tax practitioners offer different levels of opinion to express their varying levels of comfort with a given transaction. see robert p. rothman, tax opinion practice, 64 tax law. 301 (winter 2011) (explaining and quantifying tax lawyers’ varying comfort levels). “will” opinions represent the highest level of comfort, with a roughly 90% chance that a particular consequence will ensue. id. at 312, 327. “should” represents a reasonably high level of confidence, around 70-90% likelihood, that the position will be sustained. id. at 313, 327. “more likely than not” reflects a comfort level roughly between 50-70%. id. at 314, 327. “substantial authority” means “the weight of authorities in support of the position is substantial in relation to the weight of authorities supporting contrary treatment.” id. at 319. this type of opinion reflects a 35-40% comfort level. id. at 327. “[a] position has a ‘realistic possibility of success’ if a reasonable and well-informed analysis by a person knowledgeable in the tax law would lead such person to conclude that the position has approximately a one-in-three, or greater, likelihood of being sustained.” id. at 321. “reasonable basis” is higher than “merely arguable” or “merely . . . colorable.” id. at 322. finally, “not frivolous” is the lowest level at which there is still “some modicum of comfort as to a position,” where prior regulations defined “frivolous” as “patently improper.” id. at 324. 89 rev. proc. 2003-48, supra note 46. 90 rev. proc. 2005-68, 2005-2 c.b. 694. see j. william dantzler jr., spin-offs: still remarkably tax friendly, 129 tax notes 683 (nov. 8, 2010) (observing that i.r.s. still takes fourteen to seventeen weeks on average, but its ten-week goal is viewed positively by taxpayers). 91 see rev. proc. 2009-25, 2009-1 c.b. 1088 (explaining circumstances under which i.r.s. may issue letter rulings). 183 columbia journal of tax law [vol: 13:2 latter policy change allowed taxpayers to avoid disclosing extensive details about the overall context of the spin-off if they so desired. nevertheless, in 2013, the i.r.s. changed course. the service altered its former policy of ruling on an entire spin-off transaction to a new policy of ruling on only one or more significant issues presented by the transaction.92 in 2017, however, the i.r.s. reversed course, once again allowing taxpayers to obtain a private letter ruling on the entire spin-off transaction rather than on only one or more significant issues.93 although one might expect the 2013 policy change to have chilled the frequency of spin-off transactions, it seems that companies that were already considering spin-offs instead rushed to submit private letter ruling requests before the change went into effect.94 moreover, many companies continued to undertake “plain vanilla” spin-offs that did not present high levels of uncertainty and that were based solely on the opinions of their tax advisers—a practice that only expanded after the 2013 policy change.95 when the i.r.s. reverted to its previous practice in 2017, many tax lawyers had already grown comfortable advising on spin-offs without the i.r.s.’s blessing, and taxpayers became accustomed to relying solely on the advice of law firm and accounting firm opinions. as it turned out, costly, time-consuming comfort rulings were not as vital as taxpayers may have previously believed.96 an additional benefit of phasing out private letter rulings was that companies could avoid describing all related transactions that pertained to the spinoff.97 therefore, conglomerates’ decreased reliance on private letter rulings and increased reliance on opinion letters by tax counsel has likely made spin-offs less burdensome and more feasible in recent years. iii. liberty’s spin-off of tripadvisor in august 2014, liberty interactive corporation (“liberty”), an american media conglomerate that operated a broad range of digital commerce businesses including qvc and expedia, announced its completion of a tax-free spin-off of tripadvisor, inc. (“tripadvisor”).98 liberty bundled its 22% stake in tripadvisor with an online retail subsidiary called buyseasons, creating a new publicly traded 92 rev. proc. 2013-32, 2013-28 i.r.b. 55; rev. proc. 2013-28, 2013-27 i.r.b. 28. see amy elliott, irs expands no-rule policy to spin-offs to save money, 14 tax notes 23, 23-24 (july 1, 2013) (summarizing i.r.s.’s new policy). 93 rev. proc. 2017-52, 2017-41 i.r.b. 283. 94 see elliott, supra note 92 (noting that when i.r.s. previously cut back on corporate letter ruling program, taxpayers rushed to submit rulings before no-rule policy went into effect). 95 jasper a. howard, considerations in seeking private letter rulings for spin-offs, tax notes 1365, 1366 (may 27, 2019). 96 see id. (predicting taxpayers will continue solely to use tax opinions due to ease of execution). 97 id. 98 press release, liberty interactive corporation, liberty interactive corporation announces completion of liberty tripadvisor holdings spin-off (aug. 27, 2014), https://www.sec.gov/archives/edgar/data/ 1355096/000155837014000156/lint-20140827ex991479fde.htm [https://perma.cc/8wfz-yeqs]. 2022] conglomerate spin-offs 184 company called liberty tripadvisor holdings.99 the media conglomerate needed to package the large stake in tripadvisor with buyseasons to satisfy the 80% control requirement in section 355. liberty could have taken the 22% stake in tripadvisor and formed a new company to meet the control requirement, but this transaction would not have met the active trade or business requirement. thus, liberty created the newco liberty tripadvisor holdings and distributed into it the online retail subsidiary and a 22% stake in tripadvisor. the transaction qualified as a tax-free reorganization under sections 355 and 368(a)(1)(d). liberty’s board of directors was specifically forbidden from waiving a condition precedent that the conglomerate receive a will-level opinion from its tax counsel, and liberty’s law firm, baker botts llp, provided the will-level opinion, deeming the transaction proper.100 although the spin-off transaction contained some potentially abusive ingredients on which the i.r.s. refused to rule, the government ultimately blessed the transaction in a private letter ruling in 2014.101 to satisfy the nonstatutory corporate business purpose requirement, liberty offered a description of the transaction’s benefits in its request for a private letter ruling.102 the media conglomerate explained that liberty and tripadvisor would achieve higher stock prices as a result of the spin-off, rendering tripadvisor a “significantly more attractive acquisition” target.103 this would enable both the parent and spinco to “more efficiently . . . compensate their officers and employees.”104 the i.r.s. has acknowledged that increasing the stock price can constitute a compelling business purpose for a spinoff as long as the possible share price increase is not a “pure” shareholder concern. that is, the company must also draw a link between an increase in the share price and some benefit at the corporate level, such as helping to improve cash flow so that management may purchase a necessary business asset. here, what would otherwise be a pure shareholder purpose, a higher stock price, satisfied the corporate business purpose requirement because the boost in share value would supposedly help to attract corporate buyers. in accordance with its no-rule policy on the legitimacy of a transaction’s business purpose,105 the i.r.s. expressed no opinion as to whether the spin-off met the corporate business purpose requirement. the transaction satisfied the active trade or business requirement because, before the transaction, liberty and buyseasons 99 vindu goel & michael j. de la merced, i.r.s. look at spin-offs may affect yahoo plan, n.y. times (may 19, 2015), https://www.nytimes.com/2015/05/20/technology/irs-look-at-spinoffs-may-affect-yahoo-plan.html [https://perma.cc/b9g5-uems]. 100 see liberty tripadvisor holdings, inc., registration statement (form s-1) (may 5, 2014), https://sec.report/document/0001047469-14-004609/#ca71601_the_spin-off [https://perma.cc/x6uv-3rbz]; amy s. elliott, yahoo may waive receipt of favorable ruling spin-off condition, tax analysts (july 21, 2015), http://www.taxhistory.org/www/features.nsf/articles/5c5bf388237946ad85257e89005caecd ?opendocument [https://perma.cc/z4q7-eexp]. 101 see i.r.s. priv. ltr. rul. 2014-35-005 (aug. 29, 2014) (discussing rationale behind i.r.s.’s ruling). 102 see id. 103 id. at 5. 104 id. at 6. 105 rev. proc. 2003-48, supra note 46. 185 columbia journal of tax law [vol: 13:2 presented “gross receipts and operating expenses representing the active conduct of a trade or business for . . . five years.”106 in its request for a private letter ruling, liberty represented, among other things, that the spin-off was “not being used principally as a device for the distribution of the earnings and profits” of buyseasons or spinco, and that “the spin-off [was] not part of a plan or series of related transactions (within the meaning of § 1.355-7) pursuant to which one or more persons [would] acquire . . . stock representing a 50[%] or greater interest (within the meaning of § 355(d)(4)) in distributing or controlled.”107 as it did with respect to the business purpose requirement, the i.r.s. cautioned that it expressed no opinion regarding these issues either.108 the i.r.s. flagged two potentially concerning aspects of liberty’s spin-off: (1) whether the transaction satisfied the nondevice requirement, and (2) whether the transaction constituted a plan or series of related transactions in violation of the anti-morris trust provision under section 355(e).109 the i.r.s. flagged the nondevice requirement because the spinco would consist primarily of a large, appreciated 22% stake in tripadvisor—a passive investment—combined with a very small active trade or business, the online retailer buyseasons. the inclusion of buyseasons could therefore be seen as pretextual. the spin-off’s overall purpose was likely to enable a tax-free distribution of the tripadvisor shares. founded in 1999, buyseasons grew to 550 employees by 2011, but it reduced its operations to around 350 employees by 2014.110 thus, buyseasons’s size paled in comparison to liberty’s stake in tripadvisor. moreover, the spin-off was in anticipation of an acquisition: rubie’s costume co. acquired buyseasons in 2017.111 although the i.r.s. may have expressed some reservations about the transaction, it nevertheless approved liberty’s spin-off of liberty tripadvisor holdings, and the tax-free transaction was executed unchallenged. but the i.r.s. was growing increasingly concerned about potentially abusive spin-offs. the i.r.s. reached its breaking point when yahoo announced its plans to perform a tax-free spin-off of its massive, appreciated stake in alibaba, combined with the comparatively tiny yahoo small business. iv. yahoo’s failed spin-off of alibaba by 2016, yahoo! inc. (“yahoo”) had grown into an internet conglomerate. yahoo was founded in 1994 as a directory of websites.112 in the following years, it created a search engine and began to offer email, shopping, and news supported by 106 i.r.s. priv. ltr. rul. 2014-35-005, supra note 101, at 5. 107 id. at 9, 11. 108 id. at 13. 109 id. 110 melanie lawder, buyseasons acquired by rubie’s costume co., milwaukee bus. j. (july 5, 2017), https://www.bizjournals.com/milwaukee/news/2017/07/05/buyseasons-acquiredby-rubies-costume-company.html [https://perma.cc/mn7h-pkdm]. 111 see id. (discussing rubie’s costume co.’s acquisition of buyseasons). 112 goel & de la merced, supra note 99. 2022] conglomerate spin-offs 186 ad revenue.113 although its market capitalization soared to $125 billion during the dot-com bubble, yahoo lost its competitive edge to google and facebook in the early 2000s.114 as a result, yahoo attempted to recast itself as a content company, but this was at a time when users were transitioning from web portals to apps and social networks.115 in 2005, yahoo bought 40% of alibaba holding ltd. (“alibaba”), a major chinese e-commerce group, for $1 billion in cash plus the transfer of yahoo’s chinese internet operations to alibaba.116 around 2013, yahoo began an acquisition frenzy, acquiring dozens of companies, including tumblr.117 when alibaba went public in 2014, yahoo still owned a 15% stake in the firm.118 yahoo also owned a 35.5% stake in yahoo japan.119 after alibaba’s ipo, activist shareholder pressure mounted for yahoo to design a plan to distribute the appreciated shares of alibaba to yahoo’s shareholders. rather than disposing of the shares outright, which would have triggered a large corporate-level tax and would have required that yahoo’s shareholders pay some $10 billion in capital gains taxes,120 yahoo hoped to craft a tax-free spin-off of its alibaba stake that would enable yahoo to avoid over $16 billion in tax liability.121 following the i.r.s.’s approval of liberty’s spin-off of tripadvisor, yahoo decided to pursue a similar spin-off strategy.122 yahoo wished to extract its 15% interest in alibaba to enable markets to value yahoo’s core internet business independently of its alibaba holdings. if the initial spin-off was successful, yahoo contemplated a subsequent, similar tax-free spin-off of its 35.5% stake in yahoo japan. therefore, yahoo had valid business reasons for spinning off the alibaba shares and thus would have little trouble satisfying the corporate business purpose requirement. like liberty, yahoo believed that the separation of yahoo’s core internet business from the massively appreciated shares of alibaba would enable markets to value yahoo’s core operations independently and that yahoo would trade at a higher price as a result of the spin-off. nevertheless, yahoo could not spin off alibaba alone because it lacked sufficient ownership to satisfy the distribution of control requirement. therefore, yahoo had to include another business within spinco to satisfy the control test, as well as the active trade or business requirement. according to estimates by analysts at the time, if yahoo’s disposition of alibaba were taxed, yahoo’s stock was expected to have a fair market value of $40 per share.123 on the other hand, a tax-free spin-off would place the yahoo shares closer to $55 per share.124 moreover, like liberty, yahoo was 113 id. 114 id. 115 id. 116 id. 117 id. 118 id. 119 id. 120 see young ran (christine) kim & geeyoung min, insulation by separation: when dual-class stock met corporate spin-offs, 10 u.c. irvine l. rev. 1, 16-17 (2019). 121 see joshua d. blank, the timing of tax transparency, 90 s. cal. l. rev. 449, 485-86 (2017). 122 id. at 490. 123 see goel & de la merced, supra note 99. 124 id. 187 columbia journal of tax law [vol: 13:2 also interested in facilitating an acquisition of the small business unit it would spin off together with the shares.125 yahoo’s tax counsel, skadden, developed the following plan. first, yahoo would create a spinco called aabaco to which it would convey all of its 384 million alibaba shares, which were valued at $40 billion.126 together with the large stake in alibaba, yahoo would tack on a legacy ancillary small business, yahoo small business, to fulfill the control and active trade or business requirements.127 yahoo small business was an operating unit that, although profitable, never fit in well with the rest of yahoo’s portfolio of businesses.128 because yahoo had operated the small legacy business for more than five years, yahoo’s counsel expected it to satisfy the active trade or business requirement. yahoo felt confident in its strategy because the i.r.s. had approved liberty’s 2014 spin-off. moreover, despite statements in revenue procedures that the active trade or business should represent at least 5% of the total assets of the distributing corporation and the distributed corporation to satisfy section 355, revenue ruling 73–44 has expressed that the size of the active business was immaterial.129 in other words, the small business did not need to represent any particular percentage of the value of the business’s total assets. yahoo small business, however, was estimated to constitute less than 0.2% of the total value of the spinco.130 whether the spin-off would be seen as a transaction used principally as a device for distributing earnings and profits was, therefore, another potential problem. on the one hand, yahoo was widely held, and the spin-off could be justified by a strong corporate business purpose. these factors weighed in favor of nondevice. on the other hand, the spinco would hold an exceedingly high ratio of inactive or passive assets—the alibaba holdings— compared to its total assets. this weighed rather strongly in favor of device. yahoo’s endgame was for alibaba eventually to acquire the spinco in exchange for some amount of its own stock, thus placing yahoo’s alibaba shares into the hands of yahoo’s shareholders without any immediate tax consequences. if yahoo had distributed its alibaba stock directly to yahoo’s shareholders, this transaction would have produced a taxable gain at yahoo’s entity level under section 311(b), as well as taxable dividend income for the shareholders who received the distributions. under treasury regulation section 1.355–7(b)(2), to achieve tax-free status, the spin-off and business combination must not be part of a plan or of a series of related transactions that together constitute a plan.131 a plan is defined as “an agreement, understanding, arrangement or substantial negotiations regarding the acquisition or a similar acquisition at some time during the two-year period ending on the date of the distribution.”132 yahoo had no such agreement and 125 id. 126 id. 127 id. 128 id. 129 see rev. rul. 73-44, 1973-1 cb 182. 130 see amy s. elliott, size does matter: wellen explains new hot dog stand regs, 152 tax notes 480, 480 (july 25, 2016). 131 treas. reg. § 1.355-7(b)(2). 132 id. 2022] conglomerate spin-offs 188 had not engaged in any substantial negotiations with potential acquirers, so the business combination could presumably take place shortly after the completion of the spin-off. nevertheless, the parties planned to delay any merger for more than a year to avail themselves of a one-year safe harbor in the regulation.133 when yahoo announced the proposed spin-off transaction on january 27, 2015, the media criticized the plan as undeserving of the tax-free benefit.134 and when the i.r.s. refused to issue a private letter ruling blessing the transaction, yahoo’s stock price fell by over 10%.135 skadden, nevertheless, issued a will-level legal opinion affirming its confidence that the deal would be tax-free at both the entity and shareholder levels.136 in response to yahoo’s proposed spin-off—as well as other potentially abusive distributions involving rics and reits—the i.r.s. issued notice 2015– 59 (“the notice”) and a request for comments relating to sections 337(d) and 355.137 with respect to section 355, the government noted three transactional characteristics of concern. first, “ownership by the distributing corporation or the controlled corporation of investment assets, within the meaning of § 355(g)(2)(b), with modifications (investment assets), having substantial value in relation to (a) the value of all of such corporation’s assets and (b) the value of the assets of the active trade(s) or business(es) on which the distributing corporation or the controlled corporation relies to satisfy the requirements of § 355(b) (a qualifying business or qualifying business assets)”; second, “a significant difference between the distributing corporation’s ratio of investment assets to assets other than investment assets and such ratio of the controlled corporation”; and third, ownership by the distributing corporation or the controlled corporation of a small amount of qualifying business assets in relation to all of its assets.”138 the i.r.s. in the notice added transactions displaying these qualities to its list of “no-rule areas.”139 the notice explained that certain taxpayers in their requests for private letter rulings had been taking positions that their proposed transaction structures satisfied the requirements of section 355 despite exhibiting one or more of these concerning characteristics.140 the notice stated that such transactions had some or all of the following infirmities: 1) presenting evidence of device for the distribution of earnings and profits; 2) lacking an adequate business purpose or a qualifying business; 3) violating other section 355 requirements; 4) circumventing the purposes of certain provisions intended to repeal general utilities & operating co. v. helvering; and 5) the distributing corporation or the controlled corporation owning a small amount of qualifying business assets compared to its other assets (non-qualifying business assets).141 133 see treas. reg. § 1.355-7(d). 134 see kim & min, supra note 120, at 16-17. 135 see blank, supra note 121, at 485-86. 136 see elliott, supra note 100, at 374-75. 137 howard, supra note 95, at 1366. 138 i.r.s. notice 2015-59, 2015-2 c.b. 459. 139 id. 140 see id. 141 see id. 189 columbia journal of tax law [vol: 13:2 yahoo’s proposed alibaba spin-off involved the small active trade or business issue—what some refer to as a “candy store” or “hot dog stand”—and resembled a device because the spinco was exceedingly investment-heavy.142 despite its general language, it seemed clear that the i.r.s.’s notice was written partly in response to yahoo’s proposed spin-off. because of the notice, yahoo abandoned its original structure and pursued a different structure: a reverse spin-off. 143 the reverse spin-off was an alternative means of achieving a similar result in which yahoo would spin off its core assets, including its stake in yahoo japan: “yahoo’s assets and liabilities other than the alibaba stake would be transferred to a newly formed company, the stock of which would be distributed pro rata to yahoo shareholders resulting in two separate publicly-traded companies.”144 the reverse spin-off would reduce the potential tax liability but would not address many of the concerns that the i.r.s. raised in the notice.145 according to tax practitioners who were involved in the transaction, although the reverse spin-off was controversial and included certain elements of risk, skadden and simpson thacher—which was also involved in the tax planning—both expressed confidence that the reverse spin-off would work. the reverse-spinoff, however, contained many of the same infirmities as the original spin-off structure, and ultimately, yahoo determined that the likelihood was too high that the i.r.s. 142 see amy s. elliott, hot dog stand guidance will expand on factor in device regs, 151 tax notes 1458, 1458-59 (june 13, 2016). the policy behind the 2006 enactment of section 355(g), which prohibits “cash-rich” split-offs, is similar to the rationale underlying the regulatory response to yahoo’s proposed spin-off of alibaba. section 355(g) limits the amount of investment assets (that is, cash, corporate securities, debt instruments, options, forward or futures contracts, notional principal contracts, derivatives, foreign currencies, or assets of a like nature) that either parent or spinco may own immediately after a distribution. see § 355(g). section 355 does not apply to “any distribution which is part of a transaction if (a) either the distributing corporation or controlled corporation is, immediately after the transaction, a disqualified investment corporation, and (b) any person holds, immediately after the transaction, a 50-percent or greater interest in any disqualified investment corporation, but only if such person did not hold such an interest in such corporation immediately before the transaction.” § 355(g)(1). a disqualified investment corporation is any corporation in which the fair market value of its investment assets is equal to or greater than two-thirds of the fair market value of all of its assets. § 355(g)(2)(a). before the enactment of section 355(g) prohibiting “cash-rich” split-offs, a shareholder of parent could exchange its stock in the parent for stock of a controlled subsidiary holding a substantial amount of cash or other liquid assets in proportion to its other assets in a transaction intended to qualify for nonrecognition treatment under section 355. see report no. 1342, supra note 3, at 26. congress enacted section 355(g) to disallow transactions that resemble cash redemptions of the stock in distributing that is held by a large shareholder. see id. the government was concerned about transactions intended to cash out large shareholders on a tax-free basis by having distributing contribute the sale consideration to a controlled corporation and splitting it off under section 355 to the shareholder in exchange for the shareholder’s distributing shares. see id. 143 see kim & min, supra note 120, at 16-17. 144 yahoo provides update on planned spin off of remaining stake in alibaba group, ex. 99.1, https://www.sec.gov/archives/edgar/data/1011006/000119312515398244/d93711dex991.htm [https://perma.cc/qey9-b266]. 145 see alan s. kaden & michael j. alter, 2015 in review: tax regulators attempt to strike back, law360 (jan. 4, 2016). 2022] conglomerate spin-offs 190 might end up challenging the transaction’s tax-free status—placing billions in tax liability at stake.146 thus, yahoo abandoned the reverse spin-off as well. as i mentioned above, the government issued the 2016 proposed regulations, likely in response to yahoo’s high-profile proposed spin-off,147 to offer guidance concerning certain statutory requirements under section 355.148 although not authoritative, the 2016 proposed regulations announced potentially significant policy changes with respect to the device test and the minimum size for an active business. the i.r.s. introduced a device test with two prongs that, if met, would render a distribution a “per se device.” a spin-off would now be deemed a per se device if 1) distributing or controlled has a nonbusiness asset percentage of 662/3% or more of the total assets and 2) the nonbusiness assets percentage of distributing or controlled is a) 662/3% or more but less than 80% of the total assets, and the nonbusiness assets percentage of the other corporation is less than 30% of the total assets, b) 80% or more but less than 90% of the total assets, and the nonbusiness assets percentage of the other corporation is less than 40% of the total assets, or c) 90% or more of the total assets, and the nonbusiness assets percentage of the other corporation is less than 50% of the total assets.149 as discussed in part ii above, the active trade or business requirement previously could be satisfied regardless of the size of the historic active trade or business assets in comparison to the nonbusiness assets held by distributing and controlled.150 under the 2016 proposed regulations, however, a spin-off would be deemed a per se device if the proportion of nonbusiness assets to total assets met this new bright-line, two-prong test. similarly, the proposed regulations stated that for the requirements of sections 355(a)(1)(c) and 355(b) to be satisfied, the five-year-active-business asset percentage of each of controlled and distributing must be at least 5% of their total assets.151 although yahoo’s preferred transactional structure, a tax-free spin-off, and alternative structure, a tax-free reverse spin-off, were both unsuccessful because of the i.r.s.’s resistance through its tightening of the tax rules in the 2016 proposed regulations, yahoo did not give up and resign itself to retaining its conglomerate form. in 2017, the company pursued a different strategy and sold its core internet business to verizon communications for $4.48 billion in a taxable transaction.152 yahoo’s stockholders retained shares in a new company called altaba, which then 146 see kim & min, supra note 120, at 17. 147 see brett wells, reform of section 355, 68 am. u. l. rev. 447, 491-93 (2018). 148 see prop. treas. reg. § 1.355-9, supra note 44. 149 id. see also laurence m. bambino et al., treasury and irs issue new spin-off proposed treasury regulation on device and active trade or business requirements, sherman & sterling llp (july 15, 2016), https://www.shearman.com/media/files/newsinsights/publications/2016/07/treasury-and-irs-issuenew-spinoff-proposed-treasury-regulations-on-device-and-active-trade-or-business-requirementstax-071516.pdf [https://perma.cc/j2z2-9s9e]. 150 see rev. rul. 73-44, 1973-1 c.b. 182. see also wells, supra note 147, at 491-93. 151 see prop. treas. reg. § 1.355-9, supra note 44. 152 see vindu goel, verizon completes $4.48 billion purchase of yahoo, ending an era, n.y. times (june 13, 2017), https://www.nytimes.com/2017/06/13/technology/yahoo-verizonmarissa-mayer.html/ [https://perma.cc/gx7y-pgqb]. 191 columbia journal of tax law [vol: 13:2 owned a $52 billion stake in alibaba and a $9 billion stake in yahoo japan.153 in 2021, private equity firm apollo global management bought verizon’s media business consisting of yahoo and aol in a deal worth $5 billion.154 apollo has expressed that it hopes to capture value by increasing focus on the individual media brands that have been “lost inside a large corporate empire.”155 proposed regulations offer only non-binding guidance to taxpayers. the i.r.s. never finalized the 2016 proposed regulations that dissuaded yahoo from pursuing a spin-off or reverse spin-off. thus, they expired in 2019, three years after their issuance. does this mean that a conglomerate wishing to pursue a strategy like liberty’s spin-off of tripadvisor or yahoo’s attempted spin-off of alibaba could succeed today? possibly, but probably not. although the 2016 proposed regulations have expired, the i.r.s. has reiterated in various revenue procedures over the decades—and as recently as 2021—its stance that the active trade or business should represent at least 5% of the total assets of the distributing corporation and the distributed corporation to satisfy section 355.156 where so much is at stake and the risks of failure are so great, conglomerates should ensure that they fulfill the requirements under section 355, and it would be wise to follow the i.r.s.’s guidance, even if it has expired. many areas of tax law—like the taxation of certain financial instruments—lack any binding precedent. in such cases, practitioners must rely on whatever guidance is available. therefore, practitioners should do their best to follow the i.r.s.’s guidance related to spin-offs—even when such guidance has expired or is technically nonbinding. conclusion scholars and investors view deconglomeration as value-enhancing and beneficial to the real economy. fortunately for conglomerates, u.s. tax law does not make tax-free spin-offs impossible. although the spin-off rules are complex, burdensome, and byzantine, conglomerates in particular have ample resources to hire skilled teams of tax lawyers and accountants with extensive experience in navigating the spin-off rules to avoid the harsh consequences of failing to qualify under section 355. expert tax and accounting advice can all but ensure tax-free treatment provided that each of the statutory and common law requirements for taxfree spin-offs is satisfied and as long as the transaction does not overtly violate less authoritative guidance that appears in proposed—albeit expired—regulations and revenue procedures. tax law practitioners sometimes even refer to the spin-off rules as “taxpayer-friendly” because corporations are usually able to satisfy the requirements and take advantage of tax-free treatment under section 355.157 one 153 see id. 154 see edmund lee & lauren hirsch, yahoo and aol, early internet pioneers, are sold to private equity firm, n.y. times (may 3, 2021), https://www.nytimes.com/2021/05/03/business/verizon-aol-yahoo-sale.html/ [https://perma.cc/h2lc-dyqu]. 155 see id. 156 see, e.g., rev. proc. 2021-3, 2021-1 i.r.b. 140. 157 see dantzler jr., supra note 90. 2022] conglomerate spin-offs 192 important exception is the gain recognition requirement for u.s. conglomerates wishing to spin off a foreign business with appreciated assets. thus, the crossborder spin-off rules do in fact inhibit deconglomeration efforts by u.s. multinationals. the failure of yahoo’s spin-off constitutes an extremely rare, high-profile example of a conglomerate failing in its efforts to achieve a tax-free spin-off. rather than allowing yahoo to pursue the spin-off and then later challenging the transaction and assessing a $16 billion deficiency, the i.r.s. sent yahoo and its tax counsel clear signals that the plan seemed abusive and that the transaction likely would not qualify for tax-free treatment if yahoo executed either the spin-off or reverse spin-off. such warnings persuaded yahoo to reevaluate its plan and to pursue alternative, less tax-favorable strategies. here, instead of acting like a hostile adversary looking to seize on billions in potentially unpaid taxes, the i.r.s. comported itself more like a business-friendly partner or consultant that guided yahoo to pursue an approved deconglomeration strategy that would avoid devastatingly draconian results. if a spin-off transaction does not qualify for tax-free treatment, conglomerates can seek to break themselves into smaller business units using other routes: taxable stock sales, taxable asset sales, exchanges, closures, bankruptcies, or restructurings.158 but such alternatives are never as beneficial as a spin-off because they all give rise to immediate corporate-level tax liability, whereas section 355 provides the unparalleled gift of no imposition of tax at the entity level. as a flurry of conglomerates including ge, johnson & johnson, merck, and toshiba either contemplate or begin downsizing,159 tax-free spin-offs remain a critical tool for conglomerates—a vital tax-planning strategy that enables deconglomeration and thus benefits conglomerates, their shareholders, and the overall economy. 158 see michael mankins et al., how the best divest, harv. bus. rev. (oct. 2008), https://hbr.org/2008/10/how-the-best-divest/ [https://perma.cc/n8l2-h3zz]. 159 see kevin dowd, death to conglomerates: ge, j&j and toshiba all reveal plans to break themselves up, forbes (nov. 14, 2021), https://www.forbes.com/sites/kevindowd/2021/11/14/death-to-conglomerates-ge-jj-and-toshibaall-reveal-plans-to-break-themselves-up/?sh=6c677a584d70/ [https://perma.cc/2lrq-sdap]. introduction i. the problems with conglomeration ii. conglomerate spin-offs 1. statutory requirements a. distribution of control b. active conduct of a trade or business c. nondevice 2. additional statutory anti-abuse provisions a. section 355(d): “disqualified distributions” b. section 355(e): anti-morris trust provision 3. nonstatutory requirements a. corporate business purpose b. continuity of interest 4. two additional considerations a. section 367: international spin-offs b. private letter rulings iii. liberty’s spin-off of tripadvisor iv. yahoo’s failed spin-off of alibaba conclusion microsoft word fixing five flaws of the tax cuts and jobs act_print.docx fixing five flaws of the tax cuts and jobs act kimberly a. clausing* abstract the tax legislation commonly referred to as the tax cuts and jobs act (public law 115-97) came into effect in 2018. the new tax law was flawed in five important ways. first, the law generates large deficits that will reduce the ability of the government to fund important priorities in the future; these deficits also risk justifying a more tepid fiscal response to the next recession. second, after more than 35 years of increasing income inequality, the tax law moves the tax system in a regressive direction. third, while the legislation increases economic efficiency in some ways, it decreases economic efficiency in other ways, moving the tax system away from optimal design principles. fourth, the legislation misses an opportunity to combat profit shifting by multinational companies, changing the character of the problem but leaving its scale largely undiminished; also, the law provides new incentives for the offshoring of physical investment. and fifth, the legislation introduces new sources of complexity. this paper explains these five flaws in detail, setting the analysis within the context of relevant literature and facts. thereafter, the paper suggests both short term and more fundamental ways to reform the tax code. nearly immediately, simple fixes can address most of the tcja flaws. moving forward, a true tax reform can modernize the tax system to better handle the challenges posed by economic inequality, climate change, and the global nature of business activity. * thormund a. miller and walter mintz professor of economics at reed college. [vol. 11:2 columbia journal of tax law 32 table of contents i. introduction .................................................................................................... 33 ii. deficits ............................................................................................................... 34 iii. income inequality ........................................................................................ 38 iv. efficiency ........................................................................................................ 49 v. the offshoring of multinational activity ...................................... 53 vi. tax administration .................................................................................... 59 vii. fixing the tcja .............................................................................................. 61 viii. building a better tax reform............................................................. 65 ix. conclusion ...................................................................................................... 71 appendix a: estimating the revenue from a 21% per-country minimum tax .......................................................................................................... 74 appendix b: a bolder tax reform ................................................................ 75 2020] fixing five flaws of the tax cuts and jobs act 33 i. introduction a good tax system raises the revenue needs of the state in a way that is sensitive to fairness, efficiency, and tax administration. while the wisdom of that simple sentence is undeniable, the u.s. tax system has fallen short of these laudable goals for some time. first, the revenues raised by the federal tax system are insufficient in comparison with our fiscal priorities; while deficits and debt have been handled without disruption so far, the trajectory of debt over the coming decades looms large at the same time that urgent priorities go unfunded. second, despite increases in income inequality over the prior generation, the tax system has become more regressive in several important ways. the tax system can, and should, do far more to respond to pressing concerns regarding wage stagnation and soaring inequality. third, in terms of efficiency, the present tax system favors some industries over others, some forms of income over others, and some locations of income over others, all leading to tax-motivated economic decisions that distort the nature of economic activity. and finally, our tax system is notoriously complex, and i.r.s. funding is insufficient to smoothly administer the existing tax system. from this starting point, enter the 2017 tax legislation known as the tax cuts and jobs act (tcja).1 the main provisions of the law follow. • individual tax rates are cut for the period 2018 to 2025. • on a temporary basis, the standard deduction is increased, personal exemptions are repealed, and the state and local tax deduction is limited to $10,000. • the threshold for the estate tax is doubled, to $11 million, temporarily. • on a temporary basis, 20% of pass-through business income is no longer taxable for some pass-through businesses. • the corporate tax rate is cut permanently, from 35 to 21%. • foreign income of corporations is permanently exempt from taxation, subject to some base protection measures.2 previously, foreign income was taxed at the domestic tax rate (35%) upon repatriation, with foreign tax credits for tax paid abroad.3 while some aspects of the new tax law should be retained, overall the law is severely flawed. in addition to increasing deficits by nearly two trillion dollars over ten years, the tcja makes the tax system less progressive, less efficient, and more difficult to administer. the closing sections of the paper provide simple and practical ways to improve the tax system, beginning from the posttcja starting point. 1 the official title of the law is public law 115-97. budget fiscal year, 2018, pub. l. no. 115-97, december 22, 2017, 131 stat 2054. 2 id. there is a minimum tax on foreign income earned by u.s. multinationals of half the u.s. tax rate; this tax is payable only on returns (relative to physical assets) that exceed 10%. the minimum tax is assessed on a global basis, so foreign tax credits from tax paid in higher-tax countries can offset the minimum tax due from operations in lowtax countries. there is also a second minimum tax known as the beat (for base erosion and anti-abuse tax) that affects all multinational companies; it is triggered by excessive deductible payments to related parties. 3 id. under the tcja, there is a one-time tax on prior unrepatriated foreign earnings of u.s. corporations. these earnings are taxed at a rate of either 8 or 15.5%, less foreign tax credits. [vol. 11:2 columbia journal of tax law 34 ii. deficits it is abundantly clear that the tax law will increase budget deficits as well as the debt burden of the united states. originally, the joint committee on taxation (jct) estimated tcja would cost $1.5 trillion.4 including the additional interest payments due to higher debt, the congressional budget office (cbo) estimated the cost at $1.8 trillion.5 since then, the cbo has raised the tenyear numbers to $1.8 trillion (without interest) and $2.3 trillion (with interest).6 these estimates do not include dynamic effects, or ways in which higher economic growth due to provisions in the legislation might lower its revenue cost. cbo’s revised dynamic estimates indicate a revenue cost of $1.9 trillion including interest costs on the additional debt.7 nearly all dynamic estimates at the time of the legislation indicated that the cost of the legislation would certainly exceed one trillion dollars, aside from one very optimistic assessment from the tax foundation, using modeling methodology that came under criticism.8 a pennwharton budget model analysis found that growth effects from the legislation could offset a small percentage of the revenue loss, still leaving a static ten year revenue cost of $2.2 trillion over 20182027; dynamic estimates range from $1.8 to $2.0 trillion.9 tax policy center found a ten-year revenue cost of $1.3 trillion.10 barro and furman report a dynamic estimate that places the tenyear deficits under the legislation at $1.2 trillion, or $1.7 trillion if the temporary provisions are extended (which raises both economic growth and the budget cost).11 of course, one difficulty with understanding the effects of the legislation is separating the effects of the legislation from the overall effects of the underlying macroeconomy and establishing the counterfactual of what the macroeconomic trajectory would have been without the tax legislation. nonetheless, receipts of both individual and corporate income taxes are down as a share of gdp, while payroll taxes are relatively steady, indicating that the tax cuts have sharply reduced 4 specifically, the joint committee on taxation calculated total ten year costs at $1.456 trillion. joint committee on taxation, estimated budget effects of the conference agreement for h.r.1, the “tax cuts and jobs act” 8 (2017). 5 congressional budget office, estimated deficits and debt under the conference agreement of h.r. 1 (2018). 6 see john mcclelland & jeffrey werling, congressional budget office, how the 2017 tax act affects cbo’s projections (2018), available at https://www.cbo.gov/publication/53787 [https://perma.cc/hu48-x6xh]. 7 the number without interest costs is $1.3 trillion. see id. 8 critiques of the tax foundation model include william g. gale et al., tax policy center, effects of the tax cuts and jobs act a preliminary analysis, 12 (2018) available at https://www.taxpolicycenter.org/publications/effects-tax-cuts-and-jobs-act-preliminary-analysis/full [https://perma.cc/vuw5-l8tf] (noting that the tax foundation model assessment was “an outlier”) and greg leiserson, wash. ctr. for equitable growth, the tax foundation’s score of the tax cuts and jobs act (2017), available at https://equitablegrowth.org/the-tax-foundations-score-of-the-tax-cuts-and-jobs-act/ [https://perma.cc/5887-x2nc]. 9 see penn wharton budget model, the tax cuts and jobs act, as reported by conference committee (12/15/17): the static and dynamic effects on the budget and the economy (2017), available at http://budgetmodel.wharton.upenn.edu/issues/2017/12/18/the-tax-cuts-and-jobs-act-reported-by-conferencecommittee-121517-preliminary-static-and-dynamic-effects-on-the-budget-and-the-economy[https://perma.cc/l94p7nt7]. 10 see benjamin r. page et al., tax policy center, macroeconomic analysis of the tax cuts and jobs act (2017), available at https://www.taxpolicycenter.org/publications/macroeconomic-analysis-tax-cuts-and-jobs-act/full [https://perma.cc/43ju-nn3d]. 11 robert barro & jason furman, macroeconomic effects of the 2017 tax reform, 49(1) brookings papers on economic activity 257 (2018). 2020] fixing five flaws of the tax cuts and jobs act 35 revenues. federal receipts were 17.2% of gdp in 2017, and declined to 16.2% of gdp in 2018, and 16.3% of gdp in 2019, the first two years the legislation was in effect. corporate tax revenues were 1.5% of gdp in 2017 but only 1.0% of gdp in 2018 and 1.1% of gdp in 2019.12 since typically federal receipts increase (even as a share of gdp) during strong economies, there seems little doubt that the reduced tax revenues are a result of the changes in tax law. figure 1 shows the tendency of revenues to increase relative to gdp during expansions, but that is not the trend of recent years, and 2018 shows a clear dip down, despite very strong macroeconomic fundamentals. the unemployment rate for 2018 (2019) averaged 3.9 (3.7)%, down from 4.4% in 2017. figure 1: total federal receipts as a share of gdp, 1981-2019.13 deterioration in the budget deficit will be even more troubling than these tax cuts imply on their own, since spending is also on an increasing trajectory. the aging of the baby boom generation will increase federal expenditures on social security and medicare substantially over the coming decade; expenditures on each program are projected to increase by more than 1% of gdp over the coming ten years.14 thus, even absent these deficit-financed tax cuts, the u. s. government was on a trajectory of increasing debt to gdp ratios; however, that trajectory has worsened substantially due to the 12 revenue data are from the department of treasury, monthly receipts, outlays, and deficit or surplus, fiscal years 1981-2019 (feb. 1, 2020), available at https://www.fiscal.treasury.gov/reports-statements/mts/current.html [https://perma.cc/8722-wtkf]. gdp data are from federal reserve economic data database (fred), federal reserve bank of st. louis (feb. 1, 2020), available at https://fred.stlouisfed.org/series/gdp [https://perma.cc/ly2c-p42y]. 13 fred, supra note 12. note: monthly receipt data through december 2019 are included here, aggregated for the annual totals, which are then compared to gdp. recessions are shaded. 14 medicare increases from 3.5% to 5.1% of gdp from 2018 to 2028; social security increases from 4.9 to 5.9% of gdp. see congressional budget office, the budget and economic outlook: 2019 to 2029, 62 tbl.3-1 (2019). 12.0% 13.0% 14.0% 15.0% 16.0% 17.0% 18.0% 19.0% 20.0% 21.0% 22.0% 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 [vol. 11:2 columbia journal of tax law 36 new tax law. there are three important problems associated with these increased deficits at this particular moment in time. first, recessions always come. the u. s. is enjoying a very long expansion, the longest in modern u. s. history. while this expansion began after a very deep recession, it is unlikely to continue forever. when the current expansion ends, inevitably, it would be ideal if the federal government undertook expansionary fiscal policy in response, to reduce the magnitude of the recession. the deficit will certainly increase automatically due to lower tax receipts and higher spending on means-tested programs as well as unemployment insurance. however, additional discretionary stimulus is also advised, particularly in today’s macroeconomic climate, which begins with monetary policy in an unusually policy-constrained stance, due to our persistent low interest rate environment. this leaves little room for interest rate reductions as expansionary monetary policy measures.15 however, policy-makers may feel constrained by our large (and growing) debt balance when they respond to the next recession, and thus they may be tempted to take an inadequately expansionary fiscal stance at that time. while there is little sign of rising interest rates, a falling u.s. dollar, or other practical constraints on the u.s. government’s ability to borrow, the specter of rising debt burdens can reduce political appetite for deficits, even during tough times. indeed, in the great recession, policy-makers were arguably far too timid in their response for precisely this reason. therefore, running up deficits when the economy is strong, especially to pay for tax cuts, is unwise. a better use of deficit-finance would be to make public investments in infrastructure or education, both of which will pay future dividends that help justify deficits. in the case of infrastructure, deferring road and bridge maintenance is likely to make future tax burdens higher, when those investments are finally made. and investments in human capital (such as education) also pay future dividends since tomorrow’s taxpayers have higher earnings as a consequence. however, tax cuts do not satisfy these future-oriented arguments.16 second, deficits inevitably have three possible future consequences: higher tax burdens, greater spending cuts, or even more deficits (with their own future consequences). this shifts the burden of financing the state from current to future generations. already, older members of our population are getting a much better deal in terms of government benefits relative to tax payments than are younger members. thus, it would be ideal to not worsen this intergenerational inequity. further, earlier generations benefited from a time of more inclusive growth; typical households saw a doubling of incomes between the end of world war ii and 1980; in comparison, growth in incomes for typical families since 1980 has been anemic, despite strong economic growth, due to rising income inequality. 15 in addition, the federal reserve system has many assets on its balance sheet due to prior rounds of unconventional monetary policy, known as quantitative easing. while this is not a formal constraint, it may also reduce the zeal of monetary policy makers for further expansion of central bank assets. for a graphical depiction of central bank balance sheets, see board of governors of the federal reserve system, credit and liquidity programs and the balance sheet, available at https://www.federalreserve.gov/monetarypolicy/bst_recenttrends.htm [https://perma.cc/g74n-qygc]. 16 some might argue that corporate tax cuts are future-oriented if they spur substantially greater private investment; this claim will be addressed in section iii below. 2020] fixing five flaws of the tax cuts and jobs act 37 figure 2: cumulative pretax income growth in two eras17 third, deficits constrain our ability to fund urgent priorities. many priorities urgently require increased spending, including investments in the nation’s infrastructure, green research and development, education, and healthcare. beyond these areas, we also have longstanding fiscal commitments to our retired population, whose financial impact is swelling in the coming years; as noted above, social security and medicare spending increases by over 2.5% of gdp over the coming decade.18 while it is tempting to find quick ways out of this fiscal conundrum, there are no easy answers. despite decades of experimenting with supply-side economics, tax cuts have never paid for themselves. and the ideas of modern monetary theory (mmt) likewise provide no easy way around these tradeoffs. of course, there is widespread agreement that it is helpful to be able to borrow in your own currency. in addition, today’s low interest rate environment means that borrowing to make future investments (in, e.g., infrastructure or research) makes good sense, even if borrowing to pay for tax cuts is another matter. there is also longstanding agreement that deficitfinance makes good macroeconomic sense during recessions. all that said, deficits still involve tradeoffs, and there are serious limits to how expansionary fiscal policy can be. when a government undertakes expansionary fiscal policy when the economy is already operating at its capacity (full employment), the central bank may raise interest rates in order to offset the undue stimulus to the economy, either reducing investment or increasing the trade deficit.19 if it neglects to manage aggregate demand in response, or simply funds government spending by printing money, inflation will ensue. 17 thomas piketty, emmanuel saez & gabriel zucman, distributional national accounts: methods and estimates for the united states, 133 q. j. econ. 553, 578 tbl.2 (2018). 18 congressional budget office, supra note 14. 19 capital inflows are attracted by higher interest rates. this appreciates the dollar, causing a larger trade deficit. 0% 50% 100% 150% 200% 250% 300% 350% 1946-1980 1980-2014 bottom 50% middle 40% top 10% top 1% top 1/10 of 1% bottom 50% 1% increase [vol. 11:2 columbia journal of tax law 38 some mmt theorists have suggested that the federal reserve should accommodate deficitfinanced spending, and that the government can simply pay for its debts by printing money.20 while inflation may ensue, they note that tax increases could be implemented to offset incipient inflation. however, that logic simply moves the deficit reduction to a later stage in the process, rather than eliminating the need to consider deficits in general. in addition, it is unwise to put congress in charge of managing inflation; it stretches the bounds of reason to imagine a congress eager to pass tax increases under such circumstances.21 in summary, there is no escaping the fact that the deficit-financed tax cuts under the tcja come with several serious consequences; they make it more difficult to respond to the next recession, worsen intergenerational inequality, and make it more difficult to pay for urgent fiscal priorities. iii. income inequality as figure 2 (above) clearly shows, the u.s. economy has changed in important ways over the prior generation; whereas economic growth used to be felt broadly throughout society, since 1980, increasing income inequality has meant that only those at the top of the distribution are experiencing gains in standard of living that meet the expectations set by the earlier period. this phenomenon of income inequality also shows up as a divergence between the growth rate of per-capita gdp and the growth rate of median household incomes, as shown in figure 3. real gdp per-capita has grown by more than 70% between 1984 and 2017, whereas median household incomes have only increased by about 20%, a far more paltry increase.22 in years when economic expansion is particularly robust (the late 1990s, 2014-2017), the two series increase at a similar pace, but in other years, the pace of median income growth lags behind. 20 it is hard to generalize regarding the claims of mmt; it is difficult to pin down the theory as a set of well-defined principles with a clear model of how the economy works behind them. 21 we count on the federal reserve to “remove the punch bowl” despite strong political temptations to keep the party rolling, since the institution is designed to be more distant from short-term political considerations. central bank independence, and a relatively more technocratic staff, help keep monetary policy farsighted, ideally avoiding the perils of runaway inflation. 22 household size has decreased over this period, so that may (somewhat) diminish concerns about relatively stagnant household income. still, it is important to bear in mind that households also share some overhead costs, such as housing and utilities. 2020] fixing five flaws of the tax cuts and jobs act 39 figure 3: growth in real gdp per-capita and real median household income, 1984-201723 these divergent trends occur since the top 10%, and even the top 1%, are earning a much higher share of all national income now than they were a generation ago, while the shares of the bottom 90% are shrinking. table 1: pre-tax income shares, 1980 and 201424 1980 2014 bottom 50% 19.9 % 12.6 % 50-90th percentile 45.9 % 40.4% top 10% 34.2 % 47.0 % (of which, top 1%) (10.7 %) (20.2 %) there are many hypothesized causal factors behind these changes, several of which i discuss in detail in chapter two of my recent book.25 these include factors such as transformative technological change, the rising role of market power, increased international competition, 23 fred, federal reserve bank of st. louis, the puzzle of real median household income (2016), available at https://fredblog.stlouisfed.org/2016/12/the-puzzle-of-real-median-household-income/ [https://perma.cc/fa8u-4jsr]. 24 world inequality database, income inequality usa, 1913-2014, available at https://wid.world/country/usa/ [https://perma.cc/979g-msaq]. 25 see kimberly a. clausing, open: the progressive case for free trade, immigration, and global capital (2019). 100.0 110.0 120.0 130.0 140.0 150.0 160.0 170.0 180.0 jan -84 jan -86 jan -88 jan -90 jan -92 jan -94 jan -96 jan -98 jan -00 jan -02 jan -04 jan -06 jan -08 jan -10 jan -12 jan -14 jan -16 in de x w ith 1 98 4= 10 0 median household income gdp per-capita [vol. 11:2 columbia journal of tax law 40 changes in social norms, and economic policy changes that have increased incentives for those at the top to earn more income. this economic situation is damaging for a number of reasons. first, economic growth is far less meaningful for the well-being of society when it does not impact the standard of living of many in society. not only do the economic gains of those in the bottom 90% of society fall short of expectations, but the comparison between their fate and the economic privilege of those at the top creates discontent. concentrated economic power also begets political power. power disparities which concentrate control towards to the top of the economic distribution reduce the responsiveness of economic policy to the needs of typical workers, further fueling the sense that the economy is “rigged” and that our democratic institutions are not functioning as intended. while popular discontent may be understandable, it also risks the embrace of ultimately destructive economic policies. for example, nationalistic economic policies that cast foreigners as the problem have been a popular theme of the trump administration, and similarly populist discontent with eu immigration policy fueled brexit.26 yet regardless of the source of these labor market trends, the tax system is a powerful tool for addressing inequities. for example, the earned income tax credit can create negative tax rates at the bottom of the income distribution. by increasing the generosity of the earned income tax credit, the tax system can help move income towards those who have not benefited from the economic growth of recent decades. similarly, for those who have seen dramatic income growth, more can be expected in terms of tax payments. by carefully closing loopholes that allow the wealthy to classify their income in more lightly-taxed forms, the government can raise more revenue without relying on excessively high tax rates.27 and, of course, tax revenue is also vitally important in funding urgent priorities that can help address the needs of workers and the bottom 90%: infrastructure, r&d investments, education, and healthcare. unfortunately, the tcja is a wrongheaded response to rising economic inequality. not only do the tax cut benefits mostly accrue to those at the top of the distribution, but those at the bottom receive almost no gain to after-tax income. in addition, the deficit-financed nature of the tax legislation implies either less revenue for our urgent future priorities or higher future tax burdens. the nonpartisan tax policy center (tpc) did distributional analyses of the legislation; the main results are shown in figure 4.28 for those in the bottom four quintiles, the modest gains in after-income in the first year of the legislation disappear by the tenth year of the legislation, due to the expiration of the individual tax cuts. the corporate tax cuts that remain primarily benefit those at the top of the distribution. 26 id. at chapter. 3, 5, 8 (discussing the dangers of protectionism and immigration restrictions for inclusive prosperity). 27 it is particularly problematic to raise tax rates on one type of income without considering the tax avoidance response, since wealthy taxpayers are adept at rearranging their economic affairs to minimize tax burdens. by focusing on harmonizing the disparate tax treatment of different forms of income, more revenue can be raised at reasonable, uniform tax rates. 28 see tax policy center, distributional analysis of the conference agreement for the tax cuts and jobs act (2017), available at https://www.taxpolicycenter.org/sites/default/files/publication/150816/2001641_distributional_analysis_of_the_conf erence_agreement_for_the_tax_cuts_and_jobs_act_0.pdf [https://perma.cc/tfv2-mzgs]. the numbers are unchanged; see gale et al., supra note 8. 2020] fixing five flaws of the tax cuts and jobs act 41 figure 4: changes in after-tax income due to the tcja, in percent, by quintile29 due to the income differences across groups, the dollar differences are more dramatic. table 2 shows the changes in tax payments in the two years 2018 and 2027. for the bottom 80% of the population the tax cut averages $795 in 2018 and becomes a small tax increase ($15) by 2027, whereas the top 1% get tens of thousands of dollars in tax cuts in both periods. table 2: changes in tax payments, 2018 and 202730 2018 2027 lowest quintile -60 30 second quintile -380 40 middle quintile -930 20 fourth quintile -1,810 -30 top quintile -7,640 -1,260 top 1 percent -51,140 -20,660 the jct has also done distributional estimates but these are more difficult to interpret since they are divided by income group rather than by quintile.31 for taxpayers with incomes below $20,000 in 2019, tax cuts average $55. for taxpayers with incomes above $500,000, tax cuts average $35,370. by 2027, taxpayers with incomes below $20,000 pay an additional $175 in tax, while those with incomes above $500,000 still receive tax cuts of $6,290. regardless of how you cut it, these tax cuts are tilted toward the top. one source of controversy surrounding the distributional effects of the legislation concerns the effects of business tax cuts on wages. the joint committee on taxation concludes that, in the short run, 100% of business taxes fall on owners of capital, whereas in the long run 75% of 29 tax policy center, supra note 28 and gale et al., tax policy center, supra note 8. 30 gale et al., tax policy center, supra note 8. 31 see staff of the joint comm on tax’n, 115th cong., distributional effects of the conference agreement for h.r.1, the “tax cuts and jobs act” (2017). the same numbers are also reported more recently in staff of the joint comm on tax’n, 116th cong., distributional effects of public law 115-97 (2019). -0.5 0 0.5 1 1.5 2 2.5 3 3.5 4 lowest quintile second middle fourth top quintile top 1 percent pe rc en t c ha ng e in a ft er -t ax in co m e 2019 2027 [vol. 11:2 columbia journal of tax law 42 corporate income taxes and 95% of pass-through business taxes fall on owners of capital.32 the tax policy center assigns 20% of the burden to labor, 20% to capital (normal returns), and 60% to shareholders, due to supernormal returns on capital.33 other mainstream models, including those of the congressional budget office and the u.s. treasury, also conclude that the corporate tax mostly falls on capital or shareholders, with workers only bearing a small minority of the tax.34 nonetheless, administration economists have persisted in a much more rosy outlook for workers from the corporate tax cuts, implying that they could even see wage gains as high as $4,000 to $9,000 as a result.35 there are two mechanisms that could result in labor receiving benefits from business tax cuts. first, companies with excess profits may choose to share the tax windfall with their workers. there is some evidence of this mechanism in the european context, particularly using german data, but of course labor market institutions are quite different in germany than in the united states, as there is a stronger role for labor in business decisions.36 further, this mechanism should result in nearly immediate gains in wages from the business tax cuts, yet early evidence shows little changes in wages in the early data post-tcja. a second mechanism would take more time to assess. this mechanism relies on the general equilibrium models of corporate tax incidence in an open economy, which allow labor to benefit from corporate tax cuts if those tax cuts result in increased domestic investment, which raises the marginal productivity of workers, and then results in higher wages. unfortunately, careful crosscountry analyses of these mechanisms have failed to reveal clear evidence in support of higher wages in countries that have lowered corporate tax rates.37 in the present u.s. context, there are several practical issues that could stand in the way of labor benefitting from corporate tax cuts. first, we are in a period where there is a glut of capital, interest rates are very low, and debt-financed investment is actually subsidized through the tax system (conventional models of corporate tax incidence assume that investment is equityfinanced.). in that context, it is not clear how strong the investment response will be. second, even if investment responds, given the trend towards labor-displacing automation, it is not clear that, for the economy as a whole, labor demand will increase. finally, at present, there appears to be a less tight link between labor productivity and wage growth than in prior times. this loose link may have something to do with the hyper-competitive nature of many modern labor markets, the 32 see staff of the joint comm on tax’n, 113th cong., modeling the distribution of taxes on business income (2013). 33 see james r. nunns, tax policy center, how tpc distributes the corporate income tax (2012), available at https://www.taxpolicycenter.org/publications/how-tpc-distributes-corporate-income-tax [https://perma.cc/yap99j2d]. 34 for background on cbo methodology, see congressional budget office, the distribution of household income and federal taxes, 2008 and 2009, 16-18 (2012). for a discussion of the treasury assumptions, see julie anne cronin et al., distributing the corporate income tax: revised u.s. treasury methodology, 66 nat’l tax j. 239 (2013); under the trump administration, the treasury working paper version was removed from the treasury website. 35 the council of economic advisers, corporate tax reform and wages: theory and evidence 6 (2017). 36 see, e.g., clemens fuest et al., do higher corporate taxes reduce wages? micro evidence from germany, 108 am. econ. rev. 393, 393–418 (2018). 37 for a thorough overview of data and literature in this area see kimberly a. clausing, in search of corporate tax incidence, 65 tax law rev. 433 (2012) and kimberly a. clausing, who pays the corporate tax in a global economy?, 66 nat’l tax j. 151 (2013). 2020] fixing five flaws of the tax cuts and jobs act 43 declining economic power of labor relative to capital, and the rising role of company market power in many industries.38 it is instructive, though not conclusive, to consider other major countries that have run this experiment. figure 5, panels (a) to (d), show the four rich countries with gdp exceeding $2 trillion in 2017 that have cut corporate taxes substantially since 2000: the united kingdom, japan, germany, and italy. i chose these countries because they are the entire set of high-income countries with large economies that have steeply reduced corporate taxes. u.s. gdp exceeds $19 trillion in the same year. in all cases, wages are indexed from a constant local currency average wage series from the oecd; u.s. wage growth is shown as a comparison. the u.s. statutory corporate tax rate was constant over this time period, at 35%. still, the simple experience of the united kingdom, japan, germany, and italy shows the lack of a clear relationship between corporate tax rates and wage growth. in the united kingdom, wages grew more strongly than in the united states, but not during the years of the corporate tax cuts. in japan and italy, wage growth has been slow, regardless of the corporate tax cuts. in germany, recent wage growth has been stronger, coincident with a second round of corporate tax cuts, whereas the first round was not coincident with wage growth.39 figure 5a: united kingdom, wages and corporate tax rates, 2000-201740 38 see clausing, supra note 25 for a discussion of these factors. 39 both the united kingdom and japan adopted a territorial tax system in 2009. 40 organization of economic cooperation and development (oecd) database, data.oecd.org. 10 15 20 25 30 35 100 102 104 106 108 110 112 114 116 118 120 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 ta x ra te in p er ce nt in de x, 2 00 0 = 10 0 us wages wages, uk tax rate, uk [vol. 11:2 columbia journal of tax law 44 figure 5b: japan, wages and corporate tax rates, 2000-201741 figure 5c: italy, wages and corporate tax rates, 2000-201742 41 organization of economic cooperation and development (oecd) database, data.oecd.org. 42 organization of economic cooperation and development (oecd) database, data.oecd.org. 10 15 20 25 30 35 90 95 100 105 110 115 120 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 ta x ra te in p er ce nt in de x, 2 00 0 = 10 0 us wages wages, japan tax rate, japan 0 5 10 15 20 25 30 35 40 90 95 100 105 110 115 120 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 ta x ra te in p er ce nt in de x, 2 00 0 = 10 0 us wages wages, italy tax rate, italy 2020] fixing five flaws of the tax cuts and jobs act 45 figure 5d: germany, wages and corporate tax rates, 2000-201743 of course, many other things are often changing at the same time, which is why it is better to do careful econometric analyses that control for other variables. i do this exercise in clausing (2012, 2013) with every major source of wage data, every major source of tax rate data, and multiple types of specifications.44 the picture that emerges from such careful analysis is that there is simply no statistically robust relationship between corporate tax variables and countries’ wage growth. this finding is evident in both regression results and in simple scatter-plots and bar graphs. while some of the earlier studies in this area had shown larger wage effects, in many cases the largest effects were from studies that were not ultimately published, and some of these results were found to be quite fragile.45 on the other hand, there are high-quality studies that rely on subnational data that show that labor bears a larger burden of the tax. for example, suarez serrato and zidar (2016) find that workers bear 30 to 35% of the corporate tax burden in the u.s. state context; of course, capital may be far more mobile across u.s. states than across countries, and that could be one explanation for their finding.46 fuest, piechl, and siegloch (2018) find that labor may bear 50 percent of the corporate tax burden in the sub-national german context; in addition to the greater mobility of capital in the subnational context, this finding may also result from the rent-sharing mechanism, given the greater bargaining strength of labor in the german context.47 indeed, they find near-zero wage effects for foreign firms, firms that operate across jurisdictions, and larger firms, likely due to the weaker bargaining power of labor in those contexts. 43 organization of economic cooperation and development (oecd) database, data.oecd.org. 44 clausing (2012), supra note 37 and clausing (2013), supra note 37. 45 clausing (2013), supra note 37. 46 juan carlos suarez serrato & owen zidar, who benefits from state corporate tax cuts? a local labor markets appoach with heterogenous firms, 106 am. econ. rev. 2582 (2016). 47 clemens fuest et al., do higher corporate taxes reduce wages? micro evidence from germany, 108 am. econ. rev. 393–418 (2018). 0 5 10 15 20 25 30 35 40 45 90 95 100 105 110 115 120 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 ta x ra te in p er ce nt in de x, 2 00 0 = 10 0 us wages wages, germany tax rate, germany [vol. 11:2 columbia journal of tax law 46 we only have one year of data since the tax law changed, but early u.s. evidence does not suggest quick wage gains from the legislation, thus casting doubt on the rent-sharing mechanism, which should be nearly immediate. figure 6 shows annual wage growth. 2018 wage growth is positive, and thus better than the years coming out of the great recession, but it is slower than the pace of wage growth in 2015, 2016, and 2017. 2019 wage growth is similar to that in 2015-17.48 however, there is more evidence of gains to shareholders. with trump’s election, and the promise of future corporate tax cuts, the stock market likely priced in this probability as events unfolded, rising strongly in 2017. the dow jones industrial average (djia) index rose by 25% in 2017. in contrast, 2018 was a volatile year, and the stock market closed about 8 percent down. in 2019, it surged again, rising by 26%. figure 7 shows the djia index since 2014. figure 6: u.s. real wage growth, annual rate, 2014-2019 source: federal reserve economic data. median usual weekly earnings, for those employed full time. 48 this series is provided in real terms. considering instead the nominal average hourly earnings of all employees over the same period, adjusting to real terms using the cpi-u, real wage growth averaged 0.9 percent in the posttcja years (2018 and 2019) and averaged 1 percent in the five years pre-tcja. regardless of data series, there is no noticeable impact of the tcja on wage growth. 0.0 0.5 1.0 1.5 2.0 2.5 2014 2015 2016 2017 2018 2019 w ag e g ro w th in p er ce nt t er m s 2020] fixing five flaws of the tax cuts and jobs act 47 figure 7: dow jones industrial average index, 2014-2019 source: federal reserve economic data. observations are weekly, ending fridays. also of note, stock buybacks hit record levels in 2018.49 stock buybacks are one sign that the corporate tax cut windfalls of the tcja were not simply directed toward new investment spending. many companies lacked significant new investment opportunities, and instead chose to return the tax savings to their shareholders. gross domestic private investment has been far stronger than it was during the great recession, but the percent increase in investment has been comparable in 2018 to other recent years, as shown in figure 8. investment in 2019 was lower than typical investment in years prior. data for other series, such as property, plant, and equipment investment in manufacturing, as well as gross fixed capital formation, display very similar patterns.50 49 see, edward yardeni et al., yardeni research, corporate finance briefing: s&p 500 buybacks and dividends, fig.1 at 3 (2020), https://www.yardeni.com/pub/buybackdiv.pdf [https://perma.cc/475l-qkvn]. 50 all data are from federal reserve economic data (fred) database. 15000 17000 19000 21000 23000 25000 27000 29000 31000 01 /0 3/ 14 05 /0 3/ 14 09 /0 3/ 14 01 /0 3/ 15 05 /0 3/ 15 09 /0 3/ 15 01 /0 3/ 16 05 /0 3/ 16 09 /0 3/ 16 01 /0 3/ 17 05 /0 3/ 17 09 /0 3/ 17 01 /0 3/ 18 05 /0 3/ 18 09 /0 3/ 18 01 /0 3/ 19 05 /0 3/ 19 09 /0 3/ 19 in de x va lu e [vol. 11:2 columbia journal of tax law 48 figure 8: real gross private domestic investment, 2008-2019 source: federal reserve economic data. in addition to the corporate tax rate cuts in the tcja, the law also allowed full expensing of new investment on a temporary basis. this undoubtedly provides a short-term stimulus to new investment, in part since companies may want to accelerate planned investments to take advantage of the temporarily more generous tax treatment. of note, the revenue cost of expensing, relative to the corporate tax cuts, was far more modest. also, expensing targets only the normal return to new capital investment, rather than rewarding older capital investment, or excess returns above the normal rate of return. therefore, expensing is often a better policy tool than corporate rate cuts for encouraging new investment. still, international monetary fund economists have argued that the investment response to the tax act was more sluggish than expected, a finding that kopp et al. attribute to “a lower sensitivity of investment to tax policy changes in the current environment of greater corporate market power.”51 they also discuss a role for increased uncertainty. in short, there is nothing in the early data, or the larger literature, to suggest that jct and tpc need to revise upward their assumptions regarding the small share of the corporate tax that is borne by labor. therefore, it seems straightforward to take their estimates as our best guess as to how the legislation is likely to affect the distribution of after-tax income in the united states. and, unfortunately, their verdict is clear. despite over 35 years of increasing income inequality and relative wage stagnation, this legislation actually compounds economic inequality. beyond the tax cuts, there is another important provision in the legislation that worsens economic outcomes for most americans: the repeal of tax penalties enforcing the individual mandate for the affordable care act. this provision was presumably included in the legislation both as a deliberate attempt to sabotage “obamacare” as well as a way to finance larger tax cuts. the jct score placed the savings at over $300 billion over ten years, due to fewer federal subsidies that would be required for low-income people purchasing health insurance. 51 emanuel kopp et al., u.s. investment since the tax cuts and jobs act of 2017 at 2 (int’l monetary fund, working paper 19/120, 2019), available at https://books.google.com/books?id=-vhdwaaqbaj&pg=pa2&lpg=pa2&dq#v=onepage&q&f=false [https://perma.cc/k3qs-zeh4]. -25 -20 -15 -10 -5 0 5 10 15 20 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 pe rc en t c ha ng e fr om a y ea r a go 2020] fixing five flaws of the tax cuts and jobs act 49 absent the mandate, fewer people will have health insurance. the cbo estimated that mandate repeal would mean that millions fewer americans would have health insurance by 2027.52 this increases the economic insecurity of those at the bottom of the income distribution, who will experience worse health outcomes and a higher risk of medical bankruptcy. this change also weakens the structure of the affordable care act, since fewer people in the insurance pool will increase premiums for the remainder. when people wait until they are sicker to seek healthcare, healthcare is more expensive for the system as a whole, raising premiums. already, there has been a noticeable effect on 2019 premiums.53 higher health insurance premiums work against the modest tax cuts that are received in the lower and middle parts of the income distribution, eliminating any possible gains in disposable income for these groups. in fact, the predicted increase in health insurance premiums was estimated to be several times the size of the typical tax cut for families in the bottom 60% of the income distribution.54 within the tcja, there are also ample missed opportunities. the child tax credit maximum was expanded from $1,000 to $2,000, but since it is not fully refundable, the expansion did little to help those at the bottom of the income distribution, whereas the credit was expanded to reach more upper-income taxpayers. in addition, the child tax credit was limited to those with social security numbers, leaving undocumented families ineligible.55 iv. efficiency tax systems exist in order to raise revenue for the state, and a progressive tax system can also help reduce inequalities in the distribution of income. beyond these goals, the tax system should also aim to be efficient, by avoiding unnecessary distortions and waste. of course, some distortion is typically inevitable, since taxation discourages the activities that are taxed. the only exceptions are head taxes, which are both non-distortionary (since they are unavoidable) and inequitable, and pigouvian taxes, which are taxes that work to counteract negative market failures. a carbon tax is an example of a pigouvian tax; such a tax reduces carbon emissions in a socially desirable (and efficient) way, since markets left to their own devices generate inefficiently high quantities of carbon emissions. however, since pigouvian taxes are typically not sufficient to finance the needs of the state, and head taxes are rightly rejected for being inequitable, most countries rely on income or consumption taxes. these taxes inevitably discourage economic activities such as working (and, in the case of income taxes, saving), since they reduce the economic gains associated with these activities. the tcja cuts many taxes; in that respect, its colloquial title is accurate. according to the jct’s 10-year estimates, the corporate tax cuts totaled over $650 billion (net), the pass-through tax cuts totaled over $250 billion (net), and the individual tax cuts were also substantial. this section will consider the efficiency effects of these types of tax cuts, recognizing that positive tax 52 see congressional budget office, repealing the individual health insurance mandate: an updated estimate, 3 tbl.2 (2017). 53 see rabah kamal et al, kaiser family foundation, issue brief: how repeal of the individual mandate and expansion of loosely regulated plans are affecting 2019 premiums (2018). 54 this is true for all u.s. states with available data. see chye-ching huang, center on budget and policy priorities, fundamentally flawed 2017 tax law largely leaves lowand moderate-income americans behind, app. tbl.1 (2019) (showing a complete comparison of these figures). 55 id. at 9 (“the law ends the ctc for 1 million children lacking a social security number…who are overwhelmingly…undocumented.”). [vol. 11:2 columbia journal of tax law 50 rates for these types of taxes are required in order to raise adequate revenues within the u.s. tax system. thus, we cannot simply say that any tax cut is intrinsically good. first, consider the corporate tax cuts. some have argued that capital should be taxed more lightly than labor on efficiency grounds, and early theoretical models in economics buttressed this argument, since they showed that capital taxes could be quite distortionary. however, modern models including more realistic assumptions indicate that the optimal capital tax rate could be at least as high as the optimal labor tax rate. for example, while early works by atkinson and stiglitz suggested a zero tax on capital, later work by both authors concluded otherwise, and both took policy positions that were in stark contrast to this result.56 the more realistic assumptions that create a positive role for capital taxation include differences in the ability to earn returns on capital, a role for inheritance, imperfect or incomplete capital markets, and uninsurable shocks to rates of return. there is also a political economy rationale for capital taxation, in order to avoid extreme redistributions of wealth due to unchecked inequality.57 excess returns to capital above the normal market return, resulting from market power or rents, also create a powerful rationale for capital taxation. since much of the capital income tax base reflects these excess returns, that implies a far higher ideal rate of capital taxation. in most models, taxes on excess profits do not diminish the incentive to invest, although they may affect risk-taking behavior. evidence from the united states corporate tax base indicates that a rising share of the tax base, now likely over three quarters, is comprised of excess returns.58 thus, the tax system should keep a robust role for capital taxation for efficiency purposes, bearing in mind that most taxes (aside from head taxes and pigouvian taxes) generate some inefficiencies. to ensure adequate capital taxation, the corporate tax is a vital tool, since about 70% of u.s. equity income goes untaxed by the united states government at the individual level.59 prior to the tcja, the corporate tax system provided wildly different tax treatments for the normal return to capital investments, with equipment facing large negative tax rates if debtfinanced, and positive rates if equity-financed. post-tcja, and with full expensing provisions (which are temporary), the normal return to equipment investments faces a zero tax rate if equityfinanced, and continues to face a negative tax rate if debt-financed.60 56 see, e.g., anthony b. atkinson & joseph e. stiglitz, the design of tax structure: direct versus indirect taxation, 6 j. pub. econ. 55 (1976); anthony b. atkinson & joseph e. stiglitz, lectures in public economics: updated edition (2015); anthony b. atkinson, inequality: what can be done? (2015); joseph e. stiglitz, the price of inequality (2012). 57 for examples of papers with these arguments, see juan carlos conesa, sagiri kitao & dirk krueger, taxing capital? not a bad idea after all!, 99 am. econ. rev. 25–48 (2009); thomas piketty & emmanuel saez, a theory of optimal capital taxation, nat’l bureau of econ. res. (2012); thomas piketty et al., a theory of optimal inheritance taxation, 81 econometrica 1851 (2013); and emmanuel farhi et al., non-linear capital taxation without commitment, 79 rev. econ. stud. 1469 (2012). see ludwig straub & iván werning, positive long-run capital taxation: chamley-judd revisited, 110 am. econ. rev. 86–119 (2020) (showing that optimal capital tax rates are higher than those found in the early literature, even when relying on the very same theoretical models). 58 see laura power & austin frerick, have excess returns to corporations been increasing over time?, 69 nat’l tax j. 831 (2016). 59 leonard e. burman et al., is u.s. corporate income double taxed, 70(3) nat’l tax j. 675, 676 (2017). 60 see the calculations from tables 1-5 of congressional research service, issues in international corporate taxation: the 2017 revision (p.l. 115-197), 19-24 (2018). 2020] fixing five flaws of the tax cuts and jobs act 51 indeed, in the presence of expensing, the corporate tax falls only on excess returns to capital, thus reducing the argument for such a low corporate tax rate. however, there remain arguments for a low corporate rate for international competitiveness reasons. if capital can move abroad in response to taxation, that lowers the optimal capital tax rate. issues surrounding the international mobility of capital are addressed in section v. for now, it is important to remember that the elasticity of the tax base is itself a policy variable; choices about tax regimes affect the ability of capital to move to avoid taxation. at present, the current corporate tax system does not burden ordinary (equipment) capital at all, and it lightly taxes (at rates lower than top labor rates) the excess return on such capital. thus, from an efficiency perspective, the tax system is under-taxing both the normal return to capital as well as excess returns. developments in the theory of capital taxation suggest that higher tax rates are likely optimal. beyond that, the empirical literature has failed to show any clear relationship between capital tax rates and efficiency outcomes. therefore, the tcja has moved our tax system away from ideal capital taxation, by unduly lightening the tax burden on corporate income. the tcja also raises over $300 billion from a one-time tax on the prior foreign earnings of u.s. multinational companies, at either 8 or 15.5%, irrespective of whether profits are repatriated. the 15.5 % rate applies to liquid assets, and others are taxed at 8 percent. the tax is payable over 8 years and back-loaded, so that most payments occur in years 6, 7, and 8. the foreign earnings that face the deemed repatriation tax would have normally been taxed at the prior u.s. rate (35%), less any foreign tax credits, upon repatriation. thus, the tcja tax treatment represents a tax cut relative to prior law. from an efficiency perspective, there is no good argument for a tax-break on earnings that have already been earned. indeed, there are good arguments for higher than normal taxes on prior earnings, since one can not discourage something that has already happened. however, one does risk probabilistically affecting expectations about future tax policy increases. the tcja also provides large-pass through business tax cuts, totaling over $250 billion over ten years, the combination of $414 billion in cuts due to a 20 percent pass-through income deduction and an offsetting revenue gain of $150 billion from disallowing some losses. these provisions, like the individual tax cuts, expire at the end of 2025. one intention of these provisions was to “give something” to the pass-through business sector, alongside the large corporate tax cuts. this neglects the idea that businesses could always incorporate if they wanted to qualify for the corporate tax treatment, although there may be costs associated with undoing that decision. like the corporate tax cuts, these pass-through tax cuts also favor capital income relative to labor income, lowering the overall tax burden on capital. taxpayers with sufficient flexibility, and particularly those at the top of the income distribution, will have a greater incentive to disguise labor income as business income in order to benefit from lighter tax treatment. beyond these concerns, the pass-through deduction took on a rather particular form, since the drafters of the legislation went out of their way to favor some professions relative to others. those professions that won lighter tax treatment included real estate, oil and gas, manufacturing, and architecture, while those that did not qualify for the pass-through deduction included medicine, law, accounting, consulting, and professional sports. there was no rationale provided for such distinctions, and some have suggested that they stemmed from a “tribal” desire to reward industries based on their presumed political affiliations. regardless of motive, it is clear that the industrial favoritism of the provision is inefficient, since it artificially moves resources toward the taxfavored industries and away from the other industries. in addition, the pass-through provisions are [vol. 11:2 columbia journal of tax law 52 also predicted to lead to a great deal of wasteful tax planning as businesses that would otherwise not qualify for the deduction seek to rearrange their business structure so that they might nonetheless qualify.61 the individual tax provisions show no clear efficiency improvements, beyond the fact that lower rates generally reduce the inefficiency of labor taxation. however, since these lower rates are deficit-financed, they may well imply higher tax rates in the future, with associated increases in inefficiency. under the law, due to the higher standard deductions, the share of taxpayers that itemize will shrink substantially, reducing the tax preferences for home mortgage interest, state and local taxes, high medical expenditures, and charitable deductions.62 there are good arguments for limiting some of these tax incentives, particularly the home-mortgage interest deduction. yet eliminating these tax incentives for some taxpayers, while leaving them intact for the (typically wealthier) taxpayers that still itemize, does not satisfy principles of good policy design, as discussed by viard (2019).63 for example, wealthier households that continue to benefit from the home mortgage interest deduction are unlikely to change their home ownership rates due to the tax preference, whereas less prosperous prospective homeowners are now less likely to benefit from the home mortgage interest deduction, since they are less likely to itemize. among those that itemize, state and local tax deductions are limited to $10,000 under tcja. this is a clearly progressive tax increase, since the limit burdens richer taxpayers more as their tax payments increase, but this provision also has some odd design features. the provision raises tax payments more (all else being equal) for those who live in high-tax states. the fact that many hightax states are also “blue” states has raised further suspicion of political motives. this provision also “double-taxes” some income, since a taxpayer that is over the cap of $10,000 will have to pay federal tax on income that has already been taxed by the state or locality.64 of course, a second layer of tax is not substantively different from a higher tax; the number of times income is taxed is less meaningful that the total tax burden faced by that income. for a taxpayer in the top (now 37%) bracket, in a state with a 10% income tax, this provision would increase the tax rate on their marginal dollar by 3.7%. the doubling of the estate tax exemption threshold reduces the number of estates paying the estate tax from less than 2 in 1,000 estates to less than 1 in 1,000 estates. this is likely the most regressive change in the tax code, as it only benefits the top 2/10 of one percent of estates. while in theory this provision could encourage savings from those seeking to accumulate estates, it also reduces incentives for labor and savings for those that inherit.65 in sum, while there are elements of the tcja that increase efficiency, the corporate and pass-through business tax cuts unduly preference capital income. in addition, the pass-through tax cuts introduce new distortions between different forms of pass-through business income. the individual tax cuts, as a group, do not have clear efficiency effects. lighter tax rates now will 61for a detailed discussion of these issues see daniel shaviro, evaluating the new us pass-through rules, 2018 brit. tax rev. 49. 62 tax policy center, supra note 28 tbl.1 at 2. 63 alan d. viard, an economic analysis of the tcja’s larger standard deduction, tax notes 79-93 (april 1, 2019). 64 this is not as unusual as it seems. for example, state income taxes often include in their tax bases income that includes federal tax payments. 65 because heirs will be richer, they will want to consume more of all normal goods (goods for which consumption increases with income). normal goods include leisure and present consumption (as a whole). thus, heirs will work less and save less. 2020] fixing five flaws of the tax cuts and jobs act 53 likely be offset by higher tax rates in the future, and many of the other provisions have conflicting effects. v. the offshoring of multinational activity before and after tcja prior to the tcja, there were two large concerns about the u.s. system for taxing international corporate income, with competing implications. the first concern came from u.s. multinational company interests, who argued that the u.s. tax system was not “competitive”, since the u.s. statutory rate was relatively high (in comparison with other countries) and the u.s. government purported to tax the worldwide income of its resident companies, whereas most foreign countries’ tax systems purported to exempt foreign income from taxation, under “territorial” systems. the second concern was that aggressive profit shifting by multinational companies was eroding the corporate tax base. regarding the competitiveness concern, both the high u.s. statutory tax rate and the “worldwide” nature of the u.s. tax system had more bark than bite. a narrow u.s. tax base lowered effective rates far below the statutory rate (of 35%), and u.s. multinational companies often achieved particularly low effective rates due to aggressive offshore profit shifting. with respect to the “worldwide” system, the u.s. government raised almost no revenue from the taxation of foreign income, since tax was not due until repatriation, and companies were adept at shielding foreign income from u.s. tax by using foreign tax credits or simply waiting for more favorable tax treatment. waiting paid off: there was a holiday in 2005 (with repatriation allowed at a 5.25% rate), and there was also favorable treatment of prior foreign earnings in the tcja, where earnings were taxed at 8 or 15.5%. in reality, most countries operate far from either end of a spectrum between “pure” territoriality (with no claims on any form of foreign income) and a “pure” worldwide system (where foreign income would be treated the same as domestic income, and taxed immediately). indeed, it is unclear whether the old u.s. system (which purported to be worldwide) or the new u.s. system (which is purportedly territorial) is more “territorial”. the new u.s. territorial system still taxes some foreign income, and the foreign income that is taxed is taxed immediately. was the old u.s. tax system insufficiently competitive? by many metrics, u.s. multinational companies were “competitive”. figure 9 shows that u.s. corporations earned historically high after-tax profits, 50% higher relative to gdp in recent years than in the closing decades of last century. corporate tax revenues, on the other hand, were relatively stable as a share of gdp. [vol. 11:2 columbia journal of tax law 54 figure 9: u.s. corporate profits, and tax revenues, 1980-2018 source: federal reserve economic data (profits), congressional budget office (revenue). u.s. headquartered companies also occupied a disproportionate share of the forbes global 2000 lists of top global companies, shares far outweighing the u.s. share of world gdp.66 further, u.s. multinational companies were adept at profit shifting, often using clever legal and accounting arrangements to achieve single-digit effective tax rates. due to a narrow corporate tax base as well as profit shifting, u.s. corporate tax revenues were typically about fifty percent lower (as a share of gdp) than those in peer countries.67 yet, while there was scant evidence that competitiveness was a serious problem, there was abundant evidence that corporate tax base erosion was a large and increasing problem. by 2017, the u.s. government lost over $100 billion a year due to the profit shifting of multinational companies. more than half of all foreign earnings were booked in just seven very low-tax havens, and profits relative to gdp in such countries reached clearly implausible magnitudes.68 from this starting point, the tcja attempted to address both competitiveness and tax base erosion problems, regardless of the inherent inconsistency between the solutions to each problem. those seeking competitiveness wanted lower tax burdens for multinational income, and those worried of tax base erosion typically aimed for higher tax burdens on the same income. toward the competitiveness goal, the tcja dramatically lowered the corporate tax rate from 66 see kimberly a. clausing, competitiveness, tax base erosion, and the essential dilemma of corporate tax reform, 2016 byu l. rev. 1649 (2017) and kimberly a. clausing, does tax drive the headquarters locations of the world’s biggest companies?, 25 transnat’l corp. 37 (2018). 67 see clausing supra note 25, at chapter 7. for details on the competitive position of u.s. multinational companies. the large scale of pass-through businesses in the united states also contributes to lower corporate tax revenues, and pass through businesses also generate tax avoidance concerns; see michael cooper et al., business in the united states: who owns it, and how much tax do they pay?, 30 tax policy and the econ. 91 (2016). 68 for a discussion of the evidence, see kimberly a. clausing, profit shifting before and after the tax cuts and jobs act, nat’l tax j. (forthcoming 2020), available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3274827 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 19 80 19 82 19 84 19 86 19 88 19 90 19 92 19 94 19 96 19 98 20 00 20 02 20 04 20 06 20 08 20 10 20 12 20 14 20 16 20 18 as s ha re o f g dp corporate profit after tax corporate tax revenue corporate profit before tax 2020] fixing five flaws of the tax cuts and jobs act 55 35% to 21%. in addition, the tcja adopted territoriality as the default stance for the u.s. tax treatment of corporate foreign income, exempting foreign income from taxation. however, toward the corporate tax base protection goal, the tcja did not allow all foreign income to be exempt from taxation. beyond the first ten percent return on assets, the gilti (for global intangible low-taxed income) minimum tax applies, taxing companies’ foreign income when the foreign tax rate falls below a threshold. a second add-on minimum tax, the beat (for base erosion anti-abuse tax) also applies; together these taxes raise about the same amount of revenue that the other international provisions lose. table 3 summarizes the key tcja provisions that affect the corporate tax base. table 3: key tcja provisions affecting the corporate tax base69 statutory corporate rate 35 21 reduced incentive to shift out of u.s. base -1,349 (net: -654) tax treatment of foreign income no tax until repatriation, then 35 less foreign tax credit70 not taxable unless subject to minimum tax increased incentive to shift out of u.s. base -224 global minimum tax n/a 0 until threshold, then 10.5; up to 13.125 if blended with income from higher tax countries71 reduced incentive to shift profits to havens; increased incentive to earn in other countries 112 foreign-der. intangible income deduction (fdii) n/a tax preference for profits from export sales above threshold return on assets likely to have negligible effect -64 base erosion and anti-abuse tax (beat) n/a add-on minimum tax when payments to foreign related parties exceed threshold reduced incentive to shift income out of u.s. base 150 69 note: revenue numbers are from the december 18, 2017 tables provided by the jct (jcx-67-17). joint committee on taxation, supra note 4. 70 lighter rates may apply, or be anticipated, due to holidays, anticipated holidays, or expectation of future favorable treatment upon transition to a new tax system. permanently reinvested earnings are not taxed in the united states, but might be expected to encounter deemed repatriation tax upon transition to a territorial system. 71 these rates are scheduled to increase after 2025 to 13.125 and 16.4%. this analysis ignores interaction effects between the provisions. [vol. 11:2 columbia journal of tax law 56 table 3 indicates clearly that the net effect of the international provisions is nearly a wash (a small revenue loss) whereas the rate cut reduces revenue substantially.72 as a consequence, the international provisions were a disappointment to many. from the perspective of the multinational business community, the corporate tax base protections were more onerous than expected; they would have preferred a purer territoriality. whereas from the perspective of those worried about tax avoidance and corporate tax base erosion, including this author, the lack of any revenue gains from the international provisions was disappointing, particularly from a starting point where the u.s. government was losing so much revenue due to profit shifting. moreover, the law introduced troubling new incentives to offshore real economic activity (such as investment and jobs). for instance, for the gilti, the first 10% return on assets in exempt from the minimum tax. this means that additional physical investments of plant and equipment in low-tax countries reduces the bite of the gilti tax, providing a direct incentive for offshoring real economic activity.73 in addition, tcja introduced a new export incentive, the fdii, that also encourages the offshoring of real investment.74 the fdii provides a tax break for profits from u.s. export sales. but, since the tax preference is only given for export income above a certain return on assets, the more u.s. assets (all else equal), the less likely the company will qualify for the break. thus, this provision also rewards the offshoring of u.s. assets. comparing tax treatment under gilti and fdii, holding other factors constant, it is typically preferable for a company to serve the u.s. market from a tax haven, since both foreign and u.s. income receive a tax preference. further, increased physical assets increase the amount of tax-free income abroad, but have the opposite consequence at home. indeed, both gilti and fdii directly encourage the offshoring of plant and equipment; this is a new feature of tax law and a perverse consequence of the tcja. beyer et al. provide early evidence of increased foreign investment in the wake of tcja that is consistent with these offshoring incentives.75 under both current and prior law, there are tax incentives for shifting paper profits (distinguish plant and equipment). under prior law, profits earned in tax havens were not taxed by the united states until repatriation, growing tax-free in the meantime; such profits often qualified for favorable tax treatment upon repatriation (due to the 2005 holiday or the lighter repatriation tax under the tcja). under the new law, the incentive for profit shifting has increased for some companies and circumstances, and decreased for other companies and circumstances. as table 3 summarizes, the net budget effect of the international provisions implies that little progress has been made at reducing the revenue costs of profit shifting; some provisions worsen the problem, whereas others 72 horst (2019) reports an admittedly preliminary analysis of the revenue effects of tcja’s international provisions, concluding that their revenue impact will be disappointing relative to jct estimates. thomas horst, preliminary effects of the likely actual revenue effects of the tcja’s provisions, tax notes int’l 1153 (september 16, 2019). 73 from a company perspective, the strength of this incentive depends on the assumed rate of return, the tax treatment of investment abroad, and the foreign tax rate. whether offshoring makes sense for particular investments depends on the interplay of these factors. 74 many believe that this fdii provision may not be compatible with wto obligations due to the preference for export income, although there is some ambiguity regarding that issue, as discussed in sanchirico (2018). however, the fdii is unlikely to be an effective way to encourage us intellectual property activity or to buttress the tax base, and its ineffectiveness may obviate the urgency of a wto challenge. chris sanchirico, the new us tax preference for “foreign-derived intangible income” 71 tax law rev. 625 (2018). 75 see brooke beyer et al., the effect of the tax cuts and jobs act of 2017 on multinational firms’ capital investment: internal capital market frictions and tax incentives (2019). 2020] fixing five flaws of the tax cuts and jobs act 57 make it better. moving to a territorial tax system should increase the incentive to shift profits, since there will be no tax due upon repatriation for income with territorial treatment, yet both the u.s. rate reduction and the base protection measures (gilti and beat) should reduce profit shifting incentives. among these factors, the statutory rate change is more minor than it seems, since the vast majority of the revenue lost due to profit shifting occurs with respect to the lowest tax rate countries.76 (simply put, if you can get to 2%, why pay 21%?) on the other hand, the beat should unambiguously reduce profit shifting incentives, since it is triggered by excess payments to related foreign parties, a key mechanism for profit shifting. the effects of the gilti are particularly subtle. the tax is administered on a global basis, such that tax credits from earnings in high-tax countries can offset gilti tax due on haven income. for companies with excess foreign tax credits, such that all gilti tax is offset, the new law should increase profit shifting activity, since marginal dollars of income in haven countries will not trigger gilti tax (due to the excess credits) and will also not face tax due upon repatriation. also, the first 10% return on physical assets does not trigger gilti tax, so companies have an increased incentive to shift profits abroad until that threshold is reached, since there will be no gilti tax and no tax upon repatriation. still, for companies without excess foreign tax credits that face the gilti tax, profit shifting incentives are clearly reduced. indeed, the difference in the possible tax treatment of income abroad is highly compressed relative to prior law. the gilti raises the lowest possible tax rate for excess income (beyond the 10% return on assets) to 10.5%, and the gilti also simultaneously reduces the “bite” of most higher-tax foreign tax payments, since those can be used to offset gilti tax, due to the global-averaging that occurs before the minimum tax is applied. unfortunately, the global nature of this minimum tax creates its own set of perverse tax incentives. for companies without excess foreign tax credits, when they earn a dollar of income in bermuda, it should generate 10.5 cents of gilti tax, since there will not be sufficient tax credits from operations in high-tax countries to offset the gilti tax due. for such a company, consider the tradeoff between earning an additional dollar in the united states (with our new 21% tax rate) or india (with a 30% tax rate). if the dollar is earned in the united states, the two dollars generate 31.5 cents in tax (10.5 cents from the gilti on the bermuda income and 21 cents from the united states tax). if the additional dollar is instead earned in india, the two dollars generate 30 cents in tax, paid to the indian government, since the tax credits from the indian tax payment more than offset any gilti due on the bermuda income. this simple example illustrates two important features of the gilti tax that arise from its global nature. first, for companies without excess credits, it should reduce profit shifting to havens by compressing the possible tax difference between high and low tax foreign countries, which are diminished by the gilti. tax differences between the united states and havens are also reduced; those will no longer exceed 10.5% (the u.s. rate less the gilti rate). second, for companies without excess credits that have haven income, the united states becomes the worst place to book income, even relative to other high-tax countries, since u.s. income does not offset gilti tax but foreign income does. indeed, previous research shows that unless the foreign tax rate reaches 52.5%, foreign income is tax-preferred in comparison with u.s. 76 clausing, supra note 68. [vol. 11:2 columbia journal of tax law 58 income for such companies.77 while this is an undesirable result for u.s. government revenue, it is nonetheless helpful to other non-haven countries that have their own tax avoidance problems. indeed, it is possible that the gilti could be a step forward for international cooperation in this area. however, the gilti could be far more effective in protecting the u.s. corporate tax base. previous analysis shows that a per-country minimum tax would generate far more u.s. revenue and lead to a much greater reduction in haven country income, since the minimum tax consequences of haven income would no longer be blunted by credits from other foreign income.78 unfortunately, evidence so far shows little immediate effect on the flow of u.s. affiliate foreign income from haven countries. in 2018 and 2019, the first two years the tcja was in effect, u.s. multinational companies booked an amount equivalent to 1.5% of gdp in seven havens, an identical ratio as the average of the five years immediately preceding tcja (2013-2017).79 in absolute terms, from 2017 to 2019, earnings in these seven havens increased from $471 billion to $534 billion, and the share of all foreign earnings in those seven havens was stable, at about 61%. figure 10 shows the longer trends of u.s. mnc earnings in the big seven havens, as a share of u.s. gdp and as a share of foreign earnings; the data post-tcja (2018 and 2019) are nearly indistinguishable from the years prior to tcja. of course, as with other elements of the law, it may take time for the full effects to materialize. beyond that, the polices of other countries are not standing still, in ways that will continue to impact the incentives for both offshoring real activity (plant and equipment and jobs) as well as the shifting of paper profits. 77 id. this is because the foreign tax rate becomes .105 + .2*tf , where tf is the foreign tax rate. only 80% of foreign tax payments are creditable. 78 id. 79 these data include the seven largest havens in the u.s. bureau of economic analysis (bea) direct investment database: bermuda, the caymans, ireland, luxembourg, the netherlands, singapore, and switzerland. the data show only those earnings attributed to u.s. shareholders; earnings are shown after payments of foreign tax. for greater discussion see id. 2020] fixing five flaws of the tax cuts and jobs act 59 figure 10: share of u.s. mnc earnings in big 7 tax havens 80 vi. tax administration the tcja was sold as providing substantial simplification. on the business side, that argument is nearly impossible to make due to the complexity surrounding the new pass-through income deduction as well as the complexity of the new international tax rules. on the individual side, there is a stronger case for simplification. for example, the tax policy center estimates that the number of tax units that would itemize in 2018 declined from 37 million (under old law) to 16 million under tcja. jct has predicted a decline from 46.5 million itemizing returns in 2017 to 18 million in 2018.81 for those that are no longer itemizing, they will no longer need to keep records of their charitable contributions, home mortgage interest payments, or property tax payments. (state income tax record-keeping is still needed for filing state income taxes.) while those simplification gains are not zero, they are also not large. for those used to itemizing, keeping track of these items was not difficult, and if the decision to itemize is borderline, one needs to track these numbers regardless.82 in addition, much fanfare was made about reducing the complexity of the tax forms and shortening the main form, the 1040. however, the 1040 form was redesigned by moving common items off the main form and into a new schedule 1 that feeds into the 1040. since schedule 1 80 note: data are from the u.s. bea. data for 2019 are based on the first three quarters of data scaled by (4/3). the big seven havens are: bermuda, the caymans, ireland, luxembourg, the netherlands, singapore, and switzerland. 81 see tax policy center, t18-0009 impact on the tax benefit of charitable deduction of h.r.1, the tax cuts and jobs act, by expanded cash income level, 2018 (2018), available at https://www.taxpolicycenter.org/model-estimates/impact-itemized-deductions-tax-cuts-and-jobs-act-jan-2018/t180009-impact-tax [https://perma.cc/96dh-y5tc] and staff of the joint comm on tax’n, 115th cong., tables related to the federal tax system as in effect 2017 to 2026, tbl.5 at 6 (2018). 82 as one anecdotal piece of evidence, i help several friends with their taxes. when some ended up not itemizing, it really did not save more than a minute or two per return. and record-keeping costs for these items are quite minor. 0.0% 0.2% 0.4% 0.6% 0.8% 1.0% 1.2% 1.4% 1.6% 1.8% 0% 10% 20% 30% 40% 50% 60% 70% 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 20 09 20 10 20 11 20 12 20 13 20 14 20 15 20 16 20 17 20 18 20 19 sh ar e of u s gd p sh ar e of f or ei gn t ot al share of foreign total share of gdp [vol. 11:2 columbia journal of tax law 60 includes items like state tax refunds, schedule c income, capital gains, and unemployment compensation, many taxpayers were simply confused by the need for the new form, and they were required to fill out and submit more forms in total. in general, simplification on the individual side was typically either small or non-existent. on the other hand, there is no question that the business income provisions of tcja made our tax laws more complex. for pass-through businesses, there are many hurdles for determining whether one’s business income is “qualified business income” in order to benefit from the 20% pass-through deduction. a wall street journal tax reporter, richard rubin, even made a comic video detailing aspects of this complexity.83 as mentioned above, the disparate treatment of different industries furthers the complexity by increasing the incentive for clever tax planning or organizational changes to take advantage of the deduction. daneil shaviro doesn’t mince words, describing the pass-through provision as achieving “a rare and unenviable trifecta, by making the tax system less efficient, less fair, and more complicated. it lacked any coherent (or even clearly articulated) underlying principle, was shoddily executed, and ought to be promptly repealed.”84 despite this advice, a flawed legislative process was followed by a flawed regulatory process, and the complexity clearly remains.85 the international tax provisions are also tremendously complex. in part, this complexity stems from inevitable conflicts between two competing desiderata in the legislation: (1) encouraging the “competitiveness” of u.s. based multinational companies by exempting their foreign income from u.s. taxation (a so-called “territorial” system) and (2) protecting the corporate tax base from erosion due to increased profit shifting. the u.s. international tax system has often been described as stupefying and mindnumbing in its complexity. however, this new slew of acronyms (gilti, fidii, and beat) together with existing complexities surrounding foreign tax credits, expense allocation, interest deduction limitations, and other provisions, make our international tax system only more complex. in the early days of the legislation, experts at top accounting firms were simply flabbergasted by the intricacies of the new law, and often confessed that they were not certain of its ultimate impact on their client taxpayers. colorful byzantine flowcharts were generated to try to analyze the net impact of the law, but the sheer complexity made clarity elusive. even as the effects of the legislation began to clarify, the answer was most often “it depends”. all that said, one has some sympathy for the drafters of the law. given the constraints provided by the fact that multinational companies separately account for income and expenses in each country of operation (instead of being treated as a unitary whole), complexity is unavoidable if one is striving to couple a “territorial” tax system with corporate tax base protections. as troubling as the gilti and the beat may be in terms of complexity, the legislation is better with these provisions than it would be without them; the provisions do provide some limits on tax avoidance. 83 richard rubin, want a 20% busines deduction? here are the obstacles, wall st. j., april 23, 2018, https://www.wsj.com/video/series/talking-taxes/want-a-20-business-deduction-here-are-the-obstacles/3cb05210036e-4fff-ad91-7da08ee6d06a [perma.cc/rzj8-9u8e] 84 shaviro, supra note 61 at 49. 85 see shu-yi oei & leigh osofsky, legislation and comment: the making of the § 199a regulations, 69 emory law j. 209 (2018), (detailing the regulatory process). 2020] fixing five flaws of the tax cuts and jobs act 61 vii. fixing the tcja the prior sections systematically analyze five flaws with the tcja: (i) the law finances tax cuts with deficits, reducing our ability to respond to the next recession and to fund urgent fiscal priorities, (ii) the law worsens the inequality of after-tax incomes, reinforcing nearly four decades of increasing income inequality and slow wage growth (iii) the law fails to improve efficiency, worsening the present under-taxation of capital, (iv) the law encourages offshoring of plant and equipment while failing to make a substantial dent in our large profit shifting problem, and (v) overall, the tax law makes the tax system more complex. given the magnitudes of the aforementioned flaws, one simple solution would be to simply repeal the law. in this section, i instead suggest more incremental changes, repealing some provisions and building on others, with the overall goal of not just reversing the damage caused by the tcja, but improving tax law relative to its pre-tcja starting point. table 4 shows the net revenue effects of these suggested changes, including both individual and business tax changes. the ten-year revenue scores are calculated for the same window that jct used to estimate the ten-year revenue effects of the tcja. some of the legislative changes under tcja are so harmful that repeal is the right answer. for instance, repealing the pass-through deduction would make the tax system simpler, fairer, and more efficient, so that is an easy call. reinstating the prior tax treatment of estates (by undoing the doubling of the exemption) and of top incomes (by raising the top brackets) seems similarly straightforward. also, the aca individual mandate enforcement needs to be reinstated. in other areas, there are tougher judgments. one might keep the lower tax rates on the lower brackets in order to provide some tax relief to groups that have experienced slow wage growth. it is also tempting to restore personal exemptions (which make tax burdens more sensitive to family size) while lowering the standard deduction, even if more people itemize. table 4: incremental changes to the tcja86 under tcja suggested change implied 10 yr score, $b major individual provision changes increase top 4 brackets by 3 percentage points 24/32/35/37 27/35/38/40 + 669 87 exemption/deduction changes no exemptions; higher deductions restore exemptions; remove higher deduction -1212 +720 repeal pass through deduction 20% of qualified business income is deductible repeal deduction; keep new loss rules + 415 86 note: most revenue numbers are from the december 18, 2017 tables in joint committee on taxation, supra note 4. 87 this triples the revenue forecast from a ten-year estimate from cbo for the period 2019-2028 that is based on a one percentage point increase. behavioral responses could modify this very slightly downward, to the extent that they are larger for a 3% increase. [vol. 11:2 columbia journal of tax law 62 change child tax credit higher phase out (200/400k); required ssn; refundable for $1400 of $2000 phase out at lower incomes; remove ssn requirement; fully refundable 30 88 return to prior estate tax thresholds doubled exemption prior law + 83 restore aca mandate removed penalty for non-insurance restores prior law -314 major corporate provision changes statutory corporate rate 21 28 +700 global minimum tax global tax at 10.5; up to 13.125 if blended per-country tax at 21; remove exemption for first 10% return + 360 89 repeal foreign-der. intangible income deduction (fdii) tax preference for profits from export sales above threshold return on assets repeal fdii + 64 90 total revenue effect +1,455 while the increased size of the child tax credit is also a sensible way for the tax code be responsive to family size, the expanded child tax credit should ideally be made fully refundable and not tied to citizenship status, in order to help those families that are more economically vulnerable. it was also unnecessary to expand the credit in a way that made it more generous at the top end. (many more high-income families were able to claim the child tax credit post tcja.) i do not have a strong preference regarding the exemption/deduction trade off. under tcja, the combination of removing exemptions and raising the standard deduction raised about $500 billion; that revenue was used to offset some of the revenue-losing tax cuts of the tcja. indeed, that revenue gain was similar to the revenue cost of expanding the child tax credit, so the drafters of the legislation may have been seeking a different way to make tax burdens sensitive to family size. in table 4, both exemptions and the prior standard deduction are restored, but if those changes are forgone, that would provide about $500 billion in additional revenue, which could either be returned to lowand middle-income taxpayers (perhaps with a further expansion of the child tax credit) or used to fund important fiscal priorities. eventually, the role of itemized deductions should be rethought, but that is left for another day.91 88 extending to those without ssn is only $30 billion. the cost of full refundability could be offset by lowering the income threshold at which the ctc phases out. (it is now $400,000 for joint filers, but it was lower pre-tcja.). 89 see appendix a (below) for details. this estimate is based on the method of clausing, supra note 68, appendix e. 90 this uses the actual jct score. revenue effects of repeal in an upcoming budget window would be far higher since the fdii deduction loses more revenue over time in the jct score. 91 it is not ideal to tax-subsidize the purchase of certain goods (mortgage interest, charity, etc.) at a rate that is sensitive to the income of the taxpayers in question. one useful reform might be to limit the tax benefit of such deductions at the higher brackets to be the marginal rate at a lower tax bracket. such a reform would raise substantial revenue; see department of the treasury, general explanations of the administration’s fiscal year 2017 revenue proposals (2016), available at https://www.treasury.gov/resource-center/tax-policy/documents/generalexplanations-fy2017.pdf [https://perma.cc/dx7j-glu4]. more generally, it would be sensible to convert more 2020] fixing five flaws of the tax cuts and jobs act 63 under tcja, the corporate tax changes were permanent, and without further law changes, they would remain. rather than repeal these provisions, i suggest building on them to create a corporate tax package that reverses the revenue-loss from these provisions. the corporate tax cuts from tcja lost about $650 billion over ten years, setting to one side the repatriation tax revenues, which were a tax break relative to prior law. the changes i suggest below would instead raise about $500 billion over ten years, a difference of $1.1 trillion relative to the tcja. this includes an increase in the statutory rate to 28% as well as a more robust minimum tax. also, the fdii is repealed.92 the robust minimum tax differs in several substantial ways from the current global minimum tax. first, since it is a per-country minimum tax, it would not have the perverse feature of the prior minimum tax, whereby high-tax foreign country income was preferable to u.s. income. second, since all haven income would trigger immediate u.s. tax, income shifting to havens would be immediately discouraged for all u.s. companies (whereas global averaging blunts this disincentive). finally, i suggest a rate that is ¾ that of the u.s. rate, matching the original tcja corporate rate; the lower rate than the u.s. rate is meant as a compromise, given possible concerns about international comparisons and competitiveness.93 while this is one possible way to structure a minimum tax, there is also an argument for simply leaving the tax as a global minimum, but raising the rate to the u.s. rate. that may raise even more u.s. revenue, and the harmonization of the foreign rate with the u.s. rate eliminates some of the perverse incentives associated with the global feature of the minimum tax, since there is no overall advantage associated with having foreign income relative to domestic income.94 this approach may have administrative advantages over the per-country system with different rates. either reform to the minimum tax could remove the exclusion for the first 10% return on assets, and the fdii should be repealed in either circumstance. together, those two changes would eliminate the incentive to offshore physical assets that was embedded in the tcja. both types of reforms to the minimum tax, however, might be expected to increase pressure on the u.s. tax base from corporate inversions. thus, i would suggest that such a minimum tax be accompanied by strong anti-inversion measures, and that the beat be retained, and perhaps even strengthened, to further reduce such incentives. anti-inversion measures might usefully include a deductions into tax credits. for example, all taxpayers could get a tax credit for 20% of their charitable contributions, rather than being able to deduct charitable contributions from their income. 92 the fdii provision loses revenue; it is also unlikely to achieve its goal of encouraging intellectual property development in the united states; see sanchirico, supra note 74. in addition, since favorable tax treatment is conditional on exporting, it may be inconsistent with international trade law. 93 from the perspective of foreign non-haven countries, a per-country minimum tax adoption by the united states would come with both advantages and disadvantages relative to current law. on the one hand, their higher tax rates would no longer have the offsetting advantage of offsetting gilti tax for u.s. multinational companies, so the tax sensitivity of u.s. companies would increase. however, since profit shifting to havens would be less advantageous than under a global minimum tax, and since some of that shifting is also at the expense of foreign non-haven countries, this would provide an offsetting benefit. see clausing, supra note 68 (showing that these two effects are roughly offsetting in size, so foreign non-haven countries need not have a large preference about the form of the u.s. minimum tax). 94 the relative revenue effects are unclear since cross-crediting under global taxes reduces revenues relative to percountry taxes (at the same rates), yet a higher rate would increase revenues. for particular companies, the relative tax burden of the two minimum taxes would depend on the distribution of profits across countries. for example, if a company has a large amount of both haven income and high-tax country income, they could conceivable pay less minimum tax under a 28% global tax than they would under a 21% per-country tax. [vol. 11:2 columbia journal of tax law 64 management and control test, an exit tax, and a higher ownership threshold for determining foreign ownership.95 these simple measures would undo most of the flaws of the tcja, while also improving tax law relative to pre-tcja law. in particular: 1. the law no longer adds to deficits and debt. the revenue raised by the measures in table 4 is enough to counter all additional deficits from the tcja. this leaves the government with more flexibility to respond to the next recession or to fund other urgent fiscal priorities. 2. the law no longer makes the tax system more regressive; on the contrary, the changes above are progressive relative to prior law. those in the bottom of the distribution still retain their tcja tax cuts, and they benefit from the enhanced child tax credit, as well as its expanded refundability and applicability. regressive reductions in health insurance subsidies (due to the provisions weakening the aca) are reversed. the tax code will continue to be sensitive to those with large families since exemptions are restored. at the same time, more is asked from those at the top. both estate tax cuts and high-income tax cuts are reversed, and the net increase in the corporate tax will disproportionately burden shareholders. since capital income is far more concentrated that labor income, these changes will be felt at the top of the income distribution. 3. the changes in table 4 reduce the inefficient preferences for capital income (which is often rents, or above normal returns to capital) by strengthening corporate, pass-through, and estate taxation. the repeal of the pass-through deduction eliminates the new inefficiencies caused by favoring some sectors over others. 4. offshoring is no longer directly encouraged by the fdii and the gilti. profit shifting is taken far more seriously by strengthening the minimum tax on foreign income. 5. the complexities of the pass-through deduction are eliminated. however, corporate taxation remains complex, and individual taxation is slightly more complicated for those that itemize. (however, this source of complexity is overstated.) these suggestions do not tackle the controversial cap on state and local income tax deductions. i can see arguments for removing that cap, which would cost $668 billion by jct scoring methods. note that the revenue cost of increasing the amt exemption amounts and phase out thresholds under tcja (637 billion) is nearly the same size, so if both tcja changes were reversed, the combination would be approximately revenue neutral. other changes would likely be even more desirable.96 95 see stephen shay, mr. secretary, take the tax juice out of corporate expatriations, 144 tax notes 473-479 (july 28, 2014); edward d. kleinbard, competitiveness has nothing to do with it, 144 tax notes 1055-1069 (september 1, 2014); kimberly a. clausing, tax policy center, corporate inversions (2014) for more on anti-inversion measures. for the united states, one possible rule is that a u.s. resident company would be defined to include both u.s.-incorporated firms and foreign firms with their mind and management in the united states. foreign firms that have some managerial presence in the united states and that use the u.s. dollar as their functional currency would face a rebuttable presumption that they are u.s. firms. see edward d. kleinbard, the right tax at the right time, 21 fla. tax rev. 208 (2017). 96 the state and local tax deduction cap is a progressive tax law change, since the tax increase falls on higher-income taxpayers. however, critics have noted that this tax increase falls disproportionately on taxpayers in states that have relatively generous state-level public good provision, suggesting that a distributionally-neutral increase in top tax rates might be preferred to the state and local tax deduction cap. another possible reform would be to replace the cap by instead limiting all itemized deductions to a lower tax rate (such as 25%), or by simply replacing such deductions with uniform credits that do not depend on the taxpayer’s marginal tax rate. 2020] fixing five flaws of the tax cuts and jobs act 65 finally, it is important to note that table 4 is merely suggestive of possible revenue effects. there are surely interactions between the provisions above that would affect the numbers of table 4, if estimated by jct experts. thus, this table should be viewed as an indication of approximate magnitudes and not as the final word on how this combination of law changes would affect revenues. even the jct is uncertain about exact magnitudes! viii. building a better tax reform the prior section demonstrated that the essential flaws of the tcja are relatively easy to fix, and one can do better than simply repealing the entire bill. indeed, one can eliminate the additional deficits of the tcja while making the tax code more progressive than it was beforehand. it is also possible to combat profit shifting and eliminate the misguided offshoring incentives of the tcja. this section moves forward from that starting point, laying out a rough sketch of a larger scale tax reform that would make our tax system more compatible with the challenges of today’s global, technologically sophisticated economy. in particular, there are three daunting policy problems can all be addressed together through a comprehensive tax reform. first, as discussed in section iii, we’ve experienced over 35 years of increasing income inequality and relatively stagnant wage growth.97 while the economy as a whole has performed admirably, with strong growth in gdp per-capita, typical households have seen less economic progress. several key forces are jointly responsible for the subdued wage growth of those in the bottom 2/3 of the population: technological change that rewards those with high educational attainment while harming those with less education, increased market power of companies relative to workers, increased international competition, changes in social norms, and important changes in economic policy. second, our tax system is not suited to either the global nature of modern business activity nor the rising share of capital in national income. for example, 70% of u.s. equity income goes untaxed by the u.s. government at the personal level, leaving business taxation an essential role in capital taxation. yet corporate taxation is leaky; loopholes allow many profits of multinational companies to escape taxation.98 discrepancies between the tax treatment of corporate and passthrough business activity also distort the choice of organizational form and further reduce the business tax base.99 business taxation, estate taxation, and personal capital taxation could all be usefully strengthened. third, climate change is a singular threat, posing grave threats to the livability of our planet. in chapter ten of my recent book, i lay out the broad contours of a “grand bargain” tax reform that would simultaneously respond to all three challenges, and i build on section vii to suggest a similarly comprehensive reform here.100 a grand bargain brings disparate constituencies together. in this plan, those on the left may appreciate the response to climate change as well as 97 see clausing, supra note 25 (discussing these challenges alongside a thorough discussion of the casual factors that have contributed to these troubling labor market trends). 98 see leonard e. burman et al., supra note 59 (regarding the low share of u.s. equity income that is taxed by the u.s. government). see clausing, supra note 68 (regarding the profit shifting of multinational companies). 99 see cooper et al., supra note 67 (regarding the loss of revenue due to the prior favorable tax treatment of passthrough business income prior to the tcja. of course, the tcja creates its own inequities in this domain, as described above). 100 see clausing supra note 25 at chapters 10. [vol. 11:2 columbia journal of tax law 66 the greater progressivity of the tax system, while those on the right may appreciate that tax rates can be lower, and our tax system more efficient, if we close loopholes and rely on new revenue sources. what are the building blocks of a better tax reform? a good starting point is the list of incremental changes in section vii. the corporate tax provisions of section vii toughen the minimum tax substantially, helping protect our corporate tax base from the serious erosion caused by international profit shifting. together with the repeal of the pass-through deduction, these provisions do a better job of taxing capital income in a global economy. but, it is useful to go further. the plan in table 5 also addresses income inequality, wage stagnation, and climate change. an expansion of the earned income tax credit boosts incomes at the bottom and middle of the u.s. wage distribution. tackling loopholes, increasing capital taxation, and creating a stronger estate tax all address top-end income inequality. the additional tax contributions from those at the top of the income distribution are meant to ensure that all sources of income get taxed at reasonable rates, reducing inefficient tax distortions and increasing revenue. ideally, all forms of income (received by the same person/entity) would be taxed at the same rate, and these reforms move the tax system toward that goal. finally, the carbon tax provides a new source of revenue, and it responds to the world’s most important market failure. table 5: a better tax reform possible 10yr revenue, in billions of usd tcja changes (table 4 above) + 1,455 offsets revenue loss due to tcja new changes expansion of earned income tax credit/child tax credit 2,450 carbon tax, rising over ten years from $5 to $50 per metric ton co2 + 1,100 on net, new changes are revenue neutral changes to capital taxation + 700 reductions in loopholes and enhanced i.r.s. enforcement +400 more robust estate tax + 250 as a package, the changes of the prior section eliminate the deficits caused by tcja. the reforms suggested here could be pursued on either a revenue-neutral basis or on a revenueincreasing basis. keeping revenues constant still implies a baseline of increasing debt to gdp ratios, due to the aging of the baby boom generation and our prior commitments to social security and medicare. a revenue-positive reform would allow the funding of other urgent priorities 2020] fixing five flaws of the tax cuts and jobs act 67 (without resorting to even more deficits) or deficit and debt reduction; either would leave us in a better starting place when the next recession arrives. the suggestions of table 5 are relatively modest, although the politics will still be difficult. in appendix b, i consider a larger scale version of the same reforms. while that version of these reforms appears less politically feasible now, it is a useful comparison in case the range of possibilities expands. consider each of the five main tax measures in table 5. first, the earned income tax credit (eitc) is an efficient and well-designed anti-poverty tool, justifiably supported by many thinkers and policy-makers on both sides of the political spectrum. the eitc subsidizes work, since it provides negative tax rates for those with low incomes. indeed, the earned income tax credit illustrates why the tax system is a powerful redistributive tool, capable of ensuring that gains in gdp translate into gains in income for most members of society. to increase wages at the bottom of the income distribution, the earned income tax credit can be expanded to be larger and more generous for childless workers, extending benefits higher up the income ladder. at present, the eitc is far more generous for those with children than for the childless. for example, figure 11 shows that for those with two children, the eitc can add over $5,900 to their income, whereas for childless workers the maximum eitc is only $538. figure 11: the earned income tax credit in 2020 while some have argued that the eitc is unduly complex and difficult to administer, an alternative formulation could simultaneously reduce administrative burdens and reach more people. in particular, the eitc could extend to all workers regardless of the number of children, and the child tax credit could be expanded in tandem to help those with children. it would be important to make the child tax credit fully refundable so that parents received the credit even if their incomes were too low to owe tax that year. like the eitc, the child tax credit could be phased out to avoid reaching those with higher incomes who are relatively well off. despite the political popularity of the universal basic income in some circles, the eitc is a much better way to move resources toward those who need them the most. in contrast, the 0 1000 2000 3000 4000 5000 6000 7000 0 2, 00 0 4, 00 0 6, 00 0 8, 00 0 10 ,0 00 12 ,0 00 14 ,0 00 16 ,0 00 18 ,0 00 20 ,0 00 22 ,0 00 24 ,0 00 26 ,0 00 28 ,0 00 30 ,0 00 32 ,0 00 34 ,0 00 36 ,0 00 38 ,0 00 40 ,0 00 42 ,0 00 44 ,0 00 46 ,0 00 48 ,0 00 ea rn ed in co m e ta x cr ed it earned income no children two children [vol. 11:2 columbia journal of tax law 68 universality of the basic income make it very expensive. even a modest $12,000 per american ubi would cost an amount ($3.9 trillion) greater in size than the entire tax revenues of the federal government in 2018 ($3.3 trillion).101 one nice feature of the earned income tax credit is that it is directed at the true nature of our labor market problems. the unemployment rate has been quite low, standing at 3.5% as of december 2019, but the problem faced by many workers over the past few decades is that many jobs do not pay well. if you work full time at the federal minimum wage, you earn $14,500 per year, an amount that would put workers below the federal poverty line if they support even one dependent. the earned income tax credit can make a huge difference for such workers. second, consider the carbon tax. my proposal would gradually phase in a carbon tax of $50 per metric ton, increasing the carbon tax by $5 each year for ten years. thus the revenue for the ten year window ($1.1 trillion) masks an increase in revenue, such that by the end of the window the carbon tax would be raising $200 billion a year. the phase in would be a useful way to reduce disruption as the market adjusted a more correct price of carbon. this revenue estimate is from the congressional budget office estimate of a $25 per ton carbon that that would be in place over the entire ten-year-period.102 i consider a larger carbon tax in the appendix b proposal. unlike most taxes, a carbon tax increases efficiency since the market left to its own devices would overproduce carbon, since markets ignore the external costs associated with climate change and global warming. however, a carbon tax provides a powerful price signal encouraging all businesses and consumers to reduce their carbon footprints. a carbon tax also makes alternative energy sources and green technology more cost-effective, as traditional energy sources relying on carbon become increasingly expensive in comparison. this incentivizes innovation and the development of new technology. of course, it would also be sensible to devote more public spending to these goals, given the urgency of this policy priority. for political reasons, it may be wise to tighten the link between the carbon tax and tax relief. while the package above would be a direct way to make sure that tax benefits went to those who most needed them, many have argued that simply returning the carbon tax to americans on an even per-capita basis (as a carbon “dividend”) might help build political support for this critically important policy step. 101 a hybrid option would retain the phase out of the eitc as incomes rose, but would include a lump-sum initial credit, not dependent on work. in the diagram above, the credit would start at some positive amount, even with zero hours of work, and then rise less steeply. this hybrid option lacks the universality of a classic ubi (since higherincome people would no longer receive it), and unlike the eitc, it removes the link between the initial benefit and work. some favor this structure since it would be more helpful for those that could not find work. still, unemployment insurance and disability insurance are intended to help with economic hardship due to many sources of joblessness. also, because of the additional expense associated with not “phasing in” the tax credits with income, other features (such as the credit per hour of work and the maximum credit) would need to be less generous, for any given budget cost. this would reduce the wage subsidy element of the eitc. 102 see congressional budget office, the budget and economic outlook: 2018 to 2028 (2018) (outlining a baseline from which to create assumptions about carbon tax effects). here i assume that a phased in carbon tax that would average the same rate over ten years would raise the same revenue; however, ongoing revenues under this carbon tax would be higher. the cbo estimates allow behavioral response (i.e., less carbon) in their estimates; that tax would be indexed for inflation. there is of course some controversy over the exact external cost of carbon, and estimates vary substantially. see, e.g, robert s. pindyck, the social cost of carbon revisited, 94 j. of env’t econ. and mgmt. 140 (2019) (finding that the social carbon cost estimates of most experts averages quite a bit higher than $50 per metric ton, although $50 per metric ton is closer to government estimates). for example, the u.s. epa lists a social cost of carbon for 2020 of $62 at a 2.5% discount rate or $42 at a 3% discount rate. estimates are sensitive to the discount rate since many of the costs of climate change are felt in the future. 2020] fixing five flaws of the tax cuts and jobs act 69 since carbon would still be more expensive, the environmental aims would continue to be realized, even if the tax revenue were simply turned directly back to the people. and, if the revenue were handed back on an even per-capita basis, estimates suggest that 70% of americans would be better off, since the rich consume more carbon than the poor (in total).103 if such a step were necessary to build support for the carbon tax, that is definitely preferable to no action. however, combining the carbon tax with the reforms in table 5 is more intellectually appealing, since the earned income tax credit is a more direct method of moving resources toward those with the most need, whereas a uniform per-capita carbon dividend is less targeted. third, capital taxation can be further buttressed to level the playing field between capital and labor income. at present, capital gains and dividends are taxed preferentially relative to wage income. as discussed in sections iii and iv above, there is no strong theoretical foundation behind this policy stance, nor is there solid empirical evidence in favor of light capital taxation. however, there is evidence that the capital share of income is rising and that capital income is far more concentrated than labor income, both arguments for greater capital taxation. the suggested incremental reforms in table 4 move in this direction by strengthening business taxation. but there are also useful reforms on the individual level. still, some worry about the possible double taxation of equity-financed investments if both business and individual capital taxation are strengthened. there are several reasons why such worries are overstated. first, debt-financed investments are not double-taxed, since they are typically subsidized through the corporate tax system. second, 70% of equity income is not taxed at the individual level by the u.s. government.104 third, due to the generous treatment of new investments (for example, full expensing of equipment under present law), the business layer of taxation mostly falls on excess profits, profits above the normal return to capital. even prior to full expensing of equipment investment, over 75% of the corporate tax base was comprised of excess profits.105 thus, as discussed in section iv, efficiency considerations surrounding excess taxation are likely to be minimal.106 following revenue estimates from the department of treasury and the congressional budget office, i suggest four main reforms.107 1. couple a four-point increase in capital gains and dividends tax rates with reforms that would undo the step-up in basis at death for capital assets. presently, step-up in basis leaves much capital appreciation untaxed and also causes investors to retain assets too long for tax purposes. eliminating step-up in basis will increase the revenue gain from any capital gains tax increase, since higher tax rates increase investors’ desire to hold assets until death. a. [~ $250 billion over ten years] 103 see john horowitz et al., methodology for analyzing a carbon tax (2017). 104 leonard e. burman et al., supra note 59. 105 see laura power & austin frerick, supra note 58. 106 see jason furman, how to increase growth while raising revenue: reforming the corporate tax code, in tackling the tax code: efficient and equitable ways to raise revenue 285 (jay shambaugh ed., 2020) (proposing a method to make the corporate tax code more efficient). however, if instead the tax system evolves toward higher capital taxation without expensing, it might be useful to eventually consider proposals for integration, such as allowing shareholders tax credits for corporate taxes already paid on the underlying income. 107 all numbers are approximate, and it is important to account for inflation and income growth in the period between the cbo/treasury analyses and implementation. estimates for i, ii, and iv are based on estimates from department of the treasury, supra note 92; estimates for iii are from congressional budget office, supra note 103. [vol. 11:2 columbia journal of tax law 70 2. ensure that all business income of high-income taxpayers is subject to the 3.8% medicare tax through either the net investment income tax or the self-employment contributions system. extend self-employment taxes to all owners of professional services businesses. a. [~ $300 billion over ten years] 3. limit retirement contributions by capping the total employee/employer contribution to $50,000 per year, capping ira contributions, and not allowing roth ira conversions for high-income taxpayers. a. [~ $100 billion over ten years] 4. limit deferral of capital gains on “like kind” businesses or investment properties. [~$50 billion over ten years] fourth, i suggest increased i.r.s. enforcement as well as additional loophole closures that would raise $400 billion over ten years in total. repealing the carried interest loophole would raise $20 billion, requiring derivatives to be marked to market with ordinary treatment of gains/losses would raise about $20 billion, reducing fossil fuel tax breaks would raise about $40 billion, and greater i.r.s. enforcement resources alongside a better targeting of those resources would raise about $320 billion.108 after decades of poor funding, the i.r.s. needs far more resources to administer the tax code.109 giving the i.r.s. the resources they need, and focusing enforcement in the areas where it will be most productive, can raise both taxpayer morale and government revenue. finally, i suggest provisions that allow for a more robust estate tax. simply restoring the estate, gift, and generation-skipping transfer tax parameters from 2009 would raise over $200 billion; other minor provisions closing estate tax loopholes make the total closer to $250 billion.110 appendix b also considers larger revenue-raising proposals for capital taxation, the i.r.s. enforcement, and estate taxation. these follow recent suggestions from batchelder (2020) and sarin, summers, and kupferberg (2020).111 all of these numbers are approximate. while based on numbers from similar estimates from the treasury and the cbo, interactions between provisions and the effects of intervening changes in the law are difficult to estimate. both inflation and ensuing economic growth since the studies in question undoubtedly raise these estimates. table 5 should be treated as merely illustrative of the rough magnitudes of revenue increases that such law changes are likely to generate. still, the broad outline of this reform is possible, and tax rates are not dramatically higher than they were pre-tcja; for most people, they are lower! distortions between different forms of income, different industries, and different locations of income are all reduced. the tax system is made far more progressive by strengthening capital taxation and providing tax relief for those with lower incomes. climate change is addressed in a way that helps fund tax relief for lower-income americans. 108 aside from the i.r.s. numbers, the remainder of the estimates are based on department of the treasury, supra note 92. the i.r.s. numbers are a more modest version of proposals from natasha sarin & lawrence h. summers, shrinking the tax gap: approaches and revenue potential, tax notes federal 1099–1112 (2019). 109 see paul kiel & jesse eisinger, how the irs was gutted, propublica (copublished with the atlantic), (december 11, 2018) https://www.propublica.org/article/how-the-irs-was-gutted [https://perma.cc/9u32-umgc] (describing the underfunding of the i.r.s.). 110 estimates are based on department of the treasury, supra note 92. 111 lily l. batchelder, leveling the playing field between inherited income and income from work through an inheritance tax, in tackling the tax code: efficient and equitable ways to raise revenue 43 (jay shambaugh ed., 2020); natasha sarin et al., tax reform for progressivity: a pragmatic approach, in tackling the tax code: efficient and equitable ways to raise revenue 317 (jay shambaugh ed., 2020). 2020] fixing five flaws of the tax cuts and jobs act 71 none of these proposals require a fundamental rethinking of our basic system of taxation; all of these changes have been considered before and would be relatively simple to legislate. since these reforms do not require lengthy periods of technical study prior to implementation, they could be implemented relatively swiftly, although it is wise to allow adequate time for debate and reflection. in the long run, we should strive for more innovative solutions to our tax policy problems. for example, as i’ve noted elsewhere, formulary apportionment would be a useful fundamental reform of international corporate taxation. 112 however, it is also a reform that would benefit from international cooperation as well as careful study of technical implementation issues. likewise, a destination-based cash-flow tax would be best implemented within a framework of international cooperation and with adequate time to address the challenges of technical implementation.113 also, there is room for more innovation and boldness in terms of expansions to the earned income tax credit. as one example, burman (2019) suggests a massive expansion of the earned income tax credit, raising the credit to 100% matching, raising the maximum credit to $10,000, pairing with an expansion of the child tax credit, and indexing the maximum credit to gains in gdp per-capita.114 since this plan costs over $1 trillion per year when it is fully phased in, burman pairs it with an 11% value-added tax to achieve revenue neutrality. the combination is strongly progressive, and it results in substantial poverty reduction. however, given the scale of the change as well as the need for a vat, that proposal will also require time. depending on political decisions regarding the ideal role of the state, the government may need more revenue than the above proposals generate, and appendix b suggests additional revenue options. still, these proposals provide a solid foundation from which to raise additional revenue, and rates can be raised (or lowered) across the board from this starting point. more generally, it is important to remember that spending, as well as taxation, has distributional consequences; the fiscal system needs to be viewed as a whole.115 as one example, the social security system is progressive as a whole (including both benefits and taxes), even though the payroll tax that finances it is regressive. ix. conclusion with respect to every important tax policy desideratum, we can do a lot better than public law 115-97 (the tcja). there are five central ways in which the new tax law moves the tax system away from ideal tax policy principles. first, the legislation finances tax cuts with deficits. deficits are not always bad; they can be quite helpful in times of recession, and future-oriented public investments in infrastructure or human capital may justify defraying some of their tax costs 112 see reuven s. avi-yonah & kimberly a. clausing, reforming corporate taxation in a global economy: a proposal to adopt formulary apportionment, in path to prosperity: hamilton project ideas on income security, education, and taxes 319 (jason furman & jason e. bordoff eds, 2008) and kimberly clausing, taxing multinational companies in the 21st century, in tackling the tax code: efficient and equitable ways to raise revenue 237 (jay shambaugh ed., 2020). 113 see reuven s. avi-yonah & kimberly a. clausing, problems with destination-based corporate taxes and the ryan blueprint, 8 colum. j. tax l. 229 (2017). 114 leonard e. burman, a universal eitc: sharing the gains from economic growth, encouraging work, and supporting families (2019), available at https://www.taxpolicycenter.org/publications/universal-eitc-sharing-gainseconomic-growth-encouraging-work-and-supporting-families/full [https://perma.cc/r2ug-fujk]. 115 see edward d. kleinbard, we are better than this: how government should spend our money (2015). [vol. 11:2 columbia journal of tax law 72 into the future. however, the increasing deficits and debt under the tcja risk displacing other urgent fiscal priorities as well as justifying a more timid fiscal response to the next recession. second, in a time of worsening income inequality, tcja provides far larger tax cuts for those at the top of the distribution than others, both relative to incomes and in absolute terms. tax cuts for the bottom 3/5 of the income distribution turn into tax increases over time. further, even in the first year of the legislation, for most americans the tax cuts’ modest boost to their after-tax incomes is far outweighed by the higher costs of health insurance premiums, due to the deliberate weakening of health insurance markets under the tcja.116 also, despite ebullient claims from administration economists that the corporate tax cuts would ultimately cause large wage gains, there is no evidence that buttresses such assertions – either presently or in the larger body of data from past experience. third, by cutting taxes dramatically for capital income, including corporate income, passthrough business income, and estates, the tax law exacerbates the under-taxation of capital in our tax system. contemporary research provides scant theoretical rationale for lighter capital taxation, especially since excess (above-normal) profits are now a big part of the capital income tax base. also, there is no empirical evidence that reducing capital taxation creates broad benefits for the economy as a whole. cuts in capital taxation do exacerbate increased income concentration, since capital income is far more concentrated than labor income. fourth, the legislation makes limited (if any) progress on the substantial problems of profit shifting and corporate tax base erosion. there are conflicting incentives within the international provisions of the tcja; on net, the international provisions do not raise revenue relative to prior law.117 in addition, the tcja introduces new incentives for the offshoring of physical assets, since increasing assets in low-tax countries enables foreign income to be more lightly-taxed. in contrast, increasing assets in the united states reduces the tax benefits associated with the new export subsidies in the law. overall, the post-tcja tax system tilts the playing field in favor of earning foreign income and making foreign real investments. finally, any modest simplification gains on the individual side of the tcja are more than offset by increased complexity on the business side; both the new pass-through deduction and the new international provisions are enormously complex. further, the planned expiration of many provisions in the law, as well as the planned changes in tax rates, r&d amortization, and other provisions, will increase uncertainty, complexity, and the budget costs of the legislation (if provisions are extended). with so many flaws in the new tax law, it is tempting to simply repeal and start fresh. yet the new law provides a useful starting point for reforms that might improve tax law relative to pretcja law. the law can be made far more progressive by keeping the tax cuts that benefit the lower end of the income distribution, reinstating the enforcement of the individual mandate, and expanding the (now larger) child tax credit to be fully refundable and to apply to more low-income taxpayers. these changes can be coupled with changes that eliminate tax cuts for those at that top, repeal the pass-through deduction, raise the corporate tax rate, and toughen the minimum tax. this 116 the tcja repealed the tax penalty for going without health insurance. as more americans go uninsured, that increases both their own financial vulnerability (due to the high costs of illness or medical bankruptcy) and the insurance premiums for those remaining in the insurance pool. the joint committee on taxation estimates that the tcja will reduce government spending on subsidies for health insurance for low-income americans by over $300 billion. 117 this ignores the revenue from the repatriation tax on prior foreign earnings; that provision is a tax break relative to prior law. 2020] fixing five flaws of the tax cuts and jobs act 73 package of incremental changes would eliminate the additional deficits created by the tcja while making the u.s. tax code substantially more progressive than it was before the tcja. these changes can also address profit shifting and the under-taxation of capital income. in terms of profit shifting, the minimum taxes on international income under tcja are a useful starting point, but they can be strengthened to work better. to counter the under-taxation of capital income, stronger business taxation is essential, since 70% of u.s. equity income is untaxed by the u.s. government at the individual level. the aforementioned reforms address most of the flaws of the tax cuts and jobs act. however, there is still room for more comprehensive tax reform. in section viii, i suggest a reform that would strengthen incomes at the bottom and middle of the income distribution through an expanded, reformed earned income tax credit. the proposal is revenue neutral; it is funded with the proceeds of a new carbon tax, stronger individual capital and estate taxation, the closing of loopholes, and better tax administration and enforcement. this larger reform responds to several serious threats we are facing at the present moment in economic history. the world’s most important market externality is climate change, and a carbon tax is a crucial way to respond to that challenge while also funding other urgent priorities. beyond climate change, our most serious economic problem is the failure of the last four decades of economic growth to deliver broadly shared economic gains to society at large. the tax system is a powerful tool for promoting more inclusive growth, if we have the will to use it. by increasing the progressivity of the tax system, and by making the rewards to work greater for those in the bottom parts of the income distribution, we can ensure that gains in gdp benefit most americans while also funding our fiscal priorities. [vol. 11:2 columbia journal of tax law 74 appendix a: estimating the revenue from a 21% per-country minimum tax to calculate the amount of revenue that would be raised from a per-country minimum tax at 21%, i follow the method described in clausing (2020) appendix e.118 the analysis is based on two data sources: the direct investment income series reported by the u.s. bureau of economic analysis and the country by country income series reported by the u.s. i.r.s. statistics on income. table a1 shows simple mechanical estimates of the revenue gain associated with higher per-country minimum taxes for these data series. the method behind this table is simple. for each country with an effective tax rate below the minimum tax rate, the difference between the minimum tax rate and the country’s effective tax rate is multiplied by the profit in that country. two-thirds of the resulting revenue is allocated to the united states, reflecting the fact that u.s. multinational companies undertake about two-thirds of their economic activity in the united states. the remaining revenue ends up in other non-haven countries, due to reduced profit shifting from all non-haven countries under the minimum tax. due to a reduced incentive to shift profits, the pattern of taxable profits across countries is likely to change, more closely reflecting the underlying location of economic activity. thus, havens will lose tax base and non-havens will gain tax base. thus, over time, the u.s. minimum tax revenue will partially show up as increased domestic corporate tax base (rather than minimum tax revenue), due to adjustments in the distribution of taxable profits. table a1: u.s. revenue from a 21% per-country minimum tax in 2017 direct investment income series (balance of payments data; adjusted to be pre-tax) full country-by-country sample (without stateless income) average of full and positive profit country-bycountry sample (without stateless income) $30b $41b $53b to calculate a ten-year revenue estimate, i average these three estimates, account for 4% nominal growth in foreign earnings over the ten-year window, and subtract the revenues that would otherwise be earned by our current global minimum tax. that generates a ten-year revenue estimate of $360 billion for this budget window. 118 clausing, supra note 68 app. c. 2020] fixing five flaws of the tax cuts and jobs act 75 appendix b: a bolder tax reform table b1: higher revenue version of table 5 reforms possible 10yr revenue, in billions of usd tcja changes (table 4 above) + 1,455 offsets revenue loss due to tcja new changes expansion of earned income tax credit/child tax credit 4,000 carbon tax, rising over ten years from $50 to $100 per metric ton co2 + 3,000 leaves $2.1 trillion for urgent fiscal priorities changes to capital taxation + 1,100 reductions in loopholes and enhanced i.r.s. enforcement +1,100 inheritance tax + 900 this reform includes more aggressive revenue raisers in addition to more spending on the eitc/ctc. it also leaves $2.1 trillion for urgent fiscal priorities. while these will of course be determined by the congress, the challenge of climate change presents a compelling argument for allocating some of that spending toward climate mitigation as well as green r&d spending. this proposal includes a much larger carbon tax, and a more aggressive attempt to raise revenue through i.r.s. enforcement, following the proposals and estimates of sarin and summers.119 the estate tax is replaced with an inheritance tax, whereby inheritances are taxed as ordinary income, with a $1 million exemption per heir, as proposed by batchelder.120 step-up in basis and carry-over in basis would be eliminated. for inheritances under $10 million, deferral of tax liability on illiquid assets would be allowed with an interest charge. inheritance income could be spread over five-years to minimize work disincentives from spiking tax rates. capital taxation is further strengthened as well, with an additional revenue gain of $400 billion. in addition to the reforms of section viii, capital gains rates are increased to ordinary top income tax rates, again coupled with eliminating step-up in basis. this reform also ends tax preferences for charitable giving for long-term appreciated assets. see sarin, summers, and kupferberg121 for an estimate; my estimate is somewhat lower to account for interactions with the inheritance tax proposal. 119 sarin & summers, supra note 109. 120 batchelder, supra note 112. 121 sarin et al., supra note 112. the realization rule as a legal standard sloan g. speck* abstract the realization “rule” in tax law is better characterized as a legal standard. this characterization matters after the supreme court’s decision in moore v. united states, which sets the stage for future courts to decide that the constitution mandates realization— an identifiable event before accrued income is reportable by taxpayers. the stakes of a constitutional realization requirement are underappreciated. because current statutory law embeds realization as a background principle, a constitutional realization requirement would operate as a taxpayer-initiated antiabuse doctrine—a sword that taxpayers could use selectively to invalidate parts of the internal revenue code and treasury regulations. this novel constitutional tool has adverse, and underappreciated, implications for the u.s. tax system’s structure and complexity. through the lens of the longstanding academic literature on legal rules and standards, the dangers of a constitutional realization requirement extend beyond top-down risks to individual internal revenue code provisions or, as the moore majority posited, entire taxing regimes. instead, a constitutional realization requirement threatens to erode federal income tax law from the bottom up, through incremental public and private challenges to the fundamental mechanics of taxation. realization and nonrealization permeate business entity taxation in deeply technical ways. in these areas, a constitutional realization requirement may facilitate aggressive private planning, undermine the law’s coherence, and dampen reform efforts. even moore’s whisper of a constitutional realization requirement ventures into poorly charted territory, with potentially detrimental consequences that may prove difficult to unwind. moreover, a constitutional realization requirement portends increased complexity in tax law. government-asserted antiabuse doctrines constrain complexity by allowing lawmakers to write simpler rules that cover high-frequency transactions. low-frequency transactions, including those that reflect inappropriate tax planning, are addressed through (and discouraged by) open-ended standards in the enforcement process. as a taxpayer-initiated antiabuse doctrine, a constitutional realization requirement would have the reverse effect, increasing complexity by increasing the frequency of tax-planned transactions, encouraging more costly government responses to taxpayer abuse, and changing the dynamics of enforcement. the resulting complexity would be systemic—and could increase over time. * associate professor of law, university of colorado law school. thanks to sam astorga, rabea benhalim, jonathan booth, david elkins, ari glogower, kate goldfarb, amanda parsons, blake reid, and participants at the sixth annual uci law–taylor nelson amitrano llp tax symposium and national tax association’s 117th annual conference on taxation for helpful comments and discussion. 2 columbia journal of tax law [vol. 16:1 i. introduction ...................................................................................................3 ii. realization’s past, present, and future ....................................................9 a. the past: burying macomber ....................................................................10 b. the present: decisions and indecision ......................................................16 1. realization in moore ............................................................................17 2. the moore opinions ............................................................................19 c. the future: circuit courts and certiorari ..................................................21 iii. constitutional realization as an antiabuse doctrine ........................23 a. realization’s facts and circumstances ......................................................24 1. constructive sales ................................................................................24 2. gift loans ............................................................................................27 3. debt modifications ...............................................................................30 4. conclusion ...........................................................................................33 b. realization’s doctrinal elements ..............................................................33 1. context and realization .......................................................................34 2. abuse and antiabuse ............................................................................35 3. line-drawing and realization .............................................................36 4. conclusion ...........................................................................................38 c. realization as an antiabuse doctrine ........................................................38 iv. the hollowing-out of tax law ................................................................39 a. bottom-up challenges to the tax system ................................................40 b. examples from partnership taxation .........................................................43 c. examples from corporate taxation ...........................................................45 v. complexity and the realization requirement .......................................46 a. government responses: promulgation ......................................................47 b. taxpayer responses: compliance .............................................................48 c. government responses: enforcement .......................................................50 vi. conclusion ....................................................................................................50 2024] realization rule as a legal standard 3 i. introduction although often styled as a “rule,”1 the realization requirement in federal income tax law is better characterized as a legal standard.2 realization—the idea that a “taxable event” fixes the timing and amount of income reportable by a taxpayer3—ultimately turns on the bespoke facts of each situation, as interpreted ex post in the enforcement process.4 this characterization matters in the context of the supreme court’s opinion in moore v. united states, which considers (but does not decide) whether the sixteenth amendment mandates realization for income taxes exempt from the constitution’s limitations on direct taxes.5 because the internal 1 see, e.g., deborah h. schenk, a positive account of the realization rule, 57 tax l. rev. 355, 355 (2004); cf. alice g. abreu & richard k. greenstein, it’s not a rule: a better way to understand the definition of income, 13 fla. tax rev. 101, 132 (2012) (“it is not surprising that in the unrelenting deluge of apparent commandments many tax scholars and other professionals have come to assume that all of the tax law is composed of rules.”). 2 the academic literature on rules and standards is large and long-standing. this article defines rules as legal directives with greater ex ante content and standards as directives with more content developed ex post. in constructing laws, the stakes principally involve the costs of compliance and administration. see louis kaplow, rules versus standards: an economic analysis, 42 duke l.j. 557, 562-63 (1992). in taxation, private planning looms large in accounting for these costs. see david a. weisbach, formalism in the tax law, 66 u. chi. l. rev. 860, 868-69 (1999); see also infra part v. other approaches to the rules-standards debate exist. see, e.g., colin s. diver, the optimal precision of administrative rules, 93 yale l.j. 65, 72 (1983) (approaching regulatory precision from an efficiency perspective); pierre j. schlag, rules and standards, 33 ucla l. rev. 379, 381 (1985) (arguing that conventional debates about rules and standards lack a cogent normative underpinning). in tax law, see, e.g., alice g. abreu & richard k. greenstein, defining income, 11 fla. tax rev. 295, 331 (2011) (evaluating the aptness of rules and standards by “the ratio of easy to controversial applications”); david elkins, rules, standards, and the value of certainty in tax law, 22 berkeley bus. l.j. (forthcoming 2024) (arguing against standards in tax law because low audit rates create inequitable outcomes across taxpayers), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4782454 [https://perma.cc/3jjy-yd4j]; andrew t. hayashi, a theory of facts and circumstances, 69 ala. l. rev. 289, 292 (2017) (taking a game-theoretic approach to rules and standards where parties have private information). 3 classically, realization involves a “sale or other disposition of property.” see i.r.c. § 1001(a) (1986). henceforth, all “i.r.c. §” references are to the internal revenue code of 1986, as amended (26 u.s.c.), and all “treas. reg. §” references are to the treasury regulations (26 c.f.r.). for a discussion of dispositions in the realization context, see jeffrey l. kwall, when should asset appreciation be taxed?: the case for a disposition standard of realization, 86 ind. l.j. 77 (2011). 4 although transactions are structured ex ante, advisors typically give legal advice based on probable outcomes in litigation before a hypothetical court that considers the relevant issues and possesses a comprehensive set of facts. see linda galler, tax opinion policies and practices, 75 tax law. 443, 454 (2022); see also infra part iv. 5 see moore v. united states, 144 s. ct. 1680 (2024). in moore, the ninth circuit found that a constitutional realization requirement did not exist. see moore v. united states, 36 f.4th 930, 935 (9th cir. 2022) (“whether the taxpayer has realized income does not determine whether a tax is constitutional.”). then, the supreme court held in the government’s favor on other grounds. see moore, 144 s. ct. at 1685. moore has generated a large volume of academic and practitioner commentary. see, e.g., hank adler & madison s. spach, jr., more on moore, 180 tax notes fed. 2079 (sept. 18, 2023); john r. brooks & david gamage, moore v. united states and the original meaning of income (fordham l. legal. stud. res. paper no. 4491855, 2023); lee a. sheppard, supreme court urged to rule on tcja transition tax, 179 tax notes fed. 2113 (june 26, 2023). in addition, moore has received extensive coverage in the popular press. see, e.g., ian millhiser, billionaires had a surprisingly bad day in the supreme court today (dec. 5, 2023), vox, https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4782454 4 columbia journal of tax law [vol. 16:1 revenue code (code) and treasury regulations (regulations) embed realization as a background principle,6 a constitutional standard for realization would operate as a taxpayer-initiated antiabuse doctrine—a novel constitutional device that taxpayers could deploy selectively to erode the fundamental structure of the current code and regulations. this new device has adverse—and underappreciated— consequences for the structure and complexity of tax law going forward.7 from an economic perspective, rules and standards differ in how precisely their legal content is specified before the objects of this content take action.8 rules, such as numeric speed limits, provide greater specificity ex ante. by contrast, standards, such as laws prohibiting reckless driving, acquire their principal content ex post.9 identical legal content may be expressed through rules or standards.10 either design strategy may prohibit speeding, but rules contain specific up-front content, while the precise parameters of standards emerge through enforcement. in the tax context, many day-to-day questions of realization are uncontroversial, making many ex ante determinations relatively straightforward.11 just beyond the https://www.vox.com/scotus/2023/12/5/23989306/supreme-court-wealth-tax-billionaires-mooreunited-states-elizabeth-warren [https://perma.cc/k9hn-cu8r]; alan rappeport, how a legal fight over a $15,000 tax bill could upend the u.s. tax code (dec. 5, 2023), n.y. times, https://www.nytimes.com/2023/12/05/us/politics/supreme-court-corporate-taxes-explainer.html [https://perma.cc/s3hm-lxfe]; richard rubin & jess bravin, one supreme court case could mess up chunks of the tax code (dec. 3, 2023), wall st. j., https://www.wsj.com/usnews/law/one-supreme-court-case-could-mess-up-chunks-of-the-tax-code-680a9ba6 [https://perma.cc/9xy9-36z4]; mark joseph stern, sam alito’s lonely fight to defend his friend’s harebrained anti-tax scheme (dec. 5, 2023), slate, https://slate.com/news-andpolitics/2023/12/sam-alito-moore-arguments-tax-scheme.html [https://perma.cc/y3lb-abf7]. 6 this statement is not controversial as a positive matter. see boris i. bittker et al., bittker, mcmahon, & zelenak: federal income taxation of individuals § 3.2, westlaw (database updated apr. 2024) (“[r]ealization is nevertheless so basic to the taxing structure of existing law that the general principle is simply not challenged.”). as a normative matter, the code and regulations’ reliance on realization has provoked a large (and largely critical) academic literature. see, e.g., zachary liscow & edward fox, the psychology of taxing capital income: evidence from a survey experiment on the realization rule, 213 j. pub. econ. 104714 (2022) (exploring public perceptions of the realization requirement); david m. schizer, realization as subsidy, 73 n.y.u. l. rev. 1549, 1552 (1998) (noting critiques and arguing that statutory realization operates as a subsidy for capital investment). perhaps the most famous characterization of realization is as the “achilles’ heel” of the income tax system. william d. andrews, the achilles’ heel of the comprehensive income tax, in new directions in federal tax policy for the 1980s 278, 280 (charles e. walker & mark a. bloomfield eds., 1983). 7 this article does not consider whether current law that does not satisfy a constitutional realization requirement could survive as an excise tax not subject to apportionment. see john r. brooks & david gamage, taxation and the constitution, reconsidered, 76 tax l. rev. 75, 109-11 (2022) (describing the pre-macomber case law addressing federal excise taxes). 8 see isaac ehrlich & richard a. posner, an economic analysis of legal rulemaking, 3 j. legal stud. 257, 258 (1974). 9 see louis kaplow, supra note 2, at 559-60. these categories operate as a continuum, with some legal commands as rule-like and others as standard-like. for example, custom and practice may permit drivers to exceed speed limits by five miles per hour under certain conditions. id. 10 see id. (distinguishing an economic approach to rules and standards from jurisprudential approaches). 11 many sales are easily identified as realization events. see treas. reg. § 1.1001-1(e)(2), ex. 1-4 (2017) (analyzing immediate and complete transfers of property in exchange for cash). indeed, standards may become more rule-like over time, as iterative enforcement adds precision to the 2024] realization rule as a legal standard 5 quotidian, however, lies significant uncertainty,12 and the essential inquiry retains a standard’s fuzzy penumbra and after-the-fact adjudication.13 realization’s standard-like aspects emerge in relatively mundane situations.14 imagine a sale of equipment from owner to user. sales are prototypical realization events, and owner presumptively realizes (and takes into income) any gain or loss with respect to the equipment.15 alternatively, owner could lease the equipment to user for a fixed term. although not formally structured as a sale, this lease also may constitute a realization event for owner.16 under the lease, the present value of all rental payments sum to the equipment’s current fair market value, and, when the lease terminates, the equipment has no residual value.17 in effect, owner has sold the equipment to user.18 under both scenarios, additional facts—or small variations in the given facts—may yield the opposite result.19 in realization’s open inquiry into the facts and circumstances, standard’s content. see kaplow, supra note 2, at 578-79; see also schlag, supra note 2, at 428-29 (“standards tend to become concretized by means of specific rules.”). these emergent rules, of course, remain subject to challenge based on the underlying standard. id. at 429 (“rules tend to yield specific exceptions that are generated by appeal to other standards.”); kathleen m. sullivan, foreword: the justices of rules and standards, 106 harv. l. rev. 22, 96-97 (1992) (discussing cyclical evolution in rules and standards). 12 see, e.g., cottage savings assn. v. comm’r, 499 u.s. 554, 560 (1991). 13 see richard l. bacon et al., american bar association section of taxation task force report on prop. regs. § 1.1001-3: modifications of debt instruments (pts i-v), 47 tax law. 987, 1010 (1994) (“[t]he definition of a realization event has been chiefly a judicial function.”). 14 this claim is distinct from the empirical observation that most questions of realization are easily resolved, either under the relevant legal precedent or because the issue simply is not scrutinized. see abreu & greenstein, supra note 2, at 336-39 (describing realization as rule-bound). the crucial point is that uncertainty about realization emerges in situations that are neither particularly exotic nor artificially constructed. see weisbach, supra note 2, at 879 (noting that standard-based antiabuse rules operate more effectively when they do not “create uncertainty outside their intended scope”). 15 see i.r.c. § 1001(a) (defining realization); i.r.c. § 1001(c) (defining recognition). 16 see starr’s estate v. comm’r, 274 f.2d 294, 295 (9th cir. 1959) (holding that a lease involving a built-in sprinkler system was, in substance, a sale). 17 for lease-versus-sale treatment, the tax stakes are subtle. if the transaction is a lease for tax purposes, owner has income equal to user’s rental payments and recovers all basis in the equipment through statutory depreciation deductions, while user can deduct rent paid to owner under the lease. if the transaction is a sale, owner recovers all basis in the equipment and has gain or loss based on the sale price, while user has statutory depreciation deductions equal to the sale price. although owner and user generally have the same net income under either treatment, the timing and character of this income depends on myriad factors, such as the equipment’s useful life, the availability of expensing, the applicability of i.r.c. § 453a to any installment sale payments, the applicability of i.r.c. § 467 to any rental payments, and each party’s tax position exclusive of the transaction. see adam j. kolber, smooth and bumpy laws, 102 calif. l. rev. 655, 666-68 (2014) (distinguishing the rules-standards inquiry from “input-output” relationships); cf. starr’s estate, 274 f.2d at 29697 (noting that, after accounting for depreciation deductions and interest, “the attack on many of these ‘leases’ may not be worthwhile in terms of revenue”). 18 more precisely, the lease changes owner’s legal and economic relationship to the equipment in a manner that replicates a conventional sale. see cottage savings assn. v. comm’r, 499 u.s. 554, 566 (1991) (examining legal entitlements to determine realization under the code). 19 for example, owner might sell the equipment to user subject to a right to repurchase after a fixed term, or owner might lease the equipment to user for a term shorter than the equipment’s useful life, an amount less than the equipment’s fair market value, or subject to informal understandings that negate the economics evidenced by formal documentation. cf. rev. proc. 2001-28, 2001-1 c.b. 1156; rev. proc. 2001-29, 2001-1 c.b. 1160 (both providing advance irs ruling guidance for 6 columbia journal of tax law [vol. 16:1 transaction-specific inputs dominate, leaving taxpayers to rely on their advisors’ judgment or adjudicators’ discretion.20 in this sense, realization represents a quintessential legal standard, even for transactions as superficially straightforward as sales or leases under state law.21 by framing realization as a standard, this article reveals novel stakes for constitutionalizing the principle.22 taxpayers and their advisors could leverage a constitutional realization requirement as a type of taxpayer-initiated antiabuse doctrine. that is, taxpayers could treat portions of the code and regulations as safe harbors, rather than as binding, with an open and inchoate option to challenge— and perhaps invalidate—these rule-bound regimes on a constitutional basis.23 these mechanics run parallel to longstanding government-asserted antiabuse doctrines in tax law,24 which also provide a standard-based backstop for the predominately rulebound code and regulations.25 during the enforcement process, the government asserts conventional antiabuse doctrines to disregard the code’s literal language or operation, instead substituting a tax result that better comports with broader values.26 by contrast, taxpayers generally are bound by their return positions.27 a leasing transactions). 20 see elkins, supra note 2, at 49 (arguing that taxpayers “are ordinarily free to ignore [standardbased antiabuse doctrines], or at least interpret them as leniently as possible”). 21 other stakes for this inquiry involve arbitrage between nontax legal categories (such as a sale or lease under state law) and tax treatment (which typically requires a more holistic legal and factual analysis). see generally victor fleischer, regulatory arbitrage, 89 texas l. rev. 227 (2010). 22 for constitutional approaches to tax law, see bruce ackerman, taxation and the constitution, 99 colum. l. rev. 1 (1999); reuven avi-yonah, should u.s. tax law be constitutionalized? centennial reflections on eisner v. macomber (1920), 16 duke j. const. l & pub. pol’y 65 (2020); brooks & gamage, supra note 7; ari glogower, a constitutional wealth tax, 118 mich. l. rev. 717 (2020); erik m. jensen, did the sixteenth amendment ever matter? does it matter today?, 108 nw. u. l. rev. 799 (2014); marjorie e. kornhauser, the constitutional meaning of income and the income taxation of gifts, 25 conn. l. rev. 1 (1992); henry ordower, revisiting realization: accretion taxation, the constitution, macomber, and mark to market, 13 va. tax rev. 1 (1993). 23 for a rules-standards analysis of government-created safe harbors, see susan c. morse, safe harbors, sure shipwrecks, 49 u.c. davis l. rev. 1385 (2016). 24 the substance-over-form doctrine, for example, derives from the well-traveled second circuit and supreme court opinions in gregory v. helvering. helvering v. gregory, 69 f.2d 809, 810 (2d cir. 1934); gregory v. helvering, 293 u.s. 465 (1935). see generally bittker et al., supra note 6, at § 1.14 (“these presuppositions or criteria are so pervasive that they resemble a preamble to the code, describing the framework within which all statutory provisions are to function.”). 25 for a framing of antiabuse doctrines in terms of the choice between legal rules and standards, see weisbach, supra note 2. 26 see noël b. cunningham & james r. repetti, textualism and tax shelters, 24 va. tax rev. 1 (2004). 27 this principle sometimes is referred to as the danielson doctrine, though its reach greatly exceeds the facts in that third circuit case. commissioner v. danielson, 378 f.2d 771 (3d cir. 1967), cert. denied, 389 u.s. 858 (1967); see bittker et al., supra note 6, at § 1.19 (“[i]t is easier for a camel to pass through the eye of a needle, than for a taxpayer to disavow the form of his own transaction.”). some standard-driven analyses, such as the twenty-factor distinction between employees and independent contractors, may involve substance-based determinations that either taxpayers or the government may assert. see bartels v. birmingham, 332 u.s. 126 (1947) (allowing taxpayers to disavow a standard employment agreement when the substance of the arrangement was an independent contractor relationship); see generally emily cauble, reforming the non-disavowal doctrine, 35 va. tax rev. 439 (2016); robert thornton smith, substance and form: a taxpayer’s 2024] realization rule as a legal standard 7 constitutional realization requirement would flip the “one-way street” of conventional antiabuse doctrines on its head, giving taxpayers a unique tool against the government.28 because realization undergirds much of the current code and regulations, these challenges could be pervasive. justice kavanaugh, writing for the majority in moore, expressly recognized the potential “blast radius” of a broad constitutional realization requirement—the issue’s potential to wreak “fiscal calamity” on the federal government.29 although kavanaugh’s opinion worked to minimize such havoc, there remains a strong possibility that the court (or a u.s. circuit court of appeals) will find a constitutional realization requirement in the future.30 the resulting doctrinal shift would have systemic ramifications beyond those identified by kavanaugh, who, like the parties and amici in moore, focused on “top-down” threats posed by a constitutional realization requirement. these threats include the possible constitutional infirmity of both specific code provisions and entire taxing regimes, such as those applicable to partnerships or s corporations. the at-risk list is long.31 but a constitutional realization requirement also presents a “bottom-up” threat, linked to the operation of a constitutional realization requirement as a taxpayer-initiated antiabuse rule. realization and nonrealization are intertwined deeply with the current code and regulations. these principles constitute essential right to assert the priority of substance, 44 tax law. 137 (1990). 28 see jamie brown, the state of the non-disavowal principle after complex media, 183 tax notes fed. 1201, 1209 (may 13, 2024) (citing higgins v. smith, 308 u.s. 473 (1940)). this mechanic is, of course, how constitutional rights operate. 29 moore v. united states, 144 s. ct. 1680, 1693, 1696 (2024). 30 the court did not expressly disavow eisner v. macomber, 252 u.s. 189 (1920), and, based on the opinions in moore, at least four justices support a constitutional realization requirement (barrett, alito, thomas, and gorsuch). see infra part ii.c. 31 in moore, kavanaugh lists i.r.c. § 305(c), i.r.c. § 446, i.r.c. § 448, i.r.c. § 951a, i.r.c. § 1256(a), i.r.c. § 1272(a), and all of subchapter k (partnership taxation, i.r.c. §§ 701-761), subchapter s (small business corporations, i.r.c. §§ 1361-1379), subpart f (antideferral for income earned by controlled foreign corporations, i.r.c. §§ 951-964), and the entire gift tax regime in i.r.c. §§ 2501-2524. as adduced by amici and commentators, the full at-risk list includes the corporate alternative minimum tax in i.r.c. § 55(b)(2); the rules applicable to stock dividends in i.r.c. § 305(b); the percentage completion method for long-term contracts in i.r.c. § 460; mark-to-market accounting for securities dealers and traders in i.r.c. § 475(a); the taxation of certain foreign intangible assets in i.r.c. § 367(d); the personal holding company rules in i.r.c. §§ 541-547; the grantor trust rules in i.r.c. §§ 671-679; mark-to-market accounting for life insurance companies in i.r.c. § 817a, the expatriation tax in i.r.c. § 877a; the branch profits tax in i.r.c. § 884; the global intangible low-taxed income rules in i.r.c. § 951a; the wash sale rules in i.r.c. § 1091; constructive sales in i.r.c. § 1259 (see infra part iii.a.1); and the passive foreign investment company rules in i.r.c. §§ 1291-1297. see brief of american college of tax counsel as amicus curiae supporting respondent at 18-25, moore, 144 s. ct. 1680 (no. 22-800); brief of american tax policy institute as amicus curiae supporting respondent at 20-26, moore, 144 s. ct. 1680 (no. 22-800); brief of reuven avi-yonah et al. as amici curiae supporting respondent at 5-18, moore, 144 s. ct. 1680 (no. 22-800); brief of national taxpayers union foundation as amicus curiae supporting neither party at 22-27, moore, 144 s. ct. 1680 (no. 22-800); brief of tax law center at nyu law et al. as amici curiae supporting respondent at 23-25, moore, 144 s. ct. 1680 (no. 22-800); brief of theodore p. seto as amicus curiae supporting respondent at 16-26, moore, 144 s. ct. 1680 (no. 22-800). as this article elaborates, these lists are incomplete. see, e.g., infra part iii.a.2 (discussing i.r.c. § 7872 and gift loans). 8 columbia journal of tax law [vol. 16:1 administrative infrastructure,32 and revisiting realization in light of a constitutional requirement risks a sort of “hollowing out” of the existing income tax system. each taxpayer action—each step taken, each move made—must be tested against the constitutional threshold for realization.33 to the extent that the constitutional threshold controls (or is treated as controlling), the current code and regulations are eroded incrementally.34 realization is not just the pragmatic bedrock on which federal income taxation rests. in some sense, the u.s. income tax system, especially as it applies to businesses and high-income taxpayers, is realization questions all the way down. more broadly, the ultimate stakes of a constitutional realization requirement involve the long-term structure and complexity of the u.s. tax system.35 the heavily rule-bound code and regulations are notoriously complex—perhaps irreducibly so.36 conventional antiabuse doctrines tend to constrain this complexity by allowing lawmakers to write (simpler) rules that address only high-frequency fact patterns. then, the enforcement process addresses low-frequency occurrences, including those that reflect inappropriate tax planning, through standard-based antiabuse doctrines.37 as a taxpayer-initiated antiabuse doctrine, a constitutional realization requirement would have the opposite effect on complexity. among other things, a constitutional realization requirement would lower the expected costs of tax planning that leverages a literalist reading of the code and regulations.38 for this reason, even a whisper of a constitutional realization requirement ventures into poorly charted territory, with potentially detrimental consequences that may prove difficult to unwind.39 this article proceeds as follows. part ii outlines the past, present, and 32 see bittker et al., supra note 6, at § 3:2 (“[u]nrealized appreciation is treated as income only in very limited circumstances under very specific statutory provisions.”). this infrastructure, of course, may not be necessary—at least not when cutting from whole cloth. see william d. andrews, a consumption-type or cash flow personal income tax, 87 harv. l. rev. 1113, 1129-31 (1974) (“the problems of defining realization and prescribing non-recognition would obviously disappear under either a true accretion-type or a pure consumption-type tax.”). 33 this testing may occur through litigation or through the positions taken by taxpayers in consultation with their expert advisors. see infra part iv. 34 this erosion may be good or bad, depending on the content of a constitutional realization requirement. because that content is not specified ex ante (and because the current tax system is imperfect), normative claims are difficult to make. see infra part v. 35 these stakes differ from those typically associated with realization, which involve the effectiveness (or ineffectiveness) of taxes on capital income. see ari glogower, taxing capital appreciation, 70 tax l. rev. 111, 117 (2016). 36 see boris i. bittker, tax reform and tax simplification, 29 u. miami l. rev. 1, 2 (1974); see also david a. weisbach, the irreducible complexity of firm-level income taxes: theory and doctrine in the corporate tax, 60 tax l. rev. 215, 215 (2007) (arguing that firm-level income taxes increase complexity by “creat[ing] the possibility of multiple realizations of the same economic income); stanley s. surrey, complexity and the internal revenue code: the problem of the management of tax detail, 34 l. & contemp. probs. 673, 702 (1969) (“the conclusion seems inescapable that the federal income tax system will require and involve a large mass of complex detail.”). 37 see weisbach, supra note 2. 38 see infra part v. 39 as commentators emphasized when the court took moore on certiorari, the reasoning in moore matters more than the nominal outcome. see daniel j. hemel, the low and high stakes of moore v. united states, 180 tax notes fed. 563 (july 24, 2023). 2024] realization rule as a legal standard 9 possible future of the constitutional question presented by the taxpayers in moore. part iii argues that, as a legal standard, a putative constitutional realization requirement would operate as a taxpayer-initiated antiabuse doctrine. part iv outlines how a constitutional realization requirement could “hollow out” existing tax law, including examples not previously discussed in the literature. part v details how a constitutional realization requirement could affect the overall complexity of the tax system. part vi concludes. ii. realization’s past, present, and future in the united states, realization’s constitutional basis stems from the supreme court’s well-traveled 1920 decision in eisner v. macomber.40 in macomber, an individual shareholder received a stock-on-stock dividend that did not affect the shareholder’s proportionate legal interest in the underlying corporation.41 the shareholder challenged recently enacted legislation that included the stock dividend’s market value in income.42 writing for the court, justice pitney invalidated the statute, concluding that the constitution did not permit income taxation of “a true stock dividend made lawfully and in good faith.”43 for the macomber court, income famously comprised “the gain derived from capital, from labor, or from both combined,” and “[n]othing else answers the description.”44 a significant academic literature mines macomber’s holding and dicta, as well as subsequent judicial opinions, to discern realization’s ongoing constitutional significance.45 40 252 u.s. 189 (1920). 41 id. at 203. the court also takes as fact that the value of the shareholder’s holdings did not change as a result of the stock dividend, in which one share of new stock was distributed with respect to every two shares of old stock (a 3:2 stock split). see marjorie e. kornhauser, the story of macomber: the continuing legacy of realization, in business tax stories 93, 101 (paul l. caron ed., 2003) (noting that the government essentially conceded this valuation issue). this factual conclusion requires some rounding, since the stock’s trading price dropped by slightly less than the expected one-third as a result of the dividend. an empirical literature in finance finds, however, that stock splits increase share value (including over the long run) by increasing those shares’ liquidity, signaling managers’ optimism about the company, and targeting the optimal “tick size” for a stock (the ratio of the smallest allowable change in market price to the stock’s per-share trading price). see, e.g., patrick dennis, stock splits and liquidity: the case of the nasdaq-100 index tracking stock, 38 fin. rev. 415 (2003) (liquidity); robert m. conroy & robert s. harris, stock splits and information: the role of share price, 28 fin. mgmt. 28 (1999) (signaling); james j. angel, tick size, share prices, and stock splits, 52 j. fin. 655 (1997) (tick size). 42 macomber, 252 u.s. at 201 (challenging revenue act of 1916, pub. l. no. 64-271, § 2(a), 39 stat. 756, 757 (1916)). macomber, like moore, reflects cause lawyering. the dollar stakes in macomber were small, and the case moved speedily through the federal court system. the taxpayer was represented by leading attorneys of the time. kornhauser, supra note 41, at 99-100. 43 macomber, 252 u.s. at 219 (1920). courts later discerned a number of exceptions to this rule, and congress adopted the macomber outcome (and many of these exceptions) in § 305(a) and (b). see patricia ann metzer, the “new” section 305, 27 tax l. rev. 93 (1971) (discussing the history of, and revisions to, i.r.c. § 305 from 1954 to 1969). 44 macomber, 252 u.s. at 207-08. 45 compare henry ordower, supra note 22, at 56 (describing macomber as recognizing “a fundamental realization principle in the sixteenth amendment”), with alex zhang, rethinking eisner v. macomber, and the future of structural tax reform, 92 geo. wash. l. rev. 179, 228 (2024) (concluding that, among five possible readings, macomber should be read as finding an 10 columbia journal of tax law [vol. 16:1 before the court’s decision in moore, the dominant view among scholars— and in casebooks and tax treatises authored by those scholars—was that, between 1940 and the mid-1950s, the court effectively vitiated macomber’s constitutional significance without expressly overruling the decision. under this view, realization became a convention of “administrative convenience” that congress and treasury could deploy or abrogate on a pragmatic basis.46 hegemonic and little-challenged for seven decades,47 this discourse helps to explain why the court’s grant of certiorari for moore stirred so much discord among academic and other commentators.48 this part adduces the historical origins of the consensus around macomber’s obsolescence (the past), the moore court’s engagement with macomber and a constitutional realization requirement (the present), and the potential, after moore, for courts to find (or affirm) a constitutional realization requirement (the future). a. the past: burying macomber macomber’s precipitous decline came less from supreme court pronouncements, which remained resolutely vague about realization as a constitutional principle, and more from an academic consensus that emerged two decades after the court’s 1920 decision. this consensus reflected work by a few well-known policy entrepreneurs—stanley surrey, erwin griswold, and boris bittker—in the context of three intersecting dynamics in 1940s. first, the court issued a series of decisions that transparently loosened macomber’s constraints on the definition of income. second, revenue needs in world war ii cemented the federal income tax’s transformation from class tax to mass tax. this shift created new exigencies of administration to ensure that high earners contributed a fair share. third, in law school curriculum, taxation grew to encompass the planning, administrative, and technical topics—all decidedly nonconstitutional—that define the subject’s contours today. overall, this context shows an academic movement, motivated by changes in the tax system, to refocus doctrinal questions away from the constitution and, specifically, macomber. these policy entrepreneurs’ work, more than the court’s scattershot tax jurisprudence, effectively buried macomber as a doctrinal matter for decades. the academic movement to bury macomber began in 1941, when stanley surrey disavowed macomber’s constitutional holding in a law review article.49 absence of income, rather than an absence of realization). 46 helvering v. horst, 311 u.s. 112, 116 (1940). see john r. brooks & david gamage, supra note 7, at 126-34. 47 in a statutory interpretation case, the supreme court supported the “administrative convenience” view. cottage savings assn. v. comm’r, 499 u.s. 554, 559 (1991). 48 see andrew velarde, supreme court to hear transition tax case with vast implications, 180 tax notes fed. 125 (july 3, 2023). 49 stanley s. surrey, the supreme court and the federal income tax: some implications of the recent decisions, 35 ill. l. rev. 779 (1941) [hereinafter surrey, supreme court]. see also ordower, supra note 22, at 8-9 (summarizing surrey’s conclusions, which “[c]ommentators almost universally accept[ed]”); lawrence zelenak, stanley surrey and taxing unrealized appreciation, 86 law & contemp. probs. 153, 161 (2022) (“surrey was the first commentator to declare the death of eisner v. macomber, way back in 1941.”). perhaps with some tongue in cheek, surrey 2024] realization rule as a legal standard 11 surrey argued that, in the two decades since the court decided macomber, the tax system had evolved such that “the formalistic doctrine of realization . . . is not a constitutional mandate.”50 indeed, surrey contended that “the sixteenth amendment [itself] is an historical relic,”51 no longer necessary to sustain income taxation. according to surrey, “the congressional architects may proceed to build a sensible tax structure without any fear that it will later be destroyed by attacks based on constitutional grounds.”52 the “tax tower of babel” constructed on macomber’s realization “cornerstone” had been dismantled in favor of an edifice more conducive to revenue collection in a burgeoning administrative state.53 under this view, congress’s lawmaking authority was virtually unfettered when dealing with taxation.54 surrey grounded his “sound conclusion” about macomber’s constitutional relevance in the court’s 1940 decisions in bruun55 and horst.56 in bruun, the court addressed a landlord’s consequences from improvements constructed by a tenant on leased land. justice roberts, writing for the court, found that, on the tenant’s termination of the lease, the landlord had income equal to the value of those improvements at the time of termination.57 for surrey, the landlord’s receipt of possession of the land and improvements—a realization event, for the bruun court—was “hardly very significant” and simply represented an administrable alternative to other possibilities “differing only slightly in degree.”58 as long as “a recognizable variation [was] present,” congress and treasury could impose tax, perhaps based on whichever facts presented “fewer difficulties.”59 from this perspective, bruun “mark[ed] the end of one era in our tax history” and left described his article as “clearly one of the best [he] had written” and lamented his failure to publish the paper with the harvard law review. stanley s. surrey, a half-century with the internal revenue code: the memoirs of stanley s. surrey 46 (lawrence a. zelenak & ajay k. mehrotra eds., 2022). 50 surrey, supreme court, supra note 49, at 791. 51 id. at 792. 52 id. at 813-14. 53 id. at 782. 54 surrey argued in 1941 that, “[if] there be any constitutional issue in an income tax case today, it should be one of due process.” see id. at 793. in moore, the court arguably revived substantive due process claims outside of contentions against retroactivity. see moore v. united states, 144 s. ct. 1680, 1697 (2024) (“to be clear, . . . the due process clause proscribes arbitrary [income] attribution.”). 55 helvering v. bruun, 309 u.s. 461 (1940). 56 helvering v. horst, 311 u.s. 112 (1940). surrey also rooted his conclusions about the scope of tax law in a broader sense of the court’s jurisprudence. see surrey, supreme court, supra note 49, at 813-16. 57 bruun, 309 u.s. at 466-67. the land almost certainly had depreciated during the lease’s term, and so the landlord’s net economic gain on termination likely was negative. see infra note 61. 58 surrey, supreme court, supra note 49, at 784. the bruun court faced essential difficulties in determining the amount and timing of income. the taxpayer’s income could be measured by subjective or objective value and calculated either for the improvements or the real property as an integrated whole. any income could be taken into account at the start or end of the lease, or spread evenly or otherwise over the lease’s term. this range of outcomes emphasizes the standard-like nature of realization, as well as the policy factors that favor determinations based on administrative convenience. cf. infra part iii.a.2. (discussing similar parameters for gift loans). 59 surrey, supreme court, supra note 49, at 784. 12 columbia journal of tax law [vol. 16:1 realization “no more than a recognition of an expedient procedure.”60 surrey emphasized that the taxpayer’s long-term economic interest in the land and improvements did not change when possession reverted.61 by allowing the imposition of tax, the court had effected “a complete denial of the doctrine that is the heart of eisner v. macomber.”62 by looking to changes in legal relationships, bruun abrogated macomber’s emphasis on income’s economic origins. in horst, the taxpayer detached and gave some of a negotiable bond’s interest coupons to his son, who redeemed those coupons for cash within the same year.63 justice stone, writing for the court, held that the interest income from the detached coupons was taxable to the donor, rather than his son.64 surrey notes that the court eliminated “a rather neat [tax avoidance] device” to assign income among individuals with affective relationships.65 the opinion, however, reaches further in its reasoning. for surrey, stone’s choice to couch his opinion in terms of realization “has implications whose effect is not confined to the assignment cases.”66 but stone’s opinion treads perilously close to incoherence, implying that gifts constitute realization events to the extent of personal “satisfactions” derived from directing income to others and muddling assignment-of-income principles.67 in clear dicta, stone posits that realization is “founded on administrative convenience.”68 surrey juxtaposes this statement with bruun, stating that “[t]he horst decision thus supplies the theoretical justification for the bruun case” to vitiate macomber.69 neither decision, of course, expressly repudiated macomber, and both decisions could be read to support the decision’s continuing vitality under the doctrine of stare decisis.70 but the stage was set for academics to coalesce around surrey’s categorical proclamation.71 60 id. at 783. 61 id. at 784 (“if increase in value of property be conceded income in the economic sense the decision not to tax that increase for one reason or another is simply a decision to base the income tax for the time being on something less than a taxpayer’s total income.”). bruun’s facts arose in the midst of the great depression. bruun, 309 u.s. at 464. in bruun, the tenant’s abandonment of the lease reflected the property’s probable decline in aggregate value at termination. although not discussed explicitly in bruun, the landlord presumably could have leased the property to another tenant at a lower amount of rent (an implicit loss), and the landlord had legal recourse to recover damages from the former tenant under the lease agreement (a recovery of some of this implicit loss). these subsequent events yield a fuller accounting of the economic gain or loss for the taxpayer in bruun— and emphasize the imperfections of a realization-based regime. 62 surrey, supreme court, supra note 49, at 783. 63 helvering v. horst, 311 u.s. 112, 114 (1940). 64 id. at 120. section 1286 currently addresses the tax treatment of “stripped” bonds through a bifurcation approach. see i.r.c. § 1286(b). 65 surrey, supreme court, supra note 49, at 787, 791. 66 id. at 791. 67 horst, 311 u.s. at 116-17. commentators typically read horst as prohibiting taxpayers from directing the taxability of current-year income (the coupons) with respect to a retained capital investment (the bond). see, e.g., jerome m. hesch & david j. herzig, helvering v. horst: gifts of income from property, 42 actec l.j. 35, 38-39 (2016). 68 horst, 311 u.s. at 116. 69 surrey, supra note 49, at 791. 70 cf. zelenak, supra note 49, at 161-62. 71 philip e. heckerling, the death of the “stepped-up” basis at death, 37 s. cal. l. rev. 247, 264 (1964) (“[t]he tax law academicians appear to divide only on the question of which of the posteisner v. macomber decisions held unrealized appreciation constitutionally taxable.”). 2024] realization rule as a legal standard 13 subsequent work followed surrey’s lead. in 1945, roswell magill of columbia law school published a revised edition of his treatise, taxable income, that drew on bruun and midland mutual life insurance72 to argue that the court would permit congress to tax unrealized appreciation.73 midland mutual lent indirect support to an administrative convenience understanding of realization, stating that “[i]ncome may be realized upon a change in the nature of legal rights held, though the particular taxpayer has enjoyed no addition to his economic worth.”74 surrey served as a research assistant on the 1945 revision of magill’s book, and his imprint is clear.75 then, in 1951, erwin griswold of harvard law school described macomber’s “problems of realization” as “unduly conceptualistic.”76 like surrey, griswold favored realization as a pragmatic concession to administrative considerations.77 and boris bittker, in 1952, argued that, despite macomber, taxpayers could be taxed annually on certain gains or losses without realization.78 these positions emerged in the authors’ three law school casebooks, which loomed large in the postwar tax curriculum.79 to some extent, these scholarly claims about macomber’s demise are incongruous with the court’s decisions after surrey’s 1941 pronouncement.80 in griffiths81 and sprouse,82 both decided in 1943, the government twice asked the court to overrule macomber, and the court expressly declined. each case involved common-on-common stock dividends, similar to the facts in macomber.83 congress had amended the code to tax stock dividends except “to the extent that 72 helvering v. midland mut. life ins. co., 300 u.s. 216 (1937) (holding that a lender had interest income when purchasing property out of foreclosure for the debt’s principal amount, plus accrued and unpaid interest). 73 see roswell magill, taxable income 119-20 (rev. ed. 1945) (arguing that, after bruun and midland mutual, “the adoption by congress of a general plan for taxing appreciation on an inventory basis [that is, mark-to-market] would probably be upheld”). 74 300 u.s. at 225. 75 other portions of the book argue for macomber’s continuing vitality. see magill, supra note 73, at 44. 76 erwin n. griswold, charitable gifts of income and the internal revenue code, 65 harv. l. rev. 84, 86 (1951). 77 griswold conceded that realization formed part of the positive structure of income taxation. erwin n. griswold, in brief reply, 65 harv. l. rev. 1389, 1389 (1952) (“[e]ven though [realization] may not necessarily be a constitutional requirement, it is a practical conclusion.”). 78 borris i. bittker, charitable gifts of income and the internal revenue code: another view, 65 harv. l. rev. 1375, 1380 (1952). see also heckerling, supra note 71, at 270. 79 see boris i. bittker, federal income taxation cases and materials (1954); erwin n. griswold, cases and materials on federal taxation (1940); stanley s. surrey & william c. warren, federal income taxation: cases and materials (1953). 80 see, e.g., patricia ann metzer, the “new” section 305, 27 tax l. rev. 93, 107 (1971) (“the constitutional significance of the opinion in eisner v. macomber has been abrogated by subsequent supreme court decisions.”); see also zhang, supra note 45, at 185-86 (citing griffiths). 81 helvering v. griffiths, 318 u.s. 371, 404 (1943). 82 helvering v. sprouse, 318 u.s. 604, 607 (1943), rev’g 124 f.2d 315 (2d cir. 1941). sprouse consolidated a third case, strassburger v. commissioner, 124 f.2d 315 (2d cir. 1941), that involved a distribution of preferred stock with respect to common stock. the second circuit held for the government in strassburger and was reversed by the court. sprouse, 318 u.s. at 607. the transaction in strassburger was addressed in 1954 by i.r.c. § 306. 83 sprouse involved a distribution of nonvoting common stock with respect to voting and nonvoting common stock. sprouse, 318 u.s. at 606. 14 columbia journal of tax law [vol. 16:1 [such dividends did] not constitute income to the shareholder within the meaning of the sixteenth amendment.”84 the irs imposed tax on these common-oncommon stock dividends, then asked the court to reverse macomber and clarify that the constitution did not mandate realization in such circumstances. in both cases, the court held that congress intended to crystalize the sixteenth amendment’s scope as reflected by macomber’s outcome.85 these stock dividends were not income under the code, leaving no need to revisit constitutional questions of realization. at least as a formal matter, macomber still stood. in griffiths, the government’s brief spoke to the systemic upheaval faced by the federal tax system during the second world war. for the government, macomber impeded the equitable imposition of taxes at a time of exigent revenue needs—“considerations of great public importance” that “require[d]” the court to revisit the constitutional realization requirement associated with macomber.86 as in macomber, the problem involved the timing of taxes on corporations and shareholders. in 1936, congress enacted an additional tax on corporations’ retained earnings as a proxy for the taxes those corporations’ shareholders would owe on those undistributed profits, if paid to shareholders.87 treasury estimated that these retained earnings totaled more than $4.5 billion in 1936—an implied revenue loss of more than $1.3 billion in shareholder-level taxes.88 under macomber, corporations could not pay stock dividends to eliminate retained earnings and avoid additional corporate-level tax,89 and these corporations complained that the choice between shouldering an additional tax burden or foregoing the reinvestment of retained earnings was “unsound from a business point of view.”90 the government contended that macomber precluded “a much more complete and less circuitous solution” of taxing shareholders directly on retained corporate earnings. to placate corporate interests and advance “fundamental equity,” the government asked the court to abrogate macomber and permit, essentially, mark-to-market taxation for corporate stock.91 the court refused,92 leaving the wartime fiscal system to rely on corporate excess profits taxes, wage withholding, and individual surtaxes to fill revenue gaps.93 macomber’s in terrorem presence deterred direct congressional 84 revenue act of 1936, i.r.c. § 115(f)(1). 85 griffiths, 318 u.s. at 394-95 (“[w]hen these dividends were received eisner v. macomber fixed the meaning contrary to the government’s position.”). 86 brief for petitioner at 27, helvering v. griffiths, 318 u.s. 371 (1943) (no. 467). 87 revenue act of 1936, i.r.c. § 14. 88 brief for petitioner, supra note 86, at 31. see also gary e. bashian, stock dividends and section 305: realization and the constitution, 1971 duke l.j. 1105, 1148 (1972) (“the statute and budgetary need of 1936 were [ ] conducive to rejection of the eisner v. macomber doctrine.”) 89 see brief for petitioner, supra note 86, at 31. under the code, such distributions were tax-free, consistent with macomber. 90 brief for petitioner, supra note 86, at 35. 91 brief for petitioner, supra note 86, at 30-32. 92 louis eisenstein, some iconoclastic reflections on tax administration, 58 harv. l. rev. 477, 516 (1945) (noting that the court “refused to inter eisner v. macomber”). 93 taxation of shareholders on retained earnings would have advanced roosevelt’s goals of progressive taxation and loophole-closing. see joseph j. thorndike, timelines in tax history: from “class tax” to “mass tax” during world war ii, tax notes: tax history project (sept. 19, 2022), https://www.taxnotes.com/tax-history-project/timelines-tax-history-class-tax-mass-taxduring-world-war-ii/2022/09/16/7f3s2 [https://perma.cc/3f55-j8cx]. 2024] realization rule as a legal standard 15 action to tax returns to capital investments.94 despite the government’s failed “frontal assault” on macomber in the early 1940s,95 commentators coalesced around the views of surrey, griswold, and bittker that denigrated macomber’s prominence in the realization canon.96 this literature openly touted macomber’s “downfall.”97 indeed, some read griffiths’s refusal to repudiate macomber as clear evidence that macomber was, in fact, a dead letter: “[t]he [griffiths] opinion leaves small room for doubt that the entire court agreed that eisner v. macomber is wrong and that there is no constitutional prohibition against taxing any stock dividend as income.”98 the macomber decision was rendered “a somewhat lonely, but somehow wonderfully defiant figure” in the canon of academic commentary.99 all of this movement occurred before glenshaw glass,100 which commentators read (again, despite language that income had to be “clearly realized”101) as standing for the end of macomber’s constitutional restrictions on the definition of income.102 notwithstanding an emerging academic consensus against macomber’s constitutional realization requirement, tax practitioners generally (and unsurprisingly) viewed macomber as an ongoing constraint on congress’s power. robert miller, “the dean of the tax bar,” took realization as a background requirement in his 1951 exchange with griswold in the harvard law review.103 lawyers edward and sheila roehner also argued in favor of a constitutional realization requirement, and macomber’s vitality, in the tax law review.104 these perspectives gained little traction against the “host” of academic proponents of macomber’s demise, which stood “monolithic in their unanimity.”105 in effect, there emerged a largely academic consensus that macomber mattered not simply less in light of subsequent caselaw, but really not at all. finally, the early 1940s marked a transition in law schools’ pedagogical 94 the moore opinion similarly may chill congressional efforts to tax wealth. see robert goulder, losing the battle, winning the war: making sense of moore, 115 tax notes int’l 15, 18-19 (july 1, 2024); see generally ari glogower, taxing inequality, 93 n.y.u. l. rev. 1421 (2018) (introducing a combined tax on wealth and taxable income through a “wealth annuity”). 95 james s. eustice, corporations and corporate investors, 25 tax l. rev. 509, 538 (1970). 96 see henry rottschaefer, present taxable status of stock dividends in federal tax law, 22 n.c. l. rev. 85, 85 (1944) (“the preponderant view seems to be that [macomber] would be overruled [by the court]. the attempt to do so is certain to encounter strenuous opposition from taxpayers and their counsel.”). 97 charles l.b. lowndes, the taxation of stock dividends and stock rights, 96 u. pa. l. rev. 147, 170 (1947). 98 id. at 149. see also rottschaefer, supra note 96, at 85. 99 joseph t. sneed, a defense of the tax court’s result in prunier and casale, 43 cornell l.q. 339, 348 (1958). 100 comm’r v. glenshaw glass co., 348 u.s. 426 (1955). 101 id. at 431. 102 macomber’s academic downfall paved the way for a movement towards “accretionism” that began in the 1970s. see generally edward a. zelinsky, for realization: income taxation, sectoral accretionism, and the virtue of attainable virtues, 19 cardozo l. rev. 861 (1997). 103 erwin griswold, charitable gifts of income and the internal revenue code, 65 harv. l. rev. 84, 86 (1951). 104 edward t. roehner & sheila m. roehner, realization: administrative convenience or constitutional requirement?, 8 tax l. rev. 173 (1953). 105 sneed, supra note 99, at 351. 16 columbia journal of tax law [vol. 16:1 approaches to tax law.106 erwin griswold’s casebook turned away from the constitutional issues of prior decades to the more granular details of how income taxation worked. at yale law school, gerald wallace developed a tax class based principally on administrative materials—again, focused on the tax system at an operational level. wallace later joined the faculty at nyu school of law, where he helped build the institution’s storied tax law program.107 these shifts made the turn away from constitutional issues convenient and appropriate under what would grow into today’s contemporary income tax system.108 the training of tax professionals largely minimized constitutional questions in favor of the pragmatic design issues faced by lawyers, lawmakers, and regulators. through the intellectual work of legal academics, structural changes to the u.s. tax system, and pedagogical shifts in legal education, macomber was buried by the mid-1950s. by the end of the 1960s, few commentators—even among practitioners—gave significant credence to realization as a constitutional backstop.109 b. the present: decisions and indecision the constitutional outcome in moore seemed largely predetermined after oral arguments.110 there, the justices highlighted definitional issues associated with the realization doctrine. justice thomas asked the first question of the taxpayers’ counsel: “when you say ‘realization,’ what—do you have a definition for that or an explanation as to exactly what it is . . . ?”111 thomas reprised his query as the solicitor general’s first question.112 prudently, neither lawyer offered a generalizable answer.113 justices jackson and kagan expressly pressed the moores’ counsel on thomas’s query.114 justice sotomayor also returned to thomas’s topic, stating that “a word like ‘realization’ [requires] a working definition that applies to every piece of property and every way in which people gain wealth.”115 but, 106 see leo a. diamond, book review, 19 u. chi. l. rev. 147, 148 (1951) (reviewing stanley s. surrey & william c. warren, federal income taxation: cases and materials (1950) and william c. warren & stanley s. surrey, federal estate and gift taxation: cases and materials (1950)) (noting “the ‘new look’ in law school teaching”). 107 boris i. bittker, woodworth lecture november 1, 1996 federal income taxation—then and now, 23 ohio n.u. l. rev. 617, 617-19 (1997). 108 see kornhauser, supra note 22, at 21 (“the motivating force for this abandonment [of macomber] lies in the fact that a narrow interpretation of ‘income’ would cause the court to be called upon constantly to decide whether a particular provision fell within that narrowly prescribed definition of income.”). 109 this trend largely held through the court’s turn toward textualism in the 1980s. see ordower, supra note 22, at 3-4. 110 see goulder, supra note 94, at 16 (“consider the oral arguments from last december. certain things were telegraphed, early on, in the verbal exchanges.”). indeed, a substantial portion of moore’s oral argument addressed attribution of income, which kavanaugh relied on in the moore majority opinion. transcript of oral argument passim, moore v. united states, 144 s. ct. 1680 (2024) (no. 22-800). 111 transcript of oral argument at 5, moore, 144 s. ct. 1680 (no. 22-800). 112 id. at 57-58. 113 id. at 5-6. taxpayer’s counsel, mr. grossman, gave several examples of realization. solicitor general prelogar called the facts in moore “a paradigmatic case of realization.” id. at 58. 114 id. at 36-39. 115 id. at 18. 2024] realization rule as a legal standard 17 according to sotomayor, to “announce what realization is out of context” would be both illogical and “dangerous.”116 later, sotomayor quipped, “i guess the tenor of the questions is that nobody’s happy with anybody’s definition of anything, okay?”117 this definitional dissatisfaction highlights the standard-like features of the oft-maligned but omnipresent realization requirement.118 as the justices noted, the concept resists ex ante specification and begs for ex post elaboration—a task that seven out of nine justices avoided in moore. instead, the five-justice moore majority found unequivocal realization by a legal entity owned by the taxpayers, coupled with permissible attribution of this realized income from the entity to the taxpayers that owned stock in the entity. the justices left open realization’s constitutional status. this section establishes the facts in moore and why those facts implicated realization.119 then, this part discusses the moore opinions, in which four—and perhaps more—justices clearly support a constitutional realization requirement in some form.120 1. realization in moore in moore, the question presented asked “[w]hether the sixteenth amendment authorizes congress to tax unrealized sums.”121 although moore held that the taxpayers clearly realized income (and thus did not reach the constitutional question presented), the loose and easy reasoning in the moore majority opinion belies the fact that the existence of realization or nonrealization under moore’s facts was a difficult question for the court as a whole.122 in large part, this question’s difficulties arise from the fact that realization, as a standard-like concept, is not well-defined at its edges.123 because macomber’s presumed demise yielded 116 id. at 18. 117 id. at 105. justices alito, barrett, gorsuch, and kavanaugh asked questions that touched on the definition of realization. although chief justice roberts did not directly interrogate the parameters of realization, he presumably was familiar with the concept’s vagaries. in 1991, roberts argued for the government as acting solicitor general in cottage savings assn. v. comm’r, 499 u.s. 554 (1991), which addressed realization outside of the constitutional context. transcript of oral argument at 1, cottage savings, 499 u.s. 554 (no. 89-1965). 118 see lily batchelder et al., the moores lost their claim and moore, 184 tax notes fed. 1509, 1510 (aug. 19, 2024) (“[t]he concept of realization defies a clear definition.”). 119 the court presumably took moore on certiorari because the ninth circuit stated that macomber was no longer good law, even though the court has never expressly overruled the case. see moore v. united states, 36 f.4th 930, 935-38 (9th cir. 2022), cert. granted, 143 s. ct. 2656 (2023), aff’d, moore v. united states, 144 s. ct. 1680 (2024). the ninth circuit’s view reflected the general consensus among legal academics prior to moore, and this consensus had a strong basis in subsequent supreme court cases. by expressly overruling macomber, however, the ninth circuit may have overstepped its authority, at least from the supreme court’s perspective. 120 the contours of any constitutional realization requirement remain inchoate. see batchelder, supra note 118, at 1512 (“[t]he moores failed to offer a workable constitutional realization rule, and it is unclear if there is one.”). 121 petition for writ of certiorari at i, moore, 144 s. ct. 1680 (no. 22-800). 122 in moore, the majority opinion was joined by five justices, with two concurring in the result and two dissenting. see discussion infra section ii.b.2. 123 see moore, 144 s. ct. at 1704 (barrett, j., concurring) (“our cases describe many ways income might be realized; a rigid definition does not capture them all.”). this feature is, of course, classically 18 columbia journal of tax law [vol. 16:1 substantial discretion to congress in stipulating realization’s parameters, these definitional edges remain significant. the facts in moore are as follows. the taxpayers in the case, the moores, acquired an 11% interest in kisankraft, an indian company that supplied agricultural machinery, for an investment of $40,000 cash in 2005. between 2005 and 2017, kisankraft earned profits but distributed no money or property to its shareholders, and the moores had no u.s. tax liability with respect to any of kisankraft’s profits.124 under this regime, the moores had no income until kisankraft distributed profits, and taxation on their share of kisankraft’s profits was deferred until that time. then, in 2017, congress enacted the tax cuts and jobs act (tcja),125 which, among other things, transitioned the united states from taxing worldwide income to a quasi-territorial business tax system that effectively exempted some foreign earnings.126 as part of this transition, the tcja imposed a one-time tax, known as the mandatory repatriation tax (mrt), on the accumulated profits of certain foreign corporations with u.s. shareholders.127 the mrt taxes these accumulated profits at highly preferential rates—as low as 8% for reinvested earnings, and only 15.5% for earnings held in cash—and, at taxpayers’ election, on a deferred basis.128 the mrt applies only to u.s. shareholders that do not receive distributions of cash or property out of these accumulated profits.129 the moores took the position that the mrt does not satisfy an implicit realization requirement in the sixteenth amendment, which authorizes congress to tax incomes without apportionment based on states’ population.130 one tension in moore—and the factor that proved determinative in the case’s outcome—is that the moores’ tax consequences were largely inextricable from those of kisankraft. while the moores did not receive distributions from kisankraft, the company itself realized profits over more than a decade. these company-level profits established a pool of potential taxable income for kisankraft’s u.s. shareholders, which included the moores. from this perspective, the moores’ contentions revolved around the timing of income, rather than the existence of any income at all.131 the facts and doctrinal elements involved in this timing question are, however, open-ended. the source and uses of kisankraft’s profits, the composition standard-like. 124 moore, 36 f.4th at 932-33. 125 tax cuts and jobs act of 2017, pub. l. no. 115-97, 131 stat. 2054. 126 see i.r.c. § 245a (applying to domestic corporations that own 10% or more of certain foreign corporations). 127 see i.r.c. § 965. 128 for individual shareholders that structured their ownership appropriately, the deferral could be indefinite. see i.r.c § 965(h), (i). the moores, obviously, did not avail themselves of this statutory benefit, which would have mooted the issue in moore. 129 see i.r.c. § 965(d). 130 see u.s. const. art. i, §§ 2, 9 & amend. xvi. the moores, of course, relied on macomber for their position. see brief for petitioners at 16, 40, moore v. united states, 144 s. ct. 1680 (2024) (no. 22-800). 131 the moores did not press due process arguments, which might have implicated which of kisankraft’s shareholders—past or current—were properly taxable on the company’s profits. see moore, 144 s. ct. at 1686 (kavanaugh, j.); see also moore v. united states, 36 f.4th 930, 938-39 (9th cir. 2022) (finding no due process violation). 2024] realization rule as a legal standard 19 of kisankraft’s ownership in 2017,132 and the moores’ historical ownership of kisankraft all matter under the mrt—and could matter under any constitutional realization requirement. in addition, adjudication could turn on the presence or absence of various doctrinal elements, such as the degree of actual control or influence exerted by the moores over kisankraft, the existence of tax avoidance or abuse (defined objectively or subjectively), or the scope of transactions that generate realization at the entity level. these facts and doctrinal elements, to the extent relevant, also could affect the amount of income taxable to the moores.133 these uncertainties—implicated by the justices in oral arguments and alluded to in the moore opinions—show that, when the question turns to realization, the inquiry is inchoate in terms of both the relevant facts and doctrinal elements involved. the specific content of any constitutional realization requirement is left to enforcement and adjudication—a quintessential legal standard. 2. the moore opinions the moore opinions establish a much more fragile dynamic than the 7-2 outcome might suggest.134 in moore, a five-justice majority held in favor of the government, with justice kavanaugh writing the opinion.135 justice barrett concurred in the result but disagreed significantly in her reasoning, and justice alito joined this concurrence. finally, justice thomas, joined by justice gorsuch, dissented, with reasoning that largely aligns with justice barrett’s concurrence. taken together, the barrett and thomas opinions strongly support a constitutional realization requirement, while the kavanaugh majority avoids taking a position on the issue.136 only justice jackson’s concurrence takes a clear position against constitutional realization, and the absence of other justices joining her opinion emphasizes the court’s instability on the issue. in the majority opinion, kavanaugh argues that “the precise and narrow question” in moore is “whether congress may attribute an entity’s realized and undistributed income to the entity’s shareholders or partners.”137 for kavanaugh, 132 for example, if a domestic corporation owned 10% of kisankraft but u.s. shareholders did not own more than 50% of kisankraft. see i.r.c. §§ 951(b), 957(a) (defining united states shareholders and controlled foreign corporations). 133 for example, the moores could be taxable on kisankraft’s 2017 income but not on prior years’ income. transcript of oral argument at 29-31, 49, 98, moore, 144 s. ct. 1680 (no. 22-800). 134 some commentators argue that moore demonstrates the continued strength of a norm of congressional deference. see batchelder et al., supra note 118, at 1510 (arguing that “four is not five”); see also infra part ii.c (discussing the four-justice threshold for certiorari). to the extent there is not complete deference to congress, constitutional realization likely has the “bottom up” effects described in this article. see infra part iv.a. 135 moore, 144 s. ct. at 1697 (kavanaugh, j.) (affirming the ninth circuit’s judgment). 136 although the majority opinion declares that income taxes are indirect taxes (and not subject to apportionment), the majority opinion leaves open the possibility that realization is essential to the existence of income—and a tax without realization would remain a direct tax on property (and subject to apportionment). see id. at 1688; see also batchelder et al., supra note 118, at 1512-13 (arguing that moore “partly overruled” pollock). the majority’s declaration further unsettles the scope of any constitutional realization requirement, since such a requirement might not be tied to the sixteenth amendment’s text (specifically, the use of the word “derived”). 137 moore, 144 s. ct. at 1688. 20 columbia journal of tax law [vol. 16:1 lawmakers face a choice in business entity taxation. with respect to undistributed but realized earnings, congress may treat these entities either as taxpayers themselves or on a pass-through basis.138 either an entity reports its own income, or the entity’s owners report income that is attributed to them.139 congress cannot, however, choose both instruments, which kavanaugh terms “double taxation.”140 presumably, a distribution of earnings represents a second realization event on which congress may impose another round of tax; this well-pedigreed mechanism is fundamental to classical corporate taxation.141 critically, however, kavanaugh states that macomber “has no bearing on the attribution issue” raised in moore.142 for this reason, kavanaugh’s opinion does not reach the status of any putative constitutional realization requirement.143 justice barrett, concurring in the result, argues that the constitution clearly requires realization, and that the moores realized no income from kisankraft directly.144 barrett concludes, however, that the moores conceded the mrt’s constitutionality when they allowed that the mrt’s structural antecedent, subpart f, was constitutional.145 in addition, barrett complicates the broad discretion that kavanaugh’s opinion gives to congress in taxing business entities.146 barrett essentially constructs kavanaugh’s attribution theory as an inquiry into economic substance as that doctrine apples to realization.147 the substance of the moores’ relationship with kisankraft might indicate that any income realized by kisankraft was actually realized by the moores.148 indeed, subpart f does this work through statutory rules: the regime targets abusive arrangements and mechanically taxes owners on income earned through controlled foreign corporations.149 these types of substance-oriented inquiries are inherently standard-like.150 138 id. at 1690. although kavanaugh describes pass-through taxation as based on owners’ “pro rata share of the entity’s undistributed income,” id., the constitution presumably permits other economic arrangements. 139 see id. at 1697 (arguing that taxation of an entity and its shareholders on undistributed income “would not simply be a traditional pass-through”). the limitation on attribution is due process. see id. at 1691 n.4. 140 id. at 1691. 141 less clear is whether congress could tax entities on a pass-through basis and impose a second tax on distributions of cash from the entity. similarly, kavanaugh’s opinion draws into question layered rates, such as ordinary taxes and surtaxes, which have the same effect as the type of entitylevel and shareholder-level taxation that kavanaugh finds objectionable. see id. at 1688, 1691. 142 id. at 1691. 143 id. at 1697 (“to decide this case, we need not resolve that [constitutional] disagreement over realization.”). 144 see id. at 1702, 1704 (barrett, j., concurring). 145 see id. at 1709. whether this analogy works is less clear, given the somewhat distinct antiabuse purposes of subpart f and the mrt. one way to reconcile barrett’s conclusory reasoning is to treat deferral of any kind as intrinsically abusive, which seems like a stretch. 146 id. at 1700 (“i think the issue is more complex than the court lets on.”). 147 see id. at 1704. 148 see id. at 1704-05 (“as i understand our precedent, it leaves room for congress to disregard the corporate form in some circumstances.”). 149 see i.r.c. §§ 951-965. 150 see moore, 144 s. ct. at 1707 (barrett, j., concurring) (arguing that congress’s ability to attribute an entity’s income to shareholders “depends on the relationship between the shareholder and the income.”). 2024] realization rule as a legal standard 21 similarly, barrett’s construction of constitutional realization emphasizes the inquiry’s broad, contextual nature. barrett draws on bruun and horst, the same authorities cited by surrey to bury macomber. for barrett, these cases simply rejected overly narrow constructions of the still-vital constitutional concept.151 although bruun expanded the category of realization events, “[n]one of that remotely suggests that realization is not required or (relatedly) that appreciation counts as taxable income.”152 and, while horst indicates that “[r]ealization does not depend on how the user chooses to enjoy the income,” the decision does not change macomber’s essential edict that realization is constitutionally mandated.153 for barrett, “[o]ur cases describe many ways income might be realized; a rigid definition does not capture them all.”154 this analysis potentially presages the openended, standard-driven analysis that the court might apply to a constitutional realization requirement. justice thomas, dissenting, argues that the constitution requires realization, and that the moores did not realize income from kisankraft under any theory of the concept.155 for thomas, realization is formalistic except (perhaps) in cases of abuse, and, under the facts in moore, any attribution theory fails rational basis review. like barrett, thomas treats kavanaugh’s permissive attribution doctrine as “an unsupported invention.”156 thomas’s dissent previews the ways in which a categorical realization requirement would create “constitutional quicksand” that could envelop much of the current tax system.157 finally, justice jackson, concurring in the majority opinion, argues that the constitution does not require realization.158 instead, “in matters of tax policy, congress’s view [is] controlling” with only narrow constitutional limitations.159 jackson’s concurrence aligns with the postwar academic consensus about macomber, stating that the case “has long been deemed outmoded, if not overruled.”160 no other justices join jackson in this position, leaving four possible additional supporters of a constitutional realization requirement, only one of which is needed for a five-justice majority. in this way, jackson’s concurrence emphasizes the tenuous ties holding together kavanaugh’s five-justice majority. c. the future: circuit courts and certiorari the moore opinions are relevant to future challenges aimed at establishing 151 see id. at 1703 (“what we have done is reject efforts to narrow what it means to realize income.”). again, this perspective broadens the standard-like inquiry into realization. 152 id. 153 id. at 1704. barrett’s emphasis on horst’s “satisfactions” language implies that any gift of appreciated property could represent a realization event for the donor. this outcome would break significantly from current understandings of the realization requirement. 154 id. (adding that “realization may take many forms”). 155 id. at 1709 (thomas, j., dissenting). 156 id. at 1710. 157 id. at 1726. 158 id. at 1698 (jackson, j., concurring). 159 id. at 1697-99 (“[t]his court’s role in [policy-driven tax] disputes should be limited.”). 160 id. at 1698 (citing comm’r v. obear-nester glass co., 217 f.2d 56, 60 (7th cir. 1954); united states v. james, 333 f.2d 748, 752 (9th cir. 1964); prescott v. comm’r, 561 f.2d 1287, 1293 (8th cir. 1977)). 22 columbia journal of tax law [vol. 16:1 realization’s constitutional status unambiguously. at least four justices in moore support a constitutional realization requirement,161 which is enough for a grant of certiorari in a future case.162 practitioners and commentators generally seem comfortable that, given appropriate facts (without, for example, the complications caused by subpart f in moore), the court could find a constitutional realization requirement.163 finally, the moores came to the court through an express political project to revive a version of the macomber holding that mandates realization under the constitution, and the court left this question unanswered. in this context, commentators anticipate further action at the court with respect to the question presented (but not decided) in moore.164 federal circuit courts seem likely to accelerate the court’s return to realization as a constitutional issue. activist litigation has leveraged judgeshopping and various circuits’ polarization to create circuit splits and present the court with compelling certiorari petitions. more critically, circuit courts offer opportunities for taxpayers to wreak havoc with respect to the existing tax system. as this article emphasizes, an asymmetry exists for taxpayers and the government with respect to cases that assert a constitutional realization requirement as a taxreduction mechanism. to win, taxpayers only need circuit courts to affirm macomber as establishing a constitutional realization requirement—a relatively uncontroversial reading of the decision.165 by contrast, circuit courts would need to distinguish macomber to break with a constitutional realization requirement, and such courts may be loath to risk reversal in this way, especially after moore. this asymmetry illustrates how the issue could foment legal activity involving constitutional realization—and potentially sow chaos as lower courts decide cases on the topic. the reasons to be skeptical of this trajectory are similar to those raised by griffiths in 1943: then, academic prognosticators anticipated that the court would quickly overturn macomber “on the first opportunity,” with the constitutional issue squarely presented.166 the important questions (similar to those addressed in this 161 these justices are barrett and alito in concurrence, and thomas and gorsuch in dissent. see moore, 144 s. ct. 1680, 1683. 162 see joan maisel leiman, the rule of four, 57 colum. l. rev. 975, 975 (1957). this future case may have facts that are more favorable than those in moore. 163 see reuven s. avi-yonah, taxation with realization after moore, 115 tax notes int’l 25, 25 (july 1, 2024) (“the same organized groups that brought us moore are likely to try again, and at some point, they may succeed.”); jasper l. cummings, jr., moore: macomber was wrongly decided and other considerations, 180 tax notes fed. 2307, 2307 (sept. 25, 2023) (“if the supreme court reverses the ninth circuit in moore, or even if it affirms, the opinion likely will state grounds that will enmesh the income tax in a series of constitutional controversies not seen for a century.”); goulder, supra note 94, at 15 (“when a more suitable case comes along, those who favor limitations on the congressional taxing power may find themselves quite pleased.”). a change in the court’s membership also could make this outcome more or less likely. see joshua david odintz et al., moore thoughts: an incremental opinion from the u.s. supreme court, holland & knight alert (june 26, 2024), https://www.hklaw.com/en/insights/publications/2024/06/moore-thoughtsan-incremental-opinion-from-the-us-supreme-court [https://perma.cc/jc4a-3snk]. 164 see reuven s. avi-yonah, what is the best candidate for a post-moore constitutional challenge?, 113 tax notes int’l 17 (jan. 1, 2024) (discussing i.r.c. § 877a). 165 but see zhang, supra note 45, at 186 (reading macomber to permit congress to tax unrealized accretions to wealth). 166 rottschaefer, supra note 96, at 111. 2024] realization rule as a legal standard 23 article) involved broader implications flowing from “the reasoning [in] the overruling decision.”167 the court, obviously, did not revisit macomber for more than eight decades, and, during this period, the government did not pursue the issue of constitutional realization through litigation with any degree of fervor.168 as in griffiths, the moore court demurred to address realization in the constitutional context, while leaving ample breadcrumbs to imply the potential for future success in better-framed cases. after moore, however, the situation is somewhat different—a public-private asymmetry in litigation incentives. taxpayers, not the government, would litigate in favor of a constitutional realization requirement, and there are more groups and more potential controversies that might fuel this project. even if only one such effort succeeds, that success may implicate constitutional realization across broad swaths of the code and regulations. this context implies a much higher likelihood of the moore project proving successful in an ultimate sense and leading to a revitalized constitutional realization requirement. iii. constitutional realization as an antiabuse doctrine seven decades after macomber’s interment, the moore opinions, taken together, raise the specter of a constitutional realization requirement. although the precise substantive contours of a constitutional realization requirement remain relatively uncertain,169 this article gauges the effects of such a requirement by examining its form and function as operationalized by taxpayers in their annual reporting to the irs and as potential litigants in future tax controversies. this part frames a constitutional realization requirement as a taxpayer-initiated antiabuse doctrine. such a requirement allows taxpayers to assert, to the irs or in court, that a specific portion of the code or regulations is constitutionally infirm and unenforceable—a prerogative traditionally reserved for the government in evaluating taxpayers’ positions under the code and regulations. this framing— and the novel legal tool that constitutional realization gives taxpayers—has important implications for how an emergent constitutional realization requirement would affect the code and the regulations going forward. this part establishes realization’s standard-like features, including the nuanced factual inquiries implicated by realization,170 as well as the difficulty of 167 id. 168 after the second world war, congress flirted with direct contraventions of realization, see michael j. graetz, taxation of unrealized gains at death—an evaluation of the current proposals, 59 va. l. rev. 830, 830 (1973); jerome kurtz & stanley s. surrey, reform of death and gift taxes: the 1969 treasury proposals, the criticisms, and a rebuttal, 70 colum. l. rev. 1365, 1365 (1970), and treasury expanded regulations that skirted strict interpretations of realization. among academics and other policy-oriented experts, debates largely abandoned tethers to realization. see david elkins, the myth of realization: mark-to-market taxation of publicly-traded securities, 10 fla. tax rev. 375, 376 (2010); zelinsky, supra note 102, at 861-62. perhaps wisely, however, administrative actors did not press to overturn macomber through the court system. 169 after commissioner v. glenshaw glass, 348 u.s. 426 (1955), judicial opinions on realization took a statutory approach. see cottage sav. ass’n v. comm’r, 499 u.s. 554, 554-55 (1991). constitutional issues in this period tended to focus on fifth amendment due process. see, e.g., estate of whitlock v. comm’r, 59 t.c. 490, 507 (1972) (dismissing an argument that subpart f violated due process). 170 see infra section iii.a. 24 columbia journal of tax law [vol. 16:1 identifying which doctrinal factors bear on questions of realization.171 then, this part argues that policy values traditionally associated with realization— administrative ease and efficiency—shed little light on the nature of a constitutional realization requirement.172 finally, this part delineates how a constitutional realization requirement would operate as a taxpayer-initiated antiabuse doctrine.173 a. realization’s facts and circumstances any realization requirement must distinguish between facts that yield a “taxable event” and facts that do not.174 this inquiry is open-ended, and the breadth of facts and circumstances relevant to realization generally precludes rigorous ex ante specification.175 as a concept, realization requires myriad inputs to construct a binary output, and the relationship between inputs and output emerges only afterwards, on case-by-case basis. even relatively common fact patterns require textured distinctions to determine realization: the delineation between sales and various combinations of financial instruments, such as leases, loans, and more complex products176; transactions involving parties with preexisting family, social, or legal relationships177; and changes in contractual or legal rights, such as modifications to an agreement or the division of property among co-owners.178 examples from each of these categories illustrate the standard-like nature of realization,179 as well as how current law might diverge from a newly invigorated constitutional realization requirement. 1. constructive sales the code establishes a framework for determining when taxpayers account 171 see infra section iii.b. 172 see infra section iii.b. 173 see infra section iii.c. 174 realization is inextricably linked to the definition of ownership for tax purposes, which also depends heavily on factual context. see alex raskolnikov, contextual analysis of tax ownership, 85 b.u. l. rev. 431, 431-32 (2005). 175 this article does not define rules and standards based on adjudicators’ “discretion.” see sullivan, supra note 11, at 57-58 (defining rules and standards by reference to discretion); see also schlag, supra note 2, at 406-07 (arguing that discretion emerges whether directives are framed as rules or standards). instead, this article looks to when legal precepts acquire definitive content. 176 see, e.g., rev. proc. 2001-28, 2001-1 c.b. 1156; rev proc. 2001-29, 2001-1 c.b. 1160 (each establishing facts required by treasury for advance rulings on the characterization of certain leasing arrangements). see generally reid thompson & david weisbach, attributes of ownership, 67 tax l. rev. 249 (2014) (developing a series of examples involving ownership of financial instruments). 177 see, e.g., friedland v. comm’r, 82 t.c.m. (cch) 492, t.c.m. (ria) 2001-236 (2001) (finding no realization on a father-guarantor’s transfer of stock in satisfaction of a debt owed by his son’s wholly owned corporation to a third party); i.r.c. § 267(f)(2) (deferring losses on sales among members of a controlled group). 178 see, e.g., treas. reg. § 1.1001-3(c), (e) (as amended in 2011) (defining a “significant modification” for debt instruments). 179 other examples run throughout the code. see, e.g., i.r.c. § 165(g) (addressing the timing of worthlessness for securities); i.r.c. § 631 (allowing taxpayers to treat the cutting of timber as a sale). any accounting for the bargain component in below-market sales also implicates realization. see, e.g., treas. reg. § 1.1001-1(e) (computing gain on sale transactions with gift components). 2024] realization rule as a legal standard 25 for income on appreciated financial positions in the absence of an unambiguous realization event.180 for these assets, constructive sales occur, and income is accounted for, when taxpayers enter into contractual arrangements that “reduce or eliminate [those taxpayers’] risk of loss (and opportunity for gain)” with respect to an appreciated financial position.181 these offsetting positions encompass various financial instruments—short sales, notional principal contracts, and futures or forward contracts—that involve the same appreciated financial position or something “substantially identical.”182 multiple offsetting positions may be aggregated to yield a constructive sale for one financial asset, and a single offsetting position may trigger a constructive sale for only a portion of a financial asset.183 making these fact-intensive determinations requires as much art as science, and, within the predominantly rule-bound code, the constructive sale regime acquires much of its legal specificity ex post during the interpretive or enforcement processes.184 in this sense, constructive sales represent a prototypical legal standard.185 constructive sales have a fraught relationship with the legal concept of realization.186 the house report on the constructive sale regime states that “[t]ransactions designed to reduce or eliminate risk of loss on financial assets generally do not cause realization.”187 this statement presumably refers to the 180 see i.r.c. § 1259(a), (c). “appreciated financial positions” are any interest, including futures or forward contracts, shorts sales, or options, with respect to stock, certain debt instruments, and partnership interests, if realization with respect to that interest would result in gain. i.r.c. § 1259(b). 181 h.r. rep. no. 105-148, at 439 (1997). for example, consider a taxpayer that owns ten shares of stock in company x. the taxpayer enters into a “short against the box,” in which the taxpayer borrows ten shares of company x from a third party (with a promise to repay in-kind), then sells those borrowed shares for cash (a short sale). because the taxpayer can repay the third party with the already-owned shares of company x (which are in the “box”), the taxpayer no longer is subject to fluctuations in value with respect to company x stock. under i.r.c. § 1259, this type of transaction results in gain as if the taxpayer sold the already-owned company x shares. 182 see i.r.c. § 1259(c)(1)(a)-(d); see also david m. schizer, hedging under section 1259, 80 tax notes 345, 346-47 (1998) (describing constructive sales as “a hybrid that triggers recognition of gain, but not loss”). section 1259 uses similar qualifiers to define forward contracts and offsetting notional principal contracts. see i.r.c. § 1259(d)(1)-(2). this language also is used in the wash sale rules, though loss disallowance may not have constitutional implications under the legislative grace doctrine. see i.r.c. § 1091(a). in the wash sale context, the underspecified content of “substantially identical” has motivated significant tax planning. see paul kiel & jeff ernsthausen, how the wealthy save billions in taxes by skirting a century-old law, propublica (feb. 9, 2023), https://www.propublica.org/article/irs-files-taxes-wash-sales-goldman-sachs [https://perma.cc/6z7t-z7yn]. 183 h.r. rep. no. 105-148, at 440-41 (1997). 184 see andrea s. kramer & william r. pomierski, new constructive sale rules make it tougher to avoid tax on built-in gain, 25 est. plan. 291, 300 (1998). 185 in addition, the constructive sale regime operates within a network of provisions that target abuses involving financial instruments. see, e.g., i.r.c. § 1233(b) (preventing taxpayers from using short sales to accelerate losses or manipulate holding periods for capital gains purposes). 186 for a broader discussion of realization in the context of financial instruments, see david m. hasen, a realization-based approach to the taxation of financial instruments, 57 tax l. rev. 397 (2004). 187 h.r. rep. no. 105-148, at 438 (1997). see rev. rul. 72-478, 1972-2 c.b. 487 (deferring gain or loss on a short sale when the taxpayer held the same underlying securities in a separate brokerage account). 26 columbia journal of tax law [vol. 16:1 code, not the constitution, which implies that the code’s concept of realization is more restrictive than any constitutional threshold.188 alternatively, a constitutional threshold for realization may be lower (or functionally nonexistent) in abusive situations, such as those expressly targeted by the constructive sale regime.189 for these reasons, constructive sales under the code, or some subset of these transactions, may trigger realization under a constitutional standard.190 the constructive sale regime, in whole or in part, has plausible routes to survive a constitutional realization requirement. still, the statutory mechanics of constructive sales reflect possible congressional concerns about realization. nomenclature notwithstanding, constructive sales themselves do not trigger realization on those terms.191 instead, the code requires taxpayers to “recognize” income with respect to any appreciation,192 then adjust any subsequently (and actually) realized gain or loss based on this recognized income.193 constructive sales essentially bypass the code’s typical two-step mechanic of realization to establish gain or loss followed by recognition to bring that gain or loss into income.194 legislative history affirms this idiosyncratic treatment by clarifying that constructive sales are not treated as sales for other tax purposes.195 a constructive sale simply generates income on a taxpayer’s return, full stop. these statutory machinations emphasize the interpretive difficulties posed by a constitutional realization requirement. the constructive sale regime is an analytic framework aimed at particular abuses, most prominently “short sale against the box” transactions.196 as enacted by congress, the regime reaches more broadly, across several categories of financial products and with some fuzziness to anticipate private parties’ permutations in response to the statute.197 but how the 188 when congress enacted the constructive sale regime as part of the taxpayer relief act of 1997, pub. l. no. 105-34, 111 stat. 788, the scholarly and judicial consensus treated realization as a matter of “administrative convenience”—a very low threshold for constitutionality. cf. cottage sav. ass’n v. comm’r, 499 u.s. 554, 559 (1991) (citing horst). 189 in moore, various briefs (and portions of oral arguments) focused on realization thresholds in abusive situations. see, e.g., transcript of oral argument at 89-90, moore v. united states, 144 s. ct. 1680 (2024) (no. 22-800) (discussing the constructive sale rules). 190 no direct authority, including i.r.c. § 1259’s legislative history, speaks to these constitutional issues. cf. part i.a. 191 this feature of i.r.c. § 1259 supports an argument that the provision operates as a constitutional excise tax, regardless of whether realization is constitutionally required for an income tax. see aviyonah, supra note 163 (listing provisions where “a good defense” supports excise tax characterization). 192 i.r.c. § 1259(a)(1). 193 i.r.c. § 1259(a)(2), (e)(1). that is, income from constructive sales does not create basis in an asset. this result deviates from fundamental principles of income taxation. cf. i.r.c. § 1012(a) (establishing basis in an asset as a taxpayer’s cost, paid in after-tax dollars). 194 see i.r.c § 1001(a), (c). 195 h.r. rep. no. 105-148, at 440 (1997) (“except as provided in treasury regulations, a constructive sale would generally not be treated as a sale for other code purposes.”). 196 see thomas j. brennan, law and finance: the case of constructive sales, 5 ann. rev. fin. econ. 259 (2013) (discussing high-profile transactions that motivated i.r.c. § 1259). 197 see estate of mckelvey v. comm’r, 906 f.3d 26 (2d cir. 2018) (concluding that a modification of variable prepaid forward contracts constituted a constructive sale based on the probability of their exercise). congress also authorized treasury to promulgate regulations to expand the constructive 2024] realization rule as a legal standard 27 constructive sale regime intersects with realization remains unclear.198 when combined with an appreciated financial position, offsetting positions change legal entitlements with respect to property, and these changes potentially qualify as a constitutional realization event, absent any specific statutory authority.199 similarly, transactions at the penumbra of constructive sales may trigger realization, even if the constructive sale regime itself does not apply.200 and, if the constructive sale regime targets abuse, perhaps realization simply is irrelevant, and the statutory recognition mechanic governs. the code sheds only indirect light on any constitutional standard for realization. in the context of constructive sales, a constitutional realization requirement would require adjudicators to divine the appropriate factual inquiry, as well as adduce the proper transactional scope, to determine the extent to which congress’s enactments survive a constitutional analysis. 2. gift loans social context also bears on the legal concept of realization. the code, for example, assigns additional income to lenders that charge too little interest, “where the forgoing of interest is in the nature of a gift.”201 typically, these gift loans— and the “phantom” income they produce—involve members of a family or other individuals with deep social ties.202 the statute does not question gift loans’ veracity, or the fact that relationships influence these loans’ terms, often to the sale regime to transactions “hav[ing] substantially the same effect” as transactions enumerated in the statute. see i.r.c. § 1259(c)(1)(e). congress also instructed treasury to develop “necessary or appropriate” regulations under i.r.c. § 1259. see i.r.c. § 1259(f). treasury has not promulgated regulations under either provision. see generally frank g. colella, pinch-hitting for the irs: second circuit adopts phantom regulations to curb a monster abuse of financial derivatives, 4 bus. entrepreneurship & tax l. rev. 26 (2020) (critiquing mckelvey as circumventing treasury’s obligation to issue regulations under i.r.c. § 1259); john kaufmann, pontifications on mckelvey, 155 tax notes 1749 (june 19, 2017) (critiquing the tax court’s holding in favor of the taxpayer on reasoning similar to the second circuit). 198 for example, mckelvey considers probabilities in determining a constructive sale but not the relative magnitudes of possible outcomes. see thomas j. brennan & david m. schizer, transaction-specific tax reform in three steps: the case of constructive ownership, 15 colum. j. tax l. 1, 49-50 (2024). 199 see elkins, supra note 168, at 392 n.29 (“from an economic perspective, short-against-the-box transactions look too much like sales for them to be not treated as realization events.”); see also bradford v. united states, 444 f.2d 1133 (ct. cl. 1971) (treating a purchase combined with a forward contract to sell as a realization event on the date of purchase). 200 see anschutz co. v. comm’r, 135 t.c. 78 (2010), aff'd, 664 f.3d 313 (10th cir. 2011) (holding that a prepaid variable forward contract, combined with a loan of the underlying securities, constituted a sale for tax purposes but not a constructive sale under i.r.c. § 1259); see also progressive corp. v. united states, 970 f.2d 188 (6th cir. 1992) (treating the issuance of an in-themoney call option with respect to stock as a sale of that stock when exercise of that option was “virtually certain”); see generally morse, supra note 23, at 1393 (describing the space between a “sure shipwreck” and a “safe harbor” for purposes of i.r.c. § 1259). 201 i.r.c. § 7872(f)(3). 202 see stephen r. akers & philip j. hayes, estate planning issues with intra-family loans and notes, 38 actec l.j. 51, 70 (2012). 28 columbia journal of tax law [vol. 16:1 borrower-donee’s benefit.203 instead, this regime has an antiabuse function.204 for gift loans that exceed certain (generous) thresholds,205 the lender-donor must include a proxy for forgone interest payments from the borrower-donee. this proxy is less than the borrower-donee would pay to an unrelated party but greater than zero206—a legislative compromise in the treatment of fundamentally nonmarket transactions. consider parent, who loans $200,000 cash to child, interest-free. child invests the cash in assets that yield a simple annual return of 10%, or $20,000 per year. if the tax system respects this arrangement, parent has, in effect, shifted $20,000 of capital income to child, where that income may face lower marginal rates or otherwise incur lower tax liabilities. furthermore, the $200,000 loan is not permanent, and parent can recall the capital on demand or after a term formally or informally negotiated with child.207 the relationship between parent and child mediates these economic transactions and facilitates joint decision-making about which person should report taxable income earned on parent’s capital. the gift loan rules crimp this flexibility (and combat tax gaming) by requiring parent to recognize interest income based on market yields on u.s. treasury bonds—an interest rate historically treated as connected to (although almost certainly less than) the risk-free rate of return to capital.208 assume, for this example, that the assigned interest rate is 2%, or $4,000 per year in interest on the $200,000 loan from parent to child. income arises through a pair of constructive transactions. parent is treated as transferring $4,000 to child (presumably as a gift), and child is treated as paying the $4,000 back to parent as taxable interest.209 no cash, of course, actually changes hands in this round-trip arrangement, but parent 203 cf. rev. rul. 86-106, 1986-2 c.b. 28 (disregarding a loan between a parent and a trust that benefitted the parent’s children). 204 indeed, this antiabuse purpose mirrors—and perhaps is more compelling than—that of i.r.c. § 1259. see supra part iii.a.1. 205 under i.r.c. § 7872, lender-donors do not have interest income if either (1) the gift loan’s principal amount does not exceed $10,000 and the borrower-donee does not use the loan to acquire income-producing assets per i.r.c. § 7872(c)(2), or (2) the gift loan’s principal amount does not exceed $100,000 and the borrower-donee has no more than $1,000 of annual net investment income under i.r.c. § 7872(d)(1). for (2), the lender-donor has interest income only to the extent of the borrower-donee’s annual net investment income, if such income exceeds $1,000. id. see leigh osofsky & kathleen delaney thomas, the surprising significance of de minimis tax rules, 78 wash. & lee l. rev. 773, 833 (2021) (noting the complexity of i.r.c. § 7872’s de minimis rules). 206 see i.r.c. § 7872(e)(2), (f)(2)(b) (calculating forgone interest for gift loans based on short-term applicable federal rates); i.r.c. § 1274(d)(1)(c)(i) (basing applicable federal rates on market yields for u.s. treasury bonds). 207 in this sense, gift loans are distinguishable from assignment-of-income issues involving gifts of property. see helvering v. horst, 311 u.s. 112 (1940); blair v. comm’r, 300 u.s. 5 (1937). 208 see jules h. van binsbergen, william f. diamond & marco grotteria, risk-free interest rates 1-2 (nat’l bureau of econ. rsch., working paper no. 26138, 2019) (finding that government bonds slightly understate the risk-free rate of return); see also john r. brooks, taxation, risk, and portfolio choice: the treatment of returns to risk under a normative income tax, 55 tax l. rev. 255, 292-93 (2013) (describing various proxies for the risk-free return to capital). 209 i.r.c. § 7872(a)(1)(a), (b) (using the verb “treated” to describe these transactions). this example is constructed to avoid various rules that exclude smaller or nonabusive gift loans from this treatment. see supra note 206. 2024] realization rule as a legal standard 29 has $4,000 of ordinary income to report to the irs on parent’s tax return.210 gift loans, taken in their factual context, raise questions of realization on multiple levels. first, gift loans may or may not be realization events under a currently underspecified constitutional standard.211 although gifts traditionally have not qualified as realization events,212 the code’s construct of gift loans illustrates how foregone interest still may represent income to the lender-donor.213 gift loans involve an ongoing economic relationship between the two parties with affective ties.214 the initial loan of cash, coupled with eventual repayment or forgiveness, provide actual acts that support a finding of realization. borrowerdonees on gift loans may not pay periodic cash interest to lender-donors, but these other tangible transactions give ample legal tether for assigning an interest component to gift loan arrangements—perhaps based on specific facts or the parties’ intent.215 furthermore, the code’s gift loan rules operate as a type of safe harbor that relieves pressure on more fundamental questions of characterization. if a constitutional realization requirement precludes an assessment of interest income to the lender-donor, then enforcement may focus on whether these loans are better characterized as gifts or other arrangements.216 a constitutional realization requirement greatly expands the factual and legal inquiry required for gift loans. second, a constitutional realization standard may require a different timing of income inclusions than the linear annual amounts specified in the code. simple annual interest represents an administrable solution, but courts may characterize interest as prepaid or postpaid, consistent with either the initial loan of cash or the loan’s eventual resolution—physical transfers of cash that may provide a touchstone for realization. a constitutional realization standard might find child to have prepaid interest on the initial loan, or parent to have foregone interest up-front. alternatively, this standard might view child as postpaying interest at the end of the loan, or parent as forgiving accrued interest after-the-fact.217 finally, postpaid 210 for tax purposes, circular flows of cash generally are disregarded, even if they physically occur. i.r.c. § 7872 imposes a constructive transaction that reflects the converse of this principle. 211 see kornhauser, supra note 22, at 39 (discussing the income and gift tax treatment of belowmarket loans). 212 see kwall, supra note 3, at 110 (“although a gift has not historically been treated as a realization event, there is nothing inherently unique about a gratuitous transfer that would preclude congress from treating a gift as a realization event.”). 213 that is, the gift is the value of the foregone interest, rather than the interest payment itself. this construction is consistent with the forgiveness of loans by gift. in these situations, the lender-donor is treated as gifting the loan’s principal amount to the borrower-donee, and the borrower-donee is treated as repaying the loan in full (that is, there is no cancellation of indebtedness income). see jeffrey h. kahn & douglas a. kahn, cancellation of debt and related transactions, 69 tax law. 161, 197-98 (2015) (“if a creditor forgives a debt as a gift to the debtor, the cod is excluded from the debtor’s income by section 102.”). 214 by contrast, constructive sales may involve one or more coordinated or unilateral acts at arm’s length. see supra part iii.a.1. 215 cf. diedrich v. comm’r, 457 u.s. 191, 197 (1982) (holding that a gift conditioned on the donee’s payment of the donor’s gift taxes results in income to the donor to the extent the gift tax liability exceeds the donor’s basis); see also kornhauser, supra note 22, at 16-17 (discussing diedrich in the context of the supreme court’s avoidance of constitutional tax issues). 216 for concomitant effects on complexity, see infra part v. 217 these timing questions are parallel to those raised by helvering v. bruun, 309 u.s. 461, 465-66 (1940) (describing alternatives in which a landlord’s income from tenant improvements could be 30 columbia journal of tax law [vol. 16:1 interest could be assigned over the loan’s term using the time-value principles associated with original issue discount (oid), which would yield gradually increasing inclusions over the loan’s term.218 in these ways, a constitutional realization requirement unsettles the code’s clear rules about the timing and amount of income. third, the amount of any income inclusions may depend on the relevant constitutional analysis. the statutory gift loan regime uses a below-market rate to assign income to the lender-donor. the borrower-donee would pay a higher interest rate on a comparable arm’s length loan from an unrelated party, such as a bank, and courts might look to this interest rate when assigning income to the lender-donor.219 on the other hand, a lower rate may better account for the realities of the relatedparty arrangement intrinsic to gift loans, where risk of repayment may not factor into the decision of whether, or on what terms, to extend credit. no market transaction exists. in addition, a gift loan may contemplate that the borrower-donee will satisfy the loan’s principal fully with property, forgiveness by the lender-donor, or some combination of the two.220 for these reasons, a risk-free rate of return may better represent the parties’ underlying economic arrangement. if so, the code’s statutory rate understates the amount of the lender-donor’s true interest income221— and perhaps survives constitutional scrutiny because of this design choice. more broadly, however, gift loans’ facts and circumstances (including the nature of family or social relationships222) imply a range of possible income inclusions under a realization-oriented constitutional analysis. 3. debt modifications contractual arrangements (and changes to those contracts) can affect taxpayers’ relationships to property in ways that implicate realization. these issues arise, for example, when holders and obligors agree to modify the terms of a lending arrangement evidenced by a debt instrument.223 the debt instrument is property for taken into account on construction of the improvements or termination of the lease). 218 for the code’s treatment of oid, see i.r.c §§ 1272-1275. courts may apply time-value principles differently. 219 this referent historically has been used in the international tax context to apportion income across jurisdictions. see generally reuven s. avi-yonah, the rise and fall of arm’s length: a study of the evolution of u.s. international taxation (john m. olin ctr. for l. & econ., working paper no. 07-017, 2007). 220 the precise combination may be contingent on when the loan is made. see rev. rul. 77-299, 1977-2 c.b. 343 (finding no loan where there was a prewired intent to forgive). 221 if i.r.c. § 7872 seeks to deter tax gaming, then this lower rate might be optimal, depending on the provision’s effect on tax-motivated transactions. 222 the scope of familial connections may depend on context. see cerone v. comm’r, 87 t.c. 1, 3, 22 (1986) (outlining a limited role for family discord in determining tax consequences of a stock redemption); see also tessa r. davis, mapping the families of the internal revenue code, 22 va. j. soc. pol’y & l. 179, 199 (2015) (using status and contract to illustrate how family relationships are deployed by the code). 223 executory contracts and amendments to partnership agreements also raise realization questions. for example, the substitution of counterparties (or an assignment by a counterparty) may result in realization for the other party to a derivative contract or other ongoing obligation. alternatively, a change in how partners share income may affect the value of their respective interests. although difficult to distinguish conceptually from debt modifications, these types of contractual changes 2024] realization rule as a legal standard 31 tax purposes, and, individually or cumulatively, modifications to that property can yield a new debt instrument. this de facto exchange of old property for new property constitutes a realization event. the facts and circumstances that yield realization, however, are relatively difficult to discern on any kind of principled basis. 224 under current law, arcane treasury regulations govern the realization threshold for modifications of debt instruments.225 these regulations define an exchange to occur when there is a “significant modification” of a debt instrument226—two elements that do not emerge from either statutory law or court opinions and which have no clear constitutional tether.227 the regulations define “significant” and “modification” in technical, quantitative, and rule-bound ways. for this purpose, modifications reach broadly: any change in legal rights or obligations, unless they occur by the terms of the debt instrument.228 certain major alterations—substitution of obligors, changes in the recourse or nonrecourse nature of the debt instrument, conversions of debt into equity for tax purposes, and the exercise of certain options—are modifications even if pursuant to contractual operations.229 by contrast, significance arises from any of a long list of conditions, including changes in yield over numeric hurdles,230 material deferral in the timing of payments,231 and adjustments to structural features of debt instruments, such as obligors, security, and priority.232 in addition, any “economically significant” modification, based on the facts and circumstances, is significant.233 the typically are not treated as realization events. see, e.g., i.r.c. § 761(c) (allowing modifications to a partnership’s allocation provisions after year-end but before the unextended due date for the partnership’s return); james m. peaslee, modifications of nondebt financial instruments as deemed exchanges, 95 tax notes 737 passim (apr. 30, 2002) (discussing realization questions involving a range of derivative contracts in the context of cottage savings assn. v. comm’r, 499 u.s. 554 (1991)). 224 see richard l. bacon et al., supra note 13, at 1002 (“the special difficulty in dealing with debt modifications lies in the fact that these transactions are among a variety of ‘ambiguous transactions’ which have no self-evident points that clearly indicate when, or whether, the holder has ‘sold or exchanged’ the unmodified debt instrument.”). 225 for modifications of debt instruments, these regulations represent the exclusive test for realization. see treas. reg. § 1.1001-3(b). 226 id. 227 see bacon et al., supra note 224, at 1003 (“[m]any of the proposed distinctions in the proposed regulation are the kind that cannot be derived from existing section 1001 or from any judicial definition of when a sale or exchange is a ‘realization event.’”). 228 treas. reg. § 1.1001-3(c)(1). 229 treas. reg. § 1.1001-3(c)(2). debt is recourse if the lender can look to all of the borrower’s assets for repayment rather than just the specified security. for purposes of treas. reg. § 1.001-3 (and unlike other areas of tax law), recourse and nonrecourse status are determined by reference to state law. see i.r.s. p.lr. 2023-37-007 (sept. 15, 2023) (stating that a conversion from an llc to a corporation does not change the recourse nature of the debt when the lenders’ state-law rights under the debt instrument do not change). 230 treas. reg. § 1.1001-3(e)(2). 231 treas. reg. § 1.1001-3(e)(3). 232 treas. reg. § 1.1001-3(e)(4). 233 treas. reg. § 1.1001-3(e)(1). see also rev. rul. 90-109, 1990-2 c.b. 191 (finding realization “if there is a sufficiently fundamental or material change that the substance of the original contract is altered”). 32 columbia journal of tax law [vol. 16:1 regulations also specify various rules of application.234 the debt modification regulations do not reflect any high theory of realization,235 and their mechanical application sometimes meshes poorly with onthe-ground facts and circumstances. these features of the rule-bound regulations reveal the underlying standard-like analysis fundamental to realization.236 consider state-law conversions of legal entities from limited liability companies (llcs) to corporations, and vice versa.237 if the llc is a disregarded entity for tax purposes and the obligor on a debt instrument, then these conversions cause a change in obligor from the llc’s owner to the corporation (or vice versa).238 the irs, however, has ruled privately that such conversions are not realization events, either because they are not modifications or not significant—the precise reasoning is unclear.239 in these rulings, the irs relies on the text of state statutes to find that the conversions have no effect on the parties’ legal rights and obligations. these rulings do not consider the effects of state corporate and llc law (which differ in terms of managers’ fiduciary duties, the availability of distributions, and the ability of creditors to pierce owners’ limited liability protections) or any specific terms in the corporate charters or llc operating agreements. even if irrelevant under current regulations, these additional facts might bear on any constitutional realization requirement.240 indeed, under a constitutional realization requirement, each of the rulebound pieces of the debt modification regulations is subject to constitutional 234 treas. reg. § 1.1001-3(f). see also richard l. bacon & harold l. adrion, taxable events: the aftermath of cottage savings (part ii), 59 tax notes 1386, 1386-91 (june 7, 1993) (describing the proposed debt modification regulations). 235 see richard l. bacon & harold l. adrion, taxable events: the aftermath of cottage savings (part i), 59 tax notes 1228 passim (may 31, 1993) (critiquing the proposed debt modification regulations as unprincipled). 236 see schlag, supra note 2, at 422-24 (1985) (questioning the role of polycentrism in determining when to use rules and standards). 237 similar changes can result from check-the-box elections. see, e.g., treas. reg. § 301.7701-3(a), (c) (providing that an eligible business entity may elect to change its classification by filing form 8832). 238 see treas. reg. § 301.7701-3(a), (b)(1)-(2). 239 compare i.r.s. p.l.r. 2023-37-007 (sept. 15, 2023) (finding that a proposed state-law conversion of an llc into a corporation would not result in a modification of debt), and i.r.s. p.l.r. 2003-15-001 (apr. 11, 2003) (same), with i.r.s. p.l.r. 2006-30-002 (july 28, 2006) (ruling that “[t]he conversion of parent [corporation] into [an] llc as part of [a] restructuring does not result in a significant modification of the [d]ebt” under treas. reg. § 1.1001-3(e)), i.r.s. p.l.r. 2007-09-013 (mar. 2, 2007) (ruling that the change in classification from corporation to disregarded entity will not result in a significant modification of debt), and i.r.s. p.l.r. 2010-10-015 (mar. 12, 2010) (finding that the conversion of a corporate subsidiary into an llc does not result in a significant modification of debt). see also c.c.a. 2011-003 (aug. 26, 2011) (concluding that the check-the-box conversion of an insolvent foreign subsidiary of a domestic corporation into a partnership under treas. reg. § 301.7701-3(c)(1)(i) is not a significant modification of debt). 240 other examples of standard-like applications of the rule-bound debt modification regulations include the transition away from libor as a benchmark in floating-rate debt, see t.d. 9961, 20223 i.r.b. 352 (jan. 4, 2022) (finalizing regulations that generally provide for nonrealization across an array of financial products), government forbearance programs involving home mortgage loans due to the covid-19 pandemic, see rev. proc. 2020-26, 2020-26 i.r.b. 984; rev. proc. 2020-51, 2020-50 i.r.b. 1599, and lending arrangements with multiple borrowers or parties that provide credit support, see luís c. calderón gómez, whose debt is it anyway?, 76 tax l. rev. 159 (2022). 2024] realization rule as a legal standard 33 challenge. there is, for example, no clear reason why a 25-basis-point change in yield would have constitutional significance.241 similarly, the regulations generally aggregate multiple changes over time to a single contractual term but disaggregate simultaneous changes to different contractual terms.242 again, a constitutional realization requirement may look more (or less) holistically. finally, taxpayers will not always favor nonrealization over realization for contractual modifications, and the different parties to a debt instrument may have different interests.243 these divergent interests provide ample opportunities for constitutional challenges to the current debt modification regulations. what would remain after these piecemeal, idiosyncratic challenges is virtually impossible to predict. 4. conclusion as a concept, realization is contextual, based on the facts and circumstances specific to the taxpayers and transactions at issue. constructive sales illustrate that establishing the inquiry’s scope is crucial. gift loans demonstrate how facts that trigger realization intersect with determinations of the timing and amount of any resultant income. debt modifications show how ostensibly rule-bound regimes bleed into standard-like questions and create uncertainty under a potential constitutional realization requirement. these examples emphasize the primacy of ex post determinations to realization—the essential feature of a legal standard. as discussed in the following section, these factual determinations interplay with uncertainty about the proper doctrinal elements for realization. b. realization’s doctrinal elements realization addresses three distinct questions: when is income taken into account, how much income is taken into account, and who is taxable on this income? to a significant extent, these questions’ answers are interdependent. under realization, a touchstone—a “definite event”—fixes the answers to these questions as of a given moment in time.244 the doctrinal elements that implicate realization are not transparent, however, especially in the constitutional context. for this reason, realization is simultaneously fact-intensive and ambiguous in terms of those facts’ doctrinal import. doctrinally, realization may be different in different contexts, and perhaps also different for different purposes.245 as a concept, realization may be shaped by notions of abuse and antiabuse,246 as well as the distinction between legal and 241 see treas. reg. § 1.1001-3(e)(2)(ii)(a). 242 see treas. reg. § 1.1001-3(f)(3)-(4); see also i.r.s. p.l.r. 2010-10-015 (mar. 12, 2010) (examining separately changes in yield, deferral of payments, and substitution of obligors). 243 for example, realization may allow holders to claim a loss or impose cancellation of indebtedness income on obligors. see i.r.c. §§ 1001; 108. 244 see bittker et al., supra note 6, at § 28:2. 245 several justices alluded to this uncontroversial idea during oral arguments. see, e.g., transcript of oral argument at 17-18, moore v. united states, 144 s. ct. 1680 (no. 22-800). see also zelinsky, supra note 102, at 873 (“[t]he judiciary has grappled with the contours of the realization principle.”). 246 see mindy herzfeld, moore and the history of the realization requirement, 180 tax notes 34 columbia journal of tax law [vol. 16:1 economic understandings of ownership.247 for this reason, the doctrinal elements of realization are uncertain in scope and content—a problem compounded in constitutional analysis by a lack of meaningful legal development since the 1950s. this section explores the contextual nature of realization through supreme court doctrine after macomber, then discusses antiabuse exceptions to realization and the importance of legal relationships to realization. 1. context and realization the contextual nature of realization is apparent in one of macomber’s doctrinal mainstays, the idea that realization occurs when a taxpayer receives something with respect to capital for the taxpayer’s “separate use and benefit.”248 in macomber, a stock-on-stock dividend yielded nothing from the company itself: “every dollar” of the taxpayer’s “original investment” remained “the property of the company, and subject to business risks.”249 property severed from capital— sometimes framed using a fruit-tree metaphor—fixed the timing, amount, and recipient of income.250 macomber left underspecified whether severance was either necessary or sufficient for realization in different contexts. subsequent judicial decisions provide little clarity on separation’s doctrinal function. as surrey and others read macomber out of an evolving tax jurisprudence,251 macomber’s “separation” requirement also fell from prominence. in bruun, the court found income when a landlord acquired tenant improvements after retaking possession of leased property.252 bruun rejected macomber’s “separation” requirement, describing it as “not controlling.” the taxpayer had income, notwithstanding that the tenant improvements had no value separate from the leased land and that the combined land and improvements almost certainly reflected an overall loss for the taxpayer. although congress reversed bruun’s result through legislation,253 the case demonstrates that one of realization’s doctrinal elements—separation—is not necessary (but perhaps remains relevant) for evaluating whether a transaction results in income.254 then, in woodsam associates,255 the second circuit held that a cash-out nonrecourse borrowing in excess of basis, secured by real property, did not result fed. 1754, 1754 (sept. 11, 2023) (noting that congress and courts “have regularly acknowledged the validity of antiabuse provisions” in the realization context). 247 see raskolnikov, supra note 174, at 514-16 (“[t]he law of tax ownership is vast, remarkably fragmented, and thoroughly confused.”); thompson & weisbach, supra note 176, at 249 (“ownership apparently has nothing to do with whether you are exposed to an economic position.”). 248 eisner v. macomber, 252 u.s. 189, 211 (1920). 249 id. 250 indeed, the barrett and thomas opinions in moore rely heavily on the language of separation to discuss realization’s boundaries. see moore v. united states, 144 s. ct. 1680 (2024) (barrett, j., concurring; thomas, j., dissenting). 251 see supra part ii.a. 252 helvering v. bruun, 309 u.s. 461 (1940). 253 see i.r.c. § 109. 254 similarly, the moore majority opinion does little to abrogate the “separate use and benefit” requirement across all contexts. when attributing income from an entity, however, separation clearly is not required. see batchelder et al., supra note 118, at 1511. 255 woodsam assocs. v. comm’r of internal revenue, 198 f.2d 357 (2d cir. 1952). 2024] realization rule as a legal standard 35 in income to the taxpayer. the loan held the taxpayer responsible for repayment to the extent of the property’s value and not for any excess. essentially, the taxpayer received cash with respect to real property whose value was reduced by that amount—a potential separation of liquid cash from illiquid property, in the language of macomber. under the code, these facts did not constitute realization.256 one commentator argues that woodsam associates shows “the ambiguous nature of the realization requirement” and “could about as easily have gone for the taxpayer as for the treasury.”257 not only is separation not necessary for realization, but the element also is not sufficient to trigger income.258 although separation is neither necessary nor sufficient for realization, the element retains significant staying power—and figured significantly into the barrett and thomas opinions in moore, as well as portions of oral arguments.259 many conventional realization events, including sales for cash and payments under a lease or loan, involve the separation of returns from capital. separation may have relevance in some contexts and not in others. once a decisionmaker specifies the factual predicate in which realization may occur, slotting those facts into an analytic framework presents another doctrinal challenge: how to array the facts in a framework that provides a path to either realization or nonrealization. these challenges, in part, justify courts’ shift in the 1940s and 1950s towards deference to congress on issues of realization. statutory law is a convenient vehicle for crafting complex (and rule-bound) frameworks. less certain is whether these statutory frameworks would survive constitutional scrutiny, in whole or in part. 2. abuse and antiabuse efforts to police tax abuse—perhaps keyed to taxpayers’ intent or motivation to engage in a transaction—also figure into realization doctrine. many statutory deviations from realization principles reflect efforts to curb tax gaming, which, in part, motivated amicus briefs on moore’s potentially calamitous effects.260 for example, section 1256 of the code requires taxpayers to recognize income or loss annually with respect to certain derivative contracts.261 for some commodities contracts, section 1256 aligns tax outcomes with market practices, in which these contracts clear gains and losses daily for traders.262 without this 256 section 111(a) of the code, as then in effect, required a “disposition,” though this textual analysis simply begs the question of whether a separation of cash from property constitutes a disposition. see infra part iii.b. 257 marvin a. chirelstein & lawrence zelenak, federal income taxation 365 (15th ed. 2023). 258 separation’s insufficiency is evident in other contexts, such as the recovery of capital with respect to an investment. see inaja land co. v. comm’r, 9 t.c. 727, 735-36 (1947) (finding no income on a payment for an easement with respect to land); i.r.c. § 301(c)(2)-(3) (allowing shareholders to recover capital on the receipt of cash from the corporation before recognizing gain with respect to stock). 259 see, e.g., transcript of oral argument at 36-37, moore v. united states, 144 s. ct. 1680 (2024) (no. 22-800) (concession by taxpayers’ counsel that “the separation concept maybe doesn’t necessarily apply in every circumstance”). 260 see supra note 31 (listing amicus briefs). 261 i.r.c. § 1256(a)-(b). 262 for this reason, § 1256 may not deviate from a constitutional realization standard, at least for 36 columbia journal of tax law [vol. 16:1 alignment, taxpayers could arbitrage the deferral granted by strict realization and the current cash consequences generated by market clearing mechanisms. for derivative contracts without periodic clearing, section 1256 opens arbitrage between deferred gains and accelerated losses on contracts with correlated economic risk.263 treasury has addressed such abuses of statutory antiabuse rules through regulations.264 this example shows the nonlinear relationship between realization and antiabuse efforts, which depend on context rather than a one-way ratchet to move away from realization in some contexts. similarly, realization principles may produce collateral consequences that themselves lead to abuse. after macomber declared stock dividends tax-free, some corporations took the position that those tax-free dividends also reduced earnings and profits, which allowed subsequent cash distributions to qualify as returns of capital or exempt distributions out of pre-1913 earnings and profits.265 although congress closed this loophole by stipulating that tax-free stock dividends do not reduce earnings and profits,266 realization as a principle facilitates these types of disjunctures. because realization implicates the code’s fundamental plumbing, a constitutional challenge that expands or contracts realization’s scope can have idiosyncratic collateral effects that facilitate abuse by taxpayers and their advisors. doctrinally, the role of abuse and antiabuse remains underdeveloped in the realization context, since many realization-oriented antiabuse rules are statutory or regulatory. to the extent that the constitution requires realization, the doctrinal role of abuse and antiabuse warrants greater specification. 3. line-drawing and realization realization’s murky contextual and purposive underpinnings place greater pressure on principled line-drawing with respect to the factual continuum between realization and nonrealization. an element-driven approach may prove uniquely unsuited to making these judgments.267 as an alternative,268 courts might consult broader values to give content to a constitutional realization principle. potential candidates for these broader values include traditional tax policy norms such as equity, efficiency, and administrative ease. setting aside equity (and its intrinsic normativity),269 both efficiency and administrative ease provide prescriptions for giving content to a constitutional realization requirement. under either set of derivatives traded on markets with similar clearing mechanisms. 263 see wright v. comm’r, 809 f.3d 877 (6th cir. 2016) (approving a listed transaction that used correlated options on foreign currency to generate current losses and future gains). 264 see prop. treas. reg. § 1.1256(g)-2(a) (reversing the outcome in wright by eliminating markto-market taxation for certain options on foreign currency). 265 george f. james, the present status of stock dividends under the sixteenth amendment, 6 u. chi. l. rev. 215, 231-32 (1939). 266 i.r.c. § 312(d)(1)(b). 267 see david a. weisbach, line-drawing, doctrine, and efficiency in the tax law, 84 cornell l. rev. 1627, 1633-37 (1999). 268 courts’ substantial repudiation of macomber’s separation requirement indicates that adjudicators might take something other than an element-based approach to a constitutional realization requirement. 269 for a brief consideration of equity in this context, see infra part vi. 2024] realization rule as a legal standard 37 values, a constitutional approach to realization might look very different from current statutory law or judicial interpretation. for this reason, the availability of such values in constitutional analysis creates a greater range of ex post outcomes for taxpayer-initiated controversies about constitutional realization.270 in terms of efficiency, the classic approach is to delineate holding and disposing—a basic tenet of realization—so that economically similar transactions are taxed the same.271 this approach is inconsistent with both existing law and historical interpretations of realization, which take a formalistic approach oriented towards legal entitlements.272 historically, realization has turned on changes in taxpayers’ legal relationships to assets, not their economic relationships.273 economic relationships may have little to say on how realization works. for example, risk operates ambiguously in the realization context, both as a positive and normative matter.274 changes in the expected costs of risk do not have a conclusive connection to dispositions in any sense. similarly, the nature of risk may change, but again, has little linkage to dispositions. finally, risk-based rules may fail to specify which assets are subject to any change in risk. a constitutional realization requirement could incorporate these efficiency-oriented values in analyzing issues of holding and disposing. one explicit aim might be to minimize taxpayer game-playing across the line that triggers realization. such an approach to constitutional realization would ameliorate many doctrinal ambiguities but simultaneously unsettle vast areas of current law. in terms of administrative ease, the conventional legal wisdom since 1940 has hewed to the supreme court’s dicta that realization is “founded on administrative convenience.”275 realization might defer taxation until taxpayers have liquidity, though this rationale is contrary to current statutory and constitutional law. if no separation is required, then liquidity cannot always justify a realization requirement. similarly, concerns about the practicalities of valuation say little about constitutional realization, which would have to be much narrower than current law to avoid valuation issues.276 finally, realization may reduce transaction costs in measuring income, since there already is a taxable event that incurs some overlapping costs, though the scope of taxable events is uncertain enough that this overlap may be immaterial.277 more generally, administrative convenience introduces optionality to the doctrinal analysis of realization, which allows for departures from whatever substantive framework applies. this optionality adds further contingency to any constitutional realization analysis. 270 references to broader values also are consistent with this article’s characterization of a constitutional realization requirement as a taxpayer-initiated antiabuse doctrine. see infra part iii.c. 271 see weisbach, supra note 267, at 1631 (noting that distributional effects—that is, equity—also must be accounted for in line-drawing). 272 see deborah paul, another uneasy compromise: the treatment of hedging in a realization income tax, 3 fla. tax rev. 1, 5 (1996) (describing this formalism as “inevitable”). 273 see generally thompson & weisbach, supra note 176 (arguing “the concept of tax ownership of fungible securities and other financial products” does not “appear to be based on economics”). 274 see paul, supra note 272, at 21. 275 helvering v. horst, 311 u.s. 112, 116 (1940). 276 for example, in-kind remuneration for services implicates realization for the party making the payment with noncash property. see treas. reg. § 1.61-2(d)(1). 277 see schenk, supra note 1, passim (discussing various rationales for the realization rule). 38 columbia journal of tax law [vol. 16:1 to the extent connected to broader values,278 a constitutional realization requirement potentially complicates a traditional element-based approach, even if those elements are themselves contingent on context and taxpayers’ intent. any change in economic position, as well as any change in legal relationships, could affect a determination of realization or nonrealization. doctrinally, legal relationships matter, and ideas of economic substance make economic relationships matter too. this type of layering—riskier in adjudication than administration— complicates any constitutional concept of realization. 4. conclusion from a doctrinal perspective, realization requires a broad factual inquiry with little non-statutory guidance on the elements required for realization. limited authority exists on which elements are constitutionally necessary or sufficient in various contexts, and many elements, such as separation, may prove probative without being dispositive. the role of tax abuse and nondoctrinal values in this analysis is unclear. as a legal standard, realization has few doctrinal touchstones, and any constitutional realization requirement must grapple with these questions as controversies arise. the next section explores the consequences of realization’s standard-like nature in the enforcement context. c. realization as an antiabuse doctrine the rule-bound internal revenue code is backstopped by various overarching judicial and statutory standards.279 often denoted as “antiabuse” doctrines, these legal standards permit “the government (and only the government) to override the literal words of a statute or regulation” to reach a result consistent with broader values, such as systemic integrity or legislative purpose.280 wellknown antiabuse doctrines, which each comprise open-ended tests reliant on a holistic evaluation of the facts and circumstances, include the common-law step transaction doctrine, the quasi-statutory economic substance doctrine, and regulatory interventions such as the general partnership antiabuse rule.281 although antiabuse doctrines operate at varying levels of specification,282 these doctrines fundamentally rely on their standard-like characteristics to police taxpayer behavior. a revitalized constitutional realization requirement would operate as an antiabuse doctrine with a unique—and uniquely destabilizing—characteristic: taxpayers, rather than the government, generally would have the “one-way” option to assert a constitutional realization requirement to vitiate the textual application of 278 in moore, kavanaugh relies heavily on administrative (and revenue) continuity as a norm. see moore v. united states, 144 s. ct. 1680, 1696 (2024). 279 see jonathan h. choi, the substantive canons of tax law, 72 stan. l. rev. 195, 205 (2020). for a perspective on how adjudicators should parse these facts and circumstances, see hayashi, supra note 2. 280 see weisbach, supra note 2, at 860. 281 see cunningham & repetti, supra note 26. the economic substance doctrine was partially codified in i.r.c. § 7701(o) and the partnership antiabuse rule is defined in treas. reg. § 1.701-2. 282 see choi, supra note 279, at 205. 2024] realization rule as a legal standard 39 statutory or regulatory rules.283 in the conventional pantheon of antiabuse doctrines, courts have circumscribed taxpayers’ use of antiabuse doctrines—most notably, the economic substance doctrine.284 these courts hold taxpayers to the terms of their agreements, their choice of form, and their in-the-moment interpretations of applicable law.285 if applied appropriately, conventional antiabuse doctrines operate against game-playing taxpayers and do not offer a tool to generate additional games.286 for constitutional limitations on congress and treasury, similar restrictions on taxpayers’ claims do not—and cannot—apply. to the extent that the constitution mandates realization, taxpayers have a choice. taxpayers can follow the dictates of congress and treasury, or they can assert, beforeor after-the-fact, that those dictates fail to meet the constitution’s requirements. these challenges flow directly from the constitutional nature of a macomber-style realization requirement. these alternatives roughly parallel the government’s choices under conventional government-initiated antiabuse doctrines, where government sets the rules then can disclaim their application in a specific situation. under a constitutional realization requirement, taxpayers can arrange their affairs to minimize taxes, then can disavow their choice of form in favor of a better outcome under the constitution. two important differences emerge when juxtaposing conventional antiabuse doctrines and this article’s characterization of a constitutional realization requirement as a taxpayer-initiated antiabuse doctrine. first, realization and nonrealization pervade current statutory law, which gives taxpayers many opportunities to challenge the current code and regulations as violating a constitutional realization requirement of uncertain scope and doctrinal content. second, the optionality intrinsic in a constitutional realization requirement foments explicit or tacit challenges. taxpayers (and not congress or treasury) can either accept or challenge the code or regulations’ application of a constitutional realization requirement. taxpayers generally will seek the better outcome for them, with a strong likelihood of targeted claims supported by interest groups. not only is a constitutional realization requirement a one-way law in favor of taxpayers, but the existence of this taxpayer-initiated antiabuse doctrine also is likely to generate significant controversy and aggressive position-taking, which in turn have serious implications for the evolution of tax law. iv. the hollowing-out of tax law for more than a century, the supreme court left the pandora’s box of 283 see weisbach, supra note 2, at 877-79. 284 sheldon i. banoff & richard m. lipton, irs will not allow taxpayers to self-impose the antiabuse rules, 110 j. tax’n 380, 380-81 (2009). 285 see smith, supra note 27, at 146. 286 for example, consider a taxpayer that chooses an ostensibly tax-advantaged form for a transaction. on audit, the irs disallows the transaction’s purported tax benefits, leveraging principles of realization or nonrealization to do so. then, the taxpayer disavows the transaction’s form in favor of a characterization that carries some, but not all, of the expected tax advantages. see william s. blatt, lost on a one-way street: the taxpayer’s ability to disavow form, 70 or. l. rev. 381 (1991). 40 columbia journal of tax law [vol. 16:1 constitutional realization largely closed. after macomber, commentators read subsequent decisions to minimize the case’s constitutional implications in favor of an administrative understanding of the realization requirement. lawmakers, judges, and practitioners largely embraced this shift. although moore did not address a putative constitutional realization requirement directly, the case cracks the lid of pandora’s box. opening the box fully would require backfilling the content of constitutional questions latent across decades of legislation, administrative interpretation, and judicial decisions. ostensibly settled issues may acquire new life. for this reason, even moore’s whisper of a constitutional realization requirement risks a sort of “hollowing out” of federal income tax law. although entire statutory schemes might fall,287 this top-down abrogation only captures some of the systemic risk posed by a constitutional realization requirement. a constitutional realization requirement also would erode the tax system from the bottom up, as portions of the plumbing in the code and regulations run afoul of a reinvigorated constitutional realization requirement. much of this plumbing relies on some statutory or regulatory concept of realization or nonrealization, which increases the number and variety of potential targets for invalidation under the constitution. because a constitutional realization requirement operates (uniquely) as a taxpayer-initiated antiabuse rule,288 these targets face a greater number of potential challenges. not every challenge will succeed, but even a limited number of bottom-up victories threatens tax law’s systemic integrity. under a constitutional realization requirement, the hollowing out of tax law would occur through the targeted elimination of statutory and regulatory mechanics, as well as shifts in taxpayer-government dynamics that result from a constitutional realization requirement. this part elaborates three specific mechanisms that facilitate this hollowing out. then, this part develops examples of how this hollowing out might unfold in partnership and corporate taxation. a. bottom-up challenges to the tax system taxpayers can deploy a constitutional realization requirement to assert bottom-up challenges to the tax system through three distinct mechanisms that leverage the public-private nature of tax administration, as well as risk-aversion by legislators and regulators. these mechanisms involve private interpretations of tax law in structuring transactions or taking positions on tax filings, litigation against the public enforcement of the code and regulations, and government actors’ reticence to challenge constitutional boundaries when crafting new laws or rules. the effect is piecemeal erosion of tax law’s internal integrity through public and private actions and inaction. most transparently, taxpayers may litigate to invalidate provisions in the code or regulations under constitutional arguments. in the context of a constitutional realization requirement, this litigation would occur on a case-by-case basis, and some provisions may survive, while others fall. because realization 287 see supra note 31 (listing specific statutory provisions threatened by a constitutional realization requirement). 288 see supra part iii.c. 2024] realization rule as a legal standard 41 operates as a legal standard (and is relatively underdeveloped),289 specific outcomes may prove difficult to predict or conceptually inconsistent.290 human preferences and fallibility introduce some uncertainty to judicial decision-making, and not all outcomes are high-quality. the structure of u.s. federal courts amplifies these concerns. even if the supreme court avoids future cases about constitutional realization, circuit and district courts are likely to face the issue. as idiosyncratic lower-court outcomes proliferate, any structural coherence in the u.s. tax system erodes.291 to the extent that the u.s. tax system relies on coherence, the negative implications of litigation compound over time. in addition to litigation, taxpayers’ private tax positions may undermine the tax system’s fundamental structure. on returns or other filings, taxpayers may assert a constitutional realization requirement to avoid the literal application of the code or regulations.292 overwhelmingly, these private tax positions do not enter the formal controversy process, so they are not vetted to finality in a traditional sense.293 for this reason, these private tax positions may stand without government scrutiny. furthermore, these private tax positions may become known among, and spread through, professional and business communities.294 aggressive or outlier positions may persuade new adherents and shift community norms over time. through these private routes, a constitutional realization requirement may gain purchase—and acquire de facto legal content through the unchallenged advice and opinions of taxpayers’ advisors.295 outside of the conventional controversy process, a constitutional realization requirement still threatens the integrity of the existing code and regulations. finally, a constitutional realization requirement would dampen legislative and regulatory reform efforts. these effects extend beyond the category of wealth taxes or mark-to-market taxes for high-income or wealthy taxpayers.296 technical reform proposals may—and typically will—implicate issues of realization and 289 id. 290 cf. kaplow, supra note 2, at 611-16 (discussing predictability in the development of legal standards). 291 because tax cases may proceed in district court, tax court, or the court of federal claims, the potential for disparate outcomes is greater in tax law. 292 these challenges could be technical. for example, realization might require accelerated depreciation, which would unsettle businesses’ basic calculations of income and loss. see douglas a. kahn, a proposed replacement of the tax expenditure concept and a different perspective on accelerated depreciation, 41 fla. st. u. l. rev. 143, 151-56 (2013). 293 although audit rates vary substantially by income level and type of filer, they generally average under 1%. see briefing book: what is the audit rate?, tax pol’y ctr. (jan. 2024), https://taxpolicycenter.org/briefing-book/what-audit-rate [https://perma.cc/e535-b36t]; see also elkins, supra note 2, at 50 (“[a]s long as audit rates are low, standard-based [antiabuse doctrines] can have little effect on the practical tax base and unfairly discriminate against those whose returns happen to be audited.”). 294 see sloan g. speck, tax planning and policy drift, 69 tax l. rev. 549, 559-63 (2016) (describing public-private “policy communities”). 295 see id. at 563-66. (describing how private actors have a “first-mover advantage” in interpreting tax law); see also assaf likhovski, the duke and the lady: helvering v. gregory and the history of tax avoidance adjudication, 25 cardozo l. rev. 953, 968-71 (2004) (describing “cycles of statutory interpretation”). 296 see reuven s. avi-yonah, can moore be limited?, 112 tax notes int’l 963, 963 (2023) (noting that moore was brought to forestall wealth and mark-to-market taxes). 42 columbia journal of tax law [vol. 16:1 nonrealization.297 for example, several recent partnership tax reform proposals touted by sen. wyden rely on nonrealization principles to shift income among partners in tax partnerships.298 these proposals include mandating revaluations for partnership property under section 704(b), which would affect partners’ current and future net income from the partnership without requiring a partnership-level realization event,299 and requiring taxpayers to use the remedial method for section 704(c), which creates notional (and offsetting) items of income and loss for partners with respect to all property contributed to the partnership. both of these changes ostensibly prevent abuses of optionality under current law. because these reforms bear an uneasy relationship to conventional realization, a constitutional realization requirement might give lawmakers an additional reason to reject wyden’s proposals.300 in this way, a constitutional realization requirement could shape treasury’s enforcement strategies and limit congress’s options for legislative reform.301 as a constitutional realization requirement gains content through adjudication and private-sector interpretation, such a constraint also forestalls reforms that might prevent the tax-system’s erosion from the bottom up. one issue that runs through these concerns involves taxpayer elections into a nonrealization regime. writing for the court in moore, justice kavanaugh expressed skepticism that “shareholder consent” could overcome a constitutional realization requirement “and allow congress to enact an otherwise unconstitutional tax.”302 some moore amici also argued that such electivity is unconstitutional,303 while petitioner’s counsel relied heavily on elections to argue that existing law would survive a constitutional realization requirement.304 if elections out of realization are unconstitutional, then a number of legal regimes would stand on uncertain ground, at least for some taxpayers making the elections. these regimes range from elective mark-to-market regimes, which apply to dealers in securities,305 to the check-the-box rules for entity classification, which allow entities to elect corporate or partnership treatment.306 if elections are constitutional, two issues 297 see george k. yin, crafting structural tax legislation in a highly polarized congress, 81 law & contemp. probs. 241, 270-75 (2018) (describing structural and nonstructural reforms over time in various areas of business taxation). 298 see monte a. jackel, new wyden partnership tax proposals deserve consideration, 173 tax notes fed. 1709 (2021); see also walter d. schwidetzky, the wyden proposals on partnership debt: step forward or back?, 76 tax law. 389, 412 (2023) (discussing § 752). 299 see schwidetzky, supra note 298, at 410. 300 concerns about constitutionality have affected prior reform efforts, most notably efforts in the late 1960s to treat death as a realization event. see supra note 168 (discussing the legislative history of the tax reform act of 1969). 301 see mark p. gergen, the common knowledge of tax abuse, 54 smu l. rev. 131, 141-43 (2001) (discussing abuses involving elective regimes in partnership taxation). 302 moore v. united states, 144 s. ct. 1680, 1695 (2024). see also simona grossi, the waiver of constitutional rights, 60 hou. l. rev. 1021 (2023) (suggesting a framework for determining whether and how individuals may waive constitutional rights). 303 see brief for tax law center at nyu law et al. as amici curiae supporting respondent, moore, 144 s. ct. 1680 (no. 22-800). 304 see brief for petitioner at 51-52, moore, 144 s. ct. 1680 (no. 22-800). 305 i.r.c. § 475. 306 treas. reg. § 301.7701-3. for example, nonrealization principles in u.s. partnership taxation may preclude foreign entities from electing into such treatment, rather than being taxed as corporations under default rules. 2024] realization rule as a legal standard 43 arise: elections may be compelled, and elections may lack sufficient infrastructure to waive constitutional rights. under current law, qualifying electing fund (qef) elections for passive foreign investment companies (pfics) are effectively compelled, since the default regime is (intentionally) punitive to taxpayers.307 similarly, consent dividends to preserve real estate investment trust (reit) status are effectively compelled, since the consequences of lost status are typically catastrophic.308 to the extent of taxpayer electivity, the three mechanisms outlined in this section offer greater potential to sow chaos within current tax law. b. examples from partnership taxation although the moore majority effectively blessed pass-through taxation as an alternative to entity-level taxation,309 a constitutional realization requirement still poses bottom-up threats to pass-through regimes such as subchapter k, which governs tax partnerships.310 the risk is less that any form of pass-through taxation will fall in its entirety, than that an explicit or implicit realization requirement will undermine the structure of these regimes over time. the mechanism for this systemic erosion need not be federal courts. particularly in the context of partnership taxation, taxpayers may look to their legal and accounting specialists for advice that certain aspects of subchapter k violate a constitutional realization requirement. the bottom-up erosion of subchapter k may occur in several areas. in certain circumstances, current regulations permit partnerships to revalue their property for book purposes but not tax purposes. these revaluations, or “book-ups,” are mandatory on the exercise of noncompensatory options.311 in other situations, revaluations maintain economic parity among partners within the regulations’ safe harbor regime for partnership allocations—an administrative advantage that may advantage some partners while disadvantaging others. this differential treatment of partners arises because revaluations create reverse 704(c) allocations, which shift income and loss among partners at variance to those partners’ fundamental economic sharing arrangement, as embodied by the contractual agreement among the partners.312 the events that enable revaluations—such as contributions by a partner, distributions to a partner, or the exercise of noncompensatory options— may not rise to the level of realization, or may not constitute realization for all partners or the partnership itself.313 these events, however, operate to fix the 307 i.r.c. § 1295. 308 see i.r.c. § 856(g)(3) (stating that the lock-out period for reit status following termination or revocation is five years). 309 see moore, 144 s. ct. at 1685 (stating the issue in moore as one of attribution of realized income). 310 see i.r.c. §§ 701-771. 311 see treas. reg. § 1.704-1(b)(2)(iv)(f); see generally daniel s. goldberg, partnership revaluations: book-ups are your friends (usually)—planning with revaluations and their interplay with section 704(c), 74 tax law. 345 (2021). 312 see treas. reg. § 1.704-1(b)(2)(iv)(g). the partners agree on whether to revalue property, if elective, and generally agree to comply with subchapter k. 313 treas. reg. § 1.704-1(b)(2)(iv)(f)(5). to the extent that partners’ relative interests in the partnership change, “the principles of § 704(c)” may apply to determine the partners’ prospective tax consequences. see id. 44 columbia journal of tax law [vol. 16:1 income tax consequences for all partners at the time of the revaluation. to the extent that revaluations affect partners’ income without a corresponding realization event for that partner or the partnership, the revaluation regime may be infirm under a constitutional realization requirement. similarly, the statutory basis adjustments that flow from distributions of partnership property may not survive a constitutional realization requirement.314 these adjustments are required at all points after an initial election,315 as well as in contexts that potentially shift losses among partners.316 by affecting the partnership’s basis in different assets, these adjustments implicate the sharing of net income and loss among all current partners. in-kind distributions of partnership property, however, may not constitute a realization event, or may constitute a realization event only for the recipient partner. similarly, any shifting of basis among assets may or may not have a constitutional tether that mandates a particular set of outcomes.317 these mechanical and computational regimes stretch the idea of attribution in ways that implicate realization more generally.318 furthermore, certain “disproportionate distributions” to partners implicate a complex regime of deemed exchanges that generally seek to maintain partners’ relative shares of ordinary income and capital gain or loss.319 these deemed exchanges can accelerate the recognition of income for all partners, even those not involved in an actual distribution of property. there is not clear realization event for these nonrecipient partners—or the partner that receives an in-kind distribution, if such distributions are not realization events.320 as with partner and partnership basis adjustments, a court would need to determine whether these rules represent appropriate attribution of income or implicate realization principles. in either case, a constitutional judgment would apply. finally, changes in partners’ shares of partnership debt may result in deemed distributions and yield partner-level income without an unambiguous realization event.321 changes in debt shares may follow from a new or modified contractual agreement, such as a guarantee of partnership debt by a partner, or they may result from a repayment of debt by the partnership. the legal question is whether these contractual arrangements (or their modification, or debt repayment) constitute a realization event. if realization exists, there remains a further question of whose income may be affected as a result of that realization. a constitutional realization requirement implicates the outcomes of both questions. 314 see i.r.c. § 734 (detailing statutory basis adjustments). 315 i.r.c. § 754. 316 these basis adjustments are mandatory when the partnership has a substantial basis reduction. i.r.c. § 734(a). 317 see i.r.s. notice 2024-54, 2024-28 i.r.b. 24; rev. rul. 2024-14, 2024-28 i.r.b. 18 (each discussing anti-basis shifting rules). 318 more generally, subchapter k shifts income (or permits income shifts) among partners in a number of ways. see andrea monroe, what we talk about when we talk about tax complexity, 5 mich. bus. & entrepreneurial l. rev. 193, 204 (2016). 319 see i.r.c. § 751(b). this regime is notoriously infirm. see william d. andrews, inside basis adjustments and hot asset exchanges in partnership distributions, 47 tax l. rev. 3 (1991); karen c. burke, hot asset exchanges: integrating § 704(c), 734(b), and 751(b), 70 tax law. 711 (2017). 320 see brief of professor theodore p. seto as amicus curiae supporting respondent at 21-22, moore v. united states, 144 s. ct. 1680 (2024) (no. 22-800). 321 see i.r.c. § 752. 2024] realization rule as a legal standard 45 these disparate regimes compose part of partnership tax’s fundamental mechanics. each regime attempts to ensure that partners’ income properly reflects their relationship to the partnership, that subchapter k’s single-level tax operates in a coordinated manner, and that taxpayers do not abuse subchapter k’s flexibility. each regime may survive under a permissive attribution of income doctrine, and each regime may fall under a constitutional realization requirement. to the extent that all or part of these regimes is unconstitutional, subchapter k’s operation is impaired, even if pass-through taxation more generally survives. in this way, a constitutional realization requirement could eat away at subchapter k from the bottom up. c. examples from corporate taxation decades of judicial deference to congress have left many fundamental questions of realization unresolved, and those issues’ resolution against the government could unravel longstanding mechanics essential to the basic operation of tax law. in corporate taxation, the tax reform act of 1986 firmly entrenched, as a statutory matter, the repeal of the general utilities doctrine, which allowed corporate taxpayers to avoid recognizing corporate-level gain on certain distributions in-kind. whether in-kind distributions themselves are realization events remains an open question.322 to the extent that some or all in-kind distributions do not constitute a realization event under the constitution, one of the fundamental antiabuse principles in corporate taxation would be seriously impaired. for corporate-level tax, realization may not matter because the tax instrument itself is an excise not subject to the apportionment requirement.323 inkind distributions may not be excises, however, if they do not involve “doing business in a corporate capacity.”324 furthermore, in-kind distributions generate current earnings and profits that may support dividend characterization at the shareholder level, or in-kind distributions may constitute a return of shareholders’ capital before generating shareholder-level income.325 in any of these cases, a constitutional realization requirement would threaten the basic mechanics of corporate taxation. these concerns about the general utilities doctrine are more than merely theoretical. in taxable reit separations, there is a statutory requirement to expunge, or “blow out,” the new reit’s earnings and profits (e&p).326 if the integrated business’s operations are distributed as assets (for example, to a partnership operations company), the question is whether any entity-level gain would increase e&p and thus the amount of income shareholders would recognize in the separation. whether the e&p blow-out includes section 311(b) gain directly 322 see don leatherman, the scope of the general utilities repeal, 91 taxes 235 (2013). 323 see john r. brooks & david gamage, the original meaning of the sixteenth amendment, 102 wash u. l. rev. (forthcoming 2024). 324 flint v. stone tracy co., 220 u.s. 107, 146 (1911). 325 under current law, such distributions generate income first. see i.r.c. § 301(c). 326 see i.r.c. § 857(a)(2)(b). 46 columbia journal of tax law [vol. 16:1 affects shareholders’ income.327 this type of gain may survive constitutional scrutiny as an excise tax, or it may fall as an unconstitutional violation of the realization requirement. as in partnership taxation, a constitutional realization requirement threatens, or at least draws into question, the basic plumbing in corporate taxation, often in highly granular ways. such a realization requirement would pressure tax law’s integrity from the bottom up, as well as from the top down. for this reason, the current discourse about systemic concerns seriously understates the havoc that a constitutional realization requirement could wreak. v. complexity and the realization requirement a constitutional realization requirement introduces a novel tool in the iterative compliance game between the government and taxpayers. such a requirement would operate as a taxpayer-initiated antiabuse doctrine and generate concomitant bottom-up threats to the tax system’s coherence.328 from this perspective, a constitutional realization requirement has additional implications for the tax system’s complexity. this complexity flows from how congress, treasury, and taxpayers each respond to a constitutional realization requirement. the central insight is that all of these responses are likely to increase the tax system’s complexity over time. the model for these interactions is well-established.329 in a rule-bound system designed to police common transactions (such as existing tax law), private planners have an incentive to seek esoteric structures for their clients that confer tax benefits. these structures are definitionally uncommon in the absence of tax benefits. but as taxpayers adopt these structures, they become increasingly common.330 one solution is more rules that draw finer distinctions to appropriately tax these newly common transactions. these rules are (definitionally) more complex, since they increase law’s granularity.331 this phenomenon has a ratcheting effect in which rule-based complexity increases over time in response to iterative tax planning. the conventional solution to this phenomenon is overarching legal standards—government-asserted antiabuse doctrines. these doctrines constrain rules-oriented planning by muddying the line between permissible and impermissible transactions. as long as these antiabuse doctrines are well-targeted, uncommon tax-advantageous transactions are deterred, do not become common, 327 see i.r.c. § 312. 328 see supra part iv.a. 329 see weisbach, supra note 2; see also surrey, supra note 36, at 707 n.31 (“it is clear that [antiabuse doctrines] save the tax system from the far greater proliferation of detail that would be necessary if the tax avoider could succeed merely by bringing his scheme within the literal language of substantive provisions written to govern the everyday world.”). 330 this phenomenon is referred to as “the uncommon becoming common.” see weisbach, supra note 2, at 871. 331 for an overview of the literature on tax complexity, see kathleen delaney thomas, userfriendly taxpaying, 92 ind. l.j. 1509, 1514-15 (2017) (identifying rule-based, computational, structural (or transactional), and compliance complexity). tax complexity has both procedural and substantive elements. see id. at 1516-17. 2024] realization rule as a legal standard 47 and do not require rule-bound solutions. tax law can remain less complex.332 a constitutional realization requirement flips this strategy on its head. as a taxpayer-initiated antiabuse doctrine, a constitutional realization requirement allows taxpayers, and generally not the government, to challenge the existing code and regulations, which rely deeply on concepts of realization and nonrealization. these bottom-up challenges may spur responses from the government and taxpayers, and these responses have implications—generally negative—for the tax system’s complexity. this part sketches these responses. one additional question is whether a constitutional realization requirement might become more rule-like over time, as enforcement produces better delineation of the requirement’s relevant facts and doctrinal elements.333 because the bulk of interpretation of any constitutional realization requirement will occur privately, enforcement probably will have limited effect in reducing a standard-driven analysis to a clear system of rules.334 indeed, an underdeveloped realization requirement may foment widely divergent private positions that never surface in a way that settles norms or practice with respect to the issue. for this reason, a constitutional realization requirement seems likely to retain its function as a taxpayer-initiated antiabuse doctrine for a substantial period of time. a. government responses: promulgation tax law has been described as a “paradigmatic system of rules.”335 these rules are written ex ante by government actors, principally congress and treasury, in the context of government-asserted antiabuse doctrines that backstop these rules. to the extent that taxpayers can initiate their own antiabuse doctrine by asserting a constitutional realization requirement, congress and treasury should adjust their rulemaking practices to reflect the risk that their rules violate the constitution. additionally, because a constitutional realization requirement operates as a (largely underdeveloped) legal standard, congress and treasury lack certainty as to whether their rules will survive taxpayers’ challenges. one possibility is that congress and treasury will issue fewer rules, leaving tax law’s content underspecified relative to congress and treasury’s preferences.336 some of this space could be filled with “symmetrical” standards that operate in a more neutral fashion relative to antiabuse doctrines.337 examples of symmetrical standards include the distinctions between debt and equity and between employees and independent contractors. both of these examples impose notorious compliance 332 the essential insight is that the choice between rules and standards has implications for complexity in an iterative format where planning exists. see also elkins, supra note 2, at 54-55 (discussing the implications of planning and audit in the context of antiabuse doctrines). 333 see supra note 11 (discussing the evolution of standards into rules). 334 this framing highlights the jurisprudential ambiguity in the analysis of rules and standards. see schlag, supra note 2, at 424-25. 335 weisbach, supra note 2, at 860. 336 taxpayers may diverge on how much content they want congress and treasury to specify. for this reason, underspecification has distributional effects that are regressive if better-off taxpayers prefer underspecification compared to worse-off taxpayers. 337 see alex raskolnikov, relational tax planning under risk-based rules, 156 u. pa. l. rev. 1181, 1193-94 (2008). 48 columbia journal of tax law [vol. 16:1 costs on taxpayers and adjudicators. even to the extent that congress and treasury could promulgate the same legal content in a shift towards symmetrical standards, more high-frequency transactions would be governed by standards, which increase compliance costs relative to rules.338 alternatively, congress and treasury could modify the structure of their proposed rules in ways more likely to comport with a constitutional realization requirement. for example, assume that congress prefers rule a, but rule a arguably is infirm in a constitutional sense. congress could reduce the odds of invalidation (or nonacceptance by taxpayers) through three mechanisms: congress could enact rules b and c, which together have the same effect as rule a, wrap rule a inside another policy that mitigates rule a’s infirmity, or move rule a outside of the tax system.339 these workarounds impose costs when lawmakers cannot perfectly replicate the effect of rule a. when attempting to replicate rule a, there may be unavoidable policy changes. similarly, workarounds risk legislative errors to the extent that they are more difficult to execute than rule a alone. moreover, workarounds may shift compliance costs to taxpayers and adjudicators, even if the underlying policy remains the same. for these reasons, workarounds motivated by a constitutional realization requirement are likely to be less effective and efficient than congress and treasury’s preferred rules. although congress often deals with these types of workaround issues, a constitutional realization requirement would increase this type of legislative manipulation.340 finally, congress may adopt holistic strategies to address constitutional concerns about realization. for example, congress may institute a greater number of elective regimes that explicitly do not rely on realization.341 setting aside concerns about compelled elections and the adequacy of any waivers of constitutional prerogatives, elective regimes increase transactional and procedural complexity. unsophisticated taxpayers are at a disadvantage in such regimes, with adverse equity and distributional consequences. sophisticated taxpayers tend to use elective regimes to their advantage, which can have unintended effects on other aspects of the tax system.342 b. taxpayer responses: compliance in general, a constitutional realization requirement is likely to encourage 338 kaplow, supra note 2, at 577. implicitly, congress and treasury also could rely more heavily on antiabuse doctrines, which is discussed below. 339 for the reverse phenomenon, see nfib v. sebelius, 567 u.s. 519, 570 (2012) (holding the individual mandate for healthcare constitutional because it was a tax). 340 this effect could be described as uncommon legislative strategies becoming common, with concomitant implications for complexity. 341 for a discussion of elections under a constitutional realization requirement, see supra text accompanying notes 302-08. another holistic strategy could be to increase substitute taxation of counterparties to nonrealization transactions or to disallow losses to curb abuse (which might be permissible, if a constitutional realization requirement is asymmetrical with respect to gain and loss). 342 see, e.g., steven a. dean, attractive complexity: tax deregulation, the check-the-box election, and the future of tax simplification, 34 hofstra l. rev. 405, 453-55 (2005); heather m. field, checking in on “check-the-box”, 42 loy. l.a. l. rev. 451, 481 (2009). 2024] realization rule as a legal standard 49 planned transactions. to the extent that these transactions become common, the government must enact rules to regulate these transactions or rely on governmentasserted antiabuse doctrines to deter these transactions. if the government generates more rules, complexity increases, as do the costs of compliance for taxpayers that do not plan but still must learn about the law. if the government presses other antiabuse doctrines in enforcement, the costs of enforcement rise.343 this dynamic relies on the fact that a constitutional realization requirement operates as a taxpayerinitiated antiabuse doctrine. taxpayers, in a sense, act as portfolio managers with respect to their tax compliance risk. for tax-planned transactions, a constitutional realization requirement gives taxpayers another tool to succeed against the government during enforcement proceedings. in addition, taxpayer antiabuse doctrines tend to smooth discontinuities in rules from taxpayers’ perspectives only, which allows for favorable outcomes, even if taxpayers misjudge any arbitrage points in tax-planned transactions. for these reasons, a constitutional realization requirement reduces taxpayers’ risk with respect to highly tax-planned transactions, and taxpayers will have an incentive to engage in more of these types of transactions. somewhat counterintuitively, a constitutional realization requirement also increases taxpayers’ risk with respect to transactions that do not reflect tax planning. although treasury may not challenge these everyday transactions on audit, other taxpayers, through their use of a constitutional realization requirement, may cast doubt on the tax system’s underlying infrastructural rules through the “hollowing out” process described in this article. this manufactured doubt may reduce taxpayers’ confidence in how everyday transactions are treated, or how the underlying mechanics of the code and regulations operate. in this way, a constitutional realization requirement rebalances risk across taxpayers’ transactions: tax-planned transactions become relatively more attractive, while non-planned transactions become relatively less so.344 overall, the use of constitutional realization as a taxpayer-initiated antiabuse doctrine leads to uncommon tax-planned transactions becoming more common. if congress and treasury respond with more rules, the tax system becomes more complex—the reverse effect that follows from government-initiated antiabuse doctrines. this process may repeat, with a ratcheting effect. one caveat is that unsophisticated taxpayers may benefit from a constitutional realization requirement, at least to the extent that realization comports with their (uninformed) expectations about the content of law. as an antiabuse doctrine, a constitutional realization requirement would tend to smooth discontinuities in rules, which could in turn alleviate transactional complexity by aligning outcomes with the expectations of unsophisticated (or uninformed) taxpayers.345 this benefit, however, seems unlikely to outweigh (and perhaps should not normatively outweigh) any increased costs due to tax planning and this planning’s ratcheting effect on systemic complexity. 343 see infra part v.c. (discussing the government’s enforcement responses). 344 this shift has distributional effects. 345 see emily cauble, unsophisticated taxpayers, rules versus standards, and form versus subtance, 52 loy. u. chi. l.j. 329, 337 (2021). 50 columbia journal of tax law [vol. 16:1 c. government responses: enforcement a constitutional realization requirement could encourage the government to increase and broaden its application of government-initiated antiabuse doctrines during the enforcement process. for example, if the constructive sale rules of section 1259 are constitutionally deficient because they abrogate a realization requirement, treasury or courts may deploy the economic substance doctrine to argue that the taxpayer still has income, notwithstanding nonrealization. similarly, if courts abrogate the gift loan rules in section 7872, the government may press for a substitute through other judicial doctrines, which themselves are subject to significant uncertainty in application. in both cases, the government deploys a completing antiabuse rule to combat realization as a taxpayer-initiated antiabuse rule. in effect, a constitutional realization requirement encourages congress and treasury to substitute government-asserted antiabuse doctrines for rule-bound regimes in the code and regulations. this substitution has normative stakes, in that overreliance on antiabuse doctrines may impair the tax system’s overall quality. the code and regulations stipulate rules for a reason. in addition, this substitution may lead to greater uncertainty about the quantitative and qualitative outcomes possible through adjudication. while not a direct driver of complexity, uncertainty imposes costs on the enforcement process. dueling antiabuse doctrines may have adverse effects on the content of law—and those effects may closely mimic complexity. vi. conclusion after eight decades of relative quiescence, a revitalized constitutional realization requirement would present serious threats to the current income tax system. to the extent that a constitutional realization requirement operates as a taxpayer-initiated antiabuse rule, such a requirement risks a hollowing out of everyday aspects of the current tax system. what fills these gaps likely will lead to increased complexity—a negative outcome on a grander scale than envisioned by commentators and the court in moore. these mechanisms have further implications for inequity and distribution. realization is notoriously associated with inequitable treatment of taxpayers in both a horizontal and vertical sense—the reason for many of the code’s deviations from the realization norm. a constitutional realization requirement would allow welladvised and well-resourced taxpayers to press further against congress’s efforts to combat realization-oriented abuse. furthermore, the types of challenges these taxpayers bring may hollow out the tax law and lead to increased complexity. these emergent infirmities in the code and regulations will themselves have adverse distributional effects—likely disadvantaging less-savvy taxpayers. neither of these outcomes is desirable. taxation and corporate governance ariel siman* & reuven avi-yonah** abstract legal and economic scholars have examined the intersection between corporate governance and taxation; however, recent legal scholarship has generally focused on the interplay between director compensation, management measures in the face of the market for corporate control, and the double taxation of inter-corporate dividends. other aspects of the relationship between corporate governance and taxation have received limited attention. this article aims to fill this gap in the literature. first, this paper discusses the corporate agency problem and the existing justifications for the corporate tax. second, this paper argues that the corporate tax can be justified on the ground that it mitigates the corporate agency problem more effectively and with fewer adverse consequences than alternative taxation systems. * ll.m., university of michigan law school; m.b.a., the hebrew university of jerusalem; ll.b., the hebrew university of jerusalem. ** irwin i. cohn professor of law, university of michigan law school. 52 columbia journal of tax law [vol 16:1 i. introduction .................................................................................................53 ii. background ...................................................................................................54 a. corporate governance and the agency problem .......................................54 b. tax and corporate governance: main interplays ......................................55 iii. existing justifications for the corporate tax .......................................56 a. overview ....................................................................................................56 b. current justifications for the corporate tax .............................................56 iv. key role of the corporate tax in the financial reporting system ...58 a. context: the corporate tax as exterior corporate governance ...............58 b. corporate tax can strengthen the financial reporting system ................60 1. “madisonian” function: mitigating incentives to inflate income ......61 2. “shedding light” function: expanding market information .............63 c. the “monitoring” function .......................................................................64 d. comparative advantage of corporate tax (and irs) relative to sec .....65 1. economies of scope .............................................................................67 2. “skin in the (disclosure) game” .........................................................68 3. “political clout” .................................................................................70 e. the corporate alternative minimum tax and its critics ..........................70 f. summary ....................................................................................................74 v. the corporate governance justification(s) for corporate tax ........74 a. “fee for (governance) services justification” ..........................................76 b. “the governance approach to the economic justification” .....................78 c. “executives regulation justification” .......................................................81 d. re-evaluating the governance justifications .............................................83 vi. conclusion .....................................................................................................85 2024] taxation and corporate governance 53 i. introduction in recent years, legal and economic research has shown a growing interest in the interaction between corporate governance and taxation.1 some specific aspects have drawn more interest, particularly the tax rules related to the remuneration of directors,2 measures taken by management in the context of market for corporate control,3 and the double taxation of inter-corporate dividends;4 however, there is still little legal literature on many other aspects of the interplay between the two systems, and several authors have mentioned this gap in the literature and the dire need for further study in this “fertile area of research.”5 1 see, e.g., paul caron, oh presents how does the corporate tax distort choice of corporate governance? today at pepperdine, taxprof blog (jan. 22, 2024), https://web.archive.org/web/20240618021112/https://taxprof.typepad.com/taxprof_blog/2024/01/o h-presents-how-does-the-corporate-tax-distort-choice-of-corporate-governance-today-atpepperdine.html [https://perma.cc/vxq6-6ue3]. 2 see gregg d. polsky, controlling executive compensation through the tax code, 64 wash. & lee l. rev. 877 (2007); robert m. halperin, young k. kwon & shelley c. rhoades-catanach, the impact of deductibility limits on compensation contracts: a theoretical examination, 23 j. am. tax. ass’n 52 (2001); john graham & yonghan julia wu, executive compensation, interlocked compensation committees, and the 162(m) cap on tax deductibility 7 (jan. 2007) (unpublished manuscript) (on file with social science research network (ssrn)); antonio paulo machado gomes, corporate governance characteristics as a stimulus to tax management, 27 scielo brazil 149 (2016). 3 see generally kurt hartmann, the market for corporate confusion: federal attempts to regulate the market for corporate control through the federal tax code, 6 depaul bus. l.j. 159 (1993); schuyler m. moore & edwin g. schuck, jr., tax aspects of defensive strategies to corporate takeovers, 69 j. tax’n 212 (1988); eric engle, green with envy? greenmail is good! rational economic responses to greenmail in a competitive market for capital and managers, 5 depaul bus. & com. l.j. 427 (2007). 4 see william w. bratton, the new dividend puzzle, 93 geo. l.j 845 (2005); steven a. bank, is double taxation a scapegoat for declining dividends? evidence from history, 56 tax l. rev 463 (2003); skyler santomartino, double tax is double the trouble: the solution? moving toward a system of corporate integration, 15 j. bus. & tech. l. 345 (2020). another area that has garnered significant attention from academics, particularly in the last decade, is the influence of corporate governance on the level of tax avoidance. for a comprehensive review of this line of literature, see jost kovermann and patrick velte, the impact of corporate governance on corporate tax avoidance a literature review, 36 j. int’l accounting, auditing and taxation (2019). 5 mihir a. desai & dhammika dharmapala, taxation and corporate governance: an economic approach in tax and corporate governance 13, 29 (wolfgang schon ed. 2008) (arguing “[t]he historic divide between the study of taxation and the analysis of corporate governance appears to have obscured many fertile areas of research… the impact of the tax system on the market for corporate control remains substantially under-explored”); jaron h. wilde, the deterrent effect of employee whistleblowing on firms’ financial misreporting and tax aggressiveness, the acct. rev. 92, 247, 247 (2017); jeri k. seidman & bridget stomberg, equity compensation and tax avoidance: disentangling managerial incentives from tax benefits and reexamining the effect of shareholder rights, 39 the j. of the am. tax’n ass’n 21, 21 (2017); arne friese, simon link & stefan mayer, taxation and corporate governance – the state of the art in tax and corporate governance 358, 359 (wolfgang schon ed. 2008) (arguing “there is relatively little literature on the interaction of corporate governance and taxation”). yariv brauner, the non-sense tax: a reply to new corporate income tax advocacy, 2008 mich. st. l. rev. 591, 619 (2008) (arguing “[n]otably little work has been done on the relationship between tax and corporate governance to date, yet lately there is increasing interest in this interaction”; “… as will be apparent, this issue https://web.archive.org/web/20240618021112/https://taxprof.typepad.com/taxprof_blog/2024/01/oh-presents-how-does-the-corporate-tax-distort-choice-of-corporate-governance-today-at-pepperdine.html https://web.archive.org/web/20240618021112/https://taxprof.typepad.com/taxprof_blog/2024/01/oh-presents-how-does-the-corporate-tax-distort-choice-of-corporate-governance-today-at-pepperdine.html https://web.archive.org/web/20240618021112/https://taxprof.typepad.com/taxprof_blog/2024/01/oh-presents-how-does-the-corporate-tax-distort-choice-of-corporate-governance-today-at-pepperdine.html 54 columbia journal of tax law [vol 16:1 the aim of the article is to begin filling this gap by exploring some of the more intriguing aspects of this interplay between the two systems. among other things, can the corporate tax be justified on the grounds that it reduces the corporate agency problem and that alternative systems have fewer desirable effects? the article proceeds as follows: in part ii, we will briefly provide the relevant background. it will start by defining the term “corporate governance” and the agency theory that underlines this area. it will be followed by an explanation of the major interplays between taxation and corporate governance. part iii will present the current views concerning the justification for the corporate tax and criticize them. part iv will discuss the key role of the corporate tax in the financial reporting system and its relationship to the corporate governance debate. part v will return to the role of tax in corporate governance and argue that the corporate tax can help reduce agency costs and that other ways of doing so have fewer desirable effects. part vi will conclude that the corporate tax can be justified by its ability to adequately address and mitigate the agency concern. ii. background a. corporate governance and the agency problem corporate governance may be defined broadly as: “the private and public institutions, including laws, regulations and accepted business practices, which together govern the relationship, in a market economy, between corporate managers and entrepreneurs (‘corporate insiders’) on one hand, and those who invest resources in corporations, on the other. investors can include suppliers of equity finance (shareholders), suppliers of debt finance (creditors), suppliers of relatively firm–specific human capital (employees) and suppliers of other tangible and intangible assets that corporations may use to operate and grow.”6 the key focus of u.s. corporate governance systems is the “agency problem,” which arises when the owners of the corporation, the shareholders, are not the managers who are in control.7 this disparity creates an opportunity for the managers of the corporation to promote their own personal interests over those of the shareholders. the managers’ preference for their own personal interests can be expressed through inefficient management, the receipt of perquisites by the managers at the corporation’s expense, and other such problems reflective of the shareholder’s lack of representation and agency within decision-making. this problem is endemic to corporations in the u.s., since most u.s. corporations are picked up the interest of tax scholars, primarily economists, only lately. there is almost no relevant legal scholarship…”). 6 charles p. oman, corporate governance and national development, 1, 13 (oecd dev. ctr.. working paper no. 180, 2001). 7 sanjai bhagat, brian bolton & roberta romano, the promise and peril of corporate governance indices, 108 colum. l. rev. 1803, 1809-10 (2008). 2024] taxation and corporate governance 55 widely held by a large group of shareholders.8 an entirely different manifestation of the agency problem may occur when a small group of shareholders (or an individual shareholder) holds a controlling block of shares. in such a case, the agency problem occurs between the controlling shareholder and minority shareholders. the controlling shareholders have the power to make all decisions about the fate of the corporation, even though the minority also invests its assets in the corporation. the minority essentially transfers the control over its assets (its investment) to the controlling party (e.g., the agent). by doing so it exposes itself to the agency problem and the risk is that the controlling shareholder might prefer individual interest over the good of the group, thereby harming the minority’s interests. the control problem is endemic to companies outside the u.s. and u.k. (e.g., in israel most of the corporations, including publicly traded corporations, are controlled by an individual shareholder), although some of the largest u.s. corporations (e.g., meta9) are also controlled by their founders.10 corporate law and corporate governance seek to mitigate the agency problem by providing an organizing framework to facilitate and support mechanisms of firms’ corporate governance by which managers are incentivized and constrained to act in the shareholders’ interest (in order to mitigate the management problem) and the controlling shareholders are incentivized and constrained to act in the minority’s interest (in order to mitigate the control problem). “the most elemental components of” this organizing framework “are the board of directors, shareholder meetings and voting, and executive compensation.”11 b. tax and corporate governance: main interplays the interplays between tax and corporate governance can be roughly divided into two resulting phenomena. on the one hand, the rules and mechanisms of corporate governance might have some effects on the way corporations handle their tax affairs and fulfill their tax obligations. on the other hand, taxation might have an effect on corporate governance, and more specifically, on the relationship between shareholders and corporate managers (the management problem) and between the controlling shareholders and the minority (the control problem). it should be noted that this article will not make a comprehensive review of the entire literature which deals with these interplays. such a review of the literature exceeds the scope of this article and can be found in other research.12 8 zohar goshen, controlling corporate agency costs: a united states – israeli comparative view, 6 cardozo j. int’l & comp. l. 99. 101 (1998). 9 see meta platforms inc., schedule 14a information (may 29, 2024). 10 see goshen, supra note 8 at 115; see also john armour, henry hansmann & reinier kraakman, agency problems and legal strategies in the anatomy of corporate law: a comparative and functional approach 29, 29-30 (oxford university press 2009). 11 bhagat et al., supra note 7 at 1810; see also h. kent baker & ronald anderson, an overview of corporate governance in corporate governance: a synthesis of theory, research, and practice 1, 3-4 (baker & anderson eds. 2010). 12 see friese et al., supra note 5; nicola sartori, effects of strategic tax behaviors on corporate 56 columbia journal of tax law [vol 16:1 iii. existing justifications for the corporate tax a. overview can the corporate tax be justified on the grounds that it reduces the corporate agency problem and that alternative systems have fewer desirable effects? part iv of the article will try to establish this claim, but first we will discuss the existing justifications for the corporate tax. as a preliminary note, it should be mentioned that yariv brauner has already analyzed “[t]he argument that the corporate income tax has desirable corporate governance implications that justify its preservation.”13 brauner rejects this argument, but acknowledges that “the corporate governance argument has not been directly and comprehensively articulated in the legal literature” and that: “[n]one of the studies mentioned in this part limits itself to the defense of the corporate income tax, so they all fail to balance the potential benefits of the tax against its costs.”14 b. current justifications for the corporate tax there are currently four main views concerning the justifications for the corporate tax.15 1. lack of justification view the first and most common view is simply that there is no justification for the corporate tax. under this view, the planning and compliance costs it induces are extremely high relative to the revenue raised by the government on this income. this argument finds support in the fact that corporate tax is very complicated and imposes significant transaction costs on society. additionally, the corporate tax base is being eroded in practice and the corporate tax accounts today for less than a tenth of revenues, and that number is declining. further, the fact that the corporate tax applies in practice almost solely to publicly held c corporations leads to significant welfare losses to society as the tax drives business owners away from issuing public shares in their corporations. many supporters of this view suggest replacing the corporate income tax with a tax on the appreciation of stakes (shares) in publicly traded corporations (mark to market rules) and a look-through taxation system for shareholders of non-publicly traded corporations. governance (sept. 2008) (unpublished manuscript) (on file with social science research network (ssrn)); nicola sartori, corporate governance dynamics and tax compliance, int’l trade and bus. l. rev. (2009); carlo garbarino, aggressive tax strategies and corporate tax governance: an institutional approach, sda bocconi research paper no. 188 (dec. 2008); jost kovermann & patrick velte, the impact of corporate governance on corporate tax avoidance–a literature review, 36 j. of int’l acct. auditing and tax’n 1 (2019). 13 brauner, supra note 5 at 597. 14 id. at 619. 15 see generally reuven s. avi-yonah, corporations, society, and the state: a defense of the corporate tax, 90 va. l. rev. 1193 (2004); brauner, supra note 5. 2024] taxation and corporate governance 57 2. corporate tax as an indirect way of taxing shareholders the most common justification for the corporate tax is its ability to indirectly tax the shareholders. under this view there are two main advantages to the corporate tax: first, from the timing perspective, the corporate tax allows taxing the income as the corporation gains income. it is argued that without the corporate tax, individuals could shelter their income from tax by earning it through corporations. if that individual holds the stocks until his death and the estate receives a stepped-up basis, this might even lead to a complete tax exemption. second, from an administrative perspective, it is easier to collect tax from a few corporations than from many shareholders. however, it was argued that these advantages might be attained through other means. for example, replacing the corporate income tax with a mark to market taxation regime on publicly traded corporations and a look-through taxation system for shareholders of non-publicly traded corporations. 3. corporate tax as payment for benefits conferred by the u.s. government under this view, the tax is conceived as a payment in return for the benefits provided by the u.s. government. one such benefit is the benefit of incorporation, and mainly the limited liability protection. however, it is well known that many entities benefit from the same benefits as incorporated entities, without being subject to the corporate tax (e.g., llcs, s corporations, llps, and so on). another possible benefit is the access to the public equity market. rebecca rudnick argues that the corporate tax can be justified as a payment for the greater liquidity afforded by access to the public equity market.16 recall that the corporate tax applies almost only to publicly held c corporations. this fact creates a correlation between access to public equity markets and the corporate tax. however, the current corporate tax does not reflect the liquidity of the corporation and is not even linked to it (e.g., it is not linked to the outstanding corporate equity). hence, it seems that this approach supports a different system of taxation, rather than the current corporate tax. 4. restraining undesirable corporate management accumulation of power reuven avi-yonah defended the corporate tax as a means of curbing excessive accumulation of economic power by corporate managers. avi-yonah acknowledges that some of the potential harms of this accumulation of powers are already specifically regulated (environmental, labor, etc.). however, avi-yonah adds that these regulations fail to adequately address the ordinary accumulation of corporate power through straightforward money-making businesses. hence, only taxation can achieve regulation of excessive accumulation of economic power by 16 rebecca s. rudnick, who should pay the corporate tax in a flat tax world?, 39 case w. rsrv. l. rev. 965, 985–86 (1989). 58 columbia journal of tax law [vol 16:1 corporate managers.17 in the article we raise a counterargument to avi-yonah’s argument (which is distinct from the counterarguments raised by brauner).18 it appears to us that avi-yonah’s argument depends on two questions, which are highly controversial among economists: (1) who bears the economic burden of the corporate tax? and (2) what are the effects of the corporate tax on the retention of profit? the next example will illustrate this counterargument: assume a world without a corporate tax. in addition, assume that a publicly held corporation has an income of $100 million a year. each year 40% of the profits are distributed ($40 million a year) and 60% of the income is retained in the corporation ($60 million a year). these $60 million a year are accumulated in the corporation and are creating the undesirable corporate management accumulation of power. now, assume that a corporate tax of 20% is levied. what would be the result? under one scenario, it is possible that the after-tax income of the corporation will be $80 million and 60% of it will be retained, such that the manager will control only additional $48 million (60%*$80 million). but this is not the only possible scenario. an alternative scenario is that the customers or the employees will bear the economic burden of the tax. for example, the customers might pay higher prices for the corporation’s products, or the corporation might lower the employee’s salaries; as a result, the corporation may retain the same amount of after-tax income. under this scenario, the managers will retain control on the same amount of money. another possible scenario is that the after-tax income of the corporation will be indeed reduced to $80 million. however, under this scenario, the corporation might decide to reduce the amount of its distributions. for example, they may convince the shareholders that the corporation needs to retain $60 million a year; and as a result, under these circumstances, the managers will, again, retain the same amount of profits under their control. this example illustrates that avi-yonah’s argument depends on the two following questions: (1) who bears the economic burden of the corporate tax, and (2) what are the effects of the corporate tax on the retention of profit? for all of the above reasons, the dominant view in the academic literature is that there is no persuasive justification for the corporate tax. in part iv below, we will try to develop an alternative justification, based on corporate governance considerations. iv. key role of the corporate tax in the financial reporting system a. context: the corporate tax as exterior corporate governance according to modern firm theories, there are three main types of agency 17 avi-yonah, supra note 15 at 1243-44. 18 in his more recent works, avi-yonah de-emphasized the limitation on managerial power argument and instead argued that the corporate tax is a useful tool to regulate corporate behavior. see, e.g., avi-yonah, a new corporate tax, tax notes (2020); avi-yonah, introduction to research handbook on corporate tax, 2 (avi-yonah ed., elgar publishing 2023). this argument is not related to corporate governance so we will not address it further. 2024] taxation and corporate governance 59 problems: (i) conflicts of interests between shareholders and managers (“agency costs of equity”);19 (ii) conflicts of interests between controlling shareholders and outside minority shareholders (“agency cost of controlling shareholder”);20 and (iii) conflicts of interests between shareholders and debtholders (“agency cost of debt”).21 in these principal-agent relationships, shareholders rely on managers, outside minority shareholders rely on controlling shareholders, and debtholders rely on shareholders to maximize their interests. unfortunately, due to the problems of moral hazard and asymmetric information, it is necessary for the principals (the outside shareholders, the minority shareholders or the debtholders) to monitor and overlook the agents (the controlling shareholders or the managers).22 traditionally, there are two forms of supervision mechanisms—internal and external—that allow the outside shareholders (the principals) to monitor and overlook the corporate management (the agents).23 internal mechanisms include, for example, ownership structure, board of directors, stock options and other forms 19 the agency cost of equity arises where the shareholders, who own residual claims and assume residual risks, are not the managers who are in control. this separation of ownership and control creates an opportunity for the managers of the corporation to promote their own personal interests over those of the shareholders. the managers’ preference for their own personal interests can be expressed, for example, through inefficient management or the receipt of perquisites by the managers at the corporation’s expense. this problem is characteristic to corporations in the u.s. and is the key focus of u.s. corporate governance systems, since most u.s. publicly traded corporations are widely held by a large group of shareholders. see goshen, supra note 8 at 100-01 michael c. jensen, the modern industrial revolution, exit, and the failure of internal control systems, 48 the j. of fin. 831, 848 (1993). 20 the agency cost of controlling shareholder arises where a small group of shareholders (or an individual shareholder) holds a controlling block of shares. the minority (the principal) essentially transfers the control over its investment to the controlling party (the agent). by doing so it exposes itself to the agency problem and to the risk that the controlling shareholders will use the corporate resources for their own interests while other stakeholders will bear the costs. the transfer of company resources by controlling shareholders comes in many forms, including consuming perks, setting excessive salaries, stealing investment opportunities, and making inefficient investment. the control problem is characteristic of markets outside the u.s. and u.k., where ownership concentration is more pronounced. see yupana wiwattanakantang, controlling shareholders and corporate value: evidence from thailand, 9 pacific-basin fin. j. 323, 324 (2001); goshen, supra note 8 at 101; armour et al., supra note 10, at 30. 21 the agency cost of debt is often described in terms of the risk shifting problem. the potential conflict between debtholders and shareholders is such that shareholders expropriate wealth from debtholders by investing in new projects that are riskier than those presently held in the firm’s portfolio. under this scenario, since shareholders do not bear the full cost of low returns, they have incentives to take riskier projects, potentially extracting value from the debtholders. see michael c. jensen & william h. meckling, theory of the firm: managerial behavior, agency costs and ownership structure, 3 j. of fin. econ. 305, 308 (1976); ronald c. anderson, sattar a. mansi & david m. reeb, founding family ownership and the agency cost of debt, 68 j. of fin. econ. 263, 266 (2003); gustavo manso, investment reversibility and agency cost of debt, 76 econometrica 437, 437 (2008). 22 kim byungmo & inmoo lee, agency problems and performance of korean companies during the asian financial crisis: chaebol vs. non-chaebol firms, 11 pacific-basin fin. j. 327, 327-48 (2003); see also christopher s. armstrong et al., corporate governance, incentives, and tax avoidance, 60 j. acct. & econ. 1, 1 (2015), in which the authors found that “unresolved agency problems may lead managers to engage in more or less corporate tax avoidance than shareholders would otherwise prefer.” 23 see generally jensen, supra note 19 at 831; jensen & meckling, supra note 21 at 338. 60 columbia journal of tax law [vol 16:1 of performance-based payment schemes. external mechanisms include, among others, hostile takeover, contest of voting proxy, and product market competition.24 since the expression “agency costs” was first introduced by jensen and meckling in 1976,25 there have been hundreds of studies on corporate governance mechanisms.26 many important insights from these studies were well implemented in the legal literature and have influenced lawmakers.27 for many years, the financial literature has ignored one important external mechanism of firms: the corporate tax.28 not surprisingly, in the absence of financial studies, the legal literature has ignored, as well, the governance role of the corporate tax. in recent years, the potential governance role of taxes has attracted a growing attention by financial scholars, who have explored the interplay between the basic functions of corporate tax and corporate governance. the aim of this part of the article is to arm us with a new understanding concerning the governance role of corporate tax, particularly in reducing the “agency costs of equity.” more specifically, section b will present the “madisonian” function and the “shedding light” function of the tax (the financial functions). section c will present the “monitoring” function of the tax. section d, then, will examine under what conditions the irs has a comparative advantage relative to the sec in improving corporate governance. section e will discuss the new corporate alternative minimum tax (amt) enacted in 2022, which is based on financial accounting (book) income, and rebut some common criticism of it. b. corporate tax can strengthen the financial reporting system the importance of financial reports29 is directly related to the need to protect investors, since “[m]any existing and potential investors, lenders and other creditors cannot require reporting entities to provide information directly to them and must rely on general purpose financial reports for much of the financial information they need. consequently, they are the primary users to whom general purpose financial 24 weichu xu, yamin zeng & junsheng zhang, tax enforcement as a corporate governance mechanism: empirical evidence from china, 19 corp. governance: an int’l rev. 25, 26 (2011). 25 jensen & meckling, supra note 21, at 305. 26 a simplistic search in “google scholar” of the expressions “corporate governance mechanisms” combined with “agency costs” from 1976 onwards finds 17,800 results. 27 a simplistic search in “lexisnexis academic” of the expressions “agency costs” finds 466 articles in law reviews and law journals. 28 see mihir a. desai, alexander dyck, & luigi zingales, theft and taxes 1, 2 (nat’l bureau of econ. rsch., working paper no. 10978, 2004)[“…the state’s actions are not part of the standard analysis of corporate governance, which has typically emphasized legal protections for outside investors …, the role of boards... and the presence of large shareholders…] (“at the same time, the public finance literature on taxation typically ignores any effects of governance on the functioning of the corporate tax system”). 29 see robert m. bushman & abbie j. smith, transparency, financial accounting information, and corporate governance, 9 econ. pol’y rev. 65, 65 (2003) (explaining that financial reporting can be defined as the “the product of corporate accounting and external reporting systems that measure and routinely disclose audited, quantitative data concerning the financial position and performance of publicly held firms”). 2024] taxation and corporate governance 61 reports are directed.”30 indeed, skinner and milburn claim that “there is a strong tradition in accounting history to the effect that the purpose of accounting is to report on the stewardship of management.”31 they write that some suggest that financial reports are “vital to facilitate contracting and the operation of control devices to ensure the enforcement of contracts… between owners of an entity and its management, between the entity and creditors, and between management and subordinates.”32 corporate tax can strengthen the financial reporting system in two ways: firstly, it can mitigate the problem of inflated reported earnings (“madisonian” function). secondly, the corporate tax can provide further information to investors (“shedding light” function). 1. “madisonian” function: mitigating incentives to inflate income one of the main agency problems associated with financial reports is earnings management and particularly inflation of reported income.33 earnings management is often defined as “when managers use judgment in financial reporting … to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company, or to influence contractual outcomes that depend on reported accounting numbers.”34 studies35 provide 30 financial accounting standards board, statement of financial accounting concepts no. 8 as amended, at 215 (2021) (“the board agreed with these respondents and noted that, in most cases, information designed for resource allocation decisions also would be useful for assessing management’s performance”); (“both [assessing prospects for future cash flow and assessing the quality of management’s stewardship] are important for making decisions about providing resources to an entity, and information about stewardship also is important for resource providers who have the ability to vote on, or otherwise influence, management’s actions”). 31 skinner, r.m. and milburn, j.a., 2001, accounting standards in evolution (2d ed. 2001) 586. 32 id. 33 daniel shaviro, the optimal relationship between taxable income and financial accounting income: analysis and a proposal, 97 geo. l. j. 423, 425-26 (2009) (arguing earnings management, and in particular systematically inflating reported earnings, “undermines financial markets by reducing their transparency, along with shareholders’ ability to monitor managers”). indeed, a recent study employs a dynamic model, based on data on earnings restatements, to estimate that the cost to a typical ceo of misstating earnings is relatively low, with the probability of detection being less than 15%. notably, the model does not account for the tax costs of earning misstatements. see anastasia a. zakolyukina, how common are intentional gaap violations? estimates from a dynamic model, 56 j. acct. res., 5–44 (2018). 34 paul m. healy & james michael wahlen, a review of the earnings management literature and its implications for standard setting 1, 6 (nov. 1998) (unpublished manuscript) (on file with social science research network (ssrn)). 35 scott d. dyreng, michelle hanlon, & edward l. maydew, where do firms manage earnings?, 17 rev. of acct. stud. 649, 650 (2012) (“the study of earnings management dates back to at least healy (1985). in the subsequent decades, researchers have conducted hundreds of studies of earnings management. among other things, these studies have provided insights into when firms manage earnings, what types of accounts they manage, why they manage earnings, and how they manage earnings”). it should be noted that in certain circumstances firms have incentives to report lower income (e.g., due to political costs (watts & zimmerman, positive accounting theory: a review, 13 acct., org. and soc’y, 623, 626 (1986)) and compensation contracts 62 columbia journal of tax law [vol 16:1 evidence that managers manipulate earnings for a variety of reasons, including to increase managers’ bonus and option compensation and the value of managers’ stock holdings, to increase managers’ job security, to avoid violating lending contracts, and to reduce regulatory costs and to increase stock price in anticipation of an equity offering.36 the effects of earning management are indeed serious. earning management and particularly inflation of reported income undermine financial markets by reducing their transparency, along with shareholders’ ability to monitor managers. jensen has described the severe consequences of inflation of reported income: “when they [managers] do this [inflate reported income] they are taking actions that actually destroy value in the long run but generate the appearance of improved performance in the short run. and the effects in the extreme can destroy the underlying core value of the firm.”37 the corporate tax can potentially mitigate the problem of inflation of reported earnings in a simple and quite straightforward way: by taxing the reported income of the corporation. this effect is well known in the financial literature as the “book-tax trade-off,” since firms can be forced to make a “trade-off” between the benefits of inflating book earnings and the direct tax costs of increasing taxable income.38 german writers call this effect “a general conflict-solving mechanism”, since the tax can put the corporate management in a dilemma and force them to (healy, the effect of bonus schemes on accounting decisions, 7 j. of acct. and econ. 85, 106 (1985)). 36 see healy & wahlen, supra note 34 at 3-4 (“in general, the evidence is consistent with firms managing earnings to window-dress financial statements prior to public securities’ offering, to increase corporate managers’ compensation and job security, to avoid violating lending contracts and to reduce regulatory costs”); merle erickson et al., how much will firms pay for earnings that do not exist? evidence of taxes paid on allegedly fraudulent earnings, 79 the acct. rev. 387, 390 (2004) (“these studies provide evidence that managers manipulate earnings for many reasons, including to increase their compensation (citation omitted), to avoid debt covenant restrictions (citations omitted), and to increase stock price in anticipation of an equity offering (citations omitted)”). 37 michael c. jensen, the agency costs of overvalued equity and the current state of corporate finance, 10 eur. fin. mgmt. 549, 555 (2004). 38 douglas a. shackelford, joel slemrod, & james m. sallee, a unifying model of how the tax system and generally accepted accounting principles affect corporate behavior, 1, 7 (nat’l bureau of econ. rsch., working paper no. 12873, (2007) (“financial reporting costs often conflict with tax minimization because reductions in taxable income frequently result in lower book profits and/or equity. this tension forces firms to trade-off book and tax considerations”); wolfgang schon, the odd couple: a common future for financial and tax accounting?, 58 tax l. rev. 111, 143 (2004)(“[b]ook-tax conformity could lead to a balance between the over-optimistic management bias in the capital market context and the over-conservative estimates of management in the tax context. this ‘book-tax trade-off’ causes a substantial ‘friction’ with respect to aggressive tax planning. german writers call it a general conflict-solving mechanism. recent research has shown that the gradual disconnection of tax and book accounting under german law has led to a dramatic loss of ‘prudence’ in the drafting of financial accounts; provisions for future losses were heavily reduced and depreciation periods massively extended”); michelle hanlon, stacie kelley laplante, & terry shevlin, evidence for the possible information loss of conforming book income and taxable income, 48 the j. l. & econ. 407 (2005); mary margaret frank et al., tax reporting aggressiveness and its relation to aggressive financial reporting, 84 the acct. rev. 467, 470 (2009) (“[f]irms generally report either higher financial income to shareholders or lower taxable income to tax authorities because conformity between gaap and tax law compel firms to decide which measure of income is more important to manage …”). 2024] taxation and corporate governance 63 choose between achieving the earnings management goal of increasing financial reported income and the tax planning goal of reducing the taxable income.39 the best description of this effect, in our opinion, was given by shaviro who names it the “madisonian” dilemma: james madison famously described the constitutional strategy of using “[a]mbition … to counteract ambition” such as through the separation of powers.40 here, though different parties’ ambitions are not being set against each other in classic madisonian style, at least this is happening as to two different ambitions of the same people. setting the goals of reducing and increasing ‘income’ against each other, rather than permitting untrammeled pursuit of both objectives, may reduce the scope of incentive problems even if not eliminating them.41 the “madisonian” function can “lead to a balance between the overoptimistic management bias in the capital market context and the over-conservative estimates of management in the tax context.”42 suppose that the highly incentivized ceo of a public company is considering increasing the reported financial income of the company. absent the corporate tax, there would not be any direct cost to this strategy. the corporate tax has the potential to impose an additional cost to this strategy and thus to mitigate the incentive to use it. in other words, the corporate tax can potentially provide the corporate management with some built-in incentives to be less aggressive in inflating financial reported earnings. 2. “shedding light” function: expanding market information corporate tax and disclosure of corporate tax returns can shed new light on financial reports and improve their quality. the notion is that publicity of corporate tax information can enable market participants (e.g., minority stockholders, credit agencies and creditors) to compare the financial reports information with the contents of the tax returns, so they can “more easily catch inaccuracies in financial reporting… the additional information provided in the calculation of income tax could help in assessing the financial health of the company.”43 even if comparing tax returns with financial reports is challenging given sufficient time and resources and the incentive to invest in those resources: “…we believe that experts could compare tax return information 39 schon, supra note 38, at 143. 40 the federalist no. 51 (james madison). 41 shaviro, supra note 33, at 428-29. a counter-argument is that firms may have strong incentives to report high book income, rendering the “madisonian” function relatively weak. indeed, a recent article analyzed the enactment of the corporate alternative minimum tax introduced by the tax reform act of 1986. this tax base under the alternative minimum tax replaced many tax accounting methods with book accounting methods. the study found “zero average tax base responses” to the alternative minimum tax (i.e., on average, firms did not reduce their book income in a response to the enactment of the alternative minimum tax). see jordan richmond, firm responses to book income alternative minimum taxes, 236 j. pub. econ. (2024). however, the study only examined the incremental effects of the corporate alternative minimum tax and did not evaluate the “madisonian” function of the corporate tax itself. 42 schon, supra note 38, at 143. 43 david lenter, joel slemrod, & douglas shackelford, public disclosure of corporate tax return information: accounting, economics, and legal perspectives, 56 nat’l tax j. 803, 816 (2003). 64 columbia journal of tax law [vol 16:1 with financial statements to gain insight into the company’s situation that could not be garnered from financial statements by themselves. moreover, if companies know that investors and other interested individuals and organizations will scrutinize tax returns information alongside their financial statements, they may be encouraged to provide fuller financial information…”44 thus, the tax may help keep the integrity of the financial reporting system. it should be noted that while the “madisonian” function and the “shedding light” function of corporate tax are directly related to each other, they are not the same. on the one hand, the “madisonian” function is focused on the bottom line of the tax return and deals with the one specific (but very important) problem of inflation of reported income; on the other hand, the “shedding light” function is focused on the broader information contained in tax returns and generally helps investors catch inaccuracies in financial reports and better assess the financial health of publicly traded companies. c. the “monitoring” function congress has been endowed with a far reaching and expansive informationgathering authority to administer and enforce tax law, which includes the broad mandate to compel disclosures and to investigate and audit.45 while the explicit purpose of these powers is to enable the tax authorities to effectively perform the “congressionally imposed responsibilities to enforce the tax code,”46 tax authorities can employ these powers to mitigate the agency problem. desai et al., in their notable article “theft and taxes,” were the first to make this claim that tax authorities can use these extensive powers to protect the principals from the agency problem (the non-controlling stakeholders) from diversion of corporate assets and extraction of private benefits by the agents (the controlling stakeholders or management).47 desai et al. begin with a simple observation that the state, thanks to its tax claims on cash flows, is de facto the largest minority shareholder in almost all corporations.48 in corporate governance terms, the article argues that there is an alignment of interests between the non-controlling shareholders and the irs. the authors note that many procedures aimed at enforcing a corporate tax liability make it more difficult for controlling shareholders to divert corporate value to their own advantage. similarly, many transactions aimed at diverting corporate value toward controlling shareholders reduce corporate tax liabilities. since managerial diversion hurts both tax authorities and non-controlling shareholders, the two parties have a common goal: reducing managerial diversion. 44 id. at 816-17. 45 see generally cong. rsch. serv., art1.s8c1.1.4 taxes to regulate conduct, constitution annotated, https://constitution.congress.gov/browse/essay/arti-s8-c1-1-4/alde_00013390/ (last visited sept. 13, 2024). 46 united states v. euge, 444 u.s. 707, 711 (1980). 47 desai et al., supra note 28, at 592. 48 id. 2024] taxation and corporate governance 65 thus, desai et al. predict that an increase in tax enforcement will increase the probability that diversion will be detected: “the existence of a corporate tax introduces an additional monitor (the tax authority) which increases the probability that diversion will be detected and, hence, increases the expected cost of diversion.”49 indeed, tax authorities can reduce the incentive of managers and control shareholders to divert corporate assets and extract private benefits by increasing the expected cost of diversion. the expected cost of diversion equals the product of the probability of detection and the amount of punishment.50 the irs can both increase the probability of detection and can increase the amount of punishment. firstly, if the diversion harmed the government (e.g., the diversion activity illegally reduced the amount of taxes paid), then the irs can impose penalties on the corporations in an amount of the taxes withheld. since the manager’s compensation is highly correlated to the corporate performance, such a penalty indirectly affects the managers as well. the corporate executives may also incur personal risks due to tax evasion, such as loss of reputation, penalties or even the threat of legal prosecution. in this regard, the irs can subject all the “responsible persons” who willfully retain due taxes from the government to a penalty equal to the taxes withheld. moreover, when managers are involved in extreme forms of diversion, they are at risk of legal prosecution for violating rules concerning individual income tax provisions, as demonstrated in some recent notorious cases. secondly—not less important—the irs can help other agencies in the investigation and enforcement of criminal statutes. the irs can potentially provide tax information (concerning the taxpayer or other taxpayers) to other agencies and, thus, help them, which increases the likelihood that a punishment will be imposed on the accused once a diversion activity was detected.51 overall, this analysis predicts that the existence of the corporate tax introduces an additional monitor, the tax authority. the tax authorities can increase both the probability that diversion will be detected and the amount of punishment. as a result, the irs increases the expected cost of diversion. d. comparative advantage of corporate tax (and irs) relative to sec sections b and c demonstrated that the corporate tax can potentially have three governance functions. the tax can strengthen financial markets, by, first, providing corporate executives with some automatic incentives to be less aggressive in inflating financial reported earnings (“madisonian” function) and, secondly, by providing information to the market (the “shedding light” function). third, tax enforcement can increase the cost of diversion, by increasing the 49 id. at 595. 50 e.g., literature concerning criminal activity. see gary. s. becker, crime and punishment: an economic approach, 76 j. pol econ. (1968) (arguing that criminals are rational persons that behave in accordance with the expected utility arising out of the criminal activity taking into account the probability of detection and the amount of the fine). 51 it should be noted that i.r.c. § 6103 does not include a specific provision that allows the irs to grant the sec access to tax-returns for the early stages of the investigations in order to examine if there is a reasonable cause to believe that a crime was committed. 66 columbia journal of tax law [vol 16:1 likelihood that such activity would be detected and increasing the amount of punishment (the “monitoring” function). why can other government agencies not provide similar services? more specifically, when and under what conditions would corporate tax (and tax authorities) have a comparative advantage relative to the sec in providing corporate governance services? our task in this section is to show that, in some respects, the corporate tax can have a comparative advantage in protecting investors and maintaining efficient markets relative to the sec. it should be emphasized that we do not claim that the corporate tax plays a more important role than the sec in improving corporate governance; but rather that corporate tax has unique features that protect investors and maintain the integrity of the financial reporting system by strengthening the financial reporting system and increasing the overall cost of diversion activity. the sec was established under the securities exchange act of 1934 as an independent regulatory agency designed to “protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.”52 the sec was charged with administering federal securities laws, which are characterized as disclosure statutes and based on the assumption that: “[s]unlight is said to be the best of disinfectants; electric light the most efficient policeman.”53 accordingly, the sec is granted with the power to regularly require extensive company disclosures, such as annual reports, quarterly reports, current reports “to report certain specified events, within four business days after occurrence of the event.”54 crucial to the sec’s effectiveness in these areas is its enforcement authority. the sec’s ability to regulate companies and safeguard shareholders is augmented by their capacity to enforce federal laws.55 accordingly, the sec can recommend the commencement of investigations of securities law violations, by bringing civil actions in federal court or before an administrative law judge. the sec can also help law enforcement agencies bring criminal cases when appropriate. in light of these extensive powers, the effectiveness of corporate tax and tax authorities in protecting investors seems questionable. one may claim that the disclosure of corporate tax returns information has no comparative advantage relative to other disclosures. as noted above, the sec can require disclosure of information; and if some information is necessary or appropriate in the public interest or for the protection of investors, then the sec can independently require the disclosure of it and there is no special value to the disclosure of tax. moreover, since the sec can subject aggressive accounting choices to greater scrutiny, the agency can provide incentives for management to avoid inflating reported income (also effectuating the “shedding light” function). the sec can also provide monitoring services and can bring civil action against companies or individuals 52 about, u.s. securities and exchange commission, (june 29, 2024), https://www.sec.gov/about. 53 louis d. brandeis, what publicity can do, in other people’s money: and how the bankers use it 62, 62. (1933). 54 exchange act reporting and registration, u.s. securities and exchange commission (june 24, 2024), https://www.sec.gov/education/smallbusiness/goingpublic/exchangeactreporting. 55 mission, u.s. securities and exchange commission, (aug. 9, 2023), https://www.sec.gov/about/mission. https://www.sec.gov/about https://www.sec.gov/about/mission 2024] taxation and corporate governance 67 implicated in diversion activity (also effectuating the “monitoring” function). notwithstanding these arguments, the corporate tax and tax authorities have many comparative advantages relative to the sec in protecting investors and maintaining efficient markets. 1. economies of scope economies of scope is when combined production is more cost efficient than individual production. in other words, it is cheaper to produce certain goods together than producing each good separately. in the tax context, it was claimed that one of the advantages in using tax laws as a regulatory tool stem from this rationale: “[t]he use of tax laws instead of direct regulation allows the government to rely on existing and established system (the tax system). the costs incurred by the government to slightly modify an existing and established system would be lower than the costs needed to create, manage and administer a new system (the regulatory system) …”56 while this explanation may be less compelling for developed countries with special designated agencies dedicated to protecting investors,57 this rationale still has some merits even in the u.s. the notion is that the taxpayers’ duty to assess their own tax liability and to file tax returns provides the irs with an expansive database; congress has already “recognized that the irs had more information about citizens than any other federal agency. . . ”58 the tax code imposes three basic obligations on all taxpayers (including individuals and corporations): to assess their own tax liability, to file an annual tax return reporting that liability, and to pay that liability when due. in addition, third parties doing business with or providing services to those taxpayers are required to provide information that is used to supplement and verify that self-reported information. hence, in auditing a corporate tax return, the irs can turn not only to the corporate’s own returns for past years, but also to returns filed by related corporations, partnerships, and individuals, including returns filed by customers, suppliers, employees, shareholders and payors of various type of income subject to income gathering. sharing this tax information with other agencies might be costly (e.g., the need to ensure that the information would not leak) and raises a long list of concerns. in sum, an extensive and unique database about taxpayers may give tax authorities a comparative advantage relative 56 sartori, supra note 12, at 6. 57 in an early version of the article “theft and taxes,” desai et al. explained that “economies of scope” may give tax authorities a comparative advantage: “every country has a government agency specialized in collecting revenues. it is much easier, faster, and more effective to extend the tasks of these experts, than to create another ad hoc agency. for example, in russia, when the local securities and exchange commission wanted to improve enforcement, they asked the tax police for assistance as they were the only ones with the appropriate expertise. in the united states in 1909, this extension of the tax authorities’ scope to corporate returns was apparently well within their existing capabilities. this explanation may be less compelling for a country like the united states today, where an agency solely dedicated to the enforcement of security laws has been in place for the last seventy years.” (see https://www.ecgi.global/sites/default/files/working_papers/ documents/ssrn-id629350.pdf). 58 memorandum from the office of chief counsel internal revenue service to technical advisor, criminal investigation office of governmental liaison and disclosure, (july 18, 2011) (on file with the irs). 68 columbia journal of tax law [vol 16:1 to other agencies, including the sec in investigating diversion activity, which harms both the government and outside shareholders. 2. “skin in the (disclosure) game” sec enforcement against management who manipulate financial reports (e.g., transferring sales from one market to another) or inflate earnings faces a complex challenge. given the considerable discretion management has in making choices that will affect the reported income, it may be difficult for the sec to distinguish between changes in financial reports attributable to the operation of the firm and those that are attributable to manipulation by management. more specifically, management can influence financial reports through legal activities, which are “within the discretion allowed by law,”59 and thus it may be impossible for the sec or the doj to punish managers who are involved in such “legal” manipulation. the information contained in tax returns concerning the health of the corporation is distinguishable from the information contained in financial statements. the reason is straightforward: companies have “skin in the game” when their tax returns are filed with the tax authorities, since tax return information has a direct influence over the company’s tax liability.60 while managers may indeed manipulate the information contained in corporate tax returns (to reduce their taxable income), the direction will most probably be different than the direction of manipulation of financial returns. the existence of two independent sources of information can enable market participants to each other and gain insight into the company’s situation that could not be garnered from financial statements alone. this automatic incentive does not require identifying the source of the increase in the reported income. corporate tax can reduce the incentive to inflate income by using transactions that are legally permissible, and thus would survive sec scrutiny, and “yet that serve no good social purpose beyond advancing the managers’ income manipulation goal.”61 since corporate tax can impose a levy on corporate income (while the sec cannot do so), it has a comparative advantage in coping with the earning management problem and in providing valuable information to the market. it should be noted that other corporate governance mechanisms have a real challenge in coping with the earning management problem and some corporate 59 eitan goldman & steve l. slezak, an equilibrium model of incentive contracts in the presence of information manipulation, 80 j. of fin. econ. 603, 604 (2006). 60 see tanya tang, does book-tax conformity deter opportunistic book and tax reporting? an international analysis, 24 eur. acct. rev. 3, 441-469 (2015). (using publicly available financial statements from 1994 to 2007 for 16,739 firms across 32 countries, the article constructs “a new proxy for mandatory conformity and document[s] that high book-tax conformity is associated with lower levels of earnings management and tax avoidance. these results persist even after controlling for firm characteristics and institutional factors, such as legal enforcement, investor protection, legal systems, capital market development, and the adoption of international financial reporting standards.”). 61 daniel shaviro, the optimal relationship between taxable income and financial accounting income: analysis and a proposal, n.y.u. l. & econ. research paper no. 07-38, geo. l. j. vol. 97 at 1, 64 (2008). 2024] taxation and corporate governance 69 governance mechanisms are considered part of the problem. for example, during the last decades, many financial scholars have emphasized the importance of equity incentives, as an internal corporate governance mechanism which “automatically” aligns the interests of the management with the interest of the shareholders. indeed, empirical evidence shows that equity incentives induce managers to exert productive effort. however, rather than coping with the problem of earning management, it is well documented that equity incentives “places pressure on managers to increase accounting earnings often at the cost of real economic value.”62 the effect of stock incentive is sometimes referred to as a “double-edged sword, inducing managers to exert effort, which improves firm value, but also inducing managers to inflate or exaggerate performance, which, given the opportunity cost of the firm’s resources, reduces firm value.”63 many other corporate governance mechanisms are also only making the problem worse; as jenssen mentioned: “overvalued equity is managerial or organizational heroin. and the managers are a part of the problem; investment bankers and security analysts are a part of the problem, and so too are the auditors who have ended up collaborating.”64 hence, the corporate tax can potentially have a comparative advantage in 62 daniel a. cohen, aiyesha dey, and thomas z. lys, real and accrual‐based earnings management in the pre‐ and post‐sarbanes‐oxley periods, 83 acct. rev. 757 (2008) (arguing that earnings management increased steadily from 1987 until 2002, and options and stock-based compensation was a particularly strong predictor of aggressive accounting behavior); natasha burns & simi kedia, the impact of performance-based compensation on misreporting, 79 j. fin. econ. 35 (2006) (arguing that firms whose ceos have large options positions were more likely to file earnings restatements); pengjie gao & ronald e. shrieves, earnings management and executive compensation: a case of overdose of option and underdose of salary (2002) (unpublished manuscript) (on file with social science research network (ssrn)) (arguing that magnitude of discretionary accruals is greater and earnings management is more prevalent at firms in which managers’ wealth is more closely tied to the value of stock); daniel bergstresser & thomas philippon, ceo incentives and earnings management, 80 j. fin. econ. 511 (2006); qiang cheng & terry d. warfield, equity incentives and earnings management, 80 acct. rev. 441 (2005); michael c. jensen, the agency costs of overvalued equity and the current state of corporate finance, 10 eur. fin. mgmt. 549 (2004); eric ohrn, does corporate governance induce earnings management? evidence from bonus depreciation and the fiscal cliff 1, 4 (2014) (unpublished manuscript) (on file with university of michigan library) (“while the majority of empirical results have highlighted the benefits of stronger governance, jensen (2004) suggested that equity incentives may lead to unintended, counterproductive consequences. jensen (2004) considered the effect of high managerial equity incentives when analysts project high earnings and stock prices are overvalued. overvaluation places pressure on managers to increase accounting earnings often at the cost of real economic value. jensen pointed out that the pressure to engage in earnings management behaviors to artificially inflate earnings to hit targets increases as management owns a larger portion of outstanding equity.”). 63 goldman & slezak, supra note 60, at 605. 64 michael c. jensen, the agency cost of overvalued equity and the current state of corporate finance, harv. (nom working paper no. 04-29, at 554.) or another example: while the use of debt can work as a governance mechanism in other contexts, it can induce earning management and it was noted that “several studies find that firms close to violating lending covenants manage earnings … these studies suggest that avoidance of penalties associated with the violations of debt covenants is a motivation to manage earnings. a firm would manage earnings to issue new debt if earnings management allows the firm to obtain debt at more favorable terms. a firm that meets restrictive covenants can obtain more favorable financing. . .”. katsiaryna salavei bardos and nataliya zaiats, “equity and debt issuance by firms violating gaap.” 52 acct. & fin. at 14 (2012). 70 columbia journal of tax law [vol 16:1 strengthening the financial reporting system relative to the sec (and to many other corporate governance mechanisms). 3. “political clout” the third comparative advantage of tax authorities relative to the sec in protecting investors stems from the distinctive revenue implications of actions by the irs. in an unpublished version of the article “theft and taxes,” desai et al. raised this claim and stated: the irs enjoys more political clout (and a better budget) because it generates more revenues for the government, while the sec relies on annual appropriations unrelated to its enforcement actions. even if the sec generates revenues through its enforcement actions, there remains a fundamental difference. by increasing enforcement, the irs increases revenues not only from the company investigated, but also from all other companies, which are not investigated but improve their compliance out of fear. by contrast, by increasing enforcement, the sec raises revenues only from the company investigated, while losing them from other companies, which would be more compliant and hence pay fewer fines.65 the space that the irs occupies within the political system allows it to more efficiently and effectively act as a corporate governance force for strengthening financial reporting and monitoring services. e. the corporate alternative minimum tax and its critics in 2022, congress enacted a new 15% corporate alternative minimum tax (amt) based on book (financial reporting) income. this tax must be paid if it exceeds the regular corporate tax set at 21% of taxable (not book) income.66 the corporate amt fulfills the madisonian, shedding light, and monitoring functions described above in sections b and c, respectively. the corporate amt, however, has been subject to fierce criticism.67 for example, a recent article by li dang, rodney mock, and david chamberlain sharply criticized the corporate amt. the following are some counterarguments that readers may wish to consider in addition to the explanation for the rationales set out above: 1. dang, mock, and chamberlain write that: 65 m.a. desai, a. dyck, & l. zingales, theft and taxes, 84 j. of fin. econ. 3, 591-623 (2007). 66 i.r.s., irs clarifies rules for new corporate alternative minimum tax (2023), https://www.irs.gov/newsroom/irs-clarifies-rules-for-corporate-alternative-minimum-tax [https://perma.cc/v2cq-bdsz]. 67 the following is based on reuven avi-yonah, taxing the right book: arguments for the corporate amt, 181 tax notes fed. 1645 (nov. 27, 2023). https://perma.cc/v2cq-bdsz 2024] taxation and corporate governance 71 “with financial accounting, companies want to increase their earnings for shareholders, creditors, financial analysts, and other stakeholders. managers are motivated to manage earnings by decreasing (or deferring) losses and increasing (or accelerating) income. the objectives in tax accounting are the exact opposite: tax practitioners engage in complex tax avoidance strategies to reduce taxable income.”68 in our view that is exactly the main advantage of the corporate amt: because companies want to increase their earnings, they are constrained by how much they can reduce taxable income (i.e., the “madisonian” function). since managers care more about earnings per share (which affects the value of their stock options) than about taxable income, the result is a higher likelihood that the largest u.s. and foreign corporations (the only corporations subject to the corporate amt) will pay something close to a 15 percent effective tax rate. as for the risk of earnings management to decrease taxation, wolfgang schoen published an incisive critique of this argument based on the long german experience of using corporate book income as the taxable base.69 2. the author argues that: “unlike financial accounting, tax law comes from the u.s. constitution, treaties, the irc, administrative pronouncements, and judicial opinions. these authorities have the force of law, as they are created by duly authorized government officials via the 16th amendment, the administrative procedure act of 1946, elected judges, and so on. a system that determines the corporate tax base outside of tax law makes no sense and is not good tax policy. it merely degrades the taxation process by capitalizing on the public’s lack of understanding regarding the significant differences between the two systems.”70 this ignores the fact that the corporate amt is part of the internal revenue code of 1986, as amended (26 usc), duly passed by both houses of congress and signed into law by the president. it is subject to the same irs and judicial review as any other part of the code. while generally accepted accounting principles are not set by congress, congress is free to change them for the corporate amt whenever it feels the results are not appropriate, as it did for the application of refundable and transferable credits under the inflation reduction act.71 3. the authors write that: 68 li dang, rodney p. mock, & david g. chamberlain, taxing the wrong book, 181 tax notes fed. 1377 (2023). 69 schon, supra note 38, at 115. 70 id. 71 inflation reduction act of 2022, h.r. 5376, 117th cong. (2022) (enacted). 72 columbia journal of tax law [vol 16:1 “the original purpose of the federal income tax was to fund the operations of the federal government.”72 that is partly true for the individual income tax, although a major reason for the adoption of the 16th amendment was to reduce inequality (the government could have continued to be funded by tariffs like it previously was, instead of a tax that fell only on the rich). but it was not the purpose of the corporate tax of 1909 (originally set at 1 percent); that was to regulate monopolistic corporations, as shown by the legislative history.73 4. the authors write that after 1954: “the entire irc is an elaborate system of sticks and carrots to control taxpayer behavior.” that was true before 1954 as well, as stanley s. surrey shows in his memoir.74 but there is nothing wrong with that until corporate tax planning results in too low a level of tax, because then the legal incentives do not work. that is why it is so important that the corporate amt applies to all global income as opposed to just global intangible low-taxed income (gilti), since under gilti there are incentives to shift income to zero-tax jurisdictions and avoid the tax’s regulatory goals. 5. the authors write that: “despite these fundamental differences, congress’s new corporate alternative minimum tax looks to book income rather than taxable income as an alternative tax base. in addition to the conceptual differences, delegating the corporate tax base to [the financial accounting standards board] and treasury creates many practical administrative and constitutional issues.”75 this conveniently omits the fact that the global corporate minimum tax (pillar 2 of the current international tax reform effort led by the g20 and the oecd and agreed to by over 140 countries including the us) also looks to book income. so, if congress did not enact a corporate amt set at 15 percent of book income, the result would simply be that other countries would get to collect the difference. luckily, the united states was able to better align the corporate amt with pillar 2 by persuading the oecd to accept the exclusion of transferable credits. the 72 li dang et al., taxing the wrong book, 181 tax notes fed. 1377 (2023). 73 see reuven s. avi-yonah, corporations, society and the state: a defense of the corporate tax, 90 va. l. rev. 1193 (2004); avi-yonah, a new corporate tax, tax notes fed., july 27, 2020, at 654. 74 stanley s. surrey, a half-century with the internal revenue code: the memoirs of stanley s. surrey (2022); see also avi-yonah & nir fishbien, stanley surrey, the code and the regime, 25 fla. tax rev. 119 (2021). 75 li dang et al., supra note 68, at 1378. 2024] taxation and corporate governance 73 corporate amt is as close as we get to a qualified domestic minimum top-up tax (as included in pillar 2), at least in the foreseeable future. and the qualified domestic minimum top-up tax is the only defense countries have against the undertaxed profits rule, which subjects multinationals to tax if neither the residence country nor the source country taxes it at 15% of book income. 6. the authors write that: “[u]sing book income as the tax base for a minimum tax in the international context is a different story in light of the varying jurisdictions and laws. domestically, our politicians can do better. we need a stable (and equitable) corporate tax base.”76 this ignores the inconvenient fact that the international rules apply domestically as well, as noted above. our politicians cannot do better domestically because the united states does not call the shots like it used to. 7. finally, the authors write that: “legislatively postured as somehow being fairer, the new corporate amt is not very fair at all. for example, companies that do not satisfy the three-year [adjusted financial statement income] $1 billion test are not subject to the new tax, regardless of how little they pay in taxes or how low their effective tax rate is. how exactly is this equitable? why does the corporate amt only target the newsworthy megacorporations used as bait to stir outrage, playing on the public’s complete lack of understanding of the difference between book and tax accounting? unlike the prior corporate amt or the amt for individuals, why such a narrow base of taxpayers?”77 there is a very good reason to only target the largest corporations — they are much more likely to be earning economic rents not subject to competition, and therefore should be subject to higher taxes than smaller corporations.78 it is possible that these kinds of critiques will persuade a future congress to abolish the corporate amt.79 for the critics that complain about the complexity of two corporate tax bases, we have a better suggestion: abolish the regular corporate tax and use the corporate amt base to tax our largest corporations adequately at a much higher rate than 15 percent. given that this tax falls on the shareholders who are not otherwise taxable because they are tax exempt or foreign or can borrow against unrealized appreciation, and that it is also efficient because these corporations are not operating in a competitive marketplace, that would be a good 76 id. at 1379-80. 77 id. 78 for the empirical evidence, see avi-yonah, “a new corporate tax,” supra note 18. 79 the arguments are not new. see avi-yonah, the case for reviving the corporate amt, tax notes fed., nov. 8, 2021. 74 columbia journal of tax law [vol 16:1 reform. it would also better align corporate taxation with the three functions discussed above. f. summary this part of the article arms us with a new understanding concerning the governance role of corporate tax. corporate tax can potentially improve corporate governance, through three main functions. the tax can strengthen financial markets, by providing corporate executives with some automatic incentives to be less aggressive in inflating financial reported earnings (the “madisonian” function) and by providing information to the market (the “shedding light” function). in addition, tax enforcement can increase the cost of diversion, by increasing the likelihood that such activity would be detected and the amount of punishment (the “monitoring” function). v. the corporate governance justification(s) for corporate tax below, we will try to argue that imposing a corporate tax can be a way to reduce some of the agency problems that frame the corporate governance problem. in other words, the corporate tax can help prevent the management from diverting corporate resources to their own pockets. this argument relies on the groundbreaking essay of desai, dyck, and zingales’ “theft and taxes.”80 these authors explore the alignment of the interests of the corporate minority or “outside” shareholders and the irs. they argue that the tax’s enforcement limits the benefits extracted by corporate insiders, by requiring tax returns and the furnishing of information. fraudulent diversion is curbed because minority shareholders have not only their monitoring capacity, but also that of the government. in other words, if the corporate income must be declared for tax purposes, it becomes harder to conceal its theft from the corporation’s shareholders. in addition, the corporate income tax balances the dual reporting system and functions as a monitoring, cost-reducing mechanism. thanks to the corporate tax, the management faces an internal conflict with respect to profit reporting: the desire to report as much profit as possible to the market while reporting as little profit as possible to the tax authorities. this conflict keeps the system balanced. therefore, a possible conclusion is that the corporate tax may be desirable because the tax ameliorates the agency problem between outside and inside shareholders (majority and minority shareholders). this justification can explain why the corporate tax applies, in practice, only to publicly held corporations, where the agency problem arises more often. avi-yonah has rejected these arguments and wrote that: “more recently, professor mihir desai and his colleagues have argued that imposing a corporate tax can be a way of preventing management from diverting corporate resources to their own 80 desai et al., supra note 47. 2024] taxation and corporate governance 75 pockets. specifically, if corporate income must be declared for tax purposes, it becomes harder to conceal its theft from the corporation’s shareholders. this is an ingenious argument, which (as we shall see) also reflects some of the original intent in enacting the corporate tax in 1909. from today’s perspective, however, it seems like a shaky foundation for the entire corporate tax. management theft can be combated by other means, and a requirement to report income without tax (or with only a minimal tax) would do just as well to achieve the goal promoted by desai.”81 brauner has also rejected this justification. he claims that the corporate tax increases the opportunities for tax fraud, since there are simply more rules and more accounts, and the system is more complex and that: “[i]f we agree that corporate tax returns will probably never be made public, then clearly the alternative will be superior even if not less complex or costly. this is because in the alternative, all accounts will be somehow attributed to shareholders and eventually to individuals who can monitor them, resulting in an inherently more transparent system.”82 in addition, he mentions that the corporate tax provides management a powerful evasion device. he claims that the management uses taxes in general and the corporate income tax in particular, as an excuse for rent extraction activities that do not necessarily result in reduction of effective taxation of shareholders. as an example, he mentions that certain tax advantages benefit only corporations (tax-free mergers and acquisitions, certain accelerated depreciation schemes, special credits, deductions, and similar measures) and that management uses these special provisions to avoid distributions and transparency in general. in this regard, he claimed that all the research fails to balance the potential benefits of the corporate tax against its costs. moreover, he claims that the distancing of the corporate tax reporting from financial reporting makes the argument for the balancing power of the corporate tax a “non-starter.”83 in this section, we will try to cope with these and other counterarguments. first, we will argue that a proper normative evaluation of the arguments in support of the corporate income tax requires a comparison to a state of the world with an alternative tax and that existing literature has underestimated the cost and disadvantages of the suggested alternative tax system. in this regard, it seems that adopting a broad regime of a “mark to market” has significant disadvantages that were not fully discussed by brauner and other scholars (e.g., taxation of foreign residents’ passive income,84 taxation of tax-exempt entities, stability of revenues 81 avi-yonah, supra note 15, at 1209-10. 82 brauner, supra note 5, at 622. 83 id. at 629. 84 see avi-yonah, supra note 15, at 1205. basically, foreign taxpayers would probably not be subject to the “mark to market tax” (foreign source income of foreign residents), while corporations 76 columbia journal of tax law [vol 16:1 from collection of the tax, the well-known problem of “phantom gains,” liquidity problem for non-portfolio/non-dealer shareholders, characterization of the income and so on). in addition, we will claim that the corporate tax has some advantages that cannot be reached by other regulatory means (or that it would be very costly and ineffective to use them). a. “fee for (governance) services justification” under the benefit justification, “the tax is a part of the profits which must be paid to a ‘senior partner’ [of] the government, in return for services rendered.”85 the relevant benefits are the benefit of incorporation and particularly the benefit of “limited liability.” however, this justification was rejected, since non-incorporated entities also have characteristics that were traditionally associated with corporations (e.g., limited liability) and are not subject to corporate tax. this justification is also not consistent with the provision of the benefit of incorporation by the states, while the corporate tax is paid to the federal government. armed with the new understanding of the role of the corporate tax, we can reshape the benefit justification and name it the “fee for (governance) services.” this justification is directly related to the broader approach of “benefit based taxation,” under which “people ought to pay taxes that depend on how much they benefit from public goods.”86 accordingly, corporate tax could be viewed as a “fee” paid by publicly traded corporations for the governance services provided by tax authorities.87 since corporations receive services (benefit) from the government, they also must pay a fee (tax) in return.88 in other words, corporations pay for the are subject to the corporate tax even if they are held by foreign taxpayers. i find this problem as a major disadvantage of the mark to market regime, due to the significant number of foreign shareholders who hold u.s. based companies and due to the concern that u.s. shareholders would find ways to be treated as foreign taxpayers (e.g., establishing foreign corporations that will hold for them their shares in u.s. corporations). 85 journal of accountancy, what are corporate income taxes?, 77 j. acct. 303 (1944). 86 matthew weinzierl, revisiting the classical view of benefit-based taxation, nat’l bureau of econ. rsch., working paper no. 20735, at 1, 2 (2014) (“in 2011, u.s. president barack obama also sought to increase top marginal income tax rates. he applied this reasoning: ‘as a country that values fairness, wealthier individuals have traditionally borne a greater share of this [tax] burden than the middle class or those less fortunate. everybody pays, but the wealthier have borne a little more. this is not because we begrudge those who’ve done well. we rightly celebrate their success. instead, it’s a basic reflection of our belief that those who’ve benefited most from our way of life can afford to give back a little bit more.’ … as the remarkable surveys by edwin seligman (1908) and richard musgrave (1959) make clear, benefit based reasoning was a prominent, at times leading, approach among tax theorists through the 19th century. william (1677), in particular, anticipated smith’s view, and hobbes, hume, and rousseau among others subscribed to it in some form”). 87 desai et al., supra note 47, at 619 (desai et al. stated their support in this justification, by stating: “our approach can also be used to provide a new rationale for the very existence of a separate tax rate on corporate income. since minority shareholders face a free rider problem in monitoring, the corporate tax can be seen as a payment for certification services provided by the tax authorities”). 88 the corporate theory that views corporations as “real entities” perfectly fits with this justification; reuven s. avi-yonah, the cyclical transformations of the corporate form: a historical perspective on corporate social responsibility, 30 del. j. corp. l. 767, 771, 810 (2005) (“the real entity theory…views the corporation as neither the sum of its owners nor an extension of the state, 2024] taxation and corporate governance 77 services they receive. however, one may claim that while investors (capital providers) benefit from reduction in agency costs,89 other groups actually bear the burden of the tax. this claim raises the issue of the incidence of corporate tax or (put more simply) who ultimately pays the cost of the tax.90 economists argue that shareholders bear the cost of the corporate tax through lower profits.91 indeed, until 2008, the department of the treasury assumed that the entire burden of corporate tax was assumed to be borne by owners of capital.92 recently, “economists have begun to question this conclusion, finding that, in the modern economy, workers often bear a significant portion of the tax in the form of lower wages, lower employment, or both.”93 a number of theoretical studies even claim that under some circumstances labor bears the majority of the tax burden.94 in 2008 the department of the treasury revised the method for estimating the distribution of corporate tax burden. overall, the revised method assigns 82% of the corporate income tax burden to owners of capital and 18% to labor.95 as was indicated earlier, the incidence of corporate tax is highly relevant for our evaluation of the consistency of the “fee for services.” if corporate tax is fully shifted to labor, the “fee for services” justification seems quite questionable: on the one hand the investors directly and primarily benefit from the governance functions of corporate tax (by reducing agency costs); on the other hand, workers pay for it. however, if the investors ultimately bear the largest part of corporate tax (as assumed by the department of the treasury), then the tax is (roughly) paid by the same group of people who benefit from it. this result is fully consistent with the “fee for services.” the “fee for services” deals satisfactorily with the counterarguments that were raised against the original benefit-based justification. first, the justification applies quite well to the current scope of corporate tax. the reason is simple: but as a separate entity controlled by its manager [...] the delaware court, in enhancing managerial power, effectively endorsed the real entity view: a corporation was an entity with its own corporate culture, which should not be subordinated to the shareholders or to the state”). 89 the term agency cost is the sum of: (a) the monitoring expenditures by the principals; (b) the bonding expenditures by the agent and (c) the residual loss. the term residual loss is defined as “the dollar equivalent of the reduction in welfare experienced by the principal due to the divergence of interests (with the agent).” see jensen & meckling, supra note 21, at 308. hence, any reduction in agency costs (while keeping the bonding expenditures constant) increases investors’ wealth. 90 arnold harberger, the incidence of the corporation income tax, 70 j. pol. econ. 215 (1962); other studies refine the classic work, see anthony b. atkinson & joseph e. stiglitz, lectures on public economics 222–26 (1980); jennifer c. gravelle, congressional budget office, corporate tax incidence: review of general equilibrium estimates and analysis (2010). under check-thebox regulation non-incorporated entities, if not publicly traded, can elect either corporate or noncorporate classification for tax purposes and taxpayers typically want to avoid c-corporation status. see treas. reg. § 301.7701-1; see also caron, supra note 1. 91 see arnold c. harberger, the incidence of the corporation income tax, 70 j. pol. econ. 215 (1962). 92 julie a. cronin et al., distributing the corporate income tax: revised u.s. treasury methodology, 66 nat’l tax j. 239 (2013). 93 adam h. rosenzweig, a corporate tax for the next one hundred years: a proposal for a dynamic, self-adjusting corporate tax rate, 108 nw. u. l. rev. no. 3, 1029, 1032 (2014). 94 a review and critique of recent theoretical research can be found in gravelle, supra note 90. 95 cronin et al., supra note 92, at 239. http://taxprof.typepad.com/taxprof_blog/2013/10/national-tax-journal-.html http://taxprof.typepad.com/taxprof_blog/2013/10/national-tax-journal-.html 78 columbia journal of tax law [vol 16:1 corporate tax is imposed primarily on publicly traded enterprises96 and on the same time, it is primarily publicly traded entities that exhibit agency problems97 and, thus, benefit from governance services provided by tax authorities. secondly, this justification is consistent with the federal government collecting corporate tax, rather than the states. since the governance functions are provided by the federal tax authorities, the federal government has the right to collect the “fees” for these services. lastly, this justification is consistent with the legislative history, which demonstrated that protecting investors was one of the main rationales behind the enactment of the corporate tax in 1909. the “fee for services” is not a plausible justification for corporate tax if the “benefit” is overwhelmed by the “fee.” in other words, this justification is not plausible if the increase in the shareholders’ wealth due to the governance services provided by corporate tax (the reduction of the agency costs) is much lower than the actual amount of corporate tax collected by the government (“the fee”). in such a case, the shareholders of publicly traded corporations, as a group, are better off absent the enactment of the tax. hence, if the reduction in the agency costs achieved thanks to the governance functions of corporate tax is higher than the taxes paid by corporations, this rationale for corporate tax is plausible. of course, it should be noted that the “benefit” is provided to the publicly traded companies as a group and not to specific ones. rather than asking whether the reduction in “agency costs” for a company is higher than the amount of tax paid by it, the question is whether the overall corporate tax collected is higher than the overall reduction in agency costs. b. “the governance approach to the economic justification” the “economic justification” for the corporate tax has two versions. under the principle version, the use of publicly traded corporations is sufficiently inelastic, 96 under check-the-box regulation non-incorporated entities, if not publicly traded, can elect either corporate or non-corporate classification for tax purposes and taxpayers typically want to avoid ccorporation status. see treas. reg. § 301.7701-1; and see caron, supra note 1. 97 for example, jensen & meckling, supra note 21, at 309 (“since the relationship between the stockholders and manager of a corporation fit the definition of a pure agency relationship it should be no surprise to discover that the issues associated with the ‘separation of ownership and control’ in the modern diffuse ownership corporation are intimately associated with the general problem of agency”); eugene f. fama & michael c. jensen, agency problems and residual claims, 26 j. l. & econ 327, 332 (1983) (“for control of the agency problems in the decision process, the common characteristic of the residual claims of proprietorships, partnerships, and closed corporations that distinguishes them from open corporations is that the residual claims are largely restricted to important decision agents. this restriction avoids the agency problems between residual claimants and decision agents that arise because of separation of risk-bearing and decision functions in open corporations. thus, costly mechanisms for separating the management and control of decisions are avoided”). for the approach, under which while the agency costs caused by the separation of ownership and management may be reduced to some extent in family firms, other types of problems arise, see william s. schulze, michael h. lubatkin, richard n. dino, & ann k. buchholtz, agency relationships in family firms: theory and evidence, 12 org. sci 99, 108 (2001) (“we attempt to explain why private ownership, owner management, and family do not eliminate the agency costs of ownership. drawing on various economic theories, we describe problems that accompany private ownership and owner management, noting that each exposes the firm to agency problems that are overlooked by the j/m model”). 2024] taxation and corporate governance 79 due to the liquidity advantage, to make corporate tax relatively efficient.98 however, scholars have rejected this rationale since “mark to market” taxation also addresses the liquidity advantage inherent in publicly-traded stock and is directly responsive to such advantage.99 in other words, this rationale is inconsistent with the fact that corporate tax is based on the corporate income, rather than on liquidity factors, such as the value of the stocks. under the second version of the “economic justification,” corporate tax can be viewed as a pigouvian tax that is imposed on corporations due to the externalities of limited liability. this rationale is inconsistent both with the current scope of corporate tax, which does not apply to many entities with limited liability (e.g., llcs or s corporations) and with the fact that corporate tax is based on the corporate income, rather than on factors which better reflect the externalities of limited liability (e.g., basing the tax according to the risk for insolvency). armed with the new understanding of the corporate tax, we can reshape the economic justification and name it the “the governance approach to the economic justification.” the goal of corporate tax, according to this justification, is to maximize economic welfare. corporate tax is an efficient vehicle to collect taxes, since tax authorities do not only collect taxes for the government, but also provide governance services to the investors. in this perspective, the governance functions of corporate tax can be viewed as positive “externalities” of the tax. while other methods of taxation of corporate entities (e.g., mark to market) do not provide governance services, corporate tax does so. unlike the “fee for services” justification, “the governance approach to the economic justification” is concentrated with more than the investors’ welfare. while the goal of the investors is to get the highest possible return on their investment, the goal of corporate tax is to maximize economic welfare.100 however, there is a close link between corporate governance and economic growth and, thus, economic welfare. economic welfare (the goal of corporate tax) and improvement in corporate governance (the claimed effect of the tax) are related to each other primarily through finance.101 the link between corporate governance and economic growth, through finance, has been explained as follows: 98 rebecca s. rudnick, who should pay the corporate tax in a flat tax world?, 39 case w. rsrv. l. rev. 965, 985–86 (1989). 99 charles delmotte & nick cowen, the mirage of mark-to-market: distributive justice and alternatives to capital taxation, 25 critical rev.int’ soc. & pol.phil. 211, 225-26 (2022). 100 alessio m. pacces, rethinking corporate governance: the law and economics of control powers 1-2 (2012); see also panayotis kapopoulos & sophia lazaretou, does corporate ownership structure matter for economic growth? a cross‐country analysis, 30 managerial &decision econ. 155, 155 (2009) (“corporate governance features seem to be central to the dynamics by which successful firms and economies improve their performance over time as well as relative to each other”). 101 pacces, supra note 100, at 2 (finance “is not just what allows investors to make money on their savings, but more importantly, what allows firms to raise the funds necessary to be established, to commit resources to production and its development, and to grow. … most prominent international organizations (as the oecd and the world bank) consider ‘good’ corporate governance a key recipe against underdevelopment”); see also kapopoulos & lazaretou, supra note 100, at 155 (“corporate governance features seem to be central to the dynamics by which successful firms and economies improve their performance over time as well as relative to each other”). 80 columbia journal of tax law [vol 16:1 corporate governance is central to understanding economic growth in general and the role of financial factors in particular. the degree to which the providers of capital to a firm can effectively monitor and influence how firms use that capital has ramifications on both savings and allocation decisions. to the extent that shareholders and creditors effectively monitor firms and induce managers to maximize firm value, this will improve the efficiency with which firms allocate resources and make savers more willing to finance production and innovation. in turn, the absence of financial arrangements that enhance corporate governance may impede the mobilization of savings from disparate agents and keep capital from flowing to profitable investments … thus, the effectiveness of corporate governance mechanisms directly impacts firm performance with potentially large ramifications on national growth rates.102 the “governance approach to the economic justification” deals satisfactorily with the counterarguments that were raised against the original economic justification. the new justification is consistent with current scope of corporate tax, since primarily publicly traded entities primarily exhibit agency problems. this justification is also consistent with levying the tax based on the corporate income. the corporate tax must be levied on the corporate income to fulfill the governance role of the tax. firstly, levying a tax on the corporate income creates the basic alignment of interests between the government and the outside shareholders, so the government has an incentive to protect investors from many forms of value extracting activity which harms both the government and outside shareholders.103 secondly, levying a tax on the corporate income creates the “booktax” tradeoff and a corporation’s management cannot inflate the reported income through conforming earning management, without paying tax on that income. thirdly, levying a tax on the corporate income provides information to the market (information about the “taxable income”) and market participants can utilize this information in assessing the financial health of the firm (e.g., using the data concerning the “book-tax” difference). while some features of corporate tax should be fine-tuned to provide better governance services to outside shareholders, the current features of corporate tax are quite consistent with the “the governance 102 ross levine, finance and growth: theory and evidence, in handbook of economic growth 865, 865-934 (philippe aghion & steven durlauf eds. 2005). however, ross mentions that robert lucas (nobel laureate) dismissed finance as an “over-stressed” determinant of economic growth; robert e. lucas jr., on the mechanics of economic development, 22 j. monetary econ. 3 (1988), and that robinson famously argued that “where enterprise leads finance follows;” joan robinson, the rate of interest and other essays (1952); ross also notes that nobel laureate merton miller replied to these arguments by saying: “[the idea] that financial markets contribute to economic growth is a proposition too obvious for serious discussion;” merton h. miller, financial markets and economic growth, 11 j. applied corp. fin. 8, 11 (2005). 103 desai et al. referred to this reasoning in an unpublished version of their article “theft and taxes,” by stating: “a separate tax on corporate profits generates an incentive for the government to verify income, ameliorating the agency problem between insiders and outside shareholders.” 2024] taxation and corporate governance 81 approach to the economic justification,” unlike other justifications based on optimal taxation theory suggested by the literature. the “governance approach to the economic justification” is a plausible justification only if the increase in the economic welfare achieved thanks to improvement in the corporate governance is higher than the additional costs associated with corporate tax. this requirement, however, should be distinguished from the requirement needed in order to accept the “fee for services.” the next example will illustrate this distinction. assume that, overall, corporate tax reduces the agency costs of publicly traded corporations by an amount of $50 billion (due to the governance services it provides) and that the total amount of tax collected through corporate tax is $300 billion. under such a simplistic scenario, levying corporate tax will reduce the value of publicly traded corporation’s by $250 billion. in other words, the shareholders as a group are worse off after the enactment of corporate tax. of course, in such a scenario, the “benefit” from corporate tax is overwhelmed by the “fee” collected and the “the fee for services justification” does not seem like a plausible justification for corporate tax. however, corporate tax may still be the most efficient vehicle to collect revenues, if – for example – the additional costs associated with corporate tax (e.g., economic distortions created by corporate tax) are less than $50 billion. hence, even if the shareholders are better off absent the existence of corporate tax, still the “the governance approach to the economic justification” is a plausible justification for corporate tax. c. “executives regulation” justification under the “regulation justification,” corporate tax is desirable as a means to restrict and regulate corporate power. the tax restricts the corporate power because it reduces corporate income, and consequently reduces the amount of cash and hence power available for the corporation (the “limiting” function). the tax regulates corporate power, because the use of corporate assets may be impacted by the threat that the tax rate will rise if congress perceives that the assets are not used for the betterment of society (the “regulatory” function). this explanation should be rejected for two reasons. first, this justification cannot explain why corporate tax is based on the income of the corporation, rather than on retained earnings. second, this justification may be accepted only if corporate tax can regulate firms in a unique manner that cannot be achieved by other forms of regulation and avi-yonah’s explanation fails to show why other forms of direct regulation cannot limit abuse of managerial powers. in other words, beyond the restriction function (which can be better achieved by taxing retained earnings), avi-yonah fails to show the comparative advantages of corporate tax in limiting abuses of managerial power. armed with the new understanding of corporate tax’s role, we can reshape the “regulation justification” and name it the “executives regulation justification.” similarly, to the previous two governance justifications for corporate tax, the “executives regulation justification” is based on the understanding that corporate tax has an important role in improving corporate governance. however, rather than being focused on increasing investor’s wealth or increasing the society’s 82 columbia journal of tax law [vol 16:1 economic welfare, this justification is focused on the interest of a liberal democratic state in restricting managerial abuses of excessive powers. as noted by avi-yonah, there are two principal arguments why a liberal democratic state should curb excessive accumulation of power: the democratic argument and the liberal conception of equality. curbing the managerial power is directly related to improving corporate governance, since the excessive power held by management is, at least partly, the result of lack of supervision by the non-controlling shareholders. at the beginning of the twentieth century, berle has already expressed the view that the separation of ownership and control (in the broad sense)104 gives management huge powers and noted that it “led to a society in which production is carried on under the ultimate control of a handful of individuals. the economic power in the hands of the few persons who control a giant corporation is a tremendous force which can harm or benefit a multitude of individuals, affect whole districts, shift the currents of trade, bring ruin to one community and prosperity to another.”105 furthermore, berle has noted that the separation of ownership and control has abolished the restrictions that formerly limited the use of these tremendous powers: “[t]he separation of ownership from control produces a condition where the interests of owner and of ultimate manager may, and often do, diverge, and where many of the checks which formerly operated to limit the use of power disappear.…”.106 since corporate tax and tax authorities have a comparative advantage relative to the sec in restricting abuses of excessive managerial powers, a liberal democratic state should use both tools in order to curb managerial powers. corporate tax curbs managerial abuses of excessive powers through five functions. in addition to the “limiting” function and “regulatory” function (as suggested by avi-yonah), the corporate tax has three other functions which prevent managerial abuses of excessive powers: “monitoring” function; “madisonian” function and the “shedding light” function. the “monitoring” function helps in preventing general diversion activity by the corporate management, particularly in the vast cases where there is an alignment of interests between the irs and the noncontrolling shareholders. the “madisonian” function helps in preventing a specific, but important, sort of managerial abuse: inflation of reported income. the “shedding light” function helps in providing information to the market. it should be emphasized that even if these functions cannot prevent managerial abuses of excessive powers, they can decently help in restricting such abuses. in sum, the “the corporate governance regulation justification” provides that the goal of corporate tax is to promote the values of a democratic-liberal society by curbing managerial powers and improving corporate governance, through functions that 104 adolf. a berle & gardiner c. means, the modern corporation & private property 5-6 (transaction publishers eds., 1933). in the terms of berle, the term “separation of ownership from control” refers also to the case where the majority shareholder is in control while the minority shareholders are not in control: “[s]uch separation may exist in varying degrees. where the men ultimately responsible for running a corporation own a majority of the voting stock while the remainder is widely diffused, control and part ownership are in their hands. only for the remaining owners is there separation from control.” 105 id. at 46. 106 id. at 6. 2024] taxation and corporate governance 83 cannot be achieved by other corporate governance mechanisms. the previously stated counterarguments that were raised against the original regulatory justification do not apply for “the corporate governance regulation justification.” this new justification is consistent with the fact that corporate tax is based on the income of the corporation, since—as noted earlier—imposing tax on the corporate income is necessary in order to enable the governance functions of corporate tax. in addition, in many important circumstances the corporate tax has a comparative advantage relative to the sec in improving corporate governance. since the primary purpose of corporate tax—under the “executives regulation justification”—is to enhance liberal-democratic values, this justification is plausible even if the enactment of the tax reduces investors’ wealth. moreover, because this justification stems from intrinsic motivation, the justification is theoretically plausible even if corporate tax reduces the overall economic welfare, if it enhances liberal-democratic values, by curbing excessive accumulation of power. the next example will illustrate this distinction. assume again, that overall corporate tax reduces the agency costs of publicly traded corporations by an amount of $50 billion (due to the governance services it provides), that the total amount of tax collected through corporate tax is $300 billion and that the additional cost associated with corporate tax (e.g., economic distortions created by corporate tax) are in amount of $51 billion. of course, in such a scenario, it is difficult to justify the corporate tax as a fee for the benefits provided by the tax authorities, since the “benefit” is overwhelmed by the “fee.” it is also difficult to justify the corporate tax based on an optimal tax theory since the tax is overall reducing the economic welfare of the society. hence, in this example, both the “the governance benefit justification” and the “corporate governance economic justifications” do not seem like plausible justifications for corporate tax. however, corporate tax may still curb managerial excessive powers and, thus, promote liberal-democratic values. hence, even if the shareholders are better off absent the existence of corporate tax and the tax reduces the economic welfare, still the “governance regulation justification” is a plausible justification for corporate tax. d. re-evaluating the governance justifications the new point of view concerning the corporate governance role of corporate tax provides us with three new possible justifications for corporate tax: the “fee for services,” the “the governance approach to the economic justification” and the “executives regulation justification.” these justifications, which are based on the new role of corporate tax, rest upon three unique theories. respectively, the justifications imply three different goals of the corporate tax, are limited by distinct sets of constraints, and lead to varying policy recommendations. table 1 summarizes the basic differences between these three new corporate governance justifications for corporate tax. 84 columbia journal of tax law [vol 16:1 table 1: corporate governance justifications for corporate tax fee for services governance approach to the economic justification executives regulation justification goal of the “original” justification collecting a fee for the benefit of “limited liability” maximizing economic wealth by either taxing the liquidity advantage or as a pigouvian tax, which reduces the externalities of “limited liability” curbing excessive corporate power through the “limiting” function and “regulatory” function original intent of the lawmakers protecting investors n/a (this factor is not relevant) regulating corporations goal of the justification, under the new understanding of corporate tax’s role collecting a fee for the corporate governance functions of corporate tax maximizing economic wealth by reducing agency costs curbing managerial abuses of power, through three additional functions: “monitoring” function, “madisonian” function, and “shedding light” function economic threshold for accepting the justification the aggregate increase in investors’ wealth (mainly, reduction in agency costs) is higher than the total amount of corporate tax collected the reduction is agency costs and the associated improvements in productivity are higher than the additional costs associated with corporate tax (e.g., economic distortions created by corporate tax) the “governance regulatory justification” is plausible even if the tax reduces both investors’ wealth and the overall economic welfare how can we evaluate these justifications? which justification, if any, is the “right” one? the answer to this inquiry depends on both normative and empirical considerations. from the normative perspective the political theory that one holds is a relevant consideration. for example, if one is a utilitarian (or economic welfarist), she will be attracted primarily to the economic approach and will probably reject the “executives regulation justification” (unless she thinks that promoting liberal-democratic values increases economic utility). if one is not a utilitarian (or an economic welfarist) but does not believe in the intrinsic value of a liberal-democratic society, then—again—she will probably reject the “executives regulation justification.” the general approach that one holds concerning the justification for the tax system is also a relevant consideration. if one generally supports the “benefit-based taxation,” under which people ought to pay taxes that depend on how much they benefit from public goods, she is probably attracted to “fee for services justification.” if one supports optimal tax theory, he may be more inclined to support the economic justification, and if one believes that the tax system has a regulatory function, she will be inclined to support the “executives regulation justification.” while the political philosophy that one holds and the general 2024] taxation and corporate governance 85 approach to the tax system are directly related, they are not identical. for example, a utilitarian may reject benefit-based taxation (and, thus, reject the benefit-based justification for corporate tax) or accept that approach (and thus, may accept the “fee for services justification”).107 the answer also depends on some empirical issues. obviously, the preliminary empirical issue is whether corporate tax promotes—or alternatively, can promote—good corporate governance. a positive influence is a requirement for accepting any of the three justifications for corporate tax. if corporate tax promotes or can promote good corporate governance, then one should examine each justification and the different set of empirical factors (or constraints) associated with it. the “fee for services justification” raises three empirical issues: the effect of the tax on investors’ wealth (mainly the reduction in agency costs), the total amount of corporate tax collected and the incidence question. as noted earlier, if the magnitude of the positive effects of corporate tax is inherently overwhelmed by the amount of corporate tax that the government collects, one must reject the “fee for services justification,” since the investors’ wealth is lower following the enactment of the tax. in this regard, it should be noted that under the economic model of desai et al., under some circumstances (in a tax regime with low rate and high enforcement), the investors are better off in a world with a corporate tax, than without it. in addition, accepting the “fee for services justification,” depends on assuming that the incidence of corporate tax is borne by – or mainly by – the investors. “the governance approach to the economic justification” raises two empirical issues: the effect of the improvement in the corporate governance due to the governance functions of corporate tax versus the distortions created by it. while there is obviously no readily available date on these subjects, one can assume that a reduced corporate tax rate (e.g., closer to the tax rate of the original corporate tax) which reduces the distortions created by the tax, combined with high level of enforcement (that strengthen the corporate governance functions of the tax) and some changes in the features of corporate tax, can end up with an overall positive effect of corporate tax. finally, the “executives regulation justification” depends on evaluating the effects of corporate tax on curbing managerial abuses of excessive power. vi. conclusion this article tried to shed some light on the interaction between the corporate tax and corporate governance. it argues that the corporate tax can serve a major role in addressing the agency concerns that lie at the heart of corporate governance debates. specifically, it argues that the corporate tax can be justified on the grounds that it reduces the corporate agency problem and that alternative systems have fewer desirable effects. 107 weinzierl, supra note 86, at 3 (“the first contribution of this article is the finding that the classical benefit-based view can fit neatly into the mirrleesian approach once one makes a simple—and arguably needed—change to the standard setup: that is, allowing individual income-earning ability to be a function of both innate talent and public goods.”). the expansion and internationalization of mandatory disclosure rules noam noked, zachary marcone & alison tsang* abstract the panama papers, the paradise papers, and most recently the pandora papers have exposed the role of tax advisors, lawyers, financial institutions, and other intermediaries in enabling cross-border tax avoidance and evasion. in response, mandatory disclosure rules (mdrs), which require that intermediaries report their clients’ tax schemes, are becoming prominent tools in the international fight against tax avoidance and evasion. this article analyzes the development of mdrs over the past four decades as a global phenomenon with three distinct phases beginning in the 1980s. the analysis reveals several trends: expansion in the types of schemes that are reportable, extension of reporting obligations to a great diversity of intermediaries, and increasing multilateralism in the effort to curb intermediary-enabled tax avoidance and evasion. this article shows how developments in international tax policy have affected, and will likely continue to affect, the expansion and internationalization of mdrs. * noam noked is an assistant professor at the faculty of law of the chinese university of hong kong. zachary marcone is a fulbright scholar at uganda christian university; he co-authored this article while he worked as a research assistant at the faculty of law of the chinese university of hong kong. alison tsang is a tax associate at the hong kong office of baker & mckenzie. the work described in this article was fully supported by a grant from the research grants council of the hong kong special administrative region, china (project no. cuhk 14612220). 2022] mandatory disclosure rules 123 introduction .............................................................................................. 124 i. first generation: 1980s ..................................................................... 128 a. united states ............................................................................... 129 b. canada......................................................................................... 132 ii. second generation: 2000s and early 2010s ................................. 133 a. united states ............................................................................... 134 b. united kingdom.......................................................................... 137 c. other countries ........................................................................... 140 iii. third generation: 2015-present ................................................... 143 a. dac 6 ......................................................................................... 143 b. crs mdrs ................................................................................. 149 c. other countries ........................................................................... 152 iv. trends in the development of mdrs ........................................... 153 a. expansion of what should be reported .................................... 154 b. expansion of who should report .............................................. 155 c. internationalization of mdrs ..................................................... 159 v. the path ahead for mdrs .............................................................. 161 conclusion.................................................................................................. 163 124 columbia journal of tax law [vol: 13:2 introduction when nigerian mega-preacher david oyedepo decided to set up an offshore company, he turned to the bible for inspiration. oyedepo, the owner of a fortune valued at $150 million by forbes magazine, named his british virgin islands company “zadok investments limited,” after king david’s loyal priest zadok who helped suppress rebellion and restore peace in the kingdom.1 modern “kings” no longer rely on the services of priestly advisors; a new class of professional advisors have taken their place. oyedepo, like others in the global economic elite, turned instead to financial and legal professionals to help maintain his assets under an offshore structure, raising concerns of tax avoidance and evasion.2 the relationship of oyedepo and others with these intermediaries was revealed in the pandora papers, the most recent of a series of leaks over the past decade.3 these revelations have highlighted the continuing role of intermediaries in enabling tax avoidance and evasion that has been successively brought to light in the panama papers, the paradise papers, and now the pandora papers.4 to combat intermediary-enabled tax avoidance and evasion, many governments have adopted or are in the process of adopting mandatory disclosure rules (mdrs) as deterrence and information-gathering tools. in general, mdrs require the disclosure of certain schemes that may facilitate tax avoidance and evasion.5 the reporting obligations typically apply to the promoters of reportable schemes and other intermediaries who assist with the design and implementation of such schemes.6 mdrs are designed to deter intermediaries from developing and implementing schemes that could facilitate tax avoidance and evasion, identify the 1 nicholas ibekwe, pandora papers: how bishop david oyedepo set up family offshore company in tax haven, premium times, oct. 10, 2021, https://www.premium timesng.com/news/headlines/489110-pandora-papers-how-bishop-david-oyedepo-set-up-familyoffshore-company-in-tax-haven.html [https://perma.cc/x2dk-hu8b]; mfonobong nsehe, the five richest pastors in nigeria, forbes, june 2, 2011, https://www.forbes.com/ sites/mfonobongnsehe/2011/06/07/the-five-richest-pastors-in-nigeria [https://perma.cc/8f68n32w]. 2 see id. 3 see id.; greg miller et al., billions hidden beyond reach, wash. post, oct. 3, 2021, https://www.washingtonpost.com/business/interactive/2021/pandora-papers-offshore-finance [https://perma.cc/nuf4-5q3l]. 4 for further discussion, see bastion obermayer & frederik obermaier, the panama papers: breaking the story of how the rich and powerful hide their money (2016); lawrence j. trautman, following the money: lessons from the panama papers: part 1: tip of the iceberg, 121 penn st. l. rev. 807 (2017); shu-yi oei & diane ring, leak-driven law, 65 ucla l. rev. 532 (2018); james o’donovan et al., the value of offshore secrets: evidence from the panama papers, 32 rev. fin. stud. 4117 (2019); international consortium of investigative journalists, pandora papers, https://www.icij.org/investigations/pandora-papers [https://perma.cc/pb3g-qz5v] (last visited oct. 13, 2021). 5 as discussed below, many mdrs target tax avoidance schemes. certain mdrs, such as the crs mdrs discussed in infra part iii.b., target arrangements that raise concerns of tax evasion. see infra note 190 for further discussion on tax avoidance and evasion in this context. 6 as discussed below, this article focuses on mdrs that impose reporting obligations on parties other than the taxpayers themselves (i.e., third-party reporting by intermediaries). reporting obligations that only apply to the taxpayers are outside the scope of this article. 2022] mandatory disclosure rules 125 users of such schemes, and alert tax authorities of weaknesses in the tax system.7 mdrs have developed from targeted domestic measures against promoters of mass-marketed tax shelters into substantially broader reporting standards that constitute a major component of a coordinated international campaign against tax avoidance and evasion.8 from humble origins, mdrs have taken the world by storm in recent years with the implementation of the eu council directive 2018/822 (dac 6) and the publication of the oecd model mdrs for common reporting standard avoidance (crs mdrs).9 over 30 jurisdictions have adopted new forms of mdrs since 2018 alone, and there are indications that more countries will follow suit.10 these developments are part of broader trends in international tax policy and enforcement that have increased efforts to curb tax avoidance and evasion, shift the spotlight to the enablers of tax avoidance and evasion, and adopt a multilateral approach to tax norm-setting and enforcement.11 this article is the first publication to thoroughly explore the development of mdrs over time in different jurisdictions. while there exists literature discussing specific regimes, this is the first publication to identify and analyze trends across the full temporal and geographic breadth of mdrs.12 the analysis of the development of mdrs exposes trends in the evolution, maturation, and implementation of mdrs over time with a cross-jurisdictional lens. this article shows how the trends in the evolution of mdrs fit into broader movements in international tax policy. the evolution of mdrs can be divided into three distinct generations: the tax shelter registration rules of the 1980s, which were limited in scope and purpose; the reportable transaction disclosure regimes of the 2000s, which expanded reporting requirements and made some inroads into the international taxation sphere; and finally, the multilateral mdrs of the past six years, which extend reporting requirements to a great diversity of intermediaries, focus on cross-border arrangements, and create information exchange systems. 7 see michael schler, effects of anti-tax-shelter rules on nonshelter tax practice, 109 tax notes 915, 917 (2005). see also the discussion in parts i and ii for the reasons countries have adopted mdrs. 8 see infra parts i-iii (showing how the development and adoption of mdrs in different countries have built upon the experience of other countries’ earlier mdrs). 9 council directive 2018/822, 2018 o.j. (l 139) [hereinafter dac 6]; oecd, model mandatory disclosure rules for crs avoidance and opaque offshore structures (2018) [hereinafter crs mdrs]. in general, dac 6 requires the disclosure of certain schemes and arrangements by intermediaries, such as tax professionals, lawyers, investment advisors, accountants, and other service providers. see infra part iii.a. the crs mdrs require the reporting of schemes that enable the avoidance of crs reporting. see infra part iii.b. 10 mexico, argentina, the united kingdom, and all 27 member states of the eu have adopted some form of expanded mdrs since 2018. guernsey, jersey, the isle of man, and gibraltar are also in the process of adopting the crs mdrs. see infra part iii. several countries, including australia and japan, are also currently considering adopting mdrs. see infra part v. 11 see infra part iv; ruth mason, the transformation of international tax, 114 am. j. int’l l. 353 (2020) (discussing the implications of recent international tax reforms and the changes in the participants, agenda, institutions, and legal instruments of international tax). 12 publications on specific regimes are cited throughout this article. 126 columbia journal of tax law [vol: 13:2 in the 1980s, the united states and canada adopted targeted measures requiring the registration of mass-marketed individual tax shelters.13 these early reporting regimes required the promoters of individual tax shelters to report any tax schemes which matched a set of narrow criteria.14 promoters were required to provide information on the schemes to the tax authority which would then issue an identification number for taxpayers to include in their tax returns.15 in some cases, promoters were required to maintain lists of investors’ contact information and provide this information to the tax authorities.16 in the 2000s, the united states enacted rules requiring the reporting of certain “reportable transactions” that may be associated with tax avoidance.17 the new u.s. regime required the reporting of “listed transactions” and other transactions that contained certain identifiable hallmarks.18 these measures expanded the breadth of the pre-existing tax shelter registration rules to include other tax avoidance schemes, particularly those involving corporate taxpayers. in addition, this regime expanded the reporting obligations beyond organizers of tax shelters to further include any material advisors who provide tax statements with respect to a reportable transaction.19 following the united states, the united kingdom adopted a similar, but structurally different, reportable transaction disclosure regime in 2004.20 subsequently, additional countries, including south africa, portugal, ireland, and canada, adopted regimes modeled after either the united states’ or the united kingdom’s mdrs.21 the most dramatic expansion of mdrs is now underway. the oecd, as part of the base erosion and profit shifting (beps) project, suggested in 2015 that countries adopt broad mdrs as part of an international effort to curb cross-border tax avoidance.22 following this recommendation, the eu adopted in 2018 its own form of mdrs under dac 6.23 dac 6 substantially expands reporting obligations, focuses on cross-border arrangements, includes hallmarks for crs avoidance, and facilitates the exchange of information between member states.24 furthermore, dac 6 requires reporting from any intermediary that could reasonably be expected to be aware of a reportable transaction.25 this expansion is significant because it imposes reporting obligations on various intermediaries even if such parties did not advise or make statements on the tax aspects of the transaction. such intermediaries 13 see infra part i. 14 see infra notes 58, 72 and the accompanying text. 15 see infra part i. 16 see infra notes 56, 74 and the accompanying text. 17 see infra part ii.a. 18 id. 19 see id. 20 see finance act 2004 c.12, §§ 306-19 (uk) https://www.legislation.gov.uk/ukpga/ 2004/12/contents [https://perma.cc/8pw9-7byz] and its implementing regulations. see also infra note 110. 21 see infra part ii.c. 22 see oecd, mandatory disclosure rules, action 12-2015 final report (2015) [hereinafter action 12]. 23 see dac 6, supra note 9. 24 see id.; see also infra part iii.a. 25 see infra note 169 and the accompanying text. 2022] mandatory disclosure rules 127 may include lawyers, investment advisors, corporate service providers, trustees, and other professionals. in addition, the oecd published in 2018 the crs mdrs, which provide a system of mandatory disclosure for crs avoidance arrangements and opaque offshore structures. crs mdrs, like dac 6, lay the groundwork for a system of automatic information exchange between jurisdictions.26 a growing number of countries have adopted or are expected to adopt the crs mdrs.27 new mdrs have also emerged in other parts of the world.28 our analysis of the development of mdrs reveals three trends.29 first, mdrs have gradually expanded from targeted measures against certain specific transactions to comprehensive reporting regimes for different types of aggressive tax planning.30 overall, this represents a transition from a narrow rule-based approach targeting specific tax shelters to a broader standard-based approach to counter various forms of tax avoidance and evasion.31 this standard-based approach is reflected in the extensive use of generic hallmarks and the incorporation of the main benefit test in newer mdrs.32 this trend is part of an increasing international effort to curb tax avoidance and evasion.33 second, mdrs have expanded the categories of persons obligated to report. the original tax shelter registration rules specifically targeted the promoters and organizers of mass-marketed tax shelters. the most recent mdrs require a broad set of intermediaries to report even if they are not involved with the tax aspects of a transaction or an arrangement. thus, mdrs have evolved from targeting a small group of tax shelter promoters to regulating a broad set of professional service industries. these changes also align with general trends in tax policymaking and enforcement that target the enablers of tax avoidance and evasion.34 third, mdrs have changed from domestic measures with a domestic focus to multilateral standards addressing cross-border tax avoidance and evasion.35 the internationalization of mdrs has affected what needs to be reported, who needs to report, and how information is exchanged between jurisdictions. dac 6 and crs mdrs are transnational by design. they incorporate hallmarks that target crossborder transactions and arrangements, require both domestic intermediaries and 26 see oecd, international exchange framework for mandatory disclosure rules on crs avoidance arrangements and opaque offshore structures (2019). 27 see the discussion in infra parts iii.b, v. 28 see infra part iii.c. 29 see infra part iv. 30 see infra part iv.a. 31 see infra note 239 and the accompanying text. 32 see infra notes 166, 177-179, 241 and the accompanying text. 33 relevant international developments include beps, beps 2.0, the foreign account tax compliance act (fatca), and the common reporting standard (crs). in general, beps and beps 2.0 are coordinated international programs led by the oecd which aim to end tax avoidance, in particular by multinational enterprises. fatca is a u.s. law that requires the reporting of the overseas financial assets of u.s. citizens and tax residents to the u.s. government. crs is an international version of fatca, implemented by more than 112 jurisdictions, which facilitates the automatic exchange of financial account information of foreign tax residents to their jurisdictions of tax residence. see infra notes 191-193, 293 and the accompanying text. see also the discussion infra part iv.c. 34 see infra part iv.b. 35 see infra part iv.c. 128 columbia journal of tax law [vol: 13:2 intermediaries in other jurisdictions to report, and contain systems for information exchange between countries. this is in line with other recent developments in international taxation, such as crs, beps, and beps 2.0, which adopt an international and multilateral approach in the fight against cross-border tax avoidance and evasion.36 these expanded models for mdrs may spread to more countries and become new international tax norms.37 there could be pressure, in the form of eu blacklisting or oecd peer reviews, on jurisdictions across the globe to implement some form of mdrs such as the crs mdrs. interestingly, although the united states played a key role in introducing and expanding mdrs in the 1980s and 2000s, u.s. policymakers have not expressed interest in adopting more expansive rules like their european counterparts have. understanding the development of mdrs can contribute to current policy discussions around the world on whether to adopt mdrs or expand existing mdrs. this article is divided into five parts. part i discusses the targeted u.s. and canadian tax shelter registration rules of the 1980s. part ii analyzes the reportable transaction regimes of the 2000s and early 2010s, which significantly expanded in scope, but largely remained domestically focused. part iii evaluates the major expansion and internationalization of the scope and focus of mdrs since 2015. part iv reveals trends across the three generations and contextualizes them within broader movements in international tax policy. part v provides observations and comments regarding the possible directions of mdrs in the future. i. first generation: 1980s the first rules that imposed obligations on intermediaries to report tax schemes were the tax shelter registration rules of the 1980s. tax shelter registration rules were first introduced in the united states in 1984 and then in canada in 1988.38 the scope and aim of these rules were much narrower than those of the mdrs adopted in later decades, as discussed in the next parts. these rules targeted certain types of individual tax shelters that had proliferated in the united states and canada in the 1970s and early 1980s.39 unlike the regimes of later decades, these rules lacked a list of general hallmarks that flag transactions for reporting.40 furthermore, these rules did not address corporate tax shelters which would eventually pose significant tax avoidance challenges.41 36 see infra part iv.c. 37 see infra part v. 38 for the united states, see deficit reduction act of 1984 §§ 141-144 pub. l. 98-369 (1984) [hereinafter defra], which first introduced the provisions requiring “organizers” of tax shelters to register “tax shelters” and to maintain investor lists for each tax shelter, and penalties for noncompliance, in i.r.c. §§ 6111, 6112, 6707, 6708 (of 1986) (it has been replaced by the u.s. reportable transaction disclosure rules, discussed infra part ii.a). for canada, see income tax act, r.s.c. 1985 (can.) [hereinafter canadian ita], c.1, s 237.1 (of 1988) (it has since been amended by canada’s subsequent mdrs as discussed in part ii.b). 39 see mortimer caplin, tax shelter disputes and litigation with the internal revenue service 1987 style, 6 va. tax rev. 709, 709 (1987). 40 see infra part ii. 41 see id. 2022] mandatory disclosure rules 129 a. united states the united states adopted its tax shelter registration rules in 1984 in response to a proliferation of mass-marketed tax shelters.42 the use of such tax shelters had been increasing steadily since the 1960s, which contributed to the mounting federal deficit in the 1980s.43 although congress had enacted various forms of legislation to combat such tax shelters,44 these measures did little to curb the growing use of such schemes.45 in 1982, recognizing that the problem largely stemmed from promoters of tax shelters, who had been marketing shelters based on false representations, gross valuation overstatements, and unsupported positions, congress introduced promoter penalty provisions, as well as provisions allowing for injunctive relief to be sought against promoters, to tackle the issue “at [its] source.”46 however, abusive tax shelters continued to proliferate.47 this led to concerns that promoters were profiting from the u.s. treasury’s dearth of information on the tax shelter market and that the irs was unable to “examine effectively every return” to detect participation in tax shelters.48 as a result, congress introduced tax shelter registration rules in 1984.49 the purpose of these rules was to facilitate the irs’ ability to identify abusive tax shelters early and to make “better informed judgments” when deciding whether or not to audit a scheme.50 these rules were part of a larger package of changes implemented in the deficit reduction act of 1984.51 congress was concerned that tax shelters exacerbated the deficit, undermined public trust in the tax system, and inhibited economic growth by diverting funds away from more profitable investments.52 42 see j. comm. on tax’n, 98th congress, general explanation of the revenue provisions of the deficit reduction act of 1984, jcs-41-84, at 7 (1984) (“congress believed that the proliferation of tax shelters had seriously eroded the tax base . . . the increase in tax shelter activity had aggrevated [sic] the nation’s deficit problem.”). 43 see id.; see also s. comm. on finance, 98th cong., deficit reduction act of 1984 – explanation of provisions approved by the committee on march 21, 1984, at 81, 83 (comm. print 1984); dep’t treasury, tax reform for fairness, simplicity, and economic growth – the treasury department report to the president 6, 7, 138, 139, 140 (1984). 44 see tax reform act of 1969, pub. l. no. 91-172 (1969); tax reform act of 1976, pub. l. no. 94-455 (1976); revenue act of 1978, pub. l. no. 95-600 (1978); economic recovery tax act of 1981, pub. l. no. 97-34 (1981). 45 see j. comm. on taxation, general explanation of the revenue provisions of the tax equity and fiscal responsibility act of 1982, jcs-38-82, at 210-11 (1982). 46 this is an early example of the tax authorities targeting the enablers of tax avoidance as opposed to the taxpayers themselves. the provisions were introduced under the tax equity and fiscal responsibility act of 1982, pub. l. no. 97-248 (1982) [hereinafter tefra]. see id. at 21013 for the legislative background of tefra. 47 see j. comm. on tax’n, supra note 42. 48 id. at 475; marilyn a. wethekam, a critique of current state tax shelter laws, the state and local tax lawyer, 11 state & loc. tax l. 37 (2006). 49 see defra §§ 141-44. 50 see j. comm. on tax’n, supra note 42, at 476. 51 defra, supra note 49. 52 see j. comm. on tax’n, supra note 42, at 5-8. 130 columbia journal of tax law [vol: 13:2 to address these concerns, the deficit reduction act of 1984 required tax shelter organizers to register no later than the first day on which their interest was offered for sale.53 organizers would then receive a registration number which investors were required to include in their personal tax returns.54 registration required the disclosure of information about the tax shelter to the irs.55 additionally, any organizers of “potentially abusive tax shelters” were required to maintain lists of investors with their respective personal information.56 upon request, organizers were required to provide these lists to the irs.57 the deficit reduction act defined a tax shelter based on a formula. a tax shelter was defined as any investment that “any person could reasonably infer” the ratio of deductions and 200 percent of credits to the cash invested, the so-called “tax shelter ratio,” was greater than two to one as of the close of any of the first five years of the investment.58 however, this definition proved too broad and required the registration of a significant number of investments with no tax avoidance motives.59 not only did this place unnecessary burden on promoters and investors in legitimate investment schemes, but would also complicate the irs’ ability to identify and investigate abusive tax shelters.60 in august 1984, the u.s. treasury exempted from reporting certain types of investments that posed a lower risk of being considered as abusive.61 the early registration requirement imposed on organizers provided the irs with a tool to identify abusive tax shelters before any government revenue was lost. by requiring tax shelters to register on the day they first sell their products, the irs 53 the tax shelter organizer was “the person principally responsible for organizing the tax shelter.” defra § 141. the promoter of the scheme generally qualified as the organizer. see j. comm. on tax’n, supra note 42, at 476. promoters are understood in this article to mean those who market and sell tax products. 54 see defra § 141; see also j. comm. on tax’n, supra note 42, at 476 for a further discussion on this provision and others. 55 defra required the following to be included in the registration, “(a) information identifying and describing the tax shelter, (b) information describing the tax benefits of the tax shelter represented (or to be represented) to investors, and (c) such other information as the secretary may prescribe.” defra § 141. 56 the law defined a potentially abusive tax shelter as “(1) any tax shelter (as defined in section 6111) with respect to which registration is required under section 6111, and (2) any entity, investment plan or arrangement, or other plan or arrangement which is of a type which the secretary determines by regulations as having a potential for tax avoidance or evasion.” defra § 142. 57 see id. 58 for example, suppose a partnership purchases an office building and is subject to annual interest payments of $1,000,000 on a mortgage. other expenses total $400,000. the partnership has 100 investors who invest $2,000 each in the first year for a total investment of $200,000. in this case the tax shelter ratio would be $1,400,000+200∗0 $200,000 = 7. for a more detailed breakdown of a similar example, see stephen saporta, tax shelter registration: an alternative proposal that leads to the efficient identification of abusive tax shelters, 20 val. u. l. rev. 489, 521-25 (1986). the tax shelter ratio was later changed to 350% of credits in the tax reform act of 1986 to account for altered tax rates. see tax reform act of 1986 § 1531, 26 u.s.c. § 1 (1986). 59 see saporta, supra note 58, at 512, 517. 60 see id. at 517. 61 this exception applied to what was referred to as “projected income investments.” temp. treas. reg. § 301.6111-1t, q&a 57a, 57b (1985). 2022] mandatory disclosure rules 131 could begin investigating potentially abusive tax shelters earlier than before. the irs could then send pre-filing notification letters to investors to warn them of an abusive tax shelter scheme before any investors had actually used the shelter to deny the government its due revenue.62 previously, taxpayers investing in these shelters could play the audit lottery and hope that the irs’ lack of comprehensive data would shield them from consequences.63 the information obtained also allowed the u.s. treasury to identify the legislative loopholes commonly exploited in tax shelter arrangements, which eventually led congress to enact the tax reform act of 1986. the tax reform act of 1986 raised penalties for failing to comply with many of the requirements of the 1984 act including a failure to register as a tax shelter.64 the 1986 tax reform also implemented other tax measures that reduced the attractiveness of tax shelters.65 these measures in combination with the anti-tax shelter changes of 1984 were effective in suppressing the mass-marketed individual tax shelter industry.66 the number of individual tax shelters declined after 1986.67 it is not entirely clear how much of this decline resulted directly from the tax shelter registration rules. a government accountability office (gao) report from 1988 found that the tax shelter registration program could be improved.68 some analysts have argued 62 see michael j. bradley, registration of tax shelters, 63 taxes 563, 565 (1985) (“the irs decided that the only way to stop the proliferation was to identify potentially abusive tax shelters and warn gullible investors before the investments were sold, rather than attacking the transactions retrospectively . . . . this is done by issuing ‘pre-filing notification letters’ to investors, warning them of the potential pitfalls.”). for further information on pre-filing notifications, see rev. proc. 83-78, 1983-2 c.b. 595; rev. proc. 84-84, 1984-2 c.b. 782; caplin, supra note 39, at 734; allan karnes & roger lively, striking back at the irs: using internal revenue code provisions to redress unauthorized disclosures of tax returns or return information, 23 seton hall l. rev. 924 (1993). 63 for further discussion, see j. comm. on tax'n, supra note 45, at 216, wherein the problem of the audit lottery is lamented and the reasons for its persistence at the time are elaborated. for a general discussion on the audit lottery problems, see yoram keinan, playing the audit lottery: the role of penalties in the u.s. tax law in the aftermath of long term capital holdings v. united states, 3 berkeley bus. l.j. 381 (2006); matthew c. ames, formal opinion 352: professional integrity and the tax audit lottery, 1 geo. j. legal ethics 411 (1987); elena eracleous, losing the audit lottery: corporate tax shelters and judicial doctrine, 5 fordham j. corp. & fin. l. 205 (2000); joel s. newman, the audit lottery: don’t ask, don’t tell?, 40 tax notes 1438 (1988). 64 see tax reform act of 1986, supra note 58, at §§ 1532-1534 (amending i.r.c. §§ 67076708). 65 these measures included the passive activity loss rules (pal) which required that passive losses could only be used to offset other passive income. see tax reform act of 1986, supra note 58, at § 501 (amending i.r.c. § 469). 66 see dep’t treasury, the problem of corporate tax shelters – discussion, analysis and legislative proposals 27, 60, 64 (july 1999); j. comm. on tax’n, supra note 42, at 426. 67 see george k. yin, getting serious about corporate tax shelters: taking a lesson from history, 54 smu l. rev. 209, 211 (2001), for a detailed quantitative analysis of the decline in tax shelters post-1986. 68 u.s. gov’t accountability off., gao-88-69, tax administration: irs’ abusive tax shelter efforts need improvement 3, 15-16, 19 (1988). the report found that in the three districts visited by the gao not a single registered tax shelter had been penalized for abusive 132 columbia journal of tax law [vol: 13:2 that other tax measures introduced in the 1986 tax reform played a substantial role in eliminating the tax shelter problem.69 the decline in individual tax shelters after 1986 may be the result of the combined effect of the tax shelter registration rules and other tax measures. also, the implementation of tax shelter registration rules in the united states prompted another country, canada, to adopt similar rules just a few years later. b. canada canada introduced similar tax shelter registration rules in 1988 as part of a comprehensive package of reforms to curtail the “accelerating proliferation of tax avoidance schemes.”70 these new rules were inspired by the recent tax changes in the united states.71 canada’s tax shelter registration rules were generally similar to the rules in the united states. under canada’s tax shelter registration rules, a scheme was classified as a “tax shelter” based on a formula.72 promoters were required to register a tax shelter behavior between october 1984 and july 1986, despite 20 completed investigations. irs personnel reported that this was due to a lack of relevant information reported in the registration process. the personnel argued that obtaining a tax shelter’s prospectus and offering documents at the time of registration would make it easier for them to get information on the shelter’s income projections, its asset acquisition and financing, and the types of deductions or credits it used. this would have helped the irs determine the extent to which the investment is tax-motivated and allow them to verify the accuracy of the registration information. 69 see yin, supra note 67, at 219; calvin h. johnson, why have anti-tax shelter legislation? a response to professor zelenak, 67 tex. l. rev. 591, 625 (1989); calvin h. johnson, what’s a tax shelter?, 68 tax notes 879, 879-80 (1995); stanley a. koppelman, at-risk and passive activity limitations: can complexity be reduced?, 45 tax l. rev. 97, 105 (1989); jerome kurtz, the interest deduction under our hybrid tax system: muddling toward accommodation, 50 tax l. rev. 153 (1995); cecily w. rock & daniel n. shaviro, passive losses and the improvement of net income measurement, 7 va. tax rev. 1 (1987). 70 dep’t finance canada, the white paper – tax reform 1987, at 8 (1987). 71 see house of commons debates, 33-2, vol 1 (23 october 1986) at 642 (can.) (“we have made progress, but in considering the further progress we wish to make, and in light of the recent changes in the united states, we decided that a broader approach to tax reform in canada is required.”). 72 “tax shelter” was initially defined as “any property of which it is expected, based on statements or representations made or proposed to be made in connection with the property, that the aggregate of the losses or other amounts, calculated in any of the relevant years . . . will exceed the cost of the interest in the property (less prescribed benefits) to the purchaser.” see canada revenue agency, information circular ic-89-4, “tax shelter reporting” (14 august 2002). in maege v. the queen, 2006 d.t.c. 3193 and baxter v. the queen, 2007 f.c.a. 172, this definition was summarized in the equation a > (b – c) where a represents the aggregate of deductions against income, b represents the investment or cost, and c represents the prescribed benefits or tax credits received. for example, in december 1990, lazar jevremovic invested cad 10,000 in an agricultural research company named botanical technologies. he then claimed a net business loss of cad 10,000, an investment tax credit of cad 1,480, and a quebec tax credit of cad 3,614. the court found that this did indeed meet the mathematical requirement for a tax shelter given that 10,000 > (10,000 – 5,094). for a more detailed breakdown of mr. jevremovic’s case, see maege v. the queen. id. several changes were made to these laws in subsequent years. for example, amendments in 1995 and 2003 expanded the scope of these rules to cover additional schemes. see canadian ita §§ 143.2, 237.1 (of 1995 and 2003, respectively). 2022] mandatory disclosure rules 133 and distribute its identification number, as assigned by the canadian revenue authority (cra), to all investors in the tax shelter.73 investors would then include this identification number in their own income tax returns. the promoters were required to obtain their identification numbers before they began selling or issuing the tax shelter scheme. they also needed to provide the cra with a list of investors in their scheme along with their respective contact information, social insurance numbers, and the amount paid by each investor.74 promoters were defined as “any person who in the course of a business sells, issues or promotes the sale, issuance or acquisition of an interest in a tax shelter or who acts as an agent or advisor in respect of such activities.”75 penalties were imposed on promoters who failed to register.76 investors who participated in a tax shelter scheme without a registration number were denied any potential tax benefits of the shelter.77 thus, similar to the united states, canada’s tax shelter registration regime targeted the proliferation of individual tax shelters by imposing registration and reporting obligations. this narrow scope would ultimately prove inadequate to address the growth of corporate tax shelters. nevertheless, these rules laid the groundwork for the expansion of canada’s reporting regime, discussed in the next part. ii. second generation: 2000s and early 2010s with the decline of the individual tax shelter industry, the attention of tax authorities shifted to countering tax avoidance schemes for corporate taxpayers.78 while the u.s. and canadian tax shelter registration rules were too narrow to capture these schemes, they did provide a model for a reporting regime that would prove useful in addressing other forms of tax avoidance. in the 2000s, the united states, followed by several countries including the united kingdom, south africa, portugal, ireland, and canada, adopted a new type of reporting regime that was broad enough to capture the various tax avoidance schemes of corporations, individuals, trusts, and other taxpayers.79 while different countries name their 73 see canadian ita (of 1988) § 237.1. 74 see id. 75 canada revenue agency, supra note 72. 76 see id. 77 see rosemarie wertschek & james r. wilson, shelter from the storm: the current state of the tax shelter rules in section 237.1, 56 can. tax j. 285, 287 (2008) 78 see elaine church & corina trainer, reportable transactions: a comprehensive disclosure regime to combat tax shelters, 57 major tax plan 12-1, at 12-2 to -3 (2005) (“during the late 1990’s, market activity shifted from individual to corporate tax shelters. few of these emerging corporate transactions appeared to be affected by the regulations that had been developed to address the very different issues involved in shelter investments by individuals. typically, these corporate tax shelters were not ‘investment type’ transactions. . . . by 1999, when treasury launched its study of corporate tax shelters, treasury had become convinced that additional rules were needed.”). see also dep’t treasury, the problem of corporate tax shelters: discussion, analysis and legislative proposals (1999); james s. eustice, abusive corporate tax shelters: old “brine” in new bottles, 55 tax l. rev. 135 (2002). 79 at present, the u.s. and south african regimes are still in place. however, portugal and ireland have also adopted dac 6, the united kingdom has expanded its regime to implement the crs mdrs. canada is considering expanding its mdrs. see infra part iii. 134 columbia journal of tax law [vol: 13:2 reporting regimes differently, we generally refer to these rules as mdrs.80 although modeled similarly, these mdrs differ from their tax shelter registration antecedents in that they provide a list of example transactions that are required to be reported. these mdrs also list various “hallmarks,” or identifiable characteristics associated with tax avoidance schemes. these changes greatly widened the scope of reporting requirements, and thereby channeled more information to tax authorities. while all of the new mdrs share basic characteristics with each other, each regime is adapted to local conditions and differs from the others in a number of ways. each country lists different types of transactions that need to be reported. moreover, different parties are required to report in different countries. in the united kingdom, south africa, portugal, and ireland, the promoters of a reportable transaction are required to report, while taxpayers need only report when there is no promoter or the promoter fails to report.81 in the united states, both the taxpayers and material advisors must report.82 in canada, there are parallel reporting requirements on every beneficiary, scheme user, and advisor or promoter entitled to a fee in respect of the transaction.83 a. united states by the late 1990s, it was estimated that corporate tax shelters had cost the u.s. treasury 10 billion dollars annually and that this figure was “growing dramatically.”84 although congress, again, sought to tackle the issue by developing targeted responses to specific schemes, such an ad hoc approach was ineffective to curb corporate tax avoidance.85 it was therefore proposed that a generic approach, based on identified characteristics common to many corporate tax avoidance practices, was needed.86 in february 2000, the u.s. treasury introduced temporary regulations imposing a requirement on corporate taxpayers participating in a “reportable transaction” to disclose certain specified information in relation to the transaction in a disclosure statement to be attached to their tax returns for each taxable year in 80 action 12, supra note 22, follows a similar approach. annet wanyana oguttu and ann kaviskumar also refer to the disclosure rules of the 2000s and early 2010s as mdrs. notably, these authors also consider (as we do) the u.s. and canadian tax shelter registration rules of the 1980s a version of mdrs. see annet wanyana oguttu & ann kayis-kumar, curtailing aggressive tax planning: the case for introducing mandatory disclosure rules in australia (part 1), 17 ejournal tax res. 83, 85 (2019). 81 see finance act 2004, c. 12, §§ 309-10 (uk), https://www.legislation.gov.uk/ukpga/ 2004/12/contents [https://perma.cc/8pw9-7byz] [hereinafter finance act 2004]; tax administration act 28 of 2011 [hereinafter taa] § 34 (s. afr.); decreto-lei n. ̊ 1 29/2008, de 25 de fevereiro [decree-law no. 29/2008], arts. 8, 10, https://dre.pt/dre/detalhe/decreto-lei/29-2008247717 [https://perma.cc/k6vp-5tb5] (port.); taxes consolidation act 1997 (act no. 39/1997) (ir.), https://www.irishstatutebook.ie/eli/1997/act/39/enacted/en/html [https://perma.cc/qqr9ryxl] [hereinafter tca] § 817e. 82 see infra note 95 and the accompanying text. 83 see canadian ita § 237.3. 84 dep’t treasury, supra note 66, at 31. 85 see id. at 2-6, 11-12, 31, 77-78. 86 see id. 2022] mandatory disclosure rules 135 which their income tax liability is affected by the transaction.87 reportable transactions would include transactions identified by the irs in published guidance as tax avoidance transactions, i.e.,.,., listed transactions and transactions exceeding certain monetary thresholds which had certain hallmarks commonly associated with corporate tax shelters.88 from august 2000 to october 2002, the temporary rules underwent four rounds of revision, during which time the disclosure requirement was extended to non-corporate taxpayers including individuals, trusts and partnerships.89 these amendments were made because “potentially abusive tax avoidance transactions are increasingly being used by high net-worth individuals” and that “both corporations and individuals often employ partnerships and trusts to achieve unintended tax results.”90 the final regulations were issued in february 2003,91 and clarified which transactions are reportable.92 reportable transactions include those offered to a taxpayer by an advisor on a condition of confidentiality, those resulting in the taxpayer claiming a loss exceeding specified monetary thresholds, those in which the taxpayer can be refunded fees if the intended tax benefits are not obtained, and those that are the same as or are substantially similar to transactions identified by the irs in published guidance as being “of interest.”93 in 2004, the reportable transaction rules were amended once again under the american jobs creation act of 2004 (ajca).94 notably, this change imposed a parallel reporting requirement and list maintenance requirements on material advisors of reportable transactions.95 a material advisor is defined as any person who provides a tax statement96 with respect to a reportable transaction and receives 87temp. treas. reg. § 1.6011-4t. it is important to mention that the u.s. had first required the registration of corporate tax shelters under the taxpayer relief act of 1997. these rules expanded those set forth in the deficit reduction act of 1984 and required corporate tax shelter promoters to register if their tax shelter was offered under “conditions of confidentiality.” however, this law lacked a comprehensive set of listed transactions or hallmarks that the later regime would include. see taxpayer relief act of 1997 § 1028, pub. l. no. 105-34 (1997) (amending i.r.c. § 6111(d)). 88 see temp. treas. reg. § 1.6011-4t supra note 87. 89 these revisions took place in august 2000, august 2001, june 2002, and october 2002. see 65 fed. reg. 49909, 66 fed. reg. 41133, 67 fed. reg. 41324, 67 fed. reg. 64799, 67 fed. reg. 64807, for the amendments in federal registers. 90corporate tax shelters: looking under the roof: hearing before the s. comm. on fin., 117th cong. 90 (mar. 21, 2002). 91 see treas. reg. §§ 1.6011-4, 20.6011-4, 25.6011-4, 31.6011-4, 53.6011-4, 54.6011-4, 56.6011-4. the regulations were published in 68 fed. reg. 10161. 92 see treas. reg. § 1.6011-4(b) for the definition of “reportable transactions.” the lists of current “listed transactions” and “transactions of interest” are available on the irs website. recognized abusive and listed transactions, irs, https://www.irs.gov/businesses/ corporations/listed-transactions [https://perma.cc/2v38-vlp5] (last visited mar. 9, 2022); transactions of interest, irs, https://www.irs.gov/businesses/corporations/transactions-of-interest [https://perma.cc/29tt-msu6] (last visited mar. 9, 2022). 93 treas. reg. § 1.6011-4. 94 see american jobs creation act [hereinafter ajca] §§ 815-820, pub. l. no. 108-357 (2004) (amending i.r.c. §§ 6111, 6112, 6700, 6662, 6664, 6694, 6707, 6708, 7408). 95 see ajca § 815 (codified at i.r.c. §§ 6111, 6112). 96 in general, a tax statement is “any statement . . ... oral or written, that relates to a tax aspect of a transaction that causes the transaction to be a reportable transaction.” irs, instructions for irs form 8918, at 1 (rev. nov. 2021). 136 columbia journal of tax law [vol: 13:2 income above a certain threshold in respect of that transaction.97 the definition of material advisors is substantially broader than the organizer definition under the tax shelter registration rules and could include lawyers, brokers, accountants and other advisors that were not previously required to register with the irs under the tax shelter registration rules.98 furthermore, the ajca repealed the tax shelter registration rules, thereby bringing all disclosure obligations under one regime.99 the ajca also increased the penalties for failure to comply with the rules.100 thus, under the current u.s. reportable transactions regime, all taxpayers who have participated in a reportable transaction and all material advisors with respect to that transaction must concurrently disclose the transaction on forms specified by the irs for this purpose.101 parallel reporting requirements were intended to ensure that no tax shelter abusers avoided irs detection.102 material advisors must also prepare and maintain for seven years a client list for every class of reportable transactions.103 material advisors must provide the assigned reportable transaction number to the relevant taxpayers so that it can be reported in their respective tax returns.104 the reportable transaction disclosure regime in the united states has been credited for playing a critical role in the government’s crackdown on corporate tax shelters and various tax avoidance practices.105 this has led one lawyer to exclaim, 97 ajca § 815 (codified at i.r.c. §§ 6111, 6112). 98 see bruce l. ashton & robin c. gilden, new tax shelter rules under ajca: advisors beware, asppa asap, nov. 23, 2004, at 1 (“lawyers and cpas would almost certainly be material advisors, as would brokers and investment advisors.”). see also supra text accompanying note 53. the role of tax advisors in tax compliance had been previously studied in steven klepper & daniel nagin, the role of tax preparers in tax compliance, 22 pol’y sci. 167 (1989). 99 see u.s. gov’t accountability off., gao-11-493, abusive tax avoidance transactions: irs needs better data to inform decisions about transactions, (2011). 100 see i.r.c. §§ 301.6707, 301.6707a. 101 see treas. reg. §§ 1.6011-4, 301.6111-3. the relevant forms are form 8886 for taxpayers, and form 8918 for material advisors. for taxpayers, the disclosure must be made by attaching form 8886 to the tax returns, for each taxable year for which the taxpayer participates in the reportable transaction, whilst for material advisors, the disclosure must be made by filing form 8918 by the “last day of the month that follows the end of the calendar quarter in which the advisor became a material advisor with respect to the transaction.” see treas. reg. §§ 1.6011-4(e), 301.6111-3(e). for the disclosure to be considered complete, the information provided on the form must: (i) identify and describe the transaction in sufficient detail for the irs to be able to understand the tax structure of the transaction; (ii) identify all parties involved in the transaction (for taxpayers) or any material advisor(s) whom the material advisor knows or has reason to know acted as a material advisor with respect to the transaction (for material advisors); (iii) describe the expected tax treatment and all potential tax benefits expected to result from the transaction; and (iv) describe any tax result protection with respect to the transaction. 102 see u.s. dep’t treasury, the treasury department’s enforcement proposals for abusive tax avoidance transactions 2 (2002). 103 see treas. reg. § 301.6112-1. in this list, the following details for each client must be retained: (i) the date the reportable transaction was entered into; (ii) the amount invested; (iii) the tax treatment intended or expected to be derived from participation in the transaction; and (iv) the identity of other material advisors to the transaction. copies of any tax analyses or opinions provided to one or more clients or prospective clients must also be attached to the client list. 104 see treas. reg. § 301.6111-3(d). 105 see joshua d. blank, united states national report on mandatory disclosure rules, 2022] mandatory disclosure rules 137 “the tax shelter war is over. the government won.”106 in particular, after the introduction of these rules, the united states saw fewer marketed tax products while companies dedicated measurably more time to tax reporting instead of tax planning.107 the government was also able to reclaim some lost revenue.108 however, while the reportable transaction disclosure regime has helped the irs to detect and deter various tax avoidance practices, it has not fully eliminated corporate tax avoidance and aggressive tax planning, especially by multinational enterprises (mnes) engaged in cross-border transactions, as further discussed in the next part.109 b. united kingdom in 2004, the united kingdom adopted reporting requirements similar to the u.s. reportable transactions regime. the disclosure of tax avoidance schemes (dotas) regime110 was adopted to “introduce transparency in relation to the mandatory disclosure rules (forthcoming 2022), https://papers.ssrn.com/sol3/papers. cfm?abstract_id=3890935 [https://perma.cc/tq8f-99rf] (“government officials and academics in the us have widely praised the reportable transaction disclosure regime as an effective response to the tax shelter problem.”). 106pamela f. olson, now that you've caught the bus, what are you going to do with it observations from the frontlines, the sidelines, and between the lines, so to speak, 60 tax law. 567, 567-81 (2007). 107 see id. at 567-68 (“[t]ax departments were spending 23% of their time on tax financial reporting requirements in 2006, compared to 9% in 2004. during the same period, the time spent on tax planning decreased from 28% to 20%.”). 108 for example, in 2004 the irs allowed taxpayers who had participated in so-called “son of boss” tax shelters, one of the listed transactions, to voluntarily come forward and close out their tax disputes by paying the owed tax and certain penalties. over one-thousand taxpayers responded and the irs was able to obtain over $3.2 billion in unpaid taxes and penalties. for more, see id. at 569; i.r.s. notice 2000-44, 2000-2 c.b. 255; i.r.s. announcement 2004-46, i.r.b. 2004-21. 109 there were some indications that schemes moved overseas in order to avoid u.s. reporting. see u.s. gov’t accountability off., supra note 99 (“one theme that emerged from gao’s discussions with these experts is that [abusive tax avoidance transactions] marketed by promoters to corporations and wealthy individuals have declined in recent years, although the experts had different views on the extent of the decline. they also said that [abusive tax avoidance transactions] have become more international in nature.”). see also infra part iii. for further discussion on the current state of the u.s. reportable transactions regime and some proposals for reform, see joshua d. blank & ari glogower, the trouble with targeting tax shelters, 74 admin. l. rev. (forthcoming 2022). 110 as contained in part 7 of the finance act 2004, and its implementing regulations: (i) the tax avoidance schemes (prescribed descriptions of arrangements) regulations 2006, si 2006/1543 (as amended by si 2009/2033, si 2010/2834, si 2013/2595, si 2016/99, and si 2017/1171) [hereinafter arrangement regulations]; (ii) the tax avoidance schemes (promoters and prescribed circumstances) regulations 2004, si 2004/1865 (as amended by si 2004/2613 and si 2015/945) [hereinafter promoter regulations]; (iii) the tax avoidance schemes (information) regulations 2012, si 2012/1836 (as amended by si 2013/2592, si 2015/948, and si 2017/1171) [hereinafter information regulations]; and (iv) the finance act 2014 (high-risk promoters prescribed information) regulations 2015, si 2015/549. also compare taxes management act 1970, c. 9 § 98c (uk), which sets out the penalties for persons who fail to provide the information required by part 7, with the level of penalties set out in the tax avoidance schemes (penalty) 138 columbia journal of tax law [vol: 13:2 marketing and use of tax avoidance schemes” and close down such schemes more quickly.111 the dotas regime was preferred over other means of obtaining enhanced information, such as establishing a pre-transaction ruling mechanism or increasing the disclosure requirements in tax returns because it would provide realtime information and easier identification of the schemes by the tax authority.112 under the dotas regime, promoters113 of “notifiable arrangements or proposals” must disclose specified details of the schemes to hmrc within the stated time period, with taxpayers only residually subject to the disclosure obligation where there is no promoter in respect of the arrangement, where the promoter is resident outside of the united kingdom and does not make a disclosure, or where the promoter is prevented by legal professional privilege (lpp) from making a disclosure.114 an arrangement or proposal is notifiable if three conditions are met. the first condition is that the arrangement will or might be expected to enable a person to obtain a uk tax advantage.115 the second condition is that obtaining that advantage is or might be expected to be one of the main benefits of the arrangement.116 the third condition is that the arrangement bears one or more of the hallmarks applicable to the type of scheme in question.117 similar to the u.s. rules, the dotas regime contains confidentiality118 and loss-scheme hallmarks.119 however, the hallmarks in the u.s. and uk regimes are not identical. for example, in the uk these hallmarks employ an “informed observer test” under which a hypothetical informed observer must determine whether a scheme is primarily designed to procure tax advantages through losses.120 in addition to the confidentiality and loss-scheme hallmarks, the dotas regime also contains regulations 2007, si 2007/3104 (as amended by si 2010/2743), and hm revenue & customs, disclosure of tax avoidance schemes: guidance, gov.uk, https://www.gov.uk/government/publications/disclosure-of-tax-avoidance-schemesguidance/disclosure-of-tax-avoidance-schemes [https://perma.cc/ 2wnd-a4d2] (feb. 1, 2022). 111 see department of inland revenue, regulatory impact assessment: tackling tax avoidance – disclosure requirements, 2004, at 1-2 (uk). 112 see id. 113 a “promoter” is defined as any person, who, in the course of a business involving the provision of services relating to tax or a business carried on by a bank or securities house, (a) is to any extent responsible for the design of a scheme (unless he/she passes one of the “benign,” “nonadvisor” or “ignorance” tests set out in reg. 4 of the promoter regulations); (b) organizes or manages the implementation of a scheme; (c) makes a firm approach to another person with a view to making a scheme available for implementation by that person or others; or (d) makes a scheme available for implementation by others. hm revenue & customs, supra note 110. see also finance act of 2004 § 307. 114 finance act of 2004 §§ 309-10. there are also special rules when there is more than one promoter. see hm revenue & customs, supra note 110; finance act of 2004 § 308. 115 see finance act of 2004 § 306. 116 see id. 117 see id. 118 see hm revenue & customs, supra note 110. see also si 2006/1543, reg. 6 (as amended by si 2013/2595). 119 see hm revenue & customs, supra note 110, § 7.7; si 2006/1543, reg. 12. the hallmark was later amended by si 2016/99. 120 si 2006/1543, reg. 12, supra note 110. the informed observer test is also applied to the standardized tax products hallmark. si 2006/1543, reg. 10 (as amended by si 2016/99). 2022] mandatory disclosure rules 139 several other hallmarks including those relating to the payment of a premium fee to a promoter,121 the sale of a standardized tax product,122 leasing arrangements,123 employment income,124 and when a tax advantage is from the inclusion of a financial product in an arrangement.125 a reportable arrangement must be reported by the promoter within five business days beginning with the day after the promoter makes the scheme available for implementation or becomes aware of a transaction forming part of the scheme, whichever is earlier.126 where the disclosure obligation falls upon the taxpayer, disclosure must be made within 30 days of the taxpayer entering into the first transaction that is part of the reportable scheme.127 the dotas regime also imposes similar client list and scheme reference number (srn) requirements found in the u.s. rules, but with additional obligations on promoters to provide the lists to hmrc on a quarterly basis, and on clients to pass on the srn to any other person who may reasonably be expected to benefit from the scheme.128 in addition to the differences already mentioned, the uk regime differs from the u.s. regime in that it takes a promoter-based approach while the u.s. regime takes a transaction-based approach.129 in a promoter-based approach, the language of the law focuses more on the role played by the promoter in the transaction.130 in contrast, a transaction-based approach focuses more closely on identifying problematic transactions than problematic promoters.131 these differences manifest themselves in who has an obligation to report and what types of hallmarks are relied upon in the law.132 in a transaction-based approach, reporting obligations may fall on both promoters and taxpayers, whereas in a promoter-based approach the obligation mainly falls on the promoter.133 moreover, 121 see hm revenue & customs, supra note 110, § 7.5; si 2006/1543. 122 see hm revenue & customs, supra note 110, § 7.6; si 2006/1543, reg. 10 (as amended by si 20162016/99). 123 see hm revenue & customs, supra note 110, § 7.8; si 2006/1543, reg. 13-17. 124 see hm revenue & customs, supra note 110, § 7.9; si 2006/1543, reg. 18. 125 see hm revenue & customs, supra note 110, § 7.10; si 2006/1543, reg. 19 (as amended by si 2016/99). see also arrangement regulations (more details on all of the uk hallmarks). 126 see information regulations; hm revenue & customs, supra note 110. 127 see finance act of 2004 §§ 308, 310; information regulations, reg. 5. similar to the u.s. rules, under the dotas regime, the disclosure must include “sufficient information as might reasonably be expected to enable an officer of the hmrc to comprehend the manner in which the proposal or arrangement is intended to operate,” including (i) the promoter’s and co-promoters’ (for notification by promoter), or the scheme user’s and the promoter’s (for notification by scheme user) name and address; (ii) details of the provision by virtue of which the arrangements are notifiable; (iii) a summary of the arrangements and the name (if any) by which they are known; (iv) information explaining each element of the arrangements (including the way in which they are structured) from which the tax advantage expected to be obtained under the arrangements arises; and (v) the statutory provisions, relating to any of the prescribed taxes, on which the tax advantage is based. see information regulations, reg. 4. 128 see finance act of 2004 §§ 312, 313, 316; information regulations, reg. 6, 8b. 129 see action 12, supra note 22, at 32. 130 see id. 131 see id. 132 see id. 133 this is reflected in the differences between the u.s. and uk regimes. see supra notes 95, 113 and the accompanying text. 140 columbia journal of tax law [vol: 13:2 a promoter-based regime uses generic hallmarks that focus on whether there is an intended tax benefit.134 a transaction-based approach, on the other hand, would instead rely more on specific hallmarks.135 thus, the uk regime, following a promoter-based approach, lists generic hallmarks which indicate reportability by the promoter only if the main outcome of the arrangements is a tax benefit. despite these differences, there does not appear to be a significant difference in the efficacy of each approach.136 c. other countries similar reporting regimes were adopted in other countries, including south africa in 2005, portugal in 2008, ireland in 2011, and canada in 2013.137 these countries adopted reporting regimes to better detect and address tax avoidance practices.138 various sources indicate that earlier regimes influenced the adoption of these new regimes.139 additionally, during this period, several other countries 134 see action 12, supra note 22, at 32. 135 see id. it should be noted that the united states, despite employing a transaction-based approach, does use generic hallmarks. thus, the differences between a transaction-based approach and a promoter-based approach exist on a spectrum. 136 the oecd has noted that both promoter-based approaches and transaction-based approaches are generally equally effective. see action 12, supra note 22, at 32. see also antony seely, house of commons, tax avoidance: a general anti-avoidance rule – background history (1997-2010), briefing paper no. 2956 (2020). 137 see the revenue laws amendment act 45 of 2003, which introduced mdrs in a new § 76a of the income tax act 58 of 1962 (south african ita) that came into effect in 2005 (the mdrs were subsequently transferred to §§ 80m-80t of the south african ita in 2008, and to §§ 34 to 39 of the taa in 2012) (for south africa); the decreto-lei n.º 29/2008 de 25 de fevereiro [decreelaw no. 29/2008], https://dre.pt/dre/detalhe/decreto-lei/29-2008-247717, which came into effect in may 2008 (for portugal); chapter 3 of part 33 of the taxes consolidation act 1997 (act no. 39/1997), https://www.irishstatutebook.ie/eli/1997/act/39/enacted/en/html (comprising §§ 817d817o), which came into effect in january 2011 (for ireland); income tax act, r.s.c. 1985, c c-1 § 237.3, which came into effect in june 2013 (for canada). 138 for south africa, see national treasury, explanatory memorandum on the revenue laws amendment bill, at 75 (2003) (“it is proposed that special reporting rules for transactions that contain indicators of potential tax avoidance be introduced. the purpose of this reporting system is to uncover ‘innovative’ corporate tax products that effectively cost the tax system hundreds of millions (and perhaps even billions) of rand annually.”). for ireland, see committee stage debates on the finance bill in the houses of the oireachtas § 141 (feb. 24, 2010) (“the primary purpose of the new disclosure regime is to constitute what can be regarded as an effective early warning system by obtaining information on aggressive tax avoidance schemes at an early stage before a loss of taxation becomes apparent. the government can decide, if appropriate, to close such schemes down before they can do significant damage to tax revenues. mandatory disclosure will provide the revenue commissioners with an important instrument to tackle tax avoidance schemes that are leading to a significant loss of taxation revenue”). for portugal, see the introduction to decree-law 29/2008. for canada, see dep’t of finance canada, background and description of the proposals (may 7, 2010); dep’t of finance canada, explanatory notes in respect of legislative proposals relating to the income tax act and related acts and regulations, at 208 (sept. 2010); dep’t of finance canada, explanatory notes relating to the income tax act, the excise tax act and related legislation, at 446 (oct. 2012). 139 in south africa, the guidance issued by the government in 2005 describes at the beginning 2022] mandatory disclosure rules 141 adopted reportable transaction disclosure regimes that apply solely to the taxpayers and not to promoters or other intermediaries.140 despite the common origins and aims of the reporting regimes adopted between 2005 and 2013 in south africa, portugal, ireland, and canada, the substance of the rules differs, primarily on three fronts: the persons subject to the disclosure obligations, the transactions required to be disclosed, and the time when disclosure must be made. below we outline the key features of the mdrs in each of these countries. south africa adopted its “reportable arrangements” regime in 2005.141 under this regime, the primary disclosure obligation is on the promoter of the arrangement.142 if there is no resident promoter, then other “participants” of the arrangement are subject to the disclosure obligations.143 transactions that are regarded as reportable include listed arrangements and arrangements expected to of the guide the disclosure requirements in the united kingdom, the united states, and canada. see south african revenue service, reportable arrangement guide 2 (mar. 1, 2005). for ireland, see committee stage debates on the finance bill in the houses of the oireachtas § 141 (feb. 24, 2010) (“other jurisdictions such as the united kingdom, south africa, new zealand, australia, and the united states all have running through their legislation a common purpose, namely, the need to know as early as possible the details of schemes they may not consider acceptable. timely information is crucial to combating tax avoidance. it is only where schemes are known that they can be challenged and, where appropriate, existing legislation amended or new legislation introduced to deal with them. the earlier in the life cycle of a scheme that the tax authorities learn about it, the more effectively it can be closed down before it inflicts significant fiscal damage.”). in portugal, the introduction to decree-law 29/2008 cites the disclosure regimes of the united states, canada, and united kingdom as influences. in canada, several publications mentioned the u.s. and uk regimes as a model for canada’s regime. see gilles n. larin & robert duong, effective responses to aggressive tax planning what canada can learn from other jurisdictions instalment 4: united kingdom disclosure rules, rsch. chair tax’n & pub. fin. (july 2009); gilles larin, some thoughts on disclosure rules in canada: a peek into the future, 61 can. tax j. 209 (2013). 140 for example, israel adopted in 2007 a reporting requirement for taxpayers participating in certain reportable transactions. see income tax regulations (reportable tax planning) 5767-2006; vat regulations (reportable tax planning) 5767-2006. australia introduced in 2011 a reportable tax position regime which requires corporate taxpayers to report certain tax position. see michael walpole & david salter, regulation of tax agents in australia, 12 ejtr 335, 355-56 (2014). as these regimes do not impose reporting obligations on intermediaries, they are outside the scope of this article. 141 south africa initially imposed the disclosure obligation on corporate and trust taxpayers only, and only in respect of listed transactions (essentially, those involving hybrid instruments), and transactions that provide for a variation of interest, fees, etc. if the actual tax benefits differed from the anticipated tax benefits. however, the number of disclosures proved disappointing. it was noted that taxpayers “raised technical points to avoid reporting or restructured their transactions to avoid the triggers for reporting.” the mdrs were therefore substantially amended, to impose the primary disclosure obligation on promoters, and to widen the scope of the arrangements subject to the reporting requirement, with a catch-all “hallmark” linked to the gaar. see sars, explanatory memorandum on the revenue laws amendment bill 2006, at 61-66 (2006). see also sars, media release – new reportable arrangements legislation takes effect (apr. 9, 2008). 142 “promoter” is defined under taa § 34 as “[the person] principally responsible for organising, designing, selling, financing or managing the… arrangement.” 143 taa § 37. see taa § 34 which states that a “‘participant’, in relation to an ‘arrangement’, means— (a) a ‘promoter’; or (b) a company or trust which directly or indirectly derives or assumes that it derives a ‘tax benefit’ or ‘financial benefit’ by virtue of an ‘arrangement.’” 142 columbia journal of tax law [vol: 13:2 give rise to a tax benefit if they have certain hallmarks.144 a reportable transaction must be disclosed within 45 business days after an amount is first received, paid or incurred by a participant.145 portugal adopted its reporting regime for abusive tax planning arrangements in 2008. under this regime, the primary disclosure requirement is on promoters of the scheme, and scheme users are only subject to the disclosure obligation if there is no resident promoter.146 transactions that must be reported include those aimed at obtaining, solely or as its main purpose, a tax advantage147 by a taxable person and that have certain hallmarks.148 these schemes must be disclosed within 20 days following the end of the month in which the scheme was made available to clients or in which the scheme was implemented.149 ireland adopted its mandatory disclosure regime in 2011.150 under this regime, the primary disclosure obligation is on the promoters of the transaction.151 transactions that must be reported include those which fall within a set of specified categories, those that are expected to enable a tax advantage, and those for which one of the main benefits is expected to be a tax advantage.152 the disclosure must be made within five business days.153 canada adopted its reportable transaction disclosure regime in 2013.154 under this regime, there are parallel disclosure obligations on every beneficiary, scheme user, and advisor or promoter entitled to a fee in respect of the transaction.155 transactions that must be disclosed include those that are undertaken to obtain a tax benefit156 and bear at least two of three hallmarks.157 disclosures must be made “on or before june 30 of the calendar year following the calendar year in which the transaction first became a reportable transaction in respect of the person.”158 144 see taa § 35 for the specified hallmarks. 145 see taa § 37(4). 146 see decreto-lei n.º 29/2008 de 25 de fevereiro [decree-law no. 29/2008 of 25 february], arts. 8-10, https://dre.pt/dre/detalhe/decreto-lei/29-2008-247717. 147 see id. art. 3. 148 see id. art. 4 for the specified hallmarks. 149 see id. art. 7. 150 see chapter 3 of part 33 of the taxes consolidation act 1997 (tca) (comprising §§ 817d to 817o), which came into effect in january 2011. ireland’s mdrs were modeled on, and are thus substantially similar to the uk dotas regime, although additional triggers for reporting can be found in the irish mdrs. 151 scheme users are subject to the disclosure obligation if there is no resident promoter, the promoter is outside of the state or the promoter asserts that lpp prevents the disclosure from being made. see tca §§ 817e-817h. 152 see tca § 817d. see also mandatory disclosure of certain transactions regulations 2011, si no. 7 (2011), as amended by the mandatory disclosure of certain transactions (amendment) regulations 2015, si no. 28 (2015). 153 see tca §§ 817e. 154 see income tax act, r.s.c. 1985, c c-1 § 237.3, which came into effect in june 2013. 155 see id. § 237.3(2). 156 see id. § 237.3. 157 see id. § 237.3(1) for the hallmarks. 158 id. § 237.3(5). 2022] mandatory disclosure rules 143 iii. third generation: 2015-present following their demonstrated success across multiple jurisdictions in the 2000s and early 2010s, mdrs have begun proliferating globally at a muchaccelerated pace since 2015. this is primarily due to the work of the oecd and the eu. while their diffusion had once proceeded gradually on a country-by-country basis, mdrs are now being adopted simultaneously across different jurisdictions. the new mdrs, and in particular dac 6 and crs mdrs, are substantially different from their predecessors. for example, dac 6 adopts much broader reporting requirements, expands the reportability of cross-border hallmarks, and imposes significant reporting obligations on a wide set of intermediaries. a. dac 6 no jurisdiction has adopted mdrs as expansively as the eu member states. in 2018, the eu adopted council directive 2018/822 (dac 6).159 dac 6 requires all eu member states to implement domestic mdrs for cross-border transactions based on certain mandatory provisions adopted by the eu.160 at present, all 27 member states have transposed dac 6 into their national laws.161 159 see council directive (eu) 2018/822 amending directive 2011/16/eu as regards mandatory automatic exchange of information in the field of taxation in relation to reportable cross-border arrangements 2018 o.j. (l 139). see also european commission, questions and answers on new tax transparency rules for intermediaries (june 21, 2017); european commission, directorate general for taxation and customs union, summary report responses received on disincentives for advisors and intermediaries for potentially aggressive tax planning schemes (june 2017), which provides important information on pre-dac 6 perspectives on mdrs from various stakeholders in the eu including trade/business associations, national/regional parliaments, law firms, tax consultancies, financial institutions, academic institutions, private citizens, ngos, and others. among those surveyed 69% believed that mdrs for intermediaries would change aggressive tax planning schemes and 44% believed that there was a need for mdrs compared to 23% who believed there was no need. among the ngos surveyed 93% believed there was a need for mdrs while only 17% of tax consultancies and advisors shared that opinion. 160 see dac 6, supra note 9, art. 2. as a directive, dac 6 requires member states to take necessary measures to implement its mandatory provisions by dec. 31, 2019, and to apply their implementing provisions starting july 1, 2020. 161 for detailed information on the status of each member state’s individual dac 6 regime, see mandatory disclosure requirements – updates, kpmg (june 4, 2021). see also anna vilke & gunta linde, latvia – dac 6 domestic implementation, baker tilly, https://www.bakertilly.global/media/7978/latvia.pdf [https://perma.cc/ 64qe-cc92] (for latvia); lithuania publishes law to implement eu directive on reportable cross-border arrangements, orbitax (aug. 27, 2019), https://www.orbitax.com/news/archive.php/ lithuania-publishes-law-toimp-3950027 [https://perma.cc/7lcg-gzv7] (for lithuania); spain: transposition of eu directive (dac 6) completed, kpmg (may 5, 2021), https://home.kpmg/us/en/home/insights/2021/05/tnfspain-transposition-eu-directive-dac6-completed.html [https://perma.cc/n6lv-feyn] (for spain); andra casu & alexandra ovedenie, mandatory disclosure regime mdr, 2019 tax mag. 190 (2019) (for romania); baker mckenzie luxembourg, diego duarte de oliveira & olivier dal farra, mandatory disclosure rules (dac6): a look at private equity investment in luxembourg, int’l tax rev. (2020) (for luxembourg); flavia vespasiani & bognandi stefano, dac 6 and hallmarks addressing tp in italy, int’l tax rev. (, 2021) (for italy). most member states have closely aligned their tax policy to dac 6 (i.e., cross-border arrangement reporting and obligatory 144 columbia journal of tax law [vol: 13:2 dac 6 is significant since it not only adopts the best practices recommended by the oecd but goes further.162 given that the eu often sets an example for other countries to follow and that its rules apply to 27 countries, dac 6’s impact could be far-reaching. dac 6 builds upon beps action 12.163 the oecd’s beps project aimed to address weaknesses in the international tax system.164 of the 15 action reports, published in october 2015, action 12 called on countries to adopt and implement mdrs.165 action 12 includes a comprehensive set of recommendations for the design and implementation of mdrs.166 while most mdrs at the time were intermediary reporting). however, poland has extended its regime to cover domestic arrangements in addition to cross-border arrangements. this is also true in portugal and ireland where the new dac 6 rules have built upon existing mdrs. 162 for a discussion of the components of dac 6 while it was still in development, see franklin cachia, tax transparency for intermediaries: the mandatory disclosure rules and its eu impact, 27 ec tax rev. 206 (2018). see also dimitar hristov & anna zeitlinger, the impact of the proposed eu directive on tax intermediaries on the austrian foundation as tax planning tool, 24 trusts & trustees 526 (2018) for a discussion on the projected impact of dac 6 on austrian intermediaries. 163 see carole hein, eric centi & julien lamotte, dac 6: one directive, several applications, int’l tax rev. (2020) (“the european union (eu) directive on the mandatory automatic exchange of information in the field of taxation in relation to reportable cross-border arrangements (commonly known as dac6) comes from the beps initiative, notably from the beps action 12 report on the mandatory disclosure rules (mdr).”). 164 for further background about the beps project, see oecd, oecd/g20 base erosion and profit shifting project, explanatory statement: 2015 final reports, at 4 (2015), https://www.oecd.org/ctp/beps-explanatory-statement-2015.pdf [https://perma. cc/x5t7-5tds]. for extensive literature on the beps project, see, e.g., reuven s. avi-yonah & haiyan xu, evaluating beps: a reconsideration of the benefits principle and proposal for un oversight, 6 harv. bus. l. rev. 185 (2016); rifat azam, ruling the world: generating international tax norms in the era of globalization and beps, 50 suffolk u. l. rev. 517 (2017); yariv brauner, treaties in the aftermath of beps, 41 brook. j. int’l l. 973 (2016); irene burgers & irma mosquera, corporate taxation and beps: a fair slice for developing countries?, 10 erasmus l. rev. 29 (2017); allison christians, beps and the new international tax order, 2016 byu l. rev. 1603 (2016); arthur j. cockfield, shaping international tax law and policy in challenging times, 54 stan. j. int’l l. 223 (2018); mindy herzfeld, the case against beps: lessons for tax coordination, 21 fla. tax rev. 1 (2017); wu inst. for austrian & int’l tax l., implementing key beps actions: where do we stand? (michael lang et al. eds., 2019). 165 note that prior to the beps project in 2013-2015, the oecd had already noted the importance of timely, targeted, and comprehensive information to counter aggressive tax planning and the existence of mdrs in certain oecd countries in its report, tackling aggressive tax planning through improved transparency and disclosure – report on disclosure initiatives (feb. 2011). however, it was not until the beps initiative that the oecd proposed a set of comprehensive measures to tackle these issues. for further discussion on aggressive tax planning and harmful tax competition in the context of beps and various actions taken by the european union, see ana paula dourado, aggressive tax planning and harmful tax competition, in research handbook on european union taxation law 390 (christiana hji panayi, werner haslehner & edoardo traversa eds., 2020). see also tatjana svažič, anti-beps measures and their impact on business performance of multinational enterprises, 65 naše gospodarstvo/ our econ. 99 (2019) for an explanation and prediction of the consequences of beps (including action 12) on the tax and profits of mnes. 166 see action 12, supra note 22. the recommendations are largely uncontroversial: imposing a parallel or primary disclosure obligation on promoters and taxpayers; establishing a mechanism to 2022] mandatory disclosure rules 145 focused on domestic transactions, the action 12 recommendations specifically called for a comprehensive set of cross-border hallmarks and a system for the exchange of information.167 at first, action 12 had little impact on the global tax environment because it was not included in the beps project’s minimum standards; it is considered as non-binding “soft law.”168 this changed in 2018 when the eu adopted dac 6. though dac 6 incorporates many of the action 12 recommendations and adopts the same basic structure as other mdrs, it is more extensive in scope in three significant respects: the persons subject to the reporting obligations, the transactions subject to reporting, and the information exchange requirements. first, regarding who needs to report, the primary disclosure obligation under dac 6 rests not only on promoters but also on all intermediaries of the arrangement. intermediaries under dac 6 means both promoters and “any person that . . . knows or could be reasonably expected to know that they have undertaken to provide, directly or by means of other persons, aid, assistance or advice with respect to designing, marketing, organizing, making available for implementation or managing the implementation of a reportable cross-border arrangement.”169 save for a nexus requirement, the definition is not subject to any qualification, such as a materiality threshold.170 any service providers, including lawyers and accountants, who provide any “aid, assistance or advice” on the design, marketing or track disclosures and to link disclosures to scheme users; linking the timing of disclosure to when the scheme is first made available for implementation or when the scheme is first implemented; introducing penalties to ensure compliance; and having a mix of generic and specific hallmarks to target both known schemes and general areas of concern. recommended generic hallmarks include the following: confidentiality, premium fee, contractual protection, and standardized tax product hallmarks. while action 12 recognizes that different combinations of hallmarks may be suitable for different countries, it does provide a list of specific hallmarks including those for loss schemes (inspired by the mdrs in the united states, the united kingdom, canada, ireland, and portugal), leasing arrangements (inspired by the united kingdom), employment schemes (inspired by ireland), converting income schemes (inspired by ireland and portugal), schemes with entities in low tax jurisdictions (inspired by portugal), arrangements involving hybrid instruments (inspired by south africa), transactions with significant book-tax differences (inspired by the united states), listed transactions (inspired by the united states), and transactions of interest (inspired by the united states). 167 some of the recommended cross-border hallmarks include the following: multiple claims of deductions for depreciation or amortization in respect of the same asset; multiple claims of relief from double taxation in respect of the same item of income; the making of deductible cross-border payments to associated enterprises that are not resident for tax purposes in any jurisdiction or that are resident in a jurisdiction that does not impose income tax; transfers of assets where there is a material difference in the amount being treated as payable, in consideration for the assets involved. see action 12, supra note 22, at 68-69. 168 oecd, oecd/g20 base erosion and profit shifting project: 2015 final reports: frequently asked questions, at 5 (2015). 169 dac 6, supra note 9, art. 1(1). the focus of action 12 is on promoters and taxpayers, not other intermediaries and especially not those without any material connection to the tax aspects of the transaction. see action 12, supra note 22, at 33-36, 74. 170 for intermediaries to be subject to the reporting obligation, they must either be tax-resident, incorporated or registered with a professional association related to legal, tax or consultation services, or have a permanent establishment (pe), in a member state. see dac 6, supra note 9, art. 1(1). 146 columbia journal of tax law [vol: 13:2 implementation of a reportable scheme would therefore be subject to the primary reporting obligations.171 this is substantially different than the u.s. regime which only applies to material advisors who give tax statements to their clients.172 under dac 6 there is no such requirement for the intermediary to give any tax-related statements or services. thus, dac 6 applies to a much larger set of intermediaries than the u.s. regime. some have asserted that this broad definition might jeopardize the functioning of the overall tax system, promote harmful over-disclosure, and possibly infringe on the rights of taxpayers.173 others have worried about the effects of dac 6 on legal professional privilege.174 given these concerns, the constitutional courts of several eu member states are currently evaluating the consistency of dac 6 with both eu law and the laws of member states.175 such resistance is unsurprising given that dac 6, in some sense, represents a reinvention of how tax administrations, taxpayers and intermediaries approach tax policy and transparency in the eu.176 171 dac 6, supra note 9, art. 1(2). 172 see treas. reg. § 301.6111-3. see also supra note 97. 173 for further discussion on the possible complications associated with dac 6, see daniel w. blum & andreas langer, at a crossroads: mandatory disclosure under dac-6 and eu primary law – part 1, eur. tax’n 282 (2019); daniel w. blum & andreas langer, at a crossroads: mandatory disclosure under dac-6 and eu primary law – part 2, eur. tax’n 313 (2019); andrea ballancin & francesco cannas, the ‘dac 6’ and its compatibility with some of the founding principles of the european legal system(s), 29 ec tax rev. 117 (2020); arthur bianco, dac 6 and the challenges arising from its disclosure obligation, 30 ec tax rev. 8 (2021); bart peeters & lars vanneste, dac 6: an additional common eu reporting standard? 12 world tax j. (2020); bernhard fiedler & tino duttiné, dac 6: developing a common notification platform, in liquid legal 493 (kai jacob, dierk schindler & roger strathausen eds., 2020); rohit reddy muddasani, “dual citizenship and the directive on administrative cooperation (dac6) of the european union,” master’s thesis, (norwegian school of economics, 2021); danilo penetrante ventajar, “aggressive measures for aggressive schemes: human rights perspectives,” master’s thesis, (lund university, 2018); nevia čičin-šain, new mandatory disclosure rules for tax intermediaries and taxpayers in the european union – another “bite” into the rights of the taxpayer?, 11 world tax j. 77 (2019). čičin-šain, id., argues that the new intermediary reporting requirements may infringe on the right of a taxpayer to receive legal advice. čičin-šain also argues that the pace of dac 6’s implementation frustrates the right to legal certainty and that when the taxpayer is required to report his/her right to not self-incriminate may be violated. for a discussion on alternatives to dac 6, see ola nilsson, “sweden’s implementation of dac 6: a proportionate measure to prevent tax avoidance and evasion in the form of aggressive tax planning,” master’s thesis, (lund university, 2020). 174 see bianco, supra note 173; rayssa gutterres costa, “is there a collision between the eu charter and the obligation to notify that intermediaries with legal professional privilege have under dac 6?,” master’s thesis, (lund university, 2021); elke schwar, “tipping of justitia’s scale: the compatibility of mandatory disclosure for intermediaries with the right against self-incrimination and the right to confidentiality,” master’s thesis, (lund university, 2018); edward-hector spiteri, the maltese implementation of dac-6, novita fiscali (june 2021); david russell & toby graham, the deep state and the assault on confidentiality, 25 trusts & trustees 173 (mar. 2019). 175 see izabela andrzejewska-czernek et al., how do you do it? mdr in different eu member states, 61 eur. tax’n 1, 25 (aug. 30, 2021); danish mehboob, cjeu receives its first dac6 case from belgium high court, int’l tax rev. (feb. 22, 2021). 176 see, e.g., tim clappers & philip mac-lean, tax avoidance in the spotlight: the eu 2022] mandatory disclosure rules 147 second, regarding which transactions and arrangements are reportable, dac 6 contains a substantial number of cross-border hallmarks. dac 6 contains many of the generic and specific hallmarks commonly found in the mdrs of other jurisdictions.177 these include hallmarks for confidential arrangements, arrangements with fees contingent on the tax advantage, arrangements with standardized structures, and others.178 dac 6 also includes a main benefit test for some, but not all, hallmarks.179 importantly, however, dac 6, following the action 12 recommendations, incorporates the cross-border hallmarks listed as examples in action 12.180 while some of the mdrs predating dac 6 contained cross-border features, none of them have adopted a regime as comprehensive as the ones in dac 6.181 additionally, dac 6 introduces categories of hallmarks that are targeted at arrangements that might be used to facilitate tax evasion by adopting the crs mdrs described in the next part.182 dac 6 also introduces hallmarks targeted at arrangements that bear transfer pricing risks.183 third, dac 6 provides for a multilateral information exchange mechanism by requiring tax authorities of member states to communicate any information mandatory disclosure rules and their impact on asset managers and private equity, 21 finance and capital markets 1, 9 (june 3, 2019) (discussing the impact of dac 6 on the private equity industry). 177 see dac 6, supra note 9, annex iv for a full list. under dac 6, only “cross-border arrangements” are reportable. however, the term “cross-border arrangement” is very broadly defined: any arrangement that has one or more participants that is resident in another jurisdiction, that is simultaneously resident for tax purposes in more than one jurisdiction, that carries on business in another jurisdiction through a permanent establishment (pe) situated therein (provided that the arrangement forms part of the business of the pe), or that carries on an activity in another jurisdiction without being resident for tax purposes or without creating a pe in that jurisdiction, and any arrangement that has a possible impact on the aeoi or the identification of beneficial ownership, would be covered. see the definition of “cross-border arrangements” in dac 6, supra note 9, art. 1(1). 178 see dac 6, supra note 9, annex iv. 179 see id. 180 the cross-border hallmarks in dac 6 include “1. an arrangement that involves deductible cross-border payments made between two or more associated enterprises where at least one of the following conditions occurs: (a) the recipient is not resident for tax purposes in any tax jurisdiction; (b) although the recipient is resident for tax purposes in a jurisdiction, that jurisdiction either: (i) does not impose any corporate tax or imposes corporate tax at the rate of zero or almost zero; or (ii) is included in a list of third-country jurisdictions which have been assessed by member states collectively or within the framework of the oecd as being non-cooperative; (c) the payment benefits from a full exemption from tax in the jurisdiction where the recipient is resident for tax purposes; (d) the payment benefits from a preferential tax regime in the jurisdiction where the recipient is resident for tax purposes; 2. deductions for the same depreciation on the asset are claimed in more than one jurisdiction. 3. relief from double taxation in respect of the same item of income or capital is claimed in more than one jurisdiction. 4. there is an arrangement that includes transfers of assets and where there is a material difference in the amount being treated as payable in consideration for the assets in those jurisdictions involved.” dac 6, supra note 9, annex iv.c. 181 the u.s., uk, south african, and portuguese mdrs have had some cross-border elements. see, e.g., irs notice 2003-22 in which a cross-border transaction entitled offshore deferred compensation agreements is characterized as a listed transaction. however, many cross-border schemes are unlikely to be caught under these mdrs. see action 12, supra note 22, at 68-69. 182 see dac 6, supra note 9, annex iv.d. 183 see dac 6, supra note 9, annex iv.e. 148 columbia journal of tax law [vol: 13:2 obtained under their dac 6 mdrs to the tax authorities of all other member states. this is done by way of recording the information in a central repository within one month of the end of the quarter in which the information was filed.184 the information required to be exchanged includes the taxpayer’s personal and contact information, their tin, the details of the tax transaction, information on the hallmarks involved in the transaction, and other additional information.185 therefore, dac 6 has greatly expanded what should be reported, who should report, and how tax information should be shared between countries. it is possible that dac 6 is too broad, and that the cross-border hallmarks, the transfer pricing hallmarks, and the crs mdrs implemented in dac 6 are capturing too many legitimate transactions and arrangements. the compliance burden is also likely to be significant,186 and is complicated by the fact that each member state has implemented slightly different mdrs to comply with dac 6.187 as such, eu tax advisors will need to navigate 27 slightly different mdrs, whereas u.s. tax advisors, for example, only need to understand one regime when working on domestic u.s. tax schemes.188 ultimately, mdrs with the scope and reach of dac 6 have never been tested before, and it remains to be seen whether they effectively detect and deter the arrangements they seek to target. the limited data we currently have on the effects of dac 6 indicates that dac 6 is likely deterring tax avoidance but at a high cost.189 184 see dac 6, supra note 9, art. 1. 185 see dac 6, supra note 9, art. 1(2). 186 for further discussion on the compliance burden of dac 6, see christian kaeser, mark orlic & arne schnitger, dac 6 reporting requirements cause compliance headaches, 29 int’l tax rev. 22 (2018) (discussing the compliance burdens arising from dac 6, especially in the years 2018-2020 during which intermediaries and taxpayers faced significant reporting uncertainty as eu member states worked out national mdrs to implement dac 6). 187 for a detailed breakdown of the differences between each eu member state’s implementation of dac 6, see elisa casi-eberhard et al., one directive, several transpositions: a cross-country evaluation of the national implementation of dac6, 13 world tax j. 63 (2021) (proposing to reduce the compliance costs of 27 different dac 6 regimes by creating a unified reporting schema for the whole of the eu as opposed to allowing each country develop its own reporting schema). 188 for a further breakdown of the differences between u.s. mdrs and dac 6, see patricia a. brown et al., combating aggressive tax planning through disclosure: a comparison of u.s. and eu rules applicable to tax advisors, 38 aba tax times 10 (2019). 189 see alexander edwards et al., do third-party cross-border tax transparency requirements impact firm behavior? (rotman school of management, working paper no. 3792342, 2021), https://ssrn.com/abstract=3792342 [https://perma.cc/j7xt-39ue] (documenting empirical evidence showing that dac 6 has indeed deterred tax avoidance and that firms are now less likely to engage their auditors for tax-related services); raluca popa, dac 6 reporting, first conclusions. what should companies consider next?, tax mag. 124 (2021) (finding that romania only received 400 reports of cross-border transactions by jan. 1, 2021, a number lower than expected). see also andrzejewska-czernek et al., supra note 175, which surveyed tax practitioners in 11 eu member states for their thoughts on dac 6 and its recent implementation. the surveyed tax professionals argued that taxpayer obligations under dac 6 are “disproportionately burdensome,” that dac 6 may violate the nemo tenetur principle and “the principle of equal treatment or the free movement of persons or capital under eu law,” that dac 6 may violate legal professional privilege, and that the reporting requirements of dac 6 are far too vague. 2022] mandatory disclosure rules 149 b. crs mdrs for most of their existence, mdrs have been applied mainly as a measure to deter and detect basic forms of tax avoidance. however, in 2018 the oecd demonstrated the versatility of mdrs by applying them to crs avoidance which, in essence, targets potential tax evasion by the taxpayers who circumvent crs reporting.190 in general, under crs, financial institutions (fis) are required to identify account holders who are foreign tax residents and report their information to the local tax authority.191 the local tax authority then transfers this information to the tax authority of the account holders’ jurisdiction of tax residence.192 the main purpose of facilitating the automatic exchange of information (aeoi) is to detect and deter tax evasion practices that involve the holding of undisclosed offshore financial assets.193 while aeoi under crs is described by the oecd as “the largest exchange of tax information in history,”194 there are concerns that some tax evaders use loopholes and weaknesses in the crs regime to circumvent crs reporting and avoid detection.195 the oecd published the crs mdrs as part of efforts to address these loopholes and weaknesses, following the g7 finance ministers’ call for the oecd to “discuss possible ways to address arrangements designed to circumvent reporting under [crs] or aimed at providing beneficial owners with the shelter of non 190 see crs mdrs, supra note 9. tax evasion differs from tax avoidance in that the former typically involves intentionally misreporting or failing to report taxable income, assets or schemes to the authorities. tax evasion is generally unambiguously illegal. tax avoidance typically involves the exploitation of loopholes in tax requirements to minimize the tax burden without any falsified or inaccurate information submitted to the authorities. for further discussion, see erich kirchler et al., everyday representations of tax avoidance, tax evasion, and tax flight: do legal differences matter?, 24 j. econ. psychol. 535 (2003); paul merks, tax evasion, tax avoidance and tax planning, 34 intertax 272 (2006); joel slemrod, tax compliance and enforcement, 57 j. econ. lit. 904 (2019) (providing a survey of recent empirical literature on tax evasion and tax compliance). 191 see oecd, standard for automatic exchange of financial account information in tax matters (2014) [hereinafter crs]. 192 for further background about crs, see oecd, standard for automatic exchange of financial account information in tax matters 9–10 (2d ed. 2017); see also william h. byrnes, lexisnexis guide to fatca & crs compliance (2020). 193 see markus meinzer, automatic exchange of information as the new global standard: the end of (offshore tax evasion) history, in automatic exchange of information and prospects of turkish-german cooperation (leyla ateş & joachim englisch ed., 2017). 194 oecd, implementation of tax transparency initiative delivering concrete and impressive results, june 7, 2019, https://www.oecd.org/newsroom/implementation-of-tax-transparencyinitiative-delivering-concrete-and-impressive-results.htm, [https://perma.cc/729n-ukua]. 195 see, e.g., peter a. cotorceanu, hiding in plain sight: how non-u.s. persons can legally avoid reporting under both fatca and gatca, trusts & trustees 21: 1050–63 (2015); andres knobel & markus meinzer, “the end of bank secrecy”? bridging the gap to effective automatic information exchange: an evaluation of oecd’s common reporting standard, tax just. network (2014); andres knobel & frederik heitmüller, citizenship and residency by investment schemes: potential to avoid the common reporting standard for automatic exchange of information, tax just. network (2018). 150 columbia journal of tax law [vol: 13:2 transparent structures” as such arrangements frustrate the fight against tax evasion.196 crs mdrs are a model set of rules that can be adopted by countries voluntarily. crs mdrs adopt a disclosure framework similar to that recommended in action 12 and by the eu commission report that led to the drafting of dac 6.197 under crs mdrs, “crs avoidance arrangements” and “opaque offshore structures” are required to be reported. a crs avoidance arrangement is defined as “any arrangement for which it is reasonable to conclude…is designed to circumvent or is marketed as, or has the effect of, circumventing crs legislation or exploiting an absence thereof.”198 an opaque offshore structure “means a passive offshore vehicle that is held through an opaque structure.”199 these hallmarks specifically identify arrangements which attempt to avoid crs reporting or the identification of beneficial ownership. similar to dac 6, under crs mdrs, “intermediaries” of crs avoidance arrangements and opaque offshore structures are subject to the primary reporting obligation.200 an intermediary is defined under crs mdrs as being promoters (“any person responsible for the design or marketing of a crs avoidance arrangement or an opaque offshore structure”) and service providers (“any person that provides relevant services in respect of a crs avoidance arrangement or opaque offshore structure in circumstances where the person providing such services could reasonably be expected to know that the arrangement or structure is a crs avoidance arrangement or an opaque offshore structure.”)201 “relevant services” include “assistance or advice with respect to the design, marketing, 196 see g7 finance ministers, g7 bari declaration on fighting tax crimes and other illicit financial flows (may 13, 2017) at 2, http://www.g7.utoronto.ca/finance/170513-crime.html, [https://perma.cc/7brw-8ptz]. 197 see european commission, commission staff working document impact assessment accompanying the document proposal for a council directive amending directive 2011/16/eu as regards mandatory automatic exchange of information in the field of taxation in relation to reportable cross-border arrangements (june 21, 2017), https://eur-lex.europa.eu/legal-content/en/txt/?uri= celex:52017sc0236, [https://perma.cc/svy8-ylfp]. under the crs mdrs, the disclosure must include details of the arrangement, details of the users and other intermediaries in respect of the arrangement, and the jurisdictions in which the arrangement is made available for implementation, and must be made within 30 days after the intermediary makes the arrangement available for implementation. see crs mdrs, supra note 9, rules 2.2-2.3. users are only subject to the disclosure requirement where no intermediary is obligated to make full disclosure in the jurisdiction, whether because the arrangement was developed in-house and no external assistance was sought, or because all intermediaries engaged were either not incorporated, managed or resident in the jurisdiction or were prevented from making full disclosure due to legal professional privilege. see crs mdrs, supra note 9, rules 2.1, 2.4, 2.6. 198 crs mdrs, supra note 9, rule 1.1. 199 crs mdrs, supra note 9, rule 1.2. (“[a] passive offshore vehicle” means a legal person or legal arrangement that does not carry on a substantive economic activity supported by adequate staff, equipment, assets, and premises in the jurisdiction where it is established or is tax resident . . . .. an opaque structure is a structure for which it is reasonable to conclude that it is designed to have, marketed as having, or has the effect of allowing, a natural person to be a beneficial owner of a passive offshore vehicle while not allowing the accurate determination of such person’s beneficial ownership or creating the appearance that such person is not a beneficial owner.”). 200 crs mdrs, supra note 9, rule 2.1. 201 crs mdrs, supra note 9, rule 1.3. 2022] mandatory disclosure rules 151 implementation or organisation of that arrangement or structure.”202 thus, the reporting requirements under the crs mdrs capture a broad set of intermediaries, including service providers who do not provide tax statements or tax-related services. the oecd outlined a system of automatic exchange of information obtained from intermediaries.203 this system is structured such that jurisdictions which receive disclosures detailing a crs avoidance arrangement or an opaque offshore structure would automatically share that information with all other relevant jurisdictions that are also signatories to the crs mdrs.204 like the dac 6 system of automatic exchange, crs mdrs provide for the exchange of taxpayer contact information, their tins, the details of the arrangement, and information on which jurisdictions may be relevant parties to the arrangement.205 this information is to be shared only with the jurisdictions in which the taxpayer is resident for tax purposes.206 this differs from the dac 6 approach where the information is made available to all member states in a central repository.207 importantly, if an intermediary has already disclosed an arrangement to one jurisdiction that has also implemented crs mdrs and its automatic exchange of information framework, then the intermediary is not obligated to disclose again.208 adoption of crs mdrs is voluntary at this stage. countries are free to choose whether to adopt crs mdrs, and if so, how the rules should be drafted and what penalties to impose. some jurisdictions, such as the united kingdom, have adopted crs mdrs.209 the united kingdom had initially adopted dac 6 in january 2020, but following brexit decided to opt-out of some sections of dac 6.210 according to the eu-uk trade and cooperation agreement signed on december 30 2020, the uk is required only to implement the reporting standards agreed by the oecd.211 as a result, the united kingdom has chosen to only require the reporting of hallmarks under category d of dac 6, which are the crs mdrs’ hallmarks.212 while the reasoning for this reversal is not entirely clear, it is possibly related to concerns raised by british tax advisors about the complexities of dac 6 compliance and the united kingdom’s aspiration to be a taxpayer-friendly jurisdiction.213 202 crs mdrs, supra note 9, rule 1.4. 203 see oecd, supra note 26. 204 see id. at 5. 205 see id. at 9. 206 see id. 207 see supra note 184 and the accompanying text. 208 see crs mdrs, supra note 9, at rule 2.5(b) and (c). 209 see danish mehboob, uk opts out of dac6 to follow oecd rules after brexit, 32 int’l tax rev. 11 (2021). 210 see id. 211 see eu-uk trade and cooperation agreement, art. 383 (2020). the dotas rules continue to be in effect. 212 see international tax enforcement (disclosable arrangements) regulations 2020 (si 2020/25, as amended by si 2020/713 and si 2020/1649). 213 see mehboob, supra note 209 (“‘there will be many uk tax advisors very pleased to see this change, as the complexities of dac6 were such that there was a fear many uk advisors with 152 columbia journal of tax law [vol: 13:2 in addition to the united kingdom, the crown dependencies (jersey, guernsey, and the isle of man) are in the process of implementing the crs mdrs.214 gibraltar and south africa have also followed the united kingdom’s lead and adopted the crs mdrs.215 interestingly, each of these jurisdictions chose to adopt the crs mdrs over the eu’s dac 6. jersey gave two reasons for this decision. first, “[t]hese model rules reflect the international consensus in this area,” and second, “[t]he model rules are an oecd product. as such, jersey can take part in discussions as to their future development.”216 thus, despite the implementation of dac 6 across all eu member states, so far no outside jurisdictions have expressed interest in adopting that framework. moreover, with the adoption of crs mdrs in the british crown dependencies, it may only be a matter of time until other british territories such as the british virgin islands, the cayman islands, and bermuda will come under pressure to adopt the crs mdrs. this may influence other countries and territories to adopt the crs mdrs as well. c. other countries the expansion of mdrs in recent years has not been limited to europe. mexico217 and argentina218 have each adopted mdrs based on the recommendations of beps action 12. both of these regimes build upon their oecd and dac 6 precedents but also introduce some novel features of their own. the mexican mdrs came into force on january 1, 2020.219 these rules little international tax compliance experience might struggle to determine whether matters were reportable or not,’ he added” quoting gary ashford, vice president of the chartered institute of taxation). see also george bull, what happens to taxes if the uk becomes the singapore of europe, rsm (jan. 2021) (describing the prospects of prime minister boris johnson’s objective to make britain into a business-friendly destination with low taxes and light regulation). nevertheless, the crs mdrs also create compliance challenges and costs. see paul f. millen & peter cotorceanu, forming financial intermediaries into a fifth column: the oecd mdrs for crs avoidance, 25 trusts & trustees 422 (may 2019). 214 see taxation (implementation) (international tax compliance) (mandatory disclosure rules for crs avoidance arrangements and opaque offshore structures) (jersey) regulations 2020, r&o.112/2020 (sept. 9, 2020) for jersey; income tax (mandatory disclosure rules) regulations 2019, statutory doc. no. 2019/0454 (dec. 10, 2019) for the isle of man; the income tax (approved international agreements) (implementation) (mandatory disclosure rules) regulations, 2020, guernsey statutory instrument 2020 no. 2 (mar. 11, 2020) for guernsey. 215 see gibraltar legal notice no. 78 (2021); ernst & young, south africa issues new regulations to implement the common reporting standard (oct. 16, 2020), https://www.ey.com/en_gl/tax-alerts/south-africa-issues-new-regulations-to-implement-thecommon-reporting-standard [https://perma.cc/q4rf-v4px]. 216 government of jersey, consultation on implementation of mandatory disclosure rules for crs avoidance arrangements and opaque offshore structures, ministry of treasury and resources (sept. 23, 2019), at 2. 217 see código fiscal de la federación [cff], arts. 197-202 (mex.) [hereinafter mexico federal fiscal code]. 218 see general resolution no. 4838/2020, argentina official gazette (oct. 20, 2020), https://www.boletinoficial.gob.ar/detalleaviso/primera/236310/20201020?busqueda=1, [https://perma.cc/s4qg-2kc3]. 219 see mexico federal fiscal code, supra note 217. see also ernst & young, taxpayers should be aware of mexico’s new reportable transaction obligation (mar. 20, 2020). 2022] mandatory disclosure rules 153 follow the recommendations of the oecd’s beps action 12 but stop short of following the dac 6 model.220 unlike dac 6 and the crs mdrs, the mexican mdrs impose reporting obligations only on tax advisors.221 the schemes reportable in mexico include “anyone that generates or can generate, directly or indirectly, the obtaining of a tax benefit in mexico” and possesses any one of fourteen characteristics.222 many of these characteristics resemble dac 6 and action 12 hallmarks, although some are unique to mexico.223 notably, one characteristic covers structures that circumvent reporting under crs or fatca.224 once a scheme is found to be reportable, the tax advisor must provide their name and tin, a description of the reportable scheme, the tax benefit obtained or expected, and other information.225 argentina’s mdrs were adopted in october 2020 and follow the recommendations of beps action 12. under these mdrs, there is a parallel reporting requirement on both taxpayers and tax advisors.226 these mdrs require the reporting of both domestic and cross-border transactions that result in a tax advantage or benefit and have certain characteristics.227 in cases where multiple parties could report, all must report.228 while this reporting obligation is somewhat broader than mexico’s, it also does not include intermediaries other than tax advisors. the disclosure must include the information of the scheme participants, a description of the way in which the tax advantage or any other benefit was created, and the applicable legal and regulatory provisions, including foreign regulations.229 the adoption of dac 6 in the eu, crs mdrs in several countries, and new mdrs in mexico and argentina indicates that mdrs are continuing to find willing and ready policymakers to implement them in different countries around the globe. moreover, all of these new mdrs contain significant cross-border components in line with the general trend of third-generation mdrs. mdrs seem poised to continually evolve and proliferate across the globe. iv. trends in the development of mdrs thus far, we have described the development of mdrs since the 1980s. in this part, we identify three main trends in the development of mdrs over this period. first, mdrs have evolved from targeting specific tax schemes to covering a large set of tax avoidance arrangements. second, the group of persons required to 220 for a detailed breakdown of the differences between mexico’s mdrs and dac 6, see kimberly tan majure et al., insight: mandatory disclosure rules in the european union and mexico, bloomberg tax (oct. 2020). 221 see id. 222 mexico federal fiscal code, supra note 217, art. 199. 223 see majure et al., supra note 220. 224 see mexico federal fiscal code, supra note 217, art. 199. 225 see id. at art. 200. 226 see pricewaterhousecoopers, argentina adopts broad informative regime requiring domestic and international tax planning disclosures (oct. 27, 2020); see also general resolution no. 4838/2020, supra note 218, art. 6. 227 see general resolution no. 4838/2020, supra note 218, arts. 3-4. 228 id. 229 see id. at art. 11. 154 columbia journal of tax law [vol: 13:2 report has similarly expanded to a broad set of intermediaries under recent mdrs. this is part of a larger effort to target the enablers of tax avoidance and evasion. finally, mdrs have evolved from a domestic measure conceived and implemented by national governments to a multilateral regime designed and promoted by international institutions. the newest mdrs are the product of a coordinated international campaign against cross-border tax avoidance and evasion. a. expansion of what should be reported since the 1980s, mdrs have changed with respect to what needs to be reported. mdrs began in the united states and canada with a specific purpose: to stymie the proliferation of mass-marketed tax shelters for individuals.230 tax shelters were defined using specific formulas and did not extend to corporate taxpayers and other entities.231 they were not intended to wholly reinvent the government’s anti-tax-avoidance methods and create a comprehensive reporting regime for multiple types of tax avoidance by intermediaries.232 over time, the reach of mdrs has expanded. in the early 2000s, listed transactions and hallmarks were introduced, which covered not just tax shelters, but also other forms of tax avoidance and, in particular, corporate tax avoidance.233 the maintenance of a list of reportable transactions that can be expanded over time has provided governments with a valuable tool to flexibly respond to the creativity of aggressive tax planners and sophisticated intermediaries.234 it also means that, as each year goes by, more and more transactions have become reportable.235 moreover, listed hallmarks ensure that even if a certain type of tax planning transaction is not explicitly identified by the government as reportable, it will still need to be reported if it contains certain characteristics common to tax avoidance schemes. nevertheless, the enumerated hallmarks of the early 2000s were far less broad than the hallmarks of more recent mdrs, such as dac 6.236 the result is that the newest mdrs capture many different types of transactions that were not reportable under previous mdrs.237 additionally, dac 6 and crs mdrs are reimagining how mdrs can be applied to tax enforcement. both regimes contain hallmarks that target crs avoidance arrangements, which might be associated with 230 see joint comm. on taxation of the u.s. congress, supra note 42, at 5-8. 231 see supra notes 58, 72 and part i, supra. 232 see supra part i. 233 see supra part ii. 234 see joshua d. blank, overcoming overdisclosure: toward tax shelter detection, 56 ucla l. rev. 1629, 1677 (2008) (noting, with respect to listed transactions, that “[t]he status quo approach…provides the irs with flexibility to determine what changes, if any, it should make to its original designation of a listed transaction.”). 235 in the united states, for example, of the 36 listed transactions reportable in 2021; only 23 of them were reportable in 2003. thus, 13 new transactions have become reportable since 2003. see https://www.irs.gov/businesses/corporations/listed-transactions [https:// perma.cc/xrh8-c7yz]. 236 see supra parts ii and iii. 237 see bianco, supra note 173, at 15 (“potential intermediaries have indeed been complaining since the publication of [dac 6] that the hallmarks it contains are conceivably too wide or too vague to work as intended, and may capture structures that are not constitutive of tax avoidance.”). 2022] mandatory disclosure rules 155 tax evasion, and tax avoidance transactions, which have been the primary focus of mdrs since their inception.238 overall, these changes could be described as a shift away from a rule-based approach, which tries to identify and address specific weaknesses in the tax system (initially by using formulas to determine which tax schemes are reportable), toward a standard-based, anti-avoidance approach.239 this standard-based approach is reflected in the extensive use of generic hallmarks and the incorporation of the main benefit test in newer mdrs.240 the crs mdrs, for example, make direct references to the intended policy of crs when determining what arrangements must be reported.241 thus, mdrs are becoming broad anti-avoidance standards and are imposing reporting obligations on a wide variety of transactions that violate the intent of tax laws. this is consistent with an overall trend of expanding mdrs which has been identified over the past four decades. the expansion of the scope of mdrs to address various types of tax avoidance and evasion is part of a broader movement in international tax policy. as noted above, the beps project and the recent agreement on a global minimum tax under beps 2.0 aim to curb corporate tax avoidance.242 fatca and crs aim to detect and deter tax evasion associated with undisclosed offshore financial accounts.243 it is, therefore, unsurprising that the beps project included in action 12 recommendations for countries to use mdrs more extensively. similarly, it is unsurprising that dac 6 and crs mdrs went beyond the action 12 recommendations to utilize mdrs in the fight against cross-border tax avoidance and evasion.244 b. expansion of who should report in addition to expanding the criteria for what needs to be reported, mdrs have broadened the requirements for who needs to report. the original tax shelter registration rules narrowly targeted promoters and organizers of tax shelters.245 in the early 2000s, however, the u.s. expanded reporting obligations to material 238 see supra part iii. 239 for further discussion on general anti-avoidance rules, see christophe j. waerzeggers & cory hillier, introducing a general anti-avoidance rule (gaar), imf technical note (2016). for a discussion on the policy choice between rules and standards, see louis kaplow, rules versus standards: an economic analysis, 42 duke l. j. 557-629 (1992); eric a. posner, standards, rules, and social norms, 21 harv. j. l. & pub. pol’y 101 (1997). 240 see supra notes 166, 177-179, 241 and the accompanying text. 241 the generic hallmarks under the crs mdrs provide that an “arrangement therefore circumvents crs legislation where it avoids the reporting of crs information to the jurisdiction(s) of residence of a taxpayer in a way that undermines its intended policy, including by: exploiting the absence of crs legislation or inadequate implementation of such legislation; exploiting the absence of a crs exchange agreement with one or more jurisdiction(s) of tax residence of such taxpayer; undermining or exploiting weaknesses in the due diligence procedures applied by a financial institution under crs legislation; or otherwise undermining the intended policy of the crs.” crs mdrs, supra note 9, at 24 (emphasis added). 242 see supra note 33. 243 see supra notes 33, 191-193 and the accompanying text. 244 see action 12, supra note 22, and parts iii.a and iii.b, supra and the accompanying text. 245 see supra part i. 156 columbia journal of tax law [vol: 13:2 advisors,246 such as lawyers and accountants, thereby capturing a much broader set of professionals who provide tax advice or make tax statements.247 finally, the newest mdrs have expanded reporting obligations to a variety of intermediaries that may only play a minor or tangential role in a transaction and do not provide tax-related services or make tax statements.248 in the case of dac 6, intermediaries assisting with the implementation of a reportable arrangement must report if they are reasonably expected to know that the arrangement is reportable.249 this means that lawyers, trustees, investment advisors, corporate service providers, and other intermediaries may be subject to reporting requirements even if they never provide tax services to their clients.250 they cannot avoid this obligation by turning a blind eye or excluding tax-related services from the scope of services they provide. these changes in reporting obligations reveal a shifting focus among governments and international organizations toward regulating and deterring the professional service providers that enable tax avoidance and evasion schemes. a requirement to report acts as a dissuasive tool because it consumes intermediaries’ time and resources,251 while simultaneously increasing the likelihood of audits and investigations against the intermediaries and their clients.252 underlying this shift is a position that by targeting the enablers, not just the taxpayers, tax authorities can more effectively deter tax avoidance and evasion.253 the centrality of intermediaries is underscored by literature and recent document leaks which have shown that lawyers, accountants, investment advisors, and other intermediaries form a large network of professional enablers that supply arrangements that could be used for tax avoidance and evasion.254 thus, this shift represents an effort on behalf of the tax authorities to simultaneously regulate various industries that could 246 a material advisor must play a tangible role in a tax transaction. see supra note 96 and the accompanying text. 247 see part ii.a, supra. 248 see supra notes 169-170 and the accompanying text. 249 see id. 250 see id. 251 see schler, supra note 7 (“the reporting rules imposed on tax advisers for book-tax and loss transactions impose a considerable burden on tax advisers involved in normal business transactions. every law firm in the country has been required to make an enormous effort to develop, and ensure ongoing compliance with, procedures relating to those transactions. given the penalties for noncompliance, that effort usually involves considerable partner time.”). 252 see blank, supra note 234, at 1641 (“mandatory disclosure is thus designed to provide an important ‘audit roadmap’ to the irs. for example…under current law a taxpayer is now required to alert the irs if the taxpayer uses a tax strategy sold by a tax shelter promoter who promised a money-back guarantee in the event of an audit. the required disclosure statement may lead the irs agent who initially reviews this tax return to select it for audit and quickly issue an information document request to the taxpayer.”). 253 see action 12, supra note 22, at 27. 254 see prem sikka & hugh willmott, the tax avoidance industry: accounting firms on the make, 9 crit. perspect. int’l bus. 415, 431 (2013); james s. henry, the price of offshore revisited: new estimates for missing global private wealth income inequality and lost taxes, tax just. network (2012); nicholas j. lord, liz j. campbell & karin van wingerde, other people’s dirty money: professional intermediaries, market dynamics and the finances of white-collar, corporate and organized crimes, 59 brit. j. criminology 1217 (2019). for a more detailed analysis of the market for tax avoidance, see kai a. conrad, dynamics of the market for corporate tax-avoidance advice, 123 scand. j. econ. 267 (2019). 2022] mandatory disclosure rules 157 be involved in the design, marketing or implementation of reportable arrangements. intermediary reporting and third-party reporting in general also have other advantages in addition to deterring professionals from enabling tax schemes. in general, tax literature in recent years has emphasized the role third parties can play in tax compliance.255 third-party reporting ensures that the tax authorities receive a more accurate and complete picture of a tax scheme which allows them to take faster action against abusive schemes.256 third-party reporting can help deter taxpayers from demanding tax avoidance and evasion products in the first place, since they know such schemes are now more likely to be detected by the government. 257 moreover, the shifting focus of mdrs to a larger set of intermediaries is representative of a broader change in the priorities of tax authorities and international organizations, which are increasingly using an assortment of policy tools to hold the enablers of tax avoidance accountable. the united kingdom, for example, has implemented penalties and other consequences for intermediaries that enable tax avoidance behavior.258 additionally, the oecd has published several reports outlining how intermediaries enable tax avoidance and has proposed various solutions to deter them from engaging in problematic behavior.259 on the whole, 255 see paul carrillo, dina pomeranz & monica singhal, dodging the taxman: firm misreporting and limits to tax enforcement, 9 am. econ. j.: applied econ. 144 (2017) at 144; leandra lederman, statutory speed bumps: the roles third parties play in tax compliance, 60 stan. l. rev. 695 (2007) (describing how third parties help ensure compliance but can, under certain conditions, undermine it); bibek adhikari, james alm & timothy f. harris, information reporting and tax compliance, 110 aea papers & proc. 2020 162 (2020) (discussing the introduction of third-party reporting and its impacts on a particular area of taxation); james alm, john a. deskins & michael mckee, third-party income reporting and income tax compliance, andrew young sch. pol’y stud. rsch. paper series no. 06-35 (2006); henrik jacobsen kleven et al., unwilling or unable to cheat? evidence from a tax audit experiment in denmark, 79 econometrica 651 (2011); dina pomeranz, no taxation without information: deterrence and self-enforcement in the value added tax, 105 am. econ. rev. 2539 (2015); james alm, measuring, explaining, and controlling tax evasion: lessons from theory, experiments, and field studies, tul. econ. working paper series (july 2012). 256 see action 12, supra note 22, at 22; mark d. phillips, individual tax compliance and information reporting: what do the u.s. data show?, 67 nat’l tax j. 531 (2014) (showing that third-party reporting deters taxpayers from underreporting their income). 257 see action 12, supra note 22, at 27; leandra lederman, reducing information gaps to reduce the tax gap: when is information reporting warranted, 78 fordham l. rev. 1733, 173839 (2010); danshera cords, tax protestors and penalties: ensuring perceived fairness and mitigating systemic costs, 2005 byu l. rev. 1515, 1542-43 (2005); henrik jacobsen kleven, claus thustrup kreiner & emmanuel saez, why can modern governments tax so much? an agency model of firms as fiscal intermediaries, 83 economica 219 (2016). 258 see united kingdom’s finance (no. 2) act 2017, sched. 16, which outlines new penalties for tax avoidance intermediaries. in this law intermediaries are classified as “enablers” of tax avoidance, which are defined as designers, managers, marketers, enabling participants, or financial enablers of the tax avoidance arrangements. 259 see, e.g., oecd, study into the role of tax intermediaries (2008), which identified intermediaries as a significant problem in the area of tax avoidance. the report recommended various methods for reining in the intermediaries that enable tax avoidance including future compliance agreements, penalties, non-monetary sanctions (e.g., “injunctions to stop the promotion of a scheme, and censures, suspension or disbarment from practice under professional conduct 158 columbia journal of tax law [vol: 13:2 however, the eu has been the leader of this trend. the eu has developed its aggressive stance against the intermediaries of abusive tax behavior out of a growing sense that intermediaries were facilitating, and indeed encouraging, tax avoidance.260 for example, in july 2016 the european parliament specifically condemned intermediaries as playing a crucial role in tax avoidance, and also suggested the imposition of mandatory disclosure requirements on intermediaries as one solution to counter their activities.261 moreover, when suggesting that the european union adopt mdrs, the economic and financial affairs council (ecofin) of the european council specifically identified intermediaries as a target and drew inspiration from beps for ways to combat them.262 the aggressive stance against intermediaries adopted by the eu was also influenced by the release of the panama papers in april 2016 at around the same time these proposals were being developed.263 in the eyes of the eu, the panama papers shed light on the potentially dangerous role intermediaries were playing in enabling tax avoidance.264 moreover, the historical legacy of the rules”), and general anti-avoidance rules. the report also identified the mdrs of canada, south africa, the united kingdom, and united states as highly effective ways of deterring intermediaries from facilitating tax avoidance schemes (“in these four countries, much of the obligation for disclosure falls on the tax intermediary. the experiences of countries using disclosure regimes are that they have a significant deterrent effect and reduce the attractiveness of aggressive tax planning. they directly affect the economic attractiveness of aggressive tax planning, significantly reducing the time taken by the revenue body to detect a scheme and embark on a response (either legislative or through the courts). for the tax intermediary, the period in which professional fees can be earned is reduced; for taxpayers, a swifter response means a reduced period in which tax advantages accrue”). see id. at 19. this report was itself inspired by the seoul declaration, in which 39 economies and organizations agreed to find ways to counter tax avoidance including by “examining the role of tax intermediaries (e.g.,., law and accounting firms, other tax advisors and financial institutions) in relation to non-compliance and the promotion of unacceptable tax minimization arrangements.” oecd, seoul declaration, at 4 (sept. 2006). see also oecd, tackling aggressive tax planning through improved transparency and disclosure – report on disclosure initiatives, supra note 165; oecd, ending the shell game: cracking down on the professionals who enable tax and white collar crimes (2021) (describing how countries can individually and collectively identify, disrupt, and deter “professional enablers,” i.e. intermediaries, from promoting and implementing tax avoidance schemes). the report identifies mdrs as one of the primary tools for deterring tax avoidance schemes and encourages their implementation. in particular, the crs mdrs, dac 6, and beps action 12 are all listed as models that countries may consider when designing their mdrs. 260 see european commission, supra note 197, at 5-6. 261 see european parliament special committee on tax rulings, 2016/2038(ini), tax rulings and other measures similar in nature or effect (july 6, 2016) (“members regretted deeply that some banks, tax advisers, law and accounting firms and other intermediaries have been instrumental and have played a key role in designing aggressive tax planning schemes for their clients…[the commission] was also asked to come forward with a legislative proposal introducing a mandatory disclosure requirement for banks, tax advisers and other intermediaries concerning complex structures and special services that are linked to jurisdictions included on the common eu list of tax havens.”). 262 see council of the european union, commission communication on an external strategy for effective taxation and commission recommendation on the implementation of measures against tax treaty abuse, 9452/16 (2016). 263 see european commission, supra note 197, at 5. 264 see id. 2022] mandatory disclosure rules 159 2008 financial crisis and the subsequent eurozone crisis likely played a role in motivating european officials to take a strong anti–tax avoidance stance.265 these developments help explain the eu’s expansive approach to intermediary reporting. in summary, there is a growing consensus among countries and institutions that one of the best ways to ensure global tax equity is to target the enablers of tax avoidance and evasion. mdrs are increasingly used to discourage a wide variety of professional service providers from acting as such enablers. c. internationalization of mdrs from their domestic origins, mdrs have evolved into a potent multilateral instrument to counter cross-border tax avoidance and evasion. the first mdrs were initiated and developed by national governments primarily to deal with domestic tax avoidance issues. this was true of both the tax shelter registration rules of the 1980s and the reportable transaction disclosure regimes of the 2000s and early 2010s.266 however, more recent developments in mdrs have been driven by international and supranational organizations: the oecd and the eu. this started with the oecd’s beps action 12 in 2015, which was soon thereafter taken up in an expanded form by the eu and applied to its 27 member states.267 additionally, the oecd designed the crs mdrs, which are now being adopted in an increasing number of jurisdictions.268 the increasingly multilateral nature of anti-tax avoidance policy stems from a realization that many tax schemes rely on structures and transactions involving more than one country.269 this could be the result of the substantial increase in cross-border activities and the transfer of assets across jurisdictions in the years since the implementation of the first-generation mdrs in the 1980s.270 in order to combat cross-border tax avoidance and evasion, countries have increasingly been collaborating to develop and implement measures that target international tax schemes, as seen in beps, crs and other initiatives.271 the internationalization of mdrs has affected what needs to be reported, who needs to report, and how information is exchanged between jurisdictions. first, dac 6 and the crs mdrs focus on cross-border tax issues.272 while some older 265 for further discussion on the historical origins behind the eu’s aggressive implementation of the beps proposals, see sigrid j.c. hemels, implementation of beps in european union hard law, 67 ritsumeikan econ. rev. 85 (july 2018); communication from the commission to the european parliament and the council, an action plan to strengthen the fight against tax fraud and tax evasion, com/2012/0722 final, (dec. 6, 2012). 266 see supra part i and part ii. 267 see supra part iii.b. 268 see id. 269 see action 12, supra note 22, at 3; european commission, supra note 197, at 4; u.s. gov’t accountability office, supra note 99, at 9 (warning that abusive tax avoidance transactions have become increasingly international). 270 see action 12, supra note 22, at 3; european commission, supra note 197, at 4; u.s. gov’t accountability office, supra note 99, at 9. 271 see mason, supra note 11, at 355-67 (describing the evolution of international cooperation in tax enforcement since the 2008 financial crisis with a particular focus on beps). 272 see supra part iii. 160 columbia journal of tax law [vol: 13:2 mdrs contain a handful of cross-border provisions, none have tackled this issue as comprehensively as dac 6.273 additionally, the crs mdrs contain hallmarks targeting crs avoidance arrangements and opaque offshore structures.274 each of these hallmarks, by definition, deal with cross-border arrangements. finally, the new mdrs of mexico and argentina require the reporting of both domestic and cross-border transactions with certain characteristics.275 thus, the schemes that must be reported under the newest mdrs have a greater focus on cross-border transactions than older mdrs. second, the multilateral nature of the newest mdrs affects the types of intermediaries that are required to report. under most earlier regimes, only domestic intermediaries were required to report.276 however, under dac 6 an intermediary that has ties to any eu member state277 is required to report a transaction even if the transaction occurs in a member state other than that which the intermediary has ties to.278 moreover, under dac 6, intermediaries have a primary reporting obligation to their home member state even if the transaction occurred in a different member state.279 under the crs mdrs, an intermediary may be required to report to their home jurisdiction if they have not already reported to another jurisdiction in which they have a branch and where the reportable services were rendered.280 thus, both dac 6 and the crs mdrs enable tax authorities to identify intermediaries in other countries that are providing services to local taxpayers. third, multilateral mdrs are facilitating the creation of international systems of information exchange. in order for the aforementioned reporting schemes to function effectively so that the interested tax authority receives the relevant information, it is necessary for countries to have in place a method for sharing tax information.281 for example, if an intermediary in spain reports on a tax arrangement undertaken by a taxpayer that is resident in germany, then it is necessary for some mechanism to be in place for the information to be transmitted from spain to the relevant tax authority in germany. both dac 6 and the crs mdrs incorporate methods for jurisdictions to share data with each other.282 under these regimes, intermediaries are required to report to only one country which then shares this information with other countries within the same regime.283 these changes are part of broader trends in international tax policy. as 273 see supra note 181. 274 see supra part iii.b. 275 see supra part iii.c. 276 see supra part i and part iii. 277 see supra note 170; dac 6, art. 1(1). 278 see id. 279 see dac 6, supra note 9, art. 1(2). 280 see crs mdrs, supra note 9, rule 2.1. 281 see, e.g., european commission, supra note 197, at 4. 282 for dac 6, see dac 6, supra note 9, at art. 1. for the crs mdrs, see oecd, supra note 26, and the accompanying text for note 203. 283 see id. under the crs mdrs it is the responsibility of the country which received the disclosure to share that information with all other relevant countries (that are also part of crs and the crs mdrs). under dac 6, the disclosure information is recorded in a central repository that is open to all member states of the eu. 2022] mandatory disclosure rules 161 noted by ruth mason, recent developments in international policymaking, particularly beps, have transformed and multilateralized international taxation.284 international tax policy is becoming more multilateral and the oecd is continuing to play a leading role in the setting of global tax norms.285 these observations are consistent with the changes we identify in mdrs. in particular, norm-setting for mdrs is being led by the oecd and eu, and mdrs are promoting a multilateral mechanism to address international tax challenges. additionally, multilateral mdrs increase transparency across jurisdictions, complementing other transparency enhancing regimes such as crs, country-by-country reporting, and the automatic exchange of tax rulings.286 v. the path ahead for mdrs mdrs have grown and expanded over the past four decades with a rapid acceleration of these trends in the past six years. as we have shown in the previous part, these trends are directly tied to broader movements in international tax policy. if these broader international trends continue, it is likely that the expansion, proliferation, and internationalization of mdrs will continue as well. several factors may accelerate the adoption of mdrs. one factor is potential pressure from the oecd. although the adoption of the crs mdrs is currently voluntary, countries may come under pressure from the oecd to adopt crs mdrs or a similarly effective anti-crs avoidance measure. crs already requires that jurisdictions implementing crs have “rules to prevent any financial institutions, persons or intermediaries from adopting practices intended to circumvent the reporting and due diligence procedures.”287 thus, the oecd may require in the future that crs-implementing countries adopt either the crs mdrs or similarly effective rules against crs avoidance. such a requirement would likely result in a wide-scale international adoption of crs mdrs. the fact that the eu member states, the united kingdom, jersey, guernsey, and the isle of man have all adopted or are in the process of adopting the crs mdrs may indicate that these rules are on track to becoming a widely adopted international tax standard.288 another factor is a potential eu blacklisting of jurisdictions that do not adopt certain mdrs.289 for example, the eu may announce in the future that 284 see mason, supra note 11. 285 see id. 286 for further discussion on crs, cbcr, and automatic exchange of tax rulings, see crs, supra note 191; elisa casi, christoph spengel & barbara m.b. stage, cross-border tax evasion after the common reporting standard: game over? 190 j. pub. econ. (2020); michelle hanlon, country-by-country reporting and the international allocation of taxing rights, 72 bull. for int’l tax’n (2018); anjana haines, no more secret tax rulings in the eu?, int’l tax rev. (2017). 287 crs, supra note 191, at 61. 288 see leigh-alexandra basha, overview on recent developments for the legislation, regulatory and anti-money laundering us update, 25 tr. & trustees 138, 146 (feb. 2019) (“although countries are not obligated to adopt the mandatory disclosure rules, it appears likely, that, over time, many countries will adopt them and that they will become part of the international norms.”). 289 council conclusions on the criteria for and process leading to the establishment of the eu 162 columbia journal of tax law [vol: 13:2 jurisdictions that do not adopt crs mdrs would be blacklisted as non-cooperative tax jurisdictions. the eu has shown that it is willing to use the blacklisting threat as a means to force other jurisdictions to adopt eu tax norms, which now include crs mdrs as part of dac 6.290 nevertheless, even without oecd and eu pressure, it is possible that more countries will adopt new mdrs or expand their existing mdrs of their own volition. for example, mexico and argentina have recently adopted their own mdrs, and australia and japan are discussing introducing mdrs.291 it will be interesting to see whether the united states or canada, which already have their own set of second-generation mdrs, will adopt more expansive rules. thus far, the united states has expressed little interest in expanding its mdrs.292 moreover, given that the united states utilizes its own fatca regime instead of crs, it should not be expected to adopt crs mdrs.293 thus, despite initiating and leading the expansion of mdrs for decades, it does not seem likely that the united states will participate in this latest chapter in the evolution of mdrs. canada, however, has indicated that it plans to expand its mdrs to adjust them more closely to beps action 12.294 in addition to these developments, there is also the possibility of the development and adoption of a new global standard for mdrs that focuses on international tax issues. the international community has not yet rallied behind a single agreed-upon standard for mdrs to address cross-border tax challenges. instead, the eu and various countries have innovated their own mdrs. it is possible that, similar to other harmonization and cooperation trends in international taxation, more countries will seek to design and adopt an international standard for list of non-cooperative jurisdictions for tax purposes, 2016 o.j. (c 461) 2. for a description of the eu blacklisting process, see giuseppe melis & alessio persiani, the eu blacklist: a step forward but still much to do, ec tax rev. 2019-5 (2019). for a description of some of the consequences of an eu blacklisting, see aija rusina, name and shame? evidence from the european union tax haven blacklist, int’l tax & pub. fin. 27 (2020). 290 see european council, taxation: eu list of non-cooperative jurisdictions (last reviewed on oct. 7, 2021), https://www.consilium.europa.eu/en/policies/eu-list-of-non-cooperativejurisdictions/ [https://perma.cc/747j-exkr]. 291 see 2016-17 australian budget report, making our tax system more sustainable (may 2016) at 11; ey global, the latest on beps and beyond – december 2019, (dec. 17, 2019). for further discussion on australia, see oguttu & kayis-kumar, supra note 80; annet wanyana oguttu & ann kayis-kumar, curtailing aggressive tax planning: the case for introducing mandatory disclosure rules in australia (part 2) cues from the united kingdom and south africa, 17 ejournal tax res. 233 (2020); irma johanna mosquera valderrama, the oecd-beps measures to deal with aggressive tax planning in south america and sub-saharan africa: the challenges ahead, 43 intertax 615 (2015). 292 see isabelle ioannides, eu-us trade and investment relations: effects on tax evasion, money laundering and tax transparency – ex-post impact assessment, eur. parl. rsch. service, at 18 (mar. 2017) (“existing us law has statutory and regulatory disclosure rules for aggressive tax planning. there are no active proposals for change.”). 293 for further discussion on the us’ relationship with crs, see rachel e. brinson, is the united states becoming the new switzerland: why the united states' failure to adopt the oecd's common reporting standard is helping it become a tax haven, 23 n.c. banking inst. 231 (2019); basha, supra note 288. 294 peter clark & josephine chuk, canada: expansion of mandatory disclosure rules proposed in budget 2021, global compliance news (june 11, 2021). 2022] mandatory disclosure rules 163 mdrs. this standard could draw upon dac 6, crs mdrs, and the mdrs of various countries.295 conclusion mdrs have developed from domestic measures with a narrow scope into prominent tools in the international fight against tax avoidance and evasion. with more countries adopting mdrs each year, it appears that their expansion and development are likely to continue. certain mdrs, such as the crs mdrs, may become widely adopted international standards. in the next few years, policymakers in different countries may consider, either voluntarily or under international pressure, to adopt mdrs or amend their existing mdrs. understanding the development of mdrs and the underlying trends can contribute to policy discussions on whether to adopt mdrs or expand existing mdrs. this article contributes to the literature by exploring the development of mdrs over time with a cross-jurisdictional lens, exposing trends in the evolution of mdrs, and examining how the expansion and internationalization of mdrs have affected what needs to be reported, who needs to report, and how information is exchanged between jurisdictions. this article shows how the trends in the evolution of mdrs fit into broader movements in international tax policy: an enhancement of efforts to curb tax avoidance and evasion, a focus on tax avoidance enablers, and international multilateralism and cooperation on tax matters. as these trends continue, we expect to see a further expansion and internationalization of mdrs. 295 it could also build on the recommendations of action 12, although these are somewhat outdated after the developments of the past six years. introduction i. first generation: 1980s a. united states b. canada ii. second generation: 2000s and early 2010s a. united states b. united kingdom c. other countries iii. third generation: 2015-present a. dac 6 b. crs mdrs c. other countries iv. trends in the development of mdrs a. expansion of what should be reported b. expansion of who should report c. internationalization of mdrs v. the path ahead for mdrs conclusion microsoft word elkins9-1_v2 sk.docx articles the myth of corporate tax residence david elkins* abstract the issue of corporate residence has recently attracted a great deal of attention in both the popular press and in academic discourse, primarily because of the phenomenon of corporate inversions. the consensus among commentators is that the root of the problem is a flawed definition of corporate residence, and they have therefore proposed replacing the current definition, which relies upon place of incorporation, with another that relies upon control and management, home office, customer base, source of income, or the residence of shareholders. the thesis of this article is that the concept of tax residence is inapplicable to corporations. residence in tax law delineates the boundaries of distributive justice, and whereas corporations cannot be parties to a scheme of distributive justice, corporate residence is a misnomer. the incongruity of corporate residence along with the fact that residence is a fundamental concept in international taxation is one reason that the current international tax regime has proven unviable. the article then goes on to describe in broad outline an international corporate tax regime that avoids the problem of corporate residence by focusing on shareholders instead of on corporations. . * professor of law, netanya law school, israel. visiting professor of law, tulane university law school, fall 2017. ph.d., bar-ilan university 1999; ll.m. bar-llan university 1992; ll.b., hebrew university of jerusalem 1982. the ideas that developed into this paper were presented at the tax policy colloquium at loyola, los angeles, in response to a presentation by professor robert peroni. in a more developed form, this paper was presented at the law and society conference in mexico city, at the fourth international round table on taxation and tax policy in netanya, israel, and at the tulane law school intellectual life faculty workshop. i thank the participants at each of these events for their insightful comments. 6 columbia journal of tax law [vol.9:5 i. introduction...................................................................................................... 7 ii. individual residence ..................................................................................... 12 a. introduction .......................................................................................................... 12 b. ability-to-pay ...................................................................................................... 12 c. taxation of worldwide income ........................................................................... 15 d. delineating the parameters of the collective ...................................................... 16 e. taxation of nonresidents ..................................................................................... 18 iii. corporate residence ..................................................................................... 20 a. welfare ................................................................................................................. 20 b. personal connections ........................................................................................... 21 c. the categorical imperative ................................................................................. 25 d. incorporeality ....................................................................................................... 28 iv. taxing corporations and taxing shareholders .......................... 29 v. a proposal for a new international corporate tax regime . 32 a. computing the income of u.s. shareholders ...................................................... 33 b. taxing nonresident shareholders ........................................................................ 35 c. avoiding double taxation .................................................................................. 38 vi. conclusion .......................................................................................................... 42 2017] the myth of corporate tax residence 7 i. introduction although straddling the cusp between two of the more esoteric subfields of tax law—corporate taxation and international taxation—the phenomenon of corporate inversions has caught the attention of the public and the popular press.1 journalists, politicians, government officials, and scholars point out that a little paperwork can convert a domestic corporation (which pays tax on its worldwide income) into a foreign corporation (which pays tax only on its u.s.-source income).2 they go on to argue that the exploitation of this loophole by multinational corporations is unfair to ordinary citizens.3 charges of immorality, or worse, are frequent.4 responding to such concerns, 1 an inversion is a sophisticated maneuver enabling a u.s. corporation to expatriate. technically, a domestic corporation cannot become a foreign corporation. because u.s. tax law classifies corporations as domestic or foreign according to the jurisdiction that imbued them with legal personhood (a corporation created under the laws of the united states or any state is domestic, while a corporation created under the laws of a foreign jurisdiction is foreign), a domestic corporation will forever remain domestic. i.r.c. § 7701(a)(4) (defining “domestic”) and § 7701(a)(5) (defining “foreign”). for a brief history of these definitions, see david r. tillinghast, a matter of definitions: “foreign” and “domestic” taxpayers, 2 int’l tax & bus. law. 239, 252–53 (1984). granted, a domestic corporation or its shareholders can establish a new corporation under the laws of a foreign jurisdiction, but the foreign corporation will have its own legal personality and will be a subsidiary or a sibling (or some other relative) of the old domestic corporation. the domestic corporation will not have become the foreign corporation. see, e.g., tillinghast, id. at 259 (“[a] mid-life shift in a corporation's status may be achieved only at the price of ‘killing’ the old corporation and ‘creating’ a new one …”). to circumvent this obstacle to expatriation, tax planners developed a series of techniques collectively known as inversions. see, e.g., donald j. marples & jane g. gravelle, corporate expatriation, inversions, and mergers: tax issues, cong. res. serv. 4–5 (2017), https://fas.org/sgp/crs/misc/r43568.pdf [https://perma.cc/6spk-cvtn]. in a typical inversion, the subsidiary of a foreign corporation merges into a u.s. corporation that had served as the parent of a multinational group. see, e.g., steven goldman, corporate expatriation: a case analysis, 9 fla. tax rev. 71, 73–75, 84–91 (2008). simultaneously, assets that produce foreign-source income are transferred from the u.s. corporation to the foreign corporation. see, e.g., goldman, id. at 77–80, 92–98. when the smoke clears, the corporate structure may be very similar to what it was previously, except that at the peak of the corporate pyramid now stands a foreign corporation instead of a domestic corporation. see, e.g., omri marian, jurisdiction to tax corporations, 54 b.c. l. rev. 1613, 1654–55 (2013). 2 joseph a. tootle, the regulation of corporate inversions and “substantial business activities,” 33 va. tax rev. 353, 354 (2013) (“corporate inversions are transactions in which a u.s.-based company changes its place of incorporation from the united states to a foreign jurisdiction, often without an accompanying change in its business operations.”); adam h. rosenzweig, source as a solution to residence, 17 fla. tax rev. 471, 497 (2015) (“[inversions involve] a significant change in tax consequences for what was, in effect, a relatively small formal legal change with virtually no change in business model, ownership, management, or internal structure. this is precisely what concerned policymakers about inversions.”); michael j. graetz, the david r. tillinghast lecture: taxing international income: inadequate principles, outdates concepts, and unsatisfactory policies, 54 tax l. rev. 261, 321 (2001) (reporting that the chief of staff of the joint committee on taxation and the assistant treasury secretary for tax policy had expressed concern “about the legal loophole that allowed property and casualty insurers to stop paying income tax simply by moving the parent corporation to bermuda.”); jeffrey zients & seth hanlon, the corporate inversions tax loophole: what you need to know, the white house (apr. 8, 2016, 6:39 pm), https://obamawhitehouse.archives.gov/blog/2016/04/08/corporate-inversions-tax-loophole-what-you-needknow [https://perma.cc/rk7g-wqgp] (“corporate inversions are a tax loophole that allow u.s. companies to avoid paying u.s. taxes by relocating—on paper—to a foreign country”); paul krugman, corporate artful dodgers, n.y.times, july 24, 2014, at a17 (“the most important thing to understand about inversion is that it does not in any meaningful sense involve american business moving overseas … it [is] a purely paper transaction.”). 3 the white house, you don’t get to pick your tax rate. neither should corporations (sept. 26, 2014), https://obamawhitehouse.archives.gov/share/the-facts-on-inversions [https://perma.cc/g5f8-3svp] (“when large corporations invert overseas to reduce the taxes they paid in the united states, working 8 columbia journal of tax law [vol.9:5 congress in 2004 amended the internal revenue code and made it more difficult for domestic corporations to expatriate. i.r.c. § 7874 now provides that, in certain cases, the post-inversion successor to a domestic corporation will be classified as a domestic corporation, even if it was organized under the laws of a foreign jurisdiction. in 2016, the treasury issued temporary regulations that further limit the opportunity of obtaining tax advantages by inverting.5 the often emotionally charged rhetoric tends to ignore the foundational question of why the post-inversion, foreign-registered corporation should be subject to u.s. worldwide taxation. the argument seems to be that a u.s. corporation should not be able to shed its u.s. residence by the mere shuffling of papers.6 however, this argument succeeds merely in raising the question of why the pre-inversion company was subject to tax on its worldwide income in the first place. if place of incorporation (poi) is the proper determinant of residence,7 then reincorporation abroad severs the relevant tie and the post-inversion company is appropriately classified as a foreign resident. on the other hand, if poi is a not a proper determinant of residence, then the fact that the pre-inversion company was incorporated in the united states is irrelevant in establishing the residence either of it or of the post-inversion company.8 rarely mentioned in the discourse is that founders have free rein to organize their corporation in any jurisdiction they choose and that a corporation registered in a foreign jurisdiction is, from its inception, exempt from u.s. tax on its foreign-source income.9 an inversion merely equalizes the future tax treatment of corporations originally organized americans ultimately have to pay more to help fund the services we all rely on.”); andrew soergel, ask an economist: what the heck is a corporate inversion?, u.s. news & world rep. (feb. 16, 2016, 6:00 am), http://www.usnews.com/news/the-report/articles/2016-02-16/ask-an-economist-what-the-heck-is-a-corporateinversion [https://perma.cc/tmy4-kp2j] (“all of that revenue drain, who's going to pay for that? either you’re going to have to increase the budget deficit or tax all the taxpayers.”). 4 allan sloan, positively un-american, fortune (july 7, 2014), http://fortune.com/2014/07/07/taxes-offshore-dodge [https://perma.cc/l98c-hvt5] (describing inversions as “disgusting”); jennifer karr, immoral legislation and tax benefits for expat corporations, 48 conn. l. rev. 1703, 1706 (2016) (“frequent criticisms of corporate inversions tend to involve assessing the morality (or lack thereof) of corporations engaging in the practice.”); hale e. sheppard, fight or flight of u.s.-based multinational businesses: analyzing the causes for, effects of, and solutions to the corporate inversion trend, 23 nw. j. int’l l. & bus. 551, 558 (2003) (“[c]ritics of inversions have questioned the morality, patriotism and scruples of corporate directors.”). 5 temp. treas. reg. § 1.7874–8t. but see chamber of commerce of the u.s. v. internal revenue serv., no. 16–944 (w.d. tex. sept. 29, 2017) (invalidating regulations on procedural grounds). 6 see the sources cited supra note 2. 7 see supra, note 1. 8 see michael s. kirsch, the congressional response to corporate expatriations: the tension between symbols and substance in the taxation of multinational corporations, 24 va. tax rev. 475, 502, 549 (2005) (describing inversions as a “red herring” and asking, “if … a change in the corporate parent's place of incorporation is mere “paperwork” involving a new “sheet of paper,” the logical question is why does the u.s. tax code generally rely on a corporation's place of incorporation as the touchstone for defining residence?”). a similar line of reasoning applies to expatriation under other tests of corporate residence. see, e.g., marian, supra note 1, at 1647 (“if one is … concerned about management expatriation, it might be because the real reason for taxing corporation [sic] is not to regulate managers, but some other reason.” (emphasis in the original)). 9 i.r.c. § 882(b) (providing that “[i]n the case of a foreign corporation … gross income includes only—(1) gross income which is derived from sources within the united states … and (2) gross income which is effectively connected with the conduct of a trade or business within the united states.”). in this article, the term “u.s.-source income” will include both income derived from u.s. sources and income that is effectively connected to a u.s. trade or business. 2017] the myth of corporate tax residence 9 in the united states with that of corporations originally registered abroad. notably, neither the amended code nor the regulations place any restrictions on where a corporation is originally registered.10 in other words, despite the fact that poi was and remains completely discretionary, a u.s.-registered corporation that attempts to expatriate faces both moral outrage and strict anti-avoidance provisions, while a corporation whose founders had the foresight to organize under the laws of a foreign jurisdiction can quietly continue to enjoy the privileged status of a foreign corporation.11 in many instances, registration in the united states is no more than a foot fault, but with far-reaching consequences.12 another major issue in international taxation, one that has attracted considerably less attention but is much more significant in practice, is the phenomenon of u.s. corporations operating abroad via subsidiaries registered in a foreign jurisdiction. in theory, u.s. corporations are subject to tax on their worldwide income.13 in practice, foreign-source income is not subject to u.s. tax until the u.s. parent receives a dividend from, or sells its shares in, the foreign subsidiary. because the u.s. parent can defer payment of tax indefinitely, the effective rate of tax on its foreign-source income is close to zero.14 lamenting the fact that corporations are effectively subject to tax only on their u.s.-source income, some commentators have called upon congress to tighten up the rules of international corporate taxation and to require u.s. multinationals to pay tax on their worldwide income, including income earned via foreign subsidiaries.15 from the opposite end of the political spectrum, others have argued that the u.s. corporate tax is uncompetitive and have urged the adoption of a formal territorial tax structure. 16 10 see, e.g., graetz, supra note 2, at 322. 11 see, e.g., william b. barker, international tax reform should begin at home: replace the corporate income tax with a territorial expenditure tax, 30 nw. j. int’l l. & bus. 647, 665 (2010) (“for new corporations, there is considerable choice in choosing residence. for existing corporations, though tax is a strong incentive to change residence, changing residence is difficult without adverse tax and political consequences.”); president’s advisory panel on tax reform, simple, fair, and pro-growth: proposals to fix america's tax system 135 (2005) [hereinafter president’s advisory panel]; eric toder, international competitiveness: who competes against whom and for what?, 65 tax l. rev. 505, 513–14 (2012) (“there are substantial barriers preventing existing corporations from changing their corporate residence. but the start-ups that will become the corporate giants of the future have a choice of where to establish residence.”). 12 professor shaviro notes that “[t]ax lawyers who permit u.s. incorporation may be guilty of malpractice.” daniel shaviro, the david r. tillinghast lecture: the rising tax-electivity of u.s. corporate residence, 64 tax l. rev. 377, 378 (2011). 13 i.r.c. § 61(a) (defining gross income as “all income from whatever source derived”), § 63(a) (defining taxable income as gross income minus certain deductions), § 11(a) (imposing tax “on the taxable income of every corporation”). 14 the formula for computing the present value of a future liability is y=x/(1+r)n, where y is the present value, x is the nominal amount of the liability, r is the relevant rate of interest, and n is the number of years until the actual payment. as the value of n increases, the value of y decreases. in other words, the longer the taxpayer succeeds in deferring the payment of tax, the less the present value of the payment. 15 edward d. kleinbard et al., 24 international tax experts address current tax reform efforts in congress (2015), available at https://americansfortaxfairness.org/files/24-international-tax-experts-letterto-congress-9-25-15-final-for-printing.pdf [https://perma.cc/klq6-h6hw]. 16 see, e.g., michael s. knoll, taxation, competitiveness, and inversions: a response to kleinbard, 155 tax notes 619 (may 1, 2017); paul ryan & kevin brady, a better way: our vision for a confident america 10 (2016), available at https://abetterway.speaker.gov/_assets/pdf/abetterway-taxpolicypaper.pdf [https://perma.cc/u7x2-6u4c] (report of the gop tax reform tax force, appointed by speaker paul ryan and chaired by rep. kevin brady) (“our high corporate rate, our outdated worldwide tax system, and our origin-basis system that taxes exports have created a perfect storm that has encouraged so 10 columbia journal of tax law [vol.9:5 proposals for a tax holiday that would permit u.s. multinationals to repatriate, at a reduced rate of tax, earnings currently held by foreign subsidiaries have been vigorously debated.17 here, too, behind the rhetoric lies the paradox of corporate tax residence. on the one hand, if place of incorporation properly determines residence, then the subsidiary is not a u.s. resident and its income is properly not reportable until received by the u.s. parent. on the other hand, if place of incorporation is not determinative, then the fact that the corporation sitting at the apex of the corporate hierarchy was incorporated in the united states should not expose to u.s. tax either its or its subsidiaries’ foreign-source income. responding to these challenges, numerous commentators have argued that the problem lies with the current flawed definition of corporate residence. consequently, they have proposed alternative tests that look to factors other than poi, such as central management and control,18 home office,19 customer base,20 primary source of income,21 the stock exchange listing the corporation’s shares,22 or the residence of a majority of its shareholders.23 the criteria by which commentators evaluate the appropriateness of the different test are also many and varied.24 against the background of corporate inversions, many businesses to move their headquarters overseas. that is why the pace of so-called inversions … has accelerated dramatically in recent years.”). 17 ciara linnane, trump’s tax holiday won’t make much of a difference without corporate-tax reform, market watch (dec. 10, 2016), http://www.marketwatch.com/story/trumps-tax-holiday-wontmake-much-of-a-difference-without-corporate-tax-reform-2016-12-08 [https://perma.cc/5bjd-wsyr]; kevin drawbaugh, u.s. senators propose tax holiday for foreign profits, reuters (jan. 30, 2015), http://www.reuters.com/article/us-usa-tax-repatriation-iduskbn0l32cp20150130 [https://perma.cc/p8nzb46f]. in 2004, congress granted a tax holiday that permitted u.s. multinationals to repatriate profits at a 5.25% tax rate. american jobs creation act of 2004, pub. l. no. 108–357, § 965, 118 stat. 1514, 1518 (2004). 18 marian, supra note 1, at 1664; kyrie e. thorpe, international taxation of electronic commerce: is the internet age rendering the concept of permanent establishment obsolete?, 11 emory int’l l. rev. 633, 693 (1997); reuven s. avi-yonah, beyond territoriality and deferral: the promise of “managed and controlled” (univ. of mich. law sch., working paper no. 248, 2011), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1908707 [https://perma.cc/5xj9-6n23] [hereinafter avi-yonah, beyond territoriality]; henry ordower, utopian visions toward a grand unified global income tax, 14 fla. tax rev. 361, 404–05 (2013); terrence r. chorvat, book review: “a different perspective on tax competition”, 35 geo. wash. int'l l. rev. 501, 515 (2003); reuven s. avi-yonah, tax advice for the second obama administration: corporate and international tax reform: proposals for the second obama administration (and beyond), 40 pepp. l. rev. 1365, 1370 (2013). 19 marian, supra note 1, at 1645; avi-yonah, beyond territoriality, supra note 18; president's advisory panel, supra note 11, at 135; tillinghast, supra note 1, at 262; reuven s. avi-yonah, international taxation of electronic commerce, 52 tax l. rev. 507, 528 (1997). 20 george k. yin, letter to the editor, stopping corporate inversions sensibly and legally, 144 tax notes 1087 (2004). 21 rosenzweig, supra note 2, at 507. 22 marian, supra note 1, at 1664; rebecca rudnick, who should pay the corporate tax in a flat tax world?, 39 case w. res. l. rev. 965, 1099 (1988–89); john t. vandenburgh, closing international loopholes, changing the corporation tax base to effectively combat tax avoidance, 47 val. u. l. rev. 313, 347–54 (2012). 23 j. clifton fleming, jr., robert j. peroni & stephen e. shay, defending worldwide taxation with a shareholder-based definition of corporate residence, 2016 b.y.u. l. rev. 1681 (2017); robert a. green, the future of source-based taxation of the income of multinational enterprises, 79 cornell l. rev. 18, 70–74 (1993); edward d. kleinbard, the lessons of stateless income, 65 tax l. rev. 99, 160 (2011). 24 see generally david elkins, the elusive definition of corporate tax residence, 62 st. louis u. l.j. (forthcoming 2018). 2017] the myth of corporate tax residence 11 many ask which test of corporate residence is the least manipulable.25 others prefer tests that are clear and predictable. 26 some attempt to correlate residence with benefit. 27 several scholars have recently suggested looking to the purpose of corporate taxation in order to ascertain the most appropriate definition of corporate residence.28 however, the literature has hitherto failed to address what i believe to be the fundamental questions that must underlie any discussion of corporate tax residence. first, why is residence a relevant attribute when determining tax liability? second, is the concept of tax residence applicable to the corporate entity? instead, the tacit assumption underlying the discourse is that the concept of residence is in principle applicable to corporations and that it is the task of commentators and policy makers to formulate an appropriate test by which to determine the residence of corporations.29 the thesis of this article is that such an assumption is unwarranted and that tax residence is an attribute of individuals only, inapplicable to the corporate entity. already at the outset, it is important to stress that the argument is not semantic. i will not rest my claim on the fact that, as nonphysical entities, corporations cannot “reside” in a place in the same sense that natural persons can. rather, i will argue that the distinction between residents and nonresidents derives from the need to delineate the universe within which 25 fleming et al., supra note 23, at 1687–89, 1691, 1710; marian, supra note 1, at 1643, 1653; shaviro, supra note 12, at 381–85 (distinguishing between formal and substantive electivity); rosenzweig, supra note 2, at 495; michael j. mcintyre, determining the residence of members of a corporate group, 51 can. tax j. 1567, 1571 (2003); aldo forgione, clicks and mortar: taxing multinational business profits in the digital age, 26 seattle u. l. rev. 719, 725–26 (2003); daniel shaviro, why worldwide welfare as a normative standard in u.s. tax policy?, 60 tax l. rev. 155, 172 (2007); ilan benshalom, the quest to tax financial income in a global economy: emerging to an allocation phase, 28 va. tax rev. 165, 216–17 (2008); tootle, supra note 2, at 354; reuven s. avi-yonah, globalization, tax competition, and the fiscal crisis of the welfare state, 113 harv. l. rev. 1573, 1595–96 (2000) [hereinafter avi-yonah, globalization]; john a. swain, same questions, different answers: a comparative look at international and state and local taxation, 50 ariz. l. rev. 111, 117 (2008); reuven s. avi-yonah, kimberly a. clausing & michael c. durst, allocating business profits for tax purposes: a proposal to adopt a formulary profit split, 9 fla. tax rev. 497, 499 (2009) [hereinafter avi-yonah et al., allocating]; stephen e. shay, j. clifton fleming, jr. & robert j. peroni, designing a 21st century corporate tax – an advance u.s. minimum tax on foreign income and other measures to protect the base, 17 fla. tax rev. 669, 718 (2015); susan c. morse, startup ltd.: tax planning and initial incorporation location, 14 fla. tax rev. 319 (2013); daniel n. shaviro, fixing u.s. international taxation 70–71 (2014) [hereinafter shaviro, fixing]; avi-yonah, supra note 19, at 528. 26 tillinghast, supra note 1, at 258–66; rosenzweig, supra note 2, at 489; julie roin, can the income tax be saved? the promise and pitfalls of adopting worldwide formulary apportionment, 61 tax l. rev. 169, 189 (2008); kirsch, supra note 8, at 568; reuven s. avi-yonah, for haven's sake: reflections on inversion transactions, 95 tax notes 1793, 1797 (june 17, 2002). 27 rudnick, supra note 22, at 994; marian, supra note 1, at 1615, 1642 (describing this view); reuven s. avi-yonah, corporations, society, and the state: a defense of the corporate tax, 90 va. l. rev. 1193, 1205–06 (2004); kirsch, supra note 8, at 551–67; andrew mun, reinterpreting corporate inversions: non-tax competitions and frictions, 126 yale l.j. 2152 (2017) (solution to problem of corporate inversions is to align tax paid with benefits). cf. j. clifton fleming, jr., robert j. peroni & stephen e. shay, fairness in international taxation: the ability-to-pay case for taxing worldwide income, 5 fla. tax rev. 299, 315 (2001); stephen e. shay, j. clifton fleming, jr. & robert j. peroni, the david r. tillinghast lecture: ‘what’s source got to do with it?’ source rules and u.s. international taxation, 56 tax l. rev. 81, 104–05 (2002). 28 fleming et al., supra note 23; marian, supra note 1; mcintyre, supra note 25, at 1570. 29 on rare occasion, the assumption is explicit. see, e.g., tillinghast, supra note 1, at 239–40; rosenzweig, supra note 2, at 475 (“[t]his article assumes that the united states has an income tax that turns, in part, on the residency of corporations …”). 12 columbia journal of tax law [vol.9:5 certain norms of distributive justice operate and that, as the nature of the corporate entity precludes its membership in any scheme of distributive justice, the categories of “resident” and “nonresident” are inapplicable to it. part ii will explore why residence is a relevant attribute when determining the tax liability of individuals. it will explain that income tax is an application of the principle that tax liability should accord with ability-to-pay and that, in turn, ability-to-pay derives from a certain set of conceptions regarding distributive justice. under these conceptions, distributive justice is not universal in scope, but applies only to those with a significant personal connection to a given society. residents are those who are subject to taxation in accordance with their ability to pay. for nonresidents, the guiding principle in determining tax liability is not distributive justice but rather commutative justice. part iii will examine whether the concept of residence is applicable to corporations. it will argue that as corporations have no personal identity, experience neither pleasure nor pain, have no personal attachments, and are not kantian rational beings, they cannot be members of a collective to which the terms of distributive justice apply. part iv distinguishes between corporations and their shareholders. although corporations cannot be residents of a country, individual shareholders can, and as computing their ability-to-pay requires taking into account their accession to wealth derived from shareholding, a means must be found whereby to tax them on that income. in the domestic arena, the corporate income tax serves this function. however, with regard to any corporation with both u.s. and foreign shareholders, the imposition of tax on the corporate entity as a proxy for taxing individual shareholders is not feasible. consequently, the current corporate tax regime is unviable in the international arena. part v describes in broad outline an alternative international corporate tax regime that would attempt to reach the worldwide income of resident shareholders and the u.s.source income of nonresident shareholders. part vi summarizes the findings and offers some concluding thoughts. ii. individual residence a. introduction in order to examine whether the concept of residence is applicable to corporations, we first need to understand why a person’s residence is relevant when determining tax liability. this part will explore residence in the context of individual taxpayers. part iii will then turn to corporate residence. b. ability-to-pay the role played by residence in international taxation is a function of the normative underpinnings of home-country income taxation.30 contemporary literature 30 home country taxation is the tax imposed by a country on its own residents. host country taxation is the tax imposed by a country on foreign residents who engage in economic activity, including passive investment, within its territory. in other words, if we focus on income tax, an individual may be 2017] the myth of corporate tax residence 13 justifies the income tax by reference to the principle of ability-to-pay. 31 this term expresses the idea that those who are better off should contribute more to the provision of services for the general welfare than do those who are less well off. why they should do so is a question to which supporters of ability-to-pay taxation offer various answers.32 some refer to utilitarian doctrine.33 because of the decreasing marginal utility of money, taking a dollar from a wealthy individual causes less disutility than does taking a dollar from a poor individual; and taking a dollar from a wealthy individual and using it to subject to a country's income tax regime either by virtue of the fact that the individual resides in the country or by virtue of the fact that the individual derives income from sources located within that country. 31 see, e.g., professors bruins, einaudi, seligman & sir josiah stamp, report on double taxation submitted to the financial committee of the league of nations (1923), reprinted in 4 staff of joint comm. on tax’n, legislative history of united states tax conventions 4022 (1962) [hereinafter league of nations report on double taxation] (“[t]he entire exchange theory has been supplanted in modern times by the faculty theory or theory of ability to pay.”); shay et al., supra note 27, at 94 (“[t]he principal normative justification for income taxation is that it allocates the cost of government among taxpayers on the basis of comparative economic well-being, or ability to pay.”); kyle c. logue & gustavo g. vetton, narrowing the tax gap through presumptive taxation, 2 colum. j. tax l. 100, 112– 13, 121 (2010); donna m. byre, progressive taxation revisited, 27 ariz. l. rev. 739, 765 (1995); eric jensen, the taxing power, the sixteenth amendment, and the meaning of “incomes,” 33 ariz. st. l.j. 1057, 1091 (2001) (“from the beginning, supporters of the modern income tax stressed that it was necessary to tie taxation to ability to pay …”); marjorie e. kornhauser, choosing a tax rate structure in the face of disagreement, 52 ucla l. rev. 1697, 1708−17 (2005); shaviro, supra note 12, at 388−89. before the mid-nineteenth century, benefit theory dominated the tax policy discourse. see, e.g., thomas hobbes, leviathan 238 (richard tuck ed., 1996) (taxes should be imposed in accordance with “the benefit that every one receiveth thereby …”); adam smith, an inquiry into the nature of and causes of the wealth of nations 310 (1776); jeremy bentham, the principles of morals and legislation 160 (1789) (“to defend the community against its external as well as its internal adversaries, are tasks, not to mention others of a less indispensable nature, which cannot be fulfilled but at a considerable expense. but whence is the money for defraying to costs to come? it can be obtained in no other manner than by contributions to be collected from individuals; in a word, by taxes. the produce then of these taxes is to be looked upon as a kind of benefit which it is necessary the governing part of the community should receive for the use of the whole.” (emphasis in the original)); league of nations report on double taxation, supra note 31, at 4022 (“the older theory of taxation was the exchange theory, which was related directly to the philosophical basis of society in the ‘social contract,’ according to which the reason and measure of taxation are in accordance with the principles of an exchange as between the government and the individual … the benefit theory was that taxes ought to be paid in accordance with the particular benefits conferred upon the individual.”). one of the first to challenge the then-conventional view was john stuart mill, principles of political economy 398 (1848) [hereinafter mill, principles] (“if there were any justice, therefore, in the theory of justice now under consideration, those who are least able of helping or defending themselves, being those to whom the protection of the government is the most indispensable, ought to pay the greatest share of its price …”); john stuart mill, utilitarianism, liberty, representative government 54–55 (1863) (“[i]f there were no law or government the rich would be far better able to protect themselves than the poor would be, and indeed would probably succeed in making the poor their slaves … from these confusions there is no other mode of extrication other than the utilitarian.”). by the mid-twentieth century, benefit theory as a basis for broad-based taxes, such as the income tax, had been relegated to merely historical interest. henry c. simons, personal income taxation 3 (1938) (“[i]t is fair to say … that this principle, with reference to the allocation of the whole tax burden, is now of interest only for the history of the doctrine … [and] has been repudiated as completely by students as by legislatures.”). 32 the classic text examining this issue is walter j. blum & harry j. kalven, uneasy case for progressive taxation (1953). 33 see, in particular, the works of jeremy bentham and john stuart mill, supra, note 31. for a review of jeremy bentham’s writings and their applicability to tax theory, see sagit leviner, the normative underpinnings of taxation, 13 nev. l.j. 95, 113–21 (2012). 14 columbia journal of tax law [vol.9:5 provide public services or to assist the needy increases the total quantum of happiness.34 some rely on rawlsian principles. according to rawls, everyone has an equal moral claim to material resources and other primary goods.35 justice permits deviation from an equal distribution of wealth only to the extent that such inequality works to the benefit of the least well-off stratum of society.36 if the market distribution is more unequal than that —as is likely the case—then justice requires a redistribution of resources.37 some refer to sacrifice theory, according to which each person should experience the same degree of pain from paying taxes: because of the declining marginal utility of money, a wealthy individual would need to pay more than a poor person in order to experience the same degree of disutility.38 others seem to rely on an innate sense of fairness not necessarily grounded in a rigorous theory of social philosophy.39 that individuals who can afford to 34 see, e.g., henry sidgwick, the principles of political economy 519 (1887) (“the common sense of mankind, in considering these inequalities, implicitly adopts, as i conceive, two propositions laid down by bentham as to the relation of wealth to happiness: viz. (1) that an increase of wealth is—speaking broadly and generally—productive of an increase of happiness to its possessor; and (2) that the resulting increase in happiness is not simply proportional to the increase in wealth, but stands in a decreasing ratio to it … and from these two propositions taken together the obvious conclusion is that the more any society approximates to equality in the distribution of wealth among its members, the greater on the whole is the aggregate of satisfactions which the society in question derives from the wealth it possesses.”). see also jennifer bird-pollan, utilitarianism and wealth transfer taxation, 69 ark. l. rev. 695 (2016); calvin h. johnson, was it lost? personal deductions under tax reform, 59 smu l. rev. 689, 693 (2006); martin j. mcmahon, jr. & alice g. abreu, winner-take-all markets: easing the case for progressive taxation, 4 fla. tax rev. 1 (1998). see also the sources cited in jeffrey a. schoenblum, tax fairness or unfairness? a consideration of the philosophical bases for unequal taxation of individuals, 12 am. j. tax pol’y 221, 236–42 (1995). 35 john rawls, a theory of justice 103–04 (1971). 36 id. at 62, 75–78. 37 id. at 246–47 (justifying “steeply progressive income taxes” “given the injustice of existing institutions”). see also jennifer bird-pollan, unseating privilege: rawls, equality of opportunity, and wealth transfer taxation, 59 wayne l. rev. 713, 713 (2013); schoenblum, supra note 34, at 251–57 (1995) (discussing and criticizing the principles of taxation derivable from rawls). 38 jay a. soled, a proposal to lengthen the tax accounting period, 14 am. j. tax pol’y 35, 57 (1997) (describing proportional sacrifice as “one of the fundamental tenets of a progressive tax structure”); bruce anderson, strategic choice taxation: a solution to the federal revenue crisis, 1995 colum. bus. l. rev. 281, 297, n.48; mcmahon & abreu, supra note 34, at 32 (“the most persuasive arguments for the equity of progressive taxation rest on the concept … that taxation ought to exact equiproportional sacrifice”); richard winchester, parity lost: the price of a corporate tax in a progressive tax world, 9 nev. l.j. 130, 131 (2008) (“[t]he income tax in the united states has always been intended to allocate the burden based on an individual’s ability to pay. this essentially embraces a theory of fairness referred to as the equal sacrifice theory.”) david kamin, what is a progressive tax change?: unmasking hidden values in distributional debates, 83 n.y.u. l. rev. 241, 272–79 (2008); jeffrey h. kahn, personal deductions – a tax “ideal” or just another “deal”?, 2002 mich. st. u. – detroit coll. l. rev. 1, 23 (“[e]qual sacrifice theory provides the most compelling argument for progressivity.”); eric rakowski, symposium on wealth taxes part i: can wealth taxes be justified?, 53 tax l. rev. 263, 310–16 (2000); robert f. parsley, building a house of cards: a policy evaluation of tennessee’s tax reform act of 2002 with emphasis on fairness to the poor, 70 tenn. l. rev. 1177, 1181–82 (2003); kornhauser, supra note 31, at 1717–21; sagit leviner, from deontology to practical application: the vision of a good society and the tax system, 26 va. tax rev. 405, 427 (2006). 39 schoenblum, supra note 34, at 235 (“the ability to pay principle has now gained such widespread currency that its underlying premise rarely is questioned by tax law scholars. they tend to assume uncritically that there is a direct relation between ability to pay and fairness.”); fleming et al., supra note 27, at 309 (describing the ability-to-pay doctrine as “dogma”). 2017] the myth of corporate tax residence 15 do so should pay more than those who are struggling seems to strike an intuitive chord that is often sufficient to support a policy of taxation according to ability-to-pay.40 for the purpose of our discussion, it is not important to identify the precise theoretical justification for taxation according to ability-to-pay or even to determine whether it has a precise theoretical justification. all that we need to note is that the subject matter of ability-to-pay taxation is the welfare of the various members of the collective, the conflicting claims to material resources held by various members of the collective, and the rights and obligations of those who are better off vis-à-vis those who are not as well off. furthermore, in the context of tax policy, ability-to-pay is not an absolute or descriptive, but rather a relative and normative, term of art. it does not describe an individual’s absolute capacity to pay tax (a term which, when taken literally, refers to a person’s entire wealth or entire income); rather, it compares the relative effect of paying tax on the welfare of different individuals.41 granted, not all commentators accept the idea of taxation according to ability-topay. some argue that justice permits charging individuals no more than the market price of the services that they receive.42 more extreme versions hold that justice prohibits charging for services, even those that confer positive value, unless the recipient of those services explicitly contracted to pay for them.43 however, as income tax derives from the doctrine of ability-to-pay and as the question we are considering is whether residence is a concept applicable to corporations within the framework of income taxation, we do not need to consider these views here. c. taxation of worldwide income the fact that income tax derives from the concept of ability-to-pay has an important ramification in the international arena. if the appropriate measure of ability-topay is accession to wealth,44 then tax liability must be a function of worldwide income.45 40 see, e.g., sergio pareja, taxation without liquidation: rethinking “ability to pay,” 8 wis. l. rev. 841, 843 (2008) (“our tax system aims to tax people based on their ability to pay. as a society, we believe that it is fairer to make a billionaire pay more taxes than a homeless person.”); joel s. newman, a short & happy guide to federal income taxation 7 (2017) (“quite a few of us can’t afford $6,250 per year … on the other hand, there are quite a few other folks in the us who can afford to pay a lot more than $6,250 per year. so what should we do? we should levy taxes based upon ability to pay.”). 41 the text intentionally leaves the term “welfare” vague, as there are different opinions regarding the ultimate subject matter of distributive justice: pleasure, happiness, satisfaction of rational desire, access to resources necessary to realize one’s ends, and so forth. see generally rawls, supra note 35, at 25, 92–93; ronald dworkin, what is equality? part 1: equality of welfare, 10 phil. & pub. aff. 185 (1981); ronald dworkin, what is equality? part 2: equality of resources, 10 phil. & pub. aff. 283 (1981). 42 see, e.g., john r. mcculloch, for proportional taxation, in viewpoints on public finance 22, 25 (harold m. grooves ed., 1947) (“providence has not been charged with injustice because the corn and other articles used indifferently by the poor and the rich cost one class as much as they cost the other. and such being the case, how can it be pretended that governments, in laying equal duties on these articles, commit injustice? a rich man will, of course, pay taxes and everything else, with less inconvenience than one who is poor. but is that any reason why he should be unfairly treated?”). 43 see, e.g., robert nozick, anarchy, state, and utopia 95 (1974) (“one cannot, whatever one’s purposes, just act so as to give people benefits and then demand (or seize) payment. nor can a group of persons do this.”). 44 this view is not universally held. there are those who argue that consumption and wealth are better measures of ability-to-pay than is income. see, e.g., william d. andrews, a consumption-type or cash flow personal income tax, 87 harv. l. rev. 1113 (1974); david f. bradford, the case for a personal consumption tax, in what should be taxed: income or expenditure? 75 (joseph a. pechman 16 columbia journal of tax law [vol.9:5 for example, an individual with $100,000 in domestic income and $900,000 in foreignsource income has—subject to proper accounting for any foreign income tax liability— the same ability to pay tax as does an individual with $1,000,000 in domestic-source income.46 imposing tax only on their domestic-source income would constitute a clear violation of the doctrine of ability-to-pay, manifested in this context of this example as a violation of horizontal equity.47 furthermore, as the wealthy tend to have relatively more foreign-source earnings than those who are less well off, ignoring foreign-source income in calculating ability-to-pay would violate vertical equity, another principle derived from the principle of taxation in accordance with ability-to-pay. d. delineating the parameters of the collective the concept of ability-to-pay is meaningless without delineating the parameters of the collective to which it refers. in other words, whose welfare, whose needs, whose claims, and whose resources are relevant? the collective to which the principles of distributive justice apply is a contentious issue in social philosophy. social philosophers of the cosmopolitan school argue that the proper collective is humanity as a whole and that the rights and obligations of distributive justice transcend national boundaries.48 adopting such an approach would require taking into account the ability-to-pay and the needs of every person on the planet, imposing a worldwide tax, and providing worldwide benefits.49 others disagree and limit the scope of distributive justice to the confines of a political society.50 under this approach, it is the ability-to-pay and the needs of members ed., 1980); david shakow & reed shuldiner, a comprehensive wealth tax, 53 tax l. rev. 499 (2000). however, we do not need to consider these views here. the purpose of this article is not to challenge income taxation but to challenge the concept of corporate taxation within the framework of income taxation. consequently, i will accept arguendo the underlying assumptions of income taxation: that people should pay tax in accordance with their ability-to-pay, and that the appropriate measure of ability-to-pay is income. 45 in contrast, benefit theory has a difficult time justifying the taxation of foreign-source income: when income is earned abroad, it is the host country that provides the relevant services. 46 see, e.g., fleming et al., supra note 27, at 310–13; michael s. kirsch, the role of physical presence in the taxation of cross-border personal services, 51 b.c. l. rev. 993, 1043–44 (2010); rosenzweig, supra note 2, at 478; paul r. mcdaniel, territorial vs worldwide international tax systems: which is better for the u.s.?, 8 fla. tax rev. 283, 299–300 (2007); john p. steines, jr., the foreign tax credit at ninety-five bionic centenarian, 66 tax l. rev. 545 (2013). 47 horizontal equity dictates that similarly situated persons should bear identical tax burdens. see, e.g., david elkins, horizontal equity as a principle of tax theory, 24 yale l. & pol’y rev. 43 (2006); ira k. lindsay, tax fairness by convention: a defense of horizontal equity, 19 fla. tax rev. 79 (2016); james repetti & diane ring, horizontal equity revisited, 13 fla. tax rev. 135 (2012); brian galle, tax fairness, 65 wash. & lee l. rev. 1323 (2008). 48 see, e.g., brian barry, the liberal theory of justice: a critical examination of the principle doctrines in a theory of justice by john rawls 128–30 (1973); charles r. beitz, political theory and international relations 139–41, 143–53 (1979); loren lomasky, toward a liberal theory of natural boundaries, in boundaries and justice 55, 56–60 (david miller & sohail h. hashmi eds., 2001); thomas w. pogge, realizing rawls 240, 250–51 (1989); kok-chor tan, justice without borders: cosmopolitanism, nationalism and patriotism 60 (russell hardin et al. eds., 2004). 49 such a structure might not be possible without a world government with global enforcement powers. see, e.g., thomas nagel, the problem of global justice, 33 phil. & pub. aff. 113, 115 (2005) (“if hobbes is right, the idea of global justice without a world government is a chimera.”). 50 daniel bell, communitarianism and its critics 150–51 (1993); margaret canovan, nationhood and political theory 28–29 (1996); ronald dworkin, law’s empire 208 (1986); will kymlicka, politics in the vernacular: nationalism, multiculturalism and citizenship 225 (2001); avishai margalit, the ethics of memory 74–76 (2002); john rawls, the law of peoples (1999); 2017] the myth of corporate tax residence 17 of the society, not those of outsiders, that dictate who pays how much tax and how the revenue is spent. national legislatures—whether because of a principled rejection of cosmopolitanism or because of the practical limits of national sovereignty—adopt the latter approach.51 consequently, domestic law needs to distinguish between members of the collective and outsiders, between those among whom the norms of distributive justice apply and those who are beyond the parameters of those norms. while there is no universally accepted criterion by which countries delineate which individuals are members of the collective and which are not, the common denominator of all such criteria is that they reflect an individual’s personal attachments to the society in question. typical criteria include physical presence, habitual abode, personal and social attachments, and domicile.52 under u.s. tax law, the criteria for including an individual within the ambit of those whose ability-to-pay is a factor in determining tax liability are physical presence,53 citizenship,54 and formal status as a permanent resident (“green card” holder).55 those whom the law views as members of the collective are ordinarily termed “residents.” those whom the law views as outside the collective are ordinarily termed “nonresidents” or “foreigners.”56 the goal of the tax system and of the services that it funds is to promote the welfare of residents. of course, the welfare interests of residents can conflict. policies that promote the welfare of some may be detrimental to the welfare of others, and this is particularly true with regard to taxation. however, this conflict is precisely what the norms of distributive justice seek to regulate: given the fact that resources are limited, how should richard rorty, contingency, irony, and solidarity 190–91 (1989); yael tamir, liberal nationalism 121 (1993). 51 see, e.g., michael s. kirsch, taxing citizens in a global economy, 82 n.y.u. l. rev. 443, 480 (2007) (“the threshold question is whether ability-to-pay analysis should adopt a worldwide perspective, which would consider the relative incomes of all individuals worldwide, or whether it should adopt a national perspective, looking only at the incomes of members of u.s. society (however defined). commentators who have addressed this issue have generally concluded that, for both practical and theoretical reasons, u.s. tax policy should take a national perspective.”); shaviro, fixing, supra note 25, at 98–103. 52 ruth mason, citizenship taxation, 89 s. cal. l. rev. 169, 178 (2016) (“states … determine residence by evaluating connecting factors such as whether the taxpayer has a dwelling in the jurisdiction, whether her family resides there, and whether she has social and economic connections to the jurisdiction.”); edward a. zelinsky, citizenship and worldwide taxation: citizenship as an administrable proxy for domicile, 96 iowa l. rev. 1289, 1323 (2011) (“many nations, implicitly or expressly, define residence for tax purposes as domicile …”); daniel shaviro, taxing potential community members’ foreign source income 2 (new york univ. ctr. for law, econ. & org., working paper no. 15-09, 2015), available at https://papers.ssrn.com/sol3/papers2.cfm?abstract_id=2625732 [https://perma.cc/88va-9a4s] (mentioning “location of property that one owns in-country, such as a home; the place where one’s primary business or other economic ties appear to be located; and the place of residence for close family members.”). 53 i.r.c. § 7701(b)(1)(a)(ii), (3). 54 i.r.c. § 872(a) (excluding foreign source income from the gross income of “nonresident alien individuals” and leaving nonresident citizens subject to the general provisions of i.r.c. § 61(a), under which “gross income means all income from whatever source derived …”). 55 i.r.c. § 7701(b)(1)(a)(i). 56 because the united states includes citizens, whatever their other attachments to the country, within the collective, the terms employed by u.s. tax law for individuals who outside the collective is “nonresident alien.” i.r.c. § 872. nevertheless, for the sake of simplicity the text will refer to those subject to tax on their worldwide income as “residents” and to those who are not as “nonresidents” or “foreigners.” in the u.s. context, the term “residents” includes nonresident citizens, and the terms “nonresidents” and “foreigners” refer to nonresident aliens. 18 columbia journal of tax law [vol.9:5 they be distributed among the members of the collective?57 each theory of distributive justice effectively provides a matrix by which to evaluate the justice of alternative distributions of resources. for example, under a utilitarian approach, the ideal distribution is one that maximizes total welfare.58 under rawls’ difference principle, the ideal distribution is one that maximizes the well-being of the least well-off segment of society.59 alternative approaches to distributive justice might assign different values to efficiency, equality, contribution, need, and so forth and choose other distributions as ideal.60 for our purposes, the details and justifications of the various conceptions of distributive justice are not important. what is important from our perspective is that each considers the effect of public policy on the welfare of the members of the collective and attempts, each in its own way, to describe an appropriate balance. the welfare of nonresidents is not an essential element of the matrix by which national governments determine their tax policy. granted, relatively wealthy countries often provide foreign aid to countries that are less well off. however, there is both a qualitative and a quantitative difference between public funds spent on foreign aid and public funds spent on services to residents. qualitatively, the motivation for foreign aid is often the promotion of the donor country’s own power or prestige.61 in other words, it is the welfare of the donor country’s residents—those who stand to benefit from their country’s improved international standing—that serves as the basis of the distributive justice matrix. quantitatively, the amount that countries typically dedicate to foreign aid is minuscule relative the amount that they spend promoting the welfare of their own residents.62 e. taxation of nonresidents under current international usage, countries may and often do impose tax on nonresidents who engage in economic activity—including passive investment—within 57 see, e.g., rawls, supra note 35, at 4 (“[a]lthough a society is a cooperative venture for mutual advantage, it is typically marked by a conflict as well as by an identity of interests. there is an identity of interests since social cooperation makes possible a better life for all than any would have if each were to live solely by his own efforts. there is a conflict of interests since persons are not indifferent as to how the greater benefits produced by their collaboration are distributed, for in order to pursue their ends they each prefer a larger to a lesser share. a set of principles is required for choosing among the various social arrangements which determine this division of advantages and for underwriting an agreement on the proper distributive shares. these principles are the principles of social justice …”). 58 see note 34, supra. 59 see notes 35–37, supra. 60 see, e.g., menahem e. yaari, a controversial proposal concerning inequality measurement, 44 j. of econ. theory 381 (1988). 61 see, e.g., a. cooper drury, richard stuart olson & douglas a. van belle, the politics of humanitarian aid: u.s. foreign disaster assistance, 1964–1995, 67 j. of pol. 454 (2005); andrea civelli, andrew w. w. horowitz & arilton teixeira, is foreign aid motivated by altruism or self interest? a theoretical model and empirical test (feb. 2014), available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2390448 [https://perma.cc/2fc5-7kzb]. 62 in 2015, the nineteen member countries of the oecd’s development assistance council spent 0.47% of their combined gross national income on foreign aid. organisation for economic co-operation and development (oecd), development aid in 2015 continues to grow despite costs for in-donor refugees, 3 (apr. 13, 2016), http://www.oecd.org/dac/stats/oda-2015-detailed-summary.pdf [https://perma.cc/9t5j-uftm]. in contrast, total government spending by oecd countries in 2015 ranged from 29.4% (ireland) to 57.0% (finland) of gnp. oecd, general government spending (2017), https://data.oecd.org/gga/general-government-spending.htm [https://perma.cc/lwe5-pwjv]. 2017] the myth of corporate tax residence 19 their territory. furthermore, countries often provide tax-funded services to such nonresidents. however, the payment of tax and receipt of services does not mean that the rights and obligations of distributive justice apply to nonresidents economically active in a country. when formulating its policies vis-à-vis nonresidents, it is not the welfare of those nonresidents that is of primary concern to the host country, but rather the welfare of its own residents. 63 the host country provides services to nonresidents in order to encourage investment from which it hopes its residents will benefit. it collects tax from nonresidents because doing so allows it to alleviate the tax burden it imposes on its own residents or to provide them with more services without increasing their tax payments.64 the primary practical limitation on taxing nonresidents is that doing so may discourage beneficial foreign investment and, as a consequence, negatively affect the welfare of residents.65 the taxation of nonresidents derives not from principles of distributive justice— as in the case of residents—but rather from principles of commutative justice,66 a concept referred to in the tax literature as exchange theory or benefit theory.67 host countries provide services—including granting the right to operate within their sovereign territory, to access their markets, and so forth—and are entitled to charge for those services whatever the market will bear.68 with regard to nonresidents, the principle of ability to pay is irrelevant. the fact that a nonresident pays more tax than a resident who is wealthier than she, or less than a resident who is poorer than she, does not ground a claim of unjust treatment either of the nonresident (in the former case) or of the resident (in the latter). the principle of ability-to-pay applies only among residents. furthermore, although countries that impose income tax ordinarily include foreign-source income in the tax base of their individual residents, to the best of my knowledge no country attempts to tax the foreign-source income of nonresidents.69 this phenomenon too is a consequence of the inapplicability of norms of distributive justice to nonresidents. because the inclusion of foreign-source earnings in the tax base is a 63 graetz, supra note 2, at 280; shaviro, supra note 12, at 397. 64 league of nations report on double taxation, supra note 31, at 4044 (“a survey of the whole field of recent taxation shows how completely the governments are dominated by the desire to tax the foreigner.”); shay et al., supra note 27, at 89. 65 david elkins, the merits of tax competition in a globalized economy, 91 ind. l.j. 905, 932, 948 (2016). 66 for a discussion of commutative justice in taxation, see david elkins, taxation and the terms of justice, 41 u. toledo l. rev. 73, 78–82 (2009). 67 barker, supra note 11, at 665 (“the exchange or benefit principle of taxation is the primary theory that underlies source-based international taxation.”); fleming et al., supra note 27, at 307 n.13 (“because … [the tax regime applicable to nonresidents] usually reaches less than the taxpayer's entire net income, it cannot be grounded on ability-to-pay. instead, it is often rationalized as a benefit-based charge imposed by the source country.”); j. clifton fleming, jr., robert j. peroni & stephen e. shay, designing a u.s. exemption system for foreign income when the treasury is empty, 13 fla. tax rev. 397, 401 (2012) (“[e]very country has a normative claim, based on a benefits-received rationale, to tax income earned by foreigners within its borders.”); lawrence lokken, the source of income from international uses and disposition of intellectual property, 36 tax l. rev. 235, 239–40 (1981); herwig j. schlunk, how i learned to stop worrying and love double taxation, 79 notre dame l. rev. 127, 129–30 (2003); shay et al., supra note 27, at 90–91. 68 shay et al., supra note 27, at 95 (“[t]he justification for source taxation cannot be ability to pay but instead must be a charge for access to the source country market.”). 69 recall that in the case of the united states, the term “resident” in the text refers also to nonresident citizens. see note 56, supra. 20 columbia journal of tax law [vol.9:5 function of the ability-to-pay concept, and because ability-to-pay is inapplicable to nonresidents, nonresidents are not subject to tax on their foreign-source income. in summation, the distinction between residents and nonresidents is ultimately a distinction between those who are subject to taxation according to the standard of ability-to-pay and those who are not.70 iii. corporate residence part ii demonstrated that for individuals, residence means a personal connection significant enough that one’s welfare is properly taken into account as part of the matrix of distributive justice and that one is therefore properly subject to taxation in accordance with the principle of ability-to-pay. this part will examine whether the income tax concept of residence is applicable to corporations. a. welfare residence is a matter of whose welfare is important. in designing the contours of its tax structure, a country’s only or primary concern is promoting the welfare of its own residents. the potential impact on the welfare of nonresidents plays little or no role (except to the extent that the resultant behavior of nonresidents might affect the welfare of residents). therefore, when we ask which corporations are residents and which are nonresidents, we are effectively asking which corporations’ welfare should constitute part of the matrix by which we determine economic and social policy. phrasing the question in this manner underscores the absurdity inherent therein. however much the law or popular discourse might anthropomorphize the corporate entity,71 a corporation is not a sentient being.72 well-being, in the sense that is relevant to distributive justice, is not an attribute of juristic entities.73 of course, the success or failure of a corporation can affect the welfare of individuals and the fate of the corporate enterprise is consequently of interest for public policy, but it is the welfare of the affected 70 for a discussion of “[t]he paradox [that i]f you’re among ‘us’ and we care about you, you lose … since it means that [you] may have to pay tax on [your foreign source income],” see shaviro, supra note 52, at 24–29. (emphasis removed). 71 see, e.g., brent fisse & john braithwaite, the allocation of responsibility for corporate crime: individualism, collectivism and accountability, 11 sydney l. rev. 468, 482 (1988) (“we often react to corporate offenders not merely as impersonal harm-producing forces but as responsible, blameworthy entities.”) (footnote omitted). 72 see, e.g., robert b. reich, supercapitalism: the transformation of business, democracy, and everyday life 216 (2007) (“a final truth that needs to be emphasized—the most basic of all—is that corporations are not people.”). 73 see william b. barker, a common sense corporate tax: the case for a destination-based, cash flow tax on corporations, 61 cath. u. l. rev. 955, 1000 (2012) (“corporations have control over resources, but, as artificial persons, their relation to the state and society cannot be described in the same way as individuals.”) (footnote omitted); fleming et al., supra note 27, at 319 (“this taxation scheme cannot be explained on ability-to-pay grounds because liability under the corporate-level tax is calibrated to the taxable income of the corporation and bears no necessary relationship to the respective abilities to pay of any individuals.”) (footnote omitted); shaviro, supra note 12, at 395 (“[c]orporations are not sentient beings, and cannot feel benefits or burdens. thus, they are not directly of normative interest. relevant distributional goals can only relate to people.”). 2017] the myth of corporate tax residence 21 individuals rather than the success or failure of the corporation that has normative and economic import.74 in the literal, descriptive sense of the term, a corporation has an ability-to-pay tax. its ability-to-pay is equal to its net equity, the totality of its assets, or the whole of its income: the government simply cannot take more than that amount.75 however, we have already noted that in the context of tax policy, the concept of ability-to-pay is not descriptive or absolute, but rather prescriptive and relative.76 it compares the effect of paying tax on the welfare of various taxpayers and evaluates which tax schemes most closely conform to the relevant conception of distributive justice. in this sense of the term, corporations have no ability-to-pay tax because there is no such thing as the welfare of a corporation.77 the primary purpose for distinguishing between residents and non-residents is that residents and only residents are properly subject to ability-to-pay taxation. the fact that the principle of ability-to-pay is inapplicable to the corporate entity means that residence too is inapplicable to the corporate entity. b. personal connections the principle of ability-to-pay applies to those with a substantial personal connection to the country concerned.78 purely economic connections, however extensive, are in themselves insufficient to invoke the rights and obligations of distributive justice that underlie ability-to-pay taxation. granted, in borderline cases, when an individual has strong personal connections to more than one country, economic connections might be relevant in determining residence. for example, most income tax treaties include among their “tie-breaking” rules, used to assign residence when an individual is a resident of both contracting states under their domestic laws, a reference to the country “with which his personal and economic relations are closer (center of vital interests).”79 nevertheless, 74 despite its reputation as the dismal science, “[t]he ultimate goal of economic science is to improve the living conditions of people in their everyday lives.” paul a. samuelson & william d. nordhaus, economics 7 (2010). 75 whether the measure of descriptive (as opposed to normative) ability-to-pay is equity, assets, or income is a matter of definition. if ability-to-pay means the most that a corporation could pay while retaining enough assets to repay its creditors, then its ability-to-pay is equal to its equity. if ability-to-pay means the most the government could take without regard to the claims of creditors, then the corporation’s ability-topay is equal to the totality of its assets (although one might reasonably argue that the ability-to-pay of the corporation is limited to its equity and that any amount taken beyond that is part of the ability-to-pay of the creditors). if ability-to-pay means the most the government could take while allowing the corporation to continue functioning indefinitely, then the corporation’s ability-to-pay is equal to the whole of its periodic income. 76 see supra text accompanying note 41. 77 joseph m. dodge, a combined mark-to-market and pass-through corporate-shareholder integration proposal, 50 tax l. rev. 265, 274 (1995) (“the ability to pay norm … is … a maxim … of tax fairness, which has to do with how the aggregate burden of taxation should be apportioned among individuals. thus, saying that a public corporation has a separate ability to pay does not justify its being treated as a separate taxable unit from a fairness perspective, other than as … perhaps a withholding vehicle pending dividend distributions.”) (footnotes omitted); marian, supra note 1, at 1616 (“scholars agree … that for tax purposes, corporations are not real beings. rather, corporations are instruments for the taxation of individuals.”) (footnotes omitted). 78 see supra part ii.d. 79 see, e.g., united states model income tax convention, art. 4, ¶ (3)(a) (2016); u.n. dep’t of econ. & soc. affairs, u.n. model double taxation convention between developed and 22 columbia journal of tax law [vol.9:5 a number of caveats are in order. first, the united states, the oecd, and the un model income tax conventions all rely on an initial tie-breaking rule that involves a purely personal connection: the place of the individual’s permanent home. only if the permanent home test does not resolve the issue—either because the individual has a permanent home in both countries or because she does not have a permanent home in either country—do the treaties invoke “center of vital interests” as a secondary tie-breaker.80 second, the primary focus of the “center of vital interests” test itself is the individual’s personal, not economic, connections.81 third, and perhaps most important, economic connections can never establish residency. the basis for residence is the country’s determination, under its domestic laws, that the individual has a sufficient personal nexus to the country.82 the economic connection serves merely to limit a country’s right to tax an individual, despite the personal connection, because of the individual’s stronger connection to another country. the emphasis on an individual’s personal connection to a country is not capricious. those personal connections that bind members of a community together function as a trigger for the rights and obligations of distributive justice that underlie ability-to-pay taxation. assume, for instance, that one of the obligations of distributive justice is a duty to provide some level of support to those who are incapable of providing for their own needs. now consider the case of an individual whose sole connection to a country is economic. perhaps she owns income-producing property in the country. perhaps she even has active business interests in the country. should she become destitute for whatever reason, she would have no claim under the terms of distributive justice for support from the host country. the country that she would need to turn to for support would be her own country of residence, the one with which she maintains her strongest personal connections. of course, the fact that economic connections cannot serve as the basis for individual residence does not mean that economic connections cannot serve as the basis for the imposition of tax. as a sovereign entity, a country has a right under international developing countries, art. 4, ¶ (2)(a), (2011); oecd, articles of the model tax convention with respect to taxes on income and on capital, art. 4, ¶ (2)(a) (jan. 28, 2003). 80 united states model income tax convention, supra note 79, at art. 4, ¶ (3)(a); u.n. dep’t of econ. & soc. affairs, supra note 79, at art. 4, ¶ (2)(a); oecd, supra note 79, at art. 4, ¶ (2)(a). the commentary to the oecd model income tax convention c(4)–5 states that “[t]he article gives preference to the contracting state in which individual has a permanent home available to him. this criterion will frequently be sufficient to solve the conflict …” oecd, commentaries on the articles of the convention, 86 (2010). the united states model technical explanation accompanying the united states model income tax convention of november 15, 2006 ([the government has not yet published a technical explanation of the 2016 model treaty] clarifies that “[t]hese tests are to be applied in the order in which they are stated.”), available at https://www.treasury.gov/press-center/press-releases/documents/hp16802.pdf [https://perma.cc/cq8c-pby2]. 81 the commentary to the oecd model income tax convention c(4)–6 explains the “centre of vital interest” test as follows: “regard will be had to his family and social relations, his occupations, his political, cultural or other activities, his place of business, the place from which he administers his property, etc. the circumstances must be examined as a whole, but it is nevertheless obvious that consideration based on the personal acts of the individual must receive special attention.” oecd, supra note 80, at 87. 82 see, e.g., united states model income tax convention, supra note 79, at art. 4, ¶ (3)(a); oecd, supra note 79, at art. 4, ¶ (1) (“the term ‘resident of a contracting state’ means any person who, under the laws of that [contracting] state, is liable to tax therein by reason of his domicile, residence, [citizenship] … or any other criterion of a similar nature …”). the corresponding articles of the oecd and un model tax treaties are identical, except that they do not include citizenship as a criterion of residence. 2017] the myth of corporate tax residence 23 law to charge nonresidents for access to its territory and its markets.83 in the field of income taxation, this means that countries have the right to impose tax on nonresidents for income derived from domestic sources.84 they do not have the right to impose tax on the foreign-source income of nonresidents. corporations have no personal connections. due to their nature as juristic persons, the only type of connection that they can have with a country is economic. the country with which it has such a connection may impose tax on the income that the corporation derives from its economic involvement with the country. however, because an economic connection by itself is insufficient to establish a right to impose tax on foreign-source income and because a corporation cannot have any connection other than economic, there can be no justification for imposing tax on a corporation’s foreign-source income. consider the leading case of de beers, decided by the house of lords in 1906.85 de beers concerned the question of when a corporation is a united kingdom resident for the purpose of the corporate income tax. under uk law at the time, a person residing in the united kingdom was liable for tax on annual profits “from any kind of property, whether situated in the united kingdom or elsewhere” and “from any profession, trade, employment, or vacation, whether the same shall be respectively carried on in the united kingdom or elsewhere.”86 the problem facing the house of lords was that residence is a term that conceptually applies to individuals, not to corporations: “it is easy to ascertain where an individual resides, but when the inquiry relates to a company, which in a natural sense does not reside anywhere, some artificial test must be applied.”87 the house of lords decided that in determining the residence of a corporation, one should “proceed as nearly as we can upon the analogy of an individual.”88 the question was then how to analogize, with regard to residence, from a natural person to an artificial person when the terms of reference relate specifically to those characteristics of the former that are absent in the case of the latter. the taxpayer argued that a corporation resides in the country in which it is registered and that, registered in south africa, it was a resident of that territory and not of the united kingdom. in rejecting this argument, the house of lords viewed registration as corresponding not to an individual’s residence but rather to an individual’s citizenship. de beers was in an analogous position to a citizen of south africa. however, just as an individual who is a foreign national may reside in the united kingdom, so too a corporation registered abroad may be a uk resident.89 83 restatement (third) of foreign relations law § 402(1)(a) (am. law inst. 1987); nancy h. kaufman, fairness and the taxation of international income, 29 l. & pol’y int’l bus. 145, 198 (1998) (“a finding that … part of one or more [of] the considerations relevant to economic allegiance … occurs within the territory … of a state is [enough] to endow that state with a competence to tax the income thus produced …”); reuven s. avi-yonah, international tax as international law, 57 tax l. rev. 483, 490 (2004) (“the right of countries to tax income arising in their territory is well established in international law.”). 84 while host countries have the right to tax the domestic source income of nonresidents who operate within their territory, i have argued elsewhere that income is not an appropriate base for taxing nonresidents. see generally david elkins, the case against income taxation of multinational enterprises, 36 va. tax rev. 143 (2017). 85 de beers consolidated mines, ltd. v. howe [1906] ac 455 (hl) (appeal taken from eng.). 86 id. at 457–58 (quoting section 2 of the income tax act 1853, schedule d). 87 id. at 458. 88 id. 89 id. 24 columbia journal of tax law [vol.9:5 what then are the characteristics of a corporation that are analogous to the residence of an individual? “a company cannot eat or sleep,” the house of lords noted, “but it can keep house and do business. we ought, therefore to see where it really keeps house and does business.”90 in other words, for individuals, residence is a function of various aspects of their personal lives (where they eat and sleep). a corporation has no personal life. all it has is a business life. the house of lords therefore analogized between the personal life of an individual and the business life of a corporation and determined that a corporation is a resident of the country in which it conducts its business. of course, this leaves open the question of where a multinational corporation conducts its business. in the case of de beers, its head office was in south africa, it held its general meetings in south africa, its mines were in south africa, it delivered its diamonds to purchasers in south africa, some of the directors and life governors lived in south africa, and some of the directors’ meeting were held in south africa. 91 nevertheless, the house of lords was of the opinion that “the real business is carried on where the central management and control actually abides” and not where its business operations are located.92 in the case of de beers, “the majority of directors and life governors live in england [and] the directors’ meetings in london are the meetings where the real control is always exercised …” 93 consequently, the house of lords concluded that the corporation was a resident of the united kingdom and was liable for uk tax on its worldwide income.94 for our purposes, the significance of de beers is not the central management and control test, but rather the fact that the house of lords relied upon the analogy between the personal life of an individual and the business life of a corporation. upon closer examination, this analogy turns out to be false. individuals have both business lives and personal lives. their personal lives, as appropriate to the terms of distributive justice that underlie the income tax, determine where they are subject to worldwide taxation.95 their business lives—that is, the location of their investments and their business interests, where they work, and so forth—determine where they are subject to territorial taxation. an individual’s business interests, however extensive, are by themselves insufficient to trigger residence and to subject the individual to tax on foreign-source income.96 in 90 id. 91 id. at 458–59. 92 id. at. 458. 93 id. at 459. 94 for a review of the development of the central management and control test in uk case law following de beers, see william m. funk, on and over the horizon: emerging issues in u.s. taxation of investment, 10 hous. bus. & tax l. j. 1, 24–28 (2010); tillinghast, supra note 1, at 261–62. in 1988, parliament expanded the common law definition of residents by providing that a corporation incorporated in the united kingdom is a uk corporation regardless of where it is controlled and managed. finance act 1988, c. 39 (uk), https://www.legislation.gov.uk/ukpga/1988/39/contents; stephan rammeloo, corporations in private international law: a european perspective 135 (2001). since 1965 canadian income tax law has no statutory definition of corporate residence, except for a provision that companies incorporated in canada after april 26, 1965 are deemed to be residents of canada. in determining residence beyond the statutory provision, canadian courts generally follow uk case law. michael s. schadewald & tracy a. kaye, source of income rules and treaty relief from double taxation within the nafta trading bloc, 61 la. l. rev. 353, 363 (2001). 95 see supra subpart b. 96 cf. john k. sweet, formulating international tax laws in the age of electronic commerce: the possible ascendancy of residence-based taxation in an era of eroding traditional income tax principles, 146 u. pa. l. rev. 1949, 1993 (1998) (“unlike individuals, corporations, especially multinational 2017] the myth of corporate tax residence 25 contrast to individuals, corporations have no personal lives; they only have business lives.97 therefore, a proper analogy between individuals and corporations would lead to an opposite conclusion than that arrived at by the house of lords. corporations should be subject to territorial taxation wherever they have economic interests and should nowhere be subject to worldwide taxation.98 in other words, the ontological nature of a corporation precludes it from being a resident of any country. c. the categorical imperative on a deeper philosophical level, taxation in accordance with ability-to-pay, much more so than competing theories, reflects the kantian imperative always to treat rational beings not merely as means but always also as ends.99 under benefit theory, for example, the primary goal of taxation is to prevent a free ride by those who would benefit from public services without paying for them. by requiring that all persons contribute in accordance with the value that they receive, the tax prevents unjust enrichment. effectively, it views government as a means of overcoming market failure: the government provides services that the market cannot and covers the cost by charging each person a fair price for value received.100 factors such as need and relative well-being are irrelevant under benefit theory: what one pays is a function of what one gets. of course, it is difficult in practice to correlate benefits and payments precisely, and scholars have for centuries debated the question of how much each strata of society benefits from enterprises, may operate in multiple places at any given time, rendering it difficult to determine the official ‘residence’ of any particular corporation.”). it is not clear why individuals, like corporations, cannot operate in multiple places at any given time. like a corporation, an individual may have business interests and other investments in various places around the globe. 97 barker, supra note 73, at 1001 (“the essence of the individual's relationship is totality; individuals are social, political, and economic actors. the essence of a corporation's relationship is primarily economic.”). 98 cf. an earlier nontax case, cesena sulphur co. v. nicholson [1876] 1 exch. div. 28, 452 (eng.). (“the use of the word ‘residence’ is founded upon the habits of a natural man, and is therefore inapplicable to the artificial and legal person whom we call a corporation.”). 99 immanuel kant, groundwork of the metaphysic of morals 95–98 (h. j. paton trans., 1964) (1785) [hereinafter kant, groundwork]. kant claimed that his three formulations of the categorical imperative—maxims must be chosen as if they were to hold as universal laws of nature, a rational being is by its nature an end in itself, and all maxims ought to harmonize with a possible kingdom of ends—are substantively identical. id. at 103–04. the question of whether they actually are has been the subject of philosophical debate. in any case, the text focuses on the second formulation of the imperative. for kant’s own view of what we today refer to as distributive justice, see, e.g., immanuel kant, lectures on ethics 179 (peter heath & j.b. schneewind eds., peter heath trans., 1997) (“[i]f we … do a kindness to an unfortunate, we have not made a free gift to him, but repaid him what we were helping to take away through a general injustice. for if none might appropriate more of this world’s goods than his neighbor, there would be no rich folk, but also no poor. thus even acts of kindness are acts of duty and indebtedness, arising from the rights of others.”). rawls expressed his version of the kantian imperative as it applies to distributive justice when he charged that “utilitarianism does not take seriously the distinction between persons.” rawls, supra note 35, at 24. interestingly, nozick hurled the same charge against rawls’ own difference principle. nozick, supra note 43, at 228. 100 see, e.g., c.v. brown & p.m. jackson, public sector economics 27–60 (1990); david n. hyman, public finance: a contemporary application of theory to policy 67–68 (2014). 26 columbia journal of tax law [vol.9:5 government services.101 nevertheless, the overriding principle is that tax burdens should correlate as nearly as possible with value actually received.102 ability-to-pay, on the other hand, looks more to the person than to the service that the person receives. instead of viewing taxpayers merely as a means of financing public expenditures and inquiring how the distribute the burden most fairly, it views them as people with needs and desires and it places at the forefront of the discourse not what the person received from the government but how the payment of tax will affect that person’s welfare. although both benefit theory and ability-to-pay ultimately view persons as ends—under benefit theory, tax is a means by which the government provides taxpayers with welfare-enhancing services103—ability-to-pay takes the imperative one step further by applying it not only to the government’s expenditure function but also to its tax collecting function. it effectively posits that when structuring the tax system, we should treat people also as ends in themselves and not merely as sources of revenue. does the kantian imperative dictate our relationship to the legal person known as a corporation? in introducing this formulation of the categorical imperative, kant writes as follows: suppose, however, that there were something whose existence has in itself an absolute value, something which as an end in itself could be a ground of determinate law; then in it, and in it alone, would there be a ground of a possible categorical imperative— that is, of a practical law. now i say that man, and in general every rational being, exists as an end in himself, not merely as a means for arbitrary use by this or that will; he must in all his actions, whether they are directed to himself or to other rational beings, always be viewed at the same time as an end.104 101 see, e.g., hobbes, supra note 31, at 238; smith, supra note 31, at 310; mill, principles, supra note 31, at 156–57. 102 schoenblum, supra note 34, at 233 n.52; david g. duff, benefit taxes and user fees in theory and practice, 54 univ. of toronto l. j. 391, 405–06 (2004); elkins, supra note 65, at 80; marjorie e. kornhauser, the rhetoric of the anti-progressive income tax movement: a typical male reaction, 86 mich. l. rev. 465, 483–84 (1987). 103 benefit theory emerged during the age of reason as a corollary to the theory of the social contract. in medieval times, monarchs ruled by right, and taxation, although often subject to the dictates of custom with regard to manner and method, was one of the quintessential prerogatives of monarchs, who depended upon tax revenue to support themselves and their court. klaus vogel, the justification for taxation: a forgotten question, 33 am. j. juris. 19, 25 (1988) (“scholastic literature provides a list of examples of permissible purposes for taxation, including funding military armament, the living expenses of the sovereign, ransom of the sovereign from imprisonment, and the dowry for his daughters.”); maurice keen, england in the later middle ages 33–34 (2003); simons, supra note 31, at 3–4 (noting that prior to the french revolution, taxes imposed on the commoners supported the tax-exempt aristocracy and clergy); joseph m. dodge, theories of tax justice: ruminations on the benefit, partnership, and ability-to-pay principles, 58 tax l. rev. 399, 399 (2005). in contrast, the enlightenment’s theory of social contract posits that governments exist to protect and serve the governed and that taxes are payments by the public for services they receive from the state. hobbes, supra note 31, at 238; john locke, two treatises of government § 138 (1689); jean-jacques rousseau, the social contract, in social contract 167 (ernest barker ed., 1962).); cf. david hume, of the original contract, in social contract 145–66 (ernest barker ed., 1962) (rejecting the concept of an original contract based on freely given consent). 104 kant, groundwork, supra note 99, at 95 (italics in the original). 2017] the myth of corporate tax residence 27 corporations are not rational beings in the kantian sense of the term.105 they do not exist as ends inthemselves, but are rather means for the furthering of human welfare. consider, for example, jonathan swift’s satirical proposal to raise children for food.106 one reason that the proposal is morally repugnant is that it treats people as commodities.107 such prohibitions do not apply to our treatment of corporations. forming a corporation in order to exploit it for economic gain and dissolving it when the cost of maintaining its legal personhood exceeds the benefits it provides is morally permissible. granted, the extent to which a corporation is a person has generated vociferous debate in recent years. in citizens united, the supreme court held that corporations have the constitutional right to engage in political speech.108 the academic literature almost unanimously disagrees.109 some philosophers have argued that the corporation is a moral agent with moral duties in its own right (i.e., beyond those it has by virtue of acting as agent for its various stakeholders).110 others deny the corporate entity capable of bearing moral duties.111 nevertheless, to the best of my knowledge, no commentator in any field has gone so far as to advance the view that corporations are entitled to treatment as kantian “rational beings.” in fact, one argument raised against the idea of corporate 105 malla pollack, the romantic corporation: trademark, trust, and tyranny, 42 u. balt. l. rev. 81, 108 (2012) (“any likeness between a kantian-self and a business firm is purely metaphorical.”). 106 jonathan swift, a modest proposal for preventing the children of poor people from being a burden to their parents or country and for making them beneficial to the publick, in a modest proposal and other satires 226 (2004). 107 george wittkowsky, swift’s modest proposal: the biography of an early georgian pamphlet, 4 j. of the hist. of ideas 75, 101 (1943). 108 citizens united v. fed. election comm’n, 558 u.s. 310 (2010). 109 see, e.g., molly j. walker wilson, too much of a good thing: campaign speech after citizens united, 31 cardozo l. rev. 2365 (2010); william alan nelson ii, buying the electorate: an empirical study of the current campaign finance landscape and how the supreme court erred in not revisiting citizens united, 61 clev. st. l. rev. 443 (2013); ganash sitaraman, contracting around citizens united, 114 colum. l. rev. 755 (2014); amy j. sepinwall, citizens united and the ineluctable question of corporate citizenship, 44 conn. l. rev. 575 (2012); james a. gardner, anti-regulatory absolutism in the campaign arena: citizens united and the implied slippery slope, 20 cornell l. & pub. pol’y 673, 674 (2011) (“[t]he court’s decision in citizens united was subjected immediately to severe criticism from regulators, academics, journalists, and citizens.”); jocelyn benson, saving democracy: a blueprint for reform in the post-citizens united era, 40 fordham urb. l. j. 723 (2012). 110 peter a. french, collective and corporate responsibility (1984); peter a. french, corporate ethics (1995); patricia j. werhane, persons, rights, and corporations (1985); wim dubbink & jeffery smith, a political account of corporate moral responsibility, 14 ethical theory & moral prac. 223 (2010); peter a. french, the corporation as a moral person, 16 am. phil. q. 207 (1979); rita c. manning, corporate responsibility and corporate personhood, 3 j. bus. ethics 77 (1984); michael j. phillips, corporate moral personhood and three conceptions of the corporation, 2 bus. ethics q. 435 (1992). 111 thomas donaldson, corporations and morality 20–23 (1982); peter arenella, convicting the morally blameless: reassessing the relationship between legal and moral accountability, 39 ucla l. rev. 1511 (1992); john hasnas, the centenary of a mistake: one hundred years of corporate criminal liability, 46 am. crim. l. rev. 1329 (2009); manuel g. velasquez, why corporations are not morally responsible for anything they do, bus. & prof. ethics j. (1983); thomas weigend, societas delinquere non potest?, 6 j. int. crim. just. 927 (2008); susan wolf, the legal and moral responsibility of organizations, 27 crim. just. 267 (1985); g. sullivan, expressing corporate guilt, 15 oxford j. legal stud. 281 (1995) (reviewing celia wells, corporations and criminal responsibility (1993)). 28 columbia journal of tax law [vol.9:5 moral agency is that corporations clearly have no rights under the terms of distributive justice.112 if the concept of residence in the field of income taxation delineates the universe of persons for whom the overriding principle in determining their tax liability is abilityto-pay, if ability-to-pay reflects the idea that we are obliged to treat people not only as means but also as ends, and if corporations are not ends but merely means, then residence cannot be an attribute of corporations. d. incorporeality commentators have posited that the problem with assigning residence to corporations stems from their incorporeality. for example, professors fleming, peroni, and shay have observed that “precisely because corporations are fictional, they do not live anywhere. thus, determining where a corporation resides is a much more difficult endeavor than determining the residence of a human being.”113 according to professor rosenzweig, the "difficulty with defining residency for entities is that the most straightforward way to define residency—physical presence—is not available, simply because legal entities cannot be physically present in the same manner as individuals.”114 while it is certainly true that the incorporeality of a corporation renders inapplicable the classic determinants of individual residence (physical presence, habitual abode, and so forth), i believe that the fundamental issue goes much deeper. the fact that an individual lives, or is physically present in, a certain place does not have independent normative significance. the reason that the law relies upon these factors is that the law views them as indicative of membership in a collective to which the norms of distributive justice apply.115 if, counterfactually, a corporation could be the subject of distributive justice, the law would properly seek indicia of corporate membership in the relevant community. however, corporations cannot be members of a community to which norms of distributive justice apply, not because they cannot be present in a physical place, but rather because they have no personal identity, do not experience well-being in the relevant sense of the term, have no personal connections, and are not kantian rational beings.116 as a perhaps bizarre, but hopefully insightful thought experiment, imagine that there exist communities of disembodied spirits, that each community possesses resources that can produce (their equivalent of) happiness or reduce (their equivalent of) suffering and that each community has a set of rules to determine who is required to contribute to (and is entitled to benefit from) the communal resources. due to their nature, the rules that these spirits would adopt to delineate community membership would likely be quite different from ours (whether they would use the terms “residence” or some other term 112 donaldson, supra note 111, at 23 (“[i]t seems implausible that [corporations] should have to the right … to draw social security benefits.”). 113 fleming et al., supra note 23, at 1683 (emphasis in the original). 114 rosenzweig, supra note 2, at 479–80. 115 shaviro, supra note 52, at 21 (describing physical location as one factor “that would appear to have strong intuitive appeal, when one thinks about the ‘us’ category …”). 116 a similar issue arises with regard to the application of criminal law to corporations. see albert w. alschuler, ancient law and the punishment of corporations: of frankpledge and deodand, 71 b.u. l. rev. 307 (1991); weigend, supra note 111. see also lawrence friedman, in defense of corporate criminal liability, 23 harv. j.l. & pub. pol’y 833, 841–43 (2000). 2017] the myth of corporate tax residence 29 more appropriate to their circumstances is irrelevant). their rules would reflect whatever type of connection that they considered pertinent in determining who was a member of the relevant community and who was not. these disembodied spirits share with corporations the attribute that they are incorporeal, and consequently, cannot live or be physically present anywhere as can human beings. nevertheless, because they share with humans the attributes of having personal identity and personal connections, of experiencing (their equivalent of) happiness and suffering and of being kantian rational beings, it would be reasonable for them to develop a system of distributive justice and to adopt rules by which to determine who is subject to the rights and obligations of that system.117 it is because corporations lack these attributes—and not because, as incorporeal persons, they do not “reside” anywhere —that they cannot be members of a collective to which the norms of distributive justice apply. iv. taxing corporations and taxing shareholders the conclusion so far, that the concept of residence is inapplicable to corporations, means that the distinction between domestic corporations and foreign corporations is incongruous for tax purposes. granted, there are corporations with economic ties to various countries, just as there are individuals with economic ties to various countries. under the norms of international tax law, those countries are justified in imposing taxes as they see fit on the income allocable to those economic ties.118 117 kant explicitly entertained the possibility of nonhuman rational beings and averred that the moral law would apply to them. “[u]nless we wish to deny to the concept of morality all truth and all relation to a possible object, we cannot dispute that its law is of such widespread significance as to hold, not merely for men, but for all rational being as such …”. kant, groundwork, supra note 99, at 76 (italics in the original). 118 restatement (third) of foreign relations law of the u.s. § 402(1)(a) (am. law. inst. 1987); avi-yonah, supra note 83, at 490 (“the right of countries to tax income arising in their territory is well established in international law.”). the question of how to allocate a corporation’s income among the various countries in which it operates has attracted significant attention in recent years. one current proposal is a formulary approach, in which you allocate the corporation’s income to the various countries with which it has economic ties. aviyonah et al., allocating, supra note 25 at 501; reuven s. avi-yonah & ilan benshalom, formulary apportionment: myths and prospects— promoting better international policy and utilizing the misunderstood and under-theorized formulary alternative, 3 world tax j. 371 (2011); benshalom, supra note 25; ilan benshalom, taxing the financial income of multinational enterprises by employing a hybrid formulary and arm’s length allocation method, 28 va. tax rev. 619 (2009); eric t. laity, the competence of nations and international tax law, 19 duke j. comp. & int’l l. 187, 239–42 (2009); kimberly a. clausing & reuven s. avi-yonah, reforming corporate taxation in a global economy: a proposal to adopt formulary apportionment, the hamilton project (policy brief no. 2007–08, 2007), http://www.hamiltonproject.org/assets/legacy/files/downloads_and_links/reforming_corporate_taxation_in _a_global_economy-_a_proposal_to_adopt_formulary_apportionment_brief.pdf [https://perma.cc/msq3-jjcj]; benshalom, supra note 25. for critique of the formulary apportionment model, see j. clifton fleming, jr., robert j. peroni & stephen e. shay, formulary apportionment in the u.s. international income tax system: putting lipstick on a pig?, 36 mich. j. int’l l. 1, 2−3, 7 (2014); roin, supra note 26. but see oecd, action plan on base erosion and profit shifting 14 (2013), available at www.oecd.org/ctp/bepsactionplan.pdf [https://perma.cc/ze6n-xpv4] (“[t]here is consensus among governments that moving to a system of formulary apportionment of profits is not a viable way forward; it is also unclear that the behavioural changes companies might adopt in response to the use of a formula would lead to investment decisions that are more efficient and tax-neutral than under a separate entity approach.”). nevertheless, the oecd may have taken the first step toward implementing such a scheme by requiring 30 columbia journal of tax law [vol.9:5 however, the mere fact that a taxpayer—whether individual or corporate—has economic ties to a country does not warrant the imposition of a tax on foreign-source income. nevertheless, it is crucial to distinguish between corporations and their shareholders. in contrast to the corporation in which they own shares, individual shareholders can be residents of a country. as such, and in accordance with the principle of ability-to-pay, resident shareholders would need to account for their accession to wealth derived from shareholding. the only question is how best to do so. in the domestic arena, the primary means by which shareholders are subject to tax on their accession to wealth is the corporate income tax,119 which effectively operates as an indirect tax on shareholders.120 however, in the international arena, imposing tax on the corporate entity as a proxy for taxing individual shareholders is not a feasible solution country-by-country reporting. oecd, oecd/g20 base erosion and profit shifting project: transfer pricing documentation and country-by-country reporting, action 13 – 2015 final report 12, 16, 29−57 (2015), http://www.oecd.org/tax/transfer-pricing-documentation-and-country-by-country-reportingaction-13-2015-final-report-9789264241480-en.htm [https://perma.cc/f5cg-ghcl]. see also european commission, common consolidated corporate tax base (2016), available at https://ec.europa.eu/taxation_customs/business/company-tax/common-consolidated-corporate-tax-baseccctb_en [https://perma.cc/u7kp-phg3] (the european union’s proposal to reinstitute the common consolidated corporate tax base (ccctb)). 119 the text reflects the prevailing view among scholars—a view to which i subscribe—that, whatever the historical context in which it arose, the corporation income tax today functions as an administratively convenient indirect tax on shareholders. see, e.g., steven a. bank, entity theory as myth in the origins of the corporate income tax, 43 wm. & mary l. rev. 447, 452 (2001); steven a. bank, the dividend divide in anglo-american corporate taxation, 30 j. corp. l. 1, 15–18 (2004); william b. barker, a common sense corporate tax: the case for a destination-based, cash-flow tax on corporations, 61 cath. u.l. rev. 955, 996 (2012) (describing “the widespread belief that taxing corporations offers a convenient and practical way of indirectly taxing corporate shareholders.”); fleming et al., supra note 23 at 1693; graetz, supra note 2 at 302–03; kleinbard, supra note 23 at 159; david m. schizer, between scylla and charybdis: taxing corporations or shareholders (or both), 116 colum. l. rev. 1849 (2016). support for this view can be found in the fact that in certain circumstances, the law permits corporations and their shareholders to choose whether the corporation will pay tax on its income or whether the corporation will be exempt from tax and instead shareholders will pay tax directly on their proportionate share of the corporation’s income. i.r.c. §§ 1361–79 (s corporations). see also the “check-the-box” rules that apply to limited liability companies (llcs) and certain other entities. treas. reg. § 301.7701–3. for other views, see avi-yonah, supra note 27 at 1025–26; jane g. granville, the corporate income tax: a persistent challenge, 11 fla. tax rev. 73 (2011); marjorie kornhauser, corporate regulation and the origins of the corporate income tax, 66 ind. l.j. 53 (1990); marian, supra note 1 at 1647; ajay k. mehrotra, the public control of corporate power: revisiting the 1909 u.s. corporate tax from a comparative perspective, 11 theoretical inquiries in l. 497, 510 (2010). under current law, shareholders, in addition to bearing the indirect corporate-level tax, bear an additional shareholder-level tax when they receive dividends or sell their shares, although the shareholderlevel tax rate is considerably less that the rate to which individuals are ordinarily subject. i.r.c. §§ 1(h)(11), 61(a)(7). the result is a “partially integrated” corporate tax structure. however, a comprehensive analysis of the corporate tax structure and a comparison among integrated, partially integrated, and double (or “classic”) tax systems is beyond the scope of this article. see generally karen c. burke, federal income taxation of corporations and shareholders 388–403 (2003). 120 it is important to distinguish between the nature of a tax as direct or indirect and the incidence of the tax. the corporate income tax is an indirect tax on shareholders because its immediate effect is to reduce the after-tax profit available for distribution to shareholders. with regard to the incidence of the tax, the corporate income tax may affect the supply and demand curves for goods, services, and capital, and if so then individuals other than shareholders may bear the ultimate economic burden. however, this is true also with regard to a tax imposed directly on shareholders, as it is with regard to a tax imposed directly on wage earners and so forth. see generally david elkins, behind the scenes of corporate taxation 10–12 (2013). 2017] the myth of corporate tax residence 31 to the problem of taxing shareholders’ accession to wealth. in order to reach the income of all resident individuals, a country would need to tax the worldwide income of every corporation on the planet, or at least of every corporation with at least one domestic shareholder. even if it were within the power of a country to impose and enforce a worldwide corporate income tax, such a tax would constitute unjustifiable overreaching. current law does not attempt to tax the foreign-source income of all corporations. 121 instead, it distinguishes between corporations that it categorizes as “domestic” and those that it categorizes as “foreign,” and then imposes tax on the worldwide income of the former and on the domestic-source income of the latter.122 however, this approach is both over-inclusive and under-inclusive. it is over-inclusive because nonresidents who hold shares in “domestic corporations” are effectively subject to tax on their worldwide income. it is under-inclusive because residents who hold shares in “foreign corporations” are effectively subject to tax only on their u.s.-source income.123 the problem here is not the particular test used to distinguish between foreign and domestic corporations. the problem is that, however, the law makes the distinction, residents who own shares in “foreign corporations” (however defined) will effectively escape taxation on their accession to wealth attributable to the corporation’s foreignsource earnings and nonresidents who own shares in “domestic corporations” (however defined) will effectively be subject to u.s. income tax on income that is not u.s.-source. the corporate tax regime confronts an irresolvable predicament in the international arena. on the one hand, residence is a fundamental concept in the field of international taxation. on the other hand, the idea of residence is both conceptually and practically inapplicable to corporations. it is no wonder that the current international corporate tax regime has proven unworkable and that reform proposals—which continue to rely upon the concept of corporate residence—fair little better. of course, this is not to say that the corporate tax regime, as currently construed, functions properly even in the domestic arena. in the domestic arena, the corporate tax regime contains innumerable loopholes (which tax advisors are constantly trying to exploit and congress is constantly trying to close) and traps (which tax advisors are constantly trying to avoid and about which congress appears not too concerned). 124 however, the problems faced by the domestic corporate tax regime are not systemic but rather the result of certain flaws that have crept into the system. within the domestic arena, it is, in theory, possible to reform the corporate tax regime and transform it into a coherent and consistent structure.125 in the international arena, it is simply not possible to design a corporate tax structure that achieves coherence and consistency. the problem is not in the details but in the very attempt to treat corporations as taxpayers in an arena in which the concept of residence is indispensable. 121 i.r.c. § 882(b). 122 i.r.c. § 11(a) (imposing tax “on the taxable income of every corporation”) and § 882(b) (qualifying §11(a) and providing that in the case of a foreign corporation, gross income includes only income derived from u.s. sources and income effectively connected to a u.s. trade or business). 123 in certain instances, the code provides for the taxation of u.s. residents who are shareholders in “foreign corporations.” see i.r.c. §§ 951–59 (“subpart f”). 124 elkins, supra note 120, at v. 125 see, e.g., id. at 21–25, 309–12 (arguing that a great deal of the complexity and inequity of the corporate tax structure could be avoided by bifurcating the price of stock into the amount paid for the right to receive pre-acquisition earnings on the one hand and the remaining rights attached to the stock on the other). 32 columbia journal of tax law [vol.9:5 v. a proposal for a new international corporate tax regime because residence is such a crucial element in international taxation and because the concept of residence is inapplicable to corporations, the current corporate tax regime is unviable in the international arena. thus, there is no feasible alternative other than to abandon the current international corporate tax regime. this part will describe how one might go about designing an international corporate tax regime that focuses on shareholders instead of corporations.126 due to the complexity of the subject matter, a detailed proposal for such an international corporate tax regime would go far beyond the scope of the current article. what i can do here is describe in broad outline the most fundamental issues that such a regime would face and suggest how it might go about dealing with those issues.127 126 to a great extent, the analysis in this part relies upon a 1995 article by professor joseph dodge, in which he proposed abandoning the corporate income tax altogether. dodge, supra note 77. the essence of dodge’s proposal was that when shares are publicly traded, shareholders would be taxed on a mark-to-market basis, while closely held corporations would be treated for tax purposes as partnerships. however, dodge freely admitted that applying his proposal in the international arena presents complex design problems. id. at 334. he begins by stating, as a matter of fact, that u.s. corporations are subject to tax on their worldwide income and that foreign corporations are subject to tax only on their u.s.-source income. id. at 335. he goes on to analyze the tax liability of u.s. individuals who own shares in foreign corporations. id. at 336–37. he considers u.s. corporations with substantial foreign equity ownership, foreign corporations in which u.s. equity interest is “quite low,” foreign corporations in which u.s. equity interest is “fairly high” and foreign corporations “largely (say, 80%) controlled by u.s. shareholders.” id. at 338–39, 342–43. for instance, he calls for a “flat rate withholding tax directly on the foreign corporation’s net income … where the percentage of control by u.s. shareholders is fairly high,” but “a withholding tax on the foreign [corporation’s] u.s. income only” when “u.s. equity does not exceed the requisite threshold.” id. at 339. he goes on to distinguish between the described withholding tax on u.s. income and “a ‘straight’ u.s. tax on the foreign … corporation’s u.s. income.” id. at 339. i cannot here undertake a thorough review of professor dodge’s ambitious proposal and its application in the international arena. however, i would suggest that these distinctions, which greatly complicate the analysis, are both unnecessary and normatively unjustifiable. if residence is not a proper attribute of corporations, then we do not need to distinguish between u.s. corporations and foreign corporations and can focus our attention on resident shareholders and nonresident shareholders. furthermore, the tax treatment of a corporation or its shareholders should not depend upon whether u.s. equity ownership crosses a certain threshold. as i explain in the text, infra, the only distinctions that we need to make are between corporations with u.s. source income and those without u.s. source income and between corporation that provide u.s. authorities with both the relevant information and adequate audit opportunities and those that do not. i submit that reducing the number of categories into which we need to classify corporations permits a proposal that is more coherent and simpler to implement in practice. 127 because the tax regime described in the text is a response to challenges faced by the current corporate tax regime in the international arena—the fact that residence is a fundamental concept in the field of international taxation but conceptually inapplicable to the corporate entity—it is possible to adopt the proposed tax regime in the international arena while retaining something akin to the current corporate tax regime in the domestic arena. should policy makers deem it desirable to do so, i would suggest that the domestic tax regime be formally elective (“check the box”), without regard to the corporation’s poi, its economic ties to the u.s., or the residence of its shareholders. corporations electing the domestic tax regime would be liable to tax on their worldwide income. following current law, shareholders in such a corporation would be subject to further tax at reduced rates on dividends and on capital gain from the sale of shares. of course, they would be exempt from the shareholder-level tax in the proposed international corporate tax regime described it the text. already a third of a century ago, tillinghast suggested the possibility of a check-the-box regime for corporate international taxation. see tillinghast, supra note 1, at 266 (“the logic of this conclusion leads to another view so radical that it has not even been whispered for twenty years, that u.s. persons might be given the election to treat a u.s. incorporated entity as a foreign one.”). 2017] the myth of corporate tax residence 33 a. computing the income of u.s. shareholders the first issue that a shareholder-focused international corporate tax regime would need to confront is how to calculate a resident shareholder’s accession to wealth. publicly traded shares present the fewest problems in this regard. the fact that the market value of the shares at any given moment can easily be ascertained means that quantifying the shareholder’s economic gain (or loss) during the year is a simple mathematical exercise.128 within the framework of a tax regime that refrains from taxing corporations and instead imposes tax directly on shareholders,129 mark-to-market reflects the idea that a corporation’s accession to wealth is irrelevant from the perspective of the normative goals of the tax system. the fact that a corporation may have reported a profit has no normative significance if shareholders experience no economic gain. conversely, the fact that there is no reported profit on the corporate level has no normative import if shareholders do experience an accession to wealth. granted, numerous factors ranging from well-founded expectations regarding the corporation’s future prospects to unsubstantiated swings in market mood may explain why share prices do not track corporate income, so that the market price may not reflect true underlying economic value. nevertheless, by definition a shareholder’s accession to wealth is a function of the changing market values of the securities that the shareholder owns (along with any distributions that the shareholder receives), and it is the individual shareholder’s accession to wealth that has normative import from the perspective of income taxation.130 128 gain (or loss) equals (a) the market value of any shares held at the end of the year plus (b) the amount received for any shares sold during the year plus (c) any distributions received during the year minus (d) the market value of any shares held at the beginning of the year minus (e) the amount paid for any shares purchased during the year. as an example, assume that as of the end of 2016, terry, a u.s. resident individual, owned 500 shares of stock in xyz corporation and that the market value of each share of stock as of the end of 2016 was $100. on march 13, 2017, terry purchased an addition 300 shares of xyz at $120 a share. on june 15, 2017, xyz paid a dividend of $12 a share. on october 8, 2017, terry sold 200 shares of xyz for $110 a share. at the end of trading on december 31, 2017, xyz shares were worth $95 each. using the above formula, terry’s accession to wealth resulting from the investment in xyz stock would be: (600 x $95) + (200 x $110) + (800 x $12) – (500 x $100) – (300 x $120) = $2,600. 129 even within the framework of the current corporate tax regime, commentators have suggested that marking securities to market is superior to deferring recognition of shareholder-level gain or loss until realization. see, e.g., john p. bransfield, proposal to change the federal income taxation of marketable securities, 2 hous. bus. & tax l.j. 328 (2001–2002); samuel d. brunson, taxing investors on a mark-tomarket basis, 43 loy. l.a. l. rev. 507 (2010); eric d. chason, naked and coved in monte carlo: a reappraisal of option taxation, 27 va. tax rev. 135 (2007); david elkins, the myth of realization: markto-market taxation of publically-traded securities, 10 fla. tax rev. 375 (2010); timothy hurley, “robbing” the rich to give to the poor: abolishing realization and adopting mark-to-market taxation, 25 thomas m. cooley l. rev. 529 (2008); mark l. louie, realizing appreciation without sale: accrual taxation of capital gains on marketable securities, 34 stan. l. rev. 857 (1982); clarissa potter, mark-tomarket taxation as the way to save the income tax – a former administrator’s view, 33 val. u.l. rev. 879 (1999); david j. shakow, taxation without realization: a proposal for accrual taxation, 134 u. pa. l. rev. 1111 (1986); david slawson, taxing as ordinary income the appreciation of publicly held stock, 76 yale l. j. 623 (1967); david a, weisbach, a partial mark-to-market system, 53 n.y.u. tax rev. 95 (1999); but see edward a. zelinsky, for realization: income taxation, sectoral accretionism and the virtue of attainable values, 19 cardozo l. rev. 861, 889–91 (1997). 130 ordinarily the law refrains from taxing unrealized gains because of the problems of valuation and liquidity. in other words, despite the fact that appreciation in the value of one’s assets constitutes clear economic gain, requiring payment of tax would impose significant compliance and enforcement costs. with regard to publicly traded securities, these costs are minimal. as noted, the market price of a publicly traded 34 columbia journal of tax law [vol.9:5 computing an individual’s gain from shareholding in a closely held corporation is more difficult. the absence of a fluid market complicates the task of tracking the changing market value of the shares.131 in such a case, the best practical alternative may be tentatively to assume that shareholders’ (positive or negative) accession to wealth is equal to their proportionate share of the corporation’s profit (or loss) and adopt a flowthrough tax regime. under current law, a number of legal entities are subject to flowthrough regimes, prominent among them being partnerships,132 s corporations,133 and multi-member limited liability companies (llcs).134 describing in detail the contours of these regimes and the differences between them and analyzing which would be most appropriate for corporations in the international arena is beyond the scope of this article. however, i can mention in brief the common features of the various flow-through regimes. first, the entity itself pays no tax. second, its stakeholders (partners, shareholders, or members, depending on the type of entity involved) report on an annual basis their proportionate share of the entity’s gain or loss. third, when the stakeholders sell their rights in the entity, they report gain or loss reflecting the difference between their total economic gain or loss and the sum of the gains or losses periodically reported. one practical problem that could arise in this regard is that the corporation might not prepare financial statements at all, might not calculate its income in accordance with u.s. tax principles, or might not permit u.s. tax authorities to audit its books. this problem is most likely to arise when the united states does not have jurisdiction over the corporation and the u.s. shareholder is not in a position to impel the corporation to comply with the demands of u.s. tax law. in such a case, it would be reasonable to adopt the tax regime applicable under current law to u.s. persons who own shares in “passive foreign investment companies” (pfics). under the provisions of i.r.c. § 1291 (which apply to u.s. shareholders who did not make an election to be taxed on their proportionate share of the pfic’s income or to be taxed on a mark-to-market basis), tax is deferred until the sale or exchange of the stock, but the shareholder must pay interest to compensate the government for the deferral.135 under the proposed regime, deferral with the accompanying interest charge would not depend upon the percentage interest of u.s. shareholders (and certainly would not depend on the “residence” of the corporation). it share is easily ascertainable. the fact that the shareholder can sell any amount of shares with very low transaction costs solves the problem of liquidity. in other words, the taxpayer can at any given moment compute gain, determine how much of that gain belongs to the government, and can extract an amount necessary to satisfy the government’s claim. see the sources cited supra note 129. 131 furthermore, the absence of a fluid market creates problems of liquidity—the shareholder may have experienced an accession to wealth but not have cash available to pay the tax. because of the lack of a ready market and because of the possible effect on the shareholder’s control of the corporation, selling shares in a closely held corporation is fundamentally different from selling shares in a widely-held, publicly traded corporation. 132 i.r.c. §§ 701–77 (“subpart k”). 133 i.r.c. §§ 1361–78. 134 treas. reg. §§ 301.7701–3(a), (b)(1)(i) (1997). 135 the gain is considered as having accrued pro rata over the period the stock was held, the gain allocated to each year is taxed at the highest statutory rate for that year, and the tax due then accrues interest from the end of the that year. for example, assume that the stock was purchased at the beginning of year 1 for $100,000 and was sold at the end of year 10 for $300,000, that the highest statutory tax rate each year was 40% and the applicable interest is 5% a year. under i.r.c. § 1291, year 1 gain would be $20,000, year 1 tax would be $8,000, and the amount due including interest would be $8,000 x 1.059 = $12,411. year 2 gain would be $20,000, year 2 tax would be $8,000 the amount due including interest would be $8,000 x 1.058 = $11,820, and so forth. the tax due, including interest, for the entire gain would be $100,624. 2017] the myth of corporate tax residence 35 would apply to all u.s. shareholders of any corporation that, in fact, did not keep or did not produce the appropriate books.136 b. taxing nonresident shareholders the second issue that the proposed international corporate tax regime would need to confront is the treatment of nonresident shareholders. under current international norms, countries have the right to impose tax on nonresidents who earn domestic-source income.137 however, attempting to enforce a direct tax on nonresident shareholders for their proportional share of a corporation’s domestic-source income would likely prove difficult in practice. consequently, taxing nonresidents on their domestic source income probably requires the imposition of a territorial tax at the corporate level. in this context, it is important to reiterate that the proposal does not categorize corporations as “domestic” or “foreign.”138 the only relevant distinction among corporations is that some have u.s.-source income and some do not. no corporation would be subject to u.s. tax on its foreign-source income.139 all corporations would, in principle, be subject to u.s. tax on their u.s.-source income.140 the sole intended “targets” of the corporate-level tax would be nonresident shareholders. shareholders who are u.s. residents would be subject to direct tax via one of the methods already described: mark-to-market, flow-through, or realization plus interest.141 following this line of reasoning, the corporate tax rate would be the rate applicable to nonresident individuals who derive u.s. source income.142 as an example, under current law nonresidents are exempt from tax on u.s. source portfolio interest.143 if, due to the pressures of international tax competition, this policy continues, 136 as the deferral with interest regime is often onerous, it is reasonable to expect that u.s. shareholders would tend to prefer corporations that commit to maintain and produce such books. see, e.g., richard l. doernberg, international taxation 380 (2009) (“this method can be quite punitive.”). corporations that wish to attract u.s. investors might therefore voluntary comply with the requirements of u.s. tax even though they may be under no legal requirement to do so. 137 see sources cited supra note 118. 138 cf. graetz, supra note 2, at 321: “[t]he thrust of these efforts is to impose residence-based taxation whenever the foreign corporation is substantially owned or controlled by u.s. persons (including other corporations).” in other words, when a “u.s. corporation” owns a “foreign corporation,” the goal of residence-based taxation requires the current taxation of the income earned by the latter. however, it is far from clear why the residence of the “u.s. corporation” is any less artificial than the residence of the “foreign corporation.” if the concept of residence is applicable to corporations, then the income of the “foreign corporation” is the income of a foreign resident and should not be subject to u.s. taxation. if the concept of residence is not applicable to corporations, then the fact that at the apex of the corporate structure is a “u.s. corporation” is of no normative import. 139 but see the description of a possible domestic corporate tax regime that could operate parallel the proposed international tax regime, supra note 125. 140 some corporations might be exempt from the tax. see the text, infra, surrounding note 154–56. 141 see supra subpart a. subpart c, infra, considers how to prevent double taxation of u.s. residents who own shares in corporations with domestic-source income. 142 i have elsewhere argued that income is an inappropriate tax base for nonresidents in general and for multinational enterprises in particular. elkins, supra note 84. the text assumes that the united states continues its current policy of taxing nonresidents on their domestic source income. should the united states abandon that policy and adopt a base other than income for taxing nonresidents, the same tax regime would also apply to corporations. 143 i.r.c. §§ 871(h), 881(c). 36 columbia journal of tax law [vol.9:5 corporations should similarly be exempt from tax on their portfolio interest.144 such an exemption would substantively affect only nonresident shareholders, as resident shareholders would be subject to tax directly, via the previously described mark-tomarket, flow-through, or deferral-plus-interest regime. as another example, under current law nonresidents who earn “fixed or determinable annual or periodical gains, profits, and income” (“fdap income”) are subject to a 30% tax on gross income.145 as long as this policy continues to apply to nonresident individuals, then under the proposal anyone paying fdap income to a corporation would need to withhold tax at the rate of 30%.146 if a corporation receiving u.s. source income is a resident of another country in accordance with that country’s tax law (i am considering here the possibility that other countries may retain the concept of corporate residence), the corporation might be in a position to claim benefits under a tax treaty between the united states and its country of residence. ostensibly, treaty protection presents a problem for the proposed international tax regime: shareholders might be residents either of countries that do not have tax treaties with the united states or of countries the terms of whose treaties with the united states are less generous than those of the treaty between the united states and the corporation’s country of residence. for example, assume that the domestic laws of country a classify corporation x as a country a resident and that the tax treaty between the united states and country a prohibits either country from imposing tax on royalties received by residents of the other country.147 assume also that individual y owns shares in corporation x and that individual y is a resident of a country that does not have a tax treaty with the united states. were individual y to receive u.s.-source royalties directly, the royalty would be subject to u.s. tax at the rate of 30%. 148 however, because individual y indirectly receives the royalty via corporation x, the royalty will escape u.s. taxation. tax treaties to which the united states is a signatory deal with this issue, known as “treaty shopping,” by means of a limitation of benefits provision (lob).149 while the details of lob are intricate and vary from treaty to treaty, the underlying idea is that a corporation resident in one of the countries may not claim benefits under the treaty unless at least 50% of its shares are beneficially owned by individuals resident in that country or its shares are publicly traded on an exchange located in that country.150 lob is an antiabuse measure designed to prevent individuals from establishing a corporation in a country, other than that of which they themselves are residents, in order to benefit from 144 see, e.g., elkins, supra note 65, at 912; ming-sung kuo, (dis)embodiments of constitutional authorship: global tax competition and the crisis of constitutional democracy, 41 geo. wash. int’l l. rev. 181, 187 (2009), avi-yonah, globalization, supra note 25, at 1581–83; yoram keinan, the case for residency-based taxation of financial transactions in developing countries, 9 fla. tax rev. 1, 29 (2008). 145 i.r.c. §§ 871(a), 881(a). 146 for the current withholding requirement, see i.r.c. §§ 1441, 1442. under the proposal, the withholding requirement under i.r.c. § 1442 would apply not to “foreign corporations,” but to all corporations (except for those subject to a possible parallel domestic tax regime as described in note 126, supra, and those exempt from corporate-level as described in the text surrounding notes 154–56, infra). 147 see, e.g., convention for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, art. 13(1), neth.-u.s., dec. 18, 1992, 2291 u.n.t.s. 40832. 148 i.r.c. § 871(h). 149 see united states model income tax convention, supra note 79, at art. 22. 150 id., at art. 22(2)(d). 2017] the myth of corporate tax residence 37 the provisions of the tax treaty between the united states and the corporation’s country of residence.151 it might seem that for a tax regime that purports to reject the concept of corporate residence, lob as currently constituted is insufficient. when a corporation qualifies under lob, those shareholders who are not resident in the corporation’s country of residence benefit from the provisions of the treaty even though they would not so benefit were they to have received the income directly. however, i would submit that this problem is less acute than it might appear at first glance. the distinction between residents of two foreign countries is substantively different from the distinction between foreign residents and domestic residents. with regard to the distinction between domestic and foreign residents, there is a normative policy goal to tax the former on their worldwide income and to tax the latter only on their domestic-source income. taxing nonresidents on their foreign-source income or permitting residents to escape tax on their foreign-source income is inconsistent with that policy. with regard to residents of foreign countries, treaty provisions derive not from normative, but from practical considerations: each side agrees to limit its right to tax certain types of income in return for a similar commitment from the other signatory. when another country demands that corporations that it classifies as domestic residents receive benefits under the treaty, the united states has to consider whether the overall advantages of the treaty are worth the cost of agreeing to such a provision. current u.s. policy is to reject such a demand unless the corporation meets the lob criteria.152 of course, by way of reciprocity, the united states is willing to agree to impose a similar condition on u.s. corporations seeking treaty benefits. under the proposed tax regime, the united states would no longer classify corporations as either domestic or foreign. this would mean that no treaty to which the united states is currently a signatory would protect any corporation, even one wholly owned by u.s. resident individuals, from the taxing authority of the other country. therefore, the abandonment of the notion of corporate residence would require a renegotiation of the united states’ treaty network. as a condition of agreeing to allow corporations resident in the other country to benefit from the provisions of the treaty, the united states should demand protection for u.s. resident individuals who are shareholders of corporations that derive income from sources in the other country. a comprehensive discussion of how to accommodate the u.s. treaty network to the proposed tax regime is beyond the scope of this article. however, i will briefly mention two possible modifications that might be appropriate. one would be an expansion of the term “resident” to include not only a corporation that “is liable to tax therein by reason of … place of management, place of incorporation, or any other criterion of a similar nature,”153 but also a corporation a certain percentage of whose shareholders are liable to tax therein by virtue of residence. in other words, a corporation, 151 see, e.g., id. at art. 22(6) (“if a resident of a contracting state is [not] a qualified person … the competent authority of the other contracting state may, nevertheless, grant the benefits of this convention … if such resident demonstrates to the satisfaction of such competent authority a substantial nontax nexus to its contracting state of residence and that neither its establishment, acquisition or maintenance, nor the conduct of its operations had as one of its principal purposes the obtaining of benefits under this convention.”). 152 prior to 1977, the united states did not include lob in the treaties that it signed. during the 1980s and 1990s, the u.s. renegotiated its treaty network, and today all treaties to which the united states is a signatory contain lob. see generally joseph isenbergh, international taxation 280–81 (2005). 153 see united states model income tax convention, supra note 79, at art. 4(1). 38 columbia journal of tax law [vol.9:5 although not a “resident” under u.s. domestic law, might nevertheless be a “u.s. resident” for purposes of the treaty. such a provision would effectively constitute a mirror image of lob. the idea would be that a corporation with a sufficiently large percentage of shareholders who are u.s. residents would be treated for purposes of the treaty as if it itself were a u.s. resident. this problem with such a provision is that, like any provision that assigns residence to corporations, it is both under-inclusive and overinclusive.154 it is under-inclusive because it does not protect u.s. residents who are shareholders in corporations whose u.s. ownership does not reach the threshold. it is over-inclusive because it effectively protects non-u.s. residents who are shareholders in corporations whose u.s. ownership does reach the threshold. 155 another possibility would be to permit the other country to tax corporations as it sees fit, but to require it to refund a proportionate share of the tax to any shareholder of the corporation who is a u.s. resident. such a provision is more thematic in the sense that it targets all u.s. shareholders and only u.s. shareholders. the disadvantage of such a provision is that it might be more complicated to implement. as noted, the purpose of the corporate income tax as described in this subpart would be to serve as an indirect tax on nonresident shareholders. therefore, i would propose an exemption from the corporate-level tax in two cases. first, a corporation should be exempt from tax if proves that all of its shareholders are u.s. residents. second, a corporation some or all of whose shareholder are nonresidents would be exempt from tax if it proves that all of its nonresident shareholders filed u.s. tax returns in which they reported and paid tax on their share of the corporation’s u.s. source income.156 in other words, in those instances in which the corporation’s shareholders pay tax directly on the corporation’s domestic source income, the corporate-level tax would be superfluous.157 these exemptions, in addition to being conceptually thematic, would simplify the structure by preventing at the outset the double taxation of residents who own shares in corporations with domestic-source income and obviating the need for a subsequent mitigation of the double tax.158 c. avoiding double taxation the third issue that the proposed international tax regime would need to consider is how to account for taxes paid at the corporate level when computing the tax liability of resident shareholders. for the purpose of our discussion, i will assume that the united states wishes to continue its current policy of taxing nonresidents on their u.s.-source income, that other countries routinely impose tax on income derived from sources within 154 see supra part iv. 155 ostensibly, such overprotection is not of real concern to the united states. however, insisting upon such overprotection (implicit in the demand that a corporation with a certain level of u.s. ownership is entitled to treaty benefits) would increase the cost of the treaty to the other signatory, which might demand additional u.s. concessions as a quid pro quo. 156 this article does not consider the procedure by which a corporate would demonstrate either that all of its shareholders were u.s. residents or that all of its nonresident shareholders filed the necessary returns and paid the applicable tax. nor does it consider under what circumstances it might be appropriate to impose reporting or withholding obligations on the corporation to guarantee payment of tax by the shareholders. 157 these exemptions, in addition to being conceptually thematic, would simplify the structure by preventing at the outset the double taxation of residents who own shares in corporations with domestic-source income and obviating the need for a subsequent mitigation of the double tax, as described in subpart c, infra. 158 see subpart c, infra. 2017] the myth of corporate tax residence 39 their territory, and that the united states wishes to continue its policy of mitigating double taxation by permitting a credit for foreign income taxes paid by u.s. residents.159 each of these policies is controversial, and it is far from certain that an ideal international tax regime would retain all or even any of them.160 however, to keep the discussion manageable and to demonstrate how the proposed international corporate tax regime might operate under the most plausible set of assumptions regarding international tax policy that one can make at this time, i will assume that the aforementioned policies will continue. the imposition of a corporate-level territorial tax as a means of indirectly taxing nonresident shareholders complicates the taxation of u.s. shareholders. as we have seen, u.s. residents will pay tax on the income derived from their shareholding (computed mark-to-market, on a flow-through basis, or at realization with an interest charge). when the corporation has u.s.-source income, the corporate-level tax would mean that the same income would be subject to double u.s. taxation. furthermore, if the corporation has foreign-source income subject to foreign income taxes, that income would also be subject both to foreign tax (at the corporate level) and to u.s. tax (at the shareholder level).161 consequently, u.s. shareholders should be entitled to a credit equal to their proportionate share of the income tax, whether u.s. or foreign, incurred by the corporation.162 from the perspective of shareholders who are u.s. residents, this would effectively eliminate the corporate-level tax and leave only the shareholder-level tax. as the credit is indirect (a shareholder-level credit for a corporate-level tax) and is available for both u.s. and foreign corporate-level income taxes, i will refer to it as an indirect tax credit or itc. on a technical note, whenever the shareholder’s income is a function of a shareholder-level event (e.g., change in value of the shareholder’s shares, receipt of a dividend, or sale of shares), the amount of the itc would need to be considered additional income in the hands of the shareholder. the reason is that because the corporate-level tax presumably reduces the value of the shares, the taxpayer receives an implicit deduction for tax paid by the corporation. a credit in addition to the deduction 159 i.r.c. § 901. 160 with regard to the taxing the domestic source income of nonresidents, see note 140, supra. with regard to the foreign tax credit, it is arguable that foreign income taxes are properly viewed as an expense of operating in foreign countries and thus do not create a problem of double taxation. see, e.g., shaviro, fixing, supra note 25, at 68; daniel shaviro, the case against foreign tax credits, 3 j. of legal analysis 65 (2011). see also isenbergh, supra note 152, at 134 (“the only allowance for foreign income taxes in the 1913 income tax law was a deduction for taxes paid to foreign governments as a cost of doing business.”). nevertheless, as noted by shaviro, “[p]erhaps no feature of modern income tax systems has gained such consistent … approval from commentators as the foreign tax credit.” daniel n. shaviro, rethinking foreign tax creditability, 63 nat’l tax j. 709, 709 (2010). 161 as noted, this subpart will proceed from the assumption that u.s. tax policy continues to view the imposition of tax both by the source country and by the country of residence as an inappropriate double tax. 162 as tax liability is ordinarily computed on an annual basis, i would suggest that shareholders who acquired or disposed of shares during the course of a year be entitled to a proportionate share of the credit to which they would otherwise be entitled. for example, assume that a u.s. resident purchases 20% of the shares on april 1 and an additional 15% of the shares on september 1 and that the corporation incurred income tax liability (both u.s. and foreign) of $500,000. the shareholder’s foreign tax credit would equal $500,000 x [(20% x 9/12) + (15% x 4/12)] = $100,000. 40 columbia journal of tax law [vol.9:5 would overcompensate the shareholder for the corporate-level tax. 163 to avoid overcompensation, we need to eliminate the deduction before granting the credit. the same issue arises under current law when a domestic corporation claims a credit for foreign taxes paid by another corporation in which it owns stock and from which it receives a taxable dividend.164 i.r.c. § 78 provides that in such a case, an amount equal to the claimed credit will constitute income in the hands of the domestic corporation. although the framework within which § 78 operates is different from that of this article’s proposal, the method adopted by § 78 is the simplest way to “gross up” the income.165 therefore, i would propose that, whenever a shareholder’s taxable income is the function of a shareholder-level event, the itc constitute income in hands of the individual claiming the credit.166 to demonstrate, assume that pat, a u.s. resident subject to a tax rate of 40%, owns 100,000 out of abc corp’s 10,000,000 outstanding shares. during the year in question, the market price of abc shares rose from $50 a share to $58 a share, and abc paid income tax, both u.s. and foreign, of $15,000,000. the computation of pat’s u.s. tax liability would be as follows: (1) pat’s shares increased in value by $800,000.167 (2) as the owner of 1% of the shares in abc, pat would be entitled to an itc of $150,000.168 (3) pat’s taxable income attributable to holding shares in abc would be $950,000.169 (4) pat’s initial u.s. tax liability, before the itc, would be $380,000.170 163 for example, assume that sally is a resident individual who owns shares in a publicly traded corporation, that her shares appreciated by $1,000, that her proportionate share of income taxes paid by the corporation is $250, and that she is subject to tax at the rate of 40%. were we to compute her tax liability by multiplying $1,000 by 40% and then subtracting $250, we would end up with a figure of $150. this would constitute overcompensation for the corporate-level taxes. presumably, the value of the shares reflects those corporate-level taxes. in other words, without the corporate-level tax, sally’s shares would have appreciated not by $1,000 but by $1,250. at a 40% tax rate, sally would have paid tax of $500. with the corporate leveltax and the overly generous credit, she will bear a total tax burden, both direct and indirect, of only $400 (her share of the corporate-level tax is $250 and her direct tax liability is $150). in others words, instead of aftertax income of $750 ($1,250 – $500), sally will end up with after-tax income of $850 ($1,000 – $150). 164 i.r.c. §§ 902(a), 960(a)(1). 165 i.r.c. § 78 refers to a domestic corporation claiming an indirect credit for foreign taxes paid by a corporation from which it receives a dividend. the proposal presented here refers to a resident individual claiming an indirect credit for either foreign taxes or domestic taxes paid by any corporation in which the individual owns shares. 166 the adjustment described in this paragraph is not necessary in the case of a privately held corporation when the shareholder reports her proportionate share of the corporation’s tax income. the reason for this is that because income tax is not a deductible expense, taxable income represents the corporation’s income before payment of tax. for example, assume that sally’s share of the corporation’s taxable income is $1,250 that her proportionate share of the corporate-level tax is $250. as the figure of $1,250 is her proportionate share of the corporation’s income before payment of the corporate-level tax, it would not be appropriate to add the latter to the former in determining her income. in other words, to compute her tax liability we would multiply $1,250 by 40% and subtract $250 and end up with a figure of $250. she will thus bear a total tax burden, both direct and indirect, of $500 (her share of the corporate-level tax is $250 and her direct tax liability is also $250), which is equivalent to the tax burden that she would have born in the absence of the corporate-level tax. 167 100,000 x ($58 – $50) = $800,000. 168 $15,000,000 x (100,000/10,000,000) = $150,000. 169 $800,000 + $150,000 = $950,000. 2017] the myth of corporate tax residence 41 (5) following the itc, pat would pay u.s. tax of $230,000.171 however, the algorithm may have to be a little more complicated, because the simple computation just described did not consider the geographical source of earnings, nor did it take into consideration the jurisdiction to which the corporation paid tax. under current u.s. tax policy there is an important distinction between u.s.-source income and foreign-source income and between u.s. income tax and foreign income tax. foreign income taxes are creditable only to the extent of the taxpayer’s u.s. tax liability on foreign-source income. 172 the idea behind this provision is that foreign income tax should not be able to reduce u.s. income tax liability on u.s.-source income. this limitation of the foreign tax credit (ftc) is not free from controversy.173 nonetheless, as with other aspects of current u.s. international tax policy, i will assume that this policy continues to hold and will attempt to show how the proposed international corporate tax regime might accommodate it. i would suggest that to accommodate the limitations on the crediting of foreign income taxes, corporations would, as they do under current law, track and report on an annual basis their u.s.-source income, their foreign-source income, their u.s. income tax liability, and their foreign income tax liability. shareholders’ income would be allocated to u.s. sources and to foreign sources in accordance with the corporation’s ratio of u.s.source income to foreign-source income. itc from payment of foreign income tax would be treated as an ftc and subject all of the limitation applicable thereto, while itc from payment of u.s. income would be creditable without restriction. returning to our example, assume that abc corp. reported $30,000,000 of foreign-source income, $120,000,000 of u.s.-source income, $10,000,000 of foreign income tax, and $5,000,000 of u.s. income tax.174 the computation would be as follows: (1) of pat’s $950,000 in income, 175 $190,000 would be foreign-source income,176 and $760,000 would be u.s.-source income.177 (2) pat’s initial u.s. tax liability, before the itc, on the foreign-source income would be $76,000.178 her initial u.s. tax liability, before the itc, on the u.s.source income would be $304,000.179 170 $950,000 x 40% = $380,000. 171 $380,000 – $150,000 = $230,000. 172 i.r.c. § 904. 173 david hasen, tax neutrality and tax amenities, 12 fla. tax rev. 57, 64–65, 72 (2012); paul r. mcdaniel, the u.s. tax treatment of foreign source income earned in developing countries: a policy analysis, 35 geo. wash. int’l l. rev. 265, 268–69 (2003); charles e. mclure jr., legislative, judicial, soft law, cooperate approaches to harmonizing corporate income, 14 colum. j. eur. l. 377, 387 n.32 (2008). 174 in the example, the u.s. corporate tax rate on u.s. source income is extremely low ($5 million/$120 million = 4.17%). the reason that i chose these figures is to demonstrate what happens when the itc for u.s. income tax is insufficient to eliminate u.s. tax liability on u.s. source income. however, the low rate of tax is not unrealistic. for example, under current u.s. law, nonresidents are exempt from tax on portfolio interest. assuming that this policy continues, the exclusion would apply not only to foreign individuals but also to corporations. see the text accompanying notes 140–44, supra. 175 see note 169, supra. 176 $950,000 x ($30,000,000/$150,000,000) = $190,000. 177 $950,000 x ($120,000,000/$150,000,000) = $760,000. 178 $190,000 x 40% = $76,000. 179 $760,000 x 40% = $304,000. 42 columbia journal of tax law [vol.9:5 (3) of pat’s $150,000 of itc, $100,000 would be subject to the limitations of the ftc,180 and $50,000 will be creditable without restriction.181 (4) pat would not need to pay any tax on the foreign source income because the itc subject to the limits of the ftc ($100,000) is greater than the initial u.s. tax liability on foreign-source income ($76,000). pat may use the remaining $24,000 to reduce u.s. tax liability on other foreign-source income in accordance to the relevant provisions of the code. (5) regarding income attributable to u.s. sources, pat would pay tax of $254,000, derived from an initial tax liability of $304,000 and an itc of $50,000.182 from a practical perspective, the united states does not have the jurisdiction to compel all corporations to track and report u.s.-source income, foreign-source income, u.s. income tax incurred, and foreign income tax incurred; nor does it have the jurisdiction to compel all corporations to submit to an audit by u.s. administrators to verify the numbers that it does report. consequently, i would propose that when the corporation does not produce such a report or does not provide u.s. tax authorities an opportunity to conduct a satisfactory audit, all income would be deemed u.s.-source. stated in other terms, shareholders would bear the burden of refuting a presumption that the corporation’s income is all u.s. source. with regard to the itc, granting the credit would in any case depend upon the corporation providing sufficient proof of such payment to u.s. tax authorities, who could then determine how much of the itc is traceable to the payment of foreign income tax and how much is traceable to the payment of u.s. income tax. in the absence of such proof, shareholders would not be entitled to an itc. the purpose of these procedural provisions would be twofold. first, by creating a rebuttable presumption that all income is u.s.-source and that that the corporation paid no income tax, they would protect u.s. international tax policy goals by preventing the crediting of corporate-level income tax that was not in fact paid and by preventing the crediting of foreign income taxes against u.s.-source income. second, by assuming what is from the perspective of shareholders a worst-case scenario, they would create an incentive for corporations that wish to attract u.s. investment to provide the documentation shareholders would need to rebut the statutory presumptions. vi. conclusion corporate personhood is a legal fiction, useful in some contexts, less so in others. corporate residence is not a legal fiction. it is an oxymoron. it is an attempt to assign to corporations an attribute that contradicts their fundamental nature. the inapplicability of residence to corporation is not because corporations cannot “reside” in a place in the manner of human beings. this is a semantic, not a substantive issue. rather, the reason that corporate cannot be residents for purposes of income tax is that residence delineates the boundaries of taxation in accordance with ability-to-pay, and ability-to-pay is a concept that is inapplicable to the corporate entity. 180 $10,000,000 x 1% = $100,000. 181 $5,000,000 x 1% = $50,000. 182 pat cannot use the unused itc of $24,000 here, as this is u.s.-source income and the $24,000 is creditable only against u.s. tax liability from foreign-source income. 2017] the myth of corporate tax residence 43 first, taxation in accordance with ability-to-pay is an attempt to implement certain norms of distributive justice. distributive justice, in turn, concerns the distribution of resources among those who have personal identity, who are kantian rational beings, and for whom welfare is a pertinent term. as none of these attributes applies to the corporate entity, a corporation cannot conceptually be party to a scheme of distributive justice. in other words, the moral value of a redistribution of resources from one corporation to another, from a corporation to an individual, or from an individual to a corporation cannot be determined except by reference to the effect of such redistribution on the welfare of individuals. second, the principles of distributive justice as embodied in the concept of ability-to-pay are not universal in scope but apply exclusively to members of the relevant society. for this reason, only residents pay tax on their worldwide income. membership in a society is a function of one’s personal connections. a country with which one has purely economic connections may have a claim under benefit theory to tax the income deriving from those ties. it does not have a claim to tax the income derived from foreign sources. as a corporation cannot have personal ties, the idea of corporate residence is a misnomer. why, then, are corporations subject to income taxation at all? the most persuasive justification for the corporate income tax is that it is an administratively convenient indirect tax on individual shareholders. this would seem to imply that we could assign residence to corporations by looking to the residence of their shareholders. however, such a model cannot succeed. with regard to any corporation with both domestic and foreign shareholders, we would face an irresolvable dilemma: classifying it as a resident, and consequently liable to tax on its foreign-source income, would unjustifiably overtax its foreign shareholders; classifying it as a nonresident, and consequently not subject to tax on its foreign-source income, would unjustifiably undertax its domestic shareholders. because residence is such a fundamental concept in international taxation, the incongruity of corporate residence irrevocably undermines the current international corporate tax regime. therefore, there is no realistic alternative other than imposing tax directly on resident shareholders, retaining a territorial corporate income tax as a means of taxing foreign individuals who indirectly derive income from domestic sources, and adopting appropriate measures on the shareholder level to avoid double taxation of resident shareholders. the current international corporate tax regime has proven unworkable in practice. to a great extent, the seemingly insurmountable challenges encountered by the current regime—such as expatriation and the exploitation of foreign subsidiaries—are simply practical manifestations of a flaw in the underlying theoretical framework. abandoning the concept of corporate residence is the most thematic and most effective way to reform the international corporate tax regime. the worst choice for school choice: tuition tax credits are a bad idea and direct funding is wiser michael j. broyde* and anna g. gabianelli** abstract school choice is on the rise, and states use various mechanisms to implement it. one prevalent mechanism is also a uniquely problematic one: the tax credit. tax credits are deficient at equitably distributing a benefit like school choice; they are costly, and they invite fraud. instead of using tax credits, states opting for school choice programs should use direct funding. direct funding will more efficiently achieve the goals of school choice because it can be regulated like any other government benefit, even if it ends up subsidizing religious private schools. tax credits’ prevalence is not inexplicable, of course. it is based on a prior legal understanding that states were constitutionally restricted from directly funding religious schools. historically, states that wanted to include religious private schools in their school choice programs therefore felt pushed to use tax credits as their only constitutionally viable option. however, the landscape has changed. the supreme court held in 2022 that direct funding of religious private schools is not only constitutionally permissible, but it is required if a state funds non-religious private schools and provides no neutral basis for excluding religious ones. the initial reason for tax credits’ popularity therefore no longer exists; both tax credits and direct funding alike are constitutionally acceptable. it is time, therefore, to revisit the merits of tax credits and ask whether, knowing what we know now, it is worth disposing of them in favor of direct funding. this article answers that question with a resounding yes. tax credits carry significant disadvantages—specifically, inequitable distribution and difficulties in regulation—that direct funding does not. now that the law is clear, states choosing to sponsor school choice should discontinue their use of tax credits in favor of direct funding. * michael j. broyde is a professor of law at emory university, the berman projects director in its center for the study of law and religion, and the director of the sjd program at emory university school of law. ** anna g. gabianelli graduated with high honors from emory law in 2023, currently works in new york city, and will serve as a judicial law clerk in the coming years. the authors would like to thank samuel brunson, alex zhang, adam chodorow, hillel levin, allen calhoun, nicole garnett, and all of the participants in the joint faculty workshop between the law schools of emory university and the university of georgia, for their insightful comments on drafts. we also thank ashley audisho and cory conley from emory university school of law for their excellent research assistance and ari liberman for his editorial suggestions. columbia journal of tax law [vol: 15:1 78 i. introduction .............................................................................................. 78 ii. the law then and now ............................................................................. 81 a. under the u.s. constitution ...................................................................... 81 1. 1947–1983: public aid restricted to secular purposes ....................... 82 2. 1983–2011: neutral availability and private choice .......................... 84 3. 2011: standing ...................................................................................... 86 4. 2017: free exercise .............................................................................. 87 b. meanwhile, in the states ........................................................................... 90 1. no-aid provisions and state interpretations ........................................ 91 2. no-aid provisions after 2017 ............................................................... 93 iii. why tax credits are the wrong policy choice .................................. 94 a. tax credits have the effect of direct payments while circumventing rules governing direct payments .................................................................... 95 b. bad policy ................................................................................................. 97 1. why do states subsidize school choice? ............................................. 97 a. equity ................................................................................................ 98 b. pure economics ................................................................................ 98 c. freedom of choice ............................................................................ 99 2. why do tax credits fail to achieve the stated goals of school choice? ............................................................................................................. 100 a. inequitable distribution .................................................................. 100 b. fraud concerns ............................................................................... 109 3. these concerns show that tax credits are a poor instrument, regardless of a state’s reason for implementing school choice. ............. 112 a. equity .............................................................................................. 112 b. pure economic growth and freedom of choice ............................ 112 c. inefficiency ..................................................................................... 115 iv. solutions .................................................................................................. 115 v. anticipated objections and our responses........................................ 119 a. legal arguments ..................................................................................... 119 1. establishment clause .......................................................................... 119 2. no-aid clauses .................................................................................... 122 3. other state constitutional issues........................................................ 124 4. reforming, instead of replacing, tax credits .................................... 125 b. policy arguments.................................................................................... 127 vi. conclusion ................................................................................................ 128 i. introduction across the nation, state-sponsored school choice programs are becoming increasingly prevalent. such programs make state money available to families for educational costs, often including private school tuition.1 states sponsor these 1 states offering tuition tax credits include georgia (qualified education expense tax credit, ga. code ann. § 48-7-29.16), arizona (ariz. rev. stat. ann. § 43-1089), florida (florida tax credit scholarship program, fla. stat. ann. § 212.099), pennsylvania (24 pa. stat. ann. § 20-2005-b), montana (mont. code ann. § 15-30-3111), and missouri (missouri empowerment scholarship 2023] the worst choice for school choice 79 programs for various reasons, including to foster competition among private schools and to increase opportunities for students at struggling public schools. they likewise use various methods to administer them, including distributing vouchers, specially designated savings accounts, or tax credits to incentivize donations to organizations that provide scholarships. the method a state chooses to administer school choice matters, and this article explains why tax credits are the wrong choice. at the outset, it is important to note that the following piece is not meant to argue for or against school choice. the merits of such programs as a general matter are contested, yes, but we do not enter the debate. instead, we argue strictly that once a state has chosen to administer school choice, tax credits are the worst option for its execution, and direct funding is far better. it is our perspective that if a state operates school choice, its goal should be to administer the program in a way that ensures that everyone has an equal opportunity to benefit from it. moreover, our policy objectives are for states opting into these programs to ensure a truly progressive system of school choice. states could (and should) go further, in line with the goals of a progressive tax code, and provide more aid to needier families, and avoid altogether regressive systems–for example, concentrating aid on the wealthy–which would not only be unpopular but inequitable. in any event, proper administration is key to ensuring these progressive objectives. tax credits are ineffective at achieving any goal of school choice. they disproportionately benefit wealthy students at private schools who would have had school choice without tax credits, cost governments more than direct funding would, and are difficult to monitor. given these pronounced flaws, it might seem confounding as to why they are such a prevalent mechanism. but, a closer historical consideration reveals exactly why this is the case. simply, states flocked to tax credit options because they thought they had to. tax credits became a popular method of school choice because they were believed to be the only constitutional option for funding religious schools. for most of the twentieth century, the establishment clause was understood to prohibit direct funding, and, furthermore, several states also enacted “no-aid” provisions in their state constitutions, which explicitly prohibited the government from financially supporting religious schools. tax credits were a workaround because of their indirect structure. we will consider the structure of this program at some length later, but, in short, these tax credit programs involve an exchange of money, first between individual donors and private “scholarship” organizations (hereinafter “scholarship organizations”) and then between these scholarship organizations and private schools, which award funds to families as scholarships. the tax credit part comes in the first exchange. the donor might choose the (religious or secular) private school (or even the student) to which the scholarship organization directs their money, and then, at tax time, the donors receive a tax credit based on the amount of their donation to the scholarship organization. in states where the tax credit accounts program, mo. rev. stat. § 135.712). these programs continue to grow; see e.g., mike deforest, record number of students to attend private schools using state vouchers, clickorlando.com (aug. 11, 2023), https://www.clickorlando.com/news/local/2023/08/11/recor d-number-of-students-to-attend-private-schools-using-state-vouchers/ [perma.cc/uwa2-hmj6]. columbia journal of tax law [vol: 15:1 80 matches the value of the donation, the donor breaks even, effectively having directed some of their tax payment to a private school, while technically, no “state” funds are directly given to private schools. in other words, instead of the state directly paying a private school, an individual pays a private school, and the state reduces the individual’s tax bill by the amount of his donation. one can plainly see how this process is intentionally cumbersome and difficult to regulate—though it was seen as the only way to provide aid to religious schools in accordance with prior constitutional understandings.2 recently this understanding has changed. carson v. makin3 clarified that there is no constitutional issue with governments’ subsidizing religious schools. moreover, the court held that the free exercise clause forbids states that provide funding to private schools from disqualifying religious schools from that support only because they are religious; indeed, sometimes a state must support religious institutions. this change negates one of the main rationales for why tuition tax credits became so popular; their indirect structure is no longer necessary to comply with the establishment clause. yet, still, many tuition tax credit systems, and the decisions upholding them as constitutional under state no-aid provisions, remain in force. tax credits are no longer necessary for constitutionality, so the question becomes whether they are worth keeping around. we argue that they are not. states should do away with tuition tax credits and opt for direct funding4 in the form of vouchers.5 on policy grounds, tax credits are a poor mechanism for school choice. by design, they separate the government from aid going to religious schools. as collateral results, they are ineffective and prone to fraud. starting from scratch with the law as it is today, we maintain that no state wishing to achieve educational improvement or equity would use tax credits. instead, as argued below, a decision to fund private schools through tax credits only signals that the state prioritizes funding wealthy private schools and neglects private schools serving poor families. 2 see infra, text accompanying notes 110–170. 3 see carson v. makin, 142 s. ct. 1987, 2002 (2022). 4 we recognize that both vouchers and tuition tax credits can be characterized as indirect; in both cases, funding is directed by parents and does not transfer immediately from the state to the school. we describe vouchers as direct because the government directly funds the private school in question, regardless of whether it is religious. with tax credits, there is no transaction between the government and the parents, similar to how the government provides tax deductions for charitable contributions. in that sense, tax credits are indirect. 5 we use the term “vouchers” to include all programs in which the government provides direct aid to the parents which can be spent on the education of their children, including programs like arizona’s empowerment scholarship account, a version of the more common “education savings account.” in each of these voucher-type programs, parents are given public funds to use for tuition or other educational expenses. see generally nicole stelle garnett, unlocking the potential of private-school choice: avoiding and overcoming obstacles to successful implementation, manhattan inst. rep. (mar. 16, 2023), https://manhattan.institute/article/unlocking-the-potentialof-private-school-choice-avoiding-and-overcoming-obstacles-to-successful-implementation [perm a.cc/2bmy-uxpt]. we do not see these various diverse funding programs as substantially different from each other in contrast to tuition tax credits, as they work independent of the tax code. the virtues and vices of each of these types of voucher programs is discussed in the above report. 2023] the worst choice for school choice 81 direct funding, on the other hand, can be better regulated in ways commensurate with other public benefits. reducing the misuse and fraud will enable states to achieve equitable school choice goals much more effectively. a choice not to use direct funding is a choice to stick with the inequity and inefficiency of tax credits—a choice to continue publicly subsidizing private education for the rich with little government oversight. of course, proponents of tax credits would avoid articulating that their policy goal is to subsidize exclusively the wealthy’s private education and to remain programmatically unregulated, but those are—undoubtedly—the only reasons to continue using tax credits. states now clearly have the option to choose direct funding. states offering school choice, then, should use that mechanism, rejecting tax credits as an unnecessary and inefficient vestige of previous law, or else abstain from funding school choice at all. this article’s four major parts support this conclusion. first, we describe the history of the federal and state laws that explain why tax credits have come to dominate as a tool for school choice but bolster the position that more direct forms are equally constitutional. the second section then discusses why tax credits are a poor mechanism for instituting school choice. the third section then describes why direct funding in the form of vouchers is a much more effective and desirable policy choice for states with school choice programs. the final sections respond to some possible criticisms of this position, followed by a summary and conclusion. ii. the law then and now to understand why tax credits are so prevalent today—and to see why they were once appealing—it is necessary to understand how the first amendment and state law have historically been applied. while states may now fund religious schools, and in some circumstances they must, the law took a long and winding road to get here. a. under the u.s. constitution since the mid-twentieth century, the supreme court has faced a parade of cases challenging public aid in religious education. in the court’s own words, it “can only dimly perceive the lines of demarcation in this extraordinarily sensitive area of constitutional law.”6 accordingly, the doctrine has changed substantially over time. the first amendment’s religion clauses state that legislators “shall make no law respecting an establishment of religion, or prohibiting the free exercise thereof . . . .”7 the cases described below illustrate how federal rules governing public aid to private schools have changed. cases initially required that aid be restricted to secular purposes, then became less restrictive with the doctrine of private choice, and, finally, were mostly disposed of by standing free exercise 6 mueller v. allen, 463 u.s. 388, 393 (1983) (quoting lemon v. kurtzman, 403 u.s. 602, 612 (1971)). 7 u.s. const. amend. i. columbia journal of tax law [vol: 15:1 82 challenges. now, of course, states may directly fund private schools.8 if they do, however, they may not exclude religious schools on the basis that they are religious.9 but these are only recent developments, and the earlier cases show much more restrictive interpretations of the religion clauses, and, more poignantly, the higher importance of indirectness in school choice funding schemes which tax credits provided. 1. 1947–1983: public aid restricted to secular purposes beginning in the mid-twentieth century, public aid to private schools was permissible only if it was restricted to secular purposes. the supreme court first applied the religion clauses to the states in 1947.10 it upheld a new jersey program that reimbursed parents, including parents of children at parochial schools, for the costs of transporting their children to school.11 the first amendment allowed this program because it was available to all families, regardless of religion, and the services were “separate and so indisputably marked off from the religious function” of parochial schools.12 state aid to private religious schools remained permissible for the next forty years, as long as it was restricted to secular purposes. the court upheld state statutes under which states loaned secular textbooks to students in public and nonpublic schools for free13 and funded facilities at religious schools that would never be used for religious purposes.14 it was similarly permissible for states to “include church-related schools in programs providing bus transportation, school lunches, and public health facilities . . . .”15 it was not a constitutional problem that state support subsidized some costs of attending religious schools; lightening the 8 see trinity lutheran church of columbia, inc. v. comer, 582 u.s. 449, 467 (2017) (“[t]he exclusion of trinity lutheran from a public benefit for which it is otherwise qualified, solely because it is a church, is odious to our constitution all the same, and cannot stand.”); espinoza v. montana dep’t of revenue, 140 s. ct. 2246, 2261 (2020) (“a state need not subsidize private education. but once a state decides to do so, it cannot disqualify some private schools solely because they are religious.”); carson v. makin, 142 s. ct. 1987, 2002 (2022) (holding that maine’s tuition assistance payments program could not exclude otherwise eligible schools on the basis of their religious exercise). 9 carson, 142 s. ct. at 1997. 10 everson v. bd. of educ., 330 u.s. 1, 8 (1947); sch. dist. v. ball, 473 u.s. 373, 381 (1985), overruled by agostini v. felton, 521 u.s. 203, 235 (1997) (“everson made clear that the guarantees of the establishment clause apply to the state. . . .”). even before the religion clauses were incorporated against the states, louisiana taxpayers challenged a state program that loaned secular textbooks to all schoolchildren, including those in religious schools. cochran v. la. state bd. of educ., 281 u.s. 370, 374 (1930); they argued that the program violated the fourteenth amendment by taking their private property (their taxes paid) for a private purpose (aiding nonpublic schools). id. the supreme court upheld the program because it served the public purpose of education. id. at 375. the program did not single out religious schools or their students; furthermore, the program benefited the students, not the schools. id. at 374-75. 11 everson, 330 u.s. at 17. 12 id. at 18. 13 bd. of educ. v. allen, 392 u.s. 236, 238 (1968); meek v. pittenger, 421 u.s. 349, 362 (1975), overruled by mitchell v. helms, 530 u.s. 793, 808 (2000); wolman v. walter, 433 u.s. 229, 232 (1977), overruled by mitchell, 530 u.s. at 801. 14 tilton v. richardson, 403 u.s. 672, 689 (1971). 15 meek, 421 u.s. at 364, overruled by mitchell, 530 u.s. at 808. 2023] the worst choice for school choice 83 financial burden did “not alone demonstrate an unconstitutional degree of support for a religious institution.”16 while clearly secular resources like transportation were permissible during this time, the court invalidated other provisions not as easily separable from religious instruction. these included “auxiliary services” like counseling and specialized instruction to be provided on the grounds of nonpublic schools.17 these services were impermissible because the monitoring required to ensure they remained secular would necessarily require excessive entanglement between church and state.18 the court decided along these lines in 1973 in committee for public education and religious liberty v. nyquist.19 new york taxpayers challenged state law that provided direct grants from the state to nonpublic schools for facilities maintenance, reimbursed certain parents of students at nonpublic schools for some tuition expenses, and allowed other parents tax benefits corresponding to the amount they paid in nonpublic school tuition. each of these provisions was invalidated. the new york law had the impermissible primary effect of advancing religion because the funds were not restricted to secular uses:20 “in the absence of an effective means of guaranteeing that the state aid derived from public funds will be used exclusively for secular, neutral, and nonideological purposes, it is clear from our cases that direct aid in whatever form is invalid.”21 regarding the tuition reimbursements and tax benefits, the court rejected the argument that aid was permissible because it went to parents or students, instead of to the school. earlier cases considered this point; for example, the court noted that when states loan textbooks directly to students instead of to schools, “the financial benefit is to parents and children, not to schools.”22 in nyquist, the court suggested that such statements were mostly dicta: “far from providing a per se immunity from examination of the substance of the state’s program, the fact that aid is disbursed to parents rather than to the schools is only one among many factors to be considered.”23 the court did not decide the disputed issue of whether the tax benefit in nyquist was a tax credit or a deduction.24 it had qualities of both, and its constitutionality did not depend on its label.25 it was a “form of encouragement and reward for sending [one’s] children to nonpublic schools,” just like the tuition 16 see meek, 421 u.s. at 360, overruled by mitchell, 530 u.s. at 808 (quoting allen, 392 u.s. at 244). 17 meek, 421 u.s. 349, overruled by mitchell, 530 u.s. at 808; sch. dist. v. ball, 473 u.s. 373, 397–98 (1985), overruled by agostini v. felton, 521 u.s. 203, 235 (1997). 18 meek, 421 u.s. at 370, overruled by mitchell, 530 u.s. at 808. 19 comm. for pub. educ. & religious liberty v. nyquist, 413 u.s. 756, 774 (1973). 20 id. at 756, 774, 780, 793. 21 id. at 780. 22 bd. of educ. v. allen, 392 u.s. 236, 244 (1968). 23 nyquist, 413 u.s. at 781. 24 id. at 789–90. 25 id. (“as mr. chief justice burger’s opinion for the court in lemon v. kurtzman, 403 u.s., at 614, notes, constitutional analysis is not a ‘legalistic minuet in which precise rules and forms must govern.’ instead, we must ‘examine the form of the relationship for the light that it casts on the substance.’”) (citing lemon v. kurtzman, 403 u.s. 602, 614 (1971). columbia journal of tax law [vol: 15:1 84 reimbursement.26 “the only difference[,] that one parent receives an actual cash payment while the other is allowed to reduce by an arbitrary amount the sum he would otherwise be obliged to pay over to the state,” was of no moment.27 whether the aid took the form of a reimbursement or tax credit, “neither [was] sufficiently restricted to assure that it [would] not have the impermissible effect of advancing the sectarian activities of religious schools.”28 these cases illustrate the rule that governed public aid in religious education cases beginning in 1947 and ending in 1983: the establishment clause permitted public aid to private schools as long as it was restricted to secular purposes. 2. 1983–2011: neutral availability and private choice the rule governing public aid to private schools evolved in 1983. such aid, even if not restricted to secular purposes, was permitted as long as it was neutrally available and available to private schools only as a result of non-governmental choice, regardless of whether it served nonsecular purposes. mueller v. allen29 ushered in this expansion. there, the supreme court, divided five to four, upheld a minnesota statute allowing parents to deduct expenditures on their children’s tuition, textbooks, and transportation from their taxable income, regardless of where the children attended school.30 the court found that the law did not have the primary effect of advancing religion for several reasons: 1) the deduction was a permissible exercise of the minnesota legislature’s discretion in distributing its tax burden,31 2) it was available to all families with schoolchildren,32 and 3) private schools received funds “only as a result of numerous, private choices of individual parents.”33 these reasons shaped subsequent cases and so merit further examination. the first reason that the establishment clause allowed minnesota’s tax deduction was that it was a valid exercise of the state legislature’s power.34 this reason obviously would not justify, the court wrote, a direct grant or reimbursement to parents like the one invalidated in nyquist.35 even nyquist’s tax benefits did not resemble “genuine tax deduction[s]” because the amount that families saved did not correspond to the amount spent on tuition.36 mueller’s educational expenses deduction, on the other hand, was one of many available under minnesota law and perceived as an evenhanded attempt to equitably 26 id. at 791. 27 id. 28 id. at 794. 29 mueller v. allen, 463 u.s. 388 (1983). 30 id. 31 id. at 396. 32 id. at 397. 33 id. at 399. 34 id. at 396 (“[t]he minnesota legislature's judgment that a deduction for educational expenses fairly equalizes the tax burden of its citizens and encourages desirable expenditures for educational purposes is entitled to substantial deference.”). 35 mueller, 463 u.s. at 396 n.6 (“plainly, [nyquist’s] outright grants [in comm. for pub. educ. & religious liberty v. nyquist, 413 u.s. 756 (1973)] to low-income parents did not take the form of ordinary tax benefits.”). 36 id. 2023] the worst choice for school choice 85 distribute the tax burden.37 the court thus approached the mueller deduction with more deference than it did the tax benefits in nyquist. the four dissenting justices found no difference between the tax benefits in those two cases. in their view, both were impermissibly unrestricted to secular purposes and violated the establishment clause, regardless of their indirectness.38 they relied on nyquist to assert that the aid’s form did not decide its constitutionality: [f]or purposes of determining whether such aid has the effect of advancing religion,’ it makes no difference whether the qualifying ‘parent receives an actual cash payment [or] is allowed to reduce . . . the sum he would otherwise be obliged to pay over to the state.’ it is equally irrelevant whether a reduction in taxes takes the form of a tax ‘credit,’ a tax ‘modification,’ or a tax ‘deduction.’39 nonetheless, the majority’s view that the mueller tax deduction was genuine differentiated it from the benefits struck down in nyquist. the second reason listed by the court—that the minnesota aid was neutrally available to all parents—was also a critical distinction between mueller and nyquist. in nyquist, aid was available exclusively to families with children in nonpublic schools.40 mueller’s aid was available regardless of where children attended school and regardless of religion. the court held that “a program, like [minnesota’s], that neutrally provides state assistance to a broad spectrum of citizens is not readily subject to challenge under the establishment clause.” the law’s challengers argued the tax deduction was not neutrally available in practice. as the bulk of the deductible expenses were tuition payments, and given that public school students do not pay tuition, most of the “neutrally available” deductions were not actually available to their families. the supreme court found, however, that statistical reports of who happened to claim tax benefits had no place in constitutional interpretation.41 the mueller court’s third reason for upholding the minnesota program was that private schools received aid only as a result of private choice. this reason is closely related to the notion of indirectness that nyquist held was “only one among many factors to be considered.”42 mueller reinvigorated the importance of indirectness, pointing out that where the court invalidated public aid to private schools, it was usually in cases where funds were paid directly from the state to the 37 id. at 396. 38 id. at 406–07 (marshall, j., dissenting). 39 id. at 407–08 (marshall, j., dissenting) (citations omitted) (quoting nyquist, 413 u.s. at 790–91). 40 id. at 398. (both quotes). 41 mueller, 463 u.s. at 401 (“we would be loath to adopt a rule grounding the constitutionality of a facially neutral law on annual reports reciting the extent to which various classes of private citizens claimed benefits under the law. . . . [t]hat private persons fail in a particular year to claim the tax relief to which they are entitled—under a facially neutral statute—should be of little importance in determining the constitutionality of the statute permitting such relief.”). 42 nyquist, 413 u.s.at 781 (describing “the fact that aid is disbursed to parents rather than to the schools”). columbia journal of tax law [vol: 15:1 86 school without passing through the students’ or parents’ hands.43 an appealing function of tax deductions was that “aid to parochial schools is available only as a result of decisions of individual parents[, so] no ‘imprimatur of state approval,’ can be deemed to have been conferred on any particular religion, or on religion generally.”44 mueller marked a major change in cases assessing aid to public schools. in subsequent years, the court upheld government provisions of a language interpreter at a catholic school,45 tuition assistance for a religious school’s vocational training,46 and even made clear that government vouchers for tuition expenses are legal as well.47 states were also permitted to provide auxiliary teachers and equipment to private schools when such programs were neutrally available and dispensed to all eligible students, no matter where they attended school.48 this phase of establishment clause decisions also helped clarify historical cases in two ways. first, the court replaced the amorphous notion of aid’s “directness” with the private choice requirement. the private choice requirement was met if private citizens had the opportunity to direct the aid elsewhere;49 “private choice is easier to see when aid literally passes through the hands of individuals,” but “literal” passage was not what the establishment clause required.50 accordingly, even aid that was “allocated . . . based on the per capita number of students at each school” reflected private choice.51 second, the public aid in nyquist remained distinguishable from the expanding field of permissible aid under mueller. because nyquist’s program was available only to private school students, it would have failed to meet the neutrality requirement.52 3. 2011: standing in the 2011 arizona christian sch. tuition org. v. winn five-to-four decision, the supreme court cast many of these earlier establishment clause rulings into doubt.53 there, arizona taxpayers challenged a state statute allowing tax credits for donors to funds that provided scholarships to private school students, including those in religious schools. the winn court did not assess neutrality and private choice because it decided the taxpayers lacked standing. it acknowledged that while taxpayers generally have standing to challenge government spending 43 mueller, 463 u.s. at 399 (“[a]ll but one of our recent cases invalidating state aid to parochial schools have involved the direct transmission of assistance from the state to the schools themselves.”). 44 id. (citation omitted). 45 zobrest v. catalina foothills sch. dist., 509 u.s. 1, 13–14(1993). 46 witters v. washington dep't of servs. for the blind, 474 u.s. 481, 489 (1986). 47 zelman v. simmons-harris, 536 u.s. 639, 662–63 (2002). 48 see generally agostini v. felton, 521 u.s. 203 (1997) (overruling in part sch. dist. of city of grand rapids v. ball, 473 u.s. 373, 395 (1985) (invalidating auxiliary services “unmediated by the tax code and the ‘numerous, private choices of individual parents of school-age children’”). 49 see mitchell v. helms, 530 u.s. 793, 816 (2000). 50 id. at 816. 51 id. at 829–30. 52 zelman v. simmons-harris, 536 u.s. 639, 662 (2002) (“[w]e now hold that nyquist does not govern neutral educational assistance programs that, like the program here, offer aid directly to a broad class of individual recipients defined without regard to religion.”). 53 see generally arizona christian sch. tuition org. v. winn, 563 u.s. 125 (2011). 2023] the worst choice for school choice 87 under the establishment clause, arizona’s tax credits did not constitute government expenditures. contributions to scholarship funds were never “drawn from general tax revenues,” so no money had “been extracted from [the challengers] and handed to a religious institution in violation of [their] conscience.”54 the court acknowledged that it had decided earlier cases that may have had the same standing deficiency as winn but suggested that those cases might have had another source of standing.55 a four-justice dissent emphasized that no court before had distinguished between tax benefits and appropriations when applying the rule that taxpayers had standing for establishment clause challenges.56 that distinction had always been irrelevant because “cash grants and targeted tax breaks are means of accomplishing the same government objective.”57 given that “targeted tax breaks are often ‘economically and functionally indistinguishable from a direct monetary subsidy,’” allowing standing to turn on such a formalistic difference nullifies the rule allowing for taxpayer standing in establishment clause cases.58 after winn, neutrality and private choice presumptively remained the standard, but lack of taxpayer standing foreclosed further establishment clause challenges of public aid for private schools. importantly, one consequence of winn was a further increase in states’ use of tuition tax credits, now that it was clear that taxpayers lacked standing to challenge them.59 4. 2017: free exercise the standing obstacle impeded establishment clause challenges, but it did not end all litigation about public aid to private schools. government aid was instead challenged on free exercise grounds in states that funded only secular private schools. such was the case in trinity lutheran. there, a missouri program provided grants for public and private schools to cover the costs of recycled rubber playground surfaces.60 the state’s policy was to disqualify religious entities from eligibility to receive a grant—a policy entirely based on the missouri constitution’s no-aid provision.61 thus, when trinity lutheran church and preschool applied for a grant and was disqualified because of religious affiliation, a free exercise challenge developed. the supreme court held that the policy of disqualifying religious applicants violated free exercise. the policy conditioned a benefit on 54 id. at 144. 55 see id. at 145. 56 id. at 151 (kagan, j., dissenting) (“in the decades since flast, no court—not one—has differentiated between appropriations and tax expenditures in deciding whether litigants have standing.”). 57 id. at 148 (kagan, j., dissenting). 58 id. at 157 (kagan, j., dissenting) (quoting rosenberger v. rector & visitors of univ. of virginia, 515 u.s. 819, 859 (1995)). 59 thanks to professor adam chodorow for illuminating this point. 60 see trinity lutheran church of columbia, inc. v. comer, 582 u.s. 449, 453 (2017). 61 mont. const. art. i, § 7 (requiring “[t]hat no money shall ever be taken from the public treasury, directly or indirectly, in aid of any church, sect or denomination of religion, or in aid of any priest, preacher, minister or teacher thereof, as such; and that no preference shall be given to nor any discrimination made against any church, sect or creed of religion, or any form of religious faith or worship.”). columbia journal of tax law [vol: 15:1 88 abstention from religious belief, impermissibly deterring the exercise of first amendment rights. yet, the grant program did not violate the establishment clause. it was faith-neutral, and playground resurfacing money was a secular resource.62 accordingly, the court distinguished trinity lutheran from a state’s denial of a public scholarship to a student seeking religious training that had been upheld under the establishment clause. using taxpayer money to fund the training of clergy implicated antiestablishment interests in a way that using it to resurface preschool playgrounds did not.63 justice breyer agreed, writing separately that missouri’s grants were “a general program designed to secure or to improve the health and safety of children,” no different from “such ‘general government services as ordinary police and fire protection.’”64 under his view, the establishment clause allows grants for playground surfaces for the same reason it allows providing fire safety equipment to religious schools.65 the two-justice dissent disagreed, stating that this was the exact kind of direct government funding to a religious institution that the establishment clause prohibits.66 that violation could not be rectified because the facilities benefitting from the grant could not be restricted to secular purposes,67 and funding did not depend at all on private choice.68 in 2020, the supreme court applied the same reasoning to a free exercise challenge of a montana tax credit program.69 montana granted tax credits of up to $150 for contributions to organizations that funded private school scholarships. the montana supreme court held that those scholarships could not be used at religious schools because of the montana constitution’s no-aid provision.70 its order 62 trinity lutheran argued that a state-funded grant for playground resurfacing complied with the establishment clause partly because playgrounds were used only for secular purposes. brief for petitioner at 30, trinity lutheran church of columbia, inc. v. pauley, 563 u.s. 125 (2017) (no. 1 5-577), 2016 wl 1496879 (u.s. 2016) (“[r]ubber playground surfacing material . . . is devoid of any religious content and . . . cannot possibly be diverted to a religious use. . .”). 63 see trinity lutheran church of columbia, 563 u.s. at 465. 64 see id. at 471 (breyer, j., concurring). 65 justice gorsuch predicted that this distinction between discrimination based on religious status as opposed to religious use would fade into immateriality. see id. at 469 (gorsuch, j., concurring in part) (“is it a religious group that built the playground? or did a group build the playground so it might be used to advance a religious mission? the distinction blurs in much the same way the line between acts and omissions can blur when stared at too long.”). after espinoza and carson, it is clear that he was right. 66 see id. at 473 (sotomayor, j., dissenting) (“this court has repeatedly warned that funding of exactly this kind—payments from the government to a house of worship—would cross the line drawn by the establishment clause.”). 67 see id. at 476 (sotomayor, j., dissenting) (“the playground surface cannot be confined to secular use any more than lumber used to frame the church’s walls, glass stained and used to form its windows, or nails used to build its altar.”). 68 see id. at 474 n.2 (sotomayor, j., dissenting) (“because missouri decides which scrap tire program applicants receive state funding, this case does not implicate a line of decisions about indirect aid programs in which aid reaches religious institutions ‘only as a result of the genuine and independent choices of private individuals.’”) (quoting zelman v. simmons-harris, 536 u.s. 639, 649 (2002)). 69 see generally espinoza v. montana dep’t of revenue, 140 s. ct. 2246 (2020). 70 mont. const. art. x, § 6 (“(1) the legislature, counties, cities, towns, school districts, and public corporations shall not make any direct or indirect appropriation or payment from any public fund or 2023] the worst choice for school choice 89 invalidated the entire tax credit program. families hoping to use the scholarships at religious schools appealed to the u.s. supreme court, which decided that the tax credit program must continue. the court based this decision on the religion clauses. first, it held that the tax credits did not violate the establishment clause because they were neutrally available and reflected scholarship recipients’ private choice to attend religious schools. second, the court held that montana’s no-aid provision, interpreted as prohibiting this scholarship program by the montana supreme court, violated free exercise. the provision “bar[red] religious schools from public benefits solely because of the religious character of the schools.”71 under trinity lutheran, that distinction was impermissible discrimination. the montana supreme court had discontinued the tax credit program entirely before the u.s. supreme court decided this case. according to the dissenting justices in espinoza, that meant that the discriminatory granting of scholarships had ended; “[t]here simply [were] no scholarship funds to be had.”72 the majority disagreed and reversed the decision to end the program, because it had been made “by a court, and not based on some innocuous principle of state law.”73 the majority reasoned that the montana supreme court invalidated the program because it violated the state’s no-aid provision, which itself violated free exercise. if the montana supreme court had realized its state provision violated federal law, it would have had no basis on which to end the program. state courts “must not give effect to state laws that conflict with federal law,”74 so “the montana supreme court should have ‘disregard[ed]’ the no-aid provision and decided this case ‘conformably to the [c]onstitution’ of the united states.”75 in short, when a state court is faced with a program that violates the federal constitution to comply with the state constitution, it must invalidate the state provision (here, the no-aid clause), not the program itself.76 this rule exists only in the context of judicial decisions; state legislatures remain free to end or alter school choice programs.77 more importantly, shortly after espinoza, carson v. makin similarly held that free exercise required a state to financially support religious schools.78 a monies, or any grant of lands or other property for any sectarian purpose or to aid any church, school, academy, seminary, college, university, or other literary or scientific institution, controlled in whole or in part by any church, sect, or denomination. (2) this section shall not apply to funds from federal sources provided to the state for the express purpose of distribution to non-public education.”). 71 espinoza, 140 s. ct. at 2255. 72 id. at 2279. 73 id. at 2262 (emphasis added) (“the montana legislature created the scholarship program; the legislature never chose to end it, for policy or other reasons.”). 74 espinoza, 140 s. ct. at 2262 (citing armstrong v. exceptional child ctr., inc., 575 u.s. 320, 324 (2015)). 75 id. (citing marbury v. madison, 5 u.s. 137, 178 (1803)). 76 no-aid clauses are not facially unconstitutional. states can constitutionally comply with no-aid clauses by never sponsoring school choice (for either religious or non-religious private schools). when a state is already sponsoring school choice for non-religious schools, however, it cannot constitutionally refuse to extend that program to religious schools because of its no-aid clause (that application of the no-aid clause would be unconstitutional, and under espinoza, requires courts to invalidate the no-aid clause instead of ending the program). 77 espinoza v. montana dep’t of revenue, 140 s. ct. 2246, 2262 (2020) (emphasis added) (“the montana legislature created the scholarship program; the legislature never chose to end it, for policy or other reasons.”). 78 carson v. makin, 142 s. ct. 1987, 1989 (2022). columbia journal of tax law [vol: 15:1 90 maine program assisted students living in remote districts without secondary public schools. the program would pay tuition at a private secondary school for those students, as long as the school was nonsectarian. this distinction was not based on a state constitutional provision; it came instead from “an opinion by the maine attorney general taking the position that public funding of private religious schools violated the establishment clause of the first amendment.”79 the court stated that such funding did not violate the establishment clause because it was neutrally available and reflected private choice, but excluding religious schools from this public benefit violated free exercise.80 it was a straightforward application of espinoza’s holding that “[a] state need not subsidize private education. but once a state decides to do so, it cannot disqualify schools solely because they are religious.”81 nor can a state supreme court address this problem by judicially ending the aid program altogether. state legislatures can choose to aid private schools or not, but when they do, the u.s. supreme court has now held that courts deciding on programs that exclude religious schools must order inclusion of religious schools. this last phase of supreme court case law dramatically shifted the meaning of the religion clauses.82 states used to have to prove that they met an exception to the general rule that they could not fund religious entities. espinoza and carson obviated the lingering possibility that subsidizing religious entities was permissible as long as it focused on arguably secular resources, like fire protection or playground surfaces. if that were still the rule, espinoza and carson could not have upheld aid for tuition costs, because they are inseparable from the entities’ sectarianism. taxpayers have not had standing to challenge tax credits on establishment clause grounds since 2011. now it is clear that even if they did, they would lose. free exercise requires states to fund religious entities in some circumstances—situations where the state is funding private secular institutions compel the state to fund private religious institutions as well.83 b. meanwhile, in the states as federal law on aid to religious schools evolved, so did state law. the sections below outline the rise and fall of state no-aid provisions and explain why they are mostly unenforceable today. the evolution of no-aid provisions and their interpretations is important for understanding why tax credit systems exist in their current form today. 79 id. at 1994. 80 id. at 1998. 81 espinoza, 140 s. ct. at 2262 (2020) (quoted by carson v. makin, 142 s. ct. at 1997). 82 trinity lutheran church of columbia, inc. v. pauley, 788 f.3d 779, 783 (8th cir. 2015), rev’d and remanded sub nom. trinity lutheran church of columbia, inc. v. comer, 137 s. ct. 2012, 2016 (2017) (describing a ruling that a no-aid provision violates the first amendment, the relief that trinity lutheran later won, as “unprecedented”). 83 steven green, symposium: rip state “blaine amendments” — espinoza and the “no-aid” principle, scotusblog (jun. 30, 2020), https://www.scotusblog.com/2020/06/symposium-rip-sta te-blaine-amendments-espinoza-and-the-no-aid-principle/ [perma.cc/h3sr-ak6r] (describing espinoza as “inflat[ing] the free exercise component but ignor[ing] the freedom-enhancing aspect of non-establishment.”). 2023] the worst choice for school choice 91 1. no-aid provisions and state interpretations many state constitutions contain no-aid provisions explicitly stating that no public funds should be paid to religious institutions.84 traditionally, they had been held as a permissible way for states “to enforce a more strict policy of church and state separation than that required by the first amendment.”85 they are often referred to as “blaine amendments,” referring to an 1876 proposed amendment to the u.s. constitution that would have explicitly prohibited state funding of religious schools.86 the term carries a negative connotation because the blaine amendment itself was based on widespread anti-catholic sentiment.87 some states’ no-aid provisions directly followed the failure of the blaine amendment and indeed reflect anti-catholic views. others, however, were adopted before the blaine amendment conflict and were not born of that bias.88 in any event, state no-aid provisions persist. some state high courts, like montana’s in espinoza, have held that no-aid provisions prohibit tuition tax credits.89 others have gone the route in winn, holding that their state provisions do not apply to tax credits because tax credits are not actually expenditures.90 as state high courts are the ultimate decision makers on the meanings of their own constitutions, states are entitled to interpret their no-aid provisions differently. states interpreting along the lines of winn, including florida, georgia, and arizona, serve to exemplify why the mechanism of tuition tax credits became 84 id. (“38 state constitutions contain provisions that prohibit public monies being spent in aid of religious institutions or religious education.”). 85 luetkemeyer v. kaufmann, 364 f. supp. 376, 386 (w.d. mo. 1973), aff’d. 419 u.s. 888 (1974) (stating such a practice “does not present any substantial federal constitutional question”). compare locke v. davey, 540 u.s. 712 (2004) (upholding washington prohibition on state funding of training of ministers based on washington constitutional provision that “draws a more stringent line than that drawn by the united states constitution”) with carson v. makin, 142 s. ct. 1987, 1989 (2022) (invalidating “maine's decision to continue excluding religious schools from its tuition assistance program after zelman [which] promotes stricter separation of church and state than the federal constitution requires”). 86 see, e.g., mitchell v. helms, 530 u.s. 793, 828 (2000); green, supra note 83. 87 green, supra note 83. 88 id. (“15 states adopted no-funding provisions prior to the blaine amendment, with several arising in states with little or no discernible religious conflict. they also arose at a time that states were establishing their public schools and were seeking to guarantee the financial security of those fledgling schools.”). 89 espinoza v. montana dep’t of revenue, 35 p.3d 603, rev’d and remanded, 140 s. ct. 2246, 2249 (2020) (“when the legislature indirectly pays general tuition payments at sectarian schools, the legislature effectively subsidizes the sectarian school's educational program. that type of government subsidy in aid of sectarian schools is precisely what the delegates intended [the montana constitution] to prohibit.”). 90 kotterman v. killian, 972 p.2d 606, 621 (1999) (“[t]his tax credit is not an appropriation of public money.”); gaddy v. georgia dep't of revenue, 802 s.e.2d 225, 230 (2017) (“we also reject the assertion that plaintiffs have standing because these tax credits actually amount to unconstitutional expenditures of tax revenues or public funds. the statutes that govern the program demonstrate that only private funds, and not public revenue, are used.”); mccall v. scott, 199 so. 3d 359, 370 (fla. dist. ct. app. 2016) (“[t]he legislative actions challenged in this case, the authorization of tax credits under the ftcsp and the payment of private funds to private schools via scholarships authorized under the ftcsp, involve no appropriation from the public treasury. the program is funded through voluntary, private donations by individual and corporate taxpayers.”). about:blank columbia journal of tax law [vol: 15:1 92 so prevalent:91 they circumvent no-aid provisions. no-aid provisions forbade government funding of religious schools. in these states, however, tax credits were not interpreted as government funding, so they allowed the government to support religious schools and comply with no-aid provisions. consider florida, for instance. its no-aid provision states that “[n]o revenue of the state or any political subdivision or agency thereof shall ever be taken from the public treasury directly or indirectly in aid of any church, sect, or religious denomination or in aid of any sectarian institution.”92 the state provides tax credits to donors to organizations that provide scholarships, including to religious schools.93 when taxpayers challenged the tax credits for violating the no-aid provision back in 2016, florida courts found that the plaintiffs lacked standing.94 florida taxpayers have standing where they can show that government spending or taxing violates a specific constitutional limit on the government’s powers to tax and spend. here, “[b]ecause there was no diversion of any state revenues from public schools to private schools through the operation of” the tax credits, the plaintiffs could not make that showing.95 accordingly, the tax credit system and the no-aid provision were left to coexist. the court then distinguished another florida case, where taxpayers challenged “statutes that authorized the state to direct appropriations to sectarian institutions.”96 without the structure of the tax credit, those taxpayers had standing because they alleged that state statutes allowed appropriations to aid sectarian institutions.97 this example illustrates why states aid religious schools through tax credits rather than by direct means of funding—many states thought they were required to do so by their no-aid provisions. the tax credit system arose not because states thought it was the best way to support private schools, but because it was the only way they thought they could do so constitutionally. this led to the tax credit scheme used by states today: taxpayers make contributions to non-profit organizations,98 in some states with the option to indicate which school or child their contribution should be directed to.99 those organizations direct most of that money to private 91 in 2008, when georgia passed its qualified education expense credit, five other states already had similar programs. delon pinto & wade walker, elementary and secondary education: amend titles 20 and 48 of the official code of georgia annotated relating, respectively to education and revenue taxation, so as to provide for a program of educational improvement; 25 ga. st. u. l. rev. 73, 82 (2008) (arizona, florida, pennsylvania, iowa, and rhode island). 92 fla. const. art. i, § 3. 93 mccall, 199 so. 3d at 363. 94 id. at 359. 95 id. at 366. 96 id. at 359 (emphasis added) (describing council for secular humanism, inc. v. mcneil, 44 so. 3d 112 (fla. dist. ct. app. 2010)). 97 see council for secular humanism, 44 so. 3d 112, 122 (fla. dist. ct. app. 2010). 98 in georgia, a student scholarship organization must use “at least 90 percent of its annual revenue received from donations for scholarships or tuition grants to allow students to attend any qualified school of their parents’ choice,” and may not “[limit] availability to only students of one school.” ga. code ann. § 20-2a-1 (west). 99 georgia goal scholarship program, inc., designation options, georgia goal scholarship program (2023), https://www.goalscholarship.org/for_donors/page/designation-options [perma.cc/ 7jpj-fr7m] (ga allows donors to designate school); king foundation dba arizona tax credit, 2023] the worst choice for school choice 93 schools for scholarships, and the taxpayers can claim a dollar-for-dollar tax credit up to a certain amount.100 in some states, including georgia, the only eligibility requirement for receiving a scholarship is that a student is transferring into a private school from a public one. in others, students’ household income must fall below a certain level, or the student must qualify for benefits like food assistance.101 2. no-aid provisions after 2017 in 2017, the supreme court in trinity lutheran held that missouri could not, on the basis of its no-aid provision, exclude religious schools from otherwise available public benefits. its decision technically only invalidated missouri’s policy of automatically disqualifying religious schools from competition for state grants and did not directly affect missouri’s no-aid provision.102 speculation about what that decision meant for no-aid provisions103 was mostly resolved three years later in espinoza. there, the court held that montana’s application of its no-aid provision violated free exercise.104 finally, in carson, the court repudiated maine’s understanding that the establishment clause prohibits states from funding religious schools. the court held not only that no such prohibition exists, but also that free exercise requires including religious schools in otherwise-available aid. taking the trilogy of cases together, it now seems that no-aid provisions comply with free exercise only in two situations. first, if the no-aid provision is interpreted like arizona’s, meaning it allows for indirect aid like tax credits, then it is constitutional as long as the only type of aid the state provides to private schools f.a.q., arizona tax credit, https://aztxcr.org/faqs/ [perma.cc/gs8x-ktms] (arizona allows donors to designate schools or recommend individual students). florida does not allow designation of a contribution to a school or student. scholarship-funding organizations “may not restrict or reserve scholarships for use at a particular private school or provide scholarships to a child of an owner or operator.” fla. stat. ann. § 1002.395 (west). they “[m]ust allow an eligible student to attend any eligible private school and must allow a parent to transfer a scholarship during a school year to any other eligible private school of the parent’s choice.” id. in 2017, over half of the tax credit programs prohibited donors from designating their contribution to a specific individual, and about a third of programs prohibited donors from designating a specific school. u.s. gov’t accountability off., gao-19-664, private school choice: accountability in state tax credit scholarship programs (2019), https://www.gao.gov/assets/gao-19-664.pdf [perma.cc/7jle-7de m]. 100 see, e.g., ariz. dep’t of revenue, credits for contributions to certified school tuition organizations, ariz. dep’t of revenue, https://azdor.gov/tax-credits/credits-contributions-certifiedschool-tuition-organizations [perma.cc/8akk-b5kt]; fla. dep’t of educ, ftc for parents, fla. dep’t of educ (2023), https://www.fldoe.org/schools/school-choice/k-12-scholarship-programs/ftc /ftc-parent-info.stml [perma.cc/ghw6-t9er]. 101 in florida, to qualify for a scholarship, students must be on a list of students already receiving public benefits, have a household income level below 375% of the federal poverty level, or be in foster care. fla. stat. ann. § 1002.395 (west). 102 trinity lutheran church of columbia, inc. v. comer, 582 u.s. 449, 467 (2017). 103 james hirsen, symposium: a takedown of the blaine amendments, scotusblog (jul. 2, 2020), https://www.scotusblog.com/2020/07/symposium-a-takedown-of-the-blaine-amendments/ [perma. cc/3mwm-f8zk] (describing trinity lutheran as “a funeral dirge . . . for blaine funding restrictions”). 104 espinoza v. mont. dep't of revenue, 140 s. ct. 2246, 2262 (2020). columbia journal of tax law [vol: 15:1 94 is indirect.105 that way, religious schools remain eligible for all the aid available to private schools. the second way that a no-aid provision could now comply with free exercise is if the state provides no aid to private schools whatsoever.106 the takeaway for the purposes of tax credits is this: many states chose tax credits as the means to fund private schools because they thought the establishment clause or their state no-aid provisions required them to. the supreme court has now made clear that the establishment clause does not forbid direct payments.107 moreover, no-aid provisions, if interpreted to have any force, violate free exercise.108 therefore, the only thing “requiring” states to use tuition tax credits could be an impotent no-aid provision interpreted to prohibit direct funding but allow tax credits. such a provision is useless because, as the next section describes, tax credits are an inefficient, ineffective way to achieve the goals of direct funding. iii. why tax credits are the wrong policy choice because direct aid to parochial schools is permitted—even sometimes mandatory—tax credits are no longer necessary for compliance with the establishment clause. the constitutionality of the other reason for the tax credit structure, state no-aid provisions, is also now severely suspect. nevertheless, tax credits remain ubiquitous. now that the reasons for their development have been obviated, the time has come to ask whether tax credits are actually worthwhile. in other words, just because tax credits are no longer necessary, is it time to change the status quo? this section argues in the affirmative. tax credits are not only unnecessary, but they are also bad law and bad policy. the decisions upholding them as bypasses around the establishment clause or no-aid state laws rest on debatable legal ground; after all, tax credits may 105 oklahoma has seen some interesting developments with respect to its no-aid provision since carson. the oklahoma constitution requires public schools to be “nonsectarian” and “free from sectarian control.” when considering a catholic charter school, the state’s then-attorney general john m. o’connor wrote that the supreme court would probably permit a religious charter school under carson. the subsequent state attorney general, gentner drummond, withdrew that opinion and advised that a religious charter school would violate the oklahoma constitution. mark walsh, a major reversal on religious charter schools in oklahoma, education week (feb. 24, 2023), https://www.edweek.org/policy-politics/a-major-reversal-on-religious-charter-schools-in-oklahom a/2023/02 [perma.cc/kv3n-gb9e]. 106 espinoza, 140 s. ct. at 2261; (quoted by carson v. makin, 142 s. ct. 1987, 1997 (2022)) (“a state need not subsidize private education. but once a state decides to do so, it cannot disqualify some private schools solely because they are religious.”). we are inclined to think that in a universe in which vouchers are normative and paid in large enough quantities that all students use them, the distinction between “public,” “charter,” and “private” schools is merely formulaic, since all are funded by the government. 107 trinity lutheran implies that private choice is not necessary to circumvent the establishment clause, see 582 u.s. 449, and carson required direct funding to religious schools, see 142 s. ct. at 2014 (2022). 108 steven k. green, requiem for state “blaine amendments”, 64 journal of church and state, 437, 440 (2022) (“even though the supreme court stopped short of declaring montana’s no-funding provision to be unconstitutional, the espinoza decision possibly made it—and similar provisions in thirty-seven other states—dead-letter laws.”); steven green, symposium: rip state “blaine amendments” — espinoza and the “no-aid” principle, scotusblog (jun. 30, 2020), https://ww w.scotusblog.com/2020/06/symposium-rip-state-blaine-amendments-espinoza-and-the-no-aid-prin ciple/ [perma.cc/3mcd-5jbe] (“[espinoza] ha[s] now tainted all no-aid provisions, and the more general principle against government funding of religion, with the aura of discrimination.”). 2023] the worst choice for school choice 95 formally circumvent constitutional issues, but they have the same effect as direct payments. but far from being harmless vestigial features of past legal landscapes, tax credits fail to properly achieve their goals and are an inefficient waste of public resources. the weaknesses in their legal basis and their inefficiencies were not an accident; instead, those qualities were features thought necessary to the validity of tax credits. the weaknesses discussed in detail below all exist for the same reason, which is to distance the government—and its oversight—from the aid. the further removed the government was from the tax credit system, the more defensible tax credits were as compliant with the establishment clause. inherent in that distance was also a lack of regulation—the government needed to avoid entangling itself with tax credits so that they could not be challenged as public aid. with nonexistent regulation, the government avoided connection with malfeasance in the tax credit system, but it also created a system that is not only ineffective but also rife with abuse, as noted in the following sections.109 a. tax credits have the effect of direct payments while circumventing rules governing direct payments the history of establishment clause jurisprudence and no-aid provisions demonstrates that tax credits were used as a way around rules that would otherwise prohibit government aid to religious schools.110 they allowed the government to do indirectly what it could not do directly. the result is an absurdly contrived system of funding private schools with both educational and policy failings. the purpose of this section is to demonstrate that tax credits have the same effect as direct payments, but are a much more cumbersome mechanism for aiding private schools. tax credits are a formalistic bypass amounting to a dollar-for-dollar reduction in someone’s tax bill in exchange for a donation. georgia private schools, for example, promote the program on their websites under the heading “redirect your tax dollars.”111 married taxpayers filing jointly under georgia’s tax credit 109 recall that tuition tax credits work by allowing individuals or corporations to receive a tax credit, which is the right not to pay that amount to the state in taxes, in exchange for giving money to an intermediary organization (a “scholarship organization”). then, the scholarship organization makes a donation to a private school, often the private school of the donor’s choice, as a scholarship. in contrast to vouchers (where the government collects taxes and then allows individuals to direct a portion of that to a private school), a government with a tax credit program forgoes receiving dollars as taxes if they were paid to a scholarship organization. for more on this, see carl davis, state tax subsidies for private k-12 education, institute on taxation & economic policy (oct. 2016), https://itep.sfo2.digitaloceanspaces.com/k12taxsubsidies.pdf [perma.cc/55wz-37rt]. 110 see, e.g., brief of americans united for separation of church and state, gaddy v. ga. dep’t of revenue, 802 s.e.2d 225 (2017) (no. s17a0177), 2017 wl 373535 at 3 (“programs like the tax credit program, which divert tax dollars from the public schools to private religious schools, are precisely what the no-aid clause, with its careful inclusion of a prohibition on indirect as well as direct aid, was meant to forbid.”); kotterman v. killian, 972 p.2d 606 (1999) (feldman, j., dissenting) (“it is a dangerous doctrine that permits the state to divert money otherwise due the state treasury and apply it to uses forbidden by the state's constitution.”). 111 covenant christian school, georgia private school tax credit, https://www.ccssmyrna.org /give/georgia-private-school-tax-credit.cfm [perma.cc/rp2e-7c26] (“redirect your tax dollars to [covenant christian school]”); porter academy, redirect your tax dollars, porter academy, https://www.porteracademy.org/support-porter-academy/redirect-your-tax-dollars/ [perma.cc/a69l-avs4]. columbia journal of tax law [vol: 15:1 96 program who donate $5,000 to be used for scholarships at private schools will have their state tax bill reduced by $5,000.112 as long as their state tax bill before the credit would be at least $5,000, they lose no money on the donation. in other words, instead of paying $5,000 to georgia in taxes, they donated $5,000 to be used for private school scholarships. the taxpayers lose zero dollars, because their tax bill was reduced by the amount they donated, and the state loses out on $5,000 in tax revenue that it would have otherwise gained. nevertheless, georgia characterizes funds flowing through scholarship organizations as “only private funds, and not public revenue.” because private entities control the funds, they are not subject to constitutional restrictions on direct payments. the georgia supreme court characterized tuition tax credits as follows: individuals and corporations choose the [scholarship organizations] to which they wish to direct contributions; these private [scholarship organizations] select the student recipients of the scholarships they award; and the students and their parents decide whether to use their scholarships at religious or other private schools. the state controls none of these decisions. nor does it control the contributed funds or the educational entities that ultimately receive the funds.113 the money granted in tax credits resembles government spending— georgia budgets the amount that can be claimed in credits every year114—but technically, it is not government spending. nor is it regulated and enforced like government spending. whether the government pays someone $5,000 or cuts his tax bill by $5,000, the effect is the same. the tax credit system, however, lacks the regulations customarily attached to government benefits.115 in view of the standing restrictions and avoidance of constitutional snags, we understand why tax credits became a deeply appealing method to support parochial schools. though based on extremely formalistic legal reasoning, they succeeded as a work-around. and while insulating the government was a primary reason for tax credits’ success, tax credits also came with political advantages and 112 ga. code ann. § 48-7-29.16 (west); georgia goal scholarship program, inc., frequently asked questions, georgia goal scholarship program, https://www.goalscholarship.org/about_g oal/page/frequently-asked-questions [perma.cc/wby3-lvef]. 113 gaddy v. ga. dep’t of revenue, 802 s.e.2d 225, 230 (2017). 114 in 2008, when georgia’s qualified education expenses credit was first passed, the cap was $50 million, and state legislators considered how the cap would affect the state’s budget. pinto & walker, supra note 91, at 74–75. for the tax year 2023, georgia allocated $120 million to be used to reimburse taxpayers for their donations to private school tuition funds. ga. code ann. § 48-7-29 .16 (west); ga. dep’t of revenue, tax credit summaries, dep’t of revenue, https://dor.georgia.g ov/tax-credit-summaries [perma.cc/76bb-pcc7]. that cap was met on january 3, 2023, the first day that the georgia department of revenue accepted tax credit applications for that year. after the allocated $120 million had been applied for, the department of revenue ceased accepting applications for the credit. the fact that georgia allocates $120 million from its budget to be used for tax credits demonstrates the similarity between tax credits and payments from the government— if tax credits did not have the same effect as withdrawing money from the state treasury, georgia would not need to limit them like this. unlike tax deductions, which reduce the taxpayer’s bill indirectly by reducing her taxable income, tax credits are treated like state revenue by being accounted for in the budget. 115 see section ii.b.2.ii, fraud concerns, infra p. 111. 2023] the worst choice for school choice 97 other appealing draws.116 still, tax credits were, and remain, a convoluted, albeit legal, schema. now that the court has clarified that direct payments are permissible and sometimes mandatory, the extra complication inherent to tax credits is unnecessary, administratively expensive, and prevents aid from going where it is most needed. if someone with a goal of funding private school scholarships started from a blank slate today, it would be absurd to invent a complicated system like this. thus, we contend, these systems survive only because of their established popularity. the extra complication is not just a neutral inconvenience. the next section explains why the convoluted system is more than unnecessary; it is both educationally and administratively counterproductive. as a result of the tax credit system, educational quality, and ultimately the state and its people, suffer. b. bad policy tax credits were initially popular because states believed they needed to starkly separate themselves from public aid directed at private schools. for the same reason, tax credits are an unmonitored, minimally effective method of aiding poorer schools and schools serving the poor. beliefs about the establishment clause and state no-aid clauses led states to enact tax credit systems and then look the other way. that failure to monitor was not accidental; state governments intentionally chose not to play a role, lest the re-directed tax payments be considered “state money” and entangle the government with religion. because of the lack of regulation, tax credits are an unsurprisingly inefficient and ineffective way for the government to support private schools. there are plenty of stated reasons for supporting school choice, but, as detailed below, tax credits serve none of these goals well. tax credits have ended up selectively benefitting—and being abused by—wealthy schools at the expense of poor schools. direct aid better achieves the goal of promoting quality education, and now that it is clearly constitutional, states should replace tax credit systems with direct aid. the following subsections break down why tax credits are a poor mechanism for school choice. section one catalogs some of the main reasons that states pursue school choice. those reasons include plenty of worthwhile objectives, decreasing inequity and fostering competition among them. notably absent from those purported goals, however, is subsidizing private school tuition for the rich. section two explains why this unspoken result—selectively helping the rich pay for private school—is actually what tax credits achieve. it describes the two main flaws of tax credits: their inequitable distribution and evasion of regulation. section three demonstrates that because of those flaws, tax credits are a counterproductive instrument for achieving any of the stated goals of school choice. 1. why do states subsidize school choice? to understand why tax credits are not only a poor, but also counterproductive, tool for school choice, it is first necessary to understand why states pursue school choice at all. there are plenty of reasons why state governments want to fund private schools, “from raising the quality of local schools 116 these political reasons, as discussed below, are still insufficient to justify using tax credits when direct funding—unencumbered by the tax code, available regardless of people’s tax filing status, and more readily regulated—is possible. columbia journal of tax law [vol: 15:1 98 and boosting religious freedom to empowering inner-city parents.”117 broadly, they seek to improve the quality of education. the stated goal of georgia’s private school tax credit, for example, is “educational improvement.”118 some states articulate more specific goals. those goals roughly break down into three groups, including educational equity, economic competition, and protecting individual freedom of choice. below we will explain these different goals and how school choice theoretically achieves them. keep in mind our reason for doing so: to demonstrate that tax credits do not actually achieve any of these goals. we by no means suggest that these goals are unworthy, or that school choice itself is good or bad. our purpose here is only to provide necessary background to the larger point that tax credits are a poor tool for achieving any of the stated purposes of school choice. a. equity with that, we will discuss the first stated goal of school choice: educational equity. under this view, public aid enables private school access for students who could not otherwise afford it.119 historically, this has been a leading justification for school choice.120 florida, for example, seeks to “expand[] educational opportunities for children of families that have limited financial resources.”121 this can be seen as an extension of school choice’s origins as a response to desegregation in the south; it was advocated as empowering against paternalistic government control to allow black families choices of schools.122 some programs, for example, make funds available specifically to students at low-performing public schools or with family incomes below a certain level. prioritizing those students for school choice is seen as a way to increase their opportunity to achieve regardless of the district they live in.123 b. pure economics not all rationales are about equity, however. a purely economic theory championed by milton friedman has supported school choice since at least the mid 117 bruce fuller, richard f. elmore, & gary orfield, policy-making in the dark: illuminating the school choice debate, in who chooses? who loses? culture, institutions, and the unequal effects of school choice 2 (1996). 118 pinto & walker, supra note 91, at 73. 119 hillel y. levin, tax credit scholarship programs and the changing ecology of public education, 45 ariz. st. l.j. 1033, 1073 (2013) (describing one distinct group of school choice proponents as seeking redistribution of opportunity); garnett, supra note 5, at 8. 120 garnett, supra note 5, at 8 (“[a]dvocates have historically argued that parental choice is needed for children who are not well served by district public schools, including economically disadvantaged students and students with disabilities.”). 121 fla. stat. ann. § 1002.395 (1)(b), 4–5 (west); see also fla. dep’t of educ., florida tax credit faqs, fla. dep’t of educ., https://www.fldoe.org/schools/school-choice/k-12-scholarship-program s/ftc/ftc-faqs.stml [perma.cc/8dts-euad]. 122 fuller, elmore, & orfield, supra note 117, at 3. (“originally advocated in the south as a way to avoid the desegregation of public schools, school choice came to be seen by the left as a way to empower poor and working-class families to challenge paternalistic bureaucracies.”). 123 pinto & walker, supra note 91, at 84; hillel y. levin, tax credit scholarship programs and the changing ecology of public education, 45 ariz. st. l. j. 1033, 1073 (2013). 2023] the worst choice for school choice 99 twentieth century, gaining popularity in the 1980s.124 friedman proposed separating educational funding from administration; “[g]overnments could require a minimum level of education which they could finance by giving parents vouchers redeemable for a specified maximum sum per child per year if spent on ‘approved’ educational services.”125 this would foster competition among schools, “meet the just complaints of parents that if they send their children to private nonsubsidized schools they are required to pay twice for education,” and reduce the government’s overall role in administering education.126 friedman acknowledged that an obstacle to school choice was “the general disrepute of cash grants to individuals (‘handouts’) with the absence of an efficient administrative machinery to handle the distribution of vouchers and check their use.”127 writing in 1955, he asserted that such machinery was developed through “the enormous extension of personal taxation and of social security programs.”128 he was not wrong to say that there is a way to distribute government money to families to enable school choice, even if it is not as straightforward as funding a public school, as explained below in section two. c. freedom of choice another theory focuses on the importance of freedom of choice in american society.129 school choice proponents emphasize individuality; school choice allows parents to benefit from state money allocated for educational costs to personalize their children’s education “rather than accepting an education system designed to teach to the average.”130 economic effects aside, these supporters of school choice “view[] education primarily as a private good, the benefits of which are reaped by the child herself and her family,” and the most important reason for school choice is to protect parents’ freedom of choice.131 124 see generally milton friedman, the role of government in education, in economics and the public interest (robert a. solo ed.) (1955); jeffrey r. henig, the local dynamics of choice, in bruce fuller et. al, who chooses? who loses? culture, institutions, and the unequal effects of school choice, supra note 117, at 95 (discussing “the market metaphor”). 125 friedman, supra note 124, at 127; see william mcgurn, milton friedman’s school choice revolution, wall st. j. (april 3, 2023). 126 friedman, supra note 124, at 130; fuller, elmore, & orfield, supra note 117 at 12 (“choice proponents also argue that, by unleashing market dynamics and incentives, schools will be held more accountable, . . . and school principals, presently entangled in bureaucratic rules and hog-tied by teacher unions, will be able to reward strong teachers and prune their schools of weak teachers.”). 127 friedman, supra note 124, at 132. 128 id. 129 rob reich, common schooling and educational choice as a response to pluralism, in school choice policies and outcomes 21–22 (walter feinberg and christopher lubienski ed., 2008) (“[t]he equality and efficiency arguments have a virtual monopoly on the attention of policymakers and pundits. . . . [i]t is my contention that the legitimacy of school choice is founded in liberty.”). 130 jeb bush, school choice is sweeping the nation from florida to utah, wall st. j. (feb. 3, 2023), https://www.wsj.com/articles/school-choice-is-sweeping-the-nation-from-florida-to-utah-je b-bush-education-learning-students-children-parents-11675435984 [perma.cc/9vdj-68y8]. 131 see levin, supra note 123; reich, supra note 129. (“permitting parents to select a school for their children is crucial to respecting the liberty interests of parents. . . . [l]iberal societies must protect some version of school choice because the normative significance of pluralism requires the state to respect the liberty interests of parents. . . .”). https://www.wsj.com/articles/school-choice-is-sweeping-the-nation-from-florida-to-utah-jeb-bush-education-learning-students-children-parents-11675435984 https://www.wsj.com/articles/school-choice-is-sweeping-the-nation-from-florida-to-utah-jeb-bush-education-learning-students-children-parents-11675435984 columbia journal of tax law [vol: 15:1 100 all of these goals are worthwhile; states should certainly pursue educational equity, competitive schools, and robust freedom of choice for their residents. importantly, states should pursue those goals for all of their residents, not just a select few. school choice may well be a great way to do that (again, this article is neutral with regard to whether school choice itself is good or bad). school choice by way of tax credits, however, will not achieve these goals. 2. why do tax credits fail to achieve the stated goals of school choice? this section describes some phenomena endemic to tax credits today: they inequitably distribute resources and are functionally unmonitored by states. neither is accidental; both are collateral effects of tax credits’ being used to circumvent the establishment clause and no-aid clauses. as explained below, these phenomena make tax credits a horrible tool for achieving the goals of school choice. a. inequitable distribution by their nature, tax credits end up funding private schools attended by wealthy students in wealthy areas. instead of serving their stated purposes, tax credits actually exacerbate educational inequity. they purport to throw a lifeline to students in struggling schools by either a) directly enabling them to leave a struggling public school, or b) improving that struggling public school by creating public-private competition. however, the real effects are quite different. tax credits end up being a tool for the wealthy to direct more funds to their schools of choice, leaving the public schools struggling. the following subsections provide further detail, but the main point is that tax credits are an unmonitored tool selectively assisting the wealthy with directing state money toward their preferred schools. it is a stark reality that tax credits do not equitably benefit all students who would like to attend private schools. their benefits are selectively concentrated on wealthier schools, not schools that have actual need for public aid. schools that receive money from tax credit donations are both attended by families wealthy enough to pay significant income tax and organized enough to encourage donations. on the student level, the fact that scholarship eligibility is not always based on income means that tax credit scholarships do not necessarily benefit the neediest students. assisting the upper-middle class with private school tuition is simply not what state tax law is for, and it does not even serve the goal of school choice— families who can afford private school already have a choice, and tax credits do not widen the choices of poorer families that they purport to benefit. at the school level, tax credits only benefit private schools both 1) attended by students from families wealthy enough to be motivated by tax credits and 2) organized enough to publicize, encourage, and obtain donations. tax credits are celebrated as benefitting individual students and families,132 but, in reality, they 132 charles j. russo, m.div., j.d., ed.d. & william e. thro, m.a., j.d., the demise of the blaine amendment and a triumph for religious freedom and school choice: espinoza v. montana department of revenue, 46 u. dayton l. rev. 131, 163 (2021) (“it is, then, essential to afford parents greater, potentially life-changing opportunities to have their children educated in the schools of their choice, presumably because their values are consistent with those modeled and taught in the 2023] the worst choice for school choice 101 benefit the private school attended by donors’ children by serving as an extra stream of revenue enabling decreased tuition costs. in many states, donations to tuition organizations do not go to a general fund to be used for all private school scholarships. instead, taxpayers donating to a scholarship organization designate which particular private school they want their donation to support. schools encourage current students’ families to donate, knowing those contributions will be earmarked for that school.133 in some states, donors can even designate the specific student to receive their donation.134 schools must have wealthy students to benefit from tax credits because, by definition, only people who make enough money to pay income taxes are incentivized by tax credits. to a family who pays income tax, a tax credit is a form of redirecting tax dollars–donating one dollar means a dollar comes off the tax bill, and the family breaks even. but a family that does not pay income taxes loses that donated dollar; since no income tax would have been paid either way, the donated dollar is of little benefit. thus, only families who pay income taxes have the economic incentive to make a donation that will be refunded at tax time.135 because a family’s income must exceed a certain threshold to owe income taxes,136 and the amount owed increases with earnings, poorer families have no reason to donate to scholarship organizations. even refundable tax credits—which reimburse filers with no state tax liability for the amount of their donation—put poor families in a worse position to participate. refundable tax credits still require parting from a sum of money for much of the year, because donors do not receive their refund until tax time the following year.137 not having access to an amount of money for some time may not be a problem for families with wealth beyond their needs, but, for others, it is likely prohibitive. when donors can designate a school, schools already attended by wealthier families will be the ones benefiting from tax credits. schools frame tax credits as additional giving, which is natural to encourage at a private school attended by the schools they select.”); isabel chou, "opportunity" for all?: how tax credit scholarships will fare in new jersey, 64 rutgers l. rev. 295, 300 (2011) (“for these parents, a voucher or scholarship would provide their children with an immediate opportunity to receive a better education at a private school.”). 133 covenant christian school, supra note 111. 134 this problem leads to some tax credits’ working like vouchers in practice. when donors can designate the student to benefit from their donation, for example, there is no difference between that student receiving a voucher and receiving an allocation of money that was donated in exchange for a tax credit. 135 see william g. gale, tax credits: social policy in bad disguise, brookings (february 16, 1999), https://www.brookings.edu/opinions/tax-credits-social-policy-in-bad-disguise/ [perma.cc/62 dh-eg92] (“unless the credits are refundable—that is, unless they actually give people cash back instead of just reducing tax liabilities—they will not help low-income households.”). 136 for example, to owe $5,000 (the maximum tax refund under georgia’s private school tax credit law) in georgia income tax, a family must make $91,000 a year. tax tables & georgia tax rate schedule, https://dor.georgia.gov/document/document/2022-tax-tablepdf/download [perma.cc/m42 a-yk3d]. 137 it is true that refundable tax credits can be designed to help low-income households. see andrew t. hayashi & justin j. hopkins, charitable tax deduction and civic engagement, 2023 u. ill. l. rev. 1179, 1179 (2023). as explained below, even though the tax credit system can be manipulated to avoid the problems of excluding low-income households, direct funding is a simpler and easier way to distribute school choice. columbia journal of tax law [vol: 15:1 102 wealthy. but at a private school serving a low-income population, which may charge only nominal tuition, fundraising is less likely to come from parents of attending students.138 in georgia, the leading scholarship organizations distribute scholarships on recommendation from their partner schools; scholarship seekers generally apply through the admissions department of the school they wish to attend, not through the scholarship organization.139 even though the funds are given to the school to be used as scholarships, the school retains a lot of power in recommending scholarship recipients, and the money received from scholarship organizations can replace parts of the budget that otherwise would have gone to financial aid. the money coming from the scholarship organization is meant to be used for scholarships, but because the money comes from a private organization, and because the school has so much control over how it is used, the money may go to fund tuition for students who could have paid on their own, which over time keeps tuition low and serves as an extra stream of revenue for the school. in many states, including georgia, there is no wealth-based eligibility requirement for a scholarship, so if donations to a school exceed student need, the school can allocate the excess funds among other students or reduce tuition generally. in that case, there is no reason to redistribute excess funds to students with need at other schools. in fact, it would be unwise to do so. the school is better off reducing its own tuition or otherwise taking advantage of the new revenue stream internally. since money is fungible, schools will naturally reduce tuition or otherwise improve the school when provided with another revenue stream.140 tax credits thus have the effect of driving down tuition costs at private schools already attended by the wealthy. the available data in georgia bears this out. the 138 according to the u.s. department of education, the percentage of parents who report participating in school fundraising is over twenty points higher for parents at or above the poverty threshold than it is for parents below it. the percentage of parents participating in school fundraising also increases with level of parent education. rachel hanson and chris pugliese, parent and family involvement in education: 2019 (nces 2020-076). u.s. department of education: national center for education statistics, parent and family involvement in education: 2019, a-5 (2020) https://nc es.ed.gov/pubs2020/2020076full.pdf [perma.cc/u332-lysw]. 139 georgia goal scholarship program inc [scholarship process] https://www.goalscholars hip.org/for_parents/page/scholarship-process [perma.cc/72d2-3m63]; apogee scholarship fund: how to apply for scholarships https://www.apogee123.org/info/scholarships [perma.c c/5x4j-qtvr]. this also means that if a school does not partner with an sso, it cannot receive scholarship money from the tax credit program. georgia’s seven largest ssos, which accounted for 89% of donations and 90% of scholarships from 2017–19, list over 500 partner schools on their websites. greg s. griffin & leslie mcguire, special report on qualified education expense credit and student scholarship program, ga. dep’t of audits and accounts performance audit div., 6 (2021), https://www.audits.ga.gov/reportsearch/download/25619 [p erma.cc/p584-9z25] (state auditors could not determine what “percentage of private schools in the state this represents, however, because gadoe does not maintain an accurate and complete list of all private schools operating in the state.”). 140 we recognize that the question of how much of a subsidy for the wealthy is present varies from state program to state program. some states, like georgia and arizona, have no means testing at all, and other have very diverse factors, some of which functionally limit the program to the middle class or lower. but it seems to us that all tuition tax credit programs exclude the poor who pay no taxes; these programs are not subsidies for the wealthy only, but the middle class as well. our point, however, is that it is the desperately poor, located frequently in public school districts that are very low quality, who need these programs the most and are least likely to gain from tuition tax credit. 2023] the worst choice for school choice 103 percentage of scholarships in georgia awarded to students in the lowest income quartile decreased, and the percentage going to students in the highest income quartile increased, from 2015 to 2018.141 fifty-eight percent of scholarships assisted students in families earning above the state’s median income.142 relatedly, tax credits incentivize private schools to admit and retain wealthy students. as discussed above, the wealthy are uniquely positioned to make donations in exchange for tax credits. private schools know that the wealthier their student population is, the more funding they can expect to receive from scholarship organizations. when private schools recruit students accordingly, economic stratification between schools will only worsen. wealthy families can leverage their status when applying, and private schools know admitting wealthy students is likely to lead to extra revenue from scholarship organizations. as the contribution limit increases, so will the incentive for private schools to admit rich applicants. private schools will segregate into those with wealthy students, who can fund a lot of tax credits, and those without, who will not receive any funding from scholarship organizations. effectively, the wealthy get reimbursed by the state for payments made to their private school of choice. private schools receiving extra revenue from scholarship organizations can keep tuition low, but students at poorer and middle class private schools must continue to pay rising tuition without reimbursements from the state. in short, tax credits make subsidies of private education available exclusively to the wealthy. of course, not every private school’s attendees are always in the same tax bracket—it could be possible that the ability to designate a school to receive a donation enables the richer families at a private school to benefit poorer families attending that same school. however, due to the “increasingly polarized pattern of school enrollment[,]” private schools are “increasingly segregated by income.”143 the reality is that private schools attended by affluent students are not typically the same private schools attended by middleor low-income students. furthermore, few schools that serve the impoverished also serve the wealthy. there are some private schools that focus on serving low-income students. the cristo rey network of high schools, for example, “delivers . . . education in the catholic tradition for students with limited economic resources.”144 it charges nominal tuition which “generally provides less than [ten] percent of the cost of 141 samantha sunne & donnell suggs, scholarship tax credit program: $600m with little oversight, the current (sep. 23, 2020, updated feb. 3, 2022), https://thecurrentga.org/2020/09/2 3/scholarship-tax-credit-program-600m-with-no-oversight/ [perma.cc/da43-jpce]. 142 id. 143 richard j. murnane, sean f. reardon, preeya p. mbekeani & anne lamb, who goes to private school? long-term enrollment trends by family income, education next, 18(4), 58 –66 (2018); see also richard j. murnane, sean f. reardon, long-term trends in private school enrollments by family income, aera open (2018) https://files.eric.ed.gov/fulltext/ej1194132.pdf [perma.cc/e r4k-swft] (comparing “high-priced private schools that children from affluent families attend and the lower-priced . . . private schools that students from lower-income families attend”). 144 mission and history, cristo rey network, https://www.cristoreynetwork.org/about/missionhistory [perma.cc/ldj3-l9xs]. see, e.g., why all girls, mother caroline academy and information center, https://www.mcaec.org/why-all-girls/ [perma.cc/hl7y-je7n]; admissions criteria mhs, https://www.mhskids.org/admissions/admissions-criteria/ [perma.cc/4s9u-9vv2] (milton hershey school applicants must come from low-income family). columbia journal of tax law [vol: 15:1 104 educating a student.”145 such a school, which does not receive significant tuition payments and is designed for students who would not otherwise have the choice to attend private school, seems an ideal candidate for public aid. but the average income of a family of four for a cristo rey student is $38,000,146 which in georgia, means owing no more than $2,012.50 in state income taxes,147 and less in fact. contributing anything more than that to a scholarship organization would be a loss, so cristo rey can expect, at best, sso contributions of around $2,000. a school with an average family income of $95,000, however, can expect more—a family with that income would owe $5,000 in state income taxes, so that school could expect a $5,000 donation—the law’s maximum—at no cost to the parents, and even a gain.148 in any event, as described below, many scholarships funded by tax credit donations are not awarded to students who actually need a scholarship to attend private school. just as this mechanism benefits wealthy families and schools, it also benefits schools with the resources and organization to encourage families to donate and designate the school. convincing parents to donate thousands of dollars to a student scholarship organization, even though they will receive those dollars back at tax time, takes a certain level of organization that typically only private schools 145 sarah stewart, work study program provides revenue to school experience to students, national association of independent schools https://www.nais.org/magazine/independent-s chool/summer-2016/work-study-program-provides-revenue-to-school-and/ [perma.cc/up5g-m7g b]. 146 frequently asked questions, cristo rey network, https://www.cristoreynetwork.org/about/ faqs [perma.cc/7f79-vgm3]. 147 tax rate schedule, ga. dep’t of just., https://dor.georgia.gov/tax-tables-georgia-tax-rate-sche dule [perma.cc/ypu4-hxh5]. 148 gains are possible if contributions for tax credits are also deductible as charitable contributions under § 501(c)(3) of the internal revenue code. in that case, taxpayers reduce their federal taxable income by the amount of the donation, despite losing zero dollars on the donation because they received the same amount back from the state. as of august 2019, per u.s. treasury regulation, individual contributions to charitable organizations for which the taxpayer receives a state tax credit are not deductible from federal taxable income. 26 c.f.r. § 1.170a-1(h)(3)(i); see also 47a c.j.s. internal revenue § 204 (“state tax credit as a ‘return benefit.’”). in some cases, individuals may still count their contribution as payment of state or local taxes. 26 c.f.r. § 1.170a-1(h)(3)(ix) (“safe harbor for individuals”). contributions by c corporations and some passthrough entities may also still be claimed as business expenses. 26 c.f.r. § 1.162-15(a)(3) (“safe harbors for c corporations and specified passthrough entities making payments in exchange for state or local tax credits.”). tuition organizations convey that contributions are not federally deductible as charitable contributions with varying clarity. see, e.g., donor frequently asked questions, ariz. private sch. org., https://apsto.org/individualdonorfaq [perma.cc/2jyt-ea7h] (advising donors to consult with a tax advisor for deductibility of their contributions); frequently asked questions, ariz. tax credit https://aztxcr.org/faqs/ [perma.cc/c8x9-wvt7] (“since we are a 501(c)(3) nonprofit, your donation may be eligible for a federal tax deduction. . . .”). gains would also be possible if states allowed tax credits to be claimed in amounts that exceeded a taxpayer’s state tax liability, which does not appear to be common. georgia, for example, does not allow the claiming of tax credits in excess of a taxpayer’s state income tax liability, but it does allow unused tax credits to be used against tax liability for five years following the donation. ga code § 48-7-29.16(e) (2022). 2023] the worst choice for school choice 105 with wealthy populations have.149 to receive funds from tax credit donations, a private school must partner with an sso and have donors designate the school with their contributions. both of those require resources. on private schools’ webpages encouraging donations to scholarship organizations, for example, there is usually a school administrator for donors to contact.150 at least one school provides information on an interest-free loan to cover the donation until the tax credit is paid.151 these schools clearly invest resources in communicating the availability of tax credits and encouraging donations. schools serving wealthier families have also been found to have more involved parents, which makes requesting donations easier.152 so not only are poorer private schools less likely to enroll students from families willing and able to donate, they are less likely to have the resources to communicate to parents that the donation opportunity even exists. because of the hoops that a school must jump through to garner funding from donations, the donations end up going to private schools with money to spend on fundraising outreach and the organizational base to manage contributions. often, schools with the organizational infrastructure necessary to benefit from tax credits are religious schools. parents at religious schools report more participation in school fundraising than parents at non-religious schools do, whether because of a shared purpose, strong community, or peer pressure.153 tax credits may have been intended to benefit all schools, but because the aid is based on the tax code, it is used disproportionately by schools with more centralized communities and more resources, which tend to be the schools that are not in need of public aid. in hindsight, these hoops look like an unfortunate complication that (perhaps accidentally) put wealthier schools in a better position to benefit from tax credits. the inequitable result may not have been intended, but the hoops definitely were. outsourcing the fundraising to schools and allowing private organizations to manage donations and award scholarships were fundamental to states’ acceptance of tax credit systems because they distanced the government from the aid. these complications were features of the tax credit system because they gave the impression that the tax credit scholarships were not state money—the funds were raised and managed by other parties, so they could not have been used to connect the government to religious schools. 149 according to the u.s. dep’t of educ., the percentage of parents who reported receiving communications from the school addressed to all parents increased with the level of parent education, and the percentage of parents who reported receiving such communications was over ten points higher for parents above the poverty threshold than for parents below it. rachel hanson & chris pugliese, parent and family involvement in education: 2019 (2020). 150 see, e.g., westminster, ga. private sch. tax credit program, https://www.westminster.net/supp ort-westminster/georgia-private-school-tax-credit-program [perma.cc/z7fk-2wds] (“director for annual giving”); learn more about alef fund, https://drive.google.com/file/d/1etoko39_un7r wdfbsuncaoed1muuygw4/view [perma.cc/hzg5-yevy]. 151 alumni donation info., the weber sch., https://www.weberschool.org/alumni/alumni-giving [perma.cc/j2dr-thun]. 152 patricia a. bauch & ellen b. goldring, parent involvement and school responsiveness: facilitating the home-school connection in schools of choice, 17 educ. evaluation and pol’y analysis 1, 1-21 (1995). 153 parents at religious schools report more participation in school fundraising. institute of education sciences, parent and family involvement in education: 2019 (2020). columbia journal of tax law [vol: 15:1 106 in a system like georgia’s, where parents can designate the school their contribution should benefit, whether a school receives funds through the tax credit program is not based on need—it is based on whether the school has wealthy enough parents to benefit from a tax credit and whether the school has spent enough resources on communicating and encouraging donations to the program. the georgia statute enacting the tax credit program does not mention anything about a donor designating a school to receive her donation (although it does provide that no school or scholarship organization may represent that the contribution will be directed toward any individual).154 this is another feature of tax credits that, far from being an accident, made them appeal to state governments. because private organizations manage the funds, the state can disclaim responsibility for donations being concentrated at wealthy schools. while the statute does not prohibit designating schools to receive donations, the practice is much more naturally attributable to the private organizations and schools themselves than the government. this is just another way that outsourcing the management of tax credit donations allows state governments to distance themselves from the enterprise and convey compliance with the establishment clause and state no-aid provisions. on the student level, donations for tax credits are not directed to students who need them to have school choice. eligibility for these scholarships often, and increasingly, does not depend at all on a student’s wealth, so many donation-funded scholarships benefit students whose families could have financed a private education without assistance.155 as a result, public funds end up paying for private school for students who might not actually need them to have school choice, and do not contribute to school choice for the impoverished and schools that serve the impoverished. in georgia, for example, students are eligible for a qualified education expense tax credit (“qeetc”) scholarship if they attended a public school for at least six weeks immediately before receiving the scholarship.156 once donations are made to scholarship organizations, “state law does not dictate how scholarships are distributed.”157 in 2017, 56.7% of scholarship recipients’ families were in the third or fourth percentile for income.158 one of georgia’s leading scholarship organizations awarded $10,932,789 in scholarships in 2019. 47% of that amount was awarded to families with incomes over 400% of the federal poverty line.159 154 ga. code ann. § 48-7-29.16 (west). 155 garnett, supra note 5, at 17. (“all, most, or many students are now eligible to participate in private-school-choice programs in several states, and several more states seem poised to join this expansive parental-choice roster.”); the editorial board, the rising demand for sch. choice, wall st. j. (july 30, 2023), https://www.wsj.com/articles/the-rising-demand-for-school-choice-ari zona-florida-implementation-esa-1c47ce5f [perma.cc/e39g-ppcd] (detailing rise in participation in indiana’s school choice program after vouchers became “nearly universal” in part because of a raised income cap). 156 qualified education expense tax credit, ed choice https://www.edchoice.org/school-choice/p rograms/georgia-qualified-education-expense-tax-credit/#student_eligibility [perma.cc/9mca-vx yw]. 157 griffin & mcguire, supra note 139. 158 clair suggs, shifting public funds to private schools: high costs, poor track record, ga. budget & pol’y inst. (april 26, 2018), https://gbpi.org/shifting-public-funds-to-private-schoolshigh-costs-poor-track-record/ [perma.cc/bmx7-sdgf]. 159 griffin & mcguire, supra note 139. 2023] the worst choice for school choice 107 16% of it went to families with incomes lower than 125% of the federal poverty line.160 one georgia scholarship organization’s website seems to indicate that participation in the tax credit program means both donating and applying for a scholarship.161 these facts show that scholarships funded by donations for tax credits are not directed toward families who actually need them to have a choice in school attendance. rather, all these statistics show that donating to a scholarship organization is understood to come with financial benefit to the donor. some states provide more direction to scholarship organizations regarding eligibility for scholarships. eligibility for pennsylvania’s opportunity scholarship, for example, is based on whether a student lives within the attendance boundary of a failing public school.162 the florida tax credit scholarship program used to be available only to students receiving other state benefits, who have a household income level that does not exceed 375% of the federal poverty level, or who are in foster care.163 however, beginning in july 2023, any florida resident “eligible to enroll in kindergarten through grade 12 in a public school in [florida]” is eligible, though “priority must be given” to students at certain low income levels or who are in foster care.164 where tax credit programs do not have income-based eligibility requirements, the impact is easily seen. arizona, for instance, has two such programs. one leading scholarship organization there awarded 75.05% of its total scholarships for one of these programs to students whose household income exceeded 342.25% of the poverty level in fiscal year 2020–21.165 to be sure, the fact that scholarships go to wealthy students can be easily attributable to schools and scholarship organizations instead of to the state. in arizona, scholarship organizations encourage families seeking scholarships to create a website encouraging donations to their specific children.166 yet, importantly, schools with the organizational wherewithal to advise students of this opportunity, as well as students with familial help and technological access, are in an advantaged position to benefit. because any parents who pay state taxes gladly take advantage of this program to benefit the school their own children attend, 160 id. 161 gasso scholarship process details, ga. student scholarship org., https://www.georgiass o.com/donors [perma.cc/fb4m-msvn] (“step 3: . . . donate on the [sso’s] website step 4: . . . complete scholarship application on [sso’s] website”). 162 24 pa. stat. ann. § 20-2009-b (west); overview of the opportunity scholarship tax credit program, pa. dep’t of educ., https://www.education.pa.gov/k-12/opportunity%20scholarship% 20tax%20credit%20program/pages/overview-of-the-opportunity-scholarship-tax-credit-progr am.aspx [perma.cc/2vdn-lef9] (“a low-achieving school is defined as a public elementary or secondary school in pennsylvania that ranks in the bottom 15 percent of its designation as an elementary or secondary school based on combined . . . scores on the most recent annual assessment . . . .”). 163 fla. stat. ann. § 1002.395 (amended 2023) (west). 164 id. at § 1002.395(3)(2). 165 financial reports, ariz. private sch. tuition org., https://apsto.org/financialreport [perma .cc/4v9l-z8au]. 166 how it works, ariz. tuition org., https://www.azto.org/applicants/how-it-works [perma.cc/6 n6t-bxhk]. arizona also implemented universal vouchers in 2023, separate from its tax credit programs. see sarah mervosh, $7,200 for every student: arizona’s ultimate experiment in school choice, n.y. times (july 24, 2023), https://www.nytimes.com/2023/07/24/us/arizona-private-scho ol-vouchers.html [perma.cc/39dh-85tf]. columbia journal of tax law [vol: 15:1 108 schools with wealthy parents gain from this program the most, increasing governmental revenue to their schools and thus reducing tuition in the long run.167 again, this is a feature, not a bug; it is a result of the thought-necessary separation between religious schools and state governments that tax credits provide. the more the onus is on the family and the school to reach out for donations, the less it appears connected to the state. many states have provisions that aim to prevent donors from directing their contribution toward their own children.168 these provisions are meant to preclude “quid pro quos” under which donors could fund their own child’s education with donations that will be refunded in tax credits.169 donations to student scholarship organizations cannot substitute for a family’s tuition payments, for instance.170 however, while on paper a contribution does not fund the donor’s child’s tuition, such donations are still an extra revenue source for the school that will abate tuition costs. parents who pay income taxes can contribute to that revenue source for free (or better). the tax credit donations may not be formal quid pro quos, but they give 167 we are aware of the fact that scholarship granting organizations—which collect the donations that generate the tuition tax credits—typically cannot be captured by only one school, but we are not persuaded that this is at all important. no matter how many schools are under one umbrella, we think it is exceedingly likely that the scholarship granting organizations all honor the requests of parents as to which school should receive their donation, thus ensuring that tuition tax credits go to specific schools that parents direct. solving this issue (if it is a problem) would be easy to do, but we suspect that tuition tax credits would lose their attractiveness in fact if there was no quid-proquo to the parents’ children’s school at all. every parent knows that all money that goes to their children’s school reduces their burden. see generally garnett, supra note 5. 168 in georgia, donors may not designate their contribution “for the direct benefit of any particular individual,” and a student scholarship organization may not represent or direct a school to represent that the taxpayer will receive a scholarship for the direct benefit of any particular individual. ga. code ann. § 48-7-29.16 (west). “this prohibition is designed to prevent a guardian from using the tax credit as a tax avoidance mechanism while ensuring a scholarship for a dependent.” griffin & mcguire, supra note 139, at 25. scholarship organizations are not required to report to the state whether donors designate funds to particular students. garnett, supra note 5, at 3. in arizona, donors to school tuition organizations may not designate the donation for their own dependent, designate a student beneficiary as a condition of their donation, or “agree with another person to designate each other’s contribution to the school tuition organization for the direct benefit of each other’s dependent, a practice commonly known as swapping.” ariz. dep’t of revenue, school tax credits, 4 (2022) https://azdor.gov/sites/default/files/2023-03/publicatio n_707.pdf [perma.cc/p4vt-2fw2]. in florida, “[t]he taxpayer making the contribution may not designate a specific child as the beneficiary of the contribution.” fla. stat. ann. § 1002.395 (2)(f) (west). 169 if parents could fund their own child’s tuition through their contribution to a scholarship organization, which would be reimbursed to those parents by the state, it would function just as a voucher does. instead of the government giving money to the family to spend on the child’s education, the parent gives money to the scholarship organization that will fund the child’s tuition, then the parent is reimbursed for that money by the state in the form of a tax credit. arizona’s system, by making quid pro quo or donations for one’s own child illegal, seeks to prevent this from happening but does a poor job at enforcement. a much simpler solution, that we propose below, is to simply allow vouchers, making the private middleman unnecessary. we see no good reason why arizona would want to support a tax credit system for school choice while not allowing vouchers. arizona is moving in this direction; as of july 2023, the state has introduced universal vouchers through a program separate from its tax credits. mervosh, supra note 166. 170 see ga. code ann. § 48-7-29.16 (west). 2023] the worst choice for school choice 109 the impression to parents that they are an avenue to support the school with public money.171 in short, critics were not wrong that there is a way to distribute government money to families to enable school choice, even if it is not as straightforward as funding a public school. but when states felt a need to separate themselves from funding religious education, they inevitably separated themselves from regulating how state aid was directed to private schools. that separation exacerbated the lack of “administrative machinery” that milton friedman recognized.172 and it just so happens that the avenue chosen by states to fund private schools—while keeping their distance—was tax credits. that choice ends up disserving the original purpose. friedman’s theory relied on everyone having choice, but this is facilitated most easily by vouchers, not by tax credits. tax credits are easily used by the rich and much more difficult for the poor to take advantage of. the economic reasons for choice favor vouchers, accessible equally by all, over tax credits. even when tax credit scholarships are awarded to needy students, they do not cover the full cost of private school tuition.173 when the scholarship still leaves some cost for attending private school, families with money to cover that cost may eagerly use it to switch out of a struggling public school. that cost may be prohibitive to others.174 this is another way that tax credits focus their benefits on the middle class and the rich but are of no use to the truly poor. tax credit scholarships are limited in value both because they depend on private fundraising and because the amount that can be donated is usually capped. by contrast, vouchers have neither of those limitations and are usually awarded in larger amounts than tax credit scholarships.175 b. fraud concerns suffice to say, tax credit systems do not always work the way they are intended to on paper. another major issue concerns their unique vulnerability to fraud. despite attempts to monitor scholarship organizations and private schools, 171 see, e.g., georgia goal, mount pisgah christian school, https://www.mountpisgahschool .org/giving/georgia-goal [perma.cc/6cr3-xk4t] (encouraging tax credit contributions that “make it possible for [the school] to . . . provide additional programs and participation in the arts and athletics by increased enrollment [and] have greater financial flexibility in funding and supporting other [school] programs and opportunities”); alumni giving, the weber school, https://www.we berschool.org/alumni/alumni-giving [perma.cc/flp7-xcna] (“supporting [the school] through [tax credits] is just like donating money . . . and it won’t cost you anything.”); covenant christian school, supra note 111; georgia private school tax credit program, the westminster schools, https://www.westminster.net/support-westminster/georgia-private-school-tax-credit-pro gram [perma.cc/q5p3-fs8h] (“[t]he georgia private school tax credit program, combined with support from [our school’s] endowed funds and annual [school] fund, plays a critical role in the school’s overall financial aid program. participation in this program makes a real impact on the school’s ability to enroll bright, motivated, and curious students regardless of their family’s ability to pay full tuition.”). 172 friedman, supra note 124, at 132. 173 garnett, supra note 5, at 6. 174 id. at 7 (“[a]bsent financial assistance, the scholarships provided through private-school-choice programs place many private schools well out of the reach of many scholarship recipients.”). 175 id. at 6. about:blank columbia journal of tax law [vol: 15:1 110 the features of the system interfere with any real ability to ensure funds are being spent as intended. for example, georgia lacks adequate controls to prevent taxpayers from claiming credits in excess of their tax liability, which could lead to some taxpayers actually turning a profit through the tax credit system.176 georgia law also does not require scholarship organizations to report some important information, including whether only eligible students receive funds and assurances that donors do not designate their funds to a particular student.177 even when state law does require disclosures, the information is minimally helpful. georgia requires independent compliance audits from scholarship organizations, but the reports vary greatly and lack detail.178 with weak oversight comes weak enforcement. georgia, for instance, does not always verify that reports submitted by scholarship organizations meet legal requirements. when the state does verify the reports, punishment for noncompliance is simply being removed from the list of active scholarship organizations.179 compare that to other types of fraud with government money, like medicaid fraud. georgia has an office that “rigorously reviews, investigates, and audits medicaid providers and recipients to uncover criminal conduct, administrative wrongdoing, poor management practices, and other waste, fraud, and abuse.”180 there is no analogous office for scholarship organizations. as scholarship organizations do not technically handle government money—as they receive donations from private parties who later claim tax credits—the typically robust protections that accompany government benefit programs are absent. courts have held that tax credit systems like this are not government spending. some state courts, including georgia’s, have upheld tax credits while acknowledging that direct payments would be unconstitutional under the same circumstances.181 these decisions made hay of the formal distinction between tax benefits and appropriations.182 both forms of aid are means to the end of financing 176 see griffin & mcguire, supra note 139, at 11. state law limits what taxpayers can claim based on their tax liability, but “controls are not present to prevent [satisfaction of claims in excess of tax liability].” 177 see id. at 19 (“ssos have several requirements directly related to scholarship management practices that are not required to be reported to the state. . . . [l]ittle information is coming to the state regarding whether the ssos are actually complying with these scholarship management requires under other code sections.”). 178 see id. at 15–16 (“using data from the compliance audits, we attempted to compile a complete record of administrative expenses and revenues by sso; however, it was not possible because of a lack of consistency and detail in the reports. . . . while we could have run a calculation, it is not clear that all ssos were categorizing funds similarly because the statute does not define the terms.”) 179 see id. at 2 (“we also found that dor did not ensure that compliance audits verified and reported on all relevant requirements. finally, noncompliant ssos were not always removed from gadoe’s list of active participants in a timely manner.”). 180 office of inspector general, georgia department of community health, https://dch.georgi a.gov/office-inspector-general [perma.cc/z2s8-rnlu]. 181 see generally gaddy v. ga. dep’t of revenue, 802 s.e.2d 225 (2017); kotterman v. killian, 972 p.2d 606 (1999); mccall v. scott, 199 so. 3d 359 (fla. dist. ct. app. 2016). 182 to others, that same distinction is “one in search of a difference.” ariz. christian sch. tuition org. v. winn, 563 u.s. 125, 157 (2011) (kagan, j., dissenting) (“[t]argeted tax breaks are often ‘economically and functionally indistinguishable from a direct monetary subsidy.’ . . . [h]ere too 2023] the worst choice for school choice 111 an organization. decisions denying taxpayer standing, however, “enable[] the government to end-run” the rule that taxpayers can challenge government spending in support of religion.183 as another example, arizona prohibits donors from designating their own children as scholarship recipients, but it also prohibits donors from agreeing with another donor that they will each designate each other’s child, a practice known as “swapping.”184 nonetheless, there is widespread evidence that the practice persists, which is unsurprising since it is enforced essentially by the honor system.185 arizona scholarship organizations include language about the impermissibility of swapping on their websites,186 but no strong enforcement mechanism exists because the whole system is privatized. again, this lack of regulation is a feature of tax credits once thought necessary for compliance with the establishment clause or state no-aid provisions. to keep tax credits compliant with those laws, it was necessary that they were not considered government money. the responsibility to ensure compliance with rules, like the one against swapping, falls on private organizations, therefore, and not the government. form prevails over substance, and differences that make no difference determine access to the judiciary.”); to them, tax credits are constitutionally no different from government funding. kotterman v. killian, 193 ariz. 273, 309 (1999) (feldman, j., dissenting) (“[a tax credit] is a direct government subsidy limited to supporting the very causes the state’s constitution forbids the government to support.”); stanley s. surrey, tax incentives as a device for implementing government policy: a comparison with direct government expenditures, 83 harv. l. rev. 705, 717 (1970) (“a dollar is a dollar—both for the person who receives it and the government that pays it, whether the dollar comes with a tax credit label or a direct expenditure label.”); opinion of the justs. to the senate, 401 mass. 1201, 1203–04 (1987) (“the fact that the expenditure here takes the form of a tax deduction rather than a direct payment out of the commonwealth's treasury does not alter the result, for it has been recognized that the tax subsidies or tax expenditures of this sort are the practical equivalent of direct government grants.”). under that view, decisions upholding tax credits as not implicating no-aid provisions and the establishment clause would have been wrong all along. the correctness of that view is immaterial to this article. regardless of the merits of constitutional decisions on tax credits, they are inefficient and rife with fraud. these citations serve only to illustrate objections to one of the historical legal reasons that tax credits became so popular— objections to the idea that tax credits were somehow legal where direct funding was not. these objections are moot after espinoza and carson, which hold that states may, and sometimes must, subsidize religious schools regardless of the form that subsidy takes. our point is not that these objections were right or wrong, but that tax credits are a poor policy choice, and now that direct funding is clearly permissible, it should replace old tax credit systems. 183 ariz. christian sch. tuition org. v. winn, 563 u.s. at 148 (2011) (kagan, j., dissenting.). 184 donation restriction, arizona tuition organization, https://www.azto.org/contributors/don ation-restrictions [perma.cc/ev6s-tfw6]. 185 michelle reese, private school tax credits rife with abuse, east valley tribune (dec. 12, 2017), https://www.eastvalleytribune.com/news/private-school-tax-credits-rife-with-abuse/article_ 7debd2e5-d000-5aed-b813-a0d252377755.html [perma.cc/cl7m-4prk]. 186 see donation restriction, supra note 184 (“arizona tuition organization (azto) does not condone, endorse, or accept the practice of swapping donations.”); donor faq, arizona private school tuition organization, https://apsto.org/individualdonorfaq [perma.cc/4xk3-ymkw] (“unfortunately, a donor cannot claim a tax credit if the donation benefits their own dependent or they ‘swap’ donations with other parents.”). columbia journal of tax law [vol: 15:1 112 3. these concerns show that tax credits are a poor instrument, regardless of a state’s reason for implementing school choice. the flaws outlined above make tuition tax credits a poor mechanism for achieving the goals of school choice: equity, pure economic growth, and individual choice. below, we explore the reasons for this in greater detail. a. equity this is most obvious when it comes to the goal of equity. as explained above, schools that have wealthier students and that are more organized are in a better position to take advantage of tuition tax credits, within the letter of the law or otherwise.187 whether fraud outright violates a statute or exists as an undetectable wink-and-nod that tuition will stay low if parents donate, it is not an equitable way to distribute resources. either way, schools with wealthy populations and organizational chops can count on a separate stream of revenue coming from the state, whereas schools serving the poor cannot. this outcome is exactly the opposite of the equity sought by school choice proponents. instead of the public aid being directed to the private schools that need it the most, funds are disproportionately directed to the schools and students with more wealth than most. if tax credits in their current form are the only option, the goal of equity would actually be better served by having no aid to private schools at all. with no aid, resources intended for needy schools would at least not be redirected toward wealthy ones. b. pure economic growth and freedom of choice even if a state funds school choice on a purely economic theory, without any desire to equitably distribute resources, tax credits remain an inferior option to direct funding. for the reasons set out above, tax credits will only be available to some of the population. if a state believes that choice will foster healthy competition among schools and allow the best to rise to the top, that interest should be heightened for low-performing schools. using tax credits instead of direct funding ensures that desired effects are had only on schools that 1) serve families wealthy enough to pay income tax and 2) are organized enough to take advantage of tax credits. economic competition already exists in the schools where families pay sizeable tuition; those families had school choice regardless of government funding, and they exercised it by choosing a certain private school. to truly foster competition among schools, school choice must create a choice where there was not one before. when it comes to pressuring public schools to improve, this means giving a meaningful choice to students who previously only 187 recent reports note that yeshiva schools have other sources of public funding. see brian m. rosenthal, how hasidic schools reaped a windfall of special education funding, n.y. times (dec. 30, 2022), https://www.nytimes.com/2022/12/29/nyregion/hasidic-orthodox-jewish-special-e ducation.html [perma.cc/k2js-653r]; eliza shapiro & brian m. rosenthal, in hasidic enclaves, failing private schools flush with public money, n.y. times (sept. 12, 2022), https://www.nytim es.com/2022/09/11/nyregion/hasidic-yeshivas-schools-new-york.html [perma.cc/gxq6-j44a]; brian m. rosenthal & eliza shapiro, hasidic school to pay $8 million after admitting to widespread fraud, n.y. times (oct. 12, 2022), https://www.nytimes.com/2022/10/24/nyregion/ha sidic-yeshiva-fraud-central-united-talmudical-academy.html [perma.cc/q9e6-jbhx]. legal or otherwise, it takes institutional infrastructure to benefit from public funds. 2023] the worst choice for school choice 113 had the option of public school. healthy economic competition is also still needed among struggling low-income private schools, which are not well set up to benefit from tax credits. if a state wants those schools to improve by competing for government money, it should concentrate that money on low-performing schools that both need to improve and need the money. tax credits do the opposite. this is also the reason that tax credits do not serve the goal of individual freedom of choice—they only actually create choice for people within a certain tier of wealth. consider georgia’s or arizona’s system, for instance, in which donors can direct their donations to a school that their children already attend. the donor taking advantage of the tax credit already attends that school and pays tuition. the donation through the tax credit does not necessitate that someone from a lowperforming private school will transfer into the school that received the donation. the school that received the donation might direct those funds toward financial aid for existing students. a poor private school may provide a high-quality education, but because of the families it serves, it does not stand to benefit from tax credits. in short, the purely economic theory is not served by tax credits because its effects are focused on one specific area, which already enjoys a healthy level of competition. another reason that tax credits do not foster economic competition is the very problem that milton friedman anticipated: a lack of regulation and states’ inability to ensure that schools actually spend designated funds the way they are allowed to. the administrative issues outlined above are a direct result of states’ beliefs that they were not permitted to fund religious education. they also show how instead of addressing the concern that states would not be able to regulate money allocated to private parties for education, they exacerbate it. c. inefficiency the tax credit structure also means that some donated money will go to a scholarship organization’s operating costs instead of to actual scholarships. as the number of scholarship organizations increases, so does the amount of money lost to overhead.188 in georgia, for example, scholarship organizations must use at least 92% of donated money for scholarships.189 without a tax credit system, there would be no need to sacrifice the remaining eight percent to a scholarship organization; if everyone paid their full tax liability and the state assisted private schools directly, it could use one hundred percent of the amount that would have been donated for that purpose. taking out the private third party would mean more money would be available for the government to support the private schools that need it. moreover, a 2021 georgia audit found that it was impossible to determine whether the rate that scholarship organizations retain was reasonable because of insufficient data on scholarship organizations’ revenue and expenses.190 this finding reveals a much larger inefficiency of tax credit programs: they require extensive monitoring but remain vulnerable to waste and fraud. administration of direct funding will cost a state something as well. if a state administers the program, however, the required monitoring will be much more 188 garnett, supra note 5, at 14 (“the proliferation of sgos competing for taxpayer donations dilutes the impact of scholarship tax-credit programs.”). 189 ga. code ann. § 20-2a-1 (west); ga. code ann. § 20-2a-2 (west). 190 see griffin & mcguire, supra note 139, at 15. columbia journal of tax law [vol: 15:1 114 achievable, and it should be the state’s, not a private entity’s role, to administer social benefits.191 all of these issues are reasons that tax credits for private education are just not worth their cost. for every dollar the state gives up in tax revenue, it should see a dollar of improvement in education, and it should be progressive in its aid— schools that serve the poor should get more, or at least the same, aid. in theory, school choice should reduce the number of students attending failing public schools, allowing those public schools to spend more per student and improve, while also supporting students attending private schools. the results, however, show that that is not the reality. “[s]tudents in public schools that have more school choice do not perform noticeably better than students in public schools without school choice,”192 and school choice does not reliably improve educational outcomes for students who choose private school.193 tax credit systems also result in public funding of private schools that are not subject to the same regulations as public schools. the government regulates public schools for a reason, but tax credits use public money to fund schools that are not required to publish data on finances, attendance, curriculum, or test scores.194 naturally, it is difficult to determine whether students who choose private school under school choice programs fare better than they would have at public school.195 even if choice does improve long-term educational outcomes for students who choose private school,196 the fact remains that the privilege of choice is not equally distributed. recipients of tax credit scholarships are often students who do not need scholarships to attend private school, and poorer, tuition-funded private 191 interestingly, one of the most successful tax credit programs thrives in part because it operates though only one scholarship organization. florida’s “step up for students” is the only scholarship organization involved in one of florida’s tuition tax credit programs. according to a manhattan institute report, the scholarship organization “operates much like a privately operated statewide voucher program. it provides a single point of contact for schools as well as students interested in taking advantage of school choice in florida and guarantees that scholarships follow children when they transfer from one school to another.” garnett, supra note 5, at 14. this supports the move from tax credits to vouchers—this tax credit system is successful not because it is a tax credit, but because it operates like a statewide voucher. 192 pinto & walker, supra note 91, at 85. 193 paul teske & mark schneider, what research can tell policymakers about school choice, 20(4) journal of policy analysis and management 609, 619 (2001) (cataloging studies and concluding that “choice programs demonstrate modest to moderate test score improvements for some, but not all, students who participate”). 194 u.s. gov’t accountability off., supra note 99; see also stephen j. owens, opinion: vouchers prop up private schools with public money, atlanta j.-const. (dec. 21, 2022), https://www.ajc.com/ education/get-schooled-blog/opinion-vouchers-prop-up-private-schools-with-public-money/jbhm ua4sprhmdcfcs2oaztb3k4/ [perma.cc/l2bc-qmdl] (“[p]rivate schools are not held to federal protections for services provided for students with disabilities or those learning english.”). 195 teske & schneider, supra note 193. 196 patrick j. wolf et al., do voucher students attain higher levels of education? 20 (annenburg inst. at brown univ. ed working paper no. 19-115, 2019), http://www.edworkingpapers.com/ai19115 [perma.cc/nw77-qrqc] (“our findings contribute to a growing body of evaluation results indicating that private school voucher programs positively affect student educational attainment.”); matthew m. chingos & daniel kuehn, the effects of statewide private school choice on college enrollment and graduation (urban inst. 2017), https://www.urban.org/sites/default/ files/publication/93471/2017_12_05_the_effects_of_statewide_private_school_choice_on_college _enrollment_and_graduation_finalized_2.pdf [perma.cc/tp2b-g3x9]. 2023] the worst choice for school choice 115 schools do not have the attendees or the resources that lead to them receiving donations. inevitably, some students will remain at public schools, which will become more stratified as a result of school choice.197 for programs that provide such little benefit to educational systems for the poor, states sacrifice immense tax revenue and leave open opportunities to abuse the system. tax credit programs thus frequently exacerbate the problems they were intended to repair, leading to more private funding for already wealthy private schools and leaving low-cost private schools and public schools to founder. it is unsurprising that tax credit programs are not massively successful— their goal was to increase school choice, but when they were initially developed, legislators believed it was unlawful for state money to support religious schools. naturally, the roundabout system that resulted was inefficient. had the law been what it is now—not imposing any barrier between public money and religious schools—tax credit programs probably would not have been legislators’ first choice to strengthen education. regardless of whether the circumvention of understood laws was initially proper, we now have the opportunity to repair the inefficiencies of tax credit programs and effectively improve education for all–public or private, religious or secular, wealthy or poor. because the establishment clause jurisprudence is now clear, instead of clinging to the vestigial approach that has failed to prove itself, states should pursue their goals of school choice through direct funding. iv. solutions states that wish to fund private schools should therefore discard their tax credit systems in favor of direct funding that is more likely to improve education for those who need it. the most important change that a state should make with direct funding is to ensure that whatever aid it provides to private schools should benefit students in need, instead of subsidizing tuition payments that otherwise could have been paid privately. because the benefits of tax breaks are more appealing to higher earners who owe more in taxes, subsidies should avoid the tax code entirely.198 the state should aid all students, not just the children of high earners. merely disallowing scholarship organization donors from indicating the school or student to receive the donation would not solve this problem, however. florida’s tax credit scholarship program does just this already—donors may not indicate a certain student or school to receive their donation, and the private organization managing the donations may not represent that the funds will be directed to a particular student or school.199 this change might be expected to 197 kristie j.r. phillips et al., school choice & social stratification: how intra-district transfers shift the racial/ethnic and economic composition of schools, 51 social science research 30 (2014); julia a. mcwilliams, the neighborhood school stigma: school choice, stratification, and shame, 15 policy futures in education 221 (2017). 198 coverdell education savings accounts, for example, allow investments to grow tax-free and be spent tax-free on educational expenses. but only families with money to invest stand to benefit from them. internal revenue serv., u.s. dep’t of the treasury, pub. no. 970 tax benefits for education (2022), https://www.irs.gov/publications/p970#idm140550552112176 [perma.cc/8j2 m-wfxb]. 199 fla. stat. ann. § 1002.395 (west 2023). columbia journal of tax law [vol: 15:1 116 destroy any incentive to donate, but florida’s system is still robust; its tax credit scholarship program awarded $568 million in scholarships for the 2021–22 school year.200 however, it still suffers from a lack of regulation. this is because—even despite requiring (at least until july 2023201) that only certain children qualify for tax credit-funded scholarships202—it was not the government in charge of ensuring that only qualified students receive scholarships, but the private organizations that receive donations.203 the private organizations are also in charge of ensuring that the private schools submit proper financial records regarding their use of the funds.204 like in other states, outsourcing the regulation of the tax credit system to private groups creates a gap in oversight that, at worst, invites abuse. if a state truly wants to ensure that public funds are directed to students who need them to attend private school, it should dispose of the intermediary layer of the private organization receiving donations.205 even putting aside the possibility of abuse, florida has no reason to redirect money that would otherwise be state tax revenue toward private schools. nothing requires this extra complication. florida can now just allocate some of its state tax revenue to support private schools, making budgeting simpler and more regular, and it would give more predictability to their state aid. interestingly, florida operates another scholarship program that does this. florida’s family empowerment scholarship for educational options, enacted in 2019, provides vouchers that can be used at private schools, but its funds come directly from the state’s budget, instead of from donations in exchange for tax credits.206 florida expanded eligibility for this program in 2023, making these vouchers available to all florida students regardless of their families’ income.207 while the family empowerment scholarship funds are still managed by private organizations,208 the law directs those organizations to prioritize students with 200 florida tax credit scholarship program, fla. dept. of educ., off. of indep. educ. & parental choice (2022), https://www.fldoe.org/core/fileparse.php/5606/urlt/ftc-oct-2022-line. pdf [perma.cc/z86u-h3ut]. 201 fla. stat. ann. § 1002.395 (west) (amended 2023). effective july 1, 2023, there are no incomebased eligibility requirements for florida’s family empowerment scholarship program. the law directs the private organizations distributing scholarships to give priority to students with lowincome levels or who are in foster care. 2023 fla. sess. law serv. ch. 2023-16 (west). 202 ariz. private sch. tuition org., supra note 165; fla. stat. ann. § 1002.395 (west). only children who qualify for other government benefits, who are in foster care, or whose household income does not exceed 400 percent of the federal poverty level qualify for tax-credit funded scholarships. 203 fla. dept. of educ., off. of indep. educ. & parental choice, supra note 200, at 2. 204 fla. stat. ann. § 1002.421 (west 2023). 205 garnett, supra note 5, at 14 (noting that scholarship organizations are accompanied by a “risk that elite schools with ties to wealthier, more sophisticated, donors may capture a share of the available tax benefits that is disproportionate to the number of participants whom they serve.”). 206 “[family empowerment scholarships] are government-funded and the payments come from the state of florida to the scholarship funding organization . . . [florida tax credit] scholarships are privately funded. the funding for a student receiving [a florida tax credit] scholarship comes from donations to the scholarship organization that serves their household.” frequently asked questions about the family empowerment scholarship for educational options (“fes-eo”) program, aaa scholarship foundation, https://www.aaascholarships.org/wp-content/uploads/2022/03/aaafes-eo-faq-2021-22-rev20220302.pdf [perma.cc/5jwk-z3vd]. 207 2023 fla. sess. law serv. ch. 2023-16 (west). 208 fla. stat. ann. § 1002.394 (west 2023). 2023] the worst choice for school choice 117 lower family incomes or who are in foster care.209 yes, given that it is managed by private organizations, florida’s voucher program may suffer from lack of oversight just like tax credits do. however, the voucher program is preferable over the tax credit nonetheless—the funding is at least acknowledged as coming from the state budget. tax credit systems, on the other hand, claim to be privately funded when they are in fact state expenditures. most importantly, the florida voucher program is preferable over a tax credit system like georgia’s, where scholarships disproportionately benefit the rich because donors can direct their donations to specific schools. florida’s system at least makes funds available to all students; both tax credit scholarships and direct vouchers are to be distributed by the scholarship-funding organizations to any eligible student.210 this portability is very important to avoiding the concentration of public funds on well-resourced schools.211 still, the florida system could of course go further by increasing oversight by minimizing the role of private scholarship-funding organizations and actually having the state administer scholarships. it could also require directing funds toward students who actually need them to choose private school as opposed to making them uniformly available.212 but at the very least, it is preferable over a system that concentrates funds on already wealthy private schools. arizona has also taken a large step away from convoluted tax credits and toward direct funding. it recently enacted a voucher program that makes all students eligible for a voucher in the amount of around $7,200 deposited in an education savings account (“esa”). that money can be used for private school tuition or homeschooling. the good news about arizona’s program is that the money can be used at a school chosen by the student and her family, not by a donor looking to shore up a specific private school’s revenue with state money. the room for improvement lies in execution and administration: voucher recipients “tend to be relatively well-off,”213 which may be due to inadequate publicity of the vouchers or administrative hurdles to claiming them. even when funding has nothing to do with a tax credit, the more administrative hurdles that a family faces in using it, the more likely it is to disproportionately benefit wealthier children with educated parents who have the time and energy to navigate the process.214 the vouchers are also available to students who are already attending private school.215 since there is no economic eligibility requirement, these vouchers are likely assisting students who could have attended private school without them. the government is effectively covering part of private school tuition for anyone, even those who never 209 2023 fla. sess. law serv. ch. 2023-16 (west). 210 id. 211 see garnett, supra note 5, at 14. 212 florida seems to be moving in the opposite direction with regard to need-based eligibility. in 2023, it changed its statutes from mandatory income-based eligibility to directing scholarshipfunding organizations to prioritize low-income applicants. 2023 fla. sess. law serv. ch. 2023-16 (west). 213 mervosh, supra note 166. 214 garnett, supra note 5, at 16 (“while esa programs provide maximum flexibility, even welleducated parents may find the record-keeping required as a condition of participation frustrating. parents with less formal education may find it nearly impossible.”). 215 mervosh, supra note 166. columbia journal of tax law [vol: 15:1 118 thought of attending public school. to school choice supporters focused exclusively on equity, this is a weakness of arizona’s program—the money would be better spent on giving more help to poor students, so the voucher could actually cover the cost of tuition. it is not a problem, however, for the goals of school choice focused purely on economics or individual choice. an ideal system could identify private schools in need of money and fund them more, consistent with the general goals of a progressive tax code: focusing on those serving low-income populations, charging minimal tuition, and relying on donations to operate. whether aid comes directly from the state or from donations incentivized by tax credits, the responsibility for identifying qualified schools should fall on the state, not private organizations that partner with schools. deference to private organizations only results in wealthier schools benefiting the most from scholarships. if a private scholarship organization has the choice between partnering with a wealthy private school and a poor one, it will choose the wealthy school that has the resources and organization to generate donations.216 states should also minimize the hoops schools must jump through to receive aid. the more hoops there are, the more aid is disproportionately directed to schools with organizational resources, as opposed to schools actually in need.217 the goal of public aid to private schools is to make private education affordable to all, so it should be directed to struggling private schools, or to all students generally, but not merely to those sophisticated enough to jump through complex administrative hoops. requiring schools to take administrative steps, like partnering with scholarship organizations and generating donations, has the opposite effect. it directs donations toward schools with resources and infrastructure as opposed to struggling ones. making public aid “easier” to get by removing the administrative barriers will allow the schools that need it to actually benefit from it. removing administrative barriers to receiving donations also would not increase the likelihood of abuse because the regulatory responsibility would be placed on states instead of on private organizations. instead of requiring private schools to communicate with parents, fundraise, and partner with a private scholarship organization, none of which have anything to do with being deserving of public funds, states should require schools to demonstrate that they actually are deserving of public funds. georgia’s system, for example, should be revised to include qualifications for scholarship recipients that actually reflect financial need or universally fund all. moreover, the state, not private organizations seeking more donations, should ensure that public funds actually go to qualified schools and students. under a system like that, there is no need to use tax credits, and it becomes clear that the reasons tax credits were desirable in the first place—that they obscure the state’s role in providing aid and reduce transparency—do not serve the goal of educational equity and may actually be counterproductive. 216 see, e.g., goal program results, ga. goal scholarship program, inc. (july 31, 2023), https://www.goalscholarship.org/results/ [perma.cc/7e83-xfak]; financial reports, arizona christian school tuition organization, https://acsto.org/about/financial-reports [perma.cc/f s4j-adlu] (publicizing amounts they have provided in scholarships). 217 garnett, supra note 5, at 14 (noting that scholarship organizations are accompanied by a “risk that elite schools with ties to wealthier, more sophisticated, donors may capture a share of the available tax benefits that is disproportionate to the number of participants whom they serve”). about:blank about:blank 2023] the worst choice for school choice 119 the maine program challenged in carson for excluding religious schools allocated direct aid based on where a student lives. living in a district that does not operate its own public school qualifies a student for the program. qualified students designate the school they plan to attend, which can be public or private, and their home district pays that school for their cost of attendance.218 one good quality of this program is the absence of an income requirement to benefit from it (as opposed to tax credits, which only benefit those who earn a certain amount). the program does not appeal to someone because it can refund what she pays the state in taxes; it is available simply because she lives in a district without a public school. there is also not the same potential for abuse as there is with the tax credit system—a student chooses a school and the state funds his attendance; there is no illusion that the public money should be used for scholarships but ends up serving the student in lieu of public school.219 the public money is supposed to benefit the specific student. one feature of maine’s system is that it does not necessarily direct money toward the rich or poor, but, rather, is universal. a rich student and a poor student would both get private school paid for by the state as long as they live in a remote district. this is somewhat a feature of maine’s program, which aims to ensure that every student in a state with many remote areas “shall be provided an opportunity to receive the benefits of a free public education,”220 as opposed to equalizing educational opportunities or increasing choice. v. anticipated objections and our responses this section addresses two contemplated responses to the proposal to dispose of tax credits. the first is legal, namely, that states still may not fund religious schools because of federal or state law. the second is about policy: even if states are not required to use tax credits to fund public schools, they may still wish to. a. legal arguments the legal counterargument to the proposal to dispose of tuition tax credits is that the law still prohibits states from directly funding religious schools. one basis for this is the establishment clause, and another is state no-aid provisions. neither source of law, however, soundly supports that the government may not fund religious schools but may allow tax credits to fund them. 1. establishment clause first, the establishment clause does not prohibit states from funding religious schools—indeed, sometimes, it mandates it. this must be true after carson, in which the supreme court required maine to fund religious schools because it did so for non-religious private schools.221 the funding at issue in carson came directly from the state; “school administrative units,” which govern public 218 carson v. makin, 142 s. ct. 1987, 1994 (2022). 219 this could be abused if a school told qualified students that they would receive something in exchange for choosing that school. that would be egregious but could be hard to detect. 220 me. rev. stat. tit. 20-a, § 2. 221 carson v. makin, 142 s. ct. 1987, 2002 (2022) (noting that extending maine’s program to religious schools does not offend the establishment clause). columbia journal of tax law [vol: 15:1 120 education in maine, directly paid private school tuition for students living in districts without public schools.222 the court ruled that maine could not exclude religious private schools from this program.223 if a student in a district without a public school chose to attend a religious private school, then, carson requires the state to pay tuition directly to that school. the court explicitly stated that this “neutral benefit program in which public funds flow to religious organizations through the independent choices of private benefit recipients does not offend the establishment clause.”224 the supreme court’s ruling on the meaning of a constitutional provision carries as much weight as the constitutional provision itself, regardless of popular reception of the decision.225 carson’s interpretation certainly changed our understanding of the establishment clause—commentators have written that carson “called [conditions on government funding] into serious question”226 and “dismantle[s] the establishment clause”227—but the fact is that the establishment clause does not prevent direct funding to religious schools. nonetheless, there is an argument that carson was just wrong and that the law may, in the future, revert back to a starker separation between church and state. if that happens, maybe tax credits would survive under state constitutional provisions and winn, but vouchers would not be permitted to directly fund religious schools. states may thus think that sticking with tax credits instead of direct vouchers is the conservative option that is less likely to face legal obstacles in the future. carson, trinity lutheran, and espinoza were indeed landmark decisions, but there is no evidence that the law will revert back. the court viewed carson itself merely as an extension of the earlier two cases228 as did many commentators.229 and, since carson was decided in june 2022, there has been an explosion of reliance. states immediately began expanding their school choice programs. in 2023, florida, iowa, and utah approved expansions to their school 222 id. 223 id. 224 id. at 1997. 225 cooper v. aaron, 358 u.s. 1, 18 (1958) (“[t]he federal judiciary is supreme in the exposition of the law of the constitution.”). 226 ira c. lupu & robert w. tuttle, carson v. makin and the dwindling twilight of the establishment clause, american constitution (june 23, 2022), https://www.acslaw.org/expertf orum/carson-v-makin-and-the-dwindling-twilight-of-the-establishment-clause/ [perma.cc/p2ke-b vw3]. 227 marci a. hamilton, the supreme court further dismantles the establishment clause, empowers religious parents to obtain taxpayer funds for sectarian schools, and ignores the rights of the children in carson v. makin, verdict (june 22, 2022), https://verdict.justia.com/2 022/06/22/the-supreme-court-further-dismantles-the-establishment-clause-empowers-religious-par ents-to-obtain-taxpayer-funds-for-sectarian-schools-and-ignores-the-rights-of-the-children-in-cars on-v-makin [perma.cc/xc63-8bpb]. 228 carson v. makin, 142 s. ct. 1987, 1997 (2022) (“the ‘unremarkable’ principles applied in trinity lutheran and espinoza suffice to resolve this case.”). 229 justin driver, three hail marys: carson, kennedy, and the fractured détente over religion and education, 136 harv. l. rev. 208, 225, 233–34 (2022) (describing carson as “consistent with the terms of détente that emerged at the beginning of the twenty-first century” as well as with meyer v. nebraska); mark l. rienzi, religious liberty and judicial deference, 98 notre dame l. rev. 337, 384 (2022). 2023] the worst choice for school choice 121 choice programs.230 that reliance is important, because if an establishment clause challenge ever came before the court offering an opportunity to reverse carson, it would weigh against overturning that precedent. another reason that the law will not revert back is that the court’s declaration is supported by history. at its conception, the establishment clause was meant to prevent the establishment of a national church and did not necessarily invalidate public aid to religious institutions.231 some churches received state support when it was ratified.232 it is a recognized, defensible position that “the original establishment clause embraced no substantive conception of the proper relation of church and state, but merely reflected a determination that the issue be settled locally.”233 it is undeniable that the establishment clause’s history and original meaning remain “sharply contested,”234 and plumbing the complicated depths of that disagreement is outside the scope of this article. the only point relevant here is that carson was indeed a divided decision about which reasonable minds could disagree, but it was not completely without historical and jurisprudential support. carson thus defeats the argument that the establishment clause strictly prohibits state aid to religious schools. even accepting that carson holds that the establishment clause permits direct aid, it may still be argued that direct aid must reflect private choice. carson’s text characterizes maine’s program only as “a neutral benefit program in which public funds flow to religious organizations through the independent choices of private benefit recipients.”235 direct aid without tax credits can meet this standard, much like it does in maine: a state can directly fund private schools that students eligible for scholarships choose to attend. private choice of the student is still the only way that public money gets to a religious school, and there is no need for tax credits. no one really doubts that voucher aid—a fixed amount to every student in every school—is now constitutional. more fundamentally, reading trinity lutheran in conjunction with carson demonstrates that private choice is no longer a requirement. the trinity lutheran majority held that missouri could not exclude religious schools from eligibility for state grants for playground surfaces. applications for grants came from the schools themselves and were scored on criteria “such as the poverty level of the population 230 j. david goodman, a well of conservative support for public schools in rural texas, n.y. times (apr. 14, 2023), https://www.nytimes.com/2023/04/14/us/texas-school-vouchers.html [perm a.cc/u5dm-8wzb]; bush, supra note 130, at 100 (“[b]ills to establish universal choice are moving in more than a dozen states, including indiana, ohio, new hampshire, texas, and virginia. oklahoma [leaders] are committed to creating a universal esa program. . . . south carolina [leaders] have committed to fighting to expand educational opportunity.”). 231 vincent phillip muñoz, the original meaning of the establishment clause and the impossibility of its incorporation, 8 u. pa. j. const. l. 585, 590 (2006); justin driver, three hail marys: carson, kennedy, and the fractured détente over religion and education, 136 harv. l. rev. 208, 225, 233–34 (2022) (describing carson's consistency with meyer v. nebraska). 232 john c. jeffries jr. & james e. ryan, a political history of the establishment clause, 100 mich. l. rev. 279, 294 (2001). 233 id. at 293. 234 vincent phillip muñoz, the original meaning of the establishment clause and the impossibility of its incorporation, 8 u. pa. j. const. l. 585, 585–86 (2006). 235 carson v. makin, 142 s. ct. 1987, 1997 (2022). https://www.nytimes.com/2023/04/14/us/texas-school-vouchers.html columbia journal of tax law [vol: 15:1 122 in the surrounding area and the applicant’s plan to promote recycling.”236 only justice sotomayor’s dissent acknowledged that trinity lutheran did not address the private choice requirement, but the result, requiring a state to allow a benefit to a religious institution based on its application alone, implies that no private choice is required.237 accordingly, states may fund private schools in ways that do not reflect private choice. that would look like a funding program that allocates money on a basis other than per-student, and would allow states to allocate their funds available to private schools more equitably. as an example, a state could administer a program like missouri’s that enables schools to apply to the state for funding. a poor private school that charges minimal tuition could demonstrate its need and receive supplemental funding. nowhere in the process would a student or donor have to demonstrate her choice that public funds to which she is entitled be directed toward a religious school. under trinity lutheran, such a system would not violate the establishment clause.238 in short, the current supreme court has clarified that the establishment clause does not prohibit direct aid. carson was indeed a controversial decision, and the establishment clause’s history is contested, but the supreme court has not only permitted, but required the direct funding of religious institutions. that “interpretation . . . is the supreme law of the land.”239 accepting this as the law will allow states that want to fund private schools—secular and parochial—to do so in a way that allows reasonable regulation and proper supervision, like all governmental programs ought to. 2. no-aid clauses no-aid clauses purport to restrict interactions between the state and religion more than the establishment clause does.240 therefore, even though the establishment clause permits direct funding of religious schools, it may still be argued that state no-aid provisions disallow it. no-aid clauses cannot be the reason 236 trinity lutheran church of columbia, inc. v. comer, 582 u.s. 449, 455 (2017). 237 id. at 2029 n.2 (sotomayor, j., dissenting) (citing zelman v. simmons-harris, 536 u.s. 639, 649 (2002)) (“because missouri decides which scrap tire program applicants receive state funding, this case does not implicate a line of decisions about indirect aid programs in which aid reaches religious institutions ‘only as a result of the genuine and independent choices of private individuals.’”). 238 there is also an argument that some tax credit systems in existence today do not reflect private choice. recall carson’s language that maine’s system was “neutral benefit program in which public funds flow to religious organizations through the independent choices of private benefit recipients” carson 142 s. ct. at 1997. in a system like georgia’s, where donors indicate the school to receive their donations, the benefit recipient does not determine where the money goes. applicants must apply for tax credit-funded scholarships directly with georgia private schools, as opposed to receiving the scholarship and then choosing where to direct it. schools receive the money from the scholarship organizations and may allocate it to scholarships for students, unrestrained by wealthbased eligibility requirements. 239 cooper v. aaron, 358 u.s. 1, 18 (1958). 240 see, e.g., carson v. makin, 142 s. ct. 1987, 1991 (2022) (“maine’s decision to continue excluding religious schools from its tuition assistance program after zelman thus promotes stricter separation of church and state than the federal constitution requires.”); espinoza v. mont. dep’t of revenue, 140 s. ct. 2246, 2260 (2020) (“the montana supreme court asserted that the no-aid provision serves montana's interest in separating church and state ‘more fiercely’ than the federal constitution.”). 2023] the worst choice for school choice 123 that a state excludes religious schools from a benefit they would otherwise be qualified for, however. carson held that enforcing a no-aid provision in this way violates free exercise.241 carson does not necessarily render all no-aid provisions unconstitutional, however. the majority wrote “[a]s we held in espinoza, a ‘state need not subsidize private education. but once a state decides to do so, it cannot disqualify some private schools solely because they are religious.’”242 in other words, enforcing a no-aid provision complies with free exercise as long as it does not end up requiring excluding religious schools from a benefit they would otherwise qualify for. a state that does not provide any aid to private schools may constitutionally enforce a noaid provision. we neither support nor discourage such aid in this article: we merely argue that once a state sets out to aid private schools, direct aid is a better system. the interpretation of a state’s no-aid provision is for that state to make. federal courts do not have authority to say that state courts interpreted their state’s law incorrectly. georgia courts may hold that georgia’s no-aid provision permits tax credit scholarships but prohibits direct funding,243 and montana courts may hold that montana’s no-aid provision prohibits both.244 the state’s no-aid provision must submit to constitutional requirements; however, the supremacy clause requires that state courts “must not give effect to state laws that conflict with federal law.”245 no matter how a state interprets its no-aid clause, if it requires excluding religious schools from a benefit they would otherwise qualify for if they were secular, then the no-aid clause is unconstitutional as applied.246 in short, if a state’s no-aid provision prevents it from directly funding religious schools, it is not inherently unconstitutional, so long as the state responds to that interpretation by not funding private education at all.247 if that state provides aid to private schools, however, and relies on its no-aid provision to deny that aid to religious private schools, the no-aid provision cannot stand under free exercise. the argument that no-aid provisions prevent direct funding can only be used by states that do not provide aid to private schools at all, in which case, the no-aid provision does not do much work, at least in the area of education. as soon as a state relies on its no-aid provision to actually single out religious schools, however, the provision is unconstitutional and cannot be enforced. the argument that no-aid 241 see carson, 142 s. ct. at 2002. 242 id. at 2200 (citing espinoza, 140 s. ct. at 2261). 243 see gaddy v. ga. dep’t of revenue, 802 s.e.2d 225 (2017). 244 before espinoza, this was the montana supreme court’s interpretation of montana’s no-aid clause. espinoza, 140 s. ct. at 2251 (“[t]he montana supreme court struck down the program [of tax-credit funded scholarships, relying] on the ‘no-aid’ provision of the state constitution. . . .”). 245 armstrong v. exceptional child ctr., inc., 575 u.s. 320, 324 (2015) (quoted by espinoza, 140 s. ct. at 2262). 246 see carson, 142 s. ct. at 1998 (“the state pays tuition for certain students at private schools— so long as the schools are not religious. that is discrimination against religion.”); espinoza, 140 s. ct. at 2260. 247 note that if a state already operates a system of aid for private schools but excludes religious ones, its courts must order the inclusion of religious schools if a free exercise challenge is brought. the legislature can terminate the entire program, but state courts cannot respond to a challenge of a no-aid clause by ending all private school aid. see espinoza, 140 s. ct at 2246. columbia journal of tax law [vol: 15:1 124 provisions prevent states from directly funding religious schools is thus valid only in narrow circumstances: where the state funds no private schools at all.248 states were not unreasonable in believing that there were legal barriers to their direct funding of religious schools. in 1995, justice thomas famously described the supreme court’s establishment clause jurisprudence as being “in hopeless disarray.”249 the court has recently taken some opportunities to clarify it, though, and it is clear from those decisions that the establishment clause does not forbid direct funding, and that no-aid provisions cannot justify funding only nonreligious private schools. 3. other state constitutional issues state constitutions may pose other obstacles to direct vouchers. in some cases, state provisions that are perceived as preventing direct vouchers may not do so in fact. this is what happened with state no-aid clauses—governments believed no-aid clauses forbade them from subsidizing private religious schools, and it turns out that no-aid clauses, when used that way, are actually unconstitutional. the gratuities clause contained in georgia’s constitution is another example.250 this clause prohibits the state from “grant[ing] any donation or gratuity,”251 meaning it may not allow the free use of state labor or property when the state receives no substantial benefit.252 in other words, the clause prevents the state government from giving gifts.253 it has been suggested that direct vouchers in georgia would violate this clause.254 because providing public schools that do not charge tuition does not violate the gratuities clause, however, it is doubtful that vouchers would. vouchers are not a gift more than they are a public benefit provided by the government well within its power to govern education. if the state wishes to provide its school-age residents with free education, it can do so through public schools or by abating the cost of private schools; neither of those benefits would be considered a gratuity. this is our first reply to objections that other state laws forbid state governments from providing direct vouchers: ensure that the provision itself, not just its longstanding perception, actually prohibits vouchers. we do not intend this paper to be a deep exploration of state law, however, and it may well be that some state provisions genuinely prohibit vouchers but allow tax credits. we urge that 248 this is close, but not quite equivalent to, saying that no-aid provisions are worthless in light of free exercise. it is still possible to follow and enforce a no-aid provision in a constitutional way, such as if a state with a no-aid provision relied on it as the reason not to provide aid to any private schools (knowing both that it could not aid religious schools under its no-aid provision and that it could not aid only non-religious private schools under free exercise). in most cases, however, it seems that no-aid provisions which are followed have the effect of excluding religious schools, rendering them unconstitutional under carson. 249 rosenberger v. rector & visitors of univ. of va., 515 u.s. 819, 861 (1995) (thomas, j., concurring). 250 we would like to thank professor fred smith jr., charles howard candler professor of law at emory university, for bringing our attention to georgia’s gratuities clause. 251 ga. const. of 1983. art. iii, § vi ¶ vi. 252 see garden club of ga., inc. v. shackelford, 266 ga. 24, 24 (1995); 1993 op. att’y gen. u9314. 253 see garden, 266 ga. 24 at 24; mccook v. long, 193 ga. 299, 302–03 (ga. 1942). 254 see gaddy v. ga. dep’t of revenue, 802 s.e.2d 225, 231, 234 n.14 (ga. 2017). 2023] the worst choice for school choice 125 such provisions are simply bad law—they purport to allow school choice, but through a counterproductive method to the exclusion of a good one. accordingly, if a state already seeks to subsidize school choice but feels it cannot do so directly because of a state law, legislators should consider creating an exception to whatever state law stands in the way. if the state law prohibits direct funding but allows tax credits, for example, it allows school choice through what we argue is the worst means. the legislature should either remove the obstacle and allow effective administration of school choice or decide against school choice entirely. laws that permit only tax credits and prohibit direct vouchers are the worst of both worlds; they narrowly restrict the administration of school choice to a poorly regulated and flawed method. 4. reforming, instead of replacing, tax credits finally, we understand that legislators may still wish to honor the state laws that prevent direct funding but allow tax credits. we have been advised that tax credits are advantageous politically—they constitute social spending favored by liberals, but conservatives can deny that they are actually public money. if state legislators wish to maintain the tax credit as their vehicle for school choice, for political reasons or otherwise, reform to the tax credit can still address its major issues. the tax credit form is not the heart of our objection to tax credits—the main problems are actually the inequitable use and distribution and the lack of regulation. these problems can be addressed while maintaining the tax credit structure. inequitable distribution could be addressed by forbidding the designation of a specific school or student on a donation. florida, for example, does not allow donations to be designated to specific schools, which is a step in the right direction in terms of equity. inequitable use requires more reform—it could be addressed by making the tax credit refundable, meaning that donors would be refunded by the state in excess of their tax liability. tax filers with no state tax liability would receive a check from the state for the amount of their contribution. families in lower tax brackets, then, would have just as much incentive to contribute as affluent families do, so the benefit is not concentrated on the wealthy.255 the issue that remains is that benefitting from the tax credit still requires parting with a sum of money for part of the year: the donor would have to donate to the scholarship organization and wait to receive their refundable tax credit at tax time the following year.256 this is obviously much easier for the wealthy, who have more disposable income. to fully 255 a refundable tax credit is still an obstacle more easily surmounted by the wealthy than by the poor. the wealthy already have a reason to be filing and paying attention to state taxes. people who know they will have no state tax liability do not. georgians who make less than $8,100 in 2022, for example, are not required to file a state income tax return at all; see filing requirements, ga. dep’t of revenue, https://dor.georgia.gov/filing-requirements [perma.cc/4rgh-gqmm]. those who know they do not need to worry about state taxes at all will probably not go hunting down a tax credit, but those who are already filing will have more exposure to it. thus, the wealthy remain in a better position than the poor to take advantage of even refundable tax credits. 256 see andrew t. hayashi & justin j. hopkins, charitable tax deduction and civic engagement, 2023 u. ill. l. rev., 1179, 1220 (2023) (“[earned income tax credit] recipients often have significant debt that accumulates during the winter holidays that they only repay after receiving their tax refunds, making them vulnerable to delays or garnishment of those refunds.”). columbia journal of tax law [vol: 15:1 126 address the inequitable use of tax credits, then, the refund would have to be issued simultaneously with the donation. that way, recipients of the credit would not be required to part with their money for months, expanding the option to poorer families. of course, if the tax credit is issued simultaneously with the donation, it looks more like a voucher than a tax credit. if legislators would prefer to call it a tax credit for political reasons, however, we have no objection—the issues are with the inequitable distribution and the lack of regulation, not the label. addressing inequitable distribution of tax credits may also require means testing tax credit recipients, so that the tax credits are actually distributed more generously to those who need them to attend private school than to those who can afford private school on their own. this would be a step in the right direction, but it would require much more scrutiny of how schools and scholarship organizations distribute funds. this could be done with either tax credits or direct funding, but we expect it will be easier with direct funding, which allows more accountability and does not share tax credits’ long history of being insulated from the government. even with this reform, tax credits will begin to look more like vouchers because the state will have more control over how they are distributed.257 retaining the tax credit structure would also require reform in the area of regulation. as with the issues described above, there is no reason that regulation must come from outside of the states’ tax functions. if the state agency that currently administers the tax credit can adequately increase oversight of how the funds are used and awarded, then it should implement that oversight, by all means. whether the agency that regulates tax credits is new or old is not the problem—the lack of regulation is. the long tradition of tuition tax credits being characterized as completely separate from the government (due to the need to validate their use by religious schools), is likely to make adequate regulation an uphill battle. as we have discussed, tax credits also seem a cumbersome, overly complicated mechanism for distributing public benefits, hindering accountability by hiding social programs behind a complex tax code.258 while it has been argued that this is just the price to pay for tax expenditures that support personal choice, then we aver that school choice is not the place for tax expenditures. similarly, some may view the lack of regulation as a positive feature of tax credits; tax credits are less likely than direct funding to expose private schools to state regulations such as non-discrimination requirements. however, since tax credits are effectively public subsidies of private education, that kind of regulation is necessary and warranted as part of the nature of public funding.259 nonetheless, the critic might continue, if a state agency can overcome these regulatory obstacles, the required regulation could be applied while maintaining the 257 thanks to professor hillel levin for bringing our attention to means-tested tax credits. 258 thanks to professor alex zhang for his expertise on the tax debate. for more on this, see alex zhang, pandemics, paid sick leaves, and tax institutions, 52 loy. u. chi. l.j., 383, 399–401 (2021) (“scholars advocating a comprehensive tax base have contended that distributing government resources in the form of a tax concession is inefficient, poses difficulties in administrability, and shields the government from accountability by hiding spending in the tax code.”). 259 tax credits’ serving as a shield against regulation is analogous to how they used to serve as a shield against establishment clause issues. tax credits were separate enough from government funds to comply with the establishment clause. 2023] the worst choice for school choice 127 form of a tax credit.260 likewise, the mere form of a voucher alone will not solve the regulation problem; the vouchers we propose must be accompanied by regulation and accountability. we contend that vouchers, since they are not shadowed by a history of necessary separation from the government, are more readily regulated, but failure to regulate them would come with many of the problems we see with tax credits today.261 migrating the tax credit system over to vouchers will not wholly solve the problems of tax credits; the vouchers must be done right. in short, states can choose to start fresh with direct funding, or they can reform their tax credit programs to address the major issues discussed here. different states will have different views on which option is more complicated or politically advantageous. adequate reform may make the tax credit resemble a voucher, but if the issues of tax credits are addressed, that label is a non-issue. b. policy arguments the sections above make plain that neither the establishment clause nor no-aid provisions need prevent states from directly funding private schools. this section addresses the question that remains open: even though a state could fund schools directly, what if it chooses to use tax credits instead? we cannot argue that doing so would be unconstitutional. in a state like georgia, for example, where the state supreme court has held that the no-aid provision allows tax credit scholarships at religious schools, the practice is certainly constitutional. we have laid out above why interpreting a no-aid provision as prohibiting direct funding but allowing tax credits is overly formalistic. nonetheless, states continue to do so, and federal courts may not correct their interpretations of state law.262 this article urges that states should not use tax credits merely as an avenue around a state no-aid provision, however. tax credits are no longer needed to circumvent the establishment clause, and there is no good policy reason to use them to circumvent no-aid clauses (which are unconstitutional anyway if a state provides direct aid to private schools). once those justifications are stripped away, no policy reason to choose tax credits remains, other than a desire to subsidize private education for the wealthy. tax credits do not well fund schools serving poorer populations and disorganized communities. instead, they fund almost exclusively wealthy private schools—which could be a goal, but one we suspect most do not support. with direct funding as an available and stronger alternative, the downsides of the tax credit mechanism are too weighty to justify continued use.263 260 thanks to professors samuel brunson and hillel levin, as well as the participants in the joint faculty workshop between the law schools of emory university and the university of georgia for emphasizing the possibility of adequate regulation of tax credits. 261 mervosh, supra note 166 (expressing skepticism regarding voucher regulation and accountability). 262 nor would they probably because winn held that tax credits do not implicate the establishment clause. see arizona christian sch. tuition org. v. winn, 563 u.s. 125, 144–145 (2011). 263 some may argue that the downsides of tax credits—worsening educational inequality, in particular—do not outweigh the need to preserve parental choice. doing away with tax credits does not destroy parental choice, however. direct funding is an available, and better, alternative. columbia journal of tax law [vol: 15:1 128 to illustrate this point, consider three scenarios created by school choice in its different forms. first, consider a state with no school choice funding at all. people who can and want to pay for private school go to private school, and everyone else goes to public school. if the public school needs improvement, its students and their families will advocate for it. in a state that permits tax credits but not vouchers, however, rich families in the struggling public school are actually incentivized to leave rather than advocate for better public schools. they can go to private school and have part of their tuition covered by the government. the public school, meanwhile, will be left struggling with fewer advocates and resources; poorer students furthermore do not have an option to leave. consider, then, the alternative where a state uses vouchers and not tax credits. people at the struggling public school, regardless of their wealth, can stay at the public school or decide to use a standard amount of government money to abate the costs of private school. going to private school does not require drumming up donations, private schools are not incentivized to recruit the rich, and the state is covering the costs of private school equally for each student. the second option, one with tax credits but without vouchers, is the worst of both worlds—it leaves public schools struggling and subsidizes private school for the rich to the exclusion of the poor. that scenario will exacerbate educational stratification. if state law prohibits vouchers but allows tax credits, it is just bad law unless tax credits are seismically reformed to the point where they resemble vouchers. the only policy reason that supports using tax credits in their current form is a desire to subsidize private school tuition for the rich. if this is what state legislators truly wish to achieve, they should directly say so.264 otherwise, they are using a counterproductive system to support school choice for all. another important question for states is whether they should fund private schools at all, but that is outside the scope of this article. vi. conclusion this article is easily summarized in four crisp points. ● federal establishment clause jurisprudence now clearly permits (and sometimes mandates) direct aid to private religious schools along the same lines as any private school. ● tuition tax credits are an unsupervised, indirect governmental aid program for private schools that only aids schools that have parents who pay considering whether the downsides of tax credits are outweighed by the need for parental choice is therefore irrelevant; there is a way to preserve parental choice without the downsides—direct funding. 264 see, e.g., matt barnum & alicia a. caldwell, vouching helping families already in private school, early data show, wall st. j. (dec. 3, 2023), https://www.wsj.com/us-news/education/vo uchers-helping-families-already-in-private-school-early-data-show-47ced812 [perma.cc/n2dp-rj 7m]. this is, of course, unlikely to be politically wise. facially neutral policies that actually favor the wealthy are likely to see even more limelight in the near future as cases concerning legacy admissions make their way to the supreme court. in the 2023 case invalidating affirmative action, justice gorsuch wrote that policies favoring children of donors, alumni, and faculty “undoubtedly benefit white and wealthy applicants the most.” students for fair admission v. harvard, 600 u.s. 181, 301 (2023). 2023] the worst choice for school choice 129 significant state income tax. schools that appeal to poorer students and communities do not get enough aid. ● by design, tuition tax credits lack sufficient governmental supervision and are both fraud-prone and ineffectual. direct governmental aid comes with a regulatory framework that ensures that funds are properly used. ● states that want to subsidize private schools should do so through direct aid to schools. the path for financial aid to private religious schools has been a long and crooked one. it is time to straighten out the sidewalk to the front door of private school aid. keep charitable oversight in the irs philip hackney* abstract critics are increasingly calling for congress to remove charity regulation from the irs. the critics are wrong. congress should maintain charity regulation in the irs. what is at stake is balancing power between the state, charity as civil society, and the economic order. in a well-balanced democracy, civil society maintains its independence from the state and the economic order. removing charitable jurisdiction from the irs would blind the irs to dollars placed in the charitable sector increasing tax and political shelters and wealthy dominance of charities as civil society. a new agency without understanding of, or jurisdiction over, tax cannot act as the bulwark as can the irs. the critics are right that both the states and the irs are failing at charitable regulation. ideally, congress would allocate sufficient resources to the irs. however, the long history of charity regulation shows that they are unwilling to allocate the resources to this endeavor. this, in fact, is a flaw of the proposals for a quasi-federal charitable regulatory agency. these proposals will not generate new funds but will instead spread scarce resources even thinner. instead, congress should acknowledge its unwillingness to adequately fund charity regulation and shrink the tax-exempt sector by removing the parts that have limited justification for charitable benefits, such as hospitals and private foundations. * professor of law, university of pittsburgh school of law. j.d. louisiana state university paul m. hebert law center, l.lm. nyu school of law. i presented an earlier version of this paper when providing the norman a. sugarman lecture in 2016 at the case western reserve school of law and appreciated the comments i received there. i also presented an earlier version of this article at the 2022 amt conference. i thank jordan barry, emily cauble, brian galle, ari glowgower, david gamage, david hasen, andrew hayashi, christine kim, ben leff, susie morse, leigh osofsky, shu yi oei, clint wallace, and manoj viswanathan for comments on an earlier version. i also thank my terrific research assistant joey scapaletto for his assistance in this effort. 2024] keep charitable oversight 131 i. introduction ............................................................................................. 131 ii. charitable oversight now and historically .................................... 135 a. what does the charitable sector look like, and why do we need to regulate it? .................................................................................................. 136 b. states .................................................................................................... 140 1. charitable organization law origins ......................................... 141 2. state charitable law .................................................................... 143 3. state enforcement ......................................................................... 145 c. federal government/irs ..................................................................... 147 1. federal charity tax law ............................................................. 148 2. irs enforcement ........................................................................... 155 3. other regulators .......................................................................... 157 iii. proposals to remove charitable oversight ...................................... 159 a. some state and federal recommendations for modest change ......... 160 b. remove from the irs/create a new national agency ....................... 161 iv. analysis ..................................................................................................... 165 a. recent history highlighting a challenged irs ................................... 166 b. what are the goals of charity regulation? ........................................ 167 1. political justice: charity and tax in a democratic order .......... 168 2. factors to consider regarding charitable regulation ............... 170 3. big picture approach to charity regulation ............................... 173 c. challenges to some of the regulatory solutions ................................ 175 d. solution ................................................................................................ 182 v. conclusion ................................................................................................ 185 i. introduction scholars increasingly criticize the internal revenue service’s (irs) regulation of the charitable sector. many critics argue congress should remove the function from the irs.1 the primary critique is that the irs has failed absolutely as a regulator. despite the critics, congress should maintain the regulation of charity in the irs. removing the function would harm the collection of revenue. a separation would lead to significant tax and political sheltering opportunities because the irs would not be able to see dollars put into the charitable sector. while 1 see marcus s. owens, charity oversight: an alternative approach, presentation at 2013 charities regulation and oversight project policy conference (2013) in colum. acad. commons, jan. 2014; terri lynn helge, policing the good guys: regulation of the charitable sector through a federal charity oversight board, 19 cornell j. l. & pub. pol’y 1 (2009); lloyd hitoshi mayer, “the better part of valour is discretion”: should the irs change or surrender its oversight of charitable organizations, 7 colum j. tax l. 80 (2016) (arguing that the deficiencies of irs oversight are so severe that it is time to consider moving the function out of the irs); roger colinvaux, fixing philanthropy: a vision for charitable giving and reform, 162 tax notes 1007, 1013 (2019) (recommending congress convene a panel to study the question of how to structure the oversight of the tax-exempt sector); ellen p. aprill, the private foundation excise tax on self dealing: contours, comparisons, and character, 17 pitt. tax rev. 297, 336 (2020) (arguing the time has come to reconsider whether the irs is the right agency to regulate charitable organizations); see also jeffrey n. pennell & alex zhang, proposals to restore faith in exempt organizations, 183 tax notes fed. 285 (april 8, 2024) (proposing a new agency to handle initial applications and maybe some form of annual oversight as well). 132 columbia journal of tax law [vol 15:2 state charity law primarily focuses on governance to ensure insiders do not take from charity, charity tax law focuses on the tax benefits involved. these benefits raise distinct and important questions that will not be sufficiently salient, or understood, to and by a regulator outside of the irs, even one at a federal level. importantly to this case, introducing a new regulator to the regulation of the sector would simply spread already scarce resources for charity regulation way too thin. we can expect congress will continue to fail to provide the resources needed to properly oversee the sector. those interested in good federal oversight of charity should thus focus on improving the irs as a charity regulator instead. the irs charity critics approach the issue from multiple perspectives, but the critiques tend to lead to the same end: removal. some from the political right believe the irs “targeted” conservative groups (such as tea party affiliates) to try to stop them from obtaining tax-exempt status as social welfare organizations from around 2011–2013.2 such critics likely view governmental agencies as populated by unelected biased bureaucrats.3 arguably, the end this group desires is a significantly hobbled irs.4 other critics think charity regulation is important but that the irs fails to engage in enough enforcement to regulate the sector well.5 some critics believe that the challenge of the irs overseeing charity is that it involves the “political” and the irs simply ought not oversee political matters at all. it forces the service to stray from its mission of collecting revenue.6 these latter critics tend to have a common interest in functional tax policy, good enforcement of that policy, and a well-regulated charitable sector. they just think the irs is the wrong institution to regulate the charitable sector.7 some of these u.s. observers argue for a federal charity bureau, while others argue for a more private solution like finra.8 2 philip t. hackney, should the irs never “target” taxpayers: a consideration of the irs tea party affair, 49 val. l. rev. 453 (2015). 3 for this general vision of governmental agencies, see theodore j. lowi, the end of liberalism (1969); cf. anya bernstein & cristina rodriguez, the accountable bureaucrat, 132 yale l.j. 1600, 1676 (2023) (arguing that administrative agencies tend to employ systems that promote significant accountability to the public). see also dennis r. young & john p. casey, supplementary, complementary, or adversarial?: nonprofit-government relations, in nonprofits and government: collaboration and conflict 37–39 (elizabeth t. boris & c. eugene steuerle eds., 3d ed. 2016) (discussing the tendency of those who identify as conservative politically to desire more government to be carried out by nonprofits than the government itself). 4 a review of judicial watch’s approach to the irs tea party controversy illustrates this vision of the irs. see irs scandal, jud. watch, http://www.judicialwatch.org/blog/tag/irs-scandal/ (last visited jan. 27, 2024). 5 see, e.g., mayer, supra note 1 (arguing that the deficiencies of irs oversight are so severe that it is time to consider moving the function out of the irs); owens, supra note 1. 6 there are cogent arguments linking the irs’s regulation of tax-exempt organizations to harm to the irs’s ability to collect the revenue. evelyn brody & marcus owens, exile to main street: the irs’s diminished role in overseeing tax-exempt organizations, 91 chi.-kent l. rev. 859, 859, 862 n.17 (2016) (“our focus, however, should not obscure the very real corrosive impact, whether deserved or pretextual, that the irs's exempt-organization imbroglio has had on the health of the entire agency, and thus to the revenue needs of the federal government.”). 7 this frustration with the irs as federal regulator is not new. see, e.g., david ginsburg et al., federal oversight of private philanthropy, in 5 research papers 2578, 2581 (1977). 8 see helge, supra note 1; owens, supra note 1. 2024] keep charitable oversight 133 this article considers this question through the lens of political justice. by this i mean a state that furthers democracy.9 in the context of charitable organizations and their regulation, the most significant democratic factor to consider is the role of charitable organizations as a part of civil society.10 charitable organizations as civil society stand as a bulwark against the state and economic power to protect important civil rights such as the freedom of speech and association.11 our institutions and scholars regularly recognize and laud this important value of charity as civil society.12 charitable organizations and those connected with them are rewarded with subsidies.13 fundamentally, it is important that charity as civil society maintains its independence from the state and from the economic order. this article maintains that the irs is the institution best able to maintain this independence between state, charity, and the economic order. if congress were to remove charity oversight jurisdiction from the irs, the service would have little ability to observe dollars in the charitable sector to properly enforce the income, estate, and gift taxes. and obviously, a new charitable agency would have no capacity to do so either. thus, though the irs may not be handling this function well today, we can expect this problem to grow much worse with removal. in addition to arguing that charity regulation should remain with the irs, i sketch a solution that is hopefully satisfactory to a large part of the critics. though the critiques may seem like they come from disparate positions driven by stringent ideological views, i believe it is possible to find commonalities and develop a more satisfying solution. if, as almost all of these critics agree, insufficient resources are a significant part of the problem, then moving the function out of the irs will accomplish nothing. it will fragment oversight and the resources available for that oversight. an acceptance of the under-resourced theory, along with a recognition that the agency mandate is complex, also explains the bungling agency seen by the critics. to cure these problems, congress, treasury, and the irs must make the agency mandate less complex. this narrowing can also aid the irs in protecting the fisc from misuse of charitable dollars. this article thus recommends maintaining charitable oversight within the irs while simultaneously encouraging congress, treasury, and the irs to simplify the task of the irs on its oversight of 9 philip hackney, political justice and tax policy: the social welfare organization case, 8 tex. a&m l. rev. 271, 274 (2019) [hereinafter hackney, political justice]; see also philip hackney, prop up the heavenly chorus? labor unions, tax policy, and political voice equality, 91 st. johns l. rev. 315, 322 (2017) [hereinafter hackney, prop up]. others have made a similar case. see, e.g., clint wallace, a democratic perspective on tax law, 98 wash. l. rev. 947 (2023). 10 philip hackney, public good through charter schools? 39 ga. st. u.l. rev. 695, 705–06 (2023); see also theda skocpol, diminished democracy 20–24 (2003). 11 jürgen habermas, three normative models of democracy, 1 constellations 1, 8 (1994); see also jean l. cohen & andrew arato, civil society and political theory (1992). 12 bob jones univ. v. united states, 461 u.s. 574, 609–10 (1983) (powell, j., concurring) (explaining the "role played by tax exemptions in encouraging diverse, indeed often sharply conflicting, activities and viewpoints."); see also john w. gardner, the independent sector, in america’s voluntary spirit ix, xiii-xv (brian o'connell ed. 1983); elizabeth t. boris & matthew p. maronick, civic participation and advocacy, in the state of nonprofit america 394 (lester m. salamon ed., 2d ed. 2012). 13 for example, the charitable contribution deduction (i.r.c. § 170) and exemption from income tax (i.r.c. § 501). 134 columbia journal of tax law [vol 15:2 charitable organizations. though we might like to extend benefits far and wide to all sorts of new charitable organizations, we should instead narrow those benefits only to those who clearly qualify. where congress sees abuse, it should eliminate the whole field rather than come up with standards to keep the bad guys out. these possibilities are explored in part iv(d). this article also considers whether congress should grant the irs full jurisdiction over the charity governance part of charitable oversight. while it is unlikely that states or the sector would be willing to give this full authority to the irs, examining this question allows us to see both a significant challenge of the critic’s proposals and a fundamental challenge to irs charity regulation. the senate finance committee considered such a proposal twenty years ago.14 but the sector pushed back strongly against the idea and has fought all efforts by the irs to assert any jurisdiction over charitable governance. i discuss this in the analysis part iv(c). bringing the fullness of charity law to bear in one federal entity would connect governance norms found in state charity law in ways that may be helpful, unifying, and educational to both the regulator and regulated. there is much to recommend for bringing governance to the irs in a clear way. many question whether those in the irs are the right experts to oversee charity. the reality is that the irs possesses expertise on matters of what is charitable, how charity agents should behave to best further those charitable purposes, and the systems to enforce those rules. the irs civil service has built that expertise through over a century of enforcing the charitable tax law and interacting with the regulated public. indeed, the charitable tax expertise of the irs matters a lot to the enforcement of the income, gift, and estate taxes which are all intimately connected to charitable organizations. some also worry about the neutrality of the irs in overseeing this sector. however, because these organizations must either pay tax or not pay tax, the irs must oversee this sector and confront the matter of neutrality to collect the revenue accurately and fairly. it cannot avoid the neutrality problem and should, therefore, take it on directly in as transparent a manner as it can.15 fair enforcement of tax law depends upon that. what is at stake in charitable organization regulation? in 1960, karl karst put the matter as follows: “there remains substantial unanimity on one goal: the greatest possible portion of the wealth donated to private charity must be conserved and used to further the charitable, public purpose; waste must be minimized and diversion of funds for private gain is intolerable.”16 this is too narrow of a vision for charity today. it only looks at the narrowest conception of charity: wealthy people giving money to important charitable classes. the charitable sector is broad including health care, education, low-income housing, and much more, many of which are substantial businesses outside of private wealth being contributed to the 14 staff of the joint comm. on taxation, 108th cong., tax exempt governance proposals: staff discussion draft 16 (2004), see also norman i. silber, nonprofit interjurisdictionality, 80 chi.-kent l. rev. 613, 638 (2005) (suggesting that part of the challenge with attorneys general not enforcing the law might derive from the belief that the irs will intervene). 15 hackney, supra note 2, at 502 (suggesting a transparent process for the irs to adopt in evaluating applications for exemption involving politics). 16 kenneth l. karst, the efficiency of the charitable dollar: an unfulfilled state responsibility, 73 harv. l. rev. 433, 434 (1960). 2024] keep charitable oversight 135 poor.17 thus, for tax law purposes the primary purpose of irs charity oversight is to provide the irs a means of ensuring that the federal tax system is not eroded. tax-exempt organizations like charities provide substantial opportunity to avoid the corporate and individual income taxes and the only way the irs can protect that boundary is by having substantial information from charitable and other exempt organizations proving their deservedness to exemption. abuse of these highpowered incentives can happen in two primary ways—abuse of charitable deductions and the operation of a nonprofit to benefit private interests. there is another purpose of the irs charity law regime that is more consistent with the karst vision—to ensure that charitable organizations are legitimately operated to further a charitable purpose. congress built the structure of tax-exemption upon organizations that primarily fulfill a particular purpose and do not have shareholders.18 this means that these charities must be fulfilling some broad, shared, and legitimate collective purpose.19 within the charitable world, this means the irs is a de facto regulator of charitable organizations. despite being the de facto regulator, in the 21st century, congress has not allocated the amount of resources needed by the irs to carry out its charitable enforcement activities.20 still, congress has historically taken charitable regulation legislation seriously, which we can witness by its enactments of successive tax acts consistently over the past century, passing legislation penalizing misuse of charitable organizations.21 thus, there is reason to believe future congresses may similarly see the irs rules and enforcement as significant and maybe even someday properly fund it. in the end, this article takes a conservative approach to the challenge of charity regulation. it is better to keep the system that has been slowly developed over one hundred years. it is likely the best compromise we can get. it is better to work on fixing the challenges at the irs than to create a new agency. additionally, maintaining irs oversight is important to maintaining civil society’s independence from state and economic interests. furthermore, removing jurisdiction would harm the collection of revenue. in this article, part ii describes the sector, the state enforcement regime, the federal enforcement regime, and other enforcement parties. part iii describes the various reform proposals. part iv analyzes the situation and part v concludes. ii. charitable oversight now and historically states naturally took jurisdiction over nonprofit oversight. the u.s. constitution provides only limited powers to the federal government and all the rest to the states.22 though there are some legal entities established by the federal 17 see henry hansmann, the rationale for exempting nonprofit organizations from corporate income taxation, 91 yale l.j. 54, 60 n.25 (1981) (noting the importance of commercial nonprofits that do not depend upon charitable contributions in operating their business). 18 i.r.c. § 501(c)(3). 19 treas. reg. § 1.501(c)(3)-1(d)(1)(ii). 20 see infra part ii.c. 21 see paul arnsberger et al., a history of the tax-exempt sector: an soi perspective, 106 fig. a in i.r.s. soi bulletin (2007–2008) (describing congressional acts focused on tax-exempt organizations from 1894–2006). 22 u.s. const. amend. x; see u.s. const., art. i, § 8. 136 columbia journal of tax law [vol 15:2 government,23 registration and oversight of legal entities and trusts has mostly been a state law matter. but, because of the national and international impact of charity, it makes little sense to leave oversight to the states alone; it leads to a lack of vision and a lack of scope of response. the irs became an overseer of the sector upon the creation of federal income tax law. part ii first examines the charitable sector, turns to the relationship of states to charity oversight, then reviews the irs’s relationship to charity regulation, and finally considers other regulators. a. what does the charitable sector look like, and why do we need to regulate it? to address the question of the best regulatory institution for charity oversight, we need a definition of the thing to be regulated. unfortunately, charity is notoriously difficult to define. as thomas kelly stated: “[i]n the realm of american law, the term ‘charity’ is exasperatingly variable and confusing.”24 indeed, as kelly notes, we have never agreed upon a uniform concept of charity.25 the online merriam-webster dictionary provides the following definitions of charity: 1 a: generosity and helpfulness especially toward the needy or suffering also: aid given to those in need received charity from the neighbors b: an institution engaged in relief of the poor raised funds for several charities c : public provision for the relief of the needy too proud to accept charity 2: benevolent goodwill toward or love of humanity the holidays are a time for charity and goodwill. 3 a: a gift for public benevolent purposes b: an institution (such as a hospital) founded by such a gift 4: lenient judgment of others the critic was liked for his charity and moderation.26 these definitions are woefully inadequate to describe the diversity and complexity that we currently accept to be charitable under u.s. state and federal tax law. a place to start, then, is to note that charity in its legal sense is carried out by nonprofit organizations. elizabeth boris and c. eugene steuerle define nonprofit organizations as “those entities that are organized for public purposes, are self-governed, and do not distribute surplus revenues as profits.”27 henry 23 kevin r. kosar, cong. rsch. serv., rl30365, federal government corporations: an overview (2011). 24 thomas kelly, rediscovering vulgar charity: a historical analysis of the history of america’s tangled nonprofit law, 73 fordham l. rev. 2437, 2437 n.2 (2005). 25 id. 26 charity, merriam-webster dictionary, https://www.merriam-webster.com/dictionary/char ity [perma.cc/jtc7-7l83]. 27 elizabeth t. boris & c. eugene steuerle, scope and dimensions of the nonprofit sector, in the nonprofit sector: a research handbook 66, 67 (walter w. powell & richard steinberg eds., 2d ed. 2006). 2024] keep charitable oversight 137 hansmann noted that the fundamental structural element of nonprofit organizations is the bar on the distribution of net earnings, referred to as the “nondistribution constraint.”28 this feature describes a significant part of the legal entities that carry out charity but does not define charity. this part ii(a) thus keeps this constraint in mind but allows the following discussion of the charitable legal sector to begin to develop the bounds within which our society conceives of charity. to continue with the legal structure, the two predominant forms of nonprofit organization are the trust29 and the nonprofit corporation. while the charitable trust is the dominant form in england, the nonprofit corporation became the dominant form in the united states.30 those legal structures indelibly shape charity but at the same time make some of its bounds confusing. the confusion derives from the fact that the trust standard for fiduciary duties is much stricter upon its managers than the corporate standard. this leads to challenges in determining the right standard of behavior to apply to the agents of a charity both at state law and for tax law purposes: the stricter trust standard or the more lenient corporate standard that looks like the for-profit corporation standard. part ii(b) considers this matter further. despite modern-day confusion regarding the right fiduciary duty to apply, charitable trust law has largely defined the scope of charitable purposes including in tax law. the restatement (third) of the law of trusts, includes the following purposes as charitable: “the relief of poverty; the advancement of knowledge or education; the advancement of religion; the promotion of health; governmental or municipal purposes; and other purposes that are beneficial to the community.”31 these purposes are largely reflected today in the income tax in section 501(c)(3).32 are charities public or private? arguably, charitable organizations are a combination of public and private.33 some argue that part of the reason we accept that charities can be regulated by the government through an attorney general is because the funds they hold are public.34 congress made the tax returns of these organizations publicly accessible in part because their activities are thought to be an important part of our public sphere.35 critically, in the dichotomy of nonprofit organizations as either public benefit or mutual benefit, charities are by far the largest group of public benefit nonprofits. others have taken the position that the 28 henry b. hansmann, the role of nonprofit enterprise, 89 yale l.j. 835, 838 (1980). 29 though trusts have traditionally been thought of within the law as a fiduciary relationship rather than as an entity, the law has moved in modern times to think of them more as an entity. see restatement (third) of trs. § 2 cmt. a (am. l. inst. 2023) (“increasingly, modern commonlaw and statutory concepts and terminology tacitly recognize the trust as a legal ‘entity,’ consisting of the trust estate and the associated fiduciary relation between the trustee and the beneficiaries.”). 30 james j. fishman et al., nonprofit organizations, cases and materials 22 (5th ed. 2015). 31 restatement (third) of trs § 28 (am. l. inst. 2023) (alphabetical bullets removed). 32 i.r.c. § 501(c)(3). 33 see, e.g., jonathan levy, altruism and the origins of nonprofit philanthropy, in philanthropy in democratic societies 19 (rob reich et al. eds. 2016) (“philanthropy, perhaps by definition, is a form of private action. yet, historically philanthropy has always been clothed with a public character, even if, over time, the clothes have changed.”). 34 helge, supra note 1, at 15 (citing george g. bogert, the law of trusts and trustees § 411 (3d ed. 2001); james j. fishman, improving charitable accountability, 62 md. l. rev. 218, 258– 59 (2003)). 35 staff of the joint comm. on tax’n, 106th cong., 2 study of disclosure provisions relating to tax-exempt organizations 80 (2000). 138 columbia journal of tax law [vol 15:2 funds are private in nature. early judicial treatment, such as in the trustees of dartmouth college v. woodward, made it clear that we grant some private corporate rights to charitable nonprofit corporations.36 the government could not simply interfere with its contractual arrangements because the constitution forbids such interference. regardless, the legal treatment of charity places it at least into a quasi-public sphere. sometimes called the third sector or the independent sector, charitable organizations carry out a wide range of activities in spaces that are neither the government nor for-profit. they range from the very small, like a local book club or a society appreciating an obscure philosopher, to the medium, like local children’s sports associations and groups advocating to state legislatures on matters of poverty within the state, to the large, like giant hospital systems and universities spanning the globe. as mentioned in the introduction, nonprofit charitable organizations broadly fit into civil society, defined as “institutional spaces and organizations outside of the government, and outside of economic power, that facilitate and influence collective decision-making at the state level.”37 the major democratic traditions of liberalism, republicanism, and deliberative democracy all value this sector in maintaining a strong healthy democratic order.38 in the liberal model, civil society organizations protect civic rights like freedom of speech, but they also serve to bring citizen needs to the government.39 republican theorists particularly value the potential of these organizations to prevent the domination of government over individual interests and rights.40 deliberative democrats find civil society also healthy to a democratic order in protecting against government overreach and in allowing citizens to generate important information and develop opinions, and, in turn, to share those opinions with the government. nonprofit charitable organizations shape and express who we are as a society. they implement and operate important collective activities of the united states including educating and tending to the healthcare of our population. the nonprofit community engages in a deliberative process with our government to help find out the needs of the people and to meet their needs either through contracting or through other means. we all have a personal and collective interest in ensuring that charitable organizations are well-managed and regulated to further their missions. according to the urban institute, “[t]he nonprofit sector contributed an estimated $1.0472 trillion to the us economy in 2016, composing 5.6 percent of the country’s gross domestic product.”41 by far, the largest group of nonprofits are charitable organizations, according to the urban institute, making up “threequarters of revenue and expenses for the nonprofit sector as a whole ($2.04 trillion 36 trs. of dartmouth coll. v. woodward, 17 u.s. 518 (1819). 37 hackney, political justice, supra note 9, at 275. 38 id. at 284–87. 39 id. 40 id. 41 nccs project team, the nonprofit sector in brief 2019, urban institute, https://urbaninstitute .github.io/nccs-legacy/briefs/sector-brief-2019 [perma.cc/c596-l2nl]. 2024] keep charitable oversight 139 and $1.94 trillion, respectively) and just under two-thirds of the nonprofit sector's total assets ($3.79 trillion).”42 the charitable sector has grown over the past twenty years. over 1.80 million tax-exempt entities were registered with the irs in 2022.43 of those, charities comprised 1.48 million.44 comparatively, in 2002 there were 1.58 million tax-exempt entities registered with the irs and approximately 909,574 charities.45 in 2022, organizations filed over 131,000 applications with the irs to be recognized as charities under the code,46 while in 2002, organizations filed over 79,000 applications.47 in 2012, tax-exempt entities filed around 1.4 million returns, while in 2022, they filed around 1.8 million returns.48 one other note from this data is that there is great variation in the size of the charitable sector in the different states. tax-exempt organizations in california made over 185,000 returns, for instance, while in wyoming, tax-exempt entities filed only around 4,000.49 most nonprofits are small. according to irs statistics,50 in 2016, about twothirds of nonprofits had less than $500,000 in expenses.51 because the irs does not require returns from small organizations, that percentage is a significant understatement of small organizations. according to the urban sector, in 2016 human services charities were the most numerous, making up over 35% of the charity population.52 the next most numerous were education at over 17% and health-focused charities at over 12%.53 arts organizations make up about 10% and religious organizations a bit over 6%.54 these numbers only paint a small part of the picture of the charitable sector. hospitals, which make up about 2% of charities in number, earned over $1 trillion in revenue in 2016, making up about half of the revenue of the charitable sector.55 higher education generated about $226 billion in revenue, while human services brought in about $243 billion.56 arts organizations earned around $40 billion in revenue.57 approximately $400 billion of charitable revenue comes from charitable contributions. churches and religious organizations receive almost a third of that 42 id. 43 i.r.s., 2022 data book 30 tbl.14 (2022) [hereinafter 2022 data book]. 44 id. 45 i.r.s., 2002 data book 30 tbl.22 (2002). 46 2022 data book, supra note 43, at 28 tbl.12. 47 i.r.s., 2002 data book 29 tbl.21 (2002). 48 2022 data book, supra note 43, at 4 tbl.2; i.r.s., 2012 data book 4 tbl.2 (2012) [hereinafter 2012 data book]. 49 2012 data book, supra note 48, at 7 tbl.3. 50 irs data is not a perfect picture of the sector. churches, for instance, are not required to file a return (i.r.c. § 6033(a)(3)(a)(i)), and there is little data on the smallest of organizations, with annual gross profits under $50,000. see 2022 data book, supra note 43, at 7 tbl.3; i.r.s., annual electronic filing requirement for small exempt organizations — form 990-n (e-postcard), https:/ /www.irs.gov/charities-non-profits/annual-electronic-filing-requirement-for-small-exemptorganizations-form-990-n-e-postcard [perma.cc/pj7f-dqjk]. 51 nccs project team, supra note 41. 52 id. 53 id. 54 id. 55 id. 56 nccs project team, supra note 41. 57 id. 140 columbia journal of tax law [vol 15:2 revenue. education receives about 13%, human services about 12%, and health care a little under 10%.58 about a third of charitable revenue comes from government contracting.59 the size and diversity of charitable organizations and the complexity of the legal regime make it quite difficult to regulate the sector. as marion fremont-smith has said: “[t]here is no clear-cut body of american-law that can be called ‘the law of charity.’”60 as mentioned above, the main commonality unifying charitable law is the nondistribution constraint, which is not a strong unifying factor. the reality is that charitable law, consisting of a nondistribution constraint, charitable purpose, and fiduciary duties, is not the most salient fact for the various industries or sectors of the charitable community. for example, a hospital has a much different purpose, mode of operation, and applicable set of laws as compared to colleges and universities. these industries, in turn, face different issues from industries like primary and secondary private education or low-income housing. some charitable organizations do not fit into an industry but instead are primarily grantmaking operations, like private foundations. many of the different charitable industries have their own national organizations to which they are much more likely to pay attention than to a charitable sector defined by state and federal tax law.61 thus, though the state and federal tax law is a component of the compliance world that all charities must consider, it is not as salient to charities as focusing on the broader substantive range of industry issues. thus, the concept of charity is undefinable. the charitable sector is large, highly diverse, and complex. there are two primary legal structures through which charity is accomplished, and those two structures apply different legal standards. our process of assessing whether something is charitable or not is historically based and shaped communally. part ii(b) now turns to closely examine the two legal regimes that provide a structure for the legal carrying out of charity. b. states what does the state legal regime look like for charitable organizations? the state legal structure is directed toward ensuring the agents of the charity operate the organization for the beneficiaries and not the agents or some other constituency. while a for-profit business entity has owners with the ability and incentive to advocate and sue on the entity’s behalf to ensure its agents operate the entity properly, charitable organizations have no such constituency.62 there are no 58 id. 59 id. 60 marion r. fremont-smith, governing nonprofit organizations 19 (2008). 61 for instance, the american hospital association represents all types of hospitals, nonprofit, government, and for-profit. am. hosp. ass'n., about the aha, https://www.aha.org/about [perma.cc/sba5-ktsj]. there are a range of industry groups for colleges and universities, but the american association of colleges and universities (aac&u) is one of the major unifying groups for this sector. univ. ala. libr., higher education: organizations in higher education, https://guides.lib.ua.edu/c.php?g=842968&p=6025080 [perma.cc/4mw3-ymu2] (listing the primary industry organizations of higher education with aac&u showing more than 1,350 member institutions). 62 see, e.g., geoffrey a. manne, agency costs and the oversight of charitable organizations, 1999 wis. l. rev. 227, 227, 237 (1999). 2024] keep charitable oversight 141 shareholders. this is the nondistribution constraint in action. the states are thus left to ensure the agents (managers) are required to operate the organization for the benefit of a charitable class and not themselves. states have traditionally regulated nonprofits through state attorneys general using parens patriae power, i.e., power lodged in the king,63 to ensure the agents stay true to the charity’s mission.64 though the attorney general was once the exclusive source of enforcement in the states, there has been a move in many states to make them a little less important today, largely by increasing standing to sue.65 fremont-smith contends the courts may even have the predominant power over guidance in the area of charity law at the state level.66 indeed, at the state level, courts exercise the primary role in defining what is a charitable purpose under state law when probating a will.67 this part ii(b) focuses on (1) the creation of charitable trust law, (2) the development of charitable corporation law, (3) the role of state attorneys general in enforcing state charitable law, and (4) some of the other potential means of enforcing charitable law at the state level. nonprofit accounting literature helps set the theme for this part: because (1) beneficiaries do not control a charitable organization, and (2) there are limited market-based incentive structures to guide charitable organization agents—charitable organizations are likely more subject to agent/manager malfeasance than for-profit organizations.68 this fact drives much of the state regulatory regime. 1. charitable organization law origins charitable trust law is a significant influence on current charity law. the history of charitable trust law is important because it helps explain some of the challenges of the regulatory regime today. it originates in english common law and dates back to before the statute of uses of 1601.69 there were two primary purposes of that statute: (1) define legitimate charitable purposes, and (2) reform the administration of charity with commissioners to inquire into misuse of charitable 63 fremont-smith, supra note 60, at 301. 64 restatement (second) of trs. § 391 (am. l. inst. 1959); garry jenkins, incorporation choice, uniformity, and the reform of nonprofit state law, 41 ga. l. rev. 1113, 1128 (2007); ronald chester, improving enforcement mechanisms in the charitable sector: can increased disclosure of information be utilized effectively?, 40 new eng. l. rev. 447, 449 (2006); robert carlson & caitlin calder, protection and regulation of nonprofits and charitable assets, in state attorneys general powers and responsibilities 215 (emily myers ed., 4th ed. 2018); evelyn brody, whose public? parochialism and paternalism in state charity law enforcement, 79 ind. l.j. 937, 938 (2004). 65 mary grace blasko et al., standing to sue in the charitable sector, 28 u.s.f. l. rev. 37, 44 (1993). 66 fremont-smith, supra note 60, at 302. 67 olivier zunz, philanthropy in america: a history 65–103 (2012). 68 william r. baber et al., compensation to managers of charitable organizations: an empirical study of the role of accounting measures of program activities, 77 acct. rev. 679, 680 (2002); see also karst, supra note 16, at 436–37. 69 fishman et al., supra note 30, at 45 (citing 43 eliz. ch. 4; 5 austin w. scott & mark l. ascher, scott & ascher on trusts § 37.1.1 (5th ed. 2009)); see also fremont-smith, supra note 60, at 19–24 (discussing earlier versions of charitable trust like regimes dating back well before 1601 and connected to religious philosophy). 142 columbia journal of tax law [vol 15:2 funds.70 the statute followed an allowance by parliament in 1597 for local jurisdictions to levy taxes to take care of the poor.71 however, parliament left it to the local jurisdictions on how to take care of the poor, including through charitable provision.72 charitable trust law grew initially because it allowed private property to be held in perpetuity.73 judges developed this law by assessing charitable purposes in will contests between heirs and charitable organizations.74 in the gilded age, as wealth grew substantially, zunz describes that many of these wealthy titans looked to the courts to expand the concept of charitable.75 some of the biggest challenges those wealthy philanthropists faced were whether politics and lobbying could be a charitable purpose. the boundaries of charitable purpose began to shift to include more political activity with that effort. thus, the relationship of taxes, charity, and public provision of collective goods and services has been strong from its origin. in the american colonies, it would have been natural to adopt charitable trust law. but the original colonies mostly rejected english law when they rejected english rule.76 for instance, the colony of pennsylvania expressly rejected the statute of uses.77 charitable trust law finally became settled in the united states as a legitimate source of law when the supreme court held in vidal v. girard’s executors that even though pennsylvania had rejected the statute of uses, courts should still honor charitable bequests.78 but this legal development course in the american colonies was enough to make the charitable corporation more prominent than the charitable trust in the united states. charitable organization law is also deeply influenced by corporation law. charitable nonprofit corporations have the same legal antecedent as for-profit corporations.79 there were corporation-like entities in roman times and medieval europe to facilitate municipalities and municipality function,80 but the modern forms in the u.s. seem to have sprung more directly from colonial development companies in the sixteenth and seventeenth centuries.81 early in the united states, there was no distinction between private and public corporations.82 these corporations were churches, turnpikes, boroughs, universities, banks, insurance companies, and manufacturing operations.83 70 john p. persons et al., criteria for exemption under section 501(c)(3), in 4 research papers 1909, 1913 (1977). 71 id. 72 id. 73 fremont-smith, supra note 60, at 19. 74 zunz, supra note 67, at 76–103. 75 id. at 10–14. 76 peter d. hall, inventing the nonprofit sector 16 (1992). 77 id. at 31. 78 id. 79 philip t. hackney, what we talk about when we talk about tax-exemption, 33 va. tax rev. 114 (2013). 80 id. at 115. 81 id. at 115–16. 82 oscar handlin & mary f. handlin, origins of the american business corporation, 5 j. econ. hist. 1, 19 (1945). 83 hackney, supra note 79, at 116, 121. 2024] keep charitable oversight 143 because of these divergent legal forms, a real challenge became how to think about what restrictions are placed on the managers of a charitable corporation as compared to those on the managers of a charitable trust. early legal thought expressed that charitable corporations were formed to manage charitable trusts. nevertheless, many early courts explicitly stated that in the corporate form there was no trust but instead “an absolute gift to the corporation to be used for the purposes for which it was chartered.”84 this challenge of which rule should apply to corporate managers of charities continues today and is explored more below in the discussion of fiduciary duties. 2. state charitable law state charity law today focuses primarily on enforcing fiduciary rules on agents of charitable organizations and on ensuring fair charitable solicitation. the primary rules are found in the fiduciary duties of care and loyalty under corporate and charitable trust law.85 indeed, charitable trusts are “a fiduciary relationship with respect to property arising from a manifestation of the grantor’s intention to create it.”86 there is also often discussed a duty of obedience, though this typically has less import. as noted above, the two legal regimes of corporation and trust law utilize different standards to guide the behavior of those who control charitable organizations. though the nonprofit corporate legal structure has operated for a long time, the law has been slow to develop. as late as 1960, when for-profit corporate law was relatively well-developed, critics noted the lack of development of nonprofit corporation law with respect to fiduciary duties owed by nonprofit officers and directors.87 under the duty of care, the trustee, on the one hand, is generally held to the “prudent man rule” or “prudent investor rule” to which all trustees are held.88 it is a high standard. justice cardozo stated that a “trustee is held to something stricter than the morals of the marketplace. not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior.”89 corporate directors, on the other hand, are held to a less strict duty. though some cases have held corporate directors to the same prudent investor standard as trustees, the model nonprofit corporation act treats nonprofit corporation directors to for-profit corporate standards.90 a key case expressed the nonprofit corporate standard as the duty to “exercise ordinary and reasonable care in the performance of their duties, exhibiting honesty and good faith.”91 courts sometimes apply a prudent investor standard to 84 fremont-smith, supra note 60, at 51. 85 brody, supra note 64. 86 fishman et al., supra note 30, at 45. 87 karst, supra note 16, at 435. 88 george g. bogert et al., bogert’s the law of trusts and trustees § 394. 89 meinhard v. salmon, 249 n.y. 458, 464 (1928). 90 model nonprofit corp. act § 8.30 (am. bar ass’n 3rd ed. 2008). 91 stern v. lucy webb hayes nat’l training sch. for deaconesses, 381 f. supp. 1003, 1013 (d.d.c. 1974). forty-three states and the model nonprofit corporation act § 8.30 have adopted this general standard. fremont-smith, supra note 60, at 208. 144 columbia journal of tax law [vol 15:2 the managers of a nonprofit corporation if they believe a contribution created a charitable trust within the corporation.92 the nonprofit corporate standard is akin to the forgiving business judgment rule in the for-profit context and is typically called the best judgment rule.93 the idea imbued within the corporate standard is that if a director has properly informed themselves of the relevant information and attended meetings before making a decision, their judgment will be upheld. in other words, a court will not second guess a director’s decision, even if it seems unwise in hindsight. courts apply the standard inconsistently. for instance, in litigation over fiduciary duties of charitable nonprofits, courts sometimes find that because most directors are engaged in a voluntary act, they owe no fiduciary duty.94 this reflects an important, relatively widespread vision held of enforcement in the charitable sector. there is a fear that “aggressive attempts to enforce their [trustee] responsibilities are inappropriate and will discourage individuals from board service.”95 in the end, the nonprofit corporation standard may be, in part, a compromise between camps that might hold directors to a higher standard and those who would hold them to no standard at all. trustees and directors also must abide by a duty of loyalty. in a noncharitable trust, the duty of loyalty runs to the beneficiary. however, in a charitable trust, because there is no specific beneficiary, that duty runs to furthering the particular purpose of the trust.96 it is a particularly strict duty that prevents any selfdealing between the trust and the trustee; the trustee may not, for instance, sell property from the trust to themselves or borrow from the trust.97 often, in the trust form, this duty can be waived in part by the settlor, the court, or by statute. most nonprofit corporate acts also impose a duty of loyalty.98 but in the nonprofit corporation, the focus is typically on whether the transaction was fair. most nonprofit acts create a regime in which a director needs to disclose a conflict if one exists, abstain from voting on the matter, and the transaction must ultimately be fair to the corporation.99 whether the corporate duty of loyalty is complied with is often seen as procedural today. if the director discloses the conflict and removes themselves from voting on the matter, the director will typically have met the duty of loyalty. the duty of obedience focuses on ensuring that the directors or trustees carry out the purposes of the charity.100 this is anchored in the concept that a trustee is supposed to follow the wishes of the settlor.101 in modern corporate structures with many varied interests involved with large charities it is hard to figure out where that duty of obedience might lie. it has more meaning in a narrow context of a very clear settlor intent. 92 george g. bogert et al., supra note 88, at § 369. 93 fishman et al., supra note 30, at 137. 94 see, e.g., george pepperdine found. v. pepperdine, 126 cal. app. 2d 154 (1954). 95 fishman et al., supra note 30, at 127. 96 george g. bogert et al., supra note 88, at § 369. 97 id.; see also restatement (third) of trs. § 78 (am. l. inst. 2023). 98 model nonprofit corp. act §§ 8.31, 8.33, 8.60, 8.70 (am. bar ass’n 3rd ed. 2008). 99 id. 100 brody, supra note 64, at 960. 101 scott & ascher, supra note 69, § 2.2.4. 2024] keep charitable oversight 145 obviously, states also care about misuse of charitable funds, and so they care about the fraudulent raising of those funds.102 thus, states also oversee charitable solicitation.103 initially, municipalities oversaw charitable solicitation.104 states did not begin to become involved in charitable solicitation regulation until after world war ii. though not all states have fundraising laws, most states have some sort of registration and reporting requirements.105 there are many holes in these laws; the supreme court has interpreted the first amendment broadly to generally allow solicitation.106 still, because it is fairly complex to raise money from contributors from more than one state, there is a uniform registration statement that can be used across many jurisdictions.107 finally, importantly in understanding the regulatory environment to charity, charitable status at the federal level is often used by states as a factor in granting rights and opportunities. while much of the development of state charitable law consists of rules to ensure charities are well managed, legislative bodies at the state, municipal, and local government levels regularly enact laws unrelated to charitable state law that strongly incentivize the use of charitable organizations. for instance, some states provide significant tax credits for contributions made to private nonprofit charitable schools.108 state and local governments also enact laws that allow only official charitable organizations to carry out certain activities or to contract with the state to provide certain services. thus, state and local governments create high stakes around obtaining charitable status in the first place. these statebased rules and systems create high-powered incentives that increase the desire to utilize a charitable organization to carry out various activities. 3. state enforcement what does state enforcement look like? states tend to provide meager resources to regulate the charitable sector.109 with the exception of states like california, massachusetts, and new york, the vast majority of states are lucky if they have one person dedicated to regulating charitable organizations.110 some speculate this choice to provide limited regulation has its origins in the fact that nonprofits are often thought to “do good,” so the state should have less concern about abuse of these organizations.111 there is a fear expressed that greater regulation of nonprofits would lead to less charitable giving, fewer board members 102 see fishman et al., supra note 30, at 219–20 (listing some high-profile fraudulent raising of charitable funds). 103 lloyd h. mayer, regulating charitable crowdfunding, 97 ind. l.j. 1375, 1402 (2022). 104 fremont-smith, supra note 60, at 370. 105 mayer, supra note 103, at 1403; susan gary, regulating the management of charities: trust law, corporate law, and tax law, 21 u. haw. l. rev. 593, 621 (1999). 106 fremont-smith, supra note 60, at 370–72. 107 see the unified registration statement, the multi-state filer project, http://multistatefilin g.org/ [perma.cc/ctf2-4nx3]. 108 katherine h. scott, is private school tuition tax deductible?, u.s. news (sept. 10, 2021), https://www.usnews.com/education/k12/articles/is-private-school-tuition-tax-deductible [perma.cc /uf3n-uxjw]. 109 jenkins, supra note 64, at 1113; see also, mary g. blasko et al., supra note 65, at 48; karst, supra note 16, at 437 (noting in 1960 the lack of attorney general oversight). 110 jenkins, supra note 64, at 1128. 111 fremont-smith, supra note 60, at 2. 146 columbia journal of tax law [vol 15:2 willing to serve, and ultimately less “good” done.112 but there is also a political aspect to these decisions: it can be unwise politically for an elected attorney general to go after a politically protected charity and it may be politically wise for that attorney general to go after a politically unpopular charity.113 it is possible that our records of enforcement are incomplete because attorney generals often enter settlement agreements to protect the parties involved.114 still, the scholarship and the news leave one with the impression that the regulation at the state level is woefully inadequate, even in states where there is a stronger presence. what about other potential enforcement mechanisms of charitable duties under state law? beneficiaries could theoretically enforce the law. however, while a key feature of private trusts is that the trustee must provide information to the beneficiary and the beneficiary can sue to enforce the trust,115 in the charitable context, courts rarely allow a beneficiary standing to enforce fiduciary duties of directors or trustees.116 donors could also enforce duties. but donors generally do not have standing unless they reserved such a right in the instrument making the donation.117 as terri lynn helge points out, typically, donors do not reserve such a right in the instrument because they would forgo the ability to deduct the contribution from taxes if they did.118 founders and settlors of trusts (a very specific type of donor) could enforce charitable duties, but typically states do not allow such enforcement either.119 the power of visitation in some states allows the founder of a trust to enforce some aspects of administration.120 karst argues for allowing founders and substantial donors to sue and collect attorney’s fees and some of the recovery.121 some states have moved to allow such an interest.122 however, these donors tend to enforce only the terms of their donation rather than broadly attack violations of fiduciary duties.123 finally, trustees and directors are possible enforcers of fiduciary duties. some states allow trustees and directors to enforce fiduciary duties against other trustees and directors.124 but, this is no real protection as boards are often filled with self-interested individuals; acquaintances rarely work to enforce fiduciary duties.125 while the state attorney general has been the traditional and almost only enforcer, state law has increased private rights of action consistent with some of the 112 chester, supra note 64, at 452–53. 113 brody, supra note 64, at 947–48. 114 id. at 948–49. 115 gary, supra note 105, at 603–04. 116 id. at 616. 117 restatement (second) of trs. § 391 cmt. e (am. l. inst. 1959). 118 helge, supra note 1, at 42 (citations omitted). 119 see karst, supra note 16, at 445–47 (discussing ways to hinder problematic suits such as requiring a certain level of donation to bring a suit and adopting strike suit type protections such as posting security before beginning the case). 120 id. at 446; fremont-smith, supra note 60, at 338. 121 see karst, supra note 16, at 445–47. 122 edward c. halbach, jr., standing to enforce trusts: renewing and expanding professor gaubatz’s 1984 discussion of settlor enforcement, 62 u. miami l. rev. 713, 725 n.65 (2007) (stating “[m]ost prominent is unif. trust code (§ 405(c)) (amended 2005), 7c u.l.a. 486 (2006))”). 123 helge, supra note 1, at 45. 124 gary, supra note 105, at 625. 125 see karst, supra note 16, at 445. 2024] keep charitable oversight 147 ideas above. the attorney general in some states, like california, can appoint a “relator” who can pursue an action against officers and directors at their own cost. that said, the attorney general in california can take over from the relator at any time.126 it remains, though, that critics of charitable regulation are quite unsatisfied with state-level regulation. though, as discussed below in part iii(a), some have suggested that charity boards at the state level might improve state regulation, most have concluded that a larger federal presence is required to provide the oversight needed for a more effective charitable sector. regulation of charity is not happening at the state level, and it is unlikely to ever happen at a satisfactory level in the states. there are too many forces working against a functional regulatory system in the states. c. federal government/irs when congress enacted the income tax in 1913, a new potential regulator of the nonprofit sector was born.127 the sector was likely too small then to warrant such an effort. in fact, probably one of the main reasons for exempting this group of potential taxpayers was that it was small and did not generate much revenue at the time—for instance, hospitals were not yet a substantial presence.128 under these circumstances, congress exempted nonprofit corporations and associations exclusively organized and operated for charitable purposes from the income tax.129 this designation created a latent regulatory regime. as the irs issued guidance and examined the sector, and courts ruled upon irs decisions, a federal tax legal regime of a charitable organization organically took shape. there was little reason to believe the irs would fill a more significant regulatory role until 1969, when congress implemented a requirement that most charities must register with the irs.130 congress has promulgated much additional charitable organization legislation since then, and the irs and treasury department have now issued extensive guidance defining charitable organizations. though section 501(c)(3) does not extend to the irs the requirement to oversee fiduciary duties like at the state level, this part ii(c) considers some of the efforts by congress and the irs to 126 helge, supra note 1, at 47. 127 tariff act of 1913, ch. 16, 38 stat. 114, 172 (“any corporation or association organized and operated exclusively for religious, charitable, scientific, or educational purposes, no part of the net income of which inures to the benefit of any private stockholder or individual”). actually, the exemption came in the 1909 corporate excise tax. tariff act of 1909, ch. 6, 36 stat. 11, 113. there congress exempted from the corporate excise tax, the precursor to the modern income tax, corporations or associations “organized and operated exclusively for religious, charitable, or educational purposes, no part of the net income of which inures to the benefit of any private stockholder or individual.” 128 hall, supra note 76, at 13 (noting that there were only 12,500 charitable tax-exempt organizations in 1940 and that most of the growth of the large sector he observed in 1992 occurred starting in the 1960s). 129 tariff act of 1913, ch. 16, 38 stat. 114, 172. congress had also exempted nonprofits in the income tax enacted during the civil war and in the income tax enacted in the 1890s that the court struck down. hackney, supra note 79, at 117–20. 130 i.r.c. § 508. there was a sense that the irs mattered as a check upon wealthy family foundations because of the possibility that the irs might audit them. karst, supra note 16, at 442. 148 columbia journal of tax law [vol 15:2 extend jurisdiction over some fiduciary duty-like rules. the section 4958 tax on excess benefit transactions is an example.131 congress more recently placed taxes and regulatory systems on specific types of charitable organizations, such as donor advised funds and credit counseling organizations, including upon the governance of those organizations.132 in an effort to bring greater transparency and democratic control over charities, congress requires that charities provide information returns (the form 990) to the irs that are made public.133 thus the irs regulates nonprofits both by the law it enforces, the rules it promulgates, and the disclosure system that it oversees. this part ii(c) reviews the federal tax law regime that applies to charities more closely. 1. federal charity tax law the tax law rules focus first and foremost on ensuring that a charitable organization is operated to further a charitable purpose. under section 501(c)(3), a charitable organization must be “organized and operated exclusively” for a charitable purpose.134 the notion of charitable purpose is derived directly from charitable trust law.135 for example, irs guidance regarding hospitals holds that the promotion of health is a charitable purpose under the tax law because it is such a purpose under charitable trust law.136 this same idea repeats in other areas of charitable purposes such as educational,137 religious, scientific, sometimes the environment,138 poverty relief, and so on. though charitable purpose as a matter of united states law was once a question of probate, it is most publicly salient today as a matter of federal income tax law.139 in regulating charitable purposes, the irs must determine how much charity an organization must further to be considered charitable under section 501(c)(3). congress provides that a charity must be “organized and operated exclusively” for charitable purposes.140 though “exclusively” sounds absolute, a charitable organization is allowed to further non-substantial purposes other than its charitable purpose. the supreme court has held that “an organization must be devoted to [its exempt] purposes exclusively . . . . the presence of a single non-[exempt] purpose, 131 i.r.c. § 4958. 132 i.r.c. §§ 4966, 501(q). 133 i.r.c. § 6033. 134 i.r.c. § 501(c)(3). 135 bob jones univ. v. united states, 461 u.s. 574, 588 n.12 (1983) (“the form and history of the charitable exemption and deduction sections of the various income tax acts reveal that congress was guided by the common law of charitable trusts.”); see also treas. reg. § 1.501(c)(3)-1(d)(2) (stating that charitable purpose is “used . . . in its generally accepted legal sense”). 136 rev. rul. 69-545, 1969-2 c.b. 117 (“in the general law of charity, the promotion of health is considered to be a charitable purpose;” (citing restatement (second) of trs. §§ 368, 372 (am. l. inst. 1959); iv scott on trusts (3rd ed. 1967), §§ 368, 372.)). 137 treas. reg. § 1.501(c)(3)-1(d)(2) (as amended in 2017); rev. rul. 71-447, 1971-2 c.b. 230, 230; see also treas. reg. § 1.501(c)(3)-1(d)(3) (as amended in 2017). 138 see, e.g., rev. rul. 76-204, 1976-1 c.b. 152. 139 sometimes state property tax regimes or state constitutions are used to exclude hospitals from the notion of charitable. see, e.g., bruce japsen, state challenging hospitals’ tax exemptions, ny times (sep. 10, 2011), https://www.nytimes.com/2011/09/11/us/11cnchospitals.html [perma.cc/ 3qer-x8qa]. but not all states have a property tax, and there is no uniform approach to charitable purpose across states. 140 i.r.c. § 501(c)(3) (emphasis added). 2024] keep charitable oversight 149 if substantial in nature, will destroy the exemption regardless of the number or importance of truly [exempt] purposes.”141 thus, a charity may legitimately pay an employee to carry out a charitable task even though it also accomplishes the selfish ends of the employee. the non-exempt purpose in that case would not be substantial. though there are two tests inherent within section 501(c)(3)—the organizational and the operational tests—this article focuses on the operational test. treasury regulations state that this requirement is met if the organization engages “primarily in activities which accomplish” an exempt purpose.142 but the regulations further state, “[a]n organization will not be so regarded if more than an insubstantial part of its activities is not in furtherance of an exempt purpose.”143 congress assigns one other fundamental rule to the irs in its regulation of the charitable sector: the prohibition on inurement.144 in order to qualify as a charitable organization, an entity may not distribute the organization’s earnings to a “private shareholder or individual.”145 this includes anyone “having a personal and private interest in the activities of the organization.”146 paying reasonable salaries to executives does not violate the inurement prohibition.147 the prohibition, though, is an absolute: if one penny is found to have inured, the organization is in violation.148 this is the “nondistribution constraint” discussed above in part ii(a). there is little corollary to a prohibition on inurement at state law level enforcement. it is true that state law generally prohibits a nonprofit corporation from having shareholders, but there is no systematic process for rooting out such noncompliant corporations at state law. courts, together with the irs, have developed additional doctrines imposing limits on charity. this article focuses on the private benefit doctrine and the commerciality doctrine. the question both theories raise is whether the private benefit or the commerciality of a charity evinces a substantial nonexempt purpose such that the organization does not meet the operational test. fishman, schwarz, and mayer suggest that the core of the income tax private benefit doctrine is from charitable trust law requiring that a trust “must benefit a sufficiently large and indefinite charitable class” rather than further the interests of some specific private individuals.149 treasury regulations provide the strongest guidance support for the doctrine by providing that a charitable organization must serve “a public rather than a private interest.”150 thus, a nonprofit created to dredge a waterway that fronted the same property as its donors 141 better bus. bureau of wash. d.c. v. united states, 326 u.s. 279, 283 (1945). 142 treas. reg. § 1.501(c)(3)-1(c)(1) (emphasis added). 143 id. 144 i.r.c. § 501(c)(3). 145 treas. reg. §§ 1.501(c)(3)-1(c)(2), 1.501(a)-1(c) (defining private shareholder or individual). 146 treas. reg. § 1.501(a)–1(c). 147 founding church of scientology v. united states, 412 f.2d 1197, 1200 (ct. cl. 1969); cf. bubbling well church of universal love v. comm’r, 670 f.2d 104, 105 (9th cir. 1981) (a finding of an excessive salary supports a case of inurement). 148 church of scientology of cal. v. comm’r, 823 f.2d 1310, 1316 (9th cir. 1987). 149 fishman et al., supra note 30, at 430. the doctrine has other critics as well; see, e.g., john d. colombo, in search of private benefit, 58 fla. l. rev. 1063 (2006). 150 treas. reg. § 1.501(c)(3)-1(d)(1)(ii). 150 columbia journal of tax law [vol 15:2 did not qualify for exemption because it served the private benefit of the donors and did not provide enough public benefit.151 the irs used the private benefit doctrine in part in rev. rul. 69-545 setting the standards for hospitals when it focused on a bad hospital that was controlled by doctors who operated the facility to enrich themselves.152 the capstone case today of private benefit is american campaign academy v. commissioner where the court upheld an irs denial of an educational organization designed to educate only potential gop candidates because it served the private benefit of the republican party.153 whether an organization has too much private benefit is determined under the operational test, and the question is whether the activity involved evinces a substantial nonexempt purpose. the challenge of this doctrine is the lack of clarity in determining how much private benefit is enough to become substantial.154 the difference between inurement and private benefit is that inurement is focused on benefits provided to those who control the organization, while private benefit focuses upon benefits provided to persons who do not necessarily control the organization. the commerciality doctrine applies when a charity is operated more like a for-profit business than a charitable one.155 in goldsboro, the u.s. tax court stated that it considers factors such as “the particular manner in which an organization’s activities are conducted, the commercial hue of these activities, and the existence and amount of profit from these activities.”156 in bsw group, inc., the court agreed with the irs that the petitioner’s activity amounted to “the conduct of a consulting business of the sort which is ordinarily carried on by commercial ventures organized for profit.”157 any organization which is found to have a substantial commercial purpose will not qualify as charitable. there are also important ancillary legal requirements of the charity tax law regime. these include a prohibition on intervening in a political campaign, a limitation on lobbying, and a public policy limitation. each of these has a state law charitable trust conception from which it arose, but these doctrines are each ultimately very specific to tax law regulation of charity. though engaging in politics in most cases is not considered to further a charitable purpose under charitable trust law,158 in the 1950s congress added to section 501(c)(3) an absolute prohibition on “participat[ing] in, or interven[ing] in . . . any political campaign on behalf of (or in opposition to) any candidate for public office.”159 often referred to as the “johnson amendment” because lyndon b. 151 ginsberg v. comm’r, 46 t.c. 47 (1966). 152 see also i.r.s. gen. couns. mem. 39,682 (sep. 14, 1987) (arguing that there was inurement associated with doctors purchasing the revenue from a surgery center, but that it also evidenced too much private benefit). 153 am. campaign acad. v. comm’r, 92 t.c. 1053 (1989). 154 see colombo, supra note 149 (criticizing the vague way the irs uses the private benefit doctrine). 155 w. marshall sanders, the commerciality doctrine is alive and well, 16 tax’n exempts 209, 209 (2005); see also goldsboro art league v. comm’r, 75 t.c. 337 (1980). 156 goldsboro art league, 75 t.c. at 344. 157 bsw grp., inc. v. comm’r, 70 t.c. 352, 358 (1978). 158 cf. laura b. chisholm, politics and charity: a proposal for peaceful coexistence, 58 geo. wash. l. rev. 308, 314–15 (1990); see also jane h. mavity & paul n. ylvisaker, private philanthropy and public affairs, in 2 research papers 795 (1977). 159 internal revenue code of 1954, pub. l. no. 83-591, § 501(c)(3), 68a stat. 1, 163. 2024] keep charitable oversight 151 johnson was a proponent of the legislation, this has been a controversial part of charity enforcement. religious groups like pulpit freedom sunday argue it violates first amendment freedom of speech and religion.160 thus far, courts have upheld the johnson amendment.161 though controversial, in addition to a link to charitable trust law, the limitation has a real link to income tax policy. congress prohibits the deduction of expenses for political campaigns and lobbying.162 this policy emanates from a policy position that the country ought to be neutral fiscally as to political campaigns.163 were congress to allow charities to intervene in political campaigns, it would make this neutrality policy an impossibility. someone who wanted to deduct a political campaign contribution would need only make the contribution to a charitable organization. the lobbying limitation raises similar constitutional issues as does the political campaign prohibition. it provides that “no substantial part of the activities” of a charity can consist in “carrying on propaganda, or otherwise attempting, to influence legislation.”164 the focus of this limitation is on limiting the charity from advocating before legislative bodies either in a direct manner or in an indirect manner, such as through grassroots lobbying.165 the limitation has early beginnings. in 1930, judge hand in slee v. commissioner found that the american birth control league’s lobbying was too central to the organization and belied its charitable status.166 there is, unfortunately, little clarity on what a substantial part might look like. that said, section 501(h) provides a safe harbor to charities who make an election under that section. a charity with limited revenue might be able to spend as much as twenty percent of its revenue annually on lobbying, but most are limited to less.167 the supreme court upheld the constitutionality of the lobbying limitation in regan v. taxation with representation.168 finally, the public policy limitation holds that a charity cannot engage in illegal activity or activity that is against clearly established public policy.169 this is consistent with charitable trust law.170 the irs has to show that the illegal activity or public policy violation is a substantial purpose of the organization.171 the 160 see eugene scott, pastors take to pulpit to protest irs limits on political endorsements, cnn (oct. 1, 2016), https://www.cnn.com/2016/10/01/politics/pulpit-freedom-sunday-johnson-amend ment/index.html [perma.cc/fhk6-8e2f]; see also benjamin m. leff, fixing the johnson amendment without totally destroying it, 6 u. pa. j.l. & pub. affs. 115, 119 (2020); samuel d. brunson, dear irs, it is time to enforce the campaigning prohibition. even against churches, 87 u. colo. l. rev. 143, 145 (2016). 161 branch ministries v. rossotti, 211 f.3d 137, 143 (d.c. cir. 2000). 162 i.r.c. § 162(e) (the lobbying limitation was upheld in cammarano v. united states, 358 u. s. 498, 513 (1959)). 163 notably though, contributions to veteran’s organizations under section 501(c)(19) are deductible from the federal income tax, and there is no similar limitation. i.r.c. § 170. 164 i.r.c. § 501(c)(3). 165 treas. reg. § 1.501(c)(3)-1(c)(3). 166 slee v. comm’r, 42 f.2d 184 (2d cir. 1930). 167 i.r.c. § 501(h). 168 regan v. tax’n with representation, 461 u.s. 540 (1983). 169 rev. rul. 71-447; bob jones univ. v. united states, 461 u.s. 574 (1983). 170 bob jones univ., 461 u.s. 574. 171 see, e.g., i.r.s. gen. couns. mem. 34,631 (october 4, 1971) (“to determine when disqualifying activities are present to a ‘significant extent’ (that is, when they become ‘substantial’), more must be considered than the ratio they bear to activities in furtherance of exempt purposes.”). 152 columbia journal of tax law [vol 15:2 supreme court upheld a public policy violation in the case of race-based discrimination in bob jones.172 the biggest challenge for the irs in enforcing this provision is probably whether the irs has the competency to determine if an organization has violated a fundamental public policy. that challenge extends to whether the irs can act on the illegality of a charity without an agency with competency on the legal matter at issue first acting upon the violation.173 in 1969, congress added provisions to charity regulation that took aim at abuses they saw coming from wealthy individuals and their private charities or private foundations.174 after years of congressional concern of misuse and abuse of charitable organizations to further the interests of wealthy americans, congress finally acted in a strict rule-based manner to hinder the worst abuses of what are known as private foundations.175 the tax reform act of 1969 created a significant divide between what are known as public charities and private foundations.176 private foundations are charities from whom the majority of their funds derive from one donor or one family.177 public charities, on the other hand, are substantial institutions like churches, universities, hospitals, and other organizations that get broad financial support from the public.178 congress adopted a strict charitable trust regime rule for the self-dealing acts of private foundations insiders, intending to generally prohibit such acts altogether.179 concerned that wealthy interests might just park assets in an entity without delivering actual money to charity, congress required private foundations to generally spend about 5% of their assets per year on furthering charitable purposes.180 the regime prohibits jeopardizing investments181 and requires private foundations to limit the amount of ownership the charity holds of any one stock to no more than twenty percent or face an excise tax on excess business holdings.182 in a symposium reviewing that legislation in 2019, the general consensus was that, though the legislation likely made some improvements on abuse, there is a need for a new architecture to regulate the charitable world of today.183 172 id. 173 jean wright & jay h. rotz, illegality and public policy considerations, i.r.s. eo cpe text (1994). 174 tax reform act of 1969, pub. l. no. 91-172, 83 stat. 487. 175 james fishman, the private foundation rules at fifty: how did we get them and do they meet current needs?, 17 pitt. tax rev. 247 (2020). 176 i.r.c. § 509; see also aprill, supra note 1, at 301 (discussing the historical derivation of the private foundation distinction including 1950s legislation imposing a self-dealing regime similar to today’s section 4958 intermediate sanctions regime that applies to public charities today (revenue act of 1950, pub. l. no. 81-814, 64 stat. 906, 947)). 177 see i.r.c. §§ 170 & 509. 178 id. 179 i.r.c. § 4941. 180 i.r.c. § 4942. 181 i.r.c. § 4944. 182 i.r.c. § 4943. 183 philip hackney, the 1969 tax reform act and charities: fifty years later, 17 pitt. tax rev. 235 (2020) (providing an introduction and description of the findings of the articles in the symposium). 2024] keep charitable oversight 153 that leaves one additional general subject matter—tax provisions that put to the irs oversight of some fiduciary duty-like rules. much of the private foundation regime just discussed utilizes some of the strict fiduciary duty rules that apply to charitable trusts, such as strict prohibitions on self-dealing.184 this effectively adopts the strict charitable trust fiduciary duty of loyalty in tax law. congress also applies to public charities an excise tax under section 4958, often referred to as intermediate sanctions, that also looks like a fiduciary duty of loyalty.185 there is an element of a duty of care implicit in the excise tax as well. in 1996, in the taxpayer bill of rights ii, congress enacted this excess benefit excise tax; it applies to the individuals who have control over a charitable organization.186 critics had long complained that the irs had only one tool in its toolbox when charity managers engaged in inurement—revocation of the exempt status of the organization.187 the irs rarely made this choice because it would penalize the beneficiaries rather than the bad managers who should be held to account. the excess benefit regime applies a twenty-five percent tax on what is known as an excess benefit taken by a disqualified person.188 a disqualified person is one of the people who have control over the charity, such as the officers, directors and substantial contributors.189 the excess benefit is an amount that the disqualified person received from the charity to which they were not entitled.190 for instance, assume an executive director provided $100,000 worth of services to a charity. assume further that the charity pays the executive director $200,000 under these circumstances. in such a case, there would be an excess benefit of $100,000. the regime calls for the disqualified person to pay an excise tax of twenty-five percent of the amount involved and to also repay the amount. if the disqualified person does not pay the tax back within a particular time, the excise tax is increased to 200% of the amount involved.191 the excess benefit regulations are highly detailed.192 as noted above, the tax plays a similar role to the state law fiduciary duty of loyalty.193 arguably it may help go after fraudulent charitable solicitation as well.194 a comparison of these 184 i.r.c. § 4941. 185 i.r.c. § 4958. 186 pub. l. no. 104-168, 110 stat. 1452, 1475 (1996) (codified as amended at i.r.c. § 4958 (2000)); the rule also applies to i.r.c. § 501(c)(4) social welfare organizations. 187 federal tax laws applicable to the activities of tax-exempt charitable organizations: hearing before the subcomm. on oversight of the h. comm. on ways & means, 103rd cong. 39 (1993). 188 i.r.c. § 4958. 189 id. 190 id. 191 id. 192 26 c.f.r. 53.495-1 to -8. 193 see carly b. eisenberg & kevin outterson, agents without principles: regulating the duty of loyalty for nonprofit corporations through intermediate sanctions tax regulations, 5 j. bus. entrepreneurship & l. 243, 244 (2012) (stating “[w]hile state charitable trust law typically enforced by the state attorney general is one mechanism of protection, the federal government is the primary enforcer of the duty of loyalty for tax-exempt corporations.”). 194 james j. fishman, who can regulate fraudulent charitable solicitation, 13 pitt. tax rev. 1, 2 (2015) (arguing that the irs should use section 4958 to attack such solicitation and that congress also ought to change the excise tax to make it a more useful tool for such oversight). 154 columbia journal of tax law [vol 15:2 excess benefit rules with the delaware corporate law fiduciary duty of loyalty suggests the tax rule is stricter and encompasses many more people as potential insiders.195 though some thought the rule might curb rising nonprofit salaries, it has not accomplished that goal.196 the irs rarely invokes the rule. the rule’s failure might be because excess benefit transactions are hard to find or prove. regardless, it has not been a particularly effective provision.197 it fails to provide any content for how a charity might establish a system to avoid such a situation. since 2000, congress has made many additions to the charitable tax law. most of these changes have targeted specific charitable sectors or activities. for instance, in 2005, congress added an excise tax on tax-exempt entities entering prohibited tax shelters.198 in 2006, in the pension protection act, congress added a range of new rules to apply to donor-advised funds, supporting organizations, and credit counseling organizations.199 the donor-advised fund legislation took aim at sponsoring organizations allowing individual donors to direct charitable dollars in donor-advised funds back to the donors.200 congress enacted an excise tax that prohibits such personal transfers through dafs.201 congress tried to also shut down abuses by supporting organizations, a type of organization that allows a charity that primarily derived its funds from one family to be considered a public charity because it is watched over closely by an actual public charity. it directed the irs to promulgate regulations ensuring a stronger relationship between the supporting organization and its supported organization and applied some excise taxes to insider abuses of the supporting organization.202 congress also looked to shut down abuses by credit counseling organizations that appeared to be behaving in predatory ways while ostensibly counseling those in debt about how to get out of debt. the legislation prohibits credit counseling organizations from making loans, requires them to design products that do not abuse their customers with significant fees, and (adopting a governance rule) mandates that they adopt a broadly representative board.203 in the affordable care act, congress added more rules regarding hospitals. congress focused on ensuring that hospitals adopt financial assistance policies easily accessible to patients and that hospitals conduct and publish a health needs assessment.204 so, rather than focusing on the sector as a whole, congress in 195 manne, supra note 62, at 270. 196 jill manny, nonprofit payments to insiders and outsiders: is the sky the limit? 76 fordham l. rev. 735, 736 (2007). 197 see, e.g., carraci v. comm’r, 456 f.3d 444 (5th cir. 2006) (rejecting irs evaluation of value of excess benefit in sale of home health care agency by insiders of a nonprofit to themselves) 198 tax increase prevention and reconciliation act of 2005, pub. l. no. 109-222, § 516, 120 stat. 345, 368 (enacting i.r.c. § 4965). 199 pension protection act of 2006, pub. l. no. 109-280, 120 stat. 780. 200 panel on the nonprofit sector, strengthening transparency governance accountability of charitable organizations: a final report to congress and the nonprofit sector, issue lab 39 (2005). 201 i.r.c. § 4967. 202 §§ 1241(d) & 1242, 120 stat. at 1103 (§ 1242 codified additions to i.r.c. § 4958(f) applicable to supporting organizations). 203 § 1220, 120 stat. at 1086 (codifying i.r.c. § 501(q)). 204 i.r.c. § 501(r). 2024] keep charitable oversight 155 piecemeal began to attack places where it saw abuses. some of those rules mandate specific behavior and often these rules adopt governance related rules. in addition to substantive law, the tax information return of charities, the form 990, plays a crucial role in the charity tax regulatory regime.205 it serves both as an enforcement tool for the irs and as a tool of democratic governance-like accountability.206 starting in 1942 for tax years ending in 1941, many charities have had the obligation to file an information return called the form 990.207 these were made available to the public in 1950 though access was not easy to come by originally.208 in 1969, congress held a hearing on the importance to public accountability of having greater public access to the form 990.209 congress made these forms more accessible in 1996.210 commentators at the time were hopeful that this public access would bring about a significant improvement in charity oversight.211 though not a panacea, this information has become a significant part of oversight of the sector, particularly, with broad access to the form 990 data via the irs, guidestar, and propublica. with the recent move to make the data more electronically accessible, it is likely that this form will become more important to broad public oversight.212 2. irs enforcement when congress enacted the tax reform act of 1969, many had big hopes for the irs to be the important regulator of the charitable sector on the national level. the commissioner then committed to reviewing the tax-exempt status of all private foundations every five years.213 that commitment was short-lived as the irs could not maintain that even into the 1970s.214 as detailed by commentators, congress has failed to dedicate the resources needed for oversight of the charitable sector.215 according to the congressional budget office (“cbo”), the irs budget fell by 20% in real (inflation-adjusted) dollars between 2010 and 2018.216 this lack of investment in the irs led to a 22% decrease in employees. this resulted in a 205 26 u.s.c. § 6033; 26 c.f.r. § 1.6033-2. 206 philip hackney, dark money darker? irs shutters collection of donor data, 25 fla. tax rev. 140 (2021). 207 t.d. 5125, 1942-1 c.b. 101, 102. 208 revenue act of 1950, pub. l. no. 81-814, § 341, 64 stat. 960 (enacting i.r.c. § 153(c)). 209 tax reform: hearing before the h. comm. on ways & means, 91st cong. 12 (1969). 210 see taxpayer bill of rights 2, pub. l. no. 104-168, 110 stat. 1452 (1996). 211 gary, supra note 105, at 620–21. 212 husam abu-khadra & david olsen, toward automating shredding nonprofit xml files: the case of irs form 990 data, 37 j. info. syst. 169, 171 (2023) (discussing access to form 990 data, demonstrating how to convert irs data into a searchable format and noting how charities since july 1, 2019, are now required by the taxpayer first act to file electronically.). 213 ginsburg et al., supra note 7, at 2585. 214 owens, supra note 1, at 2. 215 see mayer, supra note 1. 216 cong. budget off., trends in the internal revenue service’s funding and enforcement, 1 (2020). i have recounted some of the following information associated with infra. notes 215–226 in testimony before u.s. congress. see laws and enforcement governing the political activities of tax-exempt entities: hearing before subcomm. on tax’n and irs oversight of the s. comm. on fin. (2022) (testimony of philip hackney). 156 columbia journal of tax law [vol 15:2 30% decline in enforcement employees.217 irs data books show the irs went from over 94,000 full time equivalent (“ftes”) employees in fy 2010 to 73,554 ftes in fy 2019.218 the irs’s tax-exempt organization group became almost a shell of its former self. the irs’s exempt organization workforce shrank from 889 ftes in 2010 to around 550 ftes in fy 2019.219 congress recently increased the budget for the irs, but it is not clear that those dollars will find their way to the exempt organization group.220 the exempt organizations group of the irs operates an application system called the determinations process, and an examination program, i.e., the auditing process. in determinations, annual applications for exempt status have increased significantly, but annual rejections have gone down.221 in fy 2019, the irs reviewed over 101,000 applications for exempt status, it rejected only 66 of those applications.222 comparatively, in fy 2010, the irs reviewed over 65,000 of such applications and rejected 517.223 when looking at examinations, the irs had about a 0.38% examination rate in 2010.224 tigta counted the examination rate in 2019 at 0.13%.225 it is hard to prove that this lack of resources has led to consistent oversight failures.226 the irs has rarely found significant noncompliance among charitable organizations.227 still, anecdotal evidence based on following the news suggests that something is wrong,228 and prominent groups say there are problems. for 217 cong. budget off., supra note 216. 218 i.r.s., data book, 74 tbl. 31 (2019), https://www.irs.gov/pub/irs-prior/p55b--2020.pdf [hereinafter 2019 data book]; i.r.s., data book, 66 tbl. 29 (2010), https://www.irs.gov/pub/irssoi/10databk.pdf [hereinafter 2010 data book]. 219 i.r.s. tax-exempt & governmental entities div., fiscal year 2019 accomplishments letter (2020), https://www.irs.gov/pub/irs-prior/p5329--2019.pdf [perma.cc/2gtt-xjux]. 220 council of econ. advisors, empowering the irs: understanding the full potential of the inflation reduction act’s historic investment in the internal revenue service (feb. 8, 2024) (discussing the $80 billion investment in the irs budget) https://www.white house.gov/cea/written-materials/2024/02/08/empowering-the-irs-understanding-the-full-potentialof-the-inflation-reduction-acts-historic-investment-in-the-internal-revenue-service/#:~:text=the% 20inflation%20reduction%20act%20provided,by%20the%20wealthiest%20tax%20evaders [perma.cc/w3al-d9mb]. 221 philip hackney, the real irs scandal has more to do with budget cuts than bias, the conversation (apr. 15, 2018), https://theconversation.com/the-real-irs-scandal-has-more-to-dowith-budget-cuts-than-bias-95026 [perma.cc/fnl9-5xd3]. 222 2019 data book, supra note 218, at 27 tbl. 12. 223 2010 data book, supra note 218, at 56 tbl. 24. 224 id. at 33 tbl. 13. 225 treasury inspector gen. for tax admin., obstacles exist in detecting noncompliance of tax-exempt organizations, 6 (feb. 17, 2021), https://www.oversight.gov /sites/default/files/oig-reports/tigta/202110013fr.pdf. 226 see, e.g., fremont-smith, supra note 60, at 13. 227 see generally mayer, supra note 1, at 94–96. in a hospital study and in a colleges and university study, the irs found little major noncompliance. i.r.s. exempt org., hospital compliance project, final rep. (2014); i.r.s. exempt org., colleges and universities compliance project, final rep. 2–6 (2013). 228 the author weekly receives multiple inquiries from reporters about misuse of charities and nonprofits generally. while writing this, the national rifle association was found by a jury to have 2024] keep charitable oversight 157 instance, the national taxpayer advocate in 2012 highlighted in the title of a part of its report: “overextended irs resources and irs errors in the automatic revocation and reinstatement process are burdening tax-exempt organizations.”229 the taxpayer advocate has continued to note this decline in irs resources generally in its 2015230 and 2016231 reports. the panel on the nonprofit sector reviewed the sector in 2005 and found that while there was wide compliance in the charitable sector, there were ways in which the sector could be improved.232 it provided a list of recommendations to the irs and to congress to ensure better compliance.233 to conclude, the irs became a regulator of nonprofits because of the enactment of the federal income tax. this brought about improvements in charity oversight. perhaps the most significant addition is the development of what is a charitable purpose and transparent information made publicly available regarding these organizations through the form 990. but the irs never became the robust regulator of the sector some hoped it would become. it is not on the beat, stopping bad acts as they happen, and even the enforcement that does happen is so sporadic as to call into question whether its enforcement effort has much effect at all. various scholars have highlighted the ways in which they perceived that the irs simply is not up to the task of ensuring a strong compliant charitable sector.234 more concerning, congress has disinvested in the irs, leading to a workforce that is not up to the task of regulating the sector. 3. other regulators this final part ii(d) considers a range of other sources of oversight of the sector including some governmental agencies, potential self-regulatory bodies, and the press. as already established, there is no explicit regulator of charitable activity, but a number of federal agencies beyond the irs oversee some of the activity engaged in by nonprofits. the government accounting office (gao) in a 2002 report identified five federal agencies with some oversight of the sector: federal bureau of investigation (fbi), federal emergency management association (fema), federal trade commission (ftc), united states postal inspection mismanaged its finances. meredith deliso et al., jury finds nra liable for mismanagement, says wayne lapierre violated duties, abc news (feb. 23, 2024) https://abcnews.go.com/us/juryfinds-nra-liable-mismanagement-wayne-lapierre-violated/story?id=107269909 [perma.cc/7u9b-p yjc]. 229 nat’l taxpayer advoc., 2012 annual report to congress 15 (2012), https://www.taxpay eradvocate.irs.gov/reports/2012-annual-report-to-congress/full-report/. 230 nat’l taxpayer advoc., 2015 annual report to congress 12 (2015), https://www.taxpayeradvocate.irs.gov/wp-content/uploads/2020/08/arc15_volume1.pdf. 231 nat’l taxpayer advoc., 2016 annual report to congress 3–4 (2016), https://www.taxpayeradvocate.irs.gov/wp-content/uploads/2020/08/arc16_volume1.pdf. 232 panel on the nonprofit sector, supra note 200. 233 nat’l taxpayer advoc., supra note 229, at 15. 234 see, e.g., roger colinvaux, charity in the 21st century: tending towards decay, 11 fla. tax rev. 1 (2011); marion fremont-smith & andras kosaras, wrongdoing by officers and directors of charities: a survey of press reports 1995-2002, 42 exempt org. tax rev. 25 (2003); mark sidel, the guardians guarding themselves: a comparative perspective on nonprofit selfregulation, 80 chi.-kent l. rev. 803, 804–07 (2005). 158 columbia journal of tax law [vol 15:2 service (uspis) and office of personnel management (opm).235 of these, none of them has substantial jurisdiction over charities. the fbi has no charity division but encounters charities in telemarketing and mail fraud, as well as international charities engaged in terrorism.236 the other agency with not insignificant jurisdiction would be the ftc, which is engaged in overseeing consumer protection associated with charitable solicitation but only by for-profit organizations, not by charities.237 but the government regulates charities more than the gao report would suggest. various industries have distinct federal and state regulators to oversee the activity of those types of charities. though it does not strictly regulate charities, the u.s. department of education is extensively involved in overseeing elementary and secondary education,238 as well as higher education.239 of course, state and local governments are engaged in that regulation as well. hospitals, which make up over half of the revenue of the charitable sector, as noted above in part ii(a), are overseen by the department of health and human services, as well as state authorities involved in administering medicare and medicaid. and there are many other sub-fields, like low-income housing that have federal and state regulators— such as the u.s. department of housing and urban development (hud).240 finally, governments enter contracts with charitable organizations to deliver certain services—medicare being a prime example. many have worked toward creating a self-regulatory regime of some sort. after the filer commission report recommended a quasi-governmental regulator, the independent sector formed in 1980 as a merger of two nonprofits.241 the group set out to be the spokesperson for the sector and has made strides toward that, but its membership is only a small slice of the entire sector.242 it has issued its principles for good governance243 which originated as a code of ethics in the 1990s.244 other national organizations include board source, national council of nonprofit organizations, and the urban institute on nonprofits and philanthropy.245 but there is nothing close to a national leader of the entire sector that can command the attention of a large segment of charities to claim an ability to drive the behavior of charities. again, there are industry-specific trade associations like the american 235 u.s. gov't accountability off., gao-02-526, tax-exempt organizations: improvements possible in public, irs, and state oversight of charities 69–71 (2002). 236 id. at 69. 237 fremont-smith, supra note 60, at 424. 238 u.s. dep’t. of educ., an overview of the u.s. department of education (sep. 2010), https:// www2.ed.gov/about/overview/focus/what.html [perma.cc/6nak-algc]. 239 u.s. dep’t. of educ., negotiated rulemaking for higher education 2023-2024, https://ww w2.ed.gov/policy/highered/reg/hearulemaking/2023/index.html [perma.cc/n63m-ezqc]. 240 see, e.g., off. of pol’y dev. & rsch., low-income housing tax credit (lihtc), u.s. dep’t of hous. & urban dev., https://www.huduser.gov/portal/datasets/lihtc.html [perma.cc/cqb8ade7]. 241 fremont-smith, supra note 60, at 466. 242 id. 243 independent sector, principles for good governance and ethical practice: a guide for charities and foundations (2d ed. 2015) (the author was a member of the advisory committee that participated in creating the second edition of these principles). 244 fremont-smith, supra note 60, at 467. 245 id. 2024] keep charitable oversight 159 hospital association and the american association of colleges and universities that command substantial attention of the sub-sector of charities such as hospitals and colleges and universities. congress and states provide a range of means for other groups to potentially hold nonprofits accountable. congress requires the public disclosure of forms 990. some have written about the potential for cyber-accountability because of the access to such information.246 the press makes use of this extensive information, but understanding it calls for expertise in law and accounting. guidestar used to be the main source of access to this data electronically but others like propublica have moved into the space to serve as an accountability agent.247 nevertheless, there are only so many stories that can be written, and if there is no regulator to back up and enforce the rules, the press effort can only go so far. still, the press has been an important force in regulating charity. thus, there are a handful of agencies that have jurisdiction over charity. we should not forget those. indeed, at times, the primary regulator of hospitals or universities is likely more significant to those industries than the irs or state charity aspect of their operation. the fact that congress has made form 990s available has been a success story in regulation in part. the press has used this information. but it is difficult to use it as it requires expert knowledge to interpret what is going on. iii. proposals to remove charitable oversight there is no shortage of concern regarding the regulation of charity. it is cogently expressed through studies, reports, and proposals to solve the problem. in just recent history, senator grassley, in the mid-2000s, pushed the senate finance committee to explore a range of solutions to charity regulation including publishing a discussion draft of some potential solutions.248 before these more recent efforts, long and intense work went into thinking through issues of charity to support the enactment of the 1969 tax reform act249 that transformed charity regulation at the irs. leading up to that act, the treasury department conducted a significant study on wealth and charitable tax benefits that it published in 1965 where it made recommendations on private philanthropy.250 in the mid-1970s, the privately created filer commission published a study considering federal oversight of charity.251 the authors concluded that the irs should continue to be the federal regulator of choice,252 but it also prominently discussed another group studying the 246 caroline k. craig, the internet brings ‘cyber-accountability’ to the nonprofit sector, 13 j. tax’n ex. org. 82 (2001); see also evelyn brody, sunshine and shadows on charity governance: public disclosure as a regulatory tool, 12 fla. tax rev. 183 (2012). 247 andrea suozzo et al., nonprofit explorer, propublica, https://projects.propublica.org/nonprof its/. 248 staff of the joint comm. on taxation, 108th cong., tax exempt governance proposals: staff discussion draft (2004). 249 fishman, supra note 175. 250 staff of s. comm. on fin., 89th cong., treasury dep’t rep. on priv. founds. (comm. print 1965). 251 ginsburg et al., supra note 7. 252 id. at 2578. 160 columbia journal of tax law [vol 15:2 issue that recommended the creation of a new federal agency to oversee charity.253 the solutions over time have been quite varied and include public and private and state and federal approaches as well as relatively simple fixes to wholesale removal. this part iii considers some of those efforts. a. some state and federal recommendations for modest change scholars have discussed the need for significant improvement of charitable regulation for a long time. some of the efforts are state-focused. in 1960, before the reform to the irs in 1969, karst proposed a state board of private charities to regulate charities like the english model, which employs a charity commission.254 jim fishman argued in 1985 for an expanded use of relator status to allow private modes of enforcement given the anemic enforcement by attorneys general in most states.255 in an effort to modify the law but continue to use the same structure generally, deborah demott argued in the early 1990s that the trend to adopt duty of loyalty standards of for-profit corporations where conflicts can be easily waived was a mistake.256 some state-level suggestions have focused on transparency. evelyn brody, for instance, encouraged states to consider publicly reporting about their enforcement activity such as had been done in part by the pennsylvania and massachusetts attorneys general.257 manne argued for creating private for-profit monitoring companies.258 in a federally focused fiduciary duty governance-based proposal, henry hansmann, in the early 1980s, suggested extending a strict prohibition on selfdealing for all charities between a director and the nonprofit they govern.259 peter swords encouraged improved reporting on form 990s.260 indeed, some of those suggestions came to fruition when the irs revised its reporting, and congress made more reporting on forms 990 available. congress also made it easier for the irs to share enforcement information with state enforcers. in the 2000s, national charitable associations and state enforcement agencies led discussions focused on whether sarbanes-oxley-type reforms could help improve the behavior of managers of charity.261 running with the sarbanes-oxley requirement of independent audit committees, advocates and politicians proposed requiring 253 id. at 2640 (citing, inter alia, discussion by sheldon cohen, thomas a. troyer, marion r. fremont-smith, and john nolan, ultimately published as public supervision of philanthropy and charity, can it be improved?, nonprofit report (december 1973 & january 1974)). 254 karst, supra note 16, at 476–83. 255 james j. fishman, the development of nonprofit corporation law and an agenda for reform, 34 emory l.j. 617, 673–74 (1985). gary, supra note 105, at 647 (making a similar argument). 256 deborah a. demott, self-dealing transactions in nonprofit corporations, 59 brook. l. rev. 131, 137–43 (1993). 257 brody, supra note 64, at 949. 258 manne, supra note 62. 259 henry b. hansmann, reforming nonprofit corporation law, 129 u. pa. l. rev. 497, 569 (1981) 260 peter swords, the form 990 as an accountability tool for 501(c)(3) nonprofits, 51 tax law. 571 (1998). 261 chester, supra note 64, at 461; ellen p. aprill, what critiques of sarbanes-oxley can teach about regulation of nonprofit governance, 76 fordham l. rev. 765 (2007). sarbanes-oxley (sox) act of 2002, pub. l. no. 107-204, 116 stat. 745 (codified in scattered sections of 11, 15, 18, 28, 29 u.s.c.). 2024] keep charitable oversight 161 nonprofits of a certain size to obtain an independent audit.262 some of the same groups proposed another requirement—having a cpa sign off on the internal controls of the nonprofit—and though there was some support, others were concerned it would be too costly for smaller nonprofits.263 like many in the corporate world,264 a number of nonprofit leaders rejected the idea of the federal government entering into the field of governance that they believed was dedicated to, and the proper domain of, the states.265 in 2010, lloyd mayer and brendan wilson utilized an institutional choice analysis to consider the best regulator of charity. the two concluded that regulation of the charitable sector would be most aided by relying upon state agencies connected but independent of the attorney general of each state.266 they start from the premise that there is “relative consensus regarding the goal of ensuring compliance by charity directors, trustees, and officers with their generally agreed upon fiduciary duties.”267 based on this, they do not focus their institutional choice analysis upon goal choice but only the choice of institution.268 an independent state agency then performs well as states clearly have more authority in the field of charity law than would a new federal entity outside of the irs.269 furthermore, they take the position that the irs does not have authority to do much in the way of governance and, therefore, has no expertise in the space of governance.270 some of these proposals have been enacted in various ways at the state level and at the federal level. nevertheless, there continues to be a deep level of dissatisfaction with charity regulation at the state level. b. remove from the irs/create a new national agency some critics frustrated with both state and irs regulation of charity propose removing charity regulation from the irs and creating a new national agency to enforce charitable law. some of these critics simply suggest it is time to begin seriously considering removal/new agency creation. others say it is time and have made proposals for the creation of federal agencies with varying levels of independence from the federal government. 262 aprill, supra note 261, at 771 (discussing a senate finance white paper, panel on the nonprofit sector, and california's nonprofit integrity act all requiring audits for organizations with annual gross revenues of some amount); staff of s. fin. comm., 108th cong., staff discussion draft 9 (2004); panel on the nonprofit sector, supra note 200, at 35; cal. gov’t code § 12586(e) (west 2022). 263 aprill, supra note 261, at 774–75. 264 id. at 780. 265 see, e.g., panel on the nonprofit sector, strengthening transparency governance accountability of charitable organizations: a supplement to the final report to congress and the nonprofit sector 28 (2006) (explicitly stating “congress should not expand the equity powers or jurisdiction of the tax court over charitable fiduciaries”); see also aprill, supra note 261, at 785 (noting the potential issue with the constitutionality of extending such jurisdiction to the irs or to the tax court). 266 lloyd h. mayer & brendan m. wilson, regulating charities in the twenty-first century: an institutional choice analysis, 85 chi.-kent l. rev. 479, 514–15 (2010). 267 id. at 505. 268 id. 269 id. at 521. 270 id. at 522. cf., aprill, supra note 261, at 792. 162 columbia journal of tax law [vol 15:2 the idea of a new federal regulatory agency is not new. as noted above, the filer commission considered but rejected one such proposal.271 in the late 1990s, joel fleishman proposed a new federal agency, but only if a couple of other proposals were tried and did not work.272 fleishman, inspired in part by the fact that irs charity enforcement was underfunded in the 1990s,273 argued that the nonprofit accountability enforcement mechanisms were not working.274 he argued first for a self-regulatory regime. to fleishman, the nonprofit sector should voluntarily join with groups like independent sector, the council on foundations, and other similar organizations, to create enforcement mechanisms.275 at the same time, he argued that these groups should work directly with state attorneys general to improve charity enforcement.276 additionally, fleishman argued congress ought to try to get more resources to the irs for proper enforcement. failing that, fleishman believed we should consider a federal charities commission.277 were we starting from scratch, fleishman says he would propose an sec like solution. since that is not an option, he argued instead for maintaining significant control at the irs. ultimately, his federal charities commission would be a separate independent agency, perhaps housed within the sec, that has control over matters not directly given to the irs and, therefore, focused more on fiduciary duty functions.278 marcus owens, who served as the division director of exempt organizations at the irs for ten years,279 argues for the formation of a new quasipublic agency modeled on finra.280 owens contends that the irs is not the ideal institution for the regulation of charity. he points to many factors, including: (a) inadequate funding, (b) civil service constraints, (c) institutional constraints (irs is focused on tax-collecting), and (d) irs anomalies (enforcement based on tax returns and tax privacy).281 to owens, the irs is set up to collect tax and not to regulate. any actions the irs might take against an errant nonprofit are based on a tax return that is not filed until well after the fact of the actions that an organization takes that might be problematic.282 according to owens, even if the irs determines that a nonprofit has behaved badly, its ability to share this information with state authorities, though better today, is still clumsy at best.283 owens is also concerned about the lack of ability of a wide range of interest groups to be at the legislative 271 ginsburg et. al., supra note 7. 272 joel l. fleishman, public trust in not-for-profit organizations and the need for regulatory reform, in philanthropy and the nonprofit sector in a changing america 172 (charles t. clotfelter & thomas ehrlich eds., 1999). 273 id. at 182 (citing james t. mcgovern & phil brand, ep/eo – one of the most innovative and efficient functions within the irs, 97 tax notes today 164 (1997)). 274 id. at 185. 275 id. at 186. 276 id. at 186–87. 277 id. at 188–89. 278 id. 279 loeb & loeb llp, marcus s. owens, https://www.loeb.com/en/people/o/owens-marcussherman [perma.cc/8uy2-67kq]. 280 owens, supra note 1. 281 id. at 4–6. 282 id. at 6. 283 id. 2024] keep charitable oversight 163 table to be involved in the making of charity tax law.284 the expertise needed to comment upon tax law needlessly hinders some who might reasonably want to comment upon charitable legislation from engaging in the process. owens recognizes that some may be concerned about the charitable sector regulating itself. he thus makes the case for why and when self-regulation makes sense. the advantages he sees are primarily knowledge regarding the charitable universe—knowledge of rules that will be effective, knowledge of the likely harms, and knowledge of situations where the harm is likely to fall on the participants themselves anyway.285 owens argues that the charitable sector is like the securities sector because group member behavior affects others in the group in both sectors.286 sometimes also, members are engaged in joint projects and the entire community has an interest in “common rules in the interest of ensuring a level playing field.”287 finally, for both the securities sector and the charitable sector, the success of the sectors depends upon the public perceiving the sectors as well-regulated. owens recommends adopting an institutional structure like the financial industry regulatory authority (finra)288 or the public company accounting oversight board (pcaob).289 finra derives its legal authorization from the securities and exchange act of 1934 which requires securities dealers to be members of a self-regulated organization (sro) as either an exchange or a larger group like finra. the sro must prove to the securities exchange commission (sec) that it can enforce its rules and those of the 1934 act.290 owens believes that finra has the ability to avoid the worst aspects of conflicts that an sro typically faces, while at the same time, its institutional structure provides a significant opportunity for the regulated group to be an important participant in the creation of the rules by which they must live.291 furthermore, finra is not confined by civil service regulations because it is not considered to be the government.292 congress created the pcaob as a part of the sarbanes oxley act of 2002 primarily to oversee the audits of public companies. it is effectively a public company accounting sro. but it is different from finra in that it does not have a competitor, so there is no market for lower fees or lesser regulation from another exchange, and its members are all chosen by the sec rather than in part from industry.293 284 id. at 8 (discussing the lack of representatives from all sectors of charity as the senate created the nonprofit legislation that became a part of the pension protection act). 285 id. at 10. 286 id. 287 id. 288 carrie johnson, sec approves one watchdog for brokers big and small, wash. post (july 27, 2007) https://www.washingtonpost.com/wp-dyn/content/article/2007/07/27/ar200707270010 8_pf.html [perma.cc/5nqm-d3um]. 289 auditing the auditors: creating the public company accounting oversight board, sec. & exchange com. historical society, https://www.sechistorical.org/museum/galleries/pcaob/ [perma.cc/8e9n-5sar]. 290 owens, supra note 1, at 13. 291 id. 292 id. at 14. 293 id. at 15. 164 columbia journal of tax law [vol 15:2 owens proposes congress adopt a charity oversight board (“cob”) with some elements of both finra and the pcaob.294 to be an organization recognized as exempt from tax under section 501(c)(3), the organization would need to be a member in good standing of the cob.295 membership would be composed of seven industry directors, seven irs-appointed directors, and seven independent directors.296 though a challenge would be determining its rulemaking jurisdiction, owens suggests congress grant it jurisdiction to enforce core charity tax law rules.297 the irs would have the final say both about rules and enforcement, though. for owens, a key feature of the cob would be its ability to timely enforce the law outside the tax return process.298 the entity would be funded primarily by fees for being members of the cob on a sliding scale and some by payments for services or actions. owens suggests that this arrangement would avoid some of the big problems with irs regulation detailed above.299 terri lynn helge comes to a similar conclusion as owens. consistent with the discussion in part ii, helge describes oversight of the charitable sector as too minimal because of significant bureaucratic constraints placed on both the irs and attorneys general.300 she argues that this causes harm to an important sector of our economy and that we need to make a change.301 she notes that there are “forty [state charity] jurisdictions that do not require annual reporting from non-soliciting charities . . . and thus cannot discern breaches of fiduciary duties from a substantial majority of charitable organizations.”302 in other words, there are many jurisdictions into which an unscrupulous nonprofit could operate undetected by the local jurisdiction. thus, a change is needed. helge joins owens in arguing for a federal overseer of the charitable sector. she argues though, that it should be more independent than owens’s suggestion of an sro.303 she proposes a federal charity oversight board (fcob) that would be more like the pcaob than finra, the model to which owens hews closer. congress would be the overseer of this fcob.304 the membership of the governing body would broadly represent the interests of the sector, including donors and members who operate different types of charitable organizations. however, a majority of the board would be composed of members of the government that oversee the sector.305 this board would likewise be funded by requiring all charities to be members and to pay a fee on a sliding scale. helge’s board would replace the irs in overseeing charitable tax law, though the irs would retain jurisdiction over tax matters such as charitable contributions, employment tax, unrelated business 294 id. at 18. 295 owens, supra note 1, at 13. 296 id. 297 id. at 20. 298 id. at 22. 299 id. at 24–26. 300 helge, supra note 1. 301 id. at 7–8. 302 id. at 14–15. 303 id. at 70. 304 id. at 70. 305 helge, supra note 1, at 71. 2024] keep charitable oversight 165 income tax, etc. finally, it would have the authority to promulgate regulations and guidance.306 mayer, who previously suggested state oversight enhancement, now believes it might be better to move enforcement out of the irs and to another federal regulatory body.307 he thinks that the recent failures of the irs mean that it is time to seriously begin to consider the alternatives. he also notes that given the size of the nonprofit sector as compared to all other taxpayers it would be unlikely, and likely untenable, for the irs ever to dedicate the type of resources that are needed to regulate the sector.308 ellen aprill, too, has concluded that it is time to consider alternatives to the irs.309 at this point, some critical voices within the charitable sphere have spoken regarding what is perceived as a broken system of charitable regulation that needs to be revamped. additionally, many critics express a complete lack of confidence today that the irs can be reformed to regulate the charitable sector well. iv. analysis this part iv evaluates whether oversight of charities would be better removed from the irs, or if the function should remain within. first, this part iv evaluates the most salient recent history, raising the question of whether the irs is capable of being a major regulator of charity. second, it evaluates goals that we might be aiming toward when we discuss charity regulation in as broad a sense as possible to ground the analysis. without the big picture, we can miss some goals that might be inherent in the entirety of the system but that are missing when we just think about charity oversight itself. third, this part iv evaluates the challenges to the various regulatory state and federal solutions and how those match up against the goals we ostensibly seek. finally, it considers the removal solution. fundamentally, this analysis concludes that it is best, even if not perfect, to keep charity regulation in the irs. it contends that those arguing for removal are devaluing several factors. the charity regulation we know today is both created by and structured in response to the strong incentives created by the income tax as well as the benefits that come from obtaining tax-exempt status with the irs. removing the irs from regulation will create significant tax and political activity shelters. it would also make it more likely that charity, a major part of civil society, would be more likely to be captured problematically by the economic order. though it may not be intuitive, irs regulation is the most likely institution to maintain a separateness between the state, civil society, and the economic order. additionally, it is highly unlikely that the states would be willing to turn nonprofit governance over to the federal government. furthermore, the charitable sector does not have enough in common among its different sectors to find a coalition to support national governance standards. finally, those who propose another agency must assume that with a new agency, our government or the charitable sector will commit more resources to the regulation of charity. i believe this assumption is wrong. 306 id. at 78. 307 mayer, supra note 1, at 121. 308 id. at 98. 309 aprill, supra note 1, at 336–37. 166 columbia journal of tax law [vol 15:2 a. recent history highlighting a challenged irs as demonstrated above in part ii, neither state attorneys general nor the irs have the resources or the mettle to regulate the sprawling charitable sector. because it informs the more recent calls for removal, in this part iv(a), i keep in mind the public situations where irs actions most significantly caused its critics to question its capacity to be the regulator of charity. though many crises have come before,310 there really is one key matter that began to seriously turn the tide in the evaluation of the irs as a regulator of the sector. in 2013, the treasury inspector general concluded that the irs failed in the tea party matter for three reasons: 1) it picked organizations for scrutiny based on names, 2) it found many questions the irs asked were improper, and 3) the length of delays the irs put these organizations through was unacceptable.311 this set off a political firestorm and arguably led to the irs being underfunded for about a decade. in a previous article, i found the inspector general’s claim that the irs could not use names as an enforcement tool without merit.312 still, the irs had no procedure in place detailing how to handle applications of organizations associated with one another through ideological ties. this left the irs bereft of defenses in response to claims that it acted in a biased manner. additionally, the irs seemed confused and paralyzed by a lack of clarity in the law it was trying to enforce on section 501(c)(4) organizations.313 this led to the irs unfairly taking much too long to make determinations on applications. this controversy still resonates today very strongly among many conservatives as an indication that the irs is run by individuals who are ideologically minded and not interested in enforcing the rule of law. no investigations corroborated this claim, but the belief remains.314 under any circumstances, the incident painted the portrait of an agency overwhelmed with workload, incompetent at times, and plodding in its enforcement of the law. the perception is now that the irs does not have the capacity or the interest to enforce these laws and that it actively avoids handling these matters. given the challenges exposed in the tea party controversy, the irs adjusted its operations. it adopted a much-criticized form 1023-ez to eliminate its backlog of applications and to, it claimed, focus its human resources on audits instead.315 it has also tried to pick certain sectors of the charitable sector to focus enforcement upon.316 because the irs does not have the human resources to actually review the 310 see, e.g., staff of the joint comm. on taxation, 107th cong., report of investigation of allegations relating to internal revenue service handling of tax-exempt organization matters (2000). 311 treasury inspector gen. for tax admin., inappropriate criteria were used to identify tax exempt applications for review, no. 2013-10-053, at 7 (may 14, 2013). 312 hackney, supra note 2. 313 id. 314 treasury inspector gen. for tax admin., review of selected criteria used to identify tax-exempt applications for review, no. 2017-10-054 (september 28, 2017) (finding no intentional efforts by the irs to act in a biased manner); see also, s. rep. no. 114-119 (2015). 315 see terri l. helge, rejecting charity: why the irs denies tax exemption to 501(c)(3) applicants, 14 pitt. tax rev. 1 (2016) (discussing the irs’s reasons for adopting the form and critiquing that choice). 316 see, e.g., i.r.s. exempt org., supra note 227. 2024] keep charitable oversight 167 significant number of applications it receives annually, moving to the form 1023ez made sense, even if it is far from a good solution. it acknowledges the irs’s limited resources and tries to maximize them. the taxpayer advocate has pointed to changes the irs ought to consider that could ensure a more reliable system.317 same with the focus on sectors. it allows the irs to try to make real improvements in sectors in ways that can create consistent regulatory action and ideally educates the community in important ways through the process. however, these moves are not enough to build a functional charity regulatory regime. to summarize, there have long been concerns that regulation of the charitable sector is lacking. most have given up on the states to fulfill this role and have put their trust in the irs instead. but the irs encounters significant resource constraints and role challenges. the tea party controversy highlights the real problems that can result from the irs trying to fill that role while lacking the resources and trying to fulfill at least two different functions: revenue collector and impartial regulator of nonprofits. it has significant trouble getting the law right in a timely manner and can appear in that instance to be a biased agency. the tea party episode also critically hampered the irs’s ability to collect the revenue. the gop used the episode to cut the irs budget and undermine the efforts of the agency generally. still, because of the significant tax benefits involved, it makes sense to maintain irs control of these charitable sector benefits that are primarily tax-based. congress should provide more resources to the irs for charity regulation but should simultaneously lower the burden upon the irs exempt organization group by making smart choices regarding the legal rules applicable to charitable organizations. b. what are the goals of charity regulation? this part iv(b) examines the goals of establishing and maintaining charity regulation. it starts first with a consideration of what values we should foster as we design public policy. i focus upon insuring a politically just order, meaning one that meets the general conception of a democratic order.318 utilizing those principles, it moves from big-picture conceptions of charity regulation goals to narrower ones. by big-picture, i mean to anchor into larger community goals such as a wellordered society. in other words, the system of charity is only a small part of our society, as is a system of taxation, but both systems fit into larger goals of creating a world in which all individuals feel at home in the world.319 the section then considers some narrower goals of charity regulation. this more global focus is intended to help orient a complex challenge. the discussion of the removal of charity regulation from the irs takes place in a 317 nat’l taxpayer advoc., 2015 annual report to congress, recognition as a taxexempt organization is now virtually automatic for most applicants (2015), https://www.taxpayeradvocate.irs.gov/reports/2015-annual-report-to-congress/recognition-as-a-tax -exempt-organization-is-now-virtually-automatic-for-most-applicants/ [perma.cc/4vk2-dd75]. 318 hackney, prop up, supra note 9, at 327–40 (examining why democracy is the politically just solution). 319 thomas christiano, the constitution of equality: democratic authority and its limits 61 (2008) (“the interest in being at home in the world is fundamental because it is at the heart of the well-being of each person.”). 168 columbia journal of tax law [vol 15:2 dialogue that tends to move back and forth between conceptions of state law charity regulation, in which a tax system is for the most part absent, and a taxation system, where charity fiduciary duties for the most part are absent. this movement of the discussion makes this topic of where to place charity regulation challenging to get a handle upon. 1. political justice: charity and tax in a democratic order i have previously made the case that our tax system should be designed to not hinder political justice, and ideally, it should advance political justice.320 these same principles that i explore below should apply to our charity regulation. by political justice, i mean a state that furthers democracy.321 though democracy is quite complex, i utilize an ideal model against which to evaluate the justness of a system. in its simplest, ideal, utopian sense, democracy is built on the idea that everyone is entitled to shape their own lives.322 this means with respect to any collective decision, everyone has the right to participate in creating the agenda, developing information about the decision before the group, and most importantly the right to vote on any final decision. this notion could be called political voice equality (pve).323 in this article, i try to keep in mind this drive toward political justice or pve in the regulation of charity. the ideal democratic state is a utopian vision. modern states are numerous in population, highly complex in collective decisions, and depend upon representation for actual voting on final decisions. thus, instead of the people directly engaging in deliberation, they elect representatives to represent their interests. modern states also rely upon groups that represent the interests of people in a society and to develop information and opinions to share with the state. these groups make up a part of civil society. charitable organizations fit into that mix of civil society.324 indeed, many who laud charitable organizations as a part of civil society highlight the theory of pluralism to support the sector.325 the pluralism theory recognizes the impossibility of pure democracy and finds that groups supporting citizen interests can fill that gap.326 the strongest version of pluralism 320 hackney, political justice, supra note 9. note that a democratic system and just social outcomes are not necessarily the same thing. keith dowding, are democratic and just institutions the same?, in justice and democracy: essays for brian barry 25 (keith dowding et al. eds., 2004); see also john rawls, political liberalism 13 (2005) (“a political conception [of justice] tries to elaborate a reasonable conception for the basic structure alone and involves, so far as is possible, no wider commitment to any other doctrine.”). 321 id.; see also hackney, prop up, supra note 9, at 322. others have made a similar case. see, e.g., wallace, supra note 9. 322 robert a. dahl, on political equality 4 (2006) (describing this equal value of each person as “intrinsic equality”); see also hackney, political justice, supra note 9, at 273. 323 hackney, prop up, supra note 9, at 333 (discussing “political voice equality”); see also robert a. dahl, on democracy 76 (1998) (“except on a very strong showing to the contrary in rare circumstances, protected by law, every adult subject to the laws of the state should be considered to be sufficiently well qualified to participate in the democratic process of governing that state.”). 324 hackney, supra note 10, at 698; see also skocpol, supra note 10. 325 bob jones univ. v. united states, 461 u.s. 574, 609–10 (1983) (powell, j., concurring) (explaining the "role played by tax exemptions in encouraging diverse, indeed often sharply conflicting, activities and viewpoints"); see also gardner, supra note 12; boris & maronick, supra note 12. 326 hackney, prop up, supra note 9, at 335–39. 2024] keep charitable oversight 169 suggested that any group that wanted to form could form and represent the diversity of views of citizens across the political spectrum.327 these groups could then represent the voice of something close to all citizens at some point. collective action theory, though, has significantly called that proposition into question.328 it is much harder for large groups and poorer groups to form and maintain form than it is for small and wealthy groups to form and maintain form. though the ideal conception of democracy is utopian, it is possible to make rough judgments regarding tax policy where the incentives and detriments imposed by congress through a tax system take a position that impacts political voice.329 in the case of business leagues and labor unions, congress provides an exemption from tax to each but a deduction only to business interests for payments of dues.330 both organizations are classic interest groups that advocate for their member’s interests.331 based on collective action theory and research, we know that it is much easier for business interests to form than for labor groups to form.332 still, the benefit of tax exemption and the deduction does not take this reality into effect. the tax law regime enhances business interests more. this is politically unjust because the tax law is enhancing the voice of one interest and doing very little to enhance the voice of the other—a failure of pve. congress could improve the circumstance by ending exemption and deduction associated with both. but, given the longestablished political voice inequality between business and labor, congress could justifiably maintain the exemption for labor and ensure that its members are able to deduct their dues while ending both policies for business interests.333 a greater challenge for the pve critique arises when the incentive cannot be said to directly impact the voice of interests before legislative bodies, as is the case with interest groups receiving tax benefits like business leagues and labor unions. thus, in evaluating the rationales for the exemption of social welfare organizations that are not interest groups, the question becomes modestly different.334 however, mutual benefit nonprofits like social welfare organizations are carrying out collective decisions. under democratic theory there should be some connection between the decision-making and a democratic process.335 given the lack of clarity in the law and irs guidance and a process lacking in transparency i recommended that either congress provide more clarity as to which organizations qualify or end exemption for the vague social welfare category.336 thus, if we want to make dental insurance available through tax-exempt means, congress ought to specify exactly what type of insurance such organizations need to provide rather 327 see philip hackney, taxing the unheavenly chorus: why section 501(c)(6) trade associations are undeserving of tax-exempt status, 92 den. l. rev. 265, 275 (2015). 328 see id. at 274–87. 329 hackney, prop up, supra note 9, at 340. 330 see id.; hackney, supra note 327. 331 john r. wright, interest groups and congress: lobbying, contributions, and influence 22–23 (1996). 332 hackney, prop up, supra note 9, at 342–51. 333 see id. at 377–82. 334 hackney, political justice, supra note 9, at 276. 335 id. 336 id. 170 columbia journal of tax law [vol 15:2 than have the irs loosely accept any health-related insurer into the tax-exempt club.337 in examining charitable organizations, congress and the irs provide more clarity and direction as compared to social welfare organizations. however, charitable organizations are more richly rewarded with subsidies and are still carrying out collective decisions, some of which ought to be made through a democratic process or at least be highly determined and conscribed at the legislative level. as the collective decision involved gets closer to a matter that ought to be determined by a democratic process, political justice as a value is more and more implicated. for instance, primary and secondary education ought to be democratically determined.338 thus, congress should require charitable charter schools to be more linked to democratic processes.339 with these principles in mind, how should we think about the merits of political justice as it applies to the regulation of charity? first, all charity is engaged in providing collective goods and services that the state has failed to provide. it is reasonable to expect that these decisions ought to be made through some democratic procedure. thus, it is reasonable to consider how charity is regulated by using a political justice lens. there are a number of factors to evaluate: (1) are there incentives or detriments imposed by the government dependent upon the behavior or purpose of an organization? (2) if there are incentives provided, who in society has access to them, and does the regulation of those incentives have an impact on how those benefits are allocated? (3) are the organizations involved a part of civil society? (4) what is the ideal relationship in a democratic sense between the state and the charitable organizations? (5) how transparent is the governmental regulatory system that makes determination and enforcement decisions? (6) does the system adopted ensure the collection of revenue needed to support the state? 2. factors to consider regarding charitable regulation what incentives or detriments does our system of government provide to or place upon charitable organizations? as discussed in part ii, both the federal government and state and local governments provide a range of incentives and impose some detriments upon charitable organizations. charities receive a wide range of exemptions from federal, state, and local taxes. the two most substantial exemptions are likely the exemption from the federal income tax340 and the exemption from state and local property tax. there is debate about whether the exemption from the federal income tax is a subsidy,341 but many, including the supreme court, treat it as such.342 the subsidy is equal to the current corporate tax rate (21% currently)343 times the earnings exempted from taxation. as a direct result of gaining charitable status, charities obtain the benefit of the charitable 337 id. at 323. 338 hackney, supra note 10. 339 id. 340 i.r.c. § 501(a) & (c)(3). 341 daniel halperin, is income tax exemption for charities a subsidy?, 64 tax l. rev. 283, 284 (2011); see also ellen p. aprill & lloyd h. mayer, tax-exemption is not a subsidy – except for when it is, 172 tax notes fed. 1887 (sept. 20, 2021). 342 regan v. tax’n with representation of wash., 461 u.s. 540, 544 (1983). 343 i.r.c. § 11. 2024] keep charitable oversight 171 contribution deduction, which is potentially deductible from the federal income, gift, and estate taxes by the donor.344 this benefit is considered to be a subsidy, though the income tax subsidy is only available to a small cohort of high-income earners today, perhaps around 9% of federal income tax filers.345 this benefit is thus available almost exclusively to top-income earners. local property tax exemptions result in significant amounts of forgone tax revenue that state and local authorities fight over with hospitals and other charities relatively often.346 there is a debate as well regarding whether exemption from property tax is a subsidy or is simply part of the base.347 but it is hard to understand what theory justifies the granting of large property tax exemptions to organizations like hospitals and universities. there are numerous other benefits,348 including the ability to issue taxexempt bonds.349 these benefits primarily turn upon whether an organization meets the requirements to further a charitable purpose under section 501(c)(3) of the code. who has access to these benefits? anyone can form a section 501(c)(3) charitable organization, and they can be formed to further any purpose that is charitable. nevertheless, because of the complexity of forming and operating a charitable organization, access to these benefits likely accrues in much greater amounts to those who are educated and those with wealth.350 as noted above, the charitable contribution deduction is almost exclusively available to high-income and wealthy individuals. because of a generous standard deduction, only about 9% of taxpayers have the itemized deductions necessary to allow them to make use of the charitable contribution deduction.351 the federal gift352 and estate tax353 also provides charitable contribution deductions.354 an individual generally has to have in the tens of millions of dollars of wealth in order to be subject to those taxes in the first place. while low-income individuals are sometimes beneficiaries of direct charity, they are not the primary beneficiaries of these organizations. higher education, hospitals, and churches are some of the largest parts of the charitable sector, and each of these often benefits middle-class and very wealthy individuals. 344 i.r.c. §§ 170, 2055, & 2522. 345 hackney, supra note 10, at 771; see also tax pol’y ctr., briefing book: how did the tcja affect incentives for charitable giving? 342–345. 346 fishman et al., supra note 30, at 411–15 (discussing the battles over property tax exemptions). 347 evelyn brody, legal theories of tax exemption: a sovereignty perspective, in property-tax exemption for charities: mapping the battlefield 149–51 (evelyn brody ed., 2002). 348 see bazil facchina et al., privileges & (and) exemptions enjoyed by nonprofit organizations, 28 u.s.f. l. rev. 85 (1993). 349 i.r.c. § 145. 350 this gets into the incidence of the benefit, which is hard to assess. some poor beneficiaries surely obtain some of the benefit of exemptions and deductions but given the size of hospitals and universities and the individuals to whom they cater it is highly unlikely that the benefits accrue in even modest amount to low-income or even middle-income individuals. 351 congress raised the standard deduction in the 2017 tax act, sec. 11021, pub. l. 115-97 (dec. 22, 2017). the tax policy center for instance estimates that it reduced the number of households deducting their charitable contributions from 21% of households to about 9% of households. tax pol’y ctr supra note 345. 352 i.r.c. § 2501. 353 i.r.c. § 2001. 354 i.r.c. §§ 2522, 2055. 172 columbia journal of tax law [vol 15:2 are these groups part of civil society? charities are absolutely a part of the groups that make up civil society.355 “[c]ivil society consists of associations and institutions that facilitate the formation of public opinions in spaces located outside of the for-profit or governmental sectors.”356 civil society is at its strongest when allowing citizens to generate ideas of the good to further through government and to bring that information to legislators for hopeful enactment. it tends to also be a major protector of our civic freedoms like that of speech and association. charitable groups arguably go beyond civil society when they directly carry out activities that we might think of as governmental, which ought to have the “buy-in” of society generally. what relationship is ideal between charity and the state? as part of civil society, the relationship of charity to the government is necessarily both a tense and a supportive one. it is tense in the sense that charities exist outside the state and serve to generate ideas and solve problems outside the state. in that sense, charity as civil society can be perceived as a threat to those who currently control the state.357 like the separation of church and state, we also want a separation of civil society and state. civil society most powerfully supports the state as an independent force and as a check on its excesses. the challenge is that there can never be a complete separation between the two. they are necessarily intertwined in many ways already discussed above. also, in the tense sense, we do not want to allow charity as civil society to dominate the government. this is the fear of interest groups as the dominator of the common good of the united states identified and evaluated by james madison in federalist 10 as “faction.”358 faction recognizes that interest groups can have selfish interests and might come to dominate a political body in a harmful way by overriding the common interests of the community.359 but, equally important, we do not want a civil society controlled by economic power.360 capture by the state or economic power renders civil society’s protection of freedom of speech and association defective. all that said, civil society can also be quite supportive of the state by developing and bringing to the state important information necessary for governing.361 it can also aid the state, in a traditional charity role, by fulfilling some community needs typically handled by the government. ironically, its most supportive function is likely maintaining independence from the state and economic power in order to be a critical bulwark against attacks on freedom of speech and association. thus, the state interested in a democratic system has an interest in being supportive of civil society. so, in the united states, we provide benefits to charitable civil society with this in mind. meanwhile, the significant benefits the 355 hackney, political justice, supra note 9, at 309. 356 id. 357 oonagh b. breen et al., regulatory waves: an introduction, in regulatory waves: comparative perspectives on state regulation and self-regulation policies in the nonprofit sector 6 (oonagh b. breen et al. eds., 2017). 358 the federalist no. 10, at 47 (james madison) (ian shapiro ed., 2009). 359 id. at 48. 360 habermas, supra note 11 (noting that civil society exists outside of the state and the economic power). 361 hackney, political justice, supra note 9, at 287–88. 2024] keep charitable oversight 173 state provides to charitable organizations through our taxing systems incentivize many to further their selfish interests through this charitable system. abusers of charity try to disguise their selfish interests in the cloak of charity. the government must, therefore, tread into a sacred democratic space that becomes a more adversarial relationship as a result. the regulation of charitable civil society necessarily elevates some groups and pushes down others as the government entity charged with this task picks winners and losers. the state must play a border guard role, defending the boundary between non-taxable and taxable. how transparent should the governmental regulatory system be that makes determination and enforcement decisions regarding charity? given the potentially tense nature of the relationship, there should be transparency as to the process for determining the rules and making enforcement decisions. because it cuts across all of society, there should be an inclusive process for developing rules. that transparency should, of course, not just be at the legislative level but also at the executive level and should extend to rulemaking activity of the administrative agency.362 though initial conceptions of the administrative state imagined that federal agencies overseen by the president did not make final decisions on behalf of the people, the reality is that agencies do more than carry out the direct will of the legislature.363 managing a significant economy and regulatory state like that of the united states requires expertise that legislators do not have and most people do not possess. thus, we give great discretion to a bureaucracy to operate parts of the government on our behalf.364 but that bureaucracy should ideally make those rules transparently. finally, in managing any such system, there is a necessary relationship between the state and charity to tax. because there is such a strong conception within the united states that a charity ought not pay tax, we have built a system that places those charitable organizations into a space protected from the irs. but there is nothing about charity that makes it clear that it deserves benefits. but where tax benefits are created, the regulation of charity involves ensuring that it does not create a space for tax shelters. 3. big picture approach to charity regulation in regulating the charitable sector, the regulating agency should be perceived as impartial, and it must also help to ensure that the activities it recognizes as legitimately charitable are consistent with what the people of the state demand. thus, big picture goals are: (a) charity regulation ought to be carried out in an impartial manner; (b) the public should perceive the regulation in an impartial manner, and (c) the charitable organizations the government picks as legitimate should be publicly seen to be organizations that further the general interests of the people of the united states at some general level at 362 this is of course consistent with a just democratic order to begin with. christiano, supra note 319, at 46–74 (discussing the importance of publicity of equality by the state). 363 thomas christiano, the rule of the many 239 (1996); james e. anderson, public policymaking 216 (7th ed. 2011) (“administration on the other hand, was concerned with implementing the will of the state, with carrying the effect the decisions of the political branches.”). 364 see kenneth culp davis, discretionary justice: a preliminary inquiry (1969); see also robert a. dahl, democracy and its critics 335 (1989) (discussing the concern of the complexity of the administrative state cutting policy elites from a tie to the people of a democracy). 174 columbia journal of tax law [vol 15:2 least. goal (c) is probably the most challenging as part of being impartial is that the charity regulator must not impinge, and must not be seen to impinge, on freedom of speech or association. but in making determinations about which organizations are legitimate it can appear to be making decisions regarding speech and association. these are big-picture goals. what about narrower goals specific to charity oversight? some have argued that the goal of charity regulation is primarily to enforce fiduciary duties of the leadership of these organizations.365 the karst goal noted in the introduction suggests this model. such a goal assumes that we know what a charitable purpose is and that most charities are organized to further such a purpose. in other words, the primary concern of charity governance is making sure the agents of charity carry out the mission of the charity. this idea is consistent with the history and reality of a lack of internal accountability mechanisms endemic to charitable organizations. as noted above, there are no shareholders like in a forprofit corporation to ensure that a corporation is acting for the benefit of the corporation’s beneficiaries. thus, though perhaps a narrower goal, (d) charity regulation should ensure enforcement of fiduciary duties. this has been the primary role of state oversight, and congress has gradually extended this goal to irs oversight as well, and for good reason discussed in part iii. in addition to fiduciary oversight, there is another narrow goal of charity regulation that we must consider in association with tax law: (e) charity regulation should ensure the collection of revenue.366 our income tax system is designed to tax most economic activity that occurs in the united states so that every person bears their share of tax. perhaps based on the idea of ability to pay, levying a tax on income allows the government to set rates that apply to a person’s accession of wealth. but the united states built an income tax that recognizes that certain activities in certain organized forms do not owe the corporate income tax, estate tax, gift tax, or trust income tax. and the rationale for that exemption matters to the goal of charity tax regulation. thus, the state can correctly pursue goal (e) by ensuring benefits only accrue to those whom congress intended and by enforcing the law consistently with the reasons congress decided to provide those benefits. this focuses the irs on determining a legitimate charitable purpose that congress intended to remove from the income tax system and to which to allow deductible charitable contributions. state and local governments must do the same with their property tax exemptions and any other exemptions they provide for charitable activity. breen, dunn, and sidel highlight a few other potential goals of charity regulation. (f) regulation in the charity sector should prevent unfair competition.367 for instance, congress enacted the unrelated business income tax in part to protect for-profit businesses from what it perceived as unfair competition from charities, which had no obligation to pay taxes like its for-profit competitor.368 365 mayer & wilson, supra note 266, at 505. 366 see philip t. hackney, charitable organization oversight: rules v. standards, 13 pitt. tax rev. 83, 90 (2015). 367 breen et. al., supra note 357, at 4. 368 revenue act of 1950, pub. l. no. 81-814, §§ 301, 331, 64 stat. 906, 947–53, 957–59. see susan 2024] keep charitable oversight 175 additionally, (g) charitable regulators should protect vulnerable beneficiaries.369 this one is subsumed in part by the ideas expressed above about fiduciary duties and charitable purposes. still expressly acknowledging this goal is worthwhile. finally, a charitable regulation regime could adopt a goal of incentivizing giving to charitable causes.370 the various benefits of the code, such as the charitable contribution deduction and tax exemption, both further this goal.371 in discussing the removal of charity regulation from the irs, those who argue for removal but who want good state regulation tend to have a narrower conception of charity goals. these critics tend to focus upon overseeing fiduciary duties. but focusing upon fiduciary duties alone fails to provide attention to charitable purpose and abuse of the tax law. this failure matters because highpowered tax-law incentives make the stakes of charitability much more legally and economically salient. this review highlights that the tax charity law regime looks much different from the state law regime because the stakes are much different. it seems far from clear that the two regimes are aimed at the same goals. similarly, a new entity to regulate charity will likely not prioritize the type of values that are prioritized within the irs. c. challenges to some of the regulatory solutions this part iv(c) first considers the challenges of charity regulation in a general sense and then turns to the specific regulatory solutions. i focus on six general challenges: (1) the lack of a precise definition of charity; (2) the naturally contentious relationship between civil society, where charity lays, and the state; (3) the lack of evidence on both the extent of charity mismanagement and abuse and on how to solve it; (4) the consistent failure to provide resources allocated to regulate the sector; (5) the heterogeneity of the sector; and (6) the limited sophistication of the vast majority of charity leaders. this part iv(c) then evaluates the specific challenges associated with state regulation, irs regulation, and regulation by some quasi-federal agency. the lack of a clear definition of what is charitable, including the fact that it changes over time, makes charity regulation a costly endeavor. as a filer commission study stated: “[o]ne reason that there have been few attempts to provide a comprehensive definition [of charity] is that charitable activity constantly changes, and formulating a definition is extremely difficult when the object to be defined is in flux.”372 naturally, as recognized by the supreme court in bob jones, the definition of charity changes over time.373 thus, standards rather than rules reign in charitable tax law. the irs regularly uses an all the facts and circumstances rose-ackerman, unfair competition and corporate income taxation, in the economics of nonprofit institutions 394–405 (susan rose-ackerman ed. 1986) (discussing whether there is unfair competition between nonprofits and for-profit corporations). 369 breen et. al., supra note 357, at 4. 370 id. 371 i.r.c. §§ 2055, and 2522. see also i.r.c. § 642(c) (allowing a charitable contribution deduction from the trust income tax). 372 persons et al., supra note 70, at 1934. 373 bob jones univ. v. united states, 461 u.s. 574 (1983). 176 columbia journal of tax law [vol 15:2 test to evaluate whether an organization qualifies as charitable.374 as with any standard, substantial costs are placed on both the regulator and the regulated as they try to enforce and comply with the law.375 the vague definition of charity makes it hard to tell when a charity is being run well. how do you know when an organization is validly furthering a purpose? thus, it can be unclear to the charity regulator as to whether there is a systemic problem with a charity operation. this makes it quite hard to derive best practices for regulating the sector.376 unlike a for-profit company where there are objective measures of whether an organization is succeeding by its profits, a nonprofit does not have such clear indicators.377 even with reporting of the financial health of a charity to those who can ensure agents are running the charity for its beneficiaries, it can be quite difficult to determine whether a charity is furthering its purpose.378 the publicization of the form 990 was a major effort toward increasing accountability of nonprofit organizations.379 but the form 990 information fails to provide an easy means of determining whether the charity is furthering a charitable purpose. charity regulation takes place within a conflicted society, and that regulation is often at the center of that conflict. the concept of charity has been part of a political battle within society to determine the virtuous collective activities that society and the state deem worthy of charitable benefits. that battle puts the regulator in the crosshairs of those aggravated when the charity regulator either honors or does not honor a particular purpose.380 as a significant part of civil society, the charitable sector and its regulator must be open to possibility, to dialogue, to ideas, to people, to purposes, to goals; any effort to confine charity is contentious. where the government must confront potentially critical voices, as the irs must, people will publicly worry about the intentions of the government.381 the charity regulator walks on a tightrope as they regulate the sector—it must be defined enough so that the sector can be regulated, but the sector itself will push back against efforts to define it or to confine it. after laying out the ingredients of 374 see, e.g., rev. rul. 2007-41, 2007-1 c.b. 1421 (“whether an organization is participating or intervening, directly or indirectly, in any political campaign on behalf of or in opposition to any candidate for public office depends upon all of the facts and circumstances of each case.” (emphasis added)). 375 hackney, supra note 366, at 108. 376 there have been attempts to recommend best practices for charities themselves. see, e.g., independent sector, supra note 243. 377 robert n. anthony, the nonprofit accounting mess, 9 acct. horizons 44, 44 (1995); see also, breen et. al., supra note 357, at 6 (discussing the difference between government/commercial collaborative governance relationships where the goals and indicators are much clearer than in the nonprofit sphere). 378 baber et al., supra note 68, at 680. 379 elizabeth k. keating & peter frumkin, reengineering nonprofit financial accountability: toward a more reliable foundation for regulation, 63 pub. admin. rev. 3, 3 (2003). 380 see, e.g., joseph crespino, civil rights and the religious right, in rightward bound 90 (bruce j. schulman & julian e. zelizer eds., 2008) (examining the “controversy over the irs and religious schools” and noting it “deserves a central role in any account of america’s turn toward the right in the 1970s”). 381 breen et al., supra note 357, at 3–4 (noting the tension that can be created between civil society organizations and the state). 2024] keep charitable oversight 177 a legal accountability regime, kearns notes, “[t]hese ingredients of a fully functioning system of legal accountability appear fairly straightforward, but upon close inspection it is clear that having all of them in place at any given time is a rather tall order.”382 though there have been some empirical studies of nonprofit regulation, there is sparse evidence of whether charity regulation is failing or not. as mayer notes, “it is not clear to what extent this reduced irs oversight has led to increased violations of the applicable federal tax laws by exempt organizations.”383 the sense that there is something wrong is based on little empirical evidence.384 the irs appears to be trying to remedy this situation with data, but so far has not been too successful. a recent gao study indicates that the irs is using data to flag nonprofits for examination and may be having some success.385 the gao found that, of the returns selected through this process, 87% ended up in changed returns.386 the gao notes that the irs only began using significant data in 2012. importantly, it may be that we are at the beginning of thinking about charity and accountability. international academic literature has also only more recently been concerned about the lack of accountability in nonprofit organizations.387 in any case, there is a lack of empirical evidence of whether nonprofits are behaving badly or whether regulators are regulating well or poorly. if you do not know where you are going, it is awfully hard to get there. arguably, the lack of funds our governments (federal, state, and local), as well as the charitable sector itself, are willing to dedicate to regulating charity is the most significant problem anyone arguing for greater regulation faces. there is likely not a single article looking at the question of charitable oversight for over fifty years that does not mention the significant lack of funds to regulate the sector.388 thus, since the beginning of a vibrant charitable sector, it is doubtful there has ever been a moment when any charity expert thought that the ideal amount of resources was being devoted to charity oversight. with that record it is highly optimistic to think that there is a solution to the resource problem. this is not to argue that we cannot dedicate more resources to regulating charity, but that it is 382 kevin p. kearns, accountability in the nonprofit sector, in the state of nonprofit america supra note 12, at 589. 383 mayer, supra note 1, at 94. 384 id.; see also fishman et al., supra note 30, at 9–10 (using anecdote to show some of the abuses, but also noting that the abuses might not be as widespread as these events might suggest); sidel, supra note 234, at 804–07. 385 u.s. gov. accountability off., gao-20-454, tax exempt organizations: irs increasingly uses data in examination selection, but could further improve selection processes (2020). 386 id. at 13. 387 andrew p. williams & jennifer a. taylor, resolving accountability ambiguity in nonprofit organizations, 24 voluntas: inter. j. vol. & nonprofit org. 559, 564 (2013). 388 see supra part ii.b, ii.c. see also mayer & wilson, supra note 266, at 480 (“for more than fifty years scholars have expressed concerns that while there is a general consensus regarding the legal duties of nonprofit, and particularly charity, officers, directors, and trustees, enforcement of those duties has been spotty and haphazard at best.”). mayer and wilson also note the uniform assumption critics adopted at the time of their writing was that the solution to charities behaving badly is to properly fund the government agencies regulating them, rather than asking whether the agency was the right agency to regulate. id. at 490 n.58. 178 columbia journal of tax law [vol 15:2 highly unlikely that we will provide the resources close to an ideal level. a useful exercise in this domain would be to put together a budget providing an ideal expenditure by the irs or some other regulator to have the best regulatory effect. the charitable sector is heterogeneous. a reason that we have not seen a common cause arise within the charitable sector to create a national regulator, either public or private, is likely this heterogeneity. it is substantial. within the public securities market, like that which makes up the groups that care about finra or pcaob, all the players have a common interest in generating profits in a market that has an equal playing field. there is no such similar connectivity that arises in the charitable sector because of heterogeneity of purpose. the commonality of a nondistribution constraint simply is not a connective force in the way profits and access to a public securities market are such a force. the charitable contribution deduction could be a unifying force, but the reality is that charitable contributions make up only a small part of the revenue of charitable organizations. it just could not unify the collection of organizations that are considered charitable. digging deeper into the heterogeneity problem we find that diverse charitable industries each have significant and important regulators that often matter much more than the charitable status of the members. hospitals, for instance, have many regulators, including the centers for medicare & medicaid services (cms), the drug enforcement administration (dea), and the environmental protection agency (epa), to name a few.389 realistically, cms at least likely takes precedence over the governance of nonprofit hospitals as compared to the nonprofit regulators. the same goes for universities and colleges. they have many other regulators, and the department of education likely takes precedence over the way colleges and universities think of nonprofit governance. the list of the sub-groups within the charitable space is broad and wide. for instance, religion as an interest group is highly unlikely to be willing to come to the table on this type of matter. the group that might have some interest in coming to the table to such discussions are private foundations where wealthy interests are uniquely interested in ensuring that they have as big a scope to make decisions on their own as possible—sponsoring organizations of donor-advised funds are likely to have such an interest as well. in the end, the heterogeneity problem results in great difficulty in finding unanimity across the sector for a new regulator, developing rules that apply to all, and in generating the resources necessary to form some new agency through a political process to create the agency. finally, though there are some sophisticated officers and directors who lead charities at the hospital and university level, most directors and officers are likely made up of parties who have little knowledge of the laws regulating nonprofits and charities. in this environment, where the laws are complex, it is likely that the laws have little influence on many within the sector because they are not even aware the laws exist. for instance, evidence shows that many in the nonprofit world do not understand what financial information is available or even how to read various financial reports that are available.390 389 erica mitchell, who regulates hospitals?, eoscu: health. care. an educational blog (oct. 15, 2021), https://blog.eoscu.com/blog/who-regulates-hospitals [perma.cc/g4e6-2f2x]. 390 keating & frumkin, supra note 379, at 4. 2024] keep charitable oversight 179 are there any challenges of state level charity regulation that are different from the above? all the general challenges listed above apply equally to states. in fact, the resource constraints at the state level appear to be more significant than at the federal level.391 additionally, the influence of the political structure is surely worse. housed within attorneys general’s offices, the position is highly political.392 though there have been suggestions of states adopting charity commissions, given past behavior it seems likely that the political problem at the state level will remain significant. because of the great importance of a transparent unbiased enforcement approach identified above in part iv(b), this political nature of state enforcement undermines hope of improvement at the state level if it continues to use the traditional approach. this suggests, too, that having a well-trained civil service manage the enforcement of charity likely matters a lot. it helps professionalize and depoliticize the activity. another challenge of utilizing state enforcement is that the states simply lack the ability to handle the national and international scope of today’s charitable sector. the final challenge is that state-level enforcement focuses upon governance and solicitation but lacks a focus upon tax matters. this again makes the states unsuitable for being a real charity regulation force. what about the challenges of the irs as a charity regulator? the irs faces the same general challenges mentioned above, but there are additional points to be made. a significant challenge to the irs functioning as a good regulator is that it operates on a tax time frame, not a regulatory time frame. thus, the irs is unable to take enforcement action soon after an organization engages in problematic acts. owens ably points this problem out.393 a somewhat related problem is that many within the tax world do not think the irs is the appropriate place to regulate charity. instead, the irs should focus upon the collection of revenue alone.394 thus, as an institutional matter, it becomes hard for the irs leadership to devote the right level of resources and attention to its regulation. because charity generally does not generate revenue, the irs as an institution is simply unlikely to put significant resources towards charitable regulation. the agency is also seriously disliked by constituencies who have an interest in hampering the agency.395 this also makes it hard for the irs to operate as a regulator of charity. there is another significant problem that comes with any charity tax solution. those who study regulatory agencies note the way the choice of who will do the regulating (i.e., what specialty they come from: scientist, attorney, banker, economist) can deter those interested in the regulatory area but who are not specialists from discussing the policy with the regulator. as marc allen eisner says, “the ‘barrier to entry into policy discourse’ created by specialists both within the agency and in the larger policy community limits the access and influence of groups incapable of mustering the necessary resources.”396 tax law as a subject 391 see supra part ii.b. 392 see supra part ii.b. 393 owens, supra note 1. 394 see supra part i. 395 see, e.g., jim jones, one of the most-hated federal agencies deserves some love from congress, the hill (april 19, 2022) https://thehill.com/opinion/finance/3273321-one-of-the-mosthated-federal-agencies-deserves-some-love-from-congress/#:~:text=the%20agency%20was%20 on%20the,included%2049%20percent%20of%20republicans [perma.cc/yv8m-nl4k]. 396 marc allen eisner, regulatory politics in transition 23 (1993). 180 columbia journal of tax law [vol 15:2 matter may very well lock out more people from access to the specialty than a charity bureau might.397 that said, the irs arguably has largely managed to be perceived as an unbiased regulator. though the tea party crisis was a major blow to the irs in that regard, no investigations found the irs acted in a biased manner.398 the irs also is the only place where collection of revenue and a strong understanding of the high-powered charitable incentives exists. one significant challenge at the irs level exists because of the split regulation at the state and federal levels. irs charity oversight law is partially divorced from traditional charitable trust law and corporate law that is focused upon enforcing fiduciary duties of care and loyalty.399 congress has adopted fiduciarylike rules such as the prohibition on inurement and excess benefit transactions.400 however, in none of those instances is there found a connection to the traditional duties of care and loyalty. this lack of connection of charity tax law to governance rules means charity tax law fails to provide guidance to charity leaders on how to comply with governance obligations. a similar problem exists at the state regulatory level. state charity law rarely considers the idea of a charitable purpose in a public sense.401 this disconnects state enforcers from the charitable tax incentives involved. in the mid-to-late-2000s, the irs under then tege commissioner steve miller began an effort to encourage good governance of nonprofit organizations.402 he received much pushback from practitioners saying that it is not the irs’s role to enforce governance matters.403 a good case can be made that the irs has the authority to regulate nonprofit governance based on section 501(c)(3), the additional governance oriented code based sections, and the importance congress put into making the form 990 publicly available for broad public accountability. however, for the sake of clarity, congress could consider extending governance requirements into the code so that a basic level of governance is expected of nonprofits. having clear governance benchmarks that the irs could enforce might 397 owens, supra note 1, at 8 (making the point that irs as charity regulator likely locks out many interests who might comment upon charitable regulatory rules). 398 see supra part iv.a. 399 there is a co-relative problem with state charity law, which is that the state generally cares little about whether a charitable organization that forms a charitable nonprofit is indeed furthering a charitable purpose. 400 i.r.c. §§ 501(c)(3) & 4958. 401 george g. bogert et al., supra note 88, at § 369. (discussing that the restatement of trusts does not provide a definition of charitable but instead leaves it to courts to determine whether a particular purpose qualifies or not). though probate courts ask this question, it is mostly a private matter of concern to heirs rather than the public. zunz, supra note 67, at 76–77 (“some judges relied on these [british] precedents to invalidate a will… intended to support a politically controversial activity, or propaganda, as it was called time and again. other judges interpreted these precedents loosely or ignored them, and in doing so they not infrequently broadened the scope of philanthropy.”). 402 see, e.g., steven t. miller, comm’r, i.r.s. tax exempt & gov. entities, remarks at the georgetown seminar on exempt org. panel on nonprofit governance (apr. 23, 2008). 403 see, e.g., advisory comm. on tax exempt and gov’t entities, the appropriate role of the internal revenue service with respect to tax-exempt organization good governance issues (june 11, 2008), https://www.irs.gov/pub/irs-tege/executive_summary_act governancerept.pdf. 2024] keep charitable oversight 181 help to make the charity tax law more coherent. nevertheless, this divorce of fiduciary duty rules from irs enforcement creates some discontinuity in the legal regime enforced by the irs. what are the challenges of a quasi-federal agency such as helge and owens propose? obviously, in addition to the above challenges, the cost of setting up a new agency is enormous, and the resource constraints would likely continue. indeed, as jurisdiction is split across agencies, the resource constraints may become more acute as congress or the industry divides scarce resources across two agencies. the solutions involved have the charitable sector providing the dollars for their own regulation.404 however, we will likely still, as a society, be drawing from the same scarce resources. additionally, the heterogeneity challenge will make it difficult to build the support and resources needed for this quasigovernmental agency. though owens noted that there are reasons that the sector might have a common cause to be interested in shaping the regulatory world that they face,405 one would think that common cause already would have come together either at the state level or at the federal tax level. but it has not. most fundamentally, though, i fear that the separation of tax from charity will lead to large blind spots for the irs as it tries to collect the revenue. no one proposing the removal of regulation from the irs also suggests eliminating the tax benefits that come with charitable status. those benefits are varied and significant, not just to charitable entities but, more importantly, to those connected to charitable entities. congress and the irs have long fought misuse of the charitable contribution deduction. though it might appear that the two issues are separable, very often, the question of whether a deduction is legitimate depends upon the relationship with the organization. if the irs is not focusing both on the substantial contributor’s organizations and the activities of the organization itself, there will likely be a dark space to drop tax-deducted funds that the irs will no longer be able to see. the same goes for the exemption from gift and estate taxes. charity will become more of a space for tax shelter, and possibly political shelter too, than before simply because the irs will not be able to see as clearly the activity associated therewith. the new agency is unlikely to have the expertise or the focus upon ensuring that the high-powered incentives of charitable organizations are not abused. some of this will remain with the irs, but these are likely to be quite confusing destabilizing arrangements. from a civil society perspective, this separation between the tax law and the domination of a charity would also likely lead to economic power having a more commanding relationship to charity. this could significantly harm charity as a civil society bulwark protecting freedom of speech and association. because the irs has the incentive to observe whether wealthy individuals are abusing the tax law in their relationship with a charitable organization, the irs is more likely than a charity regulator outside a tax system to police the relationship between economic power and the charitable sector. thus, the irs is much more likely to be the bulwark that charity needs to separate itself from economic power. some might contend that the irs already is a weak charitable law enforcer 404 see supra part iii.b. 405 owens, supra note 1. 182 columbia journal of tax law [vol 15:2 and that we would not lose that much even if there were a blind spot as i suggest. however, and most importantly, just because we are in a period of poor enforcement of the tax law now does not mean we should accept that poor enforcement structure as permanent. it would be foolhardy to eliminate the ability of the irs to be a good enforcer of charity and the tax incentives associated therewith just because congress has been deprived of money recently. once that charitable jurisdiction is given up, it will be hard to get back. my expectation is that if the jurisdiction were given up for most purposes the irs would largely eliminate institutionally its human and equipment resources focused on tax-exempt organizations, meaning we would lose substantial knowledge and ability that will be extremely hard to build again. splitting jurisdiction among the irs and a federal charities bureau of some sort would come with challenges as well. the irs has norms, and the charity bureau would have norms. these would likely conflict.406 silber raises an important question of divided jurisdiction leading to two regulators who fail to oversee the issues because each thinks the other is going to carry out regulation.407 silber was concerned that having ags and the irs responsible for the same matters leads to both ignoring matters because they think the other will handle a particular abuse.408 a third regulator likely makes this split jurisdiction problem even worse. a final note is that this new agency would likely need to receive authority to regulate the governance of nonprofit organizations. given that nonprofit governance has long been dedicated to the states and the strong pushback from the sector to the idea of the irs recommending governance as a factor in its oversight, it seems questionable that we could find a political agreement to extend this authority to a new agency. this seems a significant challenge in creating a new agency. it would of course be able to have jurisdiction over that which the irs has jurisdiction. there is much to recommend working to improve the current state of charity regulation. there are some factors that favor a new agency as described by scholars like owens and helge. for instance, it could be a significant improvement to have an agency that is able to act in real-time rather than within a tax schedule. additionally, a new agency would likely be more inclusive in its guidance process than is complex tax law. furthermore, it would be ideal not to impose upon the irs the duty to regulate such a lightning rod of a sector. but the harms to revenue collection, the opportunities for tax and political shelters, and the ability of the economic powers to gain control of charity remain too great to support the creation of such a new agency. d. solution though there are many reasons to be disappointed in the irs’s performance regarding the regulation of charity, and the case for a charity bureau has merit, it would be a mistake to remove charity jurisdiction from the irs. the most significant problem would be that the irs would lose critical information to enforce 406 eisner, supra note 396, at 16 (noting this type of typical conflict when there are agencies of different specialties both with jurisdiction over a matter). 407 see silber, supra note 14, at 638. 408 id. 2024] keep charitable oversight 183 the tax law broadly. the split would likely open a significant space into which those looking to avoid tax could take advantage of to engage in economic activities unseen by the irs. at the same time, the new agency would have no connection or deep understanding of the complex benefits to which charities and those who work with, or contribute to, those charities are entitled to because of the tax-exempt charitable status. it would be a problematic mismatch of systems. additionally, developing a new agency would likely split scarce resources between that agency and the irs, further harming the resource constraint of charity regulation. in this part iv(d), i first acknowledge the specific challenges the irs has faced. then i try to sketch an irs as charity regulator path that can work better than the charity regulation situation we find ourselves in at present. the charitable community years ago turned to the irs to be the national regulator. because section 501(c)(3) requires an organization to further a charitable purpose and there are significant tax incentives provided, the irs seemed a natural place from which to regulate the sector. revenue collection needs to be protected, but also, the irs is most likely to understand the consequences of the tax benefits provided to charity. furthermore, given the tax benefits involved, the irs as regulator is highly salient to the charitable sector because it has natural leverage over charities to get them to behave within a certain range of norms. additionally, the irs has a large workforce in place to enforce the laws. an ideal solution would be for congress to assess what resources the irs needs as an effective charity regulator and dedicate real resources to the agency. though this has been tried before, perhaps congress could require a small charge to charities to enhance the resources of the irs for regulating charity.409 that said, the evidence is strong that though the irs has overseen the sector for a long time, it has not been a reliable regulator of the sector.410 because of this length of time that the irs has not been a robust regulator of the sector, it is hard to make a strong claim that the irs will ever be the regulator that many wish it would be of the charitable sector. though congress and the irs might someday allocate more resources to the area, the history is a strong indicator that the regulation of the sector at the irs will always be under-resourced. as becomes clear from this review of the challenge of charity regulation, whichever institutional path we take, we must collectively lower our expectations of charity regulation. the messiness of the relationship between the state, civil society, and the u.s. federalism governance structure, makes this a nearly impossible regulatory tussle for the government. the concept of what is legitimate charitable activity will always be in a contentious flux that puts a burden on the government as it legally interacts with the sector. most importantly, though, given the past, there is no reason to believe that we will in the future come up with the resources to support charity regulation that policy experts believe would be ideal. arguably, charity tax law works to ensure the irs has the best vision of as many participants in our economy as possible to stop tax evasion. maintaining this 409 admittedly this was tried for private foundations with initially a 4% charge on net investment income, the revenue of which was to be dedicated to the examination of private foundations. tax reform act of 1969, pub. l. no. 91-172, § 101, 83 stat. 487, 492 & 498 (codifying i.r.c. § 4940). that money never found its way to enforcement at the irs. 410 see infra part ii.c.2. 184 columbia journal of tax law [vol 15:2 function within the irs, therefore, is important. when we think of this as part of the rationale, it lessens concern regarding having over and under-inclusive rules. the key is to bring as many economic participants into the revenue-collecting fold as possible, not to ensure ideal charitable regulation. the irs will not be the ideal enforcer of charity norms. both congress and the irs need to adjust accordingly. instead of asking the irs to enforce amorphous standards looking for the good in the world, we need to adopt as simple rules as possible. congress should work hard to narrow the group of organizations that are considered charitable under the code. for instance, scholars have long questioned whether hospitals, the largest sector of charitable organizations, should be seen as charitable.411 congress could reconsider the exemption for private foundations too.412 this will mean there will be instances where good organizations are kept out that maybe, in some ideal world, would be recognized as charitable and some bad organizations will achieve that status. the regime will be both over and underinclusive. it is time to recognize that in the effort to get everything precisely right in a justice sense, we are getting a lot of things very wrong. the law and regulatory needs for the charitable sector are still going to be highly complex even if congress makes such changes. however, i have argued before that the irs should use its delegation for rulemaking in the charitable sector to actively engage in promulgating simple rules so that the overwhelmed agency, as well as unsophisticated tax-exempt organizations, know the law and can comply with them.413 while standards rather than rules might be more ideal in regulating the sector, the great number of unsophisticated parties trying to comply with the law and the significant lack of resources for enforcement strongly favor rules over standards.414 the irs needs to find ways to expeditiously handle its workload. it needs a series of primarily simple, transparent rules that allow it to dispose of cases on a fair and consistent basis. without this, it seems likely that the irs will run into further “scandals” over its enforcement choices where there is significant ambiguity regarding the rules. this recommendation may not be supported strongly by those who believe the irs should be the national regulator of charitable organizations. nevertheless, consistency of enforcement and likely greater compliance would be significant attributes of such a shift. additionally, adopting a more rule-based regime should importantly help to protect the irs against charges of acting politically because the rules and decisions would be more transparent than is currently the case. the irs should make no mistake that this is some panacea against such charges, but only protection. many conservatives today object to the rules limiting campaign and lobbying activities of 411 see, e.g., mark a. hall & john d. colombo, the charitable status of nonprofit hospitals: toward a donative theory of tax exemption, 66 wash. l. rev. 307, 405 (1991) (questioning the correctness of hospitals receiving charitable status under i.r.c. § 501(c)(3) and proposing a new theory of exemption for charity that would exclude many hospitals from exemption status); hansmann, supra note 17, at 70 (“it is not clear that this theory helps to justify the exemption in such important fields as hospital care, where the contract failure theory of nonprofits seems weakest."). 412 see hackney, supra note 183 (suggesting on a democratic basis congress consider eliminating private foundations because inherently private activity that supports wealthy interests alone). 413 hackney, supra note 366. 414 id. 2024] keep charitable oversight 185 charitable organizations. assuming they continue to disagree with the rules on that front, they are likely to find trouble with the irs enforcing such rules. nevertheless, if the rules are clearer, the irs has a much stronger fallback position should it be investigated again. it would be harder for the critics to allege bias with clearer rules. finally, the irs needs to continue to use data and electronic means to hone its enforcement choices. the data will need to be better, though. this means it will need to define the information it collects on the form 990 much more directly so that when people report on the form 990 we are much more likely to be comparing apples to apples. professor mayer has detailed what we can see from the public record about the forays of the irs into using big data.415 one thing that comes through in mayer’s terrific article is that big data is no panacea for an underresourced agency.416 key problems, though, are getting it wrong based on bad data or misuse or misanalysis of the data. the most significant problems, though, are the increased harm to privacy and potential big government overreach. still, improving form 990 information collection, as well as searches of its information, should redound to better regulation of the sector. good financial information is likely even more important in nonprofit management as compared to the for-profit context.417 literature in this area, though, is not that old.418 nevertheless, accounting literature suggests that “accounting measures to ensure stewardship of contributed resources” can mitigate the natural danger of agents without principals.419 v. conclusion charitable regulation in the united states is failing. the states do not put resources towards its regulation, and when they do, it can appear to be politically motivated. congress has refused to fund the irs charitable regulatory function at close to a level where it could be a force in the oversight of charity. additionally, the irs, as a tax authority, does not fulfill our natural conception of a governance regulator. its focus is the collection of revenue and so its regulatory schedule falls on a tax timeline, not a governance enforcement timeline. furthermore, republicans have conducted a coordinated attack on the irs with a focus on its charity regulation division, trying to undermine the agency’s ability to collect the revenue. in this environment, critics are recommending congress move national charity regulation from the irs to some other national agency. though they make a good case for a quasi-federal regulator, there are several significant reasons congress should not follow their lead. instead, congress should maintain charity regulation in the irs. first, given the demonstrated inability of our government to devote adequate resources to charity regulation, we should be skeptical that the government or charity will well fund a new national charitable agency. instead, the government and charity are likely to simply spread limited resources thinly. 415 lloyd hitoshi mayer, the promises and perils of using big data to regulate nonprofits, 94 wash. l. rev. 1281 (2019). 416 id. at 1305–06. 417 id. 418 kearns, supra note 382, at 588. 419 baber et al., supra note 68, at 680. 186 columbia journal of tax law [vol 15:2 second, creating a new agency would split jurisdiction between the states, the irs, and the new agency. most troublingly, this would make the irs blind to the tax shelters of the very wealthy. it is key to the collection of revenue that the irs has information on the use of charity. in 2020, irs statistics show that charities reported an aggregate of over $5.5 trillion in assets.420 it is no small amount that the irs would likely begin to ignore and lose the capacity to observe with a new agency involved. third, finally, and relatedly, the irs is in the best position to maintain a neutral approach and provide strong oversight of charity as civil society. in a democratic order we ideally maintain a separation between the state and civil society, but also maintain independence of each of these from the economic order. the irs rather than a new federal agency is more likely to maintain both the neutrality needed for overseeing civil society and provides the best shot at ensuring that the economic power controls neither civil society nor the state. congress should evaluate the resources the irs needs to oversee a greater than $5 trillion sector and dedicate those resources to the irs. scholars could help with research modeling what good regulation of the sector from the irs would look like. however, on the strong assumption that congress will continue to provide too little resources for the irs, congress should scale down what it expects the irs as charity regulator to accomplish. it should use rules to eliminate large parts of the charitable sector to make the task of oversight scalable to the irs congress is willing to fund. two possibilities i suggested here are eliminating most hospitals and private foundations from charitable exemption. there are good arguments for eliminating both from qualifying as charitable and eliminating them would reduce the number of entities with which the irs must contend in a charitable regulatory way. the key is finding ways to reduce the load upon the irs division focused on charity. 420 i.r.s., soi tax stats charities & other tax-exempt organizations statistics, statistical tables, 501(c)(3), 2020 xl spreadsheet, https://www.irs.gov/statistics/soi-tax-stats-charities-and-other-tax -exempt-organizations-statistics [perma.cc/399z-lcl4]. note chinese state capitalism and the international tax regime cameron rotblat* abstract as signaled by its participation in the g-20/oecd base erosion and profit shifting project, china is gaining significant influence over international tax rules. yet, how exactly china intends to shape international tax law remains an open question, even amongst leading chinese tax scholars. as both a major capital importer and exporter as well as a developing economy with tremendous global economic power, china does not fit neatly into the traditional dichotomies of the international tax regime. this article argues that china’s international tax policy is likely to be strongly influenced by its unique system of state capitalism. both the history of chinese domestic tax reforms and the communist party’s current mechanisms of control over the chinese economy suggest that china’s tax policy cannot be understood separately from its system of state capitalism. this article contends that as a result, china is likely to adopt distinctive international tax policies including maintaining a worldwide system of corporate taxation, providing tacit state support for international tax planning by major chinese multinationals, and negotiating for broad exemptions in tax treaties for state-associated entities. if not proactively addressed by oecd countries, these policies may lead to significant fractures within the international tax regime. * j.d. 2018, yale law school. i would like to thank michael j. graetz for his helpful suggestions and encouragement. 78 [vol.10:1 columbia journal of tax law table of content i. introduction ................................................................................................................ 79 ii. fault lines in the international tax regime ............................................ 83 a. allocation of taxing rights.............................................................................................. 83 b. tax competition ............................................................................................................... 85 c. base erosion and profit shifting....................................................................................... 87 iii. the evolution of chinese tax policy ................................................................................... 88 a. from mao to the modern enterprise income tax ............................................................ 88 b. china’s international tax policy and diplomacy at a crossroads ................................... 87 iv. defining features of chinese state capitalism ........................................ 96 a. sasac governance of chinese soes ............................................................................. 96 b. soes in china’s “going out” and “belt and road” initiatives ..................................... 103 c. capital controls and outbound investment regulations................................................ 107 v. possibilities for distinctive chinese international tax policies and norms ............................................................................................................................. 111 a. continued income taxation of chinese soes ............................................................... 111 b. maintenance of worldwide corporate taxation ............................................................ 117 c. tacit state support for international tax-planning ........................................................ 123 d. differential treatment of soes and private enterprises ................................................ 126 vi. conclusion ................................................................................................................... 136 2018] 79 chinese state capitalism and the international tax regime i. introduction in may 2017, chinese president xi jinping hosted an international forum highlighting china’s belt and road initiative—a multi-trillion-dollar infrastructure plan spanning over 60 countries and roughly one-third of the global economy.1 chinese leaders have labeled it “the project of the century” and state media outlets have described it as ushering in “globalization 2.0.”2 china is already the world’s largest economy (on a purchasing power parity basis), largest manufacturer, largest exporter, largest trading nation, and largest holder of foreign exchange reserves.3 consequently, western observers have interpreted the initiative as a concerted effort to reshape the global economic order and rewrite the rules on international trade and investment.4 one month later, the international tax regime witnessed a major milestone in what has been described as the “most extensive attempt to change international tax norms since the 1920s.”5 on june 7, 2017, over 70 jurisdictions signed an innovative multilateral convention modifying the signatories’ existing bilateral tax treaties.6 the convention represents the culmination of a fouryear project, known as beps, spearheaded by the g-20 and the oecd to combat base erosion and profit shifting. 7 this multifaceted project, which also developed recommended measures for countries’ domestic tax laws, seeks to better ensure corporate profits are taxed “where substantive 1 see, e.g., jessica meyers, globalization 2.0: how china’s two-day summit aims to shape a new world order, l.a. times, may 12, 2017, http://www.latimes.com/world/asia/la-fg-china-belt-road-2017-htmlstory.html [https://perma.cc/xx89-7gec]; jane perlez & keith bradsher, xi jinping positions china at center of new economic order, n.y. times, may 14, 2017, https://www.nytimes.com/2017/05/14/world/asia/xi-jinping-one-belt-one-roadchina.html [https://perma.cc/z3up-sum9]. 2 charles clover, sherry fei ju & lucy hornby, china’s xi hails belt and road as ‘project of the century,’ fin. times, may 14, 2017, https://www.ft.com/content/88d584a2-385e-11e7-821a-6027b8a20f23 [https://perma.cc/d2dq-3up9]; china's belt and road initiative ushers in ‘globalization 2.0,’ people’s daily online, apr 13, 2017, http://www.chinadaily.com.cn/business/2017-04/13/content_28909176.htm [https://perma.cc/ym9w-z8gb]; belt and road initiative strives to reflect ‘globalization 2.0,’ china daily, march 26, 2017, http://www.chinadaily.com.cn/business/2017-03/26/content_28683281.htm. [https://perma.cc/2g7mgqxz]. 3 see wayne m. morrison, cong. research serv., rl33534, china’s economic rise: history, trends, challenges, and implications for the united states (2015); see also noah smith, who has the world's no. 1 economy? not the u.s., bloomberg (oct 18, 2017), https://www.bloomberg.com/view/articles/2017-10-18/who-has-the-worlds-no-1-economy-not-the-u-s (discussing the relevance of purchasing power parity in comparing the u.s. and chinese economies). 4 see michael holtz, trumpeting ‘one belt, one road,’ china bids to lead ‘globalization 2.0,’ christian science monitor (may 16, 2017), https://www.csmonitor.com/world/asia-pacific/2017/0516/trumpeting-onebelt-one-road-china-bids-to-lead-globalization-2.0 [https://perma.cc/9wxk-8pew]; see also meyers, supra note 1. 5 itai grinberg, the new international tax diplomacy, 104 geo. l.j. 1137, 1140 (2016); see also itai grinberg & joost pauwelyn, the emergence of a new international tax regime: the oecd’s package on base erosion and profit shifting (beps), asil insights (oct 28, 2015), https://www.asil.org/insights/volume/19/issue/24/emergencenew-international-tax-regime-oecd%e2%80%99s-package-base-erosion-and#_ednref2 [https://perma.cc/y5347fvn] (“a new international tax regime is emerging ….”). 6 org. econ. co-operation & dev. (oecd), multilateral convention to implement tax treaty related measures to prevent beps, http://www.oecd.org/tax/beps/ground-breaking-multilateral-beps-convention-will-closetax-treaty-loopholes.htm [https://perma.cc/buj4-zdj6]. 7 see org. econ. co-operation & dev. (oecd), base erosion and profit shifting, http://www.oecd.org/ctp/beps/ [https://perma.cc/rsm5-7hvf]. 80 [vol.10:1 columbia journal of tax law economic activities generating the profits are carried out and where value is created.”8 while many leading scholars are skeptical of the “patch-up” or “band-aid” nature of the project’s substantive tax rules, 9 the project represents a notable change in the institutional framework for tax diplomacy.10 the committee on fiscal affairs of the oecd, a small group of mostly rich countries, has long served as the leading forum for international tax reform and more recently as “an informal world tax organization,” often to the dismay of developing countries.11 however, as part of beps, the entire g-20, including non-oecd members brazil, russia, india, china and south africa, were allowed to participate “on an equal footing” with oecd members.12 these developments portend a major role for china in shaping future international tax rules. over the past decade, many have predicted that china would eventually assume meaningful influence over the international tax regime.13 following china’s participation in the beps project, it appears china has now made the transition “from a norm-taker to a norm-shaker.”14 in assessing its engagement, reuven s. avi-yonah and haiyan xu concluded that china “actively participated in both developing and implementing the beps project.”15 jinyan li has similarly reasoned that china’s beps efforts, “are likely to have significant implications for the development of international tax system.”16 those analyzing the institutional structure of the international tax regime have likewise suggested that going forward china and the brics will have a “significant” impact on tax policy reform.17 yariv brauner, for instance, has argued that any meaningful policy reforms will require cooperation from china and india and that these countries are positioned to 8 org. econ. co-operation & dev. (oecd), explanatory statement oecd/g20 base erosion and profit shifting project, https://www.oecd.org/ctp/beps-explanatory-statement-2015.pdf [https://perma.cc/l6vl-u2zr]. 9 michael j. graetz, follow the money 271 (2016); yariv brauner, what the beps, 16 fla. tax rev. 55 (2014); reuven s. avi-yonah & haiyan xu, evaluating beps, 10 erasmus l. rev. 3 (2017); new rules, same old paradigm, economist (oct. 15, 2015), https://www.economist.com/news/business/21672207-plan-curbmultinationals-tax-avoidance-opportunity-missed-new-rules-same-old [https://perma.cc/47xr-l4lf]. 10 see, e.g., grinberg, supra note 5, at 1146. 11 arthur j. cockfield, the rise of the oecd as informal “world tax organization” through national responses to e-commerce tax challenges, 8 yale j.l. & tech. 136 (2006); see infra part 2.a. 12 org. econ. co-operation & dev. (oecd), bepsfrequently asked questions, http://www.oecd.org/ctp/beps-frequentlyaskedquestions.htm [https://perma.cc/rr25-6te6]; see diane m. ring, developing countries in an age of transparency and disclosure, 2016 byu l. rev 1767 (2017). whether the inclusion of these large emerging countries in fact enhances the legitimacy of the project remains contested. see, e.g., sissie fung, the questionable legitimacy of the oecd/g20 beps project, 10 erasmus l. rev. 76 (2017). 13 see, e.g., andrew p. morriss & lotta moberg, cartelizing taxes: understanding the oecd's campaign against “harmful tax competition”, 4 colum. j. tax l. 1, 56 (2012-2013) (“china’s role will be critical in the future … since china's interests in international finance differ significantly from oecd members’ interests.”); thomas ecker & jieyin tang, business profits (articles 5, 6, 7, 8, 9, and 14 oecd), in europe-china tax treaties 78 (michael lang, jianwen liu & gongliang tang eds., 2010) (“[o]wing to its increasing importance in the world economy and the growing sophistication of the chinese tax system, china will also likely play an important role in shaping international tax norms in the next century.”). 14 jinyan li, china and beps: from norm-taker to norm-shaker (osgoode legal stud., research paper series 126, 2016), http://digitalcommons.osgoode.yorku.ca/cgi/viewcontent.cgi?article=1121&context=olsrps [https://perma.cc/q52a-7fgp]. 15 reuven s. avi-yonah & haiyan xu, china and the future of the international tax regime (law & economics working papers 140, 2017), http://repository.law.umich.edu/law_econ_current/140 [https://perma.cc/8833-8e5b]. 16 li, supra note 14. 17 see, e.g., ring, supra note 12, at 1793. 2018] 81 chinese state capitalism and the international tax regime potentially “break the dominance of the oecd in the international tax regime.”18 in short, while many debates remain as to the future of the international tax regime, it appears that china will certainly play a significant role. however, the existing literature on china and the international tax regime offers limited insight into the types of reforms chinese policy-makers may seek. extensive scholarly literature exists on the divergent international tax preferences between developed and developing countries—preferences illustrated in part by the oecd and un model tax treaties respectively.19 however, international tax scholars have almost completely ignored the ways in which china’s unique system of state capitalism may influence its international tax policy.20 in fact, wei cui and ji li appear to be the only english-language scholars to have considered the complex relationship between chinese state-owned enterprises (soes) and chinese international income taxation. yet, cui’s work has focused primarily on assessing competing theoretical justifications for taxing soes and li’s on empirical questions regarding their tax compliance.21 as a result, foundational matters remain unresolved, including “the objectives of international tax policy” for “countries that are home to many soe multinationals.”22 existing scholarship on the implications of chinese state capitalism for u.s. law has likewise failed to consider the implications of soes for international income taxation.23 this gap in the international tax literature is particularly jarring in light of the fact that the dramatic growth in chinese outbound investment over the past two decades has been dominated by soes.24 recent policies, including the belt and road initiative and a 2017 crackdown on private-sector outbound investment, suggest the chinese government intends for soes to maintain 18 yariv brauner & pasquale pistone, the brics and the future of international taxation, in brics and the emergence of international tax coordination, supra note 12, at 517; yariv brauner, treaties in the aftermath of beps, 41 brook. j. int'l l. 973, 1026 (2016). 19 see infra text accompanying notes 51-57; reuven s. avi-yonah, omri marian & nicola sartori, global perspectives on income taxation law 166 (2010); donald. r. whittaker, an examination of the o.e.c.d. and u.n. model tax treaties: history, provisions and application to u.s. foreign policy, 8 n.c. j. int'l l. & com. reg. 39 (1982). 20 see generally kelle s. tsai & barry naughton, state capitalism and the chinese economic miracle, in state capitalism, institutional adaption and the chinese miracle 11 (barry naughton & kellee s. tsai eds., 2015) (suggesting seven defining characteristics of modern chinese state capitalism); li-wen lin & curtis j. milhaupt, we are the (national) champions: understanding the mechanisms of state capitalism in china, 65 stan. l. rev. 697 (2013) (describing the unique “relational ecology” of chinese state capitalism composed of deep connections between soes and the party-state). 21 their scholarship is discussed in detail at part 5 infra. 22 wei cui, taxing state-owned enterprises: understanding a basic institution of state capitalism, 52 osgoode hall l.j. 775, 810 (2016). 23 for instance, lin and milhaupt discuss potential implications for the foreign corrupt practices act, the committee on foreign investment in the united states (cfius) process, the federal securities law disclosure regime, the antitrust regime, and bilateral investment treaties, but make no mention of international tax law. see lin & milhaupt, supra note 20, at 757-758; see also curtis j. milhaupt & wentong zheng, beyond ownership: state capitalism and the chinese firm, 103 geo. l.j. 665, 708-16 (2015) (discussing the implications of chinese state capitalism for international antitrust, anticorruption, and anti-subsidy law with respect to purportedly private chinese firms). 24 see infra part 4.b. 82 [vol.10:1 columbia journal of tax law their leading role in china’s overseas investment.25 scholarly critiques of the chinese system of soe governance and of the centrality of soes in chinese outbound investments are both forceful and plentiful.26 however, rather than engaging in debates about the overall soundness of china’s system of state capitalism, this paper proceeds on the premise that soes will remain integral to the chinese economy and outbound investment for the foreseeable future.27 if so, how may the distinctive features of chinese state capitalism shape the objectives of china’s international tax policy and thereby impact the future of the international tax regime? this paper argues that china’s system of state capitalism may lead it to pursue a set of international tax policies and norms that diverge from those currently sought by oecd nations. first, due to the prominence of soes in its outbound investment, china may favor and successfully maintain a robust system of worldwide corporate taxation despite a general trend amongst developed countries towards territorial systems.28 second, due to chinese tax administrators’ strong incentive to assist chinese soes in minimizing their foreign taxes paid, china may provide tacit state support for soe tax planning, complicating the government’s role in tax diplomacy.29 finally, chinese international tax policy is likely to provide preferential treatment to soes in domestic regulations and seek to expand preferential exemptions for soes in bilateral treaties.30 by pushing for a reconceptualization of sovereign immunity in taxation, china may create a new pressure point for tax competition between countries seeking to attract chinese direct investment. these arguments are advanced as follows. part 2 analyzes international disagreements regarding three key fault lines in the international tax regime: 1) the allocation of taxing rights between source and residence countries, 2) oecd efforts to combat tax competition, and 3) base erosion and profit shifting. part 3 traces the evolution of china’s system of business taxation and argues that chinese international tax policy stands at an inflection point with the existing literature providing limited insight on its future direction. part 4 highlights the ways in which the central government maintains extensive control over the chinese economy through its direct influence over soes and capital controls. part 5 contends that these features of chinese state capitalism may lead china to challenge the current international tax regime by pursuing a set of distinctive international tax policies and norms. finally, part 6 offers concluding thoughts and considers the impacts of such policies on oecd countries. 25 see, e.g., lucy hornby, chinese crackdown on dealmakers reflects xi power play, fin. times, aug. 9, 2017, https://www.ft.com/content/ed900da6-769b-11e7-90c0-90a9d1bc9691 [https://perma.cc/p4nm-xu5p]; tom mitchell & gabriel wildau, china’s state council puts seal on capital controls, fin. times, aug. 18, 2017, https://www.ft.com/content/3a638d1c-8405-11e7-a4ce-15b2513cb3ff [https://perma.cc/aux6-dr6k]; see also wu gong, soes lead infrastructure push in 1,700 ‘belt and road’ projects, caixin (may 9, 2017), https://www.caixinglobal.com/2017-05-10/101088332.html [https://perma.cc/7d88-ery3] (“about 50 chinese state-owned corporate giants have invested or participated in nearly 1,700 projects in countries along the new silk road routes over the past three years.”), 26 see, e.g., ligang song, jidong yang & yongsheng zhang, state-owned enterprises’ outward investment and the structural reform in china, 19 china & world econ. 38 (2011); see also chenyang xie, the legal regime of chinese overseas 85 (2015) (“china should restrict outward overseas investment by state-owned enterprises through legislation”). 27 see infra part 4.b. 28 see infra part 5.b. 29 see infra part 5.c. 30 see infra part 5.d. 2018] 83 chinese state capitalism and the international tax regime ii. fault lines in the international tax regime a. allocation of taxing rights before considering how china’s system of state capitalism may impact the objectives of its international tax policy, it is instructive to first survey three key points of disagreement between developed and developing countries regarding the current international tax regime. only after considering the major fault lines over international tax policy does the significance of china’s unique position in tax diplomacy—as an emerging economic power with significant soecontrolled capital outflows—become clear. the first, and arguably the most important, area of divergence is the allocation of taxing rights between source and residence countries. when a resident of country a earns income in country b, both countries may legitimately claim the right to tax these earnings. country a, the residence country, may assert taxing jurisdiction since it is where the income recipient resides or where a corporate taxpayer has its place of incorporation or management.31 country b, the source country, may assert taxing jurisdiction since it is where the income is earned.32 thus the “essential dilemma of international taxation” is resolving the competing claims of residence and source jurisdictions.33 much ink has been spilled over whether residence or source countries have a “better” right to tax earnings,34 and over the worldwide efficiency impacts of residence or source taxation.35 yet, self-interested countries have generally been unwilling to entirely forgo taxation of income earned by their residents abroad or by nonresidents within their borders. this can create double taxation, as earnings may be taxed twice, once by the residence country and once by the source country. while one country can unilaterally take steps to limit the burden of double taxation on its residents through the use of foreign tax credits, exemptions, or deductions, bilateral solutions are preferred.36 unilateral action requires a residence country to subordinate its tax claims over foreign income to source country claims, without any guarantee from the source country of reciprocity or of an upper limitation on taxes imposed. moreover, unilateral exemptions can result in double nontaxation.37 as a result, a network of over 3,000 bilateral tax treaties has developed to govern the taxation of cross-border business and investment.38 while the modern scope of bilateral tax treaties 31 see generally peggy b. musgrave, sovereignty, entitlement, and cooperation in international taxation, 26 brook. j. int’l l. 1335, 1336 (2001) (discussing justifications of resident country taxation); omri marian, jurisdiction to tax corporations, 54 b.c. l. rev. 1613 (2013) (analyzing the concept of corporate residence). 32 see, e.g., peggy b. musgrave, interjurisdictional equity in company taxation: principles and applications to the european union, quoted in michael j. graetz, foundations of international income taxation 6 (2003). 33 graetz, supra note 9, at 11. 34 for brief review of the literature, see veronika daurer, tax treaties and developing countries 12-17 (2014); graetz, supra note 32, at 5-12. 35 for a discussion and critique of the principles of capital import neutrality and capital export neutrality, see graetz, supra note 9, at 93-98. 36 see, e.g., allison christians, beps and the new international tax order, 2016 byu l. rev. 1603, 1610 (2016). 37 see id. at 1612. 38 see reuven s. avi-yonah, double tax treaties: an introduction, in the effect of treaties on foreign direct investment: bilateral investment treaties, double taxation treaties and investment flows 99106 (karl p. sauvant & lisa e. sachs eds., 2009) (providing an estimate of 2,500 treaties as of 2009); see also brian 84 [vol.10:1 columbia journal of tax law has expanded, the foundational purpose of these treaties has been preventing double taxation.39 scholars have considered these treaties as constituting an “international tax regime,” as the treaties are “meaningfully standard” and “largely similar in policy.”40 in particular, this network of treaties reflects what has been labeled the “1920s compromise.” as provided for in the 1928 league of nations model bilateral income tax treaties, the primary right to tax active business income is allocated to the source jurisdiction while the primary right to tax passive investment income is allocated to the residence jurisdiction.41 a form of this compromise has been embedded in both the oecd and un model treaties—which serve as the starting points for modern international tax treaty negotiations. as the presence of two competing model treaties indicates, despite the “1920s compromise” the allocation of taxing rights still remains a pressure point in the international tax regime. in signing a bilateral tax treaty, each country reduces its source-based claims on income earned by non-residents within its borders. for the source-based claims preserved by treaty, the residence country promises to avoid double taxation by providing a tax credit or exemption to its residents for income earned in the source country.42 thus, the more source-based claims preserved in a bilateral treaty the greater the allocation of taxing rights to the source country; the fewer preserved, the greater the allocation to the residence country. generally, when a set of countries has balanced bilateral investment flows, each is a source country roughly as often as it is a residence country, so both are willing to give up significant source-based claims.43 thus the oecd model treaty, which originated amongst a set of developed countries assumed to have relatively balanced investment flows, allocates taxing rights primarily to the state of residence. however, if one country receives more capital investment than it sends abroad, allocating tax rights primarily to the state of residence can cause the capital importing country to lose significant tax revenue. because developed countries are generally exporters of capital, and developing countries importers of capital, the oecd model treaty—with its bias toward residence taxation—has been criticized as favoring developed countries over developing countries.44 as a result, the un model treaty is designed to account for non-reciprocal income flows between a developed and a developing country by preserving more source-based claims.45 the allocation of taxing rights is a perennial point of contention between developed and developing countries in bilateral treaties negotiations. during the 1940s, when efforts were j. arnold, an introduction to tax treaties, http://www.un.org/esa/ffd/wpcontent/uploads/2015/10/tt_introduction_eng.pdf [https://perma.cc/uh46-y3sb] (providing an estimate of 3,000 as of 2015). 39 see thomas rixen, the political economy of international tax governance 84-116 (2008). 40 reuven s. avi-yonah, commentary (response to article by h. david rosenbloom), 52 tax l. rev. 167, 16870 (2000); brauner, supra note 12, at 975. 41 see reuven s. avi-yonah, international tax as international law 9 (2007); graetz, supra note 9, at 84. 42 see daurer, supra note 34, at 57; christians, supra note 36, at 1613. 43 see daurer, supra note 34, at 23. 44 see, e.g., tsilly dagan, the tax treaties myth, 32 n.y.u. j. int’l' l. & pol. 939 (2000). however, as further discussed infra at part 3.b., the relationship between development status and capital flows can quite be complicated, especially for large emerging economies. 45 see daurer, supra note 34, at 2. 2018] 85 chinese state capitalism and the international tax regime underway to update the league of nations model treaties, a tax conference in mexico attended mainly by latin american countries saw the development of a model granting source countries “almost exclusive taxing rights.”46a few years later in 1946 a full international tax conference in london drafted a model more favorable to residence countries, which served as the baseline for most bilateral negotiations until 1963.47 although the united nations established a committee intended to continue the model tax treaty work of the league of nations, the committee ceased to meet after 1954.48 as a result, the oecd became the main forum for international tax matters, releasing influential model treaties in 1963 and 1977, and consistent updates since 1992 in the form of an ambulatory model.49 the oecd model reduces source-based claims on passive income earned by non-residents (through lowering or eliminating withholding taxes) and retains sourcebased claims on active income only for earnings attributable to a permanent establishment.50 in 1967 the un resumed its interest in international tax matters, creating a committee of experts intended to aid developing countries in bilateral tax negotiations.51 the committee published a model treaty in 1980, which was updated in 2001 and 2011.52 the un model follows the same structure and terminology as the oecd model but preserves additional source-based claims by, among other things, allowing for higher withholding tax rates on passive income and providing a broader definition of permanent establishment.53 elements of the un model have been used in the bilateral treaties of developing countries, including china.54 however, the oecd model is said to “dominate the current tax treaty law.”55 conversely, the un model “suffers marginalization.”56 scholars continue to critique the distributional impacts of the oecd model, and some suggest the rise of the brics may help foster a more equitable distribution of taxing rights in future treaties.57 b. tax competition another major fault line in the international tax regime is the degree to which it is appropriate for nations to implement low rates and preferential tax policies in the hope of attracting foreign investment. distinguishing between acceptable and unacceptable tax competition 46 id. at 56. 47 see id. at 56. 48 see sol picciotto, regulating global corporate capitalism 223 (2011). 49 see f. alfredo garcia prats, impact of the positions of the brics on the un model convention, in brics and the emergence of international tax coordination, supra note 12, at 393; daurer, supra note 34, at 56. 50 org. econ. co-operation & dev. (oecd), model tax convention on income and on capital (dec. 18, 2017), http://www.oecd.org/ctp/treaties/model-tax-convention-on-income-and-on-capital-condensed-version20745419.htm [https://perma.cc/a8vn-kbqf]. 51 see whittaker, supra note 19, at 43-44; see also united nations, committee of experts on international cooperation in tax matters, http://www.un.org/esa/ffd/tax/overview.htm [https://perma.cc/6vpg-pz38] (describing the history of the committee of experts on international cooperation in tax matters). 52 see daurer, supra note 34, at 59; diane ring, who is making international tax policy: international organizations as power players in a high stakes world, 33 fordham int'l l.j. 649 (2010). 53 united nations, model double taxation convention between developed and developing countries (apr. 5, 2012), http://www.un.org/en/development/desa/publications/double-taxation-convention.html [https://perma.cc/v7qz-lg99]; see daurer, supra note 34, at 2. 54 see infra text accompanying note 118 ; see also daurer, supra note 34, at 255. 55 brauner, supra note 18, at 977; see prats, supra note 49, at 395. 56 pistone & brauner, supra note 18, at 12. 57 see, e.g., daurer, supra note 34, at 26-27. 86 [vol.10:1 columbia journal of tax law continues to be a point of contention.58 in the 1980s, the growing number of transactions taking advantage of tax haven jurisdictions led tax policy-makers in oecd countries to recognize a need for coordinated action. many small jurisdictions found it in their interest to offer preferential tax policies and low rates in order to attract an outsized share of global financial activities.59 in response, the oecd published a report in 1998 entitled harmful tax competition: an emerging global issue which sought to develop criteria to identify harmful tax competition. 60 two particularly notable elements of the report were its repeated invocations of the dangers of a “race to the bottom” amongst jurisdictions and its listing of low or zero effective tax rates as an element of harmful competition. then, in 2000 the oecd released a “blacklist” of 35 uncooperative tax havens which were required to take measures to eliminate their harmful tax practices or risk facing coordinated coercive measures by oecd countries—such as the denial of deductions, exemptions, or credits for transactions involving the tax havens.61 a set of scholars, practitioners, and lobbyists vehemently criticized the oecd’s approach for providing unequal treatment of oecd and nonoecd countries (oecd members switzerland and luxembourg, for instance, were not required to make any reforms), illegitimately impinging on national sovereignty, and advancing a negative view of “competition” in conflict with free market ideals.62 these allegations of illegitimacy and political bias coupled with the withdrawal of u.s. support, contributed to the failure of the initiative.63 subsequently, the oecd shifted course from focusing on tax competition to focusing on combating tax evasion through information exchange.64 following the pushback to its initiative against harmful tax competition, the oecd adopted a less confrontational approach. in 2002, it released a model tax information exchange agreement (tiea) designed to facilitate bilateral exchanges of information between countries without requiring the signing of comprehensive bilateral tax treaties. 65 this tax-transparency agenda initially witnessed limited success, with less than 25 tieas signed through 2007.66 however, 58 see christians, supra note 36, at 1630. 59 see rixen, supra note 39, at 131-42; morriss & moberg, supra note 13. 60 org. econ. co-operation & dev. (oecd), harmful tax competition: an emerging global issue (1998). 61 see martin a. sullivan, lessons from the last war on tax havens, 116 tax notes 327 (2007). 62 see richard woodward, a strange revolution: mock compliance and the failure of the oecd’s international tax transparency regime, in global tax governance 109 (peter dietsch & thomas rixen eds., 2016); allison christians, sovereignty, taxation, and social contract, 18 minn. j. int'l l. 99 (2009). 63 see markus meinzer, towards an international yardstick for identifying tax havens and facilitating reform, in global tax governance, supra note at 62, at 259; see also paul o’neil, statement on oecd tax havens (may 10, 2001), https://www.treasury.gov/press-center/press-releases/pages/po366.aspx [https://perma.cc/sec3-cnsc] (“the united states does not support efforts to dictate to any country what its own tax rates or system should be, and will not participate in any initiative to harmonize world tax systems. the united states simply has no interest in stifling the competition that forces governments—like business—to create efficiencies.”). 64 see nicholas shaxson & john christensen, tax competitiveness—a dangerous obsession, in global tax fairness 287 (thomas poggee & krishen mehta eds., 2016); timothy v. addison, shooting blanks: the war on tax havens, 16 ind. j. global leg. stud. 703 (2009). 65 org. econ. co-operation & dev. (oecd), tax information exchange agreements (tieas), http://www.oecd.org/tax/exchange-of-tax-information/taxinformationexchangeagreementstieas.htm [https://perma.cc/hc9c-bzk3]. 66 see id.; richard eccleston & helen smith, the g20, beps, and the future of international tax governance, in global tax governance, supra note 62, at 179. 2018] 87 chinese state capitalism and the international tax regime following the 2008 financial crisis, a more coercive approach was adopted. in 2009, the oecd, under the direction of the g-20, revealed a progress report which placed jurisdictions that had signed twelve or more tieas onto a white list, those that had committed to sign tieas onto a gray list, and those that had not taken sufficient transparency measures onto a black list.67 echoing the approach toward harmful tax competition, the g-20 threatened countermeasures against jurisdictions not meeting tax transparency standards.68 the approach and the lists of noncompliant jurisdictions were not without controversy.69 yet, by 2010, all jurisdictions were removed from the blacklist and by 2014 over 1,600 tieas had been signed.70 however, scholars suggest that the practical results have been limited, with many tax havens engaging in “mock compliance” by signing “near-useless” tieas amongst themselves.71 despite the mixed record of prior multilateral attempts to address tax competition and evasion, calls continue for further efforts to limit tax competition through u.s. or oecd-led harmonization initiatives.72 c. base erosion and profit shifting the newest pressure point in the international tax regime is the g-20/oecd beps project. launched in 2013, the project intends to update international tax rules to address various gaps and mismatches utilized by corporations to artificially shift profits across jurisdictions or achieve double non-taxation of income.73 in 2015, the oecd produced 15 action plans concerning current technical challenges in international tax law.74 reflecting a lack of consensus regarding certain elements of the project, most plans only offer prescriptive guidance in the form of suggested best practices. some, however, provide international minimum standards to be implemented through either the multilateral convention or domestic legislation.75 notably, the beps project lacks “even mild coercive measures,” with peer review as the only enforcement mechanism.76 yet, despite the relatively modest aims of the project’s action plans, its future remains in doubt. the united states has yet to ratify the multilateral convention and the trump administration has expressed little 67 see woodward, supra note 62, at 111-13. 68 see id.; grinberg, supra note 5, at 1149-51. 69 see infra text accompanying note 129. 70 see eccleston & smith, supra note 66, at 179. 71 see, e.g., meinzer, supra note 63, at 267, 255; woodward, supra note 62, at 111-13. 72 see, e.g., reuven s. avi-yonah, the oecd harmful tax competition report: a tenth anniversary retrospective, 34 brook. j. int'l l. 783, 793 (2009); danielle wenner & kevin zollman, how to end international tax competition, n.y. times, nov. 2, 2017, https://www.nytimes.com/2017/11/02/opinion/ending-international-taxcompetition.html [https://perma.cc/zq4q-mkpx]. 73 see org. econ. co-operation & dev. (oecd), action plan on base erosion and profit shifting (2003), https://www.oecd.org/ctp/bepsactionplan.pdf [https://perma.cc/q688-trzu]. however some more critical commentators have suggested the project represents an effort to revitalize oecd initiatives against tax competition under a new and more technical guise; see brauner, supra note 9, at 76-79; joachim englisch & anzhela yevgenyeva, the upgraded strategy against harmful tax practices under the beps action plan. 5 british tax rev. 620 (2013); brian garst, beps pivotal in fight over tax competition, cayman fin. rev. (aug. 19, 2015), http://www.caymanfinancialreview.com/2015/08/19/beps-pivotal-in-fight-over-tax-competition/ [https://perma.cc/w3y6-hffh]. 74 see org. econ. co-operation & dev. (oecd), beps actions, , http://www.oecd.org/tax/beps/bepsactions.htm [https://perma.cc/4zm2-cghp]; christians, supra note 36, at 1623; grinberg, supra note 5, at 1142. 75 see multilateral convention, supra note 6. 76 grinberg, supra note 5, at 1168. 88 [vol.10:1 columbia journal of tax law enthusiasm for the project.77 china, on the other hand, has rapidly implemented most beps action plans, reflecting its significant influence over the project and its interest in becoming the vanguard in international tax policy.78 iii. the evolution of chinese tax policy a. from mao to the modern enterprise income tax china has historically played a relatively minor role in international tax diplomacy, as its modern system of domestic corporate taxation is of recent origin. in fact, china’s current system of corporate income taxation, the enterprise income tax (eit) dates only to 2008. a brief review of the history of chinese business income taxation puts china’s international tax policy in context and reveals why many aspects remain underdeveloped or in flux. it also illustrates the ways in which changing theories of soe governance and administration have led to significant alterations in china’s business tax policy, further elucidating the underappreciated connection between china’s unique system of state capitalism and its tax policies. china’s first income tax was implemented by the nationalist government in 1936. it applied to both business profits and employment income and was territorial in scope, exempting foreign earnings.79 reforms in 1943 extended taxation to rental income and capital gains and purportedly imposed taxes on chinese citizens abroad, while offering credit for foreign taxes paid—thus following the american model. yet, during this period china was plagued by war, its tax administration was “in chaos,” and the central government had limited power.80 as a result, there is little surviving evidence on the implementation of this early attempt to tax overseas income.81 it was not until the mid-1990s that china would again seek to tax business income earned abroad.82 in the first decade following the establishment of the people’s republic in 1949, the communist party transformed china into a socialist state-planned economy. initially, 14 different taxes were imposed on private businesses at various stages of transactions. these were consciously designed to discourage private business and thus facilitate the socialist transformation.83 thanks 77 see, e.g., torsten fensby, will the beps project survive the trump administration?, tax notes (may 15, 2017), https://www.taxnotes.com/worldwide-tax-daily/base-erosion-and-profit-shifting-beps/will-beps-projectsurvive-trump-administration/2017/06/01/symv [https://perma.cc/3va5-mcdw]; robert sledz, thomson reuters hosts panel on beps mli and cbc reporting at 2017 ifa rio congress, thompson reuters (oct. 3, 2017), https://tax.thomsonreuters.com/blog/thomson-reuters-hosts-panel-on-beps-mli-and-cbc-reporting-at-2017-ifa-riocongress/ [https://perma.cc/k6ge-8ne6]. 78 see chris xing, william zhang, lilly li & conrad turley, china at the forefront of global beps implementation, int’l tax rev. (dec. 3, 2015), http://www.internationaltaxreview.com/article/3511704/china-atthe-forefront-of-global-beps-implementation.html [https://perma.cc/bd4r-zl7y]. 79 see jinyan li, taxation in the people’s republic of china 8-9 (1991); wei zhimei & liu jian [魏志梅 & 刘建], zhongguo jingwai suodeshui zhi de huigu jiejian yu zhanwang (中国境外所得税制的回顾、借鉴与展望) (china’s overseas income tax system: retrospective, lessons, and prospects], 7 tax’n res. j. 89 (2011) [税务研 究]. 80 li, supra note 79, at 10. 81 see wei zhimei, supra note 79. 82 see infra note 109. 83 see daniel h.k. ho, tax law in modern china: evolution, framework and administration, 31 hong kong l.j. 141, 146-7 (2001). 2018] 89 chinese state capitalism and the international tax regime to the expropriation of assets held by capitalists and foreign investors, by approximately 1956, the private sector had vanished and soes had become the dominant from of commercial enterprise.84 soes were themselves overseen by various government bureaucracies, the most important by central government ministries and the smallest by departments of local governments.85 from the mid-1950s until the start of china’s reform and opening up policy in late 1978, the government would experiment with various methods of transferring funds from soes to the central government. since there were essentially no foreign entities operating in china, the government’s business tax policies were entirely domestic in focus.86 at first, in the early 1950s soes were required to hand over nearly all profits to the central government under a system of direct state administration of income and expenses. however, across the 1950s and 1960s, soes were able to maintain a small portion of profits under either the “enterprise bonus system” (in which soes could retain any surplus over target levels set by the central government) or the “profit-contracting system” (in which soes would retain a pre-determined percentage of total enterprise profits). the particular system in place vacillated with the political winds.87 in 1978 china saw the implementation of deng xiaoping’s reform and opening up policy, allowing for foreign investment and market reforms. in order to attract capital, china adopted income tax regimes offering preferential treatment to foreign direct investment.88 the chineseforeign equity joint venture income tax and the foreign enterprise income tax both offered generous tax incentives including tax holidays and reinvestment refunds.89 the first applied to equity joint ventures between a foreign investor and a chinese partner and had the most generous incentives, while the second applied to other foreign direct investments.90 in 1991, these two regimes were combined with the introduction of the foreign income tax law providing uniform treatment for all foreign invested enterprises.91 across the 1990s effective tax rates for foreign invested enterprises were much lower than for domestic enterprises.92 scholars have generally 84 see li, supra note 79, at 11; ho, supra note 83, at 147; jiangyu wang, the political logic of corporate governance in china's state-owned enterprises, 47 cornell int’l l.j. 631, 644 (2014); see also aron shai, the fate of british and french firms in china, 1949-54, at 99-104 (1996) (summarizing the history of direct and indirect nationalization of western firms in china during the early 1950s). 85 see wang, supra note 84, at 646. 86 see ho, supra note 83, at 145. 87 see ho, supra note 83, at 149; isabella lam, stella cho & aldous mak, historical development of income tax law for domestic and foreign enterprises in china, 22 int’l tax j. 51, 52-55 (1996). 88 notably, most of these incentives applied to foreign direct investment and not to portfolio investment. chinese regulations at the time only permitted foreign enterprises to engage in production and business activities and strictly limited their ability to hold investments outside their corporate group. see jinyan li, the rise and fall of chinese tax incentives an implications for international tax debates, 8 fla. tax rev. 669, 702 (2007). current chinese regulations on portfolio investments are further discussed infra at part.4.c. 89 see id. at 671. 90 see vlad frants, the competence of the chinese taxation system, 18 currents: int’l trade l.j. 30, 32 (2010). 91 see xin zhang, law & practice of international tax treaties in china 22 (2003); ho, supra note 83, at 152. 92 see, e.g., li, supra note 88, at 677 (“as a result of these tax incentives, the effective tax rate for [foreign invested enterprises] was about 10 percentage points lower than that for domestic enterprises.”). 90 [vol.10:1 columbia journal of tax law concluded these tax incentives were effective in helping to attract much needed foreign investment.93 the reform and opening up policy also witnessed changes in the theory of soes governance and a concomitant alteration in the taxation of domestic enterprises. following the start of reform and opening up in 1978, soes were given more authority to make independent business and personnel decisions.94 in order to give greater financial incentives to soes, the government began to experiment with the reform of “from profit to tax.” starting in 1984, soes became subject to income and regulatory taxes.95 largeand medium-sized soes were statutorily subject to a 55 percent income tax rate, but in practice the amount of taxes paid was often “determined on a negotiated basis between the soes and the central government” rather than based “on taxing actual profits.”96 small domestic private enterprises now allowed as part of market reforms were also taxed on their earnings, but under an entirely separate regime.97 following deng xiaoping’s famous 1992 southern tour, highlighting the success of china’s initial market reforms, the central government enacted further reforms to soe governance and taxation. 98 in 1993, the government passed a comprehensive corporate law and in the following year oversaw corporatization of 100 major soes as part of an effort to enhance their competitiveness.99 corporatization would continue across the 1990s, with large and medium-sized soes consolidated into government-owned corporate groups and small soes privatized.100 that same year, china also promulgated new tax regulations, which applied the same tax rules and rates to all types of domestic enterprises. the new rules reduced the statutory tax rates on soes to 33 percent from 55 percent, but also eliminated the deductions and areas of regulatory discretion that soes had taken advantage of under the prior system.101 moreover, soes and other domestic 93 see id. at 681-86; qun li, tax incentive policies for foreign-invested enterprises in china and their influence on foreign investment, 18 revenue l.j. art. 5, 15 (2008). 94 see hongfei zhong, where is the future: china’s soe reform, 1 j. wash. inst. china studies 105, 105 (2006); xun wang, whither troubled chinese state-owned enterprises?, 1998 china rev. 363, 366-69. 95 see fuli cao, corporate income tax law and practice in the people’s republic of china 9 (2011); wang, supra note 94, at 367. 96 ho, supra note 83, at 153; see tsang shu-ki & cheng yuk-shing, china's tax reforms of 1994: breakthrough or compromise? 34 asian surv. 769, 782 (1994). 97 see ho, supra note 83, at 153. 98 see wang, supra note 94, at 370; see also the nanxun legacy and china's development in the postdeng era (john wong and zheng yongnian eds., 2001) (assessing the impact of the southern tour or nanxun as a political landmark in china’s economic reforms). 99 see wang, supra note 84, at 646. see generally yong zhang, large chinese state-owned enterprises: corporatization and strategic development (2008) (providing an in-depth investigation of corporatization of large chinese soes). 100 see wang, supra note 84, at 646; zhong, supra note 94, at 106; see also we are the champions, economist (mar. 18, 2004), http://www.economist.com/node/2495172 [https://perma.cc/5ymk-f8rd] (describing prime minister zhu rongji’s doctrine of zhuada fangxiao or “grasp the big, let go the small” regarding soe restructuring). 101 zhonghua renmin gongheguo qiye suodeshui zanxing tiaoli [中华人民共和国企业所得税暂行条例] (provisional regulations on enterprise income tax) (promulgated by the state council., nov. 26, 1993, effective jan. 1, 1994), lawinfochina (last visited jan. 1, 2017) http://www.lawinfochina.com/display.aspx?id=625&lib=law [https://perma.cc/b5jp-3x65] [hereinafter domestic enterprise income tax regulations] (china); see lam supra note 87, at 59. 2018] 91 chinese state capitalism and the international tax regime enterprises were subject to the same statutory tax rate as foreign invested enterprises, although foreign enterprises were still eligible for preferential incentives and favorable deduction rules.102 after 26 years of maintaining separate tax regimes for domestic and foreign enterprises, china promulgated a unified enterprise income tax (eit) in 2007.103 this ended the tax incentive regime for foreign investment and imposes a uniform tax rate of 25 percent on all business activity.104 thus, for the first time, eit provides equal tax treatment for domestic and foreign enterprises. however, it makes available a 15 percent tax rate and preferential deductions for companies that qualify as “high new technology enterprises.” 105 american enterprises have accused the regulations regarding hnte status of having “de facto bias against foreign companies,” as they require core ip to be owned by the entity seeking hnte tax treatment.106 under the eit, china taxes resident enterprises on their worldwide income and offers a foreign tax credit for income taxes paid in foreign countries.107 china’s system of worldwide enterprise income taxation traces its origin to the 1993 domestic enterprise income tax regulations, which applied to income from sources both within and outside of the country.108 in 1997 the state administration of taxation (sat) published regulations that 1) reaffirmed that domestic enterprises were subject to chinese taxation on foreign income and 2) permitted domestic enterprises to credit foreign taxes when calculating their taxable foreign income.109 the eit maintains this basic approach and codifies the foreign tax credit into law.110 under the eit, a chinese resident enterprise can claim a direct credit for foreign income taxes paid.111 additionally, on the receipt of dividends from a foreign subsidiary, it may also claim an indirect credit for income taxes paid that are attributable to the dividends received—subject to some controversial limitations. 112 while resident enterprises are generally not taxed on the profits of foreign subsidiaries until the receipt of dividends, the eit contains a controlled foreign corporation (cfc) provision, under which a resident enterprise may be required to include its share of undistributed 102 see cao, supra note 95, at 11. 103 zhonghua renmin gongheguo qiye suodeshui fa [ 中 华 人 民 共 和 国 企 业 所 得 税 法 ] (enterprise income tax law) (promulgated by the nat'l people's cong., mar. 16, 2007, effective jan. 1, 2008) lawinfochina (last visited jan. 1, 2017) http://www.lawinfochina.com/display.aspx?id=5910&lib=law# [https://perma.cc/p6q8-fruw] [hereinafter enterprise income tax law] (china). 104 enterprise income tax law, chapter i, art. 4; see, cao, supra note 95, at 11-12; frants, supra note 90, at 33; li, supra note 93, at 31. 105 enterprise income tax law, chapter i, art. 28; see cao, supra note 95, at 213-22. 106 see, e.g., china’s high and new-technology enterprise (hnte) program, u.s.-china business council (june 2013), http://uschina.org/sites/default/files/2013%20hnte%20backgrounder.pdf [https://perma.cc/399g85uj]. 107 enterprise income tax law, chapter i, arts. 3, 23, 24; see frants, supra note 90, at 35. under the eit, enterprises established in china under chinese law or established abroad but with their effective place of management located in china, are considered resident enterprises. see enterprise income tax law, chapter i, art. 2. 108 domestic enterprise income tax regulations, art. 1. 109 jingwai suode ji zheng suodeshui zhanxing banfa [境外所得计征所得税暂行办法] (provisional measures on levying income tax on overseas income), cai shui zi [1997] no.116; see wei zhimei, supra note 79. 110 see generally cao, supra note 95, at 241-65 (providing an overview of the taxation of income from foreign countries and region under the eit). 111 enterprise income tax law, chapter i, art. 23. 112 enterprise income tax law, art. 24; see infra text accompanying notes 136-137. 92 [vol.10:1 columbia journal of tax law profits from a cfc, if the effective tax rate on the cfc is less than 12.5 percent.113 in 2009, the state administration of taxation (sat) published regulations regarding the foreign tax credit under the eit—addressing many fundamental issues, such as the character of creditable foreign taxes and the calculation of the indirect credit.114 b. china’s international tax policy and diplomacy at a crossroads the relatively recent development of china’s foreign tax credit and cfc rules reflects the fact that china’s international tax policy currently stands at a crossroads. from the start of reforming and opening up in 1978 until quite recently, china’s international tax policy closely reflected its status as a capital importer. yet, in the decade following the 2008 global financial crisis chinese outbound investment increased dramatically and in 2015 china became a net capital exporter.115 as a result, chinese international tax policy and diplomacy is gradually changing to reflect the country’s new role in the global economy. until a decade ago, the clear objective of chinese international tax policy and diplomacy has been to attract investment from developed countries while protecting source-based taxation claims. in the early years of reform, in addition to implementing preferential tax regimes for foreign investment, china also sought to conclude bilateral income tax treaties with developed countries.116 china concluded its first treaty with japan in 1983 and by 1988 it had negotiated twenty treaties, primarily with major developed countries.117 from the japan treaty until the mid1990s, china sought to negotiate on the basis of the un model and as a result, its treaties with the united states and european countries generally reflect a hybrid of the oecd and un model treaties.118 in particular, china insisted on a broad scope for source-based taxation claims by negotiating for broad permanent establishment definitions, source-country taxation of royalties, and source-country taxation of gains from alienation of shares.119 commentary on the 1984 treaty between china and the united states, for instance, noted that the united states granted china a 113 enterprise income tax law, art. 45. 114 qiye jingwai suodeshui shou di mian youguan de tongzhi [企业境外所得税收抵免有关问题的通知] (notice on the issues concerning foreign tax credits), cai shui [2009] no. 125. 115 see, e.g., mei (lisa) wang, zhen qi & jijing zhang, china becomes a capital exporter, in china’s domestic transformation in a global context 315, 315-17 (ligang song et al. eds., 2015); china seeks balanced growth as net capital exporter, xinhua (jan. 21, 2015), http://www.xinhuanet.com/english/china/201501/21/c_133935581.htm [https://perma.cc/9rt2-ybv7]. 116 see cong zhichi “yinjin lai” dao zhuli “zuo chuqu”: zhongguo shuishou xieding gongzuo de huigu yu zhanwang [从支持“引进来”到助力“走出去”: 中国税收协定工作的回顾与展望] (from supporting “attracting in” to helping “going out”: review and future outlook of china’s tax agreements), 9 int’l tax’n in china 6, 7 (2015) [国际税收] (suggesting china’s international tax diplomacy can be divided into distinct historical stages each reflecting a different overarching purpose). 117 see william a. turner & elizabeth m. orazem, united states-people's republic of china income tax treaty: opening the door to increased economic cooperation, 13 n.c.j. int'l l. & com. reg. 527 (1988). 118 see ecker & tang, supra note 13, at 34; id. 119 see ecker & tang, supra note 13, at 48; hu & li, china tax treaty and policy: development and updates, in brics and the emergence of international tax coordination, supra note 12, at 222; zhang, supra note 91, at 32. 2018] 93 chinese state capitalism and the international tax regime very generous set of source-based taxation concessions in comparison to prior u.s. treaties.120 in order to attract foreign investment, china also sought to include tax sparing clauses in its treaties with developed countries.121 under a tax sparing mechanism, the residence country credits a taxpayer for foreign income taxes that would have been paid but for tax holidays or incentives granted by the source country. functionally, tax sparing ensured tax incentives offered by china to foreign investors would not be nullified by reductions in residence country tax credits—thus the benefit of tax incentives would flow to foreign investors rather than residence country taxing authorities. over the past decade china has begun to reassess its international tax policy and diplomacy in light of its new role as significant capital exporter. for example, as noted above, new regulations have been promulgated regarding the taxation of income earned abroad by chinese resident enterprises.122 moreover, chinese tax authorities have also begun to enforce previously ignored international tax rules, most notably china’s cfc rules. 123 in terms of bilateral tax treaty negotiations, scholars analyzing china’s recent treaties suggest that it now strives to strike a balance between securing benefits for chinese outbound investment and retaining “a robust position as a capital importer.”124 for instance, the oecd model appears to have now supplanted the un model as the starting point for chinese tax treaty negotiations.125 in particular, recent treaties have scaled back source taxation of business profits, indicating a shift away from its prior practice of staunchly defending source taxation.126 moreover, since 2009, china has stopped including tax sparing mechanisms in new or amended tax treaties.127 many of the tax sparing provisions in older treaties are also expiring thanks to temporal limitations or chinese domestic tax reform.128 china’s engagement with oecd-led multilateral tax initiatives further reflects an on-going transition in chinese international tax policy. in the past, china had a fraught relationship with the 120 critics of the treaty suggested that the foreign policy goal of gaining closer ties with china may have overshadowed economic considerations. see turner & orzem, supra note 117, at 544; paul d. reese, united states tax treaty policy toward developing countries: the china example, 35 ucla l. rev. 369, 386, 388-91 (1987). 121 see ecker & tang, supra note 13, at 36; hu & li, supra note 119, at 212. 122 see supra note 114. 123 see, e.g., hu & li, supra note 119, at 222-25; xing, supra note 78; see also wang haijun, zhao hongshun, & huang hairong [王海军, 赵洪顺 & 黄海荣], tansuo shijian takuan fan bishui gongzuo xin lingyu—shandong sheng dishui ju liyong shou kong waiguo qiye fan bishui anli ceji [探索实践拓宽反避税工作新领域——山 东省地税局利用受控外国企业反避税案例侧记 ] (exploring practices to broaden new fields of anti-tax avoidance—case study of shandong provice local taxation bureau using cfc anti-avoidance) 3 china tax’n 19 (2015) [中国税务] (discussing in detail the first administrative case concerning china’s cfc rules). 124 hu & li, supra note 119, at 186. 125 see bernhard fohls & weizhen guo, capital gains (article 13 oecd model), in europe-china tax treaties, supra note 13, at 141-42. 126 jinyan li, the great fiscal wall of china: tax treaties and their role in defining and defending china’s tax base. 66 bull. int’l tax’n 452 (2012); see also from supporting “attracting in” to helping “going out,” supra note 116, at 9 (noting that in recent tax treaty negotiations china has sought to increase the time required for construction and assembly projects to qualify for permanent establishment status, in order to benefit chinese companies engaged in construction projects abroad). 127 see hu & li, supra note 119, at 208, 213. 128 see christian massoner, miao liu, & huifang yang, in europe-china tax treaties, supra note 13, at 235. 94 [vol.10:1 columbia journal of tax law oecd’s initiative on harmful tax practices. for instance, china’s resistance to the inclusion of hong kong and macau in a 2009 list of tax havens prepared by the oecd made international news. reports indicated that at the g-20 summit, the president of china wrangled with the presidents of france and germany over the listing of these regions and the fact the listing was controlled by the oecd rather than an organization including chinese representation.129 president obama mediated a compromise whereby hong kong and macau were “relegated to a footnote.”130 the relationship between china and the oecd appears to have improved under the beps project, as all g-20 members were reportedly “playing a full part in setting the agenda, in the discussions and the decision-making process.” 131 for instance, approximately 50 chinese tax officials participated in the project and submitted over 1,000 comments or suggestions on china’s behalf.132 china has also been reforming domestic regulations to bring them into line with the beps actions plans.133 in short, recent developments suggest that chinese tax officials believe that the country’s international tax policy should better reflect its new status as a capital exporter and that china should take a leading role in multilateral tax diplomacy—both notable departures from prior practice. however, with chinese international tax policy at a turning point, existing legal scholarship provides limited insight into what chinese international tax policy will look like going forward. officials at sat see an opportunity for china to shape international rules and develop a “new international tax system with chinese characteristics.”134 neither english nor chinese-language 129 see eccleston & smith, supra note 66, at 190; william vlcek, byways and highways of direct investment: china and the offshore world, 39 j. current chinese aff., 111, 134 (2010). 130 see meinzer, supra note 63, at 267. 131 lee corrick, the taxation of multinational enterprises, in global tax fairness, supra note 64, at 183. some chinese scholars however have criticized the project, suggesting that it is difficult for non-oecd members to contribute equally and that the oecd countries are using the project to make international rules to reflect their own interests. see, e.g., zhang zeping [张泽平], beps xingdong jihua dui woguo guonei shuishou lifa de yingxiang ji yingdui [beps 行动计划对我国国内税收立法的影响及应对] (impacts of the beps action plan on chinese domestic tax legislation and responses], 6 int’l tax’n in china 28 (2015) [国际税收]. 132 see pricewaterhousecoopers china, asia pac. tax notes 16 (2016), https://www.pwccn.com/en/aptn/aptn2016-cn.pdf [https://perma.cc/jd3n-kazl]. 133 see, e.g., daniel ho, the development of china tax measures for cross-border intra-group payments in the beps era, 41 int'l tax j. 47 (2015). 134 state admin. of tax’n [国家税务总局], shendu canyu guoji shuishou gaige shuxie daguo shuiwu zeren dandang [深度参与国际税收改革书写大国税务责任担当] (deep participation in drafting international tax reforms assuming the tax responsibilities of a great power), (2017), http://www.chinatax.gov.cn/n810219/n810724/c2853451/content.html [https://perma.cc/pf3d-3u4g]; see also chen youxiang & dong qiang [陈有湘 & 董强], guojian “yidai yilu” zhanlüe xia de guoji shuishou fengxian yingdui jizhi [构建“一带一路”战略下的国际税收风险应对机制] (establishing an international tax risk response mechanism under the one belt one road strategy), 6 tax’n econ. j. 49 (2015) (税收经济研究) (arguing that china should take advantage of a period of strategic opportunity to becoming a leader in reconstructing international tax rules); wan jing [万静], g20 yige dui zhongguo yiweizhe shuxie guoji shuishou xin guize de jiyu [g20, 一个对 中国意味着书写国际税收新规则的机遇] (g20, a meaningful opportunity for china to write new rules for international taxation), legal daily [法制日报], sept. 5, 2016 (noting the opportunity for china to rewrite international tax rules). https://www.pwccn.com/en/aptn/aptn-2016-cn.pdf https://www.pwccn.com/en/aptn/aptn-2016-cn.pdf http://www.chinatax.gov.cn/n810219/n810724/c2853451/content.html 2018] 95 chinese state capitalism and the international tax regime scholarship has yet identified the potential distinguishing characteristics of such a system.135 in fact, much of recent chinese international tax scholarship has focused on administrative difficulties and horizontal inequalities caused by the foreign tax credits limitations imposed in sat’s initial 2009 regulations. scholars and practitioners have criticized the application of a country-by-country limitation as well as limitations on indirect foreign tax credits for subsidiaries below the third tier, arguing such limitations place undue burdens on chinese multinationals with complex corporate structures.136 in late 2017 sat finally addressed these criticisms, allowing corporations to choose to use an aggregate limitation and to claim indirect foreign tax credits for additional tiers of subsidiaries.137 other potential reforms anticipated by scholars and practitioners are further regulations regarding china’s cfc rules 138 and additional information exchange agreements with tax havens.139 in light of recent u.s. tax reform efforts, some scholars have also argued that china should consider lowering its enterprise tax rate140 and gradually replacing its 135 see deng liping [邓力平], cong “xianshi ban” dao “shengji ban” goujian zhongguo tese guoji shuishou de sikao [从“现实版”到“升级版” 构建中国特色国际税收的思考] (from “reality” to “improvements” thoughts on constructing international taxation with chinese characteristics), int’l tax’n in china 6, 9 (2014) [国际税收 ] (arguing that chinese scholars should explore possibilities for a chinese international taxation policy embodying “the strategy and style of a great power” and reflecting china’s goal of “national rejuvenation”). 136 see, e.g., xie, supra note 26, at 69; chen youxiang, supra note 134; wang jincheng & sun yahua [王金城 & 孙亚华], wanshan shuishou dimian zhidu cuijin qiye duiwai touzi [完善税收抵免制度促进企业对外投资] (perfecting the tax credit system to promote enterprise foreign investment), 7 int’l tax’n in china (2011) [涉外 税务]; zhang yunhua & ren yanhe [张云华 & 任言和], wanshan shuishou di mian zhidu zhu tui qiye “zou chuqu” [完善税收抵免制度助推企业“走出去] (improving tax credit system and promoting enterprises “goingout”), 6 int’l tax’n in china 72 (2015) [国际税收]. for an overview of similar debates in the united states over the appropriate mechanism for limiting the foreign tax credit under i.r.c §904(d), see, e.g., robert j. peroni, a hitchhiker's guide to reform of the foreign tax credit limitation, 56 smu l. rev. 391 (2003). 137 wanshan qiye jingwai suodeshui shou di mian zhengce wenti de tongzhi [完善企业境外所得税收抵免 政策问题的通知 ] (circular on perfecting the policy on tax revenue from overseas income of enterprises) (promulgated by the ministry of finance and taxation administration, december 28, 2017, effective january 1, 2018), cai shui [2017] no. 84; see also khoonming ho & lewis lu, china: inbound and outbound investment incentives kick off, int’l tax rev. (jan. 30, 2018), http://www.internationaltaxreview.com/article/3784113/china-newinbound-and-outbound-investment-incentives-to-kick-off-2018.html [https://perma.cc/hn9s-3j5l] (noting the option for corporations to apply “onshore pooling” rather than “country baskets” for calculating foreign tax credit limitations). 138 see, e.g., mark melnicoe, in china, more advance rulings, more cases going to court, bloomberg tax management transfer pricing report (may 31, 2016), https://www.bna.com/china-advance-rulingsn57982073273/ [https://perma.cc/c6k9-dcgj] (“current cfc rules in china are murky, making it hard to assess whether an offshore company is really engaged in active business and how to prove there is a commercial need to keep its profits overseas …. but changes are likely coming…”); dongmei qiu, collecting unpaid tax offshore: caribbean tax havens and foreign direct investment in china, 12 bull. int’l tax’n 648, 659 (2014); see also zhang wei & huang ying [ 张巍 & 黄莹], guoji bishuidi, cfc fagui yu zhongguo jingji [国际避税地， cfc 法 规与中国经济] (international tax havens, cfc rules and the chinese economy), 9 tax’n res. j. 53 (2012) (税务 研究) (proposing changes to chinese cfc regulations). 139 see, e.g., hu & li, supra note 119, at 220. 140 see gong huiwen (龚辉文), guoji shuishou jingzheng shi xiandai shuizhi gaige de zhuyao tuidongli (国 际税收竞争是现代税制改革的主要推动力) [international tax competition as a main driving force of modern tax reform], 9 tax’n res. j. 14, 19 (2017) (税务研究). https://www.bna.com/china-advance-rulings-n57982073273/ https://www.bna.com/china-advance-rulings-n57982073273/ 96 [vol.10:1 columbia journal of tax law foreign tax credit system with an exemption system.141 although these recent and suggested reforms are of significance, they all fall well within current international tax norms and practices. thus, this paper instead primarily focuses on ways in which china’s unique system of state capitalism may lead it to pursue distinctive international tax policies. iv. defining features of chinese state capitalism a. sasac governance of chinese soes since the beginning of chinese economic reforms in 1978, scores of western observers have anticipated the eventual privatization of chinese soes and a more complete transition to free-market capitalism.142 after decades of halting reforms, nearly all chinese soes have been corporatized and more than two-thirds of central government-controlled soes now have some level of foreign investment. 143 as a result, it can be natural to assume that relatively little distinguishes chinese soes from private market-oriented business enterprises. yet, as a new wave of english-language scholarship reveals, while the market forces play a significant role in most sectors, the party-state continues to function as the leading economic actor through its extensive controls over soes—resulting in a unique system of chinese state capitalism.144 in fact, both the significance of soes in the chinese economy and degree of the party control over major soes are likely to further increase under the leadership of xi jinping. today, soes are estimated to still account for 30 to 40 percent of china’s total gdp, 40 percent of industrial assets, and 20 percent of total employment.145 yet, xi jinping is actively “reversing the 141 see li tianfei (李天飞), mei zuixin shui gai jihua zhong “shudi yuanze” pingxi (美最新税改计划中 “属 地原则”评析) [comments on the “territorial principle” in the latest u.s. tax reform plan], 7 int’l tax’n in china 44, 45 (2017) (国际税收). 142 see aldo musacchio & sergio g. lazzarini, chinese exceptionalism or new global varieties of state capitalism, in regulating the visible hand?: the institutional implications of chinese state capitalism 403, 406-07 (benjamin l. liebman & curtis j. milhaupt eds., 2015) (“in china, every time there is a new group of party members in power, journalists and observers in the west speculate about …whether the privatization process will be deepened, and how much the state will retreat. yet, the outcome is always disappointing from the point of view of these observers. there is always more state intervention and more state ownership than was expected.”). 143 see matthew miller & fang cheng, china says framework for state-owned enterprise reform ‘basically complete,’ reuters (sept. 28, 2017), https://www.reuters.com/article/us-china-soe-reforms/china-says-frameworkfor-state-owned-enterprise-reform-basically-complete-iduskcn1c313p [https://perma.cc/xh4f-pnhs]. 144 see, e.g., chen li, china’s centralized industrial order (2015); regulating the visible hand?, supra note 142; lin & milhaupt, supra note 20; ming du, china’s state capitalism and the world trade law, 63 int’l & comp. l. q. 409 (2014); mark wu, the “china, inc.” challenge to global trade governance, 57 harv. int’l l. j. 261 (2016); see also barry naughton, the transformation of the state sector: sasac, the market economy, and the new national champions, in state capitalism, supra note 20, at 46, 47 (arguing chinese central soes “have developed into a powerful and profitable economic force, representing the core of state capitalism in china.”). 145 see int’l trade admin., china country commercial guide (2017) https://www.export.gov/article?id=china-state-owned-enterprises [https://perma.cc/9lva-36av]; china’s state enterprises are not retreating but advancing, economist (july 20, 2017), https://www.economist.com/news/leaders/21725295-bad-china-and-world-chinas-state-enterprises-are-notretreating-advancing [https://perma.cc/y24n-3sg9]; see also derek scissors, china’s soe sector is bigger than some would have us think, e. asia f. (may 17, 2016), http://www.eastasiaforum.org/2016/05/17/chinas-soe-sectoris-bigger-than-some-would-have-us-think/ [https://perma.cc/2rcz-erth] (discussing the difficulty in estimating the size of the soe sector and suggesting soes may account for close to 60 percent of gdp.). https://www.export.gov/article?id=china-state-owned-enterprises https://www.economist.com/news/leaders/21725295-bad-china-and-world-chinas-state-enterprises-are-not-retreating-advancing https://www.economist.com/news/leaders/21725295-bad-china-and-world-chinas-state-enterprises-are-not-retreating-advancing http://www.eastasiaforum.org/2016/05/17/chinas-soe-sector-is-bigger-than-some-would-have-us-think/ http://www.eastasiaforum.org/2016/05/17/chinas-soe-sector-is-bigger-than-some-would-have-us-think/ 2018] 97 chinese state capitalism and the international tax regime state’s retreat from the economy.”146 he has reasserted that soes should be the commanding heights of the economy.147 while chinese leadership has acknowledged the need to increase the competitiveness of soes, it has called for making soes “bigger and stronger” while maintaining them under public ownership.148 through both improving operations and merging major soes into even larger corporate giants, the government envisions the transformation of its current “national champions” into state-owned “global champions.” 149 as further discussed below, china’s recent industrial and foreign policy initiatives are designed to further increase their international prominence and global market clout. 150 at the same time, xi has asserted that communist party leadership must remain “the root and soul” of soes and under his watch the party has strengthened its influence over the business decisions of soes, as well as private chinese companies.151 the party has always maintained extensive legal and political control over major soes, but recent government pronouncements have placed a particularly strong emphasis on the importance of “party building” and “strengthening party leadership” within soes.152 moreover, 146 china’s state enterprises are not retreating but advancing, supra note 145; see also reform of china’s ailing state-owned firms is emboldening them, economist (july 22, 2017), https://www.economist.com/news/finance-and-economics/21725293-outperformed-private-firms-they-are-nolonger-shrinking-share-overall [https://perma.cc/y24n-3sg9] (reporting that chinese soes are now growing faster than chinese private-sector investment). 147 see michael martina & kevin yao, as china's leaders gather, market reform hopes fade, reuters (oct. 17, 2017), https://www.reuters.com/article/us-china-congress-reform-analysis/as-chinas-leaders-gather-marketreform-hopes-fade-iduskbn1cm142 [https://perma.cc/tu45-vkg7]. 148 he wei, china to create bigger, strong state-owned firms, china daily, oct. 20, 2017, http://www.chinadaily.com.cn/business/2017-10/20/content_33477206.htm [https://perma.cc/48jj-pfat]; see jane cai, forget privatisation, xi has other big plans for bloated state firms, s. china morning post, sept. 6, 2017, http://www.scmp.com/news/china/economy/article/2109943/how-china-making-its-state-firm-dinosaurs-bigger-andricher [https://perma.cc/5446-fakt]; see also hu angang (胡鞍钢), guoyou qiye: gonggu, tisheng he fazhan guojia nengli de zhuli jun [国有企业 :巩固、提升和发展国家能力的主力军] (state-owned enterprises: the main force for consolidating, upgrading and developing the national capabilities), 6 int’l tax’n in china 36 (2016) (国际税收) (arguing that soes will be the primary force for strengthening china’s national economic power in the future). 149 see soyoung kim & paritosh bansal, exclusive: china's state-owned firms to face more mergers, reuters (jan. 24, 2018), https://www.reuters.com/article/us-davos-meeting-china-companies-exclusi/exclusive-chinas-stateowned-firms-to-face-more-mergers-iduskbn1fd0tm [https://perma.cc/nt3f-e2ur]; gabriel wildau, china’s state-owned zombie economy, fin. times, feb. 29, 2016, https://www.ft.com/content/253d7eb0-ca6c-11e5-84df70594b99fc47 [https://perma.cc/p7m5-4lk6]; huang kaixi & song shiqing, china to accelerate soe consolidation in bid to build corporate giants, caixin (july 19, 2017), https://www.caixinglobal.com/2017-07-19/101118793.html [https://perma.cc/7smd-llkd]. 150 see infra part 4.b; see also luo hu, more needed to help soes gain world role, global times, nov. 1, 2017, http://www.globaltimes.cn/content/1073096.shtml [https://perma.cc/dx25-ffqu] (noting that chinese soes are “are supposed to capitalize on the belt and road initiative as part of their ambition to become globally competitive”). 151 emily feng, xi jinping reminds china’s state companies of who’s the boss, n.y. times, oct. 13, 2016, https://www.nytimes.com/2016/10/14/world/asia/china-soe-state-owned-enterprises.html [https://perma.cc/5qsvte4e]; see lucy hornby, communist party asserts control over china inc., fin. times, oct. 3, 2017, https://www.ft.com/content/29ee1750-a42a-11e7-9e4f-7f5e6a7c98a2 [https://perma.cc/j4ry-udsn]; see also tsai & naughton, supra note 20, at 11 (suggesting that maintaining control of soes is particularly important to the party as soes are seen as a “source of employment and patronage”). 152 see communist party still at heart of china’s state firm reform plans: regulator, reuters (nov. 14, 2017), https://www.reuters.com/article/us-china-soe/communist-party-still-at-heart-of-chinas-state-firm-reform-plans https://www.economist.com/news/finance-and-economics/21725293-outperformed-private-firms-they-are-no-longer-shrinking-share-overall https://www.economist.com/news/finance-and-economics/21725293-outperformed-private-firms-they-are-no-longer-shrinking-share-overall https://www.reuters.com/article/us-china-congress-reform-analysis/as-chinas-leaders-gather-market-reform-hopes-fade-iduskbn1cm142 https://www.reuters.com/article/us-china-congress-reform-analysis/as-chinas-leaders-gather-market-reform-hopes-fade-iduskbn1cm142 http://www.chinadaily.com.cn/business/2017-10/20/content_33477206.htm http://www.scmp.com/news/china/economy/article/2109943/how-china-making-its-state-firm-dinosaurs-bigger-and-richer http://www.scmp.com/news/china/economy/article/2109943/how-china-making-its-state-firm-dinosaurs-bigger-and-richer https://www.ft.com/content/253d7eb0-ca6c-11e5-84df-70594b99fc47 https://www.ft.com/content/253d7eb0-ca6c-11e5-84df-70594b99fc47 https://www.caixinglobal.com/2017-07-19/101118793.html http://www.globaltimes.cn/content/1073096.shtml https://www.nytimes.com/2016/10/14/world/asia/china-soe-state-owned-enterprises.html https://www.ft.com/content/29ee1750-a42a-11e7-9e4f-7f5e6a7c98a2 https://www.reuters.com/article/us-china-soe/communist-party-still-at-heart-of-chinas-state-firm-reform-plans-regulator-iduskbn1df0a6 98 [vol.10:1 columbia journal of tax law the party is currently engaging in extensive efforts to secretly train and monitor party cadres in overseas branches of soes.153 these efforts reflect xi’s insistence that “east, west, north or south, the party leads everything.”154 thus, current trends suggest the party’s extensive systems of legal and political control over soes described below, are likely to be further strengthened over the foreseeable future. the central government primarily exercises its extensive legal and political control over major soes through two main mechanisms: 1) the state-owned assets supervision and administration commission and 2) the central organization department. the first enables the government to exercise broad power associated with roles as both majority owner and regulator. the second enables the party-state to exert domineering influence by controlling the appointment, promotion, and removal of all high-level soe executives.155 as a result, china has succeeded, in words of one soe chairman, in “weav[ing] party leadership into corporate governance.”156 since its creation in 2003, the state-owned assets supervision and administration commission (sasac) has been used by the central government to reassert its control over major soes.157 in the 1990s, most chinese soes were struggling financially. as a result, the state retreated from many labor-intensive and low-value added sectors, selling off nearly half of all soes between 1997 and 2003.158 yet at the same time, the government remained committed to retaining state ownership of industrial assets in monopolized sectors and those with strategic importance—including at the time “armaments, power generation and distribution, oil and petrochemicals, telecommunications, coal, aviation and shipping.”159 assets in these sectors— regulator-iduskbn1df0a6 [https://perma.cc/ul4c-2uea]; kjeld erik brødsgaard, can china keep controlling its soes?, diplomat (march 5, 2018), https://thediplomat.com/2018/03/can-china-keep-controlling-its-soes/ [https://perma.cc/tg4d-2k85]. 153 see chinese soes cautiously carry out party building activities overseas, global times, jan. 1, 2018, http://www.globaltimes.cn/content/1085071.shtml [https://perma.cc/4wka-w8yx]. 154 nectar gan, xi jinping thought – the communist party’s tighter grip on china in 16 characters, s. china morning post, oct. 25, 2017, http://www.scmp.com/news/china/policies-politics/article/2116836/xi-jinpingthought-communist-partys-tighter-grip-china [https://perma.cc/c4j2-43re]; jeremy page & chun han wong, xi jinping is alone at the top and collective leadership ‘is dead’, wall st. j., oct. 25, 2017, https://www.wsj.com/articles/chinas-xi-elevated-to-mao-status-1508825969 [https://perma.cc/7mjg-sxqp]. 155 see wang, supra note 84, at 658-660; see also lin & milhaupt, supra note 20, at 711 (“[t]wo parallel structures provide for monitoring: one based on the corporate law, with sasac as controlling shareholder, and a second, party-based structure that shadows the corporate hierarchy, especially with respect to high-level managerial appointments.”). 156 xie yu, don’t panic! party leadership is china’s answer to west’s corporate governance issues, say soe bosses, s. china morning post, dec. 8, 2017, http://www.scmp.com/business/investorrelations/article/2123502/dont-panic-party-leadership-chinas-answer-wests [https://perma.cc/9eb9-56h6]; see also zhou xin, communist party the top boss of china’s state firms, xi jinping asserts in rare meeting, s. china morning post, oct. 12, 2016, http://www.scmp.com/news/china/economy/article/2027407/communist-party-topboss-chinas-state-firms-xi-jinping-asserts [https://perma.cc/sqa5-a2rk] (quoting central party school professor zhang xixian’s observation that “the hallmark of state companies with chinese characteristics is the party’s leadership.”). 157 see naughton, supra note 144, at 46. 158 see id. at 48; wu, supra note 144, at 270. 159 zhao huanxin, china names key industries for absolute state control, china daily, dec. 19, 2006, http://www.chinadaily.com.cn/china/2006-12/19/content_762056.htm [https://perma.cc/3wun-m44e]; see dong zhang & owen freestone, china’s unfinished state-owned enterprise reforms, 2013 econ. roundup 79, 82; li, supra note 144, at 14. (referring to these industries as “base,” “lifeblood,” “pillar,” or “strategic”). https://www.reuters.com/article/us-china-soe/communist-party-still-at-heart-of-chinas-state-firm-reform-plans-regulator-iduskbn1df0a6 https://thediplomat.com/2018/03/can-china-keep-controlling-its-soes/ http://www.globaltimes.cn/content/1085071.shtml http://www.scmp.com/news/china/policies-politics/article/2116836/xi-jinping-thought-communist-partys-tighter-grip-china http://www.scmp.com/news/china/policies-politics/article/2116836/xi-jinping-thought-communist-partys-tighter-grip-china https://www.wsj.com/articles/chinas-xi-elevated-to-mao-status-1508825969 http://www.scmp.com/business/investor-relations/article/2123502/dont-panic-party-leadership-chinas-answer-wests http://www.scmp.com/business/investor-relations/article/2123502/dont-panic-party-leadership-chinas-answer-wests http://www.chinadaily.com.cn/china/2006-12/19/content_762056.htm 2018] 99 chinese state capitalism and the international tax regime often formerly managed by central government ministries or local governments—were consolidated into approximately two-hundred vertically integrated state-owned corporate groups.160 sasac was established to serve as the owner of these soes for the central government and is tasked with their supervision and management.161 due to their massive scale and direct central government ownership, these major soes have been described by scholars as “china’s national team”162 or “china’s national champions.”163 sasac has all the powers of a controlling shareholder, including approval over all major ownership decisions, the power to consolidate and transfer control of corporations, as well as additional regulatory authority.164 notably, it also has “super control rights” over the transfer of soes and their subsidiaries that exceed those of traditional controlling shareholders under the chinese company law.165 for instance, through mergers, acquisitions, and spin-offs, it has reduced the number of central soes from 196 to 98, while increasing total assets under its control.166 sasac has announced plans for further mergers of soes in the near future.167 moreover, in its regulatory authority sasac has also promulgated particularly detailed measures specifying the permissible overseas activities of soes.168 the structure of sasac enables the chinese government to control “a majority stake in virtually every leading firm in every critical industry in china” while still allowing for some degree of market competition and foreign equity in these crucial sectors.169 for a sense of scale, of the roughly 100 soes administered by sasac, 48 were ranked in the 2017 fortune global 500, including state grid, petrochina and sinopec corp., which were ranked 2, 3 and 4, respectively.170 it controls china’s top nuclear, aerospace and aviation, petroleum and petrochemicals, telecom, electricity, automobile firms as well as its major airlines. 171 yet, the government allows 160 see li, supra note 144, at 65; lin & milhaupt, supra note 20, at 711. 161 see wang, supra note 84, at 662-664; zhong, supra note 94; wendy leutert, challenges ahead-in china’s reform of state-owned enterprises, 21 asia policy 83 (2016). 162 li, supra note 144, at 73. 163 lin & milhaupt, supra note 20. 164 see zhonghua renmin gongheguo guoyou qiye zichan fa [中华人民共和国国有企业资产法] (the law of the people’s republic of china on the state-owned assets of enterprises) (promulgated by the standing comm. nat’l people’s cong., oct. 28, 2008, effective may 1, 2009); leutert, supra note 161, at 88. 165 lin & milhaupt, supra note 20, at 744. 166 see li, supra note 144, at 75; lin & milhaupt, supra note 20, at 711; china’s centrally administered state firms report strong profit growth, xinhua (dec. 15, 2017), http://www.xinhuanet.com/english/201712/15/c_136828994.htm [https://perma.cc/32ky-6tgz]. 167 see soyoung kim & paritosh bansal, supra note 149; gabriel wildau, china prepares fresh round of stateorchestrated megamergers, fin. times, july 9, 2017. 168 see new regulations for soes’ overseas deals, global times, jan. 18, 2017, http://www.globaltimes.cn/content/1029539.shtml [https://perma.cc/9kal-mcaw]. 169 lin & milhaupt, supra note 20 at, 735; see also wu, supra note 144, at 271 (“sasac is undoubtedly one of the most powerful economic actors in the world today.”). 170 state-owned assets supervision and administration comm’n of the state council (sasac), 2017 “caifu” shijie 500 qiang gongbu guowuyuan guozi wei jianguan 48 jia yangqi shang bang [2017《财富》世界 500 强 公布 国务院国资委监管 48 家央企上榜] (2017 fortune global 500 announced--48 sasac supervised soes on the list) (july 20, 2017), http://www.sasac.gov.cn/n2588025/n2588119/c7419470/content.html [https://perma.cc/2rnm-nh6f]; globe 500, fortune, http://fortune.com/global500/2017/ [https://perma.cc/b5d5juwy]. 171 see li, supra note 144, at 159. http://www.xinhuanet.com/english/2017-12/15/c_136828994.htm http://www.xinhuanet.com/english/2017-12/15/c_136828994.htm http://www.globaltimes.cn/content/1029539.shtml http://www.sasac.gov.cn/n2588025/n2588119/c7419470/content.html http://fortune.com/global500/2017/ 100 [vol.10:1 columbia journal of tax law competition in many of these sectors, by having multiple soes fight for market shares amongst themselves.172 for instance, sasac has allowed for cutthroat competition between three major state-owned airlines over pricing and domestic routes, but has vetoed past proposed mergers between the three.173 the structure of sasac and soe groups has also enabled the government to raise significant funds through listing minority stakes of soe subsidiaries on public stock markets.174 sasac remains the 100 percent shareholder of the core holding company (or parent corporation) of most soe groups. this core holding company retains a majority share in one or more publicly traded subsidiaries. 175 by offering these minority stakes internationally, the government has been able to raise fresh capital for chinese soes without relinquishing government control.176 recently, the government has also begun experimenting with offering minority stakes in soe subsidiaries to private equity funds under the banner of “mixedownership.”177 yet, private investors admit that even in soes with the highest levels of private investment, sasac and the communist party’s personnel bureau remain “the real power behind soe decision-making.”178 although not part of sasac, the largest chinese financial institutions also remain under state ownership and control through a broadly similar mechanism. during the early 1990s, as soes were undergoing corporatization, china’s wholly-owned and central controlled financial 172 see wu, supra note 144, at 271 (“sasac controls china’s three major telecommunications companies, its three major petrochemical corporations, its three major steelmakers, and so on.”) however, there is evidence that recent sasac orchestrated megamergers may now be limiting such competition. see nicholas r. lardy, china’s soe reform—the wrong path, peterson inst. int’l econ. (july 28, 2016), https://piie.com/blogs/china-economicwatch/chinas-soe-reform-wrong-path [https://perma.cc/x47m-f6pt]. 173 see david finckling, china eastern’s promise fades, bloomberg (mar. 30, 2017), https://www.bloomberg.com/gadfly/articles/2017-03-31/airline-price-war-puts-china-eastern-in-the-firing-line [https://perma.cc/nh4g-292m]; danny lee, china eastern unites with delta to gain edge at beijing’s sevenrunway daxing airport, s. china morning post, nov. 25, 2017, http://www.scmp.com/news/hongkong/economy/article/2121554/china-eastern-unites-us-airline-delta-bid-gain-edge-beijings [https://perma.cc/u5hzkz4e]; chen huiying, li qiyan & yu ning, aviation's future and the battle for china eastern, caijing (sept. 10, 2007), http://english.caijing.com.cn/2007-10-15/100033624.html [https://perma.cc/gh6z-3c59]. 174 see li, supra note 144, at 65; lin & milhaupt, supra note 20, at 711. 175 lin & milhaupt, supra note 20, at 700; see also milhaupt & zheng, supra note 23, at 673 (reporting that “almost all of the thirty-four subsidiaries of china national offshore oil corporation (cnooc)” have some degree of private investment). 176 see li, supra note 144, at 138; monique taylor, china’s oil industry: ‘corporate governance with chinese characteristics,’ in the political economy of state-owned enterprise in china and india 79 (ed. xu yichong, 2012); see also yang ge, 5 things to know about china’s mixed-ownership reform, caixin (aug. 8, 2017), https://www.caixinglobal.com/2017-08-28/101136807.html [https://perma.cc/e466-76er] (“most big state-owned companies that have been listed to date remain firmly in control of the central government, which typically maintains 50% or more of the company’s shares. under that arrangement, the central government sees anyone who buys shares on the open market as purely financial investors, and typically gives them little or no say in the company’s management or strategic planning.”). 177 see georgina lee, mixed ownership reform an opportunity for private equity to invest in state enterprises, s. china morning post, dec. 5, 2017, http://www.scmp.com/business/companies/article/2123007/mixedownership-reform-opportunity-private-equity-invest-state [https://perma.cc/g6mp-bkcv]. 178 see gabriel wildau, china state-owned telecom privatisation seen as too timid, fin. times, aug. 27, 2017, https://www.ft.com/content/0dd0b152-8659-11e7-bf50-e1c239b45787 [https://perma.cc/k7lz-cc24]. https://piie.com/blogs/china-economic-watch/chinas-soe-reform-wrong-path https://piie.com/blogs/china-economic-watch/chinas-soe-reform-wrong-path https://www.bloomberg.com/gadfly/articles/2017-03-31/airline-price-war-puts-china-eastern-in-the-firing-line http://www.scmp.com/news/hong-kong/economy/article/2121554/china-eastern-unites-us-airline-delta-bid-gain-edge-beijings http://www.scmp.com/news/hong-kong/economy/article/2121554/china-eastern-unites-us-airline-delta-bid-gain-edge-beijings http://english.caijing.com.cn/2007-10-15/100033624.html https://www.caixinglobal.com/2017-08-28/101136807.html http://www.scmp.com/business/companies/article/2123007/mixed-ownership-reform-opportunity-private-equity-invest-state http://www.scmp.com/business/companies/article/2123007/mixed-ownership-reform-opportunity-private-equity-invest-state https://www.ft.com/content/0dd0b152-8659-11e7-bf50-e1c239b45787 2018] 101 chinese state capitalism and the international tax regime institutions were significantly reformed.179 the resulting banks were categorized as either policy banks or commercial banks.180 policy banks remain wholly-owned and directly controlled, with each dedicated to specific lending purposes and policy goals.181 in contrast, the major commercial banks more closely resemble soes—nominally operating under commercial considerations but remaining under extensive government control.182 following a series of reforms during the 1990s and early 2000s, the central huajin—a holding company established under china’s main sovereign wealth fund (the china investment corporation) retains a controlling interest in the four largest commercial banks, and in combination with other state-controlled holdings gives the government majority control in each.183 while minority shares are listed on stock exchanges and held by foreign investors, in reality, the state “has not ceded any substantial aspects of its control over these banks.”184 moreover, the party’s central organization department controls leadership appointments to each of the ten largest commercial finance institutions.185 the communist party maintains control over key soes through its authority over the appointment of senior executives. the powerful central organization department of the communist party appointments nearly all state officials throughout china and regularly evaluates high-level appointees based on performance metrics.186 the top 53 major soes are ranked at the vice-ministerial level or above, meaning their top executives have the same rank as vice provincial governors or party secretaries.187 the central organization department is thus charged with appointing and evaluating the board chairmen, ceos, and party secretaries of these soes. sasac is responsible for the appointment and evaluation of deputies in these firms and the top executives in all other centrally-controlled soes.188 in practice, personnel decisions are always jointly announced by sasac and the central organization department.189 that is to say, party 179 see generally james stent, china's banking transformation: the untold story 75-99 (2017) (describing in detail the history of bank reform in china since deng xiaoping’s reform and opening). 180 see li, supra note 144, at 127. 181 see id. at 130. 182 see id.; see also leong h. liew, state enterprise in china’s capitalist transformation: the bank of china, in the political economy of state-owned enterprise in china and india, supra note 176, at 222 (“although banks are corporatized, and even listed on international stock exchanges, the state remains the majority shareholder in the largest, commercial banks, and it is still debatable how much of their behaviors are guided solely by commercial considerations and how much are guided by official policy.”); stent, supra note 179, at 24 (describing the major chinese commercial banks as “ neither wholly an agency of the state nor wholly a creature of the market.”). 183 see stent, supra note 179, at 157. 184 li, supra note 144, at 130. 185 see liew, supra note 182, at 229; see also li, supra note 144, at 144-45 (describing the political backgrounds and career trajectories of chinese bank leaders). 186 see wang, supra note 84, at 658-660; richard mcgregor, the party organizer, fin. times, sept. 30, 2009, https://www.ft.com/content/ae18c830-adf8-11de-87e7-00144feabdc0 [https://perma.cc/dlg7-bzf9]; see also li, supra note 144, at 117 (suggesting the department is the “mightiest human resource department” of “china inc.”). 187 see leutert, supra note 161, at 87. 188 see prepared statement of curtis j. milhaupt, testimony before the u.s.-china economic and security review commission hearing on chinese state-owned and state-controlled enterprises (feb. 15, 2012), https://www.uscc.gov/sites/default/files/2.15.12milhaupt_testimony.pdf [https://perma.cc/wt9v-a4k3]. 189 see li-wen lin, reforming china’s state-owned enterprises: from structure to people, 229 china q. 107, 110 (mar. 2017); see also li, supra note 144, at 116 (“the actions of cod and sasac seem to have been concerted and the institutional connections between the two organs are close.”). https://www.ft.com/content/ae18c830-adf8-11de-87e7-00144feabdc0 https://www.uscc.gov/sites/default/files/2.15.12milhaupt_testimony.pdf 102 [vol.10:1 columbia journal of tax law organs control the appointment of all high-level soe personnel whether or not the soe has a board of directors in place.190 these appointees often serve concurrent roles on both the core holding company and on listed subsidiaries.191 appointees are virtually all long-time communist party members with strong history of political loyalty to the party.192 they have been trained in the party school system for midcareer cadres and often take specialized training courses at the central party school in beijing to study communist party ideology.193 even in publicly listed soe subsidiaries, virtually no state-appointed ceos had worked “outside the state system.”194 the extent of the party’s power over executive positions at central soes expands beyond initial appointments, as illustrated by its tradition of dramatic rotations of high-level appointees between enterprises. for instance in 2003 the party rotated the ceos of china’s top three telecommunications companies—all publicly listed in hong kong of new york—without prior notice or board consultation.195 similarly, in 2009 it rotated the ceos of three largest state airlines, and in 2011 rotated the ceos of the three central petroleum enterprises.196 by one estimate, since 2003 there have been at least 30 cases of “intra-sector” rotations of high level appointees between different soes in the same industry.197 these rotations enable the party to “reduce concentration of authority in a single individual in firms.”198 in general, senior officials are shuffled into new positions every few years and successful executives are increasingly promoted to higher-level positions in party leadership after their stint at major soes.199 party committees within soes groups give the party an additional system of oversight over the decisions of top executives. under the leadership of xi jinping these committees, composed of ranking communist party members within each enterprise, have been strengthened and granted a greater role in monitoring business decisions within soes.200 for instance, the bylaws of many soe subsidiaries now require major business to first be discussed by the 190 lin & milhaupt, supra note 20, at 739. 191 see taylor, supra note 176, at 87. 192 see id. at 115-116. 193 see li, supra note 144, at 117; lin & milhaupt, supra note 20, at 738; see also dan levin china’s top party school, foreign pol’y (march 6, 2012), http://foreignpolicy.com/2012/03/06/chinas-top-party-school/ [https://perma.cc/88na-saau] (describing the curriculum of the central party school). 194 lin, supra note 189, at 125 195 see wu, supra note 144, at 281. 196 see id.; milhaupt, supra note 188, at 6; see also taylor, supra note 176, at 76-77, 88-89 (discussing the history party personnel appointments in china’s national oil companies). 197 li, supra note 144, at 120-123. 198 lin & milhaupt, supra note 20, at 741. 199 see cheng li, china’s midterm jockeying: gearing up for 2012 (part 4: top leaders of major state-owned enterprises), 34 china leadership monitor 1 (2011); lingling wei & bob davis, for a top chinese banker, profits hinder political rise, wall st. j., feb. 18, 2013, https://www.wsj.com/articles/sb10001424127887324196204578297961462046562 [https://perma.cc/k9ybhh6c]. 200 see wu, supra note 144, at 281; gregor stuart hunter & steven russolillo, now advising china’s state firms: the communist party, wall st. j., aug. 14, 2017, https://www.wsj.com/articles/now-advising-chinas-state-firmsthe-communist-party-1502703005 [https://perma.cc/995d-7r9l]; tom mitchell, china’s communist party seeks company control before reform, fin. times, aug. 14, 2017, https://www.ft.com/content/31407684-8101-11e7-a4ce15b2513cb3ff. http://foreignpolicy.com/2012/03/06/chinas-top-party-school/ https://www.wsj.com/articles/sb10001424127887324196204578297961462046562 https://www.wsj.com/articles/now-advising-chinas-state-firms-the-communist-party-1502703005 https://www.wsj.com/articles/now-advising-chinas-state-firms-the-communist-party-1502703005 https://www.ft.com/content/31407684-8101-11e7-a4ce-15b2513cb3ff https://www.ft.com/content/31407684-8101-11e7-a4ce-15b2513cb3ff 2018] 103 chinese state capitalism and the international tax regime company’s party committee before managers are allowed to take action.201 these committees thus represent another mechanism for “supervising the implementation of [communist party] and national policies within the company.”202 thanks to party’s oversight mechanisms and its influence over appointees’ career trajectories, soe executives generally have strong incentives to obey party directives. both anecdotal and quantitative evidence suggest political allegiance, rather than profits or economic efficiency, appears to be the paramount quality in evaluating managers of china’s soes.203 in the words of one scholar, when conflicts arise between economic and political objectives, soes “often have to give priority to the political objective[s].”204 or as another has put it, “the goals of the state are dominant in soe executives’ decision-making processes.”205 soe managers are willing to sacrifice economic performance in the name of achieving other goals set by the party.206 it is this partial subordination of profits to political concerns that raises a distinctive set of issues with regard to china’s international tax policy.207 b. soes in china’s “going out” and “belt and road” initiatives another defining feature of chinese state capitalism is the role of government industrial policy in shaping the chinese economy. while china’s five-year plans no longer include strict production quotas for all commodities, as they once did under the command economy of mao zedong, they continue to lay out the government’s policy priorities and its overarching economic goals.208 the chinese government allows the market to play an important role in the economy but 201 see zhang hongpei, organic governance, global times, sept. 5, 2017, http://www.globaltimes.cn/content/1064895.shtml [https://perma.cc/y3k9-32z9]. 202 id. 203 see duanjie chen, china’s state-owned enterprises: how much do we know? from cnooc to its siblings, 6 u. calgary sch. pub. pol’y res. papers 1, 19 (june 2013) (“such party control of the top executives of central soes has ensured that those who are ambitious in climbing the government and party ladders must obey party orders more than ensuring the economic efficiency of the soes under their watch.”); feng liu & linlin zhang, executive turnover in china’s state-owned enterprises: government-oriented or market-oriented?, china j. acct. res. (2017), http://dx.doi.org/10.1016/j.cjar.2016.12.003 [https://perma.cc/ful4-wyp5] (concluding that executive evaluations in central soes tend to be government-oriented and focused on political performance in comparison to evaluations in local soes which tend to be market-oriented); shirley yam, invisible hand of the market gives way to the visible hand of the party at china’s state-owned firms, s. china morning post, july 15, 2016, http://www.scmp.com/business/companies/article/1990174/invisible-hand-market-gives-way-visible-hand-partychinas-state [perma.cc/8hl2-mnkt] (arguing that in chinese soes “politics takes precedence over economics in corporate affairs.”) 204 xie, supra note 26, at 80; see also naughton, supra note 144, at 61 (noting that “managers of state firms have very strong incentives to subordinate the interests of the individual firm to national interests”). 205 ming du, when china’s national champions go global: nothing to fear but fear itself?, 48 j. world trade 1127, 1154 (2014). 206 see han peng, why can “one belt, one road" happen so fast? credit soes, cgtn.com (oct. 25, 2017,7:50 pm), https://news.cgtn.com/news/34516a4d32597a6333566d54/share_p.html [https://perma.cc/dg2y-rvz6] (“state-owned enterprises don't only work for profit. under cpc leadership, sometimes it's an obligation for us to sacrifice short-term profit in order to achieve a bigger, national goal.”). 207 see infra part 5. 208 see cary huang, how china’s five-year plan, an overhang from the soviet era, has evolved, s. china morning post, oct. 13, 2015, http://www.scmp.com/news/china/policies-politics/article/1866736/how-chinas-fiveyear-plan-overhang-soviet-era-has [https://perma.cc/bg56-g2th] (arguing that the five-year plan remains an integral http://www.globaltimes.cn/content/1064895.shtml http://dx.doi.org/10.1016/j.cjar.2016.12.003 http://www.scmp.com/business/companies/article/1990174/invisible-hand-market-gives-way-visible-hand-party-chinas-state http://www.scmp.com/business/companies/article/1990174/invisible-hand-market-gives-way-visible-hand-party-chinas-state http://www.scmp.com/news/china/policies-politics/article/1866736/how-chinas-five-year-plan-overhang-soviet-era-has http://www.scmp.com/news/china/policies-politics/article/1866736/how-chinas-five-year-plan-overhang-soviet-era-has file:///c:/users/soniakatharani-khan/downloads/perma.cc/bg56-g2th 104 [vol.10:1 columbia journal of tax law still believes the overall direction of economic development must be determined by government policy and not market forces. through its industrial policy, the chinese government “aims to go beyond just riding the waves of markets by actively creating the waves on which to ride.”209 china’s chief economic planning authority, the national development and reform commission, has a variety of tools at its disposal to implement its plan across the economy, such as authority over the allocation of stimulus funding and over the pricing of commodities not set by the market.210 but more importantly, since the commission’s five-year plans represent a distillation of the communist party’s long-term priorities, all major economic actors in the country— including central soes—modify their strategies and rhetoric to bring them in line with the plans.211 quantitative evidence suggests that china’s five-year plans have significant impacts on the performance of soes in prioritized sectors, with soes in supported industries enjoying faster growth and access to additional financing.212 the most recent plans have prioritized high-tech and emerging industries including green energy and nuclear power, biotechnology, advanced manufacturing, and new materials.213 since the early 2000s, china’s industrial policy has prioritized outbound investment by soes in furtherance of both economic and foreign policy goals. while some soes had been engaging in overseas activities in the 1990s with government indifference,214 at the dawn of the new millennium the chinese government officially launched its “going out” (or “go global”) policy to actively encourage enterprises to pursue overseas investments. 215 under this slogan the government supported investments by large soes, in particular in acquisitions of upstream commodity assets needed to support china’s rapid economic growth.216 the central government decrees identified recommended sectors and nations for foreign investment and the state-directed part of a state-controlled and centrally planned society); why china’s five-year plans are so important, economist (oct. 26, 2015), https://www.economist.com/blogs/economist-explains/2015/10/economist-explains-24 [https://perma.cc/uz7d-33n7] (arguing that china’s five-year plans have evolved from “rigid agendas” to “rough guides to how leaders want to steer the country”). 209 sebastian heilmann & lea shih, the rise of industrial policy in china, 1978-2012, at 21 (harvard-yenching inst. working paper series, jan. 2013). 210 see wu, supra note 144, at 276. 211 see why china’s five-year plans are so important, supra note 208. 212 see donghua chen, oliver zhen li & fu xin, five-year plans, china finance and their consequences, 10 china j. acct. res. 189 (2017) (finding that “state-owned” firms in government supported industries enjoy faster growth in initial public offerings and higher offer prices…[and] enjoy faster growth in loans granted by major national banks.”). 213 tristan kenderdine, china's industrial policy, strategic emerging industries and space law, 4 asia & pac. pol’y stud. 325, 328 (2017). 214 see xiaojie xu, chinese nocs overseas strategies: background, comparison and remarks, james a. baker iii inst. pub. pol’y 4 (march 2007), https://www.bakerinstitute.org/media/files/page/94235e0c/noc_chinesenocs_xu.pdf [https://perma.cc/t5lh-akz5]. 215 see david shambaugh, china goes global: the partial power 174-76 (2013). for a discussion of the “going out” strategy in china’s recent five-year plans, see xie, supra note 26, at 7. 216 see jamil anderlini, china to deploy foreign reserves, fin. times, july 21, 2009, https://www.ft.com/content/b576ec86-761e-11de-9e59-00144feabdc0 [https://perma.cc/7jmz-wr2v]; china's “going out” strategy, economist (july 21, 2009), https://www.economist.com/blogs/freeexchange/2009/07/chinas_going_out_strategy [https://perma.cc/llq59h5e]. https://www.bakerinstitute.org/media/files/page/94235e0c/noc_chinesenocs_xu.pdf https://www.economist.com/blogs/freeexchange/2009/07/chinas_going_out_strategy 2018] 105 chinese state capitalism and the international tax regime policy banks provided subsidized financing for such investments.217 for instance, under this policy generous loans were given to state-owned oil companies to acquire stakes in foreign oil and gas production to better secure china’s access to energy resources. 218 similar support was also extended to soes to secure foreign mineral resources.219 over the decade, state officials would broaden the policy beyond natural resources and extend support to foreign projects in the transportation, telecommunications, and nuclear energy sectors.220 as a result of these policies, from 2005 to 2013, soes were responsible for upwards of 90 percent of chinese outbound direct investments.221 the 2013 announcement of the “one belt, one road” initiative sparked additional overseas investment by soes.222 the initiative has been described as an “‘upgraded’ version of china’s ‘go global’ strategy” as it seems designed, in part, to further expand the global footprint of china’s soes.223 since soes dominate infrastructure-related industries within china, the initiative’s focus on boosting transportation and energy infrastructure across eurasia places soes at its center.224 within its first two years, the initiative had already produced new lucrative business 217 see shambaugh, supra note 215, at 176; du, supra note 205, at 1134. 218 see taylor, supra note 176, at 79; peter c. evans & erica s. downs, untangling china’s quest for oil through state-backed financial deals, brookings (may, 1, 2006), https://www.brookings.edu/research/untangling-chinasquest-for-oil-through-state-backed-financial-deals/ [https://perma.cc/yxq5-fztp]; see also daniel c. o’neil, risky business: the political economy of chinese investment in kazakhstan, 5 j. eurasian stud. 145 (2014) (discussing the types of central government financial support offered to chinese oil and gas soes operating in kazakhstan). 219 erica. s. downs, whatever became of china, inc.?, brookings (june 24, 2014), https://www.brookings.edu/articles/whatever-became-of-china-inc/ [https://perma.cc/uh8c-lvfu](“driven by an unexpected surge in the country’s commodity demand and fueled by cheap loans from state-owned policy banks, chinese firms went on a resource buying binge from afghanistan to zambia.”); brad plumer, how china’s appetite for raw materials is transforming the world, wash. post, feb. 13, 2014, https://www.washingtonpost.com/news/wonk/wp/2014/02/13/how-chinas-hunt-for-raw-materials-is-changing-theworld/?utm_term=.d3e1bdc403ea [https://perma.cc/cla2-cecl]. 220 see shambaugh, supra note 215, at 176; du, supra note 205, at 1134; shannon tiezzi, china urges companies to ‘go global,’ diplomat (dec. 25, 2014), https://thediplomat.com/2014/12/china-urges-companies-togo-global [https://perma.cc/7c5q-bx4m]. 221 see wang et al., supra note 115, at 322 (“according to our calculations, between 2005 and 2013, 89.4 per cent of the us$807.5 billion of chinese odi and contracts were linked to soes.”); see also shambaugh, supra note 215, at 178 (noting the “dominant position of central level soes” in chinese odi as of 2010). 222 see zhang ye, central soes contribute to b&r initiative, global times, may 8, 2017, http://www.globaltimes.cn/content/1045920.shtml [https://perma.cc/8sxu-epvj]; see also spencer sheehan, the problem with china’s one belt, one road strategy, diplomat (may 24, 2017), https://thediplomat.com/2017/05/the-problem-with-chinas-one-belt-one-road-strategy/ [https://perma.cc/z78n7kt8](noting that projects associated with the initiative “are often tied to political pacts through which china’s stateowned enterprises get exclusive bidding rights”). 223 yu jie, china’s one belt, one road: a reality check, lse ideas, medium (july 24, 2017), https://medium.com/@lseideas/chinas-one-belt-one-road-a-reality-check-b28030ac6d3b [https://perma.cc/d8yuy7za]. 224 gisela grieger, one belt, one road (obor): china's regional integration initiative, eur. parliamentary res. serv. 6, pe 586.608 (july 2016) (“large state-owned enterprises (soes), which dominate the chinese infrastructure-related sectors, are expected to have a major stake in obor's first implementation stage ….”); see also julan du & yifei zhang, does one belt one road initiative promote chinese overseas direct investment?, 47 china econ. rev. 189 (2018) (discussing the role of soes in one belt, one road initiative related overseas direct investment). https://www.brookings.edu/research/untangling-chinas-quest-for-oil-through-state-backed-financial-deals/ https://www.brookings.edu/research/untangling-chinas-quest-for-oil-through-state-backed-financial-deals/ https://www.brookings.edu/articles/whatever-became-of-china-inc/ https://www.washingtonpost.com/news/wonk/wp/2014/02/13/how-chinas-hunt-for-raw-materials-is-changing-the-world/?utm_term=.d3e1bdc403ea https://www.washingtonpost.com/news/wonk/wp/2014/02/13/how-chinas-hunt-for-raw-materials-is-changing-the-world/?utm_term=.d3e1bdc403ea https://thediplomat.com/2014/12/china-urges-companies-to-go-global https://thediplomat.com/2014/12/china-urges-companies-to-go-global http://www.globaltimes.cn/content/1045920.shtml 106 [vol.10:1 columbia journal of tax law opportunities for the ten or so central soes focused on civil-engineering and construction.225 and by 2017, at least 40 chinese soes had multiple projects in countries associated with the initiative.226 at the end of 2014, sasac published a report highlighting the impact of the initiative on the overseas operations of central soes. at that time, nearly all central soes were active overseas. overseas operations constituted 12.7% of central soe’s total assets, 18.3% of their operational revenues, and 8.6% of their total profits.227 since the start of the initiative, central soes have on average increased their overseas assets 15% annually and their overseas revenue by 4% annually.228 one recent study suggests that thus far, nearly 70% of investment and over 95% of construction under the initiative have come from soes. 229 moreover, government pronouncements suggest central soes will continue to be the “major force” behind the next phase of the initiative.230 as a result of these government policies, soes continue to account for an outsized percentage of chinese outbound investment. recent estimates suggest central soes continue to account for between 60% and 70% of china’s outbound direct investments on a yearly basis.231 moreover, chinese cumulative capital stock held overseas “remains dominated” by soes.232 chinese government statistics indicate that soes hold more than half (54.3%) of china’s cumulative non-financial foreign investment and total overseas assets in excess of us $900 billion. 233 some scholars have suggested even these official statistics understate the total 225 see willy wo-lap lam, “one belt, one road” enhances xi jinping’s control over the economy, jamestown found. (may 15, 2015), https://jamestown.org/program/one-belt-one-road-enhances-xi-jinpingscontrol-over-the-economy/ [https://perma.cc/2t6l-fcpg]. 226 baker mckenzie, belt & road: opportunity & risk 13 (2017), https://www.bakermckenzie.com//media/files/insight/publications/2017/10/belt-road/baker_mckenzie_belt_road_report_2017.pdf?la=en. 227 see the roadmap of soe's presence in “belt and road,” people’s daily online, july 16, 2015, http://en.people.cn/business/n/2015/0716/c90778-8921479.html [https://perma.cc/m4am-ttu9]. 228 state-owned assets supervision and admin. comm’n of the state council (sasac), zhongyang qiye canyu “yidai yilu” gong jian qingkuang [中央企业参与“一带一路”共建情况] (central enterprises participation in building the “belt and road) (2017), http://www.sasac.gov.cn/n4470048/n4470081/n4582104/c4594908/content.html [https://perma.cc/9kaj-f862]. 229 ceclia joy-pérez & derek scissors, am. enter. inst., the chinese state funds belt and road but does not have trillions to spare, at 12 (mar. 28, 2018), https://www.aei.org/wpcontent/uploads/2018/03/bri.pdf [https://perma.cc/zhr5-wccb]. 230 zhong nan, soes to take lead role along belt and road, china daily, may 9, 2017, http://www.chinadaily.com.cn/business/2017-05/09/content_29258516.html [perma.cc/76tk-pbnj]. [https://perma.cc/76tk-pbnj]. 231 see central enterprises participation in building the “belt and road,” supra note 228; wendy wu, how the communist party controls china’s state-owned industrial titans, s. china morning post, june 17, 2017, http://www.scmp.com/news/china/economy/article/2098755/how-communist-party-controls-chinas-state-ownedindustrial-titans [perma.cc/9b54-3mwg]; soe overseas assets surge, xinhua (june 19, 2015), http://www.xinhuanet.com/english/2015-06/19/c_134341330.htm. [https://perma.cc/x6zw-b66s]. 232 scissors, supra note 145. 233 see ministry of commerce of the people’s republic of china, zhongguo duiwai touzi hezuo fazhan baogao [中国对外投资合作发展报告] (report on development of china’s outward investment and economic cooperation) (2017), http://fec.mofcom.gov.cn/article/tzhzcj/tzhz/upload/zgdwtzhzfzbg2017.pdf [perma.cc/3qfknalt]; overseas assets held by china's centrally owned firms top $900 billion, reuters (oct. 18, 2017), https://www.reuters.com/article/us-china-congress-soes/overseas-assets-held-by-chinas-centrally-owned-firms-top900-billion-iduskbn1cn0ue [perma.cc/xw23-z4r4]. https://www.bakermckenzie.com/-/media/files/insight/publications/2017/10/belt-road/baker_mckenzie_belt_road_report_2017.pdf?la=en https://www.bakermckenzie.com/-/media/files/insight/publications/2017/10/belt-road/baker_mckenzie_belt_road_report_2017.pdf?la=en http://www.sasac.gov.cn/n4470048/n4470081/n4582104/c4594908/content.html file:///c:/users/paulc/downloads/perma.cc/zhr5-wccb http://perma.cc/76tk-pbnj http://perma.cc/9b54-3mwg http://perma.cc/x6zw-b66s http://fec.mofcom.gov.cn/article/tzhzcj/tzhz/upload/zgdwtzhzfzbg2017.pdf http://perma.cc/3qfk-nalt http://perma.cc/3qfk-nalt http://perma.cc/xw23-z4r4 2018] 107 chinese state capitalism and the international tax regime percentage outbound foreign direct investment held by soes.234 outbound direct investment by chinese soes is not limited to developing countries as soes and their subsidiaries still dominate chinese direct investment in the united states in terms of value.235 in sum, central soes play a commanding role in chinese outbound international investment, making them particularly relevant to the future of chinese international tax policy. c. capital controls and outbound investment regulations a dramatic rise and fall in the outbound investment by chinese private enterprises and individuals in 2016 further illustrates the central government’s ability to use capital controls— another element of chinese state capitalism—to influence the character and volume of chinese overseas investment. in 2016, the chinese yuan (also known as the renminbi) declined sharply against the dollar, leading many chinese individuals and businesses to seek protection from depreciation by purchasing foreign currency or assets.236 that year, china witnessed a boom in outbound acquisitions, largely driven by private companies such as anbang insurance, dalian wanda, fosun and hna.237 for the first time, outbound investment by privately-owned chinese enterprises surpassed that of soes.238 china’s outbound m&a volume broke existing annual records in just the first six months of the year and ended up surpassing u.s. outbound m&a volume for the first time.239 yet chinese government officials soon suspected that many of these private corporations were overpaying for speculative foreign assets as a way of shifting assets outside of china.240 in response, starting in november 2016, the government tightened capital controls and regulations on outbound investment. the state administration of foreign exchange (safe), is a 234 see scissors, supra note 145; see also du, supra note 205, at 1128 (suggesting a lower bound of approximately 70% on the percentage of chinese total outbound foreign direct investment held by soes). 235 see ji li, i came, i saw, i... adapted: an empirical study of chinese business expansion in the united states and its legal and policy implications, 36 nw. j. int'l l. & bus. 143, 165 (2016). 236 see saumya vaishampayan & lingling wei, yuan weakness spurs fresh surge in china outflows, wall st. j., nov. 7, 2016, https://www.wsj.com/articles/yuan-weakness-spurs-fresh-surge-in-china-outflows-1478520675. 237 see sui-lee wee, china steps up warnings over debt-fueled overseas acquisitions, n.y. times, aug. 18, 2017, https://www.nytimes.com/2017/08/18/business/dealbook/china-companies-deals-debt.html; xie yu, china’s probes on fosun, hna and others unleash the power of the unsaid word, s. china morning post, july 8, 2017, https://www.scmp.com/business/banking-finance/article/2101762/chinas-probes-fosun-hna-and-others-unleashpower-unsaid [perma.cc/h83r-74fw]. 238 see don weinland, emily feng & sherry fei ju, state-led companies back on top in china’s outbound m&a rankings, fin. times, sept. 3, 2017, https://www.ft.com/content/18b1352c-8e26-11e7-a352-e46f43c5825d. 239 see denny thomas, china outbound m&a beats 2015 record with 6 months to spare, reuters (june 20, 2016), https://www.reuters.com/article/us-china-m-a/china-outbound-ma-beats-2015-record-with-6-months-tospare-iduskcn0z60ui [perma.cc/6bej-jask]; xie yu, record year for china’s outbound m&a as it overtakes us for the first time, s. china morning post, dec. 21, 2016, http://www.scmp.com/business/companies/article/2056099/record-year-chinas-outbound-ma-it-overtakes-us-firsttime [perma.cc/lg8c-98uq]. 240 see, e.g., heiwei tang & christopher beddor, it’s no accident that china’s tycoons are bad investors, foreign pol’y (oct. 17, 2017), http://foreignpolicy.com/2017/10/17/its-no-accident-that-chinas-tycoons-are-badinvestors [perma.cc/jm9l-dcas]; angelo katsoras, the story behind china’s crackdown on outbound investments, nat’l bank can. (oct. 4, 2017), https://www.nbc.ca/content/dam/bnc/en/rates-and-analysis/economicanalysis/geopoliticalbriefing_4oct2017.pdf [perma.cc/5jb9-yf5k]. https://www.nytimes.com/2017/08/18/business/dealbook/china-companies-deals-debt.html https://perma.cc/h83r-74fw https://perma.cc/6bej-jask https://perma.cc/lg8c-98uq https://perma.cc/jm9l-dcas https://perma.cc/5jb9-yf5k 108 [vol.10:1 columbia journal of tax law central government institution that controls whether chinese companies, both domestic and foreign-invested, may convert renminbi into foreign currency and whether they may transfer such funds overseas.241 while it previously vetted only corporate cross-border money transfers of more than us $50 million, safe reportedly started requiring pre-approval for all overseas transfers of more than us $5 million.242 government regulators also stepped-up administrative scrutiny of outbound investments with the goal of weeding out those that it deemed “irrational.”243 as a result, outbound investment declined more than 40% in the first seven months of 2017.244 in august 2017, china’s top economic planning body announced a new system of regulation for overseas investments. restrictions were placed on investments in property, hotels, film, entertainment, and sports. on the other hand, investments related to the belt and road initiative, infrastructure, energy, and high-tech businesses would be given preferential state support.245 regulations were also put in place requiring soes to prove the financial viability of overseas projects before undertaking investments and mandating stricter auditing procedures, particularly for currency transactions.246 to observers, the new regulations reaffirm the government’s preference for overseas investments to be led primarily by soes rather than private corporations.247 241 see gary lock & karen ip, getting your cash back, 28 int’l fin. l. rev. 36 (2009); friedrich wu, robbertjan korthah & ng kuan khai, how safe is safe's management of china's official foreign exchange reserves?, 14 world econ. 19, 20–21 (2013). 242 see james t. areddy & lingling wei, foreign companies face new clampdown for getting money out of china, wall st. j., dec. 1, 2016, https://www.wsj.com/articles/foreign-companies-face-new-clampdown-forgetting-money-out-of-china-1480604271; gabriel wildau, don weinland & tom mitchell, china to clamp down on outbound m&a in war on capital flight, fin. times, nov. 29, 2016, https://www.ft.com/content/2511fa56-b5f811e6-ba85-95d1533d9a62; see also engen tham & samuel shen, banks forced to cover tracks of china's forex regulator, reuters (jan. 10, 2017), https://www.reuters.com/article/uk-china-regulator-banks-exclusiveiduskbn14v0cp [perma.cc/362x-bu95] (reporting that safe transmitted instructions regarding the tightening of capital controls orally and instructed banks to keep the measures secret in order to prevent alarm); xie, supra note 26, at 55–56 (describing the gradual liberalization of safe exchange regulations from 2008 to 2015). 243 see andrew mcginty, jun wei & liang xu, hogan lovells, china’s new foreign exchange controls create fresh concerns (jan. 2017), at 2-3, https://www.hoganlovells.com/~/media/hoganlovells/pdf/chinas-new-foreign-exchange-controls-create-fresh-concerns-for-foreign-investors.pdf [perma.cc/jq3nxwgd]. 244 see china codifies crackdown on ‘irrational’ outbound investment, bloomberg (aug. 18, 2017), https://www.bloomberg.com/news/articles/2017-08-18/china-further-limits-overseas-investment-in-push-to-reducerisk. 245 jinyibu yindao he guifan jingwai touzi fangxiang zhidao yijian de tongzhi [进一步引导和规范境外投资 方向指导意见的通知] (guiding opinion on further directing and regulating the direction of overseas investments)， guo ban fa [2017] no.74; see also latham & watkins, china issues formal guidance for outbound direct investments (aug. 30, 2017), https://m.lw.com/thoughtleadership/lw-china-issues-formal-guidance-foroutbound-direct-investments [perma.cc/j3l8-n7nb](summarizing the contents of the guiding opinion). 246 guoyou qiye jingwai touzi caiwu guanli banfa [国有企业境外投资财务管理办法] (measures for the financial management of the overseas investments of soes), cai zi [2017] no. 24; emily feng, china tightens rules on state groups’ foreign investments, fin. times, aug. 3, 2017, https://www.ft.com/content/3251987c-780611e7-90c0-90a9d1bc9691; china issues rules to curb state firms’ overseas investment risks, reuters (aug. 2, 2017), https://www.reuters.com/article/us-china-economy-soe/china-issues-rules-to-curb-state-firms-overseasinvestment-risks-iduskbn1ai1bo [perma.cc/ev8b-yj44]. 247 see weinland, supra note 238; wade shepard, xi jinping to china's private sector: go home, the new silk road is not for you, forbes (july 27, 2017), https://www.forbes.com/sites/wadeshepard/2017/07/25/xi-jinping-tochinas-private-sector-go-home-the-belt-and-road-is-not-for-you/#230b364c17fb [perma.cc/3lgr-mguu]. https://perma.cc/362x-bu95 https://perma.cc/jq3n-xwgd https://perma.cc/jq3n-xwgd https://perma.cc/j3l8-n7nb https://perma.cc/ev8b-yj44 https://www.forbes.com/sites/wadeshepard/2017/07/25/xi-jinping-to-chinas-private-sector-go-home-the-belt-and-road-is-not-for-you/#230b364c17fb https://www.forbes.com/sites/wadeshepard/2017/07/25/xi-jinping-to-chinas-private-sector-go-home-the-belt-and-road-is-not-for-you/#230b364c17fb https://perma.cc/3lgr-mguu 2018] 109 chinese state capitalism and the international tax regime the chinese government’s aggressive enforcement of capital controls in 2016 targeted “irrational” outbound direct investment, reflecting the fact that chinese capital control regime has long been more accommodating to direct investment than portfolio investment. cross-border investment is generally classified as foreign direct investment when the investor owns at least 10% of the stock of a foreign entity—as equity ownership above this level presumably reflects significant influence in corporate decision making. in contrast, investment below this 10% level or in debt securities is considered passive or portfolio investment.248 since 1991, an approval and registration process has been in place for chinese enterprises to make direct investments in foreign projects.249 even after a series of significant reforms in the early 2000s, this approval process can still be arduous, requiring certifications from multiple government departments. 250 yet the regulation of outbound direct investment remains more permissive than that of outbound portfolio investment. until the mid 2000s, chinese capital controls prohibited individuals and companies from making portfolio investments in overseas stock markets or securities.251 starting in 2006, under the qualified domestic institutional investor (qdii) regime, a limited number of chinese financial institutions were granted licenses to invest in overseas securities. approved institutions are each granted a specific quota set by safe and the regime heavily restricts what foreign securities are eligible for investment. 252 these institutions may then repackage these foreign investments into financial products offered to domestic investors.253 while the government is considering pilot programs to allow additional offshore portfolio investments, further liberalization has been repeatedly delayed.254 as a result of these policies, chinese foreign outward 248 see tadeusz galeza and james chan, what is direct investment?, 52 fin. & dev. 34 (sept. 2015); see also michael j. graetz & itai grinberg, taxing international portfolio investment, 56 tax. l. rev. 537, 539 (2003) (discussing the distinction in u.s. international tax law between foreign direct and portfolio investments). 249 see hansjörg herr, capital controls and economic development in china, in financial liberalization and economic performance in emerging countries 142, 151 (p. arestis et al. eds., 2008). 250 see xie, supra note 26, at 24–27. 251 see herr, supra note 249, at 153; guonan ma & robert n. mccauley, do china’s capital controls still bind? implications for monetary autonomy and capital liberalisation 19 (bank for int’l settlements working paper no. 233, aug. 2007), https://www.bis.org/repofficepubl/arpresearch200708.1.pdf [perma.cc/c7vy-epq3]. 252 see y. nanci ni, china’s capital flow regulations: the qualified foreign institutional investor and the qualified domestic institutional investor programs, 28 rev. banking & fin. l. 299, 326–28 (2009); see also richard mazzochi, minny siu & hayden flinn, king & wood mallesons, qdii – an offshore perspective (july 2013), http://www.kwm.com/en/hk/knowledge/downloads/kwm-connect-qdii-an-offshore-perspective20130701 [perma.cc/3p2f-7mly] (describing in detail the qdii regime). 253 see ni, supra note 252, at 330–31; see also daniel ren, record number of qdii funds shows chinese investors’ hunger for offshore stocks, s. china morning post, nov. 18, 2016, http://www.scmp.com/business/companies/article/2047214/record-number-qdii-funds-shows-chinese-investorshunger-offshore [perma.cc/2547-8hge] (noting the recent popularity of the qdii related products and funds amongst chinese investors). 254 see ren wei, yuan scare: why china is putting on hold a major cross-border investment scheme, s. china morning post, feb. 1, 2016, https://www.scmp.com/business/article/1908108/yuan-scare-why-china-putting-holdmajor-cross-border-investment-scheme [perma.cc/dvp5-335l]; don weinland, china halts overseas investment schemes, fin. times, feb. 28, 2016, https://www.ft.com/content/c64b3fc6-dc2e-11e5-a72f-1e7744c66818. https://perma.cc/2547-8hge https://perma.cc/dvp5-335l 110 [vol.10:1 columbia journal of tax law portfolio investment remains minuscule both in comparison to its outbound direct investments and to that of other countries.255 the same pattern holds for inbound investments, with chinese capital controls far more permissive towards direct investment than portfolio investment by foreign investors. as previously noted, china has sought to attract inward foreign direct investment since the start of reform and opening up policy.256 while certain sectors remain off-limits to foreign investors—a point of considerable tension in u.s.-china trade relations257—there are no capital controls on inward foreign direct investment. 258 in contrast, china continues to strictly limit inbound portfolio investment.259 starting in 2002, under the qualified foreign institutional investors (qfii) regime, a limited number of qualified foreign institutional investors were first permitted to invest in the chinese stock market, chinese bonds, chinese etfs, and other securities. potential qfii investors must apply for an investment quota from chinese regulators and face minimum holding or lockup periods before being permitted to repatriate capital gains.260 china has increased the qfii regime’s quota limitations and reduced its lock-up periods three times since its original roll-out.261 in 2014 and 2016 china further liberalized foreign portfolio investment with the opening of the hong kong-shanghai and hong kong-shenzhen stock connect systems, which each allow for us $3.4 billion to flow between hong kong and each mainland stock market.262 these systems allow foreign investors to trade a subset of chinese stocks without a quota or lockup period and gives 255see john hooley, bringing down the great wall? global implications of capital account liberalisation in china, bank eng. q. bull. (dec. 20, 2013), https://www.bankofengland.co.uk/quarterly-bulletin/2013/q4/bringingdown-the-great-wall-global-implications-of-capital-account-liberalisation-in-china [perma.cc/m7f2-gvz3] (“[t]he biggest difference between the international investment positions of china and the united states is in portfolio investment. the stock of outward portfolio investment is 3% of gdp in china, compared with 49% in the united states.”); herr, supra note 249, at 156 (“fdi flows clearly dominated legal capital flows in china. this is a big difference to other developing countries, which showed much higher percentages of portfolio investment and ‘other investment’ to aggregate cross-border flows.”); thilo hanemann & daniel h. rosen, china invests in europe patterns, impacts and policy implications, rhodium group 15 (june 2012), http://rhg.com/wpcontent/uploads/2012/06/rhg_chinainvestsineurope_june2012.pdf [perma.cc/d44m-3zkg] (reporting that chinese outward portfolio flows and stocks represent 0.3% and 0.6% of global totals respectively, while chinese outward fdi represent 5.1% and 1.5% respectively); see also graetz & grinberg, supra note 248, at 538 (noting that in most years since 1990, u.s. residents’ foreign portfolio investment income has exceeded their foreign direct investment income). 256 see ma & mccauley, supra note 251, at 14. 257 see tit for tat? the shape of u.s. restrictions on chinese fdi, stratfor (feb. 10, 2018), https://worldview.stratfor.com/article/tit-tat-shape-us-restrictions-chinese-fdi [perma.cc/vhb4-e87d]. 258 see herr, supra note 249, at 151. 259 see wendy dobson & paul r. masson, will the renminbi become a world currency?, 20 china econ. rev. 124 (2009); herr, supra note 249, at 153; fred hu, capital flows, overheating, and the nominal exchange rate regime in china, 25 cato j. 357, 360 (2005). 260 see herr, supra note 249, at 153; hu, supra note 259, at 360; see also bi xiaoning, limits up for qfii investors, china daily, sept. 5, 2009, https://www.chinadaily.com.cn/bizchina/2009-09/05/content_8658520.htm [perma.cc/7rdu-7br8] (discussing the 2009 adjustments to qfii quotas and lockup periods). 261 see china relaxes qfii control, herbert smith freehills (feb. 22, 2016), https://www.lexology.com/library/detail.aspx?g=15ccba92-f44d-4b40-b9b5-62ebef8c0e23 [perma.cc/qgk2xgyn]. 262 neil gough, as china’s investors rush in, hong kong shares take a wild ride, n.y. times, apr. 30, 2017, https://www.nytimes.com/2017/04/30/business/meitu-hong-kong-stock-connect-china.html [perma.cc/7anp-36e5]. https://perma.cc/m7f2-gvz3 https://perma.cc/d44m-3zkg https://perma.cc/vhb4-e87d https://perma.cc/7rdu-7br8 https://perma.cc/qgk2-xgyn https://perma.cc/qgk2-xgyn https://perma.cc/7anp-36e5 2018] 111 chinese state capitalism and the international tax regime mainland investors access to the hong kong stock market.263 yet, commentators have noted that while this reform is significant, china remains “far from being a free, open stock market that investors from outside the country can access in its entirety.”264 unsurprisingly, china’s inward portfolio investment stock is also miniscule in comparison to inward direct investment and to inward portfolio investment in other countries.265 iv. possibilities for distinctive chinese international tax policies and norms a. continued income taxation of chinese soes as the previous part has illustrated, the chinese central government maintains extensive control over the shape of the chinese economy, through its system of soes, industrial planning initiatives, and capital controls. looking forward, china’s international tax policy is likely to be strongly influenced by this unique system of state capitalism. this part advances three ways in which the role of soes and capital controls may lead to distinctive sets of chinese tax policies and preferences. first, china’s system of state capitalism may allow it to maintain a functional system of worldwide corporate taxation despite a general international trend toward more territorial systems. second, chinese tax officials may help soes engage in foreign tax planning. finally, chinese tax law is likely to continue to provide differential treatment to soes and private enterprises engaging in investment abroad and chinese tax diplomacy may seek to ensure other countries offer favorable tax treatment to chinese soes. as a threshold matter, enterprise income taxation will likely remain the primary concern of china’s international tax policy. admittedly, the future of corporate income taxation as a significant source of government revenue remains a topic of debate amongst western scholars.266 and in recent years, notable u.s. pundits on both sides of the political spectrum have called for its abolition, suggesting offsetting increases in individual income tax or other integration schemes.267 263 enoch yiu, don’t expect qfii to disappear now that the second stock connect is ready for lift-off, s. china morning post, nov. 28, 2016, http://www.scmp.com/business/companies/article/2049765/dont-expect-qfiidisappear-now-second-stock-connect-ready-lift [perma.cc/qzs8-eca4]. 264 adam shell, china opens door to more foreign stock investors, usa today (june 22, 2017), https://www.usatoday.com/story/money/2017/06/22/playing/415307001 [perma.cc/2q3y-dlxq]; see fraser howie, the promise of china's stock connect betrayed, nikkei asian rev. (dec. 28, 2017), https://asia.nikkei.com/viewpoints/fraser-howie/the-promise-of-china-s-stock-connect-betrayed. [perma.cc/5amq-pdu6]. 265 see hooley, supra note 255 (noting that inward portfolio investment represents 4% of gdp in china and 86% of gdp in the united states). 266 see, e.g., reuven s. avi-yonah, corporations, society, and the state: a defense of the corporate tax, 90 va. l. rev. 1193 (2004); yariv braunner, the non-sense tax: a reply to new corporate income tax advocacy, 2008 mich st. l. rev. 591 (2008). 267 see, e.g., dean baker, a progressive way to end corporate taxes, n.y. times, jan. 12, 2016, www.nytimes.com/2016/01/13/opinion/a-progressive-way-to-replace-corporate-taxes.html [https://perma.cc/3z6hc5u8]; matthew yglesias, scrap the corporate income tax, slate (apr. 9, 2013), http://www.slate.com/articles/business/moneybox/2013/04/corporate_income_tax_reform_it_s_not_possible_we_sh ould_just_get_rid_of.html [https://perma.cc/wp8x-l6zu]; kevin d. williamson, end the corporate tax, nat’l rev. (apr. 26, 2017), https://www.nationalreview.com/2017/04/corporate-tax-rate-reduction-zero-percent-would-bebetter-15/ [https://perma.cc/27gx-qgfx]. https://perma.cc/qzs8-eca4 https://perma.cc/3z6h-c5u8 https://perma.cc/3z6h-c5u8 http://www.slate.com/articles/business/moneybox/2013/04/corporate_income_tax_reform_it_s_not_possible_we_should_just_get_rid_of.html http://www.slate.com/articles/business/moneybox/2013/04/corporate_income_tax_reform_it_s_not_possible_we_should_just_get_rid_of.html https://www.nationalreview.com/2017/04/corporate-tax-rate-reduction-zero-percent-would-be-better-15/ https://www.nationalreview.com/2017/04/corporate-tax-rate-reduction-zero-percent-would-be-better-15/ 112 [vol.10:1 columbia journal of tax law yet, in china, and other developing countries, relatively weak individual income tax systems coupled with an outsized role for corporate income taxes in government revenue makes the elimination of corporate income taxation appear untenable.268 in oecd members states, corporate income taxes on average represent 8.9 percent of total tax revenue, while individual income taxes represent 24.4 percent of total tax revenue.269 in fact, in all but two of the 35 oecd member states revenue from individual income taxes exceed that from corporate income taxes.270 yet in china this pattern is reversed. in 2016 the enterprise income tax accounted for 22.13 percent of total tax revenue in china, while the individual income tax accounted for only 7.74 percent.271 moreover, the relative contribution of enterprise income tax revenue has increased significantly across the new millennium. more generally, china’s total tax revenue collected as a percentage of gdp remains relatively low compared to both oecd and other bric countries and it will likely need to raise additional revenue to strengthen its social welfare programs.272 as a result, the elimination of the corporate income tax is highly unlikely, especially in light of china’s relatively underdeveloped individual income tax system.273 similarly, income taxation of soes is likely to remain an important source of tax revenue. while the percentage of loss-making chinese soes increased across the 1990s, to nearly 50 percent in 1998, following the establishment of sasac in 2003, central soes saw their operations stabilize and profits soar.274 the profits of central soes quadrupled from 2002 to 2007, jumping 268 see reuven s. avi-yonah, hanging together: a multilateral approach to taxing multinationals, in global tax fairness, supra note 64, at 114. 269 see org. econ. co-operation & dev., oecd (2017), revenue statistics 2017: tax revenue trends in the oecd, https://www.oecd.org/tax/tax-policy/revenue-statistics-highlights-brochure.pdf [https://perma.cc/4tbufxt4]. 270 slovakia and chile are the exceptions to this rule. see id. 271 see bai yanfeng & cui rui [白彦锋 & 崔芮], guoji shuishou jingzheng yu woguo qiye suodeshu gaige de lixing xuanze [国际税收竞争与我国企业所得税改革的理性选择] (international tax competition and rational choices for chinese enterprise income tax reform), 5 sub nat’l fiscal res. 31 (2017) [地方财政研究]; see also state admin. of tax’n, revenue statistics, , http://www.chinatax.gov.cn/eng/n2367736/index.html [https://perma.cc/jqa3-gsjy] (reporting in 2015 the corporate income tax similarly represented 21 percent of total tax revenues). 272 see jeffery owens [杰弗里·欧文斯], shuishou zai shixian “zhongguo meng” zhong de zuoyong [税收在 实现“中国梦”中的作用] (the role of taxation in realizing the “chinese dream”), 12 int’l tax’n in china 34 (2017) [国际税收]; see also mingxing cao [曹明星], beps fanglue: xin weiquan zhuyi chong gou guoji shuishou zhixu de jijie hao? [beps方略:新威权主义重构国际税收秩序的集结号?] (beps strategy: is it an assembly signal for new authoritarianism to reconstruct international tax order? ), 7 int’l tax’n in china 16, 20 (2014) [国际税收] (noting china’s relatively low tax revenue and arguing that as china’s economy continues to grow, both the government’s spending on the social security and its tax revenues will be required to continue to grow); revenue statistics 2017, supra note at 269, at 3 (noting the oecd average of tax revenue as percentage of gdp was 34.3 percent. in china it was 21.6 percent). 273 see dou benbin, how china’s income tax became a levy on the poor, sixth tone (feb. 22, 2017), http://www.sixthtone.com/news/1969/how-chinas-income-tax-became-a-levy-on-the-poor [https://perma.cc/5wghj5y3]; maggie zhang, china ‘not ready’ for us-style whole family income tax, although progressive changes are underway, s. china morning post, march 20, 2018, http://www.scmp.com/business/globaleconomy/article/2137876/china-not-ready-us-style-whole-family-income-tax-although [https://perma.cc/krx6gefg]. 274 see wang, supra note 84, at 647; tsai & naughton, supra note 20, at 2. http://www.sixthtone.com/news/1969/how-chinas-income-tax-became-a-levy-on-the-poor http://www.scmp.com/business/global-economy/article/2137876/china-not-ready-us-style-whole-family-income-tax-although http://www.scmp.com/business/global-economy/article/2137876/china-not-ready-us-style-whole-family-income-tax-although 2018] 113 chinese state capitalism and the international tax regime from approximately 2 percent of gdp to 3.8 percent of gdp.275 more generally, profits of all soes (including state financial firms and local soes), increased from approximately 263 billion yuan (us $41.6 billion) in 2002 to 1.089 trillion yuan (us $170.9 billion) in 2007, an annual increase of 32.6 percent.276 in 2017 total soe profits stood at 2.9 trillion yuan (us $453.2 billion), with central soe profits reaching records levels of 1.4 trillion yuan (us $217.5 billion).277 along with this increase in profitability, taxes on soes have become a significant source of government revenue. soes now contribute more than 10 percent of total enterprise income tax revenue and central soes are routinely listed as china’s largest taxpayers. 278 moreover, income taxation is likely to remain the primary mechanism for transferring earnings from soes to the central government. as noted by wei cui, taxation of soes is a widespread but severely undertheorized and studied phenomena.279 even fundamental conceptual questions—why do countries tax the income of their soes and are such taxes rational—remain unsettled.280 scholars have recognized that for wholly government-owned soes (where all profit nominally belongs to the state), the government could access soe profits by means of either a profits tax or a dividend distribution. 281 yet, like china today, most advanced economies prior to the wave of soe privatizations in the 1980s maintained an income tax on soes.282 the soviet union, which is perhaps the closest, but still inexact, analogue to chinese state capitalism, also imposed an income tax on state-owned corporations which provided the bulk of central government tax revenue.283 in his early seminal article on soe taxation, robert floyd argued that imposing the same income tax on soes as private enterprises can be justified in mixed-economies 275 naughton notes that “for comparison, exxonmobil’s record profit in 2007 was equal to 0.2% of u.s. gdp.” naughton, supra note 144, at 51. 276 see jia kang & liu wei (贾康 & 刘微), tigao guomin shouru fenpei “liang ge bizhong” ezhi shouru chaju kuoda de caishui sikao yu jianyi (提高国民收入分配 “两个比重” 遏制收入差距扩大的财税思考与建议) [thoughts and suggestions to improve the national income distribution’s “two weights” and contain the expanding income gap], 12 fiscal res. 2, 12 (2010) [财政研究]. 277 chinese soes see solid profit growth in 2017, xinhua (jan. 23, 2018), http://www.xinhuanet.com/english/2018-01/23/c_136918113.htm [https://perma.cc/gg5b-rrv8]; chinese state enterprises post record level of profits in 2017, s. china morning post, jan. 16, 2018), http://www.scmp.com/news/china/economy/article/2128446/chinese-state-enterprises-post-record-level-profits-2017 [https://perma.cc/vx8m-5gr4]. 278 see cui, taxation of state-owned enterprises: a review of empirical evidence from china, in regulating the visible hand?, supra note 142, at 109, 118; wang, supra note 84, at 647, 666. 279 cui, supra note 278, at 110. 280 see id. at 111-112. 281 see, e.g., id. at 111; robert h. floyd, some aspects of income taxation of public enterprises, 25 int’l monetary fund staff papers 310, 312 (june 1978). 282 see floyd, supra note 281, at 313; glenn p. jenkins, taxation and state-owned enterprises 1 (development discussion paper no. 225, apr. 1986), http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.577.9665&rep=rep1&type=pdf [https://perma.cc/2pqg2md2]; wei cui, supra note 278, at 110; see generally carles boix, privatizing the public business sector in the eighties: economic performance, partisan responses and divided governments, 27 brit. j. pol. sci. 473 (1997) (examining the evolution of state-owned enterprises in oecd countries during the 1980s). 283 see sergei v. aleksashenko, establishment of a taxation system in the ussr, 3 communist econ. & econ. transformation 81 (1991); vernon g. setser, the immunities of the state and government economic activities, 24 law & contemp. probs. 291, 298 (1959). http://www.xinhuanet.com/english/2018-01/23/c_136918113.htm http://www.scmp.com/news/china/economy/article/2128446/chinese-state-enterprises-post-record-level-profits-2017 http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.577.9665&rep=rep1&type=pdf 114 [vol.10:1 columbia journal of tax law where soes have a profit motive, as such a tax is required “to prevent tax-induced distortions in the allocation of resources.”284 if soes are responsive to rates of return and are able to shift investments, failure to impose an income tax on soes could result in inefficiently high levels of soe investment thanks to their tax-advantaged status.285 however, this explanation has been criticized by subsequent scholarship, as imposing seemingly identical tax rules on soes and private enterprises will still fail to place identical tax burdens on soes, since soes have greater access to financing (and thus interest deductions) and subsidies not as readily available to private enterprises.286 moreover, other alternative mechanisms exist for better ensuring that the rate of return on soe investments meets that of the private sector.287 this critique is particularly relevant in the context of china, where central soes are widely acknowledged to have easier access to credit and subsidies than private firms, thus “creating an unequal playing field for soes, private companies and foreign firms.”288 for these reason, wei cui argues that the best justification for corporate income taxation on chinese soe is as a type of forced distribution of soe earnings, designed to avoid the corporate governance challenges associated with ensuring proper levels of soe dividend payments.289 another rationale for imposing income tax on soes concerns situations of mixedownership. income taxation in comparison to pro rata dividends transfers a greater portion of soe earnings to the state rather than private investors.290 since the state receives 100 percent of income tax payments, but less than 100 percent of dividend payments, from the perspective of central government policy-makers wishing to maximize the total amount of revenue transferred to the state from a mixed-ownership soe, higher corporate income tax payments are preferable to larger dividend payments. as an example, take a hypothetical central soe, chinaco, 70 percent owned by sasac and 30 percent owned by qualified foreign institutional investors.291 chinaco earns 284 floyd, supra note 281, at 341. 285 see id. at 340 286 see jenkins, supra note 282, at 2-3; see also cui, supra note 22, at 794 (discussing and adding to these criticisms). 287 see id. at 3. 288 jane cai, private players feeling squeezed out by beijing’s support for state companies, s. china morning post, oct. 4, 2017, http://www.scmp.com/news/china/economy/article/2113869/past-its-use-date-warps-chinasantiquated-policy-picking-industry [https://perma.cc/39eg-8n96]; see state of grace, economist (nov. 17, 2016), https://www.economist.com/news/finance-and-economics/21710291-government-their-side-chinas-state-firmsborrow-cheaply-state-grace [https://perma.cc/t8ra-npkm]; gabriel wildau, supra note 149 (“soes also enjoy noncash benefits like low-interest bank loans and discounts on land, water and electricity.”); see also; kai li, heng yue & longkai zhao, ownership, institutions, and capital structure: evidence from china, 37 j. comp. econ. 471 (2009) (showing that state ownership is positively associated with leverage and firms’ access to long-term debt, while foreign ownership is negatively associated with all measures of leverage). 289 see cui, supra note 278, at 112, 130; cui, supra note 22, at 781. 290 since the primary question motivating wei cui’s theory “is how a purely state-owned firm would respond to taxation,” he briefly acknowledges that mixed-ownership may provide a partial explanation for soe taxation, but he otherwise devotes little attention to tax policy implication of mixed-ownership. see cui, supra note 278, at 112; cui, supra note 22, at 787. yet, the chinese government’s continuing support for mixed-ownership reforms of central soes would suggest such ownership structures are highly relevant to tax policy considerations—even if less relevant for theory. 291 sasac has recently made public pronouncements explicitly inviting foreign investors to participate in mixedownership reforms. see jing shuiyu, ownership reform welcomes all comers, china daily, sept. 29, 2017 http://www.chinadaily.com.cn/business/2017-09/29/content_32626118.htm [https://perma.cc/848h-vtvj]. http://www.scmp.com/news/china/economy/article/2113869/past-its-use-date-warps-chinas-antiquated-policy-picking-industry http://www.scmp.com/news/china/economy/article/2113869/past-its-use-date-warps-chinas-antiquated-policy-picking-industry https://www.economist.com/news/finance-and-economics/21710291-government-their-side-chinas-state-firms-borrow-cheaply-state-grace https://www.economist.com/news/finance-and-economics/21710291-government-their-side-chinas-state-firms-borrow-cheaply-state-grace http://www.chinadaily.com.cn/business/2017-09/29/content_32626118.htm 2018] 115 chinese state capitalism and the international tax regime $100 in china before tax. on any pro rata dividend payment, the foreign investors would be subject to a 10 percent withholding tax on the dividends received.292 as shown in table 1 below, under either the standard enterprise tax rate of 25 percent or high and new technology enterprise rate of 15 percent, more revenue goes to the state than if soe profits were untaxed. this same basic pattern holds no matter the size of the minority stake or whether it is held by foreign or chinese investors. thus, in the mixed-ownership context, income taxation of soes enables the state to claim a higher percentage of soe earnings than it would be entitled to based solely upon its ownership stake. as a result, it is unlikely that the chinese government will dramatically rollback or eliminate income taxation of soes in the near future. notably, this also creates a strong incentive for the central government to have managers of mixed-ownership soes earning only domestic income to over-pay enterprise income tax (or at minimum avoid domestic tax planning) while limiting dividend payments.293 table 1 state ownershi p percentag e foreign ownershi p percentag e withholdi ng rate on dividends 70% 30% 10% enterpris e income tax rate pre-tax earnings income tax paid dividen ds paid to the state withholding on dividends paid to foreign investors state total posttax revenu e foreign investor post-tax revenue 0% 100 $ $ 70.00 $ 3.00 $ 73.0 0 $ 27.00 15% 100 $ 15.00 $ 59.50 $ 2.55 $ 77.05 $ 22.95 25% 100 $ 25.00 $ 52.50 $ 2.25 $ 79.75 $ 20.25 whatever the underlying rationale, in practice, income tax payments by chinese soes greatly overshadow dividend payments. following tax and soe reforms of 1993-1994, under 292 see cao, supra note 95, at 52-53. this withholding rate might be reduced to 5 percent under a limited number of bilateral tax treaties. see id. at 285-289. 293 state and managerial incentives regarding soe income earned abroad are discussed in part 5.b, infra. 116 [vol.10:1 columbia journal of tax law which soes were required to pay income taxes,294 soes were no longer required to turn over dividends or excess-profits to the state and could instead reinvest all post-tax profits across their corporate group. this policy reflected the relatively poor financial status and low profits of soes during the 1990s as the government’s interest at the time was in increasing soes autonomy and independence. 295 following its establishment in 2003, sasac sought the power to collect dividends from soes. yet, this plan was delayed by an interdepartmental dispute regarding whether sasac or the ministry of finance should have the power to allocate these receipts.296 eventually, a compromise payment formula was reached, and in 2007 the government announced a pilot program under which soes in profitable sectors were required to pay either 10 or 5 percent of profits as dividend.297 in 2010-2011 the ministry of finance issued a directive increasing these requirements to 15 and 10 percent.298 and recently, in 2014 the government again called for increasing the dividends of many soes in order to make them more attractive to foreign institutional investors, with a handful of the most profitable soes ordered to pay dividends representing 20 percent of profits.299 despite the recent announcement of special dividends by shenhua energy and china mobile—two central soes—the overall value of soe dividends has actually declined 4.4 percent from 2014 to 2016, and investors continue to view “low or nonexistent dividends” of central soes as “a persistent bug bear.”300 moreover, the dividend rates of 294 see supra text accompanying notes 98-102. 295 see louis kuijs, william mako & chunlin zhang, soe dividends: how much and to whom? (world bank working paper no. 56651, 2005), http://documents.worldbank.org/curated/en/961421468243568454/soedividends-how-much-and-to-whom [https://perma.cc/yfq5-qpr2].; naughton, supra note 144, at 59-60; lan xinzhen, shaking the soes, beijing rev. (apr. 27, 2006), http://www.bjreview.cn/en/06-17-e/bus-2.htm. [https://perma.cc/zl7c-m4js]. 296 see lan, supra note 295; mikael mattlin, whose money?: the tug-of-war over chinese state enterprise profits (finnish inst. int’l aff. briefing paper 79 2011), https://www.files.ethz.ch/isn/128535/upi_briefing_paper_79.pdf [https://perma.cc/krj7-vyga]. 297 soes in the tobacco, petroleum, power, telecom, coal, or other monopolized sectors were required to pay 10 percent, while soes in the steel transportation, electronics, trade, construction, or other generally competitive sectors were required to pay 5 percent. soes in the defense industry were exempt from dividend payments. see xu yi-chong, sinews of power: the politics of the state grid corporation of china 102 (2016); hogan lovells, central government to collect huge capital income from major state-owned enterprises (march 26, 2008), https://www.lexology.com/library/detail.aspx?g=b0609c70-e502-4fd7-bbe7-79773a48bd2b [https://perma.cc/u9ac2px5]. 298 see mattlin, supra note 296. 299 see wei tian, dividends to increase at central state firms, china daily, may 7, 2014, http://www.chinadaily.com.cn/bizchina/201405/07/content_17489550.htmhttp://www.chinadaily.com.cn/bizchina/2014-05/07/content_17489550.htm [https://perma.cc/x752-auvf]. 300 fox hu & moxy ying, china's dividend superstars mask stinginess of state firms, bloomberg (aug. 29, 2017), https://www.bloomberg.com/news/articles/2017-08-28/china-s-dividend-superstars-mask-stingy-reality-forstate-firms [https://perma.cc/58mk-jwkr]; see also david keohane, for the brave china soe reform optimists out there, fin. times, march, 24, 2017, https://ftalphaville.ft.com/2017/03/24/2186349/for-the-brave-china-soereform-optimists-out-there/ (discussing the risk of extrapolating from shenhua’s special dividend); jennifer lo, chinese government is the biggest beneficiary of shenhua's fat dividend, nikkei asian rev. (march 20, 2017), https://asia.nikkei.com/markets/equities/chinese-government-is-the-biggest-beneficiary-of-shenhua-s-fat-dividend [https://perma.cc/ka39-cmh3] (noting that the chinese government stands as the largest beneficiary of shenhua’s dividend thanks to sasac’s 73 percent ownership stake in the shenhua group’s parent company). http://documents.worldbank.org/curated/en/961421468243568454/soe-dividends-how-much-and-to-whom http://documents.worldbank.org/curated/en/961421468243568454/soe-dividends-how-much-and-to-whom https://www.files.ethz.ch/isn/128535/upi_briefing_paper_79.pdf https://www.lexology.com/library/detail.aspx?g=b0609c70-e502-4fd7-bbe7-79773a48bd2b http://www.chinadaily.com.cn/bizchina/2014-05/07/content_17489550.htm 2018] 117 chinese state capitalism and the international tax regime chinese soes remain far below the average dividend rates paid by major u.s. firms or by soes in other economies.301 in conclusion, enterprise income taxation of both private enterprises and soes is likely to remain a core component of chinese tax policy. enterprise income taxation remains an important source of tax revenue. it enables the government to claim a higher percentage of soe revenue from mixed-ownership enterprises than it would be entitled to based solely upon its ownership stake. and despite recent increases in soe dividend distributions, it remains the primary mechanism for transferring soe revenue to the state. b. maintenance of worldwide corporate taxation having established that enterprise income taxation is likely to remain an important element of chinese tax policy, this part argues that its unique system of state capitalism may lead china to maintain a relatively well-functioning system of worldwide corporate taxation despite an international trend toward territorial taxation. in recent years a number of developed countries, including the united kingdom and japan have reformed their systems of international corporate taxation, shifting away from worldwide taxation and closer to territorial taxation. 302 while worldwide corporate taxation was once the oecd norm, it has become an outlier.303 under most modern territorial systems, active income earned abroad as well as dividends received from foreign subsidiaries are exempted from resident country taxation. in contrast under a worldwide system, this income is subject to taxation by the resident country, but a foreign tax credit may be available to offset foreign income taxes paid to source countries. two commonly identified rationales for shifting towards a territorial system, is that it minimizes the incentive for corporate inversions and it prevents the “lockout” of earnings by foreign subsidiaries.304 first, in order to minimize the tax burden on income earned abroad, multinationals whose corporate parent is a tax resident of a jurisdiction with a worldwide taxation system may engage in corporate inversions. through a 301 see milhaupt & zheng, supra note 23, at 679; effective discipline with adequate autonomy: the direction for further reform of china’s soe dividend policy, world bank policy note number 53254 (2009), http://documents.worldbank.org/curated/en/358411468024535236/effective-discipline-with-adequate-autonomythe-direction-for-further-reform-of-chinas-soe-dividend-policy [https://perma.cc/wlf4-6ydv]; see also song, yang & zhang, supra note 26, at 44 (“[b]y 2010, some sectors were handing over 15 percent of dividends to the government. in contrast, in some european countries, such as france, germany and the uk, soes are required to turn over 50 percent of their profits to the treasury.”); china plan on wealth gap preserves much of state firms’ cash pile, reuters (feb. 7, 2013), https://www.reuters.com/article/china-economy-inequality/china-plan-on-wealth-gappreserves-much-of-state-firms-cash-pile-idusl4n0b652t20130207 [https://perma.cc/7s9d-un6p] (reporting an average dividend ratio of “33 percent ratio for 49 soes in 16 developed economies between 2000 and 2008” compared to ratios of 9.0, 9.4, and 7.3 percent for sasac controlled soes in 2011, 2010, and 2009, respectively). 302 see thornton matheson, victoria perry & chandara veung, territorial vs. worldwide corporate taxation: implications for developing countries 4 (imf working paper wp/13/205, oct. 2013), https://www.imf.org/external/pubs/ft/wp/2013/wp13205.pdf. [https://perma.cc/d3zg-2de9]. 303 see id.; pricewaterhousecoopers, evolution of territorial tax systems in the oecd (2013), http://www.techceocouncil.org/clientuploads/reports/report%20on%20territorial%20tax%20systems_20130402b. pdf [https://perma.cc/3sml-j2qv]. 304 see matheson, perry & veung, supra note302, at 5; see also eric solomon, corporate inversions: a symptom of larger tax system problems, tax notes 1449 (sept. 17, 2002), https://www.taxnotes.com/tax-notes/corporatetaxation/corporate-inversions-symptom-larger-tax-system-problems/2012/09/17/1209951 (discussing inversions, lock-out, and other problems associated with the u.s. system of worldwide corporate income taxation). https://www.reuters.com/article/china-economy-inequality/china-plan-on-wealth-gap-preserves-much-of-state-firms-cash-pile-idusl4n0b652t20130207 https://www.reuters.com/article/china-economy-inequality/china-plan-on-wealth-gap-preserves-much-of-state-firms-cash-pile-idusl4n0b652t20130207 https://www.taxnotes.com/tax-notes/corporate-taxation/corporate-inversions-symptom-larger-tax-system-problems/2012/09/17/1209951 https://www.taxnotes.com/tax-notes/corporate-taxation/corporate-inversions-symptom-larger-tax-system-problems/2012/09/17/1209951 118 [vol.10:1 columbia journal of tax law cross-border merger of the corporate parent with a smaller foreign corporation, the parent may transform itself into a tax resident of a jurisdiction with a territorial system, thereby reducing or eliminating any additional taxation on the earnings of its subsidiaries in low-tax jurisdictions.305 secondly, multinationals whose corporate parent is a resident of jurisdiction with a worldwide taxation system may also choose to keep earnings by foreign subsidiaries reinvested abroad rather than repatriating this foreign income. by keeping foreign earnings abroad, multinationals can delay any additional taxation by the parent’s country of residence, and thus benefit from tax deferral.306 shifting towards a territorial system reduces the incentive for resident multinationals to engage in these two tax-avoidance practices.307 however, it may also increase their incentive to engage in other types of tax-avoidance such as transforming domestic profits into foreign profits through the use of transfer pricing or thin capitalization.308 thanks in part to its mechanisms of control over soes and capital outflows, inversions and the lock-out effect are likely to be of much less concern to china than to other countries with more free market economies. with soes responsible for the majority of chinese outbound investment, the party-state can leverage its position as controlling shareholder and personnel manager to limit outwardly apparent avoidance of chinese taxation. firstly, as the controlling shareholder in central soes, sasac has the power to veto any soe merger or restructuring, such as tax-motivated corporate inversions, that would undermine public confidence in the integrity of the chinese tax system. similarly, under the communist party’s personnel system, soe executives would torpedo their future career prospects if they sought to engage in a corporate inversion of the group parent of a major chinese soe, especially in light of the government’s identification of their economic success as a point of national pride.309 secondly, the state has the capability to force soes to repatriate foreign earnings, thus minimizing any lockout effect. as noted above, the central 305 see orsolya kun, corporate inversions: the interplay of tax, corporate, and economic implications, 29 del. j. corp. l. 313 (2004); daniel n. shaviro, the david r. tillinghast lecture: the rising tax-electivity of u.s. corporate residence (n.y.u. pub. law and legal theory working paper no. 232 2010), http://lsr.nellco.org/cgi/viewcontent.cgi?article=1233&context=nyu_plltwp, [https://perma.cc/u9uj-h38l]. 306 see john r. graham, michelle hanlon & terry j. shevlin, barriers to mobility: the lockout effect of u.s. taxation of worldwide corporate profits, 63 nat’l tax j. 1111 (dec. 2010). 307 see, e.g., matteo p. arena & george w. kutner, territorial tax system reform and corporate financial policies, 28 rev. fin. stud. 2250 (2015) (“we find that japanese and u.k. multinationals accumulate less cash overall, invest less abroad, and distribute more cash to shareholders through dividends and share repurchases after the adoption of the territorial system in 2009”); makoto hasegawa & kozo kiyota, the effect of moving to a territorial tax system on profit repatriation: evidence from japan, 153 j. pub. econ. 92 (2017) (“[f]oreign affiliates that retained a large stock of retained earnings … before the tax reform significantly increased dividend payments to their parent firms in response to japan's adoption of a territorial tax regime. this implies that the dividend exemption system helped to fulfill its primary goal of stimulating dividend repatriations from foreign affiliates that had amassed large amounts of foreign profits.”). 308 see matheson, perry & veung, supra note 302; see also kevin markle, a comparison of the tax‐motivated income shifting of multinationals in territorial and worldwide countries, 33 contemp. acct. res. 7 (2015) (“[o]n average, multinationals subject to territorial tax regimes shift more income than those subject to worldwide tax regimes.”). 309 see, e.g., arnold ngowani, lessons from china soes, zambia daily mail limited, (oct. 23, 2017), https://www.daily-mail.co.zm/lessons-from-china-soes/ [https://perma.cc/w9a3-z28y] (reporting on a chinese organized seminar on soes for official from developing countries and noting that chinese soes “constitute the foundation of the country’s economy and pride.”) 2018] 119 chinese state capitalism and the international tax regime government has imposed dividend requirements on central soes.310 under its authority sasac could impose a similar concomitant requirement that foreign subsidiaries of soes pay a minimum dividend to group parents. if either sasac or the central organization department placed a high priority on ensuring repatriation of foreign earnings, soe executives would have little choice to comply or risk damaging their career prospects in party leadership. in short, party-state’s extensive influence over soe governance can ensure that soes do not engage in any disfavored publicfacing tax-avoidance strategies to reduce chinese income tax paid. while the party-state exerts less direct influence over private enterprises relative to soes, the current system of capital controls and required regulatory approvals for outbound investments may limit the opportunity for private chinese multinationals to engage in tax-motivated inversions or notorious tax-avoidance strategies. according to the financial times, the dramatic tightening of chinese capital controls in 2016 caused the cancellation of at least 30 deals between chinese acquirers and u.s. and european targets, worth a total of almost us $76 billion, most of which involved private chinese corporations.311 the fact that these capital controls were imposed silently and without warning suggests that government regulators retain significant discretion as to which overseas acquisitions to allow to go forward.312 in fact, thilo hanemann, an expert on chinese fdi, suggests that in practice, the current system of investment regulations and capital controls, “allows the government to control and intervene in every single [outbound cross-border] deal.”313 as a result, even private chinese multinationals would likely find it impracticable to engage in tax-motivated inversions.314 in contrast private chinese multinationals are likely to still find it advantageous to reinvest overseas profits offshore in order to take advantage of tax deferral. therefore, it is not surprising that the sat has begun employing china’s cfc rules against private chinese companies with overseas operations and is reportedly considering reforms to make these rules easier to administer.315 moreover, if the party succeeds in its current efforts to have private chinese tech companies give the state “special management shares” and a direct role in corporate decision making,316 the state may gain the power to veto blatant attempts to avoid chinese tax. 310 see supra text accompanying note 297. 311 see claire jones, javier espinoza & tom hancock, overseas chinese acquisitions worth $75bn cancelled last year, fin. times, feb. 5, 2017, https://www.ft.com/content/b0ff426c-eabe-11e6-930f-061b01e23655. 312 see supra text accompanying notes 242-243; see also mitchell & wildau, supra note 25 (noting the long delay between the emergence of chinese investment curbs and their public recognition by state officials). 313 leslie hook, chinese capital controls hit silicon valley tech investors, fin. times, feb. 5, 2018, https://www.ft.com/content/0e78335e-0152-11e8-9650-9c0ad2d7c5b5. 314 see, e.g, jiang yuesheng [姜跃生], beps de jiazhi chuangzao lun yu zhongguo quanqiu jiazhi fenpei de helihua [beps的价值创造论与中国全球价值分配的合理化] (value creating theory reflected in the beps action plan and how to obtain reasonable share in the global value allocation), 12 int’l tax’n in china 33, 38 (2014) [国际税收] (suggesting that chinese multinationals not be allowed to move their global headquarters out of china, no matter how large their overseas sales may later become). 315 see wang haijun, zhao hongshun, & huang hairong, supra note 123; mark melincoe, in china, more advance rulings, more cases going to court, bloomberg bna (may 31, 2016), https://www.bna.com/chinaadvance-rulings-n57982073273/ [https://perma.cc/nuz6-j2ut]. 316 see li yuan, beijing pushes for a direct hand in china’s big tech firms, wall st. j., oct. 11, 2017, https://www.wsj.com/articles/beijing-pushes-for-a-direct-hand-in-chinas-big-tech-firms-1507758314; china's companies on notice: state preparing to take stakes, bloomberg (jan. 17, 2018), https://www.ft.com/content/b0ff426c-eabe-11e6-930f-061b01e23655 https://www.ft.com/content/0e78335e-0152-11e8-9650-9c0ad2d7c5b5 https://www.bna.com/china-advance-rulings-n57982073273/ https://www.bna.com/china-advance-rulings-n57982073273/ 120 [vol.10:1 columbia journal of tax law if the chinese system of state capitalism helps neutralize the two most significant drawbacks to a worldwide taxation system, the question now becomes why would the chinese government be interested in maintaining worldwide taxation? most importantly, worldwide taxation would serve to disadvantage private outbound direct investment vis a vis soe outbound investment, thus strengthening the role of the party in chinese outbound investment. moreover, worldwide taxation would provide the central government an additional mechanism for shaping the geographic and sectoral patterns of chinese outbound investment. in light of the government’s long use of tax law as an instrument for shaping the character of direct investment into china, it is likely that chinese policy-makers intend to have tax law play a similar role as a backstop to its regulatory policy regarding foreign outbound investment.317 in comparison to a worldwide taxation system, a territorial system provides resident corporations greater incentive to invest abroad. since territorial systems do not impose additional resident country tax on foreign earnings, investments in foreign low-tax jurisdictions are generally subject to lower overall tax under a pure territorial system than under a pure worldwide system.318 this is particularly relevant to china, as at least two-thirds of the countries along the belt and road initiative have statutory corporate tax rates below 20 percent, compared with china’s current statutory rate of 25 percent, making them low-tax jurisdictions relative to china. 319 recent empirical studies tend to confirm that after shifting from a worldwide to territorial system, jurisdictions see an increase in outbound foreign investment by resident corporations.320 while the net effects on tax revenue and domestic gdp from transitioning to a territorial system remain a https://www.bloomberg.com/news/articles/2018-01-17/china-s-communists-will-take-more-stakes-in-privatecompanies. 317 see supra part. 3.a.; see also he qian [何倩], guanyu guli he guifan wogou qiye duiwai touzi shuishou wenti de sikao [关于鼓励和规范我国企业对外投资税收问题的思考] (thoughts on issues of taxation concerning encouraging and regulating chinese enterprises’ foreign investments), 10 tax’n res. j. 90 (2007) [税务研究] (observing that the point of chinese “going out” initiative is not primarily the economic interest of chinese enterprises but geo-strategic issues and national competitiveness, and thus the tax departments must take active measures to help implement the strategy); wei cui, “establishment:” an analysis of a core concept in chinese inbound income taxation, 1 colum. j. tax l. 46, 77 (2010) (suggesting that “the function of chinese tax policy toward foreign investment” was as a “subordinate instrument to other regulatory policy.”). 318 see generally jane g. gravelle, moving to a territorial income tax: options and challenges, cong. res. serv. (july 25, 2012), https://fas.org/sgp/crs/misc/r42624.pdf [https://perma.cc/3prq-7p6k], at 16-18 (summarizing the literature on the relationship between territorial taxation and the location of investment by multinationals). admittedly, depending on the interest deduction allocation and foreign tax credits limitation rules adopted in conjunction with a worldwide system this general pattern may not hold in all cases. see rosanne altshuler & harry grubert, where will they go if we go territorial? dividend exemption and the location decisions of u.s. multinational corporations, 54 nat'l tax j. 787 (2001). 319 see, e.g., wang wenjing & lai hongyu [王文静 & 赖泓宇], “yidai yilu” zhanlüe de guoji shuishou xietiao [“一带一路”战略的国际税收协调] (international taxation coordination under the “belt and road” initiative), 4 int’l tax’n in china 52, 55 (2016) [国际税收]. 320 see, e.g., lars p. feld et al., effects of territorial and worldwide corporation tax systems on outbound m&as (zew – ctr. for eur. econ. res., discussion paper no. 13-088, nov. 2013), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2350755 [https://perma.cc/7fjy-acl3]; li liu, where does multinational investment go with territorial taxation? evidence from the uk (imf working paper no. 18/7, jan. 2018), https://www.imf.org/en/publications/wp/issues/2018/01/12/where-does-multinational-investment-go-withterritorial-taxation-evidence-from-the-uk-45559 [https://perma.cc/a2yl-u4xz]. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2350755 https://www.imf.org/en/publications/wp/issues/2018/01/12/where-does-multinational-investment-go-with-territorial-taxation-evidence-from-the-uk-45559 https://www.imf.org/en/publications/wp/issues/2018/01/12/where-does-multinational-investment-go-with-territorial-taxation-evidence-from-the-uk-45559 2018] 121 chinese state capitalism and the international tax regime point of contention among scholars, this debate is centered on the impacts on domestic investment from eliminating the lock-out effect and on the substitutability of foreign and domestic investment.321 it is not centered on whether territorial taxation provides an additional incentive for outbound investment.322 however, the choice of a worldwide or territorial taxation system is likely to have limited, or even reverse, incentive effects on the investment choices of resident soes. if acting as a perfect fiduciary, a manager of a wholly-owned soe should be indifferent as to whether or not foreign earnings are subject to resident country taxation. the only difference between worldwide and territorial taxation for the soe is when earnings are transferred to state coffers—after earnings are subject to source country taxation, all remaining profits belong to the state. perhaps counterintuitively, a perfect fiduciary manager of a mixed-ownership soe may actually have greater incentive to engage in foreign investment under a worldwide system than under a territorial system. under a territorial system, after foreign earnings are subject to source country taxation, soe shareholders have a pro rata claim on all residual profits. in contrast, under a worldwide system, foreign earnings may also be subject to resident country taxation, thereby increasing the state’s claim on soe revenue relative to other shareholders.323 since a worldwide taxation system may thus allow a greater portion of soe earnings to be transferred to the state vis a via private investors, a loyal manager seeking to maximize returns for the state may have greater incentive to engage in foreign investment under a worldwide system than a territorial system. in sum, the choice between a worldwide or territorial system has different incentive effects on perfectly loyal soes than on private enterprises. yet, in reality, agency problems bedevil the relationship between the chinese government and soe managers, raising additional questions as to the sensitivity of soe managers to taxation. as noted by angela huyue zhang, due to a combination of agency problems and the chinese government’s desire to grow national champions, managers of chinese soes currently have a strong motivation to engage in empire building.324 while the corporate managers of any type of enterprise have perverse incentives to engage in some degree of empire building,325 managers of chinese soes have additional motivation to increase the size and scope of their soe—beyond its optimal size and at the expense of state revenue—as doing so can bolster the manager’s political clout.326 as a result, soe managers may seek to minimize tax payments to the state through tax 321 compare altshuler & harry grubert, supra note 318, with james r. repetti, will u.s. investments go abroad in a territorial tax: a critique of the president's advisory panel on tax reform, 8 fla. tax rev. 303 (2007). 322 see, e.g., philip dittmer, a global perspective on territorial taxation, tax found. (aug. 10, 2012), https://taxfoundation.org/global-perspective-territorial-taxation/ [https://perma.cc/4nrs-vp5b] (advocating for adoption of a territorial system in the u.s. while also acknowledging territorial taxation is associated with increases in outbound foreign direct investment). 323 see supra text accompanying notes 293-296. 324 see angela huyue zhang, foreign direct investment in china: sense and sensibility, 34 nw. j. int'l l. & bus. 395, 442 (2014); see also mei wang, zhen qi & jijing zhang, supra note 115, at 329 (describing chinese soes as exhibiting a three tried principal–agent problem, with the nation as the principal, the soe managers as agent, and regulators occupying a middle position). 325 see generally michael c. jensen, agency costs of free cash flow, corporate finance, and takeovers, 76 am. econ. rev. 323 (1986). 326 see zhang, supra note 324， at 445-449. https://taxfoundation.org/global-perspective-territorial-taxation/ 122 [vol.10:1 columbia journal of tax law planning in order to retain more resources under their direct control.327 on the other hand, since the party’s evaluation of soe managers currently prioritizes political allegiance over profitability, managers may have a countervailing incentive to ensure an appropriate level of tax payments are made to the state.328 the handful of empirical studies assessing domestic tax avoidance by chinese soes paints a mixed picture of the principal-agent problem.329 most but not all studies have found chinese soes to have higher effective tax rates than private enterprises, suggesting soes practice less domestic tax planning.330 yet, in a nuanced review of the existing scholarship, wei cui also notes that there is “at least as much evidence” indicating soes exhibit some tax planning and avoidance as indicating that soes are indifferent to taxation.331 thus it appears that chinese soes “behave like ‘real’ taxpayers” to a certain degree but that they are still “less sensitive than private firms to paying the home country’s income tax.”332 in other words soe managers may not engage in as much tax-avoidance as private enterprises, but would still prefer to keep funds in corporate form rather than in state coffers. these observations suggest that in comparison to a more territorial system, maintaining a worldwide system of taxation provides a greater disincentive to foreign investment by private 327 soe managers may attempt to frame this tax-planning as a “win-win result for national interests and corporate interests” and argue that by avoiding tax payments in the short-term, they can help grow the soe and thus increase the total amount of state tax revenue in the long run. see, e.g., cheng li [程莉], guoyou qiye ruhe zuohao shuishou chouhua gongzuo [国有企业如何做好税收筹划工作] (how state-owned enterprises do a good job in tax planning), 553 acct. audit 58 (2016) [会计审计]; lü min [吕敏], guoyou qiye shifou ying jinxing shuishou chouhua [国有企业是否应进行税收筹划] (should state-owned enterprise engage in tax planning?), 236 modern bus. (2008) [现代商业]; song jiaojiao [宋姣姣], guoyou qiye shuishou chouhua zouyi [国有企业税收筹划邹议 ] (discussion of state-owned enterprise tax planning), 262 money china (2012) [财经界] (all offering a similar “win-win” justification for domestic tax planning by soes). 328 see supra text accompanying note 203; see also mark t. bradshaw, guanmin liao, & mark (shuai) ma, ownership structure and tax avoidance: evidence from agency costs of state ownership in china, j. acct. & econ. (forthcoming 2018), https://ssrn.com/abstract=2239837 [https://perma.cc/9dmg-ujzw] (suggesting that soe managers are rewarded for paying more tax by becoming more likely to be promoted). 329 see ji li, “strangers in a strange land”: chinese companies in the american tax system, 68 hastings j.l. 503, 533 (2017) (“recent empirical research on the tax behavior of soes has yet to produce conclusive evidence ….”). 330 see, e.g., bradshaw, liao, & ma, supra note 328, at 2 (finding “soes exhibit significantly higher income tax rates than do non-soes, consistent with less tax avoidance” and concluding “the state utilizes soe managers’ career concerns to promote the minimization of tax avoidance.”); clemens fuest & li liu, does ownership affect the impact of taxes on firm behavior? evidence from china (oxford univ. ctr. for bus. tax’n, working paper no. 15/05, 2015), http://eureka.sbs.ox.ac.uk/5428/1/wp1505.pdf [perma.cc/2j5y-7t52] (finding soes to be non-responsive to tax law changes and suggesting that the soes “do not perceive taxes as costs”); hongbin cai & qiao liu, competition and corporate tax avoidance: evidence from chinese industrial firms, 119 econ. j., 764, 794 (2009) (suggesting soes were less likely to engage in tax avoidance activities than private enterprises); ming jian, wanfu li & huai zhang, how does state ownership affect tax avoidance? evidence from china (sing. mgmt. univ., working paper no. 1318, 2012), https://accountancy.smu.edu.sg/sites/default/files/accountancy/pdf/papers/huaizhang_2013paper.pdf [perma.cc/6jl8-zw37] (concluding soes “avoid tax to a less extent than non-soes” and hypothesizing “executives at soes have incentives to please the government through generous tax payments.”); tao zeng, ownership concentration, state ownership, and effective tax rates: evidence from china’s listed firms, 9 acct.accounting perps. 271, 286 (2011) (finding “firms whose largest shareholders are government-related have higher effective tax rates compared to firms whose largest shareholders are nongovernment related” and suggesting that “a good reputation of paying more taxes (or avoiding tax aggressiveness) benefits management.”). 331 cui, supra note278, at 130. 332 cui, supra note 22, at 807-08. http://eureka.sbs.ox.ac.uk/5428/1/wp1505.pdf 2018] 123 chinese state capitalism and the international tax regime enterprises than soes. thus, maintaining a worldwide taxation system would help support the chinese government’s current goals of limiting private capital outflows and enabling soes to remain the driving force behind chinese foreign direct investment.333 for these reasons, it appears likely that its system of state capitalism, will enable and encourage china to successfully maintain a relatively well-functioning system of worldwide corporate taxation. c. tacit state support for international tax-planning the dominant role of soes in chinese outbound foreign direct investment creates an unusually strong incentive for the chinese government to encourage soe managers to minimize the amount of foreign taxes paid through tax planning. this point is perhaps best illustrated through an idealized example. if through clever tax-planning, a french multinational (or any multinational that is a tax resident of a jurisdiction with a territorial system) avoids paying a dollar of tax that would otherwise be owed to a foreign jurisdiction on income earned in that foreign jurisdiction, this dollar does not directly benefit the french government.334 since a territorial system does not impose tax on the multinational’s foreign income, the french government does not have a tax claim on this income. the only benefit to the french fisc comes indirectly—for instance if this additional dollar is invested in r&d that later boosts the multinationals’ domestic income. if through clever tax-planning, a mexican multinational (or any multinational that is a tax resident of a jurisdiction with a worldwide system) avoids paying a dollar of tax that it would otherwise owe to a foreign jurisdiction on income earned in that jurisdiction, this dollar may directly benefit the mexican government, but only to a limited degree.335 at maximum, it stands to impose its highest marginal corporate tax rate on the dollar, currently 30 cents for mexico .336 yet, if through clever tax-planning a wholly-owned chinese soe avoids paying a dollar of tax that it would otherwise owe to a foreign jurisdiction on income earned in that foreign jurisdiction, this entire dollar benefits the chinese government. every dollar of foreign tax avoided by a wholly-owned chinese soe represents an additional dollar of income to the state. for mixed-ownership soes, the benefit depends in part on the state’s ownership stake, but in any case, the chinese government stands to capture a greater percentage of the dollar of tax avoided than it would from a private enterprise. as a result, china stands to reap significant benefits from foreign tax planning and avoidance by soes. 333 see supra parts 4.b and 4.c. 334 see e.g., siméon moquot borde & associés, doing business in france 13-77 (matthew bender ed., 1983) (“the scope of application of the french corporate income tax is determined on a territorial basis: thus, a french or foreign company is subject to corporate income tax only on its income derived from business operations carried on in france (cgi, art. 209(i)(1)).”); see also overview of the french tax system, ministère de l’économie-direction généralegenerale des finances publiques (dec. 31, 2016), https://www.impots.gouv.fr/portail/files/media/1_metier/5_international/french_tax_system.pdf [perma.cc/6lgxyf4k] (providing an overview of france’s taxing jurisdiction). 335 see ernst & young, worldwide corporate tax guide 2017 (2017), https://www.ey.com/publication/vwluassets/worldwide_corporate_tax_guide_2017/$file/worldwide%20corp orate%20tax%20guide%202017.pdf [perma.cc/z4wf-er44]. 336 depending on the multinational’s situation with respect to foreign tax credit limitations, a reduction in foreign income tax paid may not necessarily result in any additional resident country tax owed. see id. at 994 (describing mexico’s foreign tax credit limitation calculation). 124 [vol.10:1 columbia journal of tax law yet, recent scholarship suggests that many chinese soes pay relatively little attention to international tax planning. over the past decade, numerous chinese tax professionals have argued that the international tax planning capabilities of chinese multinationals remain weak and underdeveloped and that they must urgently learn from the practices of mature foreign multinationals.337 part of this problem may be tied to the fact that tax management has never been an area of focus for most chinese soes. until recently, both tax authorities and soe managers considered the accurate taxation of soes of secondary importance compared to other tax or managerial concerns, as it only impacted whether money, already belonging to the state, was “placed in the left or right pocket.”338 as a result, soes often lack professionals well-versed in tax planning and some do not have centralized tax teams capable of developing company-wide tax procedures or strategies.339 moreover, the rigid bureaucracy and hierarchy within major chinese soes may hamper their ability to adopt consistent tax planning strategies across corporate groups.340 in light of these limitations on soes current in-house tax planning capabilities, it is not surprising that the first empirical study of chinese multinationals’ interaction with the u.s. tax system found that the vast majority of chinese multinationals rely on outside u.s. tax professionals for handling u.s. tax matters.341 recognizing the tax-related challenges faced by chinese multinationals investing abroad, chinese tax scholars and practitioners have called on the government to provide tax advisory services as part of the going out and belt and road initiatives. one common suggestion has been the creation of a governmental international tax legal aid team able to assist chinese multinationals 337 see, e.g., wang zengye, wang jinsong, & zhang hui [王增业 ，王劲松, & 张辉], shui ji qinshi he run zhuan yidong jihua dui zhongguo qiye kuaguo shuishou chouhua de yingxiang [税基侵蚀和润转移动计划对中 国企业 跨国税收筹划的影响] (the impact of tax base erosion and profit shifting on the transnational tax planning of chinese enterprises), 25 int’l petroleum econ. 79, 83 (2017) [国际油经济]; shen gengmin [沈庚民 ], shiyou qiye guoji yewu shuishou chouhua, [石油企业国际业务税收筹划] (oil companies’ international corporate tax planning), 15 china mgmt. informationization 18 (2012) [中国管理信息化]; duan chunyan [段 春燕], woguo qiye jituan de guoji shuiwu chouhua [我国企业集团的国际税务筹划] (international tax planning for china's enterprise groups), 8 china bus. 73 (2009) [经济理论研究]. 338 kong xiangfeng [孔祥峰], woguo guoyou qiye shuishou chouhua de shuiwu jianguan wenti yanjiu [我 国国有企业税收筹划的税务监管问题研究] (research on the tax supervision of chinese state-owned enterprises’ tax planning), 24 tax’n 36 (2017) [纳税]. 339 see id.; wang zengye, wang jinsong, & zhang hui, supra note 337; ou jianjun [欧健军], qiye jituan shuiwu fengxian de neikong jizhi tanjiu [企业集团税务风险的内控机制探究 ] (research on the internal control mechanism of enterprise group’s tax risks), 1 chinese j. com. 94 (2018) [中国商论]; wang kun [王琨], guoyou qiye zuohao shuiwu chouhua gongzuo de yanjiu [国有企业做好税务筹划工作的研究] (research on state-owned enterprises doing a good job in tax planning), 9 times fin. 639 (2016) [时代金融]. 340 see wang kun, supra note 339. 341 see ji li supra note329329329, at 521; see also gao yang [高阳], daxing guoqi mianlin de dianxing suihou wenti [大型国企面临的典型税收问题] (the typical tax issues faced by large state-owned enterprises), 6 int’l tax’n in china 43, 46 (2014) [国际税收] (reporting the suggestion by the cfo of one chinese soe that soes should periodically consult with international consulting companies to provide tax support to foreign subsidiaries). 2018] 125 chinese state capitalism and the international tax regime facing disputes with foreign tax authorities.342 the belief among practitioners is that chinese multinationals investing in developing countries may face a heightened risk of capricious and aggressive tax enforcement, as local tax laws and regulations may be underdeveloped and leave great discretionary power in the hands of foreign tax authorities. chinese government experts would be well-positioned to offer guidance in such situations, even if official government-togovernment intervention is not required.343 others have called for a more comprehensive approach. for instance, legal scholar qi tong has argued that sat should provide detailed industry-specific international tax guidebooks and training sessions for smaller enterprises and should conduct indepth tax research for major chinese multinationals and provide them with specialized and tailored international tax advice. 344 other scholars have suggested that sat, sasac, and related ministries should establish a specialized international tax management team that not only assists soes with foreign tax disputes but also provide guidance on overseas mergers, acquisitions, and restructurings.345 within the past few years, sat has implemented a number of new programs intended to support chinese enterprises in tax issues related to outbound investment. for instance, in 2016 it established an international tax service center and hotline intended to support chinese enterprises engaging in foreign investment by providing tax consulting services.346 press releases suggest the service center is intended to be a new platform for “strengthening china’s say on international tax matters” while also “serving the state’s development strategy.”347 in october 2017, sat released an over 250 page booklet providing guidelines to chinese corporations on the taxation of outbound investment intended to help reduce their overseas “tax risks.”348 in general, sat officials 342 see, e.g., li wei [李伟], guanyu shishi qiye “zou chuqu” zhanlüe wenti yanjiu zongshu [关于实施企业 “走出去” 战略问题研究综述] (summary of research on the implementation issues of enterprises’ “going out” strategy), 36 rev. econ. res. 45 (2017) [经济研究参考]; see also gao yang supra note 341. 343 see gao yang supra note 341; see also chen youxiang & dong qiang, supra note 134 (noting that in one recent survey, 60 percent of the problems faced by chinese enterprises operating in africa were related to tax issues, and that in another survey 43 percent of chinese enterprises reported having significant tax-related disputes during overseas investment). 344 see qi tong [漆彤], “yidai yilu” zhanlüe de guoji shuifa sikao [“一带一路”战略的国际税法思考] (reflections on the international tax law of the “one belt and one road” strategy), 6 tax’n res. j. 31, 35 (2015) [税务研究]. 345 see li xuhong & wang yingqi [李旭红 & 王瑛琦], “zou chuqu” guoyou qiye mianlin de shuiwu fengxian ji yingdui [“走出去”国有企业面临的税务风险及应对] (tax risks faced by “going out” state-owned enterprises and responses) 8 int’l tax’n in china 34, 36 (2013) [国际税收]. 346 see china opens int'l tax service hotline, xinhua (nov. 19, 2016), http://www.xinhuanet.com/english/201611/19/c_135841256.htm [https://perma.cc/gu7v-ddtb]. 347 china's international taxation service hotline launched in shanghai, xinhua news agency (nov. 18, 2016), http://www.chinatax.gov.cn/eng/n2367751/c2430750/content.html [https://perma.cc/b3ax-npnf]; taxation service big platform built to make the voice of china, state admin. of tax’n (nov. 21, 2016), http://www.chinatax.gov.cn/eng/n2367726/n2367766/c2430535/content.html [https://perma.cc/jw8m-mrcg] (describing the services as intended to “offer high-quality and efficient tax consulting services to provide numerous cross-border taxpayers with ‘six ables’ services, namely, able to listen, ask, look, inquire, appoint and handle.”). 348 see “zou chuqu” shuishou zhiyin [“走出去”税收指引] (“going out” tax guidelines), state admin. of tax’n (oct. 30, 2017), http://www.chinatax.gov.cn/n810219/n810744/n1671176/n2884609/c2884646/content.html [https://perma.cc/cjm6-6835]. http://www.xinhuanet.com/english/2016-11/19/c_135841256.htm http://www.xinhuanet.com/english/2016-11/19/c_135841256.htm http://www.chinatax.gov.cn/eng/n2367751/c2430750/content.html http://www.chinatax.gov.cn/eng/n2367726/n2367766/c2430535/content.html http://www.chinatax.gov.cn/n810219/n810744/n1671176/n2884609/c2884646/content.html 126 [vol.10:1 columbia journal of tax law have prioritized maintaining accurate and updated information on the tax policies of major destinations of chinese outbound investment and using the internet and hotline as tools for providing better advice to chinese multinationals on foreign taxation policies.349 scholars have suggested that sat should continue to build on these programs, so that its international tax experts can become a type of “think tank” for enterprises engaging in overseas investment, capable of providing tailored tax consultations.350 judging solely from the public-facing descriptions of sat’s international tax service center, it is possible that the services currently offered do not extend far beyond those provided by other tax authorities. the irs, for instance, compiles and publishes a summary of the most pertinent provisions of u.s. tax treaties in publication 901. 351 the website of the indian department of revenue allows users to select a set of tax treaties and generate interactive comparison reports.352 the australian taxation office provides brief informational video clips describing the taxation of foreign business income.353 thus, sat’s services may simply provide basic chinese international tax information in a convenient format. however, in light of the strong incentive for chinese revenue officials to help ensure that chinese soes do not overpay foreign taxes, it is likely that sat services may shade into tax planning. for instance, provincial and local chinese tax bureaus are reportedly engaging in “oneon-one” counseling with chinese multinationals headquartered in their regions providing specialized tax advice regarding anticipated foreign investments.354 other reports indicate that local tax departments have assisted major chinese multinationals in both structuring foreign operations to avoid qualifying as a permanent establishment and in qualifying for other types of foreign tax emptions.355 in short, sat official appointed as advisors for chinese soes may not only be informing managers of international tax laws, but also suggesting tax-advantaged structures and identifying other tax-planning opportunities. this would represent a new front in tax-related competition between states. scholars have traditionally defined tax competition as 349 see liao tizhong [廖体忠], shendu canyu guoji shuishou hezuo tuidong “fang’an” luodi shengxiao [深 度参与国际税收合作推动《方案》落地生效] (implementation of plan to promote increasing participating in international tax cooperation), 1 china tax’n 67 (2016) [中国税]. 350 fang fang & chen peihua [方芳 & 陈佩华], woguo qiye jingwai touzi de she shui fengxian ji fangfan [我国企业境外投资的涉税风险及防范] (chinese enterprises overseas investment tax risks and prevention), 12 tax’n res. 96 (2017) [税务研究]. 351 see u.s. tax treaties, pub. 901 (rev. sept. 2016), https://www.irs.gov/publications/p901 [perma.cc/xte8z8he]. 352 see treaty comparison, income tax dep’t, gov’t of india, https://www.incometaxindia.gov.in/pages/international-taxation/treaty-comparison.aspx [perma.cc/ul3p-st9h]. 353 see australians doing business overseas, australian tax’n off. (feb. 16, 2016), https://www.ato.gov.au/business/international-tax-for-business/australians-doing-business-overseas/ [https://perma.cc/h7xd-xfmn]. 354 see huang shirui & li haiyan [黄诗睿 & 李海燕], yangfan “yidai yilu” zhuli zhongguo “zhi zao” [扬帆 “一带一路”助力中国“智造”] (sailing along “belt and road” to help “made in china”), 6 china tax’n 20, 21 (2016) [中国税务]; see also zuoke ailimu & zhang zhengtong [佐克·艾力木 & 张正通], shuishou zhuli gu sichou zhi lu chong fang yicai [税收助力古丝绸之路重放异彩] (taxation helping to recreate the ancient silk road), 6 china tax’n 32, 33 (2017) [中国税务] (reporting that xinjiang sat sent a specialized point-person familiar with kazakhstan tax law to assist a xinjiang-based steel company in planning for future operations in kazakhstan). 355 see zuoke ailimu & zhang zhengtong, supra note 354, at 33-34. https://www.irs.gov/publications/p901 https://www.incometaxindia.gov.in/pages/international-taxation/treaty-comparison.aspx https://www.ato.gov.au/business/international-tax-for-business/australians-doing-business-overseas/ 2018] 127 chinese state capitalism and the international tax regime efforts by jurisdictions to attract foreign investment by lowering their tax rates on income earned by foreigners.356 yet, providing support for soe international tax planning, could place sat in opposition to other tax authorities not only in shaping tax policy, but also in identifying gaps or unintended tax plan opportunities within other countries’ international tax laws. d. differential treatment of soes and private enterprises chinese international tax policy is likely to provide preferential treatment to soes through both domestic regulations and international agreements. chinese domestic tax law has long provided preferential treatment to soes relative to private enterprises. initially, this preferential treatment was explicit in the form of distinct sets of tax rules.357 yet, even after implementation of the unified domestic enterprise income tax in 1994, soes have continued to receive special tax preferences. for instance, from 1994 to 2009, a set of 120 central soes were allowed to compute tax liability on a consolidated basis—offsetting profits and loses across the group—despite chinese tax law generally prohibiting consolidated returns.358 similarly, the three major oil and gas soes have been permitted to apply a preferential set of foreign tax credit rules—an aggregate rather than a country-by-country limitation—since 2011, treatment that was only expanded to all chinese enterprises in 2017. 359 wei cui argues that such treatment reflects the ability of politically-connected soe executives to successfully lobby for changes to tax regulations.360 in light of the high priority placed on soe participation in the belt and road initiative it seems likely that chinese tax regulations will allow for differential treatment between soes and private enterprises in calculating foreign tax credits or in allowable deferral. in fact, international tax preferences for soes may be necessary for ensuring the intended level of chinese outbound investment. in general, soes should prefer paying a dollar of domestic tax rather than a dollar of foreign tax, since domestic taxes go to the state-owner while foreign taxes do not. wei cui explores possible implications of this fact from the perspective of countries seeking to attract inbound soe investment.361 yet, this also has implications for countries—like china—seeking to encourage outbound soe investment. assuming soes managers are at least partially tax-sensitive,362 sat could provide an additional incentive for certain outbound soe investment by over-crediting foreign taxes paid. even if soe managers might prefer paying domestic taxes to paying foreign tax, they are also likely to prefer keeping earnings within the soe than transferring them to the state-owner (through tax or dividends). as a result, if foreign taxes paid by soes are over credited—with the soe receiving a greater than one-dollar reduction in domestic tax liability for each dollar of foreign tax paid—soe managers will have an additional incentive to make foreign investments. in other words, an overly 356 see, e.g., rixen, supra note 39, at 43; reuven s. avi-yonah, globalization, tax competition, and the fiscal crisis of the welfare state, 113 harv. l. rev. 1573, 1575-76 (2000). 357 see supra part 3.a. 358 see cui, supra note 278, at 119. 359 see id. at 124; supra text accompanying note 137. 360 see cui, supra note 278, at 118. 361 see cui, supra note 22. 362 see supra text accompanying notes 324-332. 128 [vol.10:1 columbia journal of tax law generous foreign tax credit with a marginal reimbursement rate of over 100 percent would provide soe managers greater incentive to invest abroad.363 reverse engineering the various i.r.s. efforts to limit the potential adverse revenue effects to the u.s. of its foreign tax credit provides a potential blueprint for sat in crafting a more generous foreign tax credit targeted at soes. to take one example, the i.r.s. has promulgated a complex set of regulations concerning what foreign levies qualify as a foreign income tax for the purpose of the foreign tax credit—regulations designed to prevent corporations from claiming other overseas business expenses (most notably oil royalty payments) as fully creditable foreign taxes.364 thus, by crafting an over-inclusive definition of creditable foreign taxes sat could lighten the tax burden of chinese enterprises investing overseas.365 in fact, some chinese scholars have suggested that the chinese foreign tax credit should take into account chinese multinationals’ non-tax payments made to states with low tax transparency and low nominal tax rates, but with high compulsory non-tax levies.366 providing a definition of a foreign income tax that would include types of levies regularly borne by chinese soes but not private enterprises, such as natural resource royalties, could provide a targeted benefit to soes while minimizing the additional economic distortions and negative revenue implications of a more expansive foreign tax credit. in sum, chinese domestic tax law has in the past given preferential international tax treatment to soes. going forward, one possibility for such preferential treatment is over-crediting the foreign taxes paid by soes so as to further china’s current foreign policy goal of strengthening its economic influence in the countries along the belt and road initiative. in bilateral tax treaty negotiations, china is also likely to continue to pursue—and secure—additional preferential tax treatment for soes. in fact, china’s success in expanding the number of state-owned financial institutions granted preferential tax treatment in a number of recent bilateral tax treaties may serve as a potential model for future negotiations. during the first-half of the twentieth century, source countries often unilaterally exempted income earned by foreign governments—even if earned in a commercial capacity— from taxation based on the international law principle of sovereign immunity.367 for instance, starting in 1917 the united states provided a broad statutory exemption for income of foreign governments received from sources within the united states.368 until 1946, the exemption was 363 see daniel shaviro, the case against foreign tax credits, 3 j. legal analysis 65 (2011). shaviro adopts the insightful terminology of “marginal reimbursement rate,” to argue against full credibility of foreign taxes and in favor of deductibility. however, his analysis is premised on private corporations that are indifferent between paying foreign and domestic tax. 364 treas. reg. § 1.901-2; see bret wells, the foreign tax credit war, 201 byu l. rev. 1895 (2016). 365 see glenn e. coven, international comity and the foreign tax credit: crediting nonconforming taxes, 4 fla. tax rev. 83, 84 (1999) (noting an over-inclusive description of creditable taxes may result in foreign income being taxed more lightly than domestic income). 366 see wang wenjing & lai hongyu, supra note 319, at 57. 367 see generally matthew a. melone, should the united states tax sovereign wealth funds?, 143 b.u. int'l l.j. 143, 176-89 (2009) (providing a history of the principle of sovereign immunity). 368 the initial 1917 exemption applied to investments in u.s. stocks, bonds, other domestic securities, and bank deposits and was expanded the next year to include income “from any other source within the united states.” see an act to provide revenue to defray war expenses and for other purposes, pub. l. no. 50, § 1211, 40 stat. 300, 337 (1917); an act to provide revenue and for other purposes, pub. l. no. 254, § 213(b)(5), 40 stat. 1057, 1066 (1918); 2018] 129 chinese state capitalism and the international tax regime often interpreted to apply to income earned from commercial activities undertaken by corporations wholly-owned by a foreign government.369 for example, in the 1920s, income earned by a maine corporation wholly owned by nicaragua that operated railways and steamships was found to be exempt from u.s. taxation.370 however, after 1946, the i.r.s. “did a complete about-face on this issue” and implemented varying tests designed to limit the exemption only to income related to governmental functions, making income related to commercial activities taxable.371 this reflected a general shift by the united states to a restrictive conception of sovereign immunity across all areas of law by 1952 in response to the rise of state trading corporations in the post-war era.372 by the 1970s this narrower conception of sovereign immunity was adopted by other developed nations.373 as a result, under statutory law oecd countries either tax all income earned by foreign governments or exempt only passive income not associated with commercial activity.374 a number of western scholars have argued that the remaining exemptions should be further narrowed to ensure that passive investments by foreign sovereign wealth funds are taxable.375 as a result, by the time that china began negotiating its first bilateral tax treaties in the early 1980s, its negotiation partners provided only limited exemptions, if any, for income earned by government entities. even today, perhaps reflecting the standard continental european practice,376 the text of the oecd and united nations model treaties do not include any see also melone, supra note 367, at 203-07 (discussing the legislative history of current internal revenue code section 892). 369 see melone, supra note 367, at 204. 370 see setser, supra note 283, at 298-99; see also o.d. 182, 1 c.b. 90 (1919); o.d. 515, 2 c.b. 96 (1920); o.d. 628, 3 c.b. 124 (1920) (all ruling that income earned by a foreign government in the u.s. from commercial operations was exempt from u.s. taxation). 371 see melone, supra note 367, at 204-05. 372 see david r. tillinghast, sovereign immunity from the tax collector: united states income taxation of foreign governments and international organizations, 10 law & pol'y int'l bus. 495, 531 (1978); sigmund timberg, sovereign immunity, state trading, socialism and self-deception, 56 nw. u. l. rev. 109 (1961-1962). 373 see david gaukrodger, foreign state immunity and foreign government controlled investors 10 (oecd working papers on international investment 2010/02, 2010), http://www.oecd.org/investment/investment-policy/wp2010_2.pdf [https://perma.cc/c329-hr5r]; sally-ann joseph, michael walpole & robert deutch, taxation of sovereign wealth funds: a suggested approach, 10 j. australasian tax tchrs. assoc. 2015 119, 129 (2015); see also tillinghast, supra note 372, at 533 (“if, to take an unlikely example, the government of the u.s.s.r. decided to open a plant to distill vodka in linden, new jersey, next door to the gordon's plant, the world would agree it could not claim sovereign immunity for that business. the principle of noninterference in the affairs of a sovereign pales in importance when the sovereign embarks on a profit-making enterprise within the territory of another sovereign.”). 374 see staff of joint comm. on taxation, 110th cong., economic and u.s. income tax issues raised by sovereign wealth fund investment in the united states 77 (june 17, 2008), http://www.jct.gov/x-4908.pdf [https://perma.cc/r7ug-z23p] [hereinafter jct report]; victor fleischer, a theory of taxing sovereign wealth, 84 n.y.u. l. rev. 440, 469 (2009) (“[t]axing sovereign wealth funds as private corporations is consistent with broader international tax policy norms as reflected in the current practice of other countries. the united states is alone among its oecd peers in granting categorical, unilateral immunity from taxation for sovereign wealth funds.”). 375 see, e.g., jennifer bird-pollan, the unjustified subsidy: sovereign wealth funds and the foreign sovereign tax exemption, 17 fordham j. corp. & fin. l. 987 (2012); fleischer, supra note 374. 376 under domestic law germany, norway, poland, and switzerland do not exempt foreign governments from taxation. in bilateral treaties germany never provides an exemption to foreign governments, and most other continental european countries do exceedingly rarely. see jct report, supra note 374, at 77-78, a-3; gaukrodger, supra note 373, at 33. http://www.oecd.org/investment/investment-policy/wp-2010_2.pdf http://www.oecd.org/investment/investment-policy/wp-2010_2.pdf 130 [vol.10:1 columbia journal of tax law provision exempting interest or dividend income earned by foreign governments from taxation, and their respective commentaries were only recently updated to acknowledge an alternative practice amongst some nations.377 similarly, the current u.s. model treaty does not provide for any such exemptions.378 admittedly, since the u.s. abolished its withholding tax on certain portfolio interest income in 1984,379 a number of oecd states have eliminated withholding tax on interest, making a treaty exemption for government interest portfolio unnecessary in some cases.380 however, even these countries generally retain withholding tax on dividends.381 moreover, most developing countries retain withholding taxes on both interest and dividends, as they are simple and easy to collect.382 in their tax treaties, the maximum rates for interest and dividend withholding taxes are usually 10% or 15%.383 in negotiating bilateral tax treaties, china, like a number of other developing nations, has fought to include a non-standard provision ensuring the exemption of interest payments made to 377 see org. econ. co-operation & dev. (oecd), model tax convention on income and on capital (nov. 21, 2017), commentary on art. 10 ¶ 13.2 (“[s]ome states refrain from levying tax on dividends paid to other states and some of their wholly-owned entities, at least to the extent that such dividends are derived from activities of a governmental nature.”); commentary on art. 11 ¶ 7.4 (“some states refrain from levying tax on income derived by other states and some of their wholly-owned entities (e.g. a central bank established as a separate entity), at least to the extent that such income is derived from activities of a governmental nature”); see also united nations, model double taxation convention (2011), commentary on art. 10 ¶ 13 (quoting the oecd commentary); commentary on art. 11 ¶¶ 12-16 (quoting the oecd commentary). for a detailed discussion of the debates concerning the appropriate taxation of sovereign wealth funds, which led to the adoption of these provisions in the oecd commentary (and subsequently the un commentary), see stijn janseen, how to treat(y) sovereign wealth funds? the application of tax treaties to state-owned entities, including sovereign wealth funds, in the 2010 oecd updates: model tax convention & transfer pricing guidelines a critical review 185 (dennis weber & stef van weeghel eds., 2011). 378 see united states model income tax convention (2016), https://www.treasury.gov/resource-center/taxpolicy/treaties/documents/treaty-us%20model-2016.pdf [https://perma.cc/te8m-cn8g]; see also tillinghast, supra note 372, at 526 (“only a handful of the income tax treaties to which the united states is a party make any special provision with respect to income received by the respective governments involved, and those that do relate only to interest payments.”). 379 see deficit reduction act of 1984, pub. l. no. 98-369, § 127(a), 98 stat. 494, 648-50 (codified as amended at i.r.c. § 871(h)). 380 see avi-yonah, supra note 356, at 1581-82. 381 see id.; deloitte, withholding tax rates 2018 (2018), https://www2.deloitte.com/content/dam/deloitte/global/documents/tax/dttl-tax-withholding-tax-rates.pdf [https://perma.cc/tg6s-ckgd]. 382 see khadija baggerman-noudari & rené offermanns, foreign direct investment in developing countries: some tax considerations and other related legal matters, bull. int’l tax’n 310, 315 (june 2016); deloitte, withholding tax rates 2018, supra note 381 (suggesting an average withholding). 383 see id.; ariane pickering, tax treaty policy framework and country model (papers on selected topics in negotiation of tax treaties for developing countries, paper no. 2-n, may 2013), http://www.un.org/esa/ffd/tax/2013tmttan/paper2n_pickering.pdf [https://perma.cc/j3hj-sv8e]; see also zhao shubo [赵书博], woguo yu “yidai yilu” yanxian guojia shuishou xieding wenti yanjiu [我国与“一带一路”沿线 国家税收协定问题研究] (a study on the tax treaties between china and the countries along the “belt and road”), 397 tax’n res. j. 74 (2018) [税务研究] (noting the maximum withholding rate in china’s tax treaties with countries along the belt and road initiative ranges between 10 and 20 percent). https://www.treasury.gov/resource-center/tax-policy/treaties/documents/treaty-us%20model-2016.pdf https://www.treasury.gov/resource-center/tax-policy/treaties/documents/treaty-us%20model-2016.pdf https://www2.deloitte.com/content/dam/deloitte/global/documents/tax/dttl-tax-withholding-tax-rates.pdf http://www.un.org/esa/ffd/tax/2013tmttan/paper2n_pickering.pdf 2018] 131 chinese state capitalism and the international tax regime the state or certain government entities from source countries withholding taxation.384 since china’s first bilateral tax treaty with japan, its treaties have often included a broad provision exempting not only interest payments to the contracting parties’ governments, local authorities, and central banks but also to wholly government owned financial institutions.385 for instance, all of china’s bilateral tax treaties with european countries contain this exemption in some form, and in most treaties this exemption extends to wholly owned financial institutions.386 similarly, 51 out of china’s 56 bilateral tax treaties with 56 countries along the belt and road initiative contain an exemption that extends to government owned financial institutions.387 thus, in its international tax diplomacy, china has generally succeeded in having foreign nations accord its central bank and policy banks an exemption from taxation on interest. while interest exemptions for wholly government owned financial institutions do not represent a major departure from common bilateral treaty practice—many african countries now include them in their bilateral treaties388—china’s most recent treaties take a much bolder step, exempting interest income earned by certain chinese commercial banks. as noted above, the major chinese commercial banks were once wholly government owned institutions but are now publicly-listed corporations with minority private investment and a complicated hybrid character.389 as a result, interest payments on foreign securities made to the major chinese commercial banks may be subject to withholding taxation under most chinese bilateral tax treaties. yet, china’s 2016 treaties with cambodia and romania ensure preferential tax treatment for china’s major commercial banks by broadening the government interest exemption to include financial institutions with more than 50% government ownership.390 a protocol to the 384 developing countries may include these “government interest” provisions as they indicate strong respect for the sovereignty of another state and avoid the imposition of tax on interest payments connected to state-sponsored export promotion or development aid. see daurer, supra note 34, at 275-76. 385 see agreement for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, china-japan, art. 11, sept. 6, 1983, http://www.chinatax.gov.cn/n810341/n810770/c1153042/part/1153044.pdf [https://perma.cc/6438-2jh7] (“[i]nterest arising in a contracting state and derived by the government of the other contracting state, a local authority thereof, the central bank of that other contracting state or any financial institution wholly owned by that government … shall be exempt from tax in the first-mentioned contracting state.”); see also united states-the people’s republic of china income tax convention, china-u.s., art. 10, apr. 30, 1984, https://www.irs.gov/pub/irs-trty/china.pdf [https://perma.cc/vw2e-ke8w] (including a nearly identical provision). 386 see bernhard canete, bristar mingxing cao & yun huang, passive income (article 10, 11, and 12 oecd model), in europe-china tax treaties, supra note 13, at 121-33. 387 see zhao zhou & zhang li [赵洲 & 张丽], lun “yidai yilu” kuajing lixi suode de shuishou xietiao [论“一 带一路”跨境利息所得的税收协调] (tax coordination on cross-border interests in countries along the “belt and road” initiative), 1 int’l tax’n in china 51, 52 (2018) [国际税收]; see also zhao shubo, supra note 383, at 74 (discussing the interest income exception for wholly government owned financial institutions in china’s bilateral tax treaties with malaysia, thailand, vietnam, brunei, singapore, oman and turkmenistan). 388 see daurer, supra note 34, at 275-76. 389 see supra text accompanying notes 179-185. 390 see agreement for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, cambodia-china, art. 11.3, oct. 13, 2016 , http://www.chinatax.gov.cn/eng/n2367756/c2367970/part/2367982.pdf [https://perma.cc/e4p5-3kaz] [hereinafter china-cambodia tax treaty] (“[i]nterest arising in a contracting state and paid to the government or a local authority, the central bank or any financial institution or statutory body mainly owned by the government of the other 132 [vol.10:1 columbia journal of tax law treaty with cambodia confirms that china’s four largest commercial banks qualify for this exemption.391 chinese officials have stated that they hope the new stipulations regarding tax exemption “set a good example of improving fundamentals of law for tax cooperation between china and other belt and road countries.”392 a new protocol to the tax treaty with pakistan that came into force in april 2017 granted an exemption on interest received by the industrial and commercial bank of china derived from loans associated with energy projects that are part of a us $47 billion infrastructure plan.393 according to news reports from pakistan, chinese officials were insistent in expanding the scope of the exemption despite pakistan’s reluctance.394 chinese tax scholars have noted that this exemption plays a particularly important role for reducing the foreign tax burden on overseas infrastructure construction undertaken by chinese engineering firms. many infrastructure projects on the belt and road initiative are being constructed by chinese engineering corporations and are being funded through loans made by china’s policy or commercial banks.395 in fact, by one estimate, out of all contractors participating in chinese-funded projects, 89 percent are chinese and only 7.6 percent are local companies.396 without the government interest provision, interest payments from a foreign branch or subsidiary of a chinese construction corporation to a chinese financial institution would generally be subject to withholding tax by the host country. since these loans have traditionally been tax-inclusive (with withholding income tax payable on the interest borne by contracting state, shall be exempt in the first-mentioned state. for the purposes of this paragraph, the term ‘mainly owned’ means the ownership exceeds 50 per cent.”); see also agreement for the elimination of double taxation with respect to taxes on income and the prevention of tax evasion and avoidance, china-rom., art. 11.3, july 4, 2016, http://www.chinatax.gov.cn/eng/n2367756/c2367985/part/2367997.pdf [https://perma.cc/9vpv-96dn] (similar). 391 these are the bank of china, the industrial and commercial bank of china, the china construction bank and the agricultural bank of china. see china-cambodia tax treaty, supra note 390, ¶ 3.b. 392 see china-romania tax treaty signed by wang qinfeng on behalf of china, state admin. of tax’n (sept. 9, 2016), http://www.chinatax.gov.cn/eng/n2367726/c2369301/content.html [https://perma.cc/5kcp-sesu]. 393 see the third protocol to the agreement for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, china-pak, art.1, dec. 8, 2016, http://www.chinatax.gov.cn/n810341/n810770/c1153236/part/2728748.pdf [https://perma.cc/298y-79gy] (“for the provisions of article 1 of the second protocol, the industrial and commercial bank of china and the silk road fund are included as “state banks”, but only for the purpose of interest income they derive from loans in pakistan for the energy projects mentioned in the china-pakistan economic corridor energy projects cooperation agreement signed at beijing on november 8 , 2014.”); see also katherine houreld, china and pakistan launch economic corridor plan worth $46 billion, reuters (april 20, 2015), https://www.reuters.com/article/us-pakistan-china/china-andpakistan-launch-economic-corridor-plan-worth-46-billion-iduskbn0na12t20150420 [https://perma.cc/qq74sk9] (describing the china-pakistan economic corridor). 394 see shahbaz rana, pakistan, china divided over tax exemptions, express tribune (march 10, 2016), https://tribune.com.pk/story/1062662/loans-for-cpec-projects-pakistan-china-divided-over-tax-exemptions/ [https://perma.cc/vdp9-54ch]. 395 see, e.g., peng qinqin & denise jia, china state banks provide over $400 bln of credits to belt and road projects, caixin (may 11, 2017), https://www.caixinglobal.com/2017-05-12/101089361.html [https://perma.cc/fkk6-u5qv]; see also kane wu & julie zhu, exclusive: china's ‘big four’ banks raise billions for belt and road deals – sources, reuters (aug. 22, 2017), https://www.reuters.com/article/us-ccbfundraising/exclusive-chinas-big-four-banks-raise-billions-for-belt-and-road-deals-sources-iduskcn1b20er [https://perma.cc/8w2e-vfzj]. 396 jonathan e. hillman, china’s belt and road initiative: five years later, ctr. strategic & in’tl stud. (jan. 25, 2018), https://www.csis.org/analysis/chinas-belt-and-road-initiative-five-years-later-0 [https://perma.cc/8flctth8]. 2018] 133 chinese state capitalism and the international tax regime the borrowing company), the tax savings under this bilateral treaty provision may primarily benefit the chinese engineering corporations.397 two recently settled disputes between china and foreign jurisdictions involving the imposition of withholding tax on interest payments from overseas subsidiaries of chinese enterprises to chinese wholly state-owned institutions, suggests that chinese tax officials are prioritizing enforcement of these provisions.398 moreover, expanding the exemption to apply to chinese commercial banks, appears to be of significant economic value to china. estimates suggest that the protocol with pakistan may reduce the foreign tax burden on chinese corporations by us $2 billion399 and all of the expanded government interest exemptions negotiated in 2016 may reduce the foreign tax burden by roughly us $4 billion.400 in sum, by negotiating for an exemption on withholding taxes imposed on interest payments to state-owned financial institutions, china has significantly reduced the foreign taxes owed on overseas infrastructure projects thus benefiting major soes. moreover, the recent expansions of this exemption to include some of china’s mixed-ownership commercial banks, illustrates china’s willingness to challenge the status quo regarding the international taxation of state-owned institutions and may serve as a possible model for further expanded exemptions in the future. similarly, china’s recent bilateral tax treaties with the netherlands, united kingdom, and switzerland, suggest that it is also now seeking additional preferential tax treatment for soes in the form of an exemption from dividend withholding taxes. most oecd countries retain significant withholding taxes on dividends payments to portfolio investors but apply a reduced withholding rate to dividend payments made by a subsidiary to parent corporation.401 these three updated treaties, all of which were entered into force in 2013, contain similar provisions exempting dividend payments from withholding tax if “the beneficial owner of the dividends” is the government, a government institution, or “any other entity the capital of which is wholly owned directly or indirectly” by the government.402 under this provision, dividend payments 397 see zhao shubo, supra note 383; see also qi tong, supra note 344 (discussing the role of bilateral tax treaties in creating tax incentives for belt and road infrastructure projects); better reassure enterprises going global, state admin. of tax’n (oct. 13, 2016), http://www.chinatax.gov.cn/eng/n2367751/c2414677/content.html [https://perma.cc/jx8e-ypnb]) (discussing the government interest provision and noting the way it has benefited a chinese cement company operating in tajikistan). 398 see michael wong et al., a thousand miles begin with a single step: tax challenges under the bri, int’l tax rev. (nov. 28, 2017), http://www.internationaltaxreview.com/article/3772212/a-thousand-miles-begin-with-asingle-step-tax-challenges-under-the-bri.html [http://perma.cc/q4r9-zdwn]. 399 see rana, supra note 394. 400 see wang ping [王平], fuwu “yidai yilu” jianshe shuishou dayouzuowei [服务“一带一路”建设 税收大有 作为] (tax has a big role to play in serving “belt and road” construction), 5 int’l tax’n in china 6, 7 (2017) [国际税收]; see also better reassure enterprises going global, supra note 397 (noting that interest exemptions negotiated in 2015 may have reduced foreign taxes by us $1 billion). 401 see org. econ. co-operation & dev. (oecd), model tax convention on income and on capital: condensed version 2017 ¶¶ 59-67, at 248-49 (nov. 21, 2017). 402 see agreement for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, neth.-china, art. 10.3, may 31, 2013, https://www.government.nl/documents/decrees/2013/05/31/agreement-between-the-netherlands-and-the-people-srepublic-of-china-for-the-avoidance-of-double-taxation [https://perma.cc/8fbv-uvuz]; see also agreement for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income and on capital 134 [vol.10:1 columbia journal of tax law from a dutch, u.k., or swiss resident corporation to a wholly-owned chinese soe are exempt from withholding tax, no matter the level of soe investment. commentators have noted that these exemption provisions are quite attractive for wholly-owned chinese state-owned enterprises, as they provide tax-preferred treatment to dividends not only from their subsidiaries but from any of their portfolio holdings.403 the willingness of these three countries to adopt a treaty provision intended to provide preferential tax treatment for wholly-owned chinese soes, proves that even developed nations may be willing to forego significant tax revenue from chinese soes in the hope of increased chinese investment leading to job creation. 404 thus, recent chinese bilateral tax diplomacy, suggests that it will continue to seek to broaden exemptions from source country withholding taxation for state-owned financial institutions and soes. exemptions from interest payments to state commercial banks can significantly reduce the financing costs for chinese soes operating in developing countries. exemptions from dividend payments to soes can reduce the tax-cost of operating subsidiaries in countries without a full treaty exemption for subsidiary-parent dividend payments and of making portfolio investment in countries with dividend withholding. going forward, it seems likely that china will also seek to expand the dividend exemption to mixed-ownership soes (for instance through adoption of the 50 percent threshold, like that found in recent government interest provisions). moreover, it is possible that in negotiations with developing countries, china may even push for exemptions for certain types of active income earned by soes (for instance, income associated with state-sponsored infrastructure projects), reviving earlier conceptions of state sovereign immunity with respect to tax. lobbying for an exemption for soes from all gains, u.k.-china, art. 10.3, apr. 12, 2013, https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/282522/8783.pdf [https://perma.cc/7bbj-lact] (“[d]ividends paid by a company which is a resident of a contracting state to a resident of the other contracting state shall be taxable only in that other contracting state if the beneficial owner of the dividend is the government of that other contracting state or any of its institutions; or other entity the capital of which is wholly-owned directly or indirectly by the government of that other contracting state.”); see also agreement for the avoidance of double taxation with respect to taxes on income and capital, china-switz., art. 10.3, sept. 25, 2013, http://www.chinatax.gov.cn/eng/n2367756/c2368077/part/2368086.pdf [https://perma.cc/vt6b-5s42] (similar). 403 see ernst & young, new tax treaty provisions between china and the netherlands to promote investment (2013), http://www.ey.com/publication/vwluassets/new_tax_treaty_provisions_between_china_and_the_netherlands_to _promote_investment/$file/2013g_cm3518_china%20and%20netherlands%20new%20tax%20treaty%20provisio ns%20promote%20investment.pdf [https://perma.cc/e83j-axy9]; see also erik jansen, new tax treaty between china and the netherlands to promote investments, innovative tax (feb 12, 2014), http://innovativetax.com/news/new-tax-treaty-between-china-and-the-netherlands-to-promote-investments.html [https://perma.cc/9byl-2lqh] (“if the beneficial owner of the dividends of a company is the government of the contracting state … there will not be a withholding tax proposed. it is clear that this provision is attractive for chinese state owned enterprises ….”). 404 see, e.g., new tax treaty signed with china, government of netherlands (may 30, 2013), https://www.government.nl/latest/news/2013/05/31/new-tax-treaty-signed-with-china [http://perma.cc/by4f-s2rl] (“many chinese companies are active already in the netherlands and i hope that this new treaty will be an extra incentive for even more investments in the netherlands. it will provide employment.”). http://www.ey.com/publication/vwluassets/new_tax_treaty_provisions_between_china_and_the_netherlands_to_promote_investment/$file/2013g_cm3518_china%20and%20netherlands%20new%20tax%20treaty%20provisions%20promote%20investment.pdf http://www.ey.com/publication/vwluassets/new_tax_treaty_provisions_between_china_and_the_netherlands_to_promote_investment/$file/2013g_cm3518_china%20and%20netherlands%20new%20tax%20treaty%20provisions%20promote%20investment.pdf http://www.ey.com/publication/vwluassets/new_tax_treaty_provisions_between_china_and_the_netherlands_to_promote_investment/$file/2013g_cm3518_china%20and%20netherlands%20new%20tax%20treaty%20provisions%20promote%20investment.pdf http://innovativetax.com/news/new-tax-treaty-between-china-and-the-netherlands-to-promote-investments.html 2018] 135 chinese state capitalism and the international tax regime foreign taxation, would in fact be in line with china’s general support for broad and absolute sovereign immunity in other legal contexts.405 while china is likely to continue to seek preferential treatment for soes in bilateral treaties, some countries may choose to unilaterally exempt certain income earned by soes from taxation in hope of attracting chinese investment. currently the united states and united kingdom generally exempt from taxation passive investment income earned by foreign sovereign wealth funds (swfs), a close relative of soes.406 swfs are state-owned and controlled funds that make investments in foreign assets and are dedicated to achieving national macroeconomic and financial objectives.407 australia and canada may exempt passive income earned by swfs provided the fund first establish its eligibility through administrative procedures and some additional countries offer such treatment through bilateral treaty provisions.408 while the appropriate international tax treatment of swfs remains highly controversial, scholars have demonstrated that exempting passive income earned by swfs can incentivize additional sovereign investment under certain conditions.409 building on these findings, john mclaren has argued that both foreign swfs and soes should be exempted from paying australian tax on income earned from passive investments as it would benefit the country economically by signaling australia’s openness to greater foreign investment from china.410 wei cui has noted more generally that there are many possibilities for host countries to offer “select incentives to foreign soes to make greater investments” without fear of placing private investors at a disadvantage.411 these scholars focus their work on western developed countries and acknowledge that in light of current geopolitics, offering tax inducements to chinese soes may be politically unpalatable in australia, the united states, and canada.412 however, their 405 see e.g., ferdous rahman, questioning chinese government’s stand for sovereign immunity, 9 transnat’l crops. rev. 41 (2017); matthew miller & michael martina, chinese state entities argue they have ‘sovereign immunity’ in u.s. courts, reuters (may 11, 2016), https://www.reuters.com/article/us-china-usa-companieslawsuits/chinese-state-entities-argue-they-have-sovereign-immunity-in-u-s-courts-iduskcn0y2131 [http://perma.cc/5pv8-vq49]. 406 see jct report, supra note 374, at 77. under section 892 of the internal revenue code, the united states exempts passive investment income earned in the u.s. by foreign swfs from u.s. taxation, as long as the income is not derived from conduct of commercial activity. 407 see generally org. econ. co-operation & dev. (oecd), foreign government-controlled investors and recipient country investment policies: a scoping paper 6 (2009), https://www.oecd.org/investment/investment-policy/42022469.pdf (identifying key elements that define sovereign wealth funds). 408 see jct report, supra note 374, at 77; see also fleischer, supra note 374, at 470 (discussing international practice for taxing passive income earned by foreign governments). 409 see michael s. knoll, taxation and the competitiveness of sovereign wealth funds: do taxes encourage sovereign wealth funds to invest in the united states, 82 s. cal. l. rev. 703 (2009). 410 see john mclaren, the taxation of foreign investment in australia by sovereign wealth funds: why has australia not passed laws enshrining the doctrine of sovereign immunity, 17 j. austl. tax'n 53, 83 (2015). 411 cui, supra note 22, at 811. 412 see id. at 811-12 (“such policies have evoked expressions of disbelief from some commentators, who find it incredible that a country like the united states would favour “state capitalism” over “private capitalism.”); see also mclaren, supra note 410 at 83-84 (“unfortunately, public opinion is against foreign investment especially by the chinese. . . . [a]t present, governments are reluctant to be seen to be promoting taxation benefits for foreign governments.”). 136 [vol.10:1 columbia journal of tax law arguments regarding increased investment may be most relevant to developing countries—which often have higher corporate tax rates and great need for foreign investment. these observations suggest the possibility of a type of tax competition amongst countries seeking chinese investment. since major overseas chinese investments are often dictated by soes and state-owned commercial banks, developing countries seeking to attract chinese investment may offer generous tax exemptions to such enterprises premised upon their stateownership. by offering exemptions premised upon state-ownership rather than across-the-board reductions in withholding or corporate tax rates, they may be able to incentivize additional chinese investment without significantly lowering their overall tax revenue. moreover, chinese government officials may be particularly supportive of this approach since it would stand to benefit the chinese government (a reduction in the foreign tax imposed on chinese soes leaves greater earnings for the state) with less risk of sparking a more generalized “race to the bottom” amongst developing countries over tax rates—which could harm china’s own efforts to encourage foreign investors to continue reinvesting in china.413 additionally, it could put soes at an economic advantage in comparison to other foreign multinationals operating in the same host country. thus, from the perspective of chinese tax policy makers, creating competition to pressure countries along the belt and road initiative to offer the most generous tax exemptions for state-owned enterprises may be an ideal tax policy: it benefits the chinese fisc, places chinese emperies at a competitive advantage in host countries, and does not place china at a disadvantage in terms of attracting its own foreign investment. vi. conclusion with china set to assume meaningful influence over the international tax regime, its unique system of state capitalism is likely to cause its preferred international tax rules and norms to differ significantly from those of oecd countries. maintenance of a worldwide system of taxation, state support for soe international tax planning, and advocacy for broad tax exemptions for soes are only some of many possible areas of divergence. for instance, in the highly-technical field of transfer pricing china has also been challenging aspects of the oecd consensus on arm’s length pricing.414 chinese scholars suggest that changing the transfer pricing rules related to intangible assets may help foster the development of chinese multinationals, whose economic advantages primarily come from maintaining low production costs rather than from innovative intellectual property.415 of course, numerous other divergences in tax preferences may not be directly related to china’s system of state capitalism, but rather to its status as a developing country. for example, 413 see jingwai touzizhe yi fenpei lirun zhijie touzi zan bu zhengshou yu ti suodeshui zhengce wenti de tongzhi [境外投资者以分配利润直接投资暂不征收预提所得税政策问题的通知 ] (notice concerning the deferral of withholding tax on dividends directly invested by foreign investors) (promulgated by the general tax bureau of the ministry of finance, effective january 1, 2017), cai shui, dec. 21, 2017 (providing an recent example of chinese tax policy designed to encourage foreign investors to reinvest in china); see also chen jia & wang yanfei, companies reinvesting profits can get tax break, china daily, dec. 29, 2017, http://www.chinadaily.com.cn/a/201712/29/ws5a457fefa31008cf16da4134.html [http://perma.cc/kx79-kg8l] (describing the policy rationale beyond recent tax incentives targeted at foreign reinvestment). 414 see, e.g., richard s. collier & joseph l. andrus, transfer pricing and the arm’s length principle after beps 261 n.6 (2017). 415 see, e.g., jiang yuesheng, supra note 314, at 35-36. 2018] 137 chinese state capitalism and the international tax regime china, like a number of other developing countries, has controversially attempted to impose tax on indirect transfers of taxable chinese property by foreign shareholders, in other words, transfers of shares in offshore holding companies holding primarily chinese assets. 416 in short, going forward china tax-policy makers are likely to push back against oecd tax norms on multiple fronts. it is tempting for oecd countries to assume that china’s involvement in beps and future multilateral initiatives will temper and contain most of china’s potentially heterodox international tax preferences. yariv brauner has observed that even within the context of the beps projects, there are many subtle signs that the oecd nations wish to maintain greater power over international tax norms than the bric countries, despite their supposedly equal status within beps.417 thus, the give-and-take of multinational diplomacy may create pressures for china to broadly adhere to prevailing oecd norms, even if it may continue to push for changes around the edges. for instance, during beps negotiations, chinese tax officials proposed new transfer pricing methods that seemed to represent a major departure from the oecd consensus.418 yet, following the completion of beps, china now appears to have moved much “closer to oecd orthodoxy” in its transfer pricing regulations even if its regulations also contain a few “china-unique concepts” that are “at variance with oecd.”419 this may suggest that even if chinese state capitalism creates a divergent set of international tax preferences, these will be neutralized through the consensusbuilding process of multinational negotiations. however, china’s audacious belt and road initiative may allow it to gradually push for new international tax norms through a regional—rather than global—approach that may sidestep the influence of oecd countries. official state documents regarding the belt and road initiative emphasize that it is “open to all countries” and “not limited to the area of the ancient silk road.”420 however, chinese scholars and government-associated think tanks have identified 65 or so countries associated with the initiative, the vast majority of which are non-oecd members.421 416 see, e.g., wei cui, taxing indirect transfers: improving an instrument for stemming tax and legal base erosion, 33 va. tax rev. 653, 654-55 (2014). 417 see brauner, supra note 12, at 1025-26 (suggesting the brics participation in beps has allowed the oecd to accept some changes in international tax norms “without a significant effective concession of power by the oecd itself.”); see also brauner, supra note 9, at 78 (observing that the beps action item 5 on harmful tax practices awkwardly recreates an “us” and “them” dynamic between oecd and non-oecd countries and suggesting that such language “hints that the oecd still views itself primarily as the rich countries’ club.”). 418 see kevin a. ball, china backs down on adopting controversial transfer pricing method, bloomberg bna, (april 19, 2017), https://www.bna.com/china-backs-down-n57982086872/ [https://perma.cc/4dvt-5m6c]. 419 glenn desouza, china’s new transfer pricing platform and the challenge for u.s. multinationals, bloomberg bna (may 3, 2017), https://www.bna.com/chinas-new-transfer-n73014460766/ [https://perma.cc/psu3-72gq]. 420 vision and actions on jointly building silk road economic belt and 21st-century maritime silk road, nat’l dev. & reform commission (mar. 28, 2015), http://en.ndrc.gov.cn/newsrelease/201503/t20150330_669367.html [https://perma.cc/4mvy-unqu]. 421 see hellen chin & winnie he, the belt and road initiative: 65 countries and beyond, fung bus. intelligence ctr. (may 2016), https://www.fbicgroup.com/sites/default/files/b%26r_initiative_65_countries_and_beyond.pdf [https://perma.cc/s97w-38ud]; see also wang wenjing & lai hongyu, supra note 319 (discussing the political and economic characteristics of countries along the belt and road initiative). 138 [vol.10:1 columbia journal of tax law through the initiative, china is poised to be become the dominant economic player across central and southeast asia.422 as a result, china will likely be able to leverage its role as the primary source of foreign capital investment for most countries along the initiative to push for new international tax norms. multiple chinese scholars have suggested that china can use its economic influence along the belt and road initiative to develop new regional tax rules or even a comprehensive regional tax agreement. after first shaping new international tax rules along the belt and road countries, china will then be able to more strongly influence international tax law around the globe.423 cao mingxing of the central university of economics and finance has even suggested that china can use the belt and road as a basis for a new international tax reform strategy of “neo-beps” (base expansion and profit sharing) which would embrace more substantive changes to international tax regime than the narrow and “neo-liberal” changes of beps.424 these observations indicate china’s recent tax treaties with romania and cambodia are likely only the beginning of chinese efforts to negotiate for new and potentially heterodox tax rules with countries along the belt and road initiative. in conclusion, as china gains greater influence in shaping the international tax regime, its preferences for international tax rules are likely to be heavily shaped by its system of state capitalism. just as chinese domestic tax policy reforms have been driven by the central government theories of industrial planning and soe governance, chinese international tax policy will be designed to help china’s current national champion soes grow into global champions. as a result, tax policy-makers in both oecd countries and those along the belt and road must remain cognizant of the fact that due to its unique economic system, china may pursue tax policies and norms orthogonal to the traditional battle lines between developed and developing countries. to take just one example, tax treaty provisions defining tax exempt government entities—relatively inconsequential for the vast majority of treaties between free market economies—may become the next flashpoint in international tax diplomacy. to prevent such disputes from fracturing the international tax regime, new international agreements may be required concerning the appropriate tax treatment of state-owned entities and the appropriate boundaries for assistance offered by state tax administration to domestic corporations. policy-makers must be proactive in recognizing and addressing the challenges to the current international tax system posed by future chinese international tax policies motivated by state capitalism. 422 see e.g., william t. wilson, china’s huge ‘one belt, one road’ initiative is sweeping central asia, heritage found. (nov. 21, 2016), https://www.heritage.org/asia/commentary/chinas-huge-one-belt-one-roadinitiative-sweeping-central-asia [https://perma.cc/j5fy-6dx2] (“in 2013, trade between china and the five central asian states…totaled $50 billion, while the five states’ trade with russia—previously the region’s top economic player—amounted to only $30 billion.”). 423 see qi tong, supra note 344; zhang meihong [张美红], wogou qiye haiwai touzi she shui fengxian ji qi yingdui [我国企业海外投资涉税风险及其应对] (tax risks of chinese enterprises’ overseas investment and their countermeasures), 1 tax’n res. j. 79 (2017) [税务研究]. 424 see cao mingxing [曹明星], neo-beps: tigong “yidai yilu” linian xia de guoji shui gai fang’an [neobeps：提供“一带一路”理念下的国际税改方案] (neo-beps: providing an international tax reform program under the belt and road initiative), china tax news, may 10, 2017 [中国税务报]. note the case for over-withholding federal income tax: benefits to lowincome taxpayers* susannah kroeber† abstract the w-4 tax withholding form has been used by individual taxpayers for decades to calculate their tax withholdings. it is based, however, on the faulty assumption that most u.s. workers have a single source of income. this assumption has caused millions of taxpayers to incur unnecessary tax debt. the formula for calculating federal income tax withholding for employees routinely under-withholds for low-income workers who have multiple sources of income because, without substantial documentation and calculation by the employee, employers withhold as if they are the employee’s single source of income. taxpayers may therefore see their income tax withheld at too low a marginal rate, oftentimes zero percent, and can have significant balances due on short notice at the end of the tax year. this note documents that reality and proposes a solution. it proposes a reconception of the form w-4 and the withholding formula through the lens of low-income filers and aims for a policy of over-withholding from those filers in order to reduce surprise tax due and related penalties. the proposed solution removes the bias towards achieving a “zero refund” from the form design by eliminating the tax-free threshold—for most filers, the equivalent of their standard deduction—from the withholding scheme. as discussed in the note, the proposed policy would also have the benefit of increasing tax compliance, minimizing bureaucratic burdens, and providing a revenue-neutral solution for the government. this note further suggests an extension of the proposed policy to provide a much-needed savings mechanism for low-income filers. i. tax issues for workers with multiple w-2s .................................... 173 a. the impact of multiple form w-4s on tax due ............................................... 174 b. background on the form w-2 ........................................................................... 175 c. background on the form w-4 ........................................................................... 176 1. form design: comparison of the pre-2020 form w-4 to the current form w-4 .............................................................................................................. 177 a. impact of withholdings on refund amount ........................................ 179 b. counterintuitive allowances ................................................................ 180 c. multiple sources of income .................................................................. 181 * this note received an honorable mention in the theodore tannenwald jr. foundation excellence in tax scholarship writing competition in 2020. † columbia law school, j.d. candidate ’21. 2021] the case for overwithholding federal income tax 2 2. scope of impact: single and head of household filers ............................. 181 ii. a new withholding regime for an economy of unstable incomes across multiple jobs: deliberate over-withholding .................................................................................................................................. 183 a. why over-withholding for wage workers? ..................................................... 183 1. withholdings as an accessible option for savings for low-income individuals ................................................................................................... 183 a. under-withholding causes surprise tax balances that low-income filers do not have the resources to pay ............................................. 185 b. state and federal sanctions for non-payment ..................................... 185 2. tax compliance increases with refunds and reduces bureaucratic burdens on low-income filers ................................................................................. 186 a. tax compliance .................................................................................... 186 b. bureaucratic burden ............................................................................. 187 3. maximize positive impacts of the eitc and the ctc ................................ 188 b. proposed policy: withhold from the first dollar earned .................................. 188 1. remove “zero-refund” bias from form design ........................................ 188 2. eliminate the tax-free threshold for income tax withholding purposes 189 3. examples of the current system vs. the proposed policy ........................... 189 a. single, low-income filer ..................................................................... 189 b. low-income filer with one dependent, filing as head of household 191 c. single, medium-income filer ............................................................... 193 d. medium-income filer with two dependents, filing as head of household ............................................................................................. 195 4. taxpayers who wish to adjust their withholdings can avail themselves of the w-4 ........................................................................................................ 199 c. a more radical alternative, “over-withholding plus”: withholding to force savings ............................................................................................................... 199 d. objections .......................................................................................................... 200 iii. epilogue: tax withholdings in a time of pandemic ..................... 202 i. tax issues for workers with multiple w-2s imagine a taxpayer who has two employers and earns less than the standard deduction at each job. when this taxpayer is hired, she is presented with multiple tax forms by each employer, including a w-4 to specify tax withholdings. she may even note that she should be factoring in the income received from each job, but can’t understand how, and neither of her employers view it as their job to provide guidance on how to account for other forms of employment. she tries to use the internal revenue service (irs) tools, but those provide no specific instructions for how to fill out the forms for her situation. as a result, she fills out each form without accounting for her other source of income and neither employer withholds any federal income tax. when she files her return, she finds out that she owes hundreds of dollars, perhaps over a thousand—an amount that, like most americans, she does not have. this is hardly theoretical; because of the default rules in our federal income tax withholding regime, this is the reality for many taxpayers every year. after the end of each calendar year, americans who earn income receive a variety of tax documents, including documents that detail their earnings and tax withholdings. the process of completing a tax return, for most people, involves collecting these documents 2 columbia journal of tax law [vol. 12:172 and preparing and filing a return between the end of the year and april 15, tax day.1 when a filer has a single source of income as an employee, this process is relatively straightforward. the single source of income is reported on a w-2, along with the tax that was withheld each pay period throughout the year. the filer then reports that income and either pays a balance or receives a refund. however, a disconnect occurs when filers have multiple sources of income. if a taxpayer fails to accurately predict future income or adjust their withholdings with their employer with every change to income and life circumstance, the withholding amounts can vary wildly from the actual tax owed. this is particularly true for low-income filers with more than one source of income and can result in far too little income being withheld. this note will examine the tax compliance difficulties for lowand middle-income filers with multiple sources of wage income, and propose policy solutions to change the default withholding rules to reduce surprise tax debt for those filers. while the irs and the bureau of labor statistics (bls) do not publish data on how many different sources of wage and independent contractor income taxpayers report on their returns, there is reason to believe that is a substantial number. a bls study found that americans born in the 1980s held an average of 8.2 jobs between the ages of 18 and 32.2 the study also found that earners aged 25 to 32 with less than a high school education saw more than half of those jobs end in under a year, while those with a college degree held jobs for less than a year at close to half that rate.3 even factoring in that workers with less education were likely to experience weeks of unemployment, the number of jobs held suggests an average of seven job changes for young american workers between the ages of 18 and 32. this suggests that in at least half of the calendar years young taxpayers are reporting multiple sources of income. this does not even take into account the likelihood of holding multiple jobs simultaneously, which would increase the number of years in which multiple income sources are reported on a return. a. the impact of multiple form w-4s on tax due the current tax system relies on a combination of forecasted earned income, reported on the form w-4, and end of year income, reported through the form w-2. the form w-4 requires individual taxpayers to project their expected earned income for the tax year, which is in turn translated into amount of tax withheld over the course of the year. this has led to a situation where many filers of all income levels discover only after the end of the tax year that they have mis-withheld. for those who discover they have overwithheld and are entitled to a refund, this comes as welcome news. in fact, in analogous situations, low-income filers even have a preference for receiving cash transfers through their tax refunds rather than through welfare programs.4 however, when filers find to their 1 in 2020, the irs postponed tax day for all filers to july 15, 2020, due to the covid-19 pandemic. this delayed filers’ obligation to prepare and submit their returns and to make any necessary payments by 90 days. filing and payment deadline extended to july 15, 2020 updated statement, irs (mar. 21, 2020) https://www.irs.gov/newsroom/payment-deadline-extended-to-july-15-2020 [https://perma. cc/c6d5-65pe]. in 2021, the irs again postponed tax day, this time by 32 days to may 17, 2021. tax day for individuals extended to may 17: treasury, irs extend filing and payment deadline, irs (mar. 17, 2021), https://www.irs.gov/newsroom/tax-day-for-individuals-extended-to-may-17-treasury-irs-extend-filing-andpayment-deadline [https://perma.cc/dg37-aeal]. 2 americans at age 33: labor market activity, education and partner status summary, u.s. bureau of lab. stats. (may 5, 2020), https://www.bls.gov/news.release/nlsyth.nr0.htm [https://perma.cc /ka6a-8pu8]. 3 id. 4 sara sternberg greene, the broken safety net: a study of earned income tax credit recipients and a proposal for repair, 88 n.y.u. l. rev. 515, 538-43 (2013). 2021] the case for overwithholding federal income tax 2 surprise that they owe tax, reactions vary from disgruntled to despondent.5 for many, a refund is an annual opportunity to engage in large spending events, such as home improvements or vehicle repairs. for others, it is an opportunity to add to savings or pay down debt—only a small minority use their refunds for daily expenses.6 when taxpayers find to their surprise that they are not only not receiving a refund, but that they in fact owe the government back-taxes, they are forced to tap into their already scant savings, and are unable to engage in the financially responsible activities that they would have otherwise. taxpayers across income brackets prefer refunds, and while some would prefer a net $0 refund, only a small minority of taxpayers desire the outcome of owing the government money.7 however, by 2019, after the implementation of the 2017 tax cuts and jobs act, filers were seeing almost imperceptible increases in take-home pay (0.3 percent to 0.4 percent), which resulted in substantially lower refunds, an average decrease of 8.9 percent, due to changes in the income tax withholding formula.8 this also resulted in more people owing the irs money than in prior years. the misalignment between this outcome and a preference for refunding rather than imposing a tax bill,9 as well as the public’s nearly unanimous desire to receive tax refunds, needs to be resolved. this note proposes a solution to address surprise tax bills due and also considers using withholdings as a tool for forced savings for lowand middle-income taxpayers. b. background on the form w-2 the form w-2 is designed to inform workers of their aggregate earnings, tax withholdings, and other adjustments to income.10 it is issued after the end of each calendar year by the employer to the employee and the employer separately submits the information to the irs.11 when an employee files their tax return, they must use the information on the w-2 to report their earnings, which the irs may then compare to the information submitted by the employer.12 a w-2 is issued to all employees who hold an employee status for tax purposes with their employer—other reporting mechanisms are used for independent contractors.13 the key distinction between taxpayers who are issued w-2s as opposed to 5 michelle singletary, taxpayers cry ‘#taxscam’ as total refunds are down by $6 billion, wash. post (apr. 11, 2019), https://www.washingtonpost.com/business/2019/04/11/taxpayers-cry-taxscam-totalrefunds-are-down-by-billion/ [https://perma.cc/6tm8-8xmc]. 6 darla mercado, here’s what people are doing with their tax refunds, cnbc (mar. 5, 2020), https://www.cnbc.com/2020/03/05/heres-what-people-are-doing-with-their-tax-refunds.html [https://perma.cc /86ds-v4dp]. 7 kay bell, do you want a big tax refund or bigger paycheck?, bankrate (mar. 12, 2015), https://www.bankrate.com/finance/consumer-index/money-pulse-0315.aspx [https://perma.cc/8epx-sen5]. 8 john w. schoen & darla mercado, average tax refund is down 8.7 percent from a year ago, cnbc (feb. 14, 2019), https://www.cnbc.com/2019/02/14/average-tax-refund-is-down-8point7-percent-fromyear-ago.html [https://perma.cc/y7xm-wcse]. 9 see infra part error! reference source not found. (imposing federal sanctions for significant under-withholding evidences irs preference for over-withholding to minimize any potential tax due). 10 see about form w-2, wage and tax statement, irs (dec. 11, 2020), https://www.irs.gov/formspubs/about-form-w-2 [https://perma.cc/bw5t-p9k2]. 11 topic no. 752 filing forms w-2 and w-3, irs (jan. 25, 2021), https://www.irs.gov/taxtopics /tc752 [https://perma.cc/v99j-wkh3]. 12 2021 form w-2, instructions for employee, irs, https://www.irs.gov/pub/irs-pdf/fw2.pdf [https://perma.cc/9he4-kkr5] (last visited on apr. 4, 2021). 13 note that the distinction between an employee and an independent contractor, while using the same terminology, differs in the tax and labor law contexts. see understanding employee vs. contractor designation, irs (july 20, 2017), https://www.irs.gov/newsroom/understanding-employee-vs-contractordesignation [https://perma.cc/8pkr-xwlc]. see also fact sheet #13: employment relationship under the about:blank 2 columbia journal of tax law [vol. 12:172 other tax documents associated with earned income is that this group is subject to automatic tax withholdings through their employer.14 independent contractors, by contrast, receive 1099-misc forms with no automatic withholdings and must make estimated tax payments on a quarterly basis.15 the information on a w-2 is employer-specific. employees with multiple sources of income will receive w-2s or other income reporting documents from each employer annually. an employee is required to calculate the impact of earnings from each source of employment on the others. the atomized nature of income reporting and tax withholdings will almost certainly lead to a balance owed to the irs or refunded to the taxpayer at the end of each year. c. background on the form w-4 when income is withheld from an employee’s paycheck, it is done on the basis of information provided by the employee on the form w-4. the form w-4, the “employee’s withholding certificate” (formerly the “employee’s withholding allowance certificate”), is used by filers to notify their employers of their tax situation and is used by the employer to calculate taxes to be withheld from the employee’s salary.16 if an employee does not file a w-4, or the employer does not properly adjust based on a submitted w-4, the employer is required to use a default withholding scheme and withhold as if the taxpayer files as single and takes the standard deduction.17 while this default generates a higher amount withheld than other filing options based solely on filing status and dependents, it is often insufficient to cover tax owed for filers with multiple sources of income. an unusual characteristic of the w-4 is that the user has some discretion in filling out the form. there are no penalties for incorrectly filling out the form, but if a filer fails to withhold enough to cover their tax bill, penalties may be imposed.18 for example, a filer can use the form to over-withhold—have their employer take more from their paycheck than would be indicated by their earnings—and use their annual refund as a deliberate method for savings. a filer can also choose to fill out the form to most accurately reflect their earnings, in an attempt to minimize their refund or balance owed with their tax return. however, it is nearly impossible for a taxpayer who owes federal income tax to relay enough information on the w-4 to generate a zero return—a tax return with no refund or balance owed. this is because of the variety of credits and deductions that many taxpayers are eligible for, along with the interplay of state and federal taxes, and the relative inscrutability of the w-4 itself. fair labor standards act (flsa), u.s. dep’t of lab., wage & hour div. (july 2008), https://www.dol.gov /agencies/whd/fact-sheets/13-flsa-employment-relationship [https://perma.cc/2y34-25k9]. 14 tax withholding, irs (apr. 8, 2021), https://www.irs.gov/payments/tax-withholding [https://perma.cc/e3p2-gj78]. 15 see self-employed individuals tax center, irs (mar. 17, 2021), https://www.irs.gov/businesses /small-businesses-self-employed/self-employed-individuals-tax-center [https://perma.cc/zk84-4a75]. 16 about form w-4, employee’s withholding certificate, irs (dec. 15, 2020), https://www.irs.gov /forms-pubs/about-form-w-4 [https://perma.cc/s8rs-g4x6]. 17 topic no. 753 form w-4 – employee’s withholding certificate, irs (mar. 9, 2021), https:// www.irs.gov/taxtopics/tc753 [https://perma.cc/2guj-x4w8]. 18 topic no. 306 penalty for underpayment of estimated tax, irs (mar. 5, 2021), https://www.irs. gov/taxtopics/tc306 [https://perma.cc/52gb-b4dd] [hereinafter irs, topic no. 306]. about:blank about:blank about:blank 2021] the case for overwithholding federal income tax 2 1. form design: comparison of the pre-2020 form w-4 to the current form w-4 the treasury department and the irs made substantial changes to the w-4 form for the 2020 tax year,19 which the irs stated were necessary due to the removal of personal and dependent exemptions under the 2017 tax reform.20 there are three broad complaints about the pre-2020 version of the w-4 form (“old form”): (1) lack of clarity about the impact of withholdings on the refund amount, (2) counterintuitive allowance numbering to the amount of money withheld, and (3) inability to assess withholdings for filers with multiple income streams. while the 2020 version of the w-4 (“new form”) addresses all of these issues in some way, none of the remedies are fully adequate. 19 see figures 1 and 2. 20 irs, treasury issue proposed regulations updating income tax withholding rules, irs (dec. 17, 2020), https://www.irs.gov/newsroom/irs-treasury-issue-proposed-regulations-updating-income-taxwithholding-rules [https://perma.cc/rmb6-spej]. 2 columbia journal of tax law [vol. 12:172 figure 1: form w-4, 2019, “old form.” 2021] the case for overwithholding federal income tax 2 figure 2: form w-4, 2020, “new form.” a. impact of withholdings on refund amount the old form w-4s provided only a short explanation of their utility, which did not explain the repercussions of the form on the taxpayer’s refund: “complete form w-4 so that your employer can withhold the correct federal income tax from your pay. consider completing a new form w-4 each year and when your personal or financial situation changes.”21 for the 2020 form redesign, this explanation was expanded to include a 21 supra figure 1. 2 columbia journal of tax law [vol. 12:172 discussion of the impact of the form on a filer’s refund, adding the following information: “if too little is withheld, you will generally owe tax when you file your tax return and may owe a penalty. if too much is withheld, you will generally be due a refund.”22 what “too little” and “too much” means is different for each filer, however, and is not explained anywhere on the form or in the instructions. b. counterintuitive allowances the old form used a system of allowances to calculate tax withholdings that roughly corresponded to personal exemptions on the filer’s tax return. for example, a single filer might claim themselves and list “1” as the number of allowances, while a family of four might have listed “4.” discretionary additions or subtractions to this number could cause this number to deviate from the number of exemptions claimed on a tax return.23 for example, if you were claiming the child tax credit, the number of allowances per child would differ depending on your income. however, these determinations could only be made by carefully following instructions on an accompanying worksheet. in many instances, the taxpayer was required to know what their earnings for the year would be in advance of earning them. additionally, one of the most common w-4 errors under the old form was mistaking the allowance number as a scale of how much would be withheld— but in the opposite direction—when, in fact, as the allowance number increased, it decreased the number of dollars withheld. this counterintuitive system meant that many filers who did not understand the form simply put a high number for their allowances, mistakenly believing that this would ensure they had withheld enough to be entitled to a refund at the end of the year, only to discover that the exact opposite was true after it was too late to adjust.24 the 2017 tax cuts and jobs act eliminated the system of personal exemptions in favor of a simplified higher standard deduction.25 as a result, the treasury department and the irs issued a revised w-4 in 2019 for the 2020 tax year to take into account the changes under the new law, and ostensibly to create a more streamlined and user-friendly form.26 while the counterintuitive numbering system has been removed, the new form now requires more engagement from the filer. under the old w-4, a filer always had the option to enter “0” allowances and know that the maximum base amount would be withheld.27 there is no clear method to achieve the same result and over-withhold on the new form. the only indicator of withholding status is filing status (single, married filing jointly, head of household), which cannot be overridden by simply entering “0” allowances, as had been available in the old form. this mechanism has instead been replaced with 22 supra figure 2. 23 form w-4 (2019), irs 3, https://www.irs.gov/pub/irs-prior/fw4--2019.pdf [https://perma.cc /e8nh-hssd] (last visited apr. 4, 2021). 24 scott r. schmedel, a form of confusion, chi. trib. (june 26, 1997), https://www.chicagotribune .com/news/ct-xpm-1997-06-26-9706260446-story.html [https://perma.cc/y7zk-wr2y]. 25 erica york, the tax cuts and jobs act simplified the tax filing process for millions of households, tax found. (aug. 7, 2018), https://taxfoundation.org/the-tax-cuts-and-jobs-act-simplified-thetax-filing-process-for-millions-of-americans/ [https://perma.cc/73c3-reyx]; see i.r.c. § 151(d)(5). 26 treasury and irs issue improved form w-4 for 2020 to simplify filing and increase transparency, u.s. dep’t treasury (aug. 9, 2019), https://home.treasury.gov/news/press-releases/sm753 [https://perma.cc/6rqa-xlal]. 27 for outdated advice on claiming “0” allowances, see how many allowances should i claim on form w-4?, libertytax (mar. 30, 2016), https://www.libertytax.com/tax-lounge/how-many-allowancesshould-i-claim-on-form-w/ [https://perma.cc/67ba-hxc4]. both the old and the new forms also have the option to add an additional fixed-dollar amount to be withheld per pay period. supra figures 1 and 2. about:blank 2021] the case for overwithholding federal income tax 2 three different options for calculating withholdings based on multiple jobs, two of which require worksheets or a visit to a webpage and a third, which provides a separate section for claiming dependents. all of these options require knowledge of future earnings, as well as significant interaction with the form and associated worksheets or websites. c. multiple sources of income the most significant change between the two w-4 forms is the addition of a new section for those with multiple sources of income and married couples who both work. while this is a commendable change, the complexity of the process to accurately report earnings—which requires adjustment of the form with each employer every time a wage or employment situation changes—creates a significant tax compliance burden on filers.28 only the simplest scenario requires no additional calculation: two jobs with similar pay. but even this requires some care and guesswork from the taxpayer, as it requires matching forms to be submitted to each employer, and there is no guidance for what “similar” means. 2. scope of impact: single and head of household filers there are two classes of workers who are uniquely vulnerable to large, unexpected taxes due to withholding issues: single filers with no dependents, and head of household filers with dependents aging out of eligibility. because of the peculiarly american habit of conducting social welfare through the tax code,29 for some workers, particularly those with dependents, tax owed is offset by cash distributions through the earned income tax credit (eitc) and child tax credit (ctc). for those workers, the windfall of the refundable credits will likely erase any tax owed.30 the eitc is much more generous to families with children and the ctc is targeted only at filers claiming children.31 while this might mute the distributive effect of these credits, it does mean that for low-income families who receive these benefits, large tax balances emerging suddenly at the end of the year are relatively unusual. workers who do not claim children on their tax return are left without the buffer of these refundable credits. for single filers with no dependents, the eitc pays out a maximum of $538 and phases out at $15,820 of income.32 single filers benefitted from the tradeoff in the 2017 tax reform law due to the increase in the standard deduction at the expense of the elimination of personal exemptions, which likely helped to reduce the surprise tax bills due for very low wage workers by increasing their tax-free threshold. however, for low wage workers in the $20,000 to $40,000 annual gross income range, the 2017 tax law only benefitted them to the tune of $180 to $360 in reduced taxes, an increase 28 ann carrns, check out the new w-4 tax withholding form. really., n.y. times (dec. 13, 2019), https://www.nytimes.com/2019/12/13/your-money/new-w-4-form.html [https://perma.cc/7ykt-cbbp]. 29 see social policy and the tax system, urban institute 4 (june 21, 2001), https://www.urban.org/sites/default/files/publication/59926/310418-social-policy-and-the-tax-system.pdf [https://perma.cc/fg3s-qecy]; adriene hill, why so much of the u.s. tax code is social policy, marketplace (oct. 2, 2017), https://www.marketplace.org/2017/10/02/why-so-much-us-tax-code-socialpolicy-0/ [https://perma.cc/7aq9-cgpk]. 30 see infra table 3: taxpayer 1a & table 5: taxpayer 2a. 31 thomas l. hungerford & rebecca thiess, the earned income tax credit and the child tax credit, econ. pol’y inst. 2-3 (sept. 25, 2013), https://files.epi.org/2013/the-earned-income-tax-credit.pdf [https://perma.cc/xp82-wyw5]. 32 earned income and earned income tax credit (eitc) tables, irs (feb. 3, 2021), https://www.irs.gov/credits-deductions/individuals/earned-income-tax-credit/earned-income-tax-creditincome-limits-and-maximum-credit-amounts [https://perma.cc/j6ss-yp44]. 2 columbia journal of tax law [vol. 12:172 of less than 1 percent in net income.33 small increases in income from multiple sources or a change in the type of income, from wage to independent contractor income, is likely to have a large impact on the tax burden of these workers.34 this is especially true for lowincome filers for whom payroll taxes account for 7.65 percent of income,35 a much higher percentage of their total tax bill relative to those in higher income brackets. head of household filers present a peculiar subset of the above group. although this group benefits from the eitc and ctc benefits while they have minor children, those benefits evaporate when their dependents age out of eligibility. unlike married couples filing jointly, head of household filers lose their tax-preferred filing status, which creates a simultaneous drop in tax-free income of nearly a third, at the same time that their eligibility for credits disappears. while many filers are aware that their eitc and ctc benefits will be reduced or eliminated when their children grow up, few are aware of how the change in filing status will impact their income. yet, the irs does no outreach regarding the impact of the change in status and only warns taxpayers of the ramifications of the reduction or elimination of eitc and ctc benefits.36 a mere change in filing status, which amounts to a $6,250 decline in tax-free income, can increase a taxpayer’s tax owed by $625 to $1,375 for those in the first three tax brackets (up to over $97,000 in annual income).37 table 1: 2020 income tax brackets38 rate for single individuals, taxable income over for married individuals filing joint returns, taxable income over for heads of households, taxable income over 10% $0 $0 $0 12% $9,875 $19,750 $14,100 22% $40,125 $80,250 $53,700 24% $85,525 $171,050 $85,500 32% $163,300 $326,600 $163,300 35% $207,350 $414,700 $207,350 37% $518,400 $622,050 $518,400 33 danielle kurtzleben, charts: see how much of gop tax cuts will go to the middle class, n.p.r. (dec. 19, 2017), https://www.npr.org/2017/12/19/571754894/charts-see-how-much-of-gop-tax-cutswill-go-to-the-middle-class [https://perma.cc/wf73-nf2d]. 34 see infra table 2: taxpayer 1 & table 4: taxpayer 2: single, middle-income filer. 35 topic no. 751 social security and medicare withholding rates, irs (feb. 5, 2021), https://www.irs.gov/taxtopics/tc751 [https://perma.cc/6u5a-b433] (payroll tax is comprised of a 6.2 percent social security tax plus a 1.45 percent medicare tax). 36 see eitc awareness day, irs (dec. 28, 2020), https://www.eitc.irs.gov/partner-toolkit/eitcawareness-day/eitc-awareness-day-2 [https://perma.cc/a4j9-c2vs]. 37 see infra table 1. reduction in tax-free income is derived from the difference between the standard deduction for head of household ($18,650) filers and the standard deduction for single filers ($12,400). the difference in tax owed is calculated by applying the differential tax rates from table 1. 38 income in this table refers to taxable income, which is gross income minus the standard deduction or the itemized deductions that the taxpayer is claiming. i.r.c. § 63. 2021] the case for overwithholding federal income tax 2 thirty-nine percent of americans do not have $400 of savings on hand to deal with an emergency.39 due to the complexity of our tax system, and the ways it changes annually for individuals, but does not announce the impact of those changes until the end of a calendar year, low-income individuals are uniquely vulnerable to being thrust into tax balances owed and, subsequently, tax debt. ii. a new withholding regime for an economy of unstable incomes across multiple jobs: deliberate overwithholding the key presumptions made by the w-4 form—even in the new 2020 iteration— are that all taxpayers can predict what their incomes will be prospectively; income changes will be infrequent; filers will adjust their withholdings every time they experience a change in their income; and employers will correctly follow the instructions on the w-4 when filing. this belies the realities for low-wage workers, who are not only more likely to hold multiple jobs within a tax year and be unable to predict their income with accuracy,40 but also are less equipped for the compliance costs of adjusting their withholdings. the policy proposal in this note suggests a simpler solution: create a default withholding structure that eliminates the need for w-4 use (and misuse) for lowand middle-income workers by deliberately over-withholding federal income tax. this will produce the joint benefits of reduced surprise tax bills due, and a new default savings vehicle for taxpayers who are least likely to have any savings at all. a. why over-withholding for wage workers? wage workers need over-withholding to (1) remediate the problem of chronic under-saving by low-income workers; (2) ensure the full benefits of social credits such as the eitc and ctc are felt; (3) encourage better tax compliance; and (4) prevent lowincome individuals with no savings from accruing unnecessary surprise tax bills. 1. withholdings as an accessible option for savings for lowincome individuals the conventional wisdom states that over-withholding deprives workers of income to pay for necessary expenses in the present, while the government benefits from overwithholding in the form of a no-interest loan from taxpayers as income is withheld over the course of the tax year.41 this analysis ignores that all individuals need an option for savings in order to pay for large expenses. many low-income taxpayers lack access to traditional savings or checking accounts 42 and taxpayers that do have access to the traditional banking system are not benefitting from significant interest income throughout the tax year. interest rates for savings accounts in consumer banks, used by lowand 39 federal reserve board, report on the economic well-being of u.s. households in 2018 2 (2020), https://www.federalreserve.gov/publications/files/2018-report-economic-well-being-us-households201905.pdf [https://perma.cc/c8fn-lndf]. 40 jonnelle marte & lucia mutikani, share of u.s. workers holding multiple jobs is rising, new census report shows, reuters (feb. 17, 2021), https://www.reuters.com/article/us-usa-economy-multiplejobs/share-of-u-s-workers-holding-multiple-jobs-is-rising-new-census-report-shows-iduskbn2ah2pi [https://perma.cc/pz63-al46]. 41 see infra, part error! reference source not found.. 42 see michael s. barr, brookings inst., banking the poor: policies to bring low-income americans into the financial mainstream 4 (2004), https://www.brookings.edu/wp-content/uploads /2016/06/20041001_banking.pdf [https://perma.cc/7kr3-nrrh]. about:blank 2 columbia journal of tax law [vol. 12:172 middle-income taxpayers, average 0.04 percent. 43 thus, withholdings creates an accessible savings option for certain low-income taxpayers and, for others, shifts the savings mechanism from negligible interest-bearing savings accounts to withholdings with no significant detriment to those taxpayers. instead, tax withholdings should be viewed through the lens of forced savings. middleand high-income individuals benefit from tax-preferred forced savings in the form of 401(k)s and can opt into programs such as iras or 529 plans for college savings, but low-income individuals are less likely to have access to such tax-preferred vehicles.44 low-income individuals are also less likely to have a savings account, or a bank account in general.45 even if access to consumer banking were to improve, the policy behind 401(k)s and other forms of forced saving still holds. all people are more likely to save, develop wealth, and better withstand disaster if there are default savings mechanisms in place.46 one of the key aspects of such forced savings programs is that they are intended to be long-term savings vehicles. to further that goal, participants lose access to deposited funds or incur a significant penalty if they attempt to access the funds early. early withdrawal from tax-preferred accounts like 401(k)s and traditional iras require taxpayers to pay a 10 percent penalty on the withdrawal as well as income taxes owed.47 this deters early withdrawal and helps individuals maintain their retirement accounts for the intended purpose of retirement, rather than other savings. in contrast, tax withholdings are available on an annual basis to the taxpayer, but provides no option for early withdrawal. it is similar to the concept of a lending circle,48 except that it is partially within an individual’s control what that final payout will be and there is no risk-sharing. instead, tax withholdings can, and already do, operate as a savings vehicle for low-income individuals to make large purchases on an annual basis. 49 furthermore, low-income families after the clinton-era welfare reform increasingly depend on high interest credit cards to weather financial shocks. 50 rather than disincentivizing consumer spending, tax withholdings allows individuals and families to budget based on a slightly reduced take-home pay, with the security of knowing that they are saving for larger purchases when the time is right. additionally, given the gaps in consumer banking—where low-income individuals often cannot access no-fee checking accounts51—the federal government offers taxpayers a free and secure place to store their earnings. 43 lauren perez, what is the average interest rate for savings accounts?, smartasset (feb. 25, 2021), https://smartasset.com/checking-account/average-savings-account-interest [https://perma.cc/5vwsxhey]. 44 jeff schwartz, rethinking 401(k)s, 49 harv. j. on legis. 53, 69 (2012). 45 barr, supra note 42, at 4. 46 james j. choi, et al., for better or for worse: default effects and 401(k) savings behavior, in perspectives on the economics of aging 81, 83 (david a. wise, ed., 2004). 47 topic no. 558 additional tax on early distributions from retirement plans other than iras, irs (mar. 17, 2021), https://www.irs.gov/taxtopics/tc558 [https://perma.cc/us3q-vls6]. 48 mary ager caplan, communities respond to predatory lending, 59 soc. work 149, 153 (2014). 49 mercado, supra note 6. 50 sternberg greene, supra note 4, at 548. post-welfare reforms, low-income families saw an increase in credit card debt of 184 percent relative to the period before those reforms. tamara draut & javier silva, borrowing to make ends meet: the growth of credit card debt in the ‘90s (2003), https://www.demos.org/sites/default/files/publications/borrowing_to_make_ends_meet.pdf [https://perma.cc /88mv-6yyz]. 51 barr, supra note 42, at 4. 2021] the case for overwithholding federal income tax 2 a. under-withholding causes surprise tax balances that low-income filers do not have the resources to pay for some filers, over-withholding may not be the answer to increasing savings, but it could be the answer to reducing taxes owed. as discussed above, low-income and middle-income filers with multiple sources of income, wage or otherwise, are more likely to owe taxes when they file. this is a demographic already unlikely to have savings significant enough to pay any amount of tax due in a lump sum at the time of filing, and payment plans are expensive. a quarter of filers use their refunds to pay down debt, particularly high interest credit card debt.52 for low-income filers with little to no savings, there are added costs of being unable to make a payment in full by the filing deadline—in effect a tax levied by the irs on those who lack savings. currently, it costs between $31 and $225 simply to set up a payment plan for a duration of longer than 120 days with the irs,53 and the interest rate has ranged from 3 percent to 6 percent for individuals over the past five years.54 for the nearly half of americans who would struggle to find $400 for an emergency expense, the added burden of administrative costs creates another barrier to paying down tax due or tax debt.55 b. state and federal sanctions for non-payment individuals who find themselves with surprise tax bills due may also accrue additional monetary and non-monetary penalties. for large balances owed (which includes balances exceeding $1,000, less than 90 percent of estimated tax paid in advance, or less than 100 percent of the tax owed in the prior tax year paid in the current tax year), the irs may issue a fine, compounding the tax balance already owed.56 most states that levy income tax have similar systems for fining or charging interest to those who underpay.57 states and the federal government also can engage in wage garnishment for unpaid taxes, with states varying in whether they are more or less protective than the federal government.58 some states also use other tools to penalize filers who have unpaid tax debt, 52 mercado, supra note 6. 53 additional information on payment plans, irs (feb. 19, 2021), https://www.irs.gov/payments /payment-plans-installment-agreements [https://perma.cc/7t4h-v9c9] (expand dropdowns for “long-term payment plan (installment agreement)”). 54 irs penalty & interest rates, intuit accts., https://proconnect.intuit.com/articles/federal-irsunderpayment-interest-rates/ [https://perma.cc/vln3-auh6] (last visited on apr. 3, 2021). 55 neal gabler, the secret shame of middle-class americans, atlantic (2016), https://www .theatlantic.com/magazine/archive/2016/05/my-secret-shame/476415/ [https://perma.cc/9y97-c7gc]. 56 notice 746, information about your notice, penalty and interest, irs (jun. 2020), https://www .irs.gov/pub/irs-pdf/n746.pdf [https://perma.cc/66x3-whfd]. 57 see, e.g., interest and penalties, n.y. state dep’t of tax’n & fin. (dec. 7, 2020), https://www.tax.ny.gov/pit/file/interest_and_penalties.htm [https://perma.cc/d2vc-r5xz] (penalties in new york state); estimated connecticut income taxes, conn. state dep’t of revenue servs, https://portal.ct.gov/drs/publications/informational-publications/1992/ip-9254-estimated-connecticutincome-taxes [https://perma.cc/m9fj-fmry] (interest payments in connecticut); penalty reference chart, cal. franchise tax bd. (2012), https://www.ftb.ca.gov/forms/misc/1024.html [https://perma.cc/5gdujpxu] (penalties in california). 58 information about wage levies, irs (sept. 20, 2020), https://www.irs.gov/businesses/smallbusinesses-self-employed/information-about-wage-levies [https://perma.cc/8bw7-dwuf]; compare patricia dzikowski, new york wage garnishment law, nolo, https://www.nolo.com/legal-encyclopedia/new-yorkincome-execution-wage-garnishment-law.html [https://perma.cc/xm3v-s7t8] (last visited apr. 4, 2021) with hari ender, illinois wage garnishment law, nolo, https://www.nolo.com/legal-encyclopedia/illinois-wagegarnishment-law.html [https://perma.cc/pl3b-tbxq] (last visited apr. 4, 2021) (illinois has a more protective regime than new york state). about:blank about:blank about:blank 2 columbia journal of tax law [vol. 12:172 often using methods completely apart from the tax system, such as suspending driver’s licenses.59 2. tax compliance increases with refunds and reduces bureaucratic burdens on low-income filers the benefits of over-withholding are not limited to individual filers. the irs could increase revenue and decrease enforcement costs by changing the default withholding structure to increase the number of filers facing gains rather than losses from their tax returns. this in turn would decrease the compliance costs and bureaucratic burdens on low-income filers. a. tax compliance one of the greatest challenges for low-income filers is the constantly changing landscape of tax regulation and the relatively few procedural protections for filers who cannot afford robust legal advice.60 additionally, low-income filers are justified in their perception that enforcement is unequal across income classes. as the irs has scaled back enforcement across income brackets, the rate of audits for eitc recipients—definitionally low-income, with the median recipient earning $20,000 annually—has dropped by only about a third, compared to approximately 80 percent declines for earners over $200,000.61 this has translated to a comparable audit rate of the poorest and the richest americans.62 this is a reversion to the pre-great recession mean: in the late 1990s and early 2000s, a taxpayer earning $25,000 was more likely to be audited than a taxpayer making more than $100,000.63 while disproportionately imposing tax enforcement on the poorest americans, the irs has ignored one of its most powerful tools to increase compliance: tax refunds.64 multiple analyses have found that knowing that a refund is likely on the back end makes taxpayers more likely to engage in tax-compliant behavior on the front end.65 in particular, under-withholding has a direct impact on revenue.66 filers who face a balance owed are more likely to attempt to reduce their tax liability than those who face a refund. such behavioral differences are measurable;67 if all filers facing refunds attempted to minimize tax liability in the same manner as those facing balances owed, the irs would lose $3.7 billion in revenue; if the reverse were true, the irs would gain $1.4 billion.68 in other words, the irs would be able to increase revenue simply by changing withholding guidelines and allowing taxpayers to face refunds, rather than balances owed. 59 driver’s license suspension, n.y. state dep’t of tax’n and fin. (july 31, 2019), https://www.tax.ny.gov/enforcement/collections/driver-license-susp.htm [https://perma.cc/9zyl-v9tl]. 60 leslie book, the poor and tax compliance: one size does not fit all, 51 u. kan. l. rev. 1145, 1148 (2003). 61 paul kiel, it’s getting worse: the irs now audits poor americans at about the same rate as the top 1%, propublica (may 30, 2019), https://www.propublica.org/article/irs-now-audits-poor-americans-atabout-the-same-rate-as-the-top-1-percent [https://perma.cc/58a4-hee4]. 62 id. 63 book, supra note 60, at 1158. 64 daniel hemel, tax refunds are more than a boost to your bank account—they’re good for the country, too, time (feb. 14, 2019), https://time.com/5529647/tax-refunds/ [https://perma.cc/em5m-pwnk]. 65 gideon yaniv, tax compliance and advance tax payments: a prospect theory analysis, 52 nat’l tax j. 753, 762 (1999); paul webley, et al., tax evasion: an experimental approach 83 (1991). 66 hemel, supra note 64. 67 id. 68 alex rees-jones, quantifying loss-averse tax manipulation, 85 rev. econ. stud. 1251, 1253 (2018). 2021] the case for overwithholding federal income tax 2 simultaneously, the irs would also be able to reduce enforcement infrastructure—and with it, reduce its operational budget—if fewer taxpayers were engaging in taxminimization behavior. b. bureaucratic burden tax compliance is probably the phrase most synonymous with “burden” in the american psyche. this is particularly true for low-income workers with a range of income sources. for example, gig workers who are paid as independent contractors spend on average 10 to 35 hours on tax return preparation annually.69 there is a tension between what citizens want—government services to be efficient and free from fraud—and the actual relationship between the benefit and the burden.70 professors pamela herd and donald moynihan describe a framework for evaluating administrative burdens: “[a]dministrative burdens are the learning, psychological, and compliance costs that citizens experience in their interactions with government.”71 the interplay of the various types of costs can explain the difference in the uptake or utilization rates of various programs—from the effectively 100 percent participation rate in social security, to the 80 percent participation rate in the eitc, and the roughly 65 percent participation rate of the population eligible for federal food assistance.72 the burdens are measurable: the treasury department estimates that 6.7 billion hours per year are spent on tax preparation and compliance,73 while over 40 percent of americans have returns that are sufficiently simple for the irs to prepare them on its own—translating into 225 million hours saved.74 the benefits of over-withholding in this framework are multiple. learning costs are effectively zero because withholding happens automatically. a previous learning cost—how to calculate one’s proper withholdings—is removed, as the default will generate a refund for the vast majority of lowand middle-income filers. employers have no additional learning cost, beyond what is typically required for the implementation of w-4 withholdings. compliance costs are also reduced. as discussed above, filers facing refunds are less likely to engage in tax minimization behavior that could trigger an audit. this reduces compliance costs both for the filer and for the irs. further, a reduction in balances owed eliminates a portion of the compliance costs put on filers who must enter into payment plans with the irs or state taxation agencies. as with learning costs, employers will see no change to their compliance costs—and perhaps will see a reduction in processing of w-4s as employees will not need to alter their withholdings with such frequency. finally, psychological costs are reduced on the front-end as taxpayers have a much higher assurance of a refund at the end of each year and on the back-end from a reduction in the number of people who face a surprise tax bill due when they file their taxes. unlike most policy proposals suggesting a reduction on administrative burdens for citizens, this policy does not come with increased monetary costs for the government. the 69 kathleen delaney thomas, taxing the gig economy, 166 u. pa. l. rev. 1415, 1430 (2018). 70 pamela herd & donald p. moynihan, administrative burden: policymaking by other means 12 (2018). 71 id. at 22. 72 id. at 6. 73 cass sunstein, how to simplify the tax code. simply., time (may 31, 2013), https://ideas.time.com/2013/05/31/how-to-simplify-the-tax-code-simply [https://perma.cc/zxc5-7urz]. 74 austan goolsbee, the simple return: reducing america’s tax burden through returnfree filing 5 (2006). 2 columbia journal of tax law [vol. 12:172 irs needs to do nothing more than amend its withholding formula and form w-4 and is in fact likely to see increases in revenue as discussed above. 3. maximize positive impacts of the eitc and the ctc the policy purpose of the eitc is to incentivize work, providing a bonus for increased hourly wages or salaries for low-income individuals.75 the purpose of the ctc is to provide an extra payment (or, for higher-income individuals, a reduction in tax burden) for families who take on the increased cost of child-rearing.76 the underlying goal of both is to provide cash assistance to low-income families. these programs are negated when unnecessary tax balances are owed as a result of chronic under-withholding, eating up those cash distributions. b. proposed policy: withhold from the first dollar earned the proposed policy adopts a new default withholding rule, which begins withholding income tax from the first dollar earned and assumes a “single” filing status for all wage earners, regardless of family status or number of income sources. instead of assuming that everyone has only a single employer, the proposed default rule assumes that many taxpayers have multiple sources of income, that those taxpayers with multiple jobs do not or are not able to correctly fill out a w-4, and that over-withholding has positive policy outcomes in the form of increased savings or reduced debt. under the current rule, if taxpayers are earning at a rate where their annual income is subject to the standard deduction of their filing status, often no income tax is withheld by the employer. the proposed policy simply removes the tax-free threshold for all wage-earning jobs. instead of requiring an income above the threshold to initiate income tax withholdings, the new default rule would be for employers to ignore the income tax-free threshold and start withholding from the first dollar earned, adopting the assumption that all workers are single for the purpose of calculating their withholdings. workers with a single income source who change jobs during the tax year will similarly benefit under the proposed policy. currently, a worker who leaves one job and starts another faces a default of under-withholding at their second job, as the second employer does not begin withholding at the first dollar even though the employee has already earned income in that tax year. thus, the policy of withholding from the first dollar earned would also reduce the unforeseen tax consequences of workers switching employers. 1. remove “zero-refund” bias from form design a policy of over-withholding takes as a fundamental premise that a taxpayer, when the system works correctly, will get a refund. the current policy is that the system should attempt to reconcile a taxpayer’s income using w-4s, and get the maximum number of dollars into the pockets of taxpayers today, rather than making them wait for their annual tax filing. the current policy ignores that taxpayers, on the whole, want to receive refunds, as demonstrated by the fact that very few households took advantage of an option that allowed filers who qualified for the eitc to access it during the year, paycheck by paycheck, instead of as a lump sum at the end of the year.77 additionally, calls for 75 hungerford & thiess, supra note 31, at 2-3. 76 id. at 3-5. 77 steve holt, brookings inst., periodic payment of the earned income tax credit revisited 2-3 (2015), https://www.brookings.edu/wp-content/uploads/2016/07/ holtperiodicpaymenteitc121515.pdf [https://perma.cc/mt7m-yqsm]. the enrollment requirement of this 2021] the case for overwithholding federal income tax 2 achieving a zero-refund return under the current system are not possible to achieve without either extensive tax compliance burdens on individuals or an irs-based clearinghouse to monitor and adjust withholdings across multiple sources of income on a regular basis. targeting zero under the current system entails averaging across all returns, which will necessarily push some taxpayers into owing tax at the end of the year, the least desired outcome for most taxpayers.78 importantly, the failure to withhold correctly leads not only to tax owed, but potentially to a tax penalty. filers who owe more than $1,000 to the irs can be liable for an under-withholding penalty on top of the tax owed, even if the tax is paid in full to the irs by the filing deadline.79 in other words, current tax law assumes that taxpayers will pay their tax in full by the end of the calendar year and that only small adjustments to the amount owed will be necessary. the default rules should match this principle. 2. eliminate the tax-free threshold for income tax withholding purposes under the basic version of the proposed policy, the primary goal would be to eliminate most taxes owed for low-income filers and, secondarily, to provide some savings opportunity for those filers. eliminating the tax-free threshold for withholdings is the simplest, lowest-compliance cost solution from an employer’s perspective. all this would require is a simple change to withholding software to eliminate the consideration of filing status and removing the higher withholding threshold as the default rule. further, employers will find it easier to explain withholdings in terms of the existing tax-brackets, without needing to reference other policy considerations, calculations, or formulas, as most employees will have the same withholding regime rather than the current hyperindividualized system. additionally, by establishing a default rule that works for most individuals, unlike our overly-customized current system, employers will reduce compliance costs in the form of reduced w-4 usage, both during on-boarding and after, when employees periodically seek to optimize their withholdings due to family or employment status changes. 3. examples of the current system vs. the proposed policy the following examples illustrate the difference in outcome between the current system and the proposed policy of withholding from the first dollar. these examples examine single and head of household filers at approximately the 25th and 50th percentiles for individual annual incomes in the u.s. 2020 tax law (including tax rates, deductions, eitc, and ctc tables). these examples demonstrate the policy’s ability to prevent surprise tax bills due for single filers with multiple wage-income sources and for unmarried adults with dependents as they transition out of preferential filing status (with refundable credits) to single filing status. these examples further demonstrate that this remains true at both low and middle-income levels. a. single, low-income filer under the current system, if a single taxpayer (taxpayer 1) is earning $1,000 per month at company a, their projected annualized income is $12,000, below the 2020 program, as well as compliance issues, created an administrative burden, which may also have contributed to its low enrollment numbers. see id. at 4-5. 78 bell, supra note 7. 79 irs, topic no. 306, supra note 18. 2 columbia journal of tax law [vol. 12:172 standard deduction threshold of $12,400. if that is their only job, this would be the correct withholding scheme. however, if taxpayer 1 gets a second job at company b three months into the year, also earning $1,000 a month, the taxpayer has just added $9,000 in annual income, but no income tax is withheld by default. unless the taxpayer successfully adjusts their withholdings using a w-4 form, and their employer properly adjusts the amount withheld, this taxpayer with just $21,000 in annual income would owe $860 in federal income tax at the end of the year. importantly, this tax balance owed is not the result of non-compliance, but simply because the current withholding scheme uses a default rule of a single employer. under the proposed policy, company a would have been withholding from the first dollar and $1,243 in federal income tax would have been withheld. company b would have withheld an additional $900. taxpayer 1 still pays $860, but under this policy this would be more than covered by their withholdings and they would be entitled to a $1,283 refund. while the take-home pay for this taxpayer is reduced by $82 per bi-weekly pay period, the taxpayer no longer has to worry about owing an indeterminate amount of money at the end of the year and will receive the equivalent of 73 percent of a month’s salary in a saved, lump-sum refund. 2021] the case for overwithholding federal income tax 2 table 2: taxpayer 1: single, low-income filer.80 current system company a company b total income, actual tax owed salary $ 12,000 $ 9,000 $ 21,000 standard deduction applied $ 12,400 $ 12,400 $ 12,400 apparent taxable income $ $ $ 8,600 withheld at 10% $ $ $ 860 total withheld $ total owed $ 860 refund $ (860) % of monthly earnings received (owed) (49%) proposed policy company a company b total income, actual tax owed salary $ 12,000 $ 9,000 $ 21,000 standard deduction applied $ $ $ 12,400 apparent taxable income $ 12,000 $ 9,000 $ 8,600 withheld at 10% $ 988 $ 900 $ 860 withheld at 12% $ 255 total withheld $ 2,143 total owed $ 860 refund $ 1,283 % of monthly earnings received (owed) 73% b. low-income filer with one dependent, filing as head of household taking the same earnings scenario as above, but adding an 18-year-old dependent, the withholding scenario becomes less dire for taxpayer 1a. because of a higher standard deduction of $18,650 instead of $12,400 from their head of household filing status, this taxpayer only has a federal income tax burden of $235. even though under the current scheme their employer has not withheld any federal income tax, as it did with taxpayer 1, taxpayer 1a will benefit from the eitc due to their dependent and will receive a refund 80 assumptions: (1) no w-4 is filed: under current policy, withholdings are calculated assuming the filer is a single person with no dependents claiming the standard deduction. under proposed policy, withholding begins at the first dollar. (2) only the eitc and the ctc are considered. (3) fica taxes are not considered because they are subject to separate mandatory withholding schedules and begin at the first dollar. (4) total earnings of $21,000 was selected for being approximately the 25th percentile of individual annual earned income in the united states. 2 columbia journal of tax law [vol. 12:172 of $2,972.81 under the proposed policy, taxpayer 1a’s employer would withhold from the first dollar and taxpayer 1a would receive a refund of $5,115. take-home pay for this taxpayer would have decreased by the same $82 per week as for taxpayer 1, but the refund amount would have increased from 170 percent of a month’s salary to 292 percent. while this policy may seem unnecessary for taxpayer 1a, it is designed not for this tax year, but for the one following. in the following year, taxpayer 1a’s dependent ages out of dependent eligibility for the purposes of the eitc and taxpayer 1a suddenly finds themselves in the same tax situation as taxpayer 1 in table 2 above. under the current system, the refund for this taxpayer would turn into an amount owed: as noted above, taxpayer 1a receives $2,972 when their dependent is 18, but owes a $860 tax the following year when that dependent turns 19. taxpayer 1a’s earnings are unchanged. the simple loss of preferential filing status (head of household) and the dependent’s aging out of eitc qualification effects a dramatic change in tax circumstance. under the proposed policy, taxpayer 1a would still see a dramatic decline in their refund—from $5,115 to $1,283—but unlike the current system, taxpayer 1a would no longer be pushed into a surprise tax bill due from one year to the next. while the taxpayer may not benefit in that year from the forced savings aspect of the policy as in prior years, the taxpayer also has not been pushed into the more problematic scenario of owing the equivalent of a half month’s salary instead of receiving nearly two-month’s salary as they might have expected. 81 this amount could be higher if the dependent is under age 17 and therefore qualifies the taxpayer for the ctc too, but for this example, we will assume the dependent is age 18 and thus only makes the taxpayer eligible for the eitc. 2021] the case for overwithholding federal income tax 2 table 3: taxpayer 1a: low-income filer with one dependent, filing as head of household.82 current system company a company b total income, actual tax owed salary $ 12,000 $ 9,000 $ 21,000 standard deduction applied $ 12,400 $ 12,400 $ 18,650 apparent taxable income $ $ $ 2,350 withheld at 10% $ $ $ 235 total withheld $ eitc applied $ 3,207 total owed $ 235 refund $ 2,972 % of monthly earnings received (owed) 170% proposed policy company a company b total income, actual tax owed salary $ 12,000 $ 9,000 $ 21,000 standard deduction applied $ $ $ 18,650 apparent taxable income $ 12,000 $ 9,000 $ 2,350 withheld at 10% $ 988 $ 900 $ 235 withheld at 12% $ 255 total withheld $ 2,143 eitc applied $ 3,207 total owed $ 235 refund $ 5,115 % of monthly earnings received (owed) 292% c. single, medium-income filer this policy has similar effects for medium-income filers as well. taxpayer 2 has two jobs at company a and company b, each paying $20,000 annually, for a total annual income of $40,000. each employer withholds assuming the single $12,400 standard 82 assumptions: (1) no w-4 is filed: under current policy, withholdings are calculated assuming the filer is a single person with no dependents claiming the standard deduction. under proposed policy, withholding begins at the first dollar. (2) only the eitc and the ctc are considered. (3) fica taxes are not considered because they are subject to separate mandatory withholding schedules and begin at the first dollar. (4) dependent is age 18, which qualifies the filer for the eitc, but not the ctc. (5) total earnings of $21,000 was selected for being approximately the 25th percentile of individual annual earned income in the united states. this table can be viewed in conjunction with “table 2. taxpayer 1,” or separately. viewed in conjunction, table 3’s scenario is the last year of taxpayer 1’s dependent’s eligibility for the eitc and table 2 represents the following year, depicting the precipitous drop year-to-year in taxpayer 1’s refund. 2 columbia journal of tax law [vol. 12:172 deduction, and $1,520 is withheld from taxpayer 2’s pay. however, taxpayer 2 will owe $3,115 in taxes that year, leaving them with a balance of $1,595 due when they file their return—more than what taxpayer 2 takes home in a single, bi-weekly pay period and 48 percent of their monthly wage. under the proposed policy, the employers would have started withholding from the first dollar earned, amounting to a total of $4,405. this would leave taxpayer 2 with a refund of $1,291, or 39 percent of their monthly wage. throughout the year, the taxpayer would have taken home $111 less per pay period, but under this proposed policy does not have to worry about saving for the surprise tax bill due. 2021] the case for overwithholding federal income tax 2 table 4: taxpayer 2: single, middle-income filer.83 current system company a company b total income, actual tax owed salary $ 20,000 $ 20,000 $ 40,000 standard deduction applied $ 12,400 $ 12,400 $ 12,400 apparent taxable income $ 7,600 $ 7,600 $ 27,600 withheld at 10% $ 760 $ 760 $ 988 withheld at 12% $ 2,127 total withheld $ 1,520 total owed $ 3,115 refund $ (1,595) % of monthly earnings received (owed) (48%) proposed policy company a company b total income, actual tax owed salary $ 20,000 $ 20,000 $ 40,000 standard deduction applied $ $ $ 12,400 apparent taxable income $ 20,000 $ 20,000 $ 27,600 withheld at 10% $ 988 $ 988 $ 988 withheld at 12% $ 1,215 $ 1,215 $ 2,127 total withheld $ 4,405 total owed $ 3,115 refund $ 1,291 % of monthly earnings received (owed) 39% d. medium-income filer with two dependents, filing as head of household table 5 takes the same earnings scenario as above, but assumes that the taxpayer has two dependents, ages 16 and 18, and files as head of household. as with taxpayer 1a, for filers receiving large refundable credits through the eitc or ctc, the proposed policy simply adds to the refund this filer would already be receiving. taxpayer 2a has a total income tax bill of $2,365, lower than taxpayer 2’s due to taxpayer 2a’s higher standard deduction. in addition, taxpayer 2a is receiving the eitc calculated with two eligible 83 assumptions: (1) no w-4 is filed: under current policy, withholdings are calculated assuming the filer is a single person with no dependents claiming the standard deduction. under proposed policy, withholding begins at the first dollar. (2) only the eitc and the ctc are considered. (3) fica taxes are not considered because they are subject to separate mandatory withholding schedules and begin at the first dollar. (4) total earnings of $40,000 was selected for being approximately the 50th percentile of individual annual earned income in the united states. 2 columbia journal of tax law [vol. 12:172 dependents, and the ctc for one eligible dependent. taxpayer 2a will therefore receive a refund of $2,562 under the current system, or 77 percent of their monthly gross income. under the proposed policy, with income tax withheld from the first dollar, taxpayer 2a will receive a refund of $5,447, or 163 percent of their monthly gross income, while seeing a reduction in take-home pay of $111 per bi-weekly pay period. the benefits of the proposed policy come to light in subsequent years. the above scenario describes year 0, and the following describes year 1, when the older dependent has aged out of eitc eligibility, and the younger dependent aged out of ctc eligibility but maintains eitc eligibility. under the current system, due to the loss of over $3,000 in refundable credits, taxpayer 2a will owe $674 in year 1, compared to a refund of $2,562 the year prior. under the proposed policy, the taxpayer will still see a drop in their refund, from $5,447 to $2,212—but they will still be receiving the equivalent of 66 percent of monthly gross income as a refund instead of finding to their surprise that they owe the equivalent of 20 percent of their monthly gross income at the end of the year. in this scenario, in year 2, taxpayer 2a becomes taxpayer 2. under the current system, taxpayer 2 and taxpayer 2a would have had a three-year refund trajectory of $2,562 to -$674 to -$860, whereas under the proposed policy that same taxpayer’s refund trajectory would have been $5,447 to $2,212 to $1,291. 2021] the case for overwithholding federal income tax 2 table 5: taxpayer 2a: middle-income filer with two dependents, filing as head of household, at year zero.84 current system: year 0 company a company b total income, actual tax owed salary $ 20,000 $ 20,000 $ 40,000 standard deduction applied $ 12,400 $ 12,400 $ 18,650 apparent taxable income $ 7,600 $ 7,600 $ 21,350 withheld at 10% $ 760 $ 760 $ 988 withheld at 12% $ 1,377 total withheld $ 1,520 eitc applied $ 1,406 ctc applied $ 2,000 total owed $ 2,365 refund $ 2,562 % of monthly earnings received (owed) 77% proposed policy: year 0 company a company b total income, actual tax owed salary $ 20,000 $ 20,000 $ 40,000 standard deduction applied $ $ $ 18,650 apparent taxable income $ 20,000 $ 20,000 $ 21,350 withheld at 10% $ 988 $ 988 $ 988 withheld at 12% $ 1,215 $ 1,215 $ 1,377 total withheld $ 4,405 eitc applied $ 1,406 ctc applied $ 2,000 total owed $ 2,365 refund $ 5,447 % of monthly earnings received (owed) 163% 84 assumptions: (1) no w-4 is filed: under current policy, withholdings are calculated assuming the filer is a single person with no dependents claiming the standard deduction. under proposed policy, withholding begins at the first dollar. (2) only the eitc and the ctc are considered. (3) fica taxes are not considered because they are subject to separate mandatory withholding schedules and begin at the first dollar. (4) dependents are age 16 and 18: the former qualifies as a dependent for both eitc and ctc, the latter qualifies as a dependent for eitc purposes only. 2 columbia journal of tax law [vol. 12:172 table 6: taxpayer 2a: middle-income filer with two dependents, filing as head of household, at year one.85 current system: year 1 company a company b total income, actual tax owed salary $ 20,000 $ 20,000 $ 40,000 standard deduction applied $ 12,400 $ 12,400 $ 18,650 apparent taxable income $ 7,600 $ 7,600 $ 21,350 withheld at 10% $ 760 $ 760 $ 988 withheld at 12% $ 1,377 total withheld $ 1,520 eitc applied $ 171 ctc applied $ total owed $ 2,365 refund $ (674) % of monthly earnings received (owed) (20%) proposed policy: year 1 company a company b total income, actual tax owed salary $ 20,000 $ 20,000 $ 40,000 standard deduction applied $ $ $ 18,650 apparent taxable income $ 20,000 $ 20,000 $ 21,350 withheld at 10% $ 988 $ 988 $ 988 withheld at 12% $ 1,215 $ 1,215 $ 1,377 total withheld $ 4,405 eitc applied $ 171 ctc applied $ total owed $ 2,365 refund $ 2,212 % of monthly earnings received (owed) 66% 85 assumptions: (1) no w-4 is filed: under current policy, withholdings are calculated assuming the filer is a single person with no dependents claiming the standard deduction. under proposed policy, withholding begins at the first dollar. (2) only the eitc and the ctc are considered. (3) fica taxes are not considered because they are subject to separate mandatory withholding schedules and begin at the first dollar. (4) dependent is age 17, qualifying as a dependent for eitc purposes only. the second dependent from the prior year has aged out of dependent eligibility for this taxpayer. this table can be viewed in conjunction with taxpayer 2 from table 4. the scenario in that table would be year 3 for taxpayer 2a’s scenario. 2021] the case for overwithholding federal income tax 2 4. taxpayers who wish to adjust their withholdings can avail themselves of the w-4 finally, this proposed policy does not forgo the benefits available to taxpayers under the current system: the option to customize withholdings through the w-4 would remain in place. filers who wish to calibrate their withholdings to actual earnings would retain that optionality, just as they do today. the benefit of this policy is that it adjusts the default to provide for a forced saving mechanism by having an opt-out, rather than an optin, policy for savings. in so doing, a large number of lowand middle-income participants will, by default, save a certain portion of their income passively, such that it increases both the number of workers engaging in saving and the amounts they save. the benefit of such a system has been evidenced in the retirement savings context.86 indeed, the purpose of this proposed policy is to change the default to one where fewer people owe tax balances at the end of the year and explicitly uses the power of w-4 defaults to do so. by eliminating the need for most employees to fill out and properly maintain w-4s at all moments that could impact their tax burden (point of hire, acquisition of a new job or income source, change in filing status), the proposed policy eliminates errors that could lead to those balances. for high tax-knowledge taxpayers—or those with accountants—the ability to change the default exists, just as it does in managing a retirement portfolio. c. a more radical alternative, “over-withholding plus”: withholding to force savings while the policy proposal stated above prioritizes eliminating surprise tax bills due, an “over-withholding plus” policy would prioritize turning tax withholdings into a deliberate vehicle for savings. this proposed policy would be layered on top of the basic over-withholding policy. rather than simply aligning withholdings exactly with tax brackets, an additional percentage would be withheld with the goal of generating a savings component to a tax refund. table 7: “over-withholding plus” withholding rates tax rate tax rate with savings % taxable income (single) max withheld under basic withholding additional savings under over-withholding plus 10% 15% up to $9,875 $988 $494 12% 17% $9,876 to $40,125 $4,618 $2,007 22% 27% $40,126 to $85,525 $14,606 $4,277 this proposed policy should be deployed as an opt-out system. under an opt-out system, a box would be added to the w-4 and filers would need to check the box to not have income subject to this additional withholdings. if this were instead deployed as an opt-in system, a similar box could be added to the w-4, where taxpayers would be required to check the box in order to opt-in to participation in the savings program. given that optout systems are drastically more effective at encouraging participation in many realms, 86 brigitte c. madrian & dennis f. shea, the power of suggestion: inertia in 401(k) participation and savings behavior, 116 q. j. econ. 1149, 1150 (2001). 2 columbia journal of tax law [vol. 12:172 including financial savings, the opt-out mechanism would be preferable to fulfill the policy goal of promoting saving.87 this savings program would be limited to the first three tax brackets for several reasons. the goal is to increase savings for lowand middle-income filers, all of whom are encompassed by the income limits of the first three brackets. higher income filers are much more likely to have access to traditional savings opportunities in the form of consumer banking accounts, investment accounts, and retirement accounts.88 additionally, the purpose of this program is to address a specific lack of savings among an income-based demographic, not to turn tax withholdings into the primary savings option for all tax filers. withholdings under this scheme, and even under the first-dollar withholding policy, will reduce take-home earnings for low-income families. however, there are already indications from existing tax policy that taxpayers would prefer deferred gains rather than accessing refunds earlier if it means a reduced risk of owing tax at the end of the year.89 historically, when the irs made advanced payments possible under the eitc and ctc, less than 1 percent of taxpayers availed themselves of the opportunity to access funds throughout the year, instead of in one lump-sum payment.90 while knowledge of these programs may have been limited, when presented with the option, taxpayers are extremely wary of options that, if their income changes, may result in balances owed at the end of the year.91 d. objections there are three major objections to the policy proposed here. first, overwithholding is an interest-free loan to the government that deprives workers of money as it is earned and depresses economic activity; second, that taxpayers prefer higher takehome pay, which allows for taxpayers to have access to income earned as financial shocks arise during the year, as opposed to higher annual tax refunds; and third, the current w-4 provides maximal flexibility for tax planning. a fourth objection, political in nature, not dealt with in full here, was most forcefully articulated by then-governor ronald reagan when he opposed state income tax withholdings in california: “taxes should hurt.”92 this note takes as a foundational premise that minimizing tax-related “hurt” is efficient for individuals and governmental bodies and does not deal with the political implications of these policy proposals. the most common objection to tax withholdings is that it amounts to a voluntary overpayment, functioning as an interest-free loan to the u.s. government.93 critics argue that a lack of access to funds during the year may increase debt throughout the year, and 87 john beshears, et al., the importance of default options for retirement saving outcomes: evidence from the united states, in social security policy in a changing environment 167, 170-75 (jeffrey brown, et al., eds., 2009). 88 see id. 89 see janet holtzblatt, trade-offs between targeting and simplicity: lessons from the u.s. and british experiences with refundable tax credits, in the challenges of tax reform in a global economy 39, 49 (james alm, et al., eds., 2006). 90 id. at 48 (describing the use of the eitc advanced payment mechanism in 2002). 91 id. at 49. 92 lou cannon, the leader he was, the leader he wasn’t, wash. post (apr. 26, 1980). 93 darla mercado, here’s why you shouldn’t celebrate that big tax refund, cnbc (mar. 7, 2020), https://www.cnbc.com/2020/03/06/heres-why-you-shouldnt-celebrate-that-big-tax-refund.html [perma.cc/7h3b-6y6a]; maurie backman, americans are very dependent on tax refunds this year -and that’s a problem, motley fool (jan. 16, 2020), https://www.fool.com/taxes/2020/01/16/americans-are-verydependent-on-tax-refunds-this-y.aspx [perma.cc/4q4e-3636]. 2021] the case for overwithholding federal income tax 2 that because taxpayers tend not to use their refunds for consumer spending, overwithholding depresses economic activity.94 they also argue that money now is better than money later and all taxpayers should behave accordingly.95 however, this objection is in tension with itself and with the notion that lowincome filers prefer higher take-home pay to a higher refund. interest rates for a typical savings account are, at the time of this writing, around 0.04 percent,96 and the fdic considers 19 percent of americans underbanked.97 not only do many americans lack access to traditional savings opportunities, those who do have access are not seeing notable yields—the current average interest rate on savings accounts only translates to $0.40 earned over the course of a year on a $1,000 balance. access to funds throughout the year, touted as a benefit, makes it even less likely for savings to actually accrue—there is a reason why those in higher income brackets use long-term mandatory savings options like 401(k)s, health savings plans, and 529s.98 debt that accrues will never be paid without savings, and the objection that money now is better than money later, which would tend to increase consumer spending, is in natural tension with a desire to increase consumer savings. this distillation of the time-value of money belies the general problem that low-income individuals face when confronted with the real-life implications of fiscal policy—there are contradictory messages of incentivizing present consumer spending while demonizing lack of consumer savings. the timing of these annual disbursements, as opposed to receiving smaller amounts every other week as part of a paycheck, is objected to on the basis that taxpayers may accrue debt as a result of not having access to cash when it is earned. families that undergo financial upheaval after that year’s refund has been spent will not have access to their tax withholdings until the next year. only a small portion of financial shocks that families experience will conveniently coincide with the arrival of tax refunds that can help them weather it.99 however, the purpose of forced savings in this context is to help avoid an additional financial shock in the form of tax owed and to increase the accessibility of savings to a broader group of low-income taxpayers in an environment where other savings options are not available. individuals tend to overweight their current financial needs and underweight their future needs.100 forced savings compensates for this myopia which leads taxpayers to expend income currently rather than saving for the future. additionally, optimizing savings can be a daunting process, the complexity of which is compounded for 94 taylor telford, how much do americans depend on their tax refunds? quite a lot, it turns out, wash. post (mar. 5, 2019), https://www.washingtonpost.com/business/2019/03/05/how-much-doamericans-depend-their-tax-refunds-quite-lot-it-turns-out/ [perma.cc/f55m-j2ss]. 95 see heritage explains, what you need to know about your tax refund this year, heritage found., at 10:40 (apr. 11, 2019), https://www.heritage.org/taxes/heritage-explains/what-you-need-knowabout-your-tax-refund-year [perma.cc/u9jj-5fuq] (arguing against over-withholding). 96 lauren perez, what is the average interest rate for savings accounts?, smartasset (feb. 25, 2021), https://smartasset.com/checking-account/average-savings-account-interest [https://perma.cc/5vwsxhey]. 97 ken sweet, americans who don’t have a bank account at lowest level ever, ap news (oct. 23. 2018), https://apnews.com/8b2b93d4e9474c418853e0f20e79aaa8 [perma.cc/ag4w-97x4]. 98 see linda stern, buy a house, and other forced savings, reuters (feb. 22, 2012), https://www.reuters.com/article/us-column-personal-finance/buy-a-house-and-other-forced-savingsidustre81l1x320120222 [https://perma.cc/b23e-hczd] (describing various options for forced savings). 99 sternberg greene, supra note 4, at 547. 100 louis kaplow, government policy and labor supply with myopic or targeted savings decisions, 29 tax pol’y & econ. 159, 160 (2015). 2 columbia journal of tax law [vol. 12:172 families with unstable income streams.101 the proposed policy of forced savings both helps push back against that myopia and reduces the planning needs for low-income households to engage in savings. unlike retirement funds, the forced savings become available annually; therefore, the bi-weekly income tradeoff, while real, is still predictably accessible to savers. this proposed policy is not meant to cure all the difficulties of savings for low-income families. it is simply meant to introduce a way to reduce large, predictable financial hardships, in the form of surprise tax bills due, while recognizing explicitly that tax refunds are already being used as a savings tool and making that function of the tool more deliberate. finally, defenders of the new form w-4 say that it provides maximal flexibility and addresses a wide range of withholding issues.102 this objection misses the point of this policy proposal. the current policy provides for a default withholding that directs employers to withhold as if the filer is single, takes the standard deduction, and has no other income.103 this proposal asks only for a change in the default, to minimize the number of people who need to utilize the form w-4 at all. filers who wish to engage in tax planning—be it to increase or decrease their withholdings—may continue to do so. iii. epilogue: tax withholdings in a time of pandemic the underlying premise of the w-4 withholding scheme is foreknowledge of future earnings. over 57 million new unemployment claims were filed in the first six months of the covid-19 pandemic,104 illustrating the enormous uncertainty that taxpayers faced as they filed their 2019 taxes in the early months of the pandemic. this also demonstrates the uncertainty filers faced in attempting to tax plan for 2020 as job availability and stability was upended. filing taxes for many in mid-2020 meant economic relief in the form of their refund. but for those whose withholdings were inaccurate for the variety of reasons discussed in this note, the three-month deferral of tax day to july 15, 2020 only delayed the inevitable tax bill that americans were less able to pay than ever due to the collapsing employment and earnings environment. for some, the economic impact payments105 deposited into accounts were soon returned to the irs as payment for unexpected taxes owed. for others, a tax bill that might have seemed manageable a year ago might have been insurmountable due to job loss, and filers forced to choose between basic necessities and paying taxes that were not withheld from their pay. under the policy proposed in this note, the scale would be tipped far in the other direction. almost every american earning less than $75,000—the threshold for receiving the full relief check—would have received a refund right at the time they need it most. by creating an automatic savings mechanism in the form of tax withholdings, the irs could help create a small, zero-cost relief fund for all lowand middle-income americans. 101 see id. at 160-61. 102 see sally p. schreiber, irs proposes rules to update income tax withholding, revises form w4, j. acct. (feb. 12, 2020), https://www.journalofaccountancy.com/news/2020/feb/irs-rules-income-taxwithholding-form-w-4-22959.html [perma.cc/xew2-jy8e]. 103 see press release, irs, treasury issue proposed regulations updating income tax withholding rules, irs (feb. 11, 2020), https://www.irs.gov/newsroom/irs-treasury-issue-proposed-regulations-updatingincome-tax-withholding-rules [perma.cc/k2zy-f5cv]. 104 jack kelly, jobless claims: 57.4 million americans have sought unemployment benefits since mid-march—over 1 million people filed last week, forbes (aug. 20, 2020), https://www.forbes .com/sites/jackkelly/2020/08/20/jobless-claims-574-million-americans-have-sought-unemployment-benefitssince-mid-marchover-1-million-people-filed-last-week/?sh=58da4a7a6d59 [https://perma.cc/4rcu-7rty]. 105 recovery rebate credits and economic impact payments, irs (feb. 17, 2021), https://www.irs.gov/coronavirus/economic-impact-payments [perma.cc/bmz2-p8pu]. about:blank 2021] the case for overwithholding federal income tax 2 furthermore, as tens of millions of americans navigated fluctuating employment statuses, under this policy workers who took on multiple jobs would not have had to navigate complex tax planning or worry about under-withholding, leading to large future tax bills. perhaps most importantly, the irs would not be in the position of pushing americans further into debt just as they are least able to pay new tax obligations. the tax redistribution gap eric baudry* abstract the tax revenue gap—the difference between how much the irs collects in tax revenue and how much it should collect based on the text of the internal revenue code— is both well-defined and well-studied. but raising revenue is just one purpose of taxation; the tax code also operates to redistribute wealth. drawing from the tax revenue gap and redistribution literatures, this article coins a parallel concept, the tax redistribution gap, to map the extent to which the tax system falls short of its redistributive goals. introducing a tax redistribution gap measure challenges background assumptions in current tax discourse: first, it would call out a reliance on pre-market income as a distributive baseline, which serves to overstate the redistributive impact of the tax code; second, it would increase the profile of redistribution among policymakers and the public— understandably, measures like the tax revenue gap and tax expenditure budgets focus dialogue on tax evasion and over-spending by the government. ultimately, the tax redistribution gap would provide a single measure that displays how we are falling short of a key task of the state (redistribution). and by understanding and comparing the component ways our current tax systems falls short of it intended outcomes, we can better tailor redistributive policy solutions. * faculty fellow, university of michigan law school. i thank anne alstott, reuven avi-yonah, william eskridge, ari glogower, jacob goldin, richard kaplan, ariel jurow kleiman, robert lawless, the faculties of the university of illinois and university of michigan law schools, and the attendees of the 2024 michigan law junior faculty forum for their helpful comments and insightful feedback. thanks also to the staff of the columbia journal of tax law for their excellent editorial work. 2025] the tax redistribution gap 87 i. introduction ................................................................................................ 88 ii. irs tax measures ........................................................................................ 89 a. the tax revenue gap ............................................................................... 91 1. tax revenue gap form ....................................................................... 92 2. measuring the tax revenue gap ......................................................... 93 3. tax revenue gap functions ................................................................ 94 b. the absence of a tax redistribution gap ................................................ 96 1. shortcomings of distributive analysis ................................................ 97 2. understanding redistributive avoidance ............................................ 98 3. finding space for a tax redistribution gap measure ...................... 100 ii. building the tax redistribution gap measure .................................... 104 a. what is redistribution? ........................................................................... 104 1. redistributive subjects ...................................................................... 105 2. redistributive mechanisms and goods ............................................. 105 3. redistributive baselines .................................................................... 107 b. defining redistributive taxation ............................................................ 109 1. direct transfers ................................................................................. 109 2. differential contributions ................................................................. 111 iii. implementing the tax redistribution gap measure ........................... 114 a. the eitc ................................................................................................. 115 b. the implementation gap ......................................................................... 117 1. nonparticipation ................................................................................ 117 2. underclaiming ................................................................................... 119 3. underreceiving .................................................................................. 120 iv. closing the tax redistribution gap ...................................................... 124 a. nonparticipation gap .............................................................................. 125 b. underclaiming gap ................................................................................. 127 c. underreceiving gap ................................................................................ 127 vi. conclusion .................................................................................................. 129 88 columbia journal of tax law [vol. 16:2 i. introduction why do we tax? the constitution lays out congress’ power “to lay and collect taxes . . . to pay the debts and provide for the common defence and general welfare of the united states,”1 and the 16th amendment specifically establishes congress’ ability to collect taxes “on incomes, from whatever source derived[.]”2 this language squarely frames income taxation’s revenue raising purpose; unsurprisingly, the irs measures the taxes it receives each year.3 but modern tax scholars recognize that taxation’s functions go beyond raising funds: taxes also operate as both a redistributive tool for “reducing the unequal distribution of income and wealth that results from the normal operation of a market-based economy” and a regulatory lever by which the government can “steer private sector activity in . . . [desired] directions.”4 as with total revenue raised, several government agencies measure the distributive impact of the tax code.5 these baseline measures seem to put revenue and redistribution on equal footing. but government attention to revenues goes beyond gross receipts. in 1964, the irs began to study not just how much it raised in taxes, but also how much it should have received under the tax code as written—we call the difference between these figures the tax gap.6 as one former commissioner of the irs wrote in 1979, this secondary measure reflects both that “[k]nowledge about overall compliance is important for the efficient administration of the tax laws” and that “there has also been general public interest in this problem.”7 while government agencies do measure the distributive impact of the tax code, what is missing from this analysis is a scorecard for taxation’s redistributive function—specifically, is the tax code creating as much redistribution as is built into its design? 1 u.s. const. art. i, § 8, cl. 1. 2 u.s. const. amend. xvi. 3 for fiscal year 2023, the irs processed 271.5 million tax returns and collected almost $4.7 trillion in gross tax revenue. internal revenue serv., soi tax states – irs data book, https://www.irs.gov/statistics/soi-tax-stats-irs-data-book (aug. 22, 2024) [https://perma.cc/4np2ed6v]. 4 reuven avi-yonah, the three goals of taxation, 60 tax l. rev. 1, 3 (2006). avi-yonah distinguishes between taxation’s purposes in another way: he has argued that only tax provisions that primarily seek to raise revenue should be subject to the taxing clause. reuven avi-yonah & yoseph edry, constitutional review of federal tax legislation, 1 ill. l. rev. 1, 3-4 (2023). by contrast, tax provisions effectuating redistribution “are inherently political, and thus, their distributive function of reducing inequality should not be subject to judicial review.” id. 5 see revenue estimating, joint comm. on tax’n, https://www.jct.gov/operations/revenueestimating/ [https://perma.cc/ff8v-p7ma]; trends in the distribution of household income from 1979 to 2020, cong. budget off. (nov. 14, 2023), https://www.cbo.gov/publication/59510 [https://perma.cc/97yc-6yxl]; office of tax analysis, u.s. dep’t of the treasury, https://home.treasury.gov/policy-issues/tax-policy/office-of-tax-analysis [https://perma.cc/c2v3k5su]. 6 daniel hemel et al., the tax gap’s many shades of gray 6 (u. chic. coase-sandor inst. for l. & econ., working paper no. 938, 2021). this article will refer to the concept as the tax revenue gap. 7 internal revenue serv., dep’t of the treasury, publ’n 1104, estimates of income unreported on individual income tax returns ii (1979). https://www.irs.gov/statistics/soi-tax-stats-irs-data-book https://www.jct.gov/operations/revenue-estimating/ https://www.jct.gov/operations/revenue-estimating/ https://www.cbo.gov/publication/59510 https://home.treasury.gov/policy-issues/tax-policy/office-of-tax-analysis 2025] the tax redistribution gap 89 in this article, we will examine tax measurements: what the irs measures when it comes to taxes, what it does not, and why it matters. part i highlights the disparity between respective measures for two of taxation’s core purposes: revenueraising and redistribution. it studies the form and impact of the tax revenue gap and concludes by exploring why redistribution does not receive the same attention. part ii draws from writings on redistribution and the tax revenue gap to coin the latter’s conceptual mirror image, the tax redistribution gap. it first defines redistribution and redistributive taxation to establish a clear object of study; next, it builds a framework for a tax redistribution gap consisting of three parts— nonparticipation, underclaiming, and underreceiving gaps. together, these components offer a new measure by which the irs can assess the extent to which the tax system falls short of its redistributive goals. part iii applies the framework developed in part ii to sketch how we might calculate the tax redistribution gap. the nonparticipation gap occurs when eligible taxpayers fail to file for the refundable credits; the underclaiming gap results from taxpayers who claim credits but do not claim the full amount to which they are entitled; and the underreceiving gap is caused by legal processes that result in otherwise eligible taxpayers losing their credit refunds. finally, part iv establishes the conceptual utility of a tax redistribution gap measure. introducing a tax redistribution gap can challenge normative assumptions and priorities embedded in the tax code; it can also help shape social and political discourse by raising the profile of redistribution within government and society. but perhaps most importantly, a tax redistribution gap would offer an easy-tounderstand measure that reflects how we are falling short with respect to a key task of the state. ii. irs tax measures measurement matters, or so the idiom goes.8 contemporary culture ripples with calls to measure: business blogs counsel adopting measurable targets under acronymic frameworks like smart and okr;9 the popular book and subsequent movie moneyball tells the story of how oakland athletics general manager billy beane revolutionized baseball strategy through the use of “sabermetrics”—or sports analytics—to identify diamond players in the rough;10 a decade and a half 8 some attribute the sentiment to 16th century mathematician rheticus, who professed that if we can measure something, we can exercise control over it. see matthew cornell, what’s your feed reading speed? (july 30, 2007), http://www.matthewcornell.org/blog/2007/7/30/whats-your-feedreading-speed.html#1 [https://perma.cc/9hts-4z36] (citing geography matters! (doreen massey & john allen eds., 2010)). others point to 19th century scientist lord kelvin as having said that “when you can measure what you are speaking about, and express it in numbers, you know something about it.” id. (citing han t.m. van der zee, measuring the value of information technology (2001)). 9 see leon ho, 5 reasons why it is important for goals to be measurable, lifehack (aug. 10, 2023), https://www.lifehack.org/884896/why-is-it-important-that-goals-be-measurable [https://perma.cc/6g7h-5r64]; execution is everything, what matters, www.whatmatters.com [https://perma.cc/t25e-322p]. 10 see michael lewis, moneyball: the art of winning an unfair game (2003). http://www.matthewcornell.org/blog/2007/7/30/whats-your-feed-reading-speed.html#1 http://www.matthewcornell.org/blog/2007/7/30/whats-your-feed-reading-speed.html#1 https://www.lifehack.org/884896/why-is-it-important-that-goals-be-measurable http://www.whatmatters.com/ 90 columbia journal of tax law [vol. 16:2 after fitbit revolutionized the pedometer, wrist adornments that measure our steps have largely replaced traditional watches.11 the impulse to measure and track is not without support. business professor bill tayler contends that “[h]umans are hardwired to respond to what is being measured because if it’s being measured, it feels like it matters.”12 the rise of fitbit offers one data point: the act of wearing a pedometer, even if the user did not look at it, increased daily step counts.13 hybrid car owners experienced a similar phenomenon when their dashboards began displaying fuel efficiency, triggering subtle incentives to adjust their driving in order to keep the number up.14 psychology calls this the hawthorne effect: the phenomenon that awareness of a measurement alone causes an increase in performance with respect to the measure.15 the power of measurement to motivate change also extends to government. take poverty: in 1963, food economist mollie orshansky developed a new measure of poverty levels for the social security administration based on family size; in 1965, the office of economic opportunity, the government lead for president johnson’s newly declared war on poverty, adopted orshansky’s poverty thresholds; and in 1969, orshanky’s calculations became the government’s first official statistical definition—what we now call the official poverty measure.16 while modern debates rage on the long-term success of anti-poverty efforts,17 national poverty rates fell significantly during the first years of the war on poverty, from 15.6% in 1965 to 11.9% in 1972.18 but there is a flipside to fixating too much on what we measure, which is that we can remain unaware or lose sight of that which we do not. business leaders 11 see camille gonzalez, how fitbit made the pedometer cool (again?), medium (aug. 21, 2018), https://medium.com/@camillegonzalez/how-fitbit-made-the-pedometer-cool-again-f8da4c03a6a4 [https://perma.cc/8txx-hmwe]. 12 christie allen, wearing a pedometer—even if you don’t look at it—may boost step counts, byu marriott sch. of bus. fac. rsch. (oct. 28, 2022) https://marriott.byu.edu/stories/facultyresearch/wearing-a-pedometer-even-if-you-dont-look-at-it-may-boost-step-counts [https://perma.cc/sg3c-mahx]. 13 william tayler et al., the effect of wearable activity monitor presence on step counts, 46(4) amer. j. health behav. 347 (2022). 14 see michael rosenwald, for hybrid drivers, every trip is a race for fuel efficiency, wash. post (may 26, 2008). energy scholar sarah darby explained that “[o]nce you start making fuel consumption more visible, you have something that comes to the forefront of people's minds instead of lurking in the background.” id. 15 see jim mccambridge et al., systematic review of the hawthorne effect: new concepts are needed to study research participation effects, 67 j. clinical epidemiology 267, 267 (2014). 16 gordon fisher, remembering mollie orshansky—the developer of the poverty thresholds, 68(3) soc. sec. bull. (dec., 2008), https://www.ssa.gov/policy/docs/ssb/v68n3/v68n3p79.html [perma.cc/28dy-5fc7]. 17 compare matthew desmond, why poverty persists in america, n.y. times mag. (apr. 3, 2023), https://www.nytimes.com/2023/03/09/magazine/poverty-by-america-matthew-desmond.html with dylan matthews, why even brilliant scholars misunderstand poverty in america, vox, (mar. 10, 2023) https://www.vox.com/future-perfect/2023/3/10/23632910/poverty-official-supplementalrelative-absolute-measure-desmond [https://perma.cc/c6cd-7xy4]. 18 see robert haveman et al., the war on poverty: measurement, trends, and policy, 34(3) j. pol’y analysis & mgmt. 593, 600 (2015). https://medium.com/@camillegonzalez/how-fitbit-made-the-pedometer-cool-again-f8da4c03a6a4 https://marriott.byu.edu/stories/faculty-research/wearing-a-pedometer-even-if-you-dont-look-at-it-may-boost-step-counts https://marriott.byu.edu/stories/faculty-research/wearing-a-pedometer-even-if-you-dont-look-at-it-may-boost-step-counts https://www.ssa.gov/policy/docs/ssb/v68n3/v68n3p79.html https://www.nytimes.com/2023/03/09/magazine/poverty-by-america-matthew-desmond.html https://www.vox.com/future-perfect/2023/3/10/23632910/poverty-official-supplemental-relative-absolute-measure-desmond https://www.vox.com/future-perfect/2023/3/10/23632910/poverty-official-supplemental-relative-absolute-measure-desmond 2025] the tax redistribution gap 91 call this “measurement myopia.”19 this nearsightedness can also show up in government programs. since the launch of the oft-maligned no child left behind program, the emphasis on test scores in american education has resulted in a decline in other aspects of teaching and learning. public schools across the country have slashed music and arts programs to leave more time for reading, writing, and math;20 research suggests that schools that improve standardized test scores do not simultaneously see student improvement in cognitive skills like processing speed, working memory capacity, and fluid reasoning.21 work by the new economics foundation sums up this tension by restating our original idiom: “measurement matters. it matters because it both reflects and reproduces the priorities of government. ultimately, it determines where public resources are allocated and therefore what goals will be pursued.”22 given that measurements can both spur progress and result in tunnel vision, politicians, policymakers, advocates, and citizens should want to know what the government is measuring. the rest of this part looks at irs measures with respect to revenue and redistribution; specifically, it examines the form and function of the tax revenue gap to shine a lot on the corresponding absence of a tax redistribution gap. a. the tax revenue gap the tax revenue gap, simply defined, is “the difference between tax revenues collected and those that would be theoretically expected to be collected in the absence of any evasion or late payment.”23 our tax code as written stands to raise a particular amount in revenue—for tax year 2021, taxpayers owed an estimated $4.57 trillion dollars.24 but when the irs totaled its tax receipts, taxpayers had only paid approximately $3.88 trillion.25 the difference—about $688 billion, or 15% of expected tax revenues—makes up the “gross tax [revenue] gap,” i.e. “the difference between the aggregate tax liability imposed by law for a given tax year and the amount of tax that taxpayers pay voluntarily and timely for that year.”26 of course, some taxpayers voluntarily pay their liabilities late, and irs enforcement efforts recoup an additional sum. these amounts reduce the gross tax revenue gap to result in the “net tax [revenue] gap.”27 for 2021, the irs estimated 19 paul zak, measurement myopia, the drucker inst. (jul. 4, 2013), https://drucker.institute/thedx/measurement-myopia/ [https://perma.cc/h6x5-tphl]. 20 mark aleynick et al., fitting the arts into today’s public education system, rutgers univ. comm. repository, 2 (2012). 21 see amy finn et al., cognitive skills, student achievement tests, and schools, 25(3) psych. sci. 736, 742 (2014). [changed phsychol. to physch. per t6] 22 eilís lawlor et al., new economics found., seven principles for measuring what matters: a guide to effective public policy-making 2 (2009). 23 norman gemmell & john hasseldine, the tax gap: a methodological review, 20 advances in tax’n 203, 204 (2013). 24 melanie krause et al., irs research, applied analytics & statistics, federal tax compliance research: tax gap projections for tax years 2020 & 2021 8 (oct. 2023). 25 id. 26 james m. bickley, cong. rsch. serv., rl33882, tax gap and tax enforcement 1 (feb. 16, 2007). 27 id. https://drucker.institute/thedx/measurement-myopia/ 92 columbia journal of tax law [vol. 16:2 that an extra $63 billion per year would come in through late payments and irs enforcement, making the net tax revenue gap $625 billion.28 over the two and a half decades following the introduction of the tax revenue gap measure in 1964, the irs issued three additional studies—in 1979, 1983, and 1988—estimating its magnitude.29 policy recommendations to address the tax revenue gap quickly followed: in a march 1988 report to the senate budget committee, general government division associate director jennie stathis noted that “irs’ estimates show the tax [revenue] gap remains substantial” and “[o]ur recommended improvements to several irs enforcement programs should enable irs to better identify unreported income and collect more taxes.”30 similarly, law review articles on the tax revenue gap appeared as early as 1989.31 the american bar association devoted resources to addressing the tax revenue gap with a july 1987 report.32 today, the irs dedicates a webpage and numerous publications to information about the tax revenue gap, including annual projections and backwardlooking estimates.33 the tax revenue gap is also subject to contemporary political attention—for example, president biden aimed to reduce the gross tax gap by 10% over the next decade as part of his 2021 american families plan tax compliance agenda.34 similarly, the idea regularly makes headlines in major newspapers.35 1. tax revenue gap form what makes up the tax revenue gap? the irs slices it in two ways, by type of tax and type of noncompliance. the total tax liability comes from the five 28 krause et al., supra note 24. these numbers mean that any reduction in the tax revenue gap would have a large impact: in 2019, the government accountability office noted that “a 1 percent reduction of the 2008-2010 average annual net tax [revenue] gap . . . could fund about 82 percent of irs’s enforcement budget.” see james r. mctigue, jr., u.s. gov’t accountability off., gao19-558t, tax gap: multiple strategies are needed to reduce noncompliance 2 (may 9, 2019). 29 gross income tax gap estimates: hearing before the s. budget comm. to discuss estimates by the internal revenue service of the size, scope, and composition of the income tax gap, 100th cong. 88-22 (1988) (statement of jennie s. stathis, associate director, general government division). 30 id. at 2. 31 tom weiksnar & todd van valkenburg, attacking the tax gap, 6 akron tax j. 165, 166 (1989) (“the tax [revenue] gap should be more than a passing statement. it should be a major issue to the american people.”). 32 id. 33 irs: the tax gap, internal revenue serv., https://www.irs.gov/statistics/irs-the-tax-gap (last updated oct. 10, 2024) [https://perma.cc/c5hh-65ff]. 34 u.s. dep’t of the treasury, the american families plan tax compliance agenda 13 (2021). 35 see ashlea ebeling, americans failed to pay a record $688 billion in taxes. the irs says that will change, wall st. j. (oct. 12, 2023), https://www.wsj.com/personal-finance/taxes/americansfailed-to-pay-a-record-688-billion-in-taxes-the-irs-says-that-will-change-631ce518; see also alan rappeport, tax cheats cost the u.s. $1 trillion per year, i.r.s. chief says., n.y. times (apr. 13, 2021), https://www.nytimes.com/2021/04/13/business/irs-tax-gap.html; lawrence summers & natasha sarin, the irs is leaving billions on the table. here’s how it can collect that money., wash. post (june 22, 2020), https://www.washingtonpost.com/opinions/2020/06/22/how-irs-could-fixtax-gap/. https://www.irs.gov/statistics/irs-the-tax-gap https://www.wsj.com/personal-finance/taxes/americans-failed-to-pay-a-record-688-billion-in-taxes-the-irs-says-that-will-change-631ce518 https://www.wsj.com/personal-finance/taxes/americans-failed-to-pay-a-record-688-billion-in-taxes-the-irs-says-that-will-change-631ce518 https://www.washingtonpost.com/opinions/2020/06/22/how-irs-could-fix-tax-gap/ https://www.washingtonpost.com/opinions/2020/06/22/how-irs-could-fix-tax-gap/ 2025] the tax redistribution gap 93 component taxes enforced by the irs: the individual income tax, corporate income tax, employment tax, estate tax, and excise taxes.36 in turn, the irs breaks down noncompliance for each tax into three categories: nonfiling (cases in which a taxpayer does not file a return at all), underreporting (when a taxpayer files a return but understates their tax liability), and underpayment (representing cases where a taxpayer files an accurate return but does not pay their entire liability).37 (the tax revenue gap does not include missing tax revenues from unlawful acts, whether because the government would rather eliminate than tax illegal economic activities or because estimating such lost revenue would be an impossible task.)38 of these pieces, underreporting comprises the largest portion of the overall gap—80%—with individual income tax underreporting making up the majority of that slice (56%).39 (for tax year 2021, $396 billion of the total $688 billion gross tax revenue gap resulted from individual underreporting.40) within individual income tax underreporting, sole proprietor underreporting—that is, understatement of tax liability by individuals who own an unincorporated business—presents the most significant problem: gao data estimates that 57% of sole proprietor income is misreported, compared to only 1% of wages and 18% of capital gains.41 broken down by filers, the gao found that 30% of sole proprietors misreported gross business receipts, and just over three-quarters (76%) misreported business expenses.42 the irs attributes $80 billion of the gross tax revenue gap to sole proprietor income.43 2. measuring the tax revenue gap the irs derived early tax revenue gap estimates using the taxpayer compliance measurement program, through which irs agents performed “line-byline examinations of several different types of tax returns” in order to generate estimated underpayments across a variety of tax categories.44 in the 1990s, congress objected to the irs method due to “the high cost to the irs and the compliance burden placed on taxpayers who were selected.”45 rather than abandon the enterprise of measuring the tax revenue gap, the irs introduced the national research program. by only directly auditing items that could not be independently verified, the irs sought to minimize the burden to taxpayers.46 36 krause et al., supra note 24, at 13. 37 id. at 9. 38 mark mazur & alan plumley, understanding the tax gap, 60 nat. tax j. 569 (2007). 39 u.s. gov’t accountability off., gao 23-106448, tax gap: modest reductions in the gap could yield large fiscal benefits 1 (2023). 40 krause et al., supra note 24, at 10. 41 u.s. gov’t accountability off., gao 24-105281, sole proprietor compliance: treasury and irs have opportunities to reduce the tax gap 21 (2023). 42 id. at 22. 43 id. at 1. 44 bickley, supra note 26, at 1. 45 id. 46 id. at 2. 94 columbia journal of tax law [vol. 16:2 daniel hemel et al. explain the tax revenue gap measurement method in more detail.47 the national research program relies on individual irs examiners detecting underreporting and underpayments in individual returns. examiners auditing similar tax issues with the same propensity for underreporting identify varying levels of tax noncompliance; the irs assumes that the most “successful” examiners are also the most accurate, and it scales underreporting identified by less successful examiners to that level through a process called “detection controlled estimation.”48 one study of the nrp and dce estimates that dce adjustments triple the amount of suspected underreporting.49 using this new method, the irs most recently generated tax revenue gap estimates in 2023 for tax years 2020 and 2021.50 as noted above, the gross tax revenue gap for tax year 2021 is $688 billion, a $87 billion increase over tax year 2020’s $601 billion gap.51 indeed, the tax revenue gap is growing in absolute value over time—in 2016, the irs estimated a gross tax revenue gap of $458 billion per year for tax years 2008 to 2010, while a 2022 study estimated an annual gap of $496 billion for 2014 to 2016.52 but the tax revenue gap remains stable in relative terms, at approximately 15% of the total estimated tax burden.53 3. tax revenue gap functions why does the tax revenue gap matter? its relative components can tell us about breakdowns in the tax process. for example, the prevalence of sole proprietor underreporting demonstrates a primary root of the tax revenue gap: information asymmetry between taxpayers and the irs. as leandra lederman explains, “the taxpayer knows the facts regarding the relevant transactions he or she engaged in during the tax year—or at least has ready access to that information. the government is forced to obtain that information after the fact, either from the taxpayer or from third parties.”54 when the government does not have a way to access that information—as is the case with sole proprietorships—tax compliance becomes a question of taxpayer honesty and understanding tempered by the risk of an audit. unsurprisingly, compliance rates are proportionate to the level of information the government receives: taxpayers report 98.8% of income subject to 47 hemel et al., supra note 6, at 3-4. 48 id. at 7. 49 id. at 8. 50 krause et al., supra note 24, at 4. 51 id. at 7. 52 mctigue, supra note 28, at 2; u.s. gov’t accountability off., gao 24-105281, sole proprietor compliance: treasury and irs have opportunities to reduce the tax gap 1 (2023). 53 demian brady & andrew wilford, minding the gap: recommendations for assessing, addressing, and ameliorating the tax gap, national taxpayers union foundation 4 (may 17, 2024), https://www.ntu.org/foundation/detail/minding-the-gap-recommendations-forassessing-addressing-and-ameliorating-the-tax-gap [https://perma.cc/v37j-bjr3]. see also mctigue, supra note 28, at 16 (explaining that despite irs efforts to “improv[e] services to taxpayers, and enhanc[e] enforcement of the tax laws. . . the percentage at which taxpayers pay their taxes voluntarily and on time has remained relatively constant over the past three decades.”). 54 leandra lederman, reducing information gaps to reduce the tax gap: when is information reporting warranted?, 78 fordham l. rev. 1733, 1735 (2010). https://www.ntu.org/foundation/detail/minding-the-gap-recommendations-for-assessing-addressing-and-ameliorating-the-tax-gap https://www.ntu.org/foundation/detail/minding-the-gap-recommendations-for-assessing-addressing-and-ameliorating-the-tax-gap 2025] the tax redistribution gap 95 withholding (such as wages and salaries), 95.5% of income subject to third-party information reporting but not withholding (like interest and dividends), 91.4% of income subject to partial reporting (capital gains), but only 46.1% of income subject to neither reporting nor withholding.55 but information asymmetry is not the sole cause of the tax revenue gap. the gao reports that reduced audit rates, low levels of taxpayer service, the complexity of the tax code, and opportunities to create tax shelters also contribute to missing revenue.56 the relationship between the magnitude of these factors and the pieces of the tax revenue gap can offer policymakers nuanced information about the overall efficiency of the tax system. our understanding of these intersecting causes has been consistent since initial tax revenue gap studies. summarizing the 1987 american bar association report, weiksnar and van valkenberg noted the primacy of information reporting: recognizing that “[t]he opportunity to underreport exists when the irs asks a taxpayer to supply information or record imputed transactions, like depreciation,” they concluded that “[i]ncreased third-party reporting is the most promising method available to increase compliance.”57 they also recognized other contributing factors, including negative public opinion towards taxes, frequent tax reform leading to public misunderstanding, and overall complexity of the tax code.58 importantly, achieving a particular tax revenue gap is an imperfect policy goal because tax revenue gap empirics will always be imprecise—they are based on noncompliance, which is both difficult to observe and subject to ambiguity given the complexity of the tax code.59 moreover, the lag time between a given year and irs analysis of that year’s tax revenue gap means that “the tax [revenue] gap will reflect tax policy and administration from several years in the past.”60 but the value of tax revenue gap analysis is not in a perfectly calculated number—achieving one would be impossible, leading some commentators to argue that “[t]he tax [revenue] gap should not be a performance target.”61 instead, understanding the tax revenue gap’s scale is enough understand its harms.62 overall, the tax revenue gap harms equity, trust, and efficiency. it harms equity because tax noncompliance affects compliant taxpayers: “noncompliance can create an unfair competitive advantage among businesses because those that do not pay tax debts are avoiding costs that tax-compliant businesses are incurring.”63 this creates real unfairness that undermines both horizontal and vertical equity 55 id. at 1738. 56 u.s. gov’t accountability off., supra note 39, at 2-3. 57 weiksnar & van valkenburg, supra note 31, at 173. 58 id. at 174. 59 hemel et al., supra note 6, at 5. 60 id. at 25. 61 id. at 4. 62 neil warren, estimating tax gap is everything to an informed response to the digital era, unsw business school taxation and business law, 10 (apr. 5, 2018), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3200838 [https://perma.cc/h7sl-jemj] (writing that the tax gap “is not just about establishing a single number or range of estimates of tax gap—[i]t is about understanding the nature, drivers and incidence of non-compliance behavior as reflected in tax gap estimates, which can help guide the best responses to improve compliance.”). 63 mctigue, supra note 28, at 8. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3200838 96 columbia journal of tax law [vol. 16:2 (taxpayers with equal incomes will pay different amounts in tax, while some taxpayers with more income will pay relatively less).64 by consequence, the tax revenue gap erodes public trust in the tax system.65 and, as logue and vettori explain, it also creates economic inefficiency: “people and resources will tend to move into the areas of the economy and forms of organization with respect to which noncompliance is easiest and thus taxes are lowest.”66 these harms implicate a broad range of stakeholders: from the treasury (focused on tax policy design); to the irs (focused on tax enforcement); to taxpayers and voters (concerned with tax fairness); to politicians (concerned with good government); to statisticians (concerned with data reliability).67 the harms also dictate possible solutions: responding to the asymmetry of information between sole proprietors and the government, logue and vettori propose implementing a presumptive tax, under which small business owners would be required to report gross receipts but instead of allowing business expense deductions, the irs would impute expenses via “presumed profit percentages based on historical average profit ratios within the taxpayer’s line of business.”68 addressing the underreporting that results from the use of either unskilled or corrupt tax preparers, the gao counsels congress to provide the “irs with the authority to regulate paid tax return preparers.”69 given the attention the tax revenue gap receives, it is worth exploring why we do not study or discuss the parallel slippages in implementation of our redistributive provisions. b. the absence of a tax redistribution gap as noted above, taxation’s redistributive function receives some degree of government study. as part of its broader study of household income distributions, the congressional budget office estimates the distributive impact of the tax code as a whole, with calculations going back to 1979.70 similarly, the treasury department’s office of tax analysis calculates the distributive impact of both federal taxes and proposed changes to tax law.71 and upon request from members of congress, the joint committee on taxation will analyze the distributional effects of proposed tax amendments.72 private entities also monitor distribution: like the joint committee on taxation, the tax policy center issues distributional analyses 64 kyle d. logue & gustavo g. vettori, narrowing the tax gap through presumptive taxation, 2 colum. j. tax l. 100, 113 (2011). 65 mctigue, supra note 28, at 8. 66 logue & vettori, supra note 64, at 114. 67 warren, supra note 62, at 27. 68 logue & vettori, supra note 64, at 129. 69 mctigue, supra note 28, at 18. 70 in 1975, michael graetz bemoaned that scholarly advances in the study of distributive impact of taxation had “not been combined to evaluate distributional consequences of changes in the personal income tax.” michael j. graetz, assessing the distributional effects of income tax revision: some lessons from incidence analysis, 4 j. legal stud. 351, 351 (1975). 71 office of tax analysis, u.s. dep’t of the treasury, https://home.treasury.gov/policyissues/tax-policy/office-of-tax-analysis [https://perma.cc/5l6j-u8ym]. 72 revenue estimating, joint comm. on tax’n, https://www.jct.gov/operations/revenueestimating/ [https://perma.cc/ff8v-p7ma]. https://home.treasury.gov/policy-issues/tax-policy/office-of-tax-analysis https://home.treasury.gov/policy-issues/tax-policy/office-of-tax-analysis https://www.jct.gov/operations/revenue-estimating/ https://www.jct.gov/operations/revenue-estimating/ 2025] the tax redistribution gap 97 of tax reforms, and in 1995, the american enterprise institute released a 300-page report on distributional analysis of tax policy.73 1. shortcomings of distributive analysis with respect to redistribution, each of these distributive measures suffers from both a definitional and a completeness problem. as ari glogower explains, each metric uses “market” income as a baseline against which it measures distribution by comparing changes to income caused by government taxes and spending.74 (for example, according to the congressional budget office, in 2009 the federal tax system lowered societal inequality compared to pre-tax levels by about 8.5%.75) murphy and nagel explain that the idea of a “pre-tax” distribution is oxymoronic: “private property is a legal convention, defined in part by the tax system; therefore, the tax system cannot be evaluated by looking at its impact on private property, conceived as something that has independent existence and validity.”76 without the societal systems and structures created by government because of tax revenues, none of us would have the capacity to earn an income. (hobbes wrote that our lives in such circumstances would be “solitary, poore, nasty, brutish, and short.”77) simply comparing preand post-tax market income erases the portion of an individual’s tax burden that equals the suite of public goods they consume, or, in other words, the indirect benefits they receive from government spending. consider a two-person society consisting of a and b, in which person a has a market income of 10,000 a year and person b 2,000. a pays 3,000 in taxation, while b receives 200 in tax credits. distributional analysis would conclude that the tax system has a net distributional impact of 3,200—a lost 3,000 vis-à-vis their market income and b gained 200. but this analysis ignores that the government uses its net 2,800 in tax revenue to fund public goods that both a and b consume. assume that a benefits the equivalent of 2,400 from public goods and b 600. then, a has only lost 600 from the entire tax and spending scheme, while b has gained 800, for a net redistributive swing of 1,400.78 this redistributive picture looks very different from the distributive effects of the same system: measuring redistribution 73 measuring the distribution of tax changes, tax pol’y ctr., https://www.taxpolicycenter.org/resources/measuring-distribution-tax-changes [https://perma.cc/qm2a-wmwe]; david e. bradford, am. enter. inst., distributional analysis of tax policy, (1995). 74 ari glogower, a basic needs baseline for distributional analysis, 48 byu l. rev. 1697, 170304 (2023). 75 david kamin, reducing poverty, not inequality: what changes in the tax system can achieve, 66 tax l. rev. 593, 595 (2013). 76 liam murphy & thomas nagel, the myth of ownership 8 (1st ed. 2002). glogower describes the critique another way: a distributional study seeking to evaluate the net distributional effects of government policies necessarily begins with a baseline of antecedent market income that already reflects the effects of government policies. glogower, supra note 74, at 1739-40. 77 thomas hobbes, leviathan, ch. xiii (st. paul’s churchyard, andrew crooke 1651), https://www.gutenberg.org/files/3207/3207-h/3207-h.htm [https://perma.cc/b8uz-vvve]. 78 law and economics scholars disagree over the proper proxy for aggregate benefits received from public goods. see infra part iii.a.3. https://www.taxpolicycenter.org/resources/measuring-distribution-tax-changes 98 columbia journal of tax law [vol. 16:2 without taking into account the benefits provided by public goods would be to significantly overstate the redistribution provided by the wealthy. even correcting for this definitional error, none of the above studies combine prospective and retrospective analysis to tell us whether a particular reform or the system as a whole moved the needle as much as it should have. when we measure the distributive impact of the tax system as a whole, we should also measure the potential impact of the tax system as written to learn the ways in which our implementation falls short of our actual policy. when we project the impact of a proposed tax reform, we should follow up with studies of its real-world impact to assess whether the reform achieved its projected goals. without both pieces, we are only getting half the story. 2. understanding redistributive avoidance despite redistribution being a core function of taxation, it may be that there is no collective appetite for redistribution discourse beyond distributive analysis. distributive analysis simply measures the impact of the tax system as it exists; explicitly measuring redistribution would forefront the government’s role in tackling inequality through taxation. we explore two possible explanations for why the government might shy away from doing so: either the public does not want redistribution and government follows suit in policy and priorities, or the government deprioritizes redistribution and public opinion follows. the standard intuition, under what is known as “the workhorse political economy model,” is that public demand for redistribution increases as inequality increases in society. but real-world surveys show the opposite: as inequality has increased in the united states, public support for the idea that the government should use taxation to reduce income differences has remained flat or declined slightly.79 jonathan hopkin offers one explanation rooted in the political system of the united states.80 unlike many other oecd countries which allow for proportional representation across multiple parties, the u.s. two-party system forces voters to make a binary choice. a median voter who might benefit from redistribution from the wealthy may still vote against a leftist party for fear that progressive policies would focus redistributive gains amongst the poor, leaving middle-class taxpayers with a higher tax burden.81 alesina et al. describe another based on the psychology of the united states population. according to their research, american taxpayers over-believe in the potential for class mobility relative to its actual likelihood (and their optimism is notably high in states where actual mobility is relatively low).82 this disparity could lead taxpayers to reject government redistribution due to an inflated sense of their own economic potential. 79 vivekian ashok et al., support for redistribution in an age of rising inequality: new stylized facts and some tentative explanations, 2015 brookings papers on econ. activity 367, 367. 80 jonathan hopkin, the politics of tax justice in democracies: redistribution beyond the median voter theorem, 2 lse pub. pol'y rev. 4 (2022). 81 id. at 5. 82 alberto alesina, et al., intergenerational mobility and preferences for redistribution, 108 am. econ. rev. 521, 522-23 (2018). 2025] the tax redistribution gap 99 stefanie stantcheva sees less of a tension between growing inequality and american views towards redistribution. her survey work shows that “[t]rust in government (or lack thereof) . . . seems to be a critical element in driving support for redistribution.”83 although 70% of her survey respondents reported believing that “money and wealth in the u.s. should be more evenly distributed,” almost 90% agreed with the statement that “politicians in washington work to enrich themselves and their largest campaign contributors, instead of working for the benefit of the majority of citizens.”84 public opposition may be less against redistribution and more against government as its chief implementer. under any of these explanations, voters might reject strong redistribution by the government, and politicians and policymakers might respond by deprioritizing it. hopkin describes this as the “dominant view” in political science theory, under which “voter preferences” are the key “drivers of change.”85 on the other hand, politicians and policymakers may be driving redistributive inertia. political science research shows that public opinion can follow policy changes—known as the “leadership effect”—as opposed to viceversa.86 politicians may have reasons for deprioritizing redistribution apart from voter preference, with the result that nothing catalyzes change in popular support for redistributive policies. first, redistribution is exceptionally polarized. the 70% of survey respondents who believed that wealth should be more evenly distributed in the united states are split across partisan lines, with 92% of democrats and 42% of republicans agreeing.87 (when asked if inequality was a serious or very serious issue, 69% of democrats but only 25% of republicans agreed.)88 politicians seeking to ride the middle may be hesitant to center a divisive issue. still, a majority of stantcheva’s respondents agreed that inequality is too high; a second explanation for the leadership effect may be that popular opinion is underrepresented in policymaking. hopkin explains that as politics has become dominated by party elites, the influence of the wealthy over party platforms has surged.89 the sway of the wealthy could operate as a dampening effect on redistributive policy and discourse. a third reason for a lack of government attention to tax-based redistribution separate from public opinion is that the combination of taxation and progressive social policy can feel like a misnomer. german political scientist florian fastenrath explains that left wing parties tend to focus on spending policy to carry out their 83 stefanie stantcheva, why people vote against redistributive policies that would benefit them, mit press reader (nov. 20, 2021), https://thereader.mitpress.mit.edu/why-do-we-not-supportredistribution/ [https://perma.cc/69d4-2ctc]. 84 stefanie stantcheva, understanding tax policy: how do people reason? 136 q. j. of econ. 2309, 2345 (2021). 85 hopkin, supra note 80, at 10. 86 kathleen m. mcgraw et al., “what they say or what they do?” the impact of elite explanation and policy outcomes on public opinion, 39 amer. j. pol. sci. 53, 68 (1995). see also florian fastenrath et al., why is it so difficult to tax the rich? evidence from german policy-makers, 29(5) j. eur. pub. pol’y 767, 769 (2022). 87 stantcheva, supra note 84, at 2346. 88 id. 89 hopkin, supra note 80, at 10-11. https://thereader.mitpress.mit.edu/why-do-we-not-support-redistribution/ https://thereader.mitpress.mit.edu/why-do-we-not-support-redistribution/ 100 columbia journal of tax law [vol. 16:2 policy visions, leaving the nuts and bolts of tax policy to deemed experts.90 this can further inflate the wealth effect on politics, as lobbyist groups for corporations and the wealthy can take narrative control of tax policy.91 3. finding space for a tax redistribution gap measure despite potential public or political reticence to frontline redistribution, the lack of a tax redistribution gap measure is odd for at least two reasons. first, primary theories of distributive justice agree on the importance of redistribution in a well-functioning society. 92 utilitarians, who believe “that the morally right action is the action that produces the most good,”93 arrive at a redistributive mandate from the concept of diminishing marginal utility, which concludes that “the poorest households, those in abject poverty, will derive much greater utility from an additional $1 of income compared to better-off households, even those that are only slightly better off.”94 egalitarianism places special concern on the most marginalized in society, and in particular on the difference in resources afforded to those people vis-a-vis their better-off peers; the core intuition that “an unequal distribution of resources is inherently suspect” brings the theory to a redistributive mandate even more straightforwardly than utilitarianism.95 and while libertarianism on its face appears to accept the justness of market distributions, 96 libertarian theorists often call for a minimal social safety net in order to reduce the risk of “unjustified encroachment” towards private property.97 (indeed, this reasoning infiltrated conservative politics in the 1960’s, with economist milton friedman advocating for a negative income tax and president nixon incorporating it into his family assistance plan.98) if redistribution is part of any distributive justice mandate, it should follow that a government deploying redistribution should want to know whether its policies are operating efficiently and maximally. 90 fastenrath et al., supra note 86, at 768, 772. 91 id. at 774. 92 broadly, contemporary theories of distributive justice fall into three primary categories: utilitarianism, egalitarianism, and libertarianism. see, e.g. joseph bankman & thomas griffith, social welfare and the rate structure: a new look at progressive taxation, 75 cal. l. rev. 1905, 1915-16 (1987) (describing the difference between entitlement and welfarist theories of justice). 93 julia driver, the history of utilitarianism, stanford encyclopedia of philosophy (edward zalta & uri nodelman eds., 2014), https://plato.stanford.edu/entries/utilitarianism-history/ [https://perma.cc/p9k9-hg8m]. 94 ariel jurow kleiman, low-end regressivity, 72 tax l. rev. 101, 131 (2018). see, e.g., sarah b. lawsky, on the edge: declining marginal utility and tax policy, 95 minn. l. rev. 904 (2011). 95 kleiman, id. at 110. 96 julian lamont and christi favor, distributive justice, stanford encyclopedia of philosophy (edward zalta ed., 2017), at https://plato.stanford.edu/entries/justice-distributive/. 97 daniel hemel & miranda perry fleischer, atlas nods: the libertarian case for a basic income, 2017 wis. l. rev 1189, 1210 (2017) (citing eric mack, non-absolute rights and libertarian taxation, 23 soc. phil. & pol’y 109, 125, 140 (2006)). hemel and miranda fleischer push libertarian redistribution further by arguing that it is necessary to justify market outcomes in the first instance. id. at 1219. 98 id. at 1198. https://plato.stanford.edu/entries/utilitarianism-history/ https://plato.stanford.edu/entries/justice-distributive/ 2025] the tax redistribution gap 101 second, and unsurprisingly given the first, the tax code already deploys significant amounts of redistribution, both through direct cash transfers and through its progressive curve.99 as blum and kalven, jr. point out, “[t]here are not so many methods of accomplishing peaceful redistribution.”100 for many economists and legal scholars asking how a government interested in pursuing rich-to-poor distribution might utilize its power to do so, the answer is simple: taxation. welfare economics theory places redistribution squarely in the realm of tax, with other laws organized around principles of efficiency.101 this is because taxation’s inherent relationship to distribution gives it an edge over other potential methods for redistribution. louis kaplow and steven shavell provide the primary analysis: “[u]sing legal rules to redistribute income distorts work incentives fully as much as the income tax system—because the distortion is caused by the redistribution itself—and also creates inefficiencies in the activities regulated by the legal rules.”102 based on this concept of “double-distortion,” they suggest that every non-tax redistributive is dominated by a parallel tax scheme: “[e]ven though the income tax distorts work incentives, any regime with an inefficient legal rule can be replaced by a regime with an efficient legal rule and a modified income tax system designed so that every person is made better off.”103 kaplow and shavell also note an additional reason why tax is superior to other legal regimes for effectuating redistribution: “[t]he income tax system (including transfer programs) can redistribute from all the rich to all the poor, whereas legal rules have substantially less redistributive potential.”104 this is for two reasons: first, non-tax legal rules seeking to redistribute will result in contracted 99 see infra part ii.b. 100 walter blum & harry kalven, jr., the uneasy case for progressive taxation, 19 u. chi. l. rev. 415, 487 (1952). 101 edward mccaffery & jonathan baron, the political psychology of redistribution, 52 ucla l. rev. 1745 (2005) (primarily citing work by kaplow and shavell). see also jeremy bearer-friend et al., taxation and law and political economy, 83 ohio st. l.j. 472, 479 (2022); kyle logue & ronen avraham, redistribution optimally: of tax rules, legal rules, and insurance, 56 tax l. rev. 157, 158 (2003) (making “the safe bet that a majority of legal economists hold the following view: whatever amount of redistribution is deemed appropriate or desirable, the exclusive policy tool for redistributing to reduce income or wealth inequality should always be the tax-and-transfer system.”). 102 louis kaplow & steven shavell, why the legal system is less efficient than the income tax in redistributing income, 23 j. legal stud. 667, 667-68 (1994). 103 id. at 669 (emphasis omitted). kaplow and shavell’s double-distortion argument has not been immune to scholarly critique. matthew dimick traces a number of responses to their analysis, including those of christine jolls and chris sanchirico. matthew dimick, the law and economics of redistribution, 15 ann. rev. l. & soc. sci. 559, 568-73 (2019). christine jolls applies behavioral economics insights—namely, that humans respond differently to known tax burdens than to uncertain events through which legal rules might redistribute—to complicate the comparison of distortion from taxes and legal rules. id. at 568-69. (citing christine jolls, behavioral economics analysis of redistributive legal rules, 51 vand. l. rev. 1653, 1658-63 (1998)). chris sanchirico rejected kaplow and shavell’s simplifying assumption that humans are homogenous in their precaution-taking strategies, concluding that legal rules that tie damages to income can theoretically work to improve overall welfare. id. at 569-70 (citing chris william sanchirico, taxes versus legal rules as instruments for equity: a more equitable view, 29 j. legal stud., 797 (2000)). but as dimick concludes, “[t]hese responses appear to have had only limited success in challenging the argument’s sturdy reputation.” dimick, id. at 560. 104 kaplow & shavell, supra note 102, at 674. 102 columbia journal of tax law [vol. 16:2 parties adjusting the price of transactions to reflect cost of legal rules, thereby capturing or circumventing the redistributive aims of the law; and second, redistribution through legal rules is limited to those who become parties to lawsuits.105 zach liscow further explains that taxation brings an efficiency advantage over redistributive alternatives because cash redistribution promotes the autonomy of redistributive recipients and minimizes the burden on the rich from whom redistribution is extracted.106 the primacy of redistributive taxation makes sense given tax’s function and history. as murphy and nagel explain, taxation is the primary vehicle through which the government determines “how the social product is shared out among different individuals, both in the form of private property and in the form of publicly provided benefits.”107 that is, the government sets both the tax rates—which determines “how much of a society’s resources will come under the control of government”—and how to spend the resulting revenue “in accordance with some collective decision procedure.”108 these two pieces primarily dictate levels of societal redistribution. indeed, blum and kalven, jr., in their canonical analysis of progressive taxation, connect this role to taxation’s inherent redistributive potential.109 despite questioning many of the common justifications for progressive tax schemes, they note that taxation has the undisputed ability to redress inequality: “however uncertain other aspects of progression may be, there is one thing about it that is certain. a progressive tax on income necessarily operates to lessen the inequalities in the distribution of that income.”110 still, there is nuance to be had. despite the strong arguments in favor of taxbased redistribution, logue and avraham leave space for redistribution to occur outside of taxation under specific conditions. while they conclude that “[i]ncome redistribution may be best accomplished primarily through the tax-and-transfer system (with some possible room for a supplementary lump sum tort tax),” they argue that “there are nonincome measures of inequality with respect to which the legal system should play an essential redistributive role.”111 liscow agrees: he writes that “features other than income are often desirable bases for redistributing income, and legal rules may be institutionally better equipped than taxes—or the only option—to redistribute based on such non-income features.”112 but the recognition that taxation need not be the exclusive site for governmental redistribution does not lessen the claim that it serves as its primary site. avi-yonah adds historical context to the above structural point by locating redistributive intent in the earliest u.s. income tax schemes. tracing the post-civil 105 id. at 674-75. 106 zachary liscow, redistribution for realists, 107 iowa l. rev. 495, 506 (2022). 107 murphy & nagel, supra note 76, at 76. 108 id. 109 blum & kalven, supra note 100, at 486-88. 110 id. at 486. 111 logue & avraham, supra note 101, at 169. they point to insurance as one such alternative redistributive site, noting that a “nondiscrimination rule” in health insurance coverage might be the most efficient way to redistribute with respect to inequality of lifetime health costs flowing from differences in genetic makeup. id. at 226. 112 zachary liscow, reducing inequality on the cheap: when legal rule design should incorporate equity as well as efficiency, 123 yale l. j. 2478, 2482 (2014). 2025] the tax redistribution gap 103 war shifts from a mostly agrarian society to “one dominated by large industrial corporations,” he explains that “lawmakers of both parties” found existing tax regimes—consisting of federal consumption taxes and state property taxes— insufficient to combat “a sharp rise in inequality.”113 the result was a “focused and sustained effort to enact a federal income tax on both individuals and corporations, as well as an estate tax,” ultimately resulting in the 16th amendment and the foundation for the income tax scheme most familiar to americans today.114 although the early income tax applied to only a fraction of the population (the national archives reports that less than one percent of the population had income tax liability in 1913115), avi-yonah emphasizes that “a primary goal of the income tax historically was seen as redistributing wealth from the rich to everyone else.”116 anne alstott and ben novick find another data point of redistributive tax policy beginning in 1924, when the government kept taxation high after world war i in part to provide benefits to veterans. they write, “the financial cost of the war itself and the nation’s lingering obligations to veterans kept the federal government’s revenue needs higher than otherwise and helped build taxing capacity that would be critical to thirties and forties efforts to build the welfare state and to finance the second world war.”117 particularly interesting is that these moves towards redistribution come despite the historical tendency, noted by blum and kalven, jr., “of separating progression from equalitarianism and soft-peddling its redistributive effects, [which] probably served an important function in keeping progression a respectable idea in our society.”118 it seems intuitive that a government would want to know whether its redistributive tools are having the intended effect. indeed, the tax revenue gap framework invites the parallel concept of a tax redistribution gap. a 2011 statement by the gao director of strategic tax issues invokes redistribution in passing: [i]n 2001 taxpayers underreported $6.3 billion in net income due to misreported individual retirement arrangement (ira distributions). but taxpayers also may underclaim benefits to which they are entitled. . . . [o]f tax filers who appeared to be eligible for a higher-education tax credit or tuition deduction in tax year 2005, about 19 percent . . . failed to claim any of them.119 australian tax scholar neil warren proposes tax redistribution gap analysis more directly: “there is no reason why tax [revenue] gap studies cannot be expanded beyond taxes by a revenue administration if it was also administering negative taxes 113 avi-yonah, supra note 4, at 11. 114 id. 115 16th amendment to the u.s. constitution: federal income tax (1913), national archives: milestone documents, https://www.archives.gov/milestone-documents/16th-amendment [https://perma.cc/u8r9-ug62]. 116 avi-yonah, supra note 4, at 12. 117 anne alstott and ben novick, war, taxes, and income redistribution in the twenties, 59 tax l. rev. 373, 438 (2006). 118 blum & kalven, supra note 100, at 486-87. 119 u.s. gov’t accountability off., gao-11-747t tax gap: complexity and taxpayer compliance 1 (2011). https://www.archives.gov/milestone-documents/16th-amendment 104 columbia journal of tax law [vol. 16:2 (such as tax credits and subsidies) or social (income-contingent) transfer programs.”120 with a tax redistribution gap measure, the irs would not be introducing new redistribution—it would instead be evaluating current policy. that alone could exempt introduction of the measure from public opinion or political concerns around redistribution. nor is the irs a stranger to new tax measures. before the 1960’s, the irs did not measure the tax revenue gap; that figure is now an enshrined piece of tax policy analysis. similarly, stanley surrey coined the concept of tax expenditures—a tax provisions that carve out from the tax base economic activity that would otherwise fall under accepted concepts of net income— in the 1960’s121; by 1974, congress required the president’s annual budget to include an account of all tax expenditures in the code.122 if the irs or another federal agency were to introduce a tax redistribution gap measure, how would it do so? the next two parts of this article seek to answer that question. ii. building the tax redistribution gap measure in this second section, we start to build a framework under which the irs might begin to measure the tax redistribution gap measure. we begin by defining redistribution. a. what is redistribution? to measure something, we must first define it, and so we start with theory: what does it mean to redistribute? colloquially, we think of robin hood, stealing from the sherwood forest rich to provide for the less fortunate.123 but robin hood’s antics are a kind of private redistribution, by which the people take the allocation of resources into their own hands to correct perceived injustices flowing from government action. here, we are concerned with redistribution that results from, and not in response to, governmental decisions. while redistribution by government—that is, state-sanctioned, legal reapportionment of resources— operates differently than renegade takings, both forms get at the issues at the heart of this article: “what constitutes a just society, what citizens owe to each other, and what limitations on liberty are acceptable.”124 philosopher christian barry defines four parameters indicative of governmental redistribution: 120 warren, supra note 62, at 5. 121 stanley s. surrey, the united states income tax system—the need for a full accounting, in tax policy and tax reform: 1961–1969, 573 (william f. hellmuth & oliver oldman eds., 1973). 122 stanley s. surrey & paul r. mcdaniel, tax expenditures 31 (1985). 123 howard pyle, the merry adventures of robin hood (1883). 124 alex raskolnikov, accepting the limits of tax law and economics, 98 cornell l. rev. 523, 562 (2013). 2025] the tax redistribution gap 105 (1) the subjects, such as individual persons or rigidly and nonrigidly defined groups whose holdings of goods are modified through the redistribution; (2) the baseline, the initial distribution of goods to which some other distribution is seen as a redistributive modification; (3) the social mechanism, such as a change in tax laws, monetary policies, or tort law, that engenders the redistribution of goods among these subjects; and (4) the goods, such as income and property (or perhaps opportunities and liberties), that are redistributed through this mechanism.125 1. redistributive subjects in terms of redistributive subjects, barry’s definition is multidirectional and vast. that is, it encompasses redistribution from both rich to poor subjects and poor (or middle-class) to rich, in addition to redistribution along other lines (such as identity markers like race or gender and social groups like parents or veterans). indeed, “[v]irtually any legislation has some redistributive effect to the extent that it imposes on an individual taxpayer a personal cost in excess of the value that the taxpayer receives from the expenditure” 126 or if “a subgroup of residents receives benefits that are substantially disproportionate to the related . . . costs that the same subgroup bears.”127 in these terms, clayton gillette equates “municipal funding of a homeless shelter” to “municipal funding from general tax revenues of a public golf course frequented by a small percentage of the local population” as redistributive enterprises.128 this comparison makes clear that (nearly) everything can be redistribution. gillette argues that “[a]ttempts to provide a more precise definition of redistribution are inherently problematic,”129 but too broad of a definition threatens to swallow the concept’s usefulness. accepting the broad umbrella of redistribution, we focus in this article on just the redistribution centered in distributive justice theory: redistribution down the income spectrum.130 2. redistributive mechanisms and goods this is an article about irs measures, and so unsurprisingly we focus on taxation as our redistributive mechanism.131 this is no accident given the general 125 christian barry, redistribution, the stanford encyclopedia of philosophy (edward n. zalta ed., 2018), https://plato.stanford.edu/archives/spr2018/entries/redistribution [https://perma.cc/r78z-v6c6]. 126 clayton p. gillette, local redistribution and local democracy 53-54 (2011). 127 id. at 57. 128 id. at 54. 129 id. 130 indeed, redistribution in tax-policy terms takes on the colloquial meaning—that from rich to poor. see, e.g., kaplow & shavell, supra note 102, at 667. 131 while tax-based redistribution is coined “direct” redistribution, governments can also impact the distribution of welfare across society through “indirect” redistribution such as regulating the provision of goods and services (for example, minimum wage laws or anti-discrimination provisions). emiliano huet-vaughn, minimum wages and voting: assessing the https://plato.stanford.edu/archives/spr2018/entries/redistribution 106 columbia journal of tax law [vol. 16:2 consensus that taxation is the government’s most efficient redistributive tool. accordingly, the salient “good” is money. but there is one additional gloss to add before we move on: why limit our analysis to federal tax redistribution? the answer is relatively uncontroversial. citing a litany of economists, bahl et al. write that central governments should bear responsibility for redistribution because 1. the benefits of redistribution are not limited to the geographic boundaries of states and localities and 2. redistribution at a lower level of government can be compromised by inand out-migration of people seeking to benefit from or escape redistributive taxation.132 in 2018, stephen calabrese et al. substantiated this intuition by modeling the relationship between taxation and majority rule at the local and federal level.133 as preface, they quote 20th century american economist george stigler, who argued that “redistribution is intrinsically a national policy” because “if 99 communities tax the rich to aid the poor, the rich may congregate in the hundredth community, so this uncooperative community sets the tune.”134 richard musgrave reiterated the point: “policies to adjust the distribution of income among individuals must be conducted on a nationwide basis. . . . regional differentiation leads to severe locational inefficiencies. moreover, regional measures are self-defeating, as the rich will leave and the poor will move to the more egalitarian-minded jurisdictions.”135 calabrese et al.’s model confirmed stigler and musgrave’s intuition but on slightly different grounds.136 they concluded that local taxes for redistribution do not arise in part because the difference between the median and mean income of local communities tends to be small, such that it is difficult for voting blocks of poorer constituents to move for significant redistribution.137 out-migration to escape redistribution is unnecessary because redistribution is unlikely to arise in the first instance.138 consistent with this analysis, the overwhelming effect of state taxation is regressive. the institute on taxation and economic policy recently released its 7th edition of a 50-state survey of state tax schemes.139 despite a post-covid trend of political returns to redistribution outside the tax system 1 (iza – inst. lab. econ., discussion paper no. 16416, 2023). 132 roy bahl et al., fiscal research center report no. 49: state and local government choices in fiscal redistribution 1 (ga. st. univ. andrew young sch. pol’y stud. 2000). 133 stephen calabrese et al., majority choice of taxation and redistribution in a federation, 217 j. pub. econ. 104782 (2023). 134 id. at 2 n.7. 135 id. 136 id. at 2. 137 id. 138 id. 139 inst. on tax’n and econ. pol’y, who pays? a distributional analysis of the tax systems in all 50 states (7th ed. 2024). 2025] the tax redistribution gap 107 states strengthening refundable tax credits,140 the report concludes that forty-four states’ tax systems exacerbate income inequality.141 focusing on federal taxation as the government’s primary tool to affect the redistribution of resources across the population, the final definitional question becomes against what baseline, other than pre-market income, ought we measure redistribution? 3. redistributive baselines applying his definitional framing to the tax-and-transfer system, barry writes that to know whether redistributive taxation has occurred, we must identify: (1) the extent of the benefits enjoyed by different people within a social system (or the costs that they have imposed on others); (2) the costs of providing these benefits or averting imposed costs; and (3) the contribution of each person to the provision of social benefits and compensation for costs imposed. redistributive tax-and-transfer occurs whenever people have paid taxes that are above and beyond what is required to cover the costs of the public benefits that they have received and the costs they have imposed on others.142 baked into this definition is the concept of a redistributional baseline as the point at which someone’s tax liability exactly equals the net value they receive from the suite of public goods funded by general tax revenues.143 jim hines, addressing redistribution from an economic rather than philosophical lens, arrives at the same baseline. he writes that when taxes are set to equal the value individuals receive from public goods, “[a]ny deviations [from this baseline] . . . can then be interpreted as net redistributions due to the fiscal system inclusive of both taxes and expenditures.”144 while using relative benefits to determine the shape of a tax scheme has fallen out of favor,145 it can still provide a benchmark for measuring redistribution. but as blum and kalven, jr. wrote in the early 1950’s, “the difficulties of isolating and measuring particular benefits are for the most part insurmountable.”146 140 samantha waxman, record number of states create or improve eitcs to respond to covid19, ctr. on budget & pol’y priorities blog (aug. 11, 2021, 4:35 pm), https://www.cbpp.org/blog/record-number-of-states-create-or-improve-eitcs-to-respond-to-covid19. 141 inst. on tax’n and econ. pol’y, supra note 139, at 10. 142 barry, supra note 125, at 8. 143 of note: barry describes redistribution from the rich (whose taxes might exceed the value of public benefits received); similarly, redistributive taxation to the poor occurs when people either pay less in taxes than the benefits they receive or have a negative tax liability outright. but either calculation avoids the problems, noted earlier, of using pre-tax market income as a baseline. 144 james r. hines jr., what is benefit taxation?, 75 j. pub. econ. 483, 484 (2000). 145 see ira k. lindsay, benefits theories of tax fairness, 9 stud. in tax l. hist. 93, 98-101 (2019). 146 blum & kalven, supra note 100, at 455. 108 columbia journal of tax law [vol. 16:2 indeed, as robert scherf and matthew weinzierl note, “an individual’s benefit from-and thus willingness to pay for-public goods is private information.”147 like much of law and economics analysis, deploying a redistributive baseline requires identifying an appropriate proxy. economics supports the use of either a proportional or regressive proxy. scherf and weinzierl survey four competing models to measure relative benefits from public goods: erik lindahl’s 1919 model, which ties benefits from public goods to an individual’s marginal willingness to pay; geoffrey brennan’s from 1976, which challenges lindahl’s approach by arguing for uniform pricing of public goods; hervé moulin’s from 1987, which extends lindahl’s marginal valuation approach to calculate inframarginal valuations—that is, the sum of benefits an individual receives from all state activity; and jim hines’ at the turn of the millennium, which draws from brennan’s approach to identify the point at which individuals would be equally well off if they were to purchase public goods at a common price from the private market.148 ultimately, the models differ in how to conceptualize “benefits”—as scherf and weinzierl explain, “moulin’s approach measures benefit relative to a setting in which the public goods in question are not provided; hines’s approach measures benefit relative to a setting in which the individual’s preferred level of public goods is provided.”149 these differing definitions of benefits result in different solutions to the proxy problem: lindahl’s and moulin’s models result in a proportional tax of about 20%, while brennan’s and hines’ result in regressive taxes. we need not definitively resolve this debate here.150 for our purposes, it is enough to assume that for wealthy taxpayers, a redistributive baseline (the benefits 147 robert scherf & matthew weinzierl, understanding different approaches to benefit-based taxation 2 (nat’l bureau of econ. rsch., working paper no. 26276, 2019). 148 id. at 3-7. 149 id. at 7. 150 indeed, theoretical arguments support both potential proxies. hayek writes what barbara fried calls the “classic argument” for arriving at a proportionate tax scheme from benefits analysis: “‘[a] person who commands more of the resources of society will also gain proportionately more from what the government has contributed’ to the provision of those resources, and taxation ought to be levied in proportion to the benefits so provided.” barbara fried, the puzzling case for proportionate taxation, 2 chap. l. rev. 157, 160 (1999). fried, however, dismantles the idea of proportional taxation as an appropriate proxy for benefits from public goods. to her, hayek’s claims do not stand up to serious scrutiny because individuals do not consume proportionately more public goods as incomes increase (she cites “clean air, defense, and broadcast spectra” as collectively shared public goods), nor can we establish that the wealthy derive additional utility from public goods as opposed to “social opportunities, talents, and hard work.” id. at 166. fried concludes that tying taxation to benefits is likely to result in a regressive scheme. id. still, avi-yonah, citing graetz, articulates another theoretical justification for measuring benefits proportionately to income: “[a]ll income-generating activities depend on . . . a variety of services provided by the government,” such that “all income-generating activities can be conceived as a partnership between individuals and the government, and taxation can be justified as the government receiving its share of partnership income”—in other words, higher income should be subject to higher taxation. reuven s. avi-yonah, why tax the rich? efficiency, equity, and progressive taxation, 111 yale l.j. 1391, 1404 (2002). graetz’s framing echoes adam smith’s arguments from centuries earlier: much like nagel and murphy today, smith recognized that individuals have the capacity to earn income because they exist ‘“under the protection of the state,”’ and as such a proportional tax scheme is most appropriate. matthew weinzierl, revisiting the classical view of benefit-based taxation 2 2025] the tax redistribution gap 109 they receive from public goods) will be lower than either our tax system as written or as implemented. whether a proportional or regressive scheme best approximates benefits from public goods, the baseline will cancel out when we calculate the tax redistribution gap: that is, if total potential redistribution equals the space between the total tax burden under our tax system as written and a total benefits from public goods according to a redistributive baseline (pr = tw – rb), and actual redistribution equals the space between the actual tax burden and a redistributive baseline (ar= ti – rb), then the tax redistribution gap—the space between total potential redistribution and actual redistribution—equals the space between our tax system as written and our tax system as implemented (rg = pr – ar = (tw – rb) – (ti – rb) = tw – ti). b. defining redistributive taxation according to our working definition, redistribution occurs when an individual’s tax burden varies from the redistributive baseline of benefits they receive from public goods. despite the multiplicity of tax provisions, only two redistributive mechanisms exist: first, provisions that directly transfer money to the poor via taxation (“direct transfers”151), and second, provisions that shift the relative burden of funding public goods away from a redistributive baseline (“differential contributions”152). 1. direct transfers direct transfers are the simpler of the two in that they are easier to observe and measure. they occur when a taxpayer ends up with a negative effective tax rate—that is, when an individual taxpayer receives more money from the government than they pay in taxes such that the tax transaction between the taxpayer and the government flows in the opposite direction than usual. also referred to as “pure resource distribution,” direct transfers can “be implemented by a substantial personal tax exemption, by a negative income tax (or earned income tax credit), by wage subsidies, by family allowances, or by a sizable demogrant.”153 while much (though not most) of the federal tax code has an anti-poverty focus, most anti-poverty tax provisions do not replicate the function of a direct transfer.154 the only mechanism through which the current tax code achieves an actual cash transfer is a refundable credit—defined in lay terms by the irs as “a credit you can get as a refund even if you don't owe any tax.”155 (nat’l bureau of econ. rsch., working paper no. 20735, 2014). i plan to revisit the question of redistributive baselines in future work. 151 murphy & nagel, supra note 76, at 89. 152 id. 153 id. at 92. 154 in 2014, susannah camic tahk catalogued the extensive number of tax provisions that have been passed since the 1990s with the goal of alleviating poverty. susannah camic tahk, the tax war on poverty, 56 ariz. l. rev. 791 (2014). 155 refundable tax credits, i.r.s. (jan. 17, 2025), https://www.irs.gov/creditsdeductions/individuals/refundable-tax-credits [https://perma.cc/y4y6-hmhc]. 110 columbia journal of tax law [vol. 16:2 our tax code deploys four refundable tax credits that work as cash transfers to different degrees: the earned income tax credit, the child tax credit, the premium tax credit, and the american opportunity tax credit. as tahk explains, “[t]he eitc provides a cash subsidy to low-income families in proportion to their earned income up to a certain limit, above which the credit phases out.”156 today, the eitc represents the seventh-largest tax expenditure in the tax code, distributing an estimated $67 billion for fiscal year 2024 according to the department of the treasury.157 the child tax credit (ctc) similarly aims to support taxpayers with children. like the eitc, the ctc requires a taxpayer to have earned income and varies with number of children.158 however, the ctc is only partially refundable.159 in fiscal year 2024, ctc distributions are estimated to total $45 billion.160 passed as part of the affordable care act, the premium assistance tax credit operates to help defray the cost of marketplace health insurance.161 the credit operates to fix health insurance premiums at a percentage of a taxpayer’s income (ranging from 2% to 9.5%, with higher incomes resulting in higher percentages).162 in fiscal year 2024, distributions are estimated to reach over $66 billion.163 finally, the american opportunity tax credit (aotc) provides up to $2,500 against qualified higher education expenses.164 like the ctc, the aotc is only partially refundable (up to 40% of the credit, or $1,000).165 for fiscal year 2024, the aotc is estimated to distribute $2.6 billion.166 still, tax direct transfers do not capture the full picture of direct transfers in the united states. in addition to tax credits, both temporary assistance for needy families (tanf) and social security income provide cash support (tanf for lowincome families, and social security for low-income individuals who are aged, blind, or disabled).167 the federal government also administers several in-kind direct transfers, such as the supplemental nutrition assistance program (food 156 tahk, supra note 154, at 798. 157 office of mgmt. & budget, analytical perspectives: budget of the united states government fiscal year 2024 tbl.20–4 (2023), https://www.whitehouse.gov/wpcontent/uploads/2024/03/ap_20_tables_fy2025.xlsx [https://web.archive.org/web/20240320140215/https://www.whitehouse.gov/wpcontent/uploads/2024/03/ap_20_tables_fy2025.xlsx] [hereinafter office of mgmt. & budget, analytical perspectives]. 158 see i.r.c. § 24. 159 id. § 24(d). 160 office of mgmt. & budget, analytical perspectives, supra note 157, tbl.20–4. 161 see i.r.c. § 36b; the premium tax credit – the basics, i.r.s (sept. 13, 2024), https://www.irs.gov/affordable-care-act/individuals-and-families/the-premium-tax-credit-thebasics [https://perma.cc/7zng-cwjy]. 162 i.r.c. § 36b. 163 office of mgmt. & budget, analytical perspectives, supra note 157, tbl.20–4. 164 see i.r.c. § 25a(b). 165 i.r.c. § 25a(i). 166 office of mgmt. & budget, analytical perspectives, supra note 157, tbl.20–4. 167 ariel jurow kleiman, inequality of deservingness, 23 j. contemp. legal issues 235, 241-42 (2022). 2025] the tax redistribution gap 111 stamps), the special supplemental nutrition program for women, infants & children (wic), and medicaid.168 these programs vary in size,169 but they all do important redistributive work and could easily be included in a broader analysis of federal direct transfers. as ganz and brill explain, “if a federal program that primarily benefits low-income households is included in the tax-and-transfer system, it will make the system appear more progressive. if it is excluded, the system will appear less progressive.”170 but for our analysis, non-tax direct transfers are more appropriately considered as adjusting the redistributive baseline of low-income taxpayers. when a poor individual receives a non-tax direct transfer, the total benefits they receive from public goods increases, raising their redistributive baseline.171 as noted above, the redistributive baselines cancel out when calculating the tax redistribution gap. the size and efficiency of these non-tax programs is of course a critical piece of understanding national redistribution as a whole, but they remain conceptually distinct from our present object of study—redistribution via the tax code. 2. differential contributions differential contributions result from the fact that deviations from a benefits tax scheme result in individuals paying more or less in taxation than a proportional or regressive baseline. the shape of the tax curve and associated deductions dictate the separate price of aggregate public goods for each taxpayer: more progressive curves and fewer top-end deductions will result in high earners paying disproportionately more for public goods and, all other things being equal, lead to more redistribution.172 individuals who pay a higher average tax rate than a particular redistributive baseline can be said to have contributed to redistribution, while individuals paying 168 id. at 242. 169 in fiscal year 2022, federal and state expenditures for tanf totaled $31.3 billion. see office of family assistance, u.s. dep’t of health & hum. servs., tanf and moe spending and transfers by activity, fy 2022 (jan. 22, 2024), https://www.acf.hhs.gov/ofa/data/tanf-and-moe-spending-andtransfers-activity-fy-2022 [https://perma.cc/ufr5-bw67]. federal costs for wic totaled $6.6 billion in fiscal year 2023, while snap spending reached $112.8 billion. jordan w. jones & saied toossi, econ. rsch. serv., u.s. dep’t of agric., the food and nutrition assistance landscape: fiscal year 2023 annual report 5 tbl.1 (2024). social security and medicaid eclipse all other programs. for fiscal year 2023, social security payments totaled $1.237 trillion. office of retirement and disability policy, soc. sec. admin., summary: actuarial status of the social security trust funds (may 2024), https://www.ssa.gov/policy/trust-funds-summary.pdf [https://perma.cc/7bkm-yryr]. medicaid spending reached $1,029.8 billion in 2023. nhe fact sheet, centers for medicare and medicaid services (last modified dec. 18, 2024), https://www.cms.gov/data-research/statistics-trends-and-reports/national-health-expendituredata/nhe-fact-sheet [https://perma.cc/9bmk-9nk4]. 170 alex brill & scott ganz, progressivity, redistribution, and inequality, nat’l affs., summer 2020, at 74, 76. 171 tax direct transfers could also be conceptualized under the umbrella of differential contributions in that they push an individual’s tax liability further below the redistributive tax baseline. we separate them out because of the significant role refundable credits play in our tax scheme. 172 of course, all other things are not equal. as discussed in the next section, progressive curves come with efficiency tradeoffs given the elasticity of labor and income. 112 columbia journal of tax law [vol. 16:2 lower rates (or receiving transfers) have received redistribution. this is not to say that progressivity always equates with redistribution: splinter explains that the two concepts are distinct because while “progressivity is independent of the tax level, redistribution changes with the tax level.”173 splinter is right conceptually, but at any fixed level of tax revenue, higher progressivity will by definition result in more redistribution. unlike the number of direct transfers, the list of tax provisions affecting differential contributions is extensive—in large part due to the extreme complexity of the u.s. tax code. of course, a baseline level of differential contributions is set by our tax rates and their deviation from a regressive or proportional redistributive baseline. the united states income tax curve is—and has always been— progressive. still, “[d]espite the ambiguity of economic theory, public policy over the last three decades has steadily moved toward lower marginal tax rates on high earners.”174 as former secretary of labor robert reich noted on x, top marginal tax rates peaked at 91% in 1960 and dwindled to 35% by 2010.175 but tax rates alone do not define differential contributions; tax provisions that adjust the rate structure further adjust relative tax liabilities. in 2014, tahk catalogued the provisions that “directly subsidize low-income individuals.”176 moreover, direct transfer provisions also impact differential contributions by reducing average tax rates for low-income taxpayers even if they do not lead to a cash refund.177 as kleiman notes, citing congressional budget office analysis, “the eitc has brought average tax rates down for taxpayers in the first income quintile, and the child tax credit has done the same for those in the second, third, 173 david splinter, u.s. tax progressivity and redistribution, 73 nat. tax j. 1005, 1007 (2020). 174 n. gregory mankiw et al., optimal taxation in theory and practice, 23 j. econ. persps. 147, 154 (2009). 175 robert reich (@rbreich), x (apr. 29, 2023, 8:15 pm), https://x.com/rbreich/status/1652466548202766336 [https://perma.cc/mj86-ph6c]. most recently, the top rate increased to 39.6% in 2012, but it dropped to 37% in 2018. history of federal income tax rates: 1913 – 2024, bradford tax institute (last visited june 28, 2024), https://bradfordtaxinstitute.com/free_resources/federal-income-tax-rates.aspx [https://perma.cc/3eqn-3c7h]. 176 tahk, supra note 154, at 793. tax provisions such as personal exemptions (i.r.c. §§ 151(b); 151(d)(3)(a)), dependency exemptions (i.r.c. § 151(c)), and the standard deduction (i.r.c. § 63(c)(1)) reduce a taxpayer’s liability; if a provision pushes liability below the redistributive baseline, it creates redistribution towards that taxpayer. 177 the breakdown between direct transfers and differential contributions from refundable credits depends on the fraction of eligible claimants who do not have tax liabilities. for fiscal year 2024, eitc outlays are estimated at $67 billion, whereas revenue lost (that is, total eitc credits reducing tax liability but not resulting in a refund for the taxpayer) is estimated at only $3 billion. office of tax analysis, u.s. dep’t of the treasury, tax expenditures fy2025 25 tbl.1, 37 tbl.5 (2024), https://home.treasury.gov/system/files/131/tax-expenditures-fy2025.pdf [https://perma.cc/e4z5-bus4]. the eitc therefore primarily redistributes through direct transfers as opposed to differential contributions. by contrast, the ctc resulted in foregone tax revenue of almost $64 billion and outlays of $45 billion, making it a provision that predominately results in a differential contribution. id. the refundable premium tax credit is more similar to the eitc—it is estimated to distribute almost $67 billion but will lead to revenue losses of only $15 billion. id. the aotc is grouped with the lifetime learning credit, a nonrefundable credit. like the ctc, these credits result primarily in differential contributions; together, they are estimated to result in $2.5 billion in outlays and $14 billion in foregone tax revenue. id. 2025] the tax redistribution gap 113 and fourth income quintiles.”178 each of these policies push differential contributions towards redistribution. conversely, the many income tax expenditures targeted towards the higher ends of the income spectrum, such as deductions for charitable contributions and mortgage interest expenditures, steer in the opposite direction. the treasury department estimates the deductibility of mortgage interest on owner-occupied homes, i.r.c. § 25, to be the sixth most costly tax expenditure over the next decade.179 scholars regularly criticize the mortgage interest deduction as regressive.180 focusing on the individual income tax alone provides an incomplete picture of differential contributions. we have a multi-faceted tax system, with separate tax curves for capital gains, corporate income, and payroll taxes. the impact of these different taxes on redistribution is defined in part by their incidence: the standard intuition is that the corporate income tax is imposed on the corporate entity itself; the incidence of capital gains taxes is mixed, with the congressional budget office and joint committee on taxation assuming “that capital bears three-fourths of the economic burden and workers bear one-fourth;” and the economic consensus is that payroll taxes fall entirely on workers, “regardless of where the statutory burden is imposed.”181 the preferential tax rate for capital gains in particular lowers differential contributions from the wealthy; a 2019 survey by the tax policy center concluded that the top 20% of income earners in the united states held 92% of realized capital gains.182 ultimately, differential contributions result from the composite of all tax rates and the many tax expenditures that adjust them; the composite of direct transfers and differential contributions sets the overall level of redistribution that results from the tax system.183 indeed, scholarly literature disagrees as to whether progressive rates alone correlate with redistribution. one camp contends that 178 kleiman, supra note 94, at 112 (citing cong. budget off., pub. no. 53597, the distribution of household income, 2014 25 (2018); cong. budget off., pub. no. 51361, the distribution of household income and federal taxes, 2013 20 (2016)). 179 office of tax analysis, u.s. dep’t of the treasury, tax expenditures fy2025 30-32, tbl.2b (2024), https://home.treasury.gov/system/files/131/tax-expenditures-fy2025.pdf [https://perma.cc/j927-ece6]. 180 see, e.g., andrew hanson, ike brannon & zackary hawley, rethinking tax benefits for homeowners, nat’l affs., spring 2014, at 40, 41. 181 brill & ganz, supra note 170, at 75. 182 chuck marr, ctr. on budget & pol’y priorities, propublica shows how little the wealthiest pay in taxes: policymakers should respond accordingly 9 (2021), https://www.cbpp.org/sites/default/files/7-15-21tax.pdf [https://perma.cc/l5w2-5ml3]. 183 tahk notes a third category of tax provisions with redistributive potential: “‘indirect’ policies that create incentives for third parties to fulfill certain needs of the poor.” tahk, supra note 154, at 793. see, e.g., i.r.c. § 42, the low-income housing tax credit, which rewards developers for building low-income housing; i.r.c. § 45d, the new market tax credit, which encourages investment in low-income communities; and i.r.c. §§ 51 and 1396, the work opportunity and empowerment zone employment credits, which reward employers for hiring marginalized workers. but the net redistributive impact of these credits is hazy: they indirectly increase the share of goods (housing, economic investment, and jobs) available to low-income individuals, but they directly create a financial boon for developers, investors, and employers. i save redistributive analysis of these provisions for future work. 114 columbia journal of tax law [vol. 16:2 “countries that redistribute more have less progressive tax structures.”184 another concludes “there is a negative relationship between inequality and tax progressivity, and a positive relationship between tax progressivity and redistribution.”185 despite this disagreement, there is data showing that the u.s. tax system is progressive overall. in 2020, david splinter, a member of the congressional joint committee on taxation, compiled six measures of federal tax rates, each of which showed considerable progressivity.186 splinter further found the tax system, as measured by the kakwani index,187 had become more progressive overtime: “between 1979 and 2016, . . . the kakwani index of tax progressivity increased by 46%. since 1986, tax progressivity has more than doubled.”188 the tax system is also redistributive. splinter analyzed congressional budget office data to conclude that in 2016, taxes and transfers “more than quadruple[d] the market income of the bottom quintile,” whereas “[h]igher-income groups receive[d] fewer transfers relative to market income.”189 while splinter uses market income as a redistributive baseline (and therefore likely overstates redistribution relative to a benefits baseline), he still shows an increase in redistribution over time: “between 1979 and 2016, . . . the [reynolds-smolensky] index of tax-and-transfer redistribution increased 59 percent. . . . since 1986, it increased 66 percent.”190 splinter succinctly explains that overall progressivity and redistribution do not follow declining top marginal tax rates because only “a small share of tax returns has been subject to top rates.”191 with these pieces in place, we can now illustrate the function of a tax redistribution gap by the identifying key slippages in the implementation of redistributive taxation. iii. implementing the tax redistribution gap measure to know whether a system is working as intended, we need to know both the system’s current results and its intended outcomes. estimates of the tax revenue gap compare two figures: total taxes paid and total taxes owed. similarly, the tax redistribution gap can be calculated by comparing the total redistribution created under the current system to the maximum redistribution contemplated by statute. to do so, we break total redistribution created into its component parts. 184 pablo beramendi et al., progressive taxation and redistribution 4 (nat’l rsch. found. of korea, 2020) (working paper), https://danielstegmueller.com/papers/beramendidimickstegmueller2020.pdf, [https://perma.cc/a3xw-yst9] (emphasis omitted). 185 id. at 23. 186 splinter, supra note 173, at 1008 (mapping progressivity according to six different estimates of average federal tax rates). 187 the kakwani index is the difference between the distribution of income across the population, demarcated by the lorenz curve, and the distribution of the tax burden across the population, demarcated by a concentration curve. 188 splinter, supra note 173, at 1005. 189 id. at 1016 (emphasis omitted). 190 id. at 1018. 191 id. at 1020. 2025] the tax redistribution gap 115 measuring total direct transfers from taxation is as simple as aggregating total irs outlays from refundable credits. while measuring differential contributions according to our definition is more difficult than totaling direct transfers, we have the tools to do so. as noted above, the treasury department releases annual distribution tables showing the relative impact on the federal tax system by income decile. economists could similarly calculate the proportional or regressive tax rate (according to moulin’s or hines’ work, respectively) needed to generate the same revenue levels as the current system, model the resulting tax system, and compare the results to the treasury reports.192 the more challenging task is to ascertain how much the tax system as written could redistribute. the existence of the tax revenue gap makes clear that some redistribution is left on the table come tax time. according to analysis by the national bureau of economic research, tax evasion is concentrated at the top of the income scale: “under-reported income as a fraction of true income (i.e., income that should legally be reported on tax returns) rises from about 10% in the bottom 90% of the income distribution to 16% in the top 1%.”193 this suggests that the tax revenue gap significantly decreases redistributive differential contributions by lowering average tax rates paid by the wealthy. closing the tax revenue gap would increase the progressivity of the tax system and increase redistribution; distributional analysis akin to that issued by the department of treasury could quantify roughly by how much. while that calculation could help approximate missing differential contributions, tax revenue gap estimates provide a roadmap for measuring missing direct transfers. to construct the tax revenue gap, the irs estimates total tax liability via the national research program by aggregating missing revenue from a sample of tax returns. warren describes this method as a “bottom-up” approach, by which a revenue administration uses “operational data and available 3rd party data at the taxpayer level which allows summing across the population of taxpayers to obtain national aggregates.”194 the same approach can be used to model the tax redistribution gap from direct transfers. using the eitc as an example, the rest of this section will explore the resulting contours of the tax redistribution gap for direct transfers. a. the eitc after president nixon’s family assistance plan failed to garner enough political support, the earned income tax credit (eitc) emerged as a proposal to minimize the impact of payroll taxes on low-income workers.195 the challenge for its designers was to offset social security payments and support working families while still promoting work. as democratic senator russell long, the credit’s original champion, explained on the senate floor, the eitc came out of a search 192 such a model might or might not incorporate shifts in income-earning behavior caused by the difference in rates between a baseline and the progressive reality. 193 john guyton et al., tax evasion at the top of the income distribution: theory and evidence 4, (nat’l bureau of econ. rsch., working paper no. 28542, 2023). 194 warren, supra note 62, at 13. 195 see 118 cong. rec. 33010 (1972). 116 columbia journal of tax law [vol. 16:2 “[t]o find a dignified way to provide help to a low-income working person, whereby the more he works the more he gets, and at the same time to phase it out in such a way as not to decrease the incentive to work.”196 other scholars aptly trace the credit’s subsequent political history and steady growth197—this article will not retread old ground. the earned income tax credit, codified in i.r.c. § 32, does exactly what its name describes: it provides a tax benefit to workers in proportion to their earned income.198 the credit phases as a percentage of earned income until it reaches a statutory maximum, which fluctuates with the number of qualifying children the taxpayer has.199 (for tax year 2025, households with three or more children can earn a maximum credit of $8,046; two children correlate with a maximum credit of $7,152; one with $4,328; and childless households can receive a maximum of $649.200) as goldin explains, up until this point, “the eitc induces negative marginal tax rates, with tax liability declining with each additional dollar earned.”201 once a taxpayer’s income reaches a set phaseout amount, the amount of credit declines at the statutory phaseout percentage.202 (married households do not receive greater credits; instead, they have higher phaseout amounts.203) the recipients of eitc redistribution today are the same as at its inception: low-income workers (predominantly those with children). for tax year 2020, approximately 16% of taxpayers filing individual income tax returns claimed the eitc.204 commentators recognize the eitc as “the federal government’s largest anti-poverty program.”205 bird-pollan describes it as “a powerful tool in the u.s. government’s redistributive program” and “one of the largest wealth transfer programs currently operating in the united states.”206 perhaps unsurprisingly given the scope of the credit, there is much political and scholarly focus on eitc overpayments207—that is to say, instances in which a taxpayer or household claims and receives redistributive credit to which they are not entitled. that focus is not without foundation: the tax foundation notes that eitc overpayments have increased in recent years (in parallel with overpayments 196 id. at 33011. 197 see, e.g., jennifer bird-pollan, who's afraid of redistribution an analysis of the earned income tax credit, 74 mo. l. rev. 251 (2009); dennis j. ventry, jr., the collision of tax and welfare politics: the political history of the earned income tax credit, 1969-99, 53 nat’l tax j. 983 (2000). 198 see i.r.c. § 32. 199 margot crandall-hollick et al., cong. rsch. serv., r43805, the earned income tax credit (eitc): how it works and who receives it (2023). 200 rev. proc. 2024-40, 2024-45 i.r.b. 1100. 201 jacob goldin, tax benefit complexity and take-up: lessons from the earned income tax credit, 72 tax l. rev. 59, 64 (2018). 202 crandall-hollick et al., supra note 199, at 5. 203 id. at 5-6. 204 id. at 24. 205 tahk, supra note 154, at 794. 206 bird-pollan, supra note 197, at 254, 283. 207 see 2 taxpayer advocate service, 2018 annual report to congress 93 (2018). 2025] the tax redistribution gap 117 from other refundable credits).208 in fiscal year 2022, almost one third of eitc dollars were overpayments.209 the department of the treasury reports quarterly on eitc overpayments as part of a “payment integrity scorecard.”210 but the credit’s breadth and writing on overpayments make it easy to ignore a subtler problem—people who under the terms of the statute qualify for its redistribution but do not, for one reason or another, receive it. as the taxpayer advocate service writes, “the focus on [improper payments] masks both the successes and challenges in improving eitc compliance . . . the improper payment rate does not take into account that for every dollar of eitc improper payments, 40 cents of eitc went unclaimed by taxpayers who appear to be eligible.”211 the existence of unclaimed credits does not take away from or negate the policy problem of eitc overpayments. instead, it highlights a separate policy issue: the redistribution implementation gap. b. the implementation gap each component of the tax revenue gap—nonfiling, underreporting, and underpaying—maps onto a parallel portion of the tax redistribution gap— nonparticipation, underclaiming, and underreceiving. using the eitc as an example, we explore the contours of each. 1. nonparticipation to claim the earned income tax credit, eligible taxpayers must complete two steps: first, file a tax return, and second, claim the credit. consequently, eligible taxpayers who do not file a tax return (say, because they have no tax liability for a particular tax year) or file but do not claim the credit will not receive redistribution to which they are otherwise entitled. these taxpayers make up the nonparticipation gap. the irs tracks eitc participation by state and nationally.212 to calculate rates, the irs compares census bureau data to individual tax records. more specifically, the irs models the number of eligible eitc claimants using demographic census information and matches it against the number of actual eitc claims filed.213 for tax year 2021 (the most recent year for which the irs has published its data), 80.8% of eligible taxpayers claimed the eitc.214 the number 208 scott hodge, why congress is more to blame than irs for $26 billion in refundable tax credit overpayments, tax found. (june 6, 2023), https://taxfoundation.org/blog/irs-tax-creditsoverpayments/ [https://perma.cc/sw35-ulka]. 209 id. 210 high-priority programs, paymentaccuracy, off. of mgmt. & budget, https://www.paymentaccuracy.gov/payment-accuracy-high-priority-programs/ [https://perma.cc/r5qa-9ytw] (last visited jan. 22, 2025). 211 taxpayer advocate service, supra note 207, at 91-92. 212 see eitc participation rate by states: tax years 2013 through 2020, i.r.s. https://www.eitc.irs.gov/eitc-central/participation-rate-by-state/eitc-participation-rate-by-states [https://perma.cc/55wu-nfs2] (last updated jan. 17, 2025). 213 id. 214 id. 118 columbia journal of tax law [vol. 16:2 remained quite stable over the preceding decade, never dropping below the 76.3% and never surpassing this 80.8% figure.215 detailed polling from tax year 2005 provides a more granular breakdown of eligible taxpayers who did not claim or receive the credit. taxpayers eligible for an eitc of $1–$99 (according to irs modeling) had a participation rate of just 42%, while 90% of taxpayers eligible for a credit of more than $4,000 claimed it.216 unpublished irs data on file with goldin suggests a similar nonparticipation gap with respect to total available dollars. according to his analysis, taxpayers claimed 86% of available eitc dollars in 2013.217 likewise, a report generated by the treasury inspector general for tax administration (tigta) based on 2014 census data concluded that eligible taxpayers claimed $40.3 billion in eitc credits—85% of the calculated maximum credit amount— leaving $7.3 billion in refunds unclaimed.218 compare this to the nonfiling tax revenue gap: for tax year 2021, individual taxpayers contributed $67 billion to the tax revenue gap through nonfiling. this sum represents just 2.5% of 2021’s $2.7 trillion individual income tax liability.219 by contrast, the eitc nonparticipation gap of 15% is six times as large a portion of total potential eitc dollars. (of course, underreporting is a much larger portion of the tax revenue gap, whereas the underclaiming redistribution gap is likely quite small in scale.220) still, there is a strong argument that the nonparticipation gap is insignificant relative to the scale of the program. no social welfare provision can expect 100% take-up, and other federal welfare programs, such as the supplemental nutrition assistance program (snap), the supplemental nutrition program for women, infants, and children (wic), and temporary assistance for needy families (tanf), as well as other federal redistributive credits like the child tax credit, have nonparticipation gaps.221 what contributes to this nonparticipation gap? the tax policy center suggests that factors such as absence of tax liability, lack of knowledge of eligibility, and tax complexity combine to reduce total claims.222 the irs has identified particular categories of workers who disproportionately underclaim 215 id. 216 dean plueger, earned income tax credit participation rate for tax year 2005, in recent research on tax administration and compliance: selected papers given at the 2009 irs research conference 151, 182 (2009). for the most part, participation rates increased consistently between these two poles, with the exception of a disproportionate percentage of taxpayers claiming $500–$599 credits—but that group was underrepresented in the study, which may have created “an overstated participation estimate due to sampling variability. id. 217 goldin, supra note 201, at 70. 218 off. of inspections & evaluations, treasury inspector gen. for tax admin., the internal revenue service should consider modifying the form 1040 to increase earned income tax credit participation by eligible tax filers 1-2 (2018). 219 krause et al., supra note 24, at 8. 220 see infra section iii.b.2. 221 goldin, supra note 201, at 66-67. 222 briefing book: do all people eligible for the eitc participate?, tax pol’y ctr., https://taxpolicycenter.org/briefing-book/do-all-people-eligible-eitc-participate [https://perma.cc/a69j-rgd2] (last updated jan. 2024). 2025] the tax redistribution gap 119 refundable credits: people living in rural areas, self-employed workers, individuals with disability pensions (or caring for children with disability pensions), workers without a qualifying child, non-english speakers, grandparents raising grandchildren, and workers with recent changes to their marital, parental, or employment status.223 one study explains why rural taxpayers may have lower claim rates: “professional tax preparation services are typically concentrated in poor urban neighborhoods,” and “in rural settings, many low-income families may lack the types of regular social contacts that would lead to awareness of the eitc.”224 logistical burdens are also higher; rural families face greater time and transportation costs involved with filing returns or receiving preparation assistance.225 over the two-year study of 314 rural mothers, 89–94% of respondents were eligible to claim the eitc, but only 41–58% claimed it.226 the study also affirmed that non-english speaking taxpayers are less likely to claim the eitc: in the first year of the study, participants interviewed in a language other than english were 97% less likely to claim the eitc.227 the study’s conclusions parallel the 2005 irs data showing participation increasing in proportion to credit size. focusing on income, the study found that “for every thousand dollars in earned income, the odds of eitc participation were 6% greater.”228 but even filing a tax return is not a guarantee that an eligible taxpayer will receive the eitc. according to goldin’s analysis of unpublished irs data, 8.5% of eligible filers do not attempt to claim the eitc on their returns.229 2. underclaiming where the nonparticipation gap includes taxpayers who file but do not claim the eitc, the underclaiming gap consists of taxpayers who claim the eitc but do not claim the full amount to which they are entitled. in this way, the underclaiming gap is the conceptual parallel to the underreporting tax revenue gap. goldin categorizes eitc complexity into two elements—informational complexity, representing the difficulty of obtaining the necessary information to determine a taxpayer’s eligibility and benefit amount, and computational complexity, the difficulty the taxpayer has in applying the information to actually determine credit eligibility.230 by 2015, only 2% of eitc claimants filed taxes without using some form of assisted preparation method (tax software or a free or 223 earned income tax credit & other refundable credits, i.r.s., https://www.eitc.irs.gov/ [https://perma.cc/56fe-b2g9] (last visited june 10, 2024). 224 clinton g. gudmunson et al., eitc participation and association with financial distress among rural low-income families, 59 interdisc. j. of applied fam. scis. 369, 370 (2010). 225 id. (citing donald p. hirasuna & thomas f. stinson, urban and rural differences in use of earned income credits: a study of minnesota’s working family credit, 30 int’l reg’l sci. rev. 408, 413 (2007)). 226 id. at 372, 374. 227 id. at 375. 228 id. 229 goldin, supra note 201 at 71. 230 id. at 60. 120 columbia journal of tax law [vol. 16:2 paid tax preparer).231 as goldin explains, filing assistance “dramatically reduce[s] the computational complexity associated with claiming a tax benefit,” effectively eliminating the need for taxpayers to perform their own credit calculations and therefore negating the likelihood of credit underclaiming as a result of computational complexity.232 but taxpayers must still determine and provide the relevant information in order for the tax preparation process to properly calculate credit eligibility and amount. therefore, eitc informational complexity can contribute to the underclaiming gap. goldin and kleiman argue that the eitc’s complicated childclaiming systems likely result in some number of eligible children going unclaimed, which would lower or eliminate the credit received by their caretakers.233 this has particularly significant consequences for redistribution, as “[t]he most vulnerable households are hit hardest by the exclusions and complexity that the current childclaiming rules create.”234 3. underreceiving but what about taxpayers who file a return, claim the full amount to which they are eligible, and do not receive some or all of the credit? the final third of the tax redistribution gap is the underrecieving gap—the conceptual mirror to the tax underpaying gap. this article discusses two contributors to the underreceiving gap: irs audits and bankruptcy proceedings. as the eitc grew, political concerns over noncompliance and fraud led to a dramatic increase in audits of tax returns claiming the credit.235 soon, the irs audited low-income eitc returns more frequently than higher-dollar returns: by 2004, taxpayers claiming the eitc were 1.76 times more likely to be audited than households earning more than $100,000; in 2005, 43% of individual audits targeted taxpayers who claimed the credit.236 high audit rates persisted into recent years: in the decade prior to 2022, eitc claimants have made up 20% of individual taxpayers but were the targets of 40% of individual audits.237 as noted above, these concerns were not motivated by thin air.238 but while eitc audits likely recapture some amount of overpayments, they create a hefty procedural burden and almost certainly freeze or deny refunds to eligible taxpayers. there is also a racial justice element to this irs practice. in 2023, new analysis of irs audit rates revealed that black taxpayers were audited at 2.9 to 4.7 times the 231 id. at 91. 232 id. at 92. 233 jacob goldin & ariel jurow kleiman, whose child is this? improving child-claiming rules in safety-net programs, 131 yale l. j. 1719, 1724 (2022). 234 id. at 1726. 235 see jonathan p. schneller et al., the earned income tax credit, low-income workers, and the legal aid community, 3 colum. j. tax l. 176, 187 (2012). 236 id. at 186. 237 margot l. crandall-hollick, cong. rsch. serv., in11952, audits of eitc returns: by the numbers 3 (2022). 238 see, e.g., leslie book, refund anticipation loans and the tax gap, 20 stan. l. & pol'y rev. 85, 93-94 (2009) (noting that eitc error rates between 25–35% place it above error in other parts of the tax system and well above error in other benefits programs). 2025] the tax redistribution gap 121 rate of non-black taxpayers and that 78% of the disparity was driven by disproportionate audit rates of black eitc claimants.239 eitc audits overwhelmingly occur via correspondence, a process by which the irs requests and receives information by mail.240 between fiscal years 2008 to 2016, the irs annually conducted 400,000 to 500,000 correspondence audits of returns claiming the eitc, compared to between 30,000 and 50,000 field audits.241 by fiscal year 2021, the proportion of correspondence audits increased even further: 99.8% of eitc audits closed were correspondence audits, compared to 74% of noneitc audits.242 the correspondence audit process is difficult for eitc claimants to navigate. as schneller et al. note, eitc claimants are disproportionately transient or homeless, making communication by mail challenging if not impossible.243 further, eitc claimants have lower literacy rates and more fear of the government, distrust in or lack of access to financial institutions required to prove credit eligibility, and language barriers.244 these hurdles mean that even when a taxpayer successfully receives a correspondence audit, they often cannot effectively engage with it. a 2007 taxpayer advocate service study found that more than one in four auditees did not understand from the notice that they were under audit, and approximately half did not understand what they were required to do in response.245 even taxpayers who engaged with the process faced challenges: another national taxpayer advocate study found that “more than half of audited eitc claimants reported difficulties in obtaining the requested documents, and nearly half of the same group did not understand why the documents were requested in the first place.”246 unsurprisingly, logistical and comprehension barriers translate into low success rates. less than one-third of eitc audits in fiscal year 2018 reached completion.247 43% of audited taxpayers did not respond at all to the initial audit notice, and another 26% responded but did not complete the audit process.248 these low rates are not new: in 2010, only 30% of eitc claimants who received a correspondence audit responded.249 239 hadi elzayn et al., stanford institute for economic policy research, measuring and mitigating racial disparities in tax audits 3-4 (2023). 240 schneller et al., supra note 235 at 188. 241 kathleen bryant et al., tax l. ctr. at nyu l. & ctr. for taxpayer rts., exclusionary effects of the irs correspondence audit process warrant further study 1 (2022). 242 crandall-hollick, supra note 237, at 4. 243 schneller et al., supra note 235, at 188. 244 leslie book, the irs’s eitc compliance regime: taxpayers caught in the net, 81 or. l. rev. 351, 393-405 (2002). 245 bryant et al., supra note 241, at 1 (quoting 1 taxpayer advocate service, 2018 annual report to congress 137 (2018)). 246 schneller et al., supra note 235, at 189 (citing 2 taxpayer advocate service, 2007 annual report to congress 95 (2007)). 247 crandall-hollick, supra note 237, at 5. 248 id. 249 taxpayer advocate service, irs correspondence examinations: are they really as effective as the irs thinks?, ntablog (last updated feb. 8, 2024) at 122 columbia journal of tax law [vol. 16:2 low success rates in turn reduce or remove access to the eitc, even for eligible creditors. if a taxpayer cannot complete the audit process, the irs will disallow the claimed credit “due to undelivered mail, nonresponse, or insufficient response.”250 but disallowance does not mean the taxpayer was ineligible. the 2004 national taxpayer advocate annual report recognized that many disallowed tax benefits “are actually correctly claimed.”251 in 2007, 43% of eitc claimants who requested reconsideration of an irs denial ultimately received the credit at an average of 96% of the initial claimed amount.252 as schneller et al. write, “[t]hese statistics . . . suggest that the irs's initial auditing process is only slightly more accurate than a coin toss.”253 to calculate the total amount of the underreceiving gap attributable to eitc audits, the irs could deploy a process similar to the nrp but with respect to redistribution: that is, it could measure the average amount by which irs agents improperly disallow eitc claims in the audit process and use those results to model national aggregates. but reducing eitc audits cannot on its own fully close the underreceiving gap because other legal mechanisms work to strip eitc benefits from eligible taxpayers. specifically, taxpayers entering bankruptcy can see their eitc credits applied to debts as part of the bankruptcy process. when a taxpayer files for bankruptcy, bankruptcy statutes create an estate that consists of “all legal or equitable interests of the debtor in property as of the commencement of the case” for the purpose of paying bankruptcy creditors.254 recognizing that certain federal benefits exist to support economically insecure debtors, the statute exempts from the bankruptcy estate the “debtor's right to receive . . . a social security benefit, unemployment compensation, or a local public assistance benefit.”255 this general exemption does not apply to tax refunds, nor does it name refundable credits like the eitc. consequently, it is up to the states, which can either adopt federal exemptions or enumerate their own, to provide protection for eitc amounts.256 today, most states exempt eitc refunds from the bankruptcy estate because of the eitc’s welfare-adjacent status, but not all do.257 two recent bankruptcy cases highlight the consequences for eitc recipients facing bankruptcy. https://www.taxpayeradvocate.irs.gov/news/nta-blog/ntablog-irs-correspondence-examinationsare-they-really-as-effective-as-the-irs-thinks/2012/03/ [https://perma.cc/dmu8-2klu]. 250 bryant et al., supra note 241, at 3 (quoting guyton et al., supra note 193, at 3). 251 statement of janet spragens before the irs oversight board (feb. 1, 2005), at https://www.taxnotes.com/research/federal/other-documents/testimony-other-than-irs-andtreasury/professor-calls-for-focus-on-low-income-taxpayers-before-irs/yj4c [https://perma.cc/y6ug-s8p4]. 252 schneller et al., supra note 235, at 188 (citing 1 taxpayer advocate service, 2009 annual report to congress 160 (2009)). 253 id. 254 11 u.s.c. § 541(a)(1). 255 11 u.s.c. § 522(d)(10)(a). 256 timothy m. todd, tax credits in bankruptcy, the tax adviser, jan. 2019, at 75, 76. 257 keith fogg, exempting the earned income tax credit from the bankruptcy estate, tax notes (jan. 11, 2023), https://www.taxnotes.com/procedurally-taxing/exempting-earned-income-taxcredit-bankruptcy-estate/2023/01/11/7h696 [https://perma.cc/x9hp-pkb5]. 2025] the tax redistribution gap 123 in in re moreno, the bankruptcy court for the western district of washington reviewed a claim by a bankruptcy debtor that eitc benefits were exempt from the bankruptcy estate.258 washington law as interpreted by the washington supreme court exempted public “assistance” from the bankruptcy estate.259 the bankruptcy court turned to washington law defining “public assistance” as “public aid to persons in need thereof for any cause,” including “federal aid assistance.”260 in turn, washington law defined “federal aid assistance” as including payments from “a federally administered needs-based program.”261 the question before the court was therefore whether the eitc is a needs-based program.262 the court began its analysis by reviewing treatment of the eitc by other bankruptcy courts. reviewing caselaw from idaho, minnesota, new york, and south dakota, the court noted that “courts have generally regarded the eitc to be a form of needs-based public assistance,” and that “[i]n cases where the eitc has been found nonexempt under state law, it is generally because the particular statutory scheme explicitly or implicitly gives reason to exclude the eitc.”263 the court declared that “the eitc is specifically aimed at providing monetary assistance to lower-income individuals” and “washington’s statute offers no reason to exclude the eitc or other federal tax credits.”264 the court then held that the debtor’s eitc was “protected from bankruptcy administration.”265 a ninth circuit bankruptcy appellate panel upheld the court’s holding that the eitc is a needs-based program and therefore exempt from the bankruptcy estate.266 in its decision, the court cited supreme court precedent recognizing that “[t]he earned-income credit was enacted . . . [in part] to provide relief for lowincome families hurt by rising food and energy prices.”267 in a 2022 case in which the debtor also asserted that her eitc refunds were exempt from the bankruptcy estate, the bankruptcy court for the district of new mexico reached the opposite holding.268 like the washington court, the court in in re medina recognized the “anti-poverty” purpose of the eitc.269 but the court emphasized that while many states expressly exempt the eitc from the bankruptcy estate, new mexico has not, nor does it have a general public assistance exemption.270 without a statutory hook, the court held that the eitc was not exempted from creditors’ claims.271 258 in re moreno, 629 b.r. 923 (w.d. wash. bankr. 2021). 259 wash. rev. code § 74.04.280 (1959); anthis v. copland, 270 p.3d 574 (2012) (referring to assistance protection statutes as “exemption statutes”). 260 629 b.r. at 929 (citing wash. rev. code § 74.04.005(11)). 261 id. at 930 (citing wash. rev. code § 74.04.005(8)). 262 id. 263 id. at 933. 264 id. at 934. 265 id. 266 in re moreno, no. ww-21-1124-lbs, 2021 wl 6140115 (b.a.p. 9th cir. dec. 23, 2021). 267 id. at *4 (emphasis added) (citing sorenson v. secretary of treasury, 475 u.s. 851, 864 (1986)). 268 in re medina, no. 22-10233-j7, 2022 wl 17742527 (bankr. d.n.m. dec. 16, 2022). 269 id. at *3. 270 id. at *4. 271 id. at *6. 124 columbia journal of tax law [vol. 16:2 in states like new mexico that do not exempt the eitc from the bankruptcy estate, low-income taxpayer bankruptcies contribute to the underreceiving gap by allowing redistribution to flow from the government to creditors. trustees in these states have financial incentive to pursue the eitc: 11 u.s.c. § 326(a) authorizes trustees to earn 25% of assets they administer under $5,000;272 an eitc is easy money in the sense that a trustee does not have to sell it, as they might other bankruptcy assets. this phenomenon is not just hypothetical. as one bankruptcy scholar puts it, “[e]arned-income tax credits . . . are a bit of a thing in consumer bankruptcy at the moment.”273 but without empirical study, it is impossible to compare the underreceiving gap from bankruptcy proceedings to that of irs audits or to other portions of the tax redistribution gap. these three components—the nonparticipation gap, the underclaiming gap, and the underreceiving gap—comprise the overall redistribution implementation gap with respect to the eitc. calculating the magnitude of each of these components would allow for an estimate of the overall implementation gap; adding that implementation gap to eitc payments would allow us to measure the total potential redistribution of the eitc as written and approximate the tax redistribution gap. in the final section, we further build out the tax redistribution gap’s conceptual value by mapping proposed tax reforms to their respective tax redistribution gap components. iv. closing the tax redistribution gap having used the eitc as a focal point, we now have a preliminary framework of the tax redistribution gap. for whom should it matter? warren lists the many stakeholders of tax revenue gap analysis (the treasury, the irs, taxpayers and voters, politicians, and statisticians)274—each of these stakeholders should have an interest in understanding the tax redistribution gap. a clear measure of the tax redistribution gap has both procedural and substantive value: it can highlight whether the tax system is operating as intended, and to the extent it is not, how far short it falls of its redistributive goals. to begin, we address one critique of the redistribution implementation gap: it measures an inevitability. just as it is not reasonable to expect 100% tax compliance, 100% redistribution implementation is not a feasible goal.275 still, there is value in understanding how far short of 100% compliance the current system falls and what slippages contribute to its underperformance. assuming that the tax code as written represents society’s preferred level of redistribution, slippages in implementation demonstrate overall system inefficiency, the degree of which may be more than society deems acceptable. 272 11 u.s.c. § 326(a). 273 e-mail from robert lawless, max l. rowe professor of l., univ. of ill. coll. of l., to eric baudry, mich. fac. fellow, univ. of mich. l. sch. (may 31, 2024, 12:40 p.m. est) (on file with author). 274 warren, supra note 62 at 27. 275 id. at 20. 2025] the tax redistribution gap 125 and while some amount of tax revenue gap is also inevitable, solutions abound. a 2023 government accountability office report recognized 17 proposed solutions to narrow the tax revenue gap focused on increasing education and outreach to taxpayers, adjusting the irs’ enforcement approach, and leveraging improved technology to increase government efficiency and efficacy.276 while discrete proposals to address portions of the tax redistribution gap exist, this article aggregates some of the suggested reforms to demonstrate how the concept of the tax redistribution gap allows for a more bird’s-eye view of the status quo. a. nonparticipation gap to the extent that much of the nonparticipation gap flows from a lack of taxpayer knowledge and understanding, our primary intuition might be to close the gap by increasing taxpayer education and outreach. indeed, the irs, state governments, and nonprofit organizations run extensive awareness campaigns aiming to increase eitc participation rates.277 but as noted below, evidence regarding the efficacy of taxpayer outreach is mixed at best and counsels for alternative solutions to closing the nonparticipation gap. each year, the irs sends notice letters to a group of taxpayers identified by computer filters as likely eligible for the eitc reminding them of the credits; the notices also create an alternative pathway to claiming it—if taxpayers complete and return the notice (which contains an eligibility questionnaire), irs employees can issue a refund.278 but this strategy only marginally affects overall eitc participation: in 2014, these notices prompted 175,000 taxpayers to claim the credit, increasing overall estimated taxpayer and dollar participation rates by less than one percentage point.279 a tigta report concluded that these notices “have a limited impact because they are issued to a small percentage of potentially eligible tax filers, and half do not respond.”280 one california study paints a starker picture. the study compared outreach methods to millions of likely eligible eitc recipients. it found that although “[m]ore personalized outreach led to higher levels of engagement with online resources,” none of the outreach methods increased credit take-up—“[r]egardless of the information provided, the framing of the message, or who the messenger was.”281 the study’s authors determined that it was likely no intervention method had an impact on tax filing or credit claiming “larger than a half percentage point.”282 the data pointed to one conclusion: “outreach alone is likely not enough to improve take-up among non-filing populations.”283 together, these studies imply that successful efforts to close the nonparticipation gap likely require more than digital or third-party communication 276 u.s. gov't accountability off., supra note 41 at 17. 277 see goldin, supra note 201 at 72-73. 278 off. of inspections & evaluations, supra note 218, at 4-5, 4 n.11. 279 id. at 6. 280 id. 281 elizabeth linos et al., cal. pol’y lab, increasing take-up of the earned income tax credit 16, 23 (2020). 282 id. at 15. 283 id. at 23. 126 columbia journal of tax law [vol. 16:2 with taxpayers. data suggests that in-person contact is much more impactful. when rural mothers participated in 90–120-minute interviews about tax filing (of which the eitc was only a limited part), they were 21% more likely to claim the eitc.284 pushing taxpayers to engage with free tax preparation services could also help. a study of an irs notice pointing taxpayers to such services “yielded only a small (absolute) increase in eitc and ctc participation,” but it confirmed that there is a strong correlation between filing a tax return and claiming the eitc.285 in this vein, goldin argues for continued expansion of in-person assistance programs like volunteer income tax assistance (vita) and tax counseling for the elderly (tce).286 an alternative would be to reduce or replace the taxpayer’s role in the filing process entirely. just as much of the tax underreporting gap results from information asymmetry between taxpayers and the government, with taxpayers having income data that the irs cannot access without third-party reporting, some of the nonparticipation gap flows from low-income taxpayers lacking knowledge and resources to claim the eitc despite the government having most if not all of the information it needs to determine eligibility. the tigta study finding that eitc notices were ineffective contended that modifying the basic income tax return forms to include eitc eligibility questions could “improve eligibility determinations and increase participation.”287 in 2020, two united states senators picked up the call for the irs to update form 1040 “to include sufficient information to provide an eligible filer with an automatic refund.”288 developments in artificial intelligence also enable new possibilities for closing the nonparticipation gap that would not require additional irs personnel time or changes to paper forms. while programs like turbotax of tax filing past led users down a pre-defined decision tree based on their inputs, ai tools can dynamically respond to user information in real time. the taxpayer advocate service notes that many tax preparation companies are already deploying ai functionality to improve the filing process, though the service warns that “ai assistants may encounter difficulties interpreting complex tax laws correctly or considering unique circumstances that could impact a taxpayer’s return.”289 284 gudmunson et al., supra note 224, at 379. 285 jacob goldin et al., tax filing and take-up: experimental evidence on tax preparation outreach and eitc participation 13 (nat’l bureau of econ. rsch., working paper no. 28398, 2021). 286 see goldin, supra note 201, at 100. 287 off. of inspections & evaluations, supra note 218, at 9-10 (noting that a revised form could collect residency and age information for a taxpayer’s children). 288 press release, sherrod brown, senators sherrod brown and catherine cortez masto, brown, cortez masto mark eitc awareness day, as they press irs to ensure all americans eligible for eitc receive it (jan. 31, 2020), https://www.brown.senate.gov/newsroom/press/release/browncortez-masto-mark-eitc-awareness-day-as-they-press-irs-to-ensure-all-americans-eligible-for-eitcreceive-it [https://web.archive.org/web/20240627114556/https://www.brown.senate.gov/newsroom/press/rel ease/brown-cortez-masto-mark-eitc-awareness-day-as-they-press-irs-to-ensure-all-americanseligible-for-eitc-receive-it-]. 289 is ai generated tax advice making the grade?, taxpayer advoc. serv. (june 11, 2024), https://www.taxpayeradvocate.irs.gov/news/tax-tips/is-ai-generated-tax-advice-making-thegrade/2024/06/ [https://perma.cc/x3kf-q3sj]. 2025] the tax redistribution gap 127 the irs is similarly deploying artificial intelligence models into the nrp process in an attempt to close the tax revenue gap.290 however, the government accountability office reports that the irs has yet to document either its decisionmaking process to determine what ai model to run or the technical specifications of its ultimate choice.291 the irs could engage in a parallel process and utilize ai to better detect eligible taxpayers who failed to claim refundable credits. agency use of ai is not without its dangers. danielle citron and ryan calo caution that when agencies replace technical tasks with automation, “guarantees of transparency, accountability, and due process [could] fall away.”292 other tech scholars flag that “the accountability mechanisms and legal standards that govern decision processes have not kept pace with technology.”293 the irs’ failure to document the specifics of its ai usage invokes these concerns. still, governmental use of ai will continue to grow—a 2019 executive order directed every federal agency to explore the potential for ai to increase government efficiency294—and with it comes the potential for innovation in redistribution. b. underclaiming gap to the extent that an underclaiming gap flows from informational complexity about direct transfers, its solutions likely mirror those for the nonparticipation gap: connecting taxpayers with in-person support, reducing the taxpayer role in the filing process, or reducing taxpayers’ information costs. but policymakers could also address the underclaiming gap from the policy side, reworking child-claiming rules to reduce complexity. c. underreceiving gap proposed solutions to the underreceiving gap must account for the difficulty taxpayers face understanding and engaging with legal processes. key to these solutions will be ensuring support throughout the process, not just before it. in 2005 testimony to the irs oversight board, low-income taxpayer clinic director janet spragens reiterated the importance of sustained communication to positive outcomes for taxpayers: “low income taxpayers need multiple mailings, phone calls and/or other communications or contacts to obtain information, documents and other proof supporting their deductions, credits and other tax return positions.”295 indeed, a study of irs eitc audits found that only 38% of taxpayers who received 290 tax gap: irs should take steps to ensure continued improvement in estimates, u.s. gov’t accountability off. (may 6, 2024), https://www.gao.gov/products/gao-24-106449 [https://perma.cc/uk4g-d6qq]. 291 id. 292 ryan calo & danielle keats citron, the automated administrative state: a crisis of legitimacy, 70 emory l.j. 797, 802 (2021). 293 joshua a. kroll et al., accountable algorithms, 165 u. pa. l. rev. 633, 636 (2017). 294 exec. order no. 13,859, 84 fed. reg. 3967 (feb. 11, 2019). 295 spragens, supra note 251 (citing 2 national taxpayer advocate, i.r.s., earned income tax credit (eitc) audit reconsideration study (2004)). 128 columbia journal of tax law [vol. 16:2 no calls from the irs were found eligible for the eitc; when taxpayers received three or more phone calls, eligibility rates increased to 67%.296 one method to provide support throughout an eitc audit would be to increase access to low-income taxpayer representation. as i have noted in other work, legal representation for low-income tax issues has historically been a misnomer.297 but as the tax code became a more common vehicle for federal benefits, the need for legal assistance increased. even so, tax representation today is frequently left out of general legal services.298 the supply of legal assistance for low-income tax issues comes almost entirely from i.r.c. § 7528, which authorized the irs to create and sustain a grant program for low-income taxpayer clinics. still, the irs spends many times more on eitc audits than congress allocates to low income taxpayer clinics, leading some to call for increased resources dedicated to eitc representation.299 access to representation leads to materially better results for eitc claimants. a 2007 taxpayer advocate service (tas) study found that “lowincome filers with representation were twice as likely as their non-represented counterparts to emerge from an irs audit with no change in their claimed eitc, at rates of 41.5% and 23.1%, respectively.”300 but a 2019 study revealed that 97% of low-income taxpayers do not have professional representation during a correspondence audit.301 empirical analysis of tax court outcomes suggests that the benefits of representation persist for the duration of a tax controversy. analyzing a random sample of tax court cases, lederman and hrung found that “taxpayer representation has a significant effect on financial outcome in cases that go to trial” and “the magnitude of the effect increases with the experience of the attorney and remains highly statistically significant.”302 on average, represented taxpayers in tried cases received financial outcomes that were 18% more favorable.303 these statistics suggest that lack of counsel for audited taxpayers leads directly to the underreceiving gap. indeed, a 2007 tas study estimated that a lack of representation resulted in pro se taxpayers being denied $300 million in eitc credits for which they were otherwise eligible.304 apart from ensuring additional support for taxpayers facing eitc audits, the irs could also close the underreceiving gap by pulling back on its audit 296 id. (citing 2 national taxpayer advocate, i.r.s., earned income tax credit (eitc) audit reconsideration study 10 (2004)). 297 see eric baudry, pedagogy, service, justice, tax: reconciling the tension between academic low-income taxpayer clinics and an access rights theory of change (apr. 2, 2024) (unpublished manuscript) (on file with author) (largely citing keith fogg, taxation with representation: the creation and development of low-income taxpayer clinics, 67 tax law. 3 (2013)). 298 schneller et al., supra note 235, at 191. 299 e.g., id. at 203-04. 300 bryant et al., supra note 241, at 5 (quoting schneller et al., supra note 235, at 192). 301 id. at 5-6 (citing taxpayer advocate service, 2021 annual report to congress 294 (2021). 302 leandra lederman & warren b. hrung, do attorneys do their clients justice? an empirical study of lawyers’ effects on tax court litigation outcomes, 41 wake forest l. rev. 1235, 1281 (2006) (finding that presence of an attorney did not impact outcomes of settled cases). 303 see id. at 1255. 304 schneller et al., supra note 235, at 208. 2025] the tax redistribution gap 129 practices. fewer eitc audits would result in fewer eligible taxpayers being denied credits because of information or access barriers (while admittedly reducing one strategy to address eitc overpayments). in september 2023, the irs announced that it would attempt exactly that by shifting its audit focus in future tax years away from eitc recipients.305 while the change has yet to take full effect, the move is promising in that it addresses the heart of the underreceiving gap. whereas attorneys may help reduce the underreceiving gap from audits, they are unlikely to help with the gap that results from bankruptcy procedures. courts interpreting state law regarding bankruptcy exemptions have found little grey area: state law either does or does not exempt the eitc and other public assistance from the bankruptcy estate. in states without an exemption, the routing of eitc refunds to creditors is not a result “for which the court should be blamed.”306 the patchwork legal landscape calls for a straightforward legal reform to close this portion of the underreceiving gap: as fogg argues directly, “this is an area where congress should step in. we should not require a state by state determination of whether to exempt federal anti-poverty payments.”307 vi. conclusion measurements matter. when it comes to taxation, we currently measure both total tax revenue received and the amount missing due to noncompliance or evasion. but when it comes to redistribution, we limit our measures to the overall distributive impact of the tax code; we do not attempt to aggregate the amount of redistribution that goes unclaimed or undelivered. this article coined the tax revenue gap’s mirror image, the tax redistribution gap, and offered an initial framework of how we might begin to measure it. progressive rates and refundable credits like the earned income tax credit result in both differential contributions by rich and poor taxpayers and direct transfers to low-income taxpayers. in turn, the tax revenue gap decreases differential contributions from the rich while implementation slippages—in particular, a nonparticipation gap, underclaiming gap, and underreceiving gap—reduce direct transfers received by the poor. introducing a tax redistribution gap measure challenges background assumptions in current tax discourse: first, it would call out a reliance on pre-market income as a distributive baseline, which serves to overstate the redistributive impact of the tax code; second, it would increase the profile of redistribution among policymakers and the public—understandably, measures like the tax revenue gap and tax expenditure budgets focus dialogue on tax evasion and over-spending by the government. ultimately, the tax redistribution gap would provide a single measure that displays how we are falling short of a key task of the state (redistribution). and by 305 irs announces sweeping effort to restore fairness to tax system with inflation reduction act funding, i.r.s., ir-2023-166 (sept. 8, 2023), https://www.irs.gov/newsroom/irs-announcessweeping-effort-to-restore-fairness-to-tax-system-with-inflation-reduction-act-funding-newcompliance-efforts [https://perma.cc/5dtq-g7hd]. 306 fogg, supra note 257. 307 id. 130 columbia journal of tax law [vol. 16:2 understanding and comparing the component ways our current tax system falls short of its intended outcomes, we can better tailor redistributive policy solutions. reflections on section 367(b) regulations and inbound transactions paul oosterhuis* and mayté quinn salazar** abstract cross-border combinations of u.s. and foreign public companies are unusual but happen from time to time. our broad and often arbitrary anti-inversion rules discourage such transactions utilizing a foreign parent company for the combined group. but using a u.s. parent company can also be painful to the foreign company shareholders. our section 367(b) regulations require gain recognition for the foreign company’s material shareholders subject to u.s. tax. that seems to be a high price to pay for the pleasure of bringing the foreign corporate group into the u.s. tax net. much has been discussed and written about the section 367(b) regulations that compel this result since the regulation’s finalization in 2000 and especially since the enactment of the 2017 tax cuts and jobs act. this article reflects our exploration into what led the original regulation writers down the path they took and suggests that maybe they were wrong in their thinking. our hope is that it will stimulate a broader discussion of the goals of the section 367(b) regulations as applied to inbound transactions and how they should be implemented in the current regime of section 245a deductions and gilti and subpart f inclusions. * of counsel, skadden, arps, slate, meagher & flom llp and affiliates; lecturer in law, columbia law school. ** associate, skadden, arps, slate, meagher & flom llp and affiliates. the authors would like to thank moshe spinowitz and joshua rabon for their helpful comments. please note that any opinions expressed in this article are solely our own and do not necessarily represent the opinion of any of the above commentators, or skadden arps. 162 columbia journal of tax law [vol. 16:2 i. introduction ............................................................................................ 163 ii. the history of the section 367(b) inbound asset reorganization regulations ............................................................................................. 166 a. 1997 temporary regulations ......................................................... 166 b. 1991 proposed regulations ............................................................. 168 1. the repatriation principle ............................................................ 168 2. the distortion principle ................................................................ 170 c. 2000 final regulations ................................................................... 170 iii. re-examining the scope of the inbound asset reorganization regulations: were they too broad? ................................................. 173 iv. professor andrews’ perspective on the intersection of corporate and shareholder level taxation ....................................................... 174 v. impact of 2017 tcja on inbound asset reorganization corporate level tax avoidance under reg. § 1.367(b)-3 .................................... 178 vi. shareholder level tax avoidance on inbound asset and stock reorganizations ..................................................................................... 180 vii. treatment of inbound liquidations ................................................... 183 viii. conclusion ............................................................................................... 183 2025] reflections on 367(b) regulations and inbound transactions 163 “a domestic acquirer of [a] foreign corporation’s assets should not succeed to the basis or other tax attributes of the foreign corporation except to the extent that the united states tax jurisdiction has taken account of the united states person’s share of the earnings and profits that gave rise to those tax attributes.” – 1991 preamble to proposed section 367(b) regulations1 “in general, a united states person obtains tax basis only for amounts which have been included in income.” – charles i. kingson2 “it is absolutely necessary that effect on earnings be governed by basis.” – william d. andrews3 i. introduction cross-border combinations of u.s. and foreign public companies are unusual but happen from time to time. our broad and often arbitrary anti-inversion rules discourage such transactions utilizing a foreign parent company for the combined group.4 but using a u.s. parent company can also be painful to the foreign company shareholders. consider a transaction that for foreign corporate and tax law reasons is best accomplished by merging the foreign parent company directly into the u.s. acquiring parent company in a manner described in section 368(a)(1)(a). in a purely domestic context, the merger would be a tax-free transaction to the shareholders of the acquired company. our section 367(b) regulations override that treatment and require gain recognition for the foreign company’s material shareholders subject to u.s. tax.5 that seems to be a high price to pay for the pleasure of bringing the foreign corporate group into the u.s. tax net. much has been discussed and written about the section 367(b) regulations that compel this result since the regulation’s finalization in 2000 and especially 1 1991 proposed regulations, 56 fed. reg. 41993, 41995 (aug. 26, 1991). 2 charles i. kingson, the theory and practice of section 367, 37 n.y.u. ann. inst. on fed. tax’n § 22.03[7][c] (1979). 3 william d. andrews, “out of its earnings and profits”: some reflections on the taxation of dividends, 69 harv. l. rev. 1403, 1408 (1956). 4 see i.r.c. § 7874. unless otherwise specified, all “section” references contained herein are to the u.s. internal revenue code of 1986, as amended, (the “code”) and all “regulation section” and “treas. reg. §” references are to the u.s. treasury regulations promulgated thereunder. references to proposed regulations are designated as “prop. treas. reg. §,” and references to temporary regulations are designated as “temp. treas. reg. §.” citations to preambles of regulations are noted accordingly where applicable. 5 see treas. reg. § 1.367(b)-3. 164 columbia journal of tax law [vol. 16:2 since the enactment of the 2017 tax cuts and jobs act (“tcja”). several of us at skadden wrote treasury and the internal revenue service (“irs”) in the summer of 2021 urging them to revisit the regulation.6 a new york state bar report,7 was issued in june 2022 also urging reconsideration. gary scanlon of kpmg published an article in taxes—the taxes magazine8 and led an international tax institute panel on the topic in march 2023.9 bret wells published a law review article a few months later,10 and the uf tax incubator project published its recommendations in a tax notes international special report in august 2024.11 there seems to be a consensus among these commentators that treas. reg. § 1.367(b)-3 as applied to less-than-10% u.s. shareholders12 is inappropriate after both the 2004 enactment of section 362(e) and particularly after the tcja.13 some of us came to wonder whether the regulations were even appropriate at their original adoption in 1991. we assumed they were because the original thinking behind the regulation was driven by charles kingson, who was a legendary tax lawyer of that time.14 and it was validated by subsequent commentators including the dolan et 6 paul w. oosterhuis & moshe spinowitz, firm urges irs to reconsider inbound transaction rules, 2021 tax notes today int’l 185-20 (aug. 25, 2021). 7 tax section, n.y. state bar ass’n, an analysis of potential design changes to regulation section 1.367(b)-3 in light of the tax cuts and jobs act, rep. no. 1463 (2022). 8 gary scanlon & elena madaj, code sec. 367(b): where do we go from here?, 101 taxes 263 (2023). 9 see basics of international taxation 2023, practising law inst. https://www.pli.edu/programs/basics-of-international-taxation/358873 [https://perma.cc/e4luhsuc] (last visited jan. 14, 2025). 10 bret wells, reform of section 367(a) and section 367(b) for a post-tcja era, 23 hous. bus. & tax l. j. 195 (2023). 11 uf tax incubator, potential changes to section 367 and the associated treasury regulations, 115 tax notes int’l 905 (aug. 5, 2024). 12 generally, under section 951(b), a u.s. shareholder is a u.s. person that owns (within the meaning of section 958(a) or (b)) 10% or more of the vote or value of a foreign corporation. for the remainder of this article, we use the defined term “u.s. shareholder” when referring to shareholders that meet such definition under section 951(b). 13 see, e.g., scanlon & madaj, supra note 9, at 267. 14 see generally charles i. kingson, the theory and practice of section 367, 37 n.y.u. ann. inst. on fed. tax’n § 22.03[7][c] (1979). for a biographical overview of kingson’s career, see in memoriam: charles kingson (1938–2019), n.y.u. l. news (mar. 18, 2019), https://www.law.nyu.edu/news/charles-kingson-in-memoriam-graduate-tax-programinternational [https://perma.cc/8swj-ewrr]. https://perma.cc/e4lu-hsuc https://perma.cc/e4lu-hsuc https://perma.cc/8swj-ewrr 2025] reflections on 367(b) regulations and inbound transactions 165 al. treatise15 and the bruce davis portfolio,16 though each offering criticism. notwithstanding that history, we thought a further exploration into the thinking of the regulation writers would be helpful in reaching a more definitive view of the regulation today and how or why it should be changed. this article reflects our exploration into what led the original regulation writers down the path they took and whether they were wrong in their thinking. hopefully it will stimulate a broader discussion of the goals of the section 367(b) regulations as applied to inbound transactions and how they should be implemented 15 the treatise explains the policy rationale and critiques the regulations as follows: the theory of the prior 367(b) regulations was that: (1) a corporation funds assets with equity capital, debt, and earnings; (2) a domestic corporation receives basis for assets acquired with earnings for corporate tax purposes only if it has paid tax on those earnings; (3) the u.s. parent of a foreign subsidiary that obtained deferral on its earnings should not receive full basis for the foreign subsidiary’s assets in the hands of a controlled domestic corporation in an inbound reorganization unless the u.s. parent forgoes deferral and pays u.s. corporate tax on those earnings. this theory supports in general the results of the regulations in a section 332 liquidation of a foreign subsidiary into a u.s. parent or in an inbound reorganization of a foreign subsidiary into a domestic subsidiary of its u.s. parent. it does not, however, support the results of the regulations in inbound asset reorganizations involving a widely held foreign corporation. . . . there is thus no policy justification for requiring non-section 1248 shareholders to include earnings in income or to recognize gain, and that requirement defies common sense. it is inconsistent with notions of expatriation and impatriation that have been considered over the last two decades—i.e., that there should be an exit tax (section 367(a)) when a domestic corporation expatriates and that assets should receive fair market value basis (or at least carryover basis) when they come into u.s. corporation solution. the latter result should not be contingent upon the shareholders being taxed unless they were a domestic parent corporation that was potentially subject to the subpart f and section 1248 regimes but nevertheless benefited from deferral. the final section 367(b) regulations effectively treat the tax on the shareholders as a surrogate for corporate level tax on the foreign corporation, even though the preamble to the regulations recognizes that section 367(b) policies are “unrelated to an exchanging shareholder’s outside gain on its stock.” the practical ramification of the final 367(b) regulations is that the domestic shareholders of a publicly held foreign corporation are taxed when the foreign corporation domesticates—somewhat like paying tax to break into jail! kevin d. dolan et al., u.s. taxation of international mergers, acquisitions & joint ventures ¶ 13.06[2][c] (2024). 16 see bruce davis, other transfers subject to section 367(b), (d) or (e), bloomberg tax mgmt. portfolio no. 920-3d (“thus, were it not for §367(b), a domestication transaction such as an inbound liquidation or inbound reorganization of a foreign corporation could provide an opportunity in some cases to avoid u.s. tax on the repatriation of foreign corporate e&p attributable to income with respect to which a u.s. shareholder has enjoyed deferral. a principal purpose of §367(b) is to prevent such a domestication transaction from effectively converting deferral into forgiveness of u.s. tax on foreign corporate income and e&p”). note, that, bruce davis’s portfolio has been revised and superseded by layla j. asali, transfers subject to section 367(b), (d) or (e), bloomberg tax mgmt. portfolio no. 6120-1st (2025) (“section 367(b) was originally enacted to prevent taxpayers from using an otherwise tax-free domestication transaction such as an inbound liquidation or inbound reorganization of a foreign corporation to altogether avoid u.s. tax on the repatriation of foreign corporate e&p attributable to income with respect to which a u.s. shareholder has enjoyed deferral.”). 166 columbia journal of tax law [vol. 16:2 in the current regime of section 245a deductions and gilti and subpart f inclusions.17 we first give a brief history of the regulations and then focus on the treatment of inbound asset reorganizations of foreign corporations under section 368(a)(1)(a), (c), (d) and (f) (“inbound asset reorganizations”). next, we compare the treatment of shareholders in inbound asset reorganizations with shareholders making tax-free exchanges of stock of foreign corporations for stock of domestic corporations under sections 351 and 368(a)(1)(b) (“inbound stock reorganizations”). we then describe the implications of the above on inbound liquidations of foreign corporations under section 332 (“inbound liquidations,” and together with inbound asset reorganizations and inbound stock reorganizations, “inbound transactions”). ii. the history of the section 367(b) inbound asset reorganization regulations the current version of section 367(b) was enacted in 197618 as part of broader legislation to replace the prior requirement that in-scope exchanges of stock and or assets establish “to the satisfaction of the secretary or his delegate that such exchange is not in pursuance of a plan having as one of its principal purposes the avoidance of federal income taxes.”19 the legislation provided treasury authority to draft regulations “necessary or appropriate to prevent the avoidance of federal income taxes.”20 the goal of the legislation was not to apply a different standard from the pre-existing “guidelines” of rev. proc. 68-23 (“revenue procedure guidelines”),21 which outlined the circumstances under which the irs would issue favorable private letter rulings, but to codify its standards in regulations so that taxpayers could apply the rules themselves and not be required to seek an irs ruling.22 because the key rules are not found in the statute itself, it’s important to understand the various sets of regulations issued under section 367(b); how they changed over time; and how they operate today. preambles can give us clues into the underlying principles of a set of rules. accordingly, below we summarize the various sets of regulations issued under section 367(b), highlighting differences in the various iterations, and noting where treasury and the irs provided an explanation in the preambles. a. 1997 temporary regulations 17 this article does not deal with the intersection of the section 367(b) regulations and passive foreign investment companies. 18 tax reform act of 1976, pub. l. no. 94–455, § 1042(a), 90 stat. 1634 (1976) (amending i.r.c. § 367 (1954)). 19 rev. proc. 68-23, 1968-1 c.b. 821. 20 i.r.c. § 367(b)(1). 21 rev. proc. 68-23. this legislation was first proposed less than two years after tax analysts successfully secured the release of redacted private letter rulings, thus ending, in the experience of one of the authors, the oligopoly of d.c. boutique tax firms in this area. 22 see scanlon & madaj, supra note 9, at 269–70. 2025] reflections on 367(b) regulations and inbound transactions 167 the first regulations governing inbound transactions were issued as temporary regulations in 1977 (the “1977 temporary regulations”).23 they largely followed the revenue procedure guidelines,24 distinguishing between circumstances in which the application of section 124825 could be preserved and those where it could not. in principal part, the 1977 temporary regulations provided for (1) the attribution of various amounts (the “all e&p amount”26 or the section 1248 amount) from the stock surrendered to the stock received where the section 1248 taint could be preserved or (2) the recognition of gain where the section 1248 taint could not be preserved. the 1977 temporary regulations applied as follows to undistributed corporate foreign earnings in inbound transactions: • where a domestic corporation acquired the assets of a foreign corporation in an inbound liquidation under section 332, the domestic corporation was required to either (1) include in gross income as a deemed dividend the all e&p amount attributable to its stock of the foreign corporation or (2) recognize gain with respect to its stock of the foreign corporation.27 • where a domestic corporation acquired the assets of a foreign corporation in an inbound asset reorganization under section 368, the consequences depended on whether the exchanging shareholder was a non-corporate section 1248 shareholder, a domestic corporate section 1248 shareholder, a foreign corporate shareholder, or a u.s. person that was not a section 1248 shareholder: o a non-corporate section 1248 shareholder was required to include in gross income as a deemed dividend the section 1248 amount attributable to such shareholder’s stock of the foreign corporation;28 o a domestic corporate section 1248 shareholder was required to either (1) include in gross income as a deemed dividend the all e&p 23 1977 temporary regulations, 42 fed. reg. 65152 (1977). 24 id. the most significant departure from the revenue procedure guidelines was the reduction from a 20% to a 10% threshold for corporate section 1248 shareholders (defined below) to be required to include certain amounts in gross income. the preamble to the 1977 temporary regulations did not offer an explanation for this or other departures from the revenue procedure guidelines. 25 where applicable, section 1248 generally recharacterizes a shareholder’s gain on the sale of stock of a foreign corporation as a dividend to the extent of the earnings and profits (“e&p”) of the foreign corporation (and, in some cases, of lower-tier foreign subsidiaries) attributable to that shareholder (such amount, the “section 1248 amount”). section 1248 applies to the sale of stock of a foreign corporation by a u.s. person that owns (within the meaning of section 958(a) or (b)) 10% or more of the total combined voting power of the foreign corporation at any time during the five-year period ending on the date of the sale or exchange if the foreign corporation was a controlled foreign corporation (“cfc”) at any time during that five-year period (such shareholder, a “section 1248 shareholder”) and only applies to the e&p of the foreign corporation while it is a cfc. 26 there have been various tweaks to the definition of all e&p under the regulations, but generally under treas. reg. § 1.367(b)-2(d) and as used here, the all e&p amount is the net positive e&p of the foreign acquired corporation (but not the e&p of the subsidiaries of the foreign acquired corporation) attributable to a shareholder’s ownership in the foreign corporation. 27 temp. treas. reg. § 7.367(b)-5t (1977). 28 temp. treas. reg. § 7.367(b)-7t(c)(1)(i) (1977). under the 1977 temporary regulations, the section 1248 amount recognized by a non-corporate section 1248 shareholder in an inbound asset reorganization included the e&p of lower-tier foreign subsidiaries, which inclusion was a significant departure from the revenue procedure guidelines. 168 columbia journal of tax law [vol. 16:2 amount attributable to its stock of the foreign corporation or (2) recognize gain with respect to its stock of the foreign corporation;29 o a foreign corporate shareholder was required to add certain e&p of the foreign corporation to its own e&p, specifically the e&p that would have been subject to section 1248(c)(2) had there been a disposition of stock in a first-tier foreign corporation and the e&p for pre-1963 years that was attributable to the stock;30 and o a u.s. person who was not a section 1248 shareholder was eligible for nonrecognition.31 b. 1991 proposed regulations fourteen years later, treasury and the irs issued proposed regulations that largely replaced the 1977 temporary regulations (the “1991 proposed regulations”).32 those regulations reflected considerable thinking in the intervening period by kingson and others about the role of deferral of earnings of foreign corporations.33 the regulations provided a series of changes from the 1977 temporary regulations aimed at clarifying the scope of section 367(b), streamlining compliance, and minimizing complexity.34 the preamble to the 1991 proposed regulations articulated what treasury and the irs believed to be several of the “principles” of section 367(b), including those related to the acquisition of a foreign corporation’s earnings by a u.s. corporation: the four principles are (1) the prevention of the repatriation of earnings or basis without tax (“repatriation principle”); (2) the prevention of material distortion in income (“distortion principle”); (3) the minimization of complexity; and (4) the permissibility of deferral.35 the following summary focuses on the first two principles, which continue to be the two driving forces in the regulations today. 1. the repatriation principle with regard to the repatriation principle, the preamble to the 1991 proposed regulations articulated the following: the united states generally does not tax a foreign corporation on its foreign source earnings and profits. if the foreign corporation is owned in whole or in part, directly or indirectly, by a united states person, in certain circumstances the united states does not tax the united states person on the foreign corporation’s earnings and 29 temp. treas. reg. § 7.367(b)-7t(c)(2) (1977). 30 temp. treas. reg. § 7.367(b)-7t(c)(1)(ii) (1977). 31 temp. treas. reg. § 7.367(b)-7t(a)(2) (1977). 32 1991 proposed regulations, 56 fed. reg. 41993 (aug. 26, 1991). 33 see charles i. kingson, the new theory and practice of section 367, 69 taxes 1008 (1991). 34 1991 proposed regulations, 56 fed. reg. 41993, 41995 (aug. 26, 1991). relevant changes not discussed in detail in this article include requiring the filing of a notice by any person that realizes income in a section 367(b) exchange, and eliminating the special record-keeping requirements related to attribution of certain amounts and adjustments to e&p. 35 id. at 41995-96. 2025] reflections on 367(b) regulations and inbound transactions 169 profits until those earnings and profits are repatriated (for example, through the payment of dividends) or the united states person disposes of an interest in the foreign corporation. one of the principles of the proposed regulations under section 367(b) is that the repatriation of a united states person’s share of earnings and profits of a foreign corporation through what would otherwise be a nonrecognition transaction (for example, a liquidation of a foreign subsidiary into its domestic parent in a transaction described in section 332, or an acquisition by a domestic corporation in a reorganization described in section 368) should generally cause recognition of income by the foreign corporation’s shareholders. a domestic acquirer of the foreign corporation’s assets should not succeed to the basis or other tax attributes of the foreign corporation except to the extent that the united states tax jurisdiction has taken account of the united states person’s share of the earnings and profits that gave rise to those tax attributes.36 the 1991 proposed regulations also refined the definition of “all e&p amount” to clarify the intended scope because, as the preamble elaborated, the regulation writers saw “[t]he proper measure of [e&p] that should be subject to tax is the [all e&p amount].”37 the 1991 proposed regulations also expanded the approach in the 1977 temporary regulations, requiring that all u.s. persons that were u.s. shareholders, not just domestic corporate section 1248 shareholders,38 include in gross income as a deemed dividend the all e&p amount in an inbound transaction. the preamble noted two “departures” from the 1977 temporary regulations’ general rule that all u.s. persons should include the all e&p amount in an inbound transaction. because of administrative concerns, the 1991 proposed regulations required full recognition of gain (but not loss) for small shareholders, 36 id. at 41995. 37 id. at 41996. 38 prop. treas. reg. § 1.367(b)-3(b)(1) (1991). in their article, gary scanlon and elena madaj articulate the difference between a u.s. shareholder and a section 1248 shareholder as follows: while there is significant overlap between persons that are u.s. shareholders and persons that are 1248 shareholders, these terms are not co-terminus. for starters, status as a u.s. shareholder is determined by reference to vote or value, whereas 1248 shareholder status is determined by reference solely to voting power. in addition, while a u.s. shareholder is subject to subpart f only with respect to a foreign corporation that is a cfc, a u.s. shareholder of a foreign corporation that is not, and has never been a cfc, is still a u.s. shareholder within the meaning of code sec. 951(b), and thus subject to [treas. reg. § 1.367(b)-3]. in contrast, a u.s. person can be a 1248 shareholder only with respect to a foreign corporation that is, or has been, a cfc. scanlon & madaj, supra note 9, at 268. whether the scope of section 367 is or should be based on an application to u.s. shareholders vs. section 1248 shareholders can be debated, as this article will explore. 170 columbia journal of tax law [vol. 16:2 rather than an inclusion of an all e&p amount.39 another departure from the general rule was the elimination of the implicit rule permitting taxpayers to elect taxable exchange treatment in lieu of compliance with the regulations.40 the proposed regulations instead opted for an explicit election (a “taxable exchange election”) allowing a u.s. shareholder to recognize gain (but not loss) with respect to its stock in the foreign acquired corporation (in lieu of including the all e&p amount in gross income).41 where a u.s. shareholder made such a taxable exchange election, the domestic acquiring corporation was required to reduce the attributes of the foreign acquired corporation to which the domestic acquiring corporation would otherwise succeed to the extent the all e&p amount exceeded the gain recognized.42 2. the distortion principle like its predecessors, the 1991 proposed regulations illustrate a concern with preserving the application of section 1248. in the preamble, treasury noted this as part of a larger concern with distortions of income. the preamble to the 1991 proposed regulations explained the distortion principle as follows: another objective of the regulations under section 367(b) is to prevent the occurrence of a material distortion in income. for this purpose, a material distortion in income includes a distortion relating to the source, character, amount or timing of any item, if such distortion may materially affect the united states tax liability of any person for any year. thus, for example, the regulations generally operate to prevent the avoidance of provisions such as section 1248 (which requires inclusion of certain gain on the disposition of stock as a dividend). for this purpose, the concept of ‘avoidance’ includes a transaction that results in a material distortion in income even if such distortion was not a purpose of the transaction.43 as discussed below, this statement is important in light of what is and is not considered to be a “material distortion” under the proposed regulations. c. 2000 final regulations the 1991 proposed regulations were finalized in 2000 with substantial modifications “based [on] considerations of fairness, simplicity, and 39 1991 proposed regulations, 56 fed. reg. 41993, 41997 (aug. 26, 1991). the preamble does not explain what led treasury and the irs to abandon the nonrecognition approach for small shareholders taken in the revenue procedure guidelines and the 1977 temporary regulations. 40 id. at 41996 (“[u]nder the new regulations the taxpayer never has the right to fail to comply with the regulations.”). 41 prop. treas. reg. § 1.367(b)-3(b)(2)(iii)(a) (1991). 42 id. 43 1991 proposed regulations, 56 fed. reg. 41993, 41995 (aug. 26, 1991). 2025] reflections on 367(b) regulations and inbound transactions 171 administrability.”44 first, the 2000 final regulations did not adopt the taxable exchange election with its attendant basis reduction, noting administration and fairness concerns as reasons for the rejection.45 second, the 2000 final regulations allow small shareholders to make an election to include their all e&p amount, but only if the foreign acquired corporation furnishes such shareholders adequate information to compute that amount.46 the 2000 final regulations generally retained the 1991 proposed regulation definition of the all e&p amount47 and the requirement that all 44 2000 final regulations, 65 fed. reg. 3589, 3590 (jan. 24, 2000). 45 id. at 3592. the preamble provided the following example highlighting the unfairness of the taxable exchange election: for example, consider an inbound c, d, or f reorganization involving two u.s. shareholders of the foreign acquired corporation, one that makes the taxable exchange election (because its gain on the stock is less than its all earnings and profits amount) and one that does not. in connection with the electing shareholder’s taxable exchange election, the 1991 proposed regulations required a proportionate reduction in certain tax attributes of the foreign acquired corporation. this reduction effectively allowed the electing shareholder to transfer to the acquiring corporation the burden created by its decision not to include in income its full all earnings and profits amount and, thereby, to effectively shift a portion of this burden to the non-electing shareholder (that has already paid u.s. tax on its full share of the foreign corporation’s earnings and profits). id. the preamble provided various explanations as to why the all e&p amount should be included, rather than an amount tied to a shareholder’s gain, including the fact that the all e&p amount reflected the corporate-level attributes (such as basis) of the foreign corporation and not merely shareholder-level attributes. id. at 3590. at the same time that the 2000 final regulations were published, treasury and the irs also published proposed and temporary regulations extending the ability to make a taxable exchange election for one year. t.d. 8863, 2000-1 c.b. 488. 46 2000 final regulations, 65 fed. reg. 3589, 3593 (jan. 24, 2000). treasury and the irs rejected comments to the 1991 proposed regulations requesting an election that would permit a domestic acquiring corporation to elect to include small shareholders’ all e&p amounts. apart from these changes, another less substantial change was the revision to the notice requirement under the 1991 proposed regulations: the 2000 final regulations narrowed its scope and required a notice only with respect to persons and transactions that may be subject to an inclusion under the 2000 final regulation. 47 id. at 3590. the 2000 final regulations did amend the definition to exclude amounts attributable to the holding period of non-u.s. persons, responding to the following concern: section 1.367(b)-2 (d) of the 1991 proposed regulations generally defined “all earnings and profits amount” as the allocable share of net positive earnings and profits accrued by a foreign corporation during a shareholder’s holding period. the 1991 proposed regulations provided that the all earnings and profits amount is determined according to the attribution principles of section 1248. because the section 1248 attribution rules incorporate the section 1223 holding period rules, commentators were concerned that the definition of all earnings and profits amount inappropriately included earnings and profits attributable to the holding period of non-u.s. persons by virtue of the rules of section 1223(2). id. at 3591. 172 columbia journal of tax law [vol. 16:2 exchanging u.s. shareholders48 (subject to a new de minimis exception applicable to small shareholders),49 include in their gross income such amount in inbound transactions. in the preamble, treasury acknowledged the commentators’ criticism of the scope of the all e&p amount,50 but defended its decision to retain the broad definition, arguing a definition tied to a shareholder’s section 1248 amount “too narrowly construes the role of section 367(b) by focusing on potential shareholderlevel consequences without adequately considering the section 367(b) policy of determining the appropriate carryover of corporate-level attributes in inbound nonrecognition transactions.”51 as with its predecessors with respect to inbound transactions, the 2000 final regulations were principally concerned with the carryover of e&p and basis of assets from foreign to domestic corporations, which treasury and the irs saw as having interrelated shareholder-level and corporate-level components. the preamble to the regulations articulates this concern as follows: the section 367(b) regulations have historically focused on the carryover of earnings and profits and bases of assets, simultaneously addressing the shareholder and corporate level concerns by accounting for any necessary adjustments through an income inclusion by the u.s. shareholders of the foreign acquired corporation (and without limiting the extent to which the domestic acquiring corporation succeeds to the attributes). the 1991 proposed regulations required a u.s. shareholder of the foreign acquired corporation (or, in certain cases, a foreign subsidiary of the u.s. shareholder) to currently include in income the allocable portion of the foreign acquired corporation’s earnings and profits accumulated during the u.s. shareholder’s holding period (all earnings and profits amount). the requirement to include in income the all earnings and profits amount results in the taxation of previously unrepatriated earnings accumulated during a u.s. shareholder’s (direct or indirect) holding period. this income inclusion prevents the conversion of a deferral of tax into a forgiveness of tax and generally ensures that the section 381 carryover basis reflects an after-tax amount. however, the all earnings and profits amount inclusion does not consider tax attributes that accrue during a nonu.s. person’s holding period.52 48 however, “in order to provide greater consistency among its various ownership thresholds,” the 2000 final regulations did revise the regulations “so that § 1.367(b)-3(b) applies to a foreign corporation with respect to which there is, in general, a 10 percent u.s. shareholder.” id. at 3592. 49 treas. reg. § 1.367(b)-3(c)(4) (2000). 50 commentators argued that the all e&p amount should be limited to the amount that a shareholder would include in income as a deemed dividend under section 1248. 2000 final regulations, 65 fed. reg. 3589, 3590 (jan. 24, 2000). 51 id. 52 id. 2025] reflections on 367(b) regulations and inbound transactions 173 regulations finalized in 2006 further modified the rules relating to the carryover of e&p and foreign tax credits in inbound transactions, but the framework has largely stayed the same.53 iii. re-examining the scope of the inbound asset reorganization regulations: were they too broad? one way to fully understand the underlying principles that informed the section 367(b) regulations, beyond reading the preambles cited above, is to go back to charles kingson’s writings about them, given that kingson served as deputy international tax counsel in the u.s. treasury department during the carter administration and wrote the initial regulations under section 367.54 perhaps the most accessible of kingson’s writings are his 1979 tax law review article,55 after the original 1977 temporary regulations were issued, and an article he published in tax notes in 2004,56 after the current 2000 final regulations were issued. in both articles, kingson begins by acknowledging that the statutory standard for applying section 367(b) is “tax avoidance,” defining avoidance, for this purpose, as being able to do indirectly what cannot be done directly.57 kingson stated that, with respect to inbound asset reorganizations, section 367(b) deals with both shareholder and corporate level tax avoidance. he believed shareholder level avoidance had to do with preserving or triggering the section 1248 amount and emphasized that shareholder level avoidance is wholly separate from corporate level avoidance. to deal with corporate level avoidance, he stated that the section 367(b) regulations should result in a broader income inclusion than that required to prevent shareholder level avoidance because, as cited above, “a united states person obtains tax basis only for amounts which have been included in income.”58 he cited professor andrews’ renowned article on e&p for that principle59 and posited that because an inbound asset reorganization results in basis to a u.s. corporation, the amount of income giving rise to that basis should be taxed. after all, had the income been earned directly by the u.s. person, it would have been subject to u.s. tax. kingson then explained, however, that not all such earnings should be taxed: “[t]he inclusion is limited to the earnings accumulated while the shareholder held stock in the transferor foreign corporation since … earnings accumulated prior to its participation economically represent capital.”60 in other 53 71 fed. reg. 44887 (aug. 8, 2006). 54 in memoriam: charles kingson (1938-2019), nyu law news (mar. 18, 2019) https://www.law.nyu.edu/news/charles-kingson-in-memoriam-graduate-tax-programinternational [https://perma.cc/8swj-ewrr]. 55 kingson, supra note 15. 56 see charles i. kingson, seven lessons on section 367, 105 tax notes fed. (ta) 1015 (sept. 13, 2004). 57 kingson, supra note 15, at 28-33. he analogized the standard as the negative use of the affirmative “tax avoidance” standard in section 269 as applied in the cromwell case. see also cromwell corp. v. comm’r, 43 t.c. 313, 322 (1964). 58 kingson, supra note 15, at 27. 59 see william d. andrews, “out of its earnings and profits”: some reflections on the taxation of dividends, 69 harv. l. rev. 1403, 1408 (1956). 60 kingson, supra note 15, at 28. https://perma.cc/8swj-ewrr 174 columbia journal of tax law [vol. 16:2 words, since capital as well as earnings gives rise to basis in assets, only earnings tied to current shareholders need be taxed. he went on to say that, in the context of section 367(b) and foreign corporations, the existence of avoidance at the corporate level is “cloud[ed]” by the fact that in an inbound section 361 transaction, section 367(b) can only apply at the shareholder level and not at the corporate level,61 and that in a section 332 inbound liquidation the foreign corporation disappears. this last point was not emphasized in his writing but is of crucial importance to understanding the regulations. the expansion of shareholder taxation in inbound asset reorganizations, beyond dealing with shareholder section 1248 amounts—to tax the all e&p amount rather than the section 1248 amount of section 1248 shareholders and to tax other u.s. taxpayers who are not u.s. shareholders—serves as a proxy for the tax that should have been imposed at the corporate level but could not be because of the statutory limitations on the scope of section 367(b). at various times the regulation writers considered other proxies for imposing corporate level tax, including a downward adjustment to the basis of the assets inbounded in an inbound asset reorganization to the extent all e&p was not taxed at the shareholder level. ultimately, as described above, that “fix” was rejected, not because it was inappropriate in theory, but because as a practical matter it would unfairly affect corporate level results with respect to all shareholders rather than just historical u.s. shareholders. the above thinking has led to a regime that imposes tax at the shareholder level to deal with perceived corporate level avoidance. to many observers, over time the historical rationale for taxing shareholders became obscured. but the end result is that relatively small shareholders in a foreign corporation are taxed in an otherwise tax-free inbound asset reorganization because the foreign corporate earnings that are transferred to a u.s. corporate entity and give rise to basis were not subject to u.s. corporate tax as earned and could not be subjected to u.s. corporate tax at the time of the inbound transaction. it all results from the core premise, for which kingson cites professor andrews’ article, that when earnings and assets come into u.s. corporate tax solution, basis should be given only to the extent the earnings have been subject to tax. that premise should be challenged. indeed, based on a reading of professor andrews’ article dealing with the intersection of corporate level and shareholder level taxation, we suspect he might have led the challenge. iv. professor andrews’ perspective on the intersection of corporate and shareholder level taxation professor andrews’ statement cited above on the synchronization of basis and e&p was made in the purely domestic context. it was focused on the situation where a corporation distributes property under section 311. he made the entirely logical point that corporate asset basis as an accounting matter equals the sum of 61 kingson believed that section 367(b) could not apply at the corporate level because its authority is to treat a foreign corporation as a corporation as opposed to a collection of assets; in an inbound asset reorganization such treatment is not necessary for the transaction to be tax-free to the acquiring corporation—under section 1032 it is not taxable on the acquisition of assets generally, whether or not in corporate solution. id. at 28-29. 2025] reflections on 367(b) regulations and inbound transactions 175 contributed capital and retained earnings (assuming no leverage) so that if appreciated assets are distributed by a corporation, and (as the code then provided) no gain is recognized at the corporate level, earnings and profits should be reduced only by asset basis.62 the gain should not be recognized for e&p purposes if it is not subject to tax. the need to keep e&p and asset basis in synch compelled such results. professor andrews’ point was, of course, correct in the domestic context: wherever possible, asset basis should reflect contributed capital and retained earnings, which presumably have been subject to tax unless specifically exempted. but that point was just a piece of his much broader analysis of the role of e&p in our corporate tax as it had developed by the mid-1950s. professor andrews began that analysis by positing that the taxation of shareholders on corporate earnings, as reflected in part in e&p, is best understood by comparing two polar paradigms of the intersection of corporate and shareholder level taxation. the first paradigm is that shareholder taxation of distributions should be based on the amount of corporate retained earnings that are attributable to that shareholder’s share ownership. the second paradigm is that shareholder taxation should be seen as unrelated to any corporate earnings and based solely on distributions received that are not in the nature of capital gains. he then tested the current law (as of 1955), including caselaw, to see which paradigm most closely fits. he pointed to a number of court cases where the taxation of a distribution to a shareholder was tied to the earnings of the corporation during the shareholder’s ownership period—cases relating to pre-1913 earnings distributed after 1913, distributions of post-1913 earnings by corporations with pre-1913 losses, and distributions of prior year corporate earnings in a year (like 1917) when tax rates on dividends received by individuals were increased. he concluded that “the idea that earnings realized at the corporate level are the real subject of income tax on shareholders has had more than just a passing vogue and may serve to explain, if it does not justify, some of the applications of the earnings and profits requirement.”63 he then pointed out the “number of ways in which our present taxation of shareholders does not simulate a delayed tax on corporate earnings.”64 he discussed cases involving the distribution of current earnings after years of prior deficits, pointing out that shareholders do not benefit from the losses by treating the distribution as a return of invested capital even though at the corporate level the losses are effectively so treated. he described that the proceeds from corporate liquidations are treated as capital gain rather than as a dividend to the extent of retained earnings. and he pointed out that shareholders selling their stock receive capital gain treatment even though the gain may reflect increases in retained earnings. he concluded that the taxation “of distribution[s], both in operation and in reason, is a good deal more than a mere postponement of tax on corporate earnings.”65 based on that conclusion, professor andrews suggested that the concept of e&p, while useful in the context of exempting post-1913 distributions of pre-1914 corporate earnings, has outlived its usefulness and should be eliminated 62 andrews, supra note 60, at 1408. 63 id. at 1417. 64 id. at 1418. 65 id. at 1425. 176 columbia journal of tax law [vol. 16:2 or substantially limited: the tax on shareholders mostly is, and should be, a separate tax on realized distributions and not a delayed tax on corporate earnings. professor andrews did not discuss foreign corporations in his article. but there is no basis, in his analysis at least, for distinguishing the tax on realized distributions of foreign corporations from those of domestic corporations. and, while professor andrews never used the word, his discussion of a policy that treats the tax on dividends as a delayed tax on corporate earnings could have been described as a policy of “deferral.” to him, a true delayed tax on corporate earnings would look a lot like what later became section 1248 as applied to foreign corporations that are or were cfcs. we suspect he would describe section 1248 as converting what otherwise is a separate tax on distributions by foreign companies into a delayed tax on the earnings of such companies at the shareholder level. how does all this relate to section 367(b) and corporate level tax avoidance in an inbound asset reorganization? returning to first principles, the united states does not tax a foreign corporation on its earnings that are not fdap or effectively connected to a u.s. trade or business. that is a sensible jurisdictional rule, at least assuming the corporation is not managed and controlled in the united states. noneffectively connected and non-u.s.-source amounts are excluded from gross income; section 11(d) says section 11 applies “only as provided by section 882.” section 882(b) provides that gross income “includes only” amounts that are effectively connected with a u.s. trade or business or are otherwise derived from u.s. sources. that treatment is parallel to the treatment of tax-exempt bond interest under section 103, which provides that “gross income does not include” such interest. we often say we are “deferring” the tax on a foreign corporation’s income until it is distributed, but jurisdictionally that is a misnomer. even before the 2017 tcja, the united states never taxed non-u.s. source, non-effectively connected foreign corporation income as such. apart from subpart f (and now gilti), we only taxed dividends as they were received, which is consistent with a separate tax on shareholders rather than a delayed tax on corporate earnings, just as it is in the domestic corporate context. we did provide an appropriate foreign tax credit to corporate u.s. shareholders but arguably that was justifiable as our way of managing cross-border double taxation of corporate earnings, as an alternative to a dividends-received deduction, not an indication of a system of deferred tax on corporate earnings. that is why, for example, we provided the credit for preacquisition earnings that are distributed to acquiring shareholders of a foreign corporation. nonetheless, the notion that the u.s. tax on the income of a foreign corporation generally should ultimately be imposed but is “deferred” has influenced our international tax policy for over 60 years. given the paradigm of separate shareholder taxation posed by professor andrews as a general matter, we would argue we only really adopted the paradigm that the tax on a shareholder of a foreign corporation is a deferred tax on corporate earnings with the enactment of subpart f and section 1248 (and its expansion with gilti), and the application of that paradigm is limited to section 1248 shareholders and u.s. shareholders. if a foreign company liquidates under section 331, we treat the income as capital gain to the shareholder apart from section 1248. if a u.s. company acquires a foreign corporation in a taxable transaction and subsequently liquidates it, we do not tax the foreign corporation’s pre-acquisition earnings. even 2025] reflections on 367(b) regulations and inbound transactions 177 if the u.s. corporation acquires the to-be-liquidated foreign corporation in a taxfree reorganization transaction, we do not tax the pre-acquisition earnings where the corporation was acquired from shareholders who are not subject to u.s. tax. in these liquidation cases, we appropriately exempt the foreign corporation’s earnings from u.s. tax because, other than under sections 881 and 882, as a jurisdictional matter, we do not treat pre-acquisition income of a foreign corporation as ours to tax. the corporate tax for a non-cfc foreign corporation is properly viewed as separate from the shareholder tax, just as professor andrews viewed it for a domestic corporation. if the tax on dividends is separate from the tax on corporate earnings where section 1248 shareholders and u.s. shareholders of cfcs are not involved, why should migrating a foreign corporation’s retained earnings—when they are not previously taxed e&p (“ptep”) or section 1248 amounts—to its u.s. acquiror in an inbound asset reorganization be viewed as tax avoidance? kingson’s explanation was that it is corporate level avoidance to grant an inbounding company asset basis when its earnings have not been taxed. but we suspect even he would have granted that basis derived from tax exempt income should be recognized. while we could not find a discussion in kingson’s writings, professor andrews was clear that exempt income at the corporate level creates corporate earnings and asset basis. moreover, in his 1979 article, kingson acknowledged that the migration of the e&p of a puerto rican company liquidating into a u.s. company would not give rise to section 367(b) tax avoidance because had it conducted itself as a u.s. corporation its earnings would have been exempt.66 the granting of inbound asset basis is only “tax avoidance” if the earnings that gave rise to that basis should have been subject to u.s. tax in the first place. if they are properly exempt from u.s. tax, no tax avoidance results from the resulting basis. kingson’s deferral paradigm makes sense in a world of cfcs and section 1248 shareholders; we would argue it does not make sense beyond that world.67 the preambles to the 1977 temporary regulations and the 1991 proposed regulations both posited that the regulations attempted to balance the desire for taxing repatriations that would otherwise result in avoidance with the need to minimize distortions.68 but both adopted kingson’s framework that there was corporate level avoidance (dealt with in the § 7.367(b)-3 regulation) separate from any shareholder level avoidance (dealt with in the § 7.367(b)-7 regulation) and that, since there is no authority to tax the inbounded earnings under section 367(b) directly, the earnings should be taxed to its shareholders or, if feasible, asset basis should be reduced. but if the premise that non-cfc foreign corporate earnings should be subject to u.s. tax before assets can have basis is wrong because the pretransaction earnings are exempt because they are not ours to tax, we need not worry about the magnitude of asset basis when non-cfc corporations move inbound— 66 see kingson, supra note 15, at 31. 67 in a post-loper bright world, we wonder whether taxpayers could challenge the regulations as exceeding the authority granted by congress in situations where there arguably is no “avoidance of federal income taxes.” see loper bright enters. v. raimondo, 603 u.s. 369 (2024) (overruling chevron). 68 see supra part ii.b. (overviewing the “repatriation principle” and “distortion principle”). 178 columbia journal of tax law [vol. 16:2 any more than we worry about the basis of assets of individuals when they become u.s. resident taxpayers. if this is correct, then the focus of section 367(b) with respect to corporate level avoidance in inbound asset reorganizations should be preserving or collecting the section 1248 amount.69 requiring shareholders to include the all e&p amount instead of the section 1248 amount for the acquired foreign corporation and requiring gain recognition by non-section 1248 shareholders in lieu of that inclusion becomes a distortion rather than a way of preventing avoidance. indeed, as a policy matter, one could go further and say that our current rules create an even greater distortion in an inbound asset reorganization because, while section 362 steps down the basis of any net loss assets of the foreign corporation, nothing steps up the basis of assets with net built-in gains.70 arguably, unrealized asset gains that are attributable to periods before the foreign corporation is acquired should also be seen as not ours to tax. many foreign jurisdictions take that view and provide inbound assets with a fair market value basis.71 moreover, our rules can result in double taxation because most jurisdictions (including the united states) generally trigger an exit tax on appreciated assets when a resident company liquidates, merges, or migrates to another jurisdiction.72 v. impact of 2017 tcja on inbound asset reorganization corporate level tax avoidance under reg. § 1.367(b)-3 this review of past history spotlights an arguably fundamental error in assuming the paradigm of “deferral” with respect to the taxation of shareholders on foreign corporation earnings but not with respect to domestic corporation earnings. the 2017 tcja largely eliminated the deferral paradigm with the enactment of section 245a. that provision, of course, effectively exempts dividends received by corporate u.s. shareholders in a foreign corporation to the extent of the foreign corporation’s “undistributed foreign earnings” unless the dividend is a “hybrid dividend” or unless the shareholder holds its foreign corporation stock for less than one year. assuming no “hybrid dividend” and a one-year holding period, any 69 the focus of section 367(b) with respect to shareholder level avoidance in inbound asset reorganizations will be discussed later. see infra part vi. 70 note, however, that where section 362(e)(1) applies and inbounded property has an aggregate built-in-loss, the inbounding corporation steps down the basis of the built-in-loss assets and steps up the basis of its built-in-gain assets. see i.r.c. § 362(e)(1). 71 the u.s. does allow foreign individuals coming into the u.s. tax net to engage in self-help transactions that step up asset basis prior to domestication through a check-the-box election. for instance, pursuant to treas. reg. § 301.7701-3(g)(1)(iv), such foreign individual would be treated as contributing all of the assets and liabilities of a disregarded entity to a corporation in exchange for stock of the corporation. if the election is effective on the day of the domestication, under reg. § 301.7701-3(g)(3), the deemed contribution would be treated as occurring immediately before the close of the day before the individual comes into the u.s. tax net, and so, the individual would have a fair market value basis in such inbounded assets. see i.r.s. chief counsel memorandum, am 2021-002 (april 2, 2021). 72 as a practical matter, the prevalence of these foreign exit taxes means that foreign companies consider an inbound asset reorganization only if they are (or can be restructured to be) holding companies resident in jurisdictions that exempt gain on the sale of subsidiary stock. 2025] reflections on 367(b) regulations and inbound transactions 179 distribution of a foreign corporation out of its earnings and profits is not taxed to a corporate u.s. shareholder as long as the e&p did not originate from u.s. effectively connected income or from a dividend paid by an 80%-owned u.s. corporation (“u.s.-sourced undistributed earnings”). this fundamental shift in tax policy requires us to rethink our notions of both corporate level avoidance and shareholder level avoidance; it provides an opportunity to correct the arguable mistakes of the past. we do not think that even kingson would have argued that an inbound asset reorganization should trigger u.s. tax on the undistributed foreign-source earnings of a foreign corporation after the enactment of section 245a notwithstanding his avoidance principle (i.e., avoidance is doing indirectly what could not be done directly).73 thus, even if the arguments above about the mistakes of our prior deferral policy are not accepted, it is clear there can be no corporate level avoidance in an inbound asset reorganization where all of the earnings of the foreign corporation are undistributed foreign earnings under section 245a, no hybrid dividend issue exists and the one-year holding period is met. in that circumstance the concern of the section 367(b) regulations should be entirely focused on shareholder level avoidance. that leaves questions about whether and how the exclusions from section 245a should affect the treatment of inbound asset reorganizations. first, should corporate level avoidance be an issue if the foreign corporation does have u.s.source undistributed earnings? we would argue it should not to the extent the foreign corporation is not a cfc. these undistributed earnings by definition have already been subject to u.s. tax. in most cases they will be dividends from u.s. subsidiaries of the foreign corporation, which in addition to being subject to u.s. corporate tax could well have been subject to a u.s. withholding tax. similarly, effectively connected earnings have been subject to u.s. tax and, potentially, branch profits tax.74 section 245a excludes them presumably to avoid an advantage to a u.s. corporation owning less than 80% of the stock of another u.s. corporation by holding those shares through a foreign corporation in circumstances where the dividend was not subject to subpart f inclusion. but it would be an unusual case indeed if the foreign corporation utilized to hold the stock were not a cfc, making the abuse to which the section 245a limitation applied essentially irrelevant where non-cfc foreign companies are involved. and the practical difficulties of determining the historic e&p of a foreign multinational and tracking which portion is attributable to earnings other than undistributed foreign earnings would seem to accomplish little of value other than yet more accounting firm revenues. including the section 1248 amount at the shareholder level in an inbound asset reorganization (which would trigger the section 245a deduction to the extent applicable) would thus seem to be a sufficient deterrent to any real concerns regarding u.s.-source undistributed earnings.75 73 admittedly, taking the argument to its logical conclusion, even after the enactment of section 245a, kingson may have argued that if the foreign corporation had always been a u.s. corporation, it would have been subject to u.s. tax. 74 i.r.c. § 884. 75 admittedly, this provides a benefit to inbound asset reorganizations when compared to inbound stock reorganizations, but given the practical difficulty of tracking historical domestic source 180 columbia journal of tax law [vol. 16:2 hybrid dividends, though rare in today’s post-beps world, do need to be dealt with, but also are only relevant in the context of foreign corporations that are cfcs. if a foreign corporation that is acquired in an inbound asset reorganization is a cfc and has a u.s. shareholder with a hybrid dividend account with respect to its stock, that account should be triggered to that shareholder. if the account relates to a lower-tier cfc, the account need not be triggered because the inbound asset reorganization should not affect subsequent subpart f or direct income inclusions if the lower-tier cfc pays a dividend in the future. that leaves the section 246 one-year holding period to be dealt with. the assumed rationale for this limitation is to prevent dividend stripping transactions and other midco-type planning opportunities that could arise from temporary ownership of foreign corporation stock. an easy path to prevent such planning in the inbound asset reorganization context would be to require that a substantial portion of the assets acquired in the transaction be held for one year or more in order to avoid current taxation of the foreign corporation’s e&p.76 in sum, any corporate level avoidance in an inbound asset reorganization can be more than adequately dealt with through regulations that trigger an inclusion to a section 1248 shareholder of the section 1248 amount and to a u.s. shareholder of a cfc of the hybrid dividend account for the inbounding cfc with respect to such u.s. shareholder’s stock. otherwise, there is no reason why corporate level tax avoidance should be seen as an issue and the foreign corporation’s e&p (other than any ptep) should migrate to the u.s. corporation, subject to the normal rules under section 381. there is no reason to expunge the e&p of the foreign company; given that our corporate tax is best viewed as a separate tax, its distributions out of earnings should be dividends whether or not the distributed amounts were earned before or after the transaction.77 vi. shareholder level tax avoidance on inbound asset and stock reorganizations the above analysis leads to the conclusion that, to prevent corporate level tax avoidance in an inbound asset reorganization, the section 1248 shareholders should generally be taxed on their section 1248 amounts and u.s. shareholders on any amount in their hybrid dividend accounts. but what about shareholder level avoidance? under the current reg. § 1.367(b)-3, the required inclusion of the all earnings of foreign corporations that are not cfcs, it is difficult to see this benefit as avoidance. moreover, it seems that, when adopted, regulations under section 245a (which give the secretary very broad authority) should provide a generally applicable practical limit on the need to track the historical u.s. source e&p in the case of a section 245a distribution by a foreign corporation that has never been a cfc. without such a limit, the statute is arguably unadministrable for u.s. corporations acquiring interests in such foreign corporations. 76 if necessary, taxpayers could be required to sign an agreement to file an amended return reflecting taxation of that e&p where a substantial portion of the foreign corporation assets are not retained for the twelve-month period. 77 in conformity with the section 362 imported loss rule, the regulations could limit any imported net operating loss (“nol”). technically, however, the only nol that could be imported would be one arising from effectively connected gross income, so there is a strong argument for letting section 381 apply as it would in a transaction between two domestic corporations. 2025] reflections on 367(b) regulations and inbound transactions 181 e&p amount and the triggering of gain eliminate any need to consider further any shareholder avoidance, so the regulations are silent. in that context, it is helpful to review the history of the regulations’ treatment of section 1248 shareholders and other shareholders in inbound stock reorganizations (i.e., reorganizations under section 368(a)(1)(b) or (a)(2)(e)) where shareholder level avoidance does need to be separately considered. the 1977 temporary regulations recognized a potential for shareholder level tax avoidance when a u.s. shareholder of a cfc exchanges stock in the cfc for stock in a domestic corporation. thus, the regulation (reg. § 7.367(b)-7) required an inclusion of the section 1248 amount by the exchanging section 1248 shareholder, in a manner similar to the inclusion had the shares been exchanged for stock in a foreign corporation that was not a cfc or with respect to which the exchanging section 1248 shareholder was not a section 1248 shareholder. that provision thus triggered the section 1248(c)(2) amount of lower-tier foreign corporations for a section 1248 shareholder. the 1991 proposed regulations and the 2000 final regulations took a different approach, concluding that the provision, as applied to an exchange for domestic corporation stock, was unnecessary because, though not explicitly stated, the acquiring corporation would inherit the section 1248 amount of the exchanging section 1248 shareholder. even then, it is not clear this change in direction was justified, for two reasons. first, the treatment to individual section 1248 shareholders exchanging stock in a foreign corporation differed substantially from the treatment of foreign corporate distributions to acquiring domestic corporations eligible for the foreign tax credit. second, for corporate shareholders exchanging stock in a foreign corporation, a section 1248 inclusion can often be advantageous due to the accompanying foreign tax credit and basis step-up—benefits that, absent a recognition event, pass on to the acquiring corporation.78 in today’s world, the 2000 final regulations are perhaps even more questionable given the section 245a deduction and basis step up for corporate shareholders. nonetheless, the regulation writers were apparently of the view that preserving the section 1248 amount was sufficient to satisfy the avoidance standard of section 367(b) even though that result advantaged some shareholders and disadvantaged others. of note is that, even from the perspective of the 1977 temporary regulations, the regulations drafters did not see other taxpayer favorable results from the transaction as a distortion that constituted avoidance. for example, the fact that after the exchange a corporate holder of stock was eligible for a dividendsreceived deduction on any dividend paid by the acquiring domestic corporation was not viewed as an avoidance. subsequent to the temporary and ultimately the 2000 final regulations, congress in 2002 enacted section 1(h)(11), providing a favorable tax rate on dividends from domestic corporations and certain foreign corporations. no one suggested then, or to our knowledge since then, that an exchange of stock in a foreign corporation not eligible for the favorable rate for stock of a domestic corporation creates an avoidance that should be addressed. indeed, both provisions are evidence that congress views the shareholder tax on 78 the section 1248 inclusion allows corporate u.s. shareholders an indirect foreign tax credit for a proportionate amount of the cfc’s creditable foreign taxes deemed paid. see i.r.c. § 960; see also i.r.c. § 902 prior to its repeal in the tcja. 182 columbia journal of tax law [vol. 16:2 dividends as a separate tax, not a delayed tax on corporate earnings; in both cases shareholders are eligible for favorable treatment for all eligible dividends received in a year, independent of when the amounts were earned and when the relevant shareholder acquired the corporate stock. given this history of what constitutes shareholder level avoidance in inbound stock reorganizations, triggering the section 1248 amount for section 1248 shareholders in inbound asset reorganizations should be sufficient to deal with any section 367(b) shareholder level avoidance concern. but it does lead to the question of whether the treatment of inbound stock reorganizations should be changed if the shareholder rules are changed as described above for inbound asset reorganizations. the historical view on inbound stock reorganizations was no doubt influenced by the fact that after a stock acquisition of a foreign corporation the pre-acquisition e&p of the acquired corporation would be subject to u.s. tax if distributed to the acquiring u.s. corporation and the u.s. corporation would inherit the exchanging section 1248 shareholder’s section 1248 amount. but, after the enactment of section 245a, both distributed earnings and section 1248 amounts will likely be substantially exempt. thus, avoidance arguably can occur with respect to the section 1248 amounts of exchanging individual section 1248 shareholders. whether that is a concern or not, we leave to others to ponder; suffice it to say here that if the regulations are changed to pick up the section 1248 amount of section 1248 shareholders in an inbound asset reorganization, it is worth considering the same result in inbound stock reorganizations. in any case, that consideration should not extend beyond the treatment of section 1248 shareholders and u.s. shareholders holding hybrid dividend accounts in a cfc. the treatment of distributions to other shareholders in cfcs and to any shareholder in a non-cfc differs after both an inbound asset reorganization and an inbound stock reorganization in ways that can be favorable or unfavorable, including corporate eligibility for the dividends-received deduction and the favorable dividend tax rate for individuals. in the end, these detriments and benefits should just be seen as attributes of the separate shareholder tax that differ based on whether the distributing corporation is foreign or domestic. if this is correct, then the regulatory solution of triggering the section 1248 amount for section 1248 shareholders and any hybrid dividend account for u.s. shareholders in a cfc should be sufficient to prevent tax avoidance at both the corporate and shareholder levels. eligible corporate section 1248 shareholders will receive the section 245a deduction for the foreign-sourced portion of that inclusion subject to triggering any hybrid dividend account. individual section 1248 shareholders will be fully taxed but at dividend rates reflecting the status of the acquired foreign corporation. all such shareholders will receive a basis step-up in the stock of the acquiring u.s. corporation. and the acquiring u.s. corporation will inherit the foreign corporation’s e&p under the normal rules of section 381. an important benefit of this proposal is its intersection with section 1059. the current regulations’ inclusion of the all e&p amount can lead to situations where a tax-favored inclusion given the section 245a deduction can generate a basis step up that results in a built-in capital loss in the stock of the acquiring u.s. corporation received in the exchange. that creates potential avoidance that arguably should be dealt with in the section 367(b) regulations. but by including 2025] reflections on 367(b) regulations and inbound transactions 183 only the section 1248 amount, which is limited to any built-in gain, the proposal presented here will not create a built-in capital loss to the section 1248 shareholder. a range of concerns and complexities can be avoided. one caveat to the above proposal: the section 1248 amount includes the e&p of lower-tier cfcs as well as the foreign acquired corporation. that makes sense where an exchanging u.s. shareholder receives stock in a u.s. corporation it only partially owns. but where that exchanging shareholder is, for example, part of the same u.s. consolidated group as the acquiring u.s. corporation, the need to trigger the section 1248 amount with respect to lower-tier cfcs is absent. in that circumstance the inclusion triggered by the inbound asset reorganization could exclude the section 1248 amount of the lower-tier cfcs otherwise included under section 1248(c)(2). there may be other circumstances worth considering where that lower-tier e&p amount can be sufficiently preserved to allow a more limited inclusion. vii. treatment of inbound liquidations if accepted, the above framework provides clear guidance for the treatment of inbound liquidations. the section 1248 shareholder in the section 332 inbound liquidation should pick up its section 1248 amount attributable to the liquidating foreign corporation, but not any amount under section 1248(c)(2) attributable to lower-tier foreign corporations as long as its interest in such lower-tier corporations preserves that section 1248 amount. that shareholder should be eligible for the section 245a deduction without regard to its holding period of the foreign corporation as long as after the liquidation it holds a substantial portion of the foreign corporation’s assets for one year or more. like in inbound asset reorganizations, the pre-liquidation e&p of the liquidating foreign corporation should migrate to the shareholder domestic corporation. viii. conclusion this article lays out what arguably is a fundamental rethinking of the relationship between u.s. persons and the foreign corporations in which they own stock. it takes the position that the earnings of a foreign corporation should be treated as exempt income because they are not ours to tax except with respect to section 1248 shareholders and u.s. shareholders of cfcs and then only to the extent of the subpart f, gilti and section 1248 amounts attributable to their stock and their hybrid dividend account. this position is based on the premise that our income tax on corporate earnings is best viewed as a separate tax from the shareholder income tax on distributions from corporations, and that, beyond sections 881 and 882, we do not and should not assert taxing jurisdiction over the corporate level earnings of a foreign corporation that is not a cfc. we do, of course, assert jurisdiction over distributions to u.s. taxpayers’ foreign corporations that are not cfcs, and our methods of taxing them vary from that of distributions from domestic corporations for both individual and corporate shareholders. but, as applied to shareholders other than section 1248 shareholders and u.s. shareholders in cfcs, those methods are best viewed as variations in the separate tax on 184 columbia journal of tax law [vol. 16:2 distributions, not as any kind of proxy for taxing underlying foreign corporate earnings. the consequence of this view is that the section 367(b) regulations should focus on triggering or maintaining the section 1248 and hybrid dividend amounts with regard to specific section 1248 shareholders and u.s. shareholders, not on taxing other u.s. persons on any foreign corporate earnings that might be attributed to them in a “delayed tax” or “deferral” paradigm. fortunately, the enactment of section 245a as it applies to corporate shareholders and the equalization for individual shareholders of tax rates on dividends and capital gains have potentially made embracing the recommendations of this article possible even without agreement on its premise. the “tax avoidance” stakes in any inbound reorganization are now minimal. as a result, revising the regulations dealing with inbound transactions in a manner that ends the acceleration of u.s. tax on u.s. persons holding foreign corporation stock, beyond the section 1248 amount and any hybrid dividend amounts of relevant shareholders, would seem to be a proposal most policymakers can support. in the end, understanding that the fundamental premises of the existing regulations may well have been a mistake should just make it easier to achieve that support. protective tax elections emily cauble* abstract in many instances, taxpayers can select among various available tax outcomes by simply filing (or not filing) a tax election. oftentimes, taxpayers file tax elections on a protective basis. when a taxpayer believes that filing an election may not be necessary but files it just in case, the taxpayer files a “protective tax election.” while existing academic literature explores various aspects of tax elections, the filing of tax elections on a protective basis has not been addressed. this article begins to fill that gap. in some circumstances, the tax outcome that follows from making a protective tax election is not necessarily what the taxpayer intends to claim. a taxpayer might plan to claim a given tax outcome but be wary of a risk that the claim will fail. the taxpayer files a protective tax election to opt for the taxpayer’s second choice. in other words, the taxpayer uses the election to ensure that, if the taxpayer’s intended claim does fail, the alternative tax treatment imposed upon the taxpayer is more favorable than what would befall the taxpayer in the absence of the protective tax election. this article adopts the phrase “favorable fallback protective tax elections” to refer to protective tax elections filed under these circumstances. the policy implications of favorable fallback protective tax elections are numerous. the policy disadvantages of such elections include their potential to trap unwary taxpayers as well as their propensity for encouraging well-advised taxpayers to take more aggressive reporting positions. one policy advantage of such elections is the possibility that they may encourage taxpayers to reveal useful information to the irs. this article explores the various uses of protective tax elections, assesses their policy advantages and disadvantages, and recommends ways to amplify their advantages and mitigate their disadvantages. * professor, depaul university college of law. the author would like to thank alice abreu, jennifer bird-pollan, yariv brauner, rita de la feria, david elkins, heather field, brian galle, andrew hayashi, stephanie hoffer, leandra lederman, susan morse, henry ordower, orli orenkolbinger, leopoldo parada, natalia quinones, margaret ryznar, blaine saito, steven sheffrin, clint wallace, shannon weeks-mccormack, participants at the association for mid-career tax law professors 2021 workshop, and participants at the indiana/leeds summer tax workshop series 2021 for their very helpful comments on earlier versions of this article. the author would also like to thank the editors of the columbia journal of tax law for their helpful comments and edits. finally, the author would like to thank israel del mundo for excellent research assistance. 78 columbia journal of tax law [vol: 13:2 introduction .................................................................................................................... 79 i. examples of protective tax elections .................................................................... 82 a. example of belt and suspenders protective tax election – u.s. tax classification of entity formed outside the united states ................................ 84 b. example of belt and suspenders protective tax election – elections that are (potentially) duplicative ..................................................................................... 85 c. favorable fallback protective tax elections ..................................................... 85 d. example of favorable fallback tax election that is (in a sense) not allowed – section 6015(c) election .................................................................................. 92 ii. trapping unwary taxpayers .................................................................................... 94 iii. encouraging taxpayers to take more aggressive reporting positions ....... 95 a. the concern – in brief ....................................................................................... 96 b. point of contrast – late filed elections............................................................... 96 c. why favorable fallback protective tax elections may be less objectionable than elections filed late in response to irs challenge ................................ 101 d. will taxpayers who file be more likely to be taxpayers taking defensible positions? .......................................................................................................... 103 iv. encouraging taxpayers to reveal useful information to the irs .............. 106 v. providing taxpayers with a degree of certainty ............................................. 110 a. private letter rulings ....................................................................................... 111 b. tax indemnity insurance .................................................................................. 112 c. tax opinions ..................................................................................................... 113 d. implication for favorable fallback protective tax elections .......................... 113 vi. recommendations .................................................................................................... 114 a. when an election affects only taxpayers with access to sophisticated advice ............................................................................................................... 115 b. when a wide range of taxpayers are involved ............................................. 115 appendix ............................................................................................................................ 119 2022] protective tax elections 79 introduction in many instances, taxpayers can select among various available tax outcomes by simply filing (or not filing) a tax election. tax elections pervade the internal revenue code and the treasury regulations and arise in numerous areas of tax law including individual income taxation,1 the taxation of business entities,2 international taxation,3 and other areas.4 oftentimes, taxpayers file tax elections on a protective basis. when a taxpayer believes that filing an election may not be necessary but files it just in case, the taxpayer files a “protective tax election.” in some circumstances, the taxpayer has a given tax outcome in mind that the taxpayer intends to claim, and the taxpayer files an election on a protective basis for additional assurance that the tax outcome the taxpayer has in mind is correct. this article will adopt the phrase “belt and suspenders protective tax elections” to refer to protective tax elections filed under these circumstances. as an example of this type of protective tax election, consider a taxpayer who intends to claim the tax outcome that follows from filing an election and is uncertain about whether a valid election was already filed.5 in that instance, the taxpayer might simply file a (potentially duplicative) election on a protective basis—the filing is made on a protective basis because it might be unnecessary given that a valid election may have already been filed. in other circumstances, the tax treatment that follows from making the protective tax election will not necessarily be what the taxpayer claims. this article will adopt the phrase “favorable fallback protective tax elections” to refer to protective tax elections filed under these circumstances. as an example of this use of protective tax elections, a taxpayer might plan to claim a given tax outcome, but the taxpayer may be aware of some risk that their claim will fail. in some cases, filing a protective tax election could help to ensure that, if the taxpayer’s claim does fail, the alternative tax treatment imposed upon the taxpayer is more favorable than what would befall the taxpayer in the absence of the protective tax election.6 congress, treasury, or the irs have explicitly permitted filing some tax elections on a protective basis.7 in the case of other tax elections, taxpayers routinely file on a protective basis despite lack of specific authorization.8 in the case of yet another set of tax elections, lawmakers have explicitly disallowed 1 available tax elections include an individual taxpayer’s election between claiming the standard deduction or itemizing deductions. see i.r.c. § 63(b). 2 available elections include elections that determine how business entities are classified as well as various elections that arise in the context of partnerships and corporations. see, e.g., treas. reg. § 301.7701-2; treas. reg. § 1.704-3; i.r.c. § 754; i.r.c. § 338; i.r.c. § 362(e)(2)(c). 3 see, e.g., i.r.c. § 1295. 4 for instance, various elections can also be found in the context of estate and gift taxation. 5 for further discussion, see infra part i.b. 6 for examples, see infra part i.c. 7 for example, see infra part i.c.2 (protective qef election explicitly authorized by treasury regulations). 8 for examples, see infra part i.c.3 (protective trs elections routinely made but no explicit authorization), part i.c.1 (protective section 1237 election not explicitly authorized by authority on which taxpayers can rely but favorable private letter ruling has been issued). 80 columbia journal of tax law [vol: 13:2 protective filings.9 prior to turning to an examination of protective tax elections, it is important to note that tax elections, as a broader category, give rise to various policy implications, as discussed in existing literature.10 as noted by this literature, tax elections may exacerbate inequities by offering tax benefits to only taxpayers who have access to sufficiently sophisticated tax advice.11 consequently, the use of tax elections is problematic, especially in areas of law that affect a wide swathe of taxpayers including those without access to sophisticated advice. whenever possible, in such contexts, the best course of action may be to avoid use of tax elections, or, if they must be used to serve some other policy goal, adopt design features that make them less likely to trap unwary taxpayers.12 the aim of this article is not to analyze tax elections, in general. rather, this article is focused on a question that has not yet been explored by existing literature—in particular, whether the ability to file an election protectively raises any significant policy issues, assuming that the underlying tax election exists.13 taking as a given that an underlying tax election is allowed, associated belt and suspenders protective tax elections are fairly innocuous.14 however, 9 for example, see infra part i.d. 10 see, e.g., emily cauble, tax elections: how to live with them if we can’t live without them, 53 santa clara l. rev. 421 (2013); heather m. field, choosing tax: explicit elections as an element of design in the federal income tax system, 47 harv. j. on legis. 21 (2010) [hereinafter, field, choosing tax]; heather m. field, checking in on “check-the-box” 42 loy. l.a. l. rev. 451 (2009) [hereinafter, field, check-the-box]; heather m. field, tax elections & private bargaining, 31 va. tax rev. 1 (2011) [hereinafter, field, private bargaining]; aubree l. helvey & beth stetson, the doctrine of election, 62 tax law. 333 (2008); victoria a. levin, the substantial compliance doctrine in tax law: equity vs. efficiency, 40 ucla l. rev. 1587 (1993); orli oren-kolbinger, the error cost of marriage (aug. 1 2020), (forthcoming) available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3668099 [https://perma.cc/8884l9ua]; alex raskolnikov, revealing choices: using taxpayer choice to target tax enforcement, 109 colum. l. rev. 689 (2009); emily satterthwaite, tax elections as screens, 42:1 queen’s law journal 63 (2016); george k. yin, the taxation of private business enterprises: some policy questions stimulated by the “check-the-box” regulations, 51 smu l. rev. 125 (1997); edward yorio, the revocability of federal tax elections, 44 fordham l. rev. 463 (1975). 11 see, e.g., cauble, supra note 10, at 446-47; field, choosing tax, supra note 10, at 3 1 (“[a]n election, while technically available to all eligible taxpayers, may be functionally available only to the wealthiest, most sophisticated group of taxpayers, who can best navigate the complexity of the election process.”); oren-kolbinger, supra note 10, at 5 (“taxpayers may be unknowingly locked into an inferior election and therefore not maximizing their tax benefits.”) 12 see, e.g., cauble, supra note 10, at 451-88. 13 commentators have noted the ability to file protective tax elections in particular contexts or described the mechanics of filing particular protective tax elections. for this type of discussion of protective section 362(e)(2)(c) elections, see, e.g., thomas hayes & david hering, beware asset basis reductions in carryover-basis transactions, 38 j. corp. tax’n 18, 20-22 (2011) (describing circumstances in which a taxpayer might make a protective section 362(e)(2)(c) election). for this type of discussion of protective tax elections in the entity classification context, see, e.g., bishop & kleinberger, limited liability companies: tax and business law ¶ 2.04 election mechanics (2005). however, existing literature lacks thorough description of the various contexts in which protective tax elections arise and lacks analysis of the advantages and disadvantages of allowing protective tax elections. 14 taking as a given that the underlying election is allowed, there does not appear to be any harm to allowing taxpayers to file a potentially duplicative election to ensure that the taxpayer 2022] protective tax elections 81 favorable fallback protective tax elections raise potentially thornier issues and will be the focus of this article’s analysis and policy recommendations. requiring that taxpayers file favorable fallback protective tax elections in order to secure more beneficial alternative tax treatment puts a high premium on planning and makes it very likely that only taxpayers with access to sophisticated advice will benefit from such elections.15 at the same time, allowing taxpayers to opt into more advantageous alternative tax treatment in case their claimed tax position is unavailable may encourage well-advised taxpayers to take more aggressive reporting positions (in other words, positions where irs challenge would have a greater likelihood of success).16 if a taxpayer can elect more beneficial backup tax treatment so that the taxpayer does not fall as far if the taxpayer’s claim is successfully challenged, the taxpayer may be more likely to go out on a limb and claim a position that carries with it a higher likelihood of successful challenge. while these facets of favorable fallback protective tax elections are problematic, they also may offer advantages. in some circumstances, allowing their use may provide valuable information to the irs.17 because the election only affects a taxpayer’s tax outcome if the tax outcome the taxpayer claims is unavailable, in some circumstances, the fact that the taxpayer files the election may suggest that the taxpayer concluded there was a risk that what they plan to claim may be unavailable. in addition, in some cases, taxpayers may use favorable fallback protective tax elections to manage uncertainty, which may be a useful feature of such elections.18 some favorable fallback protective tax elections are subject to restrictions that could mitigate some of the policy disadvantages and amplify some of the potential advantages.19 for instance, in some cases, a taxpayer filing such an election must provide a statement justifying the tax outcome the taxpayer intends to claim and consent to an extended statute of limitations, allowing the irs more time to examine the taxpayer’s reported tax consequences.20 curiously, other, obtains the outcome that follows from making the election and that the taxpayer, in all events, intends to claim. there may be some additional administrative cost from the irs having to process additional election forms, but the irs might also save time that would be spent responding to questions from taxpayers about whether a valid election was already filed. moreover, if the underlying election is allowed, prohibiting taxpayers from filing an associated belt and suspenders protective tax election would be impractical. if the protective tax election turns out to be duplicative of an already filed election or unnecessary because it opts for the default treatment and the irs disallows it on the basis that it is unnecessary, then the earlier filed election or default treatment is in place, so the taxpayer still obtains the outcome the taxpayer sought. if the protective tax election turns out to be not duplicative and not merely a confirmation of the taxpayer’s default treatment, then, from the irs’s standpoint, it would be indistinguishable from an election that was not filed on a protective basis. therefore, aside from penalizing taxpayers for filing duplicative elections or elections that merely confirm their default treatment (which would seem to be an odd step to take given the inoffensive nature of such tax elections), prohibiting belt and suspenders protective tax elections does not seem viable. 15 for further discussion, see infra part ii. 16 for further discussion, see infra part iii. 17 for further discussion, see infra part iv. 18 for further discussion, see infra part v. 19 for further discussion, see infra part iii.d. 20 see infra part iii.d. 82 columbia journal of tax law [vol: 13:2 arguably similar favorable fallback protective tax elections are not subject to the same restrictions.21 by examining favorable fallback protective tax elections, this article develops recommendations for restrictions on their use and considers the possibility of employing such elections in other contexts to encourage taxpayers to provide information to the irs. in addition to helping to develop recommendations, an exploration of the use of favorable fallback protective tax elections offers illustrations that are relevant to two existing strands of literature. first, an existing body of literature examines uncertainty in tax law, discusses the various ways in which uncertainty may affect taxpayers, and describes steps taxpayers may take to mitigate uncertainty.22 protective tax elections represent one additional tool that taxpayers use to cope with uncertainty. a second existing strand of literature discusses circumstances when taxpayers, by taking required steps to obtain a given tax outcome, will sort themselves into different groups in a way that reveals useful information to the irs and/or ensures that the right taxpayers obtain the specified tax treatment.23 favorable fallback protective tax elections offer an opportunity to consider the circumstances under which this will occur. this article proceeds as follows. part i provides and categorizes various examples of protective tax elections. parts ii through v analyze the policy implications of allowing favorable fallback protective tax elections. in particular, part ii assesses such elections’ propensity for trapping unwary taxpayers. part iii describes their potential to encourage well-informed taxpayers to take more aggressive reporting positions. part iv analyzes the possibility that making such elections available will encourage taxpayers to reveal useful information to the irs. part v considers whether such elections might act as a tool that taxpayers use to obtain certainty. based upon the analysis of policy implications, part vi offers recommendations for the use and design of favorable fallback protective tax elections. part vii concludes the article. i. examples of protective tax elections protective tax elections fall into two different categories. a protective tax election in the first category (a “belt and suspenders protective tax election”) offers a taxpayer more certainty that the tax treatment the taxpayer intends to claim is correct. as one example, imagine that filing a given election is necessary to obtain the taxpayer’s desired tax treatment and imagine the taxpayer is uncertain about whether a valid election has already been filed. the taxpayer might simply 21 for further discussion, see infra part iii.d. 22 see, e.g., heather field, tax lawyers as tax insurance, 60 wm. & mary l. rev. 2111 (2019); yehonatan givati, resolving legal uncertainty: the unfulfilled promise of advance tax rulings, 29 va. tax rev. 137 (2009); jeffrey h. kahn, hedging the irs – a policy justification for excluding liability and insurance proceeds, 26 yale j. on reg. 1 (2009); sarah b. lawsky, probably? understanding tax law’s uncertainty, 157 u. pa. l. rev. 1017 (2009); kyle d. logue, tax law uncertainty and the role of tax insurance, 25 va. tax rev. 339 (2005); leigh osofsky, the case against strategic tax law uncertainty, 64 tax l. rev. 489 (2011). 23 see infra notes 111-117 & 129131 and accompanying text. 2022] protective tax elections 83 file a potentially duplicative election on a protective basis.24 in the case of belt and suspenders protective tax elections, the tax treatment that follows from making the election is the tax outcome that the taxpayer intends to claim in all events. in the example given, regardless of whether the election was not duplicative (and necessary) or duplicative (and unnecessary), the taxpayer intends to claim the tax outcome that follows from having made the election. sometimes the tax treatment that follows from making the election will not, necessarily, be what the taxpayer claims. protective tax elections made under these circumstances (“favorable fallback protective tax elections”) occupy the second category. to further illustrate the use of favorable fallback protective tax elections in general terms, imagine that certain conditions must be met for a given tax election to dictate a transaction’s tax outcome. at the time the election must be filed, imagine the taxpayer has some doubt about whether those conditions are met. in these circumstances, the taxpayer might opt to file an election on a protective basis to specify the taxpayer’s desired tax treatment in the event that the conditions are met. if the conditions are met, the election dictates the tax outcome. if the conditions are not met, the election has no effect, and the claimed tax outcome differs from what would have followed from the election had the conditions been met. thus, unlike belt and suspenders protective tax elections, the tax outcome claimed by the taxpayer will not necessarily be the tax outcome that follows from making the election. this part will proceed by describing, in more detail, examples of protective tax elections. it is worth noting that the examples described below are by no means the only examples of protective tax elections.25 while the remainder of this article will focus on favorable fallback protective tax elections, this part will also briefly provide examples of belt and suspenders protective tax elections because they provide a useful point of contrast to help clarify the contours of elections that belong in the favorable fallback protective tax election category. 24 for further discussion, see infra part i.b. 25 other examples abound. for instance, a protective entity classification election might be filed by the beneficiaries of a trust who believe it constitutes an ordinary trust but want to make a protective filing to select its classification in case it is considered to be a business entity. see, e.g., bishop & kleinberger, supra note 14. as another example, in response to the 2009 financial crisis, congress enacted code section 108(i) that allowed taxpayers to elect to defer cancellation of debt income (“cod income”) realized in certain circumstances. the irs issued a revenue procedure that allowed taxpayers to file a return claiming that the reacquisition of debt did not result in cod income and, at the same time, file a protective election to defer inclusion in gross income of the cod income in the event that the irs determined that the taxpayer had, in fact, realized cod income. rev. proc. 2009-37, 2009-36 i.r.b. 309. the revenue procedure specified that, if the taxpayer made such a protective election, the irs could subsequently challenge the taxpayer’s failure to include in income the cod income even if the statute of limitations had expired for the year when the cod income was realized. id. protective tax elections under section 362(e)(2)(c) are also explicitly authorized by the treasury regulations. see treas. reg. § 1.362-4(d). other examples include protective elections under i.r.c. § 761(a), protective § 83(b) elections, the protective election allowed by treas. reg. § 1.163(j)-9(b)(2)(ii), and a number of examples in the gift and estate tax arena; just to name a few. 84 columbia journal of tax law [vol: 13:2 a. example of belt and suspenders protective tax election – u.s. tax classification of entity formed outside the united states as discussed above, belt and suspenders protective tax elections are used merely to assure the taxpayer of obtaining the tax outcome that the taxpayer intends to claim in all events. as an example, consider a group of taxpayers who form a business entity outside of the united states and assume it is not a type of business entity that is required to be treated as a corporation for u.s. tax purposes.26 imagine the owners of the business entity have decided that they want to treat the entity as a corporation for u.s. tax purposes. if no election is filed with respect to the entity, then it will be treated as a partnership for u.s. tax purposes if it is not the case that all owners of the entity have limited liability.27 in that case, filing an election is necessary to obtain the tax classification of corporation. by contrast, if all the owners have limited liability, then the entity will be treated as a corporation for u.s. tax purposes unless a contrary election is filed.28 in that case, filing an election would not be required to obtain their desired tax treatment. if the owners are not entirely certain about whether the law of the jurisdiction in which the entity is formed provides limited liability to all owners within the meaning of the treasury regulations, they may opt to file a protective tax election to treat the entity as a corporation for u.s. tax purposes.29 the election is protective because it is possible that it is not necessary (if it is the case that all owners have limited liability). the ability to file protective tax elections in this context is not explicitly addressed by the treasury regulations, but the preamble to the regulations regarding entity classification do state that protective entity classification elections are not prohibited.30 in this example, the owners consistently intend to treat the entity as a corporation for u.s. tax purposes, and the role of the protective tax election is merely to ensure that they obtain that tax treatment. filing the protective tax election obviates the need to make a more certain determination of what the entity’s classification would be in the absence of an election, which could likely be a more costly endeavor than simply filing the election.31 26 for a description of entities that are automatically treated as corporations, see treas. reg. §§ 301.7701-2(b)(1) & (3)-(8). 27 treas. reg. § 301.7701-3(b)(2). 28 treas. reg. § 301.7701-3(b)(2). 29 see, e.g., field, check-the-box, supra note 10, at 472 (describing the use of protective entity classification elections in the context of non-u.s. entities) 30 t.d. 8697, 1997-1 c.b. 215 (“protective elections are not prohibited under the regulations.”) 31 one alternative to allowing protective tax elections in this context would be to replace the current default rule with a clearer one. in addition to obviating the need to make protective tax elections, a clearer default treatment would have some ancillary benefits. under the current default rule, not all potential uncertainty is cured by allowing protective tax elections. this is true, in part, because taxpayers will not file protective tax elections with respect to some non-u.s. entities, which will necessitate an eventual determination by the taxpayer and the irs of the default treatment of those entities. despite some potential administrative benefits to adopting a clearer default rule, leaving it murky may also offer some benefits. the fact that taxpayers file protective tax elections with respect to non-u.s. entities may increase the odds of those entities getting on the irs’s radar, for instance. 2022] protective tax elections 85 b. example of belt and suspenders protective tax election – elections that are (potentially) duplicative in the example above, protective tax elections are used to address uncertainty about the default tax treatment that applies in the absence of any election at all. in some other contexts, a taxpayer may be uncertain about whether a valid election has already been filed, and, to address that uncertainty, the taxpayer may opt to file the election—perhaps for the first time (in which case it is necessary to obtain the tax treatment that the taxpayer intends to claim) or perhaps for the second time (in which case it is unnecessary). the taxpayer is uncertain about whether a filing would be the first valid filing or an unnecessary second valid filing, and, as a result, the taxpayer’s filing is made on a protective basis. for one example, imagine taxpayers have formed a business entity and desire to treat it as an s corporation for tax purposes. in addition to meeting various eligibility requirements,32 an election must be filed in order to treat an entity as an s corporation, and all persons who are shareholders on the day on which the election is made must consent to the election.33 if there is any doubt about whether an initial election has been filed or about whether it was valid, the taxpayers may opt to file an election on a protective basis to ensure that, at least going forward, the entity is treated as an s corporation.34 c. favorable fallback protective tax elections in the examples above involving belt and suspenders protective tax elections, the outcome that follows from making the election is the outcome that the taxpayer intends to claim in all events. by contrast, in other contexts involving favorable fallback protective tax elections, a taxpayer files a protective tax election that will only affect the taxpayer’s tax treatment if the tax outcome the taxpayer expects to claim is unavailable. if the taxpayer’s expected tax outcome is unavailable, the protective tax election leads to tax consequences that differ from the consequences that the taxpayer plans to claim. thus, the outcome that follows from making the protective tax election is not the outcome that the taxpayer intends to report. the pattern that arises in the context of a favorable fallback protective tax election is illustrated in the table below.35 32 i.r.c. § 1361. 33 i.r.c. § 1362(a)(2). 34 see, e.g., eustice, kuntz & bogdanski, federal income taxation of s corporations, at ¶4.01 at footnote 9 (november 2021) (“at the risk of attracting the service's attention, a taxpayer can put any future question about the validity of an original election to rest by filing a protective election in a later year.”) 35 this illustrates the pattern that arises when the default treatment that follows without the election in place is less favorable than the treatment that follows from making the election, which will not always be the case. 86 columbia journal of tax law [vol: 13:2 table 1. favorable fallback protective tax elections taxpayer’s intended tax outcome most favorable outcome taxpayer’s intended tax outcome is unavailable and election is in place intermediate outcome taxpayer’s intended tax outcome is unavailable and election is not in place least favorable outcome the left-hand side of the table illustrates the tax outcome the taxpayer expects. the taxpayer is aware of some risk that the expected tax outcome may be unavailable. if that risk becomes reality, the resulting tax outcomes are shown on the right-hand side of the table. in that event, the taxpayer will fare better if the election is in place than if it is not. as a result, the taxpayer may file the election protectively to secure the taxpayer’s second choice tax outcome in case the taxpayer’s first choice is not available. 1. example of favorable fallback protective tax election – protective section 1237 election one example of a favorable fallback protective tax election arises in the context of the sale of subdivided land. when a taxpayer sells appreciated real estate, the resulting gain generally will be classified as ordinary income if the real estate is “property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business,” as described by internal revenue code section 1221(a)(1).36 real estate fitting this description is often referred to as “dealer property.”37 if, instead, the taxpayer holds the real estate for investment purposes, the resulting gain will be capital gain.38 whether real estate is “dealer property” is determined based on all relevant facts and circumstances bearing on whether the taxpayer held the property with the intent described in section 1221(a)(1).39 courts will examine facts that include, but are not limited to: (1) the frequency and substantiality of sales, (2) the extent of improvements made to the property by the taxpayer, and (3) efforts by the taxpayer to advertise the property for sale.40 because the determination of whether sale of 36 i.r.c. § 1221(a)(1). 37 see, e.g., gerald j. robinson, federal income taxation of real estate¶ 17.13 (2019) (using the “dealer property” phrase). 38 i.r.c. § 1221(a). 39 see, e.g., biedenharn realty co. v. united states, 526 f.2d 409 (5th cir. 1976) (examining various factors including frequency and substantiality of sales, extent of improvements to the property, and solicitation and advertising efforts); united states v. winthrop, 417 f.2d 905, 911 (5th cir. 1969) (describing the facts-and-circumstances-based nature of the test). 40 see, e.g., biedenharn realty co., 526 f.2d 409; winthrop, 417 f.2d 905. 2022] protective tax elections 87 real estate produces ordinary income or capital gain is based on the facts and circumstances of each case, cases with similar fact patterns sometimes result in different outcomes across cases within a jurisdiction or across jurisdictions. as one court stated, “finding ourselves engulfed in a fog of decisions with gossamer like distinctions, and a quagmire of unworkable, unreliable, and often irrelevant tests, we take the route of ad hoc exploration….”41 when certain requirements are met, internal revenue code section 1237 effectively provides a safe harbor ensuring that at least some gain from sale of subdivided land will not be treated as gain from sale of dealer property.42 in order to qualify for this safe harbor, in addition to meeting a host of other requirements,43 the taxpayer and certain other parties must not have made any substantial improvements to the land.44 if a taxpayer does not qualify for the safe harbor because the taxpayer has made what would otherwise be considered substantial improvements to the land then, as long as the improvements fall into certain categories and as long as the taxpayer has held the land for at least 10 years, the taxpayer can make an election to treat the improvements as not substantial and still obtain the treatment afforded by the safe harbor.45 if the taxpayer makes such an election, then the taxpayer cannot include the cost of the improvements in the basis of the land.46 in order to illustrate the potential use of a protective section 1237 election, consider the following example. example 1. anne holds a parcel of land that anne subdivided into five lots and improved by adding roads. anne has held the land for at least 10 years. setting aside the cost of adding the roads, anne’s basis in the land would be $110,000. the cost of adding the roads was $20,000. anne sells the lots for a total price of $200,000. in example 1, anne might file a return taking the position that, under the general facts and circumstances test, the parcels of land are not dealer property so that she realizes $70,000 of capital gain, resulting from the difference between the $200,000 selling price and a $130,000 basis that includes the cost of adding the roads. in case this claim fails because the irs asserts that the property is dealer property under the general facts and circumstances test, anne might file a section 1237 election on a protective basis. anne would make a protective filing to preserve the ability to claim $90,000 of capital gain under the safe harbor47 rather than $70,000 of 41 winthrop, 417 f.2d 906. 42 i.r.c. § 1237. if more than five parcels from the tract of real property are sold by the taxpayer, then some portion of the gain will be treated as gain from sale of dealer property. i.r.c. § 1237(b)(1). 43 for additional requirements, see i.r.c. § 1237(a). 44 i.r.c. § 1237(a)(2). 45 i.r.c. § 1237(b)(3). to be eligible to make this election, the improvements must consist of “the building or installation of water, sewer, or drainage facilities or roads” and the land must not have been “marketable at the prevailing local price for similar building sites without such improvement.” i.r.c. §§ 1237(b)(3)(a) & (b). 46 i.r.c. § 1237(b)(3)(c). 47 if the safe harbor applies, the gain is treated as capital rather than ordinary but the taxpayer’s 88 columbia journal of tax law [vol: 13:2 ordinary income.48 anne prefers the outcome that she originally reported ($70,000 of capital gain) to either of the alternatives ($90,000 of capital gain or $70,000 of ordinary income). however, in the event that the irs challenges her first choice, anne might very well prefer recognizing $90,000 of capital gain to recognizing $70,000 of ordinary income, assuming a sufficient difference in the effective tax rate applicable to each type of income in her hands.49 thus, she may file this election on a protective basis to secure a more favorable second choice in case her first choice fails. this example follows the general pattern shown in table 1 above, as illustrated in table 2 below. table 2. section 1237 protective tax election taxpayer’s intended tax outcome $70,000 capital gain @ tax rate of 20%, results in $14,000 in tax liability taxpayer’s intended tax outcome is unavailable, and a protective tax election is in place $90,000 capital gain @tax rate of 20%, results in $18,000 in tax liability taxpayer’s intended tax outcome is unavailable, and a protective tax election is not in place $70,000 ordinary income @ tax rate of 37%, results in $25,900 in tax liability regarding the validity of a protective section 1237 tax election, the treasury regulations provide that “the rules of [s]ection 1237 are not applicable” if the real property would not have been dealer property under the general facts and circumstances test.50 arguably, this means that, if the property is not dealer property, a protectively filed section 1237 election has no effect on the property’s basis so that the cost of improvements can be included in basis. if, instead, it is dealer property under the facts and circumstances test, then the protectively filed section 1237 election does take effect. moreover, in a letter ruling issued in 1986, the irs concluded that a taxpayer could file a section 1237 election protectively, to take effect only if the irs determined that the sales of subdivided property did not qualify for capital gain basis in the property does not include the cost of the roads. 48 if the irs successfully asserts that the land is dealer property and if the taxpayer has not made an effective section 1237 election, the gain is ordinary income, but the basis of the property includes the cost of the roads. 49 this is true in the case of the assumed tax rates shown in table 2 below, for instance. 50 treas. reg. § 1.1237-1(a)(4). 2022] protective tax elections 89 treatment under the general facts and circumstances test.51 the ruling stated, “since the [question of whether property is dealer property] is generally a question of fact a taxpayer would naturally want to make a protective election under section 1237(b)(3)(c) where substantial improvements have been made. we believe that such election is proper.”52 2. example of favorable fallback protective tax election – protective qef election another example of a favorable fallback protective tax election arises in the context of the passive foreign investment company (“pfic”) rules and the qualified electing fund (“qef”) election. a u.s. person who owns stock in a nonu.s. corporation that constitutes a pfic is subject to certain tax rules generally aimed at limiting the u.s. person’s ability to benefit from deferral of u.s. tax by delaying receipt of distributions from the pfic and sale of their interest in the pfic.53 a non-u.s. corporation will be a pfic in a given year if at least 75% of its gross income for the year consists of certain types of passive income or at least 50% of its assets held that year produce passive income or are held for the production of passive income, subject to some exceptions.54 if a non-u.s. corporation is a pfic, one of several tax regimes will be imposed upon a u.s. person who owns stock in the pfic.55 one possible tax regime applies only if the u.s. person has made a qef election.56 imagine a shareholder would prefer the qef tax regime to the other alternatives in the event that the corporation is a pfic but is uncertain, at the time the election must be filed, about whether the corporation is a pfic because of uncertainty about how it will fair under the income test or asset test.57 in that event, the shareholder might opt to file a qef election on a protective basis to preserve the ability to apply the qef regime if the corporation does, indeed, turn out to be a 51 plr 8626004. only the taxpayer to whom the ruling was issued may rely upon it as discussed in more detail in part v.a. 52 id. some language in the treasury regulations could be viewed as in tension with this letter ruling’s conclusion. in particular, the treasury regulations provide that, once made, an election under section 1237(b)(3)(c) is generally irrevocable and binding on the taxpayer. treas. reg. § 1.1237-1(c)(5)(iii)(c). this could be read to suggest that a taxpayer must report the resulting gain as if the basis excluded the cost of the roads once an election has been filed. however, in the letter ruling, the irs reasoned that, in order to become irrevocable, the election must have initially been binding, and, if the property would not have been dealer property under the general facts and circumstances test, section 1237 does not apply at all so that the election would not have been binding in the first place. see plr 8626004 (“the income tax regulations recognize the fact that the election under section 1237(b)(3)(c) is binding only if the property would otherwise be considered [dealer property].”) 53 see i.r.c. §§ 1291-1298. 54 i.r.c. § 1297. 55 see i.r.c. §§ 1291, 1293, 1296. 56 i.r.c. § 1295(a)(1). 57 this uncertainty may be attributable to factual uncertainty (about the entity’s income or assets) or to legal uncertainty about how the pfic classification rules may apply in certain circumstances. https://1.next.westlaw.com/link/document/fulltext?findtype=l&pubnum=1012823&cite=26uscas1237&originatingdoc=ie3d362a72e5911db8ac4e022126eafc3&reftype=rb&originationcontext=document&transitiontype=documentitem&contextdata=(sc.userenteredcitation)#co_pp_9ff3000073020 90 columbia journal of tax law [vol: 13:2 pfic.58 the potential tax outcomes in this example correspond to the general pattern illustrated in table 1 above, as shown in table 3 below. table 3. protective qef election taxpayer’s intended tax outcome non-u.s. corporation is not a pfic most favorable tax outcome taxpayer’s intended tax outcome is unavailable, and a protective tax election is in place intermediate tax outcome taxpayer’s intended tax outcome is unavailable, and a protective tax election is not in place least favorable tax outcome the treasury regulations explicitly authorize protective qef elections but also provide guidelines regarding when and whether they will be effective.59 in particular, generally a qef election must be filed by the due date for the shareholder’s tax return (including extensions) for the first year to which the election is intended to apply.60 however, the treasury regulations allow for taxpayers to make a qef election later than that time and have it apply retroactively to a previous year if (1) the shareholder had a reasonable belief that the corporation was not a pfic as of the time of the election’s due date and (2) the shareholder filed a “protective statement” as of the election’s due date to preserve the ability to make a late, retroactive election.61 when filing a protective statement, the shareholder must also agree to extend the statute of limitations for all the tax years to which the protective election applies.62 the protective statement must also describe the shareholder’s basis for its reasonable belief that the corporation is not a pfic, and the shareholder must sign the statement under penalties of perjury.63 if the shareholder has not complied with these requirements, generally the shareholder cannot make a qef election on a retroactive basis, subject to some exceptions.64 58 see, e.g., bittker, emory & streng, federal income taxation of corporations and shareholders: forms ¶ 15.10[4][e] (describing the availability of protective qef elections) 59 see infra notes 61-64 and accompanying text. 60 i.r.c. § 1295(b)(2); treas. reg. § 1.1295-1(e)(1). 61 treas. reg. § 1.1295-3(a). the regulations also provide guidance regarding what constitutes reasonable belief. treas. reg. § 1.1295-3(d). in the case of shareholders who own small interests in the corporation, different rules apply. treas. reg. § 1.1295-3(e). 62 treas. reg. § 1.1295-3(b)(2). 63 treas. reg. § 1.1295-3(c). 64 see treas. reg. § 1.1295-3(f) (setting forth a procedure under which a shareholder can seek irs consent to make the election on a retroactive basis despite not having filed the protective statement and providing requirements that must be met to obtain that consent). also, in the case of shareholders who own small interests in the corporation, different rules apply. see treas. reg. § 1.1295-3(e). 2022] protective tax elections 91 3. example of favorable fallback protective tax election – protective trs election another example of a favorable fallback protective tax election is a “protective trs election.” an entity that qualifies as a real estate investment trust (a “reit”) can receive favorable tax treatment. unlike a regular c corporation, a reit is entitled to a deduction for the dividends that it pays to its shareholders, so that, by making sufficient distributions, a reit can effectively eliminate any entitylevel tax. 65 to qualify as a reit, an entity must meet many technical requirements.66 one such requirement provides that not more than 10% of the value of the outstanding securities of any one issuer may be held by the reit, subject to certain exceptions.67 this 10% restriction does not apply to stock that qualifies as a real estate asset,68 and shares in another reit can qualify as a real estate asset.69 the 10% restriction also does not apply to stock in a “taxable reit subsidiary” (a “trs”).70 in order to be a trs, an entity must be a corporation, it must not be a reit, some of its stock must be owned by a reit, and the reit and the trs must have jointly filed an election to treat the corporation as a trs.71 if a reit (“parent reit”) owns a large percentage of the stock of another reit (“subsidiary reit”), the failure of the subsidiary reit to meet one of the reit qualification requirements could cause the parent reit to fail to meet the 10% restriction.72 to guard against this possibility, it is common practice to file a protective trs election with respect to the subsidiary reit.73 if the subsidiary reit meets all reit qualification requirements, the protective trs election has no effect, and the subsidiary reit is entitled to the favorable tax treatments afforded to reits. if the subsidiary reit fails a reit qualification test, the protective trs election takes effect. when the trs election takes effect, the subsidiary reit becomes subject to entity level tax, but its classification as a trs protects the parent reit from violating the 10% restriction and potentially failing to qualify as a reit itself. the tax outcomes in this context follow the general pattern illustrated in table 1 as shown by table 4 below. 65 i.r.c. § 857. 66 i.r.c. §§ 856, 857. 67 i.r.c. § 856(c)(4)(b)(iv)(iii). 68 i.r.c. § 856(c)(4)(b)(iv) (“except with respect to…securities includible under subparagraph (a) [which refers to “real estate assets, cash and cash items (including receivables), and government securities”]”). 69 i.r.c. § 856(c)(5)(b). 70 i.r.c. § 856(c)(4)(b)(iv) (“except with respect to a taxable reit subsidiary…”). stock in a trs is subject to another restriction; namely, not more than 20 percent of the value of the reit’s assets may be represented by securities of one or more trss. i.r.c. § 856(c)(4)(b)(ii). 71 i.r.c. § 856(l)(1). 72 if the parent reit owns more than 10% of the stock in the subsidiary reit, the parent reit would run afoul of the 10% restriction unless the subsidiary reit is a reit or the subsidiary reit is a trs. 73 see, e.g., bittker, emory & streng, supra note 58, at ¶ 1.03[10][b] (discussing the use of protective trs elections). 92 columbia journal of tax law [vol: 13:2 table 4. protective trs election taxpayer’s intended tax outcome parent and subsidiary are both reits most favorable tax outcome taxpayer’s intended tax outcome is unavailable, and a protective tax election is in place subsidiary is a trs, but parent is a reit intermediate tax outcome taxpayer’s intended tax outcome is unavailable, and a protective tax election is not in place neither is a reit least favorable tax outcome the practice of filing a protective trs election is not explicitly authorized. however, taxpayers apparently operate under the assumption that the practice of filing protectively is effective because an entity that is a reit cannot be treated as a trs.74 thus, as long as the subsidiary reit meets the requirements to qualify as a reit, the trs election would have no effect. it would only kick in if the subsidiary reit failed to qualify as a reit, and, in that event, the election would cause the subsidiary reit to be a trs and protect the parent reit from running afoul of the 10% restriction. d. example of favorable fallback tax election that is (in a sense) not allowed – section 6015(c) election after filing a joint return, imagine a couple divorces or legally separates. subject to some exceptions, a member of the couple might file an election under internal revenue code section 6015(c).75 by making such an election, an individual will be liable only for the part of any deficiency assessed by the irs with respect to the joint return that is “properly allocable” to that individual.76 74 i.r.c. § 856(l)(1). see, e.g., bna tax management portfolio 742-4th: real estate investment trusts, detailed analysis, f. taxable reit subsidiaries (“note that a new protective election must be filed each year: a valid trs election requires that the reit making it is a reit, and the trs making it is a trs; and if the subsidiary reit qualifies as a reit throughout a year, the election for that year will be invalid. there is no authority that specifically allows for a protective trs election; however, if the parent reit is a reit for a taxable year and a subsidiary reit turns out not to be a reit for that year, the situation will meet the requirements for a trs election.”) 75 such an election will not be valid, for instance, if assets were transferred between the individuals who filed the joint return as part of a fraudulent scheme. i.r.c. § 6015(c)(3)(a)(ii). also, if the individual had actual knowledge of the deficiency, or any portion of the deficiency, at the time they signed the joint return, other rules apply. i.r.c. § 6015(c)(3)(c). 76 i.r.c. §§ 6015(c)(1)-(3). for rules governing what portion of a deficiency is properly allocable to an individual, see i.r.c. § 6015(d). 2022] protective tax elections 93 when section 6015 was initially enacted, nothing in the statute precluded taxpayers from filing such an election as soon as they were divorced. as a result, many taxpayers filed protective elections when their divorce cases were finalized to opt for the treatment provided by section 6015(c) in the event that the irs assessed a deficiency with respect to a previously filed joint return. as other scholars have noted, the irs was “deluged” with such protective elections77 and asked congress for assistance to limit its administrative burden.78 in response, in 2000, congress amended the statute to provide that a section 6015(c) election cannot be filed with respect to a return until after the irs asserts a deficiency affecting the return.79 the previous practice of filing elections at the time of divorce could be framed as an example of a favorable fallback protective tax election. the election does not affect tax consequences unless the irs assesses a deficiency. if the irs does assess a deficiency, the election affects the taxpayer’s liability. finally, while the statutory change made in 2000 ends the practice of filing the election on a protective basis, the election can be filed any time between when the irs assesses a deficiency and two years after the irs has begun collection activities affecting the individual making the election.80 given that the time of divorce or legal separation is not the deadline for filing the election, losing the ability to make the election on a protective basis is not as consequential as it would be if the election did have such a deadline.81 as a useful point of contrast, recall the example shown in table 2 in part i.c.1 involving section 1237. when tax law permits anne in that hypothetical to file a protective election, she can initially report $14,000 in tax liability and preserve an opportunity to owe $18,000 in tax liability (rather than $25,900) if the irs later challenges her treatment of the property as investment property. if she were prohibited from filing the election on a protective basis but required to make the election prior to the irs auditing and potentially challenging her treatment of the property as investment property, then she would be forced to either: (1) not make the election, report $14,000 in tax liability, and risk the irs later asserting that the proper amount of tax liability is $25,900, or (2) make the election on a non-protective basis and report $18,000 in tax liability. by contrast, if she was prohibited from filing the election on a protective 77 see stephanie hunter mcmahon, an empirical study of innocent spouse relief: do courts implement congress’s legislative intent? 12 fla. tax rev. 629, 687 (2012). 78 robert s. steinberg, three at bats against joint and several liability: (1) innocent spouse, (2) the election to limit liability and (3) equitable relief: the treasury and courts begin to interpret irc 6015 after enactment of the irs restructuring and reform act of 1998, 17 j. am. acad. matrim. law. 403, 407 (2001) (“the irs had been deluged with an overwhelming number of prophylactic elections. … administratively, the irs was ill prepared for the onslaught of attempted elections and asked congress for assistance.”) 79 i.r.c. § 6015(c)(3)(b). 80 id. 81 the later timing of the election can, nevertheless, have some consequences. when it could be filed at the time of divorce, commentators noted that divorce lawyers viewed the ability to file as a potential “bargaining chip” in divorce proceedings. see ryan donmoyor, aba tax section meeting: divorce lawyers, tax lawyers split on election of proportionate liability, 98 tax notes today 149-2 (august 4, 1998). 94 columbia journal of tax law [vol: 13:2 basis but allowed an opportunity to make the election after-the-fact if and when the irs challenged her treatment of the property as investment property, then she could still, effectively, obtain the benefit of making a protective election—namely, she could report $14,000 in tax liability, but, if the irs challenged that outcome, make the election retroactively so as to owe $18,000 in tax liability rather than $25,900. in other words, the ability to wait and see and file an election late after the development of full information can serve the same function for a taxpayer as the ability to file earlier on a protective basis. thus, because an election under section 6015(c) can (and indeed must) be made late, after the taxpayer has full information, eliminating the ability to file on a protective basis takes away very little from taxpayers, at least from a tax perspective.82 ii. trapping unwary taxpayers favorable fallback protective tax elections give rise to numerous policy implications. one of their significant policy disadvantages is their potential to trap unwary taxpayers. benefiting from a favorable fallback protective tax election requires that the taxpayer declare, to the irs, an intention to obtain a more favorable second choice tax outcome if the taxpayer’s expected tax outcome fails. requiring taxpayers to elect into obtaining a more favorable fallback position places a premium on access to information about tax law. this is true of tax elections generally.83 as existing literature notes, when taxpayers can simply file an election to obtain more favorable tax treatment, well-advised taxpayers will have no reason to not file beneficial tax elections, while only taxpayers who are unaware of the existence of the election or the advantages of filing will miss out on similarly beneficial treatment.84 of course, the ability of parties with access to sophisticated advice to fare better than less well-advised parties is not unique to tax law. this lack of uniqueness does not make the phenomenon’s existence in tax law any less concerning. moreover, given that the tax system is often pointed to as the area of law best situated to respond to distributional concerns, traps for the unwary are arguably of particular concern in tax law.85 the tendency to trap unwary taxpayers that is true of tax elections generally may be even more true of favorable fallback protective tax elections. such an election does not entail making a selection that relates to a tax position the taxpayer plans to claim but rather involves making a choice that only becomes relevant if the tax position the taxpayer plans to claim turns out to be unavailable. as a result, the potential benefits of such an election may be particularly likely to escape the notice of taxpayers without access to sophisticated tax advice. to be clear, if the underlying election still existed but lawmakers disallowed protective filing, taxpayers lacking access to sophisticated advice might be even more severely disadvantaged. however, an alternative that avoids trapping unwary 82 it may be significant for non-tax reasons as discussed above in note 81. 83 see supra note 10 and accompanying text. 84 see supra note 10 and accompanying text. 85 see, also, emily cauble, accessible reliable tax advice, 51 u. mich. j. l. ref. 589, 592-93 (2018). 2022] protective tax elections 95 taxpayers is to bestow on all taxpayers—even those who neglect to file an election—the results that would have followed from making a favorable fallback protective tax election. in order to demonstrate, consider again the example in table 2 above involving the section 1237 election. imagine the section 1237 election was still available but taxpayers could not file it on a protective basis. under that set of circumstances, at the time anne filed her return, two options would be available to her: (1) she could file the election on a non-protective basis and report tax liability of $18,000 or (2) she could take the position that the land was investment property under the facts and circumstances test and report tax liability of $14,000 but risk being subject to tax liability of $25,900 if her claim were successfully challenged. taxpayers lacking access to sophisticated advice will be less able than taxpayers with access to such advice to accurately evaluate the risk of successful challenge. as a result, when forced to make this choice, taxpayers without access to sophisticated advice may be unlikely to make the most advantageous selection. if taxpayers can file the election protectively, then anne can report $14,000 in tax liability and ensure that her resulting tax liability will be only $18,000 if her claim is successfully challenged.86 if some taxpayers have access to sufficiently sophisticated advice to become aware of the availability of the election but not sufficiently sophisticated advice to accurately gauge the risk of successful challenge, then, for some taxpayers, eliminating the ability to file protectively might exacerbate the disadvantages stemming from a lack of access to more sophisticated advice. however, an alternative to continuing to allow protective filing that would more effectively mitigate the harms following from a lack of access to sophisticated advice is to simply bestow on all taxpayers—even those who neglect to file an election—the results that would have followed from making a favorable fallback protective tax election. in the context of the section 1237 election example, for instance, anne could report $14,000 in tax liability and be subject to $18,000 in tax liability if her claim was successfully challenged even if she did not file a protective tax election. i will refer to this alternative as the “deemed protective tax election approach.” as discussed in part vi.b below, in some contexts, such an approach may not be feasible. however, when it is feasible, it ought to be used in areas of tax law that affect a wide range of taxpayers, including those without access to sophisticated advice. iii. encouraging taxpayers to take more aggressive reporting positions while taxpayers without access to sufficiently sophisticated advice may miss out on the benefits of filing favorable fallback protective tax elections, taxpayers with access to such advice may be spurred on by such elections to take more aggressive reporting positions than they would without the ability to file on a protective basis. by filing a favorable fallback protective tax election, a taxpayer ensures that, if their intended tax treatment is not available, the alternative tax 86 this assumes she is not subject to penalties. 96 columbia journal of tax law [vol: 13:2 treatment imposed upon the taxpayer will be more favorable than it would be in the absence of the election. if the prospect of the alternative tax treatment is less daunting, the taxpayer may be more willing to take a risk by claiming a tax position that is associated with a higher likelihood of successful challenge. a. the concern – in brief to demonstrate how the availability of favorable fallback protective tax elections could spur taxpayers on to taking more aggressive reporting positions, it is useful to have a concrete example in mind. example 2. consider again the facts of example 1 and the outcomes displayed in table 2. in that example, if anne sells land and reports the gain as if the property were investment property, she incurs $14,000 in tax liability. if the irs successfully asserts that the land is dealer property, she will be subject to tax liability of $18,000 as a result of having filed a protective tax election (rather than tax liability of $25,900 that would result from successful irs challenge in the absence of an election). without the ability to file the election protectively, anne would be forced to choose between: (1) reporting $14,000 in tax liability but risking $25,900 in the event of successful irs challenge or (2) reporting $18,000 in tax liability. as a result of the ability to file the election protectively, she can instead report $14,000 in tax liability and only risk $18,000 in the event of irs challenge. without the ability to file protectively, if anne opts to take the position that the land is investment property, reports $14,000 in tax liability and is successfully challenged, in addition to any explicit penalties to which she may be subject, she is subject to an implicit penalty of having missed an opportunity to file the election on a non-protective basis and secure the intermediate outcome of reporting $18,000 in tax liability. the prospect of this implicit penalty may induce some taxpayers to opt for the safer course. in particular, some taxpayers may preemptively take the position that the land is not investment property under the facts and circumstances test and file a section 1237 election on a non-protective basis, leading to tax liability of $18,000. with the ability to file the election protectively, anne can report $14,000 in tax liability without sacrificing the opportunity to be subject to $18,000 rather than $25,900 if her initial characterization of the land as investment property fails. in other words, the ability to file protectively effectively eliminates the implicit penalty described above. the elimination of this implicit penalty could encourage taxpayers in anne’s position to report $14,000 rather than play it safe and report $18,000. b. point of contrast – late filed elections as an alternative to filing a favorable fallback protective tax election, a taxpayer might claim a given tax position and attempt to file a tax election that secures a more favorable alternative tax outcome later, only if the irs challenges 2022] protective tax elections 97 the taxpayer’s claimed tax position. for instance, returning to example 2 above, anne might report $14,000 in tax liability and wait and see if the irs challenges her position that the land is investment property. if the irs does raise such a challenge, anne might, at that time, attempt to file a section 1237 election so that successful irs challenge would result in tax liability of $18,000 rather than $25,900. moreover, the advantage (from the anne’s point of view) or the disadvantage (from the irs’s point of view) of a wait-and-see approach is that it avoids attracting the irs’s attention unnecessarily by filing the election ahead of time on a protective basis. the ability to use a wait-and-see approach, however, is constrained by the deadlines for filing elections and by limitations on the ability to file elections after their deadlines. the deadline for filing an election varies from election to election.87 for many (but not all) elections, the election must be filed by the due date for the relevant tax return (sometimes including available extensions).88 for example, the treasury regulations provide that the section 1237 election must be submitted with the taxpayer’s tax return for the year in which the taxpayer sells the real estate.89 at that time, the taxpayer will not know whether the irs will challenge the results that the taxpayer intends to claim. as a result, the deadline for many elections precludes taxpayers from taking a wait-and-see approach.90 a taxpayer might attempt to overcome this obstacle by filing an election after its deadline. however, limitations on filing late elections likely hinder such efforts. when setting forth guidelines for filing late elections, the treasury regulations divide tax elections into two groups—regulatory elections (those with due dates prescribed by a regulation, a revenue ruling, a revenue procedure, an irs notice, or an irs announcement) and statutory elections (those with due dates 87 see, also, helvey & stetson, supra note 10, at 338 (describing common deadlines for filing tax elections). 88 other elections have earlier or later deadlines. entity classification elections have an earlier deadline because the effective date for such an election cannot be earlier than 75 days before it is filed. treas. reg. § 301.7701-3(c)(1)(iii). the section 121(f) election is an example of an election with a later deadline. i.r.c. section 121 allows a taxpayer to exclude from gross income up to a certain amount of gain from the sale of a principal residence, provided that various requirements are met. i.r.c. § 121. generally, the exclusion can only apply to one sale within any given two-year period. i.r.c. § 121(b)(3). if two sales occur within a two-year period that would each qualify but for this restriction, a taxpayer can elect to not exclude the gain from one sale in order to allow for the use of the exclusion for the other sale. i.r.c. § 121(f). because of the timing of this election, a taxpayer does not have to predict, at the time of the first sale, that a second sale will occur. the taxpayer could refrain from making the election at the time of the first sale and exclude the gain. later within the two-year period, if there is a second sale for which the taxpayer would prefer to use the exclusion, the taxpayer is allowed to amend the earlier return to elect to include the gain for the first sale so that the taxpayer can, then, use the exclusion for the second sale. see treas. reg. § 1.121-4(g). thus, using hindsight is permissible in the context of section 121(f). perhaps lawmakers opted to be generous in this context because of the possibility that taxpayers without access to sophisticated advice may be affected by the election. 89 treas. reg. § 1.1237-1(c)(5)(iii)(b)(1). 90 in the context of elections with later deadlines, taxpayers may be able to use a wait and see approach. for example, this is the case with the section 121(f) example discussed above in note 88. 98 columbia journal of tax law [vol: 13:2 prescribed by statute).91 generally, for regulatory elections and statutory elections that are due by the due date for a taxpayer’s return (or the due date for the taxpayer’s return with extensions), the treasury regulations allow taxpayers to obtain an automatic extension of time to file the election.92 the automatic extension of time is, in some cases, for 6 months from the election’s due date and, in other cases, for 12 months from its due date.93 there is no guarantee that this amount of additional time would allow a taxpayer to employ a wait-and-see approach. for regulatory elections that are not covered by the automatic extension of time rules, a taxpayer can request a ruling from the irs to obtain relief to file a late election.94 however, the requirements for obtaining relief would exclude taxpayers who made a calculated decision to file late only if filing proved to be advantageous in light of later acquired information that the irs challenged the taxpayer’s reporting. in particular, to obtain relief, the taxpayer must establish that he or she acted “reasonably and in good faith” in addition to complying with other requirements.95 the regulations specify that a taxpayer has not acted reasonably and in good faith if the taxpayer has filed a tax return that has been or could be subject to an accuracy-related penalty and the taxpayer wants to alter what they have claimed on the return and wants to file an election late in connection with the new outcome they intend to claim.96 this would preclude taxpayers from using a wait and see approach to file a late election if the irs challenged the results claimed by the taxpayer, at least in cases in which irs challenge could lead to the imposition of an accuracy related penalty.97 in addition, the regulations disallow relief for late filing if the taxpayer “was informed in all material respects of the required election and related tax consequences, but chose not to file the election.”98 thus, a calculated decision to use a wait and see approach appears to be incompatible with obtaining relief to file a late election. consequently, for many elections, taxpayers cannot replicate the effects of a favorable fallback protective tax election by delaying and making the election late. that is not invariably true. as discussed above in part i.d, for instance, because a taxpayer makes a section 6015(c) election after the irs assesses a deficiency, taxpayers can (and indeed must) wait and see if a deficiency is assessed.99 however, in the case of many elections, late filing cannot be used to 91 treas. reg. § 301.9100-1(b). for some tax elections, other guidelines specific to that particular election govern restrictions on late filing or preclude the possibility of obtaining relief for late filing. see treas. reg. § 301.9100-1(d)(2) (“an extension of time will not be granted…for elections that are expressly excepted from relief or where alternative relief is provided by a statute, a regulation published in the federal register, or a revenue ruling, revenue procedure, notice, or announcement published in the internal revenue bulletin”). 92 treas. reg. § 301.9100-1(b). 93 treas. reg. § 301.9100-2. 94 treas. reg. § 301.9100-3. 95 treas. reg. § 301.9100-3(a). 96 treas. reg. § 301.9100-3(b)(3)(i). 97 i.r.c. § 6662 describes when accuracy related penalties will be imposed. 98 treas. reg. § 301.9100-3(b)(3)(ii). 99 also, other elections have late filing deadlines. see supra note 88. 2022] protective tax elections 99 achieve the effects of a favorable fallback protective tax election.100 it is worth noting that deadlines for filing tax elections and limitations on the ability to file late elections to benefit from hindsight represent just one example of a myriad of ways in which tax law is hostile to a taxpayer’s attempts to benefit from hindsight. various judicial doctrines offer additional examples of limitations on a taxpayer’s ability to leverage hindsight. as one example, imagine a taxpayer engages in a transaction using one form and attempts to claim the tax outcome that would have followed from using a different transactional form, which, in retrospect, would have produced more favorable tax consequences. in such an instance, a judicial doctrine—sometimes referred to as the “actual transaction doctrine”— typically acts as a roadblock.101 in a similar vein, another judicial doctrine sometimes referred to as the “non-disavowal doctrine” makes it difficult for a taxpayer to argue that the taxpayer’s transaction should be taxed based upon its substance rather than its form.102 one explanation for this doctrine is that it is another defense against taxpayers’ attempts to benefit from hindsight by reporting the outcome of a transaction based on either its form or its substance, whichever proves to be most beneficial in light of later developed information.103 given tax law’s general hostility to taxpayers’ attempts to benefit from 100 relatedly, a taxpayer might attempt to benefit from hindsight by making a given tax election by its deadline but then revoking the tax election after the fact if later developed information makes it so that the election, in retrospect, produces undesirable tax consequences. here, limitations on the ability to revoke elections to benefit from hindsight thwart taxpayers’ attempts to employ this strategy. see, e.g., helvey & stetson, supra note 10 at 339 (noting that many elections cannot be revoked or can only be revoked with consent); yorio, supra note 10, at 480 (“the courts have generally been antagonistic to taxpayer revocations in response to tax audits.”) sometimes taxpayers are allowed to retroactively revise their elections but only in one direction. see oren-kolbinger supra note 10, at 2 (describing how married taxpayers who opt to file separately can retroactively amend their returns to opt to file jointly but not vice versa). 101 for additional discussion of the actual transaction doctrine, see, e.g., michael e. baillif, the return consistency rule: a proposal for resolving the substance-form debate, 48 tax law. 289, 310-11 (1995); emanuel s. burstein, the impact of form, and disavowing form, on characterization of sales transactions, 66 taxes 220, 224 (1988); emily cauble, rethinking the timing of tax decisions: does a taxpayer ever deserve a second chance?, 61 cath. u. l. rev. 1013, 1018-35 (2012); kenneth l. harris, should there be a “form consistency” requirement? danielson revisited, 78 taxes 88, 106-08 (2000); robert thornton smith, substance and form: a taxpayer’s right to assert the priority of substance, 44 tax law. 137, 141-43 (1990). 102 for additional discussion of the non-disavowal doctrine, see, e.g., baillif, supra note 102, at 289; michael baillif, when (and where) does the danielson rule limit taxpayers arguing “substance over form”?, 82 j. tax’n 362 (1995); william s. blatt, lost on a one-way street: the taxpayer’s ability to disavow form, 70 or. l. rev. 381 (1991); burstein, supra note 101; emily cauble, reforming the non-disavowal doctrine, 35 va. tax rev. 439 (2016); j. bruce donaldson, when substance-over-form argument is available to the taxpayer, 48 marq. l. rev. 41 (1964-1965); harris, supra note 101; christian a. johnson, the danielson rule: an anodyne for the pain of reasoning, 89 colum. l. rev. 1320 (1989); smith, supra note 101. 103 see, e.g., bailiff, supra note 101, at 298 (“[s]ome courts …worry that a taxpayer may decide alternatively to support or impeach a form based upon her post-transactional determination of the resultant tax liability”); harris, supra note 101, at 95 (“[w]here the courts believe that the taxpayer is asserting substance as a means of post-transactional tax planning, the courts are less willing to permit the taxpayer to assert that the substance of the transaction controls.”); smith, supra note 101, at 144 (listing a concern about post-transactional tax planning as one rationale for the nondisavowal doctrine). 100 columbia journal of tax law [vol: 13:2 hindsight and given the specific restrictions on the ability to use hindsight in the context of tax elections, the fact that tax law allows taxpayers to make favorable fallback protective tax elections is curious because making such an election, in a sense, allows the taxpayer to benefit from the same information taxpayers would have if they could use hindsight.104 for instance, consider a taxpayer who claims that subdivided land is investment property but files an election under section 1237 on a protective basis to secure a more favorable alternative tax outcome in the event that the irs challenges the treatment of the land and asserts that the land is, in fact, dealer property.105 if that taxpayer were precluded from filing the election on a protective basis, the taxpayer would be forced to choose between (1) taking the position that the land is investment property under the facts and circumstances test and not filing a section 1237 election or (2) taking the more conservative position that the land is dealer property under the facts and circumstances test and filing a section 1237 election. at the time the taxpayer made the choice, the taxpayer would not know whether the irs would challenge the taxpayer’s position that the land was investment property under the general facts and circumstances test. the ability to file on a protective basis, in effect, allows the taxpayer to harness the advantages of hindsight. the taxpayer can take the position that the property is investment property but, nevertheless, if the irs does challenge that position, the taxpayer secures the outcome that the taxpayer would have selected had the taxpayer known 104 this is true at least to a degree—although favorable fallback protective tax elections do not allow taxpayers to benefit from hindsight to the same degree as what would occur if taxpayers could wait until all information was available before deciding whether or not to make the election at all. allowing taxpayers to make elections after all information was available would be even more advantageous for taxpayers because some tax elections are forward-looking. they affect not just the tax consequences of events that have already transpired at the time the election is filed but also the tax consequences of future events. as an example, consider a tax election that is available under internal revenue code section 362(e)(2)(c). this election is relevant in the case of certain contributions of property by a shareholder to a corporation. it affects future tax consequences only if all the property being contributed by a shareholder to a corporation has a total basis that is more than its total value at the time of the contribution. i.r.c. § 362(e)(2). in other words, the election is only relevant when the property contributed by a shareholder has an aggregate “built-in loss.” the treasury regulations specifically authorize filing the election on a protective basis. a taxpayer might make such a filing protectively if, at the time the election is due, the taxpayer believes the election may be unnecessary because the taxpayer takes the view that the property he or she is contributing to a corporation does not have an aggregate built-in loss. however, in the event that the property does have an aggregate built-in loss, the taxpayer predicts that more favorable results follow if the election is in place than if it is not in place. the protective tax election safeguards the taxpayer against the possibility of discovering that, contrary to the taxpayer’s estimation, the property has an aggregate built-in loss at the time of the contribution. however, if the property, surprisingly, has an aggregate built-in loss at the time of the contribution, and, also, contrary to the taxpayer’s prediction, future events make it so that refraining from making the election would have led to more favorable results, the taxpayer is stuck with the less favorable results that follow from having made the election. if the taxpayer had unrestricted access to hindsight, the taxpayer could reduce his or her tax liability even further by revoking the election (or waiting to file the election later) at a time when the taxpayer had all information needed to evaluate the election’s advantages and disadvantages. thus, in cases involving forward-looking tax elections, allowing a favorable fallback protective tax election is not the same as providing taxpayers with unfettered access to the benefits of hindsight. 105 for further discussion of this example, see supra part i.c.1. 2022] protective tax elections 101 that the irs would challenge the characterization of the land as investment property. the fact that a taxpayer must, by filing the election, declare an intention to claim a more favorable fallback position in advance of any irs challenge likely explains tax law’s openness to the use of such elections notwithstanding its hostility to taxpayers’ attempts to file an election only if and when the irs challenges the taxpayer’s claimed tax position. filing protective tax elections may be allowed based on the theory that taxpayers who file them are willing to attract irs scrutiny and, therefore, are not likely taking very aggressive reporting positions. while taxpayers taking very aggressive positions might be deterred from filing protective tax elections in advance of irs challenge, they would have no similar qualms about filing an election after irs challenge. thus, the law generally disallows the filing of elections after irs challenge but allows advance, protective filings. as the next part will discuss, however, the plausibility of the theory that taxpayers taking aggressive positions will be deterred from making protective filings could vary from election to election. some protective tax elections are accompanied by features—like an extended statute of limitations and a requirement to submit a statement justifying the taxpayer’s reporting position—that may make filing particularly costly for taxpayers taking aggressive reporting positions. in the context of elections with such features, the theory is more plausible than in the context of protective tax elections unaccompanied by such features. the next part will turn to a more detailed discussion of these observations. c. why favorable fallback protective tax elections may be less objectionable than elections filed late in response to irs challenge a taxpayer must file a favorable fallback protective tax election ahead of time—prior to any potential irs challenge—alerting the irs to the taxpayer’s intention to claim a favorable fallback position in the event of successful challenge. there are at least two reasons why favorable fallback protective tax elections filed ahead of time may be less objectionable than elections filed in response to irs challenge. first, if elections could be filed in response to irs challenge, taxpayers could change the stakes of the game after the irs invested resources in auditing a transaction.106 the irs might audit a taxpayer and challenge a position taken by the taxpayer, expecting that successful challenge would lead to recovering a given amount. however, if the taxpayer could later claim the tax outcome that follows from having a favorable tax election in place, the more limited recovery obtained by the irs may be insufficient to justify the irs’s investment of resources in auditing and challenging the outcome reported by the taxpayer.107 by contrast, a 106 for articulation of a similar rationale in the context of the actual transaction doctrine, see burstein, supra note 101, at 224, quoting television industries inc. v. comm’r (“it would be quite intolerable to pyramid the existing complexities of tax law by a rule that the tax shall be that resulting from the form of transaction taxpayers have chosen or from any other form they might have chosen, whichever is less”) 107 see, also, sheldon l. banoff, unwinding or rescinding a transaction: good tax planning or tax fraud, 62 taxes 942, 944 (“approving retroactive unwindings that are tax motivated permits one to play the audit lottery: if you are audited, only then do you unwind to avoid adverse 102 columbia journal of tax law [vol: 13:2 favorable fallback protective tax elections filed prior to audit puts the irs on notice of what the outcome will be in the event of successful irs challenge. filing such an election does not entail a taxpayer switching to a different position only after the irs has invested resources challenging the taxpayer’s original position. the second reason why favorable fallback protective tax elections filed prior to irs challenge may be more palatable than elections filed after the fact is that taxpayers taking very aggressive positions may be deterred from filing in advance of audit but would have no qualms about filing after the fact. to explore this possibility, consider, again, a taxpayer who sells land for a gain. doubtless, some taxpayers who report the resulting gain as capital gain are taking very aggressive positions that likely would not withstand irs challenge if scrutinized. other taxpayers who report the resulting gain as capital gain are taking defensible positions—there may be some risk that their claims would be successfully challenged (particularly given the facts-and-circumstances-based nature of the test that determines whether real estate is investment property or dealer property),108 but the taxpayers’ positions are reasonable. to obtain the outcome that follows from a protective tax election, a taxpayer must file the protective tax election with his or her tax return for the year in which the property is sold. if taxpayers who file the election protectively are more likely to have defensible positions, then taxpayers who secure a more favorable fallback tax outcome will tend to be those making reasonable claims.109 if that is the case, then allowing filing of protective tax elections may be less problematic than allowing filing in response to audit.110 the next part will discuss, in more detail, whether or not taxpayers who file favorable fallback protective tax elections are more likely to be taxpayers taking defensible positions. tax results.”); david hasen, unwinding unwinding, 57 emory l.j. 871, 935 (2008) (describing a taxpayer who attempts to unwind a transaction in response to a challenge by the irs and stating, “permitting taxpayers to unwind in this circumstance would allow them to contest the initial denial of favorable treatment by the government and, if unsuccessful, to obtain a second-best result through the unwind. in effect, the availability of unwind treatment makes the tax liability on an alternative, less aggressive transaction the exercise price of a put option on taking a more aggressive position.”). 108 for discussion of this test, see part i.c.1 above. 109 to be clear, this would mean that, within the pool of taxpayers who would benefit from the protective tax election, taxpayers who have defensible claims may be more likely to file. in the case of some elections, some taxpayers may receive more favorable tax treatment without an election in place. those taxpayers would refrain from making an election regardless of the strength of their initial reporting positions. for further discussion, see infra part iv. 110 indeed, if taxpayers are unable to file the section 1237 election protectively, some taxpayers in anne’s position will err on the side of caution, make the election and report the results that follow from the election to lock in $18,000 in tax liability rather than report $14,000 and risk being subject to $25,900. other taxpayers will react to the uncertainty by taking their chances and reporting $14,000. there may be nothing different about the taxpayers’ transactions—they might each have an equally strong claim that the land is investment property. however, their different responses to uncertainty will prompt some to report greater tax liability than others. for further discussion of how different taxpayers respond differently to uncertainty, see, e.g., sheldon i. banoff, the use and misuse of anti-abuse rules, 48 tax law. 827, 837 (1995); mark p. gergen, reforming subchapter k: contributions and distributions, 47 tax l. rev. 173, 196-97 (1991); logue, supra note 22, at 374-75. see also osofsky, supra note 22, at 503-04. 2022] protective tax elections 103 d. will taxpayers who file be more likely to be taxpayers taking defensible positions? to consider whether, all else equal, taxpayers with defensible claims to the tax outcome they intend to report would be more likely to file protective tax elections than taxpayers with weaker claims, it is useful to view protective tax elections through the lens of the tax literature dealing with screening mechanisms. in various contexts, scholars have discussed whether certain steps that taxpayers must take to obtain more favorable tax outcomes can screen between taxpayers based on their level of tax motivation, their state of mind, or their propensity to comply with tax law. for instance, professor osofsky has analyzed whether various hurdles that taxpayers must clear in order to obtain more favorable tax outcomes tend to filter taxpayers so that taxpayers whose transactions are less significantly tax-motivated are more likely to obtain the favorable tax outcomes.111 as professor osofsky observes, this could be the case if the hurdles act not only as frictions against tax planning but also as screening mechanisms because they impose less significant costs on taxpayers whose transactions are less significantly taxmotivated.112 relatedly, professor hayashi has examined the various facts and circumstances tests that courts apply to determine a taxpayer’s intent or motive.113 professor hayashi argues that the best facts for a court to consider in such an analysis are facts that act as screening mechanisms—facts that would be costlier for taxpayers to create when they are attempting to disguise their state of mind than when they genuinely possess the state of mind that the fact is used to establish.114 as discussed in more detail below, professor field and professor satterthwaite have also discussed how the availability of certain tax elections can induce taxpayers to separate themselves into filers and non-filers in a manner that can reveal information to the irs.115 finally, professor raskolnikov has suggested the possibility of establishing two different tax enforcement regimes, allowing taxpayers to elect between the two regimes, and designing the features of the regimes in such a way that taxpayers who aim to game the tax system tend to opt for one regime (the “deterrence regime”) while other taxpayers tend to opt for the other regime (the “compliance regime”).116 while the compliance regime would carry with it lower penalties than the deterrence regime, it would be characterized by features that would be much more costly for taxpayers who seek to game the system than for other taxpayers.117 for instance, the compliance regime might carry with it the presumption in litigation that the irs’s position is correct unless proven otherwise by clear and convincing evidence, and taxpayers in the compliance 111 see leigh osofsky, who’s naughty and who’s nice? frictions, screening, and tax law design, 61 buff. l. rev. 1057 (2013). 112 id. at 1087 (“frictions serve as screening mechanisms by imposing differential (and higher) costs on …tax planners… than …non-planners.”) 113 see andrew hayashi, a theory of facts and circumstances, 69 ala. l. rev. 289 (2017). 114 id. at 300. 115 see infra part iv. 116 see raskolnikov, supra note 10, at 691-92. 117 id. 104 columbia journal of tax law [vol: 13:2 regime might be obligated to disclose additional information to the irs that would otherwise be protected by tax preparer privilege.118 essentially, these features of the compliance regime would act as screening mechanisms to discourage taxpayers who seek to game the system from opting for the compliance regime. in a similar vein, protective tax elections have the potential to act as screening devices if, all else equal, taxpayers are more inclined to file them when they have legitimate bases for claiming the tax outcomes they intend to report than when their intended reporting positions stand on weaker ground. a protective tax election has the potential to attract the irs’s attention and signal to the irs that the taxpayer believes the outcome the taxpayer reports may fail (because, if the position the taxpayer reports does not fail, then the election is not necessary).119 the extent to which this is true may vary from election to election. some protective tax elections are filed at a point in time when a taxpayer would have no concrete reason to believe that an election is necessary because the deadline for the election falls early in the year and the necessity of the election depends on events that happen later. in those instances, the likelihood of attracting irs attention may be low.120 if the taxpayer is not yet in a position to have the relevant information, the irs may not view the protective tax election as a signal of relevant information but instead assume that the taxpayer simply files it out of an abundance of caution. by contrast, if the taxpayer files the protective tax election at a time when the taxpayer generally would be in possession of the relevant information, it might attract more irs scrutiny. this could be true in the case of an election like the section 1237 election that is filed at the end of the year and relates to a transaction (sale of real estate) that has already occurred so that the taxpayer would be in possession of the relevant information. the taxpayer would know, for instance, whether the taxpayer had engaged in extensive advertising efforts that could increase the risk that the irs might challenge the taxpayer’s claim that the land was investment property. the ability of a protective tax election to perform a screening function also depends on what taxpayers must do to file the election. some, but not all, protective tax elections have one or both of two design features that may tend to make filing them more costly for taxpayers with weaker claims.121 the first such feature is that some protective tax elections trigger an extended statute of limitations.122 giving 118 id. 119 the possibility that a protective tax election could attract irs scrutiny is frequently mentioned by commentators as a downside for taxpayers of making the election. see, e.g., eustice, kuntz & bogdanski, federal income taxation of s corporations, at ¶4.01 at footnote 9 (november 2020) 120 the protective trs may provide an example. see infra text accompanying note 136. 121 in a similar vein, professor logue has argued that requiring taxpayers to disclose the fact that they have obtained tax indemnity insurance might deter taxpayers from obtaining tax indemnity insurance for particularly aggressive tax positions. see logue, supra note 22 at 402. 122 this is true in the case of the protective qef election. see supra note 62 and accompanying text. it was also true in the case of a protective section 108(i) election. see supra note 25. it is likely that the reason for requiring the extended statute of limitations in these examples is to give the irs a fair chance to evaluate new tax consequences being claimed retroactively for years that might be getting close to beyond the statute of limitations. thus, the extension of the statute of limitations may not be designed with the potential screening benefit in mind. nonetheless, it could serve that function. 2022] protective tax elections 105 the irs more time to examine the results claimed by the taxpayer is presumably a less desirable prospect for a taxpayer who has taken a position that is more vulnerable to irs challenge. the second such feature is that, in some contexts, taxpayers are required to include with the protective tax election a statement justifying the taxpayer’s reporting position.123 this feature would make the protective tax election a better screening device because taxpayers with weak positions will be resistant to the idea of providing the irs with any more information than necessary. this feature would also provide the irs with useful information to decide which, if any, of the taxpayers who do file protective tax elections ought to be subject to closer examination.124 one way to conceptualize the potential for a protective tax election to perform a screening function is to consider how filing an election affects the odds that a taxpayer will be audited and the odds that the irs, upon audit, will detect that something about the taxpayer’s claimed tax position is amiss. assume that, when filing an election, the taxpayer must agree to an extended statute of limitations and must submit a statement justifying the taxpayer’s reporting position. these requirements will allow the irs to be savvier about which taxpayers it audits from the group of taxpayers who have filed elections and also about which issues to examine when it does decide to audit a taxpayer from that group. by contrast, decisions about which taxpayers to audit and which issues to examine in the case of taxpayers who have not filed an election with the associated disclosures will be, comparatively, more random. as a result, assuming the irs audits roughly the same percentage of taxpayers from the group that files the election as from the group that does not file the election, taxpayers taking weak reporting positions may find filing particularly costly. they may fare better if they attempt to hide out in the pool of taxpayers where decisions about which taxpayers to audit and which issues to examine are less calculated and, thus, less likely to be driven by the fact that the taxpayer’s claimed tax position is weak.125 in summary, taxpayers who file favorable fallback protective tax elections may tend to be taxpayers taking defensible positions rather than very aggressive positions. this is true, at least, if a protective tax election possesses features that some, but not all, protective tax elections have already. these features include an extended statute of limitations for the irs to examine the results reported by the taxpayer who files a protective tax election and a requirement that the taxpayer filing the protective tax election include a statement justifying their initial 123 this is true in the case of the protective qef election. see supra note 63 and accompanying text. 124 relatedly, professor blank has discussed the phenomenon of “overdisclosure”—taxpayers who report non-abusive transactions in response to requirements to disclose certain, potentially abusive transactions. joshua d. blank, overcoming overdisclosure: toward tax shelter transaction, 56 ucla l. rev. 1629 (2009). he describes how various measures (such as requiring taxpayers to submit non-tax documentation related to the transactions that they disclose) can discourage overdisclosure by making disclosure more costly and also can provide the irs with information necessary to sort the transactions that are disclosed between abusive and non-abusive transactions. id. at 1686-88. 125 see appendix for further discussion. 106 columbia journal of tax law [vol: 13:2 reporting position.126 allowing taxpayers to file elections accompanied by such features could be conceptualized as akin to various instances in which tax law subjects taxpayers to lower explicit tax penalties if taxpayers have provided advance disclosure.127 as discussed above, the results of filing a favorable fallback protective tax election could be framed as a reduction in an implicit penalty imposed upon a taxpayer.128 thus, allowing the filing of such elections could be described as a regime that subjects taxpayers to lower implicit penalties in exchange for advance disclosure. iv. encouraging taxpayers to reveal useful information to the irs on the one hand, as discussed above, there are a number of potential disadvantages to allowing favorable fallback protective tax elections. first, at least compared to a deemed protective tax election approach, such elections may trap unwary taxpayers. second, permitting favorable fallback protective tax elections may encourage taxpayers to take more aggressive reporting positions, particularly if the elections are not accompanied by the design features described above—namely, the requirements that the taxpayer consents to an extended statute of limitations and submits a statement justifying the taxpayer’s reporting position. on the other hand, permitting favorable fallback protective tax elections may also offer advantages. one potential advantage is that the availability of such elections may induce taxpayers to reveal information to the irs. in particular, in some contexts, the fact that a taxpayer has or has not filed a favorable fallback protective tax election could provide an indication to the irs of the taxpayer’s assessment of the strength of his or her reporting position. other scholars have noted that some tax elections can have an information revealing effect. for instance, professor field has noted that some tax elections that must be made in order to obtain favorable tax results can induce taxpayers to reveal information about themselves that might otherwise be unavailable to the irs.129 professor satterthwaite has explored in depth the possibility that tax elections may provide information to taxing authorities, arguing that the election to itemize deductions rather than claim the standard deduction may reveal useful information about various taxpayer characteristics.130 finally, as discussed above, professor raskolnikov has suggested the possibility of providing taxpayers with the ability to elect between different tax enforcement regimes as a means to encourage taxpayers to reveal information about their attitudes towards tax compliance.131 the fact that a taxpayer has made (or has not made) a favorable fallback protective tax election also may reveal potentially useful information to the irs. 126 see supra notes 121-124 and accompanying text. 127 for additional discussion of a context in which taxpayers who fail to provide advance disclosure will be subject to additional explicit penalties, see, e.g., blank, supra note 124, at 163739. 128 see supra part iii.a. 129 see, field, choosing tax, supra note 10, at 63. 130 satterthwaite, supra note 10. 131 see supra notes 116-118 and accompanying text. 2022] protective tax elections 107 if a taxpayer claims that a transaction produces a given tax outcome but files a protective tax election that will only affect the taxpayer’s tax consequences if the transaction’s tax outcome differs from what the taxpayer claims, the filing of the election suggests that the taxpayer is aware of a risk that the taxpayer’s claim may fail. as suggested above in part iii, at least if protective tax elections include features that make filing them particularly costly for taxpayers taking indefensible positions, it could well be the case that the taxpayers who tend to file protective tax elections are not, in fact, the worst offenders. instead, those who file favorable fallback protective tax elections may tend to be taxpayers taking positions that are defensible but associated with some risk of being incorrect. by contrast, taxpayers taking positions that are very certain to be correct as well as taxpayers taking very aggressive positions may tend to not file. the features described above—namely an extended period of time for the irs to examine the claimed tax consequences and a requirement that the taxpayer provide a statement justifying the position claimed by the taxpayer—may discourage taxpayers taking very aggressive positions from joining the group that files protective tax elections. furthermore, these features, by making it so that filing the election is not entirely costless, may reduce the likelihood that taxpayers taking positions that are almost certainly correct simply file the election anyway.132 even if protective tax elections are accompanied by these features, however, a fair amount of distracting noise will mix with potentially useful information. in particular, with these features, it may well be the case that the taxpayers who file a protective tax election tend to be taxpayers taking defensible, yet somewhat risky positions, who would benefit from the result of filing an election if their claim is challenged or otherwise becomes unavailable.133 however, this leaves a number of different taxpayers in the non-filing group. in particular, the non-filing group could include (1) taxpayers taking aggressive positions who avoided filing the protective tax election so as to not attract irs attention, (2) taxpayers who did not file the protective tax election simply because, even if their original claim fails so that making the election would affect their tax consequences, they would fare better 132 along similar lines, professor blank has discussed the phenomenon of “overdisclosure”— taxpayers who report non-abusive transactions in response to requirements to disclose certain, potentially abusive transactions. blank, supra note 124. he describes how various measures (such as requiring taxpayers to submit non-tax documentation related to the transactions that they disclose) can discourage over-disclosure by making disclosure more costly. id. at 1686-88. 133 when protective tax elections were allowed under section 6015(c), it is possible that this separation into different groups would have worked out differently. for additional discussion of this election, see supra part i.d. if a member of a divorcing couple thought that filing the election would attract irs attention but, at the same time, thought that they would not be liable for any significant part of any deficiency, then the possibility of attracting irs attention might not have discouraged filing. a second reason protective filings in this context may not have provided very clear signals is that taxpayers, by not filing on a protective basis, would not lose the ability to file later after the irs assessed a deficiency. this might create less of an impetus to file on a protective basis even if a taxpayer feared there may be weaknesses in previously filed returns. a third reason to suspect that protective filings may not have been very informative in this context is that the decision to file may often have been driven by non-tax strategic considerations. some commentators noted that divorce lawyers viewed the ability to file the election as a “bargaining chip” in the divorce proceedings. see supra note 81. 108 columbia journal of tax law [vol: 13:2 under the default rule (the taxpayers in this group may be taking very aggressive positions, defensible but somewhat risky positions, or positions that have virtually no chance of being successfully challenged), (3) taxpayers who would benefit from the election if their positions were challenged but who are taking positions that have a very low chance of being successfully challenged so that a protective tax election is simply unnecessary, and (4) taxpayers who did not receive sophisticated tax advice. in some cases, it may be a straightforward exercise for the irs to distinguish taxpayers in the second group from the other groups. in particular, for protective tax elections that are due with a tax return and that affect the tax consequences of only transactions that are already completed as of that time, the irs can determine if the taxpayer would fare better under the default rule than with the election in place so that the taxpayer is a member of the second group. however, distinguishing among taxpayers within that group may be difficult. moreover, distinguishing taxpayers in the second group from the other groups becomes more difficult in the case of an election that affects the tax consequences of future events.134 without knowing a taxpayer’s prediction about future events, it will be difficult for the irs to discern whether the taxpayer would have concluded that the outcome that follows under the default rule is more favorable than the outcome that follows from making the election.135 without this information, the irs cannot discern whether the taxpayer is in the second group. the deadline for filing a protective tax election will also affect how informative it is. some tax elections must be filed quite early in time, before the taxpayer would possess the information needed to assess the riskiness of the position the taxpayer expects to take. in the case of those elections, filing on a protective basis may not reveal useful information because the taxpayer does not have useful information to reveal. the protective trs election described above in part i.c.3 offers a potential example. a taxpayer generally must file such an election within the first two and a half months of each year because the election cannot be effective earlier than two and half months before it is filed.136 typically, the taxpayer would file the election to guard against the possibility that income earned by a subsidiary reit (or some other occurrence) over the coming year could cause it to fail to qualify as a reit. at the time the election is filed, not even 134 an example of a forward-looking election with respect to which protective tax elections are authorized is section 362(e)(2)(c). for further discussion of this election, see supra note 104. for discussion of how tax elections are often forward looking so that evaluating whether an election is beneficial requires predictions about the future, see, e.g., field, choosing tax, supra note 10, at 27. 135 one thing that would cut down on the number of non-filers in group 2 would be to establish a penalty default rule (that is a rule that most taxpayers do not want) so that fewer taxpayers fall in this group. however, using a penalty default rule would have significant downsides in the context of a tax election that does not exclusively affect taxpayers with access to sophisticated advice. for additional discussion of the use of penalty default rules in the tax election context, see, e.g., cauble, supra note 10, at 459; field, choosing tax, supra note 10, at 67 (“ a penalty default rule generally provides undesirable tax treatment to those taxpayers who, for whatever reason, fail to act. this could disadvantage less knowledgeable and less sophisticated taxpayers who might not know which choice to make (or even know that there is a choice to make).”); field, private bargaining, supra note 10, at 67-68. 136 form 8875 instructions. 2022] protective tax elections 109 the taxpayer is in possession of this information (although the taxpayer may have made informed projections). therefore, the fact that the election is filed may not provide very useful information to the irs about the likelihood that the subsidiary reit qualifies as a reit. this might, in part, explain why filing them is such common practice—if they provide little useful information to the irs then they may carry with them little perceived risk of attracting irs attention (particularly, in chicken or egg fashion, given that they are so commonly filed). in summary, the availability of protective tax elections may, in some cases, induce taxpayers to provide useful information to the irs. however, there are limits on the usefulness of the information, and the usefulness of the information will likely vary a great deal from election to election. the availability of a protective tax election could be the most informative under the following conditions: (1) the election arises in a context where most taxpayers have access to sophisticated advice, (2) the election must be filed at the time of a tax return and affects only the tax consequences for the prior year, (3) for all taxpayers, the results of making the election would be more favorable than the results of not making the election in the event that the taxpayer’s initial reporting position is challenged (in other words, the election is accompanied by a penalty default rule), (4) filing the election on a protective basis results in an extension of the statute of limitations for examining the taxpayer’s initial reporting position, and (5) the taxpayer must include, with the election, a statement justifying the taxpayer’s initial reporting position. considering a hypothetical protective tax election can help to illustrate a situation in which these conditions would all hold true. under current law, if a real estate investment trust (a “reit”) sells real estate that is dealer property, the gain will be subject to entity-level tax at a rate of 100%.137 if, instead, the reit sells real estate that is investment property, generally it would be exempt from entitylevel tax.138 imagine a hypothetical protective election that a reit could file that would result in gain from dealer property being subject, instead, to an entity-level tax at a rate of 40%, for example. with such a hypothetical election, a reit could file a return for the year in which real estate was sold that took the position that the real estate was investment property under the facts and circumstances test, and the reit could file the protective election with the return so that, if this position were successfully challenged, the gain would be subject to a tax rate of 40% (instead of the 100% tax rate that would apply absent the protective tax election). for the protective tax election to be effective, however, assume the reit would have to agree to an extension of the statute of limitations for the year in which the property was sold, and the reit would have to submit a statement justifying its position that the property was investment property. this hypothetical example satisfies all five conditions noted above. if a reit does file the election, it likely suggests that its position that the real estate was investment property was risky but defensible. if a reit does not file the election with respect to a sale of real estate, then likely either it is taking an 137 i.r.c. § 857(b)(6). this 100% tax will not apply when various safe harbor requirements are met. i.r.c. § 857(b)(6). 138 because a reit is entitled to a deduction for dividends that it pays, by making sufficient distributions, it can eliminate entity-level tax. i.r.c. § 857 110 columbia journal of tax law [vol: 13:2 aggressive position when it asserts that the real estate is investment property so that the extended statute of limitations and requirement to submit a statement justifying its position were onerous or it is taking a very safe position so that filing the election was unnecessary. because a tax rate of 40% would always be preferable to a tax rate of 100%, non-filing would not be explained by the taxpayer having a preference for the default treatment that follows in the absence of an election. assuming that all reits have access to sophisticated advice, lack of filing is also not attributable to a failure to evaluate the advantages and disadvantages of filing the election. to be clear, i am not proposing the adoption of this particular election,139 but rather using it as an illustration of the circumstances under which a protective tax election has the potential to reveal information, with a minimum amount of noise, to the irs. if a taxpayer filed the election with respect to a particular sale, the taxpayer would tend to be taking a defensible but somewhat risky position that the real estate was investment property. moreover, if a taxpayer taking a very aggressive position filed the election, the extended statute of limitations and the information statement supplied by the taxpayer would provide the irs with a greater opportunity to discover this fact. if a taxpayer does not file an election with respect to a particular sale, then likely either the taxpayer’s position that the real estate was investment property is very aggressive or stands on very strong ground140—the picture is not clouded by the possibility that the taxpayer may have preferred the default treatment or simply failed to consider the possibility of filing an election. moving away from the specific example involving reits, more generally, a protective tax election approach might be used in other contexts when the tax treatment that follows if the taxpayer’s position is incorrect is particularly harsh. if lawmakers allow taxpayers to file protective tax elections to secure more favorable alternative treatment as long as they include a statement justifying their initial reporting positions and agree to an extended statute of limitations, the availability of the election may cause taxpayers to reveal useful information to the irs. this is true at least if most of the taxpayers affected by the election have access to sophisticated tax advice. v. providing taxpayers with a degree of certainty favorable fallback protective tax elections are a technique that taxpayers use to manage uncertainty. various other available mechanisms for coping with uncertainty that taxpayers have at their disposal include private letter rulings, tax indemnity insurance, and tax opinions. in some contexts, some of these other options may be entirely nonexistent or, practically speaking, unavailable. in such cases, favorable fallback protective tax elections may help to fill a void. this part 139 in this context, if the reit is aware of a risk that property will be “dealer property,” it might hold the property through a taxable reit subsidiary (a trs) to subject it to tax at the corporate tax rate rather than at a rate of 100% as another mechanism for mitigating the uncertainty. 140 in this particular context, a safe harbor will provide some taxpayers with certainty that the 100% tax will not apply. see i.r.c. § 857(b)(6). 2022] protective tax elections 111 will proceed by discussing each of these other options, in turn, to highlight the gaps that might be filled by favorable fallback protective tax elections. also, as this part will discuss, a consideration of these other options for obtaining certainty strengthens the case for imposing upon favorable fallback protective tax elections the requirements mentioned above—namely, an extended statute of limitations and a requirement that taxpayers filing such elections supply a statement of justification for their initial reporting position. a. private letter rulings if a taxpayer is uncertain about the tax consequences of a planned transaction because available legal authority does not supply a clear answer, in some cases, the taxpayer can request a private letter ruling from the irs.141 to request a private letter ruling, the taxpayer must prepare a request that describes all of the relevant facts, applicable legal authority, and the ruling the taxpayer seeks.142 in addition, the taxpayer must pay a user fee.143 the user fee is generally designed to cover the cost to the irs of considering and issuing a ruling,144 and, thus, the fee varies by type of request.145 however, because the user fee also varies based on other factors—such as the income of the taxpayer—it may not fully cover the cost of the request in all cases.146 the irs will not rule on some topics.147 notably, the irs generally will not issue rulings on topics where the taxpayer’s uncertainty stems from the fact that resulting tax consequences are governed by a standard so that the tax outcome turns on the facts of each particular case.148 many of the protective tax elections described above occupy areas of law that fit this description. for instance, a standard governs the question of whether real estate is dealer property or investment property—the context in which the protective section 1237 election arises.149 indeed, the irs specifically includes the question of whether property is dealer property on its list of topics on which it ordinarily will not issue letter rulings.150 if a taxpayer obtains a letter ruling, the taxpayer generally can rely upon it, provided that the taxpayer accurately and completely disclosed the relevant facts in the ruling request.151 thus, the taxpayer can proceed with a transaction with a fairly high degree of certainty that its tax treatment will be what the taxpayer expects and 141 see rev. proc. 2021-1, 2021-1 i.r.b. 1. 142 id. at section 7 (setting forth general instructions for requesting letter rulings). 143 id. at appendix a (listing the user fees for various types of letter ruling requests). 144 see, e.g., donald l. korb, the four r’s revisited: regulations, rulings, reliance and retroactivity in the 21st century: a view from within, 46 duq. l. rev. 323, 347 (2008) (“the fees are based on calculations of the actual cost to the service of preparing the rulings…. with discounted fees for lower income taxpayers.”). 145 see rev. proc. 2021-1, 2021-1 i.r.b. 1 at appendix a. 146 for further discussion, see, e.g., emily cauble, questions the irs will not answer, 97 ind. l.j. 523 (2022). 147 see, e.g., rev. proc. 2021-3, 2021-1 i.r.b. 140, section 3. 148 for further discussion, see, e.g., cauble, supra note 146. 149 for further discussion, see supra part i.c.1. 150 rev. proc. 2021-3, 2021-1 i.r.b. 140 at section 4.02(5). 151 see treas. reg. § 601.201(l)(5). 112 columbia journal of tax law [vol: 13:2 intends to claim. only the taxpayer who obtains a letter ruling may rely upon it.152 however, issued letter rulings are published in anonymized form so other taxpayers may look to a letter ruling as an indication of the irs’s likely position on the issues covered by the ruling.153 b. tax indemnity insurance in some cases, taxpayers who plan to engage in a transaction with uncertain tax consequences will obtain tax indemnity insurance.154 the taxpayer receives a payout under the policy if the irs successfully challenges the results that the taxpayer claims.155 functionally, such insurance is only available to taxpayers with significant resources as the policies are specifically negotiated and cover transactions with high amounts of potential tax liability at stake.156 at one time, the treasury department had issued temporary regulations that would have required taxpayers to disclose to the irs when they had obtained such insurance.157 ultimately, the disclosure requirements were not included in the final regulations.158 insurance companies criticized the temporary regulations, arguing, in part, that disclosure was unnecessary.159 in particular, the insurance companies asserted that their own rigorous processes for vetting transactions to assess the risk of successful irs challenge in order to properly price the policies made it unlikely that policies would be issued to insure tax positions that were excessively aggressive (or that, if such policies were issued, the premium charged by the insurance companies would adequately deter taxpayers because it would take into account the high degree of risk).160 other scholars have expressed skepticism about this argument, observing that insurance companies may take into account the chance of the irs detecting an aggressive position when evaluating the overall risk and determining the premium charged for the policy.161 thus, if the risk of detection is low, an insurance company might still insure a quite aggressive tax position without charging a premium that would deter taxpayers from proceeding with the transaction and obtaining the policy.162 152 see treas. reg. § 601.201(l)(1) (“a taxpayer may not rely on an advance ruling issued to another taxpayer.”). 153 see, e.g., rachelle y. holmes, forcing cooperation: a strategy for improving tax compliance, 79 u. cin. l. rev. 1415, 1427 (2011) (noting that the publication of letter rulings in redacted form provides “helpful guidance” to other taxpayers). 154 for further discussion, see, e.g., field, supra note 22, at 2126-29; kahn, supra note 22, at 79; logue, supra note 22. 155 see, e.g., field, supra note 22, at 2128; logue, supra note 22, at 388. 156 see, e.g., logue, supra note 22, at 387. 157 for discussion of this history, see, e.g., kahn, supra note 22, at 9; logue, supra note 22 at 401-02. 158 see, e.g., logue, supra note 22, at 401. treas. reg. § 1.6011-4. 159 see, e.g., logue, supra note 22, at 401. 160 see id. at 401-02. 161 see id. 162 see id. https://www.law.cornell.edu/cfr/text/26/601.201 2022] protective tax elections 113 c. tax opinions taxpayers with sufficient resources often resort to legal advice as a means of coping with uncertainty. in some cases, taxpayers obtain a formal tax opinion from an attorney that expresses, at a specified level of confidence, the attorney’s assessment of the likelihood that a given transaction will produce a particular tax outcome.163 in some cases, obtaining a tax opinion may reduce the likelihood that penalties will be imposed upon the taxpayer if the outcome claimed by the taxpayer is successfully challenged, although protection from penalties is not guaranteed.164 finally, while a number of obstacles stand in the taxpayer’s way, in some instances legal advice that misses the mark may form the basis for a malpractice claim by the taxpayer.165 d. implication for favorable fallback protective tax elections comparing favorable fallback protective tax elections with the other options described above bolsters the case for imposing upon such elections various requirements that discourage taxpayers from making use of them when they are taking excessively aggressive reporting positions. other scholars have proposed requiring disclosure of tax indemnity insurance based on concerns that, without such a disclosure requirement, the availability of insurance may encourage taxpayers to take unjustifiably aggressive tax positions.166 arguably, this concern may have even more force in the context of favorable fallback protective tax elections. in the case of tax indemnity insurance, the vetting role played by insurance companies may, to a degree, guard against using policies to cover reporting positions that would be particularly vulnerable to successful irs challenge.167 indeed, this rationale has been offered as an explanation for not requiring disclosure of the use of tax indemnity insurance to the irs.168 while there are good reasons to be skeptical about this argument even in the context of tax indemnity insurance,169 this argument is a non-starter in the case of favorable fallback protective tax elections where no similar rationale for lack of disclosure exists. of course, because favorable fallback protective tax elections are filed with the irs, disclosure is, to a degree, required. however, filing such an election does not invite scrutiny to the same degree as a letter ruling request, for instance, where the irs is asked to specifically consider the facts of a given transaction. unless the protective tax election must be accompanied by additional information, in some instances, the irs might not even be able to readily identify an election that is filed to secure a more favorable fallback tax outcome. to increase the odds that the taxpayer’s disclosure can attract irs attention in a meaningful way, the additional 163 for further discussion, see, e.g., field, supra note 22, at 2122-24. 164 see id. at 2124. 165 see id. at 2126, 2141-53. 166 see supra part v.b. 167 see supra part v.b. 168 see supra part v.b. 169 see supra part v.b. 114 columbia journal of tax law [vol: 13:2 requirements discussed above—namely, an extended statute of limitations and the required inclusion of a statement of justification for the taxpayer’s initial reporting position—ought to be imposed. a comparison with the other options for mitigating uncertainty also shows that, in some cases, favorable fallback protective tax elections have the potential to supplement these other available mechanisms. as noted above, the irs will not issue letter rulings addressing numerous questions. when the irs does not rule on a given topic, it loses an opportunity to acquire information about taxpayers’ uncertainty.170 in some cases, a taxpayer might turn to a favorable fallback protective tax election as an alternative to seeking a ruling. such an election provides the taxpayer with some assurance (albeit to a lesser degree than a ruling).171 unlike with tax indemnity insurance or tax opinions, the use of such elections allows the irs to acquire information about the taxpayer’s uncertainty regarding his or her tax treatment. the irs would acquire more valuable information if lawmakers required taxpayers to supplement protective tax elections with statements that explained and justified their initial reporting positions. moreover, the irs may be able to act upon the information provided by such elections in a way that does not necessarily require the same amount of irs resources needed to issue a letter ruling that will be published in anonymized form. vi. recommendations as discussed above in parts ii and iii, offering taxpayers the opportunity to file favorable fallback protective tax elections has a number of drawbacks. first, the ability to file such elections may encourage well-advised taxpayers to take more aggressive reporting positions. to guard against this possibility, lawmakers should require that a taxpayer filing such an election must consent to an extended statute of limitations and must include a statement justifying the taxpayer’s reporting position. second, requiring that taxpayers file protective tax elections to secure more favorable alternative tax treatment may trap unwary taxpayers. furthermore, a requirement that a taxpayer submit a statement justifying the taxpayer’s initial reporting position—a safeguard necessary to guard against the possibility that such elections will encourage taxpayers to take aggressive reporting positions—could further exacerbate the extent to which such elections are functionally out of the reach of taxpayers who lack access to sophisticated tax advice. together, these policy considerations point towards taking a different approach to tax elections depending on whether they affect only taxpayers with access to sophisticated advice or, instead, affect a wide variety of taxpayers including those who lack access to sophisticated advice. in the case of elections in the first category, carefully designed favorable fallback protective tax elections may, in some cases, 170 see, e.g., korb supra note 144, at 344 (“the rulings program constitutes a source of valuable information to the service”). 171 for one thing, unlike a letter ruling, such an election does not assure the taxpayer that the tax consequences of a transaction will be what the taxpayer expects—it merely secures better alternative tax treatment in the event that the consequences are not what the taxpayer expects. 2022] protective tax elections 115 be a useful tool. in the case of the second category, when possible, a deemed protective tax election approach ought to be employed instead. each of these recommendations is discussed, in turn, below. a. when an election affects only taxpayers with access to sophisticated advice in an area of law that affects only taxpayers with access to sophisticated advice, favorable fallback protective tax elections may be a useful supplement to other mechanisms used by taxpayers for obtaining certainty. if made available, such elections should be accompanied by safeguards like an extended statute of limitations and a requirement that the taxpayer submit a statement justifying the taxpayer’s reporting position. if a taxpayer being wrong about a claimed tax outcome results in harsh alternative tax treatment, allowing the taxpayer to file a protective tax election to secure more favorable alternative tax treatment may serve a useful purpose. assuming taxpayers who file such an election tend to be those taking defensible positions, the availability of the election can help to better focus the penalty implicit in the harsh alternative tax treatment upon taxpayers who are taking more aggressive positions. similar to the notion that advance disclosure, in various contexts, may allow taxpayers to fare better when it comes to explicit penalties, a favorable fallback protective tax election can operate as a device that ties lower implicit tax penalties to advance disclosure.172 b. when a wide range of taxpayers are involved if an election arises in an area of law that affects a wide range of taxpayers, including those without access to sophisticated advice, when possible, lawmakers ought to bestow on all taxpayers—even those who neglect to file an election—the results that would have followed from making a favorable fallback protective tax election. i will refer to this alternative as the “deemed protective tax election approach.” as an example of the deemed protective tax election approach, consider a taxpayer who sells land and files a tax return reporting the gain as capital gain, resulting in tax liability of $14,000. imagine the irs challenges that characterization and successfully asserts that the land is dealer property. imagine the taxpayer has not filed a protective section 1237 election. if the taxpayer had filed a protective section 1237 election, the irs’s challenge would result in tax liability of $18,000, but, without the election, the irs’s challenge results in tax liability of $25,900.173 under the deemed protective tax election approach, even though the taxpayer did not file the election, the irs would impose tax liability of $18,000. essentially, the taxpayer obtains the tax outcome that the taxpayer would have obtained had the taxpayer considered the possibility of a protective tax election at the time the taxpayer filed his or her return for the year when the property was sold. 172 for further discussion, see supra notes 127-128 and accompanying text. 173 for further discussion of this example, see supra part i.c.1. 116 columbia journal of tax law [vol: 13:2 in some contexts, the deemed protective tax election approach might not be feasible. some elections affect multiple taxpayers, and, while the outcome with the election in place might be more favorable for one of the taxpayers, the outcome without the election in place might be more favorable for another taxpayer. in that case, there may be no practical way for the irs to impose upon the taxpayers what they likely would have agreed to if they had considered the possibility of a protective tax election themselves.174 the deemed protective tax election approach is likely also not feasible for tax elections that affect tax consequences over multiple years.175 when assessing tax consequences for the first year that is affected by the election, it is not practical for the irs to select, for the taxpayer, the most favorable choice because that determination depends upon a prediction about events in future years.176 nevertheless, in some contexts, a deemed protective tax election approach is feasible because an election may affect only one taxpayer (or affect multiple taxpayers whose interests are aligned) and affect tax consequences for only one year. furthermore, analogies to the deemed protective tax election approach already exist in tax law. as one example, sometimes when the results of events not panning out the way a taxpayer anticipated would otherwise be particularly harsh, various relief provisions soften the taxpayer’s landing. for instance, because the failure to meet certain requirements to qualify as a real estate investment trust (a “reit”) can have very harsh consequences, in some cases, taxpayers can benefit from various relief provisions that make the consequences less dire.177 as a second example, sometimes, simply because of various features of a taxpayer’s tax profile, there happens to be a small difference between the tax outcome that a taxpayer claims and the tax outcome that would befall the taxpayer if the irs challenges that outcome. for instance, for some taxpayers, the effective tax rate that applies to ordinary income may be close to the effective tax rate that applies to capital gain so that a challenge of the taxpayer’s claim that an asset is a capital asset may impose little additional tax liability. 174 while it may be feasible to determine that the parties would have wanted the outcome that reduces their aggregate tax liability, it will not be feasible for the irs to determine how the parties would have split the resulting tax savings and to get them to that result if they do not make the election themselves. having the taxpayers jointly agree to a given tax outcome also has the virtue of ensuring that the taxpayers take consistent positions. see, e.g., field, private bargaining, supra note 10, at 44 (“joint elections also force all of the relevant taxpayers to make affirmative commitments to consistent tax treatment, thereby increasing compliance and minimizing whipsaw…”). 175 one example that arises in the context of protective tax elections is section 362(e)(2)(c). whether or not this election is made affects a shareholder’s basis in stock of a corporation and a corporation’s basis in some of its assets. thus, it affects the tax treatment of the shareholder’s sale of stock, the tax treatment of the corporation’s sale of certain assets, and, if the assets are subject to depreciation, the tax treatment of the corporation for each year that it holds the assets. 176 for similar reasons, it can be difficult for lawmakers to select a default rule to accompany such an election that would tend to reliably match (or not match) what taxpayers would prefer. see field, private bargaining, supra note 10, at 55. 177 see, e.g., i.r.c. §§ 856(c)(4) and (c)(7). for additional discussion of such relief provisions, see andrew blair-stanek, tax in the cathedral: property rules, liability rules, and tax, 99 va. l. rev. 1169 (2013); leigh osofsky & kathleen delaney thomas, the surprising significance of de minimis tax rules, 78 wash. & lee l. rev. 773, 797-98 (2021). 2022] protective tax elections 117 as a third example, for some taxpayers in the case of some elections, the treatment that follows from having not made the election is more favorable than the treatment associated with having made the election. as an example, consider the section 1237 election. imagine the facts are identical to those of anne whose tax outcomes are shown in table 2 above except that the cost of installing the roads was $50,000 rather than $20,000. in that case, if she successfully reports the results of the transaction as if the land were investment property under the general facts and circumstances test, she incurs $8,000 in tax liability.178 if her characterization is challenged and tax liability is assessed as if the land were dealer property under the facts and circumstances test, the resulting tax liability would be lower if a protective tax election were not in place than if a protective tax election were in place. in particular, without a protective tax election, she incurs $14,800 in tax liability, compared to $18,000 with a protective tax election.179 even if lawmakers disallowed filing section 1237 elections on a protective basis, a taxpayer in her position could characterize the land as investment property without sacrificing an opportunity to secure a better second choice tax outcome if that characterization failed. this is true because, for a taxpayer in this position, the better second choice tax outcome is the outcome that follows by default if the election has not been made. a deemed protective tax election approach could be seen as simply another example of this phenomenon that would provide to taxpayers that same advantage regardless of whether they benefit more from the default treatment or the treatment that follows from having an election in place. one downside to a deemed protective tax election approach (as compared to requiring that taxpayers file protective tax elections to get the benefits of a favorable fallback protective tax election) is that it sacrifices the potential screening and information revealing advantages of favorable fallback protective tax elections. in particular, as described above, when taxpayers are required to file protective tax elections in order to secure a more favorable fallback position, it may be that taxpayers who file are more likely to have defensible positions. taxpayers taking aggressive positions may be deterred from filing and, thus, subject to a greater amount of additional tax if their claims are successfully challenged. also as described above, to some degree, the filing of protective tax elections may provide useful information to the irs. for those reasons, in the case of elections that affect—exclusively or almost exclusively—taxpayers with access to sophisticated advice, retaining the requirement to file protective tax elections may be a sensible approach. however, outside of that context, it is arguably preferrable to use a deemed protective tax election approach when feasible to do so. while such an approach may sacrifice the implicit penalty of the additional tax revenue imposed upon taxpayers taking aggressive positions who might have been deterred from filing favorable fallback protective tax elections, that lost implicit penalty could 178 $8,000 is the result of applying a 20% tax rate to a gain of $40,000 (the difference between a $200,000 selling price and a $160,000 basis that includes the cost of the roads). 179 $14,800 is the result of applying a 37% tax rate to a gain of $40,000 (the difference between a $200,000 selling price and a $160,000 basis that includes the cost of the roads). $18,000 is the result of applying a 20% tax rate to a gain of $90,000 (the difference between a $200,000 selling price and a $110,000 basis that does not include the cost of the roads). 118 columbia journal of tax law [vol: 13:2 be offset by increasing the explicit penalty imposed upon taxpayers who take indefensible positions. conclusion in an area of tax law that affects a wide array of taxpayers, including those without access to sophisticated tax advice, tax elections have the potential to trap unwary taxpayers. this is at least as true in the case of favorable fallback protective tax elections as it is in the case of tax elections generally. indeed, it may be even more true in this context given that effectively using such an election requires planning not for what the taxpayer expects to happen but for what might happen. as a result, the best course of action is likely to make use of the deemed protective tax election approach in the case of elections affecting a wide range of taxpayers. in areas of law that tend to affect only taxpayers with access to sophisticated advice, lawmakers might consider a different approach. in particular, allowing favorable fallback protective tax elections, in this context, may not be all bad, at least if the elections are accompanied by safeguards. these safeguards include an extended statute of limitations and a requirement for the taxpayer to submit a statement justifying the taxpayer’s initial reporting position. 2022] protective tax elections 119 appendix in order to consider whether the ability to file a protective tax election could act as a screening device, imagine that, if the irs successfully challenged the taxpayer’s initial reporting position, the taxpayer would be subject to additional tax liability of $100 if the taxpayer had not filed a protective tax election but $50 if the taxpayer had filed such an election. the expected additional tax liability resulting from filing the election could be expressed as:180 $50 x padf x psf where padf = the probability that the irs will audit the taxpayer’s return and detect that something is amiss if the taxpayer files the election psf = the probability that an irs challenge would be successful if the taxpayer files the election the expected additional tax liability resulting from not filing the election could be expressed as: $100 x padnf x psnf where padnf = the probability that the irs will audit the taxpayer’s return and detect that something is amiss if the taxpayer does not file the election psnf = the probability that an irs challenge would be successful if the taxpayer does not file the election assume the taxpayer will not file if the expected additional tax liability resulting from filing is more than the expected additional tax liability resulting from not filing. in other words, the taxpayer will not file if: $50 x padf x psf > $100 x padnf x psnf the probability that an irs challenge would be successful should be the same regardless of whether the taxpayer files the election or not. in other words, psf = psnf as a result, the equation above could be simplified and rearranged as: 180 for a similar approach, see, e.g., raskolnikov, supra note 10, at 716-17. under professor raskolnikov’s proposal, the probability of detection and the probability of successful irs challenge varied depending upon which regime a taxpayer elected. see id. by contrast, with protective tax elections that include the specified requirements, making or not making the election affects the probability of audit and the probability of detection. 120 columbia journal of tax law [vol: 13:2 padf > 2 x padnf in other words, a taxpayer will opt to not file if the probability that the irs will audit the taxpayer’s return and detect that something is amiss upon audit is twice as great (or more) if an election is in place than if it is not. the prediction that taxpayers who file the election will tend to be those taking defensible rather than very aggressive positions is consistent with the above equation if it is the case that (1) the probability of audit if the election is filed exceeds the probability of audit if the election is not filed in the case of taxpayers taking aggressive positions by the same or a wider margin than in the case of taxpayers taking defensible positions (or, more precisely, that is predicted to be the case by taxpayers) and (2) the same is true in the case of the probability of the irs detecting that something is amiss on audit. each of these two conditions could plausibly be true if filing the election triggers an extended statute of limitations and a requirement that the taxpayer submit a statement justifying his or her initial reporting position. as to the first condition, assuming the irs audits tax election filers and tax election non-filers at roughly the same rate, taxpayers might expect that the requirement to submit a statement and the extended statute of limitations would allow the irs to be savvier about which taxpayers it selects to audit from the group that have filed elections and disproportionately audit those with weaker claims while the irs's decisions about who to audit from the group of tax election non-filers may be more random. thus, for a taxpayer taking an aggressive position, filing an election may increase the taxpayer's perceived probability of audit by a wider margin than for a taxpayer taking a defensible position. as to the second condition, if a taxpayer is taking a very defensible position, the probability of the irs detecting that something is amiss may not increase by much if the taxpayer submits a filing that contains more information about the taxpayer’s reporting position. (in other words, requiring a taxpayer to provide more information does not increase by much the odds of the irs detecting that something is amiss when there is nothing particularly amiss to detect.) as the taxpayer’s position becomes more aggressive, the difference grows between the probability that the irs detects that something is amiss if the taxpayer files an election with the required statement and the probability that the same occurs if the taxpayer has not made such an election. the discussion above assumes that the irs would audit (and that taxpayers would predict that the irs would audit) the two groups at roughly the same rate, rather than audit tax election non-filers more frequently to try to make use of the prediction that taxpayers taking aggressive positions would tend to not file. auditing non-tax election filers at a higher rate could induce taxpayers taking aggressive positions to shift into the group that file the election. at first glance, it may seem that, if the irs does not make use of the prediction that taxpayers taking very aggressive positions may tend to not file election by auditing this group of taxpayers at a higher rate, it will sacrifice any administrative benefit flowing from taxpayers separating themselves into tax election filers and non-filers. nevertheless, the separation can still be useful in two respects. first, it helps to 2022] protective tax elections 121 ensure that the implicit penalty tends to be imposed on taxpayers taking very aggressive positions rather than defensible positions. second, it is possible that the separation of taxpayers into different pools may make the probability of detecting that something is amiss when the irs audits even a tax election non-filer higher than it would otherwise be. the discussion above also assumes that a protective filed tax election will be effective even in the case of taxpayers taking very aggressive positions. if this does not hold true, then the availability of the election can even more effectively act as a screen. in other words, it is possible that, in the case of a very aggressive position, even if the election was filed the additional tax liability imposed upon the taxpayer. in that case, for a taxpayer taking a very aggressive position, the equation becomes: $100 x padf x psf > $100 x padnf x psnf which can be simplified to: padf > padnf such a taxpayer would be deterred from filing as long as that the probability of audit and detection that something is amiss if the election is filed exceeds the probability of the same occurring without filing the election by any amount. by contrast, assuming that the effects of the election are recognized if a taxpayer was taking a defensible position, such a taxpayer would be deterred from filing only if: padf > 2 x padnf under those conditions, the election could act as an even more effective screening device in that non-filing would be more likely for taxpayers taking aggressive positions than for taxpayers taking defensible positions.181 181 a similar result could occur if a taxpayer taking a very aggressive position would be subject to a penalty and the penalty was, for some reason, not proportionate to the additional tax liability assessed. for instance, assume the additional tax liability taking into account a penalty would be $75 if the election was filed and $125 if it was not filed in the case of a taxpayer taking an aggressive position. assume that, for a taxpayer taking a defensible position, the additional tax liability is $50 (if filed) and $100 (if not filed) and there is no penalty. in that case, the taxpayer taking an aggressive position does not file as long as padf > 1.67 x padnf. by contrast, the taxpayer taking a defensible position does not file as long as padf > 2 x padnf. introduction 1. example of favorable fallback protective tax election – protective section 1237 election 2. example of favorable fallback protective tax election – protective qef election 3. example of favorable fallback protective tax election – protective trs election appendix the flip and flop of taxing alimony jeffrey h. kahn* & rebecca roman** abstract since the dawn of income taxation in america, the tax treatment of alimony payments has flipped, flopped, and flipped again. the tax burden was first borne by the person paying alimony, then by the person receiving it. the burden has since shifted back to the alimony payor. this, we argue, was a flop. the tax cuts and jobs act of 2017 eliminated a tax deduction for alimony payments that served to reduce the taxable income of the payor and shift the payments into the taxable income of the recipient. congress justified this deviation from the longstanding deduction/income treatment based an old supreme court case that held alimony was to be taxed to husbands as part of their moral and legal obligations to support their wives. more likely, congress was acting for its own benefit—eliminating the deduction is estimated to raise billions for the fisc. in this article, we argue that this change was a mistake. treating alimony payments as income to the recipient better comports with the tax code’s progressive rate structure and the concept of taxing a party based on “ability to pay.” the argument proceeds in two parts. first, we argue that alimony payments do not constitute consumption by the payor. thus, like gifts, alimony payments should only be taxed to one of the parties involved in the transfer. existing scholarship seems to coalesce on this point. still, this does not tell us whom to tax: the alimony payor or the recipient? distinguishing the income tax treatment of alimony from that of gifts, we argue the latter. as a theoretical matter, allowing a deduction for alimony payments aligns with our progressive rate structure by accounting for the payor’s lower marginal “ability to pay” after making alimony payments. these payments represent future consumption by the recipient, not the payor, and thus reflect an increase in the recipient’s “ability to pay” taxes on such sums. and, as a practical matter, allowing parties the flexibility to allocate the tax burden among themselves is a negotiating chip that may grease the wheels in other areas of the divorce settlement process. we recommend that congress flip once more and return the tax treatment of alimony to what it was prior to the 2017 act reform. * harry m. walborsky professor of law, florida state university college of law. ** associate, gibson, dunn & crutcher. the authors wish to thank annalena zinati-milon for her helpful research assistance with the piece. 132 columbia journal of tax law [vol. 16:2 i. introduction .............................................................................................. 133 ii. history of the tax treatment of alimony ........................................... 133 a. initial treatment (1917–1942) ................................................................. 134 b. the shift to the recipient-spouse’s rates (1942–1984) ......................... 137 c. tax election to promote settlements ....................................................... 139 d. taxing payor-spouses to protect the purse (2017–present) .................... 142 iii. the two choices for the tax treatment of alimony ......................... 143 a. theory of human capital ........................................................................ 147 b. assignment of income doctrine .............................................................. 149 c. ability to pay ........................................................................................... 149 iv. revoking the revocation ......................................................................... 149 a. the importance of consumption ............................................................. 150 b. marginal rates of taxation and progressivity ......................................... 154 c. alimony and gifts .................................................................................... 157 d. mandating fairness or allowing flexibility ............................................ 160 v. conclusion .................................................................................................. 160 2025] the flip and flop of taxing alimony 133 i. introduction since the dawn of income taxation in america, the tax treatment of alimony payments has flipped, flopped, and flipped again. the tax burden was first borne by the person paying alimony, then by the person receiving it. most recently, as part of the tax cuts and jobs act of 2017,1 the burden shifted back to the alimony payor. this, we argue, was a flop. specifically, the 2017 act eliminated a deduction for alimony support payments made under any divorce or separation agreement executed after december 31, 2018. prior to that change, the payor-spouse could take a federal tax deduction for the payment of alimony, and the recipient-spouse would have income from receiving the alimony payment.2 a deduction for alimony, in some shape or form, had been a part of the internal revenue code3 since the early 1940s, so this revocation of the alimony deduction was a major shift in policy. and, unlike many provisions of the 2017 act, the revocation is not subject to a sunset provision.4 that is to say, the current state of nondeductibility for alimony payments is permanent unless congress passes a new law bringing the deduction back. this article argues that the revocation was a mistake. tax policy would be better served by returning the tax treatment of alimony to what it was immediately prior to the 2017 act: allowing a deduction for the payor-spouse and including the payments as income to the recipient. the article proceeds in four parts. part ii provides a brief history of the tax treatment of alimony. part iii reviews the current tax treatment of alimony and child support payments and their treatment prior to the 2017 act. part iv proposes the tax policy justifications for allowing a deduction for alimony payments. and part v concludes. ii. history of the tax treatment of alimony the concept of alimony far predates the american income tax. spousal support payments were mandated by the code of hammurabi, and the first divorce in america can be traced to the mid-seventeenth century.5 our federal personal 1 an act to provide for reconciliation pursuant to titles ii and v of the concurrent resolution on the budget for fiscal year 2018, pub. l. no. 115-97, 131 stat. 2054 (2017) [hereinafter tcja]. 2 as the name suggests, the “payor-spouse” is the party that remits alimony or child support payments. the “recipient-spouse” is the party that receives such payments. 3 the current tax system is governed by the internal revenue code of 1986, as amended. however, we will sometimes refer to or cite older versions of the internal revenue code. 4 tcja, supra note 1; see also roger wohlner, these tax cuts are sunsetting in 2026. are your clients ready?, alm: think advisor (nov. 22, 2023, 11:49 am), https://www.thinkadvisor.com/2023/11/22/these-tax-cuts-are-sunsetting-in-2026-are-your-clientsready/ [https://perma.cc/44c5-9jrr]. 5 the code of hammurabi §§ 137-38 (l. w. king trans., 1910); laura clark, the second divorce in colonial america happened today in 1643, smithsonian mag. (jan. 5, 2015), (citing william h. whitmore, a bibliographical sketch of the laws of the massachusetts colony from 1630 to 1686 99 (1890)), https://www.smithsonianmag.com/smart-news/second-divorce-colonialamerican-history-happened-today-1643-180953799/ [https://perma.cc/pyz8-396u]. https://perma.cc/44c5-9jrr https://perma.cc/pyz8-396u 134 columbia journal of tax law [vol. 16:2 income tax system was “born” in 1913.6 since then, the tax treatment of alimony has followed four arcs and a circular path as the 2017 act returned the law to where it started. from the inception of the income tax to the middle of world war ii, the person paying alimony—almost invariably husbands of heterogeneous couples— bore the tax burden for alimony payments. but as the war picked up, so too did the income tax burden, and divorced men’s payment obligations threatened to exceed their after-tax income. thus, in 1942, congress shifted the tax burden on alimony payments to the wives receiving them. in 1984, congress made the corresponding deduction for alimony payments elective instead of mandatory, leaving the tax treatment of alimony at the parties’ discretion. this tax regime persisted until 2017, when congress shifted the burden back to the person paying alimony—this time, for the government’s own benefit. a. initial treatment (1917–1942) in a single sentence, the sixteenth amendment provided the constitutional authority for the federal personal income tax: “the congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several states, and without regard to any census or enumeration.”7 the amendment left it to congress to fill in the details. but the legislation imposing the first income tax did not account for the tax treatment of alimony.8 it thus fell to the courts to decide how such payments would be taxed. the question finally made its way to the supreme court in 1917 following the high-profile divorce of howard from katherine gould.9 howard gould was a well-known money man, a financier, and the son of the even more well-known railroad magnate and speculator jay gould. howard had an affinity for women of the stage—over the course of his life he had been engaged to three women, all actresses, two of whom he married (and later divorced).10 this case arose from howard’s first marriage to then katherine clemmons. it had the makings of a great romance: the two had met in europe and enjoyed a 6 revenue act of 1913, pub. l. 63-16, 38 stat. 114. this was, however, not the very first united states federal income tax as there was an income tax used to help finance the civil war. that tax was repealed, however, in 1872. see 16th amendment to the u.s. constitution: federal income tax (1913), national archives: milestone documents, https://www.archives.gov/milestonedocuments/16th-amendment [https://perma.cc/p87m-hsyk]. 7 u.s. const. amend. xvi. congress attempted to impose an income tax prior to 1913. prior to the sixteenth amendment, congress had the power impose a “direct” tax only if it was apportioned among the states according to population. u.s. const. art. i, § 2, cl. 3. in 1894, congress instituted a federal income tax. this was challenged as unconstitutional by arguing that an income tax was a direct tax that was not apportioned by the population. the supreme court agreed and struck that act down as unconstitutional. pollock v. farmers’ loan & trust co., 158 u.s. 601, 637 (1895). the sixteenth amendment avoided this issue by removing the proportional requirement for direct taxes. 8 revenue act of 1913. 9 gould v. gould, 245 u.s. 151 (1917). it is interesting that the case that set out the tax treatment of alimony did not involve the federal government. 10 howard gould may marry miss tyler, n.y. times, nov. 9, 1894, at 12; howard gould marries, n.y. times, oct. 13, 1898, at 1; howard gould, son of financier, weds, n.y. times, may 19, 1937, at 20. https://perma.cc/p87m-hsyk 2025] the flip and flop of taxing alimony 135 long courtship.11 howard’s family did not approve of his marrying—as they saw it—below his station and threatened to disinherit him.12 but love prevailed and the two were wed in 1898.13 less than a decade later, the marriage was over. the parties had been estranged for almost a year when katherine sued for divorce in 1907, alleging charges of “desertion, nonsupport, and cruelty.”14 “a central issue in the trial was the amount of alimony that howard would pay katherine, and that, in turn, rested in part on whether he officially ‘deserted’ his wife or whether he was justified in leaving her due to her ‘habits.’”15 howard had accused katherine of heavy drinking and adultery with fellow actors dustin farnum and buffalo bill. this led to flashy headlines like “mrs. gould’s life at home, drunken orgy”16 and a deep dive into the couple’s personal lives. after much publicity, the divorce was finalized in 1909 and howard was ordered to pay katherine monthly alimony of $3,000 “for her support and maintenance.”17 the equivalent of around a million dollars annually today, it was said to be the largest alimony settlement ordered up to that time.18 the question that made its way to the highest court in gould v. gould was not about the amount of the alimony, but rather, “whether such monthly payments during the years 1913 and 1914 constituted parts of mrs. gould’s income.”19 there were four ways the court’s decision could have come down. first, the court could have held that the alimony payments were taxable to both parties: the husband pays alimony out of his gross income and the wife reports the alimony payments as income. second, it could have held that only the husband would be taxed: the husband pays alimony out of his gross income and the wife takes the funds in full without having to report them as income. third, only the wife would be taxed: the husband pays alimony out of his gross income but deducts the full amount while the wife reports the alimony as income. or neither party would pay taxes on the alimony payments: the husband pays alimony out of gross income but deducts the full amount with no corresponding income to the wife. the court’s short opinion adopted option two: to tax only the husband. alimony payments from howard were not deductible by him nor includible in katherine’s income.20 it thus laid down the rule that the payor-spouse would earn income, pay taxes on that income, and then pay his spousal support obligations 11 howard gould marries, supra note 10. 12 id. 13 id. 14 mrs. gould to ask divorce on desertion plea, l.a. herald, june 15, 1909, at 1. 15 michelle mcclellan, katherine gould’s “drunken orgy” and the perils of social climbing, the atlantic (feb. 24, 2012), https://www.theatlantic.com/health/archive/2012/02/katherine-gouldsdrunken-orgy-and-the-perils-of-social-climbing/252427/ [https://perma.cc/y2bb-s7uk]. 16 id. 17 gould v. gould, 245 u.s. 151, 152 (1917). 18 see former mrs. gould fears poisoning, n.y. times, nov. 5, 1910, at 7. 19 gould, 245 u.s. at 152. based on the opinion, it is not entirely clear why the issue mattered to the parties. perhaps katherine gould believed she should receive a gross-up if the payments were subject to taxation. 20 id. at 154 (“the net income of the divorced husband subject to taxation was not decreased by payment of alimony under the court's order; and, on the other hand, the sum received by the wife on account thereof cannot be regarded as income arising or accruing to her within the enactment.”). https://perma.cc/y2bb-s7uk 136 columbia journal of tax law [vol. 16:2 from what was left over after tax; the recipient-spouse would receive those payments in whole without reduction for federal income tax. the rationale behind this early tax treatment of alimony was based on the court’s understanding of the purpose of such payments. the court’s reasoning surely rung as soundly at the time as it does paternalistic today: “alimony . . . is not founded on a contract, express or implied, but on the natural and legal duty of the husband to support the wife. . . . permanent alimony is regarded rather as a portion of the husband’s estate to which the wife is equitably entitled . . . .”21 in that manner, the payment was treated for tax purposes like satisfying a loan obligation: the payor does not receive any deduction for paying off a loan and the recipient has no income on account of the payor satisfying the obligation. as noted by professor deborah geier in her article on the tax treatment of payments related to divorces, the supreme court looked at the divorced couple as a unit that should be taxed only once.22 for comparison, if you look at the divorced couple as individuals, it may make sense to tax alimony payments to each.23 the money used to pay alimony generally comes from the husband’s salary, which is quintessential “income.”24 and, looking at the recipient in isolation, the alimony payments represent an “undeniable accession to wealth,” bringing them under the income umbrella.25 thus, the payment would be taxed twice, much like, geier noted, “amounts paid by an employee from his wages to his housecleaner.”26 but the court instead looked at the two taxpayers together. it assumed that whether the recipient-spouse has income on account of the payment and whether the payor-spouse gets a deduction for the payment are not independent issues. any decision that determines the answer to one of those questions will also answer the other. either the payor gets a deduction and the recipient has income, or the payor does not get a deduction and the recipient does not have income. viewed as a joint exercise, the resulting question becomes not whether the payment is income, but instead whose marginal tax rate should be used in determining the tax owed. if we allow a deduction for the alimony payment with 21 id. at 153 (quoting audubon v. shufeldt, 181 u.s. 575, 577 (1901)); see also douglas v. willcuts, 296 u.s. 1, 8 (1935) (“amounts paid to a divorced wife under a decree for alimony are not regarded as income of the wife but as paid in discharge of the general obligation to support, which is made specific by the decree.”). as other commentators described it: “justice reynolds’s paternalistic attitude toward women and wives permeates the gould opinion: women require protection, which is the responsibility of men.” tessa r. davis, amy h. soled & jay a. soled, revisiting the tax treatment of alimony, 71 u. kan. l. rev. 379, 386 (2023). 22 deborah a. geier, simplifying and rationalizing the federal income tax law applicable to transfers in divorce, 55 tax law. 363, 369 (2002) (“rather than analyzing the tax consequences to each of these taxpayers independently of each other, i.e., determining whether the receipt qualifies as ‘income’ to the recipient and whether the payment qualifies as a deductible one to the payor under an ‘income’ analysis because it does not purchase discretionary personal consumption, we could view both taxpayers together.”). 23 as we will discuss later in part iv, we disagree with this evaluation of the payor-spouse and even professor geier notes that, since there is no personal consumption with an alimony payment, it may be possible to justify a deduction for the payment. id. 24 id. at 368. 25 id. 26 id. at 369. as we will elaborate later, the difference between an alimony payment and wages to a housekeeper is the lack of consumption for the payor in the alimony situation, unlike in consuming the services of a housekeeper. see discussion infra section iv.a. 2025] the flip and flop of taxing alimony 137 corresponding income to the recipient, then the marginal tax rate of the recipientspouse will be used. conversely, as applied by the supreme court, without a deduction and no income to the recipient-spouse, the marginal tax rate of the payorspouse applies. this latter state of alimony taxation remained consistent until congress stepped in during the early 1940s. b. the shift to the recipient-spouse’s rates (1942–1984) tax rates began climbing following the ratification of the sixteenth amendment, albeit slowly and focused largely on the very top earners.27 however, as it became clear that america would become involved in world war ii, congress needed money to build up the military. the first revenue act of 1940 raised surtax rates—additional taxes charged to high-earning individuals—and lowered the exemption level, “dramatically increas[ing] the number of people paying the income tax.”28 the revenue act of 1941 further raised rates and lowered the next year’s exemption level.29 during the war, the overall marginal tax rate (combining “regular” and special surtax rates) was over 90 percent.30 that meant, as the war waged on, net incomes were decreasing, while existing alimony obligations remained the same. under such a regime, alimony payments and increasing tax liabilities could exceed the annual income of some payors.31 for example, in 1941, any individual making over $26,000 was taxed at a marginal rate of over 50 percent.32 thus, any individual making above $26,000 who had agreed to pay half of his income in alimony would not be able to meet both his annual tax obligation and his annual alimony obligation from the current year’s gross income.33 moreover, there was a growing concern that the approach was unfair, even if it did not bankrupt the payor. certain congressmen felt that alimony is “in reality not income to [the husband] at all since he has no control over it as the use to which 27 see historical u.s. federal individual income tax rates & brackets, 1862-2021, tax found. (aug. 24, 2021), https://taxfoundation.org/data/all/federal/historical-income-tax-rates-brackets/ [https://perma.cc/4f9d-p2r3]. 28 joseph j. thorndike, timelines in tax history: from “class tax” to “mass tax” during world war ii, tax notes (sept. 19, 2022), https://www.taxnotes.com/tax-history-project/timelines-taxhistory-class-tax-mass-tax-during-world-war-ii/2022/09/16/7f3s2 [https://perma.cc/5vxm-jtcn]; see also carolyn c. jones, class tax to mass tax: the role of propaganda in the expansion of the income tax during world war ii, 37 buff. l. rev. 685, 686 (1988) (“the result was that the income tax rolls increased from about 7 million taxpayers in 1940 to more than 42 million in 1945.”). 29 thorndike, supra note 28. 30 see tax found., supra note 27. 31 see h.r. rep. no. 77-2333, at 46 (1942) (noting that due to surtax rates, some divorced husbands would be unable to meet tax obligations after paying alimony); see also russell v. russell, 142 f.2d 753, 754 (d.c. cir. 1944) (highlighting the same). 32 tax found., supra note 27. 33 $26k − [alimony ($26k × 50% rate)] − [tax burden ($26k × 51% rate)] = ($260). https://perma.cc/4f9d-p2r3 https://perma.cc/5vxm-jtcn 138 columbia journal of tax law [vol. 16:2 it is to be put.”34 the more cynical viewed it as “an infernal racket” such that the receipt “ought at least to be taxed.”35 this growing sentiment of perceived unfairness spurred congress to shift the tax burden of alimony from the payor-spouse (usually the husband) to the recipient-spouse (usually the wife) as part of the revenue act of 1942.36 section 22(k) of the 1943 internal revenue code defined “gross income” to include “periodic payments” from a “husband” to a “wife” made under a divorce decree or separation agreement.37 and section 23 included a corresponding deduction for, “[i]n the case of a husband . . . amounts includible under section 22(k) in the gross income of his wife, payment of which is made within the husband’s taxable year.”38 again, the tax treatment of alimony was seen as a joint endeavor. allowing a deduction for the payor-spouse for alimony while retaining the tax-free treatment for the recipient-spouse was never considered. instead, this change simply shifted who would bear the tax incidence. prior to 1942, the payor-spouse’s tax rates applied. with this change, congress shifted the income to the recipient-spouse and so her marginal rates would determine the ultimate tax burden. congress, however, did not allow this income shift to apply to all payments between divorced parties. instead, congress bifurcated the tax treatment—this new tax rule would apply to alimony payments, but it was not applicable to either property settlements between the parties or child support payments from the payorspouse to the recipient-spouse.39 not surprisingly, this bifurcation led to significant tax litigation with the government and parties arguing over what qualified as alimony and what was either property settlements or child support payments.40 parties could whipsaw the government by having the payor-spouse treat the payment as alimony (and thus receive a tax deduction) while the corresponding 34 88 cong. rec. 6377 (1942) (statement of rep. wesley disney); see also lerner v. comm’r, 195 f.2d 296, 298 (2d cir. 1952) (“such legislative history as is available stresses only the manifest fairness of charge to the wife and deduction by the husband of payments not only for alimony, but also for separate maintenance provisions ‘in the nature of or in lieu of alimony or an allowance for support.’”) (quoting h.r. rep. no. 77-2333, at 71 (1942)). 35 note, alimony taxation of indirect benefits: a critique and a proposal, 66 colum. l. rev. 1118, 1118 (1966) (quoting revenue revision of 1942: hearings before the h. comm. on ways & means, 77th cong. 2164 (1942) (statement of rep. john d. dingell, member, h. comm. on ways & means)). 36 revenue act of 1942, pub. l. 77-753, § 120, 56 stat. 798, 816-17 (codified as amended at i.r.c. §§ 71, 215 (2012)). 37 “in the case of a wife who is divorced or legally separated from her husband under a decree of divorce or of separate maintenance, periodic payments (whether or not made at regular intervals) received subsequent to such decree in discharge of, or attributable to property transferred (in trust or otherwise) in discharge of a legal obligation which, because of the marital or family relationship, is imposed upon or incurred by such husband under such decree or under a written instrument incident to such divorce or separation shall be includible in the gross income of such wife, and such amounts received as are attributable to property so transferred shall not be includible in the gross income of such husband.” i.r.c. § 22(k) (supp. iii 1943). 38 i.r.c. § 23 (u) (1942). (supp. iii 1943). 39 see i.r.c. § 22(k) (supp. iii 1943). 40 see, e.g., beverly i. moran, welcome to the funhouse: the incredible maze of modern divorce taxation, 26 harv. j. on legis. 117, 119-46 (1989). 2025] the flip and flop of taxing alimony 139 recipient-spouse would treat the payment as either child support or a property settlement and thus not report the payment as income.41 treating alimony differently from property settlements and child support necessitated rules to determine which side of the line a payment was on. the code needed to provide guidelines on how to determine what would qualify as a deductible alimony payment and what would be considered a nondeductible child support payment or property settlement. this distinction was primarily made by looking to the divorce separation agreement—anything labeled as “child support” payments in the agreement would not qualify for a deduction.42 the code also provided that all payments made by the payor-spouse satisfied the child support payment obligation first.43 what if the divorce agreement was silent about what the payments were for? somewhat surprisingly, the legislative history of the provision made it clear that unless a payment was specifically labeled as child support, it would be considered alimony and thus income to the recipient-spouse and deductible by the payorspouse. so, for example, if a divorce agreement stipulated that the payor-spouse was required to pay $1,000 per month for general support, then the entire $1,000 would be considered alimony and thus income to the recipient-spouse.44 this was true even if the agreement had some mechanism to reduce the payments owed should a child reach the age of majority or get married or die. essentially, divorcing parties were in complete control over whether child support payments would be taxable to the payor-spouse (by not allowing the payor-spouse a deduction and not recognizing income to the recipient-spouse) or taxable to the recipient-spouse (by allowing the payor-spouse a deduction but also requiring the corresponding income inclusion by the recipient-spouse).45 c. tax election to promote settlements in 1984, congress significantly changed the alimony rules once again. although the tax code continued to allow a deduction for alimony payments 41 davis, et al., supra note 21, at 392. 42 i.r.c. § 22(k) (supp. iii 1943) (“this subsection shall not apply to that part of any such periodic payment which the terms of the decree or written instrument fix, in terms of an amount of money or a portion of the payment, as a sum which is payable for the support of minor children of such husband.”). note that the code assumed the payor-spouse would be the husband. 43 see id. professor geier provided an example of how this worked. suppose payor-spouse owes $10,000 per year to recipient-spouse. of that $10,000, $6,000 is for child support and $4,000 is for alimony support payments. if payor-spouse pays only $8,000 then the code deems that the child support obligation is satisfied first. so, with this hypothetical, payor spouse is deemed to have paid the full $6,000 of child support and $2,000 of alimony. geier, supra note 22, at 373. 44 see comm’r v. lester, 366 u.s. 299, 303 (1961), where the court relied on legislative history rather than apply a substance over form analysis. “this language [in the legislative history] leaves no room for doubt. the agreement must expressly specify or ‘fix’ a certain sum or percentage of the payment for child support before any of the payment is excluded from the wife’s income. . . . we are obliged to enforce this mandate of the congress.”). 45 though, as professor geier noted, exercising this flexibility was easier for parties with sophisticated counsel than those going it alone. geier, supra note 22, at 375. 140 columbia journal of tax law [vol. 16:2 included as income by the recipient,46 it no longer mandated that the payments be taxed to the “recipient” (no longer to the “wife”). assuming the other requirements were met,47 the tax treatment of alimony payments was left up to the parties. the two sides could elect either of the tax treatments that applied to alimony payments before: (1) the payor-spouse receives a deduction for paying the alimony and the recipient-spouse has income for receiving the alimony or (2) the recipient-spouse does not report the alimony as income and the payor-spouse does not receive a deduction. essentially, under this system, the parties could elect whose tax rates would apply to the alimony payments.48 similar to their pre-1984 tax treatment, child support payments were not subject to this election. anything deemed a child support payment was not deductible by the payor-spouse and not income to the recipient-spouse. unlike in the old system, however, rules were added to attempt to classify some payments as child support even if the parties had not labeled them as such. as reviewed below, a substance-over-form analysis was applied to the payments made by the payorspouse, and it was possible that some “alimony” payments would be reclassified as child support (thereby eliminating the payor deduction for such payment and the recognition of income for its receipt by the recipient-spouse). congress felt that the deduction/income tax treatment should apply only to support payments; it should not apply to property divisions between the former spouses. one way that congress attempted to differentiate between the two was to include a requirement that, to qualify for the deduction treatment, the alimony payment must be made in cash.49 any property transfer would not be considered alimony for purposes of the code and instead would be subject to the rules of property transfers. under that treatment, any transfer between a couple incident to a divorce is treated as a nonrecognition event.50 thus, the recipient of the property has no income for receiving it and takes the same basis that the transferor had in the property.51 the transferor recognizes no gain or loss for transferring the property to the former spouse and does not receive any deduction for the transfer. this tax treatment of property transfers between ex-spouses is still applicable today. congress was also concerned that large cash alimony payments in the initial years after the divorce were disguised property settlements and therefore inappropriate for the deduction/income treatment. congress added a recapture provision to address this concern. under former code section 71(f), alimony 46 i.r.c. §§ 71, 215 (supp. iii vol. 2 1985). 47 for example, the payments were required to be in cash, the ex-spouses were not members of the same household, and there was no liability to continue making payments after the death of the recipient spouse. see i.r.c. § 71(b)(1) (supp. iii vol. 2 1985); see also deficit reduction act of 1984, pub. l. 98-369, 98 stat. 494, 795. 48 we will review in part iii the reason why a recipient-spouse would be willing to be taxed on an alimony payment rather than receive the alimony payment without tax. 49 see i.r.c. § 71(b)(1) (supp. iii vol. 2 1985). 50 i.r.c. § 1041(a). 51 essentially this treatment is the same as the rules that apply to gift transfers, although i.r.c. § 1015(a) imposes a limitation on a donee’s loss basis that applies to gifts of property. this is inapplicable to property transfers between spouses or ex-spouses under i.r.c. § 1041. the basis for the transferee under i.r.c. § 1041 will always be the transferor’s adjusted basis. 2025] the flip and flop of taxing alimony 141 amounts paid in the “post-separation years”52 were compared to the alimony amounts paid in previous post-separation years to determine if any amount should be recaptured.53 if the amounts paid in the later years were greater than $10,000 less than the payments made in the previous post-separation years, the parties were required to “recapture” that difference.54 under the provision, recapture meant that the payor-spouse would have income (to offset the previous deduction) and the recipient-spouse would receive a deduction (to offset the previous income inclusion).55 a simple example illustrates the working of this recapture provision. assume payor spouse and recipient spouse divorce on january 1, year one. they agree that payor will transfer $100,000 to recipient in year one as “alimony” but no further payments are required. in year one, payor transfers $100,000 to recipient, but pays nothing to recipient in the following five years. under the old recapture provision, $90,000 of the $100,000 “alimony” will be recaptured and payor will have $90,000 in income and recipient will get a $90,000 deduction in year two. as noted above, the policy basis for this treatment is that large reductions in payments during the first six years of the divorce likely signaled that the cash transfers were, in reality, a property settlement and not an alimony support payment. the idea is that, if the payments were truly support payments, they would continue in similar amounts each year for at least six years. if not, congress felt the deduction/income treatment should not apply as such payments were property settlements and not support payments. the recapture mechanism would claw back the alimony support treatment by requiring the payor-spouse to recognize income and provide a deduction to the recipient-spouse. similar to the alimony tax treatment from 1942 to 1984, congress again differentiated between alimony support and child support payments for tax purposes. any payment labeled “child support” would not be deductible by the payor-spouse and would not be income to the recipient-spouse. however, unlike the previous period, congress did not automatically accept the “alimony” label if the parties tried to disguise child support as alimony. any payment that was reduced on account of a specific contingency relating to a child would be treated as child support rather than alimony and thus would not be deductible by the payorspouse.56 so, for example, if the payor spouse agreed to pay the recipient spouse $40,000 a year in “alimony” but the agreement also stated that the obligation would be reduced to $15,000 a year once a child turned eighteen years old, then $25,000 52 the term “post-separation year” was defined as “any calendar year in the 6 calendar year period beginning with the first calendar year in which the payor spouse paid to the payee spouse alimony.” i.r.c. § 71(f)(4)(a) (supp. iii vol. 2 1985). this provision was amended in 1986 to liberalize the recapture rules. tax reform act of 1986, pub. l. no. 99-514, § 1843, 100 stat. 2085, 2853-54. for example, instead of six years, the post-1986 recapture rules applied only to a three-year period and the allowed reduction amount was increased to $15,000. i.r.c. § 71(f) (supp. iv vol. 4 1987). this liberalized version of the recapture rule was in effect prior to the 2017 act’s elimination of the alimony deduction. i.r.c. § 71(f) (2012). 53 i.r.c. § 71(f)(3) (supp. iii vol. 2 1985). 54 i.r.c. § 71(f)(2) (supp. iii vol. 2 1985). 55 id. 56 i.r.c. § 71(c)(2)(a)–(b) (supp. iii vol. 2 1985). 142 columbia journal of tax law [vol. 16:2 of the $40,000 payment would be treated as child support and not eligible for the deduction/income treatment.57 to avoid the reclassification, parties would reduce the payment obligation on a certain date without referencing a child. for example, rather than state that the alimony obligation would be reduced once a child turned eighteen, the agreement could state that the obligation would be reduced on a specific date that happened to be a week after the child’s eighteenth birthday. the treasury regulations attempted to deal with this workaround by providing that alimony reductions that occurred six months before or after a child’s eighteenth or twenty-first birthday or the local age of majority would be presumed to be tied to the child and considered child support payments for tax purposes.58 this presumption could be rebutted by the taxpayer if there was legitimate reason for the reduction on that date.59 otherwise, if the presumption held, the reduced alimony amount would be classified as child support instead of alimony. to summarize, during this period, divorcing parties had significant flexibility to determine the tax consequences of alimony payments. it was up to the parties whether the original rules of no deduction for the payor-spouse and no income to the recipient-spouse should apply or whether the payor-spouse should receive a deduction for the alimony payment and the recipient-spouse should have income. well-informed parties could elect the most efficient treatment which, in many cases, likely meant less tax revenue for the government but more after-tax income to the two divorced individuals. this period kept the rule that child support payments were not eligible for this election—the original rule of no-deduction/noincome applied to such payments. unlike the prior period, however, the government added some substance-over-form analysis to determine whether something labeled as alimony was actually child support. d. taxing payor-spouses to protect the purse (2017–present) everything changed rather suddenly in 2017 with the passage of the tax cuts and jobs act.60 for all divorces after 2018, the statute shifted back to the pre1942 taxation of alimony under which there is no deduction for the payor and no income to the recipient.61 there is a dearth of legislative history on this provision. according to the conference report, “the intent of the provision is to follow the rule of the united states supreme court’s holding in gould v. gould, in which the court held that such payments are not income to the recipient.”62 however, recall that gould held that alimony was not income to the recipient based on a husband’s duty to provide for his wife—an unlikely rationale in 2017.63 indeed, alimony in 2017 bore little 57 id. 58 treas. reg. § 1.71-1t(c), q&a (18) (1984). 59 id. 60 tcja, supra note 1. 61 see id. at 2089-90. 62 h.r. rep. no. 115-466, at 277 (2017) (conf. rep.) (citing gould v. gould, 245 u.s. 151 (1917)). 63 gould v. gould, 245 u.s. 151, 153 (1917). 2025] the flip and flop of taxing alimony 143 resemblance to alimony of the early twentieth century; the supreme court had since held that both husbands and wives may be entitled to alimony,64 and states had largely moved away from lifetime spousal maintenance.65 the more likely reason for the change, commentators surmise, was practical on the part of the treasury: the deduction for payment of alimony arguably had been a logistical nightmare for the internal revenue service, and repealing the deduction was estimated to raise billions of dollars for the fisc.66 there’s no question that the different tax treatments for different payments incident to divorce made the irs’s job more difficult. first, the alimony deduction made spousal support an outlier in how taxes were allocated in divorce. child support payments and property settlements have always been treated as nondeductible and nonexcludable.67 second, the irs had struggled for years with compliance. alimony payors would classify payments as deductible while recipients would classify them as nontaxable child support or equitable distribution payments.68 this inconsistent reporting is said to have cost the irs billions in revenue.69 the 2017 act eliminated the irs’s need to distinguish between alimony and child support or alimony and property settlements. everything was treated the same for tax purposes—admittedly a simpler system. money was also clearly a factor in this decision. not only did the repeal reduce compliance costs, but repealing the deduction itself was expected to result in approximately $6.9 billion in revenue over a ten-year scoring period.70 administrative challenges notwithstanding, we argue that the deduction/income treatment better comported with our progressive rate structure and urge a return to the pre-2017 tax treatment of alimony payments. iii. the two choices for the tax treatment of alimony as noted above, the 2017 act returned the tax treatment of alimony to its origins. there is no denying that, between the two options, the current treatment is the administratively simpler choice. there is no tax deduction for the payor-spouse 64 see orr v. orr, 440 u.s. 268, 282-83 (1979). 65 see jennifer l. mccoy, spousal support disorder: an overview of problems in current alimony law, 33 fla. st. u. l. rev. 501, 506-13 (2005); see also alimony laws and forms: 50-state survey, justia, https://www.justia.com/family/divorce/alimony-forms-50-state-resources/ [https://perma.cc/e6y5-azwa]. 66 staff of joint comm. on tax’n, 115th cong., estimated budget effects of the conference agreement for h.r. 1, the “tax cuts and jobs act” 3 (2017); treasury inspector gen. for tax admin., u.s. dep’t of the treasury, tigta no. 2014-40-022, significant discrepancies exist between alimony deductions claimed by payers and income reported by recipients 1-9 (2014) [hereinafter tigta alimony report]. 67 see martin j. mcmahon, jr., tax aspects of divorce and separation, 32 fam. l.q. 221, 222-23, 227, 234-35 (1998). 68 see tigta alimony report, supra note 66, at 5. 69 see id. at 4, 8. 70 staff of joint comm. on tax’n, supra note 66, at 3; see also davis et al., supra note 21, at 396 (describing findings of tigta alimony report, supra note 66, at 5). https://perma.cc/e6y5-azwa 144 columbia journal of tax law [vol. 16:2 and there is no income for receiving alimony to the recipient-spouse. this applies to any transfer from one spouse to the other under a divorce agreement. it does not matter if the payment is for alimony support, child support, or a property settlement. the tax consequences are the same for all three types of transfers. the pre-2017 act tax treatment of alimony was more complex. under those rules, if the requirements of code section 71 were met, the payor-spouse would receive a tax deduction for the amount of alimony paid and the recipient-spouse would be required to report the alimony received as income. it is worth reiterating that this tax treatment was elective, not required. there would be no deduction for the payor-spouse and no income to the recipient-spouse if the parties agreed in the divorce agreement that alimony payments would not be income to the recipientspouse and would not be deductible by the payor-spouse.71 that is to say, the parties could elect out of the deduction/income system and instead apply the “old” rules (which are now the current rules). this meant that the pre-2017 act system provided more flexibility than the current regime. of course, one might ask why any recipient-spouse would agree to treat alimony as income to them if they could elect to make the alimony payments nontaxable? the answer is tax arbitrage, which leads to more money for both parties (to the detriment of the government). take a simple example—assume the payor spouse is in the 30 percent tax bracket and the recipient spouse is in the 10 percent tax bracket. payor and recipient agree that the alimony payments should be around $20,000 per year. recipient could demand that the parties elect to apply the pre-2017 act treatment since that would mean recipient would not have to report the $20,000 alimony payments as income. however, such treatment also means no deduction to payor. instead, it would be in both parties’ interest to allow recipient to take the deduction in exchange for a higher alimony payout. in a 30 percent tax bracket, a deduction is worth $6,000 in tax savings to payor. if the payment is income to recipient, he will pay $2,000 in taxes on the alimony received. therefore, payor can offer to pay recipient $25,000 in alimony if recipient agrees to the deduction/income treatment. payor has $7,500 in tax savings so her total payout of $17,500 is less than the $20,000 it would be without the deduction. recipient has an income of $25,000, but, after paying $2,500 in taxes, he still ends up with $22,500—more than he would have if he had received $20,000 tax-free. this illustrates one normative reason why the pre-2017 act system was preferable: it allowed the recipient spouses to receive more money, after tax, than under the current rules. the price of this, of course, is less tax dollars for the government. but this “cost” to the government is severely overstated. as recognized by professor geier, allowing divorced parties to shift alimony payments into the lower-income spouse’s tax bracket merely extends the tax benefits of marriage into divorce.72 thus, the government is not really “losing” money—it is not recouping tax dollars paid by a couple who were once married and continue to live in part off of one spouse’s higher income, as they did in marriage. in any event, as discussed in part iv, any cost to the government is outweighed by the benefits 71 see i.r.c. § 71(b)(1)(b) (2012). 72 see geier, supra note 22, at 365. 2025] the flip and flop of taxing alimony 145 of increased payments to recipient spouses and the progressivity served by allowing the deduction. still, some have argued that the current tax treatment is the appropriate approach for tax policy purposes. professors tessa davis, amy soled, and jay soled have argued that shifting the tax burden back to the payor-spouse is the better approach.73 their argument proceeds in two parts. first, they contend that the tax code should affirmatively allocate the tax burden of alimony instead of leaving divorced couples the flexibility to allocate the burden among themselves to avoid lowering their overall tax burden.74 second, they argue that the payor-spouse is the proper party to bear the incidence of taxation. the code has long treated married couples as a single taxable unit to prevent tax avoidance collusion.75 additionally, as professors davis, soled, and soled suggest there is a similar incentive to work together in dividing assets after the marriage ends.76 because the parties continue to share a “common tax minimization agenda,” the authors argue that the tax code should place the tax burden on one party to avoid collusion. the authors realize that this argument does not end the discussion of how alimony and related payments should be taxed. the divorced parties were treated as a single economic unit under both the pre-1942 treatment (where there was no deduction for the payor-spouse and no income to the recipient-spouse) and the 1942–1984 system (where the payor-spouse received a deduction for alimony paid and the recipient-spouse had income). as previously noted, no one has seriously proposed that both parties should pay taxes on alimony payments (no deduction for the payor and the payments are included as income to the recipient). the authors, however, believe that the elective nature of the system was a problem as it allowed for structuring payments in a tax optimal way that hurt the public fisc.77 once again, this is best illustrated by an example. if we assume each party in a divorce is trying to maximize their share of the marital assets, they will want to ensure that the pie is as big as possible. imagine a husband with a marginal tax rate of 20 percent who wants to pay $100,000 of his gross income per year in alimony to his wife with a marginal tax rate of 10 percent. if taxed to the husband, he would be responsible for $20,000 in income tax on that amount, meaning that he would spend a total of $120,000 on alimony and taxes. the $20,000 spread between the $120,000 paid by the husband and the $100,000 received by the wife represents an opportunity for each party to improve their position at the expense of the fisc. a couple willing to work together would assign the alimony as income to the wife in exchange for a higher alimony payment between $110,001 and $119,999, which would leave both parties better off. take for instance alimony of $115,000, which would be $15,000 more than the original amount. taxed to the 73 see davis et al., supra note 21, at 401-14. 74 see id. at 402-05. 75 see, e.g., i.r.c. § 6013(a) (providing that spouses are broadly permitted to file a joint return); id. § 1041(a)–(c) (providing that no gain or loss is recognized on transfers of property incident to divorce). 76 davis et al., supra note 21, at 402-05. 77 id. at 404-05. 146 columbia journal of tax law [vol. 16:2 wife, $115,000 in alimony would have the following payout. the husband would pay only the $115,000 in alimony, thereby saving $5,000 in taxes from the $120,00 total he would pay at $100,000 of alimony taxed to himself. his wife would receive the higher alimony payment of $115,000, less $11,500 in taxes at her 10 percent rate, which would amount to a total payout of $103,500. thus, she would gain $3,500 more than the original $100,000 of alimony taxed to her husband. the federal government, however, would lose $8,500 it would have received in taxes had the parties agreed to $100,000 of alimony taxed to the husband ($20,000 from the husband in scenario 1 versus $11,500 from the wife in scenario 2). the government could prevent this kind of collusion by simply assigning the tax burden to one of the parties—the payor or the recipient—instead of allowing them to allocate it among themselves.78 however, as the example illustrates, it’s not the collusion that creates the tax problem for the government; it’s the allowance of the deduction for alimony. since the payor-spouse is generally in the higher tax bracket, allowing a deduction will always allow the parties to increase their respective share of the pie at the cost of the government’s revenues. if the parties are in the same marginal tax bracket, there would be no cost to the government; it would merely be an issue of who bears the incidence of taxation. so in many ways the collusion “problem” is misleading. if the only concern is government revenue, the current treatment (and the pre-1942 treatment) is the appropriate choice. taxing the alimony at the payor-spouse’s marginal rates should almost always lead to more revenue for the government, since it is likely the payorspouse is in a higher tax bracket than the recipient-spouse. besides the increase in tax revenue, the authors set out three reasons why they believe the payor-spouse is the proper party to tax. first, they argue that alimony payments “represent a return on human capital that the erstwhile married couple had invested in one another.”79 by this they mean that, when two people decide to get married, they each implicitly agree to make economic investments in the relationship—many times, this means that one spouse sacrifices a career to support the spouse who pursues a career for the economic benefit of both.80 the authors argue that the tax code should therefore treat alimony as nontaxable payments for lost or damaged human capital, as opposed to income to the recipient.81 second, the authors argue that taxing the payor better aligns with the assignment of income doctrine, which holds that income should be taxed to the person who earned it.82 “failure to do so,” they warn, “threaten[s] the integrity of the code’s progressive rate structure as taxpayers could strategically assign income to related taxpayers whose income was taxed at lower tax rates, thereby achieving significant tax savings.”83 finally, the authors argue that taxing the payor better comports with the idea of declining marginal utility.84 78 id. at 405. 79 id. at 408. 80 see id. at 406-08. 81 id. at 408. 82 see id. at 409-10. 83 id. 84 id. at 412-14. 2025] the flip and flop of taxing alimony 147 we disagree with the authors’ justifications and will discuss the counter arguments to each in turn. a. theory of human capital beginning with the theory of human capital, the idea that alimony is compensation for investments in human capital does not tell us whether the repayment of those investments should be taxed to the payor or recipient. the authors note that section 104(a)(2) of the tax code excludes from income payments related to damages for bodily injury, purportedly because they are considered a return of human capital as opposed to income.85 there are a few issues with this comparison. first, a return of “human capital” is not automatically nontaxable. what is important in determining tax gain or loss is not human capital, but instead the taxpayer’s adjusted basis. for example, if a taxpayer buys wood, nails, and paint to make a bookcase, and if she is able to sell that bookcase for more than the cost of those items, she will recognize income on that gain even though it is a return of her human capital in the work she put into making the bookcase. aside from the basis issue, making shared contributions to a relationship by way of human capital is fundamentally different from being compensated for damages in a negligence action. for one thing, the authors assume a loss-centric view of the human capital theory in every case; that all returns of human capital represent compensation for a loss. this may in theory work for cases where an individual is injured by the negligence of another, but not for two people who, for at least a time, worked together to build a life. under the author’s loss-centric view, alimony is compensation to a spouse for losing out on investments she could have made in herself instead of her spouse. but there are other ways to view such intangible investments. more popular seems to be a gain-centric theory, under which both spouses’ contributions to the economic relationship are recognized and under which alimony would represent the recipient spouse’s share of the mutual returns on their investment. under this view, it’s not so clear that the tax burden should be borne solely by the partner who earned the income.86 there are other policy considerations that support the exclusion for the receipt of damages on account of physical injuries that do not support the same treatment for alimony payments. first, the tax system is primarily aimed at commercial transactions. taxing transactions outside of the commercial sphere certainly can be appropriate but should be viewed with some caution. in the case of damages for physical injury, the noncommercial nature of the transaction supports the exclusion. compare favorably the fact that if a taxpayer sells a body part (such as plasma or illegally sells a part of their body) then the tax system would tax that transaction. although this transaction involves physical parts of the body, the 85 see id. at 408 n.129. 86 see linda sugin, the social meaning of the tax cuts and jobs act, 128 yale l.j. f. 403, 413 (2018) (“taxing alimony to the recipient is consistent with treating alimony as an earned amount, since earnings are always taxed to the earner. if we think about marriage as a partnership in which both spouses contribute inputs to produce shared returns, then the amounts earned in the market by one spouse are appropriately conceptualized as belonging jointly by both spouses.”). 148 columbia journal of tax law [vol. 16:2 taxpayer, by selling, has entered the commercial space and so the taxation of that income is justifiable. the noncommercial nature of a transaction alone, however, may not be enough to finalize the tax consequences. for example, medical expenses are deductible despite being personal in nature. viewed in isolation, the noncommercial nature of personal injury damages might not be enough to support the exclusion. other tax policy considerations also play a role in the exclusion. first, congress has generally allowed taxpayers to avoid gain on involuntary conversions if they purchase something similar to replace the lost property.87 obviously, this replacement is not possible in the case of a physical injury and so congress may have felt the exclusion was the right choice. congress may also have been concerned that taxing physical injury damages awards would lead to higher payouts in order to gross up the injured party’s recovery. finally, congress may have felt it was unseemly for the government to take a share of the recovery. there is an ick factor in having the government benefit from the physical injury of a taxpayer. do these policy considerations also support the nontaxation of alimony? alimony appears to fit within the noncommercial realm of taxation. however, as noted, the noncommercial nature of a transaction on its own is not per se evidence of what the tax result should be. other considerations can be at play to either support the exclusion or trump the presumption that the tax system should stay out of the noncommercial sphere. with physical injuries, it was (1) the inability to replace what was damaged, (2) the concern over higher and higher award amounts to compensate for the losses due to taxation, and (3) the unease at having the government take a share of the victim’s compensation. the replacement element is not as strong for alimony. there is no involuntary-conversion-type provision that is inapplicable in the case of alimony payments. with damages, it is simple to compare damages paid for harm done to property with damages paid for physical injuries. there also does not seem to be the same concern over increased amounts of alimony needing to be paid as there is with damage awards. in fact, because the recipient-spouse is usually in a lower bracket, the taxation of the award, combined with the alimony deduction, will usually mean more money for both parties aftertax. as we have noted, the fisc is the loser in this situation and so the concern for using the tax system to reduce alimony payments does not match the concern over increased award payments. finally, there was the unseemly argument—that is, the government should not benefit from the physical injury of a taxpayer. this factor is not nearly as strong in the case of alimony. while one could argue that the government should not share in the needed support of an ex-spouse, this sense is nowhere near the distaste the public would feel from having the government take a share from someone who has been physically injured. therefore, while the noncommercial nature of alimony supports exclusion treatment, there are other exclusion-supporting factors in the case of damages that have little or no bearing on the tax treatment of alimony. 87 i.r.c. § 1033(a)(1). 2025] the flip and flop of taxing alimony 149 b. assignment of income doctrine the authors summarily state that taxing the alimony recipient instead of the payor better comports with the assignment of income doctrine because it taxes the person earning the income. but if, under a human capital theory, that income earned post-divorce was generated by the contributions of both spouses, the assignment of income doctrine does not so cleanly apply. as noted above, this payment may represent the gains that the recipient-spouse put into the joint exercise of the marriage. in that case, the recipient-spouse is appropriately taxed since the amount was “earned” by them. and, as briefly mentioned above, there is no assignment of income concern in the marriage context because married couples are treated as a unit for purposes of the income tax system.88 the tax code implicitly acknowledges the human capital contribution that a nonor lower-earning spouse makes to the salary of the higher earner. the tax rates and tax brackets take into account that a married household may have fewer expenses than two single individuals living separately. once divorced, the question is what to do with the assignment of income doctrine. it does seem clear that the payor-spouse earned the income, but the authors stressed in their first justification that the alimony may just represent a return of human capital. if so, the payments are similar to deferred compensation and so the assignment of income doctrine may actually lead to the conclusion that the recipient-spouse is the one who earned the income and should therefore be taxed. it boils down to this. spouses who sacrifice their market participation for the benefit of a family unit that dissolves should be compensated for their investment. but what that partner is entitled to should not be determined by shifting tax burdens. instead, the partner should be affirmatively allocated his or her share. if the parties know that the share will be treated as income on which the recipient will pay taxes, they can bargain around the tax burden and allocate alimony accordingly. indeed, by placing the tax burden on the recipient, the recipient should receive more than she would because both parties would be able to share in the tax savings. c. ability to pay finally, the authors argue that taxing the alimony payor better comports with the “ability to pay” concept. we will discuss this contention in detail in part iv, but briefly, the more alimony a person receives, the higher their ability to pay taxes is, just as the inverse is true. the real issue is who should bear the incidence of taxation. iv. revoking the revocation although the current tax treatment of alimony is easier to enforce and bolsters the fisc, we believe that the 2017 act’s alimony reform was a mistake. congress should act to return to a flexible deduction/income regime for alimony 88 see i.r.c. § 6013(a). 150 columbia journal of tax law [vol. 16:2 payments. the major policy justification for our position is that the pre-2017 act tax treatment of alimony payments better comports with the theoretical underpinnings of our income tax system and progressive taxation (particularly the purpose of graduated tax rates). a. the importance of consumption our current federal tax system is “income” based. an income tax system was not the only option available. theoretically, the government could have sought to tax the money used to consume89 (a “consumption” tax), or it could have sought to use overall wealth as a measurement for taxation rather than the income earned in one tax year90 (a “wealth” tax). so, when determining whether something like the receipt of alimony payments should be subject to taxation under an income tax system, it is imperative to begin with the question: what is income? generally, academics have accepted the haig-simons measure of income. under this measure, personal income is a mathematical equation: [t]he algebraic sum of (1) the market value of rights exercised in consumption and (2) the change in value of the store of property rights between the beginning and end of the period in question.91 in other words, income for a period is the taxpayer’s current consumption during that period plus the taxpayer’s accumulation of wealth. a simple example will illustrate. assume taxpayer has $50,000 in her noninterest-bearing bank account and she earns $10,000 from performing services for others. she spends exactly $10,000 to purchase and consume food and those groceries are her only purchases during the year. taxpayer has $10,000 in income—all from current consumption. her wealth accumulation is zero as she began the year with $50,000 and ended the year with the same amount. therefore, taxpayer will have $10,000 subject to federal taxation. note that this result (in terms of the amount of dollars that taxpayer would have subject to taxation) would be exactly the same under a pure consumption tax system. why does taxing consumption make sense as a policy matter? it is useful here to step back for a moment and consider how to define consumption for purposes of this theoretical definition. professor alvin warren stated that “‘consumption’ means the ultimate use or destruction of economic resources.”92 89 a sales tax is an example of a consumption tax system, but there are examples of more complex pure consumption taxes that could also introduce progressivity. see, e.g., daniel n. shaviro, replacing the income tax with a progressive consumption tax, 103 tax notes (ta) 91, 93-97 (apr. 5, 2004) (describing four potential approaches to a progressive consumption tax). 90 see, e.g., david m. schizer & steven g. calabresi, wealth taxes under the constitution: an originalist analysis, 77 fla. l. rev. (forthcoming 2025) (manuscript at 11) (on file with authors). 91 henry c. simons, personal income taxation 50 (1938). 92 alvin warren, would a consumption tax be fairer than an income tax?, 89 yale l.j. 1081, 1084 (1980). in that piece, professor warran defined “economic resources” as marketable goods or services. id. 2025] the flip and flop of taxing alimony 151 when a person uses their income to purchase and consume, they have taken that item (whether a good or a service) away from society. under our system, the federal government essentially has a right to some portion of everything that our society produces as the “price” of providing governmental services.93 in a simple economy, the government could collect its share by collecting some percentage of everything produced at the source. if a farmer produced 100 apples, the government could collect 30 apples directly from the farmer as a tax. in a more complex economy, collection at the source is neither administrable (how would the government collect 30 percent of a law professor’s services?) nor desirable (the government prefers money to a percentage of goods and services produced). instead of collecting taxation at the source, the government imposes a tax on income. this income represents the power to consume, that is, the power to take resources away from society. the income tax imposed on each taxpayer is a proxy for the government’s share of the items or services that the taxpayer will consume. as a policy matter, taxing income that will be used for current consumption is justifiable on the basis that the taxpayer is taking away goods and services from the common pool.94 however, recall that the haig-simons definition of income also includes the accumulation of wealth. returning to our example, assume the taxpayer earns $10,000 but does not purchase or consume anything during the year. the taxpayer has exactly the same amount of income as our original example: $10,000. although her present consumption is zero, taxpayer’s accumulation of wealth is $10,000 (she started the year with $50,000 and she ended the year with $60,000). this of course is the difference between a pure consumption tax and an income tax. under a consumption tax, the taxpayer in this example would not pay any income tax since there was no current consumption. so, what is the justification for taxing accumulation of wealth when it is not used to remove goods or services from society (i.e., the taxpayer does not actually consume anything with the income)? the answer is that the government is aware that the accumulation will be used at some point in the future to consume. rather than imposing the tax when the person consumes in the future, our tax system chooses to tax the person in the present. therefore, although consumption looks like only half of the formula of the haig-simons definition of income, it is actually on both sides of the equation. a taxpayer is taxed on both their current consumption and the present value of their future consumption. 93 as supreme court justice oliver wendell holmes stated, “taxes are what we pay for civilized society . . . .” compania general de tabacos v. collector, 275 u.s. 87, 100 (1927). this quotation is carved over the entrance of the irs’s national headquarters in washington, dc. 94 see douglas a. kahn & jeffrey h. kahn, “gifts, gafts, and gefts”—the income tax definition and treatment of private and charitable “gifts” and a principled policy justification for the exclusion of gifts from income, 78 notre dame l. rev. 441, 454 (2003) (“when an individual uses an amount of income for consumption purposes in the year in which the income was received, the individual has removed the purchased goods or services from the common pool, and they are no longer available to anyone else in society. those goods or services are captured by an individual to the exclusion of everyone else. it is an appropriate scheme to tax individuals in accordance with the amount of societal goods they have taken to themselves to the exclusion of others, and the income tax system does that in regard to current consumption.”). 152 columbia journal of tax law [vol. 16:2 one more variation of our taxpayer example may be helpful to illustrate how this concept works in practice. recall that taxpayer was taxed $10,000 because she accumulated wealth equal to that amount during the year (earning $10,000 but not spending any of it). now assume that the taxpayer does not earn any income the following tax year. instead, she uses $10,000 of her savings to purchase goods and services. under this example, taxpayer does not have any income and therefore she pays no income tax. although her present consumption is $10,000, her accumulation of wealth is negative ($10,000). the consumption and accumulation-of-wealth elements of the haig-simons formula offset, and the taxpayer’s income comes out to zero. she is not taxed under the income tax system on her present consumption because she used money on which she had already paid income tax for her consumption. once she paid the income tax on her accumulation of wealth, she could use that amount to consume in any future year without incurring additional income tax. of course, our tax system does not invariably follow the haig-simons definition of income, nor should it. other policy considerations, including the administration of the tax system, come into play and may trump the presumed income tax treatment. for example, under the haig-simons definition of income, unrealized gains—such as increases in the value of one’s stock portfolio—should be taxed each year as income. if a taxpayer buys a stock for $10 at the beginning of the tax year and it increases in value to $20 by the end of the tax year, the taxpayer has accumulated wealth of $10. yet, congress has determined that the difficulty and cost imposed by implementing such a tax are greater than the policy justifications supporting including such amounts in income. thus, in most cases, we do not tax the gain on property until the taxpayer realizes the gain—such as by selling the stock for $20.95 there are also deviations from the haig-simons definition when income stems from consumption. for example, the tax code excludes from income certain fringe benefits provided by employers to employees.96 qualified meals and lodging consumed by employees are not considered income, despite the destruction of resources (once the employee consumes the food, he takes it out of market, and his use of a lodging precludes its use by others). this exclusion violates the haigsimons definition of income but competing principles (such as valuation concerns) overtake the general policy of including that consumption in income. though our tax system does not follow the haig-simons definition of income in every case, it is seen as aspirational.97 it can be thought of as the default rule to follow unless congress has decided that contrary policy considerations lead to a different outcome. the haig-simons definition is used not only as a policy device for determining whether something should be included in income for tax purposes, but also to begin the policy discussion and perhaps set the presumption of whether 95 but see i.r.c. § 475 (allowing mark to market accounting for securities dealers). 96 i.r.c. § 119. 97 see, e.g., majorie e. kornhauser, the constitutional meaning of income and the income taxation of gifts, 25 conn. l. rev. 1, 28 (1992). the haig-simons definition of income is also used to apply the “comprehensive tax base.” see joseph m. dodge, beyond estate and gift tax reform: including gifts and bequests in income, 91 harv. l. rev. 1177, 1183 (1978). 2025] the flip and flop of taxing alimony 153 something should be deductible. for example, the charitable contribution deduction is arguably supported by the haig-simons definition. if the taxpayer earns $10,000 and donates it all to a charity (assuming a full deduction without limitations or floors), that taxpayer will not pay any income tax (the $10,000 in income is fully offset by the $10,000 deduction). the haig-simons policy justification for this result is that the taxpayer did not consume any of society’s resources by donating the money—she did not take anything away from the common good. again, the haig-simons definition is not the end of our discussion, other policy considerations can come into play which congress may determine are more important. for example, charitable contributions are subject to certain limitations in size and kind.98 another example is the deduction for medical expenses. although such expenses would normally constitute consumption, there are other policy justifications which congress has determined outweigh the consumption element and it thus allows a deduction for such expenses.99 this leads back to our discussion of alimony. if alimony payments are deemed to be “consumption” under the haig-simons definition of income, then the default presumption should be that the payor-spouse should not receive a tax deduction for the transfer. and the corresponding accumulation of wealth to the recipient means that the recipient-spouse should have income. but, like contributions to charity, the alimony payor is not consuming any of society’s assets by making the payment. it seems then that alimony payments should not be considered consumption under the haig-simons definition of income. in other words, since the recipientspouse will be the one consuming, he should be the one who is taxed. and since the payor-spouse did not consume with the transfer, she should receive a deduction to reflect that fact. but determining that alimony payments are not consumption does not answer the question of whether the payor should get a deduction for the payment, it merely creates that presumption. other policy considerations may outweigh the haig-simons treatment. for example, the same consumption analysis applies to the tax treatment of gifts. such transfers are not consumption as they do not use up any of society’s resources.100 therefore, the person who will do the consuming with the gift is the donee. still, the code does not provide a deduction for the transfer of gifts, nor does it tax the recipient of the gift under the income tax system.101 instead, the income tax treatment of gifts is the same as the treatment that currently applies to alimony payments—no deduction to the donor and no income to the donee.102 this does not mean that the policy consideration of consumption is pointless for either gifts or alimony payments. the fact that such a transfer is not 98 see, e.g., i.r.c. § 170(b). 99 see jeffrey h. kahn, personal deductions – a tax “ideal” or just another “deal”?, 2002 l. rev. mich. st. univ. det. coll. l. 1, 25-29 (2002). 100 kahn & kahn, supra note 94, at 462. 101 but see i.r.c. § 2503 (application of the federal gift tax). 102 some have argued that gifts should be taxable (even without a deduction for the donor) but there are policy justifications for the current tax treatment of gifts. see kahn & kahn, supra note 94, at 461-62. 154 columbia journal of tax law [vol. 16:2 consumption supports the treatment of taxing only one party. for both gifts and alimony payments, such policy considerations support the conclusion that the appropriate tax treatment is either no deduction and no income or deduction to payor and income to recipient. the fact that only one person is or will be “consuming” counters any argument that such payments should be taxed to both parties. we will discuss and distinguish the tax treatment of gifts further in part iv.c. b. marginal rates of taxation and progressivity so far, we have established that alimony payments represent consumption by only one party to a transfer and, like gifts, should only be taxed to one party to the transfer. here we argue that party should be the alimony recipient. taxing the alimony recipient better comports with our progressive rate structure and the concept of taxing a party based on her “ability to pay.” as discussed above, income is an appropriate measurement of taxation because it represents the power of the earner to consume society’s assets whether in the current taxable year or in the future. however, that justification does not tell us what the tax rates should be. under both a flat tax and a progressive tax, the more a person earns in income, the more they will pay in nominal taxes. the more difficult issue is how much more they should pay. in the united states, progressive taxation has been a part of the federal income tax system since its adoption after the passage of the sixteenth amendment.103 the main instrument used by congress to implement progressivity has been graduated tax rates. although there have been several theoretical justifications for the graduated rate structure, in our opinion the strongest is the equal sacrifice theory. this theory accepts the general marginal utility idea, that the more of something that a person has, the less utility they derive from an additional unit.104 therefore, in order to equalize the sacrifice between two taxpayers, one with a significant amount of income and one with little income, it is appropriate to not only take more in nominal terms from the higher income taxpayer, but to also take a higher percentage of the total income earned.105 the graduated rate structure is essentially a rough guide to the marginal utility of the income earned by a taxpayer. the first dollars that a person earns are the most important; they pay for food and shelter. the more income that the person earns, the less marginal utility that they derive from those additional dollars, and thus a higher tax rate applies as income increases. this creates what is known as the marginal utility curve, representing the value a taxpayer gleans from each additional dollar earned—a visual representation of the law of diminishing marginal utility. 103 the first revenue act passed after the adoption of the sixteenth amendment “imposed a normal tax of one percent (subject to certain exemptions) and a surtax of one percent to six percent on net income over $20,000.” douglas a. kahn & jeffrey h. kahn, federal income tax 2 (8th ed. 2019). 104 kahn, supra note 99, at 21-23. 105 id. 2025] the flip and flop of taxing alimony 155 106 further justification for this theory derives from the fact that the lower tax rate brackets still apply even when a taxpayer earns enough to put them in a higher bracket. it is a common misconception that earning a dollar that places the taxpayer in a higher bracket means that all of their income is taxed at the new higher rate. even the wealthiest taxpayers benefit from the lower tax rates applied to the lower income brackets. they too receive the most utility out of the first earned dollars and therefore the government applies the lowest tax rates to that bracket, no matter how much more income they have that year. many deductions can be justified as an adjustment to the rough utility curve set out by the graduated rate structure. returning to the medical expense deduction, recall that such a deduction is not supported under the haig-simons definition of income. such expenditures are clearly consumption. however, a deduction for medical expenses is supported by the progressive tax structure of our graduated rates.107 consider a simple example. taxpayer a and taxpayer b each earn $100,000 in income in a taxable year. a is perfectly healthy and does not have any medical expenses. b has a serious illness which requires him to spend $25,000 on medical treatment. without a medical expense deduction, a and b would be taxed the same—that is, the system would believe that they have roughly the same utility curve for their income. it is clear however that b is in a significantly different position than a. for the utility curve to treat them the same would not properly take into account b’s situation. thus, the medical deduction is allowed to provide an additional zero-rate bracket since congress is aware of how important those expenditures are. thus, the graduated rate structure is congress’s attempt to roughly apply a marginal utility curve to each individual taxpayer. that curve assumes that everyone has some medical expenditures, since there is a floor that a taxpayer must 106 tejvan pettinger, diminishing marginal utility of income & wealth, econ. help (jan. 18, 2018), https://www.economicshelp.org/blog/12309/concepts/diminishing-marginal-utility-of-incomeand-wealth/ [https://perma.cc/r2tq-tkvs]. 107 see kahn, supra note 99, at 25-35. https://perma.cc/r2tq-tkvs 156 columbia journal of tax law [vol. 16:2 reach before they can begin deducting medical expenses.108 congress is aware however that taxpayers may have more medical expenses than the default curve assumes and thus an adjustment is made through the use of a deduction—essentially an increase in the zero-rate bracket. of course, this argument could be used to justify a deduction for any expense. if a had spent $75,000 on a luxury vacation, the remaining $25,000 will provide more utility than if a had not spent the money on travel. should congress provide a deduction for all expenditures? the answer of course is no—this adjustment to the utility curve argument applies only to expenditures that congress has decided should require an adjustment to the graduated-rate progressive tax structure. unsurprisingly, luxury travel is not something that congress has felt justifies the need to increase a taxpayer’s zero-rate bracket to accommodate.109 let us then return to the alimony deduction. should a deduction be provided to the payor-spouse for the payment of alimony? as we have stated, we believe that is the correct result and that an adjustment to the payor-spouse’s graduated rate utility curve is appropriate in this situation. return to our previous example with taxpayers a and b, but this time b does not have medical expenses. instead, b pays $25,000 in alimony to his ex-spouse. do a and b have the same rough utility curve for the income that they earn that year? without a deduction for the alimony payment, the tax system is treating them the same. we believe that the system should account for that payment by providing a deduction, thereby adjusting the utility curve of taxpayer b. indeed, the argument for a deduction in the case of alimony is even stronger than the one for the medical expense deduction because in the alimony situation, there is no consumption by the payor-spouse. it is fairer to tax b similar to a taxpayer who makes $75,000 rather than a taxpayer who makes $100,000 and does not have to make any alimony payments. the tax system should adjust the payor-spouse’s brackets by applying a zero-rate bracket to the alimony paid. note that this argument does not apply to child support payments and thus such payments do not warrant a deduction under this line of reasoning. it is the payor-spouse’s obligation to support his or her children, and the graduated rate structure builds such support into the rates and brackets. no adjustment should be made for such payments since they are already baked in the cake, as it were. if a (who is still married) and b (who is divorced) each make $100,000 and each spend $25,000 on their children (a spending directly and b making a child support 108 id. at 28 (“since most individuals suffer minor illnesses from time to time, a certain amount of medical expense is accommodated in the rate schedule as part of ordinary living expenses.”). the current floor for medical expenses is 7.5% of a taxpayer’s adjusted gross income (agi). i.r.c. § 213(a). an agi percentage floor (rather than a flat amount) allows for the fact that wealthier taxpayers may have more disposable to spend on medical expenses and that some medical expenses may have pleasurable aspects and so the wealthy are more likely to use them. kahn, supra note 99, at 29. 109 kahn, supra note 99, at 29 (“adjustments are made only for those events or conditions that elicit the view that the application of the standardized curve in those circumstances would be grossly inappropriate.”). 2025] the flip and flop of taxing alimony 157 payment to the ex-spouse), there is no reason to provide b a deduction. it is fair to treat a and b the same for tax purposes in this scenario.110 thus, our proposal continues the admitted administrative difficulty of determining what are legitimate alimony payments and what are hidden child support payments. in our opinion, this is a worthwhile price to pay in order to satisfy the superior tax policy result that alimony payments should be deductible and child support payments should not be deductible. others have disagreed. in her piece, professor geier argued that the parties should be able to elect the desired tax treatment for any type of transfer.111 she felt that there was no justified policy reason for the different treatment between alimony and child support.112 we have provided that justification. however, we concede that distinguishing between the two raises administrative costs and can understand why one might conclude that the cost of such administrative difficulty exceeds the benefit of following the theoretically preferable treatment. between the current treatment of alimony and allowing the parties to elect the treatment for any divorce support transfer (whether alimony or child support), we would also support the latter. c. alimony and gifts as discussed above, the current tax treatment of alimony payments is identical to the tax treatment of gifts: no deduction to payor-spouse or donor and no income to the recipient-spouse or donee. we have argued that, for the tax treatment of alimony payments, this treatment is inconsistent with both the consumption element of the haig-simons definition of income and the equal sacrifice/marginal utility argument justifying progressive tax rates. does this mean that we also support a change to the tax treatment of gifts (allowing the donor a deduction for transferring a gift)? the answer is no. despite being similar in that neither transfer should be considered consumption, the differences between alimony payments and gifts illustrate why the appropriate tax treatment for each is not identical, as we will discuss. the current tax treatment of gifts is appropriate, while the tax treatment of alimony should return to what it was before the 2017 act. at first blush, it might appear that the same treatment should apply to both transfers. under the haig-simons definition of income, one could argue that the donor should receive a deduction since the donor is not consuming any of society’s 110 only one of the divorced spouses may claim a child as a dependent and only one may use the child tax credit on their tax return. treas. reg. § 1.152–4 (as amended in 2008); i.r.c. § 24. 111 see generally geier, supra note 22, at 364. 112 geier, supra note 22, at 364 (“the reason underlying the different tax treatment applicable to alimony and child support has never been adequately articulated, though it is often difficult to distinguish between the two.”). professor geier conceded that there was justification for differentiating between alimony and property settlements. id. (“the reasons underlying the different tax treatment applicable to alimony and many cash property settlements can, in contrast be articulated as a theoretical matter . . . .”). however, she felt the administrative cost of distinguishing the two was not worth it. id. in our opinion, although imperfect, both the former code section 71(a) cash requirement and the recapture rules of former code section 71(f) provide a workable system to distinguish between alimony and property settlements. 158 columbia journal of tax law [vol. 16:2 assets and the donee should report the gift as income since the donee is the party that will use the gift to consume. when we dig further, however, we see that important counter policy considerations come into play that justify the current tax treatment. first, consider the definition of gifts for tax purposes. in commissioner v. duberstein, the supreme court held that the primary test for what should be considered a gift for income tax purposes is whether the donor held the appropriate intent when making the transfer.113 that intent, according to the court, should be “detached and disinterested generosity.”114 when that test is met, the tax treatment of gifts applies—no deduction to the donor and no income to the donee. as discussed, under our income tax system, people are taxed when they earn income, whether they use that money for current consumption or save it to consume later. should a taxpayer decide that he would prefer to wait until a later tax year to use the money to consume something, he would not be taxed again under the income tax system for that future consumption. so, for example, if a taxpayer earns $10,000 in year one and puts that money in the bank, he will be taxed on it under the income tax system despite not using it for present consumption. if the taxpayer decides to use the $10,000 to consume something in year two, that consumption will not trigger the income tax again.115 in a sense, the tax system provides that once a person has been taxed on income once, he is allowed to use that income to consume at any time without being subject to another incidence of income taxation. under an income tax system, it does not matter if the income occurs in the present year or in a future tax year, either way the taxpayer gets to consume with that income one time without paying any additional income tax. in short, the system does not care when the consumption occurs. the next question is, does it care who does the consumption? for gifts, the answer is no. by transferring a gift, the donor signals that he would get more utility from the money by having the donee do the consumption in his place.116 the system is essentially treating the donor and donee as one taxpayer for this limited purpose.117 the trite slogan of one-tax/one-consumption is met, it’s just the donee doing the consumption instead of the donor. 113 comm’r v. duberstein, 363 u.s. 278, 285-86 (1960). 114 id. at 285 (citing comm’r v. lobue, 351 u.s. 243 (1956)). 115 using an unrealistic numerical example for demonstration purposes, if taxpayer had no wealth at the start of year one and earned $10,000 which they put under their mattress for safekeeping, they would have $10,000 of income under the haig-simons definition. as set out in the formula— 0 (present consumption) + $10,000 (accumulation of wealth) = $10,000 income. if taxpayer earns nothing in year two but uses the $10,000 to consume something, then taxpayer would not have any income despite the consumption. again, as set out in the formula—$10,000 (present consumption) + ($10,000) (accumulation of wealth since taxpayer went from $10,000 wealth to zero) = $0 (zero). 116 kahn & kahn, supra note 94, at 466-67. 117 id. at 469-74. 2025] the flip and flop of taxing alimony 159 since the donee is the one doing the consumption, should she be the party that pays the income tax? that is, should we allow a deduction for the donor to reflect the fact that he has not consumed anything and income to the donee to reflect the fact that she is the one who will be doing the consumption? as noted above, it would appear that should be the presumptive tax treatment in this situation. in this case, however, the counter policy considerations outweigh that presumption. first, as noted, gifts are a special subgroup of transfers. they require a specific intent that the transferor has determined that he would get more utility from his money by vicariously enjoying the consumption made by another taxpayer. this supports the treatment of continuing to impose the tax burden on the donor. perhaps more importantly, allowing a deduction for gifts would be too easily abused for tax purposes. wealthy taxpayers could easily engage in tax arbitrage and transfer money and assets to individuals in lower tax brackets. the loser with these transfers would be the federal government. protecting the fisc in this case makes sense and so the tax treatment of gifts should remain the same. does the same reasoning apply to alimony payments? clearly such payments can be used for tax arbitrage purposes—usually the higher-income spouse is paying alimony to the lower-income spouse. the loser once again is the federal government. but as discussed, this “loss” is overstated because the parties are simply mirroring the tax treatment they enjoyed in marriage into their divorce. there is thus no divorce bonus at all. indeed, as it stands, allocating all of the income into the higher-earning spouse’s bracket, even those dollars used solely to support the lower-earning spouse, results in a divorce penalty, shrinking the pie for both parties and their children. and, in any event, alimony payments are different in ways that make them far less prone to abuse. first, alimony payments are not nearly as readily available to abuse as gifts. as noted, gifts can be transferred to anyone as long as the appropriate intent is met. while it is true that if two individuals used a “gift” to engage in tax arbitrage, the appropriate detached-and-disinterested test would not be met. this would be incredibly difficult for the government to detect and prove. without a smoking gun, it would be nearly impossible to prove that a taxpayer transferred gifts to family members only for tax savings. alimony payments are much more limited. they must be made to an ex-spouse.118 people do not marry and then divorce to engage in tax arbitrage.119 therefore, the concern over abuse is significantly less than in the case of gift transfers. as discussed, the tax treatment of gifts is justified because in this limited situation, it makes sense to treat the two parties as one person. by making valid gifts, donors signal that they would prefer the donee use the one “free” consumption rather than the donor using it. alimony payments do not have the same justification. 118 i.r.c. § 71 (supp. iii vol. 2 1985) (repealed 2017). recall as well that to qualify for the deduction treatment such payments must also be in cash, the ex-spouses are not members of the same household, and there is no liability to continue making payments after the death of the recipient spouse. id. 119 geier, supra note 22, at 364-65. 160 columbia journal of tax law [vol. 16:2 alimony payments are not gifts—they are not made out of detached and disinterested generosity but rather in accordance with a binding divorce decree or separation agreement. unlike gifts, the transfer of alimony is not a one-time payout. and, unlike gifts, the alimony payor does not make alimony payments out of a desire that the recipient get to use the consumption rather than the payor. in most cases, the opposite is likely true. therefore, this justification for taxing gifts to the donor clearly does not apply to alimony payments. d. mandating fairness or allowing flexibility though we are alimony-deduction apologists, we think that that the deduction should be elective. recall that from 1942 to 1984, congress imposed the deduction/income treatment of alimony on divorcing parties. divorce settlements are often emotional affairs. there can be bad feelings on both sides of the negotiations. allowing parties to structure alimony payments in tax advantageous ways could clear a path for agreement in other areas of the divorce settlement process. if the lawyers can show the two parties how they can both benefit (to the detriment of the federal government) by working together, this may help the two sides reach an agreeable settlement in areas outside of tax.120 we believe this flexibility is a net positive when you consider its positive external effects. v. conclusion the appropriate tax treatment of alimony is not easy to determine. there are valid considerations on both sides of the debate that lead to opposite tax treatments. the current system is clearly simpler, easier to administer for the government, less subject to abuse, and raises more money for the federal fisc. still, countervailing considerations lead us to believe that the 2017 act change was a mistake: the prior tax treatment was more aligned with several tax policy considerations and the former treatment created positive externalities allowing parties to advantageously structure alimony payments in divorce settlements. tax reform is likely to be a major element of the 2025 legislative session.121 prospects for our recommended change to the alimony rules, however, are low as president trump and the congressional republicans were the group responsible for the 2017 act that made the alimony rule change we suggest was a mistake. still, even if the short-term prospects are poor, our hope is that some future congress will reinstate the option for divorcing parties to allocate the tax burden of alimony payments among themselves. 120 see generally geier, supra note 22. 121 andrew duehren, washington prepares for the ‘super bowl of tax’, n.y. times (july 31, 2024), https://www.nytimes.com/2024/07/31/us/politics/tax-code-congress.html. transaction-specific tax reform in three steps: the case of constructive ownership thomas j. brennan* and david m. schizer** abstract similar investments are often taxed differently, rendering our system less efficient and fair. in principle, fundamental reforms could solve this problem, but they face familiar obstacles. so instead of major surgery, congress usually responds with a band-aid, denying favorable treatment to some transactions, while preserving it for others. these loophole-plugging rules have become a staple of tax reform in recent years. but unfortunately, they often are ineffective or even counterproductive. how can congress do better? as a case study, we analyze section 1260, which targets a tax-advantaged way to invest in hedge funds. this analysis is especially timely because a multi-billion dollar litigation is pending about this rule. this article proposes a three-step approach. first, when faced with a new type of tax planning, policymakers should decide whether a response is really necessary. how harmful is the transaction? how feasible is it to target this transaction without also burdening “good” transactions, which don’t involve the same abuse? this first phase determines what we call “the normative presumption” about the transaction. second, congress should define which transactions are potentially problematic. an “initial filter” should exempt transactions that clearly don’t pose the relevant concern. third, once a transaction is deemed to be potentially problematic, a sophisticated test is needed to check whether it actually is. admittedly, a sophisticated test is costly to administer. this is why initial filters are needed to limit how often it is used. along with proposing this three-part framework, this article offers a novel critique of a sophisticated test the government has begun using: a “delta” test, which measures how closely investments track each other. although delta is often considered the gold standard, we show how easy it is to manipulate. the trick is to add contingencies (e.g., so the investment terminates when the price reaches a specified level). to head off this gaming, we recommend an alternative test that focuses on value instead of on changes in value–and, more generally, on enduring features instead of temporary quirks.*** * stanley s. surrey professor of law at harvard law school. ** dean emeritus & harvey r. miller professor of law & economics at columbia law school. we appreciate thoughtful comments from jake brooks, victor fleischer, louis kaplow, michael love, bob mcdonald, alex raskolnikov, michael schler, andrew walker, david weisbach, and participants at workshops at the tax club, the american law & economics association, the national tax association, and columbia law school, as well as support from the henry and lucy moses faculty research fund at columbia law school and the harvard law school fund for tax and fiscal policy research. *** r code of the authors’ calculations can be found at https://github.com/tbrenn314/transaction specifictaxreform [perma.cc/2g3s-c66c]. columbia journal of tax law [vol 15:1 2 i. introduction ................................................................................................. 4 ii. simulating ownership of hedge funds: the transaction targeted by section 1260 .................................................................................................... 7 a. the targeted transaction: hedge fund derivatives ............................... 7 b. section 1260 ............................................................................................. 8 iii. normative criteria for evaluating transaction-specific reforms: distribution and efficiency .............................................................................. 9 a. distribution............................................................................................... 9 b. efficiency and the “hit or miss” quality of transaction-specific reforms ........................................................................................................... 9 1. administrative costs ....................................................................... 10 2. “regular” deadweight loss from real effects ............................ 11 3. planning costs ................................................................................ 12 4. building on the mecf framework ................................................ 13 iv. step 1: the normative presumption ........................................................ 14 a. fairness: distribution and trust ............................................................. 14 1. vertical equity ................................................................................ 14 2. horizontal equity ............................................................................ 15 3. trust ................................................................................................ 15 b. efficiency: the right tax burden ......................................................... 16 1. the right tax burden: the gravitational pull of fundamental reforms .................................................................................................. 16 2. the right tax burden: a consumption tax? ................................. 17 3. the right tax burden: should holding period matter? ................ 17 4. the right tax burden: should there be a capital gains preference? ............................................................................................ 18 5. the right tax burden: should we have mark-to-market accounting? ........................................................................................... 18 c. efficiency: risks of overbreadth ........................................................... 19 1. false negatives versus false positives .......................................... 19 2. costs of false positives .................................................................. 19 a. probability ................................................................................... 19 b. magnitude .................................................................................... 20 3. managing the tradeoff: false negatives versus false positives .. 20 v. step 2: preliminary filters ....................................................................... 21 a. taxpayer-based filters .......................................................................... 22 1. taxpayer income ............................................................................. 22 a. administrability advantages ....................................................... 22 b. relevance of income: higher stakes .......................................... 22 c. which income? ............................................................................ 23 2. taxpayer assets .............................................................................. 23 3. counterparty ................................................................................... 23 b. transaction-based filters ....................................................................... 24 1. tax treatment is not objectionable ............................................... 25 2. tax treatment is well settled ......................................................... 25 3. tax treatment is widely available ................................................. 26 4. transaction is an established commercial practice...................... 26 2024] transaction-specific tax reform in three steps 3 5. transaction is commercially impractical ...................................... 27 6. transaction is administratively cumbersome to police ................. 27 7. transaction is already policed by other rules ............................. 28 c. defining the scope of the relevant transaction .................................... 28 1. scope of the actual transaction ..................................................... 29 2. scope of the alternative transaction .............................................. 30 3. what is the solution? ...................................................................... 31 d. interactions among filters and adjustments over time ...................... 31 1. interaction of filters ....................................................................... 31 2. should preliminary filters become more lenient or tougher over time?...................................................................................................... 31 a. safe harbors: more lenient over time ...................................... 32 b. listed transactions: tougher over time ................................... 32 vi. step 3: the analytical stage................................................................... 32 a. more analytically rigorous comparisons: our difference-value test 33 1. valuing differences ........................................................................ 33 2. illustrative example ........................................................................ 33 3. step #1: identify the “difference contract” ................................... 34 4. step #2: compute the “difference value” ..................................... 35 5. step #3: compute the “difference percentage” ............................ 36 6. other difference contracts: using absolute value ....................... 37 a. omitting only opportunity for gain ........................................... 37 b. omitting both opportunity for gain and risk of loss ............... 37 7. valuing the difference contract: alternative methods .................. 39 8. choosing the underlying and risks of manipulation ..................... 40 b. comparison with alternative tests ........................................................ 40 1. spread test...................................................................................... 41 a. size of the spread ........................................................................ 41 b. no exposure near current price: derivative must be “out-ofthe-money” ........................................................................................ 42 c. nysba spread test can’t analyze in-the-money derivatives . 42 d. a variation of the spread test: how in-the-money is the derivative? ........................................................................................ 43 e. other limitations of the spread test: volatility and term ........ 43 2. delta test: basic case .................................................................... 44 3. delta test: barrier options ............................................................ 45 a. confounding the delta test with contingencies ........................ 45 b. potential fixes for the delta test ............................................... 47 c. key advantage of the difference-value test: treatment of contingencies .................................................................................... 48 4. the mckelvey test .......................................................................... 49 c. issues in making comparisons .............................................................. 50 1. scope ............................................................................................... 50 2. manipulative contingencies ........................................................... 51 a. coin flips .................................................................................... 52 b. more realistic contingencies ..................................................... 52 c. normative assessment ................................................................ 53 columbia journal of tax law [vol 15:1 4 d. probability-based assumptions .................................................. 53 e. updated analysis after contingencies are resolved ................ 53 3. investor control .............................................................................. 54 vii. basket options and the gwa litigation ............................................... 55 a. basket options: a potential end run around section 1260 ................. 55 1. differences from earlier hedge fund derivatives ....................... 56 2. gwa contract ................................................................................. 56 3. planning around section 1260 ....................................................... 58 4. economic similarity and general principles ................................. 58 b. inadequacy of other tests...................................................................... 59 1. spread test...................................................................................... 59 2. delta test ........................................................................................ 60 3. mckelvey test ................................................................................. 62 c. difference-value test ............................................................................ 63 1. defining the benchmark: similar to what? .................................... 63 2. comparing values: gwa and the (properly delineated) underlying ......................................................................................................... 64 3. first assumption: no buy-down .................................................... 66 4. second assumption: no “slippage” ............................................... 66 viii. conclusion ................................................................................................. 68 ix. appendix a: delta and the timing of payments in the gwa contract ................................................................................................................ 69 a. the bank’s perspective .......................................................................... 69 b. gwa’s perspective ................................................................................ 71 x. appendix b: difference value and the timing of payments in the gwa contract ................................................................................................... 73 a. the bank’s perspective .......................................................................... 73 b. gwa’s perspective ................................................................................ 74 c. the difference contract ......................................................................... 75 i. introduction as any tax planner will tell you, form matters in the tax law. with a few tweaks, taxpayers often can get almost the same economic return with very different tax treatment.1 unfortunately, as well-advised (wealthy) taxpayers jockey for better treatment, the tax system becomes less efficient and fair. in principle, fundamental tax reforms like a consumption tax or mark-to-market accounting could eliminate 1 for example, different tax rules apply to forward contracts, swaps, contingent bonds, life insurance contracts, and annuities. see i.r.c. § 1234a; treas. reg. § 1.446-3; treas. reg. § 1.1275-4; i.r.c. § 101; i.r.c. § 72. all references to sections are to the internal revenue code of 1986, as amended, and to treasury regulations interpreting the code. 2024] transaction-specific tax reform in three steps 5 these inconsistencies,2 but these reforms face familiar challenges of administrability and politics.3 so instead of major surgery, congress typically responds with a band-aid, denying favorable treatment to some transactions, while preserving it for others. these loophole-plugging rules, which we call “transaction-specific reforms,” are supposed to block a particular planning strategy, without disrupting similar transactions that aren’t tax-motivated. yet these measures are often ineffective and even counterproductive. while they complicate the law and create traps for the unwary, these measures don’t stop well-advised taxpayers, who simply adjust their planning to avoid them. to show how transaction-specific reforms can be more effective, this article uses a case study: the tax on investors4 in hedge funds.5 because these funds trade frequently, their profits usually are short-term capital gain.6 to qualify for (lower) long-term rates, investors began investing–not in the funds themselves–but in contracts based on their value.7 by holding these hedge fund derivatives8 for at least a year, investors used to be eligible for the long-term rate. in response, congress enacted a transaction-specific reform, section 1260, to treat these gains as short-term. yet taxpayers found ways to plan around this statute, which prompted pending litigation with billions of dollars at stake.9 what is the right tax 2 under a consumption tax, investment returns generally are not taxed. see generally william d. andrews, a consumption-type or cash flow personal income tax, 87 harv. l. rev. 1113, 111323 (1974) (arguing that a consumption tax would be more simple, fair, and efficient than an accretion-type tax); david a. weisbach & joseph bankman, the superiority of an ideal consumption tax over an ideal income tax, 58 stan. l. rev. 1413 (2006). under mark-to-market accounting, investment returns are taxed annually based on changes in the asset's fair market value, regardless of whether the property has been sold. see generally david j. shakow, taxation without realization: a proposal for accrual taxation, 134 u. pa. l. rev. 1111, 1111-18 (1986) (proposing broader use of mark-to-market taxation). 3 political and other obstacles to either reform are thoroughly explored elsewhere. see generally uneasy compromise: problems of a hybrid income-consumption tax (henry j. aaron et al. eds., 1988). 4 a hedge fund usually is taxed as a partnership, which means that its gains and losses are computed by the partnership, but tax is paid by the individual partners. see david m. schizer, frictions as a constraint on tax planning, 101 colum. l. rev. 1312, 1368-69 (2001) [hereinafter schizer, frictions]. 5 hedge funds engage in sophisticated trading strategies that are supposed to deliver superior returns on a risk-adjusted basis. they usually are open only to sophisticated investors who satisfy income and asset tests under the securities law. see the investopedia team, what are hedge funds? examples, types, and strategies, investopedia (aug. 11, 2022), https://www.investopedia.com/t erms/h/hedgefund.asp [https://perma.cc/m9kc-nxs7]. 6 when taxpayers hold an investment for more than one year, their capital gains qualify as “long term,” and thus are eligible for a reduced rate. in contrast, short-term gains are taxed at the (higher) rate for ordinary income. see i.r.c. § 1(h). 7 see schizer, frictions, supra note 4, at 1368-69. 8 a derivative is a contract whose value derives from some financial fact. see generally global derivatives study group, derivatives: practices and principles 26, the group of thirty (july 1993), https://group30.org/images/uploads/publications/g30_derivatives-practicesandprinciples.p df [https://perma.cc/j7ee-xuv3] (“in the most general terms, a derivatives transaction is a bilateral contract or payments exchange agreement whose value derives, as its name implies, from the value of an underlying asset or underlying reference rate or index.”). 9 gwa v. comm’r, no. 6981-19 (u.s.t.c. filed may 10, 2019). columbia journal of tax law [vol 15:1 6 treatment for hedge fund derivatives? more generally, how can transaction-specific reforms be more successful in enhancing the tax system’s efficiency and fairness? this article recommends a three-part approach. first, when faced with a new type of tax planning, policymakers should decide whether the strategy is harmful enough to warrant a response. this first phase determines what we call “the normative presumption” about the transaction. second, congress should use an “initial filter” to exempt transactions that clearly don’t pose the relevant concern. third, once a transaction is deemed to be potentially problematic, a sophisticated test is needed to check whether it actually is. for example, is a hedge fund derivative enough like the underlying fund that it should be recharacterized? with a nuanced and sophisticated rule, the government can catch transactions that actually are economically similar, regardless of what form the taxpayer uses. admittedly, a sophisticated test can be costly to administer. this is why initial filters are needed to limit how often it is used. along with proposing this three-part framework, this article offers a novel critique of a sophisticated test the government has begun using: a “delta” test,10 which measures how closely investments track each other.11 although delta is often considered the gold standard,12 we show how easy it is to manipulate. the trick is to add contingencies, for instance, so the investment terminates when the price reaches a specified level. as far as we know, this critique of delta is new to the literature. to head off this gaming, we recommend an alternative test that focuses on value instead of on changes in value–and, more generally, on enduring features instead of temporary quirks. as should be clear by now, this article focuses on incremental reform, not fundamental reform. if only modest measures are politically and administratively feasible, policymakers need to know how to choose the right ones. to give them guidance, we take the current highly imperfect system as given and explore how to implement better constructive ownership rules and, more generally, more effective transaction-specific reforms. although our approach will not achieve optimality, it can still improve the system in meaningful ways. part ii introduces our case study, section 1260. part iii lays out the normative criteria for evaluating transaction-specific reforms: distribution and efficiency. part iv explains the first step in our proposed approach, which we call “the normative presumption” about a tax planning strategy. part v explains the second of our three steps, “the preliminary filter,” which exempts transactions that do not warrant careful vetting. part vi covers the third stage, which uses sophisticated tools to specify which transactions should be recharacterized. part vii applies our approach to a pending case, gwa, llc v. commissioner. part viii is 10 see, e.g., treas. reg. § 1.871-15 (using delta to determine whether withholding is required on dividend equivalent payments on equity derivatives). 11 in the parlance of derivatives traders, “delta” measures how much the value of a derivative changes when the price of the underlying asset changes by a dollar. james chen, what is delta in derivatives trading, and how does it work?, investopedia (july 26, 2023), https://www.investo pedia.com/terms/d/delta.asp [https://perma.cc/4ypd-3r9f]. 12 see, e.g., n.y. state bar ass’n tax section comm. on fin. instruments, comments on “short-against-the-box” proposal, nysba tax section rep. #868 18-22 (march 1, 1996) [hereinafter “nysba, rep. #868”] (discussing use of delta to test for constructive sales under early proposed version of section 1259). one of us (david schizer) helped prepare this report. 2024] transaction-specific tax reform in three steps 7 the conclusion. parts ix and x are appendices, which elaborate on specific aspects of the analysis. ii. simulating ownership of hedge funds: the transaction targeted by section 1260 often, a high-profile transaction exposes a deeper problem in the tax system. but instead of addressing the underlying issues, congress opts for a more targeted response. to illustrate this common pattern, this article focuses on hedge fund derivatives. a. the targeted transaction: hedge fund derivatives to implement complex trading strategies that are supposed to deliver superior returns, hedge funds trade constantly. so instead of qualifying as longterm capital gain, their profits usually are taxed at (higher) ordinary rates. the frequent trades also mean that gains are taxed currently, instead of being deferred. this tax is paid by investors, not the fund, which typically is a partnership for tax purposes.13 as a result, taxable investors often have mixed feelings about hedge funds. they want the pre-tax return, but not the steep tax bill. in response, investment banks offered a way for investors to get hedge fund returns without the high tax: investing in a derivative based on the hedge fund’s value, instead of in the hedge fund itself. for example, an investor could enter into a forward contract with a securities dealer, committing to buy the fund interest for a preset price after a fixed term of years. this derivative would immediately transfer the hedge fund’s economic return to the investor. after all, the investor would pay the same fixed price, whether the fund gained or lost value. but unlike the fund interest, the derivative would not be taxable until it matured or was terminated. at this point, if the transaction was structured properly, the gain (or loss) would be treated as longterm capital gain.14 how could a securities dealer offer this contract? the key was for the dealer to invest in the hedge fund. by purchasing an interest in the fund, the dealer could hedge its obligation to deliver an interest to its client in the future. but didn’t this just shift the heavy tax burden to the dealer? as an investor in the fund, didn’t the dealer have to pay the very tax its client wanted to avoid? actually, the answer is “no,” since securities dealers are subject to different tax rules. in general, they mark their inventory to market and their gains and losses are ordinary income, not capital gain.15 as a result, the derivative and the hedge fund were offsetting not just economically, but also in their tax treatment. in general, ordinary income on the hedge fund was offset by ordinary loss on the derivative, and vice versa.16 13 see schizer, frictions, supra note 4, at 1368-69. 14 see i.r.c. § 1234a (termination of a contract is treated as long-term capital gain or loss). 15 i.r.c. § 475 (requiring securities dealers to mark inventory to market); i.r.c. § 1221(a)(1) (noting that inventory is not a capital asset). 16 see david m. schizer, sticks and snakes: derivatives and curtailing aggressive tax planning, 73 s. cal. l. rev. 1339, 1367-68 (2000); see also schizer, frictions, supra note 4, at 1369 n.206. columbia journal of tax law [vol 15:1 8 even so, this transaction was not invulnerable. invoking traditional principles of tax ownership, the government could argue that the real investor in the fund was the client, not the dealer. to defeat this argument, taxpayers and their advisors introduced various features to reinforce the claim that the dealer was the true owner. for example, the dealer needed to have discretion about whether (and how) to hedge its position in the contract.17 b. section 1260 in response, congress enacted section 1260 in 1999. under this provision, if a derivative tracks a hedge fund’s return too closely, a portion of the long-term capital gain on the derivative is taxed as ordinary income.18 in addition, to offset the tax deferral offered by the derivative, an interest charge is imposed once the tax comes due.19 yet section 1260 is not precise in specifying how closely the derivative’s economic return has to track the hedge fund’s return. how much of a gap is sufficient to avoid the statute? the key word in the statute is “substantial”; in general, a derivative is caught if it provides “substantially all” the risk of loss and opportunity for gain in the hedge fund.20 but what does “substantial” mean in this context?21 almost twenty-five years later, no regulations have been issued to clarify this question.22 17 see schizer, frictions, supra note 4, at 1369 n.206. 18 i.r.c. § 1260(a). 19 i.r.c. § 1260(b). 20 for example, a notional principal contract is covered if the holder “(a) has the right to be paid (or receive credit for) all or substantially all of the investment yield (including appreciation) on such financial asset for a specified period, and (b) is obligated to reimburse (or provide credit for) all or substantially all of any decline in the value of such financial asset.” i.r.c. § 1260(d)(3) (emphasis added). likewise, the statute also applies to a taxpayer who “is the holder of a call option, and is the grantor of a put option, with respect to the financial asset and such options have substantially equal strike prices and substantially contemporaneous maturity dates.” i.r.c. § 1260(d)(1)(c) (emphasis added). i.r.c. § 1260 also applies to forward contracts and, under regulations, to “other transactions (or . . . positions) that have substantially the same effect” as the transactions listed above. i.r.c. § 1260(d)(1)(d) (emphasis added). 21 guidance can be gleaned from another provision that uses similar language, section 1259, which imposes tax when taxpayers hedge appreciated assets too perfectly. in 2003, the i.r.s. indicated that a forward contract does not deliver a substantially fixed number of shares if the number would vary between 80 and 100, depending on the stock price when the forward contract matures or is terminated. “according to the agreement, delivery of a number of shares, which may vary between 80 and 100 shares, depends on the fair market value of the stock on the exchange date,” the i.r.s. said. “because this . . . is a significant variation, the agreement is not a contract to deliver a substantially fixed amount of property for purposes of §1259(d)(1).” rev. rul. 2003-7, 2003-1 c.b. 363. even so, the strategies for avoiding section 1259 and section 1260 are somewhat different. see generally schizer, frictions, supra note 4 (noting similarities in the statutory language of section 1259 and section 1260, but important differences in the nontax cost of avoiding these provisions, and thus in the strategies for planning around them). 22 likewise, there are no regulations to resolve other issues. for example, aside from the derivatives specified in the statute, congress authorized the treasury to recharacterize “other transactions . . . that have substantially the same effect” as the listed transactions. i.r.c. § 1260(d)(1)(d). along with derivatives based on hedge funds, the statute also applied to derivatives based on mutual funds, reits, and other pass-through entities. i.r.c. § 1260(c)(2). but what about derivatives based on debt instruments or common stock? congress authorized the treasury to cover these instruments 2024] transaction-specific tax reform in three steps 9 meanwhile, the government has pursued a range of cases against hedge fund derivatives that might–or might not–be covered by the statute. the george weiss case went to trial in 2022.23 as of this writing, a decision is still pending. iii. normative criteria for evaluating transaction-specific reforms: distribution and efficiency how do we know whether a rule like section 1260 is a good idea? after all, there are a host of other ways to raise (and lower) taxes. in deciding which incremental reforms to pick, policymakers should consider two familiar criteria: distribution and efficiency. a. distribution a key question is whose tax bill is changing. do they have high incomes? does the change make the system more or less progressive? policymakers should care about not only whose tax bill is cut, but also how it is cut. if the tax system is easy to game, sophisticated advice commands a premium, which is easier for wealthy taxpayers to afford. yet we should not want a system in which, in the infamous words of a famous wealthy tax cheat, “only the little people pay taxes.”24 this unequal access is not just unfair, but also demoralizing. if taxpayers believe that others are not paying their fair share, they are less likely to comply voluntarily. in response, the i.r.s. has to spend more on enforcement.25 b. efficiency and the “hit or miss” quality of transaction-specific reforms along with distribution, policymakers also need to consider efficiency. do section 1260 and other transaction-specific reforms increase the efficiency of the tax system? in general, an efficient tax changes taxpayer behavior as little as possible.26 this is a critical goal not only in fundamental tax reform,27 but also in the transaction-specific reforms analyzed here. under regulations. i.r.c. § 1260(c)(1)(b). but again, no regulations have been written on these issues as well. 23 the taxpayer filed its original petition with the tax court in may 2019. 24 top 10 tax dodges, time, https://content.time.com/time/specials/packages/article/0,28804,1891 335_1891333_1891317,00.html [https://perma.cc/qz8x-aj5n] (quoting leona helmsley, a wealthy real estate developer who was imprisoned for tax fraud). 25 see benno torgler, tax morale, rule-governed behaviour and trust, 14 const. pol. econ. 119 (2003), https://doi.org/10.1023/a:1023643622283 (trust in public officials and the legal system has a significant positive effect on tax morale). 26 to be more precise, an efficient tax changes behavior as little as possible as compared to a world with no taxes, except that taxpayers have less money. in other words, efficient taxes minimize substitution effects, but there is still an income effect. see david a. weisbach, line-drawing doctrine and efficiency in the tax law, 84 cornell l. rev. 1627, 1652 (1999) [hereinafter weisbach, line-drawing] (“tax efficiency is concerned with the difference between consumers' actual after-tax behavior and the behavior they would engage in merely because they have less revenue”). 27 see, e.g., alan auerbach, retrospective capital gains taxation, 81 am. econ. rev. 167, 168 (1991) (arguing that charging interest upon realization would enhance efficiency of tax system); columbia journal of tax law [vol 15:1 10 it is well understood that the key in an incremental reform like section 1260 is to reduce various types of social waste, including administrative costs, changes in work and savings decisions, and tax planning costs.28 there usually are tradeoffs among these costs; for instance, targeting tax planning more effectively can increase administrative costs. even if some costs increase, a reform can still enhance efficiency by cutting others, so there is a net reduction in the sum of these costs.29 1. administrative costs let’s begin with the cost of enforcing and complying with the law. transaction-specific reforms like section 1260 usually increase these costs by making the tax code more complicated.30 congressional staffers and treasury officials must draft the new rules, and then taxpayers have to pay advisors to help them comply. meanwhile, i.r.s. auditors need to monitor their compliance, and there may be litigation on contested issues.31 even so, some transaction-specific reforms increase administrative costs more than others. obviously, policymakers should look for ways to economize on these costs–a theme that features prominently in our analysis. bankman & weisbach, supra note 2 (arguing that an ideal consumption tax distorts behavior less than an ideal income tax); daniel halperin, saving the income tax: an agenda for research, woodworth lecture (nov. 7, 1997), in 77 tax notes (ta) 967, 967 (nov. 24, 1997), reprinted in 24 ohio n. u. l. rev. 493 (1998) (arguing that mark to market taxation for publicly traded securities would enhance efficiency of tax system); michael j. graetz, 100 million unnecessary returns: a simple, fair, and competitive tax plan for the united states (2008) (arguing that replacing the income tax with a vat for most americans would enhance the efficiency of the tax system); louis kaplow, the optimal supply of public goods and the distortionary cost of taxation, 49 nat. tax j. 513 (1996) (reexamining relationship between optimal supply of public goods and distortionary cost of income taxation). 28 see, e.g., daniel hemel, jennifer nou & david a. weisbach, the marginal revenue rule in costbenefit analysis, 160 tax notes 1507 (2018) (proposing method of cost-benefit analysis for tax regulations, “the marginal revenue rule,” which accounts for behavioral effects (measured indirectly through a regulation’s impact on revenue), administrative and compliance costs, and non-revenuerelated effects); daniel hemel & david a. weisbach, the behavioral elasticity of tax revenue, 13 j. legal analysis 381, 382 (2021) (proposing “behavioral elasticity of tax revenue (betr)” as “a tool for analyzing problems of tax system design,” which “allows tax laws and policies to be measured and compared using a unified metric”); daniel n. shaviro, an efficiency analysis of realization and recognition rules under the federal income tax, 48 tax l. rev. 1 (1992); joel slemrod & shlomo yitzhaki, the costs of taxation and the marginal efficiency cost of funds, 43 i.m.f. staff papers 172, 175 (1996) (“we explore an alternative approach that is limited to identifying desirable marginal changes, without a claim of optimality.”); weisbach, line-drawing, supra note 26; david a. weisbach, ten truths about tax shelters, 55 tax l. rev. 215 (2002). 29 see slemrod & yitzhaki, supra note 28, at 183 (“[w]e offer a tractable methodology that can evaluate marginal changes in tax systems and take account of all five components of the cost of tax systems. the methodology is based on the concept of the marginal cost of public funds.”). 30 see id. at 179-81 (discussing administrative and compliance costs). 31 see generally louis kaplow, rules versus standards: an economic analysis, 42 duke l. j. 557, 557-629 (1992) (noting various costs of drafting and applying laws and tradeoffs among them). 2024] transaction-specific tax reform in three steps 11 2. “regular” deadweight loss from real effects even as transaction-specific reforms increase administrative burdens, do they reduce other sources of waste? another familiar one is when tax rules distort work and savings decisions.32 in general, there is less of this “regular deadweight loss” when taxpayers have no easy way to change their behavior. in this situation (i.e., when their demand is inelastic), they are still likely to engage in the relevant transaction even if it is taxed more heavily.33 as a result, this flexibility (or “elasticity”) is a key variable. of course, the premise here is that taxpayers’ choices are socially optimal, but this isn’t the case when markets fail. for example, if an activity imposes social costs that aren’t impounded in the price (as do greenhouse gas emissions, addictive drugs, and other activities that harm third parties), discouraging this activity actually is a good thing.34 so the activity’s social value is relevant when policymakers consider changing its tax treatment. so, in deciding whether to target a particular planning strategy, policymakers should consider what the effective tax rate on the underlying activity actually should be. obviously, tax planning reduces the effective rate (i.e., what taxpayers actually pay) below the nominal rate (i.e., the rate on the books), but is this a good or a bad thing? for example, imagine that the nominal rate is 40%, but a planning strategy reduces the effective rate to 25%. if the rate really should be 40%–based on elasticity, externalities, and the like–the transaction is problematic. but if it should be 25% (or even 22% or 28%), the planning actually is bringing the effective rate closer to where it should be.35 in other words, is the relevant planning causing this activity to be undertaxed? if so, shutting down this planning can make the system more efficient. but if not–that is, if the nominal tax rate is too high–there is less reason to target the planning strategy. in the case of section 1260, for example, how bad is it to raise the tax on indirect investments in hedge funds? will investors invest less in these funds? if so, how much less and what would they do instead? in addition to this sort of analysis of elasticity, policymakers should also consider externalities. for example, do hedge funds improve price discovery? or are they just a form of zero-sum gambling? even if the social contribution of hedge funds is limited, is section 1260 32 see slemrod & yitzhaki, supra note 28, at 181 (discussing “regular deadweight loss”). 33 see weisbach, line-drawing, supra note 26, at 1658 (“if the elasticity is high, the tax should be low, and if the elasticity is low, the tax should be high.”). yet the inquiry is nuanced. while taxing inelastic activity generally is more efficient, this isn’t always the case. for instance, if demand is inelastic but taxpayers change their behavior anyway, the welfare losses can be especially large. see id. at 1656 (“the ability to raise taxes on low-elasticity items is limited because as the tax on a commodity increases, the marginal deadweight loss increases”). 34 see id. at 1654 (“to the extent that there is a market failure, the definition of an efficient tax changes. in particular, so-called pigouvian taxes are taxes, or subsidies, that attempt to cure market failures.”); david m. schizer, red white and blue–and also green: how energy policy can protect both national security and the environment, 96 s. calif. l. rev. (forthcoming 2024) (noting that pigouvian taxes should be set equal to the marginal harm from the relevant activity). 35 see weisbach, line drawing, supra note 26, at 1669 (“taxing a low-elasticity item too high is not optimal.”). columbia journal of tax law [vol 15:1 12 overbroad? does it inadvertently discourage other real activity that is more valuable, implicating other elasticities and externalities? in short, in crafting section 1260 and other transaction-specific reforms, policymakers should consider whether the measure moves the effective tax rate closer to or further from the optimal level.36 3. planning costs even if the effective rate is too high, tax planning usually is an inefficient way to reduce it. taxpayers have to invest time and resources to plan around the relevant rule.37 along with hiring the right advisors, they have to modify their transactions in ways that might be unappealing. if the effective rate needs to be cut, policymakers generally should just do that directly, instead of relying on taxpayer self-help. all else being equal, then, reducing the waste from tax planning improves efficiency. indeed, these efficiency gains can offset–and in some cases can exceed– increases in administrative costs and “regular” deadweight loss.38 but obviously, this can happen only if reforms actually discourage planning, instead of merely prompting a more elaborate variation of it. this brings us to a critically important question: does the targeted planning actually stop? or does it simply metastasize into a different (more costly) variation?39 for example, assume that the tax law distinguishes between two transactions: y (which is taxed unfavorably) and z (which is taxed favorably). for instance, y could be a hedge fund and z could be a growth stock, or y could be equity and z could be debt, or y could be subject to withholding while z is not, etc. in response to this inconsistent treatment, taxpayers develop a new transaction, x, which is economically like (unfavorable) y but is taxed like (favorable) z. for example, x could be a hedge fund derivative, which offers the economics of a hedge fund but the tax treatment of a growth stock. as taxpayers begin engaging in x, congress changes its tax treatment, so x is taxed like (unfavorable) y, instead of (favorable) z. notably, the response is usually a narrow one. congress does not eliminate the distinction between y and z. instead, congress just redefines the boundary between y and z, ensuring that x is taxed like y. but what if the new rule covers x, but not a similar but costlier variation of x that we call xx? in this case, some taxpayers may start doing (favorable) xx to 36 id. at 1679 (noting that one of the two most important factors in line-drawing is “whether transactions are taxed appropriately when considered by themselves (i.e., without regard to line drawing)”). 37 slemrod & yitzhaki, supra note 28, at 181. 38 as joel slemrod and shlomo yitzhaki have emphasized, the efficiency of an incremental reform depends on its effect on the sum of various efficiency costs, a concept they call the marginal efficiency cost of funds. id. at 183. (“[w]e offer a tractable methodology that can evaluate marginal changes in tax systems and take account of all five components of the cost of tax systems. the methodology is based on the concept of the marginal cost of public funds.”). 39 weisbach, line drawing, supra note 26, at 1670 (“we cannot simply look at how many taxpayers avoid a line. we must also look at the costs of doing so.”). 2024] transaction-specific tax reform in three steps 13 avoid the rule.40 meanwhile, others who would have done x, but consider xx an inadequate substitute, will simply do (unfavorable) y. the distribution of these reactions is important. on the one hand, if everyone who was going to do x “doubles down” on tax planning to do xx, the reform is not successful.41 the government does not collect more revenue, and distributional goals are not advanced. instead, the relevant tax planning continues but in a more elaborate way, making the tax system less efficient. on the other hand, if everyone who was going to do x “gives up” and simply does y–since xx is too hard or unappealing–the reform is successful. the government collects more revenue, distributional goals are advanced, and the planning costs of x (and of xx) are avoided. of course, with any reform there is unlikely to be a uniform reaction. some taxpayers will double down with xx (increasing planning costs), while others will give up and do y (reducing planning costs), and the net of these effects determines whether the reform actually reduces planning costs. the distribution of these reactions depends, in turn, on how well-crafted and rigorous the reform is. at the end of the day, the efficiency analysis turns on the net of all these effects–on administrative costs, real behavior, and planning. some transactionspecific reforms increase social waste, while others reduce it. 4. building on the mecf framework while others have highlighted key issues and tradeoffs in incremental tax reform, this article adds to the literature in three ways. first, we help policymakers operationalize this literature by recommending three steps, which focus on different aspects of the analysis. in asking what the right tax burden should be on the relevant transaction, the first step (“the normative presumption”) focuses on regular deadweight loss and distribution. likewise, in urging policymakers to identify the relevant transaction in a way that is both precise and economical, the second step (“preliminary filters”) and third step (“rigorous analysis”) manage the tradeoff between administrative and planning costs. second, and relatedly, we recommend using preliminary filters as a way to economize on administrative costs, enabling more precise (and administratively costly) tests to be deployed only when they are needed. this insight has broad application not just to our case study of section 1260, but to any transactionspecific anti-abuse rule. third, we identify problems with a sophisticated test that commentators have recommended and the government has used for financial transactions: comparisons based on “delta.” as far as we know, these insights are new to the literature. 40 see shaviro, supra note 28. 41 daniel n. shaviro, economic substance, corporate tax shelters, and the compaq case, 88 tax notes 221, 223 (2000) (noting that the desirability of an anti-abuse rule depends on how effective it is in “generating such deterrence rather than simply inducing taxpayers to jump through a few extra hoops before getting the desired tax consequences anyway”). columbia journal of tax law [vol 15:1 14 iv. step 1: the normative presumption let’s turn to the first of the three steps we propose: when confronted with a new planning strategy, policymakers should decide how urgently a response is needed, as well as how broad and tough it should be. in making these judgments, policymakers establish what we call the “normative presumption” about a transaction. to do so, they should consider three sets of issues, which this section explores in turn: ● first, how unfair is the targeted transaction? how does it affect the distribution of tax burdens, as well as public trust in the tax system? ● second, what is the right tax burden on the targeted transaction (in light of elasticity, externalities, and other efficiency considerations)? ● third, how costly would it be for the transaction-specific response to be overbroad, so it reaches activity other than the targeted transaction? while policymakers should consider these issues in crafting any transactionspecific reform, this part focuses on section 1260 as a case study. a. fairness: distribution and trust in deciding how tough to be, policymakers need to consider whether the targeted planning makes the system less fair. as this section shows, the relevant issues are distribution, horizontal equity, and trust in the system. 1. vertical equity since high-net worth taxpayers have better access to tax advice, they often are the main beneficiaries. when they are the main users of a planning strategy, it reduces the tax burdens of those with the greatest ability to pay. this is likely the case with hedge fund derivatives. under the securities law, hedge funds are open only to investors who satisfy income or asset tests.42 the same is true of the customized derivatives used in these transactions. they are not available on an exchange, where a broader group of customers would have access to them, but in the “over-the-counter” market, where investors need to satisfy income or asset tests. admittedly, transactions that are first crafted just for sophisticated taxpayers can become more widespread over time. for example, a variation of tax shelters that became popular in the 1980s–leveraged investments in depreciable property–were mass marketed through partnerships, so upper-middle-class dentists and accountants could use them (until congress shut them down). in principle, hedge fund derivatives might also start attracting a broader clientele over time, for instance, as legal restrictions ease and transactions costs decline.43 but as of now, hedge fund derivatives are available only to wealthy taxpayers. 42 of course, this includes pension funds and nonprofits, which may serve low-income people. 43 for example, mutual funds appeal to a much broader class of investors. some funds trade frequently, triggering current tax liability at a higher rate. to cut their investors’ tax bills, these funds might find ways to make their investments indirectly through derivatives. alternatively, 2024] transaction-specific tax reform in three steps 15 as a result, vertical equity is a plausible rationale for targeting them. yet in our view, this is not a “slam dunk,” if only because high-income taxpayers can get the same tax treatment–tax deferral and a reduced rate–with a host of other investments, including growth stocks, index funds, venture capital, private equity, and real estate. it’s not clear why getting these tax advantages this way is worse than getting them other ways. in principle, there might be a difference based on congressional intent but, in our view, this difference isn’t relevant. perhaps congress meant to reduce the tax burden on these other investments, but not on hedge fund derivatives. yet even if true,44 this is beside the point. after all, the issue explored in this article is not what congress has done, but what it should do. the relevant question is whether a transaction-specific reform like section 1260 is a good idea. the answer should turn on fairness and efficiency, not congressional intent. 2. horizontal equity arguably, policymakers should consider not just vertical equity, but also horizontal equity, which provides that similarly situated taxpayers should be taxed the same way.45 hedge fund derivatives violate this norm by allowing investors in derivatives to pay less tax than investors in the underlying fund. this inconsistency puts a premium on good advice. taxpayers who don’t know about the more taxefficient strategy face a “trap for the unwary.” in principle, horizontal equity might justify a response like section 1260, but we are skeptical, if only because both groups of taxpayers–investors in funds and in derivatives–are quite well off. how sympathetic should we be to wealthy people who have bad tax advisors? are reforms really needed to protect them? this is not to say that traps for the unwary are desirable. yet in our view, they are a problem of efficiency, not fairness: the issue is not so much that they are unfair (at least in ensnaring wealthy people), but that they encourage an overinvestment in tax advice.46 3. trust along with vertical and horizontal equity, planning by high-income taxpayers can implicate another concern as well: when publicized in the media, this planning can erode confidence in the tax system, as noted above. if other taxpayers learn of these strategies, they might think “the game is rigged” and stop paying tax voluntarily. derivatives exchanges might start offering derivatives based on the value of these mutual funds. see generally andriy blokhin, can mutual funds invest in options and futures?, investopedia (sept. 29, 2022), https://www.investopedia.com/ask/answers/091115/can-mutual-funds-invest-optionsand-futures.asp [https://perma.cc/b66x-jen2]. 44 it is not obvious that the favorable treatment of hedge fund derivatives before section 1260 was somehow inadvertent. after all, this treatment was simply an application of the general rules for derivatives that congress had enacted. see, e.g., i.r.c. § 1234 (treatment of options); i.r.c. § 1234a (treatment of the termination of derivative contracts). 45 arguably, horizontal equity is not a compelling norm, if only because it simply raises the further question of whether taxpayers actually are similarly situated. see generally louis kaplow, horizontal equity: measures in search of a principle, 42 nat’l tax j. 139 (1989). 46 we focus on planning and administrative costs in parts v & vi, infra. columbia journal of tax law [vol 15:1 16 in our view, this is a plausible, but incomplete, rationale for section 1260 and other transaction-specific reforms. confidence in the tax system undoubtedly is important, but how vigorous must the response be to preserve it? after all, if the problem is one of perception, is the mere appearance of a response sufficient? in principle, the government might achieve its goal by seeming to stop the planning, while (quietly) letting it continue. presumably, though, this symbolic response would no longer suffice–and might even be counterproductive–if the media exposes its ineffectiveness. to sum up, the most persuasive equity-based argument for targeting hedge fund derivatives is that they are available only to wealthy taxpayers. a transactionspecific reform also may be useful in reinforcing confidence in the system. b. efficiency: the right tax burden in deciding whether to target a planning strategy–and, if so, how vigorously– policymakers also need to consider efficiency. as detailed in part iii, this requires policymakers to consider three issues: the right tax burden on an activity (based on elasticity, externalities, etc.); administrative costs; and planning costs. in setting the normative presumption for a reform–which, again, is the first stage in our three-step analysis–we urge policymakers to focus on the first of these issues: the efficient tax burden. specifically, they should consider two questions, which this part discusses in turn: ● first, what is the right tax burden for the targeted transaction? ● second, how great is the risk of overtaxing “good” transactions that don’t present the relevant abuse? 1. the right tax burden: the gravitational pull of fundamental reforms in addressing the first of these questions–the right tax burden–policymakers face a fundamental issue when the planning strategy is for investments, as often is the case: how should investments be taxed? should our system use an income tax (which taxes investments) or a consumption tax (which does not)? the debate over these tax bases has raged for decades, and we do not seek to contribute to it here.47 instead, we emphasize two ways in which this debate influences transaction-specific reforms. first, if more ambitious reforms are enacted, section 1260 (and many other transaction-specific reforms) would become irrelevant. second, policymakers’ priors on fundamental reform can influence their view of a particular transaction-specific reform. after all, to assess how abusive a transaction is, they need to determine what the tax on it is supposed to be. their answer is likely to vary, for instance, depending on whether they would prefer a 47 see bankman & weisbach, supra note 2, at 1414 (“perhaps the single most important tax policy decision is the choice between an income tax and a consumption tax. the topic has been discussed and argued over since at least the time of hobbes and mill, without apparent resolution.”); see also, e.g., andrews, supra note 2; barbara h. fried, fairness and the consumption tax, 44 stan. l. rev. 961 (1992); michael graetz, implementing a progressive consumption tax, 92 harv. l. rev. 1575 (1979); alvin warren, would a consumption tax be fairer than an income tax?, 89 yale l. j. 1081 (1980). 2024] transaction-specific tax reform in three steps 17 consumption tax, on the one hand, or mark-to-market accounting, on the other. in a sense, their take on fundamental reform can exert something like a gravitational pull on their judgments about transaction-specific reforms. 2. the right tax burden: a consumption tax? so if policymakers prefer not to tax any investments, they are less motivated to backstop the tax on specific investments, such as hedge fund derivatives. for example, assume that a policymaker wants to let taxpayers deduct the cost of their investments.48 under this fundamental reform (a cash-flow consumption tax), the form and timing of investments no longer matter. hedge funds and hedge fund derivatives are taxed the same way–as are taxpayers who trade frequently and those who “buy and hold.” their tax depends on how much they save, not how they save. for a policymaker who favors this approach, allowing deferral and longterm capital gains for hedge fund derivatives is not particularly objectionable; on the contrary, it can be a step in the right direction.49 3. the right tax burden: should holding period matter? alternatively, even if policymakers want to tax investments, they still might not object to hedge fund derivatives. in part, their view might turn on how committed they are to a rule this strategy games: the holding period rule for longterm capital gains. arguably, this rule is misguided. after all, although there are reasons to encourage taxpayers to save and invest, why encourage them to stick with the same investment? is “buying and holding” really more socially valuable than monitoring markets and redeploying capital?50 on the contrary, a tax incentive not to sell–a phenomenon known as lock-in”–has familiar efficiency costs. when taxpayers keep positions they want to sell, not only are they less happy with their portfolios, but market prices don’t reflect new information as effectively. policymakers who worry about lock-in (as we do) might want to reward taxpayers for investing for over a year not just in a single position, but in a series of positions. in this spirit, they might favor a “rollover” rule that defers tax (and continues the holding period) when taxpayers sell one investment and immediately 48 as cary brown showed years ago, allowing taxpayers to deduct the cost of investments generally is equivalent to exempting the yield. see e. cary brown, business-income taxation and investment incentives, in income, employment and public policy: essays in honor of alvin h. hansen 300, 300-16 (1948), reprinted in am. econ. ass’n, readings in the economics of taxation 525, 525-37 (richard a. musgrave & carl s. shoup eds., 1959). to implement this reform, congress could offer deductible iras with no limit on the amounts invested and freedom to withdraw proceeds at any time. with these “mega-iras,” the treatment of all investments would be consistent: amounts contributed would be deductible, transactions inside the ira would have no tax consequences, and withdrawals would be taxed as ordinary income. 49 admittedly, a partial step can sometimes turn out to be less appealing than a fundamental reform– and even counterproductive–by introducing inefficiencies and inequities of its own. this is a key reason why incremental reforms are so challenging–and, indeed, why the normative presumption is just one step in our three-step analysis. 50 perhaps the concern is that taxpayers otherwise would trade too often, indulging speculative impulses and racking up transaction costs. but it is not obvious why tax policy is the right instrument to constrain these impulses. columbia journal of tax law [vol 15:1 18 reinvest the proceeds in another.51 if enacted, this provision would extend the favorable treatment of derivatives–deferral and reduced rates–to the underlying fund.52 so if policymakers would favor this reform but can’t get it enacted, would they be motivated to target hedge fund derivatives? arguably, the answer is “no.” the treatment of the derivative (a deferred tax at long-term rates) is more consistent with the rule they want (rollover) than the treatment of the underlying fund (annual taxes at short-term rates). as a result, these policymakers might view the derivative as self-help that moves the system in the right direction. 4. the right tax burden: should there be a capital gains preference? in contrast, policymakers who are skeptical of the capital gains preference have the opposite view. they want ordinary rates to apply to all investment gains, which would eliminate a key advantage of derivatives: it would be taxed at the same rate as the fund (but would still offer tax deferral). if these policymakers aren’t able to enact this reform, they will be motivated–much more than, say, proponents of a reduced tax (or no tax at all) on investments–to police the holding period rule, if only to reduce the volume of investments taxed at rates they consider too low. put another way, since they think current law taxes hedge funds appropriately, they are especially eager to keep taxpayers from avoiding this treatment. 5. the right tax burden: should we have mark-to-market accounting? the same is true of policymakers who favor mark-to-market accounting. to measure income more accurately, they want to tax gains every year, regardless of whether there has been a sale. this reform would eliminate the timing advantage of hedge fund derivatives (taxing gains every year, as generally is the case with underlying funds that trade frequently). again, if this reform is unavailable,53 these policymakers will be especially motivated–more than advocates of a reduced tax (or no tax) on investments–to target tax deferral on hedge fund derivatives. for example, section 1260 pursues this goal by imposing an interest charge when the derivative terminates. to sum up, this section has shown that a number of more ambitious reforms would eliminate the need for section 1260, as well as other transaction-specific 51 see, e.g., i.r.c. § 1033 (providing a rollover rule for involuntary conversions). tacking holding periods is the norm in tax-free reorganizations. i.r.s. pub. 544, sales and other dispositions of assets, 35 (feb. 7, 2023), https://www.irs.gov/pub/irs-pdf/p544.pdf [https://perma.cc/tb7qurar] (“if you acquire an asset in exchange for another asset and your basis for the new asset is figured, in whole or in part, by using your basis in the old property, the holding period of the new property includes the holding period of the old property. that is, it begins on the same day as your holding period for the old property.”). 52the assumption here is that the hedge fund reinvests profits, instead of distributing them to investors, so these trading gains benefit from the rollover rule. 53 this reform faces familiar political and administrative challenges. see, e.g., david a. weisbach, a partial mark-to-market tax system, 53 tax l. rev. 95 (1999). another issue is whether markto-market accounting is constitutional. the supreme court has granted certiorari on this issue. see moore v. united states, cert. granted, no. 20-36122 (june 26, 2023). 2024] transaction-specific tax reform in three steps 19 reforms. in our view, although many of these would be advisable if crafted the right way, congress is unlikely to enact them. even so, policymakers should still be guided in part by the fundamental reform they prefer in deciding whether to target a planning strategy. again, hedge fund derivatives are likely to be more troubling if one’s ideal is mark-to-market accounting, instead of a consumption tax. c. efficiency: risks of overbreadth in setting the normative presumption, policymakers should consider not just how to tax the targeted transaction, but also how to avoid “good” transactions that don’t involve the same abuse. in other words, policymakers also need to worry about overbreadth. 1. false negatives versus false positives this means policymakers have to walk a fine line. on the one hand, if a rule is too narrow, it misses some abusive transactions that should be covered. these “false negatives” have familiar costs, discussed above, in cutting the taxes of wealthy households, putting a premium on sophisticated tax advice, and the like.54 on the other hand, if a rule is too broad, it sweeps in “good” transactions that should not be covered. these “false positives” can be costly in overtaxing–and, potentially, discouraging–socially useful activity. in managing this tradeoff, policymakers have to tolerate some false positives to avoid false negatives, and vice versa. as they strike this balance, they need to make context-specific judgments about the relative costs of these different errors. ultimately, the goal should be to minimize the total cost from both types of errors. 2. costs of false positives the costs of false negatives are, in effect, the costs of allowing the relevant tax planning strategy to continue, which we already have surveyed above.55 yet what about false positives? how costly is it to cover (and, thus, overtax) transactions that do not pose the relevant abuse? to make this judgment, policymakers should analyze two issues, which we consider in turn: first, the likelihood of reaching the wrong transactions; and second, the cost of doing so. a. probability so, starting with probability, which “good” transactions are at risk of being covered? the key question is how similar an abusive transaction is to others that are not abusive. for example, how similar is a hedge fund derivative to an s&p 500 index future? or to derivatives on gold or oil, which give investors greater diversification? relatedly, are there notable differences between the abusive and “good” transactions, which a rule can use to distinguish them? for example, can a line be drawn based on who is engaging in the transaction (e.g., high-net worth individuals, corporations, etc.)? or who is offering it (e.g., public exchanges, tax-indifferent counterparties, etc.)? this sort of distinguishing characteristic is more reliable in 54 see supra part iv.a & b. 55 see supra part iv.b. columbia journal of tax law [vol 15:1 20 some contexts than in others. some tax planning strategies stand out, while others look a lot like conventional business transactions. indeed, truly gifted tax advisors make tax planning look like “business as usual.” the risks of overbreadth turn not just on the similarity between the planning and other transactions, but also on the breadth of the government’s response. needless to say, the broader the rule, the greater the risk of burdening transactions far removed from the targeted planning. for example, if you rent out a room in your home, you don’t have to worry about a (narrow) rule on hedge fund derivatives, but you probably are covered by a (broad) rule on losses from passive investments like mink farms.56 even so, when policymakers seek to avoid overbreadth, they have a motivated ally: the tax bar. tax advisors have a stake in protecting “good” transactions, so clients can keep doing them. the bar also expects (or, at least, hopes) that policymakers will sympathize with this goal. in contrast, the dynamic is quite different for false negatives. if there is an easy end run around a rule, which policymakers have missed, tax advisors have an obvious reason to stay silent: until this hole is plugged, their clients can use it. b. magnitude in assessing the risk of overbreadth, policymakers should consider not just the likelihood of false positives, but also their cost. how problematic would it be to tax these transactions more heavily? how socially valuable are they? would taxpayers really stop doing them? again, policymakers should consider elasticity and externalities in deciding what the tax burden on these “good” transactions should be. based on this analysis, if an over-broad rule would threaten a large volume of socially valuable activity, policymakers should go to greater lengths to avoid false positives, even at the cost of allowing more false negatives. in contrast, an overbroad rule is less of a concern if the costs of overbreadth are low. maybe these transactions are of only marginal importance to the economy. or maybe the relevant activity is important, but taxpayers could still pursue it without being caught by the new rule. 3. managing the tradeoff: false negatives versus false positives in short, in setting the normative presumption, policymakers need to consider not just how bad the targeted transaction is, but also how bad the collateral damage would be from targeting it imprecisely. if false negatives are the more daunting prospect, policymakers should err in the direction of overbreadth. but if false positives are the more troubling scenario, a narrower rule is needed. 56 the passive activity loss rules of section 469 are notoriously overbroad. see justyana mueller & susanna forbes, i’m not your friend—i’m a pal! passive activity loss rules explained, james moore (july 23, 2019), https://www.jmco.com/articles/tax/passive-activity-loss-rules-explained/ [https://perma.cc/5unn-gppx] (“sounds like a tax nightmare, right? unfortunately, the situation is not uncommon.”). 2024] transaction-specific tax reform in three steps 21 what if false negatives and false positives are both very costly? when this is the case, there is more pressure to craft a precise rule, which is better at distinguishing the targeted planning from “good” transactions. yet this precision isn’t free. usually, a sophisticated rule is needed, which increases compliance and enforcement costs (e.g., in requiring complex calculations, challenging valuations, subtle distinctions, and the like). as a result, policymakers face a tradeoff: on the one hand, a more sophisticated rule targets the abuse more precisely but is harder to administer. on the other hand, a blunter rule is cheaper, but it is likely to be either overbroad (with many false positives) or easy to avoid (with many false negatives). so is it better to increase administrative costs? or to tolerate more false positives and false negatives? there is no one-size-fits-all answer. instead, policymakers need to make context-specific judgments. in principle, this tradeoff can be avoided (or at least mitigated) with a test that is both accurate and administrable. to help policymakers come up with this sort of test, we propose two more steps in our three-step process. in the second step, preliminary filters should be used to lower administrative costs. in the third step, sophisticated tests should be used to draw accurate distinctions. the next two parts consider these steps in turn. v. step 2: preliminary filters part iv showed that when policymakers learn about a new type of tax planning, the first step is to decide whether it warrants a response. assuming it does, policymakers should seek to cover all the relevant variations, without burdening “good” transactions. at the same time, the response also needs to be administrable. striking this balance between precision and administrability is the job of our second and third steps. in part vi, we argue that a sophisticated test, which minimizes false positives and false negatives, should be used as the third step. but first, this part recommends a second step: to economize on administrative costs, the sophisticated test should apply to only a subset of transactions. to hone in on the right ones, policymakers should use what we call “preliminary filters.” instead of imposing tax liability, these initial tests merely determine whether a more rigorous test is warranted. as a result, they can be fairly crude, turning on indicators that correlate–sometimes only roughly–with the targeted abuse. the presence of these factors triggers further review, while their absence is a safe harbor. this part suggests two types of preliminary filters: one focuses on characteristics of the taxpayer, and the other on characteristics of the transaction. while these characteristics are likely to be relevant for various transaction-specific reforms, this part focuses on section 1260 as an illustrative example. this part concludes by highlighting challenges in administering preliminary filters, including: how to define the scope of the relevant transactions; how filters should evolve over time; and how they should interact with each other. columbia journal of tax law [vol 15:1 22 a. taxpayer-based filters let’s begin with qualities of the taxpayer. in focusing on who participates in the relevant transaction, filters can consider three qualities: income; assets; and the counterparty. 1. taxpayer income arguably, the best way to hone in on sophisticated planning is with an income test. for example, policymakers could provide that a provision like section 1260 applies only to taxpayers with incomes above a specified level (e.g., the top 1%, whose adjusted gross incomes are above $550,000). the good news is that an income test is both easy to administer and well-targeted. a. administrability advantages after all, taxpayers already compute their income and the government already monitors it. as a result, an income test adds only modestly to compliance and enforcement costs. b. relevance of income: higher stakes income is not just easy to track. it also is quite relevant for three reasons. first, in a progressive tax system, high-income taxpayers are supposed to pay more tax. ensuring that they do advances distributional goals. second, these taxpayers also are an especially promising source of tax revenue. for the same reason that bank robbers target banks–“that’s where the money is”–tax collection focuses especially on high-income taxpayers.57 since their income is taxed at a higher rate, their efforts to defer it or to convert it to capital gain cost the government more revenue.58 third, for the same reason, these taxpayers are more motivated–and, therefore, more skilled–at tax planning. they can reap greater savings from a successful strategy, so they are willing to spend more on sophisticated tax advice and tailored transactions. these taxpayers also have access to planning tools that are not available to other taxpayers, such as the over-the-counter derivatives market. since their planning is more sophisticated, blocking it is more likely to require rigorous tests, which are costly to apply and enforce. these are precisely the types of rules that benefit from a preliminary filter.59 57 when asked why he robbed banks, depression-era bank robber willie sutton supposedly replied, “that’s where the money is.” thomas j. bernard, willie sutton, encyclopedia britannica (june 26, 2023), https://www.britannica.com/biography/willie-sutton [https://perma.cc/7ty2-xkx7]. 58 although the rates for both ordinary income and capital gains are progressive, ordinary rates are higher for very-high-income taxpayers, so the differential is wider. for taxpayers in the top bracket in 2023, converting ordinary income to capital gains changes a 37% tax into a 20% tax. in contrast, taxpayers in lower brackets might change a 24% tax into a 15% tax, so the differential is only 9%, instead of 17%. 59 this is not to say that tax planning by other taxpayers is not worth policing. since they are a larger group, they still owe a lot of tax in the aggregate. while this is true of taxpayers earning $150,000 per year, taxpayers earning $60,000 are unlikely to owe much (if any) income tax. 2024] transaction-specific tax reform in three steps 23 c. which income? while the tax system already tracks income, a few tweaks would still be needed for an income-based filter. for example, the test arguably should not turn on a single year, but on a rolling average. this way, taxpayers would not be “caught” just because their income spikes in a particular year (e.g., from the sale of their home or business). likewise, taxpayers should not be able to avoid a filter by artificially reducing their income in one year (e.g., by accelerating or deferring it). taxpayers also should not be able to ignore the effect of the relevant transaction. for example, assume that congress decides to target hedge fund derivatives, but to limit the statute to high-income taxpayers. how should this filter measure income? specifically, should it count income taxpayers would have had if not for the derivative? if they had invested in the underlying fund instead, they would have had more (current) income. should the filter count this deferred income? in our view, the answer is “yes.” in determining whether a reform might apply, a filter should tentatively assume that it does apply. this approach helps the filter do its job, which is to identify taxpayers who require more vetting. someone who would have significant income, as long as the rule applies, warrants a closer look. 2. taxpayer assets in some circumstances, policymakers may wish to look not just at income, but also at assets. by analogy, the securities law looks at both in defining an “accredited investor” who is allowed to invest in securities that are not available to the general public.60 indeed, a preliminary filter can simply use the securities law test.61 admittedly, a test based solely on income often is adequate–and, indeed, preferable. adding assets usually is redundant (since asset-rich taxpayers usually have high incomes), but costly (since the tax system doesn’t already track assets). yet testing income isn’t always enough. some taxpayers actually do have significant assets but low incomes (e.g., when they have significant business losses or highly appreciated assets). like high-income taxpayers, these asset-rich taxpayers have ample incentive and capacity to engage in sophisticated tax planning, and thus warrant more careful vetting. 3. counterparty to hone in on the right transactions, a filter can focus not just on taxpayers, but also on their counterparties. the type of counterparty matters for four reasons. first, when the counterparty is a financial intermediary, it has expertise to help taxpayers comply with a sophisticated rule. for example, if the counterparty on hedge fund derivatives is a securities dealer, it can help taxpayers do valuations and other calculations needed for rigorous tests (like those discussed below in part 60 u.s. securities and exchange commission, accredited investor, www.sec.gov/education/cap italraising/building-blocks/accredited-investor [https://perma.cc/gcy5-c75r]. 61 an asset test might be relevant for taxpayers who have significant assets but have low taxable income (e.g., because they fund consumption by borrowing against appreciated assets instead of selling them, they have net operating losses, they are retired, etc.). columbia journal of tax law [vol 15:1 24 vi). but this usually won’t be the case if the counterparty is the taxpayer’s neighbor. second, the type of counterparty also can shed light on whether a deal is tax motivated. for example, compare the following two forward contracts. in the first, a taxpayer commits to buy a hedge fund interest from a securities dealer. in the second, one business partner commits to buy out the other and needs time to raise the cash. in principle, section 1260 could apply to both,62 but the identity of the counterparty shows that the second is probably motivated by conventional business reasons. third, and relatedly, a transaction is more likely to be tax motivated when the counterparty is subject to different tax rules. as noted above, this is how hedge fund derivatives became a viable tax planning strategy: although wealthy individuals did not like the tax costs of investing hedge funds, securities dealers were immune to these costs (because they mark their inventory to market).63 as this example shows, some tax planning works only when the counterparty is subject to different rules. like securities dealers, insurance companies, foreigners, and taxexempt organizations also can play this role. as a result, deals involving these “tax indifferent counterparties” arguably should receive extra scrutiny. fourth, the same is true of related parties. it is well understood that in transactions between a subsidiary and parent or between a mother and daughter, the parties’ economic interests usually are aligned enough that they can join forces to reduce their combined tax bill–for instance, by shifting income to the one with the lower tax rate. instead of fretting about whether the pre-tax terms of their deal are fair, they are free to structure the deal to minimize their combined tax liability. given this risk, the presence of related parties is another factor that can justify a closer look. b. transaction-based filters in determining when to apply a more sophisticated (and costly) test, the tax system should consider not only who the taxpayer and counterparty are, but also what they are doing. in other words, there also should be filters based on characteristics of the transaction. these filters should define categories of transactions that lie well beyond a transaction-specific reform’s scope. the goal is to exempt these transactions not just from the reform itself, but also from careful vetting. which transactions should be excluded? as noted above, there is no need to target a planning strategy that brings the tax burden closer to where it actually should be.64 alternatively, even if a planning strategy is problematic, stopping it 62 if the business is organized as an s-corporation, the second contract arguably triggers section 1260. see i.r.c. § 1260(d)(1) (defining forward contract as “contract to acquire in the future (or provide or receive credit for the future value of) any financial asset”); i.r.c. § 1260(c)(1)(a) & (c)(2) (defining “financial asset” to include not only hedge funds, but also equity interests in other pass-through entities, including s-corporations, partnerships, reits, and trusts). the treasury also has regulatory authority to treat stock in a c-corporation and debt as financial assets, but so far has not used this authority. 63 see supra part ii.a. 64 see supra part iv.a & iv.b. about:blank 2024] transaction-specific tax reform in three steps 25 might pose too great a risk to “good” transactions or prove too costly to administer.65 to operationalize these insights, this section suggests seven transactionbased filters. for any given reform, some will be a better fit than others. policymakers should make context-specific judgments about which filters to use. 1. tax treatment is not objectionable first, when the tax burden on a transaction is inappropriately high, there is no need to block–or, in some cases, even to vet–planning strategies to reduce it. arguably this is the case with short sales, which are bets that the value of an asset will decline.66 unlike other investments, short sales are never eligible for long-term capital gains rates, even when they last for more than a year. yet discouraging short sales is a bad idea. without them, market prices may not fully reflect negative information and pessimistic views. in other words, taxing pessimistic bets more than optimistic ones can have negative externalities.67 yet short sales are not the only way to bet against the market; instead, taxpayers can use derivatives, which are eligible for long-term rates.68 should congress target this use of derivatives, using a transaction-specific reform to tax them like short sales? the answer should be “no” if the treatment of derivatives is more appropriate. if this is the case, the better course is to fix the treatment of short sales. 2. tax treatment is well settled second, vetting a tax planning strategy is unnecessary not just when it is socially useful, but also when it is well accepted. for example, if a business is taxed as a partnership, the partners are taxed on their share of its income. but if the business is taxed as a corporation, investors usually aren’t taxed until they receive a dividend or sell the stock (though the corporation itself pays tax). this inconsistency is a feature, not a bug.69 taxpayers are largely free to make this 65 see supra part iv.c. 66 in short sales, investors borrow an asset, such as a share of stock, and sell it. at some point in the future, they have to buy the asset so they can return it to the person who lent it to them. so in effect, short sales reverse the usual order of investing by selling first and buying later. short sellers make a profit by selling high (initially) and buying low (later). see michael r. powers, david m. schizer & martin shubik, market bubbles and wasteful avoidance: tax and regulatory constraints on short sales, 57 tax l. rev. 233 (2004). 67 id. (the fact that “long” bets are taxed more favorably than “short” bets has the potential to distort prices). this is not to say that short sales are always socially valuable. see joshua mitts, short and distort, 49 j. legal stud. 287 (2020) (short sellers can profit by spreading rumors, using assumed names). 68 for example, if a taxpayer buys a put option (i.e., an option to sell), and cash settles it at a profit over a year later, this gain is long-term. 69 the treasury made this choice explicit in “check the box” regulations finalized on january 1, 1997. see t.d. 8697, 1997-1 c.b. 215. some organizations are corporations. treas. reg. § 301.7701-2. with others, taxpayers can option for pass-through treatment. treas. reg. § 301.77013. columbia journal of tax law [vol 15:1 26 choice, so there usually is no need for rules to recharacterize partnerships as corporations and vice versa.70 3. tax treatment is widely available third, there is less need to target a planning strategy not only when the favorable treatment is appropriate or well settled, but also when it is widely available. for example, unlike a hedge fund derivative, a derivative on a growth stock just replicates–but generally does not improve upon–the tax treatment of the underlying asset: each offers tax deferral, as well as reduced rates for long-term investments.71 so the rationale for a rule like section 1260–preventing derivatives from offering better tax treatment–does not apply to derivatives based on growth stocks.72 4. transaction is an established commercial practice fourth, transactions also should be exempted if they are common and not tax-motivated. otherwise, a tax increase on these “good” transactions could discourage economically valuable activity, as noted above.73 for example, a standard way to bet that an asset will appreciate is a call option, which entitles an investor to buy the asset (e.g., 100 shares of xyz stock) for a set price (e.g., the current price of $10 per share). yet as any derivatives trader will tell you, a call option can be replicated by buying a smaller position in the underlying (e.g., fewer than 100 shares), and constantly adjusting this position’s size as market conditions change.74 indeed, when derivatives dealers sell a call to an investor, they usually hedge it with this sort of “dynamic hedging.” notably, these two alternatives–a call option or a dynamic position in the underlying–offer different tax treatment. since the dynamic position requires frequent trading, its tax bill is usually higher. so should the tax law recharacterize the call option, treating it as a dynamic position in disguise? after all, when an investor buys a call from a securities dealer, the dealer hedges it dynamically. should these trades be attributed to the investor? this is what section 1260 does with hedge fund derivatives. should it do the same with a call option on common stock?75 our answer is “no.” the difference, again, is that call options are a wellestablished commercial practice. investors buy and sell them all the time for familiar economic reasons. the investors’ goal is not to avoid unfavorable tax 70 even in this context, though, the government has at times limited the use of the “check the box” regulations. for example, the government has focused on their use in cross-border tax planning. see generally monica gianni, international tax planning after check-the-box, 2 j. passthrough entities 39 (1999). 71 notably, the analysis of dividend-paying stocks could be different, since dividends trigger a current tax on the stock, but not necessarily on a derivative based on this stock. 72 section 1260 provides regulatory authority to cover derivatives based on common stock, but the treasury has not used it. see i.r.c. § 1260(c)(1)(b)(2). 73 see supra part iv.c. 74 the precise number depends on how closely changes in the option’s value track changes in the stock price, and this correlation varies with the stock price. 75 congress did grant regulatory authority to target derivatives based on common stock. but even if this authority is used, an at-the-money call option generally isn’t covered by the provision. 2024] transaction-specific tax reform in three steps 27 treatment from dynamic hedging–a trading strategy that, frankly, most investors don’t understand–but to pursue a longstanding commercial goal. yet even as we recommend sparing practices that are commercially common, we acknowledge a problem with this approach. implicitly, it protects favorable tax treatment for old practices, but not necessarily for new ones that have not had time to become common. unfortunately, this bias against new practices can stifle innovation. after all, what is commercially common now was once new. years ago, this practice was able to develop–and become commercially common today–because its tax treatment was not too unfavorable. otherwise, important innovations like index funds and etfs would not have succeeded. so even for novel practices, some restraint is warranted in considering whether to tax them more heavily. again, the normative presumption is relevant here. if policymakers think financial innovation (and, more generally, established commercial practices) are valuable, they should be careful not to overtax them. but if they doubt the value of these practices–and conclude that their main appeal is their tax advantage–a higher tax is warranted. 5. transaction is commercially impractical fifth, just as less scrutiny is needed for transactions that are commercially well established, the same is true of transactions that are commercially impractical, but for a different reason: even if taxpayers want to do something tax-motivated, they can’t do it anyway. after all, a tax strategy is not appealing if its non-tax costs (or “frictions”) exceed its tax benefit, so a reform isn’t needed to block it.76 for example, given the way section 1260 is drafted, it can be avoided with a derivative that offers most, but not all, of the economic return from a hedge fund. but, although this sort of imperfect tracking is easy for derivatives based on publicly-traded assets, it is much harder for derivatives based on assets (like hedge funds) that aren’t publicly-traded: dealers can’t hedge it, so they won’t be willing to offer it.77 in this situation, a legal response arguably isn’t necessary. 6. transaction is administratively cumbersome to police sixth, even if a legal response is the only way to stop a tax planning strategy, a response isn’t always worth the effort: in some cases, the administrative costs of identifying these transactions are too high.78 as emphasized above, policymakers should balance these costs against the distortions and distributional effects caused by the transaction.79 if the costs of stopping a planning strategy aren’t justified, policymakers shouldn’t target it, and can even use a preliminary filter to exempt it. again, in making these judgments, policymakers should be guided by the normative presumption. 76 see schizer, frictions, supra note 4, at 1319-33. 77 “dynamic” hedging, the strategy described above in which dealers constantly adjust the size of their position, is feasible only for publicly-traded assets. id. at 1372-90. 78 see supra part iii.b.1. 79 see supra part iv.c.3. columbia journal of tax law [vol 15:1 28 7. transaction is already policed by other rules finally, even if an abuse is clearly worth preventing, a new rule isn’t needed if an existing rule is already doing the job. for example, derivatives are not the only way to attain deferral and long-term capital gain for an actively traded portfolio: taxpayers also can trade through an offshore corporation. yet section 1260 does not have to address this strategy because other rules, including the pfic regime, already target it. 80 to sum up, preliminary filters can be used to winnow out transactions that do not warrant the expense of a rigorous test. in some cases, the tax treatment is appropriate, well settled, widely available, or already blocked by frictions. in other cases, the abuse is too costly to stop or already is policed with other rules. c. defining the scope of the relevant transaction while we believe that preliminary filters can reduce administrative costs, they cannot fix every problem. an important one that they don’t solve is the need to define the relevant transaction. this challenge arises whenever a transaction must be tested, whether in the preliminary filters discussed in this part or in the sophisticated tests discussed below in part vi.81 what counts as part of the transaction? what lies outside its scope? this is a key issue in transaction-specific reforms, since they test–and then change the treatment of–particular transactions. often, the issue is whether one transaction is enough like another. in section 1260, for example, the treatment of a hedge fund derivative is recharacterized if–and only if–it is similar enough to the underlying fund. like section 1260, many rules require a comparison of two transactions: the one taxpayers actually do (e.g., the derivative) and the hypothetical one they could have done (e.g., the direct investment in the fund).82 for clarity of exposition, let’s call the transaction that taxpayers actually do the “actual transaction,” and the one they could have done the “alternative transaction.” yet the scope of these transactions isn’t always self-evident. what specifically should be compared to what? which cash flows are included? which are not? this can be a very difficult question because cash flows can be packaged in different ways. this reality can help tax planners avoid a transaction-specific reform. in some cases, they graft the planning strategy onto another transaction. in making the necessary comparison, can taxpayers use the whole thing? or just a piece of it? in other cases, tax planners divide a transaction into components, which are formally separate. when should these components be analyzed separately? when should they be grouped together? 80 see i.r.c. § 1297. 81 see infra part vi.c.1. 82 there are many other examples as well. for instance, a derivative triggers tax withholding if it is enough like common stock. see treas. reg. § 1.871-15. a hedge causes a taxpayer to lose the dividend-received deduction if it reduces too much risk in the underlying stock. see treas. reg. § 1.246–5(c). the treatment of a hedge is recharacterized if it is enough like a sale. see i.r.c. § 1259. the treatment of offsetting positions is recharacterized if they are sufficiently offsetting, see i.r.c. § 1092, or if in combination they are too much like a debt instrument, see i.r.c. § 1258. 2024] transaction-specific tax reform in three steps 29 to keep taxpayers from manipulating the rule, policymakers need to give guidance on these questions. we raise this issue not to offer a definitive resolution, but to highlight that it is present here, just as it is present in countless other contexts. 1. scope of the actual transaction for example, under section 1260 a forward contract to buy a hedge fund interest is covered, since it provides both the opportunity for gain and the risk of loss in the fund. in contrast, if the taxpayer acquires only the opportunity for gain, without the risk of loss, section 1260 doesn’t apply. as a result, an option to buy a hedge fund interest generally is not covered, as long as there is a meaningful possibility that the option will not be exercised. so if the fund interest is worth $100, and a taxpayer acquires an option to buy it for $100, this option won’t be used if the fund’s value declines below $100. this means the taxpayer is not exposed to the full risk of loss in the hedge fund. but what if the taxpayer uses a second transaction to take on this risk of loss? for example, what if a day later she sells a put option on the hedge fund, obligating her to buy it for $100 if the hedge fund’s value declines below $100? if the two options are evaluated separately, neither is similar enough to the underlying fund to trigger the statute. but if they are evaluated as a unit, section 1260 would apply. so, should they be evaluated separately or together?83 does it matter whether the taxpayer waits a few days (or a few months) before entering into the second transaction? what if the options are with different counterparties? what if it was not the taxpayer herself–but a fund in which she is a passive investor–that entered into one of these option transactions? in that case, would the taxpayer even know what the fund is doing? rules are needed to define the scope of the actual transaction. the issue arises in deciding not just whether to combine two formally separate transactions, but also whether to split a transaction into components. for example, what if a taxpayer enters into a derivative to buy an interest in two different hedge funds? as a whole, the derivative does not track either one. but if we treat it as two derivatives, each would trigger the statute. should we bifurcate the derivative in this way? what if the derivative is based on the value of thirty-five different funds? in answering these questions, policymakers face a tradeoff between blocking avoidance strategies, on the one hand, and minimizing administrative costs, on the other. to ensure that a rule reaches the targeted transaction and other similar transactions, at least some aggregation and bifurcation is needed. but requiring taxpayers to take these additional steps–and, for that matter, requiring the government to audit them–adds to the administrative burdens of the rule. these burdens are especially unappealing in a preliminary filter, which is supposed to be easy to apply. after all, the whole idea of a filter is to keep things simple for most transactions, and to require more rigorous (and costly) scrutiny only of a subset of transactions. but if taxpayers can avoid the filter by either adding 83 section 1260 specifically requires options to be aggregated when they have “substantially contemporaneous maturity dates.” i.r.c. § 1260(d)(1)(c). columbia journal of tax law [vol 15:1 30 to or splitting up the relevant transaction, the filter will allow too many false negatives. as a result, some degree of aggregation and bifurcation is needed at this stage, and policymakers should err on the side of including more transactions, so the more rigorous test can be applied to them. one way to reduce the cost of requiring bifurcation and aggregation at the preliminary filter stage is to use more than one filter, and to ensure that at least one of the filters does not require this more burdensome analysis. for example, assume that congress decides to use both a taxpayer-based filter (which exempts taxpayers with income below a minimum threshold) and a transaction-based filter (which uses aggregation and bifurcation in some circumstances when defining the scope of the transaction). although the transaction-based filter is more costly to apply because it uses aggregation and bifurcation, the income-based threshold spares most taxpayers from having to apply it. in any event, when policymakers decide how much aggregation and bifurcation to require, the normative presumption is relevant. again, the more problematic the relevant planning is, the more motivated policymakers should be to block it. 2. scope of the alternative transaction this question of scope is relevant not just in the actual transaction, but also in the alternative one the taxpayer could have done. for example, assume a taxpayer enters into a derivative based on the s&p 500. in this case, there are at least three alternative transactions: first, an investment in 500 individual stocks; second, an investment in a mutual fund or etf that tracks the s&p 500; and, third, an investment in an “index future,” which is a derivative based on the index. so which is it? although the answer is not self-evident–since these alternatives are economically comparable–it actually determines whether section 1260 applies. on the one hand, if policymakers choose the first answer (individual stocks), section 1260 doesn’t apply (because it doesn’t cover derivatives based on common stock).84 on the other hand, if policymakers choose the second answer (a mutual fund or etf), the statute does apply (because derivatives based on passthroughs are covered).85 if policymakers choose the third answer (an index future), the answer is unclear, arguably turning on whether the future is more like the stocks themselves or a mutual fund. notably, a lot is at stake in deciding whether index futures are covered. if they aren’t, this can become a significant loophole. for example, instead of a derivative based on the value of a hedge fund, taxpayers could enter into derivatives based on an index that tracks the hedge fund’s performance. likewise, many hedge funds use specific trading strategies that can be reduced to an algorithm. what if the derivative is based on the algorithm, rather than on the hedge fund itself? is it possible to cover these derivatives, but not more “plain vanilla” derivatives that are based on, say, the s&p 500? arguably, this seems like the right 84 specifically, the statute covers common stock only under regulations, which treasury has not promulgated as of this writing. see i.r.c. § 1260(c)(1)(b)(ii). 85 see i.r.c. § 1260(c)(2)(a). 2024] transaction-specific tax reform in three steps 31 result, since the latter are conventional commercial transactions that usually are not tax motivated. but to accomplish that, the rule cannot require all indices (or, for that matter, none of them) to be covered. presumably, the line should be drawn based on how common and widely followed an index is. something that is customized–in effect, the trading strategy of a particular taxpayer–should be covered, even if more conventional indices are not. but regardless of the answer to this specific issue, the more general point should be clear: rules are needed to define and characterize the alternative transaction. this is a daunting problem because there is no such thing as “the true underlying.” the relevant cash flows can be packaged in different ways and, at least at a conceptual level, it’s hard to view one as more authentic than the others. 3. what is the solution? but although this inquiry is difficult, it can’t be avoided. so what should policymakers do? how should they define the scope of the relevant transactions? as a start, policymakers can draw on general tax principles that deal with this issue. admittedly, these principles are not always effective, but we are not seeking to add to or critique these rules here. rather, we mean to piggyback on existing rules. yet these rules can be applied in either a tough or a lenient way. in deciding which approach to take, policymakers should be guided, once again, by the normative presumption in part iv. when false negatives are a particular concern, aggregation, bifurcation, and other strict rules should be deployed more aggressively. but when false positives are a particular concern–so that an inclusive definition of scope would require vetting for a substantial number of “good” transactions–a more permissive approach is warranted. d. interactions among filters and adjustments over time the good news is that no single filter has to be perfect, since policymakers can use more than one. in addition, policymakers can refine them over time. 1. interaction of filters as this part has shown, filters based on taxpayers and transactions each have advantages and disadvantages. so which should be used? the answer is “both.” when filters are cumulative, each one takes pressure off the others. for example, if a taxpayer-based filter already screens out many transactions, there is less pressure on transaction-based filters to exempt transactions. maybe these filters aren’t needed at all? or maybe they can be tougher, exempting only clear cases? once one filter has already narrowed the field, others can fine tune at the edges, without having to exclude vast categories. 2. should preliminary filters become more lenient or tougher over time? these judgments also can change over the years. a key question, though, is how to refine filters over time. should they become more lenient or more tough? on the one hand, filters can start as narrow safe harbors–offering only limited exemptions from more rigorous vetting–and then broaden over time. on the other columbia journal of tax law [vol 15:1 32 hand, filters can move in the opposite direction, listing specific situations that require careful vetting, and then adding to this “naughty list” over time. each approach has advantages and disadvantages. a. safe harbors: more lenient over time a virtue in starting tough–that is, beginning with narrow preliminary filters and expanding them over time–is its information-forcing effect. taxpayers are more willing to tell the government about false positives than false negatives, as noted above. harnessing this impulse, this approach invites them to come forward about “good” transactions that aren’t (yet) exempted. but this approach has familiar downsides as well. if preliminary filters don’t screen out many transactions, the more rigorous test (the third step in our three-step analysis) applies more broadly, increasing compliance and enforcement costs. taxpayers have to invest more in this rigorous screening, and the government has to sift through more “good” transactions to find “bad” ones, which can be like searching for needles in a haystack.86 over time, the government can reduce these costs by gradually broadening the safe harbors, but this process can take a long time. b. listed transactions: tougher over time alternatively, starting off easy and getting tougher offers the mirror image of these costs and benefits. the government has to work harder to find the false negatives–that is, to identify “bad” transactions that are wrongly filtered out at the preliminary stage. policymakers can try to add these transactions over time, but they are likely to be a step behind.87 this means policymakers have to pick their poison. at the preliminary filter stage, do they prefer too many false positives or too many false negatives? like other aspects of this analysis, the answer turns in part on the normative presumption. vi. step 3: the analytical stage the last two parts have proposed two steps to craft transaction-specific reforms like section 1260. first, when policymakers learn of a new tax planning strategy, they should consider how problematic it is, as well as the collateral effects from targeting it. second, to distinguish this planning strategy from “good” transactions that should not be targeted, policymakers should start with preliminary filters. these “quick and dirty” tests should exempt a large volume of transactions, narrowing the pool that requires more rigorous (and costly) vetting. this brings us to the third step in our methodology. this “analytical stage” should use sophisticated tools to determine whether a transaction is covered. as a 86 this problem has arisen, for instance, with the rules for so-called “listed” transactions–an effort to identify potential tax shelters. 87 for example, the government has taken a long time to focus on potential abuses of section 1260. although the statute was enacted in 1999, some versions of these transactions were not identified as “of concern” for sixteen years. see, e.g., i.r.s. notice 2015-47, 2015-30 i.r.b. 76; i.r.s. notice 2015-48, 2015-30 i.r.b. 77; i.r.s. notice 2015-73, 2015-46 i.r.b. 660; i.r.s. notice 2015-74, 2015-46 i.r.b. 663. it probably is no accident that these notices followed a congressional study of the issue. 2024] transaction-specific tax reform in three steps 33 case study, we propose a new test for section 1260. we show why our test is better than alternatives others have suggested, highlight challenges in applying it, and show how it would apply in pending litigation. a. more analytically rigorous comparisons: our difference-value test once our first two steps have identified the actual and alternative transactions,88 the fundamental question in section 1260 (and, indeed, in many other transaction-specific reforms) is whether they are similar enough. if they are, taxpayers essentially are treated as if they engaged in the alternative transaction instead (i.e., investing in the underlying fund). this section proposes a novel way to compare these two transactions, which has key advantages over other methodologies. we frequently refer to the actual transaction as the “derivative” and the alternative transaction as the “underlying.” this reflects the paradigmatic situation (like in section 1260) where the actual transaction is a derivative contract because taxpayers are trying to use derivatives to get better tax treatment. 1. valuing differences in essence, our approach is to identify differences between the derivative and the underlying, quantify the economic value of these differences, and then compare this value with the overall value of the underlying. if the discrepancy is modest, representing only a small percentage of the total value of the underlying, we would tax holders of the derivative as if they owned the underlying. in ways, our difference methodology resembles a test, “the option-pricing methodology,” which the nysba tax section proposed for a different rule: constructive sales under section 1259.89 this provision targets planning strategies that simulate a sale of an appreciated asset without triggering tax. the key question is whether taxpayers have gotten rid of too much economic exposure (e.g., to appreciated stock). in contrast, section 1260–which uses language similar to section 1259–asks whether taxpayers have taken on too much exposure (e.g., to a hedge fund). the nysba’s option-pricing test focused on fairly simple instruments, which are based on publicly-traded assets. in contrast, our methodology is more ambitious. it accommodates more complex instruments, including ones with pricebased contingencies, and applies more broadly (e.g., to derivatives based on hedge funds).90 2. illustrative example to illustrate our difference methodology, assume that taxpayer wishes to invest in an underlying asset such as a hedge fund interest or common stock (“underlying”). but instead, taxpayer buys an option to purchase underlying at 88 this terminology is introduced in part v.c., supra. 89 see n.y. state bar ass’n tax section comm. on fin. instruments, comments on h.r. 846, nysba tax section rep. #901 28-30 (may 21, 1997) [hereinafter “nysba, rep. #901”]. one of us (david schizer) was a principal author of this report. 90 for a discussion of the differences between our difference value approach and the nysba’s option-pricing approach, see infra note 98. columbia journal of tax law [vol 15:1 34 any time in the next five years. this “call option” entitles taxpayer to pay a discounted price: taxpayer can buy underlying for $70 (the so-called “strike” or “exercise” price), which is less than underlying’s current value of $100. this means that taxpayers could make $30 if they were able to exercise the option immediately (paying only $70 for something worth $100).91 an option that offers this sort of favorable pricing is known as “in the money.” what if underlying’s price falls below $70? taxpayer does not have to buy it for $70. unlike a forward contract, an option offers a choice or option–hence the name–either to use it or to let it expire. notably, there is another difference between underlying and the call option: the timing of payment. to buy underlying, investors have to make an up-front payment of $100 (the initial value of underlying). in contrast, the option spares them from paying in full right away. although they have to buy the option itself, they don’t (yet) have to buy underlying. the option lets them wait, so they pay $70 (the price specified in the option) only if and when they actually use the option. to make the cash flows equivalent, then, we assume that the taxpayer not only buys the option, but also buys a bond to fund the $70 purchase price.92 through this bond, the taxpayer will still receive $70, even if the call option expires worthless.93 3. step #1: identify the “difference contract” the first step in our difference-value methodology is to compare the economic return on underlying with the return on the derivative (which, in this case, is a call option). how are they different? how much of the opportunity for gain does the derivative provide? what about risk of loss? assuming these investments are different, how can investors fill the gap? what additional investment would they need? we call this investment the “difference contract.” by definition, the return on underlying can be perfectly replicated with a combination of the derivative and the difference contract (or contracts).94 in our illustrative example, the call option provides the same opportunity for gain as underlying: any increase above the current value of $100 benefits a holder of this option, just as it benefits an investor in underlying. in contrast, the call option only imposes a portion of the risk of loss–from $100 down to $70–but not the risk of loss below $70. (if the option expires worthless, they will still receive $70 from the bond.) 91 taxpayer would not be getting something for nothing in this situation. the price taxpayer pays for the option is necessarily at least $30 when immediate exercise of the option would yield $30. for the sake of simplicity, we assume that the option is european, meaning that it can only be exercised upon expiration in five years. this assumption precludes the possibility of immediate exercise. 92 another way to align cash flows is to assume that a taxpayer who buys underlying would borrow $70 of the purchase price. 93 for the sake of simplicity, we assume that the asset does not pay dividends or make other distributions. we also assume that the risk-free interest rate is 5%. 94 as discussed below, the difference contract may consist of more than a single simple option. this is the case, for instance, if the derivative omits both opportunity for gain and risk of loss. in that circumstance, the values of these contracts are not netted. rather, to account for both risk of loss and opportunity for gain, the absolute value should be used. see infra part vi.a.6. 2024] transaction-specific tax reform in three steps 35 the key difference, then, is that an investor in the option is protected from risk of loss below $70. what separate contract can offer this protection? the answer is an option to sell (a so-called “put option”) entitling the holder to sell the underlying asset for $70 (so the “exercise price” is $70). what is this avoided exposure worth? the answer, of course, is the value of this put option–something that is feasible to compute. 4. step #2: compute the “difference value” this brings us to the second step in our difference methodology. once the “difference contract” has been identified–a put option with an exercise price of $70 in this example–the next step is to value it. how much would someone pay for it? notably, all put options are not created equal. they are worth more when they are more likely to be used. all else being equal, the higher the exercise price, the more likely it is to be used (since it offers a better sale price). when underlying is worth $100, a put option with an exercise price of $90 is worth more than one with an exercise price of $70, since underlying’s price does not have to decline as much for the option to become “in the money” (i.e., to offer a positive payoff when exercised). for the same reason, a longer term generally also makes the put option more valuable. compared with an option that lasts one day, an option that lasts ten years gives the price of underlying more time to decline from $100 to below $70.95 likewise, the volatility of underlying is also important. the more volatile it is, the more likely it is to trade below $70 (and, again, to generate a positive payoff). so what is the value of a put option with a five-year term and an exercise price of $70 (when underlying is worth $100)? the answer varies with the volatility of the underlying asset.96 table 1 compares the value when volatility is low (20%) and high (60%), showing that the answer is quite different: volatility 20% 60% value of difference contract (the put option) $1.31 $18.90 table 1: difference contract’s value with varying volatility 95 notably, a longer term is even more valuable when the option is “american style,” which means it can be exercised at any time. in contrast, a european style option–the kind we assume here–can only be exercised at maturity. as a caveat, though, the effects of an option’s term can be complicated and, at times, a bit counter intuitive. for example, when the strike price of a european put is well above the price of the underlying (a so-called “deep in-the-money” situation), the value of the option can become less than its intrinsic value (the value that would be obtained if immediate exercise were possible). in this case, a longer time to expiration is a disadvantage to the holder and corresponds to a lower option value. 96 under the black scholes model, interest rates also affect an option’s value. in this example, the risk-free rate is assumed to be 5%. columbia journal of tax law [vol 15:1 36 5. step #3: compute the “difference percentage” once the difference value has been computed, it should be compared to the value of underlying.97 what percentage of the total does the difference contract represent? this ratio provides a precise way to measure the significance of the omitted exposure. a smaller percentage makes the derivative a closer substitute for the underlying, so section 1260 is more likely to apply.98 in the example above, the underlying is $100 when taxpayer enters into the derivative contract. if the volatility is 60%, the difference value is $18.90. as a result, the “difference percentage” is 18.90/100 or 18.9%. alternatively, if the volatility is 20%, the difference percentage is only 1.31/100 or 1.31%. is a difference of 1.31% small enough to trigger constructive ownership? what about 18.9%? how small must this percentage be? in other words, how similar must the contract be to the underlying? in setting this threshold, congress should be guided by the normative presumption, discussed above.99 depending on 97 notably, in our example (and in many other cases), we may take the size of the transaction to be the initial price of underlying ($100). yet in more complex situations in which payment for underlying would not necessarily be paid all up-front and may be contingent, it would generally be appropriate to take the full value of payments made into account. for example, the current price of all future payments needed to purchase underlying could be determined, and this aggregate price could be used. 98 instead of using the value of the underlying as the denominator, there is another possibility, which the nysba proposed for section 1259. see nysba, rep. #901, supra note 89, at 28-30. section 1259 tests whether a hedge should be treated as a sale, evaluating how much risk of loss and opportunity for gain a taxpayer has retained. section 1260 is the mirror image, asking how much the taxpayer has transferred. either way, the effort is to assess how significant the relevant exposure is. but the nysba makes a different comparison than we do–in part because they are developing a narrow test for the (simpler) context of publicly-traded securities, while our test is more general and, therefore, more ambitious. like our test, the nysba options pricing approach computes the value of the difference between the contract and underlying and puts it in the numerator. but their denominator is different. instead of using the value of underlying, as we recommend, the nysba does an additional calculation. in essence, they value the total risk-based exposure in underlying: their denominator is the sum of the (absolute) value of the opportunity for gain in underlying (measured with an at-the-money call option) and the risk of loss in underlying (measured with an at-the-money put option). this approach has one potential advantage over our “difference value” proposal. it strips out the capital invested, so that the test focuses on risk alone. as a result, the calculation no longer can be manipulated by either stuffing in or stripping out capital with a fixed return, a danger that must be managed in our approach. however, this advantage comes at a significant cost: unlike our approach, the nysba’s method requires an additional set of calculations (i.e., valuing total risk of loss and opportunity for gain in underlying). this presumably seemed easy in the narrow setting in which they proposed this approach: hedging publicly traded stock. but this effort would be much more daunting in valuing hedge funds and their trading strategies. what is the value of the upside and downside in using a particular long-short strategy? this strikes us as a potentially intractable problem. in contrast, our denominator is much easier to compute: it is simply the investment the taxpayer could have made. as a practical matter, this is likely to be the investment that the taxpayer’s counterparty actually is making. again, our approach requires the government to police efforts to manipulate the denominator with capital stuffing or stripping, but we think that on balance this is a more administrable approach than the nysba’s methodology, at least in this context. 99 see supra part iii. 2024] transaction-specific tax reform in three steps 37 policymakers’ assessment of the relative harm from false negatives and false positives, they can set the cut-off at, for example, 5% or 10%. with either of these cutoffs, volatility is a decisive factor in our example. section 1260 is triggered if the underlying’s volatility is 20%, but not 60% (even though the contract has the same exercise price, duration, and other economic terms). this result makes sense. again, for an in-the-money call option to diverge from underlying, the latter’s value has to fall below the $70 exercise price. a more volatile underlying is more likely to trade below $70.100 6. other difference contracts: using absolute value as the above example shows, our methodology quantifies the omitted exposure on a derivative. yet this omitted exposure can take different forms. in the example above, the derivative omits only risk of loss. this subsection uses two other simple examples to illustrate how our methodology applies if instead the derivative omits only opportunity for gain or, alternatively, a combination of opportunity for gain and risk of loss. a. omitting only opportunity for gain for example, assume that underlying is still worth $100, and a taxpayer enters into a derivative that omits opportunity for gain above $150. specifically, the derivative offers opportunity for gain up to $150, as well as all the risk of loss below $100. as in our last example, the derivative is paired with a bond, which in this instance pays $100. to fill in the omitted exposure, the difference contract has to provide opportunity for gain above $150. this would be a call option to buy underlying at $150. our test would value this call option and compare it to underlying’s $100 value, yielding a result of 11.90 or 45.85 if the volatility of underlying is 20% or 60%, respectively.101 b. omitting both opportunity for gain and risk of loss instead of omitting only risk of loss or only opportunity for gain, a derivative can omit a portion of both. for example, assume it provides risk of loss below $95 and opportunity for gain above $115.102 this derivative omits exposure to price changes between $95 and $115, which a direct investment in underlying obviously would provide. 100 if underlying’s price falls below $70 upon expiration, the taxpayer has $70. although the call option is worthless, recall our assumption that the taxpayer also buys a bond, which pays $70 at maturity. so, if underlying is worth $50, the investor still has $70 (from the bond). thus, there is a divergence between the price of underlying and the call (with bond) position, which is the excess of $70 over the price of underlying (e.g., $20 when the price of underlying is $50). in contrast, when the price of underlying is at or above $70 upon expiration, the payout on the call option plus $70 has the same value as underlying. for example, if underlying’s price is $110, the call generates $40 and the bond generates $70 for a total of $110. 101 as in our prior example, we assume a risk-free rate of 5% and a term of 5 years. 102 a taxpayer can get this exposure, for instance, by purchasing an option to buy the underlying for $115 (i.e., a long call option with an exercise price of $115), and by selling an option to sell the underlying for $95 (i.e., a short put option with an exercise price of $95). columbia journal of tax law [vol 15:1 38 to fill in these gaps, taxpayers actually need two difference contracts, instead of just one. the first would give them the opportunity for gain they do not already have (from $100 to $115). since this is a way to make more money–an asset, not a liability–they would have to buy it. specifically, they would buy a derivative known as a “call spread.”103 meanwhile, the second contract would force them to take on the risk of loss they are not already bearing (from $100 to $95).104 unlike opportunity for gain, this extra risk of loss is a way to lose more money. since it is a liability–not an asset– they would be paid to take it on. they would sell a derivative known as a “put spread.”105 (again, the taxpayer also would need to buy a bond, as noted above.) again, the two difference contracts would have to be valued (step two of the difference value methodology). then, their values would be compared with the value of underlying to compute the difference percentage (step three). this brings us to an important point. from the taxpayer’s perspective, the value of one of these contracts is positive (the call spread), while the value of the other is negative (the put spread). they pay for the first and get paid for the second. yet these values should not be netted against each other. what matters here is how different the derivative is from underlying. as this example illustrates, some differences have positive value, while others have negative value. when this is the case, these differences should not cancel each other out. otherwise, our methodology would understate the differences. in an extreme case–if the omitted opportunity for gain has exactly the same value as the omitted risk of loss–the (net) omitted exposure is zero.106 this implies that the derivative is identical to underlying, which clearly is not the case. the solution to this problem is simple: disregard whether retained exposure is an asset or a liability–since this doesn’t matter–and just add their values together. in other words, use the absolute value of each component when computing the difference value. 103 a call spread actually is the combination of two options. here, taxpayers would buy a call option entitling them to buy underlying at $100 (to acquire all appreciation above $100), and then sell a call option, entitling their counterparty to buy underlying at $115 (so the taxpayers give up all appreciation above $115). in combination, these two call options provide taxpayers with appreciation between $100 and $115. 104 in general, we use the term difference contract to refer to the single contract that represents the overall difference between a derivative and the underlying. in this example, however, when we refer to two difference contracts, we are using the term to speak of two distinct components of the usual overall difference contract: omitted opportunity for gain and omitted risk of loss. this facilitates our discussion and enables us to talk separately about the aspects of each component. 105 like a call spread, a put spread also is a combination of two options. here, taxpayers would sell a put option entitling their counterparty to sell underlying to them for $100 (so the taxpayers are exposed to all risk of loss below $100), and then buy a put option entitling them to sell underlying at $95 (so the taxpayers avoid risk of loss below $95). in combination, these two put options expose taxpayers to risk of loss between $100 and $95. 106 for example, imagine a derivative that provides opportunity for gain above only $115, while imposing risk of loss only below $56, so the derivative offers a final payoff of $100 in between $56 and $115. this is arguably very different from the economics of the underlying. but if we use netting, the value of the difference contract may be small or even zero. for example, in a blackscholes model with a volatility of 20%, a risk-free rate of 5%, and a term of 5 years, the call spread and the put spread both have a price of approximately $6.65. 2024] transaction-specific tax reform in three steps 39 table 2 shows the results for this example. the key point is that the value of these two contracts should not be netted. the net value is misleadingly low (5.30 in the third line below): instead, the absolute value should be used (8.00 in the fourth line below).107 value call spread 6.65 put spread108 –1.35 sum 5.30 difference contract (sum of absolute values) 8.00 table 2: values of components and overall difference contract for derivative omitting both risk of loss and opportunity for gain notably, although our methodology needs to be able to cover derivatives that omit both risk of loss and opportunity for gain, they are less common for hedge funds than for other types of underlying assets. indeed, they are a staple of another form of tax-planning: hedging appreciated assets, without triggering a sale for tax purposes. but they are largely unavailable for hedge funds. why the difference? as one of us has emphasized elsewhere, a bank can easily offer this sort of derivative when the underlying asset is publicly traded (since the bank can hedge dynamically), but not for an underlying (like a hedge fund) that isn’t publicly traded.109 7. valuing the difference contract: alternative methods so far, this section has developed a methodology that depends on valuing what we call “difference contracts.” but how should these hypothetical contracts be valued? when comparable contracts are available in the market, market value should be used. when there is no readily ascertainable market price, the value can be determined using familiar techniques for valuing illiquid assets. since the difference contract is likely to include options (and option spreads), valuations based on theoretical models like black-scholes are likely to feature in this effort, as in the example above. 107 these are the approximate values for the put and call spread using the black-scholes pricing framework with volatility 20% for underlying, a risk-free return of 5%, and a contract term of 5 years. 108 we write the value of the put spread as negative because it represents downside exposure that must be added to the difference contract to replicate the underlying. by contrast, the call spread is positive because it represents upside exposure. 109 see schizer, frictions, supra note 4. columbia journal of tax law [vol 15:1 40 in general, the difference contract’s value should be determined in a commercially reasonable manner in light of the facts, perhaps informed by expert opinions. these opinions should be explicit about their assumptions, so the analysis can be tested and challenged. a court assessing the value would make credibility determinations and judgments as it would for any determination of fair market value. indeed, one of the advantages of our approach is that it puts courts in a familiar position. valuation disputes arise quite frequently in litigation, so courts know how to adjudicate them. admittedly, valuations can be costly and disputes about them can be daunting to litigate. but again, this is why we recommend preliminary filters to reduce the number of cases that require these valuations. 8. choosing the underlying and risks of manipulation the essence of the test we recommend is, of course, to compare the derivative with the underlying. yet as emphasized above, to compare two transactions, we need to define the scope of each of them. what should be compared to what? our methodology does not avoid this question–and, of course, alternative methodologies don’t either. any comparison, however sophisticated, must first define what is being compared. in our view, the right moment to address this issue is the preliminary filter stage, as noted above. guidance is needed, for example, about when to bifurcate a position, when to lump together positions that are formally separate, and the like. if these rules don’t completely resolve the question, judgment needs to be exercised.110 since these choices can affect the outcome, the government has to police them. b. comparison with alternative tests our difference-value methodology is not the only test for comparing investments. at least four other methodologies, which were proposed for other statutory provisions, can be adapted to section 1260: ● first, a simple test is based on the amount of exposure or “spread” that one position offers but the other does not (the “spread” test).111 ● second, a more complicated test compares how much the value of one position changes when the other position’s value changes by a 110 for example, as noted above, we have matched the cash flows on the derivative and underlying by pairing the derivative with a bond. yet a different approach would be to assume that underlying is purchased with borrowed funds. 111 this test was proposed by the new york state bar association tax section for constructive sales under section 1259, a topic closely related to constructive ownership. see nysba, rep. #901, supra note 89, at 28. the nysba’s approach with both provisions was for taxpayers to avoid the rule by either retaining (in the case of section 1259) or avoiding (in the case of section 1260) an adequate amount of exposure. in both cases, they relied on the sort of “band” of exposure described in text, while caveating that the test assumed that the band includes the current price, the underlying is not unusually volatile, and the instrument will not last more than a specified term of years. the government picked up on aspects of this approach, at least for section 1259, in rev. rul. 2003-7. 2003-1 c.b. 363. 2024] transaction-specific tax reform in three steps 41 dollar. since this ratio is known as “delta,” this is called the “delta test.”112 ● third, there is a more sophisticated variation of the delta test, which the government implemented in regulations113 after critiques were offered of prior proposed regulations.114 ● fourth, another test, applied by the second circuit, seeks to determine the probability that two positions will track each other.115 1. spread test in comparing a derivative with an underlying, a “spread test” measures the differences in a crude way, identifying the range of prices in which they offer different returns. for an underlying worth $100 (“underlying”), for instance, how much risk of loss does the derivative offer below $100? how much opportunity for gain above $100? how much, if any, of this exposure is omitted? a. size of the spread before returning to our main illustrative example (the in-the-money call option), let’s begin with one that is better suited to the spread test: the derivative, mentioned above, that provides risk of loss below $95 and opportunity for gain above $115.116 this derivative omits exposure to price changes between $95 and $115, which a direct investment in underlying obviously would provide. this means that modest moves away from the current price of $100 affect an investor in underlying, but not in this derivative. indeed, if the price doesn’t change, this derivative won’t either make or require a payment. (in the parlance of derivatives traders, it is “out-of-the-money.”) does this 95-115 price range (or “spread”) render the two sufficiently different? to answer this question, the spread test asks what percentage this spread represents of underlying’s value.117 when the nysba proposed this test, they recommended a minimum percentage of 20%, which is what this derivative provides ([115-95]/100).118 112 this test also was proposed by the nysba for constructive sales. see nysba, rep. #868, supra note 12, at 18-22, and has also been refined and enhanced by academics. see, e.g., thomas j. brennan, law and finance: the case of constructive sales, 5 ann. rev. of fin. econ. 259 (2013). 113 treas. reg. § 1.871-15. 114 see, e.g., thomas j. brennan & robert l. mcdonald, the problematic delta test for dividend equivalents, 146 tax notes 525 (2015). 115 this test was proposed by the second circuit for constructive sales. see estate of mckelvey v. comm’r, 906 f.3d 26 (2d cir. 2018). 116 see supra part vi.a.6.b. a taxpayer can get this exposure, for instance, by purchasing an option to buy the underlying for $115 (i.e., a long call option with an exercise price of $115), and by selling an option to sell the underlying for $95 (i.e., a short put option with an exercise price of $95). 117 for this purpose, the nysba uses underlying’s value at the moment when the taxpayer enters into the derivative. 118 the nysba offered this test for constructive sales. a taxpayer who retained exposure to gain and loss in a specified “spread” around the current price would not trigger a constructive sale. see nysba, rep. #901, supra note 89, at 28. in constructive ownership, by contrast, a taxpayer who eliminated exposure in this range would not trigger constructive ownership. columbia journal of tax law [vol 15:1 42 b. no exposure near current price: derivative must be “out-ofthe-money” notably, the nysba also required the omitted exposure to include underlying’s current price.119 for example, when underlying’s price is $100, a derivative that omits exposure between $200 and $220 would not satisfy the test, even though the $20 of omitted exposure does, in fact, represent 20% of underlying’s current price ($100). why do the returns on the derivative and underlying have to diverge near the current price? in other words, why must the derivative be out-of-the-money? the intuition is that these differences are more immediate–arising as soon as the price moves even a penny–so they are more significant. instead of just potential differences, the spread causes actual differences. in this example, a derivative that omits exposure from $90 to $110 is almost certain to offer a different return than underlying; after all, underlying’s price inevitably will move away from $100, even if it doesn’t move very much. in contrast, if the derivative omits exposure between $200 and $220–or, for that matter, between $10 and $30–underlying’s price would have to change a lot (either doubling or losing 70% of its value) before differences between it and the derivative begin to matter. (in other words, these derivatives are “in-the-money.”). as a result, fluctuations near the current price don’t cause the returns on the derivative and underlying to diverge. c. nysba spread test can’t analyze in-the-money derivatives as the nysba emphasized, the main virtue of the spread test is that it is easy to administer. yet as the nysba acknowledged, this simplicity comes at a cost.120 for one thing, this test puts too much weight on whether the spread includes the current price. in other words, it can’t approve in-the-money derivatives. unfortunately, this requirement can generate arbitrary results. for example, consider two options to buy underlying, which currently is worth $100, at any time during the next three years. one option entitles holders to pay $101, while the other entitles them to pay $99. while these options are quite similar–and both differ markedly from underlying–only the first passes the spread test. even though both have spreads that are larger than 20% of underlying’s current market ($100)–101% in the first ($101 to $0) and 99% in the second ($99 to $0)–only the first has a spread that includes this $100 price. in other words, only the first is out-of-themoney. because of this requirement, the spread test also flunks our illustrative example above: a call option entitling holders to pay $70 for an underlying worth $100. although the option and underlying offer different returns when the price falls below $70–a 70% spread–this spread, once again, doesn’t include the current $100 price. but although the option to pay $99 and the option to pay $70 both fail this test, they are quite different. the option to pay $70 is a closer substitute for 119 see id. at 28. 120 see id. at 28 2024] transaction-specific tax reform in three steps 43 underlying, since it exposes the investor to greater risk of loss as underlying’s price declines (i.e., from $99 down to $70).121 put another way, the option to pay $99 is only slightly in-the-money, while the option to pay $70 is much more in-themoney. d. a variation of the spread test: how in-the-money is the derivative? in principle, the spread test could be modified to account for this difference. the key issue is how much the price has to change before further changes stop affecting the derivative’s payout. put another way, the spread test could be adjusted to ask how in-the-money the derivative is. returning to our example, when an option entitles the holder to pay $99, underlying’s price has to decline by only $1 before further declines become irrelevant. this $1 decline represents only 1% of the underlying’s current $100 value (so this option is 1% in-the-money). in contrast, when an option entitles the holder to pay $70, underlying’s price has to fall by $30 or 30% (so this option is 30% in-the-money). as this percentage increases, the option becomes a closer substitute for underlying; like underlying, it exposes the holder to more price changes near the current price. to implement this new variation of the spread test, policymakers can pick a percentage that triggers section 1260 (e.g., 25%). e. other limitations of the spread test: volatility and term but even with this adjustment, the spread test is still a very blunt instrument. the problem is that all spreads with a specified size are not created equal. giving up exposure to a range of prices matters more when the investment is likely to trade only within this range. with a very stable investment, for instance, giving up the first 20% of appreciation may mean, in effect, giving up all the appreciation there is likely to be. in contrast, giving up 20% is much less meaningful with a very risky investment, whose price is likely either to double or to fall to zero. as these examples show, the more volatile an investment is, the less significant a particular spread becomes. the same also can be true of the maturity of the derivative. regardless of the underlying’s volatility, it is more likely to trade outside the spread if the contract lasts for 10 years, instead of 10 days.122 so unfortunately, the nysba’s spread test has several problems. in contrast, our difference-value test avoids these deficiencies. our test works better because it focuses–not on the size of a spread–but on its value. as a result, our test is able to analyze in-the-money derivatives and, more generally, to account for 121 the holders of both options lose money as the price falls to $99, but only the holder of the latter option loses money as the price falls from $99 to $70. once the price falls below $99 (e.g., to $90), there’s no longer a benefit to using an option to pay $99. why pay $99 for something now worth $90? in contrast, there is still a benefit to using the option to pay $70. as a result, a price decline from $99 to $70 affects the return on an option to pay $70, but not on an option to pay $99. 122 the risk-free rate of return is relevant as well. columbia journal of tax law [vol 15:1 44 volatility and duration. admittedly, our difference-value test is harder to administer, but it avoids the spread test’s limitations. 2. delta test: basic case our test also is better than another alternative, the “delta test,” which the nysba and other commentators123 have proposed and the government has tried to implement.124 like our approach, the delta test is harder to administer than the spread test, and is supposed to avoid its limitations. but unlike our approach, the delta test is easy to manipulate. this subsection shows the delta test’s advantages, while the next shows how to confound it. “delta” is a concept in finance, which measures how much the value of one position changes when the price of another changes by a dollar.125 a delta of one means these changes are dollar-for-dollar. in principle, section 1260 can use delta to assess the similarity of a hedge fund derivative and the underlying fund interest. when a taxpayer enters into this derivative, what is its delta with underlying? is it close enough to one to count as constructive ownership? to illustrate this test, let’s return to our recurring example of a call option to buy underlying for $70. when underlying is worth $100, this in-the-money option is worth $46.79 (assuming underlying’s volatility is 20%).126 what happens when the stock price increases by $1 to $101? the value of the call option increases by 95 cents to $47.74. in other words, the delta is 0.95 (i.e., 0.95/1.00).127 notably, the value of delta keeps changing as the price changes.128 how close to 1.0 must delta be to count as constructive ownership? to answer this question, policymakers need to designate a threshold, such as .90. the lower the threshold, the more transactions will be covered. in setting this level, policymakers should consider the equity and efficiency implications of hedge fund derivatives, the risks of an overbroad rule, and other factors that influence the normative presumption, as discussed in part iv. 123 brennan, supra note 112; nysba, rep. #868, supra note 12, at 18-22 . 124 see treas. reg. § 1.871–15 (testing dividend equivalent payments). 125 in other words, delta is the ratio of the incremental change in price of the contract to a corresponding incremental change in the underlying asset price. the exact value of delta is the limit of this calculation for arbitrarily small changes in the price of the underlying. it is thus the derivative, in the sense of calculus, of the price of the contract with respect to the price of the underlying. 126 we compute this value using black scholes with a 5-year term and 5% risk-free rate. note that this is only the value of the call option component of the contract and does not include the price of the bond that pays $100 at expiration. for purposes of computing delta, the bond is irrelevant because its value does not change with the price of the underlying. hence, it adds zero to the value of delta. 127 this is a rounded approximation, with each call value rounded, and then the difference of the rounded numbers taken to compute delta. computation without intermediate rounding would yield a result of 0.9442. in addition, this is a discrete approximation to delta. the true delta value is the limit of the result of such computations as the incremental adjustment to the underlying price tends to zero. that figure is 0.9430. 128 the value of delta may also be interpreted as the amount of asset that would be necessary to hedge exactly the exposure to the asset represented by the contract. this hedge is as of the time of entry into the contract. in general, the amount of asset needed for a hedge, and hence the value of delta, changes over time. 2024] transaction-specific tax reform in three steps 45 the delta test works well for “plain vanilla” options with no contingencies. unlike the spread test, it accounts for underlying’s volatility. as table 3 shows, delta in our recurring example varies with underlying’s volatility: volatility 20% 60% delta 0.943 0.869 table 3: delta for varying volatility the delta test correctly treats the low-volatility case as more similar to the underlying than the high-volatility case, and thus more likely to trigger constructive ownership. after all, when underlying is not volatile, bearing risk of loss below $70 is less significant. so as this intuition suggests, if the delta threshold is .90, the low-volatility case triggers section 1260, while the high-volatility case does not. like volatility, the time left to maturity also affects delta, so a delta test is sensitive to this variable as well.129 while our difference-value test also accounts for these differences in volatility and term, the spread test does not, as emphasized above. in other words, the delta test and our difference-value methodology are both more nuanced and accurate than the spread test. 3. delta test: barrier options even so, a delta test has a problem of its own: unlike our difference-value approach, it is easy to manipulate. the problem is that delta is “hyper local,” drawing comparisons at a specific price and moment in time. this quality makes delta especially sensitive to small changes in contract terms, even ones that are unimportant in the long run, and thus don’t influence our difference-value approach. a. confounding the delta test with contingencies to exploit this hypersensitivity, taxpayers can add contingencies to their derivatives. they can engineer results under the delta test that are quite counterintuitive–even a bit wacky. to illustrate the point, let’s add a contingency to our recurring example, a five-year call option to pay $70 for underlying, which currently is worth $100. unlike before, this call is now subject to a contingency: it can be used only after underlying’s price has declined below $98. in other words, this contingent call is activated if, and only if, underlying’s price declines from $100 to below $98 sometime during the option’s five-year term. if this “knock in” contingency does 129 for example, if the term of the call option is reduced from 5 years to 1 year, and volatility is 20%, the delta value is 0.984. this increase from 0.943 reflects the higher likelihood that the underlying price will end above $70 if only a 1-year term is allowed. columbia journal of tax law [vol 15:1 46 not occur, the option expires worthless.130 an option with this sort of contingency is known as a “barrier option.”131 what is the delta of this contingent call?132 in principle, one might expect this contingency not to alter delta very much: after all, if underlying is a risky asset (like a hedge fund interest), its price is almost certain to decline more two percent at some point over five years. therefore, this contingency is unlikely to affect the option. nevertheless, this contingency has a thoroughly unexpected effect: it turns delta negative! ordinarily, a call option appreciates when underlying’s value increases (e.g., from 100 to 101), since buying for a fixed price (e.g., of $70) becomes more appealing. but bizarrely, this contingency causes the call to lose value. likewise, call options usually decline in value as underlying’s price falls, since buying for a fixed price (e.g., of $70) becomes less appealing. but weirdly, this contingency causes the call to increase in value. so what is going on? why has this contingency turned things upside down? the key point is that this barrier option can’t be used unless underlying’s price falls below $98 at some point. if this never happens, the option is worthless. so as underlying’s price rises–moving further away from $98–the risk increases that the option will never be activated. this means that increases in underlying’s price have competing effects. on the one hand, these increases tend to make any call option more valuable, as noted above. on the other hand, these increases tend to make this call option less valuable, since it is less likely to “knock in.” when the latter effect dominates, increases in underlying’s price actually reduce the barrier option’s value, turning delta negative.133 this counterintuitive effect is more pronounced when underlying is less volatile, presumably because as underlying’s price moves further above the $98 threshold, it is less likely to come back down. as table 4 shows, delta in the low volatility case actually is negative 1.52: when underlying’s price increases from 100 to 101, the call option’s value actually declines not just by a few cents, but by a full $1.52! volatility 20% 60% delta -1.520 -0.395 table 4: delta for knock-in call 130 in this example, even if the option cannot be used, the taxpayer will still get $70. in effect, the bond portion of this transaction is not subject to this “knock in” contingency. 131 james chen, what is a barrier option? definition, and knock-in vs. knock-out, investopedia (apr. 5, 2022), https://www.investopedia.com/terms/b/barrieroption.asp [https://perma.cc/3pjx-z8 pt] (“a barrier option is a type of derivative where the payoff depends on whether or not the underlying asset has reached or exceeded a predetermined price.”). 132 a contingency that adds additional features to a derivative is called a “knock in” feature; in contrast, a condition that causes a derivative to expire prematurely is called a “knock out” feature. 133 likewise, declines in underlying’s price also causes competing effects. a call option generally loses value when the price of the underlying declines, but here the knock-in call comes closer to $98, and thus is more likely to become usable. 2024] transaction-specific tax reform in three steps 47 as this bizarre result shows, the delta test has utterly short-circuited. it is treating the call as very different from the underlying, when this just isn’t the case. without the contingency, the call actually is a close substitute, as shown above.134 nor should the contingency make much of a difference. after all, it has no effect as long as underlying’s price declines to $98 at some point in five years–something that is extremely likely to happen.135 as this example shows, delta is not an effective test for instruments with payouts based not just on the final asset value, but also on the price path to get there. delta is very sensitive to small effects at specific prices, which can obscure broader correlations. put more colloquially, it often misses the forest for the trees. b. potential fixes for the delta test admittedly, there are ways to manage these problems with a delta test, at least to an extent. perhaps a more sophisticated model could deemphasize contingencies, although we doubt it. alternatively, the test could ignore some contingencies, as other tax rules do.136 so instead of analyzing what taxpayers actually did, the rule could test a simplified hypothetical version. the government took an analogous approach in regulations under section 871, which use delta to police a strategy for avoiding withholding tax: investing in derivatives instead of common stock.137 but testing a hypothetical deal has obvious problems. among the many variations, which should be tested? what (potentially distorting) assumptions are taxpayers allowed to make? in our view, these “fixes” seem more plausible when everyone is trying to make delta work, such as when traders hedge. but here delta is used not to finetune a portfolio, but to block tax planning. so instead of looking for a reasonable solution, some taxpayers will make aggressive assumptions to try to game the system. 134 see supra part vi.a.2 & vi.b.2 (showing similarity using difference value and delta tests). 135 the risk-neutral probability of reaching $98 is 94.8% in our low-volatility case (20%) and 99.4% in our high-volatility case (60%). note that risk-neutral probabilities are a construct of the pricing model used and are not the same as real-world (so-called “physical”) probabilities. the risk-neutral values may be thought of as real probabilities adjusted to account for the risk aversion of a marginal investor, as reflected in prices. in general, real-world probabilities would correspond to a higher probability of an increase in asset price, and hence a lower probability of hitting the barrier. however, because we are interested in understanding the behavior of delta, which is also a construct of the pricing model, the risk-neutral probabilities are useful to consider. 136 by analogy, regulations on various types of debt instruments specify how various types of contingencies should be treated. see treas. reg. § 1.1272-1(c) (specifying presumptions for contingencies in computing yields). 137 specifically, taxpayers who enter into complex contracts are required to construct a simplified alternative with a delta of .8. see treas. reg. § 1.871-15(h)(2). unfortunately, the regulations fail to give clear guidance about which alternative to use (since a number of different ones could have a delta of .8). the regulations then direct taxpayers to compare the alternative–whichever it is–with the transaction they actually used. specifically, taxpayers have to compare percentage changes in the delta of what they actually did with percentage changes in the simplified version. this comparison turns out to be not just exceedingly complicated, but also manipulable. unfortunately, in the same way that knock-in and knock-out features allow for manipulation of delta, as discussed above, they also allow for manipulation of percentage changes in delta. columbia journal of tax law [vol 15:1 48 c. key advantage of the difference-value test: treatment of contingencies fortunately, our difference-value test avoids this problem: “knock-in” and “knock-out” contingencies don’t skew the results. the reason is that our test focuses on overall value, not on fleeting correlations. it considers the full range of outcomes, using probability weighting to measure the likely impact of contingencies. this keeps improbable ones from distorting the result. again, to put the point more colloquially, our test compares forests, instead of individual trees. to illustrate the difference between our test and the delta test, let’s return to the contingent call option in the example above. unlike its noncontingent counterpart, it cannot be used if underlying’s price never falls below $98. yet this outcome is quite unlikely, as long as underlying is volatile enough and the option’s term is long enough. so should this contingency affect the option’s value? the answer is “yes, but only modestly.” this is exactly what we find with our difference-value approach. as table 5 shows, the contingent call has a slightly higher difference percentage–that is, it is a bit less like underlying–because of its “knock-in” feature. volatility 20% 60% difference percentage for non-contingent call138 1.31% 18.90% difference percentage for knock-in call139 9.22% 21.77% table 5: difference percentage for simple call and knock-in call the point here is not to bash delta, but to clarify how it should be used. the key is that it focuses on an instant in time. this quality makes delta especially valuable for trading strategies that require constant adjustments, such as hedging.140 for the same reason, the tax law can use it to test conditions at a specific moment. indeed, the delta test was first proposed for section 1259, which taxes a 138 the difference contract in this case is, as discussed above, simply a put option with strike $70. the difference percentages are the ratios of the put prices in the two volatility scenarios to the $100 price of the underlying. 139 the difference contract in this case is a knock-in put option with strike $70, together with a knock-out position in the asset. the asset position is the difference if the barrier level of $98 is never hit. the price of the knock-in put in this case is the same as an unconditional put, because a simple put with strike $70 does not provide a payoff if the barrier of $98 is never crossed. 140 delta helps clarify the trader’s short-term exposure and figure out what position will be offsetting at that moment. over time, delta keeps changing, so the trader updates the hedge in a process known as “dynamic hedging.” such an update is even self-financing, under idealized modeling assumptions. notably, though, although dynamic hedging with positions in the underlying is possible for barrier options, it is more challenging than with simple options. for barrier options, it can be useful to hedge with positions in simple options in the underlying instead of just underlying positions directly. for more information regarding hedging barrier options, see, e.g., peter carr & andrew chou, breaking barriers, 10 risk 139 (1997). 2024] transaction-specific tax reform in three steps 49 hedge that is too much like a sale.141 since sales happen at an instant in time, delta is a good fit. arguably, the same is true when hedging (even just for a moment) has other tax consequences, such as tolling holding periods, deferring losses,142 and denying the dividends-received deduction.143 in these contexts, delta answers the relevant question: how much does one position offset another at a particular moment in time? but the relevant time horizon is different for constructive ownership under section 1260: the question is how closely one position tracks another–not just for an instant–but for at least a year, so gains can be taxed at long-term gains rates.144 delta is less effective in testing this sort of enduring correlation. more generally, when the tax law needs to assess similarity over time, we are better off focusing on factors that are likely and enduring, instead of ones that are improbable and fleeting. fortunately, our difference value methodology is designed to focus–more than delta can–on these lasting correlations over time. as a result, our proposal can’t be manipulated as easily by contingencies.145 4. the mckelvey test finally, instead of focusing on correlation (like delta) or value (like our proposal), another alternative is to focus on probabilities. how likely is a derivative to deliver the same economic return as the underlying? the second circuit used this sort of probability-based test in another context: assessing whether a hedge was perfect enough to be taxed as a sale under section 1259.146 in theory, the hedge in mckelvey was not perfect. the taxpayer remained exposed to some changes in the stock price. but in practice, the price would have to increase significantly before the taxpayer actually would be affected.147 although this was theoretically possible, it was quite unlikely. 141 see i.r.c. § 1259; nysba, rep. #868, supra note 12, at 18-22 . 142 see i.r.c. § 1092 (straddle rules). 143 see treas. reg. § 1246–5. 144 it is possible to create tests that are delta-based and attempt to incorporate the fact that delta may change over time. this is the approach taken in the regulations for complex contracts under § 871(m), for example. see treas. reg. § 1.871-15. still, there is a conceptual mismatch for the reasons we have explained. 145 to be sure, the value of delta is not totally irrelevant to the long-run perspective. delta may be viewed as representing an average of future expected differences in outcomes, essentially a measure of correlation between the outcomes of the contract and the underlying. but this measure can mask important issues. for example, it nets future deviations in one direction with offsetting ones in the other direction. a delta value close to 1 may show tracking that is close on average, but not uniform across potential outcomes. in contrast, our difference value methodology does a better job of identifying this sort of uniform similarity. 146 i.r.c. § 1259(d)(1). the case dealt with a contract that originally did not give rise to a constructive sale but was later modified. the court treated this modification as if it gave rise to a new contract. we do not focus on this issue here. 147 to be precise, the taxpayer entered into a “variable prepaid forward contract.” although the taxpayer committed to sell some shares, the number would vary with the stock price. the problem for the taxpayer was that this quantity would vary only if the stock price increased significantly. estate of mckelvey v. comm’r, 906 f.3d 26 (2d cir. 2018). columbia journal of tax law [vol 15:1 50 to resolve the case, the court tried to estimate the probability that this would occur. concluding that the probability was only 15%, the court treated the hedge as a constructive sale.148 in principle, policymakers could use a similar approach for constructive ownership, but we do not recommend it. the problem is that this approach focuses just on the likelihood that something will occur, but without also considering how important this scenario is. put another way, the mckelvey test considers the probability of a scenario, but not its magnitude. for example, suppose that 85% of the time there is exact equality between the underlying and a derivative. however, in the remaining 15% of the time, the derivative actually behaves like negative 10 times the underlying. arguably, this contract should not be considered equivalent to the underlying. nevertheless, the probability-only approach would ignore this large magnitude, but low probability, possibility.149 the good news is that, unlike the mckelvey test, both the difference-value test and the delta test incorporate magnitudes as well as probabilities. these tests do not share this defect of the mckelvey test.150 c. issues in making comparisons section b showed that our difference-value approach is more precise and nuanced than the spread, delta, and mckelvey tests. even so, our proposal still faces three of the same challenges: first, defining the relevant transaction; second, accounting for contingencies; and third, considering the taxpayer’s control over the underlying assets. this section briefly considers these issues in turn. 1. scope in our view, the main “achilles heel” of our proposal is that it does not answer the question, emphasized above, of what should be compared to what?151 like the spread, delta, and mckelvey tests, our approach has to define the relevant transactions in order to compare them. to manipulate any of these tests, taxpayers can tweak the transactions, as discussed above, by adding additional cash flows (so bifurcation is needed) or splitting them into components (so aggregation is needed). even so, there is one way in which our test is easier to manipulate than the delta test: the addition (or subtraction) of a fixed amount from either the derivative or underlying. for example, instead of paying the value of underlying at maturity, a derivative could pay this value minus $70.152 148 the court also dealt with a companion contract for which the probability was 13%. for our purposes, it is sufficient to consider the treatment of only one of these contracts. id. at 32-33. 149 even if policymakers want to focus on probabilities, the court did not clarify the type of probability that should be used. should it be risk-neutral probabilities? or real-world probabilities? there are arguments for either type, but the court failed to resolve this issue clearly. id. 150 in the court’s defense, this concern arguably did not arise in mckelvey. the case dealt with a specialized contract, whose payoff was largely fixed. as a result, the outcome in the low probability situation was not radically different. id. 151 see supra part v.c. 152 this is one way to describe the in-the-money option in our recurring example, which requires a payment of $70 to exercise the option. thus, for example, if the final price of the underlying is $110, the option pays $40 at expiration, rather than $110. this results in a substantial gap between 2024] transaction-specific tax reform in three steps 51 arguably, adding or subtracting fixed amounts shouldn’t matter to investors. they can get essentially the same return (the performance of underlying) by putting up either more or less cash. put another way, this is a difference in leverage, not return.153 as a result, this difference arguably should not be relevant under section 1260, which assesses economic similarity without accounting for leverage.154 so ideally, the addition or subtraction of a constant amount should be just as irrelevant under the tests we have analyzed. is this the case? the answer is “yes” for the delta test. the correlation between underlying and a derivative should not change if a lump sum is added (or subtracted) from one or the other. however, adding or subtracting a lump sum could potentially change the difference-value calculation–at least if taxpayers are deliberately trying to manipulate it. for example, recall that the difference percentage is the value of the difference contract divided by the value of underlying. but should these transactions be defined to include the fixed payment? for example, if the derivative pays $70 less than the value of underlying, should the difference contract also include a payment of $70? or should $70 be removed from underlying? the answers to these questions can affect the outcome. as a result, policymakers need to give guidance on this issue. as noted above, they can rely on general tax principles, and can tweak those based on the normative presumption. 2. manipulative contingencies another possible way to game these tests–to make a derivative seem less like the underlying asset–is to introduce contingencies. the good news, noted above, is that some contingencies are less of a problem for our proposal than they are for the delta test.155 these contingencies have less effect on a derivative’s value (and thus on our approach) because they are either unimportant or unlikely to happen.156 the difference-value is able to shrug off these minor contingencies–in a the underlying and the derivative. we eliminated this gap for payoffs above the strike price by requiring that the contract pay $70 in addition to the simple payoff of the call option. 153 by leverage, we mean financing that must be repaid regardless of the performance of the underlying. for example, if an investor borrows $70 to buy a risky asset, and must pay the $70 without regard to what happens to the risky asset, the $70 is a quintessential example of what we mean by leverage. as it turns out, some features of the gwa contract that at first seem to be pure leverage–and have no connection to underlying’s price–actually do have a connection. for a discussion, see infra appendix a. this means that this apparent advantage of delta over the difference-value method may be less than meets the eye. 154 in defining a constructive ownership transaction, section 1260(d)(1) does not account for leverage. for example, it specifically lists “a forward contract to acquire” the underlying asset without regard to whether the forward contract requires an up-front payment. i.r.c. § 1260(d)(1). similarly, it also includes “a holder of a call” and a “grantor of a put,” even though options usually involve deferred payments. i.r.c. § 1260(d)(1)(c). 155 see infra part vi.b.3.c. 156 we speak in general terms like “unimportant” and “unlikely” to convey the gist of the idea without technical details. note that in order for our difference method not to change much as a result of a contingency, both the probability of the contingency must be low, and the alternate outcome must not be too extreme. contrast this with the mckelvey test that focused only on probability and not on the size of the low-probability event. columbia journal of tax law [vol 15:1 52 way the delta cannot–because we focus on value over time, not on correlations at a point in time, as noted above.157 in contrast, contingencies pose more of a challenge to our difference-value test when they are more likely to affect the derivative’s value–that is, when either their probability or magnitude is more significant. let’s turn to some examples to illustrate this challenge and to show how the difference-value test should deal with it. a. coin flips for example, assume that taxpayer enters into a quintessential constructive ownership transaction–a forward contract to acquire an interest in underlying (a hedge fund)158–but with a twist: on the day after taxpayer enters into this contract, there is a coin flip to determine whether taxpayer is the buyer or the seller on this contract. because of this contingency, this derivative is 50% likely to be a perfect substitute for underlying (when taxpayer is the buyer), and 50% likely to be the exact opposite (when taxpayer is the seller).159 this sort of contingency can confuse both the delta and difference-value tests. before the contingency is resolved, the delta of this derivative is essentially zero, because both the “buyer” and “seller” outcomes are equally likely (and thus cancel each other out). for the same reason, its initial value also is essentially zero, so the difference-value test would generally treat it as very different from underlying.160 but this is the wrong result. this derivative can actually be a perfect substitute for underlying, as long as taxpayers are patient: if the coin toss makes them the seller, they can cancel this derivative and try again.161 eventually, the coin toss will go the right way, giving them a derivative that is a perfect substitute. b. more realistic contingencies admittedly, the coin flip seems tax-motivated, since there is no commercial rationale for it. yet other contingencies are easier to justify, including the level of unemployment or inflation, the closing of a specific transaction, the price of 157 as our knock-in call example in part vi.b.3 shows, a low probability contingency with a notvery-extreme impact on the outcome can move delta from close to positive one to well below negative one. 158 assume the term is three years, the amount of hedge fund interests to be delivered is fixed, and the purchase price is equal to the current value of the interest in the hedge fund, grown at the rate of return on treasury bills over the course of the three-year period. 159 this coin-flip example is based on an example in brennan & mcdonald, supra note 114. 160 specifically, this contract provides ownership of the underlying half the time. but the other half of the time, it provides the exact opposite, i.e., a short position in the underlying. this means the difference contract provides full risk of loss and opportunity for gain half the time, so the difference contract is zero. the other half of the time, the difference contract is actually double the value of the underlying. this is the absolute value of the difference between the underlying and its negative. the price of the difference contract is thus the same as the underlying (i.e., one-half of double the price of the underlying). thus, our difference percentage would be 100%. 161 note that this possibility implicates the question of scope discussed above as well. if we take the derivative to be not just a single coin-flip contract, but rather the entire series of contracts to be used, then we can get to the correct answer under either our test or the delta test. considerations of scope and manipulability often intersect and overlap. we discuss each in turn to highlight different facets of the overall challenge in assessing similarity. 2024] transaction-specific tax reform in three steps 53 underlying, and the like. to defend these contingencies, taxpayers can claim that they are relevant in deciding whether to invest in underlying. alternatively, taxpayers can add another contingency with a tax advantage of its own: they can invest in underlying through a variable life insurance policy, with a death benefit equal to the value of underlying on the date of death. to buy this insurance, taxpayers can pay the current value of underlying (which the insurance company uses to invest in underlying), plus a generous fee. if the form of this transaction is respected, the proceeds are tax-free, so any profit on underlying is never taxed.162 in each of the examples in this subsection, the derivative and underlying are likely to be quite similar, but a contingency makes them seem different. how should our “difference-value” methodology treat these contingencies? this is really a two-part question. first, as a matter of policy, what should the answer be? second, what are the options for implementing this policy judgment? c. normative assessment in answering the first question, policymakers should once again be guided by the normative presumption. on the one hand, how troubling are false negatives? how problematic is it for taxpayers to change their tax treatment by including these conditions? on the other hand, how harmful are false positives? to what extent will a broad rule chill socially useful transactions that are not tax-motivated? this analysis will not be the same for every contingency. if there is no commercial rationale for it (e.g., the coin toss), policymakers should discount it. but if a contingency has social value (e.g., life insurance), it warrants more deference. d. probability-based assumptions if policymakers do not want contingencies to prevent constructive ownership, they can adjust the “difference-value” methodology in two ways. first, they can require taxpayers to make assumptions about the contingency. if it is virtually certain to be satisfied, the relevant valuations should assume that it already has been satisfied. likewise, if a contingency is unlikely, the valuations should ignore it. the tax law already uses this approach, for instance, with contingent payments on debt instruments.163 e. updated analysis after contingencies are resolved second, instead of predicting whether a contingency will be satisfied, another alternative is for taxpayers to wait and see. if the relevant condition ultimately is satisfied, a (partially) updated valuation can be required. to be clear, the only update would be the inclusion of the contingency. otherwise, the analysis would still use the conditions in effect when taxpayer entered into the derivative. to illustrate this “updated ex ante” approach, assume that on january 1 of year 1, when an interest in underlying is worth $100, taxpayer enters into a threeyear call option to buy underlying for $200, which has a contingency: after two 162 see i.r.c. § 101. 163 see treas. reg. § 1.1275-2(h); treas. reg. § 1.1275-4(a)(5). columbia journal of tax law [vol 15:1 54 years, a coin toss will determine whether this purchase price on the option (the “exercise price”) is reduced from $200 to $50. imagine that this coin toss does, indeed, reduce the exercise price to $50, and over this two-year period underlying’s price has declined to $45. should section 1260 apply to this option? if the contingency is ignored in year 1, the answer probably is “no.” a three-year option to buy underlying for twice its current value (i.e., $200 when it is trading at $100) is not a close substitute for underlying. what about after the coin toss two years later? taxpayers can be required to rerun the analysis, since the exercise price on the option has now fallen from $200 to $50. but the answer depends on what other values are used. specifically, should underlying be valued at $100 (the value when taxpayer originally got the option) or at $45 (the value two years later when the exercise price was reduced). we recommend using the initial value ($100), which (in this case) makes this option more likely to trigger section 1260. in other words, the only fact we would update is the contingency itself (i.e., the new $50 purchase price on the option), but not anything else (e.g., the value of underlying). the advantage of this updating approach is that it doesn’t require assumptions that might prove incorrect. but the disadvantage is that it doesn’t provide certainty about the relevant treatment. taxpayers and the government have to wait to find out whether this derivative triggers section 1260. (presumably, interest would be imposed to compensate the government if the derivative should have been taxed less favorably, but taxpayer’s earlier returns did not reflect this less favorable treatment.) 3. investor control so far, this subsection has shown that our difference-value approach is not immune to challenges that arise in any effort to compare two transactions: the need to define their scope, and to decide how to treat contingencies. in the same spirit, there is another issue that our difference-value approach does address: whether a taxpayer exerts enough control over an asset to qualify as its owner for tax purposes. actually, control is not relevant under section 1260, which focuses instead on economic return. this statute applies when a derivative is a sufficiently close substitute for the underlying asset, regardless of whether the taxpayer is managing or controlling this asset. we agree with section 1260’s focus on return and adopt it in this article, since return usually is what matters most to investors. yet we recognize that the government sometimes focuses on control–not under section 1260–but under the law of tax ownership. for example, when a taxpayer enters into a derivative contract with a bank, and the bank hedges by purchasing particular assets, the government sometimes invokes control to argue that “the real owner” of these assets for tax purposes is the taxpayer, not the bank. knowing this, well advised taxpayers are careful not to link the derivative too closely with the bank’s hedge. for example, the payout on the derivative should not be defined as the price the bank gets in liquidating its hedge. likewise, if the derivative is based on a portfolio managed by the bank, the taxpayer should be 2024] transaction-specific tax reform in three steps 55 careful not to get too involved in managing this portfolio. under the caselaw, this sort of control can affect the result.164 we flag these issues mainly to emphasize that our “difference-value” approach does not address them. questions of ownership are pervasive in the tax law, and they are fairly well understood.165 we are not seeking to contribute to that understanding here. we should note, though, that it is not obvious to us why, as a matter of policy, a taxpayer’s active participation makes the transaction more problematic. admittedly, the optics may be less favorable when taxpayers claim not to be the owner, but still play an active management role. but so what? if the issue is really whether particular types of economic returns should be taxed one way or the other, why does it matter who is making the decisions? moreover, if control actually does matter, the government faces a difficult challenge in policing it: many trading strategies can run on “autopilot” once they have been developed. indeed, a trading strategy often can be distilled into an algorithm that is shared with the bank–a step that the government could not easily monitor. in any event, we do not seek to analyze these issues here. the significance of investor control–and its application to derivatives based on pass-through entities or managed accounts–are beyond this article’s scope. instead, our focus is on economic similarity and how to measure it. vii. basket options and the gwa litigation this part applies our difference-value approach to a type of hedge fund derivative, known as a basket option, which is the subject of a multi-billion dollar litigation, gwa, llc v. commissioner. after describing the planning strategy in this case, this part explains why section 1260 does not reach it (at least until treasury promulgates regulations), and then turns to a key issue, which looms large both in the case and in any regulations the treasury ultimately adopts: how does the economic return on the derivative compare with the return on the underlying? we flag problems in analyzing this issue with the spread, delta, and mckelvey tests, and show that our difference-value test avoids these problems, offering a more nuanced and robust analysis of the issue. a. basket options: a potential end run around section 1260 like the first generation of hedge fund derivatives described above–forward contracts to buy a fund interest166–basket options are supposed to avoid the tax cost 164 see webber v. comm’r, 144 t.c. 324 (2015); steven horowitz et al., the tangled web: substance vs. form, webber, and the revenge of the investor control doctrine, 34 j. tax’n inv. 19 (2017) 165 for an insightful discussion, see generally alex raskolnikov, contextual analysis of tax ownership, 85 b.u. l. rev. 431 (2005). 166 see supra part ii.a. columbia journal of tax law [vol 15:1 56 of frequent trading.167 after describing basket options, this section surveys issues they raise under section 1260, as well as under tax rules governing ownership. 1. differences from earlier hedge fund derivatives compared with earlier hedge fund derivatives, basket options are different in two ways. first, this trading is outsourced to derivatives dealers. using the hedge fund’s trading strategy, dealers manage a portfolio (or “basket”) of securities and grant an option to buy this basket to the hedge fund (or a potential investor in the fund).168 second, this option (supposedly) offers some protection from risk of loss in the basket, and thus (arguably) does not track it as perfectly as a forward contract.169 in 2014, a senate committee blew the whistle on basket options, claiming that they were avoiding billions of dollars in tax.170 the treasury followed up with a pair of notices, deeming basket options a “tax avoidance transaction” and requiring special disclosure about them.171 the government also challenged basket options on audit. one hedge fund, renaissance technologies, llc, reportedly settled by paying about $7 billion, which is one of the largest tax settlements in history.172 2. gwa contract meanwhile, another hedge fund, george weiss associates (“gwa”), opted to litigate the issue. the trial was held in september 2022 and, as of this writing, the judge has not yet issued a decision. 167 u.s. s. permanent subcomm. on investigation, abuse of structured financial products: misusing basket options to avoid taxes and leverage limits 1 (2014) https://www.hsgac.senate.gov/wp-content/uploads/imo/media/doc/reportabuse%20of%20structured%20financial%20products%20(basket%20options)%20(7-2214,%20updated%209-30-14).pdf [https://perma.cc/3wk4-p6bu] (“the resulting short-term profits were frequently cast as long-term capital gains”). 168 see i.r.s. notice 2015-73, 2015-46 i.r.b. 660 (noting that taxpayers “either determine the assets that comprise the reference basket or design or select a trading algorithm that determines the assets” and have the right to make (nonbinding) suggestions that the dealer generally accepts). 169 see id. (“in some cases, taxpayers are also mischaracterizing a transaction as an option to avoid application of § 1260.”). as discussed further below, the option terminates when the portfolio declines below a specified level, which is above the price the holder is entitled to pay for the underlying (the “strike price”). this feature generally causes the option to function more like a forward contract. yet this instrument does differ from a forward contract when the price declines very rapidly. in this scenario, some risk of loss can be shifted to the counterparty on the option, as noted below. see infra part vii.c.4. 170 see u.s. s. permanent subcomm. on investigation, supra note 167 (noting that strategy had been “used by at least 13 hedge funds to conduct over $100 billion in securities trades”). 171 see i.r.s. notice 2015-73, 2015-46 i.r.b. 660 (deeming basket options in effect on or after january 1, 2011 to be “listed” transactions beginning on october 21, 2015); i.r.s. notice 2015-74, 2015-46 i.r.b. 663 (deeming basket options entered into on or after november 2, 2006 and still in effect on jan. 1, 2011 to be “transactions of interest”). these two notices revoked notice 2015-47 and notice 2015-48. the later notices were similar to the earlier ones, with the difference that the later ones provided more detailed descriptions of the transactions in question to avoid overbreadth. 172 manojna maddipatla et al., renaissance executives agree to pay around $7 bln to settle tax dispute with irs, reuters (sept. 2, 2021), https://www.reuters.com/business/finance/renaissanceexecutives-pay-about-7-bln-settle-tax-probe-wsj-2021-09-02/ [https://perma.cc/8sel-rpkw]. about:blank about:blank 2024] transaction-specific tax reform in three steps 57 in this case, deutsche bank (“the bank”) managed a portfolio, which it finetuned with constant trading (“the underlying portfolio” or “the underlying”).173 gwa entered into a derivative contract with the bank (“the gwa contract” or “the contract”), which was based on the value of this portfolio. this subsection gives a somewhat high-level overview of the contract.174 gwa paid a cash premium of $10 to the bank for this contract, which was documented as a call option with a stated term of 12 years. it entitled gwa to pay $90 for a portfolio that was then worth $100. in other words, this option was somewhat in-the-money. if this were the entire story, the contract would have offered all the opportunity for gain in the managed portfolio and provided protection against losses below $90. yet unlike a conventional call option, the contract had two additional features that arguably rendered it a “forward contract in disguise.” first, the contract would terminate (or “knock out”) if the portfolio’s value declined below a preset expiration price (“ep”) of $97–that is, $3 (or 3%) below the portfolio’s initial value. second, gwa had the right to keep the contract from terminating by putting up more money and thereby lowering the knock-out threshold.175 for example, if gwa invested another $3, the ep declined from $97 to $94. if the portfolio kept declining and reached $94, gwa could put in another $3 to reduce the ep to $91, and so on. these cash infusions were tracked in a premium account, which started at $10 (reflecting gwa’s up-front premium) and increased by any amounts gwa invested to “buy down” the ep.176 if gwa allowed the contract to terminate, the bank would keep a portion of the premium account to cover declines in the value of the portfolio, and gwa would get the rest. for example, if the portfolio declined 173 the account is managed based on a specified investment strategy. as a result, the case presents investor control issues, such as those discussed in part vi.c.3. but the analysis here focuses instead on economic return. 174 two caveats are in order here. first, in order to simplify our calculations and to be consistent with our prior examples, we assume that the investment strategy for the underlying of the gwa contract follows a lognormal process, even though this is not necessarily the best model for hedge fund returns (which are often understood to be relatively stable, except for occasional large downward deviations). second, to keep the analysis tractable and the exposition clear, we oversimplify the transaction at some points. in addition, we do not have access to the full range of relevant evidence, including the trial testimony. rather, our source is the contract itself, which is described in joint trial exhibit 23-j. no. 6981-19 (u.s.t.c. filed nov. 20, 2020). as a result, our analysis is intended to be suggestive, not definitive. 175 in the actual contract, 97 is the initial “expiration notice price level” rather than the “expiration price.” when this level is reached, there is generally an opportunity for the seller to provide notice to the buyer and for the buyer to buy down the knock-out level, as described in the text. such a buydown must occur quickly upon notice, generally within a few hours. the initial “expiration price” in the contract is 94. if this level is reached before a buy-down has occurred, or before notice can be given, the contract ends. for simplicity of exposition, we treat 97 as the knock-out level, subject to the opportunity for the buyer to pay an additional buy-down amount, and we refer to this as the “expiration price.” 176 the premium account also was reduced by an amortized premium amount of 0.1 for every year during the term of the contract, reflecting a permanent payment from the investor to the bank, and a total payment of 1.2 over the course of the 12-year term. for the sake of simplicity, we do not include this feature. columbia journal of tax law [vol 15:1 58 to $97 and gwa chose to terminate the option, bank would take $3 from the premium account (to cover the portfolio’s decline from $100 to $97), leaving gwa with the remaining $7. in effect, gwa would absorb the $3 loss. because of these contingencies, gwa’s contract arguably was less like a call option than a margin account or a forward contract. the contract did not insulate gwa from risk of loss as the portfolio’s value declined, as long as gwa exercised its buy-down rights. if gwa actually desired full exposure to the underlying, it could get it by simply continuing to cover these losses. this risk of loss usually arises–not in a call option–but in a forward contract or an investment in the underlying. a key question, then, is whether gwa regularly used the buy-down feature to keep the contract from terminating. on the one hand, if the answer was “yes,” the contract was a close substitute for the underlying, as noted above. on the other hand, if the answer was “no,” the contract was less like the underlying: gwa had opportunity for gain–as long as the contract didn’t “knock out”–but gwa did not have risk of loss below $90 (since the contract would terminate at $97).177 3. planning around section 1260 even though gwa’s contract had a lot in common with the hedge fund derivatives covered under section 1260, there was an important difference: the contract was based on the value–not of a hedge fund–but of a managed account. as a result, it fell outside the language of section 1260, which applies only to derivatives based on the value of “any equity interest in any pass-thru entity.”178 in gwa’s transaction, there was no “pass-thru entity.” this is not to say that derivatives on managed accounts are “in the clear.” section 1260 gave treasury regulatory authority to cover them, although no regulations have been issued yet.179 even so, treasury has used notices to deter these transactions, as noted above.180 when treasury ultimately does write regulations, a basket option presumably will be covered only if it conveys substantially all of the risk of loss and opportunity for gain in the basket. in other words, the answer will turn on a comparison, and this part shows how it should be done. 4. economic similarity and general principles the same comparison also is relevant in the gwa litigation. even if the government cannot invoke section 1260, it can rely on general principles to claim that gwa–not the dealer–was the real owner of the portfolio. if the court agrees, gwa would be taxed on (short-term) gains from the underlying portfolio, instead of on (long-term) gain from the basket option. 177 as a middle ground, if buy-downs will only be used to a point, then a more complex analysis is needed to address how the contingencies will be resolved in various situations. 178 i.r.c. § 1260(c)(1)(a). 179 specifically, this authority covers derivatives based on common stock and debt securities. see i.r.c. § 1260(c)(1)(b) & (d)(1)(d). presumably, this authority extends to managed accounts comprised of these investments. an interesting question is whether it extends to accounts with other assets, such as commodities and cryptocurrency. if not, could taxpayers avoid the rule by including these other assets in the portfolio? how much must they include? 180 i.r.s. notice 2015-73, 2015-46 i.r.b. 660; i.r.s. notice 2015-74, 2015-46 i.r.b. 663. 2024] transaction-specific tax reform in three steps 59 in this analysis, the key question is, once again, how similar the gwa contract was to the underlying portfolio. if these two investments offered essentially the same economic return,181 a court is likely to disregard the contract and treat the underlying portfolio as owned by gwa, not the bank. but if the contract is meaningfully different–and thus has economic substance and a business purpose–a court is likely to respect the transaction’s form, taxing gwa on the contract instead of on the underlying portfolio.182 in short, this case turns to a significant extent on how similar these two positions were. this brings us back to the main issue in this part: how should the tax law assess the similarity of these two positions? should it use the spread, delta, mckelvey, or difference-value test? let’s consider each alternative in turn. b. inadequacy of other tests this section applies the spread, delta, and mckelvey tests to the gwa contract. unfortunately, none of them are well suited to analyzing this planning strategy. 1. spread test although the spread test has the virtue of simplicity, it is a poor fit for the gwa contract. in form, this contract is an option to buy an underlying for less than its current price (i.e., an “in-the-money” call). in this way, the contract resembles our recurring example of an option to pay $70 for an asset worth $100. like that option, the gwa contract fails the spread test by tracking the underlying too closely at the underlying’s current price: in other words, the spread of omitted exposure ($0 to $90) doesn’t include $100.183 perhaps failing the spread test, and hence treating the gwa contract like actual ownership, is the correct result. or perhaps it is not. it is hard to know because the spread test ignores important factors such as the volatility of underlying and the term of the option, as discussed above.184 in principle, a modified spread test could measure the discount on the option (i.e., how in-the-money it is), as noted above.185 the gwa contract purports to offer only a 10% discount (i.e., charging $90 for something worth $100), which is less than the 30% discount in our recurring example (i.e., charging only $70). this implies that the gwa option is less like the underlying. but once again, the spread test ignores important information about the contract: the “knock out” and “buy-down” features. these contingencies arguably 181 in arguing that gwa is the true owner, the government can try to offer evidence that gwa, not bank, is deciding how to invest the underlying portfolio. as noted above, this “investor control” analysis is not our focus here. see supra part vi.c.3. 182 along with showing differences in risk of loss an opportunity for gain, gwa can also claim that the contract was more leveraged than the underlying portfolio. arguably, a business purpose for using it was to circumvent regulatory limits on leverage. cf. u.s. s. permanent subcomm. on investigation, supra note 167 (criticizing use of basket options to evade limits on leverage). 183 see supra part vi.b.1. 184 see supra part vi.b.1. as proposed by the nysba, the spread test would have rejected the gwa contract for another reason as well: it’s unusually long term of twelve years. nysba, rep. #901, supra note 89, at 28. 185 see id. columbia journal of tax law [vol 15:1 60 make the gwa contract a closer substitute for the underlying, as explained above.186 admittedly, the test can be modified to consider more variables, but this may well defeat its purpose, which is to keep things simple. 2. delta test while a more sophisticated test is needed, the delta test may not be up to the job either. to be fair, the test works well with a simple in-the-money call, which doesn’t have contingencies like knock-outs and buy-downs. unlike the spread test, the delta test can account for a “plain vanilla” option’s volatility and term, as explained above.187 to see this, imagine that the gwa contract was just a simple call option, with no fancy contingencies, entitling gwa to pay $90 for an underlying that initially was worth $100: in other words, a call that was 10% in-the-money. this option would give essentially the same economic return as the underlying as long as underlying’s price did not decline by more than 10%. the delta test is effective in gauging the significance of this difference. as table 6 shows, delta is a bit higher with a 60% volatility than a 20% volatility.188 volatility 20% 60% delta 0.914 0.916 table 6: delta of gwa contract without contingencies in addition, an underlying currently worth $100 is less likely to end up below $90 as the years go by. this scenario becomes less likely with the passage of time (if only because the risk-free rate is positive, so assets generally should appreciate by at least that rate on average). as a result, options that are 10% in the money become a closer substitute for the underlying as their terms get longer. perhaps this is the reason why the gwa contract has the unusually long term of twelve years. once again, the delta test is sensitive to this difference. as table 7 shows, delta is higher for a 12-year option than for a one-year option. option term vol=20% vol=60% 12 years 0.914 0.916 1 year 0.810 0.712 table 7: delta of gwa contract without contingencies: 12-year versus 1-year term 186 see supra part vii.a.2. 187 see supra part vi.b.2. 188 as with our earlier examples, we use the black-scholes pricing model with a risk-free rate of 5% and a term of 12 years. 2024] transaction-specific tax reform in three steps 61 but although the delta test is reliable for these simple options, it misfires badly once contingencies are introduced, as explained above.189 this potential for manipulation is on full display in the gwa contract. to highlight this problem, let’s add the knock-in feature to our in-themoney option, so it terminates if underlying’s price falls below $97. let’s also assume that there’s no buy-down. in other words, gwa won’t make an additional investment to save the option. (this assumption is critical, as we discuss below.) on these assumptions, the delta test produces a crazy result: a delta greater than one. as the price of underlying declines by a dollar from $100 to $99, the contract’s value declines by more than a dollar: volatility 20% 60% delta of knock-out call 2.42 1.24 table 8: delta of gwa contract with knock-out (assuming no buy-down)190 this result is truly bizarre. after all, the contract will never–indeed, it can never–pay more than the value of the underlying. thus, the high delta value is hardly a prediction of a potential payoff. instead, it is just the product of the weird interaction between small price changes, on the one hand, and the knock-out condition, on the other. specifically, a decline from $100 down to $97 has only modest implications for the underlying portfolio, but major–potentially fatal–implications for the knock-out call. so if the underlying’s value drops from $100 to $99, the derivative’s value will decline by more than a dollar–because, again, it’s coming dangerously close to being terminated. as a result, since a decline of a dollar in the underlying leads to a decline of more than a dollar in derivative, delta is greater than 1. there are other wacky effects as well, which derive from other aspects of the gwa contract. for example, the contract includes an implicit loan from the bank to gwa (in sparing gwa from paying the full price of underlying up front). while a simple loan ordinarily would not affect delta–since the interest and principal payments do not change with underlying’s price–this loan is different: the timing of gwa’s payments do, in fact, depend in part on the underlying’s price.191 as a result, these payments have a delta of their own. as the appendix 189 see supra part vi.b.3. 190 this table reflects the delta of the knock-out call, but the contract actually has a second component: the $7 payment the holder receives when the option is terminated (i.e., from their premium account). as appendix a shows, accounting for this component reduces delta, but not by very much. appendix a also analyzes additional interest payments due under the contract. as appendix a shows, the timing of these payments depends on the underlying price. as a result, these payments have a delta of their own, which helps offset the overly-large delta caused by the contingency. 191 for instance, declines in the price cause gwa to get a portion of their premium account back (if the contract terminates) or to pay additional amounts to buy-down the expiration price. columbia journal of tax law [vol 15:1 62 shows, the delta of these payments can offset the unexpectedly large delta caused by the contingency.192 but these “adventures in delta” arguably are not a persuasive analysis of the gwa contract, at least once the buy-down feature is taken into account. this right to save the option allows gwa to take on risk of loss below $90, as emphasized above.193 so if the delta test worked as it should, it would find a closer correlation between the gwa contract and the underlying portfolio. delta should be much closer to 1.0.194 to sum up, although the delta test is effective for simple instruments, it can make a real hash of more complicated ones, especially when contingencies are involved. for example, it is confounded by the knock-out call option and yields delta values much greater than 1.0. there are ways for the delta test to get to the right answer–for instance, by simply assuming a buy-down and thus ignoring the knock-out195–but this requires a more nuanced analysis, which taxpayers may not be motivated to provide. after all, if their goal is to justify their tax planning, they may well want a misleading result, and the delta test gives them discretion to engineer it (or, at least, the illusion of it). 3. mckelvey test so far, we have shown that the spread and delta tests are not reliable ways to analyze the gwa contract. unfortunately, the mckelvey test is no better. while this test focuses on probabilities, as explained above,196 the right way to apply it to the gwa contract is not obvious. after all, the context is different. mckelvey was about a specific issue–the number of shares to be delivered–that does not really arise in gwa.197 by analogy, perhaps the right question is the probability that the gwa contract will diverge from the underlying. since this happens when the underlying’s value falls below $97, this test can ask, “how likely is underlying’s 192 if the interest payments on the loan were unrelated to the performance of the underlying, then the loan would be irrelevant and the problems with the delta would remain unchanged. 193 see supra part vii.a.2. 194 just how close it gets depends in part on how precisely the contract accounts for the time value of various payments, including the deposit returned to gwa and the payment of the exercise price to the bank. for a discussion, see infra appendix a. indeed, once these (and other) factors are taken into account, if the bank receives ongoing compensation at the risk-free rate for the outstanding balance on its implicit loan to the taxpayer, then there is in fact a delta of 1.0. this type of compensation is arguably present in the gwa contract, although it is not part of a knock-out call option in isolation. for further discussion, see infra appendix a. 195 another way to do this is to account in a more precise way for other time-value-related components of the contract. see infra appendix a. 196 see supra part vi.b.4. 197 if we get creative, we can try to characterize the issue in gwa as the number of units, but this analysis is forced. the argument would be that the knock-out produces a fixed number of units: gwa gets $7 of its deposit back, and (in a sense) this represents 7/97 (or .072) of a unit of the underlying portfolio. since the probability of a knock-out is high, as noted below, the test can find a high probability of producing a fixed amount (i.e., $7 worth of the underlying). but the real issue in gwa isn’t how likely the gwa contract is to yield a fixed amount, but how likely it is to diverge from the underlying. 2024] transaction-specific tax reform in three steps 63 value to decline below $97?” as table 9 shows, the risk-neutral probability of that outcome is extremely high: volatility 20% 60% probability 0.9389 0.9961 table 9: risk-neutral probability of knock-out applied in this way, the mckelvey test finds that the gwa contract is quite likely to diverge from the underlying. but this isn’t necessarily right. like the delta test, this analysis fails to account for buy-downs. if gwa responds by investing more money each time the threshold is triggered, there actually isn’t much difference in economic return. in short, mckelvey also doesn’t provide the precision we need. c. difference-value test in contrast, our difference-value test is better at capturing the real economics of the gwa contract. our approach is harder to manipulate with contingencies, as noted above,198 because it reflects the range of potential outcomes in a more thorough and practical way. this section applies our difference-value test to the gwa contract and responds to potential concerns about this approach. 1. defining the benchmark: similar to what? in comparing the gwa contract with the underlying portfolio, the first step is to define the scope of the two transactions. again, what is being compared to what? to compare “apples to apples,” we make two assumptions. first, like most derivatives, the gwa contract is more leveraged than the underlying. gwa can bet on underlying without paying the $90 exercise up front. yet a difference in leverage generally should not avoid constructive ownership because the statute focuses–not on leverage–but on opportunity for gain and risk of loss, and rightly so.199 to conform the leverage of the gwa contract and underlying portfolio, we assume the underlying was purchased with $90 of borrowed money.200 second, just as the derivative and underlying should have the same leverage, they also should end at the same time. as a matter of form, this is not the case. on the one hand, there is no time limit on owning the underlying portfolio. on the other hand, the gwa option has a fixed term (12 years) and can terminate earlier if the price falls below $97 (unless the investor pays to avoid this knock out). so to compare “apples to apples,” we assume that our benchmark–an investment in the underlying–would be sold whenever the gwa contract terminates (whether at maturity or after a “knock out”). 198 see supra part vi.c.2. 199 see supra part vi.c.1; supra note 154. 200 we assume that any loans in the gwa contract and the underlying bear interest at a market rate, such as the risk-free rate, and are unrelated to the performance of the underlying. if these interest payments match, our analysis can ignore them. see infra appendix a. columbia journal of tax law [vol 15:1 64 in our view, this assumption is justified for three reasons. first, the investment in underlying is hypothetical–after all, gwa is investing in the contract, not the underlying–so an assumption of some sort is needed. second, if we assume this hypothetical investment would have been either shorter or longer, we would have to make other (potentially messy) assumptions, for instance, about how gwa invests its proceeds when the contract terminates (e.g., which investment, for how long, etc.). third, the assumption that the term is the same is especially plausible because of the contract’s “buy down” feature: gwa has discretion to continue the contract, just as it would have had discretion to continue a direct investment in underlying. presumably, gwa would have made the same choice either way about how long to invest.201 2. comparing values: gwa and the (properly delineated) underlying now that we have defined the relevant transactions, what is the difference in their values? like with the delta test, let’s start by imagining that the gwa contract was just a simple call option with no contingencies. again, by allowing gwa to buy an underlying currently worth $100 for only $90, this contract gives essentially the same economic return as the underlying, as long as underlying’s price does not decline by more than 10%. how meaningful is this difference? under our difference-value approach, the first step is to define the difference contract, as explained above.202 to fill in the missing exposure, gwa would have to take on risk of loss below $90: in other words, gwa would have to sell a put option with an exercise price of $90. like the gwa contract, this put would have a twelve-year term. the second step in our methodology is to value this put option.203 like the delta test, our methodology is sensitive to the underlying’s volatility. as table 10 shows, the put is much more valuable–so the contract is more different from the underlying– when the underlying is volatile: volatility 20% 60% value of difference contract 3.77 29.04 table 10: value of difference contract without contingencies like the delta test, the difference-value test also is sensitive to the term of the contract. as table 11 shows, a longer duration makes the difference contract more valuable. 201 admittedly, the contract has a twelve-year term, while a direct investment would not. but the parties presumably could extend the contract and, even if they didn’t, twelve years is a long time. 202 see supra part vi.a.3. 203 see supra part vi.a.4. 2024] transaction-specific tax reform in three steps 65 option term vol=20% vol=60% 1 year 2.31 15.40 12 years 3.77 29.04 table 11: value of difference contract without contingencies: 12-year versus 1-year term the third step is to calculate the difference percentage.204 for a twelve-year option, it is large (29.04%) if the underlying’s volatility is 60%, but modest (3.77%) if the volatility is 20%. this makes intuitive sense. retaining exposure to declines beyond 10% is more meaningful if sharp declines in the underlying’s price are more likely. in other words, it matters whether the underlying portfolio focuses on tech startups or regulated industries. so the contract is more similar–and thus should be more likely to trigger constructive ownership–with a low volatility underlying. but this calculation is still incomplete because it does not account for the knock-out contingency. after all, the gwa contract is not really a simple call option that is 10% in the money (i.e., with a $90 exercise price when underlying is worth $100). rather, it terminates when the price of underlying declines below $97. this means gwa is protected from risk of loss below $90–not necessarily for the full twelve years–but only as long as underlying’s price does not fall below $97. let’s pause and consider the economic significance of this protection–or, really, its insignificance. if you were gwa’s risk-management officer, you might initially be pleased to know that you were protected from risk of loss below $90. that sounds good, right? but once you hear that this protection (and, indeed, the whole deal) goes away when the price hits $97, you would likely ask, “wait, this protection can never actually help us, right? after all, in order for us to need protection below $90, the value of underlying has to fall below $97, right? so doesn’t this protection terminate before we ever actually need it?” the answer is “yes” to all three questions. in other words, this protection is virtually always meaningless.205 so, returning to our difference value method, the first step is to identify a contract that would nullify this protection–and, thus, put gwa in the same position as if it was investing directly in underlying.206 like in the noncontingent case, gwa needs to sell a put with an exercise price of $90. but here, there is a contingency: this put “knocks-out” when the price falls below $97. the second step is to value this knock-out put.207 the answer, of course, is that this put has essentially no value. this is the answer whether the volatility is 60 204 see supra part vi.a.5. 205 a remote scenario in which it might actually matter, which we call “slippage,” is discussed below. 206 see supra part vi.a.3. 207 see supra part vi.a.4. columbia journal of tax law [vol 15:1 66 or 20 and, indeed, whether the term is twelve years or one year. this result should be clear not only from a black scholes analysis, but also from intuition: as noted above, protection below $90 is useless if this protection (and the investment being protected) terminates when the price falls below $97. as a result, the third step–the difference percentage–is also zero.208 in other words, compared with the spread, delta, and mckelvey tests, our difference value method is more effective in grappling with contingencies. unlike these other tests, it gives the right answer for the contingent gwa call: the contract is likely to be a close substitute for the underlying. but is our approach really better? or are we just using better assumptions? or–even worse–are we assuming they are similar, and then letting this assumption dictate the result? the rest of this subsection considers these questions, focusing on two assumptions: first, gwa does not “buy down” the contract; and second, the underlying and contract can be liquidated for the same value. 3. first assumption: no buy-down our analysis assumes that gwa does not use its “buy-down” right (i.e., to keep the contract from terminating). instead, we assume that the deal (and the downside protection) terminates when the underlying’s price falls to $97, as noted above.209 this assumption about buy downs is critical, even dispositive, in the delta test: the more buy downs we assume, the closer delta gets to one, as noted above.210 after all, if gwa always has to buy down the contract, however low underlying’s price goes, gwa bears essentially all the risk of loss. this makes the gwa contract more like a forward contract than an option, as noted above.211 however, this assumption does not loom as large in the difference-value test. in our proposal, the key assumption is not whether this contract will be extended, but whether it has the same duration as underlying. as long as these investments end at the same time–whether both are bought down or neither are bought down–there is an exact match under our methodology. put another way, once we assume that the underlying and gwa contract always end at the same time–an assumption we defend earlier212–we don’t need to know why they end or, for that matter, whether a buy-down has delayed this end. 4. second assumption: no “slippage” finally, along with assumptions about why these investments end, an assumption is needed about what happens when they end. does gwa get a different result by investing in the contract, instead of in the underlying portfolio? specifically, does the contract provide any protection from losses? the general answer is “no,” as noted above, since protection below $90 is supposed to terminate when underlying’s price falls to $97.213 208 see supra part vi.a.5. 209 see supra part vii.a.2 210 see supra part vii.b.2. delta also can be influenced in various ways by time value. for a discussion, see infra appendix a. 211 see supra part vii.a.2. 212 see supra part vii.c.1. 213 see supra part vii.c.2. 2024] transaction-specific tax reform in three steps 67 but although this protection usually terminates, it does not always. there is a scenario–admittedly, an unlikely one–when this protection turns out to be helpful: a market crash or other disruption that makes it hard to liquidate the underlying portfolio, so gwa doesn’t get the price it wants. as an example of this problem, which we call “slippage,” imagine that gwa wants to terminate its investment when the underlying portfolio’s value falls to $97, but the relevant sale is implemented too slowly, so it yields only $85, instead of $97. who bears this $12 of loss? actually, gwa bears less of it with the gwa contract than with a direct investment. on the one hand, if gwa makes this investment through the contract, the loss from $90 to $85 is borne by the bank, not gwa. on the other hand, if gwa buys the underlying instead, then gwa–not the bank–bears this $5 of loss. so even though the contract usually does not provide meaningful protection below $90, it actually does in this rare situation. a key issue, then, is the value of this protection. the good news is that our difference-value test is better than the other tests at valuing it. indeed, valuing this sort of difference is exactly what our test is designed to do. to measure the cost of this slippage, we can value the right to sell for $90 when an asset is trading at $97. in other words, to value the risk of loss below $90, which the contract shifts to the bank, we can use the value of an out-of-the-money put option, whose exercise price is $90 when the underlying price is $97. the term of this put option is the time it might take to liquidate the underlying. ordinarily, this would take minutes or even seconds. but during a market disruption, this process can take longer, so we consider 1-day and 5-day periods. as table 12 shows, the value of this protection is quite low: volatility 20% 60% no slippage 0.00% 0.00% 1-day slippage 0.00% 0.31% 5-day slippage 0.03% 7.87% table 12: cost of slippage to bank214 not surprisingly, the cost of slippage increases with volatility, as well as with the time needed to liquidate the underlying portfolio. but it generally won’t be an issue, except in extreme situations like the so-called quant meltdowns in august 2007 and march 2020.215 as a result, the gwa contract usually is still a 214 we express the prices in this table as percentages of the initial taxpayer capital investment of 10. this corresponds to a choice of underlying equal to an investment of 10 by the taxpayer, with debt financing of 90, to fund overall investments with a cost of 100. if we instead chose the overall investment as underlying, dividing by 100 rather than 10 would be appropriate, and the percentages would accordingly be one-tenth of the values reported in the table. 215 to value execution risk in extreme conditions, the simple lognormal model used here is not the best fit. instead, the better choice would be a more sophisticated model that accounts for the trading strategy used in the underlying. columbia journal of tax law [vol 15:1 68 close substitute for the underlying. more importantly, the difference-value test is the most effective way to measure how close a substitute it actually is. viii. conclusion to sum up, the tax treatment of investments is riddled with inconsistencies, but congress has little appetite for ambitious reforms, at least for now. instead, congress regularly targets specific planning strategies, such as hedge fund derivatives. to make this sort of transaction-specific reform more effective, this article recommends a three-step process. first, policymakers should ask whether a response is really necessary. for example, section 1260 defends a questionable policy: rewarding taxpayers not just for investing, but for sticking with a specific investment. arguably, instead of policing this holding period rule, congress should liberalize it, as discussed above.216 yet if policymakers still want to defend this line (e.g., to avoid a tax cut for wealthy people), they need to steer clear of “good” transactions (e.g., hedges of business risks, call options on growth stocks, etc.). this brings us to the second step: preliminary filters should screen out transactions that do not pose the relevant abuse. for example, filters should exempt taxpayers with income and assets below a specified level, common business transactions that are not tax motivated, and the like. with the right preliminary filters, the third step–a sophisticated test–applies more narrowly, and thus is less burdensome to administer. for section 1260, we recommend a “difference-value” test, which compares the value of exposure omitted from a hedge fund derivative to the total value of the underlying fund interest. we show why this approach is better than a simple “spread test,” as well as tests based on delta and probability. we also offer novel insights about delta tests, showing how they can be manipulated fairly easily with contingencies. more generally, we recommend tests that are precise and rigorous because they can provide greater certainty, while also limiting a taxpayer’s ability to use new variations of the targeted planning strategy. 216 see supra part iv.b.2. 2024] transaction-specific tax reform in three steps 69 ix. appendix a: delta and the timing of payments in the gwa contract as discussed in part vi, the gwa contract includes a knock-out call, as well as a buy-down option. unfortunately, the delta test does a poor job of dealing with contingencies in general, as noted above.217 as a result, this test is not effective in analyzing gwa’s knock-out call.218 again, the problem is that the delta test is overly focused on correlations at a moment in time. this appendix broadens the analysis to include two other features of the gwa contract: first, the bank’s implicit loan of $90 to gwa; and, second, gwa’s right to receive $7 of its deposit when the contract terminates. as it turns out, these features have a somewhat unexpected effect on delta. this appendix shows that if these components are precisely calibrated, they actually can bring delta close to 1.0. we show that the sum of the deltas of gwa and the bank in the various components of the contract is 1.0. this is not surprising. at the end of the day, the parties are jointly investing in one unit of underlying. through the contract, they divide the economic return between them, with some going to gwa and some staying with the bank. on net, the sum of this exposure should simply be the underlying–that is, delta 1. perhaps more surprisingly, we show that if the bank is compensated for the time-value of money with respect to its loan, the bank has a delta of 0. accordingly, gwa has a delta of 1.0 in this case. we show how multiple features of the contract combine to yield this result. this appendix begins by analyzing the contract from the perspective of the bank, and then turns to the perspective of gwa. as before, we base our analysis on limited information available from joint trial exhibit 23-j. no. 6981-19 (u.s.t.c. filed nov. 20, 2020). for the sake of simplicity, we also assume that the buy-down option is not used. a. the bank’s perspective let’s begin with the delta of the bank’s position. at first blush, it might seem as if the bank has no exposure to the underlying, so its delta on the contract should be zero. this makes sense if the bank is simply serving as an intermediary here, so that gwa–not the bank–is supposed to get the economics of investing in underlying. but this is not necessarily the case. the bank actually does have exposure to changes in underlying’s value, which comes through an implicit loan to gwa. specifically, the bank invests $90 up front (to buy underlying) and receives a final payment of $90 when the contract ends. since the bank receives this payment regardless of whether underlying appreciates or depreciates, the payment seems to have no connection to underlying. if this were true, it would have a delta of zero. but although the amount of this payment does not turn on underlying’s performance, the timing actually does. for instance, a decline below $97 could terminate the contract, and thus enable the bank to receive its $90 sooner. because of this linkage to the price of underlying, the bank’s claim to $90 has a negative 217 see supra part vi.b.3.c. 218 see supra part vii.b.2. columbia journal of tax law [vol 15:1 70 delta. notably, this effect arises if–and only if–the bank is not receiving a marketrate of interest on the implicit loan, an issue we address below. table a1 shows the components of delta from the bank’s point of view. volatility 20% 60% delta of $90 cash paid if and when knock-out occurs -2.22 -0.29 delta of $90 cash paid at termination if no knock-out occurs 0.97 0.06 total delta of $90 cash paid -1.25 -0.22 table a1: delta for bank with respect to $90 payment (assuming no buy-downs) there are two different effects here. first, as noted above, the bank gets its $90 back if the contract knocks out. this means that the bank does better as underlying’s price falls–so the delta of this feature is negative–because a decrease in underlying’s value increases the likelihood of a knock-out. in other words, the bank’s position improves as the underlying price falls. second, there is also a possibility that the contract never knocks out, so the bank receives $90 when the contract expires after twelve years. since increases in underlying’s price make this outcome more likely, this scenario has a positive delta, as the second line of the table shows. the bank’s overall delta is the net of these two effects. as table a1 shows, it is negative. this is surprising if one thinks that the bank does not want exposure to the underlying and seeks to act solely as an intermediary. despite this intention, it appears that the bank actually is betting against the performance of gwa’s investment strategy! the picture is not yet complete, however. the bank receives not only the promised payment of $90, but also interest on this money.219 these interest payments depend upon the outstanding loan balance, which in turn depends upon the performance of underlying. as a result, the interest payments also have a delta of their own, which is positive: if the underlying performs well–further deferring the $90 payment–the bank earns more interest. as a result, the interest payments increase with the performance of the underlying. calculating the precise delta of the interest payments is quite complicated. instead, we can take a short-cut: if we assume that the interest perfectly compensates for the time-value of money, then the delta of the interest payments must exactly offset the delta of the promised payment of $90. indeed, if the bank 219 see the definition of “basket base performance” on page 9 of joint exhibit 23-j, reducing performance by “interest expense at the specified rate plus the applicable spread … on the basket debit balance.” gwa v. comm’r, no. 6981-19 (u.s.t.c. filed nov. 20, 2020). the basket debit balance keeps track of the net amount owed to the bank. a similar interest adjustment is made in the other direction if there is a basket credit balance. 2024] transaction-specific tax reform in three steps 71 is perfectly compensated in this way, it no longer cares when the $90 is repaid. in this situation, described below in table a2, the delta of the interest perfectly offsets the delta of the $90 payment. volatility 20% 60% delta of $90 cash paid -1.25 -0.22 delta of interest payments 1.25 0.22 total delta of bank 0.00 0.00 table a2: delta for bank with respect to gwa contract including compensation for time-value of money (assuming no buy-downs) b. gwa’s perspective now that we have analyzed the bank’s exposure, let’s turn to gwa. in part vii, we focused on the knock-out call. to provide a fuller picture, we now include two other features: first, a knock-in “rebate”; and, second, the interest paid to the bank as compensation for the $90 loan. let’s begin with the knock-in rebate. when the call option knocks-out, gwa loses the call option but gets a portion of its “premium account” back. we call this payment of $7 a “knock-in rebate.” gwa receives it when the underlying price falls below $97.220 table a3 shows the delta values for the knock-out call and knock-in rebate. volatility 20% 60% delta of knock-out call 2.42 1.24 delta of $7 knock-in rebate -0.17 -0.02 delta of knock-out call and $7 knock-in rebate 2.25 1.22 table a3: delta for gwa of knock-out call and knock-in rebate (assuming no buy-downs) the delta values for the knock-out call are the same as in table 8. the delta of the knock-in rebate is calculated using our usual pricing model. this component of delta is negative because an increase in the value of the underlying delays payment of $7 to gwa, and there is no compensation for the time-value of money 220 the taxpayer also receives $7 as part of the value of the surviving call option if the barrier is never hit. we need not separately account for this – it is already incorporated into our analysis of the knock-out call from the main part of this article. columbia journal of tax law [vol 15:1 72 with respect to this delay. as the table indicates, the delta values for the knock-in rebate are modest, and the delta for the knock-out call and knock-in rebate combined remains greater than 1.00, just as was the case for the knock-out call in isolation. we can also add the interest that we discussed in part ix.a to our analysis. the bank receives its interest payments from gwa, and the two parties thus have opposite exposures with respect to the risks of these payments. we assume that the interest payment precisely compensates the bank for the time-value of money, as explained in part ix.a., and we use our prior calculations to determine the delta of interest for gwa. table a4 summarizes the deltas for the knock-out call, the knock-in rebate, and the interest, together with the overall effect of all three components. it is the same as table a3, except that it adds the interest component. the delta values for the interest paid to the bank are the negatives of the corresponding deltas for the bank in table a2. volatility 20% 60% delta of knock-out call 2.42 1.24 delta of $7 knock-in rebate -0.17 -0.02 delta of interest paid to bank -1.25 -0.22 total delta 1.00 1.00 table a4: delta for gwa with respect to gwa contract including knock-out call, rebate, and interest (assuming no buy-downs) notably, the net of all these effects is a delta of 1.0. the bottom line, then, is that the gwa contract can have a delta of 1.0 for two different reasons. first, as we discussed in part vii, this is true when the buy-down feature is used (assuming appropriate compensation for the time-value of money). second, this appendix has shown another circumstance in which delta is 1.0: the key is to account for all the features of the gwa account–that is, not just the knock-out call, but also the $7 knock-in rebate, and the interest to the bank. thus, although a knock-in call wreaks havoc with the delta test in the ways we have described, the gwa contract itself may not. the reason is that the gwa contract is not simply a knock-in call but has additional features that offset risk exposures from the knock-in feature, including both compensation to the bank for the time-value of money and the buy-down right. so in principle, the delta test can get the right answer, but only with a scrupulous accounting of all the components of the gwa contract. but again, a taxpayer who wants delta to be very different from 1.0–as a way to defend their tax planning strategy on audit–might instead focus only on the knock-out call, and thus generate a delta very different from 1.0. 2024] transaction-specific tax reform in three steps 73 x. appendix b: difference value and the timing of payments in the gwa contract as we have shown above, the delta test is easily confused by contingencies. in appendix a, we showed that there are other effects, aside from the skewed result for the knock-out call. when the contract’s other components are evaluated, their deltas can offset the distorted delta of the knock-out call. we have also shown that the difference-value test is more reliable than the delta test in evaluating contingencies. its analysis of the knock-out call is not skewed in the same way. but what about the other components of the contract? how, if at all, do they affect the difference-value analysis? the answer is “some, but not very much.” as this appendix shows, when the bank implicitly loans money to gwa, the implicit interest on this loan–and, in particular, the way this interest charge is structured and the assumptions we make about it–can have modest effects on the difference value. but even without accounting for these effects, the difference-value test is still pretty reliable. to show that this is the case, we need to identify and value the implicit interest. to do so, we consider the deal first from the bank’s perspective, and then from gwa’s perspective. we then analyze the effect of this interest, showing how its structure can have a modest impact on the difference value. a. the bank’s perspective as discussed in part vii.a, the bank gets $90 of capital back when the contract either terminates early or matures after twelve years. how much interest does the contract implicitly provide to the bank for committing this capital? to get the answer, we need to start by calculating the initial value of this $90 payment in each of the relevant scenarios–that is, when there is a knock-out and when there is not. table b1 shows the price of each possibility, and then adds them together to compute the overall price. volatility 20% 60% price of right to $90 cash payment if and when knock-out occurs 82.98 89.13 price of $90 cash paid at termination if no knock-out occurs 3.02 0.19 price of guaranteed $90 payment 86.00 89.32 table b1: price for bank of guaranteed $90 payment (assuming no buy-downs) notably, the price of the guaranteed payment is less than $90. this is not surprising. after all, the right to receive $90 in the future, with no compensation for the time-value of money, is necessarily less than $90 today. the difference between this price and $90 is, of course, the implicit interest in the contract. if we columbia journal of tax law [vol 15:1 74 assume that this interest is sufficient to make the bank whole,221 we can infer that the interest is simply the difference between $90 and the total price in table b1. we calculate this amount and summarize the result in table b2. volatility 20% 60% price to bank of gwa contract 90.00 90.00 price of guaranteed $90 payment 86.00 89.32 price of interest payments 4.00 0.68 table b2: price for bank of gwa contract (assuming no buy-downs) b. gwa’s perspective are these estimates of the implicit interest correct? one way to check is to analyze the contract from gwa’s perspective. as noted above, the contract offers gwa two potentially valuable rights: first, a knock-out call; and, second, a knockin rebate (i.e., a payment of $7 when the contract terminates). what are these components worth? using our usual pricing model, table b3 values them: volatility 20% 60% price of knock-out call 7.55 3.75 price of knock-in $7 rebate 6.45 6.93 price of knock-out call and knock-in $7 rebate 14.00 10.68 table b3: price for gwa of knock-out call and knock-in rebate (assuming no buy-downs) notably, the total value of these two components is greater than $10 (whether the volatility is 20% or 60%). at first blush, this is odd. the problem is that gwa is paying only $10 to enter into the contract. so what accounts for the difference? the answer, of course, is the implicit interest gwa must pay the bank. table b4 adds this interest to the mix, using a negative number because–unlike the call and rebate–the interest is a liability to gwa, instead of an asset. in other words, gwa owes this interest to the bank. 221 we ignore any additional fees that may be paid to the bank above and beyond pure compensation for the time-value of money. 2024] transaction-specific tax reform in three steps 75 volatility 20% 60% price of knock-out call 7.55 3.75 price of knock-in $7 rebate 6.45 6.93 price of interest payments -4.00 -0.68 price to gwa of gwa contract222 10.00 10.00 table b4: price for gwa of components of gwa contract (assuming no buy-downs) as table b4 shows, once we account for the interest, the net value of the contract to gwa is, indeed, $10. in other words, the contract actually is worth what gwa pays for it. c. the difference contract now that we have calculated this imputed interest–$4 when the volatility is 20% and $.68 when the volatility is 60%--the question is: what effect, if any, does this interest have on the difference value. the answer is, “not much, but the precise answer depends on how the interest is structured.” since the effect is modest, the difference-value test generally should offer a reasonably accurate assessment even if we don’t account for this interest but, not surprisingly, the result is even more accurate if we do. specifically, what difference (if any) is there between the contract, on the one hand, and a leveraged investment in the underlying, on the other? if we ignore financing, the payoff from the knock-out call and the knock-in rebate give gwa the same result as it would get from owning the underlying and selling if and when the price reaches $97. the only difference is thus in the financing payments. when we incorporate the financing, the answer might not change at all–or it might change slightly–depending on how the interest on this leverage is structured. to show that this is the case, table b5 considers two scenarios. first, assume that when we compare the gwa contract with a leveraged investment in the underlying, we assume that the interest on the underlying’s financing must be paid up-front as a lump sum.223 in this scenario, the difference contract has a value equal to double this interest payment, as the first line of table b5 shows: notably, the difference contract includes the price of the interest twice– that is, once for the up-front payment (which appears in the investment in the underlying, but not in the contract), and again for the alternative that pays over time with the total amount depending upon the performance of the underlying (which appears in the contract, but not in the investment in the underlying). 222 the sum of the components shown may be slightly different from the total shown because of rounding errors. 223 in terms of our example, this would be an amount of $4.00 or $0.68, depending upon whether the underlying volatility is 20% or 60%. columbia journal of tax law [vol 15:1 76 second, assume instead that this difference between the financing arrangements is eliminated. in other words, the interest payment schedule is the same for both the underlying and the gwa contract. in this scenario, the absolute value of the difference contract would have price $0, as the second line of table b5 shows. this is because there is no difference between the two contracts. volatility 20% 60% price of difference contract if underlying comparison uses up-front lump sum payment of interest 8.00 1.36 price of difference contract if underlying comparison uses same interest schedule as contract 0.00 0.00 table b5: difference contract prices (assuming no buy-downs) the values in table b5 may be divided by the $100 price of the underlying to arrive at the corresponding difference percentages. the bottom line is that, as table b5 shows, variations in the structure of the financing can yield somewhat different results, but our difference method still treats the gwa contract as fairly similar to the underlying in either case. microsoft word ordower article formatted.docx uniform international tax collection and distribution for global development, a utopian beps alternative henry ordower* abstract under the guise of compelling multinational enterprises (mnes) to pay their fair share of income taxes, the oecd and other multinational agencies have introduced proposals to prevent mnes from eroding the income tax base of developed economies by continuing to shift income artificially to low or zero tax jurisdictions. some of the proposals have garnered substantial multinational support, including recent support from the new u.s. presidential administration for a global minimum tax. this article reviews many of those international proposals. the proposals tend to concentrate the incremental tax revenue from the prevention of base erosion into the treasuries of the developed economies although the minimum tax proposal known as globe encourages low tax countries to adopt the minimum rate. the likelihood that zero tax countries will transition successfully to imposing the minimum tax seems uncertain. developed economies lack a compelling moral claim to incremental revenue so this article argues that collecting a fair tax from mnes and other taxpayers should be a goal that is independent of claims on that revenue. this article maintains that to prevent tax base erosion, the income tax base and administration must be uniform across national borders and the article recommends applying uniform rules administered by an international taxing agency. the article explores the convergence of tax rules under such an international taxing agency. distribution of tax revenue by the international agency should follow contextualized need. in addressing the conundrum of absolute poverty in the undeveloped and developing world vis á vis relative poverty in the developed world, the article proposes that the taxing agency should distribute all incremental revenue from the uniform tax where the need is greatest to ameliorate absolute poverty and improve living standards without regard to income source. the location of income production, destination of the produced * saint louis university school of law. a.b. washington university; m.a., j.d. the university of chicago. i am grateful to hannah meehan (now, hannah hope), a 3rd year law student at saint louis university school of law, for outstanding research and facilitating the progress of this paper. thanks also to david kullman, a librarian and library liaison, and joel ocampo, a recent graduate from saint louis university school of law, for additional research assistance, and my spouse ilene ordower for her support and proofreading. special thanks to allison christians for her time in wading through an earlier draft of this paper to provide indispensable suggestions and to alexis brassey, my co-author on a related article, for his insights about relative and absolute poverty. thanks also to the attendees at the presentation of an earlier draft of this paper at the law and society 2020 virtual conference and to victor fleisher, victor thuronyi, and reuven avi-yonah for comments at the 2021 critical tax conference. finally, many thanks to the editors and staff of the columbia journal of tax law for their critical reading and commentary preparing this article for publication. 2021] uniform international tax collection and distribution 127 goods and services generating the income, and residence of the income producers should not determine the tax revenue distribution. rather, the use of contextualized need for distribution determination will enable developed economies to receive sufficient revenue to maintain their existing infrastructures and governmental services. developed economies should forego new revenue, for which they have not budgeted, in favor of improving worldwide living conditions for all. the proposals for uniform, worldwide taxation and revenue sharing based on contextualized need are admittedly aspirational and utopian but designed to encourage debate on sharing of resources in our increasingly globalized world. i. introduction .................................................................................................. 127 ii. contextualizing the global taxing problem ............................. 129 iii. regionalism and taxing jurisdictions ............................................. 137 iv. international tax competition and reallocating the tax base ...................................................................................................................... 145 a. beps and other projects .................................................................................. 145 b. globe – minimum tax and base erosion ....................................................... 148 c. tax competition, avoidance, and evasion ...................................................... 152 d. tax base allocation and apportionment ......................................................... 154 v. the relative and absolute poverty conundrum ...................... 157 vi. an international taxing agency for an economically globalized world: abandoning mythical tax sovereignty ................................................................................................................................. 161 vii. revenue shares .............................................................................................. 165 viii.conclusion ....................................................................................................... 170 i. introduction international tax reform projects, including the oecd1 base erosion and profit shifting (beps) iterations, seek to collect additional tax from multi-national enterprises (mnes) under the rubric of fairer taxation. the reform projects propose various methods of reallocating income that taxpayers have sourced to low and zero tax jurisdictions to affluent developed economies for those economies to tax under their own tax regimes. such reallocations would concentrate the bulk of incremental tax revenue into the treasuries of affluent developed economies. this article maintains that the need to prevent taxpayers from avoiding payment of a fair tax amount should not result in additional tax revenue primarily for the economically developed economies. arguments that the right to tax belongs to the developed economies are largely political, not moral. the arguments lack persuasive force in a world of unequal distribution of wealth and resources with which to generate wealth. fair tax collection should yield incremental revenue to eliminate poverty and improve living conditions for all people worldwide. current international tax reform projects fail to address world poverty adequately. the article proposes as an alternative to other international projects the creation of an international taxing agency to substitute for national taxing agencies worldwide. the 1 the organisation for economic co-operation and development (oecd) is a member organization with 37 developed countries as members. member countries, oecd, https://www.oecd .org/about/document/list-oecd-member-countries.htm [https://perma.cc/nhd4-a3bm] (last visited may 21, 2020). 128 columbia journal of tax law [vol. 12:126 international taxing agency would target elimination of world poverty. the new agency would have full authority to collect income taxes from entities and individuals under uniform international, rather than disparate national, taxing rules and procedures and to distribute the revenue worldwide. this international taxing agency would render obsolete most or all international tax reform projects and eliminate the need for most or all tax treaties and tax information exchange agreements. uniform rules and rates applicable to all income worldwide without regard to the source, residence, or market from or in which the income is produced will facilitate the collection of an aggregate worldwide tax greater in amount than that currently collected by all the fragmented, national tax collection. unlike existing national tax systems, such a tax, owing to its uniformity, would not favor some taxpayers over others. since the global tax will increase tax revenue collection materially, distribution initially might follow a two-step formula. the first step would hold each country harmless from tax revenue loss so that following transition to the global tax, each country receives a share of tax revenue equal to its revenue from income tax in the preceding year, or an average of several years’ collections, possibly adjusted for inflation, and enable each country to maintain its infraand superstructure. the second step would follow a needsbased assessment under which the nutrition, housing, education, healthcare and infrastructure needs of less developed countries would be evaluated and a plan developed to ameliorate deficits in all categories worldwide. the agency would distribute incremental tax revenue pursuant to that plan. the second step would devote incremental revenue to the gradual elimination of those deficits – perhaps addressing life-threatening deficits first, followed by improvement of living standards everywhere. tax revenue thus transferred to non-affluent, developing economies initially would be small relative to the amount of revenue distributed under the first step to enable developed economies to maintain their existing infraand superstructures, but poverty amelioration costs would be moderated as a function of relative local cost of goods and labor. nevertheless, the amount of tax revenue devoted to international poverty relief would be far greater than the minimal amounts developed economies currently contribute to world poverty eradication. the article proceeds as follows. part ii contextualizes the problem of base erosion against revenue collection and distribution and provides an overview of the international taxing issues that this article addresses. part iii considers a u.s. regional context as a microcosm in which multiple and often overlapping taxing jurisdictions compete for revenue and investment. some seek to capture additional revenue by annexing high tax yield property, and others with extra tax and, at times, predatory revenue collection. many exchange tax concessions for development and highlight the problems of tax competition and proliferating taxing jurisdictions even in the face of centralized tax collection. this part presents a relatively complex proxy for the revenue-raising problems confronting multiple taxing jurisdictions that fail to coordinate their efforts despite the umbrella of a larger governmental unit to which they belong. part iv reviews a variety of proposals and related commentary—beps, globe, ccctb—highlighting the difficulty of harmonization in the face of tax competition and relentless industry pressure for taxfavored treatment. part v introduces the factor of relative and absolute poverty and regional development needs that contribute to the proliferation of taxing concessions in exchange for international investment, even where the benefit from the inbound investment is compromised by the loss of potential tax revenue and the corrupt reallocation of the potential revenue into private hands. part vi envisions relinquishment of national tax sovereignty in favor of an international taxing agency with the power to assess and collect 2021] uniform international tax collection and distribution 129 tax at a uniform rate or rates under uniform international taxing rules without regard to source, residence, or sales. it would base the authority to tax on multiple independent factors so that virtually all income is included and taxed in the worldwide base the international agency administers. part vii recommends negotiation of revenue shares to dissuade regions from tax competition. it also suggests constructing a framework for formulaic revenue distribution based on relative economic need, including the maintenance of existing infrastructures. part viii concludes and acknowledges that the article’s proposals indeed are utopian and remain distant from capturing immediate, worldwide acceptance of an international taxing agency. nevertheless, the article’s proposals are intended to motivate further international conversation of the critical need for tax base convergence in support of uniform taxation—even if only a minimum tax—and provide a model for global distribution of incremental revenue from uniform taxation to ameliorate global economic needs rather than further enriching the world’s developed economies. ii. contextualizing the global taxing problem as corporations grew and increased their cross-border reach through the twentieth century, they adapted to doing business in multiple jurisdictions under a single enterprise umbrella. such mnes centralized their management, notwithstanding national borders. many were sufficiently flexible to disperse management functions by operation or geography to maximize profitability although all functions remained answerable to central management. 2 the mne’s international business models enabled them to situate operations where costs were lowest or regional features most favorable for specific business functions. mnes flexed their economic muscle to encourage robust, interjurisdictional, and international competition for their investment. from time to time, the competition became destructive to the host jurisdiction because the fervor to meet such competition sometimes caused the host jurisdiction to relinquish resources exceeding the benefits received from the investment. taxation became a mainstay of that competition. mnes demanded and received tax concessions from a jurisdiction before making or increasing their investments in the jurisdiction. governments have not been nearly so nimble in adjusting their tax systems to capture revenue from the mnes. neither have governments adopted a unified or harmonized approach to taxation, even though compromising their taxing sovereignty with harmonized tax rules and procedures might yield better tax revenue production. instead, tax competition has trended both on project-specific items as a substitute for direct subsidies and, on the broader scale, to encourage relocation of some or all of the mnes’ activities from higher tax jurisdictions to jurisdictions that would offer substantially lower or even zero tax rates in exchange for investment. and it is not only mnes to which nations have offered tax-based investment incentives. jurisdictions commonly offer 2 oecd, multinational enterprises in the global economy—heavily debated but hardly measured (may 2018), https://www.oecd.org/industry/ind/mnes-in-the-globaleconomy-policy-note.pdf [https://perma.cc/uc28-zqcg] (activities undertaken by foreign affiliated mnes grew by $13 trillion from 2000 to 2014); mark j. perry, many large us firms sell, hire, and invest more overseas than in us and have to think globally to survive, am. enter. inst. (june 22, 2020), https://www.aei.org/carpe-diem/many-large-us-firms-sell-hire-and-invest-more-overseasthan-in-the-us-and-have-to-think-globally-to-survive/ [https://perma.cc/y4bb-tlrf] (u.s. based companies in the world’s top 100 multinational companies have foreign assets accounting for 23.8% to 82.4% of their total assets, and foreign employment accounting for 23.8% to 87.9% of their total employment). 130 columbia journal of tax law [vol. 12:126 immigrant or resident visas to investors3 and have begun to include temporary tax holidays as additional immigration incentives.4 higher tax jurisdictions have not conceded their right to tax the mnes, but they have found resourceful tax planners and competitive taxing jurisdictions to be formidable foes. efforts to overcome tax competition and planning have enjoyed limited success. regarding the income tax, combatting tax planning and tax competition (with some exceptions)5 has been largely national. some tools that legislatures and tax administrators deploy to staunch loss of revenue from competition, such as general anti-avoidance rules, have been enacted into law in similar forms in numerous jurisdictions, 6 reflecting legislative willingness to borrow tax concepts from other jurisdictions and adapt them to address challenging problems.7 the oecd has assumed the lead in the international tax arena and, for the past several decades, has supplemented tax treaties8 with other multinational tools for tax collectors to share tax information in the form of similar, but more limited, international agreements.9 as in the case of treaties,10 exchange of information through tax agency cooperation may facilitate tax offender prosecution. more recently, the oecd introduced and developed several projects designed to identify and capture individuals’ and mnes’ income that they have assigned artificially to low tax jurisdictions.11 in one project, the oecd sought to coerce low tax jurisdictions to step back from encouraging taxpayers to move investment from high tax jurisdictions to low tax ones and to cooperate in exchanging tax information so that jurisdictions could tax their resident taxpayers on income received 3 see leila adim, between benefit and abuse: immigrant investment programs, 62 st. louis u. l.j. 121 (2017); allison christians, buying in: residence and citizenship by investment, 62 st. louis u. l.j. 51 (2017). 4 e.g., raul-angelo papotti & lorenzo ferro, italy’s attractive new tax regime for wealthy pensioners, 94 tax notes int'l 443 (apr. 29, 2019); marco q. rossi, italy’s special tax regime for high-net-worth individuals, three years in, 98 tax notes int'l 1145 (june 8, 2020). 5 see discussion infra part iii. 6 general anti-avoidance rules (gaars) have become commonplace although effective use has been limited. see rebecca prebble & john prebble, does the use of general anti-avoidance rules to combat tax avoidance breach principles of the rule of law? a comparative study, 55 st. louis u. l.j. 21, 25-27 (2010). the u.s. does not have a gaar scheme but the statutory economic substance rule in section 7701(o) operates similarly to other countries’ gaars and requires that a transaction have economic substance independent of its tax benefits, although the government appears to have used that section, as well as a specific partnership anti-avoidance regulation primarily as additional arguments in litigation (although both may have had impact on settlements with taxpayers. see i.r.c. § 7701(o); treas. reg. § 1.701-2. similarly, controlled foreign corporation (cfc) anti-avoidance rules similar to those in section 951 have been enacted in several jurisdictions. see i.r.c. § 951. 7 see anthony infanti, the ethics of tax cloning, 6 fla. tax rev. 253 (2003). 8 see, e.g., convention with respect to taxes on income and capital, u.s.-can., sep. 26, 1980, 1469 u.n.t.s. 189 (tax treaty based on oecd model). 9 tax information exchange agreements, oecd, https://www.oecd.org/ctp/exchange-oftax-information/taxinformationexchangeagreementstieas.htm [https://perma.cc/43xu-6v55] (last visited june 17, 2020) [hereinafter tiea]; automatic exchange portal, oecd, http://www.oecd.org/tax/automatic-exchange/ [https://perma.cc/bl26-7uhf] (last visited june 17, 2020) (collaboration between oecd and the global forum on transparency and exchange of information for tax purposes in area of automatic exchange information with respect to common reporting standard). 10 see, e.g., convention with respect to taxes on income and capital art. xxvii, u.s.can., sep. 26, 1980, 1469 u.n.t.s. 189). 11 see infra part iii. 2021] uniform international tax collection and distribution 131 in other jurisdictions where appropriate.12 the oecd developed a list of un-cooperative tax havens and gradually removed jurisdictions from the list as they agreed to respect oecd standards of transparency and exchange of information.13 it removed the last three countries, andorra, monaco and liechtenstein, from the list in may 2009.14 the european union (eu) maintains its own active list of uncooperative tax jurisdictions that currently includes eleven island jurisdictions and oman.15 more recent projects focus on mne revenue and seek to reallocate the revenue from the source to which the taxpayer has assigned it to a higher tax jurisdiction through sourcing rules designed to diminish the ability of taxpayers to shift profit artificially from high to low tax jurisdictions. 16 a working group under the european commission introduced a voluntary proposal for a common consolidated corporate tax basis (ccctb) that, if adopted, would apportion the income of mnes formulaically and predictably among the eu states in which they are operating.17 after tabling the proposal earlier, the ec renewed the proposal in 2015 as a mandatory base with a gradual introduction.18 the eu also has become more attentive to the state aid issues prohibited by the treaty of the functioning of the eu (tfeu) 19 when its member states grant non-uniform tax concessions to enterprises to provide a welcoming tax environment for them.20 12 oecd, harmful tax competition an emerging global issue 16 (1998), https://www.oecd.org/tax/harmful/1904176.pdf [https://perma.cc/af4y-x76d] (identifying harmful tax practices and tax havens to encourage developed countries to abandon such practices and impose sanctions on tax haven jurisdictions facilitating secret investment from residents of developed economies using tax havens to avoid home country taxes) [hereinafter oecd harmful tax competition]. 13 list of unco-operative tax havens, oecd, https://www.oecd.org /countries/monaco/list-of-unco-operative-tax-havens.htm [https://perma.cc/nhm5-l968] (last visited june 17, 2020) [hereinafter oecd, unco-operative tax havens]. but see michael j. mcintyre, how to end the charade of information exchange, 56 tax notes int’l 255 (oct. 26, 2009) (arguing against the effectiveness of the tiea as a basis on which to remove jurisdictions from the list of tax havens, characterizing the u.s. switzerland agreement as changing little of the swiss bank secrecy-based assistance to international tax cheats, and proposing an alternative). 14 oecd, unco-operative tax havens, supra note 13. 15 council conclusions on the revised eu list of non-cooperative jurisdictions for tax purposes, 2020 o.j. (c 64) 8 [hereinafter eu list of non-cooperative jurisdictions] 16 base erosion and profit shifting (beps), oecd, https://www.oecd.org/tax/beps/ [https://perma.cc/tm94-6grp] (last visited july 10, 2020); michael p. devereux et al., oxford ctr. bus. tax’n., the oecd global anti-base erosion (globe) proposal 1-2 (2020). 17 proposal for a council directive on a common consolidated corporate tax base, com (2011) 121 final (oct. 6, 2011) [hereinafter 2011 ccctb proposal]. 18 european comm’n memoranda memo/15/5174, the commission, questions and answers on the ccctb re-launch (june 17, 2015), https://ec.europa.eu/commission /presscorner/detail/en/memo_15_5174 [https://perma.cc/e3j5-3fg6] [hereinafter q&a ccctb]. 19 consolidated version of the treaty of the functioning of the european union art. 107, may 9, 2008, 2008 o.j. (c 115) 47. 20 state aid control, european comm’n, https://ec.europa.eu/competition /state_aid/overview/index_en.html [https://perma.cc/7xc3-pcaj] (last visited july 10, 2020) (identifying tax relief as form of prohibited state aid). 132 columbia journal of tax law [vol. 12:126 whether the target of legislation or a multinational) project is the individual,21 the mne,22 or both,23 the legislative or project objective almost invariably is to measure income and source in a manner that disregards artificial or manipulative sourcing. a frequent indicium of such artificiality or manipulation is a related party transaction where the parties are in different taxing jurisdictions and the pricing shifts profit to low or no-tax jurisdictions. while reallocation of income by the tax collector under existing transfer pricing regulations and guidelines currently is possible, 24 existing transfer pricing regulations have proven to be inadequate in restraining tax base erosion and accompanying profit shifting. were existing transfer pricing regulation adequate, the beps projects would have been unnecessary. underlying the reallocation process is the perception that the individual or mne is manipulating income source and underpaying tax rather than simply paying tax to the wrong jurisdiction. however, with the possible exception of the ccctb which would apportion the income tax base among the eu countries in which the mne operates under a uniform set of rules in an endeavor to prevent double taxation and no taxation of income,25 an objective shared with most tax treaties,26 the international projects developed by the oecd and national anti-avoidance rules27 reallocate income to the developed economies with relatively high corporate tax rates28 rather than to less developed or developing economies. while the oecd projects purport to be neutral in identifying correct income source, reallocation favors the developed economy jurisdictions. from the oecd approach, one concludes that the underpayment of tax is significant because it deprives the treasury of a developed economy of tax revenue owed to it. if the projects increase the tax revenue of developed economies, however, they are likely to decrease investment that less developed economies may have captured with low taxes and tax incentives. 21 foreign account tax compliance act (fatca), pub l 111-147, 124 stat. 97 (codified as amended in scattered sections of i.r.c. §§ 1471-1474, 6038d) (imposing penalties and sanctions for failing to report accounts and income of u.s. persons); i.r.c. § 877a (expatriation tax on u.s. persons who relinquish citizenship or permanent residence in the u.s.), for example. 22 see i.r.c. § 7874 (taxing inverting entities that cease to be u.s. entities); 2011 ccctb proposal, supra note 17. see also, e.g., beps, supra note 16. 23 see controlled foreign corporation (cfc) provisions under section 951 in the u.s. i.r.c. § 951. see also, for example, similar provisions in other countries taxing some or all corporate income to the corporation’s shareholders. prebble & prebble, supra note 6. 24 cf. i.r.c. § 482 ( “[t]he secretary may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses”); i.r.c. § 59a(b) (the base erosion minimum tax imposing a minimum 10 percent tax on deductible amounts paid between related parties). see also i.r.c. § 267a (the disallowance of deductions in hybrid transactions when not matched with an inclusion). 25 see 2011 ccctb proposal, supra note 17. 26 tax treaties include prevention of double taxation among other functions in their title. reuven s. avi-yonah, double tax treaties: an introduction, in the effect of treaties on foreign direct investment: bilateral investment treaties, double taxation treaties and investment flows 99, 99 (k. p. sauvant and l. e. sachs eds., 2009). 27 see, e.g., i.r.c. § 951 (cfc provisions). 28 high rate of tax is a relative term. the u.s. reduced its corporate income tax rate from a maximum of 35% to 21% in 2018 and imposed a maximum rate of 50% as recently as 1985. tax cuts and jobs act (tcja) of 2017, pub. l. no. 115-97, 131 stat. 2054 (codified as amended in scattered sections of i.r.c.); i.r.c. § 11 (1982). see also federal corporate income tax rates, income years 1909-2012, tax found., https://taxfoundation.org/federal-corporate-income-taxrates-income-years-1909-2012/ [https://perma.cc/jhx6-g9lr]. 2021] uniform international tax collection and distribution 133 for all taxpayers, including mnes, the level of taxation may be a key but not the only economic factor in the analysis of where to earn income. choosing where to locate income-producing activity involves a bundle of economic and non-economic factors. tax rules often are ambiguous and economically favor certain jurisdictions, but the ambiguity also might lead to multiple tax impositions. tax rules are not alone in their ambiguity. the location of income-producing activity is also ambiguous, even more so today, when intangible, digital property produces income without any clear link to a specific and identifiable source, even with a single factor of destination of consumption as determinative. destination is an inadequate proxy for taxing all income insofar as it concentrates income in high consumption destinations. high consumption tends to coincide with a country’s level of development because increases in consumption generally correlate with increases in disposable income. 29 similarly, residence of the income producer is often uncertain and residence of the owners of an income producing entity may not be more certain as one must unpeel possible layers of ownership.30 while taxpayers may complain that the tax rules are uncertain, they exploit the ambiguity of income source to locate income where the level of taxation is lowest rather than where income-producing activity takes place. splitting genuine economic activity source from tax source enables taxpayers to minimize taxation artificially without there being certainty as to a single genuine source. competing, legitimate claims of source may belong to multiple jurisdictions. undoubtedly the income should be taxable somewhere. ideally, if all income everywhere were subject to identical tax rules and rates, the taxpayer would be indifferent as to income source and would make location decisions based on non-tax factors. commentators have expressed concern that enhanced tax capture from mnes favors the advanced economies unduly.31 those commentators who critique the income shift for taxing purposes to developed economy jurisdictions argue that the beps projects fail to allocate a sufficiently large share of the income tax base to less-developed jurisdictions. this literature suggests other “fairer” methods for allocating or apportioning the tax base. one approach recommends a modified view of value creation and suggests allocating more of the base to where value is created.32 another offers a method of formulary apportionment of the income tax base that includes a labor factor in the formula, not as a function of wages, but rather as a function of person-hours of work to prevent wage 29 see reuven s. avi-yonah, destination based corporate tax: an alternative approach, (univ. of mich. pub. l. & legal theory rsch, working paper no. 529, 2016), https://ssrn.com/abstract=2883835 [https://perma.cc/2vf5-leuk]; reuven s. avi-yonah & kimberly a. clausing, problems with destination-based corporate taxes and the ryan blueprint, (univ. of mich. pub. l. & legal theory rsch, working paper no. 16-029, 2017), https://ssrn.com/abstract=2884903 [https://perma.cc/q2gj-tjsc]; wei cui, destination-based cash-flow taxation: a critical appraisal, 67 u. toronto. l.j. 301 (2017) (critical analysis of destination-based cash flow taxation); salesfactor.org, comment letter on sales factor formulary apportionment of global profits as an alternative system of taxation of to the current u.s. federal corporate income tax (apr. 13, 2015), https://www.finance.senate.gov/imo/media/doc/sales %20factor_redacted3.pdf [https://perma.cc/5cnp-2c3h]. 30 robert j peroni, j. clifton fleming, jr. & stephen shay, defending worldwide taxation with a shareholder-based definition of corporate residence, 2016 byu l. rev. 1681, 1683-84 (2016). 31 see devereux et al., supra note 16. 32 allison christians & laurens van apeldoorn, taxing income where value is created, 22 fla. tax rev. 1 (2018). 134 columbia journal of tax law [vol. 12:126 differentials from distorting apportionment formulas in favor of high wage countries.33 a third would allocate tax base by the benefit received by investment destination rather than the benefit received from the destination by the investor.34 the goal for the oecd and the governments in developed economies has been primarily sourcing income to developed economies so that it may be taxed there under that jurisdiction’s tax regime. the more general proposition that each mne (and each individual, as well) should pay an identifiable and specific portion of their income in tax without regard to which nation receives the tax has not been prominent. if worldwide agreement on an ideal amount of tax and uniform tax rules were possible, as this article will recommend, rather than the sourcing or mis-sourcing of income, the next step would be allocation of the tax revenue among jurisdictions. artificial sourcing would not alter the amount of tax payable by any taxpayer or related group of taxpayers. while fairness certainly underlies the oecd’s beps projects, fairness there has been primarily an income source concept, maintaining that if income is attributable to a source, the source has priority in imposing its tax. even under the u.s.’s worldwide taxation of its citizens and residents,35 the u.s. has ceded taxing authority to the income source country through the foreign tax credit. 36 existing concepts of source favor developed economies. unless some innovative source concept might compensate for imbalances in opportunities and resources worldwide by imputing more level distribution of opportunities and resources and taxing income according to that imputed source, a different manner of allocating worldwide taxing opportunity is critical to enable nonaffluent nations and regions to develop and provide a reasonable standard of living to all people free from need. it would be a significant conceptual shift to jettison the competitive concept of source as the primary basis for international income taxation and adopt the more nuanced and collaborative needs-based system this article proposes. despite the developed economies’ income productivity, such a tax system would emphasize non-geographic fairness in the distribution of resources. the international community would unite on tax principles to prevent tax base erosion independent of source taxation so that the principles would not overwhelmingly favor the advanced economies. instead, the objective of the tax system would be to generate adequate governmental resources to meet worldwide revenue demands. currently, developed economies devote less than one percent of their tax revenue to development for less developed economies.37 international uniformity would require mnes (and other taxpayers) to pay some reasonable amount of tax on their income and facilitate devotion of a larger amount of tax revenue to international development. the focus of the tax principles would be on the question of whether a definable, correct set of tax rules might exist under which each taxpayer pays a “fair” amount of tax without regard to the jurisdictions in which the taxpayer operates. this article emphasizes 33 henry ordower, utopian visions toward a grand unified global income tax, 14 fla. tax rev. 361, 387 (2013) (labor factor in the income apportionment formula based on person hours of work rather than payroll amounts). 34 vasiliki koukoulioti, the benefit principle revisited – avoiding the repercussions of digitalization on the taxbase sustainability (may 29, 2020) (unpublished ph.d. dissertation in process, queen mary, university of london) (on file with author). 35 see i.r.c. § 61; treas. reg. § 1.1-1(b) (taxing u.s. citizens and residents on their income from all sources worldwide). 36 i.r.c. § 901(a), (b)(1). 37 alexis brassey & henry ordower, the village of billionaires: fair taxation and redistribution amid relative and absolute poverty, 99 tax notes int'l 97 (july 6, 2020). 2021] uniform international tax collection and distribution 135 the question of whether, assuming a “fair” measure of tax exists, distribution of that “fair” amount among jurisdictions ought to follow determinations of need with the elimination of suffering—starvation, disease, homelessness—at the forefront rather than the place of production of income. the imposition of tax can be along ability to pay principles, while distribution would follow contextualized need. this article recommends abandoning the premise that income and accompanying tax revenue, however it is measured, be allocated to where the income is produced, in favor of allocating tax revenue based on a broad, inclusive view of revenue that is need-determined to accommodate the systemic transition. developed economies would continue to have the greatest needs to meet their existing commitments and maintain existing infraand superstructures. yet, the shift in distribution principles would help address the uneven worldwide distribution of resources and level disparities between affluent and non-affluent taxpayers and communities, especially those disparities resulting in the absolute poverty prevalent in some parts of the world that generate little income.38 the revised system would preclude mnes from using their economic bargaining power to negotiate tax relief from developing economies that cannot replace the lost revenue easily. the common assertion by representatives of mnes that mnes do not seek to reduce their taxes artificially,39 but plan the placement of their income to avoid becoming subject to tax on the same unit40 of income in multiple jurisdictions is consistent with uniform tax rules and a fair rate of tax. source planning may also protect mnes from suffering a tax-based, competitive disadvantage. as long as the mne does not pay tax while its competitors avoid tax leaving the mne at a competitive disadvantage, the mnes are indifferent to reasonable levels of taxation. transparent and uniform tax rules would enable the mnes to determine their tax liability to each jurisdiction correctly. uniform rules would require the mnes’ competitors to similarly pay a correct amount of tax to each jurisdiction. taxpayers should not be subject to non-uniform tax rules in any taxing jurisdiction.41 yet, even if tax rules and rates are uniform within a taxing jurisdiction, they are not currently uniform across jurisdictions, and mnes deploy considerable resources to minimizing their taxes whether as a competitive defense or as profit-centered activity.42 38 id. 39 ryan finley, uber accepts need for new international tax system, tax notes today glob. (june 26, 2020), https://www.taxnotes.com/tax-notes-today-international/digitaleconomy/uber-accepts-need-new-international-tax-system/2020/06/26/2cnmn?highlight=pillar %201 [https://perma.cc/u3rm-l4w5]; adrian weckler & michael cogley, ‘no one did anything wrong here and ireland is being picked on... it is total political crap’ apple chief tim cook, independent.ie (sept. 1, 2016), https://www.independent.ie/business/irish/no-one-did-anythingwrong-here-and-ireland-is-being-picked-on-it-is-total-political-crap-apple-chief-tim-cook35012145.html [https://perma.cc/xle9-84p5]. in a recent ruling by the general court of the european union, the court overruled the ec’s decision as the court found that the ec had not met the legal standard necessary to show that there was an economic advantage (state aid) as required by article 107(1) tfeu. see case t-778/16 and t-892/16, ireland v. european comm’n, 2020 e.c.l.i. 338. 40 except when referring to specific u.s. tax provisions for which the u.s. dollar will be used, “unit” of income is the income measured in the functional currency of the income producing entity. 41 when taxing rules do not treat all taxpayers the same, the taxing state is discriminating among taxpayers, a possible violation of the state aid prohibition in the eu if the taxpayers are residents or nationals of different states. tfeu art. 107. likewise, states may not discriminate between residents and non-residents in the u.s. hooper v. bernalillo cty. assessor, 472 u.s. 612 (1985). 42 henry ordower, the culture of tax avoidance, 55 st. louis u. l.j. 47 (2010). 136 columbia journal of tax law [vol. 12:126 harmonization of taxation internationally under the rubric of a universally correct level of tax is elusive. efforts to achieve consensus on combatting tax avoidance may lead to some multi-national agreements, but if each signatory gets to apply its own tax rules and interpretations to the agreement, the force of the agreement diminishes. national sovereignty remains a formidable, albeit primarily rhetorical,43 barrier to the best resolution of many issues common to most nations. the recent covid-19 pandemic illustrates the difficulty of attaining international consensus on any matter; as little consensus exists even on a common authority to combat a health threat to the entire world population. the pandemic did not elicit an international call to deputize an existing world health organization to design a method to contain the spread of the virus. rather, each nation and often each governmental sub-unit took its own politically determined approach with considerable but limited harmonization of methods. on the tax side, the eu, despite being a remarkable voluntary union of sovereign and historically often warring nations, has failed to harmonize taxes except in setting a minimum value-added tax rate with incompletely harmonized operating rules.44 the eu itself as a governmental unit lacks the power to tax, although a nascent movement to grant limited taxing authority to a central eu government along with a u.s.-type federalist model of overlapping state and central taxing authority has begun to gather support among leading tax academics.45 the task of broad-based harmonization is formidable. like an earlier article recommending the creation of an international taxing agency to apportion a global income base,46 this article argues that national sovereignty and national self-interest remain impediments to fair taxation and must yield to the international need for predictable taxation at a level fair to all. the article recommends modified international tax rules administered by a single international agency that collects and distributes income tax revenue among sovereign states based on the contextualized revenue needs of each state under international fairness-based principles.47 this article inquires whether the developed economies might deploy fairer tax revenue distribution to persuade less developed economies to abandon tax competition and suggests possible coercive devices to nudge voluntary abandonment of tax competition.48 43 rhetorical insofar as the world trade organization (wto) and other international bodies cannot function successfully without relinquishment of national sovereignty. cf. discussion infra part v. 44 council directive 2006/112, 2006, 2006 o.j. (l 347) 1 (ec) [hereinafter ec council directive]. there also has been some harmonization on a few customs matters. see regulation 952/2013 of the european parliament and of the council of 9 october 2013 laying down the union customs code 2013 o.j. (l269) 1. 45 see op-ed: european solidarity requires eu taxes, eu l. live (apr. 21, 2020), https://eulawlive.com/op-ed-european-solidarity-requires-eu-taxes/ [https://perma.cc/k562-md2t]; frans vanistendael, apple: why the eu needs a common corporate income tax, 99 tax notes int’l 451 (july 27, 2020). 46 ordower, supra note 33. 47 brassey & ordower, supra note 37. 48 alongside this paper’s proposal stands another somewhat more limited impingement on national sovereignty in the form of a recent proposal for a uniform global excess profits tax to complement national taxation of mnes. tarcisio diniz magalhaes & allison christians, rethinking tax for the digital economy after covid-19, 10 harv. bus. rev. (forthcoming 2021), https://ssrn.com/abstract=3635907 [https://perma.cc/dt4x-8m5s]. 2021] uniform international tax collection and distribution 137 iii. regionalism and taxing jurisdictions with an estimated population of just under one million, 49 st. louis county, missouri has eighty-nine independent municipalities with taxing authority, and the county itself also may tax. taxing authority is derivative of the state of missouri’s taxing power50 guaranteed by the u.s. constitution.51 the st. louis county collector of revenue is responsible for billing and collecting ad valorem real and personal property taxes for over two hundred taxing districts in st. louis county.52 the number of taxing districts is more than twice the number of municipalities because the school, fire protection, sewer, and municipal taxing districts are not co-extensive with municipalities but overlap in somewhat mysterious and often historically determined ways, such that multiple school-taxing districts, for example, may overlap the borders of a single municipality. some districts are funded better than others because real estate is more valuable in some parts of the county and yields greater sums of real property tax revenue 53 than in other parts, and some municipalities have more retail space generating more sales tax revenue than do others. the state administers sales tax collection and distribution. an owner of real property in st. louis county examining their real estate tax bill finds a confusing array of taxing districts imposing a portion of the total tax consolidated into a single invoice. that array often differs from one property to another as district borders for differing types of taxing districts do not coincide. rates of tax also differ among similar types of districts. the tax base, however, is uniform. each property has a value attributed to it, and each taxing district within which that property lies applies its tax rate to that uniform value in determining the tax to impose. there is occasionally some ambiguity when a multiple-use property is involved in determining what portion of the property ought to be assessed at the commercial rather than the residential percentage and appraised values of any property may be contested. the rules are uniform for assessing, collecting, and distributing tax among taxing jurisdictions. the county administers the tax, collects the tax payment, and is responsible for sanctions for non-payment including seizure and sale of the property to collect unpaid taxes. taxing districts neither administer the tax, determine the value of the taxed property nor control sanctions for non-payment. uniformity in administration and collection is not unusual worldwide. the u.s. is exceptional in the range of governmental units that have their own administrative infrastructures devoted to tax collection.54 most countries administer and collect income 49 st. louis county, missouri, u.s. census, https://www.census.gov/quickfacts /stlouiscountymissouri [https://perma.cc/g8p4-dkqh]. 50 mo. const. art. x, § 1. 51 u.s. const. amend. x. 52 see collector of revenue, st. louis cnty. gov., https://www.stlouisco.com /yourgovernment/countydepartments/revenue/collectorofrevenue [https://perma.cc/2vvdh2ql] (last visited july 10, 2020). 53 real property taxes are generally a percentage of the value of the property taxed under rules that base the tax on an assessed value lower than the fair value of the property. for example, the assessment formula in missouri for residential property uses 19% of the appraised value of the property as the base for real property tax. the percentage used for commercial property is 32% and the percentage used for farm property is 12%. mo. state tax comm’n, property reassessment and taxation pamphlet 4 (2017), https://stc.mo.gov/wp-content/uploads/sites/5/2017/01 /property-reassessment-pamphlet-1-18-16.pdf [https://perma.cc/k5ys-7fzx] (last visited july 10, 2020). 54 each state of the u.s. has its own taxing agency responsible for state income and consumption taxes and municipalities and other taxing districts with their own agencies are not unusual. see state tax agencies, fed’n tax adm’r, https://www.taxadmin.org/state-tax-agencies 138 columbia journal of tax law [vol. 12:126 taxes, value-added taxes, and often property taxes, centrally.55 rates of tax and property values may vary regionally, but the central authority distributes the tax collected among the regional governmental units providing services and often has responsibility for the enforcement of taxes, even if local governments determine the expenditure of the tax collected. while the taxing district may set the rate applicable to the taxed property in st. louis county, state constitutional tax limitations require a public vote before a taxing district may increase a tax rate,56 and initiatives to increase a tax might succeed in one district but fail in another overlapping district. the multiplicity of rates and countydetermined property values means that the governmental services in one location may differ significantly from the services in another geographically proximate area within the county. similarly, with respect to the state-administered sales tax, purchases of identical items at identical prices in two stores near one another often incur different sales tax amounts because the sales tax rates in proximate jurisdictions may differ. rates of tax are not harmonized, but the state constitution limits the rates municipalities and other taxing districts may impose.57 the legislature may impose other limitations on permissible rates separate from the constitutional limitations.58 the result of multiple taxing jurisdictions in a relatively small geographic area59 is visible in the levels of school funding that impact the educational services for children in st. louis county.60 some public-school districts become desirable places to live because they offer well-funded, high-quality public education while others are lacking in quality and even may fail to meet state educational standards.61 educational disparities across st. [https://perma.cc/y5yv-9u4l]. for example, the city of st. louis is not part of st. louis county and has its own collector of revenue responsible for the city earnings tax as well as ad valorem property taxes. see supra note 52. 55 the eu member states collect most or all taxes centrally even where sub-jurisdictions impose differing rates in addition to the national rate. see about us, hm revenue & customs, https://www.gov.uk/government/organisations/hm-revenue-customs/about (last visited june 26, 2020) (uk’s central tax, payments and customs authority); institutional information, agencia tributaria, https://www.agenciatributaria.es/aeat.internet/en_gb/inicio/la_agencia_tributaria /informacion_institucional/informacion_institucional.shtml [https://perma.cc/q3al-pf2v] (last visited june 26, 2020); irish tax and customs, revenue comm’rs, https://www.revenue.ie/en/corporate/information-about-revenue/role-of-revenue/core-business.aspx [https://perma.cc/7sr5-rjlf] (last visited june 26, 2020). 56 see mo. const. art. x, § 22; see also ariel jurow kleiman, tax limits and the future of local democracy, 133 harv. l. rev. 1884 (2020). 57 see mo. const. art. x, §§ 8, 11 (limiting rates of tax on personal property and real property, respectively). 58 see mo. const. art. x, § 10(c) (power of the legislature to limit tax). 59 see, for example, st. louis county, which is less than one percent of the land area of missouri but has nearly 20 percent of the missouri state population and more than three percent of the state’s 6,000 special taxing districts. sales tax jurisdiction maps, mo. dep’t of revenue, https://mogov.maps.arcgis.com/apps/mapseries/index.html?appid=22cc45ec926e4f94a1f41027b1b edb0e [https://perma.cc/6m5p-e9d8] (last visited july 10, 2020). 60 quality of education of course is not solely a function of funding, but better funding generally contributes to a better educational product. 61 in 2019, the county school districts of brentwood and jennings represent the extremes. measured by dollars per average daily attendance, brentwood with $19,035 had nearly twice the funding of the jennings district with $10,676. building level per pupil expenditures 2019 report, mo. dep’t of elementary & secondary educ., https://stateofmissouri.app.box.com/s /1nvymfovyruscbmcte1b8dn838mpndlh/file/573737767611 [https://perma.cc/3s2q-azym] (last visited june 17, 2020) [hereinafter 2019 building level expenditure report]. brentwood is a midcounty district with a predominantly white enrollment. jennings is a north county district with a 2021] uniform international tax collection and distribution 139 louis county are significant. in several municipalities, children living on opposite sides of a street go to schools in different school districts and may have quite different educational experiences from one another because one school district has greater resources from tax revenue than the other. the school district disparities are somewhat selfperpetuating in that the perceived school district quality affects property values, causing prices of single-family residences in better school districts to be greater than in lower quality districts. since real estate taxes are based on property value, higher value yields more revenue, sometimes even if the tax rate is lower than in the lower quality school district. where resource disparities exist among school districts, disparities in educational quality tend to follow, often along racial lines. in brown v. board of education of topeka,62 the u.s. supreme court rejected the notion that segregated education could provide equal education and prohibited purportedly “separate but equal” schools. remedies to level opportunities for children have proved elusive. in some states, federal courts have intervened to address some educational disparities by ordering busing of students across districts to remedy imbalances in the racial composition of student bodies and afford lower-income people—often people of color—better educational opportunities in districts that historically had little or no racial diversity.63 to settle a lawsuit, st. louis county school districts beginning in 1982 initiated a voluntary program busing black students from overwhelmingly black st. louis city schools to predominately white schools in st. louis county.64 revenue sharing among districts or consolidation of districts so that all pupils, even in a small county like st. louis, are covered by identical amounts of tax revenue per student has not gained sufficient political support, even though uniform tax rules and centralized revenue collection would facilitate level revenue distribution. the state of missouri supplements school funding based on funding need but it has not sought to level funding among districts.65 school district boundaries are not an immutable characteristic of each pupil. people may move from one school district to another. while economic barriers to relocation may exist and, accordingly, relocation may be difficult, better-paying employment could open the door to relocation. the better-funded school district may not prevent the family from the less funded district from moving across the street to the better predominantly black enrollment. brentwood school district, pub. sch. rev., https://www .publicschoolreview.com/missouri/brentwood-school-district/2905880-school-district [https://perma.cc/mc6g-dq7l] (last visited june 26, 2020) (63% white enrollment as of 2020); jennings school district, great sch., https://www.greatschools.org/missouri/saint-louis/jenningsschool-district/ [https://perma.cc/t2df-blrf] (last visited june 26, 2020) (98% black enrollment). 62 brown v. bd. of educ. of topeka, 347 u.s. 483 (1954). 63 swann v. charlotte-mecklenburg bd. of educ., 402 u.s. 1 (1971) (establishing authority of courts to order busing to remediate educational segregation). 64 ryan delaney, st. louis school desegregation program begins its long wind down, st. louis pub. radio (nov 1, 2018) https://news.stlpublicradio.org/post/st-louis-school-desegregationprogram-begins-its-long-wind-down#stream/0 [https://perma.cc/dk9u-ks9w]. 65 see, e.g., 2019 building level expenditure report, supra note 61. 140 columbia journal of tax law [vol. 12:126 funded district, 66 a right that is not available across national borders.67 if, however, too many lower-income individuals move to the more affluent school district, the existing residents may choose to limit tax revenue and reject any tax increase, diminishing the quality of the public schools. those longer-term, affluent residents who do not relocate may establish private schools for their children that exclude the new residents through high costs that often serve as a proxy for prohibited racial discrimination in public education.68 no active discussion is underway in st. louis county to level tax revenue distribution countywide to eliminate the disparities in school quality and other governmental services. instead of generous cooperation among taxing districts, there is tax-based competition among governmental units. in st. louis county, municipal governments seek to annex unincorporated areas of the county along major thoroughfares where commercial development and concomitantly sales tax revenue is projected to grow.69 negotiation between private developers and governmental units for investment in new or renovated facilities that might bring employment and future tax revenue occurs on the level of temporary, sometimes long-term, tax concessions. tax concessions, however, undermine the ability of state and local governmental units to generate revenue to support necessary government services when state constitutional tax limitations already make necessary tax increases troublesome. concessions to new and existing business interests require additional taxes on non-affluent residents or a diminution of services. governmental units have utilized extra-taxing power, revenue-raising to supplement limited tax revenue. user fees have substituted for government services historically funded with general revenue.70 in st louis county, several municipal governments have resorted to predatory, revenue-based policing by aggressively enforcing municipal ordinances, especially traffic rules, to collect fines and court fees from non-affluent violators to supplement tax revenue.71 while tax concession competition has played an investment role in the u.s. for many years,72 it has become particularly robust during recent decades. mnes actively 66 there is a constitutional right to travel and reside without restriction in the u.s. see crandall v. nevada, 73 u.s. (6 wall.) 35 (1868) (state cannot impose restriction on personal right to travel); shapiro v. thompson, 394 u.s. 618, 629–31, 638 (1969) (welfare benefits may not be conditioned on duration of residency); dunn v. blumstein, 405 u.s. 330, 338–42 (1972) (durational residency requirements for voting). 67 despite their proximity, relocation from ciudad juarez, mexico to el paso, texas requires a u.s. visa to enter and reside unless one is a u.s. citizen or permanent resident. see brassey & ordower, supra note 37, at 112-13. 68 see brown, 347 u.s. 483. 69 boundary commission of st. louis county reviews proposal for annexation and consolidation. see boundary comm’n, st. louis cnty., mo., https://www.boundarycommission .com/ [https://perma.cc/wu2w-ktvd] (last visited july 10, 2020). 70 see kleiman, supra note 56; jasper l. cummings, jr., user fees versus taxes, tax analysts (nov. 4, 2011), http://www.taxhistory.org/www/features.nsf/articles /27f622b404b089f68525793e00536946?opendocument [https://perma.cc/h6v6-mc6n] (last visited july 10, 2020). 71 henry ordower, j.s. sandoval, & kenneth warren, out of ferguson: misdemeanors, municipal courts, tax distribution and constitutional limitations, 61 how. l.j. 113 (2017). 72 see robert s. chirinko and daniel j. wilson, tax competition among u.s. states: racing to the bottom or riding on a seesaw? (fed. rsrv. bank s.f., working paper 2008-3), https:// www.frbsf.org/economic-research/files/wp08-03bk.pdf [https://perma.cc/8hx5-5asu]; henry ordower, les impôts relatifs aux investissements étrangers aux états-unis d'amérique (observations générales), 1996-2 revue internationale de droit economique 185-201 (1996) (includes discussion of negotiated state or local tax concessions). 2021] uniform international tax collection and distribution 141 solicit bids from governments when they are evaluating where to locate a new or expanded facility.73 governmental units offer tax concessions as all or a portion of their proposal to entice the business decision-makers to invest in the geographic area and bring jobs and collateral businesses to the governmental unit. tax concession competition sometimes even becomes destructive as the commercial development consumes governmental resources without contributing adequately to tax revenue. occasionally, the business attracted with special tax concessions and other subsidies relocates when the period of the tax concession expires and leaves the governmental unit with facilities that cannot be adequately utilized. for example, in the case of the rams, a national football league franchise, st. louis directly and indirectly used tax revenue to provide a stadium. when the stadium no longer met stadium quality conditions included in the lease, the rams became free to abandon the st. louis area.74 business demand for tax-based government contributions has become an important—possibly indispensable—feature of major developments throughout the u.s. when governmental offers are insufficient, the businesses go elsewhere. amazon, for example, negotiated a variety of subsidies, including tax subsidies from new york city, but when local elected officials began to object due to the cost to the city, amazon abandoned its plans to locate a facility in new york city.75 more egalitarian tax revenue distribution across borders might render tax concession competition obsolescent as well as unnecessary. the u.s. has substantial competition across taxing districts and a confusing profusion of taxing units and tax bases, so that items included in one tax base frequently become subject to tax under another base as well. income may be subject to a federal income tax, a wage income tax (social security), a state income tax, and a local (wagebased) income tax, and the income remaining after the income taxes may become subject again to a consumption tax when the taxpayer deploys it for purchases and an annual property tax following purchase. each tax competes for its share of overall tax revenue. part of the competition among jurisdictions may be the absence of one of the taxes. florida and texas, for example, impose no individual state income tax.76 alaska, delaware, montana, new hampshire, and oregon impose no sales tax.77 tax competition allows private parties to allocate a portion of what should be tax revenue to themselves. tax increment financing, for example, dedicates incremental tax revenue from a private development to repayment of indebtedness incurred to fund construction of public 73 see, e.g., nick wingfield, amazon chooses 20 finalists for second headquarters, n.y. times (jan. 18, 2018), https://www.nytimes.com/2018/01/18/technology/amazon-finalistsheadquarters.html [https://perma.cc/y948-bw5v]. 74 see, e.g., robin respaut, with nfl rams gone, st. louis still stuck with stadium debt, reuters (feb. 3, 2016), https://www.reuters.com/article/us-sports-nfl-stadiums-insight/with-nflrams-gone-st-louis-still-stuck-with-stadium-debt-iduskcn0vc0ep [https://perma.cc/e86hhvv3]. 75 see, e.g., scott cohn, amazon reveals the truth on why it nixed new york and chose virginia for its hq2, cnbc (july 10, 2019), https://www.cnbc.com/2019/07/10/amazon-revealsthe-truth-on-why-it-nixed-ny-and-chose-virginia-for-hq2.html [https://perma.cc/qmv7-xm9j] (amazon withdrew from new york city when city council members balked at size of the tax concessions); jacob passy, this is what amazon’s “hq2” was going to cost new york taxpayers, marketwatch (feb. 16, 2019), https://www.marketwatch.com/story/what-amazons-hq2-meansfor-taxpayers-in-new-york-and-virginia-2018-11-14 [https://perma.cc/zqm6-fcx9]. 76 see also julie roin, changing places, changing taxes: exploiting tax discontinuities, symposium on legal discontinuities 28 (univ. of chi. pub. l. working paper, paper no. 740), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3587056 [https://perma.cc/tns8-qvms]. 77 what states impose sales/use tax? sales tax inst., https://www.salestaxinstitute.com /sales_tax_faqs/what_states_impose_sales_use_tax [https://perma.cc/2jve-bwht]. 142 columbia journal of tax law [vol. 12:126 improvements necessary to service the private development. absent the tax increment financing, the private developer would be responsible for the cost of the public improvements because those improvements are required to accommodate the development.78 similarly, the charitable contribution deduction79 enables taxpayers to allocate a portion of a taxing unit’s revenue to other private interests rather than leaving the revenue distribution to the government officials charged with distributing the public purse. in the case of charitable contributions, the private interests are charities of the donor’s choice, rather than governmentally selected functions.80 tax concessions often mean that those best able to pay taxes are not required to pay. tax concessions do not necessarily reduce tax revenues for the taxing unit granting the concessions. if the new business activity did not exist in the taxing unit previously, it was not generating tax revenue. nevertheless, business development frequently increases demand for governmental services and concomitantly the need for tax revenue to pay for the services. funding the services may require property owners, other than those receiving concessions, to pay increased property taxes if the business draws additional residents and concomitant demand for public schools. alternatively, an increased population increases sales tax revenue as greater revenue demands may be met with additional sales and use taxes to carry the increased tax burden at the expense of those with moderate income. in locales like missouri subject to statutory or constitutional tax limitations requiring voter approval for tax increases, if california and missouri are representative, voters approve rate increases for sales taxes more frequently than property taxes, even though property taxes tend to be less regressive relative to income or wealth than sales taxes.81 moreover, increased consumption tax revenue may not flow from the increased business activity, as the dedication of consumption tax revenue from the new business activity to the business’ facilities or debt servicing may be among the concessions. 82 facilities for product distribution produce relatively little incremental consumption tax revenue locally as the consumption taxes are collected and paid to the taxing authority where the purchaser receives and uses the product, if at all.83 jurisdictions that collect income or payroll taxes 78 tax increment financing: the basics, nat’l hous. conf., https://nhc.org/policyguide/tax-increment-financing-the-basics/ [https://perma.cc/baq8-h3xj]. 79 see i.r.c. § 170(a)(1). 80 see henry ordower, charitable contributions of services: charitable gift planning for non-itemizers, 67 tax l. 517, 533-36 (2014). 81 see mac taylor, legis. analyst’s off., a look at voter-approval requirements for local taxes 11 (2014), https://lao.ca.gov/reports/2014/finance/localtaxes/voter-approval-032014.pdf [https://perma.cc/3fae-yqbp] (greater approval rate for taxes like sales taxes that do not require a super majority in california). see also taxes on the ballot, ballotpedia, https://ballotpedia.org/taxes_on_the_ballot [https://perma.cc/ht87-mnw8] (missouri tax provision ballots on general and property tax increases). 82 this is a common concession for servicing indebtedness on professional entertainment facilities, including stadiums, as well as warehouses and distribution centers like amazon. arlington’s record sales-tax revenue will pay off cowboys stadium debt years early, dall. morning news (nov. 21, 2012), https://www.dallasnews.com/news/2012/11/22/arlington-s-recordsales-tax-revenue-will-pay-off-cowboys-stadium-debt-years-early/ [https://perma.cc/5ya9-4emu] (record sales tax revenue rise allows city leaders to pay off the stadium debt early). see also alicia robinson, stadium maintenance, debt eat into anaheim’s revenue from hosting angels baseball, orange cnty. reg. (sept. 25, 2019), https://www.ocregister.com/2019/09/25/stadiummaintenance-debt-eat-into-anaheims-revenue-from-hosting-angels-baseball/ [https://perma.cc/2ngp-fp2x]. 83 south dakota v. wayfair, inc., 138 s. ct. 2080 (2018) (expanding the authority of states to require vendors with no physical presence in the state to collect and pay over the sales or use tax on items sold to state residents). sales taxes are add-on taxes imposed when personal property is 2021] uniform international tax collection and distribution 143 may derive additional revenue from the workers at the new facility, but in many instances those workers are not new but have changed employment. where the workers are new taxpayers in the jurisdiction, they seem likely to be predominantly moderate to low-income workers because the facilities may require warehouse, maintenance and concession labor in greater numbers than highly compensated management employees.84 taxes applicable to them are often flat or regressive rather than progressive.85 in addition, part of the federal income tax is imposed separately on wages and self-employment income and is regressive because of its wage cap and its limitation to income from services.86 the growing disparity in wealth between affluent and non-affluent residents of the u.s. has been attributed in part to taxation. 87 proposals to introduce or expand progressivity in taxation to impose a greater tax burden on affluent taxpayers or to impose a tax on wealth have found proponents among members of congress who would deploy the revenue to improve services and living conditions for the less affluent members of the society.88 those senators have not garnered adequate political support for their positions to enact the changes. recent analysis by a group of economists addressing recovery from the economic impact of the 2020 pandemic instills new force into the wealth tax and withdrawal or freezing of tax benefits for successful businesses. 89 even if enacted, purchased for consumption rather than resale. the vendor generally collects the tax and pays it over to the state. if the vendor sells to a purchaser in another state, the purchaser becomes liable to the other state for complementary use tax. collection of use tax is difficult unless the vendor collects and pays over the tax. until the wayfair decision, states could not require a vendor to collect use tax on sales into the state unless the vendor had a direct or indirect presence there. the wayfair decision removed the physical presence requirement for vendors with substantial sales into a state so that a state may require out of state vendors to collect their use tax and pay it over less a fee for their collection services. the state of missouri has not yet enacted legislation implementing the wayfair decision for sales into missouri. see hannah meehan, sales tax for remote sellers: missouri’s response in a post-wayfair world, st. louis u. l.j. online 23, https://scholarship.law.slu.edu /cgi/viewcontent.cgi?article=1001&context=lawjournalonline [https://perma.cc/9mc5-uw9m]. 84 stadiums may be an exception if they are built to house a professional sports business employing many highly compensated athletes. 85 like earnings taxes in a number of cities, st. louis city earnings tax is imposed on income from services only at a flat rate of 1 percent and is regressive because it does not tax investment income. see st. louis, mo., mun. code ch. 5.22, https://library.municode.com /mo/st._louis/codes/code_of_ordinances/364861?nodeid=recosalo2020an_tit5refi_ch5.2 2eata [https://perma.cc/j33r-39tt]. 86 see, for example, social security tax in the u.s. that is imposed at a flat rate on wages (not income from investment or business ownership) up to a ceiling amount of $137,700 in 2020 and then zero for wages in excess of that ceiling. see social security and medicare withholding taxes, irs, https://www.irs.gov/taxtopics/tc751 [https://perma.cc/wd4r-ydx2]. 87 see emmanuel saez & gabriel zucman, the triumph of injustice: how the rich dodge taxes and how to make them pay (2019); emmanuel saez, striking it richer: the evolution of top incomes in the united states 6 (mar. 2, 2019) (unpublished manuscript), https://eml.berkeley.edu/~saez/saez-ustopincomes-2017.pdf [https://perma.cc/ff6mrt3z]; the distribution of household income, 2016, cong. budget off., https://www.cbo.gov /publication/55413 [https://perma.cc/j2z5-ekqf] (july 9, 2019); henry ordower, taxes and inequality, in inequality in america: causes and consequences of the rich poor divide (kimberley l. kinsley & robert s. rycroft eds.) (forthcoming 2021). 88 neil irwin, elizabeth warren wants a wealth tax. how would that even work?, n.y. times (feb. 18, 2019), https://www.nytimes.com/2019/02/18/upshot/warren-wealth-tax.html [https://perma.cc/835f-6qh2]; huaqun li & karl smith, analysis of sen. warren and sen. sanders’ wealth tax plans, tax found. (jan. 28, 2020), https://taxfoundation.org/wealth-tax/ [https://perma.cc/835f-6qh2]. 89 indep. comm’n for reform int’l corp. tax’n, the global pandemic, sustainable economic recovery, and international taxation (2020), https://static1.squarespace.com 144 columbia journal of tax law [vol. 12:126 however, no one is proposing distribution of increased tax revenue beyond the borders of the relevant taxing unit—whether that unit is a specialized, municipal, state, or national unit. a school taxing district in st. louis county is not sharing revenue with another school taxing district, nor a state like missouri sharing revenue with a neighboring state like arkansas, nor the u.s. sharing revenue with mexico. residents of one u.s. jurisdiction may move freely to another u.s. jurisdiction with a better tax base and better governmental services, for example, between lesser and better funded st. louis county school districts or across state lines if they have the wherewithal to change their residence. on the other hand, if the better-funded school district is in el paso, texas, and the lesser funded district in ciudad juarez, mexico, moving to the better-funded district is problematic even if the distance from one to the other is small. the existence of national borders as a barrier to opportunity renders the argument for cross-border revenue distribution even more compelling than cross-district where the individual may choose to relocate and capture access to the better funded district. even within the u.s., however, ability to relocate is circumscribed by individual economic factors including employment and accumulated wealth.90 the concept of sovereignty supports respecting a taxing unit’s choice to spend the tax revenue it manages to collect, even where the tax base is produced by activities in other places. a product manufactured in illinois but sold to missouri consumers is subject to missouri consumption tax, as a product manufactured in mexico but transported to and then sold to u.s. consumers is subject to consumption taxes in the u.s., not mexico. illinois or mexico in the examples derive no benefit from the consumption tax on sale. illinois and mexico might encourage their local vendors to assist purchasers in missouri or the u.s., respectively, to avoid missouri or other u.s. consumption taxes by shipping items directly to consumers in the other jurisdiction free from the consumption tax.91 any benefit illinois or mexico derives from increased business activity locally, even if minimal, is nevertheless more than it would have received from the consumption tax imposed by a neighboring jurisdiction. sovereignty is a political shield that fails to take unequal distribution of wealth and resources into account. despite central collection and administration in st. louis county or, with respect to consumption taxes, the state of missouri, sharing revenue across taxing unit borders remains bewilderingly difficult no matter how geographically close or closely connected the communities may be, how similar the residents are to one another, and how unequal the revenue distribution may be. leveling revenue distribution to provide comparable services and opportunities throughout st. louis county seems a desirable fairness objective. even within st. louis county’s narrow governmental overlay of central collection and administration under uniform taxing rules and with a uniform tax base, taking this next step toward fairer distribution of tax revenue remains elusive. for businesses within st. louis county where taxing rules, structures and measurement of the tax object are uniform, differentials in local property tax rates remain a factor in evaluating where to locate or expand a business facility. active tax competition and disparities in tax revenue among taxing jurisdictions in st. louis county help to make some business locations more desirable than others. taxing jurisdictions within st. louis /static/5a0c602bf43b5594845abb81/t/5ee79779c63e0b7d057437f8/1592235907012/icrict+glob al+pandemic+and+international+taxation.pdf [https://perma.cc/cv82-lrse]. 90 cf. supra note 66 and accompanying text (constitutional rights to travel and reside within the national borders but not across). 91 subject to possible use tax collection obligations. see wayfair, 138 s. ct. 2080. 2021] uniform international tax collection and distribution 145 county have not unified to distribute revenue to promote development for the entire region, but that step would be administratively feasible because the infrastructure for it is already in place. only rates of tax and the distribution formula would require revision to make fairer shares of resources available to all districts. if distribution of tax revenue to achieve greater uniformity in governmental services is a desirable goal, as this article argues it is, uniform tax rules, uniform tax rates, and a distribution formula meeting community needs is critical to achieve that goal. disparities in revenue distribution in st. louis county are easy to level with the fundamental tax base uniformity already in place, even though leveling is not occurring or even under discussion. globally, the oecd is promoting increased uniformity, not to level tax resource distribution, but to combat tax competition that diminishes tax revenue for developed economies. while frequently couched in terms of mnes and other taxpayers ceasing to engage in tax avoidance and paying their “fair share” of tax, a primarily political objective,92 generating increased tax revenue to ameliorate relative poverty locally has not been matched with worldwide tax revenue distribution to eliminate absolute poverty internationally.93 if assistance and cooperation from less developed economies in combating tax competition and tax avoidance is necessary to advance the developed economies’ efforts, fairer worldwide tax revenue distribution is critical, and less developed economies must be given a reason not to use their tax systems to compete. globally, distribution is of first importance but uniformity remains a close second in significance because without uniformity, as is present in the st. louis county administered property value tax base, it is difficult to compare tax levies to ascertain whether one country is collecting an appropriate tax on its share of the worldwide tax base. the tax base in international projects is income, but not all tax systems measure income in an identical manner. the next section considers whether international projects facilitate any movement toward uniform rules to facilitate fairer tax revenue distribution. no international project has selected tax revenue distribution, as opposed to tax base distribution, as its objective except as an incidental effect of tax base allocation. iv. international tax competition and reallocating the tax base a. beps and other projects in response to aggressive tax planning and “harmful” tax competition,94 various proposals have been crafted to prevent base erosion and profit shifting. these proposals are particularly salient in light of the increasing digitalization of the economy and a surge in intangible digital assets. as the current leader in international tax, the oecd has spearheaded most projects, such as the base erosion and profit shifting (beps) action 92 see brassey & ordower, supra note 37, at 99 (“[p]urported moral authority to address inequality within national borders is really a political demand to further the economic interests of particular groups that are already among the most economically privileged when viewed on an international spectrum.”). 93 see id. (finding that political will to confront international poverty is lacking); infra part iv. 94 speculative costs of revenue loss show that profit shifting has a more harmful effect on developing countries, with the implied long run revenue loss for advanced economies totaling 0.6% of the gdp and close to 2% of the gdp for developing countries. ernesto crivelli, et al., base erosion, profit shifting and developing countries 20 (imf, working paper no. 15/118, 2015), https://www.imf.org/external/pubs/ft/wp/2015/wp15118.pdf [https://perma.cc/rk4f-a5uz]. 146 columbia journal of tax law [vol. 12:126 reports and the global anti-base erosion (globe) proposal. in parallel with the oecd projects, the eu also has relaunched the ccctb95 to harmonize the taxing rules and standards of member states and to better incorporate the beps actions through cohesive legislation. the ccctb more simply tries to apportion the corporate income tax base consistently and predictably among the eu jurisdictions in which the company operates so that each may tax its share of an mne’s income under its own income tax rules but with no part of the income subject to tax in more than one jurisdiction or not subject to tax in any jurisdiction. 96 while the ccctb project does not seek complete uniformity in computational rules for tax purposes beyond what is necessary to facilitate apportionment, its adoption should result in considerable convergence of tax rules to create a consistent base to apportion. requested and endorsed by the g2097 leaders, the oecd aggregated 15 actions intended to combat the abuse of profit shifting as exacerbated by the digital economy. the actions confront the unique challenges of the digital economy;98 aim to neutralize hybrid mismatch arrangements; 99 strengthen cfc rules; 100 reduce base erosion via interest deductions and other financial payments;101 recognize and counter harmful tax practices;102 prevent treaty abuse;103 prevent the artificial avoidance of permanent establishment;104 ensure transfer pricing outcomes are in line with value creation;105 collect and analyze data on beps;106 require the disclosure of aggressive tax planning arrangements;107 re-examine 95 q&a ccctb, supra note 18. 96 income not subject to taxation in any jurisdiction is known as “stateless income.” see edward d. kleinbard, stateless income, 11 fla. tax rev. 699, 702-07 (2011). 97 the group of 20 is organization of finance ministers and central bank governors, and member countries account for 80% of the world’s gdp. g20 aims to unite world leaders on economic, political, and health challenges. see michael crowley, what is the g20?, n.y. times (june 27, 2019), https://www.nytimes.com/2019/06/27/world/asia/what-is-the-g20.html [https:// perma.cc/wvn8-fbur]. 98 oecd/g20 base erosion and profit shifting project, oecd, addressing the tax challenges of the digital economy, action 1 2015 final report (2015) [hereinafter action 1]. 99 oecd/g20 base erosion and profit shifting project, oecd, neutralising the effects of hybrid mismatch arrangements, action 2 2015 final report (2015). cf. i.r.c. § 267a (denying deductions or exclusions for related party and hybrid transactions resulting in a mismatch of inclusion and exclusion or deduction). 100 oecd/g20 base erosion and profit shifting project, oecd, designing effective controlled foreign company rules, action 3 2015 final report (2015). 101 oecd/g20 base erosion and profit shifting project, oecd, limiting base erosion involving interest deductions and other financial payments, action 4 2015 final report (2015). 102 oecd/g20 base erosion and profit shifting project, oecd, countering harmful tax practices more effectively, taking into account transparency and substance, action 5 2015 final report (2015). 103 oecd/g20 base erosion and profit shifting project, oecd, preventing the granting of treaty benefits in inappropriate circumstances, action 6 2015 final report (2015). 104 oecd/g20 base erosion and profit shifting project, oecd, preventing the artificial avoidance of permanent establishment status, action 7 2015 final report (2015). 105 oecd/g20 base erosion and profit shifting project, oecd, aligning transfer pricing outcomes with value creation, action 8-10 2015 final reports (2015). 106 oecd/g20 base erosion and profit shifting project, oecd, measuring and monitoring beps, action 11 2015 final report (2015). 107 oecd/g20 base erosion and profit shifting project, oecd, mandatory disclosure rules, action 12 2015 final report (2015). 2021] uniform international tax collection and distribution 147 transfer pricing;108 improve dispute resolution mechanisms;109 and create a multilateral instrument for synchronized modification of bilateral tax treaties that incorporates the oecd actions without renegotiating existing bilateral treaties.110 only four of the actions, however, were agreed upon as part of the minimum standards discussed in the beps inclusive framework and committed to by the member countries.111 despite such ambitious and all-encompassing objectives, the action plans have fallen short of some critics’ expectations.112 a repeated criticism of the beps project is that it does not address the underlying faults of the existing international tax system and instead rehashes and strengthens existing rules and principles.113 some commentators state that the foundational tax base allocation rules that pre-exist and are enforced by beps ensure that higher income countries are consistently assigned a greater share of revenue than lower income countries.114 the oecd has recognized and committed itself to being 108 oecd/g20 base erosion and profit shifting project, oecd, transfer pricing documentation and country-by-country reporting, action 13 2015 final report (2015) [hereinafter action 13]. 109 oecd/g20 base erosion and profit shifting project, oecd, making dispute resolution mechanisms more effective, action 14 – 2015 final report (2015). 110 oecd/g20 base erosion and profit shifting project, oecd, developing a multilateral instrument to modify bilateral tax treaties, action 15 – 2015 final report (2015) [hereinafter action 15]. 111 the minimum standards which have been committed to are: fighting harmful tax practices (action 5), preventing tax treaty abuse (action 6), improving transparency with countryby-country reporting (action 13), and enhancing the effectiveness of mechanisms for dispute resolution (action 14). oecd, inclusive framework on beps: progress report july 2016june 2017 9-12 (2017). to date, 139 countries are members of the oecd/g20 inclusive framework on beps. members of the oecd/g20 inclusive framework on beps, oecd, https://www.oecd.org/tax/beps/inclusive-framework-on-beps-composition.pdf [https://perma.cc /ux73-8chr] (last updated feb. 2021) [hereinafter beps members]. 112 see adam h. rosenzweig, defining a country’s “fair share” of taxes, 42 fla. st. u. l. rev. 373 (2015). for conceptual background on developing international fair taxation standards, see steven a. dean, neither rules nor standards, 87 notre dame l. rev. 538 (2011); nancy h. kaufman, fairness and the taxation of international income, 29 l. & pol'y int'l bus. 145 (1998). 113 reuven s. avi-yonah & haiyan xu, evaluating beps: a reconsideration of the benefits principle and proposal for un oversight, 60 harv. bus. l. rev.186, 208 (2016). see also mindy herzfeld, the case against beps: lessons for tax coordination, 21 fla. tax rev. 1 (2017) (project’s lack of coordinated rules results in vague standards that everyone accords different meanings within each country. further, the oecd missed the opportunity to truly examine the underlying causes of the issues and meaningfully discuss the reasons for tax competition and the tension between emerging economies and oecd members); michael p. devereux & john vella, are we heading towards a corporate system fit for the 21st century?, 35 fiscal stud. 449 (2014) (it is not a fundamental reform because the oecd does not set out to change the framework or even question the desirability or logic of the existing regime); jakib a. bartoszewski & andew p. morriss, an archipelago of contrasts: blacklists, caribbean autonomy and the new tax colonialism, ifc (june 17, 2020), https://www.ifcreview.com/articles/2020/june/an-archipelago-of-contrastsblacklists-caribbean-autonomy-and-the-new-tax-colonialism [https://perma.cc/btl6-3ee3] (arguing that the blacklisting of caribbean tax havens by the eu is a new form of colonialism and the eu should instead focus on designing its own efficient tax regime to protect its tax revenue); steven a. dean, fatca, the u.s. congressional black caucus, and the oecd blacklist, 99 tax notes int'l 83 (july 6, 2020) (discussing the role of the congressional black caucus in the u.s. withdrawal from the oecd project on harmful tax competition because of its adverse effect on low wealth, predominantly black jurisdictions). 114 christians & van apeldoorn, supra note 32, at 2. 148 columbia journal of tax law [vol. 12:126 more inclusive of developing countries,115 although some believe that the only way to achieve this is by overhauling the foundational principles of the existing system, which inherently favors higher income countries, and which beps fails to do.116 others believe that the actions may allow for greater source-country taxation, which could be beneficial for developing countries that generally are considered source countries, provided that the necessary multinational consensus on the allocation of taxing rights is forthcoming.117 action 13 re-examines transfer pricing documentation and requires country-bycountry reporting. the action includes the requirement that mnes provide relevant governments with the information necessary to correct and fair allocation of income among states,118 while action 15 contemplates developing a multilateral instrument to synchronize modification of existing bilateral treaties without the need to renegotiate those treaties.119 some consider the country-by-country reporting recommendation innovative and collaborative, as it enhances transparency and allows informed discussion. 120 the multilateral instrument proposal has been described as almost revolutionary given the current predominantly bilateral tax treaty regimes, and some have argued that success of this proposal would be sufficient to qualify the beps project as a success, regardless of the success or failure of the other actions.121 b. globe – minimum tax and base erosion following concern and criticism that the beps final actions do not go far enough in addressing the issues of profit shifting, the oecd responded with the globe proposal. pillar one of globe concerns the allocation of tax rights among jurisdictions, and pillar two imposes two new taxes: a global minimum tax on corporate profits and a tax on base eroding payments.122 encompassed within the global minimum tax is an income inclusion rule, implementing a supplementary tax on the income of foreign entities where the income otherwise would be subject to a tax below the effective minimum rate. the minimum tax also would allow residence jurisdictions to switch from an exemption to a credit method when profits attributable to a permanent establishment are subject to an effective rate below the minimum rate.123 functionally, the minimum tax would resemble the existing u.s. worldwide taxation system under which u.s. persons are taxable on their worldwide 115 oecd, public consultation document: secretariat proposal for a “unified approach” under pillar one 6 (2019), https://www.oecd.org/tax/beps/public-consultationdocument-secretariat-proposal-unified-approach-pillar-one.pdf [https://perma.cc/5dkw-6ely]. 116 see herzfeld, supra note 113. 117 david spencer, beps and allocation of taxing rights, 29 j. int’l tax’n 143, 155 (2018). 118 see action 13, supra note 108, at 23. 119 see action 15, supra note 110. 120 yariv brauner, what the beps? 16 fla. tax rev. 55, 104-05 (2014). but see devereux & vella, supra note 113, at 461-62 (noting that the information is only to be disclosed to tax authorities and not the public, therefore reducing its transparency). 121 brauner, supra note 120, at 107. see also rasmus corlin christensen & martin hearson, the new politics of global tax governance: taking stock a decade after the financial crisis, 26 rev. int’l pol. econ. 1068, 1077 (2019) (noting that the multilateral instrument is the result of deeper and broader sovereignty-constraining effects than ever before). 122 see oecd/g20 inclusive framework on beps, oecd, programme of work to develop a consensus solution to the tax challenges arising from the digitalisation of the economy (2019) [hereinafter oecd/g20 inclusive framework on beps]. 123 oecd, public consultation document global anti-base erosion proposal (globe) (pillar two): tax challenges arising from the digitalization of the economy 6 (2019) [hereinafter globe pillar two public consultation]. 2021] uniform international tax collection and distribution 149 income in the u.s.124 but the u.s. tax is reduced through a tax credit by the tax properly payable to the source jurisdiction.125 the globe tax on base eroding payments includes an undertaxed payments rule. that rule denies a deduction or imposes a tax at the payment’s source if the payment is to a party related to the payer and the payment is not subject to the specified minimum tax rate where it is received. this aspect of the globe tax proposal operates similarly to the base erosion anti-avoidance minimum tax the u.s. enacted in 2017.126 in addition, the globe tax more generally denies treaty benefits such as a reduced withholding rate if a payment does not result in income that is subject to tax at the specified minimum tax rate.127 the globe project suggests a means to remove tax from the international mix of business development incentives. although globe focuses on the digital economy, its principles apply to a broader range of problems as well. globe’s two fundamental principles resemble approaches the u.s. and other jurisdictions already have taken with respect to their own resident mnes. one principle includes the income of foreign branches and controlled entities in the income of the parent or principal entity based in the higher tax jurisdiction if the branch or controlled entity is resident in a low tax jurisdiction.128 unlike most countries that have territorial income tax systems under which branch income is only taxable where earned, the u.s. already includes the income of foreign branches under the rubric of worldwide taxation of its citizens, residents and domestic entities. unless the u.s. taxpayers interpose a foreign corporation, 129 they are taxable on foreign source income immediately and capture no benefit from operating or investing directly in a low tax jurisdiction.130 the globe proposal as applied to controlled entities resembles existing cfc131 regimes common to the u.s. and other jurisdictions.132 in the u.s., subpart f income133 of a cfc is taxable to its u.s. shareholders.134 like the globe minimum tax treatment of 124 see i.r.c. § 61; treas. reg. § 1.1-1(b). 125 see i.r.c. § 901(b)(1). 126 see i.r.c. § 59a. 127 globe pillar two public consultation, supra note 123, at 34. 128 see id. at 29-30.; devereux et al., supra note 16, at 1-2; ruth mason, the transformation of international tax, 114 am. j. int'l l. 353, 376 (2020). 129 the u.s. may not tax a foreign corporation on its income from non-u.s. sources and not effectively connected with the conduct of a u.s. trade or business directly. i.r.c. §§ 11(d), 882 (tax on foreign corporations). the controlled foreign corporation anti-avoidance rules discussed infra note 132 and accompanying text may tax all or part of the foreign corporation’s income to its u.s. shareholders. 130 new but limited territoriality in u.s. tax law under section 245a, added by the tcja , now provides a 100 percent dividends received deduction for distributions from foreign corporations to u.s. corporate shareholders owning at least 10 percent of the foreign corporation enables u.s. corporations to operate outside the u.s. through non-u.s. subsidiaries and, subject to cfc and base erosion minimum tax limitations, avoid the u.s. income tax. 131 a cfc is a foreign corporation in which united states shareholders (u.s. shareholders) own more than 50 percent of the voting shares and share value. i.r.c. § 957(a). section 951(b) defines a u.s. shareholder as a u.s. person owning, directly or indirectly, 10 percent or more of the voting shares or the share value of the foreign corporation. i.r.c. § 951(b). 132 see sebastian dueñas, cfc rules around the world,, tax found. (june 2019), https://files.taxfoundation.org/20190617100144/cfc-rules-around-the-world-ff-659.pdf [https:// perma.cc/zx9a-3v26] (describing cfc rules outside the u.s.). 133 i.r.c. § 952. 134 section 951(a) includes the u.s. shareholder’s pro rata share of the cfc’s subpart f income, as defined in section 952, in the shareholder’s u.s. income subject to tax currently without distribution from the cfc. i.r.c. §§ 951(a), 952. 150 columbia journal of tax law [vol. 12:126 rates at least equal to the minimum tax rate,135 if the foreign base company income136 portion of the subpart f income is taxed in the cfc residence country at a rate greater than 90 percent of the u.s. corporate tax rate, that portion of the subpart f income is not subject to cfc inclusion in the u.s. shareholders’ incomes.137 foreign base company income includes income from sales and services attributable to the cfc if there is little or no business reason, other than tax, for sourcing the income in that corporation.138 u.s. noncorporate shareholders of cfcs also must include their pro rata shares of the cfc’s global intangible low-taxed income (gilti) annually,139 but corporate shareholders of cfcs include only half their shares of the gilti income because they may deduct half the gilti income under the foreign derived intangible income provision.140 gilti includes income produced by intangible assets, including income from the digital economy, which is globe's focus, in u.s. shareholders’ portions of includable cfc income.141 for instance, intellectual property produces digital economy income that is predominantly intangible and which becomes part of net tested cfc income142 but generates no offsetting net deemed tangible income return 143 because intangible intellectual property is excluded from qualified business asset investment.144 the second pillar of the globe proposals, the “base erosion” proposal, disallows deductions and treaty benefits for base erosion payments. a base erosion payment but for the globe proposal rule would yield a deduction or enjoy a treaty benefit without the payment becoming subject to tax in the recipient’s jurisdiction at or above a designated minimum rate. tax rate arbitrage with related party payments is commonplace where no anti-avoidance rule or minimum tax discourages it. where the parties to the transaction have a community of economic interests as related parties do or have some other opportunity to return part of the low tax jurisdiction’s profit to other party free from a tax in the higher tax jurisdiction, the parties may share the tax savings from the structure without any non-tax economic cost to either party.145 the base erosion proposal addresses this longstanding problem of tax rate arbitrage. where the payments are between related parties, transfer pricing limitations have long enabled the tax administrator to attribute the income to a different taxpayer than the taxpayer receiving it.146 the base erosion proposal supplements the inquiry into whether the payment to a related party is an arms’ length transfer price by limiting the tax arbitrage opportunity for all related party payments. the u.s. recently sought to accomplish a similar tax arbitrage limiting function with its separate base erosion minimum tax, known as beat, for certain related party payments.147 the minimum tax and the denial of the deduction or treaty benefit would compel the low tax jurisdiction to enact a rate at least equal to the minimum rate. failing to collect 135 globe pillar two public consultation, supra note 123. 136 i.r.c. § 954. 137 i.r.c. § 954(b)(4). 138 i.r.c. § 954(d). 139 see i.r.c. § 951a (added by the tcja). 140 i.r.c. § 250 (added by the tcja). 141 i.r.c. § 951(a). 142 i.r.c. § 951a(c). 143 i.r.c. § 951a(b)(2). 144 i.r.c. § 951a(d). 145 cf. i.r.c. § 7701(o) (requiring economic substance independent of tax benefits for an arrangement to yield the tax outcomes that the parties have structured into the transaction). 146 i.r.c. § 482 and related regulations. 147 i.r.c. § 59a (added by the tcja, imposing a minimum tax at 10 percent, increasing to 12.5 percent in 2025). 2021] uniform international tax collection and distribution 151 the minimum tax amount would relinquish the potential tax revenue without having a benefit to offer to the investor because the high tax jurisdiction will capture the difference between the low tax jurisdiction’s actual tax and the minimum tax or all the revenue in the case of the base erosion payment.148 although the beps projects, when fully implemented, may represent a principle of full taxation,149 the policy consensus of the beps project has been that no or low taxation is not itself a cause of concern. 150 beps’ objectives are: (1) to prevent profit shifting by supplementing traditional transfer pricing controls with a minimum tax, and (2) to reduce tax competition by segregating transactions with related parties even if at an arms’ length price whenever they do not incur a tax equal to or greater than the minimum tax. the latter objective may be more difficult to achieve insofar as it burdens a discrete class of taxable income from transactions between related persons that is taxed less favorably than other income even though it may flow from arms’ length transactions that transfer pricing law would accept as correctly characterized and would not reallocate between or among taxpayers. critics consider the application of the deduction denial and loss of treaty benefit to even arms’ length payments between related parties as adversely affecting countries’ ability to attract investment and activity that does not abuse tax rules because a country chooses to attract investment with low or zero tax rates. the deduction denial and loss of the treaty benefit rule prevents countries from taxing profits generated through actual activity taking place within their borders at any rate they choose. that tax rate limitation diminishes the sovereignty of low and zero tax countries.151 other commentators appreciate that the minimum tax could significantly reduce the distortions of international capital allocation and remove incentives to shift profits, although it does not fully equalize the tax burden of domestic and foreign investment.152 similarly, commentators express the view that a minimum tax infringes on sovereignty is a questionable premise, as unfettered sovereignty can only be claimed in purely internal situations. in the international context, external interests may require compromise of sovereignty to maintain peaceful relations and cross-border commerce.153 the globe proposal does acknowledge that there is international capital imbalance disfavoring less developed economies. the oecd views the globe proposal as a way to remedy that imbalance. the proposal would allocate a somewhat greater share of the base to less developed jurisdictions. under the guise of tax fairness, the minimum tax will inhibit jurisdictions from engaging in tax-based competition for inbound investment with tax concessions for international investors. less developed jurisdictions will collect more tax on their larger shares of the tax base than they might have collected with robust tax competition because they will impose a tax at a rate no less than the minimum tax. like the other oecd projects, the globe project is mindful of tax sovereignty but, nevertheless, intrudes upon taxing sovereignty with effective economic compulsion to enact a minimum rate of tax through the vat directive that limits the tax sovereignty of the eu member states. 154 globe provides a trade-off for the relinquishment of tax 148 see devereux et al., supra note 16, at 1-2; discussion infra part v. 149 mason, supra note 128, at 370 (“beps both confirmed and operationalized full taxation as a new international tax norm.”). 150 devereux et al., supra note 16, at 1. 151 id. at 5. 152 joachim englisch & johannes becker, international effective minimum taxation – the globe proposal, 11 world tax j. 483 (2019). 153 id. at 492-93. 154 ec council directive, supra note 44 (vat directive in the eu). 152 columbia journal of tax law [vol. 12:126 sovereignty by restructuring the allocation of the income tax base such that more allocation is accorded to less developed countries. except for the minimum rate, the project does not promote broad taxing uniformity. neither does the project recommend uniform rules of taxation across jurisdictions. it leaves the administration and collection of tax on the jurisdiction’s share of the tax base to each taxing jurisdiction. accordingly, a jurisdiction interested in offering a tax-based subsidy might adjust its tax rules to benefit the subsidized taxpayer while maintaining a nominal tax rate equal to the minimum. the complexity of addressing all possible tax subsidization permutations will be challenging to police. despite the beps’ objective to prevent erosion of the base with international coordination, developed and dominant economies exercising tax sovereignty, even consistent with beps, have flexibility in designing their own domestic tax rules in a manner that might impose some of their rules indirectly on other economies. by applying its own taxing rules in determining whether or not an mne was subject to tax at a rate equal to or greater than the minimum tax rate, a developed and dominant economy might compel other economies to coordinate their tax rules. results would differ depending on the rules in the taxpayer’s home jurisdiction as opposed to another major economy’s rules. where the mne is operating in multiple jurisdictions and each or many jurisdictions apply their own taxing rules to determine whether the mne is paying the minimum tax amount, a cacophony of outcomes might result offering little improvement over what exists now. ultimately, it seems that the success of the globe proposal depends on the nearunanimous adoption of the minimum tax and the tax on base eroding payments. otherwise, the proposal might exacerbate tax competition problems, as non-adopting countries that refrain from implementing the measures could manipulate this to their tax advantage. they might entice mnes to move their parent company to their jurisdiction by offering a tax home free from the minimum tax requirement. countries adopting the minimum tax and base eroding tax must design methods to prevent migration of mnes as the u.s. sought to do with its anti-inversion legislation.155 similarly, harmonization of the tax base and applicable thresholds is essential to the success of the project lest countries simply continue to compete by adjusting rules of inclusion and thresholds. c. tax competition, avoidance, and evasion while the oecd pushes on with its project to overhaul taxation of mnes and has 140 countries scheduled to participate in meetings on a revised international tax framework,156 the framework is unlikely to eliminate international tax competition. even among the 140 participants, a variety of competing concerns may manifest themselves among the participants. the u.s., for example, continues to express reservations with 155 i.r.c. § 7874. 156 stephanie soong johnston, oecd postpones key meeting of global tax overhaul project, tax notes today int’l (may 5, 2020), https://www.taxnotes.com/featured-news/oecdpostpones-key-meeting-global-tax-overhaul-project/2020/05/04/2ch38 [https://perma.cc/76wnafwc]. 2021] uniform international tax collection and distribution 153 respect to digital services,157 and 53 u.n. member states158 are not even included in the oecd deliberations. moreover, while the base erosion projects address a variety of methods that taxpayers use to shift income source to low tax jurisdictions, they do not unify all computational rules and tax rates. the oecd also publicly identified tax havens that engaged in harmful tax competition to shame or coerce them to cooperate with the major market jurisdictions and share information. information sharing would assist the developed economy countries to identify investors subject to their general taxing jurisdiction when those investors conceal assets in low tax jurisdictions to avoid home country taxes.159 the harmful tax competition project has encouraged rapid growth of agreements on information sharing.160 the u.s. also coerced international cooperation by enacting legislation denying favorable u.s. tax status to foreign entities that did not provide information on their u.s. direct and indirect investors who were investing outside the u.s. and not reporting their income from those investments.161 perhaps the most interesting action regarding information gathering was when germany purchased a stolen list of german investors in liechtenstein stiftungen to discover those investors’ evasion of german tax liability.162 the u.s. approach to tax competition differs somewhat from that of other oecd countries. since the u.s. taxes its citizens, residents, and domestic entities on their income from all sources worldwide,163 operating or investing directly in low tax jurisdictions provides u.s. persons no tax benefit provided that the u.s. taxpayer reports completely and honestly. hiding assets and failing to report offshore income is tax fraud which may subject the taxpayer to civil and criminal penalties.164 the tax on worldwide income in the u.s. similarly eliminates the benefit of negotiated tax concessions insofar as the u.s. applies a credit rather than exemption165 to all foreign source income and generally cedes primary taxing authority to the source country through the foreign tax credit 166 but 157 see id.; william hoke, u.s. says oecd talks on digital economy have hit an impasse, tax notes (june 22, 2020), https://www.taxnotes.com/tax-notes-federal/digital-economy /us-says-oecd-talks-digital-economy-have-hit-impasse/2020/06/22/2cmvw [https://perma.cc/8znzx3cf]; stephanie soong johnston, business groups rally around oecd global tax deal work, tax notes today int’l (june 29, 2020), https://www.taxnotes.com/tax-notes-today-international /digital-economy/business-groups-rally-around-oecd-global-tax-deal-work/2020/06/29/2cnr7 [https://perma.cc/z657-3lqd]; stephanie soong johnston, global tax revamp talks ’not on life support,’ saint-amans says, 98 tax notes int’l 1536 (june 29, 2020), https://www.taxnotes.com/tax-notes-international/politics-taxation/global-tax-revamp-talks-notlife-support-saint-amans-says/2020/06/29/2cnj3 [https://perma.cc/z4y3-hptp]. 158 the u.n. has 193 member states, and 140 member states participate, leaving 53 nonparticipants. see about the un, un, https://www.un.org/en/about-un/index.html [https://perma.cc /q56a-tskd] (193 u.n. member states); johnston, supra note 156 (about 140 u.n. member states participate in oecd deliberations). 159 see oecd harmful tax competition, supra note 12, at 24, 50. 160 tiea, supra note 9 (showing increasing numbers of agreements from 2001 to 2012). 161 see foreign account tax compliance act (fatca). 162 ordower, supra note 42, at 124. 163 i.r.c. § 61 (gross income includes all income from whatever source derived); treas. reg. § 1.1-1(b) (worldwide income taxed). 164 i.r.c. § 7201. 165 cf. globe pillar two public consultation, supra note 123 and accompanying text (the exclusion to credit shift under pillar ii of the oecd globe proposal). 166 i.r.c. § 901. 154 columbia journal of tax law [vol. 12:126 continues to claim the difference between the u.s. tax on the income and the tax imposed by the source jurisdiction.167 u.s. taxpayers may avoid a current tax in the u.s. by operating or investing outside the u.s. through a tax opaque, non-u.s. entity.168 the u.s., however, has enacted an array of mechanisms to protect its claim to a share of the foreign source income in which u.s. persons have an indirect interest through a non-u.s. corporation, including the cfc,169 passive foreign investment company (pfic),170 expatriated entity,171 and now repealed foreign personal holding company172 provisions. the cfc provisions even permit the u.s. to reach across national borders to tax part of the income of cfcs to their u.s. shareholders without any actual or constructive distribution from the cfcs to the u.s. shareholders as a necessary requirement for the tax imposition. with respect to the hidden investment capital of u.s. persons, the u.s. has also sought to enlist the assistance of non-u.s. financial institutions in its quest to tax the income that capital generates.173 d. tax base allocation and apportionment underlying any allocation or apportionment of an income tax base is an implicit assumption that a base exists to allocate and apportion. while definitions of income for tax purposes exist,174 the elements of any income tax base enjoy commonalities with all income tax bases, but the details of inclusion, exclusion, and deduction differ across 167 i.r.c. § 904. for example, a invests in country x and earns $100. country x imposes a $10 tax on a’s income in x. the u.s. would impose a $30 tax on the $100 income from x but allows a a tax credit of $10 (the x tax) and imposes a net tax on the x source income of $20. if the x tax were $40, the u.s. tax credit for a would be limited to $30, the amount of the u.s. tax on the income. 168 tax opacity is characteristic of corporations under subchapter c of the i.r.c. and contrasts with tax transparency of partnerships and other entities under subchapter k of the i.r.c. a tax opaque entity is itself subject to the income tax while a tax transparent entity is not but its owners are taxable on their proportional shares of the entity’s income, as if the owners received the income from the source and in the manner that the entity received it. i.r.c. § 702(b). non-u.s. business entities that are included in the foreign entities list in treasury regulation section 301.7701-2(b)(8) are tax opaque, and the default classification of other foreign entities in which the entity’s owners have limited liability is also tax opaque, but the owners of the latter group may elect tax transparency. treas. reg. § 301.7701-3(b)(2) (referred to as the check-the-box regulation). both domestic and foreign tax transparent entities may elect to be tax opaque. treas. reg. § 301.7701-3(a). there also are various hybrid entities such as regulated investment companies that are tax opaque entities but are allowed a deduction for distributions to their shareholders so that they do not pay tax at entity level. i.r.c. § 852. 169 see i.r.c. § 951 (u.s. persons owning 10 percent or more of the shares of a cfc include their shares of subpart f and gilti income). 170 see i.r.c. § 1291(income recognition in respect of stock in pfics). see also i.r.c. §§ 1293, 1296 (current inclusion of pfic income election and mark to market election). 171 i.r.c. § 7874 (tax on inverted entities). 172 i.r.c. § 551 (repealed 2004). 173 under fatca, non-cooperating foreign financial institutions lose the benefit of withholding reductions on u.s. investments. see i.r.c. § 1471. 174 for example, an oft-cited definition for a comprehensive income tax base is the schanzhaig-simons’ definition where income is the algebraic sum of consumption plus or minus the change in the taxpayer’s net worth from the beginning to the end of the tax measuring period. henry simons, personal income taxation: the definition of income as a problem of fiscal policy 49 (1938). only rarely, however, do jurisdictions include unrealized appreciation and depreciation of property in their tax bases. the u.s. does not include unrealized appreciation and depreciation generally but does include both for certain financial positions under i.r.c. section 1256, dealer-held securities under i.r.c. section 483 and all property of expatriating taxpayers under i.r.c. section 877a. 2021] uniform international tax collection and distribution 155 jurisdictions. for example, most u.s. states that impose an income tax use federal adjusted gross income 175 as their point of departure for determining the base for the tax. 176 nevertheless, state income tax rules are not uniform. each state modifies the amount of adjusted gross income to arrive at the income base upon which it imposes its income tax.177 internationally, the components of income tax bases vary. while the u.s. includes gains from the sale or exchange of property in the income tax base,178 germany does not tax gain on tangible personal property held more than a year or real property held more than ten years.179 thus, a u.s. citizen who is resident in germany and sells property in germany might have no inclusion of gain from the sale of property in germany but have the gain included in their u.s. income for tax purposes without there being any difference in the taxpayer’s economic income in germany and the u.s. certainly, tax systems have tended to copy elements from other tax systems, 180 and tax rules have converged considerably over the years so that computational differences between jurisdictions may be smaller today than in earlier decades.181 yet differences endure and a single common definition of taxable income remains elusive. since beps seeks to eliminate profit shifting and base erosion, consistent definitions of profit and base are essential to pursue those goals. definitional disparities undermine the potential success of the oecd projects because parties to any international agreements may be agreeing to a methodology but not to the tax items to which it applies. the definitional disparities leave open the possibility that even if an oecd project succeeds in gaining international consensus, its success in application may remain incomplete. turning to the eu, in the hope of strengthening the single market, the updated ccctb proposal182 aims to build upon the beps actions and effectively integrate the reforms by harmonizing the approach of member states.183 this would be achieved through a two-step plan: first, the proposal calls for the implementation of a common corporate tax base (cctb) in order to implement a cohesive, mandatory corporate tax base definition and calculation system throughout the eu, and second, the ccctb proposal builds upon the cctb with additional measures for tax base consolidation and apportionment. 184 commentators view the updated cctb proposal as a significant 175 see i.r.c. § 62(a); amy b. monahan, state individual income tax conformity in practice: evidence from the tax cuts & jobs act, 11 colum. j. tax l. 57 (2019). 176 see, e.g., mo. rev. stat. § 143.121.1. 177 mo. rev. stat. § 143.121.2-6. 178 i.r.c. § 1001. 179 germany individual income determination – capital gains, pwc (feb. 13, 2021), https://taxsummaries.pwc.com/germany/individual/income-determination [https://perma.cc/g9zj775h]. see also german income tax act, (estg) einkommensteuergesetz in der fassung der bekanntmachung vom 8. oktober 2009 (bgbl. i s. 3366, 3862), https://www.gesetze-iminternet.de/estg/bjnr010050934.html#bjnr010050934bjng000208140 [https://perma.cc/jex46bez]. 180 see infanti, supra note 7. 181 see luis c. calderon gomez, transcending tax sovereignty and tax standardization: three questions, 45 yale j. int'l l. 191, 192 (2020). 182 the original ccctb proposal was in 2011. proposal for a council directive on a common consolidated corporate tax base (ccctb), com (2011) 121 final (oct. 6, 2011). 183 commission to the european parliament and the council communication for a fair and efficient corporate tax system in the european union: 5 key areas for action, com (2015) 302 final (june 17, 2015). 184 see proposal for a council directive on a common corporate tax base (cctb), com (2016) 685 final (oct. 25, 2016); proposal for a council directive on a common consolidated corporate tax base (ccctb), com (2016) 683 final (oct. 25, 2016). 156 columbia journal of tax law [vol. 12:126 improvement with respect to its focus on tax fairness and commitment to combating base erosion, as it gives equal importance to non-taxation and under-taxation as it does to overtaxation. this compares to the 2011 ccctb which was concerned primarily with overtaxation and reflected the european commission’s pro-market and pro-business emphasis in tax matters.185 significant issues remain, however. although harmonization envisions the resolution of tax competition due to transparent tax rate competition, there is some speculation that the proposal could in fact incentivize “factor-manipulation,” which would allow artificial tax base shifting to continue.186 there is also concern that in leaving out tax rate coordination, member states are not sufficiently constrained from engaging in competition through corporate income tax rates to attract economic activity, 187 and similarly, “[c]ountries may circumvent the common tax base by moving from allowances to tax credits as incentives.”188 the ccctb project has a less ambitious objective and focuses on replacing transfer pricing guidelines with formulary apportionment.189 this approach presumably requires uniform income computation rules to develop an income apportionment formula. 190 application of the ccctb proposal to mnes would have undercut the argument that mnes are at risk of multiple impositions of tax on the same income. the ccctb apportionment formula would provide predictable outcomes and assure that each unit of income is taxable only in a single jurisdiction. however, member states did not agree to the apportionment formula. 191 the ccctb proposal eliminated intangible property from the formula. with intangible property, the most fluid source factor of income apportionment removed from the formula,192 mnes would have lost a principal tool for increasing the effective income apportionment to low tax jurisdictions. only to the extent that the mne has physical property, employees, or sales in a low tax jurisdiction does the formula apportion any of the mne’s income to the low tax jurisdiction.193 the ccctb proposal is consistent with the assertion that representatives of mnes frequently make that a reasonable level of taxation under unambiguous tax rules is acceptable as long as all mnes are subject to identical and predictable rules so that none gain a competitive advantage through the tax system. the globe project similarly aligns well with assertions that there exists a concept of fair share or fair taxation. while the concept of fair share or fair taxation underlies recent discussions of a minimum tax, it is 185 see christian valenduc, corporate income tax in the eu, the common consolidated corporate tax base (ccctb) and beyond: is it the right way to go? 18 (etui, working paper 2018.06, 2018) (“[s]ince 2011, the commission has been moving from a tax policy agenda that was only ‘pro-market’ and ‘pro-business’ to a broader tax policy agenda that includes fairness and combating profit shifting and tax avoidance.”). 186 see maarten f. de wilde, tax competition within the european union revisited — is the relaunched ccctb a solution? 1 erasmus l. rev. 24 (2014). 187 hungary has a 9 percent, ireland has a 12.5 percent, and lithuania a 15 percent corporate rate, compared to france’s 32 percent rate and germany’s 29.9 percent rate. elke asen, corporate income tax rates in europe, tax found. (apr. 16, 2020), https://taxfoundation.org /2020-corporate-tax-rates-in-europe/ [https://perma.cc/69en-ferb]. 188 see valenduc, supra note 185, at 23. 189 boer, martin, a few comments on the ccctb directive 2-4 (feb. 28, 2012) (unpublished manuscript), https://ssrn.com/abstract=2012276 [https://perma.cc/7cqz-r6s6]. 190 id. at 5. 191 id. at 8. 192 see 2011 ccctb proposal, supra note 17, at 14 (paragraph 21 of preamble). 193 see id. at 49 (article 86). cf. ordower, supra note 33, at 386. 2021] uniform international tax collection and distribution 157 elusive and political. it lacks meaning other than as a politically relative concept supporting claims to a greater share of a limited resource.194 the reasonableness of a specific level of taxation should remain separate from the application of any nation’s tax rules and the correct location for the imposition of the tax, that is, the question of which nation may collect that correct amount of tax. the premise that some correct amount or rate of taxation exists underpins all the beps iterations that conclude that mnes ought to pay more tax than they do currently. while a general notion of a universally correct level of taxation may exist and each mne and possibly each individual should be subject to that level, some (or many) mnes and individuals are not paying that correct level. yet, the beps projects are not geographically neutral in their approach to collecting the fair amount of tax but conflate the fair tax concept with geographic determinations that the mnes are avoiding taxes imposed by the developed economies.195 that approach politicizes the concept of fairness rather than seeking consensus concerning the correct level of taxation free from the political issue of which nation gets the revenue.196 v. the relative and absolute poverty conundrum once oecd participants agree to an anti-profit shifting structure, mnes in the aggregate will pay additional tax. whether residence, consumption, or another metric becomes the measuring instrument to prevent profit shifting, income will be allocated so that mne’s can no longer concentrate revenue in low tax jurisdictions that are not contributing more than a minimal amount to the production of the income. allocation factors such as labor measured by person-hours rather than wages,197 international market sale value of resources rather than extraction value or some other value-added measurement198 may direct a somewhat greater share of worldwide profit to less developed economies. a minimum tax will limit the ability of less developed economies to trade their power to collect taxes for investment. under all structures under discussion internationally, the developed economies are likely to enjoy the bulk of the reallocated or increased tax bases and gain additional tax revenue. history suggests that some developed countries will deploy the additional revenue for the good of all residents while others will follow a course of concentrating benefits through reduced tax impositions into the hands of the affluent under the premise that the affluent create jobs for the less affluent members of society.199 how the incremental revenue is utilized, it is reasonably certain that little of it will find its way to international development,200 and the disparity between rich and poor nations and their citizenries seems likely to increase. just as leveling of revenue among st. louis county taxing districts to smooth wealth disparities among districts on even such an essential resource as public 194 brassey & ordower, supra note 37, at 100-02. 195 sarah paez, groups urge u.n. tax committee to reconsider oecd unified approach, tax notes today int’l (june 17, 2020), https://www.taxnotes.com/tax-notes-todayinternational/base-erosion-and-profit-shifting-beps/groups-urge-un-tax-committee-reconsider-oecdunified-approach/2020/06/17/2cmnh [https://perma.cc/fz7v-gywm]. 196 see brassey & ordower, supra note 37. 197 ordower, supra note 33, at 387-88. 198 christians & van apeldoorn, supra note 32, at 29-39. 199 see david hope & julian limberg, the economic consequences of major tax cuts for the rich (lse int’l ineq. inst., working paper 55, 2020). https://eprints.lse.ac.uk/107919/1 /hope_economic_consequences_of_major_tax_cuts_published.pdf [https://perma.cc/4cs6-gpeg] (empirical study on effects of major tax cuts for the rich on income inequality, economic growth, and unemployment). 200 brassey & ordower, supra note 37, at 102-04. 158 columbia journal of tax law [vol. 12:126 education rarely if ever captures the center of attention in public debate,201 international revenue distribution to level resource allocation internationally rarely if ever becomes the center of tax reform debate internationally despite the absence of a moral, rather than political, justification for such resource disparities. 202 many resource and wealth disparities are functions of the happenstance of serendipitous geographic location for some populations. the 2020 covid-19 pandemic is likely to augment the numbers of homeless individuals in the u.s. as unemployment renders large numbers of americans unable to meet their residential rent or mortgage obligations.203 school closings have left many children without adequate nutrition because they no longer receive the daily meals at school on which they relied for basic nutrition.204 the need for food, shelter, clothing, and healthcare in the u.s. is great205 but the need is primarily a distribution issue. since the u.s. is a principal world food exporter,206 food resources in the u.s. should be adequate for the population. even the welfare states of europe have residents in need of support for basic needs. poverty exists in all the oecd member states and it is inexcusable. on a global scale, poverty in developed economies rarely compares with the absolute poverty that plagues many undeveloped or developing economies.207 in some countries, people, often children, die from starvation.208 diseases like malaria that disable and kill many in less developed countries could be controlled or eradicated given sufficient economic resources and commitment. while fatal hunger is relatively absent in economically developed countries, fatal hunger may be ubiquitous in some less developed countries. homelessness, shortages of clothing, and limited educational opportunities are all prevalent in economically developed countries, as well as less developed and undeveloped economies, but in developed economies the housing, clothing, and education shortages are primarily a matter of resource distribution rather than lack of resources. in undeveloped economies, the shortages are more likely to be structural. 201 see supra part ii. 202 see ivan ozai, inter-nation equity revisited, 12 colum. j. tax l. 58 (2020). 203 see glenn thrush, homelessness in u.s. rose for 4th straight year, report says, n.y. times (mar. 18, 2021), https://www.nytimes.com/2021/03/18/us/politics/homelessnesscoronavirus.html [https://perma.cc/r2nq-6f48]. 204 mary kathryn poole et al., addressing child hunger when school is closed – considerations during the pandemic and beyond, nejm.org (mar. 11, 2021), https://www.nejm.org/doi/full/10.1056/nejmp2033629 [https://perma.cc/uj5p-mf3p]. 205 facts about poverty and hunger in america, feeding america, https://www.feedingamerica.org/hunger-in-america/facts#:~:text=more%20than%2037%20million %20people,to%20support%20a%20healthy%20life [https://perma.cc/e96j-fr5t] (last visited july 10, 2020) (37 million in the u.s. suffer from food insecurity). 206 which countries export the most food? world atlas, https://www.worldatlas.com/articles/the-american-food-giant-the-largest-exporter-of-food-in-theworld.html [https://perma.cc/ht5g-nawf]. 207 global issues, food, un, https://www.un.org/en/sections/issues-depth/food/index.html [https://perma.cc/9tbm-lrkp] (last visited july 10, 2020) (estimating 821 million people suffering from hunger in 2018). 208 the world counts estimates that 9 million people die each year from starvation. people who died from hunger, world counts, https://www.theworldcounts.com/challenges/people-andpoverty/hunger-and-obesity/how-many-people-die-from-hunger-each-year [https://perma.cc/u9dg-qtys] (last visited july 10, 2020). in 2015, it was estimated that 10% of the worldwide population were living in conditions of extreme poverty. decline of global extreme poverty continues but has slowed: world bank, the world bank (sept. 19, 2018), https://www.worldbank.org/en/news/press-release/2018/09/19/decline-of-global-extreme-povertycontinues-but-has-slowed-world-bank [https://perma.cc/77g5-ataa]. 2021] uniform international tax collection and distribution 159 poverty in the oecd countries is relative.209 relative to many in the developed countries’ societies or the oecd states in general, some residents have little wealth and suffer by comparison with those who are affluent. but poverty in the developed world is not absolute. 210 like the u.s., each of the oecd countries probably has adequate resources to eliminate the relative poverty in that oecd country by redeploying existing resources, without receiving additional tax revenue from mnes. many less developed countries could not address the poverty they have without substantial assistance from the affluent countries, but the affluent countries have offered only nominal aid relative to their gross national incomes211 and national budgets. most devote less than one percent of their gross national income to international development to provide relief from poverty.212 under such circumstances, private, altruistic actors such as bill and melinda gates through their foundation213 and business interests wanting natural resources or inexpensive labor drive development in nations suffering much absolute poverty.214 a non-affluent country might seize the opportunity for private, inbound investment by supplementing the competitive advantage of local low-cost labor with an agreement not to tax the investment capital or the earnings from that investment. zero tax, perhaps accompanied by other investment incentives, may provide the nudge to the international investor to invest in that non-affluent country rather than another non-affluent jurisdiction that does not offer exemption from local taxation. if taxing the mne might cause the mne to take its investment capital to another non-affluent country offering lower taxes or no tax, relinquishing the potential tax revenue seems like an easy choice. despite their exploitation by low wages, such low wage employment for residents alleviates the absolute poverty from which those newly employed residents previously may have suffered.215 if child labor best meets the international concern’s labor requirements, children often work, 209 see koen caminada et al., social income transfers and poverty: a cross‐country analysis for oecd countries, int’l j. soc. welfare (apr. 2012), https://www.researchgate.net/publication/227690060_social_income_transfers_and_poverty_a_cr oss-country_analysis_for_oecd_countries [https://perma.cc/zbq4-fdbg]. 210 brassey & ordower, supra note 37, at 104. 211 see gross national income data, oecd, https://data.oecd.org/natincome/grossnational-income.htm [https://perma.cc/q7px-y22d] (last visited july 10, 2020) (“gross national income (gni) is defined as gross domestic product, plus net receipts from abroad of compensation of employees, property income and net taxes less subsidies on production.”). 212 official development assistance as a percentage of gross national income (gni): net disbursement, all donors, oecd international development statistics, volume 2018 issue 1, oecd (2019), https://doi.org/10.1787/dev-v2018-1-table3-en [https://perma.cc/9hz9-rwna] (last visited jun. 16, 2020). 213 foundation fact sheet, bill & melinda gates found., https://www.gatesfoundation.org/who-we-are/general-information/foundation-factsheet [https:// perma.cc/h7nf-xa6z] (last visited july 10, 2020). 214 fashion victimsthe facts, war on want, https://waronwant.org/fashion-victimsfacts [https://perma.cc/uc2h-pk8e] (last visited july 10, 2020) (clothing factories in bangladesh and india); john vidal, how developing countries are paying a high price for the global mineral boom, guardian (aug. 15, 2015), https://www.theguardian.com/global-development/2015 /aug/15/developing-countries-high-price-global-mineral-boom [https://perma.cc/7vp5-atmf]. 215 see fashion victims, supra note 214. in some instances, the populace of a low wage country may suffer such exploitation from mnes in low wages, long hours and poor working conditions that it may have been better off before the investment with subsistence farming or even such occupations as trash picking. 160 columbia journal of tax law [vol. 12:126 perhaps without the knowledge of the mne, to assist their impoverished families despite international labor standards that outlaw child labor.216 the oecd projects, like u.s. worldwide taxation, might deprive the non-affluent country of the opportunity to capture the investment with the assistance of tax concessions. even if the non-affluent country manages to secure the investment and, under notions of value creation,217 the tax base distribution formula which allocates a significant share of the income of the mne to the non-affluent jurisdiction, that jurisdiction might not have the necessary infrastructure to measure the mne’s income, impose, and collect the tax. the non-affluent country historically may have relied on vats or targeted taxes, like natural resource extraction taxes, for example, rather than more complex tax bases like an income tax. the non-affluent jurisdictions may have an inadequate administrative infrastructure for such a tax. the newly tax-base-enriched jurisdiction in some instances simply may rely on or piggyback onto the computations that the affluent home country might perform. even in instances in which the non-affluent country relies on the tax infrastructure of developed economies, local collection of the tax may necessitate additional tax collection administration the country can ill afford. collection may prove inefficient and open the door to additional corruption exacerbating existing inefficiencies and corruption in the nonaffluent country’s tax infrastructure. the non-affluent country could choose not to collect the minimum tax, leaving the revenue on the table for the mne’s home country to take, but that would seem foolish. persuading some non-affluent countries to collect tax which mnes’ home countries otherwise would collect may drive those countries to create unofficial and perhaps corrupt schemes to aid the mnes to avoid their home country taxes.218 some mnes might accede to such schemes to meet competitors who already participate in such tax avoidance or even evasion and were drawn to the schemes by the promise of enhanced profitability. the result of the imposition of the globe pillars in the end might mimic historical iterations of tightened tax regulation being met with sophisticated tax planning that remains one step ahead of the tax legislators and administrators and devises strategies of varying legality to avoid new tax regulation.219 if the developed oecd economies wish to enrich affluent state coffers by seizing additional tax revenue from mnes, the oecd projects may begin to accomplish that goal. if, on the other hand, the oecd membership is offended by the success of mnes in avoiding the relatively high taxes of the developed economies and has identified a “fair tax” amount that each mne should pay, without regard to which country receives the revenue, the oecd projects also may begin to accomplish that goal. if, however, 216 see emma aisbett et al., do mncs exploit foreign workers? 38-39 (nov. 27, 2019) (unpublished manuscript) (on file with the brookings institution), https://www.brookings.edu/wpcontent/uploads/2019/12/aisbett-et-al._brookings-draft-2019.11.26_harrison.pdf [https://perma.cc /4dmw-jz5l]; danny zane et al., why companies are blind to child labor, harv. bus. rev. (jan. 28, 2016), https://hbr.org/2016/01/why-companies-are-blind-to-child-labor [https://perma.cc/rz3vcnm4]; sarah boseley, child labour is never ok. but for multinationals it is an outrage, guardian (june 26, 2018), https://www.theguardian.com/commentisfree/2018/jun/26/child-labour -tobacco-fields-multinationals-life-chances-destroyed [https://perma.cc/p557-6dkm]. 217 see christians & van apeldoorn, supra note 32, at 29-39. 218 see, e.g., oecd harmful tax competition, supra note 12, at 24 (lack of effective information exchange from tax haven jurisdictions limits timely application and collection of tax by non-tax haven jurisdictions); i.r.c. § 1471 (denying benefits to foreign financial institutions that are uncooperative). 219 see ordower, supra note 42, at 48. 2021] uniform international tax collection and distribution 161 distribution of the “fair tax” revenue in aid of international development to eliminate absolute poverty and level resources globally is the goal of enhanced tax collections, as it should be, fairer allocation of the tax base itself might do little toward that end. instead, uniform tax collection and tax revenue distribution would seem a better choice. the next section imagines an international taxing agency applying uniform tax rules to collect revenue and eliminate tax arbitrage opportunities available due to the multiplicity of taxing jurisdictions. vi. an international taxing agency for an economically globalized world: abandoning mythical tax sovereignty all base erosion projects require some compromise of tax sovereignty, a topic overdue for more serious consideration insofar as sovereignty in taxing well may be a false flag in the world of tax treaties, tax information exchange agreements, and tax blacklists designed to coerce non-cooperative jurisdictions into becoming cooperative. the business world has long accustomed itself to operating across international borders and within the framework of multiple sovereign states. income tax systems of nations participating in the oecd inclusive framework addressing base erosion and profit shifting must converge to smooth and eliminate systemic disparities so that base erosion in one state is not simply a structural element of another. lack of tax base uniformity may facilitate new base erosion as taxing units adjust their bases rather than their rates to engage in tax competition.220 a minimum rate of tax requires uniformity of the base for the tax and uniform administration of the tax to attain its goal, but existing minimum tax proposals fail to require the essential uniformity. each step toward uniformity requires nations to compromise their tax sovereignty and accept a compromise position that may accommodate or follow another nation’s tax rules. the ideal way to guarantee that uniformity of rules and administration would be a single international agency to administer the common rules with powers to operate independently of national borders. measurement of income under uniform substantive and procedural rules is essential but the determination of income source or taxpayer residence would become matters of revenue distribution, not tax collection. the international agency may collect the taxes and distribute them among nations under an internationally determined formula that is not dependent on the determination of income source or residence. much sovereignty is at stake in the beps and globe projects but voluntary relinquishment of sovereignty is not novel. nor does it represent a radical change from historic practices during the 20th century. following world war i, the league of nations emerged as a mechanism for international cooperation and resolution of disputes that would avert future wars. it failed, of course, but the united nations followed the next world war. un peacekeeping interventions have prevented some wars221 but the un has not spoken with sufficient authority to supplant sovereign decision-making that threatens peaceful intercourse among nations. 220 see de wilde, supra note 186, at 30 (“[u]nitary approach . . . reflecting inputs and outputs is generally considered to produce less opportunity for engaging in artificial tax avoidance operations.”). 221 our successes, un peacekeeping, https://peacekeeping.un.org/en/our-successes [https://perma.cc/qd5y-37bj] (last visited june 18, 2020); mano river basin, 25 years of peacekeeping, un peacekeeping, https://peacekeeping.un.org/en/mano-river-basin-25-years-ofpeacekeeping (last visited june 18, 2020). 162 columbia journal of tax law [vol. 12:126 common economic interests have been somewhat more successful in securing international cooperation. the world trade organization (wto), 222 for example, promotes international trade and provides a forum for the resolution of trade disputes and represents a compelling example of international cooperation for common economic interests.223 even the u.s. has acquiesced in adverse decisions of the wto concerning anti-competitive practices and impermissible subsidies.224 both the eu, which began as an economic community to regulate and promote trade for the benefit of its members,225 and the union of soviet socialist republics (ussr)226 were created during the twentieth century. each required ethnically and linguistically discrete countries to cede more or perhaps less voluntarily in the case of the ussr considerable economic independence to secure improved economic and trade relations beneficial for all member states. central planning in the ussr, government control over many aspects of daily life, slow economic growth, and restrictions on individual liberties contributed to the eventual failure of the ussr model, 227 while limited central government control, protections of individual liberties and national independence, as opposed to eu common interests, in many nontrade related functions has worked with considerable success in the eu model. the uk’s withdrawal from the eu228 and dissension with respect to several primarily non-economic or trade issues including immigration 229 indicates that the eu model may require adjustments for it to endure permanently without loss of additional member states. nevertheless, the willingness of nations to acquiesce in the authority of an international and voluntary administrative body to promote common economic interests exists. on a 222 what is the wto?, world trade organization, https://www.wto.org/english /thewto_e/whatis_e/whatis_e.htm [https://perma.cc/y4s7-6dxu] (last visited july 10, 2020). 223 martin vallespinos, can the wto stop the race to the bottom? tax competition and the wto, 40 va. tax rev. 93 (2020) (arguing that the wto should police tax concessions because they impact trade). 224 see, e.g., press release, european commission, wto boeing dispute: eu issues preliminary list of u.s. products considered for countermeasures (apr. 17, 2019), https://ec.europa.eu/commission/presscorner/detail/en/ip_19_2162 [https://perma.cc/69y9-skab]; press release, office of the united states trade representative, u.s. notifies full compliance in wto aircraft dispute (may 6, 2020), https://ustr.gov/about-us/policy-offices/press-office/pressreleases/2020/may/us-notifies-full-compliance-wto-aircraft-dispute [https://perma.cc/bk6w3z7h]. see also appellate body report and panel report, united states tax treatment for “foreign sales corporations,” wto doc. wt/ds108/36 (mar. 17, 2006) (the u.s. repealed the grandfather provisions of the american jobs creation act and the eti act that were subject to compliance proceedings); appellate body report and panel report, united states – import prohibition of certain shrimp and shrimp products, wto doc. wt/ds58/23 (nov. 26, 2001). 225 the history of the european union, european union, https://europa.eu/europeanunion/about-eu/history_en [https://perma.cc/2qm3-fqgr] (last visited june 18, 2020). 226 see generally, soviet union, encyc. brittanica, https://www.britannica.com /place/soviet-union [https://perma.cc/2c9r-vm4b] (last visited july 27, 2020). 227 see numa mazat, structural analysis of the economic decline and collapse of the soviet union, anpec (2016) https://www.anpec.org.br/encontro/2015/submissao/files_i/i3186e370d13d34b7043cb737da8d75390.pdf [https://perma.cc/5he7-9jdq]; michael ray, why did the soviet union collapse? brittanica, https://www.britannica.com/story/why-did-the-sovietunion-collapse [https://perma.cc/dw4a-443j]. 228 brexit – uk’s withdrawal from the eu, eur-lex, https://eur-lex.europa.eu/content /news/brexit-uk-withdrawal-from-the-eu.html [https://perma.cc/y2w9-65qw] (last visited june 18, 2020). 229 see, e.g., pablo gorondi, hungary’s orban critical of eu leaders on migration, economy, ap news (july 27, 2019), https://apnews.com/b89e682583014c7e8a1bf1cbb46e5dcf [https://perma.cc/ekm9-59bj]. 2021] uniform international tax collection and distribution 163 small scale, five economic powers have joined in a combined effort to reduce tax evasion.230 in many countries, business interests, politicians, and the populace regularly malign the taxing agencies while simultaneously looking to the taxing agency to subsidize the activities and interests they favor. in the u.s., even members of congress refer to the tax laws as the “irs code,” 231 implicitly assigning responsibility for taxation to the administrative agency as if it, and not the legislature, were responsible for the tax laws that the agency must enforce. congress and other national legislatures have grown accustomed to delivering indirect subsidies through the tax law rather than directly subsidizing activities and interests.232 while an international taxing agency enforcing internationally uniform tax rules under uniform administrative procedures and standards might continue to be a subject of derision, it would remove taxation from the domestic political sphere and allow it to serve its primary function of raising the revenue necessary to operate governments, rather than as an indirect source of funding for private activities. by separating taxation from domestic politics, international uniformity diminishes the opportunism of targeted tax subsidies and requires discussion of budgeting for a subsidy with a direct expenditure rather than the current indirect delivery through decreased tax liability. many tax subsidies currently are opportunistic and frequently provide taxpayers’ the opportunity to misdirect all or part of the intended subsidy.233 they result from the exertion of influence by limited interests and appear in statutory language that is deceptively general despite being targeted to the influential interests.234 changing tax rules under an internationalized system to subsidize specific business interests would require international agreement and is likely to be far less common than such subsidies are now. uniform taxation of income without regard to source and divorced from the distribution of the centrally collected tax revenue among nations eliminates the need for bilateral or multilateral tax treaties, as well as tieas, except for the general agreement to be part of the unified tax system and to acquiesce in the distribution formula. where a 230 joint chiefs of global tax enforcement, irs, https://www.irs.gov/compliance/jointchiefs-of-global-tax-enforcement [https://perma.cc/2lb2-rl7m] (last visited july 14, 2020). 231 michelle ye hee lee, who wrote the ‘irs code’? hint: it wasn’t the internal revenue service, wash. post (apr. 13, 2015), https://www.washingtonpost.com/news/fact-checker /wp/2015/04/13/who-wrote-the-irs-code-hint-it-wasnt-the-internal-revenue-service/ [https://perma.cc/p7kq-gkg4]. 232 see u.s. dep’t of treas., tax expenditures (2018), https://home.treasury.gov /system/files/131/tax-expenditures-fy2020.pdf [https://perma.cc/3df2-6k54] [hereinafter tax expenditures]. 233 see henry ordower, capital, an elusive tax object and impediment to sustainable taxation, 23 fla. tax rev. 625, 630-32 (2020). for contrary views approving the use of the taxing authority for non-revenue functions, see, for example, david a. weisbach & jacob nusim, the integration of tax and spending programs, 113 yale l. j. 955 (2004) and sara sternberg greene, the broken safety net: a study of earned income tax credit recipients and a proposal for repair, 88 n.y.u. l. rev. 515 (2013). 234 see, e.g., i.r.c. §§ 1400z-1, 1400z-2; subcommittee on econ. & consumer pol’y, u.s. house of representatives, lawmakers question mnuchin on possible opportunity zone abuse, tax notes today fed. (june 24, 2020), https://www.taxnotes.com/tax-notes-today-federal/opportunityzones/lawmakers-question-mnuchin-possible-opportunity-zone-abuse/2020/06/25/2cnd8?highlight =opportunity%20zones [https://perma.cc/tn9y-mrda]; brett theodos, jorge gonzalez & brady meixwell, the opportunity zone incentive isn’t living up to its equitable development goals. here are four ways to improve it, urban wire (june 17, 2020), https://www.urban.org/urbanwire/opportunity-zone-incentive-isnt-living-its-equitable-development-goals-here-are-four-waysimprove-it [https://perma.cc/k99c-a7cx]. 164 columbia journal of tax law [vol. 12:126 taxpayer earns income will no longer determine to whom the income is attributable and who has the taxing authority. income from intangible property that is currently so abstract, fluid, and challenging to source ceases to be so. if there is income, it is taxable under the uniform rules of taxation. outlier jurisdictions that do not join in the centralized taxing regime are minimally problematic. sourcing rules for the unified jurisdiction would include a range of connections—property, labor, revenue (direct or indirect), and residence of owners or beneficiaries. a taxpayer would be free from the agency’s taxing jurisdiction only if they did nothing directly or indirectly outside the residence jurisdiction that has not joined the centralized tax regime and the outlier country would receive no part of the centrally collected tax revenue. an investment in any country that is part of the unified taxing agency collection by an entity based in a non-cooperating jurisdiction would be a sufficient connection with the unified taxing jurisdiction to render the taxpayer’s income taxable by the unified agency. constructing uniform rules and assembling agreement will be a formidable task, but the project would have the virtue of binding uniformity that current international projects lack. when a country signs on to the agreement, it has little room to manipulate the rules since it will delegate tax administration and collection to the independent international agency in which all countries are represented.235 robust related-party rules will limit the ability of taxpayers to arbitrage progressive rates with multiple entities.236 universal tax transparency so that a single tax would be imposed at the ultimate ownership level might be most sensible but perhaps too difficult to administer.237 mechanisms for broad-based information reporting by financial institutions, vendors, and business consumers are critical to enforcement, and a more extensive withholding system than currently in place in most countries certainly would facilitate accurate reporting. perhaps most important would be an international, public education effort so that taxpayers worldwide receive identical and accurate messages concerning the benefits of the global system, its uniformity, and its system for currency translation to achieve economic uniformity to address hyper-inflationary currencies. supplemental to the global system and beneficial to worldwide economic stabilization that should follow from the distribution formula would be currency exchange rate stabilization and possible transition to a single international currency. for mnes, a single tax collector and single computation would be likely as well to facilitate a transition to a uniform international accounting and reporting system to replace the awkward reporting split between the generally accepted accounting principles (gaap) that the u.s. uses and the international financial accounting standards (ifrs) in 235 cf. ordower, supra note 33, at 375-78. 236 cf. i.r.c. § 318 (constructive ownership rules); i.r.c. § 267(b) (related parties for loss denial). there are many other such provisions using a variety of thresholds for treating otherwise separate individuals or entities as having common interests that limit tax separation. 237 extensive tax transparency exists in the u.s. as the income of partnerships and limited liability companies. see i.r.c. § 701; i.r.c. §1361 (for electing s corporations); treas. reg. § 301.7701-3 (non-u.s. entities that make election are taxable only to the underlying owners). commentators, including the author of this article, have recommended full tax transparency for corporations. see henry ordower, preserving the corporate tax base through tax transparency, 71 tax notes int’l 993 (sept. 9, 2013). modified transparency also exists. see i.r.c. § 851 (regulated investment companies); i.r.c. § 857 (real estate investment trusts). 2021] uniform international tax collection and distribution 165 use in much of the remainder of the world.238 the u.s. finally might transition to ifrs as has been proposed, but not finalized, by the securities and exchange commission.239 vii. revenue shares one virtue of global tax administration under uniform tax rules is that taxpayers are left with no place to hide from paying taxes. taxation under this system is borderless. tax planners undoubtedly will continue to seek, and perhaps occasionally discover, opportunities to diminish their clients’ tax liability, but borderless uniformity ideally eliminates all opportunities to reduce taxes by redirecting income or income-producing activity to other jurisdictions. globally centralized determination and collection of tax likewise precludes local political decision-making from impacting tax liability and delivering benefits through the tax system. the premise that a fundamental concept of fair taxation exists free from political determinants underlies common global tax collection under uniform rules. “fair share” becomes a global rather than domestic concept. each taxpayer should pay their “fair share” relative to global, not national, revenue needs. a global “fair share” concept recognizes that even economic activity that may seem local is not. rather, under uniform taxation and collection, global economic and social interdependency would be recognized universally and could emerge as the ultimate marker of the 21st century. the covid-19 pandemic, worldwide commercial branding and manufacturing, 240 international terrorism 241 , and cross-border intrusion into elections and the political process242 are only a few of the many elements that demonstrate how inextricably intertwined nations have become. 238 see lisa weaver, the wider implications of transitioning to ifrs—10 things to consider, ifac (dec. 3, 2014), https://www.ifac.org/knowledge-gateway/supporting-internationalstandards/discussion/wider-implications-transitioning-ifrs-10-things-consider#:~:text=the %20transition%20to%20international%20financial,reporting%20in%20the%20last%20decade [https://perma.cc/67mm-e4q9]. 239 sec unanimously approves exposing proposed ifrs roadmap for public comment, aicpa (aug. 27, 2008), https://www.ifrs.com/updates/sec/sec_approves.html [https://perma.cc /kl7r-wzv7]. 240 claire matthews, what is the secret to mcdonald’s global branding success, maistro (nov. 5, 2014) https://blog.maistro.com/procurement/secret-mcdonalds-global-branding-success [https://perma.cc/s9t9-qnvd]; sean galea-pace, inside adidas’ supply chain, supply chain, https://www.supplychaindigital.com/supply-chain/inside-adidas-supply-chain [https://perma.cc/5djy-dcgk] (last visited june 29, 2020). 241 pamela engel & ellen loanes, what happened on 9/11, 18 years ago, bus. insider (sept. 10, 2019), https://www.businessinsider.com/what-happened-on-911-why-2016-9 [https:// perma.cc/wud5-yuks]; history, famous cases & criminals, pan am 103 bombing, fbi, https://www.fbi.gov/history/famous-cases/pan-am-103-bombing [https://perma.cc/wn8l-6djz] (last visited june 23, 2020); simon burton, 50 stunning olympic moments no 26: the terrorist outrage in munich in 1972, guardian (may 2, 2010), https://www.theguardian.com/sport /blog/2012/may/02/50-stunning-olympic-moments-munich-72 [https://perma.cc/k4yc-adfg]. 242 see off. of the dir. of nat’l intelligence, assessing russian activities and intentions in recent u.s. elections (2017), https://assets.documentcloud.org/documents /3719492/read-the-declassified-report-on-russian.pdf [https://perma.cc/m4jq-ejup]; joshua kurlantzick, how china is interfering in taiwan’s election, council on foreign rel. (nov. 7, 2019) https://www.cfr.org/in-brief/how-china-interfering-taiwans-election [https://perma.cc/a6dk3jlv]. 166 columbia journal of tax law [vol. 12:126 the impetus to the oecd action plans, 243 the eu’s list of tax haven jurisdictions,244 and fatca in the u.s.,245 relies on a more limited and domestic thesis. the thesis is that mnes and other taxpayers misdirect some of their income to low tax jurisdictions to avoid paying the amount of income tax they should pay into the treasuries of major developed economies. under that thesis, the notion of fair taxation is relative and location-specific. it is valid only insofar as it defines the amount a taxpayer should pay to a specific developed nation’s treasury. the oecd framework purports to be more global.246 but it emphasizes capturing additional revenue for the treasuries of the developed economies. failing enhancement of tax revenue for those developed economies, the oecd’s leading member nations might lose interest in collecting additional tax from the mnes targeted by the beps actions. rule uniformity and central global tax collection postulates an alternative to the location-specific thesis expressed in the preceding paragraph. the alternative thesis is more abstract and independent of location. it posits the existence of a global responsibility to provide each individual with sufficient resources to secure a decent standard of living. whether that view arises from a universal human value system that demands a just world without poverty or from a sense of self-preservation that foresees physical and economic risks to those with wealth from those who are impoverished,247 the thesis requires that each taxpayer pay a correct amount of tax that depends on the taxpayer’s characteristics. those characteristics might include the taxpayer’s ability to pay measured under the common standard of the taxpayer’s income from all sources worldwide as compared with all other taxpayers. under such a thesis, the major developed economies might support a collection of that fair share even if the additional tax does not augment their governmental coffers. both the oecd actions and fatca are designed to generate additional tax revenue by redirecting income from its artificial location in a low tax jurisdiction to its correct location in a higher taxed, major developed economy. neither the oecd actions nor fatca favors one higher tax jurisdiction over another insofar as neither redirects the incidence of taxation as long as the rate imposed is sufficiently high. for example, the beps actions would not redirect income from the netherlands to germany because both countries impose a sufficiently high rate of tax, but beps might redirect income from ireland to germany because the irish corporate rate is only 12.5 percent. similarly, fatca might include income from offshore investments in a u.s. taxpayer’s income but, except under unusual circumstances where the tax is payable to a diplomatically restricted country, 248 would allow the u.s. taxpayer a credit for the tax paid to the other jurisdiction. 249 a common international taxing system with uniform rules and administration similarly will produce more income tax revenue than is generated 243 see supra part iii. 244 see eu list of non-cooperative jurisdictions, supra note 15. 245 see fatca §§ 1471-1474, 6038d (underlying principle of fatca acknowledging that u.s. taxpayers that hide assets abroad need ferreting out). 246 see oecd/g20 inclusive framework on beps, supra note 122, at 26. 247 see meetings coverage, general assembly 86th meeting, links between extreme poverty, violent extremism can be broken by creating jobs, reducing inequalities, general assembly hears as debate concludes, ga/11761 (feb. 16, 2016); ian black, poverty driving syrian men and boys into the arms of isis, guardian (may 4, 2016), https://www.theguardian.com/globaldevelopment/2016/may/04/poverty-driving-syrian-men-and-boys-into-the-arms-of-isis [https://perma.cc/c7tw-vp67]. 248 i.r.c. § 901(j). 249 i.r.c. § 901(a). 2021] uniform international tax collection and distribution 167 worldwide if current developed economy rates apply. estimates of the amount of additional revenue vary both with rates and assumptions.250 the amount of additional tax revenue from preventing profit shifting251 or reducing the tax gap252 is not trivial even if speculative.253 while developed economies do use their tax systems politically to deliver a considerable array of incentives, it nevertheless would seem to be in their interests to join a borderless tax consortium to promote fair and even-handed taxation of all participants in the economy and to augment global tax revenue production. political quibbling among advanced economies, of course, might stymie agreement as it has on adopting even a simple measure like the ccctb. with limited exceptions for a few developed economies like ireland that use their tax rates and structures to attract foreign investment, 254 the countries that rely most heavily on tax rates and concessions to attract investment fall into two broad groups. one group consists of countries with many poor, often absolutely poor, residents. those countries look to international investment for the basic development of infrastructure and provision of human essentials and jobs. they tend to lack strong bargaining power for international investment and readily offer privileges, including freedom from taxation, to international investors.255 a second group of countries are the more traditional tax haven countries, frequently island jurisdictions, with developed business or investment servicing infrastructures without the need for substantial tax revenue to carry their infrastructures. some of the groups have significant tourist industries and raise revenue through consumption taxes like hotel and meal taxes targeted at tourists. the issue for a borderless uniform income tax is how to attract those countries to join the tax consortium. for countries that rely on their low tax structure to capture international investment, the revenue distribution formula under a borderless uniform tax has to place these countries in a better position compared with their current position that relies on tax incentives to attract investment. an initial offer of all incremental revenue from the change to the borderless tax under an international tax administrator would be a good place to begin. before the economic downturn from the covid-19 pandemic, developed 250 see action 1, supra note 98, at 20. 251 devereux et al., supra note 16, at 22-35 (providing very incomplete estimates of revenue lost to base erosion and profit shifting from the digital economy in the $10 billion plus range). 252 see the tax gap, irs, https://www.irs.gov/newsroom/the-tax-gap [https://perma.cc /fz5p-tnz3] (last visited july 10, 2020) (estimating a broad non-compliance measure for 2011, 2012, and 2013 at $441 billion); frank j. bevvino & robert a. page, the tax gap: a competing values model, 167 tax notes fed. 991 (may 11, 2020). 253 see kimberly a. clausing, the effect of profit shifting on the corporate tax base in the united states and beyond (jun. 17, 2016) (unpublished manuscript), https://ssrn.com/abstract=2685442 [https://perma.cc/he95-mwax]; see also devereux et al., supra note 16, at 22-35. 254 ireland’s 12.5 percent corporate tax rate has enabled it to capture international headquarters of companies interested in minimal taxes on their european income from intangibles, including starbucks and apple. corporation tax, ireland revenue, https://www.revenue.ie/en/ companies-and-charities/corporation-tax-for-companies/corporation-tax/index.aspx [https://perma .cc/t5xj-anma] (last visited july 10, 2020); tom bergin, special report: how starbucks avoids uk taxes, reuters (oct. 15, 2012), https://www.reuters.com/article/us-britain-starbucks-taxidusbre89e0ex20121015 [https://perma.cc/8mxq-k2nl]; foo yun chee, apple spars with eu as $14 billion irish tax dispute drags on, reuters (sept. 18, 2019 https://www.reuters.com/article/us-eu-apple-stateaid-iduskbn1w31fe [https://perma.cc/36nkgt3r]. 255 annagabriella colón, pillar 2 could curb need for tax incentives, oecd official says, 101 tax notes int’l 1724 (mar. 29, 2021). 168 columbia journal of tax law [vol. 12:126 economies generally have been able to maintain and perhaps even expand their own infrastructures, including welfare benefit networks that address the relative poverty in developed countries without significantly increasing tax revenue. while no nation admits it can maintain the best that it ever had without a steady increase in tax revenue, such revenue increases have been difficult to find. anti-tax sentiment in many places has contributed to the political unwillingness of legislatures to increase rates of tax. decreased rates to meet international tax competition and political pressure to deliver subsidies through the tax system have been more common. as much as developed economies may hope for additional revenue from successful international agreements to reign in base erosion and profit shifting, those economies have not budgeted for increased revenue from beps or any other international project. thus, the incremental revenue from borderless taxation is uncommitted and could be devoted to international development, elimination of absolute poverty, and improved control of worldwide health threats. the plan might suffice to persuade those non-affluent nations to cease trading low taxes for international investment and to join the universal tax consortium. the commitment to centralized taxation could make many nations less desperate for revenue than they are today and place them in an improved bargaining position with international investors. relatively low wages and natural resources would leave many jurisdictions attractive for international investment and those that are not would have greater revenue needs and would get a larger share of the international tax revenue pool. private, shortterm selfish interests might stop being the primary driver of development, enabling those countries to identify and remedy their most acute needs. improvement of living conditions worldwide might likewise increase consumption and income that would yield even more tax revenue. rather than devoting that revenue to bulking up the treasuries of the developed economies, the international consortium should be willing to commit that revenue to international development, thereby enhancing the resources of the less developed and developing world countries and broadening the consumer base into the more distant future.256 other traditionally low tax jurisdictions like tax havens might be more difficult to enlist if they customarily offer low tax rates to enhance international investment servicing business and do not have governmental revenue needs. for those countries, coercion may be essential. since the borderless system would be independent of income sourcing, those jurisdictions would no longer be able to offer international investors freedom from taxation on their investment assets. most investors would have a sufficient connection with one or more of the consortium countries to provide a basis upon which to tax their income under the borderless system. historical tax haven economies would simply lose the benefit of offering low taxes.257 256 nathaniel hendren and ben sprung-keyser, a unified welfare analysis of government policies, 135 q. j. econ. 1209 (2020). 257 some retreat from investment management activity from tax haven jurisdictions following a change in u.s. tax law in 1997 that eased the need for actual management activity in the tax haven to avoid the incidence of the u.s. income tax on foreign investors per i.r.c. § 864(b). see generally henry ordower, demystifying hedge funds: a design primer, 7 u.c. davis bus. l. j. 323, 362-63 (2007); joe maxwell and ron tannenbaum, hedge fund administration: past, present and future, aima (nov. 30, 2020), https://www.aima.org/article/hedge-fund-administration-pastpresent-and-future.html#:~:text=the%20ten%20commandments%20required%20a,taxes%20on %20its%20offshore%20income.&text=the%201997%20taxpayer%20relief%20act,as%20we%2 0know%20it%20today [https:/perma.cc/5fu8-9llc]. 2021] uniform international tax collection and distribution 169 since the global tax will increase tax revenue, distribution initially should follow a two-step formula. the first step would hold each country harmless from tax revenue loss so that each country, following the transition, receives a share of tax revenue equal to its revenue from income tax in the preceding year or over a rolling average of years, possibly adjusted for inflation. this step preserves the status quo on revenue. while little doubt exists that every country can claim great need for increased tax revenue to fund an unlimited number of important projects in that country, those revenue needs are relative, not absolute. hence, the second step would require an evaluation that assesses nutrition, housing, education, healthcare, and infrastructure needs of less developed countries and development of a plan to ameliorate any deficits in all categories worldwide. the un has projects related to some aspects of need already, including hunger.258 the remaining revenue would be devoted to the gradual elimination of those deficits—perhaps addressing life-threatening deficits first followed by improvement of living standards everywhere. amelioration costs would vary widely since they will remain a function of relative local cost of goods and labor. the method of distributing the incremental revenue may prove more challenging than determining the amount to distribute to each country. significant regional variations of need contribute to the determination of the amount but distribution through national or regional governments and agencies requires a national or local commitment to deploy the funds as intended. local corruption is likely to remain an impediment to the intended development and retard progress toward the elimination of absolute poverty. direct international control of deployment of funds might be the best solution, but that would require further relinquishment of national sovereignty, which quite possibly can endanger international willingness to engage in the borderless tax project. such control goes well beyond the economically beneficial strategy of a uniform and borderless tax. it might prove even more difficult to persuade nations to yield control over national revenue deployment than to persuade them to become part of the borderless collection system. international control over resource distribution intrudes further upon national selfdetermination. the global pressure to join a worldwide tax consortium and subscribe to a fair tax and distribution formula might serve to moderate corruption where it becomes clear that corruption is impeding intended distribution to diminish the incidence of local poverty, as local residents begin to imagine fundamental changes in living conditions for them if they organize to prevent corrupt actors from seizing the funds and preventing development. the borderless system affords an opportunity to deploy a portion of the tax revenue to fund a universal basic income (ubi). one country, several non-governmental agencies and various governmental units have experimented with differing permutations of a ubi.259 some ubis are means tested while others simply distribute a basic sum to each individual. the means-tested, recovery rebates under the cares act and subsequent legislation260 in 258 see sustainable development programs, goal 2: zero hunger, un, https://www.un.org/sustainabledevelopment/hunger/ [https://perma.cc/862x-fwwt] (last visited july 10, 2020), for all 17 development goals, including health, education, clean water, and climate actions, see sustainable development programs, un, http://www.undp.org/content/undp/en /home/sustainable-development-goals.html [https://perma.cc/h8un-ll64] (last visited june 23, 2020). 259 sigal samuel, everywhere basic income has been tried, in one map, vox (feb. 19, 2020), https://www.vox.com/future-perfect/2020/2/19/21112570/universal-basic-income-ubi-map [https://perma.cc/5l6v-x493]. 260 see coronavirus aid, relief, and economic security act (the cares act), pub. l. 116-136, 134 stat. 281 (codified as amended in scattered sections of u.s. code), consolidated 170 columbia journal of tax law [vol. 12:126 the u.s. are a limited form of ubi.261 u.s. democratic presidential primary candidate andrew yang included a ubi in his platform.262 some commentators have recommended a universal basic income within national borders to eliminate poverty and distribute welfare while respecting the dignity and autonomy of the individual.263 some opponents of a ubi worry that free money will disincentivize work but some argue that the very limited evidence from existing experiments with ubi does not support that conclusion.264 insofar as the uniform global tax requires taxpayers to report directly to the international taxing agency without the intermediation of any national government, the agency has the direct contact necessary to distribute funds to individuals. if the borderless tax system includes everyone, without regard to income, in its database, it would be a relatively simple matter for the agency to distribute funds directly to those whose incomes fall below a geographically determined minimum amount. such a system might be less intrusive on national sovereignty than other types of control over funds, as the distributions would be independent of national borders and tied only to the local cost of living and having little to do with any characteristic that might be specific to any country. it is likely, for example, that in many instances, especially those that may be historically arbitrary, two individuals living a short distance apart on opposite sides of a border will have more similar costs of living than two individuals living at a great distance from one another in the same country.265 the ubi could supplement direct distribution to national governments yet remain substantially free from the risk of loss through governmental corruption. viii. conclusion this article proposes an international tax agency to administer a uniform borderless income tax under uniform tax rules. it complements an earlier international tax agency proposal that would have apportioned the income tax base, also determined under substantially uniform rules, among nations to give a more meaningful share of the base to less developed producing economies. this proposal expands the basic concept to collect tax revenue centrally and distribute it among nations as it is needed. needs for developed economies would include the maintenance of their existing infrastructures including welfare, while needs for less developed economies would include basic needs of the populace—food, shelter, clothing, healthcare, and education. the proposal is aspirational, appropriations act, 2021, pub. l. 116-260, 134 stat. 709 (codified as amended in scattered sections of u.s. code); american rescue plan act of 2021, pub. l. 117-2, 135 stat. 4 (codified as amended in scattered sections of u.s. code). 261 the payments of $1200 per individual plus $500 per qualifying child were uniform to all residents with income of $75,000 or less in either of the two preceding tax years. see section 2201 of the cares act adding i.r.c. § 6428. 262 matt stevens and isabella grullón paz, andrew yang’s $1,000-a-month idea may have seemed absurd before. not now, n.y. times (mar. 18, 2020), https://www.nytimes.com/2020/03/18 /us/politics/universal-basic-income-andrew-yang.html [https://perma.cc/rb5t-rf4t]. 263 see ari glogower & clint wallace, shades of basic income (ohio state pub. l., working paper no. 443, 2017), https://ssrn.com/abstract=3122146 [https://perma.cc/3wnw9zqz]; usman chohan, universal basic income: a review (aug. 2017) (unpublished discussion paper) (on file with university of new south wales), https://papers.ssrn.com/sol3/papers.cfm ?abstract_id=3013634 [https://perma.cc/ah4s-3m6d]; isabel ortiz, et al., basic income proposals in light of ilo standards: key issues and global costing (extension of social security, working paper no. 62, 2018), https://ssrn.com/abstract=3208737 [https://perma.cc/m6yu-5fbc]. 264 see donna lu, universal basic income seems to improve employment and well-being, newscientist (may 6, 2020), https://www.newscientist.com/article/2242937-universal-basicincome-seems-to-improve-employment-and-well-being/#ixzz6qa62sz6x [https://perma.cc/am2bsyux]; samuel, supra note 259. 265 cf. brassey & ordower, supra note 37, at 112-13. 2021] uniform international tax collection and distribution 171 of course, but it is designed to induce readers to think more globally about basic needs and ask questions like: what should my serendipitously wealthy nation be willing to renounce so that my poor nation neighbor may provide essential services to its populace? the concept of borderless taxation is utopian as it contemplates distribution of worldwide revenue to provide basic human needs for a comfortable and productive life independently of the happenstance of location of one’s birth. taxpayer choices, itemized deductions, and the relationship between the federal & state tax systems heather m. field* abstract almost 30 million taxpayers who itemized their federal deductions for the 2017 tax year switched to the standard deduction for 2018. the provisions of the tax cuts & jobs act (“tcja”) that led to this shift were intended to simplify the individual income tax system. this article’s empirical study of federal and state tax filing data, however, demonstrates that the tcja’s simplifying effect varied stateto-state depending on whether a state obligated its taxpayers to make the same choice for state tax purposes (i.e., to itemize deductions or take the standard deduction) as the taxpayer made for federal purposes. in states that obligated taxpayers to make the same choice, taxpayers experienced at least some simplification, and tax administration by the irs and state tax authorities became materially easier, although the irs’s simplification benefit was dampened to some degree. in states that allowed taxpayers to make state tax choices that differed from their federal choices, the tcja’s simplifying effect for many taxpayers was largely illusory, state income tax administration actually became more complex, and some tax enforcement costs were, in effect, shifted from the irs to state tax authorities. thus, this article’s study reveals that state-level rules about tax choices undermined the federal policy goal motivating the tcja’s itemization-related changes. a taxpayer’s choice whether to itemize is just one of many tax elections explicitly provided to taxpayers. accordingly, this article’s study of taxpayers’ itemization choices also serves as an example that illustrates a broader point— state-level rules about whether taxpayers must make uniform federal and state tax elections create important, but previously underappreciated, interactions between the federal and state tax systems. policymakers cannot fully understand the policy implications of many federal tax law changes unless they appreciate these federal/state interactions. this article helps policymakers do so. * stephen a. lind professor of law, university of california, hastings college of the law. i am grateful for the opportunity to present this article at the 2020 association of mid-career tax professors “zoomposium,” the university of florida levin college of law tax colloquium, the florida state university law school tax speaker series, and the 2021 law & society annual meeting. thanks to yariv brauner, neil buchanan, david hasen, steve johnson, jeff kahn, katie pratt, jim repetti, darien shanske, adam thimmesch, and manoj viswanathan, among others, for their comments and input. 2 columbia journal of tax law [vol: 13:1 introduction .................................................................................................. 3 i. the tcja’s itemization-related changes ................................ 7 a. increasing the standard deduction & limiting itemized deductions .......... 7 b. the stated policy goal: simplification ......................................................... 8 c. expectations about itemization rates and simplification ........................... 9 d. the decline in itemization rates as a proxy for simplification................. 10 1. for taxpayers .......................................................................................... 11 2. for tax authorities .................................................................................. 14 ii. using tax filing data to understand changes in taxpayers’ itemization choices......................................................... 15 a. federal itemization data ............................................................................. 15 b. a closer look at the data: variation in itemization rates by state .......... 16 1. independent itemization elections allowed: oregon .............................. 20 2. election uniformity required: maryland & nebraska ........................... 23 3. key takeaways from the data ................................................................. 30 iii. the tcja’s simplifying effect, considering taxpayers’ itemization behavior ............................................................................... 31 a. for taxpayers ............................................................................................. 32 1. where independent itemization elections are allowed ........................... 32 2. where itemization election uniformity is required ................................ 33 b. for the irs .................................................................................................. 34 c. for state tax authorities ............................................................................ 34 d. key takeaways about simplification ......................................................... 36 iv. tax elections & the relationship between the federal and state income tax regimes................................................................................................................. 37 a. broader lessons from the itemization election example .......................... 37 b. using these lessons when making tax policy decisions ........................ 39 conclusion ..................................................................................................... 41 appendix a. changes in federal itemization rates by state ................... 42 appendix b. changes in federal & state itemization (ty2017 to ty2018) for oregon, nebraska, & maryland – details ............................................ 44 2021] taxpayer choices 3 introduction the tax cuts & jobs act (“tcja”),1 enacted in december 2017, was intended to reduce dramatically the number of taxpayers that itemize their deductions, thereby simplifying the individual income tax system.2 as anticipated, the rate of itemization on federal income tax returns decreased from 30.6% for the 2017 tax year (pre-tcja) to 11.4% for the 2018 tax year (post-tcja).3 almost 30 million fewer federal income tax returns had itemized deductions. that meant almost 30 million fewer schedule a forms filed with the irs and almost 30 million fewer taxpayers whose itemized deductions the irs might audit. thus, at a high level, the tcja’s itemization-related changes—specifically, the increase to the standard deduction and limits on itemized deductions—seem to have simplified the income tax system for individual taxpayers and the irs. this article’s analysis of federal and state individual income tax filing data for 2017 and 2018, however, tells a more complex story both for taxpayers and tax administrators. specifically, the data show that a significant number of individual taxpayers in some states (including, for example, more than 22% of individual filers in oregon4) switched from itemizing to taking the standard deduction for federal purposes but continued to itemize for state purposes. thus, these taxpayers did not experience nearly as much simplification as the federal itemization data, alone, suggest. in addition, the simplification benefits experienced by the irs as a result of the tcja’s itemization-related changes were dampened because some taxpayers continued to itemize for federal purposes post-tcja even though their federal itemized deductions were less than the federal standard deduction. further, and perhaps most notably, the decline in federal itemization rates, which simplified tax administration for the irs, increased the complexity of tax administration for tax authorities in several states. the net effect was to shift some enforcement costs from the irs to state tax administrators. as this article will explain, whether one or more of the foregoing consequences arose for a particular state or its taxpayers depended largely on whether the state (a) obligated taxpayers to make the same election—to itemize or take the standard deduction—for state purposes as the taxpayer made for federal purposes, or (b) allowed taxpayers to make an independent choice about whether to itemize deductions or take the standard deduction for state purposes (i.e., regardless of the itemization choice that the taxpayer made for federal purposes). that is, a state’s 1 the official name of this legislation is “an act to provide for reconciliation pursuant to titles ii and v of the concurrent resolution on the budget for fiscal year 2018.” pub. l. no. 115-97, 131 stat. 2054 (2017). although the bill’s original title, the “tax cuts and jobs act,” was stricken from the final legislation, many commentators continue to use that name. see, e.g., kamin et al., the games they will play: tax games, roadblocks, and glitches under the 2017 tax legislation, 103 minn. l. rev. 1439 (2019). this article does the same. 2 see infra part i.b. 3 soi tax stats – individual income tax returns complete report (publication 1304), irs, https://www.irs.gov/statistics/soi-tax-stats-individual-income-tax-returns-publication-1304-com plete-report [https://perma.cc/r76l-355v] (last visited nov. 21, 2021) (table 1.4. all returns: sources of income, adjustments, and tax items, by size of adjusted gross income, tax year 2017 & tax year 2018) and author calculations. 4 see infra note 94 and accompanying text. 4 columbia journal of tax law [vol: 13:1 “tax election uniformity rule” affected the success of the federal policy goal motivating the tcja’s itemization-related changes. these consequences have been overlooked by existing scholarship. on the one hand, this omission is surprising because the tcja’s itemization-related changes were touted by proponents as simplifying.5 on the other hand, the omission may not be surprising because scholars have paid relatively little attention, either in general or in the context of the tcja, to tax election uniformity rules or the indirect interactions between federal and state tax regimes that these rules create.6 commentators analyzing the interactions between federal and state tax laws, whether in general or in the context of the tcja specifically, typically focus on conformity (i.e., whether a state’s income tax laws change to follow federal income tax law changes,7 including changes made by the tcja),8 tax preferences such as the deductibility (now capped9) of state and local taxes for purposes of the federal income tax, 10 or administrative cooperation between the federal and state tax authorities.11 even when election uniformity has been mentioned in the context of the tcja, commentators and policymakers generally focused on the impact on 5 see infra part i.b. 6 see heather m. field, binding choices: tax elections & federal/state conformity, 32 va. tax rev. 527 (2013) (the one law review article discussing policy considerations relevant to states’ election uniformity rules); see also infra note 12 (citing sources that discuss the state revenue effects of the tcja in light of states’ election uniformity rules). 7 see, e.g., jane g. gravelle & jennifer gravelle, how federal policymakers account for the concerns of state and local governments in the formulation of federal tax policy, 60 nat’l tax j. 631 (2007); leann luna & ann boyd watts, federal tax legislative changes and state conformity, 100 proc. ann. conf. on tax’n nat’l taxpayer assoc. 260 (2007); ruth mason, delegating up: state conformity with the federal tax base, 62 duke l.j. 1267 (2013); ralph b. tower & caroline m. boyd, tax base modifications: the hidden barrier to simplification, 41 st. tax notes 165 (2006). commentators also discuss the relationship between federal and state tax laws as part of broader discussions about fiscal federalism. see, e.g., daniel shaviro, an economic and political look at federalism in taxation, 90 mich. l. rev. 895 (1992); kirk j. stark, the federal role in state tax reform, 30 va. tax rev. 407, 423 (2010); david a. super, rethinking fiscal federalism, 118 harv. l. rev. 2544 (2005). 8 see, e.g., dylan grundman, what the tax cuts and jobs act means for states—a guide to impacts and options, inst. tax’n & econ. pol’y (jan. 26, 2018), https://itep.org/what-the-taxcuts-and-jobs-act-means-for-states-a-guide-to-impacts-and-options/ [https://perma.cc/7zwxn49k]; amy monahan, state individual income tax conformity in practice: evidence from the tax cuts & jobs act, 11 colum. j. tax l. 57 (2019); darien shanske & david gamage, why states should tax the gilti, 91 st. tax notes 751 (2019); adam thimmesch et al., strategic nonconformity to the tcja, part 1: personal income taxes, 97 tax notes st. 17 (2020); jared walczak, toward a state of conformity: state tax codes a year after federal tax reform, tax found. (jan. 28, 2019) https://taxfoundation.org/state-conformity-one-year-after-tcja/ [https://perma.cc/8ywn-3m3r]. 9 i.r.c. § 164(b)(6)(b), codifying pub. l. no. 115-97, § 11042(a), 131 stat. 2054, 208586 (2017) (capping the deductibility of state and local taxes at $10,000). 10 see, e.g., daniel hemel, the death and life of the state and local tax deduction, 72 tax l. rev. 151 (2019); manoj viswanathan, hyperlocal responses to the salt deduction limitation, 71 stan. l. rev. online 294 (2019). 11 see, e.g., harley duncan & leann luna, lending a helping hand: two governments can work together, 60 nat’l tax j. 663 (2007); erin adele scharff, laboratories of bureaucracy: administrative cooperation between state and federal tax authorities, 68 tax l. rev. 699 (2015). 2021] taxpayer choices 5 state tax revenue and the size of individual taxpayers’ state income tax bills,12 rather than on simplicity. admittedly, the impact of states’ election uniformity rules on the degree of simplification created by the tcja may have been difficult to identify or appreciate without a careful study of federal and state individual income tax filing data from before and after the tcja’s enactment (i.e., from 2017 and 2018). thus, i gathered and analyzed that data, and this article discusses the results and their implications. my study shows that the simplifying effects of the tcja’s itemization-related changes varied state-to-state depending on states’ itemization election uniformity rules.13 in states that allowed different federal and state itemization choices, the tcja’s simplifying effect was largely illusory for many taxpayers, and state tax administration became more complex. in contrast, in states that required uniform federal and state itemization elections, the tcja’s changes were generally much more simplifying for taxpayers and tax authorities, although the irs’s benefit was dampened, at least slightly, because states bound taxpayers to their federal itemization elections. this article’s analysis also illustrates a broader point—that states’ tax election uniformity rules are critical to understanding the relationship between the federal and state tax regimes and should be considered in the policy analysis of any tax change that relates to a tax election. there are hundreds of tax elections,14 and the itemization election, discussed here, is merely one example of where the policy implications of a federal tax law change cannot be fully understood without understanding states’ tax election uniformity rules. the same is true for many other tax elections, including a married couple’s election whether to file jointly or separately,15 an eligible corporation’s election to be taxed as an “s corporation” 12 see, e.g., grundman, supra note 8; erin huffer et al., effects of the tax cuts and jobs act on state individual income taxes, 58 wash. u. j.l. & pol’y 205 (2019); walczak, supra note 8; see also, e.g., richard auxier & kim rueben, tax policy ctr., conformity, covid-19, and state budgets 15-18 (jan. 2021) https://governor.kansas.gov/wpcontent/uploads/2021/01/tpc_kansas_ january_2021.pdf [https:// perma.cc/2shv-muhl] (in a presentation to kansas governor’s council on tax reform, discussing kansas taxpayers who pay higher state taxes but lower overall taxes because of tcja’s increased standard deduction and kansas’s itemization uniformity rule, and briefly mentioning the possibility of administration issues if kansas changed its itemization uniformity rule); n.y. state dep’t of taxation & fin., preliminary report on the federal tax cuts and jobs act (jan. 2018) https://www.tax.ny.gov/pdf/stats/stat_pit/pit/ preliminary-report-tcja-2017.pdf [https://perma.cc/ft5y-8bwp] (estimating $44 million revenue increase absent change to new york’s 2017 itemization uniformity requirement); va. dep’t of taxation, estimated impact of the tcja, 14-15, 17, 21 (nov. 19, 2018) http://leg5.state.va.us/ user_db/frmview.aspx?viewid=5343&s=23 [https://perma.cc/5yss-w3bz] (estimating that the increase in federal standard deduction coupled with virginia’s itemization uniformity law would generate over $121 million in state revenue in the 2019 fiscal year, and that allowing taxpayers to itemize for state purposes regardless of federal election would cost virginia more than $350 million in revenue in the 2020 fiscal year and more than $250 million in revenue in the 2021 fiscal year). 13 see infra part iii. 14 anthony j. dechellis & karen l. horne, ppc’s tax election deskbook (26th ed. 2020) (discussing over 300 tax elections). 15 i.r.c. § 6031. 6 columbia journal of tax law [vol: 13:1 rather than as a “c corporation,” 16 and the election to have certain corporate acquisitions taxed as asset purchases rather than stock purchases.17 these federal tax elections and others are also available at the state level in many states, and like in the case of a taxpayer’s itemization election, states differ as to whether they bind taxpayers to their federal choices or allow independent state-level choices.18 thus, states’ tax election uniformity rules for each of these and other elections are likely to affect the policy consequences of tax law changes that are relevant to taxpayers’ decisions about these elections. the itemization election provided a good opportunity for an empirical study of the effects of states’ tax election uniformity rules because the tcja’s changes were intended to alter taxpayers’ choices and because federal and state filing data from before and after the tcja were available. as a result, this example concretely illustrates the previously underappreciated interactions between the federal and state tax systems created by election uniformity rules. insights from this article’s analysis of the itemization election can be leveraged in other situations, including to help states determine which tax election uniformity rules to use for which elections and to guide policymakers as they evaluate the policy implications of many other tax law changes. for example, applying this article’s insights reveals that two recent federal tax law provisions enacted to help people weather the pandemic likely provided different degrees of assistance to married couples in different states depending on whether the states obligated couples to make the same filing status choice (married filing jointly or separately) for state purposes as they made for federal purposes.19 these types of issues will continue to arise over time, including possibly in connection with future tax changes that may be forthcoming under the biden administration. this article proceeds as follows. part i provides background about the tcja’s changes that affect taxpayers’ decisions about whether to itemize or take the standard deduction. part ii discusses 2017 and 2018 income tax return data from taxpayers in states that take different approaches to tax election uniformity. this part explains what the data reveal about how the tcja’s itemization-related changes affected taxpayers’ itemization choices. part iii uses the data discussed in part ii to analyze how states’ election uniformity rules affected the simplification achieved by the tcja’s itemization-related changes. part iv explains how this article’s insights about states’ tax election uniformity rules advance our understanding of the relationship between the federal and state tax regimes more broadly. 16 i.r.c. § 1362. 17 i.r.c. § 338(h)(10). 18 see infra part iv.a. 19 id. 2021] taxpayer choices 7 i. the tcja’s itemization-related changes the tcja was the most sweeping tax reform legislation since 1986, and it included major changes to the taxation of businesses,20 cross-border activities,21 and individuals. for individuals, the tcja reduced income tax rates, increased the standard deduction, limited many itemized deductions, suspended personal and dependency exemptions, increased the child tax credit, and reformed the individual alternative minimum tax so that it applied to fewer taxpayers, among other changes.22 according to the irs, the tcja’s increase to the standard deduction and limits on itemized deductions (the “tcja’s itemization-related changes”) are the “most substantial changes [for individual taxpayers] introduced in the tcja.”23 this part provides more detail about these changes, explains the stated policy goal behind them, and discusses their expected impact of the changes on itemization rates and simplicity. a. increasing the standard deduction & limiting itemized deductions the tcja roughly doubled the standard deduction, from $6,350 to $12,000 for single taxpayers and from $12,700 to $24,000 for married taxpayers filing jointly.24 in addition, the tcja limited itemized deductions by imposing a $10,000 cap on the deduction for state and local taxes, 25 reducing the home mortgage interest deduction, 26 limiting the deductibility of personal casualty and theft losses,27 and suspending the deductibility of miscellaneous itemized deductions.28 by raising the standard deduction and reducing the availability of certain itemized deductions,29 the tcja generally increased the financial incentive for taxpayers to take the standard deduction rather than itemizing their deductions. as a result, the tcja was expected to increase the percentage of taxpayers who take the standard deduction.30 20 business tax changes included reducing tax rates on corporations and on the income of pass-through businesses, allowing 100% bonus depreciation, and repealing the corporate alternative minimum tax. molly f. sherlock & donald j. marples, cong. rsch. serv., the 2017 tax revision (p.l. 115-97): comparison to 2017 tax law 9, 18-40 (2018). 21 the tcja moved the u.s. international tax system toward a territorial regime. id. at 4149. 22 id. at 8-19 (summarizing the individual tax provisions of the tcja). 23 83 fed. reg. 34,698, 34,700 (july 20, 2018) (in the irs’s request for comments on revisions to the individual income tax forms for 2018). 24 rev. proc. 2016-55, 2016-45 i.r.b. 432 (stating the inflation-adjusted standard deduction for 2017); i.r.c. § 63(c)(7); act of dec. 22, 2017, pub. l. no. 115-97, § 11021, 131 stat. 2054, 2072-73 (stating the standard deductions for 2018). 25 act of dec. 22, 2017, pub. l. no. 115-97, § 11042, 131 stat. at 2085-86. 26 id. § 11043, 131 stat. at 2086-87. 27 id. § 11044, 131 stat. at 2087-88. 28 id. § 11045, 131 stat. at 2088. 29 the tcja also suspended section 68’s overall limitation on itemized deductions, which actually increases, rather than reduces, the availability of itemized deductions. § 11046, 131 stat. at 2088. 30 see infra part i.c. 8 columbia journal of tax law [vol: 13:1 b. the stated policy goal: simplification simplifying the income tax system for individuals and families was a key goal motivating the tcja’s individual income tax changes.31 proponents of these changes touted that the tcja would bring “unprecedented simplicity” for families.32 they said that “[d]oubling the standard deduction . . . helps make the tax code so straightforward that 9 out of 10 americans will be able to file on a form as simple as a postcard,”33 and they promised that the tcja would make the formcompleting tasks easier for american families.34 advocates explained that “fewer taxpayers [will] need to go through the trouble of determining whether they should itemize,” 35 indicating a desire to reduce individual taxpayers’ record-keeping obligations and the number of decisions taxpayers must make when preparing their returns. in addition, proponents explained that the benefits of this simplification included reducing taxpayers’ out-of-pocket costs of filing (for example, because taxpayers would no longer need to hire “an army of lawyers and accountants”)36 and reducing taxpayers’ other costs of the filing process, including the “hassle”37 and “aggravation of itemizing.”38 this commentary suggests that, when increasing the standard deduction and limiting itemized deductions, lawmakers were primarily concerned about compliance complexity,39 which involves “the problems faced by the taxpayer in 31 treasury dep’t, unified framework for fixing our broken tax code 2-6 (2017) (emphasizing the goal of simplifying the tax system for families and individuals). indeed, the conference report accompanying the final bill lists the increase to the standard deduction and the limits on itemized deductions, among other changes, as provisions that provide “simplification” for individual taxpayers. h.r. rep. no. 115-466, at 191, 256 (2017) (conf. rep.). additional tcja changes that the conference report listed as simplifying included reduction of individual income tax rates and the reform to the individual alternative minimum tax, among others. id. at 191, 225. 32 h. comm. on ways & means, the tax cuts & jobs act: communications and policy details, at ii (quoting chairman kevin brady). 33 id. at 8. 34 see, e.g., out with the old, in with the new: tax cuts and reforms that look out for hardworking taxpayers, trump white house archives (apr. 17, 2018) [hereinafter out with the old], https://trumpwhitehouse.archives.gov/briefings-statements/old-new-tax-cuts-reforms-lookhardworking-taxpayers/ [https://perma.cc/c5c9-8lh5]. 35 h. comm. on ways & means, supra note 32, at 15. 36 out with the old, supra note 34; see also donald j. trump, remarks at loren cook company in springfield, missouri (aug. 30, 2017). 37 saying goodbye to an outdated tax code, trump white house archives (apr. 17, 2018) (quoting speaker paul ryan), https://trumpwhitehouse.archives.gov/briefingsstatements/saying-goodbye-outdated-tax-code/ [https://perma.cc/7r3c-svra]. 38 h. comm. on ways & means, supra note 32, at 8. 39 simplicity is not a particularly simple concept. there is voluminous scholarship about the meaning and importance of simplicity, and its opposite, complexity. see, e.g., david f. bradford, untangling the income tax (1986); rosemary marcuss et al., income taxes and compliance costs: how are they related?, 66 nat’l tax j. 833 (2013); edward j. mccaffery, the holy grail of tax simplification, 1990 wis. l. rev. 1267, 1270-71; n.y. state bar ass’n, report on simplification of the internal revenue code 2-6 (2002) (quoting omb as saying “tax simplification is not simple” and providing an overview of complexity); deborah h. schenk, simplification for individual taxpayers: problems and proposals, 45 tax l. rev. 121, 123 (1989); 2021] taxpayer choices 9 keeping records, choosing forms, making necessary calculations and so on.” 40 legislators appeared less concerned with rule complexity (“the problems of interpreting the written and unwritten rules”)41 and transactional complexity (“the problems faced by taxpayers in organizing their affairs so as to minimize their taxes within the framework of the rules”).42 c. expectations about itemization rates and simplification when evaluating the probable simplifying effect of the tcja’s itemizationrelated changes, much of the focus was on the expected decline in federal itemization rates. for example, the joint committee on taxation’s analysis of expected tax complexity associated with the tcja’s itemization-related changes estimated that “approximately 94-percent of taxpayers will claim the standard deduction under the bill, up from approximately 70-percent under [2017] law.”43 kathleen delaney thomas, user-friendly taxpaying, 92 ind. l.j. 1509 (2017); see also staff of j. comm. on taxation, 107th cong., jcs-3-01, study of the overall state of the federal income tax system and recommendations for simplification, pursuant to section 8022(3)(b) of the internal revenue code of 1986 (comm. print. 2001) (providing a comprehensive analysis of tax complexity). 40 bradford, supra note 39, at 266-67; see also mccaffery, supra note 39, at 1270-72 (defining compliance complexity as the complexity “relat[ing] to the variety of record-keeping and form-completing tasks a taxpayer must perform in order to comply with the tax laws”); n.y. state bar ass’n, supra note 39, at 3-4. lawrence zelenak separates out computational complexity, which is often lumped together with compliance complexity. lawrence zelenak, learning to love form 1040: two cheers for the return-based mass income tax 113 (2013). 41 bradford, supra note 39, at 266-67; see also mccaffery, supra note 39, at 1270-72 (discussing the similar concept of “technical complexity”); n.y. state bar ass’n, supra note 39, at 4-6 (parsing rule complexity further into technical complexity and interpretational complexity). 42 bradford, supra note 39, at 266-67; see also n.y. state bar ass’n, supra note 39, at 6. kathleen delaney thomas parses complexity differently, into substantive complexity (“complexity in the tax rules makes it difficult for taxpayers to comprehend those rules”) and procedural complexity (“any type of complexity that involves burdensome or numerous processes or steps”). thomas, supra note 39, at 1516-17. under thomas’s parsing, lawmakers, when discussing the tcja’s itemization-related changes, appeared more concerned about procedural complexity than substantive complexity. 43 h.r. rep. no. 115-446, at 67 (2017) (conf. rep.) (part of the jct’s tax complexity analysis). the jct published a more refined analysis in april 2018 with slightly different numbers, estimating that the number of returns with itemized deductions would fall from approximately 46.5 million for the 2017 tax year to approximately 18 million for the 2018 tax year. staff of j. comm. on taxation, tables related to the federal tax system as in effect 2017 through 2026, jcx-32-18, at 6 (2018). this means that the jct expected 88-90% of taxpayers to claim the standard deduction in 2018, up from approximately 70% under pre-tcja law. 10 columbia journal of tax law [vol: 13:1 the irs and the cbo made similar predictions about the expected decline in the number of itemizers,44 as did tax policy commentators.45 the joint committee on taxation also qualitatively explained why a decline in itemization rates was expected to reduce complexity: some taxpayers who currently itemize deductions may respond to the provision by claiming the increased standard deduction in lieu of itemizing. . . . these taxpayers will no longer have to file schedule a to form 1040, a significant number of which will no longer need to engage in the record keeping inherent in itemizing below-the-line deductions. . . . this reduction in complexity and record keeping also may result in a decline in the number of individuals using a tax preparation service, or tax preparation software, or a decline in the cost of such service or software. the provision [increasing the standard deduction] should also reduce the number of disputes between taxpayers and the irs regarding the substantiation of itemized deductions. 46 d. the decline in itemization rates as a proxy for simplification the jct’s analysis, discussed above, used the decline in itemization rates as a proxy for simplification, and many others did the same. the rest of this article also uses data about changes in itemization rates to analyze the simplifying effect of the tcja’s itemization-related changes. thus, before proceeding to the data and analysis, it is important to examine the extent to which a decline in itemization rates is a good proxy for simplification. when doing so, this part considers simplification for both taxpayers and tax authorities. although commentators discussing the tcja focused on simplification for taxpayers, 47 it is well-accepted that simplicity for the government when 44 cong. budget office, the budget and economic outlook: 2018 to 2028, at 24, 112 (2018) (“a higher standard deduction for personal income taxes will reduce by more than 50 percent the number of households who find it advantageous to itemize their deductions. . . . the combination of the higher standard deduction and the restrictions on [itemized deductions will reduce] the number of taxpayers itemizing deductions . . . from 49 million in 2017 to 18 million in 2018.”); 83 fed. reg. 34,698, 34,700 (july 20, 2018) (“the increase in the standard deduction and the limitation on the schedule a tax deductions, taken together, . . . are expected to decrease the number of schedule a filed from 46 million to 20 million”). 45 see, e.g., impact on the number of itemizers of h.r.1, the tax cuts & jobs act (tcja), by expanded cash income level, 2018, tax pol’y ctr. (jan. 11, 2018), https://www.taxpolicycenter. org/model-estimates/impact-itemized-deductions-tax-cuts-and-jobsact-jan-2018/t18-0001-impact-number [https://perma.cc/jj5r-f34a] (using a simulation model to predict that the number of itemizers would drop from approximately 46.5 million in 2017 to approximately 19.3 million in 2018). 46 h.r. rep. no. 115-466, at 676-77 (2017) (conf. rep.). jct also briefly addressed the likely impact on the government, explaining that the government would face short-term complications because the irs would need to publish new forms, publications, and withholding tables to reflect the new individual income tax provisions. 47 the rhetoric surrounding the tcja’s individual income tax changes generally omits discussions about the complexity faced by the irs (e.g., when processing returns, enforcing the tax laws, and assisting taxpayers). see supra part i.b. 2021] taxpayer choices 11 administering and enforcing tax laws (often referred to as “administrability”) is an important part of understanding simplification. 48 thus, this article considers simplification for both taxpayers and tax authorities. ultimately, this part explains that the decline in itemization rates is a better proxy for simplification experienced by tax authorities than for simplification experienced by taxpayers. 1. for taxpayers the decline in itemization rates may not be a particularly good proxy for the simplification experienced by taxpayers. itemizing entails several steps for taxpayers, including keeping records of potential itemized deductions, analyzing whether those deductions are allowed, computing the amount of allowed itemized deductions, deciding whether to itemize, completing and submitting the relevant form if they decide to itemize, dealing with a possible audit of their itemized deductions, and planning ahead about itemizing to minimize their tax liability over multiple years. switching from itemizing to taking the standard deduction simplifies some of these steps but not others. indeed, many commentators discussing the tcja’s itemization-related changes expressed doubts about whether reduced itemization would confer material simplification benefits. 49 this was because, among other reasons, taxpayers still “have to do the math to determine if they should itemize,” meaning that much of the simplification benefit of switching to the standard deduction would be “illusory.”50 if a taxpayer does not itemize, they51 clearly do not need to complete or submit a schedule a with their federal income tax returns. in addition, if a taxpayer 48 see, e.g., u.s. gov’t accountability office, understanding the tax reform debate 49-52 (2005) (discussing administrability); john guyton et al., tax compliance burden 1 (2018) (explaining two sides to tax compliance burden: “the burden experienced by taxpayers and the administrative costs incurred by the irs to administer the tax code”); mccaffery, supra note 39, at 1272 (explaining that simplicity and complexity can also be evaluated from different perspectives, including the perspective of “the taxpayer, the tax preparer, the tax planner or advisor, the internal revenue service (irs), the courts, the tax legislative system, academics or economists”); joel slemrod, optimal tax simplification: toward a framework for analysis, 76 proc. ann. conf. on tax’n nat’l tax ass’n 158 (1983) (“characterize[ing] a tax system's simplicity by the value of the resources that are expended in complying with the law and enforcing the law.”). 49 see, e.g., omri marian, we have been promised a postcard. we didn’t get a postcard., am. enterprise inst. (nov. 4, 2019) https://www.aei.org/economics/we-have-been-promised-apost card-we-didnt-get-a-post card/ [https://perma.cc/l49b-5vt2]. commentators also discussed the simplifying or complexifying impact that other tcja provisions would have on individual taxpayers. this article, however, focuses on evaluating the simplification impact of only provisions that were intended to simplify. 50 daniel shefter, tax reform: we could have done so much better!, 158 tax notes 389, 390 (jan. 15, 2018). 51 this article uses the epicene singular “they” to refer to individual (singular) taxpayers in a gender-neutral way. see merriam-webster dictionary, https://www.merriamwebster.com/dictionary/ they [https://perma.cc/36fr-vmpy] (providing that one definition of “they” is as a pronoun that is “used with a singular antecedent to refer to an unknown or unspecified person”); aba style, singular “they” https://apastyle.apa.org/style-grammarguidelines/grammar/singular-they [https:// perma.cc/ye54-r5a9] (endorsing the use of the singular “they” as part of apa style and explaining the singular “they” is used “as a generic third-person https://www.merriam-webster.com/dictionary/%20they https://www.merriam-webster.com/dictionary/%20they https://apastyle.apa.org/style-grammar-guidelines/grammar/singular-they https://apastyle.apa.org/style-grammar-guidelines/grammar/singular-they 12 columbia journal of tax law [vol: 13:1 takes the standard deduction, there is no risk of a dispute with the irs about their itemized deductions. thus, these sources of complexity are eliminated for any taxpayer who switches from itemizing to taking the standard deduction. a taxpayer who switched to the standard deduction after the tcja, however, might still have kept records of their possible itemized deductions, analyzed whether each potential itemized deduction was allowed, computed their total amount of itemized deductions allowed, and compared that total to the standard deduction, before determining that the standard deduction was larger than their itemized deductions and opting to take the standard deduction. thus, even if a taxpayer did not itemize, those preliminary steps, if taken, may have required significant time and effort for the taxpayer, especially if they prepared their returns themselves. the time spent on these steps was almost certainly lower for the ~95% of taxpayers who use a tax preparer or tax return software52 because the preparer or the software generally does most of the analysis. however, even taxpayers who use software or a tax preparer might have spent time and effort collecting records of their possible itemized deductions. admittedly, some taxpayers might have skipped the preliminary steps and taken the standard deduction without analyzing their possible itemized deductions. for these taxpayers, taking the standard deduction was likely quite simple. the number of taxpayers who take this simpler approach should grow over time if, as taxpayers adjust to post-tcja law, they grow increasingly confident that they will continue to take the standard deduction. nevertheless, it is likely that some taxpayers who itemized deductions for 2017 and took the standard deduction for 2018 continued to do the record-keeping and analysis for 2018 to determine whether they should take the standard deduction. it is, however, difficult to know which taxpayers who switched to the standard deduction took which approach to recordkeeping and analysis of their possible itemized deductions. thus, although the decline in the federal itemization rate suggests at least some reduction in compliance complexity for some taxpayers, it is difficult to rely on itemization rates to draw conclusions about the degree of simplification experienced by taxpayers who switched to the standard deduction. in addition, the tcja’s itemization-related changes may increase transactional complexity for taxpayers. 53 this is because taxpayers might, for example, plan to bunch itemized deductions (particularly charitable contributions) into a single year to maximize their total deductions over a two-year period.54 this could be a useful strategy particularly for taxpayers whose annual itemized deductions (without bunching) would otherwise be close to, but somewhat below, the federal standard deduction. given the tcja’s increase to the standard singular pronoun to refer to a person whose gender is unknown or irrelevant to the context of the usage”). 52 83 fed. reg. 34,698, 34,700 (july 20, 2018). 53 see supra notes 37, 38, 40 and accompanying text. 54 see, e.g., will tax reform affect your charitable deduction? what you need to know, fidelity charitable (july 15, 2020), https://www.fidelitycharitable.org/articles/will-tax-reformaffect-your-charitable-deduction.html [https://perma.cc/l4ye-fpp3] (recommending bunching charitable contributions post-tcja to minimize overall tax liability). 2021] taxpayer choices 13 deduction, more taxpayers likely can minimize their overall tax liability through this type of planning.55 thus, although itemization rates may provide some insight into tax complexity experienced by taxpayers, the decline in federal itemization rates between 2017 and 2018 is only a weak proxy for the simplifying effect of the tcja’s itemization-related changes.56 there are other ways to try to measure simplification.57 for example, the irs also tried to quantify the expected simplifying effects of the tcja’s itemization-related changes using the “income taxpayer burden model” (itbm). the itbm is “a microsimulation model developed jointly by ibm and the irs to estimate the amount of time and money that individuals spend on federal tax compliance.”58 the model relies on both irs data and data gathered from surveys of taxpayers and paid tax professionals, about taxpayers’ tax-related activities, compliance methods, and time and money spent on tax compliance.59 the survey seeks to capture the time and money spent by taxpayers on activities that are part of the return preparation process, even if those activities do not result in actual filings (e.g., of a schedule a).60 using the itbm, the irs estimated that the “drop in schedule a filings and the elimination of certain schedule a line items [was] expected to lead to a decrease of 241,000,000 hours and a decrease of $2,948,000,000 in out-of-pocket costs” for taxpayers. 61 the itbm, however, 55 a taxpayer pursuing this strategy would likely vacillate between itemizing and taking the standard deduction for federal purposes, so this effect may be difficult to pick up in aggregate itemization data from the irs. 56 nevertheless, many commentators implicitly use the decline in federal itemization rates as a proxy for simplification, particularly in the context of broader discussions about the tcja. see, e.g., william g. gale et al., effects of the tax cuts and jobs act: a preliminary analysis, tax policy ctr. 17 (june 13, 2018) (“tcja will simplify taxes in . . . [that] the number of people who itemize their deductions will decline significantly because of the increases in the standard deduction and the reduction or elimination of certain itemized deductions” but also highlighting how the tcja increase complexity); stephen j. pieklik et al., deducting success: congressional policy goals and the tax cuts and jobs act of 2017, 16 pitt. tax rev. 1, 27-29 (2018) (“congress was both successful and unsuccessful in meeting its goal of simplifying the tax system” – successful in that the tcja “makes paying taxes simpler for the vast majority of taxpayers because these taxpayers are likely to utilize the standard deduction” but unsuccessful because of changes unrelated to itemization). 57 commentators have used various other approaches to try to estimate the impact of tax changes on simplification. see, e.g., jason j. fichtner, bipartisan policy ctr., tax administration: compliance, complexity, and capacity 6-8 (2019), https://bipartisanpolicy.org/wp-content/ uploads/2019/04/tax-administration-compliancecomplexity-capacity.pdf [https://perma.cc/ 7mdb-3dls] (citing studies using different approaches); jason j. fitchner & jacob m. feldman, mercatus ctr., the hidden costs of tax compliance (2013). 58 guyton et al., estimating the compliance cost of the u.s. individual income tax, 56 nat’l tax j. 673 (2003) (explaining how the itbm works). 59 id. 60 see, e.g., irs, sample individual taxpayer burden survey for 2018 (2019) (question 3, for example, which asks about recordkeeping regardless of whether taxpayer used the records). 61 irs, omb control no. 1545-0074, supporting statement a, u.s. individual income tax return 33 (2018), https://www.reginfo.gov/public/do/praviewdocument?ref_nbr=201808-1545-031 14 columbia journal of tax law [vol: 13:1 remains subject to many limitations,62 but it is one way to study an aspect of simplification that a mere decline in the number of itemizers cannot capture—time and effort invested in the process of determining whether to itemize or take the standard deduction. moreover, the irs’s use of the itbm as an alternative method of measuring simplification supports the conclusion that the decline in itemization rates may not be the best proxy for the simplification experienced by taxpayers as a result of the tcja’s itemization-related changes. 2. for tax authorities in contrast, the decline in itemization rates is likely a reasonably good proxy for the long-term simplification experienced by tax authorities. the tcja’s itemization-related changes did add some short-term complications for the irs because the irs needed to revise forms, instructions, publications, and other materials to reflect the changes in the law before taxpayers filed their returns. after taxpayers filed their returns, however, the decline in itemization rates simplified the irs’s post-filing responsibilities for at least two reasons. first, there were almost 30 million fewer schedule a forms that needed to be processed in 2018 as compared to 2017. processing fewer forms is easier and presumably saved the irs time and money. second, with almost 30 million fewer schedule a forms filed in 2018, there were fewer taxpayers whose itemized deductions might need auditing and thus fewer opportunities for disputes about itemized deductions. given that “itemized deductions reported on schedule a of irs form 1040 have been among the [national taxpayer advocate’s list of] ten most litigated issues” in recent years,63 changes that dramatically reduce the number of taxpayers who itemize deductions should also reduce audits and disputes related to itemized deductions, thereby simplifying the irs’s work. the enforcement resources otherwise spent on these tasks can be saved and reallocated for other tax administration uses. these simplification benefits for the irs are likely to continue for years, as long as the tcja’s itemization-related changes persist enough to keep itemization rates down. thus, a decline in itemization rates represents a real decline in the irs resources spent administering one part of the individual income tax. [https://perma.cc/fc83-w324] (included in the information collection review (icr) submitted to office of information and regulatory affairs (oira) in connection with oira’s review of the revised u.s. individual tax return). 62 see guyton, supra note 48; guyton, supra note 58; janet holtzblatt, measuring compliance burdens: issues raised by the individual taxpayer burden model, 97 proc. ann. conf. on tax’n nat’l taxpayer ass’n 366 (2004). this scholarship identifies many concerns including, for example, that data are based on a survey of taxpayers, and although the survey is completed relatively close in time to when taxpayers file, the taxpayers may still be subject to recall bias. 63 nat’l taxpayer advocate, annual report to congress 2018 (2019); nat’l taxpayer advocate, annual report to congress 2019 (2020). 2021] taxpayer choices 15 ii. using tax filing data to understand changes in taxpayers’ itemization choices with an understanding of what a decline in itemization rates does (and does not) mean about simplification, this part delves into the data about itemization before and after the tcja. this part first examines how federal itemization rates changed after the tcja. then, this part adds state itemization data to the analysis to understand how (and why) federal and state itemization rates vary by state. a. federal itemization data filing data from the 2017 and 2018 tax years are consistent with the predictions that federal itemization rates would decline after the tcja. for the 2017 tax year, 30.6% of tax returns itemized deductions, whereas for the 2018 tax year, only 11.4% itemized deductions. 64 almost 30 million fewer tax returns itemized deductions in 2018 than in 2017. as illustrated in figure 1, federal itemization rates declined in all income categories, although the magnitude of the impact varied by income category.65 64 soi tax stats individual income tax returns complete report (publication 1304), irs, https://www.irs.gov/statistics/soi-tax-stats-individual-income-tax-returns-publication-1304complete-report [https://perma.cc/r76l-355v] (last visited nov. 21, 2021) (table 1.4. all returns: sources of income, adjustments, and tax items, by size of adjusted gross income, tax year 2017 & tax year 2018). the soi also published data broken down by state. irs statistics on income, individual income and tax data, by state and size of agi (tax year 2017 & tax year 2018). the aggregated nationwide numbers of returns and returns with itemized deductions are slightly different in the different sources, as follows: total # of returns # of returns with itemized deductions % of returns with itemized deductions decline in # of itemizers decline in itemization rate (as a % of 2017 rate) publication 1304 (table 1.4) (soi complete report) 29,320,083 62.8% ty2017 152,903,231 46,852,675 30.6% ty2018 153,774,296 17,532,592 11.4% soi state-by-state data 29,504,500 62.9% ty2017 152,455,900 47,103,650 30.9% ty2018 153,455,990 17,599,150 11.5% the numbers are quite close, but this article, when reporting aggregate nationwide data, will rely on the data from publication 1304 because the state-by-state data are rounded. 65 soi tax stats – individual income tax returns complete report (publication 1304), irs, https://www.irs.gov/statistics/soi-tax-stats-individual-income-tax-returns-publication-1304complete-report [https://perma.cc/r76l-355v] (last visited nov. 21, 2021) (table 1.4. all returns: sources of income, adjustments, and tax items, by size of adjusted gross income, tax year 2017 & tax year 2018) and author calculations. 16 columbia journal of tax law [vol: 13:1 very few lower-income taxpayers itemized before or after the tcja, but of those who did itemize in 2017, a large percentage switched to the standard deduction for 2018. 66 a substantial percentage of middleand upper-middleincome taxpayers also switched from itemizing in 2017 to taking the standard deduction in 2018. in contrast, although some of the highest-income taxpayers switched to the standard deduction, their post-tcja itemization rates remained quite high.67 b. a closer look at the data: variation in itemization rates by state federal itemization rates vary not only by income, but also by state. in 2017, federal itemization rates for taxpayers in different states ranged from a low of 17.4% (in west virginia) to a high of 46.7% (in maryland), with a median of 29.2%. 68 there are many reasons for this state-to-state variation in federal itemization behavior, including differences in income and wealth across states, state and local tax levels, home ownership rates, and home prices.69 in addition, state itemization rates vary by state among those states with an income tax. there are many possible explanations for this variation as well, 66 this is not surprising because the higher post-tcja standard deduction is larger relative to the income of a lower-income taxpayer. 67 this is also not surprising because high-income taxpayers are most likely to have itemized deductions (especially mortgage interest deductions and deductions for charitable donations) in excess of the standard deduction. 68 see appendix a showing the 2017 and 2018 federal itemization rates for every state. 69 the deductions for state and local taxes and home mortgage interest were two of the top three most commonly taken itemized deductions before the tcja (taken by >97% and >70% of 2017 itemizers respectively), and all continued to be taken at high rates in 2018. irs, individual income tax return line-item estimates 2017, pub. 4801, at 32 (2019), and author calculations. 3.0% 6.4% 10.8% 16.4% 25.1% 37.0% 52.9% 75.8% 93.4% 93.0% 91.5% 1.0% 1.9% 3.1% 4.2% 6.5% 11.5% 17.1% 26.6% 48.0% 65.7% 77.4% 0.0% 20.0% 40.0% 60.0% 80.0% 100.0% % o f f ed er al r et u rn s w it h i te m iz ed d ed u ct io n s agi category figure 1. federal itemization rates by agi & tax year 2017 ty 2018 ty 2021] taxpayer choices 17 including the factors listed above, differences in state laws regarding which expenditures are deductible (i.e., whether state tax law conforms to federal tax law), and differences in the size of states’ standard deductions. several states made changes to their tax laws in response to the tcja, particularly with respect to conformity and the size of the state’s standard deduction.70 for example, some states (e.g., missouri) increased their standard deductions to match the large posttcja federal standard deduction.71 the standard deduction in most other states (e.g., oregon, maryland, and nebraska) increased but remained significantly lower than the post-tcja federal standard deduction, although the magnitude of the gap between federal and state standard deduction varied. table 1 provides preand posttcja standard deductions for these states as examples, along with the federal standard deduction amounts for comparison. table 1. standard deductions preand post-tcja: federal and select states standard deduction for single taxpayers standard deduction for married taxpayers filing jointly 2017 2018 2017 2018 federal $6,350 $12,000 $12,700 $24,000 state missouri72 $6,350 $12,000 $12,700 $24,000 nebraska73 $6,350 $6,750 $12,700 $13,500 oregon74 $2,175 $2,215 $4,350 $4,435 maryland75 max of $2,000 max of $2,250 max of $4,000 max of $4,500 one additional factor that can affect both the federal itemization rate and the state itemization rate for a state’s taxpayers is whether the state requires election uniformity. that is, does the state obligate its taxpayers to make the same itemization decision for state purposes as the taxpayer made for federal purposes? very generally, states take three different approaches to election uniformity. some states, including georgia and virginia, require taxpayers to make completely 70 see walczak, supra note 8 (summarizing states’ conformity changes in response to the tcja). 71 compare 2018 missouri income tax reference guide 7 (2018) with 2017 missouri income tax reference guide 8 (2017). the state standard deduction increases beyond the federal amount for taxpayers over age 65. 72 id. 73 chronological history of nebraska tax rates, neb. dep’t of revenue, https://revenue. nebraska.gov/sites/revenue.nebraska.gov/files/doc/research/chronology/4-607table1.pdf [https:// perma.cc/njx9-vnuy] (last visited nov. 21, 2021) (listing income tax rate data, income tax bracket data, and standard deduction amounts by year). 74 compare or. dep’t of revenue, 2017 oregon income tax full-year resident, pub. or-40-fy at 15 (2018) with or. dep’t of revenue, 2018 oregon income tax full-year resident, pub. or-40-fy at 15 (2019). 75 comptroller of md., maryland 2017 state & local tax forms & instructions 12 (2018), https://www.marylandtaxes.gov/forms/17_forms/resident_booklet.pdf [https://perma.cc/ c59f-kem8]; comptroller of md., maryland 2018 state & local tax forms & instructions 12 (2019), https://www.marylandtaxes.gov/forms/18_forms/resident_booklet.pdf [https://perma.cc/q8f4zh59]. 18 columbia journal of tax law [vol: 13:1 uniform federal and state itemization decisions: if a taxpayer itemizes for federal purposes, they must itemize for state purposes as well, and if a taxpayer takes the standard deduction for federal purposes, they must take the standard deduction for state purposes too.76 these states are shown with horizontal stripes on figure 2 below. other states, including nebraska and maryland, require partial election uniformity. in these states, taxpayers who take the standard deduction for federal purposes must also take the standard deduction for state purposes, but taxpayers who itemize for federal purposes can make an independent choice for state purposes. these states are shown with vertical stripes in figure 2 below. yet other states, including oregon and california, allow taxpayers to make fully independent state itemization decisions. these taxpayers can make the election that is best for them for state purposes without regard to what election they made for federal purposes. these states are shown with dots in figure 2 below. states shaded dark gray do not allow state itemized deductions, and states shaded light gray do not have a broad-based state personal income tax. figure 2. itemization election uniformity laws by state (2018)77 76 some states, such as georgia that require complete election uniformity do so by explicitly requiring that taxpayers make the same choice for state tax purposes. ga. code ann. §487-27(a) (2019) (using federal agi as the conformity starting point, and then allowing a subtraction for itemized deductions if the taxpayer itemized for federal purposes and otherwise allowing a standard deduction). other states, such as colorado, use federal taxable income as their conformity starting point, thereby building in the taxpayer’s federal itemization choice for purposes of their state tax determination. colo. rev. stat. § 39-22-104(1.7) (2019). 77 map created by author using mapchart.net and research about state income taxes. state tax forms; ria checkpoint, state tax chart 56,000 (conformity starting point), 56950 (itemized deduction). see appendix a for more details about each state’s itemization uniformity rule. 2021] taxpayer choices 19 the remainder of this part analyzes the preand post-tcja itemization rates of taxpayers in states with different approaches to itemization election uniformity. oregon is used as the example of a state that allows independent itemization choices (i.e., states with dots), and nebraska and maryland are used as examples of states that require some degree of election uniformity (i.e., states with stripes).78 these three states are used as case studies for three reasons. first, their state income tax laws largely conform to federal individual income tax laws, which allows the analysis to focus primarily on the impact of the election uniformity choice (rather than on differences between federal and state income tax laws regarding, for example, what deductions are allowed).79 second, these states did not change their approach to itemization election uniformity between 2017 and 2018.80 third, state-level itemization data for both 2017 and 2018 were available 78 these states take the same approach—requiring taxpayers who take the standard deduction for federal purposes to take the standard deduction for state purposes. however, both are included because their state standard deductions and state itemization data are quite different. readers may notice that this discussion does not include an example of a state that fully binds a taxpayer to their federal itemization deductions (i.e., states with vertical stripes). this is primarily because of the unavailability of state-level itemization data from these states. however, analyzing nebraska’s and maryland’s data provides insight into the consequences for all taxpayers who, posttcja, prefer to take the standard deduction for federal purposes but prefer to itemize for state purposes. for taxpayers with these preferences, the analysis is the same regardless of whether they are in a state that fully binds taxpayers or a state that binds taxpayers only to the federal standard deduction. the taxpayers omitted by this analysis are those who, post-tcja, prefer to itemize for federal purposes but take the standard deduction for state purposes. taxpayers in states like nebraska and maryland are allowed to act on these preferences, but in states that fully bind taxpayers to their federal itemization choices, the taxpayer may not itemize for federal purposes and take the standard deduction for state purposes. however, the taxpayers who would want to do that are practically a null set, so little is lost by omitting an example of a state that requires complete uniformity. thus, this article, when referring to states that bind taxpayers to their federal elections, will also include states that bind taxpayers only to federal standard deduction, because it is binding to the federal standard deduction that is the part of the election uniformity rule with the most potentially significant impact post-tcja. 79 for 2018, all three states generally conformed to the individual income tax changes made by the tcja. in oregon and maryland, the primary disconformity with the irc for individual income taxes was that they do not allow a state deduction for state income tax (or, in maryland income tax paid to a locality). or. rev. stat. § 316.695(1)(d) (2019); md. code ann. tax-gen. § 10-218 (2017). in nebraska, no state or local taxes at all (including non-income taxes) are deductible for state income tax purposes. neb. rev. stat. § 77-2716.01(3) (2018). in contrast, california is not discussed because it generally conforms to the irc as of jan. 1, 2015 (i.e., to very dated law). cal. revenue & taxation code § 17024.5 (2019). in 2019, california adopted some (but far from all) changes to conform with the tcja but did not conform to the tcja at all in 2018. see kathleen k. wright, california conformity to the tcja (the “light” version of conformity), 93 tax notes st. 405 (2019). 80 this is why new york is not discussed. new york taxpayers were bound to their federal standard deductions for 2017 but allowed independent elections for 2018. see n.y. state dep’t of taxation & fin., preliminary report on the federal tax cuts and jobs act (jan. 2018), https://www.tax.ny.gov/pdf/stats/stat_pit/pit/preliminary-report-tcja-2017.pdf [https://perma.cc/ bmb9-f4b7] (explaining that absent change in new york’s 2017 itemization uniformity requirement, the tcja’s changes “would generate approximately $44 million in additional revenue” for 2018 because more ny taxpayers would opt for the federal standard deduction, thus obligating them to take the standard deduction for ny purposes too); n.y. state, dep’t of taxation & fin., itemized deductions (2019), https://www.tax.ny.gov/pit/file/itemized-deductions-2018.htm 20 columbia journal of tax law [vol: 13:1 for analysis. 81 for each example, the following discussion analyzes how the tcja’s itemization-related changes would, in theory, be expected to change taxpayers’ itemization behavior82 and compares those theoretical expectations to data about actual changes in itemization behavior. together, this analysis illustrates that the tcja’s itemization-related changes led to different results (not only for state purposes, but also for federal purposes) for taxpayers in states depending on each state’s itemization election uniformity rules. 1. independent itemization elections allowed: oregon oregon is an example of a state that allows independent itemization elections.83 taxpayers are free to itemize for oregon state income tax purposes even if they take the standard deduction for federal income tax purposes. a. change in itemization behavior of oregon taxpayers – theory because oregon does not require taxpayers to make uniform federal and state itemization elections, oregon taxpayers would be expected to analyze their federal and state itemization elections separately. then, they would make the federal election that best reduces federal income tax liability and make the state election that best reduces state income tax liability, even if the former and latter differ. neither election would obligate the taxpayer to make any particular choice for the other election.84 accordingly, oregon taxpayers should be expected to make whatever federal itemization choice best reduces their federal income taxes. thus, the federal itemization rate for oregon taxpayers would be expected to drop significantly [https://perma.cc/zk3b-n4zc] (“beginning with tax year 2018, the tax law allows you to itemize your deductions for new york state income tax purposes whether or not you itemized your deductions on your federal income tax return.”); n.y. state dep’t of taxation & fin., technical memorandum tsb-m-18(6)i – new york state decouples from certain personal income tax internal revenue code (irc) changes for 2018 and after (2018). minnesota made a similar change between 2017 and 2018. minn. dep’t of revenue, revenue notice #18-01: individual income tax – standard deduction or election to itemize – tax year 2018 (2018), https://www.revenue.state.mn.us/sites/default/files/2018-09/rn-18-01.pdf [https://perma.cc/cf3s-4yhd] (explaining that prior to 2018, “[t]he computation of minnesota individual income tax . . . requires taxpayers to have a consistent election [with respect to itemizing or taking the standard deduction] between their federal and state income tax returns” but that, “[f]or taxable year 2018, taxpayers may either claim the standard deduction or elect to itemize deductions on their 2018 minnesota income tax return, regardless of the election made on their 2018 federal income tax return”). 81 federal itemization data for 2018 is available from the irs soi for taxpayers from all states. however, state-level data is much harder to obtain because some states generally do not provide such data or only do so on a very delayed basis. 82 this analysis uses a rational actor model, assuming that taxpayers make utilitymaximizing decisions, measuring utility in money. 83 independent itemization elections are allowed for oregon state purposes even though oregon’s starting point for conformity is federal taxable income. or. rev. stat. §§ 316.048, 316.695(1)(c)(a) (2019). 84 a taxpayer’s state itemization choice could, however, affect the taxpayer’s salt deduction for federal purposes, and thus affect the desirability of itemizing for federal purposes. 2021] taxpayer choices 21 between 2017 and 2018. this is because the tcja’s dramatic increase in the federal standard deduction likely led many more oregon taxpayers to choose the standard deduction for federal purposes in 2018 than in 2017. this decline in federal itemization by oregon taxpayers would likely be similar to the decline in federal itemization by taxpayers nationwide. the decline in federal itemization by oregon taxpayers, however, would be expected to have no effect on oregon taxpayers’ itemization decisions for state income tax purposes. because oregon allows independent state itemization decisions, the expected change in taxpayers’ state itemization behavior should depend primarily on which itemized deductions oregon allows and on the size of oregon’s standard deduction. oregon’s state income tax laws about itemized deductions mirror the federal income tax laws with minimal exceptions.85 as a result, the tcja’s limits on itemized deductions for federal purposes also limited taxpayers’ itemized deductions for oregon state purposes beginning in 2018. however, oregon’s standard deduction increased by less than 2% between 2017 and 2018.86 thus, the financial incentive to itemize for oregon state tax purposes was largely unchanged between 2017 and 2018, except for the relatively small number of taxpayers whose itemized deductions were significantly limited by oregon’s conformity to the tcja’s limitations. therefore, in contrast to the large expected decline in the federal itemization rate by oregon taxpayers, relatively little change in the oregon state itemization rate would be expected between 2017 and 2018.87 b. change in itemization behavior of oregon taxpayers – data federal and state individual income tax filing data from 2017 and 2018 provide insight into how actual taxpayer itemization behavior changed after the tcja, and the data reveal that the actual results match the theoretical expectations. as figure 3 shows, the percentage of oregon taxpayers who itemized for federal purposes declined dramatically between 2017 and 2018 (from 37.5% to 14.6%).88 this decline was similar in magnitude to the overall decline in federal itemization.89 85 oregon is a static conformity state that regularly updates its conformity date. s.b. 1529, 79th leg. assemb., reg. sess. (or. 2018) updated oregon’s conformity date to december 31, 2017, effective for the 2018 tax year. itemized deductions for oregon purposes are the same as a taxpayer’s federal itemized deductions except that oregon income taxes are not deductible for oregon state purposes. or. rev. stat. § 316.695(1)(d) (2019). 86 see supra table 1. 87 see or. legislative revenue office, tax cuts and jobs act of 2017 – an update 18 (2018) (anticipating that oregon state itemization rates would remain at approximately 47% and anticipating that the share of oregon taxpayers who itemize for federal purposes would decline from approximately 40% in 2017 to 15% in 2018). 88 soi tax stats – historic table, individual income and tax data, by state and size of adjusted gross income, irs, https://www.irs.gov/statistics/soi-tax-stats-historic-table-2 [https://perma.cc/ ypz4-ngju] (last visited nov. 21, 2021), and author calculations. 89 see supra part ii.a. 22 columbia journal of tax law [vol: 13:1 in contrast, the percentage of oregon taxpayers who itemized for oregon state purposes declined only slightly (from 46.2% to 43.3%).90 in absolute numbers, ~441,000 fewer income tax returns from oregon taxpayers itemized deductions for federal purposes for 2018 than for 2017. 91 however, the number of oregon income tax returns that itemized deductions for state purposes declined, between 2017 and 2018, by only ~37,000. 92 thus, ~404,000 oregon taxpayers continued, post-tcja, to itemize for state income tax purposes despite switching to the standard deduction for federal income tax purposes. this represents more than 90% of oregon taxpayers who switched to the standard deduction for federal purposes93 and more than 22% of all oregon state individual income tax returns.94 appendix b provides additional details about the data. in sum, the decline, between 2017 and 2018, in the percentage of oregon taxpayers who itemized for state tax purposes was much smaller than the decline in the percentage of oregon taxpayers who itemized for federal tax purposes. thus, the tcja’s changes had a significant impact on the percentage of taxpayers who itemized for federal purposes, but a very small impact on itemization rates for 90 oregon personal income tax statistics, oregon.gov, https://www.oregon.gov/dor/programs/ gov-research/pages/research-personal.aspx [https://perma.cc/28ck-az62] (last visited nov. 21, 2021), and author calculations. 91 see supra note 88. 92 see supra note 90. 93 404,000/441,000 = 91.6% 94 the exact percentage depends on which number is used for the denominator (i.e., federal returns or state returns; 2017 returns or 2018 returns), but any denominator yields a percentage greater than 22%. see appendix b for more detailed numbers. 30.6% 37.5% 11.4% 14.6% 46.2% 43.3% 0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0% 35.0% 40.0% 45.0% 50.0% united states oregon % o f r et u rn s w it h i te m iz ed d ed u ct io n s jurisdiction figure 3. tcja's impact on u.s. itemization rates and on federal & state itemization rates for oregon taxpayers 2017 federal itemization 2018 federal itemization 2017 state itemization 2018 state itemization 2021] taxpayer choices 23 oregon state tax purposes. this disparity arose because some oregon taxpayers made different federal and state itemization choices, and that can only happen because oregon allows taxpayers to make independent state itemization choices. 2. election uniformity required: maryland & nebraska the results are quite different in states, such as maryland and nebraska, that require taxpayers who take the standard deduction for federal purposes to take the standard deduction for state purposes. in these states, a taxpayer can itemize for state income tax purposes only if they itemize for federal income tax purposes. a. change in itemization behavior of maryland and nebraska taxpayers – theory to decide whether to itemize, a taxpayer in a state requiring itemization election uniformity should determine which itemization choice minimizes their net income tax liability. for some of these taxpayers, one itemization choice may be tax-minimizing for both federal and state purposes, in which case the choice is easy. if the federal standard deduction exceeds the taxpayer’s federal itemized deductions and the state standard deduction exceeds the taxpayer’s state itemized deductions, the taxpayer should take the standard deduction for both federal and state purposes. similarly, if a taxpayer’s itemized deductions exceed both the state and federal standard deductions, the taxpayer should itemize for both purposes. other taxpayers have conflicting itemization preferences—typically preferring to take the standard deduction for federal purposes and to itemize for state purposes.95 in states that require election uniformity, the taxpayers with this set of conflicting federal/state itemization preferences must determine whether it is tax minimizing, on net, to (1) itemize for federal purposes (even though their federal standard deduction is larger) so they can also itemize for state purposes96 or (2) take the standard deduction for federal purposes even though doing so requires them to take the standard deduction for state purposes too (instead of taking their larger 95 see walczak, supra note 8, at 18 (highlighting this possibility). conflicting preferences could be reversed, where a taxpayer prefers to itemize for federal purposes but take the standard deduction for state purposes. however, that would be extremely unlikely, at least in states that largely conform to federal tax law, because no state’s basic standard deduction exceeds the federal standard deduction. see morgan scarboro, state individual income tax rates and brackets for 2018, tax found. fiscal fact no. 576 (2018); katherine loughead & emma wei, state individual income tax rates and brackets for 2019, tax found. fiscal fact no. 643 (2019); see also supra note 79. 96 h&r block, for example, explicitly flags this possibility. see what is the standard deduction vs. itemized deduction?, h&r block, https://www.hrblock.com/taxcenter/filing/adjustments-and-deductions/standard-vs-itemized-deductions/ [https://perma.cc/zw8z-hpft] (last visited nov. 21, 2021) (“there’s one situation where you may want to itemize deductions even if your total itemized deductions are less than your standard deduction. you might want to do this if you’d pay less tax overall between your federal and state taxes. this can happen if you itemize on your federal and state returns and get a larger tax benefit than you would if you claimed the standard deduction on your federal and state returns.”). 24 columbia journal of tax law [vol: 13:1 amount of state itemized deductions). 97 these taxpayers cannot make their preferred itemization choice for both federal and state purposes. they must make a single choice and either pay extra in state income tax to save even more in federal income taxes, or vice versa. ultimately, where a state requires itemization uniformity, the tax minimizing choice, on net, is a function of (a) the taxpayer’s federal marginal tax rate, (b) the amount of the taxpayer’s federal itemized deductions, (c) the size of the federal standard deduction, (d) the taxpayer’s state marginal tax rate, (e) the amount of the taxpayer’s state itemized deductions, and (f) the size of the state standard deduction.98 the tcja’s dramatic increase in the size of the federal standard deduction increased the net benefit to taxpayers of taking the standard deduction, thereby increasing the economic incentive to take the standard deduction. thus, the federal itemization rates for taxpayers in nebraska and maryland should be much lower in 2018 than they were for those same taxpayers in 2017.99 because these states require taxpayers to take the standard deduction for state purposes if they take the standard deduction for federal purposes, an increase in the percentage of taxpayers taking the standard deduction for federal purposes post-tcja should also result in a corresponding increase in the percentage of taxpayers taking the standard deduction for state purposes. thus, for taxpayers in nebraska, maryland and other states that require election uniformity, both federal and state itemization rates would be expected to decline after the tcja, and the federal itemization rate of each state’s taxpayers should be approximately equal to the state itemization rate. notwithstanding the foregoing, there is likely to be some variation in itemization rates even among states with the same itemization election uniformity rules. for example, nebraska’s itemization rate in 2017 (~28%) was significantly lower than maryland’s (~46%).100 although both would be expected to decline 97 in states that bind taxpayers only to their federal standard deduction (rather than fully binding them to their federal itemization choices), a taxpayer who prefers to itemize for federal purposes and take the standard deduction for state purposes may do so. 98 very generally, the following formula can be used to determine whether the taxpayer is better off, on net, itemizing or taking the standard deduction, assuming that the federal choice is binding for state purposes. benefit of itemizing for both federal and state purposes = state marginal tax rate * (state itemized deductions – state standard deduction) + federal marginal tax rate * (federal itemized deductions – federal standard deduction) if the benefit of itemizing is positive, itemization makes the taxpayer better off. if the benefit of itemizing is negative, taking the standard deduction makes the taxpayer better off. this formula does not consider how the itemization choice’s impact on state tax liability affects the taxpayer’s salt deduction and thus the taxpayer’s desire to itemize for federal purposes. that said, this consideration may have a limited or even no effect if the taxpayer’s total state and local taxes paid exceed the $10,000 cap. in addition, the formula could take account of the impact of the salt deduction with slightly more complex math. 99 even pre-tcja, taxpayers with conflicting federal/state itemization preferences in states that required election uniformity may have opted to take the standard deduction for both federal and state purposes. by increasing the standard deduction, limiting itemized deductions and lowering tax rates, the tcja likely just increased the incentive to take the standard deduction for both federal and state purposes. 100 comptroller of md., income tax summary report: tax year 2017, at 3 (2018), https://www.marylandtaxes.gov/reports/static-files/revenue/incometaxsummary/summary17.pdf 2021] taxpayer choices 25 substantially in 2018, nebraska’s itemization rate would likely remain lower than maryland’s. in addition, the decline in nebraska’s itemization rate would probably be more precipitous than maryland’s. these results are likely to be driven by factors similar to those that caused the itemization rate disparity pre-tcja including (a) maryland’s much lower state standard deduction, (b) maryland’s higher total state and local tax rate; (c) higher household income in maryland and higher percentages of maryland taxpayers in the highest income categories (noting that high income taxpayers typically itemize at higher rates than do lower income taxpayers),101 and (d) higher average home prices and mortgage payments in maryland102 (which would be expected to lead to higher home mortgage interest deductions and total itemized deductions) in maryland. table 2 provides a comparison for some of these numbers. table 2. basic tax & income data: nebraska and maryland nebraska103 maryland104 2017 2018 2017 2018 standard deduction (single) $6,350 $6,750 standard deduction (single) max of $2,000 max of $2,250 standard deduction (mfj) $12,700 $13,500 standard deduction (mfj) max of $4,000 max of $4,500 [https://perma.cc/vea4-km3p]; individual income tax data by size of agi, tax year 2017 table b4, neb. dep’t of revenue, https://revenue.nebraska.gov/research/statistics/nebraska-statisticsincome [https://perma.cc/ t39l-3f4a] (last visited nov. 21, 2021); and author calculations. 101 see table 2. 102 in 2018, the median home mortgage payment was $1,352 in nebraska and $1,987 in maryland. liz knueven, the average monthly mortgage payment by state, city, and year, bus. insider (aug. 6, 2020), https://www.businessinsider.com/personal-finance/average-mortgagepayment# mortgage-payments-by-state [https://perma.cc/87u7-42sa] (using data from the census bureau’s 2018 american community survey). median home value, as of an article published in early 2020, was $175,884 in nebraska and $308,041 in maryland. marissa perino & dominicmadori davis, here’s the typical home price in every state—and what you can actually get for that money, bus. insider (apr. 2020), https://www.businessinsider.com/average-home-prices-inevery-state-washington-dc-2019-6 [https://perma.cc/jr7t-l2vl] (using zillow data). hillary hoffower & libertina brandt, the most expensive and affordable states to buy a house, ranked, bus. insider (apr. 2019), https://www.businessinsider.com/cost-to-buy-a-house-in-every-stateranked-2018-8 [https://perma.cc/ra7d-ggn6] (using zillow data to report that the median listing price was $215,000 in nebraska and $329,989 in maryland). 103 chronology of nebraska tax rates – 1993 to present: table 1, income and sales tax, neb. dep’t of revenue, https://revenue.nebraska.gov/sites/revenue.nebraska.gov/files/doc/research/ chronology/4607table1.pdf [https://perma.cc/89cb-vj4z] (last visited nov. 21, 2021) (listing income tax rate data, income tax bracket data, and standard deduction amounts by year). 104 comptroller of md., maryland: 2017 state & local tax forms & instructions 12 (2018), https://www.marylandtaxes.gov/forms/17_forms/resident_booklet.pdf [https://perma.cc/ yt55-b92d] (last visited nov. 21, 2021); comptroller of md., maryland: 2018 state & local tax forms & instructions 12, https://www.marylandtaxes.gov/forms/18_forms/ resident_booklet. pdf [https://perma.cc/ uk8zj3vb] (last visited nov. 21, 2021). 26 columbia journal of tax law [vol: 13:1 top income tax rate 6.84% top income tax rate 8.95% (including county level tax)105 median household income106 $60,847 $59,566 median household income $82,747 $83,242 % of taxpayers with agi>$200k107 3.6% 4.0% % of taxpayers with agi>$200k 6.6% 7.1% % of taxpayers with agi>$100k108 16.7% 18.1% % of taxpayers with agi>$100k 23.4% 24.5% in addition, nebraska’s and maryland’s itemization uniformity requirements are expected to impact not just state itemization rates, but also federal itemization rates. this is because, where a state allows a taxpayer to itemize for state purposes only if they also itemize for federal purposes, some taxpayers likely conclude that the benefit of itemizing for state purposes (i.e., state income taxes saved) exceeds the cost of itemizing for federal purposes (i.e., extra federal income taxes paid). as a result, such a taxpayer should itemize for federal purposes so they can itemize for state purposes. the number and percentage of such taxpayers would be expected to increase after the tcja in states like nebraska and maryland, where the tcja’s increase in the federal standard deduction was not accompanied by a commensurate increase in the state’s standard deduction. 109 this is particularly likely given the tcja’s reduction in individual income tax rates, which means that the value of federal deductions was smaller in 2018 than it was in 2017. 105 maryland imposes state income tax at a top rate of 5.75%, and maryland counties also impose an additional county (or city) level tax on a taxpayer’s state taxable income. the maryland state tax authority collects this county-level income tax for the counties to assist local governments. the additional county level income tax ranges from 2.25% to 3.2%, for a combined top rate of between 8% and 8.95% of state/local income tax. tax rates maryland income tax rates and brackets, comptroller of md., https://www.marylandtaxes.gov/individual/income/tax-info/taxrates.php [https://perma.cc/g2kj-taac] (last visited oct. 8, 2021). thanks to neil buchanan for his insights about county-level income taxes in maryland. 106 gloria g. guzman, american community survey briefs: household income: 2018 at 3 (sept. 2019), https://census.gov/content/dam/census/library/publications/2019/acs/acsbr18-01.pdf [https: //perma.cc/9rfu-7cjt] (report from the u.s. census bureau reporting data in 2018 inflation-adjusted dollars). 107 soi tax stats – state data fy 2017, irs, https://www.irs.gov/statistics/soi-tax-statsstate-data-fy-2017 [https://perma.cc/9mjw-pkh6] (last visited nov. 21, 2021), and author calculations; soi tax stats – state data fy 2018, irs, https://www.irs.gov/statistics/soi-tax-statsstate-data-fy-2018 [https://perma.cc/y45r-qnxf] (last visited nov. 21, 2021), and author calculations. 108 id. 109 in contrast, in a state like maine, where the state standard deduction equals the federal standard deduction, it is highly unlikely for any taxpayer to prefer to take the standard deduction for federal purposes and itemized deductions for state purposes (absent material state disconformity). even if such a taxpayer existed, the difference between federal and state income tax rates is highly likely to mean that taking the standard deduction (the preferred option for federal purposes) minimizes net tax liability. 2021] taxpayer choices 27 b. change in itemization behavior of maryland and nebraska taxpayers – data & modeling federal and state individual income tax filing data from 2017 and 2018 provide insight into how actual itemization behavior of nebraska and maryland taxpayers changed after the tcja. again, the data reveal that the actual results match the theoretical expectations. reducing itemization rates, in general as illustrated in figure 4, the federal and state itemization rates both for nebraska and maryland taxpayers declined significantly between 2017 and 2018. 110 in each year, each state’s federal and state itemization rates are approximately equal. thus, in each state, the decline in federal itemization was accompanied by an almost identical decline in state itemization. 110 soi tax stats – state data fy 2017, irs, https://www.irs.gov/statistics/soi-tax-statsstate-data-fy-2017 [https://perma.cc/9mjw-pkh6] (last visited nov. 21, 2021); soi tax stats – state data fy 2018, irs, https://www.irs.gov/statistics/soi-tax-stats-state-data-fy-2018 [https://perma.cc/ y45r-qnxf] (last visited nov. 21, 2021); comptroller of md., supra note 100, at 3; comptroller of md., income tax summary report: tax year 2018, at 3 (2019), https://www. marylandtaxes.gov/reports/static-files/revenue/incometaxsummary/summary18.pdf [https://perma. cc/9hpv-26da] (last visited nov. 21, 2021); individual income tax data by size of agi, tax years 2017 & 2018 table b4, neb. dep’t of revenue, https://revenue.nebraska.gov/research/statistics/ nebraska-statistics-income [https://perma.cc/t39l-3f4a] (last visited nov. 21, 2021); and author calculations. 30.6% 28.2% 46.7% 11.4% 7.6% 24.0% 28.0% 45.4% 7.2% 23.7% 0.0% 10.0% 20.0% 30.0% 40.0% 50.0% united states nebraska maryland % o f r et u rn s w it h i te m iz ed d ed u ct io n s jurisdiction figure 4. tcja's impact on u.s. itemization rates and on federal & state itemization rates for ne and md taxpayers 2017 federal itemization 2018 federal itemization 2017 state itemization 2018 state itemization 28 columbia journal of tax law [vol: 13:1 although itemization rates in both states declined, the extent of the declines and the overall post-tcja itemization rates varied by state. in nebraska, the itemization rate declined by just under 75%, and between 7% and 8% of taxpayers continued to itemize after the tcja. in contrast, in maryland, the itemization rate declined by just under 50%, and approximately 24% of taxpayers continued to itemize after the tcja. the results in both nebraska and maryland were different than the nationwide results. federal itemization rates of nebraskan taxpayers declined slightly more than the nationwide decline (~63% decline), and post-tcja nebraskans itemized somewhat less frequently than taxpayers nationwide. in contrast, federal itemization rates of maryland taxpayers declined less than the nationwide decline, and post-tcja maryland taxpayers itemized more frequently than taxpayers nationwide. causing taxpayers to itemize for federal purposes (despite a larger federal standard deduction) the irs declined to gather and provide the data needed to determine the frequency with which taxpayers in states that require election uniformity opted to itemize for federal purposes even though the federal standard deduction exceeded their federal itemized deductions (i.e., paying extra federal taxes) to enable them to itemize for state purposes (i.e., so they could save even more in state taxes).111 however, basic modeling, using information that is available, allows inferences to be drawn about the existence of this effect. nebraska provides an example. in 2017, nebraska’s standard deduction matched the federal standard deduction, and it would be quite surprising if a nebraska taxpayer’s state itemized deductions exceeded their federal itemized deductions.112 so nebraska taxpayers generally would not have benefited from itemizing for state tax purposes while taking the standard deduction for federal purposes. as a result, it is highly unlikely that any nebraskan would have opted to make a less favorable federal itemization choice in 2017 to enable them to make their preferred state itemization choice. however, more nebraska taxpayers would have an economic incentive to do so in 2018, after the tcja. for example, consider a married couple filing jointly in nebraska with $100k agi in 2018. if that couple had between ~$21.5k and 111 i asked the irs statistics of income for data, parsed by state, of the number of taxpayers who checked the box on line 30 of the 2017 schedule a (indicating that a taxpayer chooses to take federal itemized deductions even though the federal standard deduction is larger) and the number of taxpayers who checked the box on line 18 of the 2018 schedule a (same question, just with a different line number). after an extensive back and forth, the irs soi explained that they do not track this data as part of their regular statistical analyses, and they declined my request that they perform a data run to pull this data for me. email exchanges between e. gross (among others) and heather m. field (last email on mar. 3, 2021) (on file with author). 112 nebraska largely conforms to federal income tax laws applicable to individuals but does not allow state or local taxes to be deducted for state purposes. thus, a nebraska taxpayer’s federal itemized deductions would generally be larger than their state itemized deductions. 2021] taxpayer choices 29 $24k of itemized deductions for both state and federal purposes in 2018 and holding everything else constant,113 the couple likely would have been better off itemizing for both federal and state tax purposes rather than taking the standard deduction for both, even though the couple would be foregoing the benefit of the higher federal standard deduction. 114 the analysis is similar with taxpayers of different filing statuses and income levels, but the exact thresholds at which it becomes economical to itemize vary. thus, it is likely that some nebraskans opted for the less favorable federal itemization choice in 2018, which is more than the number (basically zero) who likely did so in 2017. the example of maryland is similar, although slightly more complex. the maryland and federal standard deductions differed even in 2017. thus, even pretcja, some maryland taxpayers likely would have opted to itemize and pay extra in federal taxes so they could itemize for state purposes and save even more in state taxes. however, the disparity between the maryland and federal standard deduction increased in 2018. that, together with the reduction in federal individual income tax rates and the cap on the federal salt deduction, means that it even more maryland taxpayers likely had a net economic incentive to opt for the less favorable federal itemization choice in 2018 than in 2017. consider again the example of the married couple filing jointly (now in maryland) with $100k agi. in 2017, they would likely have been better off itemizing for both federal and state tax purposes than taking the standard deduction for both (even though the couple would be foregoing the higher federal standard deduction) if they had state and federal itemized deductions between approximately $10.5k and $12.7k, holding everything else constant.115 the same couple in 2018 would likely have been better off itemizing for both (even though they would be foregoing the larger federal standard deduction) if they had state and federal itemized deductions between approximately $19k116 and $24k. in this example, 113 author calculations using the formula in note 98 supra. of course, everything else is not constant. in particular, itemizing for state purposes increases the taxpayer’s salt deduction for federal purposes. this effect is ignored for ease in the basic numerical examples discussed. however, taking the effect into account would either (a) push the taxpayer’s federal itemized deductions above the federal standard deduction, meaning that the taxpayer would no longer have conflicting itemization preferences; or (b) increase the cost of itemizing for federal purposes on the margin, thereby slightly reducing the frequency with which the state-level benefit of itemizing would exceed the federal-level cost of itemizing. nevertheless, after the tcja’s imposition of the $10k cap on salt deductions, any variation in the amount of state taxes would not have this effect as long as the taxpayer’s total state taxes remained at least $10k. 114 assume, for example, the couple had $23k of itemized deductions for both state and federal purposes. by itemizing for state purposes rather than taking the standard deduction, the taxpayer would save $649.80 (($23k-$13,500)*6.84%), but itemizing for federal purposes too would only cost the taxpayer an extra $220 (($24k-$23k)*22%), meaning that the taxpayer reduces their net tax liability by itemizing for both. there are, of course, other costs that could outweigh the tax savings of itemizing, including additional tax preparation costs and the costs to the taxpayer of compiling the information. however, both of those may already be sunk once the taxpayer gets to the point of doing this analysis, in which case they should be ignored. 115 author calculations using the formula in note 98 supra. 116 this number depends on the maryland county in which the taxpayer lives. see supra note 105 (explaining the imposition of county level income taxes in addition to the state income 30 columbia journal of tax law [vol: 13:1 the range of itemized deductions in which taxpayers would benefit from making the less favorable federal itemization deduction is more than twice as large in 2018 as in 2017. in addition, with the $10k cap on the salt deduction for federal purposes, it becomes more probable, in 2018, that a maryland taxpayer’s state itemized deductions and federal itemized deductions would be equal (or at least close) in amount,117 which increases the chance that the taxpayer would have both state and federal itemized deductions in the range where the benefit itemizing for state tax purposes exceeds the cost of doing so for federal purposes. nevertheless, it is hard to know how the number of taxpayers with itemized deductions in this larger range in 2018 compares to the number of taxpayers with itemized deductions in the smaller range in 2017, at least without data that is unavailable. however, the foregoing discussion suggests that it is likely that some maryland taxpayers who might have preferred to take the federal standard deduction in 2018 (if they could make unconstrained choices) opted to itemize instead because of the value to them of itemizing for state purposes. ultimately, basic modeling illustrates that it is reasonable to conclude that, in some states that prohibit state itemization unless the taxpayer itemizes for federal purposes, 118 more taxpayers whose federal standard deduction exceeded their federal itemized deductions likely opted to itemize for federal purposes in 2018 than in 2017. thus, although the tcja’s itemization-related changes caused a large reduction in federal itemization rates, that reduction was likely not as large as it would have been had all states allowed independent itemization choices. said differently, absent the election uniformity requirement, maryland’s federal and state itemization rates, for example, would be expected to look more like oregon’s—more itemizers for state purposes and fewer itemizers for federal. 3. key takeaways from the data federal itemization rates declined in all states after the enactment of the tcja, but a close look at the data reveals that the tcja’s impact on itemization tax). if the taxpayer is in a county with the maximum 3.2% tax rate, this number is closer to $18.8k. if the taxpayer is in a county with the minimum 2.25% tax rate, this number is closer to $19.3k. 117 pre-tcja, there was always likely to be a disparity between a taxpayer’s salt deduction for federal and state purposes because the taxpayer generally could deduct maryland state income taxes for federal purpose but not for maryland state income tax purposes. however, the $10k cap on salt increases the chances that the federal and state deductions are the same amount. for example, if in 2018, a maryland taxpayer has at least $10k in local property taxes, their salt deduction for federal purposes would be capped at $10k and their local tax deduction for state purposes would also be $10k; the amount of their state income taxes would not change either. specifically, if only non-income taxes in maryland are used as a deduction for federal purposes, there are no maryland or local income taxes used as a deduction for federal purposes that would need to be added back to the itemized deductions allowed for maryland purposes. see comptroller of md., maryland 2018 state & local tax forms & instructions 11 (2019), https://www.maryland taxes.gov/forms/18_forms/resident_booklet.pdf [https://perma.cc/m92m2kyv]. 118 this effect is quite unlikely to occur in states where the state standard deduction matched the federal standard deduction because, as explained earlier, it would be rare for taxpayers in these states to have conflicting itemization preferences at all. 2021] taxpayer choices 31 rates varied state-to-state depending on whether the state bound its taxpayers to their federal itemization choices. within that core observation, there are several insights. first, in states that allowed taxpayers to make independent itemization elections (e.g., oregon), state itemization rates may have remained quite high post-tcja as they did in oregon. thus, post-tcja, many taxpayers in these states (including, for example, more than 22% of oregon individual taxpayers)119 continued to itemize for state purposes despite switching to the standard deduction for federal purposes. second, in states (e.g., nebraska or maryland) that required election uniformity, the decline in state itemization rates after the tcja was almost identical to the decline in the federal itemization rates for the state’s taxpayers. third, even among states with the same itemization uniformity rules and that largely conformed to the federal individual income tax (again like nebraska and maryland), absolute itemization rates varied significantly. fourth, in states where standard deductions did not increase commensurately with the increase to the federal standard deduction, more taxpayers had conflicting itemization preferences post-tcja (generally preferring to itemize for state purposes but preferring the standard deduction for federal purposes). fifth, in states where standard deductions did not increase commensurately with the increase to the federal standard deduction and that required itemization election uniformity, more taxpayers in 2018 chose to take the standard deduction for both federal and state purposes in 2018 even though their state itemized deductions exceeded the state standard deduction. in these same states, some other taxpayers, and likely more after the tcja than before, did the opposite—taking itemized deductions for both federal and state purposes even though the federal standard deduction exceeded their federal itemized deductions. iii. the tcja’s simplifying effect, considering taxpayers’ itemization behavior the insights provided by the data demonstrate that it matters—to taxpayers, to the irs, and to state tax authorities—whether states bind taxpayers to the tax elections they make for federal purposes. yet little attention has been paid to the simplicity and administrability implications of the interaction between state and federal itemization elections. this is surprising because simplification was the primary policy objective motivating the tcja’s itemization-related changes. however, the impact of states’ election uniformity rules on the degree of simplification created by the tcja may have been difficult to identify or appreciate without a careful study of the federal and state individual income tax filing data preand post-tcja. part ii of this article discussed the results of my study of that data. in part iii, i use the insights from the data to analyze how states’ election uniformity laws affected the simplification achieved by the tcja’s itemizationrelated changes. 119 see supra part ii.b.1.b. 32 columbia journal of tax law [vol: 13:1 a. for taxpayers recall that the decline in itemization rates is only a relatively weak proxy for the simplification experienced by taxpayers because, among other reasons, taxpayers may continue with record-keeping, analysis, and related compliance tasks even if they do not ultimately itemize.120 with the federal itemization data alone, however, it was difficult to estimate how frequently taxpayers who switched from federal itemized deductions in 2017 to the federal standard deduction in 2018 continued to perform those tasks. 121 however, the addition of state-level itemization data, as discussed in part ii allows for more insights into simplification experienced by taxpayers as a result of the tcja’s itemization-related changes, but the insights differ depending on the state’s election uniformity rules. 1. where independent itemization elections are allowed in oregon, where taxpayers can make independent itemization elections, ~414,00 oregon taxpayers switched to the standard deduction for federal purposes after the tcja, but ~404,000 of those taxpayers (i.e., >90%) continued to itemize for state purposes. 122 these returns represent more than 22% of all annual individual income tax returns filed in oregon.123 the taxpayers who filed these returns clearly continued to keep records of the possible itemized deductions, analyzed the allowability of itemized deductions, and took related compliance tasks—even though they did not itemize for federal purposes. thus, these data establish the minimum number124 of oregon taxpayers for whom the purported simplifying effect of the tcja’s itemization-related changes was largely eliminated.125 because more than 90% of the oregon taxpayers who switched to the federal standard deduction post-tcja continued to itemize for oregon state purposes, the simplification for taxpayers implied by the decline in federal itemization rates for oregon taxpayers was largely illusory. the analysis would be similar for taxpayers in other states that, like oregon, allow independent state 120 see supra part i.d.1. 121 id. 122 see supra part ii.b.1.b. 123 see supra note 94. 124 the actual number of taxpayers for whom the purported simplifying effect of the tcja’s itemization-related changes was largely eliminated may be higher if some taxpayers that ultimately switched to the standard deduction for both federal and state purposes continued to keep records and undertake analysis of possible itemized deductions to determine whether to itemize at all. 125 although federal income tax laws and state income tax laws are enacted by different people at different times, individual taxpayers often encounter these laws together, as part of the single overall undertaking of preparing their annual income tax returns. thus, a taxpayer’s experience of income tax return preparation includes all activities undertaken as part of filing federal or state returns. accordingly, this article assesses simplification for taxpayers from the taxpayer’s perspective, taking into account the totality of the taxpayer’s itemization experience—regardless of whether it is undertaken as part of filing federal or state returns. 2021] taxpayer choices 33 itemization deductions,126 although the number and percentage of affected filers likely varies by state.127 2. where itemization election uniformity is required the insights are different for taxpayers in states like maryland and nebraska, where election uniformity is required. these taxpayers cannot make different state and federal itemization elections. thus, while some maryland and nebraska taxpayers who ultimately switched to the standard deduction post-tcja may have continued to keep records and analyze possible itemized deductions, the data do not establish for certain that they did. this is unlike the example of oregon, where the data are clear that more than 90% of the taxpayers who switched to the federal standard deduction continued to keep records of itemized deductions etc. (so they could itemize for state purposes). as a result, the simplification experienced by taxpayers in states like maryland and nebraska that require itemization uniformity likely exceeded the simplification experienced by taxpayers in states like oregon that allow independent itemization deductions. the analysis of the itemization data for maryland and nebraska taxpayers provides additional insight into how simplification varied even among states that require election uniformity. specifically, the maryland and nebraska case studies show that the lower the state’s standard deduction and the higher the state’s income tax rates, the larger the incentive for taxpayers in these states to continue to keep records and analyze itemized deductions because of the possibility of itemizing for state tax purposes, and the less simplification these taxpayers experience.128 *** 126 this likely includes taxpayers in alabama, arizona, arkansas, california, delaware, hawaii, iowa, kentucky, minnesota, mississippi, montana, new york, north carolina, and wisconsin. see supra figure 2; see infra appendix a. this is less likely to occur in idaho because, although idaho allows independent itemization choices, the idaho state standard deduction matches the federal standard deduction, meaning that it would be unusual for a taxpayer to itemize for state purposes but not federal. 127 the number and percentage of filers affected in a state will depend, on state-specific information (e.g., the size of the state’s itemized deduction and the state’s tax rates) that affects how many taxpayers opt to switch to the federal standard deduction but continue to itemize for state purposes. also, recall that oregon largely conforms to the federal income tax laws regarding itemized deductions. the analysis is more complex in states where the income tax rules diverge significantly from the federal income tax rules. in these states, it becomes difficult to isolate the cause of the lack of simplification because the continued complexity experienced by taxpayers is attributable, at least in part, to the differences between federal and state law—rather than being primarily attributable to the state’s itemization election uniformity rule. 128 taxpayers in a state like maryland likely experienced less overall simplification than taxpayers in a state like nebraska that has a higher standard deduction than maryland (but still lower than the federal standard deduction). and taxpayers in nebraska likely experienced less simplification than taxpayers in a state like missouri, where the state requires itemization election uniformity but where the state standard deduction matched the high post-tcja federal standard deduction. 34 columbia journal of tax law [vol: 13:1 in sum, the possibility of itemizing for state tax purposes reduces the tcja’s simplification effect, especially (but not exclusively) for taxpayers in states that allow independent itemization decisions. b. for the irs recall that a decline in itemization rates is a reasonably good proxy for simplification experienced by the irs.129 thus, with the dramatic decline in federal itemization between 2017 and 2018, the tcja’s itemization-related changes simplified the irs’s task of administering the federal income tax. that simplifying effect for the irs, however, was likely dampened, at least slightly, by states that bound taxpayers to their federal itemization elections. to illustrate, consider maryland. absent the state requirement for itemization election uniformity, maryland’s federal and state itemization rates would be expected to look somewhat more like oregon’s—more itemizers for state purposes and fewer itemizers for federal purposes.130 that is, absent maryland’s election uniformity requirement, even more maryland taxpayers would have switched to the federal standard deduction than actually did. and this would have simplified the irs’s enforcement task even more than the tcja’s itemization-related changes actually did. however, because maryland requires itemization election uniformity, the simplification benefit experienced by the irs as a result of the tcja’s itemizationrelated changes was not quite as large as it could have been had taxpayers not been required to make uniform elections. the magnitude of this effect may be small given the infrequency with which the value of itemizing for state purposes will exceed the cost of itemizing (rather than taking the standard deduction) for federal purposes. however, there is likely to be at least some dampening of the irs’s simplification benefit with respect to taxpayers in states that require itemization election uniformity. that dampening effect for the irs, however, generally should not arise where states allow independent itemization choices. in these states, taxpayers’ state itemization choices are not affected by their federal itemization choices, so taxpayers are free to opt for the federal standard deduction if that best reduces their federal income tax. thus, the federal itemization rate in these states will likely decline as much as possible, likely yielding as much simplification for the irs as possible, without a dampening effect. c. for state tax authorities the tcja’s itemization-related changes also affect state tax administration, and the impact on state tax authorities, once again, depends largely on the states’ itemization uniformity rules and the taxpayers’ itemization choices. in states that require election uniformity, the tcja’s itemization-related changes likely simplified the administration of the state tax regimes in a manner very similar to the way they simplified the administration of the federal income tax 129 see supra part i.d.2. 130 see supra part ii.b.2. 2021] taxpayer choices 35 regime.131 in these states (e.g., nebraska and maryland), the dramatic decline in federal itemization rates was accompanied by an almost identical decline in state itemization rates. 132 as a result, state tax authorities processed fewer forms reporting itemized deductions post-tcja. and where fewer state taxpayers itemized deductions, there were fewer taxpayers whose itemized deductions might be audited by state tax authorities. these changes likely made enforcement easier and less costly for state tax authorities. the tcja’s itemization-related changes had a very different impact on state tax authorities in states that allowed taxpayers to make independent itemization choices. the decline in federal itemization rates for taxpayers in these states was not necessarily accompanied by a similar decline in state itemization. indeed, state itemization rates may not have declined much at all, even if federal itemization rates for the state’s taxpayers declined significantly. where federal itemization rates declined significantly more than state itemization rates, state tax administration became more complex, rather than simpler, post-tcja. the example of oregon helps to illustrate. recall that more than 90% of oregon taxpayers who switched to the standard deduction for federal purposes continued to itemize for state purposes. 133 this complicated oregon state tax administration for multiple reasons. post-tcja, state tax authorities could no longer benefit from data-sharing with the irs about itemized deductions reported on these returns. the returns did not itemize for federal purposes, so there were no longer federal data about itemized deductions to share.134 in addition, state tax authorities could no longer piggyback on federal audits of the itemized deductions on these returns. the returns did not itemize for federal purposes, meaning there were no itemized deductions on these returns for the irs to audit, and thus no federal audits of the returns’ itemized deductions on which to piggyback. 135 further, where taxpayers itemized deductions for state but not federal purposes, state tax authorities were less able to rely on the deterrent effect of the threat of federal audits relating to the itemized deductions. this could have increased statelevel noncompliance. 136 thus, the tcja’s itemization-related changes made it 131 see supra parts i.d.2, iii.b. 132 see supra part ii.b.2. 133 see supra part ii.b.1.b. 134 see scharff, supra note 11, at 714-15 (discussing federal to state data sharing). 135 see luna & watts, supra note 7, at 260 (discussing the states’ ability to “piggyback on federal tax audits and professional education programs, participate in data exchange programs, and cooperate in compliance initiative”). but see james alm, brian erard & jonathan s. feinstein, the relationship between state and federal tax audits, empirical foundations of household taxation 236 (martin feldstein & james m. poterba eds., 1996) (suggesting that state piggyback audits were relatively rare). even if states do not commonly initiate audits piggybacking on federal audits, many states require that taxpayers report to the state tax authority any change in tax liability paid to the irs as a result of an audit, filing of an amended return, etc. see, e.g., or. rev. stat. § 314.380 (2019). this enables easy conforming action by the state, as appropriate, even without an independent state audit. 136 see scharff, supra note 11, at 735-37; liucija birskyte, effects of tax auditing: does the deterrent deter?, research j. econ., bus. & ict, nov. 30, 2013 (concluding that deterrent effects of federal audits spill over to positively impact state tax compliance). the deterrent effect of the possibility of federal audits is particularly important if a state generally does not do many piggyback audits. see supra note 135. 36 columbia journal of tax law [vol: 13:1 harder for state tax authorities to enforce state income tax laws in states like oregon that allowed taxpayers to make independent itemization choices.137 d. key takeaways about simplification in sum, states’ itemization election uniformity rules affected the extent to which the tcja’s itemization-related changes led to simplification for taxpayers, the irs, and state tax authorities. where states obligated taxpayers to take the standard deduction for state purposes if they took the standard deduction for federal purposes, the tcja’s itemization-related changes generally simplified across the board. taxpayers likely experienced at least some simplification. for the irs and state tax authorities, tax administration became materially easier post-tcja because of the decline in the number of itemizers for federal and state income tax purposes respectively. this simplification benefit for the irs, however, was dampened to the extent that taxpayers opted to itemize for federal purpose (even though their standard deduction was larger) so they could itemize for state purposes. where states allowed taxpayers to itemize for state purposes regardless of whether they itemized for federal purposes, the tcja’s itemization-related changes had a very different effect on simplification. the irs experienced more simplification because there was no dampening effect (i.e., taxpayers would not itemize for federal purposes if the federal standard deduction was larger). taxpayers in these states, however, likely experienced less simplification. many continued to itemize post-tcja (albeit for state, rather than federal, purposes), which made the tcja’s simplification benefit for taxpayers largely illusory in some cases. in addition, state tax administration in states that allowed independent itemization elections became materially more complex post-tcja because many taxpayers continued to itemize for state purposes even though they switched to the standard deduction for federal purposes. that increase in complexity for state tax authorities reflected, at least in part, a reallocation of enforcement burden—from the irs which, post-tcja, no longer needed to worry about enforcement with respect to some taxpayers’ itemized deductions (because those taxpayers no longer itemized for federal purposes) to the state tax authorities who needed to continue to enforce the laws about taxpayers’ itemized deductions without help from the irs. thus, in states that allowed independent itemization elections, the tcja’s itemization-related changes likely resulted in a net shift of some enforcement 137 in addition, tax authorities in states that allow independent itemization decisions may have incurred slightly increased administration costs if they state-specific forms and guidance. see, e.g., or. dep’t of revenue, 2018 schedule or-a (2018). however, where a state, like oregon, largely conformed to the federal itemized deductions, the costs of creating the new form may have been relatively low. thus, in states that allow independent itemization choices, the increase in enforcement complexity, discussed in the text, is likely to be the most significant source of additional state tax administrative complexity that arose after the tcja’s itemization-related changes. 2021] taxpayer choices 37 responsibilities from the irs to state tax authorities.138 this shift likely reduced efficiency of tax administration too because it is generally more costly (in relation to revenue collected) to administer the same law at the state level than at the federal level.139 the foregoing discussion assumes that states largely conform to federal income tax laws, including the changes made by the tcja.140 but many states do not conform, which often exacerbates the complexity faced both by individual taxpayers and by the states.141 however, as this article illustrates, it is critical to consider state election uniformity laws because, even where state tax laws largely conform to federal tax laws, states’ election uniformity rules can thwart the achievement of federal tax policy goals. iv. tax elections & the relationship between the federal and state income tax regimes a. broader lessons from the itemization election example this article’s analysis of how states’ election uniformity rules affected the simplification achieved by the tcja’s itemization-related changes to federal tax laws illustrates a broader point. specifically, states’ tax election uniformity rules are critical to understanding the relationship between the federal and state tax regimes, and these rules should be considered in any policy analysis of a tax change that relates to a tax election. there are hundreds of tax elections, 142 and the itemization election, discussed here, is merely one example of where the policy implications of a federal tax law change cannot be fully understood without understanding states’ tax election uniformity rules. this is true for many other tax elections, including for example a married couple’s election whether to file jointly or separately,143 an eligible corporation’s election to be taxed as an “s corporation” rather than as a “c corporation,”144 and the election to have certain corporate acquisitions taxed as asset purchases rather 138 the magnitude of that shift would vary by state depending on what percentage of state taxpayers switched to the standard deduction for federal purposes but continued to itemize for state purposes. a higher percentage results in a larger shift of enforcement costs from the irs to the state tax authority. 139 see scharff, supra note 11, at 708. 140 this discussion also assumes states are clear about their choices to conform (or not) and to bind taxpayers to their federal elections (or not). this is not always the case. for example, some states took a while to decide how to proceed on these issues after the tcja, which created confusion, thereby further exacerbating the complexity faced by taxpayers and state tax authorities. see, e.g., jared walczak, arizona delivers rate cuts and tax conformity, tax found. (june 6, 2019), https://taxfoundation.org/arizona-income-tax-cuts-tax-conformity/ [https://perma.cc/x3sj-p72z] (explaining that arizona’s tax forms for 2018 assumed arizona’s income tax would conform to the tcja, but arizona did not actually conform until the end of may 2019). 141 see supra note 11. 142 dechellis & horne, supra note 14 (discussing over 300 tax elections). 143 i.r.c. § 6031. 144 i.r.c. § 1362. 38 columbia journal of tax law [vol: 13:1 than stock purchases.145 these federal tax elections and others are also available at the state level in many states, and as with the itemization election, states take different approaches to election uniformity requirements. 146 thus, states’ tax election uniformity rules for each of these elections are likely to affect the policy consequences of changing these elections or changing laws that would affect taxpayers’ election decisions. the married filing status election provides an example of how this article’s insights apply. married taxpayers in minnesota must use the same filing status for state income tax purposes as they use for federal purposes.147 in contrast, iowa allows married taxpayers to make a fully independent filing status elections for state purposes regardless of their federal filing status election.148 michigan’s approach falls in between: married taxpayers who file jointly for federal purposes must also file jointly for michigan purposes, but married taxpayers who file separately for federal purposes may make an independent filing status election for michigan purposes.149 a change to federal tax law that affects a married couple’s choice about their federal filing status likely has different consequences for couples in these different states. consider, for example, two federal tax provisions enacted recently to help taxpayers weather the economic distress created by the pandemic: the recovery rebate credit enacted by the cares act in march 2020, 150 and the exclusion for unemployment benefits enacted by the american rescue plan act enacted in march 2021.151 both provisions increased the incentive for some married couples to file separately rather than jointly for 2020. 152 if, because of these 145 i.r.c. § 338(h)(10). 146 with section 338(h)(10) elections, many states bind taxpayers to their federal choice, but several states do not provide guidance about whether independent state-level section 338(h)(10) elections are allowed or required. see corporate income tax 10.5.3, bloomberg tax, https://www.bloomberglaw.com/product/tax/view_menu/corporate_income_tax [https://perma.cc/twx2-ez4d] (last visited nov. 21, 2021) (identifying, for each state, whether separate state election can be made for purposes of section 338(h)(10)). with s corporation elections, states also take a variety of approaches, including providing that a corporation’s federal s corporation election applies for state purposes too, providing that a federal s corporation must file an additional state s corporation election (otherwise, the corporation will not be treated as an s corporation for state purposes), and providing that a corporation’s federal s corporation election generally applies for state purposes too but that a corporation can opt out of state s corporation treatment. a comprehensive guide to state s election requirements, eminutes (dec. 6, 2017), https://eminutes.com/a-comprehensive-guide-to-state-s-election-requirements [https://perma.cc/h6s3-zqwr]. 147 minn. stat. § 289a.08, subdiv. 6 (2020). 148 iowa dep’t of revenue, ia 1040 income tax return 2020 (2021). 149 mich. dep’t of treasury, michigan 2020 mi-1040 individual income tax forms and instructions (2021). 150 coronavirus aid, relief, and economic security act, pub. l. no. 116-136, § 6428 (2020). 151 american rescue plan act of 2021, pub. l. no. 117-2, § 9042 (2021). 152 see andrew gross et al., recovery rebates: tax planning pitfalls and opportunities, the tax adviser, july 1, 2020; amber gray-fenner, what you need to know now about nontaxable unemployment, forbes (mar. 14, 2021), https://www.forbes.com/sites/ambergrayfenner/2021/03/ 14/what-you-need-to-know-now-about-non-taxable-unemployment [https://perma.cc/m2tz-7ntk]. 2021] taxpayer choices 39 changes, a couple opted to file separately for federal purposes for 2020, the couple also had to file separately for minnesota purposes in 2020 but could still file jointly for iowa and michigan purposes. thus, minnesota couples with conflicting filing status preferences for federal and state purposes (e.g., wanting to file separately for federal purposes but jointly for state purposes) had to choose one filing status to use for both purposes. if a minnesota couple with conflicting filing status preferences filed separately for federal purposes to benefit from the recovery rebate and unemployment benefits exclusion, the couple accepted less preferred state tax treatment. if a minnesota couple filed jointly to minimize state income tax, the couple sacrificed some or all of the benefits of these recently enacted federal tax provisions. in contrast, married couples in michigan or iowa did not need to make this choice; regardless of how they preferred to file for state purposes, such couples could opt to file separately for federal purposes to benefit from the recovery rebate and unemployment benefits exclusion. this is a brief example, but it illustrates that these two recent federal tax law changes that were enacted to help taxpayers through the pandemic likely have different tax consequences for taxpayers depending on their state’s election uniformity rule regarding the married filing status election. a more comprehensive analysis, along the lines of this article’s analysis of the impact of states’ itemization election uniformity rules, could identify the policy implications of those differences, including determining the specific situations in which the federal policy goal motivating these changes is most likely to be thwarted. even without deeper analysis, however, this filing status example shows that this article’s insights about the impact of states’ election uniformity rules are generalizable to other contexts. ultimately, this article’s analysis of the itemization election reveals that states’ tax election uniformity rules create previously underappreciated interactions between the federal and state tax systems. these state-level rules can undermine the achievement of federal policy goals, and differences among these state-level rules can cause federal tax changes to apply differently to taxpayers in different states. thus, tax election uniformity rules are an important part of analyzing the policy implications of a change to any of the hundreds of federal tax elections or a change that alters taxpayers’ choices pursuant to any tax election (as the tcja’s itemization-related changes did). and when understanding the relationship between the federal and state tax regimes more broadly, scholars and policymakers should consider states’ tax election uniformity rules in addition to the more commonly discussed issues of conformity, federal tax benefits for states, and cooperative tax administration.153 b. using these lessons when making tax policy decisions this article’s insights into the cross-jurisdictional impact of states’ tax election uniformity rules might encourage action. perhaps a greater appreciation of how each regime’s laws affect the administrability of the other’s reinforces the existing scholarship encouraging federal and state legislators and administrators to 153 see supra notes 7-11 and accompanying text. 40 columbia journal of tax law [vol: 13:1 collaborate on enforcement initiatives and on tax law changes that advance shared policy objectives.154 in particular, federal policymakers should consider how states’ tax election uniformity rules might advance or hinder the federal policy objective (such as simplification) motivating any federal tax law change. to the extent that states’ election uniformity laws are likely to undermine the achievement of federal policy objectives, federal legislators could also work with state legislators to try to mitigate that effect. alternatively, proponents of the federal law change could be more circumspect about their rhetoric when touting the policy benefits of a change, as compared to how tcja proponents touted the simplifying effect of the itemizationrelated changes. adjustments to the rhetoric could increase the chances that the taxpayers’ experiences match the promises. further, to assist federal policymakers in better understanding the compliance burden associated with the interaction between federal and state tax laws, the irs might consider adding questions to the individual taxpayer burden survey to enable them to make better predictions about the compliance burdens created by the interactions between federal and state tax laws.155 more data about the taxpayer burdens created by the such interactions could inform future decision-making, both by federal policymakers and state policymakers. in addition, when state policymakers examine any of their election uniformity rules and evaluate possible changes, they should carefully consider the policy tradeoffs that their choice of uniformity rule makes.156 for example, a state that prioritizes administrability in the context of a particular election might lean toward requiring election uniformity, but a state that prioritizes state fiscal sovereignty in that context might lean toward allowing independent elections.157 further, state policymakers could pay more attention to proposed federal tax changes (particularly those touted as simplifying) that, when coupled with the state’s election uniformity rules, are likely to materially increase state-level administration costs. this could lead state policymakers to become more vocal about sharing any concerns regarding those proposed changes with federal legislators.158 state legislators could also try to measure the complexity that arises 154 see duncan & luna, note 11, at 663; gravelle & gravelle, supra note 7, at 643 (discussing a collaborative proposal intended to achieve “substantial savings in tax administration as well as compliance by taxpayers and resolution of issues in the courts”); scharff, supra note 11, at (advocating for more fed/state tax cooperativity in general, not just in the context of federal changes). 155 see supra notes 58-62 and accompanying text (discussing the irs’s income taxpayer burden model and the survey on which it relies). the itb survey currently asks for record-keeping burden and out-of-pocket-cost information explicitly excluding any such burdens arising from state and local taxes. the survey could be modified, for example, to ask about those separately or to ask for taxpayer estimates about burdens and costs both with and without the state/local considerations. 156 some states already do this to some extent. see, e.g., auxier & rueben, supra note 12 (kansas considering administrability issues). 157 see mason, supra note 7 (discussing different policy considerations that motivate statelevel choices). 158 see gravelle & gravelle, supra note 7, at 646 (encouraging states to pursue “greater vigilance regarding issues under discussion at the federal level that do not appear to have a direct impact”—more revenue focused, but equally applicable for simplicity concerns). 2021] taxpayer choices 41 for taxpayers and administrators from their existing election uniformity laws to give them more information about these state-level rules. conclusion states’ tax election uniformity rules should be considered in the policy analysis of any federal or state tax law change that relates to a tax election. otherwise, the implications of that change cannot be fully understood. however, exactly what that consideration should entail, how much weight those considerations should be given, and what additional actions federal and state policymakers should take in light of those considerations are all normative questions that merit a separate article. some possible ideas are mentioned above, but recommendations might be contentious. federal policymakers might argue, for example, that the additional complexity taxpayers and state tax authorities experience because of a state’s itemization uniformity laws is the fault of state policymakers and should be addressed by them. on the other hand, state policymakers might argue that the additional complexity for taxpayers and state tax authorities is caused by, and should be addressed by, federal policymakers who know that state tax laws are generally based on federal tax laws and who nevertheless repeatedly change federal tax laws with little regard for the complexity that ripples through the state tax system. yet, taxpayers might struggle to disaggregate which complexities are attributable to the federal income tax regime and which are attributable to the state income tax regime. and if taxpayers are promised a particular policy result (such as simplification) but do not experience it, that may harm tax morale and may undermine their faith in the tax system(s) or in political leaders more generally159— regardless of whether federal or state policymakers are responsible for the result. this article, however, does not seek to determine whether federal or state policymakers bear more blame for the gap between the simplification promised by the proponents of the tcja’s itemization-related changes and the more limited simplification experienced by many taxpayers. nor is this article concerned about which set of lawmakers is more at fault for increases in administrative complexity for the other set of tax administrators. and the goal of this article is not to push for specific changes with respect to itemized deductions, election uniformity rules, or otherwise. rather, this article’s objective is to use data regarding the itemization election as an example to illuminate the underappreciated interactions between federal and state income tax laws that arise because of whether states obligate taxpayers to make the same choices for state tax purposes as they do for federal. this gives federal and state policymakers more visibility into ways in which their federal and state tax policy decisions are intertwined, thereby enabling policymakers to consider these interactions when making future tax policy choices. 159 the magnitude of this impact, however, is unclear when trust in government officials is already quite low. 42 columbia journal of tax law [vol: 13:1 appendix a. changes in federal itemization rates by state160 2017 ty federal itemization rate 2018 ty federal itemization rate % decline in federal itemization rate (as a % of 2017 rate) state's itemization election uniformity law 2017, 2018 jurisdiction alabama 26.7% 8.5% 68.0% independent choice allowed alaska 23.0% 7.7% 66.7% no state pit arizona 29.8% 10.9% 63.2% independent choice allowed arkansas 22.8% 6.9% 69.6% independent choice allowed california 35.7% 17.7% 50.5% independent choice allowed colorado 33.6% 13.5% 59.8% conformity starting point is fti (so federal itemization choice is built in for state purposes) connecticut 41.8% 15.1% 63.7% no state itemized deductions delaware 32.9% 11.7% 64.4% independent choice allowed d.c. 40.9% 22.3% 45.5% fully bound to federal choice florida 26.2% 9.0% 65.5% no state pit georgia 33.9% 13.8% 59.2% fully bound to federal choice hawaii 30.6% 13.9% 54.4% independent choice allowed idaho 29.4% 8.9% 69.5% independent choice allowed illinois 32.5% 11.3% 65.4% no state itemized deductions indiana 23.1% 6.1% 73.6% no state itemized deductions iowa 30.8% 7.5% 75.6% independent choice allowed kansas 26.2% 8.1% 69.1% bound to federal standard deduction kentucky 26.7% 6.6% 75.3% independent choice allowed louisiana 24.4% 7.8% 68.2% deduction allowed for federal itemized deductions in excess of federal standard deduction maine 27.4% 7.4% 73.1% bound to federal standard deduction maryland 46.7% 24.0% 48.5% bound to federal standard deduction massachusetts 37.8% 14.7% 61.1% no state itemized deductions michigan 27.4% 7.6% 72.1% no state itemized deductions minnesota 35.5% 11.3% 68.3% 2018 and beyond: independent choice allowed 2017 and prior: conformity starting point was fti, so federal itemization choice was built in for state purposes mississippi 24.4% 7.7% 68.6% independent choice allowed missouri 26.7% 7.7% 71.0% bound to federal standard deduction montana 29.7% 8.9% 70.0% independent choice allowed nebraska 28.2% 7.6% 72.9% bound to federal standard deduction nevada 26.6% 9.9% 62.8% no state pit n.h 31.8% 9.9% 68.9% no state broad-based pit 160 soi tax stats – historic table, individual income and tax data, by state and size of adjusted gross income, irs, https://www.irs.gov/statistics/soi-tax-stats-historic-table-2 [https://perma.cc/ ypz4-ngju] (last visited nov. 22, 2021), and author calculations. 2021] taxpayer choices 43 2017 ty federal itemization rate 2018 ty federal itemization rate % decline in federal itemization rate (as a % of 2017 rate) state’s itemization election uniformity law 2017, 2018 jurisdiction new jersey 42.2% 17.0% 59.8% no state itemized deductions (except property taxes and medical expenses—not tied to federal itemization) new mexico 22.8% 7.3% 68.0% fully bound to federal choice new york 35.4% 12.4% 64.8% bound to federal standard deduction in 2017; independent choice allowed in 2018 n.c. 29.2% 10.3% 64.8% independent choice allowed north dakota 19.8% 5.6% 72.0% conformity starting point is fti (so federal itemization choice is built in for state purposes) ohio 26.3% 6.7% 74.6% no state itemized deductions oklahoma 23.8% 8.1% 65.8% fully bound to federal choice oregon 37.5% 14.6% 61.2% independent choice allowed pennsylvania 29.2% 8.9% 69.6% no state itemized deductions rhode island 33.3% 10.6% 68.2% no state itemized deductions south carolina 28.1% 9.5% 66.2% conformity starting point is fti (so federal itemization choice is built in for state purposes) south dakota 18.2% 5.3% 71.1% no state pit tennessee 20.3% 6.7% 67.0% no state broad-based pit texas 26.1% 9.2% 64.8% no state pit utah 36.3% 14.8% 59.2% state credit determined with reference to federal itemized deduction or standard deduction (fully bound) vermont 27.8% 7.1% 74.3% no state itemized deductions (conformity starting point fti 2017 and prior; fagi for 2018 and after) virginia 38.1% 17.7% 53.5% fully bound to federal choice washington 31.4% 13.4% 57.3% no state pit west virginia 17.4% 4.3% 75.2% no state itemized deductions wisconsin 31.8% 7.8% 75.6% state credit for certain federal itemized deductions exceed the state standard deduction (but a taxpayer can claim credit even if they do not itemize on federal return—so independent choice). wyoming 22.2% 6.5% 70.9% no state pit minimum 17.4% 4.3% 45.5% maximum 46.7% 24.0% 75.6% median 29.2% 8.9% 68.0% 44 columbia journal of tax law [vol: 13:1 appendix b. changes in federal & state itemization (ty2017 to ty2018) for oregon, nebraska, & maryland – details ty2017 ty2018 change total # of returns # of returns with itemized deductions % of returns with itemized deductions total # of returns # of returns with itemized deductions % of returns with itemized deductions decline (from 2017 to 2018) in # of taxpayers who itemize % decline (2017 to 2018) in itemization rate (as a % of the 2017 rate) or federal returns162 1,938,620 727,520 37.5% 1,965,610 286,450 14.6% 441,070 61.2% state returns163 1,785,350 824,001 46.2% 1,819,167 787,032 43.3% 36,969 6.3% ne federal returns 905,980 255,410 28.2% 909,600 69,390 7.6% 186,020 72.9% state returns164 866,360 243,000 28.0% 867,910 62,570 7.2% 180,430 74.3% md federal returns 2,986,140 1,393,890 46.7% 3,004,390 722,050 24.0% 671,840 48.5% state returns165 3,107,116 1,412,104 45.4% 3,123,790 741,204 23.7% 670,900 47.8% us federal returns 152,903,232 46,852,677 30.6% 153,774,296 17,532,594 11.4% 29,320,083 62.8% 162 soi tax stats – historic table, individual income and tax data, by state and size of adjusted gross income, irs, https://www.irs.gov/statistics/soitax-stats-historic-table-2 [https://perma.cc/ypz4-ngju] (last visited nov. 22, 2021); and author calculations. same source for oregon federal returns, nebraska federal returns, and maryland federal returns. 163 see supra note 90. 164 see neb. dep’t of revenue, supra note 100. 165 comptroller of md., income tax summary report: tax year 2017, at 3 (2018); comptroller of md., income tax summary report: tax year 2018, at 3 (2019). https://www.irs.gov/statistics/soi-tax-stats-historic-table-2 https://www.irs.gov/statistics/soi-tax-stats-historic-table-2 introduction i. the tcja’s itemization-related changes a. increasing the standard deduction & limiting itemized deductions b. the stated policy goal: simplification c. expectations about itemization rates and simplification d. the decline in itemization rates as a proxy for simplification 1. for taxpayers 2. for tax authorities ii. using tax filing data to understand changes in taxpayers’ itemization choices a. federal itemization data b. a closer look at the data: variation in itemization rates by state 1. independent itemization elections allowed: oregon a. change in itemization behavior of oregon taxpayers – theory b. change in itemization behavior of oregon taxpayers – data 2. election uniformity required: maryland & nebraska a. change in itemization behavior of maryland and nebraska taxpayers – theory b. change in itemization behavior of maryland and nebraska taxpayers – data & modeling 3. key takeaways from the data iii. the tcja’s simplifying effect, considering taxpayers’ itemization behavior a. for taxpayers 1. where independent itemization elections are allowed 2. where itemization election uniformity is required b. for the irs c. for state tax authorities d. key takeaways about simplification iv. tax elections & the relationship between the federal and state income tax regimes a. broader lessons from the itemization election example b. using these lessons when making tax policy decisions conclusion appendix a. changes in federal itemization rates by state appendix b. changes in federal & state itemization (ty2017 to ty2018) for oregon, nebraska, & maryland – details global minimum taxation: a strategic approach for developing countries leopoldo parada* abstract the world has seemingly embraced the altruistic idea of ensuring a minimum level of corporate income taxation worldwide, consolidating a “benefits for all” narrative by which both developed and developing countries apparently gain. however, this altruistic narrative proves to be quite unrealistic for many developing countries. as argued in this article, the perceived benefits of a global minimum corporate income tax in developing countries rest exclusively upon three unconvincing premises. these include the assumption that all corporate income tax incentives provided by developing countries are equally inefficient, the idea that all developing countries can seamlessly transition from corporate income tax competition to alternative forms of tax and non-tax competition, and most notably, the notion that supporting or opposing a global minimum corporate income tax could either boost or diminish tax revenue for developing countries. this article urges a departure from these premises and elaborates upon three strategic recommendations for developing countries, which include: first, viewing a global minimum corporate income tax as a concept divorced from the assumption of revenue gain or loss; second, using the global minimum corporate income tax as an opportunity to reassess their tax and non-tax incentives, encompassing alternative competitive strategies; and third, striving for simplicity and ease of administration in designing and implementing a minimum tax approach. in doing so, developing countries could perhaps find an opportunity to refine their general action plan to attract foreign direct investment (fdi) more effectively while they still try to ride the wave of minimum global corporate income taxation that the world seems to be in. * dr. leopoldo parada, llm, phd, is an associate professor in tax law and director of the centre for business law and practice (cblp) at the university of leeds school of law in the united kingdom. the author would like to specially thank research assistant ms. rui ci lee, final year student at the university of leeds, for her excellent work. the author would also like to thank eduardo baistrocchi, mindy herzfeld, aitor navarro, noam noked, and ruth mason for their comments and suggestions on earlier drafts. in addition, the author would like to thank all the participants in the various academic fora where earlier versions of this article have been presented, including the annual conference of the tax research network (trn) at the university of edinburgh (september 2022); the annual conference of the society of legal scholar (sls) at king’s college of london (september 2022); ritsumeikan university, kyoto (april 2023); the tax seminars at the london school of economics (lse) (september 2023); and the japan yin international fiscal association (ifa) in tokyo (april 2024). all errors remain those of the author. the author can be contacted at l.parada@leeds.ac.uk. 188 columbia journal of tax law [vol 15:2 i. introduction ............................................................................................. 188 ii. the global tax deal on minimum taxation ....................................... 190 a. minimum taxation in a nutshell ......................................................... 190 b. the “benefits for all” narrative .......................................................... 193 iii. minimum taxation and developing countries ................................... 194 a. the presumed inefficiency of all tax incentives ............................... 194 b. moving away from cit tax competition .......................................... 197 c. the revenue gain/loss presumption .................................................. 198 d. the costs of a “benefits for all” narrative ......................................... 201 iv. tailoring some advice for developing countries ............................ 202 a. departing from the revenue gain/loss narrative ............................. 203 b. sensitive review of tax and non-tax incentives .............................. 204 c. aiming for simplicity and administrability ........................................ 207 v. conclusions .............................................................................................. 210 i. introduction more than five years have passed since the creation of the oecd inclusive framework (if), and the world appears to have embraced, if not officially, at least de facto, the altruistic idea of ensuring a minimum level of corporate income taxation worldwide. the oecd model rules and their commentaries are the best examples of this acceptance.1 indeed, beyond their technical analysis, the purpose of which is outside the scope of this contribution, they consolidate what some scholars have denominated as a “fiscal fail-safe” approach, or, which is the same, the idea that if one country does not impose a minimum level of taxation, another country will react imposing taxation up to the minimum.2 this approach should presumably benefit all countries involved as they would all act as a sort of “default revenue collector” for corporate income tax purposes while also establishing a minimum floor for corporate income tax competition worldwide.3 essentially, therefore, the dual benefits of enhancing revenue collection and shielding countries 1 see oecd, tax challenges arising from the digitalisation of the economy – global anti-base erosion model rules (pillar two): inclusive framework on beps (2021) [hereinafter oecd, model rules]; see also oecd, challenges arising from the digitalisation of the economy: commentary to the global anti-base erosion model rules (pillar two) (2022) [hereinafter oecd, model rules commentaries]. 2 in this regard, see ruth mason, the transformation of international tax, 114 am. j. int’l law 353, 357 (2020). more recently, see also ruth mason, a wrench in globe diabolical machinery, 107 tax notes int’l 1391 (2022). for a normative criticism of the concept of fiscal fail-safe and its ultimate policy aim, which is the consolidation of the idea of “full taxation,” see leopoldo parada, full taxation: the single tax emperor’s new clothes, 24 fla. tax rev. 729, 732 (2021). 3 this idea can be traced back to the origins of the oecd pillar 2 where the oecd insisted on the fact that a global minimum effective corporate income tax rate would establish a floor for tax competition among jurisdictions, implicitly suggesting that this new scenario would benefit all countries equally. see, e.g., pasquale pistone et al., the oecd public consultation document ‘global anti-base erosion proposal (globe)pillar two’: an assessment, 74 bull. int’l tax’n 62 (2020). for a policy analysis regarding the aim of pillar 2 setting a floor for tax competition, see michael p. devereux et al., the oecd global anti-base erosion (“globe”) proposal, oxford univ. ctr. bus. tax’n 1, 5 (2020); joachim englisch, globe rules and tax competition, 50 intertax 859 (2022). 2024] global minimum taxation 189 from “excessive tax competition” emerge as the immediate gains from a global minimum corporate income tax. there is no doubt that the altruistic “benefits for all” narrative behind a global minimum corporate income tax is appealing.4 however, it is also far from the reality of many developing countries around the world.5 as argued in this article, the perceived benefits of global minimum effective corporate income taxation for developing countries rest exclusively upon three unconvincing premises. these premises are the assumption that all corporate income tax incentives provided by developing countries are equally inefficient,6 the idea that all developing countries can easily make a transition from corporate income tax competition to alternative forms of tax and non-tax competition, and most notably, the notion that supporting or opposing a global minimum corporate income tax could either boost or diminish tax revenue for developing countries. this article makes a plea to depart from these premises and elaborates upon three strategic recommendations for developing countries, which include: first, viewing a global minimum corporate income tax as a concept divorced from the assumption of revenue gain or loss; second, using the global minimum corporate income tax as an opportunity to reassess the countries’ tax and non-tax incentives, encompassing alternative competitive strategies; and third, striving for simplicity and ease of administration in the design and implementation of a minimum tax approach. in doing so, developing countries could perhaps find an opportunity to refine their general action plan to attract foreign direct investment (fdi) more effectively while they still try to ride the wave of minimum global corporate income taxation that the world seems to be in. the article is divided into five sections. section 2 briefly explains the main characteristics of the global minimum corporate income tax deal and how these characteristics help devise the “benefits for all” narrative under which the whole minimum tax proposal seems to be based. section 3 delves into the three questionable assumptions that underpin the perceived advantages for developing 4 indeed, the rhetoric of mutual benefits for all parties involved has been constantly and historically used in tax circles to promote international cooperation most generally. as explained by tsilly dagan: “[c]ooperation still seems to enjoy a positive reputation as an all-benefiting strategy, and countries are often encouraged to pursue cooperative strategies such as promoting neutrality, signing tax treaties, sharing information, and curtailing base erosion and profit shifting.” tsilly dagan, international tax policy: between competition and cooperation 143 (2019). 5 this article follows the traditional united nations (un) classification of developing countries, which includes at least 159 countries around the globe. un, country classifications, world economic situation and prospects (2014) https://www.un.org/en/development/desa/policy/ wesp/wesp_current/2014wesp_country_classification.pdf [https://perma.cc/dky6-dtr4]. accordingly, the article does not distinguish between developing and least developed countries, which is a sub-classification used by the un, and which is based on gross national income (gni) per capita. therefore, all further references to developing countries in this article must be understood as including both developing and least developed countries. for the controversies of using the term developing countries, see, e.g., tariq khokhar & umar serajuddin, should we continue to use the term “developing world”?, world bank blogs (nov. 16, 2015) https://blogs.worldbank.org/op endata/should-we-continue-use-term-developing-world [perma.cc/agr3-3r7g]. 6 the term “inefficient” used in this article refers exclusively to the amount of fdi that can be linked to a specific tax incentive. in this regard, the lower the amount of fdi, the more “inefficient” the incentive. 190 columbia journal of tax law [vol 15:2 countries supporting a global minimum corporate income tax. these include the assumption that all corporate income tax incentives provided by developing countries are uniformly inefficient, the idea that all developing countries can seamlessly transition from corporate income tax competition to alternative forms of tax and non-tax competition, and the notion that supporting or opposing a global minimum corporate income tax could either boost or diminish tax revenue for developing countries. section 4 provides specific advice for developing countries based on three main recommendations: i) understanding minimum corporate income taxation worldwide as an idea divorced from the presumption of revenue gain/loss; ii) taking the minimum global corporate income tax wave as an opportunity to review their tax and non-tax incentives, including alternative forms of competition, and; iii) aiming for simplification and ease of administration in the minimum tax approach. section 5 concludes. ii. the global tax deal on minimum taxation this section briefly explains the main characteristics of the global minimum corporate tax deal and how these characteristics have helped devise a “benefits for all” narrative on which the whole minimum tax proposal seems to be based. a. minimum taxation in a nutshell the objective of the oecd minimum tax is to guarantee that all profits of a large multinational enterprise (mne) are taxed at a minimum level of effective corporate income tax somewhere, without much concern about where that should be.7 the system basically consists of a “top-up” approach that operates through two domestic rules that act in a coordinated manner, ensuring minimum taxation.8 this very much resembles what we have already seen in the context of anti-hybrid provisions and the oecd beps action 2.9 7 leopoldo parada, taxing somewhere, no matter where: what is the globe proposal really about, multinational group tax & transfer pricing news (sep. 2, 2020) https://mnetax.com/ taxing-somewhere-no-matter-where-what-is-the-globe-proposal-really-about-39996 [perma.cc/r9 ed-2pjr] (arguing that the globe proposal appears to be all about taxing somewhere, no matter where, i.e. disconnected from a concrete distributive rule); see also parada, supra note 2, at 749– 757 (stressing the normative concerns behind taxing completely divorced from a clear distributive rule); belisa f. liotti et al., the treatment of tax incentives under pillar two, 29 transnat’l corps. 26 (2022). 8 oecd, model rules, supra note 1, at 11-4; see also oecd, model rules commentaries, supra note 1, at 24–42. 9 oecd, neutralizing the effects of hybrid mismatch arrangements, action 2-2015 final report (2015); cf. leopoldo parada, double non-taxation and the use of hybrid entities: an alternative approach in the new era of beps, 66 kluwer law int’l (2018) (providing a critical view of the effect of linking rules regarding hybrid entity structures); leopoldo parada, hybrid entity mismatches and the international trend of matching tax outcomes, 46 intertax 971 (2018) (providing a critical view of the effect of linking rules regarding hybrid entity structures); felix martínez laguna, hybrid financial instruments, double non-taxation and linking rules, kluwer int’l tax blog (nov. 25, 2019) https://kluwertaxblog.com/2019/11/25/hybrid-financialinstruments-double-non-taxation-and-linking-rules-only-some-issues-stemming-from-the-apparent 2024] global minimum taxation 191 the first of these rules is known as the income inclusion rule (iir), and it is triggered with priority in the country of the ultimate parent entity (upe) of an mne group or that of the intermediary parent entity under certain circumstances in cases in which a minimum effective level of corporate income tax of 15% is not achieved in the country where the foreign subsidiaries of the mne group are located.10 in other words, the iir allows the country of the upe to tax the residual undertaxed foreign profits to ensure that a minimum level of taxation occurs.11 for these purposes, the effective tax rate (etr) is calculated on a jurisdictional basis considering all the entities of the group in a specific country and based upon financial accounting rules.12 the second rule, known as the undertaxed profit rule (utpr), is triggered only in those cases in which the iir does not apply and would allow a country to impose a top-up tax on an mne domestic subsidiary when the profits of the other foreign subsidiaries of the mne group are subject to low tax.13 in practice, this should be materialized by higher taxation of the subsidiaries in the country executing the utpr.14 in addition to the iir and the utpr, the proposal also contemplates the possibility of excluding from the scope of the rules’ substantive activities represented by a percentage of tangible assets and payroll activities.15 this is technically known as substance-based income exclusion (sbie). in essence, sbie represents a carve-out from the global minimum tax rules for companies that require a substantive number of employees and tangible assets to generate profits.16 in other words, one could also say that it appears as a subsidy for companies of this -solution/ [perma.cc/l4fu-3uzq] (explaining double non-taxation in the context of hybrid financial instruments). 10 oecd, model rules, supra note 1, at 11–2; see also oecd, model rules commentaries, supra note 1, at 26–28. 11 id. 12 oecd, model rules, supra note 1, at 7, 29–30; oecd, model rules commentaries, supra note 1, at 9–10. 13 oecd, model rules, supra note 1, at 12–14; oecd, model rules commentaries, supra note 1, at 32–41. 14 originally, the rule was denominated “undertaxed payment rule” and operated more like an antibase erosion rule since it gave the country from where a base-eroding payment originated the possibility to deny the deductibility of such payment to the extent that this was not recognised as income in the recipient country. in simple words, it shifted the tax base back to the payor country. however, this changed with the modification of the name since the utpr seems to offer now a sort of “pot of undertaxed profit when other countries fail to adequately tax such profit.” wei cui, strategic incentives for pillar two adoption 8 (july 13, 2022) (unpublished manuscript) (on file with allard research commons, peter a. allard school of law, the university of british columbia); jinyan li, the pillar 2 undertaxed payments rule departs from international consensus and tax treaties, 174 tax notes fed. 1695,1696 (2022) (stressing the importance of the change in the wording of the utpr from payments to profits); see discussion infra section iii.c. 15 oecd, model rules, supra note 1, at 30–31. oecd, model rules commentaries, supra note 1, at 119–27. 16 some commentators argue that this should be inspired by the qualified business asset investment (qbai) of the us global intangible low-tax income (gilti) regime, and it would represent a “political compromise” between the different views regarding the purpose of a global minimum tax. englisch, supra note 3, at 6; united nations conference on trade and dev., world investment report 2022, international tax reforms and sustainable investment, 107–108 (2022) [hereinafter unctad, world investment report]; treas. reg. § 1.250(b)-2 (qualified business asset investment regulation). 192 columbia journal of tax law [vol 15:2 kind vis-à-vis companies that rely more upon intangibles or lower numbers of employees to generate business profits.17 finally, the oecd model rules also contemplate an interesting alternative for countries to introduce their own domestic minimum tax or “qualified domestic minimum top-up tax” (qdmtt). however, this alternative has two main caveats.18 first, the domestic version of the minimum tax must resemble the oecd minimum tax rules to be considered as a “qualified” domestic minimum tax. second, the revenue collection that the domestic minimum tax generates cannot be used to grant any “collateral benefits” associated with it.19 although the oecd model rules do not provide any further guidance regarding the design of the domestic minimum tax, the advantages of this option appear to be quite intuitive since a domestic minimum tax that is considered a qdmtt would be prioritized in the hierarchy of the global minimum tax rules, preventing the promised revenues derived from the application of the global minimum tax from ending up in the country of the upe.20 in contrast, a domestic minimum tax that is not considered a qdmtt but which meets the characteristics of a “covered tax” under the global minimum tax rules 17 whether this is the right incentive or even the role of the oecd pillar 2 is something that has been already discussed in the tax literature. see, e.g., mindy herzfeld, tax credits and incentives under a global minimum tax regime, 106 tax notes int’l 1605 (2022). 18 article 10.1.1 of the oecd model rules defines a qualified domestic minimum top-up tax as “a minimum tax that is included in the domestic law of a jurisdiction and that: (a) determines the excess profits of the constituent entities located in the jurisdiction (domestic excess profits) in a manner that is equivalent to the globe rules; (b) operates to increase domestic tax liability with respect to domestic excess profits to the minimum rate for the jurisdiction and constituent entities for a fiscal year; and (c) is implemented and administered in a way that is consistent with the outcomes provided for under the globe rules and the commentary, provided that such jurisdiction does not provide any benefits that are related to such rules.” oecd, model rules, supra note 1, at 64. 19 this prohibition prevents countries from using revenues associated with the domestic minimum tax for the purpose of benefiting the same companies subject to minimum taxation in their jurisdictions. the potential collateral benefits include but are not limited the granting of direct subsidies. see oecd, model rules commentaries, supra note 1, at 212. the oecd model rules commentaries do not provide a comprehensive definition of “collateral benefits.” however, the commentaries hint when a benefit could be considered a collateral benefit. for instance, the commentaries state, “[t]he word ‘benefits’ is comprehensive enough to cover any kind of advantage provided by a jurisdiction, including tax incentives, grants, and subsidies and the phrase ‘related to such rules’ is intentionally drafted with broad language to take into account different mechanisms through which the benefit is provided.” id., at 213. similarly, the commentaries provide an example of what should not be regarded as a “collateral benefit.” id., at 213. in the words of the commentaries: “for instance, assume a jurisdiction has adopted all of the provisions of the globe rules in its legislation [...] however, it provides a tax credit equivalent to a portion of the tax paid under the iir to be used against other taxes.” id. this should not be considered a collateral benefit. more on the analysis of collateral benefits is provided in noam noked, designing minimum taxes in response to the global minimum tax, 50 intertax 678, 681–2 (2022). 20 unfortunately, there is little guidance in the oecd model rules and its commentaries regarding the specific design of a domestic minimum tax to be considered as a qdmtt. mindy herzfeld, how does the qualified domestic minimum top-up tax fit into pillar 2?, 106 tax notes int’l 315, 316 (2022); noked, supra note 19 (addressing specific policy and design questions regarding domestic minimum taxes). 2024] global minimum taxation 193 would reduce the top-up tax under these rules.21 therefore, the introduction of a domestic minimum tax may ultimately become a quite sensitive decision from a developing country’s perspective. b. the “benefits for all” narrative if one considers the basic features described above, the idea of a global minimum corporate income tax is quite appealing.22 firstly, countries penalize each other for not taxing sufficiently, ensuring that a minimum level of corporate income taxation occurs somewhere.23 in other words, an ideal of “full taxation” is achieved through a specific mechanism of “fiscal fail-safe” rules, exactly as some scholars have noted already in the tax literature.24 secondly, the minimum tax approach offers protection for countries, preventing them from what one could call an “excessive” tax competition that could precipitate the so-called “race to the bottom” in corporate income taxes.25 overall, therefore, a minimum global 21 see oecd, model rules commentaries, supra note 1, at 95; noked, supra note 19, at 680. a “covered tax” is loosely defined in the oecd model rules commentaries as any tax of the following types: “(a) taxes recorded in the financial accounts of a constituent entity with respect to its income or profits or its share of the income or profits of a constituent entity in which it owns an ownership interest; (b) taxes on distributed profits, deemed profit distributions, and non-business expenses imposed under an eligible distribution tax system; (c) taxes imposed in lieu of a generally applicable corporate income tax; and (d) taxes levied by reference to retained earnings and corporate equity, including a tax on multiple components based on income and equity.” oecd, model rules commentaries, supra note 1, at 91–4 (discussing article 4.2.1); see also noked, supra note 19, at 680. for further policy analysis on these issues, see noam noked, defense of primary taxing rights, 40 va. tax rev. 341 (2021) (explaining that a domestic tax that is not considered a qdmtt but a covered tax would increase the etr, which would reduce the globe top-up tax). 22 this may be explained because the narrative behind a global minimum corporate income tax is not very different from other international cooperative efforts led by the oecd, which are based upon the same premise, that is, cooperation presupposes a default benefit for those actors involved. however, as dagan convincingly argues, this is not always the case, and it misses the fact that some states may decide to cooperate even in cases where cooperation is not the best option for them. see dagan, supra note 4, at 183. in the same order of ideas, although in the specific context of tax treaties and developing countries, eduardo baistrocchi explains that the rationale behind these countries’ decision to sign a tax treaty goes beyond the benefits of the treaty itself and is also part of being part of the club as well as the potential competition that may arise from peer countries. see eduardo baistrocchi, the structure of the asymmetric tax treaty network: theory and implications (bepress legal series working paper, paper no. 1991, 2007) https://law.bepress.com/expresso/eps /1991/ [https://perma.cc/vut3-fvvw]. see also, dagan, supra note 4, at 167 (elaborating on baistrocchi’s arguments). in the specific context of global minimum taxation, see eduardo baistrocchi, global tax hubs: theory and evidence, fla. tax review (forthcoming spring 2024) (manuscript at 66) (arguing that “pillar two is effectively creating a cartel because it is explicitly establishing a minimum price to join and remain a member of the tax treaty global network”). 23 although without regard on where that “where” should be. see parada, supra note 2, at 749–57; parada, supra note 7. 24 ruth mason defines “full taxation” as a “norm that dictates that all of a company’s income should be taxed in places where it has real business activities.” mason, the transformation of international tax, supra note 2, at 370. for a normative criticism of the notion of full taxation, see parada, supra note 2. 25 the terminology of “race to the bottom” has been widely used both by academics and activists to explain how a decrease in corporate income taxes worldwide could lead countries to reduce their general welfare. this is generally associated with the traditional debate on tax competition. see, e.g., esmé berkhout, tax battles: the dangerous global race to the bottom on corporate tax, oxfam 194 columbia journal of tax law [vol 15:2 effective corporate income taxation is presented as a win-win scenario in which revenue collection and “fair” tax competition appear as the two immediate trophies behind an ostensibly altruistic “benefits for all” narrative.26 however, although the magnanimous narrative of all countries benefiting from a cooperative worldwide action to increase their effective corporate income tax rates can be attractive, it does not work for all countries equally.27 the remaining part of this work will focus on demonstrating how the rationale of “benefits for all” not only imposes important limitations and administrative costs for developing countries willing to attract fdi but also how this rationale is an illusion in which tax competition is transferred from corporate income tax competition to other forms of tax and non-tax competition, ultimately revealing the fragility of the premises underlying the altruistic narrative behind a global minimum corporate income tax. iii. minimum taxation and developing countries this section elaborates on the three unconvincing premises on which the alleged benefits for developing countries under a worldwide minimum corporate income tax seem to be based. these include the assumption that all corporate income tax incentives provided by developing countries are uniformly inefficient, the idea that all developing countries can easily make a transition from corporate income tax competition to alternative forms of tax and non-tax competition, and the notion that supporting or opposing a global minimum corporate income tax could either boost or diminish tax revenue for developing countries. this section concludes that these premises, which serve to justify the global narrative of “benefits for all,” also force developing countries to assume further administrative costs, ultimately reinforcing a traditional international paternalism upon these countries. a. the presumed inefficiency of all tax incentives tax competition and the use of tax incentives to attract fdi is not a novel discussion in the tax literature.28 however, what is relatively new is the switch in the global rhetoric, at least from the oecd perspective. indeed, while the original approach to tax competition was based upon the clear distinction between harmful and non-harmful tax competition, the current message is blunter and more straightforward: tax competition shall be counteracted comprehensively, no matter briefing paper 9 (2016); see also s.m. ali abbas et al., a partial race to the bottom: corporate tax developments in emerging and developing economies 3 (imf working paper, 2012). but see, vera troeger, tax competition and the myth of the “race to the bottom”: why government still tax capital, 4 cage-chatham house series 1, 3 (2013). as for the oecd pillar 2 project, we find the use of the term “race to the bottom” and “harmful race to bottom” in some passages of the public consultation of november 2019. see devereux, supra note 3, at 7–8. 26 on the discussion on fairness regarding the oecd pillar 2, see, e.g., rita de la feria, the perceived (un)fairness of the global minimum corporate tax rate, in the “pillar 2” global minimum tax (w. haslehner et al. ed., 2024). 27 dagan, supra note 4, at 183. 28 see, e.g., oecd, harmful tax competition: an emerging global issue 8 (1998). see also michael keen & kai a. konrad, the theory of international tax competition and coordination 12 (max planck inst. for tax law and pub. fin., working paper no. 06, 2012). 2024] global minimum taxation 195 how harmful it may or may not be.29 let me take the example of ip box regimes. in the oecd beps action 5, there was a clear distinction between harmful and non-harmful regimes based on whether the r&d activities giving rise to income were performed in the country offering the incentive, specifically the ip box regime.30 this distinction becomes irrelevant under the oecd pillar 2 approach on minimum effective corporate income taxation.31 in fact, a closer look at the proposed rules to ensure minimum corporate income taxation worldwide demonstrates that any sort of ip box regime, which aims to ensure a low corporate income taxation regime to incentivize r&d, will lead to an effective tax rate (etr) below the minimum of 15%.32 in other words, the premise that all corporate income tax incentives do not work, meaning that corporate income tax competition shall be counteracted in any form, turns out to be accurate.33 changing the global narrative regarding corporate tax competition from a harmful/non-harmful distinction to a non-distinction involves evident challenges for developing countries. first, it creates a false presumption that any form of corporate tax incentive is incapable of attracting substantive fdi. however, this idea contrasts with the reality of many developing countries that offer incentives reliant upon both corporate and non-corporate tax features to generate real and substantive investment, employment, and economic growth. for instance, the central bank of malaysia released a study in 2017 that involved six mnes working in the electrical and electronics industry, which encompassed the period 2013–15. these mnes were recipients of investment incentives in the form of tax foregone, namely tax exemptions and allowances. the cost of the incentives was an average of myr 0.6 billion per annum (approximately usd 170 million), which was 29 in this regard, too, see michael devereux et al., pillar 2’s impact on tax competition 4–5 (oxford univ. cen. for bus. tax’n, working paper no. 11, 2022) (arguing that targeting tax competition without distinctions deviates from the long-standing policy of permitting countries to compete for real economic activities). in addition, counteracting corporate tax competition in any form ultimately contradicts the original message of the oecd beps project, which was that “[n]o or low taxation is not per se a cause of concern, but it becomes so when it is associated with practices that artificially segregate taxable income from the activities that generate it.” oecd, action plan on base erosion and profit shifting 10 (2013). in other words, while corporate tax competition was considered permissible if the low tax outcome derived from countries where the economic activities were generated, today it is targeted without any distinctions of this kind. 30 oecd, countering harmful tax practices more effectively, taking into account transparency and substance, action 5: 2015 final report 23–37 (2015). 31 although, as suggested by some commentators, this is surprising since some work of the oecd in 2019 suggested the possibility of excluding ip box regimes—compliant with action 5 oecd beps—from the context of the global minimum tax rules. see englisch, supra note 3, at 5. see also liotti et al., supra note 7, at 43 (arguing that a substance-based income exclusion—sbie—could shield an ip box regime from the global minimum tax rules). 32 this is more or less evident since ip box regimes offer low corporate income effective tax rates for income derived from qualified intellectual property. these rates are generally below 15%. therefore, ip box regimes will necessarily reduce the etr of a country. for instance, the uk patent box regime offers an effective 10% corporate tax rate on certain qualifying ip profits. for a brief explanation of the uk regime, see, e.g., sarah lord & andy jacott, a new era for the uk patent box, 1538 tax j. 8 (july 9, 2021). for a comprehensive study of ip box regimes around europe, see paloma schwarz martinez, ip box regime im europäischen steuerrecht (2017). see also lisa evers et al., intellectual property box regime: effective tax rates and policy considerations, 22 int’l tax pub. fin. 502, 504 (2015). 33 devereux et al., supra note 29. 196 columbia journal of tax law [vol 15:2 equivalent to 0.4% of the malaysian government’s total tax revenue.34 however, during the same period, 2013–15, these mnes “invested [myr] 1.2 billion (approximately usd 350 million) per year and generated average annual exports of [myr] 46 billion” (approximately usd 13.4 billion), which represented 6.1% of total gross exports.35 they also “registered a trade surplus of [myr] 16.5 billion” (approximately usd 4.8 billion) after considering gross imports; “they employed around 48,000 malaysians, with a total wage bill of [myr] 3.3 billion (approximately usd 960 million) per year,” and “collectively engaged with about 5,700 local suppliers, resulting in an overall spending on domestic inputs and services amounting to myr 13.3 billion (approximately usd 3.87 billion) per annum.”36 it is hard to say that the tax incentives granted in this case were ineffective in attracting substantive fdi to malaysia. indeed, between 2010 and 2015, the fdi in malaysia “made up close to 60% of the value of manufacturing investments that were given tax incentives . . . in the form of corporate tax exemptions, tax allowances for capital expenditure, and financial assistance such as training and r&d grants.”37 second, the presumed inefficiency of tax incentives also disregards the reality of developing countries, especially those with a lack of competitive advantages, for which the attractiveness of their tax systems plays a major role. in this sense, it should not be a surprise to anyone that some developing countries with poor political stability, an average infrastructure, an insufficient amount of skilled workers, or very limited natural resources decide to promote their corporate tax system to be competitive on the global scale. after all, capital is still mobile, and it will keep being so.38 third, this premise may increase the trade-off between cooperation and competition, which is a permanent dilemma for developing countries.39 indeed, it is evident that tax incentives create tension between those promoting international cooperation under the rhetoric of “benefits for all” and those defending the benefits of more investment under tax competition. this tension may ultimately increase the pressure on developing countries to cooperate while disregarding both the source of the cooperative rhetoric as well as the cost of it. in other words, if one agrees on the prominent role of the oecd in setting up the international tax agenda thus far, as well as the fact that international cooperation may not necessarily be inherently desirable for all since it promotes the interests of only a few within the group, it is evident that some developing countries may finally cooperate even though that cooperation will work against 34 mohd shazwan shuhaimen et al., rethinking investment incentives, cen. bank of malaysia 9 (2017). 35 id. 36 id. 37 id. at 5. 38 if this proves to be correct, the effect of restricting corporate tax competition may have just the effect of diverting competitive advantages from low-tax countries to high-tax countries, although assessing the real strength of that diversion may become a complicated task. see unctad, world investment report, supra note 16, at 130. 39 this could lead some developing countries to cooperate but not necessarily in their best interest. see dagan, supra note 4, at 166. 2024] global minimum taxation 197 their competitive interest, for example, affecting efficient corporate income tax incentives.40 b. moving away from cit tax competition as well as the presumed inefficiency associated with all sorts of corporate income tax incentives, the global narrative of “benefits for all” is based upon the assumption that all developing countries can easily switch from corporate income tax competition to other forms of competition, especially using non-tax incentives. there is no doubt that some developing countries will make the switch smoothly. this will particularly be the case for those countries with solid competitive advantages from both an individual as well as a regional perspective.41 however, others will simply be incapable of doing so. moreover, even for those countries capable of making the switch, this will not come without costs.42 indeed, any potential benefits for developing countries associated with a reduction in their levels of profit shifting may ultimately be offset by the cost of competing with nontax incentives, particularly with direct subsidies.43 this may bring new and unforeseen problems, including issues related to trade discrimination as well as under-regulation that may affect the general welfare in the country providing the incentive.44 moreover, it is important to consider whether the incentive imposed upon developing countries, forcing them to move out from corporate income tax competition, may be the wrong one, generating more aggressive competition in other areas of taxation, such as consumption and personal income taxes.45 if this is 40 id. dagan also states, “the oecd has consistently pushed non-member countries to join these initiatives, using powerful pro-cooperation rhetoric that invokes the classic strategy for overcoming collective-action problems—that it is to the benefit of all actors involved.” id. at 180. see baistrocchi, the structure of the asymmetric tax treaty network: theory and implications, supra note 22, at 26. 41 see afton titus, pillar two and african countries: what should their response be? the case for a regional one, 50 intertax 711 (2022) (elaborating on the idea of east african countries acting together). 42 most of the costs will be related to the traditional trade-offs of cooperation, even against their own interests. for a deeper analysis on the dynamics of cooperation and competition, see dagan, supra note 4. 43 in reference to east african countries, titus also stresses the administrative costs associated with the switch from tax to non-tax incentives and argues for a strict monitoring of these costs in the future. see titus, supra note 41, at 719. see also noam noked, from tax competition to subsidy competition, 42 u. pa. j. int’l l. 445, 479 (2020) (“welfare losses may occur where non-harmful tax benefits that increase welfare cannot be replaced with equivalent non-tax subsidies, or where they can be replaced but at a high cost.”). 44 titus, supra note 41, at 718. see also noked, supra note 43, at 450 (arguing that there is a risk of replacing harmful tax benefits for equally harmful non-tax subsidies); eckhard janeba & guttorm schjelderup, the global minimum tax raises more revenues than you think, or much less (cesifo working paper no. 9623, 2022) (warning that the reduction in profit shifting derived from the global minimum tax could be offset by the costs associated with non-tax subsidies). 45 see cui, supra note 14, at 21. see also feria, supra note 26, at 9–10. part of this competition outside corporate income taxation can already be seen in the context of personal income taxes. in this regard, see, e.g., rita de la feria & giorgia maffini, the impact of digitalisation on personal income taxes, 2 british tax rev. 154 (2021). other authors have already warned us regarding the potential competition that can be created still in the context of cit, especially due to the interplay between a domestic minimum tax (qdmtt) and the global minimum tax rules. this is because a 198 columbia journal of tax law [vol 15:2 the case, the remedy may ultimately prove to be worse than the illness, especially considering the importance of corporate income taxes as a revenue generator in developing countries vis-à-vis consumption or personal income taxes.46 c. the revenue gain/loss presumption perhaps the strongest premise under which the whole idea of global corporate effective minimum taxation, and especially the narrative of “benefits for all,” is based, could be called “revenue gain/loss presumption”; this is the idea that while an active endorsement of a global effective minimum corporate income tax may increase developing countries’ tax revenue collection, the countries’ inaction on these matters may reflect an important revenue loss.47 a presumption of gaining or losing revenues underlines the whole project, and perhaps the best illustration of this is the dynamic between domestic minimum taxes and the global minimum tax rules. as noted already in this work, one of the possibilities contemplated in the oecd model rules is that countries introduce a domestic minimum tax that resembles the oecd minimum tax rules.48 the advantage of this option is that a domestic minimum tax would revert the priority in the hierarchy of the global minimum tax rules, ensuring that any potential revenues derived from the application of the global minimum tax do not end up necessarily in the country of the upe but rather in the country where the undertaxed subsidiary is located.49 this argument holds true, as it is noteworthy that most of the countries of upes are developed countries with effective tax rates way over the minimum threshold. consequently, implementing a domestic minimum tax mirroring the global minimum tax emerges as a perfect mechanism for developing countries to counteract this trend, offering them a priority in the collection of tax qdmtt, which applies on excessive profits only, could incentivize countries to reduce even more their cit rates for those profits that are not “excessive,” even to zero or very close to zero. for this argument, see devereux et al., supra note 29. see also ana paula dourado, pillar two model rules: inequalities raised by the globe rules, the scope, and carve-outs, 50 intertax 282 (2022). in contrast, see, e.g., englisch, supra note 3, at 16–20. 46 however, one must be careful to measure the revenue importance of corporate income taxes (cit) in relation to other taxes in a specific country. indeed, if we consider a classic approach of determining cit revenues as a percentage of gdp, it is evident that the numbers will be rather insignificant. see, e.g., oecd, revenue statistics 2021—the initial impact of covid-19 on oecd tax revenues 3 (2021). yet, these amounts can be different when they are considered in relation to the total revenue collected in a particular country and not as percentage of gdp. for instance, according to the malaysian finance ministry’s 2022 fiscal outlook and federal government revenue estimates published in october 2021, in the year 2020, the total tax revenue collected amounted to rm 154,398 million (approximately usd 33.3 million), whereas cit revenue collected represented rm 50,065 million (approximately usd 10.8 million). this amounts to, approximately, 32.4% of the total tax revenue collected that year in malaysia. see malaysia ministry of finance, 2022 fiscal outlook and federal government revenue estimates 136 (2021). 47 this is a direct effect of the design of the minimum tax as fiscal-fail safe rules. that is, if one country does not impose a sufficient taxation, another country can step in and fill the void. for the concept of fiscal-fail safe and the global minimum tax rules, see mason, the transformation of international tax, supra note 2; mason, a wrench in globe diabolical machinery, supra note 2. for a normative criticism of the concept of fiscal fail-safe and its ultimate policy aim (“full taxation”), see parada, supra note 2. 48 supra section ii.a. 49 oecd, model rules commentaries, supra note 1, at 95. see also noked, supra note 19. 2024] global minimum taxation 199 revenues.50 in other words, the revenue gain presumption appears on the scene. on the contrary, a potential inaction by developing countries to the introduction of a domestic minimum tax is presented in the inverse in terms of potential costs. if developing countries decide not to introduce a domestic minimum tax, they would be giving up revenues since the priority to collect whatever is generated from the application of the global minimum tax rules would be allocated to the country of the upe.51 nevertheless, and as argued already, the alleged revenue gain or loss that developing countries would incur should they decide to introduce a domestic minimum tax that runs in parallel to the global minimum tax rules is relative and depends, among other factors, upon the elasticity of investment as well as the competitive advantages that may exist in the country vis-à-vis other relatively similar countries nearby.52 in simple words, the less elastic the investment in a specific sector within the country and the more competitive advantages that country possesses, the more likely it is that this country benefits from an additional revenue collection derived from a domestic minimum tax.53 on the contrary, the more elastic the investment in the country and the worse the infrastructure, political stability, or any other competitive advantage the country has vis-à-vis its neighboring competitors, the more likely it is that any potential revenue gain/loss becomes illusory.54 let me illustrate this with a simple example. let us assume an mne group with a upe in country a invests through subsidiaries in countries b and c, both developing countries. while country b offers an effective corporate income tax rate of zero, country c offers an effective corporate income tax rate of ten percent. in addition, let us presume that country b was chosen as a place to invest regardless of the fact that, in comparison to other neighboring countries, including country c, it possesses quite an unstable political environment, its infrastructure is certainly not the best in the region, and its judicial system does not seem very trustworthy either. the investor chose country b rather than country c because it regarded the tax savings as more than sufficient to compensate for the differences between countries b and c. now, let us assume that all the countries in this example implement the global minimum tax rules. however, only country b implements a domestic minimum tax that resembles the global minimum tax rules.55 if the main premise underlying the global minimum tax works in this case, countries b and c would be forced under the global minimum tax rules to increase their effective tax rates up to the minimum unless they want country a to collect 50 noam noked, the case for domestic minimum taxes on multinationals, 105 tax notes int’l 667, 672 (2022) (providing suggestions for developing countries as to what to do with these revenues). see also leopoldo parada, tailoring developing country advice: a response to noam noked, 105 tax notes int’l 783, 784 (2022). 51 noked, supra note 50 (suggesting that countries would be better off implementing a domestic minimum tax than just adopting a global minimum tax alone). 52 parada, supra note 50 (arguing that elasticities of investment and competitive advantages must be considered to determine who is better off). considering this argument in the specific context of african countries, see titus, supra note 41, at 715–16. 53 parada, supra note 50. 54 id. 55 this example is based on parada’s illustration, supra note 50, at 783–84. 200 columbia journal of tax law [vol 15:2 the residual tax revenues. similarly, if we compare countries b and c, country b would be hypothetically better off since the tax revenues would remain at home rather than being transferred to country a. in other words, the revenue gain/loss presumption derived from an active or passive endorsement of a domestic minimum tax would prove to be true thus far.56 however, the premise disregards that country b may lack other competitive advantages apart from its attractive corporate income tax system.57 in that case, it is questionable that highly elastic investors have a strong incentive to remain in country b rather than reallocating entirely their activities to country c, assuming both countries are neighbors and equally attractive for business purposes. in simple terms, the revenue gain attributed to the introduction of a domestic minimum tax in country b can be diluted in the long term or simply becomes illusory.58 another example to understand the fragility of the revenue gain/loss presumption can be taken from the application of the utpr.59 as noted already in this article, the utpr will be triggered only in those cases in which the iir does not apply, allowing a country to impose a top-up tax on an mne domestic subsidiary when the profits of the other foreign subsidiaries of the mne group are subject to low tax on their profits.60 in other words, the utpr is presented as a backstop rule that promises a country to get the revenues derived from under taxation in another country in the absence of the application of an iir in the country of a upe. however, in practice, the country willing to access those alleged new revenues is prevented from doing so unless this country decides to tax its own subsidiaries more heavily.61 in other words, what is presented as a new revenue source derived from the active endorsement of the global minimum tax rules—more precisely, the utpr—is not such. this is because the option for a country to tax its own subsidiaries more heavily has always existed, even predating the implementation of the global minimum tax rules.62 therefore, the new revenue source becomes again more illusory than real. finally, it is perhaps important to note that the whole premise of gain/loss revenues simply overestimates the importance of corporate income taxation worldwide, especially in developing countries.63 indeed, with some exceptions, corporate income taxation plays a less important role as a revenue collector in comparison to consumption and personal income taxes. for example, in some of these countries, the tax revenues from corporate income taxation represent less than five percent of the total gdp of the country, a phenomenon that is generally explained by factors such as the different levels of sophistication of tax administration in developing countries or the political powers of the richest segments of the population, among others.64 whatever the reasons for this 56 parada, supra note 50. 57 id. 58 id. 59 supra section ii.a. 60 id. 61 cui, supra note 14, at 7–8. 62 id. 63 however, we must consider the caveats in measuring the revenue importance of corporate income taxes (cit) in relation to other taxes in a specific country. see discussion supra note 47. 64 id. 2024] global minimum taxation 201 phenomenon are, what is important to understand at this point is that the relative lack of importance of corporate income taxes in developing countries certainly contrasts with the narrative constructed behind the idea of a global minimum effective corporate income tax, especially when that narrative embraces the idea that an active or passive endorsement of the project will directly impact the revenue collection in developing countries. d. the costs of a “benefits for all” narrative the narrative of “benefits for all” underlying the project for a global minimum tax is persuasive but also misleading, especially from the perspective of developing countries. indeed, it does not only start from the basis that all corporate income tax incentives offered by developing countries do not—and will not—work, but it also assumes that all developing countries have the same capabilities to adapt to the new standards of non-corporate income tax competition, offering them the holy grail of more revenues if they accept the terms of the new global deal or the hell of losing money if they do not.65 this can prove to be tremendously costly for many developing countries for various reasons. firstly, developing countries are forced to assume very high administrative costs related to the implementation of rules that are highly technical only under the assumption that they will act as “default revenue collectors” for those cases in which other countries decide to tax under the new minimum.66 however, as argued already in this article,67 this premise is very fragile, especially when one digs into the technicalities of the rules, such as the case of the application of the utpr or the introduction of domestic minimum taxes resembling the global minimum tax.68 in both cases, the alleged “benefits for all” narrative proves to be unclear when additional economic factors are considered69 or when one realizes that what is presented as a new revenue source derived from the active endorsement of the global minimum tax rules already existed in the absence of the rules.70 secondly, this narrative is quite worrisome, particularly from the perspective of the global tax dynamics between developed and developing 65 supra sections iii.a, iii.b., and iii.c. 66 englisch, supra note 3, at 18 (warning that not all developing countries’ tax administrations are in a capable position to fully cope with the “inherently complex globe rules”). see also titus, supra note 41, at 717 (doubting whether the administrative burden of the globe rules can be offset with the alleged new revenues); leopoldo parada, el acuerdo fiscal internacional: impacto en economías emergentes [the global tax agreement: impact upon emerging economies], 46 estudios de derecho tributario, derecho aduanero y comercio exterior 267, 290 (2022) (arguing that emerging economies will not only deal with the complexities of pillar two, but also with the increased sophistication of the taxpayers willing to be out of the scope of it). 67 supra section ii.c. 68 supra section ii.a. 69 this is the case of elasticities of investment and competitive advantages as two dynamic factors to be considered in the implementation of a domestic minimum tax that resembles the global minimum tax rules. parada, supra note 50. 70 this is the case of the utpr, as wei cui correctly argues: “many discussions . . . perpetuate the idea that the utpr gives the adopter country a right to dip into a pot of undertaxed profit when other countries fail to adequately tax such profit.” cui, supra note 14, at 23. however, such an understanding makes more sense when the utpr was designed as an under-taxed payment rule rather than as an undertaxed profit rule. see, e.g., li, supra note 14 (stressing the relevance of the change in the terminology of the utpr, i.e., from payment to profit). 202 columbia journal of tax law [vol 15:2 countries. indeed, in the author’s view, the “benefits for all” narrative underlying the global minimum tax rules just consolidates a well-known international paternalism towards developing countries; the message of which can be interpreted as follows: if you (developing capital importer countries) do not want to tax sufficiently, we (the rich capital exporter countries) will punish you by taking those revenues that you did not want in the first place.71 that is how the global minimum tax rules operate before and after the idea of a domestic minimum tax resembling the global rules.72 let me take the example of the domestic minimum tax and the prohibition on collateral benefits introduced in the oecd model rules to illustrate the above.73 as explained already in this work,74 the oecd model rules contemplate the possibility of countries introducing a domestic minimum tax that resembles the global minimum tax rules, turning back the priority in the collection of tax revenues.75 however, this comes with an important restriction. countries are not allowed to spend the revenue collected providing alternative or collateral benefits to the mne groups subject to the domestic minimum tax.76 although the policy rationale of this prohibition is aligned with the technical design of the rules, it is undeniable that this prohibition also reinforces the same paternalistic message behind the whole project for a global minimum tax, which now aims not only to instruct developing countries on what rate they should tax corporate profits but also on how that money should be ultimately spent. if this is not considered paternalistic behavior, what could be? iv. tailoring some advice for developing countries considering the precedent criticism against the design and the “benefits for all” narrative behind the idea of a global minimum corporate income tax, this section elaborates on some recommendations for developing countries to design a strategic approach to cope with a global minimum tax. this strategic approach is based upon three main recommendations: i) understanding that a global minimum corporate income tax is an idea divorced from the presumption of revenue gain/loss; ii) taking the minimum global corporate income tax wave as an opportunity to review their tax and non-tax incentives, including alternative forms of competition, and iii) aiming for simplification and ease of administration in the 71 see, leopoldo parada, la propuesta de un impuesto minimo global: una mirada crítica’ [the global minimum tax proposal: a critical view], in transformación digital y justicia tributaria 205 (f. a. garcía prats ed., 2022) (arguing that a global minimum tax will perpetuate the traditional international paternalism toward poor countries). in addition, the idea of punishing developing countries for not taxing sufficiently could be compared as the opposite policy motivation of tax sparing where developed countries agree not to tax their residents who benefit from a developing country’s tax incentive. for more on the interaction between global minimum taxation and tax sparing in developing countries, see aitor navarro, jurisdiction not to tax, tax sparing clauses and the income inclusion rule of the oecd pillar 2 (globe) proposal: the demise of a policy instrument of developing countries?, (copenhagen bus. sch., law research paper series 20–22, 2020). 72 supra section ii.a. (explaining the basics of a domestic minimum tax in the context of the new global minimum tax rules). 73 for the prohibition on collateral benefits, see supra note 19. 74 supra section ii. 75 id. 76 id. 2024] global minimum taxation 203 design and implementation of a minimum tax approach. in doing so, developing countries could perhaps find an opportunity to reshape their general action plan to attract fdi more effectively while they still try to ride the wave of minimum global corporate income taxation that the world seems to be in. a. departing from the revenue gain/loss narrative as stressed already in this work,77 the narrative of “benefits for all,” and particularly, the premise under which an active endorsement of the global minimum tax rules may bring new and fresh revenues, while the inaction on these matters may condemn developing countries to lose such revenues, has proved to be very persuasive to achieve the “critical mass” needed to put this project into practical operation.78 indeed, i would dare say that most of the policy advice received by developing countries thus far—at least publicly—goes in the direction of the marginal benefits associated with this project. however, convincing developing countries that a marginal benefit might arise or be simply lost depending on the endorsement of the global project seems to be short-sighted, even though the revenue gain/loss presumption might prove to be true for some developing countries with strong competitive advantages and quite inelastic levels of investment, or for any other country but only in the short-term.79 for this reason, a more sensitive approach devising any sort of advice for developing countries should start from an understanding that a minimum corporate income tax is not about generating revenues but about limiting corporate income tax competition.80 after all, the whole design of the global minimum corporate income tax rules responds to the fact that if one country does not impose a minimum level of taxation, another country will pull the trigger and get the part that is necessary to complete that minimum.81 that is, the revenue effect comes 77 supra section iii.c. 78 it is difficult to determine the true origin of the use of the expression “critical mass” in the context of pillar 2. some commentators have attributed this to the intervention of a senior oecd official being asked about countries deciding to step out of the global deal, to which he allegedly replied: “we don’t care, actually... we don’t need them.” feria, supra note 26, at 20 n.103 (citing doug connolly, global minimum tax will work, if implemented, oecd’s saint-amans says, mne tax (nov. 4, 2021), https://mnetax.com/global-minimum-tax-will-work-if-implemented-oecds-saint%20amans-says-46122%20 [perma.cc/jb9n-3djd]. however, whatever the origin is, one must recognize that it has clearly taken a privileged place in the global minimum tax narrative among tax scholars. see, e.g., english, supra note 3, at 19. see, mason, a wrench in globe diabolical machinery, supra note 2. in the author’s view, this expression is not as innocuous as it appears and represents an important element of the narrative of “benefits for all” and the ultimate success of pillar 2. after all, the expression seems to demonstrate that the greater the number of countries cooperating, the better their individual interests are satisfied, which is ultimately false. for a deeper analysis of the dynamics of international cooperation, see dagan, supra note 4, at 152, 184 (arguing that “[e]ach [international] initiative should be evaluated according to its concrete results and not the number of states that endorse it…”). 79 see noked, supra note 19; parada, supra note 50. 80 this was at least the original intent expressed in the beginning of the project for a global minimum corporate tax. see pistone, supra note 3. see also devereux et al., supra note 3; englisch, supra note 3. 81 see mason, the transformation of international tax, supra note 2; mason, a wrench in globe diabolical machinery, supra note 2 (explaining the concept of fiscal-fail safe rules). see also parada, supra note 2. 204 columbia journal of tax law [vol 15:2 only as a sort of penalty to incentivize the country that taxes under the minimum to increase its level of effective corporate income tax, or, in some cases, the revenue gain/loss simply becomes an illusion, as demonstrated in this work already.82 b. sensitive review of tax and non-tax incentives as well as departing from the revenue gain/loss premise, developing countries should focus on adopting a strategic plan regarding their tax and non-tax incentives.83 in other words, they should take the minimum global corporate income tax wave as an opportunity to review their tax and non-tax incentives, including alternative forms of competition, especially related to activities that may either generate positive externalities or that may reinforce their competitive advantages globally, such as renewable energies or high-tech development.84 in particular, this approach should involve at least three fundamental steps. the first step is understanding the scope of the global minimum tax rules and adopting a strategic approach regarding their tax incentives. “this is crucial for developing countries because it is evident that the new rules on minimum corporate income taxation will not affect all tax incentives equally.”85 indeed, some tax incentives will be excluded from the scope of the new rules either because they will not be considered for purposes of the calculation of the tax base under which the minimum taxation is determined or simply because being considered for calculation purposes, they will not reduce the etr below the minimum required.86 in other words, developing countries shall act strategically, keeping tax incentives without the elements of corporate income tax, or they shall try to make these incentives as efficient as possible for purposes of the calculation of the etr.87 let me take the example of refunding negative corporate tax in the form of a refundable credit to illustrate the foregoing. many developing countries offer the possibility of refundable credits as an alternative to a loss carry-forward for the obvious reason that a refundable credit offers some available cash for the specific business.88 this can be quite important either to incentivize some specific new business activities or simply to promote investment in r&d activities in general, especially in times of crisis.89 the oecd model rules make a clear distinction between qualified and 82 supra section iii.c. (explaining how the presumption of revenue gain/loss proves to be very fragile in the case of domestic minimum taxes and the utpr). 83 a strategic approach regarding tax incentives seems also to be promoted by the world bank although focused almost exclusively on the compatibility of tax incentives with the global minimum tax rules. see david o’sullivan & ana c. gómez, the global minimum tax: from agreement to implementation, world bank grp., 33–5 (2022). see also oecd, tax incentives and the global minimum corporate tax: reconsidering tax incentives after the globe rules, 50–2 (2022) (recognizing that countries will continue using tax incentives after a global minimum tax is adopted worldwide). 84 parada, supra note 50, at 784. 85 id. see also liotti et al., supra note 7, at 30–1. 86 id. 87 id. similarly, oecd, supra note 83, at 47. 88 id. at 36. 89 max planck inst. for tax l. & pub. fin., tax law under heavy weather (sept. 2020), https://www.tax.mpg.de/en/news/news_details?tx_news_pi1%5baction%5d=detail&tx_news_pi1 %5bcontroller%5d=news&tx_news_pi1%5bnews%5d=113&chash=b3e0ae8f879e640c8adbc1f 2024] global minimum taxation 205 non-qualified refundable credits for purposes of the rules on minimum taxation, more specifically regarding the calculation of the etr.90 in this regard, while a “qualified” refundable credit is factored “into . . . the denominator of the etr computation,” that is, not “reducing . . . [an] [e]ntity’s taxes [paid] in the year the refund or credit is claimed,” a “non-qualified” refundable credit is “excluded from income but treated as a reduction to [c]overed [t]axes in the period the refund or credit is claimed . . . [that is,] they reduce the numerator of the etr” calculation instead.91 as per this distinction, it seems more strategically sensitive for developing countries to ensure that their tax incentives in the form of refundable credits are treated as qualified refundable credits under the oecd model rules.92 in fact, only in this case will they receive treatment like a government grant without a substantive investment impact, which can be quite relevant when we speak about new investment in, for instance, sensitive areas such as renewable energy or other socially desirable outcomes.93 second, developing countries shall make an exhaustive review of those corporate income tax incentives that need to be transformed into other forms of non-tax incentives, including direct subsidies.94 this is evident since some corporate income tax incentives will simply not pass the new threshold established by the global minimum corporate tax standards, such as the case of tax holidays designed exclusively based upon corporate tax elements.95 these tax incentives will necessarily be redrafted either in the form of direct subsidies or another type of corporate benefit. for example, many of these tax holidays could be replaced by grants or loans with preferential rates, which seems to be a desirable path for some african countries facing this challenge right now.96 however, it is also evident that this process of transformation is not free of costs and will necessarily bring new challenges both from an administrative and regulatory perspective.97 therefore, it is important that developing countries pay enough attention to the process, supporting the use of automated data collection systems and other more advanced 5e662aff9 [perma.cc/fr5l-b9my]. see also unctad, world investment report, supra note 16, at 147. 90 a refundable credit is considered a qualified refundable credit under the oecd model rules if it must be paid within four years of the taxpayer satisfying the conditions for receiving the credit under the laws of the jurisdiction that grants it. oecd, model rules, supra note 1, at 65 (describing the defined terms of article 10.1). 91 oecd, supra note 1, at 215. see herzfeld, supra note 17, at 1606. 92 however, the strategy of developing countries should not be limited to make their tax incentives compatible with globe only. that is, developing countries should take the chance to make a deeper review of their status quo, as argued in this work. in a similar view, see oecd, supra note 83, at 49. 93 herzfeld, supra note 17, at 1608 (arguing that it would be unfortunate if the global minimum tax ends up reducing private investment in renewable energy). 94 supra section iii.b. 95 a “tax holiday” is a government incentive program that offers a temporary reduction or elimination of taxes, which can be corporate income taxes or other types of taxes. the new global corporate income tax rules do not prohibit the use of tax holidays. however, it is evident that a tax holiday that substantially reduces the cit rate in a country may trigger a top-up tax somewhere else. for this opinion, see also liotti et al., supra note 7, at 38. 96 titus, supra note 41, at 718–719. 97 id. at 719. see also noked, supra note 43 (stressing the risks associated to the transition to nontax subsidies). 206 columbia journal of tax law [vol 15:2 technological tools to closely monitor the whole process of transformation.98 in other words, the plea is simply to take the minimum global tax wave not only as a challenge but also as an opportunity to improve what they have, including their competitive advantages in areas of potential further development such as renewable energies and high-tech industry. fortunately, this seems to be the approach already adopted by some developing countries around the world. for instance, according to the malaysian investment development authority (mida), the government agency responsible for promoting investments in malaysia, the country has in recent years shifted its focus from using tax incentives to adopting what they denominate an “ecosystem approach.” this approach aims to ensure that malaysia remains competitive as a preferred investment destination in the region.99 in particular, mida plans to deploy high-speed broadband in selected industrial estates100 to facilitate adoption of new technologies, such as cloud computing, remote monitoring, and predictive maintenance by businesses operating in these industrial estates.101 this certainly looks like one concrete step in the right direction that other developing countries may be willing to follow. third, and finally, developing countries should take the opportunity not only to be as compliant as possible with the newly imposed international standards on minimum corporate income taxation but also to revise the general effectiveness of their tax incentives to attract fdi. however, this should not be done as an isolated process. indeed, developing countries should pay closer attention to what is done within their own region, understanding and taking the positive examples from neighboring countries, too.102 this may help create an informal common policy approach that ultimately serves to strengthen the position of a full region, representing more than one single developing country.103 similarly, and as noted already in this section, developing countries should accompany this process by 98 see, e.g., ministry of finance malaysia, public consultation paper for budget 2023— the implementation of globe rules in malaysia 34–35 (2022). 99 malaysia investment development authority, beyond tax incentives: empowering industrial estates with high-speed broadband towards a prosperous, inclusive, and sustainable malaysia, mida e-newsletter 4–5 (jan. 2, 2022), https://www.mida.gov.my/wp-content/upload s/2022/02/final-mida-newsletter-1.pdf [perma.cc/ul6x-w8hs]. 100 “industrial estates” are designated plots of land in malaysia that are developed to cater to the needs of specific industries. examples of industrial estates include technology-intensive industries, halal industries, and biotechnology parks. industrial estates house benefits like availability of land, infrastructure, quality services, and proximity to strategic markets. malaysia currently houses more than 500 industrial estates. one example is the kulim hi-tech park, an industrial park that houses high-technology enterprises such as intel. see investment in malaysia, ministry of investment, trade and industry https://www.miti.gov.my/index.php/pages/view/2460?mid=836 [perma.cc/7 q93-8ztb]; our tenants, kulim technology park corporation, https://www.khtp.com.my/o ur-tenant/ [perma.cc/ccw2-cufl]. 101 malaysia investment development authority, “powering resilience” malaysia investment performance report 2021, 121–3 (2021), https://www.mida.gov.my/wp-content/upload s/2022/03/mida-ipr-2021-1.pdf [perma.cc/zx74-jts4]. 102 titus provides a similar advice for african countries taking the example of south africa and their global business service incentive, which has been quite successful creating employment as well as attracting around 190 million usd in fdi. titus, supra note 41, at 719. 103 a specific recommendation in this regard can be found in the public consultation of malaysia on pillar 2 (“analyse approaches adopted by other asean countries and undertake comprehensive study on the impact of pillar 2”), ministry of finance malaysia, supra note 98, at 34. 2024] global minimum taxation 207 strengthening the monitoring of their tax incentives, both in terms of compliance and fdi return, aiming for automated and centralized data collection systems.104 this may help not only in understanding the profiles of the different foreign investors coming into the country prior to negotiations but also help with designing more targeted tax and non-tax incentives in the future.105 ultimately, and from a practical perspective, it can provide developing countries important information regarding the behaviours of investors associated with specific tax incentives in specific sectors, giving some important hints regarding the levels of elasticities that they possess.106 all in all, understanding the scope of the global minimum tax project, making the switch from tax to non-tax incentives when needed, and projecting the future of fdi seem to be the three sensitive steps to be followed by developing countries at this point. c. aiming for simplicity and administrability despite the current uncertainty, there is a likelihood that the narrative of “benefits for all” ultimately prevails and that a global minimum corporate income tax ultimately rules the world. if that is the case, developing countries need to be prepared to cooperate in reducing the additional transaction costs that this process will impose on both taxpayers and tax administrations by providing a simple and strategic process of implementation. in this regard, two avenues of implementation could be explored, although both require the compromise of all actors involved, that is, not only from developing countries but also, and mostly, from developed countries actively supporting this global initiative. the first avenue has already been discussed within the if and consists of providing some guidance for countries to design their domestic minimum taxes (qdmtt), resembling the oecd rules.107 if we recall, the oecd model rules contemplate an alternative for countries to introduce their own domestic minimum tax, which, to the extent it resembles the oecd minimum tax rules, it could be considered as a qdmtt, ensuring that the priority of the global minimum tax rules (iir and utpr) goes back to them.108 however, there is very little about how these domestic minimum taxes should be structured to be regarded as a qdmtt. for instance, the 2021 oecd model rules commentaries simply state: the tax must be implemented and administered in a way that is consistent with the outcomes provided for under the globe rules and their commentary, including the prohibition against the implementing jurisdiction providing any collateral or other benefits 104 id. 105 id. see also englisch, supra note 3, at 11 (recognizing that countries have preferences for certain investment profiles). 106 for the argument of elasticities of investment, see parada, supra note 50. 107 herzfeld, supra note 20, at 317. see leopoldo parada, response to the un resolution a/res/77/244 on promotion of inclusive and effective tax cooperation at the united nations 8 (2023) https://ssrn.com/abstract=4452268 [perma.cc/ks85-dt59]. 108 supra section ii.a. 208 columbia journal of tax law [vol 15:2 that are related to such domestic tax as discussed further in the commentary to the definition of a qualified iir.109 similarly, the same commentaries provide a sort of implicit compromise or declaration of principles when they state: globe implementation framework will develop process and provides guidance to facilitate co-ordinated implementation of the globe rules. this will include implementing a process to assist tax administrations in determining whether a minimum tax is considered as a qualified domestic minimum top-up tax. in order to facilitate compliance by mnes and administration by tax authorities, the outcome of these determination would be released and made publicly available.110 this not only increases the uncertainty for developing countries willing to implement a domestic minimum tax, but it also may ultimately overcomplicate their potential design. some commentators have rightfully argued that the vagueness found both in the wording of the oecd model rules and the commentaries may not be fortuitous.111 indeed, the wording seems to respond to specific but contradictory incentives. on one hand, there is the need of some countries to have a tailoreddesigned domestic minimum tax that is as close as possible to a qdmtt, such as the case of the united states and its recently announced corporate alternative minimum tax (us amt).112 on the other hand, it is in the interest of some countries to establish a domestic minimum tax that is like a qdmtt but not close enough to be considered a qdmtt but a covered tax instead. in that way, these countries secure priority over other countries’ cfc regimes.113 whatever path is ultimately adopted, it is evident that clearer guidance would help avoid a proliferation of different versions of minimum taxes around the world, increasing the already complex scenario created under the oecd minimum tax proposal.114 the second avenue explored in the tax literature is the so-called “preemptive approach.”115 the idea is to get countries out of the complexities of etr calculations except when is truly needed.116 most notably, a two-levels ex ante tests to determine full compliance under the new global minimum tax rules is 109 oecd, model rules commentaries, supra note 1, at 212. 110 id., at 212. 111 noked, supra note 21, at 685. 112 id. this matter is certainly not irrelevant since if the us amt is considered a qdmtt, other countries would be prevented from imposing a utpr (or an iir) on us mnes or us sourced earnings of foreign-parented multinationals. for an analysis of the us amt, see, e.g., mindy herzfeld, the remade corporate amt walks and talks like a duck, 176 tax notes int’l 1194 (2022) (raising the question of whether the us amt can be considered a qdmtt). 113 noked, supra note 21, at 685. 114 see dylan moroses, u.s.' shunning of top-up tax could unwind global deal, law360 tax authority (aug. 26, 2022) (media article expressing the opinion of leopoldo parada). 115 see cedric döllefeld et al., tax administration guidance: a proposal for simplifying pillar two (acct. for transparency, working paper series no. 70, 2022). 116 id. at 5. 2024] global minimum taxation 209 promoted.117 in the first level, the tax rates, tax base, and deviations of it as well, are analysed to determine whether the country is either low or high-risk under the global minimum tax rules. this first test represents a pre-emptive filter to determine whether any etr calculations are required or whether a subsequent test is needed at all.118 the second level test aims to determine the specific etr at the mne level. therefore, this test is contingent on the fact that the country test (previously applied) raises some risks or features “red flags.”119 nevertheless, the second-level test has a caveat, which is that the etr calculation will only use the national tax law for the purpose of determining compliance with the new international standard, making it simpler than the etr calculation under the pillar 2 rules.120 as a result, “[i]f the simplified calculation shows that an mne benefits from the specific red flag, a full . . . calculation [of the global minimum tax] will be required.”121 let me illustrate the foregoing with a simple example. let us assume that the first test identifies that a specific country has a nominal corporate income tax rate of 15%. this might constitute a red flag that would require an mne-level test, that is, a determination of whether a specific mne benefits from an effective rate below 15%. however, rather than taking the calculation of the etr according to the global minimum tax rules, the test would use only the national tax law. if this simplified calculation shows an etr below 15%, then the full global minimum tax compliance would apply.122 there are evident benefits and costs associated with the initiative explained in the paragraph above, especially for developing countries with no other alternative than implementing the global minimum tax rules.123 as for the immediate benefits, these countries could avoid burdensome etr calculations under the global minimum tax rules. [this] can be particularly important for developing countries with high nominal corporate income tax rates as well as small deviations between their domestic tax base and the tax base calculated under the global minimum tax rules. similarly, transaction costs for taxpayers may substantially be reduced since a multinational (mne) operating in a specific developing country will be subject to the full global minimum tax compliance only to the extent that some of the red flags appearing under the first test bring 117 id. 118 id. 119 id. at 6. 120 id. 121 parada, supra note 107 at 9; (citing döllefeld et al., supra note 115 at 5–6). döllefeld explains that such “red flags” can be either a tax rate below the minimum of 15% or certain deviations from the tax base. this is all country-specific analysis. 122 for a detailed explanation regarding the determination of red flags, see id., at 8. 123 it would not be a surprise at all if some developing countries ultimately decide to cooperate, even though that international cooperation plays against their own individual interest. see dagan, supra note 4, at 183. 210 columbia journal of tax law [vol 15:2 to the conclusion that the mne was subject to an effective rate below the global minimum.124 in this regard, it is almost impossible not to be sympathetic to such a proposal, at least from the perspective of simplicity and administrability. however, this proposal is not exempt from costs, and perhaps the most evident cost is also recognized by the promoters of this idea, that cost being the possibility of generating false positive and false negative results.125 in fact, in these cases, the pre-emptive approach proposed would serve no purpose other than incrementing the legal uncertainty related to the application of the global minimum tax rules, either falsely preventing or falsely allowing their application. in both cases, there would be important costs associated with a wrong analysis. yet, in the author’s view, these costs seem to be only minor when compared to the overall costs of implementing a global minimum tax without any such simplified options. in other words, in the classic cost-benefit economic analysis, it still appears more logical to embrace a simplified tax administrative practice both for the sake of taxpayers and tax administrations rather than doing nothing. inaction in this case may bring a realistic loss for developing countries. v. conclusions the apparently solid narrative of “benefits for all” erected behind the project for a global minimum corporate income tax is both appealing and persuasive. however, it also appears to be quite unrealistic for many developing countries. as argued in this article, the alleged benefits of global minimum taxation in developing countries seem to be exclusively based upon three unconvincing premises that simply reinforce the chosen altruistic rhetoric. yet, all these premises prove to be either entirely disconnected from the reality of many developing countries, such as the case of presuming that all corporate income tax incentives are equally inefficient to attract fdi, or they simply fall apart when additional economic considerations are added into the analysis, such as the case of the alleged revenue gain/loss attributed to the active or passive participation of developing countries in the global tax deal. either way, they all seem to hide the true motivation behind a minimum corporate income tax worldwide, which seems to be no other than changing the dynamics of tax competition globally, building up an unrealistic scenario in which zero-cost international cooperation appears as the new mantra. in this new scenario, the alternatives for developing countries seem to be very limited. after all, uncooperative countries will be punished in one way or another, at least to the extent the global tax narrative is still dominated by a narrow group of countries promoting their own interests behind the magnanimous rhetoric of benefiting all. for this reason, developing countries should take this time of 124 parada, supra note 107, at 9 (citing döllefeld et al., supra note 115 at 5–6), in a survey conducted by tax foundation in 2021, and which involved 225 countries, 115 countries had cit (nominal) rates above 20%. similarly, all countries from a list with the 20th highest corporate income tax rates worldwide (table 2) are developing countries. see sean bray, corporate tax rates around the world, 2021, 783 fiscal fact 5 (2021). 125 döllefeld et al., supra note 115, at 17 (where the authors refer exclusively to “false positive” as those cases in which the pre-emptive approach finds an etr below the minimum but then the globe etr calculation reveals that the etr is indeed over the minimum). 2024] global minimum taxation 211 pressure and challenges as an opportunity to focus on sensitive reviews of their tax and non-tax incentives, including the search for new alternative forms of competition. in doing so, developing countries may perhaps reshape their general strategies to attract fdi more effectively126 while they still try to ride this wave of minimum global corporate income taxation that the whole world seems to have embraced. 126 the terms “effectively” and “efficiently” are used interchangeably in this work. see also supra note 7.